Sri Lanka
Request for a Three-Year Arrangement Under the Poverty Reduction and Growth Facility, and Use of Fund Resources—Request for an Extended Arrangement—Staff Report; Staff Statement; News Brief on the Executive Board Discussion

This paper examines Sri Lanka’s Request for a Three-Year Arrangement Under the Poverty Reduction and Growth Facility (PRGF), and a Request for an Extended Arrangement. In line with the Poverty Reduction Strategy Paper (PRSP) and building on the progress made under the Stand-By Arrangement (SBA), the PRGF-Enhanced Fund Facility (EFF)-supported program aims to accelerate economic growth and reduce poverty. The IMF staff recommends extension to the obligations schedule of SBA repurchase expectations arising during July 2003–June 2004.

Abstract

This paper examines Sri Lanka’s Request for a Three-Year Arrangement Under the Poverty Reduction and Growth Facility (PRGF), and a Request for an Extended Arrangement. In line with the Poverty Reduction Strategy Paper (PRSP) and building on the progress made under the Stand-By Arrangement (SBA), the PRGF-Enhanced Fund Facility (EFF)-supported program aims to accelerate economic growth and reduce poverty. The IMF staff recommends extension to the obligations schedule of SBA repurchase expectations arising during July 2003–June 2004.

I. Introduction and Background

Over the past 20 years, a long civil conflict has beleaguered Sri Lanka. The conflict not only disrupted economic activity, but also hampered the sustained implementation of economic reforms. This resulted in weakened public finances, continued dominance of the state in the economy, and deepened poverty. Nevertheless, the economy’s growth potential is evident in the spurts of high growth that have followed intermittent periods of relative calm and reforms, and by Sri Lanka’s relatively favorable human development indicators. As the country and the Fund prepare to enter into three-year PRGF-EFF arrangements, this is an opportune juncture to take stock of past reforms and the policy challenges that lie ahead.

1. In 1983, simmering ethnic tensions erupted into widespread violence, marking the beginning of a 20-year long civil conflict. The impact of the conflict has been pervasive and severe (Box 1). With the North and East of the country virtually cut off, the inter-regional flows of goods and services dwindled and several key sectors of the economy, including tourism and commercial fishing, collapsed due to security concerns. The country’s infrastructure fell into disrepair as public resources became scarce, with mounting defense costs and declining tax revenue. The fiscal deficit rose sharply and the debt stock escalated. By some estimates, the conflict reduced GDP growth by 2–3 percent per year. Poverty also deepened, particularly in the war-torn regions and rural provinces.

2. Amidst the civil conflict, reforms were implemented in intermittent waves, building on the efforts initiated in the late-1970s. These changes were aimed at dismantling the economic legacy of the socialist policies of the 1960s and 1970s. Virtually all price controls were removed; most quantitative restrictions were replaced with import tariffs; exchange controls were liberalized; a range of sectors were opened to foreign direct investment; and some state-owned enterprises (SOEs) were privatized. Typically, the reforms took place against the backdrop of economic downturns, and in most instances the reforms paid off—growth increased, private investment picked up, and the balance of payments position improved. However, they remained limited. After an initial spurt of actions, either an intensification of the conflict or domestic political frictions pushed the reform agenda into the background.

3. Thus, a large reform agenda remains incomplete. The state dominates the financial and utilities sectors and remains the largest landlord and employer in the economy (around 90 percent of land and 12 percent of the labor force respectively), creating inefficiencies and impairing growth. High defense expenditure, SOE losses, and falling tax revenue have seriously weakened public finances. The banking sector is burdened with a high level of nonperforming loans and low capital adequacy, and one of the country’s largest banks—the state-owned Peoples Bank—is insolvent. Invasive and overly restrictive regulations have rendered the labor market inflexible, slowing private sector expansion and employment growth. The welfare system has become bloated and inefficient due to extensive abuse and politicization.

Sri Lanka: End of the Conflict—Peace Dividend and Challenges

After 20 years of conflict and several failed attempts to reach a settlement, the progress in the peace talks in the last few months holds promise of finally achieving lasting peace. While it is clear the most important determinant of the future of Sri Lanka’s economy is peace, it is difficult to gauge precisely the extent of the peace dividend and the transitional challenges. This box presents a broad assessment of the peace dividend and its challenges.

Effects of the Conflict

Both the humanitarian and economic impact of the 20 year long conflict has been severe. About 1.5 million (8 percent of the population) lived in areas of direct military activity. More than 60,000 have been killed, while 600,000 (3.5 percent of the population) have been internally displaced, including about 170,000 (1 percent of the population) living in refugee camps. With an estimated 1.8 million land mines in the region, the per capita incidence of landmine is comparable to that in Angola. The conflict has also led to low growth and deterioration in the fiscal position. The Central Bank estimates that the conflict has reduced Sri Lanka’s growth rate by about 2-3 percentage points per year in the last two decades. Tourism arrivals, which had grown by an average of 22 percent from 1975-82, were still lower in 2001 than in 1982. Defense expenditures rose from around 1 percent of GDP in the early 1980s to a peak of 6.5 percent of GDP in 1995. Central government debt increased by over 20 percent of GDP, during the conflict period, to stand at over 100 percent of GDP by end-2001.

End of the Conflict—The Peace Dividend

An analysis of 22 international episodes of conflict in various countries from 1985-99 shows that in the post conflict year: (i) growth picks up by around 4-5 percent above the conflict period average; (ii) capital expenditure increases substantially, particularly in the private sector; (iii) the fiscal deficit falls, due to increasing revenues and falling expenditures, the latter largely due to a reduction in defense spending, while expenditure is reoriented towards social areas. International experience indicates that lasting peace should result in considerable economic benefits to Sri Lanka:

  • Growth should increase, underpinned by an overall increase in business confidence, expansion in tourism; greater inter-regional trade; opening up of new sectors (such as commercial fishing); higher foreign direct investment: improvements in infrastructure; and increases in human capital.

  • The reduction in military expenditure and in interest payments should allow more finding for social priorities and capital needs.

  • Socio-economic indicators in the conflict-torn regions should improve, particularly as displaced populations are resettled.

The Challenges of Peace

However, the return of peace in the North and the East would entail a rise in public spending. In the immediate future the various spending needs are: (i) aid to begin the process of resettling the internally displaced population; (ii) rebuilding the regions’ administrative and institutional capacity; (iii) reconstructing the dilapidated infrastructure; and (iv) demobilizing the LTTE and government forces. Much of the spending in resettling the displaced population and rebuilding capacity would be needed immediately—demining is an obvious high priority—and peak over the next 6-12 months, while expenditure in other areas would be largely required over the medium term. In addition, as parts of the country become fully accessible and the displaced population resettles, there would be additional demands on normal public spending, such as on the welfare benefit scheme (Samurdhi program). A special fund, the North and East Reconstruction Fund (NERF), administered by the World Bank, has been established to process some of the aid directly to the region under the guidance of the joint government/LTTE Subcommittee on Rehabilitation and Development. Other aid will continue to be disbursed through the traditional government/NGO channels.

4. In April 2001, faced with a looming foreign exchange crisis and severe macroeconomic imbalances, Sri Lanka entered into a Stand-by Arrangement (SBA). Despite policy delays brought on by adverse external shocks and political instability, the SBA met its key objectives. Reserve losses were stemmed and the deterioration in fiscal accounts was arrested through several policy measures and structural reforms—including floating the currency, reducing defense spending, broadening the tax base, and improving tax administration. The final review of the SBA was completed in September 2002.

5. To support its continued reform efforts, the government has sought assistance from the Fund through new three-year PRGF-EFF arrangements. In the attached Letter of Intent and Memorandum on Economic and Financial Policies (MEFP), the authorities describe the economic program for which they request support under a PRGF arrangement with access equivalent to SDR 269 million (65 percent of quota) and a three-year EFF arrangement with access equivalent to SDR 144.4 million (35 percent of quota). The MEFP is based on the government’s medium-term economic and poverty reduction strategy program (PRSP)—Regaining Sri Lanka—that was finalized in January 2003 (EDB/03/17).

