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.

1. This statement contains information that has become available since the staff report was circulated to the Executive Board on October 11, 2006. This information does not alter the thrust of the staff appraisal.

2. The Central Bank of Sri Lanka (CBSL) left its key policy rates unchanged at its October review meeting, following a ½ percentage point increase in late September. Money growth continued to slow in August, with both broad and reserve money growth declining to 16 percent (from their respective peaks of 19 percent and 21 percent in April). Private sector credit growth also slowed somewhat to 23 percent in August (from its peak of 25 percent in June). Interest rates of government securities have increased by about 1¼ percentage points since late September (to 11–12 percent for 3-month to 2-year instruments).

3. The authorities have limited their interventions in the foreign exchange market since early October, and the rupee has depreciated by about 2 percent against the dollar. While the recent decline in world oil prices may provide limited breathing space in the balance of payments in 2006,1 growth of non-oil imports remains high. International reserves have remained around $2.4 billion (2.2 months of import cover). The central bank recently announced the issuance of foreign-currency denominated treasury bonds to nonresidents (commencing end-October) and additional foreign currency borrowing through syndicated loans from banks (in November).

4. On October 20, the CBSL issued a press release announcing the introduction of a 50 percent margin deposit requirement on imports of “nonpriority consumer items” and on the opening of letters of credit to pay for such imports. Staff has received a copy of the regulatory text by which this new exchange control measure has been introduced, and is actively engaged with the authorities to establish the facts, as well as the jurisdictional implications of the new measures.

5. Financial markets have remained relatively calm despite recent intensification of hostilities. The Colombo Stock Exchange gained a further 3.5 percent during the last two weeks, with daily turnover volumes exceeding the daily average so far this year.

6. The 2007 budget is expected to be presented to parliament on November 14. The authorities reiterated their commitment to reduce the fiscal deficit to 7½ percent of GDP (excluding tsunami-related spending), but detailed revenue measures are yet to be spelt out in the budget. The Appropriations Bill of 2007, recently introduced to parliament, points to a likely increase in capital expenditures for power, railways, ports, and agriculture (totaling about 2½ percent of GDP), and an increase in defense spending mainly for impending wage increases and new recruitment (amount to about ¾ percent of GDP). The government expects these increases to be offset by intensified revenue efforts, adjustments in subsidies and transfers to local governments, and cuts in noncore and under-funded capital projects.

7. The authorities have requested an FSAP update in 2007.

8. The government and the LTTE are scheduled to talk during October 28–29 in Geneva. Progress has also been made to bring the main opposition party (UNP) to work together on priority national issues, including the conflict in the North and East, electoral reform, good governance, economic development, nation building, and social development.

1

Based on the latest WEO oil price baseline, petroleum imports could be lowered by an estimated $90 million in 2006 and $300 million per year over 2007–2010, compared to projections in the staff report. Domestic fuel prices, liberalized in September, have also moderated, reflecting the trend in world oil prices.

Sri Lanka: Staff Report for the 2006 Article IV Consultation
Author: International Monetary Fund