Sri Lanka Economic Update

Transcription

1 September 2011 Sri Lanka Economic Update Poverty Reduction and Economic Management, SAR The World Bank

2 Sri Lanka Economic Update 1 September 2011 Overview GDP growth continues to be strong, measuring 8 percent in 2011Q1 (yoy). GDP in industry and services sectors grew strongly (11 percent and 9 percent, respectively) enough to compensate for the decline in agriculture (5 percent), which resulted from heavy rains. The European and US crises could have damaging effects on Sri Lanka s growth prospects because the EU and the US are Sri Lanka s largest export markets and because global investor uncertainty could disrupt capital flows. For the moment, Sri Lanka s sovereign risk is falling and a recent bond issue was oversubscribed, while exports to the EU and other areas have increased strongly. The fiscal position continues to improve on back of strong growth in revenue. Fiscal deficit is on track to reach the government target of 6.8 percent of GDP in 2011 down from 7.9 percent of GDP in The country has made good headway under the IMF SBA program (entered into in July 2009) with US$ 1.7 Bn disbursed as of June 2011 on a US$ 2.6Bn program. Risks going forward include the economy reaching its current capacity. Signs of this include historically low unemployment along with increasing wages and core inflation. Although the public sector is investing heavily in infrastructure, there has been relatively little of the private investment needed to expand capacity and support sustained growth. 1 This note was prepared by a team comprising of Susan Razzaz, Francis Rowe, Kirthisri Rajatha Wijeweera and Daminda Eymard Fonseka 1

3 Recent Economic Developments Real GDP Growth Remained Strong in 2011Q1. 1. Real GDP growth remained strong in 2011Q1, despite the devastating effects of heavy rains on agriculture (Figure 1 and Table 1). GDP in the industry and service sectors grew strongly enough to compensate for the decline in agriculture, leaving overall GDP growth at 8 percent. Industry growth (11 percent in 2011Q1 compared with 7 percent in 2010Q1) reflected continuing strength in both manufacturing (8 percent) as well as construction (14 percent). Within manufacturing, apparel production volume increased by 12 percent, and apparel exports increased by a healthy 28 percent on higher unit prices.. Construction growth reflects the continuing public investment in civil works as well as private investment in residential and other buildings. 2. Service growth (10 percent in 2011Q1compared with 7 percent in 2010Q1) reflected continuing strength in both wholesale and retail trade (11 percent) and transport and communication (13 percent). This growth largely reflects an increase in consumer spending, which is also seen in increased consumer credit and increased imports of consumer goods. The hotel and restaurant subsector grew by 34 percent, reflecting continued growth in tourism. Tourist arrivals were boosted in February and March 2011 when Sri Lanka co-hosted the Cricket World Cup, but have also continued to remain strong into the low (summer) season. The telecommunications sector grew by 19 percent. 14% 12% 10% 8% 6% 4% 2% 0% -2% -4% -6% Figure 1. Sectoral GDP growth, percent (yoy) 80% 60% 40% 20% 0% -20% 2007M01 Figure 2. Growth in Tourist Arrivals, yoy 2007M M M M M M M M M M M M M M M M M M q1 2007q2 2007q3 2007q4 2008q1 2008q2 2008q3 2008q4 2009q1 2009q2 2009q3 2009q4 2010q1 2010q2 2010q3 2010q4 2011q1-40% Source: Department of Census and Statistics Agriculture Industry Services Overall -60% Source: CEIC data 3. Agriculture s decline in 2011Q1 (5 percent compared with 9 percent growth in 2010Q1) was the result of heavy rain: agricultural output is expected to pick up again in the next growing season. The heavy rain in November 2010 and February 2011caused severe flooding, damaging rural infrastructure and destroying livestock and crops in the north and east. Paddy output fell by 20 percent. The damage to crop production and infrastructure are likely to 2