6. Development partners have demonstrated renewed interest to support Sri Lanka’s reform and reconstruction efforts. Last November, bilateral donors made commitments of $70 million (0.4 percent of GDP), mostly in the form of grants, to support immediate peace-related expenditure in the North and East. An international donors’ conference is planned in Tokyo in mid-June—a needs assessment being prepared with the help of the United Nations (U.N.), Asian Development Bank (AsDB), World Bank, and the Fund is to be presented at this meeting. A new World Bank country assistance strategy (CAS) is slated to be considered by its Executive Board in early-April, while discussions on a four-year PRSC arrangement are ongoing. The AsDB is providing assistance through its sectoral programs.

7. On the political front, several rounds of peace talks with the LTTE—facilitated by Norway—have resulted in significant progress. The LTTE has dropped its demand for an interim administration and indicated its intentions for early participation in mainstream politics. Both sides have agreed to share power under a federal system of government. On the economic front, the government’s reform agenda is facing resistance from interest groups and there is strong public pressure for measures to stem the rising cost of living.

II. Recent Economic Developments

8. Economic activity recovered in 2002 (Figure 1).

  • After the economy was hit by a series of exogenous shocks in the second half of 2001—the global slowdown, an attack on Colombo airport, and a severe drought, GDP for the year fell by 1½ percent, the first decline in several decades. Growth turned positive from early last year and reached 5½ percent (year-on-year) by Q32002. A robust expansion in domestic demand and tourism underpinned the rebound, as progress toward peace revived business and consumer confidence. However, external demand for goods remains weak, including in the garments sector.

  • Inflation fell from 14 percent in 2001 to 9½ percent last year. More recently, inflation has picked up due to higher world oil and wheat prices.1

  • Strong inflows of remittances and tourism receipts led to an increase in gross official reserves from $1.2 billion (December 2001) to $1.7 billion (February 2003), to a level covering 2½ months of imports and 76 percent of short-term debt. The rupee remained broadly stable in real effective terms in 2002.

  • Investor sentiment has strengthened. Since January 2002, equity prices have risen by 30 percent, notwithstanding recent declines due to the tension in the Middle East, and are now at around their 1996 levels. Moreover, the rupee forward premium has declined and foreign direct investment commitments have picked up.

Figure 1.
Figure 1.

Sri Lanka: Real and External Sector Developments

Citation: IMF Staff Country Reports 2003, 107; 10.5089/9781451823486.002.A001

Source: Data provided by Sri Lankan authorities; and CEIC.

9. Monetary policy has balanced supporting economic recovery with restraining inflation. The decline in inflation allowed the Central Bank of Sri Lanka (CBSL) to cut repo rates by 300 basis points since January 2002. Although the associated fall in lending rates raised private-sector credit growth, broad money growth has recently trended down, due to the improvement in the public sector’s financial position (Figure 2).

Figure 2.
Figure 2.

Sri Lanka: Monetary and Financial Developments

Citation: IMF Staff Country Reports 2003, 107; 10.5089/9781451823486.002.A001

Source: Data provided by Sri Lankan authorities; and CEIC.1/ Deflated by expected inflation.2/ Excess reserves and other cash in till in percent of required reserves.3/ Weighted average of indices of India, Malaysia, Indonesia, Pakistan, Philippines.

10. The fiscal deficit for 2002 is estimated at 9 percent of GDP—2 percent of GDP lower than in 2001—but higher than the budget target of 8½ percent of GDP. This outcome reflected a revenue shortfall of around 1 percent of GDP, partly offset by spending cuts of about ½ percent of GDP. The lower revenue was due to a combination of weaker-than-expected imports, a large number of exemptions granted when the GST was replaced with the VAT, and lower nontax revenue, in part, reflecting a restructuring in payments from the electricity company (CEB) to the budget. The cuts in expenditure reflected reduced capital spending (due to low project-implementation rates) and somewhat lower current spending. Shortfalls in donor financing (the World Bank called off its Private Sector Development loan, preferring to shift to more broad-based lending through the PRSC) and delays in privatization (particularly of the state-owned insurance company, SLIC) led to higher-than-anticipated domestic financing (mainly nonbank).

11. Structural reforms have advanced, in line with commitments under the SBA:

  • Following the enactment of the Electricity Reform Bill in December 2002, the unbundling of the state electricity company (CEB) is proceeding on schedule, supported by an AsDB power-sector loan. Reforms of the Ceylon Petroleum Corporation (CPC) are progressing in step with the liberalization of the petroleum sector—Indian Oil has entered the market and negotiations with another foreign oil company to take over part of the distribution network are underway.

  • The sale of the state-owned bus companies is near completion, while a 12 percent stake in Sri Lanka Telecom (SLT) was sold in December. The privatization of SLIC, which was scheduled for 2002, is expected to be completed in April.

  • Amendments to the labor laws—a new redundancy compensation formula, time-bound resolution of labor disputes, elimination of restrictions on overtime work by women, and increased penalties for child labor—were enacted in January 2003.

  • A Fiscal Management Responsibility Act (FMRA) was enacted in December 2002, which sets strict limits on borrowing from the CBSL, proposes a medium-term deficit path consistent with reducing the debt stock to 85 percent of GDP by end-2006, and mandates “pre-election budget reports” to discourage pre-election handouts. Parliament enacted a new Board of Investment (BOI) law, eliminating BOFs power to grant tax holidays and incentives outside the regular tax code. To reform the welfare system, a Welfare Benefit Law was enacted in September.

  • Amendments to the Monetary Law Act were enacted in December 2002 to provide the CBSL broader supervisory powers and greater independence. To strengthen the integrity of the banking system, the minimum CAR was raised to 10 percent for all domestic banking units from January 2003 and on a consolidated basis on all domestic and foreign banking units effective end-December 2003.

III. The New Program

12. Poverty remains one of Sri Lanka’s most daunting challenges. The PRSP identifies several factors behind Sri Lanka’s poverty—including inadequate growth; unequal opportunities for the poor; impact of the two-decade long conflict; low productivity in agriculture; and governance-related problems (Box 2).

13. To address these issues, the government has articulated in the PRSP an ambitious economic program and poverty reduction strategy. The PRSP is the result of four years of extensive consultation with stakeholders, spanning the tenure of the two main political parties. Its main objective is to “regain Sri Lanka” by accelerating growth and eliminating poverty through private sector led development. To meet its aims, the PRSP focuses on: providing a supportive macroeconomic environment; alleviating conflict-related poverty; reducing the role of the public sector in the economy; creating economic opportunities for the poor; investing in human development; empowering the poor and strengthening governance; reconstructing the North and East; and implementing an effective monitoring and evaluation system. Within this broad agenda, the roles of the Fund, World Bank, AsDB, and bilateral partners are clearly demarcated.

14. Consistent with the PRSP, the authorities’ program presented in the MEFP aims to: (i) strengthen public finances—to restore fiscal sustainability, ensure that adequate funds are available to meet priority spending needs, and release resources for private sector expansion; (ii) reform the financial sector, public enterprises, the labor market, and the trade regime—to increase efficiency and encourage private sector participation; and (iii) strengthen macroeconomic policy instruments and institutions.

Poverty in Sri Lanka

Poverty in Sri Lanka is high and multi-faceted:

  • The headcount poverty ratio increased from 20 percent in 1990-91 to 25 percent in 1995-96. Preliminary results from the 2002 Household Survey indicate that poverty rose further in the second half of the 1990’s to affect 28 percent of the population.

  • Malnutrition, however, declined during the 1990’s—the prevalence of stunting among children decreased from 23.8 percent to 13.5 percent, and of underweight, from 37.7 percent to less than 30 percent.

  • Poverty rates vary considerably across regions—ranging from 23 percent in the Western Province to 55 percent in the Uva Province. The surveys do not include the conflict areas of the North and the East, although anecdotal evidence suggests that the incidence of poverty is nearly 50 percent in these regions.

  • Poverty in Sri Lanka is mainly a rural phenomenon—88 percent of the poor reside in rural areas, some remote and isolated, and lacking basic infrastructure such as electricity and roads.

  • A significant number of the poor (95 percent) are employed. The poorest tend to work in rice farms or plantations.

  • There is little variation in the incidence of poverty across ethnicity and gender. However, plantation workers, mostly Indian Tamils, are among the poorest.

The PRSP identifies several factors that have led to Sri Lanka’s high poverty rate:

  • Insufficient economic growth—despite an average growth of more than 5 percent in the 1990s poverty increased mainly due to uneven regional economic performance. While the urban Western Province grew at 7½ percent a year, rural provinces, where the incidence of poverty is the highest, grew at less than 2 percent.

