Part I Chapter 1 - ECONOMIC AND FINANCIAL STABILITY, OUTLOOK AND POLICIES

Chapter 1
ECONOMIC AND FINANCIAL STABILITY, OUTLOOK AND
POLICIES

1.1 Macroeconomic Developments, Stability external reserves and contributing to exchange rate stability.
and Policy Responses in 2005 The fiscal position was further consolidated, especially on the
revenue front. The stability and resilience of the financial sector
● Sri Lanka’s economy demonstrated its resilience once again
improved with higher profits, enhanced risk management and
in 2005 by growing at a rate of 6 per cent, exceeding the
narrowed interest spreads, and the sector provided better access
expectations in the immediate aftermath of the tsunami
to finance.
disaster of 2004. Inflation was subdued through prudent
monetary policy measures and by the favourable ● Economic growth needs to be accelerated further to at least
developments in aggregate supply. The stability of the 8 per cent to alleviate poverty, reduce unemployment and
financial system was strengthened through improved raise the standard of living on a sustainable basis. The
supervision and regulation in line with international best government’s plans to achieve the desired growth have been
practices. The year started with several challenges posed by articulated in several policy documents, most notably in the
domestic and external shocks and their related uncertainties. ‘Mahinda Chintana’ policy document. The strategy of the
The impact of the tsunami necessitated a massive volume of government stresses the need for combining an efficient private
resources for a quick recovery, oil prices were escalating sector with a facilitative public sector, while strengthening the
rapidly, the Multi-Fibre Arrangement (MFA) came to an end on pre-requisites for growth as well as growth promoting factors.
1 January 2005 and elections related uncertainty loomed large. The government’s plans embrace infrastructure development
Additionally, the peace process was at a standstill. As the year thereby enhancing access to markets, investing in human capital
progressed, the uncertainties began to dissipate and the and encouraging technology improvements by entrepreneurs,
economy marched forward with a renewed vigour providing promoting investments throughout the country by ensuring
sufficient room for policy manoeuvrability to maintain both
policy stability and consistency, increasing institutional support
price and financial stability. High economic growth and
and providing incentives for research and development. These
relatively lower population growth pushed per capita income to
efforts have to be complemented with required reform measures
a higher level of US dollars 1,197. Responding well to monetary
to further enhance the overall efficiency of the economy.
policy measures and supported by favourable developments in
A comprehensive public awareness program on the role and
aggregate supply, inflation declined from a peak 15.9 per cent
limitations of the public sector, the benefits of liberalisation and
in February 2005, to reach 8 per cent by December 2005. The
reforms and the role of the private sector in improving
annual average inflation in 2005 was 11.6 per cent. The
unemployment rate declined to 7.7 per cent by August 2005 competitiveness and increasing access to both domestic and
from 8.3 per cent in 2004. The balance of payments (BOP) international markets through their own efforts, is needed to
recorded a surplus of US dollars 501 million, strengthening ensure public support for much needed economic reforms.

Chart 1.1 Chart 1.2

Quarterly Real GDP Growth and Inflation Savings and Investment

18
16 30
14
12 25
Percentage of GDP
Per cent

10
20
8
6 15
4
2 10
0 5
May-05

Jun-05

Jul-05

Aug-05
05 Jan-05
Feb-05

Mar-05

Apr-05

Sep-05

Oct-05

Nov-05

Dec-05

0
2001 2002 2003 2004 2005
Quarterly GDP growth CCPI inflation Gross Investment Gross Domestic Savings

Central Bank of Sri Lanka Annual Report - 2005 1

Part I Chapter 1 - ECONOMIC AND FINANCIAL STABILITY, OUTLOOK AND POLICIES

Table 1.1
Gross National Product at Constant (1996) Prices

Value As a Share Rate of Contribution

Item (Rs. in million) of GDP (%) Change (%) to Change (%)
2004 (a) 2005 (b) 2004 (a) 2005 (b) 2004 (a) 2005 (b) 2004 (a) 2005 (b)
Agriculture Sector 175,852 178,475 17.9 17.2 -0.3 1.5 -1.2 4.4
Agriculture 135,967 147,909 13.9 14.2 -0.9 8.8 -2.3 20.2
Forestry 17,107 17,400 1.7 1.7 1.3 1.7 0.4 0.5
Fishing 22,779 13,166 2.3 1.3 1.6 -42.2 0.7 -16.3
Industrial Sector 259,286 280,696 26.4 27.0 5.2 8.3 25.4 36.3
Mining and quarrying 16,946 19,335 1.7 1.9 7.9 14.1 2.5 4.0
Manufacturing 159,721 169,337 16.3 16.3 5.1 6.0 15.3 16.3
Electricity, gas and water 14,287 17,610 1.5 1.7 -2.5 23.3 -0.7 5.6
Construction 68,332 74,414 7.0 7.2 6.6 8.9 8.3 10.3
Services Sector 545,582 580,564 55.7 55.8 7.6 6.4 75.8 59.3
Wholesale and retail trade, and
hotels and restaurants 219,041 224,652 22.3 21.6 6.1 2.6 24.7 9.5
Transport, storage and communication 142,727 160,882 14.6 15.5 13.7 12.7 33.9 30.8
Financial services, real estate and
business services 114,661 122,127 11.7 11.7 5.6 6.5 12.0 12.7
Public administration, other government
services and defence and other community,
social and personal services 69,153 72,903 7.1 7.0 3.9 5.4 5.1 6.4
Gross Domestic Product (GDP) 980,720 1,039,735 100.0 100.0 5.4 6.0 100.0 100.0
Net factor income from abroad -11,300 -16,526 19.3 46.2
Gross National Product (GNP) 969,421 1,023,209 5.3 5.5

(a) Revised Source: Central Bank of Sri Lanka

(b) Provisional

● The reform efforts are timely, since Sri Lanka is gradually travelling abroad to receive educational and health services,
facing serious limitations to economic growth arising from insufficient managerial skills and the low level of research and
insufficient capacity expansion. The most notable limitation innovation activities in both the private and public sectors.
is seen in the power sector, which could stifle growth in all ● All major sectors of the economy grew at a healthy pace in
areas. Limitations in the capacity of roads, railways, port 2005. The Agriculture sector grew by 1.5 per cent, the Industrial
services, telecommunications and irrigation lead to serious sector by 8.3 per cent and the Services sector by 6.4 per cent.
drawbacks to investment, growth, regional development and The three sectors contributed 4.4 per cent, 36.3 per cent and
international competitiveness. The rapid increase in housing 59.3 per cent, respectively, to the GDP growth in 2005.
development is adding pressure on the already strained public ● The Agriculture sector rebounded from the setback in 2004.
utilities. Inadequate capacity building in human resource In 2005, both paddy and tea production reached new record
development is reflected in the large number of persons levels. Paddy harvests in both Maha and Yala seasons reached

Chart 1.3 Chart 1.4

Value of Petroleum Imports and Balance of Payments
Average Price of Crude Oil Imports
1.0
1800 60 0.5
0.0
1500 Value 50
-0.5
Price US $ per barrel
US$ million

Price
US$ billion

1200 40 -1.0
-1.5
900 30
-2.0
600 20 -2.5
-3.0
300 10 2001 2002 2003 2004 2005
0 0 Trade Balance Current A/c Balance
2001 2002 2003 2004 2005 Overall Balance

2 Central Bank of Sri Lanka Annual Report - 2005

Part I Chapter 1 - ECONOMIC AND FINANCIAL STABILITY, OUTLOOK AND POLICIES

Box 1
Policies and Strategies to Accelerate Economic Growth
and Regional Development

