IMF Executive Board Completes Second and Third Reviews Under Stand-By Arrangement with Sri Lanka and Approves US$407.8 Million Disbursement

Economic conditions are improving in Sri Lanka, and are likely to show strong growth. The current account remains strong, and tourism arrivals are rapidly improving. Monetary conditions are stable, and the central bank’s policy stance is appropriate. Reforming the board of investment will address the factors that have eroded the tax base and discouraged domestic investors. Fiscal policy adjustment is needed. Tax reform will put in place legislative changes to permanently reform tax concessions. Financial sector reform has continued in line with the program.

Abstract

Economic conditions are improving in Sri Lanka, and are likely to show strong growth. The current account remains strong, and tourism arrivals are rapidly improving. Monetary conditions are stable, and the central bank’s policy stance is appropriate. Reforming the board of investment will address the factors that have eroded the tax base and discouraged domestic investors. Fiscal policy adjustment is needed. Tax reform will put in place legislative changes to permanently reform tax concessions. Financial sector reform has continued in line with the program.

Introduction

My authorities wish to thank the Management and Staff of the IMF for their sustained and supportive engagement with Sri Lanka and, in particular, the Mission members for useful discussions held in Colombo during 12-21 May 2010 leading up to the comprehensive report recommending the completion of the 2nd and 3rd Reviews of the SBA. The SBA was approved in July 2009 at a crucial juncture of Sri Lanka’s history when recovery was just beginning to set in following the knock on effects of the global economic crisis and the end to the three decade long internal conflict, which had seriously undermined Sri Lanka’s development potential. The SBA played a catalytic role in the restoration of much needed investor confidence and in supporting policies for achieving and maintaining macroeconomic stability and economic growth. The completion of the first review on 6th November 2009 was followed by the Presidential and Parliamentary elections held in January and April 2010, respectively, in which the people of Sri Lanka overwhelmingly endorsed the social and economic developmental strategy laid out by the ruling party (Mahinda Chintana: Vision for the Future). The ruling party obtained a sizeable majority at the Presidential election and almost two-thirds majority in the Parliamentary election. Political and economic stability and an environment of reconciliation, rehabilitation, reconstruction and reintegration have ushered in a new era of economic resurgence, opportunities and challenges. My authorities wish to place on record their appreciation for the support extended by the Executive Board and Management of the IMF through challenging times. My authorities, despite the relatively comfortable position that they have progressed to, remain committed to the successful completion of the SBA and to continuing the productive engagement with the Fund in the journey towards a prosperous and peaceful Sri Lanka.

Overall Macroeconomic Developments

The adverse impact of the global economic crisis was reflected in Sri Lanka’s economic growth that slowed down to 3.5 per cent in 2009 from an average of around 6.5 per cent during 2004-2008. The economy recovered strongly to record a growth of 6.2 per cent in the fourth quarter of 2009 and is expected to strengthen further by growing by around 6.5 per cent in 2010 and 7-8 per cent in the medium term. Pre-emptive tightening of monetary policy has delivered in terms of stabilizing inflation, with the average inflation of 12 per cent during 1978-2008 falling sharply to 3.4 per cent by end 2009. Large capital inflows, steady flow of remittances and a surge in tourist earnings have increased Sri Lanka’s official external reserves to a comfortable level of six months of imports. The fiscal deficit, which averaged around 9.5 per cent of GDP during 1978-2004, was brought down to an average of 7.0 per cent during 2005-2008 and increased to 9.9 per cent in 2009. The debt to GDP ratio was brought down from a peak of 105 per cent in 2002 to 81.4 per cent of GDP by end 2008 though it increased to 86 per cent in 2009 largely due to the lower nominal GDP growth. The improvements in social indicators, such as mortality rates, life expectancy, educational attainment, access to safe drinking water, poverty as well as gender equality over the years have well positioned Sri Lanka towards achieving the Millennium Development Goals (MDGs).

