IMF Executive Board Concludes Fourth Post-Program Monitoring on Sri Lanka

Economic downturn

The International Monetary Fund (IMF) said on 14 June that Sri Lanka’s economic outlook is facing risks from the government’s inaction on key policies and a significant deterioration in the external environment.  Foreign exchange reserves have fallen by more than a third from their peak in late 2014 to $5.6 billion at the end of May, the lowest since February 2012, mainly due to foreign outflows of around $2 billion from government securities. It said that while the government seeks to undertake sizable fiscal consolidation and tackle high priority structural reforms, growth momentum can be sustained with a solid commitment to reform, a clear direction on macroeconomic policies, and restoration of market confidence.”

The report said that economic growth continued to be fairly strong in 2015, while headline inflation has remained low. The external current account deficit is projected to narrow moderately in 2015, due largely to lower oil prices. Private sector credit growth has picked up sharply in 2015. At the same time, deterioration in the overall balance of payments, the loss of central bank foreign exchange reserves, the weak state of public finances, and growing public debt are reasons for concern. Despite continued access to international debt markets, these trends suggest that financial risks for Sri Lanka have increased. To mitigate these risks, the authorities should take appropriate corrective actions to safeguard macroeconomic stability and lay the foundation for durable and inclusive growth. Improvements in the business climate, reform of state owned enterprises, and a more open trade regime are key to boosting competitiveness and growth.

In view of high public debt, fiscal developments this year pose a risk to the economy and call for ambitious measures in the 2016 budget to put Sri Lanka’s fiscal position on a more sustainable footing. Sri Lanka has a very low tax-to-GDP ratio, and high levels of current expenditure constrain needed development spending, limit policy space, and threaten debt sustainability.

Therefore, a comprehensive reform of tax policy and administration, and a prompt resumption of fiscal consolidation supported by increased revenues should be a key policy priority. With the recent acceleration in private sector credit growth and rising core inflation, there is now little scope for further monetary easing. Most factors —including the deterioration in the balance of payments and pressures on the rupee—suggest that the CBSL should be prepared to tighten monetary policy in the coming months, albeit at a gradual pace.

Another policy challenge is to reduce external vulnerabilities and address the deterioration in the balance of payments. Tighter fiscal and monetary policies could help restrict aggregate demand, contain the recent sharp rise in imports, and strengthen the external balance. However, to be more effective, these policies should be supported by greater exchange rate flexibility, reduced foreign exchange intervention, and efforts to deepen the foreign exchange market, as well as structural reforms to enhance competitiveness.

The financial sector remains relatively stable, and the authorities are taking measures to tackle remaining vulnerabilities in the non bank financial sector. However, there is the need for continued progress in consolidated bank supervision and in developing a more robust stress testing framework.

Meanwhile the IMF said that Short-term fiscal targets reestablishing fiscal consolidation should be accompanied by policy  commitments to establish milestones for putting public finances on a sustainable (and growth -friendly) medium-term path. Bearing in mind the very low level of productivity of Sri Lanka’s tax framework, basic principles underlying a credible shift in policy are

(i) a transparent budget process that costs and presents tax expenditures (tax holidays, exemptions, and special rates) as an explicit spending item in each budget; and

(ii) a multi-year process of policy reform toward a tax system that is simple, efficient, and fair. In broad terms, this encompasses the following:

  • Halting the provision of new tax holidays, exemptions, and special rates.
  • Eliminating existing tax holidays and exemptions across different types of tax; and using other incentives (such as tax credits or accelerated depreciation) with respect to investment projects.
  • Simplifying the complex tax system (including unification of rates) to create a more equitable tax framework that would also facilitate more effective tax administration and improve tax compliance.
  • Continuing with current efforts to improve tax administration—particularly through automation and removal of opportunities for discretionary tax treatment.

The authorities emphasized their strong commitment to reducing the fiscal deficit. For 2015, they stated that there are still many unknown elements (budgetary commitments) being discovered. They estimated that unsettled expenditures from 2011–14 are in the range ofRs 200 billion and could push the 2015 deficit as high as 7 percent of GDP. They agreed that revenue performance needs to improve and contribute to deficit reduction, and that increasing revenue by 1 percentage point of GDP in 2016 (as suggested in the adjustment scenario) will be difficult, but achievable.

Rather than focusing on exemptions, however, the authorities argued that the first step should be to reduce corruption in tax administration (with corruption in excises being worst), followed by increased collection efficiency. They were optimistic that the current strong growth of excise collection will continue, and saw room for further strengthening excise revenuegrowth by addressing the shortcomings in vehicle valuations (undervaluation of the actual value ofimported vehicles) and stronger implementation of checks and scans at container terminals. Tax reforms are considered to be implemented over a longer-term horizon (5 years). The authorities also signaled that they are actively exploring programmatic budget support with the World Bank and other international financial institutions as well as closer engagement with traditional bilateral partners as a means of reducing the cost of external financing.

The IMF has earlier on December 9, 2015 said that the economic outlook for Sri Lanka remains uncertain, and will depend to a large extent on the course set for economic policies in the coming months. The risks are tilted to the downside. Underlying growth momentum appears relatively firm and the outlook for headline inflation looks contained.

However, the large increase in wages and salaries in the revised 2015 budget and lower administered prices have boosted incomes. Together with a reduction in import taxes on vehicles, this has fed through to a sharp rise in imports, a deterioration in the nonoil current account balance, rising core inflation, and continued weakness in the structure of public finances.

Further, external risks have risen. Global growth prospects have weakened. Global financial conditions have tightened and may rebalance further when the U.S. Federal Reserve moves to raise interest rates.

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