The government has articulated its policies and strategies to enterprises and strengthening auditing and reporting
accelerate economic growth and development and to reduce standards and procedures.
regional imbalances and poverty on a sustainable basis in a
● Safety Nets and Social Protection: Protecting, upgrading
number of policy documents. These are the Sri Lanka New
Development Strategy - Framework for Economic Growth and and empowering vulnerable groups and disadvantaged
Poverty Reduction 2005, Report by National Council for persons in society through appropriate policies and
Economic Development, Millennium Development Goals - Sri mechanisms, including facilitating most vulnerable groups
Lanka Country Report 2005, Medium Term Expenditure to engage in productive economic activities, enhancing
Framework 2006-2008, Budget Speeches for 2005 and 2006 accessibility to care for the disabled and senior citizens, and
and Mahinda Chintana. In developing the policies and improving the quality of such services.
strategies, the government has recognised the pre-requisites ● Environment Protection: Promoting sustainable
for economic growth and development, and factors of
development by giving due emphasis to environment
economic growth and regional development. Key policies and
protection.
strategies outlined in the above documents are as follows.
A. Promoting Pre-Requisites for Economic B. Factors of Growth and Regional
Growth and Development Development
● Peace: Pursuing a negotiated settlement for lasting peace by ● Capacity Expansion: Enhancing production capacity in all
strengthening the ceasefire agreement and building sectors of the economy by promoting public, private and
consensus among the parties involved. foreign investment through appropriate reforms, such as
institutional reforms, market reforms and public service
● Legal and Regulatory System: Modernising the country’s
reforms.
legal and regulatory framework to promote the business
environment and to reduce the transaction costs of business ● Human Resources Development: Strengthening and
operations. Emphasis will be placed on commercial law upgrading primary, secondary and tertiary education
reforms and capacity building in the judicial and legal institutions, maximising the available opportunities,
profession through specialised training, modernisation of enhancing access to education, and improving the quality
physical infrastructure and technology, and strengthening and relevance of education at all levels. Providing high
law reforms with capacity building and repealing or quality, equitable, cost effective, modern and sustainable
amending outlived legislations. heath care services.
● Improving Law and Order, Safety, Property Rights and ● Infrastructure Development: Building modern, high
Effective Enforcement: Reducing the crime rate, quality and efficient infrastructure facilities to expand access
enhancing public access to the judiciary and awareness of to input and output markets. Maintaining and rehabilitating
remedies available under the judicial system to promote the existing road network, construction of highways, increasing
legal and regulatory environment to facilitate business the availability of safe drinking water, upgrading the railway
development and protect property rights and enhance sector, expanding the supply of electricity, accelerating
effective enforcement of law and order. ongoing power sector reforms in transmission and
● Policy Stability and Consistency, Transparency, distribution, and developing alternative energy to reduce the
Accountability and Governance: Improving policy cost of power while taking into consideration the social
stability, maintaining policy consistency, transparency and problems and environmental implications and transforming
accountability in procurement practices, capacity building port and airport sectors as an air-sea hub and logistic centre.
and resolving policy related matters to strengthen and ● Improving Technology and Research and Development:
streamline the government procurement system to prevent Promoting application of modern technology and
delays and inefficiencies. Improving public access to undertaking research and development activities in the
information, timely publication of annual accounts of state country to enhance competitiveness.

Central Bank of Sri Lanka Annual Report - 2005 3

Part I Chapter 1 - ECONOMIC AND FINANCIAL STABILITY, OUTLOOK AND POLICIES

Box 1 (Contd.)
C. Policies and Strategies ● Structural Reform Policies
● The National Economic Policy Framework: The overall Market Reforms: Reforming both product and factor
economic policy is formulated by integrating the positive markets to ensure efficiency and competitiveness of the
attributes of a free market economy, to ensure a modern economy. Major markets requiring reforms are the land,
and balanced approach, with the complementary labour and financial markets. The continuation of an open
participation of a socially responsible private sector and a and liberal economic policy regime in the product market
strong public sector. has benefited the country.
● Demand Management Policies: Maintaining a stable Infrastructure Reforms: The country requires an efficient
macroeconomic environment. and fast growing infrastructure system spread throughout
Fiscal: Turning round revenue deficit to a surplus, the economy to help achieve regionally balanced growth.
increasing public investments largely through financing Public sector institutions, which supply vital services such
from concessionary foreign sources and long-term as power, water, transport, and other services, are important
domestic market borrowings, eliminating domestic bank service providing institutions of the government. Most of
financing of the deficit and phasing out budgetary transfers those institutions are monopolies, yet the quality and
to state enterprises. Strengthening public finances by adequacy of the services they provide and their financial
improving public expenditure management systems, position are very poor. Hence, those institutions are
strengthening fiscal discipline, improving the effectiveness earmarked for strategic reforms.
of tax administration and improving fiscal co-ordination. Public Service Reforms: The public sector will engage in
Monetary and Financial: Avoiding demand-fuelled its critical role as facilitator, nurture, pace-setter and
inflation, ensuring the required credit growth for sustained standard bearer. The entire perspective of the public
economic activity and strengthening financial sector service will have to focus on learning to anticipate change
stability. Further strengthening the regulatory framework and meet the demands of the future in innovative ways.
for banking, insurance and other financial services. Institutional Reforms: The institutional reforms will be
Promoting a single regulatory arrangement for the implemented to make the government’s administrative
non-bank financial sector. Introducing measures to reduce machinery efficient, friendly and modern through reforms
the high interest spread, strengthening state banks as to rationalise functions of government agencies to ensure
strategic state enterprises by improving their financial that they are focused on functions relevant to current
viability and competitiveness. needs, with special emphasis on transparency.

their historically highest levels of 2,013 thousand metric tons the absence of competitive market forces. This could be due to
and 1,233 thousand metric tons, respectively. Tea production anti-competitive practices prevailing in the regions of paddy
reached a record 317.2 million kg. Output of rubber, vegetables and vegetable cultivation as well as weak infrastructure. Hence,
and other agricultural crops also increased in 2005. Coconut the government needs to intensely examine the market practices
output declined and fish production did not recover fully, but to bring about a lasting market based solution to the low farm
showed signs of recovery by end 2005. gate prices.
● Sustainable agricultural development requires measures to ● Industrial sector growth, particularly the growth in the
enhance productivity, as well as ways of improving access textile and garments sub sector, continued despite the
to finance, availability of land, infrastructure facilities, and uncertainty that prevailed in early 2005 and the surge in oil
market-based methods to deal with excessive price prices to historically high levels. With the termination of the
fluctuations. Productivity and profitability could be improved MFA in 2005, the government aggressively pursued a strategy
through further development of technology, research, extension of enhancing access to major markets and these efforts were
services and reducing post harvest losses. The government has complemented by entrepreneurs’ initiatives to capture new
already taken measures to improve access to finance and land, markets and consolidate existing markets through efforts at firm
and to develop infrastructure facilities. Market based methods level. Sri Lanka’s high labour and environment protection
to encounter adverse price fluctuations are still being standards, a conducive trade and investment promoting policy
developed. The persistent drop in farm gate prices of paddy and atmosphere and high literacy of the labour force aided this
many varieties of vegetables at the time of harvesting indicates process.

