Economic Outlook 2012

8/3/2019 Economic Outlook 2012

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February 2010April 2010April 2010

RAM Ratings (Lanka) LtdWholly owned by RAM Holdings Berhad

No. 09, Arthurs Place,

Colombo 4

Sri Lanka

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By - Dr. Yeah Kim Leng (PhD)Chief Economist

ECONOMIC

OUTLOOK

Sri Lanka

November 2011


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ECONOMIC OUTLOOK

E C O N O M I C S

Published by :

RAM Holdings Berhad(208095-U)Formerly known asRating Agency Malaysia Berhad

Suite 20.01, The GardensSouth Tower, Mid Valley CityLingkaran Syed Putra59200 Kuala Lumpur

T +603 7628 1000F +603 7628 1700E [email protected]

NOVEMBER 2011

Sri Lankas Economic Outlook

2012

Strengthening domestic resilience against global

headwinds

ReGLocal Team

Kuala Lumpur

Dr. Yeah, Kim Leng (PhD)

Group Chief Economist(603) 7628 [email protected]

Kristina FongSenior Economist

(603) 7628 [email protected]

Jason Fong

Economist(603) 7628 1703

[email protected]

Barry OoiEconomist

(603) 7628 [email protected]

Colombo

Adrian Perera

Chief Executive Officer(94) 11 259 [email protected]
mailto:[email protected]://www.ram.com.my/mailto:[email protected]:[email protected]:[email protected]:[email protected]:[email protected]:[email protected]:[email protected]:[email protected]:[email protected]:[email protected]://www.ram.com.my/mailto:[email protected]


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HIGHLIGHTS

Mounting risks against recovery momentum of developedeconomies

After having rebounded strongly from the global financial crisis with a

5.1% expansion in 2010, the global economy has hit a soft patch this

year. Uncertainties arising from the ongoing sovereign debt crises in

the Euro zone, together with the anaemic growth of the United states

(US) and Japan, have raised concerns that the global economy may

be heading towards a more pronounced slowdown in 2012, with a

higher risk of either stall speed growth or a double dip.

In particular, the US continues to deal with persistently high rates of

unemployment. We thus expect the American economy to only post asub-par expansion of 1.5%-2.0% this year, despite the Federal

Reserves efforts to inject liquidity into its system. Moreover, the

situation in the Euro zone has become more worrying of late;

substantial downside risk remains in the face of a possible intra-

regional debt-crisis contagion, which may prompt even rasher growth-

retarding austerity measures. As such, we expect economic growth for

the 17-member European Union (EU) to stall in the coming year.

The softening global economy in 2H 2011 and the elevated risk of

a double dip going into 2012 reinforces the importance of

developing economies, especially the more export-dependent ones,

shifting to domestic demand to sustain their growth momentum.

Concurrently, they also have to look at ways to further boost intra-

and inter-regional trade and investment, to offset the weak and

volatile demand from advanced economies that is envisaged to persist

through the next several years.

Sri Lanka growing from strength to strength expected to achieve7.8% growth in 2011, 7.6% in 2012

Sri Lanka charted resilient growth in 1H 2011, clocking up 8.0% year-

on-year (y-o-y). We expect this momentum to continue in the

second half of the year, on the back of strong levels of industrial and

service activities and also bolstered by robust private consumption.

This underpins our projection of a 7.8% expansion for 2011, albeit

tempered by the downside risk from the uncertain external

environment. In 2012, we expect the Sri Lankan economy to post a

slightly above-potential growth of 7.6%, on the back of continued

capacity-building activities.

The services sector remains a key contributor to the economy,

accounting for 59.3% of Sri Lankas GDP in 2010. Given the resilience

of the domestic-driven services industry (against falling prices of


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Economic Outlook

3

communications-related services and the rising importance of the

financial sector), the services sector is forecast to achieve a growth of

8.3% in 2011, followed by 8.0% in 2012.

Compared to the services sector, the industrial sector has failed to

expand significantly in the last couple of years after the end of the

countrys ethnic conflict. This is because more extensive infrastructure

development is required for any substantial increase in industrial

activity. As capacity-building remains among the main themes for

post-war liberalisation, we expect the construction sector to sustain its

momentum in the foreseeable future. This growth will also keep

fuelling demand for minerals and other materials used in construction.

We thus expect the industrial sector to record a robust expansion of

8.2% in 2011, with another 8.0% in 2012.

The agriculture sector has exhibited the most volatile performance

amid output shocks arising from inclement weather. Given the

resilience of tea and rubber production, however, we project a growth

of 4.5% in 2011 and 4.4% in 2012 for this sector.

More robust domestic-driven growth as post-conflict economystrengthens

The sudden rise in preference for consumer durables, formerly viewed

as luxury items, and properties is a welcome boon that indicates

revived optimism on political and economic stability. We anticipate afull years growth of 12.5% for private consumption in 2011, which is

seen to taper to a more sustainable 8.8% in 2012.

While public investment had helped sustain the Sri Lankan economy

through the erstwhile war era, there had also been increasing foreign

interest in the country, largely led by India. Fiscal-consolidation

efforts have underscored the governments commitment to

macroeconomic stability while boosting investor confidence.

Investment activity is expected to accelerate 11.7% this year,

followed by 8.1% in 2012.

Gross exports have been recovering from the global recession, with

imports outpacing exports, driven by strong domestic demand and

nation-building efforts. The countrys main export markets are,

however, a concern; with the US and EU still mired in stagnation,

demand is envisaged to shrink further next year, although the real

effect on growth should be minimal as Sri Lanka is not as export-

driven as some of its peers. We anticipate exports to advance 7.2%

this year and 3.7% the next while the trade deficit should widen even

further, albeit at a slower pace.


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Monetary policy remains supportive of growth against unflatteringglobal backdrop

The Central Bank of Sri Lanka (CBSL) is likely to hold repo rates at

7.0% for the coming year, as the global economy is expected to

deliver a lacklustre performance in 2012. However, gradual

normalisation may take place on the back of better economic

conditions, to ensure a more sustainable pace of growth over the

longer term.

Going forward, inflation is expected to chart a similar pattern as

movements in global commodity prices due to Sri Lankas substantial

import exposure to primary commodities typically related to food

and energy, which constituted a third of the total value of the

countrys imports in 2010. Our base-case scenario assumes mild

fluctuations in commodity prices, with foreign capital flowing in at a

sustainable pace. Under this scenario, Sri Lankas inflation is projected

to range around 6.5%-7.0% in 2012.

While the CBSL is expected to continue controlling the level of the

rupee against the US dollar in 2012, there is some room for gradual

appreciation in the near term. This is largely to give the CBSL

additional monetary leeway to manage domestic inflation, particularly

in an environment of rising commodity prices and strengthening

domestic demand.

Key risks and challenges

The persistent uncertainties plaguing the global economy remain a

key downside risk to developing countries. Currently, more than half

of Sri Lankan exports are still centered on the US and EU markets. As

such, a shift away from such reliance would help to cushion growth

prospects in light of the apparent downside risks.

