Chairman, panellists, ladies and gentlemen, I am indeed pleased to be invited as the keynote speaker at this plenary session that is dedicated to review current macroeconomic position in Sri Lanka and deliberate the policy framework that is desired for future economic progress.
At the outset I extend my best wishes for the Sri Lanka Economic Summit 2012 of the Ceylon Chamber of Commerce which has been organised for the 13th consecutive year, mobilising a wide range of specialists to review economic policies of Sri Lanka.
This summit gives me an opportunity to articulate the Government position on this important subject which is considered desirable for the future economic progress in Sri Lanka. I am sure no two Economists have the same view point and each one has his own desired path.
However, I am sure that the chamber initiative to discuss different viewpoints will enrich us on this complex subject. Further, the Summit has a promotional value as Sri Lanka has a promising outlook to share at this juncture since we have advanced quite steadily during last eight years as a middle income economy.
The summit is blessed with valuable information already released by the Central Bank of Sri Lanka through its Annual report for 2011, the Annual Report of the Ministry of Finance and Planning in terms of Fiscal Responsibility (Management) Act 2003, first quarter GDP figures, employment statistics and first six months price data as well as the 2012 Population Census, all good work of the Department of Census and Statistics.
The IMF assessment of Sri Lanka following the conclusion of 2009 Stand By Arrangement, country partnership strategywith the World Bank 2012-2015 and associated studies, Country partnership strategy with the ADB 2012-2016 and the United Nations Development Assistant Framework 2008-2012, which is being replaced by 2013-2016 are also now in public domain.
The summit is also taking place at a time the Government is entering the international capital market for the third time with a long term sovereign bond issue. This is partly to meet the obligations of maturing bond liability of US$ 500 million raised five years ago and partly to meet foreign cost of public investment instead of using domestic borrowings. It is designed in a debt neutral basis and will improve domestic liquidity, external reserves as well as reduce pressure on domestic interest rates.
The 2011 Annual Report of the Ministry of Finance and Planning gives the Ministry’s perspectives of the Government’s development performance and challenges. I will take this opportunity to take that as a reference point to develop my speech today, we all agree that this summit is taking place at a critical time in the global economy. The IMF has downscaled the global economic prospects for 2012. Euro crisis, high energy prices and slowdown in emerging economies and conflicts in the Middle East economies have created tremendous uncertainties in the global economic environment.
The recovery from the 2008-2009 financial market collapse in the US and European economies and the high energy prices till 2009 seem to have lost momentum. The world seems to have entered another downturn.
Uncertainties are so much, that the growth forecast made by IMF in March this year, has been trimmed once again.
Policy interest rates have cut by several European and emerging economies like China to regain momentum but advanced countries have not reached out a consensus on the required adjustments to ballooning fiscal deficits in those countries. South Asia and Africa are also hit by a drought.
Sri Lanka has passed several milestones in recent times. The country has completed a 3 years of peace, reconciliation and development efforts since the prolonged conflict ended in May 2009. Having reached the critical threshold of US$ 1,000 Per Capita income level in 2004, Sri Lanka has crossed US$ 2,000 Per Capita income in 2008 and is well on the way to cross US$ 3,000 level this year.
The economy during the past eight year period has also gone through the post 2004 Tsunami adjustments, severe impact of climate changes, resettlement of displaced people from the conflict, demining and restoration of normalcy in conflict affected arrears, adjustments to global energy price changes and adjustments by the export sector to post multi-fibre agreement of the US and the withdrawal of European GSP concessions.
These are difficult challenges and adjustments to a country like us which has a limited fiscal space to accommodate. The capacity in the private sector to adjust to global shocks particularly in our SME’s is also limited.
The development strategy of the Government
The country’s overall development strategy spelt out in ‘Mahinda Chinthana – Vision for Sri Lanka – a 10 year horizon development framework’ 2006-2016 and ‘Sri Lanka, The Emerging Wonder of Asia – Mahinda Chinthana Vision for the Future’ envisages that Sri Lanka will have a stable society ensuring a quality living to its people having access to decent living, electricity, water, schooling and health facilities.
