Short-term Economic Impact

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 3 [ PDF 79.1KB | 1 page ]). On the policy front, there was considerable unease within the business and investor community about the direction of economic policy under a 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 by sections of the business and investor community 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. While 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 the mid-year onwards. Inflationary pressure was fuelled on multiple fronts, not least by the conduct of an expansionary fiscal policy driven by increased subsidies and transfers.

Domestic imbalances were exacerbated by a ballooning oil import bill which saw the current account deficit on BOP widening to over 3.3 per cent of GDP in 2004 (from 0.4 per cent in 2003). This was accompanied by a deceleration of capital inflows, with longterm 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 in excess of 20 per cent and a boom in the Colombo stock market unsupported by major indicators of economic fundamentals. The peace process between the GOSL and the LTTE 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, rupee depreciation again gathered pace. On 17 December 2004, the currency fell to an historical low of SLRs.105 against the US dollar.

Against this backdrop, the immediate negative impact on output as measured by the GDP figure was expected to be fairly limited, ranging from a 0.5 to a 0.7 per cent reduction in 2005 GDP. The relatively small impact on GDP appeared somewhat surprising given the extent of human and asset losses. This was not only owing to the fact that only a relatively small sector of the economy was affected, but also because GDP captures only the annualised flow of damages to the stock of asset damages, and spending on relief efforts was expected to have an immediate positive effect on current GDP.

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