## _cr15335

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---

### Key Features of the Revised 2015 Budget — Recent developments and macroeconomic performance
- Political transition
  - January presidential elections brought a new coalition government headed by Maithripala Sirisena.
  - Government committed to a 100 day program focused on trimming presidential powers, returning to a Westminster-style system, improving governance, increasing transparency, ensuring more inclusive growth, and reconciliation with the Northern provinces.
  - Authorities seeking to complete promised political reforms and call for fresh parliamentary elections by April 24th, or as soon as possible thereafter.
- Real sector and prices (2014)
  - Real GDP growth: 7.4 percent in 2014.
  - Construction, manufacturing, and wholesale/retail trade together accounted for about 60 percent of growth.
  - Agriculture suffered from drought early in the year and heavy rains/flooding in Q4.
  - Headline inflation (end-year): 2.1 percent.
  - Core inflation (end-year): 1.2 percent.
- Fiscal outturn (2014)
  - Overall fiscal deficit (preliminary): 5.9 percent of GDP (exceeded budget target by about ¾ percent of GDP).
  - Budget target (2014): 5.2 percent of GDP.
  - Tax revenues growth: 6.9 percent.
  - Income tax collection: fell by nearly 4 percent in nominal terms.
- State-owned enterprises (SOEs) performance (2014)
  - Aggregate SOE profit (preliminary): Rs 70 billion (0.7 percent of GDP) — an increase of Rs 25 billion over 2013.
  - Ceylon Electricity Board (CEB): recorded a loss of Rs 13 billion in 2014, compared to a 2013 profit of Rs 18 billion.
  - CEB loss linked to dry conditions and a 16 percent increase in per unit generation costs.
  - CPC/CEB financial outlook for 2015: unclear, with uncertainty about rainfall, oil prices, and the introduction of an automatic fuel price adjustment mechanism.
- External sector and reserves
  - Exports: increased 7 percent in 2014.
  - Imports: increased 7.9 percent in 2014.
  - Current account: broadly stable for the year but significant intra-year volatility; first half deficit about 2 percent of GDP.
  - FDI inflows (2014, estimated): $763 million — a 10 percent decline from 2013.
  - Net inflows into Colombo stock exchange (2014): $163 million (lower than $270 million in 2013).
  - Government sovereign debt issuance (2014): $1.5 billion.
  - Foreign investors’ participation in government domestic securities: net outflow of $113 million for the year.
  - CBSL foreign exchange reserves: declined from a peak of $9.3 billion in July 2014 to $8.2 billion by end-year and dropped by an additional $1.3 billion by mid-March 2015, bringing reserve coverage to about 3.1 months of imports.
  - Reserves declined mostly due to a sovereign bond repayment ($500 million) and settlement of ACU liabilities ($400 million).
- Monetary and financial sector
  - Policy rates: lowered by 150 bps between end-2012 and January 2014.
  - Banks’ reserve requirement: reduced by two percentage points.
  - Private credit growth: 8.8 percent through December 2014 and 11 percent through January 2015.
  - Reserve growth (2014): 18.3 percent.
  - Broad money growth (2014): 13.4 percent.
  - Banking sector NPLs: 4.2 percent of total loans as of end-2014 (compared with 5.6 percent as of end-2013 and a peak of 6.2 percent in mid-2014).
  - ROE for banking system: rose from 16.0 to 16.5 percent between end-2013 and end-2014.
  - ROA: increased from 1.3 to 1.4 percent.
  - Net interest margins: 3.5 percent.
  - New government decided to suspend and review the financial sector consolidation plan initiated by the CBSL in 2014.

### Outlook and risks
- Growth and inflation projections
  - Real GDP growth projected at 6.5 percent in 2015 and beyond.
  - Headline inflation projected at 3.2 percent.
  - Core inflation projected at 2.3 percent.
- Current account and financing (2015)
  - Current account deficit projected to narrow to 2 percent of GDP in 2015.
  - Expected drivers: lower international commodity prices, relatively robust exports to the U.S., continued growth in tourism receipts.
  - Risks: increases in public sector wages and wealth effect from lower fuel and electricity prices expected to induce higher consumer goods imports.
  - FDI projected to remain stable but subject to investment risks.
- Downside risks highlighted
  - Revised budget targets a relatively low level of public investment compared to the original budget; a number of projects under review.
  - Policy uncertainty may dampen private investment.
  - Under status quo policies, the overall deficit could approach 7 percent of GDP in 2015 and higher thereafter as one-off tax measures expire — effectively crowding out private credit through a higher domestic borrowing requirement.
  - Negative spillovers from slower economic recovery in Europe.

### Box — Key features of the revised 2015 budget (authorities’ measures)
- Revenue and expenditure composition changes
  - Introduction of one-off revenue measures, including a “super gains tax” on companies and individuals with profits over Rs. 2 billion in 2013/14.
  - Introduction of a “mansion tax” on homes above Rs 100 million in value.
  - Payment by selected public institutions of profits, dividends and levies which were not “properly” transferred to the central government as non-tax revenue.
  - Increase in public employee’s monthly wages by Rs 10,000 — an effective 47 percent increase compared to the 2014 average wage.
  - Increase in pension payments (Rs 1,000 per month) for retired public servants.
  - A 200 percent increase in the monthly payments under the Samurdhi welfare scheme.
  - Reduction of public investment spending on infrastructure by 30 percent compared to the original budget.
- Price and levy reductions
  - LP gas prices lowered by 16 percent.
  - Diesel lowered by 14.4 percent.
  - Petrol lowered by 22 percent.
  - Kerosene lowered by 20 percent.
  - Prices of 13 essential food items reduced by lowering the special commodity levy and custom duties.

