The International Monetary Fund last week released the first ever Governance Diagnostic Assessment on Sri Lanka as part of its technical assistance initiative. Here is the executive summary of the 139-page report which can be accessed via online https://www.imf.org/en/Publications/CR/Issues/2023/09/29/Sri-Lanka-Technical-Assistance-Report-Governance-Diagnostic-Assessment-539804

At the request of the authorities of Sri Lanka, an inter-departmental (LEG/FAD/MCM, FIN) Governance Diagnostic Assessment (GDA) mission was conducted during 20 to 31 March 2023. In line with the IMF’s 2018 Framework on Enhanced Fund Engagement on Governance,1 the diagnostic assessment focused on corruption vulnerabilities and governance weaknesses linked to corruption in macro economically critical priority areas of: (i) the anti-corruption, anti-money laundering and combating the financing of terrorism; (ii) fiscal governance (e.g., public financial management, tax policy and revenue administration, state enterprise management, and public procurement); (iii) central bank governance; (iv) financial sector oversight; and (v) enforcement of contract and protection of property rights. Annex 1 provides additional information on the methodology and scope of the Governance Diagnostic.

Sri Lanka is an island nation that lies in the Indian Ocean off the coast of India and that is highly connected to the global market. The economy has begun the transformation from primarily agriculture to higher value added industry and service sectors and has the potential to further diversify and upgrade its economic structure. As of now, the Sri Lankan economy relies primarily on tourism, tea export, clothing, rice, and other agricultural production. 

In recent years, a confluence of shocks and policy missteps led to a deep economic and governance crisis. Two years of low tourism revenues due to COVID, loss of market access, deep reductions in tax revenues, and the debt service burden depleted reserves. The economic downturn was further exacerbated by a series of policy choices, many of which generated gains for private individuals while saddling the nation with debts. The country defaulted and FX shortages led to nationwide power cuts, shortages of essentials, and long queues for petrol. The rupee depreciated by about 40% (in dollar terms) between February and March 2022. Inflation soared and the economy contracted sharply while the banking sector was put under extreme stress by a state-granted

moratorium of domestic debt repayment. The poverty level nearly doubled from its pre-pandemic level to about 25.6% of the population living below the USD 3.65 poverty line. Popular protests against Government policies and widespread corruption, starting in March 2022, spotlighted the role of a small number of connected individuals who wielded enormous power and authority. President Rajapaksa resigned in July 2022, and Ranil Wickremesinghe assumed the Presidency later that month.

President Wickremesinghe has set out a reform program designed to stabilise the economy and country featuring a combination of steps to restore fiscal and debt sustainability, improve governance, and reduce corruption risks. The program includes measures to cut spending, raise revenues, and restructure debts, while maintaining necessary social programs to meet severe social needs. A raft of governance changes is also envisioned, including steps to strengthen the independence of the central bank, and enhance the country’s ability to confront corruption and integrity issues. The IMF approved an Extended Fund Facility (EFF) Arrangement with Sri Lanka in March 2023 to support the implementation of reforms required to address critical balance of payment issues.

Sri Lanka continues to face severe economic, social and governance challenges. Despite tentative signs of macroeconomic stabilisation with inflation moderating, exchange rate stabilising, and the Central Bank of Sri Lanka (CBSL) rebuilding reserves buffers, social tensions remain high due to falling real incomes. Government measures to address the balance of payment crisis, including tax reforms and cost-recovery pricing in the energy sector, have raised the cost of living while continued shortages of essentials, strong-arm measures against protestors, and the postponement of local Government elections have been sources of popular discontent. Large fiscal deficit and elevated debt continued to weigh on the recovery prospects. The absence of visible progress on addressing corruption and holding officials to account for past behaviour raises popular concerns that officials will continue to enjoy impunity for their misconduct.

