Sri Lanka’s 2005 Article IV Consultation reports that the fiscal deficit exceeded budget targets, and with a significant amount of government financing provided by the central bank, the growth in monetary aggregates increased, contributing to higher inflation. The near-term economic outlook is to a large extent shaped by the post-tsunami reconstruction effort. Reconstruction and a quick rebound in tourism should maintain growth momentum, but demand pressures and fuel price adjustments are expected to keep inflation in double digits.

Abstract

Sri Lanka’s 2005 Article IV Consultation reports that the fiscal deficit exceeded budget targets, and with a significant amount of government financing provided by the central bank, the growth in monetary aggregates increased, contributing to higher inflation. The near-term economic outlook is to a large extent shaped by the post-tsunami reconstruction effort. Reconstruction and a quick rebound in tourism should maintain growth momentum, but demand pressures and fuel price adjustments are expected to keep inflation in double digits.

I. Introduction and Political Background

1. Since the last Article IV consultation, political constraints and uncertainties have affected policy implementation (Box 1). In concluding the 2003 Article IV consultation, Executive Directors noted that uncertainties in the political situation and the peace process posed a risk to the implementation of essential reforms. Uncertainties have not abated since then, and while the ceasefire continues to hold, peace talks have been stalled for two years. The April 2004 elections turned power over to a coalition led by the President's party together with several other smaller parties, including the Marxist People's Liberation Front (JVP). However, difficulties in building a consensus for key reforms have been a constraint on policy implementation. The December 2004 tsunami, which took close to 40,000 lives and caused extensive damage to over two thirds of the Sri Lankan coastline, has added to the political frictions. As a result, a parliamentary majority that was established five months into the government's term only lasted until June 2005 when the JVP withdrew from the government coalition because of their opposition to a coordination mechanism with the LTTE to distribute tsunami aid to the North and East. On June 24, the government signed the Post-Tsunami Operational Management Structure (P-TOMS) with the LTTE.

Sri Lanka: Major Political Events

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2. The economic strategy of the current government differs in significant ways from its predecessor's. Greater emphasis is placed on rural development as the means to achieve poverty reduction. At the same time, the focus on the public sector as a driver of growth has increased, as evidenced by the expansion of the civil service and the halt of privatization plans for several strategic enterprises in favor of a restructuring under the newly created Strategic Enterprise Management Agency (SEMA). The government's broad economic strategy, which was outlined in an election manifesto and the 2005 budget, was further elaborated in the context of a development forum on tsunami reconstruction held in Sri Lanka during May 16–17 (donors pledged on the order of $3 billion in assistance over the next 3–4 years). In addition to the immediate task of tsunami reconstruction, the announced strategy is based on enhancing public sector financial management and public service delivery, and promoting small and medium enterprises and rural development. The government's strategy was welcomed as a first step toward a more comprehensive poverty reduction strategy. Several donors emphasized that, while strengthening the role of the state and provision of public services was useful, attention needs to be equally directed at incentives for private sector development. It was also noted that the development strategy remained unclear in several key areas such as agricultural policies and labor market regulations.

Sri Lanka: Previous Policy Recommendations

Over the past few years, Fund advice on several macroeconomic and structural reforms played a key role in policy development—for instance, in floating the exchange rate, introducing a VAT, and implementing financial sector reforms. These issues were summarized in the 2003 Article IV consultation report (IMF Country Report No. 04/68).

More recently, the authorities' implementation of staff's recommendations has been more mixed. The following is the status of the Board's main recommendations in the 2003 Article IV consultation:

  • Continue process of fiscal consolidation. The overall fiscal deficit in 2004 remained at the same level as in 2003, while the primary deficit worsened by about 1 percent of GDP. Overruns in subsidies reached 1¼ percent of GDP.

  • Improve tax administration. The creation of an independent Revenue Authority was envisaged under the PRGF/EFF-supported program. However, the authorities opted for the creation of a Revenue Board within the existing civil service. The establishment of the Revenue Board, together with recent staff changes within revenue agencies, provides scope for improved inter-agency coordination similar to what was anticipated under the proposed Revenue Authority. Establishment of a second large taxpayers unit has also resulted in some improvements in tax administration.

  • Broaden tax base and simplify tax regime. The introduction of the Economic Service Charge, a broad-based business tax, was a positive step as was bringing civil service income into the tax net. Some measures in the 2005 budget, however, made the tax system more complex, such as the introduction of two new VAT bands and surcharges on a broad range of consumption goods.

  • Stand ready to tighten monetary policy if the political situation deteriorates or severe budget pressures materialize. The end-2004 reserve money growth target was missed by more than 5 percentage points. Lax monetary policy was supportive of growth and contained the government's debt service costs but also contributed to the sharp increase in inflation and the loss of reserves. Since late 2004, policy rates have been increased three times and open market operations intensified.

