Ceylon - Development Finance Corporation Project

RESTRICTED FILE COPY Report No. p-570 This report was prepared for use within the Bank and its affiliated organizations. They do not accept responsibility for its accuracy or completeness. The report may not be published nor may it be quoted as representing their views. INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT REPORT AND RECOMMENDATION OF THE PRESIDENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED LOAN TO THE DEVELOPMENT FINANCE CORPORATION OF CEYLON November 1, 1967  INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT PRESIDENT'S REPORT AND RECOIMiENDATION TO THE EXECUTIVE DIRECTORS ON A PROPOSED LOAN TO THE DEVELOPM4ENT FINANTCE CORPORATION OF CEYLON 1. I submit the following report and recommendation on a proposed loan in an amount in various currencies equivalent to US$4 million to the Development Finance Corporation of Ceylon (DFCC). PART I - HISTORICAL 2. In 1965, after about h years during which Ceylon's econormic policies precluded any new lending by the Bank or IDA in the country, the Bank Group once more began 4o consider how it might assist Ceylon. This was part of a wider effort by a number of aid-giving countries to provide Ceylon with help in the form of emergency assistance to combat a serious balance of payments crisis and in the form of long-term finance for well conceived projects. At the request of the Government the Bank sent a number of missions to Ceylon in late 1965 and early 1966 to review the various sectors and to identify possible projects suitable for external financing. Amongst these was an IFC mission which visited Ceylon in November/December 1965 and reviewed the operations of DFCC. This mission recommended that DFCC would be a suitable recipient of a Bank loan. 3. The Bank was unwilling to consider further lending in Ceylon, however, until the Government had talcen action to restrict food subsidies to existing levels and thereby eliminate the built-in annual increase in Government expenditure for this purpose. Such action was announced in the Budget Speech of July 1966. 4. There were further discussions with Government representatives at the time of the 1966 Annual Meeting and some subsequent correspondence to clarify certain points. The invitation to negotiate a Bank loan was sent in December 1966. 5. Negotiations took place in Washington between Mlarch 22 and March 31. DFCC negotiators were led by Mr. L. A. Weerasinghe (General Manager) and the Government was represented by H.E. The Ambassador of Ceylon and Mr. Michael Seneviratne of the Ministry of Planning and Economic Affairs. It was decided to delay presentation of the proposed loan to the Executive Directors until the services of an advisor for DFCC had been secured. This condition has now been satisfied.  -2- 6. The proposed loan would be the Bank's fourth in Ceylon, the previous three being power loans made between 1954 and 1961. The following is a summary statement of Bank loans to Ceylon as at September 30, 1967: Loan No. Year Borrower Purpose (U.S. $ million) 101 CE 1954 Government of Ceylon Power 15.9 209 CE 1958 Government of Ceylon Power 7.3 283 CE 1961 Government of Ceylon Power 14.1 Total (less cancellations) - all fully disbursed 37.3 of which has been repaid to Bank and others 8.3 Total now outstanding 29.0 Amount sold 3.1 of which has been repaid 2.3 0.8 Total now held by Bank 28.2 7. There are no prospective Bank or IDA operations in Ceylon which will be ready for the Executive Directors' consideration within the next few months. The next operations are expected to be a lift irrigation pro- ject and possibly a drainage and reclamation project which are now being appraised and a highway maintenance project which is being prepared with the help of consultants financed by a Bank Technical Assistance grant. PART II - THE ECONO0iY 8. An economic report entitled "Current Economic Position and Pros- pects of Ceylon" (No. AS-126a) dated May 10, 1967, was distributed to the Executive Directors on Hv1ay 16, 1967. 9. In the years 1961 to 1965, the Government followed economic policies that precluded Bank or IDA operations in Ceylon. These policies were unsatisfactory because, broadly speaking, they entailed a large measure of financial instability and were not conducive to producing a reasonable rate of economic growth. They stressed income re-distribution in favor of the lower income groups rather than economic growth, aid sought to insulate the majority of the population from the effects of slow growth, aggravated  by adverse movement of the terms of trade. Outlays on various subsidy programs and the provision of a wide range of services free of charge or below cost raised current outlays rapidly, requiring taxation to be in- creased at the expense of private savings. Even so, a large inflationary budget deficit emerged. As a result, purchasing power rose faster than real income, and imports, in excess of export earnings and capital inflows, were sucked in to fill the gap. Reserves were rapidly depleted and import restrictions were imposed. These were successively tightened after 1960 and in later years fell increasingly heavily on imported intermediate and capital goods. Growth suffered seriously and capital assets were run down. Saving and investment in Ceylon declined, and the quality of investment deteriorated. Economic activity by the private sector was severely cur- tailed.. In the public sector, large sums were allocated for relatively unproductive projects with a large social welfare element. 10. In brief, no program of action for dealing with the problems which Ceylon faced emerged in these years. On most important fronts, action was considered politically impossible. What measures were taken, particularly with respect to the exchange situation, were insufficient to halt further deterioration. Exchange reserves were virtually exhausted and the country faced a severe economic and financial crisis. 11. The present Government took office in I-liarch 1965 in the middle of this crisis. At its invitation the Bank sent an economic mission to Ceylon in June 1965 to discuss the situation and suggest possible lines of action which might help move the economy forward. In July 1965, the Bank organized the first meeting of a group of countries interested in assisting Ceylon. Since then, a series of Banlk economic and technical missions have visited Ceylon to continue the dialogue on economic policies with the Government and to prepare reports for the Aid Group. From these analyses and discussions emerged a plan of action which rested on joint efforts by the Government and the donors. The Government, for its part, has made a strong effort to improve the policy framework in which the economy operates. The growth of monetary demand has been checked, largely as the result of a reduction in the inflationary budget deficit achieved by curbing the rate of expansion of current expenditures. The action taken last December to halve the sub- sidized rice ration promises to free more resources for investment. At the same time, the Government has used import programs to an increasing extent as a means of curbing imports of consumer goods, encouraging domestic produc- tion of import substitutes, and making the largest possible amount of exchange available for productive uses. Hlore scope has been given to private invest- ment and public investment programs are being more carefully examined with an eye to their economic benefits. 12. The Aid Group has met three times and a considerable amount of aid has been committed. However, disbursements have been rather slow  -4- because the usual problems of using aid tied to procurement of specific commodities in specific countries were encountered. The difficulties caused by these delays were aggravated by poor crops, caused by bad weather in two consecutive years, and a sharp drop in export earnings in 1966. For these reasons, Ceylon's economic recovery has not come up to earlier expectations, despite the creditable improvemiient in performance. Furthermore, exchange reserves have once again fallen to an uncomfortably low level. Since the end of 1965 gross reserves have fallen by about $16 million to $76 million (about 1