Sri Lanka
Selected Issues

This Selected Issues paper on Sri Lanka provides background information on economic developments during 1995 and the first half of 1996 and on key policy issues in the current setting. The paper notes that the economic situation has deteriorated on a number of fronts—inflation has risen; investment and growth have slowed; and the external current account deficit is large while foreign investment flows have fallen significantly. The influence of various factors on Sri Lanka’s longer-term growth performance is discussed. The implications of structural reforms for investment and growth are also examined.


This Selected Issues paper on Sri Lanka provides background information on economic developments during 1995 and the first half of 1996 and on key policy issues in the current setting. The paper notes that the economic situation has deteriorated on a number of fronts—inflation has risen; investment and growth have slowed; and the external current account deficit is large while foreign investment flows have fallen significantly. The influence of various factors on Sri Lanka’s longer-term growth performance is discussed. The implications of structural reforms for investment and growth are also examined.

I. Introduction

This paper provides background information on recent economic developments and on key policy issues in the current setting. The main economic developments in 1995 and the first half of 1996 are discussed in Chapter II, which notes that the economic situation has deteriorated on a number of fronts–inflation has risen; investment and growth have slowed; and the external current account deficit is large while foreign investment flows have fallen significantly. The high fiscal deficits for the last several years, coupled with structural weaknesses in some areas, are at the root of many of Sri Lanka’s economic problems. Recently, economic difficulties have been exacerbated by the escalation of military activities, a severe drought, and power shortages. As background for this chapter, a comprehensive set of statistical tables for the real economy, public finances, money and credit, and the external sector is provided in the Appendix.

The influence of various factors on Sri Lanka’s longer-term growth performance is discussed in Chapter III. Failure to maintain macroeconomic stability on a consistent basis and uneven progress on structural reforms have been common themes throughout the post-independence period. Looking ahead, early headway on the remaining structural reform agenda, particularly in the financial sector, labor markets, public enterprises, trade regime and agricultural sector, will be critical to create new investment and growth opportunities. The implications of structural reforms for investment and growth are examined in Chapter IV.

The broad elements of the Government’s medium-term economic strategy were laid out in the last budget speech. The main objectives include: a reduction in inflation to 5-6 percent; a gradual acceleration of economic growth to 7-8 percent; and a reduction in the external current account deficit to about 4 percent of GDP. The adjustment path consistent with these objectives will require a sustained reduction in the fiscal deficit over the next few years in order to generate the national savings needed to fund higher levels of investment. The staff has developed a scenario, based on the Government’s strategy and taking into account recent developments, to illustrate how economic developments in Sri Lanka might unfold over the next 5 years if strong macroeconomic and structural policies are pursued. This medium-term macroeconomic scenario, particularly the implications for fiscal adjustment and the associated expenditure and revenue policy changes, are described in Chapter V.

II. Recent Economic Developments

1. Real sector 1/

a. Growth, saving, and investment

Economic activity remained relatively buoyant in 1995. Real GDP grew at 5 1/2 percent during the year, matching the annual average growth over the previous 5 years (Chart II.1). Growth was fueled by a continued strong expansion of garment exports, favorable commodity prices, and generally good crop harvests. The services sector contributed about 2 1/2 percentage points to output growth, manufacturing nearly 2 percentage points, and agriculture a little over 1/2 a percentage point.



Citation: IMF Staff Country Reports 1996, 100; 10.5089/9781451823363.002.A001

Source: Information provided by the Sri Lanka authorities.

The deteriorating security situation and labor unrest, however, contributed to a significant slowing of private investment, which is estimated to have declined by nearly 2 percentage points of GDP to 17 3/4 percent in 1995. Underlying this decline were substantially lower private capital inflows, in particular of foreign direct and portfolio investment, relative to previous years. Security concerns and political uncertainties prompted delays in foreign-financed capital projects, while depressed share prices and a poor outlook for corporate profitability kept overseas institutional investors out of the market. The winding down of Air Lanka’s re-fleeting program also played a role–in 1994 the private investment ratio was boosted by the purchase of two aircraft by Air Lanka; only one such aircraft was purchased in 1995. 2/ The public investment ratio remained stable at about 7 1/2 percent of GDP, thus the overall investment ratio fell to about 25 percent of GDP in 1995.

The national savings rate fell to 18 1/4 percent of GDP in 1995, nearly one percentage point below the 1994 level. This drop reflected lower private savings in relation to GDP, which was induced in part by higher sales and excise taxes on consumption goods. Private transfers from abroad, at 5 1/4 percent of GDP, continued to contribute significantly to the national savings effort, reflecting the usual remittances for family maintenance from growing numbers of overseas workers.

Against these developments, the economy’s savings/investment gap narrowed from about 8 percent of GDP in 1994 to just under 7 percent of GDP in 1995, mirroring the decline in the trade deficit. A significant drop in capital goods imports, stemming from the slowdown in private investment, and weak demand for imported consumer durables led to a narrowing of the trade balance in 1995.

Economic activity has slowed significantly in the first half of 1996, and real GDP is projected to grow by only 3 1/2 percent for the year. The slowdown is due primarily to a prolonged drought and resulting power shortages; agricultural production and manufacturing output of small and medium-scale enterprises have been particularly hard hit. An increase in strike activity and heightened security concerns, both of which have undermined investor confidence, have also played a role. Foreign direct and portfolio investment flows continue to be very low and activity on the Colombo Stock Exchange has fallen to historical lows. The ratio of investment to GDP is thus expected to drop further in 1996 to below 25 percent. The economy’s savings/investment gap relative to GDP is projected to be about the same level in 1995.

b. Sectoral developments

i. Agriculture

Agriculture accounted for about 20 percent of GDP in 1995. The sector registered a growth rate of 3 1/3 percent in 1995, about the same as in 1994. Paddy farming continued to be a strong contributor to agricultural expansion, growing by nearly 5 percent, owing to favorable weather conditions and increased fertilizer use. Growth of the plantation sector slowed considerably in 1995 as the favorable effects of the recovery from the 1993 drought wore off. Nevertheless, the sector still registered a respectable growth rate of 3 1/4 percent, reflecting favorable prices on world commodity markets and increased production of tea, rubber, and coconuts. The performance of other crops was mixed. Potato output, for example, increased by over 40 percent because of increased yields from improved seed varieties and expansion of the cultivated area. Onion production, in contrast, dropped sharply as problems that arose in marketing the bumper 1994 crop discouraged many farmers from replanting in 1995. Sugarcane, an important industrial crop, recorded a marginal decrease in production in 1995. In the noncrop sectors, value added in fisheries increased by 5 percent, mainly due to higher sea and aquaculture fish production and increased prawn output. The addition of new boats, engines, and fishing gear contributed to this strong output expansion.

A noteworthy development in the agriculture sector in 1995 was the significant decline in rice consumption associated with the large subsidy on wheat flour. As rice prices began to decline with bumper harvests, the Government reactivated the Paddy Marketing Board (PMB) to maintain farmgate prices. To hold prices, the PMB had to purchase a record 282 thousand metric tons of paddy, 10 percent of the annual harvest, resulting in large operational losses which had to be covered by borrowing from the commercial banking system.

ii. Manufacturing

Sri Lanka’s relatively robust growth performance in 1995 continued to be underpinned by the manufacturing sector, which grew by 9 1/4 percent in 1995. The growth of manufacturing was led by a 10 percent expansion of industrial output, which accounted for over 80 percent of value added in the sector. Textiles, apparel, and leather products, which grew by nearly 15 percent, and food, beverages, and tobacco, which grew by 11 percent, contributed 80 percent of the growth in industrial output. By contrast, output of chemicals, rubber and plastic products increased by only 6 1/2 percent in 1995, compared with 9 percent in 1994, due to the temporary closure of the petroleum refinery for routine maintenance. Private sector industrial output grew by 12 percent in 1995 and accounted for 91 percent of total value added in industry. Manufacturing comprised about 20 percent of GDP in 1995.

The Government is looking to foreign investment as the main source of future industrial growth, and has used a multifaceted approach to promote such investment in Sri Lanka, including divestiture and restructuring of public enterprises, rationalization of investment incentives, and deregulation. To lure foreign investors, the investment approval process through the Board of Investment (BOI) was streamlined somewhat in 1995 and the Government began an ambitious privatization program aimed in part at foreign investors. Recognizing the importance of basic infrastructure facilities for industrial development, the Government has also taken several positive steps to encourage private investment in power, telecommunications, highways, and water supply through build-own-operate (BOO) and build-operate-transfer (BOT) arrangements. In addition, the Secretariat for Infrastructure Development and Investment was merged with the BOI in September 1995 to facilitate increased foreign investment in infrastructure projects.

iii. Services

The consolidated services sector, which accounts for about half of GDP, continued to grow at about 5 percent in 1995. Noteworthy developments were the relatively low growth–only 3 1/2 percent–in wholesale and retail trade in view of sluggish import-related trading activity. Communication services grew by 14 percent, reflecting efforts to broaden access to telephone services in the greater Colombo area. Banking, insurance, and real estate grew by 11 percent as a result of continued diversification of financial services and the opening of new bank branches. Port services grew by 7 percent in line with the volume increase in exports and transshipment cargo. Growth in the energy sector, at 10 percent, kept pace with electricity demand. However, the power generating capacity remained unchanged for the third consecutive year. As in recent years, over 90 percent of the demand was met by hydro power. Finally, tourism growth was 2 1/2 percent despite the deteriorating security situation. Arrivals had increased 5 percent in the year to September, reflecting the lagged response of tour operators to security developments, but collapsed in the last quarter as the scale of military activities escalated significantly.

iv. Other

Growth in the construction and mining sectors, which collectively contributed about 10 percent of GDP, slowed to 5 percent and 3 1/2 percent, respectively, in 1995, from 6 percent for each in 1994. Sluggish investment led to a slowdown in construction activity in the industrial and service sectors. In addition, temporary shortages of cement delayed the implementation of some housing projects. Growth in the mining sector was affected by depressed demand for gems on world markets. The slowing of construction activity also compressed demand for raw materials from domestic quarries.

c. Prices, wages, and employment

i. Prices

The annual average inflation rate, as measured by the Colombo consumer price index (CCPI), declined slightly to 7.7 percent in 1995, the second consecutive year of single digit average inflation (Chart II.2). However, the impact of the 1994 cuts in government administered prices of bread, wheat flour, and kerosene, which exerted a downward bias on recorded inflation in 1994, continued to do so in 1995. Underlying inflation during the year is thus believed to be well above the recorded rate. 1/ For example, if prices of the-affected commodities had been left at their mid-1994 levels, average inflation would have been about 10 percent. The 12-month increase in the CCPI was 11.2 percent during 1995.



(In percent)

Citation: IMF Staff Country Reports 1996, 100; 10.5089/9781451823363.002.A001

Source: Information provided by the Sri Lanka authorities

Irrespective of the price measure used, inflation has been on an upward trend since the middle of 1995 in part because of rapid monetary expansion. Specifically, average inflation rose from 4-5 percent at mid-year to almost 8 percent by the end of the year, and has continued to rise in 1996 reaching nearly 13 percent in June. Overall price increases in the last few months have been boosted by the impact of the drought on food prices. 2/

ii. Wages

There were significant wage increases in both the government civil service and private sector during 1995. Following the establishment in late 1994 of the Sri Lanka Teachers Service, a labor group representing teachers’ interests, salaries of government school teachers were increased nearly 28 percent with effect from January 1, 1995. Other central government employees received an average pay rise of 7-8 percent during 1995.

The average increase in minimum wages mandated by the Wages Boards, which covers workers in 31 blue collar trades, was 3.8 percent in 1995. However, wage increases in the formal private sector were generally much greater than the increase in the minimum wage. For example, the 27 collective bargaining agreements negotiated during 1995 typically specified double-digit wage increases. Wage increases outside the Wages Boards and the formal sector were also substantial in 1995. For example, daily wages of construction workers increased in the range of 12-13 percent, those of casual paddy workers by 9-15 percent, and those of rubber workers by 13-18 percent.

iii. Labor and employment

The unemployment rate fell from 13 percent in 1994 to 12 percent in 1995. An estimated 80-90,000 new jobs were created during the year in the formal sector–comprising the public sector, the private sector covered by the provident funds, and the BOI firms–about the same number generated in 1994. Almost half of these jobs came from expansion of the government civil service; an additional 1/3 of the new jobs were provided by BOI enterprises. Overall, the new employment opportunities generated in the formal sector in 1995 are estimated to have absorbed 60 percent of entrants to the labor force. Increased migration for foreign employment also helped to ease labor market pressures. There was also a small drop in labor force participation during the year.

