With robust growth figures, improving infrastructure, an increasingly service-dominated economy and a new reform-minded government, Sri Lanka is an economic champion that has too often been overlooked. The island nation has seen continuous growth since a recession in 2001, even during the last years of the civil war, which ended in 2008. The rising tide has lifted all boats, and pockets of poverty are relatively rare, with more and more Sri Lankans able to participate in the country’s economic success.
While international and domestic headwinds in 2015-16 revealed structural weaknesses in the economy, which is still affected by the legacy of conflict and history of state intervention, a $1.5bn deal with the IMF has bolstered investor confidence and provided a firm anchor for much-needed structural reform and fiscal consolidation. The government of President Maithripala Sirisena has set out the target of doubling the yearly per capita income – currently approximately $3800 – by 2025. This goal is ambitious, but with Sri Lanka’s strengths as an investment destination becoming more apparent, growing good will from international partners and institutions, and new momentum for pro-business reform, it is achievable.
Ravi Karunanayake, then-minister of finance and current minister of foreign affairs, announced when presenting the 2017 budget that its broader theme was “accelerating growth with social inclusion”. The aim is thus to achieve broad-based economic growth that will help eliminate remaining pockets of poverty in the country. The government’s long-term vision is to make Sri Lanka a high-income country, avoid the middle-income trap and become one of the most robust economies in Asia.
In the medium term the country’s goals include the generation of 1m new employment opportunities, enhancing income levels across the board, and ensuring land ownership for the rural working class, middle class and public sector employees, as well as broadening the middle class as a whole. The government is aware that these goals will not be achieved without strong and stable economic growth, which will be supported by both private and foreign investment. Therefore, the budget puts in place investment incentives, including enhanced capital allowances, tax credits and rebates. Further special concessions are offered to high-level investments that generate employment. In addition, the government has also moved to reform and simplify the unwieldy tax system, reducing corporate income tax to a three-tiered system, broadening the country’s tax base through the elimination of a number of unnecessary tax exemptions and tax relief measures, and seeking to reform the cumbersome “simplified” value-added tax (VAT) system, which has proven expensive to administer. A decision on VAT reforms is expected in October 2017.
These measures have broadly been welcomed by the business community, particularly in the areas of tax reforms and investment incentives. The revenue-raising measures have met with the approval of the IMF, which inked a three-year, $1.5bn loan and reform agreement in June 2016. “The tax base as a percentage of GDP has been slipping – we need to reverse this, and generally boost government revenues to encourage more foreign direct investment,” Kasun Palisena, CEO of Perpetual Treasuries, a government bond primary dealer, told OBG.
In a November 2016 report on the budget, consultancy PwC characterised the budget as having “delivered on many fronts” and described it as “business friendly compared to more recent ones”, though it noted that some policies included in Karunanayake’s budget speech, such as the de-mutualisation of the Colombo Stock Exchange, had been flagged in the 2016 budget and had yet to be implemented.
Expenditure & Income
The government expects both revenue and expenditure to rise, but the gap between income and outlay to narrow, bringing down the budget deficit. The 2017 budget forecasts total revenue of LKR2.1trn ($14.3bn), including grants, up significantly from LKR1.66trn ($11.3bn) in 2016, though the depreciation of the rupee and inflation should be taken into account. The real term increase in income will therefore likely be less than the 26.5% theoretical rise. The government expects revenue from income taxes to come in at LKR335bn ($2.3bn) in 2017, up from LKR236bn ($1.6bn) the previous year, while income from taxes on goods and services will reach LKR1.09trn ($7.4bn), up from LKR854bn ($5.8bn). Revenue from taxes on external trade will total LKR400bn ($2.7bn), increasing from LKR342bn ($2.3bn) in 2016. Non-tax revenues are projected at LKR186bn ($1.3bn), compared to LKR144bn ($981.9m), while tax sharing and devolved revenue for provincial councils is estimated to reach LKR78bn ($531.9m), up only marginally from LKR72bn ($490.9m). The budget forecasts LKR10bn ($68.2m) in grants, unchanged from the previous year. As the figures show, tax revenue from goods and services are a major contributor to the budget, worth three times more than income tax revenue.
