## _cr16152

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### Recent developments and outlook
- Headline inflation: "0.3 percent in September before rising to 1.7 percent in October."
- Core inflation (excluding fresh food, transport, and energy prices): "has risen since the beginning of 2015, reaching 4.4 percent in October."
- Preliminary government fiscal deficit in the first half of 2015: "3.7 percent of GDP."
- Bond issuance: "Successful issuance of a US$ 1.5 billion sovereign bond in October helped boost foreign reserves and partially compensate for earlier declines."
- Growth momentum: "Underlying growth momentum appears relatively firm and the outlook for headline inflation looks contained."
- Risks (tilted to the downside):
  - Large increase in wages and salaries in the revised 2015 budget.
  - Lower administered prices boosting incomes.
  - Reduction in import taxes on vehicles.
  - Sharp rise in imports and deterioration in the nonoil current account balance.
  - Rising core inflation and "continued weakness in the structure of public finances."
  - External risks: "Global growth prospects have weakened. Global financial conditions have tightened and may rebalance further when the U.S. Federal Reserve moves to raise interest rates."

### Fiscal policy — developments, assessment, and recommendations
- First half of 2015 fiscal outcome: fiscal deficit "3.7 percent of GDP."
- Tax revenue collection:
  - Tax revenues rose by "18.6 percent" over the same period in 2014, versus "35 percent growth for 2015 assumed in the budget."
  - Most growth attributable to a sharp rise in motor vehicle imports; "Tax revenues excluding motor vehicles grew by only 1 percent and nontax revenues fell by 8 percent."
- Expenditure composition:
  - "Capital spending has borne the brunt of the cuts—declining by 14 percent."
  - Recurrent spending rose by "20 percent."
- Financing:
  - "With net external financing turning negative, issuance of domestic government debt (including foreign-exchange denominated Sri Lankan Development Bonds--SLDBs) to finance the deficit increased sharply."
- Staff assessment and recommendations:
  - "In view of high public debt, fiscal developments this year pose a risk to the economy and call for ambitious measures in the 2016 budget to put Sri Lanka’s fiscal position on a more sustainable footing."
  - Priority: "a comprehensive reform of tax policy and administration, and a prompt resumption of fiscal consolidation supported by increased revenues."
  - Target recommended: fiscal deficit of no more than 5 ½ percent of GDP for 2016; additional revenue measures equivalent to over 1 percent of GDP required.

### Monetary policy — stance and implications
- Policy actions: "Following the reduction of policy rates in April 2015, the Central Bank of Sri Lanka (CBSL) has kept monetary policy unchanged."
- Staff view: With recent acceleration in private sector credit growth and rising core inflation, "there is now little scope for further monetary easing."
- Recommended approach:
  - Prepare to tighten monetary policy in the coming months, "albeit at a gradual pace."
  - Staff recommend any exit from the current policy rate be gradual—in the range of 25–50 basis points—subject to market conditions.
  - Authorities expect the credit cycle to slow to "15-16 percent (YOY) by end 2015" and would consider tightening should private credit accelerate past this benchmark.

### External sector — developments, vulnerabilities, and policy recommendations
- Developments:
  - Consumer goods imports rose by over "38.8 percent" in January-July 2015, led by vehicles.
  - Investment goods imports rose by "21 percent" in January-July 2015.
  - These import increases more than offset a "$1.3 billion" reduction in oil shipments.
  - Net interventions by the CBSL during January-September amounted to about "$2.4 billion," with gross reserves falling by "$1.4 billion."
  - Gross reserves were supported by a "$650 million" sovereign bond issue in May and two swaps totaling "$1.5 billion" with the Reserve Bank of India.
  - Daily interventions to maintain a relatively stable rupee/US dollar exchange rate drained central bank foreign exchange reserves.
- Exchange rate:
  - Rupee depreciated by about "2 percent" nominally vis-à-vis the U.S. dollar during January-August 2015.
  - Real effective appreciation of "5 percent" during January-August 2015 due to low inflation and sharp drops in the Euro and Yen.
  - Further nominal depreciation of about "4.4 percent" occurred during September 2015 after CBSL ceased daily reference rate; CBSL absence lasted one week before daily intervention resumed.
- Policy recommendations to reduce external vulnerabilities:
  - "Tighter fiscal and monetary policies could help restrict aggregate demand, contain the recent sharp rise in imports, and strengthen the external balance."
  - Greater exchange rate flexibility, reduced foreign exchange intervention, deepen the foreign exchange market, and structural reforms to enhance competitiveness.

### Financial sector — condition, risks, and supervisory priorities
- Broad condition: "The financial sector remains relatively stable."
- Indicators: Profitability increased in bank and nonbank sectors; capital adequacy and other prudential indicators do not indicate systemic stress.
- Vulnerabilities: Pockets of vulnerability remain in individual institutions—particularly in the nonbank sector and NBFIs.
- Supervisory priorities:
  - Continue progress in consolidated bank supervision.
  - Develop a more robust stress testing framework.
  - Follow up on TA recommendations: align single borrower limit (SBL) and related party lending definitions with international best practices; introduce fit and proper assessments for owners of NBFIs; train supervisory staff to evaluate banks’ individual capital adequacy assessments; amend legal framework for an efficient resolution regime.
- Recent actions and specific items:
  - Rs.6 billion provided to The Finance Company in December 2014 from the Central Bank Deposit Insurance and Liquidity Support Fund (DILS).
  - Supreme Court ruling to pay 41 percent of account balances to depositors of the defunct Golden Key Credit Card Company.

### Key quantitative indicators and projections (selected, as reported)
- Real GDP growth (2013–20 row): 3.4 4.5 5.2 5.5 5.5 5.5 5.5 5.5
- Inflation (average, 2013–20 row): 6.9 3.3 1.1 3.4 4.3 5.0 5.0 5.0
- Inflation (end-of-period, 2013–20 row): 4.7 2.1 3.2 3.6 5.0 5.0 5.0 5.0
- Core inflation (end-of-period, 2013–20 row): 2.1 1.2 5.0 5.4 4.1 4.1 4.1 4.1
- National savings (percent of GDP): 23.6 24.5 25.3 26.7 26.3 25.6 25.0 24.7
- National investment (percent of GDP): 27.0 27.1 27.7 28.2 28.6 28.8 28.7 28.6
- Savings-Investment balance (percent of GDP): -3.4 -2.6 -2.4 -1.5 -2.3 -3.3 -3.7 -3.9
- Central government balance (percent of GDP): -5.3 -5.7 -5.7 -6.5 -6.3 -6.1 -5.8 -5.7
- Government debt (domestic and external, percent of GDP): 70.8 71.8 75.0 75.6 75.5 74.9 74.0 73.4
- Reserve money (percent change, end of period): 0.9 18.3 19.5 15.8 14.8 14.8 15.2 14.8
- Broad money (percent change, end of period): 16.7 13.4 17.6 15.8 14.8 14.8 15.2 14.8
- Credit to private sector (percent change, end of period): 7.5 8.8 9.5 10.1 8.8 11.0 10.0 11.5
- Exports (US$ millions, 2013–20 row): 10,394 11,130 10,971 11,799 12,588 13,108 13,955 14,638
- Imports (US$ millions, 2013–20 row): -18,003 -19,417 -19,698 -20,431 -22,620 -24,980 -27,421 -29,241
- Current account balance (US$ millions, 2013–20 row): -2,541 -2,018 -1,927 -1,266 -2,089 -3,267 -4,062 -4,543
- Gross official reserves (end of period, US$ millions): 7,495 8,208 7,750 7,384 7,900 7,918 7,891 8,193
- Gross official reserves (months of imports): 3.9 4.1 3.7 3.2 3.1 2.9 2.7 2.5
- External debt (public and private, US$ billions): 39.9 43.0 44.3 44.4 46.2 48.5 53.0 57.6
- External debt (percent of GDP): 53.6 54.6 54.7 52.1 49.9 48.3 48.9 49.1
- Nominal GDP (in billions of rupees, memorandum): 9,592 10,292 10,981 11,979 13,179 14,599 16,173 17,915