It aims at consolidating as an emerging economy that is integrated into global economy while being competitive internationally. This vision has specifically targeted achieving the Millennium Development Goals ahead of targeted time. They include the eradication of hunger, poverty, universalisation of secondary education for all, reducing the malnutrition rate of children below 15 per cent, increasing the life expectancy to 80 years, increasing access to clean water in urban areas to 90 per cent and raising the forest coverage from 28-43 per cent.
These development goals are to be realised through a rapid economic growth and by transforming the structure of the economy to be a modern, environmentally friendly and well-connected rural-urban economy that can create employment opportunities with better remuneration.
The Government development strategy attempts to promote the benefit of growth across all segments of the population and also to prevent inequities, social exclusion and adverse environmental repercussions that have been witnessed in some of the rapidly growing economies. Hence it recognises some clear trade-off in development.
In this context the principle target of this strategy is to raise per capita income to US$ 4,000 in 2016 in order to position Sri Lanka a strong middle income country that has realised all Millennium Development goals.
Performance and challenges
In the context of this overall development framework, the Sri Lankan economy has grown well over six per cent since 2004 each year except in 2009, when the economy registered a growth rate of 3.5 percent. Since the conflict ended, the economy has registered over eight per cent annual growth in 2010 and 2011. The macroeconomic policies in recent times have enabled the country to benefit from a lower rate of inflation below seven per cent from historically high double digit rate of inflation.
The Government has been able to reduce income inequity as measure by Gini Coefficient from 0.40 to 0.36 between 2006 and 2010, poverty from 15.2 per cent to 8.9 per cent, rising access to basic facility such as electricity, water, telephone and transportation and reduce unemployment from 7.2 per cent in 2005 percent to 4.2 per cent in 2011. The fiscal deficits have also contained below seven per cent except in 2008 and 2009, during which period the economy suffered a setback due to global uncertainties.
Though fiscal adjustments have been moderate, it should be recognised that adjustments have not been made by sacrificing public investments as in the ’80s and ’90s. Instead revenue deficits have been reduced through significant adjustments in non-interest recurrent expenditure in the National Budget.
The containment of fiscal deficits and relatively high economic growth has contributed to reduce public debt from over 100 per cent of GDP prior to 2004 to 78.5 per cent in 2011. Total external debt servicing too remains below 10 per cent of exports earnings and foreign remittances. The external reserves have been maintained over US$ 6,000 million.
However, the surge in development in the post conflict phase has also confronted with many challenges. The most significant among them and the most immediate term concern is the adjustments with the widened trade deficits which have increased to US$ 10 billion in 2011, almost equivalent to the value of exports of that year.
To the extent that there is a view that there is no adequate growth in exports, one must recognise that there has been too much growth in import as well. It is a fact that the cost of higher oil prices is a cause for a large trade deficit.
The expenditure on oil imports which accounted for one fourth of total imports in 2011 is also higher by US$ 2 billion compared to an average petroleum price of around US$ 80 per barrel. The surge in motor vehicle imports raised the cost of imports by about US$ one billion in 2011. In addition to the high cost of import of oil and motor vehicles, the country also spent over US$ 4 billion to meet the local requirement of food, dairy, fertiliser, pharmaceutical, steel, cement and construction materials.
Consequently, the country is trapped with a large trade deficit which cannot be resolved only by relying on exchange rate, interest rate and on conventional macroeconomic policy instruments but requires a comprehensive policy strategy that consists of structural changes and institutional strategies to alter export and import mix in the country’s economy.
The trade deficit has become an indicator showing investment opportunities in the country, as the volumes and values of many imports reflects the extent to which domestic market has expanded in recent years. The export structure also shows that it has not reflected much change in the market composition or product mix. Further, the scope for greater value addition in the country’s export needs to be exploited.
Immediate run stabilisation task
The sustainability of the post conflict growth momentum with economic stability requires a constant refinement in policy strategies, which includes measures to tackle immediate term problems and plans to sustain medium term prospects of high investments and growth that will fulfil the Government’s overall expectation.
