Sri Lanka - Economic Update

IMF Review of Extended Fund Facility - May 2019

 

 

On 13th May, the IMF announced it is granting Sri Lanka waivers of nonobservance under the EFF criteria for the primary balance and net international reserves (for Dec 2018).

It is making available about $164mn in funding, bringing total disbursements under the arrangement to $1.16bn.

The IMF has also approved an extension of the arrangement by an additional year, until June 2020, with a rephasing of the remaining disbursements.

While extending their condolences to the government and people of Sri Lanka over the April terror attacks, the IMF commended the Sri Lankan authorities for bringing the program on track, despite important setbacks, by advancing fiscal consolidation through “a well-targeted 2019 budget”, rebuilding reserves and reviving structural reforms.

Looking forward, the IMF has highlighted the following policy priorities:

  • sustained revenue mobilization to place public debt on a downward path
  • strengthening the process for assessing and selecting large-scale investment projects
  • strengthening SOE governance and transparency. Specifically, restructuring Sri Lankan Airlines
  • completing energy pricing reforms

 

The IMF thinks the new central bank law will be “a major step in the transition to flexible inflation targeting”.  It encourages CBSL to continue its pursuit of a prudent and data-dependent monetary policy, building reserves under greater exchange rate flexibility to protect the economy against shocks.   It recommends further steps to strengthen the financial sector macroprudential policy framework.

More generally, the IMF says further structural reforms are needed to promote strong and inclusive growth.  In particular, it recommends trade liberalization, and steps to improve the business environment, promote investment and strengthen governance.

It sees room to encourage female and youth labour force participation, enhance social protection and to improve preparedness against natural disasters.

2018 Economic Performance

In 2018, real GDP growth slowed to 3.2%.  A slowdown in manufacturing and mining, and a contraction in construction were exacerbated by the political crisis at the end of the year.

Headline inflation fell to 2.8% YoY, driven by lower food and transport prices.  Core inflation was 3.1%.  These measures have since risen 4.3% and 5.6% YoY in March (within the CBSL’s band) on the back of higher housing rents, education fees and tax increases on liquor, tobacco and gasoline.

The current account deficit rose from 2.6% of GDP in 2017 to 3.2% in 2018.  This reflects lower agricultural exports, higher oil prices and a temporary surge in imports of motor vehicles.

The 2018 primary fiscal balance (a surplus of 0.6% of GDP) fell behind the 1% surplus target.  This was the result of the effect of weaker growth on revenue (c.1.4% of GDP), a waiver on fuel import duties (as fuel prices rose) and delays in the implementation of some of 2018’s budget measures.  Shortfalls were partly offset by lower execution of capital projects.   Public debt rose to 90% of GDP.

The real effective exchange rate depreciated by 13% before stabilizing in Q1 2019.  Gross international reserves declined to $6.9bn at the end of 2018, and the EMBI spread widened to 455 basis points amid credit downgrades by the credit rating agencies.  However, pressures eased somewhat in Q1 2019, with GIR recovering to $7.6bn at the end of March and the EMBI spread narrowing to 405 basis points.

Market reaction in the immediate wake of the terrorist attacks was contained through modest FX intervention by CBSL.

Outlook for 2019

The economic recovery is expected to be gradual.

Real GDP growth is projected to recover to 3.6% in 2019 (down from an earlier forecast of 4.5%).    Thereafter, it is expected to rise gradually to 5% over the medium term.

Inflation is expected to rise to 4.5% by the end of 2019, as activity recovers and food prices stabilize following weather-related disruptions in 2018.

The current account deficit is expected to narrow to 2.8%, driven by export growth supported by the correction in the exchange rate, recently-signed free trade agreements, and lower oil prices.

The 2019 budget targets a primary surplus of 1.5% of GDP.  It contains revenue measures – principally, increases in excises and reductions in customs duty waivers – worth 0.7% of GDP.  Further benefits from budget measures taken last year and the delayed implementation of the Inland Revenue Act are expected to result in “significant” revenue gains.

