Sri Lanka
Request for Stand-By Arrangement -Staff Report; Staff Supplements; Press Release on the Executive Board Discussion; and Statement by the Executive Director for Sri Lanka

This paper discusses a request from the Sri Lankan authorities for a Stand-By Arrangement (SBA). The proposed SBA (of 400 percent of quota or SDR1.65 billion) would aim to smooth adjustment to the external shock that has hit the country, restore health to the country’s public finances, allow for greater exchange rate flexibility, address weaknesses in the financial system, and protect the most vulnerable from the burden of the needed adjustment. In addition, the IMF program will provide a basis for the authorities to approach donors for supporting a longer-term reconstruction program.

Abstract

This paper discusses a request from the Sri Lankan authorities for a Stand-By Arrangement (SBA). The proposed SBA (of 400 percent of quota or SDR1.65 billion) would aim to smooth adjustment to the external shock that has hit the country, restore health to the country’s public finances, allow for greater exchange rate flexibility, address weaknesses in the financial system, and protect the most vulnerable from the burden of the needed adjustment. In addition, the IMF program will provide a basis for the authorities to approach donors for supporting a longer-term reconstruction program.

I. Context

1. Nature of the shock. Years of lax fiscal policy forced the government to rely increasingly on short-term financing from international markets. The global financial shock resulted in a sudden stop to this financing and in capital outflows. In an effort to keep the exchange rate from depreciating the central bank had until recently intervened heavily in the foreign exchange market, with reserves reaching dangerously low levels. The loss of competitiveness and a sharp fall in demand for Sri Lankan exports are likely to put additional pressure on reserves, increasing the balance of payments gap further. Despite a rebound in short-term capital inflows following the end of the conflict with the LTTE, reserves remain low and foreign exchange needs significant.

2. Growth. The growth outlook has deteriorated markedly since last year. Growth is set to fall from 6 percent in 2008 to 3 percent this year on account of the slowdown in domestic economic activity and weak external demand. The effects of a drought earlier this year hurt the agricultural sector, and growth in tourism and the construction sector slowed sharply. The end of the conflict is projected to result in increased economic activity although the full impact is not likely to be felt until next year.

3. Inflation. Inflation peaked at 28 percent in June 2008 driven by high global prices for food and fuel, but the decline in these prices and tight monetary policy have reduced inflation to single digits in 2009.

4. External sector. Lower oil prices should reduce the current account deficit significantly to 1¼ percent of GDP from 9½ percent in 2008 despite an expected 13 percent decline in merchandise exports. Nevertheless, the reversal of capital inflows since September 2008 has sharply worsened the overall balance of payments. With the exchange rate effectively pegged to the dollar, the appreciation of the real effective exchange rate (since end-2006) peaked at 22 percent in March 2009, before falling to 19 percent in June. Notwithstanding the modest depreciation of the currency since September 2008 and the sharp decline in inflation, competitiveness remains an issues. In May Standard & Poor’s downgraded their outlook on Sri Lanka citing the country’s weak external position, large fiscal deficit, and uncertainty about a loan agreement with the IMF.

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Gross Foreign Exchange Reserves

(Billions of U.S. Dollars)

Citation: IMF Staff Country Reports 2009, 310; 10.5089/9781451823615.002.A001

5. Capital flows. Project-related inflows, mainly from Japan, China, and multilateral donors remained broadly stable, but short-term private sector inflows had reversed sharply before the recent modest recovery. In the third quarter of 2008, more than $400 million in nonresident holdings of government t-bills were redeemed, and since then about $225 million in syndicated loans were not rolled over. An additional $550 million of official and private external debt service is falling due in the second half of 2009. These outflows, together with net external payments from the state oil company, sharply reduced central bank foreign exchange reserves from a peak of $3½ billion in mid-2008 to a low of around $900 million in March 2009. Reserves have recovered somewhat, partly on account of a rebound in inflows to the Treasury Bill market since the end of the war, and currently stand at $1½ billion or about 7 weeks of imports.

6. Financial sector. Stresses in the financial sector are increasingly apparent. The failure of an unregulated finance company in early 2009 led to deposit withdrawals from Seylan bank, a systemically important bank. Although short-run liquidity conditions have stabilized following the takeover of Seylan Bank by the central bank, the deterioration of system-wide asset quality and contagion effects from weaknesses in smaller finance companies exposed to real estate remain concerns. Non-performing loans for even the larger banks have begun to rise reflecting the slowdown of growth, although the banks are still well capitalized and liquid.

7. Conflict and political situation. The government’s military campaign against the LTTE is over. Sri Lanka has entered a new post-conflict era faced with numerous challenges relating to humanitarian relief, resettlement of people displaced by the war, and political reconciliation. At the same time the end of the war has opened up the opportunity for the long-term development of the North and a resurgence in economic activity. Partly as a result of its success in ending the 2½ decade long conflict with the LTTE, the ruling party’s popularity is very high and the coalition government has achieved victories in recent provincial and local elections. It is expected that democratic institutions and electoral politics can soon be re-established in the Northern province, with local government elections scheduled to take place in August this year.

