Sri Lanka - Economic Update

World Bank Summary - Autumn 2021

The World Bank has recently published an update on South Asia’s economic performance following the resurgence of COVID-19 earlier this year.  In it, the Bank has provided a summary of its expectations for the Sri Lankan economy.

Growth is expected to recover to 3.3% YoY in 2021 after a contraction of 3.6% in 2020.  Unfortunately, pre-existing economic weaknesses and the scarring effect of the pandemic are expected to cap growth in subsequent years.  Currently, the Bank is forecasting real GDP growth of 2.1% in 2022 and 2.2% in 2023.

Official reserves remain low relative to short term liabilities, and this is exerting pressure on the exchange rate. In the Bank’s opinion, “urgent policy measures are needed to address risks to debt sustainability and external stability”.

Recent Developments

Growth: Real GDP grew by 8% YoY in H1 2021, assisted by base effects.  Manufacturing, trade, financial services, and real estate activity all contributed significantly to the recovery.

However, since June, the Delta variant of the virus has become widespread.

The government’s response has been concentrated on increasing vaccinations and, in this, good progress has been made.  There has been an encouraging drop in new infections since the peak in early September.  (According to recent data, nearly 70% of people have now received at least one dose of vaccine, and 60% of people have been fully vaccinated.)  Nonetheless, the pace of economic recovery is expected to slow in H2 2021.

Inflation: Inflation, as measured by the Colombo CPI, reached 6% YoY in August.  High food price inflation (11.5% YoY) and June’s fuel price increase have both contributed to this.  The government has responded to inflationary pressures and growing concerns about food insecurity, by invoking emergency regulations to curb speculation and to ease shortages in certain key commodities.

The Central Bank has raised policy rates by 0.5% to 5% (Standing Deposit Facility) and 6% (Standing Lending Facility).  It has also increased the reserve ratio by 2%.

Trade and Current Accounts: External vulnerabilities remain elevated.  The trade deficit has increased as an increase in the cost of imports of intermediate and investment goods has offset the increase in earnings from exports.  This is despite restrictions which have been imposed on imports of non-essential goods.

The current account deficit has increased because of these factors, and because of a drop in remittances, and continuing weakness in tourism.

Reserves: As a result, official reserves decreased to $3.6bn in August – which equates to just two months of imports.   (The Bank’s reserves calculation includes an allocation of $787mn from IMF special drawing rights (distributed in August), but excludes a currency swap of RMB 10bn, or c.$1.5bn, with the People’s Bank of China.)

Currency: The Sri Lankan Rupee depreciated by 7.4% against the US Dollar in the first eight months of 2021.  Parallel market premia have been rising.  According to the Bank, “depleted net assets in the banking system, at -$3.5bn by July, suggests increasing challenges in meeting foreign exchange demand”.

Fiscal Balance: Increased expenditure, particularly on interest payments and salaries, have offset a marginal increase in revenue collection in the first four months of 2021.  For 2021, the World Bank is expecting the fiscal deficit to be 10.5% of GDP.  It is expected to remain elevated in 2022, at 10.1% of GDP, and in 2023 (9.1%).  In the first part of 2021, the central bank and banking sector financed 38.7% and 41.4% of the deficit respectively.

Outlook

The outlook remains challenging, as the high debt burden, large gross financing needs and weak external buffers will adversely affect growth and poverty reduction.

(Lower middle income poverty (at $3.20/day) is expected to fall in 2021 but the rate, at 10.9%, it will still be significantly above 2019’s level of 9.2%.)

Despite higher policy rates and price controls, inflationary pressure is expected to remain strong, as a result of partial monetisation of the fiscal deficit, currency depreciation and rising commodity prices.  If food prices worsen or shortages persist, the reduction in food insecurity and poverty could slow.

The current account deficit is expected gradually to increase towards the pre-pandemic level (3.2% of GDP in 2018).

With public debt servicing requirements estimated at more than $4bn in both 2022 and 2023, significant additional borrowings will be required to close the financing gap in 2021 and beyond.  External buffers would be reduced further if reserves continue to be drawn down for debt service.

As a result of weak revenue collection and rigid expenditures, the fiscal deficit is expected to remain high.   Public debt/GDP is forecast to reach 116.5% in 2021, and to rise further to 124.9% by 2023.

In addition to dealing with the pandemic, Sri Lanka therefore needs to take measures to reduce debt vulnerabilities and to restore fiscal and external buffers.  Financial sector vulnerabilities need to be carefully monitored. Helping students to recover learning losses following the pandemic will be important in the long term.

For the full World Bank report, which includes commentary on the outlook for seven other South Asian economies, and the potential benefits for the region resulting of digitisation and a greater services development, please use the following link:

https://openknowledge.worldbank.org/bitstream/handle/10986/36317/9781464817977.pdf