Press Release No. 03/54

Press Release: IMF Approves US$567 Million in PRGF/EFF Credit Arrangements for Sri Lanka

April 18, 2003

The Executive Board of the International Monetary Fund (IMF) today approved three-year arrangements under the Poverty Reduction and Growth Facility and Extended Fund Facility amounting to SDR 413.4 million (about US$567 million) for Sri Lanka, which will support the government's economic program for 2003-06. Of this amount, SDR 269 million (about US$369 million) is available under the PRGF, and SDR 144.4 million (about US$198 million) is available under the Extended Fund Facility (EFF). The decision will enable Sri Lanka to draw SDR 59.06 million (about US$81 million) from the IMF immediately.

The PRGF is the IMF's concessional facility for low-income countries. It is intended that PRGF-supported programs are based on country-owned poverty reduction strategies adopted in a participatory process involving civil society and development partners and articulated in a Poverty Reduction Strategy Paper (PRSP). This is intended to ensure that PRGF-supported programs are consistent with a comprehensive framework for macroeconomic, structural, and social policies to foster growth and reduce poverty. PRGF loans carry an annual interest rate of 0.5 percent and are repayable over 10 years with a 5 ½-year grace period on principal payments. The EFF is an IMF financing facility that supports medium-term programs that seek to overcome balance of payments difficulties stemming from macroeconomic imbalances and structural problems. The repayment terms are 10 years with a 4½-year grace period.

In commenting on the Executive Board's decision, Shigemitsu Sugisaki, Deputy Managing Director and Acting Chairman, made the following statement:

"Sri Lanka today stands at a pivotal point in its history. Over the past 20 years, a long civil conflict has beleaguered the country, which not only disrupted economic activity, but also hampered the sustained implementation of economic reforms. The current environment, in which peace negotiations are progressing well and economic activity is picking up, provides an excellent opportunity for Sri Lanka to implement deeper economic reforms and put the economy on a path of sustained high growth. The PRGF-EFF supported program aims to accelerate economic growth and reduce poverty through private-sector led development, in line with the authorities' Poverty Reduction Strategy Paper and building on steps taken under the IMF's Stand-By Arrangement that was completed in September 2002. Key elements of the program are fiscal consolidation; reforming the financial sector, public enterprises, labor market regulations, and the trade regime; and strengthening macroeconomic policy instruments and institutions. Sri Lanka's PRSP is a satisfactory policy framework to increase growth and reduce poverty.

"The program's focus on fiscal consolidation is appropriate in light of the public debt burden. It is also necessary to ensure that adequate resources are available to meet priority spending needs and to free resources for private sector expansion. Thus, the program emphasizes increasing revenue by broadening the tax base and strengthening tax administration as well as reorienting expenditure towards social, infrastructure, and post-conflict needs.

"Sustaining high growth depends critically on implementing the program's structural reforms. The progress made in reforming the electricity and petroleum sectors, restructuring state-owned enterprises, and strengthening the banking sector is commendable. However, further reforms are needed in financial sector, public enterprises, labor markets, and the trade regime.

"The government's attention to reducing conflict-related and rural poverty is well placed. The implementation of plans to strengthen rural infrastructure and improve access of the poor to quality education and health services are appropriate and necessary steps. In the area of welfare reforms, the new focus on depoliticization and targeting of Samurdhi benefits is commendable and should be strongly implemented.

"To fully realize the program's medium-term objectives for growth and poverty reduction, lasting peace is necessary. The authorities are fully committed to the program and have embarked on difficult reforms, while making strong efforts to preserve public support for the peace process. At the same time, continued donor financing is required to support reforms and reconstruction, as well as the momentum of the peace process", said Mr. Sugisaki.

ANNEX

Recent Economic Developments

After declining in 2001, the economy recovered last year. Following a series of exogenous shocks in the second half of 2001—the global slowdown, an attack on Colombo airport, and a severe drought, GDP for the year fell by 1½ percent, the first decline in several decades. A robust expansion in domestic demand and tourism underpinned the rebound in 2002, as progress toward peace revived business and consumer confidence. GDP growth for 2002 is likely to reach 4 percent. However, the recovery is yet to be broad based, with lingering weaknesses in private investment and exports of goods. Inflation slowed down, due, in part, to better weather conditions, with the 12-month rate dipping below 8 percent in March 2003.

Strong inflows of remittances and tourism receipts helped gross official reserves to rise from $1.2 billion (December 2001) to $1.6 billion (March 2003) covering 2½ months of imports. The rupee remained broadly stable in real effective terms.

