## _cr07373

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### Executive Summary — overall assessment and key vulnerabilities
- Recent growth performance "has been impressive but was underpinned in part by monetary and fiscal stimulus, resulting in strong demand pressures."
- Indicators suggesting economy may be operating at full capacity: "Rising inflation, a high current account deficit, and low unemployment rate."
- Key near-term risks: "High oil prices, slow fiscal consolidation, and security concerns."
- Elevated external vulnerabilities: "High stock of public debt, rising near-term debt service needs, and a low level of reserves."
- Accumulation of short-term dollar-denominated commercial debt has created "refinancing risks."
- Policy prescription summary: "Concerted tightening in macroeconomic policies is needed in the near term to reduce inflation and vulnerabilities, while facilitating the refinancing of the domestic dollar-denominated commercial debt."

### Immediate policy recommendations (summarized)
- Fiscal
  - "A more determined fiscal consolidation is essential for demand management and debt sustainability."
  - Revised 2007 budget deficit target: "7.8 percent of GDP" (a modest withdrawal of stimulus).
  - "Additional measures of about ½ percent of GDP may be required in the remainder of the year to help limit inflationary financing."
  - Risks: "Further overruns on wages and military spending pose upside risks."
  - Medium-term: credible consolidation in 2008 and over the medium-term supported by quality revenue measures.
- Monetary
  - "Further monetary tightening is warranted in view of the current fiscal stance and high rate of inflation."
  - Operational guidance: "Open market operations should be stepped up and treasury security rates be allowed to adjust to levels that would help contain liquidity and bring inflation down to single digits."
- Exchange rate
  - "Greater flexibility in the exchange rate is essential to safeguard reserves."
  - "The real effective exchange rate appears broadly in line with economic fundamentals and competitiveness does not seem to be of immediate concern."
  - Rationale: sustain high oil prices and emerging refinancing burden from public dollar-denominated commercial debt could strain the balance of payments.
- Structural and medium-term reforms
  - "Essential structural reforms are also key to improve competitiveness and productivity through broadening the tax base, improving debt dynamics, and strengthening the stability and efficiency of the financial system."

### Recent economic developments — key figures and events
- Real GDP growth in 2006: "7½ percent."
- Domestic demand growth in 2006: "about 8.7 percent."
- CPI inflation: "nearly 18 percent by end-2006 (from about 4 percent at end-2005)."
- Administered price adjustments (Sept–Oct 2006): "a weighted average of about 25 percent on fuel products, electricity, and transportation."
- Minimum wage increase (May 2007): from "Rs. 3000 to Rs. 5000 per month"; "overall minimum wage index increased by about 40 percent during May-August, correcting a cumulative real term decline of about 30 percent since June 2004."
- CBSL “Road Map” (Jan 2007) aiming "at reducing inflation to single digits by end-2007."
- Treasury security rates increased "to about 17½ percent at end-April (from 12½ percent at end-2006)."
- Inflation reversal: "inflation increased to 21¾ percent (yoy) in August."
- Fiscal 2007: revised deficit target "7.8 percent of GDP"; revised revenue target "18.5 percent of GDP (from 17.1 percent of GDP in 2006)."
- External: current account deficit projected to narrow to "4.6 percent of GDP in 2007 (from 5 percent in 2006)."
- Gross international reserves declined "to below $2.6 billion (2.2 months of imports of goods and services) at end-September 2007, from its peak of $2.9 billion in April."
- Exchange rate depreciation Jan–Sep 2007: "5¼ percent."
- CBSL foreign exchange operations: "purchased foreign exchange of $196 million during January-April;" "sold foreign exchange amounting to $272 million during May-September."
- Public domestic dollar commercial debt by end-2006: "$1.6 billion (or 6 percent of GDP) at an average maturity of 1½ years."
- October issuance: first $500 million international sovereign bond at a yield of "8¼ percent" and maturity of "5 years."
- Examples of prior issuance: "Sri Lanka Development Bonds (SLDB) of $215 million and syndicated loans of $210 million (both with maturities of 2–3 years)." Also issuance of "$400 million rupee-denominated treasury bonds to nonresidents during January-April."

### Outlook and risks — projections and scenarios
- 2007 projections:
  - "Real GDP growth is projected at around 6 percent in 2007 (taking into account the preliminary official estimates of 6¼ percent in the first half of 2007)."
  - Inflation projected: "13 percent (eop) by end-2007."
- Main risks: "a worsening of the security situation, a surge in world oil prices, and a larger than projected fiscal deficit that requires significant inflationary financing and/or further recourse to dollar-denominated debt."
- Capital account risk: over the next 2–3 years "about $1.6 billion of such debt is expected to fall due given its short average maturity."
- Medium-term projections:
  - "Real GDP growth is projected at 6 percent over 2008–12."
  - Authorities’ envisaged fiscal consolidation: reduce the deficit to "5 percent of GDP" and "bring about a primary balance by 2010."
  - Current account: "expected to narrow to 3 percent of GDP by 2011."
  - Reserve coverage projected: "around 2½ months of imports in the absence of significant increases in capital inflows."
- Important caveat: "lack of clearly-defined quality measures to broaden the tax base and risks of wages and military spending overruns remain serious concerns."

### Fiscal policy — staff views, authorities’ stance, and specific measures
- Staff view
  - Revised 2007 deficit "still high"; additional tightening of "about ½ percent of GDP in 2007 is needed."
  - Meeting revenue target of "18.5 percent of GDP" will "require further administrative efforts."
  - Need to "limit potential recurrent expenditure overruns" and rationalize portion of capital budget not externally financed.
- Authorities’ position
  - Confident the revised fiscal deficit target for 2007 will be met or lowered if external financing shortfall occurs.
  - Expected continuation of "the strong revenue performance to continue in the second half of 2007."
  - Noted elimination of the oil subsidy removed a major fiscal risk.
- Fiscal consolidation objectives (paragraph 16)
  - Authorities committed to reduce the budget deficit to "5 percent of GDP and achieve a primary balance by 2010–11."
  - Staff support: reduce total public debt to "73 percent of GDP by 2010 (from 95 percent of GDP at end-2006)."
  - Staff highlighted importance of credible consolidation in 2008 to reduce deficit to "6¼ percent of GDP."
- Tax policy, revenue measures, and incentives
  - Need for quality measures: "further broadening of the income tax base; strengthening of tax administration; gradual simplification of the VAT system."
  - Political difficulties extending VAT to retail and wholesale stages noted.
  - Staff stressed streamlining tax incentives starting in 2008 and reviewing exemption regime.
  - Footnoted measures include: increase the top corporate rate, register 38,000 additional taxpayers, place limits on loss carry forward; VAT measures to raise the markup on imports to counter under-invoicing.
- VAT administration and refunds
  - Loopholes and fraudulent claims identified; steps to separate high risk traders and suggestion to announce a timetable for returning to normal refund schedule.
- Public investment, wages, and recurrent expenditure
  - Ambitious public investment plan increases need to rationalize recurrent expenditure.
  - Staff advised restraint on real wage growth; authorities indicated public nominal wage increases limited to "20 percent over 2007–09."
- Energy sector financial viability
  - Ceylon Electricity Board (CEB) likely to incur losses of about "Rs. 20 billion (¾ percent of GDP) in 2007" due to tariffs below cost recovery.
  - Strategy: construct three coal power plants (total "900 MW") during "2008–10" expected to lower cost of energy production "by about one-third from the current level" and bring CEB to cost recovery.

### Monetary policy and liquidity management
- Staff advised tighter monetary stance to contain demand pressures and improve growth-inflation outlook.
- CBSL allowed treasury security rates to increase by "500 bps during the first half of 2007" bringing positive real interest rates.
- Critical recommendations:
  - Step up open market operations.
  - Allow treasury rates to increase to levels that will help reduce inflation to single digits.
- Limiting banks’ access to reverse repo window has contained liquidity but is not first best; periodic volatility in call money market results.
- Coordination needed: meet CBSL’s "Road Map" targets for external reserve accumulation and domestic credit growth; stepped up coordination between CBSL and Ministry of Finance for liquidity forecasting.

### Exchange rate policy, competitiveness, and trade indicators
- REER assessment: "appears broadly in line with economic fundamentals" and "close to equilibrium" in H1 2007.
  - REER movements: depreciation "23 percent during 1998–2004"; appreciation "about 14 percent in 2005–2006"; REER depreciation "about 2 percent in the first half of 2007."
- Staff advice: more market-based exchange rate regime and "greater flexibility in the rupee to help contain external vulnerabilities and safeguard reserves."
- Trade indicators: apparel exports to the United States slowed; utilization of EU GSP II quotas increased; other exports (tea, spices) enjoy relatively high profit margins.
- Areas to monitor: low labor productivity, wage growth outpacing productivity, rising unit labor costs in industry, narrow export base.
- Import margin requirements: introduced (50 percent) in Oct 2006 and removed in May 2007; 100 percent margin for certain vehicles maintained pending review.

### Debt policy, public dollar-denominated commercial debt, and DSA findings
- Near-term challenge: lengthen maturity of domestic dollar-denominated commercial debt to reduce exchange rate and refinancing risks.
- Public dollar-denominated commercial debt
  - End-2006 stock: "$1.6 billion (or 6 percent of GDP and about 65 percent of gross official reserves)."
  - Composition: mainly SLDB, loans from FCBUs, syndicated loans.
  - Average rate: "LIBOR+150 bps" and average maturity "1½ year."
  - Preliminary debt-service pressures: about "$165 million due in Q4 2007; about $600 million expected in 2008; about $800 million expected in 2009."
  - October 2007 Eurobond: "$500 million" at yield "8¼ percent" and maturity "5 years."
- Staff advice: use proceeds from international bond issues mainly to retire short-term dollar-denominated commercial debt and/or the most expensive rupee debt.
- Debt management strategy (domestic rupee debt)
  - Trading of treasury securities extended to retail investors; develop benchmark issues with longer maturities; introduce inflation indexed bonds; develop corporate bond market.
- Financing of mega infrastructure projects under the Plan:
  - Total targeted: "$4.5 billion for key infrastructure development during 2007−09."
  - About "$1.5 billion secured from major bilateral and multilateral donors."
  - Remaining financing sought: "$3 billion," including PPPs; staff recommended legal framework for PPPs and full accounting in medium-term budget framework.
- Debt Sustainability Analysis (DSA)
  - Sri Lanka has a "moderate risk of external debt distress."
  - Risk increases to "moderate-to-high for total foreign exchange debt" assuming refinanced and new dollar-denominated commercial debt at maturity of 2 years.
  - Projections: total debt service in foreign exchange, including public domestic dollar-denominated commercial debt, projected to increase sharply over 2008−2009 (to "$600 and $800 million based on the end-2006 stock").
  - Illustrative simulation: refinancing end-2006 debt at existing maturities with new money of "$300 million each year starting from 2008" could increase total debt service in foreign exchange to "about 20−25 percent of exports" over the medium term.
  - Extreme stress tests could bring total debt service in foreign exchange to "around 30 percent," indicating a high risk of debt distress.
- Public DSA — Baseline: total central government debt to GDP path from "about 90 percent in 2007 to 69 percent in 2012, and further to about 32 percent in 2027" under baseline consolidation.
- Stress tests highlight vulnerabilities if fiscal consolidation fails, interest rates rise, or refinancing conditions deteriorate.

### Financial sector policy and resilience
- Progress since 2002 FSAP: sharp decline in NPL ratios, strengthened capital base, improved operating profits, progress toward Basel II adoption in 2008.
- Remaining weaknesses and priorities:
  - Improve asset quality and strengthen credit and liquidity risk management.
    - Stress testing indicates "more than half of the banking system assets are highly vulnerable to interest rate and liquidity shocks."
    - Credit to deposit ratios rose from "about 80 percent in 2003 to 94 percent in 2006."
  - Strengthen risk-based supervision given rapid sectoral lending growth: consumer and housing sectors grew "59 percent and 45 percent by end-March, respectively."
  - Advance operational restructuring of state-owned banks and limit state interference; overstaffing led to high personnel costs accounting for "three-quarters of total operating cost."
- Recommendations: implement FSAP update recommendations, accelerate public bank restructuring, prepare for Basel II adoption in 2008, and improve incentives for primary dealer system and long-term savings.

### Detailed 2006–2013 fiscal and macro tables (selected exact figures)
- Real GDP growth (percent): 2004: 5.4; 2005: 6.0; 2006: 7.4; 2007 (est): 6.0; 2008 (proj): 6.0.
- Inflation (Sri Lanka CPI; average): 2004: 9.5; 2005: 17.7; 2006: 11.5.
- Overall central government balance (percent of GDP): 2004: -8.2; 2005: -8.7; 2006: -8.4; 2007 (est): -7.8; 2008 (proj): -6.3.
- Public debt (domestic and external) as percent of GDP: 2004: 107.5; 2005: 95.3; 2006: 94.7; 2007 (est): 90.1; 2008 (proj): 86.2.
- Total revenue (percent of GDP): 2006: 17.1; 2007 (Auth. proj): 18.4; 2008 (Proj): 18.3.
- Total expenditure and net lending (percent of GDP): 2006: 25.5; 2007 (Auth. proj): 27.7; 2008 (Proj): 26.0.
- Interest payments (percent of GDP): 2006: 5.4; 2007 (Auth. proj): 5.2; 2008 (Proj): 5.2.
- Exports and imports (millions of U.S. dollars): Exports 2006: 6,883; 2007: 7,646; 2008 (proj): 8,412. Imports 2006: 10,260; 2007: 11,307; 2008 (proj): 12,532.
- Current account balance (percent of GDP): 2006: -5.0; 2007: -4.6; 2008 (proj): -4.8.
- Gross official reserves (end-period, millions of U.S. dollars): 2006: 2,515; 2007: 2,912; 2008 (proj): 2,854. Reserves in months of imports: 2004: 2.2; 2005: 2.5; 2006: 2.4; 2007: 2.5; 2008 (proj): 2.2.
- Public dollar commercial debt (millions of U.S. dollars): 2004: 550; 2005: 1,065; 2006: 1,609; 2007: 2,396; 2008: 2,209.

