## _cr16371 ## Source details **Canonical URL:** [_cr16371](https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2016/_cr16371.pdf) ## Other formats - [Markdown version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2016/_cr16371.pdf.md) - [Structured JSON version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2016/_cr16371.pdf.json) --- ### Executive summary — context and program overview - IMF approval: 36-month extended arrangement under the Extended Fund Facility (EFF) for an amount equivalent to SDR 1.1 billion (185 percent of quota and about US$ 1.5 billion). - Arrangement start: three-year Extended Arrangement since June 2016; economy begun to stabilize supported by appropriate monetary and fiscal policies. - First review outcome: completion of the first review will make available the second purchase equivalent to SDR 119.894 million. - Political context and program risk: coalition government formed by SLFP and UNP since January 2015; political challenges, particularly over tax reforms (VAT and income taxes), constitute a key program risk. ### Recent developments and short-term outlook - Growth and activity: - GDP growth: 5.2 percent (y/y) in 2016Q1; 2.6 percent in 2016Q2. - Purchasing Managers’ Index for August 2016 points to a gradual recovery in the second half of the year. - Credit growth: 27 percent (y/y) in August 2016. - Inflation: - Headline inflation: 6 percent in June 2016; 3.9 percent (y/y) in September 2016. - Volatility driven by temporary food shortages (May floods) and suspension of VAT rate increase in July. - External sector and reserves: - Current account deficit: narrowed to 1 percent of annual GDP in the first half of the year (from 1.2 percent of GDP same period last year). - Sovereign bond issuance: government issued US$1.5 billion in international sovereign bonds in July 2016. - Net inflows from foreign holdings of government securities: net inflows of US$613 million during May–September 2016. - EMBI spread: tightened by 150 basis points over May–September 2016. - Exchange rate: depreciated by about 2 percent from beginning of May to end-October 2016. - CBSL foreign exchange operations: net purchases of about US$500 million during May–September 2016 compared with monthly average net sales of US$280 million during January 2015–April 2016. - Monetary policy: - CBSL raised policy rates by 50 basis points in both February and July 2016. - Average lending rate increased by about 150 basis points between December 2015 and September 2016. ### Staff projections (assuming steady policy implementation) - GDP growth: - 2016: projected at 4.5 percent. - 2017: revised down to 4.8 percent. - Medium term: 5.3 percent. - Inflation: - Projected to remain broadly stable at around 5 percent over 2016 and 2017. - Current account: - Projected to remain modest at around 2 percent of GDP over 2016–21. - Sources of external adjustment: - Remittances and tourism expected to offset a large part of the merchandise trade deficit; FDI prospects more modest with lower investment imports. ### Risks to the outlook - Domestic risks: - Lack of progress in revenue-based consolidation. - Further decline in growth. - Additional losses from state-owned enterprises (SOEs). - High level of central government debt (see Annex I). - External risks: - Shift in investor sentiment on emerging and frontier markets. - Slower-than-anticipated growth in the US and the EU. - Slowdown in China affecting tourism and FDI. ### Program performance and monitoring - Overall performance: Largely satisfactory; all end-June quantitative performance criteria (QPC) and indicative targets (IT) were met. - Structural benchmarks: - Structural benchmarks due in July–September 2016 were not met; authorities requested recalibration and completion now scheduled for December 2016. - Net international reserves (NIR): - End-June QPC for NIR met partly due to active use of FX swaps boosting net reserves by US$270 million in June 2016. - Indicative NIR target for September 2016 (adjusted upward due to capital inflows) was missed by US$426 million because CBSL’s FX purchase fell short of the adjusted target. - Fiscal performance (first half of 2016): - Central government overall deficit: 2.7 percent of annual GDP for the first half of 2016. - Primary deficit: slightly below the program ceiling, satisfying end-June QPC. - Tax revenue: rose by 20 percent during January–August 2016 over same period last year; end-June IT satisfied. - Total spending: higher than envisaged by 0.4 percentage points of GDP due to heavy frontloading of capital budget execution (up by 39 percent y/y) and larger-than-expected interest payments. ### Key fiscal policy issues and reforms - VAT and tax legislation: - July suspension of VAT amendments resubmitted to parliament in early October and subsequently legislated; newly approved VAT amendments in effect on November 1, 2016. - VAT amendments originally introduced in May included: (i) VAT rate increase from 11 to 15 percent, (ii) elimination of exemptions on telecoms and healthcare, and (iii) a lower threshold for the wholesale and retail sectors. - 2016 fiscal outlook: - Interim suspension revenue losses expected to be offset by stronger-than-envisaged collections of income taxes and import duties and by rationalization of spending on goods and services and public investment. - 2016 primary deficit likely to fall below the end-December ceiling of Rs 97 billion (0.8 percent of GDP). - Tax revenue likely to exceed full year target of Rs 1,428 billion (11.8 percent of GDP). - Interest payments expected to be larger than estimated by 0.4 percentage points of GDP, attributable to an upward shift in government bond yields by around 200 basis points since March, raising the overall deficit to around Rs 700 billion (5.7 percent of GDP). - 2017 budget and revenue measures: - Authorities presented a 2017 appropriation bill in October with a spending ceiling consistent with the program and aim for a primary balance in 2017. - Authorities pledged the 2017 budget would be underpinned by a well-crafted and high-quality tax policy package; tax package to be unveiled in the November 10, 2016 budget speech. - Staff recommendation: a tax package equivalent to ¾ percent of GDP focused on income tax reform including rationalization of corporate tax exemptions, removal of preferential corporate tax rates, and a uniform withholding tax rate for interest income (Annex II). - Medium-term consolidation targets: - Authorities’ commitment: reduce the overall deficit to 3.5 percent of GDP by 2020 (LOI, ¶4). - Required improvement: primary balance to a surplus of 1½ percent of GDP by 2020. - Expected impact: targeted primary balance path would reduce public debt to GDP ratio by 8 percentage points over 2015–20. - Note: Projected interest payments over 2016–20 revised upward by 0.5–0.7 percentage points of GDP in light of higher-than-envisaged interest payments in 2016 (by 0.4 percentage points of GDP) and assumed higher interest rates for new debt issuance in 2017 and beyond. ### Structural reforms and sequencing - Reform priorities and timeline: - By spring 2017 authorities plan to implement critical fiscal reforms to underpin medium-term consolidation. - Progress uneven but ongoing across fiscal policy, public financial management, and SOE reforms; correcting delays in past-due structural benchmarks is critical. - Inland Revenue Act (IRA) flagship: - Preparation for a new Inland Revenue Act (IRA) is underway with a view to submitting the bill to parliament by March 2017. - New IRA objectives: broaden tax base, modernize cross-border rules, reduce complexity via principles-based drafting, strengthen and clarify IRD powers to improve enforcement. - IMF technical assistance has supported IRA preparation; further TA for public consultation and implementation can be provided as necessary. - Complementary reforms and timelines (highlights): - VAT-centered tax administration reforms and RAMIS rollout rescheduled for completion by December. - Establishment of commitment record and control system; ITMIS pilot rollout at Ministries of Finance and Health in January 2017 (Finance delayed from December; Health advanced). - SOE reforms: SOEs’ outstanding financial obligations 11.4 percent of GDP at end-2015; preparation to publish Statements of Corporate Intent for six largest SOEs; resolution strategy for Sri Lankan Airlines to be adopted by December 2016. ### Monetary, exchange rate, and reserve policy guidance - Monetary policy stance: - CBSL tightened policy in 2016 (two 50 bps hikes) to contain credit growth and pre-empt demand-driven price pressures. - Inflation remained inside the inner consultation band on test dates; monetary policy consultation clause not triggered. - Exchange rate and reserves: - Given large external liabilities, authorities should further accumulate international reserves mainly through direct purchases of foreign exchange, while maintaining a firm commitment to greater exchange rate flexibility. - Financial sector monitoring: - Credit growth remains robust and warrants further monitoring despite early signs of inflation abating. ### Box 1 — Inland Revenue Act (summary) - Main findings: - Existing IRA (Inland Revenue Act, No. 10 of 2006) deemed "too inefficient to support sustained growth." - Complexity hinders investor understanding, tax administration, contributes to low tax-to-GDP ratio; does not adequately address modern business structures, creates distortions via ineffective incentives, targets a narrow base, limits collection and assessment powers, and is inconsistent with international best practices. - Government commitment and recommended reforms: - Cabinet approval in May 2016 committed to simplifying and modernizing the IRA. - Under the new IRA the government should: broaden the tax base by removing excess tax incentives and expanding sources of income; modernize cross-border rules to address base erosion; reduce complexity via principles-based drafting; strengthen IRD enforcement powers. - Complementary reforms and implementation timelines: - VAT compliance strategy and RAMIS expected by December. - ITMIS commitment control module pilot in January 2017. - SOE measures: publish SCIs for six largest SOEs; automatic pricing formulas for fuel and electricity models developed; resolution strategy for Sri Lankan Airlines by December 2016. - Key numeric projections and targets related to fiscal consolidation: - Medium-term fiscal consolidation envisages overall deficit of 3.5 percent of GDP by 2020 requiring primary surplus of 1½ percent of GDP by 2020. - Private credit growth: 27 percent in August expected to slow to around 18–20 percent by end 2016 and further in 2017. - CBSL land price index for Colombo District: increased by 12.5 percent (y-o-y) in June 2016. - FX swaps outstanding with domestic commercial banks: US$2.5 billion as of end-September 2016. - Gross international reserves projected to remain well below recommended range of 100−150 percent of the ARA metric throughout the program. - Financing assurances from World Bank, ADB, and key bilateral donors in place for sum of $650 million during 2016–18. - Financial sector vulnerabilities: - Of 46 licensed financial companies, 15 facing liquidity issues, with 6 at high distress and NPLs ranging from 50 to 90 percent. - Total assets of distressed companies about 1 percent of GDP (cost of