1. Our Sri Lankan authorities are appreciative of the constructive and candid discussions they had in Colombo during February – March, 2017 and in Washington DC during the Spring Meetings with the staff mission. They welcome the comprehensive assessment on the macroeconomic developments of the Sri Lankan economy as well as the reports produced in relation to the Second Review under the Extended Arrangement under the Extended Fund Facility (EFF). On their behalf, we would like to thank the management, Executive Board and staff for their sustained and supportive engagement with Sri Lanka. Sri Lanka’s program performance was broadly on track in terms of meeting quantitative performance criteria (QPC) and indicative targets (IT), amidst challenging domestic and external conditions. The QPC related to primary deficit was met and inflation remained within the target band in December 2016 as well as in March 2017. However, the QPC related to net international reserves (NIR) was missed amidst high capital outflows. Targets related to tax revenue was met but reserve money exceeded the targets. Our authorities agreed with the IMF Second Review mission, concluded in March 2017, to a new outright foreign exchange purchase target for March and April 2017 as a corrective action for missed NIR target. The purchase of foreign exchange was exceeded by the Central Bank, thereby resuming the buildup of reserves. The accumulation of external arrears, which is a continuous performance criteria, was unintended and was due to the non-availability of a payment platform to make due payments to the Export Development Bank of Iran (EDBI), although our authorities were ready and willing to make the due payments. Most of the Structural Benchmarks (SB) were implemented and significant progress has been made in ensuring that missed SB targets are back on track. However, the Second Review was impacted by the delay in submitting the new Inland Revenue Act (IRA) to the Parliament (Prior Action). Subsequently, corrective action was taken by the authorities and the IRA was submitted to Parliament on July 04, 2017.
Economic Growth and Outlook
2. Reflecting the impact of unfavorable weather conditions and weak global economic recovery, the Sri Lankan economy grew at a slower rate of 4.4 per cent in 2016 compared to 4.8 per cent in the previous year and the average growth of 6.8 per cent during 2010-2014 period. The unemployment rate declined to 4.4 per cent in 2016 from 4.7 per cent in 2015. The economy grew moderately by 3.8 per cent during the first quarter of 2017, supported by the Industry and Services sectors amidst the contraction in the Agriculture sector with the severe drought conditions affecting several provinces. Headline inflation peaked at 7.3 per cent in March 2017, reflecting the impact of drought conditions on food supply and adjustments to the tax structure, which had a one-off impact. Inflation decreased to 6.1 per cent by end June 2017. Going forward, inflation is expected to remain within the inflation band agreed under the EFF, supported by prudent and timely monetary policy measures, and the ongoing fiscal consolidation process.
3. The successful implementation of the reforms, supported by the EFF, is expected to strengthen macroeconomic stability further while improving investor confidence, thereby facilitating higher economic growth. GDP growth in 2017 is envisaged at around 4.5 – 5.0 per cent, mainly due to weather related adverse shocks experienced during the first half of the year. GDP growth is expected to rebound to around 5.5 per cent in 2018 and keep the pace over the medium term.
Monetary and Exchange Rate Policy
4. With the commencement of the monetary tightening cycle since last quarter of 2015, the Central Bank imposed cash margin requirements (subsequently removed) and maximum Loan to Value (LTV) Ratio on selected types of lending towards the last quarter of 2015, as macro prudential measures. The Central Bank also increased the Statutory Reserve Ratio (SRR) by 150 basis points with effect from January 2016 and the policy interest rates by 100 basis points in two steps, in February and in July 2016. Monetary policy was tightened further in March 2017 by raising the policy interest rates by 25 basis points as a precautionary measure to contain possible acceleration of demand side inflationary pressures due to high money and credit growth, and the build-up of adverse inflation expectations. LTV ratios implemented earlier were revised in 2017 based on type of vehicle as proposed in the Budget 2017. The policy rate increases have resulted in a significant increase in short term market interest rates and yield rates of government securities. Following the policy rate increases, lending rates of banks have also adjusted upwards. Although the expansion in credit to the private sector continued at elevated levels until February 2017, there were some signs of deceleration thereafter due to monetary policy measures and prudential measures, and year-on-year growth of credit was 20.0 per cent in April 2017. According to the most recent data, the excessive expansion in credit to certain sectors (i.e. construction sector) appears to be moderating. Our authorities are very closely monitoring these developments and remain ready to tighten monetary policy further, if private sector credit growth continues to remain high and inflationary threats emerge.
5. The monetary policy framework is being strengthened further, in line with the intention of moving towards a flexible inflation targeting monetary policy framework in the medium term. In this context, the Central Bank and the government have fulfilled a number of prerequisites over the years. As an important element of this transition, the Central Bank, jointly with a technical assistance (TA) team from the IMF, has built a Forecasting and Policy Analysis System (FPAS) to provide improved forecasts for policy analyses. The number of Monetary Policy Committee (MPC) meetings has been reduced to 8 from 12 per year, in order to provide more time to undertake analyses on economic developments and make better forecasts. Towards the successful transition to the inflation targeting framework, measures are being taken to fulfill the remaining institutional and technical pre-requisites as well. These include building the consensus among key responsible institutions on the practical implementation steps, introducing required legal and governance reforms and broadening the public understanding of inflation targeting related reforms, with the TA from the Fund.