Let me turn to immediate term problems. In the wake of a surge in trade deficit that exerted pressure on international reserves, the Government adopted a series of policy measures to stabilise the economy. First, a greater flexibility in the exchange rate is restored. Second, the demand pressure on imports and domestic economy was reduced through the reduction in overall credit growth through high interest rates, upward revisions in taxes on motor vehicle imports that cost US$ 1.7 billion in 2011 and commitment to continue adjustments towards a fiscal deficit at 6.2 per cent in 2012, following the adjustments for 9.9 per cent in 2009 to seven per cent of GDP in 2011. Third, the domestic demand for fuel use was managed by an upward revision in petroleum prices, transport fares, and electricity tariff. In order to mitigate the impact on vulnerable groups due to fuel price revisions, the Government introduced targeted subsidies to selected segments.
These adjustments are not easy, neither politically, nor economically. However, they have produced significant positive results. The greater flexibility in exchange rate has reduced the supply of foreign exchange by the Central Bank to the market significantly. On an average, the sale of foreign exchange has reduced from around US$ 500-600million per month prior to the adjustment to below US$ 200 million a month after the adjustment and below US$ 50 million in June 2012, reflecting that the bank’s intervention has been reduced. This has stabilised the country’s external reserves at around US$ 6 billion in spite of a continued higher out payments on oil imports.
It is also important that since these adjustments Colombo Stock Exchange have experienced net foreign capital inflows. Second, the importations of motor vehicles have declined by about 40 percent since April 2012 and may likely to moderate further helping the Balance of Payments outcomes this year. Although, the moderation in the credit growth and associated high cost of finance is a cause for concern for growth prospects, considering the substantial benefits in terms of managing the demand and particularly the inflationary pressures, a modest sacrifice in terms of economic growth to around seven per cent from the earlier projected level of around eight per cent is viewed as justifiable move.
The adjustments in fuel and electricity prices have contributed to contain the total loss of the Petroleum Corporation and Electricity Board. The recent moderation in global prices has improved the CPC performance. However, the impact of drought has reduced the hydro capacity in power generation resulting in a slight deviation in the CEB performance. The Ceylon Petroleum Corporation (CPC) and Ceylon Electricity Board (CEB) together, however, have maintained the projected losses in spite of the exchange cost and the impact of the prevailing drought. The commitment of the Government to keep the Budget deficit at 6.2 per cent of GDP will be realised by a greater concentration on revenue collections and expenditure commitment control on the Budget provisions.
While, these measures will certainly be required to stabilise the economy in the immediate run, they will moderate the economic performance. So the growth rate is likely to moderate towards seven per cent in 2012. The flexibility in the exchange rate has helped exports and import replacement industries, but will reduce trade, banking, leasing, finance and to some extent constructions as their import content is high. The drought and its impact on agriculture and power generation too will reduce the value addition from these sectors. The Monetary policy strategies and supply side initiatives have targeted to keep inflation at single digit level though next few months it is like to be in upper single digit level.
Medium term prospects
The medium term priorities of the Government will be to revert back the economy to 8 percent growth path with lower inflation of around six per cent. Towards this, it is vital that government will continue to consolidate fiscal adjustments toward five per cent of GDP as announced in the National Budgets and attain monetary growth of around 14 per cent with viable external reserves as well as domestic credit targets.
The macroeconomic framework adopted by the Government will have several backup supports to make it viable. First, the conclusion of the IMF programme facility together with the succession plan currently in preparation will provide a buffer to manage the Balance of Payments risks over the medium term. Second, there is a strong legal setup under the Monetary Law Act of 1950 which provides a framework to coordinate fiscal monetary relation towards managing the macro economy.
However, the panellists will agree with me that managing a macro economy is a complex task. On the one hand, overconcentration of aggregate variables tends to overlook underlying trade-off and compromises in real economy. For instance, widely accepted crowding out of private credit owing to fiscal deficit tends to push adjustments on public investments. Similarly a large development projects or foreign financed public investment activities tend to crowd out rural development initiatives and essential public service delivery mechanisms.
The Government does not believe in compromising public investment or scale down in rural development or freeze in recruitments to important services such as health, education and technical services. Equally targeting monetary aggregates should not crowd out credit to SMEs or long gestation private investments such as plantations. This Government does not agree with conventional reform approach and I see rationale behind such concerns having worked with different modules used in Sri Lanka over last so many decades.
