Economy resilient in 2009
Summary of the Central Bank Annual Report for 2009:
Section 35 of the Monetary Law Act requires
the Monetary Board of the Central Bank of Sri Lanka (CBSL) to submit a
report giving details of the state of the economy, the condition of the
Central Bank and the policies and measures adopted by the Monetary Board
during the year to the Minister in charge of the subject of Finance
within four months of the commencement of the following year. The 60th
annual report of the Monetary Board was submitted to the President on
Monday. Following are some of the highlights of the report.
The economy of Sri Lanka demonstrated its resilience by growing at
3.5 per cent in 2009 amidst challenging domestic and external
conditions.
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The Central Bank Annual Report 2009
was handed over to President Mahinda Rajapaksa by Central
Bank Governor Ajith Nivard Cabraal at the Central Bank
Auditorium on Monday. Minister Ranjith Siyambalapitiya,
Secretary to the President Lalith Weeratunga and Finance
Ministry Secretary Dr. P. B. Jayasundara were also present.
Picture by Sudath Silva |
This remarkable performance was largely due to the steady recovery in
the economy since the second quarter of the year, resulting in a notable
growth of 6.2 per cent in the final quarter.
On the external front, Sri Lanka continued to be impacted by the
spill-over effects of the global financial and economic crises, while
domestically, the conflict, which had ravaged the country for almost
three decades reached a critical juncture during the early part of the
year.
The sudden withdrawal of short-term capital by foreign investors
resulting from adverse global conditions placed an enormous strain on
the country’s foreign reserves and the management of liquidity.
The slump in global demand and the consequent contraction in external
trade as well as the slowdown in domestic economic activity had a
negative impact on government revenue.
In addition, higher government expenditure on defence, interest
payments, salaries and wages as well as the continued expenditure on
urgent resettlement, rehabilitation and reconstruction (RRR) activities
exerted a heavy burden on government finances.
Despite these unprecedented challenges, the country made an
extraordinary recovery in the second half of the year. The end to the
prolonged conflict and the coordinated and timely policy actions of CBSL
and the government, including the securing of the Stand-by Arrangement
(SBA) from the International Monetary Fund (IMF) and measures taken to
preserve financial system stability, were instrumental in turning around
the domestic economy.
Enhanced investor confidence in the economy saw a sharp reversal in
foreign financial flows helping the country to record an unprecedented
surplus in the balance of payments (BOP) of US dollars 2.7 billion by
end 2009 and raising foreign exchange reserves from a low level of US
dollars 1.1 billion in March 2009 to a historic high of US dollars 5.1
billion by end 2009.
A notable achievement in 2009 was the sharp deceleration in
inflation, a result of the stringent monetary policy measures adopted by
CBSL over the last two years and the significant decline in global
commodity prices.
Inflation, as measured by the year-on-year change in the Colombo
Consumers’ Price Index (CCPI), which reached 28.2 per cent in June 2008,
declined sharply to 4.8 per cent by end 2009, recording an average rate
of 3.4 per cent in 2009, the lowest since 1985.
This enabled CBSL to relax its monetary policy stance to support the
domestic economy, which was affected by the global economic downturn.
The Penal rate of interest applicable on reverse repurchase (reverse
repo) transactions with CBSL when participating institutions exceeded
their monthly quota, which served as an effective ceiling for interbank
interest rates was reduced gradually from 19 per cent in January 2009
and was harmonised with the Reverse Repo rate in May 2009.
Further, Repo and Reverse Repo rates were brought down in several
steps to 7.5 per cent and 9.75 per cent, respectively.
In response to the significant reduction in policy interest rates,
there was a substantial downward adjustment of market interest rates
across the term structure, albeit with a time lag. However, the demand
for credit from the private sector remained subdued largely due to the
sluggish recovery in the domestic and the global economies as well as
the cautious approach to lending by banks.
However, monetary growth, which remained subdued during the first
half of the year, began to increase during the second half with the
unprecedented expansion in net foreign assets (NFA).
The policy action of CBSL, supported by the government, successfully
mitigated the contagion of the global financial crisis and the failure
of a few entities connected to certain domestic financial institutions.
The strong regulatory and supervisory framework and enhanced risk
management systems that have been put in place over time enabled the
financial system to withstand the shocks from the external and domestic
fronts and maintain confidence in the financial system.
