The new government that assumed office in December 2001 has given high priority to establishing peace and promoting economic development. It has prepared a comprehensive policy package for improving economic management and laying the foundation for sustainable and high economic growth. The Government’s program targets a medium term growth of 8 to 10% with enhanced macroeconomic stability. This will enable the economy to withstand external shocks and reduce unemployment and poverty. The plans are extensively detailed in the policy document ‘Regaining Sri Lanka:’ (RSL), which has been well received by the international community. Its contents include some of the most far-reaching and ambitious structural reforms that have ever been attempted in the country.

Responding to the initiatives already taken by the Government to improve economic management and to accelerate economic reforms, combined with the cessation of hostilities, the economy has shown a sharp turnaround to 4 per cent in 2002, from the negative growth of the previous year of 1.5 per cent. This recovery is continuing to strengthen. Having invested heavily in developing its human resources in the past, Sri Lanka was able to achieve modest economic growth of 4 to 5 percent in the past. The new strategy will build on this base with strong economic reforms and peace. In that sense, Sri Lanka’s story is different from that of most other developing countries.

Recent Developments

Growth

The economic growth was broad-based, with agriculture and services being the main growth areas. Despite weak international demand, the industrial sector was able to record moderate growth. The beneficial effect of the ceasefire was clearly demonstrated in the improvements in agricultural production and increased domestic demand. Within the services sector, tourism, trade, port services, telecommunications and banking grew strongly. Current economic indicators point to the economy growing at a rate of 5.5 per cent.

Inflation

Inflation, which has been a matter of concern to the authorities for many years, declined to a single digit level in 2002, from the 14 per cent in 2001. Prudent monetary policy, a stable exchange rate and improved domestic production contributed to this achievement. All available indications are that the high inflationary expectations in the public mind are receding. The goal of the authorities is to reduce inflation to 5 per cent or below in the medium term.

Fiscal Developments

The Sri Lankan economy has laboured under very high fiscal deficits for a number of years. Hence, it was a major achievement in 2002 to reduce the fiscal deficit by nearly two percentage points of GDP, to 8.9 percent. This is clear demonstration of the Government’s commitment to fiscal prudence. The commitment to fiscal prudence was further strengthened by the enactment of the Fiscal Management (Responsibility) Act (FRMA), to ensure greater responsibility and transparency in public finance. Under the FRMA, the budget deficit is to be reduced to 5 per cent (or less) of GDP by 2006 and maintained below 5 per cent thereafter. The debt to GDP ratio is to be reduced to 85 per cent by end 2006 and to 60 per cent by end 2013.

A Revenue Authority is being set up to streamline tax, customs and excise functions, which will significantly increase government revenues and lower transaction costs in the private sector. This will constitute a major reform in the public sector that will have positive effects throughout the economy.

External Sector

The floating exchange rate system introduced in January 2001 has been successful. The financial and foreign exchange markets were stable during the last one and a half years. Declining inflation, the reducing fiscal deficit and ample market liquidity have already enabled easing in interest rates, encouraging investment and economic activity. The foreign exchange market has grown with increased activity. A surplus was recorded in the overall balance of payments. Foreign exchange reserves increased to a level sufficient to finance 4.5 months of imports. Foreign direct investment doubled in 2002 over the previous year, while net portfolio investments were positive after four years of net outflows. The external debt service ratio remained at a comfortable level of around 11 per cent.

The Government’s objective is to achieve a sustainable current account deficit, an overall balance of payments surplus, and build up of official reserves to a comfortable level. This was assisted by the successful completion of a Stand By Arrangement (SBA) with the IMF in September 2002 and led to the approval by the IMF of the Poverty Reduction and Growth Facility (PRGF) in 2003.

Exchange controls on capital account transactions have also been relaxed substantially. The government will next month present to Parliament the new Exchange Management Act which substantially relaxes the control system.

Following on the existing Free Trade Agreement with India, a Comprehensive Economic Partnership Agreement with India is being pursued. This will include liberalization of the trade in services and investment. Also, building on the Trade and Investment Framework Agreement (TIFA), Sri Lanka is now actively pursing an FTA with the USA. Trade agreements with a number of other countries are being discussed. All of these initiatives are designed to be building blocks aimed at liberalizing trade and integrating the country with the world economy.

Issues relating to foreign aid utilisation are being actively addressed. The disbursement ratio has already improved. A high-powered committee has been appointed to address issues in foreign aid utilization and the disbursement ratio is already recording an improvement.

Monetary Sector

Monetary management has been focused primarily on price stability. Accordingly, monetary growth in the medium term is expected to be about 12 – 13 per cent, sufficient to facilitate non-inflationary economic growth. The Central Bank will continue to make its monetary policy management more market oriented and ultimately move on to an inflation targetting framework. To this end, the Central Bank Law was amended to enable it to focus more clearly on price and financial system stability.

The Colombo Stock Exchange was amongst the best performing emerging markets in the region last year. The domestic debt market too has been transformed; with a growing secondary market and extended maturities that are establishing a reference yield curve, facilitating long- term private investment.

Reforms

Far reaching reforms are being continued to improve economic performance. Among these are privatization and reduction of state involvement in economic activity – including the privatization of the insurance, ports and telecommunications. Important initiatives are being undertaken to improve the functioning of labour and land markets. A comprehensive program to reform and update commercial laws has also made headway.

Major reforms in the financial sector have commenced. The Central Bank is being modernized with adequate powers to maintain economic and price stability and the safety of the financial system. The supervisory and regulatory framework is being strengthened to ensure stability of the financial system with the continuing liberalization of the economy. Action has also commenced to improve and modernize the payments system by introducing gross settlements in real time and scripless transactions of government securities by the fourth quarter of this year.

Challenges and Prospects

The Government’s broad policy framework emphasizes the development of the island nation as a regional hub for trade, transport, finance, communications and other services. As explained in RSL, the e-Sri Lanka initiative will enable the country to participate in and benefit from the ICT revolution.

Having identified local regional disparities in income and opportunity in Sri Lanka as the major cause of conflict, the Government emphasizes raising agricultural productivity, small and medium business development, tourism, and education and labor market reforms as major means of providing increased opportunities throughout the country.

The restoration of the economy of the strife-torn North and East will be a major challenge. The implementation of the rehabilitation program will enable the attainment of the considerable economic potential of the region after the cessation of hostilities. However, durable peace will only be realized when the people in the affected areas are provided with opportunities to freely engage in gainful economic activity.

The availability of concessional funds would facilitate the relief, rehabilitation and reconstruction efforts of the government and help to improve infrastructure facilities throughout the country and to implement deep economic reforms. This would enable the country’s economic growth rate to rise to such level that the need for Sri Lanka to seek international financial assistance would decline in the medium-term as domestic resources would increase and the economy would become more resilient.

We are confident that with the policies in place, and the support of the international community, Sri Lanka’s goal of sustainable economic development will be achieved.

Tokyo