By Andrew Colquhoun
Sri Lanka's parliamentary election on Aug. 17 confirmed the nation's political shift away from the Sinhalese-nationalist ruling style of former President Mahinda Rajapaksa.
However, the end of Rajapaksa's 10-year rule in January 2015 has not yet led to much change in economic policy. The new government has begun to talk about how better to realize the country's considerable economic potential. But little has been said so far about the more urgent task of strengthening buffers against the economic and financial pressures building on Sri Lanka and other emerging markets.
The Rajapaksa administration pursued growth and development with some success. Over the 2005-2014 period, real gross domestic product grew at a compound annual rate of 6.7%, despite a civil war that ended only in 2009. Infrastructure investment, heavily financed by China, made a visible difference in the country during Rajapaksa's time in office. For example, the new highway connecting Colombo's airport and central business district was built then with Chinese support.
Sri Lanka's foreign minister estimated in February that China had lent a total of $5 billion to the country, or about 12% of its external debt. The new government said initially it wanted to renegotiate some of these loans. However, Prime Minister Ranil Wickremesinghe recently said he wants to maintain close relations with China, so the policy strategy is not yet clear.
Fiscal laxity
The Rajapaksa administration made less progress in addressing Sri Lanka's deeper structural weaknesses. The country's sovereign debt rating tells the story: It remains BB-, three notches below investment grade, the same grade it was assigned by Fitch Ratings in December 2005.
Not that Sri Lanka's credit story has been uneventful. Its rating was downgraded in 2008 due to severe pressure on external liquidity, just before the country adopted an International Monetary Fund-supported adjustment program. It then returned to BB- in 2011.
The post-election budget did little to address a history of fiscal laxity that has left Sri Lanka with the highest ratio of government debt to GDP in Fitch-rated emerging Asia, at 75.5% as of the end of 2014.
Part of this must be ascribed to the country's long-running civil war. Still, progress on fiscal consolidation since the war ended has been glacial. The new government's first budget hiked fuel and food subsidies and public-sector wages. Most revenue-side measures were one-offs, which did nothing to address one of Sri Lanka's other standout weaknesses: its low fiscal revenue receipts. In 2014, the receipts added up to just 13% of GDP, the fifth-lowest figure across all Fitch-rated emerging markets and below those of Costa Rica and Ethiopia.
In Fitch's view, high inflation and high public deficits have contributed to a shortage of domestic savings, leaving the country reliant on Chinese loans and other foreign capital to fund investment and growth.
Correspondingly, Sri Lanka has run an annual current-account deficit since the 1980s. This position is even worse because of the country's inability to attract foreign direct investment on the same level as its peers, with inflows averaging just 1.2% of GDP a year. This compares with 5% in Vietnam.
Sri Lanka's ratio of net external indebtedness to GDP -- about 42% at the end of 2014 -- is the second highest in emerging Asia, after Mongolia, at a time when investors are increasingly nervous about the region and relations with China have grown more difficult.
Under the new government, monetary policy has loosened, allowing credit growth to pick up and sucking imports into the country. Imports of consumer goods in the first five months of 2015 were up 45% on the same period last year, adding to pressure on external balances. Fitch expects Sri Lanka's current-account deficit to widen to 3% of GDP this year from 2.7% in 2014, despite the impact of lower oil prices.
Liquidity is the pressing issue for external finances. Foreign reserves peaked at $9.2 billion in August 2014 but had dropped to $6.8 billion by the end of May. The authorities indicated a $650 million sovereign dollar debt issue and $338 million from a Sri Lanka Development Bond bolstered reserves to $7.5 billion by the end of June. But data for the following month show that reserves fell back again to $6.9 billion.
Even at the peak, Sri Lanka's ratio of foreign reserves to external payments was the third lowest in emerging Asia, after Mongolia and Vietnam. Vietnam's ratio could well better Sri Lanka's by year-end, based on current trends. A recently agreed $1.1 billion swap facility with the Reserve Bank of India could provide some relief for Sri Lanka but is not a sustainable solution.
Plenty of positives
Frustration at Sri Lanka's weaknesses should not obscure celebration of its successes. Compared with its South Asian peers, it is a relatively rich and well-developed country. Gross national income at purchasing-power parity stood at $9,500 in 2013, almost double India's $5,100 and not too far off China's $11,900.
Its broader level of human development, according to the United Nations, placed it in the 61st percentile globally in 2013, close to Malaysia at 67th and well ahead of India at 28th. Sri Lanka has just seen an orderly transition of power following a broadly peaceful election, in marked contrast to the norm in Bangladesh or Pakistan.
But on a broader scale, it is evident that much of Sri Lanka's potential remains unrealized. Incomes are well below those in Thailand or Malaysia, let alone Taiwan or South Korea. The diversification and sophistication of Sri Lanka's economy is a lot narrower than that of the Asian tigers. Narrowing the gap is a daunting task, but there is no reason why Sri Lanka's new government and its successors should lack the ambition to do so.
Andrew Colquhoun is senior director and head of Asia-Pacific sovereign ratings at Fitch Ratings in Hong Kong.
(Nikkei Asian Review)
