Sri Lanka is heating up
Published: 22 June 2011
Riding the peace wave
The Sri Lankan economy has rebounded sharply since the end of the civil war and the trough of the global financial crisis. At the trough, services, the largest part of the economy, contributed just 1.6 per cent to overall growth, but this has risen to 5 per cent today. Industry, too, is doing well, with external and domestic demand fuelling activity. Growth is projected to remain robust at 8 per cent for 2011, matching the 30-year high of 8 per cent achieved 2010.
Leif Eskesen, HSBC Chief Economist for India and the Association of Southeast Asian Nations, and Economics Associate Prithviraj Srinivas, examine what lies behind this:
For one, the end of the conflict unleashed unused potential. For example, the unlocking of the Northern and Eastern districts, previously under conflict, has boosted growth by boosting the output from agriculture (up 20 per cent last year) and fisheries. Moreover, it has opened up opportunities for the services sector, with more bank branches being set up and distribution networks of local businesses expanding into these areas. Eventually, it will also provide opportunities for the manufacturing side of the sector, and construction activity should be supported as these areas are reconstructed.
The peace dividend has also manifested itself in high consumer and business confidence, which has supported consumption and investment
But, the recovery is not just related to reconstruction and the unlocking of new areas. The peace dividend has also manifested itself in high consumer and business confidence, which has supported consumption and investment. Also, the global economic recovery has supported Sri Lankan exports, which rose by 17 per cent y-o-y in 2010 compared to -13 per cent in 2009 led by shipments of rubber, tea and industrial goods. Moreover, the return of investor risk willingness has supported capital inflows into Sri Lanka, primarily in equities and sovereign bonds. Tourists have also returned and are filling up hotels and restaurants.
Also, accommodative macroeconomic policy settings have supported the quick rebound in growth. While fiscal policy has been geared towards consolidation, this has by itself boosted growth by underscoring commitment to macroeconomic stability. Finally, monetary policy has been very accommodative, with policy rates cut several times.
However, significant reforms are still needed to sustain the high pace of growth and cash in on the peace dividend. Arguably, the economy needs large amounts of investment to leverage this pent-up potential, and the government's nation building efforts will be of help. For example, infrastructure projects now under way (12 per cent of 2010 GDP) are already supporting growth during the construction phase and are expected to boost potential growth when they are completed in two to three years. These investments are focused primarily on upgrading basic infrastructures like roads, ports, and power generation.
Simmering inflation
Inflation has so far been relatively well behaved and nothing to sneer at compared with historical levels. However, it has been creeping up. The uptick in inflation has until now primarily been driven by supply factors. Devastating floods in early January 2011 destroyed 20 per cent of the country's rice crops, and other crops were also destroyed. The supply disruption led to a spike in food prices and will keep food inflation elevated during the first half of 2011. It will moderate more notably only with the arrival of harvests from the summer crop in September.
However, inflation goes beyond food. The surge in growth is adding to underlying inflation pressures, which is starting to push up core inflation. Strong domestic demand conditions are also amplifying the price impact from the food supply disruption, which will limit the decline in food prices even as supply picks up. Moreover, rising international commodity prices add to underlying cost pressures.
Of course, the end of the conflict has meant that potential output has increased, and this will help to put a lid on inflation by essentially raising the non-inflationary speed limit of the economy as the capital stock grows, additional lands are cultivated, and more hands are utilised for productive work. However, the increase in potential output is still a gradual process and, with the quite steep cyclical upswing in demand, capacity constraints are still expected to tighten over the near term.
Time to cool it
With this outlook for inflation, the current macroeconomic policy settings are tilted too much towards supporting growth rather than addressing emerging demand-led price pressures.
The effect of this is also evident from the rapid growth in monetary aggregates. For example, growth in the broad money supply is running above the central bank's target (18.4 per cent y-o-y in April 2011 versus a 14.5 per cent target). Moreover, private credit growth has soared (31.4 per cent y-o-y in April 2011), although this also partly reflects the rapid increase in car sales following the cut in import duties last year. The recent hike in import duties may help slow credit growth a bit, but the strong credit growth goes well beyond car sales.
The government plans further fiscal consolidation, with a budget deficit target of 6.8 per cent for 2011 versus 7.9 per cent in 2010. However, the improvement in the fiscal position is based partly on the assumption of positive dynamics between tax cuts and higher tax collection through stronger growth ('Reaganomics'). However, this outcome is not a given, and revenue could consequently disappoint, leaving the deficit higher than expected. Moreover, on 7 May the government announced an extension of its fertiliser subsidy, worth 0.6 per cent of 2011 GDP. All of this means that there is a good chance the fiscal deficit could end up a notch higher than expected (HSBC estimate 7.1 per cent of GDP) and leave the fiscal stance a little less restrictive.
In addition, it is worth keeping in mind that the fiscal consolidation that Sri Lanka is undertaking actually supports growth because it effectively boosts investor and consumer confidence by demonstrating the Sri Lankan government's commitment to macroeconomic stability.
The central bank will have to do more heavy lifting to tackle the build-up in demand-led inflation pressures
This means the central bank will have to do more of heavy lifting to tackle the build-up in demand-led inflation pressures. However, the central bank will be reluctant to tighten and may not raise policy rates until Q3 2011. The somewhat shifting tone in monetary policy statements corroborates this view, the previous statements being more hawkish and the latest somewhat dovish. This creates (non-constructive) ambiguity about the monetary policy stance and suggests a lack of decisiveness.
Still, we have pencilled in 175bp of policy rate hikes, with the benchmark policy rate up from 8.50 per cent currently to 9.5 per cent by the end of 2011 (versus our previous call of 9.75 per cent) and then to 10.25 per cent during the first half of 2012, which is 50bp above our previous call. The assumption here is that the central bank will begin to move when the demand-led pressures on inflation become more visible. In that context, it also important to factor in the long lags of monetary policy, with tightening having its full impact on growth and inflation only more than a year down the road.
To help strengthen the effectiveness of monetary policy as they begin to tighten the stance, a more consistent and deliberate communication strategy would be important. This will help better anchor inflation expectation and improve the transmission of policy rate hikes. The current ambiguity about the policy stance resulting from the shifty policy statements is not constructive and could ultimately make the job harder for the central bank.
Leif Eskesen
Leif Eskesen joined HSBC in October 2010 as Chief Economist for India and ASEAN and is based in Singapore.
Before joining HSBC, he worked for close to 10 years at the headquarters of the International Monetary Fund (IMF) in Washington, DC, where he was a Senior Economist and a country mission chief.
During his time at the IMF, Mr Eskesen covered a number of Asian and European countries, including South Korea, Philippines, Singapore, Austria, Denmark, and Croatia, and was engaged in regional work across Asian countries including as co-author of the IMF's biannual report Regional Economic Outlook - Asia and Pacific.
In addition to macroeconomic and financial sector research, his responsibilities included assessing and advising governments on macroeconomic and structural policies.
Before joining the IMF, Mr Eskesen worked for Danmarks Nationalbank, Denmark's central bank, where he was Head of Section and his responsibilities related to the strategic management of the foreign exchange reserves. Before this, he worked for one of Denmark's large commercial banks and as a Research Scholar at his university. Mr Eskesen has published a number of papers across a wide range of topics, including fiscal policy and labour market issues. He holds a Master's degree in economics from the University of Aarhus, Denmark.
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