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ii Sri Lanka Economic Outlook 2012 October2012
Sri Lanka
Economic Outlook
2013
October 2012
DISCLOSURE AND UPDATE: The forecasts and outlook contained in this report are based on the prevailingassumptions and circumstances at the time of the report. Although the forecasts are intended to hold for theduration of a year, subsequent events may cause these assumptions to change and necessitate adjustments tothe viewpoints and expectations in light of the altered circumstances. Any such change will be issued by RAMHoldings Berhad in the form of a commentary or an update.
Copyright 2012 by RAM Holdings Berhad
Published by RAM Holdings Berhad. Reproduction or transmission in any form is prohibited except by permissionfrom RAM Holdings Berhad.
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Contents
I. Global conditions 3
A. Highlights 3
B. The United States 4C. Euro Area 4
D. Japan 5
E. China 5
F. Oil prices 6
II. Domestic GDP by expenditure components 7
A. Summary 7
B. Private Consumption 8
C. Public Consumption 8
D. Investment 9
E. External Trade 9
III. Domestic GDP by industry 11
A. Summary 11
B. Agriculture & Fishing 11
C. Industry 12
D. Services 13
IV. Domestic monetary and financial conditions 14
A. Highlights 14B. Inflation rate 14
C. Interest rate 15
D. Exchange rate 15
V. Medium-term growth and structural balances 16
A. Highlights 16
B. Medium-term growth 17C. Fiscal balance 17
D. External balance 18
ReGLocal Team
Kuala Lumpur
Barry Ooi
Economist
(603) 7628 [email protected]
Jason Fong
Economist
(603) 7628 1703
Yeah, Kim Leng
Group Chief Economist
(603) 7628 1010
Colombo
Adrian Perera
Chief Executive Officer
(94) 11 259 6099
mailto:[email protected]:[email protected]:[email protected]:[email protected]:[email protected]:[email protected]:[email protected]:[email protected]:[email protected]:[email protected]:[email protected]:[email protected] -
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EXECUTIVE HIGHLIGHTS
Despite Sri Lankas stellar growth in recent years, global headwinds and policy measures to curb
demand remain key considerations through the rest of 2012 and next year. As such, we have revised
our GDP growth forecast to 6.5% for this year, followed by 7.0% in 2013 as a clearer resolution to theglobal crisis emerges.
Global conditions
Risks remain largely unchanged. The United States (US) has been posting a modest recovery, which
may be hampered by political brinkmanship in the lead-up to its imminent presidential elections later
this year. Similarly, policy constraints and ineffectiveness are retarding recovery in the European Union
(EU). With the growth effects of reconstruction efforts beginning to wear off, Japans rebound
hinges on global economic stability. Elsewhere, Chinas domestic demand is still able to offset external
weaknesses.
Domestic demand
Domestic private consumption is anticipated to chart healthy growth due to the expansion of the
general economy. Nonetheless, the Central Banks tightening of policies may trickle down to the real
economy in 2013. Driven by continued support from the Chinese government, investment is expected
to increase further, although regressive policies may pose a downside risk. Public expenditure,
meanwhile, should be reined in on account of fiscal consolidation, but a larger proposed defence and
urban development budget may be of some concern. With no end in sight to the troubles plaguing its
key trading partners, Sri Lankas export performance is not envisaged to improve anytime soon. By
contrast, import growth will likely be sustained by robust domestic consumption and construction.
Domestic supply
Agriculture may decline further due to the extreme drought, which has also hit hydro-powered
electricity generation. Export-oriented manufacturing shows a downtrend due to persistently weak
demand from traditional export markets. On the flip side, a pick-up in investment will boost
construction, especially for civil infrastructure projects. The active financial and retail sectors should
also lift the services sub-sector.
Domestic monetary and financial conditions
The inflation rate is expected to ease as growth momentum slows and macro-prudential controls cool
domestic credit growth, albeit still subject to global commodity prices. The Central Bank is likely to
maintain its key policy rate in the near term due to heightened risks for growth. Short-term
stabilisation of the rupee is expected on the back of enhanced global liquidity, with gradual
appreciation a likely scenario.
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I. GLOBAL CONDITIONS
A. Highlights
United States
imminent elections impeding recoveryGrowth supported by gradual recovery of labour markets and accommodative monetary
policy.
Risks to growth include weak global conditions and political brinkmanship in lead-up to
upcoming presidential elections.
Euro Areagrowth prospects turn negative as credit conditions worsen
Policy constraints retarding resolution of sovereign debt crisis.
Protracted policy ineffectiveness will further depress economic activity.
Japan
global volatility preventing broad-based recoveryReconstruction activities supporting growth.
Recent trade deficit if it persists likely to have significant growth and fiscal implications.
