Tight monetary policy pays dividends

By Lalin Fernandopulle

The Sri Lankan economy grew at a healthy rate of 6.4 percent in 2012 while inflation was maintained at single digits for a fourth consecutive year, despite several global and domestic challenges, the annual report of the Central Bank, 2012 stated.The report was launched last week at a ceremony in Colombo. President Mahinda Rajapaksa was the chief guest at the launch.

The report stated that improved business and consumer confidence, which supported a robust economic growth of 8 percent in the preceding two consecutive years, was accompanied by high credit and monetary expansion and a widening trade deficit fuelled by high import demand.

The government implemented a comprehensive policy package in early 2012 introducing with tight monetary policy stance by the Central Bank raising policy interest rates and issuing a Direction under Section 101(1) of the Monetary Law Act in March 2012 to moderate credit growth by licensed banks.

This further strengthen the macroeconomic environment, by containing the rapid expansion of monetary aggregates and the widening trade deficit. The Central Bank also allowed greater flexibility in the determination of the exchange rate and limited its intervention in the domestic foreign exchange market, the report said.To curtail imports, tariffs on selected imports were raised. Further, to reduce the losses being incurred by state-owned enterprises and their impact on overall macroeconomic stability, several administratively determined prices, mainly relating to energy, were revised.

Inflation was maintained within single digit levels in 2012 for the fourth consecutive year. Inflation declined to a low level of 2.7 percent in February 2012.

However, the upward adjustment of energy prices and transport fares in February 2012 to reflect the rise in oil prices in the international market, the pass-through of the depreciation of the rupee, supply disruptions on account of adverse weather conditions that prevailed in major cultivation areas and the impact of past high monetary expansion resulted in inflation edging up to end the year at 9.2 percent. Nevertheless, within a relatively short period of time the impact of the policy measures adopted was evident with the trade deficit and credit granted to the private sector decelerating while managing inflation expectations also helped, containing inflation at single digit levels throughout the year.

By end 2012, the annual average rate of inflation stood at 7.6 percent. Reflecting the government's continued commitment to the fiscal consolidation process, the overall fiscal deficit was contained significantly below the previous year's level, although it marginally exceeded the target in the budget.

The slow down in economic activity and the decline in imports had a negative impact on government revenue collection. However, by maintaining a tight rein on recurrent expenditure and scaling back on capital expenditure, the overall fiscal deficit was contained at 6.4 percent of GDP, marginally above the targeted level of 6.2 percent of GDP and significantly below the 6.9 percent of GDP in 2011.

Raising the tax to GDP ratio by broadening the tax base and improving tax compliance would be critical to sustaining the fiscal consolidation process in the medium term. Although major tax reforms resulted in a simplification of the tax structure, revenue collection remained weak.

The external sector strengthened during the year benefiting from the policy measures that were adopted in early 2012 to improve macroeconomic stability. Import expenditure declined by 5.4 percent with non-fuel imports declining at a faster rate of 8.6 percent. Despite the decline in exports by 7.4 percent due to weak external demand and the decline in international commodity prices, the trade deficit contracted to 15.8 per cent of GDP in 2012.

The improvement in the trade account, increased inflows from trade in services including tourism and transportation, and continued high growth in workers’ remittances helped contain the current account deficit to 6.6 percent of GDP in 2012. The improvement in the current account together with higher inflows to the capital and financial account from the proceeds of the fifth international sovereign bond, higher inflows to the government to finance infrastructure development projects and increased foreign borrowing by commercial banks and the private sector as a result of the relaxation of exchange control regulations, resulted in the BOP recording a surplus of $ 151 million in 2012.

Accordingly, gross official reserves rose to $ 6.9 billion by end 2012.

The financial sector remained resilient and continued to support domestic economic activity despite the elevated risks from global and domestic developments.

The financial sector expanded during the year with increased access to finance although asset growth moderated as the credit ceiling was imposed early in the year. Nevertheless, soundness of financial sector institutions improved with higher capital levels, adequate liquidity buffers and healthy earnings. With the raising of funds abroad, the banking sector was able to diversify its sources of funding, further strengthening its balance sheet.

