Public Information Notice No. 98/58

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

August 12, 1998

On July 27, 1998, the Executive Board concluded the Article IV consultation with Sri Lanka¹.

Background

Despite the unfavorable regional impact of the Asian crisis, real economic growth rebounded to 6.4 percent in 1997, from 3.8 percent in 1996. There was a strong recovery in the output of traditional agricultural products (tea and paddy products); higher output and exports of manufacturing products (garments and textiles); and continued good performance in the services sector (electricity, telecommunications, and tourism). Preliminary figures suggest that the real economy grew by 5.8 percent in the first quarter of 1998, reflecting broad based growth across most sectors of the economy, especially services and manufacturing. Consumer price inflation declined from 17 percent at end–1996 to under 11 percent at end–1997. However, increases in some food prices (rice and vegetables), effects from the introduction of the Goods and Services Tax (GST) on April 1, and an increase in the growth of monetary aggregates, caused inflation to rise to 14 percent by end–June 1998.

The external current account deficit narrowed to 3 percent of GDP in 1997, reflecting strong export growth of textiles, garments, and tea; high growth of port services; and higher transfers arising from compensation payments to victims of the Gulf War. However, since mid–1997, exports of gems, rubber, and coconuts, which represent about 14 percent of total exports, have been affected by a reduction in demand and increased competition from crisis countries in the region. Capital inflows were augmented by privatization receipts and the overall balance of payments turned around from a deficit in 1996 to a surplus, improving the international reserves position. Sri Lanka has managed to avoid the worst of the Asian crisis as many of the conditions that existed in the crisis countries did not hold in Sri Lanka (e.g., overheating pressures, speculative bubble in asset prices, large flows of portfolio investment, unsustainable debt positions). The capital account is not fully open; there had been no large inflows of "hot money" in the previous years; portfolio and direct foreign investment flows account for a low proportion of capital flows; the short–term debt stock is small is mainly trade–related and the exchange rate has been allowed to depreciate gradually.

The overall fiscal deficit narrowed further in 1997, to 8 percent of GDP, in line with the budget target. However, this was achieved only at the expense of lower–than–budgeted development expenditure that more than offset a revenue shortfall, principally from indirect taxes. As a result, the current account deficit was only reduced from 4 percent of GDP in 1996 to 2¼ percent of GDP in 1997, compared to the budget target of 1½ percent of GDP. Nevertheless, higher than anticipated privatization receipts allowed the government to make repayments on its outstanding debt to the banking system, including a Rs 14 billion repayment to the Central Bank of Sri Lanka (CBSL). The 1998 budget aims to reduce the overall fiscal deficit further to 6½ percent of GDP, to be financed without recourse to bank borrowing.

The CBSL relaxed its monetary policy stance in the first quarter of 1997 with the aim of supporting economic recovery, following the drought of the previous year. Reserve requirements were lowered to increase liquidity and lower interest rates, and thereby spur the demand for credit. In the event, credit expansion remained slower than expected in the first half of the year as both lenders and borrowers remained cautious. In the second half of 1997, a surge in capital inflows from privatization receipts, foreign disbursements, and private transfers, led to a new wave of sterilization operations by the CBSL. From the end of 1997 onward, monetary policy was tightened somewhat through increases in the CBSL’s repurchase rate and in the spread vis–à–vis the rediscount rate, in an effort to ease exchange rate pressures from events in neighboring Asian countries.

Since March 1997, the growth of broad money, including all commercial bank foreign currency deposits, accelerated, reaching 16 percent in the first quarter of 1998. The increase was associated with a sharp improvement in net foreign assets, as official international reserves increased in dollar terms during the year, remaining constant at 4 months of import coverage. Net credit to government declined, following the contraction in the fiscal deficit and retirement of public debt with substantial privatization receipts. While the growth of credit to the private sector in domestic currency during the year was moderate, lending in foreign currency rose sharply.

While the CBSL has continued to manage the exchange rate in a flexible manner, the sharp depreciation of other Asian currencies during 1997, including the yen, together with higher domestic inflation, led to a real effective appreciation of the rupee during the year. However, about half of the appreciation was reversed in the first half of 1998, following an increase in the pace of rupee depreciation.