4 Central Bank of Sri Lanka Annual Report - 2005

Part I Chapter 1 - ECONOMIC AND FINANCIAL STABILITY, OUTLOOK AND POLICIES

Table 1.2
Aggregate Demand and Savings Investment Gap - 2004 and 2005

Rs. billion Growth % As a per cent of GDP

Item
2004 2005 2004 2005 2004 2005
1. Domestic demand 2,213.9 2,584.9 18.4 16.8 109.1 109.3
1.1 Consumption 1,707.0 1,958.9 15.2 14.8 84.1 82.8
Private 1,542.1 1,763.8 14.9 14.4 76.0 74.6
Public 164.9 195.1 18.4 18.3 8.1 8.2
1.2 Investment (Gross Domestic Capital Formation) 506.9 626.0 30.4 23.5 25.0 26.5
Private 402.3 463.8 36.3 15.3 19.8 19.6
Public Corporations 59.3 62.9 12.1 6.1 2.9 2.7
Government 45.3 99.3 11.0 119.2 2.2 4.2
2. Net external demand -184.5 -219.2 69.6 18.8 -9.1 -9.3
Export of goods and non-factor services 737.0 792.4 16.7 7.5 36.3 33.5
Import of goods and non-factor services 921.5 1,011.6 24.5 9.8 45.4 42.8
3. Total demand (GDP) (1)+(2) 2,029.4 2,365.7 15.2 16.6 100.0 100.0
4. Domestic Savings (3)-(1.1) 322.4 406.8 15.1 26.2 15.9 17.2
Private 400.6 470.4 18.5 17.4 19.7 19.9
Public -78.2 -63.6 34.4 -18.7 -3.9 -2.7
5. Net factor income from abroad -20.7 -30.0 25.3 45.1 -1.0 -1.3
6. Net Private Current Transfers from abroad 136.6 174.4 17.5 27.7 6.7 7.4
7. National Savings (4)+(5)+(6) 438.3 551.2 15.4 25.8 21.6 23.3
8. Savings Investment Gap
Domestic Savings - Investment ( 4)-(1.2) -184.5 -219.2 -9.1 -9.3
National Savings - Investment (7)-(1.2) -68.6 -74.8 -3.4 -3.2
9. External Current Account Deficit without official grants (2)+(5)+(6) -68.6 -74.8 -3.4 -3.2
Source: Central Bank of Sri Lanka

● The Industrial sector should strive for global sector has been the main driver of economic growth in Sri
competitiveness and should depend less on protectionist Lanka as well as in the rest of the developing and developed
measures. Several Sri Lankan industries have already world. The sector has been benefiting from globalisation and
penetrated into foreign markets with a sizeable market share. liberalisation especially in the areas of port services,
Protection increases prices of domestic goods and services, telecommunication, construction and financial services. With
which are inputs for many industries. Hence, higher prices due regard to recent efforts to liberalise multilateral and bilateral
to protection seriously distort input prices of already trade, the Services sector has been earmarked for further
competitive industries. Furthermore, competitive industries in liberalisation. Therefore, it is important for this sector to be
the domestic market could pay higher wages and rents on labour prepared for increased competition while rules and standards of
and capital. Protection adversely affects competitive firms, operation should be established to facilitate and benefit from
initiating a vicious cycle of protection and inefficiency and liberalisation.
eventually impacting negatively on efficient industries. An ● Both investment and savings improved in 2005. Investment
alternative for protection is improving productivity, which increased to 26.5 per cent of GDP from 25 per cent in 2004,
would lead to lower output prices, benefit all related industries while domestic savings increased to 17.2 per cent of GDP from
and help achieve global competitiveness. 15.9 per cent in 2004. Private investment, as a percentage of
● The Services sector maintained its growth momentum in GDP, declined marginally from 19.8 per cent in 2004 to 19.6
2005 especially in port, telecommunication, and financial per cent in 2005. Public investment including investments by
public corporations improved from 5.1 per cent of GDP in 2004
services. Its contribution to growth could have been far
to 6.9 per cent of GDP in 2005. Domestic savings improved
greater had the planned infrastructure development taken
with private domestic savings increasing from 19.7 per cent to
place, especially road development, port and airport
19.9 per cent of GDP in 2005, with public dis-savings
development, as well as further development of social
declining from 3.9 per cent of GDP to 2.7 per cent of GDP. The
infrastructure, especially, education and health services.
savings-investment gap and the corresponding current account
Capacity enhancement in the Services sector is vital for
deficit were financed through increased inflows from foreign
sustainable higher economic growth given its significant links
direct investment, portfolio investment, and loans and grants to
with the other productive sectors. the government. Dependence on external loan inflows to meet
● Sri Lanka faced greater competition and further pressure the savings-investment gap could be reduced by encouraging
on the liberalisation of trade in services in 2005. The Services foreign direct investment inflows.

Central Bank of Sri Lanka Annual Report - 2005 5

Part I Chapter 1 - ECONOMIC AND FINANCIAL STABILITY, OUTLOOK AND POLICIES

Box 2
Liberalisation of Trade in Services and Limitations
An economy consists of three major sectors: agriculture, Mode 4 - Presence of Natural Persons - Individuals
industry and services. Many developed and fast growing travelling from a foreign country to supply services in another
countries have experienced rapid expansion in the Services country. In this mode, foreigners deliver various services to
sector when compared to Agriculture and Industrial sectors. residents of Sri Lanka.
The Services sector is the fastest growing sector of the global Sri Lanka’s major exports of services are telecommuni-
economy and account for two thirds of global output, one third cation, port, tourism and labour. In 2005 earnings from
of global employment and nearly 20 per cent of global trade. services accounted for 20 per cent of total export earnings
In developed countries, the share of services in the economy (which include export earnings from both goods and services).
typically lies between 60 and 70 per cent, while it is on average This was an improvement from the share of 15 per cent in
smaller in developing and least developed countries. In South 2000.
Asian countries, the services sector accounts for a significant The revolutionary growth in telecommunication,
share of the Gross Domestic Product (GDP). In Sri Lanka, the information technology and transportation has enabled
contribution from the services sector increased to 57 per cent international trade in services among countries. As
of the GDP in 2005 from 41 per cent in 1977. international trade in services began to grow, the World Trade
The expansion in the services sector reflects the evolution Organisation (WTO) established rules of trade under the
of consumer tastes, increased economic interactions and tools Generalised Agreement on Trade in Services (GATS). Trade
of production. Back in 1857, German economist Ernst Engel in services is gradually being incorporated to trade
observed that as families grew richer, they allocated a smaller agreements, which used to be only limited to trade in goods.
portion of the household budget to food. 1 A nation with Following this trend, the Indo Sri Lanka Free Trade
growing income would spend an increasingly smaller share of Agreement (ISLFTA) signed in 1998 is being upgraded to a
its income on food, shelter and other goods with physical Comprehensive Economic Partnership Agreement (CEPA)
manifestation. The demand is increasingly for services to incorporating trade in services as a main component. Sri Lanka
make life more secure and enjoyable. The economy supplies has already made a series of commitments to the WTO under
more and more of such services to fulfil the demand, raising GATS in relation to tourism, telecommunication and financial
the services sector output. services. Liberalisation of those services has generated
Many services are major inputs of the national output. tangible benefits to the country as seen in the developments in
Education and health services enhance the quality of human those sectors.
capital needed for economic growth. Services such as Domestic regulations are more prominent in trade in
information technology, telecommunication and financial services than in trade in goods. Regulations on trade in
services are essential for growing enterprises. Thus, if a services have been formulated to maintain required standards,
country cannot produce those services adequately, it has to streamline payments, safeguard domestic employment and on
import them to support economic growth and development. the basis of related national issues. Examples are accreditation
Unlike a product, which is traded mostly cross-border, a processes adopted in professional services, capital account
service can be traded internationally in four different modes. restrictions preventing some financial services and regulations
Mode 1 - Cross-Border Supply - Services supplied from preventing the free entry of services and service providers into
an institution based in one country to another country. This countries.
mode of supplying services is similar to the supply of goods Sri Lanka possesses the potential for rapid growth in the
across borders. export of services, if domestic restrictions are liberalised
Mode 2 - Consumption Abroad - Consumers or firms in cautiously and the services sector institutions are strengthened.
the home country making use of a service in a foreign country Insufficient understanding of the mechanisms of trade in
by visiting the foreign country. For example, Sri Lanka allows services has led Sri Lanka to unduly restrict domestic
its residents to purchase services such as health care and production and exports of services such as education and
education by travelling to a foreign country to receive such health care in which Sri Lanka possesses a competitive
services, thereby enhancing access to services of foreign advantage. At the same time the country is in effect promoting
service suppliers. imports of those services through Mode 2. Some professional
Mode 3 - Commercial Presence - A foreign company services do not have the means of establishing quality
setting up commercial enterprises to provide services in the standards yet. Therefore, the relaxation of existing restrictions
home country. Foreign direct investment is attracted through and further improvements in the institutional set-up need to be
this mode. undertaken fast, if Sri Lanka is to benefit from the rapidly
1. Federal Reserve Bank of Dallas, 1994, The Service Sector; Give It Some expanding trade in services.
Respect, Annual Report, Dallas.

