1. On behalf of our Sri Lankan authorities, we would like to thank staff for candid discussions and the comprehensive and balanced assessment of the macroeconomic developments and outlook of the Sri Lankan economy under the third Post-Program Monitoring (PPM).
2. The discussions were held in Sri Lanka just after a few weeks of the presidential election held in January 2015, which led to the formation of a new Government. The new administration has placed special emphasis on the implementation of projects identified under its 100-day program, which included far reaching constitutional, institutional and social welfare reforms aimed at strengthening good governance and transparency, promoting equity and reducing poverty. The much awaited constitutional reforms are mainly focused on transferring certain executive powers currently held by the President to the Parliament and establishment of independent judiciary, police, election, public service and anti-corruption commissions. These constitutional amendments have already been forwarded to the Parliament. Although the government formed after the Presidential election has no clear majority in the Parliament, many members are likely to support constitutional reforms irrespective of political differences. The Government is also planning to call for a Parliamentary election early to ensure political stability. This will enable the new government to come up with a firm medium term macroeconomic policy framework to spur growth, strengthen stability and to address emerging imbalances in certain sectors of the economy. Therefore, our authorities share the staff’s view that as a firm medium term policy agenda of the new government will be available only after the Parliamentary elections, the medium term analysis presented in the report is incomplete.
3. The SBA supported program, which was successfully completed in 2012, helped Sri Lanka to strengthen its macroeconomic stability and build policy space. Our authorities broadly agree with the thrust of the staff assessment and stand ready to continue the close engagement with the Fund and have indicated their willingness to continue with the PPM, though technically it is not necessary, as outstanding borrowings from the Fund have now fallen below the threshold level that generally calls for PPM.
Economic Growth and Outlook
4. The growth momentum of the Sri Lankan economy continued while inflation remained contained. The economy grew by 7.4 percent in 2014 compared to the growth of 7.2 percent in 2013. The strong performance in the industry and services sectors, supported by recovering external demand, helped maintaining the growth momentum. The industry sector, which grew by 11.4 percent, bolstered by construction and manufacturing activity, contributed nearly 48 per cent to the GDP growth. The services sector growth of 6.5 percent was largely contributed by trade, tourism, transport, communications and banking and real estate sectors. The agriculture sector, which was affected by adverse weather conditions in 2014, grew only marginally.
5. Our authorities have projected 7 percent growth for 2015. While a low interest rate environment coupled with low inflation, along with improved business conditions, would help to maintain the growth momentum, expected Parliamentary elections and postponement of certain development projects, which are pending a review by the new administration, would slow the growth to some extent. Expected continuation of the global recovery and a growth supportive policy framework which is expected after the Parliamentary elections, would also help sustaining the growth momentum.
6. In terms of the Medium Term Macro Fiscal Framework (MTMFF), the 2014 budget envisaged further strengthening of fiscal consolidation by enhancing revenue collection, containing non-priority expenses and maintaining public investments at a higher level. However, the 2014 fiscal outcome reflected deviation from the original targets, mainly due to weak revenue performance, which declined to 12.2 percent of GDP compared to the targeted 14.5 percent of GDP. As a result, the budget deficit increased to 6.0 percent of GDP in 2014 in comparison to the targeted 5.2 percent, reversing the declining trend observed since 2009.
7. Our authorities recognize that the continued weak revenue mobilization has been the key challenge of fiscal consolidation. Recent efforts to enhance revenue collection including measures to broaden the tax base, improve the tax administration and to rationalize tax exemptions have not produced the expected outcome. The recent IMF TA Mission on Tax Policy has proposed important reform strategies, especially in the area of income taxation, which will be considered by our authorities at the time of preparation of forthcoming budget. In the meantime, measures have been taken to enhance tax compliance, improving tax audit and risk management at revenue authorities. Completion of the Phase I of the Revenue Administration Management Information System (RAMIS) to automate activities of the revenue authorities toward the end of 2015 would help to improve tax administration significantly. Steps are also being taken to improve operations at the Customs and Excise Departments by curtailing undervaluation, strengthening post-clearance audit, and streamlining licensing procedures.
8. Our authorities stand committed for further strengthening of fiscal consolidation. The original budget for 2015 passed in the Parliament in November 2014 targeted a budget deficit of 4.6 per cent of GDP. The Interim Budget presented by the new government in January 2015 has targeted an even lower budget deficit of 4.4 percent of GDP, with several measures to increase direct tax revenue, some of which were one-off as highlighted by the staff. The interim Budget also included measures to reduce the cost of living by reducing import related taxes on a number of food items, increase of salaries of government employees, and upward adjustment of transfers to low income groups. Given the current political developments, our authorities recognize the challenge of meeting budgetary targets set for 2015. Our authorities would introduce firm measures to enhance revenue mobilization and rationalization of expenditure after the Parliamentary election, which is expected around mid 2015.
9. The Central Bank continued to maintain a relaxed monetary policy stance in 2014, and so far in 2015, in the backdrop of well anchored inflation and inflation expectations, and to support growth in private sector credit. The year-on-year inflation declined to 2.1 percent at the end of 2014 from 4.7 percent at the end of the previous year. The inflation rate further declined to very low level of 0.1 percent in March 2015. Reduction of energy prices in line with lower international prices and reduction of import duties on a number of food items under the 100-day program of the new government also largely attributable to this sharp decline in inflation.