II. Policies

8. Fiscal policy. Sri Lanka has run chronically high budget deficits for the last several years with an average deficit for the central government of around 8 percent of GDP. With no policy adjustment the deficit for 2009 would deteriorate to more than 9 percent of GDP. Expenditures are on a declining trend, reflecting a fall in subsidies and transfers and the civil service wage bill. But revenues have also declined by an average of ¾ percentage points of GDP per year since 2006, in part because of tax exemptions granted under the Board of Investment (BOI) Act and the Inland Revenue Act. The 2009 budget reduced the VAT rate from 15 percent to 12 percent—resulting in an additional revenue loss of ¾ percent of GDP—and included a temporary, targeted, and sector specific stimulus package estimated at about ¼ percent of GDP. Public sector gross debt is now in the range of 80 percent of GDP, and its trajectory—in the absence of corrective steps—is unsustainable. The government has pledged to reduce the fiscal deficit to 5 percent of GDP by 2011, but sufficient steps to achieve this goal have thus far not been implemented.1

9. Public enterprises. Adding to the central government budget outturn, losses in 2008 for the state oil company were significant as high international oil prices were not fully passed through, and the state owned electricity company also experienced losses despite a 35 percent increase in electricity tariffs in March 2008. As a result the deficit for the two largest state enterprises increased to nearly 1¼ percent of GDP.2

10. Monetary policy. Until recently, large unsterilized foreign exchange intervention has led to a dramatic tightening of monetary conditions, with reserve money growth near zero in 2008. The loss of foreign financing of the budget has further squeezed private sector credit growth and real interest rates remain high. With inflation and domestic demand declining, the central bank has taken steps to loosen monetary policy, lowering reserve requirements from 10 to 7 percent and reducing the policy rates. At the same time the central bank has taken important steps to improve its conduct of monetary policy including eliminating the penal rate and effectively reestablishing the policy rate corridor, thereby significantly reducing the volatility of interbank interest rates.

11. Exchange rate policy. After maintaining a de facto exchange rate peg to the U.S. dollar since end-2007, the central bank announced a more flexible exchange rate regime in October 2008. While the exchange rate was allowed to depreciate by more than 6 percent until end-February 2009, the central bank continued to use large amounts of reserves to prevent the rate from depreciating further. Moreover, the central bank introduced restrictions in the form of margin requirements on a wide range of consumer goods, while raising existing margin requirements on vehicles, to reduce pressure on reserves. Since the start of program discussions in mid-March, the central bank stopped selling and started purchasing foreign exchange from the market, allowing the exchange rate to depreciate by a further 4 percent. More recently, short-term capital inflows into the treasury bill market and current account inflows following the war’s end have put upward pressure on the rate but in line with the program’s goals, the authorities have responded by stepping up foreign exchange purchases to prevent further appreciation.

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Sri Lanka: Central Bank Intervention in Forex Market

In millions of U.S. dollars

Citation: IMF Staff Country Reports 2009, 310; 10.5089/9781451823615.002.A001

Sources: Bloomberg LP.; and Central Bank of Sri Lanka.

12. Financial sector policies. The central bank has replaced the management of Seylan Bank and instructed the bank to issue shares to the public and pre-qualified institutional investors by end-August 2009 sufficient to restore the bank’s capital adequacy. Going forward, the central bank plans to address current weaknesses in the bank resolution framework including provisions for mergers and acquisitions and the liquidation of troubled banks. The government has taken steps to address problems faced by regulated finance and leasing companies including by providing temporary liquidity and encouraging consolidation. However, failures in the unregulated finance sector have not yet been addressed.

III. Program Discussions

13. Context. The authorities fully recognize the challenges they face. They realize the need to rebuild reserves and restore the competitiveness of their export sector, take measures to reverse the deterioration of the budget deficit, and head off problems in the financial sector. They view a Fund-supported program as fully consistent with these policy goals. At the same time, they see the end of the conflict as an opportunity to address the substantial reconstruction needs of affected areas, particularly in the North, and recognize that a strong track record under a Fund-supported program could help mobilize donor support to meet these needs. To this end the program aims to bring about credible deficit reduction required for debt sustainability while ensuring the availability of resources for post-war reconstruction, rebuild reserves to prudent levels while also allowing an orderly exchange rate adjustment sufficient to restore external viability, and to put in place a framework to ensure the soundness of the financial sector, resolve problem banks, and rebuild confidence. The authorities believe that this program will enable to them to maintain the impressive growth witnessed by Sri Lanka in recent years.

14. Path for budget deficit reduction. The authorities are strongly committed to achieving their policy goal of reducing the central government budget deficit to 5 percent of GDP by 2011, setting a target of 7 percent for 2009 (compared to a baseline of 9½ percent and a deficit of 7¾ percent in 2008), and 6 percent for 2010. They are also committed to bringing the accounts of the two largest state enterprises to balance by 2011. To address concerns about debt sustainability and the past over-reliance on short term external financing, the program’s fiscal adjustment—in contrast to most recent Fund-supported programs—is necessarily procyclical with a negative fiscal impulse at a time of a sharp slowdown in growth. While a countercyclical fiscal policy would be desirable to stimulate growth in the current weak economic environment, the program aims to strike a balance between limiting the contractionary fiscal impulse and moving the budget toward a sustainable medium-term path.

