OREANDA-NEWS. December 11, 2015. Executive Board of the International Monetary Fund (IMF) concluded the Fourth Post-Program Monitoring (PPM) with Sri Lanka.1

Recent economic developments reflect a more challenging external environment as well as a sharpening of macro-financial imbalances that began to emerge late in 2014. During the first half of 2015, growth picked up to 5.6 percent versus 4.5 percent in 2014. Headline inflation fell to -0.3 percent in September before rising to 1.7 percent in October, while core inflation (excluding fresh food, transport, and energy prices) has risen since the beginning of 2015, reaching 4.4 percent in October.

Preliminary data indicate that the government fiscal deficit in the first half of 2015 was 3.7 percent of GDP. Tax revenue collection picked up, but not to the extent assumed in the 2015 budget. The external accounts benefitted from the lower oil price, but higher imports of consumer and investment goods more than offset this effect. Following the reduction of policy rates in April 2015, the Central Bank of Sri Lanka (CBSL) has kept monetary policy unchanged. Successful issuance of a US\\$ 1.5 billion sovereign bond in October helped boost foreign reserves and partially compensate for earlier declines.

The economic outlook remains uncertain, and will depend to a large extent on the course set for economic policies in the coming months. The risks are tilted to the downside. Underlying growth momentum appears relatively firm and the outlook for headline inflation looks contained. However, the large increase in wages and salaries in the revised 2015 budget and lower administered prices have boosted incomes. Together with a reduction in import taxes on vehicles, this has fed through to a sharp rise in imports, a deterioration in the nonoil current account balance, rising core inflation, and continued weakness in the structure of public finances. Further, external risks have risen. Global growth prospects have weakened. Global financial conditions have tightened and may rebalance further when the U.S. Federal Reserve moves to raise interest rates.

Executive Board Assessment

In concluding the Fourth PPM Discussions with Sri Lanka, Executive Directors endorsed the staff’s appraisal, as follows:

Economic growth continued to be fairly strong in 2015, while headline inflation has remained low. The external current account deficit is projected to narrow moderately in 2015, due largely to lower oil prices. Private sector credit growth has picked up sharply in 2015. At the same time, deterioration in the overall balance of payments, the loss of central bank foreign exchange reserves, the weak state of public finances, and growing public debt are reasons for concern.

Despite continued access to international debt markets, these trends suggest that financial risks for Sri Lanka have increased. To mitigate these risks, the authorities should take appropriate corrective actions to safeguard macroeconomic stability and lay the foundation for durable and inclusive growth. Improvements in the business climate, reform of state owned enterprises, and a more open trade regime are key to boosting competitiveness and growth.

In view of high public debt, fiscal developments this year pose a risk to the economy and call for ambitious measures in the 2016 budget to put Sri Lanka’s fiscal position on a more sustainable footing. Sri Lanka has a very low tax-to-GDP ratio, and high levels of current expenditure constrain needed development spending, limit policy space, and threaten debt sustainability. Therefore, a comprehensive reform of tax policy and administration, and a prompt resumption of fiscal consolidation supported by increased revenues should be a key policy priority.

With the recent acceleration in private sector credit growth and rising core inflation, there is now little scope for further monetary easing. Most factors—including the deterioration in the balance of payments and pressures on the rupee—suggest that the CBSL should be prepared to tighten monetary policy in the coming months, albeit at a gradual pace.

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

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