10. Private sector credit growth continued to decelerate during the first 8 months of 2014, partly reflecting decline in pawning advances by commercial banks. The Central Bank reduced its Standing Lending Facility Rate (SLF) by 50 basis points in January 2014, and temporarily restricted access to the Standing Deposit Facility (SDF) of the Central Bank in September 2014, which was removed in March 2015. With these measures, private sector credit rebounded during the latter part of 2014 to record 8.8 percent of growth by the end of 2014. By February 2015, private sector credit growth further increased to 12.6 percent, y-o-y. Considering continued outlook for low inflation expectations, relatively high real interest rates in the market and further room for private sector credit growth, the Central Bank reduced its policy interest rates by 50 basis points effective from 15th April 2015.
11. Sri Lanka’s external sector resilience improved in 2014. The current account deficit declined to 2.7 percent of GDP in 2014 from 3.8 percent in the previous year, supported by slight improvement in the trade account as a percent of GDP and significant improvement in trade in services and workers’ remittances.
12. In 2014, export earnings grew at a healthy rate of 7.1 percent, largely supported by industrial exports, mainly textiles and garments. Imports increased by 7.9 percent in 2014, mainly reflecting increased expenditure on imports of petroleum products and textile and textile articles. Despite lower international prices, petroleum import expenditure increased by 6.7 percent during the year due to increased import volume for thermal power generation, as hydropower generation was affected by severe drought conditions. Expenditure on import of consumer goods, including motor vehicles also increased. With these developments, the trade deficit expanded by 8.9 percent to US $ 8,287 million in 2014, but as a percent of GDP it declined to 11.1 percent from 11.3 percent in 2013. FDI inflows, including borrowings, increased to US$ 1,685 million in 2014, while FDI excluding borrowings amounted to US$ 944 million in 2014 compared to US$ 933 million in 2013. Major inflows to the financial account in 2014 included issuance of sovereign bonds amounting to US$ 1.5 billion, and international bond issuances by SriLankan Airlines and National Savings Bank and some commercial banks. There was a net outflow of US$ 133 million of foreign investments in the government securities in 2014.
13. With these developments, the BOP recorded a surplus of US$ 1,369 million in 2014. Gross official reserves increased to US$ 8.2 billion by end 2014 compared to US$ 7.5 billion at end 2013. Gross official reserves at end 2014 were sufficient to cover 4.3 months of imports of goods and services.
14. An increased pressure in the foreign exchange market was witnessed since late 2014, mainly due to the widened trade deficit and slowdown in net capital inflows, as well as relatively high debt repayments during the first quarter of 2015. As a result, gross official reserves declined to US$ 6.7 billion at end March 2015, after meeting all short-term debt obligations, including the repayment of matured Sovereign Bond of US$ 500 million in January, 2015. Our authorities have taken several risk mitigation measures. The government issued dollar denominated Sri Lanka Development Bonds (SLDBs) up to a value of US$ 800 million. The Central Bank of Sri Lanka entered into a currency swap agreement with the Reserve Bank of India (RBI) for US$ 400 million. Further, the Government of India has approved enhancing the currency swap arrangement by an additional US$ 1,100 million. The gross official reserves are estimated to have increased to US$ 7.0 billion by mid-April 2015 excluding swap arrangements.
15. Our authorities share the staff’s view that there is no fundamental misalignment of the exchange rate. Our authorities are committed to maintain flexibility in the exchange rate determination and intervene in the market only to avoid excessive volatility in the exchange rates.
16. As highlighted by the staff, the external sector outlook for 2015 is favorable as the full benefit of sharp drop in oil prices would realize in 2015 with increased level of hydropower generation. In addition, easing of policy uncertainty after the planned Parliamentary elections and measures to address emerging risks also would help to strengthen external sector stability.
17. The financial sector remains strong and resilient with healthy CAR and high profitability and liquidity. As per provisional data, the total CAR declined to 16.7 percent from 17.6 percent in 2014. However, it is still significantly higher than the regulatory requirement of 10 percent. The banking sector NPL improved to 4.2 percent from 5.6 percent in the previous year, mainly reflecting the recovery of pawning related NPLs. Total provision coverage has also increased to 50.7 percent. The financial sector expanded significantly in recent years benefiting from buoyant economic activity. Strengthened regulatory and supervisory framework in line with international standards and best practices further enhanced the soundness of the financial sector. In 2014, the Central Bank issued guidelines on the computation of risk-mitigated assets for operational risk under the standardized approach of Basel-II capital adequacy framework, baseline security standard for information security management and stress testing.
18. The growth momentum of the Sri Lankan economy is continuing. Inflation and inflation expectations remain well anchored. The authorities’ commitment for fiscal consolidation remains high though some slippages of fiscal targets were observed in 2014 mainly due to continuing weak revenue performance. A firm macro-fiscal framework is expected after the proposed Parliamentary elections around mid 2015. The current monetary policy stance remains appropriate. The pressure in the external sector increased in recent months mainly due to widened trade deficit, slowdown in capital inflows and increased debt repayments, but prudent actions by the authorities to mitigate the risks would help to maintain the stability. The financial sector continues to remain sound and resilient.