## 1lkaea2022001

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### Key economic developments
- Real GDP growth: 3.6 percent in 2021.
- Tourism and mobility:
  - Mobility indicators largely back to their pre-pandemic levels by late 2021.
  - Tourist arrivals started to recover in late 2021.
- Fiscal outcomes and financing:
  - Annual fiscal deficits exceeded 10 percent of GDP in 2020 and 2021.
  - Causes: pre-pandemic tax cuts, weak revenue performance due to the pandemic, and pandemic-related expenditure measures.
  - Limited availability of external financing led to a large amount of central bank direct financing of the budget.
- Public debt and external position:
  - Public debt rose from 94 percent of GDP in 2019 to 119 percent of GDP in 2021.
  - Large FX debt service payments by the government and a wider current account deficit caused a significant FX shortage.
  - Official exchange rate effectively pegged to the U.S. dollar since April 2021.
- Inflation and monetary conditions:
  - Inflation accelerated to 14 percent (y/y) in January 2022 (measured by the Colombo Consumer Price Index).
  - Inflation projected to remain double-digit in the coming quarters, exceeding the target band of 4–6 percent.
- Reserves and external financing:
  - International reserves remain inadequate despite authorities’ efforts to secure FX financing from external sources.

### Outlook, scenarios, and risks
- Growth outlook:
  - GDP growth projected to be negatively affected by the FX shortage and macroeconomic imbalances through reduced economic activity and business confidence.
  - Illustrative staff projections: Real GDP growth: 2021: 3.6; 2022: 2.6; 2023: 2.7; 2024: 2.8; 2025: 2.8; 2026: 2.8.
- Inflation and monetary outlook:
  - Inflation (average, Colombo CPI): 2021: 6.0; 2022: 10.5; 2023: 7.0; 2024: 6.3; 2025: 5.8; 2026: 5.3.
  - Headline inflation breached the CBSL 4-6 percent target band and rose to 14.2 percent in January 2022.
  - Core inflation rose from 2.7 percent in January 2021 to 9.9 percent in January 2022.
- External and reserve outlook under illustrative optimistic scenario:
  - Even with fresh, still-unidentified BoP financing of US$2-3 billion each year, gross reserves would stay critically low at around 1 month of imports over 2022-26.
  - Staff projects FX debt service to reach around US$7 billion in 2022 and remain around US$7-8 billion over the medium-term.
  - Gross international reserves (million USD): 2021: 3,138; 2022: 2,204; 2023: 2,386; 2024: 2,416; 2025: 2,465; 2026: 2,532.
  - Gross international reserves (in months of imports of G&S): 2021: 1.5; 2022–2026: 1.0 each year.
- Downside risks (tilted to the downside):
  - Failure to meet fiscal and balance-of-payments financing needs could result in significant contractions in imports and private credit growth, or monetary instability if further central bank financing of fiscal deficits occurs.
  - Additional downside risks: COVID-19 resurgence, rising commodity prices, worse-than-expected agricultural production (including impacts of chemical fertilizer restriction), deterioration in banks’ asset quality, extreme weather events.
- Upside risks:
  - Faster-than-expected tourism recovery and stronger-than-projected FDI inflows.

### Fiscal position, consolidation plans, and staff assessment
- 2020–21 fiscal outcomes and public debt:
  - Fiscal deficits: 2020: -12.8 percent of GDP; 2021: -11.4 percent of GDP.
  - Primary balance (percent GDP): 2020: -6.2; 2021: -4.9.
  - Central government debt (percent GDP): 2019: 86.8; 2020: 101.2; 2021: 107.1.
  - Public debt (percent GDP): 2019: 93.6; 2020: 110.0; 2021: 118.9.
  - Staff views Sri Lanka’s public debt as unsustainable.
- 2022 Budget and risks to meeting targets:
  - 2022 Budget aims to reduce the primary deficit to 2.8 percent of GDP in 2022, a fiscal adjustment of about 2 percent of GDP from 2021.
  - Budgeted revenue measures could generate 1.6 percent of GDP but are largely one-off; January 2022 spending package equals 1.2 percent of GDP and increases permanent spending pressures.
  - Conclusion: meeting the 2022 primary balance target is at substantial risk without additional revenue measures or large capital spending cuts.
- Staff illustrative fiscal projections (percent of GDP):
  - Government revenues and grants: 2021: 8.9; 2022: 10.7; 2023: 10.8; 2024: 11.0; 2025: 11.1; 2026: 11.3.
  - Government expenditure and net lending: 2021: 20.3; 2022: 20.3; 2023: 20.3; 2024: 20.4; 2025: 20.5; 2026: 20.4.
  - Capital exp. and net lending: 2021: 3.5; 2022–2026: 2.5 each year.
  - Overall fiscal balance: 2021: -11.4; 2022: -9.6; 2023: -9.6; 2024: -9.4; 2025: -9.4; 2026: -9.1.
- Debt sustainability and stress tests:
  - Public debt projected to reach 125.3 percent of GDP in 2026 under baseline paths discussed across sections.
  - Debt stabilization probability (fan chart): 23 percent.
  - Near-term stress logit model flags stress probability close to 80 percent.
  - Staff judgment: debt is unsustainable; large fiscal and external financing gaps imply very high rollover risks.

### Policy recommendations (staff and Executive Board assessment)
- Fiscal policy:
  - Ambitious fiscal consolidation anchored on high-quality, permanent revenue measures.
  - Scope identified to raise income tax and VAT rates and minimize exemptions, complemented by revenue administration reform.
  - Continue expenditure rationalization, improve budget formulation and execution, and strengthen the fiscal rule.
  - Reform state-owned enterprises and adopt cost-recovery energy pricing; adopt automatic fuel and electricity pricing mechanisms.
- Monetary and exchange rate policy:
  - Tighter monetary policy stance needed to contain rising inflationary pressures.
  - Phase out the central bank’s direct financing of budget deficits and unwind large T-bill holdings in coordination with the MoF.
  - Gradual return to a market-determined and flexible exchange rate to facilitate external adjustment and rebuild international reserves.
  - Gradual unwinding of capital flow management measures as conditions permit.
- Financial sector and stability:
  - Continue monitoring asset quality, identify vulnerabilities through stress testing, and maintain restrictions on bank profit distributions during stress-testing/unwinding.
  - Broaden CBSL’s regulatory powers and upgrade the resolution framework; finalize and adopt the new Banking Act.
- Structural and social policies:
  - Growth-enhancing structural reforms: increase female labor force participation, reduce youth unemployment, diversify the economy, phase out import restrictions, and improve the business and investment climate.
  - Prudent management of the Colombo Port City project with strict ring-fencing of tax concessions and adherence to AML/CFT and international tax standards.
  - Strengthen governance and fight corruption.
  - Strengthen social safety nets by increasing spending, widening coverage, and improving targeting to protect vulnerable groups during adjustment.
- Executive Directors’ appraisal:
  - Commended prompt policy response and successful vaccination drive.
  - Stressed urgency of a credible and coherent strategy to restore macroeconomic stability and debt sustainability while protecting vulnerable groups.

### External sector and CFMs
- Current account and external flows:
  - Current account (percent GDP): 2018: -3.2; 2019: -2.2; 2020: -1.3; 2021: -3.8; 2022 Proj.: -3.8.
  - Exports (goods, million USD): 2019: 11,940; 2020: 10,047; 2021: 12,222; 2022 Est.: 13,598.
  - Imports (goods, million USD): 2019: -19,937; 2020: -16,055; 2021: -20,018; 2022 Est.: -22,629.
- Reserves and reserve adequacy:
  - Reserves (US$ millions): 2018: 6,919; 2019: 7,642; 2020: 5,664; 2021: 3,138; 2022 Proj.: 2,204.
  - GIR as percent of ARA metric: end-2019: 62 percent; end-2020: 46 percent; end-December 2021: 25 percent.
- CFMs and import restrictions:
  - CFMs in force include repatriation and surrender requirements, suspension of certain outward remittances, restrictions on purchases of ISBs by local banks, and others.
  - Import restrictions over 2020–21 estimated to have reduced the import bill by 2.4 percent of 2021 GDP but harmed activity by limiting intermediate and capital goods.
  - Staff recommendation: CFMs and import restrictions may be needed in near term but should be phased out and not substitute for macro adjustment.

### Financial sector performance and vulnerabilities
- Pre-pandemic and pandemic-era measures:
  - Banks account for over 60 percent of total financial sector assets; LFCs around 6 percent.
  - CBSL actions since mid-2010s: increased capital and liquidity requirements, implemented IFRS 9, and adopted risk-based supervision.
  - Since March 2020, CBSL adopted liquidity-boosting measures, relaxed capital requirements, reclassified NPLs, and provided moratoria and refinancing facilities.
- Indicators and risks:
  - Share of loans under repayment moratoria declined from around 25 percent of total loans in mid-2020 to around 9 percent in August 2021.
  - Banks’ claims on the government and SOEs rose to around 40 percent of total bank assets in 2021.
  - Regulatory capital to risk weighted assets ranged around 15.7–16.2 across 2018–2021; gross NPLs to total gross loans ranged from 3.0 to 6.0 across the period.
- Policy guidance:
  - Phase out moratoria carefully, monitor loans exiting moratoria, conduct stress tests, restore prudential requirements to pre-pandemic levels, broaden resolution tools, and harmonize regulation across banks and NBFIs where appropriate.

### Social safety nets and distributional impacts
- SSN spending and poverty impacts:
  - Total welfare spending (2020): 580,900 million Rupees, 3.9 percent of GDP.
  - Social Safety Net programs: 131,918 million Rupees, 0.9 percent of GDP.
  - Samurdhi: 52,434 million Rupees, 0.4 percent of GDP, covering nearly 1.8 million households (31 percent of total households).
  - World Bank estimate: $3.2/day poverty rate increased from 9.2 percent in 2019 to 11.7 percent in 2020; $1.9/day poverty rate expected to have doubled since 2019.
- Reform priorities:
  - Complete the social registry and Integrated Welfare Management System (IWMS).
  - Target cash transfers toward the poorest 40 percent of households and increase per-household transfer amounts.
  - Raise disability and kidney disease benefits and expand elderly benefit in line with aging population.
  - Maintain SSN spending above pre-pandemic levels with improved targeting while creating fiscal space through revenue mobilization.

### Implementation of past recommendations and governance
- Mixed implementation record:
  - 2019 tax cuts (CIT, PIT, VAT) and abolition of mandatory withholding reduced tax-to-GDP ratio.
  - E-filing mandatory for CIT from November 2021; plans to upgrade fiscal rules suspended.
  - Automatic fuel pricing mechanism in place in 2018-19 is no longer in use; electricity pricing reform halted.
  - Revised central bank law not adopted; new Banking Act expected in 2022.
- Governance and AML/CFT:
  - Need for transparency and accountability in public spending, including COVID-19 expenditures.
  - Continued efforts to strengthen AML/CFT regime and operationalize beneficial ownership registry noted.
  - Authorities appreciate IMF capacity development; IMF TA on revenue administration and other areas expected to resume.

### Growth potential, medium-term prospects, and risks
- Growth accounting and potential:
  - Cobb-Douglas production function with capital share α = 0.3 used in staff estimates.
  - Estimated medium-term growth potential: around 3.1–4.1 percent.
  - Midpoint implied growth potential around 3.6 percent given historical averages and projected labor contribution.
- Risks to potential:
  - Downside: lower public capital spending for fiscal consolidation could reduce capital growth and potential.
  - Upside: higher female labor participation, larger FDI inflows, and improved macro stability could raise potential growth.

*Source: IMF staff report for the 2021 Article IV Consultation (Sri Lanka), February 10, 2022.*

### 3.6 percent in 2021, with mobility indicators largely back to their pre-pandemic levels and

### 1lkaea2022001 - 3.6 percent in 2021, with mobility indicators largely back to their pre-pandemic levels and

### Key economic developments
- Real GDP growth: 3.6 percent in 2021.
- Tourism and mobility:
  - Mobility indicators largely back to their pre-pandemic levels by late 2021.
  - Tourist arrivals started to recover in late 2021.
- Fiscal outcomes and financing:
  - Annual fiscal deficits exceeded 10 percent of GDP in 2020 and 2021.
  - Causes: pre-pandemic tax cuts, weak revenue performance due to the pandemic, and pandemic-related expenditure measures.
  - Limited availability of external financing led to a large amount of central bank direct financing of the budget.
- Public debt and external position:
  - Public debt rose from 94 percent of GDP in 2019 to 119 percent of GDP in 2021.
  - Large FX debt service payments by the government and a wider current account deficit caused a significant FX shortage.
  - Official exchange rate effectively pegged to the U.S. dollar since April 2021.
- Inflation and monetary conditions:
  - Inflation accelerated to 14 percent (y/y) in January 2022 (measured by the Colombo Consumer Price Index).
  - Inflation projected to remain double-digit in the coming quarters, exceeding the target band of 4–6 percent.
- Reserves and external financing:
  - International reserves remain inadequate despite authorities’ efforts to secure FX financing from external sources.