These balancing tasks require policy flexibility in implementation. So, the macroeconomic framework which we have adopted and did not have difficulty in working with it with the IMF and other development partners has room for higher growth with external stability but also the flexibility to adapt to local realities.
Any successful macroeconomic strategy is required to get its fiscal framework in order. Towards this, the Government approach has been to get the revenue back on track not by simply looking at ad-hoc revenue measures but by reforming the revenue system to reach a large base to maximise yield over the medium term.
It is necessary that revenue is raised to maintain public spending at a viable level. The taxation reforms in the 2011 Budget aims at introducing a broad base and simpler tax system. It has rationalised the tax structure on four pillars of taxation namely, Income Tax, Value Added Tax, Excise and Trade base taxes. In many of these taxes, applicable base has been expanded and rates have been reduced.
Similarly, tax administration matters in tax reforms. Towards this, the Government has embarked on the changes in tax administration to manage a middle income country tax system. As the economy is rapidly growing through service sector expansion, it is necessary to introduce an automated system in tax administration linking all revenue and related agencies and develop the human resources to manage such a system.
The Ministry of Finance and Planning has embarked on a major institutional reform targeting Inland revenue Department, Customs and Excise to address a wide range of tax administrative issues and application of information technology. Reduction in personal income taxation to an average rate of about 17 per cent comparable with Hong Kong and Singapore, the simplification of systems and procedures, setting up of Tax
Interpretation Committee and Tax Appeal Commission have made system to encourage compliance and functioning with uniformity and free of administrative discretions to put better governance framework in place.
On the expenditure front, an integrated Information Management System is being developed in support of commitment controls, Treasury operation, careful project preparations for funding and productivity focused expenditure planning.
The performance of State-Owned Business Enterprises too plays a significant role in the current context as Government does not believe in privatisation as a source of revenue in fiscal adjustments as has been the practice till 2005. They play a dominant role in banking, insurance, power and energy, water, ports, aviation, commuter transport, media, lottery, pharmaceutical and fertiliser. Out of the 74 SOBEs, 27 are enterprises engaged in residual businesses left with the state after privatisation of major activities during the ’80s and ’90s.
Most SOBEs compete with the private sector except those in petroleum refinery, power, water lotteries, aviation and minerals. Most of these enterprises have potentials to generate significant profit income to the Government, once the productive capacity of these enterprises are created with new capital infusion which has taken place in recent times. These enterprises are also expected to generate return on investments and towards this the reform initiatives involve pricing, systems and procedures, financial and business management are being implemented.
While recent price revisions have contributed to make a significant turnaround in the Ceylon Petroleum Corporation its ultimate prospects is linked to the performance in Ceylon Electricity Board which is expected to shift its power generation strategy to low cost energy sources. The turnaround in these two enterprises has a significant positive impact on the performance of state banks which could also expand their activities and provide a greater competition to private sector banking and financial institutions.
The medium term aim is to raise non tax revenue of the Government to about three per cent of GDP through higher profits transfers from state enterprises. Such reforms will also reduce their borrowings from the banking systems and reduce private sector crowding out effect.
Skills and productivity development
Sri Lanka as approaching a middle income country status is trapped with two major challenges. One is the rising wages due to sustained decline in poverty, unemployment and large out flow of people for overseas employment. Hence, the country’s prospects in relying in labour intensive industries are fast evaporating. However, Sri Lanka has to compete with neighbouring countries which still have the advantage of using low paid workers for their production activities.
Therefore, the first trap in my view is the competition with competitors who are competitive due to the availability of a large pool of workers which we do not have any longer. The solution to this is to adopt technologically advanced industry and services activities. Such technology is available from advanced countries and probably from advanced emerging economies. They are costly and required a skilled workforce. This can be yet another trap, considering the limited resources.
This is why the Government and private sector must move rapidly with reform initiatives towards developing new skills that the economy would require to maintain its competitiveness in the global environment. Private sector itself can set up training institutions to improve quality of training and availability of demand driven programmes.
The public investment in education over three year medium term 2012-2014, budgetary resources are devoted towards modernising island wide primary and secondary schools with expanded facilities to science stream of education together with languages and sports, curriculum development and teacher training facilities. Equal emphasis has also been placed in vocational education system to develop skills required for the emerging growth sectors such as IT, tourism and leisure, construction, ports services, business and commerce, etc.
