Journal Issue

Sri Lanka: Third Post-Program Monitoring Discussion

International Monetary Fund. Asia and Pacific Dept
Published Date:
December 2015
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Recent Developments And Outlook

A. Political Transition

1. January presidential elections brought a new coalition government to power—headed by Maithripala Sirisena. The Sirisena government is dedicated to a 100 day program of political reform—focused on trimming the powers of the presidency and returning to a Westminster-style system of government where greater power is vested in the prime minister’s office. Other key reform pillars relate to improving governance, increasing transparency, ensuring more inclusive growth, and a firmer reconciliation with the Northern provinces. Externally, the Sirisena government is bolstering regional ties, with recent high-level visits to India and China.

2. The Sirisena government is seeking to complete promised political reforms and call for fresh parliamentary elections by April 24th, or as soon as possible thereafter. While the political transition envisioned under the 100-day program is an historic milestone, it has also hampered the government’s ability to set clear medium-term economic and reform objectives. The outcome of the next round of elections will be a key determinant in the pace of economic and structural reform—a roadmap for which will need to be articulated by the new government shortly after taking office.

B. Recent Economic Performance

3. Macroeconomic performance in 2014 was generally strong. Real GDP growth registered 7.4 percent in 2014. Growth was broad-based, with the exception of agriculture which suffered from drought early in the year and heavy rains and flooding in the fourth quarter. Particularly notable were contributions from construction, manufacturing, and wholesale/retail trade, which together accounted for about 60 percent of growth. Headline and core inflation declined to 2.1 and 1.2 percent, respectively, by end-year. Reductions in administered prices for fuels facilitated the record low levels of inflation.

4. Preliminary data indicate the overall fiscal deficit for 2014 exceeded the budget target by about ¾ percent of GDP. Tax revenues grew by only 6.9 percent—well below the growth rate targeted in the budget but broadly consistent with performance of recent years. Income tax collection was particularly weak, falling by nearly 4 percent in nominal terms. Despite tight spending control, the overall deficit is estimated at 5.9 percent of GDP, compared with a budget target of 5.2 percent. This is the largest deviation between outturn and target of recent years, and the first year since 2009 that the deficit was not reduced as a share of GDP.

5. Financial performance of state owned enterprises (SOEs) improved in 2014. According to preliminary data, SOEs recorded an aggregate Rs 70 billion profit (0.7 percent of GDP)—an increase of Rs 25 billion over 2013. This reflected mainly an improvement in banking and insurance sectors, and also the favorable impact of lower oil prices on the Ceylon Petroleum Corporation (CPC). However, Ceylon Electricity Board (CEB) recorded a loss of Rs 13 billion, compared to a 2013 profit of Rs 18 billion, mainly as a result of dry conditions in early 2014 that led to lower hydropower generation and a 16 percent increase in per unit generation costs. The CPC/CEB financial outlook for 2015 is unclear. Besides the usual uncertainty about rainfall and hydropower generation, the potential for changes in the oil price and a lack of clarity regarding the introduction of an automatic fuel price adjustment mechanism add uncertainty. The authorities are considering introduction of cost-price formula, but no decision has been made.

6. The external current account was broadly stable in 2014, but with significant intra-year volatility. For the year as a whole, stronger tourism and remittances partially offset a wider trade deficit. Exports—led mainly by industrial goods (textiles and garments) and agricultural products—increased 7 percent. This was more than offset by a substantial increase (7.9 percent) in imports (mainly consumer and intermediate goods). The stability of the current account for the year as a whole masks a significant intra-year shift. For the first half of 2014, import growth was tepid—facilitating a half-year current account deficit of only 2 percent of GDP. However, as exports hit a plateau and imports climbed in the second half of the year, the non-oil goods trade deficit increased by some 2½ times.

7. Developments in the financial account were mixed. FDI inflows are estimated to have reached $763 million in 2014—a 10 percent decline from 2013. Foreign loans to the government and the private sector remained broadly unchanged (in levels). Net inflows into the Colombo stock exchange were $163 million—lower than the $270 million net inflow of 2013. The government successfully issued sovereign debt totaling $1.5 billion in 2014. However, foreign investors’ participation in government domestic securities recorded a net outflow of $113 million for the year, despite net inflows on a cumulative basis through September. The pace of net outflows since the beginning of 2015 has subsided reaching US$4.9 million by February. Reflecting these developments, CBSL foreign exchange reserves declined from a peak of $9.3 billion in July 2014 to $8.2 billion by end year and dropped by an additional $1.3 billion1 by mid-March 2015, bringing reserve coverage to about 3.1 months of imports.

8. Monetary policy remained broadly accommodative in 2014, with private credit growth beginning to respond in the fourth quarter. Policy rates were lowered by 150 bps between end-2012 and January 2014, and banks’ reserve requirement was reduced by two percentage points. Monetary policy was again loosened in September by limiting banks’ access to the standing deposit facility (SDF)—a measure that was eliminated in late March 2015. Policy rates reached record lows, but excess liquidity in the banking system was persistently high during much of 2014. Private credit growth has recently started to rise—reaching 8.8 percent through December 2014 and 11 percent through January 2015. Reserve and broad money growth registered 18.3 and 13.4 percent growth in 2014, respectively.

