Sri Lanka: Staff Report for the 2006 Article IV Consultation

The macroeconomic stability of Sri Lanka is analyzed. Reflecting high domestic inflation relative to trading partners, the real effective exchange rate appreciated by 2 percent. Infrastructure development is a central element of the government’s medium-term development strategy. Further efforts to reduce quasi-fiscal losses of the energy companies through adjustments in electricity tariffs, combined with balance sheet restructuring and enhanced operational efficiency are encouraged. Improvement over the quality and coverage of fiscal statistics and the remaining issues needed to meet the Special Data Dissemination Standard (SDDS) requirements are encouraged.

Abstract

The macroeconomic stability of Sri Lanka is analyzed. Reflecting high domestic inflation relative to trading partners, the real effective exchange rate appreciated by 2 percent. Infrastructure development is a central element of the government’s medium-term development strategy. Further efforts to reduce quasi-fiscal losses of the energy companies through adjustments in electricity tariffs, combined with balance sheet restructuring and enhanced operational efficiency are encouraged. Improvement over the quality and coverage of fiscal statistics and the remaining issues needed to meet the Special Data Dissemination Standard (SDDS) requirements are encouraged.

I. Introduction

1. Notwithstanding decades of civil conflict, Sri Lanka’s economy has shown resilience. Growth performance has improved from an average of 4–5 percent in the a regional perspective, Sri Lanka’s growth in income per capita has markedly exceeded the pace of its neighbors since the early 1990s, reaching $1,000 in 2004, and helping to lift thousands out of poverty. The human development index and other non-income social indicators have also improved over time, and they are now far ahead of those in other South Asian economies. However, income inequality has deteriorated in the last few years,1 rural poverty remains high, and the urban-rural poverty gap and regional growth disparities widened. Meeting some of the Millennium Development Goals (MDGs) continues to be a challenge.

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Gross National Income Per Capita 1/

(Index: 1990=100)

Citation: IMF Staff Country Reports 2006, 446; 10.5089/9781451942965.002.A001

Source: World Bank, World Development Indicators.1/ Atlas method.

Selected Social Indicators in Asia

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Source: Human Development Report 2005, UNDP; and World Development Indicators, World Bank.

2003 data.

2004 data.

1990 to 2002 from the Human Development Report for the most recent year available in each country.

2. President Rajapaksa’s government has placed a strong emphasis on reducing poverty through raising economic growth over the medium term. This is to be achieved by increasing growth to 8 percent, supported by a sharp increase in investment, especially in infrastructure (power and roads). The strategy also emphasizes the need to reduce regional inequalities, create income-generating activities to assist the poor, and promote small and medium enterprise development, along with a new energy policy to increase power generation while reducing its cost. A Development Forum is being planned for early 2007.

II. Recent Developments

3. Since late 2005, there has been a sharp escalation in hostilities between the government and the LTTE. The peace talks in June failed in the last minute, bringing the four-year ceasefire close to collapse and raising fears of a return to a full-scale civil war. The authorities have made further efforts to settle the conflict through multi-party negotiations. More recently, both sides communicated their willingness to resume peace talks during October 28–29 through their facilitators. While this has raised cautious optimism, risks remain. The intensity of fighting, in particular, continues to pose a threat to the peace efforts.

4. The economy has shown strong resilience, with growth reaching 8 percent in the first half of 2006, but inflationary pressures are building (Table 1, Figure 1). Improved agricultural performance, strong tsunami-reconstruction activities, and robust service sector growth, helped mitigate the impact of rising oil prices and the removal of export quotas for textiles and apparel. GDP growth is projected at 7 percent for 2006, reflecting some easing in the second half of 2006 in an environment of rising interest rates and high oil prices. Inflation declined in 2005, but has risen since early 2006 reflecting pressures from fast credit growth, the impact of the oil price pass-through, and increases in wages and pension payments.2 Unemployment has declined to 7¾ percent at end-2005 (from 8½ percent in 2004), indicating a possible gradual tightening in the labor market. CPI inflation is projected at 12 percent for 2006.

Table 1.

Sri Lanka: Selected Economic Indicators, 2001–2006

Main exports (percent of total, 2005): garment (48), tea (14)

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

Unemployment rate (2005): 7.7 percent

Poverty rate (2004, incidence): 22 percent

FDI (2005): $200 million

Public debt (2005): 94 percent of GDP

Foreign public debt (percent of total, 2005): 43

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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.

Figure 1.
Figure 1.