Total public sector employment, defined to include both the government civil service and public enterprises, was 1.3 million in 1995, a 1 1/2 percent decline from 1994. This decline was entirely attributable to reduced employment in public enterprises. The transfer of three major plantation companies to private management and other public enterprise reforms led to a considerable reduction in public enterprise employment. On the other hand, civil service employment expanded by 5 1/2 percent in 1995. Most of the increase came in the clerical and related workers category, mainly reflecting the appointment of mobilizers and managers, following the inception of a new social welfare program in June 1995. The professional, technical, and related workers category recorded a modest 2 percent employment increase in 1995, mainly in the health area.

Employment in BOI firms grew by 13 percent to 233,000 workers in 1995. Most of the increased employment was provided by enterprises producing chemical products, food and beverages, and textiles and apparel. Data on employment in other areas of the formal private sector are not available, but indicators such as employees registered with the provident funds suggest that job opportunities also continued to grow, but at a slower rate than in the BOI firms.

Foreign employment continued to expand at a relatively rapid pace in 1995. Information collected by the Sri Lanka Foreign Employment Bureau indicates that 170,000 Sri Lankans were employed abroad in 1995, a 5 percent increase over 1994. Most of these workers were unskilled; 2/3 were females working as housemaids. Over 90 percent of new overseas workers in 1995 went to the Middle East.

The services sector, comprising nearly half of the employed labor force, was Sri Lanka’s largest employer in 1995. Agriculture provided about one-third, the manufacturing sector about 13 percent; construction about 5 percent; and mining most of the remainder of total employment.

Finally, there was considerable labor unrest in 1995, with numerous strikes during the year. More recently, action by the plantation workers’ trade union resulted in a work stoppage for one week in April 1996. The production loss from this disruption is, however, estimated to be small and recoverable over the course of the year. In May 1996, a strike by electricity workers caused widespread disruption for several days.

2. Public finance 1/

a. Structure of the public sector

The public sector in Sri Lanka comprises the Government, public enterprises, and a broad range of public institutions. The central government includes the presidential secretariat, the parliament, the judiciary, and 28 line ministries. In addition, several other departments and agencies are covered by the central government budget. Provincial councils form the next level of government, which are district, municipal, urban, and village councils. The lower levels of government provide financial, technical, and other services, and oversee the implementation of social development projects.

The approximately 200 public enterprises encompass a broad range of organizational forms, including commercial enterprises, boards, bureaus, authorities, corporations, agencies, and institutes. In 1995, the central government made budgetary transfers to nearly 100 public institutions covering the broad spectrum of production sectors in Sri Lanka. The largest recipients of transfers were the Cooperative wholesale Establishment (CWE), the Road Development Authority, the Water Supply and Drainage Board, the Mahaweli Authority, the Shipping Corporation, and the Ceylon Electricity Board. With the notable exception of the CWE, these entities were engaged in infrastructure development. Total transfers to public institutions increased substantially in 1995, to 4 1/4 percent of GDP from 3 percent in 1994, largely reflecting increased transfers to the CWE (3/4 percent of GDP) to cover a portion of the wheat flour subsidy.

b. Fiscal developments

The overall fiscal deficit (excluding grants and privatization proceeds) was again above 10 percent of GDP in 1995, exceeding the budget target by 2 percentage points (Chart II.3). The overrun was primarily due to a major escalation in military expenditure, and occurred even though capital expenditure and net lending were nearly 1 1/2 percent of GDP less than budgeted; revenue mobilization also improved considerably from the weak 1994 performance. The balance on current operations was nearly 3 percentage points of GDP in deficit, whereas the budget had targeted a small surplus. In addition, net bank financing of the deficit was over 1 percent of GDP, while the budget had envisaged a decline in bank credit of a similar magnitude.



(in percent of GDP)

Citation: IMF Staff Country Reports 1996, 100; 10.5089/9781451823363.002.A001

Source: Information provided by the Sri Lanka authorities; and staff estimates.1/ The 1996 figures refer to the government budget.2/ Before grants and privatization proceeds.
i. Revenue

Revenue collection increased to over 20 1/2 percent of GDP in 1995 from 19 percent in 1994, reflecting buoyant collections of taxes on domestic goods and services. The defense levy (now called the national security levy), a broad-based sales tax imposed on all goods other than exports and on selected services, raised 2 1/4 percent of GDP, 1/2 percentage point more than in 1994. The higher collections were due to an increase in the tax rate from 3 1/2 percent to 4 1/2 percent in June 1995 as well as improved collections following the imposition of this levy on imports at the point of Customs rather than when letters of credit are opened. Excise tax collections also increased significantly from 2 1/2 percent of GDP in 1994 to nearly 3 percent of GDP in 1995, reflecting rate increases on a range of items, most significantly on liquor, cigarettes, petrol, and diesel. Due to sluggish imports, revenues from turnover taxes grew more slowly than nominal GDP even though the lower rate band was increased from 5 percent to 6 percent. Personal and corporate income tax collections remained at about 2 1/2 percent of GDP. Personal income tax collections increased significantly through improved administrative procedures despite an increase in the exemption threshold, while corporate tax collections declined relative to GDP due to a lowering of tax rates. Revenue from import duties fell 1/4 percent of GDP to 3 3/4 percent, reflecting slow import growth, reduction in the maximum tariff rate, and duty waivers on essential food items.

Ad hoc levies on selected public enterprises helped to boost nontax revenue collections in 1995, which registered an increase of nearly 1 percent of GDP to 2 3/4 percent. These levies comprised Rs 1.5 billion on the Ceylon Electricity Board (CEB), Rs 1 billion on Sri Lanka Telecom, and Rs 250 million on the Ceylon Petroleum Corporation (CPC). In addition, interest receipts rose by nearly Rs 1 1/2 billion over the 1994 level and an across-the-board 20 percent increase in fees and charges in January 1995 contributed an additional Rs 800 million.

ii. Expenditure

Total central government expenditure and net lending was budgeted in 1995 to fall slightly as a share of GDP as a first step toward medium-term fiscal consolidation. In the event, current expenditure rose by nearly 1 1/2 percent of GDP to 23 1/4 percent, exceeding the budget target by 3 percent of GDP. As a result, total expenditure was more than 1 percent of GDP above target despite a significant shortfall on capital spending. Military expenditure, in particular, was substantially higher than budgeted. Foreign-financed purchases of military hardware amounting to $210 million (1 3/4 percent of GDP) pushed defense spending to nearly 6 1/2 percent of GDP, well above the budget target of 3 3/4 percent. The high cost of the flour subsidy boosted current transfers to public corporations to Rs 8 billion (1 1/4 percent of GDP), nearly triple the 1994 level. The spillover from ad hoc wage increases granted during 1994 and the establishment of a teachers’ service with new salary scales pushed the government wage bill up to 5 1/4 percent of GDP in 1995, from 5 percent in 1994. Spending on social welfare programs and other transfers to households (primarily civil service pensions), at 4 1/2 percent of GDP, were generally in line with the budget targets.

Capital expenditure and net lending at 7 1/2 percent of GDP was well below the budget target of 8 3/4 percent of GDP as several major projects were completed and disbursements on others were delayed. Spending on power distribution and transmission projects by the CEB was nearly Rs 3 billion below target, while disbursements for telecommunications projects were over Rs 1 billion below target. These shortfalls were offset somewhat by higher-than-budgeted disbursements to the Ports Authority. Net onlending totals were also reduced by the repayment of about Rs 1 1/2 billion in various advance accounts.

iii. Financing and debt

Foreign grants and borrowing equivalent to 4 1/2 percent of GDP financed 45 percent of the Government’s budget deficit in 1995, in comparison with about 33 percent in 1994, largely because of the exceptional increase in foreign loans connected with imports of military hardware. Domestic financing amounted to 5 1/2 percent of GDP, including slightly more than one percent of GDP of credit from the banking system. The traditional captive sources of nonbank financing, such as the Employees’ Provident Fund (EPF), Employees’ Trust Fund (ETF), and the National Savings Bank (NSB), continued to provide the bulk of the domestic financing in the form of treasury bills and longer-term rupee loans. Proceeds from the sale of state assets provided Rs 3 billion (0.5 percent of GDP) of budget financing in 1995.

Total public debt rose to over Rs 640 billion at the end of 1995, rising slightly in relation to GDP to almost 97 percent. Sri Lanka continued to benefit from high levels of concessional foreign aid; the stock of foreign debt stood at about 54 percent of GDP at end-1995. Despite the concessional nature of the foreign component of public debt, interest payments still imposed a heavy burden on government budgetary operations, taking up nearly one-third of tax revenue (i.e., almost 6 percent of GDP).

iv. 1996 budget

The 1996 budget envisaged an overall deficit of 10 1/2 percent of GDP (excluding grants and privatization proceeds), slightly above the 1995 level, despite the projection of a fall in military spending by 1 1/2 percent of GDP. With capital spending targeted to remain stable in relation to GDP, the 1996 budget also projected a large deficit on current operations of nearly 3 percent of GDP. Underlying these projections was a 1 1/2 percent of GDP drop in revenue collections as the proposed measures were not expected to offset the lack of buoyancy in the revenue system. The budget thus relied on substantial privatization proceeds (Rs 21 billion, 2 3/4 percent of GDP) to ease the financing pressures in the absence of a lower deficit.

The revenue measures in the budget, announced as an effort to eliminate anomalies and stimulate the private sector, included the following:

  • Income tax changes (plus Rs 500 million)

    • threshold increase (minus Rs 400 million)

    • wider rate bands (minus Rs 200 million)

    • employment credit removal (plus Rs 150 million)

    • qualifying payments removal (plus Rs 250 million)

    • waiver of interest on housing loans (plus Rs 100 million)

    • surcharge removal (minus Rs 650 million)

    • save the nation contribution (plus Rs 750 million)

    • other changes (plus Rs 500 million)

  • Stamp duty changes (plus Rs 400 million)

  • Turnover tax exemptions (minus Rs 200 million)

  • Excise duty changes (plus Rs 600 million)

    • exemptions (minus Rs 350 million)

    • decrease on beer (minus Rs 250 million)

    • increase on cigarettes (plus Rs 1,200)

  • National security levy reduction on capital goods (minus Rs 1,100)

  • Import duty changes (plus Rs 700 million)

    • duty exemptions and waivers (minus Rs 300 million)

    • pre-shipment inspection/improved collections (plus Rs 1,000)

  • Levy on Telecom (plus Rs 750 million)

  • Fees and charges increase (plus Rs 400 million)

Modest reductions were envisaged on the expenditure side from cuts in nonessential current and capital spending. Most of the budgeted expenditure reductions, however, were not substantiated by specific measures or cuts in programs. For example, the time table of flour price increases to contain the subsidy cost to the budgeted level (0.5 percent of GDP) was not specified, and only a modest 50 cent per kg increase has been implemented thus far in 1996. Similarly, the budgeted cuts in nonessential capital spending of Rs 2 1/2 billion were also not specified.

3. Income distribution, poverty, and social welfare programs

Sri Lanka’s record in the social area is mixed. On the one hand, impressive strides have been made in improving human welfare through increased investment in social infrastructure and an extensive array of social welfare programs. Many of Sri Lanka’s social indicators are high by international standards, and the distribution of income is among the most equal in the region. Data from the World Bank’s social indicators database indicate that in the early 1990s the top 20 percent of the distribution claimed 40 percent of the nation’s wealth while the bottom 20 percent had about 10 percent. 1/ On the other hand, Sri Lanka ranked only 90th out of 160 countries in the UNDP’s 1992 Human Development Index, and poverty remains widespread. The World Bank (1995a) estimated that 22 percent of the population was below its “dollar a day” poverty line in 1991. 2/ Moreover, the bottom quintile of the income distribution has not increased its share of the country’s national income in the past 25 years.

