IMF Executive Board Concludes 2008 Article IV Consultation with Sri LankaPublic Information Notice (PIN) No. 08/140
October 31, 2008
Public Information Notices (PINs) form part of the IMF's efforts to promote transparency of the IMF's views and analysis of economic developments and policies. With the consent of the country (or countries) concerned, PINs are issued after Executive Board discussions of Article IV consultations with member countries, of its surveillance of developments at the regional level, of post-program monitoring, and of ex post assessments of member countries with longer-term program engagements. PINs are also issued after Executive Board discussions of general policy matters, unless otherwise decided by the Executive Board in a particular case.
On October 17, 2008, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Sri Lanka.1
Sri Lanka has achieved strong growth averaging 6½ percent since 2002, raising per capita income to about $1,625 (above regional peers) and reducing the poverty rate from 22.7 percent to 15.2 percent over 2002-07. The authorities' Ten-Year Development Plan ("Mahinda Chintana") launched in early 2007 aims to sustain this performance by strengthening infrastructure investment. Rapid growth, together with rising fuel and food prices, has accelerated the inflation uptrend that began in 2006. The year-on-year (yoy) rate of inflation has edged down to 25 percent in August, but core inflation has risen and headline inflation has remained well above the rates prevailing in Sri Lanka's major trading partners and in the region.
Monetary policy tightening in 2007 was insufficient to contain inflation in 2007, but additional measures were taken in early 2008 to slow reserve money growth. Credit growth more than halved to 10.7 percent (yoy) as of July 2008. Monetary conditions tightened through early 2008 but then eased; interest rates on government securities fell as foreigners were granted greater access to the market. Policy rates were last raised in February 2007 as the Central Bank conducted monetary operations through the sale of its holdings of government securities. Access to the Central Bank's standing facilities is limited to 3 times per month per bank, with additional borrowing attracting a 19 percent penal rate.
The fiscal deficit declined by 0.2 percentage points to 7.8 percent of GDP in 2007. Revenues undershot expectations by a wide margin owing to exemptions, with the effect on the deficit broadly offset by declining transfers and subsidies (with pass-through of rising commodities prices). The fiscal deficit is projected to decline modestly relative to GDP in 2008. The budget limited tax holidays, increased excises on consumer durables, and raised customs surcharges, but also granted tax concessions, waived VAT on development projects, and cut VAT on petrol. Second-quarter data suggest that revenues would remain low (about 15 percent of GDP), but current expenditures (particularly wages and subsidies) are set to rise, and adjustment would likely fall on capital spending.
In 2007, the continued brisk pace of exports resulting from high international tea prices (a key export), improved EU access for garments exports, subdued imports, and strong remittances bolstered the current account, with the deficit more than financed by rising capital inflows. Gross official reserves rose from US$2.5 billion at end-2006 to US$3.1 billion as of end-2007, and to nearly US$3.2 billion as of end-September. In 2008, however, soaring oil prices sharply increased the oil import bill, amid softening external demand and worsening external financing conditions. The external current account deficit is projected to widen sharply in 2008.
Public debt/GDP edged down in 2007 and is expected to decline further in 2008, reflecting favorable debt dynamics (high growth and negative real interest rates) and rupee appreciation. However, increased use of foreign-currency financing poses significant risks. Foreign borrowing reflects a strategy to reduce domestic crowding out, but a widening current account deficit and bunching of near-term debt repayments imply sizeable gross external financing needs at a time when global credit markets are unsettled and likely to remain so.
Sri Lanka's domestic financial markets have been largely immune to the global financial turbulence. Sri Lankan institutions reportedly have little or no direct exposure to U.S. sub-prime assets, while a significant portion of net foreign inflows reflects investments by non-resident Sri Lankans. Money markets have been volatile but have generally reflected domestic developments, as has stock and bond markets. However, domestic fixed-income markets increasingly open to foreigners.