Growth hinges on state of global economy and exchange-rate volatility.
Chinasteady growth supported by domestic demand
Domestic demand growth can mitigate external weaknesses.
New leadership may cause significant changes to overall demand structure over time.
Oil pricesvolatile as flagging global economy weighs against supply concerns
Supply constraints only had temporary impact on global fuel prices.Expectations of slowdown in global industrial activity keeping prices in check.
Accommodative monetary policies of advanced economies likely to have longer-term impact
on prices.
Source: Various statistical agencies, the International Monetary Fund (IMF) and RAM Economics
* Estimate
** Average of West Texas Intermediate, Brent and Dubai Fateh benchmark prices
2H 2011 1H 2012 2012 forecast
Change from a year ago (%)
US 1.8% 2.3% 2.1%
Euro Area 0.8% -0.1%* -0.5%
Japan -0.6% 3.2% 1.9%
China 9.3%* 7.9%* 8.0%USD per barrel
Average oil price** 103.11 107.67 100-105
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B. The United States
The US posted a brisk 2.3% economic growth in
1H 2012, led by revived private consumption as
the labour-market situation gradually improved
amid an accommodative monetary policy.
However, the debilitating political brinkmanship
(across the 2-party ideological divide between
growth and fiscal sustainability) in the lead-up to
the American presidential elections in
November, and the likely deterioration in
European demand will stymie the pace of growth
through the rest of the year. As these conditions
had already been factored into the previous
forecast, the USs GDP growth estimate for 2012
remains unchanged at 2.1%.
The Federal Reserve the American central bank projects that the overall unemployment level will
remain elevated even while the labour market gradually improves. Policy measures implemented after
the presidential elections will be key growth determinants for the USs growth in 2013.
C. Euro Area
Economic activity in the EU the 17-nation
monetary union that uses a common currency
contracted in 2Q 2012, underscoring the
pervasiveness of the regions debt crisis.
Although some of its export-oriented economies
(i.e. Germany and the Netherlands) had still
managed to expand under adverse credit
conditions, factory output started slackening in
early 2H 2012, indicating that a recession is
highly probable for Europe. In the near term,
policy restraints brought about by self-imposed
legislation and market forces are expected to
prolong (or accelerate) the decline in the overall
demand conditions in Europe. Nonetheless, the
Euro Areas growth estimate for 2012 has been revised upwards by 0.2 percentage points to an overall
contraction of 0.5%; this is underscored by the stronger-than anticipated growth of its export-oriented
economies in the first quarter of this year.
Going forward, policies that directly address the sovereign debt crisis will remain the chief
determinant of Europes growth. While difficult credit conditions are expected to continue, the
regions overall growth potential is envisaged to stay depressed going into 2013.
-1,000
-800
-600
-400
-200
0
200
400
600
2008 2009 2010 2011 2012
Private sector
Government
Net change in employment (thousand)
Source: Bureau of Labour Statistics (US)
0
100
200
300
400
500
600
700
Italy Spain
Sovereign 10Y basis point spread against
German Bund
Source: Bloomberg
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D. Japan
Reconstruction activities, following the Great
East Japan Earthquake last year, supported
Japans economic growth in 1H 2012, even as its
merchandise trade balance remained in deficit.
While domestic demand continues to improve,
the unfavourable global conditions are expected
to dampen growth prospects as export revenue
contends with weaker demand from other
advanced economies and a volatile exchange
rate. Due to the impressive pace of the Japanese
recovery in 1H 2012, its estimated growth for
this year has been revised upwards by 0.2
percentage points to 1.9%.
In 2013, Japans expansion will depend on the revival of its export engine, which in turn relies on the
strength of the global economy. The Japanese yen/US dollar exchange rate which has experienced
significant swings in the past year as a result of overall global financial volatility will also dictate the
performance of this key sector.
E. China
Chinas growth moderated to a more sustainable
pace in 1H 2012 as global conditions waned.
Domestic demand in the worlds most populous
economy has offset the weakness of its external
sector. Notably, factory output has stagnated in
recent months, as evidenced by the declining
Purchasing Managers Index (or PMI) a measure
of manufacturing activity. Furthermore, over-
valued asset prices still pose a dormant risk to
Chinas speedy growth in the near term, and may
limit the effectiveness of its future policies. That
said, Chinas projected growth stays unchanged
at 8.0% for 2012, as its underlying growth
conditions remain intact but at risk from a sharp
external slowdown.
Chinas future growth prospects will depend on its new leadership, which is due to come into power by
2013. While the country has been highly dependent on its export capabilities to drive its economic
growth in recent years, there has been a noticeable shift in policy to strengthen its domestic private
consumption for sustainable growth. Consequently, Chinas growth next year will depend on the
effectiveness of these policies and overall global conditions.