resolution expected to be minimal). - Implementation risks and recommendations (selected): - Prioritize enactment and implementation of VAT amendments and the new IRA. - Implement RAMIS and risk-based VAT compliance by December. - Establish commitment record and roll out ITMIS pilot in January 2017. - Publish SCIs for six largest SOEs and adopt resolution strategy for Sri Lankan Airlines by December 2016. - Accumulate official international reserves mainly through direct FX market purchases; reduce reliance on FX swaps with commercial banks. - Enhance exchange rate flexibility while transitioning toward a flexible inflation targeting framework. - Use macro-prudential tools (e.g., maximum loan-to-value ratio) if credit growth does not abate or resurges. ### Annex I — Debt Sustainability Analysis (highlights) - Background and key assumptions: - Public debt: 80.4 percent of GDP at end-2015 (central government debt 76 percent of GDP; publicly guaranteed debt 3.4 percent; Fund credit outstanding 1 percent). - SOEs' outstanding financial obligations: 11.4 percent of GDP at end-2015 (not included in public debt outstanding; assessed under contingent liability shocks). - Foreign-currency denominated debt: 47 percent of total. - Gross financing needs: projected at 17.6 percent of GDP in 2016 comprising short-term debt repayment 5.2 percent, medium- and long-term amortization 6.6 percent, projected overall deficit 5.7 percent. - External debt: 55.1 percent of GDP at end-2015; ratio of debt to exports: 265 percent in 2015. - Baseline program scenario: - Real GDP growth: recover from 4.5 percent in 2016 to 5.3 percent by 2021. - Inflation: around 5 percent over the medium term. - Fiscal deficit: decrease from 5.7 percent of GDP in 2016 to authorities’ target of 3.5 percent of GDP in 2020. - Primary balance: improve from deficit of 2.2 percent of GDP in 2015 to surplus of 0.8 percent of GDP in 2018 and 1.6 percent of GDP in 2020. - Effective interest rate path revised upward by ½–1 percentage point over 2016–21 relative to previous DSA. - Public debt sustainability outcomes: - Public debt to GDP ratio projected to decline from 80.4 percent in 2015 to 70.1 percent in 2021 in the program scenario. - Gross financing needs projected to decrease from 17.6 percent of GDP in 2016 to 12 percent of GDP in 2021. - Downside shocks and outcomes: - If fiscal consolidation stalls and primary balance remains at 2016 level (-0.8 percent of GDP), reduction in debt-to-GDP over 2015−21 would be only 1½ percentage points (versus 10 percentage points in program scenario). - Individual shock impacts (relative to program scenario): primary balance shock (lower primary surplus by 0.4 percentage points for 2017−18); growth shock (GDP growth 2 percentage points lower in 2017−18); exchange rate shock (15 percent real depreciation in 2017); interest rate shock (increase by 300 basis points for new borrowings during 2017−20). - Combined shock scenario: debt to GDP ratio would reach 86 percent in 2021. - Contingent liability shock (central government liable for additional debt of 10 percent of GDP in 2017): debt to GDP ratio would reach 83 percent in 2021. - In combined shock and contingent liability shock scenarios, gross funding needs remain elevated at 15−16 percent of GDP in 2021. - Vulnerability assessment: - Heat map 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 program and shock scenarios. - External DSA: - External debt to GDP projected to decrease by 6 percentage points to 49 percent in 2021 under program scenario. - Gross external financing needs series and ratios presented in detail (examples: gross external financing need in percent of GDP: 17.0, 19.0, 16.0, 13.8, 15.7 for selected years as shown). - Tax policy options (Annex II) — revenue potential: - Staff presented policy options with potential to generate around 1.4 percent of GDP in revenue. - Examples listed: Corporate income tax options aggregate entries and Personal income tax, Financial income tax proposals (including uniform withholding tax for interest income and Capital Gains Tax expected by April 1, 2017). ### Program monitoring, TMU adjustments, and operational details - Primary balance adjustor for project loan disbursements (2016): - If gross cash disbursement of project loans in 2016 > US$1.5 billion, the floor on the primary balance for end-December 2016 adjusted downward by the difference (converted to Rupees); capped at Rs 20 billion. - Performance criterion on Program NIR: - Program NIR = CBSL conventional NIR minus CBSL outstanding liabilities (net short positions) in FX swaps with domestic commercial banks. - At end-2015: Program NIR US$ 2,893.1 million; CBSL conventional NIR US$ 5,028.8 million; CBSL FX swap liabilities US$ 2,135.7 million. - Wind-down framework: discontinue provision of FX swaps on concessional terms; reduce outstanding net short positions of FX swaps with commercial banks to below 20 percent of gross international reserves. - Valuation and exchange rates as of July 1, 2016 (select): - U.S. dollar 145.250; British pound 193.705; Japanese yen 1.411; Euro 161.249; Chinese yuan 21.829; SDR 202.763. - Monetary gold valuation: US$1,327.90 per troy ounce. - Continuous performance criteria and consultation clauses: - Continuous PC on non-accumulation of new external payments arrears on external debt contracted or guaranteed by nonfinancial public sector and CBSL. - Monetary policy consultation clause: consultation with IMF staff/Executive Board if observed year-on-year inflation on test dates falls outside specified bands measured by CCPI* methodology. - Data reporting and timetables: - Fiscal monitoring data to be provided within five weeks after month-end (with some items within seven weeks); external and monetary targets data within three weeks after month-end. - Reporting tables specified (Central Government Operations, Financing, CBSL balance sheet, FX cashflows, Gross Official Reserve Position). ### Fund staff recommendation and authority requests - Staff supports completion of the First Review under the EFF. - Staff supports authorities’ request for changes to the first-review availability date and modification of a performance criterion and the TMU. - Authorities requested that the second purchase be made available a few days before November 20 and intend to draw one tranche amounting to SDR 119.894 million upon First Review completion. - Reviews and purchases schedule under the three-year Extended Arrangement (selected items): - June 3, 2016 — 119.894 SDR millions — Board Approval. - November 18, 2016 1/ — 119.894 SDR millions — Completion of the first review (revised date). - Total — 1,070.780 SDR millions — 185.000 percent of Quota. ### Selected policy recommendations (concise action list) - Prioritize enactment and implementation of VAT amendments and the new Inland Revenue Act to support revenue-based consolidation. - Implement RAMIS and risk-based VAT compliance strategy by December to enhance revenue impact. - Establish commitment record and control system and roll out ITMIS pilot (commitment control module) in January 2017 to avoid arrears. - Publish Statements of Corporate Intent for the six largest SOEs and adopt a resolution strategy for Sri Lankan Airlines by December 2016. - Accumulate official international reserves mainly through direct FX market purchases; gradually wind down FX swaps with commercial banks toward below 20 percent of gross international reserves. - Maintain exchange rate flexibility while transitioning toward a flexible inflation targeting framework; be prepared to adjust monetary policy if inflation exits consultation bands. - Use macro-prudential tools (e.g., maximum loan-to-value regulation) if credit growth does not abate or resurges. *Source: IMF Executive Summary, November 4, 2016.* ### EXECUTIVE SUMMARY ### EXECUTIVE SUMMARY ### Context and program overview - IMF approval: 36-month extended arrangement under the Extended Fund Facility (EFF) for an amount equivalent to SDR 1.1 billion (185 percent of quota and about US$ 1.5 billion). - Arrangement start: Since the start of the three-year Extended Arrangement in June 2016, the economy has begun to stabilize, supported by appropriate monetary and fiscal policies. - First review outcome: The completion of the first review will make available the second purchase equivalent to SDR 119.894 million. - Political context: Coalition government formed by the two largest parties (SLFP and UNP) since January 2015. Political challenges, particularly over tax reforms (VAT and income taxes), are a key program risk. ### Recent developments and short-term outlook - Growth and activity: - GDP growth: 5.2 percent (y/y) in 2016Q1; 2.6 percent in 2016Q2. - Purchasing Managers’ Index for August 2016 points to a gradual recovery in the second half of the year. - Credit growth: 27 percent (y/y) in August 2016. - Inflation: - Headline inflation: 6 percent in June 2016; 3.9 percent (y/y) in September 2016. - Inflation described as volatile, affected by temporary food shortages (May floods) and suspension of VAT rate increase in July. - External sector and reserves: - Current account deficit: narrowed to 1 percent of annual GDP in the first half of the year (from 1.2 percent of GDP in same period last year). - Sovereign bond issuance: government issued US$1.5 billion in international sovereign bonds in July 2016. - Net inflows from foreign holdings of government securities: reversed to net inflows of US$613 million during May–September 2016. - EMBI spread: tightened by 150 basis points over May–September 2016. - Exchange rate: depreciated by about 2 percent from beginning of May to end-October 2016. - CBSL foreign exchange operations: shifted to net purchases of FX, purchasing about US$500 million on a net basis during May–September 2016 compared with monthly average net sales of US$280 million during January 2015–April 2016. - Monetary policy: - CBSL raised policy rates by 50 basis points in both February and July 2016. - Average lending rate increased by about 150 basis points between December 2015 and September 2016. ### Staff projections (on the expectation of steady policy implementation) - GDP growth: - 2016: projected at 4.5 percent. - 2017: revised down to 4.8 percent (from prior assessment). - Medium term: 5.3 percent. - Inflation: - Projected to remain broadly stable at around 5 percent over 2016 and 2017. - Current account: - Projected to remain modest at around 2 percent of GDP over 2016–21. - Sources of external adjustment: remittances and tourism expected to offset a large part of the merchandise trade deficit; FDI prospects more modest with lower investment imports. ### Risks to outlook - Domestic risks: - Lack of progress in revenue-based consolidation. - Further decline in growth. - Additional losses from state-owned enterprises (SOEs). - High level of central government debt (see Annex I for debt sustainability analysis). - External risks: - Shift in investor sentiment on emerging and frontier markets. - Slower-than-anticipated growth in the US and the EU. - Slowdown in China affecting tourism and FDI. ### Program performance and monitoring - Overall performance: Largely satisfactory; all end-June quantitative performance criteria (QPC) and indicative targets (IT) were met. - Structural benchmarks: - Structural benchmarks due in July–September 2016 were not met; authorities have requested recalibration