Recent Economic Developments

3. The Sri Lankan economy grew at a commendable rate of 6.4 percent in 2012, following over 8 percent growth in the preceding two years. This moderation of growth in 2012 was largely attributable to subdued external demand, tightened domestic policies and the adverse weather conditions that impacted on agricultural production and hydropower generation. The severe drought in the second and third quarters of 2012 limited agriculture sector growth to 5.8 percent, while services sector growth moderated to 4.6 percent, mainly due to lower domestic and external demand. The industry sector performed well in 2012 largely supported by the thriving construction sector.

4. The government’s development strategy focuses mainly on the development of 5 thrust areas namely, maritime, energy, aviation, knowledge and commercial sectors, in addition to the tourism sector. Significant expansion of productive capacity has been enabled by massive development of infrastructure, accompanied by increased savings and investment. Major infrastructure development projects, which have already been completed or nearing completion include 3 new sea ports, several fishery harbors, a new international airport, power plants, new roads and irrigation schemes. With the enhancement of domestic demand, along with the expected improvement in external demand, our authorities are confident that the economy would return to the high growth trajectory of 7.5 – 8.0 percent in the medium term. In terms of the World Bank’s Doing Business Survey 2013, Sri Lanka has ranked at 81, showing a significant improvement from 89 in the previous year. The gross investment/GDP ratio exceeded 30 percent in 2012, after remaining below 30 percent levels for the last 3 decades. Reflecting the greater emphasis placed on regional development and inclusive growth, the disparity between the provinces is gradually narrowing. As a result the overall poverty level has declined from 15.2 percent in 2006/07 to 8.9 percent in 2010, with a rapid decline in rural poverty. With continued economic expansion, the unemployment rate declined further to 4.0 per cent in 2012.

Fiscal Policy

5. As highlighted by the staff report, fiscal consolidation remains challenging, mainly due to some underperformance of revenue, although significant progress has been made in recent years. Our authorities’ steadfast efforts towards fiscal consolidation resulted in containing the fiscal deficit to 6.4 percent of GDP in 2012, falling from 9.9 percent in 2009 and 6.9 percent in 2011, but slightly higher than the targeted 6.2 percent for 2012. Comprehensive tax reforms were introduced in 2010 and 2011 to simplify the tax structure and broad base the tax system, under which corporate income tax was brought down from 35 percent to 28 percent; the VAT rate was unified at 12 percent; and certain other taxes were abolished. This reform is, however, yet to generate the desired outcome of enhanced revenues. To some extent, the drop in revenue was offset by the containment of recurrent expenditure, which declined from 18.2 percent in 2009 to 14.4 percent of GDP in 2012. This mainly reflected savings on account of salaries and wages, interest payments, and transfers and subsidies. The government was able to maintain public investment above 6 percent of GDP in recent years, although it declined to below 6 percent in 2012, mainly due to time slicing of capital expenditure in the face of reduction in revenue. Going forward, our authorities have targeted to reduce the fiscal deficit to 5.8 percent of GDP in 2013 and below 5 percent by 2016. Revenue is projected to increase to 15.3 percent of GDP by 2016.

6. Recent tax reforms were mainly focused on creating an enabling environment for investment. Tax incentives were realigned under the Inland Revenue Act and Strategic Investment Law to expedite the approval process and to rationalize tax incentives. Our authorities are aware of the vital need for further broadening the tax base. Steps have already been taken to bringing the wholesale and retail sectors under the VAT system. The government has placed greater emphasis on improving the tax administration to improve compliance and revenue collection. A Tax Appeals Commission and a Tax Interpretation Committee have been set up recently. Paying taxes on a self-assessment basis and making tax payments online have also been introduced with a view to promote tax compliance and timely filing of tax returns.

7. The government debt to GDP ratio, which has consistently declined from 105.6 percent in 2002, increased slightly from 78.5 percent in 2011 to 79.1 percent in 2012, largely reflecting the impact of rupee depreciation. With continued fiscal consolidation, our authorities have projected that the debt to GDP ratio would come down to around 65 percent by 2016.

Monetary and Exchange Rate Policies

8. Inflation has been maintained at single digit levels continuously since 2009, despite adverse domestic and external supply side shocks. The year-on-year headline inflation recorded at 2.7 percent in February 2012 increased to 9.2 percent by end 2012, mainly reflecting the upward adjustments in energy prices, supply disruptions due to adverse weather conditions, the pass-through of the rupee depreciation, as well as demand pressures. Inflation has moderated somewhat to 7.5 percent in March 2013 and further deceleration is expected in coming months. The Central Bank’s “Road Map: Monetary and Financial Sector Policies for 2013 and Beyond” assures the commitment of the authorities to maintain inflation, particularly core inflation, at mid single digit levels.

9. In response to tight policy measures adopted at the beginning of the year, credit growth decelerated rapidly to 17.6 percent by end 2012 from 34.5 percent in the previous year. Reserve money and money supply growth also decelerated to 10.2 percent and 17.6 percent, respectively, in 2012. These developments provided space for the Central Bank to ease monetary policy by reducing policy rates by 25 bps in December 2012. The benign inflationary outlook and existing output gap, if continued, would provide further space to ease the monetary policy.

10. Our authorities have been taking necessary steps to move towards a flexible inflation targeting framework in the medium term. Even under the current monetary targeting framework, inflation is implicitly targeted, and the Central Bank’s desire to maintain inflation at mid-single digit level is well communicated to the public. Our authorities have already taken the required steps to lengthen the current one week reserve maintenance period to two weeks commencing June 2013, thereby allowing greater flexibility for banks in managing their day-to-day liquidity. At the same time, among other measures, the Central Bank commenced conducting regular term auctions to address structural liquidity.

