Public Information Notice No. 97/18

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

August 5, 1997

The IMF Executive Board on July 23, 1997 concluded the 1997 Article IV consultation¹ with Sri Lanka.

Background

Over the past two decades, Sri Lanka’s economy has grown at an average of about 4 percent per year, resulting in per capita growth of over 2 percent annually. This performance falls far short of that of the dynamic countries in East and Southeast Asia with whom Sri Lanka shared similar initial conditions and structural characteristics in the early 1960s. Although increased openness has made the economy more resilient, structural reforms during this period have not been sufficient to put Sri Lanka on a higher growth path. In particular, the relatively low saving and investment rates, and the large portion of resources pre-empted by persistently high fiscal deficits, have been major constraints. Important strides have been made, however, in human resource development, especially education and income distribution.

In 1996 economic growth slowed to 3.8 percent—the slowest rate since 1989—due to the effects of a prolonged drought on agriculture and hydroelectric power generation. In addition, a deterioration in the security situation affected investment and tourism. The slow growth of the economy was reflected in a weakening of both exports and imports, with the current account deficit falling to 5 percent of GDP in 1996. Signs of a recovery emerged in late-1996 with a pick up in the growth of exports, intermediate and capital goods imports and tourist arrivals, as well as an upturn in the stock market. Assuming the continuation of these trends, growth is expected to rebound to 6 percent in 1997. Consumer price inflation accelerated sharply, reaching 22 percent (annual rate) in September 1996, due to food shortages and increases in administered prices and excise taxes, before subsiding to 4 percent in June 1997. However, underlying inflation, at around 10 percent, has remained broadly unchanged from 1995.

The fiscal deficit narrowed to 9½ percent of GDP in 1996. Expenditure overruns early in the year prompted an increase in the price of wheat flour to contain subsidies, a strengthening of cash controls, and increases in excise taxes. Nonetheless, the budget remained structurally weak, as evidenced by the lack of buoyancy in the tax system and a widening of the deficit on current operations. The 1997 budget aims to reduce the overall deficit further to 7.8 percent of GDP, to be financed without recourse to bank borrowing.

Although net bank credit to government was large in 1996, the weakness in money demand associated with the sluggishness of the economy led to a marked slowing in the growth of monetary aggregates and credit to the private sector. More cautious lending practices by banks in light of rising levels of nonperforming loans also played a role. In early 1997, the Central Bank lowered the high reserve requirements in an attempt to support the economic recovery, and interest rates, after falling sharply in January, have been on the decline since then. Under the Central Bank’s managed float of the rupee, reserves have declined moderately during 1996 and early 1997, to about 4-4 ½ months of imports. While the value of the rupee in nominal effective terms has been broadly stable, high inflation led to a real effective appreciation of the rupee during 1996, some of which has been reversed in recent months with a nominal depreciation and the decline in inflation.

The main recent accomplishments on the structural side include: the elimination of quantitative restrictions on food imports; the passage of legislation for a goods and services tax; the termination of the expensive early retirement benefits for civil servants; the introduction of medium-term treasury bonds; and continuation of the privatization program.

Executive Board Assessment

Directors commended the steps taken by the authorities to regain control over the fiscal situation in the second half of 1996 and noted the improved economic outlook for 1997. The main challenge now facing the authorities was to build on that success to make an urgent and comprehensive effort to strengthen macroeconomic policies and accelerate structural reforms in order to address the longstanding economic problems that were impeding Sri Lanka’s growth potential.

Directors noted that the high fiscal deficits of the preceding several years had been the source of many of Sri Lanka’s economic problems, and emphasized that fiscal consolidation must therefore be the key ingredient in the adjustment strategy to stabilize the economy and improve its growth prospects. To that end, they welcomed the planned reduction in the overall deficit by 2 percent of GDP in 1997, and urged close vigilance and prompt corrective actions to ensure that the target was not missed. In particular, they stressed the importance of removing the subsidy on wheat and putting in place a flexible pricing system for wheat flour to prevent the re-emergence of a subsidy.

Directors emphasized the importance of achieving a significant reduction in the overall budget deficit in 1998 and beyond. They stressed that it was also important to strengthen the structure of the budget and improve the buoyancy of the tax system, and noted that the introduction of the goods and services tax with the 1998 budget would be vital.

On the expenditure side, the most pressing need was to launch a comprehensive reform of the civil service and pension systems to control the wage and pension bills, to improve the targeting of social welfare programs, and to phase out transfers to public entities as they continued to be restructured, as well as to improve the overall expenditure management.

Directors stressed that it would be important to keep inflation well within the single-digit range to signal the authorities’ serious commitment to macroeconomic stability. That would require a tight monetary policy stance through more aggressive open market operations. On exchange rate policy, Directors were of the view that, although the policy of a managed float remained appropriate, it would be important to allow the exchange rate to respond more flexibly to market forces.

Directors noted the progress achieved in some areas of structural reform, notably privatization, the elimination of overgenerous early retirement benefits, and the rationalization and consolidation of social welfare programs. However, they regretted that Sri Lanka’s growth had been severely constrained by the slow progress in addressing structural weaknesses in several key areas, and urged the authorities to press ahead with an ambitious program of structural reforms. Specifically, Directors pointed out that priority should be given to strengthening the financial system and increasing its efficiency, which was crucial for ensuring medium-term macroeconomic stability. Foremost in that regard were actions to improve the financial health of the two state-owned commercial banks, which should be given greater commercial autonomy, including through legislative changes. The standards of prudential regulation and the effectiveness of financial system supervision would need to be strengthened. As for other structural reforms, the momentum on privatization should be maintained and enterprises identified for further privatization, trade reforms should be reinvigorated, and greater priority should be given to reforms aimed at promoting competitive market forces in agriculture and reducing rigidities in the labor market.

Directors welcomed the authorities’ wish to obtain IMF support under a new three-year ESAF arrangement, which they saw as an encouraging sign of the authorities’ commitment to medium-term adjustment. To establish a credible base for an ESAF-supported program, Directors stressed that it would be important to introduce a structurally sound budget for 1998 and to move from the design phase of structural reforms to the establishment of firm timetables for specific actions in the implementation of measures in priority policy areas.