-1.0
-0.5
0.0
0.5
1.0
1.5
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
Trade balance, seasonally adjusted
Yen trillion
Source: Statistics Bureau of Japan
44
46
48
50
52
54
56
58
2009 2010 2011 2012
China PMI
Breakeven level = 50
Source: Bloomberg
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F. Oil prices
The imposition of international trade sanctions
on Iran the second-largest oil producer in the
Organisation of Petroleum-Exporting Countries
(or OPEC) had exerted a temporary effect on
global fuel prices. Accommodative monetary
conditions in the advanced economies had
caused erratic bouts of speculation on
commodities, causing significant price volatility
throughout 2012. The expectation of
decelerating industrial activity in advanced
economies has dampened prices as the
European sovereign debt crisis continues to
unfold.
Despite the relatively wide swings in oil prices, we have maintained the expected full-year average oil
price of USD100-USD105 per barrel due to stagnant global demand.
80
85
90
95
100
105
110
115120
125
Aug-1
1
Sep-1
1
Oct-11
Nov-1
1
Dec-1
1
Jan-1
2
Feb-1
2
Mar-12
Apr-12
May-1
2
Jun-1
2
Jul-12
Oil price (average)
USD/barrel
Source: Bloomberg and RAM Economics
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II. DOMESTIC GDP BY EXPENDITURE COMPONENTS
A. Summary
Private Consumption
post-war consumerism still on the riseSustained growth of general economy continues to support private expenditure.
Tightening policies by Central Bank of Sri Lanka (CBSL) expected to only trickle down to real
economy in 2013.
Estimated growth of 8.7% in 2012 and 8.0% in 2013.
Public Consumptionfiscal consolidation to rein in deficit
Government expected to trim deficit this year, although larger defence and urban
development budget for 2013 may be cause for concern.
Estimated to expand 2.2% in 2012 and 5.1% in 2013.
InvestmentChinese inflows to support reconstruction and upgrading
Government-to-government partnerships, especially with China, should see increased
investment in key areas such as transport and energy infrastructure as well as tourism.
Regressive policies such as Expropriation Act still pose downside risk to foreign investment.
Estimated growth of 8.0% in 2012 and 7.6% in 2013.
External Tradelacklustre trade due to slowdown in external markets
Turbulent external markets will moderate export growth to only 2.2% in 2012, as demand
from the EU and the US slows. Should pick up to 3.7% in 2013, with clearer resolution ofglobal crisis.
Imports to add 6.7% due to domestic expansion, with increased purchases of capital and
consumption goods, rising further to 7.2% in 2013.
Annual change 2011 2012f 2013f
GDP 8.30% 6.50% 7.00%
Private consumption 16.0% 8.7% 8.0%Public consumption 2.8% 2.2% 5.1%
Investment 13.2% 8.0% 7.6%
Exports 11.5% 2.2% 3.7%
Imports 32.7% 6.7% 7.2%
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B. Private Consumption
Eager to lift the spirit and economy of the post-
war nation, the Sri Lankan government
introduced several liberalisation and
rationalisation policies in 2011, including the
reduction of import tariffs on vehicles and
durables. These, in addition to an
accommodative labour environment, fuelled a
16.0% jump in domestic private consumption last
year, surpassing our earlier estimate of 12.5%.
This had in turn accelerated the inflation rate to
6.7%, with an uptrend that had prompted
policymakers to raise interest rates twice by
April.
Personal loans and loans for consumer durables soared a respective 40% and 100% in 1Q 2012.
However, their share of total loans remained unchanged, indicating that the lofty growth rates are
solely due to an overall improvement in the domestic economy, rather than any significant shift
toward consumerism. In the first 7 months this year, the growth of M2 far outpaced that of M1, by
20.7% y-o-y to 4.2%. This implies that if there is indeed such a shift in consumerism, it has been to the
opposite direction of saving.
Due to a general slowdown in growth, we expect private expenditure to decelerate to 8.7% in 2012.
Going forward, we expect to see the tight monetary policy spill over from this year into the next due to
a delayed transmission mechanism, alongside continued external weaknesses that will further retard
growth to 8.0% in 2013.
