Sri Lanka: Second and Third Reviews Under the Stand-By Arrangement—Staff Report

The International Monetary Fund (IMF) this week released the full staff report following the conclusion of the second and third reviews under the US$ 2.6 billion Stand-By Arrangement with Sri Lanka.

The report prepared by a staff team of the IMF, was following discussions that ended on May 21, 2010, with the officials of Sri Lanka on economic developments and policies. Based on information available at the time of these discussions, the staff report was completed on June 21, 2010. The views expressed in the staff report are those of the staff team and do not necessarily reflect the views of the Executive Board of the IMF. Here are excerpts of the Report, which the Daily FT is publishing to create awareness and encourage public discussion on policy reforms.

I. BACKGROUND

1. Context

The programme has been on hold for several months following a significant breach of the end-December domestic budget borrowing ceiling, with the deficit reaching nearly 10 percent of GDP against a programme target of 7 percent. Overall economic conditions are improving as expected, and the economy is likely to show strong growth this year, reaching 6½ percent driven by favourable developments in the agricultural, tourism, and service sectors. Inflation remains subdued in the single digits.



2. Political developments

President Rajapaksa was re-elected to a second six-year term in January by a sizeable majority. The ruling party’s margin of victory in the April parliamentary elections fell just short of a two-thirds majority required for constitutional amendments. In April the president carried out his pre-election promise to significantly streamline the cabinet, and cut the number of ministerial posts from 90 to around 40. The post-election appointments of key ministers—foreign, power, oil—as well as key posts— chairmen of the Board of Investment (BOI), the tourism board, the tea board, and the state oil company—are widely regarded as qualified professionals, most with private sector experience.



3. External sector

The current account remains strong as remittance inflows continue at a high rate and tourism arrivals are rapidly improving. The current account was roughly in balance in 2009 for the first time since 1984 mainly owing to a steep fall in imports. However, high remittance flows, the pick-up in economic activity, and the expected response to the June trade liberalisation (described in paragraph 19 below) are all likely to deliver strong import growth in the months ahead. Export growth has been slow to recover and clouded by the possibility of a withdrawal of the GSP+ concessions from the EU scheduled for August 2010, although negotiations for its renewal continue. The precise impact of a GSP+ withdrawal is not certain but is unlikely to be large economically. It could though have social consequences by affecting small employment-intensive producers.



4. Monetary and exchange rate developments

Monetary conditions are stable.  Reserve money continues to increase in line with expectations. All interest rates—policy rates, treasury bill rates, and lending rates—have declined significantly since early-2009, and have been relatively stable since late-2009. Credit growth has shown some signs of picking up in the period following the elections, and demand for loans has strengthened.

Following Central Bank intervention in the face of sharp increase in foreign investor interest and capital inflows in the second half of 2009, reserves have stabilised at about $5 billion— equivalent to over four months of imports—compared with $1¾ billion projected for end- 2009 at the time of programme approval. In rebuilding reserves, the Central Bank’s intervention in the foreign exchange market has prevented foreign exchange inflows from appreciating the exchange rate, and the bank has allowed the rate to trade within a recently widened, although still narrow band.



5. Financial sector

Following the turmoil in 2009, financial sector conditions have stabilised. Non-performing loans have been on the decline since late-2009. The Sri Lankan stock market price index has doubled since the end of the war in May, reaching an all time high in recent weeks.



6. The 2009 budget outturn

The budget deficit in 2009 reached nearly 10 percent of GDP, against a programme target of 7 percent. Domestic borrowing exceeded the programme ceiling by just under 2 percent of GDP. The main factors for the overrun are:

• Capital spending was 1½ percent of GDP higher than anticipated. A large part of this is related to faster-than-programmed, lumpy disbursements for a couple of large foreign-financed infrastructure projects and their domestic counterpart funds.
• Interest payments exceeded original programme projections by nearly 1 percent of GDP. As part of treasury’s debt management strategy of replacing high interest treasury bills—originally scheduled to mature in 2010—with longer maturity bonds, some cash payments were moved forward into 2009. The authorities also underestimated in the original budget interest payments implicit in the price of reissued treasury bonds.
• Other recurrent spending is a key determinant of the authorities’ fiscal adjustment efforts. Excluding grant-related spending, this spending exceeded programmed levels by just under ½ percent of GDP, mostly because of subsidies and transfers. About ¼ of this overrun was related to the resettlement of the war’s internally displaced persons (IDPs).
• Lower revenue. Revenue lagged programme projections by ¼ percent of GDP, mainly because higher revenue-yielding imports had not yet recovered.

