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Sri Lanka

Briefing Notes for the Launch in Colombo, March 2008

Strong growth continues but inflation on the rise

  • Sri Lanka’s GDP growth in 2007 remained strong despite high international oil prices and an unsettled security situation. The country’s gross domestic product (GDP) is estimated to have grown by 6.7% in 2007, down from 7.7% in 2006. Growth in the industrial and services sectors slowed slightly, but these sectors still expanded by over 7%. Agricultural growth fell sharply due to adverse weather conditions. On the demand side, investment rose and is estimated to have reached 29% of GDP in 2007, compared with 28% in 2006.
  • Sri Lanka’s GDP growth is likely to remain about 7% in 2008, with productivity improvements in all three sectors of its economy. Several large planned infrastructure projects are expected to boost aggregate demand and output if speedily implemented. But the outlook for Sri Lanka remains vulnerable to any further escalation in the country’s ethnic conflict.
  • Sri Lanka’s inflation continued to rise, reaching an annual average of 15.8% in 2007 – up substantially from 10.0% in 2006. The increase was due to three factors including state-mandated hikes in fuel prices, supply shortages in domestic food crops, stemming from unfavourable weather, and sharply rising demand-induced inflationary pressures. The government applied a restrictive monetary policy to contain inflation. But in countries with high public debt, raising interest rates is problematic. Sri Lanka needs to balance its concern with inflation against the rising cost of public debt-servicing that has accompanied higher interest rates. The country’s central bank will continue to mop up excess liquidity through open-market operations.
  • Budget deficit came down from 8.1% in 2006 to 7.2% in 2007. This figure remains large, partly because of Sri Lanka’s large public debt and because of its security costs due to the country’s ongoing ethnic conflict. The total revenue-to-GDP ratio in 2007 rose for the third consecutive year, benefiting from measures to broaden the tax base, rationalize tax rates and strengthen tax administration. The government’s target is to bring the budget deficit down further in 2008, to 7%.
  • In 2007 estimated export earnings rose by 10% and import earnings by 8.9%. Workers’ remittances increased significantly and helped to contain the current account deficit, which is estimated to fall to 4.3% of GDP in 2007 (from 4.7% in 2006). FDI and financial flows to the Government increased substantially, yielding a surplus in the overall balance of payments. Gross official reserves increased to $3.08 billion by the end of 2007, up from $2.53 billion at the end of 2006.