C. Public Consumption
To tame a burgeoning deficit, fiscal consolidation
should see public consumption expand only 2.9%
in 2012. As of July, the government had spent
62.7% of its budget allocation for recurrent
expenses, with the bulk of the increase going to
emoluments. We expect a reduction in expenses
for 2H 2012, due to further consolidation as part
of the terms agreed with the IMF for its USD2.6
billion loan. The budget for 2013 is reportedly
13.5% larger, with a considerable portion going
to the Ministry of Defence and Urban
Development. While the demarcation between
actual defence spending and infrastructural
development remains unclear, it is understood
that the defence budget must remain large to
-10%
-9%
-8%
-7%
-6%
-5%
-4%
Official
target
(-6.2%)
Source: CBSL & RAM Economics
Note: 3Q 2012 numbers not yet available
Fiscal balance (% of GDP)
20%21%22%23%24%25%26%27%28%29%
30%
2Q10 3Q10 4Q10 1Q11 2Q11 3Q11 4Q11 1Q12
Total personal loans Consumer durables
Source: Central Bank of Sri Lanka
Ratio to total loans
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repay instalments on arms purchases made during the war. Although the Education Ministry will also
receive a welcome injection of funds, up 14% from the previous year, it is also unclear if the budget
will be spent on infrastructure. RAM Economics expects public consumption to expand 2.2% in 2012,
picking up to 5.1% in 2013.
D. Investment
Inflows of foreign direct investment (FDI) have
been encouraging, climbing 13.3% y-o-y in the
first 4 months of 2012. While this has been the
case since the cessation of the civil war,
investment levels have only just begun
approaching pre-cessation levels, which had only
collapsed at the peak of the fighting. Substantial
investment is noted in infrastructural rebuilding
efforts, particularly by the government of China.
Unlike loans from multilateral agencies, those
from China come without strict conditions. The
better terms and faster turnaround have led to an
influx of Chinese-led projects worth over USD4
billion and due to be completed by 2015, mainly
in transport and energy infrastructure.
Tourism, traditionally a strong growth area for the economy, is still expected to expand given the
governments announced development goals for the sector. As one of the few sectors permitting full
foreign ownership of assets, it is also expected to drive FDI inflows, although this may yet be tempered
by the hastily approved Revival of Underperforming Enterprises and Underutilised Assets Act. The
colloquially dubbed Expropriation Act may undermine previous reformist measures, with a particular
body, i.e. American non-profit organization International Executive Service Corps, reporting that the
Act has essentially added a 2%-5% premium on political risk insurance on loans for projects in the
country. Despite the setback, we expect the Chinese angle to dominate investment in 2012 and
expand 8.0%, followed by a slight slowdown to 7.6% next year due to investor concerns over
regressive regulations.
E. External Trade
Although exports managed to outperform expectations last year, the downtrend has been evident
since exports peaked in May 2011. The EU, Sri Lankas primary export destination by far, has been
mired in a downward spiral that has seen its demand for external goods dwindling drastically. Part of
the decline in European demand may also be attributed to the removal of the Generalised System of
Preferences Plus scheme, a tax concession. Of even greater concern is the apparent dependence on
Europe; in spite of its decline, the EUs share of exports has not budged from a third of total Sri Lankan
exports, indicating that the domestic economy has yet to find a suitable alternative market for its
products. The relaxing of the CBSLs intervention in the foreign-exchange market has seen the rupee
0
10
20
30
40
50
60 Domestic invt
Foreign invt
Source: CBSL & RAM Economics
LKR billion, 12mMA
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depreciate against the US dollar, although we expect it to gradually appreciate again due to easing
measures in the advanced economies, which will further hamper exports.
Imports are anticipated to remain fairly robust
on the back of persistent domestic demand forimported consumer goods. The CBSL
implemented initiatives to curb import demand,
contracting the import of consumer and
intermediate goods by 20.9% y-o-y and 27.4% y-
o-y in July 2012. Nonetheless, the correction in
the rupee exchange rate may dampen the effects
of those policies. The contraction in investment
goods in June and July is a reversal in trend and
signals a possible decline in future investment
activity.
As such, we expect exports to post a slight growth of 2.2% this year, followed by clearer resolution of
the global crisis that will lift exports 3.7% in 2013. Imports should plunge following the excessive
growth of 32.7% in 2011 to 6.7% in 2012, before recovering to 7.2% in 2013 based on healthier overall
growth.
-10%
0%
10%
20%
30%
40%
50% Total exportsEU exports
Source: IMF
Annual growth
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III. DOMESTIC GDP BY INDUSTRY
A. Summary
Agriculture & Fishing
drought wreaking havocExtreme and unseasonably dry weather devastated crop output.
Plans to diversify from raw commodity exports to more value-added processing and
manufacturing of agricultural products.
Estimated to expand 1.6% in 2012 and 1.2% in 2013.
Industryconstruction sector driving growth
Reconstruction efforts continue posting robust growth, funded by large foreign inflows.
Manufacturing shows downtrend due to weaker demand from traditional export markets.
Electricity and utility sector also hit by effects of drought on hydro-powered generation.
Estimated to expand 6.9% in 2012 and 6.8% in 2013.
