## _cr16150 ## Source details **Canonical URL:** [_cr16150](https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2016/_cr16150.pdf) ## Other formats - [Markdown version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2016/_cr16150.pdf.md) - [Structured JSON version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2016/_cr16150.pdf.json) --- ### Program summary and objectives - Proposed three-year IMF-supported program (Extended Arrangement) requested by the authorities with proposed access equivalent to SDR 1,070.78 million (185 percent of quota). - Sri Lanka IMF quota: SDR 578.8 million. - Program aims to: - provide a policy anchor for macroeconomic stability and structural reforms; - strengthen external resiliency in a challenging global environment; - transition toward inflation targeting with a flexible exchange rate regime; - promote sustainable and inclusive economic growth. - Key fiscal and external objectives: - (a) implement a structural increase in revenues to reduce the fiscal deficit; - (b) reverse the decline in central bank foreign exchange reserves; - (c) reduce public debt relative to GDP and lower Sri Lanka’s risk of debt distress; - (d) enhance public financial management and improve the operations of state owned enterprises. ### Program pillars (reforms to achieve objectives) - Pillar (i): fiscal consolidation. - Pillar (ii): revenue mobilization. - Pillar (iii): public financial management reform. - Pillar (iv): state enterprise reform. - Pillar (v): transition to flexible inflation targeting under a flexible exchange rate regime. - Pillar (vi): reforms in the trade and investment regime. ### Macroeconomic performance and outlook (highlights and projections) - Real GDP growth: - 2014: 4.9 - 2015: 4.8 - 2016: 5.0 (Proj.) - Medium-term: growth projected to increase to 5½ percent by 2020. - Inflation (average): - 2014: 3.3 - 2015: 0.9 - 2016: 4.1 (Proj.) - Inflation (end-of-period): - 2014: 2.1 - 2015: 2.8 - 2016: 5.4 (Proj.) - Core inflation (end-of-period): - 2014: 3.2 - 2015: 4.5 - 2016: 4.5 (Proj.) - Private credit and monetary indicators: - Private credit growth in 2015: 25 percent. - Reserve money (percent change, end of period): 2014: 18.3; 2015: 16.5; 2016: 18.4 (Proj.). - Broad money (percent change, end of period): 2014: 13.4; 2015: 17.8; 2016: 10.8 (Proj.). - Selected national accounts (nominal GDP, billions of rupees): - 2014: 10,448 - 2015: 11,183 - 2016: 12,147 (Proj.) - 2017: 13,374 (Proj.) - 2018: 14,787 (Proj.) - 2019: 16,333 (Proj.) - 2020: 18,076 (Proj.) ### Fiscal outcomes, targets, and public debt - Central government overall balance (percent of GDP): - 2014: -6.2 percent of GDP - 2015: -6.9 percent of GDP - 2016: -5.4 percent of GDP (Proj.) - 2020 target: -3.5 percent of GDP - Primary balance (percent of GDP): - 2014: -2.1 percent of GDP - 2015: -2.2 percent of GDP - 2016: -0.8 percent of GDP (Proj.) - Medium-term target: a primary surplus of 1 percent of GDP (2020) - Revenue and expenditure (percent of GDP): - Revenue and grants: 2014: 11.5; 2015: 13.1; 2016: 13.0 (Proj.); 2019: 15.5; 2020: 15.8 (Proj.) - Expenditure: 2014: 17.8; 2015: 19.9; 2016: 18.4 (Proj.) - Central government net domestic financing (percent of GDP): 2014: 3.8; 2015: 4.3; 2016: 2.3 (Proj.) - Central government debt (percent of GDP): - 2014: 70.7 percent of GDP - 2015: 76.0 percent of GDP - 2016: 77.2 percent of GDP (Proj.) - 2017: 75.5 percent of GDP (Proj.) - 2020: 68.2 percent of GDP (Proj.) - Box 1—Public debt composition (end-2015, Rs. billion and percent of GDP): - Central government debt: 8,503 ; 76.0 percent of GDP - Domestic: 4,959 ; 44.3 percent of GDP - Treasury Bills: 658 ; 5.9 percent of GDP - Treasury Bonds: 3,305 ; 29.6 percent of GDP - Other: 996 ; 8.9 percent of GDP - External: 3,544 ; 31.7 percent of GDP - Multilateral and bilateral: 2,237 ; 20.0 percent of GDP - International sovereign bonds: 958 ; 8.6 percent of GDP - Nonresident holdings of T-Bills and T-Bonds: 304 ; 2.7 percent of GDP - Other: 450 ; 0.4 percent of GDP - Financial obligations of SOEs (IMF staff estimates): 1,280 ; 11.4 percent of GDP - Ceylon Electricity Board: 237 ; 2.1 percent of GDP - Ceylon Petroleum Corporation: 424 ; 3.8 percent of GDP - Sri Lanka Ports Authority: 240 ; 2.2 percent of GDP - Sri Lankan Airlines: 309 ; 2.8 percent of GDP - Other: 690 ; 0.6 percent of GDP - Publicly guaranteed debt: 382 ; 3.4 percent of GDP - Government guarantees capped at 7 percent of GDP under the Fiscal Management Responsibility Act. ### Balance of payments, reserves, and external sector - Current account balance (in millions of U.S. dollars): - 2014: -1,989 - 2015: -2,009 - 2016: -1,202 (Proj.) - 2017: -2,419 (Proj.) - 2018: -2,916 (Proj.) - 2019: -3,343 (Proj.) - 2020: -3,812 (Proj.) - Current account balance (percent of GDP): 2014: -2.5; 2015: -2.5; 2016: -1.5 (Proj.) - Exports and imports (in millions of U.S. dollars): - Exports: 2014: 11,130; 2015: 10,505; 2016: 10,456 (Proj.); 2020: 14,093 (Proj.) - Imports: 2014: -19,417; 2015: -18,935; 2016: -18,392 (Proj.); 2020: -26,608 (Proj.) - Gross official reserves (end of period, millions of U.S. dollars): - 2014: 8,208; 2015: 7,304; 2016: 7,853 (Proj.); 2017: 9,372 (Proj.); 2018: 11,866 (Proj.); 2019: 13,033 (Proj.); 2020: 13,843 (Proj.) - In months of imports: 2014: 4.3; 2015: 3.8; 2016: 3.7 (Proj.); 2017: 4.1 (Proj.); 2018: 4.8 (Proj.); 2019: 4.9 (Proj.); 2020: 5.0 (Proj.) - External debt (public and private): - In billions of U.S. dollars: 2014: 43.0; 2015: 44.8; 2016: 45.9 (Proj.); 2020: 62.4 (Proj.) - As a percent of GDP: 2014: 53.8; 2015: 55.1; 2016: 55.8 (Proj.); 2020: 56.5 (Proj.) - Recent reserve and swap developments: - Gross reserves declined from 87 percent of the ARA reserve metric in 2014 to 76 percent in 2015. - September 2015: swap arrangement with the Reserve Bank of India (RBI) for US$1.1 billion (repaid in full in early March 2016). - Late-March 2016: fresh RBI swap line of $700 million fully drawn by the CBSL at end-March 2016. ### Capital flows, investor sentiment, and sovereign spreads - Capital and financial account weakened due to foreign exit from government securities, lower FDI inflows, and slow implementation of externally financed projects. - Equity prices: Colombo All Shares Price Index (ASPI) dropped by about 6 percent in 2015. - Sovereign spreads: - EMBI peak: 490 bps on February 11, subsequently about 380 bps—compared with 220 bps for emerging Asian economies. - Sri Lanka’s spread vis-a-vis the EMBI about 600 bps in an alternative note—compared with 440 bps for emerging markets in general, and 270 bps for emerging Asian economies (reported in different sections). - Staff estimate of a severe combined shock: - A “worst case” combined shock to the current account and the capital account could widen the financing gap by as much as $1.8 billion over 2016-17 (assuming no policy adjustment). ### Exchange rate dynamics, central bank intervention, and reserves - Downward pressure on the rupee largely reflected capital flow developments. - CBSL interventions and rupee path in 2015–early 2016: - CBSL provided about $1.9 billion to the foreign exchange market during the first eight months of 2015; the rupee depreciated by about 2 percent in that period. - Following August elections, rupee depreciated by some 4 ½ percent in that month despite net intervention of an additional $517 million. - Intervention resumed with central bank net sales of another $856 million in the remaining months of 2015; the rupee depreciated slowly by another 2 percent thereafter. - In February, net CBSL intervention fell to $190 million compared to a peak of $460 million per month in July−September 2015. - Amid stronger market pressures in March 2016, CBSL provided another $437 million to the foreign exchange market. - Spot and forward market behavior in March 2016: - Daily average transaction volume in the spot market declined from US$20 million to US$11 million between January and March. - Total transaction volume in the forward market increased from $58 million to $72 million over the same period. - High short-term volatility in the 3-month forward price: jumped from Rs 146.5 per US dollar to 151.4 during March 28−30, before settling again close to Rs 145 per dollar. - Reserve adequacy concerns: - At the beginning of 2016, gross international reserves were short of gross foreign-currency claims coming due in the year. - Gross international reserves decreased by almost $1 billion in 2015—a drop of 11 percentage points of the ARA metric to 76 percent (3.8 months of prospective imports). - Reserves fell further to 65 percent of the metric by March 2016—barely 3 months of import cover. - Net international reserves were 43.4 percent of the ARA metric at end-March 2016. ### Financial sector soundness and banking sector indicators - Financial soundness indicators for 2015 were generally favorable: - Profitability increased on the back of an increase in net interest income. - Capital adequacy remained comfortably above regulatory limits. - Interest rate developments: - Commercial banks raised prime lending rates by about 150 bps since December 2015 while increasing deposit rates by only 25 bps. - Credit composition and NPLs: - Vehicle financing accounted for much of banks’ loan growth in 2015 followed by other consumer related financing such as housing. - NPLs to gross loans declined to 3.2 percent in the fourth quarter from 4 percent in the third quarter. ### SOEs: status, vulnerabilities, and reform agenda - Number and scale: - Sri Lanka had some 235 public enterprises representing 17 percent of the nation’s economic activity in 2010. - Collective impact: - Some SOEs are profitable, but collectively they "represent a drag on the private economy and a drain on public finances (both directly, and through the state banks, which fund the largest SOEs)." - Key SOE-specific issues and obligations: - Outstanding SOE obligations identified: Rs 1.2 trillion for 4 SOEs (CPC, CEB, Sri Lankan Airlines, Sri Lanka Port Authority). - Financial obligations of SOEs (IMF staff estimates): 1,280 ; 11.4 percent of GDP (end-2015). - Reform measures and benchmarks: - Resolution strategy for Sri Lankan Airlines to be completed by September 2016, effectively removing this company from the government’s accounts. - Six major SOEs to establish Statements of Corporate Intent (SCI) specifying multiyear plans and costs of non-commercial obligations (target: December 2016). - Introduce formula-based automatic pricing mechanism for petroleum products and enhance PUC authority to set cost-reflective electricity tariffs. - Include fiscal cost of non-commercial obligations for SOEs in the central government budget. ### Tax system, VAT, NBT, and revenue mobilization - Tax-to-GDP and composition: - Ratio of tax revenue to GDP fell from nearly 13 percent of GDP in 2006 to 10.1 percent in 2014, rebounding to 12.1 percent in 2015 (largely on the basis of one-off tax measures and a short-term surge in import taxes). - Share of VAT fell by more than half while share of excises, trade taxes, and other miscellaneous taxes increased from about 40 percent of total revenue in 2006 to 60 percent in 2015. - VAT and NBT (performance and features): - VAT: single rate (raised from 11 percent in 2015 to 15 percent in 2016), credit offset system, zero-rating for exports; VAT raised only 2 percent of GDP in 2015. - NBT: turnover tax at single rate (2 percent), imposed through all production stages and on provision of services; NBT raised 0.4 percent of GDP in 2015. - Staff recommendations: - Favor VAT over NBT to limit cascading, preserve export competitiveness, and mobilize revenue. - Phase out S-VAT, introduce risk-based refund audit, simplify VAT by minimizing exemptions and setting an appropriate registration threshold. - Publish a statement of tax expenditures and rationalize tax expenditures (e.g., limit corporate tax incentives). - Introduce a new Inland Revenue Act and follow with VAT and customs reform. ### Monetary and exchange rate policy recommendations - Recent monetary actions and framework development: - Statutory reserve ratio increased from 6 percent to 7.5 percent in January 2016. - Standing deposit facility rate and lending facility rate increased by 50 basis points to 6.5 and 8 percent, respectively, in February 2016. - Authorities committed to shift toward a flexible inflation targeting framework. - Staff recommendations: - Further tightening may be needed if inflationary pressures continue or private credit growth does not moderate. - CBSL should phase out one-sided intervention, accumulate foreign exchange reserves, sterilize intervention when buying reserves to avoid undermining monetary tightening, and develop a roadmap to operationalize flexible inflation targeting within three years. - Enhance money markets, adopt standard repo documentation, remove restrictions on short-selling, broaden investor base, and roll back restrictions on banks’ net open and forward positions in foreign exchange. - Box 4 — transition to floating regime findings: - CBSL intervened heavily, supplying substantial dollar liquidity ($3.7 billion from January 1, 2015 to February 15, 2016), reducing reserves and increasing vulnerability. - Four ingredients for successful transition: (i) deep and liquid market; (ii) adequate systems to manage exchange rate risks; (iii) coherent intervention policy; (iv) appropriate nominal anchor. - Recommended a coherent and transparent intervention rule (mid-point, volatility bands, daily limits, intervention frontier). ### Fiscal consolidation path and revenue measures (program targets) - Fiscal consolidation targets: - Return to overall deficit of 3.5 percent in 2020. - Deficit reduction path: 5.4 percent of GDP in 2016 → 4.0 percent of GDP in 2018. - Primary balance improvement by 0.7–0.8 percentage point each year in 2017–18. - Base-broadening measures to generate additional revenues of about 1.2 percent of GDP annually in 2017−18. - Reduce public debt ratio from 76 percent in 2015 to 68 percent in 2020. - Central government operations (percent of GDP, select series): - Revenue and grants: 2015 13.1; 2016 13.0; 2017 14.0; 2018 15.3; 2019 15.5; 2020 15.8 - Tax revenue: 2015 12.1; 2016 11.8; 2017 12.9; 2018 14.1; 2019 14.3; 2020 14.6 - Expenditure: 2015 19.9; 2016 18.4; 2017 18.8; 2018 19.3; 2019 19.2; 2020 19.3 - Overall balance: 2015 -6.9; 2016 -5.4; 2017 -4.7; 2018 -4.0; 2019 -3.7; 2020 -3.5 - Primary balance: 2015 -2.2; 2016 -0.8; 2017 0.0; 2018 0.7; 2019 0.8; 2020 1.0 - Gross financing needs: 2015 20.7; 2016 19.2; 2017 17.8; 2018 16.4; 2019 14.7; 2020 12.2 ### Program modalities, financing, and monitoring - Proposed access and financing: - Proposed access: 185 percent of quota (SDR 1,070.780 million). - Financing gap of US$1.5 billion would arise to keep gross reserves at an adequate and increasing level as measured by the Fund’s composite metric. - Program envisages steady increase in NIR to a level commensurate with 75 percent of the ARA metric over the medium term. - Donor support: - Firm commitments from donors to fill the entire financing gap for the first 12 months. - Financial support expected to reach $650 million during 2016−18. - Monitoring and reviews: - Semi-annual program reviews with quantitative performance criteria and structural benchmarks; quarterly indicative targets and staff visits between reviews. - Test dates for first and second review: end-June and end-December 2016. - TMU quantitative performance criteria include floors on central government primary balance and net official international reserves, continuous zero ceiling on new external arrears, indicative targets on central government tax revenue and reserve money, and a monetary policy consultation clause on inflation. ### Key risks, stress scenarios, and vulnerability findings - Main risks: - (i) Revenue slippage or failure to implement revenue reforms. - (ii) Weaker than expected capital inflows widening the financing gap given gross financing needs close to 19 percent of GDP in 2016. - (iii) Lower than expected growth and/or new trade pressures. - (iv) Larger than expected SOE losses and inability to commercialize SOEs. - Stress test and scenario results: - A 30 percent real depreciation (one-time in 2017) would raise external debt to GDP ratio to about 82 percent. - Under a contingent liability shock scenario (central government liable for additional debt of 10 percent of GDP in 2017), public debt and gross funding needs would reach 80 percent of GDP and 15 percent of GDP in 2020, respectively. - Continuation of 2016 stance (primary deficit of 0.8 percent of GDP) would reduce the debt to GDP ratio by only 3½ percentage points over 2015–20, leaving public debt highly vulnerable. ### Structural reforms, trade, and competitiveness - Staff recommendations to boost external trade and private sector development: - Reduce protectionism; review trade regime including para-tariffs and other non-tariff barriers. - Increase efficiency of trade facilitation, including full implementation of electronic customs documentation (ASYCUDA). - Remove barriers to foreign investment entry and establishment; enhance access to finance; strengthen financial market infrastructure. - Pursue VAT and customs reform, streamline trade taxes, and phase out para-tariffs. - Negotiating World Bank Development Policy Credit and other donor-supported programs to enhance competitiveness. ### Implementation priorities and structural benchmarks (selected) - Prior actions proposed/ahead of Executive Board meeting: - Cabinet to issue Memorandum requiring MOF to complete by end-October 2016 a time-bound strategy to address outstanding arrears of central government obligations of SOEs, including: - completion (by end-2016) of a comprehensive database of SOE financial obligations certified by the Auditor General; - clarification of government responsibility over existing obligations related to subsidies and other non-commercial obligations of SOEs. - Ministry of Finance to issue circulars to implement tax policy and revenue measures and detail revised expenditure ceilings consistent with 2016 budget target. - Cabinet resolution adopting framework note for new Inland Revenue Act. - Suspend BOI capacity to grant tax exemptions until BOI Act amended. - Structural benchmarks include: - Publish tax expenditure statement: December 2016. - Submit new Inland Revenue Act to Parliament: March 2017. - Commitment control system and ITMIS roll-out milestones: mid-2016 to end-2017. - SOE SCIs for six major SOEs: December 2016. - Resolution strategy for Sri Lankan Airlines: September 2016. ### Staff appraisal and conclusion - Staff supports the authorities’ request for an Extended Arrangement of SDR 1,070.78 million given Sri Lanka’s balance of payments needs, policy actions taken, and commitment to implement an ambitious reform package. - Assessment notes: - Economic growth showing strain from policy-induced macroeconomic imbalances and difficult external environment. - Sizeable, front-loaded fiscal adjustment is needed to secure debt sustainability, with revenue mobilization central to preserving fiscal space for social and infrastructure spending. - Urgent need to expedite PFM and SOE reforms to avoid recurring arrears and mitigate fiscal risks. - Monetary policy should remain vigilant; a durable shift to flexible inflation targeting would bolster policy effectiveness and exchange rate flexibility. - To reach NIR objectives, CBSL should disembark from active intervention policies used over prior 20 months and deepen the forex market supported by credible macroeconomic policies. *Source: IMF staff report (Staff Report for the 2016 Article IV Consultation and Request for a Three Year Extended Arrangement under the Extended Fund Facility), May 19, 2016.