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The Monetary Board has reviewed recent economic developments and projections and has decided to maintain its policy interest rates at their current levels. The following is an assessment of the factors that were taken into consideration in arriving at this decision.

Need for Price Adjustments

The sharp increases in international fuel prices have posed a dilemma to the authorities on whether to change prices in the short-run and make necessary adjustments, or to make changes in the long-run and face the long-term undesirable consequences. It would be difficult for the current monetary policy stance and the fiscal discipline, to which the government is committed, to be maintained, if adjustments are not made in the economy to reflect adverse developments that are taking place elsewhere, which have a bearing on Sri Lanka.

In this context, the recent increase in the price of petrol and permitting the price of LP gas to be raised are steps in the correct direction. However, it would be necessary to accelerate adjustments in other prices, such as diesel and kerosene, too to reflect the current international prices. It is not prudent for the budget to bear the cost of such subsidies as it amounts to sacrificing other essential public expenditure programs.

Faster adjustment will create greater resilience in the economy, enabling it to move along the long-term growth path. Hence, all sectors of the economy would need to make quick adjustments to face prevailing conditions.

Real Sector

The growth in economic activity has continued in the second quarter of 2004, although the rate of growth is likely to be lower than in the first quarter. Agricultural production has been mixed, with output from the plantation sector continuing to increase, while paddy output has declined due to the failure of the monsoons. Industrial production has witnessed a growth of 4 per cent in the first five months of 2004, over the corresponding period in 2003, supported by higher output from industries producing for both export and domestic markets.

Available information indicates a strong demand for exports, particularly in the case of apparel, in the second half. The services sector, which has been the main contributor to economic growth, has sustained its growth momentum, with increases recorded in tourist arrivals, the expansion in external trade, port service and telecommunications.

Tourist arrivals, which declined in March and April, have recovered in May and June, and the industry expects continued growth in the second half. Given these developments, growth for the year is expected to be around 5-5.5 per cent.

Consumer Prices

The rate of inflation, which fell continuously from the second quarter of 2003, has started to pick up, as expected. Inflation as measured by the 12 month moving average of the Colombo Consumers' Price Index (CCPI) rose from 3.9 per cent in June 2004 to 4.3 per cent in July, while the point to point index increased from 6.8 per cent in June to 8.9 per cent in July.

The Sri Lanka Consumers' Price Index (SLCPI), which is computed with a lag of one month, reflected a similar trend, with the annual average of the index rising from 1.4 per cent in May to 1.7 per cent in June, while the point to point index rose from 4.7 per cent in May to 5.6 per cent in June. Inflation is expected to be around 6-7 per cent at end year, based on the CCPI, about 1-2 percentage points higher than initially projected for 2004.

External Sector

The growth in the global economy appears to be more established and broadbased, as indicated in GDP growth rates for the first quarter of 2004. However, it has been accompanied by upward inflationary pressures, which are a cause for concern. This has led some central banks to raise interest rates, while others have indicated the possibility of a further tightening of monetary policy, if inflationary pressures continue to develop.

The rise in global demand has had a favourable impact on Sri Lanka's external trade. Exports continue to post a healthy growth, increasing by 9.5 per cent in the first five months of 2004, over the corresponding period in 2003. Industrial exports contributed about 80 per cent to this growth.

The rapid growth in imports continued during this period, increasing by 18 per cent. The largest increase has been in imports of intermediate goods, which has not only been due to higher expenditure on petroleum products, but also due to an increase in imports of other intermediate goods. However, the higher increase in imports over exports caused the trade deficit to widen to US dollars 894 million during the first five months of 2004, in comparison to US dollars 616 million in the corresponding period in 2003.

Initial data for the first half of 2004 indicate that exports and imports have continued to grow, although import are likely to grow faster than exports, thereby further increasing the trade deficit. Higher inflows to the services account from tourist earnings, an increase in income from port related activities and worker remittances are only partly expected to offset the higher trade deficit, hence the current account deficit is expected to widen.

Although the decline in net inflows to the capital and financial account, particularly due to lower receipts of official foreign assistance, will be partly offset by the issue of Sri Lanka Development Bonds (SLDBs) in June, the overall balance of payments, in the first half of 2004 would be a deficit.

Overall developments in the external sector have increased the pressure and volatility in the foreign exchange market, requiring the Central Bank to intervene to stabilise the foreign exchange market. The rupee depreciated by 6.4 per cent vis-a-vis the US dollar during the first seven months of 2004, compared to a depreciation of 0.4 per cent during the same period in 2003.

During this period, the rupee also depreciated against the sterling pound (8.3 per cent), Japanese yen (1.9 per cent), euro (2.3 per cent) and Indian rupee (4.9 per cent). Reflecting these currency movements the rupee against the SDR depreciated by 4.6 per cent. Despite the rise in inflation, the continued depreciation of the rupee has helped to maintain the country's external competitiveness as reflected in the 24 currency real effective exchange rates, which has depreciated by 1.5 per cent.

Gross official reserves have declined to US dollars 2,104 million (3.5 months of imports) at end June 2004 from US dollars 2,329 million (4.2 months of imports) at end December 2003, while the total reserves of the country have declined to US dollars 3,130 million (5.2 months of imports) at end June from US dollars 3,218 million (5.8 months of imports).

Fiscal Sector

Preliminary estimates for the first half of 2004 indicate that the overall fiscal deficit increased to 4.2 per cent of GDP from 3.9 per cent during the same period in 2003. Following the same trend, the primary deficit increased to 1.1 per cent of GDP from 0.4 per cent. However, the current account deficit (government dis-savings) was maintained at 1.8 per cent of GDP as in 2003.

Monetary Sector

Monetary aggregates continue to grow and remain above the targeted levels. Reserve money was around Rs.2-4 billion above the expected level through most of July, with the increase in the net domestic assets of the monetary authority being the main cause for this expansion, as net foreign assets declined during this period. Broad money supply expanded by 16 per cent during the 12-month period ending June 2004.

Central Bank press release

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