Total forecast expenditure for 2017 amounts to LKR2.72trn ($18.6bn), an increase from LKR2.33trn ($15.9bn) the previous year. This will drive a budget deficit of LKR625bn ($4.3bn), down by around 6.7% from LKR670bn ($4.6bn) in 2016. The government plans to finance the budget deficit through a mix of domestic financing, which will cover around 56.5% of the budgetary gap, and foreign funds, at 43.5%.
Growth & Concerns
Growth in 2015 came in at around 4.8%, according to figures from the Central Bank of Sri Lanka (CBSL), despite a range of domestic and international headwinds. The year’s results reflected a strong performance from the service sector, particularly tourism. Manufacturing also rose, but made a lesser contribution to overall growth.
Nonetheless, signs of structural weakness started to show. Investment slowed, and more importantly, the country’s external and fiscal position began to raise some concerns. The fiscal deficit rose to 6.9% of GDP, with government expenditure increasing to 19.9% of GDP. The public wage bill and higher spending on goods and services were only partly offset by rising income from one-off revenue-raising measures. While the current account deficit remained at 2.5% of GDP, the same level as 2014, ratings agencies warned of a weakening balance of payments, as foreign reserves fell to $7bn by March 2015, down from a peak of $10bn in 2014. Foreign investors were more bearish, with some pulling out of Sri Lankan equities, while foreign direct investment also slowed.
Internationally, the slowdown and economic restructuring in China, lukewarm investor sentiment towards emerging markets and the expectation of a US Federal Reserve rate hike all had an impact. Domestically, political uncertainty over two elections in 2015 – presidential in January and parliamentary in August – which both led to a transition of power, had a cooling effect, as did the incoming government’s decision to put some major public and public-private projects on hold. These factors brought the country’s widening fiscal gap into focus, and it became increasingly apparent that high government spending combined with falling tax revenue as a proportion of GDP were unsustainable.
However, while outside institutions and economic analysts have warned of the risks posed by Sri Lanka’s balance of payments, debt and deficit, many within the country say the risks should not be overstated, given the strong growth path, political stability and the availability of an increasingly wide range of investment opportunities. “In the case of emerging markets, a trust gap is frequently observed. Nevertheless, I believe Sri Lanka to be a stable and secure investment destination as our government has never defaulted on bond repayment,” Palisena told OBG.
The Sri Lankan economy grew by 4.4% in real terms in 2016, down from 4.8% in 2015, according to the CBSL’s most recent “Annual Report 2016” published in early 2017. As in 2015, growth was bolstered by the services sector in particular.
Services grew by 4.2% driven by financial services, wholesale and retail trade, and personal services. Industry and related activities were up 6.7%, led by a recovery in the construction industry, and a strong performance in mining and quarrying. Agricultural activity, however, saw a 4.2% contraction over the period, resulting in a reduction in its share of real GDP to 7.1%. Factors contributing to this decline included adverse weather conditions and a drop in the production of key commodities, such as tea, rice, spices and rubber. The current account deficit widened to $1.9m, equivalent to 2.4% of GDP in 2016, up from 2.3% of GDP in 2015, mainly due to an increased trade deficit and a primary income account deficit. There were some positive signs from the external sector and the fiscal side, with the services account and the secondary income account recording surpluses.
According to the CBSL, the overall balance of payments recorded a deficit of $500m in 2016. The CBSL’s foreign exchange reserves stood at $6bn at the end of 2016, enough to cover just over 3.7 months of imports of goods, and 3.1 months of imports of goods and services. Remittances have slowed considerably from the 13.6% average annual growth rate recorded between 2000 and 2014, partly due to lower income from expatriates in the oil-rich Gulf countries as global energy prices have fallen. However, they showed signs of moderate recovery, rising by 3.7% in 2016.
