## _cr14285

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### Context and recent macro performance
- Per capita GDP: increased from US$869 in 2000 to US$3,256 in 2013.
- Structural shift: toward higher value added industrial production and rapid expansion of services (tourism and transport, IT, and other services).
- Inflation:
  - Average 2001–08: 12.6 percent.
  - Headline inflation: 4.7 percent in 2013; 3.2 percent year-on-year in May 2014.
  - Core inflation: 2.1 percent in 2013.
  - Noted five consecutive years of single digit inflation through 2013.
- Growth:
  - Real GDP growth: 6.3 percent in 2012; 7.3 percent in 2013; Q1 2014: 7.6 percent.
- External accounts and remittances:
  - Current account deficit: 6.7 percent of GDP in 2012; 3.9 percent of GDP in 2013.
  - Net remittances: equivalent to 8.4 percent of GDP in 2013 (6.4 percent a decade earlier).
  - Imports decreased by 6.2 percent in 2013 (fall in oil and fuel shipments contributed over half of the decline).
  - Rupee virtually stable in nominal terms vis-à-vis the U.S. dollar since end-October 2013.
- Fiscal:
  - Tax revenue in 2013: almost 1.5 percent of GDP short of the budget target.
  - Government came close to meeting budget deficit target of 5.8 percent of GDP in 2013.
  - FY 2014 budget targeted deficit: 5.2 percent of GDP (requires a year-end revenue increase of 26 percent relative to prior years).
- Financial sector:
  - NPLs: 3.7 percent of total loans at end-2012; 5.6 percent by end-2013.
  - Banking sector profits declined by 10 percent in 2013.
  - Total NPLs increased by Rs74 billion in 2013; Rs 56 billion (76 percent) linked to gold pawning.
  - CBSL measures: credit guarantee scheme; January 2014 consolidation plan; increase loan-to-value ratios to a maximum of 80 percent (from 65 percent); cap interest rates at 16 percent per year for pawning advances.

### Outlook, risks, and staff projections
- Baseline assumptions:
  - Potential output anchored around 6.5 percent.
  - Modest level of inflation.
  - Continued public and private investment and maintenance of sound macroeconomic policies.
- Staff projections and outcomes:
  - Gradual improvement in incomes; reduction in budget deficit and public debt; shrinking external current account deficit under baseline.
  - Authorities project higher medium-term growth: target real GDP growth of more than 8 percent.
- Near-term risks: assessed as moderate given global recovery and benign commodity price outlook; adverse climatic events remain a constant vulnerability.
- Medium-term risks and likelihoods (selected Risk Assessment Matrix entries):
  - Continued drought — Likelihood: Medium; Expected impact: M-L; Policy response: Raise electricity tariffs, increase efficiency and lower electricity generation costs, allow exchange rate flexibility, and ensure open market for food imports.
  - Tax revenues fail to strengthen as planned — Likelihood: High; Expected impact: H; Policy response: Accelerate reforms on revenue administration and broadening tax base, reduce tax exemptions.
  - GDP growth momentum fades — Likelihood: Medium; Expected impact: H; Policy response: Avoid loose macro policies; concentrate on structural reforms.
  - Surges in global financial market volatility — Likelihood: High; Expected impact: M; Policy response: Strengthen macro fiscal fundamentals and allow exchange rate flexibility.
  - Protracted slower growth in advanced and emerging markets — Likelihood: High; Expected impact: H; Policy response: Limited room for fiscal stimulus. Diversify export markets, support increased value added production.

### Debt sustainability and external debt dynamics
- IMF DSA: indicates high risks but a sustainable public debt trajectory.
- Public debt benchmarks:
  - Debt burden benchmark of 70 percent of GDP and gross financing need benchmark of 15 percent of GDP are exceeded in the baseline and in all shock scenarios.
- Public debt outcomes:
  - Fiscal deficit: peaked close to 10 percent of GDP in 2009; reduced to 5.9 percent of GDP in 2013.
  - Debt-to-GDP ratio: fell from 86 percent to 78.3 percent over the same period.
  - Authorities’ targets: reduce fiscal deficit to 3.8 percent of GDP by 2016 and debt-to-GDP below 65 percent.
  - Staff view: targets ambitious; suggested longer-term objective of targeting a debt ratio of 50 percent.
- Public debt baseline projections (selected):
  - Government debt (domestic and external, percent of GDP): 2011: 78.5; 2012: 79.2; 2013: 78.3; 2014: 76.8; 2015–2019 (proj): 74.2; 71.4; 68.8; 66.3; 63.6.
  - Public gross financing needs (percent of GDP): 2012: 28.1; 2013: 24.8; 2014: 23.5; 2019 projection: 15.2.
- External debt (public and private):
  - External debt percent of GDP: 2011: 55.4; 2012: 62.5; 2013: 59.6; 2014 (Proj.): 59.2.
  - Baseline projection: external debt expected to decrease to 52.4 percent in 2019 (key baseline series: 2011: 55.4; 2012: 62.5; 2013: 59.6; 2014: 59.2; 2015: 58.3; 2016: 55.9; 2017: 54.0; 2018: 53.0; 2019: 52.4).
  - Debt-stabilizing non-interest current account: -4.3 percent of GDP.
- Debt dynamics contributions (selected):
  - Change in external debt (percent of GDP): 2012: 7.1; 2013: -2.9; 2014: -0.4; 2015: -1.0; 2016: -2.3; 2017: -1.9; 2018: -1.0; 2019: -0.6.
  - Current account deficit excluding interest payments (percent of GDP): 2011: 6.6; 2012: 5.2; 2013: 2.2; 2014: 1.8; 2015: 1.7; 2016: 1.5; 2017: 1.2; 2018: 0.9; 2019: 0.8.
  - Automatic debt dynamics contribution examples: 2011: -6.9; 2012: 0.8; 2013: -5.2; 2014: -2.2.
- Stress tests and vulnerabilities:
  - Real depreciation of 30 percent would raise external debt to nearly 80 percent by end of the period (presented as 77–80 percent).
  - If current account deficit were on average 1.4 percent of GDP larger, external debt would remain virtually unchanged at current level.
  - Gross external financing need (US$ billions): 2011: 11.5; 2012: 13.0; 2013: 10.8; 2014–2019 projections: 10.8; 11.1; 11.4; 11.6; 11.9; 12.3.
- Policy cautions:
  - Exercise caution with external borrowing through the banking system.
  - Maintain exchange rate flexibility while limiting intervention to reserve accumulation and smoothing short-term volatility.
  - Fiscal consolidation composition matters: emphasis on revenue mobilization (tackle tax expenditures and broaden the tax base).

### Fiscal consolidation, revenue performance, and public financial management
- Fiscal outcomes and concerns:
  - Central government balance (percent of GDP): 2011: -6.9; 2012: -6.5; 2013: -5.9; 2014 (Proj.): -5.2.
  - Repeated cuts in public investment risk delaying infrastructure and human capital development, potentially worsening debt dynamics.
  - Continued decline in tax revenue-to-GDP ratio places heavy burden on expenditure compression.
- Revenue measures and metrics:
  - 2013: VAT extended to retail and wholesale level.
  - 2014: VAT threshold for wholesale and retail reduced by one half; exemptions for NBT were restricted.
  - Excise duties on tobacco, alcohol and motor vehicles increased.
  - VAT collection weak: VAT at 2.5 percent of GDP in 2013; C-efficiency of VAT collection in Sri Lanka is 0.25 (about one half of the C-efficiency for lower-middle income countries and Asia/Pacific countries).
  - Mission suggested IMF technical assistance to quantify tax expenditures.
- Public financial management and SOE oversight:
  - IMF and ADB TA focused on improving SOE oversight, budget preparation, and commitment control.
  - Payment arrears: recurrent and capital payment arrears reached about 1 percent of GDP at end-2012 and were cleared in 2013; data for end-2013 arrears are being collected.
- Public debt structure and market financing improvements:
  - Average maturity of public debt lengthened from 3.2 years in 2012 to 4.8 years in 2013.
  - 2014: authorities placed two five-year international sovereign bonds totaling US$ 1.5 billion at yields of 5-6 percent.
  - Nonresidents’ holdings of government securities in local currency capped at 12.5 percent of total domestic currency denominated debt.

