Achieving economic goals amidst global challenges
Sri Lanka Economic Association Conference – Key takes at the inauguration
By Dinali Goonewardene
The Government in addition to domestic constraints faces a series of external and global constraints and the Sri Lanka Economic Association at its annual sessions from 13-14 October 2011 discussed this under the theme ‘Achieving National Economic Goals Amidst Global Challenges’.
Prof. A.D.V de S. Indraratna and Dr. Koshi Mathai, Resident Representative of the International Monetary Fund, made presentations at the inauguration. Dr. Mathai pointed out the need to reorient towards India and towards China, which accounts for 1% of exports.
“This country needs to be a hub,” he said. Prof Indraratna pointed out that if Sri Lanka was to be the economic miracle of East Asia, she must overshoot the growth rate of the present economic powerhouses of India and China.
The technical sessions comprised presentations on ‘Emerging Supply Shocks and Demand’ by W.A. Wijewardena, ‘The Economic Impact of Energy Prices’ by Dr. Tilak Siyambalapitiya, ‘Commodity Prices and Inflation’ by C.P.A. Karunatilake, ‘The Impact of Trade Imbalances’ by Prof. Upali Vidanapathirana, ‘Trade Policies and Trade Agreements’ by Dr. Saman Kelegama, ‘Protectionism vs Free Trade’ by Dr. M. Ganeshamoorthy, ‘The Role of External Finance’ by Prof. B. Hewavitharana, ‘Prospects for and Risks in FDI and Portfolio Flows’ by Prof. Anoma Abhayaratne, ‘The Impact on Remittances and Employment Opportunities’ by Prof. H D Karunaratne, ‘The Imperative of Inclusive Development’ by Dr. Nimal Sanderatne, ‘Poverty and Deprivation’ by the Centre for Poverty Analysis and ‘Economic and Social Equity’ by Dr. R. M. K Ratnayake.
Sustaining the economy
Prof. Indraratna presenting the keynote address said Sri Lanka saw increased growth of 7.1% and 8.5% in the first and second quarters of 2010 respectively with inflation and unemployment decreasing and the volume of gross official reserves increasing. He pointed out that it was left to sustain the economy in this high growth trajectory.
The focus of accelerated growth and development had arisen from the need to sustain growth rates at 8-10 % per annum and move Sri Lanka from its lower middle income level to an upper middle income level, half poverty and reduce unemployment to a tolerable level by 2016 even overshooting the targets of Less Developed Economies.
“What are Sri Lanka’s national economic goals?” he questioned. The ‘Mahinda Chinthana – Vision for the Future’ indicates that the Government aims to make Sri Lanka the ‘Wonder of Asia’ by developing it as a naval, aviation, commercial, energy and knowledge hub and to fulfil this vision, although attaining this goal is by no means an easy task, particularly when it has to be realised within the next five to six years.
‘Wonder of Asia’
“What is the ‘Wonder of Asia’ we are talking about? To be a ‘Wonder of Asia,’ Sri Lanka to my mind must do better than the rest of Asia,” Prof. Indraratna said. She must not only perform better than the so-called economic miracle of East Asia but overshoot the growth rate of the present economic powerhouses of India and China.
To this end several objectives or targets have to be achieved in five to six years such as to reducing poverty, sustaining double digit growth of around 10%, doubling the per capita income in a matter of seven years and achieving per capita income at market prices in a much shorter time.
Inclusive development, a reduction of 40% of the population now receiving less that US$ 2 purchasing power parity per day to 20% and 6% of the population receiving less than US$ 1 per day, also includes reducing inflation from around 8% to 3% and halving the level of poverty by the end of the period.
It entails having a budget deficit of 3% of GDP, a positive current account deficit with official reserves sufficient for more than six months of imports and a national debt of less than 50% of GDP with its foreign debt component constituting less than half of it.
“You may think these numbers are coming out of a hat – no,” reiterated Prof. Indraratna. “These are the economic fundamentals Sri Lanka should have achieved by 2016 if it wishes to be seen as a ‘Wonder of Asia.’”
Sri Lanka met the challenges of a terrorist war and a global recession in 2008 and 2009 and was able to sustain an average quarterly growth rate of 8% in the last six quarters till June this year given existing productivity was difficult to reach with a very low level of domestic savings of around 18% of GDP and FDI of less than 2% of GDP.
Having to meet a huge resource gap Sri Lanka will not be able to sustain even that level of performance without a bigger flow of FDI on the one hand and enhanced productivity of investment and improving competitiveness of exports and trade balance on the other, Prof. Indraratna said. The level of efficiency or productivity of investment has been very low in Sri Lanka in comparison not only to that of developed countries but also to developing countries of Asia, he said. This is particularly marked in agriculture, he added.
