Public Information Notice No. 07/138

Public Information Notice: IMF Executive Board Concludes 2007 Article IV Consultation with Sri Lanka

November 29, 2007

On November 21, 2007, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Sri Lanka.¹

Background

Sri Lanka's strong economic growth in the past four years has lifted per capita income to about $1,300, well exceeding regional peers. Reflecting the economy's resilience, in 2006, real growth accelerated to 7½ percent despite the oil price shock and heightened security conditions.

There are, however, indications that the economy may be operating at full capacity given rising inflation, a low unemployment rate, and a high current account deficit. High oil prices, slow fiscal consolidation, and security concerns are key risks to the near term growth-inflation outlook.

Monetary policy tightening in 2006 was insufficient to contain inflation, but additional measures were taken in early 2007. In January 2007, the Central Bank of Sri Lanka (CBSL) announced its "Road Map" aiming at reducing inflation to single digit levels by the end of the year through a tighter monetary stance. To this end, the CBSL limited banks' access to the reverse repo window and strengthened prudential measures to contain excessive exposure to sectoral risks. Also, the CBSL stepped up open market operations and allowed treasury rates to increase to 17½ percent during January-June (from 12½ percent at end-2006). These measures, together with a dissipation of pass-through effects from administered price adjustments, contributed to a deceleration in inflation to (annualized) single digits in the first four months of 2007, and real interest rates started to turn positive. This favorable inflation trend has, however, reversed since May and inflation increased to 21¾ percent (yoy) in August due to the combined effect of the elimination of remaining fuel subsidies, increases in food prices, and a pause in further monetary tightening during that period.

The fiscal deficit target for 2007, at 7.8 percent of GDP, indicates a modest fiscal consolidation from a deficit of 8.4 percent of GDP in 2006. This target envisages a substantial increase in tax revenue, a full elimination of fuel subsidies, and a containment of the wage bill. Together, they are expected to more than offset increases in military expenditure, spending on goods and services, and capital spending. Revenue grew by 25 percent in the first half of 2007, but it was still at about 40 percent of the ambitious annual target. Wages and military spending have been contained as of June, but they could continue to be key fiscal risks in the period ahead. The 2008 budget proposal targets a marginal reduction in the fiscal deficit to 7.7 percent of GDP. This falls considerably short of the authorities' earlier plans to lower the deficit to 6.3 percent of GDP in 2008 (under the 2008 Budget Call announced in July).

The external current account deficit is projected to sustain at around 5 percent of GDP in 2007 while reserves are expected to remain at around 2½ months of imports. In the first half of 2007, exports and remittances continued to grow strongly, while import growth decelerated mainly owing to limited increases in world oil prices during that period. For the year as a whole, healthy exports and remittances are expected to be largely offset by the implementation of mega infrastructure projects and high oil prices since July.

In light of favorable local and global liquidity conditions in the last two years, the government has continued to resort to dollar-denominated borrowing to finance the budget while supporting reserves. By end-2006, the public domestic dollar commercial debt reached $1.6 billion (or 6 percent of GDP) at an average maturity of 1½ years. Over 90 percent of this debt was financed from domestic sources, including remittances. This has resulted in a bunching of foreign exchange debt service over the next few years, but so far favorable market conditions have allowed the government to refinance this debt at low cost. In October the government successfully issued its first $500 million international sovereign bond at a yield of 8¼ percent and maturity of 5 years.

Significant progress has been made in improving financial sector stability. Salient features include a sharp decline in the NPL ratios across banks, a marked strengthening in the capital base of the banking industry, and a sustained improvement in banks' operating profits.

Moreover, implementation of the Basel Core Principles has advanced to facilitate a planned adoption of Basel II in 2008. Nevertheless, underlying structural and operational weaknesses remain. Further efforts should focus on improving banking sector resilience to shocks through improving asset quality and strengthening credit and liquidity risk management; strengthening risk-based supervision; and advancing structural and operational restructuring in public banks and limiting state interference.

Financial viability of the energy sector is central to fiscal consolidation and debt sustainability over the medium term. Ceylon Electricity Board (CEB) is likely to incur financial losses of about 20 billion rupees (¾ percent of GDP) in 2007, due primarily to the lack of adjustment in electricity tariffs, which have fallen well below cost recovery levels. A large part of these losses was financed by loans from public banks, posing risks to the financial sector. The authorities' medium-term strategy is to use alternative and cheaper energy sources to reduce Sri Lanka's heavy reliance on oil-based thermal power generation. The construction of three coal power plants (total 900 MW) is expected to be completed during 2008-10. This will not only address the acute energy shortage in Sri Lanka but also significantly lower the cost of energy production (by about one-third from the current level) and bring the CEB to cost recovery levels.