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Sri Lanka: Fiscal Impulse 1/

(In percent of GDP)

Citation: IMF Staff Country Reports 2009, 310; 10.5089/9781451823615.002.A001

Source: Fund staff estimate.1/ Negative impulse implies policy tightening

15. Revenue measures in 2009. The authorities understand that the most sustainable way to raise revenues is to broaden the base of direct and indirect taxes through reducing the array of exemptions under the Inland Revenue Act and BOI Law. To this end, the Inland Revenue Act was amended in 2008 to limit new tax holidays to a maximum of three years, and to notify that tax holidays already granted under the Inland Revenue Act or the BOI law would not be extended beyond their current period of expiration. Given the need to raise additional revenue this year, the authorities focused on measures that would have an immediate yield, totaling 1¼ percent of GDP for the remainder of the year. Measures include:

  • Increasing the nation building tax rate from 1 percent to 3 percent effective May 2009 yielding 2/3 percent of GDP for the remainder of 2009 (Text Table 1). The budget for 2009 introduced this tax at 1 percent, but the authorities have now raised the rate to 3 percent. The base for this tax is largely the same as the VAT. This measure is now fully in place.

  • Raising excise taxes on liquor, cigarettes, and selected consumer items effective April 2009. The expected yield from these measures is ¼ percent of GDP for the remainder of 2009. This measure has already been implemented.

  • Repealing import margin requirements on consumer goods introduced last fall and the margin requirements already in place prior to that. These requirements sharply reduced imports of high revenue-yielding items. In addition, cesses and other trade taxes have been increased resulting in an expected tax yield of 1/3 percent of GDP. These measures have already been implemented.

Table 1:

Revenue and Expenditure Measures under the Program, 2008-2011

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The yield of measures in 2009 is on a nine-month basis.

Includes lower domestic interest under the program scenario and adjustments to budget allocation for capital spending.

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Fiscal Adjustment in Recent IMF Programs 1/

Citation: IMF Staff Country Reports 2009, 310; 10.5089/9781451823615.002.A001

Sources: IMF Program documents.1/ Latest projections.2/ Hungary, Georgia, Kyrgyz Republic, and Ukraine.

16. Expenditure measures in 2009. The authorities are committed to cutting spending by ½ percent of GDP relative to the 2008 budget outturn, while maintaining the level of capital spending and preserving expenditure allocations to protect the most vulnerable groups in society. To protect the vulnerable groups in society, social sector spending is targeted to increase to 7 percent of GDP in 2009 from 6.8 percent in 2008. In addition, the Government also is taking action to provide immediate relief and expand social safety net spending to resettle the displaced persons in the North within the shortest possible time.

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Special Projects for Welfare & Resettlement of IDPs

Citation: IMF Staff Country Reports 2009, 310; 10.5089/9781451823615.002.A001

17. Performance in first four months in 2009. In line with staff projections, revenues in the first four months were about 10 percent below the levels in the same period last year reflecting the collapse in tax yielding imports. At the same time, expenditures have run about 28 percent higher, primarily reflecting repayments of domestic debt contracted at much higher nominal interest rates prevailing during the second half of last year (with annualized treasury bill rates averaging about 20 percent) and the drying up of lower cost external funding. As a result, during this period the central government deficit amounted to around 4 percent of annual GDP. For the remainder of the year, revenues are expected to pick up pace in line with the projected pick up in imports and the yield of the tax measures taking effect beginning in May. The sharp decline in interest rates—from above 17 percent at end-2008 to approximately 11½ percent at end-April—is expected to bring down the domestic interest bill significantly. The pace of goods and services expenditures are projected to slow in line with the authorities’ commitments under the program. Together, these factors are expected to narrow the budget deficit during the remainder of 2009. The authorities have also identified areas where spending on low-priority investment projects could be cut or postponed if necessary, and are committed to making further cuts in spending on civilian goods and services in the event the expected revenue does not materialize and the budget targets come under threat.

18. Fiscal measures in 2010 and 2011. Part of the adjustment needed to reach the targets will come from the full-year effect of the new revenue measures introduced in 2009. In addition, the President has formed a tax commission to review current tax policy and to make recommendations on strengthening tax collection, tax auditing and enforcement, and simplifying the tax system, including a review of the tax incentive system administered by the Board of Investment. The authorities anticipate that the commission will also review the VAT with the intention of broadening the base. The interim report of this commission will be discussed during the second program review with a view to identifying base broadening measures to be included in the 2010 budget. As any new revenue measures yield results, temporary taxes—such as import surcharges—will be gradually phased out. The government has requested technical assistance from FAD to focus and assist the work of the Commission, by assessing the major elements of the tax system and providing advice on tax policy issues. On the expenditure side the authorities understand that additional cuts are needed to reduce the deficit further and make room for reconstruction spending. They envisage that these cuts would come from savings from security related spending and a reduction in transfers. The budget for 2010 is expected to be finalized in November 2009. Ahead of this measures to fill the 2010 budget gap will be discussed during the first review at the time when budget preparations are in the early process.

