Abstract
The staff report for the 2007 Article IV Consultation on Sri Lanka highlights economic growth development and performance. Rising inflation, a high current account deficit, and low unemployment rate indicate that the economy may be operating at full capacity. High stock of public debt, rising near-term debt service needs, and a low level of reserves point to elevated external vulnerabilities. A more determined fiscal consolidation is essential for demand management and debt sustainability. Greater flexibility in the exchange rate is essential to safeguard reserves.
I. Introduction
1. This supplement provides information on recent economic developments that have become available since the issuance of the staff report, including staffs preliminary assessment of Sri Lanka’s 2008 budget proposal unveiled on November 7. The new information dose not change the analysis and policy recommendations contained in the staff report. Paragraphs 9–12 below should be considered part of the staff appraisal.
II. Recent Developments and Outlook
2. The CBSL has recently revised down its real GDP growth projection to 6.7 percent for 2007, from the original projection of 7.5 percent and closer to the staff projection of 6 percent. While overall economic activity has remained broadly strong, tea and rice production has been adversely affected by labor disputes and adverse weather conditions, while tourism continued to suffer from the unsettled security situation. Inflation sustained at around 22 percent in September, reflecting a combination of demand pressures, rising oil prices, and possibly an emerging wage effect following the minimum wage adjustment in May/June.
3. Market sentiment has been boosted by the recent issuance of Sri Lanka’s first medium-term sovereign bond of $500 million. This bond issue helped a buildup in external reserves to $3.2 billion by mid-November (from $2.6 billion at end-September), covering 2.7 months of imports. The improved prospects for the funding of the government also helped to ease pressures on the rupee, which has appreciated by about 2 percent since late October.
4. The government has used the full amount of Rs. 56 billion from the bond issue to retire high interest rupee treasury bills held by the CBSL, thereby reducing the CBSL’s direct financing of the budget. The lowering of the government’s domestic borrowing requirement seems to have helped to drive treasury security rates down to 15¾ percent in mid November, from a peak of 18¼ percent in early October, while call money rates fell to 13-15 percent.
5. Continuing increases in international oil prices have heightened balance of payments risks. Based on the latest WEO projections, the current account deficit is expected to widen to 5 percent of GDP in 2007 and 6½ percent of GDP in 2008.
III. The 2008 Budget
6. The 2008 budget proposal targets a marginal reduction in the fiscal deficit to 7.7 percent of GDP (from an estimated 7.8 percent of GDP in 2007). This falls considerably short of the authorities’ earlier plan to lower the deficit to 6.3 percent of GDP in 2008 (under the 2008 Budget Call announced in July), which was supported by staff. The budget also entails major risks on both revenue and expenditure sides, raising questions on the feasibility of the authorities’ medium-term plan to reduce the budget deficit to 5 percent of GDP by 2010 (Table 1).
Sri Lanka: Summary of Central Government Operations, 2006–2011
(In percent of GDP, unless otherwise indicated)
Measures include tsunami expenditure and in 2005 interest savings from Paris Club debt moratorium.
