Columns - The Sunday Times Economic Analysis

Downside risks of global economy

By Nimal Sanderatne

External developments will have a significant impact on the Sri Lankan economy this year. While a few international developments have turned favourable recently, others are unfavourable.

International oil prices have shown signs of decreasing in recent weeks owing to reduced demand for oil from European countries and increased supplies from Saudi Arabia and other oil-producing countries. If this trend continues then there would be significant relief for the trade balance and the balance of payments. On the other hand, the instability and slowdown of European economies could affect exports adversely.

Even before the prospect of relief from oil prices, there was a wave of economic optimism generated by the reduction in consumer imports as a result of the several policy measures. This reduction in consumer imports is considered a sign that the recent policy measures have had a significant impact on reducing imports. Since there has been a reduction of consumer imports by 2.2 per cent in the first two months, it is reasonable to expect the reduction of imports to gain momentum. However this reduction has been only in consumer imports. Intermediate and investment goods imports have not shown a similar reduction.

Furthermore, the country's exports are a matter of concern. The growth in total exports is a meagre 3.3 percent in the first two months. Industrial export growth is minimal, while agricultural export earnings have declined. Unfavourable developments, especially in Europe, and the global economic slowdown could affect export demand and export prices. Therefore, the advantage in reduced oil prices may be offset by lesser earnings from exports.

Volatile oil prices

Therefore the favourable developments require to be treated cautiously, as they have their downsides and could generate exaggerated expectations. Oil prices are basically volatile. While the current European political changes and disruptions have reduced international demand for oil, there could be supply factors that could affect oil prices adversely. The Iranian oil embargo and turmoil in the Middle East could reduce the supply of oil, if the region becomes unstable. Even the expectation of such a curtailment could lead to speculation that could increase oil prices once again.

As an oil-consuming country that is significantly affected by oil prices, domestic policies should not be based on optimistic expectations of oil price decreases. Currently oil expenditure constitutes 25 per cent of import expenditure and any increase in prices of oil would have an adverse impact on the trade balance. The tariff increases and efforts at conservation of oil consumption especially by the reduction of electricity consumption have been useful measures. If the impending monsoon is a full blown one there is a possibility of reducing thermal electricity generation to reduce oil use. This is anyone's guess and everyone's hope.

It is the extent of oil imports and other intermediate imports that would have a significant impact on the trade balance. While consumer imports that at most contribute 20 percent of import expenditure have declined and may be reduced even more, intermediate import expenditure has increased in the first two months of the year by as much as 22 percent. It is the reduction of these imports that will have a beneficial impact on the trade balance.

Similarly investment goods imports must be curtailed. These have been increasing in recent years and in the first two months increased by as much as 57 percent. These imports include building materials, machinery and transport equipment. However important they may be seen for the country's long-term development, they could be too costly in the short term and could destabilise the economy. Therefore, a reduction in such expenditure so as to reduce imports is necessary in the interests of the balance of payments. Economic stability in the short term is a precondition for economic growth in the long run.

International developments are not favourable for exports. Already we have seen a poor performance in exports. Industrial exports have grown only marginally and the country's main export textiles and garments appear to be on a downtrend. Import demand in the US and the EU counties is not propitious. Garment export earnings increased by only1.5 percent indicating a slowing down of demand in the country's main export markets of the US and EU countries. This slackening of demand is likely as decreasing industrial exports have been experienced by other Asian countries as well.

Export earnings of tea declined by 10 per cent to US$ 69.8m in the first quarter of this year, compared to the same period last year. The quantity of tea exports declined by 2 per cent during the first quarter but owing to the depreciation of the rupee, earnings remained the same in terms of rupees, as in the first quarter of last year.

The poor performance in the country's two main exports of garments and tea means that export earnings could be much lower than expected. Consequently the trade deficit is likely to increase unless there is a significant fall in imports. In any event, it is the reduction of imports that matter as import expenditures are running at nearly twice that of export earnings.

Earnings from services

Much of the optimism about the balance of payments is based on higher earnings from services and larger capital inflows. There is every possibility of an increase in earnings from tourists as the trend of increased tourist arrivals is likely to increase.

The arrival of a million tourists this year is expected to bring in about US$ 1.2 billion. It is important, however, to ensure that no untoward incidents occur, that there is peace and law and order. The new tourist visa tax is also expected to bring in about a billion US dollars. Foreign investment except for the construction of hotels has been little. Therefore the expectation of Foreign Direct investment of US$ 2 billion may not be realised.

It is most likely that there would be a balance of payments deficit that would have to be met by foreign borrowing or reduction of reserves. In the current context foreign borrowing is likely to be costly. It is therefore imperative that imports be curtailed. It is not only consumer imports that should be reduced, intermediate imports and investment goods imports require to be reduced in order to make a significant reduction in the trade deficit.

Food for thought

Asian Development Bank (ADB) President Haruhiko Kuroda summed up the global situation succinctly when he said "downside risks force us to be cautious in our optimism. The biggest risk to the outlook is the potential spillover from Europe, should the region hit a financial tripwire and fall into deep recession. Caution is also called for commodity prices. Destabilization in oil producing countries casts uncertainty over oil prices."

He described developing Asia as resilient to external financial shocks as "many of them have current account surpluses, low external debt and high foreign reserves," -- characteristics Sri Lanka is woefully lacking.

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