Sri Lankan economy:

Way forward in coming decade

Prof A D V de S Indraratna

The Sri Lankan economy had performed well in the four years of 2005-2008 with an average annual growth rate of 6.7 percent with unemployment declining from the previous 8.3 percent to 5.4 percent of the labour force by the end of the period. Exports had grown continuously with the volume of exports standing nearly 20 percent above that of 2004. The BOP (balance of payments) surplus had peaked to US $ 515 million by July 2008 and gross official reserves had increased to US $ 3.5 billion, nearly four months of import value. It is noteworthy that this was the first time in the six decade history of our country since Independence, to have achieved a more than six percent annual growth during four consecutive years and has occurred despite the intensification of the terrorist war and the heavy military expenditure.

Global recession

This trend, however, reversed in the fourth quarter of 2008 with the onset of the second round effects of the global recession. There was withdrawal of investment in Treasury Bills and Bonds by foreign investors; there was drying up of commercial financing from international capital markets required for counterpart funds for foreign funded projects; Export growth had begun to decline ending in a drop of about 10 percent by May 2009 over that of 2008.

Despite the steady, and in fact slightly increasing, private remittances - private remittances in the first half of 2009 was five percent higher than in the corresponding period last year- the BOP began to be in deficit and gross official reserves had begun to decline recording the lowest of US $1.2 billion by March 2009, hardly adequate for two months of imports. Overall, the growth rate, which was more than 6.5 percent from 2005 up to the third quarter of 2008, had declined to 4.3 percent in the fourth quarter of 2008 and still further down to 1.5 percent in the first quarter of 2009.

With the launching of prudent monetary policies by the Central Bank to contain inflation and even more significantly, the end of the terrorist war in May 2009 due to the astute political leadership given by the President, Sri Lanka was able to reverse the downward economic swing. The economy once again picked up with the growth rate rising to 2.1 percent in the second quarter and accelerating in the third and fourth quarters, ended the year with an annual average of 3.5 percent. This growth rate more than doubled with 7.1 percent and 8.5 percent (on a point to point basis) in the first and second quarters of this year respectively.

Unemployment was coming down and gross official reserves reached an unprecedented level of nearly US $ 7 billion by the end of the third quarter, sufficient to meet the cost of imports of nearly seven months at current prices.

Infrastructure development

It is noteworthy that the Government was able to attain this fast and significant recovery and to sustain over six percent growth for three consecutive quarters, with single digit inflation of around six percent. This was possible because the Government, while meeting the challenges of the aftermath of the cessation of terrorist hostilities, has been utilizing the opportunities opened by it. For example, the Government has been utilizing the opportunity of liberation of one third of the country’s territory and two thirds of its sea coast, for restoration and further development, of agriculture, fisheries and tourism.

The contribution made by both agriculture and fisheries to the country’s GDP has been rising considerably since mid 2009, while tourism has made significant gains, with tourist arrivals increasing by nearly 50 percent, with tourist earnings even more than 60 percent, in the first nine months of this year over the corresponding period last year.

The Government has also been utilizing the vast pool of skilled manpower with the release of the Armed Forces from the battlefield in infrastructure development. They are, for example, now being increasingly used for delivering essential services such as rebuilding habitats, and restoring vital physical infrastructure to whole tracts of land decimated by terrorism.

Future prospect

In this scenario, can the country, as indicated in the Mahinda Chintana Idiri Dekma, sustain an high average annual growth of around eight percent in the next five to six years (2011-2015/16) or so, and able to reduce unemployment to a tolerable level of three percent (so called natural rate of unemployment-NRU), and halve poverty to meet the MDG? This is a crucial question that is being currently raised and discussed among politicians, economists and other professionals.

The growth of an economy is measured by the increase in the net value of goods and services produced within a given period at constant prices, that is the increase in the GDP in real terms.. This depends upon the increase in the level or rate of investment as a percentage of GDP and the efficiency of that investment (or in economic jargon incremental capital output ratio) The rate or level of gross investment required to attain a targeted, or given rate of growth thus depends upon the efficiency of capital. The higher this level of efficiency, the lower the rate of investment required.

