## _cr13120

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### Context and recent developments
- Growth broadly robust since mid-2009 but slowed recently; fiscal consolidation occurred; poverty and inequality declined.
- Key weaknesses:
  - Revenue growth did not respond as envisaged to a first round of tax reforms, undermining capital investment plans.
  - State-owned enterprises remain prone to large losses despite recent price adjustments.
  - Current account deficit elevated and financed mainly through debt-creating flows.
- Policy environment and objectives:
  - President’s second five-year plan aims to raise per capita incomes by a third to US$4,000 in 2016 with real growth of 8 percent per annum.
  - Priorities: second generation of tax reform; re-orient monetary policy toward low and stable inflation under exchange rate flexibility; broaden financial stability frameworks and deepen markets; address structural impediments to trade and private sector growth.
- Response to past advice:
  - Implemented fiscal consolidation, first-round tax reforms, expenditure containment (including reduced defense spending share of GDP).
  - Shortfalls: pace and quality of fiscal adjustment fell short; tax rate reductions generally took precedence over base broadening; cost-recovery pricing at state-owned energy companies yet to emerge; exchange rate allowed greater flexibility after a delay.
  - Financial sector: stronger bank supervision and regulation; deposit insurance introduced; pension regulation frameworks not addressed; investment regime improved but exemptions remain prevalent.

### Macroeconomic performance (recent)
- Growth and inflation:
  - Real GDP growth slowed to 6.4 percent in 2012.
  - Headline inflation hovered near double digits for most of 2012, easing to 7½ percent year-on-year in March 2013.
  - Core inflation trended upward; inflation expectations and private sector wage demands have risen.
- Fiscal developments:
  - 2012 budget deficit estimated to have fallen to about 6½ percent of GDP (above the budget’s 6¼ percent target) due to expenditure restraint and payment arrears.
  - Revenues significantly lower than budgeted partly reflecting new tax exemptions, lower imports undermining VAT, and weaker-than-expected income taxes.
  - Losses at CEB and CPC rose to around 2 percent of GDP in 2012 despite significant domestic price increases (drought-induced shift from hydroelectric to thermal generation).
- Monetary and external:
  - Credit ceiling allowed to expire; policy rate corridor reduced by 25 basis points in early-December to 7½–9½ percent.
  - Overnight interest rates fell by about 100 basis points as call money rates were guided to the middle of the corridor.
  - Treasury bill and bond rates declined further due to expectations of easing and healthy foreign demand.
  - Current account deficit declined to around 6½ percent of GDP in 2012 as falling imports more than offset falling exports; tourism and remittances remained robust.
  - FDI less than half of authorities’ expectations.
  - Gross official international reserves reached around US$6¾ billion (3½ months of imports) in early 2013.
- Financial sector soundness:
  - System-wide capital adequacy ratio declined by 1 percentage point from a year ago to 15 percent in December 2012 (above 10 percent regulatory minimum).
  - Profitability and liquidity robust; gross NPLs eased slightly to 3½ percent of total loans.
  - FSAP stress tests indicated credit risks warrant scrutiny.

### Outlook and risks
- Staff projections and baseline:
  - Growth projected at around 6¼ percent in 2013.
  - Moderately contractionary budget, lagged impact of tight monetary conditions and real wage compression should restrain domestic demand.
  - Recent monetary policy easing should support growth toward the end of the year.
  - Under staff baseline, external and public debt dynamics are sustainable but sensitive to current account outlook and contingent liability shocks.
  - Output gap: an excess supply gap would open with below-potential growth in 2013, helping reduce inflation pressures and the current account deficit.
- Authorities’ view:
  - Authorities expect growth of 7½ percent in 2013; expect inflation falling to mid-single digits toward end-2013.
- Key downside risks:
  - Continued tax revenue weakness → larger-than-expected budget deficit.
  - Euro area policy slippage, protracted slow European growth, or U.S. fiscal shock.
  - Emerging markets capital flow reversal, weaker FDI or remittances → pressure on reserves.
  - Inflation pressures broadening if expectations rise.
  - Global oil shock → higher SOE losses, higher inflation, weaker growth.
  - Deterioration in banks' asset quality after rapid credit growth.
- Policy responses recommended in Risk Assessment Matrix (selected):
  - Tighten monetary policy if inflation pressures broaden.
  - Adjust domestic energy prices, allow exchange rate flexibility, monitor impact on core inflation and bank asset quality in case of global oil shock.
  - Intensify risk-focused supervision and enforce prudential regulations if banks’ asset quality deteriorates.
  - Accelerate revenue administration reforms, broaden tax base, and curtail non-essential spending if fiscal space tightens.

### Growth inclusiveness and poverty reduction (Box 1 — key findings)
- Growth since mid-2009 broadly shared across the country; poorer provinces, particularly Northern province, experienced relatively stronger overall growth after end of civil conflict.
- National poverty headcount ratio fell to just below 9 percent in 2010 from over 15 percent in 2006/07.
- Poverty rates declined across most provinces; inequality declined (Gini coefficients by province reported for 2006/07 and 2009/10).
- Less-developed provinces did not consistently exhibit higher elasticities of poverty reduction; elasticity of poverty reduction during 2007–10 strongest in Western province.
- Policy implications to support inclusive growth and poverty reduction:
  - Contain inflation.
  - Expand infrastructure.
  - Improve access to health and education services.
  - Improve investment environment to support private sector growth.

### Potential growth (Box 2 — key findings)
- Staff estimates: potential output growth about 6¾ percent in the near term.
- Potential growth rose by almost 1 percentage point in recent years compared to 2003–08, reflecting capital deepening and improved factor productivity; labor’s contribution broadly unchanged.
- TFP accounted for about half of Sri Lanka’s growth over the last decade, contributing on average 3¼ percentage points per year, rising to about 3½ percentage points recently.
- Opening Eastern and Northern provinces likely raised overall real GDP growth by an average of about ¼ of a percentage point per year during 2010–11.
- Summary of potential growth estimates:
  - Potential growth (average of estimates): 6.8
  - Univariate filters: Hodrick and Prescott 6.8, Baxter and King 6.5, Christiano and Fitzgerald 6.5
  - Structural models: Multivariate filter (Benes, 2010) 7.0, Production function (Duma, 2007) 6.8
  - Memorandum: Average GDP growth (2002–12) 6.4
- Cyclical assessment:
  - Excess demand emerged in 2010–11 driven by private consumption; investments’ contribution rose to just over 3 percent of GDP from an average of 2½ percent during 2004–08.
  - Output gap estimates suggest output gap should close around end-2012; excess supply gap would open with below-potential growth in 2013.

### Fiscal position and revenue performance
- Fiscal consolidation priority: public debt around 80 percent of GDP and over 600 percent of tax revenues.
- 2013 budget targets 5.8 percent of GDP deficit—the lowest since 1977—as an appropriately contractionary stance to moderate inflation and strengthen external position.
- Deficit reduction relies on constraining expenditure growth to offset weak revenues.
- Tax revenue-to-GDP ratio estimated to have fallen to just over 11 percent in 2012.
- Public investment low compared to countries with sustained high growth; fiscal consolidation amid revenue weakness reduced investment plans.
- Tax holidays and concessions have not delivered expected FDI increases.
- Quantified changes and performance:
  - Cyclically adjusted deficit fell from 9.5 percent of GDP in 2009 to a projected 6.6 percent in 2012.
  - Tax revenues have been declining as percent of GDP by about 1½ percentage points, creating headwinds to deficit reduction.
  - 2013 budget measures (extension of VAT to large retailers and regime simplification) estimated to yield only about half a percent of GDP in new revenue, short of the budget’s target.
  - Broadening the VAT base and increasing its efficiency could raise an additional 2 percentage points of GDP in revenue above baseline scenario.
  - Authorities targeted 2013 deficit of 5.8 percent of GDP and aim to reduce it below 5 percent in medium term, with aim to reduce public debt to around 60 percent of GDP.
  - Given lower-than-expected tax revenues in 2012, the budgeted revenue increase in 2013 is acknowledged as likely out of reach.