Executive Board Assessment

Executive Directors welcomed Sri Lanka's impressive recent growth performance, which has led to a sharp reduction in unemployment and rising per capita income. At the same time, Directors noted that growth has been underpinned in part by expansionary fiscal and monetary policies, leading to an increase in macroeconomic and external sector vulnerabilities. In particular, inflation has accelerated, the external current account deficit remains large, and gross official reserves are relatively low. Directors urged the authorities to tighten macroeconomic policies, while acknowledging that a return to political stability will also be crucial in underpinning sustained economic progress going forward.

Against this background, Directors called for a determined effort to reduce the fiscal deficit to 5 percent of GDP by 2010-11 as planned. This will be essential to ensure public debt sustainability and to create space for productive and social investment. Revenue mobilization and current expenditure rationalization should be key elements of the adjustment effort. In particular, Directors underscored the importance of streamlining tax exemptions, broadening the income and value added tax base, simplifying the value added tax, and strengthening tax administration. In this regard, Directors welcomed the downward revision of the fiscal deficit target for 2007 stemming from an increase in tax revenue, elimination of fuel subsidies, and containment of the wage bill. They called for a sharper fiscal adjustment than envisaged in the 2008 budget proposal, to ensure that the 2008 budget deficit target is consistent with the medium-term fiscal consolidation plan.

Directors noted the significant risk of public debt distress in Sri Lanka, arising from heavy reliance on dollar-denominated, short-term commercial debt. They stressed the need to lengthen and smoothen the maturity profile of the debt to reduce rollover and liquidity risks, including through capital market refinancing, and to improve debt management in general.

Directors were concerned that the decision to deviate from the automatic pricing formula for diesel and kerosene in 2008 could expose the budget to large fiscal and quasi-fiscal risks, if international oil prices remain high or continue to rise. They called for full or significant pass-through of international oil price movements to contain these risks and to promote energy conservation.

Directors considered that further monetary tightening in the near term is warranted in view of the current fiscal risks, strong growth of credit, and inflationary pressures. They advised that open market operations be stepped up and that treasury security rates be allowed to adjust to levels that would help bring down inflation to single digit levels. Policy rates should also be adjusted gradually to align them with market interest rates, thereby restoring their signaling role in the conduct of monetary policy. Directors also encouraged the authorities to improve the coordination of fiscal and monetary policies.

Most Directors agreed that the real effective exchange rate remains broadly in line with economic fundamentals, given the recent trade performance. Directors underscored that greater flexibility of the exchange rate will be needed to reduce external vulnerabilities and safeguard official reserves. In this regard, they welcomed the authorities' commitment to let the exchange rate be market determined, and called for continued attention to the exchange rate in light of potential external pressures arising from high oil prices and the emerging debt refinancing burden. They recommended that intervention in the foreign exchange market be limited to smoothing excessive volatility of the exchange rate, while allowing for a build-up of foreign reserves to more comfortable levels. The authorities were urged to eliminate the exchange restriction arising from the remaining import margin requirement on motor vehicles expeditiously.

Directors commended the progress in strengthening prudential regulations, enhancing banking and insurance supervision and central bank operations, and improving financial market infrastructure. They encouraged continued financial sector reform, guided by the Financial Sector Assessment Program (FSAP) update, with particular emphasis on further improving banking sector resilience, strengthening risk-based supervision, advancing the preparatory work for Basel II adoption in 2008, and accelerating the operational restructuring of state-owned banks. Directors also urged the authorities to limit state interference in the operations of state-owned banks, and some Directors renewed the call for privatization of these banks.

Directors welcomed the launch of the authorities' broad-based Ten-Year Horizon Development Plan (2006-2016), which includes a comprehensive growth and poverty reduction strategy. They underlined the importance of building consensus on the targeted mix of policies and reforms. Regarding the energy sector restructuring plan, Directors welcomed the emphasis on reducing energy costs. However, they called for timely measures to address the current financial imbalances in the Ceylon Electricity Board, including adjustment of electricity tariffs to cost-recovery levels accompanied by adoption of an appropriate safety net to protect the poor.

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.