On the structural side, the main recent achievements include the introduction of the GST; several successful divestitures; tighter controls on government salaries and employment; and steps to improve the control of the core civil service and the efficiency of non–core institutions. There has been a strengthening of auditing standards as well as reporting and prudential requirements of financial institutions. In response to the problems in the two state banks, including high levels of nonperforming loans, the authorities signed Memoranda of Understanding with the two banks in July 1998, establishing management contracts linked to specific annual performance targets, including loan recoveries and cost reductions.

Executive Board Assessment

Executive Directors commended the authorities for maintaining macroeconomic stability in 1997, despite the continued civil strife and a difficult regional environment, and for making steady progress in addressing structural weaknesses. Directors noted that the principal challenge now facing the authorities is to consolidate recent macroeconomic gains and elaborate a comprehensive structural adjustment reform program. There were still considerable downside risks stemming from the regional crisis and the civil conflict, but the authorities’ efforts to work with parliament to pass needed legislation was commendable. In this regard, Directors underscored the critical importance of the authorities’ tightening fiscal and monetary policies and accelerating key structural reforms so as to build the foundations for strong private–sector–led growth. Directors stressed that action in these areas should pave the way for discussion on an ESAF-supported program. In this connection, it was important to elaborate feasible and credible reforms in the areas of the financial sector, the civil service, and pensions.

Directors emphasized that continuing progress in fiscal consolidation was a key ingredient in maintaining macroeconomic stability. Thus, Directors endorsed the targeted reduction in the overall fiscal deficit for 1998. They welcomed the measures recently announced by the authorities to raise excise duties on tobacco in the framework of the government’s mid–year budget review. However, in view of the uncertainty of the Goods and Services Tax (GST) revenue collection and the potential for expenditure overruns, Directors urged the authorities to take further timely corrective actions. In this regard, they suggested that the authorities broaden the tax base, especially by reducing exemptions to the GST and improving tax collections, to contribute to improving the prospects for achieving their budget target. They indicated that emphasis on revenue-raising measures should reduce reliance on sharp cuts in essential social spending and needed infrastructure to meet the budget target.

Directors strongly recommended building further on the 1998 fiscal outturn and deepening fiscal consolidation in 1999 in order to release resources necessary for the expansion of the private sector. Directors saw scope for further rationalization of the tax structure and for decisive and comprehensive restructuring of the public sector that would allow the achievement of a current fiscal surplus and a reduction in the overall central government deficit. Thus, they welcomed the authorities’ intention to eliminate unnecessary government functions, and called for the elimination of many tax exemptions, as well as reform of the core civil service and pension systems to control wage and pension outlays.

In order to signal a serious commitment to stabilization, Directors urged the authorities to tighten the monetary stance in an effort to reduce inflation to single digits by the end of the year. To maintain competitiveness, Directors stressed the need for the authorities to continue managing the exchange rate in a flexible manner—intervening in the foreign exchange market only to smooth temporary fluctuations—and supported the proposal to widen the band. They also emphasized that to maintain external competitiveness, any sustained depreciation in the market exchange rate should be viewed as a warning to tighten further monetary policy.

Drawing lessons from the Asian crisis, Directors noted that financial sector weaknesses, including the relationship between the state and the banking sector, needed to be promptly identified and corrected. Thus, they emphasized the need to move quickly and decisively to address longstanding and fundamental problems that have weakened the banking sector. While Directors welcomed the performance contracts in the form of memoranda of understanding aimed at improving the commercial viability of state banks, they urged the authorities to separate the commercial and noncommercial activities of the two state banks and to privatize them as soon as possible. Directors also saw equal urgency in further raising the standard of prudential regulations for the financial system as a whole, and making supervision much more effective.

Directors commended the authorities for the successful divestiture of the government’s holdings in a number of major enterprises, and supported the privatization program for 1998. Directors encouraged the authorities to establish a timetable for the next wave of privatization, and to continue their efforts to promote the commercialization and increase the transparency of all enterprises remaining in the public sector. Several Directors noted the slow progress in tackling labor market rigidities, calling on the authorities to overhaul the key legislation.

While recognizing the progress that had already been made, Directors urged the authorities to continue on the path of trade liberalization and to establish a more transparent and unified tariff regime by moving directly to a two-band tariff structure and by further reducing the maximum tariff rate. With regard to the capital account, Directors pointed to the benefits of further liberalization of foreign direct investment inflows.