  • Restructure state-owned banks. Financial performance of state-owned banks has improved significantly reflecting continued operational autonomy. Although privatization plans have been abandoned, restructuring continues under the supervision of the Strategic Enterprise Management Agency.

  • Tighten prudential norms and enhance supervision. Changes to provisioning rules and firmer enforcement of regulations have contributed to improvements in financial indicators in the banking system.

  • Implement automatic compensation formula for layoffs. Formula has been specified but implementation remains pending. The level of compensation in the formula, which was originally very high by international standards, was increased further in March 2005.

II. Economic Developments in 2004

3. Accommodative fiscal and monetary policies helped support growth above 5 percent in 2004, but added to inflationary pressures. These policies helped offset the adverse impact on growth of rising oil prices and a drought. Export performance was also strong in 2004, aided by textiles and tourism arrivals, but domestic demand (especially strong private investment) contributed to rapid growth in imports. Annual inflation reached 16.8 percent (SLCPI; end-of-period), reflecting demand pressures as well as higher food and oil prices (Table 1).

Table 1.

Sri Lanka: Selected Economic Indicators, 2001–2005

Nominal GDP (2004): US$20.0 billion

Population (2004): 19.3 million

GDP per capita (2004): US$1,029

Quota: SDR 413 million

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

Excluding central bank Asian Clearing Union (ACU) balances.

As reserves exclude ACU balances, they are also excluded from short-term debt to compute this ratio.

4. The fiscal deficit reached 8.2 percent of GDP in 2004, or 1½ percent higher than budgeted. Revenues fell short of the budget target owing to the late enactment of income tax amendments and lower than expected profit transfers from the central bank. Expenditure overruns were due to higher subsidies (mostly for fuel). The impact of these slippages on net domestic financing, which reached 6 percent of GDP, was exacerbated by lower privatization proceeds and shortfalls in program financing (Table 2). To bridge this gap, the government issued $250 million (1¼ percent of GDP) in dollar denominated bonds in the domestic market. As a result, government debt remained at 105 percent of GDP, underscoring concerns about overall debt sustainability.

Table 2.

Sri Lanka: Summary of Central Government Operations, 2001–2005

(In percent of GDP, unless otherwise indicated)

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

IMF projections.

5. With the central bank purchasing large amounts of treasury bills, ample liquidity was available for private credit, and money growth increased significantly. Broad money increased by 20 percent, compared with 15 percent in 2003 and 14 percent envisaged under the authorities' monetary program (Table 3). The purchases of treasury bills aimed to offset the liquidity impact of foreign exchange intervention (which was undertaken to slow the depreciation of the rupee) and keep the cost of public and private credit low. Indeed, with the increase in inflation, and despite a modest increase in policy rates by 50 basis points in November, real interest rates remained negative contributing to private credit growth of 22 percent. In contrast to the previous year, monetary expansion in 2004 was accounted for by an expansion of net domestic assets (Figure 1).

Figure 1.
Figure 1.

Sri Lanka: Real, Fiscal, and Monetary Sector Developments 1/

Citation: IMF Staff Country Reports 2005, 335; 10.5089/9781451823561.002.A001

Sources: Data provided by the Sri Lankan authorities; and CEIC Data Company Ltd.1/ GDP for FY2004 is a staff estimate.
Table 3.

Sri Lanka: Monetary Accounts, 2003–2005

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Sources: Central Bank of Sri Lanka; and Fund staff projections.

Original projections, as reflected in IMF Country Report No. 04/68.

Projections for 2005 are at end-2004 exchange rates.

6. The balance of payments shifted to a deficit of $205 million in 2004, from a surplus of $502 million in 2003. Despite robust export performance, the current account moved from near balance to a deficit of 3 percent of GDP (Table 4), reflecting the effects of both oil price increases and strong demand for investment goods. Official external financing—especially program loans—dried up significantly, with donors waiting for an articulation of the government's policy agenda. By end-2004, the rupee had lost 8 percent of its value against the dollar (y/y), despite central bank intervention, and gross official reserves had fallen to $1.8 billion (equivalent to 2.1 months of imports) (Figure 2).

Table 4.

Sri Lanka: Balance of Payments, 2003–2009 1/

(In millions of U.S. dollars, unless otherwise indicated)

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

For illustrative purposes, a one-year extension of the current PRGF/EFF arrangements until April 2007 is assumed.

Reflects economic conditions prior to the tsunami, but updated to reflect latest oil price projections.

Includes public corporations.

Net of ACU debit balances.

Valued at historical cost through 2002, and at market cost since then.

Figure 2.
Figure 2.

Sri Lanka: Financial and External Sector Developments

Citation: IMF Staff Country Reports 2005, 335; 10.5089/9781451823561.002.A001

Sources: Data provided by the Sri Lankan authorities; and CEIC Data Company Ltd.1/ Weighted average of indices of India, Malaysia, Indonesia, Pakistan, and Philippines.2/ Three-month moving average.

