Global economic crisis:

Challenges before Sri Lanka

The Asian Development Bank (ADB) in a recent discussion paper titled The impact of the global economic slowdown on South Asia discusses the effects of the current global economic environment and the problems in the domestic economy which have been evident since early 2008.

It also focuses on Government measures to alleviate the economic pressures and finally study possible upcoming challenges for policy-makers.

The Sri Lankan economy has experienced stable economic growth in the past five years, averaging about 6.3 per cent annually.

The year 2008 has been a remarkably critical year for Sri Lankans. The country has faced two crises in the same year.

The Sri Lankan economy has been indirectly affected by the global downturn. The Central Bank imposes capital controls on the inflow of short-term volatile capital and this has resulted in a relatively low stock of foreign-owned portfolio capital in Sri Lanka’s equity market.

Inflationary pressures: Inflationary pressures dominated economic policy in the first half of 2008, with inflation accelerating to 28 per cent. While inflation began to ease in 2008, inflationary expectations remain high.

Acute shortage of foreign reserves: The Central Bank was being active in the foreign exchange market during March to November 2008 to prevent the Rupee from depreciating. Coupled with a widening trade balance due to the high oil import bill in the beginning of the year, gross official reserves have been falling. Total official US Dollar reserves have declined from US$3.5bn in July 08 to US$2.0bn in November 2008. The figure is only a little over 1.5 months of import financing.

External borrowing requirement: Raising external funds in the environment may prove to be difficult and there is a possibility of the country seeking IMF help in this regard although such a situation has not occurred.

Conflict: The conflict in northern Sri Lanka has also escalated as the military intensified its campaign against the LTTE.

The impact of the crisis: The main transmission mechanisms of the effects of the crisis to the Sri Lankan economy are summarized in the following Table.

Exports: marked slowdown

Key exports from Sri Lanka include textiles, tea and other minor agricultural products like rubber and coconut. Textiles constitute 45 per cent of total exports and tea constitutes about 17 per cent of the total. Latest data from November 2008 show exports growing at 11.1%. However, the underlying trend as measured by the three month moving average of export growth shows that exports have been performing poorly.

The textile export industry of Sri Lanka has so far withstood the demand slowdown in the G7 markets as has been the case in Bangladesh and India.

Summary: Main Channels of Impact

Transmission Mechanism Assessment

Trade

*Tea and apparel form the bulk of Sri Lankanexports and latest data suggests that anexternal demand slowdown in these commoditiesis looming.

*A poorly diversified export destinationbase increases the risk of the impact onexports.

*The external demand shrinkage of apparelimporters in the G7 is more likely to impactSri Lanka than its neighbours.

Remittances

*A slowing of economic activity in theMiddle East which is the main market foroverseas workers will likely slow the demandfor overseas Sri Lankan workers and transfersback to Sri Lankan households.

Tourism

*A decline in consumption in the G7 andadverse socio-political conditions in thecountry will substantially hurt touristinflows.

External borrowing

*Deteriorating foreign reserves andunfriendly external market conditions willboth create difficulties for the governmentto finance its fiscal balance which hasbecome reliant on external financing.

On the other hand tea, exports appear to have a more elastic demand in the export markets. Tea exports have been volatile and the three month average shows a sharp fall in the second half of 2008 while textile exports have been holding up. In terms of export destinations, about 41 per cent of textiles and garments exports reached the United States, 27 per cent were exported to the United Kingdom and 23 per cent to the other European countries.

These together formed 91 per cent of the exports. Beside textiles and tea, other sectors such as rubber and minor agricultural commodities also showed a decline in November 2008 on the back of lower commodity prices and lower orders. The data for the coming months will be a better indicator of the total impact of the global downturn on Sri Lankan exports. However, we believe that Sri Lankan exporters are at a greater risk that its counterparts in other countries, for reasons discussed below.

Tougher times ahead for exporters

The risk of textile exporters’ orders being cut is more probable for Sri Lanka than India and Bangladesh because the Sri Lankan garment exports industry faces increased challenges.

There is a serious shortage of skilled labour which is driving labour costs up. Labour costs of unskilled labour are also becoming impractically high for exporters operating in a highly competitive market.