### Outlook and risks
- Growth prospect:
  - GDP growth is projected to be negatively affected by the FX shortage and macroeconomic imbalances through reduced economic activity and business confidence.
- Fiscal outlook:
  - Under current policies and the authorities’ commitment to preserve the tax cuts, the fiscal deficit is projected to remain large over 2022–26, raising public debt further over the medium term.
- External sector and reserves:
  - Due to persistent external debt service burden, international reserves would remain inadequate.
- Risks (tilted to the downside):
  - Failure to meet fiscal and balance-of-payments financing needs could result in significant contractions in imports and private credit growth, or monetary instability if further central bank financing of fiscal deficits occurs.
  - Additional downside risks: COVID-19 resurgence, rising commodity prices, worse-than-expected agricultural production, deterioration in banks’ asset quality, extreme weather events.
  - Upside risks: faster-than-expected tourism recovery and stronger-than-projected FDI inflows.

### Executive Board assessment and key policy recommendations
- Executive Directors’ appraisal:
  - Commended prompt policy response and successful vaccination drive.
  - Noted mounting challenges: public debt at unsustainable levels, low international reserves, and large financing needs.
  - Stressed urgency of a credible and coherent strategy to restore macroeconomic stability and debt sustainability while protecting vulnerable groups.
- Fiscal policy:
  - Need for ambitious fiscal consolidation based on high-quality revenue measures.
  - Scope identified to raise income tax and VAT rates and minimize exemptions, complemented by revenue administration reform.
  - Continue expenditure rationalization, improve budget formulation and execution, and strengthen the fiscal rule.
  - Reform state-owned enterprises and adopt cost-recovery energy pricing.
- Monetary and exchange rate policy:
  - Tighter monetary policy stance needed to contain rising inflationary pressures.
  - Phase out the central bank’s direct financing of budget deficits.
  - Gradual return to a market-determined and flexible exchange rate to facilitate external adjustment and rebuild international reserves.
  - Gradual unwinding of capital flow management measures as conditions permit.
- Financial sector and stability:
  - Continue monitoring asset quality, identify vulnerabilities through stress testing.
  - Welcome legislative reforms to strengthen regulatory, supervisory, and resolution frameworks.
- Structural and social policies:
  - Renewed efforts on growth-enhancing structural reforms: increase female labor force participation, reduce youth unemployment, diversify the economy, phase out import restrictions, and improve the business and investment climate.
  - Prudent management of the Colombo Port City project.
  - Strengthen governance and fight corruption.
  - Increase resilience to climate change.
  - Strengthen social safety nets by increasing spending, widening coverage, and improving targeting to protect vulnerable groups during adjustment.

### Selected indicators (from Table 1: Sri Lanka: Selected Economic Indicators, 2018–22)
- Output:
  - Real GDP growth (percent): 2018: 3.3; 2019: 2.3; 2020: -3.6; 2021: 3.6; 2022 Proj.: 2.6.
- Prices:
  - Inflation (average, percent): 2018: 4.3; 2019: 4.3; 2020: 4.6; 2021: 6.0; 2022 Proj.: 10.5.
  - Inflation (end of period, percent): 2018: 2.8; 2019: 4.8; 2020: 4.2; 2021: 12.1; 2022 Proj.: 8.3.
- Central government finances:
  - Revenue and grants (percent GDP): 2018: 13.5; 2019: 12.6; 2020: 9.2; 2021: 8.9; 2022 Proj.: 10.7.
  - Expenditure (percent GDP): 2018: 18.8; 2019: 20.6; 2020: 21.9; 2021: 20.3; 2022 Proj.: 20.3.
  - Primary balance (percent GDP): 2018: 0.6; 2019: -2.0; 2020: -6.2; 2021: -4.9; 2022 Proj.: -2.8.
  - Overall balance (percent GDP): 2018: -5.3; 2019: -8.0; 2020: -12.8; 2021: -11.4; 2022 Proj.: -9.6.
  - Central government debt (percent GDP): 2018: 84.2; 2019: 86.8; 2020: 101.2; 2021: 107.1; 2022 Proj.: 108.6.
  - Public debt (percent GDP): 2018: 91.0; 2019: 93.6; 2020: 110.0; 2021: 118.9; 2022 Proj.: 119.9.
- Money and credit:
  - Broad money (percent change): 2018: 13.0; 2019: 7.0; 2020: 23.4; 2021: 15.4; 2022 Proj.: 13.9.
  - Credit to the private sector (percent change): 2018: 15.9; 2019: 4.2; 2020: 6.5; 2021: 13.8; 2022 Proj.: 13.0.
- Balance of payments:
  - Current account (percent GDP): 2018: -3.2; 2019: -2.2; 2020: -1.3; 2021: -3.8; 2022 Proj.: -3.8.
  - FDI (percent GDP): 2018: 1.8; 2019: 0.8; 2020: 0.5; 2021: 0.9; 2022 Proj.: 1.2.
  - Reserves (US$ millions): 2018: 6,919; 2019: 7,642; 2020: 5,664; 2021: 3,138; 2022 Proj.: 2,204.
  - Reserves (months imports): 2018: 3.4; 2019: 5.0; 2020: 3.1; 2021: 1.5; 2022 Proj.: 1.0.
  - External debt (percent GDP): 2018: 60.2; 2019: 65.1; 2020: 66.4; 2021: 65.6; 2022 Proj.: 64.2.

*Source: IMF staff report for the 2021 Article IV Consultation (Sri Lanka), February 10, 2022.*

### 5.      The pandemic and necessary containment measures triggered a severe economic

### 5.      The pandemic and necessary containment measures triggered a severe economic

### Pandemic impact and recovery
- Real GDP contracted by 3.6 percent (y-o-y) in 2020.
- Real GDP grew by 4.4 percent in the first 9 months of 2021.
- Annual growth is projected to be 3.6 percent (for 2021).
- The recovery in 2021Q4 is expected to be dragged down by:
  - a temporary restriction on the use and importation of chemical fertilizer (adverse impact on agricultural production),
  - negative effects of foreign exchange (FX) shortages and suspension of certain imports on industrial activity.

### Inflation and labor market pressures
- Headline inflation breached the CBSL 4-6 percent target band and rose to 14.2 percent in January 2022.
- Core inflation rose from 2.7 percent in January 2021 to 9.9 percent in January 2022.
- Private sector wages and inflation expectations are on the rise.

### Current account, tourism, remittances, and reserves
- Current account (CA) deficit narrowed to 1.3 percent of GDP in 2020 (from 2.2 percent of GDP in 2019).
- In 2021, the CA deficit is expected to have widened to 3.8 percent of GDP.
- Gross international reserves (GIR) declined from $7.6 billion at end-2019 to $3.1 billion (1.5 months of imports, 25 percent of ARA metric) at end-2021 and to $2.4 billion at end-January 2022.
- Net international reserves have become negative since November 2021.
- Sri Lanka’s EMBI spread rose to 1,870 basis points at the onset of the pandemic and recently exceeded 2,500 basis points.
- Rating agencies have downgraded Sri Lanka to CCC and lower.
- Financial support during the pandemic included: Bangladesh (US$200 million), China (US$2.8 billion), India (US$1.4 billion).
- New SDR allocations in August 2021 amounted to $780 million; 85 percent had been converted and used for debt repayment and FX intervention as of end-2021.
- Footnote: The end-2021 GIR amount includes a currency swap with the People’s Bank of China (PBOC) equivalent of US$1.5 billion disbursed late December.

### Fiscal impact and public debt
- Fiscal deficits widened to 12.8 percent of GDP in 2020 and 11.4 percent of GDP in 2021.
- Primary deficit (cash basis) rose to 6.2 percent of GDP in 2020 (from 2.0 percent of GDP in 2019).
- Tax revenues declined from 11.6 percent of GDP in 2019 to 8.1 percent of GDP in 2020.
- Clearance of arrears accounted for 1.6 percent of GDP in 2020.
- Non-interest current spending (excluding arrears clearance) increased by 1.2 percent of GDP; capital spending (excluding arrears clearance) declined by 2.0 percent of GDP in 2020.
- Projected annual primary deficit in 2021: 4.9 percent of GDP (preliminary end-November outturns suggest similar performance).
- Public debt (including guaranteed debt and Fund credit outstanding) increased to 114 percent of GDP in 2021Q3 from 94 percent of GDP in 2019.
- Government net domestic financing (NDF) requirements: 13.3 percent of GDP in 2020; expected 12.3 percent of GDP in 2021 (against an average of 3.4 percent of GDP over 2010-19).
- CBSL’s net credit to the government increased by 9 percent of GDP between March 2020 and November 2021.
- Banks’ claims on the government and SOEs rose to around 40 percent of total bank assets in 2021.

### Monetary and exchange rate policies
- Policy rates and the statutory reserve ratio (SRR) were reduced by 250 and 300 bps, respectively, over January-July 2020 and kept unchanged through August 2021.
- Private credit growth recovered from 6½ percent (y-o-y) in December 2020 to 13½ percent in November 2021.
- In August 2021, policy rates and SRR were raised by 50 and 200 bps, respectively.
- Policy rates were further raised by 50 bps in January 2022.
- M2 growth: 22.9 percent (y-o-y) at end-2020 and 15.1 percent at end-November 2021.
- CBSL effectively fixed the official exchange rate at LKR 200-203 per U.S. dollar since April 2021, using moral suasion, surrender requirements, and direct FX sales.
- Staff identified one measure as inconsistent with Sri Lanka’s Article VIII obligations (related to a temporary incentive scheme for inward worker remittances).
- Parallel market quotes were reported at around 20 percent premium.
- Price controls for basic food items introduced mid-2021 and lifted in October 2021.
- FX shortage, price controls, and import restrictions resulted in shortages of sugar, rice, milk powder, and cooking gas.

### Reserves, debt service, and sustainability assessment
- Staff views Sri Lanka’s public debt as unsustainable.
- Public debt and gross financing needs (GFNs) are projected to have reached 118.9 percent and 30.1 percent of GDP, respectively, in 2021.
- Staff projects FX debt service to reach around US$7 billion in 2022, including the US$1 billion ISBs maturing in July 2022; FX debt service is projected to remain around US$7-8 billion over the medium-term.
- Under an illustrative optimistic scenario (authorities’ current policies plus optimistic financing assumptions):
  - Primary deficit would decline to 2.8 percent of GDP in 2022 as envisaged in the Budget.
  - Government capital spending cut from 3.5 percent of GDP in 2021 to 2.5 percent of GDP during 2022-26.
  - Fiscal deficit would remain elevated above 9 percent of GDP, leaving fiscal financing gaps averaging 5 percent of GDP per year.
  - Even with fresh, still-unidentified BoP financing of US$2-3 billion (2-3 percent of GDP) each year, gross reserves would stay critically low at around 1 month of imports over 2022-26.
  - Growth would weaken to 2.6 percent in 2022 and stay below potential (estimated in the range of 3.1-4.1 percent absent structural reforms) through 2026.
  - Private credit growth averaging 9½ percent in 2022-26 under this scenario.
  - Inflation would exceed the CBSL target band of 4-6 percent in 2022-24.

### Illustrative fiscal and external projections (selected figures from staff projections table)
- Real GDP growth: 2021: 3.6; 2022: 2.6; 2023: 2.7; 2024: 2.8; 2025: 2.8; 2026: 2.8.
- Inflation (average, Colombo CPI): 2021: 6.0; 2022: 10.5; 2023: 7.0; 2024: 6.3; 2025: 5.8; 2026: 5.3.
- Government revenues and grants (percent of GDP): 2021: 8.9; 2022: 10.7; 2023: 10.8; 2024: 11.0; 2025: 11.1; 2026: 11.3.
- Government expenditure and net lending (percent of GDP): 2021: 20.3; 2022: 20.3; 2023: 20.3; 2024: 20.4; 2025: 20.5; 2026: 20.4.
- Capital exp. and net lending (percent of GDP): 2021: 3.5; 2022–2026: 2.5 each year.
- Overall fiscal balance (percent of GDP): 2021: -11.4; 2022: -9.6; 2023: -9.6; 2024: -9.4; 2025: -9.4; 2026: -9.1.
- Gross international reserves (million USD): 2021: 3,138; 2022: 2,204; 2023: 2,386; 2024: 2,416; 2025: 2,465; 2026: 2,532.
- Gross international reserves (in months of imports of G&S): 2021: 1.5; 2022–2026: 1.0 each year.

### Risks and potential downside scenarios
- Risks are tilted to the downside: absent unidentified external financing, the country could face a disorderly adjustment through severe import compression and potentially external arrears.
- Domestic reliance to fill fiscal financing gaps could suffocate private credit growth or require further monetary financing, undermining monetary stability.
- Downside risks highlighted in Risk Assessment Matrix include: COVID-19 resurgence, rising commodity prices, potential loss of preferential trade access to the EU, potential deterioration in banks’ asset quality, worse-than-anticipated impact of the chemical fertilizer ban on agricultural production, and extreme weather events.
- Upside risks include faster-than-expected tourism recovery and stronger-than-projected FDI inflows.