7. The 2005 budget, approved in December 2004, envisaged a reduction in the deficit to 7½ percent of GDP. The budget aimed to improve economic conditions for the rural poor, increase spending on health and education, phase out numerous subsidies, including on petrol and diesel, and reaffirmed the government's commitment to meet the targets of the Fiscal Management (Responsibility) Act, albeit on a delayed timetable (Box 2).1 While the 2005 budget targets represent a welcome step toward putting government debt on a declining path relative to GDP, budget estimates appeared overly optimistic, particularly for revenue. At the time, staff estimated that additional measures equivalent to 1¼ percent of GDP would be needed to meet budget targets.

8. While some progress was being made on structural reforms by the end of 2004, financial costs in key public enterprises increased significantly. On revenue administration, the cabinet approved in June 2004 the creation of a revenue board to coordinate the activities of various revenue departments. However, much remains to be done on the concurrently approved restructuring of the Inland Revenue Department. In the financial sector, the ADB approved a program loan in support of the restructuring of People's Bank, whose performance indicators have improved. In the energy sector, however, large fiscal and quasi-fiscal costs arising from the operations of the Ceylon Petroleum Corporation (CPC) and the Ceylon Electricity Board (CEB) were incurred in 2004–05. Direct subsidies from the budget amounting to 1 percent of GDP in 2004, and ½ percent of GDP so far in 2005, have been paid to CPC to cover their losses. While electricity charges are among the highest in the region, operational inefficiencies in CEB have led to substantial losses estimated at ¾ percent of GDP in 2004, and accumulated debt and arrears amount to about 4 percent of GDP. Deadlines for reforming CEB have been postponed repeatedly.

9. While macroeconomic conditions have stabilized somewhat since the tsunami, the situation remains vulnerable. The rupee ended its downward slide on the expectation of aid inflows and has appreciated 5 percent against the U.S. dollar through end-May, and gross reserves increased by about $240 million reflecting the Fund's emergency assistance and other donor disbursements. However, weaknesses in fiscal policy remain and, despite efforts by the central bank to absorb excess liquidity, monetary aggregates continued to exceed official targets and inflation remained in double digits (15 percent y/y in the SLCPI as of April). Fuel prices have been adjusted twice so far in 2005, but they remain below cost recovery levels. Stock prices, after a dip in the immediate aftermath of the disaster, have continued their rising trend from 2004 and are up by about 25 percent so far this year.

Sri Lanka: The 2005 Budget—Excluding Tsunami

The budget targeted a deficit of 7½ percent of GDP, a contraction of some 0.7 percentage points over the previous year. Since the budget was approved, official projections have been revised to forecast a deficit of around 8 percent of GDP. This revised estimate takes into account the impact of higher oil prices on subsidies and a lower revenue projection.

Revenue was projected in the budget to increase by 1¾ percentage point of GDP to slightly above 17 percent of GDP. The main measures on the revenue side were as follows:

  • The unified VAT rate of 15 percent introduced in 2004 was supplemented with rates of 5 percent on essential food items and 18 percent on luxury goods. A 5 percent surcharge was introduced on the value of imported goods for VAT purposes, and imported capital goods exempted from VAT. A number of measures aimed at limiting refunds were also introduced.

  • The excise tax base was broadened to include several household appliances, while excise rates were raised to prohibitive levels on betting and cars. The taxes on cars were raised from 30 percent to a maximum of 115 percent, depending on engine capacity.

  • A broadening of the corporate income tax base was coupled with a reduction in personal income tax (PIT) rates. The deductibility of business expenses (e.g., for advertising, travel, entertainment) under the corporate income tax was restricted.

  • Custom duty bands were reduced from 6 to 5 with the top rate broadly unchanged. However, a cess (surcharge) of 10–20 percent was imposed on more than 300 items ranging from fruits to footwear.

The authorities have lowered their revenue projection to 16¼ percent of GDP, but staff estimates that revenue is still likely to fall short of this target by about ½ percent of GDP. The impact of improvements in revenue administration appear unlikely to materialize to the extent expected by the authorities, and the sharp decline in vehicle imports in response to the imposition of prohibitive excises has had an adverse impact on revenue performance. Moreover, privatization receipts are also likely to fall short of budget estimates.

Expenditure was budgeted to increase by 1 percent of GDP. A steep increase in public investment more than offset cuts in current outlays. Spending on health and education was budgeted to increase by 30 percent. Subsidies were projected to decline by more than 1 percentage point of GDP, following adjustments in the prices of oil, wheat, and public services. Provisions for fuel subsidies were limited to kerosene. The budget also incorporated the 2005 effects of the two-year 40 percent wage increase for civil servants and new hiring equivalent to 7 percent of existing personnel.