9. Financial sector indicators are mixed, but reflect a bottoming-out of nonperforming loans largely linked to gold pawning. 2 As of end-2014, nonperforming loans (NPLs) of the banking system declined to 4.2 percent of total loans, compared with 5.6 percent as of end 2013 and a peak of 6.2 percent in mid-2014. The decline in the NPL ratio reflected the gradual resolution of problem assets related to gold pawning, as well as a reduction in banks’ pawning activity in general. Profitability showed modest improvement. Return on equity (ROE) for the banking system rose from 16.0 to 16.5 percent between end-2013 and end-2014, while return on assets (ROA) increased from 1.3 to 1.4 percent. Net interest margins remained broadly unchanged in 2014 from end 2013 at 3.5 percent, despite a compression of interest rates. The new government has decided to suspend and review the financial sector consolidation plan initiated by the CBSL in 2014.


10. The outlook is broadly stable but set against heightened downside risks. Real GDP growth is projected at 6.5 percent in 2015 and beyond—in line with the staffs estimate of potential output. While there is considerable growth momentum in a number of sectors, the modest cooling reflects uncertainty regarding a number of supporting pillars of economic activity, including:

  • The potential impact of lower public investment. The revised budget targets a relatively low level of public investment compared to the original budget, and a number of projects are also under review.

  • A dampening effect in the short run of policy uncertainty on private investment. Higher domestic consumption supported by increases in wages and salaries under the new budget may not fully compensate.

  • The impact of an expanded fiscal deficit on private credit. Under status quo policies, the overall deficit could approach 7 percent of GDP in 2015 and higher in subsequent years as one-off tax measures expire—effectively crowding out private credit through a higher domestic borrowing requirement.

  • Negative spillovers from slower economic recovery in Europe—one of Sri Lanka’s two most important export markets.

11. On the positive side, price pressures are expected to remain contained, with headline and core inflation projected at 3.2 and 2.3 percent, respectively. Externally, the current account deficit is projected to narrow to 2 percent of GDP in 2015, driven by lower international commodity prices, relatively robust exports to the U.S., and continued growth in tourism receipts. Increases in public sector wages together with the wealth effect from lower fuel and electricity prices are expected to induce higher consumer good imports. FDI is projected to remain stable (albeit subject to the same risks to investment cited above). Increased sovereign financing and a gradual recovery of private sector inflows (mostly equities and loans to SOEs), are expected to help finance the current account deficit and increase gross reserves. However, extended policy uncertainty could potentially undermine these inflows and negatively affect the balance of payments.

Box 1.Sri Lanka: Key Features of the Revised 2015 Budget

Shortly after taking office, the new coalition government introduced a revised 2015 budget, The revised budget brought a number of significant changes compared with the budget passed under the previous regime in November 2014. The revised budget targeted further fiscal consolidation within the context of a significant shift in composition of expenditure. Some of the more important changes include the following:

  • Introduction of one-off revenue measures, including a “super gains tax” on companies and individuals with profits over Rs. 2 billion in 2013/14.

  • Introduction of a “mansion tax” on homes above Rs 100 million in value.

  • Payment by selected public institutions of profits, dividends and levies which were not “properly” transferred to the central government as non-tax revenue.

  • An increase in public employee’s monthly wages by Rs 10,000—an effective 47 percent increase compared to the 2014 average wage. This is to be accompanied by an increase in pension payments (Rs 1,000 per month) for retired public servants; and a 200 percent increase in the monthly payments under the Samurdhi welfare scheme.

  • Reduction of public investment spending on infrastructure by 30 percent compared to the original budget.

20142015 Budget (% of GDP)
Total Revenue and Grants11.714.914.3
Total Expenditures17.719.518.7

Fuel and commodity prices were also reduced. The new government lowered LP gas prices by 16 percent, diesel by 14.4 percent, petrol by 22 percent and kerosene by 20 percent. Prices of 13 essential food items were also reduced by lowering the special commodity levy and custom duties.

12. The macroeconomic framework presented herein reflects the authorities’ current policy framework and makes no assumptions regarding reforms which may emerge following the next round of elections. In this sense, the framework presents an incomplete picture for 2016 and the medium-term. While useful to highlight the risks of policy inaction, the framework may nonetheless be pessimistic in assuming a status quo with respect to current policies. The framework will be updated at the earliest opportunity, based on reform measures that take shape over the remainder of this year.

Policy Discussions

A. Maintaining Fiscal Discipline

13. The revised 2015 budget targets continued fiscal consolidation, but seeks to finance a significant boost to current spending largely through one-off revenue measures. The deficit under the new government’s revised budget is targeted to fall to 4.4 percent of GDP, from an estimated 5.9 percent of GDP in 2014. A number of significant changes were made to the original 2015 budget (passed in November 2014). First, it changed considerably the composition of spending: current spending was increased significantly, mainly due to higher wages and transfers, while capital spending was reduced. Second, it introduced a number of mostly one-off revenue measures.3 In total, the combined revenue measures from the original and revised budgets are now estimated by the authorities to yield 1.3 percent of GDP. About two thirds of this is to come from taxation of past excess profits and from bank-financed repayment of tax arrears. The budget also assumes 0.4 percent of GDP of administrative costs savings due to rationalization of wasteful expenditure and lower fuel and electricity prices.