Sri Lanka: Summary of Central Government Operations, 2006–2011
(In percent of GDP, unless otherwise indicated)
| 2006 | 2007 | 2008 | 2008 | 2009 | 2010 | 2011 | ||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| Budget | Projection | Budget | Staff Report Projections | |||||||||||
| Total revenue | 17.1 | 18.4 | 18.3 | 19.6 | 18.6 | 19.0 | 19.4 | 19.8 | ||||||
| Tax revenue | 15.3 | 16.6 | 16.3 | 17.7 | 16.8 | 17.2 | 17.6 | 18.0 | ||||||
| Income taxes | 2.9 | 3.1 | 3.4 | 3.7 | … | … | … | … | ||||||
| Value added tax/GST | 5.9 | 6.2 | 6.1 | 6.5 | … | … | … | … | ||||||
| Excise taxes | 3.3 | 3.3 | 3.3 | 3.5 | … | … | … | … | ||||||
| Taxes on international trade | 1.9 | 2.2 | 1.8 | 1.9 | … | … | … | … | ||||||
| Other | 1.4 | 1.8 | 1.7 | 2.1 | … | … | … | … | ||||||
| Nontax revenue | 1.7 | 1.8 | 1.9 | 1.9 | 1.8 | 1.8 | 1.8 | 1.8 | ||||||
| Total expenditure and net lending | 25.5 | 27.7 | 26.0 | 27.3 | 24.9 | 24.5 | 24.3 | 24.0 | ||||||
| Current expenditure | 19.6 | 18.4 | 19.0 | 18.6 | 18.4 | 18.0 | 17.8 | 17.5 | ||||||
| Civil service wages and salaries | 4.1 | 3.8 | 4.1 | 3.8 | 3.9 | 3.9 | 3.9 | 3.9 | ||||||
| Other civilian goods and services | 1.1 | 1.4 | 1.3 | 1.4 | 1.3 | 1.3 | 1.3 | 1.3 | ||||||
| Security related expenditure | 3.8 | 4.1 | 4.2 | 3.8 | 3.9 | 3.9 | 3.8 | 3.8 | ||||||
| Subsidies and transfers | 5.1 | 3.9 | 4.2 | 4.2 | 3.8 | 3.7 | 3.7 | 3.7 | ||||||
| Households | 3.7 | 3.1 | 3.3 | 3.2 | … | … | … | … | ||||||
| Of which: Samurdhi | … | 0.0 | 0.3 | 0.3 | … | … | … | … | ||||||
| pensions | … | 1.9 | 2.1 | 1.9 | 2.0 | 2.0 | 2.0 | 2.0 | ||||||
| petroleum | … | 0.0 | 0.0 | 0.0 | … | … | … | … | ||||||
| tsunami | … | … | … | … | … | … | … | … | ||||||
| Institutions, corporations, other government agencies | 1.4 | … | 0.9 | 1.0 | … | … | … | … | ||||||
| Interest payments 1/ | 5.4 | 5.2 | 5.2 | 5.5 | 5.5 | 5.2 | 5.1 | 4.8 | ||||||
| Foreign | 0.6 | … | 0.7 | 0.8 | 0.7 | 0.7 | 0.7 | 0.7 | ||||||
| Commercial | 0.4 | … | 0.4 | 0.4 | 0.4 | 0.4 | ||||||||
| Domestic | 4.8 | … | 4.1 | 4.7 | 4.4 | 4.1 | 4.1 | 3.8 | ||||||
| Capital expenditure and net lending | 5.9 | 9.3 | 7.0 | 8.7 | 6.5 | 6.5 | 6.5 | 6.5 | ||||||
| Of which: tsunami | 0.8 | 0.7 | 0.4 | 0.0 | 0.1 | 0.0 | 0.0 | 0.0 | ||||||
| mega projects | 3.6 | 1.6 | 3.7 | 1.5 | 1.5 | 1.5 | 1.5 | |||||||
| Overall balance | -8.4 | -9.2 | -7.8 | -7.7 | -6.3 | -5.5 | -4.9 | -4.2 | ||||||
| Overall balance (without tsunami measures) 1/ | -7.6 | -8.6 | -7.4 | … | … | … | … | … | ||||||
| Financing | 8.4 | 9.2 | 7.8 | 7.7 | 6.3 | 5.5 | 4.9 | 4.2 | ||||||
