In its latest Global Economic Prospects report, the World Bank predicts Sri Lanka's economic growth will pick up to 5.3 percent in this year and in both 2017 and 2018 despite monetary and fiscal tightening.
"Growth will be supported by infrastructure spending financed by sizable FDI flows as part of the government's Port City and Western Province Mega polis initiatives. Also, recent policy measures to curb imports will contribute to growth," the World Bank's flagship report the Global Economic Prospects June 2016 said.
The report notes that an expansionary fiscal policy has contributed to the increased deficit and debt levels in Sri Lanka but efforts are underway to address the deterioration in public finances, including the increase in the VAT rate from 11 to 15 percent.
In Sri Lanka, rising core inflation and high credit growth have compelled the Central Bank to tighten policy.
Noting that fiscal deficit is on the rise in Sri Lanka, which received a sovereign rating downgrade in 2016, In Sri Lanka, the report says the expansionary fiscal policy has contributed to the increased deficit and debt levels. In Sri Lanka, government debt levels are above 70 percent of GDP.
While reserve buffers remain comfortable or improved in most countries in the South Asia region, in Sri Lanka, along with its fiscal situation, import cover ratios deteriorated to an estimated 3.5 months, as the country, along with other emerging and frontier market economies, experienced significant capital outflows. Gross official reserves in Sri Lanka fell to $6.3 billion in March 2016 from $7.3 billion in December 2015.
The World Bank forecasts that weaker-than expected growth in advanced economies will dampen export growth for countries in South Asia. Fiscal consolidation in Gulf Corporation Council (GCC) countries will slow remittance flows, mainly affecting the outlook for the smaller economies that rely heavily on remittances such as Bangladesh, Nepal and Sri Lanka.
Remittance flows have been broadly steady in Sri Lanka but if the ongoing fiscal consolidation in Gulf countries is sharper than expected, remittance flows to the region could slow sharply, in particular to Bangladesh, Nepal, and Sri Lanka, the global lender predicts.
Gradually tightening financing conditions will increase external borrowing costs for economies with access to international capital markets, notably corporate public sector borrowing in Sri Lanka.
The World Bank report says against the backdrop of a fragile global economy, the priority for fiscal policy is to build fiscal buffers and reduce debt, and measures to raise direct tax revenues, which are low in Sri Lanka even by emerging market and developing country standards, will free fiscal space for much-needed public investment.
For Sri Lanka, such measures include broadening the tax base, reducing exemptions and improved tax administration.