and have taken corrective action with completion now scheduled for December 2016. - Net international reserves (NIR): - End-June QPC for NIR met by a comfortable margin, partly due to active use of FX swaps with domestic banks that boosted net reserves by US$270 million in June 2016. - Indicative NIR target for September 2016 (adjusted upward due to capital inflows) was missed by US$426 million because CBSL’s FX purchase fell short of the adjusted target. - Fiscal performance (first half of 2016): - Central government overall deficit: 2.7 percent of annual GDP for the first half of 2016. - Primary deficit: slightly below the program ceiling, satisfying end-June QPC. - Tax revenue: rose by 20 percent during January–August 2016 over same period last year; end-June IT satisfied. - Total spending: higher than envisaged by 0.4 percentage points of GDP due to heavy frontloading of capital budget execution (up by 39 percent y/y) and larger-than-expected interest payments. ### Key fiscal policy issues and reforms - VAT and tax legislation: - July suspension of VAT amendments was resubmitted to parliament in early October (meeting a prior action) and subsequently legislated; newly approved VAT amendments will be in effect on November 1, 2016. - VAT amendments originally introduced in May included: (i) VAT rate increase from 11 to 15 percent, (ii) elimination of exemptions on telecoms and healthcare, and (iii) a lower threshold for the wholesale and retail sectors. - 2016 fiscal outlook: - New VAT amendments' interim suspension revenue losses expected to be offset by stronger-than-envisaged collections of income taxes and import duties and by rationalization of spending on goods and services and public investment. - 2016 primary deficit likely to fall below the end-December ceiling of Rs 97 billion (0.8 percent of GDP). - Tax revenue likely to exceed full year target of Rs 1,428 billion (11.8 percent of GDP). - Interest payments expected to be larger than estimated by 0.4 percentage points of GDP, attributable to an upward shift in government bond yields by around 200 basis points since March, raising the overall deficit to around Rs 700 billion (5.7 percent of GDP). - 2017 budget and revenue measures: - Authorities presented a 2017 appropriation bill in October with a spending ceiling consistent with the program and aim for a primary balance in 2017. - Authorities pledged the 2017 budget would be underpinned by a well-crafted and high-quality tax policy package; tax package to be unveiled in the November 10, 2016 budget speech. - Staff recommendation: a tax package equivalent to ¾ percent of GDP focused on income tax reform including rationalization of corporate tax exemptions, removal of preferential corporate tax rates, and a uniform withholding tax rate for interest income (Annex II). - Medium-term consolidation targets: - Authorities’ commitment: reduce the overall deficit to 3.5 percent of GDP by 2020 (LOI, ¶4). - Required improvement: primary balance to a surplus of 1½ percent of GDP by 2020. - Expected impact: targeted primary balance path would reduce public debt to GDP ratio by 8 percentage points over 2015–20. - Note: Projected interest payments over 2016–20 revised upward by 0.5–0.7 percentage points of GDP in light of higher-than-envisaged interest payments in 2016 (by 0.4 percentage points of GDP) and assumed higher interest rates for new debt issuance in 2017 and beyond. ### Structural reforms and sequencing - Reform priorities and timeline: - By spring 2017 authorities plan to implement critical fiscal reforms to underpin medium-term consolidation (see Table 2 attached to the LOI). - Progress uneven but ongoing across fiscal policy, public financial management, and SOE reforms; correcting delays in past-due structural benchmarks is critical. - Tax policy flagship: Inland Revenue Act (IRA) - Preparation for a new Inland Revenue Act (IRA) is underway with a view to submitting the bill to parliament by March 2017. - IMF technical assistance has supported IRA preparation and further TA for public consultation and implementation phases can be provided as necessary. - The new IRA is intended to support planned revenue mobilization under the 2017 budget, in combination with a tax expenditure statement and a strategy to rationalize tax expenditures. ### Monetary, exchange rate, and reserve policy guidance - Monetary policy stance: - CBSL tightened policy in 2016 (two 50 bps hikes) to contain credit growth and pre-empt demand-driven price pressures. - Inflation remained inside the inner consultation band on test dates; monetary policy consultation clause was not triggered. - Exchange rate and reserves: - Given large external liabilities, authorities should further accumulate international reserves mainly through direct purchases of foreign exchange, while maintaining a firm commitment to greater exchange rate flexibility. - Financial sector monitoring: - Credit growth remains robust and warrants further monitoring despite early signs of inflation abating. *Source: IMF Executive Summary, November 4, 2016.* ### Box 1. Inland Revenue Act ### Box 1. Inland Revenue Act ### Overview and main findings - The existing Inland Revenue Act (IRA: Inland Revenue Act, No. 10 of 2006) is viewed as "too inefficient to support sustained growth." - The IRA’s higher complexity: - Hinders investors’ ability to understand the income tax system. - Hinders local tax officials’ ability to administrate. - Contributes to Sri Lanka’s low tax-to-GDP ratio. - The IRA in its current form: - Does not adequately deal with modern business structures and commercial transactions (especially cross-border transactions). - Creates distortions in investment through ineffective and inefficient tax incentives. - Targets a narrow tax base. - Limits collection and assessment powers, and encourages taxpayer challenges. - Is inconsistent with international best practices. ### Government commitment and recommended reforms to the IRA - Cabinet approval in May 2016 committed to simplifying and modernizing the IRA to improve administrative efficiency and increase revenue. - Under the new IRA, the government should: - Broaden the tax base by removing excess tax incentives and expanding the sources of income. - Modernize rules related to cross-border transactions to address base erosion and combat tax avoidance. - Reduce complexity through an improved principles-based drafting style. - Strengthen and clarify existing powers of the IRD to improve enforcement. ### Complementary reforms and implementation timelines - Tax administration - VAT-centered tax administration reforms, including adoption of a risk-based VAT compliance strategy, were delayed due to suspension of the VAT amendments, but rescheduled for completion by December. - Full rollout of the new revenue administration IT system (RAMIS) is expected by December as originally planned. - Expected outcome: improve tax collection and increase the revenue impact of new tax policy measures, including the VAT and the new IRA. - Public financial management (PFM) - Program envisages establishment of a commitment record and control system to avoid recurrence of arrears. - Commitments have been recorded up to June 2016, but creation of a system that can produce quarterly reports and commitment ceilings delayed until December to make necessary IT infrastructure changes. - Pilot rollout of the new IT system (ITMIS) with an automatic commitment control module at the Ministries of Finance and Health will take place simultaneously in January 2017 (with a delay for Finance Ministry and an advance for Health Ministry). - State-owned enterprise (SOE) reform - SOEs’ outstanding financial obligations remain large: 11.4 percent of GDP at end-2015. - Preparation is underway to publish Statements of Corporate Intent (SCIs) for each of the six largest SOEs. - Introducing automatic pricing formulas for fuel and electricity requires government action; models to estimate cost-recovery fuel and electricity prices have been developed. - A resolution strategy for Sri Lankan Airlines is to be adopted by December 2016 (with delay), including finding a strategic partner and a comprehensive cost-cutting. ### Links to broader reform agenda and macroeconomic context - Structural reforms needed to boost competitiveness include: - Removing protectionist para-tariffs and non-tariff barriers to trade. - Improving efficiency in trade facilitation (e.g., electronic customs documentation). - Strengthening access to finance. - Tax reforms—including simplification of the IRA—to attract further FDI. - The authorities announced intent to foster FDIs and accelerate growth, including by linking to global supply chains. - Staff noted simplification of the IRA and VAT amendments as two key immediate steps to support medium-term fiscal consolidation. ### Key numeric projections, targets, and risks related to fiscal consolidation and macro policy - Fiscal targets and trajectories: - Medium-term fiscal consolidation envisages an overall deficit of 3.5 percent of GDP by 2020. - This would require a primary surplus of 1½ percent of GDP by 2020. - Credit, inflation, and monetary policy: - Private credit growth: 27 percent in August (y-o-y) expected to slow to around 18–20 percent by end 2016 and further in 2017. - CBSL land price index for Colombo District increased by 12.5 percent (y-o-y) in June 2016. - Inflation expected to remain around 5 percent over 2016–17 after accounting for the effect of VAT amendments. - External sector and reserves: - SOE outstanding financial obligations: 11.4 percent of GDP at end-2015. - FX swaps outstanding with domestic commercial banks: US$2.5 billion as of end-September 2016. - Gross international reserves are projected to remain well below the recommended range of 100−150 percent of the ARA metric throughout the program. - Original end-2016 NIR target assumed outflows from government securities around US$450 million in the second half of the year (program adjustor). - Financing assurances from the World Bank, Asian Development Bank, and key bilateral donors in place for the sum of $650 million during 2016–18. - Financial sector vulnerabilities and resolution: - Of the 46 licensed financial companies in Sri Lanka, 15 are facing liquidity issues, with 6 at a high level of distress with NPLs ranging from 50 to 90 percent. - Total assets of the distressed companies are about 1 percent of GDP (cost of resolution expected to be minimal). ### Implementation risks and policy recommendations - Key risks to the program: - (i) Revenue slippage or failure to implement key revenue-related reforms. - (ii) Weaker than expected capital inflows or a reversal of capital flows. - (iii) Lower than expected growth and/or new pressures on the trade account. - (iv) Larger than expected losses at SOEs and lack of progress in SOE reforms. - Specific policy recommendations and actions: - Prioritize enactment and implementation of VAT amendments and the new IRA to support revenue-based consolidation. - Implement tax administration reforms (RAMIS, risk-based VAT compliance) by December to enhance revenue impact. - Establish the commitment record and control system and roll out ITMIS pilot in January 2017 to avoid arrears. - Publish SCIs for the six largest SOEs and adopt a resolution strategy for Sri Lankan Airlines by December 2016. - Accumulate official international reserves mainly through direct purchases from the FX market, reducing reliance on FX swaps with commercial banks. - Enhance exchange rate flexibility in tandem with transition toward a flexible inflation targeting framework. - Use macro-prudential tools (e.g., maximum loan-to-value ratio regulation) if credit growth does not abate or resurges. *Source: Box 1. Inland Revenue Act, _cr16371 - Box 1. Inland Revenue Act.