## cr17253 ## Source details **Canonical URL:** [cr17253](https://www.imf.org/-/media/files/publications/cr/2017/cr17253.pdf) ## Other formats - [Markdown version](/-/media/files/publications/cr/2017/cr17253.pdf.md) - [Structured JSON version](/-/media/files/publications/cr/2017/cr17253.pdf.json) --- ### EXECUTIVE SUMMARY — Context and Core Objectives - Extended arrangement under the Extended Fund Facility (EFF) approved June 2016 for the amount of SDR 1.1 billion (185 percent of quota and about US$ 1.5 billion) over 36 months. - Core objectives of the multi-year reform program: - Domestic revenue mobilization based on sweeping tax reforms to support multi-year fiscal consolidation. - Build up international reserves and allow for greater exchange rate flexibility. - Strengthen tax administration and public financial management. - Improve financial conditions of major state enterprises. ### Recent Developments — Growth, Inflation, Credit, Public Finances, External Sector - Growth and inflation: - Real GDP growth in 2016: 4.4 percent. - Headline inflation: peaked at 7.3 percent in March 2017; eased to 6.9 percent in April 2017. - CBSL policy actions: 50 bp hike in July 2016 and 25 bp hike in March 2017; average lending rates increased by about 200 bps between January 2016 and April 2017. - Credit and monetary: - Credit growth: peaked at 28.5 percent y/y in July 2016; decelerated to 20.4 percent in March 2017. - Public finances and SOEs: - Overall fiscal deficit: decreased from 7 to 5.4 percent of GDP between 2015 and 2016. - Tax-to-GDP ratio: unchanged at 12.4 percent in 2016. - Expenditure-to-GDP ratio: fell below 20 percent; capital spending increased slightly. - Two energy SOEs (CPC and CEB): combined profit of 0.5 percent of GDP in 2016 (compared to balance in 2015). - Public debt: rose from 82 to 84 percent of GDP between 2015 and 2016. - External sector and reserves: - Current account deficit: contained at 2.4 percent of GDP in 2015 and 2016. - Goods trade deficit: about 11 percent of GDP. - Gross international reserves: declined to $6.0 billion at end-2016 (about 3 months of imports or 56 percent of the ARA metric). - CBSL interventions and operations: net FX sales of $89 million in 2016Q4; reserves hit a bottom in February 2017; FX purchases resumed late February; a $1.5 billion sovereign bond placement in early May increased reserves. Sovereign bonds: 10-year maturity priced at 6.2 percent. ### Outlook and Risks — Staff Projections and Key Downside Risks - Staff projections: - Real GDP growth: projected to recover to 4.7 percent in 2017 and reach 5.2 percent over the medium term. - Headline inflation: likely to stay above 5 percent for much of 2017. - Current account deficit: expected to widen slightly to 2.5 percent of GDP in 2017. - Small negative output gap estimated for 2017. - Key downside risks: - Resumption of capital outflows from US dollar strengthening and higher rates. - Weakening external position and challenges to exchange rate flexibility. - Delays in revenue mobilization and SOE reforms. - Large gross financing needs: 19 percent of GDP in 2017, of which 40 percent is financed externally. - Weather shocks: larger-than-estimated fiscal cost of drought or floods (late-May 2017). ### Debt Sustainability — Baseline, Shocks, and Vulnerabilities - Public debt and composition: - Public debt: 84.2 percent of GDP at end-2016. - Central government debt: 79.3 percent of GDP. - Outstanding loans guaranteed by central government: 4.2 percent of GDP. - Outstanding Fund credit: 0.7 percent of GDP. - SOE financial obligations (end-2015, IMF staff estimate): 11.7 percent of GDP (not included in public debt; assessed under shock scenarios). - Baseline projections: - Public debt to GDP: projected to decline from 84.2 percent in 2016 to 70.5 percent in 2022 under the consolidation path. - Gross financing needs: projected to rise to 20 percent of GDP in 2018 and then decrease to around 13 percent of GDP in 2022. - Stress tests and shock scenarios (selected): - Primary balance shock: lower primary surplus by 0.5 percentage points of GDP for 2018−19. - GDP growth shock: 2 percentage points lower for 2018−19. - Exchange rate shock: 15 percent real depreciation in 2018. - Interest rate shock: increase by 300 basis points for new borrowings during 2017−20. - Contingent liability shock: central government liable for additional debt of 10 percent of GDP in 2017 → debt-to-GDP jumps to 94 percent initially and declines to 84 percent by 2022. - Combined shocks: debt-to-GDP would reach 89 percent in 2022. - Vulnerability assessment: - Heat map: high risk to debt sustainability. - Benchmarks exceeded: debt burden benchmark of 70 percent of GDP and gross financing need benchmark of 15 percent of GDP exceeded in program and shock scenarios. - External debt: high at 57 percent of GDP and vulnerable to currency risks; rollover needs increase as external sovereign debt matures beginning in 2019 (next sovereign bond repayment due in 2019: US$1.5 billion). ### Program Performance — IMF Financing, QPCs, ITs, and Structural Benchmarks - IMF purchases and schedule: - So far two purchases equivalent to SDR 239.788 million have been made; another purchase equivalent to SDR 119.894 million will be made available upon completion of the second review. - Table of reviews and purchases lists disbursements totaling 1,070.780 SDR millions (185.000 percent of Quota) over 2016–2019. - Quantitative performance: - Primary deficit contained to Rs 29 billion, meeting the 2016 QPC ceiling of Rs 97 billion. - Tax revenue: Rs 1,464 billion (above the IT of Rs 1,428 billion). - End-March primary balance and tax revenue: Rs 9 billion and Rs 415 billion (exceeding ITs of Rs -5 billion and Rs 383 billion). - NIR QPC floor missed in December by US$ 411 million due to net FX sales of $89 million in 2016Q4 rather than net FX purchases of $330 million as envisaged; March IT floor missed by US$ 169 million. - Reserve money at December: Rs 856 billion (breached IT ceiling of Rs 810 billion). - Structural benchmarks (SBs): - Of 15 SBs due by March 2017: 8 met on time, 1 met with delay, 6 not met by April. - Unmet SBs included: (i) cabinet approval of strategy to reduce tax expenditures; (ii) establishment of commitment record and control systems; (iii) introduction of automatic fuel and electricity pricing mechanisms (two separate SBs); (iv) recording fiscal cost of non-commercial obligations (NCOs) in the budget; (v) parliamentary submission of the new Inland Revenue Act (IRA) (set as a prior action for the second review). - Progress made on many SBs except automatic fuel and electricity pricing mechanisms. ### Policy Discussions and Corrective Actions — Authorities’ Commitments and Staff Recommendations - Authorities’ actions and commitments: - Prior action: new Inland Revenue Act (IRA) will be submitted to parliament (IRA subsequently submitted on July 04, 2017 in the provided content). - Strengthened tax administration and diagnostic review of VAT. - SOE oversight improving; energy pricing reforms recalibrated. - CBSL resumed reserve accumulation since March 2017 and tightened monetary policy in March 2017; stands ready to tighten further. - Staff recommended policy priorities: - Continue fiscal consolidation at a steady pace to reduce the risk of debt distress. - Legislate and implement the new IRA and strengthen the VAT system and administration. - Make further progress in expenditure management and SOE reforms. - Tighten monetary policy to rein in inflation and credit growth. - Continue reserve accumulation while allowing for greater exchange rate flexibility. - Specific downside mitigation: - Advance planning and medium-term debt management to address increased rollover needs as external sovereign debt matures starting in 2019. - Recalibrate energy pricing reforms to avoid fiscal contingent liabilities. ### Monetary Policy — Stance, Rationale, Framework Reform, and Macroprudential Measures - Recent actions and rationale: - Authorities hiked policy rate by 25 bps in March 2017 (after 50 bp in July 2016) and stand ready to tighten further. - Headline inflation remains in the upper range of the target band; credit growth still exceeds 20 percent (y/y). - Sri Lankan interest rates have not kept pace with the US policy rate since late 2016. - Recommended further measures: - Tighten monetary policy further to head off second-round inflation effects, rein in credit expansion, and protect against capital outflows. - Macroprudential instruments: raise the reserve requirement; use limits on loan-to-value ratios in vulnerable sectors; apply credit limits or increase risk weights in the housing sector. - Monetary policy framework reform: - Authorities to develop by October a roadmap for a flexible inflation targeting and exchange rate regime (new SB). - CBSL intends to establish price stability—inflation in the mid-single digits—as the primary objective and publicly communicate inflation targets. - CBSL to develop a macro forecasting model toolkit with IMF TA (May) and adopt FX intervention policies consistent with greater exchange rate flexibility. ### Reserve Accumulation, FX Operations, and External Buffers - Corrective action for missed NIR PC end-2016: - Authorities committed to net outright FX purchase of $300 million over March–April; CBSL purchased $442 million over March–April, exceeding the committed amount. - CBSL to continue net FX purchases and draw upon a syndicated loan of US$700 million; monthly monitoring of progress. - End-2017 target: - By end-2017, the GIR will return to the pre-programmed path under the first review—about $7.2 billion at 65 percent of the ARA metric and 3.3 months of prospective imports. - FX swaps with commercial banks: - FX swaps declining since end-2016; expected to gradually fall to around $2 billion by end-2017. - Exchange rate policy: - Greater exchange rate flexibility recommended as first line of defense against capital outflows; REER assessed to be overvalued notwithstanding large statistical uncertainty. ### Fiscal Policy — 2017 Budget, Targets, and Medium-Term Consolidation - 2017 budget: - Authorities aim at a primary surplus of 0.4 percent of GDP in 2017; QPC ceiling on the primary deficit: Rs 3 billion (0 percent of GDP). - Program target to increase tax collections by 0.7 percentage points of GDP to 13.1 percent of GDP (IT), underpinned by full-year effect of 2016 VAT amendment and the 2017 revenue package. - New IRA: to broaden the tax base, remove excessive tax exemptions, rationalize corporate tax incentives toward an investment-oriented regime, and strengthen powers of the tax administrator. - Fiscal accounts and selected figures (as presented): - Primary surplus target for 2017: 0.4 percent of GDP. - Total Revenue and Grants (selected entries preserved): - 1,461 13.3 (2015); 1,598 13.1 (2016 Est.); 1,694 14.3 (2016 EFF 1st rev); 2,020 15.4 (Prog. 2017); 1,894 14.5 (Budget 2017) - Total Expenditure and net lending: - 2,229 20.4 (2015); 2,298 18.9 (2016 Est.); 2,334 19.7 (2016 EFF 1st rev); 2,645 20.2 (Prog. 2017); 2,581 19.7 (Budget 2017) - Overall balance: - -768 -7.0 (2015); -699 -5.7 (2016 Est.); -640 -5.4 (2016 EFF 1st rev); -625 -4.8 (Prog. 2017); -687 -5.2 (Budget 2017) - Primary balance: - -241 -2.2 (2015); -97 -0.8 (2016 Est.); -29 -0.2 (2016 EFF 1st rev); 550.4 (Prog. 2017); -30.0 (Budget 2017) - Medium-term targets and debt management: - Authorities’ target: overall deficit of 3.5 percent of GDP by 2020 would require primary surplus of about 2¼ percent of GDP by 2020. - Debt management reforms: spread out amortization of international sovereign bonds, lengthen maturity of domestic borrowings. - Proceeds from commercializing public assets to be ring-fenced for debt service. - Fiscal Responsibility (Management) Act to establish binding targets for deficit and public debt beyond 2019. ### Revenue Mobilization, Tax Administration, and PFM Reforms - Tax administration improvements: - IRD met December 2016 SBs: adoption of KPIs on risk-based audit; adoption of VAT compliance strategy; roll-out of RAMIS IT system. - Diagnostic review of VAT system (June 2017 SB) with IMF TA to identify VAT base-broadening reforms. - Tax expenditures to be rationalized under a plan to be included in the 2018 budget (November 2017 SB). - Public financial management: - Commitment recording system established via modification of CIGAS; plan for IT-based commitment control by mid-2017 and operational for 2018 budget (January 2018 SB). - ITMIS budget planning module rolled out to all ministries (January 2017 SB). - MOF to publish quarterly financial bulletins and cost tax expenditures in annual budgets. ### SOE Reforms, Energy Pricing, and Oversight - SOE transparency and oversight: - Five key SOEs published Statements of Corporate Intent (SCIs) in March/April 2017. - SCIs define mission, multiyear corporate plans, performance indicators, and describe NCOs for CPC, CEB, NWSDB, among others. - SriLankan Airlines: - December 2016 SB for a resolution strategy met; implementing route and fleet optimization; aiming to secure a strategic partner. - Automatic pricing mechanisms: - Timeline reset: report on fiscal cost of NCOs for fuel and electricity by September 2017 (new SB); Bulk Supply Transactions Account by March 2018; Cabinet approval of automatic pricing mechanisms for fuel by March 2018 and electricity by September 2018 (reset from December 2016). - Financial performance of CPC and CEB to be monitored quarterly. ### Financial Sector, Trade, and Structural Competitiveness - Financial sector: - CAR above 14 percent; NPL ratio declining (most recent NPL: 2.6 or 2.8 percent in different tables). - Basel III Minimum Capital Requirement being implemented on a staggered basis since July 2017; full implementation by January 2019. - Efforts to resolve distressed non-bank financial companies following IMF TA. - World Bank leading modernization of financial market infrastructure; IMF TA on AML/CFT ongoing. - Trade and competitiveness: - Proliferation of para-tariffs undermines competitiveness. - GSP plus status with EU resumed; exploring new trade agreements with Asian economies. - New Trade Policy submitted to cabinet; unit to improve business environment set up in Prime Minister’s office. - FDI averages around 1 percent of GDP; need to attract higher quality FDI into tradable sectors. ### Program Monitoring, Adjustments, and Risks - Program monitoring: - Semiannual reviews with performance criteria and indicative targets (TMU/Table 1); third review on or after November 20, 2017; fourth review on or after April 20, 2018. - TMU defines Program NIR as CBSL conventional NIR minus outstanding FX swap liabilities with domestic banks. - Adjustors and definitions: - Adjustors for Program NIR floor related to foreign program financing, external commercial loans, SLDBs/FCBUs borrowings, proceeds from commercialization of public assets, and amortization of official external debt. - Valuation rates as of January 2, 2017 (SDR January 3, 2017); monetary gold at US$1,151.84 per troy ounce. - Key program risks reiterated: - Revenue slippage or failure to implement revenue reforms. - Weaker net capital inflows and reserves shortfall. - Lower growth or new trade pressures. - Larger-than-expected SOE losses and slow SOE reforms. - Arrears: - Sri Lanka accumulated US$42 million in external arrears to Export Development Bank of Iran; arrears increased by $6.5 million each in September 2016 and March 2017 (total $13 million increase, 0.016 percent of GDP). - Authorities established a payment platform and expect to clear arrears per negotiated schedules; staff supports waivers for non-observance of continuous PC. ### Selected Key Numerical Indicators (preserved as presented) - Real GDP growth (selected series): 4.8 5.0 4.5 4.4 5.0 4.8 4.7 4.8 4.9 5.0 5.1 - Inflation (average series): 2.2 4.1 4.0 4.0 5.3 5.1 6.0 5.0 5.0 5.0 5.0 - Gross international reserves (end of period, in millions of U.S. dollars series): 7,304 7,853 6,542 6,019 9,372 7,118 7,246 8,155 8,786 9,618 10,276 - Net international reserves (in millions of U.S. dollars series): 5,029 5,700 5,490 4,529 7,043 5,890 6,161 6,589 6,980 7,826 8,538 - Central government debt (percent of GDP series): 77.6 77.2 77.0 79.3 75.5 76.4 79.6 77.6 74.8 72.1 69.7 - Public debt (end-2016): Rs. billion 9,968 — 84.2 percent of GDP. - Central government external debt components (end-2016): International sovereign bonds Rs. billion 1,221 — 10.3 percent of GDP; Nonresident holdings of T-Bills and T-Bonds Rs. billion 602 — 2.2 percent of GDP. - Gross financing needs in 2016: 17.6 percent of GDP (amortization 12.2 percent; overall deficit 5.4 percent). *Source: cr17253 — IMF staff report extract.