## _cr06446

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### Executive Summary — Macroeconomic context and objectives
- Growth improved from an average of 4–5 percent in the 1980−90s to 6–7 percent recently; staff projects growth to sustain at around 7 percent over the medium term, conditional on reforms and peace.
- Government objectives: raise growth to 8 percent over the medium term; sharply increase investment (especially power and roads); reduce regional inequalities; promote small and medium enterprise development; implement a new energy policy to increase power generation while reducing cost; Development Forum planned for early 2007.
- Gross national income per capita reached $1,000 in 2004; income inequality deteriorated (Gini index increased by about 10 Gini points); rural poverty remains high.

### Recent developments — growth, inflation, external sector, reserves
- Growth and inflation:
  - Growth reached 8 percent in the first half of 2006; GDP growth projected at 7 percent for 2006.
  - CPI inflation is projected at 12 percent for 2006.
  - Inflation declined in 2005 but rose since early 2006 due to fast credit growth, oil price pass-through, and increases in wages and pension payments.
  - Unemployment declined to 7¾ percent at end-2005 (from 8½ percent in 2004); other sources report unemployment 7.7 percent (2005) and 7.2 percent in Q1 2006, 6.3 percent in Q2 2006.
- External sector and reserves:
  - External current account deficit expected to widen to 4¾ percent of GDP in 2006 (from 2.8 percent of GDP in 2005); Table projections show current account -1,281 (2006) million U.S. dollars = -4.7 percent of GDP.
  - Tsunami-related inflows: about $1 billion in 2005 (equivalent to 4 percent of GDP); additional $450 million projected in 2006 but disbursements slow.
  - Gross official reserves around $2.4 billion (Net of ACU balances reported 2,458 at end-2005; 2,662 in 2006), equivalent to 2.4 months of imports and 86 percent of short-term debt.
  - Rupee-dollar exchange rate weakened somewhat since the second half of 2005; REER appreciated by 2 percent up to June 2006.
- Monetary conditions and credit:
  - Central bank raised policy rate five times (cumulative 2 percentage points) during November 2004-December 2005, and by another 1 percentage point recently; statement notes cumulative 2½ percentage points since November 2004.
  - Reserve money growth brought below 15 percent at end-March 2006 (from 20 percent a year ago) but reversed since April due to increased central bank financing of the budget; reserve money 16 percent (2006 est).
  - Credit growth to the private sector about 24 percent in June 2006; other series show private sector credit 22.1 percent (2006) or 23 percent in August 2006.
- Fiscal developments and public debt:
  - 2005 fiscal deficit widened to 8.7 percent of GDP; excluding tsunami-related flows, deficit was 7.5 percent of GDP.
  - First half of 2006: tax revenue grew 23 percent (below budget target 27 percent); domestic financing in first six months reached Rs. 101 billion (budget estimate Rs. 123 billion for the year).
  - Excluding tsunami-related spending (1.7 percent of GDP), the 2006 deficit would be 7.4 percent of GDP.
  - Total public debt declined by 11 percent of GDP but remains high at 94 percent of GDP in 2005.
  - Foreign-currency borrowing from domestic banks/local investors during 2004–05: $935 million; about $780 million to be repaid in 2006 (including $300 million in the last quarter).
  - Authorities raised $580 million of dollar-denominated Sri Lanka Development Bonds (SLDB) during April-September 2006 with maturity of 2–3 years and average interest rate of LIBOR+140 bps.
- Financial markets and competitiveness:
  - Colombo Stock Exchange All Share Price Index rose cumulatively 70 percent during 2004–05 and another 25 percent so far in 2006; average P/E ratio about 12.
  - REER (CPI based) depreciated 23 percent during 1998–2004, appreciated 8 percent in first half of 2005, and 2 percent up to June 2006.
  - Productivity growth in industry in 2005 declined by 5.6 percent; garments and textiles (45 percent of total goods exports) export growth slowed to 3 percent in 2005.
  - Sri Lanka’s share in total world exports (0.06 percent) declined by 27 percent during 2000–05.

### Outlook and risks
- Near-term outlook: strong growth brightens near-term outlook but rising inflation, slowdown in capital inflows, and rising debt service burden increase risks.
- Key risks:
  - Continued fast credit growth.
  - Further increase in world oil prices.
  - High debt level and relatively low international reserves.
  - Setbacks in the peace process weakening confidence and potentially affecting investment.
  - Potential increases in military spending adding fiscal risks.
- Medium-term prospects conditional on reforms and peace:
  - Staff projects growth around 7 percent; growth could reach authorities’ 8 percent target or higher if challenges are overcome and reforms advanced.
- Staff assessment: "Staff assesses Sri Lanka to have a moderate risk of public and external debt distress."

### Fiscal policy — near-term stance and medium-term path
- Near-term stance and measures:
  - Meet the 2006 budget deficit target to limit stimulus; authorities confident fiscal deficit target of 9.1 percent of GDP will be met for 2006 (budget est. and staff proj).
  - Revenue collections improved in the first seven months: income tax and VAT growing at 47 percent and 12 percent, respectively; overall tax revenue projected to improve by 1 percent of GDP in 2006 to 15.2 percent of GDP.
  - Measures taken: strengthen risk assessment, reduce illegitimate VAT refunds, modify depreciation schedule for capital goods, full price pass-through for major fuel products, rationalization of fertilizer subsidies, rationalization of low-priority projects.
- Fuel pricing:
  - Domestic fuel prices increased by 35 percent (weighted average) during April-September achieving full pass-through for petrol and diesel; VAT (15 percent) removed on diesel to avoid amplifying price shocks.
- Medium-term consolidation targets and strategy:
  - Authorities aim to bring deficit down to 7½ percent of GDP in 2007 and to 5 percent by 2010 (path similar to FMRA but two-year delay).
  - Staff recommended consolidation mainly through revenue-enhancing policies and rationalization of current spending while protecting critical development projects.
  - Specific tax options: reduce exemptions, simplify VAT rates while broadening the VAT base, introduce the TIN, tighten BOI eligibility criteria.
- Recurrent expenditure rationalization:
  - Public sector hiring outpaced population and labor force growth; authorities aim overall nominal wage increase of 20 percent over 2007−09 with limited recruitment.
  - Staff advised restraining real growth in wages and salaries and improving targeting/delivery of subsidies and social programs.

### Monetary and exchange rate policies — stance and recommendations
- Monetary policy:
  - Further monetary tightening required to contain inflation expectations amid oil price pass-through and fast credit growth.
  - Authorities committed to bring down reserve money growth to around 16 percent by end-2006 (from 18 percent at end-June).
  - Plan to step up open market operations to reduce excess liquidity.
  - Staff noted loan growth to the housing sector outpaced overall credit growth and could raise NPL risks.
- Exchange rate regime:
  - Authorities committed to a market-based exchange rate and to limit intervention to reduce volatility; managed float classification since June 2006.
  - Staff recommended greater exchange rate flexibility to safeguard reserves and competitiveness.
  - Sri Lanka maintains margin deposit requirement for certain imports affecting less than 3 percent of total imports; Fund approval retained until November 2, 2007 or completion of next Article IV consultation.

### Financial sector policies and stability
- Banking sector performance:
  - NPL ratios of state-owned banks declined from 18 percent in 2003 (15.6 percent including foreign currency units) to 8 percent in June 2006.
  - Provisioning increased from 70 percent of all NPLs to 80 percent; net NPLs declined below 2 percent.
  - Capital adequacy ratios improved: Bank of Ceylon 12 percent (regulatory minimum 10 percent); People’s Bank reached 2 percent after recapitalization.
  - First tranche of People’s Bank equity capital investment: about $20 million in December 2005.
  - Plans to adopt Basel II by 2008; staff encouraged an FSAP update in 2007.
- Remaining risks and recommended actions:
  - Fast credit growth (~24 percent) could undermine loan quality; high spreads and weak cost structure.
  - Continue restructuring and recapitalization of the two large public banks; focus on credit risk management, IT, and insolvency/loan recovery frameworks.
  - Strengthen prudential standards, consolidated supervision, and consider banking industry consolidation.

### Structural policies — infrastructure, energy, trade, and competitiveness
- Energy and power sector:
  - New energy policy aims to expand capacity using cost-efficient sources (including coal) and adjust prices to remove quasi-fiscal losses; implementing this policy will require additional financing about $800 million during 2007–2010.
  - Quasi-fiscal losses currently estimated at ½ percent of GDP in 2006; further electricity tariff adjustments envisaged to eliminate quasi-fiscal losses by 2007–08.
  - Staff recommended balance sheet restructuring, operational efficiency, strengthened regulatory guidelines, and provisions to protect low-income groups.
- Roads and infrastructure:
  - Road projects progressing with World Bank and AsDB support; development forum to map financing requirements.
- Trade, textiles, and competitiveness:
  - Textile and garment export growth about 4 percent in January-July 2006; garments account for 45–48 percent of goods exports.
  - Need to strengthen backward linkages, address port and infrastructure bottlenecks, and consider moving to a low uniform tariff structure over the medium term.
  - Recent ad hoc increases in cess fees on consumer imports should be reviewed.

### Debt, financing, and public debt sustainability
- Current debt metrics and dynamics:
  - Total public debt: 94 percent of GDP in 2005; gross central government debt series: 2005: 93.9 percent; 2006: 89.6 percent; 2010: 73.8 percent; 2026: 48.3 percent.
  - Foreign-currency denominated public sector debt: 2005: 48.7 percent of GDP; projected 2010: 37.1 percent; 2026: 16.5 percent.
  - Gross financing need (percent of GDP): 2006: 32.2; 2007: 28.5; 2008: 28.4; 2009: 28.8; 2010: 25.0.
  - Debt service-to-revenue ratio (percent): 2006: 104.1; 2007: 91.2; 2008: 84.9; 2009: 93.0; 2010: 81.5.
- Drivers of near-term debt-service increase:
  - Resumption of interest and amortization payments following the Paris Club moratorium in 2005 contributed to the increase.
  - Major part reflects rollover of foreign currency commercial liabilities with relatively short (2–3 years) maturity.
  - Domestic foreign-currency-denominated loans stock as of September 2006 about $1.2 billion; assumed gradual net increase in such borrowing from 2007 at average $250 million per year.
- DSA projections and stress tests:
  - Baseline: total public and public guaranteed debt declines from 94 percent of GDP in 2005 to 74 percent in 2010 under fiscal consolidation.
  - Debt-service-to-exports projected to remain around 13 percent over the medium term under modest commercial borrowing—below the DSA indicative threshold of 20 percent for a medium performer.
  - Extreme stress tests (lower GDP growth, lower exports, exchange rate and deflator shocks) could push the debt-service-to-exports ratio to around 21 percent, indicating risk of debt distress.
  - Baseline NPV of debt-to-GDP ratio: 2006: 78; 2007: 73; 2008: 70; 2009: 68; 2010: 65; 2011: 63; 2016: 56; 2026: 45.
- Policy recommendations on debt:
  - Gradually unwind short-maturity foreign currency commercial borrowing and limit such borrowing for general budget support.
  - Coordinate with donors to fully utilize committed external concessional financing.
  - Improve debt management and develop domestic capital markets (corporate bond market) to mobilize financing.

### Tsunami relief, reconstruction, and social impact
- Disaster and aid:
  - Tsunami of December 26, 2004 killed over 35,000 people and displaced 1 million.
  - Recovery and reconstruction estimated cost about $2.2 billion; international community pledged $2.8 billion (of which $2 billion committed).
  - Sri Lanka received about $260 million in Paris Club debt moratorium and $157.5 million in Fund emergency assistance.
- Aid disbursements and housing:
  - Minimum of $500 million (2.2 percent of GDP) received in 2005; total tsunami inflows about $1 billion in 2005.
  - Government revised housing requirement to 120,000 units; at end-2005: 85,525 families assigned new locations; about 18,154 permanent houses completed and about 80,371 remained; end-June 2006: about 55,483 housing units completed, 40,589 units under construction.
  - Government plans to finish construction of all housing units by end of 2006.
- Social and implementation issues:
  - More than half of households not willing to move to government-identified sites; lost documentation hinders access to grants/loans; complaints of corruption and weak dispute resolution; shortages of building materials and manpower may raise prices.
- Economic impact:
  - Real GDP growth accelerated to 6 percent in 2005 (from 5½ percent in 2004); construction sector grew by 9 percent in 2005; fishery contracted by about 40 percent.
  - Balance of payments registered a surplus of $238 million in 2005.

