The Sri Lanka Development Update (SLDU) has two main aims. First, it reports on key developments over the past 12 months in Sri Lanka’s economy, places these in longer term and global contexts, and updates the outlook for Sri Lanka’s economy. Second, the SLDU provides a more in-depth examination of selected economic and policy issues. It is intended for a wide audience, including policymakers, business leaders, financial market participants, think tanks, non-governmental organizations and the community of analysts and professionals interested in Sri Lanka’s evolving economy.
RECENT ECONOMIC DEVELOPMENTS
Sri Lanka's economy contracted by 7.8 percent in 2022. While all key sectors contracted, manufacturing and construction sectors suffered the most amid shortages of inputs and supply chain disruptions. High frequency indicators, such as purchasing managers’ indices, indicate continued stress in the first quarter of 2023.
After peaking at an unprecedented 69.8 percent in September, headline inflation closed at 57.2 percent in 2022, reflecting the impact of elevated global commodity prices, monetization of fiscal deficits, currency depreciation, and food supply constraints due to the 2021 ban on chemical fertilizers. Since January 2022, the central bank has raised policy rates by a cumulative 1,050 basis points to try curbing inflation.
Due to the economic contraction, half a million jobs were lost in industry and services and back-up lower-paying agricultural jobs could not compensate for income losses. Combined with increases in the cost of living, this economic contraction led national and urban poverty to double (to 25 percent) and triple (to 15 percent), respectively. The crisis left 52 percent of the population in estate areas living in poverty, exacerbating spatial disparities, and led to an increase in overall inequality.
The trade deficit declined to US$ 5.2 billion in 2022 from US$ 8.1 billion in 2021, as exports, particularly textiles, grew faster than imports. This trade deficit reduction is estimated to have lowered the current account deficit, despite a fall in remittances (by 36 percent) and relatively low tourism receipts. Lower remittances – a source of income for 7.2 percent of the population- contributed to income losses and to the adoption of negative coping mechanisms, further increasing the risk of food insecurity and stunting.
The currency (LKR) depreciated by 78 percent against the US Dollar between March and May 2022 when it was floating. A return to a managed float, amid the ongoing foreign exchange management strategy, restricted the full year depreciation to 81 percent. However, due to low market confidence, bringing export earnings and remittances to Sri Lanka through formal channels has been challenging, despite mandatory repatriation and conversion rules. The unwinding of speculative Dollar holdings led to sharp appreciation of the LKR in early March 2023 amid sluggish import demand.
The overall fiscal deficit is estimated to have declined owing to the implementation of several new revenues measures (including a VAT rate increase from 8 to 15 percent), tightly controlled expenditure and a buildup of arrears to suppliers and contractors. Interest payments continued to absorb more than two-thirds of total revenue.
In the last five years, growth and poverty reduction significantly decelerated due to several shocks, including COVID-19. A restrictive trade regime, weak investment climate, episodes of loose monetary policy, and an administered exchange rate contributed to external imbalances. Years of fiscal indiscipline, driven primarily by low revenue collections, led to high fiscal deficits and large gross financing needs. Combined with these pre-existing fiscal imbalances, tax cuts in 2019 contributed to a rapid build-up of debt to unsustainable levels. Sri Lanka lost access to international financial markets in 2020 after credit rating downgrades.
Without market access, official reserves dropped from US$7.6 billion in 2019 to less than US$500 million (excluding a currency swap equivalent to US$ 1.4 billion with China) in December 2022. Net foreign assets in the banking system also fell to US$ -4.8 billion in December 2022. This severe forex liquidity constraint has been felt across the economy, particularly from the second quarter of 2022, with shortages of fuel, medicine, cooking gas, and other inputs needed for economic activity. Amid depleted reserves, Sri Lanka announced an external debt service suspension in April 2022, pending debt restructuring. A foreign exchange management strategy (covering outflows with available inflows in the absence of debt servicing), implemented in the second half of 2022, somewhat stabilized the external sector.
The IMF Board approved a US$2.9 billion-48-month Extended Fund Facility program on March 20, 2023, after securing financing assurances from official creditors to provide debt relief consistent with the IMF’s debt sustainability framework.
The fluid political situation and heightened fiscal, external, and financial sector imbalances pose significant uncertainty for the outlook. Growth prospects depend on debt restructuring and growth enhancing structural reforms. At the same time, fiscal consolidation will likely dampen these prospects, with the fiscal deficit expected to gradually fall over the medium-term. Inflation is projected to come down from a high base as monetization of fiscal deficits is reined in. The current account deficit is expected to decline thanks to import compression, despite decelerating exports due to weak global demand. Additional resources will be needed in 2023 and beyond to close the external financing gap.
Key downside risks include a slow debt restructuring process, limited external financing support, a sharper global slowdown, and a prolonged recovery from the scarring effects of the current crisis. A lower-level external trade equilibrium could have contagion effects on domestic trade, economic activity, jobs, and incomes. This and adverse effects from revenue-mobilization efforts could worsen poverty projections. The financial sector needs to be managed carefully, given rising non-preforming loans and large public sector exposures.
The necessary macroeconomic adjustments may initially adversely affect growth and poverty but will correct overall imbalances, help regain access to international financial markets, and build the foundation for sustainable growth. Mitigating the impacts on the poor and vulnerable remains critical during the adjustment. Reducing poverty requires better-targeted social assistance, an expansion of employment in industry and services, and a recovery in the real value of incomes. On the upside, the government’s reform program, supported by financing from international partners, could boost confidence and attract fresh capital inflows key to restart the labor market and restore livelihoods.
Last Updated: Apr 04, 2023
The current crisis is not a temporary liquidity shock that can be resolved by external financing support from outside. Instead, the crisis provides a unique opportunity to implement deep and permanent structural reforms that may be difficult in normal circumstances. Sri Lanka can use this opportunity to build a strong and resilient economy.
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