### Public debt sustainability, scenarios, and stress tests
- Baseline public debt path:
  - Public debt-to-GDP ratio projected to decline moderately from "75.0 percent in 2015" to "73.4 percent in 2020."
  - Gross financing needs remain "around 20 percent of GDP."
- Baseline fiscal projection assumptions:
  - Continuation of current policies; only a moderate improvement in revenue collection; continued compression of capital spending.
- Staff stress-test results and risks:
  - Heat map analysis: high risk to debt 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.
  - Vulnerability to a negative growth shock could push the debt ratio over "80 percent of GDP."
  - Average time to maturity of public debt: exceeding "6 years."
  - Bond spreads: in the middle of the "200–600 point range" of lower and upper risk benchmarks.
- Fiscal adjustment and faster growth scenario:
  - Budget revenues reach "15 percent of GDP by 2015."
  - Primary balance moves to a small surplus.
  - Real GDP growth picks up to "5.9 percent (scenario)" versus "5.5 percent" in the baseline.
  - Public debt to GDP ratio falls to "65 percent of GDP by 2020" in this scenario.
  - Gross financing needs remain "around 15 percent of GDP" during the projected period.

### External debt—composition, projections, and vulnerabilities
- Total external debt estimated at "54.6 percent of GDP at end-2014."
- Composition (end-2014):
  - "56 percent" held by the general government.
  - "5 percent" held by the central bank.
  - Deposit-taking corporations debt represented "19 percent" of total external debt in 2014.
- Baseline external debt-to-GDP path (percent): 54.2 53.6 54.6 54.7 52.1 49.9 48.3 48.9 49.1 (2012–2020)
- Gross external financing needs (selected years, US$ billions and percent of GDP):
  - 2012: 13.0 (19.0 percent of GDP)
  - 2013: 11.4 (16.2 percent of GDP)
  - 2014: 11.0 (12.5 percent of GDP)
  - 2015: 13.1 (12.2 percent of GDP)
  - 2016: 10.6 (12.7 percent of GDP)
  - 2017: 11.3 (13.3 percent of GDP)
  - 2018: 12.8 (13.1 percent of GDP)
  - 2019: 14.4 (13.1 percent of GDP)
  - 2020: 15.3 (12.7 percent of GDP)
- Sensitivities:
  - A "30 percent" real depreciation would inflate the ratio of debt to GDP by almost "50 percent."
  - External debt-to-exports ratio (percent): 273.3 264.6 257.2 255.1 232.6 222.4 217.8 218.4 221.6 (2012–2020)

### Fiscal measures and revenue developments (late 2015)
- Parliament passed revenue measures on October 20 including: the super gain tax, mansion tax, special levy on the casino industry, and several other measures.
- These measures are expected to yield additional revenues of "0.6 percent of GDP in 2015" and are included in staff’s revenue projection.
- On October 27, authorities issued a "$1.5 billion 10-year bond at a yield of 6.85 percent."
- As of November 5, CBSL gross foreign exchange reserves amounted to "$7.4 billion," equivalent to "3.6 months of import cover."

### Exchange restrictions, macroprudential measures, and reserves management
- To curb vehicle imports, CBSL imposed on October 30 a minimum cash margin of "100 percent" on Letters of Credit for imports of vehicles effective until December 1, 2015; staff assessed this as an exchange restriction inconsistent with Article VIII, Section 2(a).
- CBSL measures and swaps:
  - SAARC central bank arrangement: received "USD 400 million" in April 2015.
  - Second swap with RBI in September 2015: received "USD 1.1 billion."
  - International Sovereign Bond issues: "USD 650 million, 10-year" in June 2015; "USD 1,500 million, 10-year" in October 2015.
- Macroprudential steps:
  - Loan-to-Value ceiling of "70 percent" for vehicle loans.
  - Temporary "100 percent" margin deposit requirement on letters of credit for motor vehicle imports (30 October–1 December 2015).

### Outlook, risks, and staff appraisal
- Short-term projections:
  - Real GDP growth for 2015 projected to reach "5.2 percent."
  - Headline inflation expected to remain contained to "3.2 percent by year-end 2015."
- Key medium-term risks identified:
  - Continued low revenue performance and stress on fiscal accounts.
  - External imbalances, downward pressure on the rupee, tighter external financing, and reserve depletion.
  - Lower GDP growth from weak investment, declining net exports, and sectoral stagnation.
- Staff urging:
  - "Put Sri Lanka back on a path to fiscal consolidation using the 2016 budget to signal medium-term reform stance."
  - Undertake comprehensive tax reforms to address low tax productivity and tax expenditures.
  - "Adopt a tightening bias in monetary policy as appropriate."
  - Follow up on financial sector TA findings—especially consolidated supervision, stress testing, and legal framework reforms.
  - Support exchange rate flexibility alongside fiscal, monetary, and structural measures; protect reserves and avoid intervention except to counter unwarranted volatility.

*International Monetary Fund staff report: Fourth Post-Program Monitoring Discussion with Sri Lanka (October 27, 2015).*

### 0.3 percent in September before rising to 1.7 percent in October, while core inflation (excluding

### _cr16152 - 0.3 percent in September before rising to 1.7 percent in October, while core inflation (excluding

### Recent developments and outlook
- Headline inflation: "0.3 percent in September before rising to 1.7 percent in October."
- Core inflation (excluding fresh food, transport, and energy prices): "has risen since the beginning of 2015, reaching 4.4 percent in October."
- Preliminary government fiscal deficit in the first half of 2015: "3.7 percent of GDP."
- Bond issuance: "Successful issuance of a US$ 1.5 billion sovereign bond in October helped boost foreign reserves and partially compensate for earlier declines."
- Growth momentum: "Underlying growth momentum appears relatively firm and the outlook for headline inflation looks contained."
- Risks: "The risks are tilted to the downside." Factors noted:
  - Large increase in wages and salaries in the revised 2015 budget.
  - Lower administered prices boosting incomes.
  - Reduction in import taxes on vehicles.
  - Sharp rise in imports and deterioration in the nonoil current account balance.
  - Rising core inflation and "continued weakness in the structure of public finances."
  - External risks: "Global growth prospects have weakened. Global financial conditions have tightened and may rebalance further when the U.S. Federal Reserve moves to raise interest rates."