* ### EXECUTIVE SUMMARY ### EXECUTIVE SUMMARY ### Context - Sri Lanka’s economic reform program is supported by an Extended arrangement under the Extended Fund Facility (EFF) approved in June 2016 for the amount of SDR 1.1 billion (185 percent of quota and about US$ 1.5 billion) over 36 months. - Core objectives of the multi-year reform program: - Domestic revenue mobilization based on sweeping tax reforms to support multi-year fiscal consolidation. - Build up international reserves and allow for greater exchange rate flexibility. - Strengthen tax administration and public financial management. - Improve financial conditions of major state enterprises. ### Recent Developments - Growth and inflation: - Real GDP growth in 2016 was 4.4 percent, supported by construction and service activities and offsetting a sharp contraction in agriculture due to floods in May and drought in Q4. - Headline inflation peaked at 7.3 percent in March 2017 and eased to 6.9 percent in April 2017. - The Central Bank of Sri Lanka (CBSL) raised the policy rate by 25 basis points in March 2017 (after a 50 bp hike in July 2016). Average lending rates increased by about 200 bps between January 2016 and April 2017. - Public finances and SOEs: - Overall fiscal deficit decreased from 7 to 5.4 percent of GDP between 2015 and 2016. - Tax-to-GDP ratio remained unchanged at 12.4 percent in 2016. - Expenditure-to-GDP ratio fell below 20 percent; capital spending increased slightly. - Two energy SOEs—Ceylon Petroleum Corporation (CPC) and Ceylon Electricity Board (CEB)—recorded a combined profit of 0.5 percent of GDP in 2016 (compared to balance in 2015). - Public debt rose from 82 to 84 percent of GDP between 2015 and 2016, largely due to exchange rate depreciation and an increase in guaranteed debt. - External sector and reserves: - Current account deficit contained at 2.4 percent of GDP in 2015 and 2016; strong tourism and remittances offset an 11 percent of GDP goods trade deficit. - Financial account pressured by portfolio outflows and unwinding of an official swap line ($700 million) in Q4 2016; foreign investors repatriated $372 million in rupee-denominated government securities (0.5 percent of GDP). - Gross international reserves declined to $6.0 billion at end-2016, reserve coverage about 3 months of imports or 56 percent of the ARA metric. - CBSL intervened selling $89 million net in 2016Q4; reserves hit a bottom in February 2017 and declined by $384 million. FX purchases resumed late February; a $1.5 billion sovereign bond placement in early May increased reserves. - The sovereign bonds have a 10-year maturity and were priced at 6.2 percent. - Credit and monetary: - Credit growth peaked at 28.5 percent y/y in July 2016, decelerating to 20.4 percent in March 2017; growth robust across sectors except personal loans (growth slowed from 31 percent in 2016Q1 to 15 percent in 2016Q4 y/y). ### Outlook and Risks - Staff projections: - Real GDP growth projected to recover to 4.7 percent in 2017 and reach 5.2 percent over the medium term in line with potential. - Headline inflation likely to stay above 5 percent for much of 2017. - Current account deficit expected to widen slightly to 2.5 percent of GDP in 2017 due to drought-driven increases in oil and food imports and higher capital goods imports. - Small negative output gap estimated for 2017. - Key downside risks: - Resumption of capital outflows from US dollar strengthening and higher rates, or weakening external position. - Unproven commitment to exchange rate flexibility under capital outflows. - Domestic risks from delays in revenue mobilization and SOE reforms, and pressures from large gross financing needs (19 percent of GDP in 2017), of which 40 percent is financed externally. - Larger-than-estimated fiscal cost of drought or economic consequences of floods in late-May 2017. - Debt sustainability: - Public debt expected to rise slightly to 85 percent of GDP in 2017 due to large fiscal deficit and exchange rate depreciation. - Medium-term overall deficit target of 3.5 percent of GDP remains appropriate and would lower public debt to 76 percent of GDP by 2020 under the programmed consolidation. - If contingent SOE debt is included, total public debt would rise to 94 percent of GDP (treated as a shock scenario) and decline below 90 percent of GDP by 2020. - External debt high at 57 percent of GDP and vulnerable to currency risks; rollover needs will increase as external sovereign debt begins to mature in 2019. ### Program Performance - IMF program financing and purchases: - So far two purchases equivalent to SDR 239.788 million have been made; another purchase equivalent to SDR 119.894 million will be made available upon completion of the second review. - Quantitative performance: - Primary deficit contained to Rs 29 billion, meeting the 2016 QPC ceiling of Rs 97 billion. - Tax revenue was Rs 1,464 billion, above the IT of Rs 1,428 billion. - End-March primary balance and tax revenue were Rs 9 billion and Rs 415 billion, exceeding ITs of Rs -5 billion and Rs 383 billion respectively. - Net international reserves (NIR) QPC floor missed in December by US$ 411 million due to net FX sales of $89 million in 2016Q4 rather than net FX purchases of $330 million as envisaged. March IT floor missed by US$ 169 million. - Reserve money at December Rs 856 billion breached the IT ceiling of Rs 810 billion; reserve money still exceeded the March IT ceiling partly due to sizable FX purchases. - Structural benchmarks: - Of 15 SBs due by March 2017: 8 met on time, 1 met with delay, 6 not met by April. - Unmet SBs included: (i) cabinet approval of strategy to reduce tax expenditures; (ii) establishment of commitment record and control systems; (iii) introduction of automatic fuel and electricity pricing mechanisms (two separate SBs); (iv) recording fiscal cost of non-commercial obligations (NCOs) in the budget; (v) parliamentary submission of the new Inland Revenue Act (IRA) (set as a prior action for the second review). - Progress made on these SBs except for the automatic fuel and electricity pricing mechanisms. ### Policy Discussions and Corrective Actions - Authorities’ actions and commitments: - Authorities remain committed to the reform program and undertook corrective actions where targets were missed. - Prior action: the new Inland Revenue Act (IRA) will be submitted to parliament. - Strengthened tax administration and conducting a diagnostic review of VAT. - SOE oversight improving; energy pricing reforms being recalibrated to address earlier setbacks. - CBSL resumed reserve accumulation since March 2017 and tightened monetary policy in March 2017 in response to high inflation; stands ready to tighten further should inflation or credit growth remain high. - Recommended policy priorities going forward: - Continue fiscal consolidation at a steady pace to reduce the risk of debt distress. - Legislate and implement the new IRA and strengthen the VAT system and administration. - Make further progress in expenditure management and SOE reforms. - Tighten monetary policy to rein in inflation and credit growth. - Continue reserve accumulation while allowing for greater exchange rate flexibility. - Specific downside mitigation: - Advance planning and medium-term debt management to address increased rollover needs as external sovereign debt matures starting in 2019. - Recalibrate energy pricing reforms to avoid fiscal contingent liabilities. *Source: cr17253 - EXECUTIVE SUMMARY (IMF)* ### 12. Following a 25bp hike in March, monetary policy should be tightened further to avoid ### 12. Following a 25bp hike in March, monetary policy should be tightened further to avoid ### Monetary policy stance and rationale - The authorities hiked 25bps to head off rising inflation expectation and stand ready to tighten further if needed. - Authorities view the monetary tightening since 2016 as still working through the system toward slowing credit growth with a long lag, including through a significant rise in lending rates. - Headline inflation remains in the upper range of the target band. - Credit growth still exceeds 20 percent (y/y) with various indicators not yet presenting clear evidence of cooling credit demand. - Sri Lankan interest rates have not kept pace with the global trend as represented by the US policy rate since late 2016. - Further monetary tightening would: - head off the second-round effects of currently high inflation, - rein in credit expansion, and - protect against potential capital outflows from further US rate hikes. ### Macroprudential and complementary measures to slow credit growth - Other measures to slow credit growth include: - raising the reserve requirement, and - employing macroprudential instruments, such as: broader use of limits on loan-to-value ratios in vulnerable sectors, and a credit limit or increasing risk weights in the housing sector. - The authorities agreed to closely monitor credit growth, particularly to ensure that credit growth was directed towards productive economic activity, and to tighten monetary policy further and use macro-prudential measures, if necessary. ### Reserve accumulation, FX operations, and external buffers - As a corrective action for missing the NIR PC for end-2016, the authorities committed to a net outright FX purchase of $300 million over March‒April. - The CBSL purchased $442 million over March–April, exceeding the committed amount by a substantial margin. - The CBSL will continue to make net FX purchases, as well as draw upon a syndicated loan of US$700 million, with monthly monitoring of the progress. - By end-2017, the GIR will return to the pre-programmed path under the first review—about $7.2 billion at 65 percent of the ARA metric and 3.3 months of prospective imports. - FX swaps with domestic commercial banks have been declining since end-2016, and are expected to gradually fall to around $2 billion by end-2017. - Greater exchange rate flexibility should be the first line of defense in the event of capital outflows and would support the buildup of reserves and external competitiveness. - The real effective exchange rate is assessed to be overvalued relative to medium-term fundamentals and desirable policies, notwithstanding large statistical uncertainty (Annex II). ### Monetary policy framework reform - The authorities are developing by October a roadmap for a flexible inflation targeting and exchange rate regime (new SB). - The CBSL has developed a macro forecasting model toolkit and intends to: - establish price stability—inflation in the mid-single digits—as the primary objective of monetary policy, and - publicly communicate the inflation targets. - The CBSL can retain a role for smoothing excessive exchange rate volatility, but should adopt FX intervention policies consistent with greater exchange rate flexibility under flexible inflation targeting. - Once the roadmap is developed with inputs from IMF TA (May), time-bound reform measures will be incorporated into future program reviews. ### Fiscal policy: 2017 budget and consolidation - The 2017 budget continues to pursue revenue-based fiscal consolidation as envisaged under the program. - Authorities aim at a primary surplus of 0.4 percent of GDP in 2017, providing a buffer to achieve the QPC ceiling on the primary deficit of Rs 3 billion (0 percent of GDP). - The program targets an increase in tax collections by 0.7 percentage points of GDP to 13.1 percent of GDP (IT), underpinned by the full-year effect of the 2016 VAT amendment and the revenue package in the 2017 budget. - The new Inland Revenue Act (IRA) will be submitted to parliament, satisfying a prior action for the second review. - The new IRA aims to broaden the tax base by removing excessive tax exemptions; rationalize corporate tax incentives toward an investment-oriented regime; and strengthen powers of the tax administrator. - To avoid fiscal slippage, the authorities will benchmark the spending level to the EFF program target and align expenditures with revenue outturns on a quarterly basis under Parliamentary oversight. - In case of revenue overperformance, the authorities will use the surplus to cover possible weather-related costs above the current estimates, and then bring down debt. ### Fiscal accounts and targets (selected figures as presented) - Primary surplus target for 2017: 0.4 percent of GDP. - Program target for tax collections: increase by 0.7 percentage points of GDP to 13.1 percent of GDP (IT). - Summary table highlights (as provided in source): - Total Revenue and Grants: 1,461 13.3 (2015); 1,598 13.1 (2016 Est.); 1,694 14.3 (2016 EFF 1st rev); 2,020 15.4 (Prog. 2017); 1,894 14.5 (Budget 2017) - Total Expenditure and net lending: 2,229 20.4 (2015); 2,298 18.9 (2016 Est.); 2,334 19.7 (2016 EFF 1st rev); 2,645 20.2 (Prog. 2017); 2,581 19.7 (Budget 2017) - Overall balance: -768 -7.0 (2015); -699 -5.7 (2016 Est.); -640 -5.4 (2016 EFF 1st rev); -625 -4.8 (Prog. 2017); -687 -5.2 (Budget 2017) - Primary balance: -241 -2.2 (2015); -97 -0.8 (2016 Est.); -29 -0.2 (2016 EFF 1st rev); 550.4 (Prog. 2017); -30.0 (Budget 2017) ### Medium-term fiscal consolidation and debt management - Under staff projections, the authorities’ commitment to reducing the overall deficit to 3.5 percent of GDP by 2020 would require further consolidation to a primary surplus of about 2¼ percent of GDP by 2020. - Debt management reforms should aim to spread out the amortization of international sovereign bonds and lengthen the maturity of domestic borrowings. - Authorities plan to ring-fence proceeds from commercializing public assets for debt services over the medium term. - The Fiscal Responsibility (Management) Act should establish binding targets for government deficit and public debt to ensure fiscal consolidation beyond 2019. ### Revenue mobilization and tax administration - Improvements in tax administration capacity include the IRD meeting December 2016 SBs: - adoption of Key Performance Indicators on risk-based audit, - adoption