Sri Lanka Quarterly Economic Update

The Quarterly Economic Update (QEU) provides a comprehensive and updated analysis of the recent economic performance of Sri Lanka. The QEU for July 2012 highlights the expected economic slowdown in 2012. With inflation trending up, monetary tightening is expected to continue for a longer period. The QEU also looks at the challenges of managing fiscal policy in 2012.

About the Asian Development Bank

ADB’s vision is an Asia and Pacific region free of poverty. Its mission is to help its developing member countries reduce poverty and improve the quality of life of their people. Despite the region’s many successes, it remains home to two-thirds of the world’s poor: 1.7 billion people who live on less than $2 a day, with 828 million struggling on less than $1.25 a day. ADB is committed to reducing poverty through inclusive economic growth, environmentally sustainable growth, and regional integration.

Based in Manila, ADB is owned by 67 members, including 48 from the region. Its main instruments for helping its developing member countries are policy dialogue, loans, equity investments, guarantees, grants, and technical assistance.

Printed on recycled paper Printed in the Philippines

Asian Development Bank6 ADB Avenue, Mandaluyong City1550 Metro Manila, Philippineswww.adb.org

July 2012

SRI LANKA

Quarterly Economic Update

SRI LANKAQuarterlyEconomic Update

July 2012

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Asian Development Bank. Sri Lanka quarterly economic update.Mandaluyong City, Philippines: Asian Development Bank, 2012.

1. Economic development. 2. Sri Lanka. I. Asian Development Bank.

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ContentsMacroeconomic Developments 1

Overview 1

Sector Performance and Economic Growth 1

Inflation 2

Monetary and Financial Developments 2

External Sector Developments 3

Fiscal Performance 5

iv Sri Lanka Quarterly Economic Update

Country Director R. O’Sullivan, Sri Lanka Resident Mission (SLRM), South Asia Development (SARD)

Team Leader T. Hayashi, Senior Country Economist, SLRM, SARDTeam Members H. Wickremasinghe, Senior Economics Officer, SLRM, SARD S. Jayakody, Associate Economic Analyst, SLRM, SARD

NOTEThe fiscal year of the government ends on 31 December.

In this publication, “$” refers to US dollars, and “SLRs” refers to Sri Lanka rupees.

1

Macroeconomic Developments

Overview

• Economic growth stayed high in the first quarter of 2012, at 7.9%, but is expected to slow down in the succeeding quarters. Monetary tightening in February and April 2012 increased interest rates and thereby decelerated the expansion of banking credit to the private sector.

• Inflation is picking up. Besides the base effect1 from the energy price hike and currency depreciation in February 2012, food inflation is topping up the price pressure. Monetary tightening will continue longer than expected, and will moderate economic recovery toward 2013.

• Imports have started decreasing with the currency depreciation and economic slowdown. Exports have also dropped, with lower than expected prices. However, capital inflows have supported the buildup of gross official reserves.

• There is little fiscal space to support domestic demand. In January–April 2012, expenditure increased to 7.9% of gross domestic product (GDP), but the share of revenue remained at 4.1% (compared with 4.4% in the same period in 2011) despite high economic growth.

Sector Performance and Economic Growth

1. The economy grew by 7.9% in the first quarter of 2012 on the strength of high growth in agriculture and industry (Figure 1). Agriculture grew by 11.5%, the fastest rate among three sectors (including services), followed by industry, which expanded at 10.8%. Growth in the services sector, the largest contributor to GDP, was a slower 5.8%.

2. Agriculture rebounded from negative growth in 2011 caused by excess rainfall. Paddy production in particular grew by 35% and contributed 80% of growth in agriculture. Higher growth in inland fishing and coconut production was another notable contributor.

Figure 1 GDP Growth (Supply)

GDP = gross domesic product.

Source: Department of Census and Statistics of Sri Lanka.

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1 Observed with inflation measured year-on-year.