* ### 29. In light of the progress so far and the authorities’ policy commitments going forward, ### _cr16371 - 29. In light of the progress so far and the authorities’ policy commitments going forward, ### Fund staff recommendation - Staff supports the completion of the First Review under the Extended Fund Facility. - Staff supports the authorities’ request for changes to the first-review availability date and modification of performance criterion and the TMU. ### Real sector (figures and charts included) - Figures include time series and indicators for: - Industrial production. - Purchasing managers' index, manufacturing (RHS) and services (RHS). - Economic Activity (y/y percent change). - Colombo CPI (CCPI), Core CCPI, National CPI (NCPI) — Consumer Price Index (y/y percent change). - Trade balance (3-month cumulative), import growth % y/y 3mma (RHS), export growth % y/y 3mma (RHS) — Trade (In billions of U.S. dollars, per quarter). - Real GDP growth (y/y percent change and sectoral contributions) with sectoral breakdowns: Agriculture, forestry, fishing; Industry; Services; Taxes less subsidies. - Colombo Consumer Price Index (y/y percent change and contribution to total) with contributions for Food, Housing & utility, Transport, Other, Headline. - Real GDP growth (y/y percent change and contributions) with components Net exports, Gross capital formation, Final consumption expenditure. - Sources cited for charts: Central Bank of Sri Lanka; and IMF staff calculations. ### Fiscal sector (figures and summary) - Charts include: - Central Government Operations (Revenue, Expenditure, Overall deficit (RHS)) — (In percent of GDP). - Tax Revenue composition: Other, Excise, VAT, Income tax (In percent of GDP). - Current and Capital Expenditure (Capital, Interest, Current non-interest, Total expenditure) — (In percent of GDP). - Government Securities issuance and CBSL holding of T-bills/T-bonds (In Rs. billion, cumulative from beginning of the year). - Public Debt and Gross Financing Needs (Gross financing needs, Public debt, Primary balance (RHS)) — (In percent of GDP). - Quarterly Revenue and Expenditure (In percent of GDP). - Sources cited for charts: Central Bank of Sri Lanka; Ministry of Finance; and IMF staff calculations. ### Financial market (figures) - Charts include: - Repo and interbank rates (Repo, Reverse repo, Call market, Prime lending) — (In percent per annum). - Short-term interest rates (3-mo Tbill, 12-mo Tbill, Call market) — (In percent per annum). - Generic Government Bonds Yield (3-year, 5-year, 10-year) — (In percent per annum). - Deposit Rate and Spread (Prime Lending Rate, Deposit, Spread (prime lending-deposit) (RHS)) — (In percent). - Stock Market Index (Dec 30, 2014 = 100) for Sri Lanka and peers. - EMBI Sovereign Spreads (In basis points) for Sri Lanka and peers. - Sources cited for charts: Central Bank of Sri Lanka; CEIC Daily Database; Bloomberg Data LP; and IMF staff calculations. ### Foreign exchange and reserves (figures) - Charts include: - Exchange Rate (Rupee/US$) and 3-mo onshore forward points (basis points). - CBSL Foreign Exchange Net Absorption (Monthly and 3M average) (In millions of US$). - Effective Exchange Rate (NEER, REER) (Index, June 2009=100). - Exchange Rates (USD/LCU, Index, Jan 2015=100) for Sri Lanka and selected countries. - Foreign Ownership of Government Securities (Foreign holding in USD; Share of foreign ownership %, RHS). - International Reserves: Gross and Net (In billions of US$). - Sources cited for charts: Central Bank of Sri Lanka; APDCORE Database; Bloomberg Data LP; and IMF staff calculations. ### Monetary and financial sector (figures) - Charts and indicators include: - Capital adequacy of banking sector (Regulatory capital to risk weighted assets; Core capital to risk weighted assets) — (In percent). - Non-performing loans of banking sector (Gross NPL to total gross loans; Net NPL to total gross loans; Provisions to gross NPL (RHS)) — (In percent). - Profitability of banking sector (Return on equity (after tax); Return on assets (after tax) (RHS)) — (In percent). - Liquidity of banking sector (Liquid assets to total assets; Credit to total deposits) — (In percent). - Monetary aggregates: Reserve money, Broad money, Credit to private sector (Monetary Aggregate in year-on-year percent change; Credit to private sector (% of GDP, RHS)). - Reserve money contributions decomposition (Other, T-bill holdings, Advances to govt, Net foreign assets). - Sources: Central Bank of Sri Lanka; and IMF staff calculations. ### Selected economic indicators (Table 1 highlights) - Table titled "Sri Lanka: Selected Economic Indicators, 2014–21" presents comprehensive macro aggregates, including (excerpts visible): - Real GDP growth series (reported in-line in table). - Inflation (average) and end-of-period inflation series. - Core inflation (end-of-period). - Savings and investment (% of GDP) including National savings, Government, Private, National Investment, and component series Government and Private. - Public finances (in percent of GDP): Revenue and grants, Expenditure, Primary balance, Central government balance, Central government net domestic financing, Central government debt. - Money and credit (percent change, end of period): Reserve money, Broad money, Domestic credit, Credit to private sector, Credit to government. - Balance of payments (in millions of U.S. dollars): Exports, Imports, Current account balance (and percent of GDP), Export and import value growth (percent). - Gross official reserves (end of period) in millions of U.S. dollars and in months of imports. - External debt (public and private) in billions of U.S. dollars and as percent of GDP. - Sources: Data provided by the Sri Lankan authorities; and IMF staff estimates. ### Central government operations (Tables 2a–2d highlights) - Tables provide detailed central government operations in both rupees and percent of GDP, including: - Total revenue and grants; Total revenue; Tax revenue and components (Income taxes, VAT, Excise taxes, Other trade taxes, Other); Nontax revenue; Grants. - Total expenditure and net lending; Current expenditure and components (Civil service wages and salaries, Other civilian goods and services, Security expenditure, Subsidies and transfers, Interest payments); Capital expenditure and net lending. - Overall balance and financing (Net external financing; Net domestic financing). - Memorandum: Primary balance; Central government debt (domestic currency and foreign currency components); Fund credit outstanding; Financial obligations of nonfinancial SOEs (note: figure does not cover all nonfinancial SOEs — covers Ceylon Electricity Board, Ceylon Petroleum Corporation, Sri Lanka Port Authorities, Sri Lankan Airlines, and other SOEs). - Quarterly and multi-year projections are presented for 2016–17 in Tables 2c and 2d, including gross inflows/outflows, debt disbursements and amortizations, interest payments, and government deposits. ### Monetary accounts (Tables 3a–3b highlights) - Central Bank of Sri Lanka and Monetary survey stocks in billions of rupees (end of period), including: - Net foreign assets; Net domestic assets; Net claims on central government; Net claims on banks; Other items, net; Reserve Money. - Monetary survey: Monetary authorities; Deposit money banks; Net domestic assets; Net claims on central government; Credit to corporations (public and private); Other items (net); Broad money. - Memorandum items: Gross international reserves (in millions of US$); Net international reserves; Net Foreign Assets (in millions of US$); Private credit (in percent of GDP); Money multiplier; Broad money velocity. - Growth rates (end of period) for Broad money, Reserve money, Credit to public corporations, Credit to private sector. - Sources: Central Bank of Sri Lanka; and IMF staff projections. ### Balance of payments and external financing (Tables 4a–4c highlights) - Table 4a (2014–21) and Table 4b (2016–17 quarterly) present: - Current account components: Balance on goods (exports and imports), Balance on services (exports and imports), Primary income net, Secondary income net (including workers' remittances), Capital account. - Financial account breakdown: Direct investments, Portfolio investments (equity and investment fund shares; debt instruments and components), Other investments (currency and deposits; loans and disbursements/amortizations by sector), Errors and omissions. - Overall balance and total financing, change in reserve assets, use of Fund credit (purchases/repurchases). - Memoranda: Current account (percent of GDP); Gross official reserves (levels and months of imports); Net international reserves; In percent of ARA composite metric; GDP series (in millions of US$). - Table 4c: Gross external financing needs and sources, including borrowing by sector, sovereign bonds, bilateral and multilateral flows, FDI inflows, private sector loans, change in reserve assets, and external financing gaps and financing composition. Specific entries include: - Gross external financing needs: -3,846 -2,942 -4,425 -3,511 -3,573 -5,481 -5,265 -4,378 (series as shown). - Sources of financing and borrowing totals are presented in detail as in the table. ### Financial soundness indicators (Table 5 highlights) - Table provides banking sector indicators (All Banks, 2012–16 and quarters): - Regulatory capital to risk weighted assets series (e.g., 16.4 16.3 15.6 16.3 ...). - Tier 1 capital/risk weighted assets series. - Capital to assets ratio series. - Gross non performing loans to total gross loans (without interest in suspense) series. - Net non performing loans to total gross loans series. - Provision coverage ratio (total). - Return on equity (after tax) and Return on assets (after tax). - Interest income to gross income; Staff expenses to noninterest expenses; Total cost to total income; Net interest margin. - Liquid assets to total assets; Deposits; Borrowings; Credit to deposits. - Source: Central Bank of Sri Lanka. ### Reviews and purchases under the Extended Arrangement (Table 6) - Schedule of Reviews and Purchases under the Three-year Extended Arrangement: - June 3, 2016 — 119.894 SDR millions — 20.714 percent of Quota — Board Approval of the Extended Arrangement. - November 18, 2016 1/ — 119.894 SDR millions — 20.714 percent of Quota — Completion of the first review based on end-June 2016 and continuous performance criteria. - April 20, 2017 — 119.894 SDR millions — 20.714 percent of Quota — Completion of the second review based on end-December 2016 and continuous performance criteria. - November 20, 2017 — 177.774 SDR millions — 30.714 percent of Quota — Completion of the third review based on end-June 2017 and continuous performance criteria. - April 20, 2018 — 177.774 SDR millions — 30.714 percent of Quota — Completion of the fourth review based on end-December 2017 and continuous performance criteria. - November 20, 2018 — 177.774 SDR millions — 30.714 percent of Quota — Completion of the fifth review