Sri Lanka: 2014 Article Iv Consultation and Second Post-Program Monitoring Discussion-Staff Report Press Release

2014 International Monetary Fund
IMF Country Report No. 14/285

SRI LANKA
2014 ARTICLE IV CONSULTATION AND SECOND POST-
PROGRAM MONITORING DISCUSSIONSTAFF REPORT;
PRESS RELEASE
Under Article IV of the IMFs Articles of Agreement, the IMF holds bilateral discussions with
members, usually every year. In the context of the 2014 Article IV consultation with Sri Lanka,
the following documents have been released and are included in this package:

The Staff Report prepared by a staff team of the IMF for the Executive Boards
consideration on a lapse of time basis, following discussions that ended on May 30, 2014,
with the officials of Sri Lanka on economic developments and policies. Based on
information available at the time of these discussions, the staff report was completed on
July 9, 2014.
An Informational Annex prepared by the IMF.
A Debt Sustainability Analysis prepared by the staffs of the IMF and the World Bank.
A Press Release summarizing the staff report.
The following document has been or will be separately released.

Selected Issues Paper

The publication policy for staff reports and other documents allows for the deletion of market-
sensitive information.

Copies of this report are available to the public from

International Monetary Fund Publication Services
PO Box 92780 Washington, D.C. 20090
Telephone: (202) 623-7430 Fax: (202) 623-7201
E-mail: publications@imf.org Web: http://www.imf.org
Price: $18.00 per printed copy

International Monetary Fund
Washington, D.C.
September 2014

SRI LANKA
STAFF REPORT FOR THE 2014 ARTICLE IV CONSULTATION
AND SECOND POST-PROGRAM MONITORING DISCUSSION
KEY ISSUES
Context. Macroeconomic performance has generally exceeded expectations. Real GDP
grew 7.3 percent for 2013, up from 6.3 percent in 2012. Inflation declined to below
5 percent, and the external current account balance has improved. Private credit growth
has been slow, however, a number of financial sector indicators have deteriorated.

Outlook and Risks. Growth is expected to remain robust at 7 percent and inflation to
remain in the mid-single digits. The external current account should improve marginally,
allowing for further accumulation of foreign exchange reserves. Near-term risks appear
moderate, although there may be some bumps in the road from market turbulence and
climatic events. Medium-term risks relate to the potential for tighter external liquidity,
the challenge of further fiscal and debt consolidation while maintaining high levels of
investment in infrastructure and human capital, maintaining a balanced monetary policy,
and staying competitive in a shifting economic landscape.

Key Policy Recommendations.

Fiscal consolidation and debt reduction need to continue, but the burden of
adjustment needs to shift decisively to revenue generation. Debt targets could
potentially be recast to achieve deeper reduction over a longer period.
Monetary policy needs to maintain a balance between supporting growth and
containing inflation. A continued forward-looking approach is needed given long
lags in monetary transmission.
Financial sector consolidation could lead to economies of scale, greater resilience,
and more effective supervision, but corporate governance needs to continue to
improve, and careful supervision in the post-consolidation period will be key.
Maintaining competitiveness and achieving a more sustainable external position will
require a mix of continued innovation, sustained investment in infrastructure and
human capital, a predictable business environment, and ideally a heavier emphasis
on direct investment and equity portfolio flows than debt.
July 9, 2014
SRI LANKA

2 INTERNATIONAL MONETARY FUND
Approved By
Jerald Schiff and
Dhaneshwar Ghura
Discussions took place in Colombo May 2030, 2014. The staff team
comprised T. Schneider (Head), J. Jonas, M. Ghazanchyan (all APD), C.
Lundgren (SPR), and E. Kvintradze (Resident Representative), and R.
Wijeweera (local economist). M. Inoue, S. Boyce, and Q. Zhang also
assisted in preparation of this report.

CONTENTS
CONTEXT _________________________________________________________________________________________ 3
RECENT DEVELOPMENTS AND OUTLOOK ______________________________________________________ 4
A. Recent Economic Performance _________________________________________________________________4
B. Outlook and Risks ______________________________________________________________________________6
C. Debt Sustainability _____________________________________________________________________________9
POLICY DISCUSSIONS ___________________________________________________________________________ 9
A. Fiscal Consolidation: How Fast and How Deep _______________________________________________ 10
B. Monetary Policy: Timing Matters _____________________________________________________________ 12
C. Competitiveness and External Sustainability _________________________________________________ 14
D. Financial Sector Consolidation _______________________________________________________________ 17
POST PROGRAM MONITORING ________________________________________________________________ 19
STAFF APPRAISAL ______________________________________________________________________________ 20

BOXES
1. Dynamics of Monetary Transmission in Sri Lanka ____________________________________________ 13
2. Sri Lankas Garment Industry _________________________________________________________________ 16
3. Sri Lankas Master Plan for Financial Sector Consolidation ___________________________________ 18

FIGURES
1. Macroeconomic Developments ______________________________________________________________ 22
2. Monetary and Exchange Rate Developments ________________________________________________ 23

TABLES
1. Selected Economic Indicators, 201119 ______________________________________________________ 24
2. Summary of Central Government Operations, 201119 ______________________________________ 25
3. Monetary Accounts, 201114 ________________________________________________________________ 26
4. Balance of Payments 201219 _______________________________________________________________ 27
5. Projected Payments to the Fund, 201418 ___________________________________________________ 28
6. Financial Soundness IndicatorsAll Banks, 200813 ________________________________________ 29

SRI LANKA
INTERNATIONAL MONETARY FUND 3
CONTEXT
1. Sri Lanka has made notable advances in recent years, and appears to be on its way to
joining the ranks of upper middle income countries. Per capita GDP has increased from US$869
in 2000 to US$3,256 in 2013, and there appears to be an ongoing shift toward higher value added
industrial production, as well as rapid expansion of services. The years following the end of civil
conflict in 2009 have seen an acceleration of activity. Overall real GDP growth has risen (albeit
sometimes on the back of unsustainable booms in credit and consumption), and new areas of
economic activity (tourism and transport, IT, and other services) have emerged. Inflation has also
come downfrom an average of 12.6 percent during 200108, to mid-single digits. Infrastructure
has also visibly improved. Vulnerabilities have generally moderated with stronger economic
performance and a commitment to fiscal consolidation. Nonetheless, public debt and debt service
remain high by international comparison, reserves are limited, tax revenues are low, and medium-
term sustainability depends heavily on continued growth and a positive external environment.
2. Notable gains have been made in poverty reduction, and the government has made a
public commitment to inclusive growth and development. The national poverty headcount ratio
declined from 8.9 percent in 2009/10 to 6.7 percent in 2012/13. Also, poverty headcount has
significantly declined on a $2 and $1.25 scale from 29.1 (7.0) to 23.9 (4.1) percent, respectively within
the last two surveys. Regionally, poverty headcount ratios were lower in 18 districts and higher in 4
districts in 2012/13 compared with 2009/10. Available data suggest a gradual decrease in inequality
at national and most provincial levels with the Gini coefficient decreasing from 0.49 in 2009/10 to
0.47 in 2012/13. The lowest ratio is in the North-Central and Sabaragamuwa provinces of Sri Lanka
and highest in the North and North-Western provinces of the country. The government espouses
an inclusive development strategy
1
that focuses on six pillars: (i) macroeconomic stability; (ii) spatial
transformation (creating economic links through improved infrastructure; (iii) human resources
development; (iv) rural-centric development; (v) resilience to climate and external shocks; and (vi)
five hubs of development (knowledge, shipping, energy, aviation and commercial hubs.

1
The governments development strategy is published in the Annual Report of the 2013 Ministry of Finance and
Planning, released in May 2014.
Province 2006/07 2009/10 2012/13
Sri Lanka, national 0.49 0.49 0.47
Western 0.49 0.48 0.47
Southern 0.43 0.42 0.45
Sabaragamuwa 0.47 0.51 0.39
Central 0.48 0.48 0.40
Uva 0.47 0.46 0.50
Eastern 0.42 0.41 0.40
North-Western 0.47 0.54 0.52
North-Central 0.44 0.44 0.39
Northern n.a. 0.41 0.52
Sri Lanka, national, expenditure 0.40 0.38 0.39
Source: HIES, 2006/07 2009/10, 2012/13.
Sri Lanka. Income Inequality by Province, 2006/07, 2009/10 and 2012/13
Gini coefficient, per capita 1996 2002 2006 2010 2012
Poverty headcount ratios (% of population)
At $2 a day (PPP) 46.7 39.7 29.1 23.9 n.a
At $1.25 a day (PPP) 16.3 14.0 7.0 4.1 n.a
At national poverty line 5.3 4.3 3.0 1.8 n.a
GDP per capita, current US$ 758 904 1,614 2,400 2,923
At national poverty line 28.8 22.7 15.2 8.9 6.7
Population 18.3 18.9 19.9 20.7 20.3
Employment in industry (% of total employment) 22.4 22.4 26.6 24.2 26.3
Unemployment' total (% of total labor force) 11.3 8.8 6.5 4.9 4.0
Source: World Bank; HIES.
Sri Lanka. Poverty and Social Indicators
SRI LANKA

3. Political context and medium-term vision. President Rajapaksa is in his second term of
office, having been first elected to the presidency in 2005. Presidential elections are expected in
2015. The Presidents second five-year plan (from 201015) aims to raise per capita income to
US$4,000 by 2016 and to reach real GDP growth of 8 percent or more. Sustaining the current
momentum of development and growth will require a continued focus on macroeconomic stability,
high and sustained investment in infrastructure and human capital, and continued progress in fiscal
consolidation and debt reduction.

4. Policy consistency with staff advice. The direction of the authorities macroeconomic
policies since the 2013 Article IV Consultation has been broadly in line with past staff advice.
Progress was made on fiscal policy but in some areas more gradually than advocated by staff. The
government has implemented a number of recommendations made by the Presidential Tax
Commission (which was complemented by IMF technical assistance). Importantly, fuel and electricity
tariffs were adjusted in 2013, and measures taken to put the state-owned Ceylon Electricity Board
(CEB), and the Ceylon Petroleum Corporation (CPC) on a more commercial footing and eliminate
their financial losses. Also in 2013, the VAT was extended to the wholesale and retail level. In line
with staff advice and the authorities medium-term objectives, the 2014 budget targeted a further
reduction of the deficit. The VAT threshold at the retail level was also lowered from Rs 500 million to
250 million in quarterly turnover to broaden the tax base. Ongoing work, with support of IMF TA,
focuses on introducing a formal system for the collection, analyzing, and reporting of commitment
data. Reform of tax holidays and exemptions remains a key objective. On monetary policy, the
authorities moved to a more aggressive easing than recommended by staff, but with no adverse
affects given low private credit growth.
RECENT DEVELOPMENTS AND OUTLOOK
A. Recent Economic Performance
5. Growth and inflation. Sri Lankas economic growth has been among the fastest in Asias
frontier and developing economies in recent years, albeit somewhat volatile. After falling to
6.3 percent in 2012, real GDP growth accelerated to 7.3 percent in 2013driven primarily by a
pickup in services activity, and supported by manufacturing and construction, but also benefiting
from an increase in net exports. Price pressures meanwhile remained moderate, with headline and
core inflation reaching 4.7 and 2.1 percent, respectivelythe fifth consecutive year of single digit
inflation and a marked contrast to the average of 12 percent headline inflation in 200108. Lower
food prices played a key role in lowering the overall CPI to below 5 percent in 2013, but demand
side pressures were also contained.
2
Headline inflation declined further to 3.2 percent year-on-year
in May 2014, even while first quarter growth came in at a robust 7.6 percent.

2
The mission questioned the consistency of high levels of growth with low inflation, weak credit demand, and
reduced import of investment goods. The authorities saw the picture as broadly coherent, but reflecting structural
change. Lower food prices reflect, inter alia, improved transport infrastructure. Moderate private credit growth partly
(continued)
SRI LANKA

6. External Accounts. Sri Lankas external position strengthened in 2013 and into 2014, as
exports gained ground and imports remained subdued. The current account deficit improved from
6.7 percent of GDP in 2012 to 3.9 percent in 2013. On the export side, recovery in advanced
economies (Sri Lankas main export markets) helped boost exports in the second half of 2013 and
into 2014. Foreign exchange receipts from services (particularly tourism) have also risen steadily, and
net remittances are now equivalent to 8.4 percent of GDP, compared with 6.4 percent a decade
earlier. At the same time, imports decreased by 6.2 percent. A fall in oil and fuel shipments
(reflecting a favorable monsoon and increased hydropower production) contributed over half of the
overall decline in 2013, but intermediate and investment goods also dropped.
3
The stronger external
position and issuance of new external debt enabled the Central Bank of Sri Lanka to accumulate
additional foreign exchange reserves, and the rupee has been virtually stable in nominal terms vis--
vis the U.S. dollar since the end of October 2013.

7. Fiscal Position. During 2013, tax revenue fell almost 1.5 percent of GDP short of the budget
target. However, as in previous years, tight spending control allowed fiscal consolidation to
continue. With current and capital spending cuts, the government came close to meeting its budget
deficit target of 5.8 percent of GDP. First quarter revenue data suggest that reforms implemented in
2013-14 (extending VAT coverage, lowering the threshold, broadening the base) and aided by a
pick-up in imports, may finally be yielding some results. However, achieving the FY 2014 deficit

reflects the aftermath of a credit boom, as well as increased use of corporate debentures; and the fall in import of
intermediate and investment goods captures rising domestic production of such products and backward linkages.

3
The mission followed up on a cash margin requirement for letters of credit for vehicles, which was identified (at the
time of the first Post Program Monitoring consultation in November 2013) as an exchange restriction inconsistent
with Sri Lankas obligations under Article VIII, Section 2a of the Funds Articles. The authorities provided staff with a
copy of the Circular withdrawing the cash margin requirement effective January 2, 2014 and, based on this, staff has
found that the exchange restriction has been eliminated. No other changes have been introduced to the foreign
exchange system that could give rise to restrictions on the making of payments and transfers for current
international transactions or multiple currency practices.
0
1
2
3
4
5
6
7
8
2013 Real GDP Growth
(In percent)
Sources: IMF staff calculations (WEO)
0
1
2
3
4
5
6
7
8
9
10
April 2014: Headline Inflation
(In yoy percent change)
Sources: APDCORE Database
SRI LANKA

target of 5.2 percent of GDP will be challenging given the ambitious year-end target for revenues
(an increase of 26 percent a significant acceleration compared to previous years), and continued
tight spending control will likely be needed.

8. The banking system remains well capitalized, but a number of financial soundness
indicators have deteriorated. Nonperforming loans (NPLs) rose from 3.7 percent of total loans at
end-2012 to 5.6 percent by end-2013, and the sector saw profits decline by 10 percent. Net interest
margins have declined, reflecting high-cost term deposits, slow credit growth, and an increase in low
yielding assets. The rise in nonperforming assets appears most closely linked to gold pawning
activity (which accounts for a significant share of assets in most banks) and the sharp drop in gold
prices in 2013.
4
In this context, the CBSL has announced a credit guarantee scheme to foster a
resumption of credit growth.
5
The CBSL announced in January 2014 a financial sector consolidation
plan to reduce the number of nonbank financial institutions and create larger banks.

B. Outlook and Risks
9. The short-term outlook appears broadly positive, as Sri Lanka is well positioned to
benefit from the global economic recovery and particularly stronger growth in advanced
economies. Staffs medium-term projections, which are anchored around a potential output level of
6.5 percent, a modest level of inflation, continued public and private investment, and a maintenance
of sound macroeconomic policies, suggest gradual improvement in incomes and a reduction of key
vulnerabilities (most notably, a lower budget deficit, a reduction in public debt, and a shrinking
external current account deficit). The framework is sensitive to assumptions on growth, however, and
the authorities medium-term outlook (which targets real GDP growth of more than 8 percent)
projects a more rapid improvement in key macroeconomic balances. The mission discussed with the

4
Total NPLs increased by Rs74 billion in 2013, of which Rs 56 billion (76 percent) were linked to gold pawning. For
additional information on gold pawning activity, see EBS/13/140).
5
The CBSL aims to increase loan-to-value ratios to a maximum of 80 percent (from 65 percent) and cap interest rates
at 16 percent per year. This is part of a broader goal to support economic activity in agriculture and small and
medium enterprises (SMEs)the primary sectors that have historically taken advantage of pawning advances.
10
12
14
16
18
20
22
24
2011 2012 2013 2014
Budget Actual
Total Government Expenditures, 2011-2014
(Percent of GDP)
Sources: Ministry of Finance and Planning, staff calculations
4
5
6
7
8
2011 2012 2013 2014
Budget Actual
Government Capital Expenditures, 2011-2014
(Percent of GDP)
Sources: Ministry of Finance and Planning, staff calculations
SRI LANKA
authorities differing views on the medium-term framework, which rest in large part on estimates of
potential output (which in turn rely on key assumptions regarding the economic gain from
reintegration of Northern and Eastern provinces, and the effects of structural transformation and
development). It was agreed that IMF and CBSL staff would collaborate on potential output, with a
view to reconciling estimates.

