Public Information Notice No. 05/102

Public Information Notice: IMF Executive Board Concludes 2005 Article IV Consultation with Sri Lanka

August 2, 2005

On July 15, 2005, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Sri Lanka.¹

Background

Since the last Article IV consultation, economic growth momentum has largely been sustained, but accommodating monetary and fiscal policies have added to inflationary pressures. The Sri Lankan authorities, supported by the international community, have provided the initial stages of tsunami relief relatively efficiently. However, implementation of the more difficult reconstruction phase will affect economic performance going forward.

Export performance was strong in 2004, aided by textiles and tourism arrivals, but rising oil prices and a drought were a drag on growth. Real GDP increased by 5.4 percent, compared with 6.0 percent in 2003. Growth was led by domestic demand, especially strong private investment, which contributed to rapid growth in imports. Annual inflation reached 16.8 percent (end-of-period), reflecting demand pressures as well as higher food and oil prices.

The fiscal deficit reached 8¼ percent of GDP in 2004, or 1½ percentage points higher than budgeted. Revenues fell short of the budget target owing to the late enactment of income tax amendments and lower than expected profit transfers from the central bank. Expenditure overruns were due to higher subsidies (mostly for oil). The impact on net domestic financing, which reached 6 percent of GDP, was exacerbated by lower privatization proceeds and shortfalls in program financing. To help bridge this gap, the government issued $250 million (1¼ percent of GDP) in dollar denominated bonds in the domestic market.

With the central bank purchasing large amounts of treasury bills, ample liquidity was available for private credit, and money growth increased significantly. Broad money increased by 20 percent, compared with 15 percent in 2003. With the increase in inflation, and despite a modest increase in policy rates by 50 basis points in November, real interest rates remained negative contributing to private credit growth of 22 percent. In contrast to the previous year, monetary expansion in 2004 was accounted for by an expansion of private and public credit rather than an increase in international reserves.

The balance of payments shifted to a deficit of $205 million in 2004, from a surplus of $502 million in 2003. Despite robust export performance, the current account moved from near balance to a deficit of 3 percent of GDP, reflecting the effects of both oil price increases and strong demand for investment goods. Official external financing—especially program loans—dried up significantly, with donors waiting for an articulation of the government's policy agenda. By end-2004, the rupee had lost 8 percent of its value against the dollar (y/y), despite central bank intervention, and gross official reserves had fallen to $1.8 billion (equivalent to 2.1 months of imports).

The 2005 budget, approved in December 2004, envisaged a reduction in the deficit to 7½ percent of GDP. The budget aimed to improve economic conditions for the rural poor, increase spending on health and education, phase out numerous subsidies, including on petrol and diesel, and reaffirmed the government's commitment to meet the targets of the Fiscal Management (Responsibility) Act, albeit on a delayed timetable. While the 2005 budget targets represent a welcome step toward putting government debt on a declining path relative to GDP, budget estimates appeared overly optimistic, particularly for revenue.

Progress has been made on some structural reforms, but problems remain, especially for some key public enterprises. On revenue administration, the cabinet approved in June 2004 the listing of various revenue departments under a revenue board. However, much remains to be done on the concurrently approved restructuring of the Inland Revenue Department. In the financial sector, the ADB approved a program loan in support of the restructuring of People's Bank, whose performance indicators have improved. In the energy sector, however, large fiscal and quasi-fiscal costs arising from the operations of the Ceylon Petroleum Corporation (CPC) and the Ceylon Electricity Board (CEB) have taken place in 2004-05. Direct subsidies from the budget amounting to 1 percent of GDP in 2004, and ½ percent of GDP so far in 2005, have been paid to CPC to cover their losses. While electricity charges are among the highest in the region, operational inefficiencies in CEB have led to significant losses and accumulated debt (including arrears) amounts to about 4 percent of GDP. Deadlines for reforming CEB have been postponed repeatedly.

While still vulnerable, the macroeconomic situation has stabilized somewhat since the tsunami. The rupee ended its downward slide on the expectation of aid inflows and has appreciated 5 percent against the U.S. dollar through mid-July, and gross reserves increased by more than $300 million reflecting the IMF's emergency assistance and other donor disbursements. However, monetary aggregates have continued to grow rapidly and inflation has remained high, despite efforts by the central bank to absorb excess liquidity, and increases in policy interest rates in May and June of 25 and 50 basis points, respectively. Fuel prices have been adjusted twice so far in 2005, but fuel subsidies continue to be a drag on the budget. Stock prices, after a dip in the immediate aftermath of the Tsunami disaster, have continued their rising trend from 2004 and are up by about 25 percent so far this year.

Executive Board Assessment

Executive Directors commended the Sri Lankan government for its prompt and effective implementation of relief work to cope with the loss of life, suffering, and destruction caused by the December 2004 tsunami. A key ongoing challenge will be to manage the reconstruction activity in an efficient and transparent manner by mobilizing donor assistance effectively and maintaining macroeconomic stability. The longer-term challenges facing Sri Lanka include moving toward fiscal consolidation, implementing structural reforms that enhance the investment climate, and reviving the peace process, in order to establish a solid foundation for sustainable growth and reduction of poverty.

