A Snapshot of Sri Lankan Economy 2020 – The Corona Shock and the Policy Challenge

 

The global policy wave followed by governments to curb the spread of the Corona virus by lockdowns and social distances led to severe socio-economic instabilities that disrupted the global supply chains. As a result, markets and global economy broke down creating a global depression. Therefore, global production, consumption and investments collapsed, and unemployment skyrocketed.

 Although Sri Lanka could control the virus to a non-concerned level in 2020, the economy confronted a major setback due to the impact of the global depression created on the pandemic. This article highlights a macro picture of the Sri Lankan Economy 2020 by using selected key policy and economic outcome variables representing the real, fiscal, foreign and monetary sectors based on data presented in the Central Bank Annual Report 2020. However, there can be diverse analyses on the Sri Lanka Economy 2020 based on various viewpoints.

Real Sector

• Economic Growth

The economy shrank by 3.6% (real GDP growth) as against the growth of 2.3% in 2019. The real product of all three sectors, i.e., agriculture, industry and services, fell. Meanwhile, the contribution to the GDP by agriculture and services sectors rose while the industry sector fell.

• Per Capita Income

The GDP Per Capita declined in both Rupee and Dollar terms. It in Rupee terms fell by 0.8% to Rs. 683,106 whereas it in dollar terms fell by higher 4.4% to US$ 3,682 consequent to depreciation of the Rupee.

• Savings and Investment

Savings and investments dropped in both nominal terms and GDP ratio. The decline of the GDP ratio was from 24.7% to 23.9% for National Savings and from 26.8% to 25.2% for Investment.

• Unemployment

It rose to 5.5% from 4.8% reported in 2019. However, as compared to the significant increase in unemployment rates reported in developed countries, the marginal increase in Sri Lanka, despite the fact that many lost work, is due to definitional differences adopted in household surveys.

• Inflation

Fiscal Sector

• Budget Deficit

The increase in the budget deficit by 15.9% reflected a significant rise in the deficit-GDP ratio from 9.6% to 11.1%.  Although both govt. income and spending declined, the larger decline in the tax revenue and GDP led to rise in the GDP ratio. As the deficit was financed fully through domestic borrowing with net repayment in foreign borrowing, domestic borrowing source rose by 95%.

• Public Debt and Servicing

The outstanding public debt rose by nearly Rs. 2 trillion or 16% resulting in the debt-GDP ratio rising to 101% from 86.8% reported in 2019. The significant increase in the fiscal deficit, debt rollover and reduction in the GDP contributed to the high rise in the debt-GDP ratio. However, debt service fell by 4% in amount whereas the debt service-GDP ratio fell to 13% from 13.5% reported in 2019.

 Due to significant decline in foreign borrowing, the ratio of domestic debt in the total debt rose to 47.6% from 40%. The gross foreign borrowing declined by 30% from US$ 6,750 mn to 2,002 mn. Due to net repayment of foreign debt and considerable reduction in market prices of sovereign bonds (as reported on market price), the foreign debt stock in dollar terms fell by 17.5% to US$ 28.2 bn from 34.2 bn.

Foreign Sector

• Trade Balance

The trade deficit shrank by 25% to US$ 6,008 mn. due to the larger decline in imports than exports, i.e., the decline in imports by US$ 3,882 mn (or 19.5%) as compared to the decline in exports by US$ 1,893 mn (or 15.5%). The suspension of non-essential imports and the fall of world market prices of petroleum and commodities due to the global recession were the main reasons for the decline in imports.

• Foreign Debt Service

Debt service fell by 24% to US$ 4,382 mn. However, the debt service ratio (% of earnings on the export of goods and service) rose to 33.5% from 29.7% due to a higher decline in exports. The govt. debt service in the total debt service rose to 90.7% from 79.3% due to high govt foreign debt stock.

• Overall BOP

The economy confronted a record BOP deficit of US 2,328 mn. Such a large deficit as compared to the surplus of US$ 377 mn in 2019 was a result of the use of the foreign reserve to service govt foreign debt and significant decline in gross receipt of govt foreign loans.

• Official Foreign Reserve

The foreign reserve of the central bank fell significantly due to net supply of US$ 2,328 mn to the economy for financing the BOP deficit. The net supply of foreign exchange by the central bank to the economy is undertaken with the objective of controlling the exchange rate. As a result, the foreign reserve fell by US$ 1,978 mn or 26% to US$ 5,664 mn as compared to US$ 7,642 mn reported at the end of 2019. However, the net foreign reserve (the utilizable reserve) declined by 39.7% to US$ 3,543 mn.

• Exchange Rate

The direct unfavorable impact of the global Corona economic slum on Sri Lanka has been the excessive currency depreciation pressure. Although the excessive intervention by the central bank could reduce the annual average depreciation to 3.8%, the economy confronted a severe foreign exchange shortage in the second quarter. For example, the exchange rate for the US dollar rose by 8.5% to Rs. 197.34 on 9 April from Rs. 181.85 at the beginning of March. The central bank through its foreign exchange transactions and regulations could reduce the depreciation pressure in the second half of the year.