Sri Lanka: Real, Fiscal, and Monetary Sector Developments1/

Citation: IMF Staff Country Reports 2006, 446; 10.5089/9781451942965.002.A001

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

5. The external current account deficit has been widening, and reserves are below comfortable levels. Despite robust growth in exports and remittances, the oil shock and strong non-oil (intermediate and capital goods) imports are expected to widen the current account deficit to 4¾ percent of GDP in 2006 (from 2.8 percent of GDP in 2005) (Table 2, Figure 2).3 Tsunami-related inflows amounted to about $1 billion (including the debt moratorium and the Fund’s Emergency Assistance) in 2005, equivalent to 4 percent of GDP. An additional $450 million tsunami-related inflows is projected in 2006, but the actual disbursements have so far been slow (Appendix I). With the debt service burden rising (due in part to the expiration of the Paris Club moratorium), the government has resorted to foreign currency borrowing from domestic banks (through syndication) and to the issuance of domestic dollar-denominated bonds to buffer the balance of payments. Gross official reserves have been hovering around $2.4 billion, equivalent to 2.4 months of imports and 86 percent of short-term debt. The rupee-dollar exchange rate has weakened somewhat since the second half of 2005. Reflecting high domestic inflation relative to trading partners, the real effective exchange rate (REER) appreciated by 2 percent during the same period (Box 1).

Table 2.

Sri Lanka: Balance of Payments, 2005–2010

(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.

Includes public corporations.

From 2006 includes dollar denominated Sri Lanka Development Bonds (SLDBs) and Foreign Currency Banking Union (FCBU) borrowing.

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 2006, 446; 10.5089/9781451942965.002.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.

6. Despite monetary policy tightening, credit growth remains high. The central bank raised its policy rate five times (cumulative 2 percentage points) during November 2004-December 2005, and by another 1 percentage point recently. Reserve money growth was brought down to below 15 percent at end-March 2006 (from 20 percent a year ago), but this trend has reversed since April reflecting increased central bank financing of the budget. Credit growth to the private sector (including housing loans) remains strong (about 24 percent in June), contributing to demand pressures (Table 3).

Table 3.

Sri Lanka: Monetary Accounts, 2003–2006

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

7. The 2005 fiscal deficit widened to 8.7 percent of GDP, larger than budgeted, mainly because of tsunami-related spending. Excluding tsunami-related flows, the budget deficit was contained at 7.5 percent of GDP (compared to 8.2 percent of GDP in 2004). Revenue increased, reversing the downward trend of previous years. But there were large overruns in oil subsidies and in the wage bill,4 which were offset by cuts in other recurrent expenditures and a reduction in interest payments to protect capital spending (Table 4).

Table 4.

Sri Lanka: Summary of Central Government Operations, 2004–2010

(In percent of GDP, unless otherwise indicated)

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

Measures include tsunami expenditure and in 2005 interest savings from Paris Club debt moratorium.

8. The fiscal deficit in the first half of 2006 was contained through adjustment of capital expenditures. Tax revenue grew at a healthy 23 percent, but still fell short of the budget target of 27 percent growth. There have been sizable overruns on recurrent expenditure, emerging from larger than budgeted oil subsidies and pensions, as well as additional security and humanitarian spending. However, a generous capital budget provided scope for adjustment (in line with project execution) and helped to contain the deficit. Excluding tsunami-related spending (1.7 percent of GDP), the budget deficit target would be 7.4 percent of GDP (similar to the actual in 2005). With slower than expected tsunami-related disbursements, domestic financing of the budget in the first six months reached Rs. 101 billion, compared with the budget estimate of Rs. 123 billion for the year.

9. Total public debt declined by 11 percent of GDP, but remains high at 94 percent of GDP in 2005. Moreover, liquidity pressures are building. Out of the total $935 million foreign currency borrowing from domestic banks and local investors during 2004–05, about $780 million will need to be repaid in 2006 ($300 million of which in the last quarter). Sri Lanka was given its first international credit rating by Fitch (BB-) in December 2005, on par with Vietnam, Indonesia, Brazil, and Turkey. But with renewed security concerns, Fitch downgraded the country outlook for Sri Lanka to negative (from stable). The government decided to put the planned global bond issuance on hold and instead raised $580 million of dollar-denominated Sri Lanka Development Bonds (SLDB) during April-September 2006. The bonds carried a maturity of 2–3 years and an average interest rate of LIBOR+140 bps.

Sri Lanka: Exchange Rate Assessment and External Competitiveness

Indicators of Sri Lanka’s external competitiveness warrant close monitoring.

  • Sri Lanka’s real effective exchange rate (REER) is in the middle range compared with its main regional competitors (see figure). The REER (CPI based) depreciated by 23 percent during 1998–2004 before appreciating by 8 percent in the first half of 2005, following pledges of tsunami aid from donors (Figure 2). There was a further appreciation of 2 percent in the next 12 months up to June 2006, resulting mainly from higher relative price differentials. Given the extent of the previous depreciation, this recent appreciation is not of immediate concern but bears monitoring.

  • Unit labor costs in industry appear to be increasing and profitability decreasing. Productivity growth in industry in 2005 declined by 5.6 percent which, together with increases in firm’s costs arising from higher domestic interest rates, oil prices, and wages (from public-sector wage spillover effects) point toward declining profitability.