of a VAT compliance strategy, and - roll-out of the new IT system (RAMIS) for major domestic taxes. - A diagnostic review of the VAT system (June 2017 SB), supported by IMF TA, will help identify areas for further VAT base-broadening reforms and administrative improvements. - Tax expenditures will be further rationalized under a plan to be included in the 2018 budget (November 2017 SB). ### Commitment-based expenditure control and IT systems - The Ministry of Finance plans to establish commitment ceilings by mid-year and align expenditures and revenue outturns on a quarterly basis. - The budget planning module of the new IT system (ITMIS) was rolled out to all ministries while maintaining the existing system during the transition (January 2017 SB). - The authorities will implement an IT-based commitment control system for the 2018 budget (January 2018 SB). ### SOE reforms and energy pricing - Five key SOEs published Statements of Corporate Intent (SCIs) in March 2017 (published in April 2017), improving transparency and oversight. - SCIs define mission, multiyear corporate plan, and performance indicators, and clarify non-commercial obligations for CPC, CEB, and NWSDB, among others. - The December 2016 SB for a resolution strategy for SriLankan Airlines was met; the airline is implementing route and fleet optimization and aims at securing a strategic partner. - Timing for automatic pricing mechanisms for fuel and electricity was reset: - A report to outline the fiscal cost of NCOs for fuel and electricity (September 2017 SB). - CEB and the Public Utility Commission to establish a Bulk Supply Transactions Account (March 2018 SB). - Cabinet to approve automatic pricing mechanisms for fuel and electricity by March 2018 and September 2018, respectively (reset from December 2016). - Financial performance of CPC and CEB will be monitored quarterly in the interim. ### Financial sector and trade reforms - Financial soundness indicators remain stable: capital adequacy ratio (CAR) above 14 percent and NPL ratio declining. - CAR has been declining as rapid credit growth increases risk-weighted assets. - Basel III Minimum Capital Requirement is being implemented on a staggered basis since July 2017; all licensed commercial and specialized banks will have to maintain the minimum capital ratios and buffers starting in July 2017 (the requirement ratio will gradually increase to reach the international standard by January 2019). - Efforts to resolve distressed non-bank financial companies are underway following IMF TA in March. - World Bank is leading modernization of financial market infrastructure and institutional capacity strengthening; ongoing IMF TA on AML/CFT supports financial sector strengthening. - Trade and investment reforms: - Proliferation of para-tariffs has undermined competitiveness. - New IRA and tax reforms supported by the EFF could improve the regime and create fiscal space for reducing para-tariffs over the medium term. - Authorities secured the resumption of GSP plus status with EU, are exploring new trade agreements with Asian economies, submitted a New Trade Policy to the cabinet, and are setting up a unit in the Prime Minister’s office dedicated to improving the business environment. ### Program monitoring, arrears, financing, and risks - The attached Letter of Intent (LOI) and the MEFP describe authorities’ progress and commitments (Appendix I). - Authorities seek waivers of applicability of the June 2017 QPCs for primary balance and the NIR and for nonobservance of the continuous PC against accumulation of external arrears; staff endorses the request for waivers. - Modification of the NIR QPC for end-June, new QPCs for end-December 2017, and modification of the ITs through end-December 2017 and the inflation target bands under the MPCC are proposed, with targets on NIR, tax revenue, reserve money, and the center point of the inflation target band adjusted. - Sri Lanka has accumulated US$42 million in external arrears to the Export Development Bank of Iran; arrears increased by $6.5 million each in September 2016 and March 2017, resulting in a $13 million increase (0.016 percent of GDP) in arrears for debt service on project loans. - Authorities have established a payment platform and expect to clear the arrears on the basis of repayment schedules being negotiated with the Iranian authorities; staff supports waivers for the non-observance of the continuous PC. - The program remains fully financed for the next 12 months with firm financing assurances from the World Bank, Asian Development Bank, and key bilateral donors, but risks remain significant. - Key risks to the program: - revenue slippage or failure to implement key revenue-related reforms; - weaker than expected net capital inflows and reserves shortfall; - lower than expected growth and/or new pressures on the trade account; and - larger than expected losses at SOEs and lack of progress in SOE reforms. *Source: IMF staff report content provided in the supplied PDF extract.* ### 29. Safeguards. The safeguards assessment, updated in August 2016, identified weaknesses in ### 29. Safeguards. The safeguards assessment, updated in August 2016, identified weaknesses in ### Safeguards assessment — key findings - The safeguards assessment, updated in August 2016, identified weaknesses in the areas of the CBSL’s autonomy, governance arrangements, and legal framework (e.g., the government’s voting representation in the Monetary Board). - These issues should be addressed when the authorities amend the legal framework for central banking, starting with IMF TA on a flexible inflation targeting and flexible exchange rate regime (¶15). ### Box 2. Sri Lanka: A Break in Potential Growth? — summary findings - Sri Lanka’s GDP growth averaged at around 5.5 percent during 2000–16, but slowed lately reflecting weaker productivity. - Medium-term potential growth is estimated to be around 5 percent conditional on an investment and productivity rebound. - Strong progress in economic reforms could further enhance growth potential. - Historical context: - The early 2000s began with a low growth resulting from widespread civil conflict. - Following a ceasefire in 2002, real GDP growth rose to average about 6 percent between 2003–2009. - Following the end of the civil conflict in 2009, growth jumped to an average of 8.5 percent over 2010–2012. - Since then growth has slowed with average real GDP growth at 4.4 percent during 2013–16. - Potential growth estimates and methods: - Staff applied both filtering and production function approaches. - Using quarterly data between 1997Q1 to 2021Q4, the HP filter estimates potential growth to be between about 5–5.3 percent over the medium term. - Results show potential growth was at close to 7 percent during 2010–2012 when the economy was operating above potential. - These results are similar to a previous study (IMF Working Paper WP/14/40) that also found potential growth to be around 7 percent in 2012. - Since then, potential growth has declined and is expected to be slightly above 5 percent over the medium term. - Growth accounting findings: - Growth accounting approach indicates that the recent decline in potential growth was due to productivity slowdown. - Over 2004–2012, total factor productivity (TFP) was the main contributor to Sri Lanka’s strong growth, as the contributions of capital and labor increased little. - In 2013–2016, TFP growth declined substantially—a trend also experienced by other emerging markets. - To reach a growth rate of 5–5.5 percent, TFP growth will have to increase, accompanied by strong growth in capital stock. - Policy-relevant drivers to boost productivity: - Increase FDI inflows. - Greater trade openness. - Developing human capital. - Proactive government engagement with the private sector through infrastructure, a strong regulatory environment and secure legal framework. - These reforms align with the EFF program. ### Decomposition of actual growth rates (as presented) - 2003- 2009 2010-2012 2013- 2016 Medium Term - Real G DP G rowth Rate 5.9 4 8.5 3 4.3 9 5.0 5.5 - Capital2.60 2.72 2.39 2.42 2.6 - Labor0.53 0.53 0.66 0.70 0.7 - TFP2.81 5.28 1.35 1.92 2.2 (Note: numeric lines are preserved exactly as presented in the source text.) ### Staff appraisal — progress and priorities - Reforms under the program have moved forward and the momentum needs to increase with greater ownership. - Notwithstanding the severe drought, economic growth has held up and government finances have been strengthened consistent with the program. - Progress has been made in fiscal structural reforms, but with some delays in energy pricing and expenditure commitment control. - The authorities have begun to address the NIR shortfall through FX purchases. - Fiscal policy: - Fiscal consolidation should continue, supported by the new IRA. - Targets for 2016 fiscal balance and revenue collection have been met, owing to revenue overperformance. - The new IRA will be submitted to parliament (prior action), and will provide the foundation for further fiscal consolidation upon legislation. - Sri Lanka’s debt burden and gross financing needs remain very high, raising the urgency for further fiscal consolidation. - Continued revenue mobilization, including through robust implementation of the IRA and further improvements of the VAT, will remain the key to upholding medium-term fiscal consolidation. - Need for ownership in structural reforms: - Risk-based tax administration should strengthen further. - IT systems for tax and expenditure administration should be fully utilized. - Energy pricing reforms should make tangible progress. - Timely progress in these areas will strengthen the platform for steady fiscal consolidation. - External buffers and exchange rate policy: - Building on the recent corrective action, the authorities should continue accumulating NIR and demonstrate their commitment to greater exchange rate flexibility. - Given the primacy of reducing Sri Lanka’s high external vulnerability, NIR accumulation based on FX purchases and greater exchange rate flexibility should remain a high priority for building external buffers and improving competitiveness. - Greater exchange rate flexibility should be the first response to greater market volatility. - Monetary and financial sector policy: - Monetary policy should be tightened further, and financial sector risks managed prudently. - Following the rate hike in March, the central bank should tighten monetary stance further until clear signs emerge that inflation pressures and credit expansion have subsided. - Financial sector supervision and resolution should be strengthened, and credit growth contained including by deploying macro-prudential measures as needed. *IMF staff appraisal and analysis as presented in the source content.* ### 35. Staff supports the completion of the second review under the EFF arrangement, in light ### 35. Staff supports the completion of the second review under the EFF arrangement, in light ### Staff assessment and recommendation - Staff supports the completion of the second review under the EFF arrangement, in light of the progress so far—including the corrective actions for NIR shortfall as well as the steps undertaken to clear external arrears—and the authorities’ policy commitment to ongoing reforms. - Staff also supports the authorities’ request for modification of the NIR QPC, ITs, MPCC, SBs and the TMU, as well as a waiver of applicability of the June 2017 QPCs. ### Progress cited - Corrective actions for NIR shortfall have been implemented. - Steps have been undertaken to clear external arrears. - Authorities have expressed a policy commitment to ongoing reforms. ### Selected macroeconomic indicators (from source tables and figures) - Real GDP growth: 4.8 5.0 4.5 4.4 5.0 4.8 4.7 4.8 4.9 5.0 5.1 - Inflation (average): 2.2 4.1 4.0 4.0 5.3 5.1 6.0 5.0 5.0 5.0 5.0 - Inflation (end-of-period): 4.6 5.4 5.1 4.5 5.2 5.1 5.1 5.0 5.0 5.0 5.0 - National savings (in percent of GDP): 26.1 26.9 27.3 29.0 26.0 28.6 29.3 29.8 30.1 30.6 30.9 - Current account balance (in millions of U.S. dollars): -1,882 -1,202 -1,738 -1,942 -2,419 -1,953 -2,094 -1,980 -1,933 -1,983 -2,219 - Gross official reserves (end of period, in millions of U.S. dollars): 7,304 7,853 6,542 6,019 9,372 7,118 7,246 8,155 8,786 9,618 10,276 - Net international reserves (in millions of U.S. dollars): 5,029 5,700 5,490 4,529 7,043 5,890 6,161 6,589 6,980 7,826 8,538 - Central government debt (in percent of GDP): 77.6 77.2 77.0 79.3 75.5 76.4 79.6 77.6 74.8 72.1 69.7 ### Fiscal sector (selected items, percent of GDP / levels) - Total revenue and grants: 13.3 13.0 13.1 14.3 14.0 13.9 14.5 15.4 16.5 16.7 16.9 (percent of GDP across 2015–21 series) - Total expenditure and net lending: 20.4 18.4 18.9 19.7 18.8 19.2 19.7 20.2 20.3 20.3 20.4 (percent of GDP across 2015–21 series) - Overall balance (central government): -7.0 -5.4 -5.7 -5.4 -4.7 -5.2 -5.2 -4.7 -3.7 -3.5 -3.5 (percent of GDP across 2015–21 series) - Central government net domestic financing (in billions of rupees): 4.3 2.3 2.9 2.8 3.0 3.5 3.4 3.2 3.3 3.0 3.0 ### Monetary and financial sector highlights - Broad money (year-on-year percent change, selected): 17.8 10.8 20.0 18.4 15.4 18.2 15.9 13.9 13.2 12.8 12.4 - Reserve money (year-on-year percent change, selected): 16.5 18.4 20.3 27.1 12.0 17.0 13.0 12.8 12.7 12.5 12.4 - Private credit (in percent of GDP): 26.6 31.5 31.2 34.0 35.5 32.4 35.9 36.5 (series across available periods) - Banking sector: Regulatory capital to risk weighted assets around the mid-teens (series across 2008–2016); Gross non-performing loans to total gross loans declined to 2.6 (most recent quarterly figure in Table 5). ### External sector and financing - Gross external financing needs (in millions of U.S. dollars, selected): -2,791 -4,115 -4,192 -4,048 -5,721 -5,093 -3,885 (2015–21 series) - Sources of financing include borrowing (e.g., sovereign bonds, bilateral and multilateral), FDI inflows, and other capital inflows; change in reserve assets shown in Table 4c. - Projected payments to the Fund (Table 7): Fund repurchases and charges (in millions of SDR) across 2016–2030: 36.1 39.7 14.3 19.2 29.8 59.4 122.9 180.3 192.3 189.4 176.6 144.0 77.6 17.4 2.4; Fund credit outstanding (in millions of SDR) series starting: 412.0 537.5 893.0 1,070.8 1,060.8 1,020.8 916.4 752.8 574.3 395.9 227.4 88.9 14.8 0.0 0.0 ### Program implementation (IMF financing under the EFF) - Table of Reviews and Purchases under the Three-year Extended Arrangement (Table 6): - June 3, 2016 — 119.894 SDR millions — 20.714 percent of Quota — Board Approval of the Extended Arrangement - November 18, 2016 — 119.894 SDR millions — 20.714 percent of Quota — Completion of the first review based on end-June 2016 and continuous performance criteria - April 20, 2017 — 119.894 SDR millions — 20.714 percent of Quota — Completion of the second review based on end-December 2016 and continuous performance criteria - November 20, 2017 — 177.774 SDR millions — 30.714 percent of Quota — Completion of the third review based on end-June 2017 and continuous performance criteria - April 20, 2018 — 177.774 SDR millions — 30.714 percent of Quota — Completion of the fourth review based on end-December 2017 and continuous performance criteria - November 20, 2018 — 177.774 SDR millions — 30.714 percent of Quota — Completion of the fifth review based on end-June 2018 and continuous performance criteria - April 20, 2019 — 177.776 SDR millions — 30.715 percent of Quota — Completion of the sixth review based on end-December 2018 and continuous performance criteria - Total: 1,070.780 SDR millions — 185.000 percent of Quota *Source: IMF staff (content unit cr17253).