### Data, statistics, and surveillance
- Data coverage and timeliness:
  - Coverage and timeliness adequate for program monitoring; Sri Lanka participates in GDDS; authorities appointed SDDS coordinator in February 2003 and intend to subscribe to SDDS.
  - Outstanding statistical issues remain in real, fiscal, monetary, and external sectors (multiple CPIs, national accounts deficiencies, gaps in government finance statistics, treatment of FCBUs, ITRS shortcomings).
- Key reported indicators (selected exact figures):
  - Real GDP growth: 6.0 percent (2005); projections 7.0 percent (2006–2010).
  - Inflation (Sri Lanka CPI average): 10.6 (2005); proj. 8.0 (2006).
  - Inflation (CPI end-of-period): 3.6 (2005); proj. 12.0 (2006).
  - GDP per capita (2004): US$1,029.
  - Poverty rate (2004 incidence): 22 percent.
  - FDI (2005): $200 million.
  - Exports: 6,347 (2005); 6,950 (2006).
  - Imports: 8,863 (2005); 10,501 (2006).
  - Gross official reserves (end-2005): 2,458 (millions of U.S. dollars); reserves (2006 proj.): 2,662.
  - Total public debt (2005): 94 percent of GDP.
  - Debt service (percent of goods and services exports): 7.4 (2005); 10.4 (2006 proj.).
  - Broad money growth (annual percent change): 19.1 (2005); 16.5 (2006 proj.).
  - Private sector credit (percent change): 16.9 (2003); 22.1 (2004); 21.5 (2005); 20.7 (2006 proj.).
  - Interest rate (three-month treasury bill rate end period): 10.1 (2005); 11.8 (2006 proj.).
- Surveillance and missions:
  - Next Article IV consultation recommended on a standard 12-month cycle.
  - Authorities requested an FSAP update in 2007.

### Staff and Board priorities — recommended policy package
- Near term:
  - Contain inflation expectations and external vulnerabilities by meeting the 2006 budget deficit target, tightening monetary policy as needed, and allowing greater exchange rate flexibility.
- Medium term:
  - Pursue fiscal consolidation to reach a 5 percent fiscal deficit by 2010, emphasizing revenue measures and rationalizing current spending while protecting critical development projects.
  - Strengthen financial sector resilience: restructure state-owned banks, monitor fast credit expansion, update FSAP in preparation for Basel II (2008).
  - Address infrastructure constraints through the new energy policy while managing debt sustainability via improved debt management, regulatory reforms to attract private investment, and capital market development.
- Cross-cutting structural reforms:
  - Broaden tax base, simplify VAT rates, reduce exemptions, introduce TIN, improve VAT audit and refund governance.
  - Improve insolvency and loan recovery framework to support banking sector restructuring.
  - Protect low-income households via targeted safety nets when implementing energy/fuel price adjustments.

*Source: IMF staff report, selected pages from content unit _cr06446.*

### Executive Summary ......................................................................................................

### Executive Summary

### Introduction
- Decades of civil conflict notwithstanding, Sri Lanka’s economy has shown resilience with growth improving from an average of 4–5 percent in the 1980−90s to 6–7 percent recently.
- Gross national income per capita reached $1,000 in 2004; human development and non-income social indicators have improved and are ahead of other South Asian economies, though income inequality deteriorated (Gini index increased by about 10 Gini points) and rural poverty remains high.
- Government objectives: raise growth to 8 percent over the medium term, sharply increase investment (especially in infrastructure: power and roads), reduce regional inequalities, promote small and medium enterprise development, and implement a new energy policy to increase power generation while reducing cost. A Development Forum is planned for early 2007.

### Recent Developments
- Security and peace process:
  - Sharp escalation in hostilities since late 2005 between government forces and the LTTE; June peace talks failed; tentative willingness to resume talks during October 28−29 but risks remain.
- Growth and inflation:
  - Growth reached 8 percent in the first half of 2006; GDP growth projected at 7 percent for 2006.
  - CPI inflation is projected at 12 percent for 2006.
  - Inflation declined in 2005 but rose since early 2006 due to fast credit growth, oil price pass-through, and increases in wages and pension payments.
  - Unemployment declined to 7¾ percent at end-2005 (from 8½ percent in 2004).
- External sector and reserves:
  - External current account deficit expected to widen to 4¾ percent of GDP in 2006 (from 2.8 percent of GDP in 2005).
  - Tsunami-related inflows: about $1 billion in 2005 (equivalent to 4 percent of GDP); additional $450 million projected in 2006 but disbursements slow.
  - Gross official reserves around $2.4 billion, equivalent to 2.4 months of imports and 86 percent of short-term debt.
  - Rupee-dollar exchange rate weakened somewhat since the second half of 2005; REER appreciated by 2 percent up to June 2006.
- Monetary conditions and credit:
  - Central bank raised policy rate five times (cumulative 2 percentage points) during November 2004-December 2005, and by another 1 percentage point recently.
  - Reserve money growth brought below 15 percent at end-March 2006 (from 20 percent a year ago) but reversed since April due to increased central bank financing of the budget.
  - Credit growth to the private sector (including housing loans) about 24 percent in June 2006.
- Fiscal developments and public debt:
  - 2005 fiscal deficit widened to 8.7 percent of GDP, larger than budgeted, mainly because of tsunami-related spending; excluding tsunami-related flows, deficit was 7.5 percent of GDP (compared to 8.2 percent in 2004).
  - First half of 2006: tax revenue grew 23 percent (below budget target of 27 percent); sizable overruns on recurrent expenditures (oil subsidies, pensions, security/humanitarian spending); capital expenditure adjustment contained the deficit.
  - Excluding tsunami-related spending (1.7 percent of GDP), the 2006 deficit would be 7.4 percent of GDP.
  - Domestic financing in first six months reached Rs. 101 billion (budget estimate Rs. 123 billion for the year).
  - Total public debt declined by 11 percent of GDP but remains high at 94 percent of GDP in 2005.
  - Foreign-currency borrowing from domestic banks/local investors during 2004–05: $935 million; about $780 million to be repaid in 2006 (including $300 million in the last quarter).
  - Fitch first international rating BB- in December 2005; outlook downgraded to negative amid renewed security concerns.
  - Authorities raised $580 million of dollar-denominated Sri Lanka Development Bonds (SLDB) during April-September 2006 with maturity of 2–3 years and an average interest rate of LIBOR+140 bps.
- Financial markets and competitiveness:
  - Colombo Stock Exchange All Share Price Index rose cumulatively 70 percent during 2004–05 and another 25 percent so far in 2006; average P/E ratio about 12.
  - Indicators of external competitiveness warrant close monitoring:
    - REER (CPI based) depreciated 23 percent during 1998–2004, appreciated 8 percent in first half of 2005, and a further 2 percent up to June 2006.
    - Productivity growth in industry in 2005 declined by 5.6 percent; unit labor costs in industry appear to be increasing and profitability decreasing.
    - Garments and textiles (45 percent of total goods exports) export growth slowed to 3 percent in 2005 after elimination of quotas.
    - Sri Lanka’s share in total world exports (0.06 percent) declined by 27 percent during 2000–05.
- Fiscal and liquidity vulnerabilities: high debt level, relatively low international reserves, rising debt service burden, and buildup of liquidity pressures.

### Policy Discussions — Outlook and Risks
- Near-term outlook: strong growth brightens near-term outlook but rising inflation, slowdown in capital inflows, and rising debt service burden increase risks.
- Key risks: continued fast credit growth, further increase in world oil prices, high debt level, and relatively low international reserves that add to vulnerabilities.
- External competitiveness: monitoring needed given REER appreciation, declining export market share, and slowing export volumes in garments.

### Policy Discussions — Fiscal Policy
- Near-term stance:
  - Meet the 2006 budget deficit target to limit stimulus.
  - Revenue enhancement and rationalization of current spending are emphasized to achieve fiscal consolidation.
  - Recent decision to implement full pass-through of oil prices removed a significant component of fiscal vulnerability.
  - Authorities committed to bring fiscal deficit down to 5 percent by 2010.
- Specific fiscal facts and constraints:
  - 2005 deficit 8.7 percent of GDP; excluding tsunami 7.5 percent.
  - First-half 2006 tax revenue growth 23 percent (budget target 27 percent).
  - Overruns in oil subsidies and wage bill; a 20 percent wage hike and hiring of over 42,000 graduates contributed to wage bill pressures.
- Medium-term fiscal strategy recommendations:
  - Achieve consolidation mainly through revenue-enhancing policies and rationalization of current spending while protecting critical development projects.
  - Spell out concrete measures in the 2007 budget to support medium-term fiscal goals.
  - Improve debt management to ensure debt sustainability given increased commercial borrowing needs.

### Policy Discussions — Monetary and Exchange Rate Policies
- Monetary policy actions to date:
  - Policy rate increases: cumulative 2 percentage points during November 2004-December 2005; additional 1 percentage point recently.
  - Reserve money growth reduced to below 15 percent at end-March 2006 but reversed since April because of increased central bank financing of the budget.
- Recommended near-term actions:
  - Further interest rate adjustments may be required to contain inflation.
  - Greater flexibility in the exchange rate to help safeguard external reserves and maintain competitiveness.

### Policy Discussions — Financial Sector Policies
- Banking sector status and risks:
  - Significant progress made to improve financial stability.
  - Challenges remain, particularly in two large state-owned banks (see Box 3 reference).
  - Fast credit growth (about 24 percent) could undermine loan quality.
- Recommended actions:
  - Update Financial Sector Assessment Program (FSAP) to reflect new challenges and vulnerabilities and prepare system for transition toward Basel II in 2008.
  - Address weaknesses in state-owned banks and monitor loan quality closely.

### Policy Discussions — Structural Policies
- Infrastructure and energy:
  - Power bottlenecks, high energy cost, and large quasi-fiscal losses remain key constraints on growth.
  - Authorities implementing a new energy policy aiming to expand capacity, employ low-cost alternative sources, and adjust prices to remove quasi-fiscal losses.
  - Financing this policy implies an increase in commercial borrowing over the medium term.
- Recommendations to support infrastructure policy:
  - Improve debt management given increased commercial borrowing.
  - Enforce sound regulatory environment for private investors.
  - Develop capital markets to mobilize financing.
- Growth and poverty reduction:
  - Medium-term objective: reduce poverty by raising potential growth through fundamental reforms to improve the business climate and promote private investment.

### Staff Appraisal (summary of recommended priorities)
- Near term:
  - Contain inflation expectations and external vulnerabilities by meeting the 2006 budget deficit target, tightening monetary policy as needed, and allowing greater exchange rate flexibility.
- Medium term:
  - Pursue fiscal consolidation to reach a 5 percent fiscal deficit by 2010, emphasizing revenue measures and rationalizing current spending while protecting critical development projects.
  - Strengthen financial sector resilience with reforms in state-owned banks, monitoring fast credit expansion, and undertaking an FSAP update in preparation for Basel II.
  - Address infrastructure constraints through the new energy policy while managing debt sustainability via improved debt management, regulatory reforms to attract private investment, and capital market development.

