Economy navigates market turbulence

IMF sources last week said that Sri Lanka’s economic outlook and Budget 2014 are positive.

The economy continues to move forward, and has navigated recent market turbulence well.

Overall GDP growth has been solid, said permanent representative of the IMF in Sri Lanka, Koshi Mathai at a media briefing in Colombo.

He said that the consistency in policies, tax proposals, deficit reduction focus and the overall budget is positive.The media briefing was held after the conclusion of IMF Executive Board Ex-Post Assessment of Exceptional Access under the 2009 Stand-By Arrangement and First Post-Program Monitoring Discussion with Sri Lankan officials. According to the IMF assessment, Sri Lanka’s economy continues to move forward, and has navigated recent market turbulence well.

Overall GDP growth has been solid, but recent indicators underline some areas of concern. Trade activity has been slow to pick up, tax revenue and public spending (including capital expenditure) are relatively low, and private sector credit growth has been declining.

It projects real GDP growth of 6.5 percent for 2013, somewhat below the authorities’ forecast of 7 to 7.5 percent. Headline inflation fell to 6.2 percent in September 2013, from 9.2 percent at end-2012. Base effects have been an important factor, but pressures appears to be easing, consistent with more moderate economic growth and lower food prices.

The assessment projects end-2013 inflation at 7 percent. Risks to the inflation outlook stem mainly from potential upward shocks to world commodity prices and lagged effects of monetary easing.

The external position improved during 2013. Imports and exports slowed in the first half of 2013, reducing trade deficit. Exports have since started to pick up, while tourism receipts and inward remittances remain strong. This is expected to contribute to a projected 1½ percent of GDP reduction in the current account deficit in 2013, and broadly stabilise gross reserves.

Fiscal consolidation is facing headwinds. Despite some important tax reforms introduced in 2012, and the 2013 extension of the VAT to the retail and wholesale sectors, revenue performance has been weak thus far in 2013.

To some extent, low revenue reflects the weaker imports, but the numerous tax exemptions and tax administration weaknesses remain the important causes of lower-than-expected revenue.In response to the revenue shortfall, the authorities have kept spending under tight control and are committed not to exceed 5.8 percent of GDP 2013 deficit target. In Budget 2014, they are targeting a further deficit reduction, to 5.2 percent, based on continued restraint of current spending and steps to broaden the tax base.

During 2013, monetary policy has been progressively eased. In October 2013, citing benign inflation outlook and the desire to stimulate the economy to reach higher growth in 2014, the Central Bank of Sri Lanka (CBSL) cut policy rates by 50 basis points.

This followed the 50-point cut in May 2013 and a reduction of reserve requirements by two percentage points at end-June. The easing of monetary policy throughout the year has been slow to feed through to bank lending, and private credit growth has continued to slow.

As of June 1, 2013, the CBSL increased the reserve maintenance period of commercial banks from one week to two weeks, to allow greater flexibility in liquidity management, and further relaxation of foreign exchange regulations with effect from June 12, 2013.

The condition of the banking system has improved, and the Financial Sector Assessment Program update last year found that significant progress has been made in strengthening banking supervision.

Vulnerabilities still exist— expressed in the recent rise in nonperforming loans. The recent shift from concessional and bilateral loans to external borrowing by banks and private entities raises the risks to external sustainability.

The Executive Directors welcomed the opportunity to review macroeconomic and policy developments as part of post-program monitoring and the ex-post evaluation of exceptional access under the 2009 Stand-By Arrangement.

The directors were encouraged by Sri Lanka’s strong growth and moderating inflation, and by the economy’s resilience in the face of recent market turbulence. However, vulnerabilities remain, stemming from high debt and declining government revenues relative to GDP.

The directors commended the authorities’ commitment to fiscal consolidation. They welcomed ongoing expenditure restraint, but cautioned against further cuts in capital expenditure to meet fiscal targets.

They underlined the importance of putting tax revenues on an upward trajectory. They emphasised the need for further improvements in tax policy and administration, including elimination or rationalisation of exemptions and holidays.

The Directors said that the flexible exchange rate regime has acted as a buffer to external shocks, and welcomed the Central Bank’s move to a less active intervention strategy. In view of the risks of further market turbulence ahead, they emphasised the need to allow time for the effects of monetary policy to feed through to private credit and money growth before considering a further easing.

The Directors noted progress in financial sector development, and efforts to strengthen supervision and regulation.