Higher labour costs have already forced some garment factories in the country to shut down or downscale. According to the chairman of the Joint Apparel Association Forum, the industry is facing a brain drain with the loss of middle level management staff going to other countries to work. Sinotex, which is among the oldest apparel manufacturers in the country shut down its operations in January 2008.

As more operations shut down, we should also see consolidation within the industry as smaller manufacturers are driven out or bought over by larger exporters.

Remittances: impact not yet transmitted

The ratio of remittances to GDP for Sri Lanka is over 7.8 per cent which is more than India’s (2.3 per cent) but less than Bangladesh’s (9.7 per cent). Hence, a sharp weakening in remittances would significantly affect domestic demand and the current account balance.

As of 2007, more than 50 per cent of the country’s remittances originated from the Middle East and about 22 per cent from North America and Europe. Sri Lanka, like Bangladesh, offers cheap unskilled labour for work in oil rigs and construction sites in these countries.

Sri Lankan workers are also popular in South Asia and South East Asia as household help but this forms only a small part of the total remittance flow. As mentioned earlier, the need for employment is directly linked to oil prices which have been weakening in the past few months and could limit employment needs in the Middle Eastern corporations.

So far, though, remittance flows have held up, amounting to US$2.7bn in January to November 2008 and growing by 17.4 per cent compared to 15.0 per cent in the same period in 2007. To encourage workers to send more money home, the Sri Lankan Government has offered higher interest rates of overseas worker accounts.

Tourism: poor growth through 2009 Sri Lanka has been an attractive destination for tourism for many years. Tourism receipts form 1.5 per cent of the country’s GDP compared to 0.1 per cent for Bangladesh and 1.1 per cent for India as of 2006.

But with restrained luxury spending in the G7 market and the conflict attracting more news coverage in tourism markets, there are considerable risks to tourism prospects in the country.

There has been a steady decline in tourist inflows into the country since the beginning of 2008. Total room occupancy rates have also declined since January 2008. Marketing the country’s tourism industry abroad could be a useful policy option to attract newer markets within Asia.

External borrowing: approaching unsustainability: Sri Lanka’s external borrowing to GDP ratio is at 38 per cent. This would imply that the Government needs about US$500 million of external financing each year. This short term borrowing has been built up through the Treasury Bills and Treasury Bonds market which was partially opened to foreign investment in 2007. However, funding conditions have deteriorated in recent months:

Syndicated loan failed: Sri Lanka failed to attract foreign investors for a syndicated loan which was announced in October 2008. Earlier the Central Bank had sold a US$500 million debut sovereign bond in October 2007 and raised about US$300 million from a syndicated loan in March 2008.

Withdrawal by foreign investors: As a part of the global deleveraging process foreigners have been withdrawing their investments in the T-Bills and T-Bonds.

Poor foreign exchange reserve management: The Sri Lankan Rupee is a soft peg currency, requiring periodic government intervention. To prevent the depreciation of the Rupee the Central Bank intervened in the foreign exchange market by selling its US Dollars to purchase the Rupee, resulting in a decline in foreign exchange reserves. Later, the Central Bank noted that it will be more flexible on exchange rate policy and has allowed the currency to depreciate to 114.04 LKR/USD as of January 2009.

Currency downgrade: Recently, S&P has downgraded Sri Lanka’s foreign currency risk from B+ to B.

How resilient will Sri Lanka be?

Despite the unpleasant economic and political conditions prevalent in Sri Lanka, there are some areas which are performing relatively better and could support the negatives from the global slowdown.

Financial sector: somewhat resilient despite capital outflows

The Sri Lankan economy has been mainly indirectly affected by the global downturn.

The Central Bank imposes capital controls on the inflow of short-term volatile capital and this has resulted in a relatively low stock of foreign-owned portfolio capital in Sri Lanka’s equity market.

The banking industry is also negligibly exposed to international banks and sub-prime assets.

Capital controls have been eased in the last two years with total Net Portfolio Investment in 2007 amounting to US$101 million, almost double the US$51 million in 2006. In 2008, portfolio investors exited their positions in the equity market.

We believe that the worst of the capital outflows has now passed and expect a better outlook for the stock market, especially if military progress in the northern conflict produces a sustainable resolution of that conflict.

External Account improvement despite slowing exports and transfers: A high import bill in 2008 due to high oil prices in the beginning of the year is likely to widen the Current Account Deficit in 2008.