| Net external financing | 1.5 | 3.7 | 3.7 | 2.9 | 1.9 | 1.9 | 1.7 | 1.5 | ||||||
| Net commercial borrowing | 1.9 | … | 0.0 | … | 1.0 | 0.9 | 0.8 | 0.7 | ||||||
| Net other domestic financing | 3.9 | 4.8 | 3.3 | 4.0 | 3.0 | 2.3 | 2.0 | 1.6 | ||||||
| Privatization | 0.0 | 0.0 | 0.0 | 0.0 | 0.0 | 0.0 | 0.0 | 0.0 | ||||||
| Grants | 1.1 | 0.7 | 0.8 | 0.8 | 0.5 | 0.4 | 0.4 | 0.4 | ||||||
| Memorandum items: | ||||||||||||||
| Current account balance (excluding grants) | -2.5 | 0.1 | -0.8 | 1.0 | 0.2 | 1.0 | 1.6 | 2.3 | ||||||
| Primary balance (excluding grants) | -3.0 | -4.0 | -2.6 | -2.2 | -0.8 | -0.3 | 0.2 | 0.6 | ||||||
| Primary balance (including grants) | -2.0 | -3.3 | -1.8 | 0.1 | -0.3 | 0.1 | 0.6 | 1.0 | ||||||
| Paris Club debt moratorium | … | … | … | … | … | |||||||||
| Nominal GDP (in billions of rupees) | 2,802 | 3,242 | 3,311 | 3,825 | 3,825 | 4,420 | 5,106 | 5,900 | ||||||
| Total debt | 94.7 | 93.3 | 90.1 | 91.8 | 86.2 | 85.7 | 80.9 | 75.7 | ||||||
| Of which: domestic debt | 54.3 | 51.7 | 49.2 | 50.7 | 46.5 | 47.1 | 43.6 | 40.1 | ||||||
Measures include tsunami expenditure and in 2005 interest savings from Paris Club debt moratorium.
Sri Lanka: Summary of Central Government Operations, 2006–2011
(In percent of GDP, unless otherwise indicated)
| 2006 | 2007 | 2008 | 2008 | 2009 | 2010 | 2011 | ||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| Budget | Projection | Budget | Staff Report Projections | |||||||||||
| Total revenue | 17.1 | 18.4 | 18.3 | 19.6 | 18.6 | 19.0 | 19.4 | 19.8 | ||||||
| Tax revenue | 15.3 | 16.6 | 16.3 | 17.7 | 16.8 | 17.2 | 17.6 | 18.0 | ||||||
| Income taxes | 2.9 | 3.1 | 3.4 | 3.7 | … | … | … | … | ||||||
| Value added tax/GST | 5.9 | 6.2 | 6.1 | 6.5 | … | … | … | … | ||||||
| Excise taxes | 3.3 | 3.3 | 3.3 | 3.5 | … | … | … | … | ||||||
| Taxes on international trade | 1.9 | 2.2 | 1.8 | 1.9 | … | … | … | … | ||||||
| Other | 1.4 | 1.8 | 1.7 | 2.1 | … | … | … | … | ||||||
| Nontax revenue | 1.7 | 1.8 | 1.9 | 1.9 | 1.8 | 1.8 | 1.8 | 1.8 | ||||||
| Total expenditure and net lending | 25.5 | 27.7 | 26.0 | 27.3 | 24.9 | 24.5 | 24.3 | 24.0 | ||||||
| Current expenditure | 19.6 | 18.4 | 19.0 | 18.6 | 18.4 | 18.0 | 17.8 | 17.5 | ||||||
| Civil service wages and salaries | 4.1 | 3.8 | 4.1 | 3.8 | 3.9 | 3.9 | 3.9 | 3.9 | ||||||
| Other civilian goods and services | 1.1 | 1.4 | 1.3 | 1.4 | 1.3 | 1.3 | 1.3 | 1.3 | ||||||
| Security related expenditure | 3.8 | 4.1 | 4.2 | 3.8 | 3.9 | 3.9 | 3.8 | 3.8 | ||||||
| Subsidies and transfers | 5.1 | 3.9 | 4.2 | 4.2 | 3.8 | 3.7 | 3.7 | 3.7 | ||||||
