World Bank warns of slowdown

A development success story in many ways, Sri Lanka still faces critical challenges as it strives to become an upper middle-income country. The World Bank Group supports Sri Lanka’s transition to a more competitive, inclusive, and resilient upper-middle income country.

Sri Lanka At-A-Glance

A complex political environment and the impact of natural disasters, such as floods in May and prolonged drought across the country, made 2017 a challenging year for Sri Lanka. As a result, Sri Lanka’s macroeconomic performance slowed down. In fact, the growth rate declined to a 16-year low of 3.1 percent in 2017 – the lowest it has been since 2001.

However, a primary surplus was recorded for the first time in decades. Hence, even though the overall deficit has slightly increased due to a sharp increase in interest expenditure, public debt to GDP ratio has marginally decreased due to a primary surplus and relatively low currency depreciation.

With the support of World Bank, the government is carrying out fiscal reforms, improving public financial management, increasing public and private investments, addressing infrastructure constraints and improving competitiveness. The launch of its Vision 2025 on September 4, 2017 was designed to strengthen democracy and reconciliation, inclusive and equitable growth and ensure good governance.

Nonetheless, despite government commitment, the progress of reforms to enhance competitiveness, promote good governance and continued fiscal consolidation, have already been slowed by the effects of political uncertainty. Since these reforms are critical for sustained growth, and the key risks remain, a favorable outlook is uncertain.

COUNTRY CONTEXT 

Sri Lanka is a lower middle-income country of 21.4 million people with per capita GDP in 2017 of $4,065. Since the civil war ended in 2009, the economy has grown on average at a rate of 5.8 percent a year, reflecting a peace dividend and a commitment to reconstruction and growth, but there have been signs of a slowdown in the last three years. The economy is transitioning from a predominantly rural-based economy towards a more urbanized economy oriented around manufacturing and services.

The country has made significant progress in its socio-economic and human development indicators. Social indicators rank among the highest in South Asia and compare favorably with those in middle-income countries. Economic growth has translated into shared prosperity with the national poverty headcount ratio declining from 15.3 percent in 2006/07 to 4.1 percent in 2016. Extreme poverty is rare and concentrated in some geographical pockets; however, a relatively large share of the population subsists on slightly more than the extreme poverty line. The country has comfortably surpassed most of the MDG targets set for 2015 and was ranked 73rd in the Human Development Index in 2015.

The economy’s weak competitiveness is an issue to address. Restrictive trade policies over the past decade have created a strong anti-export bias, which has been reflected in a dramatic decline in trade. While growth in Sri Lanka has been strong over the past few years, it has been inward-oriented and based on the growth of non-tradable sectors. Sri Lanka also attracts a much lower volume of FDI than peer economies and the shortcomings of the investment climate pose obstacles for new firms.

Moreover, significantly high state participation in the economy has implications on competitiveness in a number of sectors and labor market dynamics. Low revenues as a share of GDP has been a structural issue that adversely impacts fiscal position. The major causes are the low number of number of tax payers (less than 7 percent of the labor force and formal establishments pay income tax), reductions in statutory rates without commensurate efforts to expand the tax base, inefficiencies in administration and numerous exemptions. Low revenues combined with largely non-discretionary expenditure in salary bill, transfers, and interest payments has constrained critical development spending and squeezed expenditure on health, education and social protection, which is low compared to peers.

RECENT ECONOMIC DEVELOPMENTS

Sri Lanka’s improvement in its macroeconomic performance was masked by inclement weather in 2017. Fiscal and monetary policy measures contributed to stabilization.  However, the adverse economic impact of a prolonged drought took a toll on growth (3.1 percent) and the external sector while raising inflation (6.6 percent, annual average). A primary surplus recorded for the first time in decades, albeit small, and passing of the new Inland Revenue Act helped with the successful completion of the third review of the IMF program. However, a sharp increase in interest expenditure forced the overall deficit to slightly increase while public debt to GDP ratio marginally decreased thanks to primary surplus and relatively low currency depreciation. FDI, due mainly to the long-leasing of a port asset and a large land reclamation project along with other debt creating capital flows, helped improve the reserve cover of imports to 3.8 months of imports. The currency depreciated by 2 percent against the US Dollar.

ECONOMIC OUTLOOK

The outlook remains favorable, provided the government is committed to the reform agenda of improving competitiveness, governance and public financial management. Growth is projected to rebound in 2018 from a low base and continue to be around 4.5 percent in the medium term, driven by private consumption and investment.  Inflation will stabilize at mid- single digit level as the impact of natural disasters wears off, although the upward trend in oil prices may exert some upward pressure. The external sector will continue to benefit from the GSP+ preferential access to the European Union and tourism receipts, despite the deceleration of remittances. External buffers are expected to improve, with emphasis on purchasing foreign exchange, maintaining a more market-determined exchange rate, and increased FDI. The overall fiscal deficit is projected to fall in the medium term, supported by the ongoing implementation of revenue measures. Growth should continue to translate into poverty reduction and improvement in living standards.

RISKS AND CHALLENGES

Political uncertainty is the key risk to an otherwise favorable medium-term outlook.  External risks include lower growth in key countries that generate foreign exchange inflows to Sri Lanka. Steeper than expected global financial conditions would increase the cost of debt.  It will also make rolling over the Eurobonds maturing from 2019 more difficult.  Faster than expected rises in commodity prices would increase pressure on the balance of payments and make domestic fuel and electricity price reforms more difficult. On the fiscal and debt management front, risks include the delay in implementing revenue and liability management measures, and slower than expected improvement in tax administration. The increasing occurrence and impact of natural disasters could adversely impact growth, the fiscal budget, the external sector and poverty reduction.

Sri Lanka faces several challenges that increasingly put its future economic growth and stability at risk, which must be addressed through macro and structural reforms: (1) stay on the fiscal consolidation path by broadening and simplifying the tax base and aligning spending with priorities: this is important given high public debt, SOE debt and guarantees; and large gross financing requirements;  (2) shift towards a private investment-tradable sector-led growth model by improving trade, investment, innovation and the business environment; (3) improve governance and accountability by implementing the Right to Information Act and improve SOE performance and service delivery; and (4) reduce vulnerability and risks in the economy by enhancing disaster preparedness and mitigating the impact of reforms on the poor and vulnerable with well-targeted spending. (World Bank)

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