### Fiscal table highlights (2014 preliminary / 2015 original / 2015 revised) — 2015 Budget (% of GDP)
- Total Revenue and Grants: 11.7 14.9 14.3
- Total Expenditures: 17.7 19.5 18.7
  - Current: 13.2 13.5 14.2
    - Interest: 4.2 3.8 3.8
  - Capital: 4.5 6.2 4.6
- Balance: -5.9 -4.6 -4.4

### Staff analysis and recommendations — Maintaining fiscal discipline
- Staff assessment
  - Revised 2015 budget targets continued fiscal consolidation but finances a significant boost to current spending largely through one-off revenue measures.
  - Authorities estimate combined revenue measures from the original and revised budgets yield 1.3 percent of GDP; about two thirds from taxation of past excess profits and bank-financed repayment of tax arrears.
  - Budget assumes 0.4 percent of GDP of administrative costs savings due to rationalization and lower fuel and electricity prices.
  - Staff view: 2015 deficit target would be very difficult to reach; underlying revenues (excluding one-off measures) would have to grow in excess of 20 percent compared to 2014 to reach the revenue target.
  - Use of one-off measures (e.g., super gains tax) is not viewed as a move toward a more effective tax system and creates problems for 2016 and beyond.
  - Public debt estimated at 76 percent of GDP in 2014.
- Staff recommended two-step strategy
  - Short-term (2015) objective: avoid a large increase in the fiscal deficit; main tool should be expenditure management rather than further ad hoc revenue measures.
    - Options: (i) savings within non-wage recurrent expenditure of central government; (ii) consider delaying the second wave of increases to public wage, salary and pension payments; (iii) additional reduction in low-impact capital expenditures.
  - Medium-term emphasis: strengthen the tax system:
    - Terminate the practice of providing new tax exemptions.
    - Conduct a comprehensive review of existing tax expenditures and formulate a strategy for their elimination.
    - Accompany review of tax expenditures with a diagnostic assessment of the structure of taxation and meaningful simplification to broaden the base and improve tax administration — ideally implemented as part of the 2016 budget.
    - Establish a medium-term framework for fiscal consolidation and debt reduction (FMRA cited as a useful framework).
  - Staff suggested a long-term anchor could be a target for public debt to GDP of 50 percent, with appropriate interim objectives.
- Authorities’ response
  - Emphasized commitment to continued fiscal consolidation while moving to a more progressive tax system.
  - Recognized meeting the 2015 revenue and deficit targets could be challenging; encouraged by strong excise and customs revenues in early 2015.
  - Intended measures include reduction in tax exemptions and simplification of the tax system; in the meantime pursue tight expenditure control to contain the deficit.
  - See scope for delaying domestically financed capital projects; ongoing work toward comprehensive review of government debts and efforts to renegotiate some bilateral loans to lower debt servicing costs.
  - Reiterated FMRA remains in effect and will be a useful framework for guiding policies.

### Monetary policy continued to be accommodative during 2014 — stance, effects, and guidance
- Monetary policy stance and measures in 2014–early 2015
  - Policy rates and reserve requirements remained unchanged in 2014.
  - CBSL measures to spur private credit growth:
    - January: compressed the Standing Rate Corridor by 50 basis points.
    - September: limited banks’ access to its Standing Deposit Facility (SDF) to a maximum of three times per month, with further access available only at a penalty rate.
  - The limit on access to the SDF was eliminated in March 2015.
  - Mission advice:
    - Keep monetary policy on hold for the short-term.
    - Be prepared to tighten if signs of overheating emerge.
    - Support for resumption of work toward establishing an inflation targeting framework (to be supported by IMF technical assistance).
- Credit, liquidity, and market effects
  - Private credit: year-on-year private credit growth was less than 3 percent in September 2014; private credit growth on a steady upward trend through remainder of 2014 and into 2015.
  - Authorities expected private credit to grow as high as 18 percent in 2015.
  - Substantial excess liquidity in the banking system in September 2014; banks’ excess liquidity has declined as private credit picked up.
  - Compression of the standing rate corridor does not appear to have adversely affected bank profitability.
- Side effects of accommodative stance
  - Lower investor appetite for government securities; steady decline in rates reportedly contributed to a non-rollover of a July 2014 maturity by foreign investors—lowering foreign ownership of Sri Lankan securities below 11 percent for the first time since 2012.
  - Removal of limits on SDF access added some volatility to short-term interest rates, complicating liquidity management in the interbank money market.

### External sustainability, exchange rate assessment, and adverse external financing scenario
- External trends and oil price shock
  - Three trends: leveling-off of goods exports; unwinding of import compression; weakening of capital inflows.
  - Sharp drop in oil prices produces a windfall equivalent to about $2 billion for 2015 as a whole, or roughly 2 percent of GDP.
  - With goods exports remaining in the current range, improvement in the trade balance should cushion the overall balance of payments.
  - With capital flows at comparatively normal levels, net inflows should be sufficient to keep central bank foreign exchange reserves in the range of 3.5 to 4 months of imports.
- Exchange rate assessment
  - EBA methodology points to an overvaluation of about 5 percent.
  - CGER approaches:
    - Macro balance and external sustainability approaches point to an undervaluation of 2–4 percent.
    - Equilibrium exchange rate approach suggested an overvaluation of about 7 percent.
  - Net foreign exchange sales by the CBSL amounted to some US$812 million in September 2014 to mid-March 2015, compared to a net absorption of about US$1 billion during January–August 2014.
  - Forward market data indicate expectations of depreciation in the near-term and that volatility has risen from historically low levels.
- Staff recommendations on exchange rate
  - Allow exchange rate flexibility to facilitate adjustment and to protect reserves.
  - Prefer depreciation to continued drain on reserves given reserves falling well below IMF standard metrics for adequacy.
  - Exchange rate should bear some of the adjustment burden if shifts in investor sentiment materialize.
- Adverse external financing scenario (Box summary)
  - Scenario assumptions:
    - Concurrent shocks to growth and the financial account.
    - Small policy adjustment (nominal exchange rate depreciation) but no new measures to reduce the fiscal deficit or increase policy rates.
    - Sharp decrease in non-resident exposure to T-bills and T-bonds: T-bill and T-bond rollovers at 25 and 30 percent in 2015, improving to 50 and 55 percent, respectively, in the first half of 2016.
    - Equity outflows of about 12.5 percent of total non-resident equity holdings—distributed evenly between the second half of 2015 and in the first half of 2016.
  - Potential impact:
    - Under a relatively static shock, the potential drain on CBSL foreign exchange reserves could be significant—potentially bringing Sri Lanka’s reserve cover below three months of imports, and well below the IMF’s reserve adequacy metrics.