*Source: IMF staff report, Executive Summary.*

### 11.      While growth remains robust, near-term risks and vulnerabilities have

### _cr06446 - 11.      While growth remains robust, near-term risks and vulnerabilities have

### Outlook and risks
- Growth remains robust, but near-term risks and vulnerabilities have increased since the last Article IV consultation.
- Emerging pressures and vulnerabilities:
  - Inflationary pressures are building.
  - Managing further oil price shocks remains a challenge.
  - Reserves are below comfortable levels.
  - Rising debt service burden, particularly during 2008−09, has intensified external vulnerabilities.
  - Potential increases in military spending add risks to the fiscal outlook.
  - Setbacks in the peace process have caused some weakening in confidence and could further affect investment going forward.
- Medium-term prospects conditional on reforms and peace:
  - Staff projects growth to sustain at around 7 percent over the medium term, assuming macroeconomic stability and fiscal consolidation.
  - Growth could reach the authorities’ 8 percent target or even higher if challenges are overcome and fundamental reforms are advanced.
- Downside risks to medium-term prospects:
  - Without fiscal consolidation, higher fiscal deficits would increase interest payment burden, crowd out private investment, and undermine financial sector development.
  - Entrenched problems in the labor market, trade regime, and energy sector need addressing to improve growth potential.

### Fiscal policy: near-term stance and medium-term path
- Near-term fiscal developments and measures:
  - Revenue collections improved significantly in the first seven months, with income tax and VAT growing at 47 percent and 12 percent, respectively.
  - Ongoing expansion of VAT to the financial sector and services has helped boost revenue.
  - Authorities plan within-year measures: strengthen risk assessment, reduce illegitimate VAT refunds, and modify the depreciation schedule for capital goods (e.g., with a reduction in the depreciation allowance).
  - For the year as a whole, revenue is projected to improve by 1 percent of GDP (compared to a targeted increase of 1.8 percent of GDP in the budget).
  - Recurrent spending overruns attributed to higher world oil prices (larger oil subsidies), increases in pension payments following the November election, and additional security-related spending.
  - Measures taken to offset spending overruns: enhanced revenue collection, full price pass-through for major fuel products, rationalization of fertilizer subsidies, rationalization of low-priority projects.
  - Authorities confident the fiscal deficit target of 9.1 percent of GDP will be met for 2006.
  - Plan to intensify implementation of tsunami-related projects to fully utilize committed donor resources in 2006.
- Fuel pricing and subsidies:
  - Full price pass-through for major fuel products has virtually eliminated oil subsidies in the budget, starting from September 2006.
  - Domestic fuel prices were increased by 35 percent (weighted average) during April-September, achieving full pass-through for petrol and diesel, while substantially reducing subsidies for kerosene.
  - To avoid amplifying price shocks, the authorities removed VAT (15 percent) on diesel.
  - Pricing formula revised to ensure cost recovery plus a profit margin for the two oil companies (one foreign), setting the stage for price liberalization starting from September.
- Medium-term consolidation targets and strategy:
  - Authorities aim to bring the deficit down to 7½ percent of GDP in 2007 and to 5 percent by 2010—essentially the same consolidation path as under the Fiscal Management Responsibility Act (FMRA), but with a two-year delay.
  - Staff supported this consolidation path, noting it is best achieved through:
    - Broadening the tax base and strengthening tax administration.
    - Rationalizing recurrent expenditure.
  - Specific options discussed: reducing exemptions, simplifying VAT rates while broadening the VAT base, introducing the TIN to enhance administration.
  - Authorities found it difficult to implement some measures (e.g., simplifying VAT rates) as early as 2007 without analyzing revenue implications.
  - Extending VAT to wholesale and retail stages not feasible in the near term due to constitutional issues regarding provincial councils’ power over sales taxes and the need for a revenue sharing mechanism between central and local governments.
  - Staff underscored the need to review exemption criteria in the context of the 2007 budget.
- Recurrent expenditure rationalization:
  - Public sector hiring significantly outpaced growth in population and labor force in the past five years; staff advised restraining real growth in wages and salaries with limited hiring.
  - Recommendations to improve targeting and delivery of subsidies and social programs.
  - Interest costs could be reduced through strengthened debt management to replace expensive short-term bank loans in foreign currency with less expensive, longer term instruments.
  - Authorities aim for an overall nominal wage increase of 20 percent over the next three years (2007−09) for the public sector, supported by limited recruitment.
  - Negotiations have started with labor unions of SOEs and public banks.
  - Improvements in targeting for fertilizer subsidies are envisaged in the 2007 budget.

### Tax revenue mobilization (Box 2)
- Context and recent performance:
  - Central government tax revenue at 14.2 percent of GDP in 2005—higher than India and Bangladesh, but much lower than the 1990s average (19 percent of GDP).
  - Declining trend in tax revenue reversed in 2005 due to better performance in income and excise taxes and other taxes.
  - In the first seven months of 2006, tax revenue grew by 23 percent, but remained lower than the ambitious budget target.
  - Tax revenue projected to improve by 1 percent of GDP to 15.2 percent of GDP in 2006 based on improvements in all tax categories, except VAT which is expected to remain flat as a ratio of GDP.
- VAT specifics and administration issues:
  - VAT accounts for about 41 percent of total tax revenues.
  - VAT coverage remains narrow with many exemptions causing cascading effects; wholesale and retail trade remain outside the VAT net and are taxed on turnover by provincial governments.
  - Many nonstandard exemptions: agricultural sector (including inputs), imported capital goods, pharmaceuticals, lease of residential accommodation, import by persons with Board of Investment agreements, pearls and precious stones, essential food items (e.g., rice, flour, milk, bread, fish, vegetable, tea, potatoes, onions, etc).
  - Sri Lanka has three VAT rates (5, 15, 20), plus a zero rate for exporters and domestic buyers of capital inputs.
  - Efficiency ratio of Sri Lanka’s VAT (VAT revenue to GDP divided by the standard rate) is 0.39, in line with regional averages in Asia and Latin America (both at 0.38) and Eastern and Central Europe (at 0.4).
- Options discussed to strengthen tax revenue mobilization:
  - Unifying the VAT rates to simplify administration and improve compliance.
  - Broadening the VAT base, trimming exemptions, extending to wholesale and retail sectors, and introducing a low presumptive tax for companies below the VAT registration threshold.
  - Improving VAT audit by adopting a sound risk assessment framework to enforce governance and reduce fraud in the refund system.
  - Introducing the Taxpayer Identification Number (TIN) to individual income tax payers.
  - Tightening eligibility criteria for corporations under the Board of Investment to curtail proliferation of tax exemptions.

### Debt, financing, and public debt sustainability
- Debt and debt service context:
  - Public and publicly guaranteed debt over 90 percent of GDP (noted as over 90 percent).
  - Interest payments have reached one third of tax revenue.
  - GDP per capita already above $1,000 in 2005, implying movement toward middle-income status and potentially less concessional financing.
- Recent borrowing and debt management:
  - Amount borrowed during 2004–05 was in part to cushion the oil shock.
  - Authorities have sought less expensive resources through issuance of foreign-currency-denominated SLDBs of longer maturity (2–3 years).
  - Staff noted this strategy gives breathing space in 2007 and reduces interest costs compared to treasury bonds of similar maturity, but debt service pressures in foreign exchange are expected to rise sharply from 2008 and likely exert pressures on the balance of payments.
  - Important to gradually unwind such borrowing while limiting it for general budget support.
  - Authorities encouraged to coordinate with donors to fully utilize committed external concessional financing in the pipeline.
- Financing for energy sector policy:
  - Implementing the new energy sector policy will require additional financing of about $800 million during 2007–2010.
  - Authorities exploring long-term financing options: sharing mechanisms with investors, tapping international capital markets, developing the corporate bond market.
  - Staff supported these approaches and indicated a well-developed domestic bond market would support private sector development and allocation of capital.
  - The Fund is ready to provide technical assistance if needed.
- DSA projections and stress tests:
  - Fiscal consolidation path would yield declining total public and public guaranteed debt from 94 percent of GDP in 2005 to 74 percent of GDP in 2010.
  - With modest commercial borrowing from 2007 onwards (including financing for planned energy sector projects), debt-service-to-exports projected to remain around 13 percent over the medium term—below the DSA indicative threshold for debt service distress (at 20 percent) for a medium performer under the 2005 CPIA Index.
  - Extreme stress tests (lower GDP growth, lower exports, exchange rate and deflator shocks) could bring this ratio to around 21 percent, indicating a risk of debt distress.

### Monetary and exchange rate policies
- Monetary policy stance:
  - Monetary policy should be geared toward reducing inflation expectations.
  - In light of pressures from the oil price pass-through and fast credit growth, further monetary tightening will be required.
  - Interest rate hikes could be justified in an environment of rising global and regional interest rates.
  - Authorities committed to bring down reserve money growth to around 16 percent by end-2006 (from 18 percent at end-June) and adjust interest rates as needed.
  - Plan to step up open market operations to reduce excess liquidity in the banking system.
  - Staff noted loan growth to the housing sector has outpaced overall credit growth by a significant margin, posing risks to uneven sectoral development and potential rising of NPLs.
- Exchange rate regime and interventions:
  - Authorities committed to a market-based exchange rate and to limit intervention to reduce volatility; greater flexibility in the nominal exchange rate seen as helpful to safeguard external reserves and reduce external vulnerability.
  - Intervention during May-July was to reduce volatility in response to market pressures from lumpy tsunami-related imports; net sales in August were markedly reduced, with some pick up in September.
  - Steps being taken to increase official banking services and lower the cost and time period for transfers to facilitate continued strong inflows of workers’ remittances to help mitigate future shocks.
  - Sri Lanka maintains requirements for the deposit of margin by importers of certain goods; these requirements affect approximately less than 3 percent of total imports and give rise to an exchange restriction subject to Fund approval under Article VIII, Section 2(a).
  - Based on developments in the past three years, the exchange rate regime in Sri Lanka was reclassified under the Fund system as managed float since June 2006 (from the previous free float).
  - On November 9, 2006, the Fund approved retention of the exchange restriction until November 2, 2007 or the completion of the next Article IV consultation with Sri Lanka, whichever comes earlier.
- Competitiveness and external performance:
  - Staff and authorities agreed exchange rate competitiveness is not an immediate concern given small variations in the REER in the last 12 months and current trend of export performance.
  - Decline in labor productivity and rise in unit labor costs warrant close monitoring.
  - Authorities less worried about recent drop in export market share of garments and textiles, citing promising order books and a niche market in apparel; expect Generalized System of Preferences (GSP) to yield positive results.
  - Tea exports to major European and Middle East markets have performed well to date.

### Financial sector policies and stability
- Banking sector improvements and remaining risks:
  - Banking sector soundness has improved; progress made in strengthening the supervisory framework.
  - NPL ratios of the state-owned banks declined from 18 percent in 2003 (15.6 percent including foreign currency banking units) to 8 percent in June 2006, reaching similar levels to those of domestic banks.
  - Capital adequacy ratios improved to 8.3 percent of total assets.
  - Plans to adopt the Basel II capital accord by 2008.
  - Risks remain: credit acceleration in the housing sector is a concern; high spreads in the banking system (almost double those in other economies in the region).
  - Need to foster consolidation in the banking industry to rationalize cost structure and improve competitiveness.
  - Consolidated supervision framework important given cross holding of assets by banking groups and conglomerates.
- Public banks and restructuring:
  - Continued restructuring of the two large public banks remains important for financial sector stability.
  - Although NPL ratios have declined and provisioning and profitability have improved, loan practices and risk management remain weak; the low capital adequacy ratio in the People’s Bank remains a risk.
  - Staff encouraged stepped-up implementation of the restructuring program for the People’s Bank, supported by AsDB.
  - Authorities moving toward implementing Basel II in 2008, covering the two public banks with respect to all prudential measures.
  - Authorities agreed an FSAP update in 2007 would be useful to verify improvements and examine new challenges and vulnerabilities.