Expenditure increases will now be limited to around ½ percent of GDP. Higher than expected subsidy payments will be more than compensated for by reductions in domestically and externally financed capital expenditure (excluding tsunami reconstruction). Continued high world oil prices, contrary to budget forecasts, mean that the maintenance of administered oil prices requires substantial ongoing subsidy payments, particularly on diesel.

III. Policy Discussions

A. Outlook and Risks

10. The near-term outlook is to a large extent influenced by the post-tsunami reconstruction effort, which will have a significant financial impact on the government's budget and the balance of payments (see Annex I).

  • The devastation of the fisheries sector will adversely affect growth, but a rebound in tourist arrivals has been quicker than expected. After declining sharply in January and February, tourist arrivals rebounded and for the first five months of the year, arrivals and earnings increased by 8 percent compared with the previous year. Moreover, reconstruction activity and a bumper crop earlier this year are expected to support growth at about 5¼ percent in 2005, broadly in line with last year. Demand pressures arising from tsunami reconstruction and fuel price adjustments are likely to keep inflation in double digits.

  • While the tsunami's impact on revenues is projected to be minor, government spending on reconstruction and relief will amount to 1½ percentage points of GDP. The authorities' intention is to finance additional tsunami-related spending through international support. Overruns on oil subsidies are projected to amount to ½ percent of GDP (even after assuming further price adjustments are made), and the authorities plan to reduce locally-financed development projects (compared with budget estimates) to keep domestic financing of the 2005 budget at 4½ percent of GDP.

  • The external current account deficit is expected to increase by 2½ percentage points to 5½ percent of GDP in 2005, reflecting higher imports for tsunami reconstruction, slow growth in garment exports, and a steep oil price increase.2 Total exports increased by 12 percent in the first five months of the year, and remittances by 24 percent. Coming off strong growth of 9 percent in 2004, garment exports increased by 6 percent in the first quarter of 2005. While the industry remains concerned about weaker orders for coming months, the overall adverse impact should be contained (Box 3).

  • The authorities' monetary program envisages broad money growth of 15 percent in 2005. Given a modest increase in net international reserves, and provided the government meets its domestic financing target, the expansion of private sector credit would remain at about 20 percent.

Sri Lanka: Vulnerability to the Removal of Quotas on World Textile Trade

Sri Lanka is one of many nations affected by the removal of quotas under the WTO Agreement on Textiles and Clothing on January 1, 2005. Producers have shifted production to China and India to take advantage of low cost labor in these countries. The extent and timing of the impact, on Sri Lanka's and other nations, is difficult to determine, and depends on importer's policy responses, producer strategies, and price effects.

Sri Lanka has adopted policies to mitigate the impact of the quota removal. Large companies in particular are expected to remain competitive as most of them restructured their businesses, diversified their production to out-of-quota, high value-added goods, and expanded into new export markets. Although only 12 percent of the total, these companies generate more than 70 percent of the total value of textile exports. Medium sized exporters, with an export share of roughly 25 percent, have been and will go through further restructuring and consolidation to remain competitive. Small companies are likely to close down, but they account for only 5 percent of exports. However, small- and medium-sized companies employ 38 percent of the workers in the sector. The recent Comprehensive Economic Partnership Agreement with India and FTA negotiations with the United States and other countries will also help improve market access.

Government policies and changing business strategies have prepared the textile sector for the liberalization. The gradual shift to out-of-quota goods led to a decline in the quota utilization rate of the U.S. market from 85 percent in 2000 to about 67 percent in 2003. Exports to the European Union have been quota free for some years now, also suggesting they are competitive. Overall, Sri Lanka's quota-based exports have declined from more than 60 percent in the 1990s to about 50 percent in 2003.

Staff assesses the impact of quota removal on Sri Lanka's external position to be limited. The global price effect of quota removal is estimated at negative 10 percent over a three-year period. Although producer margins are likely to be squeezed, some of the price effect could be compensated by an increase in output. In the medium term, the volume of textile exports is projected to rise by a modest 2 percent per year.

11. There are several downside risks to this outlook. As noted above, the authorities will need to be prepared to take additional measures to meet fiscal objectives, including further adjustments in domestic fuel prices, which may prove politically difficult. Capacity constraints in the construction sector could also negatively affect inflation, while limiting the effectiveness of aid inflows. Shortfalls or delays in mobilizing external assistance could potentially lead to the same effects as in 2004: inflationary budget financing, recourse to nonconcessional foreign currency bonds, and pressures on the exchange rate. Further increases in international oil prices would also cloud growth and inflation prospects and amplify external vulnerabilities.

