Srilanka Country Report-2011

8/6/2019 Srilanka Country Report-2011

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ASIAWEALTH

MANAGEMENT

CO.(PVT)LTDSRI LANKA-COUNTRY REPORT 2011


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Asia Wealth Management CO. (PVT) LTD| Country Report 2011

Head of Research

Saminda Weerasinghe

Analysts - Economic Research

Umayangana Randeniya

Dhanusha Pathirana

Analysts - Corporate Research

Amali Perera - Senior Analyst

Nuwan De Silva

Akeela Rasheed

Crishani Perera

Dilan Wijekoon

Minoli Mallawaarachchi

Shehara Fernando

Nirmala Samarawickrama

Analyst Statistics

Nuwan Kumara

Table of Contents

A PrecursorFood for Thought" 4

Gross Domestic Product (GDP) 6

Aggregate Demand and GDP Growth 7

Aggregate Consumption and Investment 7

Employee Income 8

Debt and its Composition 9

Fiscal Deficit 10

Is Government Spending Unproductive? 11

Transfer Payments 13

Inflation 15

Benchmark rates 16

Investment Structure and Inflation 18

Trade balance and the BOP 19

Remittances 21

The capital and financial account 25

Increasing foreign reserves and the exchange rate 27

REER and NEER 28

Foreign Debt Factor 29

Employment Generation and Investment Structure 30

Investment Pattern and Real Wages 31

Quality of Employment Opportunities 32

Relationship between Balance of Trade Deficit and Economic Growth 33

Balance of Trade Deficit and Government Finance 33

The way Forward Sri Lanka 35


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Stock Market Outlook Sri Lanka

2010 In Retrospective 39

2010 New Listings 41

Manufacturing 45

Plantations 46

Rubber 46

Tea 47

Oil Palm 48

Sector Performance from a stock market perspective 48

Banking and Finance 51

Licensed Commercial banks (LCB) 51

Performance of Licensed Commercial banks (LCBs) 51

Insurance 52

Life Insurance 52

General insurance 54

Leasing 54

Sector Prospects

Food & Beverages 55

Land and Property 57

Tourism 59
http://192.168.3.10/Research-1/Research/ECON1/New%20Draft%20Country%20Report/Country%20Report.docx%23_Toc288054863http://192.168.3.10/Research-1/Research/ECON1/New%20Draft%20Country%20Report/Country%20Report.docx%23_Toc288054863http://192.168.3.10/Research-1/Research/ECON1/New%20Draft%20Country%20Report/Country%20Report.docx%23_Toc288054863http://192.168.3.10/Research-1/Research/ECON1/New%20Draft%20Country%20Report/Country%20Report.docx%23_Toc288054863


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26 years

of

ethnic

conflict 21 years

prior to

ethnic

conflict

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

7.0%

1983-2008 1961-1982

Table 1 - Conflict Years and Pre-Conflict

Economic Growth

Source: Compiled according to CBSL

statistics

A Precursor Food for Thought"

The year 2010, when the thirty year civil war ended, generated much

optimism regarding Sri Lankas economic prospects. The real GNP growth

at this time seemed to bear this out. The first nine months of 2010

recorded a 7.9 percent real GDP growth, compared to 3.5 percent in

2009, and as against an expected growth rate of 7.5 percent in 2011. The

business conglomerates that incurred losses in 2009 recorded nearly a 50

percent year over year growth in net earnings during the first three

quarters of 2010. Having displayed this striking buoyancy the private

sector is expected to do even better in 2011.

These signs of a turn-around have been widely attributed foremost to the

ending of the prolonged civil war. With this presumption there is the

hope that the next few years growth rate will increase further, having

performed poorly during the war and because of the war. Yet, a

comparison with Sri Lankas war time economy hardly provides ground

for this optimism which the mere ending of war has generated.

Respectable rates of growth were achieved even during the war years of

1983 to 2008. During this 26 year period the average annual growth of

the real GDP averaged 5.8 percent, considerably higher than in the

twenty one years preceding the war from 1961-1982, when the growth

rate was only 3.8 percent (Table 1). In this connection it is also importantto note that this commendable growth rate during conflict years was

realized even without the tourist boom the offspring of peace- which

helped the economy to reach 7.9 percent growth in the immediate post-

war year 2010.

The relatively high average annual increment in GDP during the war,

suggests that growth was not adversely affected by the conflict if growth

is measured in conventional terms. It might not be wrong to say that, the

economy reaped what may be considered to be a war dividend much

larger until now than the peace dividend which was expected to accrue

once the war was over. On this reckoning, contrary to what is commonly

supposed is borne out: the war had not unduly depressed economic

growth, with the economy waiting to take off when peace and political

stability returned. The war seemed in fact to have enhanced growth

rather than curtailed it.


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two years of intense

warpost conflict period

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

7.0%

8.0%

9.0%

2006-2007 2010

Table 2 - Conflict Years and Post-Conflict Economic Growth

Further, the growth of 7.9 percent in 2010 the immediate post conflict

year - is only marginally above the average growth rate of 7.3 percent

during 2006/2007, the years of intensified fighting (Table 2) and

escalating defense expenditure. The GDP growth of 7.3 percent in these

two years was all the more notable since it took place after a high-base

output growth of 6.2 percent in 2005, as opposed to 2010 in which year

the growth performance occurred from a low base of 3.5 percent. Hence,even the average growth rate achieved during the severely war ravaged

years of 2006/07, proved to be more robust than that during the post-

conflict year 2010, allowing for a clear twelve months period.

Source: Compiled according to CBSL statistics


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Hong Kong, 226.5Singapore, 217.4

South Korea, 986.3

Taiwan, 427

Vietnam, 102

Indonesia, 695.1

Thailand, 312.6

Malaysia, 219

Sri Lanka, 50Bangladesh, 105.4

Bhutan, 1.397

India, 1430

Maldives, 1.433Nepal, 15.11

Pakistan 174.8

-2 0 2 4 6 8 10 12 14 16

Country Comparison of the Nominal GDP (USD BN) 2010 Est.

12%

28.50%59.50%

SECTOR CONTRIBUTION TO GDP 2010

Agriculture

Industry

Services

Gross Domestic Product (GDP)

The year 2010 showed signs of improvement in the Sri Lankan economicoutlook as the year witnessed the highest ever recorded GDP growth

since 2002 in the 2Q2010 of 8.5 percent. All three sectors of the economy

registered significant growth in 2010 over the same period of previous

year. The agriculture sector growth was backed by the improvement in

global market prices and the upward trend in prices of natural rubber.

The agriculture sector growth was further fuelled by increase in paddy

and fishing production with the addition of North and East to the rest of

the economy. Services sector witnessed a sound performance stimulating

economic growth. Food & beverages industry fared better in the light of

hotel & leisure sector expansion. Commendable performance was

recorded especially in banking & finance, and transportation sectors

backed by positive market sentiment. Industry sector performance was

affected by the removal of GSP+ tariff concessions coupled with the rising

production cost however it was assisted by the increase in demand for

semi precious stones, improvement in construction sector, electricity, gas

and water. The sector contribution of Agriculture, Industry, and Services

to the total GDP in 3Q2010 was 12.0 percent, 28.5 percent and 59.5

percent respectively. The 3Q GDP growth figure was well above

expectations of the central bank creating optimism that the momentum

would continue well in to next year.


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0

1000

2000

3000

4000

5000

6000RS BN

Gross Consumption and Investment

consumption (LKR bn) investment (LKR bn)

Aggregate Demand and GDP Growth

Increased consumption and investment levels, with a continuous

expansion in government spending and a positive net exports balance will

cause the rate of growth to rise. On the other hand, with negative net

exports, growth to the extent that it takes place, will owe itself primarily

to the existing effective demand. If this continues and the marketresponse to it increases as it seems to be doing, the growth will still take

place irrespective of export performance, reflecting the production

potential of the economy. However, the mechanisms which increase

internal demand independently of an external stimulus remain to be

explained. This requires disaggregating the GDP into its constituent

elements; investment, consumption, government expenditure, and

foreign inflows.