19. Public enterprises. With the fall in oil prices, the combined deficit for the two large public enterprises, the Ceylon Electricity Board (CEB) and the Ceylon Petroleum Corporation (CPC), is expected to decline in 2009. Nevertheless additional steps may be needed to ensure that the government achieves its goal of reaching a balanced budget for these enterprises by 2011. As a first step the government established an independent regulator for the electricity sector in March 2009 and are moving toward lower cost electricity generation. Also, retail prices of petrol and diesel were raised by 5-10 percent in July 2009, broadly consistent with a full pass-through of the recent increase in international oil prices. In addition, the authorities will put in place a mechanism for a regular review of the operational cash flows of these enterprises and have committed to take any adjustments—including to tariffs, management and operations—needed to bring the enterprises to break even by 2011. Any subsidies will be targeted to vulnerable groups and transparently reflected in the government budget. To monitor the operations of the enterprises and to make appropriate recommendations, the government has appointed a Joint Review Mechanism through a committee consisting of high-level representatives from the Ministry of Finance, the CEB, the CPC, and the central bank. The committee is expected to complete its report by mid-August. Progress on these steps will be assessed at the time of program reviews. The authorities have also agreed to develop a plan to address outstanding debts between the key state-owned enterprises by end-December 2009.

20. Reconstruction. Addressing the reconstruction needs of areas affected by the conflict will require a substantial effort over the next several years. The government has formed a high-level task force which is in the process of conducting a comprehensive needs assessment. At the same time significant efforts are being made to address the humanitarian needs of those affected by the conflict and to ensure the timely resettlement of internally displaced persons (IDPs) (see Box 1).

21. Financing the reconstruction. While reconstruction spending needs in the years ahead will be considerable, they will need to be balanced against the need to preserve debt sustainability. In 2009 the government intends to make room within the existing deficit targets for spending on humanitarian assistance and the resettlement of IDPs using savings in other spending categories and redeploying military personnel for demining and for the provision of basic infrastructure. The broader reconstruction strategy will be based on the needs assessment which is expected to be completed by the end of July. The experience in the Eastern province suggests that reconstruction needs could amount to about 1 percent of GDP per year. Financing for this reconstruction will be through revenue enhancements, savings in military spending of approximately ¾ -1 percent by 2011 (see Box 2) and external financing in the form of concessional loans and grants from development partners. Staff will determine during program reviews the extent to which the deficit target should be adjusted to accommodate externally financed reconstruction spending in order to preserve debt sustainability. Important factors in this assessment will include the productivity of the reconstruction projects and the concessionality of donor financing.

The post-war reconstruction plan for the Northern province

The authorities have moved quickly to provide humanitarian assistance to those affected by the conflict and to develop a post-war reconstruction plan. Their immediate priorities include satisfying the humanitarian needs of the estimated 300,000 internally displaced persons (IDPs) currently in camps while working to ensure the resettlement of 70-80 percent of IDPs within 180 days. Work is also underway on a broader reconstruction plan for the Northern province.

The overall reconstruction strategy is built on the experience gained during the reconstruction of the Eastern province which started in 2007. It is based on four Ds: (i) demilitarization; (ii) development; (iii) democratization; and (iv) devolution. Demilitarization includes demining—which is being done by the military with the assistance of local and international NGOs—as well as the restoration of law and order. Development includes the resettlement of IDPs—a process which has already begun—and the restoration of basic services including water, electricity, and education, and the development of economic and social infrastructure in consultation with local officials and communities in the affected areas. Democratization includes conducting local government and provincial council elections, the first of which are scheduled to take place in August, as well as the election of a Chief Minister for the Northern province.

A newly established Presidential Task Force for Resettlement, Development, and Security in the Northern province is leading the reconstruction effort. In addition to preparing plans for early resettlement, the task force will also be in charge of planning and monitoring implementation of the rehabilitation and development of economic and social infrastructure in the Northern province. A consultative committee of humanitarian assistance—which includes representatives from the international community—has also been set up to advise on issues relating to humanitarian assistance and the provision of basic services to IDPs.1

Reconstruction spending this year is being accommodated within existing budget limits. In particular, the authorities have allocated Rs. 18 billion (2 percent of projected central government spending) in the 2009 budget to reconstruction spending in the North. The majority of this is being used for the provision of humanitarian assistance and the resettlement of IDPs. A needs assessment is currently underway to determine additional funds needed for the broader reconstruction strategy and once completed, the authorities envisage approaching donors for financing assistance, as they did in the case of the tsunami and the Eastern province.

1/ The committee—including representatives of various UN agencies, the ICRC and the WHO, and representatives of the governments of the U.S., Sweden and Japan—last met on May 11, 2009.

