Central Bank’s 61st Annual Report says:

2011 challenging; growth forecast remains at 8.5%

Sri Lanka”s economy grew by an impressive 8.0 percent in 2010, reflecting a fast recovery from the setback suffered in 2009 and moved to a high and sustainable growth path. All key sectors of the economy demonstrated a commendable performance in 2010, underpinned by the peaceful domestic environment, improved investor confidence, favourable macroeconomic conditions and gradual recovery of the global economy from one of the deepest recessions in history.

Inflation continued to remain low at around mid-single digit levels and the benign outlook for inflation enabled the Central Bank to ease its monetary policy stance further in 2010. While significant demand pressures were absent, improved domestic supply conditions, downward adjustments of certain administered prices and the reduction of import duties on several consumer items had a favourable impact on prices.

The Central Bank reduced its policy interest rates; the Repurchase rate and the Reverse Repurchase rate, with a view to supporting economic activity further.

The growth of broad money was driven by the increase in commercial banks’ credit to the private sector reflecting the broadbased demand for credit with the recovery in domestic economic activity as well as increased post-conflict capacity expansion.

However, monetary management could be challenging in the period ahead owing to possible continued high growth in domestic credit as well as a possible increase in capital inflows, thus requiring close monitoring of macroeconomic developments and formulating appropriate demand management policies to prevent the build-up of excessive demand pressures.

An encouraging improvement in the overall fiscal situation was witnessed in 2010 with the recovery in government revenue supported by the expansion of economic activity, the addressing of certain persistent structural issues in the tax system, as well as the containment of recurrent expenditure.

The overall deficit was reduced to 7.9 percent of GDP in 2010 from 9.9 percent in 2009. The government has affirmed its ongoing commitment to fiscal consolidation by reducing the budget deficit to 6.8 percent in 2011 and to below 5 percent in the medium term.

In line with the recommendations of the Presidential Commission on Taxation, several vital revisions were introduced to the tax structure focusing on the simplification of the tax system, rationalising exemptions, improving tax compliance and strengthening tax administration.

In addition, steps were taken to streamline the tax concessions granted under the Board of Investment (BOI) Act focusing on larger and strategic investments.

The continued fiscal consolidation efforts would reinforce the conduct of monetary policy in achieving economic and price stability. The external sector, which made a remarkable turnaround since the second quarter of 2009, continued to improve in 2010. Both exports and imports recovered strongly, while increased earnings from the tourism industry and higher inward remittances offset the widening trade deficit to a great extent, reducing the external current account deficit. Increased capital and financial flows resulted in the balance of payments (BOP) recording a surplus in 2010, further strengthening external reserves of the country.

With favourable macroeconomic conditions and the recovery in economic activity and also with the supportive regulatory and supervisory framework, the performance and stability of the financial sector strengthened in 2010.

This improved performance was reflected in all prudential indicators. Credit flows significantly recovered, profitability improved, capital adequacy further increased above the threshold and the ratio of non performing loans declined, while provisions for loan losses increased.

The performance of finance companies in distress also improved rapidly, while financial markets continued to remain liquid. The branch network of banks and other financial institutions expanded, particularly with the measures taken by the Central Bank to promote financial service delivery to the Northern and Eastern provinces. Improvements to the payments system continued. A mandatory deposit insurance scheme was introduced in 2010 for licensed banks and finance companies to protect small depositors. However, intermediation costs that still remain high, as reflected by high interest rate margins, and the sluggish development in the corporate debt securities market continue to remain areas of major concern.

In 2010, the Sri Lankan economy recorded an impressive growth of 8.0 percent, the highest annual rate of growth reported in the last three decades. This far exceeds the average annual growth of 4.9 percent recorded since the liberalisation of the economy in 1977. This remarkable performance was supported by the restoration of permanent peace, which created an environment conducive for the expansion in economic activity, the strong macroeconomic environment, increased domestic demand, the development of infrastructure facilities, improved external demand with the gradual recovery in the global economy and favourable domestic weather conditions.

The improved performance in all key sectors of the economy contributed towards the high economic growth in 2010. The agriculture sector, which contributed around 11.9 percent of the GDP in 2010, grew by 7.0 percent, compared to 3.2 percent in 2009, mainly driven by the increased production of paddy, tea, rubber and minor export crops along with significant improvements in the fisheries sector output. Benefiting from favourable weather conditions, the tea sub-sector registered the highest ever annual production of 329 million kg compared to the distressed output in 2009, while rubber production also continued to increase.

In 2010, the first full year of operation subsequent to the ending of the three-decade long conflict, the economy of Sri Lanka has displayed its true potential, with impressive macroeconomic achievements. The challenge for policy-makers today is to sustain these achievements with macroeconomic stability in the face of more frequent internal and external shocks. While appropriate demand management policies are required to maintain low and stable inflation, effective addressing of supply-side impediments is also needed.

The continuous advancement of productivity, the adoption of new technology and human capital development would reduce the pressure on the labour market, while improvements to physical infrastructure and appropriate changes to the regulatory framework need to be pursued to facilitate greater labour mobility as well as greater labour availability to maintain the expected high growth.

The diversification of exports, in terms of products and markets, is needed to increase the resilience of the economy to external disturbances, and to this end, the effective utilisation of existing bilateral and multilateral treaties and actively pursuing the establishment of further trade relations with emerging regional markets as well as promoting private sector investment and strengthening the “Doing Business” environment are necessary.

The impact of disturbances arising from adverse external developments including price movements of commodities such as crude oil, could also be lessened through the implementation of necessary reforms to the institutional framework of key public enterprises to operate them more efficiently and in a commercially sustainable way to reflect market conditions. These changes will support the ongoing fiscal consolidation process, which would in turn strengthen demand management policies.