based on end-June 2018 and continuous performance criteria. - April 20, 2019 — 177.776 SDR millions — 30.715 percent of Quota — Completion of the sixth review based on end-December 2018 and continuous performance criteria. - Total — 1,070.780 SDR millions — 185.000 percent of Quota. - Note: "1/ This replaces the original date of November 20, 2016, as proposed in the Staff Report." Source: IMF staff. ### Projected payments to the Fund (Table 7 highlights) - Fund repurchases and charges (in millions of SDR, series shown): - Series (as presented): 36.1 178.5 9.5 12.6 22.8 62.5 116.3 174.2 187.0 185.0 173.0 131.2 75.4 15.5 - Corresponding series in millions of U.S. dollars (as presented): 50.4 250.4 13.3 17.8 32.3 88.5 164.5 246.4 264.6 261.8 244.7 185.6 106.7 21.9 - Fund credit outstanding series (in millions of SDR and in millions of U.S. dollars) and percent of quota and percent of GDP and percent of gross official reserves are provided for projection years through 2029 in the table. - Memorandum items include exports of goods and services series, Quota and Quota (in millions of U.S. dollars), Gross official reserves series, GDP series (in millions of U.S. dollars), and U.S. dollars per SDR (eop and avg). - Source: IMF staff estimates (as of October 28, 2016 using the new quota effective February 17, 2016). *Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2016/_cr16371.pdf* ### Annex I. Debt Sustainability Analysis ### Annex I. Debt Sustainability Analysis ### A. Background and Key Assumptions - Public debt reached 80.4 percent of GDP at end-2015. Public debt in this DSA covers: - central government debt: 76 percent of GDP - outstanding amount of loans guaranteed by the central government: 3.4 percent of GDP - outstanding Fund credit: 1 percent of GDP - SOEs' financial obligations identified by recent FAD TA (11 percent of GDP at end-2015) are not included in the public debt outstanding; possible realization of these contingent liabilities is assessed under a shock scenario. - Foreign-currency denominated debt: 47 percent of total. - Debt owed to official and multilateral creditors: about a quarter of the total. - Gross financing needs are projected at 17.6 percent of GDP in 2016, comprising: - short-term debt repayment: 5.2 percent of GDP - medium-and long-term debt amortization: 6.6 percent of GDP - projected overall deficit: 5.7 percent of GDP - Comparison with peers: - Sri Lanka’s debt to GDP ratio: higher than the median for emerging economies (57 percent; excluding major oil exporters) - gross funding needs: the fifth largest among emerging economies - Sri Lanka: Public Debt, 2015 (Rs. billion and % of GDP) - Public debt: 8,992 80.4 - Central government debt: 8,503 76.0 - Domestic: 4,959 44.3 - Treasury Bills: 658 5.9 - Treasury Bonds: 3,305 29.6 - Other (domestic): 996 8.9 - External: 3,544 31.7 - Multilateral and bilateral: 2,237 20.0 - International sovereign bonds: 958 8.6 - Nonresident holdings of T-Bills and T-Bonds: 304 2.7 - Other (external): 45 0.4 - Publicly guaranteed debt: 382 3.4 - Fund credit outstanding: 107 1.0 - Memorandum items (SOE debt and selected SOEs, Rs. billion and % of GDP): - SOE debt: 1,280 11.4 - Ceylon Electricity Board: 237 2.1 - Ceylon Petroleum Corporation: 424 3.8 - Sri Lanka Ports Authority: 240 2.2 - Sri Lankan Airlines: 309 2.8 - Other: 69 0.6 - External debt estimated at 55.1 percent of GDP at end-2015: - Predominantly owed by the public sector (55 percent held by the general government and 6 percent by the central bank) - Private external debt rose, with debt of deposit-taking financial institutions rising from 13 percent of total in 2011 to 20 percent in 2015 - Ratio of debt to exports: 265 percent in 2015 - Rollover risks: low as 83 percent of total debt is medium or long term - Next sovereign bond repayment: US$1.5 billion, not due until 2019 - About half of the central government’s external debt stock is denominated in dollars - Baseline scenario assumptions (program under EFF-supported arrangement): - Real GDP growth: recover from 4.5 percent in 2016 to 5.3 percent by 2021 - Inflation: around 5 percent over the medium term - Fiscal deficit: programmed to decrease from 5.7 percent of GDP in 2016 to authorities’ target of 3.5 percent of GDP in 2020 - Primary balance: improves from deficit of 2.2 percent of GDP in 2015 to surplus of 0.8 percent of GDP in 2018 and 1.6 percent of GDP in 2020 - Interest payments: based on projected interest payments for existing debt and secondary market rates prevailing in July–September 2016 for newly issued debt in 2016; interest rates for newly issued debt assumed to decrease gradually over the medium term - Revision note: effective interest rate path revised upward by ½–1 percentage point over 2016–21 from the previous DSA, increasing interest payments by about ½ percentage point of GDP relative to previous projections; the primary surplus compatible with an overall deficit of 3.5 percent of GDP by 2020 becomes 1½ percent of GDP in 2020 (½ percent of GDP higher than previously projected) - Publicly guaranteed debt: projected to remain broadly unchanged at the 2015 level in nominal terms - External debt projections: based on stable current account deficit around 2 percent of GDP over 2016–21 and incorporate planned purchases under the Fund’s Extended Arrangement and program loan disbursements by multilateral and bilateral creditors ### B. Public Debt Sustainability - Program scenario outcomes: - Public debt to GDP ratio projected to decline from 80.4 percent in 2015 to 70.1 percent in 2021 - Reduction in debt to GDP of about 2–3 percent annually from 2018 onwards - Gross financing needs projected to decrease from 17.6 percent of GDP in 2016 to 12 percent of GDP in 2021 - Decline supported by favorable debt dynamics with a negative interest-rate-and-growth differential - Downside risks and shock scenarios: - If fiscal consolidation stalls and primary balance remains unchanged at the 2016 level (-0.8 percent of GDP), reduction in debt-to-GDP over 2015−21 would be only 1½ percentage points (versus 10 percentage points in program scenario) - Individual shock impacts (relative to program scenario): - Primary balance shock: lower primary surplus by 0.4 percentage points of GDP for 2017−18 - Growth shock: GDP growth 2 percentage points lower than in the program scenario for 2017−18 - Exchange rate shock: 15 percent real depreciation in 2017 vis-à-vis the program scenario - Interest rate shock: increase by 300 basis points for new borrowings during 2017−20 vis-à-vis the program scenario - Combined shock scenario result: debt to GDP ratio would reach 86 percent in 2021 - Contingent liability shock scenario (central government liable for additional debt of 10 percent of GDP in 2017): debt to GDP ratio would reach 83 percent of GDP in 2021 - In the combined shock scenario and the contingent liability shock scenario, gross funding needs would remain elevated at 15−16 percent of GDP in 2021 - Vulnerability assessment: - 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 the program and shock scenarios during the projection period - Debt profile analysis indicates a moderate degree of vulnerabilities related to market perception, external financing requirement, debt held by non-residents, and debt denominated in foreign currency ### C. External Debt Sustainability - Program scenario projections: - Ratio of external debt to GDP projected to decrease by 6 percentage points of GDP to 49 percent in 2021 - Decline driven by robust GDP growth, gradual current account adjustments, and subdued FDI loans and other debt-creating private capital inflows *Source: Annex I. Debt Sustainability Analysis (Sri Lanka), IMF staff analysis.* ### 8. Nevertheless, vulnerabilities linked to inadequate reserve coverage, exchange rate ### _cr16371 - 8. Nevertheless, vulnerabilities linked to inadequate reserve coverage, exchange rate ### Key vulnerabilities and stress-test findings - Currency risk, notably related to the dollar, is high. - Large rupee depreciation could pose a significant risk, if sustained; as stress tests show that a 30 percent real depreciation would raise the external debt to GDP ratio to about 72 percent. - In the short run, tighter global liquidity and shifts in investor confidence could raise rollover vulnerabilities and costs. - Although rollover risks are generally low due to the high share of medium- to long-term debt, there are lumpy repayments starting in 2019, and external financing at non concessional terms gradually substitutes concessional financing, pointing to a need to build up buffers. - Lower than expected GDP or export growth would also deteriorate debt dynamics. ### Stress-test parameters and risk-assessment benchmarks (as presented) - Bond spread shocks considered: 200 and 600 basis points for bond spreads. - External financing requirement benchmarks: 5 and 15 percent of GDP. - Change in the share of short-term debt: 0.5 and 1 percent. - Public debt held by non-residents benchmarks: 15 and 45 percent. - Share of foreign-currency denominated debt benchmarks: 20 and 60 percent. - Gross financing needs benchmark mentioned: 15 percent. - Highlighting rule for cells: green if below lower benchmark, yellow if between benchmarks, red if above upper benchmark, white if not relevant or data unavailable. ### Public Sector DSA — selected projections and indicators - Nominal gross public debt: 2014 75.7; 2015 76.5; 2016 80.4; 2017 80.9; 2018 80.2; 2019 78.2; 2020 75.7; 2021 72.8; 2022 70.1 (table heading shows sequence "75.776.580.480.980.278.275.772.870.1" presented as a row). - Public gross financing needs (in percent of GDP) shown across projection years in charts (see figures). - Sovereign spreads: EMBIG (bp) 356; long-term bond spread over U.S. bonds example EMBIG (bp) 3/356 (presented). - Real GDP growth (in percent) projection row: 2016 4.5; 2017 4.8; 2018 4.9; 2019 5.1; 2020 5.2; 2021 5.3. - Inflation (GDP deflator, in percent) projection: 2016 4.2; 2017 4.6; 2018 5.0; 2019 5.0; 2020 5.0; 2021 5.0. - Effective interest rate (in percent) projection row: 2016 7.1; 2017 7.4; 2018 7.8; 2019 8.0; 2020 8.0; 2021 7.8. - Change in gross public sector debt (cumulative) projection to 2021: -10.4 (presented in a row). - Identified debt-creating flows (cumulative): -14.0 (presented). - Components of automatic debt dynamics and contributions: automatic debt dynamics cumulative -9.8; interest rate/growth differential cumulative -9.8; of which real interest rate cumulative 11.3; of which real GDP growth cumulative -21.1. - Residual, including asset changes (cumulative): 3.7. - Baseline and alternative scenarios displayed: Baseline real GDP growth 4.5/4.8/4.9/5.1/5.2/5.3; Historical scenario real GDP growth 4.5/6.1/6.1/6.1/6.1/6.1; Constant Primary Balance scenario primary balance fixed at -0.8 across projection years. ### External Debt Sustainability (external DSA) — key numbers and dynamics - Baseline: external debt (percent of GDP) series includes 2011 50.2; 2012 54.2; 2013 53.6; 2014 53.8; 2015 55.1; 2016 54.3; 2017 53.3; 2018 51.8; 2019 52.0; 2020 50.8; 2021 49.4. - Change in external debt (annual): 6.4, 4.0, -0.6, 0.2, 1.3, -0.8, -1.0, -1.5, 0.2, -1.2, -1.4 (years 2011–2021 as presented). - Identified external debt-creating flows (row 3): 0.0, 1.3, -2.5, -2.5, 0.8, -1.0, -1.2, -1.4, -1.4, -1.6, -1.6. - Current account deficit, excluding interest payments (in