The government’s new tax measures and declining spending as a proportion of GDP brought the fiscal deficit to 5.6% of GDP in 2016, missing its target of 5.4% of GDP, but down from 7.4% in 2015 and in line with the IMF’s medium-term target for 2020.
Reaching A Deal
Sri Lanka achieved what could prove to be a watershed moment in its post-war economic development in June 2016, when after months of negotiations it secured a $1.5bn loan package from the IMF. The package, under the fund’s extended fund facility, is set to run for 36 months and support the government’s economic reform programme, with a focus on fiscal consolidation and improving the investment environment. The agreement is aimed at meeting Sri Lanka’s balance of payments needs amidst a challenging external environment, as the country makes difficult and lengthy structural reforms. It should go some way towards giving the government breathing space to push forward its realignment of economic policy and tackle long-standing weaknesses.
The IMF “policy anchor” is expected to help the government implement reforms and reinforce investor confidence after a shaky period. The IMF agreement should also lead to the release of an additional $650m in other multilateral and bilateral loans that were conditional on the country first securing a deal with the fund. It is being disbursed in seven tranches, with the first to be released immediately on the agreement’s signing and the others conditional on quarterly review. The deal with the IMF sets out a number of necessary reforms, central to which is fiscal tightening to bring the overall fiscal deficit down from around 6.9% of GDP in 2015 to 3.5% by 2020.
Some of the major objectives of the programme include increasing revenues to help cut the deficit, reversing the fall in the CBSL’s foreign exchange reserves, lowering the public debt-to-GDP ratio and thus reducing Sri Lanka’s exposure to the risk of a debt crunch, as well as improving public financial management and the operation of state-owned enterprises. The fund additionally aims to encourage Sri Lanka to move towards a monetary policy based on flexible inflation targeting and a flexible exchange rate, and reforms to the trade and investment climate.
In November 2016 the IMF conducted its first programme review and gave a nod for the release of the second $162.6m tranche. The fund noted that the macroeconomic and financial conditions were stabilising, inflation was under control and the balance of payments had improved, while international reserves were “comfortable”. It praised the government’s plans to reintroduce changes to VAT in order to boost revenues, the 2017 budget’s revenue-raising measures and prudent monetary policy. Nonetheless, with less than a year of the programme complete, there is clearly some way to go, particularly in implementing wide-ranging tax reform and improving financial regulation.
With a reform-minded government in place, improving global market sentiment, and backing from the IMF, the World Bank and other international partners, the outlook for Sri Lanka is brighter in 2017. The CBSL forecasts growth of 5% for the year, rising to 7% thereafter, assuming structural reforms are implemented as promised. This is optimistic, particularly given the technical and political difficulties that the government faces in implementing its agenda. The IMF takes a more sanguine view, projecting growth of 5% in 2017 and 2018, rising to 5.2% in 2019 and 5.4% in 2020. As of late 2016 both domestic and foreign analysts were becoming more optimistic about the outlook for Sri Lanka. The country’s competitive advantages in location, language, cost and skills are becoming clearer, and sectors like tourism are growing strong. Its proximity to the vast Indian market, as well as much of Asia and the Middle East, strengthens Sri Lanka’s case as not only a trans-shipment hub, but also a services centre. The peaceful transfer of power in 2015, less than a decade after the end of the civil war, indicates a healthy democracy.
Services Sector Growth
Sri Lanka’s economy increasingly resembles that of an upper-middle-income country in its sectoral composition, with services growing strongly over the past few decades. As the economy has become liberalised, the private sector has grown and incomes have also risen.
As of 2015, the last year for which data was available, services accounted for 56.6% of GDP, according to the CBSL’s annual report, and grew by 5.3% in constant prices, following 5.2% expansion in 2014. The biggest contributor to the services sector, according to the central bank’s segment classification, is the wholesale and retail trade, transportation and storage, and the accommodation and food service activities category, thus including the burgeoning tourism industry as well as the growing logistics sector, with 23.2% of GDP. The segment’s growth accelerated from 4% in 2014 to 4.6% in 2015. Financial services, including real estate, comprised 12.3% of GDP. Despite difficult conditions, the sector grew by 12.3% in 2015, following 8.1% expansion during the previous year. The financial services sector is seen by some in the government as among the most promising areas for the country, with plans to develop Colombo as a financial centre, and for the city to provide services to South Asia and beyond.