Another externally driven shock lies on the supply side, in the form of

volatile commodity prices, as Sri Lanka remains highly sensitive to

movements in the prices of energy-related commodities and products

such as automotive fuel and household energy. Food security is

another issue in terms of the susceptibility of food products to

fluctuations amid adverse weather conditions. With 15% of Sri Lankas

food imports derived from India which has been experiencing

significantly high levels of inflation there is also a risk of upward

price pressure through imported inflation.

As at end-2Q 2011, loans and advances from commercial banks

amounted to 27% of GDP, i.e. a 29% y-o-y increase. Although this


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Economic Outlook

5

was mainly driven by lower interest rates in early 2011 and more

upbeat consumer sentiments, the increasing leverage in the household

sector may become unsustainable if real wage does not rise in tandem

with the heightened debt levels.

From a more structural viewpoint, the issue of twin deficits remains,

with both the budget deficit and current-account deficit still significant.

It remains imperative that policies address this to keep the country on

a sustainable growth path. On a more positive note, both these

balances are expected to show a declining trend as better economic

prospects will shift the burden of growth and employment creation to

the private sector, on the assumption that the government keeps to its

strategy of fiscal consolidation.


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I. GLOBAL ECONOMIC CONDITIONS AND OUTLOOK

A. World economic prospects Developed economies facing

strong headwinds

After having rebounded strongly from the global financial crisis with a 5.1%

expansion in 2010, the global economy has hit a soft patch this year.

Uncertainties arising from the ongoing sovereign debt crises in the Euro zone,

together with the anaemic growth of the United states (US) and Japan, have

raised concerns that the global economy may be heading towards a more

pronounced slowdown in 2012, with a higher risk of either stall speed

growth or a double dip.

Jobs still scarce in US

The US was able to achieve its pre-crisis level of national output in 2Q 2011,

after several quarters of sustained economic recovery since mid-2009.

However, much of this recovery can be attributed to significant interventions

by policymakers. These include the massive USD767 billion economic stimulus

programme known as the American Recovery and Reinvestment Act and an

extended period of easy monetary conditions, epitomised by the Federal

Reserves controversial USD600 billion asset-purchase programme

colloquially known as the second Quantitative Easing programme or QE2

that was initiated late last year.

By the first half of this year, the effects of such policies had, for the most part,

diminished. The high rate of unemployment (September 2011: 9.1%) and

decelerating output growth indicate that the American economy has yet to

return to its vibrant pre-crisis state. With more than 14 million Americans

unemployed through most of the post-crisis era, the ratio of its work force to

the entire population has declined to 58% for more than 18 months. This is

hardly representative of a healthy economy considering the average pre-crisis

ratio of around 63%.

The prolonged scenario of weak labour-market conditions has kept some 6

million people unemployed for more than 27 weeks what the US Bureau of

Labour Statistics (or BLS) defines as long-term unemployment. Apart from

depressing consumption patterns over the same period, the jobless masses

have also exerted tremendous pressure on public finances through

diminishing income-tax revenue and heftier unemployment benefits through

government entitlement programmes. Business sentiment has also weakened

as the high unemployment rate presents a baffling catch 22 situation - firms

are unlikely to hire because of poor consumer demand, but demand is weak

due to lack of employment.

US labour marketremains weak,exacerbated bypolitical foot-dragging


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Economic Outlook

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Figure 1: Labour-market indicators in the US

Source: US Federal Reserve

Moreover, long periods of high unemployment rates may have a severe

structural impact on the economy. Jobless individuals are likely to lose their

primary wage skills if they remain unemployed for an extended period, which

can turn into a permanent loss for the economy. This weakened state of

consumer demand in the US will no doubt affect Sri Lankas exports to the

worlds largest economy.

Restoring Americas labour market to its pre-crisis state would entail further

job-creating policies and, by extension, more sizeable deficit funding through

debt. However, its track record of deficit financing has already inflated the

American public sectors debt burden. This has, in turn, become a substantial

bargaining chip between the 2 major political parties since the debilitating

financial crisis culminating in a month-long debate before the almost-

imminent breach of the Congress-set debt ceiling in early August. A valuable

USD447 billion job-stimulus plan proposed by President Obama had been

jettisoned in Congress, the latest in a string of paralysing political stand-offs

largely due to ideological differences on debt and deficit levels. This indicates

that the US is unlikely to implement any effective fiscal policies to rejuvenateits ailing labour market in the immediate term.

With its persistently high rates of unemployment, we expect the US economy

to only expand at a sub-par pace of 1.5%-2.0% this year, despite the Federal

Reserves efforts to inject liquidity into its system. That said, both the upside

and downside risks to this forecast hinge on the ability of the American

political machinery to redouble its efforts to restore sustainable economic

growth in the coming months.


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Europe falling dominos

The European sovereign debt crisis has yet to reach its nadir since the

beginning of 2010. As Greece receives an additional 109 billion bailout tokeep it fiscally solvent in the near term, fears of a run on confidence in other

peripheral economies (i.e. Portugal and Ireland) have intensified to such an

extent that further deficit financing by these countries is just not possible

without tapping the 440 billion European Financial Stability Fund. Larger

economies, such as Spain and Italy, have also not been immune, as

evidenced by the increasing spreads in their sovereign yields against the

regions benchmark German bunds.

Undoubtedly, investors lack of faith in the sovereign debt papers of these

economies is not unfounded; these countries have the dubious combination of

relatively substantial current-account and fiscal deficits as well as spiralling

public debts. An excess of any of these characteristics can be detrimental to a

sovereigns repayment aptitude. Furthermore, being part of a monetary union

limits the options they may have to counter the run on confidence, i.e. they

are unable to unilaterally dictate their exchange rates, target a higher

inflation rate to reduce real repayment costs, or impose capital controls to

limit speculative flows.

Given the limited options available to these debt-laden economies, various

fiscal-reform pledges have been announced to soothe investors. However,

such policies such as raising taxes and cutting government spending will

have the effect of dampening economic growth, and could even increase their

relative debt burdens as national production would be unable to keep up with

fiscal financing requirements.

Figure 2: Fiscal characteristics of selected European economies

Source: International Monetary Fund (IMF) and RAM Economics

Note: Data represents projections for 2011 by the IMF

No end in sight for

Europes debtwoes; contagionfears notunfounded


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Economic Outlook

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Individual countries growth rates are expected to be divergent within Europe

itself; growth momentum will largely depend on the degree of fiscal austerity

implemented by each nation. Lack of growth will be compounded by the

tightening of interest rates by the regions monetary authority the European

Central Bank (ECB) earlier this year. Together, these factors are likely to

prolong the regions current slowdown (2Q 2011: 1.7% growth) and may

ignite further loss of confidence in the other economies within the region,

regardless of the present level of fiscal sustainability.

