Public Information Notice No. 04/20

Public Information Notice: IMF Concludes  2003 Article IV Consultation with Sri Lanka

March 12, 2004

On March 5, 2004, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Sri Lanka.¹

Background

Over the last 18 months, the Sri Lankan economy has advanced on several fronts: the peace process has moved ahead, albeit with interruptions; the economic recovery has taken firmer roots; external vulnerability has declined; and reforms in several areas have progressed. However, the economic effects of the two-decade long civil conflict are yet to be overcome, and many challenges remain. The government unveiled the needs assessment for the conflict-affected districts in June 2003, which, together with the poverty reduction strategy, Regaining Sri Lanka, anchors the policies and reforms to enhance growth and reduce poverty over the medium term. These policies and reforms, as well as the peace process, have received strong support from the international community. In June 2003, at a conference in Tokyo, donors pledged about US$4.5 billion in aid over the medium term. Recently, domestic political uncertainty has increased, reflecting the impasse between the President and the Prime Minister's government over the control of the Ministries of Defense, Interior, and Media.

Meanwhile, the economic recovery that began last year is becoming more broadly based. In 2002, private consumption and tourism were the main engines of growth. In 2003, exports were an added force, with private investment also picking up later in the year. GDP growth for 2003 is estimated to have risen to 5½ percent, up from 4 percent in 2002. Disinflation has been faster than projected, due to increased agricultural production and the appreciation of the rupee against the dollar until late last year, and inflation fell below 6½ percent from 9½ percent in 2002. Improved exports and strong inflows of remittances and tourism receipts likely contained the current account deficit at 1 percent of GDP, which was lower than expected. Gross reserves rose by US$500 million to US$2 billion through end-December 2003, covering roughly 2¾ months of imports and just over 100 percent of short-term debt. The financial sector's performance has improved with the economic recovery. Until early November, the equity market had made significant gains in 2003, among the largest in Asian bourses. However, the market subsequently weakened as political uncertainties increased. While bank profitability has increased markedly, including in the state-owned banks, non performing loans remain high.

With regard to macroeconomic policy, the monetary program remained on track, but the budget came under pressure last year. Broad money grew in line with expectations, with higher reserves accumulation offsetting slower credit growth. Against the background of moderating inflation, the Central Banks of Sri Lanka (CBSL) has cut repo rates by 275 basis points since end-2002. Fiscal performance through mid-2003 was weaker than expected, reflecting revenue shortfalls (particularly in VAT collections) and higher post-conflict capital spending. To bring the budget back on track, several administrative and tax policy measures were initiated in late 2003. However, due to disruptions in the parliamentary schedule related to the political events of early November, not all measures were implemented. Thus, after declining by 2 percentage points of GDP in 2002 to 8¾ percent of GDP, the fiscal deficit narrowed to 8 percent of GDP in 2003, compared with the budget target of 7½ percent of GDP.

On the structural front, significant headway has been made in various areas. Sri Lanka's public finances are being strengthened through several reforms, including the Fiscal Management (Responsibility) Act, passed in December 2002, which limits borrowing from the CBSL, sets medium-term fiscal deficit targets, and mandates "pre-election budget reports" to discourage election handouts. To improve tax administration, a draft Revenue Authority bill—aimed at unifying the Inland Revenue, Customs, and Excise departments—and its implementation plan have been presented to Cabinet.

In the financial sector, several legislative reform initiatives—amendments to the banking law (to enhance the CBSL's supervisory powers and facilitate the entry, exit, and mergers of banks) and a new Foreign Exchange Management bill that relaxes some longer-term capital account restrictions—were tabled in Parliament in November. An Asset Management Company bill to aid banks in restructuring their balance sheets has been recently approved by Cabinet. In addition to these legislative initiatives, financial sector stability is being enhanced through stepped-up CBSL supervision, higher capital requirements, and other new prudential norms.

Considerable progress has also been made in public enterprise reform, with divestments completed for several key public corporations. In addition, the telecommunications market has been liberalized, the state electricity company is being unbundled, and the retail market for petroleum has been opened to competition. With regard to the labor market framework, amendments to the laws streamlining the settlement of labor disputes, eliminating restrictions on overtime work by women, and increasing penalties for child labor were implemented in January 2004. At the same time, additional labor courts and tribunals, a mandatory compensation formula for retrenched workers, and an unemployment insurance scheme were introduced.

Economic Prospects

Economic growth in 2004 is expected to reach 6 percent, underpinned by increased investment, higher tourism and exports, and normal monsoon. After the rapid decline during 2003, inflation should stabilize at around 6 percent next year. Imports are expected to rise as investment picks up, but improved export growth, tourism, and remittances should keep the current account deficit around 2¼ percent of GDP. Gross reserves should reach about US$2.25 billion (covering 3 months of imports and 140 percent of short-term debt).

However, the risks to this outlook are considerable. On the upside, if power and infrastructure bottlenecks are reduced, tourism, shipping, and telecommunications could expand much faster than anticipated, thus bolstering economic growth. On the downside, while occasional setbacks were to be expected, a prolonged impasse in the peace process - resulting from the ongoing political instability—could hold back private investment and delay donor financing. Furthermore, it could divert increasingly the government's attention from economic to political issues, thus slowing the reform momentum. These factors could depress growth, raise the fiscal deficit and domestic financing, and keep reserves at a vulnerable level if donor financing is reduced.

