Government Of Sri Lanka’s New Economic Strategy – Analysis


By Dr. Kumar David

The November 2010 business-friendly Budget was upbeat, the Finance Minister (President Rajapakse) was confident of strong sustained growth, steady deficit reduction and trimming domestic and foreign sovereign debt. There was some justification for the complacency. It was reasonable to expect real-GDP growth in the 6 to 8% range in the short-term of one to three years thanks to a peace dividend, working class reluctance to agitate and the willingness of the populace to grumble and bear belt tightening. Some complacency may be justifiable if a global double-dip doesn’t become an Asian aliment.

Let me summarise, the nitty-gritty of the so-called investor and business friendly policies. Tax and interest rates to be held low, banks to encourage investors, handsome infrastructure support, and promotion of foreign capital flows and tourism. More important, an investor friendly climate is to be created; slums and low income homes in the city to be cleared to make room for shopping malls and high-end residential projects, hawkers moved out to benefit established shops, and the livelihood of thousands of fishermen in the Negombo Lagoon threatened by landing rights for tourist sea-planes. Prime lands in Colombo’s central business districts are being sold or handed out on 99-year leases to foreign investors.

Macro level backing for this policy shift was negotiated with the IMF which supplied standby funds in exchange for promises of fiscal and debt discipline. The government undertook to pursue austerity and bring the budget deficit to 5% of GDP in about four years (it was hovering in the 10 to 12% range before 2009) and to reduce its indebtedness which had risen close to 90% of GDP in 2009. The practical meaning was that wage restraints would be enforced, election promises brushed aside and subsidies gradually trimmed. It is political suicide to make big cuts in samauradhi (welfare handouts) but gradual evaporation can be arranged, and the health and education budgets will be pruned. Revenue losses attributable to company tax and income tax reductions will be recouped by raising mass consumption taxes – the euphemism for this is ‘widening the tax base’.

The IMF’s expectations

Sri Lanka
Sri Lanka

A delegation of IMF luminaries led by Mission Chief for Sri Lanka, Brian Atkin visited in January for consultations with the Finance Ministry and the Central Bank. What the team said at news conferences and seminars is an important measure of the optimistic medium term (2 year) prognoses for the economy. In summary, in order of importance, the key expectations are as follows.

a) Inflation can be held in check; hence the Central Bank’s lose monetary policy (low real interest rates, and heavy dollar buying in the local market to forestall rupee appreciation) remains an appropriate strategy.

b) The government will be able to hold the fiscal deficit down, and to track the promises it made to the IMF at the time the $2.6 billion standby facility was negotiated two years ago. That is, the deficit will decline to 6.8% of GDP in 2011 and 5.2% in 2012.

c) Sovereign debt (the sum of local and foreign indebtedness of the government) can be brought down to 72% of GDP by end fiscal 2012. (It is above 85% now).

d) The IMF concedes the trade balance will widen, but is confident that continuing high remittances from overseas Lankan workers will ensure that the overall current account remains in surplus in 2011 and 2012.

e) The dismal 2010 foreign direct investment (FDI) clouds will blow over and FDI in 2011 will be more than double what it was the previous year.

f) True, there is excess rupee liquidity in the banking system, but not to worry. Genuine investors (not leverage seekers for equity and property) will return and private sector borrowing from the banking system will soak up the mush.

All this is either whistling in dark not accounting for international trends nor local political dynamics. I believe the prognosis is too optimistic and it is necessary examine the more important of these expectations more closely.


It is not clear why the IMF is so sanguine about inflation concerns in Sri Lanka at a time when potential inflation has become a major debating point everywhere else in the world. Its own headquarters in Washington is wringing its hands with worry of actual, potential or incipient inflation in most of the world’s major economies – China, India, incipient in Europe and potential in the US. Inflationary pressure is driven by a variety of factors therefore they are difficult to tame, and once triggered in one of the world’s major economies becomes endemic and small nations have the least escape space. The US Federal Reserve’s dollar printing craze – the third stimulus package is already at mid-throttle, and Bernanke is talking of a fourth – is fuelling worldwide inflation. Ask the infuriated Chinese. Whether stimulus is the right way to spur recovery in the US is a separate matter, but that it is fuelling and exporting global inflation is something the IMF is hardly unaware of.

The second and third global factors fuelling inflation are food and commodity prices. I really don’t need to list corn, wheat, rice, sugar, cocoa, dairy products and meat prices; some are at record levels. The point is that no working expert in the food area says anything but: ‘The worst is yet to come; global food prices have not yet peaked; they will not begin to decline for a long time’. Prices are up for a variety of reasons – adverse weather, crop loses in agricultural super-states, export restrictions, changing dietary habits (“Have a steak son!”) and use of food grains (corn) for ethanol. In the midst of this in what planet these IMF worthies have taken up residence to reassure Lanka that all is fine on the inflation front beats rational expectations.