Fiscal Policy

The year 2009 was exceptional for fiscal policy the world over given the global crisis. Sri Lanka was, by no means an exception. Higher than expected capital expenditure and interest payments explain a major part of the expenditure over-run in 2009. Revenue collection was lower than expected mainly due to the significant slowdown in domestic economic activity and, particularly, shrinking of imports in 2009. In addition, my authorities had to deal with significant fiscal costs of resettling IDPs, providing them with basic facilities such as temporary shelter, food, medicine, demining their villages and rebuilding houses, hospitals and schools. An overriding priority was to ensure unimpeded provision of social services such as health, education and social safety nets for low income sections of the society while implementing much needed infrastructure development in all parts of the country, especially in the recently liberated Northern and Eastern provinces. Consequently, the fiscal deficit expanded to 9.9 per cent in 2009.

My authorities recognize the critical importance of fiscal consolidation in anchoring macroeconomic stability and in creating the conditions for high growth. Structural reforms in the tax system are envisaged for sustaining growth in tax revenue. The Board of Investment (BOI) has been requested to refrain from granting new tax concessions with a view to widening income and trade tax bases. Several high and prohibitive import taxes have been reduced and the import duty structure has been simplified with a view to increasing tax buoyancy and improving tax administration. Import duties on raw materials, machinery and equipment have been reduced instead of the earlier practice of providing tax exemptions only for BOI firms. These measures are expected to improve compliance and, generate higher revenues, while supporting higher investment and growth. The Presidential Tax Commission has recommended several reforms to address distortions in VAT and income taxes which are under consideration in the designing of the next wave of tax policy initiatives of the government, which are planned to be implemented with the 2011 budget as indicated in my authorities’ LOI.

On the expenditure side, the cessation of hostilities has paved the way for a reduction in direct defence expenditure by ½ per cent of GDP during 2010. Salaries and wages which constitute about 70 per cent of the defence expenditure are not expected to decline in the short term. However, most of the defence personnel are actively involved in reconstruction activities in the Northern and Eastern provinces. Total reduction in non-interest recurrent expenditure is expected to generate savings of more than one per cent of GDP. However, my authorities have given priority to rebuild basic infrastructure in the conflict-affected areas as soon as possible. Despite these challenges, my authorities have committed to a path of fiscal consolidation. The budget 2010 which will be presented to the Parliament this week expects to reduce the fiscal deficit to 8 per cent, while the 2011 budget to be presented in November 2010 aims at reducing the fiscal deficit to 6.8 per cent in 2011 and to 5 per cent by 2012. The key to achieving such targets are 1) successful implementation of tax reforms including reforms of VAT and income taxes together with higher economic growth, 2) rationalization of tax incentives 3) restraining non-interest recurrent expenditure 4) maintenance of low inflation and interest rate regime to contain interest expenditure.5) reforms in state owned enterprises. My authorities have already commenced implementation of some reforms and will continue the process through the Budget 2011. Details of further tax reforms will be discussed at the next review.

The fiscal performance during the early part of 2010 is encouraging. Revenue has increased by 26 per cent, while expenditure increased only by 2 per cent during the first three months of 2010. This performance has helped my authorities to meet fiscal targets set for the first quarter of 2010 under the current Fund program. Policies and targets set for the rest of the year are expected to be maintained, given the positive trend. The process of improving the performance and the efficiency of state own enterprises (SOEs) have been strengthened by the establishment of a separate Ministry focusing on under-performing state assets and loss- making enterprises. Management of key public enterprises has been reconstituted by appointing private sector entrepreneurs to manage these enterprises. A committee has been appointed to introduce an innovative power tariff structure by addressing distortions in the current structure, while encouraging usage of low cost power during off-peak hours. At the same time, shifting to low cost power generation is progressing with the accelerated construction of coal and hydro power plants and the development of alternative energy sources. The restructuring of the outstanding debt of the Ceylon Electricity Board is also expected to improve the financial position of the Ceylon Petroleum Corporation, significantly.

Monetary and Exchange Rate Policy

Prudent monetary policy has brought down inflation from a peak of 28 per cent on a year-on- year basis in June 2008 to 0.7 per cent by September 2009. The sharp deceleration in inflation has enabled the easing of the monetary policy stance. In 2009, the Central Bank removed the penal rate of interest on Reverse Repurchase transactions and reduced Repurchase and Reverse Repurchase rates by 300 and 225 basis points, respectively. Consequently, the 91-day Treasury bill rates have declined from high levels of above 20 per cent at beginning 2008 to around 8 per cent by mid June 2010. Other market interest rates have also followed a similar trend. Private sector credit, which contracted during much of 2009 due to the slowdown of economic activity and the lagged effect of a tight monetary policy stance, has recorded a positive growth since March 2010. The low interest rate structure and improved investor confidence have contributed positively to the recovery in private sector credit growth. My authorities are committed to maintaining inflation at a low and stable level in the future and stand ready to take appropriate monetary policy action if inflationary threats emerge.