10. Near-term risks appear moderate given the ongoing recovery of advanced economies
and a relatively benign outlook for international commodity prices. Adverse climatic events
(such as the recent drought) remain a constant source of vulnerability, but the impact of such events
on power generation and the balance of payments may be lessened by the introduction of coal-
based electricity generation. Medium-term risks remain centered on the potential for slower-than-
projected growth in the advanced economies, tighter external liquidity conditions and chronic
turbulence in international capital markets (negatively affecting rollovers and borrowing costs), and
continued weakness in government revenues (which would threaten fiscal and debt consolidation
objectives and potentially undermine confidence).

SRI LANKA

Sri Lanka Risk Assessment Matrix
6

Source of Risk Likelihood Expected Impact on Economy Policy Response
Potential Domestic Shocks
Continued drought

Medium

M-L: Adverse impact on
agriculture output, increased
costs of energy production,
higher oil imports.
Raise electricity tariffs,
increase efficiency and lower
electricity generation costs,
allow exchange rate
flexibility, and ensure open
market for food imports.
Tax revenues fail to
strengthen as planned
High

H: Pressure to cut spending to
reach deficit target, including
capital spending, with possible
adverse impact on growth.
Accelerate reforms on
revenue administration and
broadening tax base, reduce
tax exemptions.
GDP growth
momentum fades
Medium

H: Could induce excessively
stimulative macro policies and risk
higher inflation and external
imbalances.
Avoid loose macro policies;
concentrate on structural
reforms to promote domestic
and foreign investment.
Increased private and
quasi private debt,
without parallel
increase in foreign
exchange earnings.
Medium

M: Increased external indebtness
and vulnerability to external
shocks.
Monitor closely the volume
and terms of external
borrowing by private and
quasi private entities.
Potential External Shocks
Surges in global
financial market
volatility
High

M: Increased borrowing costs and
more difficult rollover of maturing
debt, with adverse impact on
fiscal consolidation and external
position.
Strengthen macro fiscal
fundamentals and allow
exchange rate flexibility.
Protracted period of
slower growth in
advanced and
emerging markets
High

H: Slower-than-projected pickup
in exports to the EU and the
United States, weaker trade
balance and growth.
Limited room for fiscal
stimulus. Diversify exports
markets, support increased
value added production.

6
The Risk Assessment Matrix (RAM) shows events that could materially alter the baseline path (the scenario most
likely to materialize in the view of IMF staff). The relative likelihood of risks listed is the staffs subjective assessment
of the risks surrounding the baseline (low is meant to indicate a probability below 10 percent, medium a
probability between 10 and 30 percent, and high a probability of 30 percent or more). The RAM reflects staff views
on the source of risks and overall level of concern as of the time of discussions with the authorities. Non-mutually
exclusive risks may interact and materialize jointly.
SRI LANKA
11. The authorities recognized potential vulnerabilities as highlighted by staff, but noted
that such risks had been part of the backdrop in planning macroeconomic and structural
reform strategies. On external risks, they highlighted measures (such as the cap on non-resident
holdings of government securities) that had limited foreign exchange inflows during the boom
period in international capital marketslimiting Sri Lankas exposure to market turbulence over the
past year. Slower growth in advanced economies is a chronic risk, but Sri Lanka is seeking to
diversify economic ties (a free trade agreement with China is being examined). With respect to
domestic risks, climatic shocks remain a potential source of vulnerability. However, the impact of
drought on power generation has, in the authorities view, at least been mitigated by new coal-
powered thermal energy stations. Sri Lanka has also agreed on a $110 million development policy
credit with the World Bank to bolster resilience to climatic shocks. The authorities were confident,
that ongoing reforms would bring a recovery in revenues, and that growth momentum would
continue. The authorities also reassured staff that new external borrowings by commercial banks
and other entities will add to Sri Lankas growth capacity, but agreed that such exposure should be
limited.
C. Debt Sustainability
12. Sri Lankas public debt sustainability assessment indicates high risks but a sustainable
debt trajectory (see DSA supplement). The debt burden benchmark of 70 percent of GDP and gross
financing need benchmark of 15 percent of GDP are exceeded in the baseline and in all shock
scenarios. This contrasts with a benign market assessment (bond spreads are within the 200600
point range of lower and upper risk benchmark). Positive market sentiment reflects: (i) sustained
fiscal adjustment and falling debt ratio; (ii) favorable global environment (iii) credible commitment
to further deficit and debt reduction in the
future; (iv) lengthening of average debt
maturity; and (v) limited nonresident holding of
government debt in domestic currency which
contributed to Sri Lankas resilience during
market turbulence. The DSA also illustrates the
critical contribution of growth to recent and
projected declines in the debt ratio. Slower-
than-projected growth (alone or combined with
a higher primary deficit and higher borrowing
costs) could stop or reverse the fall in the public
debt ratio. The high share of foreign currency
denominated debt also creates a vulnerability to currency depreciation.
POLICY DISCUSSIONS
With the above risks in mind, staff discussed with the authorities ways to enhance resilience and
further reduce macroeconomic and financial risks. In this context, the mission discussed with the
authorities ways to put fiscal consolidation on a more stable long-term trend; issues affecting
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Sri Lanka
Emerging Market
Vietnam
LKA/EM Gap (RHS)
EMBI Global Sovereign Spreads
(In basis points)
Source: APDCORE Database.
SRI LANKA

monetary transmission and the implications for monetary policy; developments with respect to
external competitiveness and sustainability; and ongoing consolidation of the financial sector.
A. Fiscal Consolidation: How Fast and How Deep
13. Staff welcomed the commitment to fiscal consolidation and debt reduction evident in
the 2013 fiscal outturn and the 2014 budget. After peaking at close to 10 percent of GDP in 2009,
the fiscal deficit has been reduced to 5.9 percent of GDP in 2013, and the debt-to-GDP ratio fell
from 86 percent to 78.3 percent during the same period. The steady decline in the fiscal deficit and
public debt as a share of GDP is a linchpin of macroeconomic stability and a critical factor in
maintaining credibility and investor confidence.
14. At the same time, the continued decline in the tax revenue-to-GDP ratio remains a
concern. Repeated revenue underperformance places a heavy burden on expenditure compression
to meet budget targets, and limits the governments ability to use counter-cyclical fiscal policy in the
event of shocks. In addition, resorting to repeated cuts in public investment could delay the
development of infrastructure and human capital required to meet ambitious growth targets. In
turn, weaker growth would worsen debt dynamics and make the ambitious debt reduction plans
(essential to reducing vulnerability) more difficult to achieve.

15. Fiscal reforms are generally moving in the right direction, but key steps on tax
exemptions and holidays should be accelerated. The authorities have taken some important
steps to broaden the tax base: in 2013, they extended the VAT to the retail and wholesale level, and
in 2014, they reduced by one half the threshold for imposition of VAT on wholesale and retail
activities, and restricted exemptions applicable to national building tax (NBT). In addition, excise
duties on tobacco, alcohol and motor vehicles were increased. While welcoming these steps, staff
highlighted that numerous tax exemptions and concessions play a key role in undermining potential
revenue gains. In addition to narrowing the tax base, these exemptions complicate tax
administration and weaken tax compliance. The granting of new exemptions also mitigates potential
0
5
10
15
20
25
30
35
1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010
Sri Lanka - Tax Revenue, 1950-2013
(Percent of GDP)
Sources: Central Bank of Sri Lanka, staff calculation
-20
0
20
40
60
80
100
Actual 2014 Budget
Sri Lanka: Tax Revenue, 1950-2014
(Percentage change)
Sources: Ministry of Finance and Planning; staff estimates
SRI LANKA
progress toward broadening the tax base and perpetuates business expectations for special
treatment. In staffs view there is significant scope for further extension of the tax base.
7
The mission
argued that a more systematic effort to broaden the tax base is needed to improve revenue
collection. In this context, the mission suggested IMF technical assistance to quantify the costs of tax
expendituresas an input to the governments own medium-term reform plan.
16. The authorities agreed that the weakening revenue position needs to be addressed.
However, they were more sanguine about the impact of measures already implemented to boost
future revenue collection. In addition to the tax broadening, they observed that a recovery of
imports should result in improved collection of border taxes (which performed particularly poorly in
the recent period). The authorities also noted that a number of tax holidays granted for a fixed
period need to be phased out gradually. Finally, the authorities highlighted tax administration
reforms, including the implementation of the Revenue Administration Management Information
System (RAMIS) at the Inland Revenue Department expected to become operational by September
2015, and the upgrade of the Customs Department to ASYCUDA WORLD system. At the same time,
the authorities noted the tax administration challenges arising due to the shift from an agriculture-
based to a more industry- and service-oriented economy.
17. Staff welcomed the authorities commitment to strengthen public financial
management. With the help of IMF and Asian Development Bank (ADB) technical assistance (TA),
Sri Lanka is moving ahead to strengthen public financial management systems. TA is focused on
improving the oversight of state-owned enterprises (SOEs), strengthening budget preparation and
improving the commitment control system. The authorities expect that these reforms will allow them
to further improve expenditure control and limit the occurrence of payment arrears.
8

18. The authorities are also using the current favorable market environment to improve
the public debt structure. With the yield on government securities falling in response to lower
inflation, a supportive global environment and increased market confidence, the authorities
succeeded in lengthening the average maturity of public debt from 3.2 years in 2012 to 4.8 years in
2013, while at the same time reducing the overall borrowing costs. In 2014, they also successfully
placed two five-year international sovereign bonds in total amount of US$ 1.5 billion at yields of 5-6
percent. A diversified funding base and longer maturities should help reduce fiscal vulnerability and
rollover risk.
19. The governments commitment to medium-term fiscal consolidation is clear, but staff
suggested some modifications. In the 2014 Budget and the revision of the Fiscal Management
Responsibility Act of 2003, the authorities announced plans to reduce the fiscal deficit to 3.8 percent

7
VAT collection is particularly weak: at 2.5 percent of GDP in 2013, the C-efficiency of VAT collection in Sri Lanka is
0.25, about one half of the C-efficiency for lower-middle income countries and Asia/Pacific countries. See M. Keen,
2013, The Anatomy of the VAT. IMF Working Paper 13/111.
8
At the end of 2012, recurrent and capital payment arrears reached about 1 percent of GDP, and were cleared in
2013. Data for end-2013 payment arrears are being collected.
SRI LANKA

of GDP by 2016, while the debt to GDP ratio is expected to fall to below 65 percent. Staff argued
that current targets for debt reduction were ambitious relative to recent revenue performance, and
also highly sensitive to assumptions on economic growth. Drawing on cross-country experience and
empirical work on debt sustainability, staff suggested the option of re-casting fiscal and debt
consolidation objectives in a longer-term contexttargeting a debt ratio of 50 percent (deemed
significant from an vulnerability perspective) over a longer time horizon (see Selected Issues Paper).
The authorities shared staffs view that long-term plans are necessary and did not disagree with the
potential debt target, but did not consider a need to reformulate their current fiscal consolidation
strategy as spelled out in the 2014 budget and the 2013 amendment of the Fiscal Responsibility Act.
20. Tariff adjustments and favorable weather conditions all but eliminated the losses of
the energy and petroleum companies. In 2012, the Ceylon Electricity Board (CEB) and Ceylon
petroleum Company (CPC) incurred total loss of almost 2 percent of GDP. However, large electricity
tariff adjustments for clients using more than 60 units and moderate fuel price adjustment in 2013,
together with ample rains that allowed increased reliance on cheaper hydro power, brought the
combined financial outcome of the two companies to a small surplus. Staff raised concerns about
renewed losses in 2014 as a result of drought during the first quarter. However, the authorities
argued that with new coal power plants now operating, there is less need for more expensive fuel
power plants and that the financial position of CEB and CPC is projected to remain solid.
B. Monetary Policy: Timing Matters
21. Monetary policy has eased but the impact on monetary aggregates has been minimal.
Following a tightening of policies to address overheating and rapid credit growth in 201112, the
CBSL began reducing policy rates in December 2012. Between December 2012 and October 2013,
the CBSL reduced the repurchase and reverse repurchase rates by 125 basis points and reduced
banks reserve requirement by 2 percentage points. In addition, the standing rate corridor was
compressed from 200 basis points down to 150 basis points, resulting in the recent reduction of the
bank interest rate spread, leaving its lower bound (the deposit rate) intact. The policy easing has fed
through to a reduction in lending and deposit rates over time, although the effect has been more
noticeable with respect to short-term rates. Aggregate private sector credit was seemingly
unaffected, with year-on-year private credit growth falling to 7.5 percent in 2013, compared to
17.6 percent in 2012 and 34.5 percent in 2011.
22. The mission discussed with the authorities the dynamics of monetary transmission in
Sri Lanka (Box 1 and Selected Issues Paper). Research by the staff in collaboration with the CBSL
suggests several important findings. First, there is a weak correlation between central bank policy
actions and money market and bank retail rates in Sri Lanka. Second, from a cross-country
perspective, the contemporaneous effects of policy rate changes in Sri Lanka are also very weak.
Short-term impact on money market and bank retail rates is limited compared with ASEAN countries
and Vietnam. Third, the contribution of the bank lending channel to the interest rate channel in
affecting output is operational, but with a significant lagon the order of five quarters. The staff
suggested that some obstacles to a more effective monetary transmission might include a strong
presence of state banks in the financial system, a shift in banks portfolios from lending to
government securities, and less-than-optimal levels of bank competition.
SRI LANKA
Box 1. Dynamics of Monetary Transmission in Sri Lanka
The efficacy of monetary transmission channels has been a key question given a slow pass-
through of policy changes to lending rates and private credit growth. The mission looked in
particular at: (i) how effective are adjustments to monetary policy instruments in effecting changes
to output and prices and (ii) what is the timing and magnitude of the effects of policy changes. A
Vector Autoregressive (VAR) model was used to analyze: (i) interest rate channel; (ii) bank lending
channel; (iii) exchange rate channel; and, (iv) asset price channel. Standard methodology proposed
by Sims (1972) in using Granger causality is followed to describe the relationship between monetary
policy variables and output and prices. The baseline VAR model is estimated using five variables
from 2000q1 and 2013q3: output, prices, money supply, interest rates, and exchange rates. The
results are summarized belowwith vertical lines showing that the channel is inoperative:

Other key findings include: (i) the policy rate has significant predictive value for output and
money supply has weak Granger effects for prices. Output declines by about 0.6 percent in the
second quarter and by about 0.5 percent during the entire period of nearly 3 years after innovations
to the repo rate; (ii) the bank lending channel contributes to policy innovations that affect output
weakly and with a significant lag. Private credit contributes to the interest rate channel by about
0.2 percent starting in quarter two but only in the model with exchange rates. The prime lending
rate has a significant Granger effect on output--reducing it by about 0.1 percent more after 5
quarters; and (iii) exchange rate and asset price channels are not significant in affecting output and
prices.

23. Given continued growth momentum and the long lags in monetary transmission, staff
argued for keeping the current monetary stance unchanged. The slow response of private credit
to successive reductions in policy rates mitigated the risk of upward pressure on prices through
more rapid growth in money supply. However, recent data on GDP growth (first quarter GDP growth
was 7.6 percent year-on-year), and rising private credit growth in areas not linked to gold pawning
Asset price
channel
Exchange rate
channel
Business and households decision
making/Investment/Domestic demand
Net External
demand
Output/inflation
Money market
rates/lending/deposit
rates/ quantity of
loans/Domestic
demand
Interest rate
channel (money
view)
Bank lending
channel
Tobins q effect /Domestic demand
Change in the
money
supply/policy
rate
SRI LANKA

suggest some risk of demand side pressures emerging later in the year. In this context, staff noted
the risk of monetary policy becoming pro-cyclical if further cuts were made and suggested that rates
remain unchanged for now.
24. On monetary policy, the authorities highlighted several structural innovations. They
noted that five years of single digit and declining inflation have altered inflation expectations
affording an opportunity to lower policy rates. For the time being, they did not envisage any further
easing, but would be ready to reduce rates further if growth falters or inflation remains low.
However, they also noted a constraint with respect to how low deposit rates could fall given the lack
of social safety nets for a significant part of the retired population, and a reliance on high rates of
return on deposits for income support (an issue they are seeking to rectify through the banking
system via introduction of annuities and longer-term instruments).
25. The authorities agreed that monetary transmission was not working as effectively as it
might. However, in reviewing the missions findings, they suggested that (i) there is sufficient
competition among banks; (ii) the shift in bank assets from lending to government securities was
partly a result of a lack of credit demand, reflecting greater use of corporate debentures; and (iii) low
credit growth is partly a supply side issue (banks reluctance to lend given the rise in non-
performing assets a result of gold pawning) which would eventually be resolved, sharpening the
transmission response from policy rates to bank lending.
C. Competitiveness and External Sustainability
26. Previous staff reports have highlighted
concerns about Sri Lankas medium-term
external sustainability. Recent improvement in
the external current account is encouraging, but
may be short-lived given the heavy role played by
import compression. Longer-term trends
signaling potential vulnerabilities include (i) a
chronic current account deficit and relatively low
reserve adequacy metrics; (ii) a gradual but steady
decline in goods exports as a share of GDP; (iii) a
similar decline in Sri Lankas share of world
exports; (iv) an already high external debt burden
and a rising cost for external financing as Sri
Lanka shifts to middle-income status and bilateral concessional debt is replaced with borrowing on
commercial terms; and (v) modest increases in foreign direct investment, which would otherwise
alleviate the need for debt financing.

