Public Information Notice: IMF Executive Board Concludes 2006 Article IV Consultation with Sri Lanka
IMF News, November 13, 2006
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- Published: November 13, 2006
Background and recent macro developments
- Real GDP increased by 6 percent in 2005 and by a further 8 percent in the first quarter of 2006.
- Growth drivers: domestic demand, improved agricultural performance, strong tsunami-reconstruction efforts, and robust service sector growth.
- Inflation developments:
- Declined from 18 percent in January 2005 to 3.5 percent at end-2005.
- Has risen since early 2006 due to fast credit growth, pass-through of higher oil prices, and increases in wages and pension payments.
- Security and political risks:
- Recent escalation of hostilities and deterioration in the security situation following unsuccessful June peace talks.
- Weakening in confidence could affect investment going forward.
- Government and main opposition party (UNP) signed a Memorandum of Understanding on five key policy areas (the ethnic conflict, electoral reform, good governance, social development, and structure for collaboration).
Fiscal position and public debt
- Fiscal outcomes:
- 2005 fiscal deficit widened to 8.7 percent of GDP, larger than budgeted, mainly because of tsunami-related spending.
- Excluding tsunami-related flows, the 2005 budget deficit was 7.5 percent of GDP (compared to 8.2 percent of GDP in 2004).
- First half of 2006: fiscal deficit contained through adjustment of capital expenditures; tax revenue grew 23 percent (below the 27 percent budget target).
- Sizable overruns on recurrent expenditure from oil subsidies, pensions, and additional security and humanitarian spending.
- Debt dynamics:
- Total public debt declined by 11 percent of GDP (to 94 percent of GDP) in 2005.
- Sri Lanka received a Fitch rating of BB- in December 2005; outlook revised from stable to negative amid renewed security concerns.
- Government put planned global bond issuance on hold and mobilized resources from domestic investors during April-September 2006.
- Fiscal targets endorsed by Directors:
- Adhering to the 2006 budget target and reducing the fiscal deficit target to 7½ percent of GDP in 2007.
- Plan to bring the fiscal deficit down to 5 percent by 2010, to be achieved through revenue enhancing policies and rationalization of current spending.
- Recommendation to limit further recourse to commercial borrowing for budgetary purposes.
External sector and reserves
- Current account and balances:
- Current account deficit narrowed in 2005 but projected to increase by end-2006 due to higher oil prices and strong demand for non-oil imports.
- Tsunami-related inflows slowed in 2006 while the debt service burden rose.
- Reserves and exchange rate:
- Gross official reserves hovering around $2.4 billion, equivalent to 2.4 months of imports and 86 percent of short-term debt.
- Rupee-dollar exchange rate weakened somewhat since the second half of 2005.
- Real effective exchange rate (REER) appreciated by 2 percent during the same period (reflecting high domestic inflation relative to trading partners).
- Board recommendations:
- Limit intervention in the foreign exchange market and allow greater flexibility in the exchange rate to help safeguard external reserves and maintain competitiveness.
Monetary policy, credit growth, and financial sector soundness
- Monetary tightening:
- Central bank raised its policy rate five times (cumulative 2 percentage points) during November 2004-December 2005, and by another 1 percentage point recently.
- Interest rates of government securities increased by about 1¼ percentage points since September 2006.
- Reserve money growth reduced to 16 percent in August 2006 (from 21 percent in April 2006).
- Credit and banking:
- Credit growth to the private sector (including housing loans) about 23 percent in August 2006, contributing to demand pressures.
- NPL ratios of state-owned banks declined from 18 percent in 2003 to 8 percent in June 2006, reaching similar levels to domestic banks.
- Capital adequacy ratios improved (to 8 percent of total assets).
- Concerns remain about fast credit growth and credit quality.
- Regulatory progress:
- Steps taken to further enhance the regulatory and supervisory framework, including plans to adopt the Basel II capital accord by 2008.
- Directors welcomed an FSAP update planned for 2007 and encouraged timely implementation of the Basel Core Principles.
Structural priorities and sectoral issues
- Infrastructure:
- Priority on power and roads; emphasis on restoring financial viability of the power sector and expanding generation capacity using more cost-efficient sources (including coal power).
- Development forum planned for early 2007.
- Energy sector:
- Encourage efforts to reduce quasi fiscal losses of energy companies through electricity tariff adjustments, balance sheet restructuring, and enhanced operational efficiency.
- Need for safety nets to protect low-income households and strengthened regulatory guidelines to broaden investor base for long-term energy financing.
- Trade and taxation:
- Directors encouraged an open trade regime with minimum distortions; curtail the cess regime and integrate fees in the tariff structure.
- A single low tariff structure could help maximize efficiency.
- Importance of further tax system reform and financial sector reforms to raise growth and reduce vulnerability.
