Economic transformation in Sri Lanka

An extract of the 60th Anniversary Oration of the Central Bank delivered by Treasury Secretary Dr P B Jayasundera on August 27 at the Centre for Banking Studies

In 1990, the Sri Lankan economy with a per capita income of US $ 400 was a less developed economy. The economy performed in the midst of an islandwide insurgency in the South and a prolonged conflict in the North. The economy was trapped in a power crisis and in a severe capacity constraint in the available infrastructure, particularly a road network and telecommunication facilities.

More seriously in 1990 Sri Lanka witnessed an annual average inflation of 21.5 percent and a monetary expansion of 15 percent. The gross official assets of the economy were US $ 435 million in comparison to the country’s total current account deficit of US $ 580 million. External debt to GDP was 55 percent and external debt service had reached 20 percent. Budget deficit had been near 10 percent of GDP with the adjustment burden regrettably falling on public investments which had declined form 18 percent of GDP in 1980 to seven percent of GDP in 1990.

Reflecting the impact of successive high fiscal deficits, weakening of the exchange rate and a low economic growth, the level of Government debt in relation to GDP had reached near 100 percent. The rate of unemployment was 15.9 percent and households living below the poverty line were in excess of 25 percent. Economic policies of the 1980s and 1990s were very much influenced by multi lateral lending agencies and reforms based on privatization and liberalization, placing trust only on the private sector for economic development.

A promising outlook

Today it’s a different story and more encouragingly with a promising outlook. There is a paradigm shift in economic policy since 2005, recognizing the importance of infrastructure development and associated investments in the service economy, policy bias towards domestic value addition in production, integrated rural and agriculture development and placing trust on both private and public sector for economic development.

The economy is enjoying over US $ 2,000 per capita income and has graduated to a middle income economy status. The progress has been rapid since 2005, during which period the economy has sustained an average growth of six percent in spite of adjustment difficulties in the midst of a global oil price hike, financial crisis and intensified conflict till it ended in mid 1999. Unemployment had declined to five percent from 15 percent in 1990. Reflecting a relatively high growth and a decline in unemployment, the incidence of poverty has declined from 24 percent in 1990 to 15 percent.

Public debt has been reduced to near 80 percent of GDP and the budget deficit has been contained at around eight percent, with public investment sustaining at little over six percent of GDP. External debt to GDP has been fallen to around 35 percent and the debt service ratio has declined to around 14 percent now. Much progress in the development of infrastructure in power generation, port and aviation facilities, road and expressway network, irrigation and supply of water and urban development and in connecting the rural economy to emerging townships so as to ensure an integrated development of the whole economy has been made in recent times in comparison to 1990s.

Great success

More importantly, the Central Bank can proudly claim for achieving the annual average inflation of around six percent with lower growth in monetary expansion - a great success the Central Bank has achieved in performing its primary responsibility - the price stability. Maintaining stability in exchange rate movements and reducing interest rates almost by 100 percent from the range of 22 to 30 percent in late 2008 are signs of economic stability.

In this context, our graduation to a middle income country status and the management of the early stage of a middle income economy over the past five years have been credible. Now that the 26-year-old conflict is history and contagious effects of the recent global financial crisis have been arrested and at least Asian economies have continued to sustain high growth performance, the economic outlook for Sri Lanka is promising. If the analysis done by the Central Bank and the Institute of Policy Studies are correct, the ending of the conflict alone must add two percentage points to our economic growth.

There have been many changes between 1990 and 2010 in Sri Lanka’s economic structure as well. The service sector share of GDP in our economy has increased from 48 percent in 1990 to almost 60 percent in 2010.

The share of primary agriculture in the economy has declined drastically from 26 percent to around 12 percent of GDP, underscoring a marked structural shift towards a service sector based economy.

In the external sector the dominance of primary export economy characteristics has been marginalized with a rise in manufactured exports from 60 to 80 percent. The structure of imports has also reflected a marked change with a decline in consumer goods imports from 26 percent in total imports in 1990 to 19 percent as of now.

The combined share of intermediate and investment goods of the total imports accounting for almost 80 percent in comparison to 70 percent in 1990 reflects the gradual transition of the economy to a more value creation process in GDP and emerging as a value added economy, in meeting both domestic and external demands. In the case of consumer goods, import of food items has declined from 14.5 percent to 12.2 percent reflecting a greater success in import substitution particularly in rice and selected food crops.

In the export sector, a similar trend can be scene in relation to several commodities such as tea, rubber, cinnamon and gem and jewellery with more value addition taking place domestically. Textiles and garment exports which were a less than 40 percent domestic value added industry has engaged with a domestic value addition close to 60 percent, in addition to the fact that this industry has shifted its reliance from protected markets to competitive markets.

The turnover in external services has reached a 3.5 billion dollar scale in comparison to US $ 700 billion in 1990. The remittance economy which was around US $ 400 million in 1990 has now reached a US $ four billion scale, altering the entire outlook of the country’s Balance of Payments.

The economic transformation that has taken place between 1990 and 2010 is a result of a series of policy initiatives that have been implemented by successive Governments. During 1980-2000, successive Governments followed policies favouring liberalization and privatization. The trade and payments liberalization that has taken place throughout the 20 year period has made Sri Lanka’s economy more liberal and globally integrated. Exports are virtually tax free and the average import duty rate has been reduced to around four percent from over 10 percent prior to 1990. The exchange rate regime has become a freely floating convertible currency. By 2005, a large part of plantation agriculture, manufacturing, construction, financial services, public transport, telecommunications, selected petroleum services, hotels and trade which were fully state-owned regulated activities had been privatized or deregulated.