14. Staff welcomed the authorities’ commitment to continued fiscal discipline, but argued that the 2015 deficit target would be very difficult to reach and that the current path put medium-term consolidation and debt reduction at risk. Even assuming that one-off measures yield the estimated revenues, underlying revenues (excluding the measures) would still have to grow in excess of 20 percent compared to 2014 to reach the revenue target, which appears unlikely. Further, unlike in previous years when revenue shortfalls were offset by lower capital spending, there is much less room for similar adjustment in 2015 as capital spending has already been compressed in the budget.4 The use of one-off measures like the super gains tax is also not, in the staff’s view, a move toward a more effective tax system, and creates additional problems for 2016 and beyond. In the absence of new measures to create a more durable increase in tax collection, revenues in 2016 will drop as the one-off measures expire, while the permanent increase to recurrent spending will push the deficit even higher—raising the level of risk to debt sustainability.5

15. Staff argued that maintaining sound public finances will be a difficult policy challenge, and recommended a two-step strategy. The short-term (2015) objective should be to avoid a large increase in the fiscal deficit Resorting to further ad hoc revenue measures is not advisable, and thus the main tool should be expenditure management Specifically, staff recommended the following options: (i) savings within non-wage recurrent expenditure of central government (which, despite the cost savings mentioned above, is still projected to increase by 0.4 percent of GDP); (ii) consider delaying the second wave of increases (the first wave having come into effect in February) to public wage, salary and pension payments; and (iii) some additional reduction in low-impact capital expenditures (i.e., those deemed to have comparatively low social or growth impact). For the medium term, the emphasis should be on strengthening the tax system. Forthcoming technical assistance will address these issues in detail, taking into account the many changes since the last major tax mission in 2009. However, fundamental pillars of a medium-term fiscal reform strategy could include:

  • The practice of providing new tax exemptions should be terminated. The government should also avoid reversing previous measures on centralized control over new tax exemptions (such as giving such control back to the Board of Investment).

  • A comprehensive review of existing tax expenditures should be conducted with a view to evaluating their cost and formulating a strategy for their elimination.

  • A review of tax expenditures should be accompanied by a diagnostic assessment of the structure of taxation.6 A meaningful simplification of the tax regime is needed, with a view to broadening the base and improving tax administration and collection—ideally to be implemented as part of the 2016 budget.

  • A medium-term framework for fiscal consolidation and debt reduction remains essential. The steady reduction in the fiscal deficit since 2009 and accompanying decline in public debt have been linchpins of macroeconomic stability and confidence. The government should move quickly to reestablish a credible medium-term macro-fiscal framework (as has been done in the past under the Fiscal Management (Responsibility) Act (FMRA) to anchor policies and expectations.7

16. The authorities emphasized their commitment to continued fiscal consolidation, while moving to a more progressive tax system. They recognized that meeting the 2015 revenue and deficit targets could be challenging, but were encouraged by a strong excise and customs revenues in early 2015. They expressed determination to address weak revenue performance after the election. While the authorities were not ready to provide specifics, they suggested that the measures should include reduction in tax exemptions and simplification of the tax system. In the meantime, the authorities said that they intend to pursue tight expenditure control to contain the deficit. Specifically, they saw some scope for delaying domestic financed capital projects. They also highlighted ongoing work toward a comprehensive review of government debts and efforts to renegotiate some bilateral loans to lower debt servicing costs. With respect to the medium-term, the authorities reiterated their commitment to financial responsibility. They noted that the FMRA remains in effect and will remain a useful framework for guiding policies.

B. Monetary Policy

17. Monetary policy continued to be accommodative during 2014—facilitating a pick-up of private sector credit late in the year. Although policy rates and reserve requirements remained unchanged in 2014, the CBSL introduced two additional measures in an effort to spur private credit growth. In January, the CBSL compressed the Standing Rate Corridor by 50 basis points. In September, with year-on-year private credit growth at less than 3 percent and substantial excess liquidity in the banking system, the CBSL limited banks’ access to its Standing Deposit Facility (SDF) to a maximum of three times per month, with further access available only at a penalty rate. Private credit growth was on a steady upward trend through the remainder of 2014 and into 2015, and banks’ excess liquidity has declined. The limited access to the SDF was eliminated in March 2015.

Sri Lanka - Private Credit, NPLs and Liquidity

(In percent or billions of rupees)

Sources: Central bank of Sri Lanka, staff estimates

18. While the CBSL’s accommodative stance helped to facilitate a pickup in private credit in the context of low inflation, there have been side effects. First, while the compression of interest rates does not appear to have adversely affected bank profitability, it seems to have negatively impacted investor appetite for government securities. The steady decline in rates was reportedly a factor behind a non-rollover of a July 2014 maturity by foreign investors—lowering the level of foreign ownership of Sri Lankan securities below 11 percent for the first time since 2012. Second, the removal of the limits on the access to the SDF added some volatility to short-term interest rates—complicating management of liquidity conditions in the interbank money market.

19. The mission advised that monetary policy be kept on hold for the short-term but that the central bank be prepared to tighten if signs of overheating emerge. First, given the long lags in monetary policy transmission, the effects of earlier steps to loosen may yet be emerging. Second, some slowdown in fourth quarter growth argues against any immediate move toward tightening. However, the incipient rise in private credit, combined with the substantial boost to domestic demand likely to come from the interim budget, and a gradual pickup in inflation so far in 2015 suggest that the credit cycle has turned and that the central bank may need to tighten in the near term to forestall any undue pressures later in the year. The mission also noted support for the resumption of work toward establishing an inflation targeting framework (to be supported by IMF technical assistance).