27. While the current account deficit has decreased in recent years, it remains financed
largely by debt-creating inflows and central bank foreign exchange reserves are at the lower
end of what is considered adequate by standard metrics. The predominance of debt-creating
inflows is reflected in a high debt component in gross reserveswhich is slowly improving along
0.00
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Goods (% of GDP)
Goods and Services (% of GDP)
Goods (% of World Exports) (RHS)
Goods and Services (% of World Exports) (RHS)
Share of Exports of Goods and Services
SRI LANKA
with the gradual decline in external debt. While gross reserves are now within the adequate band
of the composite metric, they are still on the low side relative to short-term debt and upcoming
amortizations. To raise the reserve cushion, the authorities have absorbed foreign exchange inflows.
While generally supporting the accumulation of additional reserves, the staff emphasized the need
to maintain a flexible exchange rate regime, as the CBSLs interventions had effectively stabilized the
exchange rate.
9

28. Exchange rate analysis does not signal an obvious problem of competitiveness, and
the exchange rate appears broadly in line with fundamentals. The External Balance Assessment
(the current account approach) points to a slight overvaluation of the rupee. By contrast, analysis
based on the CGER indicate that the underlying current account deficit is slightly smaller than the
level predicted by panel regressions on advanced and emerging markets, suggesting a slight
undervaluation while staying in line with the estimated current account norm. According to the
external sustainability approach, only a smaller adjustment would be compatible with a stabilization
of the external debt/GDP position. Overall, however, the relatively small degree of estimated
misalignment in either direction suggests that the exchange rate is broadly in line with
fundamentals.

29. Sri Lanka fares relatively well with respect to qualitative indicators of competitiveness,
although there remains room for improvement. Sri Lanka ranks well in the World Economic
Forum Competiveness Index as well as the overall World Bank Doing Business Index (ranking 85 out
of 189 countries and well ahead of the rest of South Asia, although areas for improvement include
tax rates and administration, enforcing contracts, and registering property). Several sectors also
report problems hiring and retaining labor at different skill levels. The garment industry (40 percent
of exports) has also shown considerable flexibility to shockssuch as the end of the Multifibre
Agreement in 2005 and discontinuation of preferential access under the EUs Generalized System of
Preferences (GSP+) in 2010by moving up the value chain (Box 2).

9
The rupee has been virtually stable vis--vis the U.S. dollar since the beginning of October 2013. As a result, the IMF
classification of Sri Lankas de facto exchange rate has been changed from managed float to stabilized
(Informational Annex).
Underlying Current Account Balance -4.0 -4.0 -2.5
Current Account Norm -4.5 -4.3 -1.3
Required Improvement in the Current Account -0.5 -0.3 1.1
Implied over (+) / under (-) valuation -3.5 -2.3 8.0
Sri Lanka - External Balance Assessment
Approach:
Macrobalance
(CGER)
External
Sustainability
Current Account
(Current Account)
SRI LANKA

Box 2. Sri Lankas Garment Industry

After trade liberalization in the late 1970s and with the support of the Multi-Fibre Agreement (MFA),
the garment industry emerged as Sri Lankas key export engine and source of employment. After
peaking at 55 percent in 2000 garments still account for over 40 percent of total exports. The sector
employs around 280,000 peoplewith significantly more indirectly dependent on the industry. FDI
and joint ventures were initial catalysts, but the industry is today dominated by local firms.

The Sri Lankan garment industry has gone through rapid structural change in the past 15 years in
response to a shifting competitive landscapenotably the phasing out of the MFA in 2005 and of
China safeguard in 2008, followed by discontinuation of the EU Generalized System of Preferences
(GSP+) in 2010. The industry responded by moving up the quality ladder, with leading companies
progressing towards becoming total service providers by designing and developing products. The
structural changes implied a decline in the number of firms, and a drop in employment from at most
340,000 in 2003. The decline in employment also reflects difficulties hiring due to perceived low
wages, as well as being a side effect of a comparatively better educated labor force (labor costs are
also higher than in most other Asian garment producing countries).

The garment sectors strategy to move even higher up the quality ladder is well placed and its track
record indicates that the sector will remain an important source of exports for Sri Lanka. However,
critical to future garment export earnings will be how volumes develop in a higher price segment. In
this respect, further diversification to markets beyond the E.U. and U.S. will be important. Given
limited backward linkages and largely imported input material, the contribution to the trade balance
will also depend on how firms decide to set up their future production chains and to what extent
they will keep lower value production segments in Sri Lanka.

Importantly, even if garment exports growth
continues to average 6 percent as during the past
decade, this will not be enough to alone reverse
the negative long-term trend in Sri Lankas overall
goods exports. Diversification to other export
sectors will be necessary and there is significant
room for existing non-garment exports to move
up the quality ladder.

Source: Diversification Toolkit; IMF Policy Paper, March 2014

30. Structural transformation may ameliorate some medium-term pressures on the
external accounts. While goods exports have decreased as a share of GDP, services receipts have
increased and now rival the garment industry as a source of foreign exchange earnings. The most
visible aspect of this is growth in tourismwhich more than doubled in dollar terms between 2011
and 2013in tandem with transportation services, supported by significant investment in port
0.77
0.78
0.79
0.8
0.81
0.82
0.83
0.84
0.85
0.86
0.87
0.88
Garments Other Manufacturing Goods
LKA, Quality Index, 2010
SRI LANKA
facilities. Rapid growth (albeit from a small base) is also visible in information technology and
accounting services. Inward remittances have also risen as a comparatively well educated Sri Lankan
work force increases its overseas presence. Net remittances as a share of GDP have increased to
about 8.4 percent of GDP in 2013, compared with 6.4 percent a decade earlierequivalent to a rise
from about one-quarter the value of total goods exports in 2003 to nearly two-thirds by 2013.

31. The mission highlighted that sustained improvement in the current account would
likely require further diversification of exports, and that cross-country experience
demonstrated greater gains from equity and direct investment relative to debt flows. The
mission noted that there appears room for further growth in the garment industry and higher value
added, but that rising competition and labor scarcity might also give rise to shifting some
operations to lower-cost locations. Further diversification of goods and services exports would rest
on continued macroeconomic stability, improvements to the investment environment (including the
tax structure, enforcement of contracts and property rights) and a predictable policy environment. In
this context, staff noted that FDI flows might also gain from such structural improvements, and that
available evidence suggest greater gains to productivity and growth from equity and FDI flows than
from debt financed investment.
10

32. The authorities had confidence that the external accounts would continue to improve,
and that the current development strategy (the Five Hubs) would facilitate diversification.
They highlighted the competitiveness of the garment industry as an example of innovation and
productivity gain despite a highly competitive environment and loss of preferential trading
arrangements. They also noted the rise in services, and that in addition to tourism and emerging
sectors such as IT, transport and logistics services were expected to increase as a result of continued
investment in port facilities. With respect to financing, they highlighted the focus on attracting FDI
and creating an enabling investment environment, but noted that a small domestic market would
likely constrain the amount of foreign investment compared to other emerging markets.
D. Financial Sector Consolidation
33. The mission discussed ongoing consolidation of the financial sector (Box 3)
highlighting potential gains and pitfalls. On the positive side, the mission noted that
consolidation could potentially increase resilience and contribute to more effective oversight. The
strong focus on consolidating nonbank financial institutions (NBFIs) sector seems warranted given
expected gains from economies of scale and enhanced efficiency of operations. While not large, the
NBFI sector has been more prone to weakness. Consolidating NBFIs with a view to building a
stronger capital base may add some resilience to shocks, potentially generate cost efficiencies, and
should also allow for closer oversight. With respect to the banking sector, consolidation could
provide sufficient scale to invest in technology and management systems to enhance efficiency and
profitability. Over the longer term, sufficient scale could also facilitate introduction of new products
and services. A larger capital base would also increase resilience to shocks.

10
Kose, et al (2006 and 2008); Bosworth and Collins (1999); and Borensztein et al (1998).
SRI LANKA

Box 3. Sri Lankas Master Plan for Financial Sector Consolidation
There are 24 commercial banks in Sri Lanka and nine specialized banks. In the NBFI sector, there are 58 firms47
finance companies and 11 specialized leasing companies. Together banks and NBFIs control 64 percent of total
financial system assets (banks control 57 percent). The financial sector is dominated by the state. The top three
banks (the Bank of Ceylon, Peoples Bank, and the National Savings Bank) are state-owned and together account
for about half of total assets of the 33 commercial and specialized banks. Twelve foreign banks account for 10
percent of market share.
Sri Lankas financial sector consolidation master plan seeks to reduce the number of NBFIs, create a set of larger
banks able to compete regionally, and to bolster the strength and resilience of the financial system.
Comprehensive plans for all mergers were required at end-May 2014, with a view to completing most mergers (or
consolidations) by end-year. Key pillars of the strategy include:
Creating a stronger banking sector comprising 5 strategically important banks with assets in excess of LKR 1
trillion; merging two development banks (DFCC and NDBnow operating as commercial banks) to a single
large development/universal banking entity; and consolidating (or absorbing) smaller state banks into larger
state banking units.
Consolidating the NBFI sectorreducing the number of institutions from the current 58 firms down to 20,
with three specialized in microfinance. CBSL will make available funds through its deposit insurance window
for any merger that may need capital infusion. If there remain any of the weakest NBFIs by March 2015, the
CBSL can direct a consolidation.
Higher minimum capital thresholds starting in 2016. Minimum capital requirements for commercial banks will
be raised to LKR 10 billion, and LKR 5 billion for specialized banks. For NBFIs minimum core capital
requirement will be raised to LKR 1bn by 1 January 2016, then LKR 1.5 billion by 1 January 2018 (compared to
LKR 200-300 million now for finance and leasing companies respectively).
Consolidations cannot result in any forced redundancies of staff, or in reduced salaries of staff.

The plan shares some common elements with consolidation efforts in other EMs, but also some differences. First,
for most EMs, cross-border mergers and acquisitions have typically accounted for a large share of consolidation
activitythis is unlikely for Sri Lanka. Second, consolidations in EM markets have often been a way of resolving
financial crises, whereas in Sri Lanka the effort is more pre-emptive. Third, market forces have played a dominant
role in mature markets, whereas in EMs (and Sri Lanka), country authorities typically had a more major role. Finally,
ownership structures and concern over job losses have been key issues in EMs, and appear to be in Sri Lanka as
well.
58
22
12
3
NBFI
Commercial Banks
Foreign banks
Large banks
Sri Lanka: Financial System: Pre-consolidation, 2013
20
15
12
5
NBFI incl. 3 microfinance inst.
Commercial Banks
Foreign banks
Large banks
Sri Lanka: Financial System: Post-consolidation
SRI LANKA
34. The mission highlighted some aspects that might limit potential gains from
consolidation. Since the plan restricts merged financial institutions from restructuring employment
or reducing salaries, gains from economies of scale may be limited. Further, as small NBFIs as a
group represent less than two percent of the financial system and are not systemically important,
the requirement to consolidate small NBFIs could provide at best marginal improvements in
financial system stability. Consolidation can also bring new risks. For example, larger financial
institutions can pose greater systemic risks. In this context, the CBSLs intention to implement
regulatory reforms in line with Basel is move in the right direction, but additional buffer
requirements for systemically important banks/NBFIs might also be considered. A post-
consolidation push to improve profitability can also trigger aggressive credit expansion and higher
risk-taking. Increased concentration can also, in some cases, hinder competition.
35. The authorities noted staffs concerns, but also highlighted that consolidation will be
an evolving process. In their view, it was important for stability to signal that no mandatory
restructuring of employment would be required, but rather, that the process could be voluntary and
done over time as institutions merged and operations were adjusted organically. They also argued
that systemic risks would be limited, as the currently largest banks in the banking system are very
close in terms of the levels of required post-consolidation capital and asset bases. Having said this,
the authorities agreed that risks exist regarding the ultimate capital structure of consolidated
companies, limited options for self-organizing staff related retentions, potential IT problems and
lags in installing effective management systems and corporate governance.
POST PROGRAM MONITORING
36. Sri Lankas capacity to repay the IMF remains broadly adequate and slightly improved
since the first post-program monitoring discussion in September 2013. Exposure to the IMF
currently stands at SDR 1.16 billion (about US$1.8 billion2.4 percent of projected 2014 GDP and
20.5 percent of current gross central bank foreign exchange reserves). Repayments to the IMF
stretch into mid-2017, although Sri Lanka is expected to fall below 200 percent of quota (the
threshold for post-program monitoring) in early 2015. External debt remains broadly sustainable,
but as highlighted by the debt sustainability analysis, significant vulnerabilities remain with respect
to exchange rate risk and baseline assumptions on growth and the course of fiscal consolidation.
The cost of external debt has also risen sharply in recent years as Sri Lanka continues to shift from
concessional, bilateral debt into new external loans on commercial terms. External borrowing by
commercial banks also remains a concern, but has been relatively limited thus far.
SRI LANKA


STAFF APPRAISAL
37. Outlook and risks. Sri Lankas recent economic performance has been better than
expectedparticularly given some headwinds from chronic market turbulence and climatic shocks.
While there remain weak spots in economic activity (such as agriculture, which has been negatively
affected by recent drought), strong activity in traditional sectors such as garment manufacture, and
new sectors such as tourism and services bode well for the near and medium-term outlook. This is
complemented by a sustained reduction in headline and core inflationbringing a new and
welcome level of stability which has hopefully fed into a new set of public expectations regarding
inflation.

38. Fiscal policy. The government has remained solidly committed to fiscal consolidation and
reduction of public debt as a mainstay of macroeconomic stability. In this context, and given rising
economic growth, the mission saw the fiscal stance for 2014 as appropriate, but raised concern
about the composition of further consolidation. Capacity in expenditure and commitment control
has increased, enhancing the governments ability to curtail spending to meet fiscal objectives.
However, given sizeable investment needs, the staff was of the view that spending cuts may have
reached their effective limit, and that the burden of adjustment needed to fall more squarely on
increasing revenue. Particularly if Sri Lanka is to maintain current growth momentum and foster
economic development and diversification, high and sustained levels of public spending on
infrastructure and human capital will be essential. Tackling the issue of tax expenditures and
broadening the tax base will be essential. The mission appreciated the steps taken thus far, but was
of the view that the pace of reform in this area could reasonably be accelerated. There is also room,
in the missions view, to take another look at the medium- and long-term strategy for debt
reduction, and consider a more ambitious debt target (more strongly associated with reduced
vulnerability) over a longer time horizon.

39. Monetary policy. The current, supportive stance of monetary policy is appropriate given
the decline in inflation and weak private credit growth. However, the overall picture is complex and
requires close monitoring. On the one hand, with economic activity apparently on the rise and
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Evolution of Gross Reserves
(In billions of U.S. dollars)
Treasuries
Eurobonds
Liabilities to IMF
Non-borrowed reserves
Gross reserves (excl. domestic assets)
Source: IMF staff estimates.
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75
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To short-term debt & amortization
"Adequate" Reserves
Sri Lanka: Reserve Metrics Dynamics
(In percent)
SRI LANKA
private credit (outside of pawning activity) beginning to show signs of recovery, the authorities
should be ready to adjust rates as needed to ensure price stabilityparticularly given the long lags
involved in monetary transmission. On the other hand, the current low inflation environment and the
apparent change in inflation expectations offers an opportunity for a downward shift in the interest
rate structure that might benefit the investment environment (and borrowing costs) over the
medium term. Given the mix of signals, a cautious approach is warranted and the staff believes
policy rates should remain on hold for the near term.
40. Exchange rate. Exchange rate policy remains broadly appropriate, but should be monitored
in light of developments in the balance of payments and inflation, and the commitment to flexibility
maintained. Staffs analysis indicates that the exchange rate is broadly in line with fundamentals, and
staff saw merit in central banks purchases to build its reserves, which remain on the lower end of
most reserve adequacy metrics. However, staff also cautioned that the persistent stability of the
rupee (vis--vis the US dollar) that has arisen as a side effect of foreign exchange absorption by the
central bank since the fourth quarter of 2013 carries risks. First, it may create the perception that the
rupee is implicitly fixeda point supported by the shift in exchange rate classification from
managed float to stabilized under the IMFs Annual Report on Exchange Rate Arrangements. This
perception could lead market participants and firms to hold un-hedged foreign exchange risk on
their balance sheets. Second, should external balance continue to improve and inflation stay low, it
could gradually lead to increasing currency misalignment. The central bank should thus be prepared
to allow sufficient exchange rate flexibility to adjust to fundamental pressures, while limiting
intervention to accumulation of reserves and smoothing short-term volatility.
41. External sustainability. Recent improvements in the trade and current account balances
notwithstanding, Sri Lanka remains vulnerable to external shocks. Medium-term sustainability will
depend on maintaining an outward orientation, diversification of the export structure, and a
judicious use of foreign borrowingparticularly given the rapid increase in debt servicing costs that
have accompanied the shift from bilateral concessional debt to new loans on commercial terms. The
Market Access Debt Sustainability Analysis (MAC-DSA) highlights the sensitivity of Sri Lankas debt
sustainability to growth and foreign exchange shocks. The staff urges caution with respect to
external borrowing through the banking system.