### Financial sector developments, vulnerabilities, and post-program monitoring
- Financial sector indicators and supervision
  - Capital adequacy ratio edged downward from 16.3 percent in 2013 to 15.6 percent by end-2014.
  - Nonperforming assets related to gold pawning activity appear to have peaked; banks reduced exposure to gold pawning activity by some 50 percent.
  - Progress toward adopting the three pillars of the Basel II Accords; guidelines issued regarding market and operational risks.
  - Slower progress on supervision of nonbank financial institutions (NBFIs) and adoption of a broader crisis management framework incorporating the entire financial sector.
  - Financial sector consolidation process halted by the new government; review committee expected to report in April.
- Post-program monitoring and external indebtedness
  - Exposure to the IMF stands at SDR 757.9 million (about US$1.05 billion—1.3 percent of projected 2014 GDP and 16.6 percent of current gross central bank foreign exchange reserves).
  - Repayments to the IMF stretch into mid-2017.
  - Sri Lanka’s outstanding credit from the Fund has fallen to 183 percent of quota (below the 200 percent threshold for post-program monitoring).
  - External debt broadly sustainable but significant vulnerabilities remain with respect to exchange rate risk and baseline assumptions on growth and fiscal consolidation.
  - Staff recommendation: extension of post-program monitoring for one year.

### Staff appraisal and policy priority
- Macro assessment
  - Recent performance strong in aggregate but risks have significantly risen from domestic and external sources.
  - Domestic risks: prospect of higher fiscal deficits is the single biggest macrofinancial vulnerability given high public debt and limited fiscal maneuvering room.
  - Interim budget’s boost to consumption will spill into imports and could be larger than expected; this may spur growth but could be offset by delays in public and private investment and wavering confidence from policy uncertainty.
- Fiscal recommendations
  - Fiscal consolidation should be addressed expeditiously.
  - Reliance on expenditure constraint has reached its limit—2014 outturn showed continued cuts to current and capital spending unable to keep pace with the decline in revenue as a share of GDP.
  - Staff strongly urges authorities to exercise cost savings where possible (and prudent with respect to high value-added spending on physical and social infrastructure) to keep the deficit under control for 2015.

### The medium-term fiscal outlook clearly signals the need for a revamping of tax policy
- Fiscal outlook and tax policy reform
  - Reform described as long overdue; absence of reforms entails significant risk.
  - Staff cognizant of constraints imposed by the current political timeline, but emphasizes need to proceed quickly with technical work on reform options in the interim.
  - Objective: formulate a set of measures that could be implemented in concert with the 2016 budget (normally presented to parliament in November).
- Fundamental elements recommended by staff
  - A comprehensive reduction in exemptions and tax holidays.
  - A streamlining of the tax structure.
  - Continued efforts to boost tax administration and collection capacity.
- Macrofiscal anchor
  - A clear and credible medium-term macro-fiscal framework that supports consolidation and debt reduction is essential.
- Monetary policy and financial conditions (selected points)
  - Headline year-on-year inflation declined to 0.1 percent in March 2015, from 0.6 percent in February 2015.
  - Core inflation increased from 0.8 percent to 1.4 percent over the same period.
  - The CBSL Monetary Board reduced policy interest rates by 50 basis points, effective April 15 (SDFR and SLFR reduced to 6 percent).
- External considerations and staff recommendation
  - Windfall from lower oil prices: $2 billion or about 2 percent of GDP in 2015.
  - Staff recommends shifting focus to exchange rate flexibility as a means of preserving a limited reserve cushion.
  - Staff recommendation: extend post-program monitoring framework for one year.

### Statement by Rakesh Mohan, Executive Director for Sri Lanka and Mr. Ranasinghe — April 29, 2015 (context and priorities)
- Context and institutional stance
  - Document dates: April 23, 2015; Statement by Rakesh Mohan, Executive Director for Sri Lanka and Mr. Ranasinghe — April 29, 2015.
  - New Government formed after January 2015 presidential election; emphasis on a 100-day program with constitutional, institutional and social welfare reforms.
  - Parliamentary elections expected around mid 2015; authorities view medium-term policy framework as likely to be solidified only after those elections.
  - Authorities ready to continue close engagement with the IMF through Post-Program Monitoring (PPM).
- Economic growth and outlook
  - 2014 GDP growth: 7.4 percent (2013: 7.2 percent).
  - Industry sector growth: 11.4 percent; contributed nearly 48 per cent to GDP growth.
  - Services sector growth: 6.5 percent.
  - Authorities’ projection for 2015 growth: 7 percent.
- Fiscal and monetary highlights
  - 2014 revenue: declined to 12.2 percent of GDP (targeted: 14.5 percent of GDP).
  - 2014 budget deficit: 6.0 percent of GDP (targeted: 5.2 percent of GDP).
  - Interim Budget (January 2015) targeted a budget deficit of 4.4 percent of GDP.
  - Private sector credit growth: 8.8 percent by end-2014; 12.6 percent y-o-y by February 2015.
  - Central Bank reduced policy interest rates by 50 basis points effective 15th April 2015.
- External sector and reserves (selected figures)
  - Current account deficit: 2.7 percent of GDP in 2014 (2013: 3.8 percent of GDP).
  - Export earnings growth: 7.1 percent in 2014.
  - Trade deficit: expanded by 8.9 percent to US $ 8,287 million in 2014; trade deficit as percent of GDP declined to 11.1 percent from 11.3 percent in 2013.
  - FDI inflows including borrowings: US$ 1,685 million in 2014.
  - FDI excluding borrowings: US$ 944 million in 2014 (2013: US$ 933 million).
  - BOP surplus: US$ 1,369 million in 2014.
  - Gross official reserves: US$ 8.2 billion at end-2014; declined to US$ 6.7 billion at end-March 2015 after meeting short-term debt obligations.
  - Risk mitigation measures: issuance of SLDBs up to US$ 800 million; RBI currency swap for US$ 400 million; Government of India approved enhancing swap by additional US$ 1,100 million.
- Financial sector indicators
  - Total CAR (provisional): declined to 16.7 percent from 17.6 percent in 2014; regulatory requirement is 10 percent.
  - Banking sector NPL: improved to 4.2 percent from 5.6 percent in the previous year.
  - Total provision coverage: increased to 50.7 percent.
- Near-term policy priorities indicated by authorities
  - After Parliamentary elections, introduce firm measures to enhance revenue mobilization and rationalize expenditure.
  - Continue tax policy and administration reforms (including IMF TA recommendations) and complete RAMIS Phase I toward end-2015.
  - Maintain exchange rate flexibility and intervene only to limit excessive volatility.
  - Continue macro-fiscal framework development once political stability is secured post-elections.