Professional services, meanwhile, contributed 11.8% to GDP, growing 1.3% in 2015, compared to a 4.3% expansion in 2014. Public administration and social services, including health care and education – both areas of increasing interest for the government and private sector alike – accounted for 8.7% of GDP, though growth fell from 5.5% to 3.2%.
Industry, including manufacturing, construction, mining and utilities, contributed 26.2% to GDP in 2015 and recorded 3% growth, down from 3.5% in 2014. The broad manufacturing sector accounted for 15.7% of GDP overall, expanding by 2.3% in 2014 and 4.7% in 2015.
The construction sector has proved somewhat volatile in recent years, becoming a major GDP contributor under the last government as it pushed forward big-ticket projects, but slowed as the incoming government in 2015 halted some of these projects. The sector has also been affected by fluctuations in the property market. In 2015 it contracted by 0.9%, following the 6.6% growth recorded in 2014, the last full year of the previous government, and accounting for 6.8% of the country’s GDP. Mining and quarrying is not a significant sector in Sri Lanka compared to some other Asian countries, though there is some extraction of gems and industrial minerals. In 2015 the sector accounted for 2.3% of GDP, contracting by 0.9% as global commodity prices fell, following 2.2% growth in 2014.
The CBSL uses the factory industry production index (FIPI) to measure the output of the manufacturing sector and segments within it. The FIPI has a base of 100 set in 2010, and it rose to 125.4 in 2015, growing 9.2%, up from 6.1% recorded in 2014. The FIPI also gives a good picture of the make-up of the manufacturing sector in Sri Lanka through its weighting. The largest weight, at 23.7%, is given to food products, which rose to 107.3 on the FIPI in 2015, up from 102.3 in 2014. The second-largest segment, with 23.1%, is apparel, which has shown strong growth in recent years, rising to 173.4 in 2015 from 149.5 the previous year. Other substantial segments include rubber and plastic products, with a weight of 10.5%, which fell from 134.2 to 131.3; tobacco products, weighted 8.4%, which rose from 87.6 to 95.4; and beverages, at 8.1%, which increased from 111.8 to 123.1 over the period.
Agriculture remains an important contributor to the economy, though its share of GDP has declined as the country has been developing.
In 2015 the agriculture sector accounted for 7.9% of Sri Lanka’s GDP, expanding by 5.5% on the back of 4.9% growth in 2014. Important subsegments include fishing, which contributed 1.4% to GDP overall; rice cultivation, at 0.9%; and oleaginous fruits – such as coconuts and oil palm – and tea, each of which contributed 0.8% to GDP. The CBSL measures agricultural performance using the agricultural production index (API), which as its name suggests, is used to analyse quantitative changes in production and that of individual segments without taking into account market pricing. The API uses as a base of 100 average output in 2007-10, and in 2015 it grew by 6.4% to reach 127.6, including fisheries, following a 1.6% drop in 2014. Overall, API – excluding fisheries – rose 9.3% in 2014 to 121.6, following a 3.3% decline in 2014.
The index’s rise was partly due to a 42.6% surge in the rice paddy segment’s API. The fact that paddy API fell by 26.9% in 2014 is indicative of the volatility of output of the crop. There was a bumper harvest in 2015, with 4.8m tonnes produced in total, which was partly thanks to gains both in the amount of land under paddy cultivation and yields per hectare.
The fruit segment also performed well, reaching 152.8, up 9.4% on the previous year, while coconut production surpassed 3bn nuts, the highest level since 2000. However, API for segments such as fisheries, rubber and tea, declined.