Reform Priorities

Fiscal consolidation

  • A plan to modernize the administration of the Inland Revenue and Customs is expected to be approved by June 2019.
  • The government has committed itself to lowering the fiscal deficit to 3.5% of GDP in the 2020 budget and promises it will be further reduced to 2% of GDP by 2024. This is designed to bring public debt to below 70% of GDP.
  • The authorities are working with the World Bank on a new Public Financial Management Act to improve the budget process, strengthen project selection and control risks from Public Private Partnerships.

 

Improving SOE governance and reducing fiscal risks

  • Ceylon Petroleum Corp., Ceylon Electricity Board and Sri Lankan Airlines recorded a combined loss of 1.3% of GDP (0.5% in 2017). An increased loss at CPC was the main contributory factor in the deterioration.
  • The October political crisis disrupted the implementation of energy price reforms, but the government has committed itself to full cost recovery by June 2019. A new pricing mechanism for electricity has been delayed to H2 2019.
  • A report on proposals for the restructuring of Sri Lankan Airlines is expected in H1 2019. It is envisaged the board will respond by the end of September with a plan for reducing the airline’s losses.
  • KPIs (Statements of Corporate Intent) have been prepared for the five major SOEs in 2017 and 2018. Ten additional SOEs are expected to publish SCIs by mid-2019.

 

Monetary policy framework

  • The cabinet approved amendments to the Monetary Law Act in March 2019. These establish price stability as the CBSL’s primary objective and a flexible exchange rate regime.  CBSL’s provision of advances to the government are to be phased out and its autonomy strengthened.
  • The CBSL has agreed to maintain a prudent data-driven approach to monetary policy and is committed to rebuilding reserves and to allowing greater exchange rate flexibility to protect the economy. Going forward, it will be consulting with IMF staff on FX market and reserve developments at least monthly.
  • The temporary exchange rate restrictions introduced during the crisis of September and October 2018 were removed in March 2019.
  • The IMF has welcomed the authorities’ plan to remove the repatriation requirement of export proceeds (introduced in 2016) in line with progress in macroeconomic adjustment.

 

Financial sector reforms

  • While capital and liquidity indicators remain adequate, NPLs rose to 3.4% in the banking sector and to 7.7% in the NBFI sector with the slower economy. Provision coverage declined to 57% in both sectors.
  • The phased introduction of the Basel III requirements for capital, and liquidity and the adoption of tighter asset classification under IFRS 9, will require additional efforts to meet capital requirements. This will be especially true of NBFIs, which account for 7.6% of system assets.
  • The CBSL has committed itself to enhancing its framework for monitoring and managing macroprudential risks, to upgrading the resolution regime for banks and NBFIs, and to providing a stronger legal foundation to deposit insurance.

 

Accelerating structural reforms to promote sustainable growth

  • Investment-based tax incentives under the Inland Revenue Act, as enhanced in the 2019 budget, are designed to promote private investment and to make income taxes more predictable and transparent.
  • The authorities have been working with the World Bank to enhance the contractual framework for business and to strengthen debt enforcement.
  • In July 2018 a new National Export Strategy was announced that aims to facilitate trade, attract investment and promote export diversification.
  • 1,200 para-tariffs have been removed since 2017. Under the 2019 budget, the special economic purpose tax (CSS) and Port and Airport Development Levy (PAL) are to be phased out over a five-year period beginning in September 2019.  A strategy to rationalize the remaining para-tariffs is expected to be approved by cabinet by March 2020.
  • A National Action Plan for Combating Bribery and Corruption in Sri Lanka was launched last March, with an actionable roadmap for 2019-23. The Bribery Act was amended in July 2018 and new courts have been established to try bribery and corruption cases.   “Considerable progress” has been made in implementing the recommendations of the Asia-Pacific Group on Money Laundering and the Financial Action Task Force action plan to address deficiencies in the AML/CFT framework.
  • The 2019 budget includes adjustments to strengthen social safety nets, such as an extension in the Samurdhi cash transfer programme to additional beneficiaries. A new social registry has been designed to help target safety net programs more effectively.

 

https://www.imf.org/en/Publications/CR/Issues/2019/05/15/Sri-Lanka-Fifth-Review-Under-the-Extended-Arrangement-Under-the-Extended-Fund-Facility-46900