Our Sri Lankan authorities value the constructive and candid policy dialogue they had in Colombo during September 2017 and in Washington DC during the Annual Meetings with the staff mission in relation to the Third Review under the Extended Arrangement under the Extended Fund Facility (EFF). They are grateful to the staff for the comprehensive set of documents. Our authorities also highly appreciate the advice and continued support by the staff and the management to Sri Lanka.
Sri Lanka’s EFF program is progressing well, with all end-June 2017 Quantitative Performance Criteria (QPC) and end-September Indicative Targets (IT) having been met. The QPC related to the primary deficit was met, NIR exceeded the target and inflation remained within the target band, under the program. The continuous PC of making no new external arrears was also met. Four of the five Structural Benchmarks (SB) to be completed by November 2017 were implemented. The missed SB, on designing compliance strategies for income taxes, has been postponed until the new Inland Revenue Act (IRA) is fully operational in 2018. The prior action for the third review on submission of Budget 2018 consistent with the EFF program was also completed. Our authorities are strongly committed to continuing the reforms and achieving the desired targets. They view these as necessary to create robust macroeconomic fundamentals needed for accelerating growth and generating employment. Against this backdrop, they request the completion of the Third Review of the EFF.
Economic Growth, Inflation and Outlook
The Sri Lankan economy grew by 3.9 per cent during the first half of 2017, compared to the growth of 3.7 per cent over the same period of 2016, driven mainly by the expansion in Industry and Services. The contraction of Agriculture-related activities, resulting from severe drought and flood related disturbances, which had some spillover impact, particularly on manufacturing activities, weighed negatively on the economic growth. Growth in the second half of 2017 will be relatively low compared to the past, although higher than the first half, mainly reflecting the impact of inclement weather conditions. Overall, the economy is expected to grow by 4.0 – 4.5 per cent in 2017. Going forward, Sri Lanka’s growth trajectory is expected to improve gradually over the medium-term, with the support of improving macroeconomic stability, ongoing structural adjustments and growth-consistent policies. The Vision 2025, which is the new economic plan of the government, announced in September 2017, contains far-reaching, growth-oriented economic policies to complement this process. Meanwhile, unemployment declined marginally to 4.3 per cent in the first half of 2017, from 4.4 per cent in the corresponding period of 2016.
Headline inflation followed an overall increasing trend, but with mixed patterns. High food inflation due to severe domestic supply disruptions was the main reason for the increase. Tax adjustments in 2016 and rising international commodity prices also contributed. However, core inflation remained low on average, reflecting the broadly contained demand driven inflationary pressures through prudent monetary policy measures adopted by the Central Bank. Although inflation is likely to remain elevated in the near term due to weather-related supply disruptions, well-anchored inflation expectations and forward-looking demand management policies are expected to contain inflation within the ranges specified in the monetary policy consultation clause of the program.
Monetary and Exchange Rate Policy
The Central Bank continued its tight monetary policy stance to preempt the buildup of excessive demand pressures and adverse inflation expectations in the economy. In addition to the 100 basis points (bps) increase in policy interest rates and the 1.50 percentage point increase in the Statutory Reserve Ratio (SRR) in 2016, the policy interest rates of the Central Bank were increased by 25 bps in March 2017. Responding to tighter monetary conditions, the most market interest rates moved upward, although short-term rates adjusted downwards recently due to increased liquidity in the domestic money market. Responding to the tight monetary policy measures and reduced loan to value ratio, growth in credit from commercial banks to the private sector also decelerated gradually to 16.2 per cent in October 2017 from the peak of 28.5 per cent in July 2016. Going forward, the overall credit expansion is expected to decelerate further with the gradual moderation in private sector credit growth and fiscal consolidation. Our authorities closely monitor the inflation dynamics and remain ready to take appropriate measures if inflationary threats emerge. They would also supplement such measures by adopting macroprudential measures, if necessary.
Further progress was made in transiting towards a flexible inflation targeting (FIT) framework in the medium-term. The Monetary Board of the Central Bank approved the Road Map for Implementing FIT in October 2017, which consists time-bound actions. This includes measures in the context of reaching consensus between the government and the Central Bank on inflation target and the time horizon, and FIT as the monetary policy framework; legislative reforms to ensure clear separation of monetary and fiscal policies; and monetary policy implementation, including monetary instruments, liquidity management and domestic market development. This process also involves building institutional and technical capacity, strengthening Central Bank credibility, autonomy and governance, as has been identified in the 2016 IMF safeguard assessment. This will be supported by enhancing monetary-fiscal policy coordination and revising the Fiscal Management (Responsibility) Act (FMRA) to strengthen responsible fiscal management.