### Monetary policy, transmission, and recommendations
- Recent easing measures:
  - Between December 2012 and October 2013 CBSL reduced the repurchase and reverse repurchase rates by 125 basis points and reduced banks’ reserve requirement by 2 percentage points.
  - Standing rate corridor compressed from 200 basis points to 150 basis points.
- Credit growth and monetary aggregates:
  - Aggregate private sector credit growth: 34.5 percent in 2011; 17.6 percent in 2012; 7.5 percent in 2013.
  - Broad money (annual percent change): 2011: 19.1; 2012: 17.6; 2013: 16.7; 2014 (Q4 end): 15.1.
  - Credit to private corporations (annual percent change): 2011: 34.5; 2012: 17.6; 2013: 10.9; 2014 (Q4 end): 8.9.
- Transmission research (VAR analysis) findings:
  - Weak correlation between central bank policy actions and money market and bank retail rates.
  - Contemporaneous effects of policy rate changes are very weak compared with ASEAN countries and Vietnam.
  - Bank lending channel affects output with a lag of about five quarters.
  - Policy rate predictive value for output: output declines by about 0.6 percent in the second quarter and by about 0.5 percent during the nearly 3 years after innovations to the repo rate.
  - Private credit contributes to the interest rate channel by about 0.2 percent starting in quarter two (only in model with exchange rates).
  - Prime lending rate has significant Granger effect on output—reducing it by about 0.1 percent more after 5 quarters.
  - Exchange rate and asset price channels are not significant in affecting output and prices.
- Policy recommendation:
  - Staff recommended keeping current monetary stance unchanged given continued growth momentum and long lags in transmission, to avoid pro-cyclical policy.
  - Staff view: policy rates should remain on hold for the near term but authorities should be ready to adjust to ensure price stability.
  - Low inflation environment offers opportunity for a downward shift in interest rate structure over the medium term.

### Competitiveness, structural transformation, and external sustainability
- Structural changes:
  - Goods exports decreased as share of GDP while services receipts increased; services now rival garment industry as a source of foreign exchange.
  - Tourism more than doubled in dollar terms between 2011 and 2013.
  - Transportation services grew with tourism; notable growth in IT and accounting services from a small base.
- Remittances:
  - Net remittances increased to about 8.4 percent of GDP in 2013 (6.4 percent a decade earlier); shift from about one-quarter of total goods exports in 2003 to nearly two-thirds by 2013.
- Mission view on current account improvement:
  - Sustained improvement likely requires further export diversification and greater equity and direct investment relative to debt flows.
  - Further diversification depends on macro stability, improved investment environment (tax structure, enforcement of contracts and property rights), and predictable policy environment.
- Competitiveness indicators:
  - Sri Lanka ranks well in World Economic Forum Competitiveness Index and World Bank Doing Business Index (ranking 85 out of 189 countries).
  - Areas to improve: tax rates and administration, enforcing contracts, registering property.
  - Garment industry: accounts for over 40 percent of total exports and employs around 280,000 people; even with 6 percent average growth, garment exports alone will not reverse long-term negative trend in goods exports.

### Financial sector consolidation: objectives, measures, and risks
- Pre-consolidation structure:
  - 24 commercial banks and nine specialized banks.
  - NBFI sector: 58 firms (47 finance companies, 11 specialized leasing companies).
  - Banks and NBFIs control 64 percent of total financial system assets (banks control 57 percent).
  - Top three state-owned banks (Bank of Ceylon, People‘s Bank, National Savings Bank) account for about half of total assets of the 33 commercial and specialized banks.
- Master plan targets and timelines:
  - Reduce NBFIs from 58 to 20, with three specialized in microfinance.
  - Create 5 strategically important banks with assets in excess of LKR 1 trillion.
  - Merge DFCC and NDB into a single development/universal banking entity.
  - Comprehensive plans for all mergers required at end-May 2014; complete most mergers by end-year.
  - Higher minimum capital thresholds starting in 2016: commercial banks LKR 10 billion; specialized banks LKR 5 billion.
  - NBFIs minimum core capital: LKR 1bn by 1 January 2016; LKR 1.5 billion by 1 January 2018 (compared to LKR 200-300 million now).
  - CBSL to make funds available through deposit insurance window for capital infusion; CBSL can direct consolidation of weakest NBFIs by March 2015.
  - Consolidations cannot result in forced redundancies or reduced salaries.
- Potential benefits and cautions:
  - Benefits: increased resilience, economies of scale, stronger capital base, investment in technology and management, enhanced oversight.
  - Cautions: restrictions on restructuring employment may limit efficiency gains; small NBFIs <2 percent of system; consolidation could increase systemic risk and concentration; consider additional buffers for systemically important institutions; risk of post-consolidation aggressive credit expansion.

### Reserves, Fund relations, and statistical issues
- Reserves and IMF exposure:
  - Gross official reserves (end of period, US$ millions): 2011: 6,749; 2012: 7,106; 2013: 7,495; 2014 (end): 8,380; 2015–2019 (proj): 9,096; 9,345; 10,044; 11,826; 12,815.
  - Gross official reserves (months of imports): 2011: 3.2; 2012: 4.0; 2013: 3.5; 2014: 3.6.
  - IMF exposure: SDR 1.16 billion (about US$1.8 billion—2.4 percent of projected 2014 GDP and 20.5 percent of current gross central bank foreign exchange reserves).
  - Repayments to the IMF stretch into mid-2017; Sri Lanka expected to fall below 200 percent of quota in early 2015.
- Exchange rate arrangement and classification:
  - De jure arrangement: free floating since January 23, 2001.
  - De facto arrangement reclassified from floating to a stabilized arrangement effective October 1, 2013 (rupee stabilized within a 2 percent band against the U.S. dollar since October 2013).
- Statistical and dissemination issues:
  - Macroeconomic statistics broadly adequate for surveillance but weaknesses in timeliness and coverage.
  - CBSL publishes IIP and BOP annually since April 2014 following BPM6; quarterly data available three months after quarter-end; plan to publish quarterly BPM6 data starting June 2014.
  - RAMIS at the Inland Revenue Department expected operational by September 2015; Customs upgrade to ASYCUDA WORLD underway.
  - Sri Lanka participates in GDDS; progress toward SDDS but further work needed (quarterly IIP and monthly central government operations).

### Staff appraisal and policy recommendations (summary)
- Outlook: recent performance better than expected; strengths in garment manufacture, tourism, and services; agriculture vulnerable to drought.
- Fiscal policy:
  - Fiscal consolidation and debt reduction are critical for macro stability.
  - Mission viewed 2014 fiscal stance as appropriate but raised concerns about composition of further consolidation.
  - Given sizeable investment needs, burden of adjustment should fall more on increasing revenue; tackle tax expenditures and broaden tax base.
  - Consider reconsideration of medium- and long-term debt reduction strategy and a more ambitious debt target over a longer horizon.
- Monetary policy and exchange rate:
  - Current supportive monetary stance appropriate given low inflation and weak private credit growth.
  - Keep policy rates on hold for near term but be ready to adjust as needed to ensure price stability.
  - Maintain commitment to exchange rate flexibility; central bank purchases to build reserves are warranted but allow sufficient flexibility to adjust to fundamentals.
- Financial sector:
  - Consolidation can yield economies of scale, new products, and greater resilience via stronger capital base.
  - Fewer restrictions on restructuring would likely speed benefits; close supervision needed to avoid excessive credit growth.
  - Monitor concentration effects and corporate governance; consider buffers for systemically important institutions.