My authorities remain committed to maintaining a flexible exchange rate regime with limited intervention to prevent wide fluctuations. Since net foreign exchange inflows continue, the Central Bank has been absorbing excess foreign exchange on net basis to prevent undue volatility in the foreign exchange market.

Financial Sector

Despite the global financial turmoil, the domestic financial sector remained sound and resilient due to a strong regulatory framework and minimal exposure to financial derivatives. Non-performing loans (NPLs) of the banking sector, which were increasing since early 2009 due to slowing economic growth, are starting to decline from a peak of about 9 per cent in 2009. The stock market indices have increased by about 38 per cent since end -December 2009 with the All Share Price Index (ASPI) reaching an all time high in June 2010.

Swift actions by the Central Bank stabilized a systemically important licensed commercial bank (Seylan Bank) which was affected by failure of one of the companies in the Ceylinco Group, a large financial conglomerate in Sri Lanka. The capital adequacy and liquidity levels of this bank have now significantly improved and share price of this bank has increased by 125 per cent from the price at which new shares were issued to raise capital in September 2009. My authorities’ timely intervention also helped to stabilize the non-bank financial entities connected to this conglomerate.

To further strengthen the soundness of the financial sector, my authorities have prepared necessary legislation for financial sector regulatory reforms as set out in the structural benchmarks. Amendments to the Banking Act are expected to be submitted to the Parliament by end September 2010, while amendments to the Finance Companies Act would be submitted to the Parliament shortly. Prudential regulations for credit card companies and payment service providers have already been issued and the Central Bank intends to issue guidelines to improve banks’ integrated risk management frameworks by end-July 2010. The Central Bank has also announced a number of reform initiatives, including the implementation of a mandatory deposit insurance scheme, regulation of pension funds and measures to further develop corporate debt and equity markets.

Post-Conflict Reconstruction and Development of the Northern Province

By the time of the last review in November 2009, my authorities had fully resettled all IDPs in the Eastern Province and restored normalcy in the province with democratically elected provincial administration. Similar processes have been initiated in the Northern Province with the highest priority accorded to demining operations and providing basic humanitarian assistance to IDPs. In parallel, basic infrastructure facilities such as roads, hospitals, schools, government administration structures and local governments elected by people in the area have been developed. These efforts have yielded very positive results. Only 50,000 IDPs remain to be resettled in their villages in the Northern Province. They are also now free to move in and out of welfare centers. Major road access linking the North and the South has been reconstructed and opened for free movement of people, goods and services. As a result of the higher integration of Northern and Eastern provinces with the other provinces, agriculture, tourism, fishing, transport, telecommunication, banking and other economic activities are expanding rapidly. With the support of bilateral and multilateral partners, my authorities intend to complete the final phase of resettlement by end August 2010. Developing major infrastructure will continue into the next couple of years. Many bilateral and multilateral agencies including China, India, Japan, the ADB and the World Bank have already committed significant amounts of financial assistance for various infrastructure and livelihood development programs in the Northern Province.

Program Design

Since the completion of the first review for meeting end-July 2009 performance criteria, my authorities have shown full commitment to the SBA by achieving all performance criteria and almost all structural benchmarks for end September 2009, end December 2009 and end March 2010 except for the end December 2009 NDF target. If there were no elections, the additional 3 reviews would have been completed and my authorities would have been able to purchase at least three tranches (SDR 620 million) according to the original schedule. In view of the delay in achieving the fiscal policy objectives of the program, my authorities have agreed to extend the SBA by another 12 months and purchase only two revised tranches (SDR 275 million), while re-phasing the balance tranches for the remaining period of the SBA.

Sri Lanka: Second and Third Reviews Under the Stand-By Arrangement-Staff Report; Press Release on the Executive Board Discussion; and Statement by the Executive Director for Sri Lanka.
Author: International Monetary Fund