  • Civil conflict—which increased poverty not only directly, but also through the resulting internal displacement or disabilities from war injuries that affected thousands of people (600,000 people are estimated to have been displaced and 60,000 killed).

  • Geographical isolation—many of the poor live in remote rural areas that lack access to markets, information or basic infrastructure. These communities are also more vulnerable to shocks, such as drought and floods.

  • Limited access to quality education—while schools are widely available, the quality of education available to the poor is vastly inferior to that available to wealthier urban households.

  • Limited access to basic social services—survey evidence indicate that only a small share of government health expenditure reaches the poorest 20 percent of the population; and that in many areas, the poor do not have adequate access to safe drinking water and basic sewage and sanitation facilities.

  • Low agricultural productivity—agricultural wages and income have remained low owing to limited land market; restrictions on land use; frequent and erratic changes in agricultural trade policies; and the lack of clear land tenure rights.

  • Governance problems—abuse and politicization of welfare programs, notably of Samurdhi, have resulted in welfare benefits being misused and not reaching the neediest.

The PRSP envisages a multi-pronged poverty reduction strategy:

  • Enhancing Sri Lanka’s growth potential by pursuing peace; a stable macroeconomic environment, notably through fiscal consolidation: and deep structural reforms that pave the way for private sector led growth.

  • Revitalizing the rural economy—by establishing clear land tenure rights and liberalizing land use policy. Reducing protection on agriculture goods (as the poor are net consumers of agricultural goods) and providing a stable import tariff regime would aid significantly in reducing rural poverty.

  • Enhancing rural infrastructure through extensive investment in roads, electrification, and improving access to safe drinking water, sewage and sanitation services.

  • Improving the quality of education—by moving to a school base management system, increased stakeholder participation and involvement of the private sector.

  • Prioritizing the health concerns of the poor—by focusing on public health issues, and better targeting health spending.

  • Depoliticizing social welfare programs—the recently enacted Welfare Reform Act sets objective criteria for the selection of beneficiaries through strict means testing.

A. Macroeconomic Framework, Outlook, and Risks

15. The ongoing economic recovery is expected to gain further momentum this year, with GDP growth projected to rise to 5½ percent. A strengthening of consumer confidence, a resumption of delayed private investment projects with the progress toward peace, a substantial increase in public investment, higher tourism, and a return to normal weather from the droughts of the past three years, underpin the higher growth forecast. In the absence of external shocks, inflation is projected to trend down to 7 percent by end-year. The current account deficit is likely to rise to 3¾ percent of GDP, as an export rebound is more than offset by higher imports related to increased activity and reconstruction needs.

uA01fig01

Sri Lanka: GDP Growth, 1990-2006

(Attmial percentage change)

Citation: IMF Staff Country Reports 2003, 107; 10.5089/9781451823486.002.A001

16. There are, however, risks to this outlook. On the upside, the return of peace could boost activity more than anticipated with increased inter-regional trade and higher private investment. On the downside, a prolonged conflict in Iraq, a slower global recovery, a resumption of drought, and escalation of domestic political frictions are the major risk factors. In case the conflict in Iraq is protracted, higher oil prices, lower tourism, a decline in worker remittances, and lower exports to the Middle East (especially tea) would be the main conduits through which the economy could be affected. Staff analysis indicates that growth could fall by 1 percent, inflation rise by 1½ percent, the current account deficit widen by 1 percent of GDP, and the fiscal deficit worsen by ½ percent of GDP under unchanged policies.2 With debt reduction being a key priority, much of the adjustment would need to be borne by monetary policy and the exchange rate. However, a prolonged conflict could require some adjustment in the fiscal stance too.

17. The authorities are confident that with continued peace and deep structural reforms envisaged in the PRSP, growth in the medium-term should average 6 ½ percent.3 The staff views this growth path to be achievable provided fiscal consolidation is continued, structural reforms are implemented, peace is lasting, and the economy is not hit by large external shocks. The envisaged medium-term growth is 1 percent higher than the average during 1990-2000—a period of intense civil conflict. Also, while the growth rate dipped in 2001-02, the envisaged medium-term rebound in 2003-06 is less than the 4-5 percentage point increase typically witnessed in other post-conflict countries in the period following the end of conflict.4 The pickup in growth is based on both higher productivity and capital accumulation, reflecting labor market and financial sector reforms, and strong public and private investment growth (Box 3). In the absence of major external shocks, prudent monetary policy, normal monsoons, and a return of oil prices to trend should help inflation fall to 4½ percent by 2006. With higher reconstruction and investment imports, the current account deficit is likely to increase, rising to 4½ percent of GDP in 2004, before falling to 3¾ percent of GDP by 2006. Reasonably strong capital inflows should help gross official reserves to rise to $3 billion (3½ months of imports).

18. Risks to the medium-term outlook are material, with stronger growth and fiscal sustainability depending critically on continued reforms. As discussed earlier, over the past two decades, reform efforts have been cut short by a variety of factors. Many of those factors, such as a faltering of the peace process or an escalation of domestic political frictions, are still present in varying degrees of likelihood, while new factors, such as the elimination of textiles quotas in 2005 (Box 4), have emerged. To assess the impact of lower growth on macroeconomic variables, the staff simulated a scenario in which growth remains at 4½ percent a year, the average for 1983-2002. Even under unchanged policies (relative to the program), key variables are adversely affected—inflation rises, interest rates increase, the fiscal deficit rises above baseline levels, and the current account deficit widens. However, the fiscal deficit path and debt dynamics remain on a downward adjustment path. By 2006, government debt declines to 93 percent of GDP, about 10 percentage points lower than at end-2002, but 10 percentage points higher than under the baseline. In addition, debt sustainability analysis (Annex III and ¶)indicates that the baseline debt dynamics are vulnerable to large external shocks or a return to the policy environment of the late-1990s.

B. Fiscal Policy in 2003 and Beyond

19. The authorities’ fiscal policy program aims to restore sustainability, while making available adequate resources for priority spending and post-conflict needs.

Sri Lanka: Outlook for Growth

While aiming for a growth of &-10 percent in the long-run, the PRSP’s macroeconomic framework projects GDP growth to average 6½ percent in 2003-06. This growth rate is 1¼ percent above that experienced in the 1990-2000, a period of civil conflict, high fiscal deficit, and limited reforms, when growth averaged 5⅓ percent.

  • To achieve this growth, total factor productivity (TFP) needs to increase by 2½-2⅓ percent a year, slightly higher than the average 2½-2¾ percent TFP growth attained during the 1990’s. Capital accumulation should contribute 2 percentage points a year, as investment rates are projected to increase to an average of about 27 percent of GDP in 2002-06 from 25 percent of GDP during the 90’s. This reflects substantial public investment (e.g., development of the southern highway and other key roadways to increase market access) and strong private investment, including FDI, reflecting the buildup in confidence as peace returns and delayed projects are brought on line. Employment growth at 3 percent a year, compared to 2¼ percent during the 1990’s would contribute the rest. Labor reforms have a crucial role to play, and while the amendments enacted in 2003 should help reach these rates in the near future, further reforms will be necessary to sustain the pace of job creation.

  • In terms of sectoral decomposition, the reintegration of the North and East to productive activity; increase in inter-regional commerce: opening up of hitherto restricted areas such as commercial fishing; increase in tourism, particularly in the East: and expansion of agro-industries reflecting easing of regulations on land use and ownership, as planned under the PRSP, are likely to boost GDP growth. The elimination of textiles quota in 2005, is likely to have a negative effect on growth but its impact should be limited given that quota-related exports form only a small fraction of total value-added (Box 4).

There are risks to this scenario:

  • In the near-term, a slower than anticipated global recovery and a protracted conflict in Iraq are major downside risks. On the upside, the “rebound” from the contraction of 2001 could be stronger than anticipated—indeed, the current framework implies an annual growth rate of below 5 percent when the average is taken for 2001-06 below the 5.3 percent average growth achieved in 1990-2000.

  • Over the medium term, drought, political instability and a stalling of the peace process are plausible downside risks. In addition, slippages in the implementation of the economic program could result in lower growth. On the other hand, the return of peace could boost activity more than anticipated. Although different circumstances make comparisons difficult, in other post-conflict cases growth has increased 4–5 percentage points, on average, in the period following the cessation of conflict.