20. The authorities agreed on the need to remain vigilant given the changing environment. They noted that they are adequately equipped with policy tools to react to a possible fiscal expansion, and similarly ready to adjust to a lower growth scenario. The authorities were not particularly concerned with recent external pressures, and highlighted that the recent firming of rates on the long end of the yield curve might mitigate net outflows.8 For the time being, they do not envisage any major policy move in either direction, and expect private credit to grow as high as 18 percent in 2015—which they saw as acceptable given the decline in private credit/GDP over the last two years.

C. External Sustainability

21. Recent balance of payments developments highlight three key trends: (i) a leveling-off of goods exports; (ii) an unwinding of import compression; and (iii) a weakening of capital inflows. On goods trade, the recovery in exports that began in mid-2013 appears to have reached a plateau under current conditions of competitiveness and market structure. With respect to imports, recent data suggest a reversion to the mean, as monthly nonoil imports (particularly consumption and intermediate goods) returned closer to historical norms in the second half of 2014 and into 2015. The shift to a more balanced export/import profile is consistent with recent growth performance, but also adds some pressure on the balance of payments. Market uncertainty regarding the direction of macro policies, and the substantial decline in interest rates may also be dampening net capital inflows.

22. The external sector outlook for 2015 appears favorable, but there are several risks. First, the sharp drop in oil prices produces a substantial windfall for Sri Lanka’s import profile—equivalent to about $2 billion for 2015 as a whole, or roughly 2 percent of GDP. Even assuming a substantial pass-through from higher wages and salaries to imports, there should be a substantial net gain. Assuming goods exports remain in the current range, the improvement in the trade balance should provide a cushion to the overall balance of payments. With capital flows at comparatively normal levels, net inflows should be sufficient to keep central bank foreign exchange reserves in the range of 3.5 to 4 months of imports. Risks to this outlook are not insignificant, however, and include (i) an eventual reversion of the oil price shock; (ii) a slowdown in goods exports in the event growth in key export markets stalls; and (iii) less optimistic assumptions regarding net capital flows.

23. Econometric analysis does not suggest a fundamental misalignment of the exchange rate. In light of significant shifts in the external environment since the 2014 Article IV Consultation, the staff updated the exchange rate analysis to assess the current level of the exchange rate. The External Balance Assessment (EBA) methodology points to an overvaluation of about 5 percent, with more than half of policy gaps explained by the fiscal balance to GDP and health expenditures. The CGER approaches suggest mixed results—the macro balance and external sustainability approaches pointing to an undervaluation of 2–4 percent, while the equilibrium exchange rate approach suggested an overvaluation of about 7 percent.

24. Qualitative analysis suggests the rupee has entered a period of downward pressure. Since September 2014, when imports began to rise, there has been a steady pattern of central bank sales of foreign exchange to the market. Net foreign exchange sales by the CBSL amounted to some US$812 million in September 2014 to mid-March 2015, compared to a net absorption of about US$1 billion during January–August 2014. Despite the favorable outlook for the balance of payments with respect to trade in goods and services, market expectations (based on forwards) are leaning toward a depreciation of the rupee.

Sri Lanka: Exchange Rate and Cumulative Foreign Exchange Intervention, 2013-2015

Sources: Central Bank of Sri Lanka, staff calculation

Sri Lanka: Evolution of Gross Reserves, 2013-2015

(In US$ billions)

Sources: Central Bank of Sri Lanka

25. Staff emphasized that exchange rate flexibility should be allowed to facilitate adjustment and to protect reserves. While the evidence does not suggest the exchange rate is fundamentally out of alignment, continued intervention appears to be impeding a market adjustment. Particularly given CBSL’s foreign exchange reserves falling well below the IMF’s standard metrics for adequacy, allowing depreciation is preferable to a continued drain on reserves. Staff further observed that, even if not justified by the underlying fundamentals (projected developments in balance of payments), forward market data indicate expectations of depreciation in the near-term and that volatility has risen from historically low levels and could rise further amid increasing divergence of monetary policy stance among advanced economies. Looking ahead, the staff stressed that, although Sri Lanka is less exposed to volatile capital flows than many EMs given the cap on ownership of government securities, shifts in investor sentiment (given policy uncertainty) could pose additional risks, and that the exchange rate would need to bear some of the adjustment burden should these risks materialize.

Box 2.Sri Lanka: Potential BOP Impact of Adverse Scenario

An adverse external financing scenario illustrates how a potential slowdown in capital inflows could diminish CBSL foreign exchange reserves. This scenario assumes concurrent shocks to growth and the financial account of the balance of payments in line with downside risks highlighted earlier. It assumes a small policy adjustment (nominal exchange rate depreciation) but no new measures to reduce the fiscal deficit or any increase in policy rates.

The main shock assumptions—drawn from past crises, discussions with the authorities and market participants—include the following:

  • A sharp decrease in non-resident exposure to Sri Lankan T-bills and T-bonds (T bill and T-bond rollovers at 25 and 30 percent in 2015, improving to 50 and 55 percent, respectively, in the first half of 2016), and lower rollovers for non-concessional loans.