But as oil prices have now receded, the burden on the trade deficit is also likely to ease allowing for a narrowing of the current account deficit in 2009. Some concerns regarding possible sluggishness in remittance flows and falling tourism income pose further threats to the current account deficit. But unless there is a sudden and unexpected slowdown in tourism or remittances, the net effect on the current account should be positive.

Domestic economy: panic has abated

The painful period of high inflation is now in the past and the domestic economy is more suited to tackle a slowing external environment. The main areas of growth in the domestic economy are in:

Agriculture: A bumper harvest in 2008 will allow for surplus which could be exported in 2009 for potatoes, onions and chillies. Also lands in the North which have been out of bounds will now be open for agricultural use.

Fisheries: Fishing is currently limited in Sri Lanka but as the Government is becoming more interested in fisheries as a revenue earner the prospects for the industry are growing.

In the Government news portal it says that the Government will allow fisherman from any part of the country to fish in the Northern and Eastern coasts. The government has also said that it will take action in creating the infrastructural requirements like harbours and ferries to support the industry.

Inflation: still uncomfortably high: While inflation has eased, inflationary risks remain. The inflation rate has been rising since 2005 when the Government eased monetary and fiscal policies.

Average reserve money growth for 2007 was 16.1 per cent, which raised inflationary pressures considerably. Sri Lanka began 2008 with uncontrollably high inflation at 21.9 per cent in January 2008 and this went on to cross 28 per cent later in the year. The deceleration in inflation since then has been mainly due to the fall in oil prices.

Nevertheless, inflationary risks remain given current loose monetary conditions that prevailed until recently. M2 has been growing by over 16 per cent per year since 2004. The latest monetary aggregate data however shows a drastic fall in M2 from 15.8 per cent in January 2008 to 7.3 per cent in December 2009. Policy-makers should perhaps focus greater attention on the impact of current monetary conditions on future inflation.

Policy response

The Government policy has focused on a pro-active response to the risk that slowing external demand will hurt the economy rather than on the risks of future inflation.

Monetary measures

The Central Bank has signalled a period of monetary easing in 2009 after monetary tightening was used to address high inflation in 2008. The penal rate charged on reverse repurchase transactions was cut by 200 basis points on January 12, 2008 and 50 basis points on February 11, 2008. The repo and the reverse repo rates have also been lowered by 25 basis points each to 10.25 per cent and 11.75 per cent on 11th Feb 08. These are the first such reductions since October 2003 reflecting the Central Bank’s switched focus on growth.

Stimulus measures

The Government introduced a stimulus package directly targeting supply side dynamics to improve market conditions. The package includes:

Easing fuel prices: The Government is pro-actively passing on falling global oil prices to consumers. This will help bring inflation down to single digits in 2009. The reduced subsidy burden will alleviate the fiscal balance and ease Government financing ability.

Export incentives: Aware of the brewing problems among exporters, the government included a 15 per cent reduction on surcharge in certain industries like leather, rubber and tourism.

Tea industry:The Government has introduced special incentives for the tea industry which range from better loan access, minimum price purchases and exemptions on loans for modernizing factories.

More flexibility on the currency: The Government has also promised that it will be more flexible on the currency and this is noticeable in the gradual depreciation in the last few months.

Augmenting remittances to support external financing: As foreign investors are pulling out their monies, the Government is now looking toward overseas Sri Lankans to assist with the external financing. The Central Bank is hoping to raise US$ 500 million through remittances.

The Central Bank will maintain a sinking fund for Diasporas’ investments in T-Bills and T-Bonds to boost the confidence of investors and said it will facilitate the withdrawal of investments when required. The investors will have the option to invest in any currency and withdraw in the same currency.

The Central Bank has also assured prospective investors that the interest on these securities will be higher than in most advanced economies even if the Rupee depreciates further.

The outcome of the diasporas bonds will only be known in the coming months. However, we believe that there is some weakness in this plan.

Remittances may fall short of target: Since the diaspora bonds project the current levels of remittances to continue, there is a worry of the remittances failing their target as the slowdown hits Middle Eastern economies.

Need for remittances to fund household consumption: During tougher times overseas workers are less likely to lock their earnings into bonds but more liable to transfer their income to their family which may be in the pressing need for cash.

The success of using diaspora bonds to finance the external debt will only be known in the coming months and if the reaction is positive, this could be a viable tool for the future.