12. The staff and the authorities agreed that the medium-term outlook hinges critically on Sri Lanka's ability to move toward fiscal consolidation, revive the peace process, and raise investment to levels comparable to its East-Asian peers. To support poverty reduction, the authorities are targeting growth at 6–7 percent annually. Economic strategies would focus on effective implementation of tsunami reconstruction and providing more room for private investment by reducing the overall fiscal deficit to 4½ percent of GDP by 2008, with adjustment predicated on improving revenue performance. In addition, a sound monetary policy would lower inflation to single digits, and exports would be promoted through further rationalization of tariff and trade policies, enhanced trade facilitation, and investment arrangements with partner countries.

13. Achieving growth and poverty reduction objectives will depend on the implementation of a sound and credible economic program. In this regard, further work will be needed to develop the government's strategy unveiled during the May 16–17 Development Forum into a comprehensive Poverty Reduction Strategy. Looking forward, there is scope for significant gains in agriculture productivity and further development of tourism and telecommunication services, and significant untapped growth potential exists in the North and East of the country.3 There are also good reasons to believe that private investment will respond strongly if political stability and an improved investment climate can be established: literacy rates are among the highest in the region, administrative corruption is moderate, and preferential trade access to the European Union, India, and other regional partners should help counterweigh any adverse effects from the removal of textile quotas. However, land and labor market rigidities, poor road infrastructure, and unreliable and expensive electricity are major obstacles that need to be eased for private investment to flourish. Credible progress toward fiscal consolidation is also needed to improve investors confidence and provide a means for ending the financial repression that constrains capital market development.

14. Sri Lanka has traditionally had strong social indicators, and progress towards many of the Millennium Development Goals has been recorded. For example, Sri Lanka is on track to meet the targets on primary enrollment, and infant and maternal mortality (Table 8). However, reductions in income poverty have been limited and mask wide disparities within the country. Despite per capita GDP growth of 3.5 percent during the 1990s, the incidence of poverty fell by a modest 3 percentage points to 22.7 percent in 2002 (excluding the North and East), compared with the MDG target to reduce poverty to 13 percent by 2015. The reduction was much larger in urban than in rural areas, with the incidence of poverty in the seven poorest districts increasing from 30 percent to 37 percent. Persistent poverty in rural areas, and in the North and East, underscores the need to upgrade infrastructure and improve performance in the agricultural sector, as well as finding a durable solution to the civil conflict. The tsunami disaster, which hit hardest in the north, east and south, has also reportedly aggravated the unequal poverty trend.

Sri Lanka: Poverty Indicators 1/

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Sources: Central Bank of Sri Lanka, Annual Report; and Development Forum discussion paper by the Ministry of Finance and Planning (May 2004), Department of Census and Statistics.

Excludes the North and East, for which data are not yet available.

B. Fiscal Consolidation and Debt Sustainability

15. Fiscal developments thus far in 2005 reflect departures from budget estimates in several areas. While many aspects of the improved revenue performance evident in the fourth quarter of 2004 have carried over into 2005, collections in several areas have fallen short of expectations, including excise tax and import duties (as discussed in Box 2). On the expenditure side, subsidies for fuel have been considerably higher than budget provisions (despite price increases in May and June), and Rs. 20 billion has already been spent on tsunami relief. Domestic financing of the budget in the first five months reached Rs. 50 billion, compared with the budget estimate of Rs. 105 billion for the year. The authorities explained that, to remain within the budget target for domestic financing, cash flow relief provided by debt moratoria/cancellation will offset the tsunami relief expenses incurred earlier in the year and the implementation of locally-financed investment projects will be paced according to the availability of financing.

16. Staff indicated that careful implementation of fiscal policy was critical for maintaining macroeconomic stability, especially in view of demand pressures likely to be associated with tsunami reconstruction. Staff argued for consideration of additional near-term revenue measures. These could include reducing the prohibitive excise duty on vehicle imports, streamlining tax exemptions, or increasing the number of items subject to the top VAT rate of 18 percent. For expenditure, there is no feasible alternative to further adjustment in domestic prices to end subsidies for diesel and, while there is a public policy role for maintaining subsidies on kerosene to protect the poor, there is scope for cutting back on the size of the subsidy. The authorities' plans to reduce spending on lower priority locally-financed development projects would also be desirable in view of significant spending on tsunami reconstruction expected in the second half of the year.

17. The authorities agreed with this overall approach, but remain somewhat more optimistic on revenue prospects. They expect to achieve the revised revenue estimate of 16¼ percent of GDP and believe that performance would improve significantly by midyear reflecting the extension of the Economic Service Charge (ESC)—a minimum corporate tax—to Board of Investment (BOI) companies, and an expected increase in dutiable imports. On this basis, they would review revenue developments in the first six months and take additional measures if needed to meet the revised target. Following the fuel price increases in May and June, they plan to implement further adjustments over the next several months to eliminate the subsidy for diesel. Price adjustments are also expected to be implemented for electricity, railways, and buses.