The capital outflow ratio is a measure of productivity although not the most satisfactory measure and it has been in the order of 4.2 i.e. 4.2 units of capital or investment have been utilised to produce one unit of output. With the new infrastructure investment that is being undertaken in Sri Lanka since the cessation of hostilities, productivity is likely to increase somewhat, thereby reducing the level of investment necessary to produce a given level of output.
Since 2008 despite the end of the terrorist war and the return of peace and political stability, FDI has been decreasing instead of increasing, Dr. Indraratna said. “From more than $ 800 million in 2008, it came down to $ 680 million in 2009 and $ 560 million in 2010. It increased to US$ 413 million in the first half of 2011 alone and may exceed the 2008 level by the end of the year. My guess is that the increase would be marginal.
To add to this, Sri Lanka’s trade deficit has been on the rise. The trade deficit of US$ 3,122 million in 2009 rose to US$ 5,205 million in 2010 and is US$ 5,077 million already this year and is expected to be more than $ 8,000 million for the whole of 2011, Prof. Indraratna said.
Although worker remittances have been on the rise, they have not been increasing/decreasing as much as the current account deficit. This has more than doubled to US$ 1.94 billion from January to July this year, from $ 7,805 million in the corresponding third month of 2010. Sri Lanka cannot be complacent that the balance of payment has been in surplus. It had gross official reserves of US$ 8.1 billion and total reserves of US$ 9.5 billion at the end of 2011, sufficient for six to seven months of imports.
“In addition to the constraints we tie up so far there are several global challenges that Sri Lanka faces in achieving economic growth,” Prof. Indraratna continued.
The global challenges are both economic and non economic. Firstly in a global recession, the recessionary conditions can be expected to continue for quite some time both in the US and the EU. The EU is affected with a debt crisis and they are two big markets of industrial exports and industrial products, particularly garments. Our tea exports also will be affected. Increasing protection may be another challenge. The US has a huge trade deficit – with Sri Lanka alone the trade deficit is around US$ 1.5 billion. President Obama’s new reform package includes cutting down imports and Sri Lanka is high on this list. Any possible increase in protection would impact adversely on Sri Lanka’s exports.
The political turmoil in North African and Middle East countries is another challenge. The tea exports would be particularly affected, especially those to Egypt, Lybia and Syria which are good markets for Sri Lankan tea.
The largest part of worker remittances comes from the Middle East and these too are likely to be adversely affected. The frequency of natural disasters, tornadoes and hurricanes as have been recently experienced in the rest of the world have impacted on their economies and is likely to include their domestic demand for exports to their countries including our own.
Another challenge of which serious note has not been taken particularly by countries like Sri Lanka are global warming and consequent climate change, resulting in variability in the pattern of rain fall and drought, he said. These are likely to affect the world production of agricultural products and consequently exports.
Agriculture imports by the world are projected to decrease to anything from 3% to 16% as a result. The impact of this is bound to be more on countries like Sri Lanka most of whose people depend on agriculture. It is reported that 30% of paddy can be affected by rain fall variations. The yield of the remaining 70% can be affected by variability in drought patterns. This should be of serious concern to both the Government and the public as Sri Lanka is contemplating development of paddy as the commercial crop, Prof. Indraratna said.
Posing a question about the exchange rate, he said he preferred to categorise this as an external challenge because the exchange rate is determined by the supply of and demand for foreign currency. The demand for and supply of currency is determined by the international trade of goods and services. Under normal circumstances the rupee should depreciate because of the persistent current account deficit but it has been appreciating instead owing to mainly short term debt including sovereign debt of US$ 1 b. With Sri Lanka’s inflation high relatively to that of a trading partner the real effective inflation rate has been appreciating and this has affected the competitiveness of exports. All these challenges mentioned so far would have a negative effect on Sri Lanka’s exports.
There is an external challenge affecting the growth of FDIs into the country indirectly. The political lobbies of USA, Canada, Australia and international non government organisations at the instigation of the LTTE diaspora about the national Government of Sri Lanka and its armed forces, Prof. Indraratna pointed out.
“I do not have to elaborate on this persistent and unprincipled campaign against Sri Lanka on the violation of human rights supported to some part by the Darusman Report and the Channel Four video of ‘Sri Lanka Killing Fields’ and affected by United Nations Secretary General and Human Resources Council Director General,” he accused. “Amidst all these challenges what is the prospect of making Sri Lanka the ‘Wonder of Asia’?” he questioned.