Towards making such reforms in both private sector and public institutions the Government has sought partnership with the World Bank and Asian Development Bank as well as with bilateral development partners to mobilise required financial support for reforms in skills development, promotion of knowledge bases activities and deepening science stream of education in schools to provide multi skills education. The private sector need to adjust in this direction rather than seeking conventional labour market reforms to enact hiring and firing legislations, because they seem inappropriate and politically not feasible.
Private sector capital formation
In terms of high growth strategy that the Government has visualised for the medium to long term requires a sustain increase in investments from the private sector. In support of private sector development, several major reform initiatives had already put in place. The 2011 Budget focused the taxation reforms toward broadening the base and reducing tax rates. The reforms have reduced the personal and corporate taxes significantly. Tax concessions have been simplified and several taxes removed. Investment incentives are provided through specific tax statutes in support of expansion as well as new investments. SME’s, Exports, construction, agriculture, tourism have been brought under 12 per cent tax rate.
Infrastructure facilities have been improved significantly and constraints to doing business have been reduced. The land alienation issues are being streamlined with longer term leases paid up front. As the availability of large scale state land is limited, out grower small holder operations are promoted with medium size lands being identified to the private sector particularly for agriculture. The land alienation for tourism facilities has made a significant progress with several resort locations and to be promoted with special product themes. The promotional activities of the country are projecting its tourism. Investments and export potentials to be undertaken through a coordinated strategy by all concerned stakeholders such as SriLankan, Board of Investment, Tourism Authority, Tea Board, Sri Lankan missions abroad and private sector.
The urban outlook is being transformed with the provisions of a wide range of value creation services. Unused urban lands are being released for multipurpose development projects capable of altering the landscape. Logistic facilities at ports, customs, Immigration and the Airport as well as basic community facility at public places have been significantly improved to promote investment climate.
The Logistic Performance Index moving Sri Lanka from 137th place to 81 and Doing Business Index from 102 to 89 over a period of two years of reforms in trade and transport related infrastructure, quality of logistic services, business registration and approval process, availability of information, etc., show that the Government has made concerted efforts to put those reforms in place. The reforms have begun to produce incremental progress. The Government vision over the next three years is to deepen these reform initiatives to place the country within the top 30 countries for doing business in the world. That itself speaks for the commitment of the Government to put desired governance in place for doing business in the country.
Investment fund accounts have been created in each commercial bank to provide long term lending and banking institutions are being incentivised to set up investment banking in provinces. Two State banks have already moved in this direction by setting up six district bank branches dedicated to enterprise development. These banks are expected to build capacity of the staff on SMEs and enterprise lending, project and financial management, develop instruments within banking system to lend through risk sharing mechanisms.
The Government has sought multilateral lending agencies to join hands with the Government to develop financing facilities on a long term basis to private sector in plantation, greater value addition business enterprises high value tourism product marketing IT related services, etc. Private banks are expected to enter investment banking as well as tax on such banking is reduced to 24 per cent.
A greater upsurge has been evident since 2009 with private sector investment rising by over two per cent of GDP to 22 per cent and foreign direct investment to two percent of GDP in 2011. In addition to six to seven per cent public investment, the expected private investment in 2016 is 27 per cent of GDP which include foreign direct investment of four percent of GDP and to reach 33-34 per cent investment level.
In this regard the Government has been successful in mobilising large investments from well-connected global players in to areas such as ports, tourism, urban development and manufacturing. A several major investments are also being lined up following the success achieved in the port sector by attracting large foreign investments on a Private-Public Partnership (PPP) basis.
Base on this experience, the Government is now working on the Northern super highway network connecting Colombo, Kandy, Jaffna and Trincomalee, power generation to augment the present capacity further and diversify the power generation mix and solid waste management with private investment giving new opportunities to domestic and foreign investor participation. The Government has also demonstrated its capacity to manage large PPP type instruments in recent years. However, one should not forget that these investments need to be managed not only based on the administrative and infrastructure capacity but also by strengthening our own on institutional, legal and human resource capacity.
Associated procedural requirements such as environment assessments, resettlements, availability of domestic resources and land use planning are also challenging. The absorption capacity in the economy cannot be permitted to be overheated, nor crowd out private or public investments each other.