### Policy recommendations (staff)
- Implement revenue-based fiscal consolidation and tighten monetary policy.
- Move away from an unsustainable de-facto exchange rate peg and restore a market-determined exchange rate while containing risk of disorderly exchange rate movements.
- Mitigate adverse impacts on vulnerable groups by strengthening social safety nets.
- Undertake institution-building reforms, such as revamping the fiscal rule, to ensure credibility.
- Develop a comprehensive strategy to restore debt sustainability; staff view that fiscal consolidation and macroeconomic policy adjustments alone cannot restore debt sustainability.

### Authorities’ views
- Authorities consider staff’s outlook overly pessimistic and expect real GDP growth to rebound to 5 percent in 2022 and accelerate to 7 percent of GDP over the medium term.
- Authorities expect rebasing of GDP to result in an upward revision on nominal GDP levels from 2015 onwards.
- Authorities view BoP and debt challenges as temporary and expect near-term FX shortages to be addressed by government-to-government loans, currency swaps, expedited FDI, monetization of underutilized assets, and temporary export surrender requirements.
- India provided new bilateral support totaling US$1.4 billion (a central bank currency swap, a credit line for fuel imports, and deferment of clearing Sri Lanka’s balance at the Asian Clearing Union).
- Authorities argue that the new SDR allocation and disbursement would have been more effective if made at the outset of the pandemic.

*Source: https://www.imf.org/-/media/files/publications/cr/2022/english/1lkaea2022001.pdf*

### 21.      Planned fiscal consolidation in 2022 is welcome, but meeting its deficit target is at

### 1lkaea2022001 - 21.      Planned fiscal consolidation in 2022 is welcome, but meeting its deficit target is at

### Fiscal consolidation in 2022: objectives and risks
- The 2022 Budget aims to reduce the primary deficit to 2.8 percent of GDP in 2022, a fiscal adjustment of about 2 percent of GDP from 2021.
- The budget includes revenue measures (one-time income tax surcharge applied retroactively to 2020/21 income, a turnover tax, a new Special Goods and Services Tax (SGST), and a higher VAT rate on financial services) that could generate 1.6 percent of GDP.
- Budgeted expenditure assumes optimistic revenue growth—tax revenues excluding measures are projected to rise by 27 percent from 2021.
- In January 2022 authorities introduced a 1.2 percent of GDP spending package (public sector wages, pensions, social transfers) which increases permanent spending pressures.
- Conclusion: meeting the 2022 primary balance target is at substantial risk without additional revenue measures or large capital spending cuts.

### Medium-term fiscal anchor and revenue strategy
- Staff recommends anchoring consolidation in high-quality, permanent revenue measures and achieving at minimum a primary balance of zero by 2024.
- The authorities’ objective of a primary surplus by 2025 is close to staff’s minimum path.
- Emphasis: consolidation should be primarily revenue based because Sri Lanka’s tax-to-GDP ratio is among the lowest in the world due to 2019 tax cuts and low collection efficiency.
- Concern: the authorities commit to preserving 2019 tax reforms (large PIT, CIT and VAT rate cuts and exemption increases), while 2022 budget measures are overwhelmingly one-off; the January 2022 package likely increases permanent wage and pension spending.

### Tax policy recommendations
- Strengthen CIT and PIT: minimize exemptions and tax holidays that have eroded revenue; raise rates where appropriate to mobilize needed revenues from CIT, PIT, and VAT.
- Reinstate mandatory withholding requirements under the Inland Revenue Act (IRA).
- Reverse undesirable measures: retroactive income taxes undermine tax certainty; turnover taxes are less efficient than VAT due to cascading.
- Reduce multiplicity of indirect taxes and high para-tariffs that render the system unpredictable and hinder competitiveness.

### Revenue administration and institutional recommendations
- Continue shift to risk-based compliance management, strengthen the Large-Taxpayer Unit, and expand digitization.
- Do not make the Treasury administer the new SGST (would increase fragmentation); instead, improve capacity at Customs and Excise Departments.
- Reinstate mandatory withholding and improve tax collection efficiency to raise tax-to-GDP ratio.

### Expenditure management and SOE-related fiscal risks
- Spending discipline required: scale back non-priority expenditure and improve spending efficiency to accommodate higher social safety net needs.
- Develop an overarching strategy to manage and reverse the rising public wage bill trend.
- Expenditure rationalization is complementary but not a substitute for revenue mobilization given non-interest recurring expenditures are not out of line with peers.
- Energy pricing: adopt automatic fuel and electricity pricing mechanisms to ensure periodic adjustments in line with cost-recovery levels and eliminate regressive energy subsidies.
- If subsidies remain, they should be transparently remunerated through the budget within targeted fiscal deficits.
- Need overarching strategy to address high SOE debt and growing currency mismatches on energy SOEs’ balance sheets.

### Budget formulation, execution, and fiscal governance
- Past budgets overestimated revenues and underestimated interest payments, contributing to unrealistic resource assessments and frequent expenditure arrears.
- Commendations: creation of Macro-Fiscal Unit at the Ministry of Finance, rollout of ITMIS electronic platform for commitment-based spending controls and fiscal reporting, move from annual to quarterly commitment ceilings.
- Recommendations: strengthen the Macro-Fiscal Unit, adopt GFSM 2014 fiscal reporting standards, and revamp the current fiscal rule (not satisfied since 2003) in line with international best practice.

### Authorities’ views on fiscal strategy
- Authorities committed to reducing the primary deficit to 2.8 percent of GDP in 2022 and achieving a primary surplus by 2025.
- They intend to finance January 2022 relief spending within the budget envelope without changing the low-tax regime; they disagree with staff’s recommendation to raise income tax and VAT rates.
- Authorities expect a strong economic recovery and improved tax compliance (Large Taxpayer Unit, digitalization, information sharing) to raise tax-to-GDP ratio over the medium term.
- They view SGST as improving tax administration efficiency and defend tax incentives for promoting investment.

### Monetary policy, exchange rate, and external sector recommendations
- Monetary tightening: staff views further near-term monetary tightening as warranted given rising inflationary pressures and negative real policy rate relative to historical average of 2½ percent per annum (over the past decade).
- Notable policy action: a 50-bps policy rate increase to 5.5-6.5 percent in January 2022.
- Objective: ensure breach of 4–6 percent inflation target band is temporary; launch of first Monetary Policy Report welcomed.
- Phase out direct central bank financing of the budget: further monetary financing would aggravate inflation risks; an exit strategy to unwind large T-bill holdings is critical.
- Exchange rate: recommend gradual return to market-determined and flexible exchange rate; phase out moral suasion and limit FX intervention to truly disorderly conditions; coordinate sequencing as part of comprehensive macroeconomic adjustment.
- External position: 2021 current account projected deficit of 3.8 percent of GDP, assessed as weaker than medium-term fundamentals imply; reserves precariously low.
- Measures: growth-friendly fiscal consolidation, restore debt sustainability, prudent monetary policy with exchange rate flexibility, rebuild reserves, structural reforms to boost exports and FDI.

### Import restrictions, CFMs, and repayment capacity
- Import restrictions in 2020–21 are estimated to have reduced the import bill by 2.4 percent of GDP but are detrimental to activity and should be phased out.
- CFMs introduced or tightened during the pandemic should be temporary and are not a substitute for comprehensive macro adjustment.
- Fund credit outstanding and repayment profile:
  - Credit outstanding to the Fund: SDR902 million (US$1.3 billion) at end-2021.
  - Payments (repurchases and charges) due averaging US$170 million over 2022-29.
  - Credit outstanding was 1.5 percent of GDP at end-2021.
  - Payments due are around 1 percent of total exports over 2022-27.
- Sri Lanka’s precarious reserves, debt overhang, and persistent fiscal and BoP financing shortfalls pose high risks to capacity to repay the Fund.

### Authorities’ views on monetary and exchange policies
- Authorities view current monetary stance as appropriate and attribute inflationary pressures largely to transitory supply-side factors; they consider past policy actions (rate increases, abolition of interest rate caps) to have addressed demand-side pressures.
- Authorities caution that raising policy rates could burden businesses under loan moratoria and increase government interest costs.
- On exchange rate policy, authorities disagree with staff: they argue FX pressures will dissipate with tourism and remittances recovery and that a floating rupee risks disorderly movements harming inflation and public debt dynamics.
- Authorities consider import restrictions, surrender requirements, and other CFMs temporary and expect limited adverse growth impact; they have strengthened incentives for workers’ remittances.

*Source: 1lkaea2022001 - 21.      Planned fiscal consolidation in 2022 is welcome, but meeting its deficit target is at*

### 39.      Reflecting commendable efforts by the CBSL to strengthen the regulatory and

### Reflecting commendable efforts by the CBSL to strengthen the regulatory and supervisory frameworks

### Financial sector performance and policy response
- Prior to the pandemic, financial sector performance was satisfactory reflecting CBSL reforms:
  - Banks account for over 60 percent of total financial sector assets.
  - Licensed finance companies (LFCs) account for around 6 percent of total financial sector assets and cater to higher-risk borrowers.
  - CBSL actions since the mid-2010s: increased and upgraded capital and liquidity requirements based closely on the Basel standards; implemented the International Financial Reporting Standard 9; enhanced supervisory methods with a new risk-based approach.
  - Non-performing loans (NPLs) rose due to the economic slowdown in 2019.
- COVID-19 impact and measures:
  - Several lockdowns and the collapse of tourism constrained borrowers’ ability to service debt.
  - Since March 2020, CBSL adopted measures to boost liquidity, relax capital requirements, and reclassify NPLs, allowing banks to delay loan-loss provisioning.
  - Measures to relieve borrowers included moratoria on loan repayments and a new refinancing facility.
- Moratoria and loan status:
  - Share of loans under repayment moratoria declined from around 25 percent of total loans in mid-2020 to around 9 percent in August 2021, with banks restructuring loans as needed.

### Risks, vulnerabilities, and stress-testing needs
- Key financial stability risks:
  - Banks’ large exposure to the government and SOEs strengthens the sovereign-bank nexus and could constrain private sector lending if public sector borrowing remains large (¶11 referenced).
  - Sovereign rating downgrades have constrained banks’ access to external financing and import credit, amplifying FX shortages.
  - Banks’ exposure to exchange rate risks mitigated by minimal net open FX positions (as required by regulations) and relatively tight FX lending standards (such as the requirement for FX income).
- Policy sequencing and vigilance:
  - Planned unwinding of COVID-19 relief measures (scheduled expiration of repayment moratoria for individuals and businesses affected by COVID-19 and for the tourism sector in March and June 2022, respectively) is welcome.
  - CBSL should closely monitor quality of loans exiting moratoria and proactively identify vulnerabilities through stress testing.
  - Maintaining restrictions on bank profit distributions during stress-testing/unwinding would help ensure capital adequacy.
  - Capital and other prudential requirements should be restored to pre-pandemic standards under a feasible timeframe.

### Regulatory, supervisory, and resolution framework reforms
- Priority measures to build on pre-pandemic progress:
  - Broaden CBSL’s regulatory powers.
  - Upgrade the resolution framework by setting up a special resolution regime for financial institutions, expanding resolution tools, improving deposit insurance, and enhancing emergency liquidity assistance.
  - Finalization and adoption of the new Banking Act should help achieve these goals.
  - Harmonize regulatory and supervisory requirements for banks and nonbank deposit-taking financial institutions while ensuring a level playing field—recognizing larger/sophisticated institutions warrant tighter requirements but that banks and LFCs conduct essentially the same banking operations.
- Authorities’ position:
  - Authorities agreed on monitoring loans under moratorium and conducting stress tests, and on pursuing longer-term reforms including adoption of the new Banking Act.
  - CBSL acknowledged consolidation of LFCs as needed but did not support full unification of regulatory frameworks for banks and LFCs, noting LFCs provide services not provided by banks including in rural areas.