### Fiscal policy — developments and assessment
- First half of 2015 fiscal outcome: fiscal deficit "3.7 percent of GDP."
- Tax revenue collection: "picked up, but not to the extent assumed in the 2015 budget"; tax revenues rose by "18.6 percent" over the same period in 2014, versus "35 percent growth for 2015 assumed in the budget."
- Drivers of revenue: most of the growth in tax revenue attributable to "a sharp rise in motor vehicle imports"; "Tax revenues excluding motor vehicles grew by only 1 percent and nontax revenues fell by 8 percent."
- Expenditure composition: "Capital spending has borne the brunt of the cuts—declining by 14 percent." Recurrent spending rose by "20 percent."
- Financing: "With net external financing turning negative, issuance of domestic government debt (including foreign-exchange denominated Sri Lankan Development Bonds--SLDBs) to finance the deficit increased sharply."
- Staff assessment and recommendation highlights:
  - "In view of high public debt, fiscal developments this year pose a risk to the economy and call for ambitious measures in the 2016 budget to put Sri Lanka’s fiscal position on a more sustainable footing."
  - "Sri Lanka has a very low tax-to-GDP ratio, and high levels of current expenditure constrain needed development spending, limit policy space, and threaten debt sustainability."
  - Priority: "a comprehensive reform of tax policy and administration, and a prompt resumption of fiscal consolidation supported by increased revenues."

### Monetary policy — stance and implications
- Policy actions: "Following the reduction of policy rates in April 2015, the Central Bank of Sri Lanka (CBSL) has kept monetary policy unchanged."
- Staff view: "With the recent acceleration in private sector credit growth and rising core inflation, there is now little scope for further monetary easing."
- Risks and recommended approach: "Most factors—including the deterioration in the balance of payments and pressures on the rupee—suggest that the CBSL should be prepared to tighten monetary policy in the coming months, albeit at a gradual pace."

### External sector — developments and vulnerabilities
- Net effect of oil price fall: "The external accounts benefitted from the lower oil price, but higher imports of consumer and investment goods more than offset this effect."
- Current account and reserves: "The overall balance of payments has deteriorated sharply, putting downward pressure on the rupee and leading to a substantial decline in central bank foreign exchange reserves."
- Drivers of deterioration: "increase in imports of consumer and investment goods (partially spurred by higher government recurrent spending), lower remittance growth and a decline in foreign investment."
- Policy recommendations to reduce external vulnerabilities:
  - "Tighter fiscal and monetary policies could help restrict aggregate demand, contain the recent sharp rise in imports, and strengthen the external balance."
  - Supportive measures: "greater exchange rate flexibility, reduced foreign exchange intervention, and efforts to deepen the foreign exchange market, as well as structural reforms to enhance competitiveness."

### Financial sector — condition and risks
- Broad condition: "The financial sector remains relatively stable."
- Indicators: "Profitability has generally increased in the bank and nonbank sectors, and capital adequacy and other prudential indicators do not indicate stress."
- Remaining vulnerabilities: "There are remaining pockets of vulnerability in individual institutions—particularly in the nonbank sector."
- Supervisory priorities: "continued progress in consolidated bank supervision and in developing a more robust stress testing framework."

### Key quantitative indicators and projections (selected, as reported)
- Real GDP growth (2013–20 row): 3.4 4.5 5.2 5.5 5.5 5.5 5.5 5.5
- Inflation (average, 2013–20 row): 6.9 3.3 1.1 3.4 4.3 5.0 5.0 5.0
- Inflation (end-of-period, 2013–20 row): 4.7 2.1 3.2 3.6 5.0 5.0 5.0 5.0
- Core inflation (end-of-period, 2013–20 row): 2.1 1.2 5.0 5.4 4.1 4.1 4.1 4.1
- National savings (percent of GDP): 23.6 24.5 25.3 26.7 26.3 25.6 25.0 24.7
- National investment (percent of GDP): 27.0 27.1 27.7 28.2 28.6 28.8 28.7 28.6
- Savings-Investment balance (percent of GDP): -3.4 -2.6 -2.4 -1.5 -2.3 -3.3 -3.7 -3.9
- Central government balance (percent of GDP): -5.3 -5.7 -5.7 -6.5 -6.3 -6.1 -5.8 -5.7
- Government debt (domestic and external, percent of GDP): 70.8 71.8 75.0 75.6 75.5 74.9 74.0 73.4
- Reserve money (percent change, end of period): 0.9 18.3 19.5 15.8 14.8 14.8 15.2 14.8
- Broad money (percent change, end of period): 16.7 13.4 17.6 15.8 14.8 14.8 15.2 14.8
- Credit to private sector (percent change, end of period): 7.5 8.8 9.5 10.1 8.8 11.0 10.0 11.5
- Exports (US$ millions, 2013–20 row): 10,394 11,130 10,971 11,799 12,588 13,108 13,955 14,638
- Imports (US$ millions, 2013–20 row): -18,003 -19,417 -19,698 -20,431 -22,620 -24,980 -27,421 -29,241
- Current account balance (US$ millions, 2013–20 row): -2,541 -2,018 -1,927 -1,266 -2,089 -3,267 -4,062 -4,543
- Current account balance (percent of GDP): -3.4 -2.6 -2.4 -1.5 -2.3 -3.3 -3.7 -3.9
- Gross official reserves (end of period, US$ millions): 7,495 8,208 7,750 7,384 7,900 7,918 7,891 8,193
- Gross official reserves (months of imports): 3.9 4.1 3.7 3.2 3.1 2.9 2.7 2.5
- External debt (public and private, US$ billions): 39.9 43.0 44.3 44.4 46.2 48.5 53.0 57.6
- External debt (percent of GDP): 53.6 54.6 54.7 52.1 49.9 48.3 48.9 49.1
- Nominal GDP (in billions of rupees, memorandum): 9,592 10,292 10,981 11,979 13,179 14,599 16,173 17,915

### Executive Board and staff conclusions (high-level)
- The Executive Board: endorsed staff appraisal noting "economic growth continued to be fairly strong in 2015, while headline inflation has remained low," but flagged concerns: "deterioration in the overall balance of payments, the loss of central bank foreign exchange reserves, the weak state of public finances, and growing public debt."
- Recommended priorities to mitigate risks and restore confidence:
  - "appropriate corrective actions to safeguard macroeconomic stability and lay the foundation for durable and inclusive growth."
  - Improve business climate, reform state owned enterprises, and adopt a "more open trade regime" to boost competitiveness and growth.
  - Fiscal: "prompt resumption of fiscal consolidation supported by increased revenues" and comprehensive tax reform.
  - Monetary and external: readiness to "tighten monetary policy in the coming months," greater exchange rate flexibility, reduced foreign exchange intervention, and deepen foreign exchange markets.
  - Financial sector: strengthen consolidated supervision and stress testing framework.

