“It is therefore not surprising that Sri Lanka cannot sustain 8-10 per cent rate of average growth unless it expands its capacity level, and not the capacity utilization level,” noted Sirimal Abeyratne, Professor of Economics at Colombo University.
He was commenting, at the request of the Business Times, on a March 2014 International Monetary Fund (IMF) Working Paper titled “Estimating Sri Lanka’s Potential Output” which said that “Sri Lanka’s potential output growth appears to be around 6¾ (6.7) per cent per year”,
He said the study based on a quantitative analysis, confirms the actual post-war growth outcome of Sri Lanka.
Dr. Abeyratne said that the basic finding of the IMF paper is that Sri Lanka’s potential output (GDP) growth, which has slightly increased after 2009, remains at 6.7 percent per annum. In other words, Sri Lanka’s actual GDP growth would remain fluctuating around this figure, as it has been so during the past decade; during 2002-2012, it has grown only at 6.4 per cent per annum.“When we try to grasp what this finding means to us, we must be cautious about the use of the technical term ‘potential output’ in economics, compared to ‘economic potential’ of the country,” he said.Potential output, the economist asserted, is the real GDP warranted by the existing capacity – the country’s capital stock, human resources, and technological standards. “It does not mean the ‘potential of the economy’ in which we understand the output growth that the country can achieve from the expansion of the capacity through investment, human resource development, and technological advancement”.
He said the capacity utilization has improved after the end of the war so that the actual output grew over 8 per cent in two consecutive years, and slows down to its typical annual averages.
“This is because high growth was based more on capacity utilization than on capacity expansion,” he added.
Lankan GDP targets should be based on curbing excess demand, IMF economists say
International Monetary Fund (IMF) economists say that Sri Lanka should allow a period of below-potential economic growth over the next few years to curb excess demand (in the economy)
“On balance, all approaches suggest that, if macroeconomic stability is to be maintained, policies should be geared toward allowing a period of below-potential economic growth over the near term to reduce excess demand,” they said in a March 2014 IMF Working Paper titled “Estimating Sri Lanka’s Potential Output”.
Prepared by Ding Ding, John Nelmes, Roshan Perera and Volodymyr Tulin of the fund’s Asia and Pacific Department, the paper contained the usual ‘rider’ saying “The views expressed in this Working Paper are those of the author(s) and do not necessarilyrepresent those of the IMF or IMF policy’
Below are a few, salient extracts of the report which could be understood by economists but is too technical and complex for the average reader: “This paper presents various techniques to estimate Sri Lanka’s potential output and output gap, including statistical and model-based approaches. Compared to conventional statistical filters that rely exclusively on information in a single series, the model-based approaches allow potential output estimates to incorporate information contained in observable data series including inflation, actual output, unemployment and capacity utilization. The estimation results suggest that Sri Lanka’s potential output has risen slightly in the last few years.
This topic is particularly interesting for Sri Lanka because its economy grew rapidly over the two years following the end of the civil conflict in 2009, but thereafter reverted to around the average growth pace of the last decade. Did the growth spurt reflect faster potential output growth and thus a permanent upward shift in the country’s growth plane, or was it a transitory increase that may have pushed the economy up against capacity constraints? The answers to such questions are important from a longer-term perspective of Sri Lanka’s possible progression through the ranks of middle income status, and from a near-term perspective they would help to indicate whether using macroeconomic policy levers to stimulate a return to high growth could come at the cost of fostering macroeconomic imbalances. To date, however, there has been limited empirical work carried out to estimate Sri Lanka’s potential output.
The sample period for the data is 1997Q1-2012Q4, the period for which quarterly data for GDP, the unemployment rate, and inflation are available. Real GDP growth averaged 6.2 per cent during the period 2003-2012, although there were two distinct phases. Prior to the global financial crisis of 2008, the economy grew on average at about 5.7 per cent. Following the end of the conflict in 2009, growth rose dramatically for a few years before easing in 2012, for an average of around 7.5 per cent.
While in most countries the global financial crisis of 2009 led to a significant contraction in output, growth in Sri Lanka slowed sharply, but the impact was partly countered by an increase in domestic activity following the end of the conflict. The opening of areas in the Northern and Eastern provinces, for example, led to an increase in agriculture, fishing, and services activities. Output of the Northern Province grew by an average of over 15 per cent during 2010–11. Sri Lanka’s post-conflict growth spurt may be related to higher potential output, reflecting the availability of various factor inputs (land and labour for example) and higher productivity associated with the end of the conflict. Consistent with this interpretation, inflation moderated significantly, while wage pressures were subdued despite a decline in the unemployment rate.Alternatively, the growth increase could reflect a positive, but ultimately transitory, increase in demand. The expenditure composition of real GDP indicates that consumption expenditure contributed significantly to real GDP growth in 2010–11, and was accompanied by a surge in imports that resulted in a large negative contribution from net exports. Capital formation’s contribution to growth did not increase markedly.
All the results of all estimation techniques presented in this paper point to similar business cycle patterns in Sri Lanka’s recent history. The rate of potential growth eased around the time of the global crisis, but has picked up since then, a period that coincided with the end of the civil conflict, very rapid growth in actual output, and, initially, benign inflation conditions.
Sri Lanka’s potential output growth appears to be around 6.7 per cent per year. Measured by output gap, the economy operated below potential during the global financial crisis, but the strong recovery subsequently generated excess demand conditions, reflected in rising inflation rates in late 2012 and early 2013. Methodologies that do not explicitly incorporate relevant cyclical information, including capacity utilization and the unemployment rate, suggest the output gap was close to zero in 2012. However, more structural techniques suggest the economy was operating slightly above potential in 2012. On balance, all approaches suggest that, if macroeconomic stability is to be maintained, policies should be geared toward allowing a period of below-potential economic growth over the near term to reduce excess demand.”