42. Financial sector reform. Financial sector consolidation has potential benefits in the form of
economies of scale, new products and services, and a greater resilience (via a stronger capital base)
to shocks. The benefits of consolidation would likely be more rapid if fewer restrictions were placed
on restructuring operations. Continued progress on corporate governance is also key. Close
supervision during and after the consolidation process could also help avoid some of the pitfalls
encountered by other countries in episodes of financial sector restructuring, such as excessive credit
growth. Consolidation may also result in increased concentration and hinder effective competition if
larger and state-owned banks continue to grow and dominate the banking sector.

43. It is recommended that the next Article IV consultation take place on the standard 12-
month cycle.
SRI LANKA

Figure 1. Sri Lanka: Macroeconomic Developments
GDP growth has picked up in recent quarters.

Headline and core inflation have declined.

Imports fell, exports have picked up and trade
balance has improved ...

... as did the current account balance, supported by
stronger export of services.

Tax revenues rose moderately in 2013 but 2014
budget targets strong growth

Fiscal deficit has been falling, contributing to a gradual
decline in the debt to GDP ratio

Sources: Central Bank of Sri Lanka; CEIC; Bloomberg LP; and IMF staff estimates.
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S
e
p
-
1
3
M
a
r
-
1
4
Real GDP growth
Industrial production 1/
Economic Activity
(y/y percent change)
1/Industrial productionas of Sep 2013: latest number.
0
5
10
15
J
a
n
-
1
1
M
a
y
-
1
1
S
e
p
-
1
1
J
a
n
-
1
2
M
a
y
-
1
2
S
e
p
-
1
2
J
a
n
-
1
3
M
a
y
-
1
3
S
e
p
-
1
3
J
a
n
-
1
4
M
a
y
-
1
4
Headline
Core
Consumer Price Index
(y/y percent change)
-80
-60
-40
-20
0
20
40
60
80
-3.0
-2.0
-1.0
0.0
1.0
2.0
3.0
M
a
r
-
0
9
J
u
n
-
0
9
S
e
p
-
0
9
D
e
c
-
0
9
M
a
r
-
1
0
J
u
n
-
1
0
S
e
p
-
1
0
D
e
c
-
1
0
M
a
r
-
1
1
J
u
n
-
1
1
S
e
p
-
1
1
D
e
c
-
1
1
M
a
r
-
1
2
J
u
n
-
1
2
S
e
p
-
1
2
D
e
c
-
1
2
M
a
r
-
1
3
J
u
n
-
1
3
S
e
p
-
1
3
D
e
c
-
1
3
M
a
r
-
1
4
Trade deficit (LHS)
Export growth, % y/y 3mma, (RHS)
Import growth, % y/y 3mma, (RHS)
Trade Deficit
(In billions of U.S. dollars, per quarter)
-50
-40
-30
-20
-10
0
10
20
30
40
50
2007 2008 2009 2010 2011 2012 2013
Exports of Services Exports of Goods
Imports of Services Imports of Goods
Currecnt Account
Current Account Balance and Imports, Exports
(In percent of GDP)
0.0
6.0
12.0
18.0
24.0
30.0
2
0
0
9
2
0
1
0
2
0
1
1
2
0
1
2
2
0
1
3
2
0
1
4

B
u
d
g
e
t
Tax Revenue Expenditure
Annual Growth in Expenditure and Tax Revenue
(In percent)
-12.0
-10.0
-8.0
-6.0
-4.0
-2.0
0.0
0.0
20.0
40.0
60.0
80.0
100.0
2008 2009 2010 2011 2012 2013
Foreign Debt Domestic Debt
Fiscal Balance (RHS)
Fiscal Balance and Public Debt
(In percent of GDP)
SRI LANKA
Figure 2. Sri Lanka: Monetary and Exchange Rate Developments
Monetary policy has been eased... ... Growth of credit to private sector has slowed sharply...

... and credit as percent of GDP has declined. Spot exchange rate has been recently stable.

Central bank reserves have been increasing partly
as a result of new borrowing ...

... and partly due to CBSL absorption of forex from the
market.

Sources: Central Bank of Sri Lanka; CEIC Data Company Ltd.; Bloomberg LP; and IMF staff estimates.
1/ The horizontal line shows a 3 percent "warning threshold" (September 2011 GFSR)
5
6
7
8
9
10
11
12
13
14
D
e
c
-
1
1
M
a
r
-
1
2
J
u
n
-
1
2
S
e
p
-
1
2
D
e
c
-
1
2
M
a
r
-
1
3
J
u
n
-
1
3
S
e
p
-
1
3
D
e
c
-
1
3
M
a
r
-
1
4
J
u
n
-
1
4
Repo
Reverse Repo
Call martket, net tax
Weekly prime lending rate
Repo and Interbank Rates
(In percent per annum)
0
5
10
15
20
25
30
35
40
Credit Growth
M2 Growth
Credit and M2 Growth
(In percent, yoy, adjusted for depreciation)
-6
-4
-2
0
2
4
6
2
0
0
4
Q
1
2
0
0
4
Q
4
2
0
0
5
Q
3
2
0
0
6
Q
2
2
0
0
7
Q
1
2
0
0
7
Q
4
2
0
0
8
Q
3
2
0
0
9
Q
2
2
0
1
0
Q
1
2
0
1
0
Q
4
2
0
1
1
Q
3
2
0
1
2
Q
2
2
0
1
3
Q
1
2
0
1
3
Q
4
Change in credit to GDP (yoy)
Change in Credit to GDP Ratio 1/
(In percentage points, yoy change)
110
115
120
125
130
135
140
80
85
90
95
100
105
110
F
e
b
-
1
2
A
p
r
-
1
2
J
u
n
-
1
2
A
u
g
-
1
2
O
c
t
-
1
2
D
e
c
-
1
2
F
e
b
-
1
3
A
p
r
-
1
3
J
u
n
-
1
3
A
u
g
-
1
3
O
c
t
-
1
3
D
e
c
-
1
3
F
e
b
-
1
4
A
p
r
-
1
4
REER
NEER
Spot (RHS)
Exchange Rate
(Index, June 2009=100; Rupee/US$)
3
4
5
6
7
8
9
F
e
b
-
1
2
A
p
r
-
1
2
J
u
n
-
1
2
A
u
g
-
1
2
O
c
t
-
1
2
D
e
c
-
1
2
F
e
b
-
1
3
A
p
r
-
1
3
J
u
n
-
1
3
A
u
g
-
1
3
O
c
t
-
1
3
D
e
c
-
1
3
F
e
b
-
1
4
A
p
r
-
1
4
J
u
n
-
1
4
Gross Net
International Reserves
(In billions of US$)
Sovereign,
1,000 mln
USD
Sovereign,
1,000 mln
USD
Sovereign,
500 mln
USD
Private,
500 mln
USD
Private,
750 mln
USD
Note: the vertical lines markthe dates and amount of which
sovereign or private debt were issued
Private,
500 mln
USD
-600
-400
-200
0
200
400
600
M
a
y
-
1
2
A
u
g
-
1
2
N
o
v
-
1
2
F
e
b
-
1
3
M
a
y
-
1
3
A
u
g
-
1
3
N
o
v
-
1
3
F
e
b
-
1
4
M
a
y
-
1
4
Monthly 3M average
CBSL Foreign Exchange Net Absorption
(In millions of US$)
SRI LANKA

Table 1. Sri Lanka: Selected Economic Indicators, 201119

2011 2012 2013 2014 2015 2016 2017 2018 2019
Prel.
GDP and inflation (in percent)
Real GDP growth 8.2 6.3 7.3 7.0 6.5 6.5 6.5 6.5 6.5
Inflation (average) 6.7 7.5 6.9 3.8 5.4 5.5 5.5 5.5 5.5
Inflation (end-of-period) 4.9 9.2 4.7 5.2 5.5 5.5 5.5 5.5 5.5
Core inflation (end-of-period) 4.7 7.5 2.1 4.3 4.6 4.6 4.6 4.6 4.6
Savings and investment (in percent of GDP)
National savings 22.2 23.9 27.7 28.6 28.8 29.4 29.7 30.0 30.1
Government -0.9 -1.2 -0.8 0.4 0.9 1.6 1.8 1.9 2.5
Private 23.0 25.1 28.6 28.2 27.8 27.8 27.9 28.1 27.6
National Investment 30.0 30.6 31.6 32.0 32.2 32.6 32.6 32.7 32.8
Government 6.3 2.3 2.9 3.1 3.0 3.1 3.2 3.2 3.4
Private 23.6 28.4 28.8 29.0 29.2 29.5 29.5 29.5 29.5
Savings-Investment balance -7.8 -6.7 -3.9 -3.5 -3.4 -3.2 -3.0 -2.7 -2.7
Government -7.3 -3.6 -3.9 -3.0 -2.1 -1.6 -1.4 -1.4 -0.9
Private -0.4 -3.0 0.0 -0.4 -1.2 -1.6 -1.5 -1.3 -1.8
Public finances (in percent of GDP) 1/
Revenue 14.3 13.0 12.2 13.1 13.7 13.9 14.1 14.3 14.5
Grants 0.2 0.2 0.2 0.3 0.1 0.1 0.1 0.1 0.1
Expenditure 21.4 19.7 18.3 18.7 18.3 18.1 18.2 18.5 18.3
Central government balance -6.9 -6.5 -5.9 -5.2 -4.5 -4.2 -4.0 -4.1 -3.7
Central government domestic financing 3.5 2.7 4.6 1.8 2.7 3.0 2.9 2.4 3.1
Government debt (domestic and external) 78.5 79.2 78.3 76.8 74.2 71.4 68.8 66.3 63.6
Money and credit (percent change, end of period)
Reserve money 21.9 10.2 0.9 15.0 14.3 14.9 14.4 14.7 13.3
Broad money 19.1 17.6 16.7 15.1 14.1 14.7 14.3 14.8 13.3
Domestic credit 34.3 21.7 13.9 11.9 12.3 12.7 12.4 11.3 11.9
Credit to private corporations 34.5 17.6 7.5 14.9 14.9 15.2 14.5 14.0 13.7
Credit to government 33.7 29.6 24.6 8.0 8.2 8.4 8.5 6.0 8.0
Balance of payments (in millions of U.S. dollars)
Exports 10,559 9,773 10,394 11,822 12,774 13,845 15,006 16,509 17,822
Imports -20,269 -19,190 -18,003 -21,399 -23,322 -25,240 -27,217 -29,422 -31,696
Current account balance -4,615 -3,983 -2,606 -2,491 -2,663 -2,748 -2,759 -2,771 -2,996
Current account balance (in percent of GDP) -7.8 -6.7 -3.9 -3.5 -3.4 -3.2 -3.0 -2.7 -2.7
Export value growth (percent) 22.4 -7.4 6.4 13.7 8.1 8.4 8.4 10.0 7.9
Import value growth (percent) 50.7 -5.3 -6.2 18.9 9.0 8.2 7.8 8.1 7.7
Gross official reserves (end of period) 2/
In millions of U.S. dollars 6,749 7,106 7,495 8,380 9,096 9,345 10,044 11,826 12,815
In months of imports 3.2 4.0 3.5 3.6 3.6 3.4 3.3 3.6 3.6
External debt (public and private)
In billions of U.S. dollars 32.7 37.1 39.7 42.4 45.5 47.7 50.3 53.9 58.2
As a percent of GDP 55.4 62.5 59.6 59.2 58.3 55.9 54.0 53.0 52.4
Memorandum items:
Nominal GDP (in billions of U.S. dollars) 59.2 59.4 66.7 71.6 78.2 85.3 93.1 101.7 111.0
Sources: Data provided by the Sri Lankan authorities; and IMF staff estimates.
2/ Including central bank Asian Clearing Union (ACU) balances.
Proj.
1/ Revenue and expenditure from 2011 to 2013 may be different from numbers published by Sri Lankan authorities due to different accounting
methodology.
SRI LANKA
Table 2. Sri Lanka: Summary of Government Operations, 201119

2011 2012 2013 2014 2015 2016 2017 2018 2019
Prel.
Total revenue (including grants) 1/ 14.5 13.2 12.4 13.5 13.8 14.0 14.2 14.4 14.6
Total revenue 14.3 13.0 12.2 13.1 13.7 13.9 14.1 14.3 14.5
Tax revenue 12.4 11.2 10.6 11.5 12.0 12.2 12.4 12.7 12.8
Income taxes 2.4 2.3 2.4 2.5 2.6 2.6 2.8 2.9 2.9
VAT 3.3 2.7 2.5 2.8 3.1 3.2 3.3 3.4 3.5
Excise taxes 2.8 2.5 2.4 2.5 2.5 2.5 2.5 2.6 2.6
Other trade taxes 1.4 1.4 1.4 1.5 1.6 1.6 1.6 1.6 1.6
Other 2.5 2.2 1.9 2.1 2.2 2.3 2.3 2.3 2.2
Nontax revenue 1.9 1.9 1.5 1.7 1.7 1.7 1.7 1.7 1.7
Grants 0.2 0.2 0.2 0.3 0.1 0.1 0.1 0.1 0.1
Total expenditure and net lending 1/ 21.4 19.7 18.3 18.7 18.3 18.1 18.2 18.5 18.3
Current expenditure 15.4 14.4 13.2 13.1 12.9 12.4 12.4 12.5 12.0
Civil service wages and salaries 2.7 2.4 2.2 2.3 2.4 2.4 2.4 2.4 2.4
Other civilian goods and services 0.9 0.8 0.7 0.7 0.7 0.7 0.8 0.8 0.8
Security expenditure (including contingency) 3.1 2.7 2.4 2.5 2.4 2.4 2.3 2.3 2.2
Subsidies and transfers 3.3 3.1 2.8 2.9 2.9 2.8 2.8 2.8 2.8
Interest payments 5.5 5.4 5.1 4.8 4.5 4.2 4.1 4.3 3.8
Capital expenditure and net lending 6.0 5.3 5.0 5.6 5.5 5.7 5.8 6.0 6.3
Overall balance of the central government -6.9 -6.5 -5.9 -5.2 -4.5 -4.2 -4.0 -4.1 -3.7
Financing 6.9 6.5 5.9 5.2 4.5 4.2 4.0 4.1 3.7
Net external financing 3.4 3.8 1.2 3.3 1.9 1.2 1.2 1.6 0.7
Net domestic financing 3.5 2.7 4.6 1.9 2.7 3.0 2.9 2.4 3.1
Memorandum items:
Primary balance (excluding grants) -1.66 -1.27 -0.97 -0.8 -0.2 -0.1 0.0 0.1 0.0
Total public debt 78.5 79.2 78.3 76.8 74.2 71.4 68.8 66.3 63.6
Domestic currency 42.9 42.7 44.2 42.0 38.7 37.2 36.5 35.8 36.4
Foreign currency 35.6 36.5 34.1 34.7 35.5 34.2 32.3 30.5 27.2
Nominal GDP (in billion of rupees) 6,543 7,579 8,674 9,638 10,819 12,154 13,654 15,338 17,231
Proj.
(In percent of GDP)
1/ Revenue and expenditure from 2011 to 2013 may be different from numbers published by Sri Lankan authorities since it excludes the tax exemptions
granted for specific projects and the amounts of tax concessions granted on importatiton of motor vehicles by public servants from revenue and
corresponding expenditures
SRI LANKA

Table 3. Sri Lanka: Monetary Accounts, 201114

2011 2012 2014
Mar. Jun. Sept. Dec.
Central Bank of Sri Lanka
Net foreign assets 340 396 394 366 479 529 551
Net domestic assets 99 88 118 134 -14 -41 11
Net claims on central government 263 279 265 233 134 114 49
Other items, net -165 -192 -151 -94 -143 -170 -53
Reserve Money 440 484 512 500 466 489 562
Monetary survey
Net foreign assets 98 -26 -106 -169 -88 -76 -133
Monetary authorities 340 396 394 366 479 529 551
Deposit money banks -242 -422 -499 -535 -567 -605 -684
Net domestic assets 2,394 2,955 3,195 3,339 3,377 3,494 4,067
Net claims on central government 834 1,045 1,180 1,264 1,292 1,301 1,356
Credit to corporations 2,204 2,651 2,731 2,767 2,809 2,899 3,356
Public corporations 198 292 336 334 339 365 444
Private corporations 2,006 2,358 2,396 2,433 2,470 2,534 2,912
Other items (net) -644 -742 -716 -692 -724 -707 -645
Broad money 2,492 2,929 3,090 3,170 3,289 3,418 3,934
Memorandum Items
Gross international reserves (US $millions) 5,758 6,878 6,806 6,541 7,071 7,495 8,091
Net international reserves (US $millions) 4,011 4,162 4,317 3,994 4,748 5,149 6,640
Money multiplier 5.7 6.0 6.0 6.3 7.1 7.0 7.0
Broad money velocity 1/ 2.6 2.6 2.8 2.7 2.6 2.5 2.5
Broad money 19.1 17.6 15.6 15.8 16.3 16.7 15.1
Reserve money 21.9 10.2 8.8 9.3 -1.6 0.9 15.0
Credit to corporations 47.8 20.3 13.4 10.2 9.4 9.4 15.7
Credit to private corporations 34.5 17.6 10.9 8.9 7.6 7.5 14.9
Sources: Central Bank of Sri Lanka; and IMF staff projections.
2013
(in millions of rupee, unless otherwise indicated, end of period)
1/ Calculated using end-period quarterly GDP, annualized.
(Stocks, in billions of Sri Lankan rupees)
(Annual percentage change)
SRI LANKA
Table 4. Sri Lanka: Balance of Payments, 201219, BPM6

