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Statement by Rakesh Mohan, Executive Director for Sri Lanka and K.D. Ranasinghe, Alternate Executive Director, November 27, 2013

Author(s):
International Monetary Fund. Asia and Pacific Dept
Published Date:
September 2014
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1. Our Sri Lankan authorities thank staff for the useful dialog they had with the Ex-Post Evaluation (EPE) and Post-Program Monitoring (PPM) mission teams, on the 2009 SBA, which was concluded in July 2012. The successful implementation of the SBA supported program, which was commenced soon after the end of the decades long internal conflict in May 2009, helped Sri Lanka to strengthen its macroeconomic stability and build policy spaces in many areas. Our authorities are of the view that the EPE report provides a comprehensive assessment of the SBA, its design, execution and outcomes as well as lessons that could be drawn for both the authorities and staff for future engagements. The PPM report provides a broad assessment of the Sri Lanka’s economy and its outlook.

Ex-Post Evaluation (EPE)

2. The IMF Executive Board approved a 20 month SBA for Sri Lanka in July 2009. The key objectives of the SBA, as highlighted in the Memorandum of Economic and Financial Policies (MEFP), were to cushion the impact of the global financial crisis, consolidate efforts to bring down inflation, and maintain Sri Lanka’s strong economic growth. Accordingly, the SBA had been designed to rebuild the country’s international reserves to a comfortable level, strengthen its fiscal position, improve the financial position of key SOEs, strengthen financial system stability and maintain monetary stability. Under a difficult global environment, the SBA provided required assurance and policy support to strengthen the macroeconomic stability, and bolster investor and consumer confidence, fairly quickly, along with the positive sentiment brought about by the ending of the decades-long internal conflict.

3. Sri Lanka’s macroeconomic fundamentals have improved significantly in recent years. Economic growth during 2010 – 2012 averaged 7.5 percent. Inflation remained consistently at single digits since beginning 2009. The fiscal deficit has been brought down to 6.4 percent of GDP in 2012, from 9.9 percent in 2009, and the debt to GDP ratio reduced by 7 percentage points from 2009 to 2012. International reserves increased to USD 6.9 billion, equivalent to 4.3 months of imports by end 2012, compared to the 3.5 months envisaged under the program. By end September 2013, the reserves have further increased to USD 7 billion, equivalent to 4.4 months of imports. Although the financial conditions of two key SOEs, namely, Ceylon Petroleum Corporation (CPC) and Ceylon Electricity Board (CEB) got strained during the program period due to volatile oil prices, weather related shocks including sharp reduction in hydropower generation, and delays in price adjustments, their performance has improved robustly in 2013. It is expected that both entities would operate at a breakeven level or even better from 2013 onwards, supported by reductions in cross subsidies, increased low cost power generation capacity, sizable price adjustments and improved financial management.

4. The key financial system stability indicators show significant improvement and resilience in the financial system since 2009. Our authorities share the staff’s view that the initial 20 month period for the SBA was too short to implement deep structural reforms. However, all structural benchmarks, under the SBA, except one, have been implemented and most of them were in relation to financial sector stability. With continued reforms and efficiency improvements, Sri Lanka’s ranking under the World Bank’s ease of doing business index improved to 81 in 2013, from 102 in 2009. As also highlighted in the staff report, Sri Lanka’s EMBI Global spread has narrowed sharply and sovereign ratings of the country have also been upgraded during this period.

5. Notwithstanding the ownership and commitment of our authorities to implement the SBA supported program, recalibration of certain targets was required due to unexpected domestic and global developments, such as sharp changes in world commodity prices, weather related shocks, national elections, surge in post-conflict import demand driven mainly by rehabilitation and reconstruction activities. Our authorities are appreciative of the flexibility shown by staff and the Executive Board to update the targets to reflect real world challenges helping to enhance the effectiveness of the program. However, our authorities consider that the SBA could have generated more benefits to the economy, if there were no extensive delays in the approval process.