### Protecting the vulnerable and raising potential growth
- Pandemic impact on poverty and employment:
  - World Bank estimate: Sri Lanka’s $3.2/day poverty rate increased from 9.2 percent in 2019 to 11.7 percent in 2020.
  - Earnings losses concentrated on the bottom 40 percent of households, exacerbating income inequality.
  - Revenue, employment, and salary expenditures of micro, small, and medium enterprises declined by around 60-80 percent during the first COVID-19 wave.
  - Informal sector accounts for two thirds of total employment.
- Social safety nets (SSN):
  - SSN spending, at around 0.4 percent of GDP (excluding COVID-19 relief), remains low compared with peers.
  - Need to improve coverage and targeting and raise per-family benefit while preserving progressivity.
  - Revenue mobilization is critical for creating space for higher SSN spending and fair burden-sharing of fiscal consolidation.
- Structural reforms to boost growth:
  - Address falling labor force participation (LFP) and widen female LFP—female LFP disproportionately hit by the pandemic; youth unemployment stands out among peers.
  - Recent reform to increase minimum retirement age is welcome; further reforms should improve female LFP and reduce youth unemployment via improved access to finance, realigned vocational training, and job search support.
  - Trade and economic liberalization needed to facilitate export diversification and boost productivity; reducing non-tariff barriers can improve medium-term productivity, especially for sectors reliant on global value chains.
  - Colombo Port City project: maximize investment promotion benefits while ring-fencing tax concessions, ensuring compliance with international tax and AML/CFT standards, and shielding the domestic financial sector from offshore banking activities.
  - Government role and market distortions:
    - Government administers or influences prices of basic commodities (rice, wheat, milk powder, cement) through direct price controls, which led to supply shortages and rationing and had to be rolled back as price pressures built up in late 2021 (¶13).
    - SOEs: more than 400 SOEs across key sectors. Reforms of price controls and the SOE sector are warranted.

### Governance, IMF capacity development, and authorities’ views
- Governance and anti-corruption:
  - Need for transparency and accountability in use of public resources, including COVID-19 spending.
  - Pandemic-related spending subject to normal procurement standards and donor-supported spending subject to donor transparency/accountability standards.
  - Continued efforts to strengthen AML/CFT regime and operationalize the beneficial ownership registry were noted.
  - Upgrading anti-corruption legislation should be a priority; Cabinet decision to resume reform process after delay in 2020-21 is welcome.
- IMF capacity development (CD) and technical assistance (TA):
  - TA on revenue administration expected to resume after pandemic-related delays.
  - Training provided to the Macro-Fiscal Unit; continued IMF engagement on public financial management and fiscal statistics expected.
  - Financial sector TA following the 2019 Financial Sector Stability Review covered macroprudential policy arrangements, stress testing, regulation and supervision of nonbank financial institutions, including through a resident advisor.
  - SARTTAC provided TA on key macro statistics and monetary policy operations.
- Authorities’ views:
  - Authorities emphasized the effectiveness of extraordinary financial sector measures and that both banks and LFCs have remained well capitalized and profitable with declining moratoria shares.
  - Authorities agreed on monitoring loans under moratorium, conducting stress tests, adopting the new Banking Act, and pursuing SSN adjustments and female labor force participation research.
  - Noted that Colombo Port City Act makes prevailing AML/CFT legislation applicable to the Port City and that laws/regulations will be followed without exemption.
  - Authorities appreciated IMF CD support.

### Staff appraisal and recommended comprehensive strategy
- Staff assessment:
  - Authorities’ prompt policy response cushioned COVID-19 impact; vaccination drive noted as commendable.
  - Pandemic aggravated preexisting debt overhang and inadequate external buffers; staff assesses Sri Lanka’s public debt is unsustainable.
  - Country experiencing a combined debt and BoP crisis; avoiding depletion of gross reserves requires sizable and persistent FX inflows.
- Recommended comprehensive strategy to restore stability and debt sustainability:
  - Credible and coherent macroeconomic strategy covering near and medium term is urgently needed, combining macroeconomic policy adjustments and targeted measures to protect the vulnerable.
  - Medium-term fiscal consolidation should be credible and based on concrete policy measures; planned fiscal consolidation in 2022 is welcome but additional revenue measures or drastic cuts to capital spending would likely be needed to meet the primary balance target.
  - Fiscal consolidation should be primarily revenue-based given Sri Lanka’s very low tax-to-GDP ratio; mobilize revenue from CIT, PIT, and VAT by raising rates, minimizing exemptions, and ensuring greater contributions from high-income earners.
  - Support fiscal consolidation with revenue administration reform, expenditure rationalization, and stronger budget formulation and execution.
  - Adopt cost-recovery based energy pricing through automatic fuel and electricity pricing mechanisms to mitigate SOE fiscal risks.
  - Revamp the fiscal rule to anchor fiscal consolidation.
  - Tighter monetary policy and a market-based exchange rate:
    - Near-term monetary policy tightening warranted given rising inflationary pressures and expectations.
    - CBSL’s initial steps to unwind large holdings of Treasury bills are welcome and should continue in close coordination with the MoF.
    - Replace the current policy of fixing the official exchange rate with a gradual return to a market-determined and flexible exchange rate to facilitate external adjustment.
  - Strengthen SSNs to protect the most vulnerable by improving coverage, targeting, and per-family benefits while creating fiscal space through revenue mobilization.
  - Continue vigilance to ensure financial sector stability: monitor loans exiting moratoria, perform stress testing, finalize and adopt the new Banking Act to broaden CBSL powers and upgrade resolution framework.
  - Renewed efforts on growth-enhancing structural reforms: increase female labor force participation, reduce youth unemployment, phase out import restrictions on a schedule, develop a wide-reaching investment promotion strategy to avoid overreliance on tax incentives, manage Port City project prudently, and reform price controls and the SOE sector.
  - Continue efforts to strengthen governance and reduce corruption vulnerabilities.

*Source: 1lkaea2022001 - 39. Reflecting commendable efforts by the CBSL to strengthen the regulatory and supervisory frameworks (excerpt).*

### 60.      Staff recommends that the next Article IV Consultation with Sri Lanka takes place on

### 1lkaea2022001 - 60.      Staff recommends that the next Article IV Consultation with Sri Lanka takes place on

### Real sector
- Real GDP recouped part of its COVID loss in the first nine months of 2021, as manufacturing and services rebounded.
- Recovery supported by a recovery in final consumption expenditure.
- PMIs and industrial production have been modestly expansionary of late, with the exception of a brief contraction during the third wave.
- Trade deficit normalized towards pre-pandemic levels as activity recovered.
- Both headline and core inflation are on a rising trend, as food inflation remains elevated and price pressures in non-food categories start to build.
- Sources cited: Department of Census and Statistics; CBSL; IMF Consensus Forecast Database; and IMF staff estimates.

### Fiscal sector
- A collapse in revenues, due to both policy changes and pandemic impact, drove up budget deficits in 2020-21, leading to a sharp rise in public debt and a continued increase in gross financing needs.
- VAT and income tax cuts, import restrictions, and the economic downturn reduced the tax to GDP ratio.
- Non-interest current spending increased in 2020, while interest payments reached 6.5 percent of GDP.
- Local currency bond yields have been rising since the authorities removed the auction yield caps in September 2021.
- Sri Lanka’s EMBI spreads remain at very high levels.
- Sources cited: CBSL; Ministry of Finance; JP Morgan Chase & Co.; and IMF staff estimates.

### Financial markets
- T-bill and T-bond yields rose recently, pushing the yield curve above its pre-pandemic level, following monetary policy rate hikes in August 2021 and January 2022.
- The central bank’s purchase of T-bills in primary markets led to loose liquidity conditions until mid-2021 and kept interest rates at low levels until the recent reversal.
- Lower short-term rates passed through to bank deposit and lending rates, with the low-rate environment propping up the equities market.
- Sources cited: CBSL; CEIC Daily Database; Bloomberg Data LP; and IMF staff estimates.

### Foreign exchange and reserves
- The official exchange rate has been de facto fixed since April 2021, while the forward FX market has been volatile.
- Sri Lanka’s rupee has depreciated more than its peers since 2020.
- Nominal effective exchange rate has depreciated over the past years, with real effective exchange rate little changed since 2018.
- Efforts to build up reserves through FX purchases have been hampered since the onset of the pandemic.
- Most foreign holders of local currency T-bills and T-bonds have exited and stayed out.
- GIR have declined amid Sri Lanka’s loss of market access since March 2020, while NIR recently dipped into the negative territory.
- Sources cited: CBSL; Bloomberg Data LP; CEIC Data Company Limited; INS; and IMF staff estimates.

### Monetary and financial sector
- Monetary aggregates expanded rapidly during the pandemic as private credit also started to rebound.
- Central bank holdings of government debt made up for falling NFAs and contributed to reserve money growth.
- Banks’ reported capital adequacy appears largely intact, while NPLs only marginally increased, likely reflecting the loan moratoria introduced during the pandemic.
- The low-rate environment benefited banks’ profitability by widening the net interest margin.
- The banking sector on the whole remains liquid.
- Sources cited: CBSL; and IMF staff estimates.

### Balance of payments and external sector
- Goods exports suffered from lower global demand in 2020, while imports also contracted as the country entered lockdowns and imposed import restrictions.
- As a result, the current account deficit shrank in 2020, while external financing conditions tightened substantially in 2020 as market access was lost.
- Most of Sri Lanka’s reserve accumulation since the late 2000s has been financed by external borrowings, leading to high interest bills for the government and contributing to a persistent current account deficit.
- Sources cited: CBSL; Ministry of Finance; and IMF staff calculations.

### Key statistics and projections (selected exact figures from Table 1 and related tables)
- Real GDP growth (series): 2019: 2.3-3.6; 2020 Act: 3.6; 2021 Act: 2.6; 2022 Proj.: 2.7; 2023 Proj.: 2.8; 2024–26 Proj.: 2.8.
- Inflation (average, Colombo CPI) series: 2019: 4.3; 2020: 4.6; 2021: 6.0; 2022: 10.5; 2023: 7.0; 2024: 6.3; 2025: 5.8; 2026: 5.3.
- Inflation (end-of-period, Colombo CPI) series: 2019: 4.8; 2020: 4.2; 2021: 12.2; 2022: 8.3; 2023: 6.7; 2024: 6.0; 2025: 5.5; 2026: 5.0.
- Public debt (Table 1, public debt 2/ as percent of GDP): 2019: 93.6; 2020: 110.0; 2021: 118.9; 2022: 119.9; 2023: 121.1; 2024: 122.3; 2025: 123.7; 2026: 125.3.
- Central government debt (percent of GDP): 2019: 86.8; 2020: 101.2; 2021: 107.1; 2022: ...; 2023: 108.6; 2024: 110.2; 2025: 111.7; 2026: 113.5; 2026 (alternate): 115.4.
- Gross official reserves (end of period, millions of U.S. dollars): 2019: 7,642; 2020: 5,664; 2021: 3,138; 2022 Proj.: 2,204; 2023 Proj.: 2,386; 2024 Proj.: 2,416; 2025 Proj.: 2,465; 2026 Proj.: 2,532.
- Gross international reserves (Table 4 memo, millions of U.S. dollars): 2019: 7,642; 2020: 5,664; 2021: 3,138; 2022: 2,204; 2023: 2,386; 2024: 2,416; 2025: 2,465; 2026: 2,532.
- Current account balance (in percent of GDP): 2019: -2.2; 2020: -1.3; 2021: -3.8; 2022: -3.8; 2023: -2.8; 2024: -2.6; 2025: -2.6; 2026: -2.6.
- Central government overall balance (percent of GDP): 2019: -8.0; 2020: -12.8; 2021: -11.4; 2022: -8.8; 2023: -9.6; 2024: -9.6; 2025: -9.4; 2026: -9.1.
- Central government interest payments (percent of GDP): 2019: 6.0; 2020: 6.5; 2021: 6.4; 2022: 6.0; 2023: 6.8; 2024: 7.1; 2025: 7.3; 2026: 7.4.
- Central government gross financing needs (percent of GDP): 2019: 20.6; 2020: 26.2; 2021: 30.1; 2022: 32.8; 2023: 36.2; 2024: 36.9; 2025: 38.6; 2026: 40.1.
- Monetary aggregates (Table 3): Broad money (end of period, in billions of rupees): 2019: 7,624; 2020: 9,406; 2021: 10,857; 2022 Proj.: 12,367.
- Net international reserves (millions of U.S. dollars, Table 3): 2019: 5,871; 2020: 3,543; 2021: -334; 2022 Proj.: -919.

### Central government operations (Tables 2a and 2b—selected exact figures)
- Total revenue and grants (in billions of rupees): 2019: 1,899; 2020: 1,373; 2021 Act.: 1,461; 2022 Est.: 2,223; 2023 Proj.: 1,998; 2024 Budget: 2,197; 2025 Proj.: 2,460; 2026 Proj.: 2,704; 2026 alt: 2,968.
- Total expenditure and net lending (in billions of rupees): 2019: 3,095; 2020: 3,284; 2021 Act.: 3,325; 2022 Est.: 3,851; 2023 Proj.: 3,776; 2024 Budget: 4,155; 2025 Proj.: 4,561; 2026 Proj.: 4,979; 2026 alt: 5,373.
- Interest payments (in billions of rupees): 2019: 901; 2020: 980; 2021: 1,054; 2022 Est.: 1,115; 2023 Proj.: 1,262; 2024 Budget: 1,455; 2025 Proj.: 1,621; 2026 Proj.: 1,796; 2026 alt: 1,942.
- Overall balance (in billions of rupees): 2019: -1,196; 2020: -1,910; 2021: -1,864; 2022 Est.: -1,628; 2023 Proj.: -1,778; 2024 Budget: -1,958; 2025 Proj.: -2,101; 2026 Proj.: -2,276; 2026 alt: -2,404.