* ### 2015. The rupee continues to face downward pressure—largely reflecting capital flow ### _cr16150 - 2015. The rupee continues to face downward pressure—largely reflecting capital flow developments. ### Program summary and objectives - Proposed new IMF-supported program aims to: - provide a policy anchor for macroeconomic stability and structural reforms; - strengthen external resiliency in a challenging global environment; - transition toward inflation targeting with a flexible exchange rate regime; - promote sustainable and inclusive economic growth. - Key objectives related to fiscal policy and the balance of payments: - (a) implement a structural increase in revenues, facilitating a reduction in the fiscal deficit; - (b) reverse the decline in central bank foreign exchange reserves; - (c) reduce public debt relative to GDP and lower Sri Lanka’s risk of debt distress; - (d) enhance public financial management and improve the operations of state owned enterprises. - Program financing request and modality: - Authorities requested a three-year arrangement with proposed access equivalent to SDR 1,070.78 million (185 percent of quota). - Sri Lanka IMF quota: SDR 578.8 million. ### Program pillars (reforms to achieve objectives) - Pillar (i): fiscal consolidation. - Pillar (ii): revenue mobilization. - Pillar (iii): public financial management reform. - Pillar (iv): state enterprise reform. - Pillar (v): transition to flexible inflation targeting under a flexible exchange rate regime. - Pillar (vi): reforms in the trade and investment regime. ### Macroeconomic performance and near-term outlook (highlights for 2014–16) - Real GDP growth: - 2014: 4.9 - 2015: 4.8 - 2016: 5.0 (Proj.) - Inflation (average): - 2014: 3.3 - 2015: 0.9 - 2016: 4.1 (Proj.) - Inflation (end-of-period): - 2014: 2.1 - 2015: 2.8 - 2016: 5.4 (Proj.) - Core inflation (end-of-period): - 2014: 3.2 - 2015: 4.5 - 2016: 4.5 (Proj.) - Private credit growth and monetary indicators: - Private credit growth in 2015: 25 percent. - Reserve money (percent change, end of period): 2014: 18.3; 2015: 16.5; 2016: 18.4 (Proj.). - Broad money (percent change, end of period): 2014: 13.4; 2015: 17.8; 2016: 10.8 (Proj.). ### Fiscal outcomes and public debt - Central government balance: - 2014: -6.2 percent of GDP - 2015: -6.9 percent of GDP - 2016: -5.4 percent of GDP (Proj.) - 2020 target: -3.5 percent of GDP (implied target for 2020 deficit) - Primary balance: - 2014: -2.1 percent of GDP - 2015: -2.2 percent of GDP - 2016: -0.8 percent of GDP (Proj.) - Medium-term target: a primary surplus of 1 percent of GDP (2020). - Revenue and expenditure (in percent of GDP): - Revenue and grants: 2014: 11.5; 2015: 13.1; 2016: 13.0 (Proj.); 2019: 15.5; 2020: 15.8 (Proj.) - Expenditure: 2014: 17.8; 2015: 19.9; 2016: 18.4 (Proj.) - Central government net domestic financing (percent of GDP): 2014: 3.8; 2015: 4.3; 2016: 2.3 (Proj.) - Central government debt: - 2014: 70.7 percent of GDP - 2015: 76.0 percent of GDP - 2016: 77.2 percent of GDP (Proj.) - 2017: 75.5 percent of GDP (Proj.) - 2020: 68.2 percent of GDP (Proj.) - Box 1 summary—Public Debt composition (end-2015, Rs. billion and percent of GDP): - Central government debt: 8,503 ; 76.0 percent of GDP - Domestic: 4,959 ; 44.3 percent of GDP - Treasury Bills: 658 ; 5.9 percent of GDP - Treasury Bonds: 3,305 ; 29.6 percent of GDP - Other: 996 ; 8.9 percent of GDP - External: 3,544 ; 31.7 percent of GDP - Multilateral and bilateral: 2,237 ; 20.0 percent of GDP - International sovereign bonds: 958 ; 8.6 percent of GDP - Nonresident holdings of T-Bills and T-Bonds: 304 ; 2.7 percent of GDP - Other: 450 ; 0.4 percent of GDP - Financial obligations of SOEs (IMF staff estimates): 1,280 ; 11.4 percent of GDP - Ceylon Electricity Board: 237 ; 2.1 percent of GDP - Ceylon Petroleum Corporation: 424 ; 3.8 percent of GDP - Sri Lanka Ports Authority: 240 ; 2.2 percent of GDP - Sri Lankan Airlines: 309 ; 2.8 percent of GDP - Other: 690 ; 0.6 percent of GDP - Publicly guaranteed debt: 382 ; 3.4 percent of GDP - Government guarantees capped at 7 percent of GDP under the Fiscal Management Responsibility Act. ### Balance of payments and external sector - Current account balance (in millions of U.S. dollars): - 2014: -1,989 - 2015: -2,009 - 2016: -1,202 (Proj.) - 2017: -2,419 (Proj.) - 2018: -2,916 (Proj.) - 2019: -3,343 (Proj.) - 2020: -3,812 (Proj.) - Current account balance (percent of GDP): 2014: -2.5; 2015: -2.5; 2016: -1.5 (Proj.) - Exports and imports (in millions of U.S. dollars): - Exports: 2014: 11,130; 2015: 10,505; 2016: 10,456 (Proj.); 2020: 14,093 (Proj.) - Imports: 2014: -19,417; 2015: -18,935; 2016: -18,392 (Proj.); 2020: -26,608 (Proj.) - Export and import value growth (percent): - Export value growth: 2014: 7.1; 2015: -5.6; 2016: -0.5 (Proj.); 2019: 7.0; 2020: 11.3 (Proj.) - Import value growth: 2014: 7.9; 2015: -2.5; 2016: -2.9 (Proj.) - Gross official reserves (end of period): - In millions of U.S. dollars: 2014: 8,208; 2015: 7,304; 2016: 7,853 (Proj.); 2017: 9,372 (Proj.); 2018: 11,866 (Proj.); 2019: 13,033 (Proj.); 2020: 13,843 (Proj.) - In months of imports: 2014: 4.3; 2015: 3.8; 2016: 3.7 (Proj.); 2017: 4.1 (Proj.); 2018: 4.8 (Proj.); 2019: 4.9 (Proj.); 2020: 5.0 (Proj.) - External debt (public and private): - In billions of U.S. dollars: 2014: 43.0; 2015: 44.8; 2016: 45.9 (Proj.); 2020: 62.4 (Proj.) - As a percent of GDP: 2014: 53.8; 2015: 55.1; 2016: 55.8 (Proj.); 2020: 56.5 (Proj.) - Recent reserve and swap developments: - Gross reserves declined from 87 percent of the ARA reserve metric in 2014 to 76 percent in 2015. - September 2015: swap arrangement with the Reserve Bank of India (RBI) for US$1.1 billion (repaid in full in early March 2016). - Late-March 2016: fresh RBI swap line of $700 million fully drawn by the CBSL at end-March 2016. ### Key macroeconomic findings and policy recommendations from staff discussions - Context and risks: - Sri Lanka has good underlying momentum but is showing signs of strain from unbalanced macroeconomic policies and a difficult external environment. - A significant political transition created a window to re-set policies and undertake structural reforms. - Program risks are substantial given complexity of reforms and need for strong political commitment. - Fiscal policy recommendations: - Put tax revenues on an upward path as part of growth-friendly fiscal consolidation and debt reduction. - Significant reduction in the 2016 deficit to 5.4 percent of GDP needs follow-up with further revenue-based consolidation toward the 2020 deficit target of 3.5 percent of GDP (primary surplus of 1 percent of GDP). - Support on tax policy and revenue administration essential to create a simple, efficient, and equitable tax system. - Implement automatic pricing mechanisms for fuel and electricity prices to prevent fiscal risk. - Monetary and exchange rate recommendations: - Recent tightening of monetary policy was necessary given rising core inflation and high private credit growth; further tightening may be needed. - Over the medium-term, the CBSL will shift to a flexible inflation targeting framework. - It is essential that the CBSL begin an exit from the present intervention framework, which has depleted reserves over the past 20 months. - Structural and external orientation: - Reform of state owned enterprises, trade policy, and the investment environment is envisioned. - Trade policy reform and elimination of para-tariffs is needed for a stronger outward orientation and to build resilience. - Reforms to support trade and investment aimed at strengthening external sustainability. ### Selected memorandum item - Nominal GDP (in billions of rupees): - 2014: 10,448 - 2015: 11,183 - 2016: 12,147 (Proj.) - 2017: 13,374 (Proj.) - 2018: 14,787 (Proj.) - 2019: 16,333 (Proj.) - 2020: 18,076 (Proj.) *Source: IMF staff report (Staff Report for the 2016 Article IV Consultation and Request for a Three Year Extended Arrangement under the Extended Fund Facility), May 19, 2016.* ### 4. Capital flows have also been a key driving force behind the deterioration in the ### _cr16150 - 4. Capital flows have also been a key driving force behind the deterioration in the ### Capital flows, investor sentiment, and sovereign spreads - Capital and financial account position weakened due to foreign exit from government securities, lower FDI inflows, and slow implementation of externally financed public and private projects. - Investor sentiment worsened reflecting global market volatility and concern over domestic policies. - Equity prices on the Colombo All Shares Price Index (ASPI) dropped by about 6 percent in 2015. - Sri Lanka’s spreads over the 5-year US Treasury: - Sri Lanka’s spread vis-a-vis the EMBI peaked at 490 bps on February 11, but has since dropped to about 380 bps—compared with 220 bps for emerging Asian economies. - Spillovers from external shocks were magnified by domestic imbalances, including higher volatility around the two elections (January and August 2015) and the official budget passed in November 2015. - Staff estimate of a severe combined shock: - A “worst case” combined shock to the current account and the capital account could widen the financing gap by as much as $1.8 billion over 2016-17 (assuming no policy adjustment). ### Exchange rate dynamics, central bank intervention, and reserves - Downward pressure on the rupee largely reflected capital flow developments. - CBSL interventions and rupee path in 2015–early 2016: - CBSL provided about $1.9 billion to the foreign exchange market during the first eight months of 2015; the rupee depreciated by only about 2 percent in that period. - Following August elections, rupee depreciated by some 4 ½ percent in that month despite net intervention of an additional $517 million. - Intervention resumed with central bank net sales of another $856 million in the remaining months of 2015; the rupee depreciated slowly by another 2 percent thereafter. - In February, net CBSL intervention fell to $190 million compared to a peak of $460 million per month in July−September 2015. - Amid stronger market pressures in March 2016, CBSL provided another $437 million to the foreign exchange market. - Reserves and gross foreign-currency claims: - At the beginning of 2016, gross international reserves were short of gross foreign-currency claims coming due in the year. - Spot and forward market behavior in March 2016: - Daily average transaction volume in the spot market declined from US$20 million to US$11 million between January and March. - Total transaction volume in the forward market increased from $58 million to $72 million over the same period. - High short-term volatility in the 3-month forward price: jumped from Rs 146.5 per US dollar to 151.4 during March 28−30, before settling again close to Rs 145 per dollar. ### Government bond market and market rigidities - Late March 2016 government bond market volatility: - CBSL initially announced issuance of Rs 40 billion in treasury bonds, but instead issued bonds of Rs 80 billion at a higher rate than that prevailing in the secondary market. ### Financial sector soundness and banking sector indicators - Financial soundness indicators for 2015 were generally favorable: - Profitability increased on the back of an increase in net interest income. - Capital adequacy remained comfortably above regulatory limits. - Interest rate developments: - Commercial banks raised their prime lending rates by about 150 bps since December 2015 while increasing deposit rates by only 25 bps. - Credit composition and NPLs: - Vehicle financing accounted for much of banks’ loan growth in 2015 followed by other consumer related financing such as housing. - The ratio of NPLs to gross loans declined to 3.2 percent in the fourth quarter from 4 percent in the third quarter because of growth in the overall portfolio of loans. ### Outlook and key macroeconomic projections - Short-term outlook challenging; medium-term prospects favorable if macro-financial imbalances are addressed. - Real GDP projections: - Real GDP is projected to rise from 4.8 percent in 2015 to 5 percent in 2016. - Growth is projected to increase to 5½ percent by 2020 (in line with estimated potential output). - Inflation projection: - Inflation is projected to stabilize at 5 percent. - Drivers of the projected uptick: - Resumption of investment projects stalled in 2015, continued strong growth in services, and a modest increase in foreign direct investment. - Risks highlighted: - Key risks stem from (i) government inaction on key policies; and (ii) a significant deterioration in the external environment. - Specific external risks include: additional capital outflows, reduction in export growth (textile/apparel markets — the U.S. and EU), further drop in inward remittances due to lower oil prices and negative impact on host countries in the Middle East, or a drop in services activity from slower global trade and tourism downturns. ### Fiscal stance, revenue performance, and debt vulnerabilities - Fiscal and revenue trends: - Ratio of tax revenue to GDP fell from nearly 13 percent of GDP in 2006 to 10.1 percent in 2014, rebounding to 12.1 percent in 2015 (largely on the basis of one-off tax measures and a short-term surge in import taxes). - Composition shift: share of VAT fell by more than half while share of excises, trade taxes, and other miscellaneous taxes increased from about 40 percent of total revenue in 2006 to 60 percent in 2015. - VAT and NBT (Box 2 highlights): - VAT features: single rate (raised from 11 percent in 2015 to 15 percent in 2016), credit offset system, zero-rating for exports; VAT raised only 2 percent of GDP in 2015. - NBT features: turnover tax at single rate (2 percent), imposed through all production stages and on provision of services; NBT raised 0.4 percent of GDP in 2015. - VAT is favored over NBT on limiting tax cascading, preserving export competitiveness, and mobilizing revenue; challenges include administering refunds and fraud risk. - Recommendations include phasing out S-VAT, introducing risk-based refund audit, simplifying VAT by minimizing exemptions and setting an appropriate registration threshold. - 2016 fiscal measures and targets: - Authorities revised down the 2016 budget deficit target to 5.4 percent of GDP (0.5 percentage points lower than the original budget target). - Tax measures to maintain 2015 revenue-to-GDP ratio included increasing the VAT rate to 15 percent (from 11 percent) and removing exemptions on telecommunication services starting from May 2016. - Authorities scaled back plans to exempt wholesale and retail sectors from VAT, to introduce multiple VAT rates, and to raise the NBT rate from 2 percent to 4 percent. - On expenditure, authorities plan to control spending by streamlining non-critical expenditure on goods and services and capital spending. - Public debt sustainability and shock scenarios: - Public debt DSA indicates a high level of risk to medium-term sustainability. - Debt burden benchmark of 70 percent of GDP and gross financing need benchmark of 15 percent of GDP are exceeded in all shock scenarios. - Under a contingent liability shock scenario (central government becomes liable for additional debt of 10 percent of GDP in 2017), public debt and gross funding needs would reach 80 percent of GDP and 15 percent of GDP in 2020, respectively. - Continuation of envisioned fiscal stance for 2016 (a primary deficit of 0.8 percent of GDP) would reduce the debt to GDP ratio only by 3½ percentage points over 2015–20, leaving public debt highly vulnerable to downside risks. ### Policy recommendations and reform priorities - Medium-term commitment to revenue mobilization and fiscal consolidation as outlined under the proposed Extended Arrangement, adhering to principles in Box 3. - Tax policy reform: - Create a simple, efficient, equitable tax regime focused on collecting revenue rather than distributing benefits and incentives. - Rationalize income tax expenditures and enact a new Inland Revenue Act; follow with VAT and customs reform. - Revenue administration and IT systems: - Build capacity in revenue administration with government ownership; establish performance benchmarks for efficient and effective tax administration and shift toward risk-based audit. - Full and expedited rollout of IT systems for tax and customs administration (RAMIS and ASYCUDA) with linkages between the two systems. - Expenditure management: - Rationalize ineffective public spending (e.g., replacing ill-targeted subsidies with cash transfers targeted for the poor). - Improve public expenditure management, particularly commitment control; implement commitment record and quarterly commitment ceilings using current IT system and expedite rollout of the new ITMIS system for fully automated commitment control. - State enterprise reform: - Restructure or resolve loss-making enterprises such as Sri Lankan Airlines. - Ensure other enterprises operate on a commercial footing, including market-based pricing of fuel, electricity, and other utilities. - Establish clear commercial relationships via annual statements of corporate intent (SCI) signed by the Ministry of Finance, the line ministry, and the SOE to clarify government obligations for non-commercial operations. *Source: IMF staff report excerpt (pages and figures as provided in the source content).