6 Central Bank of Sri Lanka Annual Report - 2005

Part I Chapter 1 - ECONOMIC AND FINANCIAL STABILITY, OUTLOOK AND POLICIES

Table 1.3 ● Sri Lanka succeeded in facing competition in international

External Sector Developments trade as a result of the combined efforts of entrepreneurs
and the government to enhance market access. Exports grew
US $ mn
Growth (%) by 10.2 per cent to US dollars 6,347 million and imports grew
2004 2005
by 10.8 per cent to US dollars 8,863 million in 2005. Industrial
Exports 5,757 6,347 10.2 exports continued to drive export growth in 2005 with a
Agricultural products 1,065 1,154 8.3 dominant share of 78 per cent and contributing 75 per cent to
Industrial products 4,506 4,948 9.8
overall export growth. Agricultural exports accounted for 18 per
Mineral exports 120 143 19.5
Other exports 66 101 53.3 cent of total exports and contributed 15 per cent to export
Imports 8,000 8,864 10.8 growth, followed by mineral and other exports, which
Consumer goods 1,623 1,644 1.3 accounted for 4 per cent of total exports and contributed 10 per
Intermediate goods 4,645 5,317 14.5
cent to export growth in 2005. The expansion of economic
Investment goods 1,670 1,870 12.0
Other 61 33 -46.0
activities in the country, facilitated by the appreciation of the
Trade balance -2,243 -2,517 12.3 exchange rate and the low interest rate regime, and post tsunami
Services, net 419 338 -19.3 reconstruction activities, raised import demand, over the high
Receipts 1,527 1,540 0.9 base of the previous year, especially for intermediate and
Payments 1,108 1,202 8.5
investment goods.
Income, net -203 -299 47.3
Receipts 157 35 -77.7 ● Historically high oil prices caused a severe strain on the
Payments 360 335 -6.9
financing of the country’s import expenditure in 2005.
Private current transfers, net 1,380 1,828 32.5
Private remittances, net 1,350 1,736 28.6
The expenditure on petroleum imports increased by 37 per cent
Receipts 1,564 1,968 25.8 to US dollars 1,655 million in 2005. This increase was due to
Payments 214 233 8.8 an increase in prices of a similar magnitude. The domestic
Current account balance -647 -650 0.5 prices of petrol, diesel and kerosene rose only partially by 18
Capital account 64 250 289.0
per cent, 19 per cent and 20 per cent, respectively, in 2005. The
Financial account 567 974 71.8
Direct investment, net 227 234 2.9 required adjustments in domestic consumption did not take
Inflows 233 272 16.7 place in 2005 due to only a partial adjustment of domestic
Outflows 6 38 564.4 prices. The largest petroleum user in Sri Lanka is the transport
Private long-term,net 14 11 -21.0
sector (50 per cent), followed by power generation (25 per
Inflows 169 197 16.6
Outflows 155 186 20.0
cent). Industries, households and other sectors account for the
Government, long-term,net 440 553 25.8 other 25 per cent of consumption. Passenger transport prices
Inflows 771 747 -3.1 and electricity prices were not fully adjusted in 2005 to reflect
Tsunami related inflows 93 the actual cost of petroleum, thereby causing a heavy burden on
Outflows 331 194 -41.5
Short-term: -112 176 -256.6
the government’s budget and the viability of related public
Portfolio investment, net 11 60 451.4 sector enterprises.
Errors and Omissions -189 -72
● Large inflows to the government and increased private
Overall balance -205 501
remittances bolstered the external finance position, leading
Gross official reserves 2195.8 2735.1 to a surplus in the balance of payments and an appreciation
Months of imports 3.3 3.7
Total gross reserves 3438.5 4200.6
of the rupee. The trade deficit widened to US dollars 2,516
Months of imports 5.2 5.7 million, but the current account deficit widened only marginally
Debt moratorium 264.0 to US dollars 650 million largely due to a sharp growth of
Export price 95.7 98.9 22.6 per cent in worker remittances which, reached US dollars
Import price 91.7 98.9
1,918 million in 2005. As a ratio of GDP, the current account
Terms of trade 104.4 100.0
deficit declined from 3.2 per cent in 2004 to 2.8 per cent in
Exchange rates (Average) Rate of 2005. Net inflows to the government increased by 51 per cent
Approciation
in 2005 with large tsunami related inflows, and lower debt
(%)
Rs. / US $ 101.19 100.50 0.7
service payments resulting from the debt moratoria following
Rs. / Yen 0.94 0.91 3.3 the tsunami, contributing to an overall BOP surplus of US
Rs. / Euro 125.79 125.10 0.6 dollars 501 million. These capital inflows raised gross official
Rs. / STG 185.35 182.87 1.4 external reserves to US dollars 2,735 million (3.7 months of
Source: Central Bank of Sri Lanka imports). This, in turn, improved debt servicing capacity and led

Central Bank of Sri Lanka Annual Report - 2005 7

Part I Chapter 1 - ECONOMIC AND FINANCIAL STABILITY, OUTLOOK AND POLICIES

Chart 1.5 Chart 1.6

Government Revenue, Expenditure and Budget Deficit Government Debt

30 120
25
100
Percentage of GDP

20

Percentage of GDP
15 80
10
5 60
0 40
-5
-10 20
-15
0
2001 2002 2003 2004 2005
2001 2002 2003 2004 2005
Expenditure Revenue Overall Deficit
Domestic Foreign

