Cheers and concerns from IMF

Background

The three-decade war complicated economic policy formulation, hindered development, and reduced Sri Lanka’s growth potential, leaving the country with few policy options to manage the unfolding global crisis in late-2008.

In the face of a sudden reversal in capital flows at the time and heavy intervention by the Central Bank to maintain a relatively stable exchange rate against the U.S. dollar, foreign exchange reserves fell to significantly low levels by March of 2009.

Inflation was successfully brought under control through tight monetary policy, but as expected this resulted in a slowdown of output growth and a surge in banks’ non-performing loans, compounded by a decline in exports as global demand weakened in 2009. Budget revenues remained weak and the deficit high.

Short-term vulnerabilities eased significantly following the end of the war in May and the approval of the IMF Stand-By Arrangement in July 2009. A sharp increase in foreign investor enthusiasm led to large and persistent capital inflows. Remittances also increased, and exports began to rebound. The Central Bank responded by aggressively purchasing foreign exchange to prevent an appreciation of the rupee, boosting reserves to historically-high levels.

The economic recovery that began in the second half of 2009 has been gaining momentum, and output is expected to grow by seven per cent this year driven by strong growth in the agricultural and services sectors. Recent inflation numbers have been below five per cent, with a favourable harvest containing food price inflation.

All signs point to a strong pickup of imports this year, with further growth expected for 2011. This rebound from the sharp import decline in 2009 will result in a sizeable, one-off widening of the current account deficit, from half per cent of GDP in 2009 to around 4.5 per cent in 2010-11. Exports should grow modestly this year, and growth in tourism and remittances will remain robust. Banks’ balance sheets have improved, with the non-performing loan ratio falling to pre-crisis levels.

The 2010 Budget passed by Parliament in June entails a deficit of eight per cent, incorporating sizeable cuts in recurrent spending while allowing for significant spending on infrastructure and reconstruction. Fiscal performance in the first eight months of this year is in line with the full-year deficit target, with a recovery in budget revenues driven mainly by buoyant import-related taxes.

Recent monetary policy has been appropriate. As yet there are few signs of demand pressures, credit growth remains sluggish, property prices are stable, and risk of an acceleration of inflation has receded. The Government’s financial sector reform agenda remains on track with some key regulatory gaps addressed by the issuance of prudential regulations on credit card companies and submission of amendments to the Finance Business Act.

Executive Board Assessment

Executive Directors commended the authorities for their satisfactory program performance, which has helped stabilise the economy and improve Sri Lanka’s near-term growth prospects.

The current favourable environment offers a window of opportunity to address remaining macroeconomic challenges and build a strong foundation for private sector-led growth. This will require continued fiscal adjustment, a more efficient capital market, and an improved business environment.

Growth in the medium term will depend on progress in rebalancing the economy from traditional drivers of growth toward export of services, building on Sri Lanka’s strategic geographical location and comparative advantage in services.

While acknowledging the improvement in fiscal performance, Directors emphasised the need for forceful action to reduce the budget deficit and public debt.  

In addition to cuts in security-related expenditure, they encouraged the authorities to implement well-sequenced tax reform measures that would create fiscal space for social spending and for much needed reconstruction and infrastructure investment.  Directors stressed that the 2011 budget would be a key step in embarking on a credible reform strategy, aimed at broadening the tax base, simplifying the tax and tariff systems, and improving tax administration.

They welcomed the planned legal steps to establish a new investment incentive regime, complementing ongoing reforms to boost competitiveness. Continued efforts to achieve full cost recovery of energy services are also important for fiscal sustainability.

Directors commended the Central Bank for bringing inflation under control and endorsed the current monetary policy stance. Given weak demand pressures and sluggish credit growth, there may be room for further cuts in interest rates, while being watchful for a possible recurrence of inflation.

Directors recommended a gradual move toward a more flexible monetary policy framework that targets inflation more directly, taking into account a wide range of factors, including exchange rate developments and demand conditions. Greater exchange rate flexibility in both directions would contribute to appropriate adjustment in the event of downward pressure on the exchange rate, while protecting foreign exchange reserves.

Directors noted that the Government’s financial sector reform actions have gone a long way toward addressing past weaknesses. Further efforts will be needed to put in place a deposit insurance system, establish a regulatory framework for private sector pensions, improve access to bank financing by small- and medium-sized enterprises, and deepen capital markets.  

In particular, the development of the corporate bond market will be important for increasing the availability of financing for infrastructure investment.