The effectiveness of Sri Lanka’s social welfare programs in eliminating poverty has been limited by poor targeting of beneficiaries. The lack of effective targeting has also resulted in high budgetary costs. The Government thus began in June 1995 to consolidate the main poverty alleviation programs (the Janasaviya, 3/ the midday meal, and the food stamp programs) into the Samurdhi (prosperity) program, with a view to streamlining the social safety net to provide greater relief to the truly needy at a lower cost. 4/ There is, nevertheless, still scope for improved targeting as the Samurdhi program currently provides benefits to over 1.2 million families, 35 percent of the population. Income supplements are being distributed at two levels (Rs 500 and Rs 1,000) with the objective of ensuring a monthly income of Rs 1,500 for families below the poverty line. The program also provides Rs 100-200 per month for single or two-member families. The budgetary cost of the Samurdhi program was just over Rs 2 1/2 billion (0.4 percent of GDP) during 1995 when it was in operation for the second half of the year.

A key objective of the Samurdhi program is to promote self-reliance on the basis of nurturing saving habits. Accordingly, all participants are encouraged to save a part of their income supplement–Rs 200 per month by the poorest and Rs 100 per month by the rest–to finance new income-earning activities. Samurdhi participants are estimated to have already saved Rs 430 million in 1995. Beneficiaries exit from the program when their income exceeds Rs 2,000 per month for a continuous period of six months or when at least one family member finds long-term employment. As Samurdhi beneficiaries exit from the program, new entrants to poverty will be able to join. The identification and screening of beneficiaries is being undertaken by nearly 23,000 rural mobilizers, mainly recent school graduates.

4. Financial and monetary developments 1/

A large bomb was detonated by Tamil separatists on January 31, 1996, outside the Central Bank’s headquarters building in the heart of Colombo’s financial district. The explosion and ensuing fires killed nearly 100 people, including over 40 bank staff, and injured more than 1,000. The central bank building and other nearby buildings housing some of Sri Lanka’s largest companies were destroyed. The direct financial impact of the bombing, however, was limited as basic banking operations were restored within a few days.

a. Overview of the financial system

The financial system includes the Central Bank, 26 commercial banks, the NSB, three merchant banks, two development finance institutions, a state mortgage investment bank, and other nonbank financial institutions. Long-term financial resources are mobilized mainly by the two large provident funds, the EPF and the ETF, and five large insurance companies. About 230 companies are currently listed on the Colombo Stock Exchange, which has a capitalization of just over Rs 100 billion ($2 billion).

Considerable progress has been made since the late 1980s in laying the foundation for a modern financial system, but many structural impediments remain, constraining Sri Lanka’s growth potential. In the banking sector, competition continues to be hampered by the 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 banking system assets despite the establishment of new banks and branches of foreign banks. The state banks were recapitalized in April 1993. However, their close relationship with the Government has made it difficult to enforce the supervisory regulations, for example, the provisioning for bad loans. In addition, despite some restructuring following the recapitalization, the banks still do not operate on a fully commercial basis, and there are signs of emerging problems with their loan portfolios. 1/ The lack of effective competition and commercial orientation of the dominant players has also resulted in high interest rate spreads that keep up the cost of finance for the private sector. 2/ Legislation to improve the efficiency of the two banks continues to be delayed by trade union opposition.

The market for savings deposits has been distorted by the operations of the state-owned NSB. The NSB mobilizes deposits from small savers nationwide through a vast 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. Further, the NSB had been mandated to invest a large proportion of its funds in government paper. Legislation giving the NSB greater autonomy in its investment decisions was passed late in 1995 and could eventually result in diversification of its investment portfolio.

Money and securities markets are characterized by a lack of competition and depth. For example, while short-term interest rates are market oriented, the primary treasury bill market on occasion operates on the basis of a de facto interest rate floor with the Central Bank absorbing the residual amount being auctioned, and the secondary market is still very limited. In addition, the range of available financial instruments is narrow as 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 Treasury. Legislation was passed in late 1995 that could lead to a more active secondary market and the auction of longer-term government securities.

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, inter alia, statutory reserve requirements, refinance facilities, selective credit controls, and moral suasion. Since 1992, greater emphasis has been placed on indirect instruments of monetary control, including open market operations in treasury bills and central bank securities, supported by reserve money programming. However, indirect monetary management has been hampered by the lack of depth in money and securities markets.

The environment in which the Central Bank has conducted monetary policy in the past 18 months has differed significantly from that of previous years when large capital inflows complicated monetary management. The main policy response of the authorities to these inflows was sterilized intervention through aggressive open market operations. Since late 1994, external monetary pressures have been minimal with the slowing of foreign inflows. Domestic pressures, however, have intensified during this period as a result of increased recourse by the Government to bank credit to finance the high fiscal deficit, and strong demand for consumer and trade credit. Monetary policy has largely accommodated the fiscal slippage and other credit demands, and broad money growth has continued to be high despite a largely unchanged external reserve position.

c. Developments in money, credit, and interest rates

Broad money growth, at 19 1/4 percent, was well above target in 1995, perpetuating the high underlying inflation (Chart II.4). Virtually all of the liquidity growth–18 1/4 percentage points–was due to the expansion of net domestic assets, reflecting the sharp increase in domestic credit in 1995 (by over 26 percent, relative to the money stock at the beginning of the year).



Citation: IMF Staff Country Reports 1996, 100; 10.5089/9781451823363.002.A001

Source: Information provided by the Sri Lanka authorities.

Despite high real interest rates, credit to the private sector expanded at unprecedented levels during the year (by over 28 percent), reflecting strong demand for trade and consumer credit. The drying up of capital inflows from abroad, reduced availability of funds from the depressed stock market, and liquidity problems of struggling business enterprises also contributed to higher credit demand. Commercial banks economized on reserves, aggressively competed for new deposits, and ran down balances held abroad to mobilize funds to meet the credit demand.

The public sector also became a net contributor to domestic credit expansion in 1995 for the first time in several years, reflecting the need to finance the large fiscal deficit. Net credit to Government increased by almost Rs 7 1/2 billion (equivalent to 3 3/4 percent of the money supply or 1.1 percent of GDP) during the year, primarily in the second half, after the nonbank captive sources had been fully tapped. Bank credit to public corporations also increased significantly during the year. This reflected higher borrowing by the CPC following the destruction of some of its oil storage facilities and the failure of budgetary transfers to the CWE to cover fully the cost of the flour subsidy. The Paddy Marketing Board also required over Rs 2 billion in bank advances to finance its record rice purchases during the year.

Reserve money increased by 15 1/2 percent in 1995, down from 20 1/2 percent in 1994. Approximately two-thirds of this increase came from net foreign assets of the monetary authorities as the Central Bank continued to accumulate reserves, particularly from commercial banks which, as noted above, mobilized foreign currency assets to finance their domestic lending activities. Increased central bank financing of the fiscal deficit also contributed modestly to reserve money growth during the year. The money multiplier remained relatively stable during the year in a range of 2.9-3.0. The trend of slowly declining velocity of the past few years continued in 1995, reflecting further monetization of the economy.

The accommodative monetary policy stance and poor treasury cash flow management led to wide swings in treasury bill yields during 1995, as was the case in 1994 (see Chart II.4). For example, short-term rates dropped sharply early in 1995 to 13-14 percent as a result of large cash advances to the Treasury from the Central Bank, but rose to almost 20 percent by end-year in response to the need to finance the high budget deficit.

The accommodative monetary policy has continued thus far in 1996. With increased deficit financing pressures and continued strong credit demand from other sources, broad money growth has accelerated to 23 1/2 percent, despite net external reserves remaining largely unchanged. With the accommodative policy stance, the same “seasonal” pattern of a sharp decline in treasury bill rates early in the year was repeated in 1996. Short-term treasury bill yields fell sharply to 12-14 from mid-February until early June, but have started rising again in recent weeks as a result of the Treasury’s heavy demand for deficit financing.

5. Balance of payments and external debt 1/

a. Overall developments

The external position weakened in 1995 due to growing uncertainties in the economic environment. Although the current account deficit (before official transfers) declined by one percentage point to 6 3/4 percent of GDP in 1995, the balance of payments recorded an overall deficit of almost 1 percent of GDP due to the drop, by more than one-third, in net capital inflows (Chart II.5). 2/ A “wait and see” stance adopted by foreign investors because of growing uncertainties in the economic environment accounted for the sharp deterioration of the capital account.



Citation: IMF Staff Country Reports 1996, 100; 10.5089/9781451823363.002.A001

Source: Information provided by the Sri Lanka authorities.1/ Authorities’ definition, with commercial banks’ reserve position below the line.2/ Excluding official transfers.

The Central Bank relieved exchange market pressures by allowing the rupee rate to depreciate. The rupee depreciated by 8 percent against the U.S. dollar during the 12-month period ending December 1995, translating into a real effective exchange rate (REER) depreciation of 2 percent over the same period and thus preserving external competitiveness (Chart II.6). Movements in the rupee REER in 1995 continued to mirror those in the U.S. dollar REER, as in past years. Gross reserves declined slightly in relation to imports from 5 months in 1994 to 4 3/4 months in 1995.




Citation: IMF Staff Country Reports 1996, 100; 10.5089/9781451823363.002.A001

Sources: IMF, Information Notice System; and Reuters.

b. Current account transactions

The decline in the current account deficit in 1995 reflected movements in the trade account, which narrowed primarily because of a small decline in import volume growth (following 20 percent growth in 1994). The fall in import volume reflected lower growth rates of major import categories such as investment goods, non-food consumer goods, and crude oil. Imports of investment good plummeted by 15 percent in real terms in 1995 due to the downscaling of Air Lanka’s re-fleeting program, lower imports of public transport vehicles (e.g., buses), and weak demand for equipment and materials. Non-food consumer imports dropped by 7 percent in real terms, largely reflecting lower demand for cars and motorcycles due to the introduction of a tax on diesel and elimination of duty concessions on car imports. Crude oil import volumes also fell by 4 percent due to the temporary closure of the oil refinery for maintenance in January 1995, and the bombing of the storage facilities in October 1995. In contrast, imports of wheat and fertilizer rose sharply in 1995 as a result of the price subsidies. Military imports, primarily of equipment (e.g., transport planes, helicopters, and gun boats) rose sharply following the escalation of the ethnic conflict.

Export volume growth decelerated to 7 1/2 percent in 1995 from 17 percent in 1994 as growth of agricultural exports slowed (e.g., vegetables, coffee, chilies). Exports of garments and other industrial products remained strong, with volumes rising by 12 percent in 1995. The garment expansion was largely the result of rising exports to “quota” markets. For other industrial products, higher exports were due in part to new fiscal and financial incentives granted (e.g., for leather goods, and mechanical and electrical appliances) by the Export Development Board.

Reflecting favorable international prices for key exports products, traditional (e.g. tea and rubber) as well as nontraditional (e.g., garments), the export price index rose by 4 percent in 1995 after declining by 5 percent in 1994. The import price index rose by 6 percent, however, reflecting higher world prices for wheat, fertilizer, and rice.

As for the direction of foreign trade in 1995, exports continued to shift to industrial countries and imports to Asian countries (excluding Japan). The share of exports to industrial countries rose from 71 percent in 1994 to 73 percent in 1995, with the United States accounting for 36 percent of total exports and the European Union 32 percent. This gradual shift in exports reflected increased production of textiles and clothing and the relatively liberal access offered to Sri Lanka for these products under the Multifiber Arrangement. The share of imports from Asia (excluding Japan) rose to 50 percent in 1995 compared with 48 percent in 1994. This increase paralleled the decline in the combined import share of the European Union and the United States to 20 percent in 1995, from 22 percent in 1994.

The services account remained essentially in balance in 1995 as lower net investment income outflows offset the decline in net tourism receipts. As a result of terrorist attacks in Colombo in the last quarter of 1995, the start of the high tourist season, net tourism receipts plunged by 40 percent to SDR 26 million for the year. Net investment income outflows fell due to an increase in central bank placements abroad and higher world interest rates. Net private transfers rose by 2 percent in 1995, compared with 9 percent in 1994.

c. Nonmonetary capital flows

Non-monetary capital flows dropped by 3 percentage points of GDP to 5 1/2 percent in 1995, reflecting a drying up of net private capital inflows. Direct investment fell by SDR 100 million to SDR 36 million, of which SDR 25 million were proceeds from the sale of Colombo Gas. Private loan disbursements also fell, reflecting a decline in foreign financing requirements in connection with the winding down of Air Lanka’s re-fleeting program and decreased demand for new investment project financing. Private short-term capital flows dropped sharply in 1995 as BOI firms’ demand for supplier’s credits fell. The latter reflected decisions to defer purchases of raw material imports in favor of drawing down existing stocks.

