WORLD ECONOMY HEALTH CHECK: Prospects and Challenges in 2011, and Implications for Sri Lanka

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By Anushka Wijesinha, Dharshani Premaratne, Devangi Perera and Harini Weerasekera

The global economy is transitioning from a ‘bounce back’ phase of recovery into a slower but apparently sustainable period of growth. According to the IMF’s World Economic Outlook (WEO) Update (January 2011) and the World Bank’s Global Economic Prospects (GEP) Report 2011, global GDP is projected to grow at a markedly slower pace in 2011 compared to 2010. In 2012, growth is projected to pick up slightly once the drag on economic activity in high income economies, caused by restructuring, somewhat eases.
This post takes a bird’s-eye view of the prospects for the global economy in 2011, takes a quick ‘health check’ of Sri Lanka’s two main export markets, flags some challenges to stability to look out for, and concludes with overall implications for the domestic economy.

Growth in 2011: A ‘Mixed Bag’ of Prospects

US – Slow but steady
The US economy is to expect continued, gradual recovery this year, according to the IMF, and a projected 2011 growth rate of 3% (higher than the 2.3% that was forecasted in October 2010). Weak recovery in the US is being attributed to the persistently high rates of unemployment and long unemployment duration. In December 2010, the unemployment rate stood at 9.4%, and has hovered in the 9-10% region for nearly 2 years. Frustration at the poor labour market performance is also reflected in the weak consumer confidence. The Consumer Confidence Index (compiled by The Conference Board1) dropped to an all-time low of 53.3 in December 2010. However, there are signs of improvement in 2011. The Consumer Confidence Index rose to 60.6 in January. Unemployment fell marginally to 9% in January, but the number of jobs created, 36,000, was far below the projected 140,000.
The IMF has also warned that the high household savings rate, which had risen from the pre-crisis rate of about 2.5% to around 6% in 2010, aggravated by weak labour market conditions, has led to a continued drag on consumption.

In 2011, the household savings rate in high-income countries could decrease as a result of cyclical improvements in the year. However, this is likely to be offset by an increase in public savings (fiscal tightening), as well as the tendency for private savings to rise again (attracted by higher interest rates due to fiscal stimulus drawback).
EU – Gloomy outlook
In the EU, the economic outlook appears damper. Based on IMF figures, the EU is projected to grow by 1.7% this year – no change from the 2010 growth rate. The unemployment rate in the EU was 9.6% in November 2010, up from 9.4% a year earlier, as reported by Eurostat. Spain recorded the highest rate of unemployment of 20.6% with Greece recording the highest increases in unemployment from 9.7% to 12.9% between the third quarters of 2009 and 2010.

The sovereign debt crisis which shook the region since early 2010 only worsened the conditions of a still weak financial system. Triggered by Greece’s public debt problems, the crisis has spread through much of the Euro area, with the exception of Germany which appears to be fundamentally stronger and recovering well. Although policy efforts have helped to contain the problem, real GDP levels remain well below their pre-crisis levels and recovery is much slower than in the US. Greece, Portugal and Spain, three of the most badly-hit economies, are set to experience lagging growth in 2011, between -2.6% and 0.7%, according to the IMF. With severe public debt challenges, Portugal and Spain have both recently gone for sovereign bond issues to bridge fiscal deficits. However, the low investor confidence in the ability of these economies to reign in fiscal decay has been reflected in the unusually high interest rates that these bonds settled at.

European consumer confidence has dropped in January 2011, reaching the lowest level since August 2010. Although investor confidence has also taken a dip and market jitters continue, the World Bank states that it will have limited impacts on the real economy, as was the case in May 2010 when the first spell of market jitters about sovereign debt arose. However, the Bank does caution that albeit the limited impacts on the region so far, “the consequences of a disorderly resolution to European fiscal tensions” would be a significant reason for uncertainty among developing countries, especially those with close trading and financial ties with the economies concerned.
Asia – Era of ‘two-speed growth’
Asia, too, is expected to experience slower growth in 2011 owing to the slow pace of recovery in developed countries, but there is already evidence of ‘two speed growth’ taking root. In its WEO Update, the IMF forecasts growth of developed economies to stagnate at 2.5%, while growth in Asia-Pacific developing economies is predicted at 8.4% this year (compared to a high of 9.3% in 2010). Asian growth champions, China and India, boasting a high level of domestic demand, are predicted to grow strongly in 2011 at 9.6% and 8.4% respectively. However, as a result of lacklustre growth in the developed economies, export-dependent economies in Asia will no doubt feel the effects of a global trade slowdown. As the US and EU recover from the global economic crisis, their medium-term policies appear to be dominated by the rebalancing of their public accounts and general macroeconomic management.
Challenges to Stability
Hot money flows

