By Anoop Singh and Koshy Mathai
In our recently-released Regional Economic Outlook (REO) for Asia and the Pacific, we note that the global economy shows signs of improving as major tail risks emanating from advanced economies have receded. Asia also faces better prospects.
After a year of subdued performance, Asian growth should pick up over the course of 2013, to about 5¾%, on robust domestic demand, supported by favourable labour market conditions and easy financial conditions.
Asia is also expected to benefit from intraregional demand spillovers, reflecting growing Chinese demand, the near-term fiscal stimulus in Japan, and, in the case of ASEAN economies, growing integration in final consumer goods trade. Inflation is expected to remain broadly unchanged from 2012 and generally within central banks’ comfort zones.
Risks to the outlook have become more balanced since our last REO update in October 2012, mainly because the risk of an acute euro area crisis has diminished and worst-case scenarios related to the US “fiscal cliff” have been avoided. However, the potential impact of external shocks on Asia’s open economies remains considerable, and the region faces important homegrown risks as well, including possibilities of financial imbalances and rising asset prices in some economies, trade disruptions from a natural disaster or geopolitical tensions, a loss of confidence in Japan’s efforts to restore economic health, or an unexpected slowdown in China.
Asia’s policymakers face a delicate balancing act in the near term. Central banks in the region maintained, or loosened further, their easy monetary policy stance in 2012, which was welcome given low and stable inflation and the need to support growth. But with output now close to, or slightly above potential in most economies, and given the risks of building up, and the difficulties of unwinding, financial imbalances, monetary policy makers should stand ready to tighten decisively in response to shifting risks. Macro prudential measures will also have to play an important role where credit growth remains too rapid, especially if accompanied by persistently strong capital inflows.
Differing country circumstances will dictate the appropriate turning points for monetary policy, and the appropriate pace of fiscal consolidation. However, in many Asian economies, structural deficits are still higher than pre-crisis levels and will improve only slowly on current policies, implying the need for greater adjustment; this could also offset the overheating effects of capital inflows. Strengthening fiscal space and frameworks is also needed to achieve sustained inclusive growth over the medium term. And policy measures and structural reforms may be needed for emerging Asian economies to avoid the “middle-income trap” and sustain high rates growth.
In Sri Lanka, growth slowed to about 6½% in 2012, and is projected at around 6¼% this year, reflecting the lagged impact of earlier monetary tightening, projected contractionary fiscal policy, and weak global demand. Headline inflation fell to 6½%by April largely on account of base effects, but some reversal is likely given the recent increase in electricity tariffs. The current account deficit is narrowing slowly and gross international reserves have risen, though most metrics indicate that they should be boosted further. The fiscal deficit amounted to 6½% of GDP in 2012, only slightly above the targeted level, but tax revenues underperformed substantially and were among the lowest, relative to GDP, in the entire Asian region. The 2013 budget appropriately calls for a further reduction in the deficit, to 5¾% of GDP, but the budgeted increase in revenues will likely not be achievable given recent shortfalls. In the public enterprise sector, the losses of the CEB and CPC reached 2% of GDP in 2012, but are expected to fall by about half this year because of increased reliance on hydroelectric generation as well as recent electricity tariff increases. The financial sector has been stable, though rapid credit expansion in recent years justifies heightened vigilance for systemic vulnerabilities.
Exchange rate flexibility has served Sri Lanka well over the past year, contributing to current account adjustment, safeguarding foreign-exchange reserves, and providing a buffer against external shocks. This flexible regime should be maintained. Sri Lanka is enjoying its longest-ever period of single-digit inflation, but the level is still too high, and we see the need for monetary policy to remain on hold for the time being.
As well, with public debt levels around 80% of GDP, fiscal consolidation must be pursued, particularly through raising revenues, so that space can be created for infrastructure and key social spending—the tax base must be broadened, via reducing and reforming exemptions, and tax administration must be strengthened. Looking beyond the central government, the performance of state enterprises must be further improved, including by moving to an automatic pricing formula that is designed to ensure cost recovery.
Looking further ahead, certain policy changes will be needed if Sri Lanka is to attain the growth rates targeted by the authorities. These include improvements in the business climate, further investment in infrastructure—particularly with increased private-sector involvement—and in education, financial market development, and tariff reforms accompanied by a geographical reorientation of trade to reverse the long-term decline in exports.
Sri Lanka faces a number of challenges in this still uncertain global environment, but with wise policy steps, it has the potential to achieve its economic promise.
Anoop Singh is the Director of the Asia and Pacific Department of the International Monetary Fund and Koshy Mathai is IMF's resident representative to Sri Lanka and Maldives