### Staff appraisal and overall policy message
- Growth performance has been impressive but partly underpinned by expansionary fiscal and monetary policies, increasing macroeconomic and external vulnerabilities.
- Emphasis areas: tax reforms to broaden resource base, streamline tax incentives, improve financial sector stability and efficiency, address energy sector imbalances.
- Immediate policy priority: "Concerted policy tightening is needed in the near term to reduce inflation and vulnerabilities" while ensuring balance of payments viability and facilitating refinancing of short-term dollar debt.

### Supplementary notes — recent updates, 2007 budget and 2008 fiscal outlook
- CBSL revised down its real GDP growth projection to "6.7 percent for 2007" from "7.5 percent."
- External reserves built up to "$3.2 billion by mid-November (from $2.6 billion at end-September)," covering "2.7 months of imports."
- Treasury security rates fell to "15¾ percent in mid November, from a peak of 18¼ percent in early October" after the $500 million bond issue.
- Staff projects current account deficit to widen to "5 percent of GDP in 2007 and 6½ percent of GDP in 2008" based on latest WEO projections.
- 2008 budget proposal targets a fiscal deficit of "7.7 percent of GDP" (marginal reduction from "7.8 percent of GDP in 2007"); staff calls for additional adjustment of "about 1¼ percent of GDP" to deliver a deficit of "6½ percent of GDP in 2008" as indicated in the Staff Report.
- Risks to 2008 budget: underestimated subsidies, potential "about 1 percent of GDP" cost from deviating from automatic diesel/kerosene pricing formula, potential recurrent spending overruns "around 2 percent of GDP," and new public hiring costs (estimated "around ½ percent of GDP").
- Staff recommendations: implement concrete revenue measures, review oil subsidies and consider full or substantial pass-through, strengthen social safety nets, and contain wage bill—seek World Bank assistance for civil service reform.

### IMF–World Bank and World Bank Group relations (selected)
- World Bank activities cover public administration, health, education, rural development, peace/reconstruction in North and East, private sector environment, legal reform, energy, water, roads, and tsunami response.
- World Bank active portfolio (as of October 12, 2007): "13 IDA credits/grants and one GEF grant" total commitment "$778.4 million."
- IFC activities: held portfolio with "total committed exposure of US$155 million" in eight companies and SME support via IFC-SEDF with initial funding "US$5.5 million."
- Bank and IMF collaborate closely on financial sector issues, including a Corporate Governance Review and FSAP update.

*Source: Executive Summary and selected excerpts of IMF staff report _cr07373 (Staff Report for the 2007 Article IV Consultation; informational annexes and DSA materials).*

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

### Executive Summary

### Overall assessment and key vulnerabilities
- Sri Lanka’s recent growth performance has been impressive but was "underpinned in part by monetary and fiscal stimulus, resulting in strong demand pressures."
- Indicators suggesting the economy may be operating at full capacity: "Rising inflation, a high current account deficit, and low unemployment rate."
- Key near-term risks: "High oil prices, slow fiscal consolidation, and security concerns."
- Elevated external vulnerabilities: "High stock of public debt, rising near-term debt service needs, and a low level of reserves."
- Accumulation of short-term dollar-denominated commercial debt has created "refinancing risks."
- Policy prescription summary: "Concerted tightening in macroeconomic policies is needed in the near term to reduce inflation and vulnerabilities, while facilitating the refinancing of the domestic dollar-denominated commercial debt."

### Immediate policy recommendations (summarized)
- Fiscal:
  - "A more determined fiscal consolidation is essential for demand management and debt sustainability."
  - The revised 2007 budget deficit target is "7.8 percent of GDP" and "represents a modest withdrawal of fiscal stimulus, but remains high."
  - "Additional measures of about ½ percent of GDP may be required in the remainder of the year to help limit inflationary financing."
  - Risks to the fiscal deficit: "Further overruns on wages and military spending pose upside risks."
  - Medium-term: "A credible fiscal consolidation in 2008 and over the medium-term, supported by well-defined and quality revenue measures, is essential for ensuring macroeconomic stability and debt sustainability."
- Monetary:
  - "Further monetary tightening is warranted in view of the current fiscal stance and high rate of inflation."
  - Operational guidance: "Open market operations should be stepped up and treasury security rates be allowed to adjust to levels that would help contain liquidity and bring inflation down to single digits."
- Exchange rate:
  - "Greater flexibility in the exchange rate is essential to safeguard reserves."
  - Assessment: "The real effective exchange rate appears broadly in line with economic fundamentals and competitiveness does not seem to be of immediate concern."
  - Rationale: "Sustained high oil prices and an emerging refinancing burden from the public dollar-denominated commercial debt could strain the balance of payments. Further exchange rate flexibility will help contain vulnerabilities."
- Structural and medium-term reforms:
  - "Essential structural reforms are also key to improve competitiveness and productivity through broadening the tax base, improving debt dynamics, and strengthening the stability and efficiency of the financial system."

### I. Background (selected points)
- Recent per capita income: "about $1,300."
- Authorities launched a "Ten-Year Horizon Development Plan (Plan) in early 2007" focused on "industrial infrastructure (including power, roads, and ports)."
- Strategy: "increasingly relying on commercial borrowing" and thus requiring policies to "improve economic fundamentals and foster favorable investor sentiment."
- Conflict/peace context: "The near-term macroeconomic impact of the conflict is expected to be limited but remains a concern." Government captured "a large part of the East" though "there has been limited progress on future peace talks."

### II. Recent Economic Developments (selected findings and exact figures)
- Real GDP growth in 2006: "7½ percent."
- Domestic demand growth in 2006: "about 8.7 percent."
- CPI inflation: accelerated "to nearly 18 percent by end-2006 (from about 4 percent at end-2005)."
- Administered price adjustments (Sept–Oct 2006): "a weighted average of about 25 percent on fuel products, electricity, and transportation."
- Minimum wage increase approved in May 2007: from "Rs. 3000 to Rs. 5000 per month"; "overall minimum wage index increased by about 40 percent during May-August, correcting a cumulative real term decline of about 30 percent since June 2004."
- Monetary policy actions:
  - CBSL “Road Map” announced in January aiming "at reducing inflation to single digits by end-2007."
  - Treasury security rates increased "to about 17½ percent at end-April (from 12½ percent at end-2006)."
  - Result: "deceleration in inflation to (annualized) single digits in the first four months of 2007, and real interest rates turned positive."
- Inflation reversal: "inflation increased to 21¾ percent (yoy) in August" due to "elimination of remaining fuel subsidies (a weighted average increase of 22 percent during May-July, on top of a 25 percent adjustment in last September-October), increases in food prices, and a pause in further monetary tightening during July-August."
- Fiscal 2007:
  - Revised fiscal deficit target: "7.8 percent of GDP" (modest consolidation from "8.4 percent of GDP in 2006").
  - Revenue grew "by 25 percent in the first half of 2007," but "it was still at about 40 percent of the ambitious annual target."
  - Revised revenue target for 2007: "18.5 percent of GDP (from 17.1 percent of GDP in 2006)."
- External sector and reserves:
  - Current account deficit projected to narrow to "4.6 percent of GDP in 2007 (from 5 percent in 2006)."
  - Gross international reserves declined "to below $2.6 billion (2.2 months of imports of goods and services) at end-September 2007, from its peak of $2.9 billion in April."
  - Exchange rate depreciation Jan–Sep 2007: "5¼ percent."
  - CBSL purchase/sales: "purchased foreign exchange of $196 million during January-April;" "sold foreign exchange amounting to $272 million during May-September."
- Public domestic dollar commercial debt:
  - By end-2006: "$1.6 billion (or 6 percent of GDP) at an average maturity of 1½ years."
  - Over 90 percent of this debt "was financed from domestic sources, including remittances."
  - Recent international issuance: "In October, the government successfully issued its first $500 million international sovereign bond at a yield of 8¼ percent and maturity of 5 years."
  - Footnote examples of prior issuance: "Sri Lanka Development Bonds (SLDB) of $215 million and syndicated loans of $210 million (both with maturities of 2–3 years)." Also issuance of "$400 million rupee-denominated treasury bonds to nonresidents during January-April."

### III. Outlook and Risks (projections and risks, exact figures)
- 2007 projections:
  - "Real GDP growth is projected at around 6 percent in 2007 (taking into account the preliminary official estimates of 6¼ percent in the first half of 2007)."
  - Inflation projected: "13 percent (eop) by end-2007."
- Main risks to growth-inflation outlook: "a worsening of the security situation, a surge in world oil prices, and a larger than projected fiscal deficit that requires significant inflationary financing and/or further recourse to dollar-denominated debt."
- Current account risks: "stiff competition in the apparel sector, slower-than-expected remittance growth, and further oil price hikes."
- Capital account risks: "the need to refinance the existing public dollar-denominated commercial debt." Over the next 2–3 years "about $1.6 billion of such debt is expected to fall due given its short average maturity."
- Medium-term projections:
  - "Real GDP growth is projected at 6 percent over 2008–12."
  - Authorities’ envisaged fiscal consolidation path: lower the deficit to "5 percent of GDP" and "bring about a primary balance by 2010."
  - External current account: "expected to narrow to 3 percent of GDP by 2011."
  - External reserve coverage projected: "around 2½ months of imports in the absence of significant increases in capital inflows."
- Important caveats: "lack of clearly-defined quality measures to broaden the tax base and risks of wages and military spending overruns remain serious concerns."

### IV. Policy Discussions — Fiscal Policy (staff views and authorities’ stance)
- Staff view:
  - "The authorities revised 2007 fiscal deficit target is still high, but is a step in the right direction."
  - Additional fiscal tightening of "about ½ percent of GDP in 2007 is needed to contain budget financing in line with the CBSL’s 'Road Map' targets."
  - Meeting revised revenue target of "18.5 percent of GDP" will "require further administrative efforts."
  - Need to "limit potential recurrent expenditure overruns in order to protect priority development spending while delivering a lower deficit."
  - "With more than three quarters of the year already gone, there may be a need to further rationalize the portion of the capital budget that is not fully externally financed" to contain domestic financing, reduce inflation risks and debt service cost, and support private sector and capital market developments.
- Authorities’ position:
  - Confident "the revised fiscal deficit target for 2007 will be met, or even lowered in the event of external financing shortfall."
  - Expected continuation of "the strong revenue performance to continue in the second half of 2007" and intended to "further strengthen their efforts in tax administration."
  - Noted that "the elimination of the oil subsidy in the budget removed a major fiscal risk."
  - Acknowledged that "the revised capital budget is still above the historical trend" and there is "further scope to rationalize projects that are not fully externally financed."

*Source: Executive Summary (pages excerpt) of IMF staff report.*

### 16.      The authorities indicated their renewed commitment to the medium-term fiscal

### 16.      The authorities indicated their renewed commitment to the medium-term fiscal consolidation to reduce the budget deficit to 5 percent of GDP and achieve a primary balance by 2010–11.

### Fiscal consolidation objectives and staff support
- Authorities committed to medium-term fiscal consolidation to reduce the budget deficit to 5 percent of GDP and achieve a primary balance by 2010–11.
- Staff supported this path as it would:
  - Reduce total public debt to 73 percent of GDP by 2010 (from 95 percent of GDP at end-2006).
  - Lower interest costs.
  - Create space for private investment.
  - Support demand management.
- Staff highlighted the importance of a credible fiscal consolidation in 2008 to reduce the budget deficit to 6¼ percent of GDP (as indicated in the recent Budget Call) while clearly articulating the fiscal strategy underpinning this deficit reduction.

### Tax policy, revenue measures, and incentives
- Authorities and staff agreed quality measures are needed to support the medium-term fiscal consolidation, including:
  - Further broadening of the income tax base.
  - Strengthening of tax administration.
  - Gradual simplification of the VAT system.
- Political difficulties were noted in extending the VAT net to cover the retail and wholesale sectors over the next few years.
- Provincial councils object to revenue sharing over sales taxes, currently collected and retained by local governments.
- Staff warned that absence of strong and sustainable revenue measures could undermine investor confidence and pose risks to fiscal consolidation.
- Staff stressed streamlining tax incentives starting in 2008 and conducting a fresh review of benefits and costs of the current exemption regime.
  - Concerns expressed over new exemptions introduced in the 2007 budget (including leather, construction, film, rubber, and coconut processing industries).
  - The current corporate exemption regime under the Board of Investment (BOI) distorts resource allocation and undermines tax buoyancy; mega infrastructure projects are likely to fall under these schemes.
- Authorities noted BOI companies pay little corporate tax but contribute significantly to growth, income generation, employment, and other taxes, and emphasized competitive pressures in Asia that influence Sri Lanka’s use of tax incentives.
- Footnoted income tax and VAT measures include: increase the top corporate rate, register 38,000 additional taxpayers, place limits on loss carry forward; and VAT measures to raise the markup on imports to counter under-invoicing.

### VAT administration and refunds
- Authorities identified loopholes in VAT refunds as a major factor undermining the VAT system; a large number of fraudulent claims were found.
- Steps taken to separate high risk traders from the rest.
- Staff suggested announcing a clear timetable for returning to a normal refund schedule following the cleanup process to facilitate business forward planning and protect VAT credibility.

### Public investment, wages, and recurrent expenditure
- Ambitious public investment plan over the next few years increases the need to rationalize recurrent expenditure.
- Staff advised restraint on real wage growth, supported by policies to reduce inflation, limit public sector hiring, and resist pressures on sharp nominal wage increases.
- Authorities indicated overall public nominal wage increases have been limited to 20 percent over 2007–09, and real wage growth has already been curtailed in 2007 (compared to the outcome in 2006).

