## _cr09310

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---

### Context: nature of the shock and macroeconomic backdrop
- Nature of the shock
  - Years of lax fiscal policy led to increasing reliance on short-term financing from international markets; the global financial shock caused a sudden stop to this financing and capital outflows.
  - Central bank intervened heavily to defend the exchange rate, with reserves reaching dangerously low levels.
  - Loss of competitiveness and a sharp fall in demand for Sri Lankan exports likely increased pressure on reserves and the balance of payments gap.
- Growth and inflation
  - Growth: fall from 6 percent in 2008 to 3 percent in 2009; end of conflict expected to boost activity with full impact unlikely until next year.
  - Inflation: peaked at 28 percent in June 2008; declined to single digits in 2009; recorded one percent in June 2009.
- External sector, capital flows, and reserves
  - Current account deficit projected to narrow to 1¼ percent of GDP in 2009 from 9½ percent in 2008 despite an expected 13 percent decline in merchandise exports.
  - Real effective exchange rate appreciation peaked at 22 percent in March 2009, falling to 19 percent in June 2009.
  - Q3 2008: > $400 million in nonresident holdings of government t-bills redeemed; ~ $225 million in syndicated loans not rolled over.
  - Additional $550 million of official and private external debt service due in second half of 2009.
  - CBSL foreign exchange reserves: peak ~$3½ billion mid-2008 → around $900 million in March 2009 → recovered to $1½ billion (about 7 weeks of imports) after purchases.
- Financial sector
  - Failure of an unregulated finance company early 2009 led to deposit withdrawals from Seylan Bank; central bank takeover stabilized short-run liquidity.
  - System-wide asset quality deterioration and contagion risks from smaller finance companies remain concerns; non-performing loans for larger banks have begun to rise though banks remain well capitalized and liquid.
- Conflict and political situation
  - Military campaign against the LTTE is over (May 2009); post-conflict era requires humanitarian relief, resettlement, political reconciliation.
  - Local government elections in the Northern province scheduled for August 2009.

### Policies: current stance and near-term measures
- Fiscal stance and risks
  - Average central government deficit in recent years around 8 percent of GDP.
  - Without adjustment 2009 deficit would deteriorate to more than 9 percent of GDP.
  - 2009 budget reduced VAT from 15 percent to 12 percent—additional revenue loss of ¾ percent of GDP—and included a temporary stimulus estimated at about ¼ percent of GDP.
  - Public sector gross debt around 80 percent of GDP.
  - Government pledged deficit reduction to 5 percent of GDP by 2011 but actions to achieve this not yet sufficient.
- Specific 2009 revenue and expenditure measures (total yield and commitments)
  - Revenue measures (total yield 1¼ percent of GDP for remainder of 2009):
    - Nation building tax rate: from 1 percent to 3 percent effective May 2009 → yield 2/3 percent of GDP for remainder of 2009. This measure is fully in place.
    - Raising excise taxes on liquor, cigarettes, and selected items effective April 2009 → expected yield ¼ percent of GDP for remainder of 2009. Implemented.
    - Repeal of import margin requirements and increase in cesses and trade taxes → expected yield 1/3 percent of GDP. Implemented.
  - Expenditure measures:
    - Commit to cut spending by ½ percent of GDP relative to 2008 budget outturn while maintaining capital spending.
    - Protect vulnerable groups; social sector spending targeted to increase to 7 percent of GDP in 2009 from 6.8 percent in 2008.
    - Immediate relief and expanded social safety nets to resettle displaced persons.
  - Performance Jan–Apr 2009:
    - Revenues ~10 percent below same period last year due to collapse in tax-yielding imports.
    - Expenditures ~28 percent higher, driven by repayments of domestic debt contracted at higher nominal interest rates and drying up of lower cost external funding.
    - Central government deficit during this period ≈ 4 percent of annual GDP.
    - Sharp decline in interest rates—from above 17 percent at end-2008 to approximately 11½ percent at end-April—expected to reduce domestic interest bill.

### Program objectives, financing, and modalities
- Program goals
  - Rebuild reserves, restore export competitiveness, reverse budget deterioration, and address financial sector problems.
  - Bring credible deficit reduction for debt sustainability while ensuring resources for post-war reconstruction.
  - Rebuild reserves to prudent levels while allowing orderly exchange rate adjustment.
  - Put in place framework for financial sector soundness and bank resolution.
- IMF financing and access
  - Exceptional access requested: 400 percent of quota (SDR 1.65 billion) during 20-month Stand-By Arrangement.
  - Proposed flat purchase schedule; first purchase around $313 million (SDR 206.7 million).
  - With access at this level, the program would be fully financed.
- Other donor financing (selected figures)
  - World Bank: ~ $100 million earmarked for existing Northern province projects; additional $225 million annually earmarked for sectoral projects (could be used for reconstruction if requested).
  - AsDB: $160 million loan agreement for power sector; possible up to $150 million in budget support (with co-financing from Japan) once Fund program approved.
  - Japan: continued annual lending program of about ¥25-30 billion for infrastructure.

### Fiscal path and 2010–2011 measures
- Deficit targets
  - Authorities committed to central government budget deficit of 5 percent of GDP by 2011.
  - Targets: 7 percent for 2009 (vs baseline 9½ percent and deficit of 7¾ percent in 2008), 6 percent for 2010.
- Table (selected program targets, percent of GDP)
  - Program revenue target: 2008: 14.9; 2009: 14.8; 2010: 15.4; 2011: 16.0
  - Total revenue without adjustment: 2008: 13.7; 2009: 13.8; 2010: 14.0
  - Additional revenue needed: 2008: 1.1; 2009: 1.6; 2010: 2.0
  - Nation building tax yields: 2008: 0.6; 2009: 0.8; 2010: 0.9
  - Excise taxes yields: 0.2 (2008), 0.2 (2009), 0.2 (2010)
  - Cesses and other surcharges yields: 0.3 (2008), 0.3 (2009), 0.3 (2010)
  - Remaining revenue gap: 2008: 0.0; 2009: 0.3; 2010: 0.7
  - Program expenditure target: 2008: 22.6; 2009: 21.9; 2010: 21.5; 2011: 21.0
  - Total expenditure without adjustment: 2008: 23.2; 2009: 23.2; 2010: 23.5
  - Additional expenditure cuts needed: 2008: 1.4; 2009: 1.7; 2010: 2.5
  - Expenditure measures agreed: 2008: 0.9; 2009: 0.2; 2010: 0.1
  - Remaining expenditure gap: 2008: 0.0; 2009: 1.5; 2010: 2.4
  - Program deficit target: 2008: 7.7; 2009: 7.0; 2010: 6.0; 2011: 5.0
  - Deficit without adjustment: 2008: 9.5; 2009: 9.4; 2010: 9.5
  - Adjustment required: 2008: 2.5; 2009: 3.4; 2010: 4.5
  - Identified adjustment: 2008: 2.5; 2009: 1.5; 2010: 1.4
  - Remaining gap: 2008: 0.0; 2009: 1.9; 2010: 3.1
- Tax commission and 2010 budget timing
  - President formed a tax commission to review tax policy, strengthen collection/auditing/enforcement, simplify tax system, review VAT with intention to broaden base.
  - Interim report to be discussed during second program review; budget for 2010 expected finalized in November 2009.
  - Government requested FAD technical assistance on tax policy issues.

### Expenditure-side adjustments and public enterprises
- Expenditure adjustments
  - Expected savings from security-related spending and reduction in transfers.
  - Authorities to discuss measures ahead of 2010 budget during first review.
- CEB and CPC objectives and steps
  - Combined deficit for CEB and CPC expected to decline in 2009 with fall in oil prices.
  - Government goal: balanced budgets for these enterprises by 2011.
  - Steps: independent electricity regulator established March 2009; move toward lower cost generation; retail petrol and diesel prices raised by 5-10 percent in July 2009; mechanism for regular review of operational cash flows; commitment to tariff/management/operation adjustments; subsidies targeted and transparently reflected in budget.
  - Joint Review Mechanism committee expected to complete report by mid-August 2009.
  - Plan to address outstanding debts between key SOEs by end-December 2009.

### Reconstruction needs, priorities, and financing
- Reconstruction scale and plans
  - Reconstruction needs require substantial multi-year effort; government formed high-level task force for needs assessment.
  - 2009 fiscal allocation: Rs. 18 billion allocated to reconstruction spending in the North; Rs. 18 billion equals 2 percent of projected central government spending; majority used for humanitarian assistance and resettlement of IDPs.
  - Needs assessment expected by end-July 2009.
  - Evidence from Eastern province suggests reconstruction needs could be about 1 percent of GDP per year.
- Financing sources for reconstruction:
  - Revenue enhancements.
  - Savings in military spending of approximately ¾ -1 percent by 2011.
  - External financing in the form of concessional loans and grants from development partners.
- Selected Box 1 points (Northern province)
  - Humanitarian priorities: estimated 300,000 IDPs in camps; resettlement goal: 70-80 percent of IDPs within 180 days.
  - Strategy built on four Ds: (i) demilitarization; (ii) development; (iii) democratization; (iv) devolution.
  - Institutional arrangements: Presidential Task Force for Resettlement, Development, and Security in the Northern province leads reconstruction; consultative committee of humanitarian assistance advises on humanitarian assistance and basic services to IDPs.
  - Authorities plan to approach donors once needs assessment completed.

### Exchange rate policy, reserves, and restoring external competitiveness
- Reserve and exchange rate objectives
  - Reserve target: rebuild to more than 3½ months of imports ($4 billion) by end of program period.
  - Exchange rate to be sufficiently flexible to address loss of competitiveness (notably in garments) and allow orderly adjustment.
  - Program adjusts net international reserve targets upward to allow reserve buildup to come through current account adjustment rather than external borrowing.
  - Consultation clause: staff to be consulted if supply-demand gaps produce a more sudden and disruptive depreciation than anticipated.
- Monetary policy anchor
  - With floating exchange rate regime and absence of effective interest rate transmission, base money will continue to anchor monetary policy.
  - Program monetary targets aim to control inflation while ensuring adequate credit to private sector.

### Financial sector reforms and bank resolution
- Immediate and planned measures
  - Resolve issues from Seylan Bank takeover: CBSL directed Seylan Bank to issue Rs. 3 billion in share capital to recapitalize the bank.
  - Consolidate weak finance and leasing companies to avoid spillovers.
  - Develop contingency plan for potential system stresses.
  - Strengthen capital requirements and integrated risk management frameworks; amend laws to improve bank resolution framework and supervisory gaps in banking, credit card, and finance company sectors.
- Structural benchmarks (selected, dates)
  - Recapitalization of Seylan Bank through a public share issuance — Structural Benchmark — 9/30/2009.
  - Contingency plan for orderly workouts — SB — 9/30/2009.
  - Approval by Monetary Board of revised Banking Act and related laws — SB — 9/30/2009.
  - Submission by tax review commission of interim report — SB — 10/15/2009.
  - Develop plan to address outstanding debts between CEB, CPC and state-owned banks — SB — 12/31/2009.
  - Submission to parliament of revised Finance Company Act — SB — 12/31/2009.
  - Issuance of prudential regulations to credit card companies and payment service providers — SB — 12/31/2009.
  - Submission to parliament of the 2010 budget consistent with program targets — SB — 12/31/2009.

### Social policies and safeguards
- Social protection priorities
  - 15 percent of the population below the poverty line; protect social transfer expenditures to the most vulnerable.
  - Safety net: Samurdhi program, limited social welfare/care services, disaster relief to displaced persons.
- Safeguards
  - Safeguards assessment (May) found CBSL developed a relatively strong safeguards framework; CBSL committed to implementing recommendations focusing on external audit and data reporting.

### Conditionality, monitoring, and performance criteria
- Conditionality focus
  - Quantitative and qualitative conditionality oriented to achieving programmed deficit reduction, building reserves, restoring external viability, and safeguarding financial sector stability.
  - Reviews based on quantitative performance criteria assessed quarterly; first two reviews require observance of quantitative criteria for end-July 2009 and end-September 2009.
- Prior actions implemented (selected)
  - Removal of import margin requirements.
  - Amendments to Nation Building Tax: raise rate from 1 to 3 percent.
  - Amendments to excise taxes on liquor, cigarettes and other items.
  - Harmonize penal rate for commercial bank borrowing from CBSL with reverse repo rate.
  - CBSL ceased sales to the foreign exchange market and purchased > $400 million since March.
- Quantitative performance criteria and indicative targets (selected figures)
  - Net international reserves (NIR) of CBSL (floor, cumulative change from beginning of year, in million US$): -1,385; -109; -13; -785
  - Reserve money of CBSL (ceiling, eop stock, in million rupees): 268,425; 274,130; 280,370; 300,525; 310,886
  - Net domestic financing (NDF) of central government (ceiling, cumulative, in million rupees): 314,289; 282,004; 305,001; 331,817; 82,234
  - Continuous performance criterion: Contracting and guaranteeing of medium and long-term non-concessional external debt by the government (ceiling, cumulative from end-April 2009, in million US$): ... 1,750; 1,750; 1,750; 1,750
  - Indicative target: Overall balance of CEB and CPC (floor, cumulative, in million rupees): -49,847; ......; -35,387; ...

### Debt sustainability, risks, and staff assessment
- Staff judgment: Sri Lanka at moderate risk of external debt distress over 2009–14.
- Key public debt and fiscal indicators (selected annual values)
  - Public sector debt (percent of GDP): 98.4 (2005); 94.9 (2006); 90.7 (2007); 86.5 (2008); 90.5 (2009); 93.0 (2010); 88.2 (2011); 84.6 (2012); 80.5 (2013).
  - Revenues (incl. grants, percent of GDP): 16.6 (2005); 17.3 (2006); 16.6 (2007); 14.9 (2008); 15.0 (2009); 15.6 (2010); 16.2 (2011).
  - Gross financing need (percent of GDP): 42.1 (2005); 39.2 (2006); 36.4 (2007); 36.4 (2008); 34.7 (2009); 35.4 (2010); 31.0 (2011).
- Debt portfolio risks and recent evolution
  - Public debt nearly doubled since 2000; shift toward domestic debt issuance in 2008 when international markets closed.
  - Nominal domestic interest rates rose to almost 19 percent on T-bills and T-Bonds in 2008.
  - Domestic interest costs estimated to be over 26 percent of government expenditures in 2009.
  - More than 40 percent of domestic debt maturing in 2009—significant roll-over risk.
  - Stock of U.S. dollar denominated domestic debt increased to about 10 percent of total portfolio.
- DSA baseline assumptions and outcomes
  - Growth projected 2008–2013: 5.3 percent average; current account deficit average 2.7 percent of GDP during 2008–2013.
  - Foreign exchange reserves projected > 3.7 months of import coverage by end-2010.
  - External debt indicators remain below indicative thresholds under program baseline but are sensitive to fiscal execution, export performance, and exchange rate shocks.
- Policy implication: effective implementation of fiscal consolidation and a pro-active medium-term debt management strategy required to reduce costs and risks, extend maturities, and limit reliance on commercial borrowing.