A wide range of risks involved in FDI needs to be carefully managed. Such investments should not marginalise domestic private sector either and the complementary role that the local construction industry could play should be well recognised. Backward integration is vital to create high value chain in the domestic economy in promoting private investment.
Government has also identified several areas which are already in the private sector but operate significantly below market potentials for higher private investments. For instance despite three to four large international cement manufactures operating in Sri Lanka 52 percent of the domestic market cement requirement is imported. Similarly, 60 percent of the steel requirement is imported despite steel industry is in the hands of private sector. Sugar and dairy has large domestic market potentials of generating over a billion dollar saving over the medium term in the Balance of Payments.
Incentives have already being offered for local dairy industry to be value added activity on the economy. This is one area backyard economy as well as SME and large investors could work in a well-integrated system. Despite a massive public expenditure by the Government itself as well as by the private sector on health, the country relies on imported pharmaceutical products and associated goods from abroad.
Domestic agriculture is another area in which not only, primary agriculture can make a significant difference to national income, but also to the manufacturing sector through a wide range of processing and manufacturing activities. Many of the food processing activities at present are based on imported raw material including items such as dried chilies and peanuts. Investment potential to promote food security and exports of food products by way of storage, warehousing and logistic support is huge.
The construction industry which has come up well due to massive public investment initiatives during last eight years has also constrained by inadequate supply of building material locally and time has come right to encourage such investments particularly in view of the likely high demand for construction industry in the coming years in construction activities in super highways, urban and tourism facilities, etc. So, while more export concept is a welcome proposal, I am of the view that foreign exchange saving industries should also be given due recognition in the same way that exports earning are promoted. This is not a strategy of promoting protection but a strategy of expanding our production frontiers.
In the export sector Sri Lanka needs two fundamental shifts. First, to look at emerging markets for further expansion and market diversification. Out of the total exports of US$ 10 billion, almost 8 billion is directed at traditionally matured markets and to the Middle East economies. However, exports to emerging economies including India and China remain well below US$ 2,000 million. Nevertheless, imports from these economies are well in excess of US$ 10 billion.
Experience with two free trade agreements with two major South Asian countries demand us to improve the working arrangements by removing state Government’s entry barriers in those large economies to make full use of trade. Equally the Government has committed towards seeking market access in the East Asian economies like Japan, Korea, China through trade reforms bilaterally.
While many imports such as pharmaceuticals, sugar, dairy, essential food commodities could be promoted Sri Lanka beyond domestic market demand through increased private investments in those areas in which the progress achieved so far is encouraging the Sri Lanka’s exports such as fashioned garments, leather, high value rubber products, value added tea and spices, gem and jewellery, IT and enabling processing services, quality water and food etc, could be expanded to emerging markets significantly.
The country needs high value chain export activities, as such activities are likely to get benefited from greater flexibility in exchange rate, lower profit taxes and emerging investment climate in the country which promote both export and import replacement industries. Second, as far as the government policy strategies are concerned the services sector has significant prospects in augmenting export earnings. Port and airport related services are one such area in which Sri Lanka’s future could be altered.
The initiatives already taking place in promoting logistic facilities to attract free port industrial activities could earn significant earnings as well as promote the support industries such as bunkering, aviation and shipping maintenance facilities. All three ports at Colombo, Hambantota and Trincomalee have already attracted investments in heavy industries, processing and manufacturing, ship building and recycling industries.
In conclusion, Sri Lanka has got a good blend of an inclusive growth strategy to address its future prospects. The rural-centric development strategy, improved connectivity, security law and order have become strong pillars of development. The underlying global and local market potentials underscore investment prospects in export promotion and import replacement activities.
Political leadership and the commitment of the Government to transform Sri Lanka to a middle income country provide new opportunity to all of us. I am sure the five panellists have their own perspectives and viewpoints. Let me therefore stop here by thanking all of you for permitting me to express my viewpoints at this summit.
Ladies and gentlemen, I hope I have not disappointed those who seeking more governance and less Government. However, I do not think I have provided everything what private sector has in its shopping list. But I am convinced that the Government has put in place necessary building blocks that many could be satisfied.