Sri Lanka to end 2015 with 5-5.5% growth

• Commends rupee float, policy rates should tighten as core inflation and private sector credit increases   

IMF Staff Mission Leader Todd Schneider

Given current growth trends the country is likely to end this year with growth of around 5.5%, the IMF projected, adding that the Central Bank should look to tighten policy rates over the next few months.

The mission welcomed the Central Bank’s recent decision to cease setting daily spot prices for the rupee and let market forces play a greater role in determining the exchange rate. The commitment to exchange rate flexibility should continue in order to maintain competitiveness and facilitate an increase in foreign exchange reserves, the IMF noted.

The mission encouraged the Central Bank to work toward deepening foreign exchange markets and to revitalise a review of foreign exchange controls to enable inward investment. Additionally, the mission found the overall financial system stable and current monetary stance appropriate – but recommended vigilance given rising core inflation, the resurgence of private credit and signs of receding slack in the economy.

“The current set of policy rates is not necessarily inappropriate because Sri Lanka is still in a low inflation environment, at least in terms of headline inflation, but the Central Bank should have a pro-tightening bias looking forward,” IMF Staff Mission Leader Todd Schneider said.

The reasons include rising core inflation since the beginning of the year, which is at the moment relatively high at 3.9% and rise in private sector credit that is now at 19.4%.

“Credit needs to grow in line with the economy. It’s worth watching. Given the lag between monetary policy decisions and their impact on the market the Central Bank needs to look at changes two to three quarters in advance,” he advocated.

First half GDP data indicate a pickup in growth—likely to continue in the range of 5-5.5% through end-2015—driven mainly by strong growth in services and a recovery in agricultural output, an IMF mission statement released on Friday said. The increase in consumer spending created by the sharp rise in public wages and salaries has also contributed to a sizeable increase in imports of consumption and other goods—more than offsetting savings from lower oil prices. The resulting deterioration in the nonoil trade balance has contributed to persistent downward pressure on Central Bank foreign exchange reserves during the first eight months of the year.

Following is the full text of the IMF statement released on Friday.

A staff mission led by Todd Schneider visited Colombo from September 8 - 18 to conduct Post-Program Monitoring discussions. This enhanced surveillance is routine for countries that have had “exceptional access” to IMF resources, as is the case for Sri Lanka, which successfully completed a $2.6 billion IMF program in 2012. The mission met with the Prime Minister, Government, and Central Bank of Sri Lanka (CBSL) officials, as well as civil society and private sector representatives.

At the end of the visit, Mr. Schneider issued the following statement:

“First half GDP data indicate a pickup in growth—likely to continue in the range of 5 to 5.5% through end-2015—driven mainly by strong growth in services and a recovery in agricultural output. The increase in consumer spending created by the sharp rise in public wages and salaries has also contributed to a sizeable increase in imports of consumption and other goods—more than offsetting savings from lower oil prices. The resulting deterioration in the nonoil trade balance has contributed to persistent downward pressure on central bank foreign exchange reserves during the first eight months of the year. Headline inflation is currently near zero but is expected to end the year around 3%. Core inflation has risen steadily since the beginning of the year, consistent with higher demand for domestic non-tradables and a gradual reduction in economic slack. Risks to outlook are tilted to the downside with more volatile external financing conditions resulting from the expected monetary policy tightening in the U.S. and uncertainties over growth prospects in emerging markets.

“The mission welcomes the CBSL’s recent decision to cease setting daily spot prices for the rupee and let market forces play a greater role in determining the exchange rate. Moving ahead, the commitment to exchange rate flexibility should continue in order to maintain competitiveness and facilitate an increase in CBSL foreign exchange reserves. The mission encouraged CBSL to work toward deepening foreign exchange markets and to revitalize a review of foreign exchange controls to enable inward investment. Additionally, the mission found the overall financial system stable and current monetary stance appropriate – but recommended vigilance given rising core inflation, the resurgence of private credit, and signs of receding slack in the economy. In this context, a tightening bias appears prudent.

“The mission agreed with the authorities on the need to take immediate and credible steps to reestablish fiscal consolidation and reduce of public debt. The mission projects a fiscal deficit in the range of 5.5 to 6% of GDP in 2015—higher than budgeted and financed mainly by domestic borrowing. Looking ahead, the 2016 budget is an opportunity to shift decisively back to a durable medium-term path of fiscal consolidation and to set macroeconomic priorities for 2016 and beyond. The mission strongly recommended to keep the 2016 fiscal deficit to 5.5% of GDP—and to base consolidation on a combination of expenditure restraint and durable revenue reforms. The mission emphasized the need to eliminate tax expenditures (exemptions, tax holidays and reduced rates) as the most important component in a strategy to make the tax system simple, fair, and efficient.

“The mission welcomes the authorities’ attention to the need for market-based structural reforms and efforts to reinvigorate key initiatives. Fuel and electricity pricing, subsidies, trade policy, liberalization of factor markets (particularly land), and the investment environment are areas that could play an essential role in sustaining high rates of economic growth. Putting state firms on a commercial footing, allowing them to make market-based financial decisions (including pricing) and subjecting them to the greater financial discipline will also help to reduce risks to the budget and the financial system.

“A discussion on Post Program Monitoring by the IMF’s Executive Board is expected in mid-November, 2015.”