To assess the robustness of the PRSP framework, staff has simulated a lower growth scenario. This scenario envisages that, despite the peace process and the implementation of structural reforms, growth fails to pick up and remains at 4½ percent, the average during 1982-2002, reflecting lower-than-expected domestic and external demand. As □ result, under unchanged policies relative to the baseline, which is predicated on both continued peace and strong reform; higher domestic financing raises inflation and interest rates; the fiscal deficit declines over the medium term, but only to about 6¼ percent of GDP or 2 percent of GDP higher than in the baseline case; and government debt declines to 93 percent of GDP or 9 percent of GDP higher than in the baseline. Thus, to achieve the same reduction in debt-to-GDP ratios as in the baseline requires revisiting plans for total spending. While the external current account balance widens, reserves still increase to cover 3 months of imports. If lower growth were to be caused by a faltering peace process or delays in structural reforms, the fiscal deficit would be even higher relative to the baseline, as a result of further revenue shortfalls and expenditure overruns, particularly in defense. And while the external current account balance would not differ significantly from the baseline case, reserves would remain only slightly above 2 months of imports over the medium term reflecting the lack of official financing.

Sri Lanka: Low Growth Seenario, 2002-2006

(In percent of GDP, unless otherwise noted)

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Source: Data provided by the Sri Lanka authorities, and staff estimates and projections.

Sri Lanka: External Competitiveness

Sri Lanka has maintained its external competitiveness in recent years. The real effective exchange rate remained broadly unchanged in the last two years. However, looking forward, the country faces a number of challenges. In particular, the liberalization of markets to which Sri Lanka has preferential access and insufficient commodity and market diversification could hinder exports.

Sri Lanka’s main exports—tea and apparel—rely heavily on the U.S. and EU markets. Sri Lanka accounts for almost one-fifth of global tea exports. The average yield, however, is lower than that of its major competitors, Kenya and India, while the cost of production in Sri Lanka has been increasing, mainly due to an increase in wages, and fuel and electricity charges. The share of textiles, apparel and leather products in merchandise exports has risen to over 50 percent, with almost 95 percent of these exports directed to the United States and the EU. About 60 percent of exports to the United States are subject to quotas, also facing an average 20 percent import tariff rate. While Sri Lanka’s exports to the EU are quota-free, they are subject to an average 12.5 percent import duty. The relatively high rate of quota utilization (SO percent) suggests that Sri Lanka’s goods have been competitive in the U.S. market.

Sri Lanka’s preferential access to developed countries’ markets is gradually being diluted by the proliferation of regional arrangements and gradual multilateral liberalization. Free trade arrangements and recent concessions have allowed many of the least developed countries quota- and tariff-free access to the otherwise heavily-protected apparel and textile markets of the United States and the European Union (EU). In addition, after the removal of apparel and textiles quotas by 2005, Sri Lanka would also have to compete with countries currently facing binding quotas, such as China.

The impact of quota removal, however, is likely to be moderate. The share of quota-related exports in total apparel exports is 32 percent. The larger companies, accounting for 85 percent of apparel exports, have been adjusting their operations to the free-market environment, shifting their production to out-of-quota, high value-added goods. Medium-sized companies (10 percent of exports) are expected to consolidate to maintain their competitive edge. Small companies are likely to close down, but they account for only 5 percent of exports and 3 percent of employment in the sector.

However, the industry faces other challenges too. Wages in the apparel sector are somewhat higher than in many of Sri Lanka’s competitors, although the lack of data on labor productivity makes it difficult to draw definite conclusions about competitiveness. However, an industry paper 1/ cites infrastructure bottlenecks in the energy sector, transportation, port services, and customs administration, the country’s remoteness from its main markets, and reliance on imported inputs as added costs to the sector. In the 2003 budget, the government announced the creation of a Garment Forum (a private-public partnership) to oversee the 2005 transition and committed to contribute to the initial capital of the association.

uA01fig02

Hourly Labor Costs in 2000: International Comparison

(In U.S. dollars)

Citation: IMF Staff Country Reports 2003, 107; 10.5089/9781451823486.002.A001

Sri Lankan Apparel Industry, and Fund Staff estimates.
1/Sri Lankan Apparel Industry: Five-year Strategy.
  • Fiscal sustainability—public debt now stands at 104 percent of GDP, while interest payments amount to 7½ percent of GDP, raising serious sustainability concerns. With considerable resources being expended to finance the double-digit fiscal deficits of the last decade, private sector development was also crowded out. Thus, to restore sustainability, the PRSP aims to reduce the fiscal deficit, on average, by about 1¼ percent of GDP per year over the medium term, entailing an average increase of ¾ percent of GDP in the primary balance. Thus, by 2006, the deficit is targeted to fall to 4⅓ percent of GDP, the debt-to-GDP ratio to 84 percent, and interest payments to 5½percent of GDP. Achieving these objectives will require revenue to be raised and expenditure rationalized and reoriented to priority needs.

  • Stress tests—the program’s positive debt dynamics are relatively robust to shocks although they are rendered unsustainable by a return to the policies of the late-1990s (Annex III). For the program path, most shocks—lower growth, higher real interest rate, and weaker revenue—raise the debt-to-GDP ratio, but the debt dynamics remain on a downward trend. For example, if GDP was to remain flat in 2003 and 2004 (compared to growth of 5½ percent and 6½ percent), the debt-to-GDP ratio would rise to 106 percent by 2004, but subsequently decline to 88 percent by 2007. A return to the policy environment of the late 1990s, however, reverses the positive debt dynamics, and the debt-to-GDP ratio keeps rising over the medium term. With around 50 percent of the debt denominated in foreign currency, external shocks play a significant role in the debt dynamics—for example, a 30 percent nominal depreciation in 2003 raises the debt-to-GDP ratio to above 125 percent, before it declines to 101 percent by 2007.

  • Priority spending—under the program, capital spending rises from 4½ percent of GDP in 2002 to 7 percent of GDP in 2006. Budgeted social spending declines in 2003 compared to 2002, as better targeting of benefits is expected to lower welfare spending and the previous rapid expansion of nonessential staff in education and health is reversed. Social spending, thereafter, remains stable at 7½ percent of GDP, with continued savings in welfare spending allowing a near doubling of capital expenditures in health and education.

  • Post-conflict needs—while the potential “peace dividend” in the form of higher growth, reduced poverty, and lower defense costs is substantial, it will be some time before it is fully realized. Meanwhile, to support the peace process, additional public spending is needed to aid resettling the internally displaced population, rebuilding the administrative and institutional capacity and dilapidated infrastructure in the North and the East, and cover additional demands on welfare payments. Precisely estimating such needs is difficult at this time, but the program includes ½ percent of GDP each year of post-conflict spending.

20. In line with the above, the 2003 budget targets a deficit of 7½ percent of GDP.

  • The budget aims to increase revenue by ½ percent of GDP. To achieve this, the VAT was extended to the financial sector at the 10 percent rate; VAT exemptions lifted on some items; the debits tax extended to savings accounts from only current accounts; and a 2-10 percent duty imposed on all currently exempt imports, except crude oil, pharmaceuticals, wheat and textbooks. The budget also planned to extend VAT to the wholesale and retail sectors in July 2003. However, this has been postponed until January 2004, due to technical complications, including those related to sharing revenue with provincial councils, who currently collect a turnover tax on retail trade. The authorities clarified that resolving these issues would not require constitutional changes, and thus expect to settle them and put in place the required intermediate steps (e.g., taxpayer registration) by end-2003 (MEFP ¶ 14).5 The amount of revenue accruing to the budget from this measure will depend, in part, on the specifics of the revenue sharing arrangement. To encourage better tax compliance and investment, the top income tax rate has been cut from 35 percent to 30 percent.

  • Expenditure is projected to decline by 1 percent of GDP, despite capital outlays rising by ¾ percent of GDP. The budget includes expenditure rationalizing measures such as a continued general hiring freeze and no increase in the salary structure; closing of redundant cadre positions; a reduction in defense costs; and a refinancing of expensive domestic debt (e.g., outstanding overdrafts) with long-term bonds. The authorities estimate an extra ½ percent of GDP may be needed in 2003 for spending in the North and East, over and above the ½ percent of GDP already budgeted. This extra spending would be included through a supplementary budget later in the year, if foreign financing were available.

