## 1lkaea2023001 ## Source details **Canonical URL:** [1lkaea2023001](https://www.imf.org/-/media/files/publications/cr/2023/english/1lkaea2023001.pdf) ## Other formats - [Markdown version](/-/media/files/publications/cr/2023/english/1lkaea2023001.pdf.md) - [Structured JSON version](/-/media/files/publications/cr/2023/english/1lkaea2023001.pdf.json) --- ### Executive summary and context - Crisis origin and scale - Series of shocks and policy missteps: large fiscal imbalances, large tax cuts, COVID-19, 2017 drought, 2018 political crisis, 2019 terrorist attacks. - Loss of market access since spring 2020. - Usable gross international reserves declined from $7.6 billion at end-2019 to $1.6 billion at end-2021. - External debt service suspended on April 12, 2022; default on ISBs on May 18, 2022. - Rupee depreciated by about 40 percent (in dollar terms) in 3 months since February 2022. - IMF staff-level agreement on a 48-month EFF arrangement reached September 1, 2022 following authorities’ request in April 2022. - Social impacts: severe shortages, nationwide protests in 2022; 33 percent of households experiencing some form of food insecurity (World Food Program). ### Recent policies and immediate response - Emergency measures and social protection - Tightened import restrictions and FX management measures to mitigate FX shortages and depreciation pressure. - Digital fuel rationing system implemented. - Social transfers scaled up; external humanitarian support mobilized. - Annual SSN spending increased from about LKR 60 billion (pre-pandemic average) to LKR 100-140 billion during 2020-22. - SSN spending around 0.6 percent of GDP in 2022; beneficiaries rose from 2.3 million in 2019 to about 3.3 million in 2022. - Policy reversals and monetary stance - Downsizing of monetary financing and policy rate increases: policy rate hikes by 700 basis points in April 2022, 100 basis points in July 2022, and 100 basis points in March 2023 to 15.5-16.5 percent. - CBSL announced elimination of FX market guidance with effect March 7, 2023. ### Macroeconomic outcomes and outlook - 2022 performance and near-term projections - Real GDP contracted by 7.1 percent y/y in the first three quarters of 2022; projected contraction of 8.7 percent in 2022 (chapter figures) and -3 percent in 2023. - Output in 2024 estimated below trend real GDP by 18 percent; projected growth 1.5 percent in 2024 and converge to around 3.0–3.1 percent over the medium term. - Inflation and disinflation path - Colombo CPI (CCPI) peaked at 70 percent y/y in September 2022; slowed to 54 percent in January 2023; core inflation declined from 50 percent to 46 percent over same period. - Projection: decline towards 15 percent by end-2023 and return to CBSL target band of 4-6 percent by early 2025 (some sections state by end-2024). - External sector and reserves - Exports expanded 5 percent y/y in 2022; imports contracted -11 percent y/y in 2022. - Gross international reserves about $1.9 billion at end-December 2022, including unusable $1.4 billion PBOC yuan deposits; freely usable reserves insufficient for essential imports. - REER depreciated by about 5 percent in 2022 (average terms); staff assesses a REER overvaluation of about 8 percent in 2022 (EBA CA and EBA-lite). - Balance of payments - 2022 current account projected to shrink to 1.9 percent of GDP from 3.8 percent in 2021. - Net external liabilities increased to 74 percent of GDP in 2022Q3 from 51 percent (average 2012-2018). ### Fiscal developments and targets - 2021–22 outturns - Cash primary deficit declined to 3.8 percent of GDP in 2022 from 5.7 percent of GDP in 2021. - Tax revenue-to-GDP ratio was 7.3 percent in 2021; central government revenue collection reported 8.4 percent in 2022 in some sections. - Unpaid bills: LKR 106 billion (0.5 percent of GDP) at end-December 2022; LKR 60 billion considered in arrears. - On-lending to CPC ~1 percent of GDP in 2022; without it primary deficit would have been 2.8 percent of GDP in 2022. - Program fiscal targets and measures - 2023 budget target: central government primary deficit reduced to 0.7 percent of GDP in 2023 (quantitative performance criterion). - Program aims: primary balance surplus of 0.8 percent of GDP in 2024 and 2.3 percent of GDP from 2025 onwards. - Additional revenue measures of 2.7 percent of GDP in 2024-25 envisaged. - Authorities committed to clearing all outstanding spending arrears by end-June 2023 (QPC). - Tax policy actions (since May 2022 and 2023 measures) - PIT: reduced tax-free allowance to Rs 1,200,000; top marginal rate set to 36 percent; withholding taxes reinstated (implemented January 1, 2023). - CIT: statutory rate raised from 24 to 30 percent and sector-specific exemptions removed (implemented October 1, 2022). - VAT: raised from 8 to 12 percent (May 2022) and to 15 percent (September 1, 2022); registration threshold lowered to Rs 80 million (implemented October 1, 2022); revamp planned by January 1, 2024. - Fuel excises raised to yield 0.3 percent of GDP (implemented January 1, 2023). - Commitments to introduce property tax, gift and inheritance tax before 2025. ### Social safety nets (SSN) - Spending floors and reforms - Program SSN floor: LKR 187 billion in 2023 (0.6 percent of GDP, indicative target). - Maintain SSN spending at least 0.6-0.7 percent of GDP beyond 2023. - Welfare Benefits Board (WBB) operational; new Social Registry populated with 3.7 million applicants. - Parliamentary approval of welfare benefit payment scheme and new eligibility criteria expected by May 2023 (structural benchmark); ineligible beneficiaries to stop receiving Samurdhi by January 2024. ### Energy sector and SOE governance - Rationale and fiscal implications - Energy SOE losses and off-budget FX-financed subsidies accumulated to 3.8 percent of GDP at end-2022; delays in CEB payments to CPC accumulated to 0.4 percent of GDP at end-2021. - Pricing reforms and safeguards - Retail fuel price: cost-recovery monthly formula (continuous structural benchmark); Cabinet reinstated 2018 fuel pricing formula (Nov 21, 2022). - Electricity tariff: cost-recovery semi-annual formula; tariffs increased by 75 percent on average in August 2022 and by 66 percent on average in February 2023. - Non-commercial obligations below cost to be recorded as government expenditure and compensated by transfers (indicative target and continuous structural benchmarks). - Improve Bulk Supply Transaction Account (BSTA) by December 2023 (structural benchmark); legislative reforms by June 2024 to assign Minister of Power and Energy responsibility for implementing cost-recovery adjustments. - SOE governance measures - Cabinet approval of comprehensive balance-sheet restructuring strategy for CPC, CEB, Road Development Authority, and SriLankan Airlines by June 2023 (structural benchmark). - Publish audited financial statements for all 52 major SOEs; prohibition of new FX borrowing by non-financial SOEs with limited FX revenues. ### Financial sector vulnerabilities and recapitalization - Key vulnerabilities and exposures - Common Equity Tier 1 capital ratio fell from 12.9 percent at end-2021 to 12.2 percent in September 2022. - NPLs increased from 7.6 percent at end-2021 to 10.9 percent in September 2022; broader measure including significant deterioration rose to 32 percent of loans. - Total public sector exposure exceeds 40 percent of banks’ assets; market values of FX sovereign securities imply loss of more than 60 percent of face value, partially offset by provisions of over 20 percent. - Banks’ FX assets share rose from 16 percent at end-2021 to 25 percent post-depreciation; restructuring or rupee repayment of FX public debt could create FX short positions. - Cost of rupee funding high: average rates on new deposits reached 23 percent in December; treasury yields around 28–33.14 percent; prime lending rates peaked at 29.67 percent. - Diagnostic and recapitalization roadmap - CBSL hired two independent specialist firms for diagnostics and AQRs. - AQRs for two largest state-owned banks and three largest private banks to be completed by April 2023 (structural benchmark); extended AQRs for four more banks by August 2023. - By July 2023, CBSL to develop roadmap for financial sector restructuring and recapitalization (structural benchmark); MOF to determine conditions for public funds use by October 2023 (structural benchmark). - DSA incorporates a contingency for bank recapitalization of around 6 percent of 2022 GDP. - Supervisory and legal reforms - Cabinet approved Banking (Special Provisions) Act; full revision of Banking Act expected Cabinet approval by June 2023 and Parliamentary approval by December 2023 (structural benchmarks). - Strengthen resolution authority, deposit insurance, regulatory standards, and governance frameworks for state-owned banks. ### Debt restructuring and DSA outcomes - Debt stock and objectives - Public debt-to-GDP projected at 128 percent in 2022. - Authorities’ objectives: reduce public debt below 95 percent of GDP by 2032; reduce average central government gross financing needs below 13 percent of GDP in 2027–32; keep FX debt service of central government below 4.5 percent of GDP in any year during 2027-32. - Restructuring perimeter and instruments - FLFC debt excludes IFIs, central bank swaps, emergency credit lines in 2022, and new disbursements after moratorium announcement. - LLFC debt (SLDBs and FX bank loans) to be restructured, with option to convert to local currency instruments. - LLLC debt treatment being weighed to preserve financial stability. - Illustrative restructuring scenario and baseline projections - Staff’s illustrative scenario assumes T-bill exchanges, selected domestic reprofiling, principal reduction for external private debt, and NPV-equivalent relief from official bilateral creditors. - Baseline (restructuring scenario) public debt projections (percent of GDP): - Prel. 2022: 128.11; 2023: 111.2; 2024: 108.5; 2025: 107.8; 2026: 106.8; 2027: 104.4; 2028: 101.3; 2029: 98.5; 2030: 95.6; 2031: 92.8; 2032: 90.1; 2033: 87.5. - Gross financing needs (GFNs) (percent of GDP): 2022: 34.5; 2023: 26.6; 2024: 17.9; 2025: 15.4; 2026: 15.9; 2027: 14.2; 2028: 13.1; 2029: 14.0; 2030: 12.2; 2031: 12.5; 2032: 12.2; 2033: 11.5. - DSA financing assumptions: IMF ~$3 billion (SDR 2.286 billion) over 4 years; expected external support from World Bank and ADB of US$3.75 billion. - Under baseline, US$17 billion in debt service reduction required during 2023-27 (staff baseline). - Scenario without restructuring - Even with large fiscal adjustment, debt remains above targets and GFNs remain elevated without restructuring; reserves and sustainability compromised. ### Program modalities, access, and monitoring - Arrangement and access - Proposed 48-month normal-access EFF; access SDR 2.286 billion (395 percent of quota or about US$3 billion). - All EFF purchases to take form of budget support. - Objective: rebuild GIR to about 100 percent of ARA metric by end-2027. - Prior actions and structural benchmarks - Nine prior actions completed; selected prior actions met include: Parliamentary approval of 2023 budget consistent with program, legislative revisions to implement 2023 revenue measures, CBSL update of ELA framework, Cabinet approval of automatic fuel and electricity pricing mechanisms, Cabinet approval of new Central Bank Act, and hiring independent firm for bank diagnostic. - Numerous structural benchmarks with specified dates (examples: ITMIS rollout by end-September 2023; PFM law submission by end-December 2023; asset quality review completion by end-April 2023). - Monitoring framework and TMU - Program monitored via quantitative performance criteria (QPCs), continuous performance criteria (external arrears, Article VIII obligations), indicative targets, and Monetary Policy Consultation Clause (MPCC). - Key QPCs and indicative targets include Program NIR floors (Program NIR to be adjusted per TMU), CBSL net credit to government ceilings, central government primary balance floor, stock of expenditure arrears ceiling, central government tax revenue floors, and SSN spending floors. - Program NIR targets predicated on CBSL net FX purchases of $1.4 billion in 2023 (net basis). ### Exchange restrictions, MCPs, and CFMs - Measures in place and phase-out commitment - Temporary measures include import restrictions, exchange restrictions (8 identified), multiple currency practices (7 identified), and tightening/new CFMs. - By June 2023, authorities to prepare plan for phased removal conditioned on macro stability progress. - Authorities requested Fund approval of all but one exchange restriction and all MCPs; staff supports temporary approvals. - Program commitments: during program period authorities will not introduce/intensify exchange restrictions/MCPs, impose/intensify import restrictions for BOP purposes, or conclude bilateral payment agreements inconsistent with Article VIII (continuous performance criteria). ### Governance, anti-corruption, and transparency reforms - Governance diagnostic and legislation - IMF governance diagnostic mission underway; report to be published by September 2023 (structural benchmark). - Anti-corruption draft legislation under government review; Parliamentary approval expected by June 2023 (structural benchmark); comprehensive asset recovery provisions to be developed by March 2024. - Transparency measures - Online transparency platform to publish semi-annually: all significant public procurement contracts; list of firms receiving BOI tax exemptions; list of individuals and firms receiving tax exemptions on luxury vehicle imports (operational by March 2023). - Quarterly public debt bulletin initiated; PDMA to be established by December 2023 and completed by December 2024. ### Safeguards, capacity to repay, and program risks - Safeguards and CBSL reforms - Update safeguards assessment completed February 2023; recommends legal reforms addressed by new CBA to strengthen autonomy and monetary financing prohibition. - CBSL to develop medium-term balance sheet plan; CBSL’s audit and reporting based on international standards. - Capacity to repay and risks - Fund exposure to Sri Lanka at end-December 2022: SDR 798 million (138 percent of quota or about 56 percent of gross reserves). - Under program, Fund credit outstanding would peak at 3.6 percent of GDP in 2026 (12.7 percent of exports of goods and services and 27 percent of gross reserves). - EFF repurchases and charges peak in 2031 at 2.1 percent of exports and 3.5 percent of gross reserves. - Capacity to repay assessed adequate under program scenario but subject to significant risks contingent on successful implementation and debt restructuring. - Main program risks - High implementation risk due to complex debt restructuring, unfavorable external environment, persistent inflation risks, political and social challenges, and weak reform track record. - Financial sector risk: FX liquidity shortfalls and capital shortfalls from restructuring could trigger banking stress. - Contingency measures: remedial fiscal adjustments, FX intervention rules, emergency policy rate hikes, recapitalization plans, and use of IMF and development partner CD. ### Key quantitative program figures (selected exact values preserved) - Arrangement access: SDR 2.286 billion (395 percent of quota or about US$3 billion). - Program external support expected: US$3.75 billion from World Bank and ADB. - Program NIR net FX purchases target in 2023: $1.4 billion (CBSL net basis). - DSA assumptions: - Exchange rate (eop., Rupees/$): 363 (DSA table). - Nominal GDP (memo, billions of Rupees): 23,688. - Real GDP growth (percent): 2022: -8.7; 2023: -3.0; 2024: 1.5; 2025: 2.6; 2026: 3.0; 2027–2033: 3.1. - Inflation (GDP deflator; percent): 2022: 46.6; 2023: 30.0; 2024: 10.7; 2025: 5.6; 2026: 5.2; 2027–2033: 5.1–5.0. - Public debt trajectory under restructuring scenario: Prel. 2022: 128.11; 2023: 111.2; 2024: 108.5; 2025: 107.8; 2026: 106.8; 2030: 95.6; 2032: 90.1; 2033: 87.5. - Gross financing needs (GFNs) percent of GDP: 2022: 34.5; 2023: 26.6; 2024: 17.9; 2025: 15.4; 2027: 14.2; 2028: 13.1. - Effective interest rate (percent, memo): 2022: 9.7; 2023: 7.2; 2024: 7.2; 2027: 6.9; 2033: 6.9. - Bank recapitalization contingency assumed: around 6 percent of 2022 GDP. *Source: 1lkaea2023001 — International Monetary Fund.* ### EXECUTIVE SUMMARY ### EXECUTIVE SUMMARY ### Context - Sri Lanka fell into an unprecedented crisis from a series of shocks and policy missteps: large fiscal imbalances, large tax cuts, the onset of COVID-19, and other shocks (2017 drought, 2018 political crisis, 2019 terrorist attacks). - Access to international capital markets was lost since the spring of 2020. - Usable gross international reserves declined from $7.6 billion at end-2019 to $1.6 billion at end-2021. - With reserves depleted, the authorities suspended external debt service on April 12, 2022, and defaulted on international sovereign bonds (ISBs) on May 18, 2022. - The rupee depreciated by about 40 percent (in dollar terms) in 3 months since February 2022. - Following the authorities’ request in April 2022, IMF staff and the authorities reached a staff-level agreement on a 48-month arrangement under the Extended Fund Facility on September 1, 2022. - Social and political fallout: severe shortages of food, fuel, cooking gas, and daily power cuts led to nationwide protests in 2022, political resignations, and elevated public dissatisfaction. As of reporting, 33 percent of households are experiencing some form of food insecurity according to the World Food Program. ### Recent Policies and Immediate Response - Extraordinary measures implemented to manage FX shortages and depreciation pressure included tightened import restrictions and other balance of payment measures. - A digital fuel rationing system was introduced to help manage access to fuel. - Social transfers were scaled up and external humanitarian support was mobilized to protect the vulnerable. - Since mid-2022, authorities have taken decisive actions including: - Downsizing of monetary financing and raising policy rates to rein in inflation. - Introducing tax measures to improve fiscal balance. - Raising electricity prices and introducing automatic energy pricing mechanisms. - Embarking on institutional and structural reforms. - The CBSL announced that with effect from March 7, 2023 this FX market guidance will be eliminated. ### Macroeconomic Outlook and Recent Developments - Real GDP contracted by 7.1 percent y/y in the first three quarters of 2022, largely driven by manufacturing and construction. - Inflation (Colombo CPI, CCPI): - Peaked at 70 percent y/y in September 2022. - Slowed to 54 percent in January 2023. - Core inflation declined from 50 percent to 46 percent over the same period. - Balance of Payments and reserves: - Exports expanded 5 percent y/y in 2022. - Imports contracted -11 percent y/y in 2022. - Tourist arrivals and inflows recovered in December 2022 to about a third of pre-pandemic levels. - Gross international reserves (GIR) stood at about $1.9 billion at end-December 2022, including unusable $1.4 billion worth of yuan deposits at the People’s Bank of China (PBOC). - Freely usable reserves are insufficient to cover essential imports such as fuel and energy. - External financing: World Bank and ADB repurposed project loans for emergency assistance; India provided emergency loans and currency swaps; payments through the Asian Clearing Union were deferred. ### Fiscal Developments (2021–22) - Cash primary deficit declined to 3.8 percent of GDP in 2022 from 5.7 percent of GDP in 2021, reflecting spending restraint due to tight cash constraints. - The 2022 primary deficit was slightly smaller than the target of 4 percent of GDP previously agreed with Fund staff. - Tax revenue-to-GDP ratio increased only marginally in 2022; gains from tax policy measures were partly offset by cyclical decline in revenue and decreased import-related taxation. - Unpaid bills: LKR 106 billion (0.5 percent of GDP) at end-December 2022, of which LKR 60 billion are considered in arrears. - On-lending of a short-term loan from the government to the Ceylon Petroleum Corporation (CPC) amounted to about 1 percent of GDP in 2022; without this loan the primary deficit would have declined to 2.8 percent of GDP in 2022. ### Financial Sector Vulnerabilities - Backward-looking reported capital positions: Common Equity Tier 1 capital ratio fell from 12.9 percent at end-2021 to 12.2 percent in September 2022. - Non-performing loans increased from 7.6 percent at end-2021 to 10.9 percent in September 2022. - A wider measure including loans with significant deterioration in credit quality rose to 32 percent of loans. - Banks face substantial FX liquidity challenges; income from FX sovereign debt investments has been suspended. - Total exposure to the public sector accounts for over 40 percent of banks’ assets. Market values of FX denominated sovereign securities imply a loss of more than 60 percent of face value, partially offset by provisions of over 20 percent. Provisions on domestic currency public sector exposures are minimal. ### Program Strategy (IMF EFF Proposal) - Staff proposes a 48-month normal-access Extended Arrangement under the Extended Fund Facility (EFF) with access to Fund resources of SDR 2.286 billion (395 percent of quota or about US$3 billion). - Program priorities: - Ambitious revenue-based fiscal consolidation, accompanied by stronger social safety nets, fiscal institutional reforms, and cost-recovery based energy pricing. - Restoration of public debt sustainability, including through a debt restructuring. - A multi-pronged strategy to restore price stability and rebuild reserves under greater exchange rate flexibility. - Policies to safeguard financial sector stability. - Structural reforms to address corruption vulnerabilities and enhance growth. - Key policy actions to be implemented upfront during initial stabilization include revenue measures and central bank autonomy; longer-term institution-building reforms will be sequenced under visible reform ownership. ### Program Risks and Contingency Considerations - Risks to program implementation are exceptionally high due to: - Complex debt restructuring process. - Unfavorable external environment. - Elevated risks of persistently high inflation. - Challenging political and social situation. - Sri Lanka’s weak track record of reform implementation raises significant risks of slippages in fiscal consolidation, revenue mobilization, and reserves buildup. - A deeper crisis could be induced by further economic fallout, a weakened banking sector, exchange rate pressure, and loss of market confidence. - Contingency plans are crucial and policies should remain agile to adjust to evolving circumstances. *Approved March 6, 2023 — International Monetary Fund (Executive Summary of Sri Lanka program).* ### 7. The authorities have been managing the crisis with exceptional measures while ### 7. The authorities have been managing the crisis with exceptional measures while ### Exceptional administrative and emergency measures - Administrative BOP measures - FX shortages triggered tightening of import restrictions on non-essential goods since March 2022. - Authorities tightened FX management measures, including measures giving rise to multiple currency practices and exchange restrictions, to mitigate FX shortages and depreciation pressure. - Fuel and food support system - A digital fuel rationing system was implemented to address fuel shortage, which helped reduce queues at fuel stations in recent months. - Food Security and Livelihood Restoration Emergency Assistance launched in August 2022 to improve access to food and protect livelihoods for the poor and vulnerable. - Social transfers and SSN spending - SSN programs (including Samurdhi cash transfers, support for the elderly, disabled people, kidney patients, and COVID-19 relief) partly mitigated adverse impacts on the poor. - Annual SSN spending increased from about LKR 60 billion on average before the pandemic to LKR 100-140 billion during 2020-22. - The real value of cash transfers eroded in 2022, especially for poorer households facing disproportionately higher inflation. - Monetary financing - Government significantly increased borrowing from the CBSL to finance the budget, expanding monetary financing and contributing to elevated inflation. - CBSL purchases of government securities in the primary market fell from a peak three-month average of LKR 120 billion a month in June 2022 to LKR 43 billion a month in January 2023. - Tax measures - Part of comprehensive tax reform (see ¶12) to strengthen PIT, CIT, and VAT. - Energy pricing and spending restraint - Automatic price adjustment mechanisms for fuel and electricity adopted in 2022, setting framework for elimination of energy subsidies in 2023. - Monthly fuel price adjustment mechanism operational; electricity tariffs raised substantially in August 2022 and February 2023. - Revised 2022 budget reduced primary deficit target to 4 percent of GDP from 5.7 percent of GDP in 2021; outperformed at 3.8 percent of GDP in 2022. - Capital spending envelope reduced while making room for additional SSN spending and transfers to the CEB to cover 2022 losses from below-cost electricity pricing. ### Outlook and macroeconomic projections - Real GDP projections - Real GDP projected to contract by 8.7 percent in 2022 and 3 percent in 2023, before expanding by 1.5 percent in 2024 and gradually converging towards around 3 percent over the medium term. - Factors: (i) fuel shortages, power cuts, and supply disruptions of intermediate goods (including construction materials and fertilizer); (ii) fiscal adjustment under the program, with the fiscal multiplier assumed at 0.5; (iii) banking sector’s limited capacity to support private sector activity; and (iv) a significant sovereign debt restructuring requiring bank recapitalization. - Output in 2024 estimated below trend real GDP by 18 percent. - Inflation path - Inflation peaked at 70 percent in September 2022 and is projected to decline towards 15 percent by end-2023 before reaching the CBSL’s target band of 4-6 percent by early 2025. - Drivers of disinflation: monetary policy tightening, discontinuation of monetary financing, fiscal consolidation, waning base effects from currency depreciation, and moderation of imported inflation. - External position and exchange rate policies - Sri Lanka’s external position in 2022 assessed as weaker than level implied by medium-term fundamentals and desirable policies. - REER depreciated by about 5 percent in 2022 in average terms; initial sharp real depreciation largely dialed back by soaring inflation. - Removal of CBSL exchange rate guidance, commitment to a flexible exchange rate, and ongoing disinflation expected to support additional real depreciation. - Fiscal adjustment and export competitiveness gains from envisaged real exchange rate depreciation expected to help restore a non-interest external current account surplus starting in 2023 and support rebuilding reserves. - Debt sustainability and banking sector contingency - Sovereign debt restructuring expected to restore public debt sustainability on a forward-looking basis. - Preliminary contingency for banking sector recapitalization needs of around 6 percent of 2022 GDP incorporated in the public DSA, arising from impairments on banks’ exposures to the public sector through debt restructuring and to the private sector through adverse