*International Monetary Fund staff report: Fourth Post-Program Monitoring Discussion with Sri Lanka (October 27, 2015).*

### 5.      The external accounts have come under pressure as a surge in consumer and

### 5.      The external accounts have come under pressure as a surge in consumer and

### External accounts: recent developments
- Consumer goods imports rose by over 38.8 percent in January-July 2015, led by vehicles.
- Investment goods imports rose by 21 percent in January-July 2015.
- These import increases more than offset a $1.3 billion reduction in oil shipments (windfall from lower oil prices).
- Net interventions by the CBSL in the foreign exchange market during January-September amounted to about $2.4 billion, with gross reserves falling by $1.4 billion.
- Gross reserves were supported by a $650 million sovereign bond issue in May and two swaps totaling $1.5 billion with the Reserve Bank of India.
- Steady exit of foreign investors from government T-bills, lower external borrowing, and a drop in foreign direct investment contributed to a sharp deterioration in the overall balance of payments during the first half of the year.
- Daily interventions to maintain a relatively stable rupee/US dollar exchange rate drained central bank foreign exchange reserves.

### Exchange rate developments
- The rupee depreciated by only about 2 percent in nominal terms vis-à-vis the U.S. dollar during January-August 2015.
- In real effective terms the rupee appreciated by 5 percent during January-August 2015, reflecting low inflation and sharp drops in the Euro and Yen relative to the U.S. dollar.
- Further nominal depreciation of about 4.4 percent occurred during September 2015 after the CBSL ceased giving a daily reference rate and exited daily intervention; the nominal drop in September likely erased some of the earlier real effective appreciation.
- The CBSL’s absence from the market lasted only one week before daily intervention resumed.

### Monetary policy and credit
- Policy rates were reduced by 50 bps in April 2015 to a new historical low; this appears to be the last move in a cycle beginning with the first easing in December 2012.
- Despite substantial easing of monetary policy over the past two years, near-zero inflation meant real interest rates increased over the past year.
- Private sector credit growth accelerated to over 20 percent through August 2015; credit to state enterprises rose to over 30 percent.
- The overhang of excess liquidity visible during the second half of 2014 has been eliminated and call market rates have begun to move upwards as government borrowing from the domestic market surged.
- Staff estimates of the neutral policy rate (Taylor rule) indicate near alignment with existing policy rates.
- Staff estimates suggest some slack of roughly 0.5 percent of GDP (potential output at 5.5 percent).
- Given long lags in monetary transmission (4–5 quarters) and rising core inflation, staff argue further rate cuts should be avoided and recommend any exit from the current policy rate be gradual—in the range of 25–50 basis points—subject to market conditions.
- Authorities expect the credit cycle to slow to 15-16 percent (YOY) by end 2015 and would consider tightening should private credit accelerate past this benchmark.

### Financial sector developments and risks
- Banking sector recorded net profit growth of over 20 percent in the first half of 2015, driven by wider net interest margins.
- Loan portfolios expanded; demand for vehicle loans increased following reduction in taxes for small cars.
- Exposure to gold-backed pawning declined markedly.
- Banks’ investment portfolios rose mainly through corporate debentures and government securities reflecting large expansion of domestic debt.
- Non-performing loans (NPLs) increased due to further declines in the price of gold and delinquencies related to credit with select trading partners (mainly Russia).
- Nonbank financial institutions (NBFIs) net profits more than doubled (YoY) in first half 2015 on healthy growth in net interest income, though liquidity levels in NBFIs remain relatively weak.
- The financial system appears generally well capitalized and stable; liquidity ratios have decreased but remain well above prudential levels and peer-country averages.
- NBFIs—including the state pension system—have absorbed a considerable amount of new government debt; pockets of potential risk remain particularly within the NBFI sector.

### Outlook and medium-term risks
- Real GDP growth for 2015 is projected to reach 5.2 percent.
- Headline inflation is expected to remain contained to 3.2 percent by year-end 2015.
- Staff identify three key risks to the medium-term outlook:
  - Continued low revenue performance, related stress on fiscal accounts and public debt, leading to further cuts to investment spending.
  - External imbalances, continued downward pressure on the rupee, tighter external financing, and draining of international reserves.
  - Lower GDP growth as a result of weak investment, declining net exports, and stagnation in key sectors.
- Global growth prospects have weakened and growth projections for emerging markets have generally declined; global financial conditions have tightened and may rebalance further when the U.S. Federal Reserve moves to raise interest rates.
- Direct spillovers from economic malaise in emerging markets are thought to be limited: exports to Russia and China are less than 3 percent and 2 percent of total exports, respectively.

### Fiscal policy: road to revenue and recommendations
- Higher recurrent spending in the revised 2015 budget, coupled with measures that boosted household income (higher wages, salaries, pension payments, reductions in fuel and electricity prices, and some import tax reductions), have driven a surge in consumption and imports and increased macroeconomic imbalances.
- The February 2015 post-program monitoring mission estimated roughly one third of the nominal increase in household income would leak out through imports; actual leakage and consumption were higher than expected, putting downward pressure on the exchange rate and draining reserves.
- Staff argued the absence of measures to bring durable increases in revenue has halted fiscal consolidation and raised debt sustainability risks.
- One-off measures in 2015 (super-gains tax, mansion tax, and other one-off measures) may contain the 2015 fiscal deficit to about the same level as 2014, but the debt-to-GDP ratio is expected to climb in 2015 and subsequent years without a concerted fiscal consolidation and fundamental re-set of revenue policies.
- Baseline projection without additional measures suggests the overall deficit could rise to an estimated 6.5 percent of GDP.
- Staff recommended targeting a fiscal deficit of no more than 5 ½ percent of GDP for 2016, consistent with a reduction in net domestic financing requirement and a modest reduction in the debt-to-GDP ratio; this requires renewed tight control of public expenditures and additional revenue measures equivalent to over 1 percent of GDP.
- Basic principles for a credible medium-term policy shift include:
  - Halting the provision of new tax holidays, exemptions, and special rates.
  - Eliminating existing tax holidays and exemptions across different types of tax; using other incentives (such as tax credits or accelerated depreciation) for investment projects.
  - Simplifying the complex tax system (including unification of rates) to create a more equitable framework to facilitate effective tax administration and improve tax compliance.
  - Continuing efforts to improve tax administration—particularly through automation and removal of opportunities for discretionary tax treatment.

### Authorities’ stance and fiscal challenges
- Authorities emphasized commitment to reducing the fiscal deficit but noted many unknown budgetary commitments being discovered; unsettled expenditures from 2011–14 are estimated in the range of Rs 200 billion and could push the 2015 deficit as high as 7 percent of GDP.
- Authorities agreed revenue performance must improve and that increasing revenues by 1 percentage point of GDP in 2016 (as suggested in the adjustment scenario) is difficult but achievable.
- Authorities prioritized reducing corruption in tax administration (noting corruption in excises as worst) and increasing collection efficiency over immediate focus on exemptions; they expected strong excise revenue growth to continue and saw room to strengthen excise collection by addressing undervaluation of imported vehicles and stronger checks and scans at container terminals.
- Tax reforms are intended to be implemented over a longer-term horizon (5 years).
- Authorities are exploring programmatic budget support with the World Bank and other international financial institutions and closer engagement with bilateral partners to reduce external financing costs.

