Public Information Notice No. 01/45

Public Information Notice: IMF Concludes Article IV Consultation with Sri Lanka

May 14, 2001

On April 20, 2001, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Sri Lanka.¹

Background

Over the last decade, Sri Lanka's economy has grown steadily, but at a relatively slow rate. During the late 1980s and 1990s, financial markets were liberalized, the outward orientation of the economy was significantly increased, and a more diversified export base established. Progress has been made in other areas, most notably privatization. However, underlying the modest growth performance have been relatively low levels of saving and investment. Prolonged periods of public dissaving have reflected substantial fiscal deficits that averaged more than 9 percent of GDP. Moreover, modest progress was made in other key structural areas, including restructuring of the civil service and state monopolies, financial and labor market reforms, and increased spending on education and health, thus undermining the economy's growth potential.

After slowing in the aftermath of the Asian crisis, economic activity picked up from mid-1999 to the third quarter of 2000 (with annualized growth increasing to about 7 percent) as a result of recovery in Sri Lanka's main export markets, particularly for textiles, garments, and tea. Growth subsequently slackened to about 5 percent, as poor monsoons affected agricultural output and high interest rates worsened the general business environment. The savings-investment gap widened to 7 percent of GDP: gross domestic investment increased as a result of increased private investment in the garments and textiles sector, ports, and power plants, while gross national savings declined as a result of a substantial decline in public savings.

From the fourth quarter of 1999 the rupee came under considerable pressure. Although exports grew strongly, the higher cost of oil imports, and increased military imports resulted in a sharp increase in the external current account deficit in 2000. As a result, gross official reserves dropped by more than $600 million, to less than 1½ months of imports in 2000. Despite progressively widening the band to allow a 10 percent depreciation of the rupee against the dollar during the second half of 2000, the central bank was forced to defend the lower end of the exchange rate band. However, because of the weakening of other partner country exchange rates vis-à-vis the dollar, the rupee only depreciated by 6½ percent in nominal effective terms, and appreciated by 1½ percent in real effective terms. Some external vulnerability indicators worsened in 2000, but the high share of concessional external debt, and limited portfolio flows, suggest medium-term external vulnerability is not especially high.

After declining in 1999 and the first half of 2000, consumer price inflation rose sharply in the second half of 2000, on account of increases in administered prices of petroleum products, transport fares, and public utility charges. As a result, inflation was 10¾ percent at end-2000, and has increased further in the first two months of 2001, owing to the impact of the depreciation and further utility price increases.

The overall fiscal deficit rose to 9¾ percent of GDP in 2000, reversing the fiscal consolidation achieved in 1999. This outcome, sharply worse-than-originally projected, reflected both increased security-related expenditure due to the escalation of the civil conflict, and a shortfall in tax revenue. As a result, public savings were significantly negative and domestic bank financing was 3½ percentage points of GDP higher than projected.

Monetary policy has been constrained by the fiscal situation, requiring high real interest rates to counter exchange rate and inflationary pressures. As a result, the Central Bank of Sri Lanka raised the overnight repo and reverse repo rates by 6-7 percentage points in the second half of 2000. In spite of the sharp increase in lending to the public sector, overall broad money growth was contained at 13 percent as a result of a sharp decline in net foreign assets, reflecting the fall in official reserves.

Structural reforms are focused on current plans to improve the financial sector, public enterprises, public administration, and pensions. The authorities are implementing plans for restructuring and management changes in the two state banks and for an enhanced bank supervision framework for the commercial bank sector. While the privatization and state enterprise restructuring program continues, the challenge remains to reform the civil service and pensions systems. Prospects for regional trade integration were boosted by the Indo-Lanka Free Trade Agreement, which came into effect in February 2000.

Economic Prospects

Reduced growth of 4-4½ percent is expected in 2001, led by slower growth in services and manufacturing output. Although continued buoyancy of the garment sector should boost manufacturing activity, the rapid expansion of garment sales to the U.S. in 2000 is not expected to be maintained. Early indications are that agricultural output will remain sluggish, affected by delayed and poor monsoon rains. The pace of inflation is expected to ease by mid year once the exchange rate depreciation and increases in administered prices have taken their full effect. The new stabilization program will reduce domestic demand, especially for consumer imports, through a higher tax burden and lower real incomes. With substantial official financing and privatization proceeds, gross official reserves are projected to rise to US$1.5 billion, about two months of imports of goods and services.