*Italic source: IMF staff report — "Recent Developments and Outlook" section and related excerpts from _cr15335.*

### 1. Key Features of the Revised 2015 Budget ___________________________________________________________ 6

### 1. Key Features of the Revised 2015 Budget

### Recent developments and macroeconomic performance
- Political transition
  - January presidential elections brought a new coalition government headed by Maithripala Sirisena.
  - Government committed to a 100 day program focused on trimming presidential powers, returning to a Westminster-style system, improving governance, increasing transparency, ensuring more inclusive growth, and reconciliation with the Northern provinces.
  - Authorities seeking to complete promised political reforms and call for fresh parliamentary elections by April 24th, or as soon as possible thereafter.
- Real sector and prices (2014)
  - Real GDP growth: 7.4 percent in 2014.
  - Growth sources: construction, manufacturing, and wholesale/retail trade together accounted for about 60 percent of growth; agriculture suffered from drought early in the year and heavy rains/flooding in Q4.
  - Headline inflation (end-year): 2.1 percent.
  - Core inflation (end-year): 1.2 percent.
  - Reductions in administered prices for fuels facilitated record low levels of inflation.
- Fiscal outturn (2014)
  - Overall fiscal deficit (preliminary): 5.9 percent of GDP (exceeded budget target by about ¾ percent of GDP).
  - Budget target (2014): 5.2 percent of GDP.
  - Tax revenues growth: 6.9 percent.
  - Income tax collection: fell by nearly 4 percent in nominal terms.
  - This is the largest deviation between outturn and target of recent years, and the first year since 2009 that the deficit was not reduced as a share of GDP.
- State-owned enterprises (SOEs) performance (2014)
  - Aggregate SOE profit (preliminary): Rs 70 billion (0.7 percent of GDP) — an increase of Rs 25 billion over 2013.
  - Ceylon Electricity Board (CEB): recorded a loss of Rs 13 billion in 2014, compared to a 2013 profit of Rs 18 billion.
  - Drivers: improvement in banking and insurance sectors; favorable impact of lower oil prices on Ceylon Petroleum Corporation (CPC); CEB loss linked to dry conditions and a 16 percent increase in per unit generation costs.
  - CPC/CEB financial outlook for 2015: unclear, with uncertainty about rainfall, oil prices, and the introduction of an automatic fuel price adjustment mechanism.
- External sector and reserves
  - Exports: increased 7 percent in 2014 (led mainly by industrial goods and agricultural products).
  - Imports: increased 7.9 percent in 2014 (mainly consumer and intermediate goods).
  - Current account: broadly stable for the year but significant intra-year volatility; first half deficit about 2 percent of GDP; non-oil goods trade deficit increased by some 2½ times in second half.
  - FDI inflows (2014, estimated): $763 million — a 10 percent decline from 2013.
  - Net inflows into Colombo stock exchange (2014): $163 million (lower than $270 million in 2013).
  - Government sovereign debt issuance (2014): $1.5 billion.
  - Foreign investors’ participation in government domestic securities: net outflow of $113 million for the year.
  - Pace of net outflows since beginning of 2015 subsided to US$4.9 million by February.
  - CBSL foreign exchange reserves: declined from a peak of $9.3 billion in July 2014 to $8.2 billion by end-year and dropped by an additional $1.3 billion by mid-March 2015, bringing reserve coverage to about 3.1 months of imports.
  - Note: Reserves declined mostly due to a sovereign bond repayment ($500 million) and settlement of ACU liabilities ($400 million).
- Monetary and financial sector
  - Policy rates: lowered by 150 bps between end-2012 and January 2014.
  - Banks’ reserve requirement: reduced by two percentage points.
  - Monetary policy loosened in September 2014 by limiting banks’ access to the standing deposit facility (SDF) — SDF eliminated in late March 2015.
  - Private credit growth: 8.8 percent through December 2014 and 11 percent through January 2015.
  - Reserve growth (2014): 18.3 percent.
  - Broad money growth (2014): 13.4 percent.
  - Banking sector nonperforming loans (NPLs): 4.2 percent of total loans as of end-2014, compared with 5.6 percent as of end-2013 and a peak of 6.2 percent in mid-2014.
  - Return on equity (ROE) for banking system: rose from 16.0 to 16.5 percent between end-2013 and end-2014.
  - Return on assets (ROA): increased from 1.3 to 1.4 percent.
  - Net interest margins: 3.5 percent (broadly unchanged from end-2013).
  - The new government decided to suspend and review the financial sector consolidation plan initiated by the CBSL in 2014.

### Outlook and risks
- Growth and inflation projections
  - Real GDP growth projected at 6.5 percent in 2015 and beyond.
  - Headline inflation projected at 3.2 percent.
  - Core inflation projected at 2.3 percent.
- Current account and financing (2015)
  - Current account deficit projected to narrow to 2 percent of GDP in 2015.
  - Drivers: lower international commodity prices, relatively robust exports to the U.S., continued growth in tourism receipts.
  - Risks: increases in public sector wages and wealth effect from lower fuel and electricity prices expected to induce higher consumer goods imports.
  - FDI projected to remain stable but subject to investment risks.
  - Increased sovereign financing and gradual recovery of private sector inflows (mostly equities and loans to SOEs) expected to help finance the current account deficit and increase gross reserves; extended policy uncertainty could undermine these inflows.
- Downside risks highlighted
  - The potential impact of lower public investment: revised budget targets a relatively low level of public investment compared to the original budget; a number of projects under review.
  - Dampening effect of policy uncertainty on private investment.
  - Impact of an expanded fiscal deficit on private credit: under status quo policies, the overall deficit could approach 7 percent of GDP in 2015 and higher thereafter as one-off tax measures expire — effectively crowding out private credit through a higher domestic borrowing requirement.
  - Negative spillovers from slower economic recovery in Europe.