### Staff tax reform recommendations (paragraph 17)
- To broaden the base:
  - Further expand VAT coverage of the wholesale and retail sectors, with long-term objective of repealing the Nation Building Tax.
  - Value all existing tax holidays and exemptions, then rationalize costly or ineffective ones, or convert them to accelerated depreciation or investment tax credits linked to investment amounts.
  - Introduce a single and simplified small taxpayer regime for businesses under the VAT threshold.
- To simplify system and strengthen administration:
  - Implement a comprehensive risk-based VAT refund management system to replace existing procedure.
  - Streamline and restructure Inland Revenue Department along functional lines.
  - Strengthen the Large Taxpayer Unit.
  - Improve audits and compliance risk management.

### Authorities’ stance on fiscal measures (paragraphs 18–19)
- Authorities committed to keep 2013 deficit at 5.8 percent of GDP and to reduce it below 5 percent in the medium term.
- Determined to meet deficit target by reducing expenditure; with less scope for lowering current spending, capital spending would be the focus of reductions.
- Authorities agreed higher tax revenues are key to medium-term consolidation but were not prepared to take revenue measures in 2013 beyond budget announcements; any new measures could be implemented in 2014 at earliest.
- Authorities indicated refinement of VAT coverage of wholesale and retail sectors under consideration and acknowledged need to monitor and reassess VAT refund system modalities.

### Public Financial Management (PFM)
- Core PFM processes fairly robust; more advanced practices appropriate for middle-income status.
- Recommended reforms (roadmap with IMF TA):
  - Build on progress in updating legal and regulatory framework.
  - Improve budget preparation, including medium-term rolling budget framework.
  - Strengthen budget execution, including recording/reporting of commitments and arrears, oversight/monitoring of public enterprises, and more efficient cash management.
- Authorities developing oversight and reporting framework for SOEs and updating financial regulations with IMF TA.

### State-owned enterprises: CPC and CEB
- Staff emphasized addressing structural shortcomings undermining long-term commercial viability of CPC and CEB; large losses unsustainable and electricity prices high by regional standards.
- Recommended comprehensive approach: better management, lowering generation costs, raising efficiency, moving toward cost-recovery pricing, and adoption of an automatic price adjustment mechanism.
- Emphasized need for targeted social protection measures to mitigate impact of higher prices on the poor.
- Authorities increased diesel and petrol prices, plan to increase electricity tariffs, and implement cost-recovery pricing for heavy fuels.

### Monetary and exchange rate policy
- Monetary stance:
  - Cautious stance appropriate given elevated headline and core inflation, rising private sector wage demands, and potential second-round effects from further energy price hikes.
  - Monetary policy should remain on hold until stronger evidence that inflation pressures have begun to dissipate.
  - Staff recommended moving toward flexible inflation targeting; initial steps include developing strategy, institutional arrangements, and technical capacity to understand inflation process and transmission.
- Liquidity management improvements needed:
  - Reliance on overnight operations led to excess structural liquidity and weakened transmission.
  - Structural liquidity should be monitored; use of longer-term liquidity operations should be expanded; overnight operations used for fine-tuning.
  - Banks’ liquidity management could be improved by strengthening statutory reserve requirement system.
- Exchange rate and reserves:
  - Real effective exchange rate depreciated compared to a year ago but staff analysis suggests it remains slightly above equilibrium; reserves appear low by several metrics.
  - Staff view: maintain flexibility so real exchange rate moves into line with fundamentals; CBSL should seize opportunities to increase reserves further and deepen FX market.
  - Limits on banks’ forward transactions eased and NOP limits partially rolled back, but NOP limits remain significantly tighter than in other countries.
  - Government guarantees for offshore wholesale bank funding should be avoided due to contingent fiscal liabilities and debt sustainability risks.

### External sector assessment (Box 4 — key findings)
- CGER and pilot External Balance Assessment indicate underlying current account deficit slightly higher than predicted; a 5–8 percent real depreciation, ceteris paribus, necessary to bring deficit down to current account norm.
- External sustainability approach finds around a 4 percent real depreciation would be needed to stabilize net foreign liability/GDP position.
- CGER-style analysis of equilibrium REER points to slight undervaluation around 3 percent, but results within margin of error; broader trade balance trends suggest slight overvaluation.
- Capital account flows disappointing relative to expectations for large FDI inflows; foreign investor interest in government paper strong.
- Reserves increased recently but coverage still somewhat low by common metrics and compared to regional peers:
  - Reserves above three months of prospective imports of goods and services but low relative to short-term debt and prospective amortization, and just below IMF’s new composite metric adequacy range for floating regimes.
- Staff assessment: external position would benefit from further strengthening; over medium term fiscal consolidation and structural reforms to reduce protectionism, improve productivity, and broaden export base are essential.

### Financial sector stability (FSAP findings and recommendations)
- Progress in banking supervision: risk-based supervision guidelines issued; stress testing and early warning systems refined.
- Nonbank supervision improved, but regulatory arbitrage opportunities may exist; capacity should be strengthened.
- Recommendations: develop more robust consolidated supervision and macroprudential frameworks.
- Rapid credit growth warrants vigilance; indicators signaled a credit boom with rapid credit-to-GDP growth and emergence of an excess credit gap, though credit growth now slowing.
- FSAP stress tests:
  - Most banks well placed to deal with severe liquidity stress due to large holdings of short-term government securities.
  - Market risk broadly contained except for one bank exposed to re-pricing risk on large government debt holdings.
  - A very severe credit shock raising NPLs to around 23 percent would leave 7 of the 12 largest banks undercapitalized, requiring about ½ percent of GDP in fresh capital.
- Staff recommended:
  - Develop annual stress tests for systemically important banks.
  - Raise capital buffers in banks found vulnerable.
  - Increase general and special-mention loan loss provisioning.

### Financial safety nets, pensions, and crisis management
- Deposit insurance and lender-of-last-resort broadly appropriate but operational arrangements could be clarified.
  - Recommendations: establish target range for deposit insurance reserves; clarify borrowing conditions; phase out use of insurance scheme for emergency liquidity assistance to nonbanks.
- Pension funds:
  - Need overall strategy and robust supervisory framework for pension funds.
  - Box 5: "Develop an overall pension strategy and introduce a robust supervisory and governance framework for all pension funds, including the EPF." Time Frame: Medium term. Status: "Authorities do not agree with the recommendation."
- Crisis management and resolution:
  - Recommendations: formalize roles/responsibilities for crisis management; clarify legal priority of creditor claims; require systemically important banks to design and submit recovery and resolution plans.
- Expected benefits: documented crisis management plan and clear legal priorities would enhance preparedness and enable more orderly resolution of stress events.

### Post-Program Monitoring (PPM) and Article IV schedule
- Managing Director recommends initiation of PPM:
  - Last Fund arrangement expired July 2012.
  - "Fund credit outstanding will exceed 200 percent of quota (PPM threshold) until 2015."
  - Recommendation: "PPM be conducted on a semiannual basis until the external position strengthens significantly, the underlying risks are adequately addressed, and the stock of outstanding obligations to the Fund falls below the PPM threshold."
  - A PPM mission and Board discussion envisioned for second half of 2013.
- It is recommended that PPM takes place on a semiannual basis.
- The next Article IV Consultation takes place on the standard 12-month cycle.