### Key macro projections and statistics (selected figures)
- Main exports (percent of total, 2008): garment (43), tea (16)
- GDP per capita (2008, est.): US$1,972
- Unemployment rate (2008): 5.4 percent
- Poverty rate (2007, incidence): 15.2 percent
- FDI (2008, est.): $691 million
- Public debt (2008): 81.1 percent of GDP
- Selected macro projections (Real GDP growth, 2006–2011): 7.7; 6.8; 6.0; 3.0; 5.0; 6.5
- Inflation (average, 2006–2011): 10.0; 15.8; 22.6; 4.6; 13.0; 9.6
- Central government balance (2006–2011): -8.0; -7.7; -7.7; -7.0; -6.0; -5.0
- Revenue (percent of GDP, 2006–2011): 16.3; 15.8; 14.9; 14.8; 15.4; 16.0
- Expenditure (percent of GDP, 2006–2011): 24.3; 23.5; 22.6; 21.9; 21.5; 21.0
- Government debt (2006–2011, percent of GDP): 88.7; 85.8; 81.1; 83.7; 84.4; 81.0
- Balance of payments and reserves (selected, 2008)
  - Exports: 8,137 (millions of U.S. dollars)
  - Imports: 14,009 (millions of U.S. dollars)
  - Current account balance: -3,719 (millions of U.S. dollars); -9.4 percent of GDP
  - Gross official reserves (end-2008): 1,580 (millions of U.S. dollars)
  - Gross official reserves (2009 projected end): 2,492 (millions of U.S. dollars); months of imports: 2.4 (2006), 1.6 (2008), 3.7 (2010), 4.0 (2011)

### Risks, contingencies, and program monitoring
- Main risks
  - Exchange rate and reserves: prior defense of a stable exchange rate at expense of reserves; program requires departure from that stance.
  - Fiscal risks: poor track record of fiscal adjustment; quality of revenue measures less than ideal; expenditure cuts politically difficult; risk of relying on cuts in politically sensitive capital spending.
  - Financial sector: weaknesses could deepen as economy slows; risk of problems in systemically important banks.
  - External: sharper slowdown in trading partners and fall in remittances; sudden withdrawal of non-resident foreign exchange deposits (risk presently relatively low).
  - Possible peace dividend: upside from remittances and capital inflows; downside if political reconciliation delays deter donors.
- Program monitoring and reporting
  - Quarterly reviews with quantitative performance criteria (TMU); data reporting timeliness: external/monetary data within 3 weeks of month-end; fiscal data within 5–9 weeks; CEB/CPC balances within 4 weeks.
  - First review on or after July 30, 2009; second review on or after September 30, 2009.
- Adjustment rules and memorandum items (selected)
  - Ceiling on contracting non-concessional external debt: cumulative ceiling of 1,750 (million US$) from end-April 2009.
  - Memorandum items include external loans, external grants, external debt service in million rupees as cumulative program assumptions.

### Policy recommendations and program priorities (implicit in the text)
- Implement fiscal consolidation to achieve central government deficit of 5 percent of GDP by 2011 and balance CEB and CPC budgets by 2011.
- Implement immediate-yield revenue measures in 2009 while preparing broad-based tax policy and administration reforms for 2010 budget.
- Allow flexible exchange rate adjustment to restore external competitiveness and rebuild reserves.
- Implement comprehensive financial sector reforms, strengthen supervision, and ensure prompt corrective action in banks.
- Secure donor engagement and channel defense savings to reconstruction while preserving fiscal consolidation.

*Source: _cr09310 - IMF staff report excerpts and accompanying technical material*

### 1. The Post-War Reconstruction Plan for the Northern Province .......................................12

### 1. The Post-War Reconstruction Plan for the Northern Province

### Context: nature of the shock and macroeconomic backdrop
- Nature of the shock
  - Years of lax fiscal policy led to increasing reliance on short-term financing from international markets; the global financial shock caused a sudden stop to this financing and capital outflows.
  - Central bank intervened heavily to defend the exchange rate, with reserves reaching dangerously low levels.
  - Loss of competitiveness and a sharp fall in demand for Sri Lankan exports likely increased pressure on reserves and the balance of payments gap.
- Growth
  - Growth is set to fall from 6 percent in 2008 to 3 percent this year due to a slowdown in domestic economic activity and weak external demand.
  - A drought earlier this year hurt the agricultural sector; growth in tourism and construction slowed sharply.
  - The end of the conflict is projected to increase economic activity, with full impact unlikely until next year.
- Inflation
  - Inflation peaked at 28 percent in June 2008 driven by high global food and fuel prices.
  - Decline in these prices and tight monetary policy reduced inflation to single digits in 2009.
- External sector
  - Lower oil prices should reduce the current account deficit significantly to 1¼ percent of GDP from 9½ percent in 2008 despite an expected 13 percent decline in merchandise exports.
  - Real effective exchange rate appreciation peaked at 22 percent in March 2009, before falling to 19 percent in June.
  - Standard & Poor’s downgraded their outlook on Sri Lanka citing weak external position, large fiscal deficit, and uncertainty about a loan agreement with the IMF.
- Capital flows and reserves
  - In Q3 2008, more than $400 million in nonresident holdings of government t-bills were redeemed; about $225 million in syndicated loans were not rolled over.
  - An additional $550 million of official and private external debt service is falling due in the second half of 2009.
  - Central bank foreign exchange reserves fell from a peak of $3½ billion in mid-2008 to around $900 million in March 2009; reserves have recovered somewhat and currently stand at $1½ billion or about 7 weeks of imports.
- Financial sector
  - Failure of an unregulated finance company in early 2009 led to deposit withdrawals from Seylan Bank; central bank takeover stabilized short-run liquidity.
  - Deterioration of system-wide asset quality and contagion from weaknesses in smaller finance companies exposed to real estate remain concerns.
  - Non-performing loans for larger banks have begun to rise, though banks remain well capitalized and liquid.
- Conflict and political situation
  - Military campaign against the LTTE is over; Sri Lanka entered a post-conflict era with humanitarian relief, resettlement, and political reconciliation challenges.
  - End of the war opens opportunities for long-term development of the North and a resurgence in economic activity.
  - Local government elections in the Northern province are scheduled for August this year.

### Policies: current stance and measures
- Fiscal policy and fiscal risks
  - Average central government deficit for recent years around 8 percent of GDP.
  - Without policy adjustment the deficit for 2009 would deteriorate to more than 9 percent of GDP.
  - Expenditures trending down due to falls in subsidies/transfers and the civil service wage bill; revenues have declined by an average of ¾ percentage points of GDP per year since 2006.
  - 2009 budget reduced the VAT rate from 15 percent to 12 percent—resulting in an additional revenue loss of ¾ percent of GDP—and included a temporary, targeted, and sector specific stimulus package estimated at about ¼ percent of GDP.
  - Public sector gross debt is now in the range of 80 percent of GDP; trajectory without corrective steps is unsustainable.
  - Government pledged to reduce the fiscal deficit to 5 percent of GDP by 2011 but sufficient steps to achieve this have not yet been implemented.
- Public enterprises
  - Losses in 2008 for the state oil company were significant as high international oil prices were not fully passed through; state-owned electricity company experienced losses despite a 35 percent increase in electricity tariffs in March 2008.
  - Deficit for the two largest state enterprises increased to nearly 1¼ percent of GDP.
  - Note: oil company hedging contract losses mounted to an estimated $400-600 million (as much as 1½ percent of GDP); central bank suspended payments and issue is in international arbitration.
- Monetary policy
  - Large unsterilized foreign exchange interventions tightened monetary conditions; reserve money growth near zero in 2008.
  - Loss of foreign financing squeezed private sector credit growth; real interest rates remained high.
  - Central bank loosened policy by lowering reserve requirements from 10 to 7 percent and reducing policy rates; eliminated the penal rate and reestablished the policy rate corridor to reduce interbank rate volatility.
- Exchange rate policy
  - De facto exchange rate peg to the U.S. dollar since end-2007; central bank announced a more flexible regime in October 2008.
  - Exchange rate allowed to depreciate by more than 6 percent until end-February 2009; central bank continued large reserve use to prevent further depreciation and later stopped selling and started purchasing foreign exchange since mid-March discussions.
  - Authorities responded to upward pressure from short-term inflows after the war by stepping up foreign exchange purchases to prevent further appreciation.
  - Central bank introduced and later repealed margin requirements on various consumer goods to reduce pressure on reserves.
- Financial sector policies and bank resolution
  - Central bank replaced management of Seylan Bank and instructed issuance of shares by end-August 2009 to restore capital adequacy.
  - Plans to address weaknesses in bank resolution framework including mergers, acquisitions, and liquidation of troubled banks.
  - Government provided temporary liquidity and encouraged consolidation for regulated finance and leasing companies, but failures in the unregulated finance sector have not yet been addressed.

### Program discussions and objectives
- Program objectives and rationale
  - Authorities seek to rebuild reserves, restore export competitiveness, reverse budget deterioration, and address financial sector problems; view Fund-supported program as consistent with these goals.
  - Program aims to: bring about credible deficit reduction required for debt sustainability while ensuring resources for post-war reconstruction; rebuild reserves to prudent levels while allowing orderly exchange rate adjustment; and put in place a framework for financial sector soundness and bank resolution.
- Path for budget deficit reduction
  - Authorities committed to reducing central government budget deficit to 5 percent of GDP by 2011.
  - Targets: 7 percent for 2009 (compared to a baseline of 9½ percent and a deficit of 7¾ percent in 2008), and 6 percent for 2010.
  - Program fiscal adjustment is explicitly procyclical with a negative fiscal impulse during a sharp slowdown in growth, balancing sustainability with limiting contractionary impact.
- Revenue measures in 2009 (total yield 1¼ percent of GDP for the remainder of 2009)
  - Increasing the nation building tax rate from 1 percent to 3 percent effective May 2009 yielding 2/3 percent of GDP for the remainder of 2009. The base for this tax is largely the same as the VAT. This measure is now fully in place.
  - Raising excise taxes on liquor, cigarettes, and selected consumer items effective April 2009; expected yield ¼ percent of GDP for the remainder of 2009. This measure has already been implemented.
  - Repealing import margin requirements on consumer goods introduced last fall and reverting to prior margin requirements; increasing cesses and other trade taxes resulting in an expected tax yield of 1/3 percent of GDP. These measures have already been implemented.
- Expenditure measures in 2009
  - Authorities committed to cutting spending by ½ percent of GDP relative to the 2008 budget outturn while maintaining the level of capital spending.
  - Preserve expenditure allocations to protect the most vulnerable groups; social sector spending targeted to increase to 7 percent of GDP in 2009 from 6.8 percent in 2008.
  - Government taking action to provide immediate relief and expand social safety net spending to resettle displaced persons in the North promptly.
- Performance in first four months of 2009 and near-term outlook
  - Revenues in the first four months were about 10 percent below levels in the same period last year due to collapse in tax-yielding imports.
  - Expenditures ran about 28 percent higher, primarily reflecting repayments of domestic debt contracted at much higher nominal interest rates and the drying up of lower cost external funding.
  - Central government deficit during this period amounted to around 4 percent of annual GDP.
  - For the remainder of the year, revenues expected to pick up with projected recovery in imports and yield from tax measures effective beginning in May.
  - Sharp decline in interest rates—from above 17 percent at end-2008 to approximately 11½ percent at end-April—is expected to reduce the domestic interest bill significantly.
  - Authorities identified low-priority investment projects where spending could be cut or postponed and are committed to further cuts in civilian goods and services if revenues do not materialize and budget targets are threatened.

*Source: _cr09310 - 1. The Post-War Reconstruction Plan for the Northern Province*

### 18.      Fiscal measures in 2010 and 2011. Part of the adjustment needed to reach the targets

### Fiscal measures in 2010 and 2011. Part of the adjustment needed to reach the targets

### Revenue measures and tax commission
- Full-year effect of new revenue measures introduced in 2009 will contribute to part of the adjustment in 2010–2011.
- The President has formed a tax commission to:
  - review current tax policy;
  - make recommendations on strengthening tax collection, tax auditing and enforcement;
  - simplify the tax system, including a review of the tax incentive system administered by the Board of Investment;
  - review the VAT with the intention of broadening the base.
- The interim report of the commission will be discussed during the second program review to identify base broadening measures to be included in the 2010 budget.
- As any new revenue measures yield results, temporary taxes—such as import surcharges—will be gradually phased out.
- The government has requested technical assistance from FAD to assess major elements of the tax system and provide advice on tax policy issues.
- Budget timing:
  - The budget for 2010 is expected to be finalized in November 2009.
  - Measures to fill the 2010 budget gap will be discussed during the first review while budget preparations are in the early process.