4 be short lived: the next season of paddy production provides a fresh start and a large part of the damaged infrastructure is already being repaired. Real Growth,%,yoy 2009 Q1 2010Q1 2011Q1 Share of GDP in 2010 Agriculture, Forestry & Fishing (5.1) 12.2 Agriculture, Livestock & Forestry (6.6) 11.0 Fishing Industry Mining & Quarrying (4.3) Manufacturing Electricity, Gas & Water (2.4) Construction Services Wholesale & Retail Trade (2.5) Hotels & Restaurants (16.7) Transport & Communication Banking, Insurance & Real Estate Ownership of Dwellings Government Private Gross Domestic Product External Sector: Navigating in an Uncertain External Environment 4. Sovereign risk continues its post-conflict decline. Sri Lanka specific sovereign risk is falling relative to other emerging market economies (Figure 3), as the post-conflict macroeconomic outcomes continue to be favorable. In July, Sri Lanka successfully issued a US$1 billion 10-year US-denominated sovereign bond that was more than seven times oversubscribed. At an issue price of 6.25 percent coupon rate (or 332 basis points over ten-year treasuries), the issue followed S&P and Moody s move to raise country s (foreign currency sovereign credit) outlook from stable to positive, while Fitch raised its rating from B+ to BB-. 3

5 Figure 3. Sri Lanka Sovereign Risk and Recent Sovereign Issues Sri Lanka: Declining Sovereign Risk Conflict Ends in May ,200 1, Sri Lanka: Sovereign Bond Issues US$ Mn % Basis Points M M M M M M M M M M M M M M M M M M M M M M M07 Note: The graph plots the Sri Lankan government bond spread minus the average emerging market sovereign bond spread and is meant to capture Sri Lanka specific risk. Source: World Bank GEM Source: CBSL 5 Year Maturity 5.25 Year Matutity 10 Year Maturity 10 Year Maturity Amount raised Coupon rate The sovereign issue helped to bolster robust foreign exchange inflows. Net capital inflows fell slightly in 2010 to 5 percent of GDP, but were still above pre-crisis levels (Figure 3). Data from the first half of 2011 were encouraging. Importantly, a transition away from short-term foreign held T-Bills to longer-term government financing is taking place (Figure 4). Foreign direct investment (FDI) remained relatively insignificant at less than 1 percent of GDP in 2010, down slightly from However, during the 1H2011, FDIs increased by 99 percent (y/y) to record US$ 413 Mn -- over ½ of which, on account of the investment by Shangri-La Hotels. The government expects to achieve US$ 900 Mn foreign direct investment inflow (on net basis) or 1.8 percent of GDP in 2011.Remittances continues to grow rapidly (up 26 percent y/y in 1H2011) and are now over 8 percent of GDP. Taken together, these inflows are a macro economically significant 13.4 percent of GDP. While they are helping to build the central bank s foreign exchange reserves -- which reached new highs (almost 6 months of imports) after the sovereign bond issue in July, they are likely to put pressure on the real exchange rate going forward. The real exchange rate appreciated and average 2.8 percent in 2010, but has been below historical highs reached in late 2008 (Figure 4) Figure 4. Sri Lanka Foreign Exchange Flows and Real Effective Exchange Rate Capital Flows and Remittances, as a percent of GDP Sri Lanka: Real Effective Exchange Rate (2005=100) + = appreciation (1.0) FDI Long Term Government Financing Portfolio Investment Short Term Government Financing Remittances (right axis) Source:Central Bank of Sri Lanka Source: IMF, International Financial Statistics 6. Robust capital flows have been financing a large part of the growing trade deficit. The trade deficit widened in 2010 to $4.9 billion or 9.9 percent of GDP in 2010, up from 7.4 percent in For the first six months of 2011, the deficit grew 63 percent relative to the first half of 2010 reaching $4.26 4

6 billion or 15 percent of 1H2011 GDP. While exports, in both value and volume terms showed strong growth lead by apparel and tea, imports (value and volume terms) outpaced export growth by a wide margin. Food and beverages and other consumer goods showed strong increases relative to the first half of 2010 as domestic demand continues to remain robust. Post-war reconstruction needs are also driving import growth as imports of investment goods increased by 66.0 per cent year-on-year in June, owing to higher imports of machinery and equipment. 7. Remittances and strong growth in tourism are keeping the current account deficit in check. The current account deficit is estimated at 2.2 percent in 2010, compared with near-balance in For the first half of 2011 the current account deficit was 5.6 percent, up from 4.8 percent in 1H2010. Tourist arrivals were up 37 percent in the first half of the year yielding an increase in tourism export earnings of 51 percent compared to 1H2010. Continued strength in both tourism and remittances, and growing transshipment services are helping to offset the growing trade deficit. The full year current account deficit for 2011 is likely to be in range of of 5-6 percent. 8. Risks to the outlook are growing. The evolving European and US debt crisis and its potential global fall-out is an important risk for external sector developments going forward. On the real side, the EU and the US are Sri Lanka s largest export markets, which risks exacerbating the growing trade deficit. In terms of financing, global investor uncertainty resulting from the crisis has the potential to interrupt capital flows critical to financing the current account deficit. Any reevaluation of emerging market risks, may hit Sri Lanka particularly hard with a public debt to GDP ratio at a still high 82 percent (with a growing share of external debt Figure 6) and credit ratings still well below investment grade. 2,000 1,500 1, Figure 5: External Trade, US$ Million Figure 6: Government Debt and Fiscal Deficit ( ) 12 (% of GDP) , , Source: CEIC Trade Balance Imports cif Exports fob Source: CEIC data Foreign currency debt/gdp Foreign Currency Debt / GDP Fiscal Deficit/GDP (left axis) 5