Significant and volatile capital flows are an emerging challenge for the emerging economies. Interest rates in the developed economies are at an all time low and investors are looking for higher rates of return in emerging economies. This coupled with the latest edition of Quantitative Easing in the US has meant that major Asian economies are having to deal with the spike in short-term portfolio capital inflows of speculative nature. These are entering purely seeking high rates of return in the short-term, instead of more stable capital formation, as in the case of FDI. This has already led to asset market bubbles and heightened exchange rate pressures in some countries (e.g., Brazil, Malaysia, Thailand, Vietnam, and others), and are becoming concerned of the impact of these ‘hot money’ inflows on their economies, as well as of the risk of quick reversal in the event of an external shock or speculative attack on their currencies. To ward off this risk, many East Asian countries have already begun introducing some forms of capital controls, probably due to the bitter aftertaste that the 1997 Asian crisis has left among these countries’ policymakers.

Inflationary pressure
With the ‘two-speed’ growth taking root, the output gaps of emerging economies are narrowing relative to those of developed economies, and there is a risk that this would cause inflationary pressures as a result of overheating. Rapid growth in emerging economies is pushing energy prices up, and oil is at its highest price in two years at US$100 a barrel in January 2011. Rising global food prices have also been touted as a key contributing factor, with the UN’s FAO noting a 20% rise in prices in 2010 from a year earlier. Resulting food price inflation has been creeping up in emerging economies in recent months and, according to the IMF, consumer prices in these economies are projected to rise 6% this year. Both of these challenges hold real risks for many economies in the developing world, like Sri Lanka, as these rising prices feed in to headline inflation.
Food price rise: Hype or real risk?
The escalation of food prices in 2007 and 2008 relaxed somewhat by 2009 and 2010, but world food prices are creeping upwards once again, mainly caused by adverse weather phenomena and a recent spike in the incidence of natural disasters worldwide. While there has been a lot of debate lately on prospects of another global food price crisis beginning in 2011, it remains to be seen if it will be on the same scale as in 2008, with social unrest in many countries, or whether it is a cyclical jump that will wither away.

Natural disasters and extreme weather have affected the crop output of major food exporting countries like Russia, Canada, and Australia. Fires in Russia have affected wheat output and floods in Australia have affected wheat and sugar output. With the anticipated extreme weather conditions worldwide caused by ‘La Nina’, the spike may last longer than anticipated.

However, in real terms, food prices still remain below the 2008 peaks. A key difference between the current price spike and that of 2008 is the price of oil. In 2008, a barrel of oil was US$ 140. This has helped keep fertilizer and other operational costs down. Moreover, it must be borne in mind that the international market for food is narrow – not all major food producers are food exporters – and only a fraction of total food produced is actually traded between countries and on commodity exchanges.

There is criticism that adverse weather and demand pressures are over emphasized as the causes of the food crisis, masking other fundamental causes that need addressing2. The underlying reality is that agricultural practices, particularly productivity improvement and investment in high-yielding, more resilient crop varieties, in underdeveloped countries have been slacking for decades. Thus, the hype over the food price crisis may be justified as there appear to be real risks ahead, but a sustainable solution would be to address these underlying issues which risk being relegated to a backseat by the ones receiving most ‘hype’.
Implications for Sri Lanka
Fragile export markets
The global financial crisis coupled with the recent European sovereign debt crisis has raised concerns about the health of Sri Lanka’s two main export markets – the United States and the European Union, which together account for 61% of the country’s exports. Despite strong policy actions to restore market stability, recovery in these economies has been sluggish. The key question many exporters are asking is – “should we be worried about our order books and earnings for this year?”
As highlighted earlier in this article, it is clear that 2011 is likely to see a lethargic recovery in Sri Lanka’s key markets and it is something Sri Lankan exporters need to watch carefully. Both the US and EU economies are still hurting. US consumer confidence is low, unemployment is high, and domestic consumption is likely to remain damp particularly with the stimulus being gradually drawn down. These can have significant implications for US imports from trade-dependent countries like Sri Lanka. The outlook for the EU is gloomy, with fiscal austerity and economic restructuring measures taking a toll on the economic activity in many of the countries in the region. These anxieties, coupled with the loss of the EU GSP+ scheme – which has been a serious challenge for many exporters – can have significant implications on Sri Lanka’s exports to the EU in 2011.