### Energy sector financial viability
- Financial viability of the energy sector is central to fiscal consolidation and debt sustainability over the medium term.
- Ceylon Electricity Board (CEB) likely to incur financial losses of about Rs. 20 billion (¾ percent of GDP) in 2007, due primarily to lack of adjustment in electricity tariffs below cost recovery levels.
- A large part of these losses was financed by loans from public banks, posing risks to the financial sector.
- Authorities’ medium-term strategy: use alternative and cheaper energy sources to reduce heavy reliance on oil-based thermal power generation.
  - Construction of three coal power plants (total 900 MW) expected to be completed during 2008–10.
  - Expected outcome: address acute energy shortage and significantly lower cost of energy production (by about one-third from the current level) and bring the CEB to cost recovery levels.

### Monetary policy recommendations and stance
- Staff advised a tighter monetary stance to contain demand pressures and improve the near term growth-inflation outlook.
- CBSL’s decision to allow treasury security rates to increase by 500 bps during the first half of 2007 helped bring about positive real interest rates and contributed to reducing inflation.
- Recent pause in monetary tightening is a concern given fiscal risks, continued high domestic credit growth, and rising inflationary expectations.
- Critical actions recommended:
  - Step up open market operations.
  - Allow treasury rates to increase to levels that will help effectively contain liquidity and reduce inflation to single digits.
- Limiting banks’ access to the reverse repo window has contained liquidity but is not first best and causes periodic volatility in the call money market.
  - When inflation moderates sufficiently, CBSL should consider a gradual exit from this arrangement, accompanied by adjustments in policy rates to align with treasury security rates.
- Improved coordination between monetary and fiscal policy is critical:
  - Meeting CBSL’s “Road Map” targets for external reserve accumulation and domestic credit growth is important.
  - Recent pick up in bank financing of the budget above target levels during August-September warrants intensified coordination.
  - Stepped up coordination between the CBSL and Ministry of Finance needed for liquidity forecasting and improving open market operations.

### Exchange rate policy and competitiveness
- Staff analysis suggests the real effective exchange rate (REER) appears broadly in line with economic fundamentals and competitiveness is not an immediate concern.
  - REER movements:
    - Depreciation of 23 percent during 1998–2004.
    - REER appreciated by about 14 percent in 2005–2006 due largely to tsunami-related inflows and high domestic inflation.
    - Unwinding effects plus a nominal exchange rate depreciation of 3 percent resulted in a REER depreciation of about 2 percent in the first half of 2007.
  - Estimates of the equilibrium REER indicate REER in the first half of 2007 is close to equilibrium.
- Trade indicators:
  - Apparel exports to the United States have slowed, but utilization of the European Union’s GSP II quotas has increased, together with Sri Lanka’s E.U. market share.
  - Other exports continue to enjoy relatively high profit margins (e.g., tea and spices).
- Areas warranting close monitoring:
  - Labor productivity appears low relative to regional competitors.
  - Wage growth seems to have outpaced labor productivity in past few years and unit labor costs in industry appear to be increasing.
  - Export base remains narrow and vulnerable to global commodity and apparel price changes.
- Authorities reported exports continue to grow at above 10 percent in dollar terms and order books of the apparel sector in 2007 are full; efforts to strengthen competitiveness include establishing backward linkages of apparel to the textile sector.
- Staff advised a more market-based exchange rate regime:
  - Greater flexibility in the rupee to help contain external vulnerabilities and safeguard reserves.
  - Limit intervention to smoothing excessive volatility.
- Authorities emphasized commitment to a market-based exchange rate, allowing orderly depreciation throughout the year.
  - Increased intervention attributed mainly to lumpy oil import bills larger than the daily foreign exchange market.
  - Steps taken to allow Ceylon Petroleum Corporation (CPC) to gradually accumulate foreign exchange funds earmarked for future oil imports.
- Import margin requirements:
  - Import margin requirements (50 percent) introduced in October 2006 were removed in May 2007.
  - Margin requirements (100 percent) with respect to certain vehicles will be maintained due to continued high demand for vehicle imports; decision to be reviewed during the 2008 Article IV consultation discussions.
  - The Board approval of this restriction expired on November 2, 2007; at this point, staff do not propose an approval of this restriction.

### Debt policy and near-term risks
- Main near-term challenge: lengthen maturity of domestic dollar-denominated commercial debt to reduce exchange rate and refinancing risks.
  - Short-term dollar financing, while at more favorable interest rates than rupee funds, renders Sri Lanka vulnerable to exchange rate and refinancing risks; could lead to sharp deterioration in debt sustainability if not addressed.
- Authorities reviewing options:
  - Issuing longer-term SLDBs to replace shorter maturity ones falling due.
  - Tapping international financial markets under favorable conditions.
  - Issued first sovereign debt of $500 million with five-year maturity; expected to help set benchmark for longer term SLDBs.
- Staff advised proceeds from international bond issues should be used mainly to retire short-term dollar-denominated commercial debt and/or the most expensive rupee debt.
- Mobilizing other funding sources, including remittances, remains important.
- Sound macroeconomic policies and comfortable external reserves are critical during transition to improved debt dynamics.
- New debt management strategy (mainly on domestic rupee debt) endorsed by Cabinet and implementation underway:
  - Trading of treasury securities extended to retail investors through bank branches in urban and rural areas.
  - Continued efforts to develop benchmark issues with longer maturities, introduce inflation indexed bonds, and develop a domestic corporate bond market.
  - Challenges: strengthening primary dealer system, providing adequate incentives to brokers, encouraging long-term savings.
- Financing of mega infrastructure projects under the Plan:
  - Total targeted: $4.5 billion for key infrastructure development during 2007−09.
  - About $1.5 billion secured from major bilateral and multilateral donors, mostly long maturities and concessional/soft terms.
  - Government seeking financing for remaining $3 billion, including from private sector investors in form of PPPs.
  - Authorities guided by principle of balanced risk sharing and minimizing contingent liabilities.
  - Staff recommended a legal framework governing PPPs as first step to ensure proper risk management and good governance.
  - Staff advised financing of mega infrastructure projects should be fully accounted for in the medium-term budget framework.
- Debt Sustainability Analysis (DSA) shared with authorities:
  - Sri Lanka has a moderate risk of external debt distress.
  - Risk of debt distress increased to moderate-to-high for total foreign exchange debt, assuming refinanced and new dollar-denominated commercial debt are at maturity of 2 years.
  - Lengthening maturity of dollar-denominated debt could significantly reduce debt service burden and improve debt dynamics.
  - Projections and simulations:
    - Total debt service in foreign exchange, including servicing public domestic dollar-denominated commercial debt, projected to increase sharply over 2008−2009 (to $600 and $800 million based on the end-2006 stock).
    - An illustrative simulation, assuming full refinancing of the end-2006 debt stock at existing maturities with new money of $300 million each year starting from 2008, indicates increased total debt service in foreign exchange to about 20−25 percent of exports over the medium term.
    - Mitigating factors: mobilizing medium to long-term international and domestic funds to retire short-term foreign exchange commercial debt.
    - Debt dynamics are highly sensitive to fiscal deficit, growth, exports, and interest rates; extreme stress tests including lower growth, lower exports, and interest rate shocks could bring total debt service in foreign exchange to around 30 percent, indicating a high risk of debt distress.

### Financial sector policy and resilience
- Since the 2002 FSAP, significant progress in financial sector stability:
  - Sharp decline in NPL ratios across banks.
  - Marked strengthening in capital base of the banking industry.
  - Sustained improvement in banks’ operating profits.
  - Implementation of Basel Core Principles advanced to facilitate planned adoption of Basel II in 2008.
- Remaining structural and operational weaknesses; further efforts should focus on:
  - Improving banking sector resilience to shocks through improving asset quality and strengthening credit and liquidity risk management.
    - Stress testing indicates more than half of the banking system assets are highly vulnerable to interest rate and liquidity shocks, and to a lesser extent to exchange rate risk and deterioration in asset quality.
    - Credit to deposit ratios rose from about 80 percent in 2003 to 94 percent in 2006, indicating increased reliance on commercial borrowing and accentuated credit and liquidity risks.
  - Strengthening risk-based supervision in view of recent rapid growth in sectoral lending.
    - Consumer and housing sectors grew by 59 percent and 45 percent by end-March, respectively, on top of high growth in 2006, contributing to asset price inflation.
  - Advancing structural and operational restructuring in state-owned banks and limiting state interference.
    - During 2002–06, NPLs in state-owned banks declined markedly while the capital base strengthened (Bank of Ceylon’s capital adequacy ratio is well above the 10 percent minimum requirement).
    - State influence remains significant: large loan exposures to government and public corporations, directed lending to some sectors.
    - Overstaffing resulted in high personnel costs, accounting for three-quarters of total operating cost.

### Staff appraisal and overall policy message
- Recent growth performance has been impressive, supporting sharp reduction in unemployment and improvement in per capita income.
- Sustaining growth momentum requires macroeconomic stability and strengthened structural reforms to improve competitiveness, promote FDI, and enhance productivity.
- Emphasis areas: tax reforms to broaden the resource base, streamline tax incentives, improve financial sector stability and efficiency, and address financial imbalances in the energy sector.
- Concerted policy tightening is needed in the near term to reduce inflation and vulnerabilities:
  - Near-term risks: rising inflation, large external current account deficit, and gross official reserves below comfortable levels.
  - A tighter macroeconomic policy stance is needed to rebalance the growth-inflation outlook while ensuring balance of payments viability.

*Source: _cr07373 - 16.*

### 38.      A more determined fiscal consolidation in 2007 is critical for demand

### A more determined fiscal consolidation in 2007 is critical for demand

### Fiscal consolidation and public debt
- The revised lower fiscal deficit target in 2007 is described as "a step in the right direction, but it still remains high."
- Additional fiscal measures may be required to contain the fiscal deficit to 7½ percent of GDP to:
  - limit inflationary financing; and
  - help meet the “Road Map” targets.
- Suggested fiscal policy actions:
  - additional rationalization of capital spending to the historical norms while protecting key development spending;
  - ensure measures introduced in 2006–07 are fully implemented to meet ambitious revenue targets;
  - exercise prudence to limit risks of future recurrent expenditure overrun.
- Medium-term fiscal objective:
  - reduce the fiscal deficit to 5 percent of GDP by 2011 to reduce the public debt stock, lower debt service pressures, and create space for productive investment.
- Revenue and expenditure reforms recommended:
  - extend VAT to retail and wholesale stages;
  - further broaden the income tax base;
  - strengthen tax administration;
  - greater prioritization and efficiency in expenditure;
  - fully incorporate financing of mega infrastructure projects in the medium-term budget framework;
  - establish a legal framework for PPPs to minimize quasi-fiscal risks.

### Monetary policy and liquidity management
- Further monetary tightening in the near term is warranted given the current fiscal stance and the rate of inflation.
- Recommended central bank actions:
  - conduct open market operations so treasury security rates can adjust to levels that would help bring down inflation to single digit levels;
  - adjust policy rates upwards gradually to align with treasury security rates, restoring their signaling role and allowing proper functioning of the standing facility in liquidity management.
- Timely actions on these fronts are called "instrumental in ensuring macroeconomic stability."

### Exchange rate policy and external vulnerabilities
- Greater downward flexibility in the exchange rate is needed to reduce vulnerability and safeguard reserves in a challenging environment.
- Risks identified:
  - sustained high oil prices; and
  - an emerging refinancing burden from existing public dollar-denominated commercial debt could exert pressures on the balance of payments.
- Policy guidance:
  - limit foreign exchange market intervention to smoothing excessive volatility;
  - avoid frequent intervention that may send mixed signals and generate uncertainty.
- Assessment:
  - "The REER appears to be in line with economic fundamentals given the recent trade performance," but other indicators warrant close monitoring given Sri Lanka’s relatively low labor productivity.

### Public dollar-denominated commercial debt and refinancing
- Managing refinancing of public dollar-denominated commercial debt is expected to take center stage over the next few years.
- Key strategies:
  - limit further reliance on short-term dollar-denominated commercial borrowing;
  - manage refinancing through longer maturity while favorable market conditions last;
  - underpin refinancing efforts with sound macroeconomic policies to ensure stability and investor confidence;
  - broaden financing sources, including through remittances and long-term international market funds.

### Financial sector reform priorities
- Implement FSAP update recommendations with focus on:
  - improving resilience of the banking sector;
  - strengthening risk-based supervision;
  - advancing preparatory work for Basel II adoption in 2008;
  - accelerating operational restructuring of public banks to improve risk management and efficiency.
- Policy advice: limit state interference in public banks.

### Energy sector and quasi-fiscal risks
- Authorities’ energy policy may lower the cost of energy production over the medium term, but timely transition measures are needed to address current financial imbalances in CEB.
- Recommended approach:
  - increase electricity tariffs to cost recovery levels, starting in the 2008 budget, to minimize quasi-fiscal losses and potential damage to public banks;
  - consider safety net provisions to protect the poor.

*Source: _cr07373 - 38.      A more determined fiscal consolidation in 2007 is critical for demand*

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

### 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.
- The Executive Board is expected to conclude the 2007 Article IV consultation on October 29, 2007.
- It is expected that the next Article IV consultation with Sri Lanka will be in accordance with the provisions applying to countries on the standard consultation cycle.