Sri Lanka: Developments in Security-Related Spending

Over the past decade, security-related spending in Sri Lanka has fluctuated, broadly reflecting the intensity of conflict with the LTTE.1 As the conflict with the LTTE intensified, security-related expenditure rose from 3.3 percent of GDP in 2005 to 3.9 percent in 2008. During this period, defense wages have been relatively stable in a range of 1.5-1.7 percent of GDP, while defense spending on goods and services increased.

Sri Lanka’s military expenditure as a share of GDP is higher than World and regional averages. The authorities do not expect significant reductions in military spending for 2009, but see some scope for military savings in 2010 and 2011. In the context of reconstruction, a needs assessment is expected to determine additional funds needed, which will be found primarily through revenue enhancement, savings in military spending beginning with the 2010 budget, and additional donor financing (see paragraph 11 of MEFP).

Comparative Military Expenditure, 2008

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Source: Stockholm International Peace Research Institute.

South Asian Association for Regional Cooperation, including Afghanistan, Bangladesh, Bhutan, India, Maldives, Nepal, Pakistan and Sri Lanka.

1/ Expenditure on public order and safety (police, immigration, etc) is included in this measure.

22. Exchange rate policy and reserve targets. Rebuilding reserves while addressing the loss of competitiveness and restoring external viability are central policy aims of the program. To this end the program targets a reserve buildup to more than 3½ months of imports ($4 billion) by the end of the program period.

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Sri Lanka: Share of World Exports

(In percent, 12mma)

Citation: IMF Staff Country Reports 2009, 310; 10.5089/9781451823615.002.A001

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Exchange Rate Depreciations

(In percent since end-2007)

Citation: IMF Staff Country Reports 2009, 310; 10.5089/9781451823615.002.A001

23. Restoring external competitiveness. A return to external viability will require addressing the loss of competitiveness, which is evidenced by the steady decline in its export market share. Moreover, Sri Lanka will face stiff competition once a global recovery begins to emerge from other competing countries which have already adjusted, particularly for garments exports. While the program is anchored on reserve targets, the exchange rate would need to be sufficiently flexible to address these circumstances. To ensure that the source of the reserve buildup is through current account adjustment rather than external borrowing as was previously the case, the program is designed to adjust the net international reserve targets upward for short-term capital flows into the domestic bond market. Because the supply and demand for foreign exchange will be uncertain over the program period, the program includes a clause whereby the authorities would consult with the Fund staff on the appropriate policy response in the event that the gap between supply and demand of foreign exchange results in a more sudden and disruptive depreciation of the exchange rate than anticipated by the staff and authorities.

24. Monetary policy. Consistent with the floating exchange rate regime—and given the absence of an effective interest rate transmission mechanism—base money will continue to anchor monetary policy. The program’s monetary targets aim to control inflation while ensuring adequate credit to the private sector.

25. Financial sector reforms. The program entails a comprehensive and ambitious structural reform agenda for shoring up the financial sector and addressing recent problems. Measures include:

  • Resolving the remaining issues from the takeover of the systemically important Seylan Bank. The central bank has already directed Seylan Bank to issue Rs. 3 billion in share capital at the prevailing market price to recapitalize the bank.

  • Consolidation of weak finance and leasing companies with the aim of avoiding spillovers to healthy financial institutions.

  • Developing a contingency plan to deal with potential stresses in the financial system.

  • Implementing a wide range of measures to improve financial sector regulation, focused in part on strengthening capital requirements and banks’ integrated risk management frameworks.

  • Amending laws and regulations to improve the bank resolution framework and address the major supervisory gaps in the banking, credit card, and finance company sector.

26. Social policies. With 15 percent of the population below the poverty line, and large numbers of people in the North and East displaced by the conflict, the economic downturn will undoubtedly have significant social consequences. It is essential therefore that the program protect expenditures on social transfers to Sri Lanka’s most vulnerable. The current budget allocation achieves this goal, and the staff will coordinate with the authorities, the World Bank, and other donors to ensure these objectives are met going forward. The safety net system comprises Samurdhi, the main cash transfer program to address chronic poverty and channel disability payments. In addition, the system provides limited social welfare and care services, and disaster relief to displaced persons.

27. Safeguards. A safeguards assessment was concluded in May and found that the CBSL had developed a relatively strong safeguards framework. The CBSL is committed to working with IMF staff in the coming months to implement the recommendations outlined in the assessment report with a focus on the priority recommendations in the areas of external audit and data reporting.

IV. Program Modalities

28. Access. Given the steady depletion of foreign currency reserves, the potential for non-resident deposit outflows, and fragile confidence in the local currency, the program will need to ensure a substantial increase in resources available to the central bank. An excessive depreciation of the currency would be very damaging to the financial system given foreign currency dominated lending to borrowers who lack a natural hedge. Normal access would be insufficient to achieve a reasonable level of reserves while preventing a disorderly exchange rate adjustment. Exceptional access from the Fund of 400 percent of quota (SDR 1.65 billion) during the course of the 20 month Stand-By Arrangement would help reinforce confidence and avert a balance of payments crisis (the four criteria for exceptional access are reviewed in Box 3). Sri Lanka’s access during the first year under the proposed SBA would exceed 200 percent of quota. Sri Lanka is therefore subject to the requirements under the current exceptional access policy. With access at this level, the program would be fully financed.