macro developments. ### Risks and uncertainties - Major downside risks - External risks: intensification of regional conflicts, supply disruptions, renewed surge in global commodity prices (could induce further exchange rate depreciation and runaway inflation); global growth slowdown and systemic financial vulnerabilities could weigh on exports. - Domestic risks: renewed social unrest and political instability from reform fatigue and alleged corruption; weak reform track record increases risk; elevated upside inflationary pressure implies significant risk of persistently high inflation. - Financial risks: FX liquidity shortfalls or sharp deterioration of banks’ asset quality from sovereign debt restructuring or macro shocks could trigger banking sector stress with severe repercussions. - Upside risks - Faster-than-expected growth recovery led by stronger tourism and FDI. ### Program objectives and policy package - EFF-supported program aims - Restore macroeconomic stability and debt sustainability. - Mitigate economic impact on the poor and vulnerable. - Safeguard financial sector stability. - Strengthen governance and medium-term growth potential. - Comprehensive policy package components - Ambitious revenue-based fiscal consolidation, fiscal institutional reforms, stronger SSNs and SOE reforms (Section A). - Deep restructuring of public debt (Section B). - Multi-pronged strategy to restore price stability and rebuild reserves under greater exchange rate flexibility (Section C). - Policies to safeguard financial sector stability (Section D). - Stepped up structural reforms to reduce corruption vulnerabilities (Section E) and enhance growth (Section F). ### Fiscal situation, targets, and revenue measures - Pre-crisis fiscal deficits and tax performance - Fiscal deficits reached 12.1 percent of GDP in 2020 and 11.6 percent of GDP in 2021. - Tax revenue to GDP ratio was 7.3 percent in 2021. - 2023 budget and medium-term fiscal path - 2023 budget aims to reduce primary deficit to 0.7 percent of GDP in 2023 (quantitative performance criterion) from 3.8 percent of GDP in 2022, with tax revenue targeted at about 10 percent of GDP (indicative target). - Program aims for a primary balance surplus of 0.8 percent of GDP in 2024 and 2.3 percent of GDP from 2025 onwards. - Achieving targets entails additional revenue measures of 2.7 percent of GDP in 2024-25, combined with expenditure rationalization. - Authorities committed to clearing all outstanding spending arrears by end-June 2023 (quantitative performance criterion). ### Tax policy, administration, and expenditure rationalization - Tax policy measures implemented since May 2022 - PIT: raised marginal PIT rate schedule, reduced PIT tax-free allowance, and introduced mandatory withholding taxes starting January 2023. - CIT: raised statutory CIT rate from 24 to 30 percent and removed almost all sector-specific CIT exemptions from October 2022. - VAT: raised VAT rate from 8 percent to 12 percent in May 2022 and to 15 percent in September 2022; reduced VAT registration threshold from September 2022. - Fuel excises raised to yield 0.3 percent of GDP in January 2023. - VAT exemptions on basic food items maintained to mitigate adverse distributional impacts. - Commitments: revamp VAT system before 2024 by removing almost all product-specific VAT exemptions; significantly speed up valid VAT refunds; abolish the Simplified VAT (SVAT) system. - Commitments to introduce a property tax, and a gift and inheritance tax before 2025. - Revenue administration reforms - Reinstated mandatory withholding taxes on employment income, services payments, and capital income from October 2022. - Plans to improve the Large Taxpayer Unit, strengthen IT-based tax administration, publish estimated direct costs of corporate tax incentives. - IMF CD support including a revenue administration diagnostic assessment in January 2023. - Strengthen audit transparency through third-party information sharing and centralizing tax audits using risk-based filters (World Bank CD support). - Expenditure rationalization - Strategies to limit growth in public sector wage bill and public pension spending. - Authorities decided to restrain wage and pension increases to well below inflation in 2023. - Fiscal space for capital spending constrained; measures to raise public investment efficiency and strengthen project appraisal and selection processes. ### Strengthening social safety nets (SSN) - SSN reform objectives and spending floor - Program will set a floor on SSN spending of LKR 187 billion in 2023 (0.6 percent of GDP, indicative target). - Beyond 2023, authorities will maintain SSN spending at least at 0.6-0.7 percent of GDP. - Coverage and targeting reforms - Welfare Benefits Board (WBB) made operational to coordinate SSN programs and reforms. - New Social Registry populated; parliamentary approval of new eligibility criteria for SSN programs obtained. - Parliamentary approval of the welfare benefit payment scheme and application of new eligibility criteria expected by May 2023 (structural benchmark). - By January 2024, beneficiaries ineligible under new criteria would no longer receive Samurdhi cash transfers. - Reforms assisted by the World Bank to improve targeting and coverage. ### Public financial management (PFM) and fiscal governance - Core PFM strengthening measures - Enact a new PFM law clarifying budget process, roles of government agencies, and revamped fiscal rules framework, with submission to Parliament by December 2023 (structural benchmark). - Develop a medium-term fiscal framework to provide binding multi-year fiscal policy guidance. - Complete rollout of Integrated Treasury Management Information System (ITMIS) by September 2023 (structural benchmark). - Strengthen Macro-Fiscal Unit in the MOF. - Improve public investment efficiency through better appraisal and selection processes. - Update fiscal reporting to the GFSM 2014 standard. ### Energy sector reforms and pricing mechanisms - Rationale - Retail fuel and electricity prices were generally set below cost-recovery levels, creating losses for CPC and CEB and off-budget subsidies financed by FX loans from state-owned banks (accumulated to 3.8 percent of GDP at end-2022), and delays in CEB payments to CPC (accumulated to 0.4 percent of GDP at end-2021). - Debt overhangs hindered infrastructure investment, contributing to high electricity production costs. - Policy measures - Retail fuel prices set to cost-recovery levels with monthly formula-based adjustments (continuous structural benchmark); November 2022 Cabinet approval reinstated 2018 fuel pricing formula suspended in November 2019. - End-user electricity tariff schedule set to cost-recovery level with semi-annual formula-based adjustments (continuous structural benchmark); electricity tariff schedule increased in August 2022 by 75 percent on average, and raised by 66 percent on average in February 2023 under the approved automatic pricing mechanism. - Non-commercial obligations where retail fuel or electricity prices temporarily fall below costs to be recorded as government expenditure to avoid off-budget subsidies; costs to be compensated by government transfers (indicative target and continuous structural benchmarks). - By December 2023, authorities will improve the Bulk Supply Transaction Account (BSTA) used to settle transactions between generators, the transmission operator, and distributors to accurately measure cost-recovery based electricity tariff and government transfer requirement (structural benchmark). *Source: 1lkaea2023001 - 7. The authorities have been managing the crisis with exceptional measures while* ### 16. The program will strengthen the governance of SOEs and address their debt ### 16. The program will strengthen the governance of SOEs and address their debt ### Strengthening SOE governance and addressing debt overhangs - SOE reform measures beyond energy pricing reforms: - (i) Cabinet approval of a comprehensive strategy to restructure the balance sheets of the CPC, CEB, the Road Development Authority, and SriLankan Airlines by June 2023 (structural benchmark). - (ii) Prompt publication of audited financial statements for all 52 major SOEs. - (iii) Prohibition of new FX borrowing by non-financial SOEs with limited FX revenues. - Further governance steps: - Clarify mandates of key SOEs through Statements of Corporate Intent. - Review the framework for selecting SOE board members. ### Restoring public debt sustainability - Current assessment and drivers: - Public debt assessed as unsustainable. - Debt-to-GDP ratio is projected to have reached 128 percent of GDP in 2022, due to exchange rate depreciation, the fiscal deficit, and negative real GDP growth. - Authorities’ fiscal adjustment alone cannot reduce debt to sustainable levels. - Authorities’ objectives: - (i) Reduce the level of public debt below 95 percent of GDP by 2032. - (ii) Reduce average central government gross financing needs (GFNs) in 2027–32, including from the materialization of contingent liabilities, below 13 percent of GDP, so that rollover risks under stress are manageable. - (iii) Keep FX debt service of the central government below 4.5 percent of GDP in any year during 2027-32. - (iv) Ensure that the fiscal and external financing gaps are closed. - Debt restructuring process and timing: - External debt service moratorium announced on April 12, 2022. - Authorities hired financial and legal advisors and started creditor engagement; announced plan to make an announcement on the coverage and parameters of the external and domestic debt operations before end-April 2023. - Debt data and information sharing (¶38) and reconciliation of debt sustainability and relief analysis with creditors will continue, followed by agreements with official creditors and debt exchanges with private creditors. - Restructuring perimeter and instruments: - Foreign law foreign currency (FLFC) debt: - Excludes debt owed to IFIs, central bank currency swaps, emergency credit lines extended in 2022, and any new disbursements made after the moratorium announcement. - Remaining FLFC debt to official bilateral and commercial creditors expected to be restructured through extension of grace period and maturity, interest rate reduction, nominal haircut, or a combination of these. - Local law foreign currency (LLFC) debt: - Plan to restructure LLFC debt—held in Sri Lanka Development Bonds (largely held by banks) and FX bank loans of the government and SOEs—with an aim of achieving substantial flow relief. - An option to convert LLFC debt to local currency debt instruments has been offered and taken up by some creditors. - Local law local currency (LLLC) debt: - Maturity shortening and interest rate increase of LLLC debt in recent periods contributed to a sharp increase in the government’s GFNs. - Authorities and financial advisors are weighing different options and legal procedures to optimize an LLLC debt treatment while preserving financial stability. - Improving public debt management and transparency: - Establish an operationally independent debt management agency. - Begun to publish a quarterly debt bulletin. - New PFM law (see ¶14) will clarify the definition of central government debt and strengthen guidelines for issuing treasury guarantees, prohibiting issuance of guarantees for SOEs with negative equity and on SOE liabilities in foreign currency. ### Restoring price stability and rebuilding external buffers - Recent inflation dynamics: - Headline inflation peaked at 70 percent and core inflation peaked at 50 percent in September 2022. - One-year ahead inflation expectations rose from the 4-6 percent target range and peaked above 50 percent in September 2022. - Headline and core inflation have fallen in recent months driven by lower food prices, but underlying inflationary pressure excluding food and other energy prices remain elevated. - Disinflationary forces: waning base effect of depreciation and commodity prices, and weak demand as the economy continues to shrink. - Upside inflationary risks: lagged effect of monetary financing, possible exchange rate adjustments as exchange rate guidance and FX control measures are gradually lifted, and potential second round effects from the increase in electricity prices. - Monetary policy strategy and targets: - CBSL objective: reduce the headline CCPI inflation (y/y) back to the CBSL’s target band of 4-6 percent by early 2025. - Monitoring mechanism: monetary policy consultation clause (MPCC; featuring inner/outer bands of ±1.5/3 percentage points for June 2023 and thereafter). - Recent policy rate actions: - Policy rate hikes by 700 basis points in April 2022 and by 100 basis points in July 2022. - Further 100 basis points in March 2023 to 15.5-16.5 percent. - Complementary actions: - CBSL should stand ready to further adjust policy over the eight annual monetary policy review cycles to deliver the programmed inflation path. - Policy communication should pursue sufficiently positive real policy rates (on a forward-looking basis) until inflationary pressures are clearly receding. - Estimated natural rate of interest of 2.5 percent to inform the path toward a neutral stance. - Monetary financing and balance sheet normalization: - Program will ensure CBSL refrains from direct financing of the budget deficit and unwinds large holdings of treasury securities; monitored through a ceiling on CBSL’s net credit to the government (quantitative performance criterion). - CBSL’s primary T-bill market purchases and special issuances to finance the budget deficit since 2020 reached 14 percent of 2021 GDP as of December 2022. - Since August 2022, CBSL downscaled monetary financing and plans to offload holdings of treasury securities under the program. - Under the program, monetary financing is envisaged only in the case of a shortfall in budget support from IFIs during the first 6 months of the program. - Exchange rate flexibility and reserves rebuilding: - Authorities committed to restoring a market-determined and more flexible exchange rate; announced to drop the market guidance with effect of March 7, 2023. - CBSL will gradually rebuild gross international reserves including through outright FX purchases, supported by a non-interest current account surplus, new external financing and other non-debt creating inflows, and sovereign debt relief. - Meeting Net Official International Reserves (NIR) targets (quantitative performance criterion) is predicated on CBSL’s outright FX purchases on a net basis of $1.4 billion in 2023. - FX intervention principles: limited to truly disorderly market conditions; transparently disclosed; capped consistent with meeting NIR targets. - FX control measures and phased removal: - Temporary FX control measures in place include import restrictions, exchange restrictions, multiple currency practices (MCPs), and capital flow management (CFM) measures. - Import restrictions over 2020-22 suspended many non-priority non-critical goods, containing the import bill but hurting economic activity. - Sri Lanka has measures that give rise to eight exchange restrictions and seven MCPs, adopted new CFMs, and tightened existing CFMs during the pandemic and recent crisis. - By June 2023, authorities will prepare a plan for phased removal of these measures during the program period conditioned on progress with achieving macroeconomic stability. - Authorities have requested Fund approval of all but one exchange restriction and all MCPs; staff assesses approval criteria are met and supports the request for temporary Fund approval. - Program commitments: during the program period, authorities will not (i) introduce or intensify exchange restrictions or introduce or modify MCPs; (ii) impose or intensify import restrictions for balance of payments purposes; or (iii) conclude any bilateral payment agreements inconsistent with Article VIII (continuous performance criteria). ### Institutional and legal framework reforms for monetary policy and FX flexibility - Central Bank Act reforms to strengthen central bank autonomy and support flexible inflation targeting: - New CBA to: (i) establish price stability as CBSL’s primary objective and financial stability as its other objective; (ii) prevent any form of government representation or participation on the Governing Board or Monetary Policy Board; and (iii) prohibit the CBSL from providing monetary financing and from primary market purchases of treasury securities. - New CBA was approved by the Cabinet in December 2022, with Parliamentary approval expected by April 2023 (structural benchmark). - CBSL macro-forecasting models will play a more prominent role and pave the way for a new Monetary Policy Report to enhance policy communication. - Authorities committed to fostering a deeper and more liquid FX market and developing systems for managing exchange rate risks. ### Ensuring financial stability - Banking sector vulnerabilities and exposures: - Bank vulnerabilities built up during the pandemic due to forbearance measures on loan repayment and provisioning. - External financing of the public sector had dried up earlier, strengthening the domestic sovereign-bank nexus, with public sector exposures accounting for more than 40 percent of bank assets. - Reported capital ratios have remained stable, and high net interest margins have allowed banks to absorb rising impairments, but the crisis will continue to crystallize vulnerabilities. - Banks likely to face ongoing credit losses from sharply rising NPLs. - Restructuring or repayment in rupees of FX-denominated government securities (around 5 percent of bank assets) is expected to result in losses, worsen severe FX liquidity shortages, and create currency mismatches. - Large state-owned banks have substantial FX loans to the government and SOEs, expected to be restructured or repaid in Rupees. - Cost of rupee funding remains well above CBSL policy rates (average rates on new deposits reached 23 percent in December) and some banks have experienced periods of rupee liquidity stress. - Credit growth has turned negative since the depreciation of the rupee in 2022Q2. - Contingency measures: - Significant recapitalization needs are possible, including at public banks; the DSA incorporates a contingency for recapitalization costs (Annex V). *Source: IMF staff summary of program chapter 16, as provided in the supplied content.* ### 26. Against this background, the program envisages measures to adequately recapitalize ### 1lkaea2023001 - 26. Against this background, the program envisages measures to adequately recapitalize ### Recapitalization and banking-sector diagnostic - The CBSL has hired two internationally reputable independent specialist firms to conduct a diagnostic exercise for nine major banks, including a comprehensive asset quality review (AQR). - AQRs for the two largest state-owned banks and the three largest private banks will be completed by April 2023 (structural benchmarks). - To support the diagnostic exercise, the authorities will provide the assessors with guidance on the expected impact of the debt restructuring. - By July 2023, the CBSL will develop a roadmap for financial sector restructuring and recapitalization to address capital and FX liquidity shortfalls identified through the diagnostic exercise, and to intervene in banks assessed to be non-viable (structural benchmark). - By October 2023, the government will determine conditions for any potential use of public funds to support the roadmap and to close capital shortfalls at viable banks (structural benchmark). - A coordination committee on financial stability will be established as soon as possible to manage current and future risks to financial stability. ### Strengthening supervision, resolution framework, and crisis management - Cabinet has approved the Banking (Special Provisions) Act to strengthen banking resolution tools for the CBSL with clear legal mandates and improved funding arrangements. - A full revision of the Banking Act is underway, with Cabinet and Parliamentary approval expected by June and December 2023, respectively (structural benchmarks). - The Acts will strengthen: - (i) the resolution authority, mandate, and powers of the CBSL; - (ii) the deposit insurance framework and the regime for liquidation of financial institutions; and - (iii) regulatory standards in areas including bank licensing, bank ownership, consolidated supervision, the capital and liquidity framework, large exposures and related party transactions, governance requirements, and recovery planning and early intervention powers. - The CBSL’s emergency liquidity assistance (ELA) framework has also been updated. ### Regulatory and governance framework for state-owned banks - The Banking Act will ensure that state-owned banks meet the same regulatory requirements as private banks, including on large exposures, related party lending, and governance. - The Act will include binding time-bound transition periods for the reduction of existing large exposures to SOEs. - Framework changes for appointment of directors and senior managers for state-owned Licensed Commercial Banks and Licensed Specialized banks will ensure nominees are independent, have clear periods of appointment, and possess appropriate professional experience. - Clear mandates will be defined to ensure state-owned banks are run at arm’s length and lend to SOEs on a commercial basis. - State-owned banks will be supervised by the CBSL within standard prudential requirements as defined by the Banking Act, including for concentration risk, foreign currency lending, and the suitability and independence of board members and senior executives. - New nomination and appointment processes will be defined for directors and management. ### Non-bank deposit-taker sector supervision - Heightened supervision of the smaller non-bank deposit-taker sector (8 percent of deposit-taker assets) will continue. - The CBSL has tightened non-performing loan classification and capital requirements in line with requirements for banks, and liquidated five leasing companies whose licenses had previously been suspended. - Reported NPLs increased from 11 percent at end 2021 on the previous standard to 17 percent at end-September 2022 as a result of the change in classification, although almost all lending in this sector is collateralized. ### Governance, anti-corruption, and AML/CFT reforms - Strengthening governance and anti-corruption framework is prioritized to restore long-run economic, social, and political stability. - IMF governance diagnostic mission has started; the diagnostic report will be published by September 2023 (structural benchmark). The report will identify specific priority and time-bound reforms for the program. - Anti-corruption legislation upgrades are underway to harmonize with the United Nations Convention against Corruption (UNCAC), supported by IMF CD: - The legislation aims to strengthen the asset declaration system, including coverage of officials and public access to the declaration results. - It creates a new anti-corruption independent commission with strengthened investigative power. - The draft legislation (which does not cover comprehensive asset recovery provisions) is under review by a government review committee before Cabinet approval, with Parliamentary approval expected by June 2023 (structural benchmark). - Comprehensive asset recovery provisions in compliance with the UNCAC standard are expected to be developed in consultation with IMF staff and incorporated into a separate draft legislation by March 2024. - To ensure full compliance with UNCAC, the draft law should clearly delineate a transparent and merit-based process for selection of independent commission members. - Authorities will expand digitalization in revenue administration and procurement to reduce opportunities for corruption. - Fiscal transparency measures: an online transparency platform will be established to publish, on a semi-annual basis, (i) all significant public procurement contracts, (ii) a list of all firms receiving tax exemptions through the Board of Investment, and (iii) a list of individuals and firms receiving tax exemptions on luxury vehicle imports. - AML/CFT: Amend the legal framework on beneficial ownership of legal persons to align with recently updated FATF standards; strengthen risk-based AML/CGT supervision; increase use of financial intelligence and cooperation among the Financial Intelligence Unit, law enforcement, and Anti-corruption Commission to facilitate parallel investigations and prosecutions. ### Raising potential growth — structural impediments and reform priorities - Observed constraints: - Potential growth had already slowed prior to the crisis due to debt overhang and macroeconomic uncertainties. - Labor force growth and productivity stagnated reflecting aging population and resource misallocation. - Highly protective trade regime hindered import competition, export diversification, and entry of foreign firms. - Labor force participation (LFP) rate has fallen to a decade low; female LFP disproportionately hit and youth unemployment higher than peers. - Private sector growth hampered by limited credit and land access, administrative restrictions, and inefficient delivery of power, water, transport, and energy. - SOEs play significant roles across ports, energy, water, finance, retail, production of basic food, mining, and construction; scope to improve operational efficiency. - Authorities will develop a structural reform agenda later in the program with support from the World Bank, ADB, and other development partners. - Reform areas and measures: - Trade and investment: develop a concrete medium-term plan to rationalize para-tariffs; phase implementation with consideration of revenue implications and support measures for local businesses; reform restrictive investment regime, including full implementation of a national single window. - Opportunities for women and youth: boost female LFP and reduce youth unemployment via improved access to transportation and financial services, proper benefits/remuneration for flexible work, affordable childcare, and expanded technical and vocational education programs. - SOEs and private sector: reduce government and SOE roles to improve resource allocation, foster competition, and boost productivity; strengthen SOE governance (¶16); promote digital technology and access to digital platforms for SMEs; improve private sector access to land, upgrade labor skills, and enhance labor market flexibility. - Electricity sector: pursue structural reforms following adoption of automatic cost-recovery tariff adjustment, with technical support to reduce high electricity cost and address large investment needs in generation and transmission. - Climate change: strengthen adaptation efforts, including contingency budgeting and insurance schemes for natural disasters. ### Program modalities, access, and financing - Type of Arrangement: proposed 48-month normal-access EFF arrangement. - Access: SDR 2.286 billion (395 percent of quota or about $3 billion). - Expected external support: budget support from the World Bank and ADB in the amount of US$3.75 billion expected under the program. - Objective: rebuild gross international reserves to about 100 percent of the ARA metric by end-2027. - All purchases under the EFF arrangement are proposed to take the form of budget support to ease domestic financing needs. - External financing needs in 2022 were covered by savings from