  • Export volume growth appears to be moderating, including in the garments sector. With the elimination of the textiles quota, Sri Lanka’s export growth in garments and textiles (45 percent of total goods exports) slowed to 3 percent in 2005 as compared to that of Bangladesh and Vietnam, which were at 15 percent and 12 percent, respectively. It is not clear to what extent this reflects underlying trends versus short-term fluctuations—garments industry representatives report strong order books, a growing niche market for Sri Lankan apparels, and increased backward linkages which would reduce costs and turnover periods. Furthermore, Sri Lanka has maintained its competitive edge in tea and spice exports, which accounts for about 15 percent of total exports.

  • Sri Lanka’s market share in world exports appears to be declining. Sri Lanka’s share in total world exports (0.06 percent) declined by 27 percent during 2000–05, mainly from a loss of market share in the United States and EU. Over the same period, Bangladesh and Pakistan’s share in total world exports was broadly maintained at 0.08 percent and 0.13 percent, respectively. This deteriorating trade performance reflects in part structural weaknesses and political vulnerabilities particular to Sri Lanka which have affected FDI and business sentiment, and in part to competition from rapidly growing Chinese and Indian exports.

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Regional Real Effective Exchange Rates

Citation: IMF Staff Country Reports 2006, 446; 10.5089/9781451942965.002.A001

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Regional Export Volume Growth

Citation: IMF Staff Country Reports 2006, 446; 10.5089/9781451942965.002.A001

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Regional Share of Export

(In percent of world export)

Citation: IMF Staff Country Reports 2006, 446; 10.5089/9781451942965.002.A001

Source: IMF DOTS.

10. Sri Lanka’s financial markets have been holding up despite increased security concerns and volatility in international financial markets. The Colombo Stock Exchange (CSE) has become one of the best performers in the region. The All Share Price Index rose by a cumulative 70 percent during 2004–05, and is up by another 25 percent so far in 2006, owing to a large extent to the performance of the telecommunication industry and the financial sector. The average P/E ratio of 12 is similar to those in Bangladesh and Pakistan, but lower than in India. The decline during the emerging market sell-off in May was modest (by only 2.5 percent), reflecting in part investor optimism over the near-term economic outlook, as well as the lack of alternative channels for other high yield investments in Sri Lanka.

III. Policy Discussions

A. Outlook and Risks

11. While growth remains robust, near-term risks and vulnerabilities have increased since the last Article IV consultation. Inflationary pressures are building; managing further oil price shocks remains a challenge; and reserves are below comfortable levels. The rising debt service burden, particularly during 2008–09, has intensified external vulnerabilities. Potential increases in military spending also add risks to the fiscal outlook. The setbacks in the peace process, which have caused some weakening in confidence, could further affect investment going forward.

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Sri Lanka: Business Confidence Index

Citation: IMF Staff Country Reports 2006, 446; 10.5089/9781451942965.002.A001

Source: LMD-ACNIELSEN Business Confidence Index.

12. Sri Lanka’s medium-term prospects are favorable, provided that peace resumes, near-term risks are managed, and essential reforms are implemented (Table 5). The country has significant untapped growth potential, including in the conflict affected areas in the North and East, and could also benefit from productivity gains by an educated labor force and rapid growth in major countries in the region. Staff projects growth to sustain at around 7 percent over the medium term, assuming macroeconomic stability and fiscal consolidation, but noted that growth could reach the authorities’ 8 percent target or even higher if the above-mentioned challenges are overcome and fundamental reforms are advanced.

Table 5.

Sri Lanka: Medium-Term Macroeconomic Framework, 2005–2010

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

Excluding central bank Asian Clearing Union (ACU) balances.

13. Otherwise, medium-term prospects are subject to significant downside risks. Fiscal consolidation is key to creating space for critical infrastructure investment and social spending without jeopardizing debt sustainability. Without it, higher fiscal deficits would increase the interest payment burden on the budget, crowd out private sector investment, and undermine financial sector development. Other reforms, addressing entrenched problems in the labor market, trade regime, and energy sector, will also help Sri Lanka to improve its growth potential.

14. The authorities are aware of the risks to the economic outlook. They emphasized that maintaining macroeconomic stability and increasing growth to 8 percent are the two pillars underpinning their medium-term strategy. They acknowledged that far-reaching structural policies will be required for improving the business climate for private investment and job creation. They are focusing on fiscal consolidation and debt sustainability, reforms of the banking sector and state-owned enterprises, infrastructure development, and reducing rural-urban income disparities. In addition, they are working on deepening regional integration, including with India and Pakistan. Against this background, the discussions centered on managing short-term risks and vulnerabilities, as well as some key elements of the structural reform agenda.

B. Fiscal Policy

15. The authorities agreed that adhering to the 2006 fiscal deficit target would help address inflationary risks and strengthen the credibility of fiscal consolidation. Revenue collections have improved significantly in the first seven months, with income tax and VAT growing at 47 percent and 12 percent, respectively. The ongoing expansion of VAT to the financial sector and services has already helped boost revenue. The authorities also plan to implement some within-year measures to strengthen risk assessment, reduce illegitimate VAT refunds, and modify the depreciation schedule for capital goods (e.g., with a reduction in the depreciation allowance). For the year as a whole, revenue is projected to improve by 1 percent of GDP (compared to a targeted increase of 1.8 percent of GDP in the budget).