Source: CBSL

Aggregate Consumption and Investment

Total consumption (including government recurrent expenditure) is

expected to record in 2010 a 22.5 percent increase to reach

approximately LKR 4,845 bn and in 2011 to around 13.3 percent increase

to reach LKR 5,487 bn. This indicates the expansionary influence of

effective demand in the economy. Investment levels (including

government capital expenditure) are also anticipated to increase by 2010by circa 28.7 percent to reach LKR 1,524 bn and by 2011 to increase

around 17.3 percent to reach LKR 1,788 bn depending on the success of

the business community in exploiting existing profit opportunities.

What appears, however, on the basis of these influences is a low ratio of

investments to consumption in the economy. During the period 2003 to

2010 a ratio of investment to consumption of 0.31 demonstrates that

consumption growth and the increasing effective demand in the

economy were not primarily broughtabout by rising investments. A huge

500

550

600

650

700

0.0

2.0

4.0

6.0

8.0

10.0

Q1,09Q2,09Q3,09Q4,09Q1,10Q2,10Q3,10

REAL

P(RS.B

)

%

GDP GROWTH

REAL VALUE OF GDP (RS.BN)


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25%

15%

1%8%

4%

6%

28%

7% 6%

Commercial Bank Lending Portfolio

Consumption

Housing

Tourism

Industrial

Agriculture

Financial

Trading

Other Loans

Services

Debt and its Composition

The structure of Sri Lankas commercial banks lending portfolio is

revealing in this regard. Trading, consumption and housing in 2010 have

absorbed 77 percent of total advances to the private sector andmanufacture and agriculture together only 12 percent. A further

disaggregation of commercial banks advances to the private sector

reveals that Paddy and Apparels have received only 0.63 percent and

6.63 percent, respectively, of the total credit supply, while a new source

of consumer credit has come in to being in the form of pawning. Pawning

has absorbed a staggering LKR 131.9 bn or 10.23 percent (2.7 percent of

the GDP) of total commercial bank advances to the private sector, and is

the largest credit absorption ratio by sub categories; all of it is

presumably to meet immediate consumption needs. Credit created by

pawning is only marginally less than Sri Lankas tea export earnings in

2010 which were LKR 152.1 bn. Also the scale of banking sector pawning

more than exceeds twice the total gross tourist income (circa LKR 60.8

bn) in 2010 when there was a surge in tourist arrivals. Sampath Bank, the

third largest private commercial bank in the country in terms of branch

network and assets recently reported that 23 percent of its total

advances were absorbed by pawning and 45 percent of its growth in

lending in 2010 was driven by it, indicating that pawning is leading the

credit expansion of the economy and has become the main growth area

of the banking sector.

The non-banking sector inclusive of finance companies and pawning

centres has also witnessed an increasing trend in the pawning business.

According to CBSL sources, the non-banking sector has undergone a

phenomenal growth in pawning activity. Banking sources also reveal that

element of risk in pawning is extremely low and more than 97.5 percentof advances made through pawning are redeemed. Although growth in

pawning could suggest a situation of economic distress among the

marginalized and less privileged with prevailing high inflationary

pressures, it also indicates an advantageous situation for the banks given

the fact that interest rates in pawning are considerably above the rate of

interest on bank loans, resulting higher earnings of the financial sector,

contributing to the increasing growth rate. It reveals that pawning is a

significant source through which money supply in the system is increasing

causing the effective demand and business profits to rise.


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0

20

40

60

80

100

120

0

500

1000

1500

2000

2500

3000

3500

4000

4500

5000

1990 2002 2003 2004 2005 2006 2007 2008 2009 2010

LKRBN

Public debt levels as a % GDP

Public debt (LKR bn)(RHS) Debt (% of GDP)- (LHS)

Fiscal DeficitA continuous fiscal deficit creates fundamental macroeconomic

imbalances particularly for a developing nation hence taming the fiscal

deficit is a key objective in sustaining macroeconomic stability of a

country. In 2010 Sri Lankas government deficit for the period January to

November 2010 stood at Rs 409.8 bn down by 5.27 percent whencompared with the figure of Rs 432.6 bn recorded for the same period in

2009, indicating an encouraging outlook towards attaining long term

macroeconomic stability. The total revenue recorded an increase of 14.43

percent amounting to Rs. 749.3 bn from Rs. 654.8 bn recorded for the

same period in 2009 and the tax revenue grew by 16.74 percent to Rs.

654.6 bn from Rs. 560.7 bn accounted for in the corresponding period of

2009. This was largely due to the increase in imports fuelled by the

reduction in import duties especially on motor vehicle importation.

The total expenditure for the ten month period grew by 6.59 percent

amounting to Rs. 1159.1 bn compared to Rs. 1087.4 bn recorded for the

same period in 2009. Recurrent expenditure during the period increasedby 3.11 percent to Rs. 852.9 bn from Rs. 827.1 bn while capital

expenditure increased by 17.67 percent to Rs. 306.2 bn from Rs. 260.2

bn. The fiscal deficit figure for the first 11 months of 2010 reached 7.34

percent of GDP well within the IMFs recommended target deficit rate of

8 percent of GDP.

The government has made significant fiscal reforms to attain fiscal

consolidation in its 2011 budgetery proposals. In this regard the

government imposed major changes in taxation and transfers as a

measure of curbing the trade deficit while assisting the private sector in

achieving macroeconomic challenges. Altering of the tax system seems

pro investor as well as pro consumer as the reduction of direct taxes on

income, profits and consumer items will encourage more spending and

investment in the economy. Furthermore the reduction in tax rates

would enable the government to increase revenue despite reduced tax

rates as the expansion in the tax base would increase the tax revenue

collection. The reduction in budget deficit from 9.9 percent recorded in

2009 to 7.34 percent signals that the government is stepping in the right

direction.

0

20

40

60

80100

120

HongKong

Singapore

SouthKorea

Taian

Vietna

Indonesia

Thailand

alaysia

SriLanka

Bangladesh

Bhutan

India

Pakistan

Country Comparison-Public debt as a

% GDP


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0

5

10

15

20

25

0

2

4

6

810

12

1990 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010P 2011E

%%

Fiscal Performance

Fiscal Deficit -% GDP (LHS) Revenues/GDP (%) (RHS)

Nevertheless,addressing the fiscal imbalance remains to be a complex

and a sensitive issue which ought to be dealt with extra diligence. While

adhering to IMF requirements any comprehensive measure which aims at

altering the distribution of resources should render special attention to

the socio-economic and political impacts.

IsSource: CBSL

Is Government Spending Unproductive?

Increasing fiscal deficits have been widely regarded as the fundamental

cause of current price inflation in Sri Lanka which is a growing concern to

the public and the policy makers. Also Central Bank opting to print money

in order to finance deficits of successive governments is believed to be a

main catalyst driving inflation. However, the CBSL statistics indicate that

the increase in broad money supply owing to the increase of CBSLs net

domestic assets by providing provisional advances to the government

remains at insignificant levels. The annual average amount of CBSLsadvances to the government over the past ten years is only LKR 3.8 bn;

and compared to the extremely high inflation rates witnessed by the

economy over corresponding period, the figure of LKR 3.8 bn turns out to

be highly extraneous. Furthermore, CBSLs provisional advances to the

government as a percentage of the fiscal deficit over the past decade are

demonstrating an extremely low rate averaging 1.6 percent. Hence, the

conventional notion that monetary authority of the country opting to

The major tax reforms and subsidies of Government budget 2011

The exemption of PAYE tax for annual incomes less than LKR 600,000.

Decreasing the corporate tax from 35percent to 28percent.

Reduction of income tax on Venture capital corporations up to 12percent.

Exemption of Economic Service Charge for investment trusts.

Reduction of Value Added Tax (VAT) from 20percent to 12percent for

financial services.

Removal of the Social Responsibility Levy.

Imposing CESS on primary goods and raw material exports.


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55 43 45 45 46 48 39 38 37 33 37 38

42 54 58 58 59 55 52 50 48 48 50 44

1990 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Government debt mix as a % GDP

External Government Debt Domestic Government Debt

55 43 45 45 46 48 39 38 37 33 37 38

42 54 58 58 59 55 52 50 48 48 50 44

1990 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Government Expenditure as a % GDP

External Government Debt Domestic Government Debt

print money to finance fiscal deficits is causing inflation appears

extremely unsubstantiated.

