While the near term economic environment of Sri Lanka doesn’t look very promising and more challenging than it has ever been so far, the country is very unfortunate that all factors affecting its growth are expected to converge next year, a prominent report reveals. The Institute of Policy Studies last week published its report on [...]

Business Times

Challenging times ahead for Sri Lanka’s economy next year


While the near term economic environment of Sri Lanka doesn’t look very promising and more challenging than it has ever been so far, the country is very unfortunate that all factors affecting its growth are expected to converge next year, a prominent report reveals.

The Institute of Policy Studies last week published its report on ‘Sri Lanka: State of the Economy 2018’. The institute’s Executive Director, Dr. Dushni Weerakoon explained the status of the country going forward in summary.

The macroeconomic fundamentals of Sri Lanka are much sound today than they were couple of years back, but the economy faces significant threats and rising risks, said Dr. Weerakoon. “Looking at the positives in the last 18-24 months, we have greater public finances, more prudent management of monetary and exchange rate policy within the constraints that Sri Lanka currently faces. In terms of performance outcomes there is a turnaround in key sectors of exports and foreign direct investments (FDI’s),” she added.

She stated that on the side of risks there is growth, rising debts and currency turmoil. Fiscal outcomes are in much better shape. Deficit has been shrinking. Estimates for the year 2018, the first half suggests that the fiscal deficit is within the target set for the year slightly under 5 per cent of GDP. Monetary policy has also been effective from attaining credit growth and inflation in the economy credit growth is now under 15 per cent and annual inflation is under 5 per cent.

Management of the exchange rate policy is an area of some controversy, but there has been a qualitative improvement. Official reserves have accumulated. The Central Bank has been a net purchaser in 2017 and into the first quarter of this year building up Sri Lanka’s non-borrowed reserves. There has been a qualitative improvement and a calamity exchange rate to gradually adjust to market fundamentals.

The report shows that there has been a turnaround in exports last year which is continuing into the first half of this year. Export earnings have grown by 6.5 per cent. There has been a turnaround in FDI’s as well. But growth is sluggish, growth is still under 4 per cent for the sixth consecutive quarter and worryingly Sri Lanka is still continuing to build up its outstanding stock of external debt while debt accumulation is accelerating rather than decelerating.

In the 2017 State of the Economy report it was argued that external developments remain most critical for economic stability and growth and that the Sri Lankan economy faces elevated vulnerability to exogenous shocks. “The manifestation of those vulnerabilities were long expected and now a reality is that we are seeing a change in global financial markets.” Decisive interest rates have increased in the US. This means that US monetary policy becomes tighter and there isn’t comparable adjustments in other advanced economies. The dollar strengthens and emerging markets like Sri Lanka are hit through the increase in US interest rates and the appreciation of the US dollar.

In a nutshell Sri Lanka relies excessively on foreign capital finance investments under favourable external financial conditions. Now those conditions are unwinding and the country is feeling the disruptions primarily in the form of a depreciating currency. The immediate proximate causes for the Sri Lankan rupee to come under pressure was a combination of imports increasing as a result of tax adjustments and adjustments to international fuel prices in the first six months of this year. Import expenditure on vehicles went up by 120 per cent while import expenditure on oil went up by 30 per cent. Therefore the trade imbalance widened and Sri Lanka started to see an outflow of foreign investors from the country’s treasury bills and bonds market from around April this year. Given the fact that Sri Lanka’s foreign exchange market is thin, any one of these factors could have exerted pressure on the currency but in combination all these have meant significant pressure on the rupee, stressed Dr. Weerakoon.

“It is not only confined to Sri Lanka but other countries in the region have also seen a sharp depreciation in the South Asian and South East Asian region. The Indian rupee has depreciated much more than Sri Lankan rupee, but the economy wide impacts of depreciation to the Sri Lankan Rupee is slightly far more on the Sri Lankan economy simply because we hold a large stock of external debt.” Sri Lanka’s total external debt at the end of 2017 was 60 per cent of GDP, 36 per cent of which was in the form of foreign public debt, about 3 per cent of the GDP of foreign debt is held by the Central Bank and 21 per cent of foreign debt is held by Sri Lanka’s corporates and state owned enterprises.

“What is the possible policy response? An area subjected to lot of discussion whether the Central Bank should be defending the rupee. Simply said you can delay depreciation by using the reserves, but markets will often force a sharp devaluation. It is almost a conclusion given the limited reserves that the Central Bank holds and that forced devaluation is often a very sharp one and is better avoided. The same happened in 2015, 2012, 2008 and 2001,” she explained.

Looking at the reserves position, Sri Lanka had US$10 billion official reserves in April this year and now it’s down to $7.2 billion, the same volume of reserve Sri Lanka had a year ago in September 2017. More importantly the import cover of reserves has dropped from 5.5 months to 4 months. The daily threshold is about three months of import cover. There is very limited room for the Central Bank to use this reserve to defend the currency even if it wished to do so, she noted.

There are some limited time-bomb interventions that can be adopted and Sri Lanka has already adopted some of them. Attempts to curb non-essential luxury imports, try and encourage exporters to repatriate their earnings. One policy tool that has been considered is temporary controls on capital outflows. This will remain somewhat of a hypothetical option for the simple reason that Sri Lanka needs to keep going to international capital markets from 2018 onwards to settle the large outstanding external debt. What is on ground is only the international sovereign bonds and the syndicated loans. “If Sri Lanka is to refinance some of the outstanding foreign debt, the country needs to keep going into capital markets and retaining foreign investor confidence and one critical area is that you must have a fiscally sustainable regime in place,” emphasized Dr. Weerakoon.

She said: “Looking at the near term it is clear that the economic environment is going to be more challenging than it’s been so far. On the external front, the global economic outlook is dimming as a result of the escalating tradeoffs as well as the surge in debt, particularly private debt. US monetary policies are likely to tighten further and oil prices are set to climb further. Sri Lanka will also be borrowing in order to settle debt outstanding in 2019, 2020 and 2021.”

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