Public Information Notice No. 06/132

Public Information Notice: IMF Executive Board Concludes 2006 Article IV Consultation with Sri Lanka

November 13, 2006

On October 25, 2006, 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, the economy has shown resilience in an environment of rising oil prices and the removal of export quotas for textiles and apparel. Real GDP increased by 6 percent in 2005 and by a further 8 percent in the first quarter of 2006. Growth was led by domestic demand and underpinned by improved agricultural performance, strong tsunami-reconstruction efforts, and robust service sector growth. Inflation declined from 18 percent in January 2005 to 3.5 percent at end-2005, helped by monetary policy tightening and a sharp decline in food prices. Inflation has, however, risen since early 2006, reflecting pressures from fast credit growth, the pass-through of higher oil prices, and increases in wages and pension payments.

The recent escalation of hostilities could pose a risk to future economic prospects. Peace talks in June did not generate an outcome for an early settlement of the ethnic conflict, bringing the four-year ceasefire close to collapse and the security situation has deteriorated further in recent months. The setbacks in the peace process, which have caused some weakening in confidence, could further affect investment going forward. The government and the main opposition party (UNP) have recently signed a Memorandum of Understanding on five key policy areas (the ethnic conflict, electoral reform, good governance, social development, and structure for collaboration) to facilitate consensus building.

The 2005 fiscal deficit widened to 8.7 percent of GDP, larger than budgeted, mainly because of tsunami-related spending. Excluding tsunami-related flows, the budget deficit was contained at 7.5 percent of GDP (compared to 8.2 percent of GDP in 2004). Revenue increased, reversing the downward trend of previous years. But there were large overruns in oil subsidies and in the wage bill, which were offset by cuts in other recurrent expenditures and a reduction in interest payments to protect capital spending.

The fiscal deficit in the first half of 2006 was contained through adjustment of capital expenditures. Tax revenue grew at a healthy 23 percent, but still fell short of the budget target of 27 percent growth. There have been sizable overruns on recurrent expenditure, emerging from larger than budgeted oil subsidies and pensions, as well as additional security and humanitarian spending. However, a generous capital budget provided scope for adjustment (in line with project execution) and helped to contain the deficit.

Sri Lanka's debt remains high by international standards and dollar-denominated commercial borrowing is building up. Total public debt declined by 11 percent of GDP (to 94 percent of GDP) in 2005. Sri Lanka was given its first international credit rating by Fitch (BB-) in December 2005, on par with Vietnam, Indonesia, Brazil, and Turkey. But renewed security concerns resulted in Fitch revising the country's outlook from stable to negative. The government decided to put the planned global bond issuance on hold and mobilized resources from domestic investors during April-September 2006.

The current account deficit narrowed in 2005, contributing to a stronger balance of payments despite the oil shock. However, further oil price increases and strong demand for non-oil imports are expected to contribute to an increase in the current account deficit by end-2006. Tsunami-related inflows have also slowed somewhat in 2006 while the debt service burden rose. Gross official reserves have been hovering around $2.4 billion, equivalent to 2.4 months of imports and 86 percent of short-term debt. The rupee-dollar exchange rate has weakened somewhat since the second half of 2005. Reflecting high domestic inflation relative to trading partners, the real effective exchange rate (REER) appreciated by 2 percent during the same period.

Despite monetary policy tightening, credit growth remains high. The central bank raised its policy rate five times (cumulative 2 percentage points) during November 2004-December 2005, and by another 1 percentage point recently. Interest rates of government securities have also increased by about 1¼ percentage points since September 2006. Reserve money growth was brought down to 16 percent in August 2006 (from 21 percent in April this year). Credit growth to the private sector (including housing loans) remains strong (about 23 percent in August), contributing to demand pressures.

Banking sector soundness has improved, and progress has been made in strengthening the supervisory framework. The NPL ratios of the state-owned banks declined from 18 percent in 2003 to 8 percent in June 2006, and reached similar levels to those of domestic banks. Capital adequacy ratios have also improved (to 8 percent of total assets), and steps have been taken to further enhance the regulatory and supervisory framework, including plans to adopt the Basel II capital accord by 2008. Progress has also been made in restructuring the two large state-owned commercial banks—their NPL ratios have declined while provisioning and profitability have improved. Fast credit growth is, however, raising concerns about credit quality.

Infrastructure development (power and roads) is a central element of the government's medium-term development strategy. Their emphasis is on restoring the financial viability of the power sector while expanding generation capacity by using more cost-efficient sources (including coal power). A development forum is being planned for early 2007.

