The Sunday Times Economic Analysis

The paradoxical situation of the country's trade and balance of payments is barely credible. The country has one of the highest, if not the highest ever, levels of foreign exchange reserves.

At the same time, the trade deficit has reached unprecedented levels. While we can be satisfied that the country is not facing a foreign exchange crisis, yet the trade performance indicators, as well as the emerging international scenario foreshadow hard times this year and in the future.

At the end of March, the end of the first quarter of the year, foreign exchange reserves had reached a record US $ 4.4 billion, rising from US$ 4.2 billion at the end of last year. These reserves are estimated to be adequate to finance 5.8 months of imports, according to the Central Bank. This amount of foreign exchange reserves is almost unprecedented. We have to go far back to the fifties when the booming market for rubber during the Second World War and later the Korean War increased our reserves to levels that could finance as much as seven to eight months of imports.

The sixties onwards were however years of foreign exchange crises that led to the closing up of the economy to liberal trade that the country followed since independence. Now we find ourselves once again in a happy position of ample foreign exchange reserves.

Even though there are large foreign exchange reserves the trade situation is worrying. The accumulation of foreign reserves has not been due to a good outturn in trade, it has been in spite of a large trade deficit.

Each successive year we have been running a higher and higher deficit propelled by the ever-increasing oil price hikes. In the first quarter of this year we have run up a trade deficit of US$ 784 million, nearly twice what it was for the corresponding period last year. This year's trade deficit is on course to surpass last year's trade deficit of US $ 2.5 billion that was the highest ever. This year's trend in trade is likely to lead the country to a very large deficit of perhaps around US$ 3 billion or more.

Trade deficits have been a recurring phenomena. The country has sustained continuous trade deficits since 1978.

The last time the country had a small trade surplus was in 1977 under a strictly controlled import policy regime. During the last 27 years trade deficits have risen rather than reduced. This year's trade deficit will most likely be the highest in the country's economic history.

The main reason for the recent large increases in trade deficits has been the unprecedented rise in international oil prices and the consequent high costs of petroleum imports. Last year petroleum import costs increased by 37 per cent to US dollars 1,655 million. This year it would increase even more.

Consequently the trade deficit would increase above last year's US $ 2,516 million.

The increase in the country's import bill has not been matched by a commensurate increase in our exports. Actually, while import expenditure has increased by 19 per cent, exports have hardly increased in the first quarter. Total exports have increased by only 0.6 per cent.

While agricultural exports have increased by 6.6 per cent, industrial exports have increased by less than one per cent (only 0.6 per cent) A decline in mineral exports by 3.7 per cent, as well as "other" exports by as much as 82 per cent has resulted in the poor performance in exports. This is indeed a worrisome position especially as garments exports that account for the largest share of gross export incomes, declined by 1.6 per cent in the first quarter. This is a reversal of the trend of recent years and has to be taken seriously.

It is a danger signal. It is an indicator that our competitive strengths may be eroded. In the face of the rising oil bill a reversal of our industrial export capacity could lead us to a serious balance of payments problem, in spite of our current high foreign exchange reserves.

Remittances by Sri Lankans resident abroad have been an important source of balance of payments support for the last two decades. In 2005 there was a particularly high increase in inflows. Remittances grew by 22.7 per last year to US dollars 1,918 million. This trend has continued into 2006 and in the first quarter remittances have increased by a further 26 per cent to US$ 615 million in the first three months.

These remittances are an important factor that offsets nearly 75 per cent of the trade deficit. Consequently, last year the current account deficit declined to 2.8 per cent from 3.2 per cent of GDP in 2004. The first few months experience indicates that once again remittances would play a significant role in offsetting the trade deficit. Yet if the trade deficit grows to the proportions indicated earlier, this backing will not be adequate.

Between the end of last year and the end of March this year foreign exchange reserves increased by 4.4 per cent or US $ 183 million. While the detailed statistics of balance of payments items are not readily available we can surmise that the same items that contributed to the increase in foreign exchange reserves last year would have been responsible for the increase in reserves. Given the larger trade deficit this means that other items in the balance of payments had offset the trade deficit. That is the explanation for this build up of foreign exchange reserves.

The main factor for this development is the increased remittances from abroad, the inflow of investment funds and the increased flow of aid. Like last year, remittances would increase but investment flows and aid flows may decline especially owing to the lack of progress in containing violence in the country. The bottom line is: mind the trade gap.