An economic recession in the US with a worldwide economic downturn could result in a decline in demand for Sri Lanka’s exports to key markets which may trigger lower domestic economic activity, National Economic Council of Sri Lanka (NEC) Secretary General and Chief Economist Prof. Lalith Samarakoon said.
He said Sri Lanka is already facing a subdued growth environment. After recording a 3.2% GDP growth in 2018, growth is expected to slow down to 3% or below in 2019 largely due to the economic impact of the Easter Sunday bomb attacks.
“It is in this context, that one would have to assess the implications of a potential US recession and a global slowdown on the Sri Lankan economy,” Prof. Samarakoon said.
US economic growth fell sharply from over three percent in the first three months this year to around two percent, a pace of expansion many economists consider the new normal following the 2008 financial crisis. Most independent forecast along with the Federal Reserve expects economic growth to trundle along at an annualized rate around two percent the rest of the year and into 2020. Economists also believe an inverted yield curve is a warning sign and not a foregone conclusion.
“The yield curve has predicted the past five US recessions. The 10-year vs two-year yield inverted as early as December 2005 which was 23 months before the start of the recession in December 2007 and 32 months before the US financial crisis that began in September 2008. The recession lasted for 18 months from December 2007 to June 2009. In fact, the yield curve inverted before each of the last five US recessions in 1980, 1981, 1990, 2001 and 2007,” Prof. Smarakoon said.
However, he said lower domestic economic activity could further dampen aggregate demand by reducing domestic demand, leading to reduced demand for imports as well adding that Sri Lanka’s export as well as import growth could slow leading to a narrower trade balance,” Prof. Samarakoon said.
“As a point of reference, during the last US recession in 2009 , Sri Lanka’s exports declined by 13%, imports fell by 28% and, as a result, the trade balance shrank by 48%.Tourism is a key component of the balance of payments of Sri Lanka since it is the largest contributor to the services account,” Prof. Samarakoon said adding that a global slowdown will likely cause people to be more cautious about discretionary spending on leisure leading to a decline in tourism earnings.
He said Sri Lanka has already experienced a decline following the Easter Sunday attacks, with tourism earnings dropping by 19% in dollar terms in the first seven months of 2019.Workers’ remittances are the largest contributor to the income account of the balance of payments of Sri Lanka.
Prof. Samarakoon also noted that a global economic slowdown could dampen the demand for foreign workers. Growth in workers’ remittances has shown a secular downturn and growth has already declined by about 10% in the first half of 2019.
Despite a decline in foreign remittances for two consecutive years earnings from expatriate workers surpassed US4.7 billion in 2018 accounting for 7.9 percent of the GDP.
However, according to economists lower economic activity could widen the budget deficit due to the fall in tax revenue.
“Any fiscal stimulus programs implemented by the government to mitigate the impact of a downturn will lead to higher government expenditure. As stated earlier, the expected lower domestic growth combined with a global slowdown could result in a 2019 budget deficit larger than the target of 4.4%,” he said.
The government revised down its budget deficit target from 4.8 percent to 4.4 percent this year which still according to economists is an uphill task given the possible expenditure overruns as the country get near to an election time.
In a global economic downturn, foreign investments abroad also tend to decline due to a decreased appetite for making new equity investments and lending funds to foreign enterprises. This means potential decline in new foreign direct investments (FDI) to Sri Lanka. It is worth noting that FDI flows to Sri Lanka fell by 44% in 2009.
“Foreign capital inflows to government securities could also accelerate if foreign portfolio investors see opportunities to pick up extra return by investing in emerging markets,” Prof Samarakoon said interest rates worldwide are likely to be lower as more and more central banks start cutting rates in order to mitigate against potential decline in economic growth due to the slowdown in the US and world growth.
He said this might result in further shrinking of interest rate differentials between emerging markets and the US. Despite narrowing interest rate differentials, however, some foreign portfolio investors will look for countries to earn a higher yield than what is available in the West.
If Sri Lanka maintains a higher inflation-adjusted return in dollar terms on government securities, then we might see more foreign capital flow into government securities. During the last US recession in 2009, Sri Lanka received a record level of 1,369 million dollars of net foreign inflows into government securities. In addition to attractive interest rates offered by government securities, this sharp increase of inflows was also influenced by the peaceful environment after the end of war in May 2009, the political stability and improvement of macro fundamentals.
However, Prof. Samarakoon noted that the attractiveness of Sri Lankan Government securities to foreign investor is predicated on Sri Lanka maintaining a fairly stable political and macro environment. The upcoming election cycle and the expected slower growth due to the impact from Easter Sunday bomb attacks are factors that might increase the risk premium on Sri Lanka in the global financial markets. Even in a US downturn scenario, the US stock markets might still be considered relatively attractive since stock markets in emerging markets are likely to be affected by slower growth in their economies.
“Thus it is important that monetary and fiscal policymakers analyze the potential economic consequences of a US recession and global slowdown. At a minimum, analysis of the experience during the 2008/2009 global financial crisis and the US recession will provide useful indications of potential economic impact for Sri Lanka,” Prof. Samarakoon said, adding that one should keep in mind that the economic performance of 2009 was also influenced by the last stages of the civil war, which ended in May 2009. Nevertheless he said such an analysis will help design possible monetary and fiscal responses under alternative scenarios. - LF