In contrast to private capital flows, net capital flows to the Government increased by SDR 115 million, to SDR 312 million. This increase reflected nonconcessional medium- and long-term loans in connection with military imports during 1995. Net concessional loan disbursements remained virtually constant. The bulk of gross loan disbursements consisted of medium- and long-term loans for project assistance. As was the case in 1994, the main creditors were Japan (SDR 135 million), IDA (SDR 71 million) and AsDB (58 million).

d. External debt

The external debt and debt-service burden increased slightly in 1995. The debt-service ratio (in percent of exports of goods and services) rose by more than one percentage point to 13 1/4 percent in 1995, reflecting heavier amortization payments due on foreign borrowing contracted in the early 1990s, mostly by public corporations such as Air Lanka. Amortization payments due on private foreign debt tripled to 64 million in 1995. The external debt-to-GDP ratio rose from 75 percent in 1994 to 79 percent to 1995. The ratio of concessional debt to GDP also rose from 49 percent in 1994 to 50 1/2 percent in 1995.

e. Exchange and trade system

Detailed descriptions of developments in the exchange and trade system are provided in the Annual Report on Exchange Arrangements and Exchange Restrictions. 1995. The main recent developments are highlighted below.

i. The foreign exchange market and exchange rate developments

Sri Lanka’s floating exchange rate remained closely managed during 1995 despite the widening of the Central Bank’s intervention points from one to two percent in March 1995. 1/

ii. 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.

iii. Trade policy

In 1995, Sri Lanka reduced the maximum tariff rate from 45 to 35 percent, achieving a three-band system with rates of 10, 20, and 35 percent. Sixty nine items, however, remain outside the three-band tariff system, including several zero-rated items, principally pharmaceuticals and fertilizer, and numerous items (e.g., automobiles, alcoholic beverages and tobacco products) with tariffs in excess of the maximum standard rate.

Duty waivers remain in place for several items. New full waivers were offered during the year for imports of cement, some food items (e.g., dried fish and sprats), machinery and equipment imported under the Integrated Rural Development Project, and cotton yarn, among other products. Partial waivers were offered for imports of some food items (e.g., canned fish and sugar) and intermediate inputs (e.g., aluminum tagger foil) for the food processing industry. Specific waivers were also granted on a case-by-case basis.

Trade taxes were increased on various items during 1995. These included increases in the cess duty on rubber in February (from Rs 3.35/kg to Rs 3.85/kg); and the defence levy in June (from 3.5 to 4.5 percent).

BOI firms maintained their duty free import privileges and the right to clear customs on their own authority. In addition, incentives were granted (e.g., for projects with a minimum capital investment of Rs 100 million and those utilizing advanced technology) to promote new industrial investment.

III. Factors Influencing Growth Performance

1. Introduction

Since independence in 1948, Sri Lanka has made considerable strides in human development and now rivals more advanced economies in many areas (Table III.1). In particular, literacy and primary school enrollment are nearly universal, and infant mortality has declined markedly. Despite this progress, the poverty problem remains substantial–the World Bank estimated that 22 percent of the population still fell below the “one-dollar-a-day” poverty line and a substantial proportion was just above it in the early 1990s. 1/ Moreover, Sri Lanka has fallen well behind the dynamic East Asian economies in raising its per capita income. For example, Sri Lanka’s per capita GNP in 1960 was estimated at $141 in current (1960) dollars, substantially higher than that of Thailand ($96) and Indonesia ($51), and not far from that of Korea ($156) and Malaysia ($273). By 1994, however, per capita GNP had only risen to $640 (in current dollars), in comparison with $8,220 for Korea, $3,520 for Malaysia, $2,210 for Thailand, and $880 for Indonesia.

Table III.1.

Sri Lanka: Achievements in Social Development

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Source: World Development Report.

Weighted averages.

While Sri Lanka’s longer-term growth performance–annual average growth of 4 1/2 percent since 1960–compares favorably with most of the developing world, it falls short of what could have been achieved. 1/ With its favorable natural and human resource endowments, Sri Lanka’s growth record could have rivalled the high-performing East Asian economies. The human costs of failing to do so have been high. A stronger growth performance would have allowed a much deeper reduction in poverty and even greater progress in social development than was achieved.

Recent empirical studies of the implications of growth theories suggest there is a link between long-run growth performance and national economic policies. 2/ This chapter uses the results of some of these studies to identify the key policy factors that could be behind Sri Lanka’s disappointing growth performance with a view to drawing lessons for the future. In Section 2, the impact of factor accumulation on per capita income growth is evaluated. In Section 3, total factor productivity (TFP) residuals are calculated and in Section 4, several proxies for distortions and policy interventions are used to identify any systematic correlations with output growth and to identify channels (capital accumulation or productivity growth) through which policies appear to affect growth. Conclusions on the impediments to growth in Sri Lanka and their implications are presented in Section 5.

2. Cross-country evidence on per capita income growth

Goldsbrough et. al. (1996) and others have used cross-country regressions to estimate the relationship between per capita income growth and investment in human and physical capital, while controlling for population growth and the initial level of per capita income. In these studies, average per capita income growth for a large number of countries was regressed on investment in human and physical capital, the population growth rate, and the gap in 1960 between real per capita income in each country in relation to the United States. Under the hypothesis that, ceteris paribus, poorer countries can be expected to grow more rapidly than richer ones, the relative income gap was used to measure the extent of convergence or “catching up”.

The parameter results of the cross-country regressions suggest that the accumulation of both physical and human capital are important determinants of long-term growth. 1/ The results also support the “conditional convergence” hypothesis that poorer countries tend to grow faster than richer ones, after controlling for investment and education levels. The time lags involved in “catching up”, however, can be quite long.

These relationships can be used to assess the impact of factor accumulation on per capita income growth in Sri Lanka. As reported in Table III.2, Sri Lanka’s actual growth is only slightly higher than predicted by the equation estimated by Goldsbrough et. al., suggesting modest contributions from TFP growth over the past few decades. In terms of regional comparisons, Sri Lanka had a better record in human capital development, and similar physical capital accumulation, yet did not grow more rapidly than its South Asian neighbors. That it failed to do so suggests TFP growth in Sri Lanka was slower than in the rest of South Asia.

Table III.2.

Sri Lanka: Comparisons of Factor Accumulation, 1960-92

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Source: Goldsbrough et. al. (1996). The data, except for those on primary and secondary school enrollment rates are from the Penn World Tables, Mark 5.6 (Summers and Heston, 1994). School enrollment rates are from the World Bank’s social indicators of development database.

Ratio of real per capita GDP to that of the United States in 1960.

Primary and secondary enrollment rates in 1960.

Growth rates refer to real GDP adjusted for cross-country differences in purchasing power parity.

Sri Lanka’s growth performance has also been well below that of the East Asian countries. The regional comparisons in the table indicate that slow accumulation of physical capital is an important factor in explaining Sri Lanka’s poor growth performance relative to East Asia. At the same time, the parameter estimates obtained from the cross-country regressions predict a substantially higher proportion of actual growth for Sri Lanka than for the East Asian countries. This suggests that improvements in TFP played a much greater role in East Asia’s growth performance than in Sri Lanka.

The relatively modest contributions from TFP growth in Sri Lanka could reflect inefficiencies in resource allocation due to inappropriate policies (see below), low-quality investment in human and physical capital, slow adoption of technological innovations, as well as the negative side effects of the civil conflict since the early 1980s and political uncertainty. Thus, Sri Lanka’s relatively high educational levels do not appear to have been translated into a highly productive labor force. Similarly, for much of the period, capital accumulation was driven by low-productivity public investment, in particular in the Mahaweli irrigation scheme.

3. Total factor productivity residuals

Several studies have used a more direct production function-based approach to examine the relative contributions of factor accumulation and productivity growth. The analysis reported here follows a similar approach and calculates TFP residuals for Sri Lanka using data from 1960 to 1988.

The exercise assumes a production function in which output is a function of labor and physical capital. Factor shares are imposed to satisfy constant returns to scale. The TFP estimates–the “Solow residuals”–are given by:


Table III.3 summarizes the main results of these calculations. 1/ The results corroborate the findings in section 2 and show that for the period 1960-88 the high performing East Asian countries grew significantly faster than Sri Lanka because of much more rapid growth of their capital stocks as well as higher TFP contributions. The Solow residuals in fact suggest that there was virtually no contribution from TFP during the period. Over the longer timeframe, the TFP performance in Sri Lanka does not compare favorably even with Africa and Latin America. The results for the subperiod 1980-88 do suggest, however, that Sri Lanka’s productivity improved markedly in the 1980s, which likely reflects the response to economic reforms initiated in 1977 (see also Chart III.1).

Table III.3.

Sri Lanka: Factor Contributions to Output Growth, 1960-88

(Period average: percent change in real terms)

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Sources: Summers and Heston (1991) for real GDP growth; World Bank staff estimates for labor force; and King and Levine (1994) for capital stock. Staff calculations.


(In percent)

Citation: IMF Staff Country Reports 1996, 100; 10.5089/9781451823363.002.A001

Source: Staff estimates.1/ Five-year backward-looking moving average.

4. Effect of policies on growth, investment, and productivity

Can the relatively low growth and productivity performance in Sri Lanka be “explained” by policy-related factors such as macroeconomic instability, structural distortions, or by exogenous developments such as adverse external terms of trade shocks? In this section, empirical evidence on the linkages between such factors and output growth, capital accumulation, and TFP growth is examined.

a. Macroeconomic stability and growth

Numerous empirical studies have been conducted to examine the links between macroeconomic and structural policies and growth. As it is difficult to construct measures of variables that are directly controllable by policies, researchers have proxied economic policies with variables that reflect the outcomes of policies. These variables, however, can also be affected by other nonpolicy-related factors, suggesting that any apparent linkages between the proxy variables and growth should be interpreted with caution.

Macroeconomic stability has been proxied by variables such as the rate and variability of inflation, the fiscal position, and the parallel market premium on foreign exchange. The parallel market premium can be viewed as a general indicator of overall policy uncertainty. Following Fischer (1993), Goldsbrough et. al. (1996) used pooled cross-section and time series data from 1970 to 1992 and estimated regressions to examine the links between growth and these indicators of macroeconomic stability. 1/ Their main results suggest that the parallel market exchange premium and the rate of inflation are significantly negatively correlated with growth, while improvements in the terms of trade are positively correlated with growth. A positive, albeit statistically weak, correlation between growth and the budget surplus suggests that countries with small fiscal deficits tend to grow more rapidly than those with large imbalances.

The channels through which macroeconomic stability affects growth were assessed by Goldsbrough et. al. using two additional regressions–with the growth rate of the capital stock and with productivity growth (as measured by the “Solow” residuals described above) as dependent variables–using the same set of explanatory variables as in the growth regression. Several of their results are noteworthy. First, the rate of inflation is significantly negatively correlated with both capital accumulation and productivity growth. Second, the negative correlation between the black market premium on the exchange rate and growth appears to work primarily through its influence on capital accumulation, while the positive correlation between changes in the terms of trade and growth appear to be channeled through their impact on productivity growth. Third, the results suggest that budget surpluses are negatively correlated with capital accumulation. By contrast, a positive correlation between the budget surplus and productivity growth signals a positive influence of government savings on productivity growth.

These results can be used to assess the likely impact of macroeconomic policies on Sri Lanka’s longer-term growth performance over the past two decades (Table III.4). Sri Lanka’s chronic budget deficits were on average much higher than for the sample as a whole, exerting a significant negative impact on growth. In addition, while Sri Lanka did not experience unduly high inflation, the failure to bring it down to single digits for long periods also harmed growth performance. The parallel market premium on foreign exchange was also relatively high in Sri Lanka, but not excessively so by world standards. As noted in the next chapter, foreign exchange restrictions have been substantially relaxed, if not completely eliminated, in recent years and with it, the parallel market premium has virtually been eliminated. Nevertheless, the exchange premium was very high in comparison with the successful East Asian economies. Finally, changes in the terms of trade were probably not an important influence on Sri Lanka’s growth performance since the 1970s.

Table III.4.

Sri Lanka: Comparisons of Macroeconomic Policy Performance, 1970-92

(Period averages, in percent)

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Sources: Data for inflation are from the International Financial Statistics; data for the budget surplus are from the Government Finance Statistics Yearbook; all other data are from Fischer (1993).