to a moderate appreciation of the rupee against major of GDP in 2004. The overall budget deficit of the government
currencies. in 2005 amounted 8.7 per cent of GDP, an increase from the
● Sri Lanka obtained debut sovereign ratings from two expected deficit of 8.2 per cent in 2005. The deficit, excluding
international rating agencies in 2005. The Fitch Ratings tsunami expenditure in 2005, reached 7.3 per cent of GDP
assigned the country rating of BB- (BB minus) while Standard compared to the expected deficit of 6.8 per cent of GDP.
& Poor’s Ratings (S&P) Services rated Sri Lanka at B+ The budget deficit was financed with domestic resources
(B plus). These will facilitate the mobilisation of financial (5.2 per cent of GDP) and foreign resources (3.5 per cent of
resources in international markets by both the government and GDP).
the private sector. ● The outstanding government debt declined to 93.9 per cent
● Fiscal policy in 2005 was aimed at achieving pro-poor and of GDP from 105.5 per cent in 2004. This was mainly due to
pro-growth development objectives of the government, the appreciation of the rupee against major foreign currencies
supporting a speedy recovery of the economy from the and the higher growth in nominal GDP. The total government
unexpected tsunami disaster and moving towards fiscal debt increased by Rs. 82.8 billion to Rs. 2, 222.3 billion in
sustainability in the long run. Overall fiscal management was 2005. Though the debt to GDP ratio declined in 2005, the
challenging in 2005 as the government had to be involved in the government debt still remains high. This situation poses several
tsunami rebuilding process, while facing the implications of the threats including rising interest payment commitments, adverse
international oil price hike. This had to be achieved in an implications for monetary and fiscal policies and reducing the
environment of rising interest rates while servicing the already country’s ability to withstand external shocks. Thus, it
high debt burden. The policy stance continued to be underscores the need for strong measures to further improve the
expansionary to address the immediate needs of the tsunami fiscal consolidation process to reduce the debt burden and
recovery as well as the adverse impact of high oil prices. The achieve fiscal sustainability in the medium to long run.
tsunami rebuilding process received the assistance of donors ● The gradual tightening of monetary policy, begun in 2004,
and the private sector in addition to the government’s efforts. was continued in 2005 with the objectives of containing
● Some positive developments were seen in the fiscal inflationary pressures, containing the rapid growth of
consolidation process in 2005. The revenue collection rose to monetary aggregates and facilitating the recovery of the
16.1 per cent of GDP in 2005 from 15.4 per cent in 2004, as economy. The tsunami devastation prompted a temporary
expected in the revised Budget 2005. Tax revenue increased to change in the focus of monetary policy in 2005. The daily open
14.2 per cent of GDP from 13.9 per cent in the previous year. market operations (OMOs) were temporarily suspended from
Total expenditure and net lending, including tsunami early in January 2005, to ensure the smooth functioning of
expenditure amounted to 24.7 per cent of GDP in 2005, which financial markets during the early post-tsunami period. OMOs
is similar to the anticipated expenditure in the revised Budget were subsequently recommenced late in February 2005 as the
2005. This was due to the higher current expenditure of 18.7 per threat of the tsunami on the financial sector and economic
cent compared to the revised target of 18.4 per cent in 2005. activities began to dissipate gradually. Subsequently, OMOs
Public investment including government on lending to public had to be conducted aggressively to contain the inflationary
corporations in 2005 increased to 6.3 per cent from 4.8 per cent pressures. The tightening of the monetary policy stance through

8 Central Bank of Sri Lanka Annual Report - 2005

Part I Chapter 1 - ECONOMIC AND FINANCIAL STABILITY, OUTLOOK AND POLICIES

aggressive OMOs was further buttressed by taking measures to Financial sector infrastructure was further improved with
contain the reserve money expansion. Accordingly, the Central measures being taken to increase the efficiency of the payment
Bank refrained from purchasing Treasury bills in the primary and settlement systems, the introduction of new legislation to
market as far as possible, conducted secondary market outright facilitate the smooth functioning of the financial system, and
sales to mop up excess liquidity from the market permanently improvements made to the regulatory and supervisory
and raised the Central Bank’s policy interest rates, viz. framework in line with international best practices.
Repurchase and Reverse repurchase rates, in four steps: 25 basis The Payment and Settlement Systems Act, No. 28, enacted in
points in May, 50 basis points in June, 25 basis points in September 2005, enables the Central Bank to oversee the
September, and a further 25 basis points in December 2005. national payment and settlement systems. Further an
● The economy responded well to the tightening of monetary amendment was made to the Banking Act in 2005 to prohibit
policy as made evident from the slowing down of monetary fraudulent network marketing practices. The efficiency of the
expansion, the moderation in inflation and the decline in Real Time Gross Settlement (RTGS) system and the Scripless
inflation expectations. Reserve money expansion decelerated Securities Settlement (SSS) system was improved and access
to the targeted growth path by end December 2005 and broad to those systems was widened. To improve the retail payment
money growth also slowed down, although the growth rate and settlement system, a Cheque Imaging and Truncation (CIT)
remained high. Greater stability in the external sector too system will be implemented in 2006. Financial institutions were
supported monetary operations in achieving monetary policy requested to enhance their capital and new regulations have
objectives. Inflation decelerated from the high level in early been issued in relation to the single borrower limit, related party
transactions and disclosure of information. Banks have been
2005 by the end of the year, supported by monetary tightening,
advised to adopt the Basel II capital accord by 2008. The fit and
greater stability in exchange rates and favourable developments
proper criteria for selecting the board of directors of financial
in the aggregate supply. A decline in inflation expectations was
institutions have been further strengthened. The Central Bank
reflected in the lower secondary market yield rates pertaining
continued its public awareness campaign aimed at educating the
to government securities and the lower premia in the foreign
public on the risks of investing in unregulated and fraudulent
exchange forward markets.
financial institutions and investing in fraudulent net work
● The financial sector expanded with improved stability and marketing schemes. To enhance public confidence and to
resilience in 2005. The performance of financial institutions generate public awareness of the stability of the financial
improved in terms of profits, soundness and a widening of the system, the Central Bank published the second Financial
array of financial products and services during 2005. Access to Stability Review 2005 updating the status of financial system
finance was further enhanced with financial institutions offering stability.
new facilities and with the setting up of a new institution ● The resolution of several important issues relating to the
catering especially to Small and Medium scale Enterprises cost of intermediation, the supervision of conglomerates and
(SMEs). Activities in financial markets surged to record high improvements in corporate governance may further
levels, particularly in the foreign exchange and share markets, enhance the resilience and stability of the financial system
with rising confidence in economic prospects. while improving confidence in the financial system.
● During 2005, the Central Bank took several measures to The intermediation cost of banks, represented by the interest
further improve the stability of the financial system. spread, has declined in the recent past, but still remains high

Chart 1.7 Chart 1.8

Growth in Reserve Money and Broad Money Interest Rate Movements

25 % Repo Rate
12 Reverse Repo Rate
20 Weighted Average Call Money Rate
11
15 10
Per cent