### Macroeconomic performance and outlook (real sector)
- Real GDP growth:
  - 2004: 5.4
  - 2005: 6.0
  - 2006: 7.4
  - 2007 (est): 6.0
  - 2008 (proj): 6.0
- Contributions to real GDP growth by sector (brief chart summary): Agriculture, Industry, Services shown as changes in percent of previous year's GDP.
- Inflation (Sri Lanka CPI; average and end-of-period):
  - Inflation (average): 2004: 9.5; 2005: 17.7; 2006: 11.5
  - Inflation (end-of-period): 2004: 17.9; 2005: 13.0; 2006: 11.0
  - Table 5 projections (average): 2006: 9.5; 2007: 17.7; 2008: 11.5; 2009: 9.5; 2010: 9.0; 2011: 8.5
  - Table 5 projections (end-of-period): 2006: 17.9; 2007: 13.0; 2008: 11.0; 2009: 10.0; 2010: 9.5; 2011: 8.5
- GDP per capita (2006, est.): US$1,300
- Unemployment rate (2006): 6.3 percent
- Poverty rate (2004, incidence): 22 percent

### Fiscal sector highlights
- Fiscal deficit and public debt:
  - Overall central government balance (in percent of GDP): 2004: -8.2; 2005: -8.7; 2006: -8.4; 2007 (est): -7.8; 2008 (proj): -6.3
  - Overall balance (excluding tsunami): 2004: -8.2; 2005: -7.3; 2006: -7.6; 2007 (est): -7.4; 2008 (proj): -6.3
  - Primary balance (in percent of GDP): 2004: -2.2; 2005: -3.6; 2006: -3.0; 2007 (est): -2.6; 2008 (proj): -0.8
  - Public debt (domestic and external) as percent of GDP: 2004: 107.5; 2005: 95.3; 2006: 94.7; 2007 (est): 90.1; 2008 (proj): 86.2
- Central government operations (selected items, percent of GDP):
  - Total revenue: 2006: 17.1; 2007 (Auth. proj): 18.4; 2008 (Proj): 18.3
  - Tax revenue: 2006: 15.3; 2007 (Auth. proj): 16.6; 2008 (Proj): 16.3
  - Total expenditure and net lending: 2006: 25.5; 2007 (Auth. proj): 27.7; 2008 (Proj): 26.0
  - Interest payments (percent of GDP): 2006: 5.4; 2007 (Auth. proj): 5.2; 2008 (Proj): 5.2
  - Capital expenditure and net lending: 2006: 5.9; 2007 (Auth. proj): 3.7; 2008 (Proj): 7.0
- Financing:
  - Net external financing (percent of GDP): 2006: 1.5; 2007 (Auth. proj): 3.7; 2008 (Proj): 3.7
  - Grants (percent of GDP): 2006: 1.1; 2007 (Auth. proj): 0.7; 2008 (Proj): 0.8

### Monetary and financial sector developments
- Monetary aggregates (end-period percent change):
  - Reserve money: 2005: 20.9; 2006: 15.8; 2007 (Aug/Dec): 21.2/11.5; 2008 (proj): 12.7
  - Broad money: 2005: 19.6; 2006: 19.1; 2007 (Aug/Dec): 17.8/16.3; 2008 (proj): 14.0
  - Domestic credit (percent change): 2005: 22.4; 2006: 19.1; 2007 (Aug/Dec): 29.5/17.0; 2008 (proj): 18.3
  - Private sector credit (percent change): 2005: 22.1; 2006: 26.3; 2007 (Aug/Dec): 24.0/21.9; 2008 (proj): 21.0
- Interest rates:
  - 91-day T-bill rate (end of period): 2004: 7.3; 2005: 10.1; 2006: 12.8; 2007: 19.0; 2008 (proj): 14.5
  - The Central Bank allowed treasury rates to increase to close to 18 percent, bringing about positive real interest rates; the yield curve inverted slightly recently.
- Banking indicators (2006):
  - Nonperforming loans (as percent of total loans): 2006: 5.4
  - Risk-based capital asset ratio: 2006: 11.9
- Stock market:
  - Strong performance in 2006 with signs of deceleration in the first half of 2007; ASPI (1985=100): 2006: 2,722

### External sector and balance of payments
- Trade and current account (in millions of U.S. dollars unless otherwise noted):
  - Exports: 2004: 5,757; 2005: 6,347; 2006: 6,883; 2007: 7,646; 2008 (proj): 8,412
  - Imports: 2004: 7,999; 2005: 8,863; 2006: 10,260; 2007: 11,307; 2008 (proj): 12,532
  - Trade balance: 2006: -3,377; 2007: -3,661; 2008 (proj): -4,120
  - Current account balance: 2004: -646; 2005: -650; 2006: -1,339; 2007: -1,337; 2008 (proj): -1,528
  - Current account balance (in percent of GDP): 2004: -3.2; 2005: -2.8; 2006: -5.0; 2007: -4.6; 2008 (proj): -4.8
- Gross official reserves:
  - End-period (millions of U.S. dollars, excluding ACU balances): 2004: 1,833; 2005: 2,458; 2006: 2,515; 2007: 2,912; 2008 (proj): 2,854
  - Reserves in months of imports: 2004: 2.2; 2005: 2.5; 2006: 2.4; 2007: 2.5; 2008 (proj): 2.2
- External debt:
  - Total external debt (public and private) as percent of GDP: 2004: 63.9; 2005: 55.4; 2006: 52.8; 2007 (est): 52.6; 2008 (proj): 51.6
  - Total stock of public dollar commercial debt (millions of U.S. dollars): 2004: 550; 2005: 1,065; 2006: 1,609; 2007: 2,396; 2008: 2,209
- Exchange rate and reserves developments:
  - The rupee depreciated by 5.7 percent against the dollar in 2006 and a further 5¼ percent in the first three quarters of 2007.
  - Gross official reserves stand at 2.2 months of imports, about the same level as end-2006.

### Balance of payments medium-term projections (selected)
- Real GDP growth (percent): 2006: 7.4; 2007: 6.0; 2008–2012: 6.0 (each year)
- Trade balance (percent of GDP): 2006: -12.5; 2007: -12.5; 2008: -13.1; 2009: -12.8; 2010: -12.5; 2011: -12.3; 2012: -11.9
- Current account balance (percent of GDP): 2006: -5.0; 2007: -4.6; 2008: -4.8; 2009: -4.3; 2010: -3.7; 2011: -3.1; 2012: -2.8
- Gross official reserves (millions of U.S. dollars): 2006: 2,515; 2007: 2,912; 2008 (proj): 2,854; 2009 (proj): 3,015; 2010 (proj): 3,262; 2011 (proj): 3,742; 2012 (proj): 4,248

### Fund relations, facilities, and safeguards
- Membership: Joined 8/29/50; accepted Article VIII, Sections 2, 3, and 4, March 1994.
- Quota and holdings:
  - Quota: SDR Million 413.40 (100.00 percent)
  - Fund holdings of currency: 489.58 (118.43 percent of quota)
  - Reserve position in Fund: 47.86 (11.58 percent of quota)
- Outstanding purchases and loans (SDR Million; Percent Quota):
  - Emergency Assistance: 103.35 (25.00)
  - Extended arrangements: 20.67 (5.00)
  - PRGF arrangements: 38.39 (9.29)
- Financial arrangements (approval and amounts drawn):
  - EFF Apr 18, 2003–Apr 17, 2006: Amount Approved SDR 144.40; Amount Drawn SDR 20.67
  - PRGF Apr 18, 2003–Apr 17, 2006: Amount Approved SDR 269.00; Amount Drawn SDR 38.39
  - Stand-by Apr 20, 2001–Sep 19, 2002: Amount Approved SDR 200.00; Amount Drawn SDR 200.00
- Safeguards assessment:
  - Full safeguards assessment completed on July 30, 2003 for the CBSL in relation to the PRGF arrangement; assessment concluded that CBSL had made commendable progress and upgraded risk ratings in four of five areas; some remaining vulnerabilities identified and most proposed measures implemented.
- Exchange rate arrangement: Managed float; the central bank floated the rupee on January 23, 2001. Some import margin requirements introduced last October were removed in May 2007; 100 percent margin requirements on import of certain vehicles remain in place.
- Projected obligations to the Fund (obligation basis, SDR million):
  - Principal (by year): 2007: 1.72; 2008: 46.04; 2009: 62.80; 2010: 24.04; 2011: 11.12
  - Charges/interest (by year): 2007: 2.43; 2008: 8.67; 2009: 6.13; 2010: 3.65; 2011: 3.15
  - Total (by year): 2007: 4.16; 2008: 54.71; 2009: 68.92; 2010: 27.70; 2011: 14.27
- FSAP and ROSC participation:
  - MFD: FSSA and FSAP reports completed in 2002.
  - MCM: FSAP update in June 2007.
  - STA: Data ROSC completed and published in 2002.
  - FAD: Fiscal transparency ROSC completed and published in 2002; ROSC update published in July 2005.
- Resident Representative: The resident representative office in Colombo was closed in January 2007.

### Key social and development indicators
- Main exports (percent of total, 2005): garment (48), tea (14)
- FDI (2006): $451 million
- Foreign public debt (percent of total, 2006): 43
- Millennium Development Goal indicators (selected):
  - GDP per unit of energy use (2004): 7.3
  - Gross capital formation (percent of GDP, 2006): 26.2
  - Life expectancy at birth (total, 2006): 74.7
  - Population (total, 2006): 19.6 million
  - GNI per capita, Atlas method (current, 2004–2006): 2004: 470.0; 2002: 850.0; 2004: 1,000.0; 2006: 1,160.0

*Prepared by the Asia and Pacific Department; Staff Report for the 2007 Article IV Consultation—Informational Annex; November 7, 2007.*

### ANNEX II: SRI LANKA—RELATIONS WITH THE WORLD BANK GROUP

### ANNEX II: SRI LANKA—RELATIONS WITH THE WORLD BANK GROUP

### Overview and context
- CAS presented in April 2003 during a period of optimism; situation changed markedly thereafter, notably due to the December 2004 tsunami and renewed violence.
- Average growth remained about 5-6 percent, which was insufficient for significantly reducing poverty beyond urban areas.
- Fiscal situation remained under stress and needed reforms were elusive amid political instability.
- Political constraints and uncertainties affected the peace process, policy implementation and the environment for pro-poor, broad-based economic growth.
- (As of October 12, 2007)

### IMF–World Bank collaboration and financial sector work
- The Bank and the IMF are working closely together on financial sector issues.
- The Bank is embarking on a Corporate Governance Review of the Banking Sector to complement the upcoming IMF FSAP review.
- Prior sector work: “Sri Lanka: Improving Access to Financial Services” highlighted opportunities for promoting higher financial inclusion and the need for a multi-pronged approach.
- IMF contribution: support trade reforms focused on progress toward a simplified and transparent two-band tariff system, including reducing agricultural protection.

### World Bank activities — public administration and public expenditure management
- Support on implementation of reforms in public administration and public expenditure management.
- e-Sri Lanka Development Project aims to enhance growth, employment and equity by promoting affordable access to and wide use of on-line public information and services by citizens and businesses and private sector competitiveness, particularly of knowledge industries and small and medium enterprises.
- The Bank has led dialogue on public expenditure issues, primarily to assist efforts to implement a medium term budget framework (MTBF).

### World Bank activities — health
- Ongoing National HIV/AIDS Prevention project assisting in curbing the spread of HIV infection.
- Bank assisted authorities in developing a health sector strategy/program leading to financing of the Health Sector Development operation.
- Analytical work underway on ageing; recent completion of work on nutrition.

### World Bank activities — education
- Education Sector Development Project: promotes equitable access to and improved quality of basic and secondary education.
- Improving the Relevance and Quality of Undergraduate Education project supports tertiary sector reform.

### World Bank activities — rural development and sector studies
- Completed major study: “Sri Lanka: Promoting Agricultural and Rural Non-Farm Sector Growth” identifying constraints: poor access to critical infrastructure and services; ineffective public sector expenditure programs; poor flow of information on technology transfer; dominance of public sector as service provider and underutilization of private sector initiatives.
- Major study on tea and rubber sectors focusing on constraints and actions to sustain sector growth and improve welfare of tea- and rubber-dependent households.
- Community Development and Livelihood “Gemi Diriya” project addresses poverty reduction and reinvigoration of the rural economy.

### World Bank activities — peace, reconstruction and housing in North and East (NE)
- North East Irrigated Agriculture Project II (NEIAP II): helps conflict-affected communities restore livelihoods, enhance agricultural and other production and incomes, and build capacity for sustainable social and economic reintegration.
- North East Housing Reconstruction Project (NEHRP): provides poorest conflict-affected families in NE (meeting vulnerability criteria) with improved and affordable housing units.
- Sri Lanka Puttalam Housing Project: supports integration of internally displaced persons (IDPs) in Puttalam by upgrading habitat, water and sanitation facilities for both IDPs and select non-IDPs.

### World Bank activities — private sector environment, legal reform, energy, water, roads, tsunami response
- Joint Bank/ADB Investment Climate Assessment (ICA) of urban formal sector and rural entrepreneurship to assess and improve environment for private sector.
- Legal and Judicial Reform Project closed in early 2007; second stage under preparation; focused on efficiency, transparency and responsiveness of legal/judicial framework.
- Renewable Energy for Rural Economic Development (RERED): supports off-grid renewable energy technologies to bring electricity to remote communities and promote private sector power generation from renewable energy resources.
- Second Community Water Supply and Sanitation (CWSSP II): supports demand-responsive and sustainable rural water and sanitation services.
- Large Road Sector Assistance Project aims to lower transportation costs through sustainable delivery of an efficient national road system.
- Post-tsunami: Bank (with ADB and Japan Bank for International Cooperation) conducted preliminary damage and needs assessment and released a joint report in early February 2005; assessment formed the basis for Tsunami Emergency Recovery Program (TERP) covering roads, rail, power, water, housing, health, education and livelihoods.

### World Bank Group strategy and lending operations
- CAS for Sri Lanka considered by Bank’s Board on April 1, 2003, designed to support 2003 PRSP’s three core themes: peace, growth and equity.
- December 2005 CAS Progress Report reflected significantly changed operating environment; program continued support to peace and equity pillars and tsunami reconstruction/recovery, with shift in growth pillar emphasis toward: (i) support human development; (ii) further recovery in conflict-affected areas; and (iii) assist roads and irrigation to support pro-poor growth.
- A new CAS under preparation to go to the Board in mid-FY08.