- Social policy:
- Commended improvements in social indicators over the last decade and emphasis on reducing rural poverty and narrowing rural-urban income inequality.
- Welcomed extensive consultations with stakeholders to build consensus for the national development strategy.
- Data and governance:
- Encouraged improved quality and coverage of fiscal statistics and resolution of remaining issues to meet SDDS requirements.
- Welcomed passage of anti-money laundering legislation in 2006.
Executive Board assessment — policy guidance
- Near-term policy focus:
- Reduce inflation and external vulnerabilities.
- Further monetary tightening may be needed to contain credit growth and anchor inflation expectations.
- Fiscal consolidation:
- Strong fiscal adjustment critical to avoid adverse debt dynamics and preserve ability to meet poverty reduction and Millennium Development Goals.
- Develop a well-defined medium-term fiscal policy framework and improvements to debt management.
- Financial stability:
- Further strengthen prudential standards and monitoring of systemic risks.
- Further restructuring of two large public banks should focus on improving lending practices and strengthening capital adequacy.
Selected economic indicators (key figures)
- Real GDP growth (percent): 2002: 4.0; 2003: 6.0; 2004: 5.4; 2005: 7.0; 2006 Proj.: ...
- Inflation (percent, end of period, Sri Lanka consumer price index): 2002: 6.6; 2003: 1.0; 2004: 16.8; 2005: 3.6; 2006 Proj.: 12.0
- National savings (percent of GDP): 2002: 19.5; 2003: 21.6; 2004: 23.7; 2005: 22.6
- Gross investment (percent of GDP): 2002: 21.2; 2003: 22.1; 2004: 25.0; 2005: 26.5; 2006 Proj.: 27.3
- Revenue (percent of GDP): 2002: 16.5; 2003: 15.7; 2004: 15.3; 2005: 16.1; 2006 Proj.: 17.0
- Expenditure (percent of GDP): 2002: 25.4; 2003: 24.0; 2004: 23.5; 2005: 24.7; 2006 Proj.: 26.0
- Overall deficit (percent of GDP) 2/ (Excluding grants and privatization receipts): 2002: -8.9; 2003: -8.3; 2004: -8.2; 2005: -8.7; 2006 Proj.: -9.1
- Total government debt (percent of GDP): 2002: 105.6; 2003: 105.8; 2004: 105.4; 2005: 93.9; 2006 Proj.: 89.6
- Exports (in millions of U.S. dollars): 2002: 4,699; 2003: 5,133; 2004: 5,757; 2005: 6,347; 2006 Proj.: 6,950
- Imports (in millions of U.S. dollars): 2002: 6,105; 2003: 6,673; 2004: 7,999; 2005: 8,863; 2006 Proj.: 10,501
- Current account balance (in millions of U.S. dollars): 2002: -236; 2003: -74; 2004: -646; 2005: -650; 2006 Proj.: -1,281
- Current account balance (in percent of GDP): 2002: -1.4; 2003: -0.4; 2004: -3.2; 2005: -2.8; 2006 Proj.: -4.7
- Capital and financial account balance (in millions of U.S. dollars): 2002: 444; 2003: 722; 2004: 632; 2005: 1,224; 2006 Proj.: 1,556
- Of which, direct investment 3/ (in millions of U.S. dollars): 2002: 186; 2003: 201; 2004: 227; 2005: 234; 2006 Proj.: 324
- Gross official reserves (excluding ACU balances, in millions of U.S. dollars): 2002: 1,560; 2003: 2,146; 2004: 1,833; 2005: 2,458; 2006 Proj.: 2,662
- Gross official reserves (in months of prospective imports): 2002: 2.4; 2003: 2.8; 2004: 2.2; 2005: 2.5
- Real effective exchange rate (percent change, period average) 4/: 2002: 0.1; 2003: -4.9; 2004: -5.1; 2005: 8.8
- External debt (in percent of GDP): 2002: 62.6; 2003: 64.1; 2004: 63.9; 2005: 55.4; 2006 Proj.: 49.2
- Debt service (in percent of goods and services exports) 5/: 2002: 12.3; 2003: 10.9; 2004: 10.1; 2005: 7.4; 2006 Proj.: 10.4
- Broad money growth (annual percent change) 6/: 2002: 13.4; 2003: 19.6; 2004: 19.1
- Of which, net credit to government: 2002: -4.2; 2003: 25.1; 2004: 11.9
- Of which, credit to the private sector: 2002: 16.9; 2003: 21.5; 2004: 20.7
- Interest rate (percent, end of period) 7/ (Three-month treasury bill rate): 2002: 9.9; 2003: 7.3; 2004: 11.8
Public Information Notice (PIN) No. 06/132 — November 13, 2006. Executive Board concluded the Article IV consultation with Sri Lanka on October 25, 2006.