a. Growth, saving, and investment

Despite a good harvest, real GDP growth slowed late in 1994 and averaged about 5 1/2 percent, almost 1 1/2 percentage points below the previous year’s strong performance. Of the output growth, agriculture contributed about 1 percentage point, manufacturing 2 percentage points, and most of the remainder came from a further expansion of the services sector.

The ratio of overall investment to GDP increased by about 1 1/2 percentage points to 27 percent in 1994. This increase was fully accounted for by the purchase of two airplanes by Air Lanka. Private investment stagnated as the political uncertainties led to delays in capital spending, while public investment also slowed in response to significant project delays.

The ratio of national saving to GDP, which recorded significant increases in 1992–93, decreased by a little over one percentage point to about 19 percent in 1994. This decline reflected a large increase in public sector dissaving in relation to GDP that was only partly offset by an increase in private sector saving. The former resulted from a weak revenue effort and lack of expenditure control, while the latter reflected, in part, the household sector’s response to efforts by the banking sector to mobilize increased savings.

Against these developments, the economy’s saving/investment gap widened from about 5 1/2 percent of GDP in 1993 to about 8 percent of GDP in 1994. This widening mirrored a significant increase in the trade deficit, which resulted from strong import volume growth and a significant deterioration in the terms of trade.

b. Sectoral developments

c. Prices, wages, and employment

a. Structure of the public sector

The public sector in Sri Lanka consists of three interrelated branches: the Government, public enterprises, and a broad range of public institutions. The central government includes the presidency, the parliament, the judiciary, 28 ministries, and several other departments and agencies which are covered by the central government budget. The local government sub-sector also includes district, municipal, urban, and village councils, which provide financial, technical, and other services, and oversee the implementation of social development projects.

Sri Lanka’s approximately 200 public enterprises encompass a variety of organizational forms, including commercial enterprises, boards, bureaus, authorities, corporations, agencies, and institutes. In 1994, the central government made budgetary transfers to over 90 public corporations and institutions, including the following sectors: agricultural and fisheries, manufacturing and mining, energy and water supply, trade and commerce, transport and communications, and development. The largest recipients were the Mahaweli Authority, the CEB, the Central Transport Board, the National Water Supply and Drainage Board, and the Road Development Authority, which were generally engaged in large-scale infrastructure projects. The total transfers to public enterprises declined only slightly, from 3.4 percent of GDP in 1990 to 3.1 percent of GDP in 1994, mainly because savings from privatization under the public enterprise reform program were offset by the cost of subsidizing operations affected by the 1994 relief measures.

b. Fiscal developments

After two years of fiscal consolidation, the budget position deteriorated significantly in 1994. The overall fiscal deficit (excluding grants) increased to 10 percent of GDP, compared with 8 percent in 1993, largely reflecting a reduction in the tax base and expenditure overruns associated with relief measures introduced before and after the parliamentary elections in August 1994 and lax control over other expenditures. ^1/ The deficit on current operations, which declined to less than 1 percent of GDP in 1992 and 1993, jumped to 3 percent of GDP in 1994. Pressures on current expenditures from the security situation continued throughout the period, with defense expenditures expanding from 3 percent of GDP in 1990 to 4 3/4 percent of GDP in 1994. Capital expenditures recovered somewhat in 1991, with an increase in foreign resources. The revenue-to-GDP ratio fell from about 20 percent in 1993 to 19 percent in 1994, owing to the tax relief. A greater portion of the deficit was financed by domestic borrowing though the Government made little recourse to bank financing.

c. Tax reform

Sri Lanka’s tax system has a relatively sophisticated structure for its stage of economic development, with a higher tax-to-GDP ratio than most Asian countries. A number of specific measures to improve the system were introduced in the context of the 1995 budget. The lower band of turnover tax was increased from 5 percent to 6 percent in preparation for the adoption of a value-added tax system in October 1995. The new tax, the Goods and Services Tax (GST), will be revenue neutral with two rates. Items included at the lower rate will be mass consumption goods such as milk, sugar, kerosene, diesel, and soap. The GST will eliminate the current markup of 25 percent applied to the computation of turnover tax on imports. The system of trade taxes has also been simplified, with the introduction of a three-band import tariff system with a lower maximum rate and a reduction in several export tax rates (see Chapter VII).

Substantial progress by the Inland Revenue Department has been made in improving tax administration, increasing compliance, and enhancing enforcement of penalties. A parallel computerized system to improve tariff collections and increase the efficiency of administration in the Customs Department is being implemented. In addition, Customs collection should be improved in the future with the introduction of preshipment inspection of both imports and exports. This inspection will aid correct valuation and classification of external trade.

a. Overview of the financial system

The financial system in Sri Lanka is relatively diverse and sophisticated. The banking system includes the Central Bank of Sri Lanka, 23 commercial banks, a national savings bank (NSB), three merchant banks, two development finance institutions, and a state mortgage investment bank, among other institutions. Long-term financial resources are mobilized mainly by the two large pension funds, the EPF and the ETF, and five insurance companies. In the capital market, activity in the Colombo Stock Exchange has picked up sharply in recent years after the adoption of a scripless trading system and increased participation by foreign investors.

While considerable progress has been made in recent years in laying the foundation for a modern financial system, many structural impediments remain, constraining Sri Lanka’s growth potential. In the banking sector, competition has been hampered by the continued dominance of the two largest banks, which are state owned. The market share of these banks has been broadly unchanged since 1990 at about 60 percent of total assets of the commercial banking system despite the establishment of new banks and branches of foreign banks. In addition, their close relationship with the Government has made it difficult to enforce the supervisory regulations, for example, the provisioning for bad loans, and as a result a recapitalization was necessary in April 1993. The lack of effective competition has resulted in large interest rate spreads that keeps up the cost of finance for the private sector.

The market for deposits has been distorted by the operations of the state-owned NSB. The NSB mobilizes deposits from small savers nationwide through a decentralized network of branches and post offices. However, there are no limits on the size of deposits and even corporate depositors are allowed to deposit funds. The deposits carry a government guarantee and the NSB is not subject to reserve or liquidity requirements. The interest rates offered by the NSB, which must be approved by the Minister of Finance, have tended to put a floor on all deposit rates. This lack of flexibility has at times resulted in average term deposit rates higher than the NSB can earn from investing in treasury bills.

Monetary management in Sri Lanka is hampered by a lack of depth and competition in money and securities markets. For example, there is no active market for government securities with maturities over one year. Although a substantial part of the Government’s financing requirement has been covered by issuing long-term rupee securities, these have been placed with captive sources, primarily the EPF and the NSB, at fixed interest rates determined by the authorities. Further, while short-term interest rates are market oriented, the primary treasury bill market is not fully operated according to market principles and the secondary market is still very limited.

b. Monetary policy

The Central Bank has used a combination of direct and indirect policy instruments to influence the growth of monetary aggregates in recent years. These have included, among other instruments, statutory reserve requirements, refinance facilities, selective credit controls, and moral suasion. Since 1992, however, greater emphasis has been placed on indirect instruments of monetary control, including open market operations in treasury bills and central bank securities, within the context of reserve money programming. Accordingly, the basic monetary approach followed by the Central Bank has been to target the annual growth of reserve money in the context of a Fund program. The annual targets are converted to intra-year paths taking into account seasonal and other variables, such as the government cash flow pattern, and are monitored by the Central Bank on a weekly basis.

The conduct of monetary policy in 1993 and early 1994 was significantly complicated by large unanticipated inflows of interest-sensitive capital, which rendered the system of reserve money management more difficult. The main policy response of the authorities to these inflows was aggressive sterilization by open market operations through the Central Bank’s secondary window. However, with a rapidly declining inventory of treasury bills to carry out open market operations, the Central Bank considerably eased the degree of sterilization in late 1993. Since then, the authorities have experienced difficulties in containing domestic liquidity expansion, and have, as a result, adopted a passive policy stance that continues at the present time. Few policy actions were taken in 1994 to curtail liquidity creation: the Central Bank belatedly began issuing its own securities again—which it had ceased in April—in September in a vain attempt to drain liquidity; and its short-term refinance facility was phased out and no new medium- and long-term refinance was extended during the year.

