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FINANCIAL CHRONICLE™ » DAILY CHRONICLE™ » Economic recovery or optimistic expectations?

Economic recovery or optimistic expectations?

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Redbulls

Redbulls
Director - Equity Analytics
Director - Equity Analytics
Written by Arthika Vishleshaka

Despite the serious setbacks the economy faced in the early part of the year, the Central Bank and the government are quite optimistic about the country’s economic performance this year. They expect the economy to grow by 7.2 percent; inflation to remain at single digit levels; imports to decline and provide a respite to the trade balance; the balance of payments to record a surplus; and the fiscal deficit is expected to be contained at 6.2 percent of GDP. Everyone must hope for these expectations to be realized as these would help stabilize the economy.

However, realizing these expectations would not be easy. In most instances, the developments in the first half indicate a poor performance in the economy and serious economic challenges continue. The favorable developments have been the fall in oil prices, reduction in import expenditure, the onset of the monsoon and higher generation of hydroelectricity. These developments would, no doubt, benefit the economy. The extent of their favorable impacts on economic growth, inflation and balance of payments are too early to assess.

In its July Monetary Policy Statement, the Central Bank said: “provisional data shows that the growth of import expenditure has been shrinking sharply in the first five months of the year, thereby narrowing the trade deficit, compared to the high levels recorded in 2011”. Further, the Central Bank observed: “With weaker global demand, most international commodity prices are also on a declining trend, which should, on a net basis, further ease pressure on the country’s imports this year, although the continuing sluggish global economic recovery may affect export earnings as well.” The fall in oil prices, the reduction in imports owing to fiscal and monetary measures and exchange rate depreciation are expected to improve the country’s external finances.

Economic growth
The attainment of an economic growth rate of 7.2 percent that the Central Bank expects is difficult to achieve in the depressed global economic environment that has resulted in a fall in exports. In fact, the Central Bank statement itself points out that “the continuing sluggish global economic recovery may affect export earnings as well.” The loss of exports has affected the industrial sector seriously.

This has not been peculiar to Sri Lanka. The high economic growth of India and China too has been arrested by the global economic depression. The latest IMF assessment of the global economy has not given much hope of an economic upturn. The sluggish demand for the country’s main exports would be a significant factor in reducing the rate of economic growth, the reduction of export incomes and losses in employment and earnings.

Drought conditions have already affected tea and food production significantly. Improvements in weather conditions could improve agricultural production in the second half of the year, but unlikely to offset fully the loss in production in the first half of the year. In any event changes in agricultural output will not determine the national GDP growth that much as agricultural output contributes less than 12 percent to GDP.
It is industrial output and the contributions in services that really matter. These are affected by the fall in exports, and in the case of services, the decline in imports as well. Tourism is, however, growing and will contribute to services income.

Inflation
Although inflation accelerated to a high 9.3 percent last month, the Central Bank expects inflation to be contained at single digit proportions. One of the underlying reasons for the increase in inflation to 9.3 percent in June 2012 from a year earlier was the sharp rupee depreciation from Rs.110 to 133 levels. With lesser demand for imports and stronger reserves owing to inflows from the Sovereign bond of US 1 billion, the rupee is not expected to depreciate further. In fact, the Rupee may appreciate somewhat. These developments together with a reduction in taxes on several consumer items are likely to reduce the consumer price index figures and lower inflation. The reduction in tariffs of consumer items will reduce the general price level.

The government, no doubt, motivated by gains in the upcoming provincial council elections, cut taxes on several imported foods. The tax on canned fish had been cut to 50 rupees a kilogram from Rs.85. The tax on dry fish has been reduced from Rs.100 to Rs.75 and the tariff on fish reduced from 30 percent or 35 rupees to 10 percent or 10 rupees a kilo. The tariff on sprats has been reduced from 30 rupees to 10 rupees. Import taxes on potatoes were reduced from 30 rupees a kilogram to 10 rupees and on large onions from 35 rupees to 25 rupees. All these will bring down the rate of inflation. If, however, prices are increased after the elections, then the rate of inflation will rise again.

Cooking gas prices were cut by 150 rupees for a 12.5 kilogram cylinder. It would not be surprising if petroleum, diesel and kerosene prices are also reduced. The latter, in fact, is most likely, as global petroleum prices have plummeted during the past several months. So far only gas prices have been cut. These reductions in prices would assert a significant downward pressure on the price level and the consumer index that has a high food weightage would, no doubt, decline in July and August. It is a moot question whether prices would be increased again after the elections to cope with the repercussions of these on the trade balance.

Fiscal outturn
The economic downturn and several recent policy changes would make it extremely difficult to reduce the fiscal deficit to 6.2 percent of GDP. It is likely to increase to over 7 percent of GDP this year. This is so as recurrent expenditure is continuing to increase significantly, while revenue expectations are not likely to be realized. The fiscal deficit for the first four months of Rs.139.8 billion when annualized indicates a deficit of 11.5 percent of GDP, according to the Finance Ministry. Despite these fiscal results, the Treasury is of the view that “the fiscal operations in the year as a whole are expected to remain consistent with the targeted deficit of 6.2 percent of GDP.”

It is difficult to understand how the fiscal deficit could be contained at 6.2 percent. The fiscal outturn in the first four months indicates that it would be extremely difficult to contain the deficit this year within the target of 6.2 percent of GDP. A shortfall in revenue is likely owing to the economic downturn and export import reductions. Government expenditure would undoubtedly increase the fiscal deficit this year. In the first four months of 2012, the fiscal deficit doubled with current spending growing at twice the rate of tax revenues. Despite the Treasury’s intent of containing the fiscal deficit to its target of 6.2 percent of GDP, adverse economic developments are making it difficult to achieve it. Revenues have fallen and will continue to decline as several sectors that contribute tax revenue are likely to not increase output thereby decreasing revenue. A lower growth in import duties, export levies and internal trade will reduce revenue.

Conclusion
The expectations of economic growth have, no doubt, been fuelled by several recent changes. International prices of oil and commodities have fallen. The oil bill in particular could be reduced as a consequence, provided domestic demand too is contained at current levels. The onset of the monsoon has relieved the water shortage and increased the hydroelectricity generation. There could be a revival of agricultural production in some crops as well as agriculture in some regions. Inflation is likely to abate but containing the fiscal deficit to 6 percent is a challenging task.
http://www.nation.lk/edition/opinion/item/8482-economic-recovery-or-optimistic-expectations?.html

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