6. Our authorities remain committed to pursuing a flexible exchange rate regime with intervention limited to prevent wide fluctuations and to build up official reserves, which will also support the move towards the flexible inflation targeting framework. The full flexibility in determination of the exchange rate is constrained by the high reserve target set by the IMF under the program, which requires the Central Bank to purchase foreign exchange from the market. A gradual correction in the overvaluation of the exchange rate is envisaged, under the flexible inflation targeting regime.
Financial Sector Developments
7. The financial sector remained sound and resilient amidst challenging global and domestic conditions. The capital and liquidity levels of the banking sector were maintained well above statutory minimum requirements. The asset base of the banking system increased by 14.9 per cent in May 2017, driven by expansion in loans and advances in line with the growth in deposits while its non-performing loans (NPLs) remained at a healthy level of 2.8 per cent, by end May. The bank branch network expanded, thereby enhancing financial inclusion in the country. Commencing from July 01, 2017, licensed commercial banks will adopt Basel III capital standards to strengthen their resilience. This is based on the Direction issued by the Central Bank in late 2016 in line with the Basel III guidelines issued by the Bank for Resettlement (BIS), related to capital, leverage and liquidity, to strengthen resilience of banks. Licensed banks will meet the increased Basel III minimum capital requirements against risk weighted assets on a staggered basis in line with the international timeline for full implementation by January 01, 2019. Going forward, the Central Bank envisages issuing guidelines to banks on Basel III Leverage Ratio and Net Funding Ratio standards as well in line with the international timelines. Several amendments are planned to be introduced to the Banking Act to streamline and strengthen the regulatory and supervisory framework for licensed banks in line with the best global standards and practices taking note of potential business expansion, activities and innovations in the banking industry.
8. The performance of the non-bank financial sector improved in terms of asset growth, capital position, profitability and branch network expansion. In the context of few financially distressed finance companies, the Central Bank has already established an enforcement unit to further strengthen the regulatory and supervisory framework. In order to regulate microfinance institutions, the Microfinance Act was enacted in 2016.
External Sector Policies
9. The country’s external balance was adversely affected by high net foreign outflows. This reflected the continued domestic demand for imports from certain sectors of the economy, the impact of rising global interest rates, particularly on the government securities market, weak external demand for domestic products and relatively low foreign direct investment flows. Despite the improvements in earnings from tourism and other service exports as well as workers’ remittances, these developments resulted in a deficit in the BOP, thereby decreasing the country’s official external reserves. Although developments during the first half of the year 2016 were favorable in meeting the NIR target comfortably, subsequent developments made the meeting of NIR target a difficult task. The unexpectedly high capital outflows since October 2016, which continued until end February 2017, created considerable pressure on the domestic forex market, compelling the Central Bank to intervene in the forex market by supplying foreign exchange. The total net supply amounted to US$ 367.3 million during this period. Amidst these developments, the rupee depreciated against US dollar by 3.8 per cent during 2016 and 2.5 per cent so far during 2017 up to July 10, 2017, helping to improve the country’s competitiveness. With the easing of the pressure on capital outflows by February 2017, the forex market stabilized and the Central Bank was able to purchase from the market and build up foreign reserves. Preliminary data reveals that gross official reserves are estimated at US$ 7 billion by end June 2017, supported by the proceeds from the International Sovereign Bond issue of US$ 1.5 billion, syndicated loans of US$ 450 million and outright purchases of foreign exchange from the market. The reserve coverage is estimated to have increased to 4.1 months of imports as at end June 2017. As agreed with the staff, foreign exchange swaps with commercial banks have been excluded from the reserve assets in calculating the program NIR. The gradual wind down of these swaps is being continued and the outstanding amount has declined to US$ 1.9 billion by April 2017 from US$ 2.4 billion.
Fiscal Policy and SOE Reforms
10. The improvement in fiscal performance in 2016 continued, as reflected by the performance during the first four months of 2017. This was mainly due to the efforts taken to improve tax policy, tax administration and public financial management by the authorities with the support of the EFF. The end December target of primary balance under the program was met comfortably and the overall deficit was also declined significantly to 5.4 per cent of GDP in 2016, supported mainly by the over performance in revenue compared to the program target. This improvement is expected to continue to ensure medium term debt sustainability. During the first four months of 2017, total revenue increased by 24.6 per cent, led by 90.9 per cent increase in VAT, reflecting the positive impact of the VAT reforms introduced in 2016 and improvements in tax administration.