Table 1: IMF projections on output and inflation for selected European

economies in 2011

GDP

(annual change)

Output gap

(as % of potentialGDP)

Inflation

(annualchange)

France 1.6 -3.1 2.1

Germany 2.5 -0.5 2.2

Greece -3.0 -2.8 2.5

Ireland 0.5 -6.4 0.5

Italy 1.1 -3.0 2.0

Netherlands 1.5 -0.9 2.3

Portugal -1.5 -4.0 2.4

Spain 0.8 -2.8 2.6Source: IMF World Economic Outlook update

Consequently, we expect economic growth for the 17-member euro area to

stall in 2011. There is substantial downside risk as the threat of the intra-

region debt-crisis contagion is still highly plausible; this may prompt even

rasher growth-retarding austerity measures. The slim, but possible, upside to

this glum scenario is a coordinated policy effort (such as implementing a

politically distasteful region-wide fiscal union) that could restore investor

confidence in the regions sovereign bonds, together with a more gradual

approach to fiscal discipline. If the regions debt concerns persist, business

sentiment could deteriorate and may heighten risk aversion, thereby further

suppressing global investment activity.

Japan a seismic change

The Great East Japan Earthquake on 11 March this year has extended Japans

recession (2Q 2011: 1.0% contraction). Overall production capacity has been

severely reduced amid the loss of lives and physical capital. As Japan is the

technological leader in the eastern hemisphere, this had immediately

disrupted the supply chains of higher-end manufactured goods in the Asia-

Pacific region especially in automotives and electronics. However, the

Supply chain hasrecovered butappreciating yenhinders Japaneserecovery and

growth


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regional supply chain has since recovered, with manufacturing regaining near-

full capacity. Nonetheless, the effects of the shock had been felt by the entire

East Asian manufacturing sector throughout 2Q 2011.

Much of Japans growth in the second half of this year will depend on the pace

of reconstruction and its export sector. Despite the pressing need for large-

scale rebuilding efforts and the massive liquidity injections by the Bank of

Japan, the signs are only slightly encouraging, if somewhat muted. If

historical data is any judge, Japan certainly has the capacity to rebuild.

Figure 3 : Japans construction-related indicators

Source: Ministry of Economy, Trade and Industry (Japan) and Ministry of Land, Infrastructure and Transport (Japan)

Japans net exports provided a negative net contribution of 1.3% to its overall

GDP performance in 2Q 2011 making it the key culprit of its economic

contraction. While this can be attributed to worsening demand conditions in

the other advanced economies and the nations internal supply shortfall since

the earthquake, the negative price effects arising from the persistent

appreciation of the Japanese yen has not helped. At its peak (on 9

September), the yen had appreciated nearly 8% against the USD since the

start of the year. Additionally, recent weaknesses in the other advanced

economies have pushed up the Japanese currency. This had prompted up to 2

policy interventions in as many weeks by Japans Ministry of Finance, in a bid

to weaken its currency. The yen is likely to experience further upward

pressure, largely due to the USs continued easy monetary policy and the

worsening of the European sovereign debt crisis.

We expect the Japanese economy to record a marginal growth of up to 0.5%

in 2011. Upside potential hinges upon the success of the planned 800 billion

yen debt issuance to fund reconstruction and help companies cope with the

strong yen, and a dramatic turnaround in global economic conditions.


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Economic Outlook

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China growing pains

Chinas economy expanded 9.5% in 1H 2011 - a remarkable achievement

given its sheer size. However, rising inflation (September 2011: 6.1%) has

become a concern for the worlds second-largest economy.

The latest bout of inflation in China is due to a combination of rising income,

its preference for a managed exchange rate, divergent global growth

prospects, relatively easy liquidity conditions in the advanced economies and

intermittent internal supply disruptions. While various monetary and capital

controls have been frequently employed in the last 2 years since the

ostensible end of the global financial crisis, inflation has remained relentless.

This is most evident in the prices of food - a substantial component in the

nations Consumer Price Index (CPI) which accelerated to a 2-year high in

July.

Figure 4: Chinas inflation and w age indicators

Source: National Bureau of Statistics (China) and RAM Economics

In recent months, the persistent rise in prices has pushed up nominal wages

particularly for the export-oriented manufacturing sector despite the

inherently vast labour supply within the worlds most populous country. This,

coupled with appreciation of the Yuan, has dented Chinas export

competitiveness.

The cooling measures employed by the public sector, such as reducing access

to loans and improving physical supply constraints, have helped curb price

increases. Furthermore, with gradually retracing global commodity prices and

the appreciating Chinese Yuan, imported inflation has likewise eased. The

effects of these measures are already evident in the countrys decelerating

manufacturing pace as measured by its Purchasing Managers Index (or PMI)

and slower loan growth. In view of this, Chinas rate of inflation is expected

to slow down in the coming quarters.

China stillexpected to driveglobal economy,but inflation fearspersist


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Consequently, Chinas growth prospects are expected to remain intact this

year (RAM Economics forecast: 9.0%), especially given the continued

expansion of its middle-class population. Nonetheless, inflation could

substantially disrupt growth if price hikes are persistent. The sustainability of

Chinas growth is of significant concern to Sri Lanka as the former has become

a major exporter to the latter and a driving force behind global growth.

Global financial conditions shaken and stirred

For the better part of 1H 2011, the sovereign debt crises raging on both sides

of the Atlantic had frayed the nerves of many participants in the global

financial markets. This had been exacerbated by the end of easy liquidity as

the Federal Reserves QE2 programme came to a close in June and the

tightening of the key policy rate by the ECB. In the course of these events,

there had been a flight to safe-haven assets, which had in turn dramatically

propelled the prices of commodities such as precious metals; for instance, the

price of gold had shot up nearly 30% over the same period. Likewise,

sovereign debts and currencies that are not denominated in euro had also

appreciated markedly.

This had reached a tipping point by early August, when the US averted an

imminent debt default via a literal eleventh-hour deal. The haphazard nature

of the deal had led to a downgrade of its sovereign credit rating by one of the

3 prominent international credit-rating agencies. The downgrade had, in turn,

triggered another round of capital flight to safe assets, which ironically

included the very asset that had had its credit rating downgraded earlier.

Figure 5: Indicators of US financial volatility and gold prices

Source: Bloomberg

With risk-averse behaviour permeating the capital and financial markets in the

advanced economies, there is a distinct possibility that capital may flow to

markets where returns are higher, such as the faster-growing economies in

Asia. The Federal Reserves pledge to hold US interest rates at near-zero

Capital flight toquality a distinctpossibility, withthreat of minorvolatility in short

term


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Economic Outlook

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levels over the next 2 years is likely to encourage further cross-border capital

movements.

In light of the above, we expect only a small degree of financial volatility (i.e.

on a scale that is much smaller than what occurred in 2008) through the rest

of the year. This may translate into mild volatility in global exchange rates,

capital flows, speculative asset prices and heightened inflationary pressures in

rapidly expanding economies with rigid exchange-rate regimes. The degree of

volatility in these markets will mainly depend on the near-term growth

prospects of the advanced economies. Smaller risk appetites will inevitably

dampen prospects for global investment, which may affect growth in the short

term.

Commodities an oily patch

Energy prices particularly oil had risen steadily since the geopolitical crises

in the Middle East erupted in late 2010, before peaking in early May 2011.