* ### 15. The authorities agreed with the need for revenue-based fiscal consolidation and ### _cr16150 - 15. The authorities agreed with the need for revenue-based fiscal consolidation and ### Fiscal consolidation and public financial management - Starting from a significant reduction in the 2016 deficit to 5.4 percent of GDP, the authorities aim to steadily reduce the deficit further to 3.5 percent of GDP or less by 2020 (equivalent to a primary surplus of 1 percent of GDP to ensure continued debt reduction). - Fiscal consolidation needs to be revenue based in light of substantial needs for social and infrastructure spending. - Planned measures and reforms: - Introduction of the new Inland Revenue Act to help simplify the income tax system. - Reform the current regime of corporate income tax incentives toward a targeted, transparent, and rule-based system. - Improve tax administration through digitalization and newly developed IT systems. - Streamline untargeted subsidies and continue zero-based budgeting to prioritize high-quality government projects. - Strengthen capacity to identify and execute infrastructure projects efficiently; improve commitment control including by expediting roll-out of a new IT system. - Move swiftly on the issue of outstanding obligations of SOEs. ### Key tax performance observations and quantitative indicators - Estimated revenue foregone due to corporate profit exemptions was in the range of 1 1/3 percent of GDP in 2012–13, roughly equal to corporate tax collections. - Tax administration and collection indicators and comparative productivity charts are reported for: - Corporate Income Tax Productivity, 2014 (Corporate tax collection in percent of GDP/corporate tax rate). - Personal Income Tax Productivity, 2014 (Personal income tax in percent of GDP/personal income tax rate). - VAT/Sales Tax Productivity, 2014 (VAT/sales tax revenue in percent of GDP/tax rate). - Revenue Collection Efficiency (Percent of GDP) using Sri Lanka's tax rate and average sample efficiency of collection. ### Box 3 — Tax Reform Strategy in Sri Lanka (findings and recommendations) - Overarching goal: simple, efficient, and equitable system tailored to Sri Lanka; large potential revenue gains from base-broadening and tax administration reforms. - Direct taxes: - Adopt a simple and broad-based corporate income tax regime to preserve revenue while facilitating competitive statutory rates. - Limit corporate tax incentives to those linked to strategic investment. - Personal income tax should treat individuals equally regardless of occupation, with an appropriately set rate scale to alleviate income inequality. - Income from capital can be taxed at a low flat rate and collected at source. - Rationalizing tax expenditures (noted examples: corporate tax holidays, low tax rates for professionals, exemptions for debt securities issued by listed companies). - Indirect taxes: - Single-rate VAT should have minimal exemptions and an appropriate registration threshold. - Review base erosion from measures exempting excisable goods (petroleum products, cars, tobacco, alcohol) replaced with increases in excise rates. - Abolish the Nation Building Tax (NBT). - Levy excises on a few key items at appropriate rates to support revenue and address externalities. - Other taxes: - Strengthen property taxes, streamline import tariffs and para-tariffs, and establish simple/coherent regimes for taxing SMEs. - Tax administration reform: - Use tax withholding and third-party information to increase voluntary compliance. - Employ risk management and taxpayer segmentation to use resources efficiently. - Set up risk-based compliance strategies by tax type, taking advantage of a new IT system. - Simplification of tax legislation to improve administration. - Lessons from past reforms: - 2011 tax reform improved efficiency (Board of Investment tax incentives into legal framework; import taxes streamlined; VAT rates unified; some nuisance taxes abolished) but reduced corporate and personal rates without commensurate base-broadening and retained the NBT. - New tax incentives and exemptions have been added virtually every year since, eroding the tax base and complicating administration. - The Ex Post Evaluation of the 2009 Stand-By Arrangement emphasized prioritizing base broadening, calibrating pace of rate reductions, and aligning revenue targets; annual revenue targets should be supported by clearly-specified, bottom-up measures with strong ownership. ### Upgrading monetary and exchange rate policies - Recent monetary policy actions: - Statutory reserve ratio increased from 6 percent to 7.5 percent in January 2016. - Standing deposit facility rate and lending facility rate increased by 50 basis points to 6.5 and 8 percent, respectively, in February 2016. - March data suggest core inflation and private credit growth have begun to moderate. - Staff recommendations on monetary policy: - Further tightening may be needed if inflationary pressures continue or private credit growth does not continue to moderate. - CBSL should stand ready to further raise policy rates and tighten liquidity, and be prepared to strengthen macroprudential measures where warranted. - Actions should be supported by planned reduction in the government budget deficit. - Framework development: - Authorities committed to shift toward a flexible inflation targeting framework given lack of close relationship between monetary aggregates and inflation. - Short-term forecasting tools and medium-term DSGE techniques are being studied; inflation expectations surveys conducted. - Staff recommends development of a roadmap to set milestones in development, testing and operationalizing a shift to flexible inflation targeting within the next three years, supported by additional IMF technical assistance as needed. - Monetary policy stance and authorities’ view: - Authorities consider current stance broadly appropriate but stand ready to adjust. - They expect inflation to remain at the mid-single digits and private credit growth to decelerate to about 15−16 percent for the year. - Government commitment to fiscal consolidation is essential to avoid an expansionary fiscal stance fueling domestic demand and crowding out private credit. - Authorities support greater exchange rate flexibility, clear communication, and seek technical assistance on capital market developments. ### Exchange rate analysis, reserves, and external considerations - Quantitative findings: - Econometric estimation suggests Sri Lanka’s current account gap is small (-0.2 percent of GDP) with a cyclically-adjusted current account deficit close to the norm predicted by fundamentals. - Policy imbalances are high, at 0.8 percent of GDP. - Other analysis of equilibrium real exchange rate points to an overvaluation of about 11 percent. - Reserves and swap lines: - Gross international reserves have fallen to a point short of gross foreign currency claims coming due in 2016 amid CBSL accommodation of foreign exchange demands from non-resident exit of the government securities market. - Renewed swap arrangements with the RBI ($700 million) and through the SAARC line ($400 million) provide additional buffer space, but are likely to be short-lived. - Intervention and recommendation: - Steady, one-sided intervention policies of the past 20 months have drained net reserves by about $3.2 billion and are unsustainable. - Staff view: foreign exchange intervention is useful to contain volatility, but not to respond to underlying outflows; authorities should phase out intervention in the foreign exchange market or buy foreign exchange reserves while sterilizing intervention to avoid undermining monetary tightening. - CBSL should start to accumulate foreign exchange reserves to replenish buffers and limit supply of residual foreign exchange to the market to the minimum. - External debt and risks: - External debt remains sustainable with low rollover risk (medium and long-term debt represents 83 percent of external debt), although currency risk is elevated. - Net IIP has been increasingly skewed away from equity investments and toward debt and loans. - Recommended structural measures to support a flexible exchange rate regime: - Enhance money markets via continued use of term operations generally with maturities between 7 and 30 days (longer instruments for managing structural liquidity) and removal of restrictions on short-selling of securities while broadening the investor base. - Adopt standard repo documentation across the markets. - Review foreign exchange laws and regulations and develop a timeline for rolling back restrictions on banks’ net open and forward positions in foreign exchange and phase out remaining capital account restrictions. ### Box 4 — Pathway to Greater Exchange Rate Flexibility (findings and operational guidance) - CBSL intervened heavily, supplying substantial dollar liquidity ($3.7 billion from January 1, 2015 to February 15, 2016), reducing reserves and increasing vulnerability. - Four ingredients for a successful transition to a floating regime: (i) a deep and liquid market; (ii) adequate systems to review and manage exchange rate risks; (iii) a coherent intervention policy consistent with a floating regime; and (iv) an appropriate nominal anchor. - A coherent and transparent intervention rule is recommended; components could include: - The mid-point, maximum volatility band, neutral band, daily intervention limit, and intervention frontier. - Need to deepen forex market and reduce constraints on market participants (allowing higher net open positions), develop derivative markets, and increase hedging opportunities. - Current market depth: spot and forward markets exist but are shallow (average daily interbank volumes are about $30 million). - A shift to inflation targeting could facilitate exchange rate flexibility by anchoring price stability, ensuring central bank independence and accountability, and using forward-looking procedures that incorporate forecasts into policy. ### Building resilience, competitiveness, and outward orientation — risks and scenarios - Sri Lanka has shown resilience but faces several external risks that could have sharper impacts: - A sharper than expected global growth slowdown (particularly in European countries) and lower non-oil commodity prices could depress exports, widen the current account deficit, and reduce economic growth; dampening oil prices could mitigate but lower oil-related fiscal revenue would reduce that mitigation. - Slower global and regional growth could deter new FDI projects and slow implementation of new projects, complicating a shift from public debt to greater private financing. - Tighter external financing conditions: sovereign borrowing spreads have widened; further widening could increase public financing costs and public debt rollover risks. - Stronger de-risking trends could reduce remittance inflows; anecdotal evidence suggests current remittance slowdown is not primarily associated with de-risking, but reduced financial services from global/regional banks could exacerbate pressures, add to current account pressures, and slow growth through reduced household consumption and investment. *Italic: IMF staff report content from _cr16150 - 15. The authorities agreed with the need for revenue-based fiscal consolidation and* ### 23. Sound macroeconomic policies and larger fiscal and external cushions (greater fiscal ### _cr16150 - 23. Sound macroeconomic policies and larger fiscal and external cushions (greater fiscal ### Macroeconomic resilience and policy framework - Sound macroeconomic policies and larger fiscal and external cushions (greater fiscal space and higher net international reserves) are essential for maintaining resilience. - Policy package recommended: - An ambitious and credible fiscal consolidation path anchored around debt sustainability, while being mindful of growth implications, to help replenish fiscal buffers. - Recent interest rate hikes would help attract foreign capital, while monetary policy should remain attuned to domestic conditions. - Renewed commitment to exchange rate flexibility with minimal recourse to intervention and capital flows measures to allow the exchange rate to absorb new external shocks—reducing balance of payments disequilibria and facilitating reserves buildup. - Structural reforms to strengthen the monetary policy framework, deepen the foreign exchange market, and increase transparency in foreign exchange intervention policy to maintain an internally coherent monetary policy framework and provide a clear operating environment for the market. ### Competitiveness, trade regime, and integration - Renewed efforts to improve competitiveness and integrate into regional and global supply chains are key to sustained high growth and greater resilience. - Staff recommendations to boost external trade and private sector development: - Reduce costs by addressing protectionism; review Sri Lanka’s trade regime including evaluation of para-tariffs and other nontariff barriers (which have raised Sri Lanka’s effective rate of protection to high levels). - Increase efficiency of trade facilitation, including full implementation of electronic customs documentation. - Remove barriers to foreign investment entry and establishment; enhance access to finance; strengthen financial market infrastructure. - Empirical note: A recent IMF Board paper showed that these reforms are among those with the highest productivity payoff for emerging markets. - Box findings on trade regime and performance: - Trade taxes in use: Cess Levy, Special Commodity Levy, and Port and Airport Development Levy, which amounted to 1.4 percent of GDP in 2015 while import duties were 1.2 percent of GDP. - World Bank estimates (as of 2011): average total nominal protection rate about 24 percent, with para-tariffs amounting to 12 percent. - Sri Lanka’s trade performance: exports and total trade as a share of world market declined over the 2000s and stagnated in recent years. - Service sector performed better than goods exports; FDI remains relatively low, highlighting cost of policy uncertainty. ### Financial sector surveillance and stability - Financial soundness indicators for Q4 2015 were generally favorable with capital adequacy comfortably above regulatory limits. - Asset quality of state banks appears broadly sound; loans to state enterprises guaranteed by the government amount to 18 percent of total loans of state banks. - Risks and recommendations: - Vigilance on potential rise in non-performing loans (NPL). - Close scrutiny and stress testing of state banks including contingent liability risk from state enterprises; absence of clear and consistent government policy on non-commercial operations (such as subsidies) creates contingent risks. - Steps welcomed toward consolidated supervision and shifting to Basel III: - Preliminary draft amendments to the Banking Act to align the single borrower limit (SBL) and related party lending definitions with international best practices, assessed by IMF TA in mid-April 2016. - CBSL assessing fit and proper assessments for owners of finance companies. - Requirements on the Basel III capital standard expected to be introduced in the first half of 2016 in line with the international timeline. - Strengthen legal framework for crisis preparedness and resolution; IMF to provide TA to support a resolution framework for finance companies operating insolvent or below regulatory minimum capital adequacy (possible use of a special purpose vehicle). - Authorities’ view and actions: - Financial system viewed as robust and well capitalized; existing weaknesses mostly in nonbank financial sector. - Some finance companies (comprising 16 percent of the non-banking sector) need capital replenishment; total assets of these companies about 1 percent of GDP. - Authorities committed to finalizing a resolution framework for weak finance companies—through establishment of a special purpose vehicle—by the end of this year, seeking IMF TA. ### Proposed Fund-supported program: objectives, pillars, and key targets - Program aims: provide a policy anchor for macroeconomic stability and structural reforms, strengthen external resiliency, and transition toward flexible inflation targeting with a flexible exchange rate regime. - Key objectives: - Structurally increase revenues to facilitate fiscal deficit reduction. - Reverse decline in foreign exchange reserves. - Reduce public debt to GDP ratio and lower Sri Lanka's risk of debt distress. - Enhance public financial management and improve the operations of state owned enterprises. - Promote sustainable and inclusive economic growth. - Six reform pillars: (i) fiscal consolidation; (ii) revenue mobilization; (iii) public financial management reform; (iv) state enterprise reform; (v) transition to flexible inflation targeting under a flexible exchange rate regime; and (vi) reforms in the trade and investment regime. - Program rationale: meet Sri Lanka’s BOP needs arising from legacy past policies and external deterioration—providing sufficient reserve cover to buffer against new shocks; structural nature and time required justify use of an extended facility. ### Pillar #1: Fiscal consolidation — targets and projections - Fiscal path and targets: - Return to fiscal consolidation guided by authorities’ goal of an overall deficit of 3.5 percent in 2020 (MEFP ¶4). - Deficit reduction path from 5.4 percent of GDP in 2016 to 4.0 percent of GDP in 2018. - Corresponding improvement in the primary balance (the program’s fiscal anchor) by 0.7–0.8 percentage point each year in 2017–18. - Base-broadening tax policy measures envisaged to generate additional revenues of about 1.2 percent of GDP annually in 2017−18. - Revenue-based consolidation expected to preserve fiscal space for infrastructure and key social spending while attaining steady primary surpluses and reducing public debt ratio from 76 percent in 2015 to 68 percent in 2020. - Fiscal consolidation will reduce gross financing needs by 6 percent of GDP over the program period—allowing room for orderly expansion of private sector credit. - Table of central government operations (In percent of GDP): - Revenue and grants: 2015 13.1; 2016 13.0; 2017 14.0; 2018 15.3; 2019 15.5; 2020 15.8 - Tax revenue: 2015 12.1; 2016 11.8; 2017 12.9; 2018 14.1; 2019 14.3; 2020 14.6 - Without measures: 2015 12.1; 2016 11.8; 2017 11.8; 2018 11.8; 2019 11.8; 2020 11.7 - Measures (cumulative from 2017): 2017 ......; 2018 1.1; 2019 2.3; 2020 2.5; 2021 2.9 - Nontax revenue and grants: 2015 0.9; 2016 1.2; 2017 1.2; 2018 1.2; 2019 1.2; 2020 1.2 - Expenditure: 2015 19.9; 2016 18.4; 2017 18.8; 2018 19.3; 2019 19.2; 2020 19.3 - Current non-interest: 2015 10.5; 2016 9.3; 2017 9.2; 2018 9.2; 2019 9.2; 2020 9.2 - Interest: 2015 4.7; 2016 4.6; 2017 4.7; 2018 4.7; 2019 4.6; 2020 4.5 - Capital: 2015 4.7; 2016 4.5; 2017 4.9; 2018 5.4; 2019 5.5; 2020 5.6 - Overall balance: 2015 -6.9; 2016 -5.4; 2017 -4.7; 2018 -4.0; 2019 -3.7; 2020 -3.5 - Primary balance: 2015 -2.2; 2016 -0.8; 2017 0.0; 2018 0.7; 2019 0.8; 2020 1.0 - Central government debt: 2015 76.0; 2016 77.2; 2017 75.5; 2018 73.1; 2019 70.7; 2020 68.2 - Gross financing needs: 2015 20.7; 2016 19.2; 2017 17.8; 2018 16.4; 2019 14.7; 2020 12.2 - Memorandum items: - Overall balance without measures: 2017 ......; 2018 -5.8; 2019 -6.3; 2020 -6.2; 2021 -6.4 - Primary balance without measures: 2017 ......; 2018 -1.1; 2019 -1.6; 2020 -1.7; 2021 -1.9 ### Pillar #2: Revenue mobilization — measures - Revenue mobilization as linchpin of adjustment via base-broadening tax policy and risk-based tax administration, plus simplification: - Tax policy measures (MEFP ¶7): - Publish a statement of tax expenditures to catalogue and cost all existing tax exemptions, holidays, and special rates, and subsequently rationalize these tax expenditures (for example limiting corporate tax incentives to expenditure-based ones tied to investment). - Introduce a new income tax law to simplify and broad-base income tax, supported by Fund TA. - Follow income tax reform with base-broadening VAT reform including rationalizing VAT exemptions. - Streamline the trade tax regime. - Tax administration reform (MEFP ¶8): - Improve administrative efficiency of the Inland Revenue Department (IRD) through adoption of risk-based compliance strategies for VAT and income tax and introduction of Key Performance Indicators on number of risk-based VAT audits. - Timely roll out of new IT systems for domestic tax and customs administration (RAMIS and ASYCUDA). - Pursue organizational and business procedure reform for the IRD, including creating a design and monitoring unit. ### Pillar #3: Public financial management reform — measures - Improve expenditure management and fiscal risk monitoring (MEFP ¶11): - Commitment control system based on commitment records and quarterly expenditure commitment ceilings, starting from mid-2016. - Timely roll-out of the Integrated Treasury Management Information System (ITMIS) to expand PFM capabilities including commitment control, budget preparation, treasury, accounting, and procurement. - Improve fiscal transparency: - Publish quarterly financial bulletins summarizing government fiscal operations. - Ensure annual budgets explicitly cost out tax expenditures. - Adhere to Government Financial Statistics Manual (GFSM) standards. - Include in annual budget analysis of fiscal risks those related to SOEs and PPPs. ### Pillar #4: State enterprise reform (overview) - Program measures (illustrative from program design): - Resolution strategy of SOEs' obligations (PA, SB). - SOEs' non-commercial obligations included in the budget (SB). - Statement of Corporate Intent for major SOEs (SB). - Pricing reform for energy and other utility (SB). - Aim to reduce contingent fiscal liabilities and improve SOE governance and transparency. *Source: IMF staff report content provided in the supplied PDF excerpt.