29. Phasing. The proposed program envisages a flat purchase schedule. The first purchase would be around $313 million.

30. Other donor financing. The World Bank’s Country Assistance Strategy (CAS) includes approximately $100 million of funds earmarked for existing projects in the Northern province that have already been committed but not yet disbursed. An additional $225 million annually is earmarked for sectoral projects it could in theory be used for reconstruction projects if needed and requested by the government. In this context, the World Bank is in preliminary discussions with the authorities on funding community development projects in the Northern province which aim to facilitate the resettlement of IDPs. The AsDB recently concluded a $160 million loan agreement to fund the development of the power sector in Sri Lanka and has indicated that the government could qualify for up to $150 million in budget support—with co-financing from Japan—once the Fund-supported program is approved. If this budget support materializes, it would replace more expensive domestic financing and could help reduce the interest bill from levels currently assumed in the program. In addition, Japan has indicated that they intend to continue with the annual lending program of about ¥25-30 billion focused on infrastructure projects in the water, power and road sectors.

Sri Lanka: Exceptional Access Request

  • I. The member is experiencing or has the potential to experience exceptional balance of payments pressures on the current or capital account resulting in a need for Fund financing that cannot be met within the normal limits. The balance of payments pressures are predominantly on the capital account. Although there has been a recovery in capital inflows following the end of the conflict, these are mostly of a short-term and speculative nature and could rapidly reverse. Thus the reserve position remains fragile, and there could be a resurgence of pressures in the foreign exchange market. Preventing these pressures from emerging is a key objective of the program, justifying the need for exceptional access to replenish the weak international reserve position and bolster confidence in the currency.

  • II. A rigorous and systemic analysis indicates that there is a high probability that the member’s public debt is sustainable in the medium term. The external and public debt sustainability analysis indicates that Sri Lanka has a moderate risk of debt distress. However, the comprehensive package of medium-term policies implemented as part of the proposed SBA-supported program, including bringing the fiscal deficit down to 5 percent of GDP by 2011 and a return to a more flexible exchange rate regime, would substantially reduce the risk of debt distress (including from private sector spillovers) and ensure public debt sustainability going forward.

  • III. The member has prospects of gaining or regaining access to private capital markets within the timeframe when Fund resources are outstanding. In the past few years, Sri Lanka has had good access to private markets having floated its $500 million maiden sovereign bond in October 2007 and raised various syndicated loans amounting to $100-150 million each over the past few years, the last one being in June 2008. In the first half of 2008, the government of Sri Lanka also sold US$600 million in domestic-currency denominated Treasury Bills to nonresident investors. There is no reason to believe that as private capital markets normalize, Sri Lanka could not regain similar access.

  • IV. The policy program of the member country provides a reasonably strong prospect of success, including not only the member’s adjustment plans but also its institutional and political capacity to deliver that adjustment. As always, there are risks to the program. However, the broad policy framework outlined above provides the basis for averting the pending economic and social crisis, and the program entails strong upfront actions to demonstrate ownership. These include spending and revenue measures consistent with achieving the program target for 2009 and a commitment to stem the loss of reserves in the period leading up to the Board meeting. In the event, the authorities have begun rebuilding reserves by purchasing large amounts of foreign exchange from the market in response to the recent rebound of capital inflows. The government’s institutional and political capacity to deliver the program’s adjustment is strong. The high popularity of the government provides room to take tough measures when needed. Professionals in the civil service, particularly in the Central Bank and the Ministry of Finance, are experienced and skilled. A relatively sophisticated foreign exchange market could rapidly adapt to a return to exchange rate flexibility.

31. Conditionality. Conditionality is focused on achieving the programmed deficit reduction, building reserves and restoring external viability, and safeguarding financial sector stability. The quantitative and qualitative conditionality is described in Tables 1-3 attached to the government’s Memorandum of Economic and Financial Policies. Reviews will be based on quantitative performance criteria assessed quarterly during the program period.

Table 1.

Sri Lanka: Selected Economic Indicators, 2006–2011

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Sources: Data provided by the Sri Lankan authorities; CEIC Data Company Ltd.; Bloomberg LP.; and Fund staff estimates and projections.

Staff projections of domestic interest costs are based on a weighted average of yields on government paper. Actual interest payments have, however, averaged about 2 percent points of GDP lower in 2006-08. The consolidated government balance includes the Ceylon Electricity Board and the Ceylon Petroleum Corporation.

Excluding central bank Asian Clearing Union (ACU) balances.

Staff estimates based on total stock outstanding of foreign exchange commercial debt plus nonresident purchase of rupee-denominated treasury bonds.

Table 2.

Sri Lanka: Summary of Central Government Operations, 2006–2011

(In percent of GDP, unless otherwise indicated)

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Sources: Data provided by the Sri Lankan authorities; and Fund staff estimates.
Table 3.