  • Equity outflows of about 12.5 percent of total non-resident equity holdings—distributed evenly between the second half of 2015 and in the first half of 2016.

Sri Lanka: Illustrative Adverse Scenario--Impact on CBSL Reserves

Under a relatively static shock (i.e., minimal adjustment as noted above), the potential drain on central bank foreign exchange reserves could be significant—potentially bringing Sri Lanka’s reserve cover below three months of imports, and well below the IMF’s reserve adequacy metrics.

26. The authorities agreed on the generally positive outlook for the balance of payments, reiterated their commitment to exchange rate flexibility, but underscored the importance of timing. Specifically, the authorities noted that greater flexibility needs to be synchronized with foreign inflows such as sovereign bond issuance. They mentioned that the recent stability of the rupee should not be interpreted as a lack of commitment to greater exchange rate flexibility, but rather, a search for optimal timing. They further noted that developments in the global economy would also affect future actions with respect to intervention and exchange rate policy. Regarding the global context, the authorities argued that positive developments with respect to growth in the U.S. would provide some momentum to the Sri Lankan economy. They also saw potential benefits from a more active approach to building markets—including through a potential new trade agreement with China and existing trade agreement with India and Pakistan, as well as regaining preferential access to the EU market through the Generalized System of Preferences (GSP). In case risks to the balance of payments materialize, the authorities agreed that the exchange rate should be the one of the first lines of defense. But other measures, including a new swap line with India9, are also being used to bolster the external position and prepare for external volatility in the months ahead.

D. Financial Sector

27. Financial sector risks appear manageable, with recent data suggesting improved profitability and lower non-performing loans. For the system as a whole, the capital adequacy ratio edged downward from 16.3 percent in 2013 to 15.6 percent by end-2014. However, the sizeable increase in nonperforming assets that began with the sharp fall in gold prices 2012 appears to have reached its peak. Banks have reduced their exposure to gold pawning activity by some 50 percent, and enforced tighter loan-to-value ratios.10 Overall profitability, as measured by ROE and ROA, has improved for the system as a whole. The bottoming-out of pawning related provisioning is likely to have a favorable impact on bank bottom lines going forward. Some problematic nonbank financial institutions (NBFIs) are being dealt with on a case by case basis.11

28. The mission welcomed continued improvements in the area of bank supervision (included consolidated supervision) and regulation. In particular, steps have been taken toward adopting the three pillars of the Basel II Accords, with guidelines issued to banks regarding approaches for market and operational risks. An Information Sharing Act (to facilitate information exchange between regulators and supervisors in the country) has received cabinet approval and is being drafted for submission to Parliament. However, progress has been slower with respect to supervision of nonbank financial institutions, and the adoption of a broader crisis management framework that would incorporate the entire financial sector. Forthcoming technical assistance should help to identify key priorities for reform.12

29. The financial sector consolidation process has been halted by the new government, and an ongoing review is considering ways forward. At the time of the change of government only five consolidation (merger) transactions had been completed, but with a significant number agreed in principle. The process has been suspended pending both the next round of elections and the findings of a review committee. The committee is comprised of senior representatives from the banking community, and is expected to report on its findings in April. Staff expressed concern about the need for timely decisions on the way forward to reduce uncertainty in the financial system.

30. The authorities noted staff’s concerns over consolidation plans, broader supervision and lower capital adequacy ratios. They expressed assurance that the committee selected by the government will consider carefully the pros and cons of consolidation in the bank and nonbank sectors. The CBSL also expressed confidence that completed transactions under the plan will not be reversed. The authorities agreed on the need to conduct regular stress testing of the banking system, adopt a consolidated supervision framework including NFBIs and develop a clearly defined and well documented financial crisis management plan for the entire financial system. They welcomed the Fund’s technical assistance in this area. On capital adequacy, the authorities noted that one large state owned commercial bank has been provided budgetary provisions to support expansion and enhance its resilience to shocks.

Post Program Monitoring

31. Sri Lanka’s capacity to repay the IMF remains broadly adequate. Exposure to the IMF currently stands at SDR 757.9 million (about US$1.05 billion—1.3 percent of projected 2014 GDP and 16.6 percent of current gross central bank foreign exchange reserves). Repayments to the IMF stretch into mid-2017, but Sri Lanka’s outstanding credit from the Fund has fallen to 183 percent of quota (below the 200 percent threshold for post-program monitoring). External debt remains broadly sustainable, but as highlighted by the most recent debt sustainability analysis, significant vulnerabilities remain with respect to exchange rate risk and baseline assumptions on growth and the course of fiscal consolidation. The cost of external debt has also risen sharply in recent years as Sri Lanka continues to shift from concessional, bilateral debt into new external loans on commercial terms. The low revenue base also implies limited fiscal maneuvering room and very high debt- and debt service-to-revenue ratios. Reserves have also fallen below the Fund’s standard adequacy metrics in the past few months. Given heightened risks and desirability of maintaining close engagement, the staff recommends an extension of post-program monitoring for one year.

Evolution of Gross Reserves

(In billions of U.S. dollars)

Source: IMF staff estimates.