* ### 35. Sri Lanka had some 235 public enterprises representing 17 percent of the nation’s ### _cr16150 - 35. Sri Lanka had some 235 public enterprises representing 17 percent of the nation’s ### State-Owned Enterprises (SOEs): status and reform agenda - Sri Lanka had some 235 public enterprises representing 17 percent of the nation’s economic activity in 2010. - Collective impact: - Some SOEs are profitable, but collectively they "represent a drag on the private economy and a drain on public finances (both directly, and through the state banks, which fund the largest SOEs)." - Large obligations are largely tied to SOEs, highlighting the need for financial discipline. - Specific SOE issues: - Ceylon Petroleum Corporation (CPC) and Ceylon Electricity Board (CEB) incurred financial losses fulfilling non-commercial obligations due to implicit energy subsidies—retail fuel and electricity prices set below cost-recovery levels. - Sri Lankan Airlines has been a loss-making SOE, reflecting competition with international airlines in the region. - Reform measures (authorities will introduce far-reaching SOE reforms; see MEFP ¶12): - A resolution strategy for Sri Lankan Airlines will be completed by September 2016, effectively removing this company from the government’s accounts. - Enhance oversight and financial discipline of SOEs: - Drawing on FAD TA recommendations, six major SOEs will establish (with agreement of MOF and the relevant line ministry) a Statement of Corporate Intent (SCI) including: the SOE’s objectives and multiyear corporate plan; capital expenditure and financing plans; explicit financial and non-financial targets; and cost of non-commercial obligations. - Authorities will consider strengthening the legal framework for governance and oversight of SOEs. - Reform of energy and other utility subsidies: - Introduce a formula-based automatic pricing mechanism for petroleum products to avoid future CPC losses and large retail adjustments. - Grant the Public Utilities Commission enhanced authority to set electricity and water tariffs in a cost-reflective manner. - Include the fiscal cost of non-commercial obligations for SOEs in the central government budget. ### Monetary policy framework and objectives (Pillar #5) - Primary focus: keep inflation in the low single digits while allowing a durable transition to a more flexible exchange rate regime. - Monitoring and operational arrangements: - Inflation performance monitored through a monetary policy consultation clause; exchange rate flexibility enforced by programmed accumulation of net international reserves (NIR). - The program establishes an inflation target band around the projected inflation path; if inflation falls outside the band, the authorities will consult with the Fund on causes and proposed policy responses, which may include adjustment in the CBSL’s policy interest rates. - Reserve money will be monitored as an indicative target. - Strengthening of reserve adequacy guided by NIR as a percentage of the ARA reserve metric, anchored with a PC (floor) on NIR. - Program includes a clause for consultation with Fund staff if the gap between supply and demand of foreign exchange results in a sudden disruptive depreciation. - Transition toward flexible inflation targeting and financial market deepening: - Technical assistance supports development of more sophisticated econometric models for macroeconomic forecasting. - Roadmap milestones during the program period include: adopting an inflation forecasting model; announcing a medium-term numerical inflation objective; introducing a policy rate in the middle of the corridor as an operational target; and establishing an effective communication arrangement. - Need for appropriate legal and organizational frameworks to ensure accountability and credibility of inflation targeting. - Policy stance guidance: - CBSL should stand ready to further tighten monetary policy if inflationary pressures continue, private credit growth does not moderate, or capital outflows and downward exchange-rate pressure persist. ### Trade, investment, and external sustainability (Pillar #6) - Objective: greater integration into regional and global supply chains, higher FDI, and enhanced private sector investment prospects. - Trade agreements and developments: - Sri Lanka has signed FTAs with India, Pakistan, and Iran; strengthened cooperation with India through the India Economic and Technical Cooperation Agreement (ETCA) signed in early 2016; an FTA with China is under discussion. - Strengthened economic relationship with the U.S. through the Trade Investment Framework Agreement (TIFA). - EU lifted a ban on fisheries imports from Sri Lanka in April 2016, facilitating talks toward regaining GSP Plus status potentially by the end of this year. - Member of SAFTA, APTA, and BIMSTEC (which aims to achieve its own free trade area by 2017). - Program measures to boost trade and private-sector competitiveness: - Reduce protectionism and simplify the trade regime: limit number of rates, phase out para-tariffs, minimize duty exemptions. - Review of trade regime including evaluation of para-tariffs and other nontariff barriers. - Negotiating a World Bank program loan to enhance competitiveness focusing on: trade facilitation (ratify WTO Trade Facilitation Agreement; establish NTFC; full implementation of electronic customs documentation), removal of barriers to foreign investment entry and establishment (including access to land), enhanced access to finance, and strengthened financial market infrastructure. - Creation of a one-stop-shop for foreign investors to reduce processing time for investment approval. ### Program modalities, financing, and prior actions - Program monitoring: - Semi-annual program reviews based on quantitative targets and structural benchmarks, with quarterly indicative targets and staff visits between reviews. - Test dates for first and second review: end-June and end-December 2016. - An update safeguards assessment of the CBSL is underway to be completed no later than the first program review (last assessment completed in 2009). - Proposed access and financing: - Proposed access is 185 percent of quota (SDR 1,070.780 million). - A financing gap of US$1.5 billion would arise to keep gross reserves at an adequate and increasing level as measured by the Fund’s composite metric. - Program envisages a steady increase in NIR to a level commensurate with 75 percent of the ARA metric over the medium term. - Choice of a three-year arrangement under the Extended Fund Facility motivated by structural, longer-term challenges. - With proposed access, outstanding Fund credit would reach a peak of SDR 1,070.78 million by 2019 (6.7 percent of exports). - Donor support: - Firm commitments from donors to fill the entire financing gap for the first 12 months of the arrangement. - Financial support expected to reach $650 million during 2016−18, with strong technical assistance also provided. - Prior actions proposed ahead of the Executive Board meeting: - Cabinet to issue a Memorandum requiring the Ministry of Finance to complete by end-October 2016 a time-bound strategy to address outstanding arrears of central government obligations of state enterprises. The Memorandum will specify that the strategy include: - Completion (by end-2016) of a comprehensive database of SOE’s financial obligations, including a breakdown of arrears and non-arrears to be certified by the Auditor General for use in creating a registry of such obligations. - Clarification of the government’s responsibility over existing obligations related to subsidies and other non-commercial obligations of the SOEs (i.e., what proportion of these debts to assume, if any). - Ministry of Finance to issue circulars to: - formally implement tax policy and other revenue measures outlined in the Cabinet Memorandum of March 4, 2016; - detail revised expenditure ceilings for government ministries and agencies consistent with the overall budget deficit target for 2016. - Cabinet resolution adopting a framework note (agreed with IMF staff) for a new Inland Revenue Act embodying key tax policy drivers, overarching legal design framework, and the tax law reform roadmap as outlined in the March 2016 IMF Legal Department technical assistance mission Aide Memoire. - Formally suspend by Cabinet order the Board of Investment's capacity to grant tax exemptions, tax holidays, and special tax rates until such time as the BOI Act can be formally amended. - Monitoring metrics and targets: - Semiannual quantitative performance criteria on the government primary balance and net official international reserves of the CBSL. - Monetary policy consultation clause applied with respect to inflation. - Continuous performance criterion (a zero ceiling) on new external arrears. - Indicative targets on central government tax revenue (floor) and reserve money (ceiling). - Structural benchmarks established to gauge progress; staff will monitor the stock of gross debt adjusted for exchange rate changes. ### Risks, staff appraisal, and policy priorities - Key program risks: - (i) Revenue slippage or failure to implement key revenue-related reforms. - (ii) Weaker than expected capital inflows could widen the projected financing gap given gross financing needs of close to 19 percent of GDP in 2016. - (iii) Lower than expected growth and/or new pressures on the trade account. - (iv) Larger than expected losses at SOEs and/or inability to bring these firms to a commercial footing. - These risks could challenge public debt sustainability (see DSA in Annex III). - Mitigation: policy dialogue and technical assistance from the Fund, World Bank, and other institutions. - Staff appraisal highlights: - Economic growth showing strain due to policy-induced macroeconomic imbalances and a difficult external environment; real GDP growth has stalled despite a boost to consumption from public wage, salary, and transfer increases. - The authorities’ program under the EFF offers a credible plan to: (i) implement a structural increase in revenues to reduce the fiscal deficit; (ii) reverse the decline in central bank foreign exchange reserves; (iii) reduce public debt relative to GDP and lower risk of debt distress; and (iv) enhance public financial management and improve SOE operations. - Sizeable fiscal adjustment is needed over the medium term; the adjustment profile is ambitious and front-loaded with a projected shift into primary fiscal surpluses through revenue gains. - Tax policy and administration reforms must be sustained over several years; a new Inland Revenue Act and broader VAT and customs base reforms are critical. - Urgent need to expedite public financial management and SOE reforms to avoid recurrence of spending arrears and mitigate fiscal risks: - Establish an effective commitment control system based on commitment record and expenditure ceilings and expedite roll-out of the new IT system. - Address outstanding obligations of SOEs and clarify future central government responsibility for non-commercial obligations. - Establish market-based pricing for fuel and electricity to minimize subsidies and enable SOEs to operate commercially. - Monetary policy should remain vigilant and may need further tightening; a durable shift to flexible inflation targeting would bolster policy effectiveness and exchange rate flexibility. - Exchange rate policy: - To reach NIR objectives, CBSL will need to disembark from active intervention policies used over the prior 20 months. - Evidence of market dysfunction from loss of confidence and one-sided intervention; need to deepen the foreign exchange market supported by credible macroeconomic policies and a clear framework. - Financial sector stability: - Banking system does not appear to be a current source of vulnerability, but careful scrutiny needed regarding state enterprise obligations to public banks and potential for rising NPLs as private credit growth decelerates. - Pockets of vulnerability remain in the nonbank sector and should be addressed. *Source: IMF country documentation (content unit provided).* ### 56. Achieving high and sustained rates of economic growth over the medium-term ### 56. Achieving high and sustained rates of economic growth over the medium-term ### Structural reforms to sustain medium-term growth - Achieving high and sustained rates of economic growth over the medium-term hinges on implementation of an ambitious program of structural reform. - Reforms planned for the structure of the tax system, revenue administration, budget management, utility pricing and state enterprise operations, financial market deepening, as well as the trade and investment regime can, if implemented fully, unleash Sri Lanka’s considerable economic potential and capacity to fully exploit comparative advantages in geographical position and human capital. ### Risks to the program and mitigation - Risks to the program are significant. - The proposed program will require strong political commitment and implementation by a relatively new government. - The key risk is that essential reforms will be delayed, watered down, or abandoned in the face of challenges. - External shocks, such as weaker-than-anticipated capital inflows and lower-than-projected growth can challenge the reform effort. - Mitigating factors and recommended actions: - The authorities’ top level commitment to the reform planned outlined in the Memorandum of Economic and Financial Policies should mitigate this risk. - Public outreach should also be bolstered to explain both the short-term costs and the medium-term gains to shareholders and the general public. - Contingency planning for the most likely shocks should also be considered. ### IMF staff assessment and financing request - Staff supports the authorities’ request for an Extended Arrangement. - In view of Sri Lanka’s balance of payments need, the policy actions already taken, and the authorities’ commitment to implement an ambitious reform package over the duration of the program, staff supports the authorities’ request for an Extended Arrangement in an amount equivalent to SDR 1,070.78 million. *Source: _cr16150 - 56. Achieving high and sustained rates of economic growth over the medium-term* ### 59. It is recommended that the next Article IV Consultation with Sri Lanka be held on ### _cr16150 - 59. It is recommended that the next Article IV Consultation with Sri Lanka be held on ### Recommendation - It is recommended that the next Article IV Consultation with Sri Lanka be held on the 24-month cycle, subject to Decision No. 14747, as amended. ### Macroeconomic developments — key projections and indicators (Table 1) - Real GDP growth: 2014: 4.9; 2015: 4.8; 2016: 5.0; 2017: 5.0; 2018: 5.0; 2019: 5.2; 2020: 5.4 - Inflation (average): 2014: 3.3; 2015: 0.9; 2016: 4.1; 2017: 5.3; 2018: 5.1; 2019: 5.0; 2020: 5.0 - Inflation (end-of-period): 2014: 2.1; 2015: 2.8; 2016: 5.4; 2017: 5.2; 2018: 5.0; 2019: 5.0; 2020: 5.0 - Core inflation (end-of-period): 2014: 3.2; 2015: 4.5; 2016: 4.5; 2017: 4.3; 2018: 4.1; 2019: 4.1; 2020: 4.1 - National savings (percent of GDP): 2014: 24.5; 2015: 25.9; 2016: 26.9; 2017: 26.0; 2018: 26.2; 2019: 25.9; 2020: 25.7 - National investment (percent of GDP): 2014: 27.0; 2015: 28.4; 2016: 28.3; 2017: 28.8; 2018: 29.3; 2019: 29.2; 2020: 29.2 - Current account balance (in millions of U.S. dollars): 2014: -1,989; 2015: -2,009; 2016: -1,202; 2017: -2,419; 2018: -2,916; 2019: -3,343; 2020: -3,812 - Current account balance (percent of GDP): 2014: -2.5; 2015: -2.5; 2016: -1.5; 2017: -2.8; 2018: -3.1; 2019: -3.3; 2020: -3.4 - Exports (in millions of U.S. dollars): 2014: 11,130; 2015: 10,505; 2016: 10,456; 2017: 10,942; 2018: 11,838; 2019: 12,664; 2020: 14,093 - Imports (in millions of U.S. dollars): 2014: -19,417; 2015: -18,935; 2016: -18,392; 2017: -20,763; 2018: -22,606; 2019: -24,357; 2020: -26,608 - Gross official reserves (end of period, in millions of U.S. dollars): 2014: 8,208; 2015: 7,304; 2016: 7,853; 2017: 9,372; 2018: 11,866; 2019: 13,033; 2020: 13,843 - Gross official reserves (in months of imports): 2014: 4.3; 2015: 3.8; 2016: 3.7; 2017: 4.1; 2018: 4.8; 2019: 4.9; 2020: 5.0 - External debt (public and private, in billions of U.S. dollars): 2014: 43.0; 2015: 44.8; 2016: 45.9; 2017: 49.0; 2018: 53.4; 2019: 58.4; 2020: 62.4 - External debt (percent of GDP): 2014: 53.8; 2015: 55.1; 2016: 55.8; 2017: 55.9; 2018: 56.3; 2019: 57.1; 2020: 56.5 - Nominal GDP (in billions of rupees): 2014: 10,448; 2015: 11,183; 2016: 12,147; 2017: 13,374; 2018: 14,787; 2019: 16,333; 2020: 18,076 ### Fiscal sector — revenues, expenditures, balances (Tables 2a–2c) - Revenue and grants (percent of GDP): 2014: 11.5; 2015: 13.1; 2016: 13.0; 2017: 14.0; 2018: 13.6; 2019: 13.0; 2020: 14.0; 2019 proj: 15.3; 2020 proj: 15.5; 2020 proj: 15.8 (table shows multi-year series) - Total expenditure and net lending (percent of GDP): 2014: 17.8; 2015: 19.9; 2016: 18.4; 2017: 18.8; 2018: 19.3; 2019: 19.2; 2020: 19.3 - Overall central government balance (percent of GDP): 2014: -6.2; 2015: -6.9; 2016: -5.4; 2017: -4.7; 2018: -4.0; 2019: -3.7; 2020: -3.5 - Primary balance (percent of GDP): 2014: -2.1; 2015: -0.6; 2016: -2.2; 2017: -1.8; 2018: -0.8; 2019: 0.0; 2020: 0.7; 2019 proj: 0.8; 2020 proj: 1.0 (Table 2b and 2a memorandum) - Central government debt (percent of GDP): 2014: 70.7; 2015: 76.0; 2016: 77.2; 2017: 75.5; 2018: 73.1; 2019: 70.7; 2020: 68.2 - Central government net domestic financing (percent of GDP): 2014: 3.8; 2015: 4.3; 2016: 2.3; 2017: 3.0; 2018: 1.3; 2019: 2.3; 2020: 2.3 - Selected central government 2016 quarterly (Table 2c, in billions of rupee): - Total revenue and grants (2016 annual): 1,574 - Total expenditure and net lending (2016 annual): 2,233 - Overall balance (2016 annual): -659 - Primary balance (2016 annual): -97 ### Monetary and financial sector (Tables 3a–3b, Table 5) - Broad money (end of period percent change): 2014: 13.4; 2015: 17.8; 2016: 10.8; 2017: 15.4 - Reserve money (end of period percent change): 2014: 18.3; 2015: 16.5; 2016: 18.4; 2017: 12.0 - Credit to private sector (percent change, end of period): 2014: 8.8; 2015: 25.1; 2016: 10.0; 2017: 14.3 - Broad money (levels, end period, in billions of rupees): 2014: 3,876; 2015: 4,566; 2016: 5,061; 2017: 5,840 - Gross international reserves (in millions of U.S. dollars) — memorandum: 2014: 8,208; 2015: 7,304; 2016: 7,853; 2017: 9,372 - Financial soundness indicators — all banks (selected): - Regulatory capital to risk weighted assets: 2012: 16.4; 2013: 16.3; 2014: 15.6; 2015: 16.3 - Gross non-performing loans to total gross loans (without interest in suspense): 2012: 3.7; 2013: 5.6; 2014: 4.2; 2015: 4.3 - Return on equity (after tax): 2012: 20.3; 2013: 16.0; 2014: 16.6; 2015: 16.7 - Liquid assets to total assets: 2012: 26.6; 2013: 31.9; 2014: 32.2; 2015: 31.0 ### Balance of payments and external financing (Tables 4a–4c) - Balance on goods (in millions of U.S. dollars): 2014: -8,287; 2015: -8,430; 2016: -7,936; 2017: -9,820; 2018: -10,768; 2019: -11,693; 2020: -12,515 - Balance on services (in millions of U.S. dollars): 2014: 1,880; 2015: 2,325; 2016: 2,760; 2017: 3,251; 2018: 3,797; 2019: 4,405; 2020: 4,887 - Primary and secondary income, net (combined, in millions of U.S. dollars): 2014: 4,418; 2015: 4,096; 2016: 3,974; 2017: 4,150; 2018: 4,055; 2019: 3,946; 2020: 3,817 - Amortization (in millions of U.S. dollars): 2014: -1,860; 2015: -837; 2016: -2,606; 2017: -1,416; 2018: -1,302; 2019: -2,854; 2020: -2,537 - Gross external financing needs (in millions of U.S. dollars): 2014: -3,849; 2015: -2,845; 2016: -3,808; 2017: -3,835; 2018: -4,218; 2019: -6,196; 2020: -6,348 - Sources of financing (gross borrowing, in millions of U.S. dollars): 2014: 5,397; 2015: 3,196; 2016: 3,698; 2017: 4,737; 2018: 6,090; 2019: 7,114; 2020: 7,155 - Change in reserve assets (in millions of U.S. dollars): 2014: -1,549; 2015: -350; 2016: -549; 2017: -1,519; 2018: -2,494; 2019: -1,168; 2020: -806 ### IMF-supported arrangement and financing schedule (Tables 6 and 7) - Proposed Three-year Extended Arrangement — Reviews and Purchases (Table 6): - June 3, 2016: Amount (SDR millions) 119.894; Percent of Quota (%) 20.714; Condition: Board Approval of the Extended Arrangement - November 20, 2016: Amount (SDR millions) 119.894; Percent of Quota (%) 20.714; Condition: Completion of the first review based on end-June 2016 and continuous performance criteria - April 20, 2017: Amount (SDR millions) 119.894; Percent of Quota (%) 20.714; Condition: Completion of the second review based on end-December 2016 and continuous performance criteria - November 20, 2017: Amount (SDR millions) 177.774; Percent of Quota (%) 30.714; Condition: Completion of the third review based on end-June 2017 and continuous performance criteria - April 20, 2018: Amount (SDR millions) 177.774; Percent of Quota (%) 30.714; Condition: Completion of the fourth review based on end-December 2017 and continuous performance criteria - November 20, 2018: Amount (SDR millions) 177.774; Percent of Quota (%) 30.714; Condition: Completion of the fifth review based on end-June 2018 and continuous performance criteria - April 20, 2019: Amount (SDR millions) 177.776; Percent of Quota (%) 30.715; Condition: Completion of the sixth review based on end-December 2018 and continuous performance criteria - Total: Amount (SDR millions) 1,070.780; Percent of Quota (%) 185.000 - Projected payments to the Fund (Table 7, selected lines): - Fund repurchases and charges (in millions of SDR): 2016: 176.5; 2017: 177.8; 2018: 8.5; 2019: 11.4; 2020: 21.4; 2021: 61.2; 2022: 115.0; 2023: 173.0; 2024: 186.0; 2025: 184.2; 2026: 172.3; 2027: 130.6; 2028: 75.0; 2029: 15.1 - Fund repurchases and charges (in millions of U.S. dollars): 2016: 246.1; 2017: 248.9; 2018: 11.9; 2019: 16.0; 2020: 30.2; 2021: 86.1; 2022: 161.8; 2023: 243.4; 2024: 261.8; 2025: 259.1; 2026: 242.4; 2027: 183.8; 2028: 105.5; 2029: 21.2 - Fund credit outstanding (in millions of SDR), end-of-year: 2016: 412.0; 2017: 537.5; 2018: 893.0; 2019: 1,070.8; 2020: 1,060.8; 2021: 1,010.8; 2022: 906.4; 2023: 742.8; 2024: 564.3; 2025: 385.9; 2026: 217.4; 2027: 88.9; 2028: 14.8; 2029: 0.0 - Fund credit outstanding (in millions of U.S. dollars), end-of-year: 2016: 576; 2017: 752; 2018: 1,252; 2019: 1,506; 2020: 1,493; 2021: 1,422; 2022: 1,275; 2023: 1,045; 2024: 794; 2025: 543; 2026: 306; 2027: 125; 2028: 21; 2029: 0 - Fund credit outstanding (in percent of quota): 2016: 71; 2017: 92.9; 2018: 154.3; 2019: 185.0; 2020: 183.3; 2021: 174.6; 2022: 156.6; 2023: 128.3; 2024: 97.5; 2025: 66.7; 2026: 37.6; 2027: 15.4; 2028: 2.6; 2029: 0.0 - Memorandum — Gross official reserves (in millions of U.S. dollars) projected: 2016: 7,853; 2017: 9,372; 2018: 11,866; 2019: 13,033; 2020: 13,843; 2021: 15,595; 2022: 16,095; 2023: 16,595; 2024: 17,095; 2025: 17,595; 2026: 18,095; 2027: 18,595; 2028: 19,095; 2029: 19,595 *Source: IMF staff and data provided by the Sri Lankan authorities (content unit: _cr16150).