Sri Lanka Economic Outlook 2013

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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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1 Sri Lanka Economic Outlook 2012 October2012

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

[email protected]

Yeah, Kim Leng

Group Chief Economist

(603) 7628 1010

[email protected]

Colombo

Adrian Perera

Chief Executive Officer

(94) 11 259 6099

[email protected]
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.


5/22


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


6/22


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


7/22


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


8/22


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


9/22


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%


10/22


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


11/22


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


LKR billion, 12mMA


12/22


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


13/22


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.


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.


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


Annual growth, 12mMA


14/22


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


15/22


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


LKR billion


16/22


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


17/22


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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Documents

Sri Lanka Economic Outlook 2013