7. Sources of higher capital spending

To help assess fiscal developments given the difficulty of predicting the timing of disbursements for large infrastructure projects, staff established a detailed project-by-project framework for monitoring specific foreign-financed project commitments and spending under the programme, including for reconstruction in the north and east. This framework currently incorporates over 80 infrastructure projects either already underway or where financing is currently being sought, including some 35 for postwar reconstruction. Based on this framework, higher capital spending in 2009 relates to faster-than-programmed implementation of foreign-financed projects, including some $150 million (½ percent of GDP including domestic counterpart funds) in disbursements for the Chinese-financed southern port project which were not expected until early 2010.



8. Fiscal developments in 2010

Revenue has been increasing as a share of GDP broadly as projected, reflecting a modest increase in revenue-yielding imports. Spending through April was governed by the pre-election (vote-on-account) budget. With parliamentary passage of the full-year budget not expected until July, spending since April has been governed by a temporary presidential directive. According to the constitution, this directive gives the government the authority to limit spending on a discretionary basis. The authorities have indicated their intention to use this discretion to limit domestic borrowing to cover only debt service, which if carried out would imply an annualised deficit through July in the range of 7-8 percent of GDP. The authorities have committed in the LOI to limit spending under the decree to a level consistent with their overall 2010 deficit target. Domestic budget borrowing through early-June has been relatively tight, consistent with this deficit target.



9. Donor financing

The ADB recently approved a $50 million loan to improve fiscal operations, and a $150 million emergency loan for projects to support the rehabilitation of refugee communities in the north and east. The World Bank recently approved projects totaling $108 million, consisting of $50 million for north and east local service improvement, $40 million for higher education, and $18 million for sustainable tourism. Sizeable bilateral project loan disbursements from China, India, and Japan—primarily infrastructure-related— continue.



10. Internally displaced persons

According to the UN resettlement of IDPs has accelerated since October 2009, with the UN Refugee Agency (UNHCR) reporting that about 247,000 have either returned to their places of origin or to host families, leaving about 50,000 in three government camps. The IDPs remaining in the camps are allowed full freedom of movement. On May 28th, the president issued instructions to shut down the remaining camps within the next three months and complete the resettlement by August 2010. The UN's assessment is that there has been good progress in resettling IDPs but that further work is needed in improving their post-resettlement quality of life, including through reconstructing housing and ensuring opportunities to pursue livelihoods.



11. Programme performance and changes to programme design

All quantitative targets for end-March have been met. The end-April structural benchmark on submission to parliament of a full-year 2010 budget consistent with programme targets was not met and it has been changed to parliamentary approval of the budget by end-August 2010.

The submission of the Finance Company Act to parliament, an end-May structural benchmark, has been delayed, but the authorities expect submission before the Executive Board discussion of this review. The remaining three structural benchmarks—the approval of the pre-election budget, addressing the outstanding debts of the key state enterprises, and prudential guidelines for credit card companies have been met.



II. POLICIES AND DISCUSSION



A. Improving the Investment Climate



12. Promoting private investment

The authorities have determined that in the postconflict environment and with elections over, and given the infrastructure needs of the country, now is the time to undertake a wholesale reform of the investment regime, including reforms aimed at reducing the currently high cost of doing business in Sri Lanka. To this end the government has established a high-level committee headed by the senior advisor to the president to identify laws and regulations obstructing investment. In addition, the government began liberalising the trade regime and announced its intention to ratify a comprehensive economic partnership agreement with India in line with its development strategy.

To be contd. tomorrow

Background to the Presidential Tax Commission

Sri Lanka’s revenue-to-GDP ratio has been on a declining trend since the 1990s. Reversing the erosion of revenues is critical to restore health to public finances and to reach the steady-state fiscal deficit target of 5 percent as stipulated by the Fiscal Management Responsibility Act.

Sri Lanka’s current revenue ratio of 14½ percent of GDP is low compared with other Asian emerging market countries. Using this set of comparators, Sri Lanka’s central government revenue is unusually dependent on taxes on goods and services, driven in particular by VAT and excise tax collections. The revenue yield of direct taxes in Sri Lanka is low, reflecting the narrow base, despite relatively high rates by emerging market standards. Corporate income tax collection is lagging mainly owing to the narrow base, which has been eroded by widespread exemptions under the BOI regime and tax evasion. Personal income tax collections are also low, though comparable to other Asian emerging market countries, reflecting a narrow base due to exemptions and low compliance. On the trade side, multiple taxes on imports, which have been adopted in recent years for revenue enhancement, have created a complex and distortionary trade regime.  The revenue productivity of VAT is below average in Sri Lanka owing to a relatively narrow base from exemptions and low compliance. Against this background, a Presidential Tax Commission was appointed in June 2009 to study why tax revenue-to-GDP has declined and what measures—including base broadening measures and simplification of the highly complex tax regime—are needed to achieve a revenue-to-GDP ratio comparable to other emerging market countries.