IMF Executive Board Concludes Sri Lanka Assessment

By Eurasia Review-December 3, 2013

On November 27, 2013, the Executive Board of the International Monetary Fund (IMF) concluded the Ex-Post Evaluation of Exceptional Access under the 2009 Stand-By Arrangement (SBA), and the first Post-Program discussion with Sri Lanka.

Sri Lanka’s need for IMF support under the 2009 SBA was triggered by the onset of the global financial crisis, and set against a backdrop of rising fiscal and external vulnerabilities. These circumstances also coincided with the end of its decades-long conflict, necessitating international support in order to avert a potential balance of payments crisis. In July 2009, a 20-month SBA was initiated with the IMF. The envisaged access was 400 percent of quota (SDR 1.65 billion). The program was aimed at restoring viability to the balance of payments position, correcting fiscal imbalances that were interlinked to external imbalances, and strengthening the financial sector. Following two extensions, the Stand-By Arrangement was completed in July 2012.

Sri Lanka’s economy continues to move forward, and has navigated recent market turbulence well. Overall GDP growth has been solid, but recent indicators underline some areas of concern: trade activity has been slow to pick up, tax revenues and public spending (including capital expenditures) are relatively low, and private sector credit growth has been declining. Staff project real GDP growth of 6.5 percent for 2013 as a whole, somewhat below the authorities’ forecast of 7 to 7.5 percent. Headline inflation fell to 6.2 percent in September 2013, from 9.2 percent at end-2012. Base effects have been an important factor, but pressures appear to be easing, consistent with more moderate economic growth and lower food prices. Staff projects end-2013 inflation at 7 percent. Risks to the inflation outlook stem mainly from potential upward shocks to world commodity prices and lagged effects of the monetary easing. The external position has improved during 2013. Both imports and exports slowed in the first half of 2013, reducing the trade deficit. Exports have since started to pick up, while tourism receipts and inward remittances remain strong. This is expected to contribute to a projected 1½ percent of GDP reduction in the current account deficit in 2013, and broadly stable gross reserves.

Fiscal consolidation is facing headwinds. Despite some important tax reforms introduced in 2012, and the 2013 extension of the VAT to the retail and wholesale sectors, revenue performance has been weak thus far in 2013. To some extent, low revenues reflect the weaker imports, but the numerous tax exemptions and tax administration weaknesses remain the important causes of lower-than-expected revenues. In response to the revenue shortfall, the authorities have kept spending under tight control and are committed not to exceed the 5.8 percent of GDP 2013 deficit target. In the budget for 2014, they are targeting a further deficit reduction, to 5.2 percent, based on continued restraint of current spending and measures to broaden the tax base.

During 2013, monetary policy has been progressively eased. In October 2013, citing benign inflation outlook and the desire to stimulate the economy to reach higher growth in 2014, the Central Bank of Sri Lanka (CBSL) cut the policy rates by 50 basis points. This followed the 50 points cut in May 2013 and a reduction of reserve requirements by 2 percentage points at end-June. The easing of monetary policy throughout the year has been slow to feed through to bank lending, and private credit growth has continued to slow. In addition, as of June 1, 2013, the CBSL increased the reserve maintenance period of commercial banks from one week to two weeks, in order to allow greater flexibility in liquidity management, and announced further relaxation of foreign exchange regulations with effect from June 12, 2013.

The condition of the banking system has improved, and the Financial Sector Assessment Program update last year found that significant progress has been made in strengthening banking supervision. Having said this, vulnerabilities still exist—expressed in the recent rise in nonperforming loans. In addition, the recent shift from concessional/bilateral loans to external borrowing by banks and private entities raises the risks to external sustainability.

Executive Board Assessment

Executive Directors welcomed the opportunity to review macroeconomic and policy developments as part of post-program monitoring and the ex-post evaluation of exceptional access under the 2009 Stand-By Arrangement.

Directors were encouraged by Sri Lanka’s strong growth and moderating inflation, and by the economy’s resilience in the face of recent market turbulence. They noted, however, that vulnerabilities remain, stemming from high debt and declining government revenues relative to GDP.

Directors commended the authorities’ commitment to fiscal consolidation. They welcomed ongoing expenditure restraint, but cautioned against further cuts in capital expenditure to meet fiscal targets. Instead they underlined the importance of putting tax revenues on an upward trajectory. They emphasized, in particular, the need for further improvements in both tax policy and administration, including elimination or rationalization of exemptions and holidays.

Directors noted that the flexible exchange rate regime has acted as a buffer to external shocks, and welcomed the central bank’s move to a less active intervention strategy. In view of the risks of further market turbulence ahead, they emphasized the need to allow time for the effects of monetary policy to feed through to private credit and money growth before considering a further easing.

Directors noted progress in financial sector development, and efforts to strengthen supervision and regulation. However, they saw remaining vulnerabilities, including the recent rise in nonperforming loans, and risks from the increase in external borrowing by banks and private entities on commercial terms. Given Sri Lanka’s high level of debt and potential vulnerability to external shocks, they emphasized that close monitoring is warranted.

Directors welcomed the opportunity to review Sri Lanka’s experience with the 2009 exceptional access Stand-By Arrangement, and agreed with the thrust of its conclusions.

They concurred that the key program objectives of supporting macroeconomic stabilization and averting a balance of payments crisis were achieved. They noted, however, that the wider objectives of the program were only partially achieved as fiscal and external vulnerabilities persist, while durable progress needs to be made in reducing the losses of state-owned enterprises. Directors also highlighted the importance of aligning program design with a careful consideration of structural and implementation capacity.