18. Staff agreed with the authorities that the key priority for fiscal adjustment, and for meeting medium-term objectives, was revenue enhancement. However, the authorities' medium-term framework relies on revenue projections that are very ambitious (rising from 15 percent of GDP in 2004 to 19½ percent in 2008). The authorities explained that they were committed to improving revenue but had not yet decided on specific policies, while they were also more optimistic than staff on the gains from improved tax administration. The staff emphasized that, until significant progress in improving revenue has been demonstrated, the medium-term fiscal framework should be based on lower revenue targets and more adjustment on the expenditure side to meet FMRA targets (Table 5). In addition to the near-term revenue measures noted above, extension of the VAT to the wholesale and retail sectors, continued improvements in tax and customs administration, and other base-broadening measures should be the priorities over the medium term.

Table 5.

Sri Lanka: Medium-Term Macroeconomic Framework, 2004–2009

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Sources: Data provided by the Sri Lankan authorities; and Fund staff estimates and projections.

Medium-term projections assume disbursements under the PRGF-EFF arrangements, which were approved in 2003, and continued program financing from multilateral agencies. Tsunami-related reconstruction is projected to take place over 2005–2007.

Excluding central bank Asian Clearing Union (ACU) balances.

19. Persistent problems in improving revenue performance underscore the importance of rationalizing and improving the efficiency of government spending. Expenditure reforms would need to include elimination of most subsidies, improved administration and targeting of welfare benefits, and better debt management. Increasing public employment levels and significant pay increases aggravate the problems caused by an overstaffed civil service and provide yet another factor that complicates medium-term consolidation. A comprehensive plan for civil service reform needs to be developed that takes into account the objectives to increase average pay levels, decompress the wage structure, and improve the efficiency of the civil service.

20. With public debt over 100 percent of GDP, debt sustainability is a serious concern. This underscores the importance of having the FMRA in place, and in taking credible steps to get on a path consistent with meeting the legislative targets by 2008, as envisaged by the government. The scenarios depicted in Annex II indicate that if this is done, the debt outlook would be sustainable. However, if fiscal performance does not improve or failure to address structural problems undermines future growth, the outlook quickly deteriorates. The staff also expressed concern about debt management, especially since recent developments such as the terms of the Paris Club debt moratorium and issuance of domestic bonds at high coupon rates will increase debt service costs in the future.4 5 While the authorities have expressed interest in an extension of the Paris Club debt service moratorium to help finance tsunami reconstruction, they also want to maintain their future access to commercial credit and are considering requesting an international sovereign rating.

21. Some welcome improvements in tax administration over the last six months are evident. The new Revenue Board has created the potential for improved inter-agency coordination, the scope of the Large Taxpayers Unit has been expanded, civil servants have been brought into the tax net, and the introduction of the Economic Service Charge has improved income tax collections. While this is a good start, much more will be needed to underpin improved revenue performance in the future. Consistency in tax policy by avoiding ad hoc adjustments in rates and charges would help improve administration. Efforts should also be focused on upgrading technology, introducing a uniform taxpayer ID number and risk-based audit procedures, and strengthening collection and enforcement efforts.

22. Since the 2002 fiscal ROSC, some progress has been made in improving budgetary procedures, but many of the weaknesses still remain. There has been progress with respect to the quality of budget documentation and in the reporting of intra-year fiscal data. Problems remain, however, in the coverage of fiscal data. Priority should also be given to a more comprehensive monitoring of fiscal risks—such as those posed by the losses of CEB—in particular by systematically accounting for implicit and contingent liabilities in both the short and medium-term and through analysis of the overall public sector debt burden.

C. Monetary and Exchange Rate Policy

23. The staff welcomed recent central bank efforts to reduce liquidity and recommended a more aggressive tightening of monetary policy. Outstanding credit to the government by the central bank declined by about ½ percent of GDP from December to May—a reversal from the experience of 2004. Noting that monetary growth is still above target, and that the CBSL quarterly targets leave a considerable amount of adjustment to take place at the end of the year, the staff argued that a faster tightening would reduce the risk of a sharper and potentially disruptive correction in interest rates later on. Delays in tightening the monetary policy stance risk entrenching current inflation pressures, especially since tsunami reconstruction is expected to place considerable pressure on wages and prices in the second half of the year. The authorities indicated that they would continue to gradually tighten monetary policy, reflecting their desire for policy to remain supportive of growth. In late May and June, the repo/reverse repo policy corridor was increased by 25 basis points and 50 basis points, respectively, raising expectations of future adjustments in coming months. The staff also stressed the importance of reducing fiscal dominance, granting more autonomy to the CBSL to strengthen its credibility, and to increase the transparency of monetary policy by, for example, publishing the minutes of the meetings of the Monetary Board.