 Monetary Sector

• Money Printing (Base Money)

The increase in base money was low at Rs. 31 bn or 3.1%. The reason for the low growth was the supply of foreign exchange by the central bank to the economy for financing the BOP causing a contractionary pressure on the base money, despite the high rate of money printing to finance the government through the purchase of Treasury bills by the central bank from weekly auctions while controlling the yield rates within the monetary policy targets.

• Money Supply

Money supply M2b rose significantly by 23.4%. The state borrowing from the banking sector was the major contributory factor. Bank credit granted to the state (net credit to the govt and credit to state enterprises) rose by Rs. 1,936 bn or a record 53.6%. However, the expansion of bank credit to the private sector was only Rs. 374 bn or low 6.5% due to high credit risk arising from economic recession and uncertainties. The decline in the net foreign reserve due to BOP financing had a negative impact on the money supply. Therefore, the economy could have confronted a severe depression through acute shortages of funds and aggregate demand if not for such a high rate of state credit expansion.

 As the increase in base money was low, the expansion in money supply occurred mainly through the creation of credit/money by the banking system. This is reflected by the increase in the money multiplier from 8.2 to 9.8. The cut of the statutory reserve requirement from 5% to 2% and the increase in the state credit demand contributed to the higher money multiplier. However, the banking system operated at a high volume of excess reserves due to a low rate of credit delivery to the private sector (nearly 6% growth). Banks found it profitable to park their excess reserves in standing deposits at the central bank earning a risk-free interest rather than risky lending.

• Interest Rates

As the central bank pursued a relaxed monetary policy to help the economy recover from the global Corona crisis, interest rates fell considerably. Such relaxed policies were globally followed. For example, policy interest rates in developed countries were close to zero. Those were negative in some countries. Policy rates corridor was 3.35%-4.00% in India.

 The central bank cut its rates corridor by 2.5% from 7%-8% to 4.50%-5.50%. Accordingly, the average inter-bank overnight lending rate fell from 7.45% to 5.55% whereas the 364-day primary Treasury bill yield fell from 8.45% to 5.05% consequent to the intervention by the central bank through its OMO, ILF and purchase of Treasury bills from the auctions. Bank deposits and lending rates also fell accordingly. The objective of the low-interest rates policy is to boost the economy from the slowdown or recession through expansion in aggregate demand induced by bank credit expansion at a lower cost. The production and aggregate supply are expected to rise in the future in response to the increased demand and credit.

 2020 Global Macroeconomic Management Strategy

The policy strategy followed by many countries including developed countries to combat the Corona pandemic and the economic hit consists of the lockdowns and social distancing and ultra-lose fiscal and monetary policy packages to help economies recover from the disruption of production and supply chains caused by the lockdowns and social distancing. Such policy packages were implemented to provide state grants to businesses and households financed through bank credit. Therefore, central banks relaxed monetary policies to print money at low-interest rates to enable the states as well as the public to borrow at a low cost.

 This policy strategy envisaged providing financial support through state spending and bank credit to businesses and households affected by the pandemic and thereby raise aggregate demand to recover the economic growth, income and employment. Therefore, govt spending, budget deficits, govt debt, money printing, bank credit and money supply rose at historic rates. However, concerns over inflationary pressures possible in the future consequent to such ultra-loose fiscal and monetary policy packages were not considered. It was believed that such inflationary pressures caused by supply-side disruptions were transitory and would disappear with the recovery of the economies and global supply chains.

Economy 2021 and Beyond – The Policy Challenge

The economy of Sri Lanka and the living standards of its people are heavily dependent on the foreign sector, i.e., large current account deficit financed by the govt foreign borrowing and its rollovers. Further, the monetary/financial front of the economy is also highly dependent on the foreign debt flow to the government that determines the foreign reserve and the domestic liquidity. The Corona pandemic has disrupted this economic structure as seen from grave difficulties in the foreign exchange market, govt foreign debt repayment and the foreign reserve. As a result, businesses and households have started encountering acute shortages of essential goods and services for investment and consumption activities.

 This has got worsened by the fast spread of the virus in the second and third waves since April 2021. Therefore, uncertainties and instabilities in the country are enormous on all segments and the recovery of the economy from its 2020 setback will be difficult. The BOP first half of 2021 shows alarming signals with the increase in the trade deficit by US$ 1,055 mn or 32.3% and the overall BOP deficit to US$ 1,261 mn by 65.9%. Therefore, the government has no option but to follow the ultra-lose policies at elevated levels. it is also essential that reliable sources of foreign funding through instruments recognized in the international financial system are tapped in order to stop further disruption to businesses and households. In this regard, the abundance of reserve currencies in the global financial markets consequent to historically ultra-lose monetary policies in the developed countries is a very supporting factor. As modern monetary economies operate on globally spread money and credit systems, a country like Sri Lanka has no other tested options to keep the living standards of the people. It is not rocket science but the duty that should be fulfilled by the mandated state officials.