In late March 1995, the Central Bank began to issue additional amounts of its own securities to restrain credit growth. However, after success-fully rolling over SL RS 3/4 billion plus an additional SL Rs 1/4 billion in late March, subsequent issues have been limited because low demand resulted in high expected yields. The Central Bank has been reluctant to take any further action because of the impact on interest rates that have begun to rise.

c. Developments in money, credit, and interest rates

Developments in major monetary and credit aggregates in 1994 should be viewed against the backdrop of the passive policy stance adopted by the authorities. Monetary policy accommodated both the fiscal slippage and the private sector’s strong demand for credit, resulting in a large increase in net domestic assets (NDA) of the banking system during the year. Reinforced by a surplus in the balance of payments, broad money grew by 20 percent in 1994, a level similar to the average expansion during the early 1990s, perpetuating the high underlying inflation. Unlike in 1993, when growth of monetary aggregates largely reflected the accumulation of net foreign assets (NFA) of the banking system, NDA and NFA contributed about equally to liquidity expansion during 1994. Monetary aggregates have continued to expand rapidly thus far in 1995, particularly credit to the private sector, in the absence of decisive measures to tighten monetary policy.

Net credit to the public sector declined by 4 percent during 1994. Improved profitability of the CPC stemming from lower world petroleum prices enabled public corporations to reduce their bank financing by 34 percent during the year. However, net credit to central government increased by 4 percent, in contrast with significant declines in 1992–93. The Government was forced to seek recourse to SL Rs 6 billion in additional bank financing during the last quarter of the year to finance the widening fiscal deficit as the nonbank captive sources were fully tapped.

The modest decline in net credit to the public sector failed to offset the 21 percent expansion in credit to the private sector. Notwithstanding the relatively high real lending rates (on the order of 4–6 percent), bank credit to the private sector increased unabated, reflecting continued strong demand for trade finance and a sharp increase in consumer credit and housing loans. Unlike in the recent past, the Central Bank did not attempt to stem credit growth through increases in the required reserve ratio or through moral suasion on the commercial banks. Government-directed credit schemes did not contribute significantly to private credit expansion during the year.

Although foreign inflows fell considerably from 1993 levels, the increase in the Central Bank’s NFA still accounted for 10 percentage points of broad money growth and all of the increase in reserve money in 1994. The Central Bank’s lack of instruments with which to carry out open market operations constrained its ability to sterilize the impact of the inflows. Owing to the lack of instruments as well as the passive policy stance adopted by the monetary authorities, reserve money continued to expand at over 20 percent.

The passive stance of monetary policy also led to wide swings in short-term interest rates on treasury bills. Treasury bill rates, which peaked at about 21 percent in September 1993, began to soften as the Central Bank eased sterilization operations, reaching about 13 percent in March 1994. Short-term rates stabilized in the middle part of the year as inflows of foreign capital abated. However, rates began to fall again in July in the face of high domestic liquidity, reaching 11 1/2 percent at end-October, before rising sharply to 19 percent by end-year in response to the Government’s need to finance the widening budget deficit. Short-term rates subsequently fell quickly to 13 1/4 by early February in response to a surge in liquidity related, in part, to renewed capital inflows. Rates have firmed somewhat in recent weeks to over 15 percent in response to the modest tightening by the Central Bank.

Because of institutional factors that inhibit market adjustments in the banking System, the large movements in short-term rates were generally not reflected in lending and deposit rates, which remained broadly positive in real terms. In the latter half of 1994, however, lending and deposit rates declined by 1–2 percentage points in response to pressure exerted by the Government on commercial banks to lower interest rates. Nonetheless, the spread between deposit and lending rates remained large, at 8–10 percent, throughout the year and continued to keep up the cost of finance for the private sector.

a. Overall developments

External sector performance had remained strong in recent years. The current account deficit declined from 7.5 percent of GDP in 1991 to 6.1 percent in 1992 and further to 5.3 percent in 1993. Capital inflows were strong and rising since 1992, in large measure due to the strength of foreign direct investment. In 1993, a sharp decline in the current account deficit together with the strength of capital inflows produced a particularly large overall surplus and a sizable increase in gross official reserves to 5.1 months of imports. However, in the face of loose financial policies, the current account deficit widened to an estimated 7.9 percent of GDP in 1994. The overall surplus in 1994 was, nevertheless, sufficient to maintain gross official reserves at about five months of imports.

b. Current account transactions

The terms of trade, which improved slightly in 1992 and 1993 (1.7 percent over the two years), worsened significantly in 1994 (3.4 percent), owing mainly to a decline in export prices for key goods including garments and tea. Export volume growth in 1993–94 averaged about 16 percent per year owing to the strength of nontraditional exports, which averaged about 20 percent real growth per year. Garments and textiles comprised about 75 percent of nontraditional exports with the remainder including mainly machinery and electrical appliances, leather, rubber, paper, wood and ceramic products. The growth in traditional export volumes—tea, rubber, and coconuts—averaged about 10 percent real growth after a 12 percent decline in 1992.

Owing in large part to tariff cuts and a reduction in the scope of import licensing restrictions, import volume growth in 1993 and 1994 was robust—over 18 percent in each year. This reflected mainly strong textile imports—linked to clothing exports—but also revealed the growth in imported investment goods, including the purchase of commercial aircraft by Air Lanka. In 1993, somewhat less than one-half of the volume growth in investment goods was attributable to purchases by Air Lanka—SDR 62 million. In 1994, when two Airbus Industries aircraft were purchased (valued at SDR 142 million) more than one-half of the volume growth in investment goods was attributable to this lumpy purchase. Overall, when these purchases are eliminated, import volume growth remains robust at 14 percent in 1994, compared with about 17 percent in 1993.

In 1994, net private transfers remained strong, showing about 9 percent growth over the high level of 1993. Nevertheless, consistent with the view that the 1993 surge reflected interest-rate sensitivity, this was a sharp reduction in the growth of private transfers relative to 1993, which was about 23 percent over 1992. Profit and dividend outflows in 1994 were also substantially higher than in 1993, presumably reflecting a temporary delay in repatriations in 1993. Thus, the deepening of the current account deficit in 1994, apart from the strength of imports due to loose financial policies, also reflected events in the services trade and private transfers.

The direction of foreign trade has remained broadly stable since 1992. The United States absorbed about 35 percent of Sri Lanka’s total exports in 1993–94. Exports to the European Union were about 31 percent and just over 5 percent went to Japan in 1993–94. Apart from Japan, Asia countries consumed less than 10 percent of exports from Sri Lanka during this period. Since 1988 there has been a appreciable shift in the direction of exports away from Asia and toward the European Union and the United States. Whereas the United States and the European Union received about 50 percent of total exports from Sri Lanka in 1988, in 1993–94 over 65 percent of exports flowed to these two groups. This mainly reflects Sri Lanka’s increased production of textiles and clothing and the relatively liberal access offered to Sri Lanka for these products under the Multifibre Arrangement by the European Union and United States. Sri Lanka’s imports have been more concentrated in Asia. Some 60 percent of imports were from Asia (including Japan) in 1993–94, whereas less than a quarter originated in the European Union and the United States combined.

c. Nonmonetary capital flows

Net capital flows increased sharply in 1993–94 owing to the strength of foreign direct investment, to continued high levels of concessional aid to the central government, and to large trade credits linked to Air Lanka’s purchases of commercial aircraft. Private investment flows—both direct and portfolio investment in the Colombo Stock Exchange—were particularly strong in 1993, with net portfolio inflows reaching twice the levels of 1991–92. With both presidential and parliamentary elections during 1994 and a change of government, uncertainty contributed to the overall drop in portfolio inflows during the year. The increase in private short-term inflows during 1993–94 reflects both an increase in credits from foreign suppliers to export-oriented firms (Board of Investment—BOI—firms) for the importation of raw materials and an increase in lending by foreign-currency banking units to these BOI firms.

d. External debt

Sri Lanka’s external debt-service burden continued to ease during the past two years, with the total debt-service ratio falling from about 20 percent of exports of goods and nonfactor services in 1992 to under 12 percent in 1994. The ratio of debt-to-GDP rose somewhat to about 76 percent in 1993, but preliminary information points to a slight decline in 1994, due in part to a shortfall in project lending. As has been the case throughout the 1990s, most of Sri Lanka’s increased debt was on concessional terms with the International Development Association and the Asian Development Bank, the primary multilateral lenders. Japan was by far the largest bilateral lender on concessional terms during this period.

a. The foreign exchange market and exchange rate developments

Sri Lanka’s foreign exchange regime can be characterized as a very closely managed float. Under current procedures, the Central Bank announces intervention points each morning at which it stands ready to buy or sell U.S. dollars, the intervention currency. A number of factors enter the Central Bank’s daily rate-setting decision, including developments in rupee bilateral rates, the rupee/SDR rate, and the rupee real effective exchange rate (REER).