the debt moratorium ($2.8 billion), emergency support from the IFIs from repurposing of existing project loans and support from key bilateral partners, such as India (food and fuel credit lines, currency swap, and ACU balances accumulation). ### Phasing, prior actions, and program monitoring - Phasing: access to be phased uniformly over the 48-month arrangement, with semi-annual reviews following approval. - Prior actions: nine prior actions completed to set stage for reforms; three important upfront measures implemented: - (i) Parliamentary approval of the 2023 budget that is in line with program parameters; - (ii) Parliamentary approval of necessary legislative revisions to implement the 2023 revenue measures; - (iii) update by the CBSL of the Emergency Liquidity Assistance framework for banks. - Examples of prior actions include: - Cabinet approval to automate monthly retail fuel price adjustment as prescribed by the 2018 fuel pricing formula to achieve cost recovery. - Cabinet approval to automate semi-annual cost-recovery based electricity price adjustment. - Cabinet approval of the new Central Bank Act with amendments from the bill submitted to Parliament in November 2019 in consultation with IMF staff. - Cabinet approval of Banking (Special Provisions) Act to strengthen key elements of the CBSL’s crisis management powers. - Hiring by the CBSL of an independent firm to conduct banking sector diagnostic exercise based on Terms of Reference and timeline established in consultation with IMF staff. - Increase monetary policy interest rates by 100 basis points to ensure forward-looking real policy rates on a firmly upward path. - Program monitoring: performance will be monitored through quantitative performance criteria (QPCs), continuous performance criteria related to external arrears and Article VIII obligations, indicative targets (ITs), and the monetary policy consultation clause. Structural benchmarks focus on government budgets consistent with program parameters; PFM and SSN reforms; cost-recovery energy price adjustments; stronger central bank autonomy; financial sector stability; and stronger governance and anti-corruption frameworks. Implementation will be supported by IMF CD. ### Lending into arrears, financing assurances, and private creditor engagement - Credible and specific assurances on debt relief and financing or consent to IMF lending notwithstanding official arrears have been obtained from official bilateral creditors. - Paris Club creditors, India, Hungary, and the Export-Import Bank of China (which holds more than 90 percent of the Chinese official bilateral claims subject to restructuring) have provided assurances and indicated readiness to finalize specifics of debt treatment in coming months. - China consented to Fund financing notwithstanding arrears to Chinese Government and the China Export and Credit Insurance Corporation (the guarantor for several Chinese commercial loans that are in default). - Sri Lanka owes official arrears to Iran, Kuwait, Pakistan, and Saudi Arabia; these four need more time to consider consenting to Fund financing notwithstanding these arrears. - Authorities committed in the MEFP and a letter to the Paris Club to resolve debt to all official bilateral creditors on comparable terms and to refrain from making payments to any of their creditors until a debt treatment can be agreed that restores debt sustainability in line with the EFF-supported program. - Authorities are willing to use additional safeguard mechanisms, including appropriate contractual commitments such as most favored creditor clauses, acceptable to relevant creditors at the time. - Staff assesses remaining arrears and associated claims are expected to be treated on terms consistent with program parameters and equitably; these arrears constitute a form of financing contribution to the program prior to restructuring. - Sri Lanka has been in arrears to external private creditors since the April 2022 moratorium, including $1,633 million to International Sovereign Bond (ISB) holders, $338 million to China Development Bank (CDB), and $7 million to other foreign commercial creditors as of December 2022. - Authorities, through financial and legal advisors, are making good faith efforts to reach collaborative agreements with private creditors; engaged in early dialogue since June 2022; shared an investor presentation in September 2022 and detailed debt statistics in November 2022; advisors have shared key information under non-disclosure agreements with ISB committees and CDB advisors. - An ad hoc group of ISB holders (holding about half of outstanding ISBs) issued an open letter to the IMF in February 2023 expressing readiness to negotiate debt relief consistent with program parameters. - Staff assesses authorities’ good faith efforts satisfy the Fund’s Lending into Arrears (LIA) policy. - Staff is not aware of private sector external debt arrears arising from the imposition of exchange controls. *Source: IMF staff summary contained in the provided content unit.* ### 39. Safeguards. An update safeguards assessment was completed in February 2023. The update ### 39. Safeguards. An update safeguards assessment was completed in February 2023. The update ### Safeguards assessment — key findings and actions - The update assessment (February 2023) reiterated the need to complete legal reforms for the CBSL to strengthen its mandate, aspects of governance arrangements, and its autonomy, including a monetary financing prohibition. - The recommended legal amendments will be addressed by the new CBA. - The CBSL’s audit and financial reporting functions are based on international standards. - The CBSL’s internal control environment is anchored in a strong compliance culture, but some functions require continued modernization, including through an expanded scope of financial risk management. - While the CBSL’s financial position has deteriorated during the crisis, the CBSL has started forward-looking assessment of its balance sheet with the aim of developing a medium-term plan to strengthen its financial position, supported by IMF CD. ### Capacity to repay the Fund — projections and risks - At end-December 2022, the Fund’s exposure to Sri Lanka stood at SDR 798 million (138 percent of quota or about 56 percent of gross reserves). - Under the program, Fund credit outstanding would peak at 3.6 percent of GDP in 2026, corresponding to 12.7 percent of exports of goods and services and 27 percent of gross reserves. - The EFF repurchases and charges would peak in 2031, at 2.1 percent of exports of goods and services and 3.5 percent of gross reserves. - Capacity to repay is assessed to be adequate under the program scenario but is subject to significant risks and critically contingent on the successful implementation of program measures and debt restructuring that restore debt sustainability. - Delays in finalizing debt restructuring with bilateral and private creditors and/or weak implementation of policy commitments may erode capacity to repay and further increase risks. - A government-guaranteed international bond of SriLankan Airlines went into arrears ($6 million) in January 2023 after a consent solicitation failed to attract sufficient participation; authorities are continuing bilateral discussions with the bondholders. ### Program risks — types and specific vulnerabilities - Overall assessment: Risks to program implementation are high, given adverse initial conditions, political risk, a complex debt restructuring with a potential for delay, ambitious fiscal consolidation, large downside risks to the baseline scenario, and Sri Lanka’s weak track record for reform and program implementation. - Macroeconomic risks: - Unexpected economic and financial developments could deepen the crisis and complicate program implementation (see ¶9). - Given elevated upside inflationary pressure, the risk of persistently high inflation is significant (¶20). - Fiscal risks and political economy: - Commitment to ambitious fiscal consolidation and wide-ranging fiscal reforms is uncertain; Sri Lanka has had a primary surplus on three occasions, never for more than two years. - The program entails an unprecedented sized fiscal adjustment for Sri Lanka given low historical revenue-to-GDP ratios. - Large real cuts to public sector wages and public pension payments amid high inflation in 2022 could prompt backlash from current and retired civil servants. - Debt restructuring risks: - Finalizing a restructuring agreement with all creditors in line with program parameters could be delayed. - Realization of debt sustainability risks could require broader and deeper debt restructuring, raising significant risks to financial stability given banks’ substantial sovereign exposure, implying additional fiscal burden. - Implementation capacity: - The broad scope of proposed reforms may pose risks to the authorities’ ability to implement their multi-faceted program. ### Contingency planning and mitigation measures - Program implementation risks are mitigated by: - Support for economic reforms in principle from the business community and the Parliamentary opposition. - Upfront implementation of critical reform measures ahead of the program, including for revenue measures, automatic cost-recovery energy pricing, social safety nets, and central bank autonomy. - Extensive CD support from the IMF and development partners. - Authorities’ contingency options (examples): - Correct policy slippages with remedial measures (e.g., further cuts in capital spending on non-priority or low-efficiency projects if revenue measures or cost-recovery energy pricing are delayed). - Introduce explicit FX intervention rules (e.g., monthly and/or quarterly FX intervention budgets) if slippage on the NIR target arises from undue exchange rate defense. - Emergency policy rate hike if further depreciation pressure and signs of runaway inflation appear. - Implement measures to recapitalize the banking system, strengthen the crisis management framework, and develop a detailed contingency plan in case of banking sector stress. - Use extensive CD support to compensate for technical implementation capacity constraints (see Annex III on capacity development). - Lock in program overperformance (e.g., CBSL’s commitment to save any overperformance with regard to the NIR target). ### Enterprise risks to the Fund and mitigation - The Fund faces three types of enterprise risks: - Financial risks from significant risks to Sri Lanka’s capacity to repay (¶40). - Operational risks from social unrest and socio-political tensions affecting IMF staff missions and the field office. - Reputational risks if the public perceives program policies as too tight, weakening public support. - Key mitigation measures: - Authorities’ firm commitment to restore debt sustainability through public debt restructuring (¶18). - Upfront implementation of critical reform measures early in the program (¶42). - Focus on social safety nets (¶13) and anti-corruption (¶30) as key program pillars. - Extensive CD support from the IMF and other development partners. ### Staff appraisal — summary judgments and priorities - Current conditions: - Sri Lanka is operating with depleted reserves and no access to international capital market, relying on exchange and capital controls, and rationalizing fuel and electricity usage. - Economic and financial conditions remain fragile with FX shortages in the banking system, an unsustainable public debt, and high inflation amid a severe recession. - Policy actions and priorities: - Authorities started implementing challenging policy actions to combat inflation, improve the fiscal position, reform energy pricing and social safety nets, and tackle corruption. - Swift and timely reform implementation, under strong and consistent ownership by the authorities, is critical for the success of the EFF-supported program. - Fiscal strategy: - Ambitious fiscal consolidation supported by strengthened fiscal frameworks is needed to restore fiscal sustainability and promote a clean break from past policy slippages. - A revenue-based fiscal consolidation strategy is crucial to rebuild fiscal space and restore sustainability. - Deep institutional reforms to the fiscal framework, capacity building (e.g., revenue administration and PFM), and strong ownership across the political spectrum are critical. - Adhering to automatic pricing mechanisms for cost recovery energy pricing and ensuring their efficiency is crucial to minimize fiscal risks from SOEs. - Rigorous SOE and energy sector reforms are critical to ease burden for electricity users and bring down energy costs. - Social protection and equity: - Protecting the vulnerable is a program priority: authorities are committed to strengthen SSN by ensuring minimum SSN spending and improving coverage and targeting. - The tax reform package under the program is designed to be progressive and promote equity. - Monetary and exchange rate policy: - Commitment to the multi-pronged disinflation strategy is crucial; authorities have increased policy rates and started to unwind monetary financing to reduce inflation. - Further steps are needed as inflation levels remain high with signs of rising persistence; monetary policy needs to stand ready to act pre-emptively against entrenching inflation expectations, supported by fiscal consolidation and discontinuing monetary financing. - The new CBA sets a strong legal foundation to support the disinflation strategy and safeguard the credibility of the CBSL’s inflation target regime. - External sector and exchange rate flexibility: - Greater exchange rate flexibility will facilitate external rebalancing and rebuild reserve buffer. - Authorities are committed to phasing out administrative measures imposed to temporarily support the balance of payments; as market confidence returns, authorities should refrain from market intervention and allow exchange rates to adjust freely, with due regard to potential disorderly market conditions and adverse balance sheet effects. - A non-interest current account surplus and new external financing would help gradually rebuild reserves buffer. - Financial stability: - Financial stability hinges on a well recapitalized banking system and strengthened legal framework. - Banks’ exposure to the sovereign and problem loans under forbearance need close monitoring with intensified supervision. - A plan with binding deadlines for financial sector recapitalization is needed to address capital and FX-liquidity shortfalls and support recovery. - Efforts to strengthen financial supervision and crisis management framework are crucial. ### Program approval and conditions - Staff supports the authorities’ request for a 48-month extended arrangement under the EFF in the amount equivalent to SDR 2,286 million (395 percent of quota). - Staff supports the approval of all but one exchange restrictions (¶23) for a period of twelve months, as the measures giving rise to them are maintained for BOP reasons, are non-discriminatory, and are temporary. - Staff supports the approval of all MCPs for a period of twelve months, as the measures giving rise to them are maintained for BOP reasons, are temporary, and don't give Sri Lanka an unfair competitive advantage. ### External Sector Assessment — diagnosis and policy implications - Sri Lanka’s external position in 2022 is assessed as weaker than the level implied by medium-term fundamentals and desirable policies; this assessment is informed by the current account model and staff’s estimate for the 2022 current account, while subject to large uncertainty. - High external debt vulnerabilities materialized when the country defaulted on external public debt in April 2022. - Reserves remained precariously low against adequate levels, leading to widespread foreign exchange shortages and posing severe vulnerabilities to external shocks. - Improving Sri Lanka’s external position would require: - Restructuring public debt in line with program parameters to restore debt sustainability. - Implementing primarily revenue-based fiscal consolidation. - Conducting prudent monetary policy accompanied by a flexible and market determined exchange rate. - Rebuilding international reserves to adequate levels. - Structural reforms to boost Sri Lanka’s export capacity and steps to encourage FDI in export sectors. *Source: 1lkaea2023001 - 39. Safeguards. An update safeguards assessment was completed in February 2023. The update* ### 1. Sri Lanka’s balance of payments remained under extreme pressure in 2022 amid ### 1. Sri Lanka’s balance of payments remained under extreme pressure in 2022 amid external default and depletion of reserves ### Balance of payments and 2022 outcomes - Pre-existing vulnerabilities and policy missteps led to a full-blown balance of payments and sovereign debt crisis: thin reserves buffer, high debt level, eroded fiscal space, loss of access to international capital markets; continued payment of elevated external debt service from reserves; tightened import restrictions and FX control measures; monetary financing amid an effectively fixed exchange rate from April 2021; reserves depleted and external public debt default in spring 2022. - 2022 current account: projected to shrink to 1.9 percent of GDP from 3.8 percent in 2021. - Exports expanded by 5 percent y/y, aided by better export prices and improved competitiveness. - Imports contracted by 11 percent y/y due to lower demand after exchange rate depreciation, widespread FX shortages, and import restrictions. - Remittances: slowly picking up from a low level. - Tourist-related inflows: more than doubled versus 2021 but remained far below pre-pandemic levels. - Gross international reserves (GIR) at end-December 2022: about $1.9 billion (about 1 month of prospective imports), including unusable $1.4 billion worth of yuan deposits at the People’s Bank of China (PBOC). Freely usable reserves insufficient to cover essential imports such as fuel and energy, even after external debt default. - Exchange rate and REER: - Following sharp depreciation, exchange rate stabilized at about 360 rupees per U.S. dollar under CBSL FX market guidance since May 2022. - Real effective exchange rate (REER) depreciated by about 5 percent in 2022 in average terms, with initial sharp real depreciation largely dialed back by soaring inflation. ### External liabilities and net position - Net external liabilities increased from 51 percent of GDP (average 2012-2018) to 74 percent of GDP in 2022Q3. - Gross external liabilities rose from 64 percent to 86 percent of GDP. - Gross external assets fell from 15 percent of GDP in 2019 to 11.7 percent of GDP in 2022. - FDI accounted for about a quarter of net external liabilities; other investment (debt portfolios and/or bank loans) accounted for about 60 percent. - About 85 percent of total external debt liabilities (74 percent of GDP) are long-term. - Government holds 70 percent of total external debt liabilities. ### External position assessment and REER overvaluation - Staff assessment: external position in 2022 weaker than level implied by medium-term fundamentals and desirable policy settings. - External Balance Assessment (EBA) CA model: - Projected 2022 CA [1]: -1.9% - Cyclically adjusted actual CA [3]: -3.6% - Covid-19 adjustors [4] (Tourism/Travel): 0.7% - Adjusted projected CA [5]: -2.9% - CA Norm (from model) [6]: -0.8% - CA Gap [9]=[5]-[8]: -2.1% of GDP - Of which Relative policy gap: -3.7% - Fiscal balance: -1.2% - Health expenditure: 0.2% - Change in FX reserves: -2.3% - Private credit: -0.6% - Elasticity [10]: -0.25 - REER gap, in % [11]=[9]/[10]: 8.2% (interpreted as about 8 percent REER overvaluation; "-" undervalued ER; "+" overvalued ER) - EBA-lite REER model: REER overvaluation of about 8 percent (corresponding CA gap -2.0 percent of GDP). - EBA External Sustainability (ES) approach: REER undervaluation of about 1.3 percent. - Staff places greater weight on EBA CA and EBA-lite REER models and assesses a negative current account gap exceeding 2 percent of GDP in 2022, consistent with a REER overvaluation of about 8 percent, subject to large uncertainty given crisis conditions. ### Reserve adequacy and FX interventions - GIR relative to ARA metric: - Declined from 62 percent of the Fund’s ARA metric at end-2019 to 25 percent at end-2021 and 16 percent at end-December 2022. - Usable GIR in 2022 (excluding temporarily unusable PBOC swap assets) estimated at 4 percent of the ARA metric. - Recommended adequacy range: 100-150 percent of ARA metric. - CBSL FX interventions and guidance: - CBSL market guidance since May 2022 confined daily interbank movements within a band around previous day’s weighted average, effectively pegging rupee at about 360 per U.S. dollar. - Net FX interventions were substantially sell-side, funded by surrender requirement. - In 2022 CBSL cumulatively sold $4.8 billion and purchased $4.0 billion in spot and forward FX markets; spot sales primarily directed at financing critical imports such as fuel and energy. ### FX control and capital flow management measures - Authorities introduced or tightened temporary FX control measures: import restrictions, exchange restrictions, multiple currency practices (MCPs), and capital flow management (CFM) measures under the Fund’s Institutional View. - Over 2020-22 many non-priority non-critical imports were suspended, containing the import bill but hurting economic activity and distorting markets. - Given acute BOP tensions and ongoing crisis, maintaining CFM measures in the short run is appropriate; measures should not substitute for a comprehensive policy package and ongoing macroeconomic adjustment and should be phased out as the balance of payments stabilizes. --- ### Annex II — Public Debt Sustainability Analysis (DSA) ### Current debt situation and arrears - Definition: public debt includes central government debt, SOE debt guaranteed by central government, and external liabilities of CBSL arising from 2016-20 EFF and bilateral currency swap arrangements. - Public debt-to-GDP ratio in 2022: 128 percent. - 14 percentage point increase since 2021 attributed largely to Rupee depreciation and a still large fiscal deficit. - FX depreciation increased share of foreign-law debt to half of public debt. - Real value of domestic debt significantly reduced by high inflation. - Sovereign arrears: close to $3 billion as of end-2022 (following external debt service suspension announced April 12, 2022). - Authorities stopped servicing foreign-law government and government guaranteed debt, except multilateral debt and emergency credit lines from India in 2022; engaged legal and financial advisors and dialogues with official and private creditors. ### DSA macroeconomic assumptions - Real GDP: projected to contract by 3 percent in 2023 before recovery toward medium-term potential of 3.1 percent under baseline. - Inflation (CCPI): projected to trend down from 57 percent (y-o-y) at end-2022 toward 15 percent by end-2023 and back within target band of 4-6 percent by early 2025. - Primary balance: projected to improve from -3.8 percent of GDP in 2022 to 2.3 percent of GDP by 2025 under ambitious fiscal adjustment and major tax reforms. - REER: projected to depreciate by about 30 percent in 2022-27 to achieve external adjustment under the program and gradually stabilize around new norm over the medium term. - Exchange rate (eop., Rupees/$): 363 (as reported in DSA table). - Nominal GDP (billions of Rupees): 23,688 (memo in DSA table). ### DSA financing assumptions - Until 2026 external financing limited to official sources per program assumptions. - Program financing (2023-27): about $3 billion from IMF over 4 years, and $3.75 billion from other multilateral institutions. - Project loan disbursements: assumed $1.4 billion in 2023, $1.5 billion in 2024, and grow at 3 percent annually thereafter (U.S. dollar terms). - External market access: assumed restored in 2027 with annual international bond issuance of $1.5 billion (1.8 percent of GDP) in 2027 and broadly growing with GDP thereafter. - Residual fiscal financing met domestically via T-bills and T-bonds. - Domestic T-bond interest rates assumed to decline from around 21 percent (period average) in 2022 to around 10 percent in 2026. - T-bill rates assumed to decline from around 20 percent in 2022 (period average) to 7.5 percent in 2026. - Market rates expected to adjust higher if inflation surprises on the upside. ### Contingent liabilities and banking sector recapitalization assumptions - DSA assumes central government will need to pay debt service of (i) guaranteed FX debt of SOEs and (ii) guaranteed local-currency debt of the Road Development Authority; these are included in debt stock. - Bank recapitalization needs: assumed around 6 percent of 2022 GDP due to recognition of NPLs to private sector caused by recession and losses from sovereign restructuring; government capital injections assumed. ### Debt restructuring targets under SRDSF - Debt stock: public debt should decline below 95 percent of GDP by 2032. - Post-program gross financing needs: average annual gross financing needs of central government in 2027-32 should remain below 13 percent of GDP. - Post-program FX debt service: annual FX debt service of central government should remain below 4.5 percent of GDP in each year over 2027-32. - Program financing gaps: debt service reduction during 2023-27 should be sufficient to close external financing gaps; under staff baseline, US$17 billion in debt service reduction required, including arrears accumulated in 2022. ### Scenario without debt restructuring - Illustrative “pre-restructuring” scenario: even with large fiscal adjustment, debt remains unsustainable if the external financing gap in 2022-27 is closed through additional new external financing (which Sri Lanka does not presently have access to). - Under baseline macro assumptions, debt stock and gross financing needs would remain above targets (95 percent of GDP and 13 percent of GDP) throughout projection horizon. - FX debt service would spike in post-program period, exceeding new financing, leading to rapid decline in reserves if downside risks materialize. *Source: IMF staff report excerpt (1lkaea2023001).