21. The authorities recognize the need to limit nonconcessional borrowing to finance the budget. Including the SLIC divestment (½ percent of GDP), privatization receipts would be 1 percent of GDP. With grants around ½ percent of GDP and net external financing around 2 percent of GDP, net domestic borrowing would be cut to 4 percent of GDP, from 8 percent of GDP last year, allowing government bank credit to fall by 1 percent of GDP. The program sets $510 million (medium- and long-term) and $50 million (short-term) limits on contracting nonconcessional loans. The medium and long term borrowing limit includes $100 million of commercial borrowing to refinance previously contracted (1999-2000) defense-related debt. The remainder is expected to be made of bilateral donor project loans—related to rehabilitating the children’s hospital, rebuilding bridges, restructuring CEB, and rural developments—with an average grant element of 25 percent (reflecting, in part, the current low comparator market interest rates) and are expected to be disbursed over the next 3-4 years. These projects are identified in the PRSP as part of the strategy to reduce poverty and reconstruct the economy. To further reduce debt service, the authorities stressed that they would work closely with donors to substantially lower the use of nonconcessional loans in future years (MEFP ¶ 16). Also, the government is revamping its public debt office to improve debt management, with technical assistance from the World Bank and the United States.

22. As required under the Fiscal Management Responsibility Act, the government will conduct a mid-term review of public finances in July 2003. The authorities recognize that there are pressures on the budget, on both revenue and expenditure. There are still extensive exemptions on various taxes, with pressures from interest groups to grant more. On the expenditure side, demands to increase civil service wages (the last general wage increase was in October 2001) and relief to mitigate some of the effects arising from the conflict in Iraq, such as higher oil prices and the decline in tea exports, are mounting. The government has already taken some steps to allay the impact of the recent spike in oil prices. Since mid-February, the government has subsidized diesel and kerosene prices (the monthly fiscal cost is small and fully offset by spending cuts elsewhere in the budget). The measure is intended to last for at most two months.6 At the mid-year review, an assessment will be made whether additional revenue (further reduction of corporate tax exemptions) and expenditure (additional cuts in transfers and subsidies to corporations) measures are needed to meet the deficit target. The government does not intend to grant any general wage increase, unless during this review, a determination is made that funds are available to cover the resulting increase in the wage bill (MEFP ¶28).

23. Over the medium term, to achieve the needed consolidation, the revenue base will need to be broadened. To this end, the government plans to conduct this year a study of the costs and benefits of the large and varied types of current tax exemptions and incentives. Based on this study, for the 2004 budget the government will consider various options, including extending the VAT to more items; reducing income tax exemptions; cutting down the number and length of tax holidays and the level and duration of the tax concessions; imposing stricter limits on roll over of tax holidays; and limiting tax incentives to strategic sectors (MEFP ¶ 14). However, the authorities pointed out that VAT exemption on some items, such as basic food items, would need to be sustained for some time.

24. The authorities plan to set up a medium-term expenditure framework (MTEF) by midyear (MEFP ¶ 15). This will allow a more detailed costing of the priorities identified in the PRSP, thus helping to rationalize and reorient expenditure towards priority needs and poverty reduction. To aid in developing the MTEF and better manage public resources, annual public expenditure reviews (PERs) are planned, with help from the World Bank. The government also needs to decide which of the vast number of noncommercial public entities are essential and close down the rest, while privatizing or liquidating commercial SOEs.

25. The authorities consider the establishment of the revenue authority as key to strengthening tax administration. The revenue authority is expected to encompass Inland Revenue, Customs, Excise, and the tax and customs components of the BOI. A workshop, organized by the Fund and AsDB, is planned for late-April in Singapore to help formulate parliamentary acts governing the authority and design a realizable work plan by June (MEFP ¶ 18). The authorities envisage also using this opportunity to modernize its information system and improve staff recruitment.

26. Looking ahead, fiscal federalism is likely to surface as a key item on the reform agenda. Sri Lanka already has devolved some power to the provinces, although, as the PRSP points out, the devolution was incomplete and the system is mired in complex and frequently parallel systems of administration and poor accountability mechanisms, with provinces having very little revenue raising options. The exact nature of the reforms to the federal structure will depend, in part, on the understandings reached between the government and the LTTE on power sharing. The government plans to formulate a new constitution, rather than make piece meal amendments to the existing federal structure.

C. Monetary and Exchange Rate Policies

27. The flexible exchange rate regime has served the economy well and will be continued. Thus, market interventions will be limited to smooth short-term volatility or meet the reserves target in line with the monetary program. The authorities agreed that if downward pressures on the currency intensified, reflecting geo-political uncertainties, the exchange rate would have to depreciate to absorb the pressures (MEFP ¶ 28).

28. Monetary policy will continue to be guided by the need to support economic recovery, while restraining inflation. Under the program, supporting anchors for monetary policy will be provided by a ceiling on central bank NDA and a floor on NIR. Broad money is projected to grow at 13½ percent in 2003, broadly in line with nominal GDP growth. If the pace of disinflation and fiscal consolidation picks up in the coming months, then a modest easing of policy rates would be appropriate. The CBSL launched its active open market operations in March 2003, and a short-term IMF advisor has been provided to the CBSL to help in the early stages.

D. Structural Reforms

29. In line with the PRSP, the program will focus on reforms that help to accelerate growth with the private sector as its main engine. The main areas of the agenda will be to reduce state dominance in the economy; to strengthen the financial sector; to improve labor market flexibility and the regulatory framework; to implement civil service and pension reforms to raise public sector efficiency and ensure the adequacy and sustainability of the social safety net; to streamline the welfare system by targeting better the truly needy; and to establish a rationalized and transparent tariff system to enhance external competitiveness.

30. While the financial position of the main public corporations and the two state banks improved in 2002, their ongoing restructuring needs to be continued. CPC increased its profits, aided by the establishment of an automatic petroleum pricing mechanism in January 2002, and losses of the CEB fell, reflecting a 35 percent increase in electricity tariffs. The restructuring of both the utilities is progressing as planned, with help from the AsDB and Japan. The two state banks strengthened their financial position, reflecting increased loan recoveries and higher interest margins. Peoples Bank is estimated to have made a profit of Rs1 billion (½ percent of assets), while the Bank of Ceylon profit is projected at Rs 1 ¼ billion (¾ percent of assets). Bank of Ceylon met most of the World Bank established restructuring targets for end-2002, including loan recovery and return on assets. This year’s privatization program includes further sale of shares of the telecom company (SLT) and the state’s share in the Colombo Hilton (MEFP ¶22).

31. With the gradual end of state monopolies and increase in private sector competition, Sri Lanka’s regulatory framework needs to be modernized. To this end, a multisector regulatory bill was enacted last September. Three multisector regulatory bodies covering utilities, transport and communication have been established and a fourth for financial services is envisaged. To enhance competition in telecommunication, access to international gateways was liberalized in January 2003. The Securities and Exchange Commission Act was amended this January to broaden the regulatory scope of the agency.

32. Restructuring Peoples Bank is an urgent priority. In line with the PRSP, the authorities have a clear strategy and timetable to restructure Peoples Bank under the direction of a restructuring committee formed in January 2003 (the first-year program includes two related structural benchmarks). A World Bank-financed investment consultant, appointed this March, will assist the authorities in the commercialization of the bank through evaluation of assets and liabilities, and assessment of proposed restructuring arrangements. As its first option, the government will seek a strategic investor to take over Peoples Bank as a single unit. The external evaluation of the bank’s assets and liabilities is to be completed by September, along with carving out the loans to be transferred to an asset management company (AMC). At this time, the consultant will seek investor interest (both domestic and international) through an open and transparent process. During the process, the CBSL will conduct “fit and proper” tests of potential investors, in line with the provisions of the amended Banking Law. If by December 2003, the single unit option is found not to be viable, the bank will be separated into a savings and a commercial bank—the former remaining under government control and the latter divested with the help of the consultant. In either case, the government aims to complete the restructuring by March 2004 (MEFP ¶22).7

33. To help improve bank performance, an asset management company (AMC) law is being prepared. The banking sector, including private banks, remains mired in a high level of nonperforming loans and thus low profitability, despite high lending-deposit rate margins. The aim of the AMC law is to provide troubled banks with a mechanism to effectively deal with their nonperforming assets, while ensuring that perverse incentives are not created for banks to adopt imprudent lending strategies. The draft (AMC) law is expected to be presented to parliament by June 2003. The Fund and the World Bank are providing technical assistance in this area.