This particular market is highly volatile as traders had speculated on the

potential outcome of the raging crises in the oil-rich region for the most part

of the year. The failure of the 12-member Organisation of Petroleum-

Exporting Countries (or OPEC) to reach an output quota at its semi-annual

meeting had exacerbated the volatility of oil prices. Recent developments

offer mixed indicators on future movements in oil prices: the resolution of the

Libyan uprising should see the countrys output resume at 1.6 million bpd and

check prices, but rumblings in other oil-producing nations such as Algeria mayput a dampener on that. Under the circumstances, we have revised

downwards our earlier forecast on the price of oil, to an average of

approximately USD90 for the remainder of the year.

Oil prices expectedto trenddownwards, butrice may still faceupward pressures


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Figure 6: Oil-price indicator

Source: Bloomberg

Prices of agricultural produce have been moving in different directions this

year due to a host of reasons, such as variances in weather patterns,

substitutability and policy actions. Demand and supply levels seem to be

reverting to normal amid less inclement weather while physical supply

constraints have become the focus of many policymakers, especially in food-

price-sensitive China.

That said, the price of rice may experience some upward pressure this year

due to the internal environments in the 2 largest global exporters of this Asian

staple Thailand and Vietnam. The planned enactment of Thailands populist

policies particularly with regard to elevating the price of locally produced

rice may price the commodity out of the export market while the recent

floods have decimated output. Conversely, accelerating domestic inflation in

Vietnam may drive up production costs, which may also affect world prices.

As the year-end macroeconomic conditions in both countries are far from

certain, it is premature to gauge the overall impact they will have on Asian

food prices and inflation.


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Economic Outlook

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B. Implications for developing economies

Increased dependence on large emerging economies

The Outlook published in 2010 had highlighted the impact of the 2008/09

global crisis on the rebalancing of global demand from the crisis-hit advanced

economies to the large emerging economies, and also increased global

liquidity flows to commodity markets and emerging economies.

The softening of the global economy in the second half of this year and the

elevated risk of a double dip going into 2012 reinforces the importance of

developing economies, especially the more export-dependent ones, shifting to

domestic demand to sustain their growth momentum. At the same time, they

have to look at ways to further boost intra- and inter-regional trade and

investment to offset the weak and volatile demand from advanced economies,

which is envisaged to persist through the next several years.

Volatile financials and commodity prices

Depending on the direction, magnitude and duration of the swings in

commodity prices, the volatile commodity markets have detrimental effects on

producer and consumer countries alike, with the net effect being a reduction in

trade and loss of economic efficiency. Of particular concern to low-to-middle-

income developing economies is that there is a need to increase investment in

agricultural production to boost food security, not to mention to explore new

initiatives with exporting countries to bolster supply, especially amid disrupted

supply caused by natural calamities. Governments also need greater fiscal

flexibility to mitigate sizeable price shocks through the short-term provision of

food and energy subsidies.

Sharper swings in capital flows

As evidenced by the EUs sovereign-debt contagion effects, emerging financial

and capital markets have been roiled by the flight to safety behaviour of

global investors seeking the safe haven of USD-denominated assets. Emerging

economies have been affected in varying degrees, depending on the

magnitude of the pull-out of foreign capital and the impact on market prices,

including local currencies. A clear lesson from this latest episode of rising

global-market volatility is the need to strengthen domestic financing and

banking systems, as a safeguard against sharp swings in short-term capital

flows.


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II. SRI LANKAS SHORT- AND MEDIUM-TERM OUTLOOK

C. Services to propel economy, driven by resurgent tourismindustry

After a robust growth of 8.0% in 2010, the Sri Lankan economy maintained

its growth momentum in 1H 2011, clocking up an 8.0% y-o-y growth. Given

official estimates of 8.3% growth this year, we expect its momentum to

continue in the second half on the back of its robust industrial and services

sectors, bolstered by healthy private consumption. We project a marginally

lower growth of 7.8% this year, given the downside risks of persistent

uncertainties in the external environment. We expect the Sri Lankan economy

to expand 7.6% in 2012, i.e. slightly above its potential output level, on the

back of continued capacity-building activities.

Table 2: Economic performance in the first half of the year

Agriculture,Forestry & Fishing

Industry Services GDP

1H 2009 4.2% 2.4% 1.1% 1.9%

2H 2009 2.1% 5.9% 5.4% 5.1%

1H 2010 7.8% 8.0% 7.6% 7.8%

2H 2010 6.1% 8.8% 8.4% 8.3%

1H 2011 -1.8% 10.3% 9.1% 8.0%

Following on from the robust trend in 2010, the services sector maintained its

expansionary momentum at 9.1% for the first half of 2011. Notably, the

agriculture, forestry and fishing sector charted the poorest growth

performance on the back of adverse weather conditions at the beginning of the

year, which had destroyed large tracts of agricultural land and the

corresponding produce.

The tourism sub-sector, in particular, experienced a surge in activity, with

tourist arrivals rising 34.3% y-o-y in the first 9 months of this year. There has

also been increased interest in post-war Sri Lanka as a holiday destination in

the last 2 years, with the majority of tourists from Western Europe. The

establishment of better-quality visitor services and tourist infrastructure, such

as hotels and dining venues, has also fuelled the interest in Sri Lanka.

Growthmomentum tocontinue, buttempered byexternal

uncertainties


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Economic Outlook

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Figure 7: Broad view of economic performance

Source: Department of Census and Statistics, Sri Lanka

The requirement for these services has driven the growth of this sub-sector,

which has proven immensely lucrative given its high-growth stage of

development. The latest estimates from the CBSL cite a 49% jump (or USD

521.7 million) in tourism receipts for the first 8 months of this year. Needless to

say, the tourism industry as a whole is an important driver of services growth

and remains one of the chief areas of focus for the countrys development plans,with additional allocations to this sector in Sri Lankas latest 5-year economic

plan. Moreover, given the continued resilience of domestic-driven services (on

the back of falling prices for communications-related services and the rising

importance of the financial sector), the services sector is forecast to achieve a

growth of 8.3% in 2011, followed by another 8.0% in 2012.

Popularity astourist destinationdrives services

sector


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Figure 8: Tourism sector leading the way in services grow th


The industrial sector has been exhibiting a convincing uptick since the global

recession, expanding 10.3% in the first half against 8.4% in 1H 2010. In

particular, this has been driven by mining and quarrying activities; more robust

demand from the construction sub-sector has been propelling the production of

building inputs and materials. The government aims to lift the industrial sectors

share of GDP to 35% by 2015, from 28.7% in 2010. The industry and services

sectors shares of GDP are expected to edge up to a respective 29.0% and

59.7% by 2012.