### Box — Key features of the revised 2015 budget (authorities’ measures)
- Revenue and expenditure composition changes
  - Introduction of one-off revenue measures, including a “super gains tax” on companies and individuals with profits over Rs. 2 billion in 2013/14.
  - Introduction of a “mansion tax” on homes above Rs 100 million in value.
  - Payment by selected public institutions of profits, dividends and levies which were not “properly” transferred to the central government as non-tax revenue.
  - Increase in public employee’s monthly wages by Rs 10,000 — an effective 47 percent increase compared to the 2014 average wage.
  - Increase in pension payments (Rs 1,000 per month) for retired public servants.
  - A 200 percent increase in the monthly payments under the Samurdhi welfare scheme.
  - Reduction of public investment spending on infrastructure by 30 percent compared to the original budget.
- Price and levy reductions
  - LP gas prices lowered by 16 percent.
  - Diesel lowered by 14.4 percent.
  - Petrol lowered by 22 percent.
  - Kerosene lowered by 20 percent.
  - Prices of 13 essential food items reduced by lowering the special commodity levy and custom duties.

### Fiscal table highlights (2014 preliminary / 2015 original / 2015 revised) — 2015 Budget (% of GDP)
- Total Revenue and Grants: 11.7 14.9 14.3
- Total Expenditures: 17.7 19.5 18.7
  - Current: 13.2 13.5 14.2
    - Interest: 4.2 3.8 3.8
  - Capital: 4.5 6.2 4.6
- Balance: -5.9 -4.6 -4.4

### Policy discussions — Maintaining fiscal discipline (staff analysis and recommendations)
- Staff assessment
  - The revised 2015 budget targets continued fiscal consolidation but finances a significant boost to current spending largely through one-off revenue measures.
  - Authorities estimate combined revenue measures from the original and revised budgets yield 1.3 percent of GDP; about two thirds from taxation of past excess profits and bank-financed repayment of tax arrears.
  - Budget assumes 0.4 percent of GDP of administrative costs savings due to rationalization and lower fuel and electricity prices.
  - Staff view: 2015 deficit target would be very difficult to reach. Even if one-off measures yield estimated revenues, underlying revenues (excluding the measures) would have to grow in excess of 20 percent compared to 2014 to reach the revenue target — appearing unlikely.
  - Unlike previous years when revenue shortfalls were offset by lower capital spending, there is much less room for similar adjustment in 2015 as capital spending has already been compressed.
  - Use of one-off measures (e.g., super gains tax) is not viewed as a move toward a more effective tax system and creates problems for 2016 and beyond.
  - Risk to debt sustainability: in absence of measures creating durable revenue increases, revenues in 2016 will drop as one-off measures expire while permanent increases to recurrent spending will push the deficit higher.
  - Public debt estimated at 76 percent of GDP in 2014. Last DSA discussed in July 2014 assessed public debt as sustainable but subject to relatively high risks; next DSA slated for early 2016.
- Staff recommended two-step strategy
  - Short-term (2015) objective: avoid a large increase in the fiscal deficit; main tool should be expenditure management rather than further ad hoc revenue measures.
    - Options: (i) savings within non-wage recurrent expenditure of central government (non-wage recurrent expenditure is still projected to increase by 0.4 percent of GDP); (ii) consider delaying the second wave of increases to public wage, salary and pension payments; (iii) additional reduction in low-impact capital expenditures (those with comparatively low social or growth impact).
  - Medium-term emphasis: strengthen the tax system. Fundamental pillars could include:
    - Terminate the practice of providing new tax exemptions; avoid reversing centralized control over new tax exemptions.
    - Conduct a comprehensive review of existing tax expenditures with a view to evaluating their cost and formulating a strategy for their elimination.
    - Accompany review of tax expenditures with a diagnostic assessment of the structure of taxation; meaningful simplification of the tax regime to broaden the base and improve tax administration and collection — ideally to be implemented as part of the 2016 budget.
    - Establish a medium-term framework for fiscal consolidation and debt reduction to reestablish a credible macro-fiscal framework and anchor policies and expectations (FMRA cited as a useful framework).
  - Staff suggested a long-term anchor could be a target for public debt to GDP of 50 percent, with appropriate interim objectives.
- Authorities’ response
  - Emphasized commitment to continued fiscal consolidation while moving to a more progressive tax system.
  - Recognized meeting the 2015 revenue and deficit targets could be challenging; encouraged by strong excise and customs revenues in early 2015.
  - Intended measures include reduction in tax exemptions and simplification of the tax system; in the meantime pursue tight expenditure control to contain the deficit.
  - See scope for delaying domestically financed capital projects; ongoing work toward comprehensive review of government debts and efforts to renegotiate some bilateral loans to lower debt servicing costs.
  - Reiterated FMRA remains in effect and will be a useful framework for guiding policies.

*Italic source: IMF staff report — "Recent Developments and Outlook" section and "Box 1. Sri Lanka: Key Features of the Revised 2015 Budget" (excerpts).*

### 17.      Monetary policy continued to be accommodative during 2014—facilitating a pick-up

### _cr15335 - 17.      Monetary policy continued to be accommodative during 2014—facilitating a pick-up

### Monetary policy stance and measures in 2014–early 2015
- Policy rates and reserve requirements remained unchanged in 2014.
- CBSL measures to spur private credit growth:
  - January: compressed the Standing Rate Corridor by 50 basis points.
  - September: limited banks’ access to its Standing Deposit Facility (SDF) to a maximum of three times per month, with further access available only at a penalty rate.
- The limit on access to the SDF was eliminated in March 2015.
- Mission advice:
  - Keep monetary policy on hold for the short-term.
  - Be prepared to tighten if signs of overheating emerge, because:
    - Long lags in monetary policy transmission mean earlier loosening effects may still be emerging.
    - Incipient rise in private credit, substantial boost to domestic demand likely from the interim budget, and a gradual pickup in inflation so far in 2015 suggest the credit cycle has turned and the central bank may need to tighten in the near term.
  - Support for resumption of work toward establishing an inflation targeting framework (to be supported by IMF technical assistance).