11. Greater flexibility has been allowed in the exchange rate since early February 2012, by limiting the Central Bank’s intervention in the domestic foreign exchange market. The intervention of the Central Bank during 2012 was limited only to the extent needed to settle a portion of petroleum import bills, mainly during the first few months of the year, while surplus foreign exchange liquidity in the market was absorbed as and when appropriate. The rupee depreciated vis-á-vis the US dollar by 10.4 per cent during 2012. Building on successful completion of the SBA, external buffers were further strengthened in 2012. External reserves increased to US dollars 6.9 billion by end 2012 from US dollars 6 billion at end 2011. In terms of months of imports, gross official reserves were equivalent to 4.3 months by end 2012, a significant improvement from 3.5 months at end 2011. The limits on net open positions (NOP) and forward transactions of commercial banks were relaxed in January 2013. It has been noted that even at the current limits, the utilized amount of NOP is much lower, suggesting that the NOP limit does not constrain forex market activity.

Financial System Stability

12. Despite challenging global and domestic market conditions, overall soundness of the financial sector improved with higher levels of capital, adequate liquidity buffers, and healthy earnings. This has been enabled by enhanced supervisory and regulatory frameworks and integrated risk management arrangements. Further, public confidence in the financial system improved with financial safety net mechanisms, including mandatory deposit insurance and consumer protection measures in place. Obligations of customers and banks were published in the form of a customer charter. The access to finance increased with the extension of branch networks, in particular in the regional areas. Continuous close supervision and timely guidance helped sustaining the credit quality amidst sharp credit growth. Given the current NPL ratio of 4.2 percent, the stress test scenario in the FSAP report, showing an increase of industry-wide NPL ratio to 23 percent, is a highly improbable extreme event and may lead to erroneous interpretation.

13. The recent FSAP report contains some recommendations, which had already been identified by our authorities for implementation. Our authorities are taking steps to implement such recommendations at an appropriate pace. Steps have been taken to harmonize the regulatory framework of non-banks with banks and several regulations have already been issued in this regard. The Insurance Board of Sri Lanka (IBSL) has already commenced two projects with TA from the World Bank to improve insurance sector supervision, which is scheduled to be commenced in the 2^nd quarter of 2013. A draft bill for a supervisory framework for pension funds has been drafted. Our authorities have, however, clearly indicated that certain other impractical recommendations in the FSAP report will not be implemented.

Structural Reforms

14. Our authorities recognize the urgent need of addressing financial difficulties of key state owned enterprises, mainly Ceylon Petroleum Corporation (CPC) and Ceylon Electricity Board (CEB). While measures are being taken to improve operational efficiency and financial management, the government has already allowed considerable upward adjustment of energy prices both in 2012 and 2013. This politically sensitive and bold decision to make the necessary upward adjustments of energy prices reflects authorities’ commitment to improve financial viability of these entities. Accordingly, the prices of petroleum products were raised by 37 – 51 percent in February 2012 and further adjustments were made in December 2012. Moreover, the sale of heavy fuels to CEB at below cost price, a major source of CPC losses, was discontinued from April 2013. With respect to CEB, a substantial tariff increase of around 35 percent was implemented from April 20, 2013, in addition to the fuel adjustment charge (FAC) ranging between 25-40 percent of the monthly bill implemented from February 2012. With the commissioning of the low cost 600 MW coal power plant in 2014, it is expected that these entities will reach breakeven level by end 2014.

Strengthening Trade and Broadening Growth

15. Sri Lanka has one of the most open and least protective trade regimes in the region in terms of tariff and non-tariff barriers as Sri Lanka commenced liberalization of external trade since 1977, well before other countries in the region. Therefore, our authorities do not agree with the staff view that Sri Lanka is moving towards a more protectionist tariff regime. In the recent few years, import duties for very few agricultural products have been changed to maintain stable domestic prices for farmers, especially in the Northern and Eastern Province after the end of the conflict as a large extent of fertile land was opened for cultivation. Hence, import duties on certain agricultural items are increased during the harvesting season and reduced during the off-season, so that prices remain stable throughout the year for farmers and consumers. This cannot be considered as a protectionism measure and in fact this should be encouraged from food security point of view. Further, the total import value of such items was less than 2 percent of total imports in 2012.

16. The rapid development of infrastructure, improvements to the business climate, fiscal incentives, improved access to finance and relaxation of capital account transactions, will help to increase export oriented investments. At the same time, our authorities have recognized that Sri Lanka has an enormous potential to substantially increase services exports as witnessed in recent years in the areas of tourism, ports, aviation and ICT and BPO. Net services income in the BOP has increased 3 fold since 2008. Actual FDI inflows have also increased to record levels in recent years, although they are below the authorities’ ambitious targets, mainly due to current global situation.

Conclusion

17. Our authorities are committed to further strengthening macroeconomic stability and building buffers to improve resilience. Supported by continued post conflict optimism, infrastructure development, improved business climate, political stability and appropriate policy, Sri Lanka’s economy is expected to return to a high growth trajectory, though conditional on recovery in external demand. Being committed to fiscal consolidation, the government will take appropriate measures to strengthen the revenue base and improve Public Financial Management Reforms, with help from the Fund’s TA programme. The substantial adjustment in energy prices and reforms to enhance operational and financial management of key State Owned Enterprises (SOEs) will help to improve their financial viability and reduce possible burden on the budget and the banking system. A TA team from the Fund is presently in Sri Lanka for consultations on SOE Governance. Our authorities support the proposed PPM and acknowledge the fruitful engagement with the Fund and look forward to strengthening the cooperation.