2012 2013 2014 2015 2016 2017 2018 2019
Prel.
Current account -3,983 -2,606 -2,491 -2,663 -2,748 -2,759 -2,771 -2,996
Balance on goods -9,417 -7,608 -9,577 -10,547 -11,395 -12,211 -12,913 -13,875
Goods credit (exports) 9,773 10,394 11,822 12,774 13,845 15,006 16,509 17,822
Goods debit (imports) -19,190 -18,003 -21,399 -23,322 -25,240 -27,217 -29,422 -31,697
Non-oil imports -14,145 -13,695 -16,186 -18,478 -20,445 -22,191 -24,189 -26,187
Oil imports -5,045 -4,308 -5,213 -4,844 -4,794 -5,026 -5,233 -5,510
Services 1,260 1,180 1,705 2,007 2,294 2,559 2,931 3,336
Credit (exports) 3,799 4,685 5,886 6,823 7,747 8,671 9,783 10,962
Debit (imports) -2,539 -3,505 -4,180 -4,816 -5,453 -6,112 -6,852 -7,626
Primary income, net 1/ -1,219 -1,817 -841 -881 -925 -971 -1,020 -1,070
Secondary income, net 2/ 5,392 5,639 6,222 6,759 7,278 7,865 8,231 8,613
Workers' remittances (net) 5,339 5,619 6,200 6,736 7,254 7,839 8,204 8,586
Capital account (+ surplus / - deficit) 130 71 100 73 101 102 102 103
Balance from current account and capital account -3,853 -2,536 -2,391 -2,590 -2,646 -2,657 -2,669 -2,893
Financial account (+ net lending / - net borrowing) -4,275 -3,120 -2,391 -2,590 -2,646 -2,657 -2,669 -2,893
Of which : Short term liabilities /3 -649 108 150 200 200 200 200 200
Direct investments -877 -850 -964 -1,067 -1,183 -1,311 -1,452 -1,780
Portfolio investments -2,126 -2,106 -1,968 -1,424 -779 -785 -1,290 -296
Other investments -2,031 -1,276 -343 -815 -933 -1,260 -1,708 -1,806
Of which : Loans -3,081 -942 -163 -635 -753 -1,080 -1,528 -1,626
Central bank 4/ -791 459 733 565 517 274 0 0
Deposit taking corporations -579 -124 -180 -400 -400 -400 -500 -500
General government -992 -821 -890 -953 -1,016 -1,093 -1,156 -1,244
Other sectors -719 -456 174 153 146 138 129 117
Change in reserve assets 760 1,112 885 716 249 699 1,782 989
Errors and omissions -422 -585 0 0 0 0 0 0
Memorandum items:
Current account (in percent of GDP) -6.7 -3.9 -3.5 -3.4 -3.2 -3.0 -2.7 -2.7
Gross official reserves /5 7,106 7,495 8,380 9,096 9,345 10,044 11,826 12,815
(In months of imports of goods and nonfactor services) 4.0 3.5 3.6 3.6 3.4 3.3 3.6 3.6
(In percent of composite metric) 101 97 101 104 101 101 109 109
Net international reserves 4,162 5,149 6,766 8,048 8,813 9,787 11,568 12,558
GDP 59,378 66,696 71,608 78,169 85,331 93,150 101,685 111,002
Sources: Data provided by the Central Bank of Sri Lanka; and IMF staff estimates and projections.
1/ Under BPM5 known as Income.
2/ Under BPM5 known as Transfers.
3/ Net incurrence of short term liabilities (portfolio debt securities and loans).
4/ Credits and loans with the IMF (other than reserves).
5/ Gross reserves data in previous staff reports were adjusted for Sri Lanka's net balance with the Asian Clearance Union.
Proj.
(In millions of U.S. dollars, unless otherwise indicated)
SRI LANKA

Table 5. Sri Lanka: Projected Payments to the Fund, 201418

2014 2015 2016 2017 2018
Fund repurchases and charges
In millions of SDR 488.4 370.4 331.5 173.4 0.3
In millions of U.S. dollars 755.9 578.5 523.2 276.3 0.5
In percent of exports of goods and NFS 4.3 3.0 2.4 1.2 0.0
In percent of quota 118.1 89.6 80.2 41.9 0.1
In percent of gross official reserves 9.0 6.4 5.6 2.8 0.0
Fund credit outstanding
In millions of SDR 861 500 172 0.0 0.0
In millions of U.S. dollars 1,333 780 272 0.0 0.0
In percent of quota 208 121 42 0.0 0.0
In percent of GDP 1.9 1.0 0.3 0.0 0.0
In percent of gross official reserves 15.9 8.6 2.9 0.0 0.0
Memorandum items:
Exports of goods and services (in millions of U.S. dollars) 17,707 19,597 21,592 23,677 26,292
Quota 413 413 413 413 413
Quota (in millions of U.S. dollars) 640 646 652 659 663
Gross official reserves (in millions of U.S. dollars) 8,380 9,096 9,345 10,044 11,826
GDP (in millions of U.S. dollars) 71,608 78,169 85,331 93,150 101,685
(In millions of SDR, unless otherwise indicated)
SRI LANKA


Table 6. Sri Lanka: Financial Soundness IndicatorsAll Banks, 200813

2010 2011 2012 2012 2013 2013 2013 2013
Sept. Q1 Q2 Q3 Q4
Regulatory capital to risk weighted assets 16.2 16.0 15.0 15.0 16.0 16.1 15.8 16.3
Tier 1 capital/risk weighted assets 14.3 14.4 13.3 13.1 13.9 13.9 13.6 13.7
Capital to assets ratio 8.3 8.7 8.6 8.5 8.4 8.4 8.2 8.2
Gross nonperforming loans to total gross loans
(without interest in suspense) 5.4 3.8 3.6 4.2 4.7 5.2 5.6
Net nonperforming loans to total gross loans 3.0 2.1 2.4 2.1 2.3 2.7 2.0 3.3
Provision coverage ratio (total) 1/ 58.1 57.1 50.9 54.5 45.4 44.9 50.9 40.4
Return on equity (after tax) 22.2 19.7
20.5
20.2 7.3 24.6 23.2 22.5
Return on assets (after tax) 1.8 1.7 1.7 1.7 0.6 2.1 2.0 1.9
Interest income to gross income 83.1 85.5 85.3 86.3 66.4 69.5 70.5 69.7
Staff expenses to noninterest expenses 45.2 43.7 45.7 45.2 45.9 46.5 46.1 44.9
Personnel expenses to total income 12.0 12.2 10.9 10.7 n.a. 25.5 25.0 25.0
Total cost to total income 71.9 73.9 74.3 75.6 79.1 91.2 n.a 56.8
Net interest margin 4.6 4.2 4.1 4.1 3.8 6.8 5.8 5.7
Liquid assets to total assets 31.4 26.8 27.1 26.5 28.0 29.2 30.6 31.9
Deposits 72.8 72.3 70.5 70.5 70.2 n.a n.a n.a
Borrowings 14.3 14.9 16.2 15.8 11.2 11.6 n.a n.a
Capital to external funds 9.5 10.0 9.9 9.9 8.4 8.4 n.a 8.2
Credit to deposits 76.4 84.7 87.6 87.4 85.7 n.a n.a n.a
Source: Central Bank of Sri Lanka.
Capital adequacy
Asset quality
4.0
Earnings and profitability
Assets/funding structure
Liquidity
1/ The drop in the provisioning ratio reflects an increase in NPLs (loans categorized as substandard or belowthe denominator), with the bulk of
new NPLs at the low end of provisioning requirements. For the given stock of NPLs, this ratio is expected to increase as the stock of new NPLs
migrates from substandard to lower categories (doubtful and loss) and provisioning requirements increase.

SRI LANKA
STAFF REPORT FOR THE 2014 ARTICLE IV
CONSULTATION AND SECOND POST-PROGRAM
MONITORING DISCUSSIONINFORMATIONAL
ANNEX

Prepared By

Asia and Pacific Department

FUND RELATIONS ________________________________________________________________________ 2
RELATIONS WITH THE WORLD BANK GROUP __________________________________________ 5
RELATIONS WITH THE ASIAN DEVELOPMENT BANK __________________________________ 7
STATISTICAL ISSUES ____________________________________________________________________ 10

CONTENTS
July 10, 2014
SRI LANKA
FUND RELATIONS
(As of May 31, 2014)

Membership Status
Joined 8/29/50; accepted Article VIII, Sections 2, 3, and 4, March 1994.

General Resources Account SDR Million % Quota
Quota 413.40 100.00
Fund holdings of currency (Exchange Rate) 1528.25 369.68
Reserve Tranche Position 47.86 11.58

SDR Department SDR Million % Allocation
Net cumulative allocation 395.46 100.00
Holdings 5.75 1.45

Outstanding Purchases and Loans SDR Million % Quota
Stand-by Arrangements 1162.69 281.25
Latest Financial Arrangements

Type
Date of
Arrangement
Expiration
Date
Amount Approved
(SDR Million)
Amount Drawn
(SDR Million)
Stand-By 7/24/09 7/24/12 1,653.60 1,653.60
ECF
1
4/18/03 4/17/06 269.00 38.39
ECF 4/18/03 4/17/06 144.40 20.67
1
Formerly PRGF.

Projected Payments to Fund
2

(SDR million; based on existing use of resources and present holdings of SDRs)

Forthcoming
2014 2015 2016 2017 2018
Principal 301.44 361.73 327.28 172.25
Charges/interest 6.16 8.64 4.20 1.16 0.39
Total 307.60 370.36 331.47 173.41 0.39
2
When a member has overdue financial obligations outstanding for more than three months, the amount
of such arrears will be shown in this section.

SRI LANKA
Exchange Rate Arrangement
The de jure exchange rate arrangement is free floating since its introduction by the Central Bank of
Sri Lanka (CBSL) on January 23, 2001. The CBSL intervenes in the foreign exchange market to limit
volatility in the exchange rate. Since October 2013, the Sri Lanka rupee has stabilized within a
2 percent band against the U.S. dollar. Accordingly, the de facto exchange rate arrangement has
been reclassified from floating to a stabilized arrangement, effective October 1, 2013. Sri Lanka
maintains an exchange system free of exchange restrictions on the making of payments and
transfers for current international transactions, except for the exchange restrictions imposed by Sri
Lanka solely for the preservation of national or international security.

Safeguards Assessment
Under the Fund's safeguards assessment policy, the Central Bank of Sri Lanka (CBSL) was subject to
an update safeguards assessment with respect to a Stand-by Arrangement approved in July 2009.
The assessment, completed in July 2009, found that the CBSL continues to have a relatively strong
safeguards framework, especially in the external audit, financial reporting and control areas. The
assessment recommended measures to improve the process of program data reporting to the Fund
and to modernize and strengthen the internal audit function. Also the external audit arrangements
were not fully institutionalized. The authorities have implemented majority recommendations of the
report. However, staff has not received 2012-2013 Management Letters issued by the CBSLs
external auditor. Delivery of this monitoring information by the CBSL is required under the
safeguards policy.

Article IV Consultation
It is proposed that the next Article IV consultation take place in 12 months.
FSAP and ROSC Participation
MFD: Both the FSSA and the FSAP reports were completed in 2002.
MCM: An FSAP update took place in July 2012.
STA: A data ROSC was completed and the report published in 2002.
FAD: A fiscal transparency ROSC was completed and the report published in 2002. A ROSC
update was completed and the report published in July 2005.
Resident Representative

Mrs. Eteri Kvintradze has been the resident representative since March 2014.

Technical Assistance

FAD. A number of TA missions in tax policy and administration took place during the 2000s. A
series of TA missions in revenue administration were conducted in 2003. Tax policy missions
took place in 2001 and 2009, to provide advice on the reform of the tax system. In 2012, a
mission visited Sri Lanka to evaluate the state of the Inland Revenue Department, with a
particular focus on the effectiveness of the administration of the Value Added Tax (VAT) and
SRI LANKA
secondarily the Nation Building Tax to identify measures to staunch and reverse the decline in
VAT collections and improve the overall performance of the VAT system and taxpayers
compliance. In addition, a number of missions took place during 20122014 to strengthen
Public Financial Management, improving oversight of the State-Owned Enterprises,
strengthening budget preparation and improving the commitment control system.
MCM. In August 2001, a TA mission to develop a strategy for strengthening the framework and
implementation of monetary and foreign exchange cooperation took place. In May 2002, an
IMF/World Bank mission advised the government of Sri Lanka on options for reform of Peoples
Bank. In 2003, TA mission on financial sector issues and financial sector reforms took place,
followed by 2005 mission to provide advice on the introduction of new deposit insurance
scheme.
STA. In November 2012, a mission visited Sri Lanka to report on data dissemination practices
with respect to the requirements of the Special Data Dissemination Standards (SDDS). During
20132014, Sri Lanka has received TA provided by the IMF/STA as part of the Asia module of the
JSA Project on the Improvement of statistics in the Asia and Pacific Region. This TA focused on
improving data collection and compilation of ESS including balance of payments, IIP, EDS, and
Reserves Data Template (RDT), and supporting the authorities in their transition to the BPM6
format. In 2013, TA missions also took place to review work on methodological improvements to
the consumer price index and the development of the new producer price index, and to provide
guidance on rebasing of GDP estimates and quarterly national accounts. In 2014, a mission took
place to review the Government Financial Statistics (GFS) compilation system and make
recommendations on the implementation of the GFSM 2001 and its 2014 update (GFSM 2014).

SRI LANKA
RELATIONS WITH THE WORLD BANK GROUP
(As of May 30, 2014)

As set out in the Country Partnership Strategy (CPS) for FY1316, the World Bank Group is
supporting Sri Lanka in addressing its long-term strategic and structural development
challenges as it transitions to middle-income country (MIC) status. Key elements of this
transition include boosting investment, including in human capital, realigning public spending and
policy with the needs of a middle income country, enhancing the role of the private sector, including
the provision of an appropriate environment for increasing productivity and exports, and ensuring
inclusive growth. The CPS set out to contribute to achieving these goals through three areas of
engagement: (i) facilitating sustained private and public investment; (ii) supporting structural shifts
in the economy; and (iii) improving living standards and social inclusion.

A CPS Progress Report prepared this fiscal year provided an opportunity to review the
country program and strategy together with the government, taking stock both of progress
to date and the governments evolving development needs and agenda. While the strategic
objectives of the CPS remain relevant through FY16, the Progress Report proposed a refocusing of
some activities as well as the addition of a fourth strategic area of engagement, namely increasing
resilience to disasters and climate change, deemed central to Sri Lankas current development
agenda and poverty reduction efforts. As the country shifts from reconstruction to addressing the
challenges of development on a middle income trajectory greater emphasis has been placed on
facilitating and creating the enabling environment for increased foreign and domestic investment.
At the same time, continued pockets of poverty highlight the need for renewed efforts to target
development to the poor.

The World Bank has been supporting Sri Lankas development for close to six decades, having
accompanied the country as it has grown to join the ranks of middle-income countries. Sri
Lanka re-emerged as a blend IDA-IBRD country in FY12, regaining access to IBRD resources after a
26-year hiatus. It will remain a blend IDA-IBRD country through the IDA17 cycle. The current active
World Bank portfolio in Sri Lanka comprises the following 15 projects, with a total net commitment
value of $1.77 billion:

SRI LANKA
Summary of World Bank IDA Operations

Board
Approval
Revised
Closing Date
Net Comm
Amount
($mil)

Dam Safety & Water Resource Planning 03/27/2008 05/15/2018 148.3
Improving Climate Resilience
Catastrophe DDO
04/22/2014
04/22/2014
05/30/2019
05/31/2017
110.0
102.0

Comm Livelihoods in Conflict Areas 06/22/2004 12/31/2014 124.7
2
nd
Com Dev & Livelihood improvement 09/10/2009 09/30/2014 75.0
N&E Local Services Improvement 05/13/2010 12/31/2015 50.0
LK Road Sector Assistance 12/15/2005 09/30/2014 298.1
Provincial Roads Project 12/17/2009 03/31/2015 105.0
Metro Colombo Urban Development 03/15/2012 12/31/2017 213.0
Sri Lanka Strategic Cities Development 05/05/2014 12/31/2019 147.0
SME Development Facility 09/07/2010 03/31/2014 57.4
Warehouse Receipts Financing 06/01/2012 05/31/2015 6.5
Higher Education for 21
st
Century 05/13/2010 06/30/2016 40.0
Transforming School Education 11/29/2011 06/30/2017 100.0
Second Health Sector Development 03/27/2013 09/30/2018 200.0

Source: World Bank.