Leveraging on Asia’s buoyancy
Given the uncertainty of the current health of the US and EU, there is a compelling case for greater intra-regional cooperation in Asia in order to increase exports to Asian economies with a large and growing domestic demand. This is true of the South Asian region as well. India, with its dynamic economic growth and large domestic market offers strong opportunities for exports from other South Asian nations. Moreover, India’s increasing economic integration with East Asia would in turn help to link other South Asian economies with East Asia.

Sri Lanka needs to look at developing stronger linkages with her trading partners in the healthier economies of Asia, exploring new markets, and moving away from the excessive dependence on the US and EU. This need seems to have been already identified by Sri Lanka’s Export Development Board, which has stated that it aims to help reduce the country’s export dependence to the US and EU from the current 61% to 50% by 2015.

However, in developing greater trade and investment between countries in the region, trade constraints ranging from tariff and non-tariff barriers, to poor physical connectivity, burdensome behind-the-border procedures, ambiguity in terms of related trade procedures, corruption, and very importantly, better visa facilitation for businessmen would have to be addressed aggressively.
Food crisis – both external and domestic factors
Although much has been written on the likelihood of another global food price crisis, it remains to be seen how much, and how quickly, this permeates into the Sri Lankan economy. Regardless of the global picture, however, there are critical issues in the food sector much closer to home that need addressing. This is particularly urgent in the light of the two cycles of severe floods recently, affecting major agricultural regions of the country. A column by a well-known economist argued that the loss of Maha season paddy crop is estimated to be around 30% of the total crop3, and it is likely that a fair amount of rice may need to be imported to cover losses and bridge supply constraints. As it is, Sri Lanka is a net importer of food; approximately 18% of total food consumption is imported. So, a domestic food shortage will only compound problems for Sri Lanka as it depends on imports for all its wheat requirements, most of its sugar and milk requirements, and now, additional rice requirements. The supply of many varieties of vegetables have been affected as well and prices have risen sharply, with items like onions retailing at Rs 350/kg and green chilies at Rs 425/kg at Colombo’s Manning Market. Yet, as in the global case, fundamental structural issues in the agriculture market and supply chain need urgent attention.
(Await a more detailed post to follow on the risks of food price rise in Sri Lanka and the underlying challenges that need addressing)

Citations:

1. The Conference Board, USA http://www.conference-board.org/
2. ‘The Global Food Crisis: Hype & Reality’ – Rosario Bella Guzman, Pesticide Action Network Asia & the Pacific & People’s Coalition on Food Sovereignty
3. ‘International food crisis and domestic food shortages’, Nimal Sanderatne, Sunday Times, January 23rd 2011

  • deshal d

    >nice one.

    what's your take on implications for FDI? thus far news of new investments has been almost entirely dominated by tourism, but less so on other sectors. the low FDI in 2010 was explained away as being due to lagged effects of the financial crisis – but FDI into Malaysia increased by 410%, indonesia 163%, Singapore 123%, HK 30%, so domestic factors must dominate in some way. to what extent have these been addressed by last budget proposals?

  • Anushka Wijesinha

    >Thank you for your comment Deshal.

    Yes, most of the FDI in the latter part of 2010 and early 2011 have been in tourism and a few in land acquisition for leisure/recreation projects and little in other sectors. I am not entirely convinced that the dip in 2010 FDI was fully due to the lagged economic crisis effects, but rather the uncertainty that prevailed regarding the future of the BOI incentives regime, etc., given that investors were waiting to see what the Budget would say on it.

    Even at present, this is not fully certain as the Budget 2011 announced in November last year did not give a clear indication as to the future of the BOI incentives granting regime. Hence, only the big FDI players (largely in tourism so far) have come forward. For mid-sized FDI to flow in on a larger scale, I think the signalling of what government policy is going to be is KEY – future of BOI? a new robust, all-encompassing approvals system supported by new easy-to-follow rules? a clear industrial policy? a clear services sector policy?

    For tourism, a key reason for the spike in FDI and general investment interest has been the new approvals procedure adopted by the Tourist Board. It brings together all relevant govt bodies and agencies around one table to quickly go through the requirements and do the needful after assessment.

  • deshal d

    >I agree. most of the investment opportunities in SL now is in services. it's getting increasingly difficult to successfully engage in manufacturing in SL bc of the costs and availability of labour, raw materials and energy.

    the most exciting sectors that hold immediate promise are hazy in terms of regulation – in construction many of the big ticket ventures are on PPP basis where still there is a lack of clarity in some procedures, tertiary education (lack of clear policy), energy (heavy regulation, price controls) etc. – this could be a reason for the reluctance in non-tourism FDI.

  • i hettiarachchi

    >the asian growth is mostly driven by demographics and related factors but what if the western countries speed up its technological advancements and create a wave of new growth from it ?