### Credit, liquidity, and market effects
- Private credit:
  - Year-on-year private credit growth was less than 3 percent in September 2014.
  - Private credit growth was on a steady upward trend through the remainder of 2014 and into 2015.
  - Authorities expected private credit to grow as high as 18 percent in 2015.
- Banking system liquidity and profitability:
  - Substantial excess liquidity in the banking system in September 2014; banks’ excess liquidity has declined as private credit picked up.
  - Compression of the standing rate corridor does not appear to have adversely affected bank profitability.
- Side effects of accommodative stance:
  - Lower investor appetite for government securities; steady decline in rates reportedly contributed to a non-rollover of a July 2014 maturity by foreign investors—lowering foreign ownership of Sri Lankan securities below 11 percent for the first time since 2012.
  - Removal of limits on SDF access added some volatility to short-term interest rates, complicating liquidity management in the interbank money market.

### External sustainability and balance of payments outlook
- Recent BOP developments highlight three trends:
  - Leveling-off of goods exports.
  - Unwinding of import compression (monthly nonoil imports, particularly consumption and intermediate goods, returned closer to historical norms in the second half of 2014 and into 2015).
  - Weakening of capital inflows.
- Oil price shock:
  - Sharp drop in oil prices produces a windfall equivalent to about $2 billion for 2015 as a whole, or roughly 2 percent of GDP.
  - With goods exports remaining in the current range, improvement in the trade balance should cushion the overall balance of payments.
  - With capital flows at comparatively normal levels, net inflows should be sufficient to keep central bank foreign exchange reserves in the range of 3.5 to 4 months of imports.
- Risks to external outlook:
  - (i) eventual reversion of the oil price shock;
  - (ii) slowdown in goods exports if growth in key export markets stalls;
  - (iii) less optimistic assumptions regarding net capital flows.

### Exchange rate assessment and policy guidance
- Exchange rate valuation:
  - EBA methodology points to an overvaluation of about 5 percent, with more than half of policy gaps explained by the fiscal balance to GDP and health expenditures.
  - CGER approaches:
    - Macro balance and external sustainability approaches point to an undervaluation of 2–4 percent.
    - Equilibrium exchange rate approach suggested an overvaluation of about 7 percent.
- Recent market and intervention patterns:
  - Since September 2014 central bank sales of foreign exchange to the market have been steady as imports rose.
  - Net foreign exchange sales by the CBSL amounted to some US$812 million in September 2014 to mid-March 2015, compared to a net absorption of about US$1 billion during January–August 2014.
  - Forward market data indicate expectations of depreciation in the near-term and that volatility has risen from historically low levels.
- Staff recommendations:
  - Allow exchange rate flexibility to facilitate adjustment and to protect reserves.
  - Prefer depreciation to continued drain on reserves given reserves falling well below IMF standard metrics for adequacy.
  - Exchange rate should bear some of the adjustment burden if shifts in investor sentiment materialize.

### Adverse external financing scenario (Box summary)
- Scenario assumptions:
  - Concurrent shocks to growth and the financial account.
  - Small policy adjustment (nominal exchange rate depreciation) but no new measures to reduce the fiscal deficit or increase policy rates.
  - Sharp decrease in non-resident exposure to T-bills and T-bonds:
    - T-bill and T-bond rollovers at 25 and 30 percent in 2015, improving to 50 and 55 percent, respectively, in the first half of 2016.
    - Lower rollovers for non-concessional loans.
  - Equity outflows of about 12.5 percent of total non-resident equity holdings—distributed evenly between the second half of 2015 and in the first half of 2016.
- Potential impact:
  - Under a relatively static shock, the potential drain on CBSL foreign exchange reserves could be significant—potentially bringing Sri Lanka’s reserve cover below three months of imports, and well below the IMF’s reserve adequacy metrics.

### Authorities’ stance on exchange rate and external tools
- Authorities agreed on a generally positive BOP outlook and reiterated commitment to exchange rate flexibility, noting timing is important:
  - Greater flexibility should be synchronized with foreign inflows such as sovereign bond issuance.
  - Recent stability of the rupee reflects search for optimal timing rather than lack of commitment to flexibility.
- Other measures:
  - New swap line with India being used to bolster the external position and prepare for external volatility.

### Financial sector developments and risks
- System indicators:
  - Capital adequacy ratio edged downward from 16.3 percent in 2013 to 15.6 percent by end-2014.
  - Nonperforming assets related to gold pawning activity appear to have peaked; banks reduced exposure to gold pawning activity by some 50 percent and enforced tighter loan-to-value ratios.
  - Overall profitability (ROE and ROA) has improved for the system as a whole.
- Supervision and regulation:
  - Progress toward adopting the three pillars of the Basel II Accords; guidelines issued regarding market and operational risks.
  - Information Sharing Act has received cabinet approval and is being drafted for submission to Parliament.
  - Slower progress on supervision of nonbank financial institutions (NBFIs) and adoption of a broader crisis management framework incorporating the entire financial sector.
  - Forthcoming technical assistance expected to identify key priorities for reform.
- Consolidation and governance:
  - Financial sector consolidation process halted by the new government; review committee (expected to report in April) to consider way forward.
  - Authorities agreed on need for regular stress testing, consolidated supervision including NBFIs, and a clearly defined financial crisis management plan.
  - One large state owned commercial bank has been provided budgetary provisions to support expansion and enhance resilience to shocks.
- Remaining concerns:
  - Staff expressed concern about need for timely decisions on consolidation to reduce uncertainty.
  - Some problematic NBFIs are being dealt with on a case by case basis.

### Post-program monitoring and external indebtedness
- IMF exposure and reserve context:
  - Exposure to the IMF stands at SDR 757.9 million (about US$1.05 billion—1.3 percent of projected 2014 GDP and 16.6 percent of current gross central bank foreign exchange reserves).
  - Repayments to the IMF stretch into mid-2017.
  - Sri Lanka’s outstanding credit from the Fund has fallen to 183 percent of quota (below the 200 percent threshold for post-program monitoring).
- Debt and reserve vulnerabilities:
  - External debt broadly sustainable but significant vulnerabilities remain with respect to exchange rate risk and baseline assumptions on growth and fiscal consolidation.
  - Cost of external debt has risen sharply as Sri Lanka shifts from concessional, bilateral debt into new external loans on commercial terms.
  - Low revenue base implies limited fiscal maneuvering room and very high debt- and debt service-to-revenue ratios.
  - Reserves have fallen below the Fund’s standard adequacy metrics in the past few months.
- Staff recommendation:
  - Extension of post-program monitoring for one year.