A01ufig01

Sri Lanka: Changes in CBSL Claims on the Government, January 2004–May 2005

(In billions of rupees, monthly)

Citation: IMF Staff Country Reports 2005, 335; 10.5089/9781451823561.002.A001

24. The authorities reiterated their commitment to the flexible exchange rate regime. Staff emphasized that interventions in the foreign exchange market should be limited to moderating short-term fluctuations in the rate, or increasing reserves to targeted levels when market conditions are conducive. The authorities maintained that interventions undertaken in 2004 and 2005 were meant to stabilize and smooth the transition in the rate in response to market pressures. While there has been some appreciation in the nominal and real effective rates thus far in 2005, overall competitiveness was not an immediate concern as the real effective exchange rate has depreciated slightly over the last three years. Staff agreed with the authorities that, given possible differences in the timing of tsunami-related aid flows and the corresponding import needs, exchange rate volatility could pick up, and the central bank could intervene during the time of inflows to provide scope for selling foreign exchange to the market later, if necessary, to finance imports that are the counterpart to tsunami-related aid. However, a sustained drop in foreign reserves (as happened in 2004) below current low levels should be avoided at a time of downward pressure on the rate. Staff also advised against using protectionist trade policies or exchange control measures in an attempt to stem downward pressures on the currency.

D. Priority Structural Reforms

25. The financial performance of some large public enterprises has deteriorated to the point where they could threaten economic and financial stability. Fuel price adjustments will reduce government subsidies to the CPC, and once prices have been adjusted to reflect prevailing international levels, reinstatement of the automatic pricing formula would prevent the problem from recurring in the future. For CEB, there is a more urgent need for fundamental restructuring. There appears to be no option but to move forward as quickly as possible with the long-delayed unbundling of production, transmission, and distribution being supported by the ADB and Japan Bank for International Cooperation (JBIC), while securing the necessary investments to reduce the reliance on expensive sources of power. More independent regulation of public utilities would also be important for avoiding political interference. There are similar fiscal risks (but on a much smaller scale) in the operations of railways, buses, and other utilities that need to be addressed. In addition to adjusting fuel prices, the authorities stressed their commitment to bring in another foreign investor to increase competition in the distribution of oil products, and to press forward with CEB reforms. At the time this report is being issued, the government was still negotiating with labor unions on CEB restructuring.

26. There are several examples where the performance of enterprises has been enhanced through privatization or improved management. These include Sri Lanka Telecom, Air Lanka, the Ports Authority, Bank of Ceylon, and even People's Bank (although much more remains to be done). These examples show that strong management teams and increased commercial autonomy can contribute to significant improvements in performance, and staff noted that these positive experiences could be better leveraged to build public consensus for reform.

27. There have been improvements in the overall regulation and supervision of the financial system. Commendable progress has been made since the completion of the FSAP in 2002. NPAs have come down, provisioning increased, and capital positions improved across the entire banking system (Table 6). Among other things, this should help reduce banks spreads between deposit and lending rates which at about 4 percent are relatively high.6 This progress has been largely due to changes in prudential regulations that reduced the value of collateral consistent with more realistic recovery rates, enhanced supervisory efforts, and improved procedures for collection and recovery of bad debts. However, by not requiring provisioning against loans overdue between 3–6 months, capital remains somewhat overstated. Staff is also concerned that the current rapid growth in lending—in a context of negative real interest rates—could lead to a deterioration of asset quality in the future. In response to the authorities' plans to implement a system of mandatory deposit insurance, staff noted the need to ensure that necessary preconditions are satisfied, including the need to strengthen legal and financial institutions. The CBSL has addressed all of the recommendations of the full Safeguards Assessment of June 2003, including through revisions in the Central Bank Act that are expected to be approved in 2006.

Table 6.

Sri Lanka: Vulnerability Indicators, 2000–2004

(In percent of GDP, unless otherwise indicated; end-of-period)

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

Excludes foreign currency banking units prior to 2002. Indicators are weighted averages of individual bank data.

Indicators for 2004 are estimates based on unaudited accounts.

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: Projected Payments to the Fund, 2005–2009

(In millions of SDRs, unless otherwise indicated)

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Source: Fund staff estimates.

Taking into account emergency assistance of 25 percent of quota in 2005. For illustrative purposes, a one-year extension of the current PRGF/EFF arrangements until April 2007 is assumed.

On an obligation basis.

28. Significant improvements have also been made in the financial position and operation of the two large state-owned banks. Bad loans have been written off and/or recovered, provisioning increased, government interference declined, and better credit risk practices were installed. People's Bank, however, still has a long way to go before it could be considered a financially sound entity. While progress has been made in disposing and provisioning for the stock of NPAs on the books, it is too early to tell whether new lending policies are significantly increasing the quality of the loan portfolio. To avoid repeating the mistakes with previous recapitalizations, capital injections should be directly linked with performance indicators as envisaged under the restructuring plan agreed with SEMA.