6. The authorities’ views of the EPE are given in detail in Appendix 1 to the staff report.

Post –Program Monitoring (PPM) Economic Growth and Outlook

7. The Sri Lankan economy grew by 7.8 percent in the third quarter of 2013 up from 6.8 percent in the second quarter. This growth was driven by the turnaround in the agriculture sector, high growth in factory industry, electricity, trade and port services. The agriculture sector recovered strongly to record a 7.0 percent growth in the third quarter, compared to weather affected negative growth of 0.5 percent in the same quarter of the previous year. Reflecting a gradual recovery in the external demand, the factory industry subsector grew by 6.8 percent, compared to the 3.2 percent in the previous year. Services sector grew by 7.9 percent over the 4.6 percent in the previous year.

8. The growth momentum is expected to continue in the fourth quarter of 2013 and in 2014. The relaxed monetary conditions, gradual recovery in external demand as witnessed since June 2013, and industrial production would largely underpin the higher growth. With the completion of several major infrastructure projects, production capacity of the economy is also undergoing expansion. Growth is estimated to be around 6.9 percent in the first nine months of the year. Overall, our authorities have projected 7.0 – 7.5 percent growth for 2013, and 7.5 per cent growth for 2014.

Fiscal Policy

9. Fiscal consolidation is given utmost priority in our authorities’ policy agenda. The fiscal deficit has been steadily reduced over the recent years to record 6.4 percent of GDP in 2012. The government’s target is to bring the deficit further down to 5.8 percent of GDP in 2013, and below 5 percent in the medium term. Our authorities recognize that the fiscal operations in 2013 remain challenging mainly due to a shortfall in the tax revenue. Tax revenue as a percent of GDP has declined to 5.0 percent during the first six months of 2013, from 6.1 percent during the same period of the previous year. Supported by strict control of recurrent expenditure within the budgetary target, prioritizing capital expenditure and turnaround expected in the revenue collection during the second half of the year with the recovery in the external trade and in other economic activities, the government is positive in achieving the targeted fiscal deficit for 2013.

10. The reduction in the government revenue for 2013 was largely reflected in the imports based tax collection. As highlighted during the Article IV discussions in May 2013, this reduction can also be partly attributable to the tax reforms introduced in 2011, which sought to simplify the tax structure, broaden the base and lower the tax rates. Going forward, however, they are expected to have a significant positive impact. The government continued to take measures to strengthen the revenue base. It has streamlined granting of tax exemptions, specially focusing on strategically important large scale investments. At the same time, those companies which enjoy tax exemptions at present will come under the tax net within the next few years when the tax exemption agreements expire. The wholesale and retail businesses have been brought under the VAT net. Steps have also been taken to improve tax administration and compliance by introducing the Revenue Administration Management Information System (RAMIS), Treasury Management Information System (TMIS) and paying taxes on self assessment basis etc.

11. The 2014 budget was presented in the Parliament on November 21, 2013. The main focus of the budget and revenue enhancing measures proposed are given below:

The main focus of the budget;

  • 7.5 - 8.0 percent of economic growth in the medium term

  • Support the maintenance of inflation at around mid-single digit levels

  • Strengthen fiscal consolidation: reduce budget deficit to 5.2 percent of GDP in 2014; 4.5 percent in 2015 and 3.8 percent in 2016 and reduce public debt to GDP ratio to 65 percent by 2016

  • Facilitate the expansion of value creation and import competing industries

  • Enhancing export earnings;

    • - Diversify products, markets and promote value addition

    • - Continue with flexible exchange rate regime and improvement in productivity to boost exports

  • Ensuring profitability of State Owned Enterprises (SOEs)

  • Strengthening public investment, food security and rural economy

Revenue Enhancing Measures:

  • Extension of Nation Building Tax (NBT) covering all banking and financial

  • institutions

  • Broadening the base for Value Added Tax (VAT) on supermarket retail trade by reducing the threshold to Rs 250 million from Rs 500 million per quarter, while limiting the exemption to 25 percent of the turnover

  • Telecommunication levy increased to 25 percent from 20 percent

  • Revision of motor vehicle depreciation schedule for Customs Duty to prevent undervaluation

  • Revision of cess rates on primary commodity exports and items vulnerable to undervaluation

  • Revision in Special Commodity Levy/Customs Duty

The government expects an additional revenue of Rs 41.4 billion from the above measures in 2014. Accordingly, revenue as a percent of GDP is estimated to increase to 14.5 percent in 2014 from 13.6 percent in 2013, and budget deficit to decline to 5.2 percent in 2014 from 5.8 percent.