percent of GDP): 6.0, 4.5, 2.0, 1.0, 1.0, 0.5, 0.6, 0.5, 0.4, 0.3, 0.4 (2011–2021). - Exports (percent of GDP): 20.9, 19.8, 20.3, 20.9, 20.8, 21.3, 21.1, 21.0, 20.8, 20.4, 20.1. - Imports (percent of GDP): 34.1, 31.7, 28.9, 28.9, 28.3, 28.1, 28.0, 27.5, 26.9, 26.2, 25.4. - Net non-debt creating capital inflows (negative): -1.4, -1.7, -1.5, -1.3, -0.7, -0.7, -0.9, -1.1, -1.0, -1.1, -1.2. - Automatic debt dynamics (row 9): -4.6, -1.5, -3.0, -2.3, 0.5, -0.8, -0.8, -0.8, -0.8, -0.8, -0.8. - Contribution from nominal interest rate (row 10): 1.1, 1.3, 1.4, 1.4, 1.5, 1.6, 1.6, 1.6, 1.7, 1.7, 1.6. - Contribution from real GDP growth (row 11): -3.2, -4.4, -1.7, -2.4, -2.5, -2.4, -2.5, -2.4, -2.4, -2.5, -2.5. - Residual, including change in gross foreign assets (row 13): 6.4, 2.7, 1.9, 2.7, 0.6, 0.2, 0.2, -0.1, 1.6, 0.4, 0.2. - External debt-to-exports ratio (in percent): 240.0, 273.3, 264.6, 257.1, 265.0, 255.3, 253.1, 246.3, 250.5, 248.3, 246.1. - Gross external financing need (in billions of US dollars): 11.1, 13.0, 11.9, 11.1, 12.7, 10.9, 11.4, 12.3, 15.3, 16.8, 18.4 and in percent of GDP series include 17.0, 19.0, 16.0, 13.8, 15.7 (presented in table/figure context). ### Additional stress-test scenarios (highlights) - Individual shocks: permanent one-half standard deviation shocks; permanent 1/4 standard deviation shocks applied to real interest rate, growth rate, and current account balance in combined tests. - One-time real depreciation of 30 percent occurs in 2017 in a specified shock, which raises external debt to GDP to about 72 percent (as noted above). - Combined shock scenarios and CA shock scenarios produce higher external debt trajectories compared with baseline (figures depict baseline 49 percent external debt vs shocks 52–55 percent or 72 percent under 30% depreciation). ### Tax policy options (Annex II) — revenue potential and measures - Staff presented a set of policy options that have the potential to generate around 1.4 percent of GDP in revenue. - Corporate income tax (CIT) options (table entries preserved as presented): - Corporate income tax1.500.96 - Tax exempt profits at standard rate of 28 percent ...0.52 - Eliminate reduced rates and tax at standard rate ...0.36 - Eliminate qualifying payments ...0.06 - Tax remittances at standard rate ...0.02 - Personal income tax (table entry preserved as presented): - Personal income tax 0.34... (with measures: Rationalize tax rate structure......; Rationalize tax deductions......; Expand coverage of withholding tax on labor income ......) - Financial income tax (table entries preserved as presented): - Financial income tax0.560.24 - Introduce uniform withholding tax rate for interest income...0.24 - Implement capital gains tax...... (Capital Gains Tax expected by April 1, 2017) - Note on revenue estimation: 1/ Revenue yield is estimated from FY2014/15 tax return data; yields may be underestimated if database misses firms that did not file; grandfathering preferential treatment would reduce yields. ### Program and policy signals (from Letter of Intent excerpt) - Dates and documents: Columbus/Colombo, November 3, 2016; letter supplements Letter of Intent dated May 12, 2016 and MEFP. - Economic outlook statements: - The Sri Lankan economy is showing signs of stabilizing. - Since June, sovereign spreads have fallen and the exchange rate has stabilized, reflecting improved market confidence. - Real GDP growth surprisingly slowed in the second quarter, not least due to floods, but is expected to rebound in the second half of the year. - Headline inflation is expected to remain broadly stable around 5 percent for the remainder of the year. - Program performance and policy actions: - Program performance has been broadly on track; all end-June 2016 quantitative targets have been met. - The Central Bank of Sri Lanka (CBSL) has appropriately tightened monetary policy stance by way of raising policy interest rates in two occasions, while adjusting the statutory reserve ratio to absorb a part of excess liquidity. - Fiscal policy remained on track, thanks to improvement in tax revenue. - Overall, the policy adjustment has contributed to improving market confidence and thereby easing pressures on external balances. *Source: IMF staff (content unit: _cr16371 - 8. Nevertheless, vulnerabilities linked to inadequate reserve coverage, exchange rate).* ### 3. We expect the 2016 fiscal targets on tax revenues and the primary balance to be met. ### 3. We expect the 2016 fiscal targets on tax revenues and the primary balance to be met. ### Fiscal outturn and 2016 targets - VAT amendments: Supreme Court suspended VAT amendments in July; government reinstated amendments with a bill approved by Cabinet in September and by Parliament in October, to become effective on November 1. - Revenue compensation measures: - Stronger-than-envisaged collection of income taxes and import duties. - Rationalization of goods and services spending and public investment. - Primary balance and overall deficit projections for 2016: - Primary deficit will be contained to less than Rs 97 billion (0.8 percent of GDP) in 2016 as originally planned. - Larger-than-envisaged interest bill will raise the overall deficit to around Rs 700 billion (5.7 percent of GDP). - Central government tax revenue (indicative target, cumulative from the beginning of the year): 1,428 (reported in Table 1 as a program figure for Dec. 2016). ### Medium-term fiscal consolidation and 2017 budget - Commitment: remain committed to the medium-term fiscal consolidation plan, envisaging an overall deficit of 3.5 percent of GDP by 2020. - Consolidation strategy: mainly through revenue measures to broaden the tax base and improve the efficiency of collection. - 2017 budget: - Will target a primary balance, underpinned by a well-crafted and high-quality tax policy package. - Appropriation bill for the 2017 budget, in line with the program target, was gazetted in early October and to be submitted to Parliament in due course. - Tax policy package to be announced in the upcoming budget speech to Parliament in November. - New Inland Revenue Act is being drafted for parliamentary submission in March 2017 to widen the tax net and create transparent legislation on par with international best practices. ### Structural reform agenda and benchmarks - Progress and timing: - Structural benchmarks for July and September were delayed; preparatory work is underway and target completion dates reset to December 2016. - Commitment record and control system: plan to modify existing public financial management system (CIGAS) by end-December to handle commitment management for capital expenditures at the six largest ministries, departments and agencies (MDAs); use this system to establish quarterly expenditure commitment ceilings for 2017. - Adoption of KPIs on the number of risk-based VAT audits and VAT compliance strategy to be completed by end-December. - Submission and Cabinet approval of a resolution strategy for Sri Lankan Airlines to be completed by end-December. - End-year structural benchmarks on track: - Include a tax expenditure statement and the fiscal cost of non-commercial obligations for state-owned enterprises (SOEs) as part of the official government budget. - Prepare a strategy to rationalize tax expenditures. - Produce Statements of Corporate Intent for the six largest SOEs. - Fully roll out the new revenue administration IT system (RAMIS). - ITMIS rollout adjustment: - Expect rollout of automated commitment control modules to occur simultaneously at the Ministries of Health and Finance in January (advances Health from April, delays Finance from December). - Price-setting mechanisms: - Plan to introduce automatic fuel and electricity pricing mechanisms by the end of the year. ### Monetary policy and reserves - Inflation targeting: - CBSL will continue to target keeping inflation in the mid-single digits. - Two rate hikes in 2016 provided adequate monetary tightening; CBSL will stand ready to adjust policies further if needed. - International reserves: - CBSL raised net official international reserves (NIR) back to US$ 5.26 billion in end-August 2016 following a sizable drain due to capital outflows in H1 2016. - Going forward, CBSL aims to keep building reserves through outright purchase of foreign exchange and improve the quality of reserve composition. - CBSL will gradually wind down the stock of foreign exchange (FX) swaps with commercial banks by only partially rolling over maturing swaps. - TMU amendments regarding reserves and swaps: - (i) Introduce a new “program NIR” that excludes foreign exchange swaps with commercial banks from the reserve asset, and adopt targeted improvements in the program NIR as the quantitative performance criterion on international reserves going forward. - (ii) Remove the adjuster on net capital flows into treasury bills and bonds, while keeping in place the adjuster to account for net government borrowings in Sri Lankan Development Bonds from both residents and non-residents. - (iii) Add a framework to wind down the CBSL’s outstanding liabilities in foreign exchange swaps with domestic commercial banks. ### Program monitoring, timing, and financing requests - Program documentation: - Table 1 and the Technical Memorandum of Understanding attached to the letter set out quantitative targets through 2017. - Table 2 sets out a proposed prior action for approval of the First Review and amended target dates for several delayed structural benchmarks. - Review and purchase timing: - Request that the second purchase be made available a few days before November 20, the original availability date. - Second and third reviews under the arrangement are expected to be completed on or after April 20, 2017, and November 20, 2017, respectively. - Financing draw: - Request completion of the First Review of the Extended Arrangement under the EFF, following which the government intends to draw one tranche amounting to SDR 119.894 million. ### Key quantitative performance items and memorandum figures (selected from Table 1 and TMU) - Central government primary balance (floor, cumulative from the beginning of the year, in billion rupees): program figures include -97 for 2016 (floor). - Net official international reserves (CBSL's conventional definition, end of period stock, in millions of US$): 5,029 (Dec. 2015), 4,309 (Mar. 2016), 5,419 (Mar. program), 5,277 (Sep. actual), 5,490, 6,446, 6,212, 5,819, 5,890 (various dates reported in Table 1). - Program net official international reserves (floor, cumulative change from the beginning of the year, in million US$): reported program cumulative changes include 262, 1,161, 1,125, 769, 958 on various test dates. - Central government tax revenue (floor, cumulative from the beginning of the year, in billion rupees): 1,356 (Dec. 2015), interim program points 325, 652, 652, 685, 1,021, and program Dec. 2016 figure 1,428; other periodic figures reported in Table 1. - Reserve money of the CBSL (ceiling, end of period stock, in billion rupees): 673 (Dec. 2015), program and act values include 792, 791, 757, 794, 810, 851, 899, 935, 948 across test dates. - Year-on-year inflation in Colombo Consumers Price Index (in percent) — actual/center point figures reported: 2.5, 1.9, 3.4, 3.4, 4.7, 4.5, 4.5, 4.5, 4.9, 5.2, 4.9, 5.1, 5.1 (various dates in Table 1). - Memorandum items (selected): - External commercial loans by central