Sri Lanka: Monetary Accounts, 2006–2011

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

32. Prior actions. The authorities have implemented all prior actions (Text Table 2). On the budget side the authorities have taken the necessary steps to implement the agreed revenue measures and eliminate all import margin requirements, including those that were in place prior to the additional requirements introduced October 2008. The central bank has also ceased sales to the foreign exchange market and shown a readiness to allow the exchange rate to be more flexible reflecting the need to rebuild reserves to meet the program targets. Indeed, the central bank has purchased more than $400 million of foreign exchange since March.

Table 2.

Sri Lanka: Prior Actions and Structural Conditionality

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33. Capacity to repay. If the government carries out its commitment to maintaining a competitive exchange rate and rebuilding reserves, Sri Lanka’s strong export base gives reasonable assurances of the capacity to repay the Fund. If purchases are made as scheduled, there will be a peak in repurchases to the Fund in 2014. The staff’s Debt Sustainability Analysis shows that with a floating exchange rate the central bank would accumulate enough reserves to repay the Fund and maintain a level of gross reserves of at least 3½ months of imports. The authorities have expressed their willingness to consider a transition to a concessional arrangement once the immediate crisis has been averted, which would help establish a program for reconstruction and other investment spending and facilitate a steady path of structural reform over a longer horizon.

34. Debt sustainability analysis. The external debt sustainability analysis indicates that Sri Lanka has a moderate risk of external debt distress over the medium term. The comprehensive package of medium term policies implemented as part of the program, especially bringing the fiscal deficit down to 5 percent of GDP by 2011 and a return to a more flexible exchange rate regime, if fully implemented, would bring Sri Lanka to a sustainable path.3

V. Risks

35. There are substantial risks to the program. While the program’s economic goals are consistent with the government’s own intentions, achieving these goals will require a great deal of government commitment to implementing necessary measures, particularly for the budget and the exchange rate. At the same time, the end of the war would have a positive economic impact.

  • Exchange rate and reserves. Prior to entering program discussions the government had shown a willingness to defend a stable exchange rate at the expense of two-thirds of the country’s reserves. The program will require however a sharp departure from this policy view. In program discussions the authorities strongly maintained their commitment to the program’s reserve targets, and recent actions by the central bank to purchase foreign exchange from the market while allowing the rate to depreciate have demonstrated the credibility of this commitment, but this commitment may be tested going forward.

  • Fiscal risks. The government has expressed strong ownership of the program’s fiscal targets and has taken significant steps to boost revenues while recognizing the need to cut expenditures to meet these targets and create the room for reconstruction spending over the medium term. Nevertheless, the government has had a poor track record of fiscal adjustment. Moreover, the quality of the revenue measures taken so far is less than ideal, while the expenditure cuts will be politically difficult. The program includes steps to develop a more comprehensive revenue reform and to solidify expenditure cuts, and includes a commitment by the authorities to undertake additional expenditure cuts to offset revenue shortfalls. However, there may be a need for further measures to address fiscal shortfalls as the program progresses. There is also a risk that meeting the fiscal targets will result in a second best reliance on cuts in politically sensitive capital spending.

  • Foreign exchange deposits. A sudden withdrawal of non-resident foreign exchange deposits from the banking sector would put pressure on reserves and could jeopardize the program’s reserve targets. However, at this stage this risk appears relatively low. These deposits are related to remittances inflows and are for the most part not speculative in nature, and an IMF program would help reassure depositors and mitigate the risk of a large outflow.

  • Financial sector. Weaknesses in the financial sector are likely to increase as the economy slows, and the program is designed to address existing weaknesses and establish an orderly and transparent method for dealing with problems should banks experience a rapid increase in nonperforming loans. While a sudden system-wide withdrawal of deposits is unlikely, there is a risk that problems could emerge in systemically important banks and reduce confidence in the banking sector as a whole.

  • Output growth. Sri Lanka’s trading partners could see a more rapid growth slowdown than currently expected, reducing exports and overall growth. Prolonged real exchange rate overvaluation could also put a drag on export and output growth.

  • Possible peace dividend. On the upside, the war’s end has already led to an increase in remittances and other capital inflows. If these continue the outlook for the balance of payments and for growth could be better than forecasted. On the downside, delays in the authorities’ willingness to follow through on commitments to put in place a political solution to ease ethnic tensions may adversely affect donor participation and northern reconstruction.

VI. Staff Appraisal

36. Overview. Sri Lanka has been hit hard by the global financial crisis. Several years of lax fiscal policy, reliance on short-term external financing, and an overvalued exchange rate had left the country particularly vulnerable to this shock. There is now an urgent need for the government to enact policies to shore up the balance of payments, rebuild reserves, reverse the deterioration of the budget deficit, and head off problems in the financial sector.

37. Program. The authorities’ program aims to bring about credible budget deficit reduction required for debt sustainability, rebuild reserves to prudent levels while also allowing an orderly exchange rate adjustment sufficient to restore external viability, and put in place a framework to ensure the soundness of the financial sector, resolve problem banks, and rebuild confidence.