Servicesrobust activity in retail and financial services
General economic growth led to nascent consumer culture, aided by flourishing financial
sector.
Tourism sector booming since end of war, creating need for more hotel rooms to
accommodate inflow of visitors.
Estimated to grow 7.2% in 2012 and 8.2% in 2013.
Annual change 2011 2012f 2013f
GDP 8.30% 6.50% 7.00%
Agriculture & Fishing 1.5% 1.6% 1.2%
Industry 10.3% 6.9% 6.8%
Services 8.6% 7.2% 8.2%
B. Agriculture & Fishing
A drought, by some reports the worst since
1992, has been throttling tea output in Sri Lanka,forcing some factories to shut down amid low
intake of leaves. Although rainfall in May
provided some brief respite, the dry season has
persisted into September, wreaking havoc on the
countrys food supply. Despite tea output falling
4.3%, the overall growth of the agriculture sector
was fairly strong in 1H 2012, thanks to the
healthy growth of other crops. In spite of reports
of the devastation of paddy fields in the North
Central and Eastern regions, paddy output
-10%
-5%
0%
5%
10%
15%
Dec-1
0
Feb-1
1
A
pr-11
Jun-1
1
Aug-1
1
O
ct-11
Dec-1
1
Feb-1
2
A
pr-12
Jun-1
2
Aug-1
2
Tea production
Source: CBSL & RAM Economics
Annual growth, 12mMA
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surged 35.5% in the same period, underpinned by the low-base effect brought on by floods at the start
of 2011. At the same time, fishing also increased 9.7%.
We estimate that the drought is likely to bring agriculture growth down to 1.6% this year under the
base-case scenario, decelerating further to 1.2% in 2013 as the government attempts to increase thesectors value addition by reducing reliance on the export of raw commodities.
C. Industry
The drought has also affected the electricity, gas
and water sector. Meagre rainfall has hit the
countrys hydro-powered generation particularly
hard, with water inflows reportedly at their
lowest levels in 2 decades. Increased capacity in
the form of new hydro plants has been fornaught, and the country has had to cut power for
the first time in 10 years, after the failure of a
new coal plant.
Largely represented by the export-oriented textiles and garment industries, the manufacturing sector
posted a 6.5% growth in 1H 2012, driven by the strong uptrend in private consumption. However,
waning demand in its major export markets, i.e. the EU and the US, along with a less-than-competitive
labour market, has caused a decline in manufacturing output and a loss in attractiveness relative to
other low-cost peers such as India, Bangladesh and Cambodia. The government has offered a number
of incentives for investments aimed at modernising the ailing local textile industry, but the efficacy ofsuch programmes remains to be seen.
The construction sector stands out as the
success story for the industrial sector, expanding
17.9% in 1H 2012 on the back of sustained
rebuilding and capacity-building efforts. The
focus remains on transportation and ports via
large-scale government-to-government deals,
particularly with China. The higher interest rates
are unlikely to deter construction, as private-sector participation in large-scale projects are
limited by a restrictive public-private partnership
framework. FDI in the tourism sector, including
the construction of a USD500 million mall and a
USD450 million Sheraton hotel, are notable
examples of the continued expansion of this sub-sector. Against this backdrop, we expect the
industrial sectors growth to moderate to 6.9% in 2012, and 6.8% in 2013.
0%2%
4%6%8%
10%12%14%16%18%
Industrial Production Index
Source: CBSL
Annual growth
200
210
220
230
240
250
260
270
280
290
300
2Q10 3Q10 4Q10 1Q11 2Q11 3Q11 4Q11 1Q12
Construction
loans
Source: CBSL
LKR billion
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D. Services
Since 2009, the Sri Lankan tourism sector has been booming, achieving impressive growth in tourist
arrivals and foreign-exchange earnings and proving resilient against external headwinds. Income from
hotels and restaurants has been rising over 20% y-o-y each quarter since 3Q 2009. Given the spillover
effects on the general population, the government has lofty development goals for this sector. The
cessation of fighting and the countrys well-preserved heritage sites have helped spur tourism, but the
uptrend has moderated of late, owing to lack of sufficient accommodation and a shortage of trained
personnel. The governments target of USD400 million in FDI inflows bodes well for this sector.
The improvement in the general economic well-
being of the population and a thriving consumer
culture have been a boon for the wholesale and
retail sector, which expanded 5.3% y-o-y in 1H
2012. The favourable labour market and
elevated consumer demand should continue
lifting this sector, along with the supporting
financial segment, which has avoided the
repercussions from the CBSLs tightening
policies. Loan applications are at elevated levels
and the debt market is expected to remain
robust amid the required financing for capital
investments. Overall, services should expand
7.2% in 2012 before rising further to 8.2% in 2013, as a clearer market outlook alleviates general
concerns and reticence.