### External sector policy recommendations
- Staff welcomed the CBSL decision to cease setting daily spot rates and allow the market greater role in determining the rupee.
- Econometric analysis suggests the rupee is not fundamentally misaligned, but balance of payments pressures stem from macro-fiscal policies, external shocks (falling demand from the Middle East and Russia), and investor confidence.
- Eliminating the policy-based misalignment implicit in the current fiscal stance and a clear and steady commitment to a flexible exchange rate are essential to restoring equilibrium in the foreign exchange market and rebuilding international reserves.
- The September approach—CBSL stepping out of the foreign exchange market and communicating the move to market participants—should be reestablished to allow sufficient rupee movement to affect relative prices and restore a market-based equilibrium level.
- Authorities reiterated desire for the rupee to be determined by market forces while reserving intervention for large transactions or to mitigate unwarranted volatility; they expect inflows from export earnings and remittances and increased external financing flows—preferably at low rates—to help bring equilibrium to the market.
- Authorities indicated acceleration in interventions since mid-September was driven largely by the need to provide foreign exchange in response to foreign exit from the government securities market.

*Italic: International Monetary Fund staff report excerpts (content unit provided).*

### 21.      Staff recommended follow up on recent TA recommendations pertaining to financial

### _cr16152 - 21.      Staff recommended follow up on recent TA recommendations pertaining to financial

### Financial sector supervision and regulatory recommendations
- Staff recommended follow up on recent TA recommendations pertaining to financial sector stability.
- Key elements of an effective framework for consolidated supervision should include:
  - bringing the single borrower limit (SBL) and related party lending definitions in line with international best practices;
  - introducing fit and proper assessments for owners of non-bank financial institutions;
  - training supervisory staff to evaluate banks’ individual capital adequacy assessments and establishing a robust framework to set appropriate minimum capital adequacy requirements for individual banks that reflect their risk profiles.
- Further work is needed to amend the legal framework to allow for a more comprehensive and efficient resolution regime.
- The government is investigating the possibility of a more formalized mechanism for dealing with problem assets in a range of NBFIs—potentially in the form of a special purpose vehicle (SPV) that would take on problem assets.

### Stress testing, liquidity, and nonbank vulnerabilities
- Financial sector stress testing—while improving—needs to be forward looking and assess impacts beyond capital adequacy, explicitly including solvency, liquidity, and potential contagion.
- Recent actions and vulnerabilities:
  - recent settlement of one long-standing troubled institution and liquidity injection into a second finance company through the Central Bank Deposit Insurance and Liquidity Support Fund (DILS).
  - Rs.6 billion was provided to The Finance Company in December 2014 from the DILS.
  - The Supreme Court had earlier given a ruling to pay 41 percent of account balances to depositors of the defunct Golden Key Credit Card Company.

### External pressures, exchange rate, and reserves
- Balance of payments pressures and capital flow developments:
  - CA deficit almost doubled during the first half of 2015, mainly due to a 24 percent increase in non-oil imports.
  - remittances growth slowed to 2 percent from 11 percent in 2014.
  - foreign investors deleveraging from government securities; foreign holding of government papers decreased.
- Exchange rate and reserve dynamics:
  - The rupee has depreciated 7.2 percent since January despite heavy intervention by the CBSL (US$2.4 billion as of Sept 28, 2015).
  - Forward market predicts further depreciation.
  - Econometric analysis suggests the rupee is not fundamentally misaligned; External Balance Analysis (EBA) estimations show the cyclically-adjusted CA is close to its norm, but policy gaps are relatively high, at more than 1.5 percent.
- External debt and NIIP:
  - External debt estimated at 54.6 percent of GDP at end-2014.
  - Ratio of debt to exports was 257 percent in 2014.
  - Stress tests show a 30 percent real depreciation would raise the debt to GDP ratio to about 70 percent.
  - 83 percent of total debt is long term and the next sovereign bond repayment is due in 2019 (US$ 1.5 billion).
  - NIIP is increasingly skewed towards debt and loans rather than equity.

### Fiscal and monetary policy assessment and recommendations
- Fiscal policy:
  - Fiscal consolidation has stagnated and public debt is once again on the rise.
  - Staff view: a deficit of 5.5 percent of GDP or less could be achieved in 2016 with a combination of revenue reforms and expenditure constraint.
  - For 2017 and beyond, staff urges a medium-term fiscal framework targeting a steady reduction of the fiscal deficit and a fall in the public-debt-to-GDP ratio to 50 percent.
  - The steady decline in tax revenue as a share of GDP is critical; Sri Lanka’s tax-to-GDP ratio is now one of the lowest in the world.
  - Staff recommends overdue second-generation tax reforms, addressing tax expenditures (tax holidays, exemptions, and special rates) as central to restoring tax productivity.
- Monetary policy:
  - With policy rates near the neutral rate, there appears little room for further easing; core inflation running above 4 percent through September, private credit growth in excess of 20 percent, and declining unemployment point to declining slack and the need for a tightening bias.
  - Staff notes the signaling effect of monetary tightening is important given domestic and external pressures.
- Exchange rate policy:
  - The move toward exchange rate flexibility was welcome but short-lived; staff reiterates that the exchange rate is not fundamentally misaligned.
  - A flexible rupee must be accompanied by fiscal constraint, support from monetary policies, clear messaging to markets, and structural reforms.
  - The staff urges the central bank to protect the limited cushion of reserves and refrain from intervention aside from addressing unwarranted volatility.
- Macroprudential and import-curbing measures:
  - CBSL macroprudential measures (including a ceiling of 70 percent for vehicle loan-to-value ratios) should help curb imports and reduce reserve outflows.

### Post Program Monitoring and repayment capacity
- Sri Lanka’s access to IMF resources currently stands at 120.8 percent of quota.
- Capacity to repay the IMF remains adequate, but risks have increased since the previous PPM discussion, including:
  - low and declining foreign exchange reserve coverage (in nominal terms and by the Fund’s reserve adequacy metrics);
  - reliance on debt and portfolio flows to finance current account deficits;
  - exchange rate risks highlighted in the DSA.

### Inflation, distributional impacts, and household effects
- Recent inflation context and differential impacts:
  - Inflation was 2.1 percent at end 2014 but averaged about 9 percent during the last decade.
  - Poor households face disproportionately higher inflation than higher-income households overall.
  - For poor households inflation is higher for housing (including utilities), clothing, and health.
  - Poor households face higher food inflation than richer counterparts.
  - With rising oil prices in 2007, utilities and electricity inflation with full pass-through was 8 percent for poor households—three times as high as the highest income household.
  - Food inflation in 2007 exceeded 16 percent for the lowest income and 4 percent for the highest income strata; the divergence ratio is also about three in 2014.
  - The authorities pointed to administered prices—mostly on staple food items with higher consumption share by the poor—and cross subsidies on energy, which should have affected positively the poor segments during the period analyzed.