38. Reconstruction. Beyond this, the end of the conflict provides the government with the opportunity to address the substantial reconstruction needs of affected areas, particularly in the North. Financing the reconstruction effort will be a large undertaking, and the credibility of the authorities’ reconstruction spending plans will require a strategy for expenditure savings in other areas of the budget. The authorities’ commitment to carry out sizeable reductions in defense spending will go a long way toward making room for reconstruction spending while allowing further budget deficit reduction. Greater engagement with bilateral and multilateral donors will also be an important element of the reconstruction strategy, and a strong track record under a Fund-supported program could help mobilize this donor support.

39. Fiscal policy. The authorities are firmly committed to reaching their budget deficit target of 5 percent of GDP and balancing the state enterprises’ budgets by 2011. This involves putting in place difficult measures now to address the decline in revenues and reign in spending in order to achieve a targeted deficit of 7 percent this year. The staff would have preferred revenue measures aimed at eliminating exemptions and broadening the tax base, but the need to boost revenues this year requires measures which would provide an immediate yield. The authorities recognize the need for a broader and more durable tax base, and are committed to a comprehensive review of tax policy and administration, making preparations this year to implement high quality revenue reforms as part of next year’s budget.

40. Monetary and exchange rate policy. To rebuild reserves and reduce external imbalances, it will be essential for the central bank to allow the currency to move flexibly. The adjustment needed under the program will be difficult. However, this adjustment must take place to create the basis for sustained output growth once the global economy recovers, both by ensuring that Sri Lanka’s strong underlying export base remains competitive and by creating the room for a recovery in private sector credit growth.

41. Financial sector policies. The program’s financial sector reform agenda is comprehensive and ambitious, and will go a long way toward addressing the sector’s current weaknesses and preparing for any future difficulties associated with a slowdown in output growth. To maintain the health and confidence of sector the central bank will need to act decisively in implementing the program’s reform measures, and take prompt action to correct problems when they emerge.

42. Risks. As outlined above, there are substantial risks to the program. These needs to be weighed against the risk of not having the framework of a Fund-supported program in place. Given Sri Lanka’s acute short-run external financing problems, the country would not be able to avoid a balance of payments crisis without a program involving significant financial resources. The authorities would have few options other than a disruptive devaluation of the exchange rate, with highly destabilizing social consequences. On balance, the Fund-supported program, with all its inherent risks, provides an opportunity to prevent this crisis, offers a guide for needed policies, and a path for bringing the country to fiscal and external solvency.

43. While there are risks, the government’s program is ambitious and merits Fund support. Staff recommends the approval of the requested Stand-By Arrangement.

Figure 1.
Figure 1.

Growth Indicators

Citation: IMF Staff Country Reports 2009, 310; 10.5089/9781451823615.002.A001

Sources: CEIC Data Company Ltd.; and Fund, World Economic Outlook and staff estimates.
Figure 2.
Figure 2.

Measures of Inflation and Monetary Policy

Citation: IMF Staff Country Reports 2009, 310; 10.5089/9781451823615.002.A001

Sources: Central Bank of Sri Lanka; CEIC Data Company Ltd.; and Fund staff estimates.
Figure 3.
Figure 3.

External Sector Developments

Citation: IMF Staff Country Reports 2009, 310; 10.5089/9781451823615.002.A001

Sources: CEIC Data Company Ltd.; Bloomberg LP.; and Fund staff calculations.
Figure 4.
Figure 4.

Fiscal Indicators

Citation: IMF Staff Country Reports 2009, 310; 10.5089/9781451823615.002.A001

Sources: Country authority; CEIC Data Company Ltd.; and Fund staff estimates.
Figure 5.
Figure 5.

Financial Market Developments

Citation: IMF Staff Country Reports 2009, 310; 10.5089/9781451823615.002.A001

Sources: Central Bank of Sri Lanka; CEIC Data Company Ltd.; and Fund staff calculations.1/ January 2006 =100. Asian index is market capitalization weighted index for India, China, Pakistan and Thailand.2/ Market capitalization weighted for India, China and Thailand.3/ Gross non-performing advances ratio.4/ Refers to 2008 data.
Table 4.

Sri Lanka: Balance of Payments, 2006–2011

(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.

Comprises SLDBs, FCBUs, and other commercial loans.

Table 5.

Sri Lanka: Medium-Term Macroeconomic Framework, 2006–2014

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Sources: Data provided by the Sri Lankan authorities; CEIC Data Company Ltd.; Bloomberg LP.; and Fund staff estimates and projections.

Excluding central bank Asian Clearing Union (ACU) balances.

Table 6.

Sri Lanka: Preliminary External Financing Requirements, 2008–2011

(In millions of U.S. dollars)

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Sources: Sri Lankan authorities; and Fund staff estimates and projections.
Table 7.

Sri Lanka: Projected Payments to the Fund, 2006–2012

(In millions of SDRs, unless otherwise indicated)

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Source: Fund staff estimates.
Table 8.

Sri Lanka: Reviews and Disbursements under the Proposed 20-month Stand-By Arrangement

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Table 9.

Sri Lanka: Financial Soundness Indicators - All Banks

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Source: Central Bank of Sri Lanka.