_Prepared by IMF staff for the 2014 Article IV Consultation and Second Post-Program Monitoring Discussion (Informational Annex), July 10, 2014._

### 1. Dynamics of Monetary Transmission in Sri Lanka ____________________________________________ 13

### 1. Dynamics of Monetary Transmission in Sri Lanka ____________________________________________ 13

### Context
- Per capita GDP increased from US$869 in 2000 to US$3,256 in 2013.
- Shift toward higher value added industrial production and rapid expansion of services (tourism and transport, IT, and other services).
- Inflation: average of 12.6 percent during 2001–08; declined to mid-single digits in recent years.
- Vulnerabilities remain: public debt and debt service remain high by international comparison, reserves are limited, tax revenues are low, and medium-term sustainability depends heavily on continued growth and a positive external environment.
- Poverty and inequality:
  - National poverty headcount ratio declined from 8.9 percent in 2009/10 to 6.7 percent in 2012/13.
  - Poverty headcount at $2 a day (PPP): from 29.1 to 23.9 percent between surveys cited.
  - Poverty headcount at $1.25 a day (PPP): from 7.0 to 4.1 percent between surveys cited.
  - Gini coefficient decreased from 0.49 in 2009/10 to 0.47 in 2012/13.
- Government’s inclusive development strategy focuses on six pillars: (i) macroeconomic stability; (ii) spatial transformation; (iii) human resources development; (iv) rural-centric development; (v) resilience to climate and external shocks; and (vi) five hubs of development (knowledge, shipping, energy, aviation and commercial hubs).

### Political context and policy consistency
- President Rajapaksa in second term; presidential elections expected in 2015.
- President’s second five-year plan (2010–15) aims to raise per capita income to US$4,000 by 2016 and reach real GDP growth of 8 percent or more.
- Authorities broadly followed past IMF staff advice; measures implemented in 2013 include:
  - Adjustments to fuel and electricity tariffs.
  - Measures to put CEB and CPC on a more commercial footing and eliminate their financial losses.
  - Extension of VAT to the wholesale and retail level and lowering the retail VAT threshold from Rs 500 million to Rs 250 million in quarterly turnover.
  - Ongoing IMF TA-supported work on commitment data collection and reporting.
  - Reform of tax holidays and exemptions remains a key objective.
- On monetary policy, authorities pursued more aggressive easing than recommended by staff (with no adverse effects given low private credit growth).

### Recent Developments and Outlook — A. Recent Economic Performance
- Growth:
  - Real GDP growth: 6.3 percent in 2012; accelerated to 7.3 percent in 2013.
  - First quarter growth in 2014: 7.6 percent.
- Inflation:
  - Headline inflation: 4.7 percent in 2013; headline inflation declined further to 3.2 percent year-on-year in May 2014.
  - Core inflation: 2.1 percent in 2013.
  - Noted five consecutive years of single digit inflation through 2013.
- External accounts:
  - Current account deficit improved from 6.7 percent of GDP in 2012 to 3.9 percent in 2013.
  - Net remittances equivalent to 8.4 percent of GDP (compared with 6.4 percent a decade earlier).
  - Imports decreased by 6.2 percent in 2013; fall in oil and fuel shipments contributed over half of the overall decline.
  - Rupee virtually stable in nominal terms vis-à-vis the U.S. dollar since end-October 2013.
- Fiscal position:
  - Tax revenue in 2013 fell almost 1.5 percent of GDP short of the budget target.
  - Government came close to meeting its budget deficit target of 5.8 percent of GDP in 2013 through current and capital spending cuts.
  - FY 2014 budget targeted a deficit of 5.2 percent of GDP; achieving this requires an ambitious year-end revenue increase of 26 percent relative to prior years and likely continued tight spending control.
- Financial sector:
  - Nonperforming loans (NPLs) rose from 3.7 percent of total loans at end-2012 to 5.6 percent by end-2013.
  - Banking sector profits declined by 10 percent (2013).
  - Total NPLs increased by Rs74 billion in 2013, of which Rs 56 billion (76 percent) were linked to gold pawning.
  - Net interest margins have declined due to high-cost term deposits, slow credit growth, and an increase in low yielding assets.
  - CBSL announced a credit guarantee scheme and a January 2014 financial sector consolidation plan to reduce the number of nonbank financial institutions and create larger banks.
  - CBSL aims to increase loan-to-value ratios to a maximum of 80 percent (from 65 percent) and cap interest rates at 16 percent per year for pawning advances.

### Recent Developments and Outlook — B. Outlook and Risks
- Baseline macroeconomic projection assumptions:
  - Potential output anchored around 6.5 percent.
  - Modest level of inflation.
  - Continued public and private investment and maintenance of sound macroeconomic policies.
- Staff projections imply gradual improvement in incomes and reduction of key vulnerabilities: lower budget deficit, reduction in public debt, and shrinking external current account deficit.
- Authorities project higher medium-term growth (targeting real GDP growth of more than 8 percent), implying a more rapid improvement in macro balances.
- Near-term risks described as moderate given global recovery and benign commodity price outlook; adverse climatic events remain a constant vulnerability.
- Medium-term risks:
  - Slower-than-projected growth in advanced economies.
  - Tighter external liquidity and turbulence in international capital markets.
  - Continued weakness in government revenues.
  - High share of foreign currency denominated debt creates vulnerability to currency depreciation.
- Risk Assessment Matrix (selected entries):
  - Continued drought — Likelihood: Medium; Expected impact: M-L (Adverse impact on agriculture output, increased costs of energy production, higher oil imports); Policy response: Raise electricity tariffs, increase efficiency and lower electricity generation costs, allow exchange rate flexibility, and ensure open market for food imports.
  - Tax revenues fail to strengthen as planned — Likelihood: High; Expected impact: H (Pressure to cut spending to reach deficit target, including capital spending, with possible adverse impact on growth); Policy response: Accelerate reforms on revenue administration and broadening tax base, reduce tax exemptions.
  - GDP growth momentum fades — Likelihood: Medium; Expected impact: H (Could induce excessively stimulative macro policies and risk higher inflation and external imbalances); Policy response: Avoid loose macro policies; concentrate on structural reforms to promote domestic and foreign investment.
  - Surges in global financial market volatility — Likelihood: High; Expected impact: M (Increased borrowing costs and more difficult rollover of maturing debt, with adverse impact on fiscal consolidation and external position); Policy response: Strengthen macro fiscal fundamentals and allow exchange rate flexibility.
  - Protracted period of slower growth in advanced and emerging markets — Likelihood: High; Expected impact: H (Slower-than-projected pickup in exports to the EU and the United States, weaker trade balance and growth); Policy response: Limited room for fiscal stimulus. Diversify exports markets, support increased value added production.

### Recent Developments and Outlook — C. Debt Sustainability
- IMF public debt sustainability assessment indicates high risks but a sustainable debt trajectory.
- Debt burden benchmark of 70 percent of GDP and gross financing need benchmark of 15 percent of GDP are exceeded in the baseline and in all shock scenarios.
- Factors supporting benign market assessment (bond spreads within the 200–600 point range of lower and upper risk benchmark):
  - Sustained fiscal adjustment and falling debt ratio.
  - Favorable global environment.
  - Credible commitment to further deficit and debt reduction.
  - Lengthening of average debt maturity.
  - Limited nonresident holding of government debt in domestic currency.
- DSA highlights critical contribution of growth to recent and projected declines in the debt ratio; slower-than-projected growth (alone or combined with a higher primary deficit and higher borrowing costs) could stop or reverse the fall in the public debt ratio.

### Policy Discussions (summary)
- Discussions focused on enhancing resilience and reducing macroeconomic and financial risks via:
  - Putting fiscal consolidation on a more stable long-term trend.
  - Examining monetary transmission and implications for monetary policy.
  - Addressing external competitiveness and sustainability.
  - Continuing consolidation of the financial sector.
- Authorities highlighted measures taken to limit exposure to market turbulence (e.g., cap on non-resident holdings of government securities) and ongoing efforts to diversify economic ties (including consideration of a free trade agreement with China).
- Authorities noted a $110 million World Bank development policy credit to bolster resilience to climatic shocks.
- Authorities agreed that new external borrowings by commercial banks and other entities should be limited to avoid adding vulnerabilities.

