‘Corrective action stabilized economy in 2016’


Dr. Indrajit Coomaraswamy, the Governor of the Central Bank of Sri Lanka presenting the Annual Report 2016 to Ravi Karunanayake, the Minister of Finance. Dr. R.H.S. Samaratunga, Secretary to the Ministry of Finance and ex-officio member of the Monetary Board, S. Lankathilake, Deputy Governor of the Central Bank, C.J.P. Siriwardana and K.D. Ranasinghe, Assistant Governors of the Central Bank, and Dr. Yuthika Indraratna, Director of Economic Research of the Central Bank are also in the photo.

In terms of Section 35 of the Monetary Law Act No. 58 of 1949, the sixty seventh Annual Report of the Monetary Board of the Central Bank of Sri Lanka was presented to Ravi Karunanayake, the Minister of Finance, by Dr. Indrajit Coomaraswamy, the Governor of the Central Bank of Sri Lanka.

A summary of the performance of the Sri Lankan economy in 2016 as reflected in the Annual Report is given below:

Overview: Following a period of uncertainty, the Sri Lankan economy showed early signs of stabilisation during the year 2016 in response to corrective actions adopted by the government and the Central Bank. Unfavourable weather conditions and sluggish global economic recovery caused the economy to grow at a slower rate of 4.4 per cent in 2016 in real terms, in comparison to 4.8 per cent in the previous year, although a steady acceleration in quarterly growth was observed from the second quarter of the year amidst tightened fiscal and monetary policies. Increased investment expenditure, especially in the construction sector, drove economic growth during the year, while consumption expenditure slowed in response to the policy environment in place.

Inflation, which remained low in the first four months of the year, increased thereafter to record an annual average of 4.0 per cent in 2016 (both National Consumer Price Index (NCPI, 2013=100) and Colombo Consumer Price Index (CCPI, 2013=100) based). The high levels of inflation observed during some months in 2016 as well as in the first quarter of 2017 were mainly due to the adverse impact of weather related disruptions, tax adjustments and rising international commodity prices, but the increasing demand pressures of the economy were evident in core inflation remaining at elevated levels.

Movements in external sector balances reflected the continued domestic demand for imports from certain sectors of the economy, weak external demand for the limited basket of domestic products, persistent failure of the country to attract increased direct investment flows as well as the impact of rising global interest rates particularly on the government securities market. These developments resulted in the balance of payments (BOP) recording a deficit for the second consecutive year in spite of improvements in earnings from tourism and other service exports as well as workers’ remittances. The Central Bank’s heavy intervention in the foreign exchange market continued in the first four months of the year resulting in a broadly stable exchange rate during this period. However, the exchange rate was increasingly allowed to reflect market conditions thereafter by limiting Central Bank intervention to dampen the pressure on the exchange rate arising from outflows of foreign investments from the government securities market.

Considering the possible rise in demand driven inflationary pressures, the Central Bank continued to tighten monetary policy and monetary conditions throughout the year. Accordingly, in addition to increasing the Statutory Reserve Ratio (SRR) applicable on rupee deposit liabilities of licensed commercial banks (LCBs) in December 2015 to be effective from January 2016 and the continued application of the loan-to-value (LTV) ratio as a selective macroprudential demand management tool, the Central Bank raised its key policy interest rates by a total of 100 basis points in two steps during 2016, the first in February 2016 and the second in July 2016. Open market operations of the Central Bank also guided the short term market interest rates to move to the upper bound of the policy interest rate corridor, resulting in a considerable increase in the market interest rate structure. In response to tightened monetary conditions, the acceleration of broad money growth subsided while the growth of credit extended to the private sector by LCBs that peaked at 28.5 per cent in July 2016, on a year-on-year basis, also decelerated to 21.9 per cent by end 2016. However, the deceleration of monetary and credit expansion was below expectations, and the Central Bank again adjusted its policy interest rates upwards by 25 basis points in March 2017 with the view of signalling to the market the intent of the Central Bank in maintaining inflation in mid single digits in the medium term, within its increasingly forward looking monetary policy framework in which the management of inflation expectations plays a vital role. The financial sector, in the meantime, continued to expand during the year whilst exhibiting resilience amidst challenging market conditions both globally and domestically.

