Public Information Notice No. 99/96

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

October 22, 1999

On October 13, 1999, the Executive Board concluded the Article IV consultation with Sri Lanka.¹

Background

Over the last decade, Sri Lanka's economy has grown steadily, but at a relatively slow rate. Underlying this modest performance has been relatively low levels of saving and investment. Prolonged periods of public dissaving have reflected substantial fiscal deficits that averaged more than 10 percent of GDP. However, there has been a trend reduction in the fiscal deficit in recent years. During the late 1980s and 1990s, financial markets were liberalized and the outward orientation of the economy was significantly increased and a more diversified export base established. Progress has been made in other areas, most notably privatization. However, less improvement was made in other priority areas including civil service and pensions, state trading monopolies, and financial and labor market reforms.

Despite the Asian crisis and the civil conflict, macroeconomic performance was satisfactory in many respects in 1998. Though less than in 1997, real GDP growth was 4¾ percent, broadly in line with long-run trends. This result was based on good harvests and buoyant domestic demand, including increased investment in the transport, communications, and utilities sectors. Both public and private investment increased in 1998, supported by a faster growth in the construction sector, and foreign direct investment. Higher private, especially corporate, savings pushed the domestic savings ratio to 19 percent, narrowing the savings-investment gap to 2 percent of GDP.

The terms of trade improved in 1998. Consumer price inflation declined to 3¾ percent at end-1998. Key factors were lower import prices, improved food supplies and relatively tight monetary policy. The external current deficit (excluding official transfers), fell to 2 percent of GDP as tea export prices rose sharply and import prices declined significantly. The declining external debt to GDP ratio; reasonable reserve coverage of short-term debt; the high share of concessional external debt; and limited portfolio flows suggest external vulnerability is not high.

Nevertheless, the near-term outlook is somewhat less encouraging. GDP in the first half of 1999 was only 3 percent above the first half of last year and growth is projected to reach only 3½-4 percent for 1999 because of depressed export markets and weakening private sector activity. Responding to the developments in the foreign exchange market, the central bank intervened to smooth erratic fluctuations in a thin market. The central bank recorded net sales in the foreign exchange market--the commercial bank exchange rates have been at or close to the selling rate of the central bank band--and gross official reserves declined to $1.7 billion by July 1999. The external outlook for the remainder of 1999 is uncertain, with the sharp reversal of the terms of trade.

Inflation performance has been mixed in early 1999. Inflation rose to 7¾ percent at end-April 1999 on a 12-month basis, before falling to 5½ percent in September. Despite the most recent reported slowing of consumer price increases, led by a record harvest and a strong domestic supply of agricultural products, inflationary expectations are generally still high.

The overall fiscal deficit rose to 9¼ percent of GDP in 1998 (compared to an original budget target of 6½ percent), reversing the progress achieved over the previous three years. This outcome reflected both the less than expected realization of budgetary cuts in current expenditure (especially on defense), and a shortfall in tax revenue, principally from the Goods and Services Tax (GST). As a result, public savings were sharply negative and domestic bank financing was 2 percentage points of GDP higher than projected.

Monetary policy has been constrained by the fiscal situation, requiring high real interest rates to counter exchange rate and inflationary pressures. The decline in the relative contributions to broad money growth of foreign inflows and private sector credit offset the sharp increase in lending to the public sector, a trend maintained through end-August 1999. Real interest rates remain higher than in other countries in the region. The Central Bank of Sri Lanka (CBSL) has adjusted downward the overnight repurchase rate on three occasions (from 12.1 percent in September 1998 to 9.5 percent from July 30, 1999) considering the downward trend in inflation.

Structural reforms are focussed on current plans to improve the financial sector, public administration and pensions, and trade reform. The banking sector has problems--with large nonperforming loans and low risk-weighted capital adequacy. The authorities are developing plans for restructuring and management changes in the two state banks and for an enhanced bank supervision framework for the whole commercial bank sector. While the privatization and state enterprise restructuring program continues, the challenge remains to reform the civil service and pensions systems. Further rationalization of the import tariff structure is expected, while also moving ahead with regional integration.