Directors observed that near-term prospects for economic growth remain positive, with reconstruction activity and a strong performance of the agricultural sector expected to offset the tsunami's adverse impact on fisheries and tourism. They cautioned, however, that inflationary pressures could be exacerbated if reconstruction faces bottlenecks. Accordingly, Directors emphasized the importance of effective management of the reconstruction, with the government continuing to coordinate official tsunami assistance and oversee arrangements to monitor private aid flows. They welcomed the establishment of the Task Force for Reconstruction of the Nation and the appointment of an external auditor, and called for periodic reports on the use of aid directly to the public and the donor community, as well as implementation of audit procedures to ensure transparency and accountability.

With the reconstruction plans in place, Directors considered that emphasis should now be placed on Sri Lanka's longer-term challenges. Positive factors behind the growth outlook include the significant untapped potential in the North and East of the country, the country's open trade policies, and increased commercial links with its fast growing neighbors. At the same time, Directors noted that a complex tax system, labor market rigidities, poor infrastructure, and an underdeveloped capital market constrain private investment and impede growth.

Directors cautioned that the recent large fiscal deficits and the high level of public debt constitute a potential source of macroeconomic instability. Noting that meaningful progress toward the path of fiscal consolidation envisaged under the Fiscal Management (Responsibility) Act has been elusive, Directors called for stronger efforts at fiscal consolidation. Improvements in debt management, and curtailment of central bank financing of the budget in the context of a medium-term budget framework, remain essential.

Directors welcomed the recent improvement in revenue performance, noting, in particular, that several measures had helped increase tax revenue relative to GDP in 2004. However, the authorities were encouraged to consider additional measures if needed to ensure that the revised 2005 budget targets for revenue are achieved. In addition, Directors encouraged the authorities to give priority to a comprehensive tax reform, including improvements in tax and customs administration as well as broadening of the tax base.

Directors considered that fiscal adjustment will also need to focus on the expenditure side, with the aim of shifting expenditure to priority infrastructure and poverty-related projects. The authorities were urged to cut fuel subsidies, particularly for petrol and diesel, by raising prices to cost-recovery levels. Directors also reiterated the need for civil service reform to contain the wage bill and decompress the wage structure. To protect the poor from the effects of these measures, Directors encouraged the authorities to proceed with earlier plans to improve the targeting of welfare benefits.

Directors commended the central bank's recent actions to tighten monetary policy and increase transparency. Nevertheless, inflation remains high and monetary and credit aggregates continue to grow rapidly. Accordingly, Directors recommended appropriately paced additional monetary tightening in order to signal the central bank's determination to curb inflation and reduce inflationary expectations. Some Directors also felt that greater independence of the central bank would contribute toward these objectives.

Directors reiterated their support for the flexible exchange rate regime, which has helped cushion the external and domestic shocks of 2004-2005. They concurred that some smoothing of the exchange rate path is appropriate, especially given the large aid inflows and import needs over the coming months. However, Directors underscored the risks of trying to avoid an exchange rate depreciation through protracted intervention. They also advised that reserves be increased to more comfortable levels over the medium term. Directors urged the authorities to maintain their long-standing commitment to an open trade regime, which will play an important role in ensuring that Sri Lanka benefits from strong global and regional growth.

Directors encouraged the authorities to move forward with the restructuring of key public enterprises. They welcomed the creation of the Strategic Enterprise Management Agency (SEMA) to monitor those enterprises expected to remain in the public sector. Directors expressed concern that the fiscal and quasi-fiscal costs incurred by the Ceylon Electricity Board (CEB) and Ceylon Petroleum Corporation (CPC) threaten to undermine fiscal sustainability and economic performance, and urged the authorities to make further tariff adjustments and proceed with their restructuring. More broadly, Directors suggested a more comprehensive monitoring of public enterprises' fiscal risks.

Directors commended the authorities for the progress made in the regulation and supervision of the financial system since the completion of the Financial Sector Assessment Program (FSAP) in 2002. As a result, financial indicators have improved across the entire banking system, including in the two state-owned commercial banks. However, Directors warned that the recent rapid growth in lending could lead to a deterioration of asset quality. They emphasized that the planned recapitalization of People's Bank should proceed on the basis of the achievement of agreed performance targets. Looking ahead, Directors encouraged efforts to promote greater competition in the banking system, and some called for the increased commercialization of the state-owned banks.

Directors considered that Sri Lanka's statistical information is adequate for surveillance purposes and encouraged the authorities to improve the quality and coverage of fiscal statistics and address the remaining issues needed to meet Special Data Dissemination Standard (SDDS) requirements. They commended the authorities for successfully addressing the recommendations of the Safeguards Assessment.

Directors expressed regret about the delays in completing the reviews under the Poverty Reduction and Growth Facility and Extended Arrangements. They looked forward to continued progress in the near future toward the development of a credible and sustainable economic reform program based on a broad domestic consensus.