Sources: CBSL

Source: CBSL

Therefore, an alternative explanation is required to illustrate the real

factors which influence a general rise in price levels. The commodities

which have increased in price are the essential items such as food, crude

oil, transportation and power while the price of non-food articles and

services such as consumer durables, communication, other electronic

items and motor vehicles have decreased. Considering the inflexibility ofdemand due to natural limit in amount an individuals consumption of

essential food in a fixed period of time, the notion that increasing

government spending exerts upward pressure on the price of rice or

vegetables appears unrealistic. According to the statistics of the UN

Food& Agricultural Organization, from 1998 to 2004 Sri Lankas per capita

rice consumption fell by 0.79 percent.


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-15.0%

-10.0%

-5.0%

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

-15.0

-10.0

-5.0

0.0

5.0

10.0

15.0

20.0

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

LKR bn

Central Bank advances to the Government and Inflation

Central Bank Advances to the Government (LKR bn)

Central Bank Advances to the Government as a % of fiscal deficit

Annual average inflation

Therefore, the relationship between rising food prices and government

spending remains questionable. More importantly, if government opts to

reduce spending by scaling down on healthcare, economic services and

public education, its recurrent and capital expenditure will decrease

leading to a budget surplus. Yet, such a move will raise the market price

of the services mentioned as the private sector will now provide them

with an unsubsidized price tag. Consequently, inflation levels will risereducing the already rigid real wages. With this aggregate demand in the

economy would deteriorate dragging down the real GDP growth rate. It

will further, increase unemployment by nearly 10.1 percent since the

private sector is not experiencing a crowding out effect of labour by

government provided employment opportunities.

Sources:

CBSL


Transfer Payments

The role of transfers also seems to resemble an interesting correlation

with current price inflation and GDP growth. The government subsidies

on rice, electricity, fertilizer and crude oil absorb part of the increasing

cost of production of the private sector. Unlike non-essentials, the rise in

prices of these articles is likelyto create a ripple effect in price increases

as they directly bear on the production process of a large complex of

goods and services. Although world market price of crude oil rapidly

increased over last two years, the government to a considerable extent

has prevented a contagion effect on domestic price levels and keptinflation substantially below the level it would prevail under

uninterrupted functioning of market forces by subsidizing the prices.

Consequently, the graph below demonstrates an inversely related

movement between Sri Lankas point-to-point inflation and world market

crude oil prices; in the absence of a transfer it would have indicated a

positive movement.


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0

5

10

15

20

25

30

$0.00

$20.00

$40.00

$60.00

$80.00

$100.00

$120.00

Jan-09

Feb-09

Mar-09

Apr-09

May-09

Jun-09

Jul-09

Aug-09

Sep-09

Oct-09

Nov-09

Dec-09

Jan-10

Feb-10

Mar-10

Apr-10

May-10

Jun-10

Jul-10

Aug-10

Sep-10

Oct-10

Nov-10

Dec-10

Jan-11

Crude Oil prices vs Inflation

Crude oil price per barrel Point to Point Inflation

Sources: CBSL


Hence, the principal function of government transfers is achieving a

stable monetary stance by holding back the flood waves of world

inflation which threaten to breach the domestic sphere through

humongous fury of foreign goods flowing in to the country. These

government transfers are holding down the cost of production of the

private sector and thereby increase its competitive power above the level

which would prevail under normal market conditions. Under this back

drop, any form of scaling down of welfare expenditure would go hand in

hand with a destabilization of the economy by lowering the effective

demand in the system. Hence, the profit margins of the business

community would fall, subjecting the economy to disorder if government,

like the private sector, considers itself to be a profit generatinginstitution. Finally, if welfare spending is reduced to the pattern

mentioned earlier, government will suspenddomestic borrowings owing

to its increased revenue. The risk free interest incomes -in the form of

government domestic interest payments- of individuals and the financial

conglomerates which amounted to circa LKR 274 bn in 2009 (5.7 percent

of GDP) will then be wiped out. This will hold true as there is no crowding

out of credit to the private sector by large-scale government borrowing

as is evident from the countrys low investment to consumption ratio

(0.31) and the reduction of policy rates by 25 and 50 basis points

respectively by CBSL in order to activate or mop up unemployed capital

of circa LKR 140 bn. In fact deficit spending preserves the capital value of

the surplus by activating the unemployed capital unabsorbed by private

investments. Although it is creating inflationary pressures in the economy

it has the positive aspect of maintaining aggregated demand, making

fiscal deficita mixed blessing for the private sector.


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-5

0

5

10

15

20

25

30

185

190

195

200

205

210

215

220225

230

235

Aug-08

Sep-08

Oct-08

Nov-08

Dec-08

Jan-09

Feb-09

ar-09

Apr-09

May-09

Jun-09

Jul-09

Aug-09

Sep-09

Oct-09

Nov-09

Dec-09

Jan-10

Feb-10

ar-10

Apr-10

May-10

Jun-10

Jul-10

Aug-10

Sep-10

Oct-10

Nov-10

Dec-10

CCPIIndex

Inflation

Index Monthly Change Point to Point Change Annual Average Change

0

5

10

15Country Comparsion-Inflation rate(%)

InflationInflation has witnessed a gradual increase in year 2010. The year started

with an annual average of 3.1 percent which gradually climbed to 5.9

percent in December 2010. The low inflation levels at the beginning of

the year was due to contraction in demand prompted by decliningexternal reserves and the global economic downturn .However with the

gradual increase in global food prices, point to point inflation for the

month of December 2010 stood at 6.9 percent. The annual average

inflation which has been hovering over 5 percent since August 2010

reached 5.9 percent by December 2010, the highest reported since

reaching 3.1 percent in January of the same year. The increase was

largely due to supply side constraints in the world food production and

local supplies which led to the increase of most food prices such as rice,

vegetables, sea food and sugar. Food imports account to circa 14 percent

of the total import cost of the country, therefore the increase in the

import cost of staple food items will continue to widen the impact of

imported inflation in the domestic sphere. The supply constraints areworsened by the rise in oil prices towards the latter part of 2010 which

exerts pressure on production costs. The soaring food prices due to

supply constraints together with the rising capital inflows to the country

could further exert upward pressure on inflation; however the Central

Bank anticipates the inflation to be contained within single digits in 2011.


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0

5

10

15

20

25

%

LKR BOND RATES

1YR Maturity

2YR Maturity

3YR Maturity

4YR Maturity

5YR Maturity

6YR Maturity

Benchmark rates

The Central bank eased benchmark rates gradually throughout the year

taking advantage of the low levels of inflation which prevailed in the first

half of 2010 .The reduction in rates were mainly aimed at spurring privatesector investment as a means of stimulating economic growth.

Source: CBSL

Concurrently, the four year benchmark yield rate which stood at 9.78

percent in January 2010 was slashed to a low of 9.09 percent by August,

2010 and was further reduced to 8.20 percent by January 2011.Furthermore; The inadequate growth in export earnings, together with

the discontinuation of the European Union export concessions prompted

the central bank to reduce borrowing costs of private sector in order to

bring down cost of production and increase export sector competiveness

in global trade. One of the biggest obstacles to private sector led

economic expansion was the high interest rates prevailing in the country

as it invariably increases cost of capital. Hence the move was encouragingto the private sector and consequently the private sector loan book

expanded by 31 percent in the final half of 2010.

Sri Lanka however was in contrast with most other parts of the world as

many countries borrowing rates such as India, Thailand, Malaysia andChina witnessed a gradual increase in order to curb rising inflation. In

addition The US and the Euro Zone also faced high yield rates as the risk

of uncertainty hovered over most of the western economies.


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Source: CBSL

Nevertheless domestic inflationary pressures gradually increased towards

the latter part of 2010 and the rising food prices compelled the

government to reduce tariffs of essentials such as milk powder and crude

oil which will have to be continued well into the near future. Such costly

measures coupled with the reconstruction expenditure incurred due to

the recent adverse weather conditions which prevailed in the latter part

of 2010 would further augment government expenditure resulting in

further increase in government domestic borrowings. This coupled with

the possible upward revision in tax rates to mitigate the additional

government expenditure could further exert inflationary price pressures,

therefore; The central bank will take a cautious stance with regard topolicy rates and will be compelled to conduct monetary policy carefully in

order to keep inflation within single digits while sustaining economic

recovery .In this regard it is highly likely that the borrowing rates would

remain stable throughout 2011.