Whole sample average for inflation excludes Argentina, Bolivia, and Brazil.

b. Structural policies

Several studies have also examined the linkages between various indicators of structural policies, including measures of tariff protection, human capital accumulation, and financial sector reforms, on growth. Fischer (1993) found that an indicator of trade protection is significantly negatively correlated with productivity growth and that human capital accumulation is significantly positively correlated with physical capital accumulation. 1/ Other studies (King and Levine, 1992 and 1993, and Levine and Zervos, 1993) found that indicators of financial development are positively associated with long-run growth, through both the investment and productivity channels. 2/

Cross-country regressions have also been estimated to examine the linkages between indicators of structural distortions/policies and the growth of output, capital stock, and productivity. The explanatory variables included the indicators of macroeconomic policies described above and indicators of tariff protection, human capital accumulation, financial deepening, and real GNP per capita in 1960. The results indicate that real GNP per capita in 1960 is significantly and negatively correlated with output and productivity growth, confirming the evidence presented above in support of the tendency of poorer countries to “catch up” to richer ones. In addition, the measure of protection is negatively correlated with productivity growth (although it is not significant with either output growth or the capital accumulation) and the measure of financial deepening is significantly positively correlated with output growth (but not with capital accumulation or productivity growth). Human capital accumulation also has a positive but weak correlation with growth.

Table III.5 presents averages for several structural indicators for Sri Lanka and regional groupings for the 1960-88 period. Several comparisons are worth noting. First, the measure of human capital accumulation for Sri Lanka is very high by world standards–higher even than for the East Asian countries–suggesting a positive growth impact. 1/ Second, the measure of average effective trade taxes for Sri Lanka was high by international standards, suggesting that distortions in the trade system could have been important factors in explaining Sri Lanka’s long-term growth performance. 2/ Finally, as measured by the three financial development indicators shown in the table, Sri Lanka does not compare very favorably with other regions, especially the East Asian countries. In particular, the PRIVATE indicator is very low relative to other country groups, indicating that a large proportion of credit in Sri Lanka has been channelled to the public sector, including for unproductive public investment, such as the Mahaweli irrigation scheme. It would be reasonable to conclude that Sri Lanka’s underdeveloped and inefficient financial sector has constrained growth performance. 3/

Table III.5.

Sri Lanka: Comparisons of Structural Indicators, 1960-88 1/

(Period averages)

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Sources: Goldsbrough et. al. (1996) for AVETAR; Barro and Lee (1993) for BHK; and King and Levine (1992) for LLY, BANK, and PRIVATE.

AVETAR is the ratio of total trade taxes to total value of merchandise trade. BHK is a measure of human capital accumulation, which is defined as the number of years of education received by the population over age 25. LLY is the ratio of total liquidity to GDP. BANK is the ratio of credit from deposit money banks to total credit from deposit money banks and the central bank. PRIVATE is the ratio of private sector credit to total domestic credit.

Figures refer to the 1970-92 period.

5. Conclusions

Sri Lanka’s growth performance over the past two decades was well below the average achieved in East Asia. The analyses outlined above suggest that, over the long term, the chronically high fiscal deficits, distortions in the trading system, the relatively underdeveloped financial sector, and overall policy uncertainty (as proxied by the parallel market premium on foreign exchange) have been associated with Sri Lanka’s relatively poor growth performance. By contrast, unfavorable developments in the terms of trade have not played a role in this modest growth performance. Furthermore, the substantial achievements in human resource development, in particular the high levels of education, do not appear to have paid off in terms of rapid income or productivity growth. 1/ It is noteworthy, however, that following the reforms initiated in 1977, there was an improvement in productivity during the 1980s. 2/

The above analysis has many important policy implications for the medium term. In particular, it points to the need for an early and decisive fiscal consolidation to increase the private investment rate and productivity. Sustained progress will also be needed in enhancing the efficiency of the financial system and in further liberalizing the trade and payments system. Further, the low TFP growth despite a high human resource endowment points to the need to undertake labor market reforms so that Sri Lanka’s extensive human capital base can be used more intensively and efficiently. As discussed in more detail in the next chapter, progress has been made in some of these areas since the late 1980s, but considerably more will need to be made in the coming years if the Government is to achieve its longer-term objective of sustainable income growth of 8 percent per annum by the year 2000.

IV. The Implications of Structural Reforms for Investment and Growth

Real growth in Sri Lanka over the last two to three decades has averaged between 4 and 5 percent coupled with positive growth in real per capita income through most of this period. The presence of a relatively open trade regime, a competitive exchange rate, a strong private sector, and a relatively well-endowed resource base have enabled sustained growth even in difficult periods. However, when Sri Lanka’s growth record is compared with that of the dynamic East Asian economies, and viewed in light of its initial stock of human capital and relatively favorable natural resource endowment, the country’s growth performance has been modest. As discussed in the preceding chapter, both macroeconomic as well as structural factors are responsible. Relatively unstable macroeconomic conditions, due in particular to loose fiscal policy, and structural impediments arising from an inefficient and underdeveloped financial sector, distortions in the trade regime and factor markets, and unproductive investments in human resources and physical infrastructure have contributed to this outcome.

From the late 1980s through early 1994, Sri Lanka undertook efforts to improve financial stability, sustain external viability, and correct structural weaknesses in its economy, supported by successive SAF and ESAF arrangements. 1/ Structural reforms were undertaken in several sectors of the economy between 1989 to 1994. This chapter discusses the nature of these reforms in some key sectors, the extent to which they were successful, where they failed and why, and the structural problems that remain to be addressed. The discussion covers areas where significant progress has been made such as in trade reform, areas where progress has been more limited such as in the financial sector and public enterprises, and finally areas where virtually no liberalization has occurred such as in the labor market and in agriculture. The discussion highlights the realized as well as potential impact of reforms across these different sectors of the economy. Although structural issues relating to public finance are not discussed here, fiscal consolidation is key to further progress in many of these areas. 2/

1. Financial sector reform

Sri Lanka’s prospects for economic growth and diversification are constrained by its inefficient financial sector. Despite the implementation of a number of reforms during the late 1970s as well as the early 1990s, the sector remains characterized by high costs and a narrow range of financial instruments. 3/

The first phase of financial sector reform was initiated in 1977. The money market was liberalized by deregulating interest rates. Operational restrictions on foreign banks were removed and commercial banks were allowed to operate foreign currency banking units and develop offshore banking facilities in the country. 1/ While these measures helped increase the depth of the financial sector to some extent, they did not go far enough. 2/ Inefficiencies continued with persistently high intermediation spreads of 6 to 10 percent and continued pressures on the two state-owned banks to lend at subsidized rates to priority areas. Deposit rates remained negative in real terms through most of the late 1970s and 1980s. The institutional structure of the banking system also remained virtually unchanged with the state-owned banks continuing to account for more than 70 percent of total assets of the banking system and the government continuing to absorb over one-third of total institutional savings.

During the second phase, between 1989-94, a wider range of financial sector reforms were implemented. In June 1990, the Colombo Stock Exchange (CSE) was opened to foreign investors and within a year sixty foreign funds had been authorized to invest in the stock exchange. Various regulatory and tax incentives were granted to encourage equity investment and growth of the CSE. 3/ Starting in early 1991, nonresidents and foreign citizens were allowed to hold resident accounts while residents were permitted to open foreign currency accounts. In 1991, the government allowed the formation of unit trusts and operation by private insurance companies in order to address the lack of domestic institutional investors. 4/ Progress was also made towards institutional strengthening by restructuring the National Savings Bank and divesting government shares in the Merchant Bank of Sri Lanka and the Development Finance Corporation of Ceylon.

The two state-owned banks, Bank of Ceylon and People’s Bank were recapitalized in 1993 and their nonperforming loans were transferred to independent collection agencies. 1/ Although a timetable was also approved for commercializing the two banks, along with administrative measures to increase their managerial autonomy in lending policies, this was not implemented, in part due to union opposition. Finally, monetary management was also improved with the introduction of a reserve money programming system, competitive treasury bill auctions, and the removal of tax and other legislative obstacles to secondary market activity. 2/

The impact of these measures was reflected in the growth of the financial sector. Foreign brokers set up offices in Sri Lanka and more than 20 new international investment funds entered the market. Foreign portfolio investment inflows increased from Rs 390 million in 1989 to Rs 1.1 billion by 1992 and market capitalization increased from $365 million in 1985 to $2.5 billion by end 1993. 3/ The liberalization of banking regulations resulted in the entry of private commercial banks. By 1995, there were 26 private commercial banks operating in the country. The liberalized banking environment was also reflected in an increased share of nonresident deposits in total deposits of the banking system, from about 8 percent in the 1984-88 period to about 14 percent in the post-reform 1989-94 period (Table IV.1).

Table IV.1.

Sri Lanka: Financial Sector Indicators Before and After Reforms

(In percent)

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Source: Data provided by the Sri Lanka authorities.

Excluding government enterprises.

Difference between rates on savings deposits and the midpoint rate for the range of lending rates for loans secured by government securities.

Overall, however, the impact of the financial reforms has been rather limited as indicated by several financial market indicators (Table IV.1). Deepening of the financial sector has been modest, with broad money to GDP rising only moderately (to 34.5 percent in 1995) and does not compare favorably with the performance of some East Asian economies or India (Chart IV.1). The reforms have also only moderately increased the availability of resources to the private sector as given by the share of private sector credit in total credit.



(In percent of GDP)

Citation: IMF Staff Country Reports 1996, 100; 10.5089/9781451823363.002.A001

Sources: Information provided by the Sri Lanka and other country authorities.

The limited impact of the financial sector reforms is mainly due to their failure to correct the fundamental structural weaknesses in the financial system. These weaknesses relate mainly to the continued dominance of the two state-owned banks which remain inefficient, overstaffed, and plagued by weak portfolios, despite their earlier recapitalization. The state banks still account for about 60 percent of total assets of the banking system, only slightly lower than their share a decade ago. As a result, financial innovation and competition in the banking sector is still limited and interest rate determination remains uncompetitive. Estimates of lending and deposit rates indicate unchanged large spreads of more than 9 percent on average through the post-reform years, with possibly some widening of the spread in recent years (Chart IV.2). 1/ The dominance of the state banks is facilitated by government support which also obligates them to channel credit to sectors that are commercially nonviable.



(In percent)

Citation: IMF Staff Country Reports 1996, 100; 10.5089/9781451823363.002.A001

Source: Information provided by the Sri Lanka authorities.1/ Midpoint of the range for rates on loans secured by government securities.2/ Savings deposit rate.

Despite significant growth of the capital market in the post-reform period, Sri Lanka does not compare favorably in this regard with the East Asian economies. Although there has been a substantial increase in market capitalization, Sri Lanka’s stock market is still relatively small and market capitalization to GDP ratio is about 15 percent compared to 60 percent or more for countries such as Indonesia, Malaysia, and Thailand, and also India. Market liquidity is low and trading activity is concentrated. The debt and equities markets remain weak with continued dependence by private firms on retained earnings to finance investment activity. High returns on treasury bills and fixed term deposits with less risk cause funds to flow into savings instruments rather than the stock exchange. Similarly, regulations on contractual savings institutions like the Employees’ Provident Fund (EPF) and the Insurance Corporation of Sri Lanka, require them to hold the majority of their portfolios in short-term public securities, diverting funds from the private sector and hurting mobilization of long-term savings and liquidity of the capital market. 2/

Monetary management also continues to be hampered by the lack of depth and competition in money and securities markets. There is no active market for government securities with maturities over one year. Although a large part of the government’s financing requirement has been covered by issuing long-term rupee securities, these have been placed with captive sources at fixed interest rates determined by the authorities. Also, while short-term interest rates are market-oriented, the primary treasury bill market on occasion operates on the basis of a defacto interest rate floor (with the Central Bank absorbing residual amounts being auctioned), and the secondary market remains very limited.

Various reform measures in the financial sector will be needed to increase efficiency and competitiveness. Foremost among these measures is the restructuring of the two state-owned banks. While strong union opposition may make such a move difficult, passage of the long-delayed legislation on the amendments to the Bank of Ceylon Ordinance and the People’s Bank Act, which were gazetted for 1996, would enable the two banks to function as autonomous commercial banks by increasing the focus on profitability, levelling the playing field with private commercial banks, minimizing government intervention in their credit decisions, increasing managerial autonomy, and increasing their authorized share capital. The spread between deposit and lending rates would also be reduced with improved soundness of the two state-owned banks, if also supplemented by measures to improve liquidity management by the commercial banks, and lower intermediation costs arising from high levels of unremunerated excess reserves.