*Source: _cr14285 - 1. Dynamics of Monetary Transmission in Sri Lanka*

### 13. Staff welcomed the commitment to fiscal consolidation and debt reduction evident in

### _cr14285 - 13. Staff welcomed the commitment to fiscal consolidation and debt reduction evident in

### Fiscal consolidation, debt dynamics, and public investment
- Findings:
  - Fiscal deficit: after peaking at close to 10 percent of GDP in 2009, the fiscal deficit was reduced to 5.9 percent of GDP in 2013.
  - Debt-to-GDP ratio: fell from 86 percent to 78.3 percent during the same period.
  - The steady decline in the fiscal deficit and public debt as a share of GDP is described as a linchpin of macroeconomic stability and critical for maintaining credibility and investor confidence.
- Risks and trade-offs:
  - Continued decline in the tax revenue-to-GDP ratio places a heavy burden on expenditure compression to meet budget targets and limits counter-cyclical fiscal policy options.
  - Repeated cuts in public investment could delay development of infrastructure and human capital needed to meet ambitious growth targets, which in turn would worsen debt dynamics and make debt reduction plans harder to achieve.
- Government targets and staff assessment:
  - Authorities’ targets (2014 Budget and 2013 amendment of the Fiscal Management Responsibility Act): reduce the fiscal deficit to 3.8 percent of GDP by 2016 and reduce the debt-to-GDP ratio to below 65 percent.
  - Staff view: current targets are ambitious relative to recent revenue performance and sensitive to growth assumptions; staff suggested considering a longer-term objective of targeting a debt ratio of 50 percent.

### Revenue performance and tax reform
- Findings on tax base and recent measures:
  - In 2013, VAT was extended to the retail and wholesale level.
  - In 2014, the threshold for imposition of VAT on wholesale and retail activities was reduced by one half, and exemptions applicable to national building tax (NBT) were restricted.
  - Excise duties on tobacco, alcohol and motor vehicles were increased.
- Concerns:
  - Continued decline in the tax revenue-to-GDP ratio is a concern.
  - Numerous tax exemptions and concessions undermine potential revenue gains, complicate tax administration, and weaken tax compliance.
  - Granting new exemptions perpetuates business expectations for special treatment and narrows the tax base.
- Specific tax metrics and technical assistance:
  - VAT collection is particularly weak: at 2.5 percent of GDP in 2013, the C-efficiency of VAT collection in Sri Lanka is 0.25, about one half of the C-efficiency for lower-middle income countries and Asia/Pacific countries.
  - Mission suggested IMF technical assistance to quantify the costs of tax expenditures as input to the government’s medium-term reform plan.

### Tax administration, authorities’ views, and implementation timelines
- Authorities’ position and measures:
  - Authorities agreed the weakening revenue position needs addressing but were more sanguine about the impact of implemented measures.
  - They expect recovery of imports to improve collection of border taxes.
  - Noted a number of tax holidays granted for a fixed period need to be phased out gradually.
  - Tax administration reforms: implementation of the Revenue Administration Management Information System (RAMIS) at the Inland Revenue Department expected to become operational by September 2015.
  - Upgrade of the Customs Department to ASYCUDA WORLD system is underway.
  - Authorities noted tax administration challenges from the shift from an agriculture-based to a more industry- and service-oriented economy.

### Public financial management, SOE oversight, and arrears
- Reforms and technical assistance:
  - With IMF and Asian Development Bank (ADB) technical assistance, reforms are focused on improving oversight of state-owned enterprises (SOEs), strengthening budget preparation, and improving the commitment control system.
  - Authorities expect these reforms to improve expenditure control and limit payment arrears.
- Payment arrears:
  - At end-2012, recurrent and capital payment arrears reached about 1 percent of GDP and were cleared in 2013. Data for end-2013 payment arrears are being collected.

### Public debt structure and market financing
- Improvements in debt profile:
  - Average maturity of public debt lengthened from 3.2 years in 2012 to 4.8 years in 2013, while reducing overall borrowing costs.
  - In 2014, authorities placed two five-year international sovereign bonds in total amount of US$ 1.5 billion at yields of 5-6 percent.
  - A diversified funding base and longer maturities are expected to reduce fiscal vulnerability and rollover risk.

### Energy sector financials
- 2012 outcome and 2013 improvement:
  - In 2012, the Ceylon Electricity Board (CEB) and Ceylon Petroleum Company (CPC) incurred total loss of almost 2 percent of GDP.
  - Large electricity tariff adjustments for clients using more than 60 units and moderate fuel price adjustment in 2013, together with ample rains enabling more hydro power, brought the combined financial outcome of the two companies to a small surplus.
- Risks:
  - Staff raised concerns about renewed losses in 2014 due to drought in the first quarter.
  - Authorities argued new coal power plants reduce reliance on more expensive fuel power plants and project the financial position of CEB and CPC to remain solid.

### Monetary policy: transmission, recent measures, and recommendations
- Recent monetary easing and limited impact:
  - Between December 2012 and October 2013, the CBSL reduced the repurchase and reverse repurchase rates by 125 basis points and reduced banks’ reserve requirement by 2 percentage points.
  - The standing rate corridor was compressed from 200 basis points down to 150 basis points.
  - Aggregate private sector credit growth: 7.5 percent in 2013, compared to 17.6 percent in 2012 and 34.5 percent in 2011.
- Research findings on transmission (VAR analysis):
  - Weak correlation between central bank policy actions and money market and bank retail rates.
  - Contemporaneous effects of policy rate changes are very weak compared with ASEAN countries and Vietnam.
  - Bank lending channel affects output with a significant lag—on the order of five quarters.
  - Policy rate has significant predictive value for output: output declines by about 0.6 percent in the second quarter and by about 0.5 percent during the entire period of nearly 3 years after innovations to the repo rate.
  - Private credit contributes to the interest rate channel by about 0.2 percent starting in quarter two but only in the model with exchange rates.
  - Prime lending rate has a significant Granger effect on output—reducing it by about 0.1 percent more after 5 quarters.
  - Exchange rate and asset price channels are not significant in affecting output and prices.
- Policy recommendation and authorities’ stance:
  - Staff recommended keeping the current monetary stance unchanged given continued growth momentum and long lags in monetary transmission, to avoid monetary policy becoming pro-cyclical.
  - Recent data: first quarter GDP growth was 7.6 percent year-on-year.
  - Authorities noted structural factors: five years of single digit and declining inflation altered inflation expectations, allowing opportunity to lower policy rates; they did not envisage further easing for the time being but would be ready to reduce rates if growth falters or inflation remains low.
  - Authorities highlighted constraints on lowering deposit rates due to lack of social safety nets for a significant part of the retired population and reliance on deposit returns for income support; they are seeking to address this via annuities and longer-term instruments.

### Competitiveness and external sustainability
- Longer-term external vulnerabilities identified:
  - Chronic current account deficit and relatively low reserve adequacy metrics.
  - Gradual but steady decline in goods exports as a share of GDP.
  - Decline in Sri Lanka’s share of world exports.
  - Already high external debt burden and rising cost for external financing as concessional debt is replaced with commercial borrowing.
  - Modest increases in foreign direct investment relative to needs.
- Current account and reserves:
  - Current account deficit has decreased but remains financed largely by debt-creating inflows.
  - Gross reserves are now within the “adequate” band of the composite metric but are still low relative to short-term debt and upcoming amortizations.
  - To raise reserve cushion, authorities have absorbed foreign exchange inflows; staff emphasized maintaining a flexible exchange rate regime as CBSL interventions had effectively stabilized the exchange rate.
- Exchange rate assessment:
  - External Balance Assessment (current account approach) points to a slight overvaluation of the rupee.
  - CGER-based analysis indicates the underlying current account deficit is slightly smaller than predicted by panel regressions, suggesting a slight undervaluation.
  - Overall, the relatively small estimated misalignment in either direction suggests the exchange rate is broadly in line with fundamentals.
- Competitiveness indicators and sectoral notes:
  - Sri Lanka ranks well in World Economic Forum Competitiveness Index and the overall World Bank Doing Business Index (ranking 85 out of 189 countries).
  - Areas for improvement include tax rates and administration, enforcing contracts, and registering property.
  - Garment industry: still accounts for over 40 percent of total exports and employs around 280,000 people; sector has moved up the value chain but further diversification and higher-value production chains are needed to reverse long-term negative trend in overall goods exports.
  - Even if garment export growth averages 6 percent (as during the past decade), this will not be enough alone to reverse the negative long-term trend in Sri Lanka’s overall goods exports.

