Recent Developments

The political situation has grown more tense in the run-up to the April 2 elections. Several election-related incidents of violence have occurred, and observers remain concerned about the potential for further violence as the elections near.

Financial markets, while still sensitive to political developments, have stabilized in recent weeks. The rupee nearly reached Rs 100 per U.S. dollar in mid-February, but has now returned to a range of Rs 97-98 per U.S. dollar. This reflects a combination of improved market sentiment and export proceeds, as well as some central bank intervention (about $40 million since end-2003). Official reserves have been kept stable, and amounted to $2.1 billion at end-February (equivalent to 2¾ months of imports and about 100 percent of short-term debt). Equity prices have risen by 20 percent since mid-February, when they bottomed out at two-thirds of their late-October 2003 levels. Interest rates, which had risen about 40 basis points between end-October and end-January, have risen a further 20 basis points since then, reaching 7.7 percent in the most recent 3-month T-bill auction.

Indicators for which more recent data are available suggest that economic performance has continued to hold up. Inflation moderated further in February, falling to 4.4 percent on an annualized basis, as food prices remained stable despite the ongoing drought. Tourism hit a record high in December, growing nearly 40 percent year-on-year, although it could have been affected since then by recent political developments. In the banking sector, the nonperforming-to-total loan ratio declined during Q4 2003, from 16½ percent to 14 percent, reflecting in particular the government’s assumption of nonperforming bank debt owed by a public sector corporation (Cooperative Wholesale Enterprise).

Policy Implementation

Preliminary data for January indicate that fiscal performance was in line with staff projections. Total tax revenue amounted to Rs 21 billion, roughly 13½ percent higher than one year earlier, thanks to higher import duties and VAT (with the latter perhaps reflecting higher imports as well).

The government recently issued a “Pre-election Budgetary Position Report” for 2004, as mandated by the Fiscal Management (Responsibility) Act. The deficit target has been revised upward to 7.3 percent of GDP, from the budgeted 6.8 percent, and includes the cost of conducting the elections and of recent measures to provide cost of living relief. This compares with the staff projection of 7.2 percent of GDP. With regard to the outstanding revenue measures (planned in 2003 and those proposed in the 2004 budget), some have been implemented (e.g., adjustment in import duties), while others have been adopted through administrative orders (e.g., unification of the VAT rates) but still require formal enactment.

Further delays in the commercialization of People’s Bank are likely. In light of the political uncertainties in the run-up to the elections, the government has postponed the start of the World Bank-financed investment advisor’s on-site work until May. While off-site work is continuing, this will delay the restructuring timetable set out in the staff report.

Finalization of the Voluntary Retirement Scheme for the civil service has also been postponed until after the elections. This should allow sufficient time for the proposal to be strengthened in line with World Bank recommendations, which aim to limit the budgetary impact of the reform while ensuring that it is targeted effectively.

The Central Bank of Sri Lanka’s audited financial statements for 2003 were published last week. They show substantial progress in implementing recommendations made in the safeguards assessment.