Although indicators show moderate non-performing loans and relatively healthy capital and liquid asset ratios for the banking system as a whole, weaknesses persist in one state-owned bank. Banks prudently built large capital buffers during the credit-cycle upswing, but rising non-performing loans (NPLs) suggests growing credit risks. Moreover, significant liquidity, credit, and market risks remain, and vulnerability to higher interest rates is sizeable. The authorities are currently implementing the Basel Core Principles.
Executive Board Assessment
Executive Directors commended Sri Lanka for its impressive record of economic growth over the last few years, with the rate of unemployment and poverty indicators falling. The authorities' bold decision to adjust administered fuel prices, transport fares, and electricity prices will reduce fiscal risks over the medium term. Directors welcomed the significant tightening of monetary policy to address inflationary pressures.
At the same time, Directors expressed concern that the combined build-up of macroeconomic imbalances, balance sheet vulnerabilities, high inflation, and external financing pressures poses serious risks to economic stability. The recent increases in international food and fuel prices and the global financial crisis have heightened the challenge facing the authorities. Amid increased international risk aversion, raising external finance will become increasingly challenging, and Sri Lanka's external accounts are vulnerable to a reduction in international investor risk appetite.
Against this background, Directors urged the authorities to put in place a comprehensive package of reforms aimed at bringing down inflation, limiting external risks, and helping to preserve Sri Lanka's impressive growth record. This would need to involve a front-loaded fiscal consolidation, complemented by monetary tightening, steps toward greater exchange rate flexibility, and a further strengthening of financial supervision and regulation.
Directors welcomed the authorities' plans for medium-term fiscal consolidation, as envisaged in the Fiscal Responsibility Act, and called for their decisive implementation in order to reduce pressure on the external account, inflation, and the exchange rate. They encouraged the authorities to implement promptly measures aimed at broadening the tax base by significantly rationalizing exemptions and to restrain current spending. The resulting fiscal space should be used to preserve infrastructure spending.
Directors noted the risks of public debt distress arising from the increasing reliance on dollar-denominated, short-term commercial debt. While recognizing the authorities' efforts to strengthen debt management, Directors saw a need for further improvements in this area, in particular by lengthening the maturity profile of debt to reduce refinancing risks, and by facilitating non-debt finance for development spending.
Directors commended the authorities for exercising significant restraint with respect to reserve money growth, and encouraged further monetary policy tightening to help anchor inflation expectations. In this context, most Directors suggested that raising policy rates toward market interest rates would reinforce the authorities' quantitative strategy by signaling their commitment to disinflation. A few Directors, however, were not convinced of the effectiveness of the interest rate channel in Sri Lanka, and cautioned that an increase in the policy interest rate might encourage capital inflows.
Directors took note of the staff's assessment that the real effective exchange rate of the rupee is overvalued, and that the de facto peg risks contributing to external instability by attracting speculative inflows that could reverse quickly. At the same time, they considered that risks to external stability are associated directly with a loose fiscal policy and a build-up of short-term and foreign-currency debt. Against this background, Directors saw fiscal adjustment as key to supporting external stability and providing room to raise productivity- and competitiveness-enhancing infrastructure spending. Most Directors noted that additional exchange rate flexibility would help ward off destabilizing short-term capital inflows, and encouraged the authorities to move in this direction as part of a comprehensive policy package that would underpin confidence in the currency.
Directors welcomed the authorities' efforts to strengthen the financial system, including the recent measures to address the maturing credit cycle, the progress made in implementing Basel II, the introduction of corporate governance guidelines for banks, and tighter oversight of state banks. Reforms to financial supervision and regulation should continue. Directors encouraged the authorities to monitor closely short-term foreign liabilities and maturity risk. They advised the authorities to limit state interference in the operations of state banks.
Directors encouraged the authorities to eliminate the exchange restriction arising from the import margin requirement on the importation of certain motor vehicles.