*Source: _cr06446 - 11. While growth remains robust, near-term risks and vulnerabilities have (IMF staff report content provided).*

### 29.      Staff sought clarification regarding the new role of SEMA as a holding company

### _cr06446 - 29.      Staff sought clarification regarding the new role of SEMA as a holding company

### SEMA as holding company and supervisory clarity
- Staff sought clarification regarding the new role of SEMA as a holding company of strategic SOEs, including public banks.
- Importance of addressing the risk of conflict of interests was emphasized, as this arrangement could potentially open the door for connected lending between the industrial groups and public banks all under the purview of SEMA.
- It is critical to ensure the role of the CBSL as the sole regulatory power to supervise and regulate operations of all public banks under SEMA.
- Staff noted: "It is also important to clarify the role of SEMA as a holding company for both strategic SOEs and public banks, and the CBSL’s sole regulatory power should be protected."

### State-owned banks: diagnostics and recent progress (Box 3)
- The banking sector is dominated by two commercial state-owned banks, Bank of Ceylon and the People’s Bank, together accounting for about a third of banking system assets.
- Historical weaknesses:
  - Recapitalization in the 1990s was not combined with effective restructuring, resulting in underperformance, and negative equity in the case of the People’s Bank.
  - The 2002 FSAP identified these banks as the key vulnerability in the banking system.
- Recent restructuring and recapitalization:
  - People’s Bank restructuring plan calls for recapitalization with a loan from the Asian Development Bank over a period of five years.
  - The first tranche of equity capital investment—of about $20 million—took place in December 2005 upon completion of some of the benchmark targets.
  - Bank of Ceylon restructuring plan (2004) included targets in asset reconstruction, systems upgrading, human resource development, and capital enhancement to be achieved within a two-year period; the bank was able to achieve its targets for 2005.
  - Changes in the Board and senior management of both banks appear to have strengthened these institutions.
- Financial performance improvements:
  - NPL ratios of the state banks improved from 18 percent in 2003 (15.6 percent including foreign currency units) to 8 percent in June 2006.
  - NPL ratios have reached similar levels to those of domestic private banks, but remain high compared to the 1 percent NPL ratio of foreign banks operating in the country.
  - Provisioning increased from 70 percent of all NPLs to 80 percent.
  - Net NPLs (net of interest in suspense and loan loss provisions) have declined below 2 percent.
  - People’s Bank reported a positive net worth of about Rs. 4 billion in 2005, from a negative net worth of Rs. 6 billion in 2001.
  - Capital adequacy ratio of Bank of Ceylon has increased to 12 percent, above the regulatory minimum of 10 percent, and that of People’s Bank turned positive following the recapitalization and has since reached 2 percent.
  - Profitability ratios have increased on the back of a stronger economic and robust credit growth.
- Remaining structural weaknesses and risks:
  - Large stocks of bad debt, poor risk management practices, inadequate information technology, and very difficult labor problems hinder modernization and restructuring.
  - Weaknesses in the legal system and framework for dealing with insolvencies and loan recoveries compound challenges.
  - Lending by state-owned banks to state-owned enterprises increases the risks of the banking system.

### Infrastructure, energy, and roads (structural policies)
- Infrastructure development (power and roads) is central to the government’s medium-term development strategy.
- Emphasis on restoring financial viability of the power sector while expanding generation capacity by using more cost-efficient sources (including coal power).
- Tariff and quasi-fiscal losses:
  - Authorities indicated that, following an initial increase in electricity tariffs in September, further adjustments are envisaged with a view to eliminate future quasi-fiscal losses by 2007–08 (currently estimated at ½ percent of GDP in 2006).
  - Staff encouraged speed up of operational restructuring of the power companies to reduce system losses and improve efficiency.
  - Strengthening regulatory guidelines to promote private investment including FDI was recommended.
  - Remaining quasi-fiscal losses could be brought on budget.
  - Design of the new tariff structure should consider provisions to protect low-income groups.
  - The new formula to liberalize domestic fuel prices is based on commercial principles; any temptations to interfere should be limited.
- Roads:
  - Road projects are progressing well with the support of the World Bank and AsDB.
  - Authorities expect the forthcoming development forum will help map out financing requirements with donor support.
- Staff recommendations:
  - Further adjustments in tariffs, combined with balance sheet restructuring and enhanced operational efficiency, is key to eliminate quasi-fiscal losses and generate internal funds for investment.
  - Strengthening regulatory guidelines for the energy sector could help broaden the investor base for long-term energy sector financing.

### Poverty, rural-urban inequality, and safety nets
- Reducing rural-urban income inequality remains a priority.
- Concern that recent price increases for energy products, while bringing fiscal and efficiency gains, could lower real income of the poor.
- Income gap between the rich and the poor has widened during the last decade.
- Staff suggested introducing safety net measures to cushion the real income impact on the poor.
- Several scenarios estimating the social impact of energy price adjustment were discussed to identify ways to address the issue in the 2007 budget.
- Authorities indicated some cash payments may be considered in 2007 for targeted low income households and will review other affordable and transparent safety net means in the context of their development plan.

### Trade, textiles, and competitiveness
- Post-MFA environment challenges:
  - Textile and garment exports grew at only about 4 percent in January-July.
  - Sri Lanka’s market share in apparel to the United States and EU may continue to decline given increased competition and lack of full-utilization of the GSP access due to issues regarding rules of origin.
- Authorities’ responses:
  - Plans developed to strengthen backward linkages of the garments sector with textile factories to help reduce input costs and turnover periods.
  - Plans underway to address poor infrastructure, particularly weaknesses in port operations, which raise manufacturing and exporting costs.
- Trade policy:
  - Maintaining a liberal trade system is critical.
  - Recent ad hoc increases in fees (cesses) on a number of consumer imports have complicated the system and sent wrong signals to the private sector.
  - Authorities argue these fees cover limited consumer goods and are earmarked for specific use including export promotion and development related activities.
  - Staff encouraged review of the cess issue with assistance from the World Bank.
  - Staff advised that moving to a low uniform tariff structure will help minimize distortions and inefficiencies.
  - A number of bilateral trade negotiations are ongoing, including with India and Pakistan.
  - Over the medium term, a single low tariff structure could be considered to help maximize efficiency.

### Macroeconomic policy and staff appraisal highlights
- Near- and medium-term prospects depend critically on progress on the peace front and implementing essential reforms.
- Authorities’ medium-term framework emphasizes raising growth and reducing vulnerability through:
  - Fiscal consolidation.
  - Infrastructure development.
  - Supporting rural and small and medium enterprises.
  - Creating income-generating activities to assist the poor.
- Need for clearer measures to create fiscal space for increased investment and social spending.
- Growth target:
  - Achieving 7−8 percent growth will require improvement in investment efficiency and productivity.
- Near-term macro policy priorities:
  - Reduce inflationary expectations and external vulnerabilities.
  - Recent increase in policy rates is appropriate; further interest rate hikes may be needed to contain credit growth and keep inflation expectations in check.
- Exchange rate regime:
  - Current exchange rate regime remains appropriate.
  - Authorities should limit intervention to smoothing excessive volatility and allow greater flexibility in the exchange rate.
  - A sustained drop in external reserves below current levels should be avoided.
  - Authorities committed to eliminate deposit margin exchange restriction measures shortly; staff is assessing whether the exchange restriction warrants Fund approval.
- Fiscal policy and 2007 budget:
  - Authorities’ commitment to adhere to the 2006 budget deficit target is appropriate.
  - 2007 budget should firmly advance fiscal consolidation.
  - Avoid reliance on overly optimistic revenue projections.
  - Budget should adopt revenue measures that simplify the tax system, enhance administration, and improve tax buoyancy through base broadening.
  - Reducing exemptions should be a priority and could be implemented without delay.
  - Greater spending efficiency required, including restraining real wage growth through limited hiring and improving targeting for subsidy programs.
  - Rural development expenditure should proceed in line with revenue-enhancing efforts.
- Debt sustainability:
  - Hinges on strength of fiscal consolidation and policies to improve potential growth.
  - Insufficient fiscal adjustment could lead to adverse debt dynamics and compromise poverty reduction and MDG objectives.
  - Increased debt service pressures in the next few years could complicate debt management.
  - A well-defined medium-term fiscal policy framework and improved debt management policy are important.
  - Further recourse to commercial borrowing for budgetary purposes should be limited.
  - Capital market development, particularly the corporate bond market, could help channel private investment.
- Financial sector stability:
  - Good progress in strengthening financial sector stability and implementing 2002 FSAP recommendations.
  - Enhancing regulatory and supervisory framework and restructuring two large public banks contributed to improvements in financial soundness indicators and declined NPL ratios across the banking system.
  - Further actions recommended:
    - Strengthen prudential standards to mitigate risks from rapidly rising credit and enlarged exposures.
    - Strengthen framework for consolidated supervision to monitor system risks, including among banking groups and financial conglomerates.
    - Satisfactory progress in meeting the Basel Core Principles is essential prior to planned adoption of Basel II in 2008.
    - Banking industry consolidation could help rationalize cost structure and prepare banks for regional competition.
    - Restructuring efforts for the two large public banks need to focus on credit risk management and improving framework for dealing with insolvencies and loan recoveries.
    - An early FSAP update would be beneficial.

### Key statistics and exact figures cited
- State banks’ NPL ratios: 18 percent in 2003 (15.6 percent including foreign currency units) to 8 percent in June 2006.
- Foreign banks’ NPL ratio: 1 percent.
- Provisioning of NPLs: increased from 70 percent to 80 percent.
- Net NPLs: declined below 2 percent.
- People’s Bank net worth: about Rs. 4 billion in 2005 (from negative Rs. 6 billion in 2001).
- Capital adequacy ratio, Bank of Ceylon: 12 percent (regulatory minimum 10 percent).
- Capital adequacy ratio, People’s Bank: 2 percent.
- First tranche of equity capital investment for People’s Bank: about $20 million in December 2005.
- Quasi-fiscal losses in 2006: currently estimated at ½ percent of GDP.
- Growth target referenced: 7−8 percent.
- Textile and garment export growth: about 4 percent in January-July.
- Basel II planned adoption: 2008.

*Source: Excerpt from the IMF staff report content unit _cr06446 - 29.      Staff sought clarification regarding the new role of SEMA as a holding company*

### 43.      It is recommended that the next Article IV consultation with Sri Lanka take place on

### _cr06446 - 43.      It is recommended that the next Article IV consultation with Sri Lanka take place on

### Recommendation on Article IV consultation
- It is recommended that the next Article IV consultation with Sri Lanka take place on a standard 12-month cycle.

### Real, fiscal, and monetary sector developments
- GDP growth continued to be strong; inflation subsided by end-2005 but the trend reversed in 2006.
- All main sectors performed better than in 2004 and this continued in Q1 2006.
- Real GDP growth and inflation (selected observations):
  - Real GDP growth: 6.0 percent (2005); projections: 7.0 percent (2006, 2007, 2008, 2009, 2010) in Table 5.
  - Inflation (Sri Lanka CPI; average): 10.6 (2005), 8.0 (2006 proj).
  - Inflation (Sri Lanka CPI; end-of-period): 3.6 (2005), 12.0 (2006 proj).
- Fiscal developments:
  - The fiscal deficit, excluding tsunami-related spending, was contained in 2005.
  - Public debt declined owing to strong growth.
  - Public debt (2005): 94 percent of GDP (summary page).
- Monetary developments:
  - Monetary policy was tightened through active open market operations and policy interest rate moves.
  - Monetary aggregates (Twelve-month percent change): Reserve money and Broad money series shown for 2002–2006 (figures).
  - Contributions to reserve money growth from net foreign assets and net domestic assets highlighted.

### Interest rates, yields, and financial indicators
- The Central Bank increased its policy rate by 2½ percentage points since November 2004.
- Recent steepening of the yield curve suggests increased inflation expectations.
- Nominal interest rates (figure): Repo rate, Reverse Repo rate, 3-month T-bill rate (2002–2006 series).
- Yield curve snapshots: June 2006; October 2005; May 2005 (tenors 91D, 182D, 364D, 2Y, 3Y, 4Y).