29. Sri Lanka's commitment to an open trade regime needs to be maintained to benefit from strong global and regional growth. Recent ad hoc changes in import surcharges and fees have complicated the system and send mixed signals to the private sector. Staff argued that this system should be rationalized into the current tariff structure and the remaining 10 percent surcharge on imports removed once revenue improvements have been secured. The authorities responded that they remain fully committed to an open trade regime. The various fees placed on a number of consumer imports (cesses) are specific charges earmarked to fund export promotion and development activities. They indicated their intention to further rationalize the tariff structure in the future.

A01ufig02

India: Import Growth by Trading Partner

(1990=100, U.S. dollar value)

Citation: IMF Staff Country Reports 2005, 335; 10.5089/9781451823561.002.A001

30. There are large trade opportunities within the region, especially with respect to the fast growing Indian economy. Sri Lanka was slow to pick up on the large trade potential that its fast growing neighbor provides, but since 2001 the pace of export growth to India has picked up substantially. The Comprehensive Economic Partnership Agreement with India and other regional trade initiatives provide the basis for further expansion.7 Staff stressed that, to fully capture the benefits of regional trade integration, progress should also be made in moving to a low uniform tariff structure to minimize distortions and inefficiencies than can result from preferential agreements.

31. Lack of capital market development threatens to constrain future growth performance. While capitalization in the stock market has continued to grow, the corporate bond market remains underdeveloped. The Employee Provident Fund (EPF) and National Savings Bank (NSB), with assets amounting to about 30 percent of GDP, remain important captive sources of government financing. While these institutions plan to seek alternative investments in the future, very little movement in this direction has yet taken place. These captive sources have enabled the government to access financing at rates that are below the prevailing inflation rate, but this financial repression is also acting as a constraint on broader banking and capital market development.

Regional Comparison of Firing Costs and Regulations

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Sources: 2005 Doing Business database, World Bank; and staff estimates.

Estimated firing costs for a 20-year tenure worker. The figure for Sri Lanka reflects recent legal changes while the figures for other countries refers to January 2004.

32. High redundancy payments for private sector workers continue to undermine the efficiency of the labor market. At a maximum of four years of salary, Sri Lanka has one of the most generous schemes in the world. Moreover, the private sector is concerned with a recent government initiative to mandate specific wage increases. Staff noted that such interference in wage setting was unwarranted and could damage competitiveness of some sectors. The authorities, however, felt that the strength of labor unions and the protections provided to workers were a positive feature and stressed the need for strategic partnerships between the government, the private sector, and unions.

E. PRGF and Extended Arrangements

33. The authorities indicated their desire to resume discussions on a Fund-supported program in the near future and requested that the Fund continue to provide policy advice and focused technical assistance. The authorities recognized the usefulness of a formal financial framework with the Fund in underpinning macroeconomic discipline, providing a framework for donor coordination, and supporting domestic reform efforts. However, they also stressed the importance of ownership for program success and felt that more time was needed to generate domestic consensus for key reforms. Staff agreed that establishing credibility of the reform program was essential, especially in view of the slippages experienced in the implementation of the current program (Table 9). The authorities expressed interest in further technical assistance from the Fund in key areas, including deposit insurance, revenue administration, and debt management. A staff visit is envisaged in September to review progress and discuss the framework for the 2006 budget.8

Table 8.

Sri Lanka: Millennium Development Goals 1/

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Source: World Development Indicators database, April 2004.

In some cases the data are for earlier or later years than those stated.

Halve, between 1990 and 2015, the proportion of people whose income is less than one dollar a day. Halve, between 1990 and 2015, the proportion of people who suffer from hunger.

Ensure that, by 2015, children everywhere, boys and girls alike, will be able to complete a full course of primary schooling.

Eliminate gender disparity in primary and secondary education preferably by 2005 and to all levels of education no later than 2015.

Reduce by two-thirds, between 1990 and 2015, the under-five mortality rate.

Reduce by three-quarters, between 1990 and 2015, the maternal mortality ratio.

Have halted by 2015, and begun to reverse, the spread of HIV/AIDS. Have halted by 2015, and begun to reverse, the incidence of malaria and other major diseases.

Integrate the principles of sustainable development into country policies and programs and reverse the loss of environmental resources. Halve, by 2015, the proportion of people without sustainable access to safe drinking water.

Develop further an open, rule-based, predictable, non-discriminatory trading and financial system. Address the special needs of the least developed countries. Address the special needs of landlocked countries and small island developing states.

Table 9.

Sri Lanka: Structural Policy Actions Under the First Year of the PRGF-EFF Arrangements

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Was to be given more specificity in the context of the first review.

Most measures planned for 2004 were never enacted after the change in government. In the 2005 budget, new incentives outnumber the elimination of existing incentives.