### Staff appraisal: overall assessment and actions urged
- Macro imbalances have grown since the last PPM discussion; corrective policy actions are needed to mitigate near-term risks and ensure a medium-term framework for inclusive growth.
- Staff recommendations and urgings:
  - Put Sri Lanka back on a path to fiscal consolidation using the 2016 budget to signal medium-term reform stance.
  - Undertake comprehensive tax reforms to address low tax productivity and tax expenditures.
  - Adopt a tightening bias in monetary policy as appropriate given domestic and external developments.
  - Follow up closely on financial sector TA findings—especially consolidated supervision, stress testing, and legal framework reforms—to strengthen financial stability.
  - Support exchange rate flexibility alongside fiscal, monetary, and structural measures; protect reserves and avoid intervention except to counter unwarranted volatility.

*Italic: IMF staff report excerpt from the supplied content unit.*

### 30.      Structural reforms need to focus on giving market forces a greater role in economic

### _cr16152 - 30.      Structural reforms need to focus on giving market forces a greater role in economic

### Structural reforms and competitiveness
- Objective: Give market forces a greater role in economic activity and increase competitiveness.
- Policy actions welcomed by staff:
  - Revive discussions on GSP plus.
  - Address issues related to the EU ban on import of fishery products.
- Anti-corruption and institutional measures recommended:
  - Further strengthen anti-corruption efforts.
  - Implement international standards regarding domestic politically exposed persons.
  - Enhance cooperation between the financial intelligence unit and the anti-corruption commission.
- Trade policy recommendations:
  - Promote an open trade regime and outward orientation.
  - Include a clear government commitment to avoid selective trade protection and para-tariffs and nontariff barriers.
- State enterprise and price reforms:
  - Reform state enterprises—putting them on a commercial footing.
  - Allow key tariffs (mainly fuel and electricity) to reflect market developments.

### Macroeconomic assumptions used in staff analysis
- Growth in the medium-term is projected at 5.5 percent.
- Inflation is projected to gradually pick up to around 5 percent.
- Baseline fiscal projection assumptions:
  - Continuation of current policies.
  - Only a moderate improvement in revenue collection reflecting ongoing improvements in tax administration.
  - Low revenues are assumed to necessitate a continued compression of capital spending.
  - Upside risks if the 2016 budget contains policies to raise revenue while restoring spending discipline.
- External sector assumptions:
  - Following a decline in 2015 and 2016 thanks to low oil prices, the current account is projected to widen gradually.
  - In the absence of policy adjustments to boost investment sentiment, FDI and other private capital inflows are assumed to remain subdued.

### Public debt sustainability—baseline findings and projections
- Recent change in assessment: Public debt outlook has weakened relative to the 2014 Article IV Report.
- Baseline public debt path:
  - Public debt-to-GDP ratio projected to decline only moderately, from 75.0 percent in 2015 to 73.4 percent in 2020.
  - Gross financing needs remain around 20 percent of GDP.
- Primary balance and fiscal deficit:
  - Primary balance projected to improve gradually but remains in deficit during the projected period.
  - Fiscal deficit path under current policies: from 6.5 percent of GDP in 2016 to 5.7 percent of GDP by 2020.
  - The primary deficit contributes (cumulatively) a 10 percentage point increase in the debt ratio compared to the previous DSA.
- Growth revision driving weaker debt dynamics:
  - Staff reduced projected medium-term growth from 6.5 percent to 5.5 percent following rebasing and revision of national accounts.

### Risk assessment and stress-test results
- Heat map analysis: Indicates a high risk to debt 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.
- Market indicators:
  - Market perception of risks thus far remains moderate, with bond spreads in the middle of the 200–600 point range of lower and upper risk benchmarks.
  - Spreads have been widening recently.
- Debt structure:
  - Terms structure improved; average time to maturity now exceeding 6 years.
- Vulnerabilities:
  - Public debt path particularly vulnerable to negative growth shock, which could push the debt ratio over 80 percent of GDP.
  - Absence of effective measures to raise revenues and reduce the deficit could weaken market confidence, increase borrowing costs and worsen debt dynamics.
- Upside scenario:
  - Fiscal adjustment could materially reduce risks to the public debt outlook.
  - Baseline assumes no new revenue measures, though it assumes a 1 percentage point increase in the tax revenue-to-GDP ratio in 2015–20 due to administrative improvements already underway.

### Key numeric indicators and projections (selected)
- Medium-term growth projection: 5.5 percent.
- Inflation projection (gradual pick-up): around 5 percent.
- Public debt-to-GDP ratio:
  - 2015: 75.0 percent.
  - 2020: 73.4 percent.
- Fiscal deficit (central government):
  - 2016: 6.5 percent of GDP.
  - 2020: 5.7 percent of GDP.
- Gross financing needs: around 20 percent of GDP.
- Contribution of primary deficit to debt ratio: cumulative 10 percentage points (relative to previous DSA).
- Assumed increase in tax revenue-to-GDP ratio from administrative improvements: 1 percentage point in 2015–20.
- Average time to maturity of public debt: exceeding 6 years.
- Bond spreads: in the middle of the 200–600 point range of lower and upper risk benchmarks.
- Public debt benchmarks exceeded under shocks: debt burden benchmark 70 percent of GDP; gross financing need benchmark 15 percent of GDP.

*Source: IMF staff report (Fourth Post-Program Monitoring Discussion with Sri Lanka, October 27, 2015) — selected excerpts.*

### introduction of new revenue measures along the lines recommended by staff could significantly improve

### _cr16152 - introduction of new revenue measures along the lines recommended by staff could significantly improve

### Fiscal outlook — fiscal adjustment and faster growth scenario
- Introduction of new revenue measures along the lines recommended by staff could significantly improve fiscal outlook.
- Lower deficits would reduce risk to fiscal sustainability, strengthen investors’ confidence, and lower costs of financing.
- Higher revenues would protect public investments from repeated cuts, supporting faster growth.
- Scenario assumptions and outcomes:
  - Budget revenues reach 15 percent of GDP by 2015.
  - Primary balance moves to a small surplus.
  - Real GDP growth gradually picks up to 5.9 percent (scenario) versus a flat path of 5.5 percent in the baseline.
  - Public debt to GDP ratio falls to 65 percent of GDP by 2020 in this scenario.
  - Gross financing needs remain around 15 percent of GDP during the projected period.

### External debt sustainability — overview and composition
- Total external debt was estimated at 54.6 percent of GDP at end-2014.
- Composition:
  - 56 percent of external debt held by the general government.
  - 5 percent held by the central bank.
  - Deposit-taking corporations debt represented 19 percent of total external debt in 2014 (up from 13 percent in 2011).
- Debt burden and rollover:
  - Debt-to-exports ratio was 257 percent in 2014.
  - 83 percent of total external debt is long term.
  - Next sovereign bond repayment due in 2019 (US$ 1.5 billion).