* ### 9. Staff’s restructuring scenario serves purely illustrative purposes. There are many ### 9. Staff’s restructuring scenario serves purely illustrative purposes. There are many ### Illustrative restructuring scenario - Purpose: Staff’s restructuring scenario serves purely illustrative purposes; many alternative restructurings could achieve the same debt restructuring targets. - Authorities’ objectives: - Take each creditor’s specific needs into account when designing the restructuring operation. - Ensure fair burden sharing across creditors. - Perimeter and safeguards: - Perimeter of restructuring based on preliminary considerations shared by the authorities and their financial advisors, taking into account the need to safeguard domestic financial stability. - Main elements of the staff’s illustrative restructuring scenario: - T-bills held by the Central Bank are exchanged into longer term debt instruments. - Footnote: Potential implications on the CBSL’s balance sheet and its capital position are contingent liabilities of the government. - A select pool of the remaining domestic debt is assumed to be reprofiled to reduce gross financing need while limiting the impact on the financial sector. - External private debt: a principal reduction is assumed, with amortization beyond the program period, implying a large NPV reduction. - Official bilateral debt: similar debt relief in NPV terms is assumed, implemented through a long maturity extension — with amortization payments starting in 2033. ### Debt sustainability assessment and risk stance - Overall assessment: Sri Lanka is in debt distress. - Staff’s assessment points: - Fiscal adjustment combined with debt restructuring will eventually restore debt sustainability; downside risks remain high under a restructuring scenario. - Long-term risks: slowing growth due to a declining labor force and climate vulnerabilities. - Risks remain high under a restructuring scenario due to relatively high levels of debt and GFNs, a strong sovereign-bank nexus, and the economy’s vulnerability to large shocks. - Sustainability assessment: Sustainable (as indicated in the staff table summary), but vulnerabilities remain and reduction of debt vulnerabilities to safe levels will take time. - Note on resolution: Unsustainable debt can only be resolved through exceptional measures (such as debt restructuring). A sovereign can face stress without debt being unsustainable; non-restructuring measures (fiscal adjustment, new financing) can remedy some stress situations. ### Debt coverage and disclosures (DSA perimeter) - DSA perimeter includes: - Central government debt; - SOE debt guaranteed by the central government; - Liabilities of the central bank arising from the 2016-20 EFF and bilateral swap arrangements. - Question: If central government, are non-central government entities insignificant? — Yes. - Subsectors captured in the baseline: - Budgetary central government: Yes - Public nonfinancial corporations: Yes - Central bank: Yes - Extra budgetary funds (EBFs), Social security funds (SSFs), State governments, Local governments, Other public financial corporations: No - Commentary: Other public financial corporation holdings of central government debt includes holdings by state-owned banks (estimated based on end-September information) but excludes retirement funds. ### Public debt structure indicators (selected observations) - Commentary highlights: - Accelerating inflation reduced the real value of domestic debt in 2022. - Exchange rate depreciation led to a large increase in external and foreign-currency debt. - Foreign-law debt accounts for more than half of Sri Lanka’s debt. - The debt operation is assumed to rebalance the maturity profile. - Residual maturity: - Residual maturity: 6. years (as shown in the public debt by maturity chart). ### Baseline (Restructuring Scenario) projections — key series (Percent of GDP unless indicated otherwise) - Public debt (Prel. and projections): - Prel. 2022: 128.11 - 2023: 111.2 - 2024: 108.5 - 2025: 107.8 - 2026: 106.8 - 2027: 104.4 - 2028: 101.3 - 2029: 98.5 - 2030: 95.6 - 2031: 92.8 - 2032: 90.1 - 2033: 87.5 - Change in public debt: - 2022: 13.8 - 2023: -17.0 - 2024: -2.7 - 2025: -0.7 - 2026: -1.0 - 2027: -2.4 - 2028: -3.1 - 2029: -2.8 - 2030: -2.8 - 2031: -2.8 - 2032: -2.7 - 2033: -2.7 - Contribution of identified flows: - 2022: 7.9 - 2023: -1.0 - 2024: -0.4 - 2025: -1.1 - 2026: -1.4 - 2027: -2.2 - 2028: -2.3 - 2029: -2.3 - 2030: -2.4 - 2031: -2.4 - 2032: -2.3 - 2033: -2.3 - Primary deficit: - 2022: 3.6 - 2023: 0.7 - 2024 onward (2024–2033): -0.8, -2.3, -2.3, -2.3, -2.3, -2.3, -2.3, -2.3, -2.3 (as reported across years) - Noninterest revenues: - 2022: 8.4 - 2023: 10.9 - 2024: 13.3 - 2025: 14.9 - 2026: 15.0 - 2027–2033: 15.1 (repeated) - Noninterest expenditures: - 2022: 12.0 - 2023: 11.6 - 2024: 12.5 - 2025: 12.6 - 2026: 12.7 - 2027–2033: 12.8 (repeated) - Automatic debt dynamics: - 2022: 4.3 - 2023: -4.2 - 2024: -0.9 - 2025: 0.7 - 2026: 0.3 - 2027: 0.1 - 2028: 0.0 - 2029: 0.0 - 2030: -0.1 - 2031: -0.1 - 2032: 0.0 - 2033: 0.0 - Real GDP growth (percent) — memo row: - 2022: -8.7 - 2023: -3.0 - 2024: 1.5 - 2025: 2.6 - 2026: 3.0 - 2027–2033: 3.1 (repeated) - Inflation (GDP deflator; percent) — memo: - 2022: 46.6 - 2023: 30.0 - 2024: 10.7 - 2025: 5.6 - 2026: 5.2 - 2027–2033: 5.1, 5.0, 5.0, 5.0, 5.0, 5.0 (as reported) - Nominal GDP growth (percent) — memo: - 2022: 33.9 - 2023: 26.0 - 2024: 12.3 - 2025: 8.3 - 2026: 8.4 - 2027–2033: 8.3 (repeated) - Effective interest rate (percent) — memo: - 2022: 9.7 - 2023: 7.2 - 2024: 7.2 - 2025: 7.3 - 2026: 7.2 - 2027: 6.9 - 2028: 6.7 - 2029: 6.7 - 2030: 6.7 - 2031: 6.7 - 2032: 6.8 - 2033: 6.9 - Gross financing needs (GFNs): - 2022: 34.5 - 2023: 26.6 - 2024: 17.9 - 2025: 15.4 - 2026: 15.9 - 2027: 14.2 - 2028: 13.1 - 2029: 14.0 - 2030: 12.2 - 2031: 12.5 - 2032: 12.2 - 2033: 11.5 - Of which: debt service: - 2022: 30.9 - 2023: 25.9 - 2024: 18.7 - 2025: 17.7 - 2026: 18.2 - 2027: 16.5 - 2028: 15.4 - 2029: 16.3 - 2030: 14.5 - 2031: 14.8 - 2032: 14.5 - 2033: 13.8 - GFNs by currency: - Local currency: - 2022: 21.5 - 2023: 21.3 - 2024: 14.5 - 2025: 13.1 - 2026: 14.9 - 2027: 13.0 - 2028: 11.1 - 2029: 11.9 - 2030: 10.0 - 2031: 10.3 - 2032: 10.2 - 2033: 9.8 - Foreign currency: - 2022: 9.4 - 2023: 4.6 - 2024: 4.2 - 2025: 4.5 - 2026: 3.3 - 2027: 3.5 - 2028: 4.3 - 2029: 4.3 - 2030: 4.5 - 2031: 4.4 - 2032: 4.3 - 2033: 3.9 ### Medium-term risk analysis — selected indicators (Table 6) - Debt fanchart and GFN financeability indexes (percent of GDP unless otherwise indicated): - Fanchart width: 72.0 - Probability of debt not stabilizing (pct): 11.3 - Terminal debt level x institutions index: 64.5 - Debt fanchart index: ...2.5 - Average GFN in baseline: 15.1 - Bank claims on government (pct bank assets): 34.1 - Change in claims on government in stress (pct bank assets): 12.8 - GFN financeability index: ...20.5 - Medium-term index signals: - Both MT tools point to a high level of risks associated with relatively high levels of debt and GFNs, a strong sovereign-bank nexus, and the economy’s vulnerability to large shocks. - Probabilities for crisis detection (2023–2028): - Prob. of missed crisis, 2023-2028 (if stress not predicted): 54.5 pct. - Prob. of false alarm, 2023-2028 (if stress predicted): 3.4 pct. ### Policy measures, reforms, and capacity development (selected program elements) - Fiscal consolidation and institutions: - Primarily revenue-based fiscal consolidation, accompanied by fiscal institutional reforms and cost-recovery based energy pricing, aimed at restoring fiscal sustainability and strengthening fiscal discipline. - Tax policy reforms (objectives and milestones): - Raise the tax-to-GDP ratio to at least 14 percent by 2026 through a sequenced package of tax measures. - Measures taken (May 30, 2022 package): about 0.5 percent of GDP in 2022 — increased marginal PIT; raised standard CIT and removed firm-specific tax holidays; raised standard VAT; lowered VAT registration threshold; removed some VAT exemptions; reinstated mandatory income tax withholding. - 2023 targets: - Reduce the primary deficit to 0.7 percent of GDP by 2023 through multiple tax measures (detailed list of measures included in the text). - Parliamentary approval of necessary legislative revisions to implement the 2023 revenue measures will be taken. - 2024 target: - Achieve a primary fiscal surplus of 0.8 percent of GDP via abolishing most VAT exemptions, speeding-up VAT refunds, abolishing the Simplified VAT system, and introducing automatic indexation of excises to inflation. - 2025 target: - Achieve a primary fiscal surplus of 2.3 percent of GDP by revamping the property tax system, introducing a wealth transfer tax, and introducing a gift and inheritance tax. - Revenue administration: - Measures taken: new paper-based and digital sticker system boosted alcohol excise revenues; shift toward risk-based compliance, strengthening Large Taxpayer Unit, increased digitization. - Future outcomes: develop reform plan to increase efficiency and effectiveness, step up administration efforts to ensure compliance with PIT withholding, strengthen Large Taxpayer Unit, strengthen VAT compliance via e-filing and RAMIS IT system. - Public financial management (PFM): - Measures taken: a draft PFM bill was developed under the 2016-20 EFF program; an updated draft and fiscal rules will be formulated. - Future outcomes: Submit to Parliament new PFM Law (with new fiscal rules); complete rollout of ITMIS expanded to all 220 national budget execution agencies; strengthen MFU macro-fiscal analytical capacity; develop medium-term fiscal framework; improve public investment efficiency and update fiscal reporting to GFSM 2014 standard. - Energy SOEs and pricing: - Measures taken: - 2022H1: retail fuel prices raised to cost-recovery levels through multiple price hikes. - Cabinet approved entry of additional private sector firms into downstream petroleum sector in June 2022. - Cabinet Memo authorizing reinstatement of 2018 fuel pricing formula approved by Cabinet on November 21, 2022. - Electricity tariff schedule increased on August 10, 2022 — 75 percent on average across consumers. - Objective: Mitigate fiscal risks arising from the energy SOEs. *Source: Fund staff.* ### introduction of automatic tariff ### introduction of automatic tariff ### Energy price reforms and automatic tariff adjustment - Cabinet approval of an introduction of automatic tariff adjustment mechanism on November 21, 2022. - Under the framework, the electricity tariff schedule was raised by 66 percent on average in February 2023. - Measures taken / commitments: - Set retail fuel prices to their cost recovery levels with monthly formula-based adjustments, and compensate the CPC for providing any fuel subsidies with on-budget transfers. - Set the end-user electricity tariff schedule to its cost-recovery with semi-annual formula-based adjustments and compensate the electricity sector for providing any residual subsidies with on-budget transfers. - Improve the Bulk Supply Transaction Account (BSTA) to accurately measure the electricity subsidy. - By June 2024, introduce legislative reforms making the Minister of Power and Energy responsible for implementing cost-recovery based fuel and electricity price adjustments. ### Governance of state-owned enterprises (SOEs) - Measures taken: - Audited financial statements of several major SOEs for 2021 were published, including CPC. - Cabinet approval of a comprehensive strategy to restructure the balance sheets of the CEB, CPC, SriLankan Airlines, and the Road Development Authority. - Future actions / outcomes: - Publish audited financial statements of all 52 major SOEs for 2021 and for 2022 by end-June 2023. - Prohibit new FX borrowing by non-financial SOEs with less than 20 percent of their revenues denominated in FX. ### Social Safety Nets (SSN): recent developments and reform priorities - Recent impact and indicators: - Around 33 percent of the households facing food insecurity (World Food Program, February 2023). - Median poor household in 2022 faced an inflation rate of 66.4 percent in the cost of their consumption bundle, compared to 56.2 percent inflation faced by a median non-poor household (World Bank, 2022). - Poverty (based on $3.65 per day) estimated to increase from 11.3 percent pre-pandemic to 25.6 percent in 2022 (World Bank, 2022). - Consumption in 2022 declined by 9.5 percent among the bottom 40 percent, compared to a decline of 7.1 percent for the top 60 percent. - Gini index projected to increase from 37.7 in 2019 to 39.9 in 2022 (World Bank, 2022). - Government SSN spending and coverage: - SSN spending was around 0.4 percent of GDP during 2015-19, increased to 0.9 percent of GDP in 2020 and 0.6 percent of GDP in 2021. - SSN spending was around 0.6 percent of GDP in 2022, partly due to emergency support of around $326 million (0.4 percent of GDP) from the World Bank and Asian Development Bank. - Beneficiaries increased by about 40 percent from 2.3 million in 2019 to about 3.3 million in 2022. - Scaled-up SSN transfers estimated to have had a poverty-reducing impact of 3.1 percent in 2022, meaning the poverty rate would have been 28.7 percent, compared to the current projection of 25.6 percent (World Bank, 2022). - Identified shortcomings: - Adequacy: In 2019, social assistance represented 12 percent of beneficiary pre-transfer consumption; for the four SSN programs considered, adequacy was 10 percent of average household consumption in the poorest 20 percent. - Coverage and targeting: Fragmented implementation across several agencies; Samurdhi coverage for the poorest quintile fell from over 50 percent in 2006 to 38 percent in 2019; around 12 percent of households in the richest quintile received SSN transfers in 2019. - B. Reform priorities under the EFF-supported program: - Authorities committed to SSN spending of Rs. 187 billion (0.6 percent of GDP) in 2023 covering the four monitored SSN programs and accounting for projected inflation in 2023. - Total beneficiaries initially expected to remain at around 3.3 million (the same level as at end-2022); future beneficiary numbers to be determined by new eligibility criteria. - Authorities plan to maintain SSN spending at least at around 0.6-0.7 percent of GDP beyond 2023. - Institutional reforms and implementation steps: - Operationalized the Welfare Benefit Board (WBB) under the Ministry of Finance; WBB revived in August 2022 with new Chairman and staff, empowered under the Welfare Benefits Act, No. 24 of 2002. - Developed a new Social Registry (SR) with 3.7 million applicants registered to receive welfare payments; new eligibility criteria based on objective and verifiable household characteristics (education, health, income, assets, housing conditions). - Next steps: enumeration process to validate SR data; rank prospective beneficiaries based on deprivation score; apply cut-off thresholds to select beneficiaries. - Introduce a new Welfare Benefit Payment Scheme covering the four monitored SSN programs; Parliamentary approval expected by May 2023 to enable benefit payments to commence in June 2023. - Transitional arrangements: transitional period until end-2023 to implement the new Scheme; by January 2024, ineligible beneficiaries would no longer receive cash transfers and could graduate onto lighter support such as Samurdhi livelihood programs. ### Statistics, public debt sustainability, and debt management - Fiscal reporting and statistics: - By end-September 2023, the MOF’s Department of State Accounts to report monthly cash flows from revenues, expenditures, and financing by the third business day of the subsequent month. - Update fiscal reporting framework to the GFSM 2014 standard. - Form a committee to hold bi-weekly meetings to address timeliness, accuracy, and coverage of fiscal data. - Public debt sustainability goals: - Reduce the ratio of public debt to GDP to below 95 percent by 2032. - Reduce the central government’s annual gross financing needs below 13 percent of GDP, on average, in 2027-32. - Reduce the central government’s annual debt service in foreign currency below 4.5 percent of GDP in every year in 2027-32. - Debt management: - A quarterly bulletin on public debt and debt service has been drafted. - Establish a public debt management agency by December 2023 and complete the establishment by December 2024. - MOF to publish a quarterly bulletin on public debt and debt service. ### Restoring price stability and rebuilding external buffers - Monetary policy actions and targets: - Policy rates were raised by 700 basis points in April 2022, 100 bps in July 2022, and 100 bps in March 2023. - Program objective: reduce the headline CCPI inflation and stabilize it around its target band of 4-6 percent (YoY) by end-2024. - Reduce CBSL’s T-bill holdings and discontinue monetary financing. - Central Bank framework: - A new draft Central Bank Act (CBA) has been approved by the Cabinet. - Parliamentary approval of the new Central Bank Act is a future outcome. - Exchange rate and reserves: - Temporarily introduced market guidance to confine daily exchange rate movements within a pre-defined band; guidance to be removed effective March 7, 2023. - Future actions: rationalize FXI decision based on objective criteria, subordinate it to CBSL’s price stability mandate, ensure FX intervention budget is consistent with meeting the NIR targets. - Foster a deeper and more liquid foreign exchange market and develop systems for managing exchange rate risks. ### Ensuring financial stability and banking sector reforms - Banking system and recapitalization: - Assessors appointed for bank diagnostic exercise. - Completion of the bank diagnostic exercise and development by the CBSL of a roadmap for addressing banking system capital and FX liquidity shortfalls. - Determination by the government of the size, instruments, and terms and conditions for potential government recapitalization of viable banks. - Financial sector supervision and crisis management: - A new Banking (Special Provisions) Act has been approved by Cabinet, updating the current Banking Act to strengthen CBSL's crisis management powers. - Update by the CBSL of the Emergency Liquidity Assistance framework for banks. - Drafting of revised Banking Act is underway. - Future approvals sought: Parliamentary approval of the Banking (Special Provisions) Act; Cabinet and Parliamentary approval of revised Banking Act. - Governance of State-owned Banks (SOBs): - Provisions in the Banking Act to strengthen resilience and governance of SOBs. - Reforms to governance of SOBs and appointment process for directors and senior management. ### Anti-corruption, governance, and transparency measures - Measures taken and planned: - Draft of the anti-corruption legislation is underway. - Enact new anti-corruption legislation to harmonize it with the United Nations Convention Against Corruption. - Publication commitments (to be published on a semi-annual basis): - all significant public procurement contracts; - a list of all firms receiving tax exemptions through the Board of Investment; - a list of individuals and firms receiving tax exemptions on luxury vehicle imports. - Operationalize an online transparency platform by March 2023. - Statistics and transparency overlap: - A quarterly bulletin on public debt and debt service has been drafted which will help enhance debt transparency. - Improve fiscal transparency by improving timeliness and accuracy of fiscal data and enhancing debt transparency. *Source: 1lkaea2023001 - introduction of automatic tariff* ### References ### 1lkaea2023001 - References ### References cited - World Bank, (2022), Sri Lanka Development Update: Protecting the Poor and Vulnerable in a time of Crisis. The World Bank. - World Food Program, (2023), WFP Sri Lanka Situation Report. WFP. - FAO and WFP, (2022), Special Report – FAO/WFP Crop and Food Security Assessment Mission (CFSAM) to the Democratic Socialist Republic of Sri Lanka. FAO. ### Annex V. Financial‑Sovereign Nexus — key findings and vulnerabilities - Structure and scale - Total assets of financial institutions amounted to 141 percent of GDP by the end of 2021. - 32 commercial and specialized banks constitute 70 percent of total system assets. - Four banks are designated by the CBSL as domestically systemically important. - Nonbank financial institutions (NBFIs) consist mainly of deposit-taking Licensed Finance Companies (LFCs), pension funds, and insurance companies. - Table summary as presented: Total141100 - State ownership and concentration - The two largest commercial banks are state-owned, accounting for over one third of total banking assets. - Retirement fund sector dominated by government-owned Employees’ Provident Fund (EPF) and Employees’ Trust Fund (ETF), which manage over 90 percent of total retirement fund assets. - Sovereign exposure and valuation risk - Public sector credit exposure accounts for more than 40 percent of banks’ assets, and higher at state-owned banks. - More than two thirds of this exposure is in domestic currency, and around half in the form of Treasury bonds. - Banks hold foreign currency exposures including ISBs and SLDBs and state-owned bank loans to SOEs and the government. - Banks made substantial provisions against ISBs in 2022, but provisions still imply lower losses than market valuations; ISBs currently trade at prices below 40 percent of par. - Most local currency government bonds are accounted for on an amortized cost basis and are booked well above current market value, as 10-year T-bond yields have risen to around 28 percent from 12 percent at end-2021. - NBFI sovereign concentration - EPF holds around 29 percent of total domestic local currency government debt, with 94 percent of its investments in government debt. - ETF invested 80 percent of its portfolio in government debt by 2021. - Insurance companies’ exposures to government debt accounted for 43½ percent of their assets. - Capital and FX shortfall risks from sovereign restructuring - Banks’ exposure to the public sector as of end-September 2022 amounts to 33 percent of projected 2022 GDP, more than 5 times their total capital of 6½ percent of GDP. - Staff analysis indicates an illustrative restructuring scenario (from the DSA, Annex II) combined with a severe asset quality shock could result in capital shortfalls for some banks. - Private sector capital may be difficult to secure until the economy stabilizes, especially for state-owned banks; authorities committed in the MEFP to a plan for potential bank recapitalization and the DSA includes a contingent liability to reflect this. - Banks’ net open foreign exchange position would deteriorate significantly in a restructuring scenario: - Share of FX assets increased from 16 percent at end-2021 to 25 percent of banks’ assets (post‑depreciation). - Restructuring of public FX debt, or repayment in rupees, could cause banks’ FX liabilities to significantly exceed FX assets, creating FX short positions that could generate further losses if the rupee depreciates or if banks cannot secure sufficient FX inflows. - Policy implication: banks and the authorities require a plan to close the net open FX position in the banking sector. ### Annex VI. Central Bank Act — reforms and provisions - Legislative timeline and context - The current legal framework is the Monetary Law Act (MLA), enacted in 1949 and amended to incorporate amendments up to 2014. - Authorities developed a Central Bank Act (2023 CBA); Cabinet approved the 2023 CBA in December 2022, with Parliamentary approval expected by April 2023. - Key features of the 2023 CBA - Clarification of objectives: - Price stability is clarified as the CBSL’s primary objective, ensuring Sri Lanka’s commitment to becoming a flexible inflation targeter under a flexible exchange rate regime. - Financial stability is clarified as a secondary objective. - Strengthened autonomy: - The new CBA removes government representation from both the Governing Board and the Monetary Policy Board. - Qualification criteria disqualify government officials from being board members, closing potential loopholes for future appointments of government officials to these boards. - Prohibition of monetary financing: - The new CBA will prohibit the CBSL from (i) purchasing securities issued by the government or any other public entity in the primary market, and (ii) directly or indirectly granting credits to the government or any public entities. - This reverses MLA permissions that allowed advances, guarantees, and participation in primary T-bill auctions. - Enhanced transparency and accountability: - The CBA legally mandates the CBSL to communicate Monetary Policy Board decisions. - Requires the CBSL to submit reports to the Minister of Finance in the event of economic disturbances threatening price stability. - Provides legal underpinning for an Audit Committee consisting of non-executive Board members to assist the Governing Board in oversight, including budget approval, financial reporting, risk management, and internal controls. ### Annex VII. Governance Diagnostic and Anti‑Corruption Legislation — agenda and timelines - Governance Diagnostic (GD) - Objective: GD will examine the severity of corruption and identify macro‑economically critical governance weaknesses and corruption vulnerabilities; it does not aim to identify corrupt institutions, individuals, or transactions. - Scope: Six core state functions — (i) fiscal governance, (ii) financial sector oversight, (iii) central bank governance, (iv) market regulations, (v) rule of law, and (vi) AML/CFT. - Modality: IMF experts will interact with authorities and broader stakeholders including civil society organizations and international partners. - Output: Findings will be published in a Governance Diagnostic report by September 2023; report to include prioritized, tailored, and sequenced recommendations. - Anti‑corruption legislation and implementation - New anti‑corruption law is under government review before submission to Parliament; expected to be enacted by June 2023. - Draft law provisions include: - Creation of an anti‑corruption commission with authority to initiate investigations on its own accord. - Asset declaration requirements for public officers in accordance with the G-20 High-Level Principles on asset disclosure, including coverage of officials and reporting standards. - Strengthened conflict of interest system with clear standards and procedures. - Creation of a centralized system to receive, manage, verify asset and conflict declarations. - Dissemination of asset declarations to the public. - To ensure full compliance with UNCAC, authorities plan an additional bill by March 2024 covering comprehensive asset recovery provisions (identify, trace, freeze, return and dispose foreign assets upon conviction) with IMF technical assistance. - Recommendations for implementation: - Specify timelines for implementing electronic asset declaration systems and verification. - Clarify interaction of the Commission with other law enforcement and oversight agencies given overlapping offenses in the draft. - Ensure anti‑corruption institutions have sufficient resources and that judiciary members are independent and qualified. - Promote international cooperation, particularly on proceeds of corruption. - Broader agenda: Adoption of the new law should be part of a comprehensive anti‑corruption agenda including platforms for meaningful public participation. ### Appendix I. Letter of Intent — program request and commitments (selected facts) - Date and primary statements - Letter dated March 6, 2023, from Sri Lanka to IMF Managing Director. - Describes Sri Lanka as facing the worst economic crisis in its history; inflation peaked at 70 percent in September 2022. - Requests IMF support and commits to comprehensive economic adjustment program. - IMF program request specifics - Requests a 48-month Extended Arrangement under the Extended Fund Facility (EFF) in the amount of SDR 2,286 million (395 percent of quota). - Requests IMF Executive Board approve making available SDR 254 million (43.9 percent of quota) upon approval of the arrangement. - Notes the arrangement will catalyze support from Asian Development Bank and the World Bank. - Policy commitments and safeguards - MEFP and TMU to set quantitative targets and structural benchmarks; eight semi-annual reviews under the arrangement. - Commitment to restore public debt sustainability; declaration of debt service standstill in mid-2022 and engagement with creditors. - CBSL safeguards assessment completed in February 2023; authorities will put in place a memorandum of understanding between CBSL and Ministry of Finance clarifying responsibilities for timely servicing of IMF obligations. - Request for temporary approval of exchange restrictions and multiple currency practices as permitted under IMF policies. - Authorities consent to IMF publication of the letter and attachments. *Source: 1lkaea2023001 - References (content unit text).