### Bank assistance program (portfolio and FY07 lending)
- Bank’s active portfolio as of October 12, 2007 comprises 13 IDA credits/grants and one Global Environmental Facility (GEF) grant for a total commitment (net of cancellation) of $778.4 million.
- FY07 lending program included:
  - one new project (Puttalam Housing) approved in February 2007
  - supplemental financing (Renewable Energy) approved in June 2007

### Economic and sector work (selected completed and ongoing)
- Completed FY04–FY07 reports/policy notes include:
  - Treasures of the Education System in Sri Lanka: Restoring Performance, Expanding Opportunities and Enhancing Prospects
  - Sri Lanka: Improving the Rural and Urban Investment Climate
  - Post-Tsunami Recovery Program: Preliminary Damage and Needs Assessment
  - Sri Lanka Development Forum: The Economy, The Tsunami and Poverty Reduction
  - Attaining the Millennium Development Goals in Sri Lanka
  - Sri Lanka: Improving Access to Financial Services
  - Decentralization and Service Delivery in Sri Lanka: Assessment and Options
  - Poverty Assessment for Sri Lanka—Engendering Growth with Equity: Opportunities and Challenges
  - Tea and Rubber Sector Review
- Other diagnostic work completed: Country Procurement Assessment Review (CPAR), Country Financial Accountability Assessment (CFAA), ROSC Accounting and Auditing Assessment, Health Sector Policy Note, Roads Policy Note.
- Economic and sector work underway: ageing, corporate governance in the banking sector, higher education, private renewable energy and growth potential in lagging regions.

### Summary of World Bank operations (As of September 30, 2007)
- Total commitment (net of cancellation): $778.4 million; GEF: 8.0; Undisbursed: 422.0
- Project list with IDA amount and Undisbursed (In millions of US$):
  - 3673 2002 Renewable Energy for Rural Economic Development — IDA Amount 115.0 — Undisbursed 43.8
  - 3781 2003 Improving Relevance and Quality of Undergraduate Education — IDA Amount 40.3 — Undisbursed 19.0
  - H013 2003 National HIV/AIDS Prevention — IDA Amount 12.6 — Undisbursed 7.5
  - H035 2003 Second Community Water — IDA Amount 39.8 — Undisbursed 18.8
  - H078 2004 Community Development and Livelihood — IDA Amount 51.0 — Undisbursed 27.2
  - H095 2004 Health Sector Development — IDA Amount 60.0 — Undisbursed 22.5
  - 3935 2004 North-East Irrigated Agricultural Project II — IDA Amount 64.7 — Undisbursed 55.4
  - 4014 2005 North East Housing Reconstruction Program — IDA Amount 75.0 — Undisbursed 37.2
  - 3986 2005 E-Sri Lanka Development — IDA Amount 53.0 — Undisbursed 37.3
  - 4039/H147 2005 Tsunami Emergency Reconstruction Program Phase II — IDA Amount 75.0 — Undisbursed 4.6
  - H196 2006 Education Sector Development Project — IDA Amount 60.0 — Undisbursed 44.4
  - 4138 2006 Road Sector Assistance — IDA Amount 100.0 — Undisbursed 72.6
  - 4261 2007 Puttalam Housing — IDA Amount 32.0 — Undisbursed 30.6
- GEF Projects:
  - 51248 2002 Renewal Energy for Rural Economic Development — GEF Amount 8.0 — Undisbursed 0.9
- Notes from table:
  - FY is the fiscal year of Board approval.
  - All loan accounting is done in SDR. As these figures are in U.S. dollars, exchange rate fluctuations may result in undisbursed balances that are greater than original principal amounts.
  - LIL: Learning and Innovation Loan.
  - Global Environment Facility.
  - Not counted as a separate project.

### IFC activities and SME support
- As of September 30, 2007, IFC’s held portfolio in Sri Lanka consisted of investments in eight companies, with a total committed exposure of US$155 million.
- Portfolio sectors: financial institutions, power, health care, manufacturing, ports and telecommunications.
- Greater investment involvement is linked to progress on the political/security situation.
- IFC remains interested in investing in Sri Lanka (especially in infrastructure, manufacturing and financial markets) depending upon progress on reforms.
- In FY06, IFC opened a dedicated small and medium enterprise development technical assistance program for Sri Lanka and the Maldives under the South Asia Enterprise Development Facility (‘IFC-SEDF’).
- Initial funding for IFC-SEDF from IFC and the Governments of the Netherlands and Norway: US$5.5 million; fund raising efforts are continuing.
- Program components: Access to Finance, Value Addition to Firms (VAF) and Business Enabling environment.
- Program aim: support growth of SMEs to contribute to broader-based economic growth and sustainable poverty reduction in Sri Lanka and Maldives.
- Questions may be referred to Elaine Tinsley (458-4920) and on IFC to Neil Gregory (473−8559).

---

*Prepared by the World Bank staff (As of October 12, 2007).*

### ANNEX IV: SRI LANKA––STATISTICAL ISSUES

### ANNEX IV: SRI LANKA––STATISTICAL ISSUES

### Staff assessment
- Coverage and timeliness of available data 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 expressed intention to subscribe to the Special Data Dissemination Standard (SDDS) and appointed an SDDS coordinator in February 2003; substantial work remains to meet all SDDS requirements and prepare necessary metadata.
- Most data ROSC recommendations have been implemented; remaining items are expected to be implemented in the near future.
- Recent improvements noted:
  - Most data now disseminated on the Census and Statistics and central bank websites.
  - 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.
  - The CBSL has issued an advance release calendar and designated a contact person to assist data users.

### Outstanding statistical issues — Real sector
- Price indices
  - Multiple consumer price indices produced: Sri Lanka Consumer Price Index (SLCPI) and Colombo Consumer Price Index (CCPI) by the Department of Census and Statistics (DCS).
  - SLCPI is based on spending patterns of the lowest 80 percent of households for the entire country excluding the Northern and Eastern provinces.
  - CCPI is based on 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.
  - DCS publishes a Greater Colombo Price Index (GCPI). The Central Bank of Sri Lanka (CBSL) produces a Colombo District CPI (CDCPI) and a Wholesale cum-Producer Price Index (WPI/PPI).
- National accounts
  - Suffer from lack of data sources and undeveloped statistical techniques.
  - No periodic comprehensive benchmarks or system for conducting regular annual surveys of establishments.
  - No statistical business register to serve as main basis for sample surveys; existing surveys lack good sample frames.
  - Detailed data needed to measure output and intermediate consumption are mostly unavailable or not collected.
  - Estimates of gross value added rely on outdated fixed ratios from base year 1996, outdated studies, or ad hoc assumptions.
  - Quarterly indicators used for compiling quarterly value added estimates; methodology for deriving GDP at constant prices is not satisfactory.
  - Expenditure estimates available only annually and rely mostly on commodity flow techniques.
  - Estimates validated and checked with other sources whenever possible.

### Outstanding statistical issues — Fiscal sector
- In May 2003, a STA mission followed up on ROSC recommendation to develop migration path to compile data in accordance with Government Finance Statistics Manual 2001 (GFSM 2001).
- Authorities agreed to revise from end–2003 the budgetary classifications and accounting structure to match GFSM 2001 classifications and apply chart of accounts to all general government units.
- Progress with implementation needs to be assessed.
- Cash data through 2005 were reported for publication in the 2006 GFS Yearbook; these data cover only the budgetary accounts of central government.
- No data provided on the four extra-budgetary funds or the provincial and local governments.
- No sub-annual data are 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.
- To adjust for proportion of nonresident foreign currency deposits (NRFC) actually held by residents, 50 percent of these deposits are reclassified from foreign liabilities to domestic deposits.
- June 2003 STA mission clarified treatment of Fund accounts; recommended repos be treated as collateralized loans (rather than on a change of ownership basis); resolved discrepancies between monetary authorities’ data reported to STA and to APD.
- Authorities have not submitted data for the monetary authorities’ accounts since September 2006; most recent data published in IFS are for April 2006.

### Outstanding statistical issues — External sector
- Central Bank of Sri Lanka publishes balance of payments statistics on a quarterly and annual basis; quarterly data are available three months after the end of the quarter.
- Data largely follow the fifth edition of the Balance of Payments Manual.
- December 2004 STA mission highest priority issues for the ITRS:
  - Deal with large values of unclassified transactions.
  - Include FCBUs in the data.
  - Provide an instruction book to assist ITRS reporters to apply classifications and coding more accurately.
- Mission advised development of a comprehensive survey to implement medium-term plan to introduce international investment position statistics.
- GDDS website indicates FCBUs are now included and work has been done toward compiling international investment position statistics.

### Table of Common Indicators (as of September 20, 2007) — selected notes
- Exchange rates: Date of latest observation 9/20/2007; Date received 9/20/2007; Frequency: Daily (D).
- International reserve assets and reserve liabilities of the Monetary Authorities: Date of latest observation 7/31/2007; Date received 9/2007; Frequency: Daily (D) for latest obs; Reporting/Publication frequency: Weekly (W).
- Reserve/base money, Broad money, Central bank balance sheet, Consolidated balance sheet of the banking system: Date of latest observation 7/31/2007; Date received 9/11/2007; Frequency: Weekly (W) for reserve/base money, Monthly (M) for broad money and balance sheets.
- Interest rates: Date of latest observation 9/7/2007; Date received 9/11/2007; Frequency: Weekly (W).
- Consumer price index (SLCPI): Date of latest observation 7/2007; Date received 9/2007; Frequency: Monthly (M).
- Revenue, expenditure, balance and composition of financing—central government: Date of latest observation 6/2007; Date received 9/2007; Frequency: Monthly (M).
- Stocks of central government and central government-guaranteed debt: Date of latest observation 6/2007; Date received 9/2007; Frequency: Monthly (M).
- External current account balance, Exports and imports of goods and services, GDP/GNP: Latest observation Q2/2007; Date received 9/2007; Frequency: Quarterly (Q).
- Gross external debt: Date of latest observation 12/2006; Date received 3/30/2007; Frequency: Annually (A).
- Data quality assessments reflect the 2002 data ROSC (mission June 2001) and indicate varying degrees of observation (O, LO, LNO, NO) across methodological soundness and accuracy/reliability for different datasets.

### Debt Sustainability Analysis 2007 — Background (selected findings)
- LIC DSA indicates a moderate risk of debt distress for external debt; risk rises to moderate-to-high when total debt service in foreign exchange, including public dollar-denominated domestic commercial debt, is taken into account.
- Public DSA suggests overall debt dynamics are sustainable over the projection period, conditional on sound fiscal adjustment and prudent macroeconomic policies to reduce debt burden, improve refinancing environment, and lower interest costs.
- Sri Lanka’s total public debt stock (including publicly guaranteed debt) declined to 95 percent of GDP in 2006 from its peak of 106 percent of GDP in 2003.
- Debt stock composition at end-2006: 46 percent external debt, 7 percent domestic dollar-denominated commercial debt, and 47 percent domestic rupee debt.

### External debt and debt-service characteristics
- External debt is primarily concessional and public or publicly guaranteed.
- Multilateral and bilateral donors comprised about 70 percent of total external debt during 2001–2006.
- At end-2006, medium-to-long-term debt accounted for about 82 percent of total external debt with an effective interest rate of just over 2.5 percent; currency composition primarily SDRs, Japanese yens, and U.S. dollars.
- External debt stock and service indicators improved over 2002–2006; debt-to-GDP ratio reduced by 10 percent during this period.
- External debt service averaged 10.5 percent of exports over 2002–06 (noting variation due to Paris club moratorium in 2005 and resumption of payments in 2006).

### Public dollar-denominated commercial debt
- Stock reached $1.6 billion by end-2006 (or 6 percent of GDP and about 65 percent of gross official reserves).
- Composition: mainly Sri Lanka Development Bonds (SLDB), loans from FCBUs, and syndicated loans from local and offshore banks.
- Major funding source: domestic foreign currency deposits (FCDs), largely from remittance inflows.
- Stock has average interest rate of LIBOR+150 bps and a short average maturity of 1½ year, resulting in bunching of debt service over 2007–09.
- First eight months of 2007: public dollar-denominated commercial borrowing mainly to rollover existing debt.
  - March 2007: government issued $215 million of SLDBs.
  - April 2007: borrowed $210 million in syndicated loans through foreign banks.
  - Average maturity of new debt increased to about 2½ years; interest rates remained LIBOR+150 bps.
- Debt-service pressures expected to increase sharply from 2008 given short maturities.
  - Preliminary estimates: about $165 million due in Q4 2007; about $600 million expected in 2008; about $800 million expected in 2009.
- October 2007: government issued $500 million Eurobond, attracting $1.25 billion bids, issued at a yield of 8¼ percent and maturity of 5 years; proceeds partly to retire expensive rupee debt and to help set a benchmark for refinancing future SLDBs.

### Domestic rupee debt
- Consists mainly of treasury bonds and bills (about 70 percent) and other loans including advances from banks.
- Share of longer-term treasury bonds increased, reaching nearly three times treasury bills outstanding at end-2006.
- Interest rates on treasury securities:
  - Around 7½–10 percent during 2004–05
  - About 12 percent by end 2006
  - 18¼ percent at mid-October 2007 (reflecting monetary tightening by CBSL).

### Baseline for the DSA — key assumptions and numerical projections
- Baseline informed by historical ten-year averages and four-year averages since 2002 ceasefire.
- Table of selected historical averages and baseline projections (preserve exact figures):
  - Real GDP growth (in percent): 10-year Historical 6.0; 4-year Historical 5.5; Baseline 4.9 (2007–12); 6.2 (2013–27).
  - GDP deflator (in U.S. dollar terms, change in percent): 10-year Historical 1.8; 4-year Historical 0.9; Baseline 2.0 (2007–12); 6.4 (2013–27).
  - Current account deficit (percent of GDP): 10-year Historical 3.6; 4-year Historical 2.6; Baseline 3.0 (2007–12); 2.8 (2013–27).
  - Growth of exports (U.S. dollar, in percent): 10-year Historical 8.9; 4-year Historical 7.9; Baseline 6.0 (2007–12); 9.3 (2013–27).
  - Growth of imports (U.S. dollars, in percent): 10-year Historical 8.8; 4-year Historical 8.2; Baseline 7.1 (2007–12); 13.3 (2013–27).