The achievement of sustained double digit growth, per capita income in real terms: in 2010 and the first two quarters of 2011 Sri Lanka was able to sustain an average growth rate of 8% . This was realised with a gross investment of around 28% and domestic savings of 18% making the huge resource gap of 10% of GDP. However, Sri Lanka cannot sustain such high growth with increased borrowings much longer. A large scale investment of around 35% or more of GDP at a level of efficiency of investment of around 3.5% to 1 ratio is required.
Speaking of the cessation of hostilities, he elaborated on the increase in infrastructure investment; roads, bridges, airports, power and energy and ICT. Overall productivity as measured by the capital investment and output ratio is likely to improve as a result of this. In my view there are signs of this already happening. Because the capital output ratio in the five years to 20005-2009 was 4.2. Sri Lanka should maintain and even improve this level of efficiency of investment of 3.5% in the next five years, Prof. Indraratna said, adding that agricultural productivity should be substantially increased.
He next approached the question of domestic savings. Domestic savings is comprised both public and private savings and is indicated by the decrease in the budget deficit. The estimated budget deficit for this year and the next is 6.8% and 5.4% of GDP. The deficit in the first seven months of this year is already 4.5%. It is distressing that the budget deficit for this year would go above the targeted 6.8%. The actual for 2012 would be very much more than the target of 5.4%, though it would be still less than that of 2011. It is noteworthy that the Government budget deficit has been coming down, he pointed out. It was 10% of GDP in 2009 and around 8% in 2010.
Inflation is on a declining trend since April this year when it was 8.9%. Headline inflation or point to point has fallen to 6.4%. This trend is expected to continue. Inflation should fall and real interest rates to rise further with per capita income also rising alongside savings. In 2012-2016 the budget deficit should be around 3%, he said. With regard to FDI the prospect is not that clear. It would not be sufficient to reduce below a sustainable level.
With regard to FDIs, Sri Lanka has to increase more than its fast growing neighbours such as India, China and East Asia. “But still FDIs of even one billion would not be enough to raise the level of FDIs to that required to achieve a growth rate of 10% and more per annum,” Prof. Indraratna said. “From where does this rate of increase in investment come?” he questioned. The public sector has been increasing its contribution from about 4.2% in 2005 to 6.4% in 2010.
In Sri Lanka imports were rising faster than exports. Exports which were contributing around one third of the GDP in 1950 are now contributing only half of that. Total gross investment to the economy has decreased. For instance average annual contribution from 2001-2010 was 21% of GDP while it was higher, around 23% of GDP, in the preceding period of 1991 to 2000.
“What I don’t know is, was it the domestic environment? Was it the terrorist war? Or weren’t there enough fiscal and other incentives? Or wasn’t there enough public private sector partnership or was the overall business climate poor as was indicated by Sri Lanka’s very low ranking in the Ease of Doing Business index?” Prof. Indraratna questioned. Whatever the reason they must change to provide a better business climate and an enabling environment for increased investment, he said.
The terrorist war is over. The Government has been offering fiscal incentives to the private sector in recent months. They say that not being subject to high volatility, inflation has been on a falling trend since 2008 side by side with declining nominal interest rates, he added. The overall change is reflected in the recent improvement in Sri Lanka’s Competitiveness Index.
The Government has a lot more to do towards the establishment of an enabling environment without good governance, corruption law and order, rule of law simple rules and procedure in investment application and modernisation of education to meet the demand for services. The fact that the Government has realised its responsibility and made a start in the right direction should be a source of encouragement and strength to the private sector, he said.
Engine of growth
The private sector must play a lead role as an engine of growth and exports must be the driver of this growth if Sri Lanka wants to achieve its goal of being the ‘Wonder of Asia’. The Government can and should act as a provider of infrastructure services facilitation, moderation and mediation. This is productive investment to achieve the set goal; a share of the private sector including FDIs. “Where could this increase in investment go?” he questioned.
We require value addition and increased new products, he said. The private sector must be a growth engine. Sri Lanka has been investing less than 0.2 % of GDP in research and development and of this less than 1% has come from the private sector. In order to go in for new products and increased value addition and differentiation of products to capture new niche markets particularly emerging market economies like, China, India and Vietnam Sri Lanka must increasingly turn to getting into their value chains .
The private sector has invested much more in R&D than before. With the private sector money employed, there is wide scope for further value addition in Sri Lanka’s export goods, he said. For example, there is still some scope for rubber exports with further value addition, value addition for Middle Eastern markets.
Another area for increased investment is industrial products. Of industrial exports to the country only 1.5% is in high tech exports. With more FDIs also coming in the private sector must think of going in for more high tech exports, he said.