Total demand in the economy rose by 7% in 2015 in current market prices, according to the CBSL figures, down from 8.9% in 2014 and 9.8% in 2013. In constant 2010 prices, aggregate demand increased by 4.8%, compared to 4.9% in 2014 and 3.4% in 2013.
Domestic consumption, which is the major driver of demand, grew by 8.9% in nominal terms in 2015, indicating fairly robust consumer confidence. Private consumption expenditure accounts for 88.6% of aggregate consumption expenditure. This growth was driven by rising disposable incomes, due to a one-off hike for public sector workers, cuts in taxes for some commodities and the slashing of controlled energy prices, which freed up resources for spending on other areas. Consumer goods expenditure was robust in 2015, as there was particularly strong demand for items such as vehicles and smartphones. Government consumption expenditure, meanwhile, increased by 13.4% in 2015 in nominal terms. This was down somewhat from 16.6% in 2014, with expenditure in 2015 mainly directed to public services like health care and education.
Investment expenditure – including both the private and government sectors – grew by just 0.6% in 2015 in nominal terms, compared to 4.8% in 2014. Investment in machinery and equipment and weapons systems remained strong, rising by 6.8%, while construction investment recovered and expanded by 2.3% following a 7.8% contraction in 2014. The growth of government investment in construction slowed, however, which indicates that a considerable amount of this slack was taken up by the private sector.
Inflation has historically been a major challenge in Sri Lanka, undermining macroeconomic stability and substantially eroding citizens’ disposable income. However, in recent years inflation has been restrained thanks both to global factors and the central bank’s tighter policy.
The Colombo Consumer Price Index (CCPI) reached nearly 30% in the run-up to the 2008 economic crisis, driven by factors such as a rapid increase in the money supply due to the use of the central bank in deficit financing, massive government expenditure on defence due to the climax of the civil war, substantial public spending on infrastructure projects, and import price increases due to a surge in global commodity prices and the weakening rupee.
CBSL monetary tightening, supply-side developments, better labour productivity, more prudent fiscal policy, lower commodity import prices and a more stable exchange rate all contributed to bringing inflation down again in the following years. Annual average inflation fell every year from 2012 to 2015, from 7.6% to just 0.9%, according to the CBSL.
In the first nine months of 2016 inflation remained in the single digits, CBSL data shows. This was despite price pressures from agricultural supply shocks due to adverse weather conditions that pushed up food costs and the impact of government tax adjustments, such as an increase in value-added tax (VAT), and the abolition of certain exemptions to VAT and Nation-building tax, which was introduced before the year 2000 to support the security forces and areas most affected by the war.
Inflation then declined again in the third quarter of 2016, largely due to the normalisation of supply conditions and the suspension of some tax changes. It peaked at 6.4% in June 2016, falling back to 4.7% in September 2016 and 4.1% by the end of December. In 2016 food prices rose by 3.8%, while non-food products increased by 4.4%. The US Federal Reserve’s policy of monetary tightening, in addition to an environment of relatively low global oil and commodity prices, has helped keep a lid on global inflation recently, feeding through to Sri Lanka.
Nonetheless, with underlying and average inflation trending upwards and credit growth fairly high, the central bank moved pre-emptively to tighten its fiscal policy. The current cycle of monetary tightening began in December 2015, when the CBSL announced it would increase the statutory reserve ratio (SRR) by 150 basis points to 7.5% from January 2016, while keeping interest rates on hold. The SRR is a proportion of rupee deposit liabilities that commercial banks are obliged to deposit with the central bank, generally known internationally as a reserve requirement. By increasing it, the central bank is reducing the amount of commercial banks’ deposit pool that they can lend to clients, potentially acting as a drag on lending growth. In the case of the CBSL’s 2015 decision, it was seen as a response to a perception of excess liquidity in the market, with the broad money supply growing at an annual rate of around 17% in October 2015 and the amount of credit extended to the private sector by commercial banks up 26.3% year on year in the same month.