* ### Annex I. Debt Sustainability Analysis ### Annex I. Debt Sustainability Analysis ### A. Background and Key Assumptions - Public debt reached 84.2 percent of GDP at end-2016. - Public debt composition in this DSA: - Central government debt: 79.3 percent of GDP. - Outstanding amount of loans guaranteed by the central government: 4.2 percent of GDP. - Outstanding Fund credit: 0.7 percent of GDP. - SOEs' financial obligations identified by recent FAD TA (12 percent of GDP at end-2015) are not included in the public debt outstanding; impact of possible realization of contingent liabilities is assessed under a shock scenario. - Foreign-currency denominated debt accounted for 48 percent of total. - Debt owed to official and multilateral creditors accounted for about a quarter of the total. - Gross financing needs in 2016: 17.6 percent of GDP, comprising: - Amortization payments (including short-term debt repayment): 12.2 percent of GDP. - Overall deficit: 5.4 percent of GDP. - Comparative position: debt to GDP ratio higher than median for emerging economies (57 percent; excluding major oil exporters); gross funding needs are the third largest among them. - Table of selected aggregates (2015‒2016): - Public debt: Rs. billion 8,996 — 82.2 percent of GDP (2015); Rs. billion 9,968 — 84.2 percent of GDP (2016). - Central government debt: Rs. billion 8,503 — 77.6 percent of GDP (2015); Rs. billion 9,387 — 79.3 percent of GDP (2016). - Domestic: Rs. billion 4,959 — 45.3 percent of GDP (2015); Rs. billion 5,342 — 45.1 percent of GDP (2016). - Treasury Bills: Rs. billion 658 — 6.0 percent of GDP (2015); Rs. billion 780 — 6.6 percent of GDP (2016). - Treasury Bonds: Rs. billion 3,305 — 30.2 percent of GDP (2015); Rs. billion 3,715 — 31.4 percent of GDP (2016). - Other domestic: Rs. billion 996 — 9.1 percent of GDP (2015); Rs. billion 477 — 7.2 percent of GDP (2016). - External: Rs. billion 3,544 — 32.4 percent of GDP (2015); Rs. billion 4,046 — 34.2 percent of GDP (2016). - Multilateral and bilateral: Rs. billion 2,237 — 20.4 percent of GDP (2015); Rs. billion 2,437 — 20.6 percent of GDP (2016). - International sovereign bonds: Rs. billion 958 — 8.7 percent of GDP (2015); Rs. billion 1,221 — 10.3 percent of GDP (2016). - Nonresident holdings of T-Bills and T-Bonds: Rs. billion 304 — 2.8 percent of GDP (2015); Rs. billion 602 — 2.2 percent of GDP (2016). - Other external: Rs. billion 450 — 0.4 percent of GDP (2015); Rs. billion 128 — 1.1 percent of GDP (2016). - Publicly guaranteed debt: Rs. billion 382 — 3.5 percent of GDP (2015); Rs. billion 497 — 4.2 percent of GDP (2016). - Fund credit outstanding: Rs. billion 110 — 1.0 percent of GDP (2015); Rs. billion 83 — 0.7 percent of GDP (2016). - Financial obligations of SOEs (IMF staff estimates): Rs. billion 1,280 — 11.7 percent of GDP (2015). - Ceylon Electricity Board: Rs. billion 237 — 2.2 percent of GDP. - Ceylon Petroleum Corporation: Rs. billion 424 — 3.9 percent of GDP. - Sri Lanka Ports Authority: Rs. billion 240 — 2.2 percent of GDP. - Sri Lankan Airlines: Rs. billion 309 — 2.8 percent of GDP. - Other: Rs. billion 69 — 0.6 percent of GDP. - Memorandum item: Public debt and financial obligations of SOEs: Rs. billion 10,276 — 93.8 percent of GDP. - External debt (end-2015) and structure: - External debt estimated at 56 percent of GDP at end-2015. - Predominantly owed by the public sector: 55 percent held by the general government and 6 percent by the central bank. - Private external debt has risen; debt of deposit-taking financial institutions rose from 13 percent of total in 2011 to 20 percent in 2015. - Debt to exports: 265 percent in 2015. - Rollover risks low: 83 percent of total debt (public and private) is medium or long term. - Next sovereign bond repayment due in 2019 (US$1.5 billion). - About half of the central government’s external debt stock is denominated in dollars. - Baseline macro assumptions under the EFF-supported program scenario: - Real GDP growth: from 4.4 percent in 2016 to 5.2 percent by 2022. - Inflation: around 5 percent over the medium term. - Fiscal deficit: decrease from 5.4 percent of GDP in 2016 to the authorities’ target of 3.5 percent of GDP in 2020. - Primary balance: improves from deficit of 2.2 percent of GDP in 2015 to a balance in 2017 and a surplus of 2.2 percent of GDP in 2020. - Interest payments: based on projected interest payments for existing debt and secondary market interest rates prevailing thus far in 2017 for newly issued debt in 2017; interest rates for newly issued debts assumed to decrease gradually over the medium term. - Publicly guaranteed debt: projected to remain broadly unchanged at the 2016 level in nominal terms. - External debt projections: based on projected current account deficit path from 2.5 percent of GDP in 2017 to around 2 percent of GDP over the medium term; incorporate planned purchases under the Fund’s Extended Arrangement and disbursements of program loans by multilateral and bilateral creditors. ### B. Public Debt Sustainability - Program scenario projections and outcomes: - Ratio of public debt to GDP projected to decline from 84.2 percent in 2016 to 70.5 percent in 2022 under the consolidation path. - Debt to GDP ratio projected to decline by about 2–3 percent annually from 2018 onwards. - Gross financing needs projected to rise to 20 percent of GDP in 2018 and then decrease to around 13 percent of GDP in 2022. - Favorable debt dynamics expected due to a negative interest-rate-and-growth differential and primary surpluses. - Downside risks and shock scenarios: - If fiscal consolidation stalls and primary balance remains at a historical level (-1.5 percent of GDP), the debt-to-GDP ratio would remain at about the same level as in 2016. - Individual shock scenarios: - Primary balance shock: lower primary surplus by 0.5 percentage points of GDP for 2018−19. - GDP growth shock: 2 percentage points lower than in the program scenario for 2018−19. - Exchange rate shock: 15 percent real depreciation in 2018 vis-à-vis the program scenario. - Interest rate shock: increase by 300 basis points for new borrowings during 2017−20 vis-à-vis the program scenario. - Combined shocks: debt to GDP ratio would reach 89 percent in 2022. - Contingent liability shock scenario (central government liable for additional debt of 10 percent of GDP in 2017): debt to GDP ratio would jump to 94 percent of GDP initially and gradually decline to 84 percent of GDP in 2022. - The likelihood of such a contingent liability scenario has increased due to delays in introducing fuel and electricity pricing mechanisms, crucial to ensure profitability of oil and electricity SOEs. - In the combined shock and contingent liability shock scenarios, gross funding needs would remain elevated at 16−18 percent of GDP in 2022. - Debt level is high relative to revenues, constraining repayment capacity. - The envisaged improvement in the cyclically adjusted primary balance by 3.3 percentage points of GDP over 2016−18 is higher than in 80 percent of international experiences, highlighting the challenge of the fiscal consolidation plan. - Heat map and vulnerability assessment: - Heat map analysis indicates a high risk to debt sustainability. - Debt burden benchmark of 70 percent of GDP and gross financing need benchmark of 15 percent of GDP are exceeded in the program and shock scenarios during the projection period. - Under the program scenario, the debt to GDP ratio and gross financing needs as a percent of GDP were 85 percent and 19 percent in 2017, respectively. - Debt profile analysis indicates a moderate degree of vulnerabilities related to: - Market perception. - External financing requirement. - Debt held by non-residents. - Debt denominated in foreign currency. ### C. External Debt Sustainability - External debt projections under the program scenario: - External debt projected to decrease from 57 percent of GDP in 2016 to 50 percent in 2022. - Decline driven by robust GDP growth and gradual current account adjustments, with increased FDI and other debt-creating private capital inflows. *Source: Sri Lankan authorities and IMF staff estimates.* ### 8. Nevertheless, vulnerabilities linked to inadequate reserve coverage, exchange rate ### 8. Nevertheless, vulnerabilities linked to inadequate reserve coverage, exchange rate ### Risks to debt servicing and external debt dynamics - Currency risk, notably related to the dollar, is high. - Large rupee depreciation could pose a significant risk, if sustained; stress tests show that a 30 percent real depreciation would raise the external debt to GDP ratio to about 73 percent by 2022. - In the short run, tighter global liquidity and shifts in investor confidence could raise rollover vulnerabilities and costs. - Although rollover risks are generally low due to the high share of medium- to long-term debt, there are lumpy repayments starting in 2019. - External financing at non-concessional terms gradually substitutes concessional financing, pointing to a need to build up buffers. - Lower than expected GDP or export growth would also deteriorate debt dynamics. ### Public DSA — baseline projections and key indicators (selected figures as of May 26, 2017) - Nominal gross public debt: 2015: 75.78; 2016: 82.28; 2017: 84.28; 2018: 84.78; 2019: 82.67; 2020: 79.37; 2021: 76.17; 2022: 73.37; (in percent of GDP) 70.5 (last listed) - Public gross financing needs: 2015: 22.6; 2016: 21.1; 2017: 17.6; 2018: 18.6; 2019: 19.6; 2020: 17.3; 2021: 14.3; 2022: 13.3 (in percent of GDP) - Real GDP growth (in percent): 2015: 6.2; 2016: 4.8; 2017: 4.4; 2018: 4.7; 2019: 4.8; 2020: 4.9; 2021: 5.0; 2022: 5.1; 5.2 (projection years) - Inflation (GDP deflator, in percent): 2015: 8.9; 2016: 0.8; 2017: 3.6; 2018: 5.6; 2019–2022: 5.0 (each year) - Effective interest rate (in percent): 2015: 7.5; 2016: 7.1; 2017: 7.2; 2018: 7.3; 2019: 7.9; 2020: 8.1; 2021: 8.4; 2022: 8.6; 8.7 (last listed) - Change in gross public sector debt (cumulative to 2022): -13.7 (in percent of GDP) - Identified debt-creating flows (cumulative to 2022): -18.8 (in percent of GDP) - Primary deficit (cumulative to 2022): -9.2 (in percent of GDP) - Primary (noninterest) revenue and grants: 2015: 13.2; 2016: 13.3; 2017: 14.3; 2018: 14.5; 2019: 15.4; 2020: 16.5; 2021: 16.7; 2022: 16.9; 6.9 (appears in table) - Primary (noninterest) expenditure: 2015: 14.8; 2016: 15.5; 2017: 14.6; 2018: 14.5; 2019: 14.4; 2020: 14.5; 2021: 14.6; 2022: 14.7; 8.7 (appears in table) - Exchange rate depreciation contribution (selected years): 2015: 1.0; 2016: 3.2; 2017: 1.5 (in percent of GDP in contribution table) - Residual, including asset changes (cumulative to 2022): 5.1 (in percent of GDP) ### DSA alternative scenarios and stress tests (selected outcomes) - Real depreciation shock: One-time real depreciation of 30 percent occurs in 2017; under this shock, external debt to GDP ratio rises to about 73 percent by 2022. - Combined shock and other stress tests are reported; charts show gross nominal public debt and public gross financing needs under: - Baseline - Primary Balance Shock - Real GDP Growth Shock - Real Interest Rate Shock - Real Exchange Rate Shock - Combined Macro-Fiscal Shock - Contingent Liability Shock - Stress-test indicators (visual summaries in the source): - Gross nominal public debt paths under shocks reach higher percent-of-GDP levels through 2022 (charts depict ranges up to and above 90+ percent in adverse scenarios). - Public gross financing needs increase under several stress scenarios (charts show increases up to the mid-20s percent of GDP in extreme cases). ### External debt sustainability and bound tests - Baseline external debt (in percent of GDP): 2012: 54.2; 2013: 53.6; 2014: 54.2; 2015: 56.4; 2016: 57.1; 2017: 56.8; 2018: 55.7; 2019: 54.7; 2020: 53.0; 2021: 51.2; 2022: 50.1 - Change in external debt (selected years): 2015: 2.1; 2016: 0.8; 2017: -0.4; 2018: -1.1; 2019: -1.0; 2020: -1.7; 2021: -1.8; 2022: -1.1 (in percent of GDP) - Identified external debt-creating flows (4+8+9) (selected): 2015: 1.3; 2016: 0.7; 2017: -1.2; 2018: -1.6; 2019: -1.8; 2020: -1.9; 2021: -1.7; 2022: -1.7 (in percent of GDP) - Current account deficit, excluding interest payments (selected): 2015: 0.8; 2016: 0.8; 2017: 0.8; 2018: 0.5; 2019: 0.3; 2020: 0.2; 2021: 0.3; 2022: 0.4 (in percent of GDP) - Exports (in percent of GDP): 2015: 21.7; 2016: 22.5; 2017: 23.0; 2018: 22.7; 2019: 22.3; 2020: 21.8; 2021: 21.2 - Imports (in percent of GDP) (selected): 2015: 29.4; 2016: 30.1; 2017: 29.9; 2018: 29.2; 2019: 28.3; 2020: 27.5; 2021: 26.5 - External debt-to-exports ratio (in percent): 2015: 263.5; 2016: 252.5; 2017: 241.9; 2018: 240.6; 2019: 237.1; 2020: 234.5; 2021: 236.9 - Gross external financing need (in billions of US dollars): 2015: 11.8; 2016: 11.1; 2017: 10.6; 2018: 10.7; 2019: 12.8; 2020: 13.0; 2021: 13.5; 2022: 14.4 - Gross external financing need (in percent of GDP): 2015: 14.8; 2016: 13.7; 2017: 10.6 (selected values shown) ### External sector assessment — reserves, exchange rate, and policy priorities (Annex II) - External position is weaker than implied by fundamentals and desirable policy settings; the current account gap points to a moderate overvaluation of the real effective exchange rate (REER). - Reserve coverage has deteriorated owing to capital outflows and heavy intervention in the foreign exchange market. - Immediate priorities: rebuild reserves and rebalance macroeconomic policies. - Longer-term priorities: address structural competitiveness issues that hold back export expansion and capital inflows, particularly high quality FDI. Key facts on reserve dynamics and FX intervention (2016 context) - The current account deficit was contained at 2.4 percent of GDP, the same as in 2015, as strong tourism revenue and remittances offset the large trade deficit of 11 percent of GDP. - After having fallen by US$900 million in 2015, gross international reserves (GIR) further declined by US$1.3 billion in 2016. - GIR at end-2016 stood at around 3 months of imports, and 56 percent of the ARA metric. - This level of GIR covers only about 80 percent of foreign exchange claims falling due in 2017, leaving Sri Lanka heavily reliant on rolling over its FX swaps and other external liabilities to meet its foreign claims. - The program-defined NIR stood at US$2.0 billion—covering about one month of import—after having declined by more than US$800 million during 2016. - The CBSL intervened heavily in the FX market: - First wave of capital outflow over US$500 million occurred between January and April 2016; net sales of FX in the spot market reduced gross reserves by US$1.2 billion while the rupee depreciated by only 0.12 percent during this period. - Between May-September, capital outflows reversed with inflows to government securities of US$ 613 million, and the CBSL accumulated quite some reserves. - Market pressures resumed in mid-October; the CBSL supplied around $170 million to the foreign exchange market in October and November. - A sizable FX purchase in December was not enough to make up for earlier losses. The program’s end-December NIR target was missed by a substantial margin. *Source: IMF staff (as presented in the provided content).