In this context, the authorities have requested IMF assistance to analyse governance weaknesses and corruption vulnerabilities that are macro-critical in their own right and stand in the way of achieving the objectives of the reform program. The recommendations provided are designed to align laws, institutions, and incentives towards more effective public sector performance and better outcomes. In keeping with the IMF’s Framework for Enhanced Governance Engagement, efforts to address governance weaknesses and corruption vulnerabilities in Sri Lanka are approached as complements and essential to sustained progress on fiscal consolidation and inclusive social and economic growth. Analysis and recommendations exclusively concern the areas established in the 2018 Framework and do not capture governance concerns that are beyond these parameters.2 The report is based on information gathered before and during March 2023, and does not capture

reforms introduced since March. The publication of the Governance Diagnostic by the end of September 2023 is a structural benchmark in the Fund’s program.

The GDA revealed systematic and severe governance weaknesses and corruption vulnerabilities across state functions, with particular macroeconomic impact in: budget credibility; expenditure control; public investment management and control of spending); public procurement; management and oversight of State-Owned Enterprises (SOEs); transparency of revenue policy and the integrity of revenue administration; the governance and legal frameworks of the Central Bank; the application of financial sector regulations; and clarity and security of land ownership and the integrity of the judicial sector. Corruption vulnerabilities are exacerbated by weak accountability institutions, including the Commission to Investigate Allegations of Bribery and Corruption (CIABOC) that have neither the authority nor competency to successfully fulfil their functions. 

Current governance arrangements have not established clear standards for permissible official behaviour, acted to deter and sanction transgressions, nor pursued individuals and stolen public funds that have exited the country. Regular civil society participation in oversight and monitoring of Government actions is restricted by limited transparency, the lack of platforms for inclusive and participatory governance, and by broad application of counter-terrorism rules. 

These weaknesses and vulnerabilities highlight several broader governance themes that need to be addressed for planned reforms to be sustained. Problematic structural issues that shape governance dynamics include the compromised independence of key governance institutions, critical gaps in the legal and regulatory infrastructure for managing and overseeing public resources, limited fiscal discipline and transparency, and a disorganised regulatory and legislative process that provides for insufficient review and engagement. Minimal progress has been made in integrating modern information technology into public sector operations and public private interfaces, or in linking information to detect and correct inefficiencies and improprieties. These governance features form the basis for the substitution of informal mechanisms of control for rule-based system of accountability for performance and integrity over an expansive state. The impunity for misbehaviour enjoyed by officials undermines trust in the public sector and compounds concerns over limited access to efficient and rule-based adjudication process for resolving disputes.

Specific weaknesses in each area can be summarised as the following:

• Anti-corruption legal frameworks and institutional arrangements are in flux due to the very recent passage of the Anticorruption Act (“ACA”). The act substantially improved the legal environment for addressing corruption. Gaining full benefit of the improved legal framework hinges on the creation of a transparent and merit-based process, informed by input from acknowledged experts in governance and anticorruption, for selection of Commissioners of the Commission to Investigate Allegations of Bribery or Corruption (CIABOC), given their role in day-to-day operations. Improvement brought about by the passage of the ACA needs to be complemented by the drafting and enactment of a modern law on Asset Recovery. Rapid operationalising of the ACA will be critical to address current corruption vulnerabilities associated with the lack of a functional system for receiving, publishing, and reviewing asset declarations by public officials, and procedural and competency issues in the investigation and prosecution of corruption cases. The ability of the current anticorruption arrangements to effectively prevent, identify, and sanction corrupt behaviour is further constrained by limitations on the sharing of information across institutions, such as among the Supreme Audit Agency, the Financial Intelligence Unit, and the Anticorruption Agency. Transparent standards for public officials, including a Conflict-of-Interest system, are lacking, and opportunities for public participation and oversight of official behaviour, including by civil society, are increasingly restricted.
  
   
• While anti-money laundering mechanisms can contribute to reducing corruption vulnerabilities, current approaches to Anti-Money Laundering/Combatting Financing of Terrorism (AML/CFT) largely fail to support effective state action. Issues in legal definitions and processes to capture and share information on beneficial ownership of companies have not been addressed, since they were first observed in 2015.