From March 1992 through March 1995, a one percent difference separated the Central Bank’s intervention points and an interbank foreign exchange market operated within this narrow range. If the rupee/dollar rate moves to the top (bottom) of the band and there remains excess demand for (supply of) dollars in the interbank market, the Central Bank sells (buys) as many dollars as are demanded (supplied) at that rate. Because of the narrowness of the spread, the interbank rate frequently moved to the top or bottom of the band, thereby limiting interbank transactions.

On March 20, 1995 the Central Bank increased the spread between intervention points from one percent to two percent in order to increase the scope for transactions in the interbank market. The Central Bank intends to monitor developments in the interbank market and the functioning of the exchange rate system before determining whether to widen the spread further.

The REER was little changed from beginning-1993 to end-1994, but it fluctuated substantially during this period. The authorities have tended to depreciate the rupee against the U.S. dollar gradually by the amount of the effective inflation differential, regardless of exogenous movements in the nominal effective exchange rate. As a result, broad-based swings in the dollar have been transmitted directly to the rupee REER. The depreciation of the dollar against the yen and the D-mark through mid-April 1995 stimulated essentially no change in the rupee/dollar rate. In 1995, the rupee is estimated to have depreciated by about 6 1/2 percent in real effective terms through mid-April.

b. Forward exchange market developments

A forward market for foreign exchange is provided by commercial banks and forward rates are market determined. Through March 1993, however, commercial banks were prohibited from writing forward contracts with maturities of more than six months. The forward market was then liberalized to allow contracts with maturities of as much as one year. Most forward transactions continue to involve contracts with maturities of three months or less. While the Central Bank quotes forward rates for the U.S. dollar at the request of commercial banks, it was not an active participant in the forward market in 1993–94.

c. Exchange restrictions

Sri Lanka accepted the obligations of Article VIII, Sections 2, 3, and 4 in March 1994 and maintains an exchange system that is free of restrictions on payments and transfers for current international transactions.

d. Trade policy

Sri Lanka has maintained essentially a four-band tariff system since November 1991, when it adopted standard rates of 10, 20, 35 and 50 percent. In November 1993, the maximum standard tariff was reduced from 50 percent to 45 percent. Further unilateral liberalization occurred in February 1995, when the maximum rate was again reduced to 35 percent, achieving a three-band system with rates of 10, 20, and 35 percent.

Several zero-rated items (principally pharmaceuticals and fertilizer) remain. Moreover, some items, for example automobiles, alcoholic beverages and tobacco products, face tariffs in excess of the maximum standard rate. Duty waivers are in place for a number of items and occasionally new waivers are introduced. BOI firms have duty free import privileges and are empowered to clear customs on their own authority.

During 1993–94 the Government removed export licensing restrictions on all but four items, most justified for reasons of environmental protection. A large number of import licensing restrictions were also removed, with most of the remaining restrictions justified for reasons of national security, public health, public morals, or environmental protection.

a. General considerations

Consumer price indices are only proxy measures of inflation, as true inflation also reflects changes in prices of capital goods and services as well as those for consumers. The above considerations suggest that the CCPI is neither a good indicator of underlying inflation nor a particularly accurate reflection of price movements of consumer goods and services. There is little doubt that price increases affecting the average family in Colombo were much higher than those indicated by the CCPI in 1994. Rent, for example, increased sharply in a range of 15–20 percent in the Colombo area during the year but was not even captured by the index. Hence, alternative indicators must be looked at to assess underlying inflation and price developments in Sri Lanka during 1994.

Most definitions of underlying inflation employed in the literature revolve around some notion of a long-run, persistent component of changes in the measured price index that is typically, but not always, linked in some manner to monetary expansion. Thus, most measures of underlying inflation attempt to remove transitory or random effects on the price level, such as food and oil price shocks, and non-competitive forces such as administrative price controls. The United States Department of Labor, for example, has devised a measure of underlying inflation by removing food, energy, and shelter-related prices from the consumer price index and rescaling the remaining components.

b. Alternative approaches to estimating underlying inflation

Perhaps the most straightforward approach to estimating underlying inflation in 1994 is to simply remove the impact of duty waivers and administered price reductions from the index. The impacts of duty waivers were broad-based and spread over many categories of goods over a period of several months, and thus are difficult to estimate with any degree of precision. However, the administered price reductions were implemented at discrete points in time on particular goods that are easily identified. The impact of cuts in administered prices of wheat flour, bread, and kerosene is simulated by adding back to the official price index the index point reductions that are estimated to have resulted from the price changes. This method yields an annual average inflation of 11.7 percent and a December-to-December price increase of 11.9 percent in 1994 (Table 2 and Chart 1). As these estimates exclude the impact of duty waivers, they could be viewed as a lower bound for underlying inflation in 1994.

Table 2.

Sri Lanka: Alternative Colombo Consumer Price Indices, 1993–94

Sources: Data provided by the Sri Lanka authorities; and staff estimates.

^1/Excludes the impact of cuts in administered prices of wheat flour, bread, and kerosene.

^2/Reflects the monthly increase in the miscellaneous component of the official index from May onward.

Table 2.

Sri Lanka: Alternative Colombo Consumer Price Indices, 1993–94

	Official	Alternative	Alternative
	Index	A 1/	B 2/
	(1952 = 100)
1993: Dec.	1,498.7	1,498.7	1,498.7
1994: Jan	1,536.8	1,536.8	1,536.8
Feb	1,554.4	1,554.4	1,554.4
Mar	1,561.9	1,561.9	1,561.9
Apr	1,574.1	1,574.1	1,574.1
May	1,543.2	1,543.2	1,582.3
Jun	1,546.6	1,546.6	1,586.4
Jul	1,502.1	1,552.1	1,632.4
Aug	1,520.7	1,570.7	1,645.5
Sept	1,467.3	1,572.3	1,646.6
Oct	1,456.6	1,571.3	1,657.2
Nov	1,502.2	1,617.2	1,672.7
Dec	1,561.8	1,676.8	1,683.9
	(Percentage change)
Animal average	8.4	11.7	14.4
Dec-to-Dec	4.2	11.9	12.4

Sources: Data provided by the Sri Lanka authorities; and staff estimates.

^1/Excludes the impact of cuts in administered prices of wheat flour, bread, and kerosene.

^2/Reflects the monthly increase in the miscellaneous component of the official index from May onward.

View Table

Table 2.

