INCLUSIVE GROWTH TRAJECTORY

Sri Lanka needs to address vulnerability to poverty to ensure inclusive growth – ADB

 

As the Central Bank of Sri Lanka notes, Sri Lanka’s economy witnessed a gradual revival in 2023 from the deepest economic downturn in its post-independence history.

Decisive policy adjustments and structural reforms implemented by the previous government and the Central Bank played a significant role in restoring macroeconomic stability, despite the challenges faced by economic stakeholders including the citizenry.

The economy displayed resilience, achieving a growth rate of 4.5 percent in the fourth quarter of 2023, according to the national accounts estimates compiled by the Department of Census and Statistics. This helped limit the annual contraction for 2023 to 2.3 percent, indicating a gradual recovery.

According to the Central Bank of Sri Lanka’s Annual Economic Review 2023, these measures were essential in preventing a deepening of the crisis and guiding the economy towards a sustainable recovery.

In view of the ongoing risks however, a continued commitment from policy makers and public support are crucial to advancing the economic reform agenda and achieving debt sustainability.

The economy expanded in the second half of 2023, ending a record six quarter streak of contractions. Moreover, the persistent twin deficits in the government budget and external current account – the primary drivers of the economic downturn – showed signs of correction during the year.

This economic momentum, the Annual Economic Review notes, is expected to carry forward in the coming years, supported by ongoing reforms under the IMF’s Extended Fund Facility (EFF) arrangement.

A broad based expansion across all sectors is anticipated, alongside the preservation of domestic price stability, aided by increased independence and accountability of the Central Bank in monetary policymaking, and a ban on monetary financing of the government’s budget deficit.

SERVICES In 2023, services contracted slightly, primarily due to a downturn in financial services and IT programming. External reserves, which hit rock bottom at the height of the economic crisis, were gradually strengthened over the year.

INDUSTRY The contraction in industrial activities in 2023 was primarily driven by declines in the construction and manufacturing sectors.

Industrial activities contracted by 9.2 percent, exacerbating the 16 percent downside reported in the previous year. The manufacturing sector absorbed a 3.2 percent decline although a few activities experienced growth in 2023.

Growth revived in the second half of 2023, and is expected to continue in 2024 and 2025

Asian Development Outlook

AGRICULTURE Growth in agricultural activities was a highlight, primarily driven by increased rice and fruit cultivation, which contributed to overall economic performance.

In 2023, the three major economic sectors – agriculture, industry and services – contributed 8.3 percent, 25.6 percent and 59.9 percent to GDP at current prices respectively.

INFLATION At the end of 2023, inflation was contained to single digit levels, down from its peak in 2022, enabling the advent of monetary policy normalisation.

As the Central Bank notes, Sri Lanka’s rate of inflation in 2023 registered 16.5 percent, marking a 33.2 percent decrease from the previous calendar year.

Factors contributing to this decline included reductions in both food and non-food inflation, as well as a decrease in underlying inflation within the economy. The Central Bank projected that inflation would stabilise around the target level of five percent over the medium term, supported by appropriate policy measures and well anchored inflationary expectations.

Meanwhile, headline inflation as measured by the Colombo Consumer Price Index (CCPI) dropped from 57.3 percent at the end of 2022 to four percent in December 2023, marking a period of disinflation.

VIEWPOINTS The Asian Development Outlook (ADO) 2024 update released in September notes that while Sri Lanka’s economy contracted in the first half of 2023, it grew by three percent in the second half, showcasing signs of recovery.

Although GDP declined in 2023, the emergence of green shoots of recovery indicates a positive trajectory with the ADO stating that “growth revived in the second half of 2023, and is expected to continue in 2024 and 2025.”

The ADO update adds that inflation, which peaked in 2022, slowed to single digits in 2023, and is projected to remain below 10 percent in both 2024 and 2025.

However, the ADO asserted at the time that “challenges remain and the upcoming electoral cycle must not delay the reforms required to address the recent economic crisis. Sri Lanka needs to address vulnerability to poverty to ensure inclusive growth.”

In the meantime, the Asian Development Bank (ADB) is optimistic about a gradual economic recovery for Sri Lanka in 2024 and 2025. It notes that key indicators such as the Purchasing Managers’ Index (PMI) and Industrial Production Index (IPI),display signs of improvement.

It adds that construction, which virtually stalled at the peak of the crisis, is resuming but will be moderated by the increase in VAT, raising raw material prices and dampening housing construction.

Recent increases to VAT rates and removal of exemptions are found to hurt the poorest income decile the most

State of the Economy 2024

The services sector is expected to benefit from increased tourist arrivals and spending while the finance sector will see support from lower interest rates, boosting demand for credit.

Moreover, the ADB forecasts that as the economy gradually stabilises, consumer and business confidence should improve, leading to a cautious recovery in private consumption and investment. On this score, it is noteworthy that business confidence continues to remain higher than it was in the past.