Sri Lanka: Reserve Metrics Dynamics

(In percent)

Source: IMF staff estimates.

Staff Appraisal

32. Sri Lanka’s recent performance has been strong in aggregate but a combination of domestic and external factors have significantly raised the level of risk. Externally, Sri Lanka faces the same challenges as other frontier emerging markets, including continued slow global growth and divergence between Sri Lanka’s two key export markets (the EU and the U.S.), volatile commodity markets, the prospect of tighter liquidity and potentially less investor appetite for Sri Lankan securities. Domestically, the prospect of higher fiscal deficits is a serious concern given the high level of public debt and lack of fiscal maneuvering room. The external balance of payments is likely to benefit from lower oil prices, but this is not guaranteed, nor is it clear how long oil prices will remain at current low levels. The boost to consumption from the interim budget will spill over into imports and could be larger than expected. The increase in consumption may spur growth, but dampening effects could come from delays in public and private investment, and wavering confidence should policy uncertainty continue.

33. The fiscal situation constitutes Sri Lanka’s single biggest macrofinancial vulnerability and should be addressed expeditiously. The reduction in the overall deficit since 2009 is a noteworthy accomplishment. However, the staff remains of the view that reliance on expenditure constraint as a means of reaching fiscal targets has already reached its limit—as evidenced by the outturn for 2014 where continued cuts to current and capital spending were unable to keep pace with the decline in revenue as a share of GDP. The interim budget targets a level of fiscal consolidation which seems unlikely even under optimistic assumptions. The staff strongly urges the authorities to exercise what cost savings are possible (and prudent with respect to high value-added spending on physical and social infrastructure) to keep the deficit under control for 2015.

34. The medium-term fiscal outlook clearly signals the need for a revamping of tax policy. Reform in this area is long overdue, and the staff sees significant risk in the absence of reforms. The staff is cognizant of the constraints imposed by the current political timeline, but emphasizes the need to proceed quickly with the technical work on reform options in the interim—with a view to formulating a set of measures that could be implemented in concert with the 2016 budget (normally presented to parliament in November). Fundamental elements in a reform package should include a comprehensive reduction in exemptions and tax holidays, a streamlining of the tax structure, and continued efforts to boost tax administration and collection capacity. A clear and credible medium-term macro-fiscal framework that supports consolidation and debt reduction is essential.

35. Monetary policy is broadly appropriate but faces a diverse set of risks. Inflation is contained at a comfortably low level, and external push factors appear modest. Private credit has begun to recover, and given the relatively high level of excess liquidity remaining in the banking system and the sharp drop in financial intermediation (private credit/GDP) over the past two years, has room to rise further. However, with credit cycle now appears to be turning a corner. Given the long lags in monetary transmission, and the prospect of higher domestic demand, the CBSL should be prepared to tighten monetary policy should signs of overheating emerge.

36. The overall balance of payments is expected to strengthen, but the authorities should shift focus to exchange rate flexibility as a means of preserving a limited reserve cushion. The sizeable windfall (an estimated $2 billion or about 2 percent of GDP in 2015) from lower oil prices is likely to ease pressure on the balance of payments from the goods side. Econometric evidence does not suggest the exchange rate is fundamentally misaligned. However, the steady and one-sided nature of central bank intervention, combined with a not insignificant degree of real effective appreciation as a result of low inflation and exchange rate movements among major currencies, suggest the need for exchange rate flexibility. Particularly given Sri Lanka’s limited reserve cushion, the central bank should refrain from sustained intervention to support the rupee in the face of strong market pressures.

37. The staff recommends extending the post-program monitoring framework for one year given heightened external vulnerabilities and the need to maintain close engagement for the near future while work on a medium-term set of macroeconomic policies and structural reforms is underway.