Sri Lanka's financial markets have been holding up despite increased security concerns and volatility in international financial markets. The Colombo Stock Exchange (CSE) has become one of the best performers in the region. The All Share Price Index rose by a cumulative 70 percent during 2004-05, and is up by another 25 percent so far in 2006, owing to a large extent to the performance of the telecommunication industry. The average P/E ratio of 12 is similar to those in Bangladesh and Pakistan, but lower than in India. The decline during the emerging market sell-off in May was modest, reflecting in part investor optimism over the near-term economic outlook, as well as the lack of alternative channels for other high yield investments in Sri Lanka.

Executive Board Assessment

Executive Directors commended the authorities' efforts to maintain macroeconomic stability and high growth in a challenging political and economic environment, and observed that the economy has demonstrated remarkable resilience in the face of adverse shocks. Directors welcomed monetary policy actions to contain inflation, full pass-through of oil prices to reduce fiscal vulnerability, and enhance revenue collections to help meet the fiscal deficit target in 2006.

Directors noted, however, that inflationary pressures are rising, the external current account is widening, and reserves are below comfortable levels. In this context, the rising debt service burden adds to the economy's vulnerability to external shocks.

Directors agreed that macroeconomic policies in the near term should be geared towards reducing inflation and external vulnerabilities. They emphasized that further monetary tightening may be needed to firmly contain credit growth and keep inflation expectations in check. Directors encouraged the authorities to limit intervention in the foreign exchange market and allow greater flexibility in the exchange rate to help safeguard external reserves and maintain competitiveness.

Directors noted that, over the medium term, strong fiscal adjustment will be critical to avoiding adverse debt dynamics, which would compromise the ability of the government to meet its poverty reduction and Millennium Development Goals. As increased debt service pressures in the next few years could complicate debt management, prompt action to ensure fiscal consolidation will be critical, along with the development of a well-defined medium-term fiscal policy framework and improvements to debt management.

Against this background, Directors welcomed the authorities' commitment to adhering to the 2006 budget target and reducing the fiscal deficit target to 7½ percent of GDP in 2007. Directors also endorsed the authorities' plan to bring the fiscal deficit down to 5 percent by 2010, and stressed that this would be best achieved through revenue enhancing policies and rationalization of current spending, so as to protect critical development projects. Further recourse to commercial borrowing for budgetary purposes should also be limited.

Directors supported the authorities' medium term framework, which emphasizes raising growth and reducing vulnerability. They noted that achieving these goals depends critically on progress towards durable peace and on implementing essential structural reforms. This includes articulating policies to further reform the tax system and the financial sector, rationalizing the trade regime, and improving the business climate.

Directors commended the authorities for progress made in strengthening the prudential regulations and in implementing the 2002 FSAP recommendations. They encouraged the authorities to make efforts to further strengthen prudential standards to help improve the monitoring of systemic risks. Timely implementation of the Basel Core Principles is also essential for the planned adoption of Basel II in 2008. Further restructuring of the two large public banks should focus on improving lending practices and strengthening capital adequacy. Directors welcomed the authorities' recent decision to conduct an FSAP update in 2007.

Directors encouraged further efforts to reduce quasi fiscal losses of the energy companies through adjustments in electricity tariffs, combined with balance sheet restructuring and enhanced operational efficiency. In this context, they emphasized the need to develop safety nets to protect low-income households. Also, strengthening regulatory guidelines for the energy sector could help broaden the investor base for needed long-term energy sector financing.

Directors noted that an open trade regime with minimum distortions would best serve Sri Lanka to benefit from regional and global growth. They encouraged the authorities to curtail the cess regime and integrate these fees in the tariff structure. They noted that a single low tariff structure could help maximize efficiency.

Directors commended the authorities for significant improvements in social indicators in the last decade. They welcomed the emphasis of the authorities on reducing rural poverty and narrowing rural-urban income inequality. They also welcomed the extensive discussions with the public and private sector, NGOs, civil society, and other stakeholders to build consensus for the national development strategy.

Directors encouraged the authorities to improve the quality and coverage of fiscal statistics and to address the remaining issues needed to meet the SDDS requirements. They welcomed the passage of anti-money laundering legislation in 2006.

¹ Under Article IV of the IMF's Articles of Agreement, the IMF holds bilateral discussions with members, usually every year. A staff team visits the country, collects economic and financial information, and discusses with officials the country's economic developments and policies. On return to headquarters, the staff prepares a report, which forms the basis for discussion by the Executive Board. At the conclusion of the discussion, the Managing Director, as Chairman of the Board, summarizes the views of Executive Directors, and this summary is transmitted to the country's authorities.