Monetary policy balanced the need to support the economic recovery with restraining inflation. The decline in inflation allowed the Central Bank of Sri Lanka (CBSL) to cut repo rates by 300 basis points since January 2002. As a result, other lending rates also declined and helped the recovery of private-sector credit.

The fiscal deficit for 2002 is estimated at 9 percent of GDP-2 percent of GDP lower than in 2001—but higher than the budget target of 8½ percent of GDP. This outcome reflected a revenue shortfall of around 1 percent of GDP, partly offset by spending cuts of about ½ percent of GDP. The lower revenue was due to a combination of weaker-than-expected imports, a large number of exemptions granted when the GST was replaced with the VAT, and lower nontax revenue, in part, reflecting a restructuring in payments from the electricity company (CEB) to the budget. The cuts in expenditure reflected reduced capital spending (due to low project-implementation rates) and somewhat lower current spending.

Reforms were advanced in several areas. Following the enactment of the Electricity Reform Bill in December 2002, the unbundling of the state electricity company (CEB) is proceeding on schedule, while Ceylon Petroleum Corporation (CPC) reforms are progressing in step with the liberalization of the petroleum sector. A 12 percent stake in Sri Lanka Telecom (SLT) was sold in December 2002 and the privatization of Sri Lanka Insurance Corporation (SLIC) was completed in early April 2003. Several amendments to the labor laws were passed by Parliament in January 2003. A Fiscal Management Responsibility Act (FMRA) came into force in December 2002, while a Welfare Benefit Law was enacted in September to reform the welfare system.

Program Summary

The government's economic program supported by the combined PRGF-EFF arrangements, is based on their medium-term economic and Poverty Reduction Strategy Paper (PRSP)—Regaining Sri Lanka—that was finalized in January 2003.

Under the PRGF-EFF supported program, the ongoing economic recovery is expected to gain further momentum this year, with GDP growth projected to rise to 5½ percent. A resumption of delayed private investment projects, a substantial increase in public investment, higher tourism, and a return to normal weather underpin the projection. Inflation is expected to slow to 7 percent by end-year. The current account deficit is likely to rise to 3¾ percent of GDP, as an export rebound is more than offset by higher imports related to increased activity and reconstruction needs. Gross reserves are targeted to reach $1.9 billion (2¾ months of imports) by end-2003.

In line with the PRSP, growth is expected to average 6½ percent over the medium term. This reflects both higher productivity and capital accumulation, reflecting labor market and financial sector reforms, and strong public and private investment. In the absence of major external shocks, prudent monetary policy and normal monsoons should help inflation decline to 4½ percent by 2006. With substantial reconstruction and investment imports, the current account deficit is likely to rise to 4½ percent of GDP by 2004, before falling to 3¾ percent of GDP by 2006. Reasonably strong capital inflows should help gross official reserves to rise to $3 billion (3½ months of imports).

The program' fiscal strategy aims to restore fiscal sustainability, while ensuring that adequate resources are available for priority spending and post conflict needs. Public debt now stands at 104 percent of GDP, while interest payments amount to 7½ percent of GDP, raising serious sustainability concerns. To bring the level of debt to a manageable level, the program aims to reduce the fiscal deficit by 1¼ percent of GDP per year, on average, over the medium term, bringing it down to 4⅓ percent of GDP by 2006.

Achieving these objectives will require revenue to be raised and expenditure rationalized and reoriented to priority needs. The aim is to increase revenue by broadening the tax base—through rationalizing tax exemptions and incentives—and by strengthening tax administration—in part, by establishing an efficient revenue authority. The program envisages capital spending to rise over the medium term, while continued savings in welfare, reflecting better targeting of beneficiaries, is expected to allow a near doubling of capital expenditures in health and education. A medium-term expenditure framework (MTEF) is planned to be established by mid-2003 to better reorient expenditure towards social and post-conflict needs. Financing of the budget is programmed to be increasingly shifted away from expensive debt to concessional donor funds.

The flexible exchange rate regime has served the economy well and will be continued. Thus, market interventions will be limited to smooth short-term volatility or meet the reserves target in line with the monetary program. Monetary policy will continue to be guided by the need to support economic recovery, while restraining inflation.

The structural reform agenda of the program will focus on the following aspects of the PRSP:

• Financial sector reform—particularly restructuring the Peoples Bank

• Improvement in tax administration—including steps to establish a Revenue Authority

• Restructuring of public corporations—particularly the electricity and petroleum monopolies.

• Implementing labor market and trade reforms.