20
25
30
35
40
45
50
2006 2007 2008 2009 2010 2011 2012
Outstanding credit card
balance per card
Source: CBSL & RAM Economics
LKR billion
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IV. DOMESTIC MONETARY AND FINANCIAL CONDITIONS
A. Highlights
Inflation rate
deceleration expected as growth momentum slows, but still subject to globalcommodity prices
Price pressures to ease as interest-rate hikes and other macro-prudential controls cool
domestic credit growth.
Lacklustre growth of global economy to make price deceleration more pronounced.
Volatile global food and fuel prices will continue affecting Sri Lankas inflation rate.
Interest ratesCBSL likely to maintain key policy rate in short term
Heightened risk to growth as weak external conditions preventing normalisation of interest
rates.
Monetary conditions not likely to ease amid significant loan growth.
LKR/USD exchange rateshort-term stabilisation expected, gradual appreciation likely
Rupees depreciation halted likely by enhanced global liquidity.
Steady increases in tourism revenue and foreign capital inflows expected to offset rise in
imports of capital goods, thus supporting rupees longer-term appreciation
B. Inflation rate
Inflation, as measured by the Colombo
Consumer Price Index (CCPI), increased at a
quicker pace of 7.0% in the first three quarters of
2012. Rising food and fuel prices accelerated the
CCPIs growth momentum. This was largely due
to supply concerns (both global and domestic),
increased global liquidity amid the
accommodative monetary policies of the
advanced economies and a weaker rupee. As
most of these conditions are likely to persist
through the remainder of the year, the CCPI is
anticipated to register a growth of 7.4% for 2012
(2011: 6.7%).
Unit 1H 2012 2012e 2013f
Colombo ConsumerPrice Index
% change from a year ago 5.7% 7.4% 7.2%
Reverse repo rate Percent (%), end-period 7.75% 7.75% 7.75%
Exchange rate USD/LKR, average 124.3 128.0 125-130
-4.0
-2.0
0.0
2.0
4.0
6.0
8.010.0
12.0
2009 2010 2011 2012
Food Housing & utilities Transport Other
Percentage point contribution to CPI annual change (%)
Source: CBSL
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Going forward, Sri Lankas inflation rate is expected to ease as demand for loans will decelerate to a
more sustainable pace, in response to the slow recovery of the global economy, domestic macro-
prudential measures and the upward adjustment of interest rates. Nevertheless, as a substantial
proportion (77%) of the CCPI is represented by food and fuel price indices, Sri Lankas overall price
levels are highly susceptible to movements in global commodity prices and domestic supply
conditions.
C. Interest rate
This year, the CCBL increased its key policy rate
the reverse repurchase rate (RRR) by 75 basis
points to 7.75% to date. These upward revisions
of the policy rate represent the first changes in
Sri Lankas benchmark interest rate since January
2011. The tightening of the interest-rate policy
had been in response to the constant
acceleration in private-sector loan growth, which
peaked at 35% in March 2012, and had been
deemed unsustainable by Sri Lankas main
financial regulator.
Despite the expected slower domestic loan growth next year, the CBSL is unlikely to adjust its current
accommodative policy stance as the uncertainties looming over the global recovery may weigh on Sri
Lankas near-term growth prospects. That said, if domestic loan growth continues at the present pace,
the possibility of further monetary-policy tightening will be heightened as the CBSL has shown that it
will maintain domestic financial stability to ensure the sustainability of the countrys medium-termgrowth.
D. Exchange rate
By end-2011, the CBSL had largely ceased its
intervention in the foreign-exchange market.
This had allowed the rupee a certain degree of
flexibility while giving the CBSL some space to
combat inflation in the interest of
macroeconomic stability. The relaxation of
exchange-rate controls had led to a 16.3%
depreciation for the rupee in 1H 2012. In the
following months, the rupee had stabilised amid
the easing of advanced economies monetary
policies. The rupee is expected to appreciate to
an average USD/LKR rate of 128 for the full year.
The volatile global economic landscape will likely translate into a weak near-term appreciation for the
rupee; the currency is expected to appreciate 1%-3% on average to a range of USD/LKR 125-130 in
2013. Over the longer term, the rupee is envisaged to appreciate as tourism revenue and capital
inflows counter Sri Lankas persistent negative trade balance.