Per cent

9
10
Reserve Money Growth 8
5 Broad Money Growth 7
0 6
Sepp

Sepp

Sepp
Marr

Marr

Marr

v
y

y
May
Jul

Nov

May
Jul

Nov

May

Jul

Nov

Mar
May
Jul

Nov

Mar
May
Jul

Nov

Mar
May
Jul

Nov
Jan-03

Jan-04

Jan-05

Jan-03

Sep

Jan-04

Sep

Jan-05

Sep

Central Bank of Sri Lanka Annual Report - 2005 9

Part I Chapter 1 - ECONOMIC AND FINANCIAL STABILITY, OUTLOOK AND POLICIES

relative to regional standards. Efforts need to be made by banks Table 1.4

to improve efficiency and productivity to lower the high Global Economic Developments and Outlook
(Annual percentage change unless otherwise indicated)
intermediation cost. Recent issues relating to the concentration
of share ownership of financial institutions, which undermines Actual Projections
public and investor confidence, underscore the necessity for 2004 2005 2006 2007
strengthening corporate governance in financial institutions. World output 5.3 4.8 4.9 4.7
This has been evident in the cross shareholdings in financial Advanced economies 3.3 2.7 3.0 2.8
conglomerates and the resulting conflicts of interest. The United States 4.2 3.5 3.4 3.3
Euro area 2.1 1.3 2.0 1.9
Central Bank has already taken initiatives to enhance corporate United Kingdom 3.1 1.8 2.5 2.7
governance through strict enforcement of the Banking Act and Japan 2.3 2.7 2.8 2.1
imposing market discipline through greater disclosure of Developing countries 7.6 7.2 6.9 6.6
Developing Asia 8.8 8.6 8.2 8.0
information by financial institutions.
China 10.1 9.9 9.5 9.0
India 8.1 8.3 7.3 7.0
1.2 External Economic Environment World trade volume
● With continuing growth and subdued inflation in the global (Goods and services) 10.4 7.3 8.0 7.5
Imports
economy, the external economic environment remains
Advanced economies 8.9 5.8 6.2 5.6
favourable to Sri Lanka’s economic growth prospects. Developing economies 15.8 12.4 12.9 11.9
Despite the continuous surge in international oil prices and the Exports
frequent occurrence of natural disasters, global GDP growth in Advanced economies 8.5 5.3 6.6 6.1
Developing economies 14.6 11.5 10.9 10.3
2005 reached 4.8 per cent. This followed the economic growth Price Movements
of 5.3 per cent in 2004, the highest in the past few decades. Consumer prices
However, the growth in the volume of world trade slowed down Advanced economies 2.0 2.3 2.3 2.1
Developing economies 5.7 5.4 5.4 4.8
to 7.3 per cent in 2005 from 10.4 per cent in 2004, reflecting
Commodity prices
the slow down in global economic growth. Global headline Oil 30.7 41.3 14.8 2.9
inflation picked up marginally in 2005 in response to higher oil Non-fuel 18.5 10.3 10.2 -5.5
Six month London interbank
prices, but core inflation remained stable and inflation
offered rate (per cent)
expectations have remained well grounded given the gradual On US dollar deposits 1.8 3.8 5.0 5.1
withdrawal of the monetary policy stimulus in many countries.
Source: World Economic Outlook (April 2006), IMF
Future prospects for global economic growth remain robust and
the global GDP is projected to grow in 2005 at a slightly higher
rate of 4.9 per cent in 2006. However, there are a number of specific factors contributed to the marginal slow down. In
downside risks to the projected global outlook. High and emerging Asia, India and China continued to exceed expected
volatile oil prices and their impact on price levels could threaten growth rates, supported by strong domestic and external
the current stability in core inflation. The avian flu could demand. Middle Eastern countries and the Commonwealth of
become pandemic leading to extremely high human and Independent States benefited from rising oil prices. There are
economic costs. The rising global imbalances, especially the no signs of a slowing down of activity in emerging markets and
large current account deficit in the USA and its growing developing countries.
external indebtedness, pose the risk of disorderly adjustment if ● Efforts to strengthen the rule based trading system
financing those deficits becomes difficult. continued and Sri Lanka made further progress in securing
● The economic growth of Sri Lanka’s major export market access through multilateral, regional and bilateral
destination countries remains robust. The projected growth trading arrangements in 2005. Sri Lanka remained firmly
in the USA is expected to moderate but will still remain committed to the multilateral trading system, being a founder
relatively higher than the growth in other industrial countries. member of the World Trade Organisation (WTO). At the Sixth
In Japan, economic activity is expected to pick up strongly, WTO Ministerial Meeting in Hong Kong SAR held in 2005,
easing deflationary pressures. Despite the weak performance of some progress was achieved in implementing the Doha
the Euro area in 2005, its expansion gained momentum from the Development Agenda. Substantial progress was made in
fourth quarter of 2005 onwards. The economic growth of phasing out agriculture subsidies and granting extra
emerging market economies and developing countries also concessions to Least Developed Countries. On the regional
remained robust, despite slowing down marginally to 7.2 per front, Sri Lanka agreed to convert the South Asian Preferential
cent in 2005 from the 7.6 per cent growth in 2004. The rising Trading Arrangement (SAPTA) into the South Asian Free
oil prices, the slowing down of the global economy and country Trade Area (SAFTA). A further stride in regional agreements

10 Central Bank of Sri Lanka Annual Report - 2005

Part I Chapter 1 - ECONOMIC AND FINANCIAL STABILITY, OUTLOOK AND POLICIES

was made with Sri Lanka achieving substantial progress in movements. Energy producing state-owned enterprises need to
finalising the draft Free Trade Area (FTA) of the Bay of Bengal be reformed to ensure their financial viability and thereby
Initiative for Multi-Sectoral Technical and Economic the provision of uninterrupted supply of energy at a
Cooperation (BIMST-EC). Sri Lanka continued to receive tariff competitive price.
concessions from member countries under the Global System
of Trade Preferences (GSTP), which was established as a 1.3 Medium Term Macroeconomic Outlook,
framework for the exchange of tariff preferences among Challenges and Policies
developing countries. Bilateral negotiations between Sri Lanka ● The Medium Term Macroeconomic Framework (MTMF)
and the European Union (EU) on the GSP+ scheme yielded a presented with the Budget 2006 expects the country to move
breakthrough in 2005, but further negotiations are required to onto a higher growth path with improved macroeconomic
reap its full benefits. Negotiations on the Comprehensive stability in the medium term. In the next four years, GDP
Economic Partnership Agreement (CEPA) between Sri Lanka growth is expected to accelerate substantially bolstering
and India continued in 2005. The bilateral framework regional development as well as the nation rebuilding
agreement signed by Sri Lanka and Pakistan on trade became programme of the government in the aftermath of the tsunami
operational from June 2005, after resolving issues relating to devastation. The growth is intended to be achieved through
concessions sought by both countries. Several other bilateral enhanced savings and investment supported by productivity and
trade discussions took place in 2005 with Thailand, USA and capacity improvements. The external sector is expected to
Iran. It is important for Sri Lanka to rationalise the existing further improve in the medium-run benefiting from the
economic relations by taking into account the collective impact improving political and macroeconomic environment, domestic
on the medium to long-term path of liberalisation and ensuing supply improvements, global demand, higher inflows through
economic developments. remittances and foreign direct investment, and greater
● Global financial market conditions remained orderly in 2005. utilisation of foreign assistance. The fiscal consolidation
Although short-term interest rates continued to rise due to the process will also be continued through further measures to
monetary policy tightening in the USA and the Euro area, long- increase revenue, and to rationalise expenditure, leading to a
term global interest rates remained low. Higher net savings by surplus in the current account. Benefiting from the strengthened
both emerging markets and the corporate sector in developed fiscal consolidation and the higher economic growth rate public
countries and increased oil revenues provided ample liquidity to investment may rise and the debt burden may decline. Monetary
global financial markets, which also helped maintain stable long- policy and monetary management over the medium term will
run interest rates. The short-run interest rate differential continue to aim at maintaining price stability while facilitating
favourable to the US dollar led to greater financial flows to the economic growth.
USA and the appreciation of the US dollar which helped finance ● Achieving the targets of the MTMF depends on several
the growing current account deficit in the USA without causing crucial factors. Restoring permanent peace would boost
any disorderly adjustments. A notable development in emerging investor confidence and accelerate expansion in economic
Asia during 2005 was the introduction of more flexible exchange activities. Prudent macroeconomic policies have to be put in
rate regimes in China and Malaysia, which relaxed their place to ensure macroeconomic stability. The capacity of the
currencies’ longstanding peg to the US dollar. This move is economy to grow can be significantly enhanced through a
expected to partly address global current account imbalances. comprehensive reform programme that would encompass the
However, an orderly adjustment of global imbalances requires development of pre-requisites for economic growth and
further appreciation of currencies in surplus Asian and oil fostering of growth supportive factors. These include
producing countries against the US dollar. Many emerging countering asymmetric information problems such as the
markets and developing countries issued international bonds with principal agent problem and rent seeking and enhancing public
favourable interest spreads to meet their borrowing needs. sector accountability as well as the delivery mechanism. These
● High oil prices may prevail, but any further escalation efforts have to be complemented by conducting a
remains uncertain. A fundamental uncertainty about comprehensive public awareness program on the role and
both demand for and supply of oil arises from the pace of limitations of the public sector, benefits of liberalisation and
global economic growth, usage of oil, continuing reforms, and the role of the private sector in improving
political uncertainty and limited spare capacity. The uncertain competitiveness and increasing access to both domestic and
global energy situation requires Sri Lanka to be cautious in its international markets through their own efforts. A successful
energy policy. The undue fiscal burden due to fuel subsidies and outcome in oil exploration could turn Sri Lanka into a trade
high fuel consumption could be reduced through a consistent surplus country, providing resources to further accelerate the
energy pricing policy that reflects international price growth process.

