I. Introduction

1. This paper provides background information on recent economic developments and on selected policy issues facing Sri Lanka. The main economic developments in 1996 and the first quarter of 1997 are discussed in Chapter II. In 1996, a severe drought, power shortages, and an escalation in the military conflict contributed to a sharp deterioration in the economic situation. With the end of the drought and power shortages, and a rise in investor confidence, macroeconomic conditions in 1997 are more favorable—output growth has picked up, inflation has subsided, and the external position remains manageable. On the policy front, faced with growing fiscal imbalances, a number of steps have been taken to reassert control over public finances. As background for this chapter, a set of tables for economic activity and prices, public finances, money and credit, and the external sector is provided in an Appendix.

2. Over the past two decades, Sri Lanka’s economy has grown at an average of about 4 percent per year, far less than the dynamic countries in East and Southeast Asia with whom Sri Lanka shared similar initial conditions and broadly comparable structural characteristics as recently as 1960. The relatively low saving and investment rates, and the large portion of available resources pre-empted by persistently high fiscal deficits, have been major constraints. With a view to drawing policy lessons for Sri Lanka, Chapter III examines the policy strategy pursued by four Asian countries (Korea, Indonesia, Malaysia, and Thailand) that may have contributed to the breakthrough to a virtuous circle of market liberalization, growth, saving, investment, and further growth. Special focus is placed on the role of fiscal policy to boost Sri Lanka’s weak record on public saving.

3. In a number of countries, the demand for money has become much less stable following financial liberalization, rendering monetary aggregates an inadequate guide for the conduct of monetary policy. The issue of instability in the demand for money is particularly relevant in Sri Lanka, where, although inflation has rarely exceeded the high teens, monetary policy has not succeeded in permanently bringing down inflation. The estimates of money demand presented in Chapter IV provide weak evidence of a stable demand for broad money, but suggest that changes are under way that are likely to make the use of broad money as the primary intermediate target of monetary policy more difficult. Alternative frameworks for guiding monetary policy under such circumstances are also discussed.

4. Sri Lanka’s record on trade liberalization over the last two decades and the changing pattern of trade are analyzed in Chapter V. Estimates of the impact of economic activity (in both Sri Lanka and abroad), real exchange rates, and trade liberalization on Sri Lanka’s exports and imports are also presented. The evidence points to a close positive linkage between Sri Lanka’s trade liberalization and improved export performance. A key conclusion of the analysis is that further liberalization of import tariffs would result in substantial increases in Sri Lanka’s exports.

5. Finally, Chapter VI reviews the important strides Sri Lanka has made in the social aspects of development. Government expenditure on social services and recent reforms in social transfer programs are also analyzed. This review suggests that there is room for reducing the costs and inefficiencies of social welfare programs without jeopardizing the government’s long-standing commitment to assist the poor. In addition, as the economy grows, the ability to improve the distribution of income will hinge importantly on reforms in the agricultural sector and labor markets.