| Households | 3.7 | 3.1 | 3.3 | 3.2 | … | … | … | … | ||||||
| Of which: Samurdhi | … | 0.0 | 0.3 | 0.3 | … | … | … | … | ||||||
| pensions | … | 1.9 | 2.1 | 1.9 | 2.0 | 2.0 | 2.0 | 2.0 | ||||||
| petroleum | … | 0.0 | 0.0 | 0.0 | … | … | … | … | ||||||
| tsunami | … | … | … | … | … | … | … | … | ||||||
| Institutions, corporations, other government agencies | 1.4 | … | 0.9 | 1.0 | … | … | … | … | ||||||
| Interest payments 1/ | 5.4 | 5.2 | 5.2 | 5.5 | 5.5 | 5.2 | 5.1 | 4.8 | ||||||
| Foreign | 0.6 | … | 0.7 | 0.8 | 0.7 | 0.7 | 0.7 | 0.7 | ||||||
| Commercial | 0.4 | … | 0.4 | 0.4 | 0.4 | 0.4 | ||||||||
| Domestic | 4.8 | … | 4.1 | 4.7 | 4.4 | 4.1 | 4.1 | 3.8 | ||||||
| Capital expenditure and net lending | 5.9 | 9.3 | 7.0 | 8.7 | 6.5 | 6.5 | 6.5 | 6.5 | ||||||
| Of which: tsunami | 0.8 | 0.7 | 0.4 | 0.0 | 0.1 | 0.0 | 0.0 | 0.0 | ||||||
| mega projects | 3.6 | 1.6 | 3.7 | 1.5 | 1.5 | 1.5 | 1.5 | |||||||
| Overall balance | -8.4 | -9.2 | -7.8 | -7.7 | -6.3 | -5.5 | -4.9 | -4.2 | ||||||
| Overall balance (without tsunami measures) 1/ | -7.6 | -8.6 | -7.4 | … | … | … | … | … | ||||||
| Financing | 8.4 | 9.2 | 7.8 | 7.7 | 6.3 | 5.5 | 4.9 | 4.2 | ||||||
| Net external financing | 1.5 | 3.7 | 3.7 | 2.9 | 1.9 | 1.9 | 1.7 | 1.5 | ||||||
| Net commercial borrowing | 1.9 | … | 0.0 | … | 1.0 | 0.9 | 0.8 | 0.7 | ||||||
| Net other domestic financing | 3.9 | 4.8 | 3.3 | 4.0 | 3.0 | 2.3 | 2.0 | 1.6 | ||||||
| Privatization | 0.0 | 0.0 | 0.0 | 0.0 | 0.0 | 0.0 | 0.0 | 0.0 | ||||||
| Grants | 1.1 | 0.7 | 0.8 | 0.8 | 0.5 | 0.4 | 0.4 | 0.4 | ||||||
| Memorandum items: | ||||||||||||||
| Current account balance (excluding grants) | -2.5 | 0.1 | -0.8 | 1.0 | 0.2 | 1.0 | 1.6 | 2.3 | ||||||
| Primary balance (excluding grants) | -3.0 | -4.0 | -2.6 | -2.2 | -0.8 | -0.3 | 0.2 | 0.6 | ||||||
| Primary balance (including grants) | -2.0 | -3.3 | -1.8 | 0.1 | -0.3 | 0.1 | 0.6 | 1.0 | ||||||
| Paris Club debt moratorium | … | … | … | … | … | |||||||||
| Nominal GDP (in billions of rupees) | 2,802 | 3,242 | 3,311 | 3,825 | 3,825 | 4,420 | 5,106 | 5,900 | ||||||
| Total debt | 94.7 | 93.3 | 90.1 | 91.8 | 86.2 | 85.7 | 80.9 | 75.7 | ||||||
| Of which: domestic debt | 54.3 | 51.7 | 49.2 | 50.7 | 46.5 | 47.1 | 43.6 | 40.1 | ||||||
Measures include tsunami expenditure and in 2005 interest savings from Paris Club debt moratorium.
7. Achieving the proposed tax revenue target of 17.7 percent of GDP in 2008 (from an estimated 16.3 percent in 2007) will be a challenge, in view of new measures estimated to yield only about 0.6 percent of GDP.