### Monetary accounts (Table 3—selected exact figures)
- Central Bank of Sri Lanka reserve money (end of period, in billions of rupees): 2019: 933; 2020: 964; 2021: 1,324; 2022 Proj.: 1,508.
- Monetary survey broad money (end of period, in billions of rupees): 2019: 7,624; 2020: 9,406; 2021: 10,857; 2022 Proj.: 12,367.
- Net foreign assets (Central Bank, in billions of rupees): 2019: 896; 2020: 527; 2021: -346; 2022 Proj.: -514.
- Net international reserves (in millions of U.S. dollars): 2019: 5,871; 2020: 3,543; 2021: -334; 2022 Proj.: -919.

### Balance of payments (Table 4—selected exact figures)
- Current account (in millions of U.S. dollars): 2019: -1,843; 2020: -1,083; 2021: -3,153; 2022 Est.: -3,331; 2023 Proj.: -2,504; 2024 Proj.: -2,482; 2025 Proj.: -2,605; 2026 Proj.: -2,711.
- Balance on goods (in millions of U.S. dollars): 2019: -7,997; 2020: -6,008; 2021: -7,796; 2022 Est.: -9,031; 2023 Proj.: -9,346; 2024 Proj.: -9,592; 2025 Proj.: -9,918; 2026 Proj.: -10,187.
- Exports (goods, in millions of U.S. dollars): 2019: 11,940; 2020: 10,047; 2021: 12,222; 2022 Est.: 13,598; 2023 Proj.: 14,254; 2024 Proj.: 15,003; 2025 Proj.: 15,730; 2026 Proj.: 16,474.
- Imports (goods, in millions of U.S. dollars): 2019: -19,937; 2020: -16,055; 2021: -20,018; 2022 Est.: -22,629; 2023 Proj.: -23,600; 2024 Proj.: -24,595; 2025 Proj.: -25,647; 2026 Proj.: -26,661.
- Financial account overall (in millions of U.S. dollars): 2019: -2,469; 2020: 1,484; 2021: -671; 2022 Est.: 238; 2023 Proj.: -373; 2024 Proj.: -322; 2025 Proj.: 285; 2026 Proj.: -910.
- Overall balance (need of inflow, in millions of U.S. dollars): 2019: 9; 2020: -1,744; 2021: -2,470; 2022 Est.: -3,557; 2023 Proj.: -2,119; 2024 Proj.: -2,149; 2025 Proj.: -2,877; 2026 Proj.: -1,789.
- Financing gap (in millions of U.S. dollars): 2019: 336; 2020: -1,690; 2021: -2,470; 2022 Est.: -785; 2023 Proj.: 369; 2024 Proj.: 261; 2025 Proj.: 280; 2026 Proj.: 284.
- Unidentified financing (Table 4): 2019: 0; 2020: 0; 2021: -2,772; 2022 Est.: -2,487; 2023 Proj.: -2,409; 2024 Proj.: -3,157; 2025 Proj.: -2,075.

### Financial soundness indicators and Fund obligations
- Selected banking-sector indicators (Table 5): Regulatory capital to risk weighted assets ranged around 15.7–16.2 across 2018–2021; gross nonperforming loans to total gross loans ranged from 3.0 to 6.0 across the period; return on equity (after tax) series includes 17.2 for 2018 and 15.1 for 2021.
- Projected remaining payments to the Fund (Table 6, in millions of SDR / U.S. dollars): Fund repurchases and charges 2022 Q1–Q4 and beyond listed (e.g., In millions of SDR for 2022 total figures: 50.4; 114.5; 138.1; 166.2; etc.); Fund credit outstanding (in millions of SDR) 2019: 902.3; 2020: 797.9; 2021: 668.8; 2022 Proj.: 510.1; 2023 Proj.: 351.4; 2024 Proj.: 202.7; 2025 Proj.: 83.9; thereafter lower values to 0.0.
- Gross official reserves (Table 6 memo, in millions of U.S. dollars): series includes 3,138 (2021), 2,204 (2022), 2,386 (2023), 2,416 (2024), 2,465 (2025), 2,532 (2026), 3,032 (2027), 3,532 (2028), 4,032 (2029), 4,532 (2030), 5,032 (2031), 5,532 (2032), 6,032 (2033).

*Source: Data excerpts and figures from the IMF staff report content provided in the supplied PDF content unit.*

### Annex I. Implementation of Past Article IV Recommendations

### 1lkaea2022001 - Annex I. Implementation of Past Article IV Recommendations

### Implementation of Past Article IV Recommendations
- Reduce fiscal deficit by mobilizing revenue:
  - In late 2019, the authorities reduced tax rates for corporate income tax (CIT), personal income tax (PIT), and VAT and abolished mandatory income tax withholding for most employees.
  - The 2021 Budget included several new tax exemptions.
  - Revenue administration: e-filing mandatory for CIT from November 2021.
  - Plans to upgrade the fiscal rules were suspended.
- SOE and energy pricing reforms:
  - An automatic fuel pricing mechanism was in place in 2018-19 but is no longer in use.
  - Electricity pricing reform was halted.
  - Plans to restructure Sri Lankan Airlines were suspended.
  - Recommendation to recognize off-budget fuel and electricity subsidies as central government expenditure to prevent buildup of contingent liabilities (implementation not completed).
- External reserves and exchange rate:
  - The CBSL’s cumulative net FX purchases in 2019-21 were negative.
  - The exchange rate is heavily managed through intervention and moral suasion.
- Monetary policy and central bank law:
  - Monetary policy has been largely data driven, consistent with the IT framework, but pandemic and public debt overhang have complicated independent conduct of monetary and exchange rate policies (¶30).
  - A revised central bank law has not been adopted.
- Financial sector regulation and supervision:
  - Prior to COVID-19, measures included implementation of IRFS 9, an increase in the capital adequacy requirement, introduction of liquidity requirements based on Basel standards, and adoption of risk-based supervision of banks.
  - Finalization and adoption of the new Banking Act is expected in 2022 to broaden CBSL regulatory powers and upgrade the resolution framework.
  - Authorities do not see the need to unify regulatory and supervisory frameworks for banks and NBFIs.
- Social safety nets and disaster risk financing:
  - Social safety net reforms have been implemented with mixed progress.
  - Natural disaster related spending has been allocated on an ad hoc basis, not yet following the developed framework.
  - Emergency and disaster management plans are being developed.
- Structural reforms:
  - Trade barriers remain high as authorities favor import substitution.
  - Authorities intend to improve the business and investment climate and encourage female labor force participation, but coherent strategies are yet to be implemented.

### Potential Growth in Sri Lanka (Growth Accounting and Estimates)
- Method and data:
  - Cobb-Douglas production function with capital share α = 0.3.
  - Data from World Bank WDI, Sri Lanka Labor Force Surveys (total employment), and Penn World Table 10.0.
  - TFP (A) computed as the residual.
- Historical drivers:
  - Post-civil war growth spurt in 2010-12 featured faster capital formation and robust productivity growth; subsequent deceleration driven by weaker factor accumulation and TFP.
  - Labor supply contribution decreased notably, coinciding with slowing growth in working age population.
- Adverse events affecting potential:
  - Natural disasters, the 2018 political crisis, the 2019 terrorist attack, chronic BoP challenges, policy uncertainties, and demographic headwinds (aging population) may have lowered growth potential.
  - COVID-19 shock could cause “super-hysteresis” effects if not managed properly.
- Estimated medium-term growth potential:
  - Estimated to be around 3.1–4.1 percent at this juncture.
  - Assumptions:
    - Capital share of income remains 0.3.
    - Growth of labor supply proxied by working age population annualized growth just over 0.1 percent (UN World Population Prospects, medium variant), implying very little labor contribution.
    - Capital contribution projected at around 2 percent over the medium-term.
    - TFP growth expected to fall in the range of 1–2 percent based on backward-looking accounting.
- Historical averages and midpoint:
  - Contribution from capital stock and TFP growth has averaged 1.7 and 1.8 percent, respectively, between 1971–2020.
  - These historical averages, together with projected labor contribution of 0.1 percent, imply a growth potential of around 3.6 percent (midpoint of the estimated range).
- Risks and upside:
  - Downside: lower public capital spending for fiscal consolidation could reduce capital growth and potential.
  - Upside: higher female labor participation, larger than expected FDI inflows, and improved macroeconomic stability/policy certainty could raise capital stock and TFP.

### Risk Assessment Matrix (selected entries)
- Domestic risks:
  - More binding (fiscal and BoP) financing constraints than envisaged under the illustrative baseline scenario:
    - Likelihood: High
    - Expected impact: H (forces disorderly adjustment via import compression, larger spending cuts, arrears, monetary financing, or combination; disrupts production and investment; erodes confidence; destabilizing inflation and exchange rate dynamics)
    - Policy response: Implement a credible and coherent strategy to restore fiscal and debt sustainability, regain macroeconomic stability, and fundamentally address the FX shortage issue, covering near and medium term (see paragraph 18 of staff report).
  - Worse-than-anticipated impact of the temporary chemical fertilizer ban on agricultural production:
    - Likelihood: High
    - Expected impact: H (weighs on growth, aggravates food supply shortages and inflation; emergency food imports add to BoP pressures)
  - Sharper deterioration in banks’ asset quality:
    - Likelihood: Medium
    - Expected impact: M (tightening of domestic credit conditions, potential fiscal costs; hinder access to foreign financing and tighten FX liquidity)
    - Policy response: Stress testing, maintain restrictions on bank profit distributions, recognize and address solvency and capital adequacy issues upfront.
  - Loss of GSP+ preferential trade access to the EU:
    - Likelihood: Medium
    - Expected impact: M (adverse effect on exporting industry and BoP)
    - Policy response: Continue engagement with the EU; liberalize trade regime; improve investment climate to diversify exports.
- External risks:
  - Global resurgence of the COVID-19 pandemic:
    - Likelihood: High
    - Expected impact: H (disrupt economic activity, delay tourism recovery, fuel social discontent)
    - Policy response: Continue vaccination drive to achieve herd immunity; targeted containment to minimize economic impact.
  - Rising commodity prices amid bouts of volatility:
    - Likelihood: Medium
    - Expected impact: H (widen current account deficit, aggravate BoP pressures, add to inflation)
    - Policy response: Restore fiscal and debt sustainability; rely on exchange rate flexibility as first line of defense; tighten monetary policy to preserve price stability.
  - Higher frequency and severity of natural disasters related to climate change:
    - Likelihood: Medium
    - Expected impact: H (disrupt agriculture, increase food inflation, worsen current account, challenge fiscal consolidation)
    - Policy response: Develop comprehensive disaster financing framework, including contingency budgeting and disaster-linked social protections; implement structural reforms to improve growth potential.

### Debt Sustainability Assessment (summary findings and assumptions)
- Overall assessment:
  - In staff’s view, debt is unsustainable. Even under benign financing assumptions, debt would continue to increase under the baseline scenario. Downside risks are substantial.
  - Fiscal consolidation required to bring down debt to safe levels would be too large to be economically and politically feasible.
  - Large fiscal and external financing gaps imply very high rollover risks.
  - Assessment supported by IMF’s new Sovereign Risk and Debt Sustainability Framework (SRDSF).
- Background and key facts:
  - Primary deficits averaged 1 percent of GDP in 2010-19 (on cash basis) and were not enough to reduce debt.
  - Interest bill: 6.5 percent of GDP in 2020.
  - Central government external debt service increased from US$1.3 billion in 2009 to US$4.1 billion in 2020.
  - Public debt-to-GDP ratio increased from 93.6 percent at end-2019 to 113.6 percent at end-September 2021.
  - Public debt projected to reach 118.9 percent of GDP at end-2021 (estimate includes CBSL liabilities of US$1.7 billion from currency swap arrangements).
- Composition and recent developments:
  - Central government debt stood at 101.2 percent of GDP at end-2020; three fifths owed to domestic creditors (including CBSL).
  - Commercial banks held 25 percent of central government debt.
  - At end-September 2021, central government debt was 104 percent of GDP and the domestic share increased to 62 percent.
  - External government debt declined nominally; ISBs maturing in 2020, 2021, and January of 2022 totaling US$2.5 billion were not rolled over.
  - US$1.9 billion decline in external government debt from end-2019 to September 2021 was achieved by drawing down reserves which fell by US$4.9 billion during the same period.
- Contingent liabilities and SOEs:
  - SOE debt reached 15.8 percent of GDP in 2020.
  - Less than half of SOE debt (6.6 percent of GDP in 2020) is covered by explicit guarantees; many SOEs required to supply fuel and electricity below cost recovery, creating fiscal support needs.
- Financing environment and CBSL actions:
  - Sri Lanka lost access to international capital markets in 2020Q1; spreads hovered between 1,000 and 2,700 basis points.
  - All three international ratings agencies downgraded Sri Lanka to CCC and lower.
  - Authorities temporarily imposed strict ceilings on interest rates in treasury security auctions, causing auction shortfalls and primary T-bill purchases by the CBSL.
  - CBSL provided 3.5 percent of GDP in direct financing in 2020 and around 5 percent of GDP in the first 3 quarters of 2021.
- Baseline DSA assumptions and projection:
  - Under the illustrative baseline, projected primary deficit adjusts to 2.8 percent of GDP in 2022 and to 1.8 percent by 2026 (phasing-out COVID-related spending, wage bill restraint, cyclical revenue gains, sharp cut to capital spending due to lack of financing).
  - Growth remains below pre-pandemic trend; guaranteed debt assumed constant as a share of GDP.
  - Financing assumption: necessary external financing mobilized at interest rate of 7 percent to close financing gaps (more benign than likely commercial creditor charges but less generous than bilateral support in 2020–21).