*Source: _cr14285 - 13. Staff welcomed the commitment to fiscal consolidation and debt reduction evident in (PDF); canonical URL: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2014/_cr14285.pdf*

### 30. Structural transformation may ameliorate some medium-term pressures on the

### _cr14285 - 30. Structural transformation may ameliorate some medium-term pressures on the

### Structural transformation and external accounts
- Goods exports have decreased as a share of GDP while services receipts have increased and now rival the garment industry as a source of foreign exchange earnings.
- Tourism more than doubled in dollar terms between 2011 and 2013.
- Transportation services grew in tandem with tourism, supported by significant investment in port facilities.
- Rapid growth (albeit from a small base) is visible in information technology and accounting services.
- Inward remittances:
  - Net remittances increased to about 8.4 percent of GDP in 2013.
  - Net remittances were 6.4 percent of GDP a decade earlier.
  - Equivalent shift: from about one-quarter the value of total goods exports in 2003 to nearly two-thirds by 2013.
- The mission’s view on improving the current account:
  - Sustained improvement likely requires further diversification of exports.
  - Cross-country evidence suggests greater gains from equity and direct investment relative to debt flows.
  - There appears room for further growth and higher value added in the garment industry, but rising competition and labor scarcity could shift some operations to lower-cost locations.
  - Further diversification of goods and services exports depends on:
    - Continued macroeconomic stability.
    - Improvements to the investment environment (including the tax structure, enforcement of contracts and property rights).
    - A predictable policy environment.
  - FDI flows might gain from structural improvements; available evidence suggests greater gains to productivity and growth from equity and FDI flows than from debt-financed investment.
- Authorities’ perspectives:
  - Confident external accounts would continue to improve under the current development strategy (the Five Hubs).
  - Highlighted competitiveness of the garment industry and rise in services (tourism, IT, transport and logistics).
  - Emphasized focus on attracting FDI and creating an enabling investment environment, but noted the small domestic market would likely constrain foreign investment levels compared to other emerging markets.

### Financial sector consolidation (Box 3 and mission assessment)
- Structure pre-consolidation:
  - 24 commercial banks and nine specialized banks.
  - NBFI sector: 58 firms — 47 finance companies and 11 specialized leasing companies.
  - Together banks and NBFIs control 64 percent of total financial system assets (banks control 57 percent).
  - Top three state-owned banks (Bank of Ceylon, People‘s Bank, National Savings Bank) together account for about half of total assets of the 33 commercial and specialized banks.
  - Twelve foreign banks account for 10 percent of market share.
- Master plan objectives and targets:
  - Reduce number of NBFIs from 58 firms down to 20, with three specialized in microfinance.
  - Create a stronger banking sector comprising 5 strategically important banks with assets in excess of LKR 1 trillion.
  - Merge two development banks (DFCC and NDB—now operating as commercial banks) into a single large development/universal banking entity.
  - Consolidate (or absorb) smaller state banks into larger state banking units.
  - Comprehensive plans for all mergers required at end-May 2014, with a view to completing most mergers (or consolidations) by end-year.
  - CBSL will make available funds through its deposit insurance window for any merger that may need capital infusion.
  - If any of the weakest NBFIs remain by March 2015, the CBSL can direct a consolidation.
  - Higher minimum capital thresholds starting in 2016:
    - Minimum capital requirements for commercial banks will be raised to LKR 10 billion.
    - Minimum capital requirements for specialized banks will be raised to LKR 5 billion.
    - For NBFIs minimum core capital requirement will be raised to LKR 1bn by 1 January 2016, then LKR 1.5 billion by 1 January 2018 (compared to LKR 200-300 million now for finance and leasing companies respectively).
  - Consolidations cannot result in any forced redundancies of staff, or in reduced salaries of staff.
- Mission’s assessment of potential benefits:
  - Consolidation could increase resilience and contribute to more effective oversight.
  - Consolidating NBFIs could yield economies of scale, enhanced efficiency, a stronger capital base, and allow for closer oversight.
  - Banking sector consolidation could provide sufficient scale to invest in technology and management systems, enhance efficiency and profitability, facilitate new products and services, and increase resilience via a larger capital base.
- Mission’s caution on limits and risks:
  - Restrictions on restructuring employment or reducing salaries may limit gains from economies of scale.
  - Small NBFIs as a group represent less than two percent of the financial system and are not systemically important; consolidating them could provide at best marginal improvements in stability.
  - Consolidation can increase systemic risk if larger institutions become systemically important.
  - Consideration of additional buffer requirements for systemically important banks/NBFIs may be warranted.
  - Post-consolidation pushes to improve profitability could trigger aggressive credit expansion and higher risk-taking.
  - Increased concentration can hinder competition.
- Authorities’ response:
  - Emphasized consolidation as an evolving, largely voluntary process without mandatory restructuring of employment.
  - Argued that systemic risks would be limited because the largest banks are close in required post-consolidation capital and asset bases.
  - Agreed risks remain regarding capital structures of consolidated entities, limited options for staff retention arrangements, potential IT problems, and lags in installing effective management systems and corporate governance.

### Post-program monitoring, reserves, and external sustainability
- IMF exposure and reserve metrics:
  - Exposure to the IMF currently stands at SDR 1.16 billion (about US$1.8 billion—2.4 percent of projected 2014 GDP and 20.5 percent of current gross central bank foreign exchange reserves).
  - Repayments to the IMF stretch into mid-2017.
  - Sri Lanka is expected to fall below 200 percent of quota (the threshold for post-program monitoring) in early 2015.
- External debt and borrowing:
  - External debt remains broadly sustainable but vulnerabilities persist with respect to exchange rate risk and baseline assumptions on growth and fiscal consolidation.
  - The cost of external debt has risen sharply as Sri Lanka shifts from concessional bilateral debt to new external loans on commercial terms.
  - External borrowing by commercial banks remains a concern, though relatively limited thus far.
  - Market Access Debt Sustainability Analysis (MAC-DSA) highlights sensitivity of debt sustainability to growth and foreign exchange shocks.
  - Staff urges caution with respect to external borrowing through the banking system.
- Reserve dynamics (staff estimates presented in charts):
  - Staff saw merit in central bank purchases to build reserves, which remain on the lower end of most reserve adequacy metrics.
  - Persistent rupee stability vis-à-vis the US dollar since Q4 2013 may create perception of an implicitly fixed exchange rate; this perception could lead market participants to hold un-hedged foreign exchange risk.
  - If external balance improves and inflation stays low, persistent stability could gradually lead to increasing currency misalignment.
  - Central bank should be prepared to allow sufficient exchange rate flexibility to adjust to fundamentals, limiting intervention to accumulation of reserves and smoothing short-term volatility.