### External sector, trade, and reserves
- Trade balance and external flows:
  - Trade deficit narrowed slightly in 2005 owing to strong export growth and a slowdown in non-oil imports but began to widen in 2006.
  - Exports (in millions of U.S. dollars): 6,347 (2005); 6,950 (2006).
  - Imports (in millions of U.S. dollars): 8,863 (2005); 10,501 (2006).
  - Current account balance (in millions of U.S. dollars): -650 (2005); -1,281 (2006).
  - Current account balance (in percent of GDP): -2.8 (2005); -4.7 (2006).
- Reserves and exchange rate:
  - Large tsunami aid inflows and workers’ remittances helped strengthen the balance of payments and build up reserves.
  - Gross official reserves (Net of ACU balances; in billions of U.S. dollars): 2,458 (end-2005); 2,662 (2006).
  - Rupee exchange rate: REER and NEER indices and Rupees per U.S. dollar series (January 2002 = 100 basis).
- Stock market:
  - Stock market performed strongly during most of 2005, but declined sharply following upsurge of violence (Colombo stock exchange index series, January 2002=100).

### Key country statistics and selected indicators (as reported)
- Main exports (percent of total, 2005): garment (48), tea (14).
- GDP per capita (2004): US$1,029.
- Unemployment rate (2005): 7.7 percent.
- Poverty rate (2004, incidence): 22 percent.
- FDI (2005): $200 million.
- Public debt (2005): 94 percent of GDP.
- Foreign public debt (percent of total, 2005): 43.
- Balance of payments (selected levels, in millions of U.S. dollars):
  - Exports: 4,817 (2001), 4,699 (2002), 5,133 (2003), 5,757 (2004), 6,347 (2005), 6,950 (2006).
  - Imports: 5,974 (2001), 6,105 (2002), 6,673 (2003), 7,999 (2004), 8,863 (2005), 10,501 (2006).
  - Gross official reserves (end of period): 1,183 (2001), 1,560 (2002), 2,146 (2003), 1,833 (2004), 2,458 (2005), 2,662 (2006).
- Nominal GDP (in billions of U.S. dollars): 15.7 (2001), 16.5 (2002), 18.2 (2003), 20.1 (2004), 23.5 (2005), 27.4 (2006 est).

### Summary of central government operations (2004–2010, selected)
- Total revenue (percent of GDP): 15.3 (2004), 16.1 (2005), 17.8 (2006 budget est.), projections through 2010 in Table 4.
- Total expenditure and net lending (percent of GDP): 23.5 (2004), 24.7 (2005), 26.9 (2006 budget est.).
- Overall balance (percent of GDP): -8.2 (2004), -8.7 (2005), -9.1 (2006 budget est. and staff proj).
- Overall balance (excluding tsunami measures): -8.2 (2004), -7.5 (2005), -7.3 (2006).
- Primary balance (excluding grants): -2.2 (2004), -3.6 (2005), -3.5 (2006 est.).
- Total government debt (percent of GDP): 105.4 (2004), 93.9 (2005), projected declines thereafter (Table 4).

### Monetary accounts (2003–2006, selected)
- Reserve money (level, in billions of Sri Lankan rupees): 141 (2003 Dec), 171 (2004 Dec), 198 (2005 Dec), 212 (2006 June).
- Reserve money (percent change): 11.9 (2003), 20.9 (2004), 15.8 (2005), 16.0 (2006 est).
- Broad money (in billions of rupees): 718 (2003 Dec), 859 (2004 Dec), 1,022 (2005 Dec), 1,089 (2006 June).
- Broad money (percent change, 12-month): 15.3 (2003), 19.6 (2004), 19.1 (2005), 16.5 (2006 est).
- Private sector credit (percent change, 12-month): 8.9 (2003), 12.0 (2004), 16.9 (2005), 22.1 (2006).

### Balance of payments projections (2005–2010, selected from Table 2)
- Current account (in millions of U.S. dollars): -650 (2005), -1,281 (2006), projections: -1,734 (2007), -1,501 (2008), -1,244 (2009), -1,173 (2010).
- Trade balance (in millions of U.S. dollars): -2,516 (2005), -3,551 (2006), -4,371 (2007), -4,600 (2008), -4,793 (2009), -5,267 (2010).
- Exports: 6,347 (2005), 6,950 (2006), 7,588 (2007), 8,213 (2008), 8,863 (2009), 9,565 (2010).
- Imports: 8,863 (2005), 10,501 (2006), 11,959 (2007), 12,813 (2008), 13,656 (2009), 14,832 (2010).
- Transfers: 1,828 (2005), 2,140 (2006), 2,398 (2007), 2,775 (2008), 3,135 (2009), 3,539 (2010).
- Gross official reserves (millions of U.S. dollars): 2,458 (2005), 2,662 (2006), 2,674 (2007), 2,489 (2008), 2,664 (2009), 2,860 (2010).
- Net international reserves: 2,076 (2005), 2,351 (2006), 2,393 (2007), 2,277 (2008), 2,546 (2009), 2,778 (2010).

### Tsunami relief and reconstruction update (Appendix I)
- Disaster impact and international response:
  - The tsunami of December 26, 2004 killed over 35,000 people and displaced 1 million.
  - Recovery and reconstruction process expected to take 3–5 years with an estimated cost of about $2.2 billion.
  - International community pledged $2.8 billion for recovery and reconstruction activities, of which $2 billion were committed.
  - Sri Lanka received about $260 million in debt moratorium from Paris Club creditors and $157.5 million in emergency assistance from the Fund.
- Aid disbursements and receipts:
  - A minimum of $500 million (2.2 percent of GDP) was received in 2005.
  - Tsunami inflows amounted to about $1 billion (including Fund emergency assistance and Paris Club moratorium) and helped offset the current account deficit.
- Housing and reconstruction progress:
  - Government revised total housing requirement from 98,525 units to 120,000 units.
  - About 13 percent of total units in housing program are donor funded.
  - At end-2005: 85,525 families assigned new locations (53,000 transitional shelter; 32,525 private homes).
  - At end-2005: about 18,154 permanent houses completed and about 80,371 remained.
  - Government plans to finish construction of all housing units by end of 2006.
  - At end-June 2006: about 55,483 housing units completed, 40,589 units under construction.
- Social and implementation issues:
  - Relocation debates created social conflicts; more than half of households are not willing to move to government-identified sites.
  - Lost documentation (identity cards and ownership documents) hinder access to grants and loans.
  - Reports of complaints of corruption and absence of an effective dispute resolution mechanism.
  - Shortage of building materials and manpower may raise prices as reconstruction gathers pace.
- Economic impact:
  - Real GDP growth accelerated to 6 percent in 2005 (from 5½ percent in 2004).
  - Construction sector grew by 9 percent in 2005; fishery contracted by about 40 percent.
  - Balance of payments registered a surplus of $238 million in 2005, compared with a deficit of $205 million in 2004.
  - Year-on-year inflation slowed to 3.6 percent at end-2005, compared with 16.8 percent at end-2004.
- Household income and employment effects:
  - Needs Assessment Survey for Income Recovery: 15 percent income non-recovery rate among households with men; 35 percent non-recovery among those with women.
  - Displaced people more vulnerable to unemployment and earn less when employed.
  - Changes in household income sources with increases from remittances and government welfare and significant fall in fisheries income.
- Main source of household income by sector (Before / Tsunami / Now, in percent):
  - Agriculture and livestock: 5 / 4 / ?
  - Fisheries: 43 / 30 / ?
  - Manual labor and manufacturing: 20 / 24 / ?
  - Private services and small business: 23 / 21 / ?
  - Public sector/government services: 5 / 6 / ?
  - Temporary relief work with NGOs: 0 / 2 / ?
  - Income not from work (foreign remittances, government welfare, charity, loans, pensions, selling personal belongings): 21 / 2 / ?
  - (Table heading and values provided as "Before / Sector / Tsunami / Now" and source: Joint Status Report of the United Nations Group and the Sri Lankan Government.)

### Debt sustainability analysis (Appendix II)
- Framework and baseline assumptions:
  - DSA assumes strong growth, fiscal consolidation, and a gradual increase in foreign currency commercial borrowing to support infrastructure.
  - Growth over 2007–2010 projected at 7 percent; fiscal consolidation path assumes reduction in fiscal deficit to 5 percent by 2010 and to 4 percent by 2026.
  - Export growth assumed at 9 percent in the medium term; reserves maintained at around 2 months of imports.
  - Analysis includes pressures from domestic foreign-currency-denominated loans stock as of September 2006 (about $1.2 billion) and assumes a gradual net increase in such borrowing from 2007 onwards at an average of $250 million per year.
  - Risks reflected via extreme stress tests.
- Central government debt sustainability:
  - Baseline: central government debt falls linearly from 94 percent of GDP in 2005 to 74 percent in 2010 and 48 percent in 2026 (Table II.1).
  - Main driver: continued interest rate/growth differential; projected real growth 7 percent over 2006–2010 and 6 percent through 2026 versus projected real interest rates on domestic and foreign debt of 5.8 percent for 2006–2012.
  - Alternative scenario A2 (continuation of recent policies 2003–2005): primary deficit 1.6 percent, average real interest rate 1.5 percent, real growth 5.8 percent. Under A2, NPV of debt-to-GDP would decline marginally from 78 percent in 2006 to 75 percent in 2010 and to 70 percent in 2026.
  - Alternative scenario A1 (growth and primary balances continue at 10-year average / reverse of reforms): NPV of debt-to-GDP would increase to 80 percent of GDP in 2010 and to 104 percent in 2026.
  - Under scenarios A1 and A2, debt service-to-revenue ratio remains around the high level of 2005, constraining ability to increase other expenditures.
- External debt sustainability:
  - Nominal external debt consistently above 50 percent of GDP in the last decade; majority is public and publicly guaranteed (PPG) with medium- to long-term maturity.
  - Private external debt mainly short-term (export trade credits).
  - External debt concessionality: about 70 percent concessional; effective interest rates just over 2 percent.
  - External debt ratios vulnerable to rupee movements against SDR, JPY, and USD as 90 percent of external debt denominated in these currencies.
  - Baseline projects NPV of PPG external debt ratios to decline over 2006–2026 and remain below indicative thresholds for low-income countries with medium policy frameworks.
  - Debt-service-to-exports ratio increases rapidly from 5 percent to 15.5 percent over 2005–2006 and averages at a higher level thereafter (Figure II.2 referenced).

*Source: _cr06446 (selected pages and tables from Sri Lanka Article IV staff report).*

### 10.5 percent over 2007–2011. In part, this reflects the resumption of interest and

### _cr06446 - 10.5 percent over 2007–2011. In part, this reflects the resumption of interest and amortization payments following the Paris Club moratorium in 2005

### Debt dynamics and near-term vulnerabilities
- Public sector debt (gross central government debt) levels (selected years, in percent of GDP):
  - 2003: 105.8
  - 2004: 105.4
  - 2005: 93.9
  - 2006: 89.6
  - 2007: 84.3
  - 2008: 80.4
  - 2009: 76.9
  - 2010: 73.8
  - 2011: 70.7
  - 2016: 60.8
  - 2026: 48.3
- Of public sector debt: foreign-currency denominated (selected years, in percent of GDP):
  - 2003: 55.4
  - 2004: 56.1
  - 2005: 48.7
  - 2006: 45.2
  - 2007: 42.8
  - 2008: 40.4
  - 2009: 38.7
  - 2010: 37.1
  - 2011: 35.6
  - 2016: 26.1
  - 2026: 16.5
- Change in public sector debt (selected years, percent of GDP): 2006: 0.2; 2007: -0.4; 2008: -11.5; 2009: -4.3; 2010: -5.3; 2011: -4.0; 2016: -1.6; 2026: -1.1.
- Gross financing need (in percent of GDP): 2006: 32.2; 2007: 28.5; 2008: 28.4; 2009: 28.8; 2010: 25.0; 2011: 24.3; 2016: 20.0; 2026: 15.0.
- Debt service-to-revenue ratio (in percent): 2006: 104.1; 2007: 91.2; 2008: 84.9; 2009: 93.0; 2010: 81.5; 2011: 82.8; 2016: 68.1; 2026: 49.3.
- Key macro assumptions (selected):
  - Real GDP growth (in percent): 2006: 6.0; 2007: 5.4; 2008: 6.0; 2009: 4.5; 2010: 2.3; 2011: 7.0; 2012–2016: 7.0 (annual); 2026: 6.0.
  - Average nominal interest rate on forex debt (in percent): 2006: 1.3; 2007: 1.4; 2008: 0.6; 2009: 1.4; 2010: 0.3; 2011: 1.6; 2016: 1.9; 2026: 2.3.
  - Inflation rate (GDP deflator, in percent): 2006: 5.0; 2007: 9.4; 2008: 10.0; 2009: 8.7; 2010: 2.7; 2011: 9.0; 2016: 5.0; 2026: 5.0.