*Source: 1lkaea2022001 - Annex I. Implementation of Past Article IV Recommendations*

### 8.      In staff’s view, current fiscal policies are not sustainable. Under the baseline, public debt

### 8.      In staff’s view, current fiscal policies are not sustainable.

### Fiscal sustainability assessment
- Under the baseline, public debt would keep increasing throughout the projection horizon, reaching 125.3 percent of GDP in 2026 (Figure 1).
- Interest payments will remain above 70 percent of tax revenues throughout the projection horizon.
- The deficit generates financing needs that exceed the domestic financial system’s capacity.
- Continued reliance on central bank financing would eventually lead to a de-anchoring of inflation expectations.
- Despite improvements in commitment control, the size of the fiscal financing challenge suggests that new domestic expenditure arrears could emerge in the years ahead.

### Contingent liabilities from state-owned enterprises (SOEs)
- CEB and CPC’s balance sheets remain highly exposed to currency fluctuations.
- Unless international fuel prices and energy generation costs are passed through to consumers, CPC and CEB are likely to incur further operational losses.
- Sri Lankan Airlines, already in distress before the pandemic, was hit hard by the pandemic and is in need of regular transfers from the government.
- Sri Lankan Airlines will most likely also need support to service its Eurobond (US$175 million) maturing in 2024.
- At end-2020, credit to the government accounted for 31 percent of banking sector assets.
- The baseline scenario assumes net domestic financing of 5 percent of GDP for 2023-26, a level consistent with limited crowding-out of credit to the private sector and a slowdown in money growth relative to 2020–21.

### Macroeconomic and shock risks to the debt trajectory
- The debt trajectory is subject to large macroeconomic risks, including pandemic uncertainty and sensitivity to exchange rate shocks.
- Inflationary pressures from recent monetary expansion would lead to a lower real interest rate in the short term but could eventually cause the CBSL to raise its policy rates.
- While banks appear well capitalized, asset quality in the financial sector remains uncertain.
- Shock scenarios (Figure 4) indicate high sensitivity of the outlook to shocks, including:
  - materialization of SOE contingent liabilities (10 percent of outstanding guaranteed debt per year); and
  - materialization of a one-time financial sector contingent liability shock in 2022.
- Most vulnerability indicators in the heatmap (Figure 5) signal high risk.

### Staff judgment on debt sustainability and financing needs
- In staff’s view, Sri Lanka’s debt is unsustainable.
- Fiscal consolidation necessary to bring debt down to safe levels would require excessive adjustment over the coming years, pointing to a clear solvency problem.
- The DSA realism tools (see Figure 3) indicate that the primary balance adjustment projected under the baseline already falls into the top 10th percentile of historically observed consolidations across countries.
- A more ambitious adjustment, required to significantly reduce debt, would put Sri Lanka even further into the upper tail.
- Rollover risk is very high.
- FX debt service needs of US$7 billion each year will require access to very large amounts of external financing at concessional rates and long maturities, sustained over many years.

*Source: IMF staff analysis as presented in the original content unit.*

### 12.      To further assess debt risks, several model-based approaches are used (Figure 6).

### 1lkaea2022001 - 12. To further assess debt risks, several model-based approaches are used (Figure 6)

### SRDSF model-based risk assessment — summary findings
- The new SRDSF tools indicate high near and medium-term risks under the baseline scenario.
- Near-term stress logit model:
  - Flags an increase in the stress probability to close to 80 percent, driven by the debt-to-revenue ratio and the annual change in debt to GDP.
- Medium-term tools indicate high risk:
  - GFN tool indicates high risk, due to (i) elevated GFN in 2021-26, and (ii) an already high level of banking sector credit to the government (as a share of banking sector assets), limiting the ability to provide additional domestic financing in case of a renewed loss of market access.
  - Fan chart tool indicates high risk, due to the 2026 central government debt level and the debt stabilization probability of only 23 percent.
- Staff analysis under an ambitious adjustment scenario with more favorable growth assumptions:
  - The risk ratings would remain unchanged, supporting staff’s assessment of unsustainable debt.

### Key model outputs and indices (Figure 6 SRDSF results)
- Debt fanchart components and mechanical signal:
  - Fanchart width: 62.7% (Index 0.53)
  - Prob of debt non-stabilization: 76.9% (Index 1.12)
  - Debt(t+5) x institutions: 72.2% (Index 1.57)
  - Debt fanchart index: 3.21 → Signal: High
  - Thresholds: Moderate-high 2.08; Low-moderate 1.13
  - Memo:
    - Debt(t+5): 113.8%
    - Institutional quality index: 0.63
- GFN financeability index (components and signal):
  - Indicator weights and values:
    - Average GFN-to-GDP ratio in the baseline: weight 0.34; value 35.1%
    - Initial bank claims on the govt (pct of assets): weight 0.32; value 31.0%
    - Change in bank claims on govt, stress scenario (pct of assets): weight 0.33; value 5.2%
  - GFN financeability index: 23.8 → Signal: High
  - Thresholds: Moderate-high 17.9; Low-Moderate 7.6

### Public debt outlook and stress-test highlights (selected figures and projections)
- Nominal gross public debt (percent of GDP), selected years:
  - 2019: 79.7
  - 2020: 93.6
  - 2021: 110.0
  - 2022: 118.9
  - 2023: 119.9
  - 2024: 121.1
  - 2025: 122.3
  - 2026: 123.7
  - 2026 (alternate label): 125.3
- Public gross financing needs (percent of GDP), selected values:
  - 2019: 21.1
  - 2020: 20.6
  - 2021: 26.2
  - 2022: 30.1
  - 2023: 32.8
  - 2024: 36.2
  - 2025: 36.9
  - 2026: 38.6
- Real GDP growth (in percent), projections:
  - 2019: 5.6
  - 2020: 2.3
  - 2021: -3.6
  - 2022: 3.6
  - 2023–2026: 2.6, 2.7, 2.8, 2.8 respectively (noted in plots)
- Debt dynamics and stabilization metrics:
  - Debt stabilization probability (fan chart): 23 percent (implied by narrative)
  - Change in gross public sector debt (cumulative projection 2021–2026): 15.3 (percent of GDP)
  - Identified debt-creating flows (2019–2026 cumulative scenarios shown in table and charts)
- Stress-test scenarios presented (macro-fiscal and additional tests):
  - Primary Balance Shock, Real GDP Growth Shock, Real Interest Rate Shock, Real Exchange Rate Shock, Combined Shock, Contingent Liability Shock, SOE contingent liability shock.
  - Charts show severe increases in gross nominal public debt and public gross financing needs under several shocks (percent-of-GDP and percent-of-revenue scales indicated in figures).

### Composition of public debt (selected entries from Table 1, end-2019 and end-2020)
- Total public and publicly guaranteed debt and CBSL external liabilities:
  - end-2019: 14,048 billion Rupees / 77,343 million USD / 93.6 percent of GDP
  - end-2020: 16,472 billion Rupees / 88,364 million USD / 110.0 percent of GDP
- Central government debt:
  - end-2019: 13,032 billion Rupees / 71,746 million USD / 86.8 percent of GDP / 100.0 percent of central govt. debt
  - end-2020: 15,158 billion Rupees / 81,318 million USD / 101.2 percent of GDP / 100.0 percent of central govt. debt
- Domestic currency central government debt (end-2019 / end-2020):
  - 6,005 billion Rupees / 33,061 million USD / 40.0 percent of GDP / 46.1 percent of central govt. debt
  - 7,948 billion Rupees / 42,639 million USD / 53.1 percent of GDP / 52.4 percent of central govt. debt
- Foreign currency central government debt (end-2019 / end-2020):
  - 7,027 billion Rupees / 38,686 million USD / 46.8 percent of GDP / 53.9 percent of central govt. debt
  - 7,210 billion Rupees / 38,678 million USD / 48.2 percent of GDP / 47.6 percent of central govt. debt
- Selected creditor composition (end-2019 / end-2020):
  - Multilateral: 1,470 / 8,092 / 9.8% of GDP / 11.3% central govt. debt → 1,642 / 8,811 / 11.0% / 10.8%
  - Bilateral (total): 1,132 / 6,232 / 7.5% / 8.7% → 1,163 / 6,239 / 7.8% / 7.7%
  - Commercial: 4,425 / 24,361 / 29.5% / 34.0% → 4,404 / 23,628 / 29.4% / 29.1%
  - International sovereign bonds (part of foreign law): 2,734 / 15,050 / 18.2% / 21.0% → 2,619 / 14,050 / 17.5% / 17.3%
- CBSL external liabilities and Fund credit outstanding (selected):
  - CBSL external liabilities (end-2019): 238 billion Rupees / 1,312 million USD / 1.6% of GDP
  - Fund credit outstanding (end-2019): 238 billion Rupees / 1,312 million USD / 1.6% of GDP
  - Fund credit outstanding (end-2020): 253 billion Rupees / 1,355 million USD / 1.7% of GDP

### Assessment implications
- Multiple model-based approaches (SRDSF tools, GFN tool, fan chart, stress-tests) consistently indicate high debt vulnerability in the near and medium term under the baseline and under an ambitious adjustment scenario.
- The combination of elevated public gross financing needs through 2021-26, high central-government debt levels projected for 2026 (Debt(t+5) 113.8%), and significant banking sector exposure to government debt (initial bank claims on govt 31.0% of assets) constrains domestic financing capacity and raises recession/market-access risks.
- Overall model outputs support staff’s assessment that Sri Lanka’s public debt is unsustainable under the baseline and remains vulnerable under alternative, more optimistic growth assumptions.

*Source: Sri Lankan authorities and IMF staff estimates (extracted content from the IMF chapter "1lkaea2022001 - 12. To further assess debt risks, several model-based approaches are used (Figure 6)").*

### Annex V. External Sector Assessment

### 1lkaea2022001 - Annex V. External Sector Assessment

### Assessment summary
- Sri Lanka’s external position in 2021 is assessed as weaker than the level implied by medium-term fundamentals and desirable policies.
- External debt vulnerabilities are high, and reserves remained precariously low against an adequate level.
- Improving the external position requires: implementing revenue-based fiscal consolidation, restoring debt sustainability, conducting prudent monetary policy with greater exchange flexibility, rebuilding international reserves to adequate levels, and structural reforms to boost export capacity and encourage FDI in export-oriented sectors.

### Balance of payments shocks and trajectory
- 2020 pandemic and loss of market access:
  - Current account deficit narrowed to 1.3 percent of GDP in 2020 from 2.2 percent in 2019.
  - Gross international reserves (GIR) decreased from US$7.6 billion at end-2019 to US$5.7 billion at end-2020.
  - Average REER: appreciation of 1 percent in 2020; REER depreciated by 6 percent through October 2021.
  - Maturing Eurobonds: $1 billion repaid out of GIR in October 2020.
- 2021 and medium-term outlook:
  - Projected 2021 current account deficit: -3.8 percent of GDP.
  - GIR declined to US$3.1 billion at end-December 2021.
  - Current account deficit expected to gradually decline to around 2.6 percent of GDP by 2026 as tourism recovers.
  - Financial account and GIR expected to remain under pressure due to large government external financing needs.

### External liabilities, NIIP, and debt sustainability
- Net external liabilities:
  - Increased from 53 percent of GDP (average during 2012-2017) to 65 percent of GDP in 2020.
  - Gross external liabilities rose from 67 to 78 percent of GDP in 2018-20.
  - Gross external assets remained at 13 percent of GDP.
- Composition:
  - FDI accounted for about a quarter of net external liabilities.
  - Other investment (debt portfolios and/or bank loans) accounted for about 60 percent.
  - Some 85 percent of total debt liabilities (66 percent of GDP) are long-term.
  - Government holds close to two thirds of total external debt liabilities.
- Staff view: Sri Lanka’s public debt is unsustainable (Annex IV). Restoring debt sustainability will help raise NIIP and reduce external sustainability risks.