The recently introduced market-based Treasury bond auction system and the proposed Liability Management Act are expected to insulate monetary policy from fiscal dominance, thereby enhancing the independence of the monetary policy. The new Treasury bond auction system has reduced the volatility in yields on government securities, corrected the distortion between the policy rates and market interest rates and reduced the monetization of fiscal deficits, thereby strengthening the effectiveness of the monetary policy.
Our authorities remain committed to pursuing a flexible exchange rate regime with intervention limited to preventing wide fluctuations and building up official reserves. This will also support the move towards the FIT framework. The Road Map for Implementing FIT contains several proposals to improve foreign exchange operations and the market. Greater exchange rate flexibility, introduction of a transparent auction mechanism to build up international reserves and adopting measures to deepen the foreign exchange market are key among those.
Meanwhile, the new Foreign Exchange Act (FEA), which was introduced by the government by repealing the Exchange Control Act, came in to effect from 20 November 2017. The new FEA envisages to further liberalizing capital flows and simplifying the processes associated with current account transactions and various types of foreign currency/rupee accounts. In line with this, the Central Bank recently established the Department of Foreign Exchange to implement the provisions of the new FEA, in place of the Exchange Control Department.
The financial sector continued to expand and remained stable amidst challenging global and domestic conditions with higher levels of capital, adequate liquidity buffers, and healthy earnings. The asset base of the banking sector continued to grow and the NPL ratio improved. The bank branch network expanded, contributing to improved financial inclusion in the country, particularly in the regional areas. The implementation of the Basel III framework is progressing, which should further enhance the resilience of the banking sector. The asset base of non-bank financial institutions (NBFIs) expanded at a slower pace compared to that of 2016.
The Central Bank is in the process of establishing a new Resolution and Enforcement Department to further strengthen the regulatory and supervisory framework. Measures are being taken to strengthen the AML/CFT regime by addressing the remaining deficiencies, including the enactment of Financial Action Task Force (FATF) compliant AML/CFT laws and regulations. Scenario-based stress testing for the banking sector, systemic risk survey, early warning indicators, etc. are being used to strengthen the macroprudential surveillance framework while expansion of network analysis is in progress. The macroprudential surveillance framework would identify risks and vulnerabilities early in a holistic manner and would propose measures for systemic risk mitigation. These measures will further strengthen the macroprudential framework. Further, some macroprudential tools, such as LTVs on motor vehicles, have also been implemented.
Fiscal Policy, New Legislations and SOE Reforms
As highlighted in the staff report, revenue-based fiscal consolidation remains the key for improving the country’s public finances. Our authorities’ steadfast efforts towards fiscal consolidation have resulted in significant improvement in fiscal performance. Accordingly, the primary balance was maintained within the end-June PC and end-September IT. This was mainly due to improved revenue collection, reflecting the measures taken by the authorities in the context of tax policy and tax administration with the support of the EFF. In particular, there was a significant increase in tax revenue, driven by the VAT reforms introduced in 2016. In fact, the primary balance recorded a surplus during the first 6 months, although it declined thereafter to a deficit due to unexpected drought and flood related expenditures, which will also lead to a marginal deviation of the annual budget deficit from the envisaged target. The government, in its policy statements, has already announced its strong commitment to reduce the deficit gradually to 3.5 per cent of GDP and debt to GDP ratio to 70 per cent from the projected 80 per cent in 2017.
The recently presented Budget 2018 has the theme of “Blue-Green Enterprise Sri Lanka”. It intends to achieve economic progress in an eco-friendly manner. The budget expects to continue to strengthen the fiscal performance on the already built foundation. The projected revenue target is expected to be met by consolidating the tax policy, including the implementation of the recently enacted IRA, which includes a simplified tax law, revisions to tax rates, realigned tax incentives and introduction of international best practices to the Sri Lankan tax system. It also places greater emphasis on improving tax administration to increase compliance and revenue collection by effectively using the automation through the newly established Revenue Administration Management Information System (RAMIS). Rationalization of expenditures, IT-based spending commitment controls and other improvement in public financial management is expected to keep expenditure on track. As a combined outcome of these policies, a primary surplus is expected in 2018 with a further decline in overall fiscal deficit. In compliance with program requirements, a tax expenditure statement and statement on fuel and electricity Non-Commercial Obligations (NCOs) also have been presented in Budget 2018, raising its transparency. The submission of Quarterly Expenditure and Income Outcome Reports to the Parliament strengthens Parliamentary control over public finances.