Domestic savings

The level of efficiency of our investment or productivity of our capital has been very low in comparison with productivity not only of developed countries but also in comparison with that of even developing countries of Asia. In the last five completed years, the average ratio has been 4.2 :1, i.e in order to produce I unit of output, 4.2 units of investment or capital have been utilized. On this basis, for a real growth rate of eight percent of GDP, a gross investment rate of nearly 34 percent of GDP is required.

In the past five years the gross rate of investment has been only 27 percent of GDP. The rate of domestic savings available to meet even this level of investment has been as low as 17 percent. This investment-savings gap (or the resource gap) had to be met by mainly domestic and foreign borrowing. For the flow of FDI has been rather slow.

Growth rate

When the required level of investment goes up to 34 percent of the GDP, the gap increases by 70 percent, at the present level of savings, and this gap becomes more difficult to fill. This makes a growth rate of eight percent or more appear unsustainable. But we should not be pessimistic. Prospects are not bad, and all indications are that, if a multi pronged attack is made, the gap could be reduced if not all-together eliminated. It has to be multi pronged, because the gap should be resolved firstly by increasing the level of efficiency of investment, thereby reducing the percentage of GDP required to be invested for the targeted rate of growth (that is reducing the capital or investment output ratio; secondly it has to be done by raising the present percentage of domestic savings and thirdly by increasing FDI in order to augment the domestic investment).

The ominous signs for the first two appear bright as judged by the experience of growth in the last quarter of 2009 and the first two quarters of 2010. The growth rate has been rising steadily from about 6.2 percent in the last quarter of 2009 to 7.1 percent in the first, and 8.5 percent in the second, quarter of 2010, with only a slight increase in the rate of gross investment above 27 percent (in the second quarter of 2010 it is estimated to be around 28 percent of the GDP).

This means that there has been some improvement in the level of efficiency of investment.

If we can increase the present level of efficiency of capital by about 10 percent to around 3.75:1, then we should be able to attain the targeted growth rate of 8 percent with a gross investment of only 30 percent, a 11 percent increase over the present level.

Public service

Both of these we should be able to reach and sustain in the next five to six years. With the heavy physical infrastructure projects in the road network, harbours and airports and IT, etc. that are being implemented, it should not be a difficult task to reach and even go beyond a level of 30 percent of gross investment.

The increase in the level of efficiency of investment or productivity by around 10 percent is also attainable if we implement a host of measures such as good governance with law and order but without waste and corruption, a competent and independent public service, efficient public institutions, simple tax system, customs, license, BOI and other official procedures, industrial peace with good employer-labour relations and good labour laws, easy collateral system for bank loans particularly for farmers who may not possess clear title to land, etc. Mahinda Chintana Idiri Dekma (MCID) has highlighted some of these.

Private sector

Then we have the other side of the equation to examine. That is the increased savings required to finance this higher level of investment, maintaining the average inflation at more less the present level of five percent - six percent. In other words, the increased resource gap has to be reduced by increasing the domestic savings on the one hand and increasing the FDI on the other.

Savings must be promoted by reducing the budget deficit by the Government and by encouraging private sector savings by maintaining attractive real market interest rates (i.e., nominal rates markedly above inflation).

The Government has already put in place several measures to bring the budget deficit down from last year’s near 10 percent to eight percent The relatively much faster rise in current revenue plus grants of 20.3 percent, relatively to only 7.6 percent increase in current expenditure, in the first seven months of 2010 is ominous of this, even though rising capital expenditure may prevent it from reaching the targeted eight percent.

Financial institutions

Real interest rates have remained positive after 2008 with inflation coming down to single digit. The banks and other non-bank financial institutions are also advised to maintain attractive deposit rates. We can, therefore, expect domestic savings to increase somewhat. But such increase will not be adequate to close the gap between the required investment and the available savings.

To be continued