Construction sub-sector propelledindustry to record

growth


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Economic Outlook

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Table 3: Contributions and shares of industries w ithin Sri Lankas

economy

GDP Agriculture Industry Services

A. Annual change %

2007 6.8 3.4 7.6 7.1

2008 6.0 7.5 5.9 5.6

2009 3.5 3.2 4.2 3.3

2010f 8.0 7.0 8.4 8.0

2011f 7.8 4.5 8.2 8.3

2012f 7.6 4.4 8.0 8.0

B. Contribution to GDP growth (% points)

2007 6.8 0.4 2.1 4.2

2008 6.0 0.9 1.7 3.4

2009f 3.5 0.4 1.2 1.9

2010f 8.0 0.8 2.4 4.8

2011f 7.8 0.5 2.4 4.9

2012f 7.6 0.5 2.3 4.8

C. Share of GDP (%)

2007 100.0 11.9 28.5 59.6

2008 100.0 12.1 28.4 59.5

2009f 100.0 12.0 28.6 59.3

2010f 100.0 11.9 28.7 59.3

2011f 100.0 11.6 28.8 59.6

2012f 100.0 11.2 28.9 59.8

Notably, the industrial sector has failed to chart any significant growth in the

last couple of years relative to the services sector, as more extensive

infrastructure development is required for the prominent expansion of industrial

activities. Capacity-building remains the governments focus, with multilateral

grants and loans centred on the building of much-required infrastructure.

However, the latest Global Competitiveness Report by the World Economic

Forum shows that Sri Lanka fares quite well in terms of infrastructure

development compared to its peers.

Developmentfocused on post-war infrastructure

reconstruction


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Figure 9: Infrastructure status of lower-middle-income countries in

South Asia

Source: Global Competitiveness Report, 2011; World Economic Forum

As capacity-building remains one of the main themes to leverage on for post-

war liberalisation, we expect the construction sub-sector to be able to sustain its

expansion in the foreseeable future. In turn, this growth will keep fuelling

demand for minerals and other materials used in construction.

Figure 10: Gradual build-up of the industrial sector


Output from the manufacturing sector has been steadily trending upwards

since late 2009, with a surge in industrial-based output - such as chemicals,

petroleum and rubber products - underlining the largest consistent expansion

in production. The principal drivers of this output growth also include the

strong uptrend in private consumption, which has led to a jump in the sales of


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Economic Outlook

21

cars and other durable goods. Such healthy consumption indicates heightened

consumer confidence and more employment as well as brighter prospects for

the country. Nonetheless, textiles and apparel which account for over 40%

of Sri Lankas exports by value may record less robust growth in the coming

year amid softening global demand. Even so, the industrial sector is still

expected to post robust growth rates of 8.2% in 2011 and 8.0% in 2012.

Figure 11: Industrial output trends reflective of export-oriented

growth


On the whole, the agriculture sector has exhibited the most volatile growth

due to output shocks arising from inclement weather. The devastating floods

at the start of this year had destroyed major agricultural areas in the northern

and eastern regions of the country while the widespread damage has led to

the need for more funds to be allocated for rebuilding purposes.

Rising domestic

consumptionpowersmanufacturing

sector

Agricultural outputremains volatileamid inclement

weather


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Figure 12: Performance of the agriculture sector


In particular, coconut production is perceived as the most volatile when

measured by the coefficient of variation. Rubber output, on the other hand,

has been rising steadily, benefiting from the global shortage of natural rubber

that has kept prices lofty while turning it into an attractive agricultural activity.

Figure 13: Agriculture-based production affected by supply shocks


The agriculture sector is also perceived to carry the highest level of downside

risk overall. Notably, however, the sectors contribution to GDP growth is

declining, albeit marginally. Given the resilience of tea and rubber production,

in particular, we project respective growth rates of 4.5% and 4.4% in 2011

and 2012 for the agriculture sector.

Coefficient of VariationTea: 16%Rubber: 17%

Coconut: 21%


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Economic Outlook

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Table 4: Summary of GDP grow th by industry

2008 2009 2010 2011f 2012f

Agriculture, Forestry &

Fishing7.5% 3.2% 7.0% 4.5% 4.4%

Industry 5.9% 4.2% 8.4% 8.2% 8.0%

Services 5.6% 3.3% 8.0% 8.3% 8.0%

GDP 6.0% 3.5% 8.0% 7.8% 7.6%

Source: Department of Census and Statistics, Sri Lanka and RAM Economic Research


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D. Resurgent consumer and investor confidence to further drive

domestic demand

Sri Lankas first full fiscal year untainted by ethnic conflict features a

considerable upswing in private consumption and investment. Notably, the

economy has rapidly shifted to more sustainable private-sector-led growth.

While the quick recovery is not unexpected on the back of the cessation of

hostilities, the increase in public spending and investment has not crowded

out consumer demand and private investment appetite. We thus expect

private consumption to advance 12.5% in 2011, before tapering to a more

sustainable 8.8% in 2012.

Figure 14: Private consumption provides grow th impetus

Source: Department of Census and Statistics & RAM Economics

The newfound peace has allowed the country to focus on rebuilding and

advancing the domestic economy. Consumers have responded favourably to

the accommodative interest rates by increasing their appetite for debt (refer

to Figure 15). The sudden rise in preference for consumer durables, formerly

viewed as luxury items, and properties is a welcome boon that indicates

revitalised optimism in the countrys political and economic stability.

Passenger car sales swelled 155% in 1H 2011, continuing the strong trend of

over 100% over the past two half-years. With interest rates expected to be

held fairly steady through the rest of this year and the next, this pattern

should continue in 2012. Several liberalisation and rationalisation policies by

the government, such as significant reductions in import tariffs on vehicles

and consumer durables, are largely responsible for the change in preferences

Domesticconsumption tounderpin growth,

driven by credit


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Economic Outlook

25

and demand. Meanwhile, the governments equally commendable efforts to

reduce the cost of living for pensioners, public servants and other affected

groups through cost-of-living allowances and various subsidies should lead to

a sizable increase in public spending. In such a scenario, we expect a 11%

rise in government expenditure this year, followed by another 7.3% the next.

Figure 15: Consumer debt propels sales of consumer durables

Source: Central Bank of Sri Lanka & RAM Economics

Unemployment has eased to an all-time low of 4.3%, as more workers return

to the labour force and businesses ramp up their hiring to meet the rise in

demand. However, the downside risk to private consumption is depressed

wages since the start of the year, particularly in the agriculture industry, as

severe flooding at the start of the year had badly affected the countrys rice

crop. The industry employs over 30% of Sri Lankas work force, i.e. twice that

of the manufacturing and commerce industry. Depressed wages, combined

with the upward trend in credit growth, may also lead to unsustainable private

consumption. However, the temporary effects of the shock combined with the

governments efforts on rural aid as well as its land and plantation

development agenda should minimise the negative impact on demand.