Figure 1.Sri Lanka: Macroeconomic Developments

Figure 2.Sri Lanka: Interest Rates

Figure 3.Sri Lanka: Foreign Exchange and Reserves

Table 1.Sri Lanka: Selected Economic Indicators, 2012–20
GDP and inflation (in percent)
Real GDP growth6.
Inflation (average)
Inflation (end-of-period)
Core inflation (end-of-period)
Savings and investment (in percent of GDP)
National savings23.926.023.925.925.625.625.425.525.7
National Investment30.629.927.627.928.228.328.428.528.7
Public finances (in percent of GDP)
Central government balance−6.5−5.9−5.9−6.7−7.4−7.3−7.2−7.4−7.4
Central government domestic financing4.
Government debt (domestic and external)79.278.375.977.
Money and credit (percent change, end of period)
Reserve money10.20.918.315.113.513.513.413.713.6
Broad money17.616.713.413.213.513.513.413.713.6
Domestic credit21.713.510.69.812.512.312.212.312.2
Credit to private sector17.
Credit to government29.624.612.920.827.823.120.419.318.1
Balance of payments (in millions of U.S. dollars)
Current account balance−3,981−2,606−2,790−1,639−2,282−2,557−3,131−3,408−3,682
Current account balance (in percent of GD−6.7−3.9−3.7−2.0−2.6−2.7−3.0−3.0−3.0
Export value growth (percent)−
Import value growth (percent)−5.3−
Gross official reserves (end of period) 1/
In millions of U.S. dollars7,1067,4958,2169,30110,16411,24411,89813,23414,485
In months of imports4.
External debt (public and private)
In billions of U.S. dollars37.139.742.645.147.650.353.258.563.3
As a percent of GDP62.558.957.156.054.452.751.051.451.0
Memorandum items:
Nominal GDP (in billions of rupees)7,5798,6749,74110,57711,65112,94414,47516,18618,100
Sources: Data provided by the Sri Lankan authorities; and IMF staff estimates.
Table 2.Sri Lanka: Summary of Central Government Operations, 2012–20 1/(In percent of GDP)
Total revenue (including grants) 2/13.212.411.713.312.412.612.913.113.3
Total revenue13.012.211.613.112.312.512.913.113.3
Tax revenue11.210.610.111.410.811.011.411.611.7
Income taxes2.
Excise taxes2.
Other trade taxes1.
Nontax revenue1.
Total expenditure and net lending 1/19.718.317.720.019.819.920.120.520.7
Current expenditure14.413.
Civil service wages and salaries2.
Other civilian goods and services0.
Security expenditure (including contingency)
Subsidies and transfers3.
Interest payments5.
Capital expenditure and net lending5.
Overall balance of the central government−6.5−5.9−5.9−6.7−7.4−7.3−7.2−7.4−7.4
Net external financing2.
Net domestic financing4.
Memorandum items:
Primary balance (excluding grants)−1.3−1.0−1.8−2.3−3.2−3.0−2.8−2.6−2.6
Total public debt79.278.375.977.
Domestic currency42.744.243.942.444.546.548.550.352.1
Foreign currency36.534.132.034.633.631.729.527.625.9
Nominal GDP (in billion of rupees)7,5798,6749,74110,57711,65112,94414,47516,18618,100
Sources: Data provided by the Sri Lankan authorities; and IMF staff estimates.
Table 3.Sri Lanka: Monetary Accounts, 2012–16(In millions of rupee, unless otherwise indicated, end of period)
(Stocks, in billions of Sri Lankan rupees)
Central Bank of Sri Lanka
Net foreign assets396529690762819
Net domestic assets88−41−112−97−65
Net claims on central government279114147108155
Other items, net−192−170−277−222−237
Reserve Money484489578665754
Monetary survey
Net foreign assets−26−76177698
Monetary authorities396529690762819
Deposit money banks−422−605−673−686−721
Net domestic assets2,9553,4943,8584,3134,881
Net claims on central government1,0451,3011,4361,7432,301
Credit to corporations2,6512,8993,2043,3513,431
Public corporations292365446531605
Private corporations2,3582,5342,7582,8202,826
Other items (net)−742−707−783−781−851
Broad money2,9293,4183,8764,3894,979
Memorandum Items
Gross international reserves (US $millions)7,1067,4958,2169,30110,164
Net international reserves (US $millions)4,1625,1496,5248,0829,419
Private credit/GDP31.129.228.326.724.3
Money multiplier6.
Broad money velocity 1/
(Annual percentage change)
Broad money17.616.713.413.213.5
Reserve money10.20.918.315.113.5
Credit to public corporations47.324.822.219.113.9
Credit to private sector17.
Sources: Central Bank of Sri Lanka; and IMF staff projections.
Table 4.Sri Lanka: Balance of Payments, 2012–20, BPM6(In millions of U.S. dollars, unless otherwise indicated)
Current account−3,981−2,606−2,790−1,639−2,282−2,557−3,131−3,408−3,682
Balance on goods−9,417−7,608−8,299−7,401−8,580−9,347−10,394−11,336−12,074
Goods credit (exports)9,77310,39411,11812,04212,99114,43616,07817,86019,964
Goods debit (imports)−19,190−18,003−19,417−19,443−21,571−23,782−26,471−29,196−32,038
Non-oil imports−14,145−13,695−14,820−16,769−18,298−19,978−22,141−24,342−26,603
Consumer goods−2,995−3,182−3,853−4,536−4,684−5,242−5,825−6,436−7,164
Intermediate goods−6,560−6,259−6,815−7,502−8,397−9,007−10,022−11,012−12,206
Investment goods−4,590−4,253−4,152−4,731−5,217−5,729−6,294−6,893−7,233
Oil imports−5,045−4,308−4,597−2,673−3,273−3,804−4,331−4,854−5,435
Credit (exports)3,8004,6855,4586,2437,0807,8288,7639,89510,880
Debit (imports)−2,538−3,505−4,005−4,801−5,307−5,800−6,340−6,875−7,456
Primary income, net 1/−1,218−1,817−2,140−2,236−2,385−2,548−2,724−2,916−3,125
Secondary in come, net 2/5,3925,6396,1966,5556,9107,3097,5647,8258,094
Capital account (+ surplus / - deficit)1317161168101102102102102
Balance from current account and capital accoun−3,850−2,535−2,729−1,471−2,181−2,456−3,029−3,306−3,580
Financial account (+ net lending / - n et bo rrow−4,273−3,120−2,538−1,471−2,181−2,456−3,029−3,306−3,580
Direct investments−877−850−763−771−862−965−1,078−1,205−1,346
Portfolio investments−2,125−2,106−1,943−1,610−732−555−130−758−839
Other investments−2,031−1,275−552−175−1,449−2,016−2,475−2,679−2,645
Of which : Loans−3,081−942−801−45−1,319−1,911−2,395−2,599−2,565
Central bank 3/−791459690472475252000
Deposit taking corporations−579−124−680−200−250−450−450−450−350
General government−992−821−485−248−658−690−748−833−833
Other sectors−719−456−326−69−886−1,023−1,197−1,316−1,382
Change in reserve assets7601,1127211,0858621,0806541,3371,250
Errors and omissions−422−584191000000
Memorandum items:
Current account (in percent of GDP)−6.7−3.9−3.7−2.0−2.6−2.7−3.0−3.0−3.0
Gross official reserves /47,1067,4958,2169,30110,16411,24411,89813,23414,485
(In months of imports of goods and nonfacto4.
(In percent of composite metric)1019898107110113110112114
Net international reserves4,1625,1496,5248,0829,41910,75011,40512,74113,991
Sources: Data provided by the Central Bank of Sri Lanka; and IMF staff estimates and projections.
Table 5.Sri Lanka: Projected Payments to the Fund, 2015–20 1/(In millions of SDR, unless otherwise indicated)
Fund repurchases and charges
In millions of SDR332.9331.1173.
In millions of U.S. dollars468.6466.0243.
In percent of exports of goods and NFS2.
In percent of quota80.580.
In percent of gross official reserves5.
Fund credit outstanding
In millions of SDR5001720.
In millions of U.S. dollars7032420.
In percent of quota121420.
In percent of GDP0.
In percent of gross official reserves7.
Memorandum items:
Exports of goods and services (in millions of U.S. dollars)18,28520,07122,26324,84127,75530,844
Quota (in millions of U.S. dollars)582600604607613619
Gross official reserves (in millions of U.S. dollars)9,30110,16411,24411,89813,23414,485
GDP (in millions of U.S. dollars)80,59187,46195,474104,222113,771124,196
Source: IMF staff estimates.
Table 6.Sri Lanka: Financial Soundness Indicators—All Banks, 2010–14
Capital adequacy
Regulatory capital to risk weighted assets16.216.016.416.317.016.916.915.6
Tier 1 capital/risk weighted assets14.314.414.713.714.414.414.313.1
Capital to assets ratio8.
Asset quality
Gross nonperforming loans to total gross loans (without interest in suspense)
Net nonperforming loans to total gross loans3.
Provision coverage ratio (total) 1/
Earnings and profitability
Return on equity (after tax)22.019.820.316.016.115.316.516.5
Return on assets (after tax)
Interest income to gross income83.185.586.369.785.786.085.385.1
Staff expenses to noninterest expenses45.244.245.844.945.144.644.243.4
Personnel expenses to total income12.012.210.725.010.410.810.610.5
Total cost to total income72.
Net interest margin4.
Liquid assets to total assets31.126.826.631.933.834.133.432.2
Assets/funding structure
Capital to external funds9.510.
Credit to deposits76.484.787.482.279.077.979.683.1
Source: Central Bank of Sri Lanka.