Source: CBSL

0

5

10

15

20

25

Feb'09 Apr'09 May'09 Jun'09 Sep'09 Nov'09 Jul'10 Aug'10 Jan'11

%

Policy rates and Benchmark rates vs Inflation

CBSL Repo Rate CBSL Reverse Repo Rate Annual Avg.Inflation Bond Yeilds at 4YR Maturity

0

5

10

15

20

25

1YR Maturity 2YR Maturity 3YR Maturity 4YR Maturity 5YR Maturity 6YR Maturity

%

Benchmark yeilds

Jan-11

Dec-10

Nov-10

Jul-10

Dec-09

Jul-09

Jan-09


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Investment Structure and Inflation

Inflation is viewed by economists as a monetary phenomenon emanating

from growth in money supply when Central Bank of the country opts to

finance fiscal deficits through provisional advances, increasing Central

Banks net domestic assets. The credibility of this explanation was briefly

examined in the previous section. In the proceeding segment, inflation

will be very briefly reviewed in terms of the structure of the prevalent

capital formation in the economy.

The spheres of investment in the economy dominated by imports trade

do not allow the decrease of production costs through increasing labour

productivity by replacing capital for labour. Owing to this fact the degree

of increase in productivity of labour in the economy and the reduction in

production costs by means of a substitution of capital for labour has been

insignificant. This particular characteristic of investments effectively

precludes economies of scale of a decreasing unit cost of production.

Entrepreneurs are thus compelled to raise the market price of goods and

services in order to increase business profits causing the price of

imported material to increase independent from exchange rate

fluctuations. This is a deciding element governing the inflationary

pressures prevalent in the economy.

The allegation that a Trade Lobby is controlling the prices of essential

products is therefore, not a phenomenon limited to the growth of

monopoly power, but is essentially related to the limited cost reduction

options which govern spheres of investments. Hence, it is not the

increasing supply of money as an abstract category that is forcing the

prices of essentials to escalate but the concrete nature of money supply

growth or rather the type of activity which essentially increases thesupply of broad money which increase inflation. In fact the growth of

money supply has the tendency to reduce inflation if the additional

supply of cash was directed to investments which allow reduction of

production costs through increased capital formation.


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67%

11%

%7%

2%10%

2%

Export Composition of Singapore

Manufact.

Fuels

Minerals

Transport

Travel

other

Agro

17%

2%2%4%1%3%

41%

0%

EXPORT COMPOSTION

Tea

Rubber

Coconut

Minor Agri

Products

Gems

Petroleum

products

Textile &

Garments

Other Industrial

exports

Further, the fall in real incomes owing to the inflationary pressures

emanating from the structure of investments has a tendency to increase

demand for consumer debt which is demonstrated by the staggering

growth of advances by commercial banks in the form of consumer loans.

Therefore, inflation has also unlocked a vast new sphere for lending for

financial institutions which positively contributes to their earnings growth

as well as to countrys high growth rate. If we may repeat, the increase inthe growth rate is not a consequence of permanent ending of war but of

the peculiarity of investment pattern and the consequent expansion of

consumer debt.

Trade balance and the BOP

Sri Lanka experienced a continuous rise in import expenditure

unmatched by a corresponding growth in export earnings throughout2010. The cumulative earnings from exports during the year 2010

increased by 17.3 percent YoY to USD 8,307 mn, while the cumulative

expenditure on imports during the corresponding period increased by

32.4 percent YoY amounting to USD 13,512 mn. As a result, the trade

deficit expanded by 66.7 percent to reach USD 5,204 mn during 2010

compared to USD 3,122 mn recorded for 2009.

The import base of Sri Lanka mainly consists of commodities with a

relatively inelastic demand such as crude oil and food imports which

account for 39 percent of total imports. However the major exports on

the other hand mainly comprises of primary commodities with a

relatively elastic demand making the country highly vulnerable to price

volatilities of the global market.

Furthermore; Sri Lankas export base is composed of primary goods such

as tea and rubber which bear technologically stagnant production

practices relative to the industrialized economies of the developed world.

In addition the garment exports although accounting for 41 percent of

the total exports are more of a bulk export with relatively low levels of

technological sophistication, hence not creating a niche in the world

-10,000

-5,000

0

5,000

10,000

15,000

20,000

2000 2002 2004 2006 2008 2010(a)

USD MN Imports & Exports VS Trade Balance

EXPORTS IMPORTS TRADE BALANCE


20/62


Hong Kong, 383

Singapore, 358

South Korea, 466

Taiwan, 278

Vietnam, 71

Indonesia, 146

Thailand, 191Malaysia, 193

Sri Lanka, 8 Bangladesh, 16

Bhutan, 1

India, 201

Nepal, 1

Pakistan, 20

Country Comparison- Total Export Value (USD BN)

market. This is in contrast to the emerging Asian economies such as

South Korea, Malaysia and Singapore which achieved rapid export led

economic growth, with more than 60 percent of exports consisting of

commodities with high levels of technological sophistication such as

motor cars, electrical appliances and computer hard ware. Sri Lanka

remains concentrated on export sectors with lower technological

intensity therefore generating extraordinary lower incomes. Thus, astructural change in the export composition in favour of technologically

progressive industries is imperative to address the deteriorating trade

balance of Sri Lanka.

Source: Compiled according to the statistics of CIA World Fact book and The World Bank

In addition, Western countries continue to be the major destination for

Sri Lankas exports. Europe and U.S.A together account for 60 percent of

countrys exports. Hence the recent unfavourable economic conditions

prevailing in the US coupled together with the sovereign debt crisis ofEuro zone could negatively impact the export earnings of Sri Lanka. The

expected reduction in export earnings coupled with the expected rise in

all segments of imports fuelled by the increase in consumption is most

likely to continue to negatively affect the trade balance well in to the next

year.


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Remittances


Remittances

The increase in the flow of remittances greatly assisted to ease the

pressure on the current account triggered by the increase in the

unfavourable position of the trade balance. Private remittances

continued its favourable trend recording a significant growth of 21.9percent during the course of January to October 2010. Inflow of private

remittances for the first ten months of 2010 marked as USD 3,380.4 mn

relative to the USD 2,773.8 mn recorded in the corresponding period of

2009. Workers remittances are expected to exceed USD 4.1 billion in

2010, up by 24 percent from previous year .The Current account deficit

expanded to USD 935mn by September 2010 (provisional) already

surpassing the deficit figure of USD 214 mn recorded for the year 2009 by

more than four folds.

Source: CBSL

The heavy dependency of Sri Lankas economy on foreign remittanceswith respect to effective demand is continuously being highlighted by

economists. In the proceeding section, the factors which fuel the growth

of remittances and their macroeconomic implications will be briefly

reviewed in terms of the investment structure of the economy.

The total earnings Sri Lanka received via remittances in 2010 is

approximately USD 4175 mn, the magnitude is so large it exceeds seven

times the gross foreign exchange income from tourism (circa USD 547

mn) during the same period which saw a massive surge in tourist arrivals.

Since no production costs are involved in departures foreign employment

-40

-20

0

20

40

60 Country Comparison-Current account Balance (USD BN)

-8,000

-6,000

-4,000

-2,000

0

2,000

4,000

6,000USD MN REMITTENCES VS TRADE BALANCE

TRADE BALANCE REMITTENCES


22/62


0

10

20

30

40

50

60

0

1,000

2,000

3,000

4,000

5,000

6,000

7,000

8,000

9,000

USDMN

Remittances VS Exports income

Exports( USD MN) Remittances( USD MN) Remittances as a percentage of exports income

does not induce an outflow, and hence, the netforeign exchange income

of tourism which is below the gross level would further increase the

above multiple. In this connection, growth of remittances stands as the

significant non-debt driven inflow increasing the effective demand and

business profits and relieving Sri Lankas expanding trade deficit. Foreign

employment ranked as the fifth largest contributor to foreign exchange

earnings in 1990 and since then, it has become the premier net foreignexchange earner in Sri Lanka from 2009 onwards. The percentage of total

exports to private remittances was 20.9 percent in 2000 and is as high as

51.8 percent in 2010 (annualized) indicating that the growth of

remittances has outpaced the increase of exports. This means the

importance of the entrepreneur is relatively substituted by (mainly)

housemaids in increasing foreign exchange income of the economy.