### Table: Revenue and Expenditure Measures under the Program, 2008-2011 (in percent of GDP)
- Program revenue target:
  - 2008: 14.9
  - 2009: 14.8
  - 2010: 15.4
  - 2011: 16.0
- Total revenue without adjustment:
  - 2008: 13.7
  - 2009: 13.8
  - 2010: 14.0
- Additional revenue needed:
  - 2008: 1.1
  - 2009: 1.6
  - 2010: 2.0
- Revenue measures agreed, of which:
  - 2008: 1/... 1.1
  - 2009: 1/... 1.3
  - Nation building tax:
    - 2008: 0.6
    - 2009: 0.8
    - 2010: 0.9
  - Excise taxes: 0.2, 0.2, 0.2
  - Cesses and other surcharges: 0.3, 0.3, 0.3
- Remaining revenue gap:
  - 2008: 0.0
  - 2009: 0.3
  - 2010: 0.7
- Program expenditure target:
  - 2008: 22.6
  - 2009: 21.9
  - 2010: 21.5
  - 2011: 21.0
- Total expenditure without adjustment:
  - 2008: 23.2
  - 2009: 23.2
  - 2010: 23.5
- Additional expenditure cuts needed:
  - 2008: 1.4
  - 2009: 1.7
  - 2010: 2.5
- Adjustments relative to baseline 2/:
  - 2008: 0.5
  - 2009–2011: ......
- Expenditure measures agreed 1/...:
  - 2008: 0.9
  - 2009: 0.2
  - 2010: 0.1
- Remaining expenditure gap:
  - 2008: 0.0
  - 2009: 1.5
  - 2010: 2.4
- Program deficit target:
  - 2008: 7.7
  - 2009: 7.0
  - 2010: 6.0
  - 2011: 5.0
- Deficit without adjustment:
  - 2008: 9.5
  - 2009: 9.4
  - 2010: 9.5
- Adjustment required:
  - 2008: 2.5
  - 2009: 3.4
  - 2010: 4.5
- Identified adjustment:
  - 2008: 2.5
  - 2009: 1.5
  - 2010: 1.4
- Remaining gap:
  - 2008: 0.0
  - 2009: 1.9
  - 2010: 3.1
- Notes:
  - 1/ The yield of measures in 2009 is on a nine-month basis.
  - 2/ Includes lower domestic interest under the program scenario and adjustments to budget allocation for capital spending.

### Expenditure-side adjustments
- Authorities understand additional cuts are needed to reduce the deficit further and make room for reconstruction spending.
- Expected sources of cuts:
  - savings from security related spending;
  - reduction in transfers.
- Measures to be discussed ahead of the 2010 budget during the first review.

### Public enterprises (CEB and CPC)
- With the fall in oil prices, the combined deficit for the Ceylon Electricity Board (CEB) and the Ceylon Petroleum Corporation (CPC) is expected to decline in 2009.
- Government goal: reach a balanced budget for these enterprises by 2011.
- Steps taken and planned:
  - independent regulator for the electricity sector established in March 2009;
  - moving toward lower cost electricity generation;
  - retail prices of petrol and diesel were raised by 5-10 percent in July 2009, broadly consistent with a full pass-through of the recent increase in international oil prices;
  - mechanism for regular review of operational cash flows of these enterprises;
  - commit to take adjustments—including to tariffs, management and operations—needed to bring the enterprises to break even by 2011;
  - any subsidies will be targeted to vulnerable groups and transparently reflected in the government budget.
- Oversight:
  - Joint Review Mechanism committee of the Ministry of Finance, the CEB, the CPC, and the central bank appointed to monitor operations and make recommendations; committee expected to complete its report by mid-August.
- Authorities agreed to develop a plan to address outstanding debts between key state-owned enterprises by end-December 2009.

### Reconstruction: needs and financing
- Reconstruction needs will require a substantial multi-year effort.
- The government formed a high-level task force conducting a comprehensive needs assessment.
- In 2009 the government intends to make room within existing deficit targets for humanitarian assistance and resettlement of IDPs by:
  - using savings in other spending categories;
  - redeploying military personnel for demining and provision of basic infrastructure.
- Needs assessment expected to be completed by end of July (2009).
- Evidence from the Eastern province suggests reconstruction needs could amount to about 1 percent of GDP per year.
- Financing sources for reconstruction:
  - revenue enhancements;
  - savings in military spending of approximately ¾ -1 percent by 2011;
  - external financing in the form of concessional loans and grants from development partners.
- Staff will determine during program reviews the extent to which the deficit target should be adjusted to accommodate externally financed reconstruction spending, considering project productivity and concessionality of donor financing.

### Box 1 — Post-war reconstruction plan for the Northern province (selected points)
- Humanitarian priorities:
  - estimated 300,000 internally displaced persons (IDPs) currently in camps;
  - resettlement goal: 70-80 percent of IDPs within 180 days.
- Broader strategy built on four Ds: (i) demilitarization; (ii) development; (iii) democratization; (iv) devolution.
- Demilitarization includes demining by the military with local and international NGO assistance and restoration of law and order.
- Development includes resettlement of IDPs, restoration of basic services including water, electricity, and education, and development of economic and social infrastructure in consultation with local officials and communities.
- Democratization includes local government and provincial council elections, the first scheduled to take place in August (2009), and election of a Chief Minister for the Northern province.
- Institutional arrangements:
  - Presidential Task Force for Resettlement, Development, and Security in the Northern province leads reconstruction;
  - consultative committee of humanitarian assistance including international community representatives advises on humanitarian assistance and basic services to IDPs.
- Fiscal allocation in 2009:
  - Rs. 18 billion allocated to reconstruction spending in the North;
  - Rs. 18 billion equals 2 percent of projected central government spending;
  - majority used for humanitarian assistance and resettlement of IDPs.
- Authorities plan to approach donors for financing once needs assessment is completed.

### Box 2 — Developments in Security-Related Spending (selected points)
- Security-related spending rose from 3.3 percent of GDP in 2005 to 3.9 percent in 2008.
- Defense wages relatively stable in range of 1.5-1.7 percent of GDP; increase driven by goods and services.
- Sri Lanka’s military expenditure as a share of GDP is higher than World and regional averages:
  - World: 2.4 (percent of GDP)
  - Asia: 2.0
  - SAARC 1/: 2.2
- Authorities do not expect significant reductions in military spending for 2009 but see scope for military savings in 2010 and 2011.
- In the context of reconstruction, additional funds would be found primarily through revenue enhancement, savings in military spending beginning with the 2010 budget, and additional donor financing.

### Exchange rate policy, reserves, and restoring external competitiveness
- Program central aims: rebuild reserves, address loss of competitiveness, restore external viability.
- Reserve target: rebuild to more than 3½ months of imports ($4 billion) by the end of the program period.
- Exchange rate policy considerations:
  - exchange rate would need to be sufficiently flexible to address loss of competitiveness and increased competition in garments exports;
  - program designed to adjust net international reserve targets upward for short-term capital flows into the domestic bond market to ensure reserve buildup comes through current account adjustment rather than external borrowing.
- Program includes a consultation clause with Fund staff if supply-demand gaps in foreign exchange produce a more sudden and disruptive depreciation than anticipated.

### Monetary policy
- Consistent with a floating exchange rate regime and absence of an effective interest rate transmission mechanism:
  - base money will continue to anchor monetary policy.
- Program monetary targets aim to control inflation while ensuring adequate credit to the private sector.

### Financial sector reforms
- Program measures include:
  - Resolving remaining issues from takeover of Seylan Bank: central bank directed Seylan Bank to issue Rs. 3 billion in share capital at the prevailing market price to recapitalize the bank.
  - Consolidation of weak finance and leasing companies to avoid spillovers to healthy financial institutions.
  - Developing a contingency plan to deal with potential stresses in the financial system.
  - Implementing measures to improve financial sector regulation, including strengthening capital requirements and banks’ integrated risk management frameworks.
  - Amending laws and regulations to improve the bank resolution framework and address supervisory gaps in the banking, credit card, and finance company sector.

### Social policies and safeguards
- Social protection priorities:
  - 15 percent of the population below the poverty line;
  - protect expenditures on social transfers to Sri Lanka’s most vulnerable.
- Safety net system comprises Samurdhi (main cash transfer program addressing chronic poverty and channeling disability payments), limited social welfare and care services, and disaster relief to displaced persons.
- Safeguards:
  - A safeguards assessment concluded in May found the CBSL had developed a relatively strong safeguards framework.
  - CBSL committed to implementing assessment recommendations with focus on external audit and data reporting.

### Program modalities: access, phasing, and donor financing
- Access:
  - Exceptional access requested: 400 percent of quota (SDR 1.65 billion) during the 20 month Stand-By Arrangement.
  - Sri Lanka’s access during the first year under the proposed SBA would exceed 200 percent of quota.
  - With access at this level, the program would be fully financed.
- Phasing:
  - Proposed program envisages a flat purchase schedule.
  - The first purchase would be around $313 million.
- Other donor financing:
  - World Bank’s Country Assistance Strategy includes approximately $100 million earmarked for existing projects in the Northern province that have been committed but not yet disbursed.
  - An additional $225 million annually is earmarked for sectoral projects and could in theory be used for reconstruction projects if needed and requested by the government.
  - The AsDB concluded a $160 million loan agreement to fund development of the power sector and indicated the government could qualify for up to $150 million in budget support—with co-financing from Japan—once the Fund-supported program is approved; if realized, this would replace more expensive domestic financing and could help reduce the interest bill from levels currently assumed in the program.
  - Japan intends to continue an annual lending program of about ¥25-30 billion focused on infrastructure projects in water, power and road sectors.

### Box 3 — Exceptional Access Request (selected points)
- I. Balance of payments pressures justify exceptional access: pressures predominantly on the capital account, short-term and speculative capital inflows could rapidly reverse, reserves fragile.
- II. Debt sustainability: External and public debt analysis indicates Sri Lanka has a moderate risk of debt distress. The proposed SBA measures, including bringing the fiscal deficit down to 5 percent of GDP by 2011 and returning to a more flexible exchange rate, would substantially reduce the risk of debt distress.
- III. Prospects of regaining private capital market access: Sri Lanka has previously floated a $500 million sovereign bond in October 2007, raised syndicated loans of $100-150 million each, and in the first half of 2008 sold US$600 million in domestic-currency denominated Treasury Bills to nonresident investors.
- IV. Policy program prospects: Program entails strong upfront actions consistent with achieving the 2009 program target and a commitment to stem reserve loss; authorities have begun rebuilding reserves by purchasing large amounts of foreign exchange from the market in response to rebound of capital inflows.

*Source: _cr09310 - 18. Fiscal measures in 2010 and 2011. Part of the adjustment needed to reach the targets*

### 31.      Conditionality. Conditionality is focused on achieving the programmed deficit

### Conditionality

### Program objectives and conditionality
- Conditionality is focused on achieving the programmed deficit reduction, building reserves and restoring external viability, and safeguarding financial sector stability.
- The quantitative and qualitative conditionality is described in Tables 1-3 attached to the government’s Memorandum of Economic and Financial Policies.
- Reviews will be based on quantitative performance criteria assessed quarterly during the program period.

### Prior actions (summary)
- The authorities have implemented all prior actions (Text Table 2).
- On the budget side the authorities have taken the necessary steps to implement the agreed revenue measures and eliminate all import margin requirements, including those that were in place prior to the additional requirements introduced October 2008.
- The central bank has ceased sales to the foreign exchange market and shown a readiness to allow the exchange rate to be more flexible reflecting the need to rebuild reserves to meet the program targets.
- The central bank has purchased more than $400 million of foreign exchange since March.

### Capacity to repay
- If the government carries out its commitment to maintaining a competitive exchange rate and rebuilding reserves, Sri Lanka’s strong export base gives reasonable assurances of the capacity to repay the Fund.
- If purchases are made as scheduled, there will be a peak in repurchases to the Fund in 2014.
- The staff’s Debt Sustainability Analysis shows that with a floating exchange rate the central bank would accumulate enough reserves to repay the Fund and maintain a level of gross reserves of at least 3½ months of imports.
- The authorities have expressed their willingness to consider a transition to a concessional arrangement once the immediate crisis has been averted, which would help establish a program for reconstruction and other investment spending and facilitate a steady path of structural reform over a longer horizon.

### Debt sustainability analysis
- The external debt sustainability analysis indicates that Sri Lanka has a moderate risk of external debt distress over the medium term.
- The comprehensive package of medium term policies implemented as part of the program, especially bringing the fiscal deficit down to 5 percent of GDP by 2011 and a return to a more flexible exchange rate regime, if fully implemented, would bring Sri Lanka to a sustainable path.

### Structured items from Table 2 (selected actions and benchmarks)
- Removal of import margin requirements imposed in October and November 2008. — Prior Action — Implemented
- Amendments to the Nation Building Tax to raise the rate from 1 to 3 per cent. — Prior Action — Implemented
- Amendments to the excise taxes on liquor, cigarette and other items. — Prior Action — Implemented
- Finalisation of the terms of reference of a tax commission to review tax policy — Prior Action — Implemented
- Harmonize the penal rate for commercial bank borrowing from the CBSL and the reverse repo rate. — Prior Action — Implemented
- Announcement of a recapitilization plan for Seylan Bank. — Prior Action — Implemented
- Recapitalization of Seylan Bank through a public share issuance. This would restore public confidence in the banking system. — Structural Benchmark — 9/30/09
- A contingency plan for orderly workouts of problem banks and financial institutions will be developed by the CBSL. — Structural Benchmark — 9/30/09
- Approval by the Monetary Board of a revised Banking Act and other pertinent laws and legislations that: (i) improve the bank resolution framework that more clearly defines the provisions for acquisition, and roles of the conservator and liquidator; and (ii) strengthens the definition of large exposures and related parties to better capture all material risks. — Structural Benchmark — 9/30/09
- Submission by the tax review commission of an interim report, including on base broadening measures to be incorporated into the 2010 budget. — Structural Benchmark — 10/15/09
- Develop a plan to address outstanding debts between the CEB, CPC and state-owned banks. — Structural Benchmark — 12/31/09
- Submission to the parliament of a revised Finance Company Act which includes clarifying the legal authority of the CBSL in enforcing its regulations on all deposit taking finance companies. — Structural Benchmark — 12/31/09
- Issuance of prudential regulations and guidelines to credit card companies and payment service providers. — Structural Benchmark — 12/31/09
- Submission to parliament of the 2010 budget consistent with program targets. — Structural Benchmark — 12/31/09

### Risks
- There are substantial risks to the program. Achieving the program’s goals will require strong government commitment, particularly for the budget and the exchange rate. The end of the war would have a positive economic impact.

- Exchange rate and reserves
  - Prior to entering program discussions the government had shown a willingness to defend a stable exchange rate at the expense of two-thirds of the country’s reserves.
  - The program requires a sharp departure from this policy view.
  - In program discussions the authorities strongly maintained their commitment to the program’s reserve targets, and recent central bank actions to purchase foreign exchange from the market while allowing the rate to depreciate have demonstrated credibility, but this commitment may be tested going forward.

- Fiscal risks
  - The government has expressed strong ownership of the program’s fiscal targets and has taken significant steps to boost revenues while recognizing the need to cut expenditures to meet these targets and create room for reconstruction spending over the medium term.
  - The government has had a poor track record of fiscal adjustment.
  - The quality of the revenue measures taken so far is less than ideal, while expenditure cuts will be politically difficult.
  - The program includes steps to develop a more comprehensive revenue reform and to solidify expenditure cuts, and includes a commitment by the authorities to undertake additional expenditure cuts to offset revenue shortfalls.
  - There may be a need for further measures to address fiscal shortfalls as the program progresses.
  - Risk that meeting fiscal targets will rely on cuts in politically sensitive capital spending.