* ### 1. Sri Lanka encountered the most challenging year in 2022 in its post-independence ### 1. Sri Lanka encountered the most challenging year in 2022 in its post-independence ### II. Economic Program — objectives and pillars - Program objectives: - Restore macroeconomic stability and public debt sustainability. - Rebuild international reserves and restore price stability. - Safeguard financial stability, address governance and corruption vulnerabilities, and unlock growth potential. - Key pillars of the program: - (i) an ambitious primarily revenue-based fiscal consolidation, accompanied by fiscal institutional reforms and cost-recovery based energy pricing; - (ii) a stronger social safety net to protect the most vulnerable; - (iii) a sovereign debt restructuring strategy aimed at restoring public debt sustainability; - (iv) a multi-pronged strategy to restore price stability and rebuild international reserves under greater exchange rate flexibility; - (v) policies to safeguard financial stability; - (vi) focused reforms to address governance and corruption vulnerabilities; - (vii) broader structural reforms to unlock Sri Lanka’s growth potential. ### III. Macroeconomic outlook and program baseline projections - Real GDP projections: - Contract by 8.7 percent in 2022. - Contract by 3 percent in 2023. - Converge gradually towards growth of 3.1 percent over the medium term. - Key factors behind projections: - Fuel shortages, power cuts, and supply disruptions of intermediate goods (including construction materials and fertilizer) in the near term. - Significant fiscal policy tightening under the program. - The banking sector’s limited capacity to support private sector activity. - Inflation and monetary policy: - Inflation slowed to 57 percent by end-2022. - Tight monetary policy under the program, moderation of imported inflation, and base effects will support a disinflation path consistent with the target bands under the Monetary Policy Consultation Clause (¶17), and toward the CBSL’s target band of 4-6 percent by end-2024. - External sector: - Fiscal adjustment, recovery in tourism, and competitiveness gains through exchange rate adjustment will help restore a non-interest current account surplus in the near term, supporting rebuilding reserves. ### IV. Fiscal consolidation targets and program quantitative goals - Central government primary surplus target: - Achieve a central government primary surplus of 2.3 percent of GDP by 2025 and in subsequent years. - Primary balance path (program milestones): - Primary balance: -3.8 percent of GDP in 2022 (preliminary estimate). - Primary balance: -0.7 percent of GDP in 2023. - Primary balance: 0.8 percent of GDP in 2024 (quantitative performance criterion). - Programmatic fiscal governance commitments: - National budgets approved by Parliament will be consistent with program parameters including targets on the primary balance, revenues, and non-interest expenditure. - Needed revenue measures will be approved by Cabinet by July of the preceding year (structural benchmarks). - Quantitative targets and indicative targets: - Increase tax revenue collection (indicative target). - Protect and increase social safety net spending (indicative target). - Reduce the stock of budget expenditure arrears to zero (quantitative performance criterion). - Limit the issuance of treasury guarantees (indicative target). ### V. 2022 fiscal outturn and revised 2022 budget details - Revised 2022 budget prior actions and targets: - Targeted a 2022 primary deficit of Rs 954 billion (4.0 percent of GDP). - Outturn overperformed relative to this target by Rs 59 billion (0. 25 percent of GDP). - Expenditure allocations and outturns: - Capital expenditure in revised budget: Rs 801 billion. - Additional cash transfers allocated: Rs 140 billion. - Allocation to cover remaining CEB losses: Rs 93 billion. - Actual capital spending reached Rs 715 billion (3 percent of GDP). - Ceylon Petroleum Corporation (CPC) short-term loans: - Short-term government loans to CPC amounting to US$0.7 billion were extended and will be repaid in 2023 due to CPC’s larger than expected working capital requirements. ### VI. Revenue measures and tax reform package (sequencing and specifics) - Medium-term revenue goal: - Raise tax revenue to at least 14 percent of GDP by 2026 (from 7.3 percent in 2021). - May 30, 2022 tax reform package (about 0.5 percent of GDP in 2022; 1.2 percent of GDP in annual terms): - Increase marginal personal income tax (PIT) rate schedule, raising the top marginal rate to 32 percent and reducing the tax-free allowance to Rs 1.8 million, with the tax rate rising by 4 percentage points for every Rs 1.2 million above this allowance up to the top rate. - Raise the standard corporate income tax (CIT) rate from 24 to 30 percent and remove some firm-specific tax holidays. - Raise the standard value added tax (VAT) rate from 8 to 12 percent, lower the VAT registration threshold to Rs 120 million, and remove some VAT exemptions. - Reinstate mandatory income tax withholding. - VAT rate hike took effect on June 1. - Additional and more ambitious revenue measures (to meet 2023 primary deficit target of 0.7 percent of GDP): - Increased the marginal PIT rate schedule: top marginal rate set to 36 percent and the tax-free allowance to Rs 1.2 million, with the tax rate rising by 6 percentage points for every Rs 0.5 million above this allowance up to the top rate. - Reintroduced non-final withholding taxes on all payments other than dividends, and introduced a final withholding tax for dividends, at the tax rates specified under the May 30 tax reform package. - Removed all sector-specific CIT exemptions, unifying the CIT rate structure at the standard rate of 30 percent. - Raised the standard VAT rate from 12 to 15 percent, removed a selected list of VAT exemptions, and lowered the VAT registration threshold to Rs 80 million. - Increased excises on alcohol and tobacco products by 20 percent each on January 3, 2023, and January 1, 2023, respectively, and will do so again before end-June 2023, with the latter adjustment subject to review in consultation with IMF staff. - Increased fuel excises yielding 0.3 percent of GDP. - Cabinet approval of the revenue measures needed for programmed fiscal consolidation in 2023 (prior action); legislative revisions to implement 2023 revenue measures approved by Parliament in December 2022. - VAT and excise reforms toward 2024 and 2025: - Revamp the VAT system, abolish the vast majority of exemptions, speed up valid VAT refunds, and abolish the Simplified VAT (SVAT) system. Reform proposal to be submitted to Cabinet for approval by April 2023. - Introduce automatic indexation of excises to inflation by January 1, 2024. - To reach a primary fiscal surplus of 2.3 percent of GDP by 2025, revamp the property tax system and introduce a wealth transfer tax: - Introduce a nationwide real property tax and adjust transfers between central and provincial governments. - Introduce a gift and inheritance tax with a tax-free allowance and minimal exemptions. - Preparatory work for these tax reforms will commence by mid-2023, supported by IMF technical assistance. ### VII. Revenue administration and tax compliance reforms - Ongoing and planned measures: - Newly introduced paper-based and digital sticker system boosted alcohol excise revenues. - Made withholding tax mandatory for all employees earning more than the tax free allowance. - Imposed withholding tax on service payments exceeding Rs 100,000 per month to individuals such as high-income professionals at the rate of 5 percent, effective from January 1, 2023. - Step up administration efforts to ensure compliance with withholding requirements. - Strengthen the capacity of the Large Taxpayer Unit by adopting recommendations from IMF TA. - Strengthen VAT compliance using VAT e-filing and the fully implemented RAMIS IT system. - Document all tax expenditures provided under the Strategic Development Projects and Board of Investment Acts. - Implement necessary measures and arrangements to ensure timely implementation of the SVAT abolishment and the VAT refund reform, and introduction of property, gift, and inheritance taxes. ### VIII. Expenditure rationalization while protecting priorities - Containment and efficiency measures: - Develop strategies to limit growth in the public sector wage bill and public pension spending while avoiding salary cuts. - Allow limited public sector salary and public pension payment increases to partially account for inflation during the program within the program’s primary balance targets. - Boost public investment efficiency in light of fiscal space constraints on capital expenditure, following recommendations of the 2018 IMF Public Investment Management Assessment. - Protection of priority spending: - Preserve spending on health, education, and social protection. ### IX. Social Safety Nets (SSN) — expansion, targeting, and institutional reforms - 2022 SSN emergency support and spending: - Emergency top-up/additional cash transfers of Rs 5,000-7,500 per month per family during May-December 2022 to 2.5 million existing recipients and 0.8 million waitlisted recipients of the Samurdhi program and categorical programs. - SSN spending on these programs reached Rs 142 billion in 2022 (0.6 percent of GDP). - Programmatic SSN reforms and targets: - Gradually raise SSN spending and improve coverage and targeting to reduce inclusion and exclusion errors. - Improve coverage of categorical programs by including all eligible recipients and increasing per-beneficiary amounts. - In 2023, with World Bank support, provide new cash transfers targeted to the poorest quintile by implementing new selection criteria. - Spending floor on SSN spending of Rs 187 billion in 2023 (indicative target) comprising cash transfers under Samurdhi and three categorical programs. - 2023 budget allocation: Rs 134.33 billion; Cabinet approval obtained for an additional Rs 53.75 billion through the contingency budget allocation under the Department of National Budget. - Raise and protect social spending related to nutrition and education (school nutrition program and nutrition for expectant mothers) over the medium-term. - Institutional improvements: - Operationalized the Welfare Benefits Board (WBB) under the Ministry of Finance; appointed the Chairman and assigned staff. - WBB to carry out registration, selection and validation of beneficiaries, and coordinate payments of welfare benefits. - Developing a new Social Registry, an electronic database of applicants for welfare programs; registry has been populated and data validation will be completed. - New eligibility criteria for targeted cash transfers based on objective and verifiable characteristics were developed with World Bank technical support and approved by Parliament in February 2023. - Parliamentary approval of the welfare benefit payment scheme and application of the new eligibility criteria to identify low-income families by May 2023 (structural benchmark); beneficiary selection process using new criteria to start in June 2023. - From January 2024, no ineligible beneficiaries will receive Samurdhi cash transfers. - Develop a graduation program for Samurdhi recipients who no longer require full support, transitioning them to a lighter package (e.g., Samurdhi livelihood program). - Establish donor coordination teams within the Ministry of Finance to lead discussions on external financing for SSN programs. ### X. Energy sector reforms — automatic cost-recovery pricing and fiscal safeguards - Rationale: - Retail fuel and electricity prices had generally been set below cost-recovery levels, leading to loss-making CPC and CEB and a debt overhang that hindered infrastructure investments. - Fuel pricing reforms: - Cabinet approval obtained to automate monthly retail fuel price adjustment as prescribed by the 2018 fuel pricing formula (prior action). - Going forward, retail fuel prices will be set to their cost-recovery levels on a monthly basis using the formula. - CPC will be compensated for any residual fuel subsidies with on-budget transfers (continuous structural benchmark). - Electricity pricing reforms: - Cabinet approval obtained to automate semi-annual cost-recovery based electricity price adjustment (prior action). - Electricity tariffs were raised by 75 percent in August 2022 and by 66 percent in February 2023. - Going forward, end-user electricity tariff schedule will be adjusted to cost-recovery levels with semi-annual formula-based adjustments in January and July each year (effective from January 1 and July 1, respectively). - CEB will submit tariff revision requests to the Public Utility Commission of Sri Lanka by end-October (for January revisions) and by end-April (for July revisions). - Residual electricity subsidies will be compensated with on-budget transfers (continuous structural benchmark). - Improve the Bulk Supply Transaction Account (BSTA) to accurately measure the electricity subsidy; start using it to determine cost-recovery based electricity tariff and government transfer requirement by December 2023 (structural benchmark). - Fiscal safeguards on energy SOEs: - A zero ceiling on the cost of non-commercial obligations for fuel and electricity (net of government transfers) will be set under the program (indicative target; see the Technical Memorandum of Understanding). - By June 2024, introduce legislative reforms making the Minister of Power and Energy responsible for implementing cost-recovery based fuel and electricity price adjustments. *International Monetary Fund — Sri Lanka program chapter content unit* ### 11. We will improve the timeliness, accuracy, and coverage of fiscal data. By end- ### 11. We will improve the timeliness, accuracy, and coverage of fiscal data. By end- ### Fiscal data timeliness, accuracy, and coverage - By end-September 2023, the MOF’s Department of State Accounts will report monthly cash flows from revenues, expenditures, and financing by the third business day of the subsequent month. - Update fiscal reporting framework to the GFSM 2014 standard. - Form a committee that will hold bi-weekly meetings to address any issues regarding the timeliness, accuracy, and coverage of fiscal data. ### Strengthening core public financial management (PFM) functions - Objective: strengthen macro-fiscal analysis and forecasting, fiscal data collection and reporting, fiscal management, budget formulation and execution, and public debt management through sequenced reforms. - Identified problem: government budgets have systematically overestimated revenues and underestimated interest payments, combined with weak expenditure management, leading to budget overruns and spending arrears. - Actions: - Better integrate the MOF’s recently established Macro-Fiscal Unit into fiscal policy decision making by clearly defining its roles and responsibilities, and strengthening its macro-fiscal analytical, forecasting, and reporting capacity. - Strengthen commitment-based spending controls by completing rollout of the Integrated Treasury Management Information System (ITMIS), a full-fledged IT-based PFM platform, and by introducing a more rigorous IT-based commitment control framework such as an e-procurement system for public investment. - Realize full functionality of the accounting, budget execution, and commitment modules of the ITMIS, and expand its coverage to all 220 heads (national budget execution agencies), by end-September 2023 (structural benchmark). - Expected outcome: improve analytical content of in-year budget execution reports. - Progress towards developing a medium-term fiscal framework (MTFF): - In 2023, develop multi-year baseline fiscal projections. - Work towards producing a Fiscal Policy Statement early in the budget preparation cycle to provide binding multi-year guidance for the budget and public investment. - Enact a new PFM law, supported by IMF TA: - Clarify the budget formulation process, specify roles and responsibilities of the MOF and spending agencies, and establish information and accountability requirements. - Include a revamped fiscal rules framework drawing on the draft bill developed under the 2016-20 EFF program, including a legally binding government debt ceiling consistent with the outcome of debt restructuring, augmented with an automatic correction mechanism and well-defined escape clause. - Set a legal definition of public debt and government deficit, consistent with GFSM 2014 and the Public Debt Statistics Guide for Compilers and Users. - Include stricter guidelines regarding the issuance of treasury guarantees (see ¶14). - Submit the new PFM law to Parliament by end-December 2023 (structural benchmark). - Improve public investment efficiency by implementing 2018 IMF Public Investment Management Assessment recommendations, focusing on strengthening project appraisal and selection processes by relying more on cost-benefit analysis. ### Structural reforms for state-owned enterprises (SOEs) - Objective: strengthen governance of SOEs and make them financially viable. - Measures to avoid renewed build-up of CPC liabilities: - (i) make automatic cost-recovery based fuel price adjustments (¶10); - (ii) take steps to make the CPC more efficient. - Cabinet approved the entry of additional private sector firms into the downstream petroleum sector in June 2022. - Debt overhang actions: - Reduced CPC debt overhang by transferring majority of its government-guaranteed FX debt to the government’s balance sheet. - By end-June 2023, obtain Cabinet approval of a comprehensive strategy with clear timelines and modalities to restructure balance sheets of the CEB, CPC, SriLankan Airlines (SLA), and the Road Development Authority, in consultation with IMF staff (structural benchmark). - Cabinet approval in November 2022 of a draft strategy by the SOE restructuring unit to reform the business model of SriLankan Airlines through phased divestment of the three subsidiaries. - Following envisaged restructuring of SLA’s balance sheet, any residual government-guaranteed FX loans will be transferred to the government’s balance sheet by September 2023; at that point, there will be no more government guarantees for the SLA’s FX loans. - Strengthen governance and financial transparency of SOEs: - (i) clarify mandates through Statements of Corporate Intent and hold management accountable using key performance indicators; - (ii) review framework for selecting SOE board members to ensure qualified and independent boards; - (iii) ensure all 52 major SOEs publish their audited financial statements on a dedicated website. - Status: For 2021, 33 SOEs have so far published audited financial statements for 2021. - Commitment: ensure remaining 19 major SOEs publish audited financial statements for 2021 and that audited financial statements for 2022 will be published by end-June 2023. ### Strengthening the framework for SOE borrowing - Policy throughout the program: - New SOE borrowing limited to financing commercially viable activities (e.g., investment projects); subsidies and quasi-fiscal activities to be remunerated through government transfers. - Except for project loans on-lent by the Treasury and short-term trade financing, no new borrowing in foreign currency for non-financial SOEs with less than 20 percent of revenues denominated in foreign currency. - New PFM law (¶12) provisions: - (i) prohibit new Treasury guarantees to SOEs with negative equity; - (ii) prohibit new Treasury guarantees on SOE liabilities in foreign currency. - Strengthen governance and oversight of state-owned banks so lending to SOEs is guided solely by commercial considerations (see ¶24). ### Restoring public debt sustainability - Commitments and quantitative targets: - Reduce ratio of public debt to GDP to below 95 percent by 2032 from around 128 percent in 2022. - Reduce the central government’s annual gross financing needs below 13 percent of GDP, on average, in 2027-32, from 34.6 percent of GDP in 2022. - Reduce the central government’s annual debt service in foreign currency below 4.5 percent of GDP in every year in 2027-32, from 9.4 percent of GDP in 2022. - Debt restructuring and negotiations: - Suspended external debt service payments to certain categories of creditors including private and official bilateral creditors from April 12, 2022 onwards. - Hired legal and financial advisors to support engagement with creditors and continue good-faith negotiations. - Reclassifications effective retroactively at end-December 2022 (cabinet decision in January 2023): - Loans from China Exim Bank earlier reclassified as debts of the CEB, SLPA, and AASL have been recognized as central government debt. - Majority of guaranteed FX debt of the CPC recognized as central government debt (see also ¶13). - Commitment to debt resolution consistent with IMF program parameters and fair and equitable burden sharing among creditors. - Engaged external commercial creditors through early dialogues, timely information sharing, and opportunities for input on restructuring strategies. - Received specific and credible assurances from the Paris Club, India, Hungary, and the Export-Import Bank of China that they will provide debt relief consistent with restoring Sri Lanka’s debt sustainability under the IMF program. - Other bilateral official creditors have consented to Fund financing notwithstanding arrears and committed to continue working towards debt treatment consistent with restoring debt sustainability. - Sri Lanka will refrain from resuming debt service payments to any external commercial or bilateral creditor unless it agrees to a comprehensive debt treatment in line with IMF program parameters, debt sustainability targets, and the comparability of treatment principle. - Willingness to use additional safeguard mechanisms, including appropriate forms of contractual commitments such as Most Favored Creditor Clause, acceptable to relevant creditors at the time. - Exploring options for a domestic debt operation aimed at providing substantial liquidity relief to the government, in line with the program parameters, while preserving financial stability. - Concluding preparatory work and plan to make an announcement on coverage and parameters of the external and domestic debt operations before end-April 2023. - Disclosure: - Provided amounts and terms on all outstanding debt obligations, including contingent liabilities, to IMF staff. - Confirm none of the loans obtained or guaranteed by the government are collateralized. ### Improving debt management and debt transparency - Institutional reforms: - Public debt currently managed by the CBSL’s Public Debt Department, the MOF’s External Resources Department and Treasury Operation Department. - Complete legislative requirements to establish a public debt management agency (PDMA) in line with international best practices by December 2023 and complete establishment of the agency by December 2024. - PDMA functions: - Report to and be accountable to the Ministry of Finance but have significant operational autonomy. - Assume overall policy responsibility for debt management by formulating medium-term debt strategies and annual borrowing plans. - Direct implementation of annual borrowing plans, including decisions on auction cut-offs. - Oversee all domestic and international market-based financing decisions and participate in evaluation of all debt, derivatives, and guarantees. - Debt transparency measures: - MOF will regularly publish a quarterly bulletin of public debt and debt service. - First bulletin published in February 2023 covers debt situation as of end-September 2022. - Continue quarterly bulletin and publish by end-April 2023 the debt situation as of end-2022. - Commitment to gradually broaden the bulletin’s coverage to stock and debt service flows of all liabilities and contingent liabilities of the budgetary central government and of extrabudgetary central government units. - Issue guidelines regarding the statistical treatment of guaranteed debt of distressed corporations, and the transfer of government liabilities to SOEs, to be approved by Cabinet. ### Restoring price stability and rebuilding external buffers - Disinflation strategy and inflation target: - Reduce headline CCPI inflation towards and stabilizing it around target band of 4-6 percent (YoY) by end-2024. - Monitoring through a Monetary Policy Consultation Clause (MPCC), including both inner and outer bands (of ±1.5 and 3 percentage points). - Policy consultation with IMF staff ahead of each Monetary Policy Board meeting before the inflation target is reached. - A breach of the inner and outer bands would require completion of a policy consultation with the IMF staff and the IMF Board, respectively (see Technical Memorandum of Understanding). - Monetary policy stance: - Following increases in policy rates by 700 basis points in April and 100 bps in July 2022, CBSL raised the policy rate by another 100 bps in March 2023 (prior action), which currently stand at 15.5-16.5 percent. - Headline and core inflations eased to 54 and 46 percent by January 2023 as food inflation moderated. - Note: inflation levels may remain high in the coming months due to the electricity price hike announced in February 2023. - Expectation: inflationary pressures to gradually ease as recent tightening of monetary conditions helps re-anchor inflation expectations, supported by moderation of cost-push inflation and base effects. - Observations: Treasury yields and the prime lending rate have risen to 28 and 24 percent, respectively, and private credit has been contracting in context of contracting economic activity. - Under flexible inflation targeting, CBSL stands ready to adjust policy stance to deliver programmed disinflation path and reach and maintain forward-looking real policy rates at sufficiently positive levels until inflationary pressures are clearly receding. - Ready to tighten further as needed, guided by inflation performance against the MPCC, while closely monitoring underlying inflation pressures and financial stability implications of rising interest rates. - Refraining from monetary financing: - Fiscal adjustment, debt relief, and new external financing under the program will allow deficits to be financed sustainably without relying on inflationary monetary financing (direct credit to government). - Reduction in net domestic financing needs and improvement in net international reserves will enable CBSL to gradually unwind remaining large holdings of Treasury securities. - Pace of reduction informed by market’s estimated capacity to absorb CBSL’s divestment and need to prevent excessive expansion of CBSL’s balance sheet from rebuilding reserves. - Reduction and discontinuation of monetary financing will be monitored by quantitative performance criterion on ceiling of CBSL’s net credit to the government (excluding CBSL’s temporary holdings of treasury securities for short-term monetary operations; see TMU). - Ceiling for end-June 2023 set at the level recorded at end-January 2023, and programmed to be reduced by Rs 150 billion during 2023H2. - A program adjustor will be introduced to allow monetary financing in case of potential shortfall in external program financing