6.0
7.0
8.0
9.0
10.0
11.0
-10
0
10
20
30
40
2008 2009 2010 2011 2012
Private sector domestic credit
Policy rate, reverse repo rate (RHS)
Annual change (%) Percent
(%)
Source: CBSL and RAM Economics
100
105
110
115
120
125
130
13580
85
90
95
100
105
110
2008 2009 2010 2011 2012
Nominal Effective Exchange Rate
Real Effective Exchange Rate
LKR/USD (RHS, reverse scale)
2010 = 100 Rupee per USD
Source: CBSL and Bank of International Settlements
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V. MEDIUM-TERM GROWTH AND STRUCTURAL BALANCES
A. Highlights
Medium-term growth
growth of underlying factor inputs to support expansionFavourable demographic structure ensures longer-term consumption and labour-supply
growth.
Skills re-training programmes and better tertiary-education enrolment optimise allocation of
Sri Lankas human resources.
Foreign capital inflows from large emerging economies likely to sustain growth due to small-
but-developing manufacturing and financial sectors.
Fiscal balanceexpected moderation of fiscal deficit
Fiscal balance to improve on back of expanding economy and enlarged revenue base.Debt burden influenced by exchange-rate fluctuations and domestic interest-rate adjustments.
Contingent liabilities pose latent risk to sovereigns financial strength.
External balancecurrent-account deficit to keep narrowing
Trade balance likely to remain in deficit as demand for capital goods increases in line with Sri
Lankas growth prospects.
Boost in tourism-related revenue expected to help narrow overall current-account balance
Forecast period Value
Cumulative average growth rate (%)
Medium-term growth 2013-2020 6.0%-6.5%
As a % of GDP
Fiscal balance 2013 -6.0%
Current-account balance 2013 -4.9%
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B. Medium-term growth
Sri Lanka is expected to post a medium-term average growth of 6.0%-6.5% for the remainder of this
decade. This expectation is primarily based on a favourable demographic profile, where the young-agedependency ratio the ratio of the population aged under 15 years against those aged between 15
and 64stands at nearly 40%. This ensures Sri Lankas medium -term consumption and labour-supply
growth, thus providing an underlying basis for economic expansion. The various fiscal programmes to
restructure the workforce following the civil war and the continuous growth in tertiary-education
enrolment encourage growth as they facilitate better allocation of human resources, which would in
turn expand Sri Lankas production possibility frontier. Furthermore, the continuous inflow of capital,
particularly from large emerging economies, will provide the means for Sri Lanka to accelerate its
growth potential in the coming years.
The primary risk to this growth estimate stems from the Sri Lankan regulatory environment. Althoughthe World Bank has noted that the countrys business environment has indeed improved, there is
considerable scope for further progress. This is especially true with regard to the bureaucratic or
regulatory costs involved in obtaining construction permits, registering property, paying taxes and
enforcing contracts. Enhancing the role of the private sector in Sri Lankas development provides a
certain degree of dynamism that is essential for more sustainable longer-term growth.
C. Fiscal balance
Sri Lankas resilient post-civil war economic growth has been the main driver in the improvement of
the nations fiscal balance, which showed a smaller deficit of 7.0% in 2011 (2009: 9.9% deficit). The
government this trend to continue in 2012, on the back of higher tax revenue. Likewise, Sri Lankas
sovereign debt load has moderated since 2004, as nominal GDP growth during this period has
consistently outpaced the governments primary fiscal deficit.
Doing Business rankings out of 183 countries 2013 Rank 2012 Rank
Overall rank 81 89
Starting a Business 33 38
Dealing with Construction Permits 112 111
Getting Electricity 103 95
Registering Property 143 161
Getting Credit 70 78
Protecting Investors 49 46
Paying Taxes 169 173
Trading Across Borders 56 53
Enforcing Contracts 133 136
Resolving Insolvency 51 42