16. The authorities attributed the sizable recurrent spending overruns to date to certain unforeseen factors. The most important was higher world oil prices, contributing to larger than anticipated oil subsidies. There were also increases in pension payments following the November election, and additional security-related spending more recently.

17. Nevertheless, the government has taken measures to offset spending overruns. Revenue collection efforts have been enhanced. Steps were also taken to achieve full price pass-through for major fuel products (see ¶18) and to rationalize fertilizer subsidies. They are confident that with these measures, together with further rationalization of low-priority projects, the fiscal deficit target of 9.1 percent of GDP will be met. They plan to intensify the implementation of tsunami-related projects to fully utilize committed donor resources in 2006.

18. Full price pass-through for major fuel products has virtually eliminated oil subsidies in the budget, starting from September 2006. Domestic fuel prices were increased by 35 percent (weighted average) during April-September, achieving full pass-through for petrol and diesel, while substantially reducing subsidies for kerosene. To avoid amplifying price shocks, the authorities have removed VAT (15 percent) on diesel. Moreover, the pricing formula was revised to ensure cost recovery plus a profit margin for the two oil companies (one foreign), setting the stage for price liberalization starting from September.

19. The authorities are committed to fiscal consolidation over the medium term. They aim to bring the deficit down to 7½ percent of GDP in 2007 and to 5 percent by 2010—essentially the same consolidation path as stipulated under the Fiscal Management Responsibility Act (FMRA), but with a two-year delay. Staff supported this consolidation path, and noted that this is best achieved through two-pronged reforms to broaden the tax base and strengthen tax administration, while rationalizing recurrent expenditure (Box 2). Staff discussed options including reducing exemptions, simplifying VAT rates while broadening the VAT base, and introducing the TIN to enhance administration. The authorities agreed in principle that quality changes are required, but found it difficult to implement some measures, like simplifying VAT rates, as early as 2007 without adequately analyzing the revenue implications of different rate options. They indicated that extending VAT to wholesale and retail stages would not be feasible in the near term as it would require changes in the constitution to modify the power of provincial councils over sales taxes to prevent potential double taxation at both the central and local levels. In addition, a revenue sharing mechanism between the central and local governments will be needed. Noting exemptions were rising, staff also underscored the need to review the exemption criteria in the context of the 2007 budget.

20. Increased infrastructure and social spending have placed a premium on the need to rationalize recurrent expenditure. In view of Sri Lanka’s public sector hiring, which significantly outpaced growth in population and labor force in the past five years, staff advised to restrain real growth in wages and salaries with limited hiring. In addition, efforts are needed to improve targeting and delivery of subsidies and social programs. Interest costs could also be reduced through strengthened debt management to replace the expensive short-term bank loans in foreign currency with less expensive, longer term, instruments. The authorities responded that efforts have been made in these areas. In particular, they are targeting an overall nominal wage increase of 20 percent over the next three years (2007–09) for the public sector, supported by limited recruitment. Negotiations have started with labor unions of SOEs and public banks. Moreover, improvements in the targeting for fertilizer subsidies are also envisaged in the 2007 budget.

Sri Lanka: Challenges with Tax Revenue Mobilization

Tax revenue mobilization remains a challenge in Sri Lanka, posing a constraint to government goals of fiscal consolidation. At 14.2 percent of GDP in 2005, central government tax revenue in Sri Lanka is higher than in India and Bangladesh, but remains much lower than levels observed in the 1990s (averaged 19 percent of GDP), reflecting to a large extent the impact of trade reforms through reductions in tariffs. This declining trend in tax revenue was reversed in 2005 (for the first time since 1999), largely due to better performance in income and excise taxes, as well as in other taxes.

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Sri Lanka: Revenue, 1993–2005

(In percent of GDP)

Citation: IMF Staff Country Reports 2006, 446; 10.5089/9781451942965.002.A001

In the first seven months of 2006, tax revenue grew by a healthy 23 percent, but still lower than the ambitious budget target. Tax revenue is projected to improve by 1 percent of GDP to 15.2 percent of GDP in 2006 based on improvements in all tax categories, except VAT which is expected to remain flat as a ratio of GDP.

VAT collection, the largest category in all taxes, accounts for about 41 percent of total tax revenues. The coverage of VAT, however, remains narrow with many exemptions causing cascading effects. In particular, wholesale and retail trade remains outside the VAT net and are taxed on the basis of turnover by the provincial governments. There are many nonstandard exemptions, including in the agricultural sector (including inputs), imported capital goods, pharmaceuticals, lease of residential accommodation, import by persons having an agreement with the Board of Investment, pearls and precious stones, essential food items (e.g., rice, flour, milk, bread, fish, vegetable, tea, potatoes, onions, etc). Moreover, Sri Lanka currently has three VAT rates (5, 15, 20), plus a zero rate for exporters and domestic buyers of capital inputs, complicating VAT administration and increasing the scope for fraud. Despite these weaknesses, the efficiency ratio of Sri Lanka’s VAT (defined as the ratio of VAT revenue to GDP divided by the standard rate), at 0.39, is in line with the regional average in Asia and Latin America (both at 0.38) and Eastern and Central Europe (at 0.4).