7 Inflationary Pressures Particularly Demand Pull Factors Warrant Close Monitoring 9. Higher inflation remains the foremost medium to short term risk factor. While the country experienced a burst of increased CPI during the 1Q of the year largely reflecting the supply side impacts associated with floods and also in part higher international commodity prices such effects began to moderate towards second and third quarter of the year. Headline inflation dropped to 7.0 percent (yoy) in August 2011 after having reached nearly 9 percent in the immediate aftermath of the floods. However, raising concern is that core inflation has been in the rise since of late. Core inflation excludes fuel and food, and as such is a better indicator of demand pull factors underlining the CPI. Core inflation 2 increased for the fifth consecutive month in July to record 32 month high of 8.9 percent (yoy) signaling the growing importance of demand pull factors M2 2009M5 Source: CEIC data 2009M8 Figure 7: Inflation, %, yoy 2009M M2 2010M5 2010M8 Core CPI Food 2010M M2 2011M5 2011M8 10. The monetary authorities have taken initial steps towards curbing growing demand 13 Figure 8: Policy Rates, % pressures but more may have to be done if the threat is to be managed effectively. In April, after more than two years without change, the Central Bank raised the SRR (Statutory 9 Reserve Requirement) applicable on bank rupee 8 deposits by 100 bps-from 7.00 percent to percent. The measure had the effect of 6 tightening liquidity in the system by withdrawing an estimated Rs 18 Bn from the repo system. Despite the tightening, money markets Source: Central Bank of Sri Lanka Reverse Repo SRR continue to experience copious liquidity. Excess market liquidity during the 2Q11 recorded an average Rs 69 Bn per day compared to Rs 105 Bn per day in 1Q11 and Rs 46 Bn per day in Reserve money growth during 1H11 (20 percent) was considerably above the target stipulated under the Central Bank of Sri LankaRoad Map-Monetary and Financial sector policies for 2011 and beyond (14.5 percent). The growth in the reserve money has been primarily a reflect of increasing Net Domestic Assets (NDA) position while the Net Foreign Assets (NFA) has decline marginally -- owing to Central Bank currency operations in the foreign exchange markets. 2 As measured by the new CPI index introduced from June The new CPI index based on the HIES of 2006/7 attaches comparatively lower weight to food than the earlier (2002 HIES based) CPI. 6

