IMF Executive Board Concludes 2013 Article IV Consultation and Supports Proposal for Post-Program Monitoring with Sri LankaPublic Information Notice (PIN) No. 13/49
May 9, 2013
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 May 1, 2013, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Sri Lanka.1
Sri Lanka has achieved notable progress on a number of economic fronts in recent years, although there have also been challenges. While slowing recently, growth has been generally robust, fiscal consolidation has taken place, and poverty and inequality have declined. Other aspects of Sri Lanka’s development agenda, however, require continuing effort. The authorities are keen to broaden and deepen economic development, building on the achievements of the recently completed Stand-By Arrangement with the Fund. Safeguarding macroeconomic stability and launching a new phase of structural reforms would facilitate ambitious medium-term development goals.
Real growth slowed to 6.4 percent in 2012 as macroeconomic policies were tightened, spillovers from weak global growth undermined exports, and drought and subsequent floods adversely affected agriculture. Headline inflation hovered near double digits for most of the year following an upward shift due to exchange rate depreciation and higher food and administered prices, before easing in early 2013 due in large part to base effects. Core inflation trended upward, and inflation expectations and private sector wage demands rose. The current account deficit declined to around 6½ percent of GDP.
The government’s 2012 budget deficit is estimated to have fallen to about 6½ percent of GDP, above the budget’s 6¼ percent target, due to expenditure restraint and payment arrears, while revenues were significantly lower than budgeted. The 2013 budget targets a 5.8 percent of GDP deficit. Losses at the state-owned energy companies rose to around 2 percent of GDP in 2012 despite significant domestic energy price increases, as drought induced a shift in electricity generation away from inexpensive hydroelectric to expensive thermal sources.
With inflation elevated and growth slowing, monetary policy is facing a challenging task. Policy was eased recently, but further stimulus should be on hold until inflation pressures decline. Financial soundness indicators are robust, and progress has been made in strengthening banking supervision, however rapid credit expansion in recent years justifies heightened vigilance for vulnerabilities.
Growth is projected at around 6¼ percent in 2013. A moderately contractionary budget and the lagged impact of tight monetary conditions and real wage compression should restrain domestic demand, while external demand is projected to remain tepid. Inflation pressures should moderate through the year, although headline inflation would be affected if domestic energy prices are increased further, and the current account deficit should narrow further. Near-term risks to the outlook are on the downside, and include revenue weakness, a weaker-than-anticipated global environment, and continued inflation pressures.
Executive Board Assessment
Executive Directors commended the authorities for prudent policy implementation, which, supported by the Stand-By Arrangement concluded last year, has facilitated the achievement of robust growth and poverty reduction in a difficult environment. The near-term outlook presents challenges, including slower growth and elevated inflation. Directors emphasized that a new phase of reforms is needed to ensure a sustainable fiscal position, achieve low and stable inflation, safeguard financial stability, and support high and inclusive growth over the medium term.
Directors welcomed the authorities’ continued efforts toward fiscal consolidation, particularly on recurrent spending, given a high public debt ratio, and supported the goal of reducing the budget deficit while clearing expenditure arrears. However, they noted that revenues have fallen to very low levels, placing the burden of adjustment on expenditure, notably capital spending. To enhance space for infrastructure and critical social spending, Directors stressed the need to broaden the revenue base and improve tax administration, including by extending the VAT fully to the retail and wholesale sectors, reforming the refund system, and revising tax holidays and exemptions. Directors further underscored the need to put state-owned energy enterprises on a sound financial footing. They noted that the recent electricity price hike should help reduce losses, and advised adopting an automatic price adjustment mechanism, complemented by targeted social protection safeguards. Recent efforts to strengthen public financial management will support the overall fiscal consolidation strategy.
With rising wage and cost pressures, Directors cautioned against a further easing of monetary policy in the near term. Exchange rate flexibility should be maintained to cushion external shocks, while deeper markets and a gradual move toward a flexible inflation targeting regime would strengthen inflation control. Directors noted that international reserves are relatively low by most metrics, and encouraged strengthening the reserve position as circumstances permit. They cautioned that government guarantees for foreign currency borrowing by banks, if introduced, could undermine exchange rate flexibility, create contingent liabilities, and raise debt sustainability risks.
Directors concurred that the banking system appears sound and welcomed the progress in strengthening financial sector supervision and regulation. They called for vigilance following recent high credit growth and encouraged the authorities to draw on the recommendations of the updated Financial Stability Assessment Program to bolster financial stability further.
Directors noted the long-term deterioration of the export-to-GDP ratio and growing reliance on debt for current account deficit financing. They encouraged the authorities to boost competitiveness, including through strengthening trade, expanding infrastructure, and further improvements in the business climate to attract foreign direct investment. Directors supported the proposal for post-program monitoring.