in the first 6 months of the program. - Exchange rate flexibility and rebuilding reserves: - Committed to restoring a market-determined and flexible exchange rate as a buffer against external shocks. - Sharp rupee depreciation since March 2022 expected to close the REER and current account gaps by 2023, supporting external adjustment (2021 Article IV consultation Fund staff report estimated a real overvaluation of 17 percent in 2021). - Temporarily introduced market guidance to confine daily exchange rate movements within pre-defined band around weighted average spot interbank rate of previous trading day; will eliminate this market guidance with effect of March 7, 2023. - Gradually rebuild gross international reserves including through outright FX purchases in the market, supported by a non-interest current account surplus, new external financing and other non-debt creating inflows, and sovereign debt relief. - Commit to meet program targets on Net Official International Reserves (NIR) (quantitative performance criterion), predicated on CBSL’s outright FX purchases on a net basis by $1.4 billion in 2023. - Commit to save any overperformance in accumulating the NIR. - Limit FX intervention to truly disorderly market conditions that could lead to destabilizing inflation and/or balance sheet effects and transparently disclose intervention transactions. - Rationalize intervention decision based on objective criteria and subordinate it to CBSL’s price stability mandate while ensuring FX intervention budget is consistent with meeting NIR targets. - Institutional framework for inflation targeting and exchange rate flexibility: - New Central Bank Act (CBA) prepared during 2016-20 EFF arrangement with IMF technical assistance and submitted to Parliament in November 2019; commitment to enact new CBA to strengthen CBSL independence and modernize policy framework for credible inflation targeting. - Provisions to (i) establish price stability as CBSL’s primary objective and financial stability as a core objective; (ii) buttress CBSL’s operational autonomy by removing government representation from the Monetary Policy Board; (iii) prohibit monetary financing of the fiscal deficit. - Act will include modification to remove government representation from the Governing Board and a new transitional arrangement for gradually unwinding CBSL’s large government securities holdings (¶18). - Authorities worked with IMF staff on amendments to ensure (i) consistency of Act with the Constitution; (ii) accountability of the central bank to parliament; (iii) a coordination mechanism between CBSL and MOF. - To allow new Act to become effective in 2023, obtained Cabinet approval in December 2022 (prior action) and submitted Act to Parliament in February 2023, with aim to ensure approval by Parliament by end-April 2023 (structural benchmark). - Commitment to foster a deeper and more liquid foreign exchange market and develop adequate systems for managing exchange rate risks, including with IMF technical assistance. *Source: 1lkaea2023001 - 11. We will improve the timeliness, accuracy, and coverage of fiscal data. By end-* ### 21. We will phase out the administrative measures imposed to support the balance of ### 21. We will phase out the administrative measures imposed to support the balance of payments, including those introduced on an emergency basis, once conditions allow. ### Phase-out commitment and conditions - Commit to phasing out import restrictions, exchange restrictions, multiple currency practices (MCPs), and capital flow management (CFM) measures as the balance of payments stabilizes. - By June 2023, prepare a plan for the phased removal of these measures during the program period, conditional on progress in: - achieving macroeconomic stability, particularly with respect to the exchange rate, debt sustainability, and financial stability; - improved market access prospects; and - accumulation of reserves above critical levels. - Program undertakings during the program period: - will not introduce or intensify exchange restrictions or MCPs; - will not impose or intensify import restrictions for balance of payments purposes; - will not conclude any bilateral payment agreements inconsistent with Article VIII (continuous performance criteria). ### Import restrictions (2020-22) - Over 2020-22 suspended the import of many non-priority non-critical goods to contain the import bill and relieve BOP pressures, noting these measures also hurt economic activity. ### Exchange restrictions in place (enumerated) - (i) Prioritization and rationing of FX by CBSL and CBSL’s informal guidance to Authorized Dealers (ADs) to prioritize access to FX for essential items, resulting in undue delays and payment arrears for current international transactions. - (ii) Prohibitions on converting LKR into FX for certain current international transactions (e.g., servicing certain external loans, payment of any income on certain nonresident investments). - (iii) Unremunerated cash margin deposit requirements on imports of certain items under letters of credit (LC), documents on payment (DP) and documents on acceptance (DA) payment terms. - (iv) Levy of a 2.5 percent stamp duty on credit card transactions abroad. - (v) Levy of a 14 percent remittance tax on nonresidents’ profits. - (vi) Limits on repatriation by nonresidents of proceeds derived from current transactions. - (vii) Requirement to provide a tax clearance certificate prior to permitting transfers for certain current transactions. - (viii) Sri Lanka’s net debtor position under the Asian Clearing Union payment arrangement that is pending settlement for longer than 90 days (understood cannot be approved under Fund policies). ### Multiple currency practices (MCPs) identified - (i) Unremunerated cash margin deposit requirement on imports of certain items made under LC, DA and DP payment terms. - (ii) Use of a weekly volume weighted average exchange rate for the mandatory surrender of FX by ADs of certain proceeds to the CBSL. - (iii) Official exchange rate calculated based on the previous day’s transactions in the interbank FX market and used for CBSL’s FX transactions with the government. - (iv) Use of the weekly volume weighted average rate for CBSL`s FX sales in bilateral non-Request for Quote outright spot transactions with ADs. - (v) Levy of a 2.5 percent stamp duty on credit card transactions abroad. - (vi) Levy of a 14 percent remittance tax on nonresidents’ profits. - At the time of Sri Lanka’s 2022 Article IV consultation, one MCP arising from incentives on inward worker remittances remained in place: an incentive of LKR 1,000 provided through ADs towards covering the transactions costs of each inward worker remittance equivalent to LKR 20,000 or more that is converted into LKR through such ADs remains in place. Previously, inward remittances of FX sent by workers abroad through ADs in Sri Lanka and exchanged into LKR were converted at an exchange rate that was LKR 2 per 1 USD above the exchange rate used by ADs for conversion of any other inward remittances (terminated on January 1, 2023). For a short period between December 2021 and March 2022, an additional incentive of LKR 8 per 1 USD was paid (discontinued on March 8, 2022). ### Capital flow management (CFM) measures - New CFMs introduced and existing CFMs tightened, including on payments outside of Sri Lanka from foreign currency deposit accounts during the pandemic and recent crisis. - Main CFM measures introduced or tightened in 2020-2022 and currently in force include: - (i) a repatriation requirement for exports of goods and services; - (ii) a surrender requirement for exporters on proceeds from exports of goods; - (iii) a surrender requirement for banks on purchases of export proceeds; - (iv) a 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. ### Approvals sought from the Fund - Seeking temporary approval of exchange restrictions (i)-(vii) and all MCPs. Acknowledge exchange restriction (viii) cannot be approved under Fund policies. --- ### VI. Ensuring Financial Stability ### Banking sector vulnerabilities and diagnostic exercise - Banks face large exposures to the public sector, increasing credit risk in private sector loan books, and shortages of foreign exchange. - CBSL hired two internationally reputable independent specialist firms without conflicts of interest to undertake a diagnostic exercise for a group of banks accounting for more than 70 percent of domestically-owned bank assets as of end-June 2022, including the two largest state-owned banks and the three largest private sector banks, based on a Terms of Reference agreed with IMF staff. - The diagnostic will assess the impact on banks’ capital from asset quality deterioration, FX depreciation, and the sovereign default. - CBSL will provide assessors with guidance on the expected impact of debt restructuring on impairment and the risk-weighting of public sector debt exposures and ensure heightened supervision of banks’ valuation, classification, and impairment practices for exposures to the sovereign and the broader public sector, and to loans which have benefited from moratoria and forbearance measures. - Independent firms to conduct the diagnostic have been hired (prior action). - Asset quality review component for the five banks to be completed by April 2023 (structural benchmark) and remaining components shortly after key debt restructuring terms are clarified. - Asset quality review will be completed by August 2023 for four more banks (three private and one public) accounting for a further 20 percent of domestically owned banking assets. ### Capital restoration, FX positions, and recapitalization roadmap - The five assessed banks required to submit time-bound plans for capital restoration and closure of their FX net open positions by June 2023. CBSL to define plan content, review credibility, and oversee implementation. - CBSL to take appropriate action regarding banks unable to ensure viability, beginning with intensifying supervision and imposing prompt corrective actions. - By July 2023, CBSL will develop a roadmap for financial sector restructuring and recapitalization to address capital and FX liquidity shortfalls identified through the diagnostic exercise, and intervene in banks assessed to be non-viable (structural benchmark). Roadmap will include binding deadlines for compliance with capital requirements including buffers to be restored. - MOF will determine size, timing, instruments, and terms and conditions for potential government recapitalization of viable banks unable to close capital shortfalls from private sources by October 2023 (structural benchmark). - A similar process for the remaining four banks: CBSL will develop a roadmap by November 2023 and MOF will determine the detailed recapitalization plan by January 2024. - Authorities will consult with IMF staff on design and implementation. ### Crisis coordination and contingency planning - Establish as soon as possible a coordinating committee to manage response to financial sector issues, including representatives from the MoF, CBSL (including resolution and deposit insurance departments) and other CBSL departments and authorities as needed (e.g., regulators for insurance and pension funds). - Committee responsibilities: high-frequency monitoring, in-crisis coordination, information-sharing, effective communication among authorities and the general public, and oversight of contingency plans for regulated entities. - CBSL will act as committee secretariat. ### Strengthening supervisory and resolution frameworks - Cabinet approved the Banking (Special Provisions) Act in November 2022 to strengthen CBSL’s crisis management powers (prior action); Parliamentary approval to be obtained by April 2023. - Full revision of the Banking Act to be approved by Cabinet by June 2023 (structural benchmark) and by Parliament by December 2023 (structural benchmark), with a view to implementing by January 2024. - Reforms will strengthen: - (i) resolution authority mandate of the CBSL, powers, tools, and funding mechanisms for resolution of distressed financial institutions; - (ii) deposit insurance framework – including appropriate backstop funding arrangements from the government – and the regime for liquidation of financial institutions; - (iii) regulatory standards in areas including bank licensing, bank ownership, consolidated supervision, capital and liquidity framework, large exposures and related party transactions, governance requirements, and recovery planning and early intervention powers; - (iv) regulation and supervision of state-owned banks. - For non-bank deposit-takers, CBSL has eliminated regulatory arbitrage on non-performing loan classification and capital requirements. Review of the Banking Act and the Finance Business Act will take further steps to end regulatory arbitrage. - Structure, staffing, and funding of the Resolution and Enforcement Directorate in the CBSL will be strengthened. - CBSL updated Emergency Liquidity Assistance framework in November 2022 and will review access by non-bank financing companies; liquidity provision to these companies by the deposit insurance fund will be ended. --- ### VII. Reducing Corruption Vulnerabilities ### Governance and anti-corruption program pillars - Asked IMF staff to conduct a governance diagnostic TA mission; the IMF governance diagnostic report will be published by end-September 2023 (structural benchmark) and will identify priority reforms for the program. - Develop comprehensive legislation harmonizing anti-corruption laws with the United Nations Convention against Corruption (UNCAC), supported by IMF technical assistance, including: - strengthening the asset declaration system in accordance with the G-20 High-Level Principles on asset disclosure by public officials (coverage of officials and reporting standards); - creation of an anti-corruption commission with authority and strengthened independence for investigations. - Draft legislation (not covering comprehensive asset recovery provisions) under review by a review Committee before final Cabinet approval; legislation to be enacted by June 2023 (structural benchmark). - Transparent and merit-based process for selecting members of the independent commission to be integrated explicitly into the legislation. - Comprehensive asset recovery provisions in compliance with UNCAC expected to be developed in consultation with IMF staff and incorporated into separate draft legislation pertaining to Proceeds of Crime by March 2024. ### Other anti-corruption and transparency measures - Expand reliance on digitalization in revenue administration and procurement to reduce corruption opportunities. - Improve fiscal transparency by enhancing timeliness and accuracy of fiscal data and debt transparency. - Commit to publishing on a semi-annual basis: - (i) all significant public procurement contracts; - (ii) a list of all firms receiving tax exemptions through the Board of Investment; - (iii) a list of individuals and firms receiving tax exemptions on luxury vehicle imports. - An online transparency platform will be operational by March 2023. ### Strengthening AML/CFT and institutional capacity - With World Bank TA, update National ML/FT Risk Assessment (NRA) to inform national AML/CFT strategy for 2023-28. - Strengthen AML/CFT legal framework via amendments: - Companies Act amended to strengthen beneficial ownership provisions relating to legal persons (the only remaining non-compliant aspect of the FATF 40 Recommendations). - Amendments being finalized for the Prevention of Money Laundering Act, the Convention on Suppression of Terrorist Financing Act, the Financial Transactions Reporting Act, and the Voluntary Social Service (Registration and Supervision) Act. - Strengthen risk-based AML/CFT supervision through regular supervision of financial institutions and designated non-finance businesses and professions and joint supervisory activities via other regulatory bodies (BSD, SNBFI, SEC & IRCSL). - Conduct AML/CFT risk-based supervision focusing on compliance with beneficial ownership requirements and enhanced due diligence for politically exposed persons. - Strengthen use of financial intelligence to identify potential corruption and cooperation between FIU, law enforcement, and CIABOC to facilitate parallel investigations and prosecutions. - Strengthen institutional framework of the FIU by providing adequate resources and leverage development partner support. --- ### VIII. Advancing Growth-Enhancing Structural Reforms ### Near-term focus and longer-term agenda - Near-term commitments focus on stabilizing the macro economy and restoring debt sustainability. - Later development of an agenda of structural reforms to unlock full growth potential, including improving SOE efficiency. ### Trade liberalization and para-tariffs - Fully committed to trade liberalization to attract investment and boost productivity. - Will revisit the 5-year plan for rationalizing remaining para-tariffs developed under the 2016-20 EFF arrangement, aimed at removing an impediment to foreign investment. - Implementation will be carefully phased with consideration of revenue implications and complemented with measures to support local businesses’ competitiveness. - Strengthen implementation of a single window for trade and pursue further trade reforms with TA from development partners. ### Labor market and female participation - Labor market reforms to promote female labor force participation to mitigate population aging’s negative impact on labor supply. - Develop a comprehensive and actionable strategy which can include: - (i) improving public transport infrastructure; - (ii) promoting financial inclusion including through credit guarantee schemes supporting female entrepreneurs; - (iii) increasing the number of affordable child and elderly care facilities; - (iv) providing a legal framework for flexible work arrangements and ensuring proper benefits and renumeration; - (v) expanding training and vocational education programs aimed at closing the gender gap in skills and upgrading skills to promote higher labor productivity. ### Broader reforms with development partner support - Reforms to address impediments to private investment, large public sector role, inefficient electricity sector, and climate change, including: - reducing red tape and modernizing regulatory and doing business environment; - reducing electricity cost by improving generation mix and distribution efficiency; - reducing government’s and SOEs’ role to enable more efficient resource allocation, foster competition, and boost productivity; - strengthening climate change adaptation, including through contingency budget and insurance scheme for natural disasters. *Source: 1lkaea2023001* ### 27. We stand ready to deploy contingency measures should downside risks materialize. ### 1lkaea2023001 - 27. We stand ready to deploy contingency measures should downside risks materialize. ### Risks to program implementation - Risks are high due to adverse initial conditions, a complex debt restructuring with potential delays, and large downside risks to the program baseline. - Specific downside scenarios: - A delay in concluding debt restructuring negotiations with creditors could suspend access to financial support from IFIs, causing a deeper and prolonged BOP crisis. Realization of debt sustainability risks could require broader and deeper debt restructuring. - Lack of macroeconomic policy space in the near term could necessitate a tighter monetary policy stance than envisaged under the baseline to address further depreciation pressures and signs of runaway inflation; policy would aim at reaching positive real policy rates (on a forward-looking basis) at a much faster speed. - Stress on the banking system increases the need to strengthen crisis management and develop a detailed contingency plan, including strengthening the CBSL’s emergency liquidity framework and measures to strengthen bank capital. - Program implementation risks highlighted the need to stay current on payments to the IMF and Multilateral Development Banks and to step up engagement with creditors to minimize restructuring delays. ### Contingency measures and remedial actions - Commitment to deploy contingency measures should downside risks materialize. - Remedial measures to correct any program underperformance include: - (i) Unforeseen increases in current non-interest spending will be financed through additional revenue measures so that substantial cuts to capital spending can be avoided. - (ii) Delays in implementing revenue measures and cost-recovery based electricity pricing would require further cuts in capital spending; slower-than-programmed reserves buildup would require the introduction of explicit FX intervention rules to avoid hindering needed exchange rate adjustment; delays in key structural reforms should be avoided to allow program reviews to conclude as scheduled. - (iii) Program overperformance resulting from better-than-expected outturns should be locked in to the extent possible, to assure achieving the program objectives. - Banking-sector specific contingencies: strengthen crisis management, develop detailed contingency plan, strengthen CBSL emergency liquidity framework, and measures to strengthen bank capital as previously described. ### Program monitoring, reviews, and safeguards - Program subject to semiannual reviews with performance criteria, the MPCC bands, and indicative targets set out in Table 1 attached to the MEFP and TMU. - Completion of first and second reviews requires observance of quantitative performance criteria for end-June 2023 and end-December 2023, respectively, as well as continuous performance criteria and structural benchmarks in Table 2. - Timing of first two reviews: on or after September 1, 2023 and March 1, 2024, respectively. - Request the use of IMF financing for budget support; the authorities will finalize an MoU between the CBSL and the Ministry of Finance on responsibilities for servicing financial obligations to the IMF. - Recognition of the safeguards assessment of the Central Bank finalized in February 2023; steps will be taken to address resulting recommendations. ### Key quantitative performance criteria and indicative targets (as presented) - Proposed quantitative performance criteria (cumulative from beginning of the year, unless otherwise noted): - Central government primary balance (floor, in billion rupees) — end-Dec. end-Mar. end-Jun. end-Sep. end-Dec.: -895 -56 -113 -160 -209 - Program net official international reserves (Program NIR, floor, end of period stock, in million US$) 1/ 2/ — end-Dec. end-Mar. end-Jun. end-Sep. end-Dec.: -3,540 -3,188 -2,830 -2,068 -1,592 - Net credit to the government of the CBSL (ceiling, end of period stock, in billion rupees) 3/ — end-Dec. end-Mar. end-Jun. end-Sep. end-Dec.: 2,834 2,890 2,890 2,840 2,740 - Stock of expenditure arrears of the central government (ceiling, in billion rupees) — end-Dec. end-Mar. end-Jun. end-Sep. end-Dec.: 6030000 - Proposed continuous performance criteria (cumulative from beginning of the program): - New external payment arrears by the nonfinancial public sector and the CBSL (ceiling, in million US$): 00000 - Proposed monetary policy consultation clause (Year-on-year inflation in Colombo Consumers Price Index, in percent) 4/: - Outer band (upper limit): ...55.0 34.0 20.0 18.0 - Inner band (upper limit): ...53.5 32.5 18.5 16.5 - Actual / Center point: 61.3 52.0 31.0 17.0 15.0 - Inner band (lower limit): ...50.5 29.5 15.5 13.5 - Outer band (lower limit): ...49.0 28.0 14.0 12.0 - Proposed indicative targets: - Central government tax revenue (floor, in billion rupees): 1,751 650 1,300 2,100 2,940 - Social spending by the central government (floor, in billion rupees): 142 357 0 120 187 - Cost of non-commercial obligations (NCOs) for fuel and electricity (net of government transfers) (ceiling, in billion rupees) 5/: ...0000 - Treasury guarantees (ceiling, in billion rupees): 1,159 1,700 1,700 1,700 1,700 Notes in table (verbatim): - 1/ The CBSL's conventional definition of net official international reserves (NIR) includes outstanding liabilities in foreign exchange swaps with domestic commercial banks. The Program NIR excludes the outstanding liabilities in foreign exchange swaps with domestic commercial banks from the CBSL's conventional NIR definition. See TMU for details. - 2/ Program NIR will be adjusted upward/downward by the cumulative amounts of (i) foreign program financing by the central government, (ii) net borrowings from SLDBs and FCBUs by the central government, (iii) external commercial loans (including Eurobonds and syndicated loans) by the central government, (iv) the amount of project loans and grants, and (v) proceeds from commercialization of public assets to non-residents, that are higher/lower than assumed under the program; and by the cumulative amounts of (vi) amortization and interest payment of total external debt of the central government, and (vii) interest payments on SLDBs and FCBUs by the central government in US dollar terms, that are - 3/ Excludes holdings of treasury securities for monetary policy purposes and Rupee-denoimated government deposits. See TMU for details on the calculation for the test date. - 4/ See the TMU for how to measure year-on-year inflation. - 5/ NCOs refer to the obligation of CPC and CEB to supply fuel and electricity at administered prices. See TMU for how to measure the cost of NCOs. ### Prior actions and structural benchmarks under the EFF-supported arrangement - Prior actions (selected, status as presented): - Cabinet approval of revenue measures to support fiscal consolidation during 2023, in line with program parameters — Met - Parliament approval of a revised 2022 budget that is in line with program parameters — Met - Submission to Parliament of the 2023 Appropriation Bill that is in line with program parameters — Met - Cabinet approval to automate monthly retail fuel price adjustment as prescribed by the 2018 fuel pricing formula to achieve cost recovery — Met - Cabinet approval to automate semi-annual cost-recovery based electricity price adjustment — Met - Cabinet approval of the new Central Bank Act with amendments from the bill submitted to Parliament in November 2019 in consultation with IMF staff — Met - Cabinet approval of Banking (Special Provisions) Act to strengthen key elements of the CBSL’s crisis management powers — Met - Hiring by the CBSL of an independent firm to conduct banking sector diagnostic exercise based on Terms of Reference and timeline established in consultation with IMF staff — Met - Increase policy interest rates by 100 basis points to ensure forward-looking real policy rates on a firmly upward path — Met - Selected structural benchmarks with timing (verbatim): - Set retail fuel prices to their cost-recovery levels with monthly formula-based adjustments, and compensate the CPC for providing any fuel subsidies with on-budget transfers — Continuous - Adjust the end-user electricity tariff schedule to its cost-recovery level (overall across different types of final consumers) with semi-annual formula-based adjustments on a forward-looking basis in January and July each year (effective from January 1 and July 1, respectively); the CEB submits tariff revision requests to the Public Utility Commission of Sri Lanka by end-October (for January tariff revisions) and by end-April (for July tariff revisions); and compensate the electricity sector for providing any residual subsidies with on-budget transfers — Continuous - Parliamentary approval of the welfare benefit payment scheme and the application of the new eligibility criteria to identify low-income families for receiving welfare benefit payments — End-May 2023 - Cabinet approval of a comprehensive strategy (laying out clear timelines and modalities) to restructure the balance sheets of the CEB, CPC, SriLankan Airlines, and the Road Development Authority, in consultation with IMF staff — End-June 2023 - Cabinet approval of revenue measures to support fiscal consolidation during 2024, in line with program parameters — End-July 2023 - Completion of the rollout of the ITMIS, expanding its coverage to all 220 heads (national budget execution agencies) — End-September 2023 - Submission to Parliament for the first reading of the 2024 Appropriation Bill that is in line with program parameters — End-October 2023 - Parliamentary approval of the 2024 Appropriation Act and the spending allocations in line with program parameters — End-December 2023 - Submission to Parliament of a new PFM law, in consultation with IMF staff, that will authorize the budget formulation process, roles and responsibilities of relevant agencies, and information and accountability requirements — End-December 2023 - Improve the Bulk Supply Transaction Account (BSTA) to accurately measure the electricity subsidy, and start using it to determine the cost-recovery based electricity tariff and government transfer requirement — End-December 2023 - Parliamentary approval of the new Central Bank Act prepared in consultation with IMF staff — End-April 2023 - Completion of the asset quality review component of bank diagnostic exercise for the two largest state-owned banks and the three largest private sector banks — End-April 2023 - Cabinet approval of a full revision of the Banking Act in consultation with IMF staff — End-June 2023 - Development by the CBSL of a roadmap for addressing banking system capital and FX liquidity shortfalls and intervening in banks assessed to be non-viable — End-July 2023 - Determination by the MOF of the size, timing, instruments, and terms and conditions for potential government recapitalization of viable banks which are unable to close capital shortfalls from private sources — End-October 2023 - Parliament approval of a full revision of the Banking Act in consultation with IMF staff — End-December 2023 - Enact new anti-corruption legislation to harmonize it with the United Nations Convention Against Corruption, pending comprehensive asset recovery provisions, in consultation with IMF staff — End-June 2023 - Publication of the report of an IMF-led governance diagnostic technical assistance mission to assess Sri Lanka's anti-corruption framework — End-September 2023 ### Tax and revenue measures (selected, timing and status as presented) - Personal Income Tax (implemented measures and timing verbatim): - Set the tax-free allowance to Rs 1,200,000 per year, and raise the marginal PIT rate by 6 percentage points for every Rs 500,000 per year up to a top rate of 36 percent. — Implemented (January 1, 2023) - Make withholding tax on employment income (APIT/PAYE) mandatory for all taxpayers exceeding the tax-free allowance of Rs 1,200,000 per year. — Implemented (January 1, 2023) - Impose withholding tax on service payments exceeding Rs 100,000 per month made to individuals such as professionals at the rate of 5 percent. — Implemented (January 1, 2023) - Reintroduce non-final withholding taxes on all payments other than dividends. Refrain from introducing a separate allowance for interest income. — Implemented (January 1, 2023) - Introduce a final withholding tax for dividends. — Implemented (January 1, 2023) - Corporate Income Tax: - Remove all sector-specific exemptions and reduced corporate income tax (CIT) rates provided under the Inland Revenue Act, and increase the statutory CIT rate to 30 percent. 