34. Several steps are being taken to strengthen financial sector soundness. Last December, the CBSL revoked the license of the insolvent Pramuka Bank, signaling the end of its supervisory forbearance. The bank is small, accounting for ½ percent of the sector’s assets, and, so far, there has not been any fallout on other banks. Amendments to the Banking Act, which are expected to be presented to parliament in June 2003, aim to enhance CBSL’s supervision capacity (including in conducting “fit and proper” tests of new entrants and penal actions for violation of prudential norms) and facilitate mergers and takeovers of banks. In line with FSAP recommendations, the CBSL also plans to raise the rates at which collateral value of impaired assets are discounted. The central bank is closely monitoring time-bound plans of some smaller banks to meet the new CAR requirements. To help deepen the nonbank financial sector, the functioning of the pension funds need to be enhanced by making benefits transferable between the public and private sector and allowing the portfolios of EPF and other pension funds to be managed privately. As part of the government’s pension reform plans, a contributory pension scheme for all new public servants was enacted in January 2003. To modernize the exchange market, the Exchange Management Act is being amended—in particular while retaining existing controls over short-term capital movements, the amended act permits some longer term capital accounts transactions such as foreign borrowing by the private sector of over five year maturity. The draft legislation has benefited from Fund technical assistance.

35. Increasing labor market flexibility is key to securing high long-term growth. In line with the recent amendments to the labor laws, the government intends to gazette, in April, a new redundancy compensatory formula and a time-bound rule for settling labor disputes (MEFP ¶22). The compensatory formula, the exact parameters of which have not yet been determined, and the time-bound dispute settlement rule, are significant improvements over the current discretionary rulings by the labor commissioner. To provide a cushion against loss of labor income, an unemployment benefits scheme is being designed with assistance from the ILO. To minimize budgetary costs, a combination of provident fund (EPF) resources and contributions from employers and employees is being contemplated to finance the scheme. Over the medium term, a systematic overhaul of the Termination of Employed and Workmen Act (TEWA) is still needed.

36. Improving governance in the public sector is an important element of the authorities’ reform agenda. To depoliticize the civil service, a new Public Service Commission was constituted in late 2002. Other civil service reforms, including right sizing the service, are planned with the help of the World Bank, working closely with the Fund to ensure that the wage bill is sustainable. In order to reduce duplication of functions and administrative fragmentation, the Expenditure Reform Commission initiated, in 2002, a “zero based review” of various government departments and agencies. A high-level Program Management Committee has been set up to improve the execution rate of planned capital projects, particularly those funded by donors.

37. To enhance external competitiveness, the authorities plan to implement further trade reforms. Although Sri Lanka is a relatively open economy, further rationalization of import duty exemptions, waivers, and licensing would improve the transparency of the trade regime and resource allocation. To this end, the government intends to cut the 20 percent import surcharge to 10 percent by January 2004, eliminating it by January 2005. In the 2004 budget, the authorities plan to present a clear timetable, including interim targets, for rationalizing the existing tariff structure to a simplified three-band regime by 2005 (MEFP ¶22). As noted in the PRSP, high protection of agricultural goods has led to high food prices, hurting the poor, who are net consumers of these products.

IV. Poverty and Social Protection

38. The incidence of poverty rose in the last decade. Poverty increased significantly in the 1990s, as the headcount ratio (percent of population below the poverty line) rose from 20 percent in 1990 to 28 percent in 2002. However, these figures mask the full extent of poverty in Sri Lanka. The surveys did not cover the conflict-torn North and the East, where poverty is significantly more widespread and intense than the national average. Thus, the authorities are undertaking an updated poverty assessment, based on a specific study of the North and East, integrated to the 2002 household survey.

39. The PRSP aims to alleviate poverty by widening opportunities for the poor to benefit fully from the private sector-led growth strategy. Given that 90 percent of the poor live in rural areas, the authorities aim to revitalize rural development by reforming agricultural policies and encouraging the growth of medium and small-scale enterprises. As discussed in the PRSP, limited land tenure rights and restrictions on land use have fostered inefficient production in agriculture. The government has prepared a draft land ownership law, which is likely to be presented to parliament in the first half of 2003. The law provides a framework to establish private ownership and clear land property rights. The World Bank is providing support in this area. In addition, the government considers that improving access of rural communities to markets through better transport and telecommunication infrastructures and increasing access of the poor to better education and health services will play a key role.

40. Sri Lanka provides support to its poor through extensive and wide-ranging government programs. Of these programs, Samurdhi is the largest. The program provides cash grants to over 2 million families (about 50 percent of the population), while also operating a range of rural savings schemes, bank societies, and village development projects. Over the years, due to rampant abuse and politicization, the program became mired in inefficiencies. To address these issues, the recently enacted Welfare Benefit Law sets clear and transparent eligibility criteria, and provides guidelines for the termination of the benefits and penalties to reduce politicization and mistargeting. In 2002, around 250,000 families graduated from the program, and over the next three years, the target is to graduate 200,000 beneficiaries each year, through stricter targeting and means testing. Weaknesses in the other functions of Samurdhi are also being addressed. The program currently employs around 25,000 workers and managers. To lower operating costs, the Ministry of Welfare is marketing the use of Samurdhi’s network and officers to other state agencies and NGOs.

41. The authorities intend to initiate a poverty and social impact analysis (PSIA) of the key policy reforms in 2003, with help of the World Bank and DFID. Some of the proposed reforms, such as public sector restructuring and the changes to labor laws could impose short-term costs on the poor (Box 5). The government is undertaking counter measures, such as establishing an unemployment benefits scheme, and is discussing options on voluntary retirement schemes with donors. Once the PSIA is completed, the authorities intend to update the PRSP to incorporate specific poverty concerns related to the proposed reforms and policies.

V. Financing Issues, Access, and Phasing

42. The requested total access of 100 percent of quota over the three years—65 percent of quota under a PRGF arrangement and 35 percent of quota under an EFF arrangement—is appropriate. The access would yield a total projected disbursement of about $560 million, phased equally over seven disbursements. Sri Lanka’s relatively large medium-term balance of payments needs—averaging about $400 million a year—reflect the strengthening of the economy and post-conflict reconstruction. The targeted increase in official reserves (to 3½ months of import cover by end-2006) is modest, in light of the large external shocks the economy has been subjected to in the past and the uncertainty surrounding future external developments. The program is strong—containing a broad array of difficult structural reforms and sizeable fiscal adjustment in 2003 and over the medium term, and the government has demonstrated firm commitment to reforms over the past year. Unlike many developing countries, Sri Lanka has access, albeit limited, to international capital markets, given its exemplary debt servicing record, and thus a blend of PRGF-EFF funds is appropriate. Including the new arrangements, Sri Lanka’s debt service to the Fund will be around 1¼ percent of exports of goods and services in the medium term, compared to total debt service of 11½ percent. Exposure to the Fund will rise from 1¾ percent of GDP in end-2002 to 2½ percent of GDP by 2006, making up 6 percent of total public external debt.

43. The 2003 program is fully financed, and a projected remaining financing gap of $70 million, on average, over 2004–2006, can be met by additional donor support. The support would depend on making continued progress on the peace and economic reform fronts. Over the program period, the World Bank proposes to disburse $800 million–$1 billion (high-case scenario) of IDA funds. Of this amount, half ($380 million) would be in the form of program financing (PRSC) and around $120 million in grants. The AsDB’s total assistance would be $400 million over 2003–06, with balance of payments support around $200 million. If the unidentified gaps are not filled by bilateral funds, market borrowing would be necessary, which, at present, is not envisaged for 2004–06 in the program. In the extreme situation of having to access the market for the entire financing gap, the debt stock would not change discemibly (Annex III), but the debt service ratio would rise, on average, by about 2 percent per year. In light of a continued balance of payments need, including resources from the Fund, the authorities have requested that the SBA repurchase expectations arising during July 2003–June 2004 be moved to obligations basis.

Sri Lanka: How Do Policy Reforms Affect the Poor?

The Sri Lankan authorities plan to undertake a poverty and social impact analysis of key policy reforms in 2003, with the help of the World bank. This box contains a preliminary and qualitative evaluation of the likely impact of some of the key reforms supported by the PRGF-EFF supported program.