However, the bank stated that this is expected to be tempered by higher prices due to the VAT increase and uncertainty surrounding the electoral cycle at the time of its report.

Meanwhile, Sri Lanka aims to conclude its debt restructuring process by year end with expectations of a prompt exit from the default rating category soon thereafter.

Governor of the Central Bank Dr. Nandalal Weerasinghe says: “To complete the process, certain procedures must be followed including documentation, due diligence and related formalities.”

Thanks to the support from the International Monetary Fund and international advisors, Sri Lanka, has secured a debt restructuring agreement with its official creditors; it has also reached an in-principle deal with private creditors. The agreement with bondholders includes macro linked bonds that are tied to the country’s economic growth.

An IMF delegation visited Sri Lanka in November for the third review under the country’s EFF programme. Following this review, the IMF is expected to release the next instalment in the near future.

FISCAL AFFAIRS The Mid-Year Fiscal Position Report 2024 released by the Ministry of Finance highlights signs of economic recovery beginning in the third quarter of 2023, driven by enhanced supply conditions, improved external demand and a revival of the tourism industry.

The economy grew by five percent in the first half of 2024, which represents a healthy rebound from the 7.3 percent contraction in the same period of 2023.

This report also notes that with positive developments in the external sector, the Sri Lankan Rupee appreciated by nearly eight percent against the US Dollar by the end of August. Export earnings rose by 6.1 percent, reaching US$ 8,499 million in the first eight months of 2024 – up from 8,010 million dollars in the same period of 2023.

The export performance was driven by higher earnings from industrial, agricultural and mineral exports; and this was fuelled by the recovery of the domestic export sector and stronger demand from overseas.

Expenditure on imports rose by 10 percent to in excess of US$ 12,072 million in the first eight months of 2024, up from 10,974 million dollars during the same period in the prior year.

This increase was driven by higher spending on consumer, intermediate and investment goods, spurred by the revival of economic activity, lifting of import restrictions and impact of elevated global commodity prices.

Consumer, intermediate and investment goods accounted for 18 percent, 64.2 percent and 17.7 percent of total import expenditure respectively.

Sri Lanka’s external sector showed positive momentum in the first eight months of 2024 with higher inflows from workers’ remittances and earnings from tourism, despite the widening trade deficit.

Workers’ remittances grew by 11 percent to over US$ 4,288 million in the first eight months of 2024 – up from nearly 3,863 million dollars in the same period of 2023. This increase was attributed to a rise in departures for foreign employment and higher remittances sent through formal channels, supported by government policies encouraging the use of official channels.

Earnings from tourism saw a substantial rise of 66 percent, reaching US$ 2,167 million in the first eight months of 2024, compared to less than 1,305 million dollars during the same period of in the preceding year.

Inflows to the services sector improved during this period.

With stronger foreign currency inflows, Sri Lanka’s gross official reserves rose to US$ 6 billion by the end of August, which includes a swap facility from the People’s Bank of China.

In his column titled Building Better in 2024 in the May 2024 edition of LMD, columnist Shiran Fernando asserted that “with a slowdown in imports – and improvements in remittances, and higher inflows from tourism and services – Sri Lanka was able to register its first current account surplus since 1978. It is typical for countries that undergo debt or economic crises to promptly record a surplus with a contraction of growth and tapered imports.”

“The Central Bank expects to maintain a current account surplus in 2024 as well despite higher imports… Meanwhile, the export of services related to transport (e.g. air and maritime), IT and construction are expected to grow this year, and thereby support the current account balance,” he explains.

Fernando reiterated that there continue to be concerns about inflation, tightening of interest rates by global central banks and trade disruptions that are unlikely to support any near-term rebound in growth. Elections in key export markets such as the US and UK are also risks to look out for from a consumer demand point of view, he cautioned.

BIZ CONFIDENCE The LMD-PEPPERCUBE Business Confidence Index (BCI) displayed similar sentiments at the end of 2023 compared to 2022 with the barometer declining by only one basis point in December to settle at 85.

By March 2024 however, which marked the end of the financial year under review, the index saw an increase to 93. In big terms however, concerns over inflation, the cost of living and the tax regime reflected a lack of confidence within the business community at the time.

POLICY REVIEW The Institute of Policy Studies (IPS) released its State of the Economy 2024 publication in October, focussing on ‘Economic Scars of Multiple Crises: From Data to Policy.’

The report emphasises Sri Lanka’s ongoing economic recovery while highlighting the socioeconomic challenges ahead and policy decisions that will shape the country’s future.

It points out that “recent increases to VAT rates and removal of exemptions are found to hurt the poorest income decile the most.” An IPS research economist notes that the poorest households spend about 10 percent of their income on VAT, compared to six percent for higher income groups.

In contrast, direct income taxes such PAYE and personal income tax (PIT) were found to be more progressive – the wealthiest 10 percent of households contribute 95 percent of PAYE and PIT, it notes.

However, the findings also reveal widespread tax evasion with less than a third of the estimated Rs. 131 billion PIT payable being collected in 2023.