However, the spill-over effects of the global economic downturn on
the domestic economy posed a challenge for banks and other financial
institutions. In this challenging environment, financial institutions
remained profitable and reasonably well capitalised, although credit
risk increased due to tight market conditions.
The impact of the challenging domestic and global environment
resulted in an overall setback in fiscal operations in 2009. Despite
several revenue measures introduced during the year, there was a
significant shortfall in revenue due to the slowdown in economic
activities and the contraction in imports.
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The Finance
Ministry overlooking the commmercial hub |
In addition, government expenditure increased due to higher security
related spending during the decisive phase of the conflict and continued
urgent RRR activities in the second half of the year, as well as
increased salaries and wages, interest payments and expenditure on
continuing public investment projects.
Accordingly, the budget deficit widened to 9.8 per cent of GDP in
2009 compared to the revised target of 7.0 per cent leading to an
increase in the borrowing requirement.
In financing the deficit, greater reliance was placed on domestic
sources during the early part of 2009. However, the availability of
foreign financing during the latter part of the year enabled the
settlement of some high cost domestic debt.
The higher financing requirement together with lower growth in
nominal GDP led to an increase in the debt to GDP ratio, reversing the
declining trend observed in the recent past.
Real sector developments
The economy grew by 3.5 per cent, in real terms, in 2009, a
commendable achievement in spite of a number of external and domestic
shocks. The economy recovered strongly to record a notable 6.2 per cent
growth in the fourth quarter from 1.6 per cent in the first quarter.
The impact of adverse global developments that affected almost all
sectors of the economy at varying levels, and unfavourable domestic
weather conditions that lowered agricultural output were the main causes
for the lower growth rates in the first quarter.
However, since the second quarter, growth has rebounded driven by the
end to the conflict and the gradual recovery of the global economy.
In 2009, all major sectors of the economy contributed positively to
economic growth. The Agriculture sector recorded a low growth of 3.2 per
cent compared to a high growth of 7.5 per cent in 2008, mainly owing to
the contraction in the output of tea and paddy.
However, within the Agriculture sector, the fisheries sub-sector
performed well recording a 6.9 per cent growth driven by increased
coastal fishing with the relaxation of security restrictions.
While tea production was adversely affected by the drought in the
major tea planting districts in the early part of the year, paddy
production in the Yala season was severely affected as a result of the
delay in the monsoon.
Coconut production in 2009 declined largely owing to the lagged
effect of the unfavourable weather conditions that prevailed during the
previous year.
Sugar production also declined during the year due to the decline in
sugar cane supply on account of adverse weather conditions.
Nevertheless, the healthy performances of several sub-sectors, such
as rubber, other field crops mainly maize and big onions, fisheries and
livestock, helped maintain a moderate growth in the Agriculture sector
in 2009.
The Industry sector slowed down registering a growth rate of 4.2 per
cent compared to a growth of 5.9 per cent in 2008.
All sub-sectors of the Industry sector, except for electricity, gas
and water, recorded low growth rates compared to the previous year,
largely as a result of the fall in demand in both international and
domestic markets.
The output of textile, wearing apparel and leather products, rubber
based products and other export market based products recorded a low
growth in 2009. However, major players in the textile, wearing apparel
and leather products category continued to maintain their
competitiveness by supplying high quality and high valued products.
Small and medium scale manufacturers were affected by the low demand
in both export and domestic markets and the increase in the cost of
production. Lower growth in disposable income and subdued performance in
the construction sub-sector contributed towards the low demand for
domestic market oriented industries.
However, the food, beverages and tobacco products category was able
to maintain its growth momentum in 2009 as a result of access to new
markets in the Northern and the Eastern provinces and the revival of
tourism, including domestic tourism, during the second half of the year.
The Services sector grew by 3.3 per cent in 2009 contributing 55 per
cent to the overall economic growth.
The wholesale and retail trade sub-sector, which is the largest
contributor to the Services sector, registered a sluggish performance,
mainly reflecting the contraction in import and export trade.
The transport and communication sub-sector also slowed down
considerably due to the low growth in telecommunication services and
cargo handling. The hotels and restaurants sub-sector recovered strongly
compared to the set-back it faced in 2008, due to the end of conflict
and the expansion in both local and foreign tourist activities.
Meanwhile, the banking, insurance and real estate sub-sector grew
moderately due to the slowdown in domestic economic activity.