### Economic performance (summary observations and projections)
- Growth:
  - Real GDP growth: 6.4 percent in 2012; projected 6.3 percent in 2013; 6.8 percent in 2014; 6.5 percent in 2015.
- Inflation:
  - Inflation (average): 7.5 percent in 2012; projected 7.9 percent in 2013; 7.1 percent in 2014; 6.8 percent in 2015.
  - Inflation (end-of-period): 9.2 percent in 2012; projected 7.9 percent in 2013; 6.7 percent in 2014; 6.5 percent in 2015.
  - Core inflation (end-of-period): 7.5 percent in 2012; projected 7.0 percent in 2013; 6.7 percent in 2014; 6.5 percent in 2015.
- External sector:
  - Exports: US$9,774 million in 2012; projected US$10,317 million in 2013; US$10,995 million in 2014; US$11,804 million in 2015.
  - Imports: US$19,183 million in 2012; projected US$20,269 million in 2013; US$21,669 million in 2014; US$23,096 million in 2015.
  - Current account balance: -US$3,915 million in 2012; projected -US$3,700 million in 2013; -US$3,735 million in 2014; -US$3,791 million in 2015.
  - Current account (percent of GDP): -6.6 percent in 2012; projected -5.7 percent in 2013; -5.3 percent in 2014; -4.9 percent in 2015.
- Reserves:
  - Gross official reserves (end of period): US$6,677 million in 2012; projected US$6,964 million in 2013; US$6,798 million in 2014; US$7,095 million in 2015.
  - Reserves in months of imports: 3.5 months in 2012; projected 3.4 months in 2013; 3.1 months in 2014; 3.0 months in 2015.

### Fiscal developments, financing, and debt projections
- Fiscal outcomes and targets:
  - Central government balance (percent of GDP): -6.4 in 2012; target -5.8 in 2013; projected -5.4 in 2014; -5.0 in 2015.
  - Consolidated government balance (percent of GDP): -8.6 in 2012; projected -7.0 in 2013; -6.1 in 2014; -5.4 in 2015.
- Revenues and expenditure:
  - Revenue: 13.0 percent of GDP in 2012; projected 13.2 in 2013; 13.7 in 2014; 14.1 in 2015.
  - Expenditure: 19.7 percent of GDP in 2012; projected 19.3 in 2013; 19.3 in 2014; 19.3 in 2015.
- Financing and debt:
  - Central government domestic financing: 4.1 percent of GDP in 2012; projected 4.4 in 2013; 3.6 in 2014; 3.3 in 2015.
  - Government debt (domestic and external): 80.2 percent of GDP in 2012; projected 79.9 in 2013; 78.0 in 2014; 75.8 in 2015.
  - Fiscal strategy assumptions: 2013 fiscal deficit assumed at 5.8 percent of GDP; deficit projected to fall to 5.0 percent of GDP in 2015 and to 4.75 percent in 2017.
  - Revenues: tax revenues projected to increase by slightly over 1 percent of GDP over the medium term; nontax revenues assumed to grow broadly in line with nominal GDP.
  - Expenditure: current expenditures projected to fall by about ¼ percent of GDP; capital spending share assumed flat.
  - Financing: net external financing of the budget projected below 2 percent of GDP.

### Debt sustainability analyses and scenarios
- Public sector baseline:
  - Public sector debt: 80.2 percent of GDP in 2012; projected 79.9 in 2013; 78.0 in 2014; 75.8 in 2015; 73.8 in 2016; 71.8 in 2017.
  - Debt-stabilizing primary balance implied: -2.5 percent of GDP.
- Scenario impacts:
  - A 30 percent real depreciation would push the debt ratio to close to 100 percent of GDP.
  - A contingent liability shock would raise the debt ratio to around 90 percent of GDP.
  - A no policy change scenario (primary balance does not improve) shows slower reduction in debt ratio but still a declining trend.
- External debt:
  - External debt (public and private): US$33.7 billion in 2012; projected US$35.7 billion in 2013; US$37.8 billion in 2014; US$40.3 billion in 2015.
  - External debt-to-GDP: 56.7 percent in 2012; projected 54.8 in 2013; 53.7 in 2014; 52.5 in 2015; 51.7 in 2016; 51.1 in 2017.
  - Outstanding Eurobonds total US$3.5 billion (maturities: US$500 million in 2015; US$1 billion per year in 2020 and the following three years).
  - Around half of government’s foreign debt stock contracted on concessional terms with long amortization schedules.
- Risks and monitoring:
  - Main downside risk: continued revenue weaknesses that impede deficit reduction.
  - Risks from failure to sustain expenditure restraint and contingent liabilities from increased external borrowing by banks.
  - Failure to allow exchange rate flexibility could keep current account deficit elevated and force higher external borrowing.

### Monetary, financial, and other operational details (selected exact values)
- Policy rate corridor: 7½–9½ percent (policy rate corridor unchanged following April 12 meeting).
- Broad money growth: 17.6 percent in 2012; projected 15.5 percent for 2013–2015.
- Reserve money growth: 10.2 percent in 2012; projected 16.0 in 2013; 14.8 in 2014; 14.5 in 2015.
- Financial Soundness Indicators (2012, prelim):
  - Regulatory capital to risk weighted assets: 15.0.
  - Tier 1 capital/risk weighted assets: 13.1.
  - Net nonperforming loans to total capital funds: 11.9.
  - Return on equity (after tax): 20.2.
  - Return on assets (after tax): 1.7.
- Energy tariff reform:
  - Electricity costs increased on average by around 35 percent effective April 20.
  - First-round impact on CPI estimated at around 1¾ percentage points.
  - Increase estimated to reduce combined losses of state-owned energy companies by around one percentage point of GDP in 2013.
  - Sale of heavy fuels to CEB at below cost price discontinued from April 2013.
  - Commissioning of 600 MW coal power plant in 2014 expected to help entities reach breakeven by end 2014.
- Poverty and labor:
  - Poverty declined from 15.2 percent in 2006/07 to 8.9 percent in 2010.
  - Unemployment rate declined to 4.0 per cent in 2012.

### Policy recommendations and staff/executive board advice (selected)
- Fiscal:
  - Continue fiscal consolidation, particularly on recurrent spending, to reduce budget deficit and clear expenditure arrears.
  - Broaden revenue base and improve tax administration (extend VAT fully to retail and wholesale sectors, reform refund system, revise tax holidays and exemptions).
  - Put state-owned energy enterprises on sound financial footing; consider automatic price adjustment mechanism complemented by targeted social protection.
- Monetary and exchange rate:
  - Avoid further easing of monetary policy in near term until inflation pressures decline.
  - Maintain exchange rate flexibility to cushion external shocks and support current account consolidation.
  - Strengthen international reserves as circumstances permit.
- Financial sector:
  - Maintain vigilance following rapid credit growth; implement FSAP recommendations to bolster supervision and regulation.
  - Avoid government guarantees for foreign currency borrowing by banks or carefully assess contingent liability implications if considered.
- External sector and competitiveness:
  - Boost competitiveness via trade measures, infrastructure expansion, and improvements in business climate to attract FDI.
- Monitoring:
  - Implement semiannual PPM; support for post-program monitoring endorsed.