- Box 1 — Baseline assumptions (numeric highlights)
  - Real GDP growth over 2007–2012 projected at 6 percent; longer run projected at 5.5 percent.
  - GDP deflator projected to increase at 9 percent over 2007–2012 in local currency terms and about 2.5 percent in U.S. dollar terms.
  - Fiscal consolidation: fiscal deficit reduced from 8½ percent of GDP in 2006 to 5 percent of GDP by 2010, and gradually to about 3 percent of GDP by 2027; primary fiscal surplus (excluding grants) achieved from 2011 onwards.
  - Revenue measures introduced in 2006–07 budgets increased revenue by about one percent of GDP in 2006 and another 1 percent of GDP expected in 2007.
  - Effective interest rates for public debt service assumed positive in real terms (averaged at about 2 percent).
  - Current account balance projected to decline from 5 percent of GDP in 2006 to about 3 percent of GDP by 2012 and remain at that level long-term.
  - Export value growth assumed at 9 percent over 2007–2012 and 8 percent over 2013–2027.
  - Import value growth projected at 9 percent over 2007–2012 and 8 percent over 2013–2027.
  - External reserves assumed at around 2–2½ months of imports of goods and services over the projection period.
  - External concessional financing expected to decline as ratio to GDP; baseline assumes net commercial borrowing from external creditors of about $100 million per year over 2008–12 and $200 million per year from 2013 onwards.
  - Net borrowing in dollars from domestic sources assumed at $300 million per year over 2008−2012 and $200 million per year from 2013 onwards.
  - Recent $500 million Eurobond issue is included on assumption of full refinancing when it falls due.
  - Mega infrastructure financing: $2.5 billion (out of targeted $4.5 billion) included in baseline over 2007−2012; debt financing from bilateral and multilateral sources on soft terms assumed; $1.5 billion of such financing committed as of mid-2007.

*Source: IMF staff assessments and Debt Sustainability Analysis materials contained in the annex.*

### 9.      The baseline scenario indicates medium-term external debt ratios are on a

### _cr07373 - 9.      The baseline scenario indicates medium-term external debt ratios are on a

### Baseline external debt trajectory and composition
- The baseline scenario indicates medium-term external debt ratios are on a sustainable path, reflecting a gradual decline in external concessional debt.
- Ratios of the NPV of PPG external debt, as a percent of GDP, exports, and revenues, are projected to decline over 2007–2027 and remain well below the indicative thresholds of debt distress for low-income countries with medium policy frameworks.
- The grant element in external debt is projected to fall continuously, together with a mild degree of debt decummulation given the projected extent of Sri Lanka’s market access.
- The baseline and historical scenarios reflect similar tendencies in the medium term over 2007–2012; in the longer term they diverge slightly as the historical scenario reflects the severe conflict, whereas the baseline reflects a moderate level of disruption to economic activity from any renewed conflict.
- Both scenarios indicate that debt stock ratios, including the planned mega infrastructure investments, would be contained even under a low-growth scenario as illustrated by the historical scenario.
- External debt-service ratios appear to be contained within the debt distress thresholds. Both debt-service ratios initially decline over 2007−2012 as concessional debt (including repayment of the Paris Club moratorium) is repaid, but subsequently rise from 2012 as repayments for the medium-term external commercial debt commences.
- The debt-service-to-revenue ratio rises subsequently, indicating that fiscal consolidation is key to containing debt service pressures in the long-term.

### IMF/World Bank indicative debt-burden thresholds (Medium performer) and comparison values
- Indicative Thresholds (Medium performer)200720122027
- NPV of debt/exports1501058428
- NPV of debt/GDP40342711
- NPV of debt/revenues25018613853
- Debt service/exports2010119
- Debt service/revenues30181816

### Stress tests on PPG external debt (sensitivity analysis)
- Sensitivity analyses show a contained trajectory for PPG external debt stock ratios but indicate potential vulnerabilities in the debt-service ratio under simultaneous shocks.
- A one standard deviation shock to the historical export value growth would increase the NPV of external debt to GDP to 40 percent in 2009.
- A combined shock on GDP, exports, the deflator and new borrowing, would increase the NPV of external debt to GDP to 47 percent in 2009.
- Stress tests on the debt-service indicators reflect increased vulnerability to export growth and combination shocks, particularly in 2012 when the most extreme test shows:
  - an increase in the debt-service ratio to about 17 percent of exports, and
  - an increase in the debt-service ratio to about 27 percent of revenues.

### Inclusion of public dollar-denominated commercial debt
- While the baseline external debt-service ratios are contained, total debt service in foreign exchange including for servicing the public dollar-denominated commercial debt is projected to increase sharply over 2008−2009.
- An illustrative simulation indicates that full refinancing of the end-2006 debt stock at existing maturities (about two years), with new money of $300 million each year over 2008-2012 and $200 million over 2013–2027, could increase debt service in total foreign exchange to close to the debt service distress threshold of 20 percent of exports over the medium term.
- Under the same scenario, debt-service to revenue would increase to 30–35 percent, above the debt distress threshold of 30 percent.
- Lengthening the maturity of this short-term debt to beyond three years will be essential to ease the bunching pressures in debt service going forward.
- A recent successful international bond issuance of $500 million at 5-year maturity (with a substantial oversubscription) is encouraging, indicating a favorable market appetite for longer-term dollar instruments from Sri Lanka; this issuance would also help set a benchmark for future issuance of longer term SLDBs.
- While FCD inflows are relatively stable, net annual inflows, at about $200–$300 million in recently years, limit the scope for raising additional funds from this source.
- As a result, Sri Lanka may need to continue to rely on international capital markets for funds, in which case an increase in global risk aversion could lead to a surge in risk premia.

### Public DSA — Baseline
- The baseline brings the path of the total central government debt to GDP from about 90 percent in 2007 to 69 percent in 2012, and further to about 32 percent in 2027.
- Under this scenario, NPV of debt-to-GDP, debt-to-revenue, and debt service-to-revenue are expected to decline at a similar rate.
- The main contributor to this improvement is fiscal consolidation and a continued growth/interest rate differential (as the real growth rate is assumed to exceed the real interest rate on government debt by about 3 percent, broadly similar to the historical average of the past 10 years).

### Public DSA — Stress tests
- Sensitivity tests indicate that a lack of fiscal consolidation could subject the baseline to substantial risks.
- Assuming the baseline growth rate, but with fiscal deficit staying around 7½ percent of GDP, the NPV of debt–to-GDP would decline to only about 83 percent by 2027, well above the values in the baseline.
- The NPV of debt-to-revenue and debt service-to-revenue ratios would also exceed the baseline values by substantial margins under this scenario.
- The baseline is also sensitive to interest rate shocks. A one standard deviation increase in the LIBOR and treasury rates (about 2 percentage and 3 percentage points, respectively) for 2008–09 increases debt service costs as a share of revenue by about 4 percent over 2011–17, narrowing to about 2 percent of revenue by 2027.

### Conclusion
- The baseline indicates declining debt stock ratios and contained debt-service ratios under central assumptions, but stress tests highlight vulnerabilities—especially in debt service—if export growth, interest rates, fiscal consolidation, or refinancing conditions deteriorate.

*Source: _cr07373 - 9.      The baseline scenario indicates medium-term external debt ratios are on a*

### 17.      Sri Lanka has a moderate risk of debt distress based on external debt service

### _cr07373 - 17.      Sri Lanka has a moderate risk of debt distress based on external debt service

### Risk assessment and main conclusion
- Sri Lanka has a moderate risk of debt distress based on external debt service indicators and a declining public debt stock to GDP under the baseline scenario of modest growth and fiscal consolidation.
- The public DSA suggests that overall debt dynamics are sustainable over the projection period (2007–2027) under the baseline.
- The risk of debt distress increases to moderate-to-high when the total debt service in foreign exchange is taken into account.
- Policy emphasis: "A credible fiscal consolidation path over the medium term, together with prudent macroeconomic policies to contain inflation and an effective debt management strategy to lengthening maturity, are critical to help reduce Sri Lanka’s high stock of debt and debt service burden."

### Indicators and projections (2004–2027; baseline and projections)
- Projection horizon: 2007–2027.
- Public sector debt (percent of GDP):
  - 2004: 107.5
  - 2005: 95.3
  - 2006: 94.7
  - 2007: 90.3
  - 2012: 82.2
  - 2017: 68.5
  - 2027: 31.8
- Public sector foreign-currency denominated (percent of GDP):
  - 2004: 56.1
  - 2007: 47.5
  - 2017: 39.5
  - 2027: 20.6
- NPV of public sector debt (percent of GDP):
  - 2007: 86.1
  - 2012: 74.1
  - 2017: 61.5
  - 2027: 24.5
- NPV of external debt (percent of GDP and of exports; selected values):
  - NPV of external debt (percent of GDP): 34.8, 35.5, 33.7, 32.4, 30.9, 29.5, 29.4, 23.7, 13.8 (series shown in table)
  - In percent of exports (series shown): 110.2, 110.1, 103.0, 98.3, 93.4, 89.4, 90.3, 68.0, 34.9
- Debt service ratios (selected series and observations):
  - Debt-service-to-exports ratio (in percent): 10.1, 7.4, 11.5, 12.1, 12.7, 11.3, 10.1, 8.7, 11.9, 11.4, 10.2 (series shown)
  - PPG debt service-to-exports ratio (in percent): 8.0, 5.0, 9.5, 10.1, 10.0, 9.4, 7.7, 7.5, 10.7, 9.5, 8.5
  - PPG debt service-to-revenue ratio (in percent): 18.8, 10.5, 17.6, 17.8, 17.7, 16.2, 13.1, 12.4, 17.5, 16.3, 16.1
- Total gross financing need (billions of U.S. dollars; selected series):
  - Series includes: 2.6, 2.9, 3.8, 4.4, 4.6, 4.8, 4.9, 4.9, 5.7, 8.4, 17.0

### Stress tests, alternative scenarios, and sensitivity analyses
- Figures and tables present indicators of public and publicly guaranteed external debt under alternative scenarios for 2007–2027, including:
  - Baseline, Threshold, Historical scenario, Most extreme shock (most extreme stress test is test that yields highest ratio in 2017).
- Sensitivity analyses reported for key indicators (2007–27) include:
  - Alternative scenarios: key variables at historical averages; new public sector loans on less favorable terms.
  - Bound tests: real GDP growth at historical average minus one standard deviation; export value growth shock; U.S. dollar GDP deflator shock; net non-debt creating flows shock; combination shocks; one-time 30 percent nominal depreciation relative to baseline in 2008.
- Selected bound-test and scenario outcomes (examples from tables, indices shown as series across projection years):
  - NPV of Debt-to-GDP ratio, NPV of Debt-to-Exports ratio, NPV of Debt-to-Revenue ratio, Debt service-to-exports ratio, Debt service-to-revenue ratio all reported under Baseline, A1, A2, B1–B6 scenarios across 2007–2027.

### Key macroeconomic and fiscal assumptions (series and values as reported)
- Real GDP growth (in percent; series across years and projections):
  - 5.4, 6.0, 7.4, 4.9, 2.5, 6.0, 6.0, 6.0, 6.0, 6.0, 6.0, 6.0, 5.5, 5.5, 5.5
- GDP deflator in U.S. dollar terms (change in percent; series):
  - 4.2, 10.7, 6.6, 2.0, 4.6, 2.5, 1.6, 2.1, 2.2, 2.8, 3.3, 2.4, 0.9, 0.9, 0.9
- Effective interest rate (percent; series):
  - 2.2, 1.6, 2.8, 2.7, 0.7, 2.8, 2.7, 2.7, 2.7, 2.7, 2.7, 2.7, 3.2, 4.1, 3.4
- Growth of exports of G&S (U.S. dollar terms, in percent; series):
  - 11.3, 8.3, 7.9, 6.0, 7.3, 10.9, 9.4, 8.9, 8.9, 8.6, 7.9, 9.1, 7.8, 7.8, 7.9
- Growth of imports of G&S (U.S. dollar terms, in percent; series):
  - 18.5, 10.5, 15.5, 7.1, 10.3, 10.2, 10.5, 8.2, 8.0, 7.9, 7.9, 8.8, 8.3, 8.1, 8.2
- Grant element of new public sector borrowing (in percent; series includes): 5.8, 17.6, 14.8, 13.6, 13.6, 6.7, 12.0, 9.2, 2.9, 7.4
- Aid flows and grants (billions of U.S. dollars; series includes zeros and small grant amounts):
  - Aid flows (in billions): 0.0 (series)
  - Of which: grants: 0.1, 0.3, 0.3, 0.2, 0.2, 0.1, 0.1, 0.2, 0.2, 0.2, 0.5
- Grant-equivalent financing (in percent of GDP; series):
  - 0.9, 1.1, 0.9, 0.8, 0.8, 0.6, 0.7, 0.5, 0.6
- Memorandum: Nominal GDP (billions of U.S. dollars; selected series):
  - 20.1, 23.5, 26.9, 29.3, 31.5, 34.1, 37.0, 40.3, 44.2, 60.4, 113.2

### Fiscal dynamics and debt drivers (selected values and contributions)
- Change in public sector debt (percent of GDP):
  - 2004: -0.4
  - 2005: -12.2
  - 2006: -0.6
  - 2007: -4.4
  - 2007–12 average and 2013–27 averages reported in tables (series shown).
- Identified debt-creating flows (percent of GDP; series):
  - -0.5, -8.8, -3.1, -3.6, -3.2, -3.6, -3.7, -4.3, -4.2, -2.3, -2.0
- Primary deficit (percent of GDP; series includes positive and negative values):
  - 1.8, 2.2, 2.0, 2.1, 1.1, 1.6, 0.3, -0.1, -0.6, -1.0, -0.9, -0.1, -0.8, -1.6, -1.0
- Revenue and grants (percent of GDP; series):
  - 15.8, 17.4, 18.1, 18.9, 19.1, 19.4, 19.8, 20.2, 20.3, 20.7, 21.4
- Automatic debt dynamics and contribution decomposition (selected items):
  - Automatic debt dynamics: -4.2, -11.5, -7.1, -5.2, -3.6, -3.5, -3.1, -3.3, -3.3, -1.4, -0.5
  - Contribution from nominal interest rate and real GDP growth and price/exchange rate changes shown in tables (series values preserved).