### Drivers of the projected debt-service increase
- Resumption of interest and amortization payments following the Paris Club moratorium in 2005 contributed to a projected increase in debt service (the text notes "2.5 percent of the total increase in debt service over 2006–2011").
- Major part of the increase reflects rollover of foreign currency commercial liabilities of the public sector with relatively short (2–3 years) maturity.
- Including all foreign currency liabilities increases debt service pressures further, particularly over 2008–2009.
- Characteristics amplifying vulnerability:
  - Rapid increase in debt service-to-exports ratio (though below debt-distress thresholds).
  - Lumpy payment schedule and high rollover risk.
  - Significant liquidity pressures on the public sector balance sheet and increased vulnerability of debt dynamics to shocks.
- Identified debt-creating flows and automatic debt dynamics (selected values, percent of GDP):
  - Primary deficit (2006–11 average): 0.9
  - Revenue and grants (selected years, percent of GDP): 2006: 16.2; 2007: 15.8; 2008: 17.4; 2009: 18.5; 2010: 18.3; 2011: 18.6; 2016: 19.1; 2026: 19.9.
  - Primary (noninterest) expenditure (selected entries show series in text; preserve exact figures where listed above).

### Sensitivity and stress-test results
- Baseline assessment: staff assesses Sri Lanka to have a moderate risk of public and external debt distress.
- Sensitivity to export growth shocks:
  - A one standard deviation shock to historical export growth will increase the NPV of external debt to GDP by 6 percent over 2006–2008, falling to the 2006 level in 2013.
  - The same shock would increase the NPV of external debt to exports by 45 percentage points over 2006–2008, falling to the 2006 level in 2018.
- Debt-service stress tests:
  - Stress tests on debt-service-to-exports reflect increased vulnerability to export growth and combination shocks, particularly over 2012–2013.
  - The most extreme test shows an increase in the debt-service-to-exports ratio to about 16.4 percent of exports (year referenced: 2012–2013).
  - Including all foreign currency liabilities propels debt-service vulnerability further, pushing the ratio to just under 21 percent in 2013.
- Medium-term projection under current commercial borrowing assumptions:
  - The debt-service-to-exports ratio plateaus at approximately 9 percent of exports.
- Sensitivity analysis tables (selected summary projections, NPV of debt-to-GDP ratio, percent of GDP):
  - Baseline NPV of debt-to-GDP ratio series: 2006: 78; 2007: 73; 2008: 70; 2009: 68; 2010: 65; 2011: 63; 2016: 56; 2026: 45.
  - Alternative scenarios and bound tests are presented showing higher ratios under adverse scenarios (for example, A1 historical averages and several B tests produce higher future ratios up to low triple-digits in debt-to-revenue measures).

### Staff assessment and policy recommendations
- Overall assessment:
  - "Staff assesses Sri Lanka to have a moderate risk of public and external debt distress."
  - Debt sustainability could be significantly improved if meaningful fiscal consolidation takes place and key structural reforms are implemented to unleash growth potential.
  - Under the baseline of strong and sustainable growth and fiscal consolidation, the path of Sri Lanka's public debt is favorable and the debt service burden appears manageable.
- Risks highlighted:
  - Extreme stress tests (slower growth, lower exports, deflator and exchange rate shocks) could raise debt service indicators to debt distress thresholds.
  - Potential lumpy repayments in the next few years due to domestic foreign currency loans cumulated during 2005–06.
- Policy recommendations and priorities:
  - Implement meaningful fiscal consolidation in the medium to longer term.
  - Implement key structural reforms to unleash growth potential.
  - Establish a well-defined medium term fiscal framework.
  - Improve debt management policy.
  - Develop domestic capital markets to prepare for potential decline in concessional financing as the country moves toward middle-income status.

### Key external-debt indicators and projections (selected highlights)
- External debt (nominal, percent of GDP): 1996–2005 historical series and projections show a declining trajectory from 61.0 (1996) to 47.2 (2005) and projected further declines to 31.2 (2016) and 20.8 (2026) in the series presented.
- NPV of external debt (in percent of GDP) and in percent of exports:
  - NPV of external debt (selected projected years, percent of GDP): 2016: 31.2; 2026: 13.1.
  - In percent of exports (selected projected years): 2016: 79.9; 2026: 56.3.
- Debt service-to-exports ratio (in percent), historical and projected highlights:
  - Historical range (selected years): 15.3 (1996) down to 12.1 (1997) etc.; projections include values such as 16.8, 13.3, 15.0 for various years and stress-test outcomes up to just under 21 percent in 2013 when including all foreign-currency liabilities.
- Total gross financing need (billions of U.S. dollars) presented in the staff simulations for longer horizons (series provided in table).

### IMF relations and institutional context (appendix highlights)
- Membership and IMF financial exposures (as of dates cited in source):
  - Membership: Joined 8/29/50; accepted Article VIII, Sections 2, 3, and 4, March 1994.
  - Quota: 413.40 (SDR Million) = 100.00 percent quota.
  - Fund holdings of currency: 513.74 (SDR Million) = 124.27 percent quota.
- Outstanding purchases and loans (SDR Million; percent quota):
  - Emergency Assistance: 103.35 = 25.00 percent quota.
  - Extended arrangements: 20.67 = 5.00 percent quota.
  - PRGF arrangements: 38.39 = 9.29 percent quota.
  - Stand-by arrangements: 24.16 = 5.84 percent quota.
- Financial arrangements table (selected):
  - EFF Apr 18, 2003–Apr 17, 2006: Amount Approved (SDR Million) 144.40; Amount Drawn 20.67.
  - PRGF Apr 18, 2003–Apr 17, 2006: Amount Approved 269.00; Amount Drawn 38.39.
  - Stand-by Apr 20, 2001–Sep 19, 2002: Amount Approved 200.00; Amount Drawn 200.00.
- Exchange rate arrangement: Managed float; the central bank floated the rupee on January 23, 2001.
- Safeguards assessment: Full safeguards assessment completed July 30, 2003; risk ratings upgraded in four of five areas; remaining vulnerabilities identified with authorities implementing most proposed measures.
- Article IV consultation: Next consultation expected on standard cycle; Executive Board concluded the 2005 Article IV consultation on July 15, 2005.
- FSAP and ROSC participation: FSSA and FSAP reports completed in 2002; data ROSC completed and published in 2002; fiscal transparency ROSC completed and published in 2002 with an update published July 2005.
- Resident Representative: A resident representative has been stationed in Sri Lanka since 1977. Current Senior Resident Representative: Mr. Valdivieso.

*Source: Sri Lankan authorities; and Fund staff estimates and projections, as presented in the IMF staff report content unit _cr06446.*

### 8.0 percent; education, 11.4 percent; finance, 7.8 percent; transport and communications,

### _cr06446 - 8.0 percent; education, 11.4 percent; finance, 7.8 percent; transport and communications,

### Lending by the Asian Development Bank, 1998–2005
- Table heading: (In millions of U.S. dollars)
- Commitment: 190184209100157315       184       n.a.
- Net resource transfer: 93724765125166 116 123
- Disbursement: 126997691171225       186       206
- Source: Asian Development Bank.

### Staff Assessment — Coverage and timeliness
- Overall assessment: coverage and timeliness of available data in Sri Lanka are adequate for program monitoring and surveillance purposes.
- Authorities supply key data to the Fund on a timely basis and publish data regularly, including daily information on stock, money, and foreign exchange through electronic media.
- Sri Lanka is a participant in the General Data Dissemination System (GDDS); metadata were posted on the Fund’s DSBB in July 2000.
- Quarterly national accounts and monthly monetary and fiscal revenue data are published regularly.
- Authorities appointed an SDDS coordinator in February 2003 and expressed intention to subscribe to the Special Data Dissemination Standard (SDDS), but substantial work remains to meet all SDDS requirements and prepare necessary metadata.

### Implementation of ROSC recommendations
- Most data ROSC recommendations have been implemented; others are expected to be implemented in the near future.
- Dissemination: most data now disseminated on Census and Statistics and central bank websites.
- Censuses and surveys: a census of industries is underway; a Census of Agriculture (including the North and East) has been finalized; a labor force survey is being conducted quarterly.
- CBSL actions: issued an advance release calendar and designated an SDDS contact person.

### Outstanding Statistical Issues — Real Sector
- Multiple consumer price indices exist: Sri Lanka Consumer Price Index (SLCPI), Colombo Consumer Price Index (CCPI), Greater Colombo Price Index (GCPI), Colombo District CPI (CDCPI), Wholesale cum-Producer Price Index (WPI/PPI).
- SLCPI basis: spending patterns of the lowest 80 percent of households for the entire country excluding the Northern and Eastern provinces.
- CCPI basis: spending patterns of the lowest 40 percent of households within the Colombo municipal area; CCPI uses an outdated consumption basket and weighting system and has become increasingly irrelevant as a measure of general inflation.
- STA (October 1998) recommendation: produce a single, high quality official CPI covering all households and include a reliable price indicator for rent and owner-occupied housing.
- Response: a new nationwide CPI, covering the second to eighth income deciles, is being published; STA expects to publish this new index in IFS, following an assessment of its quality.
- National accounts deficiencies: lack of data sources, undeveloped statistical techniques, no periodic comprehensive benchmarks, no system for regular annual surveys of establishments, no statistical business register, poor sample frames for surveys.
- Estimation practices: detailed data for output and intermediate consumption mostly unavailable; estimates of gross value added rely on outdated fixed ratios from base year 1996 and ad hoc assumptions; quarterly indicators used for quarterly value added estimates; methodology for GDP at constant prices not satisfactory; expenditures estimates available only annually and rely mostly on commodity flow techniques.

### Outstanding Statistical Issues — Fiscal Sector
- STA mission (May 2003) follow-up on GFSM 2001 migration path.
- Authorities agreed to revise from end–2003 the budgetary classifications and accounting structure to eventually match GFSM 2001 classifications of all stocks and flows and to apply that chart of accounts to all general government units.
- Progress with implementation needs assessment.
- Data gaps: Data for 2002 were reported for publication in the 2004 GFS Yearbook, but no updates received since then; these data cover only budgetary accounts of central government. No data on the four extra-budgetary funds or provincial and local governments are provided. No sub-annual data provided for publication in IFS.

### Outstanding Statistical Issues — Monetary Sector
- Foreign Currency Banking Units (FCBUs) classified as resident institutions in the monetary survey (since 1998).
- Adjustment for nonresident foreign currency deposits (NRFC): 50 percent of these deposits are reclassified from foreign liabilities to domestic deposits to adjust for the proportion actually held by residents.
- Authorities started reporting adjusted monetary data to STA from January 1999.
- STA monetary statistics mission (June 2003) clarified treatment of Fund accounts; recommended repos be treated as collateralized loans (rather than on a change of ownership basis); resolved valuation and methodological discrepancies between monetary authorities’ data reported to STA and to APD.

### Outstanding Statistical Issues — External Sector
- CBSL publishes balance of payments statistics quarterly and annually; quarterly data available three months after quarter end; data largely follow the fifth edition of the Balance of Payments Manual.
- STA mission (December 2004) highest priority issues: shortcomings in the international transactions reporting system (ITRS) including large values of unclassified transactions, inclusion of FCBUs, and need for an instruction book for ITRS reporters.
- Mission advised development of a comprehensive survey to implement a medium-term plan to introduce international investment position statistics.
- GDDS website advises FCBUs are now included and work has been done on international investment position statistics.
- CBSL provides gross and net official reserves and intervention data in U.S. dollar terms on a weekly basis.