Tariff lines available to Sri Lanka such as SAPTA, Indo-Lanka Free Trade and the Asia Pacific Trade Agreement were also referred to. There is scope for further investment in the transport industry. A market of 2.5 million tourists by 2016 means an increase of more than 30%. The Sri Lankan business sector has to invest in a big way alongside the foreign investors.
ICT is another fast expanding area in Sri Lanka relative to South Asian nations. The Government is playing a lead role in IT education and IT resources. Already accounting and finance BPOs have become a foreign exchange earner which has the potential for further growth and the private sector must exploit this, Prof. Indraratna said.
He concluded saying Sri Lanka is a fortunate country well-endowed with natural and human resources, with oil exploration having just begun. Our domestic front must be geared, he said.
Dr. Koshi Mathai, the Resident Representative of the International Monetary Fund, made the next presentation at the inauguration. Dr. Mathai spoke on what is happening in the global environment and implication for Sri Lanka.
“We at the IMF see that global activity really isn’t under threat,” he opined. “There should be a global rebalancing. The private engine of growth is going to have to take over because stimulus would naturally have to take off after awhile. We are not seeing private economies picking up in the way that we would like,” he said.
The second point he made was about global demand rebalancing: “We have had this model for many years where you all know countries like China export like mad and countries like the US consume like mad,” he pointed out.
“Household savings in the US went down to zero. As somebody living in the US, I can tell you how many credit card offers I receive everyday. With this global crisis there is now a need to build up savings. There is a need to export less and maybe start consuming more. For countries like China to start saving less and consuming more, provide their own engine of growth because the US engine is not going to be ticking,” he said.
“That rebalancing is not happening today. The large surpluses and deficits remain quite large. They have reduced somewhat but still are larger than before, we are linking those to some policy adjustment,” Dr. Mathai said.
First of all the need for more fiscal adjustment and what we call the balance sheet effect. That is in the case of banks recapitalisation, in the case of households building up their wealth, through this process, he said. Rebalancing demand in these Asian economies relying on domestic demand. “Now what we have seen in the recent past?” he questioned. “We have seen some good news but most of it is good news that we expected. We’ve also seen a great deal of bad news and much of that has been unexpected.”
Euro restraints have increased quite dramatically. There are fairly major problems coming up in Europe: the sovereign debt crisis, in the US the flow of recent data has not been all that great. Generally the flow of data in the US has indicated a growth momentum much weaker than what we expected, Dr. Mathai said, especially in terms of consumption.
“We see this global stock market correction. Stock markets with equities held so widely that it indicates a decline in consumption, in wealth of households. We are likely to be stuck in a slow period for long,” Dr. Mathai explained. “Lots of bad news. On the good side Japan is picking up quite well after the general earth quake they went through, emerging markets are growing quite strongly and after the tsunami we’ve seen oil prices coming back down again, he said. Still quite high but some what rationalised this year,” he added.
There is a vicious interaction between the real financial sector, he said. You’ve got the peripheral European sovereign debt crisis where bonds become expensive and that in turn has implications for the real economy, Dr. Mathai pointed out. The costs for banks borrowing – the spreads – have risen dramatically in the last few months particularly in the Euro area rather than for the US.
He drew attention to capital flows since January 2010. These have seen substantial flows in to emerging markets and then the Greece crisis happened. The equity markets are showing huge declines. Flows into the equity markets are reversing. There has been a massive run up in both food and oil prices. Food prices have remained high, oil prices have come down, they are substantially more but still higher than what they were a year ago, he pointed out. In advanced economies consumption growth is slowing down. Emerging economies are quite all right.
Looking at the employment to population ratio not just looking at the unemployment rate Dr. Mathai pointed and questioned how many people are employed out of the total population and said that in the US there was a secular increase.
In the US they ask, what are the expectations of family income? Expectations of family income have fallen through the floor, he said. “We assume that the world doesn’t explode. We are not assuming that the European crisis gets out of control. We are not assuming that the US economy stops growing or shrinks dramatically. We are assuming that the financial system recovers but in a rather slow way,” he said, explaining that under that sort of assumption we come up with the negative prediction.
The projection that world growth would be 4% this year, with the emerging markets growing very fast more than 6% and countries in developing Asia growing at eight or nine or even 10% but the advanced economies stuck in the doldrums growing at less than 2%, Dr. Mathai said.
“We’ve got the US growing at just 1.5%.and the Euro area (1.75%) doing about the same; Japan contracting this year because of the earthquake. In developing Asia we got much more robust growth, an uneven sort of recovery across the world,” he said. He said that 4% growth is not that bad as in 2009 the world economy shrank 5.6%.