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VI. Program Design, Monitoring, and Data Issues

44. The program’s quantitative performance criteria and benchmarks will be based broadly on the specifications that were adopted in the SBA (EBS/02/59). A ceiling on net domestic financing (NDF) will continue to be the key test on fiscal performance. The first-year program has one prior action—bringing SLIC to a point of sale (MEFP Table 2). There is a structural performance criterion, at the time of the first review, related to the revenue authority, which needs to function efficiently to strengthen tax administration. The program includes structural benchmarks related to Peoples Bank restructuring, which is crucial in maintaining banking sector soundness, in light of the bank’s systemic importance. Other benchmarks relate to changes in the tax regime, privatization, labor reforms, and banking and exchange management laws—all of which are closely linked to strengthening macroeconomic performance (Box 6).

45. Sri Lanka’s statistical information is adequate for program monitoring, but weaknesses remain in a number of areas. A GFS technical assistance mission is planned for Sri Lanka in April-July 2003, focusing on existing classification and compilation issues and the plans for migrating to the publication of fiscal data in accordance with the GFSM 2001 methodology. Sri Lanka is a participant in the GDDS, and the authorities expect full compliance on SDDS by mid-2004. In addition, the government plans to establish a monitoring and control framework to track and protect poverty-reduction expenditures. In this regard, a monitoring system for the Samurdhi program is being implemented to track movement of beneficiaries in and out of the program, with help from the World Bank.

VII. Safeguards

46. The CBSL has made good progress in implementing the recommendations of the August 2001 Safeguards Assessment Report. The CBSL has also supplied TRE with the documentation necessary for a follow-up assessment, which is expected to be completed by the first review of the forthcoming PRGF arrangement. The CBSL’s 2002 accounts (on full IAS basis) have been audited by Ernst and Young, New Zealand.

VIII. Staff Appraisal

47. The Sri Lankan economy now stands at a crossroad. Over the past year, many changes have taken place. There is growing optimism, both within and outside Sri Lanka, that lasting peace may finally be within sight. The ceasefire has held for more than a year and the peace negotiations have progressed well. The economy is recovering, after being hit hard by a series of shocks in 2001. There is renewed interest within the international community to support the reforms and reconstruction of the economy. The government has displayed a commitment to fiscal consolidation and structural reforms in a difficult economic and political terrain. Thus, the current conjuncture presents a rare opportunity to implement deeper economic reforms and put the economy on a path of sustained high growth.

Sri Lanka—Structural Conditionality: Collaboration With Other Donor Partners

Coverage of structural conditionality in the current PRGF-EFF arrangements

  • The structural conditionality in the PRGF-EFF supported program focuses on: (i) improving tax administration and tax policy (ii) financial sector reform (iii) privatization and (iv) labor market reform (MEFP, Table 2). These reforms which were initiated under the SBA and are critical to the program’s macroeconomic objectives.

  • The fiscal measures are designed to improve revenue collection and broaden the narrow tax base (see ¶ and ¶23). Thus, the presentation of the revenue authority law to parliament, which will bring the revenue collecting agencies (Inland Revenue, Customs, Excise, and tax and customs component of BOI) under one body, is a performance criterion under the program. Rationalization of tax incentives and extension of the VAT to the wholesale and retail sectors are structural benchmarks.

  • Financial sector reforms aim to strengthen the soundness of the sector and the CBSL’s supervisory capabilities (the amendments to the Banking and Exchange Management Acts and an AMC law) and restructure the insolvent Peoples Bank, which is systemically important. Withdrawing the state from commercial activities is a key aim of this program and the PRSP and remains vital to ensure that high quality growth is sustained over the medium term. Thus the privatization of key SOEs is included as prior action and structural benchmarks. Reform of labor laws is critical to encouraging FDI and expanding employment in the formal sector. Thus the implementation of a new compensatory formula and new time-bound redundancy rules feature in the program as a structural benchmark. Also important for medium-term macroeconomic performance is the reduction of policy-induced distortions in the external sector. Hence, liberalizing the trade regime is a major component in the PRSP, and the phasing out the import surcharge is included as a benchmark. This would help to improve allocative efficiency in the economy and improve the transparency of the tariff structure.

Status of structural conditionality from earlier programs

  • A SAF (March 1988) and an ESAF (September 1991) aimed at civil service and pension reform as well as the reform of the state banks and implementing tax policy and tax administration reform. The results were mixed and several of the structural objectives were not met, reflecting either an intensification of the conflict or escalation of domestic political frictions, which waned interest for further reforms.

  • Under the SBA, the authorities completed all the structural benchmarks albeit with some delays. The measures in the SBA focused on state bank reform, privatization, steps to improve domestic petroleum pricing by CPC and tax reforms. In addition, to promote investment and improvement in the external position, the SBA included measures to liberalize FDI flows as well as critical actions identified by the safeguards assessment report.

Structural areas covered by World Bank and AsDB lending and conditionality

  • The World Bank’s four-year PRSC program will focus on: factor market reforms—labor, financial, and land—and in the power sector under PRSC-I, the acceleration of rural development and the reform of the welfare system under PRSC-II; and on the public administration/civil service reforms under PRSC-III. Under each PRSC, a number of priority actions aimed at strengthening governance in the public sector in general and public expenditure management in particular will be supported. The specific focus areas to be covered under PRSC-IV will be determined on the basis of the findings of the planned Development Policy Review study to be carried out in 2003/2004. The AsDB’s programs focus on public enterprises restructuring and the development of small and medium-term enterprises.

  • In terms of the division of labor, while the World Bank’s PRSC-I will also address the reform of Peoples Bank, there has been close collaboration with the Fund on the various aspects of the restructuring. The Bank would focus on helping the restructuring committee with investment consultants as well as in the bidding process for the restructuring, and in the design of the AMC law. For labor market reforms, the PRSC will focus on the systematic overhaul of the Termination of Employed and Workmen (TEWA) Act over the medium-term.

Other relevant structural conditions that are not included in the current program

  • Areas in which the current program has not set conditionality, and which have macroeconomic relevance, include civil service and pension reforms and public enterprise restructuring. This is in part to streamline the program’s structural conditionality, but also because the World Bank programs will cover civil service and pension reforms as well as the restructuring of CPC. Nevertheless, Fund staff would work closely with the Bank to ensure the longer-term affordability and sustainability of the wage and pension bills. The PRGF does not include any conditionality on the restructuring of the state-owned Ceylon Electricity Board (CEB), given that the AsDB is taking the lead in this area. The Japanese Bank for International Corporation (JBIC) also provides financing for public enterprise restucturing, power sector reform and rural development. The ILO is providing advice on the design of the unemployment benefit scheme.

48. Seizing this opportunity, the government has articulated an appropriately ambitious strategy to generate sustained growth and reduce poverty. The staffs of the World Bank and Fund consider the PRSP, which is the result of strong ownership and extensive consultations, to be a good framework to enhance growth and reduce poverty. However, there are some areas that need to be strengthened—including prioritizing policies to reflect a detailed costing of the reform agenda, assessing the impact of policies on the poor and disadvantaged groups, and appraising the extent of poverty and reconstruction needs of the North and East.

49. The authorities’ program for the first year of the requested arrangements provides a sound basis to achieve its medium-term macroeconomic objectives. However, the economic recovery is not yet broad based, with exports still remaining weak and private investment just beginning to pick up. Strong and steadfast implementation of reforms will be needed to generate growth sufficient to reduce poverty in any significant way.

50. In view of the large stock of public debt and high interest payments, the program’s focus on continued fiscal consolidation is appropriate. The staff supports the strategy of raising revenue by broadening the tax base, while rationalizing and reorienting expenditure to make available adequate resources for priority social spending and post-conflict needs. In this regard, the recent enactment of the FMRA is a welcome development and will help underpin fiscal integrity. Looking ahead, the authorities need to establish a MTEF to better estimate the cost of the PRSP priorities, and set up a monitoring framework to track and protect poverty-reduction expenditures. The medium-term revenue path needs to be further enhanced, by limiting tax exemptions and incentives to only a few basic items and strategic sectors, and strengthening tax administration by setting up an efficient revenue authority.

51. The staff supports the maintenance of the flexible exchange rate regime, which has served the economy well over the past year. The flexibility of the exchange rate is an added policy instrument to respond to exogenous shocks, and the monetary authorities should use it fully, given that fiscal policy is constrained by the large debt burden.