Lower real wagesmay dampendemand


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Figure 16: Trends in labour force and real w ages

Source: Central Bank of Sri Lanka, Dept. of Census and Statistics, & RAM Economics

Despite the countrys generally stellar performance throughout 2010-2011,

only 2 provinces charted growth last year that surpassed that during 2004-

2008 amid the ongoing civil war then, i.e. the Northern and Eastern regions

(refer to Figure 17). These areas ravaged by war have enjoyed significant

improvements in their infrastructure following reconciliation, thereby creating

positive spillover effects on employment, availability of credit and the revival

of the agriculture industry. Proposed developments such as the recently

implemented East Reawakening programme should also enable these regions

to catch up with the rest of the provinces and help narrow the income

disparity within the country. Public investment should remain strong in these

regions in the near term, but should taper off slightly for the country as a

whole as private investment picks up the slack.

Public investmentscentre ondeveloping andreintegrating

Northern andEastern provinces


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Economic Outlook

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Figure 17: War-torn regions focus of development

Source: Central Bank of Sri Lanka & RAM Economics

While public investment had helped sustain the Sri Lankan economy through

the erstwhile war era, there had also been increasing foreign interest in the

country, largely led by India. Fiscal-consolidation efforts have underscored the

governments commitment to macroeconomic stability while boosting investor

confidence. Although total realised foreign investments has slowed down over

the past year, the lower ratio of FDI to total private investment in 2010 is an

encouraging sign that domestic investors are stepping up. Investment growthhas primarily manifested itself in the construction of non-residential buildings

and transport equipment, indicative of a country that is still in the process of

rebuilding. Even though the number of investment approvals has been lower

than anticipated, it is still expected to fuel the growth of realised investments

this year to 11.7%, with another 8.1% in 2012.

FDI inflows sloweddown this year,but domesticprivate investorsexpected to stepup


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Figure 18: Investment growth slower but still robust

Source: Central Bank of Sri Lanka, Dept. of Census and Statistics, World Bank & RAM Economics

Gross exports have continued recovering from the global recession, with

annual growth rates of over 30% nearly every month in 1H 2011.

Nonetheless, imports still outpace exports, driven by strong domestic demandand nation-building efforts. The countrys main export markets are a concern;

with the US and Europe still mired in stagnation, demand should shrink

further next year. However, the real effect on growth should be minimal,

considering Sri Lanka is not as export-driven as some of its peers. We

anticipate exports to rise 7.2% this year and 3.7% the next while the trade

deficit should widen even further, but at a slower pace.

Trade deficit towiden as poor

external conditionsweaken foreign

demand


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Economic Outlook

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Figure 19: Trade deficit still w idening as exports remain focused on

developed economies

Source: Central Bank of Sri Lanka, International Monetary Fund, & RAM Economics

Table 5: Summary of GDP growth by expenditure component

2007 2008 2009 2010 2011f 2012f

Private consumption 3.9 7.5 1.5 9.0 12.5 8.8

Public consumption 7.4 9.8 16.0 3.5 11.0 7.3

Investment 9.1 5.3 1.3 9.2 11.7 8.1

Exports 7.3 0.4 -12.3 5.8 7.2 3.7

Imports 3.7 4.0 -9.6 13.0 11.0 7.3

GDP 6.8 6.0 3.5 8.0 7.8 7.6


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E. Monetary policy focused on growth as inflation takes backseat

The CBSL had reduced its key policy rate the repurchase or repo rate by25 basis points (bps) to 7.00% at its first monetary policy meeting this year.

This had been aimed at mitigating the economic impact of the floods that had

taken place in late 2010. The deteriorating external conditions particularly in

the US and Europe and the geopolitical crises in the Middle East in the first

half of this year had dimmed domestic growth prospects and subsequently

stayed the monetary authoritys hand in normalising interest rates to a higher,

pre-crisis level. Accordingly, the prime lending rate for Sri Lankas financial

institutions had remained relatively stable through this year, only fluctuating

between 9.1% and 9.4% following the steady decline since 2009.

Figure 20: Sri Lankas key interest rates

As the global economy is expected to deliver a lacklustre performance in 2012,

the CBSL is likely to keep interest rates unchanged in the coming year.

Additional analysis suggests that the projected growth rate of 7.6% - despite

the uncertain global conditions in 2012 will result in a mild positive output

gap for the economy, implying that industries may face some capacity

constraints in the near future.

Interest rate likelyto be held at 7.0%due to growth and

inflation concerns


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Economic Outlook

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Figure 21: Sri Lankas GDP grow th and estimated output gap

Consequently, the CBSL may begin a gradual normalisation of interest rates

to ensure a more sustainable pace of growth over the longer term, as

persistent price hikes may result in significant structural inefficiencies within

the economy.

The tumultuous year for the advanced economies has caused significant

volatility in currency markets. The rupee, being a heavily managed currency

against the US dollar, has only appreciated mildly so far this year. However,

there has been tremendous pressure for the Sri Lankan currency to appreciate

as the US continued its USD 600 billion liquidity programme initiated late last

year. Furthermore, the mid-year debate on the USs public-debt ceiling had

frayed many investors nerves, almost culminating in a default for the worlds

largest economy. Although the debt ceiling was eventually raised at the 11th

hour in early August, the subsequent downgrading of the USs credit rating a

few days later had caused a flight to quality to ironically, the very asset

whose rating had been lowered more US debt, which had then triggered asudden and sharp appreciation for the greenback.


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Figure 22: Movement of the Sri Lanka rupee against the US dollar and

the euro

Against the euro, the rupee has experienced large and frequent swings in its

valuation throughout the year. This volatility has been largely due to the

deteriorating fiscal conditions in Greece and the ensuing inconsistent policy

measures announced by various European governments in a bid to prevent a

continent-wide run on confidence. Investors pessimism on several European

economies reached a tipping point in late August, finally leading to a dramatic

tumble for the euro. Meanwhile, the inflow of foreign capital into Sri Lanka

had also supported its strength against the euro, particularly after 2 major

credit-rating agencies had upgraded its sovereign rating in July.

While the CBSL is expected to continue controlling the level of the rupee

against the US dollar in 2012, there is some room for a gradual appreciation

in the near term. This is largely to give the CBSL additional monetary space to

manage domestic inflation, particularly in an environment of rising commodity

prices and strengthening domestic demand. This anticipated appreciation is

also supported by the CBSLs decision to relax its foreign-exchange

regulations in June and August, which implicitly and gradually reduces the

countrys reliance on the US dollar in international trade.

In the first 3 quarters of 2011, the Colombo Consumer Price Index (CCPI)

grew by 7.3% y-o-y. While rising food prices remained the primary

contributor to inflation, accelerating costs associated with transport as well as

housing and utilities became a prominent feature of escalating prices in Sri

Lanka this year.

Rupee to beallowed someroom for gradualappreciation tomanage domestic

inflation


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Economic Outlook

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Figure 23: Contributors to Sri Lankas inflation

This sudden increase had been largely due to the geopolitical crises in the oil-

rich Middle East and North African region, which had pushed up energy prices.

This had caused the prices of energy-related commodities or products such

as automotive fuel and household energy to accelerate substantially in Sri

Lanka. Furthermore, domestic prices had also been affected by other

commodity price shocks, such as accelerating food prices in India (which

supplies approximately 15% of Sri Lankas food imports) throughout the year.