### Policy recommendations and priorities (as stated)
- Implement a credible fiscal consolidation path over the medium term.
- Maintain prudent macroeconomic policies to contain inflation.
- Adopt an effective debt management strategy to lengthen maturities and reduce the debt service burden.
- These measures are critical to reduce Sri Lanka’s high stock of debt and debt service burden and to lower the risk of debt distress, particularly when foreign-exchange debt-service obligations are considered.

*Source: IMF staff projections, simulations, and tables for Sri Lanka; Supplementary Information, Staff Report for the 2007 Article IV Consultation (2007).*

### 1.      This supplement provides information on recent economic developments that have

### _cr07373 - 1.      This supplement provides information on recent economic developments that have

### Recent Developments and Outlook
- CBSL revised down its real GDP growth projection to 6.7 percent for 2007, from the original projection of 7.5 percent and closer to the staff projection of 6 percent.
- Sectoral and demand developments:
  - Tea and rice production adversely affected by labor disputes and adverse weather conditions.
  - Tourism continued to suffer from the unsettled security situation.
  - Inflation sustained at around 22 percent in September, reflecting demand pressures, rising oil prices, and possibly an emerging wage effect following the minimum wage adjustment in May/June.
- Market and external position:
  - Sri Lanka issued its first medium-term sovereign bond of $500 million.
  - External reserves built up to $3.2 billion by mid-November (from $2.6 billion at end-September), covering 2.7 months of imports.
  - Rupee appreciated by about 2 percent since late October.
- Government debt management and money markets:
  - Government used the full amount of Rs. 56 billion from the bond issue to retire high interest rupee treasury bills held by the CBSL, reducing CBSL’s direct financing of the budget.
  - Treasury security rates fell to 15¾ percent in mid November, from a peak of 18¼ percent in early October.
  - Call money rates fell to 13–15 percent.
- External risk:
  - Continuing increases in international oil prices have heightened balance of payments risks.
  - Based on the latest WEO projections, the current account deficit is expected to widen to 5 percent of GDP in 2007 and 6½ percent of GDP in 2008.

### The 2008 Budget — Key Features and Risks
- Fiscal target:
  - 2008 budget proposal targets a marginal reduction in the fiscal deficit to 7.7 percent of GDP (from an estimated 7.8 percent of GDP in 2007).
  - This falls short of the authorities’ earlier plan to lower the deficit to 6.3 percent of GDP in 2008 (under the 2008 Budget Call announced in July).
  - Raises questions on feasibility of the medium-term plan to reduce the budget deficit to 5 percent of GDP by 2010.
- Revenue targets and measures:
  - Proposed tax revenue target: 17.7 percent of GDP in 2008 (from an estimated 16.3 percent in 2007).
  - New measures estimated to yield only about 0.6 percent of GDP.
  - Base-broadening and revenue-raising measures listed include:
    - Limiting tax holidays (allow existing 5-year tax holidays to lapse; restrict future tax holidays to 3 years for major investment only).
    - Broadening the income tax base and improving collection of tax arrears.
    - Significant increases in excises on motor vehicles and other consumer durables, telecommunication, and liquor and cigarettes, as well as fees and levies on services.
    - Trade measures: broadening of the cess regime and increase in surcharges on custom duties (could contribute to tax revenue but may distort the trade system).
  - Concessions and offsets included in the budget:
    - Numerous new tax concessions for fishery, gem and jewelry, shipping, and textile industries.
    - Waived VAT on all key development projects.
    - Substantially reduced VAT on petrol to partly offset impact of price adjustments required under the automatic formula.
- Expenditure projections and risks:
  - Recurrent expenditure is budgeted to be contained in real terms, but potential overrun is sizable (estimated at around 2 percent of GDP).
  - Subsidies:
    - Overall subsidies appear substantially underestimated.
    - Authorities decided to deviate from the automatic pricing formula for diesel and kerosene, starting from January 1, 2008.
    - Likely cost of this decision estimated at about 1 percent of GDP; budget seems to have omitted this cost (by applying the oil price at $70 per barrel).
    - Other subsidies, budgeted to decline by 0.4 percent of GDP from the level in 2007, also seem low.
  - Wages and allowances:
    - Provisions for wages and salaries, living and pension allowances seem low.
    - Planned new recruitment of an additional 15,000 college graduates into public service and additional funds to help resolve distressed debt of government employees.
    - Preliminary estimates indicate the costing of these policies could be around ½ percent of GDP.
  - Capital budget:
    - Ambitious capital budget is up by 2¾ percent of GDP (compared to the historical trend) or by 1¾ percent of GDP (compared to the projected level in 2007), which could provide a buffer.

### Staff Assessment, Scenarios, and Policy Recommendations
- Assessment of fiscal outlook and risks:
  - Staff indicates the 2008 budget deficit target of 7.7 percent of GDP is only a marginal consolidation (from 2007) and subject to significant risks of deficit overrun, with heightened risks for debt sustainability and that could adversely affect debt distress.
  - Even if tax revenue targets are fully met, there could still be a potential overrun in recurrent spending amounting to about 2 percent of GDP, mainly due to oil subsidies and wages and allowances.
  - To ensure credibility of the medium-term fiscal consolidation plan, authorities need to overperform the 2008 budget deficit target by about 1¼ percent of GDP to deliver the fiscal consolidation path planned earlier.
- Staff fiscal adjustment call:
  - Staff calls for a total fiscal adjustment of about 1¼ percent of GDP (after adjusting the buffer of 2 percent of GDP in the capital budget) to deliver the fiscal deficit of 6½ percent of GDP in 2008 as indicated in the Staff Report.
  - Implementing concrete revenue measures under the budget to deliver their intended targets will be crucial.
  - Additional measures to further streamline tax exemptions and broaden the VAT base may be needed to ensure that the impact of new tax incentives in the budget is fully compensated.
- Expenditure-side recommendations:
  - Staff urges authorities to conduct an early review of oil subsidies in light of recent developments in world oil prices.
  - The decision to deviate from the automatic pricing formula for diesel and kerosene in 2008 could expose the budget to large fiscal and quasi-fiscal risks, as recent increases in international oil prices seem unlikely to be reversed any time soon.
  - Authorities are encouraged to consider full, or at a minimum, substantial partial pass-through to contain these risks and to help promote energy conservation.
  - Strengthening the social safety net is recommended to protect the poor if pricing adjustments are implemented.

*Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2007/_cr07373.pdf*

### 12.      The new public hiring is expected to have a lasting impact on the budget. While

### 12.      The new public hiring is expected to have a lasting impact on the budget. While

### Fiscal impact and policy recommendations
- The new public hiring is expected to have a lasting impact on the budget; near term corrective measures may be required.
- The authorities should seek assistance from the World Bank to review the need for civil service reform, aimed at containing the overall wage bill in real terms as stipulated under the authorities’ medium-term consolidation plan.
- The fiscal deficit target for 2007 is 7.8 percent of GDP, a modest consolidation from 8.4 percent of GDP in 2006.
- The 2008 budget proposal targets a marginal reduction in the fiscal deficit to 7.7 percent of GDP; this falls short of the authorities’ earlier plan to lower the deficit to 6.3 percent of GDP in 2008 (under the 2008 Budget Call announced in July).
- Directors called for a determined effort to reduce the fiscal deficit to 5 percent of GDP by 2010–11.
- Recommended fiscal measures emphasized by Directors:
  - Revenue mobilization and current expenditure rationalization.
  - Streamlining tax exemptions.
  - Broadening the income and value added tax base.
  - Simplifying the value added tax.
  - Strengthening tax administration.
  - Containment of the wage bill.
  - Full or significant pass-through of international oil price movements to contain fiscal and quasi-fiscal risks.

### Summary of central government operations (Staff Report Projections, 2006–2011; in percent of GDP unless otherwise indicated)
- Total revenue: 17.1 (2006), 18.4 (2007), 18.3 (2008), 19.6 (2009), 18.6 (2010), 19.0 (2011), 19.4 (2012), 19.8 (2013)
- Tax revenue: 15.3 (2006), 16.6 (2007), 16.3 (2008), 17.7 (2009), 16.8 (2010), 17.2 (2011), 17.6 (2012), 18.0 (2013)
  - Income taxes: 2.9 (2006), 3.1 (2007), 3.4 (2008), 3.7 (2009)
  - Value added tax/GST: 5.9 (2006), 6.2 (2007), 6.1 (2008), 6.5 (2009)
  - Excise taxes: 3.3 (2006), 3.3 (2007), 3.3 (2008), 3.5 (2009)
  - Taxes on international trade: 1.9 (2006), 2.2 (2007), 1.8 (2008), 1.9 (2009)
  - Other: 1.4 (2006), 1.8 (2007), 1.7 (2008), 2.1 (2009)
- Nontax revenue: 1.7 (2006), 1.8 (2007), 1.9 (2008), 1.9 (2009), 1.8 (2010), 1.8 (2011), 1.8 (2012), 1.8 (2013)
- Total expenditure and net lending: 25.5 (2006), 27.7 (2007), 26.0 (2008), 27.3 (2009), 24.9 (2010), 24.5 (2011), 24.3 (2012), 24.0 (2013)
- Current expenditure: 19.6 (2006), 18.4 (2007), 19.0 (2008), 18.6 (2009), 18.4 (2010), 18.0 (2011), 17.8 (2012), 17.5 (2013)
  - Civil service wages and salaries: 4.1 (2006), 3.8 (2007), 4.1 (2008), 3.8 (2009), 3.9 (2010), 3.9 (2011), 3.9 (2012), 3.9 (2013)
  - Other civilian goods and services: 1.1 (2006), 1.4 (2007), 1.3 (2008), 1.4 (2009), 1.3 (2010), 1.3 (2011), 1.3 (2012), 1.3 (2013)
  - Security related expenditure: 3.8 (2006), 4.1 (2007), 4.2 (2008), 3.8 (2009), 3.9 (2010), 3.9 (2011), 3.8 (2012), 3.8 (2013)
  - Subsidies and transfers: 5.1 (2006), 3.9 (2007), 4.2 (2008), 4.2 (2009), 3.8 (2010), 3.7 (2011), 3.7 (2012), 3.7 (2013)
    - Households: 3.7 (2006), 3.1 (2007), 3.3 (2008), 3.2 (2009)
    - Pensions: 1.9 (2006), 2.1 (2007), 1.9 (2008), 2.0 (2009), 2.0 (2010), 2.0 (2011), 2.0 (2012)
- Interest payments 1/: 5.4 (2006), 5.2 (2007), 5.2 (2008), 5.5 (2009), 5.5 (2010), 5.2 (2011), 5.1 (2012), 4.8 (2013)
  - Foreign: 0.6 (2006), 0.7 (2008), 0.8 (2009), 0.7 (2010), 0.7 (2011), 0.7 (2012)
  - Commercial: 0.4 (2006), 0.4 (2008), 0.4 (2009), 0.4 (2010), 0.4 (2011)
  - Domestic: 4.8 (2006), 4.1 (2008), 4.7 (2009), 4.4 (2010), 4.1 (2011), 4.1 (2012), 3.8 (2013)
- Capital expenditure and net lending: 5.9 (2006), 3.9 (2007), 7.0 (2008), 8.7 (2009), 6.5 (2010), 6.5 (2011), 6.5 (2012), 6.5 (2013)
  - Of which: tsunami: 0.8 (2006), 0.7 (2007), 0.4 (2008), 0.0 (2009), 0.1 (2010), 0.0 (2011), 0.0 (2012), 0.0 (2013)
  - Mega projects: 3.6 (2006), 1.6 (2007), 3.7 (2008), 1.5 (2009), 1.5 (2010), 1.5 (2011), 1.5 (2012)
- Overall balance: -8.4 (2006), -9.2 (2007), -7.8 (2008), -7.7 (2009), -6.3 (2010), -5.5 (2011), -4.9 (2012), -4.2 (2013)
- Overall balance (without tsunami measures) 1/: -7.6 (2006), -8.6 (2007), -7.4 (2008)
- Financing: 8.4 (2006), 9.2 (2007), 7.8 (2008), 7.7 (2009), 6.3 (2010), 5.5 (2011), 4.9 (2012), 4.2 (2013)
  - Net external financing: 1.5 (2006), 3.7 (2007), 3.7 (2008), 2.9 (2009), 1.9 (2010), 1.9 (2011), 1.7 (2012), 1.5 (2013)
  - Net commercial borrowing: 1.9 (2006), 0.0 (2007), 0.0 (2008), 1.0 (2009), 0.9 (2010), 0.8 (2011), 0.7 (2012)
  - Net other domestic financing: 3.9 (2006), 4.8 (2007), 3.3 (2008), 4.0 (2009), 3.0 (2010), 2.3 (2011), 2.0 (2012), 1.6 (2013)
  - Grants: 1.1 (2006), 0.7 (2007), 0.8 (2008), 0.8 (2009), 0.5 (2010), 0.4 (2011), 0.4 (2012), 0.4 (2013)
- Memorandum items:
  - Current account balance (excluding grants): -2.5 (2006), 0.1 (2007), -0.8 (2008), 1.0 (2009), 0.2 (2010), 1.0 (2011), 1.6 (2012), 2.3 (2013)
  - Primary balance (excluding grants): -3.0 (2006), -4.0 (2007), -2.6 (2008), -2.2 (2009), -0.8 (2010), -0.3 (2011), 0.2 (2012), 0.6 (2013)
  - Primary balance (including grants): -2.0 (2006), -3.3 (2007), -1.8 (2008), 0.1 (2009), -0.3 (2010), 0.1 (2011), 0.6 (2012), 1.0 (2013)
  - Nominal GDP (in billions of rupees): 2,802 (2006), 3,242 (2007), 3,311 (2008), 3,825 (2009), 3,825 (2010), 4,420 (2011), 5,106 (2012), 5,900 (2013)
  - Total debt: 94.7 (2006), 93.3 (2007), 90.1 (2008), 91.8 (2009), 86.2 (2010), 85.7 (2011), 80.9 (2012), 75.7 (2013)
  - Of which: domestic debt: 54.3 (2006), 51.7 (2007), 49.2 (2008), 50.7 (2009), 46.5 (2010), 47.1 (2011), 43.6 (2012), 40.1 (2013)

### Macroeconomic performance, outlook, and risks
- Recent performance:
  - Real GDP growth: 5.4 (2004), 6.0 (2005), 7.4 (2006); projected 6.0 (2007), 6.0 (2008)
  - Inflation (Sri Lanka CPI; average): 7.9 (2004), 10.6 (2005), 9.5 (2006); 17.7 (2007), 11.5 (2008)
  - Inflation (Sri Lanka CPI; end-of-period): 16.8 (2004), 3.6 (2005), 17.9 (2006); 13.0 (2007), 11.0 (2008)
- The economy may be operating at full capacity given rising inflation, a low unemployment rate, and a high current account deficit.
- Key risks to near-term growth-inflation outlook: high oil prices, slow fiscal consolidation, and security concerns.