* ### 3. Over time, a notable relationship between the real effective exchange rate and reserve ### 3. Over time, a notable relationship between the real effective exchange rate and reserve accumulation has emerged ### Relationship between REER and reserve accumulation - The tendency to defend the nominal exchange rate has led to a steady appreciation of the real effective exchange rate (REER) accompanied by low reserve accumulation. - High frequency data confirm that periods of REER appreciation have tended to coincide with reserve losses. - The trend decline in reserves over the last 2½ years indicates that the strategy to prevent depreciation by intervention cannot be sustained without the risk of a sudden and more disruptive nominal exchange rate adjustment later. - As the country becomes more integrated with global capital markets, external buffers will be scrutinized; rollover risks will rise significantly over the medium term as large sovereign bond repayments begin to fall due. - Foreign participation in government securities is limited—at around 5 percent of outstanding Tbills and Tbonds. ### Competitiveness and external balance - REER appreciation has deepened competitiveness challenges, manifesting through a high trade deficit and declining capital flows. - The non-oil trade deficit has worsened in the last two years, now standing at 7.2 percent of GDP. - This is close to the level seen in 2011 when the current account deficit was more than 7.1 percent of GDP. - The current account deficit has steadily improved since 2011, driven primarily by lower oil prices and higher service exports, but the non-oil trade deficit deterioration is driven by a steady decline in goods exports and higher non-oil goods imports over the last two years. - Over the last five years, capital inflows have rapidly shrunk amid declining investor confidence. - These developments suggest recent current account adjustments have been caused by declining competitiveness and tightening FX liquidity constraints. ### External balances assessment and exchange rate misalignment - The External Balances Assessment (EBA) current account model predicts a cyclically adjusted current account norm of -1.0 percent of GDP, against the 2016 outturn of -2.4 percent. - Cyclically adjusted CA outturn-2.4% - Cyclically adjusted CA norm-1.0% - CA gap- 1.4% - Estimation using the EBA’s CA methodology concludes Sri Lanka’s CA gap is -1.4 percent weaker than implied by fundamentals and desired policies, consistent with an exchange rate overvaluation of around 8 percent. - The large positive residual of the model suggests missing fundamentals or policy distortions not captured by the model, including remittances, tourism revenue, and FX liquidity constraints. - Using the EBA Lite equilibrium REER model, Sri Lanka’s REER overvaluation is estimated at around 18 percent. - The correlation coefficient of tourism receipts and the current account in Sri Lanka is high at 0.66. - The EBA Lite model’s positive residual suggests limited exchange rate flexibility contributes to the REER overvaluation. - Policy gap and components (as presented): - Policy gap1.1% - Fiscal0.1% - Change in reserves/GDP-0.3% - Private credit/GDP0.1% - Health expenditure0.7% - Capital control0.5% - Residual-2.6% ### Structural factors and FDI - Despite geographic advantages, FDI averages only around 1 percent of GDP. - Current FDI has been concentrated in construction, utilities, and service sectors, which are largely non-tradable and create few opportunities for technology transfer, import replacement, or export expansion. - Several studies indicate FDI into the tradable sector has positive effects on export performance; conversely, dominance of FDI in non-tradable sectors tends to be associated with larger current account deficits. - Sri Lanka is ranked 110th out of 190 countries in the World Bank’s 2017 Doing Business report. - The country performs relatively poorly on enforcement of contracts, paying taxes, and registering property. - Labor market rigidities: Sri Lanka has the second highest severance pay in the world for workers with more than 10 years of tenure, creating a bias against young workers and protection for possibly less productive workers, particularly in small and medium firms. ### Short-term priorities and policy recommendations - Immediate priority: rebuild reserves and rebalance macroeconomic policies to strengthen external sustainability. - Fiscal savings envisaged under the EFF can contribute to reducing external imbalances. - A strengthened monetary framework will help stem capital outflows while containing inflation. - Longer-term policies must address structural competitiveness issues that hold back export expansion and capital inflows, particularly high quality FDI. ### Macroeconomic outlook and fiscal program actions (from MEFP) - Growth is projected to recover from 4.4 percent in 2016 to around 5 percent in 2017. - Credit growth will likely slow in coming months in a lagged response to monetary tightening in 2016 and recent tightening in 2017. - The current account deficit is expected to improve in 2017, but could be adversely affected by severe weather events which will increase oil and food imports. - Headline inflation is projected to temporarily rise above the midpoint of the program’s inflation consultation band, but is expected to stay within the inner band. - Since July 2016, fiscal policy has been largely on track, but reserve accumulation and some structural measures have been delayed. - The end-December quantitative targets were met for the primary balance and tax revenues. - The NIR target was missed by $411 million. - The reserve money target was breached by Rs 46 billion. - Fiscal consolidation achievements and targets: - The government reduced the overall fiscal deficit to 5.4 percent of GDP in 2016, from a deficit of 7 percent in 2015. - For 2017, the budget targets a primary surplus of Rs 55 billion (0.4 percent of GDP), supported by revenue measures equivalent to Rs 140 billion (1 percent of GDP). - Target to bring the overall central government deficit down to at least 3.5 percent of GDP by 2020, which should lower the central government debt to about 70 percent of GDP. - Aim to increase the tax to GDP ratio by about 1 percentage point of GDP annually in 2017−18. - Debt management and asset commercialization: - Developing a medium-term debt management framework and strengthening technical capacity. - Legislative reforms toward active liability management are underway to smooth amortization requirements. - Proceeds from commercializing public assets, if any, will be earmarked for debt services over the medium term, including for maturing international sovereign bonds starting in 2019. - Revenue mobilization and tax reforms: - Cabinet suspended the Board of Investment Act in May 2016, concentrating exemption powers in the Ministry of Finance. - The VAT amendment enacted in November 2016 raised the VAT rate from 11 percent to 15 percent and broadened the VAT net by eliminating exemptions for telecommunication and private healthcare (excluding diagnostic tests, dialysis and services provided by the Outpatient Department (OPD)), while VAT continues to apply to wholesale and retail trade. - The 2017 budget includes measures to broaden the tax base, transforming corporate tax exemptions to investment-based ones and eliminating exemptions for financial income tax. - The government is redrafting the Inland Revenue Act (IRA) to widen the tax net through elimination of tax exemptions and to modernize the legal framework. - Commitments and structural benchmarks: - Submit the new IRA consistent with IMF staff recommendations to increase tax revenue by broadening the base through removing exemptions, modernize the legal framework, promote the business climate, and improve compliance by strengthening administrative powers of the Inland Revenue Department (IRD). - Complete a diagnostic review of the VAT system by June 2017 (structural benchmark), and implement amendments to simplify and strengthen the VAT system. - Annual budgets began to include a catalogue of tax expenditures; Cabinet did not yet adopt a time bound strategy to reduce or eliminate these tax expenditures as agreed with IMF staff (structural benchmark). The government will include a plan to rationalize tax expenditures and a tax expenditure statement in the annual budgets for 2018 and 2019 (modified structural benchmark). *Source: cr17253 - 3. Over time, a notable relationship between the real effective exchange rate and reserve accumulation* ### 10. Improvements to tax administration complement tax policy reforms. Changes to tax ### 10. Improvements to tax administration complement tax policy reforms. Changes to tax ### Tax administration reforms and implementation status - Tax policy changes will be ineffective without strengthened revenue administration capacity. - IRD efforts underway include automation and use of information technologies. - End-December structural benchmarks for tax administration were met: - For VAT administration: IRD adopted a VAT compliance strategy that includes a time-bound plan to implement risk-based audits and KPIs to measure their effectiveness. - IRD fully rolled out the RAMIS IT system. - Income tax administration: - A concrete plan is critical to ensure the new IRA is implemented timely and effectively, including training of tax officers. - Implementation steps initiated: establishing a steering committee and its terms of reference; creating project teams at the IRD; initiating stakeholder consultation and communication via publication of detailed tax manuals. - A public outreach campaign is planned to educate and sensitize taxpayers to the new framework. - IRD will adopt compliance strategies for corporate and personal income taxes (structural benchmark), following successful implementation of the new IRA. - Broader organizational and business procedure reforms at IRD: - Restructuring along functional lines. - Creating a design and monitoring unit. - Making management structure more efficient to speed up interaction with taxpayers. - Strengthening the Large Taxpayer Unit. - Introducing mandatory e-filing. - Enhancing the use of taxpayer identification numbers. - Customs administration IT improvements: - ASYCUDA system improved, with case selection for risk-based cargo audit now automated. ### Public financial management (PFM) measures - A disciplined approach to government spending and prioritization of public investment complements revenue-based fiscal consolidation. - Welfare and social protection: - Welfare Benefits Board established to rationalize social assistance schemes through a consolidated national database for social assistance beneficiaries. - Cash support will be provided to drought-affected families within the overall budget envelope. - Procurement, public investment, and debt management: - With assistance from the World Bank and other development partners, procurement processes will be upgraded. - A national policy statement for public investment management will be produced. - Capacity in debt management will be strengthened. - Fiscal management and transparency enhancements: - A commitment recording system has been established via modification of existing IT system (CIGAS) and manual reporting from line ministries to track spending commitments monthly. - Plan to put in place an IT-based commitment control system by mid-2017 with commitment ceilings for line ministries for the rest of the year. - Commitment control system to be implemented from the beginning of 2018 using the ITMIS system (new structural benchmark). - ITMIS rollout and phases: - Phase I (budget planning module) rolled out to all ministries in December 2016, including Ministries of Finance and Health (structural benchmark). Module includes a system of commitment controls to implement a formal commitment record system and quarterly expenditure ceilings; being operated in parallel to existing system with plans to operationalize beginning in 2018. - Phases II and III rolled out to the Ministries of Finance and Health with full rollout of these modules expected next year as internal capacity is developed. - Transparency commitments: - MOF will begin publishing quarterly financial bulletins summarizing government fiscal operations. - Annual budgets will explicitly cost out tax expenditures. - Adherence to Government Finance Statistics Manual (GFSM) standards. - Budgets will include analysis of fiscal risks, including those related to SOEs and PPPs. ### State-owned enterprises (SOEs): liabilities, oversight, and reform strategy - Sri Lanka has about 200 public enterprises. - With IMF technical assistance, outstanding obligations of central government and SOEs totaled Rs 1.36 trillion in end-2015: - Outstanding obligations of the central government totaling Rs 58 billion, which were settled during 2016. - Outstanding obligations of 4 SOEs (CPC, CEB, Sri Lankan Airlines, and the Sri Lanka Port Authority) totaling Rs 1.2 trillion. - Strategy elements: - Statements of Corporate Intent (SCIs) were signed in March 2017 and published in April 2017 for the five largest SOEs (CPC, CEB, National Water Supply and Drainage Board, Airport and Aviation Services Limited, and Sri Lanka Ports Authority). SCIs include mission, high level objectives, multiyear corporate plan, capital expenditure and financing plans, explicit financial and non-financial targets, and description and cost of non-commercial obligations (NCOs). - Plan to publish NCOs in the annual budget for 2018 and 2019 (modified structural benchmark). - Work to strengthen legal framework for governance and oversight of SOEs, including coherent financial regulations on governance, accountability, and funds management. - Sri Lankan Airlines: - Resolution strategy implemented (originally approved by Cabinet in 2015); route and fleet optimization have reduced operational losses. - Next steps: secure a strategic partner, resolve capital injection and debt consolidation to remove company from government accounts. - Financial performance to be reported quarterly (see TMU). Due to restructuring, the airline did not participate in SCI publication. - Aim to put airline on a commercial footing and resolve fiscal contributions, if any, to liabilities; this milestone can be a structural benchmark for future program reviews. - Automatic fuel and electricity pricing mechanisms: - Structural benchmark for establishing automatic pricing mechanisms has not been met. - Sequence to get reform back on track: - Complete a report outlining the cost of non-commercial obligations for fuel and electricity by September 2017 (new structural benchmark), supported by IMF TA. - For electricity costs: CEB and the Public Utility Commission will establish a Bulk Supply Transactions Account and start using it to settle transactions as specified in November 2015 tariff methodology by March 2018 (new structural benchmark). - Once NCOs for fuel and electricity are known, explicitly account for them in program targets beginning in the third review. - Obtain cabinet approval of the automatic pricing mechanism for fuel by March 2018 and for