Statement by Mr. Subir Vithal Gokarn, Executive Director and Mrs. Swarna Gunaratne, Alternate Executive Director on Sri Lanka Executive Board Meeting, June 3, 2016

Context. The Sri Lankan economy has good underlying momentum but is starting to show signs of strain from a combination of unbalanced macroeconomic policies and an increasingly difficult external environment. A significant political transition has brought a new unity government to the fore. There is now an important window of opportunity to re-set macroeconomic policies to support stability and resilience, as well as undertake structural reforms to help Sri Lanka achieve high and sustained economic growth. Fiscal Policy. There is a clear need to put tax revenues on an upward path as part of a growth-friendly phase of fiscal consolidation and debt reduction. The significant reduction in the 2016 deficit to 5.4 percent of GDP will need to be followed by further revenue-based fiscal consolidation over the medium-term, guided by the 2020 deficit target of 3.5 percent of GDP (a primary surplus of 1 percent of GDP). Support on tax policy and revenue administration will be essential to successful implementation and creation of a simple, efficient, and equitable tax system.

Abstract

Context. The Sri Lankan economy has good underlying momentum but is starting to show signs of strain from a combination of unbalanced macroeconomic policies and an increasingly difficult external environment. A significant political transition has brought a new unity government to the fore. There is now an important window of opportunity to re-set macroeconomic policies to support stability and resilience, as well as undertake structural reforms to help Sri Lanka achieve high and sustained economic growth. Fiscal Policy. There is a clear need to put tax revenues on an upward path as part of a growth-friendly phase of fiscal consolidation and debt reduction. The significant reduction in the 2016 deficit to 5.4 percent of GDP will need to be followed by further revenue-based fiscal consolidation over the medium-term, guided by the 2020 deficit target of 3.5 percent of GDP (a primary surplus of 1 percent of GDP). Support on tax policy and revenue administration will be essential to successful implementation and creation of a simple, efficient, and equitable tax system.

1. We wish to express our authorities’ deep appreciation to the Fund staff for the candid discussions held in Colombo during 1-5 February, 2016 and 31 March - 11 April, 2016 and during the Spring Meetings in Washington D.C, on the proposed three-year Extended Arrangement under the Extended Fund Facility (EFF). Also, we wish to express our gratitude for the conscientious set of papers that have been produced in connection with 2016 Article IV Consultation and Request for a Three-Year Extended Arrangement under the EFF amounting to USD 1.5 billion (equivalent to185 per cent of Sri Lanka’s quota). The economic program supported by EFF is expected to correct underlying imbalances in the fiscal and external sectors, by improving fiscal sustainability and rebuilding foreign exchange reserves while facilitating sustained and inclusive economic growth in Sri Lanka.

2. The conclusion of internal conflict in Sri Lanka in 2009 created a conducive environment for attracting investment and enhancing economic activity including in the conflict affected Northern and Eastern provinces. The rebuilding efforts of the country after the internal conflict were supported by the Stand by Arrangement (SBA) program which was successfully completed in 2012. Accordingly, the economy performed well from 2010-2015, achieving average real GDP growth of 6.4 per cent during the period. Inflation was maintained at single digit level throughout the period. Foreign reserves improved and fiscal deficit declined. However, macro-economic performance in 2015 was affected by the difficult external environment posed by the decline in commodity prices, slowdown in demand for exports and capital outflows, and deterioration in fiscal accounts due to low government revenue and increased debt level, as well as election related uncertainties. The new government is strongly committed to the strengthening of macroeconomic and financial stability while reducing vulnerabilities, thereby supporting sustainable high economic growth through the implementation of appropriate macroeconomic policies and structural reforms. Our authorities expect that the extended arrangement under the EFF, together with the support from other International Financial Institutions (IFIs), would help to reinforce investor confidence and correct underlying imbalances through buildup of fiscal and external buffers to better weather adverse shocks.

Economic Growth and Outlook

3. Sri Lanka’s economy grew by 4.8 per cent in 2015, compared to 4.9 per cent in 2014, supported by accommodative monetary and fiscal policies and favorable weather conditions. The low and stable inflation and low interest rates facilitated economic activity while credit growth remained high, though it was from a low base. On the fiscal front, increase in public sector salaries and pensions and downward revision of administratively determined prices contributed to the inducing of domestic demand. All the main sectors -agriculture, industry and services- contributed positively to the growth of the economy. However, the contribution from the industry sector moderated due to slow down in large scale infrastructure construction projects, as a result of the change in new government’s policy stance to re-evaluate several large projects with the intention of improving transparency and effective implementation of the projects and to ensure that the associated financial terms were not detrimental to Sri Lanka.

