On June 1, 2018, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation [1] with Sri Lanka and completed the fourth review under the Extended Arrangement under the Extended Fund Facility (EFF). [2] Completion of this review makes available SDR 177.774 million (about US$ 252 million). The EFF arrangement in a total amount of SDR 1.1 billion (about US$1.5 billion, or 185 percent of quota) was approved on June 3, 2016 (see Press Release No. 16/262).

The Sri Lankan economy is expected to normalize gradually. Following subdued growth in 2017 due to the lingering effects of weather-related shocks, a recovery is underway as agriculture has started to rebound and growth in exports remains robust. Real GDP growth is expected to reach 4 percent in 2018 and around 5 percent over the medium term. The Central Bank of Sri Lanka (CBSL) has effectively curbed credit growth and stabilized inflation, despite recent pressures. However, the economy remains vulnerable to adverse domestic and external shocks, given the still sizable public debt, large refinancing needs, and low external buffers.

Performance in the first half of the EFF program has remained broadly on track. Despite some implementation delays and weather-related shocks, the authorities achieved a primary surplus in 2017, through expenditure management and revenue mobilization. The CBSL conducted monetary policy prudently, bringing inflation back within its band. Taking advantage of favorable market conditions, the CBSL also stepped up its pace of reserve accumulation in 2017.

The authorities have achieved major milestones in their reform agenda. These include the launch of the new Inland Revenue Act, important progress with SOE and energy-pricing reforms, as well as adoption of the CBSL’s Roadmap to flexible inflation targeting. Going forward, the authorities should push ahead with their “Vision 2025” objectives, by further advancing fiscal consolidation through stronger fiscal rules and SOE governance; modernizing monetary and exchange rate frameworks; accelerating their inclusive growth reform agenda through trade liberalization, climate budgeting, and greater female labor force participation, as well as better-targeted social protection programs. Keeping the reform momentum is key to increase Sri Lanka’s resilience to external shocks and lay the foundation for more sustainable and robust growth.

Executive Board Assessment [3]

Executive Directors commended the progress made by Sri Lanka under the Fund-supported program. Directors welcomed the authorities’ efforts to improve the policy mix through continued fiscal consolidation, prudent monetary policy, and landmark structural reforms. However, they noted that the economy remains vulnerable to adverse shocks given the still sizable public debt, large refinancing needs, and low external buffers. Against this background, Directors welcomed the authorities’ commitment to the program and agreed that sustained reform momentum is critical to safeguard the economic gains to date, strengthen resilience, and support inclusive growth.

Directors welcomed the launch of the new Inland Revenue Act (IRA) to support the authorities’ fiscal consolidation efforts. They emphasized that progress with revenue mobilization can help safeguard important social and infrastructure spending, including in response to natural disasters. They also underscored the importance of enhancing public investment efficiency. In this area, they emphasized the need for systematic and transparent project appraisal and selection of large-scale investment projects, ensuring consistency with fiscal targets and mitigation of fiscal risks, given the country’s still high public debt. Going forward, Directors supported the authorities’ commitment to anchor debt reduction plans through a robust fiscal rule and medium-term debt management strategy.

Directors saw the recent approval of an automatic fuel pricing formula as a major achievement towards reducing the still elevated fiscal risks posed by state-owned enterprises (SOEs). They encouraged the authorities to complete energy pricing reforms with an automatic pricing formula for electricity, implement a restructuring plan for Sri Lankan Airlines to put it on a solid commercial footing, and further strengthen SOEs governance and transparency. Directors welcomed ongoing efforts to strengthen social safety nets to help mitigate the distributional impact on the most vulnerable.

Directors concurred that the Central Bank of Sri Lanka (CBSL) should continue to manage monetary policy prudently, following a data-dependent approach, in the face of inflationary pressures and market volatility. Directors underscored the need for continued efforts to build up international reserves and that exchange rate flexibility should be the first line of defense against volatile global capital flows. Directors welcomed the CBSL’s roadmap to flexible inflation targeting and the planned amendments to the central bank law to further strengthen the CBSL’s mandate, governance, and autonomy.

Directors welcomed efforts to further strengthen the resilience of the financial sector, including with Basel III implementation. They noted that macro-prudential tools could be used to rein in excessive credit growth in the real estate sector and encouraged the authorities to address identified weaknesses in non-bank financial institutions. They commended ongoing efforts to improve the AML/CFT regime and looked forward to timely implementation of FATF-compliant laws and regulations.

Directors underscored the importance of implementing growth-enhancing structural reforms as outlined in the authorities’ medium-term strategy. They recommended gradual liberalization of the trade regime and further improvements to the investment climate, including through robust implementation of the new IRA. To foster inclusive growth, Directors encouraged additional measures to enhance the effectiveness of social safety nets and female labor force participation through labor market reforms and gender budgeting. They also noted that a well-designed natural disaster risk financing framework can help Sri Lanka address costs associated with climate change.