*Source: IMF staff report — Sri Lanka: Staff Report for the 2013 Article IV Consultation and Proposal for Post-Program Monitoring (content unit _cr13120).*

### 1. Growth Inclusiveness and Poverty Reduction ____________________________________________________5

### 1. Growth Inclusiveness and Poverty Reduction

### Context and recent developments
- Sri Lanka achieved notable progress on several economic fronts, though challenges remain: growth has been generally robust but slowed recently; fiscal consolidation occurred; poverty and inequality declined.
- Key weaknesses highlighted:
  - Revenue growth did not respond as envisaged to a first round of tax reforms, undermining capital investment plans.
  - State-owned enterprises remain prone to large losses despite recent price adjustments.
  - The current account deficit remains elevated and is financed mainly through debt-creating flows.
- Policy environment and objectives:
  - The President’s second five-year plan aims to raise per capita incomes by a third to US$4,000 in 2016 with real growth of 8 percent per annum.
  - Priorities identified: a second generation of tax reform; re-orienting the monetary policy framework toward low and stable inflation under exchange rate flexibility; broadening financial stability frameworks and deepening markets; addressing structural impediments to trade and private sector growth.
- Response to past advice:
  - Implemented a range of policies consistent with previous Fund advice and program conditionality: fiscal consolidation path with first-round tax reforms and expenditure containment, including reduced defense spending as a share of GDP.
  - Shortfalls: pace and quality of fiscal adjustment fell short; tax rate reductions generally took precedence over base broadening; cost-recovery pricing at state-owned energy companies yet to emerge; exchange rate allowed greater flexibility after a costly delay.
  - Financial sector improvements: stronger bank supervision and regulation, deposit insurance introduced; pension regulation frameworks not addressed; investment regime improved although exemptions remain prevalent.

### Macroeconomic performance (recent)
- Growth and inflation:
  - Real GDP growth slowed to 6.4 percent in 2012.
  - Headline inflation hovered near double digits for most of 2012, before easing to 7½ percent year-on-year in March 2013 due mainly to base effects.
  - Core inflation trended upward; inflation expectations and private sector wage demands have risen.
- Fiscal developments:
  - 2012 budget deficit estimated to have fallen to about 6½ percent of GDP (above the budget’s 6¼ percent target) due to expenditure restraint and payment arrears.
  - Revenues were significantly lower than budgeted, partly reflecting new tax exemptions, lower imports undermining VAT, and weaker-than-expected income taxes.
  - Losses at state-owned Ceylon Electricity Board (CEB) and Ceylon Petroleum Corporation (CPC) rose to around 2 percent of GDP in 2012 despite significant domestic price increases (drought-induced shift from hydroelectric to thermal generation).
- Monetary and external:
  - Central Bank actions: credit ceiling allowed to expire; policy rate corridor reduced by 25 basis points in early-December to 7½–9½ percent; overnight interest rates fell by about 100 basis points as call money rates were guided to the middle of the corridor.
  - Treasury bill and bond rates declined more due to expectations of further easing and healthy foreign demand for rupee-denominated government debt.
  - Balance of payments: current account deficit declined to around 6½ percent of GDP in 2012 as falling imports more than offset falling exports; tourism and remittances remained robust.
  - FDI was less than half of the authorities’ expectations.
  - Gross official international reserves reached around US$6¾ billion (3½ months of imports) in early 2013.
- Financial sector soundness:
  - System-wide capital adequacy ratio declined by 1 percentage point from a year ago to 15 percent in December 2012, remaining above the 10 percent regulatory minimum.
  - Profitability and liquidity are robust; gross nonperforming loans (NPLs) eased slightly to 3½ percent of total loans.
  - FSAP stress tests indicated credit risks warrant scrutiny.

### Outlook and risks
- Staff projections:
  - Growth projected at around 6¼ percent in 2013.
  - A moderately contractionary budget and lagged impact of tight monetary conditions and real wage compression should restrain domestic demand; external demand projected to remain tepid.
  - Recent monetary policy easing should support growth toward the end of the year.
  - Under the staff’s baseline scenario, external and public debt dynamics are sustainable, though sensitive to the current account outlook and shocks to contingent liabilities.
  - An excess supply gap would open with below-potential growth in 2013, helping to reduce inflation pressures and the current account deficit.
- Authorities’ view:
  - Authorities expect growth of 7½ percent in 2013, supported by monetary easing, removal of the credit ceiling, and infrastructure investments; they expect inflation falling to mid-single digits toward end-2013.
- Key downside risks identified:
  - Tax revenue weakness continuing → larger-than-expected budget deficit.
  - Stalled or incomplete delivery of Euro area policy commitments, protracted slow European growth, or fiscal policy shock in the U.S.
  - Emerging markets capital flow reversal, weaker FDI or remittance inflows → pressure on reserves.
  - Inflation pressures broaden if expectations rise.
  - Global oil shock → higher losses at SOEs, inflation, weaker growth.
  - Deterioration in banks' asset quality after rapid credit growth.
- Policy responses recommended in the Risk Assessment Matrix (selected):
  - Tighten monetary policy if inflation pressures broaden.
  - Adjust domestic energy prices, allow exchange rate flexibility, and monitor impact on core inflation and banks' asset quality in case of a global oil shock.
  - Intensify risk-focused supervision and enforce prudential regulations if banks’ asset quality deteriorates.
  - Accelerate revenue administration reforms, broaden tax base, and curtail non-essential spending if fiscal space tightens.

### Box 1 — Growth inclusiveness and poverty reduction (key findings)
- Growth since mid-2009 has been broadly shared across the country; poorer provinces, particularly the Northern province, experienced relatively stronger overall economic growth after the end of the civil conflict.
- National poverty headcount ratio fell to just below 9 percent in 2010 from over 15 percent in 2006/07.
- Poverty rates declined across most provinces; inequality declined (Gini coefficients by province reported for 2006/07 and 2009/10).
- Despite stronger growth, less-developed provinces did not consistently exhibit higher elasticities of poverty reduction; elasticity of poverty reduction during 2007–10 was strongest in the Western province.
- Policy implications to support inclusive growth and poverty reduction:
  - Contain inflation.
  - Expand infrastructure.
  - Improve access to health and education services.
  - Improve the investment environment to support private sector growth.

### Box 2 — Potential growth (key findings)
- Staff estimates suggest Sri Lanka’s potential output growth is about 6¾ percent in the near term.
- Potential growth has risen by almost 1 percentage point in recent years compared to 2003–08, reflecting equally capital deepening and improved factor productivity; labor’s contribution broadly unchanged.
- Total factor productivity (TFP) growth accounted for about half of Sri Lanka’s growth over the last decade, contributing on average 3¼ percentage points per year, rising to about 3½ percentage points recently.
- Opening of Eastern and Northern provinces likely contributed a marginal boost to potential: raised overall real GDP growth by an average of about ¼ of a percentage point per year during 2010–11, mostly reflecting the service sector and to a lesser extent agriculture.
- Estimates and model results:
  - Potential growth (summary of estimates): 6.8 (average of estimates); Univariate filters: Hodrick and Prescott 6.8, Baxter and King 6.5, Christiano and Fitzgerald 6.5; Structural models: Multivariate filter (Benes, 2010) 7.0, Production function (Duma, 2007) 6.8.
  - Memorandum item: Average GDP growth (2002–12) 6.4.
- Cyclical assessment:
  - Excess demand emerged in 2010–11 driven primarily by private consumption; investments’ contribution rose to just over 3 percent of GDP from an average of 2½ percent during 2004–08.
  - Output gap estimates suggest the output gap should close around end-2012; an excess supply gap would open with below-potential growth in 2013.

### Policy discussions and recommendations
- Fiscal policy and state enterprise reform:
  - Fiscal consolidation remains a key priority: public debt around 80 percent of GDP and over 600 percent of tax revenues.
  - 2013 budget targets a 5.8 percent of GDP deficit—the lowest since 1977—an appropriately contractionary stance to moderate inflation and strengthen external position.
  - Deficit reduction continues to rely on constraining expenditure growth to offset weak revenues.
  - Reducing the deficit below 5 percent of GDP over the medium term is central for debt sustainability.
  - Tax revenues have been declining as a percent of GDP for years; tax revenue-to-GDP ratio estimated to have fallen to just over 11 percent in 2012, lower than most regional peers.
  - Public investment is low compared to countries with sustained high growth; fiscal consolidation amid revenue weakness has reduced investment plans and led to shortfalls relative to plans.
  - Tax holidays and concessions have not delivered the expected increase in FDI.
  - Evidence from emerging Asia points to strong government investment multipliers, implying increased infrastructure investment to remove bottlenecks and broaden growth is important to realize ambitious growth objectives.