4. The implementation of sound macro-economic policies by the government, in line with the EFF program, is expected to improve market confidence and encourage investment, thereby facilitating the economic growth of around 5 per cent during 2016 and around 6 - 7 per cent annually in the medium term. Improved fiscal consolidation and appropriate monetary policy measures to ensure low inflation are expected to create an investor friendly environment for private sector participation in economic activities. Recovery in the construction sector and the sustained momentum of the services sector, including tourism, transport, communication and IT related activities, are expected to contribute to achieve projected growth. It is also expected that the gradual recovery of the global economy will provide the required impetus to maintain Sri Lanka’s external demand at a favorable level. Sri Lanka’s strong base of human capital and reliable infrastructure compared with other South Asian economies, along with its strategic location in the Indian Ocean are the country’s strengths in achieving sustainable high economic growth.

Recent Devastating Natural Disaster

5. The heaviest rains in a quarter of a century in Sri Lanka, followed by cyclonic conditions in the Indian Ocean during mid-May 2016 caused severe flood and landslides, affecting human lives, destroying houses, other properties and agricultural crops. Official figures show that nearly half a million people have been affected by the flood and landslides, with a large number of them seeking shelter at state-run relief camps. The death toll from landslides currently stands at 101 while about 125 people are reported missing and over 200,000 are displaced. The floods and landslides have completely destroyed close to 30,000 houses while around 128,000 houses have been left partially damaged. This unfortunate incident has incurred a significant burden to the government budget, in terms of providing immediate relief and compensation for the rebuilding of destroyed houses, livelihoods as well as restoring public amenities. The total additional cost due to the floods has been estimated at around USD 2.0 billion. Also, in the short run, there is likely to be some upward pressure on inflation due to the destruction of agricultural crops.

Fiscal Policy

6. Fiscal management in 2015 was extremely difficult given the two key national elections held during the year, the uncertainty that prevailed during the inter-election period and the resultant slowdown in economic activity as well as external sector related issues, including the tightening of international financial market conditions and the slowdown in foreign inflows. These challenges were reflected in the fiscal performance during the year, leading to a notable deviation from fiscal targets announced in January 2015 in the interim budget for 2015, despite the improvement seen in some areas. The overall budget deficit widened to 7.4 per cent of GDP compared to the deficit of 5.7 per cent in 2014 and the targeted deficit of 4.4 per cent in the interim budget for 2015. The deficit was largely financed by domestic sources, given the slowdown in foreign financing during the year. The debt to GDP ratio increased to 76 per cent in 2015 from 70.7 per cent in 2014. This was partly reflective of the debt financing of fiscal deficit as well as the impact of rupee depreciation on the stock of foreign currency denominated debt.

7. The government revenue improved in 2015, in contrast to the declining trend in the revenue to GDP ratio observed since 2011, mainly benefiting from the imposition of several one off taxes and the significant expansion in revenue from excise duties on the increased motor vehicle imports. However, higher government expenditure on salaries and wages, interest payments and subsidies and transfers to households exerted a heavy pressure on government finances, leading to a higher deficit than envisaged.

8. Our authorities have taken a number of measures to address weaknesses in revenue collection and to increase government revenue as well as rationalize and prioritize government expenditure. Redrafting of tax laws with technical assistance from the IMF to simplify the tax laws, improvements in tax administration, including the revenue Administration Management Information System (RAMIS) at the Inland Revenue Department (IRD), introducing single window system at Sri Lanka Customs (ASYCUDA) linking all stake holders, automation of the activities of the Ministry of Finance (MOF) and the setting up of Budget Implementation and Monitoring Unit (BIMU) to ensure close monitoring of expenditure programs are among the important initiatives already taken in this context.

9. The medium term objective of the government is to reduce the budget deficit to 3.5 per cent of GDP by 2020. As a major step toward this objective, the government revised down its originally anticipated budget deficit of 5.9 per cent to 5.4 per cent in 2016. The government expects to reduce its primary deficit to zero level in 2017 and a gradual increase in its primary surplus thereafter. This would enable to reduce debt to GDP ratio to 68 per cent of GDP by 2020. One of the major steps taken by our authorities to achieve revenue target has been the increasing of VAT from 11 per cent to 15 per cent and removing exemptions on telecommunications services, effective from May 2016. Also, VAT will continue to apply to wholesale and retail trade at a lower threshold. On the expenditure side, measures have been taken to curb spending to within the available fiscal space by streamlining non-critical expenditure on goods and services and capital spending.