Budget 2018 expects to improve the overall performance of the economy by focusing mainly on enhancing private sector participation, creating a conducive environment to promote exports, supporting the digitalization of the economy and enhancing investments in human capital. It has also proposed to introduce revisions to several laws for Sri Lanka to be a more vibrant and a dynamic market economy. Accordingly, archaic and regressive laws, including the Public Contracts Act, Land (Restrictions and Alienation) Act, Rent Act, Shop and Office Employees Act and Bankruptcy laws will be amended. New Acts, such as Liability Management Act, Public Finance Management Act, National Audit Act, Demutualization Act, Securitization Act, Development Bank Act, and Public Enterprises Act will be introduced to facilitate economic progress.
The introduction of Liability Management Act will be a priority for our authorities to face the challenge of handling the bunching of scheduled debt service payments, particularly from 2019 onwards. This proposed Act will allow the Treasury to create a buffer fund to meet expenditure and debt service needs, and smoothen out the issuing process and maturity structure. It will also enable the use of funds from the commercialization of government assets for liability management purposes.
Our authorities are committed to implementing reforms in SOEs to improve the financial viability to lower the pressure on the government budget. Domestic prices of fuel and electricity are expected to be determined by a formula in March and September, as the first step of the recalibrated sequence of steps. Our authorities are also in the process of introducing a resolution strategy for SriLankan Airlines. The Statements of Corporate Intent (SCIs), which were signed with five key SOEs in March 2017, creating a framework to monitor their performance under specific KPIs, will be extended to other selected SOEs as well.
Sri Lanka’s external sector showed some signs of improvement in 2017. Exports recorded continuous growth since March 2017, reversing the lackluster performance during the past two years. However, trade deficit widened, since imports also increased due to higher demand for petroleum imports for domestic power generation and rice, due to severe drought conditions. Earnings from tourism declined while workers’ remittances moderated amidst the slowdown in the Middle Eastern economies. Hence, the current account balance did not improve as expected. Despite the increased current account deficit, the pressure on the BOP continued to ease with higher inflows under the financial account.
With the improved external sector performance, the Central Bank limited its intervention in the foreign exchange market only to build up international reserves, with minimal impact on the exchange rate. The Sri Lankan rupee has depreciated by 2.6 per cent against the US dollar so far, this year. The gradual winding down of the swaps with commercial banks is being continued and the outstanding amount has declined to US$ 1.8 billion by end-October 2017 from US$ 2.5 billion recorded in end-December 2016.
Trade and Investment Regime
Sri Lanka has taken several important initiatives to promote exports. A New Trade Policy (NTP) was approved by the Cabinet of Ministers in August 2017 with the view of having more liberal, simple and transparent trade regime in the country. The government is negotiating new trade agreements with several partner countries and the FTA with Singapore is expected to be signed in January 2018. The EU-Sri Lanka Investor Dialogue was relaunched in 2017 to resolve trade and investment-related problems and enhance the bilateral economic cooperation.
Meanwhile, a National Trade Facilitation Committee was established to drive the implementation of commitments under the WTO Trade Facilitation Agreement (TFA), which Sri Lanka ratified in 2016. On trade facilitation, a single electronic window has been established at Sri Lanka Customs and will be operational shortly. An Anti-Dumping and Countervailing Measures Bill and a Safeguard Measures Bill will be presented to the Parliament soon.
The Budget 2018 has proposed several measures, including to abolish para-tariffs applicable on selected tariff lines; introduce an “Export Market Access Support” program as a part of the trade adjustment program; establish a trade portal allowing the exporters to access reliable and timely trade information and trade promotional tools; facilitate product development assistance to exporters; drive a comprehensive “Multi-National Corporation Outreach” program to attract global electronic and electrical machinery players into the country to create value chain linkages or joint ventures with Sri Lankan exporters; and automate documentation processes, required for imports.
Our authorities highly value the continued support and insights provided through technical assistance by the Fund over the years, which has helped Sri Lanka to improve its policy formulation and implementation. They expect to continue this engagement to complement the efforts towards further strengthening of growth and macroeconomic stability in the country.
With the help of strong policy initiatives, complemented by the measures taken under the EFF, macroeconomic stability is being gradually restored in Sri Lanka, while achieving a satisfactory level of economic growth. This has helped to strengthen investor confidence. Given the progress of the reform momentum, Sri Lanka’s sovereign rating outlook was revised from negative to stable by S&P on 20 November 2017. Our authorities are committed to continuing structural reforms and building buffers to improve resilience. Supported by the ongoing policies and reforms, the Sri Lankan economy is expected to return to a high and inclusive growth trajectory, thereby helping to achieve broader objectives of employment generation and raising incomes of its citizens.