*Source: IMF staff and authorities (excerpts from the provided IMF country report content).*

### 16.      A high-quality fiscal consolidation that makes space for increased spending on

### 16.      A high-quality fiscal consolidation that makes space for increased spending on infrastructure while safeguarding critical social expenditures—to support inclusive robust growth and further gains in equality and poverty reduction—will require reversing the decline in tax revenues.

### Fiscal position and revenue performance
- The 2013 budget included measures such as the extension of VAT to large retailers and regime simplification, but these measures are estimated to yield only about half a percent of GDP in new revenue, significantly short of the budget’s target.
- New exemptions were introduced, and profit taxes could underperform with moderate growth.
- Revenue efficiency is below comparator countries, particularly for VAT.
- Broadening the VAT base and increasing its efficiency could raise an additional 2 percentage points of GDP in revenue above the baseline scenario.
- Key quantified changes:
  - The cyclically adjusted deficit fell from 9.5 percent of GDP in 2009 to a projected 6.6 percent in 2012.
  - Tax revenues have been declining as percent of GDP, by about 1½ percentage points, creating headwinds to deficit reduction.
  - The authorities targeted a 2013 deficit of 5.8 percent of GDP and aim to reduce it below 5 percent in the medium term, with the aim of reducing public debt to around 60 percent of GDP.
  - Given lower-than-expected tax revenues in 2012, the budgeted revenue increase in 2013 is acknowledged as likely out of reach.

### Box 3 — Fiscal stance analysis (key findings)
- While stronger growth contributed to recent years’ deficit reduction, most of the decline reflects structural effort.
- Deficit reduction was driven exclusively by lower spending, which fell by over 4 percent of GDP.
  - Lower capital spending contributed about one-fourth of the spending decline; the balance was due to lower current spending.
  - Lower interest payments contributed over 1 percent of GDP.
  - Primary current spending fell by 2 percent of GDP, reflecting cuts in military spending and lower subsidies.
- As the cyclically adjusted balance strengthened, the fiscal stance shifted from highly expansionary to contractionary in 2012.
- The contractionary stance resulted from an increasingly restrictive expenditure stance and an increasingly expansionary revenue stance.

### Staff tax reform recommendations (paragraph 17)
- To broaden the base:
  - Further expand VAT coverage of the wholesale and retail sectors, with the long-term objective of repealing the Nation Building Tax.
  - Value all existing tax holidays and exemptions, and subsequently rationalize costly or ineffective ones, or convert them to accelerated depreciation or investment tax credits linked to investment amounts.
  - Introduce a single and simplified small taxpayer regime for businesses under the VAT threshold.
- To simplify the system and strengthen administration:
  - Implement a comprehensive risk-based VAT refund management system to replace the existing procedure.
  - Streamline and restructure the Inland Revenue Department along functional lines.
  - Strengthen the Large Taxpayer Unit.
  - Improve audits and compliance risk management.

### Authorities’ stance on fiscal measures (paragraphs 18–19)
- Authorities committed to keep the 2013 deficit at 5.8 percent of GDP and to reduce it below 5 percent in the medium term.
- Determined to meet the deficit target by reducing expenditure; with less scope for lowering current spending, capital spending would be the focus of reductions.
- Authorities agreed higher tax revenues are key to medium-term consolidation but were not prepared to take revenue measures in 2013 beyond those announced in the budget; any new measures could be implemented in the 2014 budget at the earliest.
- Authorities indicated a further refinement of VAT coverage of the wholesale and retail sectors is under consideration and acknowledged the need to monitor and eventually reassess the modalities of the VAT refund system.

### Public Financial Management (PFM)
- Core PFM processes are fairly robust, but more advanced practices are appropriate for middle-income status.
- Reforms recommended (roadmap with IMF technical assistance):
  - Build on progress in updating legal and regulatory framework.
  - Improve budget preparation, including development of a medium-term rolling budget framework.
  - Strengthen budget execution, including recording and reporting of commitments and arrears, oversight and monitoring of public enterprises, and more efficient cash management.
- Authorities are developing an oversight and reporting framework for state-owned enterprises and updating financial regulations with IMF technical assistance.

### State-owned enterprises: CPC and CEB
- Staff emphasized addressing structural shortcomings undermining long-term commercial viability of CPC and CEB; large losses are unsustainable and electricity prices are high by regional standards.
- Recommended comprehensive approach: better management, lowering generation costs, raising efficiency, moving toward cost-recovery pricing, and adoption of an automatic price adjustment mechanism.
- Staff emphasized need for targeted social protection measures to mitigate impact of higher prices on the poor.
- Authorities have increased diesel and petrol prices, plan to increase electricity tariffs, and to implement cost-recovery pricing for heavy fuels.

### Monetary and exchange rate policy
- A cautious monetary policy stance remains appropriate given elevated headline and core inflation, rising private sector wage demands, and potential second-round effects from further energy price hikes.
- Monetary policy should remain on hold until stronger evidence emerges that inflation pressures have begun to dissipate.
- Staff recommended moving toward flexible inflation targeting to give weight to inflation as a nominal anchor while considering policy’s impact on growth; initial steps include developing strategy, institutional arrangements, and technical capacity to understand the inflation process and transmission mechanism.
- Liquidity management improvements needed:
  - Reliance on overnight open market operations led to periods of excess structural liquidity and weakened transmission.
  - Structural liquidity should be monitored; use of longer-term liquidity operations should be expanded; overnight operations used for fine-tuning.
  - Banks’ liquidity management could be improved by strengthening the statutory reserve requirement system.
- Authorities plan to lengthen the statutory reserve maintenance period and agreed to monitor liquidity closely, but expressed reservations about longer-term operations earned at higher interest rates.

### Exchange rate flexibility and reserves
- Real effective exchange rate has depreciated compared to a year ago but staff analysis suggests it remains slightly above its equilibrium value; reserves appear low by a number of metrics.
- Staff view: maintain flexibility so real exchange rate moves into line with fundamentals; CBSL should seize opportunities to increase reserves further and deepen the foreign exchange market.
- Limits on banks’ forward transactions eased and NOP limits partially rolled back, but NOP limits remain significantly tighter than in other countries, limiting risk hedging and market development.
- Government guarantees for offshore wholesale bank funding should be avoided due to contingent fiscal liabilities and debt sustainability risks.
- Authorities viewed current exchange rate as broadly in line with fundamentals and noted recent foreign exchange purchases; given thin market, CBSL needs to be ready to intervene to prevent disorderly movements.

### Box 4 — External sector assessment (key findings)
- CGER and pilot External Balance Assessment indicate underlying current account deficit is slightly higher than predicted, with a 5–8 percent real depreciation, ceteris paribus, necessary to bring deficit down to the current account norm.
- External sustainability approach finds around a 4 percent real depreciation would be needed to stabilize the net foreign liability/GDP position.
- CGER-style analysis of equilibrium REER points to a slight undervaluation of around 3 percent, but results are within margin of error; broader trends in the trade balance suggest a continued slight overvaluation.
- Capital account flows have been disappointing relative to expectations for large FDI inflows; foreign investor interest in government paper has been strong.
- Reserves have increased recently but coverage still appears somewhat low by common metrics and compared to regional peers:
  - Reserves are above three months of prospective imports of goods and services but low relative to short-term debt and prospective amortization, and just below IMF’s new composite metric adequacy range for floating regimes.
- Staff assessment: external position would benefit from further strengthening; over the medium term fiscal consolidation and structural reforms to reduce protectionism, improve productivity, and broaden export base are essential.