electricity by September 2018 (modified structural benchmarks). - To monitor progress, financial performance of the CPC and the CEB will be reported quarterly (see TMU). - Intend to introduce cost-reflective water tariff settings when the PUC starts regulating the water sector. ### Monetary and exchange rate policy - Monetary policy objective: - Focus on keeping inflation in the mid-single digits. - Policy actions and outcomes: - Throughout 2016, CBSL tightened monetary policy by raising the statutory reserve ratio in January 2016 and raising policy rates by 50 bps each in February 2016 and again in July 2016. - Credit growth remained robust at 20.4 percent y-o-y in March 2017. - Inflation picked up in early 2017 due to VAT amendments in November and impact of drought. - CBSL raised policy rates by 25 bps in March 2017 and stands ready to further tighten monetary policy in 2017 as warranted. - Monetary policy will be monitored through a monetary policy consultation clause (see TMU), supported by monitoring of reserve money developments. - Flexible inflation targeting (IT) roadmap: - Roadmap for flexible inflation targeting to be completed by October 2017 to establish inflation as the nominal anchor, moving away from using the exchange rate as the de-facto anchor. - CBSL will develop a macro forecasting model with IMF TA and take steps including establishing price stability as the primary objective and publicly communicating inflation targets. - CBSL intends to retain a role for smoothing excessive exchange rate volatility while guarding against conflicts of objectives; FX intervention policies will be consistent with a flexible exchange rate regime. - CBSL will develop a road map and identify time-bound reform measures as described in Table 2 (new structural benchmark), guided by IMF TA in May 2017. Time-bound measures to be incorporated into future program reviews. - Objectives to establish: (i) legal framework including central bank independence from fiscal or political pressures conflicting with an inflation objective; (ii) a sound financial system reducing conflict between monetary and financial stability objectives; (iii) well developed technical infrastructure including improved forecasting and modeling capabilities; (iv) a policy decision making process governed by guidelines on choice of targets and response to unanticipated shocks. - Exchange rate policy stance: - CBSL will continue a market-oriented approach to exchange rate policy and intends to durably transition to a more flexible exchange rate regime. - Aims: (i) deeper and more liquid FX market; (ii) adequate systems to review and manage exchange rate risks; (iii) a transparent intervention policy consistent with an inflation targeting regime. - Since late February, CBSL has intervened in the FX market only to build up reserves or to stem excessive movements and will continue to do so. - Reserve coverage and corrective actions: - Gross official reserves (GIR) close to 3 months of imports by end-April 2017. - Net outright FX purchase of $442 million made in March and April (corrective action for missing the NIR target for end-2016), with significantly limited FX sales during that period and monetary tightening. - Program NIR recovered to $2.3 billion by end-April (per TMU definition). - Between January to end-May 2017, the exchange rate depreciated by around 1.8 percent against the US$. - Commitments: continue corrective actions to fully offset the end-December NIR shortfall within 2017 while allowing greater exchange rate flexibility. - Commit to monthly consultation with IMF on corrective actions in foreign exchange intervention if significant deviations from agreed benchmarks. - If supply-demand gap results in highly disruptive exchange rate movements, consult with Fund staff on policy response. - Plan to gradually wind down FX swaps with domestic commercial banks to around US dollars 2.0 billion by end December 2017, and further reduce swap liabilities gradually during 2018. - External transaction and exchange guarantee commitments: - During the program, will not impose or intensify restrictions on payments and transfers for current international transactions; introduce or modify multiple currency practices; conclude bilateral payments agreements inconsistent with Article VIII; or impose or intensify import restrictions for balance of payments reasons. - CBSL and the government will abstain from providing exchange guarantees for foreign currency borrowing. ### Financial sector policies - Planned measures to strengthen the financial system: - Deploy, as needed, macro-prudential tools such as a sector-specific limit on the loan-to-value ratio including in the construction and real estate sectors. - Implement the Basel III capital standard and assess its impact on capital positions of state owned banks. - Improve financial sector risk management for greater exchange rate flexibility. - Develop a resolution mechanism for distressed non-bank financial companies (in coordination with IMF TA in April 2017). - Financial soundness and risks: - Financial soundness indicators remain adequate for the banking system as a whole, but the capital adequacy ratio (CAR) has been declining as robust credit growth increased risk-weighted assets. - Central bank autonomy and governance: - Stand ready to further strengthen CBSL’s autonomy and governance arrangement. - IMF safeguards assessment completed in August 2016 identified issues: government voting representation in the Monetary Board, absence of recapitalization provisions, and inadequate limits on credit to government. - These issues will be addressed as the legal framework for the central bank is amended. - IMF Legal department participated in IMF TA on inflation targeting in May; next steps with dedicated TA planned later in 2017. ### Policies to strengthen trade and investment - Objectives: - Greater integration into regional and global supply chains. - Higher levels of FDI and enhanced private sector investment prospects. - Institutional steps: - Establishment of an Agency for Development (to prioritize infrastructure development). - Establishment of an Agency for International Trade (responsible for trade promotion and negotiation of trade and investment agreements). - Lifting of EU ban on fishery imports and reinstatement of GSP plus trade status with EU in May 2017. - Competitiveness and trade facilitation: - Review of trade regime including evaluation of para-tariffs and other nontariff barriers causing high effective protection and hampering exports. - Work with the World Bank to strengthen structural competitiveness. - Aim to increase efficiency of trade facilitation, remove barriers to foreign investment entry and establishment (including access to land), enhance access to finance, and strengthen financial market infrastructure to attract FDI and complement public investment. ### Risks and contingencies - Main program risks identified: - (i) Acceleration of capital outflows reflecting further strengthening of the US dollar and higher rates leading to further decline in already low reserves. - (ii) Weaker than projected revenues. - (iii) Weaker than expected capital inflows, widening the projected financing gap given gross fiscal financing needs of about 19 percent of GDP in 2017. - (iv) Lower than expected growth or new pressures on the trade account. - (v) Weaker than expected performance of state owned enterprises. - Potential impacts: - These risks could further challenge public debt and external sustainability. - Contingency stance: - Should risks materialize, the government stands ready to adjust promptly its policies, in close consultation with the IMF staff, to ensure the achievement of a sustainable external position at the end of the program. *International Monetary Fund — content unit from cr17253* ### 24. Our program will be subject to semiannual reviews with performance criteria and ### cr17253 - 24. Our program will be subject to semiannual reviews with performance criteria and ### Program reviews and timing - The program will be subject to semiannual reviews with performance criteria and indicative targets set out in Table 1 attached to the MEFP and TMU. - Completion of the third and fourth reviews will require observance of the quantitative performance criteria for end-June 2017 and end-December 2017, respectively, as well as continuous performance criteria and assessment of progress on structural benchmarks in Table 2. - The third and fourth reviews of the program will take place on or after November 20, 2017 and April 20, 2018, respectively. ### Quantitative performance criteria and indicative targets (overview from Table 1) - The TMU lists the following quantitative performance criteria and indicative targets: - a quantitative performance criterion on central government primary balance (floor); - a quantitative performance criterion on net official international reserves (floor); - a continuous quantitative performance criterion on new external payment arrears by the nonfinancial public sector and the CBSL (ceiling); - a monetary policy consultation clause (inflation bands); - an indicative target on central government tax revenue (floor); - an indicative target on reserve money of the CBSL (ceiling). - Selected numerical targets and indicators (as presented in Table 1): - Central government primary balance (floor, in billion rupees): -85; -85; -35; -97; -97; -29; -5; -5; 9; -8; -4; -3. - Net official international reserves (CBSL's conventional definition, floor, in million US$): 330; 675; 243. - Program net official international reserves (Program NIR, floor, in million US$): 262; -267; -678; 1,161; 56; -113; 2,027; 1,976; 2,236. - Continuous performance criterion — New external payment arrears by the nonfinancial public sector and the CBSL (ceiling, in million US$): 0; 0; 7; 0; 0; 7; 0; 0; 13; 0; 0; 0. - Monetary policy consultation clause — Year-on-year inflation in Colombo Consumers Price Index (in percent): - Outer band (upper limit): 7.5; 7.5; 7.9; 7.9; 8.2; 8.2; 7.9; 8.8; 8.5. - Inner band (upper limit): 6.0; 6.0; 6.4; 6.4; 6.7; 6.7; 6.4; 7.3; 7.0. - Actual / Center point: 4.5; 4.5; 4.5; 4.9; 4.9; 4.2; 5.2; 5.2; 6.5; 4.9; 5.8; 5.5. - Inner band (lower limit): 3.0; 3.0; 3.4; 3.4; 3.7; 3.7; 3.4; 4.3; 4.0. - Outer band (lower limit): 1.5; 1.5; 1.9; 1.9; 2.2; 2.2; 1.9; 2.8; 2.5. - Indicative targets: - Central government tax revenue (floor, in billion rupees): 1,021; 1,021; 1,067; 1,428; 1,428; 1,464; 383; 383; 415; 803; 1,232; 1,718. - Reserve money of the CBSL (ceiling, end of period stock, in billion rupees): 794; 794; 794; 810; 810; 856; 851; 851; 892; 905; 935; 967. - Selected memorandum items (as presented in Table 1): - Foreign program financing by the central government (in million US$): 200; 325; 185; 0; 125; 125; 225. - External commercial loans by the central government (in million US$): 2,000; 2,186; 2,186; 2,186; 1,500; 0; 1,950; 1,950; 2,200. - Proceeds from commercialization of public assets (in million US$): 0; 200; 200. - The cumulative net change in the amount of SLDBs and foreign holdings of Treasury Bills, Treasury Bonds assumed under the program (in million US$): -1,124...-621. - Net borrowings from SLDBs (in million US$): -669; -1,056; 0; 408. - Net borrowings from SLDBs and FCBUs (in million US$): 627; 627; 627. - Amortization of official external debt by the central government (in million US$): 713; 858; 1,015; 1,017; 352; 365; 529; 889; 1,065. - CBSL's outstanding liabilities in FX swaps with domestic commercial banks (in million US$): 2,466; 2,497; 2,339. - Net official international reserves (CBSL's conventional definition, end of period stock, in million US$, market exchange rate): 5,359; 5,272; 5,490; 4,529; 6,446; 4,353; 6,168; 6,023; 6,161. - Notes and adjustors specified in Table 1: - 1/ Indicative target. 7/ See the TMU for how to measure year-on-year inflation. Note June 2017 onwards the MPCC and inflation is based on the new index (2013=100). - 6/ Arrears arising due to Iranian payment issue. - 5/ If the amount of amortization of official external debt by the central government in U.S. dollar terms is higher/lower than assumed under the program, the floor on the Program NIR will be adjusted downward/upward by the cumulative differences on the test date. - 3/ If (i) the amount of foreign program financing by the central government, (ii) the amount of external commercial loans (including Eurobonds and syndicated loans) by the central government, and (iii) proceeds from commercialization of public assets is higher/lower in U.S. dollar terms than assumed under the program, the floor on the Program NIR will be adjusted upward/downward by the cumulative differences on the test date. - 4/ Rules for adjustments related to SLDBs and foreign holdings of government paper differ by test date as described in the TMU. - 2/ Under the CBSL's conventional definition of net official international reserves (NIR), outstanding liabilities in foreign exchange swaps with domestic commercial banks are not part of the CBSL's foreign liabilities. The Program NIR is measured as the difference between the CBSL's conventional definition of NIR and outstanding liabilities in foreign exchange swaps with domestic commercial banks. ### Structural benchmarks and proposed prior actions (summary from Table 2) - Proposed prior action: - Submit to Parliament a new Inland Revenue Act, complete with schedules for investment incentives and exemptions, with a view to simplifying and broadening the income tax in line with staff recommendations. - New structural benchmarks (selected): - MOF to implement an IT-based commitment control system with commitment ceilings for line ministries for the 2018 budget. Target Completion Date: January 2018. Comment: The ITMIS modules for budget planning and commitment control will be operational for the 2018 budget enabling transition to commitment-based control. - MOF to complete a report outlining the cost of non-commercial obligations for fuel and electricity. Target Completion Date: September 2017. Comment: A step toward automatic fuel and electricity pricing reform. - CEB and the Public Utilities Commission (PUC) to establish a Bulk Supply Transactions Account and start using it as specified in the November 2015 tariff methodology. Target Completion Date: March 2018. - Develop a roadmap for flexible inflation targeting and flexible exchange rate regime identifying timebound reform measures during the program period. Target Completion Date: October 2017. Comment: IMF TA mission for designing the roadmap took place in May 2017. - Modified structural benchmark: - Submit to Parliament the 2018 budget that is in line with program targets and includes: (i) a tax expenditure statement, (ii) a plan to rationalize tax expenditures in 2018 as agreed with IMF staff, and (iii) the estimated fiscal cost of non-commercial obligations (including subsidies) for SOEs. Target Completion Date: November 2017. - Existing structural benchmarks (selected status notes): - Submit to Parliament the 2017 budget in line with the program targets. Target Completion Date: November 2016. Status: Met. Comment: The 2017 budget was submitted on November 10, 2016. - Publish a tax expenditure statement as part of the official government budget. Target Completion Date: December 2016. Status: Met. Comment: Published