- Foreign exchange deposits
  - A sudden withdrawal of non-resident foreign exchange deposits from the banking sector would put pressure on reserves and could jeopardize the program’s reserve targets.
  - At this stage this risk appears relatively low.
  - These deposits are related to remittances inflows and are for the most part not speculative, and an IMF program would help reassure depositors and mitigate the risk of a large outflow.

- Financial sector
  - Weaknesses in the financial sector are likely to increase as the economy slows.
  - The program is designed to address existing weaknesses and establish an orderly and transparent method for dealing with problems should banks experience a rapid increase in nonperforming loans.
  - While a sudden system-wide withdrawal of deposits is unlikely, there is a risk that problems could emerge in systemically important banks and reduce confidence in the banking sector as a whole.

- Output growth
  - Sri Lanka’s trading partners could see a more rapid growth slowdown than currently expected, reducing exports and overall growth.
  - Prolonged real exchange rate overvaluation could also put a drag on export and output growth.

- Possible peace dividend
  - On the upside, the war’s end has already led to an increase in remittances and other capital inflows; continued inflows could improve the balance of payments and growth outlook.
  - On the downside, delays in authorities' willingness to follow through on commitments to put in place a political solution to ease ethnic tensions may adversely affect donor participation and northern reconstruction.

*Source: _cr09310 - 31. Conditionality. Conditionality is focused on achieving the programmed deficit reduction, building reserves and restoring external viability, and safeguarding financial sector stability*

### 36.      Overview. Sri Lanka has been hit hard by the global financial crisis. Several years of

### Overview. Sri Lanka has been hit hard by the global financial crisis.

### Context and immediate challenges
- Several years of lax fiscal policy, reliance on short-term external financing, and an overvalued exchange rate left Sri Lanka particularly vulnerable to the global financial shock.
- Urgent policy needs: shore up the balance of payments, rebuild reserves, reverse the deterioration of the budget deficit, and head off problems in the financial sector.

### Program objectives (authorities’ program)
- Bring about credible budget deficit reduction required for debt sustainability.
- Rebuild reserves to prudent levels while allowing an orderly exchange rate adjustment sufficient to restore external viability.
- Establish a framework to ensure the soundness of the financial sector, resolve problem banks, and rebuild confidence.

### Reconstruction priorities (post-conflict)
- End of the conflict (May 2009) creates opportunity to address substantial reconstruction needs, especially in the North.
- Financing reconstruction will be large; credibility of reconstruction spending plans requires a strategy for expenditure savings elsewhere in the budget.
- Authorities committed to sizeable reductions in defense spending to create fiscal space for reconstruction and deficit reduction.
- Greater engagement with bilateral and multilateral donors is highlighted; a strong track record under a Fund-supported program could help mobilize donor support.

### Fiscal policy stance and measures
- Authorities committed to reaching a budget deficit target of 5 percent of GDP and balancing state enterprises’ budgets by 2011.
- Targeted deficit of 7 percent of GDP for the current year (2009).
- Immediate revenue measures prioritized to boost yield this year, though staff preferred measures to eliminate exemptions and broaden the tax base.
- Authorities committed to a comprehensive review of tax policy and administration, preparing to implement high quality revenue reforms as part of next year’s budget.

### Monetary and exchange rate policy
- Essential for the central bank to allow the currency to move flexibly to rebuild reserves and reduce external imbalances.
- Program calls for an exchange rate adjustment to restore competitiveness and create room for recovery in private sector credit growth.
- Adjustment noted as difficult but necessary to underpin sustained output growth once the global economy recovers.

### Financial sector policies
- Program includes a comprehensive and ambitious financial sector reform agenda to address current weaknesses and prepare for slowdown-related difficulties.
- Central bank must act decisively in implementing reform measures and take prompt corrective action when problems emerge to maintain health and confidence in the sector.

### Risks and rationale for Fund support
- Substantial program risks exist and must be weighed against the risk of no Fund-supported framework.
- Given acute short-run external financing problems, without a program involving significant financial resources Sri Lanka would likely face a balance of payments crisis and limited policy options, including a disruptive devaluation with destabilizing social consequences.
- The Fund-supported program is presented as an opportunity to prevent crisis, provide a guide for needed policies, and a path to fiscal and external solvency.
- Staff recommends approval of the requested Stand-By Arrangement.

### Key statistics and projections (selected figures cited in the text and tables)
- Main exports (percent of total, 2008): garment (43), tea (16)
- GDP per capita (2008, est.): US$1,972
- Unemployment rate (2008): 5.4 percent
- Poverty rate (2007, incidence): 15.2 percent
- FDI (2008, est.): $691 million
- Public debt (2008): 81.1 percent of GDP

Selected macro projections (2006–2011, as presented)
- Real GDP growth (2006–2011, Est./Proj.): 7.7, 6.8, 6.0, 3.0, 5.0, 6.5
- Inflation (average, 2006–2011): 10.0, 15.8, 22.6, 4.6, 13.0, 9.6
- Central government balance (1/) (2006–2011): -8.0, -7.7, -7.7, -7.0, -6.0, -5.0
- Consolidated government balance (1/) (2006–2011): -8.2, -8.0, -8.8, -7.7, -6.4, -4.9
- Revenue (percent of GDP, 2006–2011): 16.3, 15.8, 14.9, 14.8, 15.4, 16.0
- Expenditure (percent of GDP, 2006–2011): 24.3, 23.5, 22.6, 21.9, 21.5, 21.0
- Government debt (domestic and external) (percent of GDP, 2006–2011): 88.7, 85.8, 81.1, 83.7, 84.4, 81.0

Balance of payments and reserves (selected)
- Exports (2008): 8,137 (millions of U.S. dollars)
- Imports (2008): 14,009 (millions of U.S. dollars)
- Current account balance (2008): -3,719 (millions of U.S. dollars); (in percent of GDP) -9.4
- Gross official reserves (end of period, 2008): 1,580 (millions of U.S. dollars)
- Gross official reserves (2009 projected end): 2,492 (millions of U.S. dollars); (In months of imports) 2.4 (2006), 1.6 (2008), 3.7 (2010), 4.0 (2011)

Program financing and IMF engagement
- Government requests a Stand-By Arrangement with exceptional access in an amount of SDR 1,653.6 million (400 percent of quota).
- Table of proposed reviews and disbursements under the 20-month Stand-By Arrangement indicates equal disbursements of 50 percent of quota (206.731 SDR) or 312.5 in USD per scheduled review, totaling 400 percent of quota / 1,653.6 SDR / 2,500 in USD.

### Policy priorities / recommendations implicit in the program
- Implement fiscal consolidation to achieve a central government deficit of 5 percent of GDP by 2011 and balance state enterprise budgets (CPC and CEB) by 2011.
- Adopt immediate-yield revenue measures this year while preparing broad-based tax policy and administration reforms for next year’s budget.
- Allow flexible exchange rate adjustment to restore external competitiveness and rebuild reserves.
- Implement comprehensive financial sector reforms and act promptly on emerging banking problems.
- Secure donor engagement and channel defense savings to reconstruction needs while preserving fiscal consolidation.

*Source: IMF staff report (Content unit: _cr09310).*

### 1.      The economic outlook for this year is challenging. Growth is projected to slow

### 1.      The economic outlook for this year is challenging. Growth is projected to slow

### Economic outlook and macro projections
- Growth is projected to slow from 6 percent in 2008 to about 3 percent in 2009 on account of the worsening global environment and the fall in domestic demand.
- Inflation trajectory:
  - Reached a high of 28 percent on a year-on-year basis in June 2008.
  - Decelerated sharply to one percent in June 2009.
  - Expected to remain in single digits in 2009 as a result of recent monetary policy efforts and significantly lower commodity prices.
- Current account:
  - Current account deficit recovered from 9 percent of GDP in 2008 to around 1¼ percent by end-2009.
  - Factors supporting recovery: relatively lower oil prices, a sharp decline in imports, a steady flow of remittances, and continued flexibility in the exchange rate.
- Medium-term outlook:
  - Economy should begin to recover in 2010 and beyond assuming a recovery in global economic conditions and gradual normalization of economic activity in the North and the East.
  - Growth in 2010 expected to increase while inflation is expected to remain low.
  - Macroeconomic and structural policies in the Mahinda Chintana (measures to reduce cost of living, boost infrastructure by attracting foreign direct investment, and increase competitiveness and productivity) should help accelerate economic growth.
  - Downside risk from unusual uncertainty about global economic prospects; upside from rebound in confidence following the end of the war.

### Fiscal policy: targets, measures, and financing
- Fiscal targets and revenue goals:
  - Government’s fiscal framework targets reduction in overall central Government deficit to 5 percent of GDP by 2011.
  - Government committed to increasing tax revenue by at least 2 percent of GDP by 2011 via base broadening, significantly reducing tax exemptions, and further improving tax enforcement.
- 2009 deficit objective and adjustment strategy:
  - Aim to contain overall Government deficit to 7 percent of GDP in 2009 compared with 6½ envisaged in the 2009 budget.
  - Without action, 2009 budget deficit would worsen considerably compared to the 7¾ percent outturn in 2008 because of global crisis and the January 2009 stimulus package.
  - Revenue-enhancing measures expected to yield about ¼ percent of GDP relative to the 2008 level.
  - Expenditure rationalization expected to result in savings of about ½ percent of GDP.
  - Adjustment in 2009 will rely more on expenditure restraint while protecting vulnerable groups; prompt action to contain other current expenditure or raise further revenue in case of shortfalls or overruns.
  - Additional expenditure from higher-than-expected external grants will be accommodated within the program.
- Implemented and planned tax measures:
  - Introduced a nation building tax and raised excise taxes on liquor, cigarettes, and other consumer items.
  - Directed Government institutions to maintain strict budget controls and justify cost overruns.
  - Restrictions on tax holidays: beginning April 2008, current tax holidays for most projects under the BOI Act and the Inland Revenue Act are restricted to a maximum of three years from fifteen years previously; these tax holidays will not be extended after they expire.
  - Formation of a Tax Commission to review current tax policy and make recommendations; Commission to submit an interim report by mid-October 2009 with proposals for base broadening including further rationalization of income tax holidays under the Board of Investment for consideration in preparing the 2010 budget.
  - Intention to phase out temporary taxes, including import surcharges, as new revenue measures yield results.
- Financing and public debt management:
  - Given difficult external environment, financing of central Government deficit during 2009 expected to come mainly from domestic sources.
  - Engaged development partners for significant budget support and exploring private market external financing to supplement donor resources.
  - Will limit such external borrowing to less than US$1,750 million during the course of the program to keep financing consistent with public debt sustainability.
  - CBSL will work with Ministry of Finance to improve Government cash flow management.
- State-owned enterprises (SOEs) and circular debt:
  - Policy aim: ensure state owned commercial enterprises run efficiently and do not rely on Treasury subsidies; specifically target Ceylon Electricity Board (CEB) and Ceylon Petroleum Corporation (CPC) to break even by end-2011.
  - Measures taken:
    - CEB: tariffs raised by 35 percent in March 2008; Sri Lanka Electricity Act passed in March 2009 establishing an independent regulator.
    - CPC: fully passed through increases in international oil prices by raising domestic petrol price.
  - Continuous assessments of operational cash flows; targeted subsidies transparently reflected in Government budget.
  - Joint Review Mechanism (committee from Ministry of Finance, CEB, CPC, and CBSL) expected to submit report by end-August 2009.
  - Plan to address outstanding debts between key SOEs to be finalized by end-December 2009, clearly identifying circular debt elements and a mechanism/timeframe for settling these debts; Ministry of Finance to monitor and coordinate.
- Reconstruction and humanitarian spending:
  - Immediate priority: address humanitarian needs of estimated 280,000 internally displaced persons (IDPs).
  - Government aims to resettle 70-80 percent of IDPs by the end of the year.
  - Resettlement plan includes restoring basic services (water, electricity, health, education) and developing economic and social infrastructure in consultation with local officials and communities.
  - Reconstruction plan for Northern province led by newly established Presidential Task Force; consultative committee of humanitarian assistance includes international community representatives.
  - Key reconstruction elements: restoration of law and order, conducting local government and provincial council elections (first scheduled to take place in August), rebuilding essential infrastructure.
  - Reconstruction spending:
    - In 2009 about two percent of the projected government spending will be used for humanitarian assistance and resettlement of displaced persons.
    - Needs assessment expected to be completed by end July 2009 to determine additional funds for broader reconstruction strategy.
    - Additional funds to be found through savings in military spending beginning with the 2010 budget, and external financing in concessional loans and grants from development partners.
  - In 2009, make room within programmed deficit targets for humanitarian and resettlement spending using savings in existing budget provisions, redeployment of certain categories of military personnel for demining and basic infrastructure, and any external grants.

### Exchange rate and monetary policy
- Exchange rate policy and reserves objective:
  - CBSL has allowed greater flexibility in the exchange rate to facilitate adjustment to the global crisis while rebuilding international reserves.
  - CBSL intends to allow necessary flexibility in the exchange rate to build up international reserve coverage to at least 3 ½ months of imports by the end of the program, and will limit intervention to smooth volatility.
  - Government will pursue other steps to build reserves including bilateral swaps and the sale of diaspora bonds.
  - Government committed to staying current on all external debt obligations.
- Monetary policy stance:
  - Monetary policy will aim to control inflation while ensuring adequate provision of resources to the private sector.
  - Reserve money will continue to be the nominal anchor; policy interest rates will be adjusted as appropriate to signal stance.
  - Harmonzied penal rate for commercial bank borrowing from CBSL and the reverse repo rate; removed restrictions on commercial banks’ access to repo and reverse repo facility, establishing an explicit corridor for money market interest rates.
- Exchange restrictions:
  - During program period will not intensify any existing exchange restrictions or introduce new restrictions or multiple currency practices.
  - Temporary restrictions imposed by the CBSL in October and November 2008 on margin deposit requirements on importation of vehicles and selected consumer goods and on forward sales and purchases of foreign exchange were removed in March and April 2009.