“We are not saying that this is the second international crisis, we are not saying that this is the second depression. But it is clearly a slowdown relative to what we were expecting,” he said. “We do this forecasting exercise every few months and relative to the last update we did in June here is how we have revised it downwards.”
Across the US, Europe, developing Asia and Latin America the IMF has basically marked everybody’s growth down, particularly so for the US, he said. Inflation had dropped sharply during the crisis. It picked up once again particularly in the emerging markets and now it has started to moderate. “We are not in deflation here,” Dr. Mathai said. “We have lost concerns we have about over heating for emerging markets,” he added.
“Central banks here in emerging markets have little space. Going back to 2008 the imbalances were growing. Things changed very dramatically – a much more balanced pattern than we had in the 1990s,” he said. “We are left with rather large current account surpluses and deficits. I talked about the need for consumption in emerging markets to take off and to replace some of the consumption in advanced economies. We see consumption in advanced economies picking up and powering growth going forward,” he said.
“For advanced economies we are basically saying it’s important to keep monetary policy easy – don’t succumb to the temptation to worry about inflation and start hiking interest rates,” Dr. Mathai said. He added that interest rates should be kept low and monetary policy easy.
“On the fiscal side in Europe we have seen this debate. The US also has a medium term fiscal problem. The key is the medium term,” he said. Putting the brakes on now would be a real recipe for disaster, Dr. Mathai said. “What we think is important is to develop a medium term plan. Let’s deal with rising health care cost, let’s deal with that programmes that are getting out of control,” he said.
That should create some space to create some fiscal measures in the short run, he explained. Going for a balanced budget as precisely people are arguing for in the US would be the wrong prescription, he said. “We need stimulus right now but can only get it if we can assure markets that something is being done to sort things out. That’s the situation in the medium term,” he said.
“For the emerging economies we have said you can continue tightening monetary policy. Last year we were telling all emerging markets to put the brakes and look at inflation before it gets out of hand. In some countries now inflation has started abating. There are these threats out there in the global economy,” Dr. Mathai said. These countries don’t need to hike interest rates right now. Speaking on fiscal policy, he said there was a need for fiscal policy normalisation removing measures during the deepest part of the crisis and tightening fiscal policy.
Given that there are threats to global activity there are restraints in some of these global markets to restrain some of these stimulus measures. There is a need for structured reforms and currency appreciation In order to control these imbalances, Dr. Mathai prescribed.
Sri Lanka’s export performance
Speaking on Sri Lanka’s export performance he said the export to GDP share has dropped from 30 % to 15% in the last 19 years. Exports as a share of world exports have declined from .08% of rural exports to .06%. This is 15 years of Sri Lanka’s economic history, he said.
When talking of the nominal growth of exports its important to normalise things, he said. “How exports are doing relative to global trade flows. They are not doing that well. The US and Europe are not growing. The US accounts for 20% of our exports and the EU 36%. We need to re-orient towards India and towards China which is just 1% of exports,” he said.
This is easier said than done, he explained. In this back ground of declining exports, very fast growth and a skewed break geographically points to two things:
“I must give the Government credit for the ‘Mahinda Chinthana’ policy – a lot of it seems very optimistic but it is fundamentally absolutely solid. This country should be trying to be a hub, should be trying to provide services to the region because the region is growing. The comprehensive economic partnership with India, anyone can realise that if we don’t take advantage of 8% growth in India we are being utterly foolish,” he said. “There is a lot of uncertainty in the world so while we have 4% growth there is a lot of uncertainty. My high school literature teacher quoted that ‘No man is an island unto itself’.
No country is an island
“No country is an island unto itself. It is not an island unto itself; it is closely connected to other parts of the global economy. And if exposed in terms of remittances, capital flows and exports there are inter connections with the global economy. When there are storm clouds on the horizon, the IMF would say it pays to get ready. Not worrying about the drizzles of rain right now but worrying about the hurricane, the typhoon that will come tomorrow. I’m talking about reserves. There is a need to accumulate more reserves in order to prepare for bad circumstances. Holding reserves in an expensive no interest is costly.”
“We have had some dispute over the exchange rate policy. How much of reserves come from Treasury bills and bonds and from IMF borrowings?” Dr. Mathai questioned. “Subtract all those amounts and you will find that the amount of non borrowed reserves is really quite small. The amount of reserves that have been generated through export performance through Sri Lanka’s current account through FDIs are really quite small. Over time this is unsustainable and needs to be addressed,” he said.