### Staff appraisal: outlook, fiscal, monetary, exchange rate, and financial sector reform
- Outlook and risks:
  - Recent economic performance has been better than expected despite chronic market turbulence and climatic shocks.
  - Weak spots remain (e.g., agriculture affected by drought), while strong activity in garment manufacture, tourism, and services bodes well for the near and medium-term outlook.
  - Sustained reduction in headline and core inflation has stabilized public inflation expectations.
- Fiscal policy:
  - Government committed to fiscal consolidation and reduction of public debt as a mainstay of macroeconomic stability.
  - Mission viewed the fiscal stance for 2014 as appropriate, but raised concern about the composition of further consolidation.
  - Capacity in expenditure and commitment control increased, enhancing ability to curtail spending to meet fiscal objectives.
  - Given sizeable investment needs, staff viewed that spending cuts may have reached their effective limit and that the burden of adjustment should fall more on increasing revenue.
  - High and sustained public spending on infrastructure and human capital is essential to maintain growth and diversification.
  - Tackling tax expenditures and broadening the tax base is essential; mission saw scope to accelerate pace of reform.
  - Staff suggested reconsideration of medium- and long-term debt reduction strategy and a more ambitious debt target over a longer time horizon.
- Monetary policy:
  - Current supportive stance appropriate given decline in inflation and weak private credit growth.
  - Authorities should be ready to adjust rates as needed to ensure price stability, given long lags in monetary transmission.
  - Low inflation environment and changed inflation expectations offer opportunity for a downward shift in interest rate structure that could benefit investment and borrowing costs over the medium term.
  - Given mixed signals, a cautious approach is warranted; staff believes policy rates should remain on hold for the near term.
- Exchange rate policy:
  - Exchange rate policy broadly appropriate but should be monitored in light of balance of payments and inflation developments; commitment to flexibility should be maintained.
  - Staff analysis indicates exchange rate broadly in line with fundamentals.
  - Central bank purchases to build reserves are warranted given low reserve adequacy metrics, but the central bank should allow sufficient flexibility to adjust to fundamentals.
- Financial sector reform (summary):
  - Consolidation can yield economies of scale, new products and services, and greater resilience via a stronger capital base.
  - Benefits would likely be more rapid if fewer restrictions were placed on restructuring operations.
  - Continued progress on corporate governance is key.
  - Close supervision during and after consolidation could help avoid pitfalls such as excessive credit growth.
  - Consolidation may increase concentration and hinder effective competition if larger and state-owned banks continue to dominate.

*INTERNATIONAL MONETARY FUND*

### 43. It is recommended that the next Article IV consultation take place on the standard 12-

### _cr14285 - 43. It is recommended that the next Article IV consultation take place on the standard 12-

### Recommendation on Article IV consultation
- It is recommended that the next Article IV consultation take place on the standard 12-month cycle.
- It is proposed that the next Article IV consultation take place in 12 months.

### Macroeconomic developments and near-term outlook
- Real GDP growth: "GDP growth has picked up in recent quarters." (Figure note)
- Inflation developments:
  - "Headline and core inflation have declined." (Figure note)
  - Inflation (average): 2011: 6.7; 2012: 7.5; 2013: 6.9; 2014: 3.8; 2015–2019 (proj): 5.4, 5.5, 5.5, 5.5, 5.5 (Table 1).
  - Inflation (end-of-period): 2011: 4.9; 2012: 9.2; 2013: 4.7; 2014: 5.2; 2015–2019: 5.5, 5.5, 5.5, 5.5, 5.5 (Table 1).
  - Core inflation (end-of-period): 2011: 4.7; 2012: 7.5; 2013: 2.1; 2014: 4.3; 2015–2019: 4.6, 4.6, 4.6, 4.6, 4.6 (Table 1).
- External sector and trade:
  - "Imports fell, exports have picked up and trade balance has improved" (Figure note).
  - "Current account balance improved, supported by stronger export of services" (Figure note).
  - Exports (US$, in millions): 2011: 10,559; 2012: 9,773; 2013: 10,394; 2014: 11,822; 2015–2019 (proj): 12,774; 13,845; 15,006; 16,509; 17,822 (Table 1).
  - Imports (US$, in millions): 2011: -20,269; 2012: -19,190; 2013: -18,003; 2014: -21,399; 2015–2019 (proj): -23,322; -25,240; -27,217; -29,422; -31,696 (Table 1).
  - Current account balance (US$, in millions): 2011: -4,615; 2012: -3,983; 2013: -2,606; 2014: -2,491; 2015–2019 (proj): -2,663; -2,748; -2,759; -2,771; -2,996 (Table 1 & Table 4).
  - Current account balance (percent of GDP): 2011: -7.8; 2012: -6.7; 2013: -3.9; 2014: -3.5; 2015–2019 (proj): -3.4; -3.2; -3.0; -2.7; -2.7 (Table 1 & Table 4).
- Fiscal sector:
  - Tax revenue (percent of GDP): 2011: 12.4; 2012: 11.2; 2013: 10.6; 2014: 11.5; 2015–2019 (proj): 12.0; 12.2; 12.4; 12.7; 12.8 (Table 2).
  - Total revenue (including grants, percent of GDP): 2011: 14.5; 2012: 13.2; 2013: 12.4; 2014: 13.5; 2015–2019 (proj): 13.8; 14.0; 14.2; 14.4; 14.6 (Table 2).
  - Total expenditure and net lending (percent of GDP): 2011: 21.4; 2012: 19.7; 2013: 18.3; 2014: 18.7; 2015–2019 (proj): 18.3; 18.1; 18.2; 18.5; 18.3 (Table 2).
  - Central government balance (percent of GDP): 2011: -6.9; 2012: -6.5; 2013: -5.9; 2014: -5.2; 2015–2019 (proj): -4.5; -4.2; -4.0; -4.1; -3.7 (Table 2).
  - Government debt (domestic and external, percent of GDP): 2011: 78.5; 2012: 79.2; 2013: 78.3; 2014: 76.8; 2015–2019 (proj): 74.2; 71.4; 68.8; 66.3; 63.6 (Table 1).
  - Primary balance (excluding grants, percent of GDP, memorandum): 2011: -1.6; 2012: -1.2; 2013: -0.9; 2014: -0.8; 2015–2019 (proj): -0.2; -0.1; 0.0; 0.1; 0.0 (Table 2).

### Monetary and exchange rate developments
- Monetary policy:
  - "Monetary policy has been eased." (Figure 2 note)
  - Repo and interbank rates charted; weekly prime lending rate shown (Figure 2).
- Credit and money:
  - "Growth of credit to private sector has slowed sharply" (Figure 2 note).
  - Broad money (annual percent change): 2011: 19.1; 2012: 17.6; 2013: 16.7; 2014 (Q4 end): 15.1 (Table 3).
  - Credit to private corporations (annual percent change): 2011: 34.5; 2012: 17.6; 2013: 10.9; 2014 (Q4 end): 8.9 (Table 3).
  - Credit to government (annual percent change): 2011: 33.7; 2012: 29.6; 2013: 24.6; 2014 (Q4 end): 8.0 (Table 3).
  - Credit to private corporations (stock, in billions of rupees, end period): 2011: 2,006; 2012: 2,358; 2013: 2,396; 2014 (Mar/Jun/Sep/Dec): 2,433 / 2,470 / 2,534 / 2,912 (Table 3).
- Exchange rate and reserves:
  - "Spot exchange rate has been recently stable." (Figure 2 note)
  - "Central bank reserves have been increasing partly as a result of new borrowing ... and partly due to CBSL absorption of forex from the market." (Figure 2 notes)
  - Gross official reserves (end of period, US$ millions): 2011: 6,749; 2012: 7,106; 2013: 7,495; 2014 (end): 8,380; 2015–2019 (proj): 9,096; 9,345; 10,044; 11,826; 12,815 (Table 1 & Table 4).
  - Gross official reserves (in months of imports): 2011: 3.2; 2012: 4.0; 2013: 3.5; 2014: 3.6; 2015–2019 (proj): 3.6; 3.4; 3.3; 3.6; 3.6 (Table 1 & Table 4).

### Balance of payments and financial flows
- Balance of payments (BPM6, Table 4 highlights):
  - Goods credit (exports): 2012: 9,773; 2013: 10,394; 2014: 11,822 (Table 4).
  - Goods debit (imports): 2012: -19,190; 2013: -18,003; 2014: -21,399 (Table 4).
  - Services credit (exports): 2012: 3,799; 2013: 4,685; 2014: 5,886; 2015–2019 (proj): 6,823; 7,747; 8,671; 9,783; 10,962 (Table 4).
  - Workers' remittances (net): 2012: 5,339; 2013: 5,619; 2014: 6,200; 2015–2019 (proj): 6,736; 7,254; 7,839; 8,204; 8,586 (Table 4).
  - Financial account (net borrowing): 2012: -4,275; 2013: -3,120; 2014: -2,391; 2015–2019 (proj): -2,590; -2,646; -2,657; -2,669; -2,893 (Table 4).
  - Change in reserve assets: 2012: 760; 2013: 1,112; 2014: 885; 2015–2019 (proj): 716; 249; 699; 1,782; 989 (Table 4).

