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CB Report Notes Structural Challenges

by Amavasya Sirisena

  • Considering the possible rise in demand driven inflationary pressures, the Central Bank says it continued to tighten monetary policy and monetary conditions throughout the year
  • Unfavourable weather conditions and sluggish global economic recovery caused the economy to grow at a slower rate of 4.4 per cent in 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

Dr. Indrajit Coomaraswamy

The Central Bank, in its annual report released last week, noted that some structural challenges need to be addressed decisively without delay with broad public consensus.

The report warns the postponement of essential reforms is no longer feasible if the country is to progress along a sustainable and equitable growth trajectory.

“The performance of the Sri Lankan economy in 2016 reconfirmed the necessity of addressing the deep rooted structural issues, in order to enable the country to progress towards a higher growth trajectory, as envisaged,” the report says.

The report, which was handed over to Finance Minister Ravi Karunanayake and is to be handed over to Parliament, said that while the government’s recent efforts, with the support of multilateral agencies including the IMF, to formulate policy frameworks required to address these issues as well as emerging challenges are commendable, it is essential that such policies are implemented swiftly with consistency in order to improve productivity and efficiency of the economy and to attract much needed foreign direct investments (FDIs) and boost investments from the domestic private sector, while seamlessly integrating with the global production networks.

“The structural challenges faced by the Sri Lankan economy have been consistently highlighted by the Central Bank of Sri Lanka in its previous Annual Reports and regular reports to the government, and also by the research community and international development agencies on numerous occasions in the past. Along with strengthening macroeconomic fundamentals through improved fiscal performance and the conduct of monetary policy in a forward looking framework, it is essential that these structural issues are addressed decisively without delay with broad public consensus, as the postponement of these essential reforms is no longer feasible if the country is to progress along a sustainable and equitable growth trajectory,” the report said.

The report noted that 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 says it 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 macro prudential 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.

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.

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 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. Meanwhile, total assets of the insurance sector expanded in 2016 with the contribution of both long term insurance and general insurance business categories. Total profits earned by the insurance sector marked a considerable growth in 2016 led by an impressive performance in the general insurance sector. With regard to superannuation funds, total assets of the sector recorded a modest growth in 2016 as a combined result of the increase in income generated through investments and net contributions by the members of these funds.

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