Source: SLBFE

Considering foreign employment by the manpower categories involved,

housemaids continued to be the largest category among migrant

workers. Out of the total females who left the country in search of

employment 89 per cent were housemaids who are a poorly paid

manpower category with no bargaining power in labour markets.

In spite of these hazards Sri Lankans continue to migrate in search of

employment as a measure of last resort. Major factors that influence Sri

Lankans to work abroad even under these conditions are stagnant real

incomes, unemployment/underemployment, high inflation,

indebtedness, and a virtual inability to exist in the home country. The

growing remittances are conventionally regarded as an achievementwhen they are an indicator of increasing employment issues, falling real

wages and indebtedness. An aggravation of these conditions has a

tendency to increase the rate of departures and the foreign employment

income of the country, demonstrating a positive link between the

growths of remittances and the inadequate demand for labour in the

economy. This increasing restraint to absorb the labour force is the

outcome of the investment patterns explained earlier.


23/62


-15

-10

-5

0

5

10

15

20

25

30

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

%

Foreign employment data - Comparative growth patterns

% of labour force growth % of foreign employment growth foreign employment as a % of total employment

Source: CBSL & SLBFE

Evidence of the low absorption rate of the work force is shown by theextremely high percentage of migrant workers compared to the total

employed population of the country. The figure has increased to

staggering 25.9 percent in 2010 which stood at 13.5 percent in 2000.

Nevertheless, concomitant with a low labour absorption rate, the private

sector conglomerates as mentioned earlier, have witnessed a surge in net

earnings and the trend is expected to continue undeterred.

This coexistence of expanding profits and insufficient level of labour

absorption demonstrates that in spite of the fact that resources of the

country are underutilized corporate profits are set to rise. It illustrates

that the increase in business profits is continuing to advance relatively

independently from the levels of employment generation; this has a

tendency to increase the deterioration of the latter by investments

continuing to flow in to the same limited unproductive spheres. It also

points to the positive link between increasing profits and consumer debt

causing the growth rate to rise while economic resources remain

underutilized.

In this connection it should also be noted that the expanding export of

labour has obscured the real unemployment levels as given in official

statistics. A comparison of the data compiled by Department of Census

and Statistics and Foreign Employment Bureau show a strong inverse

correlation between countrys official unemployment rate and the

growth of foreign employment as a percentage of total employment(FEPE). In 1993 the official unemployment rate was high as 13.8 percent

which stood significantly above FEPE figure of 8.8 percent.


24/62


Throughout the course of past 17 years the official rate of unemployment

has effectively declined and currently stands at 4.9 percent, while the

FEPE figure has moved to 25.9 percent exceeding the rate of

unemployment by a great margin.

Source: Compiled according to Foreign Employment Bureau and Department of Census and

Statistics

More importantly, the escalation of this disguised -unemployment in the

economy has been the major source of relief to the increasing trade

deficit and boosting domestic aggregate demand; it has reduced

unemployment while demand for labour remains inert. Growth of this

disguised-unemployment increases the purchasing power of less

privileged in spite of the general fall in real wages noted earlier. It would

thus seem that the increase in this disguised-unemployment and

stagnant real incomes cause the rate of growth to rise indicating anunemployment-led growth pattern in the country instead of an export -

led development.

0

10

20

30

%

Inverse correlation between Foreign employmemtgrowth and Unemployment rates

foreign employment as a % of total employment Unemployment rates


25/62


0

200

400

600

800

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010Est.

USD MN FDI (NET)

31%

2%

37%

17%

13%

FDI-SECTOR CLASSIFICATION

(JAN -SEP 2010)

Manufacturing

Agriculture

Infrastructure-

Telephone, Telecommunicat

ion & NetworkInfrastructure-other

Services

22%

18%

13%10%6%

5%

4%

22%

FDI CLASSIFIED BY COUNTRY OF INVESTMENT

(JAN-SEP 2010)

India

Malaysia

UK

U.A.E.

Hong Kong

Mauritius

Netherlands

Other

The capital and financial account

The FDIs have been on a declining trend since 2008. FDI in the first half

of 2010 contracted to USD 208 mn. Meanwhile, the FII(Foreign Indirect

Investment) in the form of short term funds in the Colombo bourse,

increased from circa US$ 315 mn in 2009 to a forecasted figure ofstaggering circa US$ 1,110 mn for 2010 (+ 254.6 percent YoY). This

observation indicates a fundamental shift of foreign investor patterns in

Sri Lanka from direct to indirect investment. It implies that foreign

ownership of financial assets is growing at a rate faster than the foreign

ownership of real assets, signaling a financialisation of foreign capital

accumulation in Sri Lanka. Most importantly, this fundamental shift of

foreign investor pattern from FDI to FIIs would not assist the realisation

of desired outcomes of Sri Lankan government which is currently aiming

at rapid economic development.

Source: CBSL

However; it is expected that the 2010 pro investor budgetary proposals

introduced by the government, together with the renewed investorconfidence of Sri Lanka, and the development of North and East would

gradually improve FDI flows to the country to reach circa USD 700 mn by

the end of 2011(IMF estimates).The development of North and East

would further improve FDI flows to the country.

Source: Compiled according to the statistics of BOI Sri Lanka


26/62


0

2

4

6

8

10

12

14

16

18

20

-8000

-6000

-4000

-2000

0

2000

4000

6000

2005 2006 2007 2008 2009 2010(a)

%USD MN EXTERNAL SECTOR OUTLOOK

TRADE BALANCE REMITTENCES FDI NET GVT. INFLOWS BOP SURPLUS DEBT SERVICE RATIO

The foreign financial flows to government in terms of treasury bills and

bonds increased in the first eight months of 2010 amounting to USD2,

246mn.The external debt servicing cost as a percentage of exports

income fell from 17.2 percent in first half of 2009 to 11.7 percent in the

same period of 2010. Hence, despite the trade balance remaining in

negative territory the overall BOP recorded a surplus of USD 1.3 bn for

the first ten months of 2010 backed by the higher foreign inflows interms of foreign debt and portfolio inflows.



27/62


Increasing foreign reserves and the exchange rate

The year 2010 witnessed a significant inflow of foreign reserves .The

gross official reserve which fell to a low of USD 1272 mn (sufficient for a

mere 1.2 months of imports) at the beginning of year 2009 exceeded USD

7 bn by end of 2010. The total reserves for November 2010 stood at theequivalent of 6.1 month of imports.


With a strong foreign reserve base that exceeds USD 7 bn, Sri Lanka was

in a position to relax foreign exchange controls with the objective of

further expanding the economy injecting more foreign capital especially

into the equity and debt market. The sovereign bond issue which took

place in September 2010 was oversubscribed by 6 times clearly

emphasizing the restored foreign investor confidence bringing in a

further inflow of USD 1 bn sharply increasing the foreign reserves. The

IMFs further disbursement of USD 212.5 mn in October 2010 under its

standby arrangement bringing total disbursements under the

arrangement to an amount equivalent to USD 1,274.8 mn, the improving

sovereign ratings, coupled with the rising remittances throughout the

year further increased the foreign inflows to the country. Such

developments and the depressed US economic conditions together with

the Euro Zone sovereign debt crisis have appreciated the LKR against

other currencies.

The rupee appreciated 2.2 percent against USD and 7.4 percent againstthe Euro by end Sep2010. However the appreciation of the rupee is by

and large due to the Capital account of the BOP as the Current account

continues to deteriorate amounting to a trade deficit of USD 4,039 mn

during the first 10 months of 2010.The Central Bank intervened andmopped up the excess volatility by way of net absorption of USD 241 mn

in September 2010 as a measure of retaining export competitiveness.

An appreciating rupee creates mixed macro economic consequences. On

one hand it would deteriorate the export competitiveness, and negatively

0

100

200

300

400

500

Country Comparison-Total Foregin reserves (USD BN)


28/62


0

50

100

150

2009 Aug Sep Oct Nov Dec 2010 Jan Feb Mar Apr May Jun Jul Aug

IndexPointsNo.

