SL at crossroads
October 24, 2010, 6:48 pm
The IMF released its publication the ‘Regional Economic Outlook Asia and Pacific: Consolidating the Recovery and Building Sustainable Growth’ last week which included a section on Sri Lanka.
"The three-decade war distorted economic policy, hindered development, and reduced Sri Lanka’s growth potential. Carrying out a national, integrated investment strategy proved very difficult with the country in a persistent state of conflict—infrastructure suffered, and political uncertainty and security concerns held back private domestic and foreign investment," the Regional Economic Outlook said.
"In an effort to offset these concerns, the government relied on sweeping tax concessions to attract investment, resulting in an erosion of the tax base and chronically high budget deficits financed in large part by external borrowing. The tax system became increasingly ad hoc and distorted, with a narrowing portion of economic activity taxed at high rates. Public debt grew to unsustainable levels as security and interest expenditures increased, with the resulting debt dynamics raising the risk of ultimate debt distress," it said.
As a result, the IMF said the country was left with few policy options to manage the unfolding global crisis. In the face of a sudden reversal in capital flows at the end of 2008 and heavy intervention by the central bank to maintain the de facto peg, foreign exchange reserves fell to dangerously low levels by March of 2009 (to almost US$ 1 billion). Inflation was successfully brought under control through tight monetary policy, but as expected this resulted in a slowdown of output growth and a surge in banks’ nonperforming loans, compounded by a decline in exports as global demand weakened in 2009. Budget revenues remained weak and the deficit high, reaching 9.9 percent of GDP in 2009.
Mid 2009, the Executive Board of the IMF approved a US$ 2.6 billion standby facility for balance of payments support which gave investors a degree of comfort but it was the end of the conflict in May 2009 that changed things significantly for Sri Lanka.
"Short-term vulnerabilities eased significantly following the end of the war in May and the approval of the IMF programme in July 2009. A sharp increase in foreign investor enthusiasm led to large and persistent capital inflows. Remittances also increased, and exports began to rebound. The central bank responded by aggressively purchasing foreign exchange to prevent an appreciation of the rupee, boosting reserves to historically high levels," the IMF said. Today, reserves exceed US$ 7 billion.
"With the end of the war and the crisis averted, future growth prospects have improved markedly. But the country is now at a crossroads, and significant near- and medium-term macroeconomic challenges need to be addressed if Sri Lanka is to take full advantage of the current favorable environment.
First, fundamental tax reform is needed to simplify the existing system, broaden the tax base, spread the tax burden more equitably, and support economic growth, all while boosting the revenue-to-GDP ratio. The resulting fiscal space would allow increased public capital spending on reconstruction and infrastructure as well as social spending.
"But higher growth potential requires investment significantly higher than historical levels, and it is clear that these investment needs cannot be met through the government budget alone. Private-sector investment needs to play a critical role. To foster this investment, policies will need to be geared toward preserving macroeconomic stability, ensuring external competitiveness, facilitating capital market development, and improving the investment climate. These challenges are intertwined and cross-cutting, but each is focused on the ultimate goal of restoring and boosting further Sri Lanka’s growth potential over the medium term," the IMF said.
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