### Table of Common Indicators Required for Surveillance (As of September 20, 2006) — selected items and data-quality assessments
- Exchange rates: Date of Latest Observation 7/31/06; Date Received 8/04/2006; Frequency of Data D; Frequency of Reporting D; Frequency of Publication D.
- International reserve assets and reserve liabilities of the Monetary Authorities1: Date of Latest Observation 06/30/2006; Date Received 07/2006; Data Quality—Methodological Soundness D; Frequency of Data W; Frequency of Reporting W; Frequency of Publication W.
- Reserve/base money: Date of Latest Observation 10/31/2005; Date Received 02/06/2006; Frequency of Data W; Frequency of Reporting W; Frequency of Publication W; Data Quality—Methodological Soundness LO, O, O, NA, NA.
- Broad money: Date of Latest Observation 10/31/2005; Date Received 02/06/2006; Frequency of Data M; Frequency of Reporting M; Frequency of Publication M.
- Central bank balance sheet: Date of Latest Observation 10/31/2005; Date Received 02/06/2006; Frequency of Data M; Frequency of Reporting M; Frequency of Publication M.
- Consolidated balance sheet of the banking system: Date of Latest Observation 02/28/2006; Date Received 05/08/2006; Frequency of Data M; Frequency of Reporting M; Frequency of Publication M; Data Quality—Methodological Soundness LO, LO, LO, LO.
- Interest rates2: Date of Latest Observation 02/2/2006; Date Received 05/08/2006; Frequency of Data W; Frequency of Reporting W; Frequency of Publication W.
- Consumer price index (SLCPI): Date of Latest Observation 7/2006; Date Received 9/16/2006; Frequency of Data M; Frequency of Reporting M; Frequency of Publication M; Data Quality—Methodological Soundness O, LNO, LO, O; Data Quality Accuracy and Reliability O, LO, O, NA, NA.
- Revenue, expenditure, balance and composition of financing — central government3: Date of Latest Observation 12/2005; Date Received 7/12/2006; Frequency of Data M; Frequency of Reporting M; Frequency of Publication M; Data Quality—Methodological Soundness O, O, O, O; Data Quality Accuracy and Reliability LO, NA, LO, NA, LO.
- Stocks of central government and central government-guaranteed debt5: Date of Latest Observation 12/2005; Date Received 7/12/2006; Frequency of Data M; Frequency of Reporting M; Frequency of Publication M.
- External current account balance: Date of Latest Observation Q4/2004; Date Received 3/31/2005; Frequency of Data Q; Frequency of Reporting Q; Frequency of Publication Q.
- Exports and imports of goods and services: Date of Latest Observation Q4/2004; Date Received 3/31/2005; Frequency of Data Q; Frequency of Reporting Q; Frequency of Publication Q; Data Quality—Methodological Soundness LO, LO, LO, LO; Data Quality Accuracy and Reliability LO, LO, LO, NA, LO.
- GDP/GNP: Date of Latest Observation 12/2005; Date Received 8/16/2006; Frequency of Data Q; Frequency of Reporting Q; Frequency of Publication Q; Data Quality—Methodological Soundness LO, LO, LNO, LNO; Data Quality Accuracy and Reliability LNO, LNO, LO, NA, O.
- Gross external debt: Date of Latest Observation 12/2004; Date Received 4/29/2005; Frequency of Data A; Frequency of Reporting A; Frequency of Publication A.

Notes (as presented in the table):
- 1 Includes reserve assets pledged or otherwise encumbered as well as net derivative positions.
- 2 Both market-based and officially-determined, including discount rates, money market rates, rates on treasury bills, notes and bonds.
- 3 Foreign, domestic bank, and domestic nonbank financing.
- 4 The general government consists of the central government (budgetary funds, extra budgetary funds, and social security funds) and state and local governments.
- 5 Including currency and maturity composition.
- 6 Frequency codes: Daily (D); Weekly (W); Monthly (M); Quarterly (Q); Annually (A); Irregular (I); Not Available (NA).
- 7 Reflects assessment provided in the data ROSC published in May 2002 based on the June 2001 mission; assessment indicates whether international standards concerning concepts and definitions, scope, classification/sectorization, and basis for recording are fully observed (O), largely observed (LO), largely not observed (LNO), or not observed (NO), not applicable (NA).
- 8 Same as footnote 7, except referring to international standards concerning source data, statistical techniques, assessment and validation of source data, assessment and validation of intermediate data and statistical outputs, and revision studies.

### Statement by the IMF Staff Representative (October 25, 2006)
- Purpose: Information available since staff report circulated October 11, 2006; does not alter thrust of staff appraisal.
- Monetary policy: CBSL left key policy rates unchanged at its October review meeting, following a ½ percentage point increase in late September.
- Money and credit growth (August): broad and reserve money growth declined to 16 percent (from peaks of 19 percent and 21 percent in April); private sector credit growth slowed to 23 percent in August (from peak of 25 percent in June).
- Interest rates: interest rates of government securities increased by about 1¼ percentage points since late September (to 11–12 percent for 3-month to 2-year instruments).
- Exchange rate and reserves: authorities limited foreign exchange market interventions since early October; rupee depreciated by about 2 percent against the dollar; international reserves remained around $2.4 billion (2.2 months of import cover).
- External financing measures: central bank announced issuance of foreign-currency denominated treasury bonds to nonresidents (commencing end-October) and additional foreign currency borrowing through syndicated loans from banks (in November).
- Exchange control measure: on October 20, CBSL announced introduction of a 50 percent margin deposit requirement on imports of “nonpriority consumer items” and on opening of letters of credit to pay for such imports; staff is engaged with authorities to establish facts and jurisdictional implications.
- Financial markets: relatively calm despite intensification of hostilities; Colombo Stock Exchange gained 3.5 percent during the last two weeks, with daily turnover volumes exceeding daily average so far this year.
- Fiscal outlook and 2007 budget: 2007 budget expected to be presented on November 14; authorities reiterated commitment to reduce fiscal deficit to 7½ percent of GDP (excluding tsunami-related spending); Appropriations Bill of 2007 points to likely increase in capital expenditures totaling about 2½ percent of GDP and increase in defense spending amounting to about ¾ percent of GDP; government expects offsets via intensified revenue efforts, adjustments in subsidies and transfers to local governments, and cuts in noncore and under-funded capital projects.
- Authorities requested an FSAP update in 2007.

*Source: IMF staff report content provided in the PDF chapter/section.*

### 8.      The government and the LTTE are scheduled to talk during October 28–29 in

### _cr06446 - 8.      The government and the LTTE are scheduled to talk during October 28–29 in

### Background and political context
- The government and the LTTE are scheduled to talk during October 28–29 in Geneva.
- Progress made to bring the main opposition party (UNP) to work together on priority national issues, including:
  - the conflict in the North and East,
  - electoral reform,
  - good governance,
  - economic development,
  - nation building,
  - social development.
- Peace talks in June did not yield an early settlement; the four-year ceasefire came close to collapse and the security situation deteriorated, weakening confidence and posing risks to investment and future economic prospects.
- The government and the UNP signed a Memorandum of Understanding on five key policy areas: the ethnic conflict, electoral reform, good governance, social development, and structure for collaboration.

### Recent macroeconomic performance
- Real GDP growth:
  - increased by 6 percent in 2005,
  - increased by 8 percent in the first quarter of 2006.
- Growth drivers: domestic demand, improved agricultural performance, strong tsunami-reconstruction efforts, robust service sector growth.
- Inflation developments:
  - declined from 18 percent in January 2005 to 3.5 percent at end-2005,
  - rose since early 2006 due to fast credit growth, pass-through of higher oil prices, and increases in wages and pension payments.
- Monetary policy actions: policy rate raised five times (cumulative 2 percentage points) during November 2004–December 2005, and by another 1 percentage point recently.
- Reserve money growth: brought down to 16 percent in August 2006 (from 21 percent in April 2006).
- Credit growth to the private sector: about 23 percent in August 2006.

### Fiscal developments and public debt
- 2005 fiscal deficit widened to 8.7 percent of GDP, larger than budgeted, mainly because of tsunami-related spending.
- Excluding tsunami-related flows, the 2005 budget deficit was 7.5 percent of GDP (compared to 8.2 percent of GDP in 2004).
- Revenue increased in 2005, reversing a prior downward trend; however, large overruns occurred in oil subsidies and the wage bill, offset by cuts in other recurrent expenditures and reduced interest payments to protect capital spending.
- First half of 2006: fiscal deficit contained through adjustment of capital expenditures; tax revenue grew 23 percent but missed the budget target of 27 percent growth; sizable overruns on recurrent expenditure (oil subsidies, pensions, security and humanitarian spending).
- Authorities’ fiscal commitments:
  - adhere to the 2006 budget target,
  - reduce the fiscal deficit target to 7½ percent of GDP in 2007,
  - bring the fiscal deficit down to 5 percent by 2010,
  - emphasis on revenue-enhancing policies and rationalization of current spending to protect critical development projects.
- Total public debt:
  - declined by 11 percent of GDP in 2005 (to 94 percent of GDP).
- Government decision: put planned global bond issuance on hold and mobilized resources from domestic investors during April–September 2006.
- Directors cautioned that further recourse to commercial borrowing for budgetary purposes should be limited.

### External sector and reserves
- Current account:
  - narrowed in 2005,
  - expected to increase by end-2006 due to further oil price increases and strong demand for non-oil imports.
- Tsunami-related inflows slowed somewhat in 2006 while debt service burden rose.
- Gross official reserves: hovering around $2.4 billion, equivalent to 2.4 months of imports and 86 percent of short-term debt.
- Exchange rate: rupee-dollar exchange rate weakened somewhat since second half of 2005.
- Real effective exchange rate (REER): appreciated by 2 percent during the same period (reflecting high domestic inflation relative to trading partners).
- Directors encouraged limiting foreign exchange intervention and allowing greater exchange rate flexibility to safeguard reserves and competitiveness.

### Financial sector and markets
- Banking soundness improvements:
  - NPL ratios of state-owned banks declined from 18 percent in 2003 to 8 percent in June 2006,
  - Capital adequacy ratios improved (to 8 percent of total assets).
- Plans: adopt the Basel II capital accord by 2008; FSAP update in 2007.
- Concerns: fast credit growth raising concerns about credit quality.
- Restructuring: progress in restructuring two large state-owned commercial banks—declining NPLs, improved provisioning and profitability; further restructuring should focus on lending practices and capital adequacy.
- Colombo Stock Exchange performance:
  - All Share Price Index rose by a cumulative 70 percent during 2004–05,
  - up by another 25 percent so far in 2006,
  - average P/E ratio of 12.

### Infrastructure and energy sector
- Infrastructure development (power and roads) central to the government’s medium-term development strategy.
- Emphasis on restoring financial viability of the power sector and expanding generation capacity using more cost-efficient sources (including coal power).
- Development forum planned for early 2007.
- Directors urged efforts to reduce quasi fiscal losses of energy companies through electricity tariff adjustments, balance sheet restructuring, and enhanced operational efficiency, combined with safety nets for low-income households and strengthened regulatory guidelines to broaden the investor base for long-term energy financing.