With regard to the 2004 policy framework, the government plans to gear its policies towards maintaining macroeconomic stability and advancing key structural reforms. The 2004 budget, which targets a fiscal deficit of 6¾ percent of GDP, aims to improve fiscal sustainability while providing adequate resources for post-conflict and reconstruction needs. A number of tax measures, including the unification of VAT, the introduction of a minimum corporate tax, and a reduction in tax incentives, will boost revenue. On the expenditure front, there will be an increased focus on priority needs, with post-conflict spending budgeted at close to 1 percent of GDP, and capital spending set to increase to 5½ percent of GDP. To improve civil service performance, a three-year reform has been launched, which targets a significant reduction in employment (through a voluntary retirement scheme) and increases public sector wages. Monetary policy is expected to continue to strike a judicious balance between supporting the economic recovery and restraining inflation, while structural reforms will focus on strengthening the financial sector, reducing the state's role in commercial activities, and improving the labor market framework.

Executive Board Assessment

Executive Directors commended the Sri Lankan government's efforts since the ceasefire to put in place policies and reforms to sustain strong economic growth and reduce poverty over the medium term. As a result, investor confidence is returning and exports and tourism are recovering, contributing to strengthened economic growth and reduced external vulnerability in an environment of falling inflation.

Directors observed, however, that the uncertainties in the political situation and the peace process pose a risk to the implementation of essential further reforms. They stressed that, if Sri Lanka is to benefit fully from the broadly positive domestic economic developments and the boost in global demand expected in the period ahead, the authorities will need to make further progress in establishing a political environment that fosters lasting peace and engenders broad-based popular support for their reform efforts.

Directors considered that the key medium-term challenge remains restoring fiscal sustainability, while ensuring that there are adequate resources for priority poverty reduction and post-conflict spending. This will call for improved revenue performance, in particular through simplification of the tax regime and reduction of exemptions, to increase compliance, improve tax system equity, and reverse the declining trend in the tax effort.

In that vein, Directors welcomed the tax reforms proposed in the 2004 budget, particularly the unification of the value-added tax rates and the reduction of exemptions. Over the next few months, the authorities should press forward urgently with fundamental reforms in tax administration, not only to arrest the long-term deterioration in revenues, but also to realize fully the benefits of changes in tax policy. In this regard, several Directors urged that rapid progress be made following the April elections in establishing the Revenue Authority. Tight control over spending should be maintained, and further demands for measures to adjust for the increase in the cost of living should be resisted. Directors emphasized the need to take corrective revenue and expenditure measures if tax collections fall below the level needed to meet the deficit target.

Directors commended the authorities for maintaining a stability-oriented, prudent monetary policy. This, together with the deficit reduction effort, has been key to lowering inflation and inflationary expectations in 2003. As a result, interest rates have declined, supporting higher private sector credit growth, thus helping to strengthen the economic recovery. The authorities should stand ready to tighten monetary policy if the political situation deteriorates or severe budget pressures materialize, to head off a potential rise in inflation and sharp exchange rate adjustment. To facilitate the conduct of monetary policy, the authorities were encouraged to broaden the range of policy instruments. Directors reiterated their support for the flexible exchange rate regime introduced in 2001, which has greatly helped in reducing external vulnerability and absorbing capital inflows.

Directors highlighted the importance of strengthening the banking sector to improve the monetary transmission mechanism and deepen financial intermediation. They viewed the restructuring of state-owned banks as critical to achieving these goals, and encouraged the government to move decisively with the restructuring of People's Bank. Directors welcomed the recent initiatives to tighten prudential norms and enhance supervision, the Central Bank of Sri Lanka's plans to further revamp the banking and monetary laws, and the progress made in drafting anti-money laundering legislation.

Directors reiterated their support for the government's strategy to eradicate poverty through private-sector-led growth. They welcomed the progress made in improving governance and the privatization of several state-owned enterprises, but noted the delays affecting some of the larger enterprises. The restructuring of the power sector—currently a major bottleneck to growth—should be accelerated. Directors concurred with the government's emphasis on establishing high-quality regulatory agencies, as a clear regulatory framework will become increasingly important in strengthening the private sector's role in the economy. They endorsed the government's strategy to improve the access of the poor to basic services and markets, and to strengthen land tenure rights. Directors encouraged the government to speed up the implementation of a well-targeted social safety net, taking into account the results of the poverty and social impact analysis that is being undertaken with respect to key poverty alleviation initiatives.

Directors welcomed the recent labor market reforms, which should enhance the flexibility and predictability of the labor market. However, concern was expressed that the mandated level of redundancy pay, which is high by regional standards, could hurt Sri Lanka's competitiveness. Directors also welcomed the government's plans to streamline the civil service, although they stressed that the proposed voluntary retirement scheme should be targeted carefully, and not unduly burden the budget in coming years.

Directors considered that Sri Lanka's statistical information is adequate for surveillance and program monitoring, and looked forward to full compliance with the Special Data Dissemination Standard in 2004. They commended the authorities for the considerable progress they have made in implementing the recommendations of the Safeguards Assessment.

Directors noted that political circumstances are delaying completion of the first reviews under the Poverty Reduction and Growth Facility and Extended arrangements. They hoped that sufficient progress would be made on the reform agenda, including the enactment of the tax measures proposed in the 2004 budget, presentation of the Revenue Authority bill to Parliament, and advances in restructuring People's Bank, to allow for completion of the first reviews at the earliest possible juncture.

It is expected that the next Article IV consultation with Sri Lanka will be held on the 24-month cycle, subject to the applicable Executive Board decision on Article IV consultation cycles, and discussions with the authorities.