Fiscal Imperatives for Growth and Stability

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Fiscal consolidation efforts as set out in the Budget 2013 were not entirely unexpected.[1] With revenue collection falling short of the target, adjustments to ensure that the deficit for 2012 remains close to the forecast 6.2% of GDP is to be brought about by a sharp cut back in public investment. Indeed, fiscal consolidation efforts appear to be on track with the deficit expected to decline further to 5.8% of GDP in 2013 (Table 1).

Table 1: Fiscal developments

Source: MOFP, Department of Fiscal Policy.

The public investment-led development drive is set to continue and underpin the economic recovery efforts, with public investment as a percentage of GDP set at 6.1% in 2013. In a departure from recent years when foreign financing comprised a large chunk of the deficit financing requirement, the Budget 2013 has opted to rely heavily on domestic borrowing to bridge the deficit. Of the relatively high domestic financing component of 4.8% of GDP, 3.3% is to be raised from non-bank borrowing.

With the government tapping domestic sources for the bulk of its deficit financing requirement, a pertinent question is whether Sri Lanka’s private sector, starved of funding in 2012 through the imposition of a credit ceiling on commercial bank lending, will be crowded-out further in 2013 from undertaking investment. Indeed, a related issue is the extent to which Sri Lanka is making room for private investment to step-in, and relieve the fiscal burden of driving the country’s investment growth in the current post-conflict phase of development.

At first glance, it appears that conditions to ease the current monetary policy stance and encourage private investment growth in 2013 are emerging. Policy interventions introduced in February/March 2012 to curb credit growth is having the intended results. In August 2012, credit growth to the private sector eased below 30% for the first time since March 2011. However, the conditions for an immediate easing of the monetary policy stance are not present in view of a greater recourse to domestic borrowing by the government in the last quarter of 2012 to bridge end-year budgetary financing gaps. As a result, even as credit growth to the private sector has been cut off, upward pressure on interest rates is continuing (Figure 1).

However, with inflationary pressures moderating in the economy, with end year annual inflation targeted to be 8.5% in 2012, and fewer price pressures expected in 2013 with a muted economic recovery, better agricultural output, and slowdown in international oil prices, inflationary pressures in 2013 too can be expected to remain fairly moderate. Thus, the conditions to ease monetary policy and reset interest rates at a lower rate in the first quarter of 2013 in support of higher GDP growth are emerging.

Figure 2: Monetary Conditions

Note: Click image to view large

Source: CBSL, Monthly Economic Indicators, various issues.

Sri Lanka’s private sector may thus benefit from an easing of monetary policy in the first quarter of 2013. However, it appears unlikely that a more favourable environment to undertake investments can persist over the course of the year, if as suggested by fiscal policy projections for 2013, the government resorts to a high volume of domestic borrowing for deficit financing purposes. Sri Lanka’s private sector is likely to find itself competing with the government for investment finance that will drive up interest rates in the economy, and be crowded out once again from a more vigorous participation in the country’s post-conflict growth process.

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