### Strengthening the financial system
- Immediate interventions and capital measures:
  - Swift action by CBSL with respect to Seylan Bank restored confidence; CBSL directed the Bank to issue an appropriate number of voting shares to generate a capital infusion of around Rs. 3 billion by end-August to meet minimum capital adequacy by end-December 2009.
  - CBSL will continue to implement the eight point stimulus package for finance and leasing companies to avoid spillovers to healthy financial institutions.
- Prudential regulation enhancements:
  - Already adopted measures include: adopting Basle II capital adequacy framework; introducing new share ownership policy for banks; issuing mandatory direction on corporate governance; issuing revised direction on loan classification, provisioning and income recognition including imposing a one percent general provision on outstanding loans; issuing a direction on maximum amount of accommodation.
  - CBSL aims to ensure banks’ compliance with all regulations including capital adequacy, exposure limits and foreign exchange net open position limits by end-2009.
  - Given expected slowdown and potential rise in non-performing loans, CBSL will instruct all banks to have adequate capital to cover future losses in line with international best practice in loss recognition.
  - Steps taken to raise capital requirement of finance companies; intend to raise capital requirements in the insurance sector as part of proposed Insurance Companies Act.
- Supervisory framework and legal amendments:
  - CBSL intends to issue guidelines to improve banks’ integrated risk management frameworks and reinforce CBSL’s ability for consolidated supervision.
  - Broaden scope of financial sector supervision by introducing greater clarity for CBSL’s legal authority in enforcing regulations on deposit taking financial institutions through amendment to the Finance Company Act by end-December 2009 and Banking Act by June 2010.
  - Monetary Board will approve a draft amendment to the Banking Act by end-September 2009 as an interim measure.
  - Proposed amendment to the Banking Act will strengthen definition of large exposures and related party lending to better capture material risks.
  - CBSL intends to issue prudential regulations and guidelines to credit card companies and payment service providers during 2009.
- Framework for workout and contingency planning:
  - CBSL intends to put in place framework for orderly workout of problem banks and finance companies to preserve financial stability.
  - Proposed amendments to Banking Act and Finance Company Act will address weaknesses in current law on liquidation and acquisition processes, make Finance Company Act and Banking Act compatible with new Companies Act, and introduce measures to encourage unwinding of unviable institutions.
  - CBSL will further improve contingency plan for addressing future financial sector instability and strengthen intervention procedures, including approach to dealing with potential stresses in banks and finance companies.

### Other policies
- Safeguards assessment:
  - A safeguards assessment concluded in May found that the CBSL has developed its safeguards in many respects and has a relatively strong safeguards framework.
  - CBSL will work with IMF staff in coming months to implement recommendations from the safeguards assessment report, focusing on priority recommendations in external audit and data reporting.

### Risks and contingencies
- Key program risks:
  - Sharper-than-anticipated economic slowdown in trading partner countries slowing export growth further.
  - A fall in remittances inflows.
  - Capital outflows.
- Policy stance if risks materialize:
  - Government stands ready to adjust policies, in close consultation with IMF staff, to ensure achievement of a sustainable external position by the end of the program period.
  - In the event of a potentially disruptive movement in the nominal exchange rate against the U.S. dollar in either direction, the authorities will consult with Fund staff on the appropriate policy response.

### Program monitoring
- Review and monitoring arrangements:
  - Program subject to quarterly reviews with quarterly performance criteria as set out in the technical memorandum of understanding (TMU).
  - Completion of first two reviews scheduled for September 2009 and November 2009 will require observance of quantitative performance criteria for end-July 2009 and end-September 2009, respectively, as specified in Table 1.
  - First two reviews will also assess progress towards observance of the structural benchmarks specified in Table 2.

*Source: _cr09310 - 1.      The economic outlook for this year is challenging. Growth is projected to slow*

### 22.      The Government authorizes the IMF to publish this Letter of Intent and its

### _cr09310 - 22.      The Government authorizes the IMF to publish this Letter of Intent and its

### Quantitative Performance Criteria and Indicative Targets (Table 1)
- Net international Reserves (NIR) of the Central Bank of Sri Lanka (CBSL) (floor, cumulative change from the beginning of the year, in million US$) 1/ 2/ 3/: -1,385 -109 -13 -785
- Reserve money of the CBSL (ceiling, eop stock, in million rupees): 268,425 274,130 280,370 300,525 310,886
- Net domestic financing (NDF) of the central government from the banking system and the non-bank sector (ceiling, cumulative from the beginning of the year, in million rupees) 4/ 5/ 6/: 314,289 282,004 305,001 331,817 82,234

Continuous performance criteria:
- Contracting and guaranteeing of medium and long-term non-concessional external debt by the government (ceiling, cumulative from end-April 2009, in million US$): ... 1,750 1,750 1,750 1,750
- Accumulation of new external payment arrears (ceiling, eop, in million US$): 0 0 0 0 0

Indicative target:
- Overall balance of the Ceylon Petroleum Corporation and the Ceylon Electricity Board (floor, cumulative from the beginning of the year, in million rupees): -49,847 ...... -35,387 ...

Memorandum items (cumulative from the beginning of the year):
- External loans assumed under the program (in million rupees) 4/: 80,415 55,928 75,238 109,392 49,896
- External grants assumed under the program (in million rupees) 5/: 31,222 5,644 7,825 9,631 3,326
- External debt service assumed under the program (in million rupees) 6/: 109,268 72,994 89,735 136,841 42,146
- Privatization proceeds to the central government in connection with the sale of central government assets: 0 0 0 0 0
- Foreign program financing assumed under the program (cumulative, in million US$) 1/: 230 204 0 0 0
- Cumulative net change in the amount of foreign holdings of Treasury Bills and Treasury Bonds assumed under the program (cumulative, in million US$) 1/: -2 13 15 15 150
- Official external debt service assumed under the program (cumulative, in million US$) 2/: 80 24 46 58 88 837 200
- Repayment of foreign currency loan from the CBSL by the Bank of Ceylon and the People's Bank (cumulative, in million US$) 3/: 40 26 12 8 32 83 28 30

Adjustment rules referenced in Table 1:
- 7/: If the amount of privatization proceeds to the central government in connection with the sale of central government assets is higher/lower than assumed under the program, the cumulative ceiling on NDF of the central government will be adjusted downward/upward by the cumulative receipt/reimbursement of any privatization proceeds.
- 5/: If the amount of external grants is lower in rupee terms than assumed under the program, the cumulative ceiling on net domestic financing of the central government will be adjusted upward by the cumulative difference in external grants on the test date.
- 6/: If the amount of external debt service by the central government in rupee terms is higher/lower than assumed under the program, the ceiling on net domestic financing of the central government will be adjusted upward/downward by the cumulative difference in external debt service payments measured in rupees.
- 1/: If the amount of program financing and the cumulative net change in the amount of foreign holdings of Treasury Bills or Treasury Bonds is higher/lower in U.S. dollar terms than assumed under the program, the floor on NIR will be adjusted upward/downward by the cumulative differences on the test date.
- 2/: If the amount of official external debt service by the central government in U.S. dollars is higher/lower than assumed under the program, the floor on NIR will be adjusted downward/upward by the cumulative differences on the test date.
- 4/: If the amount of external loans is higher/lower in rupee terms than assumed under the program, the cumulative ceiling on net domestic financing of the central government will be adjusted downward/upward by the cumulative difference in external loans on the test date.
- 3/: The floor on NIR will be adjusted upwards by any repayments for the foreign currency loan from the CBSL by the Bank of Ceylon and the People's Bank in excess of the repayment schedule.

### Structural Benchmarks (Table 2)
- Recapitalization of Seylan Bank through a public share issuance. (Type: SB) Date: 9/30/2009
- A contingency plan for orderly workouts of problem banks and financial institutions will be developed by the CBSL. (SB) Date: 9/30/2009
- Approval by the Monetary Board of a revised Banking Act and other pertinent laws and legislations that: (i) improve the bank resolution framework that more clearly defines the provisions for acquisition, and roles of the conservator and liquidator; and (ii) strengthens the definition of large exposures and related parties to better capture all material risks. (SB) Date: 9/30/2009
- Submission by the tax review commission of an interim report, including on base broadening measures to be incorporated into the 2010 budget. (SB) Date: 10/15/2009
- Develop a plan to address outstanding debts between the CEB, CPC and state-owned banks. (SB) Date: 12/31/2009
- Submission to the parliament of a revised Finance Company Act which includes clarifying the legal authority of the CBSL in enforcing its regulations on all deposit taking finance companies. (SB) Date: 12/31/2009
- Issuance of prudential regulations and guidelines to credit card companies and payment service providers. (SB) Date: 12/31/2009
- Submission to parliament of the 2010 budget consistent with program targets. (SB) Date: 12/31/2009

### Actions Already Taken by the Government (Table 3)
- Removal of all import margin requirements.
- Amendments to the Nation Building Tax to raise the rate from 1 to 3 per cent.
- Amendments to the excise taxes on liquor, cigarette and other items.
- Finalization of the terms of reference of a tax commission to review tax policy.
- Harmonization of the penal rate for commercial bank borrowing from the CBSL with the reverse repo rate.
- Announcement of a recapitalization plan for Seylan Bank.

### Technical Memorandum of Understanding — Overview and Monitoring
- Purpose: Sets out a framework for monitoring Sri Lanka under the program supported by the Stand-By Arrangement (SBA), specifying performance criteria, indicative targets (including adjustors), monitoring procedures, and reporting requirements.
- Review schedule: The first review will take place on or after July 30, 2009, and the second review on or after September 30, 2009.

III. Fiscal targets — Net Domestic Financing (NDF)
- Definition: NDF = change in net credit to the central government by the domestic banking system + net change in holdings of treasury bills and other government securities by the domestic non-bank sector. Central government includes line ministries, departments, and other public institutions. Excludes CBSL, state-owned enterprise, parastatals and agencies that do not receive subventions from the central government.
- Composition (2008): NDF amounted to Rs. 314.3 billion; net borrowing from the domestic banking system Rs. 195.2 billion; net borrowing from the domestic non-bank sector Rs. 114.8 billion; net borrowing from other sources Rs. 4.2 billion.
- Adjustment rules reiterated:
  - External loans higher/lower in rupee terms → cumulative ceiling on NDF adjusted downward/upward by the cumulative difference in external loans in rupees.
  - External grants lower in rupee terms → cumulative ceiling on NDF adjusted upward by the cumulative difference in external grants in rupees up to a limit of Rs. 5 billion.
  - External debt service higher/lower in rupee terms → cumulative ceiling on NDF adjusted upward/downward by the cumulative difference in external debt service payments measured in rupees.
  - Privatization proceeds higher/lower → cumulative ceiling on NDF adjusted downward/upward by cumulative receipt/reimbursement of any privatization proceeds.

IV. Indicative target on CEB and CPC overall balance
- Measurement: Sum of overall profit or loss position of the Ceylon Electricity Board (CEB) and the Ceylon Petroleum Corporation (CPC) from operating income statements, measured above the line on an accrual basis.
- End-December 2008 level: Rs. -50 billion.

V. Monetary targets — Reserve Money of the CBSL
- Definition: Reserve money = currency in circulation (with banks and with the rest of the public) + financial institutions’ domestic currency deposits at the CBSL + deposits of specified government agencies (National Defence Fund A/C No. 4278; Buddha Sasana Fund A/C No. 4279; Road Maintenance Trust Fund A/C No. 4281).
- End-December 2008 level: Rs. 268.4 billion.
- Adjustments:
  - If any bank fails to meet its legal reserve requirement → ceiling on reserve money adjusted downward by the shortfall.
  - Changes in required reserve regulations will modify the reserve money ceiling according to the formula:
    BrBrrBM
    
    00
    where M denotes the change in reserve money, 0 r denotes the reserve requirement ratio prior to any change; 0 B denotes the reservable base in the period prior to any change; r is the change in the reserve requirement ratio; and B denotes the immediate change in the reservable base as a result of changes to its definition.

VI. External sector targets
- Performance Criterion on Net Official International Reserves (NIR)
  - Definition: NIR = (i) gross foreign assets minus liabilities of the CBSL and (ii) balance of State Treasury’s (DSTs) Special Dollar and Yen Revolving accounts, expressed at market values.
  - Components included in gross foreign assets: monetary gold; foreign exchange balances held outside Sri Lanka; foreign securities (market valued); foreign bills purchased and discounted; reserve position at the IMF and SDR holdings; Crown Agent’s credit balance.
  - Exclusions: participation in international financial institutions; holdings of nonconvertible currencies; precious metals other than monetary gold; claims on residents that are pledged, non-liquid, collateralized or encumbered; claims from derivative transactions.
  - Gross foreign liabilities: all foreign currency denominated liabilities of the CBSL to non-residents; use of Fund credit; Asian Clearing Union debit balance; commitments to sell foreign exchange from derivatives.
  - Includes DSTs’ Special Dollar and Yen Revolving accounts (foreign currency accounts held by the Treasury and managed by the CBSL).
  - End-December 2008 NIR: U.S. dollars 1,424.9 million.
  - Adjustors:
    - Foreign program financing and cumulative net change in foreign holdings of Treasury Bills/Bonds higher/lower in U.S. dollar terms → floor on NIR adjusted upward/downward by cumulative differences on the test date.
    - Official external debt service by the central government higher/lower in U.S. dollar terms → floor on NIR adjusted downward/upward by cumulative difference in official external debt service payments.
    - Any repayments for the foreign currency loan from the CBSL by the Bank of Ceylon’s and the People’s Bank in excess of the repayment schedule in Table 4 → floor on NIR adjusted upwards.
    - Increase in Sri Lanka’s SDR allocation from the IMF → floor on NIR adjusted upward. Sri Lanka’s SDR allocation at approval: SDR 70.868 million.

- Performance Criterion on contracting and guaranteeing medium and long-term non-concessional external debt
  - Scope: Continuous performance criterion for contracting and guaranteeing medium and long-term non-concessional external debt by the Government (central government and the CBSL).
  - Debt definition: Current liability under contractual arrangement requiring future payments of assets or services; forms include loans, suppliers credit, leases (present value at inception excluding operation/repair/maintenance payments). Arrears, penalties, and judicially awarded damages arising from failure to pay contractual obligations that constitute debt are included. Medium and long-term debt = maturity ≥ one year.
  - Exclusion: Purchases under the stand-by arrangement of the IMF.
  - Non-concessional borrowing: Grant element < 35 percent per SM/96/86 methodology. Discount rates = six-month and ten-year Commercial Interest Reference Rates (CIRRs) averages as computed by the Strategy and Policy Review Department of the IMF. Six-month CIRRs updated mid-February and mid-August; ten-year CIRRs updated mid-December. Six-month CIRRs used for loans with maturity < 15 years; ten-year CIRRs used for loans with maturity ≥ 15 years.