### Executive Board assessment and policy recommendations
- Directors commended efforts to maintain macroeconomic stability and high growth amid political and economic challenges.
- Near-term policy priorities:
  - gear macroeconomic policies toward reducing inflation and external vulnerabilities,
  - further monetary tightening may be needed to contain credit growth and anchor inflation expectations,
  - limit intervention in the foreign exchange market and allow greater exchange rate flexibility.
- Medium-term priorities:
  - strong fiscal adjustment to avoid adverse debt dynamics and protect the ability to meet poverty reduction and Millennium Development Goals,
  - develop a well-defined medium-term fiscal policy framework and improve debt management,
  - articulate policies to reform the tax system and the financial sector, rationalize the trade regime, and improve the business climate.
- Structural recommendations:
  - strengthen prudential standards and implement Basel Core Principles ahead of Basel II adoption in 2008,
  - further reduce quasi fiscal energy losses and implement safety nets,
  - curtail the cess regime and integrate fees into the tariff structure; consider a single low tariff structure to maximize efficiency.
- Directors welcomed: authorities’ commitment to reduce the fiscal deficit, plan to reach 5 percent by 2010, and recent passage of anti-money laundering legislation in 2006.
- Directors encouraged improvements in the quality and coverage of fiscal statistics and addressing remaining issues to meet SDDS requirements.

### Key quantitative indicators (selected, as reported)
- Real GDP growth: 6 percent (2005); 8 percent (first quarter 2006).
- Inflation: 18 percent in January 2005; 3.5 percent at end-2005.
- Fiscal deficit: 8.7 percent of GDP in 2005 (8.2 percent in 2004); excluding tsunami-related flows 7.5 percent of GDP in 2005.
- Tax revenue growth (first seven months of 2006): 23 percent (staff note: tax revenue grew 23 percent; budget target was 27 percent).
- Reserve money growth: 16 percent in August 2006 (21 percent in April 2006).
- Credit growth to private sector: about 23 percent in August 2006.
- Gross official reserves: around $2.4 billion (equivalent to 2.4 months of imports and 86 percent of short-term debt).
- Total public debt: 94 percent of GDP in 2005 (declined by 11 percent of GDP in 2005).
- NPL ratios (state-owned banks): 18 percent in 2003; 8 percent in June 2006.
- Capital adequacy ratios (banks): 8 percent of total assets.
- Colombo Stock Exchange All Share Price Index: +70 percent during 2004–05; +25 percent so far in 2006.
- Selected figures from "Sri Lanka: Selected Economic Indicators" table (series highlights and projections as presented in the source):
  - Real GDP growth (percent): 4.0 (2002), 6.0 (2003), 5.4 (2004), 6.0 (2005), 7.0 (2006 Proj.)
  - Inflation (percent, end of period): 6.6 (2002), 1.0 (2003), 16.8 (2004), 3.6 (2005), 12.0 (2006 Proj.)
  - National savings (percent of GDP): 19.5 (2002), 21.6 (2003), 21.6 (2004), 23.7 (2005), 22.6 (2006 Proj.)
  - Gross investment (percent of GDP): 21.2 (2002), 22.1 (2003), 25.0 (2004), 26.5 (2005), 27.3 (2006 Proj.)
  - Revenue (percent of GDP): 16.5 (2002), 15.7 (2003), 15.3 (2004), 16.1 (2005), 17.0 (2006 Proj.)
  - Expenditure (percent of GDP): 25.4 (2002), 24.0 (2003), 23.5 (2004), 24.7 (2005), 26.0 (2006 Proj.)
  - Overall deficit (percent of GDP, excluding grants and privatization receipts): -8.9 (2002), -8.3 (2003), -8.2 (2004), -8.7 (2005), -9.1 (2006 Proj.)
  - Total government debt (percent of GDP): 105.6 (2002), 105.8 (2003), 105.4 (2004), 93.9 (2005), 89.6 (2006 Proj.)
  - Exports (millions of U.S. dollars): 4,699 (2002), 5,133 (2003), 5,757 (2004), 6,347 (2005), 6,950 (2006 Proj.)
  - Imports (millions of U.S. dollars): 6,105 (2002), 6,673 (2003), 7,999 (2004), 8,863 (2005), 10,501 (2006 Proj.)
  - Current account balance (millions of U.S. dollars): -236 (2002), -74 (2003), -646 (2004), -650 (2005), -1,281 (2006 Proj.)
  - Current account (percent of GDP): -1.4 (2002), -0.4 (2003), -3.2 (2004), -2.8 (2005), -4.7 (2006 Proj.)
  - Gross official reserves (excluding ACU balances, millions of U.S. dollars): 1,560 (2002), 2,146 (2003), 1,833 (2004), 2,458 (2005), 2,662 (2006 Proj.)
  - Reserves (in months of prospective imports): 2.4 (2002), 2.8 (2003), 2.2 (2004), 2.5 (2005), 2.4 (2006 Proj.)
  - External debt (percent of GDP): 62.6 (2002), 64.1 (2003), 63.9 (2004), 55.4 (2005), 49.2 (2006 Proj.)
  - Debt service (percent of goods and services exports): 12.3 (2002), 10.9 (2003), 10.1 (2004), 7.4 (2005), 10.4 (2006 Proj.)
  - Broad money growth (annual percent change): 13.4 (2002), 15.3 (2003), 19.6 (2004), 19.1 (2005), 16.5 (2006 Proj.)
  - Credit to the private sector (percent): 12.0 (2002), 16.9 (2003), 22.1 (2004), 21.5 (2005), 20.7 (2006 Proj.)
  - Interest rate (percent, end of period, three-month treasury bill rate): 9.9 (2002), 7.4 (2003), 7.3 (2004), 10.1 (2005), 11.8 (2006 Proj.)

### Authorities' statement highlights (Statement by Amal Uthum Herat, October 25, 2006)
- 2006 performance: GDP growth of 8 percent in the first half of 2006; annual growth of 7 percent or higher for 2006 expected.
- Unemployment: declined to 7.2 percent in Q1 2006 and to 6.3 percent in Q2 2006.
- Inflation: brought down to single digits by end-2005 but rose again due primarily to increased fuel prices; authorities taking measures to dampen inflationary pressure.
- Investment: rose from 22.1 percent of GDP in 2003 to 25 percent in 2004 and 26.5 percent in 2005; increasing trend expected to continue in 2006.
- Fiscal stance: committed to fiscal prudence while increasing revenue and capital expenditure, curtailing unnecessary expenditure, and providing safety nets to low-income groups.
- Revenue performance: tax revenue increased by 23 percent in the first seven months of 2006; revenue increased by 0.7 percent of GDP in 2005.
- 2006 Budget projection: containment of the fiscal deficit to 9.1 percent of GDP in 2006 (as projected in the source text).

*Source: IMF Public Information Notice (PIN) No. 06/132 — IMF Executive Board Concludes 2006 Article IV Consultation with Sri Lanka, November 13, 2006.*

### 8.7 percent in 2005.  In fact, if tsunami related expenditure is excluded, the deficit is

### _cr06446 - 8.7 percent in 2005.  In fact, if tsunami related expenditure is excluded, the deficit is

### Fiscal position and tsunami recovery
- Fiscal deficit reported as 8.7 percent in 2005.
- If tsunami related expenditure is excluded, the deficit is projected to be limited to 7.3 percent of GDP, implying a reduction in the deficit in both 2005 and 2006.
- Significant need for increased infrastructure investment to maintain growth; investment of the magnitude or areas required are not likely to come from the private sector, hence public investment will be increased.
- Public sector-private sector partnerships will continue to be explored.
- Tsunami recovery progress:
  - Fishing and tourism sectors have recorded a notable recovery.
  - The vast majority of houses to be reconstructed are expected to be completed by the end of 2006.
  - Reconstruction of other infrastructure, including roads and railways, is expected to be completed within 2-3 years, as planned.

### Trade and external sector
- Post–Multi Fiber Arrangement environment presented new challenges.
- Sri Lanka achieved a 5 percent increase in the value of exports of textiles and garments in the first eight months of 2006.
- Exporters have established themselves in niche markets; increasing backward linkages and concessions from the GSP+ scheme for the European Union support exporters’ confidence.
- High international fuel prices:
  - Cost of petroleum imports increased by a third in 2005.
  - In the first eight months of 2006, the cost of petroleum imports increased by a further 46 percent, offsetting gains from increased imports and exacerbating the trade deficit.
- Free trade agreements with India and Pakistan have led to expanded trade; further growth expected as these economies expand.
- Foreign remittances have increased substantially and provide a relatively stable and large inflow of funds; government taking steps to create additional employment opportunities overseas and facilitate remittance flows through the banking sector.
- Commitment to maintaining open trade policies; tariff reductions proceed cautiously due to impact on government revenue given high levels of public debt.

### Monetary policy and exchange rate
- Monetary policy focused on containing inflation while not depressing economic expansion.
- Money and credit expansion generated demand pressure; the Central Bank has tightened monetary policy significantly.
- Policy rates have been increased on three occasions in 2006.
- Responding to monetary policy measures, inflation is expected to moderate in the coming months.
- Central Bank will continue to monitor market developments and make appropriate changes to the stance of monetary policy.
- Bank operations conducted with a high degree of transparency; monthly monetary policy announcements convey policy stance clearly.
- Authorities committed to a market determined exchange rate; intervention designed to counteract injurious, excessive volatility.
- Staff notes that the system has served Sri Lanka well and there is no misalignment of the exchange rate.

### Financial sector performance and reforms
- Need for a strong and well regulated financial sector to ensure stable economic growth; market development and adequate prudential regulation are priorities.
- Improvements in banking sector vulnerability indicators over past few years:
  - Non-performing loan ratios have declined substantially.
  - Risk based capital asset ratios have increased.
  - Adequate provisioning has taken place.
  - The sector continues to be highly profitable.
- Two state owned banks improved after being given commercial autonomy rather than privatization; they have been profitable and provided banking services throughout the country.
- The banking sector continues to be highly competitive and is open to foreign investment; foreign banks currently account for 50 percent of all banks in the country.
- The Central Bank, in consultation with the banking industry, has decided to adopt the Basle II capital accord from 2008.
- Legislation to combat the financing of terrorism and counter money laundering has been passed; a Financial Intelligence Unit has been activated.
- Authorities have requested the Fund to conduct an update of the FSAP.

### Structural issues and infrastructure development
- Energy sector concerns:
  - High international price of fuel has burdened the government through the cost of subsidies.
  - Government has gradually permitted a full pass through of price increases in gasoline and diesel to ultimate consumers; domestic oil companies are free to charge market prices.
  - A small, but greatly reduced, subsidy is still maintained for kerosene to protect low income groups.
  - Electricity tariffs have been increased, improving the financial viability of the Electricity Board.
  - Government embarking on developing lower cost sources of electricity; projects to build coal based sources and expand hydro power have commenced with financial assistance from bilateral and multilateral sources.
- Highways and regional connectivity:
  - Work on planned major highways is in progress.
  - Construction on the highway from the capital to the south is underway with multilateral and bilateral assistance; completion expected to increase economic activity and reduce regional income disparities.
- Financial and capital account liberalization measures:
  - Financial markets strengthened and debt markets developed.
  - Government securities market partially opened to non-residents: non-residents now permitted to hold up to 5 percent of government bonds that have a maturity exceeding two years.
- Strategic state owned enterprises:
  - Action to improve operations so they become net contributors to government revenue.
  - These enterprises will not be privatized; the Strategic Enterprises Management Agency will assist in revamping operations.

### Future directions, social objectives, and governance
- National economic policy aims to integrate positive attributes of a free market economy with domestic aspirations, supporting domestic enterprises while encouraging foreign investment.
- Government committed to prudent macroeconomic policies.
- Concern that income disparities have increased despite recent growth; measures being adopted to filter benefits of economic development to the general public, particularly lower income groups.
- Strong efforts to strengthen small and medium scale industries; a small and medium enterprises bank has been established to assist these enterprises.
- Government in the final stage of preparation of a national development strategy with extensive consultations; plan to present the draft to Parliament later this year for comprehensive discussion and acceptance.
- Commitment to achieving the Millennium Development Goals (MDGs); Sri Lanka aims to achieve and even exceed all MDGs.
- Government deeply committed to the peace process and open to discussions and negotiations, conscious of the benefits of peace to the people of the country.

*Source: _cr06446 - 8.7 percent in 2005.  In fact, if tsunami related expenditure is excluded, the deficit is*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2006/_cr06446.pdf_