### External Balance Assessment (EBA) results and REER assessment
- EBA CA model and adjustments:
  - Projected 2021 CA: -3.8% of GDP.
  - Cyclical contributions: 0.7%.
  - Cyclically adjusted actual CA (2021): -4.5% of GDP.
  - Additional temporary factors (COVID-19 tourism adjustor): 1.7%.
  - Adjusted projected CA: -2.7% of GDP.
  - CA Norm (from model): -1.6% of GDP.
  - Adjustment to the norm (to ensure sustainability): 1.9% of GDP.
  - Adjusted CA Norm: 0.3% of GDP.
  - CA Gap (Adjusted CA - Adjusted CA Norm): -3.0% of GDP.
    - Of which relative policy gap: -2.1% of GDP.
      - Fiscal balance: -0.5% of GDP.
      - Health expenditure: 0.3% of GDP.
      - Change in FX reserves: -1.7% of GDP.
      - Private credit: -0.3% of GDP.
      - Capital controls: 0.2% of GDP.
    - Residual: -0.9% of GDP.
  - Elasticity: -0.18.
  - REER gap calculated: 16.8% (3/ [11] = [9]/[10]).
- Alternative EBA approaches:
  - EBA-lite REER model: REER overvaluation of about 14.8 percent.
  - EBA External Sustainability (ES) approach: REER overvaluation of about 3 percent.
- Staff assessment:
  - Placing greater weight on EBA CA and EBA-lite, staff assesses Sri Lanka’s external position is weaker than fundamentals and policies imply.
  - Negative current account gap in 2021 exceeds 2 percent of GDP and is consistent with a REER overvaluation of about 17 percent.

### Reserve adequacy and external financing pressures
- GIR and ARA metric:
  - GIR as percent of Fund’s ARA metric: declined from 62 percent at end-2019 to 46 percent at end-2020 and 25 percent at end-December 2021.
  - Recommended adequacy range: 100-150 percent of ARA metric.
- FX debt service needs:
  - FX debt service for 2022–26: $7-8 billion per year, including maturing International Sovereign Bonds of $1–2 billion per year.

### Exchange rate policy and FX interventions
- CBSL interventionist approach:
  - Between March 2020 and November 2021, CBSL cumulatively sold $4.4 billion and purchased $4.3 billion in spot and forward FX markets including through swap transactions.
  - Rupee was allowed to fluctuate through March 2021, then de-facto pegged to the U.S. dollar since April 2021.
  - Parallel market quotes once reported at around 20 percent premium (limited scale).
  - Until mid-September 2021, private commercial banks offered more depreciated exchange rates than official one to some clients.
- Policy measures used to stabilize FX:
  - Suspension of certain non-priority imports.
  - Surrender requirements for exports and converted remittances.
  - Other capital controls.

### Capital flow management measures (CFMs)
- 2020 impacts and policy response:
  - Net capital inflows declined by 4.8 percent of GDP in 2020.
  - FDI inflows declined by 37 percent in 2020.
  - Portfolio investment inflows reversed, with foreign holdings of domestic government securities declining from about 0.6 percent of GDP at end-2019 to about 0.1 percent of GDP at end-2020.
- CFMs introduced/extended:
  - April 2020 measures and further tightenings in 2021.
  - Main CFMs currently in force include:
    - (i) repatriation requirement for exports of goods and services;
    - (ii) surrender requirement for exporters on proceeds from exports of goods and services;
    - (iii) surrender requirement for banks on purchases of export proceeds;
    - (iv) surrender requirement for banks on purchases of inward worker remittances;
    - (v) suspension of outward remittances on capital transactions;
    - (vi) restrictions on purchases of Sri Lankan ISBs by local banks;
    - (vii) restrictions on outward transfers of funds for emigrants for emigrants.
  - Between September and October 2021, CBSL temporarily introduced a 100 percent non-interest-bearing cash margin deposit requirement on Letters of Credit for importing over 600 consumer goods and prohibited banks from lending to importers to meet these margins.
  - Measures (i) and (vii) constitute tightenings of existing CFMs; others are new CFMs on outflows.
- Role and guidance:
  - CFMs may be needed in the near term to mitigate capital outflow risks, but should not substitute for warranted macroeconomic adjustment.
  - To facilitate private inflows, CBSL also offered free FX cover for non-resident investment into domestic government securities and for private sector FX borrowing and lifted limits on short term FX borrowing by commercial banks.

### Import restrictions (Annex VI): scope, savings, and costs
- 2020 import restriction overview:
  - Temporary suspension of imports of non-priority/non-essential goods and licensing regimes (ICR #1-11 of 2020 and ICR #1-15 of 2021).
  - Initially focused on consumer goods (notably personal vehicles) and later expanded in 2021 to intermediate and investment goods (e.g., pneumatic tyres, ceramic products, palm oil, special purpose motor vehicles, chemical fertilizers).
  - Some exemptions: imports for exports; importation using funds of foreign buyers; raw materials not available locally for manufacturing with at least 35 percent local value added; imports required for flagship projects (except those in MOF "Negative List").
- Estimated gross savings and overruns:
  - Estimated gross savings of the import bill in 2020: about US$1.2 billion (1.5 percent of GDP).
  - Total goods imports: US$19.9 billion (24 percent of GDP) in 2019 to US$16.1 billion (20 percent of GDP) in 2020.
  - Top 3 gross savings in 2020:
    - Ban on importing personal vehicles: $506 million (43 percent of total gross savings).
    - Restrictions on transport equipment: $139 million (12 percent).
    - Building materials: $90 million (8 percent).
  - Consumer goods accounted for 70 percent of gross savings ($827 million); investment and intermediate goods accounted for 7 percent and 23 percent, respectively.
  - Largest overruns occurred in oils and fats, household and furniture items, and machinery and equipment.
- 2021 incremental savings and composition:
  - Expected incremental savings in 2021: about US$0.8 billion (0.9 percent of GDP).
  - Import restrictions over 2020–21 expected to save the imports bill by 2.4 percent of 2021 GDP.
  - Incremental savings sources: continuation of 2020 restrictions and new 2021 restrictions contribute about 50 percent each.
  - Composition of incremental savings: about $276 million (36 percent) on consumer goods; $487 million (64 percent) on intermediate and investment goods.
- Economic costs and sector impacts:
  - New 2021 restrictions disproportionately limit intermediate goods (27 percent of savings) and capital imports (37 percent), harming domestic production and investment.
  - Affected macro-critical sectors: agriculture (8 percent share of GDP) and transport (11 percent share of GDP).
  - Example impacts:
    - Chemical fertilizer ban introduced in May 2021 (revoked late November 2021) hurt tea and rubber production and exports and weighed on domestic rice production, necessitating rice imports.
    - Vehicle import ban increased prices of used vehicles and squeezed consumer access during the pandemic.
    - Local rice market experienced high prices due to lack of competition and import ban; emergency imports of 100,000 metric tons were approved in June 2021 and the rice import ban removed in November 2021.
- Policy recommendation:
  - While import restrictions reduce BoP pressures, they inhibit trade, impede economic growth, and distort markets; authorities should develop a schedule for them to be phased out.

*Source: Annex V and Annex VI. External Sector Assessment and Import Restrictions (content unit 1lkaea2022001).*

### Annex VII. The Social Safety Net: Recent Developments and

### Annex VII. The Social Safety Net: Recent Developments and Reform Priorities

### Recent developments and the COVID-19 pandemic
- Total welfare spending composition and levels (2020):
  - Total welfare spending: 580,900 million Rupees, 3.9 percent of GDP.
  - Social Safety Net programs: 131,918 million Rupees, 0.9 percent of GDP.
  - Cash transfer programs: 64,110 million Rupees, 0.4 percent of GDP.
  - Samurdhi (cash transfer and other programs): 52,434 million Rupees, 0.4 percent of GDP.
  - Assistance to elderly (over 70 years of age): 9,868 million Rupees, 0.1 percent of GDP.
  - Disability allowance: 32 million Rupees, 0.0 percent of GDP.
  - Allowance for kidney patients: 1,776 million Rupees, 0.0 percent of GDP.
  - Covid-19 relief: 67,571 million Rupees, 0.5 percent of GDP. 1/ (Excluding Rs.11.7 billion cash relief recorded under the Samurdhi program, and Rs. 38.2 billion Covid spending for quarantine, health infrastructure, and others.)
  - Additional cash transfers: 57,652 million Rupees, 0.4 percent of GDP.
  - Livelihood support program: 9,919 million Rupees, 0.1 percent of GDP.
  - Disaster assistance: 237 million Rupees, 0.0 percent of GDP.
  - Other welfare spending: 448,982 million Rupees, 3.0 percent of GDP.
  - Education (scholarships, nutrition programs etc.): 24,191 million Rupees, 0.2 percent of GDP.
  - Pension: 257,833 million Rupees, 1.7 percent of GDP.
  - Assistance to military families: 37,460 million Rupees, 0.3 percent of GDP.
  - Subsidies (mostly on agriculture): 39,595 million Rupees, 0.3 percent of GDP.
  - Free medicines (in public hospitals): 83,685 million Rupees, 0.6 percent of GDP.
  - Public facilities (including free transport): 6,218 million Rupees, 0.0 percent of GDP.
  - Source note: IMF Staff estimates based on the Ministry of Finance Annual Report 2020.

- Trends and program coverage:
  - Total welfare spending rose from 2.5 percent of GDP on average during 2010–2014 to 3 percent of GDP during 2015-19; surged to 3.9 percent of GDP in 2020 driven by COVID-19 relief of about 0.5 percent of GDP.
  - SSN spending doubled from 0.2 percent of GDP on average during 2010–14 to 0.4 percent of GDP during 2015–20 (excluding COVID-19 relief).
  - Samurdhi remains the largest SSN program, benefiting nearly 1.8 million households (31 percent of total households) with monthly cash grants ranging Rs 420–3,500 for households earning less than Rs 1,500/month.
  - In 2020 authorities allocated additional Rs. 67.6 billion for monthly cash grants of Rs. 5,000/family and in-kind transfers during March–April and October–November.
  - Total COVID-19 related spending in 2020 estimated at Rs. 117.5 billion (0.8 percent of GDP), including Rs. 49.9 billion (0.3 percent of GDP) for quarantine, health infrastructure, medicines, and others. A further Rs. 210 billion (1.3 percent of GDP) was allocated in 2021, including Rs. 18.5 billion (0.1 percent of GDP) for cash transfers and an estimated Rs. 191.5 billion (1.2 percent of GDP) for vaccination, quarantine, medical supplies and infrastructure, and other COVID-19 measures.
  - Preliminary phone-survey evidence (UNICEF/UNDP 2020) found COVID-19 relief measures reached 66 percent of households.

- Poverty and distributional impacts:
  - World Bank (2021) estimates: $3.2/day poverty rate increased from 9.2 percent in 2019 to 11.7 percent in 2020.
  - $1.9/day (extreme) poverty rate is expected to have doubled since 2019.
  - Poverty gap estimated to increase from 17.9 percent in 2019 to 20 percent in 2020, indicating that 500,000 have fallen into poverty due to COVID-19.
  - World Bank estimates COVID-19 relief measures could reduce the share of population living under the $3.2 poverty line by 1.4 percent from the estimated baseline of 11.7 percent in 2020.

### Challenges and reform progress
- Key challenges:
  - Low spending and modest transfers:
    - SSN spending (excluding COVID-19 relief) has remained at 0.4 percent of GDP, lower than regional peers and Asian emerging market and developing countries.
    - Monthly cash allowance of Rs. 5,000/household was distributed only in some months during the lockdown in 2020–21; in 2020, on average each eligible household received Rs. 22,000, about 7 percent of annual expenditure of the poorest households, or less than 2 percent of annual revenue of micro informal firms (pre-pandemic).
    - Poorer households tend to be larger and therefore receive lower transfers per person.
  - Coverage and targeting shortcomings:
    - Samurdhi: 69 percent of beneficiaries come from the poorest 40 percent of households, but UNICEF (2020) found 58 percent of households who were meant to receive Samurdhi did not receive the benefits (exclusion error), while 58 percent of households who were not supposed to receive have in fact received the benefits (inclusion error).
    - Causes include lack of a centralized and integrated eligibility system, no standard reporting and sharing of household data between programs, discretionary beneficiary selection at local levels, absence of effective exit mechanisms, and political obstacles to removing ineligible beneficiaries.
  - Institutional and implementation constraints:
    - Welfare Benefits Board (WBB) established in 2016 but functioning and reform implementation slower than expected due to limited capacity, fragmented institutions, complex legal constraints, and the COVID-19 pandemic.
    - New eligibility criteria for Samurdhi established in 2019 (objective and verifiable characteristics) have not been implemented because Parliamentary approval, supporting regulations, and completion of the social registry are pending.
    - Technical infrastructure completion is important given increased poverty and vulnerability from the pandemic.