- Performance Criterion on External Payment Arrears
  - Continuous performance criterion: Nonaccumulation of external payment arrears on external debt contracted or guaranteed by the central government or the CBSL.
  - External payments arrears: External debt-service obligations (principal and interest) on debt as defined that have not been paid when due. Overdue debt and debt service obligations in dispute are not considered arrears for program monitoring.

### Data Reporting Requirements
- Reporting obligations: Sri Lanka shall provide the Fund, through reports at intervals or dates requested by the Fund, with information requested in connection with progress under the Memorandum of Economic and Financial Policies.
- Providers: All program monitoring data to be provided by the Ministry of Finance and the Central Bank of Sri Lanka (CBSL).
- Timeliness:
  - External and monetary targets data: furnished within no more than three weeks after the end of each month.
  - Fiscal targets: data in table 5 furnished within no more than five weeks after the end of each month; data in table 6 within no more than nine weeks after the end of each month.
  - Overall balance estimates for the CEB and CPC: available within four weeks.

*Document: Letter of Intent and Technical Memorandum of Understanding (Stand-By Arrangement) — Sri Lanka*

### 19.      For the purpose of monitoring the fiscal performance under the program, data will be

### _cr09310 - 19.      For the purpose of monitoring the fiscal performance under the program, data will be

### Monitoring frameworks and data formats
- For the purpose of monitoring the fiscal performance under the program, data will be provided in the format as shown in Tables 5 and 6.
- For the purpose of monitoring the monetary targets under the program, data will be provided in the format shown in Table 7.
- For the purpose of monitoring the external sector performance under the program, data will be provided in the format shown in Tables 8 and 9.

### Key tables and monitoring aggregates (as presented)
- Table 1. Sri Lanka: External Financing Assumptions (cumulative from the beginning of the year, in millions of U.S. dollars)
  - Sample figures shown: External loans 55,928.3; 75,238.2; 109,392.4; 49,896.0 (by quarter labels July September December March for 2010).
  - External grants 5,644.2; 7,825.1; 9,630.9; 3,326.4.
  - External debt service 72,993.9; 89,734.9; 136,841.0; 42,146.4.
- Table 2. Sri Lanka: Assumptions on Privatization Proceeds (cumulative from the beginning of the year, in millions of rupees)
  - Privatization proceeds 0.0; 0.0; 0.0; 0.0 (July September December March 2010).
- Table 3. Sri Lanka: External Financing Assumptions for NIR purposes (cumulative from the beginning of the year, in millions of rupees)
  - Program loans 0.0; 20.0; 40.0; 0.0.
  - Treasury Bills/Bonds 15.0; 15.0; 15.0; 0.0.
  - Official External debt service 445.6; 587.8; 836.5; 200.0.
- Table 4. Repayment Schedule for the Foreign Currency Loan from the CBSL by the Bank of Ceylon and the People's Bank (cumulative from the beginning of the year, in millions of U.S. dollars)
  - Repayments 261.0; 283.0; 283.0; 0.0 (July September December March 2010).
- Table 5. Sri Lanka: Summary of Central Government Operations 1/ (In millions of rupees)
  - Aggregates listed include: Total revenue; Tax revenue; Income taxes; Value added tax; Excise taxes; Nation Building Tax; Taxes on international trade; Other; Nontax revenue; Total expenditure and net lending; of which: Interest payments (Foreign, Commercial, Domestic); Overall balance of central Government (Excluding grants); Financing; Net domestic financing; Net external financing; Privatization.
  - Note: "1/ As agreed for the purpose of monitoring the program"
- Table 6. Sri Lanka: Central Government Expenditure 1/ (In millions of rupees)
  - Aggregates listed include: Total expenditure and net lending; Current expenditure; Civil service wages and salaries; Other civilian goods and services; Security related expenditure; Subsidies and transfers; Households (Of which: Samurdhi, Pensions, Fertilizer); Institutions, corporations, other government agencies; Interest payments (Foreign, Commercial, Domestic); Capital expenditure and net lending.
  - Note: "1/ As agreed for the purpose of monitoring the program"
- Table 7. Sri Lanka: Balance Sheet of the Central Bank 1/ (In millions of rupees)
  - Aggregates listed include: Net foreign assets; Foreign assets (Cash and balances abroad, Foreign securities, Claims on ACU, SDRs, IMF related assets, Receivables, Foreign currency reserve); Foreign liabilities (IMF and nonresident account, Liabilities to ACU); Net domestic assets (Claims on government: Advances, Treasury bills and bonds, Cash items in collection, Government deposits; Claims on commercial banks: Medium and long term, Short term; Other items net); Reserve money (Currency in circulation, Commercial bank deposits, Government agencies deposits).
  - Note: "1/ As agreed for the purpose of monitoring the program"
- Table 8. Sri Lanka: Summary of Central Bank Foreign Exchange Operations 1/ (In millions of USD)
  - Sections shown: 1. Total inflows (Loans: Program, IMF, Project (cash component only); Interest earnings, forex trading profits, cap gains; Purchases of foreign exchange; Change in balances in DST's A/Cs; Other inflows; Borrowing from SLDBs; Loans from FCBUs; Syndicated Loans; Commercial loans; Repayments of BOC and PB claims).
  - 2. Total outflows (Public Debt Service Payments: Amortization; Principal (foreign loans); Settlement SLDBs; Settlement FCBU; Settlement of syndicated loans; Interest; Foreign loans; Domestic foreign currency loans; Payments to the IMF/ change in valuation of liabilities; Foreign exchange sales to commercial banks; Foreign exchange deposits at BOC and PB).
  - 3. Net flow at current rates (1-2); Net International Reserves; Gross International Reserves; Cumulative net change in foreign holdings of Treasury Bills/Bonds.
  - Note: "1/ As agreed for the purpose of monitoring the program"
- Table 9. Sri Lanka: Estimated Gross Official Reserve Position (in US$ million) 1/
  - Complex layout including Central Bank and Government gross liabilities, Reserves managed by IOD, DST's positions, Official Reserves, Date/Position, Agent's accounts, Special Credit, Drawings from the I.M.F., and other reserve components.
  - Note: "1/ As agreed for the purpose of monitoring the program"

### Debt Sustainability Analysis: Overview and main findings
- Document: Debt Sustainability Analysis 2009 prepared by IMF and World Bank staff; approved July 17, 2009.
- Main conclusion: Sri Lanka has a moderate risk of external debt distress over the medium term under the program baseline scenario.
- This moderate risk rating assumes that external borrowing is more concessional than in recent years when the government built up a significant amount of short-term commercial debt.
- All debt indicators are projected to remain below indicative thresholds under the program baseline scenario.
- The conclusion depends heavily on satisfactory implementation of the program, especially fiscal consolidation measures.
- Domestic debt cost and roll-over risk significantly add to total public debt burden and call for a pro-active medium-term debt management strategy aiming to reduce costs and risks in the overall public debt portfolio.

### The debt portfolio: recent evolution and risks
- Public debt stock nearly doubled since 2000, driven mainly by financing persistent primary fiscal deficits.
- Recent reliance shifted toward domestic debt issuance, particularly in 2008 when international capital markets were largely closed.
- Robust GDP growth contributed to a decline in the debt-to-GDP ratio from a peak of 98 percent of GDP in 2005 to 87 percent in 2008.
- Factors explaining the falling debt burden in 2006-09 (Table 1):
  - Change in public sector debt: -3.5; -4.2; -4.2; 3.9 (for 2005-06, 2006-07, 2007-08, 2008-09 respectively).
  - Primary deficit: 2.2; 1.9; 2.3; 0.8.
  - Real GDP growth: -7.0; -6.0; -5.1; -2.5.
  - Real Interest Rate: -0.2; 0.0; 0.2; 4.5.
  - Real Exchange rate (+depreciation): -0.8; -4.0; -3.5; 2.5.
  - Residual: 2.3; 4.0; 1.9; -1.4.
- Structural shifts increasing costs and risks:
  - Shift from lower-cost external concessional borrowing to higher-cost domestic and non-concessional external borrowing.
  - Nominal domestic interest rates increased to almost 19 percent on T-bills and T-Bonds in 2008.
  - Domestic interest costs estimated to be over 26 percent of government expenditures in 2009.
  - More than 40 percent of domestic debt stock maturing in 2009, indicating significant roll-over risk.
  - Stock of U.S. dollar denominated domestic debt increased to about 10 percent of total portfolio, adding exchange rate risk.
- Public debt composition snapshots:
  - 2004 composition (In percent of total stock): External Concessional 45.4; Domestic T-Bonds 29.3; Domestic T-Bills 11.1; Domestic Other 9.1; Domestic $US 2.6; External Other 2.4.
  - 2008 composition (In percent of total stock): External Concessional 35.6; Domestic T-Bonds 35.8; Domestic T-Bills 11.3; Domestic Other 6.2; Domestic $US 9.2; External Other 1.9.

### Macroeconomic assumptions underpinning the DSA (baseline)
- Baseline builds on program scenario; external and fiscal adjustments close financing gaps during the program period.
- Growth:
  - Growth over 2008–2013 is projected at 5.3 percent.
  - Growth over 2014-2028 projected to remain slightly higher than the historical average.
- Exports:
  - Export growth projected at 2.9 percent in 2008-2013 (3.7 percentage points lower than 10-year historical average).
  - Exports projected to recover in 2014-2028 with higher growth than the 10-year historical average.
- Imports:
  - Oil imports projected to decline to an average growth of 4 percent during 2008-2013.
  - Non-oil imports projected at 3.2 percent in 2008-2013 and expected to grow at 11 percent over 2014-2028.
- External balances and reserves:
  - Current account deficit projected at average 2.7 of GDP during 2008–2013.
  - Foreign exchange reserves projected to increase over 3.7 months of import coverage by end 2010.
- External financing:
  - Assumptions consistent with the program: main sources over the medium term are multilateral and bilateral loans; commercial borrowing assumed to have dried out during the global financial crisis and projected to gradually increase after 2013 but remain manageable.
- Fiscal projections:
  - Revenues and grants projected to increase from around 14.9 percent of GDP in 2009 to around 16.7 percent of GDP by 2011.
  - Total primary expenditure declines in relation to GDP from 17 percent of GDP in 2008 to about 16 percent of GDP by 2010.
  - Primary deficit projected to decline from 2.3 percent of GDP in 2008 to a surplus 0.8 percent of GDP by 2011.
- Inflation:
  - Inflation expected to increase somewhat in 2010 reflecting growth recovery and exchange rate depreciation; medium- to long-term inflation expected to remain in single digits.
- Table of comparative indicators (Historical Average vs Baseline excerpts):
  - Real GDP growth: 2008-13 5.3; 2014-28 5.5; 1998-2007 5.0; 2003-07 6.4.
  - Current account deficit (percent of GDP): 2008-13 2.7; 2014-28 2.9; 1998-2007 2.9; 2003-07 3.1.
  - Growth of exports: 2008-13 2.9; 2014-28 10.0; 1998-2007 5.5; 2003-07 10.2.
  - Growth of oil imports: 2008-13 4.0; 2014-28 10.0; 1998-2007 21.1; 2003-07 26.6.
  - Growth of non-oil imports: 2008-13 3.2; 2014-28 11.0; 1998-2007 5.6; 2003-07 10.7.

### Public debt sustainability: baseline outcomes and risks
- Under baseline macroeconomic assumptions:
  - Public debt burden indicators projected to remain on a downward trend over the medium term.
  - Debt service to revenue ratio projected to remain manageable throughout the projection period, conditional on implementation of program revenue measures to raise revenue-to-GDP ratio.
- Sensitivity and stress tests:
  - Path of total public debt particularly sensitive to changes in fiscal adjustment assumptions and to a one-time depreciation of the exchange rate.
  - Biggest risks posed by failure to carry out the envisaged adjustment in the primary balance.
- Methodological note:
  - DSF template modified to include stock of short-term debt in total public debt to capture significant short-term public external and domestic debt; all charts and tables reflect this change.

### External debt sustainability: baseline outcomes and sensitivities
- All external debt burden indicators remain below indicative thresholds under the program baseline scenario (Tables I.3, I.4 and Figure I.2 as referenced).
- PV of external debt to exports, debt to GDP and debt to revenue ratios projected to remain close to indicative thresholds in 2009-2010 and decline thereafter.
- Grant element in external debt projected to decline rapidly from 2013 as commercial financing increases.
- Sensitivity analyses:
  - Slower export growth and further depreciation of the rupee could worsen debt and debt service ratios.
  - Debt-to-GDP and debt-to-revenue ratios particularly sensitive to exchange rate movements.
  - Debt service-to-revenue ratio most sensitive to exchange rate movements.
  - Debt service-to-exports ratio adversely affected by lower export growth.

### Policy implications and recommended actions (implicit in analysis)
- Effective implementation of fiscal consolidation and program measures is a precondition for fiscal sustainability.
- Pro-active medium-term debt management strategy is required to:
  - Reduce costs and risks in the overall public debt portfolio.
  - Shift away from short-term and higher-cost domestic and non-concessional external borrowing.
  - Extend domestic debt maturities (government adopted strategy to extend T-bill maturities from 3 month issues to one year maturities).
  - Limit reliance on commercial borrowing while restoring concessional financing where possible.

*Source: INTERNATIONAL MONETARY FUND — SRI LANKA: Debt Sustainability Analysis 2009 (IMF/World Bank staff text excerpt).*

### 10. Staff considers Sri Lanka to be at moderate risk of external debt distress over the

### _cr09310 - 10. Staff considers Sri Lanka to be at moderate risk of external debt distress over the

### Risk assessment and overall judgment
- Staff considers Sri Lanka to be at moderate risk of external debt distress over the period 2009–14.
- Debt dynamics are projected to return to a more sustainable path with credible fiscal consolidation to offset a decline in exports and unsettled global financial market conditions.
- Sensitivity analyses indicate that slower export growth and further sharp depreciation of the rupee could worsen debt and debt service ratios.
- Stress tests indicate that prolonged maintenance of an expansionary fiscal policy or a permanently lower GDP growth rate could pose risks to long-run fiscal sustainability.
- These considerations reinforce the need for the adoption of a more restrained fiscal stance over the medium term.