Significant attention was directed over the year towards strengthening the effectiveness of the regulatory and supervisory framework, in line with international standards and best practices and providing an enhanced focus on governance practices and risk management to address potential risks to financial stability. The payments and settlement system too continued to operate with a high degree of availability and safety, facilitating the financial intermediation function.

Real sector developments

The economy grew by 6.4 percent in real terms in 2012 amidst the slow recovery in global demand and the multi-pronged policy measures introduced to strengthen macroeconomic stability. All key sectors contributed positively to economic growth in 2012. The Industry sector was the main driver of growth with the construction sub sector making the most significant contribution, reflecting the massive public investment program and several private sector real estate projects. Growth in the Services sector moderated largely on account of the slowdown in external trade and the deceleration in the transport sub sector.

Despite adverse weather conditions in the second half of the year, the Agriculture sector performed better in 2012 than in 2011. Reflecting the expansion in economic activities, the unemployment rate declined to 4 percent in 2012 from 4.2 percent in 2011.

The Agriculture sector grew by 5.8 percent in 2012, recovering from a slow growth of 1.4 percent in 2011, amidst drought conditions in the third quarter of the year and heavy monsoonal rains and floods in the latter part of the year.

The Industry sector grew by 10.3 percent, contributing substantially to the expansion of the economy in 2012. The sustained increase in construction activities, which accelerated the growth momentum of the construction sub sector spurred the growth in the Industry sector.

The continuation of major government funded infrastructure development projects and increased construction activities of the private sector, including tourism related new construction and renovation activities, contributed to this growth.

A high level of activity in the construction sector bolstered demand for minerals and construction material enabling the mining and quarrying sub sector to increase its share in GDP.

Manufacturing, the largest sub sector within the Industry sector, decelerated in terms of value added growth due to subdued domestic and external demand. The factory industry sub sector, which accounted for around 90 percent of manufacturing output, decelerated in 2011.

The apparel industry has been able to sustain its performance despite the slowdown in major export destinations due to the high quality of export products and strong domestic demand arising from the tourism sector. The contribution from the electricity, gas and water sub sector to industry growth was also lower in comparison to the previous two years, partly due to the drop in value addition from hydro-power generation during the second and third quarters of the year.

Government initiatives in the form of regional industrial development, productivity improvements, support for small and medium enterprises (SME) and research and development for innovation continued to be the focus of industrial policy in 2012.

Services sector growth moderated to 4.6 percent in 2012 from an expansion of 8.6 percent in 2011 mainly due to the deceleration in the wholesale and retail trade sub sector. As a result, the relative share of the Services sector in GDP reduced to 58.5 percent in 2012 from 59.5 percent in 2011. The wholesale and retail trade sub sector grew by a modest 3.7 per cent in 2012 from 10.3 percent in the previous year.

The slowdown in import trade, reflecting the impact of policy measures taken to curb imports, and the decline in exports due to the sluggish recovery in the global economy largely contributed to the deceleration in this sub sector. Transport and communications, banking, insurance and real estate and hotels and restaurants sub sectors grew at a positive, albeit slower pace in 2012, also contributing to the modest growth in the Services sector.

Domestic and national savings improved considerably as a result of the improvement in the current account deficit. The lower growth in consumption expenditure mainly on account of imports resulted in an increase in the domestic savings rate to 17 percent of GDP in 2012 from 15.4 percent of GDP in 2011.

However, there was a deterioration in government dis-savings during the year. The continued growth of private remittances from abroad raised the overall national savings rate to 24 percent of GDP in 2012 from 22 per cent of GDP in 2011. Hence, despite the increase in investment as a percentage of GDP to 30.6 percent, the savings-investment gap as a percentage of GDP, improved to 6.6 percent in 2012, from 7.9 percent in 2011.

External sector developments

Overcoming the challenges encountered towards the latter part of 2011, the external sector performed well during 2012 benefiting from the comprehensive policy package implemented by the Central Bank and the government during early 2012. These policy measures mainly aimed at reducing the widening trade deficit in 2011 and early 2012, by curtailing non-essential imports and improving export competitiveness. The imposition of the ceiling on credit growth, and the upward revision to policy interest rates and tariff rates on selected imports helped curtail expenditure on imports during the year.