A top international bank said this week that while it was encouraged by Sri Lanka’s growth prospects, it was concerned by the lack of ‘concrete programmes’ to integrate the minority Tamil population back into the broader society. “Also, we are troubled that the political institutional framework has been weakened by the parliament abolishing presidential term limits, eliminating the supervisory Constitutional Court and gives the president authority to directly appoint officials,” said HSBC Global Research in a report on Asian bond markets released this week.
The report said it believes the IMF has influenced the government to slow down recurrent expenditure while holding public sector investment steady as a share of GDP. “Apart from the headline budget deficit improvement, we view favourable simplifying of the tax structure and broaden the tax base to increase revenues as a share of GDP. On expenditure, we believe the IMF has influenced the government to slow recurrent expenditure while holding public sector investment steady as share of GDP. These budgetary steps should persuade Fitch to upgrade Sri Lanka by one notch in 2H11,” it said.
The report said the Sri Lankan government’s focus has been on bolstering economic growth in 2010 by stimulating private sector investments and rebuilding war-ravaged public sector infrastructure. “As a result, HSBC Economics projects real GDP growth in 2010 doubling to 7% from an anaemic 3.5% a year earlier. From the external credit metric side, HSBC Economics projects import coverage to rise to 5.3 months in 2010 from a low of 2 months in 2008 on the back of rapid foreign exchange reserves accumulation,” it said.
The bank said these were the key two factors triggering S&P to lift Sri Lanka’s rating by one notch to B+/stable and encouraged Fitch to raise the outlook to ‘positive’ from ‘stable’ on its B+ sovereign rating.
Looking to 2011, the HSBC sovereign model upgrades Sri Lanka’s credit rating to BB-/stable from B+/positive to reflect initiatives on fiscal consolidation and continued efforts to stimulate private sector capital formation. “To be specific, the government projects a budget deficit of 6.8% of GDP compared with an 8% shortfall in 2010, although HSBC Economics see risks to this target due to the planned tax cuts.”
It said growth has in 2010 benefited from the peace dividend and the global economic recovery. It has been broad based and is expected to reach more than 7% in 2010. Improved labour market conditions and tax cuts announced in the 2011 budget are likely to lift personal consumption. Moreover, investment activity will continue to gain momentum as rebuilding efforts pick up pace and as mega infrastructure projects in the pipeline are implemented. Exports may consolidate a bit, partly due to the loss of preferential trade agreement with the EU and the strengthening of the currency. However, this could be partly offset by continued growth in tourism.
It said domestically generated demand pressures are expected become more prominent next year and could push inflation above the comfort zone. “The central bank will, therefore, have to step in and we expect that they will begin to tighten monetary policy, no later than the second half of 2011,” it said.
Cutting taxes to raise revenues, textbook “Reaganomics,” has been done before and success or failure of this approach is controversial to say the least, it said. “Before taking this route, the government should have taken a more cautious approach to fiscal consolidation through further efforts to broaden the narrow tax base.”
The report spoke of a number of risks on the horizon. Inflation could rise more than anticipated. Moreover, the fiscal consolidation strategy face risks related to a tax strategy, which may not pay off. If these risks materialize, it will raise concerns about macroeconomic stability and could hurt growth prospects, it said.
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