Sri Lanka: Selected Issues and Statistical Appendix

This Selected Issues paper focuses on the fiscal position of Sri Lanka. The standard analysis shows that, prior to the adjustment announced in the 2002 budget, fiscal policy was clearly unsustainable, leading to a rising debt-to-GDP ratio. The paper looks at external debt and complements the analysis of the public debt dynamics. The baseline scenario shows that debt ratios decline significantly in the medium term, as a result of strong growth founded on renewed peace and political stability, far-reaching structural reforms, and stable macroeconomic conditions.

Abstract

This Selected Issues paper focuses on the fiscal position of Sri Lanka. The standard analysis shows that, prior to the adjustment announced in the 2002 budget, fiscal policy was clearly unsustainable, leading to a rising debt-to-GDP ratio. The paper looks at external debt and complements the analysis of the public debt dynamics. The baseline scenario shows that debt ratios decline significantly in the medium term, as a result of strong growth founded on renewed peace and political stability, far-reaching structural reforms, and stable macroeconomic conditions.

I. Executive Summary

  • As part of the Article IV surveillance, the staff conducted sustainability assessments for Sri Lanka. Given that the range of possible outcomes is vast, three aspects of sustainability were examined–in terms of the fiscal position, external debt, and the external current account.

  • Chapter II focuses on the fiscal position. Standard analysis shows that, prior to the adjustment announced in the 2002 budget, fiscal policy was clearly unsustainable, leading to a rising debt-GDP ratio. If the adjustment, centering on tax policy reform and expenditure restraint, continues into the medium term, then fiscal policy is sustainable. However, if growth fails to take off, then fiscal policy will be unsustainable, even in the presence of strong adjustment. Other risks include: a failure of revenue reform to produce results; a fall in external financing; recourse to nonconcessional foreign borrowing; and higher capital spending.

  • Chapter III looks at external debt and complements the analysis of the public debt dynamics in the fiscal chapter. The baseline scenario shows that the debt ratios decline significantly in the medium term, as a result of strong growth founded on renewed peace and political stability, far-reaching structural reforms, and stable macroeconomic conditions. However, this scenario is highly sensitive to assumptions on growth and, to a lesser extent, non-debt creating capital inflows. The main message from the sensitivity analysis is that if there is no radical departure from past outcomes (including on growth, exports and FDI) and the associated policies, the external debt ratio will be significantly higher than the baseline by 2006. Debt ratios are resilient to temporary shocks to interest rates, growth, and the current account, but a combination of these or any large depreciation of the exchange rate could jeopardize sustainability.

  • Chapter IV looks at the external current account using the macroeconomic balance approach. The results indicate that during 1999-2000, the actual savings-investment balance was out of line with the estimated equilibrium savings-investment balance, reflecting mainly the larger fiscal deficit. However, by end-2001 the imbalance had been eliminated. Extending the savings-investment balance analysis to the equilibrium exchange rate, shows that the real exchange rate was also overvalued during 1999-2000. A forward looking analysis shows that, if adjustment measures continue, the external position would stay on a sustainable path that is consistent with the baseline medium-term projections. However, radical departures from the fiscal stance assumed in the baseline would pose a risk to external sustainability.

  • Chapter V provides a summary on tax policy reforms that were outlined in the 2002 Budget. The tax changes were designed to increase revenue significantly in 2002 and to develop a sustainable resource envelope in the medium term. The main reform is the transformation of the GST and NSL into a new VAT, which came into effect on August 1, 2002. The income tax base was also broadened by phasing out special tax incentives. Stamp duties levied by the central government have been eliminated. To improve tax administration, the administrative function of the large taxpayer unit was consolidated under a single commissioner.