government assumed under program (cumulative from beginning of year, in million US$): program assumptions include 1,650 (Dec. 2015), 2,000 (Mar. prog.), and 2,186 (Sep. actual) among others. - Amortization of official external debt by the central government assumed under the program (cumulative from beginning of year, in million US$): 798 (Dec. 2015), 328, 475, 493, 713, 858, 1,015, 352, 586, 969, 1,217 (various dates reported). ### TMU and monitoring framework (high-level) - TMU specifies performance criteria and indicative targets listed in Table 1: - Quantitative performance criterion on central government primary balance (floor). - Quantitative performance criterion on net official international reserves (floor). - Continuous quantitative performance 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). - Definition and measurement notes: - Central government defined to include line ministries, departments, and other public institutions; CBSL, SOEs, parastatals and agencies that do not receive central government subventions are excluded. - Primary balance of the central government on cash basis is defined as central government revenues and grants minus expenditures and net lending, plus interest payments; spending recorded when cash disbursements are made. - For program monitoring, primary balance measured as overall balance of central government plus interest payments; overall balance measured from financing side as the negative sum of specified net borrowing and financing items. - Historical 2015 primary balance measured this way: Rs –241 billion (overall balance Rs –768 billion; interest payment Rs 527 billion). - Examples of 2015 component amounts: net borrowings from Treasury instruments Rs 257.6 billion; SLDBs and commercial borrowings Rs 455.7 billion; project/program loans Rs 69.7 billion; net increases in non-market borrowings etc. Rs –10.1 billion; net decreases in central government deposit Rs –4.4 billion; all other bonds/loans/advances Rs –0.5 billion. *Source: Letter of Intent, Tables, and Technical Memorandum of Understanding (TMU) as provided in the source content.* ### 6. If the actual amount of gross cash disbursement of project loans in 2016 is higher than ### _cr16371 - 6. If the actual amount of gross cash disbursement of project loans in 2016 is higher than ### Primary balance adjustor for project loan gross cash disbursements (2016) - If the actual amount of gross cash disbursement of project loans in 2016 is higher than US$1.5 billion in U.S. dollar terms, the floor on the primary balance of the central government for end-December 2016 will be adjusted downward by the difference between the actual amount and US$1.5 billion. - The difference will be converted to the amount in Rupee terms by using the exchange rates as indicated in Table 1. - The downward adjustment of the primary balance target will be capped at Rs 20 billion. - If the actual amount of gross cash disbursement of project loans in 2016 is lower than US$1.5 billion in U.S. dollar terms, the floor on the primary balance of the central government for end-December 2016 will not be adjusted. - Note: "Rupee Loans" are defined as a medium to long-term debt instrument issued with maturities more than two years on tap basis or as private placements by the CBSL on behalf of the government under the Registered Stock and Securities Ordinance. ### Performance criterion on Net Official International Reserves (Program NIR) - Program NIR is measured as the difference between: - (a) the CBSL’s conventional definition of NIR (gross foreign assets minus liabilities and DSTs' Special Dollar, Japanese Yen, and Chinese Yuan Revolving accounts; market values), and - (b) the CBSL’s outstanding liabilities (net short positions) in foreign exchange swaps with domestic commercial banks. - At end-2015: - Program NIR stood at US$ 2,893.1 million. - The NIR as per the CBSL’s conventional definition stood at US$ 5,028.8 million. - CBSL outstanding liabilities in foreign exchange swaps with domestic commercial banks stood at US$ 2,135.7 million. - Components and exclusions for gross foreign assets (CBSL conventional definition) are specified, including monetary gold; foreign exchange balances held outside Sri Lanka; foreign securities (market-priced); foreign bills purchased and discounted; reserve position at the IMF and SDR holdings; Crown Agent’s credit balance. Exclusions include participation in international financial institutions; holdings of nonconvertible currencies; non-monetary precious metals; claims on residents; pledged/encumbered foreign assets; derivative claims. - Gross foreign liabilities include all foreign currency denominated liabilities of the CBSL to non-residents (including currency swap arrangements with foreign central banks), use of Fund credit, and Asian Clearing Union debit balance. Commitments to sell foreign exchange to residents arising from derivatives such as futures, forwards, swaps, and options are not included. ### Framework to wind down FX swap liabilities - The wind-down framework includes: - Discontinuing the provision of FX swaps on concessional terms. - Gradually reducing outstanding net short positions of FX swaps with commercial banks to below 20 percent of gross international reserves. ### Valuation and exchange rates for program accounting (as of July 1, 2016) - All foreign-currency related assets and liabilities will be converted into U.S. dollar terms at the exchange rates prevailed on July 1, 2016. - Monetary gold valuation: US$1,327.90 per troy ounce (price prevailed on July 1, 2016). - Table 1. Sri Lanka: Exchange Rates (Rates as of July 1, 2016) - U.S. dollar 145.250 - British pound 193.705 - Japanese yen 1.411 - Canadian dollar 112.084 - Euro 161.249 - Chinese yuan 21.829 - SDR 202.763 - Source: CBSL and IMF. ### NIR floor adjustors for financing and amortization (Table 2 assumptions) - If actual amounts differ from program assumptions in U.S. dollar terms on the test date, the floor on the program NIR will be adjusted by the cumulative differences. These adjustors apply to the NIR floor for end-December 2016 and thereafter. - Program assumptions (cumulative from the beginning of the year, in million US$) — Table 2: - Foreign program financing by the central government: 325 000 200 - Net borrowings from Sri Lankan Development Bonds (SLDBs): -669 000 - External commercial loans (including Eurobonds and syndicated loans) by the central government: 2,186 1,500 1,500 1,500 1,500 - Amortization of official external debt by the central government: 1,015 352 586 969 1,217 - Note: 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. ### Continuous performance criteria - 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: - Nonfinancial public sector follows the 2001 Government Financial Statistics Manual and the 1993 System of National Accounts; includes the central government and nonfinancial public enterprises. - External payments arrears consist of debt-service obligations (principal and interest) to nonresidents not paid when due, subject to any applicable grace period. - Overdue debt and debt service obligations that are in dispute are not considered external payments arrears for program monitoring. ### Monetary policy consultation clause (inflation measurement and consultations) - Inflation target bands around the projected 12-month rate of inflation in consumer prices are specified in Table 1 attached to the Letter of Intent; inflation measured by headline Colombo Consumers Price Index (CCPI). - 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) = { 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 end-December 2016 or end-June 2017 falls outside the outer bands in Table 1 attached to the Letter of Intent, authorities will complete a consultation with the IMF Executive Board focusing on (i) the stance of monetary policy and program track, (ii) reasons for deviation, and (iii) proposed policy response. Access to Fund resources would be interrupted until consultation and relevant program review are completed. - If observed year-on-year inflation falls outside the inner bands in Table 1 attached to the Letter of Intent for end-December 2016, end-March 2017, end-June 2017, or end-September 2017, authorities will complete a consultation with IMF staff on reasons and proposed policy response. ### Indicative targets and definitions - Indicative target on central government tax revenue: - Central government tax revenue excludes revenues from asset sales, grants, and non-tax revenues; target is cumulative from beginning of year. - For 2015, central government tax revenue defined this way was Rs. 1,356 billion. - Indicative target on reserve money of the CBSL: - Reserve money consists of currency in circulation (with banks and with the rest of the public), financial institutions’ domestic currency deposits at the CBSL, and deposits of specified government agencies (National Defence Fund Acc. No. 4278; Buddha Sasana Fund A/C Acc. No. 4279; Road Maintenance Trust Fund Acc. No. 4281). - At end-December 2015, reserve money defined in this manner stood at Rs. 673.4 billion. - Adjustments to reserve money ceiling: - 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. - Changes in required reserve regulations will modify the reserve money ceiling according to the formula: - ΔM = ΔB0 r0 + B0 Δr + ΔB r0 (formula as presented in source) - where variables are defined in the source text (MΔ, r0, B0, rΔ, BΔ). ### Data reporting requirements and timetables - Sri Lanka shall provide the Fund with requested information in connection with progress on objectives and policies set out in the Memorandum of Economic and Financial Policies dated May 12, 2016, and Letters of Intent. - Program monitoring data providers: Ministry of Finance and the CBSL. - Fiscal monitoring data (Tables 3 and 4) will be provided 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 subcomponents): within no more than seven weeks after the end of each month. - Data on total recurrent expenditure and interest payments: within no more than five weeks after the end of each month. - External and monetary targets data (Tables 5, 6, and 7) will be furnished within no more than three weeks after the end of each month. - Tables for reporting (as specified in source): Table 3 (Central Government Operations), Table 4 (Central Government Financing), Table 5 (Balance Sheet of the Central Bank of Sri Lanka), Table 6 (Foreign Exchange Cashflows of the Central Bank and the Government), Table 7 (Gross Official Reserve Position). ### Staff and Authorities’ statements and recent developments (November 2016) - Fiscal performance through end-September (preliminary): - Primary deficit over January–September: Rs 35 billion, exceeding the target by Rs 50 billion (0.4 percent of GDP). - Tax revenue collection was Rs 46 billion higher than the target. - Revenue outperformance largely from income tax and import duties; VAT amendments suspended during July–October. - Budget for 2017 (presented November 10): - Envisages a primary surplus of 0.4 percent of GDP, higher than the program target of a primary balance. - Revenue projection includes full-year effect of VAT amendments and revenue measures (simplification of corporate tax structure; base-broadening of financial income taxes). - Authorities commit to adjust spending in line with revenue collection; budget contains explicit statement that revenue shortfalls will warrant expenditure realignment with parliamentary approval. - Structural benchmark: introduction of quarterly expenditure commitment ceilings (structural benchmark for December 2016). - New Inland Revenue Act scheduled to take effect in April 2017 is key to meeting revenue goals. - Monetary policy and foreign exchange flows (Monetary Board meeting October 31, 2016): - Policy rates unchanged. - Headline inflation: 4.2 percent in October (year-on-year); core inflation unchanged at 4.2 percent. - Foreign holdings of government securities declined by about US$ 200 million in October and through early November. - Rupee depreciated against the US dollar by about ⅔ percent during this period but remained stable following the U.S. presidential election. - Gross international reserves fell from US$ 6.4 billion at end-September to US$ 6.1 billion at end-October. - Executive Directors’ statement (November 18, 2016) summarizes program progress and structural benchmarks, including reinstatement and implementation of VAT amendments with effect from 1st November 2016, delays and expected completion of VAT compliance strategy benchmarks by December 2016, and progress on resolution strategy for SriLankan Airlines, commitment record system, quarterly expenditure commitment ceilings, and roll-out of ITMIS with automated commitment control module by end-December. *Source: _cr16371 - 6. If the actual amount of gross cash disbursement of project loans in 2016 is higher than (IMF staff report excerpts).