Central Bank of Sri Lanka Annual Report - 2005 11

Part I Chapter 1 - ECONOMIC AND FINANCIAL STABILITY, OUTLOOK AND POLICIES

Box 3
Welfare Cost of Subsidies
Subsidies are of different types: transfers of budgetary billion, respectively. These subsidies amounted to 1.4 per cent
resources, tax holidays, tax concessions, supplying goods or of GDP in 2005, which could be compaired with the total
services below cost and policies that create transfers through public spending on health in 2005 (Rs.44.8 billion) and the
the market mechanism. Subsidies are popular means of cost of the Norochcholai power project (Rs.47.9 billion). It is
providing relief by governments to categories of persons almost equal to the total estimated cost of the Southern
(e.g. farmers), private agents and public enterprises, enabling Highway (Rs.33.9 billion). This is several times higher than
them to either purchase or sell a good or a service at a cost the allocation (Rs.0.35 billion) made for the new Uva Wellassa
below the market price. University in 2005. The annual cost of subsidies could be
The welfare cost of subsidies is multi faceted. They lead utilised to construct about 1,300 schools or about 160 base
to governments incurring a budgetary burden, which has to be hospitals per year. In addition to these, a wide range of
met through either increased taxing of the population or corporate tax holidays and tax concessions exists leading to a
increasing the government’s indebtedness or covering the cost loss of fiscal revenue.
by cutting fiscal expenditure, frequently by reducing The key issues in managing subsidies are the size,
expenditure on public investment. Thus, subsidies often incidence and distortions in allocation. The adverse
involve a serious opportunity cost of growth and development implications of subsidies could be minimised by their
with the reallocation of resources from productive public reduction through provision of subsidies only to the needy
investment to current expenditure. Furthermore, lower prices, through proper targeting. Though the need for reducing
mostly below the cost of production paid by economic agents subsidies has been recognised, intervention by various
on goods and services could lead to over exploitation and pressure groups and insufficient consensus on reforming
misallocation of resources. Utilities such as water, electricity subsidies, often does not allow the implementation of such
and petroleum in many countries are subject to subsidies and policies.
those resources are being over exploited. Such over Rationalisation of subsidies can remove economic
exploitation could lead to a worldwide shortage of resources. distortions, thereby improving efficiency and growth, reduce
In Sri Lanka, subsidies are widespread. Annual subsidies the budgetary burden and significantly enhance much needed
for fuel and fertiliser amount to Rs.26 billion and Rs.6.8 public investment.

● The government has shown its commitment to achieving a restrained. The expansion of credit to the private sector from
durable and lasting peace. Peace talks recommenced in banks has to be curtailed in a manner that is not harmful to
February 2006 bolstering market confidence and prospects for private investment while government borrowing from the
economic development. banking sector has to be reduced. The continuation of the
● Further consolidation of macroeconomic stability that has flexible exchange rate regime will prevent the build up of any
been achieved so far is essential to developing a conducive destabilising forces.
environment for markets to operate effectively and the ● The current high international oil prices may cause a
economy to remain stable. Though the debt to GDP ratio destabilising effect unless long-term solutions are found.
declined in 2005, the relatively higher level of debt poses a With the increase in thermal power generation in the absence
threat to long-term debt sustainability. Further improvements of other alternate energy sources, the country’s dependence on
are needed to contain the primary and current account deficits imports of oil has increased over the years. High oil prices,
thereby generating surpluses needed for debt sustainability and while exerting significant pressures on the government
building up of external reserves. A strong and sustainable fiscal budgetary resources, BOP, the exchange rate and inflation,
adjustment process is implied in the medium-term targets of the could further weaken the financial position of the Ceylon
Fiscal Management (Responsibility) Act (FMRA). Fiscal Electricity Board (CEB) and the Ceylon Petroleum Corporation
consolidation would pave the way for monetary policy to (CPC) unless appropriate price adjustments are made to
operate effectively in containing monetary expansion and economise consumption. The country’s ability to withstand
maintaining price stability. To contain further monetary pressure from high oil prices should be strengthened by
expansion, the growth of its major components, namely, private adopting appropriate policies within the macroeconomic
sector credit and net credit to the government, needs to be framework, developing alternative energy sources, minimizing

12 Central Bank of Sri Lanka Annual Report - 2005

Part I Chapter 1 - ECONOMIC AND FINANCIAL STABILITY, OUTLOOK AND POLICIES

Box 4
Prevalence and Macroeconomic Impact of the Principal Agent Problem and Rent Seeking
Many developed and developing countries suffer from public goods such as roads, and in bureaucrats and politicians
problems associated with asymmetric information and, unduly rewarding special interest groups. The Budget 2005
especially, rent seeking, due to two reasons. First, the non- highlights that ‘In fact, tax concessions, customs duty
recognition of the prevalence of those problems and second, reductions, exemptions, VAT rebates, and such other
although the problems are recognized, measures to counter concessions that the business community constantly seeks and
them are inadequate. secures from the Treasury, are much more than the entire
Asymmetric information problems refer to problems budgeted subsidy bill. These are hidden subsidies, which the
arising from one party in a transaction or a contract having more affluent and influential sections of our community enjoy
more or better information about the transaction or the in our country placing a tremendous burden on the country’s
contract to make accurate decisions. The presence of annual budget.’
asymmetric information leads to adverse selection, moral Rent seeking imposes a significant cost on the economy
hazard and associated principal-agent problems, and rent and retards economic growth through altering the incentive
seeking, impacting on the economy and sometimes causing system, misallocation of resources, and breeding inefficiency.
market failure.1 Firms may begin to spend resources on rent seeking rather
The principal agent problem is a moral hazard problem than improving competitiveness through productivity
that arises when managers in control (the agents) of a firm or enhancement and innovation. Further, the receipt of undue
of the economy act in their own interest rather than in the benefits by special interest groups may cause disappointment
interest of the stakeholders or owners (the principals), and frustration among others leading to lacklustre
because the managers have less incentive to maximise profits performance in the economy.
than the stockholder-owners do. This is especially relevant to Rent seeking results in a sub-optimal allocation of
managing state owned enterprises when the government resources and may reduce efforts to enhance productivity.
(or the public), as the principal has to depend on appointed Those with authority could favour their special interest
agents to run those enterprises. Agents may not manage the groups who may campaign to elect them again. Under such
enterprises in a way that principals would like them to if an circumstances, bureaucrats and politicians may not act in the
appropriate incentive/penalty system were not put in place. best interest of society. These actions would distort the
Rent seeking also arises from moral hazard, where structure of economic and social incentives and lead to a
individuals or firms lobby governments or the caretakers of misallocation of resources, resulting in welfare losses and
the country’s resources to grant them favours unduly or hindering economic growth.
allocate some of the resources for their private use, causing The incidence of asymmetric information related
a substantial social cost. Rent seeking is found commonly in problems could be reduced through improved governance,
lobbying for lowering taxes, imposing tariff to avoid ensuring accountability, proper auditing, public disclosure of
competition, obtaining subsidies, obstructing the provision of transactions, and conducting public awareness programs.
Efforts of the civil society as watchdogs of governance, the
1. Akerlof, George A., “The Market for ‘Lemons’: Quality Uncertainty and the
Market Mechanism.” Quarterly Journal of Economics, 84(3), pp. 488-500, environment, human rights, etc., also help mitigate these
1970; and Tullock, G. (1967). ‘The Welfare Costs of Tariffs, Monopolies and problems.
Theft’ Western Economic Journal, 5, pp. 224-232.

