Economic developments in Sri Lanka :
After expanding rapidly in 2006 the economy slowed in 2007, but still showed robust growth of an estimated 6.7%. Several important characteristics emerge from these 2 years, which were marked by a renewed, and escalating, civil conflict. First, the economy has proven more resilient than expected by most observers (both local and international).
Second, post-tsunami reconstruction, rising credit expansion, and public sector investment continued to fuel growth in construction, which now accounts for almost 7.4% of GDP. Third, expansionary fiscal policies, largely negative real interest rates, and high remittances also substantially boosted aggregate demand. On the supply side, services remained strong (especially telecommunications, finance, international port services, and logistics), contributing 64% of GDP growth in 2007 despite the conflict-related
slowdown in tourism (Figure 3.21.1). While tourism contributes only 1–2% of GDP, the social costs of fewer tourists are high, as an estimated 300,000 jobs are linked to the industry. Agriculture fell back to its lackluster performance of the past, unable to sustain the post-tsunami recovery of 2006. The garment industry—the industrial mainstay—
continued to weather difficult conditions. It grew by 7%, increasing exports to the European Union (EU) by 24%, taking advantage of the GSP Plus concessions granted in 2005, while its exports to the United States (US) decreased by 3.4%. Soaring global prices for fuel and food and high government bank borrowing were the main causes of the doubling of inflation in the Sri Lanka Consumer Price Index (SLCPI), from 9.6% to 20.2% . Inflation was 5 percentage points higher than the targeted rate in the Monetary and Financial Policy Road Map published by the central bank in January 2007. The bank largely met its targets of reserve money and broad money growth by the end of the year, although there
were sizable deviations during the course of it. As in 2006, monetary policy was conducted primarily through open-market operations, which pushed interest rates higher with the 91-day Treasury bill rate climbing by 7 percentage points over the year to 19%. To implement tightening, the central bank restricted access to the reverse repo window (for lending to commercial banks), but left its rate unchanged at 12.0%. Unlimited access to this window by some banks was a major factor fueling high credit growth in 2006. However, after interbank rates began to fluctuate, peaking at 40%, the central bank changed its policy in August.
Access to the reverse repo window is now liberalized, though a penal rate ensures that its use is limited. Higher interest rates reduced private sector credit growth from 24%
to 20% year on year. However, the central bank cautioned in its Road Map that the success of its policies to bring down inflation would depend on government borrowing being kept within limits set by the central bank.
Inflation in Sri Lanka is sensitive to public-sector credit expansion that causes an increase in the money supply. The continued heavy government borrowing from the banking system will exacerbate inflation pressure. The inflation impact of past modes of deficit financing is corroborated by the findings of the Government’s think tank for
economic policies, the Institute of Policy Studies of Sri Lanka, as well as the International Monetary Fund. The sharp rise in inflation also reflects global food and fuel price
increases, with their impact magnified by depreciation of the local currency against the US dollar for most of the year. Due to the global wheat shortage, wheat import prices rose by over 60% (in Sri Lanka rupee terms) in 2007. Reflecting both this and rises in other inputs (such as labor, transport, and marketing costs that are not solely supply driven), bread prices alone rose by almost 200%. The large share of food in the SLCPI (71.2%) is therefore a policy concern.
There were also substantial changes in government-administered fuel prices. Figure 3.21.4 shows the contribution to inflation of the food; transport; and housing, electricity, and fuel price subgroups in the new Colombo Consumer Price Index (CCPI-N), which shows that food was the prime source for the run-up in prices during the year. Inflation as
measured by the CCPI-N, however, is slightly below that of SLCPI because of a lower weight for food. Continued modernization of revenue administration broadened the tax base with the opening of 79,000 new tax files in 2006 and 2007. Lowered tax thresholds and increases in some import duties also raised revenue collection. These moves, in combination with lower than expected expenditure, contributed to a further reduction of the fiscal deficit to an estimated 7.7% of GDP.