### Staff appraisal and policy priority
- Macro context:
  - Recent performance strong in aggregate but risks have significantly risen from domestic and external sources.
  - External risks: slow global growth, divergence between EU and U.S. (key export markets), volatile commodity markets, tighter global liquidity, potentially less investor appetite for Sri Lankan securities.
  - Domestic risks: prospect of higher fiscal deficits is the single biggest macrofinancial vulnerability given high public debt and limited fiscal maneuvering room.
  - The interim budget’s boost to consumption will spill into imports and could be larger than expected; this may spur growth but could be offset by delays in public and private investment and wavering confidence from policy uncertainty.
- Fiscal recommendations:
  - Fiscal consolidation should be addressed expeditiously.
  - Reliance on expenditure constraint has reached its limit—2014 outturn showed continued cuts to current and capital spending unable to keep pace with the decline in revenue as a share of GDP.
  - Interim budget targets a level of fiscal consolidation which seems unlikely even under optimistic assumptions.
  - Staff strongly urges authorities to exercise cost savings where possible (and prudent with respect to high value-added spending on physical and social infrastructure) to keep the deficit under control for 2015.

*Source: _cr15335 - 17.      Monetary policy continued to be accommodative during 2014—facilitating a pick-up*

### 34.      The medium-term fiscal outlook clearly signals the need for a revamping of tax policy.

### _cr15335 - 34.      The medium-term fiscal outlook clearly signals the need for a revamping of tax policy.

### Fiscal outlook and tax policy reform
- The medium-term fiscal outlook signals the need for a revamping of tax policy; reform is described as long overdue and absence of reforms entails significant risk.
- Timing and preparatory work:
  - Staff is cognizant of constraints imposed by the current political timeline, but emphasizes the need to proceed quickly with the technical work on reform options in the interim.
  - Objective: formulate a set of measures that could be implemented in concert with the 2016 budget (normally presented to parliament in November).
- Fundamental elements of a reform package recommended by staff:
  - A comprehensive reduction in exemptions and tax holidays.
  - A streamlining of the tax structure.
  - Continued efforts to boost tax administration and collection capacity.
- Macrofiscal anchor:
  - A clear and credible medium-term macro-fiscal framework that supports consolidation and debt reduction is essential.

### Monetary policy and financial conditions
- Current assessment:
  - Monetary policy is broadly appropriate but faces a diverse set of risks.
  - Inflation: contained at a comfortably low level; external push factors appear modest.
  - Private credit has begun to recover; there is a relatively high level of excess liquidity remaining in the banking system and a sharp drop in financial intermediation (private credit/GDP) over the past two years.
- Risks and guidance:
  - With the credit cycle appearing to be turning a corner, and given long lags in monetary transmission and the prospect of higher domestic demand, the CBSL should be prepared to tighten monetary policy should signs of overheating emerge.
- Recent policy action (supplementary information):
  - Headline year-on-year inflation declined to 0.1 percent in March 2015, from 0.6 percent in February 2015.
  - Core inflation increased from 0.8 percent to 1.4 percent over the same period.
  - The CBSL Monetary Board reduced policy interest rates by 50 basis points, effective April 15 (Standing Deposit Facility Rate (SDFR) and Standing Lending Facility Rate (SLFR) reduced to 6 percent).

### Balance of payments, reserves, and exchange rate policy
- External developments:
  - The overall balance of payments is expected to strengthen.
  - A sizeable windfall from lower oil prices is estimated at $2 billion or about 2 percent of GDP in 2015, likely easing goods-side balance of payments pressure.
- Exchange rate assessment and recommendations:
  - Econometric evidence does not suggest the exchange rate is fundamentally misaligned.
  - The steady and one-sided nature of central bank intervention, combined with a not insignificant degree of real effective appreciation (resulting from low inflation and exchange rate movements among major currencies), suggest the need for exchange rate flexibility.
  - Given Sri Lanka’s limited reserve cushion, the central bank should refrain from sustained intervention to support the rupee in the face of strong market pressures.
- Reserve considerations:
  - The staff urges shifting focus to exchange rate flexibility as a means of preserving a limited reserve cushion.

### Engagement and program monitoring
- The staff recommends extending the post-program monitoring framework for one year given heightened external vulnerabilities and the need to maintain close engagement while work on a medium-term set of macroeconomic policies and structural reforms is underway.

### Selected key numeric points (as presented in the text)
- Windfall from lower oil prices: $2 billion or about 2 percent of GDP in 2015.
- 2016 budget: normally presented to parliament in November.
- Headline year-on-year inflation: 0.1 percent in March 2015 (0.6 percent in February 2015).
- Core inflation: increased from 0.8 percent to 1.4 percent (March 2015).
- CBSL policy rate change: reduced by 50 basis points, effective April 15; SDFR and SLFR reduced to 6 percent.
- Staff recommendation: extend post-program monitoring framework for one year.

*Source: IMF staff report excerpt (_cr15335 - 34. The medium-term fiscal outlook clearly signals the need for a revamping of tax policy).*

### 7.5 per cent, respectively.

### _cr15335 - 7.5 per cent, respectively.

### Context and institutional stance
- Document dates: April 23, 2015; Statement by Rakesh Mohan, Executive Director for Sri Lanka and Mr. Ranasinghe — April 29, 2015.
- New Government formed after January 2015 presidential election; emphasis on a 100-day program with constitutional, institutional and social welfare reforms aimed at strengthening good governance, transparency, promoting equity and reducing poverty.
- Parliamentary elections expected around mid 2015; authorities view medium-term policy framework as likely to be solidified only after those elections.
- Authorities ready to continue close engagement with the IMF through Post-Program Monitoring (PPM) despite not being technically required.

### Economic Growth and outlook
- 2014 GDP growth: 7.4 percent (2013: 7.2 percent).
- Sector contributions and performance in 2014:
  - Industry sector growth: 11.4 percent; contributed nearly 48 per cent to GDP growth.
  - Services sector growth: 6.5 percent (noted contributions from trade, tourism, transport, communications, banking and real estate).
  - Agriculture sector: grew only marginally due to adverse weather in 2014.
- Authorities’ projection for 2015 growth: 7 percent.
- Factors affecting 2015 growth:
  - Supportive: low interest rates, low inflation, improved business conditions, continuation of global recovery, expected growth-supportive policy framework after Parliamentary elections.
  - Constraints: expected Parliamentary elections, postponement/review of certain development projects.