### Financial sector stability (FSAP findings and recommendations)
- Progress in banking supervision: risk-based supervision guidelines issued; stress testing and early warning systems refined.
- Nonbank supervision improved, but opportunities for regulatory arbitrage may exist; capacity should be strengthened.
- Recommendations: develop more robust consolidated supervision and macroprudential frameworks (Box 5 summarizes core FSAP recommendations).
- Recent rapid credit growth warrants heightened vigilance; indicators signaled a credit boom with rapid growth in credit-to-GDP ratio and emergence of an excess credit gap, though credit growth is now slowing.
- FSAP stress tests:
  - Most banks are well placed to deal with severe liquidity stress due to large holdings of short-term government securities.
  - Market risk broadly contained except for one bank exposed to re-pricing risk on large government debt holdings.
  - A very severe credit shock raising NPLs to around 23 percent would leave 7 of the 12 largest banks undercapitalized, requiring about ½ percent of GDP in fresh capital.
- Staff recommended authorities:
  - Develop a program of annual stress tests for systemically important banks.
  - Raise capital buffers in banks found to be vulnerable.
  - Increase general and special-mention loan loss provisioning.

*Source: IMF staff report (content unit _cr13120).*

### 34.      Further enhancing frameworks for financial safety nets, pensions, and crisis

### 34.      Further enhancing frameworks for financial safety nets, pensions, and crisis management would strengthen safeguards

### Financial safety nets and deposit insurance
- Lender-of-last-resort facility and deposit insurance schemes are broadly appropriate, but operational arrangements could be further clarified.
- Recommendations:
  - Establish a target range for deposit insurance reserves.
  - Clarify conditions under which the insurance scheme can borrow.
  - Phase out use of the insurance scheme for emergency liquidity assistance to nonbanks.
- Expected impact:
  - Clarifying operational arrangements and reserve targets would strengthen preparedness and reduce ambiguity in crisis responses.

### Pension funds and supervision
- An overall strategy and robust supervisory framework for pension funds is needed.
- Box 5 (FSAP update) entry:
  - "Develop an overall pension strategy and introduce a robust supervisory and governance framework for all pension funds, including the EPF."
  - Time Frame: Medium term
  - Status: "Authorities do not agree with the recommendation."
- Policy implication:
  - Formalizing supervision and governance for pension funds would reduce systemic vulnerabilities associated with large pension fund exposures and governance weaknesses.

### Crisis management, resolution, and legal clarity
- Recommendations:
  - Formalize roles and responsibilities for crisis management and place them in a comprehensive framework.
  - Clarify the legal priority of creditor claims.
  - Require systemically important banks to design and submit recovery and resolution plans.
- Expected benefits:
  - A documented crisis management plan and clear legal priorities would enhance overall preparedness and enable more orderly resolution of stress events, mitigating systemic risk.

### Banking supervision, macroprudential frameworks, and related measures
- Progress noted in several areas:
  - Guidelines being issued for annual stress tests for systemic banks.
  - Updated examination manual; legal basis for consolidated supervision expected by mid-year.
  - A state-owned bank is implementing a capital improvement plan.
- Remaining gaps:
  - FSAP recommendations to strengthen crisis preparedness, and pension and macroprudential frameworks have yet to be initiated or are at early stages.
- Specific supervisory recommendations:
  - Require bottom-up stress testing by all systemically important banks and increase capital and liquidity buffers in those found to be vulnerable (Box 5).
  - Continue to enhance corporate governance at state-owned banks (Box 5).
  - Harmonize bank and nonbank prudential framework to mitigate regulatory arbitrage (Box 5).
  - Formalize roles and responsibilities of members of the Inter-Regulatory Institutions Council to strengthen the macroprudential framework (Box 5).

### Staff appraisal highlights relevant to financial safeguards
- "Improvements to financial safety nets, more robust provisioning, and developing frameworks for pension supervision and crisis management would further safeguard stability."
- Monitoring and preparedness recommendations underline the need for:
  - Enhanced financial safety nets and clarified operational rules.
  - Recovery and resolution planning by systemically important banks to mitigate systemic risk.

### Other relevant procedural and monitoring notes
- In accordance with Fund policy, the Managing Director recommends initiation of Post-Program Monitoring (PPM):
  - Last Fund arrangement expired July 2012.
  - "Fund credit outstanding will exceed 200 percent of quota (PPM threshold) until 2015."
  - Recommendation: "PPM be conducted on a semiannual basis until the external position strengthens significantly, the underlying risks are adequately addressed, and the stock of outstanding obligations to the Fund falls below the PPM threshold."
  - "A PPM mission and Board discussion would be envisioned for the second half of 2013."

*Source: _cr13120 - 34.      Further enhancing frameworks for financial safety nets, pensions, and crisis management would strengthen safeguards*

### 51.      It is recommended that PPM takes place on a semiannual basis, and the next Article IV

### _cr13120 - 51.      It is recommended that PPM takes place on a semiannual basis, and the next Article IV

### Recommendation on Post-Program Monitoring and Article IV Schedule
- It is recommended that PPM takes place on a semiannual basis.
- The next Article IV Consultation takes place on the standard 12-month cycle.

### Economic Performance (summary observations)
- Growth:
  - Real GDP growth: 6.4 percent in 2012; projected 6.3 percent in 2013; 6.8 percent in 2014; 6.5 percent in 2015.
  - Growth has moderated in recent quarters.
- Inflation:
  - Inflation (average): 7.5 percent in 2012; projected 7.9 percent in 2013; 7.1 percent in 2014; 6.8 percent in 2015.
  - Inflation (end-of-period): 9.2 percent in 2012; projected 7.9 percent in 2013; 6.7 percent in 2014; 6.5 percent in 2015.
  - Core inflation (end-of-period): 7.5 percent in 2012; projected 7.0 percent in 2013; 6.7 percent in 2014; 6.5 percent in 2015.
- External sector:
  - Exports: US$9,774 million in 2012; projected US$10,317 million in 2013; US$10,995 million in 2014; US$11,804 million in 2015.
  - Imports: US$19,183 million in 2012; projected US$20,269 million in 2013; US$21,669 million in 2014; US$23,096 million in 2015.
  - Current account balance: -US$3,915 million in 2012; projected -US$3,700 million in 2013; -US$3,735 million in 2014; -US$3,791 million in 2015.
  - Current account (percent of GDP): -6.6 percent in 2012; projected -5.7 percent in 2013; -5.3 percent in 2014; -4.9 percent in 2015.
- Reserves:
  - Gross official reserves (end of period): US$6,677 million in 2012; projected US$6,964 million in 2013; US$6,798 million in 2014; US$7,095 million in 2015.
  - Reserves in months of imports: 3.5 months in 2012; projected 3.4 months in 2013; 3.1 months in 2014; 3.0 months in 2015.

### Fiscal Developments and Public Finances
- Fiscal outcomes:
  - Central government balance (percent of GDP): -6.4 in 2012; target -5.8 in 2013; projected -5.4 in 2014; -5.0 in 2015.
  - Consolidated government balance (percent of GDP): -8.6 in 2012; projected -7.0 in 2013; -6.1 in 2014; -5.4 in 2015.
- Revenues and expenditure:
  - Revenue: 13.0 percent of GDP in 2012; projected 13.2 in 2013; 13.7 in 2014; 14.1 in 2015.
  - Expenditure: 19.7 percent of GDP in 2012; projected 19.3 in 2013; 19.3 in 2014; 19.3 in 2015.
- Financing and debt:
  - Central government domestic financing: 4.1 percent of GDP in 2012; projected 4.4 in 2013; 3.6 in 2014; 3.3 in 2015.
  - Government debt (domestic and external): 80.2 percent of GDP in 2012; projected 79.9 in 2013; 78.0 in 2014; 75.8 in 2015.
- Fiscal strategy assumptions:
  - 2013 fiscal deficit assumed at 5.8 percent (authorities’ target).
  - Fiscal consolidation projected to continue: deficit projected to fall to 5.0 percent of GDP in 2015 and to 4.75 percent in 2017.
  - Revenues: tax revenues projected to increase by slightly over 1 percent of GDP over the medium term; nontax revenues assumed to grow broadly in line with nominal GDP.
  - Expenditure: current expenditures projected to fall by about ¼ percent of GDP; capital spending assumed to remain flat as a share of GDP.
  - Financing: net external financing of the budget projected below 2 percent of GDP.