Effective Exchange Rate Indices: 24- Currencies

(2006=100)

NEER

REER

affect the tourism industry as tourist interest would shift to cheaper

destinations. On the other hand currency depreciation could worsen the

foreign debt burden as debt servicing cost increases with depreciation. A

stronger currency would reduce the price of essential food items and

reduce the cost of living of an import dependent economy. However, the

reducing cost of imports will increase the demand for foreign goods,

creating upward pressure on the trade deficit. Furthermore theconsiderable build up of foreign reserves will increase the ability to

withstand external shocks. Therefore the currency appreciation cannot

be solely viewed from the competitiveness angle and the prevention of

creating imbalances to the rest of the economy should be taken in to

consideration. Although Sri Lankas trade deficit continues to be in

negative territory, it isexpected that the LKR would continue on anappreciating trend gradually by 2 percent-3 percent over 2011 with the

increase foreign investor confidence which would further increase

foreign inflows to the country.

REER and NEER

The balance of trade deficit is expected to reach circa USD 5,175.2 million

in 2010 widening the gap between Real Effective Exchange Rate (LKR

123.17) and Nominal Effective Exchange Rate (LKR 89.7). A sudden

withdrawal of foreign portfolio investments and a divestment of

government securities by foreign holdings will exert upward pressure on

REER and NEER. And the gap between REER and NEER will decline sharply

with real exchange rate increasing to reach the nominal exchange rate

figure. Consequently, the rupee cost of imports would build up

inflationary pressures in the economy and raise the governments

external debt servicing cost, thereby widening the fiscal deficit.



29/62


0

2,000

4,000

6,000

8,000

USD MN Gross Foreign Reserves increasing subsequent to the

IMF SBA

IMF SBA

Foreign Debt Factor

However, domestic credit will not rise in the face of a declining external

reserves and a lack of access to foreign capital markets. It is governed by

a corresponding expansion of foreign debt to maintain rising

consumption based on foreign goods. For instance, the sudden spurt of

activity from the beginning of 2010 was preceded by a period of

escalating economic turmoil where first two quarters of 2009 recorded

negative real GDP growth and foreign reserves of the country watered

down to levels below USD 1.4 bn while exchange control measures

increased, lowering effective demand in the economy, and notably

curtailing domestic credit expansion.

However, the approval of USD 2.6 bn IMF Stand-By Arrangement (SBA) in

June 2009 which amounts to nearly 400 percent of the official quota

allocated for Sri Lanka, improved the countrys growth prospects. This

made the foreign capital markets willing to provide loans to the

government at low risk premiums, and with the borrowed funds and

portfolio inflows Sri Lanka managed to tide over its FOREX problems from

July 2009 onwards. Although IMF money is not obtainable, and is not

utilizable to settle balance of payment dues, the Funds presence itself

created space for the government to sell bonds and to publicize the

positive prospects of the economy to draw in foreign direct and portfolio

inflows. The IMF has become an unofficial guarantor of sorts until Sri

Lanka is able to attract foreign inflows on its own. Much more than the

credit Sri Lanka is receiving from the IMF, its presence instilled in

investors, the comfort and credibility to invest in government bonds and

in the stock exchange. With borrowed funds and portfolio inflows

external reserves improved dramatically and sustained a volume of

imports without a corresponding improvement in exports, thus widening

the balance of trade deficit; as a result, the growth rate started to risesignificantly to reach 7.9 percent in the year 2010.


During the course of last ten years the foreign debt has nearly

quadrupled; from approximately LKR 542 bn in 2000 to above LKR 1,950

bn in 2010.


30/62


0

10

20

30

40

50

60

0

500

1000

1500

2000

2500

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 E

%LKRBN

Government Foreign Debt

Government foreign debt (LKR bn) Foregin Debt as % of GDP

Source: CBSL

Nevertheless, the increase in growth rate and the stagnation of real

incomes will continue to rise simultaneously, given liberal external and

domestic financing to sustain the investment pattern. The relationship

between investment structure and expansion of external and consumer

debt will be reviewed in the proceeding sections.

Employment Generation and Investment

Structure

These lending patterns are linked with the negative trade balance and to

huge portion of credit that has been allocated for import-led

consumption purposes rather than for productive investments. The fact

that trading, consumption and housing in 2010 have absorbed 77 percent

of total advances to the private sector and pawning has absorbed 10.23

percent demonstrates that consumer debt has undergone a staggeringgrowth, superseding the flow of credit into production. With a low level

of productive investments in the private sector demonstrated by the

low percentage of advances to manufacturing- credit growth has been

primarily consumption driven alongside relatively low investment

expenditure. This pattern of capital formation and the corresponding

banks lending structure weakens the economys potential to expand

employment. On the other hand, it carries with it the tendency to

increase unproductive credit growth in the economy which has a

propensity to affect productivity and the competitive levels.

The expansion of financial & non-financial services, primary products

such as garments and plantation crops and its connection with the low

investment to consumption ratio in the economy is important in

illustrating the factors which weaken the economys potential to

generate productive employment. Compared to industrialized economies

the expansion of services, import trade and primary products do not

require the entrepreneur to incur large-scale fixed capital investments.

Demand for large scale fixed capital investments in the non-

manufacturing sector remains considerably low. This exceptional

attribute of services as also of primary products lowers the investment to

consumption ratio of the economy despite investments are taking place.

This is demonstrated by the high unemployment rate of capital


31/62


0.26 0.30.33 0.34 0.34 0.32

0.720.79 0.82

0.85 0.860.9

2003 2004 2005 2006 2007 2008

Investment/Consumption ration

Sri Lanka VS Taiwan

investment/consumption ratio SL investment/consumption ratio Taiwan

demonstrated by the excess liquidity of over LKR 140 bn weakening the

volume of employment of labour even when loans growth of commercial

banks is exceeding 26 percent. Excess liquidity in the system is two times

more than the gross tourist income in 2010 and is 10.9 percent of

commercial banks total advances to the private sector and could be

noted as the rate of unemployment of capital.

Hence, the investment structure indicates a lack of qualitative aspects

required to generate employment. A recent World Bank report on youth

unemployment in Sri Lanka provides details supporting the above

argument. Youth unemployment -representing the most productive

segment of the workforce- was nearly 80 percent of all unemployed in

year 2006. The information provided by the Department of Census and

Statistics shows much the same trend. Overall unemployment for those

between the ages of 15 to 24 and 25 to 29 is 21.3 percent and 10.3

percent respectively, and youth unemployment is more than six times

that of the adult unemployment.

Investment Pattern and Real Wages

The investment structure comprised of services, import trade and

primary products with a minimal of fixed capital bears a low tendency to

increase labour productivity through scientific and technological

advances. Hence, the expansion of the prevailing investment structure

undermines employment creation and real wage growth, compared to

industrialized economies. The general stagnation in real wages noted

earlier can be attributed to the prevailing pattern of investments of the

entrepreneurs and this has a tendency to increase demand for consumer

debt making the latter a significant source of net earnings of

conglomerates and real GDP growth.

A revealing comparison is with the real wages in China and India since

2003 both of which recorded an increase of 40-50 percent while in

Taiwan during the last ten years real wages increased by 17.5 percent

and in Singapore during 2006 and 2007 real wages rose by 10.4 percent.

The investment to consumption ratio in China, Taiwan and Hong Kong

was 0.9 in 2008 and is showing an upward trend, indicating the growing

fixed capital formation centering around industrialization.

Source: Compiled according to CBSL and National Bureau of Statistics China


32/62


-5

0

5

10

15

20

25

30

35

40

45

0 0.5 1 1.5 2 2.5 3 3.5Tertiary-Educated work force as a percentage of total work force 2009/2010

Sri Lanka

Singapore

USA

Source: MAS Annual Report 2009/2010

:

Quality of Employment Opportunities

The choice of services, import trade and primary products as an area of

Investment means an employment creation of low profile type; as the

provision of services and primary products is technologically stagnant,

demand for high skilled employees in the economy remains ossified.

Hence, creation of employment remains qualitatively inferior.