### Fiscal policy
- 2014 fiscal performance:
  - Revenue declined to 12.2 percent of GDP (targeted: 14.5 percent of GDP).
  - Budget deficit increased to 6.0 percent of GDP (targeted: 5.2 percent of GDP).
- 2015 budget targets:
  - Original 2015 budget (passed November 2014) targeted a budget deficit of 4.6 per cent of GDP.
  - Interim Budget (January 2015) targeted a budget deficit of 4.4 percent of GDP and included measures to increase direct tax revenue (some one-off), reduce import-related taxes on food items, increase government employee salaries, and upwardly adjust transfers to low income groups.
- Revenue mobilization challenges and reforms:
  - Recent measures to broaden tax base, improve tax administration and rationalize exemptions have not yet produced expected outcomes.
  - IMF TA Mission on Tax Policy proposed reform strategies, particularly in income taxation, to be considered for forthcoming budget.
  - Administrative measures underway: enhance tax compliance, improve tax audit and risk management, completion of Phase I of RAMIS toward end of 2015 to automate revenue authority activities.
  - Customs and Excise measures: curtail undervaluation, strengthen post-clearance audit, streamline licensing procedures.
- Authorities committed to strengthen fiscal consolidation and to introduce firm measures after Parliamentary election.

### Monetary policy
- Inflation developments:
  - Year-on-year inflation: 4.7 percent at end-2013; declined to 2.1 percent at end-2014.
  - Inflation further declined to 0.1 percent in March 2015.
  - Decline driven by reduced energy prices and reduced import duties on food items under the 100-day program.
- Policy actions and credit:
  - Central Bank reduced Standing Lending Facility Rate (SLF) by 50 basis points in January 2014.
  - Temporary restriction on Standing Deposit Facility (SDF) in September 2014, removed in March 2015.
  - Private sector credit growth: 8.8 percent by end-2014; 12.6 percent y-o-y by February 2015.
  - Central Bank reduced policy interest rates by 50 basis points effective 15th April 2015.
- Authorities maintain a relaxed monetary policy stance to support private sector credit amid well-anchored inflation and inflation expectations.

### External sector
- 2014 external aggregates:
  - Current account deficit: 2.7 percent of GDP (2013: 3.8 percent of GDP).
  - Export earnings growth: 7.1 percent (industrial exports, mainly textiles and garments).
  - Imports growth: 7.9 percent; petroleum import expenditure increased by 6.7 percent in 2014 due to higher import volume for thermal power generation.
  - Trade deficit: expanded by 8.9 percent to US $ 8,287 million in 2014; trade deficit as percent of GDP declined to 11.1 percent from 11.3 percent in 2013.
  - FDI inflows including borrowings: US$ 1,685 million in 2014.
  - FDI excluding borrowings: US$ 944 million in 2014 (2013: US$ 933 million).
  - Major financial inflows: sovereign bond issuance US$ 1.5 billion; international bond issuances by SriLankan Airlines and National Savings Bank and some commercial banks.
  - Net outflow from foreign investments in government securities: US$ 133 million in 2014.
- Balance of payments and reserves:
  - BOP surplus: US$ 1,369 million in 2014.
  - Gross official reserves: US$ 8.2 billion at end-2014 (end-2013: US$ 7.5 billion); sufficient to cover 4.3 months of imports of goods and services.
  - Gross official reserves declined to US$ 6.7 billion at end-March 2015 after meeting short-term debt obligations, including repayment of matured Sovereign Bond of US$ 500 million in January 2015.
  - Risk mitigation measures: issuance of SLDBs up to US$ 800 million; Central Bank entered currency swap agreement with RBI for US$ 400 million; Government of India approved enhancing swap by additional US$ 1,100 million.
  - Gross official reserves estimated to have increased to US$ 7.0 billion by mid-April 2015 excluding swap arrangements.
- Authorities’ view and outlook:
  - Authorities share staff’s view that there is no fundamental misalignment of the exchange rate; committed to exchange rate flexibility and intervening only to avoid excessive volatility.
  - External outlook for 2015 seen as favorable due to full benefit of sharp drop in oil prices, increased hydropower generation, easing of policy uncertainty after Parliamentary elections, and measures to address emerging risks.

### Financial sector
- Key indicators and developments:
  - Total CAR (provisional): declined to 16.7 percent from 17.6 percent in 2014; regulatory requirement is 10 percent.
  - Banking sector NPL: improved to 4.2 percent from 5.6 percent in the previous year (improvement mainly from recovery of pawning related NPLs).
  - Total provision coverage: increased to 50.7 percent.
  - Strengthening measures: regulatory and supervisory framework aligned with international standards; 2014 Central Bank issuances included guidelines on risk-mitigated assets for operational risk under Basel-II standardized approach, baseline security standard for information security management, and stress testing.
- Assessment: financial sector described as strong and resilient with healthy CAR, high profitability and liquidity.

### Conclusion and policy priorities
- Overall assessment:
  - Growth momentum continuing; inflation and inflation expectations well anchored.
  - Authorities committed to fiscal consolidation, though 2014 fiscal slippages occurred due to weak revenue performance.
  - Current monetary policy stance remains appropriate.
  - External sector pressures increased recently due to widened trade deficit, slowdown in capital inflows and increased debt repayments; authorities have undertaken prudent mitigation measures.
  - Financial sector remains sound and resilient.
- Near-term policy priorities indicated by authorities:
  - After Parliamentary elections, introduce firm measures to enhance revenue mobilization and rationalize expenditure.
  - Continue tax policy and administration reforms (including IMF TA recommendations) and complete RAMIS Phase I toward end-2015.
  - Maintain exchange rate flexibility and intervene only to limit excessive volatility.
  - Continue macro-fiscal framework development once political stability is secured post-elections.

*Statement by Rakesh Mohan, Executive Director for Sri Lanka and Mr. Ranasinghe — April 29, 2015*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2015/_cr15335.pdf_