Sri Lanka: Alternative Colombo Consumer Price Indices, 1993–94

	Official	Alternative	Alternative
	Index	A 1/	B 2/
	(1952 = 100)
1993: Dec.	1,498.7	1,498.7	1,498.7
1994: Jan	1,536.8	1,536.8	1,536.8
Feb	1,554.4	1,554.4	1,554.4
Mar	1,561.9	1,561.9	1,561.9
Apr	1,574.1	1,574.1	1,574.1
May	1,543.2	1,543.2	1,582.3
Jun	1,546.6	1,546.6	1,586.4
Jul	1,502.1	1,552.1	1,632.4
Aug	1,520.7	1,570.7	1,645.5
Sept	1,467.3	1,572.3	1,646.6
Oct	1,456.6	1,571.3	1,657.2
Nov	1,502.2	1,617.2	1,672.7
Dec	1,561.8	1,676.8	1,683.9
	(Percentage change)
Animal average	8.4	11.7	14.4
Dec-to-Dec	4.2	11.9	12.4

Sources: Data provided by the Sri Lanka authorities; and staff estimates.

^1/Excludes the impact of cuts in administered prices of wheat flour, bread, and kerosene.

^2/Reflects the monthly increase in the miscellaneous component of the official index from May onward.

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SRI LANKA: ALTERNATIVE COLOMBO CONSUMER PRICE INDICES, 1993–94

(1952=100)

Citation: IMF Staff Country Reports 1995, 060; 10.5089/9781451823356.002.A001

Sources: Data provided by the Sri Lanka authorities; and staff estimates.

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Another approach to estimating underlying inflation is to look at the price changes of goods that are not affected by the duty waivers and administered price cuts. In the Sri Lanka context, the miscellaneous component—comprising, among other items, various household goods, alcohol, tobacco products, newspapers, medicine, entertainment, transport, and school fees—of the CCPI was probably least affected by administered price changes and duty waivers, but has a weight of only 18.7 percent in the overall index. The miscellaneous component and the overall CCPI moved quite closely together through 1993. Over the period 1980–93, for example, the CCPI indicated an annual average inflation rate of 13.2 percent against an average of 13.6 percent for the miscellaneous component. After May 1994, however, the miscellaneous component continued to increase while the overall index declined.

In light of this, one method of estimating underlying inflation in 1994 would be to revise the overall index to reflect the increase in the miscellaneous component from May onward when the duty waivers and administered price reductions began to take effect. Applying the monthly increase in the miscellaneous component to the overall index beginning in May indicates an annual average inflation of 14.4 percent and a December-to-December price increase of 12.4 percent in 1994 (Table 2 and Chart 1). This approach is subject to upward bias as the reduction in the cost of purchasing necessities enabled a greater proportion of consumers’ income to be spent on other goods, such as those in the miscellaneous category. This, in turn, could have put pressure on miscellaneous items, resulting in greater price increases of these goods than would have been the case otherwise. However, this bias is considered to be modest owing to the time lags involved.

Another approach seeks to relate underlying inflation to monetary expansion. Broad money growth of about 20 percent during 1994, together with real GDP growth that averaged 5.6 percent and an estimated slight decline in velocity, suggests an increase in the GDP deflator of 11–13 percent in comparison with an official estimate of 9.7 percent. Given the methodology employed in Sri Lanka for calculating the GDP deflator, which utilizes the CCPI to estimate certain components, a deflator of 11–13 percent would be consistent with a December-to-December increase in consumer prices of 12–14 percent and consumer price inflation of 14–16 percent. The downward bias in the deflator may also have resulted in an overestimation of real GDP growth, which would imply even higher consumer price inflation.

A final consideration on underlying inflation is to look at the rate of increase of factor costs, such as the rental price of capital and unit labor costs. In this connection, it is interesting to note that interest rates on loans ranged from 17 to 20 percent during the year while civil service wages rose 12 1/2 percent and private sector wages outstripped the increase in the CCPI by a wide margin. For example, the minimum wage of workers in the service industry increased by about 18 percent, while workers in the textile industry received wage increases in a range of 17–19 percent. These developments provide further evidence that underlying inflation was well above the recorded inflation in 1994.

a. The plantation sector

Although the plantations formally belong to the regulated sector in the sense that they are subject to a high degree of labor market regulation, it is best to consider them separately because of their unique features. The tea plantations currently provide employment to about 450,000 mainly Tamil workers, which is about 8 percent of total employment. Tamils were originally brought from India by the British during the colonial period, and only recently became citizens of Sri Lanka. Fears of ethnic clashes between the Sinhalese majority and the Tamil minority, and other barriers, have limited the geographical mobility of the Tamil plantation workers outside the plantations (Rama 1994). Wages are very low on the plantations: the average plantation wage was about SL Rs 80 per day in 1993, in comparison with SL Rs 95 per day for a casual laborer in paddy, itself a relatively poorly paid occupation.

Lack of mobility is a major problem because there is substantial excess employment in the plantations. Since their nationalization in 1970, the plantations have been over-staffed owing to generous hiring of workers’ children by the Government and declining levels of replanting investment. As a result, the plantations’ financial position deteriorated steadily, and Sri Lanka’s share of the world tea market fell from nearly 40 percent at independence to about 10 percent at present. The performance of the sector began to improve somewhat in 1992 with the privatization of the management of the estates, although the improvement has been modest owing to constraints placed by the Government on the private managers. For example, the new managers have been prevented from retrenching staff for economic reasons, although disciplinary dismissals are allowed. Further, the duration of the management contracts is not long enough for replanting to be profitable. Hence, little new investment has been made, and it appears that the overstaffing problem will persist.

b. The regulated sector

The regulated sector covers roughly one fourth of employed workers—about 1 1/3 million persons—comprising civil servants in central and local government agencies, the military, state enterprises, and about one fifth of those employed in the private sector. Workers in the regulated sector benefit from the enforcement of a profuse array of government regulations that provide distinct advantages such as job security, high wages, and generous pensions. These advantages, in turn, provide a strong incentive to work in the regulated sector.

The Government either sets or regulates wage and non-wage benefits in the regulated sector. Government wages, at least in the lower skill grades, are well above comparable wages paid in the private sector. In the private sector, the Government sets minimum wages for most skilled trades through the Wages Boards. Although actual wages are usually higher than the minimum wages, the activities of the Wages Boards serve to keep regulated sector wages well above those in the other segments.

Perhaps the most important non-wage benefit is the pensions. Government employees benefit from a pension (or lump sum settlement) upon retirement, and their heirs benefit from a Widows and Orphans Protection Fund. Employees of public enterprises and private companies that fall under the regulated sector are covered by the Employees’ Provident Fund (EPF) and the Employees’ Trust Fund (ETF). The EPF is financed by employer contributions of 12 percent of the wage bill and employee contributions of 8 percent. Employers also contribute 3 percent of the wage bill to the ETF. In addition, employers must hold another 4 1/2 percent of wages in reservation under the Gratuity Act of 1983.

Job security is another important element of the regulated sector. Retrenchment restrictions are legislated by the Industrial Disputes Act and the Termination of Employment of Workmen Act (TEWA). ^1/ The TEWA prevents companies with more than 15 employees from laying off workers for non-disciplinary reasons without either obtaining their agreement or the prior written approval of the Commissioner of Labor. The TEWA covers lay-offs motivated by retrenchment or business closure, even termination for incompetence. Moreover, it is usually not possible to obtain permission to terminate workers from the Commissioner of Labor, so that downsizing or closure typically necessitates generous severance packages to induce voluntary retirement.

Workers in the protected segment also benefit from 26 public holidays per year, and typically from the two-day weekend common in industrial countries. Overtime and work on public holidays are remunerated at 1 1/2 times the basic wage rate, adding further to the burden of regulated sector employers.

c. The nonregulated sector

The majority of Sri Lanka’s workers—about 3 1/2 million persons—are employed in the non-regulated sector. Although much of the nonregulated sector comprises agricultural activities, it also includes numerous private manufacturing and service enterprises in urban areas. Many urban enterprises have avoided labor regulations by being below the size threshold—the TEWA does not apply to firms with less than 15 employees. Other firms are able to avoid labor market legislation with impunity owing to bureaucratic inefficiency. In addition, some firms have received compliance waivers from the Commissioner of Labor. For example, most foreign companies setting up operations in the Export Processing Zones (EPZs) have been able to negotiate very lax application of labor regulations. ^2/ Because their employers largely avoid the intricate array of labor market legislation, workers in the non-regulated sector receive correspondingly lower wages and fewer nonwage benefits.

a. Queuing

The available evidence indicates that young graduates conduct an extended search for coveted jobs in the regulated sector, especially in government and the state enterprises. This search is motivated by the superior benefits and job security described above. There is thus a voluntary aspect to this unemployment. The advantage of public sector employment are sufficiently high that they appear to justify queuing even when the probability of obtaining such employment is relatively low. Reflecting this, two thirds of the unemployed are 24 years old or younger, and half have attained their General Certificate of Education (Ordinary or O-level).