While GDP grew by 7.9% in the first quarter of 2012, a slowdown is anticipated in the succeeding quarters.

2 Sri Lanka Quarterly Economic Update

3. Growth in the industrial sector held steady at more than 10% in the last 3 quarters. Manufacturing and the electricity, gas, and water subsectors grew more slowly in the first quarter of 2012 than in the same period in 2011; construction and mining and quarrying, on the other hand, performed better. The manufacturing subsector, which is the highest contributor to industry, grew by only 6.7% compared with 8.2% in the same quarter in 2011. Construction grew by 17.5%, compared with 14.3% in the same quarter of 2011. Activities related to construction showed progress with total cement demand2 increasing from 1,070,945 tons to 1,802,351 tons, or by 68.3%, within the reference period. Loan funds disbursed for the construction of houses, business premises, and other buildings increased by 20.8% in the first quarter of 2012.

4. The services sector experienced a slowdown as the trade and telecommunications subsectors experienced low growth. Export trading recorded 1.7% growth, as against 15.3% in the same quarter of the previous year. Domestic trading was also slower than the previous year, growing by 6.8% against the 8.5% growth rate in the first quarter of 2011. Growth in the posts and telecommunications subsector, a high growth area for several years, plunged to 6.8% in the first quarter of 2012 from 18.7% in the same period in 2011. Tourism related activities, on the other hand, continued to perform well, with tourist arrivals increasing by 21.1%, from 215,124 to 260,525, in the reference period. Earnings from tourism, room occupancy rate, and guest nights increased by 39.6%, 2.7% and 7.0% respectively.

5. GDP growth is expected to slow down further in the succeeding quarters of 2012. Power generation, a significant indicator of overall economic activity, decelerated to 3% year on year growth in May 2012, and is foreseen to report negative growth in the following months (Figure 2). The slackening growth in power generation reflects weakness in the economy, and perhaps also the power cuts and energy efficiency measures taken in anticipation of power shortages. Furthermore, imports have decreased across all items, from nonfood consumer goods (25% year-on-year drop in June 2012) and non-petrol intermediate goods (19% drop) to investment goods (28% drop), indicating an overall weakening in domestic demand (Figure 3). The Industrial Production Index also fell below 1% growth in March and April 2012 (Figure 4) before recovering to 4.2% in May. A slowdown from the first quarter record is anticipated for the industry sector. In agriculture, production will be affected by the serious drought now causing extensive damage in some districts in the North, North Central, North Western, and Eastern provinces, in the wake of a significant

GDP = gross domestic product, GWh = giga-watt hours

Source: Central Bank of Sri Lanka

Figure 2 Electricity Generation and GDP Growth

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Source: Central Bank of Sri Lanka

Figure 3 Imports of selected items

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Figure 4 Industrial Production Index

IPI =Industrial production index

Source: Central Bank of Sri Lanka

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2 Local production plus imports.

Macroeconomic Developments 3

shortfall of rainfall during the southwest monsoon. Rainfall in April–July 2012 remained at 50%–77% of normal rainfall in Anuradapura, Kurunegala, Puttalam, and Angamedilla (Polonnaruwa) (Figure 5). Rainfall shortages have also affected power generation, which now depends less on hydropower. The share of hydropower was more than 50% in January–April 2011, but was less than 20% in the same period in 2012.

Inflation

6. Year-on-year inflation rose to 9.8% in July 2012 from 9.3% in June 2012, as price increases in the food category topped up those in nonfood items (Figure 6). The prices of rice, coconut, fresh fish, sugar, fruits, vegetables, and prepared food stoked inflation in the food category. Prices in the transport subcategory have been decelerating from 30.1% in March 2012, but were still at 20.3% in July 2012.