The budget introduced some base-broadening measures, including limiting tax holidays (i.e., by allowing the existing 5-year tax holidays to lapse, while restricting future tax holidays to 3 years for major investment only), further broadening the income tax base, and improving the collection of tax arrears. In addition, significant increases are proposed in excises on motor vehicles and other consumer durables, telecommunication, and liquor and cigarettes, as well as fees and levies on services. Measures on trade, including a broadening of the cess regime and an increase in surcharges on custom duties, could contribute to tax revenue, but they may also potentially distort the trade system.
At the same time, the budget granted numerous new tax concessions (including for the fishery, gem and jewelry, shipping, and textile industries), waived VAT on all key development projects, and substantially reduced VAT on petrol to partly offset the impact of price adjustments required under the automatic formula.
8. Recurrent expenditure is budgeted to be contained in real terms, but its potential overrun is sizable (estimated at around 2 percent of GDP).
The overall subsidies appear to be substantially underestimated in the budget. The authorities decided to deviate from the automatic pricing formula for diesel and kerosene, starting from January 1, 2008. The likely cost of this decision is estimated at about 1 percent of GDP, while the budget seems to have omitted this cost (by applying the oil price at $70 per barrel). Other subsidies, which are budgeted to decline by 0.4 percent of GDP from the level in 2007, also seem to be low.
Provisions for wages and salaries, as well as living and pension allowances, also seem to be low, particularly as a number of new measures is expected to boost recurrent spending. This includes the planned new recruitment of an additional 15,000 college graduates into public service, as well as additional funds to help resolve distressed debt of government employees. Preliminary estimates indicate that the costing of these policies could be around ½ percent of GDP.
Nevertheless, the ambitious capital budget, up by 2¾ percent of GDP (compared to the historical trend) or by 1¾ percent of GDP (compared to the projected level in 2007), could provide a buffer (as in the past).
9. Staff assessment indicates that the 2008 budget deficit target, at 7.7 percent of GDP, is only a marginal consolidation (from 2007) and subject to significant risks of deficit overrun, with heightened risks for debt sustainability and that could adversely affect debt distress. Even if tax revenue targets are fully met, there could still be a potential overrun in the recurrent spending, amounting to about 2 percent of GDP, mainly due to oil subsidies and wages and allowances.1 In addition, to ensure the credibility of the authorities’ medium-term fiscal consolidation plan, there is a need to overperform the 2008 budget deficit target by about 1¼ percent of GDP in order to deliver the fiscal consolidation path planned earlier.
10. Staff calls for a total fiscal adjustment of about 1¼ percent of GDP (after adjusting the buffer of 2 percent of GDP in the capital budget) to deliver the fiscal deficit of 6¼ percent of GDP in 2008 as indicated in the Staff Report. To this end, implementing concrete revenue measures under the budget to deliver their intended targets will be crucial. Additional measures to further streamline tax exemptions and broaden the VAT base may also be needed to ensure that the impact of new tax incentives in the budget will be fully compensated.
11. On the expenditure side, staff urge the authorities to conduct an early review of oil subsidies in light of the recent developments in world oil prices. The decision to deviate from the automatic pricing formula for diesel and kerosene in 2008 could expose the budget to large fiscal and quasi-fiscal risks, as recent increases in international oil prices seem unlikely to be reversed any time soon. The authorities are encouraged to consider full, or at a minimum, substantial partial pass-through to contain these risks, and also to help promote energy conservation. This should be supported by a stronger social safety net to protect the poor.
12. The new public hiring is expected to have a lasting impact on the budget. While near term corrective measures may be required, the authorities should also seek assistance from the World Bank to review the need for civil service reform, aimed at containing the overall wage bill in real terms as stipulated under the authorities’ medium-term consolidation plan.
Military expenditure is budged at 3.9 percent of GDP in 2008, compared to the projected 4.2 percent of GDP in 2007.