A necessary condition of voluntary unemployment is that the unemployed must be wealthy enough to afford it. Evidence from household surveys indicates that the median duration of unemployment is 15 months and that more than one in ten of the unemployed have been so for more than four years. Moreover, survey data indicate that virtually all unemployed school leavers receive assistance from their families. These findings, together with the fact that well over half of the unemployed have never had a job, suggest that the majority of the jobless are the children of relatively wealthy families.

Many observers have attributed the high voluntary unemployment to government hiring practices that favor the unemployed. As described above, government jobs provide generous benefits and a high degree of job security in comparison with private sector jobs in the non-regulated sector. In addition, there is a great deal of prestige attached to government jobs. Those queuing do not take other employment because of a perceived or real government preference for hiring the unemployed. Although this contention is controversial, recent action by the Government to hire large numbers of unemployed graduates as teachers reinforces this perception. Irrespective of the actual behavior of the Government, the widespread perception, that it favors the unemployed in its hiring practices contributes to the unemployment problem in that young school leavers do not accept jobs in the nonregulated sector because they believe it reduces their chances of obtaining more desirable employment in the public sector.

Survey evidence indicates that many of the unemployed young engage in a variety of activities while waiting for government jobs, such as studying to retake the O- and A-level examinations, to become eligible for such jobs while receiving financial support from their families. The high rate of second and further sittings for O- and A-level exams confirms this. ^1/ Young people in Sri Lanka may also prefer unemployment to accepting a low-wage job in the non-regulated sector because they can count on parental support, and choose not to work if not required to do so by their parents. The evidence also suggests that low-wage employment in the nonregulated sector is not taken because of the stigma attached to it by the relatively well-educated segments of the population.

b. Relative price

Government policies increasing the cost of labor relative to capital induce investment in labor-saving and capital-intensive manufacturing technology, and thus slow the growth of employment. The main policies that increase labor costs are the TEWA and the 23 percent social security tax rate on wages. The TEWA, in particular, has been viewed as being a major constraint to efficient utilization of factors of production, resulting not only in a more capital-intensive production structure than relative factor endowments would dictate, but also in a lack of vertical integration of industrial operations as firms have sought to stay under the 15 worker threshold over which the TEWA becomes operative. ^2/ The TEWA prevents any retrenchment on non-disciplinary grounds without the written consent of the workers concerned in production units with fifteen or more personnel. Historically, firms that have attempted to discontinue all or part of their operations without the workers’ consent have paid dearly for doing so. In virtually every case, the Commissioner of Labor—the legislated arbiter of labor disputes—has sided in favor of labor, often imposing compensation amounts equivalent to several years wages per worker. Since consentment requires generous severance pay, the TEWA has been viewed by private firms as a major constraint to expanding or diversifying their operations, and provides them a powerful incentive to minimize the size of their work force.

Duty waivers and reductions on the import of capital goods used in export industries, a common practice in Sri Lanka for firms located in the EPZs, could also lead to lower employment growth because they raise the price of labor relative to capital. Policy measures that lower the price of capital, such as interest subsidies, which are a common feature of various government industrial development programs, might also be resulting in greater utilization of capital than relative factor costs would dictate.

a. Trade-liberalizing measures: 1993–94

Under the ESAF II, the Government aimed at reducing the maximum tariff under the four-band system from 50 percent to 45 percent by April 1993. In the event, this reduction was implemented with the 1994 budget (November 1993). At the same time, the Government’s commitment to further trade liberalization was strengthened when it announced that the maximum rate would again be reduced to 35 percent in the 1995 budget. ^1/ In the event, the 1995 budget submitted to Parliament by the People’s Alliance further consolidated the tariff system by reducing the maximum standard tariff rate from 45 percent to 35 percent.

Consistent with the Government’s intention to consolidate the tariff system and to eliminate anomalies, all specific tariffs on textiles were converted to an ad valorem rate of 100 percent in April 1993. The official ad valorem rate on textiles was then reduced in November 1993 from 100 percent to 50 percent. Also in the 1994 budget, the specific tariffs on various garments were removed, leaving these items with a 50 percent ad valorem customs duty. A significant number of other items that had previously combined specific and ad valorem rates—applying the higher of the two—were brought into the four-band system in the 1994 budget. ^1/

Another significant development in 1993 involved the duty treatment of various automobiles. Progress was made toward integrating automobiles into the standard tariff bands when the Government announced a downward adjustment in duties, with cuts differentiated by engine size. The 1993 revision specificd auto tariffs of from 50 percent to 100 percent (Table 10). ^2/

Table 10.

Sri Lanka: Nonstandard Customs Duties, 1994–95

^1/Nonstandard rates include all ad valorem rates outside the four-band system in 1994 (outside the three-band system in 1995), and all specific tariffs.

^2/Most items in the range HS 49.01–49.07 are duty free.

^3/Items in HS 71.18 are duty free.

^4/Items HS 52.01.00, and HS 5503.10. 5503.20, 5503.30, 5503.40, 5503.90.

^5/HS 2523.10.

^6/HS 2523.29.03.

^7/Includes HS 2709.00, 2710.00.02, 2710.00.07.

^8/Item HS 2709.00 went from 35 percent or Rs 2500 per MT in 1994 to 35 percent or Rs 3000 per MT in 1995.

^9/Items HS 6914.10, 6914.90.

^10/Item HS 8714.91.01.

^11/Includes items in HS 57.01, 57.02, 57.03, 57.04, and 57.05.

^12/All items in HS 57.01 and 57.02 were changed to 35 percent in the 1995 budget. However, the remaining items are not identified as having been lowered to 35 percent.

Table 10.

Sri Lanka: Nonstandard Customs Duties, 1994–95

Product	Nonstandard Customs Duties1/
	1994	1995 Budget
Pharmaceuticals	zero-rated	no change
Fertilizers	zero-rated	no change
Various Printed Materials 2/	zero-rated	no change
Gold and Silver Coins 3/	zero-rated	no change
Selected Items for Physically Impaired	zero-rated	no change
Certain Cotton & Synthetic Fibers not Carded or Combed or otherwise processed for spining 4/	3 percent	zero-rated
Cement Clinker 5/	5 percent	no change
Certain Portland Cement in Bulk 6/	7.5 percent	no change
Various Yarns not for Retail Sale	25 percent	20 percent
Textiles and Clothing	50 percent	35 percent
Various Agricultural Products	Typically include a standard ad valorem rate and a specific tariff, with the higher of the two applied.	Specific duties eliminated, ad valorem rate now at 35 percent.
Various Tobacco Products	From 50 percent to not less than 250 percent; specific tariffs remain in some cases and the higher of the specific and the ad valorem apply.	no change
Various Alcoholic Beverages	Specific tariffs as high as Rs 570 per liter.	no change
Certain Petroleum Products 7/	35 percent or Rs 2500 per metric ton.	Specific tariff eliminated, except one item, for which the specific tariff was increased.,8/
Certain Articles of Porcelain or China 9/	45 percent or Rs 90	20 percent
Certain Tiles, Cubes and Similar Articles	45 percent or Rs 3	no change
Bicycle Frames 10/	35 percent or Rs 2503	20 percent
Carpets and Other Textile Floor Coverings 11/	50 percent	A subset of items changed to 35 percent. 12/

^1/Nonstandard rates include all ad valorem rates outside the four-band system in 1994 (outside the three-band system in 1995), and all specific tariffs.

