Sri Lanka: State of the Economy 2010

‘Sri Lanka: The State of the Economy 2010’ is an analysis of recent economic developments. This annual ‘State of the Economy’ report of the Institute of Policy Studies of Sri Lanka (IPS), like its previous volumes, is an important contribution to the understanding of the country’s economy.

It provides useful analyses of the country’s economic issues and is quite objective in its discussion of economic performance. This issue discusses the country’s economic performance, policies and prospects within the framework of the country’s political developments and under the theme ‘Growth and Stability in Post-conflict Economic Recovery’ that is most relevant.

The study is in four parts. The first part of the report consisting of three chapters deals with the relevant issues for ‘Growth and Stability in Post-conflict Economic Recovery’. This part of the report would interest most readers and is perhaps the most significant.

Its first chapter on Policy Perspectives raises several issues including the question as to why the post conflict period did not produce as much of the expected economic growth. Among the reasons adduced are the distraction of the Government and country from economic issues to political ones, the downturn in the global economy and the uncertainties in economic policies.

It asserts that “Sri Lanka made significant progress towards long term peace and stability in 2009 with the successful end to a 30-year armed separatist conflict in the country. The economic dividends, however, were slow to materialise, held down not only by a severe global economic downturn but also by the distractions of presidential and Parliamentary elections.”

Need to focus on economic development

The need to focus on economic development rather than be constantly distracted by other issues has been an observation expressed by several economists. Donald Snodgrass and John Williamson have characterised the country’s economic history as one of missed opportunities. Ethnic and political distractions have been a root cause of this.

The end of the war provided a fresh opportunity to resolve these issues and focus on economic development. The failure to bring about a durable solution to minority issues that would result in national integration continues to be a serious constraint to achieving the country’s economic potential.

Impliedly the IPS analysis states that the end of the conflict alone would be inadequate for the economy to achieve high rates of growth. It stresses the need for a post conflict resolution of the conflict with an indigenous solution and economic policies fashioned to meet the peculiar conditions of the war affected areas.

“In so far as post-conflict development relates to the economic sphere, the primary objective is to reduce the major risk factors of conflict recurrence by formulating economic policies that are sensitive to issues of inequities among groups. ...Sri Lanka, like other conflict-affected states, must fashion an approach that is context-appropriate to its own circumstances. Above all, it must be owned, formulated and driven by national actors.”

Move in the right direction



Although it is not within the purview of the IPS to suggest what the specific policies should be, it considers the Government’s development policies as a move in the right direction. The various economic policies to reconstruct and reawaken the north and east that is integrated in the national economic policies are seen as a means of national reconciliation as much as of economic development.

“The intention is clearly to deliver rapid economic development to the war ravaged north and east, while focusing on bridging the rural-urban divide in the rest of the country. ...Its economic message – rapid infrastructure improvements to rural Sri Lanka – has also become a decisive factor to an important constituency of voters.”

Others have pointed out that while economic policies could help, if they are a distraction from meaningful steps towards national reconciliation, their benefits would be limited. Some commentators are of the view that the focus on infrastructure development, rapid economic growth and regime consolidation is an approach that diverts attention from substantial measures towards ethnic reconciliation. The lack of national integration could continue to be a serious setback to more rapid economic development.

Need for appropriate economic policies and reforms

The need for appropriate economic policies and reforms are stressed in the report as a sine qua non for post conflict economic recovery and development. These include a credible macroeconomic policy framework and the reduction of the fiscal deficit.

“The need for a credible macroeconomic policy framework is very real as Sri Lanka grappled with an expansion of its projected budget deficit of seven per cent of GDP for 2009 to a realised figure of 9.8 per cent of GDP by year end. While it can be explained in part by falling tax revenues in the midst of an economic downturn, expenditure needs – partly related to rehabilitation and resettlement of Internally Displaced Persons (IDPs), etc. – were on the rise. Nonetheless, such fiscal constraints are a reminder that the challenges for macroeconomic management over the next few years will be highly complex. Macroeconomic policy will be called on to support high growth – as almost a precondition to minimising conflict risk – while ensuring that stability is not compromised in the process.”

The report cautions that this will entail some trade-offs between growth and stability. “Indeed, it may even mean tolerating moderate inflation and budget deficits to support Sri Lanka’s post-conflict economic recovery process. What is important is the recognition that such a path will hold fewer risks if a medium term macroeconomic framework is underpinned by a clear and transformative process of economic policy reforms.”

Financing of infrastructure investment

The financing of infrastructure investment is a significant issue raised in the report. “The priority for fiscal policy” in IPS’s view “is to release financing for infrastructure investment and reconstruction spending. This entails that a mix of far reaching economic, institutional and policy reforms accompany a re-orientation of public finances.”