Fiscal consolidation over the medium term requires a significant strengthening in tax revenue on a sustainable basis. This could be achieved through tax base broadening, further improvements in tax administration, and a more intensive and efficient use of information technology. Options discussed with the authorities include:

  • Unifying the VAT rates to simplify administration and improve compliance;

  • Broadening the VAT base, including trimming exemptions and extending to wholesale and retail sectors, and introducing a low presumptive tax for companies below the VAT registration threshold;

  • Improving VAT audit by adopting a sound risk assessment framework to enforce governance and reduce fraud in the refund system;

  • Introducing the Taxpayer Identification Number (TIN) to individual income tax payers; and

  • Tightening the eligibility criteria for corporations under the Board of Investment with the aim to curtail further proliferation of tax exemptions.

21. Fiscal consolidation and strengthened debt management are critical for medium-term debt sustainability. Staff noted that chronic fiscal deficits have propelled public and publicly guaranteed debt to over 90 percent of GDP, and interest payments have reached one third of tax revenue. With GDP per capita already above $1,000 in 2005, Sri Lanka is likely to move towards middle-income status in the next few years, implying potentially less concessional financing. Therefore, a meaningful fiscal consolidation is essential. The authorities explained that the amount borrowed during 2004–05 was in part to cushion the oil shock. Recently, they have sought to mobilize less expensive resources through issuance of foreign-currency-denominated SLDBs of longer maturity (2–3 years). Staff noted that while this strategy gives a breathing space in 2007 and reduces interest costs as compared to treasury bonds of similar maturity, debt service pressures in foreign exchange are expected to rise sharply from 2008, and likely to exert pressures on the balance of payments. It is important to gradually unwind such borrowing while limiting it for general budget support. The authorities were also encouraged to coordinate closely with donors to establish a framework, aimed at fully utilizing the committed external concessional financing in the pipe line.

22. The authorities emphasized that implementing the new energy sector policy will require additional financing of about $800 million during 2007–2010. They are currently exploring various long-term financing options, including sharing mechanisms with investors, tapping international capital markets, and developing the corporate bond market. Staff supported these approaches, and indicated that a well-developed domestic bond market would provide a system for shared risks and improve the allocation of capital to its most productive users, thereby stimulating productivity. Moreover, it would be an important vehicle to support private sector development. Early implementation of this policy will help prepare Sri Lanka for the potential decline in concessional financing as the country moves toward middle-income status. The Fund is ready to provide technical assistance if needed.

23. The DSA presented to the authorities highlighted the sensitivity of debt dynamics to the fiscal deficit, growth, and exports. The fiscal consolidation indicated above would yield a declining path for Sri Lanka’s total public and public guaranteed debt, falling from 94 percent of GDP in 2005 to 74 percent of GDP in 2010. With a modest level of commercial borrowing from 2007 onwards (including financing for the planned energy sector projects), debt-service-to-exports is projected to remain at around 13 percent over the medium term, below the DSA indicative threshold for debt service distress (at 20 percent) for a medium performer under the 2005 CPIA Index. However, extreme stress tests, including lower GDP growth, lower exports, and exchange rate and deflator shocks, could bring this ratio to around 21 percent (Table II.1, Appendix II), indicating a risk of debt distress.

C. Monetary and Exchange Rate Policies

24. The authorities agreed that monetary policy should be geared toward reducing inflation expectations. In light of pressures from the oil price pass-through and fast credit growth, further monetary tightening will be required. Interest rate hikes could also be justified in an environment of rising global and regional interest rates. The authorities are committed to bring down reserve money growth to around 16 percent by end-2006 (from 18 percent at end-June) and adjust interest rates as needed. They also intend to step up open market operations to reduce excess liquidity in the banking system. Staff noted that loan growth to the housing sector has outpaced the overall credit growth by a significant margin, posing potential risks to uneven economic development among sectors and potential rising of NPLs.