^2/Most items in the range HS 49.01–49.07 are duty free.

^3/Items in HS 71.18 are duty free.

^4/Items HS 52.01.00, and HS 5503.10. 5503.20, 5503.30, 5503.40, 5503.90.

^5/HS 2523.10.

^6/HS 2523.29.03.

^7/Includes HS 2709.00, 2710.00.02, 2710.00.07.

^8/Item HS 2709.00 went from 35 percent or Rs 2500 per MT in 1994 to 35 percent or Rs 3000 per MT in 1995.

^9/Items HS 6914.10, 6914.90.

^10/Item HS 8714.91.01.

^11/Includes items in HS 57.01, 57.02, 57.03, 57.04, and 57.05.

^12/All items in HS 57.01 and 57.02 were changed to 35 percent in the 1995 budget. However, the remaining items are not identified as having been lowered to 35 percent.

View Table

Table 10.

Sri Lanka: Nonstandard Customs Duties, 1994–95

Product	Nonstandard Customs Duties1/
	1994	1995 Budget
Pharmaceuticals	zero-rated	no change
Fertilizers	zero-rated	no change
Various Printed Materials 2/	zero-rated	no change
Gold and Silver Coins 3/	zero-rated	no change
Selected Items for Physically Impaired	zero-rated	no change
Certain Cotton & Synthetic Fibers not Carded or Combed or otherwise processed for spining 4/	3 percent	zero-rated
Cement Clinker 5/	5 percent	no change
Certain Portland Cement in Bulk 6/	7.5 percent	no change
Various Yarns not for Retail Sale	25 percent	20 percent
Textiles and Clothing	50 percent	35 percent
Various Agricultural Products	Typically include a standard ad valorem rate and a specific tariff, with the higher of the two applied.	Specific duties eliminated, ad valorem rate now at 35 percent.
Various Tobacco Products	From 50 percent to not less than 250 percent; specific tariffs remain in some cases and the higher of the specific and the ad valorem apply.	no change
Various Alcoholic Beverages	Specific tariffs as high as Rs 570 per liter.	no change
Certain Petroleum Products 7/	35 percent or Rs 2500 per metric ton.	Specific tariff eliminated, except one item, for which the specific tariff was increased.,8/
Certain Articles of Porcelain or China 9/	45 percent or Rs 90	20 percent
Certain Tiles, Cubes and Similar Articles	45 percent or Rs 3	no change
Bicycle Frames 10/	35 percent or Rs 2503	20 percent
Carpets and Other Textile Floor Coverings 11/	50 percent	A subset of items changed to 35 percent. 12/

^1/Nonstandard rates include all ad valorem rates outside the four-band system in 1994 (outside the three-band system in 1995), and all specific tariffs.

^2/Most items in the range HS 49.01–49.07 are duty free.

^3/Items in HS 71.18 are duty free.

^4/Items HS 52.01.00, and HS 5503.10. 5503.20, 5503.30, 5503.40, 5503.90.

^5/HS 2523.10.

^6/HS 2523.29.03.

^7/Includes HS 2709.00, 2710.00.02, 2710.00.07.

^8/Item HS 2709.00 went from 35 percent or Rs 2500 per MT in 1994 to 35 percent or Rs 3000 per MT in 1995.

^9/Items HS 6914.10, 6914.90.

^10/Item HS 8714.91.01.

^11/Includes items in HS 57.01, 57.02, 57.03, 57.04, and 57.05.

^12/All items in HS 57.01 and 57.02 were changed to 35 percent in the 1995 budget. However, the remaining items are not identified as having been lowered to 35 percent.

Table 10.

Sri Lanka: Nonstandard Customs Duties, 1994–95

Source: Staff’s compilation from Sri Lankan Customs Schedule of 1994 and changes announced in the official directive to customs officers (Ref. No. PL/RPO\95\02 dated February 9, 1995, from the Director General of Customs).

^1/Item HS 4808.90.09.

^2/Items HS 8703.10 and 8703.21.09

Table 10.

Sri Lanka: Nonstandard Customs Duties, 1994–95

Product	Nonstandard Customs Duties1/
Certain Paper and Paper Board, Corrugated, Creped, Crinkled, Embossed or Perforated in Rolls or Sheets 1/	50 percent	no change
Vehicles Specially Designed for Travelling on Snow, Golf Cars and Similar Vehicles 2/	50 percent	no change
Automobiles up to 1500 cc	50 percent	no change
Automobiles from 1500 to 2000 cc	75 percent	no change
Automobiles Greater than 2000 cc	100 percent	no change

Source: Staff’s compilation from Sri Lankan Customs Schedule of 1994 and changes announced in the official directive to customs officers (Ref. No. PL/RPO\95\02 dated February 9, 1995, from the Director General of Customs).

^1/Item HS 4808.90.09.

^2/Items HS 8703.10 and 8703.21.09

View Table

Table 10.

Sri Lanka: Nonstandard Customs Duties, 1994–95

Product	Nonstandard Customs Duties1/
Certain Paper and Paper Board, Corrugated, Creped, Crinkled, Embossed or Perforated in Rolls or Sheets 1/	50 percent	no change
Vehicles Specially Designed for Travelling on Snow, Golf Cars and Similar Vehicles 2/	50 percent	no change
Automobiles up to 1500 cc	50 percent	no change
Automobiles from 1500 to 2000 cc	75 percent	no change
Automobiles Greater than 2000 cc	100 percent	no change

Source: Staff’s compilation from Sri Lankan Customs Schedule of 1994 and changes announced in the official directive to customs officers (Ref. No. PL/RPO\95\02 dated February 9, 1995, from the Director General of Customs).

^1/Item HS 4808.90.09.

^2/Items HS 8703.10 and 8703.21.09

The Government made additional progress in 1993 toward eliminating all import and export licensing restrictions not justified for reasons of national security, public health, public morals, or environmental protection. Of the eleven items remaining under export licensing control in 1993, ^3/ the Government removed all but four from the list.

Regarding import licensing restrictions, the Government eliminated all but a few restrictions not justified under the above criteria in 1993. Items removed from import licensing control included, for example, various agricultural products, ^4/ articles of jewelry and parts thereof, automobiles not exceeding three years in use, other motor vehicles not exceeding ten years in use, various photocopying equipment, newsprint in roles or sheets, and photographic or cinematographic film.

b. Setbacks to trade liberalization: 1993–94

A setback to the Government’s overall policy of trade liberalization became effective December 22, 1993, when it imposed a number of import surcharges intended to provide temporary protection to local manufacturing sectors. ^1/ The order implementing these surcharges called for their automatic expiration at end-1994. ^2/ Surcharges were imposed on exercise books, woven cotton fabrics, sarongs, steel bars and rods, razors and razor blades, certain batteries, and bicycles. In the case of cotton fabrics, the surcharges partially restored the level of protection that had been lost when the ad valorem rate on textiles was cut from 100 percent to 50 percent in November 1993. Regarding the other products, the authorities maintained that these surcharges were necessary to offset foreign “dumping.” ^3/ It is also evident, however, that in some cases the intent of these surcharges was to restore a measure of the protection that had been lost when specific tariffs were eliminated in the 1994 budget. ^4/

Notwithstanding its commitment under the ESAF arrangement to eliminate all quantitative restrictions not justified for reasons of national security, public health, public morals or environmental protection, the UNP Government introduced in 1992 and 1993 a number of new import licensing restrictions not meeting the agreed profile. Import licensing restrictions were introduced in June 1992 on several additional agricultural products in order to secure more effective protection for domestic producers. ^1/ In January 1993, the Government introduced new licensing restrictions on the importation of certain diesel engines. ^2/ The latter measure was taken in order to stanch the recently observed tendency to substitute diesel engines for petrol engines, which had arisen largely in response to the Government’s policy to subsidize diesel fuel. The Government expressed its intention to remove these restrictions by end-June 1994. In the event, these were not removed.

a. The tariff structure at end-1994

The tariff structure through end-1994 was dominated by the four-band tariff system with rates of 10, 20, 35, and 45 percent. Generally, the 45 percent rate applied to finished goods and certain food products, but a large number of items fell outside these categories. ^3/ The 35 percent rate was less amenable to categorization, but was applied to a number of intermediate goods some of which are manufactured locally, a number of consumer goods, various flours and cereal grains, and miscellaneous other items. The 35 percent band appears to have served more as an exceptional rate to the 45 percent band than as the primary rate for a well-defined set of items. This was also true of the 20 percent rate, although it was slightly more dominated by components and parts than was the 35 percent band. ^4/ The 10 percent band applied principally to capital goods and raw materials, including various chemical products.

