Economy grows 6.4%, inflation remains single digit in 2012

The Sri Lankan economy grew at a healthy rate of 6.4 % in 2012 while inflation was maintained at single digits for a fourth consecutive year, despite several global and domestic challenges.

This was disclosed by Governor, Central Bank Ajith Nivard Cabraal while presenting the 63rd annual report of the Monetary Board President and the Minister of Finance and Planning Mahinda Rajapaksa yesterday.

Improved business and consumer confidence, which supported a robust economic growth of 8 percent in the preceding two consecutive years, was accompanied by high credit and monetary expansion and a widening trade deficit fuelled by high import demand.

To further strengthen the macroeconomic environment, by containing the rapid expansion of monetary aggregates and the widening trade deficit, the Central Bank and the government implemented a comprehensive policy package in early 2012.

Accordingly, the Central Bank adopted a tight monetary policy stance by raising policy interest rates and issuing a Direction under Section 101(1) of the Monetary Law Act in March 2012 to moderate credit growth by licensed banks.

The Central Bank also allowed greater flexibility in the determination of the exchange rate and limited its intervention in the domestic foreign exchange market. To curtail imports, tariffs on selected imports were raised.

Further, to reduce the losses being incurred by state owned enterprises and their impact on overall macroeconomic stability, several administratively determined prices, mainly relating to energy, were revised.

Inflation was maintained within single digit levels in 2012 for the fourth consecutive year.

Inflation declined to a low level of 2.7 percent in February 2012.

However, the upward adjustment of energy prices and transport fares in February 2012 to reflect the rise in oil prices in the international market, the pass-through of the depreciation of the rupee, supply disruptions on account of adverse weather conditions that prevailed in major cultivation areas and the impact of past high monetary expansion resulted in inflation edging up to end the year at 9.2 percent.

Nevertheless, within a relatively short period of time the impact of the policy measures adopted was evident with the trade deficit and credit granted to the private sector decelerating while managing inflation expectations also helped, containing inflation at single digit levels throughout the year. By end 2012, the annual average rate of inflation stood at 7.6 percent.

Reflecting the government’s continued commitment to the fiscal consolidation process, the overall fiscal deficit was contained significantly below the previous year’s level, although it marginally exceeded the target in the budget.

The slowdown in economic activity and the decline in imports had a negative impact on government revenue collection.

However, by maintaining a tight rein on recurrent expenditure and scaling back on capital expenditure, the overall fiscal deficit was contained at 6.4 percent of GDP, marginally above the targeted level of 6.2 percent of GDP and significantly below the 6.9 percent of GDP in 2011.

Raising the tax to GDP ratio by broadening the tax base and improving tax compliance would be critical to sustaining the fiscal consolidation process in the medium term. Although major tax reforms resulted in a simplification of the tax structure, revenue collection remained weak.

The external sector strengthened during the year benefiting from the policy measures that were adopted in early 2012 to improve macroeconomic stability. Import expenditure declined by 5.4 per cent with non-fuel imports declining at a faster rate of 8.6 per cent. Despite the decline in exports by 7.4 percent due to weak external demand and the decline in international commodity prices, the trade deficit contracted to 15.8 percent of GDP in 2012.

The improvement in the trade account, increased inflows from trade in services including tourism and transportation, and continued high growth in workers’ remittances helped contain the current account deficit to 6.6 percent of GDP in 2012. The improvement in the current account together with higher inflows to the capital and financial account from the proceeds of the fifth international sovereign bond, higher inflows to the government to finance infrastructure development projects and increased foreign borrowing by commercial banks and the private sector as a result of the relaxation of exchange control regulations, resulted in the BOP recording a surplus of US dollars 151 million in 2012. Accordingly, gross official reserves rose to US dollars 6.9 billion by end 2012.

The financial sector remained resilient and continued to support domestic economic activity despite the elevated risks from global and domestic developments.

The financial sector expanded during the year with increased access to finance although asset growth moderated as the credit ceiling was imposed early in the year. Nevertheless, soundness of financial sector institutions improved with higher capital levels, adequate liquidity buffers and healthy earnings. With the raising of funds abroad, the banking sector was able to diversify its sources of funding, further strengthening its balance sheet.

Significant attention was directed over the year towards strengthening the effectiveness of the regulatory and supervisory framework, in line with international standards and best practices, and providing an enhanced focus on governance practices and risk management to address potential risks to financial stability. The payments and settlement system too continued to operate with a high degree of availability and safety, facilitating the financial intermediation function. The financial sector remained resilient and continued to support domestic economic activity despite the elevated risks from global and domestic developments. The financial sector expanded during the year with increased

access to finance although asset growth moderated as the credit ceiling was imposed early in the year. Nevertheless, soundness of financial sector institutions improved with higher capital levels, adequate liquidity buffers and healthy earnings.

With the raising of funds abroad, the banking sector was able to diversify its sources of funding, further strengthening its balance sheet. Significant attention was directed over the year towards strengthening the effectiveness of the regulatory and supervisory framework, in line with international standards and best practices, and providing an enhanced focus on governance practices and risk management to address potential risks to financial stability. The payments and settlement system too continued to operate with a high degree of availability and safety, facilitating the financial intermediation function.