25. The authorities underscored their commitment to a market-based exchange rate and to limit intervention to reduce volatility. They concurred that greater flexibility in the nominal exchange rate will help safeguard external reserves and reduce external vulnerability.5 The authorities explained that the intervention undertaken during May-July was to reduce volatility in response to market pressures arising from lumpy tsunami-related imports. Net sales in August were markedly reduced, although there has been some pick up in September. They also noted that steps are being taken, including increasing official banking services and lowering the cost and time period for transfers, to facilitate a continuation of strong inflows of workers’ remittances to help mitigate future shocks.6 Sri Lanka maintains requirements for the deposit of margin by importers of certain goods. These requirements affect approximately less than 3 percent of total imports. They give rise to an exchange restriction that is subject to Fund approval under Article VIII, Section 2(a) of the Fund’s Articles of Agreement.*

26. Staff shared its analysis on Sri Lanka’s real exchange rate and medium-term competitiveness, highlighting the likely intensified competition in global markets. Staff agreed with the authorities that exchange rate competitiveness is not an immediate concern in view of the small variations in the REER in the last 12 months and the current trend of export performance. However, the decline in labor productivity and the rise in unit labor costs warrant close monitoring. The authorities appeared less worried about the recent drop in the export market share of garments and textiles, noting that order books look promising for the year, and that Sri Lanka still maintains a niche market in apparel. They also expect the Generalized System of Preferences (GSP) to yield positive results. Moreover, Sri Lanka’s tea exports to major European and Middle East markets have performed well to date.

D. Financial Sector Policies

27. Banking sector soundness has improved, and progress has been made in strengthening the supervisory framework. The NPL ratios of the state-owned banks declined from 18 percent in 2003 (15.6 percent including foreign currency banking units) to 8 percent in June 2006, and reached similar levels to those of domestic banks. Capital adequacy ratios have also improved (to 8.3 percent of total assets), and steps have been taken to further enhance the regulatory and supervisory framework, including plans to adopt the Basel II capital accord by 2008 (Box 3). However, risks remain. While credit growth is a welcome sign of financial deepening, credit acceleration in the housing sector is a concern. Supervision will need to be strengthened to mitigate risks of a potential rise in NPLs, including raising loan-specific capital buffers or increasing provisions for fast growing credit categories. Moreover, the banking system continues to be characterized by high spreads which are almost double those in other economies in the region. Fostering consolidation in the banking industry would help rationalize the cost structure and improve competitiveness. Given the current structure of cross holding of assets by the banking groups and conglomerates, it is also important to implement a consolidated supervision framework to monitor financial risks among these entities.

28. Continued efforts in restructuring the two large public banks remain important for financial sector stability (Box 3). While their NPL ratios have declined and provisioning and profitability have improved, loan practices and risk management remain weak, and the low capital adequacy ratio in the People’s Bank is still a risk. Staff encouraged a stepped up effort toward implementing the restructuring program for the People’s Bank, supported by AsDB. The authorities indicated that they are moving toward implementing Basel II in 2008, and that will cover the two public banks with respect to all prudential measures. They also agreed that an FSAP update in 2007 would be useful to verify the improvements and examine new challenges and vulnerabilities in these banks.

29. Staff sought clarification regarding the new role of SEMA as a holding company of strategic SOEs, including public banks. The importance of addressing the risk of conflict of interests was emphasized, as this arrangement could potentially open the door for connected lending between the industrial groups and public banks all under the purview of SEMA. In this regard, it is critical to ensure the role of the CBSL as the sole regulatory power to supervise and regulate operations of all public banks under SEMA.

E. Structural Policies

30. Infrastructure development (power and roads) is a central element of the government’s medium-term development strategy. Their emphasis is on restoring the financial viability of the power sector while expanding generation capacity by using more cost-efficient sources (including coal power). The authorities indicated that, following the initial increase in electricity tariffs in September, further adjustments are envisaged with a view to eliminate future quasi-fiscal losses by 2007–08 (currently estimated at ½ percent of GDP in 2006). Staff encouraged the authorities to also speed up operational restructuring of the power companies to reduce system losses and improve efficiency, and strengthen the regulatory guidelines to promote private investment including FDI. The road projects are progressing well with the support of the World Bank and AsDB. The authorities expect that the forthcoming development forum will help map out the financing requirements of their development strategy with donor support.

Sri Lanka: State-Owned Banks

The financial situation of the Sri Lankan banking sector depends crucially on the performance of the state-owned banks. The banking sector is dominated by two commercial state-owned banks, Bank of Ceylon and the People’s Bank, together accounting for about a third of banking system assets. Both banks have had a long history of recapitalization and restructuring. For both banks, recapitalization in the 1990s was not combined with effective restructuring, resulting in underperformance, and negative equity in the case of the People’s Bank. The 2002 FSAP identified these banks as the key vulnerability in the banking system.

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Sri Lanka: Nonperforming Loans

(In percent)

Citation: IMF Staff Country Reports 2006, 446; 10.5089/9781451942965.002.A001

Progress has been made in the restructuring of the two state-owned banks recently. For People’s Bank the restructuring plan calls for recapitalization with a loan from the Asian Development Bank over a period of five years. The first tranche of equity capital investment—of about $20 million—took place in December 2005 upon completion of some of the benchmark targets. The restructuring plan formulated for Bank of Ceylon in 2004 included targets in the areas of asset reconstruction, systems upgrading, human resource development, and capital enhancement, to be achieved within a two-year period. The bank was able to achieve its targets for 2005. There have also been changes in the Board and senior management of both banks that appears to have strengthened these institutions.