At end-1994, a significant number of items continued to face customs duties outside the four-band system (Table 10), Virtually all pharmaceuticals and fertilizers were zero-rated. A number of printed materials were also zero-rated. ^1/ Various silver and gold coins and certain devices for the physically impaired also were zero-rated in the customs schedule. It is noteworthy that the set of zero-rated items applying to devices for the physically impaired is a subset of all such items. ^2/ Among the most significant items facing customs duties in excess of 45 percent at end-1994 were automobiles (described above), as well as most textiles and garments (50 percent). Various tobacco products carried customs duties of 50 percent or more, with some greater than 250 percent. ^3/, ^4/ As indicated in Table 10, a small number of items other than textiles and garments also faced customs duties of 50 percent. Other miscellaneous rates outside the four-band system also continued to apply in 1994. Revisions that occurred in the 1995 budget are reported in Table 10.

Because of a number of special charges and markups in place through 1994 and into 1995, the full discriminatory tax treatment of imports is not captured by the customs duty alone. In the case of goods with duties at 45 percent or above, a special surcharge, the Export Development Board (EDB) cess, is imposed. ^5/ The EDB cess is assessed at 10 percent of the import duty. Thus, with the highest standard duty at end-1994 set at 45 percent, the EDB cess added 4.5 percent to the customs duty.

In addition to the EDB cess, a discriminatory element exists in the calculation of two domestic taxes. While turnover taxes and the defense levy apply to both imports and domestically sourced products, these taxes are not simply applied to the CIF value of imports, nor to the CIF value plus customs duties (customs duty plus EDB cess). Instead, these “nondiscriminatory” taxes, are applied to imports in a discriminatory manner. The turnover tax, for example, when applied to a product whose customs tariff is 45 percent, is calculated on the basis of the CIF price plus duties, plus a 25 percent markup. ^1/ The defense levy also is calculated based on a 25 percent markup. The markup, which has been changed from time to time, implies a de facto increase in the discriminatory tax treatment of imports. In the case of a 20 percent turnover tax and a 3.5 percent defense levy, the 25 percent markup adds over 8 percent in additional discriminatory taxes on imports (i.e., a discriminatory element in excess of the customs duty and the EDB cess). Because an item in the 45 percent tariff band (applicable through end-1994) pays 49.5 percent before the application of domestic taxes—due to the EDB cess—and because the calculation of domestic taxes includes about a 9 percent discriminatory element, the full discriminatory tax treatment of a good in the 45 percent tariff band may exceed 58 percent. ^2/

A number of specific tariffs also remained as anomalies in the four-band system at end-1994 (Table 10). Among the agricultural products, specific tariffs applied to potatoes, onions, green and black gram, lentils, chilies, rice, beedi leaves, sugar, and tobacco (other than beedi tobacco). Specific tariffs also applied to certain petroleum products, alcoholic beverages and spirits, certain ceramic tiles, and bicycle frames.

b. The tariff structure established in the 1995 Budget

The 1995 budget reduced the maximum standard tariff rate from 45 percent to 35 percent. This folded the old four-band system into a new three-band system with standard rates of 10, 20, and 35 percent. Virtually all items that had been in the 45 percent band (described above) were moved to the 35 percent band. Items that had been at 10, 20 and 35 percent remained virtually unchanged. In addition, the budget incorporated all textiles and clothing (previously facing a 50 percent tariff) into the 35 percent band. As indicated in Table 10, several other nonstandard tariffs were eliminated in 1995, but some remain.

The EDB cess and the use of markups before the application of turnover tax remained in place under the new three-band system. With the implementation of the goods and services tax (GST), expected for October 1995, the markups, but not the cess, would be removed. The cess is currently slated for elimination at end-1995.

c. Duty waivers and exemptions

An important problem in the trading system that was clearly evident through mid-1994 was the practice of granting duty waivers and exemptions. The practice was nontransparent and was not constrained by a narrowly defined set of rules or procedures. The Minister of Finance (de facto this implied either the Secretary or the Deputy Secretary to the Treasury) was empowered to waive all or part of any customs duty. The recommendation of line ministries and/or the Cabinet were taken into account in granting such waivers. While such actions were typically gazetted (i.e, formally opened to public notice), frequently these notices were issued well after the fact. The Fund and the World Bank have expressed great concern about the practice of granting duty waivers and exemptions and the new Government has expressed similar concerns. ^1/

The distinction between duty exemptions and duty waivers is blurred. Both can apply to either a specific product or to a specific class of importer. One distinction that can be made is that, while all exemptions imply full relief from the customs duty, duty waivers may be either full or partial. It is noteworthy that duty waivers in Sri Lanka have been granted both on a standing basis and on the basis of individual import consignments. Standing duty waivers remain in place until further notice, or until expiration. Waivers granted for individual consignments have been far less transparent and evidence of their frequent use is anecdotal and unofficial.

At end-1993, the official list of full duty waivers contained 25 items including, for example, nurses’ uniforms, certain cellular telephones, items donated to schools and educational institutions, and all products imported for use in new and existing tourist hotels. The list of partial duty waivers at end-1993 included a number of agricultural products, certain milk powder, and some strike-related items temporarily in short supply, 13 items in all. ^2/ With the revisions in the tariff code contained in the 1995 budget, the Government narrowed the list of duty waivers—19 categories with full waivers and 4 with-partial waivers remained as of February 8, 1995. A number of the items removed from the list were simply placed into the zero rate in the tariff code.

A list of 34 categories of duty exemptions was also in place at end-1993. While importers claiming a duty exemption must typically receive certification from the Director General of Customs, some require the specific authorization of the Secretary or Deputy Secretary to the Treasury. Representative of the list of duty exemptions in force at end-1993 are: (i) containers and accessories for use for the safe carriage of goods as defined by and subject to the conditions laid down by the Director General of Customs; (ii) drugs proved to the satisfaction of the Director General of Customs as being homeopathic drugs; (iii) materials proved to the satisfaction of the Director General of Customs as having been imported for the manufacture of pharmaceuticals; (iv) goods imported for display or use at exhibitions, fairs, meetings, or similar events, approved by the Secretary/ Deputy Secretary to the Treasury, subject to the conditions laid down.

The list of duty exemptions was narrowed somewhat in the 1995 budget to 22 categories. Among the categories removed from the previous list of exemptions are, for example, certain work trucks, certain shrimp feed and chemicals, and certain rough diamonds and semi-precious stones. About 40 percent of the categories remaining on the list are health-care items, items used in pharmaceutical production, or certain homeopathic drugs.