A second important area for action is the development of a long-term market for debt. A key measure required in this context is the introduction of medium-term treasury bonds and effective markets for such securities. Some progress has been made with the passing of the amendments to the Local Treasury Bills Ordinance and the Registered Stocks and Securities Ordinance in 1995. The former provides for the issue of scripless Treasury Bills and the latter allows for the issue of Treasury bonds with fixed coupon rate of interest and maturities exceeding one year, with auction-based issues of long-term treasury bonds slated to start in late 1996. Another important step to develop the capital market is to provide contractual savings institutions, which currently serve as captive sources of deficit financing, with more autonomy in their investment decisions. 1/ The proposed insurance bill to be gazetted in 1996 would enable insurance companies to pursue more diversified portfolio management policies by reducing the required minimum investment in government securities. These measures would facilitate mobilization of long-term savings and the channeling of investment resources to the private sector.

2. Public enterprise reform and privatization

The Sri Lankan government launched its public enterprise reform program in 1990. 2/ This included a divestiture program to privatize a wide range of manufacturing enterprises and selected public utilities. There was also some attempt to restructure the largest loss making public enterprises to improve their financial and economic performance.

Between 1989 and 1995, about 40 enterprises were privatized. These mostly included enterprises in the manufacturing sector as well as some important public service enterprises such as Ceylon Shipping Lines and the National Development Bank. 1/ The government also sold up to 90 percent of its stock in mining companies to corporate investors and distributed the remaining 10 percent to enterprise workers. Total proceeds from privatization amounted to Rs 8.4 billion at the end of 1994, or about 1 1/2 percent of GDP, with about 30 percent of the proceeds from foreign buyers. The privatization program was facilitated by regulatory reforms encouraging participation and transfer of ownership to foreigners, including the elimination of the tax on transfer of equity to foreigners and the removal of a 40 percent limit on foreign ownership.

A restructuring program was also initiated at this time to increase the managerial autonomy and efficiency of important public enterprises. In 1992, management of 449 public estates in the plantation sector were transferred to 22 private management companies on a profit-sharing basis. 2/ The Sri Lanka Telecommunications Department was converted into a public corporation, with more autonomous management, and the opening of telecommunications services, except for basic telephone services, to the private sector. The Sri Lankan Railway was transformed into a semi-autonomous authority and restructured by reducing the number of workers from 26 thousand in 1989 to 17 thousand by 1992.

In 1995, the public sector accounted for about 10 percent of value added in industry. Nevertheless, the government continues to play a dominant role in the provision of most infrastructural services such as telecommunications, transport, power, irrigation, ports, and wholesale and retail trade and distribution, as well as in the financial sector (discussed earlier). 3/ In many of these areas, despite some attempts at deregulation in the early 1990s, monopolistic influences by government enterprises continue owing to the presence of price controls, subsidies, and restrictive marketing arrangements that discourage entry by the private sector. 1/ For instance, imports of wheat grain and the internal distribution of wheat flour and several agricultural products remain under the monopoly of the Cooperative Wholesale Establishment (CWE). 2/ The monopoly is also facilitated by the lack of competition in the milling of wheat flour. For similar reasons, the Paddy Marketing Board continues to monopolize the import, distribution, and marketing of rice and the Ceylon Petroleum Corporation remains the exclusive importing and marketing agency for petroleum and petroleum products.

Even where public enterprises have been privatized, the realization of benefits has been limited by regulatory restrictions and government intervention. In the case of the sugar industry, which was privatized in 1992, the benefits have been hampered by the limited number of importers operating under restrictive import arrangements, high specific import levies, and minimum guaranteed prices for private sector producers. Similarly, restrictions on retrenchment of workers for a period of two years after privatization prevented the privatized enterprises from restructuring and realizing potential efficiency and financial gains. 3/ The government also continued to intervene in wage setting and production decisions in many privatized or corporatized enterprises, such as in the plantation sector. 4/

Recognizing the drain on the economy due to inefficient public enterprises, the new government established the Public Enterprise Reforms Commission (PERC) in March 1995 to reformulate and accelerate the privatization program. Forty seven enterprises out of a total of 200 public entities have been targeted for full or partial divestiture over a three year period. 5/ Some 15 enterprises are targeted for sale in 1996 in areas such as sugar, fisheries, finance and insurance, trading, and fertilizers. The privatization will take place mainly through offerings on the Colombo Stock Exchange and in some cases, by offering a strategic share to foreign investors along with management control. Worker support will be sought through employment and wage guarantees and free allocation of 10 percent of the shares. Although privatization proceeds have fallen far short of PERC’s expectations–reaching Rs 3.1 billion in 1995 compared to a target of Rs 13 billion–some progress has already been made. Management control of Colombo Gas, the duty free shops, several plantations, and several small enterprises in diverse areas have been turned over to the private sector; some loss-making enterprises have been closed or sold off; and preparations for the divestiture of several major enterprises such as Sri Lanka Telecom and the National Development Bank are also well advanced. Private participation in infrastructure is also being increased through build-own-operate (BOO) and build-operate-transfer (BOT) schemes. 1/ An important influence on the success of the current privatization program will be the government’s ability to implement supporting reforms, particularly in the financial sector and trade and pricing policies.

3. Labor market reform

Sri Lanka’s labor market is characterized by persistent, high open unemployment, estimated most recently at about 12 percent. 2/ This is in contrast to most developing countries where disguised unemployment and underemployment tend to be high. There is severe market segmentation, including a formal, highly regulated sector (including state-owned plantations) and an unregulated, informal sector. 3/ There is also a high level of union activity that results in frequent job disruptions and protracted dispute settlement procedures. These inefficiencies are largely due to complex and restrictive labor laws that dictate wage and nonwage benefits in private and public firms and limit firms’ autonomy with regard to retrenchment, wage setting, training, and social security contributions. 4/ The distorted and inflexible labor market has had an adverse impact on resource allocation, economic efficiency, and growth. Labor market reform has lagged reforms in other areas which will make it difficult to realize the full benefits of reforms in other sectors of the economy.

Several studies by the World Bank indicate that restrictive labor market regulations, particularly with regard to retrenchment and dispute settlement, constitute a major structural impediment to an efficient and well-functioning labor market in Sri Lanka. 1/ Significant among these are the Termination of Employed Workmen Act (TEWA) and the Industrial Disputes Act (IDA). The TEWA prohibits firms with 15 or more employees from laying off workers for nondisciplinary reasons. This prevents firms from firing workers for reasons such as inefficiency, outdated and inadequate skills, and downsizing for restructuring purposes. Since redundancy permission is generally not granted by the Labor Commissioner for nondisciplinary reasons, the TEWA forces employers to agree to large settlements with workers, imposing heavy costs on firms.

The IDA, which covers dismissals for disciplinary reasons, also imposes severe limitations on firms, requiring them to obtain the Labor Commissioner’s consent to fire workers on disciplinary grounds. The review process, however, is protracted, often taking up to a year or more, during which time firms must continue to pay the wage bill. Given the heavy costs involved in dispute settlement, few firms want to make use of this institutional mechanism and instead prefer reallocating their workers to other branches or production lines or natural attrition to scale down employment. Thus, both the TEWA and IDA significantly limit labor market flexibility by creating high costs of labor turnover and discouraging labor hiring and employment-creating investments.

The heavy regulations, however, have not brought labor peace. There is a high degree of unionization and work disruptions. Over the last several years, on average there have been more than 100 strikes per year, involving more than 50,000 workers on average, and a significant loss of work days (Chart IV.3). Furthermore, since the reported number of strikes represents only 30 to 35 percent of the actual number of disputes in a year, the loss in economic activity and foregone earnings due to labor market disruptions has in fact been even greater. 2/



Citation: IMF Staff Country Reports 1996, 100; 10.5089/9781451823363.002.A001

Source: Information provided by the Sri Lanka authorities.

Government regulations on wage and nonwage benefits in the protected sector constitute another major source of distortion in the labor market. Wages in government administration and public enterprises are determined by administrative order and tend to be above nongovernment wages. 3/ Workers in the regulated sector also participate in generous pension schemes, enjoy long and numerous holidays, job security, and prestige. The high value of these benefits creates incentives among the unemployed to indulge in a long search process for jobs in the privileged sector. The wait-and-see nature of such unemployment is evident from the fact that more than 70 percent of the unemployed can endure unemployment periods of more than a year (Table IV.2) and that over 90 percent of them receive financial assistance from their families (Table IV.3). Furthermore, over two-thirds of the unemployed live above the poverty line, after receiving assistance (Chart IV.4). Voluntary unemployment is also motivated by uneconomic government hiring practices with periodic “en masse” hiring of the unemployed as teachers at salaries that are above comparable private sector wages in terms of skills and training. Hence, government intervention in the labor market significantly distorts incentives, resulting in an inefficient use of productive resources.

Table IV.2.

Sri Lanka: Duration of Unemployment, 1995

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Source: Department of Census and Statistics (1995)
Table IV.3.

Sri Lanka: Unemployed Persons by Sources of Assistance and Sector, 1995

(In percent of total)

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Source: Department of Census and Statistics (1995).


Citation: IMF Staff Country Reports 1996, 100; 10.5089/9781451823363.002.A001

Source: World Bank.

Structural rigidities also result from the wage settlement process in the regulated sector and its spillover effects on wages in the rest of the economy. Presently, wages are primarily determined by the Wages Board mechanism or collective bargaining between firms and unions. There are 37 Tripartite Wage Boards consisting of government appointed members, private employers, and major trade union representatives, that set minimum wages for each skill level in all sectors of the economy. 1/ There are several problems with this system of wage determination. First, it is biased in favor of wage increases by the nature of the Wages Board’s composition and the pressures exerted by public sector wage increases on private sector wages. Second, although these wages are frequently not binding, they tend to impart a general upward bias to wages in the entire regulated sector since they serve as a basis for collective bargaining between private sector firms and unions. Also, under these negotiated wage settlements, firms tend to grant much higher wage increases in exchange for labor peace given the strength of labor unions and potential for job disruptions and union activity. Finally, these wage settlement arrangements are not linked to productivity. 2/

The labor market distortions are compounded by relatively low quality of labor skills and a mismatch between labor skills and employment needs. This relates in particular to government vocational training programs. In 1992, the Sri Lankan government had nearly 3,000 training programs for public employees and the public at large. 1/ However, evidence indicates that these programs are not particularly effective in generating employment. Nearly 50 percent of the participants who complete the programs fail to obtain employment within two years of graduation and over 20 percent of those who do obtain employment, work in fields unrelated to their training. 2/ Vocational training also does not have a significant impact on earnings. Surveys of the private sector indicate that these training programs are not well tuned to the needs of the private sector. Managers usually complain that these programs are not updated and that the selection of the trainees is subject to politics and patronage. The poor quality of labor skills also reflects general biases in the education system with its emphasis on white collar professions and public sector careers and a general anti-business bias. 3/

Given the various sources of distortion in the labor market, amending labor market regulations such as TEWA would reduce labor costs of restructuring, encourage hiring and labor-intensive investments, and promote easier entry into the labor market. Reduced intervention in wage and employment decisions in the regulated sector, with greater emphasis on profitability would promote more efficient resource allocation and use. This would also involve rationalizing civil service hiring, linking wages to productivity, the budgetary situation, and private comparators, and stopping the large-scale hiring of the unemployed in order to reduce incentives for queuing up for jobs in the public sector. Rapid private sector growth that is employment-creating rather than government intervention to guarantee and secure employment, will ultimately be more effective in reducing unemployment.

4. Trade reform

Sri Lanka has made significant progress in trade liberalization since 1977. Prior to that date, the country’s trade regime was characterized by a highly differentiated tariff structure, a variety of nontariff barriers, including quantitative restrictions, licensing and foreign exchange restrictions, and a general bias towards import-substitution activities. 4/ Between 1977-85, the government radically altered its trade orientation by adopting an outward-looking trade strategy. The trade regime was streamlined by lowering tariff rates and dispersion, dismantling quantitative restrictions, eliminating discretionary measures, and liberalizing import administration. 1/

Following a hiatus and some policy reversals between 1985 and 1989, the trade reform program was revived in the 1990s. By 1995, a three band system was in place with rates of 10, 20, and 35 percent. During 1989-95, specific duties on products such as textiles were reduced and converted to ad valorem tariffs. Steps were also taken to reduce nontariff barriers. A wide range of products were put under Open General Licensing. Import quotas and licensing restrictions were eliminated except for reasons of national security, health, and environment and for a number of agricultural products, and exchange restrictions were removed. Measures were also undertaken to reduce the role of state trading monopolies in the import of agricultural commodities. 2/

A key feature of the trade liberalization program was its emphasis on export promotion. For instance, export duties were lowered and ultimately eliminated in December 1992. This was particularly significant for traditional agricultural exports which till then had accounted for the bulk of export taxes (Table IV.4). 3/ Several institutions were also established to promote exports. Chief among these was the Board of Investment which was established to promote foreign investment in export-oriented activities. 4/ BOI firms received incentives in the form of duty-free import privileges and authorization to clear customs on their own authority. Export-oriented firms could avail of duty drawback schemes, concessionary financing facilities, and a variety of fiscal incentives.