2/ — Implemented (October 1, 2022) - Start estimating and publishing the direct costs imposed by tax incentives granted under the Strategic Development Projects and Board of Investment Acts. — January 1, 2024 - Value-Added Tax: - Raise the standard VAT rate to 15 percent. — Implemented (September 1, 2022) - Reduce the VAT registration threshold to Rs 80 million and apply the same threshold to the wholesale and retail sectors. — Implemented (October 1, 2022) - Remove the zero-rating of tourism-related services. — Implemented (June 1, 2022) - Remove the VAT exemption on condominium residential apartments. — Implemented (January 1, 2023) - Revamp the VAT system by abolishing the vast majority of exemptions. — January 1, 2024 - Take measures to significantly speed up valid VAT refunds and abolish the SVAT system. — January 1, 2024 - Excises and Customs Duties: - Increase excise taxes on alcohol and tobacco products by 20 percent. The first increase was implemented on January 1 for tobacco and on January 3 for alcohol; the second increase to be implemented before end-June 2023. Introduce automatic indexation of excises to inflation. — January 1, 2024 - Property, Wealth, and Wealth Transfer Taxes: - Introduce a nationwide real property tax including a review of related fiscal transfers, requesting technical assistance as needed. — January 1, 2025 - Introduce a gift and inheritance tax with a tax-free allowance and minimal exemptions. — January 1, 2025 - Other taxes: - Introduce a “Social Security Contribution” on liable turnover over Rs 120 million per year at the rate of 2.5 percent. — Implemented (October 1, 2022) - Introduce a fuel tax yielding 0.3 percent of GDP. — Implemented (January 1, 2023) - Increase the tax rates pertaining to the Betting and Gaming Levy in line with the May 30 tax proposal. — April 1, 2023 ### Technical Memorandum of Understanding — monitoring framework (selected) - The TMU sets the framework for monitoring program performance under the EFF, specifying performance criteria and indicative targets (including adjustors) assessed through semiannual reviews, and specifying monitoring procedures and reporting requirements. - Quantitative performance criteria and indicative targets listed in Table 1 (as cited) include: - a) quantitative performance criterion on central government primary balance (floor); - b) quantitative performance criterion on the stock of expenditure arrears of the central government (ceiling); - c) quantitative performance criterion on net official international reserves (floor); - d) quantitative performance criterion on the CBSL’s net credit to the government (ceiling); - e) continuous quantitative performance criterion on new external payment arrears of the nonfinancial public sector and the CBSL (ceiling); - f) monetary policy consultation clause; - g) indicative target on central government tax revenue (floor); - h) indicative target on social safety net spending (floor); - i) indicative target on cost of non-commercial obligations for fuel and electricity (net of government transfers) (ceiling); - j) indicative target on treasury guarantees (ceiling). - Definitions and measurement conventions: - Central government is defined to include line ministries, departments, and other public institutions. CBSL, state-owned enterprises, parastatals and other agencies that do not receive subventions from the central government are excluded. - Debt is defined in accordance with paragraph 8 of the Guidelines on Public Debt Conditionality in Fund Arrangements attached to Executive Board Decision No. 16919-(20/103), adopted October 28, 2020. - Performance criterion on central government primary balance (summary of measurement approach): - Primary balance of the central government on cash basis is defined as central government revenues and grants minus expenditures and net lending, plus interest payments. Proceeds from privatization or commercialization of public assets to residents or non-residents will not be recorded as part of central government revenues. Spending recorded when cash disbursements are made. - For program monitoring the primary balance is measured as the overall balance of the central government plus the interest payment of the central government. The overall balance is measured from the financing side as the negative of the sum of specified financing items (net borrowings, changes in balances, net increases in CBSL advances, SLDBs, commercial borrowings, official project and program loans, other borrowings, and proceeds from privatization). Example 2021 figures (verbatim): - Primary balance of the central government on cash basis measured in this manner was minus Rs 1,010 billion (the overall balance was minus Rs 2,058 billion and the interest payment was Rs 1,048 billion). - a) Net borrowings from issuances of Treasury Bills, Treasury Bonds, and loans in local currency. In 2021, the total amount of such net borrowings was Rs 1898 billion. - b) Net decreases in the balances (deposits minus overdrafts) of the central government in the banking system. In 2021, the total amount was Rs 334.6 billion (a decline in bank balances). - c) Net increases in CBSL advances, net of changes in central government deposits at the CBSL. In 2021, the total amount was Rs -3.0 billion. - d) Net borrowings from Sri Lankan Development Bonds (SLDBs) and domestic loans in foreign currency. In 2021, the total amount was Rs -170 billion. - e) Commercial borrowings issued under foreign law, including international sovereign bonds and syndicated loans. In 2021, the total amount was Rs -69 billion. - f) Net borrowings from official project and program loans and trade credit lines. In 2021, the total amount was Rs 55 billion. - g) Net borrowings from all other bonds, loans, and advances contracted by the central government. In 2021, the total amount was Rs 12 billion. - h) Proceeds from privatization or commercialization of public asset to residents and nonresidents. In 2021, the total amount was Rs 0 billion. *Source: MEFP, TMU, and attachments in 1lkaea2023001.* ### 6. For the purpose of program monitoring, the government’s equity injections into banks ### 6. For the purpose of program monitoring, the government’s equity injections into banks ### Treatment of equity injections and primary balance - Government’s equity injections into banks for recapitalization purposes will not be recorded as central government expenditure. - Accordingly, the primary balance as defined in paragraph 5 will be reduced by the amounts transferred to banks. - By contrast, government equity injections into other corporations (both private and state-owned) will be recorded as central government expenditure, consistent with GFSM 1986. - Accordingly, the primary balance as defined in paragraph 5 will not be reduced by the amounts transferred to other corporations. - Net lending by the government is recorded as a government expenditure, in line with GFSM1986. Example: - Funds lent by the government to CPC in 2022 related to fuel credit lines from India are recorded above the line (increasing the deficit). - A repayment in 2023 will similarly be recorded above the line (reducing the deficit). ### Performance criterion on the stock of expenditure arrears of the central government - Expenditure arrears are defined as: - (i) any invoice received by a spending agency from a supplier for goods, services, and capital goods delivered and verified, unpaid within the contractually agreed period (or, absent a grace period, within 3 months after the due date); and - (ii) wages, pensions, or transfers expensed by the central government, for which payment has been pending for longer than 3 months to domestic or foreign residents. ### Performance criterion on Net Official International Reserves (Program NIR) - Program NIR is measured as the difference between: - (a) the CBSL’s conventional definition of NIR (sum of (i) difference between gross foreign assets and liabilities of the CBSL and (ii) the balance of State Treasury’s (DSTs) Special Dollar, Japanese Yen, and Chinese Yuan Revolving accounts, expressed in market values), and - (b) the CBSL’s outstanding liabilities (net short positions) in foreign exchange swaps with domestic commercial banks. - On January 3, 2023: - The Program NIR, evaluated at market exchange rates, stood at minus US$3,524 million. - The Program NIR, evaluated at the program exchange rates, stood at minus US$3,520 million. - The NIR as per the CBSL’s conventional definition, evaluated at market exchange rates, stood at minus US$3,222 million. - The CBSL’s outstanding liabilities in foreign exchange swaps with domestic commercial banks stood at US$302.4 million. - Components excluded from gross foreign assets include: participation in international financial institutions; holdings of nonconvertible currencies; holdings of precious metals other than monetary gold; claims on residents (e.g., statutory reserves on foreign currency deposits of commercial banks and central bank foreign currency deposits with resident commercial banks); pledged, non-liquid, collateralized or otherwise encumbered foreign assets (except for assets held under the PBOC swap arrangement); claims on overseas subsidiaries of domestic commercial banks; claims in foreign exchange arising from derivative transactions (futures, forwards, swaps and options). - Gross foreign liabilities include all foreign currency denominated liabilities of the CBSL to non-residents (including currency swap arrangements with foreign central banks); the use of Fund credit (including for budget support purposes); and Asian Clearing Union debit balance. - Commitments to sell foreign exchange to residents arising from derivatives (e.g., futures, forwards, swaps, options) are not included in gross foreign liabilities. ### Program exchange rates and gold price (Rates as of January 3, 2023) - Currency units of currency per 1 US dollar: - Sri Lanka rupee 363.11 - British pound 0.838012 - Japanese yen 132.650000 - Canadian dollar 1.365800 - Euro 0.948317 - Chinese yuan 6.892800 - Australian dollar 1.497006 - Swiss franc 0.939650 - SDR 0.752014 - Memorandum: - Gold price, US$/oz 1831.62 - Note: JPY and AUD rates as of December 23, 2022. ### Adjustments to the Program NIR floor - Adjustment applies if actual cumulative amounts differ from program assumptions (in U.S. dollar terms) for any of: - (i) foreign program financing (exclusive of EFF disbursements) by the central government; - (ii) net borrowings from SLDBs and FCBUs by the central government; - (iii) external commercial loans (including international sovereign bonds and syndicated loans) by the central government; - (iv) project loans and grants disbursed to the central government; - (v) proceeds from commercialization of public assets to non-residents. - If these amounts are higher/lower than assumed, the floor on the Program NIR will be adjusted upward/downward by the cumulative differences on the test date. - Proceeds from commercialization of public assets are defined as cash receipts from sale or lease of publicly held assets (including publicly held land, public holdings of infrastructure or commercial real estate, and public or quasi-public enterprises). - Adjustment for amortization and interest: - If the sum of amortization of total external debt and interest payments on total external debt owed by the central government (excluding IMF) in U.S. dollar terms, plus interest payments on SLDBs and FCBUs by the central government in U.S. dollar terms, is higher/lower than assumed, the floor on the Program NIR will be adjusted downward/upward by the cumulative differences on the test date. - Total external debt refers to external debt owed by the central government to all foreign creditors (excluding IMF), as defined in the 2013 External Debt Statistics: Guide for Compilers and Users. - If NIR outcome outperforms program target(s), the CBSL will consult with IMF staff on raising targets for subsequent test dates to safeguard such overperformance. ### Program assumptions (Table 2; Cumulative from the beginning of each calendar year, in million US$) - Mar. 2023; Jun. 2023; Sep. 2023; Dec. 2023 - Foreign program financing of the central government: 0 33 0750 900 - Net borrowings from SLDBs and FCBUs by the central government: 0 0 0 0 - External commercial loans (including Eurobonds and syndicated loans) by the central government: 0 0 0 0 - Proceeds from commercialization of public assets to non-residents: 0 0 0 0 - Amortization of total external debt owed by the central government (excl. IMF): 2397 788 877 989 - Interest payments on total external debt owed by the central government (excl. IMF): 4710 733 7568 - Interest payments on SLDBs and FCBUs by the central government in US dollar terms: 0 0 0 0 - Project loans and grants disbursed to the central government: 2195 488 761,204 - Note: In the event of formatting in the source, numeric entries are preserved exactly as provided. ### Performance criterion on the CBSL’s Net Credit to the Government (NCG) - NCG measured as difference between: - (a) CBSL’s claims on the central government (provisional advances, government securities acquired by CBSL through primary market purchases, central government’s special direct issuances to the CBSL, long-term or outright open market operations). For program monitoring, government securities acquired through purchases solely for monetary policy purposes or ELA operations on a temporary basis with agreement to reverse in less than 90 days are excluded. Stock of government securities held by the CBSL measured at face value. - (b) Central government’s Rupee-denominated deposits at the CBSL. Deposits related to foreign program financing (including IMF disbursements) placed at the government’s account at the CBSL are not part of these Rupee-denominated deposits. - Adjustment: - The ceiling on the CBSL’s NCG will be adjusted upward by the amount of shortfalls in foreign program financing of the central government (measured against programmed amounts as set out in Table 2). - This adjustor applies only to the NCG ceiling during six months after the program approval and will not apply to the NCG ceiling for end-December 2023 and thereafter. - Foreign currency amounts will be converted to Sri Lankan rupees using the program exchange rates defined in paragraph 9. ### Continuous performance criteria - A continuous performance criterion applies to non-accumulation of new external payment arrears on external debt contracted or guaranteed by the nonfinancial public sector and the CBSL. - Nonfinancial public sector defined following the 2001 Government Finance Statistics Manual and the 1993 System of National Accounts; includes central government and nonfinancial public enterprises where government holds a controlling stake. - External payments arrears consist of debt-service obligations (principal and interest) to nonresidents not paid when due per contractual agreements, subject to any applicable grace period. - Overdue debt and debt service obligations that are in dispute will not be considered external payments arrears for program monitoring. - Arrears from nonpayment for which a rescheduling or restructuring agreement is being sought are excluded. - Non-observance must be reported immediately to the Fund. - Other continuous criteria (Sri Lanka will not during the program period): - a) impose or intensify restrictions on the making of payments and transfers for current international transactions; - b) introduce or modify multiple currency practices (MCPs); - c) conclude bilateral payment agreements inconsistent with Article VIII of IMF Articles of Agreement; - d) impose or intensify import restrictions for balance of payments purposes. ### Monetary policy consultation clause (inflation monitoring) - Inflation target bands around the projected 12-month rate of inflation measured by the headline Colombo Consumers Price Index (CCPI; 2021=100) are specified in Table 1 attached to the MEFP. - CCPI index (2021=100) will be used to measure actual inflation. - Year-on-year inflation for each test date measured as: - { CCPI*(t) – CCPI*(t-12) } / CCPI*(t-12) - where: - t = the month within which the test date is included - CCPI(t) = CCPI index (all items) for month t - CCPI(t-k) = CCPI index (all items) as of k months before t - CCPI*(t) = { CCPI(t-2) + CCPI(t-1) + CCPI(t) } / 3 - CCPI*(t-12) = { CCPI(t-14) + CCPI(t-13) + CCPI(t-12) } / 3 - If observed year-on-year inflation for end-June 2023 or end-December 2023 falls outside the outer bands in Table 1 attached to the MEFP, authorities will complete consultation with the IMF Executive Board focusing on: (i) monetary policy stance and program trajectory; (ii) reasons for deviation; (iii) proposed policy response. Access to Fund resources would be interrupted until consultation and relevant program review completed. - If observed year-on-year inflation falls outside the inner bands in Table 1 attached to the MEFP for end-March 2023, end-June 2023, end-September 2023, and end-December 2023, the authorities will consult with IMF staff on reasons for deviation and proposed policy response. ### Indicative targets - Indicative target on central government tax revenue: - Central government tax revenue refers to taxes collected by the central government; excludes revenues from asset sales, grants, and non-tax revenues. - Revenue target calculated as cumulative flow from beginning of year. - For 2021, central government tax revenue defined in this manner was Rs 1,298 billion. - Indicative target on Social Safety Net (SSN) spending: - SSN spending comprises: (1) Samurdhi cash transfers; (2) assistance to the elderly (over 70 years of age); (3) allowance for disabled people; (4) financial support for kidney patients. Classifications align with Ministry of Finance Annual Report reporting. - Indicative target on cost of Non-Commercial Obligations (NCOs) for fuel and electricity (net of government transfers): - NCOs refer to CPC and CEB obligations to supply fuel and electricity at prices below cost-recovery. - Indicative target is cost of fuel and electricity NCOs net of government transfers (costs not compensated by central government budget). - Cost of NCOs for fuel during each quarter measured as cost of sales (including fuel cost, terminal charges, transport charges, personnel cost, other operational expenses, exchange rate variation, and finance cost; excluding sales taxes) minus revenues (net of sales taxes) for fuel supplies by CPC across sectors. If revenues (net of taxes) exceed cost of sales, cost of NCOs for fuel is zero. - Government transfers to cover fuel NCOs measured as central government current transfers disbursed to CPC. - Cost of NCOs for electricity: - Starting January 1, 2024: measured as total expenditures (including energy purchases and allowed revenue for transmission) minus total sales revenues from 5 distribution licensees under CEB, as shown in the Bulk Supply Transaction Account. - Until January 1, 2024: measured by total losses as reported on the CEB’s financial statement. - If sales revenues exceed total expenditures, cost of NCOs for electricity is zero. - Government transfers to cover electricity NCOs measured as central government transfers disbursed (including capital injection as specified in paragraph 6) to CEB. - Measurement of cost of fuel and electricity NCOs net of government transfers for program monitoring (accounting for time lag): - For test date end-March 2023: - NCO(2022Q4) – G(2023Q1) - For test date end-June 2023: - { NCO(2022Q4) + NCO(2023Q1) } – { G(2023Q1) + G(2023Q2) } - For test date end-September 2023: - { NCO(2022Q4) + NCO(2023Q1) + NCO(2023Q2) } – { G(2023Q1) + G(2023Q2) + G(2023Q3) } - For test date end-December 2023: - { NCO(2022Q4) + NCO(2023Q1) + NCO(2023Q2) + NCO(2023Q3) } – { G(2023Q1) + G(2023Q2) + G(2023Q3) + G(2023Q4) } - Definitions: - NCO(q) = cost of NCOs for fuel and electricity during quarter “q” - NCO_fuel(q) = cost of NCOs for fuel during quarter “q” - NCO_electricity(q) = cost of NCOs for electricity during quarter “q” - NCO(q) = NCO_fuel(q) + NCO_electricity(q) - G(q) = central government transfers to CPC and CEB disbursed during quarter “q” - G_fuel(q) = central government transfers to CPC disbursed during quarter “q” - G_electricity(q) = central government transfers to CEB disbursed during quarter “q” - G(q) = G_fuel(q) + G_electricity(q) - Indicative target on Treasury guarantees: - Treasury guarantees defined as outstanding debt guarantees issued by the central government (explicit legal obligation to service debt in event of nonpayment by recipient). Excludes letters of comfort. - Outstanding guarantees defined as drawn amounts of guaranteed debts (distinct from issued guarantees which include undisbursed amounts). - Treasury guarantees include outstanding guarantees published in the Statement of Contingent Liabilities in the Ministry of Finance Annual Report. - Rupee values for guarantees issued in other currencies calculated using exchange rate for last day of calendar year as in the Statement of Contingent Liabilities. - As of end-2021, outstanding treasury guarantees were valued at Rs 1,506 billion. *Source: IMF staff and Central Bank of Sri Lanka material as presented in the provided content.