* ### Annex I. Response to Past Fund Policy Advice ### Annex I. Response to Past Fund Policy Advice ### Engagement summary - The authorities have actively engaged in a policy dialogue with the Fund (both before and after elections in January and August 2015). - Some IMF recommendations have been implemented, but some policies deviated from previous IMF advice. ### Fiscal consolidation and debt - Recommendation: Continue fiscal consolidation and debt reduction, but shift the burden of adjustment to revenue generation. - Outcome and findings: - Fiscal consolidation stalled in 2014 and 2015. - Revenue gains achieved, but only through one-off measures and higher collection of trade-related taxes (from increase in imports). - Debt targets could potentially be recast to achieve deeper reduction over a longer period. - Fiscal targets have been re-set, but without setting a deeper reduction to the debt target over a longer period. ### Tax policy and administration - Recommendation: A more systematic effort to broaden the tax base to improve revenue collection. - Outcome and actions: - Currently underway with redrafting of Inland Revenue Act as first stage in comprehensive reform of tax system. - IMF technical assistance to quantify the costs of tax expenditures—as an input to government’s own medium-term reform plan. - Technical assistance on tax policy, tax legislation, and public financial management undertaken (basis for current reform program). ### Monetary policy and exchange rate - Recommendation: Staff argued for keeping the current monetary stance unchanged. - Outcome: - Monetary policy subsequently loosened. - Recommendation: Maintain a flexible exchange rate regime, as the CBSL’s interventions had effectively stabilized the exchange rate. - Outcome: - Central bank intervention continued while the exchange rate was kept virtually steady until September 2015. ### Financial sector consolidation - Observation and staff advice: The mission highlighted some aspects that might limit potential gains from the government’s proposed financial sector consolidation plan. - Outcome: - Financial sector consolidation plan was abandoned following January 2015 elections. *Source: Annex I. Response to Past Fund Policy Advice (IMF staff report excerpt).* ### 8. Nevertheless, vulnerabilities linked to inadequate reserve coverage, exchange rate ### _cr16150 - 8. Nevertheless, vulnerabilities linked to inadequate reserve coverage, exchange rate ### Key vulnerabilities - Currency risk, notably related to the dollar, is high. - Further rupee depreciation could pose a significant risk, if sustained; stress tests show that a 30 percent real depreciation would raise the external debt to GDP ratio to about 82 percent. - Inadequate reserve coverage and early deleveraging could pose a risk for debt servicing. - Tighter global financing liquidity and declining investor confidence could raise rollover vulnerabilities and costs—public external financing at non concessional terms substitute gradually for concessional financing to which Sri Lanka does not have access anymore. - Lower than expected GDP or exports rebound from their current dip would deteriorate debt dynamics. ### Reserve coverage and balance of payments - Gross international reserves decreased by almost $1 billion in 2015—a drop of 11 percentage points of the ARA metric to 76 percent (3.8 months of prospective imports). - Reserves fell further to 65 percent of the metric by March 2016—barely 3 months of import cover. - Gross reserves are largely borrowed: FX swaps with domestic banks of $2.1 billion, a swap arrangement with the Reserve Bank of India (RBI) of $700 million, and SAARC arrangement of $400 million provide a temporary buffer. - At the beginning of 2016, gross reserves were short of gross foreign-currency claims coming due in the year. - Net international reserves were 43.4 percent of the ARA metric at end-March 2016. - Balance of payments pressures in 2015 relative to 2014: current account deficit contained at 2.5 percent of GDP; net FDI at 0.8 percent of GDP; foreign holdings of government securities dropped by 1.1 percent of GDP. ### Stress tests and scenario results - A 30 percent real depreciation (one-time in 2017) raises external debt to GDP ratio to about 82 percent. - External Debt Sustainability: baseline external debt trajectory (selected years, external debt in percent of GDP): - 2011: 50.2 - 2012: 54.2 - 2013: 53.6 - 2014: 53.8 - 2015: 55.1 - 2016: 55.8 - 2017: 55.9 - 2018: 56.3 - 2019: 57.1 - 2020: 56.5 - 2021: 55.8 - Change in external debt (selected years): - 2011: 6.4 - 2012: 4.0 - 2013: -0.6 - 2014: 0.2 - 2015: 1.3 - 2016: 0.6 - 2017: 0.1 - 2018: 0.4 - 2019: 0.7 - 2020: -0.6 - 2021: -0.7 - Identified external debt-creating flows (4+8+9) (selected): 2011: 0.0; 2012: 1.4; 2013: -2.5; 2014: -2.5; 2015: 0.8; 2016: -2.1; 2017: -1.0; 2018: -0.9; 2019: -1.1; 2020: -1.5; 2021: -2.7 - Current account deficit, excluding interest payments (selected): 2011: 6.0; 2012: 4.5; 2013: 2.0; 2014: 1.0; 2015: 1.0; 2016: -0.1; 2017: 1.1; 2018: 1.3; 2019: 1.5; 2020: 1.7; 2021: 1.2 - Gross external financing need (in billions of US dollars) (selected): 2011: 11.1; 2012: 13.0; 2013: 11.9; 2014: 11.1; 2015: 12.7; 2016: 10.6; 2017: 11.9; 2018: 13.0; 2019: 14.6; 2020: 15.7; 2021: 16.0 - Gross external financing need (in percent of GDP) (selected): 2011: 17.0; 2012: 19.0; 2013: 16.0; 2014: 13.9; 2015: 15.7 ### Debt dynamics, composition, and projections (public sector DSA highlights) - Nominal gross public debt (percent of GDP) projections: - 2014: 74.9 - 2015: 75.0 - 2016: 79.5 - 2017: 80.3 - 2018: 78.3 - 2019: 75.7 - 2020: 73.1 - 2021: 70.3 - Public gross financing needs (percent of GDP) projections: - 2014: 21.5 - 2015: 24.3 - 2016: 20.7 - 2017: 19.2 - 2018: 17.8 - 2019: 16.4 - 2020: 14.7 - 2021: 12.2 - Real GDP growth (in percent) baseline projections: - 2016: 5.0 - 2017: 5.0 - 2018: 5.0 - 2019: 5.2 - 2020: 5.4 - Inflation (GDP deflator, in percent) baseline projections: - 2016: 3.4 - 2017: 4.9 - 2018: 5.3 - 2019: 5.0 - 2020: 5.0 - Effective interest rate (in percent) projections: - 2016: 6.6 - 2017: 6.7 - 2018: 6.9 - 2019: 6.9 - 2020: 7.0 - Composition of public debt by maturity and currency shows a large share of medium and long term debt and a mix of local currency-denominated and foreign currency-denominated debt (figures presented as percent of GDP in the DSA charts). ### Policy implications and recommendations (as stated) - Strengthening external sustainability will require: - Addressing domestic policy imbalances. - Greater exchange rate flexibility. - Structural reforms to rebuild buffers, increase investor confidence and improve competitiveness. - Recognize mitigation factors: - Low rollover risks due to the large share of medium and long term debt. - Mitigating effect of long maturities and Sri Lanka’s access to international financial markets on currency risk. *Source: IMF staff (Sri Lanka Public Sector Debt Sustainability Analysis and Annex IV. 2016 External Sustainability Assessment).* ### 3. In the absence of decisive policy actions to boost investor’s confidence, reserve coverage is ### _cr16150 - 3. In the absence of decisive policy actions to boost investor’s confidence, reserve coverage is ### Balance of payments and reserve coverage - Reserve coverage likely to deteriorate further if decisive policy actions to boost investor confidence are not taken. - Current account (CA) pressures expected to recede as: - Oil prices are expected to remain on average lower than in 2015. - The peak of high vehicle imports growth has passed owing to macroprudential measures. - Efforts that could help boost exports in the near term: - Lifting the ban on fish exports to the EU. - Finalizing trade arrangements with the United States. - Headwinds to export improvement: - Weak global demand. - Weak commodity prices. - Remittances growth likely to remain anemic because almost three fourths of inflows originate from regions under economic stress (55 percent from the Middle East and 18 percent from the European Union). ### Capital and financial account pressures; portfolio flows - Capital and financial account expected to remain under pressure; investor sentiment has worsened due to: - Concerns over domestic policies. - External vulnerabilities. - Volatility in global markets. - Foreign holdings of government securities: - 6.1 percent of the stock at March 4, 2016 (from 6.9 percent at end-December 2015). - Outflows reached $551 million in the first quarter of 2016. - Securities maturing in 2016 amounted to $248 million. - Remainder stock at risk: $1.5 billion. - Regulatory measures: - A regulatory ceiling on the share of foreign holdings of T-bills and T-bonds to total stock during periods of inflows (10 percent in 2015) has helped contain spillovers. - FDI inflows and project loans expected to resume only gradually; repayment of external liabilities will put a dent on reserves. ### FX intervention, market distortions, and exchange rate dynamics - CBSL net intervention in the spot market: $3.7 billion from January 1, 2015 to February 15, 2016. - Peak intervention: $441 million per month in July–September 2015. - Intervention receded to US$190 million in February 2016 as CBSL allowed greater rupee flexibility starting in September 2015. - Despite intervention and moral suasion, the rupee depreciated 9.8 percent from January 1, 2015 to February 15, 2016; signs of stabilization in February (spot rate flat). - Market pressures resumed in March; CBSL supplied $437 million to the foreign exchange market in March, helping keep the spot rate mostly unchanged. - CBSL actions pushed more trading from the spot market to the forward market: - 3-month forward market rate: 151 rupees per U.S. dollar for three days at the end of March. - Dropped to 146.6 rupees per U.S. dollar at end April, 1.8 percent higher than the spot rate. - Reduced volume in the spot market; forward market gained relative share. ### Exchange rate assessment and misalignment evidence - Real effective exchange rate (REER) depreciated by 4.7 percent in 2015, mainly driven by nominal changes. - External Balance Assessment (EBA) results: - CA gap: -0.2 percent (very small; CA deficit larger but close to the norm predicted by fundamentals). - Policy imbalances: 0.8 percent (high). - Implied overvaluation of the real exchange rate is within model margins of error, though EBA may inadequately capture Sri Lanka’s exchange rate dynamics. - Alternative estimation: - Equilibrium Real Effective Exchange Rate model suggests an overvaluation of about 11 percent. - Econometric estimations (VAR literature): one percent depreciation of the real effective exchange rate could improve the CA balance by 0.1–0.2 percentage points of GDP. ### Competitiveness, structural weaknesses, and exports - Real depreciation during 2013–15: 11 percent; real exchange rate back to pre-2012 levels (after a 6 percent appreciation in 2012). - Structural weaknesses weigh on external sustainability: - Sri Lanka ranked 107 out of 189 countries in the 2016 World Bank’s Doing Business ranking. - Significant weaknesses: enforcing contracts, paying taxes, registering properties. - Improvements: ease of starting a business, getting electricity, dealing with construction permits — but these remain bottlenecks. - Constraints in finding and retaining experienced labor. - Consequences: - Peer countries with better Doing Business rankings have higher export shares and more integration in global value chains. - Export profitability in Sri Lanka has been trending down (export deflator/Private sector wages index). ### External debt, currency risk, and sustainability - External debt estimated at 55.1 percent of GDP at end-2015. - Predominantly owned by the public sector: 61 percent of total. - Debt-to-exports ratio: 265 percent. - Currency risk elevated: - Half of external debt is denominated in dollar. - Stress test: - A 30 percent real depreciation would raise the debt-to-GDP ratio to over 80 percent. - Other risks: - Lower-than-expected GDP or export growth would deteriorate debt dynamics. - Tighter global financing liquidity and declining investor confidence could raise rollover vulnerabilities and costs. - Mitigating factors: - Low rollover risk with 83 percent of medium and long term debt. ### External financing and market access - Sri Lanka tapped international capital markets three times in 2015 despite domestic imbalances and tighter global conditions. - Bilateral and multilateral institutions (World Bank, ADB, JICA) renewed commitments to assist financing of investment needs, providing a cushion against private capital flight. - Risks: - Higher servicing costs from recent spread hikes. - Risk of losing access to international financial markets if the country’s rating is further downgraded. - Rating action: In end February, Fitch downgraded Sri Lanka’s rating from BB- to B+ and revised its outlook to negative. - Sri Lanka’s spread vis-a-vis the EMBI is about 600 bps—compared with 440 bps for emerging markets in general, and 270 bps for emerging Asian economies. ### Policy recommendations and program intentions - Rebalancing macroeconomic policies and structural reforms needed to contain balance of payments pressures and strengthen external sustainability. - Key policy directions: - Improve investor sentiment to contain capital outflows and attract foreign investment through government commitment to prudent macro policies. - Commit to exchange rate flexibility within a strengthened monetary policy framework to deal with short-term volatility. - Structural reforms to boost competitiveness and exports, including: - Ending the EU fishery import ban. - Regaining GSP plus status. - Pursuing bilateral trade agreements. - Reviewing weaknesses identified in the World Bank’s Doing Business index. - Deep structural reforms to improve competitiveness and restore eroding export profitability in the face of weak global demand and declining non-oil commodity prices. - Authorities’ program proposal (MEFP and EFF request): - Request for a 3-year Extended Arrangement under the Extended Fund Facility with access equivalent to SDR 1,070.78 million (185 percent of quota). - Program expectations: - Economic growth to come close to 5½ percent over the medium term. - Inflation to remain contained to low single digits. - International reserves to reach over 4 months of imports by the end of the program. - Structural reform agenda highlights: - Revenue administration and tax policy improvements to raise domestic revenues. - Public financial management reforms to strengthen budget planning and execution and eliminate arrears. - Restructuring state enterprises to reduce fiscal risk and economic distortions. - Reviewing and reforming the external tariff structure while pursuing trade agreements to support productivity and competitiveness. - Steps toward flexible inflation targeting and measures to deepen foreign exchange markets and a more flexible exchange rate regime. - Strengthening financial sector supervision and increasing the role of private credit and financial intermediation. *Source: IMF staff report and accompanying Memorandum of Economic and Financial Policies (May 12, 2016).