In 2009, total investments of the country declined, while the savings
and investment gap narrowed. Private investment declined significantly
to 17.9 per cent of GDP from 21.1 per cent in the previous year, while
public investment increased marginally to 6.6 per cent. As a result,
total investment as a percentage of GDP declined to 24.5 in 2009 from
27.6 in 2008.
Meanwhile, national savings increased to 23.9 per cent of GDP from
17.8 per cent in the previous year.
The decline in investments coupled with the significant increase in
national savings narrowed the savings-investment gap to 0.7 per cent of
GDP in 2009 from 9.8 per cent in 2008, reflecting the significant
contraction in the current account deficit of the BOP.
The slowdown in domestic economic activity resulted in a marginal
increase in the unemployment rate (excluding the Northern Province), to
5.8 per cent in 2009 from 5.4 per cent in 2008.
External sector developments
The external sector recovered strongly during 2009 amidst a
challenging global economic environment. The external sector position
deteriorated from the latter part of 2008 until the end of the first
quarter of 2009.
The sharp outflow of foreign investment, the non-rollover of
short-term debt, drying up of new commercial financing and higher
petroleum bills were the main reasons for this downturn.
Amidst the challenging domestic and external environment, gross
official reserves declined to a low level by end March 2009.
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The Central
Bank |
However, with the end to the conflict and improved investor
confidence, the external sector rebounded strongly, recording the
highest ever level of reserves by end of the year.
External trade, which contracted in 2009 due to the impact of the
global economic crisis, improved towards the latter part of the year.
Earnings from exports declined by 12.7 per cent, led by lower demand
for industrial exports, while expenditure on imports declined by 27.6
per cent, mainly due to the substantially lower expenditure on petroleum
and fertilizer imports.
Accordingly, the trade deficit contracted by 47.8 per cent to US
dollars 3,122 million in 2009 compared to the 63.6 per cent expansion in
2008 to US dollars 5,981 million, reflecting a significantly larger
reduction in import expenditure in 2009 relative to the decline in
export earnings.
The current account of the BOP improved remarkably due to the lower
trade deficit and increase in migrant workers’ remittances. In spite of
the sluggish growth in the first quarter of the year, workers’
remittances grew by 14.1 per cent to US dollars 3,330 million in 2009.
The current account, which recorded a surplus of US dollars 339
million for the first nine months of the year, turned around to record a
deficit of US dollars 214 million due to the increase in the trade
deficit during the last quarter of 2009.
The current account deficit was US dollars 3,886 million in 2008. As
a percentage of GDP, the current account deficit narrowed substantially
from 9.5 per cent in 2008 to a marginal level of 0.5 per cent in 2009.
The inflows to the capital and financial account increased
substantially during the second half of the year.
As a result of these developments, the overall BOP, which was a
deficit of US dollars 1,385 million in 2008, recorded an unprecedented
surplus of US dollars 2,725 million in 2009. The BOP recorded a deficit
of US dollars 688 million by end of the first quarter of 2009.
However, it improved to record a surplus from the second quarter of
the year in response to measures taken by CBSL, which was further
reinforced by improved investor confidence with the ending of prolonged
conflict and the approval of the IMF-SBA facility of Special Drawing
Rights (SDR) 1.65 billion (US dollars 2.6 billion) as BOP support.
The first two tranches of the SBA facility amounting to US dollars
652 million and the SDR allocations by IMF of US dollars 508 million
were received during the second half of the year.
Accordingly, the total external official reserves, excluding Asian
Clearing Union (ACU) receipts, rose to its highest ever level of US
dollars 5,097 million by end 2009 compared to US dollars 1,594 million
at end 2008, which was sufficient to cover 6 months of imports compared
to 1.4 months of imports in 2008.
Fiscal Sector Developments
The fiscal sector came under severe stress in 2009 as in many other
countries, resulting in a significant deviation from the original fiscal
targets. According to Budget 2009, the overall budget deficit was
expected to reduce to 5.9 per cent of GDP after grants.
However, with the subsequent developments in the domestic as well as
the external fronts, the budgetary estimates were revised, targeting an
overall deficit of 7.0 per cent of GDP. During the first half of 2009,
there was a severe strain on fiscal operations mainly due to the lower
growth in government revenue as a result of the slowdown in domestic
economic activity and the contraction of imports reflecting the adverse
impact of the global economic crisis.
Meanwhile, the intensified security situation, urgent RRR activities
in the Northern and the Eastern provinces and increased interest
payments, while continuing expenditure on the public investment
programme, raised government expenditure.