### Baseline external debt projections and drivers
- Baseline projection: total external debt expected to decrease only slightly, stabilizing just under 50 percent of GDP over the medium term.
- Key drivers and assumptions mentioned:
  - GDP growth offsets exchange rate depreciation effects and increases in official borrowing.
  - Official borrowing examples: swap with Reserve Bank of India of US$1.1 billion and issuances of a sovereign bond of US$650 million and Sri Lankan Development Bonds.
  - Improvement relative to 2014 DSA due to higher rebased nominal GDP and assumed lower private borrowing.
- Gross external financing needs (projections, in billions of US dollars and percent of GDP):
  - 2012: 13.0 (19.0 percent of GDP)
  - 2013: 11.4 (16.2 percent of GDP)
  - 2014: 11.0 (12.5 percent of GDP)
  - 2015: 13.1 (12.2 percent of GDP)
  - 2016: 10.6 (12.7 percent of GDP)
  - 2017: 11.3 (13.3 percent of GDP)
  - 2018: 12.8 (13.1 percent of GDP)
  - 2019: 14.4 (13.1 percent of GDP)
  - 2020: 15.3 (12.7 percent of GDP)
- Baseline external debt-to-GDP path (in percent):
  - 2012: 54.2
  - 2013: 53.6
  - 2014: 54.6
  - 2015: 54.7
  - 2016: 52.1
  - 2017: 49.9
  - 2018: 48.3
  - 2019: 48.9
  - 2020: 49.1

### Alternative scenarios and stress tests
- Exchange rate sensitivity:
  - A 30 percent real depreciation would inflate the ratio of debt to GDP by almost 50 percent.
- Other shocks:
  - Individual shocks (permanent one-half standard deviation) and combined shocks were analyzed via scenario charts and bound tests.
  - Combined macro-fiscal shock and other standard alternative shocks would not fundamentally derail debt consolidation, except large real depreciation.
- Scenario highlights (selected assumptions shown exactly as in source for scenarios):
  - Baseline real GDP growth: 5.2 / 5.5 / 5.5 / 5.5 / 5.5 / 5.5 (2015–2020)
  - Combined "Fiscal adjustment and faster growth" scenario real GDP growth: 5.2 / 5.5 / 5.6 / 5.7 / 5.8 / 5.9 (2015–2020)
  - Baseline primary balance (in percent of GDP): -1.5 / -2.0 / -1.9 / -1.6 / -1.4 / -1.3 (2015–2020)
  - Fiscal adjustment scenario primary balance (in percent of GDP): -1.5 / -1.0 / -0.2 / 0.6 / 0.5 / 0.5 (2015–2020)
  - Real interest rate and effective interest rate projections noted across scenarios (examples):
    - Baseline effective interest rate: 6.4 / 6.6 / 6.5 / 6.6 / 6.6 / 7.2 (2015–2020)
    - Real Interest Rate Shock effective interest rate: 6.4 / 6.6 / 7.1 / 7.6 / 7.9 / 8.7 (2015–2020)
- Public gross financing needs (projection, in percent of GDP):
  - Illustration shows levels up to around 25 percent in scenario charts; gross financing needs benchmark of 15 percent of GDP flagged as relevant in risk assessment.

### Risks and policy implications
- Risks to assessment are broadly balanced.
- External debt could increase if:
  - Private investment strengthens (leading to higher private external borrowing).
  - Government contracts more project loans.
  - Central bank enters new swap arrangements.
  - Government negotiates new bilateral or multilateral financing arrangements.
  - Growth does not strengthen or exports do not recover.
- Positive offsetting factor:
  - A reversal of FDI inflows from debt-creating financing to equity-type investments would improve debt dynamics.
- Policy note:
  - Authorities’ plan to reduce public debt is welcome and would improve public external debt sustainability; however, an equivalent increase in private sector external borrowing to finance the current account deficit would not reduce external vulnerabilities for the economy as a whole.
- Capital account opening:
  - Future external debt levels and vulnerabilities will depend on authorities’ policies in terms of opening up the capital account further.

### Debt dynamics decomposition and selected statistics
- Identified external debt-creating flows (selected years, in percent of GDP):
  - Current account deficit, excluding interest payments:
    - 2012: 4.5
    - 2013: 2.0
    - 2014: 1.2
    - 2015: 0.9
    - 2016: 0.0
    - 2017: 0.7
    - 2018: 1.7
    - 2019: 2.2
    - 2020: 2.2
  - Net non-debt creating capital inflows (negative):
    - 2012: -1.7
    - 2013: -1.5
    - 2014: -1.3
    - 2015: -1.3
    - 2016: -1.3
    - 2017: -1.4
    - 2018: -1.4
    - 2019: -1.6
    - 2020: -1.7
  - Automatic debt dynamics (in percent of GDP):
    - 2012: -0.6
    - 2013: -3.2
    - 2014: -2.7
    - 2015: -1.3
    - 2016: -1.4
    - 2017: -1.1
    - 2018: -1.0
    - 2019: -0.9
    - 2020: -0.9
- External debt-to-exports ratio (in percent):
  - 2012: 273.3
  - 2013: 264.6
  - 2014: 257.2
  - 2015: 255.1
  - 2016: 232.6
  - 2017: 222.4
  - 2018: 217.8
  - 2019: 218.4
  - 2020: 221.6
- Selected macroeconomic assumptions (key variables):
  - Ten-year historical averages and projections for real GDP growth, GDP deflator in US dollars, nominal external interest rate, growth of exports and imports (US dollar terms), current account balance, and net non-debt inflows are presented in the source tables and used in baseline and scenario projections.

### Supplementary information (post-report developments)
- Staff projections and the thrust of the staff appraisal remain unchanged as of the supplement.
- Inflation update:
  - Following several months of negative headline inflation, year-on-year headline inflation rose to 1.7 percent in October.
  - Core inflation in October reached 4.4 percent.

*Source: IMF staff report content as provided in the document fragment.*

### 3. On October 20, Parliament passed several revenue measures that were originally

### _cr16152 - 3. On October 20, Parliament passed several revenue measures that were originally

### Revenue measures and near-term impact
- Parliament passed several revenue measures on October 20 that were originally contained in the revised 2015 Budget, including:
  - the super gain tax
  - mansion tax
  - special levy on the casino industry
  - several other measures
- These measures are expected to yield additional revenues of 0.6 percent of GDP in 2015, and are already included in staff’s revenue projection.

### Recent borrowing, reserves, and external pressures
- On October 27, the authorities issued a $1.5 billion 10-year bond at a yield of 6.85 percent—the highest rate since 2009.
- As of November 5, Central Bank of Sri Lanka’s (CBSL) gross foreign exchange reserves amounted to $7.4 billion, equivalent to 3.6 months of import cover.
- External sector developments:
  - Exports fell by about 20 percent in August compared to 2014.
  - Imports declined by 12 percent in August compared to 2014.
  - Trade August trade deficit remained broadly unchanged from last year.
  - Net intervention in the foreign exchange market by the CBSL amounted to $278 million in October and $72 million so far in November.
  - The rupee was broadly stable against the US dollar during that period.
  - In real effective terms, the rupee has depreciated by about 4 percent during January–September 2015.

### Exchange restrictions and trade measures
- To curtail vehicle imports, the CBSL imposed on October 30 a minimum cash margin of 100 percent on Letters of Credit open by commercial banks for imports of vehicles. This measure is to remain in effect until December 1, 2015.
- Staff assessment:
  - Staff assessed the measure to be an exchange restriction inconsistent with Sri Lanka’s obligations under Article VIII, Section 2(a).
  - As this assessment was reached only recently, the mission team has not had a chance to discuss this finding with the authorities in detail or assess whether the criteria set by the Board under Decision No. 1034-(60/27), dated June 1, 1960 for approval of an exchange restriction are met.
  - Therefore, at this time, the authorities have not requested and staff does not recommend approval of the measure.