Going forward, inflation is expected to chart a similar trend as global

commodity price movements due to Sri Lankas large exposure to imported

primary commodities typically food and energy commodities that accounted

for a third of the total value of the nations imports in 2010. While global

economic growth is expected to stay fragile due to the structural adjustments

in the advanced economies, world commodity prices will chiefly be determined

by the demand from large emerging nations and also supply conditions.

Another risk factor in Sri Lankas inflation is a possible surge in foreign capital

flows into the country. While investors risk appetite may be tempered by

recent events in the advanced economies, a significant amount of global

capital has been flowing into higher-yielding emerging economies throughmost of the year. These sizeable flows can exert upward pressure on the

prices of Sri Lankas asset markets, thus accelerating the pace of inflation.

That said, the imposition of more stringent capital controls or a renewed

pessimism among global investors may reduce the likelihood of this occurring.

On the domestic front, the combination of relatively low interest rates, rising

household wealth and upbeat consumer sentiment may elevate prices. This is

evident in the aforementioned increases in the purchases of durable goods

particularly, transport vehicles in recent months.

Inflationarypressures persist,with further upsiderisk from risingcommodity prices,strongerconsumption andforeign capital

inflows


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Consequently, the base-case scenario which assumes relatively mild

movements in commodity prices and foreign capital inflows at a sustainable

pace estimates that Sri Lankas inflation (as measured by the CCPI) will

range between 6.5% and 7.0% in 2012.

As at the end of 2H 2011, loans and advances from commercial banks

summed up to LKR1.6 trillion, or roughly 27% of Sri Lankas GDP. This

represents a significant 29% y-o-y increase that can be attributed to the

reduction in interest rates early this year, as well as better consumer

sentiment.

Figure 24: Commercial banks loan indicators

Although the rapid loan growth is worrying, the amount of deposits has kept

pace for the most part. Indeed, the industrys loans-to-deposits ratio has

reverted back to a more sustainable pace of approximately 75% throughout

the year. This is likely to dip further as rising risk aversion may slow any

immediate or near-term investment decisions.

The capital markets experienced a flurry of activity in 2010, as investor

confidence picked up in line with post-conflict optimism. Last year, Sri Lankas

debt market charted its largest-ever annual issuance of LKR15 billion; the

equity market recorded a respectable LKR3.3 billion of initial public offerings1.

Further evidence of investors confidence in Sri Lanka can be seen from its

sovereign bond yields.

1Source: Colombo Stock Exchange

Loans and depositsregistered healthygrowth


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Economic Outlook

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Figure 25: Yield indicators for Sri Lankan government bonds

The risk premium as shown by the yield spread between Sri Lankan and US

government bonds on Sri Lankan government bonds has remained relatively

flat this year, with a small uptick to denote global risk aversion amid the

unfolding of world events. The current premium is significantly lower than that

during the height of the civil war in 2009.

The shorter end of the sovereign yield curve has risen relative to the

previous year as unanticipated inflation has caused investors to shift to

higher-yielding asset classes. However, the yields of longer-tenured Sri

Lankan sovereign bonds have fallen, implying stronger demand for this

particular debt tenure; it also reflects an uptick in long-term investor

sentiment in Sri Lanka.

Going forward, Sri Lankas post-war growth prospects remain relatively robust;

it is still an attractive destination for investors. The underlying potential for

growth would imply higher returns and long-term growth for less risk-adverse

investors, and may encourage further capital inflows into the economy.

While additional funds are needed for the development of Sri Lankas post-war

economy, prudent use of capital controls may be warranted to ensure thatexcessive demand does not cause a significant deviation in asset prices from

their true fundamental values. Mispricing of assets may cause structural

defects in the economy and jeopardise the longer-term growth prospects of

the country.

Flattening yieldcurve and flat yield

spread indicateinvestorsimproving long-

term outlook


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36

III. POST-CONFLICT ECONOMIC AND BUSINESS

ENVIRONMENT

Sustaining growth and macroeconomic stability over the mediumterm

Sri Lanka is expected to record a slightly stronger average growth momentum

of 6.6% throughout 2011-2015. The projection compares favourably against

those for other similarly rated countries (Figure 26), all of which are expected

to also show healthy expansion. The higher expected growth will boost Sri

Lankas standing in terms of GDP per capita among its peers that are rated the

same or even a notch or 2 higher.

Figure 26: Selected countries projected average annual GDP growth

through 2011-2015 and per capita GDP in 2011

Source: IMF World Economic Outlook September 2011 and RAM Economics; foreign-currency ratings by S&P

Sri Lanka is expected to show strong improvement in its management of price

stability. In this regard, its average consumer price inflation is expected to be

halved over the next 5 years (Figure 27).

Nevertheless, 2 key macro challenges remain: the nations twin government

and current-account deficits. Both are expected to show a declining trend as

brighter economic prospects will shift the burden of growth and employment

creation to the private sector, on the assumption that the government

maintains its fiscal consolidation.


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Figure 27: Consumer price trends and projections for Sri Lanka and

selected countries

Figure 28: Managing tw in deficits

Source: IMF World Economic Outlook September 2011 and RAM Economics; foreign-currency ratings by S&P


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Significant reliance on foreign aid - need to focus on domestic-

driven growth

Foreign aid refers to assistance from external parties - usually multilateral

organisations and large, advanced economies to support a countrys growth.

The first form of foreign aid is classified as humanitarian aid, where relief

supplies and personnel are provided to cater for the immediate needs of a

nations citizenry. This generally refers to the provision of emergency supplies

of food and medicines in a war-torn or disaster-struck country. The second

form of foreign aid, also known as official development assistance (or ODA), is

the support given to alleviate poverty over the longer term. Typically, ODA

comes in the form of financial or technical support that develops a countrys

physical infrastructure, education or health systems. There have been some

cases where recipients of ODA have used these funds to develop the nations

primary industries (usually to improve crop yields) or to spur sufficient

structural changes to attain longer-term economic goals.

According to the World Bank, Sri Lanka has received a total of USD18.2 billion

of net ODA since 1960. Despite the vast social improvements, especially with

regard to health and education, Sri Lankas economic development still lags

behind that of many of its East Asian neighbours. Furthermore, there are

pockets where poverty has become increasingly entrenched, thus making

income inequality even more pronounced. This may bring into question the

role or rather, the sustainability of ODA in Sri Lankas future economic

growth.

Positive side of foreign aid

Proponents of ODA suggest that certain development goals not just outright

wealth generation cannot be attained without external aid. For instance, the

widespread practice of modern medicine which can only be obtained from

more developed economies has been proven to have lowered mortality rates

for infants under 5 years of age while helping to prevent deaths associated

with treatable diseases, such as polio and tuberculosis. Preventing the spread

of communicable or easily transmittable maladies as well as the provision of

potable water has also extended the average life expectancy of manyemerging economies populations in the last 2 decades.

External assistance is also a prerequisite for more robust production. The

Green Revolution the era when agricultural production had effectively

doubled in a short span as a result of better technology from richer nations

is an oft-quoted example of growth-oriented external aid. Better yields for

various crops and more sophisticated farming techniques have improved food

security, and would later become a catalyst for some nations to facilitate their

economic structural changes to higher value-added production, such as


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39

manufacturing as the demand for agricultural labour become significantly

reduced.