### Debt sustainability analysis (public sector) — selected indicators and trajectories
- Public sector debt (selected annual values, in percent of GDP): 98.4 (2005), 94.9 (2006), 90.7 (2007), 86.5 (2008), 90.5 (2009), 93.0 (2010), 88.2 (2011), 84.6 (2012), 80.5 (2013); projections include 54.9 (2018) and 23.7 (2028).
- Share foreign-currency denominated (percent of GDP): 42.9 (2005), 46.8 (2006), 43.8 (2007), 38.4 (2008), 39.4 (2009), 44.6 (2010), 42.3 (2011), 39.9 (2012), 38.0 (2013); projections include 24.4 (2018) and 10.4 (2028).
- Change in public sector debt (percent of GDP): 4.8 (2005), -3.5 (2006), -4.2 (2007), -4.2 (2008), 3.9 (2009), 2.5 (2010), -4.8 (2011), -3.6 (2012), -4.1 (2013); average projection -4.6 (2014–28 average) and -2.5 (2018).
- Identified debt-creating flows (percent of GDP): -6.4 (2005), -5.5 (2006), -8.2 (2007), -6.1 (2008), 5.4 (2009), 0.4 (2010), -4.3 (2011), -3.7 (2012), -2.8 (2013); projection -2.5 (2014–28 average) and -1.5 (2018).
- Primary deficit (percent of GDP): 2.5 (2005), 2.2 (2006), 1.9 (2007), 2.2 (2008), 1.0 (2009), 2.3 (2010), 0.8 (2011), 0.1 (2012), -0.9 (2013); projection -1.2 (2014–28 average) and -1.1 (2018).
- Revenues (inclusive of grants, percent of GDP): 16.6 (2005), 17.3 (2006), 16.6 (2007), 14.9 (2008), 15.0 (2009), 15.6 (2010), 16.2 (2011), 16.5 (2012), 16.9 (2013); projection 17.3 (2014–28 average) and 19.5 (2018).
- Primary (noninterest) expenditure (percent of GDP): 19.0 (2005), 19.5 (2006), 18.6 (2007), 17.2 (2008), 15.8 (2009), 15.7 (2010), 15.3 (2011), 15.3 (2012), 15.8 (2013); projection 16.9 (2014–28 average) and 19.1 (2018).
- Automatic debt dynamics contribution (percent of GDP): -10.2 (2005), -8.0 (2006), -10.1 (2007), -8.4 (2008), 4.5 (2009), 0.3 (2010), -3.4 (2011), -2.5 (2012), -1.6 (2013); projection -2.1 (2014–28 average) and -1.1 (2018).
- Gross financing need (percent of GDP): 42.1 (2005), 39.2 (2006), 36.4 (2007), 36.4 (2008), 34.7 (2009), 35.4 (2010), 31.0 (2011), 25.6 (2012), 23.9 (2013); projection 11.3 (2014–28 average) and 7.3 (2018).
- PV of public sector debt-to-revenue and grants ratio (percent): 334.6 (2005), 311.3 (2006), 528.1 (2007), 575.9 (2008), 595.7 (2009), 585.0 (2010), 538.7 (2011), 510.3 (2012), 479.7 (2013); projection 322.2 (2014–28 average) and 122.1 (2018).
- Debt service-to-revenue ratio (percent): 31.3 (2005), 29.4 (2006), 31.2 (2007), 38.1 (2008), 40.7 (2009), 37.2 (2010), 35.5 (2011), 32.5 (2012), 32.2 (2013); projection 23.2 (2014–28 average) and 8.4 (2018).

### External debt sustainability — selected indicators and trajectories
- External debt (nominal, percent of GDP): 53.3 (2005), 50.2 (2006), 51.5 (2007), 44.3 (2008), 43.9 (2009), 50.8 (2010), 48.4 (2011), 46.7 (2012), 45.3 (2013); projection 29.4 (2018) and 12.8 (2028).
- PPG external (percent of GDP): 51.8 (2005), 48.8 (2006), 49.8 (2007), 42.7 (2008), 43.2 (2009), 50.5 (2010), 48.3 (2011), 46.3 (2012), 44.8 (2013); projection 28.9 (2018) and 11.9 (2028).
- Change in external debt (percent of GDP): -8.6 (2005), -3.1 (2006), 1.3 (2007), -7.2 (2008), -0.4 (2009), 6.9 (2010), -2.4 (2011), -1.7 (2012), -1.3 (2013); projection -2.8 (2014–28 average) and -1.0 (2018).
- Identified net debt-creating flows (percent of GDP): -8.0 (2005), -3.6 (2006), -3.7 (2007), 5.1 (2008), -1.5 (2009), -2.2 (2010), -2.1 (2011), -2.2 (2012), -3.0 (2013); projection -0.1 (2014–28 average) and 2.7 (2018).
- Exports (percent of GDP): 32.5 (2005), 30.1 (2006), 29.1 (2007), 25.6 (2008), 22.4 (2009), 25.7 (2010), 25.2 (2011), 24.9 (2012), 24.6 (2013); projection 22.6 (2014–28 average) and 16.8 (2018).
- Net FDI (negative = inflow, percent of GDP): -1.0 (2005), -1.6 (2006), -1.7 (2007), -1.1 (2008), 0.3 (2009), -1.7 (2010), -1.4 (2011), -1.2 (2012), -1.3 (2013); projection -1.3 (2014–28 average) and -1.1 (2018).
- PV of PPG external debt (percent of GDP): values shown in tables imply elevated ratios through the projection horizon with improvements over time (selected projection: 37.6, 36.3, 35.4, 34.7 for intermediate years; 22.6 (2018) and 9.3 (2028) in specific projection rows).
- Debt service-to-exports ratio (percent): 7.4 (2005), 11.0 (2006), 13.0 (2007), 16.8 (2008), 20.2 (2009), 16.2 (2010), 17.6 (2011), 19.9 (2012), 17.6 (2013); projection 15.6 (2014–28 average) and 9.2 (2018).
- PPG debt service-to-revenue ratio (percent): 7.5 (2005), 12.9 (2006), 16.6 (2007), 24.1 (2008), 23.1 (2009), 21.2 (2010), 22.1 (2011), 25.5 (2012), 21.4 (2013); projection 15.7 (2014–28 average) and 5.8 (2018).
- Total gross financing need (billions of U.S. dollars): 5.4 (2005), 6.6 (2006), 7.2 (2007), 10.9 (2008), 9.7 (2009), 8.7 (2010), 7.8 (2011), 7.9 (2012), 7.1 (2013); projection 9.5 (2014–28 average) and 19.9 (2018) in memorandum entries.

### Key macroeconomic and fiscal assumptions (selected)
- Real GDP growth (percent): 6.2 (2005), 7.7 (2006), 6.8 (2007), 5.0 (2008), 2.5 (2009), 6.0 (2010), 3.0 (2011), 5.0 (2012), 6.5 (2013); projection averages include 6.0, 5.5, 5.3, and baseline projection 5.0 (2014–28 average).
- Average nominal interest rate on forex debt (percent): 1.2 (2005), 2.3 (2006), 2.5 (2007), 2.3 (2008), 0.6 (2009), 4.2 (2010), 3.9 (2011), 3.9 (2012), 3.9 (2013); projection 4.1 (2014–28 average), 4.4 (2018).
- Average real interest rate on forex debt (percent): 1.4 (2005), 3.6 (2006), 6.6 (2007), 12.8 (2008), 7.3 (2009), -0.7 (2010), 14.9 (2011), 28.9 (2012), 11.4 (2013); projections include 10.9, 10.4, 12.6, with later averages 4.5, 2.6, 3.2 in selected rows.
- Change in GDP deflator (percent): 11.2 (2005), 7.6 (2006), 7.1 (2007), 2.6 (2008), 5.1 (2009), 15.5 (2010), 1.3 (2011), -11.6 (2012), 1.4 (2013); projection 1.3 (2014–28 average), 1.7 and 1.6 in other projection entries.
- Growth of exports of G&S (US dollar terms, percent): 8.9 (2005), 7.3 (2006), 10.7 (2007), 5.7 (2008), 7.1 (2009), 7.7 (2010), -8.7 (2011), 6.6 (2012), 5.6 (2013); projection 6.0 (2014–28 average), 6.2, 3.9, 9.5 in different rows.
- Grant element of new public sector borrowing (percent): reported for projection years as 20.8, 25.7, 23.7, 22.7, 12.9, 13.2, 19.8, 14.9, 14.9 in selected projection rows.

### Sensitivity analyses, stress tests, and alternative scenarios
- Sensitivity tables show alternative scenarios and bound tests for key indicators (PV of debt-to-GDP ratio, PV of debt-to-revenue ratio, debt service-to-revenue ratio) under:
  - A1. Real GDP growth and primary balance at historical averages.
  - A2. Primary balance unchanged from 2008.
  - A3. Permanently lower GDP growth (assumes real GDP growth is at baseline minus one standard deviation divided by the length of the projection period).
  - Bound tests B1–B5 (real GDP growth lower, primary balance lower, combinations, one-time 30 percent real depreciation in 2009, 10 percent of GDP increase in other debt-creating flows in 2009).
- The most extreme stress test in various figures corresponds to different shocks (e.g., One-time depreciation shock, Terms of trade shock, Non-debt flows shock) and is defined as the test yielding the highest ratio in 2018.
- Specific bound test outcomes include, for example, one-time 30 percent real depreciation in 2009 producing large increases in PV and debt service ratios in the tables and figures.

### Policy implications and recommendations
- Adopt a more restrained fiscal stance over the medium term to contain risks from slower export growth, exchange rate depreciation, and prolonged expansionary fiscal policy.
- Ensure credible fiscal consolidation to help return debt dynamics to a sustainable path.
- Monitor external vulnerabilities closely given sensitivity of debt indicators to export performance and exchange rate movements.

*Prepared by the Finance and Strategy, Policy, and Review Departments. Approved by Andrew Tweedie and Dominique Desruelle. July 20, 2009.*

### 1.      This note assesses the risks to the Fund arising from the proposed Stand-By

### Risks to the Fund Arising from the Proposed Stand-By Arrangement for Sri Lanka

### Background
- Authorities request a 20-month SBA with access of SDR 1,653.6 million (400 percent of quota).
- Arrangement phasing (flat purchase schedule): first purchase of SDR 206.7 million (50 percent of quota) upon approval, followed by seven purchases; access during the first year would reach about 250 percent of quota and the last purchase would be available in March 2011.
- Table of proposed SBA—Access and Phasing (availability date / SDR mn / Purchase / Cumulative):
  - 2009 July (approval) / 206.7 / 50.0 / 50.0
  - 2009 September / 206.7 / 50.0 / 100.0
  - 2009 November / 206.7 / 50.0 / 150.0
  - 2010 February / 206.7 / 50.0 / 200.0
  - 2010 May / 206.7 / 50.0 / 250.0
  - 2010 August / 206.7 / 50.0 / 300.0
  - 2010 November / 206.7 / 50.0 / 350.0
  - 2011 March / 206.7 / 50.0 / 400.0
  - Total / 1,653.6 / 400.0 / 400.0
- As of end-May 2009, Fund credit outstanding to Sri Lanka under the GRA is about SDR 60.3 million (or 15 percent of quota), and under the PRGF is about SDR 30.7 million (or 7 percent of quota). All obligations to the Fund have been met in a timely manner.

### Sri Lanka’s Debt Profile and Comparators
- At end-2008, total external debt stood at 44.2 percent of GDP; public sector accounted for almost three-quarters of total external debt.
- Private sector external debt: 11.5 percent of GDP in 2008, mainly short-term.
- Public external debt as a ratio of GDP is higher than that in several recent exceptional access cases though not among the highest.
- Public debt: declined from about 102 percent of GDP in 2004 to about 81 percent at end-2008; public sector external debt declined by about 10 percentage points of GDP to 32.7 percent in 2008.

### The New Stand-By Arrangement — Risks to the Fund
- Access under proposed arrangement would be higher than previous GRA arrangements for Sri Lanka and would surpass the annual access limit.
- Projected GRA credit outstanding if all purchases made as scheduled:
  - Rise to about 61 percent of quota upon approval.
  - Rise to 251 percent of quota during the first year of the arrangement.
  - Peak at about 401 percent of quota in March 2011.
- In SDR terms, projected peak GRA exposure of SDR 1,659 million would be almost four times higher than Sri Lanka’s previous peak in Fund credit outstanding (early 1980s), but lower than in a number of recent exceptional access cases.
- If all purchases are made, GRA credit outstanding to Sri Lanka would be equivalent to 6.5 percent of GDP and about 60 percent of gross international reserves by 2011.
- Debt service to the Fund (assuming all repurchases made as scheduled):
  - Projected to peak at about SDR 762 million in 2014.
  - Debt service to the Fund would be about 78 percent of total public external debt service in the peak year.
  - Peak debt service to the Fund as a share of exports of goods and services, at about 8.3 percent, would be among the highest recent exceptional access cases.
- Surcharges: level-based surcharges calculated according to current schedule: 100 basis points for credit outstanding over 200 percent of quota and 200 basis points for credit outstanding above 300 percent of quota; new system of surcharges applying to credit outstanding above 300 percent of quota to go into effect on August 1, 2009, subject to grandfathering at the member’s request.

### The New Stand-By Arrangement — Impact on the Fund’s Liquidity and Risk Exposure
- Overall impact on Fund liquidity and credit risk exposure characterized as relatively modest.
- One-year Forward Commitment Capacity (FCC) currently stands at SDR 91,534.1 million; commitments under the proposed arrangement would reduce the FCC by about SDR 1,653.6 million (about 2 percent).
- After the first purchase, Fund credit to Sri Lanka would represent 0.9 percent of total GRA Fund credit (Sri Lanka as one of the smaller users of Fund resources).
- Share of the top five users of Fund resources of total outstanding credit would decrease to about 83.1 percent.
- Charges on GRA obligations for Sri Lanka would equal about SDR 4.4 million in 2009, about 14.8 percent of the current estimated residual burden-sharing capacity.
- Potential GRA exposure to Sri Lanka would be small relative to the Fund’s precautionary balances:
  - After the first purchase, Fund GRA credit outstanding to Sri Lanka would be 2.9 percent of the Fund’s current precautionary balances.
  - Total access amounts to about 23.3 percent of current precautionary balances.
- Burden-sharing mechanism: the Fund’s mechanism would be able to handle arrears on charges accruing to Sri Lanka’s GRA obligations; the mechanism relies on a floor for remuneration at 85 percent of the SDR interest rate and no corresponding ceiling on the rate of charge.