Current practices by financial institutions largely fail to identify suspicious transaction and prevent money laundering. At the same time, weaknesses in the legal framework, problems in domestic cooperation on corruption related issues between competent authorities, and issues in establishing effective protocols for collaboration with foreign jurisdictions impair sanctioning corrupt officials for money laundering offenses or recovering stolen assets.

• The lack of a robust legal framework and poor processes utilised in Public financial management (PFM) create corruption vulnerabilities due to limitations in the coverage of the budget, the lack of transparency in the process used for managing commitments, and for poor investment planning and management. The acceptance of unsolicited capital investment proposals in processes that lack transparency and competition have contributed to a large and growing portfolio of “problem” projects and raised corruption concerns. Substantial governance weaknesses exist across the management of state-owned enterprises, including a lack of clarity in the Government’s portfolio, the absence of an explicit state policy to guide the management of its financial stake, and limited regulatory guidance and monitoring of the selection of executives and representatives of the state on Boards of Directors. The lack of oversight and transparency around the operation of state enterprises enhances exposure to corruption vulnerabilities, especially regarding procurement and other forms of contracting, and capital investments. Weaknesses in internal audit and control processes generate additional governance challenges and place an excessive burden on the Auditor-General to identify corruption risks. The absence of effective mechanisms to follow up on audit

findings and observations contributes to the persistence of problematic procedural and managerial practices while restricting accountability for past actions.

• Corruption vulnerabilities in Public Procurement remain high. The absence of a public procurement law creates ambiguity in the legal framework, and has contributed to high-levels of political engagement in the selection of procurement winners, poor contract management, limited transparency and a lack of oversight of procurement processes and outcomes Additional issues are generated by poor procurement planning, reliance on non-competitive means for contract awards, inadequate competition, and inconsistent attention to contract performance and the enforcement of contract terms. The lack of information on beneficial ownership of companies increases the risk of conflict of interest in the awarding of contracts.
  
   
• Governance risks are also generated by current Tax Policy practices. Sri Lanka has recently made marked progress in increasing the clarity of the legal framework around taxes, including reducing the number of tax incentives, and providing for integrity and oversight provisions. However, modifications of the tax laws occur frequently and with little notice or centralised consideration. Substantial corruption vulnerabilities are created through the granting of high-value and long-lasting concessions for investments determined to be of strategic importance in a process that lacks clarity and transparency. In a similar fashion, corruption risks stem from the Special Commodity Levy, which provides for excessive levels of ministerial discretion in granting tax changes relating to specific commodities with immediate effect. 

Concerns about the use of Government authority relating to tax policy highlight limited Government attention to protecting competition, including the lack of a competition policy agency on the one hand and extensive Government control of markets in critical sectors, including agriculture and construction materials.

• The absence of clear mechanisms for information sharing among authorities responsible for tax policy and Revenue Administration limits the soundness of policy choices while it restricts the ability to identify and address shortfalls in expected revenue collection. Exposure to corruption in customs and tax administration is substantial, given the absence of effective systems for performance monitoring and detecting and sanctioning of officials for improper behaviour. The limited progress that has been made in digitizing processes in tax and customs requires users to maintain high levels of direct interaction with officials and reduces the ability to identify integrity issues through data analytics.
  
   
• Weaknesses relating to Central Bank governance arrangements under the recently repealed legal framework revolved around safeguards to the central bank autonomy and the conflict of interest created by the Central Bank of Sri Lanka’s (CBSL) direct management of the Employee Provident Fund and Sri Lanka’s Debt Management office. The enactment of the Central Bank of Sri Lanka Act is a critical step in addressing some of these issues, including by improving aspects of the CBSL’s institutional, personal, and financial autonomy, as well as the appointment process and qualifications for the Governor of the Central Bank and other senior officials.
  