8 11. Despite the SRR increase the monetary Figure 9: Credit to Private Sector policy remains considerably accommodative. 40% 5% 35% The benchmark Repurchase (REPO) and the 4% 30% Reverse Repurchase rates (RREPO) were last 25% 3% changed in January 2011 to 7 percent and % 2% 15% percent respectively compared to levels of 10% 1% 10.5 percent and 12 percent at the start of the 5% 0% GFC. Accommodative monetary policy has 0% -1% seen a considerable increase in bank lending to -5% -10% -2% the private sector, with total private sector credit growth recording 34 percent (yoy) in June This has drawn concern of Source: CEIC % Change, yoy - L/Axis % Change, mom-r/axis possible credit bubbles. Increased private sector lending has seen portfolio expansion in some of the more risky segments of bank credit namely in auto financing and pawning. In this light increased surveillance of banks and their portfolios are necessary in order to ward off a systematic deterioration of asset quality. Jan2008 Mar2008 May2008 Jul2008 Sep2008 Nov m1 2009m3 2009m5 2009m7 2009m9 2009m m1 2010m3 2010m5 2010m7 2010m9 2010m m m m05 Fiscal Trends Fiscal policy remains on track for planned deficit reduction. 12. Government fiscal position further improved in 2011 and looks set to meet the anticipated fiscal deficit target of 6.8 percent of GDP for the year. Preliminary estimates for the first six months of the year show the recorded fiscal deficit at 7 percent of GDP, compared to 8.2 percent of GDP recorded during 1H10 4. Strong growth in revenues coupled with somewhat modest expenditure growth has resulted in the consolidation of the primary balance (from an estimated -3.9 percent of GDP in 1H10 to -1.9 percent of GDP in 1H11). In step with falling interest rates, the effective interest cost on government debt dropped to 9.08 percent in 1H2011 from 9.79 percent in the 1H2010. With this the government interest bill remained more or less unchanged from the previous year contributing the lowering of the primary deficit. Under current projections the fiscal deficit for the year is likely to reach just under 7 percent of GDP, ceteris paribus, which is aligned with government budget targets and also the IMF program. 13. Revenues continue to grow strongly, backed by the growth momentum of the economy, increased imports and fiscal measures taken in the previous year. Total revenue (including grants) 3 The relatively low base reflecting the effects of the global financial crisis is partly responsible for this exceptional growth. Nevertheless, it remains as something to be concerned of going forward. 4 Based on a full year of (estimated) GDP, the deficit during 1H11 recorded 3.4 percent compared to 3.8 percent in IH10. 7 Figure 10: Government Finances - Monthly Cumulative, Rs Bn Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Overall Deficit Overall Deficit Capital Exp Capital Exp Source: Central Bank of Sri Lanka 2010 Total Expenditure 2011 Total Revenue

9 during the 1H2011 increased by 20 percent (y-o-y) on the back of a 22 percent increase in tax revenues and a 12 percent increase in non-tax revenues. This compared to a base (nominal GDP) increase of 18.5 percent experienced during the same period. Revenue buoyancy (measured in real terms) is estimated to have dipped somewhat owing to relatively faster growth in revenue experienced in 1H10 5 (over 1H09). From the detailed revenue estimates available as of May much of the robust tax revenue performance is attributed to growth in excise taxes (up 60 percent (yoy) through May), income taxes (up 22 percent), import duties (up 43 percent) and Value Added Tax (VAT) (up 10 percent 7 ). Excise tax collections more than doubled following government moves in the middle of last year to slash excise taxes on imported motor vehicles. The volumes of new cars imported rose 1138 percent (y-o-y) to 24,800 up to May Furthermore, the increases in excise rates on liquor and higher cigarette sales in the North and East also contributed to the jump in excise tax collections. Income tax collections were primarily driven by the growth in corporate and individual income taxes. The bulge in imports (see discussion earlier) contributed to higher import duty collections while contributing to increased VAT intake. The growth in VAT the single largest revenue source of the government was on back of a 29 percent growth in import VAT, while domestic VAT collection dropped by 3 percent Total expenditure during the first half of the year rose 13.1 percent largely reflecting higher capital spending. Government recurrent expenditure rose by a modest 6.5 percent despite significant increases in salaries, wages and pensions payments. Measures announced in the budget for 2011 to provide all public servants with a special allowance equivalent to 5 percent of their basic salary and an increase in the cost of living allowance (COLA) for both the non-staff grade public sector workers as well as for the pensioners contributed to higher outlays on remunerations and pensions. r. Capital expenditure rose nearly 40 percent in the 1H2011 with ramped up investments focused on rural infrastructure (including irrigation), national highways, power generation and port development. 15. In line with the budget, deficit financing in the 1H2011 was mainly through domestic channels. Non bank (domestic) financing accounted for over 50 percent of the total (amounting to 3.8 percent of GDP) while bank financing met 38 percent of the overall deficit (or 2.7 percent of GDP). The budget for 2011 anticipated that around a quarter of the financing requirement would be met by foreign sources but as of 1H2011 this ratio was around 10 percent. However, with the proceeds of the US$ 1bn sovereign bond issue the financing mix is likely to converge to the anticipated budget mix. The salient performance on the fiscal front during the first half of the year is summarized below: 5 Primarily reflecting effects of GFC suppressing revenue in the 1H09. 6 Mid Year Fiscal Position Report 2011, published by the Department of Fiscal Policy, Ministry of Finance and Planning. 7 Net of Refunds 8 Largely due to effects of consolidating in the VAT rates (to a single uniform rate) announced in the budget