* ### 25. Sri Lanka shall provide the Fund, through reports at intervals or dates requested by the ### 1lkaea2023001 - 25. Sri Lanka shall provide the Fund, through reports at intervals or dates requested by the Fund, with such information as the Fund requests... ### Reporting requirements for program monitoring - Sri Lanka shall provide the Fund, through reports at intervals or dates requested by the Fund, with such information as the Fund requests in connection with the progress of Sri Lanka in achieving the objectives and policies set forth in the Memorandum of Economic and Financial Policies and Letters of Intent. - All program monitoring data will be provided by the Ministry of Finance and the CBSL. - Formats for reporting: - Fiscal performance and expenditure arrears: Tables 3, 4, and 5. - NCG targets: Table 6. - External sector performance: Tables 7 and 8. - Indicative target on social safety net spending: Table 9 (quarterly). - Financial performance of three state-owned enterprises—CEB, CPC, and SriLankan Airlines: Tables 10, 11, and 12 (quarterly). - Indicative target on the cost of fuel NCO (net of government transfers): Table 13 (quarterly). - Indicative target on treasury guarantees: Table 14 (quarterly). ### Timetables for data submission - Fiscal targets (Table 3, Table 4, and Table 5): - Furnished within no more than five weeks after the end of each month. - Exception: data on salaries and wages, goods and services, subsidies and transfers (and its subcomponents) furnished within no more than seven weeks after the end of each month. - Total recurrent expenditure and interest payments furnished within no more than five weeks after the end of each month. - Monetary targets (Table 6): furnished within no more than four weeks after the end of each month. - External targets (Table 7 and Table 8): furnished within no more than three weeks after the end of each month. - Indicative target on social safety net spending (Table 9): furnished within no more than two months after the end of each quarter. - Three state-owned enterprises (Tables 10–12): furnished within no more than 2 months after the end of each quarter. - Indicative target on the cost of fuel NCO (Table 13): furnished within no more than 5 weeks after the end of each quarter. - Indicative target on treasury guarantees (Table 14): furnished within no more than two months after the end of each quarter. ### Financial sector monitoring (bank-by-bank) - Monthly written update on progress of the bank diagnostic exercise plus the following bank-by-bank data: - Liquidity monitoring template, with breakdown by currency (daily). - Liquidity forecast template, with breakdown by currency (weekly). - LCR template, with breakdown by currency (monthly). - Net open foreign currency positions (weekly). - Exposures to the central government and SOEs, with breakdown by entity, currency, and instrument (monthly). - Maturities of exposures to the central government and SOEs (monthly). - Arrears of state-owned banks (monthly). - Impairment schedule including breakdown of impairments on public sector exposures (monthly). - Monthly supervisory returns to CBSL including statements of financial position and comprehensive income (monthly). - Top 10 largest depositors (quarterly). - Large exposures exceeding 15 percent of capital (quarterly). - Capital adequacy template (quarterly). - Financial soundness indicators (quarterly). - Data submission timing by frequency: - Daily financial sector data: within one week of the end of the reporting period. - Weekly data: within two weeks. - Monthly data: within four weeks. - Quarterly data: within six weeks. ### Specified table content (selected headings preserved as in source) - Table 3: Central Government Operations (In millions of rupees). - Table 4: Central Government Financing (In millions of rupees). - Table 5: Unpaid Bills and Arrears 1/ (In millions of rupees). - Table 6: CBSL’s Balance Sheet 1/ (In millions of rupees). - Table 7: Foreign Exchange Cashflows of the Central Bank and the Government 1/ (In millions of U.S. dollars) — includes detailed inflows/outflows, swaps, Net International Reserves, Gross International Reserves, Changes in Reserve Related Liabilities, and related items. - Table 8: Gross Official Reserve Position 1/ (In millions of U.S. dollars) — includes Gross Official Reserves, Net International Reserves, ACU, swaps, DST accounts, Foreign Assets (FA), Domestic Assets (DA), memorandum items. - Table 9: Social Safety Net Spending (by Month) 1/ (In millions of rupees). - Table 10: Financial Outturn of Ceylon Electricity Board 1/ (In millions of rupees) — includes Total revenue, Sale of electricity, Total expenditure, Direct generation cost, Operating profit/loss, Liquidity position, Borrowings from banks, Outstanding debt to banks, Purchases from CPC and IPP, Outstanding to CPC and IPP. - Table 11: Financial Outturn of Ceylon Petroleum Corporation 1/ (In millions of rupees) — includes Total revenue, Octane 90, Diesel, Total expenditure, Cost of sales, Finance cost, Operating profit/loss, Outstanding dues to state banks. - Table 12: Financial Outturn of SriLankan Airlines 1/ (In millions of rupees) — includes Total revenue, Passenger, Cargo, Total expenditure, Aircraft fuel cost, Employee cost, Operating profit/loss, Capital contribution. - Table 13: Cost of Non-Commercial Obligations for Fuel 1/ (In millions of rupees, unless otherwise noted) — detailed by product categories (A. TRANSPORT; B. POWER GENERATION; C. AVIATION; D. INDUSTRIES; E. DOMESTIC; F. AGRO), cost components (Cost of NCOs, revenue net of sales taxes, Cost of sales, Terminal charge, Transport charge, Personnel cost, Other expenses, Exchange rate variation, Finance cost), Sales quantity (Million liters), and memorandum item: Central government current transfers to CP. - Table 14: Treasury Guarantees 1/ (In millions of rupees) — includes Treasury Guarantees Issued, Treasury Guarantees Outstanding, Total Treasury Guarantees, and by entity (Ceylon Electricity Board, Ceylon Petroleum Corporation, National Water Supply and Drainage Board, Road Development Authority, SriLankan Airlines, Other). ### Recent policy and procedural updates (supplementary information) - Timeline and consents regarding bilateral creditors: - Consent received from Pakistan on March 8, 2023. - Consent received from Saudi Arabia on March 9, 2023. - Consent received from Kuwait on March 12, 2023. - Signed memorandum of understanding between the Central Bank of Sri Lanka and the Ministry of Finance on March 10, 2023, clarifying responsibilities for timely servicing of financial obligations to the IMF. - The President of Sri Lanka issued an open letter to official bilateral creditors on March 14, 2023, making three commitments: - (i) to communicate transparently on financial liabilities and agreed debt treatments; - (ii) not to resume debt service without a treatment consistent with IMF program parameters and comparability of treatment (CoT); - (iii) to ensure comparable treatment of all external creditors. - Abolishment of banks’ surrender requirements (effective March 7, 2023): - CBSL repealed the requirement that banks sell to the CBSL a fraction of their purchases of FX from export proceeds and inward workers’ remittances. - The Multiple Currency Practice (MCP) arising from the weekly volume weighted average rate for mandatory surrender has been eliminated. - Two Capital Flow Measures (CFMs) related to surrender requirements for purchases of export proceeds and inward worker remittances have been eliminated. - Staff supports approval of all remaining MCPs for a period of twelve months or until the next Article IV consultation, whichever is sooner, on the basis that the measures giving rise to them are maintained for BOP reasons, are temporary, and do not give Sri Lanka an unfair competitive advantage or discriminate among members. ### Annex I — Lending into Official Arrears: staff assessment of three criteria - Staff assesses that conditions are met for the Fund to provide financing to Sri Lanka despite outstanding arrears to Iran, based on the three Lending into Official Arrears criteria: 1. Prompt financial support from the Fund is considered essential and the member is pursuing appropriate policies. - The authorities are pursuing an EFF-supported arrangement with ambitious revenue-based fiscal consolidation, comprehensive debt restructuring, a multi-pronged strategy to restore price stability and rebuild external buffers, safeguarding financial stability and social safety nets, reducing corruption vulnerabilities, and enhancing growth prospects. 2. The debtor is making "good faith" efforts to reach agreement with the creditor on a contribution consistent with Fund program parameters. - Sri Lanka has engaged in good faith with bilateral official creditors; Iran received bilateral letters on process updates on two occasions; the Alternative Executive Director reached out to the Iranian counterpart with debt data and information. - Authorities committed to continue good faith efforts until remaining arrears are resolved on terms consistent with restoring debt sustainability and program parameters, offering comparable terms to all creditors. 3. Providing financing despite these arrears is not expected to have an undue negative effect on the Fund’s ability to mobilize official financing packages in future cases. - Creditors representing a large majority of official bilateral claims (95 percent) subject to a debt treatment have indicated commitment to debt restructuring and provided specific and credible financing assurances, including China, Hungary, India and the Paris Club. - Saudi Arabia “expressed its support for the process and acknowledged the importance to offer financing assurances in the near future.” - Debt service to Iran is 0.7 percent (small relative to total official bilateral debt service subject to restructuring). - Historical track record: Iran has limited history of providing relief in Fund-supported programs. - Staff view: providing financing is not expected to have an undue negative effect given strong international support and credible assurances from creditors accounting for a large majority of bilateral claims. ### Further supplementary information (update) - Subsequent update: staff has since learned that the Iranian authorities have indicated that they consent to the provision of Fund financing to Sri Lanka, notwithstanding official arrears owed by Sri Lanka to Iran. *Source: Excerpt from the IMF document titled "REQUEST FOR AN EXTENDED ARRANGEMENT UNDER THE EXTENDED FUND FACILITY—SUPPLEMENTARY INFORMATION AND REVISED PROPOSED DECISIONS" (Sri Lanka), as provided in the content unit.* ### 2. Consent by the Iranian authorities under the Fund’s Lending into ### 2. Consent by the Iranian authorities under the Fund’s Lending into ### LIOA consent and implication - Official consent by the Iranian authorities under the Fund’s Lending into Official Arrears (“LIOA”) policy makes the assessment proposed in Supplement 1 unnecessary. - Given creditor consent, under the LIOA policy the Fund may proceed to provide financing to Sri Lanka notwithstanding its official arrears to Iran. - Date of statement: March 16, 2023. ### Authorities’ statement of appreciation and program request - Statement by Krishnamurthy Subramanian, Executive Director for Sri Lanka and Chandranath Amarasekara, Alternate Executive Director — March 20, 2023. - Authorities express deep appreciation to the mission team led by Messrs. Breuer and Nozaki and to the Managing Director, management, and the Asia Pacific Department. - Authorities thank nations that provided financing assurances and support, “particularly to India for leading the way,” enabling staff to submit Sri Lanka’s request for a 48-month Extended Arrangement under the Extended Fund Facility (EFF) with an access to Fund resources of approximately US$ 3 billion (395 percent of quota) to the Executive Board for consideration. - Authorities expect the EFF-supported program to bring stability and pave the way for longer-term sustained and inclusive growth. ### Crisis history and causes - 2022 described as “the worst socio-economic and political crisis in its post-independent history.” - Contributing events since 2018: constitutional crisis in 2018, Easter Sunday terrorist attacks in 2019, and the COVID-19 pandemic. - Policy missteps cited: unsustainable direct and indirect tax cuts; continued monetary financing of fiscal deficits at suppressed interest rates; prolonged period of low interest rates causing excessive monetary expansion and balance of payments pressures; flawed pricing policies for petroleum products, electricity and other public utilities; ill-timed ban on chemical fertilizer; defense of the exchange rate at the expense of foreign exchange reserves. - By early 2022 Sri Lanka had lost access to conventional international financial markets and exhausted fiscal, monetary, external sector and financial sector buffers. - Resulting effects in 2022: rising inflation, shortages of essentials, long power cuts, collapse of business confidence, severe impact on tourism recovery, and widespread public protests leading to changes in key government positions. - Government actions: requested close IMF engagement and a Fund-supported stabilization program; announced a debt service standstill in April 2022; commenced stabilization measures broadly in line with 2021 Article IV recommendations; reached a Staff-Level Agreement (SLA) with the Fund on September 1, 2022. ### Macroeconomic stabilization priority - Immediate priority: stabilize the economy as a prerequisite for long-term growth. - Stabilization program objectives: ensure durable fiscal consolidation, restore public debt sustainability, restore price stability, rebuild external reserves, safeguard financial stability, strengthen social safety nets, address governance and corruption vulnerabilities, and implement structural reforms to unlock growth potential. - Authorities acknowledge normalization of economic activity following a debt crisis could be slow. ### Growth and outlook - The Sri Lankan economy contracted by an unprecedented 7.8 percent in 2022. - All three sectors—Agriculture, Industry, and Services—were severely affected in 2022. - Near-term impact of corrective policy measures is dampening economic activity. - Recovery drivers: rebound in some agricultural subsectors, rebound in tourism, gradual return of business confidence. - Economy projected to contract by around 3 percent in 2023. - Authorities aim for a faster medium-term recovery but emphasize stabilization first. ### Fiscal developments, targets, and measures - Central government revenue collection: 8.7 percent, 8.3 percent, and 8.4 percent of GDP in 2020, 2021 and 2022, respectively. - Revenue and deficit targets: - Raise revenue collection to 15.0 percent of GDP by 2026. - Reduce the overall fiscal deficit to below 5.0 percent of GDP by 2025. - Register a primary surplus of 2.3 percent of GDP by 2025. - Near-term primary balance: projected to improve to -0.7 percent of GDP in 2023 from -5.7 percent in 2021. - Key revenue measures implemented: - Increase schedule of rates for marginal personal income tax (PIT), raise the top marginal rate, reduce tax-free threshold, rationalize incremental tax slabs. - Increase standard rate for corporate income tax (CIT), remove tax holidays and sector-specific CIT exemptions, unify the rate structure for CIT. - Reinstate the value added tax (VAT) rate at 15 percent from 8 percent, lower the VAT registration threshold, and remove some VAT exemptions. - Reinstate the mandatory withholding tax. - Increase rates for excise tax on alcohol and tobacco products, and on fuel. - Planned future tax measures: - Further revamp the VAT system to minimize exemptions, speed up valid VAT refunds, and abolish the Simplified VAT system. - In 2024 implement automatic indexation of excise taxes to inflation. - In 2025 revamp the property tax system and introduce a wealth transfer tax. - Revenue administration reforms to strengthen tax compliance; documentation of all tax expenditures provided under the Strategic Development Projects Act and the Board of Investment Act to enhance fiscal transparency. - Expenditure containment measures: - Reduce operational expenses and increase accountability. - Limit expansion of the wage and public sector pension bill while ruling out pay cuts. - Raise public investment over the medium-term with measures to enhance efficiency and transparency. - Reduce the stock of budget expenditure arrears to zero and limit issuance of treasury guarantees. - Social spending and safety nets: - Social safety net spending maintained at Rs. 142 billion (0.6 percent of GDP) in 2022. - Government proposed a spending floor of Rs. 187 billion for 2023. - Welfare Benefits Board (WBB) being operationalized as focal point; donor coordination system being established. - SOBE (state-owned business enterprise) fiscal risk management: - Mitigation measures and sector reforms planned. - Fuel and electricity prices adjusted to international market prices with regular formula-based revisions. - Comprehensive SOBE reform strategy expected by mid-2023. - Framework to limit SOBE borrowing to commercially viable activities; prevent foreign currency borrowing by non-financial SOBEs without adequate foreign currency revenue. - Transparent remuneration of subsidies and quasi-fiscal activities through government transfers. - Public Financial Management (PFM) law: - Expected in place from 2024. - Will introduce binding fiscal rules including a legally binding government debt ceiling. - Will establish legal definitions for public debt and government deficit, clarify budget formulation, specify responsibilities of the Ministry of Finance and spending units, establish information and accountability requirements, and introduce stricter guidelines on issuing treasury guarantees. ### Inflation, monetary developments, and monetary policy - Colombo Consumer Price Index (CCPI) year-on-year inflation accelerated from 5.7 percent in September 2021 to 69.8 percent in September 2022. - Contributing factors to inflation acceleration: depreciation of the Sri Lanka rupee, disruptions to domestic food production, global fuel and food price shocks, domestic price revisions for fuel, electricity, and cooking gas, and unsustainable monetary financing that de-anchored inflation expectations. - Inflation decelerated to 50.6 percent in February 2023 in response to policy tightening. - Monthly inflation hovered within a range of -0.7 percent and 0.5 percent over the past five months, indicating high year-on-year inflation is largely due to legacy effects. - Central Bank policy rate corridor increased from 5.00-6.00 percent at end 2021 to 15.50-16.50 percent by March 2023, including a decisive seven percentage-point hike in April 2022. - CBSL target and expectations: - CBSL confident of bringing down inflation to single digit levels by end 2023. - Target range of 4-6 percent by 2024. - Market rates and credit developments: - Prime lending rate peaked at 29.67 percent. - Yields on Sri Lanka Rupee denominated Government securities peaked at 33.14 percent. - Year-on-year growth of credit to the private sector by commercial banks decelerated from 20.3 percent in April 2022 to 6.2 percent at end 2022. - Credit to the private sector, after adjusting its foreign currency-denominated component for exchange rate depreciation, “contracted by 3.3 in 2022.” - Credit to the small and medium scale enterprise (SME) sector contracted by 8.3 percent in 2022. - Monetary financing and reform: - In the absence of required foreign financing flows, domestic financing expanded with significant contribution from the CBSL. - Monetary financing of the fiscal deficit shall be prohibited under the new Central Bank bill expected to be enacted by end-April 2023. - Further safeguards are proposed under the program for the interim period. - Borrowing requirements of SOBEs expected to decline due to cost-recovery based pricing mechanisms. - Enactment of the new Central Bank bill intended to prohibit monetary financing, enhance CBSL independence, institutionalize flexible inflation targeting with exchange rate flexibility, and increase CBSL accountability for price stability. ### External sector developments - Sri Lanka experienced severe balance of payments pressures over the past few years with catastrophic effects in 2022. - Shocks affecting external sector performance included the Easter Sunday attacks, the COVID-pandemic, and the uncertainties in 2022 that significantly affected earnings from tourism. - Worker remittances declined considerably in 2021 and (text truncated). *1lkaea2023001 - 2. Consent by the Iranian authorities under the Fund’s Lending into* ### 2022. While merchandise exports remained resilient, the expectation of an imminent exchange rate ### 2022. While merchandise exports remained resilient, the expectation of an imminent exchange rate ### Balance of payments, reserves, and trade - Large trade deficit of US$ 8.1 billion in 2021 despite import controls. - Trade deficit narrowed to US$ 5.2 billion in 2022 following: - sharp depreciation of the Sri Lanka Rupee in early 2022, - tight monetary policy stance, - decline in real incomes and purchasing power, - tighter controls on imports. - Loss of access to the international conventional capital market led to dried-up financial account flows. - Sizable debt service payments made until mid-April 2022 contributed to a significant loss of gross official reserves (GOR) in 2020, 2021 and 2022 and exhausted usable reserves. - Worker remittances and tourism: - Worker remittances are on an upward trend. - Tourist arrivals have begun to show signs of sustained recovery. - Provisionally, worker remittances are estimated at US$ 885 million in the first two months of the year, while earnings from tourism are estimated at US$ 332 million during the same period. (footnote b) - In 2023 to date, the CBSL has been able to purchase over US$ 950 million on a net basis to build up reserves. - The Sri Lanka Rupee has appreciated by around 11 percent against the US$ during this period in 2023. ### Exchange rate policy and capital flow measures - Stability of the foreign exchange market benefited from: - the debt service standstill, - capital flow measures (CFM), - the quota system for fuel distribution. - With improving domestic market sentiments, the CBSL eliminated guidance on the exchange rate and allowed it to be determined by market forces. - The CBSL remains committed to: - a flexible exchange rate policy consistent with the flexible inflation targeting framework, - building up reserves through regular intervention in the domestic foreign exchange market as envisaged in the program. - Authorities have requested temporary approval of the remaining exchange restrictions and multiple currency practices until a sustainable outcome in the foreign exchange market is achieved. ### Financial sector developments and stability - Macroeconomic crisis impacts on the financial system: - subdued economic activity, reduced disposable income, and lack of demand for credit led to deceleration in asset growth in the banking sector, - deterioration in asset quality and profitability of the banking sector in 2022, - similar developments observed across the rest of the regulated financial sector. - Authorities’ commitments and actions: - government and CBSL committed to ensuring financial system stability and addressing vulnerabilities, - mindful of significant impact of macroeconomic stabilization measures on financial sector activity and monetary policy transmission. - Diagnostic and supervisory measures: - comprehensive diagnostic exercise ongoing for a group of banks covering more than 70 percent of domestically-owned bank assets; - asset quality review component expected to be concluded by April 2023; - CBSL to develop a roadmap for financial sector restructuring and recapitalization by July 2023; - asset quality review expected to be extended to a larger group of banks accounting for an additional 20 percent of domestically-owned banking assets, expected to be completed in August 2023. - Legal and institutional strengthening: - CBSL’s crisis management powers and financial sector supervision framework being strengthened through appropriate legislation to be enacted this year; - CBSL has updated its framework for Emergency Liquidity Assistance for banks; - a coordinating committee will be appointed with representation of financial sector regulators and the Ministry of Finance to ensure effective management of risks to financial stability; - the new Central Bank Act will establish the CBSL’s authority for macroprudential regulation and supervision. - Anti-money laundering / countering the financing of terrorism (AML/CFT): - authorities continuing to strengthen the AML/CFT framework, including legislative reforms to align with international standards; - envisaged amendments to the Companies Act will address the only remaining non-compliant aspect of the FATF 40 recommendations. ### Restoring public debt sustainability - IMF DSA and program parameters imply two core objectives: - reduce the ratio of public debt to GDP from around 128 percent in 2022 to below 95 percent over a 10-year period; - reduce the central government’s annual gross financing needs and its annual debt service in foreign currency. - Fiscal consolidation measures alone are insufficient; creditor assistance required. - Government actions for transparent negotiations: - reclassified certain debts previously in SOBE balance sheets as central government debt (in consultation with Fund staff); - a comprehensive Public Debt Summary and a Quarterly Bulletin of Public Debt and Debt Service are now public. - External financing assurances and creditor engagement: - government appreciative of specific and credible financing assurances from India, the Paris Club, Hungary, and China, and consent of other official bilateral creditors to Fund financing notwithstanding arrears; - cooperation from external commercial creditors appreciated. - Commitments on debt treatment and comparability: - Presidential letter to all bilateral official creditors: - assuring transparency on any debt treatment terms agreed with any creditor or group before formalization; - committing not to resume debt service to any creditor unless that creditor agrees on a comprehensive debt treatment in line with IMF-supported program parameters and the comparability of treatment principle; - reiterating commitment to comparable treatment of all external creditors to ensure equitable burden sharing. - An announcement on the coverage and parameters of debt operations is expected to be made before end-April 2023. ### Reforms to facilitate long-term growth and sustainability - Program components aim to strengthen macroeconomic fundamentals and support sustained growth; government will continue growth-supportive reforms including: - improving the investment climate, - trade liberalization and export diversification, - reforms addressing deficiencies in the labor market and other factor markets to improve overall productivity. - Coordination with development partners: - government working with the World Bank, ADB and other development partners on implementing these reforms. - Climate and institutional reforms: - climate change adaptation and mitigation remain key areas due to island economy susceptibility to climate shocks. - greater focus on structural reforms as the stabilization phase of the IMF-supported program progresses. - Anti-corruption and governance: - government views reduction of corruption vulnerabilities as critical; - Fund invited to conduct a governance diagnostic of Sri Lanka’s anti-corruption framework; - government committed to supporting the diagnostic exercise, publishing the report by end-September 2023, and implementing identified reforms under the EFF; - government will work with the IMF to strengthen legislation and enhance compliance in line with international best practices; - efforts to digitalize revenue administration, procurement processes and other government services expected to reduce opportunities for corruption. ### Concluding remarks and next steps - Government recognizes that EFF approval alone is insufficient to resolve the country’s issues. - Delay in seeking Fund assistance regretted; designing stabilization program and securing prerequisites, creditor coordination, and financing assurances took 12 months and extraordinary efforts. - Government hopes next steps in finalizing debt treatment will be faster to avoid lengthening the economic recovery. - Government has benefited from close engagement with the Fund through policy discussions and technical assistance in fiscal, financial sector, and institutional reforms. - Government expects EFF approval to catalyze support from World Bank, ADB and other partners and to rebuild confidence as reforms progress. - Authorities acknowledge serious downside risks and express determination to decisively address these under the IMF-supported economic program. - Authorities commit to timely implementation of essential reforms and to use the crisis as an opportunity to durably address institutional weaknesses and ensure macroeconomic stability and sustainability. - Following Executive Board approval, authorities propose to present the IMF-supported economic program to Parliament for discussion and to mobilize necessary consensus for implementation. _Italic: Content summarized from 1lkaea2023001 - 2022. While merchandise exports remained resilient, the expectation of an imminent exchange rate (PDF)._ --- _Source: https://www.imf.org/-/media/files/publications/cr/2023/english/1lkaea2023001.pdf_