inefficient use of fuel, restructuring energy related public energy sources and enhance the efficiency of transportation and
institutions and phasing out wasteful subsidies associated with other energy users.
high oil prices. In this regard, the CEB should develop the ● It is necessary to undertake critical structural reforms
capability to meet the future electricity demand of the country, urgently since the current state of infrastructure has posed
for otherwise, the high growth expectations in the medium to a serious capacity limitation on continuing growth. A series
long run would be impeded. Sri Lanka may be fortunate to find of reforms would be necessary to develop economic and
petroleum resources as indicated by a recent seismic survey, social infrastructure essential for the continuation of economic
which shows the existence of oil deposits in off-shore areas of growth, the generation of a series of tradable services and
the Western and North-Western regions. However, while those supporting poverty alleviation. The present serious supply
efforts are intensified, Sri Lanka has to develop alternative shortages and regional disparities in roads, electricity,

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Part I Chapter 1 - ECONOMIC AND FINANCIAL STABILITY, OUTLOOK AND POLICIES

Table 1.5
Medium Term Macroeconomic Framework 2005 - 2009

Projections
Indicator
Unit 2005(a) 2006 2007 2008 2009
Real Sector
GDP at Market Prices Rs. bn 2,366 2,732 3,139 3,563 4,018
Real GDP Growth % 6.0 6.9 7.4 8.1 8.4
Inflation-GDP Deflator % 9.9 8.0 7.0 5.0 4.0
Total Investment % of GDP 26.5 30.0 32.0 33.9 34.8
Private Investment % of GDP 19.6 21.6 24.3 26.2 27.0
Public Investment % of GDP 6.9 8.4 7.7 7.7 7.8
Domestic Saving % of GDP 17.2 20.5 22.0 24.8 26.4
Private Saving % of GDP 19.9 21.4 21.5 22.7 23.5
Public Saving % of GDP -2.7 -0.9 0.5 2.1 2.9
National Saving % of GDP 23.3 26.5 27.8 30.5 31.9
External Sector
Trade Gap US $ mn -2,516 -2,916 -3,372 -3,443 -3,560
Exports US $ mn 6,347 6,995 7,748 8,585 9,460
Imports US $ mn 8,863 9,911 11,120 12,028 13,021
Services US $ mn 338 409 411 474 504
Receipts US $ mn 1,540 1,737 1,888 2,062 2,245
Payments US $ mn 1,202 1,328 1,477 1,589 1,741
Current Account Balance US $ mn -650 -886 -1,124 -1,009 -973
Current Account Balance % of GDP -2.8 -3.3 -3.8 -3.1 -2.7
Overall Balance US$ mn 501 400 320 210 353
External Official Reserves
(Months of Imports) Months 3.3 3.3 3.3 3.2 3.2
Debt Service Ratio (b) % 7.9 10.9 9.9 10.6 10.0
Fiscal Sector (c)
Revenue % of GDP 16.1 17.8 18.1 18.5 18.6
Expenditure % of GDP 24.7 26.9 25.3 23.5 23.6
Current Account Balance % of GDP -2.7 -0.9 0.5 2.1 2.9
Overall Budget Deficit % of GDP -8.7 -9.1 -7.2 -5.7 -5.0
Domestic Financing % of GDP 5.2 4.5 3.2 2.2 2.4
Financial Sector (d)
Reserve Money Growth % 15.8 15.0 14.9 14.5 13.0
Broad Money Growth (M2b) % 19.1 15.0 14.9 14.5 13.0
Narrow Money Growth (M1) % 22.4 13.0 12.9 12.5 11.0
Growth in Credit to Private Sector % 21.5 16.0 19.3 17.0 13.6
Growth in Credit to Public Sector % 0.7 4.2 -5.7 -5.0 -5.1
(a) Provisional. Sources: Budget 2006
(b) Total debt service payments as a percentage of earnings from merchandise exports and services. Central Bank of Sri Lanka
(c) Includes tsunami expenditure.
(d) Point-to-point growth in end year values.

telecommunication, transportation, water supply, health and needs, and has not been able to generate the required human
education facilities constrain growth. Anticipated regional capital needed for rapid economic development.
development cannot be achieved without an efficient system ● The over-dependence of the private sector on the
of infrastructure linking economic centres to the peripheral government for social equity, protection and subsidies
rural sector. The continuing regional disparity could generate needs to be rationalised in view of short-term budgetary
public agitation, if opportunities are not equitably provided, constraints and long term economic costs. Any
by addressing the infrastructure limitations. Institutions successful economy, for the most part, is driven by the efforts
supplying those services need to be strengthened and a higher of private agents. The skill, entrepreneurship and
level of efficiency and accountability has to be ensured. Pricing resource endowments of the private sector drive the economy
of services without covering at least the cost of production to generate higher income. The private sector needs
forces institutions providing infrastructure facilities to depend to take their own initiatives to intensify competitiveness
on budgetary support from the government. Independent through increasing productivity, continuously engaging
regulatory mechanisms are lacking in some sectors and some in research and development activities, and facing the
of the existing mechanisms are weak. Health care is saddled challenges of globalisation while reaping benefits from it,
with labour disputes, insufficient investment and improper without seeking any undue protection from the government
targeting. Education displays serious mismatches with market at a high social and economic cost. The effectiveness of

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Part I Chapter 1 - ECONOMIC AND FINANCIAL STABILITY, OUTLOOK AND POLICIES

protection from domestic and international competition is private sector institutions to provide impetus to growth
usually short-term since efforts by domestic and international has to be validated by putting in place mechanisms to
competitors in technology improvements enhances enhance productivity, accountability and improved
productivity and lowers production and transport costs thereby governance. The government being the principal has to depend
enabling easier access to markets. Measures to provide on appointed agents to manage public sector institutions. Thus,
protection in one sector raises the cost of production in all there has to be mechanisms and a reform programme to ensure
other sectors leading to lower competitiveness of the nation that those agents perform their tasks to generate benefits to the
and hence results in a large economic cost. Poorly targeted country rather than seeking personal benefits. Rent seeking occurs
and undue subsidies drive budgetary resources away from when individuals and firms receive benefits through lobbying the
productive investment. Therefore, the general public must be government, which could cause serious social and economic
enlightened about the benefits of free and liberal economic costs. Most of the existing subsidies, concessions and measures of
policies, structural reforms, competition, and the welfare cost protection have imposed serious social and economic
of protection and subsidies. costs though they benefit a select few. The public sector has
● Finally, the government’s dependence on the public sector to be subject to a proper mechanism to ensure accountability
institutions to enhance service delivery and the domestic and efficiency.

Central Bank of Sri Lanka Annual Report - 2005 15