Executive Board Assessment

Executive Directors commended the authorities for maintaining broad macroeconomic stability, and making further progress in addressing some of the economy's long-standing structuralweaknesses, despite a difficult domestic and external environment. They noted that real GDP growth was relatively strong, and both inflation and unemployment rates continued on a downward trend. Looking ahead, Directors stressed that the main challenge for the authorities is to build on recent progress by resuming fiscal consolidation, and pressing ahead with the key structural reforms to pave the way for sustained high-quality growth. Regarding the near-term fiscal prospects, Directors urged early measures to contain the 1999 overall fiscal deficit outcome as closely as possible to the revised projection, and to anchor the targeted reduction in the deficit for 2000. In this context, they welcomed the authorities' intention to maintain strict limits on the wage bill, transfer payments, and unproductive expenditures. However, Directors cautioned that a sustainable fiscal adjustment would also require greater revenue mobilization, especially in the Goods and Services Tax, a further reduction and rationalization of the tax exemptions and stronger tax administration. Directors encouraged the authorities to formulate a contingency fiscal plan to ensure that their medium-term deficit target is achieved while maintaining expenditure in the priority sectors of health and education.

Directors welcomed the recent reduction in inflation, but stressed the importance of maintaining a restrained monetary stance and containing government borrowing. They cautioned against a premature relaxation of monetary policy before there is more convincing evidence of a decline in inflation. Looking ahead, Directors encouraged the authorities to target publicly a low inflation rate. This, combined with tight fiscal policy, should help bring about a durable reduction in inflationary expectations, and thereby break the long-standing cycle of price increases and exchange rate depreciation. Directors recommended that the authorities continue to manage the exchange rate in a flexible manner to maintain competitiveness--intervening in the foreign exchange market only to smooth temporary fluctuations--and supported a widening of the band when conditions permit.

While welcoming the progress made in strengthening the banking system, particularly in the area of supervision, Directors noted the need for further reforms. Directors urged the authorities to expedite a fundamental reform of the two state banks as a matter of urgency. This would require management changes and rationalization of activities, including a separation of commercial from noncommercial operations. They reiterated the need to privatize both banks when this becomes feasible. Directors also encouraged the authorities to raise prudential regulations of the banking system to international standards and further improve the effectiveness of supervision, including over nonbanks.

Directors endorsed the authorities' objective of reducing the size of the public sector. They urged the authorities to expedite implementation of public administration reforms. Directors also emphasized the need for reform of the civil service pension scheme.

Directors supported the authorities' recent and prospective privatization initiatives and hoped that privatization would proceed rapidly. They strongly supported the Government's goal to restructure, privatize, or liquidate a number of enterprises over the next few years.

Noting that labor market rigidities acted as a serious obstacle to private sector development and job creation, Directors urged an overhaul of key legislation, to simplify the legal requirements, so as to allow enterprises greater freedom in determining appropriate staffing levels.

Directors commended the authorities for the progress achieved in trade liberalization, and welcomed the plan to introduce a two (non-zero) tariff band system in 2000. They recommended the authorities to further reduce the maximum tariff rate, eliminate the special regime for Board of Investment companies, and incorporate the remaining nonstandard tariffs into the general regime. With regard to the capital account, Directors recommended the removal of remaining limits on foreign equity and direct investment, and a phased reduction of certain restrictions on capital outflows, which would encourage foreign investment. They cautioned, however, that liberalization of the capital account, and particularly short-term capital inflows, should be handled in a prudent and cautious way, in tandem with a strengthening of the financial sector.

Directors noted that, while key economic data are provided to the Fund on a timely basis, there are still deficiencies in the statistical base, which create some difficulties in the monitoring of developments in the formulation of macroeconomic policies. Directors welcomed the efforts being taken to improve the coverage of inflation measures, and also the increased transparency in public finances.

Directors hoped that Sri Lanka will soon be able to formulate and implement a program that could be supported by the Fund under the Enhanced Structural Adjustment Facility.