### Public debt and debt sustainability
- Background:
  - "During the last decade, central government debt fell from over 90 percent of GDP to below 80 percent of GDP." (Debt sustainability section)
  - "Following the launch of international sovereign bond issuance in 2007 ... the share of non-concessional debt in total foreign debt increased from about one fourth in 2009 to one half in 2013." (Debt sustainability section)
  - Nonresidents’ holdings of government securities in local currency are capped at 12.5 percent of total domestic currency denominated debt. (Debt sustainability section)
- Baseline projections and risks:
  - Under the baseline scenario, public debt-to-GDP is projected to decline by about 15 percentage points, to 63 percent GDP by 2019. (Debt sustainability section)
  - Medium-term macro assumptions explicitly stated:
    - Growth in the medium-term is projected at 6.5 percent.
    - CPI inflation projected to settle at 5.5 percent in the medium term.
    - 2014 central government budget deficit is projected to decline to 5.2 percent of GDP, implying a 0.7 percent of GDP deficit reduction relative to 2013.
  - Heat map analysis: "The debt burden benchmark of 70 percent of GDP and gross financing need benchmark of 15 percent of GDP are exceeded in all shock scenarios." (Debt sustainability section)
  - Identified risks:
    - Slower-than-projected growth, higher primary deficits, and higher borrowing costs could stop or reverse the decline in debt ratio.
    - High share of foreign currency-denominated debt creates vulnerability to currency depreciation.
    - Increasing reliance on nonconcessional financing and normalization of global financial conditions will push up borrowing costs.
  - Authorities' view: Authorities project debt ratio to fall to 65 percent of GDP by 2016 versus staff projection of 71 percent of GDP by 2016; authorities project average real GDP growth 2014–2016 at 8.1 percent versus staff average projected growth of "6 2/3 percent" (text).

### Fund relations, safeguards, and technical assistance
- Membership and IMF position data (as of May 31, 2014):
  - Quota: 413.40 SDR Million (100.00 percent of quota).
  - Fund holdings of currency (Exchange Rate): 1528.25 SDR Million; 369.68 percent of quota (table format as provided).
  - Reserve Tranche Position: 47.86 SDR Million; 11.58 percent of quota.
  - Net cumulative SDR allocation: 395.46 SDR Million (100.00 percent of allocation); holdings 5.75 SDR Million (1.45 percent).
- Outstanding purchases and loans:
  - Stand-by Arrangements: 1,162.69 SDR Million (281.25 percent of quota) listed under outstanding purchases and loans; Stand-By arrangement approved 7/24/09, expiration 7/24/12, Amount Approved: 1,653.60 SDR Million, Amount Drawn: 1,653.60 SDR Million (table entries).
  - ECF arrangements listed with amounts and draws (tables).
- Projected payments to Fund (SDR million; based on existing use and holdings of SDRs):
  - Principal forthcoming: 2014: 301.44; 2015: 361.73; 2016: 327.28; 2017: 172.25.
  - Charges/interest forthcoming: 2014: 6.16; 2015: 8.64; 2016: 4.20; 2017: 1.16; 2018: 0.39.
  - Total forthcoming: 2014: 307.60; 2015: 370.36; 2016: 331.47; 2017: 173.41; 2018: 0.39.
- Exchange rate arrangement and safeguards:
  - De jure exchange rate arrangement: free floating since January 23, 2001.
  - De facto arrangement reclassified from floating to a stabilized arrangement, effective October 1, 2013 (rupee stabilized within a 2 percent band against the U.S. dollar since October 2013).
  - Safeguards assessment (July 2009 update) found CBSL has "a relatively strong safeguards framework" with recommendations to improve program data reporting and internal audit; authorities implemented majority recommendations but staff has not received 2012–2013 Management Letters from CBSL’s external auditor—delivery required under safeguards policy.
- Technical assistance (selected):
  - FAD: multiple TA missions in tax policy and administration in 2000s; revenue administration missions in 2003; tax policy missions in 2001 and 2009; 2012 mission on Inland Revenue Department and VAT; missions in 2012–2014 on Public Financial Management, oversight of SOEs, budget preparation, commitment control system.
  - MCM: TA mission August 2001 on monetary and FX cooperation; May 2002 IMF/World Bank mission on People’s Bank reform; 2003 mission on financial sector issues; 2005 mission on deposit insurance.
  - STA: November 2012 mission on SDDS data dissemination; 2013–2014 JSA Project TA on ESS, BPM6 transition, CPI and PPI methodological work, GDP rebasing and quarterly national accounts; 2014 mission on GFS compilation and GFSM 2001/2014 implementation.

### Statistical issues, dissemination, and data quality
- General: Macroeconomic statistics are "broadly adequate for surveillance," with weaknesses in timeliness and coverage of certain series. Sri Lanka participates in GDDS since July 2000.
- Price statistics:
  - DCS released a new Consumer Price Index for Colombo in 2007; a core inflation index is compiled by DCS; CBSL produces a WPI/PPI.
- National accounts:
  - National accounts suffer from insufficient data sources and undeveloped statistical techniques; some gross value added estimates rely on fixed ratios and outdated studies; GDP at constant prices relies on annual expenditure estimates, often commodity flow techniques.
- Government finance:
  - Migration path to compile data per GFSM 2001 agreed in 2003; April 2014 STA mission as part of Japan-funded IMF project on GFSM 2001 and GFSM 2014.
- Monetary statistics:
  - FCBUs classified as resident since 1998; 50 percent of NRFC deposits are reclassified from foreign liabilities to domestic deposits to adjust for deposits actually held by residents.
- External sector statistics:
  - Since April 2014, CBSL publishes IIP and BOP statistics on an annual basis following BPM6; quarterly data available three months after quarter-end; plan to publish quarterly BPM6 data starting June 2014.
- Dissemination and standards:
  - Sri Lanka participates in GDDS; has pursued SDDS subscription since 2003 and made substantial progress but still needs work to meet all SDDS requirements (including quarterly IIP and monthly central government operations).
- Table of Common Indicators Required for Surveillance (as of June 17, 2014): provides frequencies and data quality assessments for key series (exchange rates, reserves, money, interest rates, CPI, government finance, external accounts, GDP, external debt, IIP) with varied timeliness and methodological assessments as listed in the table.

### Financial sector soundness (selected indicators)
- Capital adequacy (All banks, Table 6):
  - Regulatory capital to risk weighted assets: 2010: 16.2; 2011: 16.0; 2012: 15.0; 2013 (Q1–Q4 range): 15.0–16.3.
  - Tier 1 capital/risk weighted assets: 2010: 14.3; 2011: 14.4; 2012: 13.3; 2013 (Q1–Q4 range): 13.1–13.7.
- Asset quality:
  - Gross nonperforming loans to total gross loans (without interest in suspense): 2010: 5.4; 2011: 3.8; 2012: 3.6; 2013 (Q1–Q4 range): 4.2–5.6.
  - Net nonperforming loans to total gross loans: 2010: 3.0; 2011: 2.1; 2012: 2.4; 2013 (Q1–Q4 range): 2.1–3.3.
  - Provision coverage ratio (total) 1/: 2010: 58.1; 2011: 57.1; 2012: 50.9; 2013 (Q1–Q4 range): 54.5–40.4.
- Profitability and liquidity:
  - Return on equity (after tax) and return on assets (after tax) shown for 2010–2013 with quarterly variations (Table 6).
  - Liquid assets to total assets: 2010: 31.4; 2011: 26.8; 2012: 27.1; 2013 (Q1–Q4 range): 26.5–31.9.
- Note on provisioning: "The drop in the provisioning ratio reflects an increase in NPLs ... For the given stock of NPLs, this ratio is expected to increase as the stock of new NPLs migrates from substandard to lower categories (doubtful and loss) and provisioning requirements increase." (Table 6 footnote)

*Prepared by IMF staff for the 2014 Article IV Consultation and Second Post-Program Monitoring Discussion (Informational Annex), July 10, 2014.*

### 62.5 percent of GDP at end-2012 driven by strong GDP growth and price and exchange rate

### _cr14285 - 62.5 percent of GDP at end-2012 driven by strong GDP growth and price and exchange rate

### External debt trajectory and drivers
- External debt was 62.5 percent of GDP at end-2012.
- Baseline projection: external debt is expected to decrease gradually to just over 50 percent in 2019, with GDP growth being the main contributor to the decline.
- With relatively modest FDI inflows, the decline to just over 50 percent in 2019 is slow; stronger FDI inflows would reduce reliance on debt-creating inflows.
- Key baseline external debt projections (external debt in percent of GDP):
  - 2011: 55.4
  - 2012: 62.5
  - 2013: 59.6
  - 2014: 59.2
  - 2015: 58.3
  - 2016: 55.9
  - 2017: 54.0
  - 2018: 53.0
  - 2019: 52.4
- Debt-stabilizing non-interest current account: -4.3 (percent of GDP).

