Government’s Letter of Intent for fresh IMF support under SBA

Following is the text of the Letter of Intent signed by Deputy Finance Minister Gitanjana Gunawardena and Central Bank Governor Nivard Cabraal and dated 15 March 2012 sent to IMF Managing Director Christine Lagarde in connection to fresh support under the Stand By Arrangement.

This letter supplements the Memorandum of Economic and Financial Policies of July 16, 2009 and the Letters of Intent dated October 30, 2009; June 19, 2010; September 14, 2010; January 17, 2011; and March 15, 2011.

The economy performed well in many respects in 2011. Output growth stayed strong, at 8 1/4 percent, and inflation remained subdued. Program performance under the Seventh Review was also on track in the first half of 201 1, with all of the end-June 2011 quantitative targets and most of the outstanding structural benchmarks met.

Though economic fundamentals were healthy, there were emerging signs in the third quarter that the balance of payments was coming under pressure. A stronger-than- expected rebound in the growth of credit and domestic demand, as well as higher-than- expected oil prices, led to a significant increase in imports, and despite healthy growth in exports and remittances, the current account deficit widened sharply to 7 1/2 percent of GDP. As a result, although the end-December target for net domestic financing of the budget was met, the floor on net international reserves was missed by a large margin. Moreover, higher international petroleum prices and lower hydroelectricity production due to low rainfall resulted in the Ceylon Petroleum Corporation and the Ceylon Electricity Board continuing to incur significant losses.

Recognizing the downside risks of these emerging trends against the backdrop of global uncertainties, the Sri Lankan authorities introduced several corrective measures:

 nFollowing a 3-percent depreciation of the rupee in November 2011, the trading band on the exchange rate was discontinued in early February 2012 to allow greater exchange rate flexibility and reduce intervention in the foreign exchange market.

nPolicy rates were raised and directions were given to banks to limit their credit growth, which will result in limiting the expansion of credit to below 20 percent and significantly decelerating monetary expansion in 2012.

nIn keeping with global price developments, domestic petroleum and electricity prices were increased by an average of 32 percent and 20 percent, respectively. This revision offset increased costs and reduced the losses of the state energy corporations. An increase in petroleum taxes also served to fund measures to cushion the impact of the price increases on the most vulnerable, non-electrified household consumers, the fisheries sector and small service operators, and ensure the achievement of the fiscal deficit target of 6 1/4 percent of GDP for 2012.

As a result of these policy changes, the rupee depreciated by around 5 percent to Rs. 120/$ immediately after the trading band was removed and is now trading freely at around Rs. 124/$. Since early February, we have limited Central Bank sales of foreign exchange to supporting the oil bill on a declining scale. This has sharply reduced the level of intervention in recent weeks and the corresponding decline in reserves. More immediately, we expect to start rebuilding our net international reserves and aim, at least, to reverse the recent decline in net international reserves completely by end-2012. We are confident that the package of measures taken will reduce the external current account deficit towards a sustainable level by the end of 2012.We are firmly committed to a flexible monetary and exchange rate policy under which we will take whatever necessary steps that are needed to achieve these objectives.

Beyond these changes, our policy agenda remains in line with the Sri Lanka - Emerging Wonder of Asia: Mahinda Chintana - Vision for the Future: The Development Policy Framework of the Government of Sri Lanka, which has been described in the program’s Memorandum of Economic and Financial Policies and subsequent Letters of Intent. We will continue the restructuring of the state-owned Electricity Board and Petroleum Corporation to place them on a financially sound footing. We have already restructured overdue obligations between these two enterprises. Cabinet approval for the amendments to the Petroleum Act to strengthen the regulatory framework is on track and is expected to be received in the second quarter. The Cabinet has also approved amendments to the Banking Act to reform the banking regulatory and supervisory framework, and we look forward to the forthcoming FSAP update, which will help strengthen our banking supervision framework further.

We request completion of the Seventh Review of the Stand-By Arrangement (SBA), following which we intend to draw one tranche amounting to SDR 275.6 million.

We request waivers of non-observance for the end-December 2011 performance criteria on net international reserves given the corrective actions discussed in paragraph 3, as well as the performance criteria on reserve money, which was missed for technical reasons, though the central bank’s target was met by a comfortable margin.

We request an extension of the SBA to July 23, 2012 and that the remaining purchase be re-phased to provide more time for our new flexible exchange rate regime to become established while we stabilize and then start rebuilding net international reserves before the program expires.

At that time we could review the way forward to continue the above reforms and policy measures and ensure that the economy is placed firmly on a sustainable growth path.

We request the establishment of end-June 2012 performance criteria and indicative targets with respect to the completion of the Eighth and final review under the arrangement to be scheduled for July 16 as discussed in the Technical Memorandum of Understanding and the attached table.

We believe that the policies set forth in this and previous Letters of Intent are adequate to achieve the objectives of our economic program, but the authorities stand ready to take additional measures as appropriate to ensure achievement of the objectives.

We will continue to liaise with the IMF when modifying measures contained in this letter, or adopting measures that would deviate from program goals, and provide the IMF with the information necessary for program monitoring.

In keeping with its policy of transparency, the Government has authorized the publication of this letter and the attached Technical Memorandum of Understanding.