Background

The tsunami struck at a time when the Sri Lankan macro economy was already under pressure on several fronts, reigniting fears of a slide into the kind of crisis that was seen in 2001 when the economy contracted by 1.5 per cent (Table 1 [ PDF 254KB | 10 pages ]). Some of the same problems that produced the 2001 crisis were re-emerging.

The 2001 crisis was driven primarily by a rapidly deteriorating domestic policy and political environment in the context of accumulated macroeconomic imbalances, aggravated by lower exports due to depressed global economic conditions and lower agricultural output due to adverse weather. The situation was turned around then by a series of political and economic policy initiatives. The initiation of a ceasefire agreement (CFA) with the Liberation Tigers of Tamil Ealam (LTTE) was seen as a first step towards solving the country’s long standing ethnic conflict. The prospect of a lasting peace and a substantive set of economic reforms – including the floating of the currency – succeeded to some extent in garnering donor support and renewing investor confidence. GDP growth resumed at an annual rate of 6 % in 2003, fiscal consolidation efforts saw the budget deficit reduced progressively to 8 % from 10.8 % in 2001 while inflation moderated to 6.3 per cent from 14.2 per cent in 2003. There was considerable unease within the business and investor community about the direction of policy under the new government elected in April 2004. Its programme, with the stated goal of ‘growth with equity’, and a strong emphasis on rural economic development, was viewed as being populist and interventionist.

Economic growth began to slow from the second quarter of 2004 and ended the year with a growth rate of 5.4 per cent. Whilst the election related uncertainties and the ensuing policy vacuum no doubt contributed to the slowdown in economic activity, some policy weaknesses and the slow pace of reforms contributed to the lacklustre performance. The most visible, and potentially the most destabilizing manifestation of weakening macroeconomic management in 2004 was a persistent build up of inflationary pressure from mid-year onwards. Inflationary pressure was fuelled on multiple fronts, not least by the conduct of government fiscal policy. A budget deficit of 8.2 per cent of GDP in 2004 far exceeded the set target; current expenditures (with 85 per cent taken up in equal proportions by payments on wages and salaries, interest payments, and transfers and subsidies) saw a sharp increase as a direct result of policy intervention. Transfers and subsidies increased from 4 per cent of GDP in 2003 to 5.2 per cent 2004 as subsidy costs rose. Though the fiscal deficit was reined in by cutting back on capital expenditure, the large government borrowing required to finance the deficit kept credit growth high, and credit to the government grew at 20 per cent in 2004.

A ballooning oil import bill saw the current account deficit on the balance of payments (BOP) widening to over 3.3 % of GDP from 0.4 % in 2003. This was accompanied by a deceleration of capital inflows, with long-term inflows to the government (consisting primarily of foreign concessional loans) declining by US$ 130 million in 2004. Foreign borrowings by the commercial banking sector increased significantly in 2004 raising the country’s foreign private debt exposure. The currency depreciated by 8.5 per cent against the US dollar despite efforts to bolster the exchange rate which contributed to the decline in Sri Lanka’s gross official reserves from US$ 2.3 billion at the beginning of 2004 to US$ 1.9 billion by November.

These domestic and external developments led to an acceleration of inflation from mid- 2004, and real interest rates turned negative. Symptoms of a bubble economy began to emerge: a sharp increase in credit growth to the private sector in excess of 20 per cent, with an estimated 40 per cent of the increase for consumption spending; and a boom in the Colombo stock market unsupported by major indicators of economic fundamentals. The peace process appeared to have stalled, and with privatization initiatives shelved concerns over the government’s ability to reduce the fiscal deficit began to increase. Markets started to get jittery with the growing realization that fundamental imbalances in the economy were intensifying. Though the external payments situation improved marginally in December 2004 the rupee depreciation again gathered pace. On 17 December 2004 the currency fell to a historical low of Rs.105 against the US dollar.

Thus, the tsunami came at a time of bleak economic news. If there was no effective policy response, a slide into crisis became a serious possibility. The tsunami diverted attention away from these imbalances but did not eliminate them. As we look at the posttsunami recovery issues and the policy scenarios, it is important to emphasise that the successful post-tsunami recovery is inextricably tied to the resolution of these fundamental structural imbalances.

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Comment(s)

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1. Dushi Weerakoon, one of the co-authors
   (posted 31 March 2006 / 11:43:50 AM)
   
   In response to the comment below:
   
   Besides funeral expenses, etc. a cash grant of $50 per month and $3.75 cash and food ration were given to all affected households (for approximately 4 months). For residents outside the buffer zone, if a house is more than 40% damaged, a grant of $2,500 is given in 4 instalments, based on progress. If a house is less than 40% damaged, then a grant of $1,000 is provided, disbursed in 2 stages. For residents within the buffer zone, the government planned to assist not only landowners, but all residents (including encroachers) with some form of housing. This was estimated to require around 50,000 permanent houses. Further quite considerable details on government handouts are contained in the report itself.
   
2. ken bacon
   (posted 18 December 2005 / 06:57:36 PM)
   
   This chapter notes that the government immediately paid money for funeral expenses, livelihood and cooking utensils. What additional government compensation has been provided? I am particularly interested in how the relatively generous post earthquake compensation program in Pakistan compares to government compensation for loss following the tsunami.