Private sector presence

These, policies have transformed Sri Lanka in to a predominantly private enterprise economy. Even some other sectors which are still predominantly in the domain of the public sector such as the postal service, electricity, petroleum, port and airport services vocational training and hospital services, have shown the gradual entry of the private sector in varying degrees. State monopolies as at present are confined only to railways, water supply, electricity and education.

The share of private sector in GDP has increased to nearly 80 percent.

There have been some unique changes in the fiscal front too. The tax to GDP ratio has dropped from around 18 percent in 1990 to 14 percent, reflecting the decline in tax revenue generated from export and import trade which have declined from around 5.5 percent of GDP in 1990 to around two percent, in line with trade liberalization. Growth in revenue from income tax and other domestic taxes has not been commensurated with the development in the private sector. The facets of public expenditure reflect the complex public finance dynamics. The financial sector liberalization towards market oriented debt instruments has made the national budget being sensitive to developments in the debt market and the conduct of monetary policy.

This together with successive high budget deficits has raised expenditure on interest on public debt as a major component of the budget. Financing of the Budget through administrative borrowings from captive sources, has been replaced with borrowings thorough market sources based on a market determined maturity structure and interest rates. A sizable expenditure on public sector salaries and pensions, and security related expenditure have been a strain on the conduct of fiscal policy though other recurrent expenditure and transfer payments have bene subject to structural changes.

Prudent policies

The conduct of monetary policy and the operations of the Cental Bank itself have been subject to similar influence. The manage float exchange rate regime that prevailed in 1990, has gone through a major transformation, first in 1993 when Sri Lanka adapted Article VIII status of the IMF which made the Sri Lankan rupee freely convertible for all current accounts transactions and then in 2000 when the exchange rate was floated permitting market forces to determine the exchange rate subject to broad surveillance of the Central Bank.

During this 20 year period, the Central Bank has also systematically moved away from engaging in squash-fiscal activities by doing away with Central Bank refinance facilities provided under the Medium and long Term Credit Fund and removing credit controls and interest rate ceilings and promoting market determined interest rate structure and credit disbursements.

The reliance on the required reserve ratio, deposit margins and other administrative interventions in conducting monetary policy was substantially minimized, or used as temporary emergency measures. In comparison to 1990, the Central Bank today relies entirely on market based policy instruments such as, interest and exchange rates for the conduct of monetary policy. The recent initiatives promoted by the present Governor, such as operations of the Monetary Policy Committee and the announcement of a Monetary Policy Road Map at the beginning of the year are further progressive steps, reflecting the maturity of the Central Bank.

Not only these changes signify the institutional image of the Central Bank but also the composition of the Monetary Board of the Central Bank is fundamentally different from what it was in 1990. As you may be aware, in 1990 there were only three members in the Monetary Board with only one position opened to the private sector, as the appointed member. The Governor was a public sector personality.

The Treasury Secretary represented the Government as per the provision of the Monetary Law Act as the official member interfacing fiscal-monetary corporation. Since 2002, it is a different chemistry. Three positions have been created in the Monetary Board for appointed members, essentially to accommodate members from outside the public sector. Since 2005, the Central Bank Governor has also been selected from the private sector. In a five member board, Secretary to the Treasury is the only ex-officio member. This change in the composition itself is to provide a wider forum for interaction among the Central Bank, the Government and the private sector. In fact, the private sector has a wider voice and influence in this composition now than in 1990.

The framework for conducting fiscal policy has also gone through some major changes Until 2002, it was only the Constitutional provisions and enabling legislation with regard to revenue, expenditure and borrowings that were available for fiscal authorities to perform their responsibilities in respect of the country’s public finance.

However, since 2002 with the enactment of the Fiscal (Management) responsibility Act, further responsibilities have bene assigned on fiscal authorities by way of specific legal requirements and obligations to be fulfilled with regard to the issuance of Government guarantees, management of debt, preparation of the Budget and associated documents. Special responsibilities of the Minister of Fiance and the Secretary to the Ministry of Finance have also been specified. Consequently, the preparation of the Annual Report, special reports to the Parliament to be presented with the National Budget, Mid-year Report, Pre-Election Assessment Report etc. have been introduced.

Without compromising

Country’s unique and fast recovery from the worst ever natural disaster - the Tsunami and the worst ever manmade disaster - the 26 year long LTTE terror, demonstrate how the country is capable of mobilizing its resources and strengths to address such challenges without compromising the fundamental economic policy framework.

These challenges have been managed without compromising the soundness in the conduct of momentary policy or fiscal policy or seeking debt forgiveness from lenders. The country has also not reversed its prudent economic policies in the midst of the recent global food crisis and financial crisis during which time many countries resorted to interventionist and protectionist policies.

It has also proved its capability of re-engineering economic policies to make it home-grown and suit country needs while respecting fundamental economic principals and the global economic framework as amply demonstrated in the Mahinda Chintana - Vision for the Future - the 10 year Development Framework.

All these, not only explain various building blocks that have been built into the system of macroeconomic management over a 20 year transition to a middle income economy, but also explain the many progressive steps that have taken place under the extremely difficult and unpredictable environment Sri Lanka had to go through, due to the 26 year conflict. Anybody commenting on Sri Lanka and its Central Bank-Government relationship needs to give due recognition to these improvements. I am not aware of any conflict affected nation that had gone through all these reforms and still sustained not only economic progress but also improvements in human resource development, social indicators and bio-diversity in the natural environment.

I just touched upon some critical milestones to reflect how our economic policy and institutional developments have evolved during the last 20 year transitional phase and to set the stage to discuss the evolving relationship between the Central Bank and the Government.