### Identified debt-creating flows and dynamics (external DSA)
- Change in external debt (percent of GDP):
  - 2012: 7.1
  - 2013: -2.9
  - 2014: -0.4
  - 2015: -1.0
  - 2016: -2.3
  - 2017: -1.9
  - 2018: -1.0
  - 2019: -0.6
- Identified external debt-creating flows (sum of items 4+8+9):
  - 2012: 4.1
  - 2013: -4.7
  - 2014: -2.1
  - 2015: -1.8
  - 2016: -1.9
  - 2017: -2.1
  - 2018: -2.2
  - 2019: -2.1
- Components (selected):
  - Current account deficit, excluding interest payments:
    - 2011: 6.6
    - 2012: 5.2
    - 2013: 2.2
    - 2014: 1.8
    - 2015: 1.7
    - 2016: 1.5
    - 2017: 1.2
    - 2018: 0.9
    - 2019: 0.8
  - Net non-debt creating capital inflows (negative) around -1.5 to -1.7 in projections.
  - Automatic debt dynamics (contribution):
    - 2011: -6.9
    - 2012: 0.8
    - 2013: -5.2
    - 2014: -2.2
    - 2015: -1.8
    - 2016: -1.7
    - 2017: -1.6
    - 2018: -1.4
    - 2019: -1.3
  - Contribution from nominal interest rate (selected years): 2011: 1.2; 2012: 1.5; 2013: 1.7; 2019: 1.9
  - Contribution from real GDP growth (selected years): 2011: -3.5; 2012: -3.5; 2013: -4.1; 2019: -3.2
  - Contribution from price and exchange rate changes: 2011: -4.6; 2012: 2.8; 2013: -2.9 (projection line includes impact of price and exchange rate changes).

### Stress tests, alternative scenarios, and vulnerabilities
- Standard alternative scenarios identify a real depreciation shock as the main vulnerability:
  - A real depreciation of 30 percent would lead external debt to nearly 80 percent at the end of the period (presented as 77–80 percent in stress test figures).
- Current account sensitivity:
  - If the current account deficit were on average 1.4 percent of GDP larger over the period, external debt would remain virtually unchanged at the current level.
- Other scenario results (external debt in percent of GDP):
  - Historical scenario: 59.2 (2014), 57.6 (2015), 54.9 (2016), 52.9 (2017), 51.8 (2018), 51.1 (2019).
  - CA shock and combined shocks increase external debt versus baseline (examples: CA shock 59; combined shock 57).
  - Permanent 1/4 standard deviation combined shock (real interest rate, growth rate, current account) and 30% depreciation considered in bound tests.
- Gross external financing need (in billions of US dollars):
  - 2011: 11.5
  - 2012: 13.0
  - 2013: 10.8
  - 2014–2019 projections: 10.8, 11.1, 11.4, 11.6, 11.9, 12.3
- Gross external financing need in percent of GDP: 2011: 19.5; 2012: 21.9; 2013: 16.2; other percent-of-GDP projections shown in charts.

### Risks and policy implications
- Key downside risks:
  - Weaker-than-expected external demand and lower tourism receipts.
  - Adverse climatic events (e.g., drought).
  - Slower-than-projected growth in advanced economies and tighter external liquidity conditions, raising rollover and borrowing-cost risks.
  - Continued weakness in government revenues threatening fiscal and debt consolidation.
  - Opening the capital account from relatively tight capital controls could affect external vulnerabilities depending on policy execution.
  - If public debt reduction is offset by an equivalent increase in private sector external borrowing to finance the current account deficit, external vulnerabilities for the economy as a whole will not be reduced.
- Positive mitigants:
  - Stronger inflow of FDI would have beneficial growth effects and decrease the need for debt-creating inflows.
- Staff cautions:
  - Exercise caution with respect to external borrowing through the banking system.
  - Maintain outward orientation, diversify export structure, and use foreign borrowing judiciously given rising debt servicing costs from commercial loans.
  - Central bank should be prepared to allow sufficient exchange rate flexibility while limiting intervention to accumulation of reserves and smoothing short-term volatility.
  - Monetary policy: keep policy rates on hold for the near term but be ready to adjust to ensure price stability; low inflation environment may allow for a downward shift in the interest rate structure over the medium term.
  - Fiscal policy: composition of consolidation matters; further consolidation should emphasize revenue mobilization (tackle tax expenditures and broaden tax base) given investment needs for infrastructure and human capital.

### Public debt DSA baseline (selected public sector indicators)
- Nominal gross public debt (percent of GDP), selected years:
  - 2012: 79.2
  - 2013: 78.3
  - 2014: 76.8
  - Projections decline across 2015–2019 in baseline charts.
- Public gross financing needs (percent of GDP), selected years:
  - 2012: 28.1
  - 2013: 24.8
  - 2014: 23.5
  - 2019 projection: 15.2
- Real GDP growth (in percent), baseline projections:
  - 2012: 6.3 (actual)
  - 2013: 7.3 (actual)
  - 2014–2019: 7.0, 6.5, 6.5, 6.5, 6.5, 6.5
- Inflation (GDP deflator, in percent), baseline projection: 2014: 3.8; 2015–2019: 5.4, 5.5, 5.5, 5.5, 5.5
- Primary balance (percent of GDP), baseline projection:
  - 2012: -0.7
  - 2013: -0.2
  - 2014: -0.1
  - 2015: 0.0
  - 2016: 0.1
  - 2017–2019: 0.0
- Change in gross public sector debt (cumulative, 2014–2019): -14.7 (cumulative change indicated).

### Key short-term macro indicators (2011–2014)
- Real GDP growth: 2011: 8.2; 2012: 6.3; 2013: 7.3; 2014 (Proj.): 7.0
- Inflation (average): 2011: 6.7; 2012: 7.5; 2013: 6.9; 2014 (Proj.): 3.8
- Central government balance (percent of GDP): 2011: -6.9; 2012: -6.5; 2013: -5.9; 2014 (Proj.): -5.2
- Government debt (domestic and external, percent of GDP): 2011: 78.5; 2012: 79.2; 2013: 78.3; 2014 (Proj.): 76.8
- Current account balance (in millions of U.S. dollars): 2011: -4,615; 2012: -3,983; 2013: -2,606; 2014 (Proj.): -2,491
- Current account balance (percent of GDP): 2011: -7.8; 2012: -6.7; 2013: -3.9; 2014 (Proj.): -3.5
- External debt (public and private, in billions of U.S. dollars): 2011: 32.7; 2012: 37.1; 2013: 39.7; 2014 (Proj.): 42.4
- External debt (percent of GDP): 2011: 55.4; 2012: 62.5; 2013: 59.6; 2014 (Proj.): 59.2
- Gross official reserves (end of period, in millions of U.S. dollars): 2011: 6,749; 2012: 7,106; 2013: 7,495; 2014 (Proj.): 8,380
- Reserves in months of imports: 2011: 3.2; 2012: 4.0; 2013: 3.5; 2014 (Proj.): 3.6
- Nominal GDP (in billions of U.S. dollars): 2011: 59.2; 2012: 59.4; 2013: 66.7; 2014 (Proj.): 71.6

*Source: IMF staff.*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2014/_cr14285.pdf_