SRI LANKA
RELATIONS WITH THE ASIAN DEVELOPMENT BANK
(As of June 26, 2014)

Country Strategy for Sri Lanka
Country Partnership Strategy: ADBs Country Partnership Strategy (CPS) for Sri Lanka,
approved in 2011 identifies three pillars, (i) inclusive and sustainable economic growth, (ii) catalyzing
private investment and enhancing the effectiveness of public investment, and (iii) human resource
and knowledge development, as the focus of operations over the period 201216. ADB continues to
focus on transport, energy, water supply and waste water management, and irrigation sectors in
infrastructure development, and education sector.
Indicative Resources: The allocation for 2014-2016 consists of $562 million from ordinary
capital resources (OCR) and $437 million from the Asian Development Fund (ADF).
Indicative Pipeline for 2014-16
Country Operations Business Plan (COBP) for the period 201416 indicates that the
indicative project pipeline for 2014-2016 addresses the priority agendas of middle-income countries,
such as skills development, integrated transport network development, sustainable energy, and
integrated water resource management. To ensure critical mass and continuity, the COBP will take
an investment program approach, and financing modalities will include multi-tranche financing
facility (MFF), results based lending (RBL) programs, and additional financing. To the extent possible,
thematic priorities such as gender, governance, climate change, and regional cooperation will be
included in each project. Co-financing and private sector operation opportunities will be explored.
The Skills Sector Enhancement Program (RBL) approved in 2014 develops skills relevant to Sri Lankas
economy by supporting priority sectors where large skills gaps exist. The program focuses on increasing
employability of the Sri Lankan workforce, particularly the youth by transforming Sri Lanka's technical and
vocational education training (TVET) system into a more market responsive, inclusive, and quality-
oriented one. The program will strengthen the engagement of private sector employers and bodies in
TVET planning and delivery through (i) industry sector skills councils to validate skills gap analysis,
training plans, competency standards, and curricula; and (ii) introduction of an employment-linked
training agreement model where employer can deliver training to bridge the skills gaps.
The Integrated Road Operation and Development Investment Program (MFF) is being processed in
2014 to support the Governments program to connect 1,000 villages to city centers. It includes
rehabilitation and upgrading of rural, provincial and national roads in 6 provinces. The Expressway
Connectivity Investment Program (MFF) for 2015 will optimize the connectivity of highways and
expressways. This includes providing the access to the expressway network from Colombo City to
limit congestion. The most priority expressways to be constructed under the project will be (i)
SRI LANKA
elevated expressway from Kelani Bridge to Colombo Port (port access road) and (ii) elevated
expressway from Kelani Bridge to Kirulapone (baseline road).
The Green Power Development and Energy Efficiency Improvement Investment Program (MFF) to be
approved in 2014 addresses the energy sector focus in four areas: (i) diversifying energy sources by
increasing the share of renewable energy, including wind, hydro, and solar; (ii) strengthening
transmission infrastructure to absorb additional capacity from renewable energy sources, and
expanding access in post-conflict areas and lagging regions;, (iii) improving network efficiency
through technical loss reduction; and (iv) enhancing regional cooperation.
The Greater Colombo Water and Wastewater Management Improvement Investment Program (MFF)
focuses on reducing nonrevenue water (NRW) and improving wastewater management in the
greater Colombo area. It targets NRW reduction in Colombo City from 60 percent to about 18
percent in critical areas and to about 20 percent elsewhere after project completion. The Program
will be a platform to mobilize co-financing and to introduce publicprivate partnerships (PPPs). The
first two tranches focus on water supply, while the third and fourth tranches (planned in 2015 and
2016) primarily address wastewater management.
The Water Resources Development Investment Program (MFF) will assist the government complete
outstanding water conveyance investments under the Mahaweli Development Program (MDP).
Completion of MDP is a key priority of the government and will maximize the productivity of
Mahaweli River Basin water resources by transferring available water to Sri Lankas northern dry
zone areas for irrigation, drinking and commercial purposes. This will accelerate local and national
economic growth. The first tranche scheduled for 2015.
In the absence of a PPP framework, ADB will adopt a project-based approach to promote PPP in Sri
Lanka. Performance-based contracts can be structured as part of regular sovereign projects, such as
in water and wastewater management and road maintenance. ADBs Private Sector Operations
supports finance sector development by providing loans, equity investments, or guarantees for
banks or nonbank institutions to enable them to expand activities in targeted areas including
housing, small and medium-sized enterprise finance, leasing, renewable energy, and infrastructure
lending. ADB may also provide transaction advisory services to structure and procure developers for
PPP projects as needed.
Ongoing Projects
Projects approved in 2013: During 2013, ADB approved 3 new projects for a total of
$363 million as follows:

- Education Sector Development Program ($100 million from OCR and $100 million from ADF)
- Southern Road Connectivity Project ($70 million from OCR and $5 million from ADF)
SRI LANKA
- Greater Colombo Water And Wastewater Management Improvement Investment Program -
Tranche 1 ($70 million from OCR and $18 million from ADF)
Portfolio Performance: As of 31 December 2013, ADB has approved a total of 166 loans,
with cumulative lending of $5.8 billion to Sri Lanka. In addition, ADB has provided $358 million grant
assistance (including ADB-administered co-financed grants) for projects and $123 million through
259 technical assistance grants.
The current portfolio includes 49 ongoing loans and grants for 29 projects with a net loan amount
of $2.1 billion. Cumulative contract awards reaches $1.0 billion, and disbursements $0.7_billion. 80%
of the ongoing portfolio are in transport, urban and water, and energy sectors. The sector
composition of the ongoing loan portfolio is in Figure 1.

Source: Asian Development Bank
2%
8%
18%
19%
24%
29%
Figure 1 : Sectoral Distribution
Finance Multisector Education Energy Transport Urban and Water
SRI LANKA
STATISTICAL ISSUES
Macroeconomic statistics are broadly adequate for surveillance, but weaknesses remain in the
timeliness and coverage of certain statistical series. Sri Lanka is a participant in the General Data
Dissemination System (GDDS) since July 2000.

Price statistics. The Department of Census and Statistics (DCS) released a new Consumer Price Index
for Colombo in 2007, based on the spending pattern reflected in the Household Income and
Expenditure Survey. It is based on the spending patterns of all urban households in the Colombo
district. A core inflation index is also compiled by the DCS to provide a measure of underlying
inflation. The Central Bank of Sri Lanka (CBSL) produces a Wholesale cum-Producer Price Index
(WPI/PPI).

National accounts. The national accounts suffer from insufficient data sources and undeveloped
statistical techniques. Most of the data used for national accounts are obtained on a timely basis.
However, detailed data needed to measure both output and intermediate consumption are mostly
unavailable or not collected. As a result, some of the estimates of gross value added are prepared
directly relying on fixed ratios, often with outdated studies or ad hoc assumptions. Quarterly
indicators are used for compiling quarterly value added estimates. The methodology for deriving GDP
at constant prices relies on expenditure estimates which are available only annually and rely mostly on
commodity flow techniques. Whenever possible, estimates are validated and checked with other
sources.

Government finance. In May 2003, a STA mission followed up on the ROSC recommendation to
develop a migration path to compile data in accordance with the Government Finance Statistics
Manual 2001 (GFSM 2001). As part of that plan, the authorities agreed to revise (beginning in end
2003) the budgetary classifications and the accounting structure to eventually match the GFSM 2001
classifications of stocks and flows and to apply that chart of accounts to all general government units.
In April 2014, a STA mission took place in the context of the Japan-funded IMF project on
implementing GFSM 2001 and its update (GFSM 2014), for compiling, analyzing and reporting fiscal
data.

Monetary statistics. Foreign Currency Banking Units (FCBUs) are classified as resident institutions in
the monetary survey since 1998. To adjust for the proportion of nonresident foreign currency deposits
(NRFC), which are actually held by residents (mainly returning migrant workers), 50 percent of these
deposits are reclassified from foreign liabilities to domestic deposits.

In June 2003, a STA mission followed up on issues raised during the 2001 ROSC mission. In particular,
the mission clarified the methodology for the treatment of Fund accounts; recommended that repos
be treated as collateralized loans (rather than on a change of ownership basis); and resolved
discrepancies between the monetary authorities data reported to STA and to APD, which reflected
problems in the valuation of Fund accounts and other shortcomings.

SRI LANKA
External Sector Statistics (ESS). Since April 2014, the CBSL publishes its International Investment
Position (IIP) and balance of payments statistics on an annual basis following the sixth edition of the
Balance of Payments Manual (BPM6). Quarterly data are available three months after the end of the
quarter and the CBSL plans to start publishing these data following the BPM6 in June 2014. For
Quarterly external debt statistics (QEDS) for GDDS participants, Sri Lanka disseminated data up to
2013 Q1. During 2013 and 2014, Sri Lanka received TA provided by the IMF as part of the Asia module
of the JSA Project on the Improvement of ESS in the Asia and Pacific Region. This TA focused on
improving data collection and compilation of ESS, including balance of payments, IIP, EDS, and
Reserves Data Template (RDT), and supporting the authorities in their transition to the BPM6 format.

Dissemination System/Standards (GDDS/SDDS). Sri Lanka is a participant in the General Data
Dissemination System (GDDS) since July 2000. In February 2003, the authorities appointed a
coordinator with the objective of subscribing to the Special Data Dissemination Standard (SDDS) and
have since made substantial progress. However, additional work is still needed for meeting all SDDS
requirements, including quarterly IIP and monthly central government operations.

General
A data ROSC mission visited Sri Lanka in 2001, followed by BCP, CPSS, IOSCO, MFPT, RSSS and Fiscal
ROSC missions in 2002. A fiscal ROSC update was conducted in 2005 and reassessments of the BCP in
2007 and 2012 and of CPSS in 2007. [Most of its recommendations have been implemented while
others are expected to be implemented in the near future.]

The authorities report key data to the Fund on a timely basis. On government finance, annual cash
data were regularly reported for publication in the GFS Yearbook. These data cover only the
budgetary accounts of central government; and no data on the extrabudgetary funds or the
provincial and local governments are reported. At the same time, no sub-annual data are reported
for publication in IFS. The authorities have been encouraged to reduce the time lag for data
reporting. The authorities have not yet begun reporting data in the format of Standardized Report
Forms, which were developed by STA for reporting monetary data and reflect principles for
classifying positions by economic sector, financial instrument, and currency of denomination
recommended in the Monetary and Financial Statistics Manual.

Sri Lanka: Table of Common Indicators Required for Surveillance
As of June 17, 2014
Date of Latest
Observation
Date
Received
Frequency of
Data
7
Frequency
of
Reporting
7
Frequency of
Publication
7
Memorandum Items:
Data QualityMethodological
Soundness
8
Data Quality Accuracy
and Reliability
9
Exchange rates Today Today D D D
International reserve assets and reserve liabilities
of the Monetary Authorities
1
6/13/2013 Today D D D
Reserve/base money 12/2013 3/2013 M M M LO, LO, LO, LO LO, O, O, NA, NA
Broad money 12/2013 5/2014 M M M
Central bank balance sheet 12/2013 5/2014 M M M
Consolidated balance sheet of the banking system 12/2013 5/2014 M M M
Interest rates
2
Today Today D D D
Consumer price index (New Colombo CPI) 5/2014 5/2014 M M M O, LNO, LO, O O, LO, O, NA, NA
Revenue, expenditure, balance and composition
of financing
3
general government
4

Revenue, expenditure, balance and composition
of financing
3
central government

12/2013 4/2014 M M M O, O, O, O LO, NA, LO, NA, LO
Stocks of central government and central
government-guaranteed debt
5
12/2013 4/2014 M M M
External current account balance 2013Q4 4/2014 Q Q Q
Exports and imports of goods and services 3/2014 5/2014 Q Q Q LO, LO, LO, LO LO, LO, LO, NA, LO
GDP/GNP 2013Q4 3/2014 Q Q Q LO, LO, LNO, LNO LNO, LNO, LO, NA, O
Gross external debt

2013Q4 6/2012 A A A
International Investment Position
6
2013 4/2014 A A A
1
Any reserve assets that are pledged or otherwise encumbered should be specified separately. Also, data should comprise short-term liabilities linked to a foreign currency but settled by other
means as well as the notional values of financial derivatives to pay and to receive foreign currency, including those linked to a foreign currency but settled by other means
2
Both market-based and officially-determined, including discount rates, money market rates, rates on treasury bills, notes and bonds.
3
Foreign, domestic bank, and domestic nonbank financing.
4
The general government consists of the central government (budgetary funds, extra budgetary funds, and social security funds) and state and local governments.

5
Including currency and maturity composition.
6
Includes external gross financial asset and liability positions vis--vis nonresidents.
7
Daily (D); Weekly (W); Monthly (M); Quarterly (Q); Annually (A); Irregular (I); Not Available (NA).
8
Reflects the assessment provided in the data ROSC published in May 2002 and based on the findings of the mission that took place during June 2001 for the dataset corresponding to the
variable in each row. The assessment indicates whether international standards concerning (respectively) concepts and definitions, scope, classification/sectorization, and basis for recording
are fully observed (O), largely observed (LO), largely not observed (LNO), not observed (NO), or not applicable (NA).
9
Same as footnote 8, except referring to international standards concerning (respectively) source data, statistical techniques, assessment and validation of source data, assessment and
validation of intermediate data and statistical outputs, and revision studies.

S
R
I

L
A
N
K
A

1
2

I
N
T
E
R
N
A
T
I
O
N
A
L

M
O
N
E
T
A
R
Y

F
U
N
D

SRI LANKA
STAFF REPORT FOR THE 2014 ARTICLE IV
CONSULTATION AND SECOND POST-PROGRAM
MONITORING DISCUSSIONDEBT SUSTAINABILITY
ANALYSIS

Sri Lankas public debt sustainability assessment remains broadly unchanged from the assessment
in 2013 Article IV report. While still relatively elevated, public and external debt remains on a
sustainable trajectory.

Macroeconomic assumptions:
Growth in the medium-term is projected at 6.5 percent, broadly in line with the
estimated potential output growth, and below the authorities projection of 8 percent.
After falling sharply in the second half of 2013 and early 2014 to below 4 percent, CPI
inflation is projected to settle at 5.5 percent in the medium term. This projection is based
on relatively benign external conditions, and absence of domestic supply shocks.
The 2014 central government budget deficit is projected to decline to 5.2 percent of
GDP, in line with the authorities target. This implies a 0.7 percent of GDP deficit reduction
relative to 2013. Tax revenues are projected to improve moderately as a percent of GDP,
though less than envisaged in the authorities budget. Revenue improvements reflects the
pickup in imports, some limited tax measures, and the efforts to improve tax
administration and compliance. In line with the experience of previous years, lower-than-
budgeted revenues are assumed to be offset by lower-than-budgeted expenditures,
keeping the deficit on target.
The current account is expected to continue a gradual consolidation, mainly driven by a
further strengthening of the services balance, coupled with only a modest increase in FDI.

Approved By
Jerald Schiff and
Dhaneshwar Ghura
Prepared by the Staff Representatives for the 2014
Consultation with Sri Lanka
July 10, 2014
SRI LANKA
Public Debt Sustainability

Background: During the last decade, central government debt fell from over 90 percent of GDP
to below 80 percent of GDP, reflecting relatively low borrowing costs and strong growth,
supported by gradually improving primary balance. However, with the reduced role of
concessional financing and increased role of commercial borrowing, the average borrowing costs
of foreign debt have been recently increasing. The share of local and foreign currency-
denominated debt has remained broadly constant, but the average maturity of the debt has
been increasing, reflecting the authorities effort to rely less on issuance of short-term debt.
Following the launch of international sovereign bond issuance in 2007 and pickup in non-
concessional bilateral and multilateral loans, the share of non-concessional debt in total foreign
debt increased from about one fourth in 2009 to one half in 2013. Nonresidents holdings of
government securities in local currency are capped at 12.5 percent of total domestic currency
denominated debt, and the authorities are not currently envisaging increasing that ceiling.
Baseline: Under the baseline scenario, the ratio of public debt-to-GDP is projected to decline by
about 15 percentage points, to 63 percent GDP by 2019. The primary balance is projected to
remain close to zero, about 3 percent of GDP stronger than the debt-stabilizing primary balance.
Baseline scenario is based on a conservative growth projection - somewhat lower than other
international financial institutions projections, and 1 percentage point lower than the
authorities target. The projected strengthening in Sri Lankas cyclically adjusted primary balance
is relatively modest, placing it broadly in the middle of distribution of adjustment size among the
comparator countries.
Heat map analysis suggests high risks to debt sustainability. The debt burden benchmark of
70 percent of GDP and gross financing need benchmark of 15 percent of GDP are exceeded in all
shock scenarios. This contrasts with a benign market assessment (bond spreads are well within
the 200600 point range of lower and upper risk benchmark). Favorable market sentiment
reflects: (i) strong economic growth; (ii) favorable global environment; (iii) sustained fiscal
adjustment and falling debt ratio; (iv)credible commitment to further deficit and debt reduction
in the future; and (v) limited nonresident holding of government debt in domestic currency
which contributed to Sri Lankas resilience during market turbulence.
Risks. The DSA illustrates the critical contribution of growth to recent and projected reduction in
the debt ratio. Slower-than-projected growth (alone or combined with a higher primary deficit
and higher borrowing costs) could stop or reverse the decline in debt ratio (see macro-fiscal and
slow adjustment shocks). The high share of foreign currency-denominated debt also creates a
vulnerability to currency depreciation. Sri Lankas debt is also high as a percent of government
revenuea moderate increase in borrowing costs could eat up a large share of revenues.
Looking ahead, increasing reliance on nonconcessional financing, together with the
normalization of global financial conditions will push up borrowing costs. Further reduction of
the deficit and debt (via revenue gains) is crucial for maintaining market confidence and solid
growth.
SRI LANKA
The authorities views. There were no major disagreements about the conclusions of debt
sustainability analysis. However, the authorities have somewhat more sanguine view, and project
a faster reduction of the debt ratio, to 65 percent of GDP by 2016, compared to 71 percent of
GDP projected by staff. The main reason for their more favorable debt trajectory is higher
projected real GDP growth, averaging 8.1 percent in 20141016, compared to staffs average
projected growth 6 2/3 percent. In addition, the authorities project a somewhat faster fiscal
deficit reduction, reflecting more optimistic revenue projection.