Approximately 70 percent of the work force has not received education

beyond grade nine and the tertiary-educated workers are merely 1.6

percent of the total work force. Unemployment among graduates is

exceeding 25,000 and latter as a percentage of tertiary-educated workers

in the country is 19.5 percent. According to 2008 Labour Ministry Survey,

the average employment rate for graduates one year after completing

their studies demonstrated a low trajectory of 38.9 percent while out of

the total employed workforce 61.9 percent is informally employed with

neither any job security nor a possibility to advance their pay.

In contrast, the tertiary-educated workers in Singapore have grown from

nearly 25 percent in 1990 to nearly 33 percent in 2010. In United States

of America the figure stands close to 36 percent (Monetary Authority of

Singapore MAS- Annual Report 2009/2010). These facts indicate that

the pattern of investment in industrially mature regions generates

qualitatively superior employment with higher incomes relative to non-

industrialized economies.


33/62


Relationship between Balance of Trade Deficit

and Economic Growth

The relationship between the trade deficit and the rate of growthprovides vital insight concerning the patterns of economys intrinsic

functioning. The widening of trade deficit demonstrates a corresponding

increase in the real GDP growth indicating a positive link between the

rate of growth and the expansion in balance of trade deficit, provided

that sufficient gross external reserves exist. This is to say, an increasing

growth rate goes hand in hand with a growing trade deficit. A contracting

trade deficit would therefore lower the real GDP growth rate. The CBSLs

statistical data illustrates this pattern of relationships.


As demonstrated in the graph, during 2001 real GDP growth rate dropped

to negative levels and the balance of trade deficit also contracted in the

same year; and since then the real GDP growth rate continued to gather

momentum parallel to the gradually expanding trade deficit. In 2009

alongside a significant drop in balance of trade deficit the growth rate

declined to 3.5 percent from 6.3 in 2008 and the economic activity

significantly lost momentum; it however, rapidly picked-up to record 7.9

percent real GDP growth which went hand in hand with widening balance

of trade deficit in 2010.

Balance of Trade Deficit and Government Finance

The structure of government tax revenue is an indicator of the specific

investment spheres of the private sector from which government tax

revenue is mostly derived. The tax revenue structure illustrates that a

significantly large portion of consumer tax income comes from import-led

activity.

In 2009, approximately 80.9 percent of government consumer tax

revenue (which accounts for nearly 80 percent of the governments total

revenue) was derived through imports; and the latter figure during the

last ten years has averaged 78.6 percent (see graph). The heavy

dependency of government revenue on the import trade creates an

-2

0

2

4

6

8

10

0

1,000

2,000

3,000

4,000

5,000

6,000

7,000

USDMN

Positive relationship between real GDP growth and

B.O.T deficit

Trade deficit (USD MN) GDP GROWTH%


34/62


inverse link between the fiscal deficit and the balance of trade deficit of

the economy. For instance, the escalating trade deficit in 2010 caused

government revenue to increase significantly owing to the positive

relationship which prevails between government revenue and the

balance of trade deficit. Therefore, the tendency is, for the fiscal deficit to

fall when the trade deficit expands.


For instance in 2009, when trade deficit dropped to 7.3 percent of GDP

from 14.7 percent of 2008, fiscal deficit increased to 9.8 percent of GDP

from 7 percent of 2008. In 2010 trade deficit increased to 10.6 percent of

GDP with imports surging and consequently fiscal deficit fell from 9.8

percent of GDP in 2009 to 7.34 percent during first eleven months of

2010. However, this inverse link operates only when import expenditure

rises faster than export income; it is not so when an expanding trade

deficit is triggered by a fall in export income.


72

74

76

78

80

82

0

100

200

300

400

500

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

LKRBN

Composition of indirect tax income

Imports based Consumer tax income (LKR bn)

Non Import based consumer tax

Imports based tax income as of Total Indirect tax income

0

10

20

30

40

50

60

70

0

2

4

6

8

10

12

14

16

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010(f)

Governmentdebtasa%ofGDP

%

The inverse movement of Trade deficit and Fiscal Deficit

Trade deficit as a % of GDP Fiscal Deficit as a % of GDP

Government debt as a % of GDP


35/62


In this connection, it is also important to note that when trade deficit

expands government is less inclined to borrow domestically since as

explained earlier, expansion of the deficit has a tendency to reduce fiscal

deficit by increasing government revenue. Notice the inverse correlation

between government domestic borrowings as a percentage of GDP and

balance of trade deficit; during 2002 to 2008 the former graduallydeclined in relation to increasing trade deficit. And the two indices

moved inversely during next two years. This tendency will also have abearing on the excess liquidity levels of the financial sector of the

economy.

Considering these underlying trends we forecast the fiscal deficit to

consolidate below 7 percent of the GDP in 2011 despite the fact that

damage caused by recent floods will increase relief expenditure and

domestic and external borrowings. The increased government

expenditure will be supported by the rising balance of trade deficit

expected to reach circa 12.6 percent of the GDP in 2011 from 10.6

percent in 2010driving up governments import based tax revenue.

The way Forward Sri Lanka

Industrialization marks the greatest divide in the contemporary world

that of between the poor and the rich nations. The advanced world is

linked to the underdeveloped regions by a peculiar division of economic

activity: an industrially mature area on one hand, zones producing and

largely exporting primary products on the other. The importance of

industry above agriculture and services and the importance of specifictypes of industry above others should be explained in order to lay bear

the dynamics of a nations economic development.

Industrial progress is not merely an acceleration of GDP growth, but an

acceleration of sustainable development, because of, and through,

economic and social transformation. The qualitatively new ways of

producing industrialization creates, unlike services and agriculture, bear

the propensity of generating linkages to integrate the entire economic

structure in to a single whole. Industrialization creates mutually

interactive investments which has automatic continuity leading to a self-

expansion of the capital accumulation process. For instance, the

technological methodology which was invented by the Americans to build

fire arms with interchangeable units was borrowed to produce sewing

machines and later, to build the automobile. The production of

automobile automatically sprouted up dozens of more industries, an

outcome creating a cluster effect in the economy leading to a self-

expansion of capital accumulation and generation of qualitatively

superior employment. Such material expansion of the production

structure is impossible to achieve by expanding production of neither

primary goods such as garments and plantation crops or services. Such

economic and scientific rationality and the progress of knowledge it

brings forth is unattainable with investment patterns predominantly

structured on import trade and servicing its deficits through remittances

received mainly from housemaids. Increasing the number of housemaids

employed abroad appears to be carrying the highest degree of

comparative advantage relative to Sri Lankas other primary exports, as


36/62


foreign remittances do not incur a production cost and hence no outflow

of foreign exchange. Though such form of FOREX inflows can phase-out

balance of payments issues, feed the growing corporate profits and

increase GNP, interpretation of it as economic development can be

termed imprudent.

Development and non-development is determined by the structure ofproducts a country invests in. The level of economic development is not

determined by expansion of services which increase luxury resorts,

imports, property & real estate or supercentres. These are once for all

investments not leading to further investments and nor any automatic

continuity as mentioned earlier. The private sector of Sri Lanka has

initiated extensive capital investments but not necessarily in economic

spheres which lead to economic development. Wasteful or unproductive

activity can generate profits and increase growth rate without realizing

economic development. Hence, the use of growth rate as a parameter

determining quality of growth or economic development of a nation

remains questionable.

It should be noted that prevailing investments structure is incurring

wastage of FOREX gains of remittances and exports by siphoning the

latter to meet the prospects of merchant and financial interests instead

of manufacture. Hence, the rational in seeking Direct Foreign Investment

for economic development is questionable when even the existing

domestic resources comprised of current FOREX earnings and the large

net earnings of conglomerates are unproductively utilized and huge

portion of local capital is unemployed. The development of the economy

therefore necessarily implies, in the present circumstance, the

contraction of some bloated areas of the urban economy and diversion of

these resources to the productive spectrum. Sri Lanka requires a

substitution of its economic structure currently built upon investments

concentrated around services and primary goods exports, to a structure

derived from, and primarily basing itself on, technologically progressive

industrial operations.