- Reform progress:
  - Updates to social registry and digital systems:
    - Progress in updating household data in the social registry and developing the Integrated Welfare Management System (IWMS), the first e-Government system to integrate information across government administration levels.
    - IWMS aims to digitalize the registry to improve identification, enrollment, delivery of support, management of disbursements, queries, appeals, and complaints.
    - Department of Samurdhi Development initiated a pilot targeting mechanism to identify the poorest households for cash transfers and gradually transition others to a lighter package of support.
  - National Social Protection Strategy (NSPS):
    - NSPS being developed by the National Planning Department under the Ministry of Economic Policies and Plan Implementation in consultation with the Presidential Task Force for Economic Revival and Poverty Alleviation; task force established in April 2020.
    - NSPS process early-stage with a first draft expected by 2022; expected to identify medium-term challenges and policies and provide an action plan for coordination, delivery systems, and resource commitments.

### Policy priorities and recommendations
- Macroeconomic priority:
  - Provide adequate fiscal space to raise SSN spending and broaden coverage while keeping it affordable and better targeted.
  - Maintain SSN spending above pre-pandemic levels with improved targeting.
  - Suggested approaches:
    - Graduate high-income Samurdhi beneficiaries onto lighter sub-programs (livelihood and empowerment programs).
    - Target cash transfers toward the poorest 40 percent of households and increase the per-household transfer amount.
    - Raise disability and kidney disease benefits (currently reaching only about half of eligible households).
    - Expand elderly benefit in line with aging population.

- Structural and implementation priorities:
  - Near-term (while NSPS is formulated):
    - Complete the social registry and IWMS with focus on digitalization and systems development to make delivery more responsive and adaptive to economic shocks.
  - Medium-term:
    - Establish an institutional framework to coordinate welfare programs and lead reforms in line with NSPS.
    - Develop effective coordination among fragmented institutions that manage social protection programs.
    - Ensure supporting infrastructure (digital recording and delivery system, social registry, IWMS) is well-functioning to enable improved coverage and targeting.
  - Governance and transparency measures implicit in reform progress:
    - Implement objective, verifiable eligibility criteria once technical infrastructure and legal/regulatory approvals are in place.
    - Introduce effective exit mechanisms and reduce discretionary local-level beneficiary selection to improve transparency and targeting.

*Source: IMF Staff estimates based on the Ministry of Finance Annual Report 2020 and Annex VII.*

### 5.      Compliance with international tax standards is important for avoiding negative

### 5.      Compliance with international tax standards is important for avoiding negative perceptions

### Compliance with international tax standards
- Creation of a low-tax jurisdiction is likely to draw attention from the international community given a renewed focus on such matters, including in the context of the recently agreed OECD-led Inclusive Framework (which introduces a global minimum tax of 15 percent for large multinational corporations starting 2023).
- It would therefore be important to adhere to international tax and regulatory standards and information exchange agreements established with foreign counterparts, including those guided by the OECD’s Common Reporting Standard.
- Footnote note: As of February 2022, Sri Lanka has not endorsed the agreement. However, a uniform global minimum tax rate, once widely adopted, implies that any concessions offered below such level would just constitute a transfer of taxing power to other countries.

### Regulation and supervision of offshore financial services
- Offshore financial services should be regulated and supervised in keeping with global norms to shield the domestic financial sector from offshore activities in the Port City.
- Regulations should be carefully drafted to avoid major regulatory gaps between the onshore and offshore financial sectors and by ensuring the CBSL’s adequate representation in the offshore financial sector regulatory authority (provided for by the SEZ legislation).
- Offshore institutions should be prohibited from:
  - providing financial services to residents, and
  - accessing the central bank’s liquidity window and deposit insurance in Sri Lanka.
- Any direct or indirect financial linkages between the onshore and offshore financial sectors (including through cross-ownership) should be closely monitored to assess and mitigate potential spillover risks.
- This is particularly important given the scope to improve regulatory and supervisory requirements for non-bank financial institutions.

### Transparency, AML/CFT, and information exchange
- Stronger transparency requirements would help alleviate AML/CFT concerns associated with offshore financial services.
- Full compliance with international standards on reporting, supervision, bank secrecy, and beneficial ownership, and customer due diligence requirements would help mitigate risks of illicit financial flows through the Port City.
- The current AML/CFT legal framework in Sri Lanka is expected to be applicable to the new offshore banks/financial institutions.
- The Financial Intelligence Unit’s AML/CFT responsibilities should extend to offshore financial services in the Port City and adequate due diligence checks should be carried out on all prospective offshore financial institutions, especially those that originate from higher risk jurisdictions.
- A renewed commitment to comply with FATF standard will be welcome to avoid potential adverse impact on capital inflows of any non-compliance.

### Investment promotion strategy and tax incentives
- The Port City project provides a good opportunity for attracting foreign investment and for experimenting with growth enhancing reforms that are otherwise more difficult to undertake in the onshore economy.
- While the idea of setting up a one-stop shop to facilitate foreign investment is welcome, it would not by itself be sufficient to alleviate the macroeconomic challenges faced by Sri Lanka.
- Fundamental policy adjustments and structural reforms aimed at restoring macro stability and improving the business and investment climate are needed.
- Tax incentives:
  - Tax incentives are often not a critical determinant for attracting investment and the revenue forgone could be better spent on human capital and infrastructure, while improving the doing business environment.
  - An investment promotion regime resting on discretionary incentives is not conducive for attracting new investors as it lacks transparency and clarity.
- Footnote note: The ringfencing needs to be rigorous enough to ensure tax concessions and exemptions are not granted on transactions and/or income that are linked to onshore business activities, in order to mitigate risks of tax evasion by resident companies. However, such ringfencing would be costly to administer and prone for abuse; and could be perceived as “harmful tax competition” by the OECD and the EU. A codified investment tax credit based on stringent qualifying criteria would be more efficient, less prone to abuse, and more effective in preserving the tax base than discretionary tax holidays.

*SRI LANKA STAFF REPORT FOR THE 2021 ARTICLE IV CONSULTATION—INFORMATIONAL ANNEX*

### 1. We thank the mission team led by Mr. Nozaki for the frank discussions held in Colombo

### 1lkaea2022001 - 1. We thank the mission team led by Mr. Nozaki for the frank discussions held in Colombo

### Background and Growth Outlook
- Sri Lanka entered the COVID-19 pandemic after a weakened position exacerbated by the Easter Sunday terrorist attacks in 2019, which severely affected tourism and investor confidence.
- The economy recorded its second annual contraction in history in 2020, contracting by 3.6 percent; IMF had predicted 4.6 percent and the World Bank had predicted 6.7 percent.
- Authorities expect:
  - economic growth of around 4 percent in 2021;
  - improvement to around 5 percent in 2022.
- Vaccination progress (authorities’ figures):
  - more than 65 percent of the population fully vaccinated;
  - more than 78 percent receiving at least one dose;
  - more than 30 percent receiving the booster dose.
- Tourism and market indicators:
  - more than 136,000 tourists visited in the first 1 ½ months of 2022 (compare: average of 350,000 arrivals during the same period in 2018 and 2019);
  - Colombo All Share Price Index increasing 80.5 per cent in 2021;
  - Purchasing Managers’ Indices (PMIs) for both manufacturing and services have shown expansionary trends since Q3 2021.
- GDP rebasing (with IMF technical assistance):
  - rebasing to year 2015 expected by March 2022;
  - expected to result in 5-8 percent higher nominal GDP annually from 2015 than currently recorded, reflecting improved coverage of Colombo Port City and the digital economy.

### Fiscal Policy, Labor Market, Poverty, and Structural Reforms
- Fiscal context:
  - pandemic affected revenue collection, expenditure management, and financing amid necessary fiscal interventions;
  - government committed to medium term fiscal consolidation.
- Revenue and expenditure measures:
  - measures to recoup revenue losses include a one-time surcharge tax, introduction of a special Goods and Services Tax (GST), a social security contribution, and increasing the Value Added Tax (VAT) on financial services;
  - expenditure management strengthened by quarterly commitment ceilings in Budget 2022;
  - government enacted Fiscal Management (Responsibility) (Amendment) Act No. 12 of 2021 targeting debt to GDP ratio at 60 percent by 2030.
- Fiscal targets:
  - overall fiscal deficit planned to be brought down from around 11.1 percent of GDP in 2021 to 4.4 percent by 2024;
  - a primary surplus expected in 2024.
- SOE and energy reforms:
  - reforms ongoing for SOEs including Ceylon Petroleum Corporation (CPC), Ceylon Electricity Board, and SriLankan Airlines;
  - domestic petroleum prices revised in June and December 2021 to improve CPC balance sheet;
  - policy to increase reliance on renewable energy to 70 percent by 2030.
- Labor market and social measures:
  - authorities concerned about pandemic effects on labor markets and poverty;
  - long-term measures noted and pursued: raise female labor force participation, address informality, pension reforms, address inequality, better targeting of welfare, improve resilience to climate change;
  - increase of retirement age of government officials implemented in 2022 to extend population dividend and productivity gains.

### External Sector Developments and Policies
- Tourism and remittances:
  - loss of over US$10 billion in tourism earnings over about 2 ½ years due to Easter attacks and the pandemic;
  - authorities expect over one million tourist arrivals in 2022 (compare: 2.3 million arrivals in 2018).
  - workers’ remittances declined from US$7.1 billion in 2020 to US$5.5 billion in 2021 (a 22.7 percent decline).
  - measures to encourage formal remittance channels include incentives and digital solutions; temporary additional incentive of Rupees 8 per US$ remitted through formal channels, in place until the end of the traditional festive season in April 2022.
- Trade and current account:
  - merchandise exports recorded historically highest value in 2021; imports rose after removal of most restrictions, widening the trade deficit;
  - other services exports, including IT/BPO, estimated to have recorded healthy expansion in 2021;
  - external current account deficit likely expanded to around 3.5 percent of GDP in 2021 (previous year: 1.3 percent of GDP).
- Non-debt inflows and reserve-building:
  - measures to strengthen non-debt foreign exchange inflows:
    - diversify merchandise and services exports with partner economies;
    - enhance remittances through skilled and semi-skilled migration and digital transfers;
    - attract investments including monetization of non-strategic and under-utilized state assets;
    - absorb part of export proceeds and workers’ remittances to build non-borrowed foreign exchange reserves.
  - Central Bank absorbed around US$ 700 million in 2021 and thus far in 2022.
- Bridging financing and external debt exposure:
  - interim Road Map to secure bridging financing from a number of countries, including swaps with People’s Bank of China, Reserve Bank of India, and Bangladesh Bank (noted by staff as part of public debt in the Report);
  - observed reduction in exposure to International Sovereign Debt market from US$15.05 billion at end 2019 to US$11.55 billion by end 2022.
- SDR allocation:
  - Sri Lanka received SDR 554.8 million from IMF general allocation in August 2021.

### Inflation, Monetary Policy, and the Financial Sector
- Inflation:
  - recent rise in inflation driven mainly by food inflation (latest at 25 percent), rising petroleum prices, and supply chain disruptions.
  - government measures taken to mitigate impact on cost of living.
- Monetary policy actions:
  - Central Bank tightened monetary policy since August 2021 and further increased policy rates in January 2022 within a flexible inflation targeting framework that envisages inflation in a target range of 4-6 percent over the medium term.
  - monetary measures taken since August 2021 include:
    - increased policy rates;
    - allowing interbank market rates to increase to the upper bound of the policy interest rate corridor;
    - allowing liquidity in the domestic money market to move into negative territory;
    - removal of maximum ceilings on auctions for Government securities;
    - allowing market interest rates to adjust upwards.
  - Central Bank committed to ensuring an early return of inflation to the target range.
- Financial sector resilience and reforms:
  - financial sector described as resilient amid the pandemic;
  - supports and moratoria for affected sectors to be phased out;
  - commitments to strengthen regulatory, supervisory, and resolution frameworks;
  - develop frameworks for the planned international financial center in Colombo Port City;
  - fast-track consolidation master plan for non-bank financial institutions;
  - continued strengthening of AML/CFT frameworks; Sri Lanka was removed from the FATF gray list in October 2019;
  - planned amendments expected to be enacted this year to: Financial Transactions Reporting Act, Prevention of Money Laundering Act, and Suppression of Terrorist Financing Act; improvements to reporting and beneficial ownership registry.

### Technical Assistance and Capacity Building
- Authorities thank IMF and development partners for technical assistance and capacity building support, particularly in macro statistics, macro modelling, fiscal, financial, and monetary policy analyses and operations.

### Concluding Remarks and Requests to the Fund
- Authorities characterize the current episode as one of the most difficult in Sri Lanka’s history but express confidence in a rebound as pandemic effects subside and policies take effect to strengthen resilience and uplift living standards.
- Authorities request the Fund to support efforts while looking beyond standard prescriptions for emerging market economies and to consider recommendations aligned with Sri Lanka’s socio-economic traditions and expectations.

*Source: 1lkaea2022001 - 1. We thank the mission team led by Mr. Nozaki for the frank discussions held in Colombo*

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_Source: https://www.imf.org/-/media/files/publications/cr/2022/english/1lkaea2022001.pdf_