Reserves declined mostly due to a sovereign bond repayment ($500 million) and settlement of ACU liabilities ($400 million).

Pawning is a form of collateralized lending based on gold jewelry or biscuits, and is a significant lending product in many Sri Lankan banks and nonbank financial institutions (NBFIs). Pawning loans are usually 12 months, with little restriction on their use. The sharp drop in gold prices in 2012 had a significant negative impact on such loans.

The most significant of which is a “super gains tax” – a 25 percent retroactive tax on individuals or companies that earned more than Rs 2 billion in profit in 2013/14.

The new government has stated that it will carefully review all new projects in the pipeline, but continue with existing capital projects. However, anecdotal evidence suggests that the review process has extended to a wider range of investment projects.

Public debt is estimated at 76 percent of GDP in 2014. The last Debt Sustainability Analysis (DSA) was discussed in July 2014 as part of the Article IV Consultation, and assessed Sri Lanka’s public debt as sustainable but subject to relatively high risks. The next DSA is slated for early 2016 in line with plans for the Article IV Consultation.

IMF technical assistance missions on tax expenditures, tax policy, and public financial management were conducted in March-April 2015, with final reports currently under preparation.

In line with recommendations from the 2014 Article IV Consultation (see ISCR 14/286), staff believe a long-term anchor under this strategy could be a target for public debt to GDP of 50 percent, with appropriate interim (i.e., medium-term) objectives. Staff intends to resume detailed discussion of medium- and long-term fiscal objectives in the next post-program monitoring mission.

The authorities were also of the view that reducing exposure to non-resident ownership of government securities was prudent (the limit had been expanded at a time when the need for external financing was more acute).

The Reserve Bank of India (RBI) on March 25, 2015 signed a US$400 million currency swap agreement with the Central Bank of Sri Lanka for three years that will allow the CBSL to draw the amount in dollars or Euros in multiple tranches.

However, with a partial market risk guarantee introduced by the CBSL from June 2014, effective LTV ratios in participating institutions have been raised to around 80 percent—close to pre-crisis levels.

The legal foundation for non-bank supervision is provided by the Finance Business Act and the Finance Leasing Act. In general, supervision of NBFIs is similar to that of banks. However, the crisis management framework is not uniform. Current NBFIs under consideration by the CBSL are “legacy” cases from past years.

A multi-faceted MCM mission centered on financial sector stability and supervision is expected in the near future.

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