52. The program’s proposed structural reforms should help to accelerate private-sector led growth. The restructuring of the state-owned CPC, CEB, and CWE, needs to be continued with as planned, while privatization of the many remaining SOEs should be accelerated. The restructuring of Peoples Bank, which is critically important given the bank’s systemic importance, needs to be carried out in an open and transparent manner, while ensuring the financial integrity of the restructured entity. The proposed AMC law would help to improve bank performance, but needs to guard against encouraging imprudent lending practices.

53. The recent amendments to the labor laws are important first steps to improve labor market flexibility, helping to encourage employment growth. The new redundancy compensation formula, however, should balance workers’ concerns with keeping the separation costs low. To ensure that the new time-bound labor dispute rules can be properly adhered to, the government also needs to increase adequately the number of labor tribunals. In addition, the proposed unemployment benefit scheme needs to be designed such that the cost to the budget is minimized and perverse labor market incentives are not created by making the unemployment benefits too generous. To reach the PRSP employment growth targets, it will be necessary to systematically overhaul Sri Lanka’s labor laws.

54. Poverty in Sri Lanka is multi-faceted and remains a daunting challenge. The government’s attention to reducing conflict-related poverty is timely and supported by the staff. More generally, as envisaged in the PRSP, the authorities’ plans to strengthen rural infrastructure and improve access of the poor to quality education and health services are necessary steps. With poverty being mainly a rural phenomenon, revitalizing the rural economy, through land tenure reforms and liberalization of land use policy, along with reducing the high protection accorded to agricultural goods, are also needed. In the area of welfare reforms, the new focus on depoliticization and targeting of Samurdhi benefits should be strongly implemented.

55. There are risks to the program. Near-term growth could be adversely affected if the global economy slows down or the conflict in Iraq becomes protracted. If the peace process falters or domestic political frictions escalate, the program’s medium-term objectives for growth and poverty reduction are unlikely to be realized. In addition, the removal of textile quotas in 2005 could have a larger adverse effect than envisaged. There are also policy implementation risks. The budget could yield to numerous interest group pressures—both on the revenue and expenditure side—and reap the “peace dividend” prematurely. The pace of reforms could also be slowed down if they were seen to threaten public support for peace. The program includes measures that could mitigate some of the risks, but by their nature, many of the risks cannot be fully offset. Nevertheless, the authorities are committed to the program and are taking political risks, by embarking on difficult structural reforms, while making strong efforts to preserve public support for the peace process.

56. In light of these considerations and to join the international partnership to support Sri Lanka’s peace and reform process, the staff recommends extension to the obligations schedule of SBA repurchase expectations arising during July 2003-June 2004 and approval of the Sri Lanka’s request for the use of Fund resources under the three-year PRGF-EFF arrangements.

Table 1.

Sri Lanka: Selected Economic Indicators, 2000-2003

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Source: Dam provided by the Sri Lanka authorities; and staff estimates and projections.

Actuals for inflation, fiscal sector, monetary sector, exhange rate, and official reserves.

Includes foreign currency banking units.

Includes aircraft purchases by Sri Lankan Airlines (3 in 1999 valued at $297.5 million, and 3 in 2000 valued at $297.5 million).

Excluding central bank ACU balances.

Projections based on staff estimates of partner country inflation and exchange rates. 1995 trade weights.

Based on residual maturity, including amortization of public and publicy guranteed debt. As reserves exclude ACU balances, they are also excluded from short-term debt.

Short-term debt defined as trade credits, Central Bank ACU balances, commercial bank liabilities, CPC acceptance credits, and amortization due.

Table 2.

Sri Lanka: Summary of Central Government Operations, 2001-2003

(In percent of GDP, unless otherwise indicated)

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

The Fiscal Management Responsibility Act prescribes a maximum deficit of 5 percent of GOP by 2006.

Financing mix for 2003 does not correspond to budget due to delayed privatization receipts and market borrowing in 2002.

Table 3.

Sri Lanka: Monetary Program, 2001-2003 1/

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Using the program exchange rate of Rs 100/USS for 2003.

Table 4.

Sri Lanka: Balance of Payments, 2001-2006

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Source: Data provided by the Central Bank of Sri Lanka; and staff estimates and projections.

Includes public corporations.

Includes valuation gains or losses from 1998 onwards.

Financing gaps in 2003-2006 are assumed to be filled mostly with concessional borrowing from international financial institutions, and donor funds raised during the consultative group meeting slated for May/June 2003.

For program purposes, gross reserves are shown here net of ACU debit balances.

There is a break in the series, as beginning in 21)02 the stocks are at a market value, while previously they are at historical cost.

Table 5.

Sri Lanka: Program Macroeconomic Framework, 2000-2006

(In percent of GDP unless otherwise noted)

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

Preliminary estimates.

Table 6.

Sri Lanka: Vulnerability Indicators, 1999-2003

(In percent of GDP, unless otherwise indicated)

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

Official risk indicators, end-September 2002, Stock market, March 6; index for fmancials, end-February; Reserves, March 5; Public debt, end-October; external trade, January-November; BOP, January-September; exchange rate, March 7; monetary data, end-December.

Excluding foreign currency banking units (FCBUs).

Weighted averages of individual bank data.

Including foreign currency banking units (FCBUs).

Includes CPC acceptance credits, other trade credits. Central Bank ACU balances, and commercial bank liabilities.

Based on residual maturity, including amortization of public and publicly guaranteed debt.

Table 7.

Sri Lanka; External Financing Needs and Sources, 2001-2006

(In millions of U.S. dollars)

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Original maturity of less than 1 year. Stock at the end of the previous period. Includes all short term outflows and changes in commercial banks’ NFA.

Includes those transactions that are undertaken for the purpose of financing a balance of payments deficit or an increase in reserves.

Includes both loans and grants. Includes the IMF.

Includes all other net financial flows, and errors and omissions.

Includes prospective IMF disbursements.

Table 8.

Sri Lanka: Indicators of Fund Credit, 1999-2006

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Sources: Treasurer’s Department and staff calculations.

End-of-period.

Based on prospective purchases and repurchase obligations.

ANNEX I Sri Lanka—Debt Sustainability Analysis

This annex is an overview of Sri Lanka’s current public debt situation and analyzes the vulnerability of the program’s projected debt path to shocks to key macroeconomic variables. In line with the Fund’s standard debt-sustainability guidelines, the shocks are applied as temporary (generally of two year duration) deviations from the baseline. Some analysis of permanent shocks is also reported. These experimental shocks are based on the experience in the last 3-10 years. Overall, the DSA showed that while under the adjustment scenario the debt is sustainable, significant departures from the adjustment scenario would jeopardize sustainability.

I. Introduction

57. Sri Lanka’s debt dynamics have worsened considerably since the late-1990s. During the first half of the 1990s (1991-97), the debt-to-GDP ratio declined by over 10 percent, to stand at 86 percent of GDP in 1997, despite an average fiscal deficit of 9½ percent. Much of this decline reflected strong economic growth averaging over 5 percent and low debt servicing costs. However, in the face of expanding fiscal deficit in 2000 and 2001, as the conflict escalated and the economy fell into recession, the debt stock shot up to 104 percent of GDP and interest payments climbed to 7½ percent of GDP. In 2002, under the SBA, the debt-to-GDP ratio was stabilized, as the budget deficit was brought down from 11 percent of GDP in 2001 to 9 percent in 2002 and growth rebounded.

Figure 1.
Figure 1.

Sri Lanka: Central Government Debt

(In percent of GOP)

Citation: IMF Staff Country Reports 2003, 107; 10.5089/9781451823486.002.A001

Sources: Sri Lankan Authorities; and Staff estimates.

58. About 60 percent of Sri Lanka’s central government debt is held domestically, with 40 percent at longer term maturities. Total debt in the main SOEs (CPC, CEB and CWE) amounted to about 13¼ percent of GDP at end-2002. A public sector debt stock is difficult to construct because of a lack of reliable data for the rest of the public sector, thus the debt stock referred to in this annex only includes central government. However, the external debt stock measure includes both public and private external debt. The government’s foreign debt is made up mostly of concessional loans.

Sri Lanka: Outstanding Central Government Debt, end-2002

(In percent of GDP)

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Source; Data provided by the Sri Lankan authorities.