During the second half of the year, the positive impact of the ending
of the conflict in May 2009 and the rebound in domestic economic
activity in line with the gradual recovery in the global economy eased
fiscal operations to some extent, with the overall budget deficit
recording 9.8 per cent of GDP in 2009.
The high deficit was a combined outcome of a shortfall in revenue,
overrun in recurrent expenditure and increased expenditure on
infrastructure projects. The government revenue was significantly below
the targeted level.
The total revenue as a percentage of GDP declined to 14.6 per cent in
2009 compared to 14.9 per cent in 2008 and 16.3 per cent in 2006.
Meanwhile, total expenditure and net lending increased to 24.9 per
cent of GDP, compared to that of 22.6 per cent in 2008 and 24.3 per cent
in 2006.
Recurrent expenditure increased significantly, as a percentage of GDP
to 18.2 per cent from 16.9 per cent in 2008. Public investment increased
to an encouraging level of 6.8 per cent of GDP in 2009 compared to 6.0
per cent in the previous year.
In financing the deficit, the government raised more funds from
domestic sources during the early part of 2009 and from foreign sources
during the latter part of the year.
The increased borrowing requirement and the tight liquidity
conditions in the international capital markets led the government to
depend heavily on domestic borrowings during first half of the year.
However, the significant increase in foreign investments in
government securities and the receipt of proceeds from the international
sovereign bond during the second half of the year enabled the government
to retire a large amount of Treasury bills held by CBSL.
As a result, total borrowing from the banking sector declined to Rs.
49 billion by end 2009 compared to Rs. 189.6 billion at end July 2009.
Total net domestic financing in 2009 amounted to 5 per cent of GDP
while net foreign financing was 4.8 per cent of GDP, which consisted of
foreign loans (1.8 per cent of GDP) and foreign investments in
government securities (3.0 per cent of GDP).
Meanwhile, the outstanding government debt to GDP ratio increased
slightly to 86.2 per cent in 2009 mainly reflecting the higher budget
deficit and the lower growth in nominal GDP.
Monetary sector developments
CBSL relaxed its monetary policy stance in 2009 to support domestic
economic activity. Accordingly, the Penal interest rate applicable on
reverse repo transactions when participating institutions exceeded the
maximum number of times they could access the reverse repo window, which
was introduced in November 2007, was reduced gradually and harmonised
with the Reverse Repo rate in May 2009.
At the same time, restrictions on access to Central Bank’s repo and
the reverse repo facilities were also removed, thus re-establishing the
interest rate corridor.
The Central Bank’s policy interest rates were also gradually reduced
during the year: the Repo rate was reduced by 300 basis points to 7.50
per cent and the Reverse Repo rate was reduced by 225 basis points to
9.75 per cent. In addition, margin deposit requirements that were
imposed to restrict the demand for credit for certain categories of
vehicle and non-essential imports, were removed during the first half of
the year, to ease credit conditions. CBSL took timely and appropriate
measures to manage rupee liquidity in the market. The continued capital
outflows during the first quarter of the year necessitated CBSL to
supply foreign currency to the market resulting in a drain in rupee
liquidity from the market.
CBSL lowered the Statutory Reserve Ratio (SRR) by a further 75 basis
points to 7 per cent in February 2009, following the reduction in the
SRR imposed on all rupee deposits of commercial banks by 225 basis
points in the last quarter of 2008 releasing about Rs 9 billion to the
market.
In addition, CBSL purchased Treasury bills from the primary market,
while also engaging in reverse repo transactions to enhance rupee
liquidity. CBSL also removed the restriction on access to reverse repo
standing facility by market participants in 2009.
However, since June 2009, there has been a turnaround in liquidity,
posing a challenge to managing the surplus. Renewed investor confidence
with the end to the conflict and the securing of the SBA facility from
IMF substantially increased foreign investments in government securities
from May 2009 onwards. The proceeds of these inflows were purchased by
CBSL to stabilise the foreign exchange market and to build official
reserves.
The resulting increase in rupee liquidity in the market was absorbed
through the Central Bank’s open market operations (OMO), thus leading to
a significant reduction in the Central Bank’s holdings of government
securities necessitating the use of alternative instruments to conduct
OMO.
Accordingly, Central Bank Securities were issued to absorb liquidity
on overnight basis and term basis from October 2009.