External Debt Sustainability

Structure of debt: While the majority of the external debt, 56.1 percent at end-2013, is still
owed by the government, this relationship is quickly changing. The recent increase in private
debt has, however, been primarily long term debt. 96.8 percent of public external debt is long
term with still a large share of that being contracted on concessional terms, which limits the
rollover risks. Outstanding Eurobonds end-April 2014 total US$5 billion, with US$0.5 billion
maturing in January 2015 and US$1.5 billion in 2019.

Baseline: as of end-2013 total external debt is estimated to 59.6 percent of GDP, down from
62.5 percent of GDP at end-2012 driven by strong GDP growth and price and exchange rate
dynamics. With relatively modest FDI inflows, total external debt as share of GDP is expected to
decrease only gradually to just over 50 percent in 2019, GDP growth continuing being the main
contributor to this decline.

Other scenarios: the standard alternative scenarios point to a depreciation shock as the main
vulnerability, with a real depreciation of 30 percent leading to external debt increasing to nearly
80 percent at the end of the period. Meanwhile, if the current account deficit were to be on
average 1.4 percent of GDP larger over the period, this would leave external debt virtually
unchanged at the current level.

Risks: this assessment is based on the assumption of continued strong growth and an
improvement in the current account, and weaker than expected external demand and lower
tourism receipts pose obvious risks. On the positive side, a stronger inflow of FDI would not only
have beneficial growth effects, but also decrease the need for debt-creating inflows to finance
the current account deficit. Overall, the future external debt levels and vulnerabilities will also
depend on the authorities policies in terms of opening up the capital account from its current
relatively tight capital controls. The authorities ambition to reduce public debt is very welcome,
but if it comes with an equivalent increase in private sector external borrowing to fill the
financing of the current account deficit, external vulnerabilities for the economy as a whole will
not be reduced.
SRI LANKA
Sri Lanka
Source: IMF staff.
Sri Lanka Public DSA Risk Assessment
1/ The cell is highlighted in green if debt burden benchmark of 70% is not exceeded under the specific shock or baseline, yellow if exceeded under specific shock but not
baseline, red if benchmark is exceeded under baseline, white if stress test is not relevant.
Real Interest
Rate Shock
External
Financing
Requirements
Real GDP
Growth Shock
Heat Map
Upper early warning
Evolution of Predictive Densities of Gross Nominal Public Debt
(in percent of GDP)
Debt profile
3/
Lower early warning
(Indicators vis--vis risk assessment benchmarks, in 2013)
Debt Profile Vulnerabilities
Gross financing needs
2/
Debt level
1/
Real GDP
Growth Shock
Primary
Balance Shock
3/ The cell is highlighted in green if country value is less than the lower risk-assessment benchmark, red if country value exceeds the upper risk-assessment benchmark,
yellow if country value is between the lower and upper risk-assessment benchmarks. If data are unavailable or indicator is not relevant, cell is white.
Lower and upper risk-assessment benchmarks are:
Change in the
Share of Short-
Term Debt
Foreign
Currency
Debt
Public Debt
Held by Non-
Residents
Primary
Balance Shock
Real Interest
Rate Shock
Exchange Rate
Shock
Contingent
Liability Shock
Exchange Rate
Shock
Contingent
Liability shock
5/ External financing requirement is defined as the sum of current account deficit, amortization of medium and long-term total external debt, and short-term total external
debt at the end of previous period.
4/ Long-term bond spread over U.S. bonds, an average over the last 3 months, 06-Mar-14 through 04-Jun-14.
2/ The cell is highlighted in green if gross financing needs benchmark of 15% is not exceeded under the specific shock or baseline, yellow if exceeded under specific shock
but not baseline, red if benchmark is exceeded under baseline, white if stress test is not relevant.
200 and 600 basis points for bond spreads; 5 and 15 percent of GDP for external financing requirement; 0.5 and 1 percent for change in the share of short-term debt; 15
and 45 percent for the public debt held by non-residents; and 20 and 60 percent for the share of foreign-currency denominated debt.
Market
Perception
20
60
42%
1 2
200
600
342
bp
1 2
5
15
16%
1 2
0.5
1
-
0.4%
1 2
Bond spread
External Financing
Requirement
Annual Change in
Short-Term Public
Debt
Public Debt in
Foreign Currency
(in basis points) 4/ (in percent of GDP) 5/
(in percent of total) (in percent of total)
0
10
20
30
40
50
60
70
80
90
2012 2013 2014 2015 2016 2017 2018 2019
10th-25th 25th-75th 75th-90th Percentiles: Baseline
Symmetric Distribution
0
10
20
30
40
50
60
70
80
90
2012 2013 2014 2015 2016 2017 2018 2019
Restricted (Asymmetric) Distribution
no restriction on the growth rate shock
no restriction on the interest rate shock
2 is the max positive pb shock (percent GDP)
5 is the max real appreciation shock (percent)
Restrictions on upside shocks:
15
45
44%
1 2
Public Debt Held
by Non-Residents
(in percent of total)

Source : IMF Staff.
1/ Plotted distribution includes program countries, percentile rank refers to all countries.
2/ Projections made in the spring WEO vintage of the preceding year.
3/ Not applicable for Sri Lanka, as it meets neither the positive output gap criterion nor the private credit growth criterion.
4/ Data cover annual obervations from 1990 to 2011 for advanced and emerging economies with debt greater than 60 percent of GDP. Percent of sample on vertical axis.
Sri Lanka Public DSA - Realism of Baseline Assumptions
Forecast Track Record, versus program countries
Boom-Bust Analysis
3/
Assessing the Realism of Projected Fiscal Adjustment
-12
-10
-8
-6
-4
-2
0
2
4
6
2004 2005 2006 2007 2008 2009 2010 2011 2012
Year
2/
Real GDP Growth
Interquartile range (25-75)
Median
Sri Lanka forecast error
-0.09
38%
Has a percentile rank of:
Sri Lanka median forecast error, 2004-2012:
Distribution of forecast
errors:
1/
(in percent, actual-projection)
-6
-5
-4
-3
-2
-1
0
1
2
3
2004 2005 2006 2007 2008 2009 2010 2011 2012
Year
2/
Primary Balance
Median
-0.15
52%
Has a percentile rank of:
errors:
1/
(in percent of GDP, actual-projection)
-10
-8
-6
-4
-2
0
2
4
6
8
10
2004 2005 2006 2007 2008 2009 2010 2011 2012
Year
2/
Inflation (Deflator)
Median
3.33
72% Has a percentile rank of:
errors:
1/
(in percent, actual-projection)
p
e
s
s
i
m
i
s
t
i
c
o
p
t
i
m
i
s
t
i
c
-6
-4
-2
0
2
4
6
8
10
t-5 t-4 t-3 t-2 t-1 t t+1 t+2 t+3 t+4 t+5
Real GDP growth
Sri Lanka
(in percent)
Not applicable for Sri Lanka
0
2
4
6
8
10
12
14
L
e
s
s
-
4
-
3
-
2
-
1012345678
Distribution 4/
Sri Lanka
3-Year Adjustment in Cyclically-Adjusted
Primary Balance (CAPB)
(Percent of GDP)
M
o
r
e
3-year CAPB adjustment
greater than 3 percent of GDP
in approx. top quartile
has a percentile
rank of 41%
0
2
4
6
8
10
12
L
e
s
s
-
4
-
3
-
2
-
1012345678
Distribution 4/
Sri Lanka
3-Year Average Level of Cyclically-Adjusted Primary
Balance (CAPB)
(Percent of GDP)
M
o
r
e
3-year average CAPB level
greater than 3.5 percent of
GDP in approx. top quartile has a percentile
rank of 66%
S
R
I

L
A
N
K
A

I
N
T
E
R
N
A
T
I
O
N
A
L

M
O
N
E
T
A
R
Y

F
U
N
D

5

SRI LANKA
As of June 04, 2014
2/
2012 2013 2014 2015 2016 2017 2018 2019 Sovereign Spreads
Nominal gross public debt 88.4 79.2 78.3 76.8 74.2 71.4 68.8 66.3 63.6 EMBIG (bp) 3/ 312
Public gross financing needs 28.1 24.8 23.5 19.4 18.5 15.3 14.5 15.6 15.2 5Y CDS (bp) n.a.
Real GDP growth (in percent) 6.4 6.3 7.3 7.0 6.5 6.5 6.5 6.5 6.5 Ratings Foreign Local
Inflation (GDP deflator, in percent) 9.7 8.9 6.7 3.8 5.4 5.5 5.5 5.5 5.5 Moody's B1 B1
Nominal GDP growth (in percent) 16.7 15.8 14.5 11.1 12.3 12.3 12.3 12.3 12.3 S&Ps B+ B+
Effective interest rate (in percent)
4/
7.2 8.0 7.4 6.8 6.8 6.6 6.7 7.1 6.6 Fitch BB- BB-
2012 2013 2014 2015 2016 2017 2018 2019 cumulative
Change in gross public sector debt -2.6 0.7 -0.9 -1.5 -2.6 -2.8 -2.6 -2.5 -2.6 -14.7
Identified debt-creating flows -4.2 -0.2 -2.6 -2.3 -3.6 -3.7 -3.5 -3.3 -3.4 -20.0
Primary deficit 2.5 1.3 1.0 0.7 0.2 0.1 0.0 -0.1 0.0 0.8
Primary (noninterest) revenue and grants 15.1 13.0 12.2 13.1 13.7 13.9 14.1 14.3 14.5 83.6
Primary (noninterest) expenditure 17.6 14.3 13.1 13.8 13.9 14.0 14.1 14.2 14.5 84.5
Automatic debt dynamics
5/
-6.6 -1.7 -3.5 -3.0 -3.7 -3.8 -3.6 -3.2 -3.4 -20.8
Interest rate/growth differential
6/
-7.3 -5.3 -4.9 -3.0 -3.7 -3.8 -3.6 -3.2 -3.4 -20.8
Of which: real interest rate -2.3 -1.0 0.2 1.9 0.7 0.5 0.6 0.8 0.4 4.8
Of which: real GDP growth -5.0 -4.3 -5.0 -4.9 -4.4 -4.3 -4.1 -4.0 -3.8 -25.6
Exchange rate depreciation
7/
0.7 3.6 1.4
Other identified debt-creating flows -0.1 0.3 -0.1 0.0 0.0 0.0 0.0 0.0 0.0 0.0
Privatization/Drawdown of Deposits (neg-0.1 0.3 -0.1 0.0 0.0 0.0 0.0 0.0 0.0 0.0
Contingent liabilities 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0
Please specify (2) (e.g., ESM and Euroare 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0
Residual, including asset changes
8/
1.6 0.9 1.7 0.8 1.0 1.0 0.9 0.8 0.8 5.3
Source: IMF staff.
1/ Public sector is defined as central government.
2/ Based on available data.
3/ Long-term bond spread over U.S. bonds.
4/ Defined as interest payments divided by debt stock (excluding guarantees) at the end of previous year.
5/ Derived as [(r - (1+g) - g + ae(1+r)]/(1+g++g)) times previous period debt ratio, with r = interest rate; = growth rate of GDP deflator; g = real GDP growth rate;
a = share of foreign-currency denominated debt; and e = nominal exchange rate depreciation (measured by increase in local currency value of U.S. dollar).
6/ The real interest rate contribution is derived from the numerator in footnote 5 as r - (1+g) and the real growth contribution as -g.
7/ The exchange rate contribution is derived from the numerator in footnote 5 as ae(1+r).
8/ Includes asset changes and interest revenues (if any). For projections, includes exchange rate changes during the projection period.
9/ Assumes that key variables (real GDP growth, real interest rate, and other identified debt-creating flows) remain at the level of the last projection year.
Sri Lanka Public Sector Debt Sustainability Analysis (DSA) - Baseline Scenario
-3.4
balance
9/
primary
(in percent of GDP unless otherwise indicated)
Debt, Economic and Market Indicators
1/
2003-2011
Actual
Projections
Contribution to Changes in Public Debt
Projections
2003-2011
Actual
debt-stabilizing
-20
-15
-10
-5
0
5
10
2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019
Debt-Creating Flows
Primary deficit Real GDP growth Real interest rate Exchange rate depreciation
Other debt-creating flows Residual Change in gross public sector debt
projection
(in percent of GDP)
-30
-25
-20
-15
-10
-5
0
5
10
15
cumulative
SRI LANKA


Baseline Scenario 2014 2015 2016 2017 2018 2019 Historical Scenario 2014 2015 2016 2017 2018 2019
Real GDP growth 7.0 6.5 6.5 6.5 6.5 6.5 Real GDP growth 7.0 6.6 6.6 6.6 6.6 6.6
Inflation 3.8 5.4 5.5 5.5 5.5 5.5 Inflation 3.8 5.4 5.5 5.5 5.5 5.5
Primary Balance -0.7 -0.2 -0.1 0.0 0.1 0.0 Primary Balance -0.7 -2.4 -2.4 -2.4 -2.4 -2.4
Effective interest rate 6.8 6.8 6.6 6.7 7.1 6.6 Effective interest rate 6.8 6.8 5.6 5.4 5.5 4.6
Constant Primary Balance Scenario
Real GDP growth 7.0 6.5 6.5 6.5 6.5 6.5
Inflation 3.8 5.4 5.5 5.5 5.5 5.5
Primary Balance -0.7 -0.7 -0.7 -0.7 -0.7 -0.7
Effective interest rate 6.8 6.8 6.6 6.7 7.1 6.6
Source: IMF staff.
Underlying Assumptions
(in percent)
Sri Lanka Public DSA - Composition of Public Debt and Alternative Scenarios
Alternative Scenarios
Composition of Public Debt
Baseline Historical Constant Primary Balance
0
10
20
30
40
50
60
70
80
90
2012 2013 2014 2015 2016 2017 2018 2019
Gross Nominal Public Debt
(in percent of GDP)
projection
0
5
10
15
20
25
30
2012 2013 2014 2015 2016 2017 2018 2019
Public Gross Financing Needs
(in percent of GDP)
projection
0
20
40
60
80
100
120
2003 2005 2007 2009 2011 2013 2015 2017 2019
By Maturity
Medium and long-term
Short-term
projection
(in percent of GDP)
0
20
40
60
80
100
120
2003 2005 2007 2009 2011 2013 2015 2017 2019
By Currency
Local currency-denominated
Foreign currency-denominated
projection
(in percent of GDP)
SRI LANKA
Primary Balance Shock 2014 2015 2016 2017 2018 2019 Real GDP Growth Shock 2014 2015 2016 2017 2018 2019
Primary balance -0.7 -0.6 -0.6 0.0 0.1 0.0 Primary balance -0.7 -0.4 -0.6 0.0 0.1 0.0
Real Interest Rate Shock Real Exchange Rate Shock
Primary balance -0.7 -0.2 -0.1 0.0 0.1 0.0 Primary balance -0.7 -0.2 -0.1 0.0 0.1 0.0
Combined Shock
Real GDP growth 7.0 5.1 5.1 6.5 6.5 6.5
Inflation 3.8 5.1 5.1 5.5 5.5 5.5
Primary balance -0.7 -0.6 -0.7 0.0 0.1 0.0
Effective interest rate 6.8 7.1 6.9 7.3 7.8 7.5
Source: IMF staff.
Sri Lanka Public DSA - Stress Tests
Macro-Fiscal Stress Tests
Baseline Primary Balance Shock
Real GDP Growth Shock
Real Interest Rate Shock
(in percent)
Real Exchange Rate Shock
Combined Macro-Fiscal Shock
Additional Stress Tests
Baseline
Underlying Assumptions
Slow adjustment shock
50
55
60
65
70
75
80
2014 2015 2016 2017 2018 2019
(in percent of GDP)
300
350
400
450
500
550
600
2014 2015 2016 2017 2018 2019
(in percent of Revenue)
0
5
10
15
20
25
2014 2015 2016 2017 2018 2019
(in percent of GDP)
50
55
60
65
70
75
80
85
2014 2015 2016 2017 2018 2019
(in percent of GDP)
300
350
400
450
500
550
600
650
2014 2015 2016 2017 2018 2019
(in percent of Revenue)
0
5
10
15
20
25
2014 2015 2016 2017 2018 2019
(in percent of GDP)
SRI LANKA


i-rate
shock
53
Baseline
52
20
30
40
50
60
70
80
90
100
2009 2011 2013 2015 2017 2019
Interest rate shock (in percent)
Sri Lanka: External Debt Sustainability: Bound Tests 1/ 2/
(External debt in percent of GDP)
Sources: International Monetary Fund, Country desk data, and staff estimates.
1/ Shaded areas represent actual data. Individual shocks are permanent one-half standard deviation
shocks. Figures in the boxes represent average projections for the respective variables in the baseline
and scenario being presented. Ten-year historical average for the variable is also shown.
2/ For historical scenarios, the historical averages are calculated over the ten-year period, and the
information is used to project debt dynamics five years ahead.
3/ Permanent 1/4 standard deviation shocks applied to real interest rate, growth rate, and current
account balance.
Historical
51
Baseline
52
0
5
10
15
20
25
20
30
40
50
60
70
80
90
100
2009 2011 2013 2015 2017 2019
Baseline and historical scenarios
CA shock
59
Baseline
52
20
30
40
50
60
70
80
90
100
2009 2011 2013 2015 2017 2019
Combined
shock
57
Baseline
52
20
30
40
50
60
70
80
90
100
2009 2011 2013 2015 2017 2019
Combined shock 3/
30 %
depreciation
77
Baseline
52
20
30
40
50
60
70
80
90
100
2009 2011 2013 2015 2017 2019
Real depreciation shock 4/
Gross financing need
under baseline
(right scale)
Non-interest current account shock
(in percent of GDP)
Growth
shock
54
Baseline
52
20
30
40
50
60
70
80
90
100
2009 2011 2013 2015 2017 2019
Baseline:
Scenario:
Historical:
3.5
3.8
2.6
Baseline:
Scenario:
Historical:
6.5
5.8
6.6
Baseline:
Scenario:
Historical:
-1.2
-2.6
-3.4
Growth shock
(in percent per year)