10. As the financial condition of some of the State Owned Enterprises (SOE) has deteriorated significantly, a comprehensive strategy is currently being developed by our authorities to decisively address the issues related to SOEs and thereby minimize the associated fiscal risk. The national carrier, Sri Lankan Airlines continues to incur significant losses. A resolution strategy for Sri Lankan Airlines is expected to be completed by September 2016, thus removing the company from government’s accounts. Cabinet approval has already been obtained for the government to take over all its liabilities and to identify a suitable partner who can successfully manage the operations of the airline, on the foundation of a clean balance sheet. The Ceylon Petroleum Corporation (CPC) and Ceylon Electricity Board (CEB) have incurred losses due to implicit energy subsidies. Therefore, an automatic fuel and electricity pricing mechanism that ensures retail prices above cost recovery levels will be introduced by end 2016. To enhance oversight and financial discipline, the six largest SOEs are expected to publish Statements of Corporate Intent (SCI) highlighting their mission, objectives, corporate and financing plan to meet future objectives. Also, the legal framework for governance and oversight of SOEs will be strengthened.

Monetary Policy

11. Inflation in Sri Lanka continuously remained at single digit levels for a period of over seven years, due to favorable domestic supply conditions, subdued global commodity prices supported by the demand management policies of the Central Bank. Inflation fell further during the year, with substantial downward revisions to administratively determined prices, including domestic petroleum products. Accordingly, year on year headline inflation (as measured by Colombo Consumers’ Price Index) recorded negative rates during July-September 2015 and was at 2.8 per cent by December 2015. Nevertheless, core inflation increased to 4.5 per cent from 3.2 per cent reflecting buildup of some demand pressures in the economy. The recent increase in the Value Added Tax (VAT) rate and the removal of certain exemptions applicable on VAT and the Nation Building Tax (NBT) are expected to have a one-off impact on inflation, while the supply side disruptions due to prevailing adverse weather conditions could exert some upward pressure on inflation in the immediate future. In spite of these temporary disruptions, inflation is expected to remain in mid-single digit levels supported by appropriate demand management policies.

12. The monetary policy stance of the Central Bank of Sri Lanka (CBSL) continued to be accommodative during 2015 with the objective of supporting economic activity. Benefiting from low interest rates and fiscal measures such as reduction in taxes on selected motor vehicle imports, credit growth accelerated from 8.8 per cent in 2014 to 25 per cent by end 2015, while money supply expanded from13.4 per cent at end 2014 to 17.8 per cent by end 2015. As credit and monetary expansion was higher than expected, and excess liquidity in the domestic money market remained persistently high, CBSL commenced tightening of its monetary policy towards end 2015. Accordingly, the CBSL raised the Statutory Reserve Ratio (SRR) applicable on all rupee deposit liabilities of commercial banks by 1.50 percentage points to 7.50 per cent in January 2016 and raised its policy interest rates viz; Standing Deposit Facility (SDF) and Standing Lending Facility (SLF) rates by 50 basis points to 6.50 per cent and 8.00 per cent respectively, in February 2016.

13. Several other measures were also taken to contain credit flows to selected sectors. As a significant surge in motor vehicle imports was observed in 2015, a minimum cash margin requirement of 100 per cent was imposed on Letter of Credit (LCs) opened with commercial banks for the importation of motor vehicles with effect from 30 October 2015 as a temporary measure for a period of one month. Subsequently, as a macro-prudential measure, a maximum Loan to Value ratio (LTV) of 70 per cent was imposed in respect of loans and advances granted for the purpose of purchases or utilization of motor vehicles. The CBSL is closely monitoring any signs of buildup of demand and inflationary pressures and stands ready to take any further monetary tightening measures should it be required.

14. Over the past several years, the CBSL and the government have fulfilled a number of prerequisites required to moving towards Inflation Targeting in the medium term. At present, as an interim arrangement, the CBSL conducts its monetary policy within an enhanced monetary policy framework with features of both Monetary Targeting (MT) and Flexible Inflation Targeting frameworks (FIT). Under this framework, CBSL focuses on stabilizing inflation in mid-single digits level over the medium term, while supporting the growth objectives and flexibility in exchange rate management. The CBSL currently uses the average call money rate as its operating target and increasingly relies on market based instruments, namely policy interest rates and open market operations. Over the medium term, as our authorities continue to address the remaining barriers for gradually moving towards FIT regime, the CBSL will continue its current initiatives with the IMF to improve its macroeconomic modelling framework and forecasting capabilities.

External Sector

15. Sri Lanka’s external sector showed a subdued performance in 2015, due to challenging global economic environment and several domestic factors. The decline in external demand for major export commodities due to the slow recovery of the global economy and the withdrawal of foreign investments from the government securities market anticipating normalization of monetary policies in advanced economies and the slowdown in FDIs were major reasons for the lower performance of the external sector. Also, increased consumption demand through excessive fiscal expansion, as well as policy uncertainties amidst two national elections exerted a pressure from the domestic front on the external sector in 2015. However, foreign investors’ appetite for the International Sovereign Bonds remained intact during the year, and two sovereign bond issues amounting to US dollars 2.15 billion were completed successfully.