In addition, CBSL commenced foreign exchange swap transactions as an
additional instrument for absorbing liquidity from November 2009.
The targets for monetary aggregates, which were initially set out in
the Monetary Programme for 2009 and announced in the Central Bank’s
‘Road Map: Monetary and Financial Sector Policies for 2009 and beyond’
(Road Map) were subsequently revised downward. The reduction in the SRR,
the rapid decline in inflation and the slowdown in the domestic economy
were the main factors that warranted this downward revision.
Accordingly, the target for the growth in reserve money was revised
downward from 5 per cent to 2.8 per cent, while that of broad money was
lowered from 14 per cent to 13 per cent.
Although the growth in reserve money contracted during the first
three quarters of 2009 largely due to the lowering of SRR in the last
quarter of 2008 and the first quarter of 2009, it began to increase in
the last quarter of 2009, due to the increase in credit to the
government from CBSL and the dissipation of the impact of the changes in
SRR in the last quarter of 2008, on reserve money.
Accordingly, the annual average growth in reserve money contracted by
0.7 per cent, which was within the target set in the revised Monetary
Programme for 2009.
The growth in broad money, which moderated during the first half of
the year, gathered pace thereafter, with annual average broad money
growing by 13.6 per cent, which was marginally above the target set in
the revised Monetary Programme for 2009. Interest rates across the term
structure shifted downwards in line with the changes in the policy rates
and the improvements in market liquidity.
The average weighted call money rate (AWCMR) was brought within the
policy interest rate corridor, improving the effectiveness of the
Central Bank’s monetary policy operations. Other market interest rates
also declined in line with these changes, although lending rates of
commercial banks declined at a slower pace.
During 2009, the financial sector remained resilient and financial
system stability was maintained despite challenging market conditions.
Financial sector institutions were confronted with the stresses caused
by the spill-over effects of the global financial crisis and the
consequent decline in demand in the domestic economy which had an
adverse impact on their business operations.
Financial system stability
As the global financial turmoil deepened and the global economy
contracted, there was an outflow of foreign investments in government
securities creating a liquidity shortage in money markets, although this
situation turned around with the money market becoming liquid and the
equity market rebounding after the end of the conflict in May 2009.
The loss of investor confidence and liquidity constraints faced by
several entities connected to banks and finance companies in the
Ceylinco Group had an adverse impact on the finance and leasing sectors.
However, swift and decisive actions taken by CBSL and the government
contributed towards restoring public confidence and continued stability
in the financial system.
CBSL successfully resolved the liquidity problems encountered by
Seylan Bank, a systemically important licensed commercial bank (LCBs),
which was a part of the Ceylinco Group.
Seylan Bank was recapitalised by issuing new shares and is currently
carrying on normal business operations. With a view to resolving the
liquidity constraints faced by distressed registered finance companies (RFCs)
and specialised leasing companies (SLCs) in the Ceylinco Group, CBSL
appointed managing agents and obtained the services of a panel of
experts to advise and guide the recovery process.
In addition, a special stimulus package and a guarantee scheme were
put forward by CBSL with the support of the government to assist RFCs
and SLCs that were experiencing liquidity problems.
These measures were successful in facilitating the commencement of
business operations and bringing stability to the sector.
Outlook
The end to the prolonged internal conflict and the restoration of
peace provide a greater optimism for economic prosperity and a strong
basis for long-term sustainable development, supported by appropriate
policies.
The opportunities created by the restoration of peace, will be
complemented by the ongoing global economic recovery.
The low inflation and interest rate regime that prevails also
provides a conducive environment to fuel economic activities. To harness
these opportunities, the existing bottlenecks that hinder a faster
growth need to be addressed urgently.
Infrastructure projects, already commenced and planned, need to be
accelerated to expand the productive capacity of the economy and to
improve the efficiency and productivity of economic activities. At the
same time, special attention needs to be paid to implement much needed
structural and institutional improvements, including the enhancement of
the profitability and productivity of public enterprises that are a
significant drain on public finances.
The fiscal consolidation process also needs to be strengthened. The
contribution of the private sector to overall economic development needs
to be increased.
The regulatory framework has to be further strengthened.
Establishment of a strong development planning and monitoring process
would be helpful to prioritise projects, avoid delays and ensure the
optimal allocation of resources.
In the short to medium-term, moving to a high growth trajectory,
while maintaining price stability remains a key policy challenge. |