* ### 1. The economic outlook is stable and underlying momentum and positive prospects ### 1. The economic outlook is stable and underlying momentum and positive prospects ### Economic outlook and external sector - Real GDP growth projection: improve to 5 percent in 2016 with sound macroeconomic policy and restoration of market confidence. - Inflation: moderated to 2.7 percent in February 2016. - Monetary readiness: "we stand ready to tighten monetary policy further should inflationary pressure emerge." - External sector: current account deficit projected to fall from 2.5 percent of GDP in 2015 to 1.5 percent in 2016, allowing for accumulation of international reserves by the central bank. - Downside/mitigating factors: tighter fiscal and monetary policies; measures to curb rapid increase in credit and imports seen in 2015. - Medium-term view: economic activity should be sustained near the estimate rate of potential (non-inflationary) growth, supported by human capital, infrastructure, strategic location, and expanding services (tourism, IT, accounting). ### Structural growth drivers and policy priorities - Identified needs to achieve high, inclusive, and sustained growth: - Stronger macroeconomic management. - Decisive strengthening of outward orientation. - Stronger role for the private sector and market forces. - Further investment in physical infrastructure and human capital. ### Key statistics and projections (exact figures) - Real GDP growth: 5 percent in 2016. - Inflation: 2.7 percent in February 2016; headline inflation expected to gradually increase to about 5 percent by end-2016. - Current account deficit: 2.5 percent of GDP in 2015 → 1.5 percent in 2016. --- ### FISCAL POLICY — objectives and targets - Main priority: durable reduction of the fiscal deficit and public debt through a growth-friendly emphasis on revenue generation. - Fiscal consolidation history: achieved over the last decade but skewed toward cutting expenditure amid secular decline in revenue. - Tax-to-GDP: described as "one of the lowest in the world" and below comparator countries (no numeric replacement provided). - Government deficit and primary balance targets: - Aim to reduce overall fiscal deficit to no more than 5.4 percent of GDP in 2016 (compared with a deficit of 6.9 percent in 2014). - Aim to bring the overall central government deficit down to at least 3.5 percent of GDP by 2020 (Prime Minister’s November 2015 speech). - Target primary balance to be achieved in 2017 and a primary surplus of 0.7 percent of GDP in 2018. - Increase in the tax to GDP ratio by about 1.2 percent of GDP annually in 2017−18. - Budget process and anchoring: - Annual budget proposals for 2017−19 will be in line with program targets (structural benchmark). - Fiscal consolidation beyond 2019 to be ensured through revision of the Financial Responsibility Act to include binding targets for government deficit and level of overall public debt. ### Fiscal policy instruments and measures - Emphasis on broadening the tax base and improving efficiency of collection rather than slashing expenditure. - Tax policy measures included in the 2016 fiscal framework: - VAT will continue to apply to wholesale and retail trade (at a lower threshold), extended to telecommunication and private health. - VAT rate increased to 15 percent; VAT rate will remain unified. - Initial plans to raise the NBT rate to 4 percent scaled back. - Thresholds for personal income tax to be maintained to capture sufficient portion of tax base. - Medium-term tax reform actions: - Cabinet suspended the Board of Investment Act to concentrate exemption powers in the Ministry of Finance. - Redraft the Inland Revenue Act to create new income tax legislation; submit draft act to Parliament by March 2017 (structural benchmark). - Conduct a diagnostic review of the VAT by June 2017 (structural benchmark). - Annual budgets to include a catalogue of tax expenditures and their cost (structural benchmark by December 2016). - Cabinet to adopt a time-bound strategy to reduce or eliminate tax expenditures by December 2016, as agreed with IMF staff (structural benchmark). --- ### TAX ADMINISTRATION AND PFM REFORMS - Tax administration reforms to complement tax policy: - Strengthen capacity for risk-based revenue administration. - Bolster public financial management, especially commitment control, financial planning and discipline. - Specific Inland Revenue Department (IRD) structural benchmarks and reforms: - Adoption by IRD of Key Performance Indicators (KPIs) on the number of risk-based VAT audits by September 2016 (structural benchmark). - Adoption by IRD of a VAT compliance strategy including time-bound plan to implement risk-based audits by September 2016 (structural benchmark). - Adoption by IRD of compliance strategies for corporate and personal income taxes by June 2017 (structural benchmark). - Full roll out of RAMIS by December 2016, including web-based tax filings (structural benchmark). - Organizational and business procedure reforms: restructure IRD along functional lines, create a design and monitoring unit, strengthen Large Taxpayer Unit, introduce mandatory e-filing, enhance use of taxpayer identification numbers. - Public financial management (PFM) commitments: - Identified outstanding obligations of the central government and SOEs totaling Rs 1.36 trillion. - Outstanding obligations of the central government totaling Rs 58 billion to be settled during 2016. - Obligations of 4 SOEs (CPC, CEB, Sri Lankan Airlines, Sri Lanka Port Authority) totaling Rs 1.2 trillion. - Commitment control system to be implemented by July 2016 based on a commitment record system with quarterly reports and quarterly expenditure commitment ceilings for 2016 and 2017 budgets (structural benchmark). - Introduction of ITMIS commitment control module completed for the Ministry of Finance by December 2016 and for the Ministry of Health by April 2017 (structural benchmarks); full roll-out to all ministries, agencies, and spending sub-units by end-2017. - MOF will begin publishing quarterly financial bulletins; budgets to cost out tax expenditures and adhere to GFSM standards; budgets to include analysis of fiscal risks including SOEs and PPPs. --- ### STATE ENTERPRISES — risks and reform actions - Overview: - More than 200 public enterprises; collectively represent a risk to public finances. - CPC and CEB incurred financial losses due to implicit energy subsidies; Sri Lankan Airlines incurs significant monthly losses. - Identified SOE obligations and resolution strategy: - Outstanding SOE obligations total Rs 1.2 trillion for 4 SOEs (CPC, CEB, Sri Lankan Airlines, Sri Lanka Port Authority). - Government will devise plans for each SOE to resolve and repay obligations through a resolution strategy for Sri Lankan Airlines, establishment of Statement of Corporate Intent, and reform of utility subsidies. - Near-term SOE reform elements and structural benchmarks: - Resolution strategy for Sri Lankan Airlines to be completed and approved by Cabinet by September 2016, effectively removing this company from the government’s accounts (structural benchmark). - Six largest SOEs (CPC, CEB, Sri Lankan Airlines, National Water Supply and Drainage Board, Airport and Aviation Services Limited, Sri Lanka Ports Authorities) to agree with MOF and relevant line ministry and publish a Statement of Corporate Intent (SCI) covering mission, multiyear corporate plan, capital expenditure and financing plans, explicit financial and non-financial targets, and description and cost of non-commercial obligations by December 2016 (structural benchmark). - Strengthen legal framework for governance and oversight of SOEs, including coherent financial regulations on governance, accountability, and funds management. - Utility subsidy and pricing reforms: - Implement a formula-based automatic pricing mechanism for petroleum products to reduce future CPC losses and avoid large retail price adjustments. - Enact legislative reforms to ensure Public Utilities Commission (PUC) has sole authority to set electricity tariffs in a cost-reflective manner. - Automatic fuel and electricity pricing mechanisms to ensure retail prices above cost-recovery levels and a financial position of CPC and CEB capable of covering debt service to be introduced by December 2016 (structural benchmark). - Extend strategy for water tariff settings when PUC starts regulating the water sector. - Government will record fiscal cost of non-commercial obligations (such as utility subsidies) for SOEs in the central government budget starting from the 2017 budget (structural benchmark by November 2016). --- ### MONETARY AND EXCHANGE RATE POLICY - Monetary policy objective: keeping inflation in the mid-single digits. - Recent monetary policy actions: - CBSL increased statutory reserve ratio of commercial banks from 6 percent to 7.5 percent in January 2016. - CBSL increased the standing deposit facility rate and lending facility rate by 50 basis points to 6.5 and 8 percent, respectively, in February 2016. - Inflation and policy stance: - Headline inflation expected to gradually increase to about 5 percent by end-2016, reflecting the VAT increase in May 2016, rupee depreciation, and anticipated increase in international food prices. - CBSL aims at maintaining headline inflation within a range of 3 percent from the projected path. - The CBSL "stands ready to further adjust its policy stance to achieve its inflation objective." - Monetary framework development: - Continue to improve liquidity management to avoid extended periods of excess liquidity and to maintain good control of interest rates. - Medium-term intention: gradually move toward a flexible inflation targeting framework. - First step: formulate and make public a well-articulated plan spelling out actions taken and milestones for moving gradually to a flexible inflation-targeting framework. - Plan components to address: - (i) legal framework, including central bank independence; - (ii) sound financial system to reduce conflict between monetary and financial stability objectives; - (iii) well developed technical infrastructure, including improved forecasting and modeling capabilities; - (iv) choice of targets and treatment of unanticipated shocks; - (v) policy decision making process. *Source: 1. The economic outlook is stable and underlying momentum and positive prospects (IMF country document).* ### 16. We aim to transition over the life of the program to a market-oriented approach to ### _cr16150 - 16. We aim to transition over the life of the program to a market-oriented approach to ### Exchange rate policy and prerequisites - Objective: transition over the life of the program to a market-oriented, more flexible exchange rate regime. - Rationale: past uneven flexibility reflected a thin foreign exchange market and desire to avoid currency turbulence spilling into inflation and external debt and debt service; at times of stress this led to delayed adjustment and loss of reserves. - Preconditions to be pursued: - (i) a deeper and more liquid foreign exchange market; - (ii) adequate systems to review and manage exchange rate risks; - (iii) a transparent intervention policy, consistent with a flexible inflation targeting framework. - Policy constraint during program: the CBSL and the Government will abstain from providing exchange guarantees for foreign currency borrowing. ### Reserve policy and contingency clause - Strengthening reserve coverage will be programmed, guided by the level of net reserves as a percentage of the ARA reserve metric, and supported by purchases under the Extended Arrangement. - Program clause: if the gap between supply and demand of foreign exchange results in a more sudden and disruptive depreciation of the exchange rate than anticipated, the authorities would consult with Fund staff on the appropriate policy response. ### External transactions and restrictions - During the program we will not: - impose or intensify restrictions on the making of payments and transfers for current international transactions; - introduce or modify multiple currency practices; - conclude bilateral payments agreements that are inconsistent with Article VIII; - impose or intensify import restrictions for balance of payments reasons. ### Policies to strengthen trade and investment - Medium-term objective: greater integration into regional and global supply chains, higher levels of FDI, and enhanced prospects for private sector investment. - Institutional steps already taken: - Establishment of a Development Agency (to prioritize infrastructure development); - Establishment of a Trade Agency (responsible for trade promotion and negotiation of trade and investment agreements). - Near-term development: The EU ban on fishery imports will be removed in the next few months, facilitating resumption of GSP plus trade status. - Reform actions planned: - Review of Sri Lanka’s trade regime, including evaluation of para-tariffs and other nontariff barriers that have led to high effective protection and hampered exports. - Negotiation of a Development Policy Credit with the World Bank aimed to: - increase efficiency of trade facilitation; - remove barriers to foreign investment entry and establishment (including access to land); - enhance access to finance; - strengthen financial market infrastructure. - Expected outcome: attract FDI and complement public investment. ### Risks and contingencies - Main risks identified: - (i) a slowdown in the economic recovery of key external trade partners and continued volatility in global financial markets; - (ii) weaker than projected revenues; - (iii) weaker than expected capital inflows, which would widen the projected financing gap given already substantial gross fiscal financing needs of close to 19 percent of GDP in 2016 ; - (iv) lower than expected growth and/or new pressures on the trade account; - (v) weaker than expected performance at state owned enterprises. - Potential consequence: these risks could further challenge public debt sustainability. - Response: should such risks materialize, the government stands ready to adjust promptly its policies, in close consultation with IMF staff, to ensure the achievement of a sustainable external position at the end of the program. ### Program monitoring and review schedule - Semiannual reviews with performance criteria and indicative targets set out in Table 1 attached to the MEFP and the TMU. - Completion of the first and second reviews requires observance of quantitative performance criteria for end-June 2016 and end-December 2016, respectively, and continuous performance criteria. - Reviews will also assess progress toward observance of the structural benchmarks specified in Table 2 attached to the MEFP. - Review dates: - First review: on or after November 20, 2016; - Second review: on or after April 20, 2017. ### Key quantitative performance criteria and indicative targets (as presented) - Central government primary balance (floor, cumulative from the beginning of the year, in billion rupees): - Dec. 2015 Act: -241 - Mar. 2016 Est./PC/IT: -26 - Jun. 2016 PC/IT: -46 - Sep. 2016 PC/IT: -85 - Dec. 2016 PC/IT: -97 - Dec. 2017 PC/IT: -3 - Net official international reserves (floor, cumulative change from the beginning of the year, in million US$) 1/ 2/: - Dec. 2015 Act: -1,489 - Mar. 2016 Est.: -720 - Jun. 2016 PC/IT: 390 - Sep. 2016 PC/IT: 330 - Dec. 2016 PC/IT: 671 - Dec. 2017 PC/IT: 1,343 - Continuous performance criteria: - New external payment arrears by the nonfinancial public sector and the CBSL (ceiling, in million US$): 0 at all listed test dates. - Monetary policy consultation clause and year-on-year inflation in Colombo Consumers Price Index (in percent) bands and actual/center point: - Outer band (upper limit): 6.4, 7.5, 8.2, 8.1 - Inner band (upper limit): 4.9, 6.0, 6.7, 6.6 - Actual / Center point: 2.5, 1.9, 3.4, 4.5, 5.2, 5.1 - Inner band (lower limit): 1.9, 3.0, 3.7, 3.6 - Outer band (lower limit): 0.4, 1.5, 2.2, 2.1 - Indicative targets: - Central government tax revenue (floor, cumulative from the beginning of the year, in billion rupees): - Dec. 2015: 1,356 - Mar. 2016: 325 - Jun. 2016: 652 - Sep. 2016: 1,021 - Dec. 2016: 1,428 - Dec. 2017: 1,721 - Reserve money of the CBSL (ceiling, end of period stock, in billion rupees): - Dec. 2015: 673 - Mar. 2016: 792 - Jun. 2016: 791 - Sep. 2016: 794 - Dec. 2016: 797 - Dec. 2017: 893 - Memorandum items (selected): - Foreign program financing by the central government assumed under the program (cumulative from the beginning of the year, in million US$) 1/: - Dec. 2015: 0 - Mar. 2016: 0 - Jun. 2016: 0 - Sep. 2016: 200 - Dec. 2016: 325 - Dec. 2017: 200 - Cumulative net change in foreign holdings of Treasury Bills, Treasury Bonds, and SLDBs (in million US$) 1/: - Dec. 2015: -903 - Mar. 2016: -560 - Jun. 2016: -842 - Sep. 2016: -1,124 - Dec. 2016: -1,407 - Dec. 2017: 100 - External commercial loans (including Eurobonds and syndicated loans) by central government assumed under the program (cumulative from the beginning of the year, in million US$) 1/: - Dec. 2015: 1,650 - Mar. 2016: 0 - Jun. 2016: 2,000 - Sep. 2016: 2,000 - Dec. 2016: 2,000 - Dec. 2017: 300 - Amortization of official external debt by the central government assumed under the program (cumulative from the beginning of the year, in million US$) 2/: - Dec. 2015: 798 - Mar. 2016: 238 - Jun. 2016: 475 - Sep. 2016: 713 - Dec. 2016: 950 - Dec. 2017: 1,070 - Net official international reserves (end of period stock, in millions of US$): - Dec. 2015: 5,029 - Mar. 2016: 4,309 - Jun. 2016: 5,419 - Sep. 2016: 5,359 - Dec. 2016: 5,700 - Dec. 2017: 7,043 - Adjustor rules noted: - If amounts of foreign program financing, changes in foreign holdings of government instruments, or external commercial loans differ in U.S. dollar terms from program assumptions, the floor on net official international reserves will be adjusted upward/downward by the cumulative differences on the test date. - If amortization of official external debt in U.S. dollar terms is higher/lower than assumed, the floor on net official international reserves will be adjusted downward/upward by the cumulative differences on the test date. ### Structural benchmarks and prior actions (selected) - Prior actions [Met] (examples): - Cabinet to issue a Memorandum requiring the Ministry of Finance to complete by end-October 2016 a time-bound strategy to address outstanding arrears of the central government and obligations of state enterprises, including: (i) completion (by end-2016) of a comprehensive database of SOE’s financial obligations certified by the Auditor General; (ii) clarification of government responsibility over existing obligations related to subsidies and other non-commercial obligations of the SOEs. - Ministry of Finance to issue circulars to implement tax policy and other revenue measures outlined in the Cabinet Memorandum of March 4, 2016; and detail revised expenditure ceilings for government ministries and agencies consistent with the overall budget deficit target for 2016. - Cabinet to adopt a framework note for a new Inland Revenue Act (Prior action [Met]). - Formally suspend by Cabinet order the Board of Investment's capacity to grant tax exemptions, tax holidays, and special tax rates until the BOI Act can be amended (Prior action [Met]). - Structural benchmarks (dates and status listed in Table 2) include: - Submit to Parliament the 2017 budget in line with program targets: November 2016. - Submit to Parliament the 2018 budget in line with program targets: November 2017. - Submit to Parliament the 2019 budget in line with program targets: November 2018. - Publish a tax expenditure statement as part of the official government budget: December 2016. - Approve by cabinet a time-bound strategy to reduce or eliminate tax expenditures: December 2016. - Submit to Parliament a new Inland Revenue Act to simplify and broad-base the income tax: March 2017. - Complete by MOF a diagnostic review of the VAT system: June 2017. - Tax administration and IT benchmarks, PFM commitment record and ITMIS roll-outs, and a set of state enterprise reform actions (dates ranging from July 2016 to December 2016) are specified in Table 2. ### Technical Memorandum of Understanding (TMU) highlights - TMU establishes monitoring framework for the EFF-supported program; first review on or after November 20, 2016, second on or after April 20, 2017. - Quantitative performance criteria and indicative targets listed in Table 1: - central government primary balance (floor); - net official international reserves (floor); - continuous criterion on new external payment arrears by the nonfinancial public sector and the CBSL (ceiling); - monetary policy consultation clause; - indicative target on central government tax revenue (floor); - indicative target on reserve money of the CBSL (ceiling). - Definitions and scope: - Central government includes line ministries, departments, and other public institutions; excludes CBSL, state-owned enterprises, parastatals and other agencies that do not receive subventions from the central government. - Debt defined in accordance with paragraph 8 of the Guidelines on Public Debt Conditionality in Fund Arrangements attached to Executive Board Decision No. 15688-(14/107), adopted December 5, 2014. ### Measurement of key performance criteria (extracts) - Central government primary balance (cash basis) definition: central government revenues and grants minus expenditures and net lending, plus