7. Nonfood items have contributed little to month-to-month inflation, but food inflation has been the main contributor since April 2012 (Figure 7). Most of the year-on-year nonfood inflation in recent months was therefore caused by a low base effect from the energy price adjustment and currency depreciation in February 2012. Prices in the subcategory of housing, water, electricity, gas, and other fuels underwent a month to month decline in July as gas prices were reduced.

8. In June 2012, drought in certain districts of the country prompted the government to ban the export of rice until the 2012/13 Maha3 production is harvested, to ensure adequate rice stocks at affordable prices for domestic consumption.

Monetary and Financial Developments

9. Following the monetary tightening in February 2012 (which raised the repo rate by 50 basis points [bp]) and again in April (leading to a further 25 bp hike in the repo rate), interest rates have continued to go up. The prime lending rate increased to 13.8% in July 2012, compared with 10.5% at the end of 2011 (Figure 8). Credit expansion to the private sector, which had plateaued since mid 2011, began decelerating in April 2012. However, it was still at a high 31.6% at the end of June (SLRs2,235 billion outstanding), compared with the 18% target announced by the Central Bank of Sri Lanka in February

Figure 5 Rainfall

Source: Meteorological Department of Sri Lanka

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K uruneg ala A ng am ed illaA nurad ap ura P uttalam

No rm al year 2012 ac tual

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3 The Maha season coincides with the northeast monsoon from September to March of the following year.

Figure 6 Inflation (year-on-year)

%

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Source: Department of Census and Statistics

Figure 7 Inflation (month-to-month)

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Food N onfood A ll item

Source: Department of Census and Statistics of Sri Lanka

The expansion of banking credit to the private sector has been slowed down by higher interest rates, but still exceeds targets.

Inflation is picking up because of higher food prices.

4 Sri Lanka Quarterly Economic Update

2012. Unless the credit target is relaxed, banks are expected to cut back on credit to the private sector later in the year, further slowing down economic growth. Credit to the government also slowed down (SLRs1,010 billion outstanding), but is still growing by 37.5%.

10. Stock prices have been sluggish, although there has been a net inflow of foreign investors since January 2012. At the end of June, the All Share Price Index stood at 4,876 (20% below the December 2011 value) and the Milanka Price Index at 4,279 (18% below).

External Sector Developments

11. Exports and imports have been decreasing (Figure 9). In June 2012, exports declined by 7.9% and imports by 15.0%. Export earnings from textiles and garments weakened by 6.3% due to lower export prices. Agriculture exports also declined by 11.7%, reflecting lower prices in the international market for tea, rubber and coconut. Expenditure on imports also declined in June 2012 due to reduced expenditure on imports of consumer, intermediate, and investment goods. With exports at $0.8 billion and imports at $1.5 billion, the monthly trade deficit decreased from $1.1 billion in November 2011 to $0.6 billion in June 2012.

12. Tourist arrivals have continued to climb monthly on a year on year basis since the conflict ended in 2009. Growth exceeded 20% in 2011, but is foreseen to slow down gradually. Tourist arrivals from other South Asian countries declined by about 10%. Earnings from tourism expanded by 20% in the first 5 months of 2012, to $397 million. Workers’ remittances to Sri Lanka went up by 12% in June 2012, to $452 million (Figure 10).

Figure 8 Credit Growth and Interest Rates

Figure 9 Exports and Imports

Source: Central Bank of Sri Lanka.

M2b = consolidated broad money supply.

Source: Central Bank of Sri Lanka.

Gove rnm ent secto r cred it (annua l g row th , le f t)

P riva te secto r cred it (annua l g row th , le f t)

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Figure 10 Revenues from Tourists and Workers’ Remittances

Source: Central Bank of Sri Lanka

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Imports have been decreasing since the

currency depreciation, and exports have dropped due

to lower international prices.

Macroeconomic Developments 5

Figure 11 Gross Official Reserves and Foreign Exchange Rate

Source: Ministry of Finance and Planning.