Meanwhile, fiscal operations registered a notable improvement in both revenue and expenditure fronts, resulting in the containment of the overall budget deficit at the envisaged level of 5.4 per cent of Gross Domestic Product (GDP). In spite of these achievements, central government debt as a percentage of GDP increased, illustrating the narrowing fiscal manoeuvrability within the overall macroeconomic policy framework and highlighting the necessity of continued efforts to sustain the fiscal consolidation process.

Real Sector Developments: In 2016, the Sri Lankan economy grew by 4.4 per cent in real terms, amidst numerous global and domestic challenges. Unfavourable weather conditions that prevailed during the year adversely impacted economic activity, primarily in the Agriculture sector. Services related activities, which constitute 56.5 per cent of real GDP, grew by 4.2 per cent in 2016, on a year-on-year basis, supported by the expansion in financial services, insurance, telecommunications, as well as transportation, and wholesale and retail trade. Industry related activities, which account for 26.8 per cent of real GDP, recorded a notable growth of 6.7 per cent, year-on-year, driven by the subsectors of construction, and mining and quarrying. Within the Industry sector, the growth in manufacturing activities was low at 1.7 per cent. Agriculture, Forestry and Fishing related activities contracted by 4.2 per cent in 2016, resulting in a reduction in their share in real GDP to 7.1 per cent in 2016. Adverse weather conditions that prevailed in 2016 resulted in a contraction, mainly in paddy, tea and rubber subsectors.

As per expenditure approach estimates, economic growth in 2016 was primarily driven by the expansion in investment expenditure during the year. Accordingly, gross domestic capital formation, which represents the level of investment activity of the economy, grew by 19.6 per cent, while accounting for 31.5 per cent of the nominal GDP. Higher investment growth predominantly emanated from the expansion in construction activities during the year. Meanwhile, consumption expenditure, which is the largest expenditure category of the economy, recorded a modest growth of 4.1 per cent in nominal terms, which was a considerable moderation compared to the growth of 10.3 per cent recorded in the previous year. The slowdown in consumption was driven by the moderation in private sector consumption expenditure due to tightened monetary and fiscal policies, while public sector consumption expenditure also moderated in 2016 with ongoing fiscal consolidation efforts. Although domestic demand grew by 8.2 per cent in nominal terms (6.2 per cent in real terms) during the year, net external demand declined by 9.6 per cent in nominal terms (22.5 per cent in real terms) in 2016 reflecting both weakness in Sri Lanka’s export markets and a decline in the competitiveness of the economy as evidenced by the continued fall in the country’s share of global exports. Amidst these developments, domestic savings increased to 23.8 per cent of nominal GDP, with an improvement in both private sector savings and government dissavings during the year. National savings also improved in 2016 as a result of the expansion in net current transfers from the rest of the world while net primary income from the rest of the world declined. Consequently, national savings as a percentage of nominal GDP improved to 28.9 per cent in 2016 compared to 26.0 per cent in 2015. With the increase in both investment and savings, the domestic savings-investment gap as well as the national savings-investment gap remained broadly unchanged from the previous year at 7.6 per cent of GDP and 2.5 per cent of GDP, respectively, in 2016.

The unemployment rate declined to 4.4 per cent in 2016 from 4.7 per cent in the previous year, while the number employed, increased by 1.5 per cent during the year with the expansion in the Industry and Services related activities in the economy. Both female and male unemployment rates declined, to 7.0 per cent and 2.9 per cent, respectively, in 2016, from 7.6 per cent and 3.0 per cent, respectively, in 2015. During 2016, the unemployment rates by level of education, declined across all categories, although unemployment amongst youth (15-24 years) increased to 21.6 per cent in 2016 from 20.8 per cent in 2015. Meanwhile, the Labour Force Participation Rate (LFPR) remained unchanged in 2016 at 53.8 per cent. Responding to policy actions by the government to minimise the social impact of unskilled female migration and the subdued economic performance in a majority of Middle Eastern economies and other labour destinations, departures for foreign employment declined in 2016. However, the improvement in the skill profile of the temporary migrants contributed to a moderate increase in remittance inflows. Meanwhile, labour productivity increased marginally during the first three quarters of 2016. Labour productivity in the Agriculture sector remained at a level significantly lower than in the Industry and Services sectors.

