Monetary policy should be tightened

The IMF Completed the Second Review of the Extended Arrangement Under the EFF with Sri Lanka and Approved a US$ 167.2 Million Disbursement. In completing the review, the Executive Board granted a waiver of nonobservance of the continuous performance criterion on accumulation of external arrears which was missed due to continued difficulties of establishing a payment platform and waivers of applicability of the performance criteria for end-June 2017 on floor of the central government primary balance and the program net official international reserves of the Central Bank of Sri Lanka, given the unavailability of the information necessary to assess observance.

The Sri Lankan economy showed signs of stabilization during 2016, which is continuing in 2017. The EFF played an important role in helping the authorities to achieve this progress, particularly in implementing reforms and strengthening macroeconomic stability, while strengthening much needed investor confidence. In this context, despite the delay in completing the second review, our authorities remain committed to the successful completion of the EFF as a step towards achieving the broader objectives of socio economic and social policies. Going forward, our Sri Lankan authorities are strongly committed to implement appropriate policy reforms to sustain this improvement towards creating external and fiscal buffers and a conducive environment to achieve high and sustainable economic growth with the support of the international community and in close association with the Fund and staff, complemented by continued technical assistance. In this context, our authorities request the completion of the Second Review of the Extended Arrangement under the EFF.

Sri Lanka’s economic reform program is supported by an Extended arrangement under the Extended Fund Facility (EFF) that was approved in June 2016 for the amount of SDR 1.1 billion (185 percent of quota and about US$ 1.5 billion) over 36 months. So far two purchases equivalent to SDR 239.788 million have been made, and another purchase equivalent to SDR 119.894 million will be made available upon completion of the second review.

Economic growth held up in 2016 despite the fiscal consolidation and weather-related shocks. Growth was supported by robust activity in the industry and service sectors, and improved confidence following the EFF program agreement in June. Despite some delay in passing the VAT amendments, the authorities met the program targets on tax revenues and the primary balance.

However, the end-2016 reserve target was missed reflecting the resumption of portfolio outflows late in the year and intervention to limit currency depreciation. Progress has been made in most fiscal-structural reforms, but energy pricing reforms have stalled due to political resistance.

The authorities remain committed to the economic reform program and undertook meaningful corrective actions where targets were missed. As a prior action, the new Inland Revenue Act (IRA) will be submitted to parliament.

The authorities also strengthened tax administration and are conducting a diagnostic review of VAT. SOE oversight is improving, and energy pricing reforms are being recalibrated to address earlier setbacks. The central bank took steps to address the missed end-2016 reserve target by resuming since March 2017 the build-up of reserves. In response to high inflation, the central bank tightened monetary policy in March 2017, and stands ready to tighten further should inflation or credit growth stay high.

Going forward, the reform momentum should strengthen further, building on the progress made so far. To reduce the risk of debt distress, fiscal consolidation should continue at steady pace. This would require legislating and implementing the new IRA, strengthening the VAT system and administration, and making further progress in expenditure management and SOE reforms.

Monetary policy should be tightened to rein in inflation and credit growth, and reserve accumulation should continue while allowing for greater exchange rate flexibility. (IMF)