http://www.doingbusiness.org/data/exploreeconomies/sri-lanka#starting-a-businesshttp://www.doingbusiness.org/data/exploreeconomies/sri-lanka#dealing-with-construction-permitshttp://www.doingbusiness.org/data/exploreeconomies/sri-lanka#getting-electricityhttp://www.doingbusiness.org/data/exploreeconomies/sri-lanka#registering-propertyhttp://www.doingbusiness.org/data/exploreeconomies/sri-lanka#getting-credithttp://www.doingbusiness.org/data/exploreeconomies/sri-lanka#protecting-investorshttp://www.doingbusiness.org/data/exploreeconomies/sri-lanka#paying-taxeshttp://www.doingbusiness.org/data/exploreeconomies/sri-lanka#trading-across-bordershttp://www.doingbusiness.org/data/exploreeconomies/sri-lanka#enforcing-contractshttp://www.doingbusiness.org/data/exploreeconomies/sri-lanka#resolving-insolvencyhttp://www.doingbusiness.org/data/exploreeconomies/sri-lanka#resolving-insolvencyhttp://www.doingbusiness.org/data/exploreeconomies/sri-lanka#enforcing-contractshttp://www.doingbusiness.org/data/exploreeconomies/sri-lanka#trading-across-bordershttp://www.doingbusiness.org/data/exploreeconomies/sri-lanka#paying-taxeshttp://www.doingbusiness.org/data/exploreeconomies/sri-lanka#protecting-investorshttp://www.doingbusiness.org/data/exploreeconomies/sri-lanka#getting-credithttp://www.doingbusiness.org/data/exploreeconomies/sri-lanka#registering-propertyhttp://www.doingbusiness.org/data/exploreeconomies/sri-lanka#getting-electricityhttp://www.doingbusiness.org/data/exploreeconomies/sri-lanka#dealing-with-construction-permitshttp://www.doingbusiness.org/data/exploreeconomies/sri-lanka#starting-a-business -
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2009 2010 2011 2012f
LKR billion
Total revenue and grants 725.6 834.2 937.0 1,126.1
Total revenue 699.6 817.3 923.2 1,106.1
o Tax 618.9 724.8 827.5 1,000.6
o Non-tax 80.7 92.5 95.7 105.5
Grants 25.9 17.0 13.8 20.0
Total expenditure 1,201.9 1,280.2 1397.2 1,594.9
Current 879.6 937.1 1,018.8 1,107.9
Capital and net lending 322.4 343.1 378.4 487.0
Fiscal balance -476.4 -446.0 -460.0 -468.9
Gross Government debt 4,161.4 4,590.2 5,133.4 -
Foreign 1,760.5 2,024.6 2,329.3 -
Domestic 2,401.0 2,565.7 2,804.1 -
Interest payments 309.7 352.6 356.7 -
Foreign 35.7 55.5 68.6 -
Domestic 274.0 297.1 288.1 -
As a % of GDP
Fiscal balance -9.9% -7.9% -7.0% -6.2%
Gross Government debt 86.1% 81.9% 78.5% -
However, the risks to Sri Lankas medium-term fiscal performance are substantial. Slower economic
growth as a result of a more subdued global economy and the CBSLs tightening stance will
dampen tax revenue. The higher interest rate set by the CBSL and the recent depreciation of the rupee
will, likewise, adversely affect the overall fiscal balance through higher interest payments. Volatile
global commodity prices particularly with regard to fuel prices will likely burden large state-owned
energy enterprises, which can pose risk to the sovereigns finances in the future.
That said, the recent efforts of the authorities to improve domestic tax administration especially with
regard to the Value-Added Tax are expected to enhance the sovereigns revenue profile. At 14.5% of
GDP in 2011, Sri Lankas version ofthis tax is relatively low compared to most other economies.
D. External balance
In 2011, Sri Lankas current-account deficit widened to LKR511.1 billion or 7.8% of GDP, thanks to a
larger trade deficit. This was due to higher global commodity prices and the robust domestic economic
growth that had driven demand for imports. Sri Lankas current-account deficit is generally moderated
by the surplus in the services account, which is generally represented by tourism revenue and has seen
larger inflows in recent years. The positive net transfers chiefly represent remittances of funds from
the Sri Lankan worker diaspora, which is roughly equivalent to 3 million people or 15.2% of the
countrys population. The substantial emigrant population is expected to increase in the near term due
to the sizeable labour demand and wage differentials in the expanding economies of the Middle East
and East Asia. We note that Sri Lankas capital and financial account benefits from long-term capital
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inflows. These inflows originate from large, emerging economies and participate heavily in the
countrys major infrastructure projects. These flows are expected to accelerate after the relaxation of
the CBSLs foreign-exchange controls and the longer-term growth potential of the domestic economy.
Nevertheless, Sri Lankas external balance tends to be very volatile as it is a net energy importer. There
is substantial risk of global energy supply shocks to the countrys balance of payments ; this may
diminish the effectiveness of the CBSLs monetary policy tools in reducing short-term macroeconomic
volatility.
2008 2009 2010 2011
LKR billion
Current account balance -420.0 -24.2 -121.5 -511.1
Trade balance -647.2 -358.7 -545.4 -1073.9
Services balance 43.6 44.8 79.8 121.6
Net income -105.0 -55.8 -69.8 -72.0
Net transfers 288.6 345.5 413.9 513.2
Capital and financial account 193.7 299.4 322.0 458.4
Capital account 31.5 26.8 18.5 18.1
Net long-term financial flows 109.2 149.8 268.2 362.4
Net short-term financial flows 53.1 122.8 35.3 77.9
As a % of GDP
Current account balance -9.5% -0.5% -2.2% -7.8%
Official reserves
LKR billion 338.5 774.3 891.5 820.0
Times short term external debt 2.3 6.6 5.9 3.8
Months of current account purchases 2.0 2.2 3.1 2.8
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