10 % First 6 months % Rs Bn Actual Budget Change Change Revenue Including Grants % % Tax % % Non Tax % % Grants % % Total Expenditure 1,280 1,420 11% % Current 937 1,017 9% % Capital % % Revenue Minus Current Exp (102) (31) -69% (102) (58) 76% Overall Balance (445) (434) -3% (216) (217) 0% Outlook: A Delicate Policy Mix Prudent Structural, Fiscal and Monetary Policy Mix needed to avoid overheating 16. Signs are emerging that the economy is reaching the limits of its existing capacity. A rough guide to determining whether a country is operating at or above capacity is to measure the output gap - the difference between actual GDP and potential GDP. While such a measure is not meant to offer precision, especially in the case of a post-conflict Sri Lanka, it can signal the possibility of inflationary pressures in the face of continued fast growth. Recent output gap estimates indicate that the gap is positive (figure 11). 9

11 17. Other indicators also suggest that the demand pressures warrant close monitoring in the coming periods. Unemployment has fallen to a historic low of 4.3 percent and wages are increasing. Wage trends have mirrored sectoral GDP trends: first quarter wage rates rose strongly in industry and services, while falling in agriculture. In the construction subsector, wages grew by 4 to 12 percent depending on the skills category. Industry capacity utilization rates published by the Central Bank of Sri Lanka show overall capacity utilization close to 90 percent at the end of In tourism, the increased number of tourists has been accommodated through increased occupancy rates, which reached over 80 percent in the fourth quarter of Capacity Utilization Ratio ( % ) Food, Beverage and Tobacco Products 93 Fabricated Metal Products, Machinery 92 Textile, Wearing Apparel & Leather 90 Products Non Metallic Mineral Products 90 Manufactured Products 90 Paper and Paper Products 85 Chemical, Petroleum, Rubber & Plastic 77 Wood and Wood Products 76 Basic Metal Products 64 Average 89 Source: Central Bank of Sri Lanka Figure 11. Output Gap Figure 11: Real GDP growth and output gap, % 10% 9% 8% 7% 6% 5% 4% 3% 2% 1% 0% Output gap - R/Axis Real GDP Growth Source: Department of Census and Statistics, Sri Lanka and World Bank staff estimates 4% 3% 2% 1% 0% -1% -2% -3% -4% Figure 12. Real Wages Figure 12: Minimum Real Wage Rate Indices of Workers in Wages Board Trades, 4QMA, 2006Q4=100 Agriculture Industry Services Source: Central Bank of Sri Lanka 18. Structural policies to expand investment will help reduce capacity constraints. Positive policy signals to the private sector have already been transmitted via the 2011Budget with its list of tax reforms and plans to clarify the role of the Board of Investment. The response, however, has been muted so far. Both FDI and private domestic savings fell in 2010 (as a share of GDP). Building on the 2011 Budget proposal, one key area to help restore savings and investment is to harden budget constraints for state-owned or public enterprises (PEs). Doing so can help contain the fiscal burden (see below) and ensure that PEs involved in infrastructure provision or carrying out public investments do so efficiently, as this would enhance the profitability and attractiveness of private investment. 10

12 19. Fiscal consolidation must stay the course. The Ministry of Finance expects an overall deficit outturn of 6.2 percent of GDP in 2012The present medium term fiscal framework (MTFF) assumes that revenue growth experienced in will be sustained into the future. However, this is subject to country maintaining its robust growth momentum into the medium term. The revenue outturn over the medium term is also subject to the caveat that the tax rate reductions 9 which had a one-off effect in boosting revenue in the 2H10 and in 2011 is likely to have its effects petered out by The tax measures in the 2011 budget -- to simplify and consolidate the tax system -- aimed at increasing tax compliance although highly laudable are likely to take some time to show its full effects. A focus on expenditure composition and additional revenue measures, such as broad basing of the VAT to include the retail and the wholesale sectors and removing the existing exemptions list under the VAT are additional consolidation measures that could be undertaken in the medium term. 20. The emerging signs of cyclical overheating suggest a less accommodative monetary policy. While the accommodative monetary policy in effect since the onset of the Global Financial Crisis, has helped the economy during the recovery process the focus now clearly has shift to restraint. Going forward, the authorities need to remain vigilant on the need to gradually tighten policy and communicate in a consistent manner in order to help anchor inflationary expectations which is vital to maintain domestic stability and sustain economic growth. 9 Particularly custom duties and excise taxes. 11