In the past, there have been significant delays between the time various duty waivers and exemptions were issued and the time when they were formally gazetted. In the interest of minimizing discretionary elements in the trade regime and maximizing transparency, the UNP Government agreed with the Fund and the World Bank in February 1994 to revise its policy toward waivers and exemptions. ^1/ Under the new policy, the Government would issue in a timely fashion a press release indicating the product(s) involved, the recipient(s), and the time frame, if any, for all new duty waivers and exemptions. This was not intended to substitute for the formal gazetting of waivers and exemptions, but to act as a vehicle for increasing the transparency of such actions. The Government also stated its intention in January 1994 to refrain from issuing new duty waivers, except under exceptional circumstances. Notwithstanding this commitment, the Ministry of Finance announced a significant number of new waivers during the first half of 1994. ^2/

The new Government has expressed its concern over past practices and now reports that the procedures for granting all new duty waivers or exemptions have been significantly tightened. Under the new system, any request for a new waiver or exemption would be sent for Cabinet deliberation. The Cabinet would then determine whether a waiver or exemption would be in the “public interest”. If so, the Cabinet would approve the new waiver or exemption, the Minister of Finance would sign the order, and a press release would be issued immediately on that decision. Whether the new practice will produce greater restraint will ultimately depend on how broadly ministers choose to define the “public interest.” At end-March 1995, the Government had already announced the first new duty waiver under the new system. ^3/

d. Special status of Board of Investment (BOI) firms

Another problematic aspect of Sri Lanka’s trade regime into 1995 involved the preferential status assigned to BOI firms. ^1/ These firms are export-oriented firms approved by the Board of Investment. Among other tax concessions, BOI firms are granted duty-free import privileges and are empowered to clear customs on their own authority. Nominally, this policy is intended to create an incentive for setting up nontraditional export-oriented manufacturing operations by reducing the cost of foreign-sourced intermediate and capital goods. However, there is strong anecdotal evidence that the special status of BOI firms has been an important source of leakages at the border. Customs officials currently have no authority to check BOI imports for unauthorized goods. In early 1994, the UNP Government indicated that it was in the process of establishing a special “import-monitoring unit” within the Treasury with the authority to monitor the import consignments of BOI firms. This initiative was taken in lieu of establishing a preshipment inspection (PSI) scheme, which had been rejected by the authorities in early 1994. The authorities also indicated that they intended to extend the duty-free status of BOI firms to certain other export-oriented firms.

With the change in government, the special status of BOI firms was reconsidered. By early 1995, the new authorities were actively pursuing the implementation of a PSI scheme, which is expected to be in place by as early as September 1995. Imports of BOI firms will be subject to PSI review and this is expected to stanch some of the leakages at the border.

e. Export taxes

A benchmark under the second annual ESAF arrangement (ESAF II), the Government eliminated all on-budget export duties in December 1992. ^2/ While export duties were formally abolished, a number of export cesses and “royalties” remain. Royalty payments are required upon the export of live elephants, natural graphite, coral and similar materials (including conch shell), quartz (silica), and iron and non-alloy steel. Export cesses apply to various coconut products, including fibers, coir mats/rugs, and pads/mattresses for bedding. Cesses also apply to tea packets and bags, rubber, cashew nuts in shells, and raw hides and skins. Both cesses and royalties are off budget.

f. Export and import licensing

By 1994, just four items remained under export licensing restrictions. These were timber, coral shanks and shells, ivory and ivory products, and old vehicles (1945 vintage or older).

While most of the items currently under import license are justified for reasons of national security, public health, public morals, or environmental protection, a few exceptions remain. These exceptions include a number of agricultural products, certain used transport vehicles, ^1/ and certain diesel engines. ^2/ Under the terms of the third annual arrangement under ESAF, the government stated its intention to eliminate the licensing restriction on diesel engines by end-June 1994. Presently, the new Government intends to eliminate the diesel-engine licensing restriction by end-1995. The authorities expressed the intention in February 1994 to subject pharmaceuticals and chemical products to GATT-conforming automatic licensing procedures. ^3/

g. Regional trade agreements

Sri Lanka is a member of the Bangkok Agreement, which is intended to promote regional economic development through trade expansion among members of the Economic and Social Commission for Asia and the Pacific (ESCAP). Under the Bangkok Agreement, Sri Lanka offers concessional tariff rates to Bangladesh, India, Lao P.D.R, the Republic of Korea, and Papua New Guinea. ^4/ The product coverage is about 300 items.

Sri Lanka is also a member of the South Asian Association for Regional Co-Operation (SAARC), established in 1985. SAARC countries are committed to step-by-step liberalization of trade in a such a manner that all countries in the region share the benefits of trade expansion equitably. In July 1992, a decision was reached to draft an agreement for a SAARC Preferential Trading Arrangement (SAPTA). The draft Agreement was submitted to the SAARC Standing Committee in December 1992 with the recommendation that all formalities for operationalizing the SAPTA, including the finalization of schedules of concessions, be completed before 1995. ^5/ The end-1994 deadline was not met. By January 1995, Sri Lanka had forwarded its “request list”—which will form the basis for negotiations on national schedules of concessions—to all contracting states except Pakistan and had received a formal request list in return only from Bangladesh.

h. Overview of Uruguay Round market access commitments

The import coverage of Sri Lanka’s tariff bindings ^1/ committed under the Round is among the least ambitious undertaken by developing countries (Table 12). Among all developing countries, the percentage of bound tariff lines for industrial products rose from 21 to 73 percent. Sri Lanka’s tariff line coverage for industrial products went from 4 percent to 8 percent under the Round. Prior to January 1, 1995, Sri Lanka had 125 tariff lines bound at the 8-digit HS level, at rates ranging from 75 percent to 100 percent, all well in excess of applied rates. With the implementation of the Round, 2,128 tariff lines at the 8-digit HS level are now bound and bindings are set at 50 percent. ^2/ Tariff bindings after the Uruguay Round cover about 11 percent of the value of imports of industrial products, as against about 7 percent prior to the Round.

Table 12.

Sri Lanka: Tariff Bindings on Industrial Products for Selected Developing Countries ^1/

Source: GATT (1994).

^1/Excludes petroleum.

Table 12.

Sri Lanka: Tariff Bindings on Industrial Products for Selected Developing Countries ^1/

	Pre-Uruguay Round		Post-Uruguay Round
Country	Shares of lines	Shares of imports	Shares of lines	Shares of imports
Argentina	5	21	100	100
Brazil	6	23	100	100
Chile	100	100	100	100
Colombia	1	3	100	100
Costa Rica	100	100	100	100
El Salvador	100	100	100	100
Hong Kong	1	1	24	23
India	4	12	62	68
Indonesia	10	30	93	92
Jamaica	0	0	100	100
Korea Rep.	10	24	90	89
Macau	0	0	10	10
Malaysia	0	2	62	79
Mexico	100	100	100	100
Peru	7	20	100	100
Philippines	6	9	59	67
Romania	21	10	100	100
Senegal	29	40	32	41
Singapore	0	0	65	73
Sri Lanka	4	7	8	11
Thailand	2	12	68	70
Tunisia	0	0	46	68
Turkey	34	38	37	39
Uruguay	3	11	100	100
Venezuela	100	100	100	100
Zimbabwe	8	11	9	13

Source: GATT (1994).

^1/Excludes petroleum.

View Table

Table 12.

Sri Lanka: Tariff Bindings on Industrial Products for Selected Developing Countries ^1/

	Pre-Uruguay Round		Post-Uruguay Round
Country	Shares of lines	Shares of imports	Shares of lines	Shares of imports
Argentina	5	21	100	100
Brazil	6	23	100	100
Chile	100	100	100	100
Colombia	1	3	100	100
Costa Rica	100	100	100	100
El Salvador	100	100	100	100
Hong Kong	1	1	24	23
India	4	12	62	68
Indonesia	10	30	93	92
Jamaica	0	0	100	100
Korea Rep.	10	24	90	89
Macau	0	0	10	10
Malaysia	0	2	62	79
Mexico	100	100	100	100
Peru	7	20	100	100
Philippines	6	9	59	67
Romania	21	10	100	100
Senegal	29	40	32	41
Singapore	0	0	65	73
Sri Lanka	4	7	8	11
Thailand	2	12	68	70
Tunisia	0	0	46	68
Turkey	34	38	37	39
Uruguay	3	11	100	100
Venezuela	100	100	100	100
Zimbabwe	8	11	9	13

Source: GATT (1994).

^1/Excludes petroleum.