   
• The Central Bank has successfully worked to avoid a banking crisis and has established mechanisms to monitor compliance with core financial sector rules. At the same time, its ability to perform its function in Financial Sector Oversight has been constrained by the CBSL’s own governance arrangement. The new CBSL, enacted in September 2023, improves the structure of governance, and is a significant step forward but governance weaknesses remain Exposure to governance and integrity risks are generated by differences in regulations applied to state-owned banks and by corporate governance provisions, often defined in state bank statutes, that do not reflect good practice and international standards in areas like the competency and integrity of directors and the composition and role of the Board. Regulatory consistency is also hampered by the rules and regulatory practices applied to Non-Bank Financial Institutions (NBFI), which are not aligned with proportionality considerations. Oversight of prudential regulations around lending limits to borrowers is undermined by exemptions given in the “maximum amount of accommodation,” regulation. The tendency for financial regulations to be applied in a somewhat fragmented manner encourages excessive focus on narrow compliance checking, without adequate attention to broader governance risks. Overall, the development of rigorous, independent, and arms-length financial sector oversight has been challenged by the weight of the public sector shareholding in the banking sector, which generates opportunities for influencing the behaviour of financial institutions through non-transparent means.
  
   
• Governance weaknesses associated with increased risks of corruption are present around Contract Enforcement and the Protection of Property Rights in ways that substantially constrain private sector development. Multi-year waiting times for the resolution of contract disputes prevent reliance on courts for effective and fair resolution of disputes and encourage disputants to find ways, not always legal, to speed up adjudication. Widespread confusion over the allocation of property rights and the lack of progress in digitizing property records generates extensive long-term legal disputes and similarly promotes resort to opaque means to influence the resolution of disputes. Corruption risks around state owned land, estimated at approximately 80% of the country, are particularly severe due to the combination of lack of clarity around titles, the absence of a property registry, and ambiguity in processes for the divestiture of state property. Concerns about the integrity of the judiciary have grown over time, given the strong incentives of private parties to use illicit payments as a way to solve legal problems that have little chance of being resolved in the near term, and have focused attention on the need to strengthen the independence and competency across the legal sector.

The report highlights immediate and short-term measures to address key corruption issues, as well as structural reforms that require more time and resources but are essential to strengthen governance and initiate lasting change. A list of “priority” recommendations is provided below. They primarily focus on measures related to critical risks, including addressing gaps in existing legal frameworks and the public provision of essential information for oversight and monitoring. Priority recommendations are explored in more depth in the subsections of the report, which also contain more extensive recommendations, including structural and institutional measures to achieve more transparent and efficient governance that operates with integrity and in accordance with the rule of law.

The recommendations are designed as a coherent approach to improving governance through a focus on:  clarity of authority and responsibility for core functions; financial and operational independence of essential accountability and law enforcement institutions; transparency in Government practices and performance, especially relating to the planning, spending, and accounting for the use of public funds and assets; inclusive, accessible, and rule-based means to enforce private agreements and challenge official behaviour; and efficient mechanisms for making information public and holding organisations and individuals to account for their performance and behaviour. The combination of short-term actions to deliver concrete and observable improvements and long-term structural initiatives to change how the public sector functions in Sri Lanka is essential to achieving the social and economic aspirations of the country.

It is acknowledged that comprehensively addressing governance weaknesses would require medium – and long-term initiatives, significant resources, and prolonged efforts, including with support from Sri Lanka’s international partners. The recommendations coming out of this diagnostic will contribute to the formulation of governance and anticorruption policies and programs, improvement of the legal and institutional frameworks, as well as governance and anti-corruption reform measures agreed to in the Staff Level Agreement for an Extended Credit Facility Arrangement for Sri Lanka.

Footnote

2 A large variety of governance diagnostics exist, reflecting different analytical frameworks and concerns. For example, the World Bank’s Systematic Country Diagnostics provide an assessment of the constraints and drivers of progress towards the twin goals of ending poverty and boosting

shared economic prosperity. The Bertelsmann Transformative Index measures the development status and governance of political and economic transformation processes. The Ibrahim Index of African Governance is a biennial survey-based assessment of the quality of governance relating to

the provision of political, social, economic, and environmental goods that a citizen has the right to expect from the state. For Sri Lanka, the recently published “Civil Society Governance Diagnostic Report” provides an alternative governance perspective.

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