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13. With the $415 million final disbursement under the International Monetary Fund Stand-By Arrangement and the successful $1 billion sovereign bond issue in July 2012, gross official reserves (excluding Asian Clearing Union balances) amounted to $7.1 billion, or 4.2 months of imports, in July 2012, up from $5.5 billion in February 2012 (Figure 11). Following the decision made by the Central Bank of Sri Lanka in February 2012 to limit its intervention in the foreign exchange market, the exchange rate reached $1 = SLRs132.9 in July 2012, 18% below the value of the Sri Lanka rupee in July 2011.

Fiscal Performance

Table 1 Summary of Fiscal Performance, Jan–Apr 2011 and Jan–Apr 2012)

Jan–Apr 2011

Jan–Apr 2012

Revenue and Grants (SLRs billion) 286.2 307.7

Revenue 284.9 305.6

Grants 1.3 2.1

Expenditure (SLRs billion) 458.5 593.5

Recurrent expenditure

Interest payment 142.3 173.7

Capital expenditure 103.9 152.4

Fiscal Balance (SLRs billion) (172.3) (285.8)

Revenue / GDP (%) 4.4 4.1

Recurrent Expenditure / GDP (%) 5.6 5.9

Capital Expenditure / GDP (%) 1.6 2.0

Fiscal Balance / GDP (%) (2.7) (3.8)

( ) = negative, GDP = gross domestic product.

Source: Mid-Year Fiscal Position Report 2012, Ministry of Finance and Planning, Sri Lanka.

14. The country is facing a challenging year for fiscal policy in 2012. In January–April, government revenue increased by 7.3%, and decreased its GDP share from 4.4% to 4.1% (Table1). On the other hand, government expenditure grew by 29.4%, behind a robust increase in public spending (by 46.6%), a higher cost of interest payments (by 22.0%) due to a hike in interest rates and a depreciation of the currency, and larger welfare expenditure and fertilizer subsidies. Government expenditure increased its share of GDP from 7.2% to 7.9% in the reference period. Accordingly, the budget deficit in the first 4 months reached 3.8% of GDP (against the annual target of 6.2%), up from 2.7% in 2011.

6 Sri Lanka Quarterly Economic Update

15. Fiscal expenditure in the second half of 2012 is expected to be restrained, to meet the annual fiscal deficit target of 6.2% of GDP set in the 2012 budget. Economic growth will slow down further because of this.

16. Sri Lanka’s public debt as a share of GDP declined to 78.5% in 2011, from 86.2% in 2009. While the currency depreciation increased the amount of foreign debt as measured in Sri Lankan rupee, the debt ratio for 2012 is estimated to be 77.7% of GDP.

8 Sri Lanka Quarterly Economic Update

Sri Lanka Quarterly Economic Update

The Quarterly Economic Update (QEU) provides a comprehensive and updated analysis of the recent economic performance of Sri Lanka. The QEU for July 2012 highlights the expected economic slowdown in 2012. With inflation trending up, monetary tightening is expected to continue for a longer period. The QEU also looks at the challenges of managing fiscal policy in 2012.

About the Asian Development Bank

ADB’s vision is an Asia and Pacific region free of poverty. Its mission is to help its developing member countries reduce poverty and improve the quality of life of their people. Despite the region’s many successes, it remains home to two-thirds of the world’s poor: 1.7 billion people who live on less than $2 a day, with 828 million struggling on less than $1.25 a day. ADB is committed to reducing poverty through inclusive economic growth, environmentally sustainable growth, and regional integration.

Based in Manila, ADB is owned by 67 members, including 48 from the region. Its main instruments for helping its developing member countries are policy dialogue, loans, equity investments, guarantees, grants, and technical assistance.

Printed on recycled paper Printed in the Philippines

Asian Development Bank6 ADB Avenue, Mandaluyong City1550 Metro Manila, Philippineswww.adb.org

July 2012

SRI LANKA

Quarterly Economic Update