interest payments; spending recorded when cash disbursed. - For program monitoring primary balance measured as overall balance of the central government plus interest payment. - 2015 example: primary balance was Rs –241 billion (overall balance Rs –768 billion; interest payment Rs 527 billion). - Components of financing in 2015: net borrowings from Treasury Bills, Treasury Bonds, and Rupee Loans Rs 257.6 billion; SLDBs and commercial borrowings Rs 455.7 billion; project and program loans Rs 69.7 billion (after adjustment); net increases in non-market borrowings etc. Rs –10.1 billion; net decreases in central government deposit Rs –4.4 billion; net borrowings from other bonds/loans Rs –0.5 billion. - Adjustment rule for project loan disbursements: - If gross cash disbursement of project loans in 2016 > US$1.5 billion, the floor on the primary balance for end-December 2016 will be adjusted downward by the difference (converted to Rupees using exchange rates in Table 1), capped at Rs 20 billion. - If gross cash disbursement of project loans in 2016 < US$1.5 billion, no adjustment to the primary balance floor for end-December 2016. - Net Official International Reserves (NIR) definition and scope: - NIR = gross foreign assets minus gross foreign liabilities of the CBSL, plus balance of the State Treasury’s Special Dollar, Japanese Yen, and Chinese Yuan Revolving accounts, all in market values. - Gross foreign assets components include monetary gold; foreign exchange balances held outside Sri Lanka; foreign securities (market prices); foreign bills purchased and discounted; reserve position at the IMF and SDR holdings; Crown Agent’s credit balance. Foreign exchange balances, securities, and bills denominated in Chinese Yuan included. - Exclusions from gross foreign assets: participation in international financial institutions; holdings of nonconvertible currencies; holdings of precious metals other than monetary gold; claims on residents; pledged/non-liquid/encumbered foreign assets; claims arising from derivative transactions. - Gross foreign liabilities: all foreign currency denominated liabilities of the CBSL to non-residents; use of Fund credit; Asian Clearing Union debit balance; commitments to sell foreign exchange from derivatives. - DST accounts are foreign currency accounts held by the Treasury and managed by the CBSL as agent of the government. - End-December 2015 NIR (defined in this manner): US$ 5,028.8 million. *Source: _cr16150* ### 8. For the purpose of the program, all foreign-currency related assets and liabilities will be ### 8. For the purpose of the program, all foreign-currency related assets and liabilities will be converted into U.S. dollar terms at the exchange rates prevailed on April 29, 2016 ### Conversion and valuation rules - All foreign-currency related assets and liabilities will be converted into U.S. dollar terms at the exchange rates prevailed on April 29, 2016, as specified in Table 1. - Monetary gold will be valued at US$1,274.1 per troy ounce, which was the price prevailed on April 29, 2016. ### Table 1 — Exchange rates (Rates as of April 29, 2016) - Sri Lankan Rupee per U.S. dollar: 143.900 - Sri Lankan Rupee per British pound: 210.698 - Sri Lankan Rupee per Japanese yen: 1.341 - Sri Lankan Rupee per Canadian dollar: 114.776 - Sri Lankan Rupee per Euro: 163.801 - Sri Lankan Rupee per Chinese yuan: 22.229 - Sri Lankan Rupee per SDR: 203.954 - Source: CBSL and IMF. ### Adjustment mechanisms for Net International Reserves (NIR) - If (i) the amount of foreign program financing by the central government, (ii) the cumulative net change in the amount of foreign holdings of Treasury Bills, Treasury Bonds, and SLDBs, and (iii) the amount of external commercial loans (including international sovereign bonds and syndicated loans) by the central government—as set out in Table 2—are higher/lower in U.S. dollar terms than assumed under the program, the floor on NIR will be adjusted upward/downward by the cumulative differences on the test date. - If the amount of amortization of official external debt by the central government in U.S. dollar terms—as set out in Table 2—is higher/lower than assumed under the program, the floor on the NIR will be adjusted downward/upward by the cumulative differences on the test date. - Official external debt refers to external debt owed to multilateral and official bilateral creditors, as defined in the 2013 External Debt Statistics: Guide for Compilers and Users. ### Table 2 — Program assumptions (cumulative from the beginning of the year, in million US$) - Calendar columns: Dec. 2015 | Mar. 2016 | Jun. 2016 | Sep. 2016 | Dec. 2016 | Dec. 2017 - Foreign program financing by the central government: 000 | 200 | 325 | 200 | (blank) | (blank) - Cumulative net change in the amount of foreign holdings of Treasury Bills, Treasury Bonds, and SLDBs: -903 | -560 | -842 | -1,124 | -1,407 | 100 - External commercial loans (including Eurobonds and syndicated loans) by the central government: 1,650 | 0 | 2,000 | 2,000 | 2,000 | 300 - Amortization of official external debt by the central government: 798 | 238 | 475 | 713 | 950 | 1,070 ### Continuous performance criterion on external payment arrears - A continuous performance criterion applies to the non accumulation of new external payments arrears on external debt contracted or guaranteed by the nonfinancial public sector and the CBSL. - Definition and scope: - The nonfinancial public sector is defined following the 2001 Government Financial Statistics Manual and the 1993 System of National Accounts. It includes (but is not limited to) the central government as defined in ¶3 and nonfinancial public enterprises, i.e., boards, enterprises, and agencies in which the government holds a controlling stake. - External payments arrears consist of debt-service obligations (principal and interest) to nonresidents that have not been paid at the time they are due, as specified in the contractual agreements, subject to any applicable grace period. - Overdue debt and debt service obligations that are in dispute will not be considered as external payments arrears for the purposes of program monitoring. ### Monetary policy consultation clause — inflation measurement and consultations - Inflation target bands around the projected 12-month rate of inflation in consumer prices, as measured by the headline Colombo Consumers Price Index (CCPI) published by the Department of Census and Statistics of Sri Lanka, are specified in Table 1 attached to the MEFP. - Year-on-year inflation for each test date is measured as: - { CCPI*(t) – CCPI*(t-12) } / CCPI*(t-12) - where t = the month within which the test date is included - CCPI(t) = CCPI index (all items) for month t - CCPI(t-k) = CCPI index (all items) as of k months before t - CCPI*(t) = { CCPI(t-2) + CCPI(t-1) + CCPI(t) } / 3 - CCPI*(t-12) = { CCPI(t-14) + CCPI(t-13) + CCPI(t-12) } / 3 - Consultation triggers: - If observed year-on-year inflation for the test date of end-June 2016 or end-December 2016 falls outside the outer bands specified in Table 1 attached to the MEFP, the authorities will complete a consultation with the IMF Executive Board focusing on: (i) the stance of monetary policy and whether the Fund-supported program remains on track; (ii) the reasons for the deviation; and (iii) proposed policy response. When this consultation is triggered, access to Fund resources would be interrupted until the consultation takes place and the relevant program review is completed. - If observed year-on-year inflation falls outside the inner bands specified in Table 1 attached to the MEFP for the test date of end-June 2016, end-September 2016, or end-December 2016, the authorities will complete a consultation with IMF staff on the reasons for the deviation and the proposed policy response. ### Indicative targets - Indicative target on central government tax revenue: - Central government tax revenue refers to revenues from taxes collected by the central government. It excludes all revenues from asset sales, grants, and non tax revenues. - The revenue target is calculated as the cumulative flow from the beginning of the year. - For 2015, central government tax revenue defined in this manner was Rs. 1,356 billion. - Indicative target on reserve money of the CBSL: - Reserve money of the CBSL consists of currency in circulation (with banks and with the rest of the public), financial institutions’ domestic currency deposits at the CBSL, and the deposits of the following government agencies: the National Defence Fund (General Ledger Acc. No. 4278), the Buddha Sasana Fund A/C (General Ledger Acc. No. 4279); and the Road Maintenance Trust Fund (General Ledger Acc. No. 4281). - At end-December 2015, reserve money defined in this manner stood at Rs. 673.4 billion. - Adjustment: If any bank fails to meet its legal reserve requirement, the ceiling on reserve money will be adjusted downward to the extent of any shortfall in compliance with the requirement. - Formula for changes in required reserve regulations: - ΔM = ΔB0 r0 + B0 Δr + ΔB r0 (expressed in the source as: BrBrrBM with variable definitions) - where ΔM denotes the change in reserve money, - r0 denotes the reserve requirement ratio prior to any change; - B0 denotes the reservable base in the period prior to any change; - Δr is the change in the reserve requirement ratio; and - ΔB denotes the immediate change in the reservable base as a result of changes to its definition. ### Data reporting requirements and timelines - Sri Lanka shall provide the Fund, through reports at intervals or dates requested by the Fund, with such information as the Fund requests in connection with progress in achieving the objectives and policies set forth in the Memorandum of Economic and Financial Policies. All the program monitoring data will be provided by the Ministry of Finance and the CBSL. - Reporting formats: - Fiscal performance monitoring: data will be provided in the format shown in Tables 3 and 4. - Monetary targets monitoring: data will be provided in the format shown in Table 5. - External sector performance monitoring: data will be provided in the format shown in Tables 6 and 7. - Timeliness: - Data relating to the fiscal targets (Table 3 and Table 4) will be furnished within no more than five weeks after the end of each month, except: - Data on salaries and wages, goods and services, subsidies and transfers (and its subcomponents) will be furnished within no more than seven weeks after the end of each month. - Data on total recurrent expenditure and interest payments will be furnished within no more than five weeks after the end of each month. - Data relating to the external and monetary targets (Tables 5, Table 6, and Table 7) will be furnished within no more than three weeks after the end of each month. ### Tables and monitoring templates (descriptive headings) - Table 3: Sri Lanka: Central Government Operations 1/ (In millions of rupees) — includes line items such as Total Revenue & Grants, Total Revenue, Tax revenue, Income Tax (Personal & Corporate; Corporate & non-corporate), PAYE, Economic Service Charge, Tax on interest income, Taxes on goods & services (VAT, Excise Taxation with subitems Liquor, Cigarettes, Motor vehicles, Petroleum, Other), Other Taxes & Levies (NBT, Stamp duties, Telecommunication Levy, Motor vehicles Taxes & Other, Sales tax, Debit tax, Telephone Subscriber Levy, National Security Levy, Tax on treasury bills), Taxes on External Trade (Imports, Cess, Special Commodity Levy, PAL), Non-Tax Revenue (Property income, Fines, Fees & Charges, Other), Grants, Total Expenditure, Recurrent Expenditure, Salaries & wages, Goods & Services, Interest Payments, Subsidies & Transfers (Public Corporations, Public Institutions, Households), Capital Expenditure, Net lending, Primary Balance, Overall balance, Total Financing, Total Foreign Financing (Net), Total Domestic Financing (Net), Privatization. - Table 4: Sri Lanka: Central Government Financing 1/ (In millions of rupees) — includes sections 1. Domestic instrument borrowings (T-Bills (net), T-Bonds, Rupee Loans, Other); 2. Domestic non-instrumental borrowings (Sri Lankan Development Bonds (SLDB), Non market borrowings, CBSL advances, Government deposit at CBSL, Government import bills, Cash items in process of collection (CIPC), Overdraft to government, Short term loans, Deposit with commercial banks, Oversee Banking Units, Other); 3. Net foreign financing (Net T-Bill purchase by nonresidents, Net T-Bond purchase by nonresidents, International sovereign bonds, Project loans, Other); Total financing (1+2+3); Memorandum items for T-Bonds, SLDBs, ISBs, Project loans with Gross borrowings, Repayments, Net borrowings. - Table 5: Sri Lanka: Balance Sheet of the Central Bank of Sri Lanka 1/ (In millions of rupees) — includes Net foreign assets (Foreign assets: Cash and balances abroad, Foreign securities, Claims on ACU, IMF Related Assets, SDRs, RR on FCDs of banks, Receivables (Accrued Interest), Derivative Financial Instruments; Foreign liabilities: IMF & nonresident a/c, SDRs, Liabilities to ACU, Payables, Derivative Financial Instruments), Net domestic assets (Claims on Government: Advances, Treasury bills & Treasury Bonds, Treasury Bonds, Cash items in collection, Government deposits; Claims on commercial banks: Medium and long-term, Short-term; Other assets (net)), Reserve money (Currency in circulation, Commercial bank deposits, Government agencies deposits). - Table 6: Sri Lanka: Foreign Exchange Cashflows of the Central Bank and the Government 1/ (In millions of U.S. dollars) — includes 1. Total inflows (Loans: Program, IMF, Project (cash component only), Commercial borrowing (incl. new and rolled over SLDBs); Interest earnings, forex trading profits, cap gains; Purchases of foreign exchange; Change in balances in DST's A/Cs; Other inflows; Borrowing from SLDBs; Loans from FCBUs; Syndicated Loans; International Swaps/Commercial Loans/Sovereign Bonds; OMO FX swap transactions), 2. Total outflows (Public Debt Service Payments: Amortization, Principal (foreign loans), Settlement SLDBs, Settlement FCBU, Settlement of syndicated loans; Interest: Foreign loans, Domestic foreign currency loans, SWAP/Loan interest, ISB interest; Payments to the IMF/ change in valuation of liabilities; Foreign exchange sales to commercial banks; OMO FX swap transactions), 3. SWAP (Inflow, Outflow Including Interest), 3. Net flow at current rates (1-2), Net International Reserves, Gross International Reserves. - Table 7: Sri Lanka: Gross Official Reserve Position 1/ (In millions of U.S. dollars) — includes Government Liabilities, Central Bank Gross Official Reserves, Net International Reserves, Overall balance (with ACU & SWAP & without DA), Other Deposits, Asian Clearing Union, Drawings from the IMF, International Currency Swap, Total, Reserves managed by IOD, Reserve Position at I.M.F. & SDR holdings, Crown Agent's Credit Balance, DST's Special Dollar Revolving Cr.balance, DST's Yen Accounts (without ACU & DA & with Swap), Foreign Assets (FA) (with ACU & Without DA), Domestic Assets (DA) (BOC & PB). *Source: Excerpt from the IMF staff report and MEFP materials contained in the provided content.* ### 1. In the Country Partnership Strategy (CPS) for FY13–16, the World Bank Group supported ### 1. In the Country Partnership Strategy (CPS) for FY13–16, the World Bank Group supported ### CPS objectives and mid-course update - CPS FY13-16 focused on: - (i) facilitating sustained private and public investment; - (ii) supporting structural shifts in the economy; and - (iii) improving living standards and social inclusion. - A CPS Progress Report prepared in FY 14: - Proposed inclusion of a fourth strategic area: increasing resilience to disasters and climate change. - Emphasized creating an enabling environment for increased foreign and domestic investment as Sri Lanka transitioned to a middle-income trajectory. - Highlighted need for renewed efforts to better target the poor due to continued pockets of poverty. ### Systematic Country Diagnostic (SCD, 2015) — priority constraints and cross-cutting challenge - SCD identified priority areas: - (i) fiscal sustainability; - (ii) enhancing competitiveness and promoting more and better jobs for the bottom 40 percent; - (iii) providing for social inclusion for disadvantaged segments of the population; and - (iv) longer term sustainability (especially of the environment, political stability, and an aging population). - Governance was identified as a cross-cutting challenge. ### Country Partnership Framework (2017–2020) pillars and IFC/MIGA priorities - Three major pillars: - Pillar one: improve macroeconomic stability and competitiveness. - Pillar two: promote inclusion and opportunities. - Pillar three: enhance resilience and management of natural assets. - IFC priorities: - sustainable infrastructure (through PPPs), financial inclusion, and access to input/output markets, products, services and jobs. - MIGA: - will, where possible, support foreign investment projects across sectors. ### World Bank support to macro-critical areas and planned operations - Development Policy Financing (DPF): - Preparing a DPF operation to support long-term competitiveness through a first package of reforms to eliminate obstacles to private sector competitiveness, enhance transparency and public sector management and improve fiscal sustainability. - Actions supported by the proposed DPF represent an initial set of reforms expected to be part of a longer-term policy reform package. - Bank anticipates extensive implementation support, some to be carried out jointly with the Fund. - Ongoing Bank support includes: - Support to increase competitiveness and FDI attraction, to develop a Public Finance Bill and implementation strategy, and to strengthen the public debt management framework and analytical capacity. - Ongoing support for statistical capacity building to better measure poverty and to update the national poverty line, and updating analysis of the distributional impact of tax and expenditure. ### Active World Bank portfolio (summary) - Current active World Bank portfolio: - 12 projects (10 IDA and two IBRD operations) with a total net commitment value of $1.48 billion. - Human development accounts for 33 percent of the overall portfolio. - Urban development accounts for 24 percent. - Water accounts for 21 percent. - Resilience to climate and disaster risk accounts for 14 percent. - Portfolio comprises six recipient-executed trust funds with a total net commitment value of $54.4 million. - Project-level commitments (as presented): - Dam Safety & Water Resource Planning — Board Approval 03/27/2008 — Closing Date 05/15/2018 — Net Comm. Amt ($mil) 148.3 - Improving Climate Resilience — Board Approval 04/22/2014 — Closing Date 05/30/2019 — Net Comm. Amt ($mil) 152.0 - Catastrophe DDO — Board Approval 04/22/2014 — Closing Date 05/31/2017 — Net Comm. Amt ($mil) 102.0 - N&E Local Services Improvement — Board Approval 05/13/2010 — Closing Date 12/31/2016 — Net Comm. Amt ($mil) 70.0 - Metro Colombo Urban Development — Board Approval 03/15/2012 — Closing Date 12/31/2017 — Net Comm. Amt ($mil) 213.0 - Sri Lanka Strategic Cities Development — Board Approval 05/05/2014 — Closing Date 12/31/2019 — Net Comm. Amt ($mil) 147.0 - Higher Education for 21st Century — Board Approval 05/13/2010 — Closing Date 06/30/2016 — Net Comm. Amt ($mil) 40.0 - Transforming School Education — Board Approval 11/29/2011 — Closing Date 06/30/2017 — Net Comm. Amt ($mil) 100.0 - Second Health Sector Development — Board Approval 03/27/2013 — Closing Date 09/30/2018 — Net Comm. Amt ($mil) 200.0 - Skills Development Project — Board Approval 06/20/2014 — Closing Date 12/31/2019 — Net Comm. Amt ($mil) 101.5 - LK Water supply and Sanitation Project — Board Approval 06/24/2015 — Closing Date 12/31/2020 — Net Comm. Amt ($mil) 165.0 - Early Childhood Development Project — Board Approval 06/24/2015 — Closing Date 06/30/2021 — Net Comm. Amt ($mil) 50.0 ### Relations with the Asian Development Bank (ADB) — strategy and resources - ADB Interim Country Partnership Strategy (ICPS, 2016–2017) (approved in 2015) priority sectors: - agriculture, natural resources, rural development, transport, energy, water supply and wastewater management, irrigation, and education. - Indicative Resources for 2016-2018: - $741.78 million from ordinary capital resources (OCR). - $468.99 million from the Asian Development Fund (ADF). - Indicative pipeline (2016–18) priorities: - human resource development, rural road connectivity, rural electrification, expressway and railways, SME and agriculture assistance, thematic priorities including gender, governance, climate change, and regional cooperation. - Select ADB project and program intentions: - Expressway Connectivity Investment Program (MFF) for 2017 with priority highways: - (i) elevated highway from Kelani Bridge to Colombo Port (port access road); - (ii) highway from Meerigama to Kurunegala (central highway). - Electricity Supply Reliability Improvement Project to support achieving 100% electrification (currently 98%) and provide electricity to more than 17,500 rural households, including in the Northern and Eastern provinces. - TA loan for Preparing the Power Development and Interconnection Project to support connectivity and power trade between Sri Lanka and India. - Wind Power Generation Project proposed to develop renewable energy potential and ensure energy security; PPP approach to be explored. - Urban and water sector additional financing and projects for Jaffna Kilinochchi Water Supply (including desalination), Greater Colombo Wastewater Management, and Local Government Enhancement Sector Project (additional financing) with CKD-affected area works. - SME Credit Line with auction pricing mechanism and attached TA for export-oriented cluster enabling environment. - Capital Market Development Program Loan proposed for 2016 to combine policy reforms with ICT investments and TA. - Transaction Advisory Service mandate (signed February 2016) for East Container Terminal of Colombo Port; projected capacity 2.4 million TEUs once project is complete. ### ADB approvals, portfolio and sector distribution (select figures) - Projects approved in 2015: - ADB approved 3 new sovereign projects for a total of $478 million and 1 new non-sovereign loan facility of $100 million. - Greater Colombo Water and Wastewater Management Improvement Investment Program (tranche 3): $123 million from OCR and $5 million from ADF. - Mahaweli Water Security Investment Program (tranche 1): $76 million from OCR and $74 million from ADF. - Integrated Road Investment Program (tranche 3): $175 million from OCR and $25 million from ADF. - Lanka Orix Leasing Finance Company PLC and Lanka Orix Leasing Company Micro Credit Limited: ADB loan up to $55 million and B loan up to $45 million. - As of 31 December 2015: - ADB cumulative lending to Sri Lanka: $6.97 billion. - Grant assistance: $358 million (including ADB-administered co-financed grants). - Technical assistance: $130 million through 280 technical assistance grants. - Current portfolio: 53 ongoing loans and grants for 28 projects with a net loan amount of $2.9 billion. - Cumulative contract awards: $1.7 billion. - Disbursements: $1.3_billion - Sectoral distribution of ongoing loan portfolio (Figure 1): - Transport, 30% - Urban & Water, 27% - Energy, 19% - Education, 13% - Agriculture and Natural Resources, 5% - Multisector, 5% - Finance, 1% ### Statistical Issues Appendix — data adequacy, standards, and reporting - General: - Macroeconomic statistics are broadly adequate for surveillance but weaknesses remain in timeliness and coverage of certain series. - National Accounts: - In 2015, Department of Census and Statistics (DCS) released a comprehensive revision of the national accounts: - change of base year from 2002 to 2010; - expanded coverage for the service sector; - several improvements in compilation methods. - DCS updated quarterly national accounts methodology and began publishing quarterly estimates in 2015, based on quarterly indicators for most economic activities. - GDP data by expenditure are only available on an annual basis and rely mostly on commodity flow methods. - Price Statistics: - DCS released a new national Consumer Price Index (CPI) and Producer Price Index (PPI) during 2015. - National CPI is based on weights from the 2012/13 Household Income and Expenditure Survey. - Monthly PPI is currently disseminated on a quarterly basis, with goal of monthly release by end of 2016. - Core inflation index compiled from Colombo CPI by excluding some food items, energy and transportation services. - Central Bank of Sri Lanka (CBSL) produces a Wholesale Price Index (WPI) based on old weights (from 1974). - Government Finance Statistics: - April 2015 STA mission in context of Japan-funded IMF project on implementing GFSM 2001 and its update (GFSM 2014). - Authorities incorporated Chart of Accounts aligned with GFSM2014 into the new IFMIS system. - Steps underway to integrate fiscal data of extra-budgetary central government, local government and social security funds into annual general government GFS reporting. - Sri Lankan authorities report budgetary central government debt data to the Public Sector Debt Statistics database on a quarterly basis. - Monetary and Financial Statistics: - Monetary data for the central bank and other depository corporations (ODCs) are submitted in a highly summarized format with limitations in classification of financial instruments and sectorization. - January 2015 STA mission started introduction of standardized report forms (SRFs) for central bank and ODCs; follow-up mission tentatively scheduled for July 2016 to complete introduction. - Authorities report 11 core and nine encouraged financial soundness indicators (FSIs) for deposit takers and two FSIs on real estate markets to STA. - External Sector Statistics: - Since 2014, CBSL reports to STA its International Investment Position (IIP) and balance of payments statistics (BOP) on a quarterly basis following BPM6. - May 2015 TA mission observed commendable progress and remarkable improvement in data quality. - Data standards and quality: - Sri Lanka graduated to the Special Data Dissemination Standards (SDDS) in November 2015. - A data ROSC mission visited Sri Lanka in 2001 and prepared a comprehensive report on quality of statistics. - Reporting to STA: - Authorities report key data to the Fund on a timely basis. - Annual cash government finance data reported for publication in the GFS Yearbook cover only budgetary accounts of central government; no data on extrabudgetary funds or provincial and local governments are reported. - No sub-annual government finance data are reported for publication in IFS; authorities encouraged to reduce reporting lag. ### Table of Common Indicators Required for Surveillance (selected metadata) - As of March 23, 2016 — sample entries: - Exchange rates — Date of Latest Observation: Today — Date Received: Today — Frequency of Data: D — Frequency of Reporting: D — Frequency of Publication: D - International reserve assets and reserve liabilities of the Monetary Authorities — Date of Latest Observation: 10/2015 — Date Received: 2/2016 — Frequency of Data: D — Frequency of Reporting: D — Frequency of Publication: D - Consumer price index (New Colombo CPI) — Date of Latest Observation: 1/2016 — Date Received: 3/2016 — Frequency of Data: M — Frequency of Reporting: M — Frequency of Publication: M - External current account balance — Date of Latest Observation: 2015Q3 — Date Received: 1/2016 — Frequency of Data: Q — Frequency of Reporting: Q — Frequency of Publication: Q - GDP/GNP — Date of Latest Observation: 2014Q3 — Date Received: 12/2014 — Frequency of Data: Q — Frequency of Reporting: Q — Frequency of Publication: Q - International Investment Position — Date of Latest Observation: 2015Q3 — Date Received: 1/2016 — Frequency of Data: Q — Frequency of Reporting: Q — Frequency of Publication: Q *Source: World Bank / Asian Development Bank / Department of Census and Statistics / Central Bank of Sri Lanka (as presented in the supplied content).* ### 20. It does not alter the thrust of the staff appraisal. ### _cr16150 - 20. It does not alter the thrust of the staff appraisal. ### Natural disaster (mid-May flooding and landslides) - Heavy rains since mid-May triggered flooding and landslides in multiple regions including Colombo district. - As of May 29, 294,000 people were estimated to have been affected (about 1.4 percent of population), with Colombo accounting for two thirds of this total. - 105 deaths confirmed; 116 people remain missing. - About 4,500 houses have been damaged. - Government intensified rescue and rehabilitation efforts with international community support. - The economic damage of the flooding has yet to be fully estimated. ### Data update (inflation, fiscal) - Headline inflation rose to 4.8 percent in May from 3.1 percent in April, largely due to increases in health and communication prices and the impact of the increase in the VAT rate from 11 to 15 percent. - Core inflation rose to 6.6 percent; there is some upside risk given recent flooding. - Preliminary fiscal data (January–April): central government recorded an overall deficit of Rs 233 billion (1.9 percent of annual GDP) and a primary deficit of Rs 37 billion (0.3 percent of annual GDP). ### Monetary policy and foreign exchange management (May 2016) - Monetary Board of the CBSL decided to maintain the current monetary policy stance and keep policy rates unchanged at its 20 May 2016 meeting. - CBSL net foreign exchange purchases of US$78 million in first 30 days of May—breaking a 20-month pattern of net FX sales. - Rupee remained broadly stable: spot and 3-month forward rates depreciated 1.3 percent and 1.9 percent, respectively, since end-April. ### Statement overview (Executive Directors on Sri Lanka; Executive Board Meeting June 3, 2016) - Authorities expressed appreciation for Fund staff discussions during 1-5 February, 2016; 31 March - 11 April, 2016; and Spring Meetings in Washington D.C. - Request for a Three-Year Extended Arrangement under the EFF amounting to USD 1.5 billion (equivalent to185 per cent of Sri Lanka’s quota). - EFF-supported program expected to correct underlying fiscal and external imbalances by improving fiscal sustainability and rebuilding foreign exchange reserves while facilitating sustained and inclusive economic growth. ### Economic growth and outlook - 2010–2015 average real GDP growth: 6.4 per cent. - 2015 economy grew 4.8 per cent (2014: 4.9 per cent). - Inflation maintained at single digit levels throughout 2010–2015. - 2015 performance affected by decline in commodity prices, slowdown in export demand and capital outflows, deterioration in fiscal accounts, and election-related uncertainties. - Authorities expect: - Growth around 5 per cent during 2016. - Growth around 6 - 7 per cent annually in the medium term. - Drivers for projected growth: improved fiscal consolidation, appropriate monetary policy, recovery in construction, sustained services momentum (tourism, transport, communication, IT), gradual global recovery. ### Recent devastating natural disaster (mid-May 2016 floods and landslides — authorities’ figures) - Nearly half a million people affected; large numbers in state-run relief camps. - Death toll from landslides: 101; about 125 people reported missing. - Over 200,000 displaced. - Close to 30,000 houses completely destroyed; around 128,000 houses partially damaged. - Total additional cost due to floods estimated at around USD 2.0 billion. - Short-run upward pressure on inflation likely due to destruction of agricultural crops. - Significant burden to government budget for immediate relief, rebuilding houses, livelihoods, and restoring public amenities. ### Fiscal policy: 2015 performance and medium-term objectives - 2015 overall budget deficit: 7.4 per cent of GDP (2014: 5.7 per cent; interim budget target for 2015: 4.4 per cent). - Debt to GDP ratio: 76 per cent in 2015 (2014: 70.7 per cent). - Government revenue improved in 2015 due to one-off taxes and increased excise duties from motor vehicle imports. - Higher expenditure on salaries and wages, interest payments, subsidies and transfers increased fiscal pressure. - Measures taken to improve revenue and rationalize expenditure: - Redrafting tax laws with IMF technical assistance. - Improvements in tax administration including RAMIS at IRD. - Introducing single window system at Sri Lanka Customs (ASYCUDA). - Automation of MOF activities. - Setting up Budget Implementation and Monitoring Unit (BIMU). - Medium-term fiscal targets: - Reduce budget deficit to 3.5 per cent of GDP by 2020. - Revised 2016 deficit from originally anticipated 5.9 per cent to 5.4 per cent. - Reduce primary deficit to zero in 2017 and gradual increase in primary surplus thereafter. - Reduce debt to GDP ratio to 68 per cent by 2020. - Revenue measures: increase VAT from 11 per cent to 15 per cent and remove exemptions on telecommunications services, effective from May 2016; VAT to continue to apply to wholesale and retail trade at a lower threshold. - Expenditure measures: streamline non-critical goods and services and capital spending to stay within fiscal space. ### State Owned Enterprises (SOEs) and contingent fiscal risks - Comprehensive strategy being developed to address SOE weaknesses and minimize fiscal risk. - Sri Lankan Airlines: - Continues to incur significant losses. - Resolution strategy expected by September 2016 to remove company from government accounts. - Cabinet approval obtained for government to take over all its liabilities and identify a suitable partner. - Ceylon Petroleum Corporation (CPC) and Ceylon Electricity Board (CEB) incurred losses due to implicit energy subsidies. - Automatic fuel and electricity pricing mechanism ensuring retail prices above cost recovery to be introduced by end 2016. - Oversight and financial discipline measures: - Six largest SOEs expected to publish Statements of Corporate Intent (SCI). - Legal framework for governance and oversight of SOEs to be strengthened. ### Monetary policy (recent stance, instruments, and measures) - Inflation remained at single digit levels for over seven years; headline inflation recorded negative rates during July-September 2015 and was 2.8 per cent by December 2015. - Core inflation increased to 4.5 per cent from 3.2 per cent. - One-off inflation impact expected from VAT increase and NBT removal; supply disruptions from adverse weather may exert upward pressure. - CBSL accommodative stance in 2015; credit growth rose from 8.8 per cent in 2014 to 25 per cent by end 2015. - Money supply expanded from 13.4 per cent at end 2014 to 17.8 per cent by end 2015. - Tightening measures: - SRR raised by 1.50 percentage points to 7.50 per cent in January 2016. - SDF and SLF rates raised by 50 basis points to 6.50 per cent and 8.00 per cent respectively in February 2016. - Macroprudential measures: - Minimum cash margin requirement of 100 per cent on LCs for motor vehicle imports (temporary, from 30 October 2015 for one month). - Maximum Loan to Value (LTV) ratio of 70 per cent for loans for motor vehicles. - CBSL conducting policy within an enhanced framework combining Monetary Targeting (MT) and Flexible Inflation Targeting (FIT), focusing on stabilizing inflation in mid-single digits while supporting growth and exchange rate flexibility. - CBSL using average call money rate as operating target and relying on market-based instruments; ongoing IMF collaboration to improve macroeconomic modelling and forecasting. ### External sector performance and policies - 2015 external sector subdued due to weak global demand, withdrawal of foreign investments, slowdown in FDIs, increased domestic consumption demand, and policy uncertainties. - Two sovereign bond issues totaling US dollars 2.15 billion were completed in 2015. - Trade deficit widened due to increased non-oil imports and slower export earnings but was partly offset by low oil import expenditure. - Current account deficit: 2.4 per cent of GDP (almost unchanged from previous year), aided by increased services export earnings and surplus in secondary income account. - BOP: overall deficit of US dollars 1,489 million in 2015. - Gross official reserves: US dollars 7.3 billion at end 2015 (equivalent to 4.6 months of goods imports). - Authorities’ priorities: promote export sector integration, establish Development Agency for infrastructure prioritization and Trade Agency for promotion and negotiation. - Progress: Sri Lanka delisted from EU ban on fishery imports; measures underway to regain GSP+ trade status. ### Exchange rate policy and FX developments - Late 2014 onward: increased FX market pressure from trade deficit, slowdown in net capital inflows, increased debt service, repayment of matured ISB of USD 500 million in early 2015, and unwinding of foreign investment in government securities. - CBSL intervened supplying about USD 1.9 billion net during first eight months of 2015. - On 03 September 2015 CBSL limited intervention and allowed market determination of exchange rate; rupee depreciation against US dollar during 2015 was 9.03 per cent. - CBSL net supply of foreign exchange during 2015: US dollar 3.2 billion. - First four months of 2016: CBSL intervention amounted to US dollar 1.16 billion while rupee depreciated by 0.1per cent. - Renewed SWAP arrangements: Reserve Bank of India for USD 700 million and SAARC for USD 400 million provided additional buffer. - May 2016: CBSL purchased about USD 76 million on net and stabilized exchange rate; attributed to improved investor confidence after successful IMF program negotiations. - Authorities plan to take necessary steps to meet preconditions for an increasingly flexible exchange rate regime. ### Financial sector soundness - Financial sector stability and soundness improved in 2015: high capital and liquidity levels and increased profitability. - Banking sector Capital Adequacy Ratios (CAR) above regulatory minimum of 10 per cent. - As at end 2015: total CAR 14.2 per cent; core CAR 11.9 per cent. - NPL ratio declined to 3.2 per cent in 2015 from 4.2 per cent in 2014. - Total loan loss provisions increased with higher specific provisions for NPLs in loss category. - Liquidity Coverage Ratio under Basel III implemented in 2015; Basel III Capital Standards to be implemented in line with international timelines. - Authorities committed to finalizing resolution framework for weak finance companies (total assets approximately 1 per cent of GDP) via establishment of a Special Purpose Vehicle; IMF technical assistance sought. ### Conclusion (authorities’ view on EFF request) - Authorities thank the Executive Board for consideration of three-year EFF request. - They believe Fund arrangement would support essential reforms to improve external and fiscal buffers and promote high and sustainable economic growth with international support. - Required prior actions completed and authorities fully committed to program implementation. - Program risks: elevated economic and financial risks due to global environment uncertainties and uncertain domestic conditions, including recent natural disaster; such conditions need consideration for suitable adjustment. *Statement by Mr. Subir Vithal Gokarn, Executive Director and Mrs. Swarna Gunaratne, Alternate Executive Director on Sri Lanka — Executive Board Meeting June 3, 2016.* --- _Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2016/_cr16150.pdf_