16. Although the trade deficit continued to widen due to an increase in non-oil imports and slowdown in export earnings, a substantial increase was largely avoided as a result of the low expenditure on oil imports. The current account deficit, at 2.4 per cent of GDP, remained almost unchanged from the previous year’s level, benefiting from increased earnings from services exports and the surplus in the secondary income account. Inflows to the financial account of the balance of payments (BOP) was adversely affected by the decline in foreign investments, slowdown in inflows to the government and unwinding of foreign investments from the government securities market. This resulted in the BOP recording an overall deficit of US dollars 1,489 million in 2015. Gross official reserves remained at US dollars 7.3 billion at end 2015 which was equivalent to 4.6 months of goods imports.

17. Promoting Sri Lanka’s export sector with greater integration into regional and global supply chains is one of the main priorities of our authorities. For this purpose, a Development Agency for the prioritization of infrastructure investments and Trade Agency for trade promotion and negotiation of trade and investment agreements will be established. On the more positive note, Sri Lanka is now delisted from the EU ban on fishery imports while measures are being taken to regain the GSP+ trade status.

Exchange Rate Policy

18. An increased pressure in the foreign exchange market was witnessed since late 2014. This was largely due to the increased trade deficit, slowdown in net capital inflows, increased debt service payments of the government as a result of the depreciation of Sri Lanka Rupee against the US dollar, repayment of the matured International Sovereign Bond of USD 500 million in early 2015 and the unwinding of foreign investment in government securities market. The CBSL intervened in the foreign exchange market to reduce undue pressure on the exchange rate by supplying about USD 1.9 billion, on net basis, during the first eight months of the year. However, on 03 September 2015 the CBSL decided to limit its intervention in the domestic foreign exchange market and allowed the exchange rate to be largely determined in the market. This resulted in Sri Lankan rupee depreciating at a higher magnitude during the rest of the year. Accordingly, rupee depreciation against the US dollar during the year was 9.03 per cent. The CBSL’s net supply of foreign exchange during the year amounted to US dollar 3.2 billion, largely driven by capital account transactions.

19. During the first four months of 2016, some pressure was observed in the foreign exchange market despite the correction in the nominal and real exchange rates, partly attributable to market uncertainties and delays in repatriation of export proceeds. CBSL intervention during the period was amounted to US dollar 1.16 billion while the rupee depreciated by 0.1per cent. However, the renewed SWAP arrangements with the Reserve Bank of India (RBI) for USD 700 million and the South Asian Association for Regional Cooperation (SAARC) for USD 400 million provided an additional buffer. During May 2016, a turnaround of CBSL intervention was seen with CBSL purchasing about USD 76 million, on net basis, alongside the stabilization of the exchange rate. This could be mainly attributed to improved investor confidence in the wake of the successful negotiations for a program facility with the IMF. Going forward, our authorities will take necessary steps to meet essential preconditions for an increasingly flexible exchange rate regime.

Financial Sector

20. The financial sector stability and soundness improved in 2015, reflecting high capital and liquidity levels and increased profitability. The Capital Adequacy Ratios (CAR) in the banking sector have been maintained well above the regulatory minimum ratio of 10 per cent. As at end 2015, the total CAR and core CAR remained at 14.2 per cent and 11.9 per cent respectively. The banking sector recorded increased level of profits in 2015, largely attributed to the healthy growth in net interest income. Meanwhile, non-performing loans (NPL) ratio declined to 3.2 per cent in 2015 from 4.2 per cent in 2014. However, total loan loss provisions have been increased with an increase in the specific provisions made for NPLs in the loss category. In line with the current regulatory developments, the Liquidity Coverage Ratio under Basel III was implemented in 2015 and the Basel III Capital Standards are expected to be implemented in line with international timelines. Our authorities are committed to the finalization of a resolution framework for weak finance companies (the total assets of which approximately 1 per cent of GDP) through the establishment of a Special Purpose Vehicle and the IMF’s technical assistance is currently being sought for this purpose.

Conclusion

21. The Sri Lankan authorities wish to thank the Executive Board for considering their request for financial support under a three-year EFF. They believe that the proposed arrangement by the Fund would support implementation of essential policy reforms to improve external and fiscal buffers and create a conducive environment to achieve high and sustainable economic growth with the support of the international community. Our authorities have already completed required prior actions and are fully committed to implementation of the program. While program ownership will be strengthened, there could be elevated economic and financial risks to the program due to uncertainties with respect to the global economic environment as well as uncertain domestic conditions similar to the recently experienced devastating natural disaster. Such conditions need to be taken into consideration for suitable adjustment.