Both banks have seen improvements in their financial performance. The NPL ratios of the state banks have improved from 18 percent in 2003 (15.6 percent including foreign currency units) to 8 percent in June 2006 and have reached similar levels to those of domestic private banks. However, they are high compared to the 1 percent NPL ratio of foreign banks operating in the country. At the same time, provisioning has increased from 70 percent of all NPLs to 80 percent. As a result, net NPLs (net of interest in suspense and loan loss provisions) have declined below 2 percent. People’s Bank reported a positive net worth of about Rs. 4 billion in 2005, from a negative net worth of Rs. 6 billion in 2001. The capital adequacy ratio of Bank of Ceylon has increased to 12 percent, above the regulatory minimum of 10 percent, and that of People’s Bank turned positive following the recapitalization and has since reached 2 percent. Profitability rations have also increased on the back of a stronger economic and robust credit growth.

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Sri Lanka: Capital Adequacy Ratios

Citation: IMF Staff Country Reports 2006, 446; 10.5089/9781451942965.002.A001

Notwithstanding these improvements, the state banks face entrenched structural weaknesses and operating challenges. They still suffer from large stocks of bad debt, poor risk management practices, inadequate information technology, and very difficult labor problems that stand in the way of modernization and restructuring. This is compounded by weaknesses in the legal system and framework for dealing with insolvencies and loan recoveries. Furthermore, lending by state-owned banks to state-owned enterprises increases the risks of the banking system.

31. Reducing rural-urban income inequality remains a priority of the government. While recent price increases for energy products bringing fiscal and efficiency gains, they could exert significant impact on the poor by lowering their real income. This is of concern in Sri Lanka as the income gap between the rich and the poor has widened during the last decade. Staff suggested that safety net measures be introduced to cushion the real income impact on the poor.7 Several scenarios estimating the social impact of energy price adjustment were discussed, with a view to identify ways to address this issue in the 2007 budget. The authorities indicated that some cash payments may be considered in 2007 for targeted low income households, and that they will review more thoroughly other affordable and transparent safety net means in the context of their development plan.

32. Sri Lanka’s performance in the post-MFA environment highlights potential challenges in the period ahead. Recent data indicate that textile and garment exports grew at only about 4 percent in January-July, and Sri Lanka’s market share in apparel to the United States and EU may continue to decline given increased competition and lack of full-utilization of the GSP access due to issues regarding rules of origin.8 The authorities explained that plans have been developed recently to strengthen the backward linkages of the garments sector with textile factories to help reduce input costs and turnover periods. Also, poor infrastructure, particularly weaknesses in port operations, raises the cost of manufacturing and exporting, and plans are underway to address these issues.

33. Maintaining a liberal trade system is critical for Sri Lanka to benefit from regional and global trade. In this regard, the recent ad hoc increases in fees placed on a number of consumer imports (cesses) have complicated the system and sent wrong signals to the private sector. The authorities reiterated their continued commitment to an open trade regime. They were less concerned about the cesses, arguing that these fees cover limited consumer goods and are earmarked for specific use including export promotion and development related activities. The staff encouraged them to review this issue with assistance from the World Bank. A number of bilateral trade negotiations are ongoing, including with India and Pakistan.9 In this context, staff advised that moving to a low uniform tariff structure will help minimize distortions and inefficiencies.

IV. Staff Appraisal

34. Sri Lanka’s near- and medium-term economic prospects depend critically on progress on the peace front and on implementing essential reforms. The authorities’ medium-term framework rightly places its emphasis on raising growth and reducing vulnerability through fiscal consolidation, infrastructure development, supporting rural and small and medium enterprises, and creating income-generating activities to assist the poor. This strategy, however, is yet to be fully articulated in terms of well-defined measures to create the fiscal space needed for increased investment and social spending. Achieving 7–8 percent growth will also require an improvement in investment efficiency and productivity. In this context, policies will need to be fleshed out to further reform the financial sector, rationalize the trade regime, and improve the business climate to lift the growth potential over the medium term.

35. Macroeconomic policies in the near term should be geared toward reducing inflationary expectations and external vulnerabilities. The economy has shown remarkable resilience against adverse shocks. However, with the strong growth momentum, demand pressures are increasing as evidenced by rising inflation and a widening current account deficit. Continuing the current policy stance with fast credit growth would pose upside risks to inflation. In this context, the recent increase in policy rates is appropriate, signaling the commitment of the authorities to price stability. Nevertheless, further interest rates hikes may still be needed to firmly contain credit growth and keep inflation expectations in check.