### Monetary policy and financial sector stability
- Monetary policy tightening in 2006 was insufficient to contain inflation; CBSL announced a “Road Map” in January 2007 aiming to reduce inflation to single digit levels by year-end.
- Policy actions: limited banks’ access to reverse repo window; strengthened prudential measures; stepped up open market operations; treasury rates allowed to increase to 17½ percent during January-June (from 12½ percent at end-2006).
- Inflation decelerated to (annualized) single digits in the first four months of 2007, then rose to 21¾ percent (yoy) in August due to elimination of fuel subsidies, food price increases, and a pause in further monetary tightening.
- Directors recommended further monetary tightening in the near term; step up open market operations; allow treasury security rates to adjust; gradually align policy rates with market interest rates; improve coordination of fiscal and monetary policies.
- Financial sector progress:
  - Sharp decline in NPL ratios across banks.
  - Marked strengthening in capital base of the banking industry.
  - Sustained improvement in banks’ operating profits.
  - Implementation of the Basel Core Principles progressed to facilitate planned adoption of Basel II in 2008.
- Remaining concerns and recommended actions:
  - Improve banking sector resilience by improving asset quality and strengthening credit and liquidity risk management.
  - Strengthen risk-based supervision.
  - Advance structural and operational restructuring in public banks and limit state interference.
  - Some Directors renewed calls for privatization of state-owned banks.

### External position, debt composition, and reserves
- External current account deficit projected to sustain around 5 percent of GDP in 2007; reserves expected to remain around 2½ months of imports.
- Government resorted to dollar-denominated borrowing; by end-2006 public domestic dollar commercial debt reached $1.6 billion (or 6 percent of GDP) at an average maturity of 1½ years.
- Over 90 percent of this debt was financed from domestic sources, including remittances.
- October issuance: first $500 million international sovereign bond at a yield of 8¼ percent and maturity of 5 years.
- Directors noted significant risk of public debt distress from heavy reliance on dollar-denominated, short-term commercial debt; recommended lengthening and smoothing maturity profile and improving debt management.
- Exchange rate: Directors considered the real effective exchange rate broadly in line with fundamentals; recommended greater exchange rate flexibility, limited intervention for smoothing, and elimination of remaining import margin requirement on motor vehicles.

### Energy sector and public enterprise issues
- Financial viability of the energy sector central to fiscal consolidation and debt sustainability.
- Ceylon Electricity Board (CEB) likely to incur financial losses of about 20 billion rupees (¾ percent of GDP) in 2007 due primarily to lack of electricity tariff adjustment.
- Losses financed by loans from public banks, posing risks to the financial sector.
- Medium-term strategy: use alternative and cheaper energy sources; construction of three coal power plants (total 900 MW) expected to be completed during 2008–10.
  - Expected outcome: address acute energy shortage and significantly lower cost of energy production (by about one-third from the current level) and bring CEB to cost recovery levels.
- Directors called for timely measures to address current financial imbalances in CEB, including adjustment of electricity tariffs to cost-recovery levels accompanied by adoption of an appropriate safety net to protect the poor.
- Directors were concerned that deviating from automatic pricing formula for diesel and kerosene in 2008 could expose the budget to large fiscal and quasi-fiscal risks if international oil prices remain high.

### Executive Board assessment (summarized)
- Directors welcomed impressive recent growth and reduction in unemployment, but noted it was underpinned in part by expansionary fiscal and monetary policies, increasing macroeconomic and external vulnerabilities.
- Key assessments and recommendations:
  - Tighten macroeconomic policies; return to political stability important.
  - Aim for fiscal deficit reduction to 5 percent of GDP by 2010–11.
  - Prioritize revenue mobilization, current expenditure rationalization, and tax reforms.
  - Lengthen and smoothen debt maturity profile and improve debt management.
  - Further monetary tightening warranted; improve coordination with fiscal policy.
  - Continue financial sector reforms per FSAP update; prepare for Basel II adoption in 2008; accelerate restructuring of state-owned banks and limit state interference.
  - Support the authorities’ Ten-Year Horizon Development Plan (2006–2016) and build consensus on policy mix.

*Sources: Data provided by the Sri Lankan authorities; and staff estimates.*

### 1. The Executive Director’s office and the Sri Lankan authorities wish to express their

### _cr07373 - 1. The Executive Director’s office and the Sri Lankan authorities wish to express their

### Appreciation and data notes
- The Executive Director’s office and the Sri Lankan authorities express appreciation to the staff for a well focused set of papers, and thank the Executive Board and the Management of the Fund for useful advise and assistance to Sri Lanka.
- GDP data used are estimates compiled by the Department of Census and Statistics (DCS) of Sri Lanka.
- Authorities decided in early 2007 to use DCS GDP estimates for timely release; DCS GDP data for 2006 were used for comparison.
- Numbers in this report may differ marginally from those in the Staff Reports.

### Recent economic developments and outlook
- Growth
  - Growth in 2006: 7.7 percent.
  - Growth in first six months of 2007: 6.2 per cent.
  - Projected growth for 2007: 6.7 per cent.
  - Growth is broad based: manufacturing and services sectors growing faster; agriculture contributing positively.
- Labor market
  - Unemployment rate in Q1 2007: 6.2 per cent (record low).
  - Unemployment rate in Q2 2007: 6.5 per cent (marginal rise due to decline in agriculture employment).
  - Outlook: unemployment expected to remain low due to job creation in manufacturing and services.
- Inflation and monetary policy
  - Inflation decelerated until June 2007, reversed since July 2007 due to upward adjustments in certain administered prices and removal of subsidies on diesel and kerosene.
  - Removal of subsidies expected to reduce inflationary financing of the Government budget and contribute to lowering inflation in the future.
  - Authorities announced a “Road Map for Monetary and Financial Sector Policies for 2007 and Beyond” targeting containment of money supply growth and to bring down inflation to a single digit level by end 2007.
  - Central Bank policy: tight stance; policy interest rates raised by 50 basis points during the year; aggressive open market operations to maintain desired market liquidity.
  - Reserve money targets achieved during the first three quarters of the year.
  - Steps taken to strengthen Central Bank communication through regular and occasional press releases.
- Fiscal policy
  - Tax revenue increase in first nine months of 2007: 20.9 per cent.
  - Recurrent expenditure expected in 2007: 17.8 per cent of GDP.
  - Recurrent expenditure in 2006: 18.7 per cent of GDP.
  - Overall fiscal deficit trend:
    - 2001: 10.8 per cent (declining steadily since).
    - 2006 overall deficit: 8.1 per cent of GDP.
    - Revised Government Budget 2007 projects overall deficit: 7.2 per cent of GDP.
    - Budget 2008 proposes overall deficit: 7.0 per cent of GDP.
  - Measures: strengthen tax administration, streamline tax incentives and exemptions, enhance tax compliance and enforcement, rationalize expenditure while maintaining adequate public investment.
- Exchange rate and external competitiveness
  - Authorities committed to a market determined exchange rate with limited intervention to smooth excessive volatility.
  - Staff estimates indicate current REER broadly in line with economic fundamentals.
  - Import margin requirement (50 per cent) introduced in October 2006 on selected goods was removed in May 2007.
  - 100 per cent margin requirement maintained on selected vehicle imports as a prudential measure.
- External sector and balance of payments
  - Oil import bill accounted for 20 per cent of imports in 2006.
  - Petroleum subsidies removed; domestic petroleum prices allowed to align with international prices since July 2006.
  - Export growth in first 8 months of 2007: 11.7 per cent.
  - Import growth in first 8 months of 2007: 3.5 per cent.
  - Remittances growth: 17 per cent; financed over 80 per cent of the trade deficit.
  - Foreign direct investment in 2006: US$ 604 million (record level).
  - Overall BOP surplus in first half of 2007: US$ 192 million.
  - Projected overall BOP surplus by end 2007: US$ 450 million.
  - Gross official reserves:
    - End-2006: US dollars 2,526 million.
    - Expected end-2007: US dollars 2,971 million.
- Public debt
  - Public debt outstanding in 2004: 102.5 per cent of GDP.
  - Outstanding Government debt projected for 2007: 85.5 per cent of GDP.
  - Authorities mindful of Debt Sustainability Analysis issues.

### Financial sector developments and stability
- General developments
  - Financial sector expansion supported by increased competition, innovations, and economic growth.
  - Banking sector indicators (profitability, capital, asset quality) improved.
  - Some volatility observed in money, exchange and capital markets due to market uncertainty and high inflation expectations.
- Regulatory and infrastructure improvements
  - Measures adopted to improve risk management, enhance access to finance, strengthen payments and settlement systems, and improve supervision and regulation.
  - Inter Regulatory Institutions Council set up in early 2007 for effective regulation of financial conglomerates.
  - Real Time Gross Settlement System operated with almost 100 per cent system availability.
  - Cheque imaging and truncation system operational since early 2007.
  - Scripless security settlement system and central depository system for government securities in place.
- State-owned banks and privatization stance
  - Authorities do not consider privatization a panacea; instead they granted commercial autonomy to two state owned banks which performed extremely well in 2006.
  - Financial performance of the two state banks in 2006 outclassed many private and foreign banks.
- Liberalization and standards
  - Foreign investors permitted to invest in Sri Lanka Rupee denominated Government Securities subject to a limit.
  - New Companies Act enacted in 2007 incorporating international best practices.
  - Implementation of Basel II from January 2008, adoption of a mandatory Code of Corporate Governance for banks, and move towards International Accounting Standards for financial reporting expected to strengthen stability.
- International bond issuance
  - Debut international bond issue: US$ 500 million launched last month (relative to document timing).
  - Issuance received an overwhelming response despite adverse market conditions such as the subprime crisis.
  - Proceeds intended for infrastructure projects including a sea port, two power plants, two highway projects and several irrigation projects approved in Budget 2007.
- FSAP engagement and assessment
  - Authorities requested FSAP update due to improvements since initial 2002 assessment.
  - Authorities engaged in major reforms; legislative changes and reforms have strengthened regulatory and supervisory capacity.
  - Authorities broadly agree with FSAP observations; specific comments on two ROSCs noted in Appendix I and Appendix II to the FSAP.
  - Two highlighted authority positions:
    - (a) Privatization is not the only way to improve SOE performance; greater autonomy and operational independence can achieve improvements (citing state bank performance).
    - (b) Presence of the Secretary to the Treasury on the Central Bank board does not pose conflict of interest or lack of independence; it ensures policy consistency and close co-operation between the Central Bank and the Ministry of Finance.
- Commitment
  - Authorities will continue implementing policies and changes to strengthen financial system stability and resilience.

### Structural issues, reforms, and future directions
- Structural reforms and public administration
  - Strategic Enterprise Management Agency introduced reforms in public enterprises.
  - IT systems introduced in registration of births, marriages and deaths and in database management.
  - Legal reform project underway; several regional Appeal Courts set up in the year to accelerate appeal proceedings.
- Development framework and infrastructure strategy
  - Future economic direction framed under “Mahinda Chintana, vision for a new Sri Lanka, a Ten Year Horizon Development Framework 2006-2016”.
  - Strategy built on free market concepts with support for domestic enterprises including SMEs and encouragement of foreign investment.
  - Authorities expect to maintain high economic growth, ensure regionally balanced growth, and improve livelihoods including for those in abject poverty.
  - Key infrastructure projects embarked upon in power generation, irrigation, highways, ports and airports.
- Regional trade and ISLFTA/CEPA negotiations
  - Efforts to widen Indo-Sri Lanka Free Trade Agreement (ISLFTA) beyond goods to include services under Comprehensive Economic Partnership Agreement negotiations with India.
  - Issues being negotiated: relaxation of rules of origin, reduction of the existing negative list, implementation issues under ISLFTA, Customs co-operation and trade facilitation, dispute resolution, and preferential safeguard measures.
  - Authorities view these measures as facilitating further trade expansion, particularly with regional partners.

*Source: _cr07373 - 1. The Executive Director’s office and the Sri Lankan authorities wish to express their*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2007/_cr07373.pdf_