It warns that “in the absence of such reforms, Sri Lanka will falter in putting its public finances in order – that is, cutting back on recurrent spending to support capital investment. Without such flexibility, a heavy infrastructure-led development drive will inevitably rely on borrowed funds. This will not only lead to an accumulation of the country’s stock of public debt, and associated risks for macroeconomic stability, but will also mean that Sri Lanka’s development priorities do not have the financing that is needed on a predictable basis.”

The rationale is that the much-needed increase in infrastructure should come from reduced Government expenditure rather than through foreign borrowing. This is a cautionary note on the manner in which the Government’s current infrastructure is financed.

Further, there is need for prioritisation of infrastructure investment on the basis of cost benefit analyses and the gestation period of such investment. All infrastructure investments are not of high benefit. Foreign funded large infrastructure projects should have potential for generating foreign exchange earnings, as otherwise it would be a burden on the balance of payments.

Lack of adequate focus on economic reforms



Sri Lankan economic policies have lacked adequate focus on economic reforms that have been repeatedly stressed by international agencies for quite some time. The IPS quite correctly focuses on this issue.

“The absence of a broader programme of economic reforms will have another downside effect. Undoubtedly, investing in a critical mass of infrastructure projects will facilitate a growth take-off. Infrastructure spending creates not only public assets but pushes money into the economy with all its multiplier effects. However, for such a growth process to be sustainable beyond the medium term, overall productivity in the economy has to improve. Lower costs that come with improved infrastructure – in transport, energy, communication – can help firms to be more competitive. But, raising the overall productivity in the economy also calls for improvements in the allocation of factors of production.

“In the absence of such improvements via economic reforms, Sri Lanka’s growth will be sub-optimal, and will be subject to increasing volatility as the economy comes up against supply-side rigidities. The concern is that in the absence of a broader reform effort, improved infrastructure delivery will only take the country so far and no further.”

The second chapter – ‘Growth and Stability in Post-Conflict Economic Recovery’ – provides an in-depth analysis of the most salient aspects of the economy. It deals with inter alia, employment, savings and investment, fiscal policy management, deficit financing and debt, monetary policy for economic recovery, the external sector and related issues. The third chapter discusses ‘Developments in the External Economy and its Role in Post-Conflict Recovery’.

‘Post Conflict Economic Challenges’

The second section of the report on ‘Post Conflict Economic Challenges’ consists of six chapters that discuss inter-linked issues such as poverty, employment, education and skill development, industrial development, environmental issues, health and food crop production. These chapters evaluate several aspects of the economy and development strategy that are most appropriate at a time of national reconstruction and development.

The analysis of the food crops sector is of special relevance as it discusses the challenges for food crop cultivation in the current context of an international food crisis. These chapters are comprehensive coverage of a whole range of economic policy issues of interest to those interested in a critical review of the economy.

‘Post Conflict Development Challenges’

The third section consists of Policy Briefs on the theme ‘Post Conflict Development Challenges’. The seven chapters deal with infrastructure, tourism, fisheries, industrial development, ICT in agriculture, education rights in conflict areas and post-conflict sustainable challenges in forestry. These provide forward-thinking strategies and directions for development in the post-conflict future.

The final chapter on Prospects draws attention to a number of issues that should be considered as the economy attempts to traverse a fast track economic growth strategy. These include the widening trade deficit, containment of the fiscal deficit, and the impact of foreign capital inflows on foreign exchange rate management.

It stresses the need for reforms in several sectors and cautions the government on its strategy of large infrastructure development through foreign funding and suggests that much of the infrastructure development be through savings of the Government.

An important issue it raises is that the large foreign exchange reserves allow the country to maintain the exchange rate. However this may weaken the country’s international competitiveness.

“An appreciation of the exchange rate has been dictated by the rising volumes of foreign capital inflows – heavily tilted towards Government borrowing – as opposed to the ‘corrective’ depreciation of a currency in line with a deteriorating current account deficit.” It points out that “such ‘distortions’ can impact adversely on the competitiveness of the country’s export sector.”

Guarded optimism

The IPS report ends with guarded optimism. “Harnessing the rapid recovery of Sri Lanka’s post-conflict economy with a transformative process of economic reforms holds out the most promising outcome for sustained long term growth. The country has made a positive start and with a prudent management of the economy and related policy reforms, it stands poised to reap the full economic dividends of a post-conflict phase of development.”

‘The State of the Economy 2010’ report is an important contribution to the understanding of the country’s economic performance. It provides useful analyses of economic issues and is quite objective in its assessment of economic performance, underlying economic factors and policies.