Overview of Macroeconomic Developments in 2020
The complex challenges encountered by the Sri Lankan economy in 2020 were efficaciously addressed through extraordinary policy interventions by the Government and the Central Bank. These interventions were essential to mitigate the socio-economic impact of the spillovers of the COVID-19 pandemic and the resultant scarring of households and enterprises.
Alongside the global economic downturn induced by the pandemic, the Sri Lankan economy contracted by 3.6 per cent in real terms in 2020, recording the deepest recession since independence.
The sharp contraction observed in Industry activities during the year was driven by the significant slowdown in construction and manufacturing activities. Services activities also registered a notable contraction due to the pandemic driven deceleration in transportation, other personal services, and accommodation, food and beverage services. The Agriculture sector, too, registered a contraction during the year as the impact of the pandemic outweighed the positive effects of timely policy support and favourable weather conditions. Investment expenditure contracted in 2020, reflecting subdued investor sentiments, while consumption expenditure displayed a marginal growth. The contraction of investment expenditure exceeded the reduction in national savings, resulting in a decline in the savings-investment differential in 2020. Meanwhile, the unemployment rate rose above 5 per cent for the first time since 2009, with a decline in the labour force participation rate, in the wake of uncertainties surrounding the pandemic.
Reflecting the combined effect of the contraction in Gross Domestic Product (GDP) at current market prices and the depreciation of the Sri Lankan rupee against the US dollar, GDP per capita declined to US dollars 3,682 in 2020 from US dollars 3,852 in the previous year. The pandemic also caused a decline in the overall size of the economy to US dollars 80.7 billion in 2020 from US dollars 84.0 billion in 2019.
Supported by timely policy measures undertaken by the Government and the Central Bank, the external sector battled strong headwinds in 2020. The slump in merchandise exports due to the mobility restrictions and lockdown measures was swiftly overcome, demonstrating the resilience of Sri Lankan exporters. Accordingly, export earnings rebounded within a relatively short span of time to reach pre-pandemic levels. Measures to curtail non-essential imports, together with the significantly low global petroleum prices, helped reduce the import expenditure in 2020, resulting in a notable improvement in the trade deficit.
Workers’ remittances recorded a notable recovery during 2020, despite the decline witnessed at the onset of the pandemic. With these developments and policy-induced adjustments, the external current account deficit improved to 1.3 per cent of GDP in 2020 from 2.2 per cent of GDP in 2019.
Meanwhile, inflows to the financial account moderated amidst heightened global uncertainties and the cautious approach adopted by investors towards foreign direct investment (FDI) and portfolio investment. Despite pressures experienced during March-April 2020, and in late 2020, significant volatilities in the exchange rate were prevented with timely measures, and the depreciation of the Sri Lankan rupee against the US dollar was contained at 2.6 per cent in 2020. Overall, the Central Bank absorbed foreign exchange from the domestic foreign exchange market on a net basis during 2020, and gross official reserves were recorded at US dollars 5.7 billion at the end of 2020, which provided an import cover of 4.2 months.
Pressures on the fiscal sector were aggravated by constrained access to foreign financing in 2020 amidst unfavourable global financial market conditions and downgrades of Sri Lanka’s rating by sovereign rating agencies.
Reflecting the expanded budget deficit and resultant large financing requirements as well as the contraction of GDP, the outstanding central government debt rose to 101.0 per cent of GDP at end 2020, from 86.8 per cent of GDP at the end of 2019.
Nevertheless, the relative share of outstanding foreign debt to total central government debt declined notably to 40.0 per cent at the end of 2020, from 47.6 per cent at the end of 2019. Amidst adverse speculation, the Government continued to maintain its impeccable debt service record.
Meanwhile, subdued inflationary pressures and well-anchored inflation expectations provided the necessary space for the Central Bank to significantly relax its monetary policy stance during 2020.
The Central Bank implemented extremely accommodative monetary policy measures during 2020, through the reduction of the key policy interest rates to historic lows with a downward adjustment of 250 basis points in total, and the lowering of the Statutory Reserve Ratio (SRR) applicable on rupee deposit liabilities of licensed commercial banks (LCBs) by a total of 300 basis points and the Bank Rate by 650 basis points.
