On October 17, 2008, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Sri Lanka and commended Sri Lanka’s recent economic performance and endorsed Sri Lanka’s macroeconomic policies under the Ten-Year Development Plan. At the same time, they drew attention to some emerging risks arising from the recent financial crisis. The Key points of the Public Information Notice, which sets out the IMF Staff Assessment and the Executive Board Assessment, are summarized below.

IMF Staff Assessment

•    Sri Lanka has achieved strong growth averaging 6½ percent since 2002, raising per capita income to about $1,625 (above regional peers) and reducing the poverty rate from 22.7 percent to 15.2 percent over 2002-07. The authorities' Ten-Year Development Plan ("Mahinda Chintana") launched in early 2007 aims to sustain this performance by strengthening infrastructure investment.

•    Rapid growth, together with rising fuel and food prices, has accelerated the inflation uptrend that began in 2006. The year-on-year (yoy) rate of inflation has edged down to 25 percent in August, but core inflation has risen and headline inflation has remained above the rates prevailing in Sri Lanka's major trading partners and in the region.
•    In 2007, the continued brisk pace of exports resulting from high international tea prices, improved EU access for garments exports, subdued imports, and strong remittances bolstered the current account, with the deficit more than financed by rising capital inflows. Gross official reserves rose from US$2.5 billion at end-2006 to US$3.1 billion as of end-2007. In 2008, however, soaring oil prices sharply increased the oil import bill, amid softening external demand and worsening external financing conditions. The external current account deficit is projected to widen sharply in 2008.

•    Public debt/GDP edged down in 2007 and is expected to decline further in 2008, reflecting favorable debt dynamics and rupee appreciation. However, increased use of foreign-currency financing poses significant risks. Foreign borrowing reflects a strategy to reduce domestic crowding out, but a widening current account deficit and bunching of near-term debt repayments suggest growing gross external financing needs at a time when global credit markets are unsettled and likely to remain so.

•    Sri Lanka's domestic financial markets have been largely immune to the global financial turbulence. Sri Lankan institutions reportedly have little or no direct exposure to U.S. sub-prime assets, while a significant portion of net foreign inflows reflects investments by non-resident Sri Lankans.

 Executive Board Assessment

•    The Executive Directors have commended Sri Lanka for its impressive record of economic growth over the last few years, with the rate of unemployment and poverty indicators falling. The authorities' bold decision to adjust administered fuel prices, transport fares, and electricity prices has also been commended as a decision that will reduce fiscal risks over the medium term. Directors welcomed the significant tightening of monetary policy to address inflationary pressures.

•    However, the Directors have expressed concern that the combined build-up of macroeconomic imbalances, balance sheet vulnerabilities, high inflation, and external financing pressures poses serious risks to economic stability. The recent increases in international food and fuel prices and the global financial crisis have heightened the challenge facing the authorities. Amid increased international risk aversion, raising external finance will become increasingly challenging, and Sri Lanka's external accounts are vulnerable to a reduction in international investor risk appetite.

•    At the same time, the Directors have welcomed the authorities' plans for medium-term fiscal consolidation, as envisaged in the Fiscal Responsibility Act, and called for their decisive implementation in order to reduce pressure on the external account, inflation, and the exchange rate. They have also encouraged the authorities to implement promptly, measures aimed at broadening the tax base by significantly rationalizing exemptions and restraining current spending. The resulting fiscal space should be used to preserve infrastructure spending.

•    The Directors have also commended the authorities for exercising significant restraint with respect to reserve money growth, and encouraged further monetary policy tightening to help anchor inflation expectations.

•    In addition, the Directors welcomed the authorities' efforts to strengthen the financial system, including the recent measures to address the maturing credit cycle, the progress made in implementing Basel II, the introduction of corporate governance guidelines for banks, and tighter oversight of state banks. They have also indicated that reforms to financial supervision and regulation should continue.

CENTRAL BANK OF SRI LANKA
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