Take commodity prices. Gold has set a record, copper price is at an all time high, iron is very high, coal is tracking oil, as it always did and will therefore push up electricity prices, and then there is the big one, oil. Predicting oil prices is a challenge that no clairvoyant or Baba will embark on, but the IMF surely knows that raw material prices are on the up with little sign of reversal. Worldwide inflation in commodity and energy prices, and thence the products they enter, that is everything, follows.

Fiscal deficit

The IMF team does concede that there will be some slippage in meeting fiscal deficit reduction targets, but it attributes this exclusively to urgent unforeseen expenses related to the December-January flood havoc. This is an optimistic view in that it overlooks structural effects that will be forced on the government by political realities. On matters contingent to the floods, expenditure will not be confined to repair of tanks, water-courses, roads and infrastructure, but involve supporting price subsidies whether directly by state led imports (eggs and chicken already) or import tariff reductions. The experience has been that food prices do not quickly decline to previous levels after a major disruption but remain elevated or partially elevated for an extended period. This effect will be greatly amplified at the present time due to fast rising global food prices and supply side shortages. The IMF’s concession of limited and temporary slippage is sanguine.

The more serious defect in the IMF’s optimistic prognosis is that it fails to factor in structural changes that will have long-term and irreversible consequences. The most significant is a wage hike because how much longer the government can renege on Rajapakse’s promise of a Rs2500 monthly wage rise made during the January 2010 presidential election campaign is moot. Increase in the real cost of living (the Lankan headline index is doctored to deflate inflation) is creating pressure that I believe the government will not be able to resist for more than another year. The psychological impact on GoSL of events in the Middle East is also patent; state TV is under strict instructions to ignore the uprisings but the events are too big to hide from even the most remote villages in the country.

If my prognosis that GoSL will be forced into wage hikes and subsidies is borne out it will suffer a large structural (persisting long term) impact on its fiscal deficit. The IMF would have been on the ball had it factored this into its felicitous deficit reduction pronouncements. But that is impolitic and the IMF is constrained to play politics.

The loop between worsening fiscal deficit and inflation can now be closed. Collapse of wage restraints in the government sector will have an immediate knock-on effect on private sector wages and an inflationary impact on all consumer prices. I am not pressing the point about abandoning the compact between GoSL and the business class though that too will be a casualty, rather I am asserting that the IMF’s low inflation, easy monetary policy, low interest rate cycle will be broken once deficit reduction expectations go up in smoke.

Foreign Direct Investment (FDI)

I will skip several items in the IMF wish list and deal with one more matter only; the very disappointing post-war FDI scenario. The shared view was that with the end of the war, the subduing of Tamils, the political stability of the Rajapakses exemplified in two election victories, and the carrot of quick bucks for investors willing to venture into North-Eastern wastelands, foreign investors will romp in. But they have stayed away and newspaper columns and seminars have been scratching their heads. The IMF visitors have not ventured explanations either. FDI flows into Lanka in post-war 2009, 2010 and early 2011 have been unexpectedly disappointing. In 2010 FDI was $350 million while the expectation was over $1 billion; for 2011 the government has lowered its expectation to $1 billion but the IMF has grudgingly said it may get $750 million. Why it expects the figure to more than double (750/350 = 2.14) in a year is not explained.

The explanation I offer for low FDI inflows is that though there is visible calm after the war and apparent Rajapakse regime stability, foreign and local capitalists still doubt long-term political stability, what I call the Big Picture. Investors are uncomfortable with the Big Picture. Hot money is happy to flood into and flow out of the Lankan bourse, but it’s about a commitment for five to ten years that capital has developed cold feet. Volatile cash in the equity market and currency plays do nothing for growth. Development needs investors who stay for several years in productive plants and services. At this time only tourism and hotels show robustness.

Why local and foreign capitalism’s perception that the Big Picture future is not rosy? Abuse of power, domesticating the judiciary and politicising the police, do not make for a good investment climate and can provoke a mass backlash. Inability, nay unwillingness to settle with the Tamils is destabilising – the Tamil worm may turn sooner than expected. Ominously war crimes investigations hang like a sword over the regime’s head; if there is prosecution in any tribunal anywhere in the world the regime and its agents and hangers on will go berserk.

Corruption and bribing politicians is all in a days work for investors all over the world – vide India – they have gone along with that for ages; capital is amoral. But uncertainty in capital security in the long-term Big Picture is problematic, it is destabilising. This is why FDI isn’t still coming Lanka’s way in a big way and why even local capital is laid back.


SAAG is the South Asia Analysis Group, a non-profit, non-commercial think tank. The objective of SAAG is to advance strategic analysis and contribute to the expansion of knowledge of Indian and International security and promote public understanding.

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