In contrast to Sri Lanka, the pursuit of private profit in newly

industrialized countries (NICs) like Singapore, South Korea, Malaysia,

China, Taiwan and Hong Kong, led to a perpetual technological revolution

in the production process and social transformation; while the

entrepreneur choices of Sri Lanka appears to be sustaining the pre-

industrial character of the economy. The manufacturing sector of

Singapore is composed of industries with high levels of technological

sophistication such as automobile, electrical appliances, computer

hardware, textile and heavy machinery. The economic development of

these nations can be attributed to the specific entrepreneur choices of

their investing community which brought about a radical transformation

of production functions.

It is often assumed that an economy of private enterprise has an

automatic bias towards innovation, but the investment patterns of Sri

Lankas entrepreneur economy has not yet reflected similar outcomes.


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Source: CBSL

The popular as well as more professional view of the economy is

underscored by a sense of belief that free and uninterrupted functioning

of market forces will automatically place the economy on a path of

development now that the war is over. But the intrinsic functioning of the

economy suggests quite the contrary. The economy will not shed its

backwardness merely owing to the ending of war. The relatively high

growth rate of the country deserves admiration; however, it

demonstrates the specific pace of expansion of backward operations. The

investing community, regarded as the engine of growth, therefore holdsthe task of bringing about a transformation in investment structure by

developing a progressive relationship between the economy and itself.

Hence, conscious and collective effort is required to restructure the

investment of resources (labour and capital) for the development of

modern industry.

17%

2%

2%

4%

1%

3%

41%

30%

Export composition of Sri Lanka

Tea

Rubber

Coconut

Minor Agri Products

Gems

Petroleum products

Garments

Other Industrial exports


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Stock Market Outlook Sri Lanka


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2010 In Retrospective

Key Events that had a bearing on the market

The forward march from a stunning year 2009 persisted as the Colombo

bourse continued it climb up during 2010 to record a YTD return of 96.0

percent. After being recognized as the second best performing market by

Reuters in 2009, CSE sustained the momentum to touch 7,000


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levels in October 2010 and overtook Mongolia to emerge as the top

performer in the world for 2010. However, CSE performance lost grounds

thereafter shedding above 500 basis points till December.

The more liquid Milanka Price Index (MPI) also gained in line with the

broader market index by 83 percent during 2010 and surpassed its 7,000

milestone in September 2010. Despite the dip in the CSE since October2010, MPI regained its 7,000 levels with the revival that was seen in the

bourse over the past couple of weeks.

Turnover levels were concurrent with the market performance taking the

YTD average daily turnover to LKR2.4 bn.

The YTD foreign interest recorded a net outflow of LKR 32.6 bn. Havingovercome few of the bottlenecks for investment in Sri Lanka; inclusive of

political instability monetary and fiscal disciplines last year, we believe

foreigners would revert their attention to Sri Lankas equity market.


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2010 New Listings

Entities continue to show interest for listing especially from the finance

sector due to regulatory obligations. All the Initial Public Offers (IPOs)

during 2010, were over-subscribed reflecting the positive investorappetite.

*Initiated trading in January 2011

New Listings 2010 by Sector

Company

(Offer for

Subscription)

No of Shares

Offered

Issue Price

(LKR)

Date of Issue No. of Times

oversubscribed

Date

Listed

Value of the Issue (LKR

mn)

Renuka Agri

Foods

120,000,000 2.25 27-Nov-09 12.07 4-Jan-10 270

Ceylon Tea

Brokers

14,000,000 2.00 16-Feb-10 10.52 16-Mar-10 28

Raigam

WayambaSalterns

80,000,000 2.50 29-Mar-10 19.71 29-Apr-10 200

Vallibel

Finance

5,200,000 22.00 31-Mar-10 9.12 4-May-10 114.4

Odel 16,700,000 15.00 5-Jul-10 63.90 4-Aug-10 250.5

PC House 57,233,300 11.00 5-Aug-10 4.26 26-Aug-10 629.53

Hydro Power

Free Lanka

35,000,000 10.00 26-Oct-10 57.05 25-Nov-10 350

Laugfs Gas -

voting

75,000,000 23.00 4-Nov-10 16.45 8-Dec-10 1725

-

non voting

52,000,000 15.00 4-Nov-10 17.90 9-Dec-10 780

*Pan Asian

Power

200,000,000 3.00 7-Dec-10 7.00 7-Jan-11 613.1

*Singer

Finance

26,670,000 15.00 15-Dec-10 120.00 17-Jan-11 400.05

HVA 19,900,000 16.00 11-Jan-11 24 15-Feb-11 318.4

Sector No of Issues No of Shares Indexed Value (Rs.)

Banks Finance & Insurance 3 66,756,241 114,400,000

Beverage Food & Tobacco 2 683,457,320 470,000,000

Services 1 114,000,000 28,000,000

Information Technology 1 228,933,334 629,566,300

Footwear & Textiles 1 144,950,000 250,500,000

Power & Energy 2 496,088,198 2,855,000,000

Total 10 1,734,185,093 4,347,466,300


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Source : Colombo Stock Exchange

Sector performance 2010 at a glance

-100% 0% 100% 200% 300% 400% 500%

ASI

Bank Finance & Insurance

Construction & engineering

Diversified

Hotels & Travels

Investment Trust

land & Property

Motors

Power & Energy

Stores Supplies

Telecom

% Change In Indices

YTD % change in Indices


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Banks, finance and insurance, one of the heavy weight sectors, exhibited

strong performance in terms of earnings during the year, majorly due to

accelerated economic activities in the country. The same momentum can

be expected going forward which would be backed by significant

investment in branch expansion and investor friendly policies imposed by

the government. The major contributors to this growth are HattonNational Bank, Commercial Bank & LOLC.

The Hotel & Travels sector saw a great revival during the latter part of

2010 as many hotels plunged into operations after their refurbishments

in mid 2009. Colombo city hotels such as Galadari, Cinnamon Lakeside

and Cinnamon Grand highly benefited with the corporate activity level

grabbing in many foreign visitors. Resort hotels were also able to improve

their bottom line with the seasonal foreign tourist arrivals. Going ahead,

with Sri Lanka having already catered to 654,476 tourists during year

2010, is targeting 2.5 mn tourists by 2016. The hotel and the leisure

sector as a whole will be a direct beneficiary of these expectations.

Thefood & beverage, one of the key sectors listed in CSE, posted positive

earnings during the year. Poultry sector players (Bairaha Farms and

Three Acre Farms) sustained their growth story benefiting from the

increased chicken consumption in the country. Cargills (Ceylon) also

contributed to the sector growth with the addition of the North and East

markets to its customer base whilst momentum continued in liquor

oriented businesses (Distilleries, Lion Brewery and Ceylon Brewery).

The sector would sustain its growth as most of the counters that

contributed to the sectors performance to continue to capitalize on the

post war scenario. However, certain counters such the Distilleries, Lion

Brewery and Ceylon Brewery; despite increase in their top line the sectorwould find their net earnings being squeezed with the increment of

corporate taxes to 40 percent from 35 percent and the upward revision in

the excise duty structure.

Throughout the past, earnings of the Manufacturing sector had been

highly volatile, which was mainly due to seasonal impacts and

unfavorable macroeconomic outcomes in the global economy. Chevron

Lubricants, Royal Ceramics and Tokyo Cement further strengthened the

sector earnings during 2010.

Though the telecommunication sector includes only 2 counters, it

contributed approximately 5 percent to the total market. The sectorwitnessed healthy earnings posted by two participants during the year.

Going forward the sector has potential in the local context with the

technological advances together with the high penetration levels in the

island. Further with government reducing the call charges we expect the

revenue to grow due to the high elasticity of the product coupled with

the growing per capita income.

The Diversified sector earnings approximately doubled during the year.

The earnings growth was shouldered by the heavy weight John Keells

Holdings with its capital gains through Asian Hotels & Property and Keells


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Hotels. Even though the sector earnings show high fluctuations on QoQ

basis the earnings has usually outperformed the sector and the market.

Going forwards we expect the diversified sector to report higher earnings

on the back of the high geared local economy. Further the sector would

benefit with the low interest rates persistent in the island together with

the high investment rate as the sector is prone to diversification.

During June 2010 government reduced import duty

Documents

Srilanka Country Report-2011