* ### 3. The implementation of sound macroeconomic policies by the government ### 3. The implementation of sound macroeconomic policies by the government ### Growth outlook and strategy - Economy expected to grow by "5.0-5.5 per cent in 2016" with recovery in agriculture and continued expansion in services, manufacturing and construction. - Projected growth for 2017 is "6.3 per cent". - Medium-term ambition: higher growth momentum of about "7 per cent" facilitated by pro-business reforms, Colombo International Financial City, Megapolis project opportunities, proposed Special Economic Zones, and foreign investment. - Economic policy statement (presented October 2016) focuses on private-sector-led growth, improving the doing business environment, export expansion via economic partnership agreements with India, China and Singapore, and establishing two development corridors. - 2017 budget (presented 10th November 2016) aligns with these objectives and proposes strong pro-business policies. ### Monetary policy actions and outlook - Macro-prudential measures in late 2015: cash margin requirements (subsequently removed) and maximum Loan to Value (LTV) ratio on selected lending. - Statutory Reserve Requirements raised by "1.50 percentage points" effective January 2016. - Standing Deposit Facility Rate (SDFR) and Standing Lending Facility Rate (SLFR) raised in two steps in February and July 2016 by a total of "100 basis points". - Effects observed: immediate increase in short-term interest rates and gradual rise in long-term market rates. - Credit and money growth by end-August 2016: - Credit growth moderated to around "27 per cent". - Broad money growth moderated to around "17.3 per cent". - Further moderation in these rates expected by end December 2016 or early 2017. - Proposed 2017 budget limits on LTV for certain vehicle categories: - three wheelers "25 per cent", - motor cars and vans "50 per cent", - commercial vehicles "90 per cent". - Authorities expect to move to a flexible inflation targeting framework in the medium term. - CBSL developing a comprehensive macroeconomic forecasting model with IMF assistance. - IMF technical support to fulfill remaining prerequisites. - Continued exchange rate flexibility will be maintained to facilitate the move. ### Fiscal policy performance and 2017 budget - Fiscal performance through first nine months of 2016: - Primary deficit target (PC) under EFF met comfortably at end June 2016. - Primary balance and tax revenue outperformed end-September indicative targets (IT). - Revenue and expenditure developments: - Total government revenue increased, driven by VAT, income taxes, import duties, Port and Airport Development Levy (PAL) and other import related taxes. - Total expenditure declined compared to 2015, mainly due to lower capital expenditure. - End-December 2016 expectations: - End-December PC on primary deficit expected to be met at "Rs.97 billion (-0.8 per cent of GDP)". - Overall fiscal deficit expected to be around "5.4 per cent of GDP" as envisaged in the program. - Public debt to GDP ratio expected to be around "76 per cent in 2016". - 2017 budget theme: "Accelerating growth with Social Inclusion". - Budget focuses: promoting exports, developing labor skills and productivity, improving digitalization, addressing land, housing, education and health, de-bureaucratization of public services, and uplifting living standards consistent with the UN Sustainable Development Goals (SDGs) 2030. - 2017 fiscal targets and composition: - Primary fiscal balance (PC) target within program. - Overall fiscal deficit targeted to reduce to "4.6 per cent". - Total revenue expected to rise to "15.5 per cent of GDP in 2017" from "13.4 per cent in 2016". - Total expenditure expected to be maintained at "20 per cent of GDP" in 2017 compared to "19 per cent in 2016". - Fiscal risk management and execution: - Quarterly expenditure and income outcomes to be presented to Parliament within a month after any quarter. - Integrated Treasury Management Information System (ITMIS) being set up at MOF to automate key departments. - If revenue shortfalls occur, expenditure will be realigned to maintain fiscal consolidation path. - Medium-term fiscal anchors: - Reduce overall budget deficit to "3.5 per cent of GDP" and public debt to GDP ratio to "65 per cent by 2020". - 2017 tax policy changes (major proposals): - Corporate tax: three tier rates "14 per cent", "28 per cent" and "40 per cent"; standard rate "28 per cent". - Removal of exemptions on income from listed securities, dividends, unit trusts and other instruments and removal of notional tax credit on secondary market transactions. - Capital Gains Tax of "10 per cent". - Withholding Tax on interest income increased to "5 per cent" from "2.5 per cent". - Removal of Cess on 100 items. - Individual income tax revised to a progressive structure with maximum tax rate of "24 per cent". - Tax expenditure under proposed tax structure estimated at around "1.6 per cent of GDP". - Time bound strategy to reduce tax expenditure to be completed by end 2016. - Tax administration reforms: - Re-drafting of the Inland Revenue Act with IMF technical assistance to be completed in 2017. - Proposal to decentralize the Inland Revenue Department (IRD) and establish a revenue monitoring unit in the General Treasury of MOF. - Consolidation of the VAT Act incorporating amendments up to date. - Automation under Revenue Administration Management Information System (RAMIS) at IRD to be fully implemented by end of 2016. - State Owned Enterprises (SOEs): - Measures to reduce SOE losses and improve balance sheets through credible restructuring. - Strategic partner for Sri Lankan Airlines sought; process expected to be completed by end 2016. - Statements of corporate intent for six largest SOEs to be signed and published by end 2016. - Financial positions of Ceylon Petroleum Corporation (CPC) and Ceylon Electricity Board (CEB) improved; further improvements expected with cost reflective pricing mechanisms. ### External sector policies and reserves - External pressures: weak global recovery, lower global demand for exports, slowdown in remittances, tepid FDI, steady outflow of capital from government securities market → imbalance in external balance and reduction in official reserves. - Impact of EFF: Sri Lanka's entry into a three year EFF helped restore investor confidence; together with delayed further rate hikes in the USA, outflows from government securities market reversed. - Reserve developments: - CBSL built up foreign reserves through direct foreign exchange purchases and met end-June Net International Reserves (NIR) target comfortably. - Foreign exchange purchases, proceeds of international sovereign bond issue and a syndicated foreign currency loan improved gross foreign reserves to "US dollars 6.5 billion", equivalent to "4.1 months of imports by end September 2016". - Adjustments to NIR targets and swaps: - Original NIR targets for September and December considered too ambitious; sizable FX purchases could destabilize market. - Agreed to exclude foreign exchange swaps with commercial banks from reserve assets as per safeguard assessment recommendations. - Authorities agreed with staff to gradual wind-down of FX swaps with outstanding amount of around "US $2.4 billion". - Authorities requested removal of the adjuster on net foreign inflows to government treasury bills and bonds to avoid large swings in the target. - NIR path has been revised to be more realistic. - Market pressures October–November 2016: - Considerable pressure in FX market due to unexpectedly high capital outflows from government securities market since beginning of October. - CBSL intervened by supplying foreign exchange: total net supply from beginning of October to 14th November amounted to "US dollar 141.5 million". - Rupee depreciated by "2.2 per cent" from May to October as CBSL allowed flexibility to improve external competitiveness. - Authorities view developments after signing of Letter of Intent as posing significant risk to meeting end-December NIR target. ### Financial sector resilience and actions - Banking sector performance first eight months of 2016: - Total assets of the banking sector increased by "6.8 per cent". - NPL ratio decreased to "3.0 per cent" by end of August from "3.2 per cent" at end December 2015. - Provision coverage ratio increased from "36 per cent" to "46.6 per cent" year-on-year by end August 2016. - Liquid assets to total assets ratio stood at "29 per cent" at end August, above statutory minimum of "20 per cent". - Bank branch network expanded, increasing financial inclusion. - Non-bank financial sector showed positive asset growth while preserving asset quality, liquidity, capital position and profitability. - For finance companies in difficulty, government and CBSL actions include restructuring through establishment of a Financial Asset Management Company (FAMA). ### Technical assistance - Authorities acknowledge IMF technical assistance across tax administration reforms, public financial management, monetary statistics and macroeconomic modeling, national accounts and prices. - Continued technical assistance by the Fund throughout the EFF expected and considered instrumental in achieving program objectives. ### Conclusion and request - Significant progress achieved in maintaining macroeconomic stability since entering the Fund-supported program despite challenging global environment. - Authorities are strongly committed to achieving program objectives through policies in close association with Fund staff and continued technical assistance. - Authorities are requesting completion of the first review under the EFF arrangement. *Source: _cr16371 - 3. The implementation of sound macroeconomic policies by the government* --- _Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2016/_cr16371.pdf_