Executive Board Assessment

They noted that notwithstanding the effect of the civil conflict on Sri Lanka's economy, robust growth of exports supported by the authorities' efforts to implement sound macroeconomic policies have led to respectable economic growth over the past decade. Against the background of the serious economic difficulties that arose in 2000, the Directors generally welcomed policy adaptations adopted by the authorities, especially the substantial fiscal consolidation, the concerted improvement in the financial position of the public enterprises, and a flexible exchange rate policy. Directors expressed serious concern, however, at the slow pace of reform implementation.

Directors agreed that the fiscal targets for 2001 and 2002 and the underlying revenue and expenditure measures were appropriate. In this context, they considered that the main challenge facing the authorities in the short term was to arrest the severe deterioration in the fiscal accounts that took place in 2000 by putting security-related spending under control and improving revenue collection.

Directors called for strengthening the financial position of the public enterprises. In this regard, they noted that the impact of high oil prices was considerable in 2000, and commended the authorities for significant increases in administered prices. These changes should reverse the operating losses of the Ceylon Petroleum Corporation by the end of 2001 and lessen the fiscal cost of other subsidies. Directors welcomed the authorities' commitments to put in place an automatic pass-through mechanism, which would ensure that domestic fuel prices respond to changing world oil prices.

Directors welcomed the authorities' adoption of a fully flexible exchange rate mechanism. They emphasized that the central bank should limit its intervention in the foreign exchange market to dampening volatility, as well as to permit the central bank to build up reserves. In this regard, Directors welcomed the recent relaxation of foreign exchange regulations and urged the authorities to rationalize the remaining regulations in order to reinforce the market determination of the exchange rate.

Directors expressed concern over the increase in inflation in 2000, while noting that this was largely related to exogenous developments. Nevertheless, Directors urged the authorities to maintain tight monetary policy, at least until the fiscal adjustment takes hold, inflation declines, and reserves start to increase. In this context, several Directors cautioned against any premature easing of interest rates. The authorities would also need to ensure that the use of open-market operations is consistent with the monetary targets. Directors urged the central bank to develop further its reserve money framework with the assistance of MAE.

Looking forward, Directors noted that for Sri Lanka's medium-term viability, the authorities would need to press ahead with an ambitious structural reform agenda. In view of widespread poverty, Directors expressed the hope that the authorities would design and implement a program to foster sustainable growth and poverty reduction under a program that could be supported by a PRGF arrangement. In this context, Directors urged the authorities to improve the performance of the public sector, and improve the prospects for private sector activity to establish an economic environment conducive to a higher growth path. They noted that the structural reform agenda should be supported by medium-term fiscal consolidation, which would help release resources for more productive private sector activities. Thus, Directors endorsed the government's medium-term objective to reduce the overall deficit to below 5 percent of GDP. Looking ahead to a possible PRGF arrangement, some Directors stressed the critical importance of controlling security-related expenditures and ensuring that they did not crowd out social programs and outlays for poverty alleviation.

Directors recommended that plans be developed to make the civil service pension scheme more affordable, while the treatment of government and nongovernment employees should be unified to increase labor mobility. They called on the authorities to improve the functioning of the labor market by moving ahead with the proposed revision of the procedures for dispute settlement and arbitration. An overhaul of key labor legislation would also allow enterprises greater freedom to determine appropriate staffing levels and thereby facilitate job creation.

Directors emphasized the need to strengthen the financial system and increase its efficiency, and in this context they welcomed the authorities' participation in the joint Bank-Fund Financial Sector Assessment Program. They called on the authorities to implement fundamental reform of the state banks without delay, with the government committing public funds only after serious restructuring has taken place.

Directors noted that the authorities have been providing the Fund with key economic statistics on a timely basis that are adequate for program monitoring and macroeconomic surveillance, while urging the authorities to take the remaining necessary steps for subscription to the SDDS.