External Sector

12. The external sector remained resilient in 2013, despite weak external demand during the first six months of the year. Export earnings have gradually picked up since June 2013 and recorded an 11 percent year-on-year growth in September 2013. Overall, export earnings up to September during the year have recorded a marginal positive growth while imports recorded a marginal decline, leading to narrowing of the trade deficit by 2 percent. The current account deficit declined by 27 percent during the first half of 2013 with increased remittances, and services exports, including increased earnings from tourism. Our authorities have projected that the current account deficit would improve to 4.3 percent of GDP in 2013 compared with 6.6 percent in 2012. Reflecting relaxation of foreign exchange regulations and improved investor confidence, the capital and financial account also has strengthened with increased FDI, portfolio investment and other inflows to the private sector and to the banks. The Balance of Payments recorded a surplus of US dollars 585 million by end September 2013. Despite significant valuation losses due to depreciation of some major currencies against the US dollar, and sharp decline in the price of gold, the gross official reserves increased to US dollars 7.0 billion, equivalent to 4.4 months of imports by end September 2013.

13. As highlighted in the staff report, Sri Lanka remained largely resilient to the recent financial market volatility. Our authorities have prudently managed short-term capital flows and taken timely measures to address volatility that arose due to global uncertainties. Sri Lanka has opened only 12.5 percent of outstanding stock of Government Securities for nonresident investors, and a larger part of that constitutes investments in long term bonds by major investors. The exchange rate policy continued to focus on maintaining flexibility with cautious intervention to smoothen high volatility. From the second week of June through end August the Rupee depreciated by 5.01 per cent and gained value thereafter. Overall the rupee depreciated by 2.94 per cent against the US Dollar by end October 2013. On net basis the Central Bank had purchased US Dollars 239 million up to end October 2013.

14. Banks are allowed to raise funds abroad with prudent limitations to strengthen their Tier II capital and to provide long term funding for the SME sector and plantations, construction, industry and manufacturing sectors.

Monetary Policy

15. Inflation continues to remain well anchored despite various supply-side shocks. The year-on-year inflation, which remained at single digit levels for nearly 5 years, moderated to 6.7 percent by October 2013, from 9.2 percent at end 2012. Core inflation has come down sharply to a lowest level of 2.6 percent in October from 7.5 percent at end 2012.

16. Private sector credit growth remained subdued since mid 2012, following tight policy measures introduced during early 2012, and the money supply growth remained well within the targeted level. Administered prices, mainly energy prices, have been substantially adjusted in 2012 and 2013 to reflect the cost and therefore, significant upward adjustments in the near term is unlikely. The pressure on the Balance of Payments has also been contained with a mix of policy measures introduced since early 2012. The benign inflation expectations and still negative output gap provided ample space for the authorities to loosen the monetary policy by reducing policy rates by 100 basis points in two stages in May and in October 2013 and reducing SRR to 6 percent from 8 percent, in July 2013.

Financial Sector Policies

17. The financial sector remains sound and resilient with strong CAR, and healthy profitability and liquidity. In the context of slow credit growth, asset quality of the banking sector slightly weakened with NPL ratio rising from 3.6 percent at end 2012 to 4.7 percent at end June 2013. The increase in the NPL ratio was largely attributable to the increased NPLs relating to gold pawning, as delinquencies increased with the sharp drop in the market price of gold. The share of advances granted against gold has been about 15 percent of the total bank lending. The provision coverage ratio also declined to 44.9 percent by end June, largely due to the increase in pawning related NPLs which did not require provisioning as the value of gold collateral covered the loan value. Banks have however, now started to make provisions for uncovered exposures and lowered their internal LTV ratios in relation to gold pawning.

18. As highlighted in the staff report, one small finance company, representing less than 0.06 percent of the total financial sector assets, faced liquidity problems due to mismanagement. The Central Bank immediately removed the CEO of the company and brought its management under a managing agent, which is an experienced and leading licensed finance company. The managing agent has prepared a restructuring plan, which has been approved by the Monetary Board of the Central Bank. Under the general guidelines issued by the Central Bank, liquidity could be provided to such finance companies with liquidity problems through the Deposit Insurance Fund (DIF), backed by 100 percent resalable assets. However, no such liquidity has been provided so far through the DIF.

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