Table IV.4.

Sri Lanka: Trade Indicators Before and After Reforms

(In percent)

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Source: Data provided by the Sri Lanka authorities.

Covers the period 1989-92; export duties were eliminated in December 1992.

The export promotion measures were also supported by the liberalization of the external payments system. Operational constraints on export-oriented businesses and foreign investors in the Colombo Stock Exchange were removed by liberalizing restrictions on the repatriation of profits and dividends, on foreign exchange limits for service account payments, on commercial bank holdings of foreign exchange subject to prudential limitations, and on the purchase of foreign currency and remittances. By 1994, all exchange restrictions on current account transactions, including export surrender requirements had been eliminated. 1/

The impact of the reforms in the trade and payments system are reflected in the effective rates of protection in the pre- and post-reform periods. The average rate of effective protection for the whole manufacturing sector declined from as high as 3.13 in 1983 to 1.80 in 1990 and further to 1.30 by 1993. 2/ Within manufacturing, average effective protection rates were reduced by 50 percent or more over this period for sectors such as textiles and clothing and chemicals and chemical products. 3/

The impact of trade liberalization is also evident from the significant growth in trade in the post-reform period (Table IV.4). The export promotion measures resulted in increased average export growth and reduced share of export duties to total trade taxes in the post-reform years. They also led to a considerable diversification of the export base away from traditional export items like tea and rubber and towards manufacturing exports, particularly, textiles and garments (Chart IV.5). 4/ Import growth also increased significantly in the post-reform 1989-94 period. The rapid growth in exports and imports as well as the diversification of the export structure mainly reflected the expansion of trade and investment in the BOI sector, stimulated by a variety of incentives (Table IV.5). 5/ Overall, substantial progress was made towards Sri Lanka’s integration into the world economy through trade and investment liberalization and deregulation of industrial activity in export-oriented sectors.



(In percent)

Citation: IMF Staff Country Reports 1996, 100; 10.5089/9781451823363.002.A001

Source: Information provided by the Sri Lanka authorities.
Table IV.5.

Sri Lanka: Realized Investment in Board of Investment (BOI) Enterprises, 1991 and 1995 1/

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Source: Data provided by the Sri Lanka authorities.

Figures for 1995 axe provisional.

There are nevertheless still some distortions that remain in the trading system. Removal of these distortions would increase the role of competitive forces, increase efficiency, and help to fully realize and sustain the benefits from trade reform. Foremost amongst these are further reductions in the maximum tariff rate and reduced tariff dispersion to further streamline the tariff regime. In addition, increasing tariff bindings beyond the present 8 percent of total tariff lines would enhance confidence in the government’s liberal trade policies. 1/ Agriculture still remains highly protected by tariff and nontariff barriers, with several agricultural products still subject to import licensing restrictions and prohibition. 2/ Trade and distribution of some products such as wheat grain and petroleum are still dominated by state trading monopolies.

There are also various discretionary elements in the trading system that are not captured in the duty structure. These include full and partial duty waivers and exemptions, export cesses on certain products, and an Export Development Board (EDB) surcharge that is still assessed on imports which are subject to the highest duty rate or above. 3/ Elimination of these ad hoc charges and levies would streamline the trade regime and increase transparency. Finally, further diversification of the export base, which has gone from excessive concentration in plantation crops to excessive dependence on low value added textiles and garments exports, would help reduce vulnerability to external market conditions and enable Sri Lanka to exploit its comparative advantage in other areas. Such diversification will require not only a liberal trading environment and a competitive exchange rate, but also reforms in other sectors to encourage investment in new lines of labor-intensive products.

5. Agricultural reform

Despite substantial diversification of the economy’s productive base over the last two decades, agriculture remains an important sector in the Sri Lankan economy. Between 1984-1994, agriculture accounted for about 20 percent of GDP and close to 40 percent of total export earnings (Table IV.6). The sector provides employment to about one-third of the labor force and livelihood to more than 60 percent of the population. Growth performance in this sector has, however, been rather poor, averaging little over 2 percent per year over the 1984-1994 period and product diversification has been limited (Chart IV.6). The agricultural sector has also been characterized by low productivity growth and an inefficient use of land, water, and human resources. Given the sector’s continued importance to the economy, agricultural reform is critical to improving long-term growth prospects and reducing poverty. This section highlights some of the key policy-related and structural constraints to agricultural growth in Sri Lanka, drawing upon analysis by the World Bank.

Table IV.6.

Sri Lanka: Performance of the Agricultural Sector Before and After Reform

(In percent)

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Source: Data provided by the Sri Lanka authorities.

In SDR terms.

Covers the period 1989-92; export duties were eliminated in December 1992.



(In percent)

Citation: IMF Staff Country Reports 1996, 100; 10.5089/9781451823363.002.A001

Source: Information provided by the Sri Lanka authorities.1/ Excludes forestry and fishing.

Government regulations on the use of factor resources such as land and labor have greatly contributed to inefficiencies in the agricultural sector. Regulations on land use and ownership are particularly restrictive. About 60 percent of land in Sri Lanka is publicly owned, including two-thirds of land under tea cultivation and 30 percent of land under rubber production. There are many restrictions on the diversification of land use, on full private ownership of land by farmers in settlement schemes, and on the transfer of public land. As stipulated by the Land Reform Laws of 1971 and 1975, private land holdings are limited to 50 acres and land tenure legislation places a ceiling of 25 acres on private owner operated paddy land and of 5 acres on land under tenant farming and public sector irrigation schemes. 1/ Until 1991, there were also legal constraints to the reallocation of land from paddy cultivation to other crops, under the Agrarian Laws Act. In addition to these restrictions, a weak land titling system which results in frequent title disputes, vague ownership claims, and complex and lengthy transfer procedures further constrain the development of the private land market. Thus land regulations limit the scope for diversification, the exploitation of economies of scale, and impede investments in the agricultural sector. Similarly, labor market regulations regarding wage and nonwage benefits for workers on the plantation estates create rigidities and raise production costs, as discussed earlier.

The agricultural sector’s poor growth record is also attributable to policy biases towards certain import-competing agricultural products that have resulted in inefficient investments and hurt the development of existing and potential areas of comparative advantage. For instance, within the nonplantation sector, self sufficiency in rice production has been a major goal and government policies have favored paddy production over other crops. Given the irrigation-intensive nature of paddy production, incentives have been given to paddy producers through liberal investment in irrigation, free provision of water, fertilizer subsidies, and cheap loans. Paddy producers have also been favored with price and trade controls. A duty rate of 35 percent is levied on rice imports. 2/ These incentives have led to inefficient land use with the expansion of paddy production to areas that are not sustainable for growing rice. 1/ The inefficiencies are indicated by the high Domestic Resource Cost (DRC) of rice production, estimated at 1.53 for rainfed rice production and 2.16 for large scale irrigated rice production, with an overall average DRC of 1.73. This implies that on average Rs 1.73 of resources were used to produce one rupee worth of rice valued in foreign exchange. Hence, while the government invested a large amount of water and land resources in rice production, Sri Lanka did not possess a comparative advantage in this crop and could have obtained rice for much less internationally. 2/

Similarly, production of other import-competing crops that have been encouraged such as onions, chilies, and potatoes has also been characterized by inefficiency. 3/ The preference given to import-competing crops through trade and pricing policies and subsidies on nontraded factors has prevented diversification to higher value added crops like fruits and vegetables where the country does have a comparative advantage. In addition, as noted earlier, regulations on land use and ownership have prevented farmers from increasing their farm size and developing a diversified portfolio of income generating crops. 4/

The government has taken some measures to remove some of the structural impediments to agricultural growth and productivity. The anti-export bias on agricultural products has been reduced with the elimination of export duties, although some royalties and cesses still remain. Agricultural export taxes as a share of total trade taxes fell from over 15 percent in the 1984-88 period to 4 percent in the 1989-92 period, with the average share of export duties on important items like tea and rubber falling significantly over these periods (Table IV.6). In addition, surrender requirements and ad hoc levies and specific duties on these exports have been eliminated. The positive impact of the reduced anti-export bias is evident from the slightly improved agricultural export and growth performance in the post-reform period (Table IV.6).

Another important step towards agricultural reform has been in the plantation sector. In 1992, the two state plantation corporations were restructured and commercialized. The commercially viable estates were converted into 22 autonomous public companies whose management was transferred to the private sector under five year contracts. 1/ However, since the contracts were too short given the time and scale required for replanting and other investments in this sector, and since government intervention in land and labor use and marketing continued, there was little impact on the companies’ financial performance and productivity. However, in 1995, the government commenced the extension of the five year lease contracts for private management to 53 years, with effect from 1992. The extension of the contracts is likely to have a beneficial effect on output, exports, and productivity in the plantation sector.

Overall, the limited efforts have done little to remove the basic structural distortions in the agricultural sector. Reducing government intervention in the land, labor, and credit markets, elimination of measures that distort production incentives such as pricing subsidies, protection of selected agricultural products, and government monopoly in the imports of agricultural items would help increase productivity, promote diversification, and fully realize the export potential in the agricultural sector. 2/

6. Concluding remarks

Sri Lanka has made considerable progress in structural reform in certain sectors of the economy, particularly in trade and payments reform and more recently, in public enterprise reform in the context of its relatively advanced and well-formulated privatization program. However, important steps still need to be taken in several areas. Most important among these are steps to increase competitiveness and efficiency of the financial sector, primarily by reforming the two state-owned commercial banks; reducing government intervention in the labor market to increase flexibility in the allocation and use of labor resources; and removing policy biases in agriculture that run counter to the country’s comparative advantage.

As noted at the outset, fiscal reform is crucial for facilitating progress in many of these areas. Without fiscal consolidation, particularly, improved expenditure management, progress in areas such as reducing financial repression may prove difficult. At the same time, given the important linkages between reforms across many of these sectors, the entire structural reform package needs to be viewed in its totality if progress is to be sustained and benefits are to be maximized.

It is difficult to quantify the growth implications of these various structural measures. However, as the preceding discussion has indicated, the potential benefits from increased public sector efficiency, increased integration into the global trading system, greater flexibility of factor markets, and improved channeling and use of productive resources are likely to be considerable.

V. Medium-Term Fiscal Consolidation

Sri Lanka’s fiscal situation has deteriorated significantly in recent years. The overall fiscal deficit (excluding grants and privatization receipts) is estimated to have been about 10 1/2 percent of GDP in both 1994 and 1995, and the 1996 budget envisaged a deficit of a similar magnitude. 1/ The adverse consequences of high fiscal deficits are becoming increasingly evident:

  • The task of regaining macroeconomic stability is made more difficult, with an excessive burden placed on monetary policy.

  • National savings are depressed, limiting the scope for domestic investment, and public debt is very high at 97 percent of GDP.

  • The process of structural reform is jeopardized, particularly financial sector reform as the government continues to rely on financial repression.

  • The ability to attract sustainable foreign savings in the form of foreign direct investment is diminished by the likelihood of continued macroeconomic instability.

  • The crowding out of spending in the health and education sectors and the slowdown in capital expenditures endanger future economic growth.

Thus, substantial fiscal adjustment is required for Sri Lanka to achieve both rapid growth and financial stability that would allow it to make durable progress in poverty reduction and employment creation. Furthermore, the structure of the budget needs to be improved by reducing the proportion of unproductive expenditures and making the tax system more elastic. This chapter first presents alternative medium-term fiscal consolidation scenarios. These illustrative scenarios are followed by an analysis of the revenue and expenditure policies that will be required to achieve a large and sustainable reduction of the fiscal deficit.

1. Fiscal consolidation scenarios

Two alternative scenarios have been prepared to illustrate how economic developments in Sri Lanka might unfold over the medium term. The first scenario assumes that strong fiscal adjustment and major structural reforms are implemented beginning in 1997. The second scenario assumes that fiscal consolidation is weaker and that the pace of structural reforms is slower.