as part of the 2017 budget. - Approve by cabinet a time-bound strategy to reduce or eliminate tax expenditures. Target Completion Date: December 2016. Status: Not met. Comment: Partial steps taken; comprehensive multi-year plan not adopted. - Submit to Parliament a new Inland Revenue Act with a view to simplifying and broadening the income tax. Target Completion Date: March 2017. Status: Not met (implemented as a prior action). Comment: A complete draft prepared, submission is a prior action for the second review. - Complete by MOF a diagnostic review of the VAT system. Target Completion Date: June 2017. Status: In progress. Comment: IMF TA missions for VAT diagnostics took place during April–May 2017. - Public financial management and SOE reform benchmarks (selected): - MOF to roll out ITMIS with an automated commitment control module for Ministry of Finance and Ministry of Health. Target Completion Date: January 2017. Status: Met. Comment: System fully rolled out to all ministries; to be operated in parallel with existing IT system. - Cabinet to approve a resolution strategy for Sri Lankan Airlines. Target Completion Date: December 2016. Status: Met. Comment: Substantial reforms undertaken under a strategy approved June 2015. - Record the fiscal cost of non-commercial obligations (including subsidies) for SOEs in the central government budget, starting in 2017. Target Completion Date: November 2016. Status: Not met (implemented in effect for major SOEs). Comment: Statement of Corporate Intent (SCI) information published for 5 large SOEs in April 2017; publication built into 2018 and 2019 benchmarks. - MOF to introduce automatic fuel and electricity pricing mechanisms ensuring retail prices above cost-recovery levels and financial positions of CPC and CEB capable of covering debt service. Target Completion Dates: December 2016 (originally), reset to March 2018 and September 2018 for fuel and electricity respectively. Status: Not met. Comment: Implementation delayed to allow public consultation and education; target dates reset. ### TMU: monitoring framework and definitions (Attachment II) - Purpose: The TMU sets out the framework for monitoring Sri Lanka’s performance under the EFF-supported program, specifying performance criteria, indicative targets (including adjustors), monitoring procedures, and reporting requirements for semiannual reviews. - Central government definition: Includes line ministries, departments, and other public institutions. Excludes the CBSL, state-owned enterprises, parastatals and other agencies that do not receive subventions from the central government. - The TMU reiterates the quantitative criteria and indicative targets specified in Table 1 (see list under Quantitative performance criteria and indicative targets). - Adjustors and measurement conventions are specified (see Table 1 notes), including treatment of amortization of official external debt, foreign program financing, external commercial loans and proceeds from commercialization of public assets, and treatment of SLDBs and foreign holdings of Treasury paper for adjustments to Program NIR. - Measurement of NIR: Under the CBSL’s conventional definition of NIR, outstanding liabilities in foreign exchange swaps with domestic commercial banks are not part of the CBSL’s foreign liabilities. The Program NIR is measured as the difference between the CBSL’s conventional definition of NIR and outstanding liabilities in foreign exchange swaps with domestic commercial banks. See the TMU for details on adjustments and definitions. *Source: Attachment II (Technical Memorandum of Understanding), Table 1, and Table 2 of the MEFP as presented in the provided content unit.* ### 4. The primary balance of the central government on cash basis is defined as central ### 4. The primary balance of the central government on cash basis is defined as central ### Definition of the primary balance (cash basis) - The primary balance of the central government on cash basis is defined as central government revenues and grants minus expenditures and net lending, plus interest payments. - Spending is recorded in the period during which cash disbursements are made. ### Measurement for program monitoring - For the purpose of program monitoring, the primary balance of the central government on cash basis will be measured as the overall balance of the central government plus the interest payment of the central government. - The overall balance of the central government is measured from the financing side, as the negative of the sum of the items listed below (net borrowings = gross disbursements minus principal repayments). - 2015 outcome: - Primary balance of the central government on cash basis: Rs –241 billion (the overall balance was Rs –768 billion and the interest payment was Rs 527 billion). ### Financing components (items a–f) and 2015 amounts - a) Net borrowings from issuances of Treasury Bills, Treasury Bonds, and Rupee Loans. In 2015, the total amount of such net borrowings was Rs 257.6 billion. - Note: Rupee Loans are a medium to long-term debt instrument issued with maturities more than two years on tap basis or as private placements by the CBSL on behalf of the government under the Registered Stock and Securities Ordinance. - b) Net borrowings from Sri Lankan Development Bonds (SLDBs) and commercial borrowings including international sovereign bonds and syndicated loans. In 2015, the total amount was Rs 455.7 billion. - c) Net borrowings from project and program loans. In 2015, the total amount was Rs 69.7 billion, after adjustment for program loans that were contracted and disbursed during 2014 but were recorded in the 2015 fiscal account (Rs 61.6 billion). - d) Net increases in non-market borrowings, CBSL advances, government import bills, government overdraft from the banking system, cash items in process of collection, and borrowings from offshore banking units of domestic commercial banks. In 2015, the total amount was Rs –10.1 billion. - e) Net decreases in the deposit of the central government in the banking system. In 2015, the total amount was Rs –4.4 billion (an increase in deposit). - f) Net borrowings from all other bonds, loans, and advances contracted by the central government. In 2015, the total amount was Rs –0.5 billion (net repayment). ### Adjustment for project loans (2017) - If the actual amount of gross cash disbursement of project loans in 2017 is higher than Rs 230 billion, the floor on the primary balance of the central government for end-December 2017 will be adjusted downward by the difference between the actual amount and Rs 230 billion. - The downward adjustment of the primary balance target will be capped at Rs 20 billion. - If the actual amount of gross cash disbursement of project loans in 2017 is lower than Rs 230 billion, the floor on the primary balance of the central government for end-December 2017 will not be adjusted. ### Performance Criterion on Net Official International Reserves (NIR) — definitions and levels - For program monitoring, NIR will be measured as the difference between (a) and (b) below, called the “Program NIR.” - Program NIR evaluated at market exchange rates: - At end-2015: US$ 2,893.1 million. - At end-2016: US$ 2,032.1 million. - Targets for the Program NIR are set for cumulative flows from the end of the previous year. To calculate cumulative flows, the Program NIR at the test dates and the end of the previous year are evaluated at the program exchange rates and gold price specified in paragraph 9. - (a) CBSL’s conventional definition of the NIR: - (i) the difference between the gross foreign assets and liabilities of the CBSL and - (ii) the balance of State Treasury’s (DSTs) Special Dollar, Japanese Yen, and Chinese Yuan Revolving accounts, both expressed in terms of market values. - Gross foreign assets of the CBSL consist of monetary gold; foreign exchange balances held outside Sri Lanka; foreign securities (valued in market prices); foreign bills purchased and discounted; the reserve position at the IMF and SDR holdings; and the Crown Agent’s credit balance. - Foreign exchange balances, securities, and bills denominated in Chinese Yuan are part of gross foreign assets. - Exclusions from gross foreign assets include participation in international financial institutions; holdings of nonconvertible currencies; holdings of precious metals other than monetary gold; claims on residents; pledged, non-liquid, collateralized or otherwise encumbered foreign assets; and claims in foreign exchange arising from derivative transactions. - Gross foreign liabilities are all foreign currency denominated liabilities of the CBSL to non-residents (including currency swap arrangements with foreign central banks); the use of Fund credit; and Asian Clearing Union debit balance. - DST accounts are foreign currency accounts held by the Treasury and managed by the CBSL as an agent of the government. - NIR as per the CBSL’s conventional definition, evaluated at market exchange rates: - At end-December 2015: US$ 5,028.8 million. - At end-December 2016: US$ 4,529.0 million. - (b) CBSL’s outstanding liabilities (net short positions) in foreign exchange swaps with domestic commercial banks: - At end-December 2015: US$ 2,135.7 million. - At end-December 2016: $2,496.9 million. ### Framework to wind down FX swap liabilities - The framework will include discontinuing the provision of FX swaps on concessional terms and gradually reducing outstanding net short positions of FX swaps with commercial banks as described in the MEFP. ### Valuation for program purposes (paragraph 9) - All foreign-currency related assets and liabilities will be converted into U.S. dollar terms at the exchange rates prevailed on January 2, 2017 (January 3, 2017 for SDR). - Monetary gold will be valued at US$1,151.84 per troy ounce (price prevailed on January 2, 2017). ### Adjustors to the Program NIR floor (paragraphs 10–11) - Adjustor 1 (paragraph 10): - If (i) foreign program financing by the central government, (ii) net borrowings from SLDBs and FCBUs by the central government, (iii) external commercial loans (including international sovereign bonds and syndicated loans) by the central government, and (iv) proceeds from commercialization of public assets—as set out in Table 2—are higher/lower in U.S. dollar terms than assumed under the program, the floor on the program NIR will be adjusted upward/downward by the cumulative differences on the test date. - Proceeds from commercialization of public assets are defined as cash receipts from the sale or lease of publicly held assets to non-residents (including publicly held land, public holdings of infrastructure or commercial real estate, and public or quasi-public enterprises). - These adjustors apply to the NIR floor for end-June 2017 and thereafter. - Adjustor 2 (paragraph 11): - If the amount of amortization of official external debt by the central government in U.S. dollar terms—as set out in Table 2—is higher/lower than assumed under the program, the floor on the program NIR will be adjusted downward/upward by the cumulative differences on the test date. - Official external debt refers to external debt owed to multilateral and official bilateral creditors, as defined in the 2013 External Debt Statistics: Guide for Compilers and Users. - These adjustors apply to the NIR floor for end-June 2017 and thereafter. ### Exchange rates (Rates as of January 2, 2017; SDR as of January 3, 2017) - Sri Lankan Rupee per currency unit: - U.S. dollar 149.9747 - British pound 185.2338 - Japanese yen 1.2835 - Canadian dollar 111.7047 - Euro 157.7659 - Chinese yuan 21.5095 - SDR 1/200.49 - Source: CBSL and IMF. - 1/ As of January 3, 2017 ### Table 2: Program assumptions (cumulative from the beginning of the year, in million US$) - Test dates: Jun. 2017, Sep. 2017, Dec. 2017 - Foreign program financing by the central government: 125, 125, 225 - Net borrowings from SLDBs and FCBUs by the central government: 627, 627, 627 - External commercial loans (including Eurobonds and syndicated loans) by the central government: 1,950, 1,950, 2,200 - Proceeds from commercialization of public assets: 0, 200, 200 - Amortization of official external debt by the central government: 529, 889, 1,065 ### Continuous performance criteria - A continuous performance criterion applies to the non-accumulation of new external payments arrears on external debt contracted or guaranteed by the nonfinancial public sector and the CBSL. - Definition of nonfinancial public sector: follows the 2001 Government Finance Statistics Manual and the 1993 System of National Accounts; includes central government as defined in ¶3 and nonfinancial public enterprises (boards, enterprises, and agencies in which the government holds a controlling stake). - External payments arrears: debt-service obligations (principal and interest) to nonresidents that have not been paid at the time they are due, as specified in contractual agreements, subject to any applicable grace period. - Overdue debt and debt service obligations that are in dispute will not be considered as external payments arrears for program monitoring. ### Monetary policy consultation clause (inflation bands and measurement) - Inflation target bands around the projected 12-month rate of inflation in consumer prices are measured by the headline Colombo Consumers Price Index (CCPI) (new CCPI index 2013=100). - Year-on-year inflation for each test date is measured as: - { CCPI*(t) – CCPI*(t-12) } / CCPI*(t-12) - where t = the month within which the test date is included - CCPI(t) = CCPI index (all items) for month t - CCPI(t-k) = CCPI index (all items) as of k months before t - CCPI*(t) = { CCPI(t-2) + CCPI(t-1) + CCPI(t) } / 3 - CCPI*(t-12) = { CCPI(t-14) + CCPI(t-13) + CCPI(t-12) } / 3 - Consultation triggers: - If observed year-on-year inflation for end-June 2017 or end-December 2017 falls outside the outer bands specified in Table 1 attached to the MEFP, the authorities will complete a consultation with the IMF Executive Board focusing on: (i) the stance of monetary policy and whether the Fund-supported program remains on track; (ii) the reasons for the deviation; and (iii) proposed policy response. When this consultation is triggered, access to Fund resources would be interrupted until the consultation takes place and the relevant program review is completed. - If observed year-on-year inflation falls outside the inner bands specified in Table 1 attached to the MEFP for end-June 2017, end-September 2017, or end-December 2017, the authorities will complete a consultation with IMF staff on reasons for the deviation and proposed policy response. ### Indicative targets - Indicative target on central government tax revenue: - Central government tax revenue = revenues from taxes collected by the central government; excludes all revenues from asset sales, grants, and non tax revenues. - The revenue target is calculated as the cumulative flow from the beginning of the year. - For 2015, central government tax revenue defined in this manner was Rs. 1,356 billion. - Indicative target on reserve money of the CBSL: - Reserve money consists of currency in circulation (with banks and with the rest of the public), financial institutions’ domestic currency deposits at the CBSL, and the deposits of following government agencies: the National Defence