The increase in the SRR was followed by two rate hikes in 2016, the first since 2012. The rate change, which came in February 2016, took markets by surprise. The central bank raised the standing deposit facility rate and the standing lending facility rate by 50 basis points each to 6.5% and 8%, respectively. The move followed a continued acceleration in broad money and credit growth despite some increases in commercial interest rates, with the CBSL saying that it was looking to curb macroeconomic risks by moving pre-emptively to dampen the build-up of inflationary pressures. Analysts also linked the rate change to Sri Lanka’s IMF negotiations, with the fund having commented months before that monetary policy should remain vigilant. In July 2016 the CBSL raised rates by a further 50 basis points, again describing the move as pre-emptive. The bank’s statement added that it also aimed to support the balance of payments, and keep inflation in the mid-single digits, which it sees as conducive to continued economic growth.
The bank’s expectation going forward is that tighter monetary policy will help reduce pressure on the external sector by lowering import-intensive credit flows and reducing the risk presented by portfolio capital outflows.
The move can be seen in the context of the US Federal Reserve’s gradual policy of interest rate normalisation, which has led to outflows from emerging markets to dollar-denominated assets and dollar time deposits as their yields have risen. Nonetheless, in late 2016 the bank continued to perceive risks from external sources – relatively slow global growth and the potential shocks caused by the UK’s vote to leave the EU – and from Sri Lanka’s continuing difficulties in attracting long-term capital inflows.
In February 2017 the CBSL elected to keep rates on hold for a sixth straight month, noting that the economy was responding to measures that were put in place since 2015, but it also gave notice that it would tighten policy again in “corrective measures” if necessary. Additionally, the central bank may be keen to defend the value of the Sri Lankan rupee, particularly in an environment of further expected rate hikes by the US Federal Reserve.
In March 2017 the CBSL followed through on this announcement, and increased both the deposit rate and the lending rate by 25 basis points to 7.25% and 8.75%, respectively, as a pre-emptive policy measure to control inflationary pressures.
Sri Lanka’s unemployment rate is fairly low by international standards, at an average of 4.4% in 2016, down from 4.7% in 2015, according to data from the CBSL. However, the headline figure disguises substantial discrepancies among different demographic groups. Unemployment for women stood at 7% for 2016, a decrease from 7.5% in 2015, while the ratio stood at 2.9% for men, the same as in the prior year. At 21.6% youth unemployment also remained high in 2016. Thus, the government is currently prioritising job creation. On coming to office, the Sirisena government pledged to put in place a series of policies to create 1m jobs. While the promise has been treated with scepticism in a number of quarters, there are signs that policy-making with the support of international partners may help boost employment.
In July 2016 the World Bank approved a $100m credit package from its International Development Association for Sri Lanka to support the government’s economic reform programme, and specifically the job creation programme.
The package focuses primarily on enhancing the country’s competitiveness, transparency and macroeconomic stability, and thus dovetails with the IMF programme inked the month previously. It aims to help the government reduce barriers to private sector growth, including productivity gains and integration with the global economy, and strengthen public sector management and fiscal oversight.
International and domestic headwinds caused the Sri Lankan economy to slow in the past two years and March 2017 saw reserves at a multi-year low; yet the government rolling out a number of policies to build the foundation for sustainable growth. While tighter monetary and fiscal policy may be having an effect on headline growth, they will lay firmer foundations for long-term economic development, heading off debt crunches and inflation.
The landmark IMF deal and agreements that followed provide policy direction and financial support that should stand the government in good stead, while a renewed drive to attract investors and partners is set to increase global engagement with Sri Lanka’s reform agenda. Major international players and institutions such as McKinsey Consulting and Harvard University are working with government agencies on various economic reforms. Meanwhile, a series of initiatives to further open up trade and increase the number of free trade agreements are dovetailing with the reinstatement of Generalised System of Preferences Plus status in May 2017. And perhaps most importantly, the development of a new National Export Strategy – focusing on trade-led growth, and developed together with the International Trade Centre, is nearing completion.
Nevertheless, the government’s to-do list remains long: extensive tax reform, improvements to the business climate, and investment in infrastructure and public services – all while paring back spending.
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