The scenario with strong adjustment and reform is broadly consistent with the Government’s medium-term strategy outlined in the 1996 budget speech. The main objectives outlined in that speech included: a reduction in inflation to 5-6 percent; a gradual acceleration of economic growth to 7-8 percent; and a reduction in the external current account deficit to about 4 percent of GDP. The driving force underlying this scenario is a major fiscal consolidation to reduce the government’s large claim on resources. The primary fiscal deficit (after grants) is assumed to fall from a projected 2 1/2 percent of GDP in 1996 to under 1/2 percent of GDP in 1997; thereafter, fiscal policy is assumed to target primary surpluses rising to about 1 1/4 percent of GDP by 2001, the end of the scenario period (Table V.1 and Chart V.1). This adjustment is based entirely on a reduction in non-interest current expenditures.

Table V.1.

Sri Lanka: Medium-Term Macroeconomic Framework, 1994-2001 (Strong Adjustment Scenario)

(In percent of GDP unless otherwise indicated)

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

Excludes proceeds from partial divestiture of Sri Lanka Telecom in 1997 used to retire short-term domestic debt.



Citation: IMF Staff Country Reports 1996, 100; 10.5089/9781451823363.002.A001

Sources: Information provided by the Sri Lanka authorities; and staff projections.1/ Before grants.2/ After grants.3/ Excluding official transfers.

With strong adjustment, especially in the early years of the scenario, fiscal consolidation would be facilitated by a reduction in the burden of domestic debt service over the medium term. The scenario incorporates an increase in the average real interest rate on public domestic debt because of declining financial repression. As the maturing portion of public debt is rolled over at market rates, the share of debt at higher interest rates increases. Nevertheless, with declining inflation and, hence, nominal interest rates, the interest bill would fall relative to GDP. 1/ Thus, the overall fiscal deficit would show an improvement of about 6 percentage points of GDP over the medium term. Public debt would decline markedly from 97 percent of GDP in 1996 to about 70 percent by 2001.

The reduction in the overall fiscal deficit is also reflected in an elimination of public dissaving in the next two years, after which public savings rise to 4 1/2 percent of GDP at the end of the scenario period. The improvement in public savings reduces crowding out of private investment, enabling the latter to rise significantly over the medium term. Also underlying the sustained rise in private investment are a range of structural measures that create new investment opportunities. These include measures to reduce existing structural rigidities in the labor market, measures to deepen the financial sector and increase the efficiency of financial intermediation, privatization of public enterprises, and increased private participation in the provision of current public services. 1/ Over time, government investment would account for a larger proportion of the overall fiscal deficit.

The high investment and growth rates in this scenario should be sustainable given relatively high levels of domestic and foreign savings. The domestic savings rate is assumed to increase by more than 7 percentage points of GDP between 1997 and 2001. Although this is mainly due to the improved public savings performance, private savings are also assumed to have a moderate upward trend due to income growth and financial sector reform. 2/ Foreign savings are assumed to remain fairly high throughout the period, reflecting a substantial increase in non-debt creating flows such as foreign direct investment from 1997 onwards, and corresponding growth in investment-related imports.

In the absence of strong fiscal adjustment and structural reforms, the medium-term macroeconomic outlook is likely to be much less promising. Specifically, in the weak adjustment scenario, primary fiscal deficits are assumed to persist for the next several years. Although a primary surplus is projected to be achieved in the last year of the scenario, this adjustment path would yield only a modest 2 1/2 percentage points of GDP reduction in the overall fiscal deficit over the five year timeframe because of continued high interest costs. Interest payments would absorb over one-third of tax revenues, suggesting continued vulnerability of the budget to changes in macroeconomic conditions. Public debt would only fall to about 85 percent of GDP, and the government would continue to absorb a large proportion of national savings and crowd out private investment. With lingering inflationary pressures and high interest rates, growth would likely stagnate at about half the level of the strong adjustment scenario. Chart V.1 highlights alternative paths for key macroeconomic indicators under the strong adjustment scenario and under a weaker adjustment case. The considerable divergence in the paths for the fiscal deficit, public debt and debt service, national savings, and the external current account under the two cases illustrates the significant risks to a strategy of gradual adjustment. The vulnerability of the economy would, of course, be much greater if there was no fiscal adjustment.

2. Policies to reduce the deficit

A balanced and sustainable fiscal correction will require adjustments which are also consistent with improving both the efficiency of operations and the incentives for private investment. Hence, the quality and composition of fiscal adjustment are no less important than the magnitude and speed of deficit reduction. Specifically, the demands for productive spending in areas such as education, health care, and infrastructure will need to be met. To provide room for such expenditure, other current spending, including on subsidies and on the wage and pension bill, will need to be restrained.

a. Revenue

Total revenues in Sri Lanka amount to about 20 percent of GDP, of which about 17 1/2 percent come from tax revenues. These ratios are fairly high and it is not expected that they could (or should) be raised significantly in the medium term. 1/ However, the tax system remains quite inelastic, and the rise in the revenue ratio in recent years has been due to improvements in tax administration, the introduction of new taxes (e.g., the national security levy), and adjustments in tax rates. Maintaining the revenue effort in the future will therefore require a more buoyant system.

The planned introduction of the Goods and Services Tax (GST) in 1997 will be critical to improving the elasticity of the tax system and reducing distortions. The determination of the GST rate will need to take into consideration both revenue needs and a realistic assumption of the level of compliance with the tax laws. To simplify the tax system, increase its economic efficiency, and broaden the base of the planned GST, consideration should also be given to replacing the national security levy with a GST surcharge. The scope of exemptions to the GST should be limited to goods which form part of the basic foodbasket or are widely consumed by the low income population; financial and educational services; and duty free and diplomatic goods. With a single rate set at an appropriate level (plus a zero rate for exports), and with broad coverage and minimal exemptions, the GST would be a major step forward in mobilizing revenues without frequent recourse to ad hoc rate adjustments and new taxes.

Broadening the overall tax base, for example by bringing the civil service into the income tax net and removing duty waivers and exemptions, would also assist in bolstering revenue in the medium term. A move from the present three-band tariff system (with rates of 10, 20, and 35 percent) to a two-band system with low rates would simplify the tax system and encourage greater compliance, apart from yielding efficiency gains for the economy. The potential revenue loss due to tariff reduction could be partly alleviated by improving customs administration, especially an extension of inspection powers to cover firms that are presently exempted from such examination. 1/

b. Expenditure

High government expenditure, especially current expenditure, has been the main source of fiscal pressure in recent years, and is the area of the budget that must inevitably bear the brunt of the fiscal adjustment in the medium term. Although the rise in military spending from 3 percent of GDP in 1989-90 to 6 1/2 percent in 1995 is a major reason for the rise in spending, it would not be prudent to base the strategy for medium term fiscal consolidation exclusively on a substantial decline in such expenditure. Even if there is an early settlement of the ethnic conflict, military spending is likely to remain high for some time, given the long history of the conflict, the uncertainties that will persist, and the lags in demobilization. 2/

The re-introduction of commodity subsidies is another major factor underlying the deterioration in the fiscal position in the last few years. The elimination of the subsidies on wheat flour and fertilizers, and the cross subsidy on kerosene would result in budgetary savings of about 1 1/2 percent of GDP. 3/ In the absence of further domestic price increases, the cost to the budget of the flour subsidy alone is estimated to be about 1 1/4 percent of GDP in 1996. 4/ This subsidy is poorly targeted–the 1990/91 household consumption survey suggests that one-third of the subsidy accrues to the wealthiest 20 percent of the population–and it has induced a large shift in consumption away from rice which has adversely affected domestic producers.

Progress has been made in consolidating some of the social transfer schemes into the newly created Samurdhi program. There is further scope for strengthening the existing social transfer regime while still achieving some savings. 1/ An important early step in this direction would be to stop payments under the previous Janasaviya scheme, which presently costs the budget about 1/4 percent of GDP. 2/ Better targeting of the Samurdhi program and reducing overhead costs by limiting the number of mobilizers would allow limited resources to be used more effectively. 3/ In addition, establishing a clear exit strategy for beneficiaries of social welfare will prevent an escalation of costs in the future. 4/

The pension bill for civil service personnel has quadrupled since 1990 and is the largest single item in government transfers amounting to 2 1/4 percent of GDP in 1995. A series of modifications to the pension scheme over the last decade has led to it becoming financially unsustainable and very generous compared to other countries at similar levels of per capita income. For example, Circular 44/90 was introduced in 1990 as a temporary measure to support a voluntary departure scheme, but it still remains in force. This measure provides the possibility of retirement after only ten years of service, regardless of age. Besides an early withdrawal of this circular, additional savings could be achieved by bringing the pension scheme more into line with international practice, for example by reducing the lump sum payments from 24 to 12 months of the pensionable base; scaling back the replacement rate for beneficiaries in the survivor program from 100 percent to 50-75 percent; and establishing a contributory system. 5/

The size of the civil service (approximately 570,000 in 1995) and the civil service wage bill (3 1/2 percent of GDP) have also put considerable strain on expenditure. 6/ Again, recent developments have exacerbated the situation, with substantial numbers of additional positions added to the civil service since 1993, negating the retrenchment program implemented in 1990-91. A medium-term reform program to address issues such as the size, scope, structure, and organization of the civil service is necessary both to contain fiscal pressures in the future and to meet the requirements of an increasingly market-based economy.

A first step in the process of civil service reform would be to establish a system to document actual employment on a timely basis. The lack of such a system leads to excessive budgetary appropriations and precludes the effective imposition of a hiring freeze. With this system in place, budget appropriations for wages should be based on actual staff employed rather than the notional “authorized cadre.” In addition, following a functional review of government organizations and documentation of actual employment, a medium-term program of staff retrenchment will be required. Moreover, pending the results of the functional review, a moratorium on restructuring and creating new government institutions and boards would prevent a further worsening of the problem. Based on the conclusions of the functional review, unnecessary institutions and boards will need to be eliminated, along with a streamlining of the central administration.

The financial condition of public enterprises is mixed. Many enterprises are net contributors to the budget, but a few could pose serious fiscal problems in the medium term unless they are abolished or reformed. Two public enterprises that have experienced large losses in recent years, and whose functions could be handled by the private sector in a market economy, are the Sri Lanka Transport Board and the Paddy Marketing Board. Similarly, with the elimination of the flour subsidy and liberalization of domestic and international trade in agricultural commodities, the activities of the Cooperative Wholesale Establishment could also be handled by the private sector. Water tariffs will also need to be raised to make the National Water Supply and Drainage Board financially viable. An overall review of the transport sector is also needed with a view to improving performance or privatizing the operations of Sri Lanka Railways. More generally, expanding the scope of privatization and accelerating the process could generate resources to retire domestic debt and hence lower interest costs.

With the measures described above, it should be possible to reduce non-interest government expenditures by about 4 percent of GDP over the next five years, while still leaving room for capital expenditures and social projects. Reducing expenditure by this amount would lead to the improvement in the primary fiscal deficit assumed in the strong adjustment scenario described above.

A final note of caution is that fiscal and financial pressures from devolution proposals are potentially very large. Devolution offers a number of opportunities, including an improvement in the allocation of public expenditure through greater local input into spending decisions. However, in several countries, decentralization has made it harder to eliminate structural fiscal deficits. 1/ Hence, it will be critical to introduce strong institutional constraints to prevent inappropriate financial behavior by new regional entities so that the medium-term fiscal adjustment program is not compromised.


Table 1.

Sri Lanka: Gross Domestic Product and Expenditure Components, 1991-95 1/

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

At market prices.

Provisional estimates.

Preliminary estimates, including external debt-financed military imports.

Includes investment by public corporations not financed through the government budget.

Capital expenditure and net lending by the central government, excluding privatization proceeds.

Table 2.

Sri Lanka: Saving, Investment, and the Current Account, 1991-95

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

Provisional estimates.

Preliminary estimates, including external debt-financed military imports.

Current revenue minus current expenditure.

Includes investment by public corporations not financed through the government budget.

Capital expenditure and net lending by the central government, excluding privatization proceeds.

Includes net factor income and transfers from abroad.

Table 3.

Sri Lanka: Gross Domestic Product by Industrial Origin at Current and Constant Prices, 1991-95

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Source: Data provided by the Sri Lanka authorities.

Provisional estimates.

Including forestry end fishing.

Tea, rubber, and coconuts.

Based on factor costs.