### Political context and policy timing
- Political developments:
  - General election held in August 2015; Presidential election held in January 2015.
  - UNP won 106 of 225 Parliament seats; UPFA secured 95 seats; UNP and SLFP formed a National Government of Consensus.
- Policy timing:
  - The first budget of the new government to be presented on the 20th of November 2015; authorities consider medium term analysis in staff report aligned with a baseline scenario until budget specifics are announced.
  - Hon. Prime Minister presented an Economic Policy Statement on the 5th of November 2015 outlining medium term vision and reforms; specific measures to be in the forthcoming budget.

### Growth performance and outlook
- Growth outcomes:
  - The economy achieved growth of 5.6 per cent during the first half of 2015, compared to 1.3 per cent growth in the first half of 2014.
  - Growth supported by agriculture and services; industrial growth decelerated due to weak construction and manufacturing.
  - On the demand side, pickup in domestic demand supported by increased wages and lower oil prices.
- Authorities’ projection:
  - My authorities have projected a 5.7 per cent of growth for 2015 compared to the growth of 4.5 per cent in 2014.
- Other developments:
  - Sri Lanka subscribed to the IMF’s Special Data Dissemination Standards (SDDS) on the 3rd of November 2015.

### Monetary policy and inflation
- Inflation:
  - Year on year headline inflation was 2.1 per cent at the end of 2014, declined to below zero during July to September 2015, then rebounded to 1.7 per cent in October 2015.
  - Inflation is expected to be in the range of 2 - 3 per cent by end 2015.
  - Core inflation stood at 4.4 per cent in October 2015.
- Monetary operations:
  - In March 2015, CBSL removed the restriction on access to its Standing Deposit Facility (SDF) that had been in place since September 2014, contributing to increased and volatile short term money market rates.
  - CBSL reduced policy rates by 50 basis points in April 2015 to minimize volatility and signal continuation of a relaxed monetary stance.
  - Net impact: increase in short term market interest rates from levels observed until February 2015.
  - Credit developments:
    - Credit to the private sector grew to 21.3 per cent year on year by end August 2015.
    - Monetary expansion increased from 13.4 per cent at end 2014 to 16.8 per cent by August 2015 year-on-year.
  - Macroprudential measures taken by authorities include enforcing a Loan to Value Ratio (LTV) and a margin deposit requirement on letters of credit to contain credit growth.
  - Authorities intend to undertake preemptive monetary policy measures in a timely manner.

### Financial sector soundness
- Capital and liquidity:
  - Capital Adequacy Ratios (CAR) in the banking sector remained well above regulatory minimum of 10 per cent.
  - At end June, total CAR was 16 per cent and core CAR was 13.5 per cent.
- Profitability and asset quality:
  - Profitability expanded due to business expansion, higher margins, increased lending and investment.
  - Non-performing loans (NPL) increased slightly from 4.2 per cent at end 2014 to 4.3 per cent at end June 2015.
  - Commercial banks are maintaining sufficient buffers.
- Regulatory measures:
  - Authorities have taken proactive measures to strengthen regulatory and supervisory frameworks and to adhere to BASEL III international standards.

### External sector measures and reserve management
- Factors affecting external sector:
  - Decline in external demand for major export commodities, withdrawal of foreign investments from government securities, and increased debt service payments contributed to weaker external performance.
  - CBSL intervened by supplying about USD 1.9 billion, on a net basis, during the first 8 months of 2015; since 4th September CBSL decided to limit intervention.
- Specific measures undertaken to support reserves and manage external pressures:
  - CBSL currency SWAP with Reserve Bank of India (RBI) in April 2015: received USD 400 million under SAARC central bank arrangement.
  - Second currency SWAP agreement with RBI in September 2015: received USD 1.1 billion.
  - International Sovereign Bond issues:
    - USD 650 million, 10-year maturity issued in June 2015.
    - USD 1,500 million, 10-year maturity issued in October 2015.
  - Measures to contain motor vehicle import impact on BOP:
    - 100 per cent margin deposit requirement against letters of credit on motor vehicle imports imposed from 30 October 2015 effective till 1st December 2015 (temporary).
    - LTV of 70 per cent for loans for purchase/utilization of motor vehicles imposed with effect from 15th September 2015; implementation deferred till 1st December 2015.
  - More flexibility allowed in exchange rate determination from first week of September 2015; CBSL intervention limited to avoid excessive volatility.
- Exchange rate movements:
  - The rupee depreciated by 7.0 per cent during 2015 up to end October 2015.
  - Authorities note Staff’s view that there is no fundamental misalignment of the exchange rate.

### Fiscal situation and consolidation plans
- 2015 fiscal outcomes and projections:
  - Original 2015 budget (passed November 2014) targeted a budget deficit of 4.6 per cent of GDP.
  - Interim budget (January 2015) targeted a budget deficit of 4.4 per cent of GDP anticipating enhanced revenue collection.
  - Actual 2015 budget deficit likely to exceed target; budget deficit in 2015 is more likely to be around 6.0-6.5 per cent while the debt to GDP ratio would be around 75.0 per cent.
- Policy commitments and planned measures:
  - Authorities committed to strengthening fiscal consolidation.
  - Firm measures to enhance revenue mobilization expected in the 2016 budget to be presented on the 20th of November 2015.
  - Development agenda to introduce policies on public investment and strict monitoring of project implementation.
  - Proposal to establish a State Holding Corporation Limited to manage state owned enterprises and provide state entrepreneurship; all state owned enterprises to come under this institution.
- Revenue mobilization challenges and administrative reforms:
  - Continued weak revenue mobilization identified as a key challenge.
  - Reforms to simplify the tax system, broaden the tax base and improve tax compliance have been implemented but were inadequate.
  - Revenue Administration Management Information System (RAMIS) being introduced at the Inland Revenue Department (IRD) expected to address some concerns.
  - An IMF TA is being arranged to identify weaknesses in tax laws and recommend improvements to legal frameworks and tax law redrafting.

### Conclusion and outlook
- Summary assessment:
  - Sri Lanka’s economic growth continued to remain strong with benign inflation outlook; financial sector stability remains healthy.
  - 2015 features political uncertainty with two elections and some policy slippages mainly in fiscal and external sectors, partly attributable to global developments.
  - In the absence of a firm medium term macroeconomic program, the staff report reflects only a baseline analysis.
- Next steps:
  - Government’s medium term vision and economic strategies presented on 5th of November 2015.
  - More precise reforms and policies to be presented in the 2016 budget on the 20th of November 2015; these measures expected to help maintain macroeconomic stability and support sustainable high economic growth.

*Prepared by Asia and Pacific Department, November 10, 2015 — Statement by Mrs. Swarna Gunaratne, Alternate Executive Director on Sri Lanka, Executive Board Meeting November 13, 2015.*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2016/_cr16152.pdf_