Inflation: Consumer price inflation moved upwards during the first half of 2016, although it stabilised somewhat during the remainder of the year, while core inflation broadly followed an upward trend in 2016. Headline inflation, as measured by the year-on-year change in NCPI was subdued in the first quarter of the year as a result of imported deflationary effects associated with low international commodity prices. Headline inflation registered an increase during the second quarter of the year reflecting the impact of domestic supply side disruptions, particularly due to adverse weather conditions, and tax adjustments. However, some deceleration in inflation was observed during the third quarter due to the suspension of the implementation of changes to the government tax structure and the recovery in domestic supply conditions. Inflation remained broadly stable thereafter, although the implementation of new Value Added Tax (VAT) rates with effect from November 2016, exerted some upward pressure on prices. Accordingly, year-on-year headline inflation based on the NCPI, which peaked at 6.4 per cent in June 2016, gradually decelerated to 4.2 per cent by end 2016, thus registering the same rate as at end 2015. Following a similar trend, CCPI based headline inflation also reached a peak of 5.8 per cent in July 2016, before registering 4.5 per cent at end 2016. Core inflation, which measures the underlying inflationary pressures in the economy, displayed an upward trend in 2016 although some volatility was observed on a monthly basis. The impact of demand driven inflationary pressures arising from the continued expansion in monetary and credit aggregates was shrouded by relatively low international commodity prices and administered price revisions, while the revision made to the tax structure had an upward effect on core inflation during the first half of 2016. Although core inflation stabilised for a few months, as a result of the suspension of the changes made to the government tax structure, the reimposition of the tax changes caused core inflation to move upwards towards end 2016. Accordingly, NCPI based core inflation stood at 6.7 per cent by end 2016, year-on-year, remaining higher than 5.8 per cent recorded at end 2015. Year-on-year core inflation based on the CCPI declined from 6.7 per cent at end 2015 to 5.8 per cent by end 2016. The prevailing drought conditions, the effect of the tax changes and rising international commodity prices affected the movements in inflation in the first quarter of the year 2017 as well, although tightened monetary and fiscal policies enabled reining in of demand pressures on inflation to a great extent.

External Sector Developments: Sri Lanka’s external sector performance remained subdued in 2016, with foreign exchange outflows exceeding the moderate inflows during the year. Monetary policy normalisation in the United States of America (USA), subdued external demand due to the slow pace of economic recovery in several advanced economies and emerging market economies, and persisting geopolitical tensions in the Middle East, significantly dampened the performance of the external sector. The trade deficit as a percentage of GDP expanded to 11.2 per cent in 2016 compared to 10.4 per cent in 2015. Although the services account and the secondary income account recorded surpluses, the increase in the trade deficit and the primary income account deficit, caused the current account deficit to widen to 2.4 per cent of GDP in 2016 from 2.3 per cent of GDP in 2015. The subdued performance of the financial account of the BOP stemmed from continued outflows on account of debt repayments amidst modest non debt inflows. In July 2016, Sri Lanka successfully raised US dollars 1,500 million through its 10th International Sovereign Bond (ISB), which was its first dual-tranche issuance as well. Meanwhile, in view of the deterioration in the BOP and to obtain support for the government’s reform agenda, Sri Lanka requested a three year Extended Fund Facility (EFF) of Special Drawing Rights (SDR) 1.1 billion (approximately US dollars 1.5 billion) from the International Monetary Fund (IMF), and the first and the second tranches under this facility amounting to US dollars 332 million were received during the year. - CBSL



To be continued

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