### Monetary, Financial, and External Sector Developments
- Monetary policy and liquidity:
  - Reserve money growth: 10.2 percent in 2012; projected 16.0 in 2013; 14.8 in 2014; 14.5 in 2015.
  - Broad money growth: 17.6 percent in 2012; projected 15.5 percent for 2013–2015.
  - After tightening earlier, monetary conditions have eased recently.
  - Credit growth and excess liquidity declined.
- Financial sector indicators:
  - NPL ratio of the banking system remains low; capital adequacy eased slightly.
  - Financial Soundness Indicators (all banks, 2012, prelim):
    - Regulatory capital to risk weighted assets: 15.0.
    - Tier 1 capital/risk weighted assets: 13.1.
    - Net nonperforming loans to total capital funds: 11.9.
    - Return on equity (after tax): 20.2.
    - Return on assets (after tax): 1.7.
- Exchange rate and external liquidity:
  - The de jure exchange rate arrangement is free floating since January 23, 2001; de facto reclassified to floating effective February 9, 2012.
  - External reserves have stabilized after declining in 2011.
  - The real exchange rate depreciated, though some of this has subsequently reversed.

### Debt Sustainability Analysis — Public Sector
- Baseline public debt trajectory:
  - Public sector debt: 80.2 percent of GDP in 2012; projected 79.9 in 2013; 78.0 in 2014; 75.8 in 2015; 73.8 in 2016; 71.8 in 2017.
  - Debt-stabilizing primary balance implied: -2.5 percent of GDP (table value).
  - Identified debt-creating flows and primary deficits detailed in public sector DSA table.
- Scenario impacts:
  - A 30 percent real depreciation would push the debt ratio to close to 100 percent of GDP.
  - A contingent liability shock would raise the debt ratio to around 90 percent of GDP.
  - A no policy change scenario (primary balance does not improve) shows a slower reduction in the debt ratio but still a declining trend.
- Risks to public debt sustainability:
  - Main downside risk: continued revenue weaknesses that impede deficit reduction.
  - Risks from failure to sustain expenditure restraint.
  - Contingent liabilities: current explicit guarantees are less than 4 percent of GDP, but increased external borrowing by banks could create fiscal risk.
  - Sensitivity to currency movements illustrated by 2012 experience.
- Upside potential:
  - Comprehensive tax policy and administration reform could significantly increase revenue and allow deficit reduction with higher public infrastructure investment.

### Debt Sustainability Analysis — External Debt
- Structure and stock:
  - External debt (public and private): US$33.7 billion in 2012; projected US$35.7 billion in 2013; US$37.8 billion in 2014; US$40.3 billion in 2015.
  - External debt-to-GDP: 56.7 percent in 2012; projected 54.8 percent in 2013; 53.7 percent in 2014; 52.5 percent in 2015; 51.7 percent in 2016; 51.1 percent in 2017.
  - Outstanding Eurobonds total US$3.5 billion (maturities: US$500 million in 2015; US$1 billion per year in 2020 and the following three years).
  - Around half of the government’s foreign debt stock contracted on concessional terms with long amortization schedules.
- Baseline and scenarios:
  - Baseline: external debt-to-GDP expected to fall gradually to 51 percent by 2017.
  - A one-time real depreciation of 30 percent in 2013 would increase the debt-to-GDP ratio to around 80 percent before gradual decline.
  - A permanent one-half standard deviation shock to the growth rate still yields a declining external debt ratio, ending around 53 percent of GDP by the end of the projection period.
  - A persistent noninterest current account deficit around 4.5 percent of GDP would result in the debt-to-GDP ratio increasing slightly over the projection period.
- Risks and monitoring needs:
  - Failure to allow exchange rate flexibility could keep the current account deficit elevated and force higher external borrowing.
  - Weaker-than-expected global growth could reduce tourism and export receipts.
  - Encouraging private sector external borrowing may reduce central government external debt but increases aggregate rollover and reserve risks; external debt burden and maturities require enhanced monitoring.

### Macroeconomic Assumptions Underpinning Projections
- Growth assumptions:
  - Growth projected at 6¼ percent in 2013 (document text: "Growth is projected at 6¼ percent in 2013").
  - From 2015 onward growth projected at 6½ percent.
- Inflation and monetary policy:
  - Inflation expected to come down from high to mid-single digits over the medium term with movement toward flexible inflation targeting.
- Fiscal assumptions summarized:
  - 2013 fiscal deficit assumed at 5.8 percent of GDP.
  - Revenues: tax revenue increase by slightly over 1 percent of GDP over the medium term.
  - Expenditures: current expenditures fall by about ¼ percent of GDP; capital spending share remains flat.
  - Financing: net external financing of the budget projected below 2 percent of GDP.
- External sector assumptions:
  - Trade deficit expected to remain around 14 percent of GDP.
  - Current account expected to consolidate from 2011 peak due to tourism and remittances growth.
  - FDI expected to increase gradually to around 2 percent of GDP.
  - Long-term private sector external flows expected to be significant; inflows into domestic bond and equity markets expected to remain relatively robust (subject to prudential cap on foreign participation in domestic bond market).

### Policy Recommendations and Staff/Executive Board Advice
- Fiscal policy:
  - Continue fiscal consolidation, particularly on recurrent spending, to reduce budget deficit and clear expenditure arrears.
  - Broaden the revenue base and improve tax administration (e.g., extend VAT fully to retail and wholesale sectors, reform refund system, revise tax holidays and exemptions).
  - Put state-owned energy enterprises on a sound financial footing; consider automatic price adjustment mechanism complemented by targeted social protection.
- Monetary and exchange rate policy:
  - With rising wage and cost pressures, avoid further easing of monetary policy in the near term until inflation pressures decline.
  - Maintain exchange rate flexibility to cushion external shocks and support current account consolidation.
  - Strengthen international reserves as circumstances permit.
- Financial sector:
  - Maintain vigilance following rapid credit growth; draw on FSAP recommendations to bolster supervision and regulation.
  - Avoid government guarantees for foreign currency borrowing by banks or, if considered, carefully assess contingent liability implications.
- External sector and competitiveness:
  - Boost competitiveness via trade measures, infrastructure expansion, and improvements in business climate to attract FDI.
- Monitoring:
  - Proposal to implement semiannual PPM; support for post-program monitoring endorsed.

### Key Figures and Indicators (selected exact values)
- Real GDP growth: 6.4 (2012), 6.3 (2013 proj.), 6.8 (2014 proj.), 6.5 (2015 proj.).
- Inflation (average): 7.5 (2012), 7.9 (2013 proj.), 7.1 (2014 proj.), 6.8 (2015 proj.).
- Central government balance (percent of GDP): -6.4 (2012), -5.8 (2013 target), -5.4 (2014 proj.), -5.0 (2015 proj.).
- Government debt (domestic and external): 80.2 percent of GDP (2012); 79.9 (2013 proj.); 78.0 (2014 proj.); 75.8 (2015 proj.).
- External debt (public and private): US$33.7 billion (2012); projected US$35.7 billion (2013); US$37.8 billion (2014); US$40.3 billion (2015).
- External debt-to-GDP: 56.7 percent (2012); projected 54.8 (2013); 53.7 (2014); 52.5 (2015); 51.7 (2016); 51.1 (2017).
- Gross official reserves (end of period): US$6,677 million (2012); US$6,964 million (2013 proj.); US$6,798 million (2014 proj.); US$7,095 million (2015 proj.).
- Current account balance: -US$3,915 million (2012); projected -US$3,700 million (2013); -US$3,735 million (2014); -US$3,791 million (2015).