Fund (General Ledger Acc. No. 4278), the Buddha Sasana Fund A/C (General Ledger Acc. No. 4279); and the Road Maintenance Trust Fund (General Ledger Acc. No. 4281). - At end-December 2015, reserve money defined in this manner stood at Rs. 673.4 billion. ### Adjustments to reserve money ceiling (compliance and reserve requirement changes) - If any bank fails to meet its legal reserve requirement, the ceiling on reserve money will be adjusted downward to the extent of any shortfall in compliance with the requirement. - Changes in required reserve regulations will modify the reserve money ceiling according to the formula: - ΔM = ΔB·r0 + B0·Δr + ΔB·Δr - where: - ΔM denotes the change in reserve money, - r0 denotes the reserve requirement ratio prior to any change; - B0 denotes the reservable base in the period prior to any change; - Δr is the change in the reserve requirement ratio; and - ΔB denotes the immediate change in the reservable base as a result of changes to its definition. ### Data reporting requirements - Sri Lanka shall provide the Fund, through reports at intervals or dates requested by the Fund, with such information as the Fund requests in connection with the progress of Sri Lanka in achieving the objectives and policies set forth in the MEFP and Letters of Intent. - All program monitoring data will be provided by the Ministry of Finance and the CBSL. - Fiscal monitoring data formats: Tables 3 and 4. - Monetary targets monitoring format: Table 5. - External sector monitoring formats: Tables 6 and 7. - Financial performance of three state-owned enterprises (Ceylon Electricity Board, Ceylon Petroleum Corporation, SriLankan Airlines) formats: Tables 8, 9, and 10. - Reporting timetables: - Data relating to the fiscal targets (Table 3 and Table 4) will be furnished within no more than five weeks after the end of each month, except: - Data on salaries and wages, goods and services, subsidies and transfers (and its subcomponents) will be furnished within no more than seven weeks after the end of each month. - Data on total recurrent expenditure and interest payments will be furnished within no more than five weeks after the end of each month. - Data relating to the external and monetary targets (Tables 5, Table 6, and Table 7) will be furnished within no more than three weeks after the end of each month. - Data relating to the three state-owned enterprises (Tables 8–10) will be furnished within no more than 2 months after the end of each quarter. *Source: IMF staff report (text as provided).* ### 3. Net flow at current rates (1-2) ### 3. Net flow at current rates (1-2) ### Reserve and external sector developments - Current account deficit: US$708 million (0.8 percent of annual GDP) in 2017Q1 (compared to a surplus of US$35 million one year ago). - CBSL net FX purchases: additional net FX purchases of about US$280 million during May–June 2017. - Exchange rate movement: depreciated by about 1 percent against the US dollar during May–June 2017; depreciated by 3.8 per cent during 2016 and 2.5 per cent so far during 2017 up to July 10, 2017. - Gross official reserves: estimated at US$ 7 billion by end June 2017. - Reserve coverage: estimated to have increased to 4.1 months of imports as at end June 2017. - External financing contributions noted: - International Sovereign Bond issue: US$ 1.5 billion. - Syndicated loans: US$ 450 million. - Foreign exchange swaps with commercial banks: - Outstanding amount declined to US$ 1.9 billion by April 2017 from US$ 2.4 billion. - As agreed with staff, foreign exchange swaps with commercial banks have been excluded from the reserve assets in calculating the program NIR. ### Recent macroeconomic performance and outlook - GDP growth: - 2016: 4.4 per cent (slower than 4.8 per cent in the previous year and the average growth of 6.8 per cent during 2010-2014). - 2017Q1: 3.8 percent (year-on-year); agriculture contracted by 3.2 percent, industry grew by 6.3 percent, services grew by 3.4 percent. - 2017 outlook: envisaged at around 4.5 – 5.0 per cent. - 2018 outlook: expected to rebound to around 5.5 per cent. - Private sector credit growth: 20 percent in April 2017 (year-on-year). - Inflation: - Headline inflation: peaked at 7.3 percent in March 2017; declined to 6.1 percent (year-on-year) in June 2017. - Food inflation: persistently higher at about 9 percent during March–June 2017. - 3-month average inflation in June: 6.3 percent (remained within the inner band under the Monetary Policy Consultation Clause). - Fiscal outturn (January–April 2017): - Primary surplus: Rs 9 billion (compares with program floor of Rs -8 billion for the January–June period). - Tax revenues: increased by 26 percent (year-on-year). - Total revenue (first four months of 2017): increased by 24.6 percent; VAT led with a 90.9 percent increase. ### Monetary and exchange rate policy actions - Monetary tightening timeline and measures: - Cash margin requirements and maximum Loan to Value (LTV) Ratio on selected lending imposed towards Q4 2015 (later removed/revised). - Statutory Reserve Ratio (SRR) increased by 150 basis points with effect from January 2016. - Policy interest rates increased by 100 basis points in two steps (February and July 2016). - Policy interest rates raised by 25 basis points in March 2017. - LTV ratios revised in 2017 based on type of vehicle as proposed in the Budget 2017. - Effects and monitoring: - Policy rate increases resulted in significant increase in short term market interest rates and yields of government securities; lending rates adjusted upwards. - Signs of deceleration in credit growth after February 2017; authorities remain ready to tighten further if private sector credit growth remains high. - Monetary framework transition: - Move towards a flexible inflation targeting framework in the medium term. - Forecasting and Policy Analysis System (FPAS) built with IMF TA. - Number of Monetary Policy Committee (MPC) meetings reduced to 8 from 12 per year. - Remaining prerequisites include legal and governance reforms and public outreach, with TA from the Fund. - Exchange rate stance: - Authorities committed to a flexible exchange rate regime with limited intervention to prevent wide fluctuations and to build official reserves. - Full flexibility constrained by high reserve target under the program, which requires the Central Bank to purchase foreign exchange from the market. - A gradual correction in the overvaluation of the exchange rate is envisaged under the flexible inflation targeting regime. ### Financial sector developments - Banking sector: - Asset base of the banking system increased by 14.9 per cent in May 2017. - Non-performing loans (NPLs): 2.8 per cent by end May 2017. - Capital and liquidity levels maintained well above statutory minimum requirements. - From July 01, 2017, licensed commercial banks to adopt Basel III capital standards. - Licensed banks to meet increased Basel III minimum capital requirements on a staggered basis in line with international timeline for full implementation by January 01, 2019. - Central Bank envisages issuing guidelines on Basel III Leverage Ratio and Net Funding Ratio standards. - Amendments planned to the Banking Act to streamline and strengthen regulatory and supervisory framework. - Non-bank financial sector: - Improved asset growth, capital position, profitability and branch network expansion. - Enforcement unit established to address financially distressed finance companies. - Microfinance Act enacted in 2016 to regulate microfinance institutions. ### Fiscal policy reforms and SOE performance notes - Revenue and tax reforms: - VAT reforms introduced in 2016: tax rate increase from 11 per cent to 15 per cent and removal of a number of exemptions. - New Inland Revenue Act (IRA) drafted with TA from the Fund and submitted to Parliament on July 04, 2017; expected to transform the income tax system and introduce a new investor investment incentive scheme based on enhanced depreciation allowance linked to investment, employment generation and location. - Fiscal outcomes: - End December target of primary balance under the program was met comfortably. - Overall deficit declined significantly to 5.4 per cent of GDP in 2016. - Improvement underpinned by overperformance in revenue. - SOE financial outturns (tables referenced): - Ceylon Electricity Board: revenue, expenditure, operating profit/loss, liquidity position, and bank borrowings items are reported (values presented in tabular form in the source). - Ceylon Petroleum Corporation: total revenue by product and total expenditure items are reported (values presented in tabular form in the source). - Sri Lankan Airlines: total revenue (passenger, cargo, other income), total expenditure (aircraft fuel cost, employee cost, other operating expenses, financial cost), operating profit/loss, and capital contribution items are reported (values presented in tabular form in the source). - 1/ As agreed for the purpose of monitoring the program (applies to SOE tables). ### Program performance and administrative notes - Program performance: - Quantitative performance criteria (QPC) and indicative targets (IT) broadly on track despite challenging conditions. - QPC related to primary deficit met; inflation remained within target band in December 2016 and March 2017. - QPC related to net international reserves (NIR) was missed amid high capital outflows; corrective action agreed (outright foreign exchange purchase target for March and April 2017) and purchases were exceeded, resuming reserve buildup. - Accumulation of external arrears occurred due to non-availability of a payment platform to make payments to the Export Development Bank of Iran (EDBI); authorities were ready and willing to make payments. - Most Structural Benchmarks (SB) were implemented; missed SB targets are being brought back on track. - Prior action delay: submission of the new Inland Revenue Act (IRA) to Parliament was delayed; IRA subsequently submitted on July 04, 2017. - Disaster recovery: - Efforts continue to recover from severe floods in May 2017; development partners and emergency humanitarian funds provided support. - Rapid Impact and Needs Assessment to be conducted, supported by the United Nations and the World Bank. - Northern part of the country still recovering from the 2016 drought. - Prepared by Asia and Pacific Department July 11, 2017. *Source: cr17253 - 3. Net flow at current rates (1-2)* ### 12. The introduction of compliance strategies for VAT and corporate personal income ### 12. The introduction of compliance strategies for VAT and corporate personal income ### Tax administration reforms and IT systems - Introduction of compliance strategies for VAT and corporate personal income taxes (on-going). - Implementation of risk-based VAT audits. - Roll out of the Revenue Administration Management Information System (RAMIS) at the Inland Revenue Department (IRD) to automate the tax collection process. - IRD preparing to implement the new IRA with IMF support, including measures to improve public awareness of the new revisions to ensure smooth transition to the new income tax system. - Newly rolled out Integrated Treasury Management Information System (ITMIS) at the Ministry of Finance (MOF) will be operationalized beginning in 2018, automating key functions related to public financial management system in Sri Lanka. ### Natural disasters, economic impact, and climate policy - Two natural disasters, drought and floods, occurred in the first half of 2017, adversely impacting 2017 growth and having some impact on the government budget. - Additional expenditure required for reconstruction and rehabilitation activities, particularly for infrastructure and houses damaged due to the most recent floods and for assistance to people affected by severe drought in some parts of the country. - Authorities are seriously considering policies to better manage climate related adversities given increasing vulnerability to devastating natural disasters. ### State-Owned Enterprises (SOEs) and energy pricing - Measures to strengthen SOEs are progressing. - A resolution strategy introduced for Sri Lankan Airlines. - Statements of Corporate Intent (SCIs) were signed by five key SOEs in March 2017, creating a framework to monitor performance under specific KPIs. - Authorities committed to implementing the energy pricing formula in line with the new timeline indicated in the staff report, despite missing the original date of meeting the SB. ### Budget transparency and reporting - As per Budget 2017, quarterly progress reports on actual expenditure and revenue of the budget are required to be submitted to Parliament. - The quarterly expenditure and income outcome report for the first quarter of 2017 was presented to the Parliament on July 05, 2017. - The report includes: a summary report on actual expenditure, a detailed report of the actual expenditure and a report on the revenue. ### Strengthening trade and Foreign Direct Investment (FDI) - Authorities identify potential for Sri Lanka to become a trading and service hub in the South Asian region through enhanced trade and FDI. - Measures in the staff report are key priorities to improve growth potential and strengthen external sustainability. - To improve the investment climate, a Road Map to Improve Investment Climate in Sri Lanka was launched on July 05, 2017, in collaboration with the Australian Government and the World Bank Group. - The Road Map groups stakeholders under eight Task Forces (each covering one of eight areas under the Doing Business ranking). - It defines initial reforms, timeframes for accomplishment, and a mechanism to monitor progress and promptly identify and address bottlenecks. - Implementation is expected to eliminate unnecessary regulatory and procedural obstacles to enterprises and entrepreneurs. ### Technical assistance - Authorities highly value continued technical assistance (TA) from the Fund. - TA areas over the years: tax policy and tax administration, public financial management, monetary and exchange rate policy, macroeconomic modelling and forecasting, financial system stability and national accounts. - Authorities expect continued engagement to complement efforts towards strengthening macroeconomic stability. ### Conclusion and program status - The Sri Lankan economy showed signs of stabilization during 2016, continuing in 2017. - The EFF played an important role in achieving this progress, particularly in implementing reforms, strengthening macroeconomic stability, and bolstering investor confidence. - Despite the delay in completing the second review, authorities remain committed to successful completion of the EFF to achieve broader socio economic and social policy objectives. - Authorities commit to appropriate policy reforms to create external and fiscal buffers and a conducive environment for high and sustainable economic growth with international support and continued Fund staff engagement, complemented by continued technical assistance. - Authorities request the completion of the Second Review of the Extended Arrangement under the EFF. *Source: cr17253 - 12. The introduction of compliance strategies for VAT and corporate personal income — https://www.imf.org/-/media/files/publications/cr/2017/cr17253.pdf* --- _Source: https://www.imf.org/-/media/files/publications/cr/2017/cr17253.pdf_