11. The VAT reforms introduced in 2016, including the tax rate increase from 11 per cent to 15 per cent and the removal of number of exemptions, despite the stiff opposition by some segments in the society, signify the authorities’ commitment to reforms under the ongoing revenue based fiscal consolidation process. Our authorities accept the fact that more public awareness is necessary to sensitize the general public about the need and future benefits of tax as well as other reforms. While consolidating the VAT reforms further, the new Inland Revenue Act (IRA), which has been drafted with TA from the Fund and submitted to Parliament on July 04, 2017, is expected to play a catalytic role in transforming Sri Lanka’s income tax system by providing clarity, simplicity and administrative convenience while increasing tax compliance and improving tax administration further. Under this, a new investor investment incentive scheme, based on enhanced depreciation allowance, which will be linked to the extent of investment undertaken, employment generation and geographical location, will be introduced, leading to the closing of widespread loopholes in the existing income tax system.
12. The introduction of compliance strategies for VAT and corporate personal income taxes (on-going), risk-based VAT audits and roll out of the Revenue Administration Management Information System (RAMIS) at the Inland Revenue Department (IRD), which automates the tax collection process, will strengthen tax administration further. The IRD is doing preparatory work to implement the new IRA with the support of IMF, particularly to improve public awareness of the new revisions to ensure smooth transition to the new income tax system. The newly rolled out Integrated Treasury Management Information System (ITMIS) at the Ministry of Finance (MOF) will be operationalized beginning in 2018, automating the key functions related to public financial management system in Sri Lanka.
13. Efforts are being made to manage the economic and social implications of the two natural disasters, drought and floods, that occurred in the first half of 2017, which had an adverse impact on this year’s growth. These have had some impact on the government budget as well. Additional expenditure will be required for reconstruction and rehabilitation activities, particularly for the infrastructure and houses damaged due to the most recent floods as well as for the provision of assistance to the people affected by the severe drought in some parts of the country. Policies to better manage climate related adversities are being seriously considered by the authorities as it appears that the country has increasingly become vulnerable to devastating natural disasters.
14. Measures to strengthen the State-Owned Enterprises (SOEs) are progressing. A resolution strategy has been introduced for Sri Lankan Airlines and the Statements of Corporate Intent (SCIs) were signed by five key SOEs in March 2017, creating a framework to monitor their performance under specific KPIs. Our authorities are committed to implementing the energy pricing formula in line with the new timeline indicated in the staff report, despite the missing of the original date of meeting the SB.
15. As per the Budget 2017, it is required to submit a quarterly progress report on actual expenditure and revenue of the budget to Parliament. Accordingly, the quarterly expenditure and income outcome report for the first quarter of 2017 was presented to the Parliament on July 05, 2017. This includes a summary report on actual expenditure, a detailed report of the actual expenditure and a report on the revenue.
Strengthening Trade and Foreign Direct Investments (FDI)
16. Our Sri Lankan authorities have clearly identified the enormous potential of the country to become a trading and service hub in the South Asian region through the enhancement of trade and FDI, thereby benefiting from a changing global marketplace. The measures indicated in the staff report are among the key priorities in this context of improving growth potential and strengthening external sustainability. As the improvement of doing business environment in the country is also a high priority in attracting and sustaining investments, our authorities, on July 05, 2017, launched a Road Map to Improve Investment Climate in Sri Lanka, in collaboration with the Australian Government and the World Bank Group, which provides a holistic platform for reforming the investment climate in Sri Lanka. It defines the roles and responsibilities of all stakeholders grouped under eight Task Forces (which will each cover one of eight areas under the Doing Business ranking), a set of initial reforms that will be pursued, the timeframe for accomplishment of the reforms expected and a mechanism to monitor progress on an ongoing basis, and promptly identify and address bottlenecks. The implementation of this Road Map is expected to eliminate unnecessary regulatory and procedural obstacles to enterprises and entrepreneurs.
17. Our Sri Lankan authorities highly value the continued support provided through technical assistance by the Fund. Over the years, the TA has mainly been in the areas of tax policy and tax administration, public financial management, monetary and exchange rate policy, macroeconomic modelling and forecasting, financial system stability and national accounts. The insights provided through these TA have helped the country to improve policies and processes and our authorities expect to continue this engagement to complement the efforts towards strengthening macroeconomic stability.
18. The Sri Lankan economy showed signs of stabilization during 2016, which is continuing in 2017. The EFF played an important role in helping the authorities to achieve this progress, particularly in implementing reforms and strengthening macroeconomic stability, while strengthening much needed investor confidence. In this context, despite the delay in completing the second review, our authorities remain committed to the successful completion of the EFF as a step towards achieving the broader objectives of socio economic and social policies. Going forward, our Sri Lankan authorities are strongly committed to implement appropriate policy reforms to sustain this improvement towards creating external and fiscal buffers and a conducive environment to achieve high and sustainable economic growth with the support of the international community and in close association with the Fund and staff, complemented by continued technical assistance. In this context, our authorities request the completion of the Second Review of the Extended Arrangement under the EFF.