### Capacity to Repay Indicators (selected figures from Table 4, assuming full drawings and repurchases on obligations schedule)
- GRA credit to Sri Lanka (SDR millions): Jul-09: 206.7; 2009: 206.7; 2010: 639.9; 2011: 1,452.1; 2012: 1,658.8; 2013: 1,603.7; 2014: 1,136.9; 2015: 387.6; 2015: 25.8 (table lists sequence—preserve exact entries).
- In percent of quota (corresponding): (50.0), (50.0), (154.8), (351.3), (401.3), (387.9), (275.0), (93.7), (6.3).
- Charges due on GRA credit (SDR millions): 4.4; 16.1; 28.9; 30.9; 25.3; 12.4; 3.5.
- Debt service due on GRA credit (SDR millions): 32.0; 30.7; 28.9; 86.0; 492.1; 761.7; 365.3.
- Selected ratios (in percent of GDP): GRA credit to Sri Lanka: 0.8 (Jul-09), 2.5 (2009), 6.1 (2010), 6.5 (2011), 5.9 (2012), 3.9 (2013), 1.2 (2014), 0.1 (2015).
- Debt service due on GRA credit (in percent of exports of goods and services): 0.5; 0.5; 0.4; 1.2; 6.4; 8.3; 3.7.
- GRA credit to Sri Lanka (percent of total external debt): 1.8; 5.3; 11.2; 12.4; 11.8; 8.4; 2.9; 0.2.
- Debt service due on GRA credit (percent of total external debt service): 3.0; 3.7; 2.9; 7.0; 53.5; 56.3; 26.9.
- GRA credit to Sri Lanka (percent of total public external debt): 2.5; 7.1; 14.5; 15.9; 15.4; 11.3; 4.0; 0.3.
- Debt service due on GRA credit (percent of total public external debt service): 3.8; 4.4; 3.3; 7.5; 58.5; 78.1; 29.1.

*Source: Sri Lankan authorities, Finance Department, World Economic Outlook, and IMF staff estimates.*

### 8.      The proposed Fund-supported program with Sri Lanka intends to support the

### 8.      The proposed Fund-supported program with Sri Lanka intends to support the

### Program objectives and design
- Provide immediate relief to Sri Lanka’s acute short-term balance of payments pressures through proposed access.
- Support authorities’ program of fiscal retrenchment while ensuring availability of resources for reconstruction spending, greater exchange rate flexibility, financial sector reform, and social protection.
- Smooth the necessary adjustment to the external shock that has hit the economy.

### Financial access and timing (Press Release highlights)
- IMF Executive Board approved a 20-month Stand-By Arrangement in an amount equivalent to SDR 1.65 billion (about US$2.6 billion).
- Upon approval, an amount equivalent to SDR 206.7 million (about US$322.2 million) becomes immediately available.
- The remaining amount will be phased in, subject to quarterly reviews.
- Total IMF resources made available under the arrangement equals 400 percent of the country’s quota.

### Key program aims (Press Release and Program Summary)
- Strengthen the country’s fiscal position while ensuring resources for post-conflict reconstruction and relief efforts.
- Rebuild international reserves and strengthen Sri Lanka’s domestic financial system.
- Protect the most vulnerable from the burden of needed economic adjustment.
- Lay a macroeconomic foundation to approach the broader international community for financial support in post-conflict reconstruction.

### Risks to program success and repayment capacity
- Required depreciation to meet reserve targets over the next several months could exceed what the government might consider politically acceptable if market conditions worsen.
- Critical importance that fiscal adjustment be sustained: implement difficult measures now to offset the decline in revenues and to reign in spending to achieve the targeted deficit this year.
- Financial sector weaknesses likely to increase as the economy slows, particularly if Sri Lanka’s trading partners experience a more rapid growth slowdown than currently expected.
- A sudden withdrawal of non-resident foreign exchange deposits from the banking sector, although unlikely at this point, would put pressure on reserves and could jeopardize the program’s reserve targets.
- Overall financial risks associated with the proposed arrangement are considerable, though the comparatively small scale of access in absolute terms would contain potential adverse impact on the Fund’s finances.
- Fund exposure in terms of the stock of reserves and debt service to the Fund as a share of total external debt service will peak at levels higher than those in many recent exceptional access cases.
- Authorities’ commitment to firmly implement the program and Sri Lanka’s track record of servicing external obligations provide comfort that financial obligations to the Fund will be met in a timely manner.

### Recent economic developments (Annex)
- Global crisis impact:
  - Growth deteriorated to around 3 percent expected in 2009 compared to 6 percent in 2008.
  - Economic slowdown has put stress on the financial sector.
- External official reserves:
  - Reserves rose to US$ 3.6 billion in July 2008 (all time high).
  - Reserves dropped by more than 65.0 percent from US$ 3.2 billion in September 2008 to US$ 1.1 billion by end-Q1 2009.
  - Since March 2009 CBSL has purchased US$ 704 million from the market; gross official reserves of CBSL have improved by 48.0 percent.
- Trade and current account:
  - Exports dropped by 18.9 percent and imports dropped by 38.0 percent during the first five months of 2009.
  - Trade deficit contracted by 61.9 percent during the first five months of 2009 as compared to the corresponding period of 2008.
  - Private remittances surged to US$ 1,309 million during the first five months of 2009 compared to US$ 1,272 million during the same period of 2008.
  - Current account deficit expected to narrow to 1.2 percent of GDP in 2009 from 9.3 percent in 2008.
  - External debt and liabilities as a percentage of GDP expected to decline to 43.5 percent in 2009 compared to 51.0 percent in 2007 and 43.7 percent in 2008.

### Program fiscal framework and measures
- Fiscal targets:
  - Reduce central government budget deficit to 5 percent of GDP by 2011, from a target of 7 percent of GDP this year, in line with the Fiscal Responsibility Act.
  - Medium term targets supported by at least 2.0 percent additional growth in tax revenue and rationalization of expenditures.
- Revenue measures and tax policy:
  - Revenue performance projected at 14.8 per cent of GDP for 2009.
  - Measures implemented include upward revision of the Nation Building Tax from 1.0 to 3.0 percent, and raising excise taxes on liquor, cigarettes and several other consumer items.
  - Decision not to extend tax holidays granted under BOI Act at their expiry and limit such holidays in future to only 3 years.
  - Tax Commission formed to review taxation policies; an interim report due in mid October 2009 to inform the 2010 Budget.
- Expenditure rationalization:
  - Cuts in military and other expenditures to make room for post-conflict reconstruction and relief spendings.
  - Directive issued to all government institutions to maintain strict controls on expenditure.
- Debt and interest costs:
  - Public debt to GDP ratio dropped from 102.3 percent in 2004 to 81.1 percent in 2008.
  - Sharp decline in yield rates of government securities from about 17.0 percent early in the year to around 11.0 percent in July will result in significant reduction in interest cost of public debt.

### Monetary, exchange rate, and financial sector policies
- Monetary policy:
  - CBSL pursued tight stance through quantity targeting and limits on access to CBSL credit; subsequently eased policy as inflation declined.
  - Statutory reserve ratio reduced from 10.0 percent in October 2008 to 7.0 percent in February 2009.
  - Overnight call market rates have fallen and remain within the policy rate corridor of 8.5 percent and 11.0 percent.
  - Yield rates of Treasury Bills and Bonds have shown a marked decline in the range of 630 – 680 basis points so far during the year.
  - “Road Map - Monetary and Financial Sector Policies for 2009 and Beyond” aims to control inflation while ensuring adequate credit to the private sector.
- Exchange rate policy:
  - CBSL has allowed greater flexibility in the exchange rate and has not engaged in sale of foreign currency in the market since late March 2009.
  - CBSL states its intervention has not made the exchange rate overvalued and that intervention prevented a sharp appreciation earlier in 2008.
  - Without CBSL action since April 2009, exchange rate would have appreciated sharply by now (authorities’ view).
  - CBSL removed margin requirements on importation of certain vehicle categories and selected consumer goods to facilitate more exchange rate flexibility.
- Financial system measures:
  - Government implemented a plan to recapitalize the troubled Seylan Bank.
  - Authorities intend to develop a contingency plan to deal with potential stresses in the financial system and to improve regulation and supervise gaps.
  - Program includes measures to strengthen the banking system by improving regulatory framework and enhancing bank supervision.

### Social protection and reconstruction financing
- Social protection objectives:
  - Protect expenditures on social transfers to the country’s most vulnerable (with 15 percent of the population living below the poverty line).
  - Secure spending on post-conflict humanitarian assistance through savings from expenditure cuts and external financing and grants from multilateral institutions and the donor community.
- Reconstruction priorities:
  - Early resettlement of the internally displaced is the topmost priority.
  - Savings on military spending and possible concessional donor financing should help finance reconstruction spending needs.

### Authorities’ statements and outlook
- Growth and expectations:
  - Real GDP growth rate averaged around 6.5 per cent during 2004 - 2008.
  - Growth rate for Q1 2009 dropped to 1.5 per cent.
  - Real GDP growth projected to decelerate to 3.0 percent in 2009 (authorities’ statement).
  - Authorities confident growth will bounce back in 2010 and return to high growth trajectory in 2011 as external conditions improve.
- Fiscal commitment:
  - Government committed to fiscal consolidation with fiscal deficit targeted at around 5.0 percent of GDP in 2011.
  - Emphasis on reconstruction, development efforts, and social safety nets for vulnerable groups.

*IMF Executive Board press release and annex material contained in the provided content unit.*

### 13. Following a large outflow of capital in 2008 and in the first  four months of 2009, Sri

### _cr09310 - 13. Following a large outflow of capital in 2008 and in the first  four months of 2009, Sri

### Capital flows, financial markets, and investor sentiment
- Following a large outflow of capital in 2008 and in the first four months of 2009, Sri Lanka is now experiencing significant inflows.
- Inflows driven by:
  - growing private remittances;
  - increased foreign investment in domestic currency denominated government securities and debt.
- Foreign investors have purchased Sri Lanka government securities amounting to US$220 million since mid-May to mid-July 2009.
- Equity market move:
  - The all-share price index of the Colombo Stock Exchange has risen by 59.3 percent from 1503.0 by end December 2008 to 2395 on July 17, 2009, mainly on account of growing investor confidence.

### Financial sector soundness and regulatory framework
- Banking system strength and indicators:
  - Sri Lanka has a strong and resilient banking system as manifested in impressive financial soundness indicators - high capital adequacy ratios, relatively low non-performing loan (NPL) ratios and healthy profitability ratios - though they have deteriorated marginally in 2008 compared to 2007.
- Regulatory measures implemented:
  - Implementation of Basel II and a mandatory Direction on Corporate Governance.
  - Revised direction on loan classification, provisioning and income recognition including a general provision of one percent on all outstanding performing loans.
  - Limits on share ownership and maximum amount of accommodation.
- Proposed and planned supervisory enhancements:
  - Amend the Banking Act.
  - Issue guidelines on integrated risk management of banks.
- Crisis management and targeted support:
  - Swift action by the CBSL ensured the stability of a systemically important licensed bank affected by failure of an unregulated credit card company in a large financial conglomerate.
  - The CBSL will continue to implement the eight-point stimulus package for finance and leasing companies with the objective of avoiding spillovers to healthy financial institutions.

### Post-conflict reconstruction and development of the Northern Province
- Humanitarian response and resettlement:
  - Since the full liberation of the terrorist controlled areas in the Northern Province and end of conflict in May 2009, authorities prioritized humanitarian assistance to nearly 300,000 Internally Displaced Persons (IDPs) and developed a post conflict reconstruction and development plan.
  - Experience from Eastern Province (liberated late 2007) informs the strategy for the Northern Province; Eastern Province progress includes near completion of de-mining, rapid completion of roads and bridges, electricity, water supply and drainage projects, promotion of cottage industries, restoration of agriculture (paddy, maize, vegetables), fisheries and livestock, and resettlement of almost all IDPs.
- Institutional arrangements:
  - A Presidential Task Force (in terms of Article 33 (f) of the constitution of Sri Lanka) and a Consultative Committee on Humanitarian Assistance consisting of members of the international community were constituted immediately after the war ended in May 2009.
  - The Task Force is entrusted with formation and implementation of the post war reconstruction plan for the Northern Province.
- Programme pillars and targets:
  - Programme based on (a) De-militarization; (b) Development; (c) Democratization and (d) Devolution.
  - The Task Force has declared a timeframe of 180 days to accomplish assigned tasks and is expected to resettle at least 80 percent of the IDPs during this period.
  - De-mining and sanitization are prerequisites for resettlement and are being done by the military with assistance of local and international NGOs.
  - Significant progress has been made on de-militarization and restoration of law and order; resettlement and provision of basic needs (food, water, healthcare, sanitation, education, counseling, welfare for displaced children and disabled, legal and other services) are being ensured.
- Democratization and elections:
  - Under “Democratization” civil administration is expected to be re-established soon.
  - Elections to main local government institutions will be held on August 8, 2009.
  - Elections to other local authorities and the Northern Provincial Council will be held as soon as the de-militarization programme comes to an end.
- Reconstruction financing and project timeline:
  - Reconstruction activities are funded through Rs.18.0 billion (US $ 157 million) set aside in the 2009 Budget and donor assistance.
  - Authorities expect enhanced funding from multilateral agencies such as the World Bank, Asian Development Bank and other development partners for medium to long-term infrastructure projects (power generation and distribution, water supply, railways and road network, construction of schools and hospitals).
  - The government has identified major projects and is hoping to complete most of the work during the next 2-3 years with a major part of infrastructure development programme to take place in 2010 and 2001.

### Program support, IMF engagement, and outlook
- Authorities’ stance and expected impact:
  - Sri Lankan authorities have a clear understanding of the goals and sequencing of the Fund programme.
  - The proposed SBA with the IMF will boost investor confidence and help the country pass through this challenging period towards successful implementation of reconstruction and development programmes in the war torn areas, while also making progress in development programmes in the rest of the country.
  - Authorities are fully committed to implementation of the programme in all aspects.
  - Authorities are confident that with the support of the Fund, the economy of Sri Lanka will return to its trajectory of high growth with stability by the end of the programme.

*Source: _cr09310 - 13. Following a large outflow of capital in 2008 and in the first  four months of 2009, Sri*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2009/_cr09310.pdf_