Benefits of reducing the need for foreign aid

On the other hand, the main argument against ODA is the inefficiencies in its

use. Financial resources, especially, can prove highly inefficient as there is

always the possibility of diverting funds from their intended use whether

intentionally (corruption or fraud) or unintentionally (regulatory burden or the

cost of bureaucracy). Ineffective use of ODA can also manifest itself in the

overprovision of public services e.g. an oversupply of hospitals in a sparsely

populated area. Besides blunting the effectiveness of these funds within the

economy, inefficiencies can also widen the income-inequality gap and may

hamper confidence, as it may promote social instability in the long run.

Besides, unproductive use of ODA can give investors a dim view of the

management of the public sector and may raise the cost of deficit financing in

the future. This will, again, retard the countrys growth.

Meanwhile, poor technological diffusion the ability of a country to absorb and

learn new technologies is also cited as a failure of foreign aid vis-a-vis

development. Lower-income nations tend to have relatively lower education

levels, which can result in less-than-effective use of any technical support

provided by advanced economies. A common example of this is higher-end

agricultural equipment that has been imported into an agrarian-based

economy, which is then stripped to its individual components for resale whenrepairs are required for the original equipment. While critics of this argument

may claim that constant aid flows may be the panacea for this problem, it can

propagate economic dependency that can in turn have growth implications

(e.g. lopsided trade agreements) in the future.

Aid in practice

The different growth drivers and constraints for each country render it very

difficult to estimate the effectiveness of ODA. However, there have been some

general indicators that the overall standard of living for the developing world

has improved through decades of foreign aid. This is evidenced by the rising

Human Development Index a composite index measuring the life expectancy,literacy, education level and standards of living of a countrys citizens for

developing nations over the past few decades. It is especially pertinent when

conventional economic thinking half a century ago suggest that economies, left

to their own devices, are able to independently break out of the poverty trap

through sufficient savings.

Although there have been success stories among some ODA recipients, there

has been an equal number of disheartening episodes where foreign aid has

failed or worse - deteriorated a countrys long-term growth prospects. The

Foreign aid is vitalfor furtherdevelopment ofemergingeconomies, butsuccess largelydepends on itseffectiveness andefficiency


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decades-long ODA debate in both academic and political circles has yet to be

resolved and remains inconclusive. There have been some areas where

general agreement is required on the extent of aid such as the provision of

basic medicines and the introduction of modern medical practices, subsidised

fertilisers and high-yield crop seeds, and construction of the requisite

infrastructure for clean water.

Sri Lanka and foreign aid

Grants have been on a declining trend with foreign grant receipts declining by

34.8% in 2010; of this, 67.1% are attributable to multilateral donors. In

tandem with the countrys heightened budget deficit (expected to reach 6.8%

of GDP in 2011) and hefty expenditure requirements, Sri Lankas external

exposure and foreign claims have noticeably increased in terms of net foreign

financing as a proportion of total financing sources, from about 41% in 2007

to 54.8% in 2010. The rapid build-up of basic infrastructure requirements inrecent years, after the official cessation of the civil war, has brought about

increased multilateral financial support for the island nation.

Figure 29: Sources of deficit financing


The value of grants to GDP has been rationalised at a moderate pace over the

past few years; by 2010, this only accounted for 0.3% of Sri Lankas GDP. As

the value of foreign aid tapers off, Sri Lanka tends to receive ad hoc foreigngrants and transfers under specific circumstances, such as for flood relief and

rebuilding efforts, which were apparent in 2011.

The heavier reliance on foreign debt financing has also pushed up repayments

as a percentage of GDP, to 1.4% in 2010. As the government tries to

consolidate its spending and increase revenue to finance its expenditure,

attempts to reign in the budget deficit as a percentage of GDP remains high on

the authorities agenda.

Reliance on foreignaid replaced byforeign debtfinancing, puttingpressure onwidening budgetdeficit


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Figure 30: Level of foreign aid and deficit financing


Part of the strategy for long-term sustainability of government spending is the

continued strengthening of viable revenue sources. Tax revenue forms the

bulk of government revenue, reaching 88.7% in 2010. This has been a

relatively steady pattern over the past 5 years, although there has been a

slight shift to increased contributions from tax revenue derived from incomegeneration (i.e. net income and profits); this comes on the back of the

countrys robust growth. As evident from Figure 31 below, the value of indirect

taxation consistently far exceeds that of direct taxation; this trend is expected

to be maintained, supported by healthy private consumption.

Robust domesticprivateconsumptionshould expandincome from

indirect taxes


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Figure 31: Sources of tax revenue


The governments commitment to reducing the impediments against doing

business is evidenced by a number of fiscal and administrative reforms in the

past year. The improvements have pushed Sri Lanka up 9 notches to 89th

position in the latest World Bank Ease of Doing Business Survey. The reduction

of corporate tax rates and other business taxes may diminish collections of

direct taxes in the immediate term but nonetheless, these structural economic

reforms are expected to spur FDI and bolster business activities of the private

sector.

As such, less reliance on foreign monetary assistance and the private sectors

better capacity-building aptitude are seen as positives that propel the

economy forward while putting government fiscal balances on a more

sustainable footing. The establishment of a more conducive environment to

further stimulate domestic sources of growth will be imperative to such efforts.

Improved overallbusinessenvironmentshould draw moreFDI, raise output,and widen tax

base


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IV. SUMMARY AND CONCLUDING OBSERVATIONS

The persistent uncertainties plaguing the global economy remain a key

downside risk for developing economies. Currently, more than half the

nations exports are still centered on the US and EU markets. Given this, a

shift away from its present dependence will help cushion growth in light of the

apparent downside risks.

From the domestic viewpoint, further policy initiatives are needed to

rationalise the governments moderately high budget deficit, to maintain

sustainable growth and achieve the medium-term growth estimates for

continued economic development. On a more positive note, both the current

account and fiscal deficits are expected to be reduced as brighter economic

prospects will shift the burden of growth and employment creation to the

private sector, on the assumption that the government maintains its fiscal

consolidation.

Although inflationary pressures have increased this year, they are expected to

moderate next year. However, Sri Lanka is highly susceptible to volatile

commodity prices (for energy and food); unexpected supply shocks remain of

utmost concern to policy makers and industry players. Moving forward, the

country is anticipated to show strong improvement in its management of pricestability while its average consumer price inflation is expected to be halved

over the next 5 years.

Despite these global headwinds, Sri Lanka is expected to sustain a slightly

stronger growth momentum of 6.6% on average throughout 2011-2015. This

would boost the countrys standing in terms of GDP per capita among its peers

rated the same or even a notch or 2 higher and in turn, strengthen Sri Lankas

financing ability - while attracting more foreign investment - thereby boosting

the progress of its economic development.


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Published by RAM Holdings Berhad

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Copyright 2011 by RAM Holdings

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