*Source: IMF staff report — Sri Lanka: Staff Report for the 2013 Article IV Consultation and Proposal for Post-Program Monitoring (April 12, 2013) — content unit _cr13120.*

### 1.      The Monetary Board of the Central Bank of Sri Lanka kept policy rates

### The Monetary Board of the Central Bank of Sri Lanka kept policy rates

### Monetary policy stance and monetary aggregates
- Policy rate corridor unchanged at 7½–9½ percent following the April 12 meeting.
- Growth of broad money moderated to 17 percent year-on-year in February.
- Credit to the private sector moderated to 13¼ percent year-on-year in February.
- Reserve money growth decelerated to 10.2 percent in 2012.
- Money supply growth decelerated to 17.6 percent in 2012.
- Credit growth decelerated to 17.6 percent by end 2012 from 34.5 percent in the previous year.
- Central Bank reduced policy rates by 25 bps in December 2012.

### Market financing and bond issuance
- The Bank of Ceylon issued a US$500 million five-year bond with a 5.325 percent coupon.
- The issue was six times oversubscribed and upsized from an initially planned offer of US$300 million.
- There were no government guarantees for the issue.
- Fitch rated the issue at BB-.
- The yield was substantially lower than a similar bond issued a year ago at 6.875 percent.

### Energy tariff reform and first-round inflation impact
- New electricity tariff structure approved effective April 20.
- Electricity costs increased on average by around 35 percent.
- Tariff methodology revised; cost structure remains progressive though effective increase was greater for small consumers than for large consumers.
- Increase estimated to reduce combined losses of state-owned energy companies by around one percentage point of GDP in 2013.
- First-round impact on the consumer price index estimated at around 1¾ percentage points.
- Fuel adjustment charge (FAC) implemented since February 2012 ranged between 25-40 percent of the monthly bill.
- Prices of petroleum products were raised by 37 – 51 percent in February 2012 and further adjustments in December 2012.
- Sale of heavy fuels to CEB at below cost price discontinued from April 2013.
- Commissioning of a low cost 600 MW coal power plant in 2014 expected to help entities reach breakeven by end 2014.

### Recent economic performance and outlook
- Real GDP growth: 6.4 percent in 2012 (after over 8 percent growth in the preceding two years).
- Agriculture sector growth: 5.8 percent in 2012 (adversely affected by severe drought in Q2–Q3 2012).
- Services sector growth: 4.6 percent in 2012.
- Industry sector performed well, largely supported by construction.
- Authorities expect return to a high growth trajectory of 7.5 – 8.0 percent in the medium term, conditional on improved external demand.
- Gross investment/GDP ratio exceeded 30 percent in 2012.
- Poverty declined from 15.2 percent in 2006/07 to 8.9 percent in 2010.
- Unemployment rate declined to 4.0 per cent in 2012.
- Net services income in the BOP has increased 3 fold since 2008.
- Actual FDI inflows increased to record levels in recent years but remain below authorities’ targets.

### Fiscal policy, revenues, and public debt
- Fiscal deficit contained to 6.4 percent of GDP in 2012 (from 9.9 percent in 2009 and 6.9 percent in 2011); slightly higher than targeted 6.2 percent for 2012.
- Government targeted fiscal deficit of 5.8 percent of GDP in 2013 and below 5 percent by 2016.
- Revenue projected to increase to 15.3 percent of GDP by 2016.
- Recurrent expenditure declined from 18.2 percent of GDP in 2009 to 14.4 percent of GDP in 2012.
- Public investment maintained above 6 percent of GDP in recent years, but declined to below 6 percent in 2012.
- Corporate income tax reduced from 35 percent to 28 percent under reforms introduced in 2010 and 2011.
- VAT rate unified at 12 percent under the same reforms.
- Government debt to GDP ratio increased slightly from 78.5 percent in 2011 to 79.1 percent in 2012, after consistently declining from 105.6 percent in 2002.
- Authorities project debt to GDP ratio to come down to around 65 percent by 2016.

### Tax administration and reform measures
- Recent tax reforms focused on creating an enabling environment for investment and realigning tax incentives under the Inland Revenue Act and Strategic Investment Law.
- Steps taken to bring the wholesale and retail sectors under the VAT system.
- Tax Appeals Commission and Tax Interpretation Committee established.
- Self-assessment and online tax payments introduced to promote compliance.

### Inflation and exchange rate developments
- Year-on-year headline inflation: 2.7 percent in February 2012, increased to 9.2 percent by end 2012.
- Inflation moderated to 7.5 percent in March 2013; further deceleration expected.
- Central Bank’s objective: maintain inflation, particularly core inflation, at mid single digit levels.
- Greater exchange rate flexibility allowed since early February 2012 by limiting Central Bank intervention.
- Rupee depreciated vis-à-vis the US dollar by 10.4 per cent during 2012.
- External reserves increased to US dollars 6.9 billion by end 2012 from US dollars 6 billion at end 2011.
- Gross official reserves equivalent to 4.3 months of imports by end 2012, up from 3.5 months at end 2011.
- Limits on net open positions (NOP) and forward transactions of commercial banks relaxed in January 2013; utilized amount of NOP remains much lower than limits.

### Financial sector soundness and regulatory actions
- Financial sector soundness improved: higher capital, adequate liquidity buffers, and healthy earnings.
- Mandatory deposit insurance and consumer protection measures in place; customer obligations published as a customer charter.
- Access to finance increased through branch network expansion, particularly in regional areas.
- Nonperforming loan (NPL) ratio at 4.2 percent.
- FSAP stress test scenario showing industry-wide NPL ratio rising to 23 percent described as a highly improbable extreme event by authorities.
- Steps to harmonize regulatory framework of non-banks with banks; several regulations issued.
- Insurance Board of Sri Lanka (IBSL) commenced two projects with TA from the World Bank scheduled to commence in the 2nd quarter of 2013.
- Draft bill for supervisory framework for pension funds has been drafted.
- Authorities will not implement certain impractical FSAP recommendations.

### Structural reforms and SOE financial viability
- Authorities recognize urgent need to address financial difficulties of key SOEs, mainly Ceylon Petroleum Corporation (CPC) and Ceylon Electricity Board (CEB).
- Upward adjustments of energy prices in 2012 and 2013 aimed at improving operational efficiency and financial management.
- Substantial tariff increase of around 35 percent for electricity implemented from April 20, 2013.
- Measures expected to improve SOE financial viability and reduce potential budgetary and banking system burdens.
- A Fund TA team is in Sri Lanka for consultations on SOE Governance.

### Trade policy and export development
- Authorities state Sri Lanka has one of the most open and least protective trade regimes in the region and reject characterization of moving toward protectionist tariffs.
- Import duties for a few agricultural products adjusted seasonally to stabilize domestic prices for farmers; total import value of such items was less than 2 percent of total imports in 2012.
- Infrastructure development, improved business climate, fiscal incentives, improved access to finance and relaxation of capital account transactions expected to increase export-oriented investment and services exports.

### Policy commitments and outlook
- Authorities committed to further strengthening macroeconomic stability and building buffers to improve resilience.
- Commitment to fiscal consolidation, strengthening the revenue base, and improving Public Financial Management with Fund TA support.
- Authorities support the proposed PPM and look forward to strengthening cooperation with the Fund.

*Statement by Rakesh Mohan, Executive Director and K.D. Ranasinghe, Alternate Executive Director for Sri Lanka; April 26, 2013.*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2013/_cr13120.pdf_