Projections
2011 2012 2013 2014 2015 2016 2017 2018 2019 Debt-stabilizing
non-interest
current account 6/
1 Baseline: External debt 55.4 62.5 59.6 59.2 58.3 55.9 54.0 53.0 52.4 -4.3
2 Change in external debt 5.2 7.1 -2.9 -0.4 -1.0 -2.3 -1.9 -1.0 -0.6
3 Identified external debt-creating flows (4+8+9) -1.8 4.1 -4.7 -2.1 -1.8 -1.9 -2.1 -2.2 -2.1
4 Current account deficit, excluding interest payments 6.6 5.2 2.2 1.8 1.7 1.5 1.2 0.9 0.8
5 Deficit in balance of goods and services 14.6 13.7 9.6 11.0 10.9 10.7 10.4 9.8 9.5
6 Exports 23.1 22.9 22.6 24.7 25.1 25.3 25.4 25.9 25.9
7 Imports 37.6 36.6 32.2 35.7 36.0 36.0 35.8 35.7 35.4
8 Net non-debt creating capital inflows (negative) -1.5 -1.9 -1.7 -1.7 -1.7 -1.7 -1.7 -1.7 -1.7
9 Automatic debt dynamics 1/ -6.9 0.8 -5.2 -2.2 -1.8 -1.7 -1.6 -1.4 -1.3
10 Contribution from nominal interest rate 1.2 1.5 1.7 1.7 1.7 1.8 1.8 1.8 1.9
11 Contribution from real GDP growth -3.5 -3.5 -4.1 -3.9 -3.5 -3.5 -3.3 -3.2 -3.2
12 Contribution from price and exchange rate changes 2/ -4.6 2.8 -2.9 ... ... ... ... ... ...
13 Residual, incl. change in gross foreign assets (2-3) 3/ 7.0 3.0 1.8 1.7 0.9 -0.4 0.1 1.2 1.6
External debt-to-exports ratio (in percent) 240.0 273.3 263.6 239.5 232.4 221.0 212.4 205.0 202.2
Gross external financing need (in billions of US dollars) 4 11.5 13.0 10.8 10.8 11.1 11.4 11.6 11.9 12.3
in percent of GDP 19.5 21.9 16.2 10-Year 10-Year 15.1 14.3 13.4 12.5 11.7 11.1
Scenario with key variables at their historical averages 5/ 59.2 57.6 54.9 52.9 51.8 51.1 -6.5
Historical Standard
Key Macroeconomic Assumptions Underlying Baseline Average Deviation
Real GDP growth (in percent) 8.2 6.3 7.3 6.6 1.4 7.0 6.5 6.5 6.5 6.5 6.5
GDP deflator in US dollars (change in percent) 10.3 -5.6 4.7 6.7 6.7 0.3 2.5 2.5 2.5 2.5 2.5
Nominal external interest rate (in percent) 2.8 2.7 3.0 2.6 0.5 3.0 3.2 3.3 3.5 3.7 3.9
Growth of exports (US dollar terms, in percent) 22.9 -0.5 11.1 9.1 10.2 17.4 10.7 10.2 9.7 11.0 9.5
Growth of imports (US dollar terms, in percent) 46.2 -2.4 -1.0 12.5 19.6 18.9 10.0 9.1 8.6 8.8 8.4
Current account balance, excluding interest payments -6.6 -5.2 -2.2 -3.4 2.7 -1.8 -1.7 -1.5 -1.2 -0.9 -0.8
Net non-debt creating capital inflows 1.5 1.9 1.7 1.4 0.4 1.7 1.7 1.7 1.7 1.7 1.7
1/ Derived as [r - g - r(1+g) + ea(1+r)]/(1+g+r+gr) times previous period debt stock, with r = nominal effective interest rate on external debt; r = change in domestic GDP deflator in US dollar terms,
g = real GDP growth rate, e = nominal appreciation (increase in dollar value of domestic currency), and a = share of domestic-currency denominated debt in total external debt.
2/ The contribution from price and exchange rate changes is defined as [-r(1+g) + ea(1+r)]/(1+g+r+gr) times previous period debt stock. r increases with an appreciating domestic currency (e > 0)
and rising inflation (based on GDP deflator).
3/ For projection, line includes the impact of price and exchange rate changes.
4/ Defined as current account deficit, plus amortization on medium- and long-term debt, plus short-term debt at end of previous period.
5/ The key variables include real GDP growth; nominal interest rate; dollar deflator growth; and both non-interest current account and non-debt inflows in percent of GDP.
6/ Long-run, constant balance that stabilizes the debt ratio assuming that key variables (real GDP growth, nominal interest rate, dollar deflator growth, and non-debt inflows in percent of GDP)
remain at their levels of the last projection year.
Actual
Sri Lanka: External Debt Sustainability Framework, 2011-2019
(In percent of GDP, unless otherwise indicated)
S
R
I

L
A
N
K
A

1
0

I
N
T
E
R
N
A
T
I
O
N
A
L

M
O
N
E
T
A
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Y

F
U
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Press Release No. 14/371
FOR IMMEDIATE RELEASE
July 29, 2014

IMF Executive Board Concludes 2014 Article IV Consultation and Second Post
Program Monitoring Discussion with Sri Lanka

On July 23, 2014, the Executive Board of the International Monetary Fund (IMF) concluded
the Article IV consultation
1
and second Post-Program Monitoring discussion with Sri Lanka
and considered and endorsed the staff appraisal without a meeting.
2

Sri Lankas economic growth has been one of the fastest among Asias developing
economies in recent years. After falling to 6.3 percent in 2012, real GDP growth accelerated
to 7.3 percent in 2013driven primarily by a pickup in services activity, and supported by
manufacturing and construction, but also benefiting from an increase in net exports. Inflation
has remained low, falling to 4.7 percent at the end of 2013 and to 3.2 percent year-on-year in
May 2014. Fiscal consolidation has continued, with the overall fiscal deficit falling to 5.9
percent of GDP in 2013. A strong recovery in exports in the second half of 2013 and into
2014, combined with declining imports and continued inflow of remittances and services
receipts, has bolstered the balance of payments. Together with issuance of external debt, this
has allowed the Central Bank of Sri Lanka to accumulate international reserves. Monetary
policy has been accommodative, but private credit growth has been slow.

The short-term outlook appears broadly positive, as Sri Lanka is well positioned to benefit
from the global economic recovery and particularly stronger growth in advanced economies.
Real GDP growth is expected to remain robust at about 7 percent in 2014, while inflation is
likely to remain in the mid-single digits. The government has targeted a further reduction of
the fiscal deficit to 5.2 percent of GDP, which should allow for even more reduction of
public debt. With a continued robust export performance, the current account deficit is
expected to narrow further and allow for some additional accumulation of international
reserves.

1
Under Article IV of the IMFs Articles of Agreement, the IMF holds bilateral discussions with members,
usually every year. A staff team visits the country, collects economic and financial information, and discusses
with officials the country's economic developments and policies. On return to headquarters, the staff prepares a
report, which forms the basis for discussion by the Executive Board.
2
The Executive Board takes decisions under its lapse-of-time procedure when the Board agrees that a proposal
canbe considered without convening formal discussions.
International Monetary Fund
700 19
th
Street, NW
Washington, D.C. 20431 USA

2
Near-term risks appear moderate given the ongoing recovery of advanced economies and a
relatively benign outlook for international commodity prices. Adverse climatic events (such
as the recent drought) remain a chronic source of vulnerability. Medium-term risks center on
the potential for slower-than-projected growth in the advanced economies, tighter external
liquidity conditions and chronic turbulence in international capital markets (negatively
affecting rollovers and borrowing costs), and continued weakness in government revenues,
which could threaten fiscal and debt consolidation objectives.

Executive Board Assessment

In concluding the 2014 Article IV consultation with Sri Lanka, Executive Directors endorsed
the staffs appraisal as follows:

Sri Lankas recent economic performance has been better than expectedparticularly given
some headwinds from chronic market turbulence and climatic shocks. While there remain
weak spots in economic activity (such as agriculture, which has been negatively affected by
recent drought), strong activity in traditional sectors such as garment manufacture, and new
sectors such as tourism and services bode well for the near and medium-term outlook. This is
complemented by a sustained reduction in headline and core inflationbringing a new and
welcome level of stability which has hopefully fed into a new set of public expectations
regarding inflation.

The government has remained solidly committed to fiscal consolidation and reduction of
public debt as a mainstay of macroeconomic stability. In this context, and given rising
economic growth, the mission saw the fiscal stance for 2014 as appropriate, but raised
concern about the composition of further consolidation. Capacity in expenditure and
commitment control has increased, enhancing the governments ability to curtail spending to
meet fiscal objectives. However, given sizeable investment needs, the staff was of the view
that spending cuts may have reached their effective limit, and that the burden of adjustment
needed to fall more squarely on increasing revenue. Particularly if Sri Lanka is to maintain
current growth momentum and foster economic development and diversification, high and
sustained levels of public spending on infrastructure and human capital will be essential.
Tackling the issue of tax expenditures and broadening the tax base will be essential. The
mission appreciated the steps taken thus far, but was of the view that the pace of reform in
this area could reasonably be accelerated. There is also room, in the missions view, to take
another look at the medium- and long-term strategy for debt reduction, and consider a more
ambitious debt target (more strongly associated with reduced vulnerability) over a longer
time horizon.

The current, supportive stance of monetary policy is appropriate given the decline in inflation
and weak private credit growth. However, the overall picture is complex and requires close
monitoring. On the one hand, with economic activity apparently on the rise and private

3
credit (outside of pawning activity) beginning to show signs of recovery, the authorities
should be ready to adjust rates as needed to ensure price stabilityparticularly given the long
lags involved in monetary transmission. On the other hand, the current low inflation
environment and the apparent change in inflation expectations offers an opportunity for a
downward shift in the interest rate structure that might benefit the investment environment
(and borrowing costs) over the medium term. Given the mix of signals, a cautious approach
is warranted and the staff believes policy rates should remain on hold for the near term.

Exchange rate policy remains broadly appropriate, but should be monitored in light of
developments in the balance of payments and inflation, and the commitment to flexibility
maintained. Staffs analysis indicates that the exchange rate is broadly in line with
fundamentals, and staff saw merit in central banks purchases to build its reserves, which
remain on the lower end of most reserve adequacy metrics. However, staff also cautioned
that the persistent stability of the rupee (vis--vis the US dollar) that has arisen as a side
effect of foreign exchange absorption by the central bank since the fourth quarter of 2013
carries risks. First, it may create the perception that the rupee is implicitly fixeda point
supported by the shift in exchange rate classification from managed float to stabilized
under the IMFs Annual Report on Exchange Rate Arrangements. This perception could lead
market participants and firms to hold un-hedged foreign exchange risk on their balance
sheets. Second, should external balance continue to improve and inflation stay low, it could
gradually lead to increasing currency misalignment. The central bank should thus be
prepared to allow sufficient exchange rate flexibility to adjust to fundamental pressures,
while limiting intervention to accumulation of reserves and smoothing short-term volatility.

Recent improvements in the trade and current account balances notwithstanding, Sri Lanka
remains vulnerable to external shocks. Medium-term sustainability will depend on
maintaining an outward orientation, diversification of the export structure, and a judicious
use of foreign borrowingparticularly given the rapid increase in debt servicing costs that
have accompanied the shift from bilateral concessional debt to new loans on commercial
terms. The Market Access Debt Sustainability Analysis (MAC-DSA) highlights the
sensitivity of Sri Lankas debt sustainability to growth and foreign exchange shocks. The
staff urges caution with respect to external borrowing through the banking system.

Financial sector consolidation has potential benefits in the form of economies of scale, new
products and services, and a greater resilience (via a stronger capital base) to shocks. The
benefits of consolidation would likely be more rapid if fewer restrictions were placed on
restructuring operations. Continued progress on corporate governance is also key. Close
supervision during and after the consolidation process could also help avoid some of the
pitfalls encountered by other countries in episodes of financial sector restructuring, such as
excessive credit growth. Consolidation may also result in increased concentration and hinder
effective competition if larger and state-owned banks continue to grow and dominate the
banking sector.

4
Sri Lanka: Selected Economic Indicators, 201114

2011 2012 2013 2014

Prel. Proj.
GDP and inflation (in percent)
Real GDP growth 8.2 6.3 7.3 7.0
Inflation (average) 6.7 7.5 6.9 3.8
Inflation (end-of-period) 4.9 9.2 4.7 5.2
Core inflation (end-of-period) 4.7 7.5 2.1 4.3
Savings and investment (in percent of GDP)
National savings 22.2 23.9 27.7 28.6
Government -0.9 -1.2 -0.8 0.4
Private 23.0 25.1 28.6 28.2
National Investment 30.0 30.6 31.6 32.0
Government 6.3 2.3 2.9 3.1
Private 23.6 28.4 28.8 29.0
Savings-Investment balance -7.8 -6.7 -3.9 -3.5
Government -7.3 -3.6 -3.9 -3.0
Private -0.4 -3.0 0.0 -0.4
Public finances (in percent of GDP) 1/
Revenue 14.3 13.0 12.2 13.1
Grants 0.2 0.2 0.2 0.3
Expenditure 21.4 19.7 18.3 18.7
Central government balance -6.9 -6.5 -5.9 -5.2
Central government domestic financing 3.5 2.7 4.6 1.8
Government debt (domestic and external) 78.5 79.2 78.3 76.8
Money and credit (percent change, end of period)
Reserve money 21.9 10.2 0.9 15.0
Broad money 19.1 17.6 16.7 15.1
Domestic credit 34.3 21.7 13.9 11.9
Credit to private corporations 34.5 17.6 7.5 14.9
Credit to government 33.7 29.6 24.6 8.0
Balance of payments (in millions of U.S. dollars)
Exports 10,559 9,773 10,394 11,822
Imports -20,269 -19,190 -18,003 -21,399
Current account balance -4,615 -3,983 -2,606 -2,491
Current account balance (in percent of GDP) -7.8 -6.7 -3.9 -3.5
Export value growth (percent) 22.4 -7.4 6.4 13.7
Import value growth (percent) 50.7 -5.3 -6.2 18.9
Gross official reserves (end of period) 2/
In millions of U.S. dollars 6,749 7,106 7,495 8,380
In months of imports 3.2 4.0 3.5 3.6
External debt (public and private)
In billions of U.S. dollars 32.7 37.1 39.7 42.4
As a percent of GDP 55.4 62.5 59.6 59.2
Memorandum items:
Nominal GDP (in billions of U.S. dollars) 59.2 59.4 66.7 71.6
1/ Revenue and expenditure from 2011 to 2013 may be different from numbers published by Sri Lankan authorities due to
different accounting methodology.
2/ Including central bank Asian Clearing Union (ACU) balances.

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2014 International Monetary Fund

IMF Country Report No. 14/285

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