36. The current exchange rate regime has served Sri Lanka well and remains appropriate in the period ahead. The authorities should limit intervention in the foreign exchange market to smoothing excessive volatility, and allow greater flexibility in the exchange rate to help safeguard external reserves and maintain competitiveness, particularly in view of the declining trend in Sri Lanka’s export market share and rising unit labor costs. In view of potential external shocks and an expected rise in debt service burden over the medium term, a sustained drop in external reserves below the current level should be avoided. With regard to the exchange restriction arising from the requirments that importers of certain goods deposit margin, the authorities have committed to eliminate the measures shortly. Staff is looking into whether the exchange restriction warrants approval in accordance with Fund policies.*

37. The authorities’ commitment to adhere to the 2006 budget deficit target is appropriate, and the 2007 budget should firmly advance to fiscal consolidation. This will help achieve a more balanced policy mix for growth and stability. Recent steps toward full pass-through for major petroleum products have removed a major element of fiscal vulnerability. For the 2007 budget, the tendency to rely on overly optimistic revenue projections to deliver adjustment should be avoided, as this complicates fiscal management when the envisaged revenue yields do not materialize. The budget will need to focus on adopting revenue measures that simplify the tax system, enhance administration, and improve tax buoyancy through base broadening. Reducing exemptions should be a priority, which could be implemented without delay. Sustainable fiscal adjustment will also require greater spending efficiency, including restraining real wage growth through limited hiring and improving targeting for subsidy programs. This will help free resources for productive investment as well as deficit reduction. Rural development also represents a potentially large expenditure commitment, and should proceed in line with revenue enhancing efforts.

38. Debt sustainability in Sri Lanka hinges on the strength of fiscal consolidation and policies to improve potential growth over the medium term. While the authorities’ medium-term fiscal consolidation path provides a strong rationale for reform, implementation is key. To date, however, concrete fiscal and structural measures supporting this adjustment path remain to be spelled out. Insufficient fiscal adjustment could lead to adverse debt dynamics, further compromising the ability of the government in meeting its poverty reduction and MDG objectives. Moreover, increased debt service pressures in the next few years could complicate debt management. A well-defined medium-term fiscal policy framework, supported by an improved debt management policy, will be important to help manage this situation. Further recourse to commercial borrowing for budgetary purposes should be limited. Capital market development, in particular the corporate bond market, could help channel private investment envisaged under the medium-term development plan.

39. Good progress has been made in strengthening financial sector stability and in implementing the 2002 FSAP recommendations. Enhancing the regulatory and supervisory framework and restructuring the two large public banks have contributed to visible improvements in financial soundness indicators and declined NPL ratios across the banking system. Building on this positive momentum, efforts could be made to further strengthen prudential standards to mitigate risks posed by rapidly rising credit and enlarged exposures. Strengthening the framework for the consolidated supervision is also critical for monitoring system risks, including among the banking groups and financial conglomerates. Satisfactory progress in meeting the Basel Core Principles is an essential prior to the planned adoption of Basel II in 2008. Moreover, banking industry consolidation could help rationalize the cost structure and prepare banks for regional competition. Restructuring efforts for the two large public banks will need to focus on credit risk management to ensure that new lending policies will significantly improve the quality of the loan portfolio, and improving the framework for dealing with insolvencies and loan recoveries. In this context, an early FSAP update would be beneficial. It is also important to clarify the role of SEMA as a holding company for both strategic SOEs and public banks, and the CBSL’s sole regulatory power should be protected.

40. The energy sector plays a vital role in economic growth. In the next few years, the cost of energy will remain high and quasi-fiscal losses could continue if electricity prices remain below cost recovery levels. Further adjustments in tariffs, combined with balance sheet restructuring and enhanced operational efficiency, is key to eliminate these losses and generate internal funds for investment. Remaining quasi-fiscal losses could be brought on budget. Design of the new tariff structure should consider provisions to protect low-income groups. In addition, with the new formula to liberalize domestic fuel prices based on commercial principles, any temptations to interfere should be limited. Strengthening regulatory guidelines for the energy sector could also help promote a broadening of the investor base for needed long-term energy sector financing.

41. An open trade regime with minimum distortions will best serve Sri Lanka to benefit from regional and global growth. Consideration could be given to curtail the cess regime with an aim to integrate these fees in the tariff structure. Over the medium term, a single low tariff structure could be considered to help maximize efficiency.

42. Staff encourages the authorities to further develop their medium-term policy framework into a comprehensive growth and poverty reduction strategy. Sri Lanka has made significant progress in the last decade to improve its social indicators and revitalize the economy, and the government’s emphasis on reducing poverty and narrowing the rural-urban income inequality will go a long way to support a sustainable economic development. Moving forward, the authorities are encouraged to build consensus for needed policies to support their growth and poverty reduction objectives. This strategy will also benefit from more regular and broad-based participatory consultations with relevant parties to spell out policy debates. Provincial and district-level participation is also important for targeting and costing of poverty reduction policies.

43. It is recommended that the next Article IV consultation with Sri Lanka take place on a standard 12-month cycle.

Table 6.

Sri Lanka: Vulnerability Indicators, 2001–2005

(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. Indicators are 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: Projected Payments to the Fund, 2006–2010

(In millions of SDRs, unless otherwise indicated)

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Source: Fund staff estimates.

On an obligation basis.

Table 8.

Sri Lanka: Millennium Development Goals 1/

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Source: World Development Indicators database, April 2006.

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.