Fiscal deficit and public debt sustainability in South Asia

  • Public debt remains a serious problem for most countries in South Asia, including Sri Lanka. While domestic public debt is becoming a larger component of total public debt, it has received relatively less attention despite its serious economic and social implications. Excessive reliance on debt, whether domestic or external, carries macroeconomic risks that can hinder economic and social development. High domestic public debt pushes up interest rates and crowds out private investment, which is much needed to promote economic growth.
  • When most government revenues are devoted to debt servicing, fiscal policy cannot be used to provide basic services, such as education, health, safe drinking water and housing. When public debt level reaches a very high level, a larger fiscal deficit becomes unavoidable. As a result, inflation starts climbing, pushing domestic interest rates and the cost of debt servicing further up. This vicious cycle leads to a debt trap and eventually the complete collapse of the economy and widespread poverty. Therefore, countries should pursue vigorous macroeconomic policies to contain public debt, including domestic public debt before they become totally unmanageable.
  • At 93% of GDP in 2006, the public debt in Sri Lanka was the result of years of high fiscal deficits. The intensification of civil conflict from the mid-1980s contributed to a high fiscal deficit. When concessional foreign financing became scarce, government debt service ballooned and government reliance on shorter term domestic debt instruments increased. The debt-GDP ratio has come down recently, but this reflects more of fast nominal GDP growth rather than improved debt dynamics. The real burden of public debt is in its servicing. In Sri Lanka, more than 90% of government revenues went to debt servicing in 2006.
  • For Sri Lanka, IMF debt sustainability analysis shows that, if GDP growth and primary balances continue at the average of the last decade, an already high debt-to-GDP ratio would continue rising – an unsustainable situation. But fiscal consolidation and improved growth can bring the debt ratio down to more sustainable levels.
  • The debt sustainability analysis by IMF shows that the ratio of public debt to GDP and the ratio of public debt service to government revenue can be reduced significantly over the medium term by promoting growth and adopting fiscal consolidation policies. In the case of Sri Lanka, which has high public debt, the ratio of public debt service to government revenue can be reduced by more than 20% within five years. The financial resources from lower debt servicing can be devoted to education, health or other development activities. An ESCAP secretariat analysis shows that a 20% decrease in the public debt service ratio in Sri Lanka can make resources available to raise development expenditure by 50%, expenditure on education by 114% or expenditure on health by 152% from the existing level.
  • There are some lessons that policymakers would find useful in their efforts to contain public debt. The sustainability of debt is crucially dependent on the size of the economy. Moreover, past experience suggests that it is difficult to bring public debt ratios down without robust economic growth. Therefore, policies promoting GDP growth should be vigorously pursued.
  • As budget deficits are a major cause of public debt, every effort should be made to maintain a primary surplus in the budget. A high budget deficit in Sri Lanka is a cause for concern. Therefore, the pace of government revenue growth through the strengthening of tax administration and broadening of the tax base must continue to rise so that the country’s debt-carrying capacity can increase. Debt sustainability becomes an issue of growing concern when the growth of government interest payments exceeds that of government revenues.
  • Strengthening tax administration is crucial. Tax rates are not low in South Asia, but inefficient tax systems and corruption keep revenues low. A simpler tax system, with fewer exemptions, less discretion and better compliance, should be a focus. Improving documentation of the economy will also help. Greater use of information technology could strengthen tax administration.
  • Widespread poverty and lack of basic services mean that demand for public spending is high. The challenge for governments is to contain wasteful public spending and orient it towards priority sectors. Public expenditure should promote pro-poor growth; basic services, such as education, health, sanitation and housing, should be a priority.

Addressing the neglect of agriculture – two-pronged approach needed

  • The rural poor account for around 70% of the poor in the Asia-Pacific region, and agriculture is their main livelihood. Another worrisome trend is the widening gap between the rich and the poor because the benefits of growth are not shared equally by different sectors, regions or income groups. Agriculture appears neglected, even though it still provides jobs for 60% of the working population and generates about a quarter of the region’s GDP. Growth and productivity in agriculture are slowing, and the green revolution has bypassed millions. In South Asia, growth in agriculture output dropped from 3.6% in the 1980s to 3.0% in 2000-2003.
  • Agricultural labour productivity has a significant impact on poverty reduction. ESCAP estimates show that a 1% increase in agricultural productivity would lead to a 0.37% drop in poverty in the Asia-Pacific region. Given the large agriculture productivity gaps among countries in the region, the potential gains appear substantial. Raising the region’s average agricultural productivity to that in Thailand can take 218 million people out of poverty, roughly a third of total poor in the region. Large gains in poverty are also possible through comprehensive liberalization of global agriculture trade, which could lift another 48 million people out of poverty in the region.
  • Therefore, a policy priority should be to revitalize agriculture. Revitalizing agriculture requires connecting the poor to markets by improving rural infrastructure, improving availability and management of water, improving agricultural technology, increasing the capacity to adapt technologies, and speeding diversification and commercialization. It also requires improving the distribution of land and the access to agricultural credit and extension - and making macroeconomic policy friendlier to agriculture, all enabling the poor to make a dent on poverty by themselves.
  • While agriculture growth will help in reducing poverty particularly in rural areas, yet some poor will shift from agriculture to industry and services, which offer them a better chance of escaping poverty. Policies should be put in place to make this transformation easy. Public policy could thus adopt a two-pronged approach, taking both aspects into account; revitalizing agriculture while facilitating the migration of excess labour from agriculture to industry and services. Farmers can leave agriculture for non-farm activities in rural areas or for work in urban areas. This requires creating opportunities in the non-farm sector as well as urban planning. Both require better opportunities for skills development and strategies for raising overall economic growth.