The Central Bank and the banking sector provided necessary financing to the Government to carry out fiscal operations in an undeterred manner amidst the pandemic. Consequently, alongside the expansion of credit to other sectors, net credit to the government from the banking system increased substantially during 2020, thereby resulting in a notable expansion of the broad money supply.
Medium-Term Macroeconomic Outlook
The Sri Lankan economy is expected to rebound strongly in 2021 and sustain the high growth momentum over the medium term, buoyed by growth-oriented policy support.
While the export-oriented manufacturing sectors are expected to be strengthened with the establishment of dedicated industrial zones, the opening up of the Colombo Port City for foreign and domestic investment would bolster the country’s services sector, in particular.
While cautious management of external sector pressures in the near term is crucial in maintaining macroeconomic stability, the implementation of policies to strengthen non-debt creating foreign exchange inflows is expected to improve the resilience of the sector in the medium term.
Major inflows of foreign investment are expected to the Colombo Port City and the Industrial Zone projects, among others.
The near term needs to meet large foreign currency debt service payments of the Government is expected to be fulfilled with the support of bilateral and multilateral sources of financing, while ongoing improvements in the external debt profile and efforts to enhance non-debt creating foreign exchange inflows are expected to ensure the sustainability of Sri Lanka’s external debt in the period ahead.
In line with the Government’s policy agenda, the fiscal sector is expected to improve over the medium term, underpinned by the envisaged revival of economic activity. The business-friendly tax regime, which was put in place from the end of 2019, is expected to continue over the medium term, thereby facilitating a gradual increase of government revenue as businesses and other economic activities continue to expand. The expected rebound of government revenue would also be facilitated by revenue administration reforms to strengthen the tax net.
The fiscal burden stemming from underperforming State-Owned Business Enterprises (SOBEs) is expected to be reduced with productivity improvements and enhanced managerial efficiency. Although the need for fiscal support for economic activities to recover from the effects of the COVID-19 pandemic would keep the budget deficit elevated in the near term, it is expected to decline to 4.0 per cent of GDP over the medium term with the envisaged improvements on the government revenue and expenditure fronts.
Meanwhile, the reliance on deficit financing on foreign sources would be minimized in line with the expressed preference of the Government to reduce exposure to foreign liabilities. Measures have already been taken to streamline foreign-funded public investment projects, while encouraging public-private partnerships, thereby lessening the debt burden of the Government. Consequently, the outstanding debt of the Central Government is expected to gradually reduce from the current elevated levels to around 80 per cent of GDP by the year 2025.
With proactive policies to roll back any excessive policy stimulus when aggregate demand conditions normalize, inflation is anticipated to be maintained within the targeted range over the medium term. Inflation is projected to hover around lower single-digit levels during most of 2021, reflecting the slack in economic activity.
Adherence to the envisaged fiscal consolidation path by the Government as well as appropriate monetary policy adjustments made in a forward-looking manner as economic conditions normalize will help stabilize inflation and anchor inflation expectations in the 4-6 per cent range over the medium term within the FIT framework.
The envisaged low inflation environment will help the maintenance of the low interstate structure, facilitating credit flows to the private sector at a reasonable cost and thereby supporting the expected high economic growth, while providing a reasonable real return to savers.
While the prevailing low-interest rate structure presents tremendous opportunities for new and existing business ventures, it also poses significant challenges for economically vulnerable groups that rely on incomes from interest-bearing deposits.
The increased focus towards the introduction of safe and alternative financial products that yield reasonably high returns would benefit savers who are adversely affected by the low-interest rates.
Improvements in the Sri Lankan economy over the medium term are expected to be driven by the implementation of the Government’s novel economic policy framework based on Vistas of Prosperity and Splendor, which aim sat addressing longstanding macroeconomic imbalances and ensuring equitable, shared and sustained economic growth.
On the fiscal front, the economy has been grappling with high and rigid expenditure and persistently low revenue mobilization largely due to the lack of any sizeable expansion in the tax base and weak tax administration. The resultant expansion in the fiscal deficit has led to the rapid accumulation of debt to disconcerting levels.
The Central Bank’s maintenance of a low-interest environment will also enable domestic ventures to benefit from the Government’s pro-growth policies focused on expanding the productive potential of the economy.
0 comments: