Ceylon - Review of the economic situation and foreign exchange problem (Vol. 1 of 2)

RESTRICTED Report No. AS- 1 18a 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 The report may not be published nor may it be quoted as representing their views.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 INTERNATIONAL DEVELOPMENT ASSOCIATION REVIEW OF THE ECONOMIC SITUATION AND FOREIGN EXCHANGE PROBLEM OF CEYLON (in two volumes) VOLUME I MAIN REPORT December 1, 1966 Asia Department  CURRENCY EQUIVALENTS Currency Unit - Ceylon Rupee US $1 = 4.76 Rupees 1 Rupee = US $0. 21 1 Million Rupees = US $210, 000  This report was prepared by a mission comprising Messrs. Manfred G. Blobel (Chief of Mission), William S. Humphrey, Raihan Sharif, Herman G. van der Tak and Basil G. Kavalsky.  TABLE OF CONTEMTS Page No. BASIC DATA SUMMARY AND CONCLUSIONS i - iv I. THE ECONOMY OF CEYLON IN 1966 - 1 - 19 PROGRESS AND PROBLEMS Introduction 1 The Problem of Savings 3 The Problem of Investment 9 The Problem of Foreign Exchange 12 The Problem of Economic Management 16 II. DEVELOPMENT PROGRA4S AND PROJECTS 20 - 35 The Framework for Development, 1966-1971 20 Agriculture 21 Fisheries 31 Manufacturing 32 Other Sectors 35 III. AN EIPORT PROGRAM AND BALANCE OF PAYMENTS 36 - 44 FORECAST FOR 1967 The Import Program 36 The Balance of Payments 41 AnNEX I THE COMIMODITY AID PROGRAMS STATISTICAL APPENDIX  BASIC DATA Area: 25,332 square miles Population: (1965) 11,228,000 Rate of Growth 2.4% p.a. Population Density (per sq. mile): 443 Population Density (per sq. mile of arable land) 1964: 1,100 Gross National Product (1965): Rs. 7882 million Rate of Growth (1965): 2.0 Rate of Growth (1960-1965): 3.0 Real Income Growth (1960-1965): 2.0 GNP per capita: US$ 142 equivalent at official exchange rate Gross Domestic Product at Factor Cost (1965) Rs. 7,404 million of which, in percentage, Agriculture: 41 Manufacturing: 8 Construction: 6 Public Administration: 7 MIiscellaneous Services: 38 Percent of GDP at Market Prices 1965 1959-1964 Gross Investment: U 15 Gross Savings: 12 13 Balance of Payments Current 1/ Account Deficit: 0 2 Investment Income Payments: less than 1 less than 1 Government Revenue: 24 22 Resource Gap as % of Investment: - 1/ 13 Sept. 30, 1966 Average Annual change 1961-1966 (in , ) Total Money Supply: 1678 6.6 Time and Savings Deposits: 604 14.8 Bank Credit to Public Sector: 2110 14.5 Bank Credit to Private Sector: 762 9.5 Rate of Change in Prices: o 0.6 1.3 (Official Cost-of-Living Index) 1965/66 1960/61-1965/66 Public Sector Operations (Rs million) Government Current<Receipts: 1798 4.9 Government Current Expenditure: 1747 5.0 Surplus or Deficit: 51 - Government Capital Expenditure: 573 2.1 Total External Assistance to Public Sector (net): 87 1/ In 1965 deficit was negligible. (cocntinued)  jBas.c Data continued) External Public Debt (US$ million) Oct. Average 1966 1961-1965 Total Debt Outstanding 174 105 Total Annual Debt Service 13 8 (max.1969) Debt Service Rate 3.5% 2.0% Balance of Payments (US$ million) 1966 1965 (est.) Total Exports 368 402 Total Imports 448 403 Net Invisibles -14 -2 Net Current Account Balance -94 -3 Increase in Exchange Reserves (-) 23 -22 1966 1965 1954-56 (est.) Commodity Concentration of Exports (3 major exports) 92% 93% 94% (in US$ mill.) end September 1966 Gross Foreign Exchange Reserves 72 92 154 Net Foreign Exchange Reserves n.a. 28 131 Average External Financial Assistance 1966 1965 196A-64 (US$ million) (est.) Total Disbursements 73 29 20 Grants 4 13 10 Loans 69 1/ 16 10 1/ Includes disbursements of $53 million under 1st and 2nd Commodity Aid Programs.  SUMMARY AND CONCLUSIONS 1. About 20 months have now passed since the present Government took office, and about a year and a half have gone by since the Aid Group first met to consider financial assistance for Ceylon. In the meantime, nearly $100 million in aid has been committed. In addition, the INF has permitted net drawings on its resources to the extent of $29 million. Once again, Ceylon is now approaching members of the Aid Group with a request for a large amount of aid to help carry forward in 1967 the joint effort to promote the recovery and growth of its economy. 2. This is the third successive report to aid-giving countries on Ceylon's economic progress and aid requirements. In its evaluation of Ceylon's part in this joint effort, this report concludes that in those policy areas con- sidered most essential in previous reports for overcoming the immediate ob- stacles confronting the economy, creditable improvements in performance have been achieved. In many important aspects, the state of the economy in late 1966 has advanced markedly over the condition as it existed in mid-1965. At that time, the framework of economic and financial policies, which had been inherited from the previous Government, hindered, rather than helped, making the best use of the Country's resources for economic development. In the past 18 months, this situation has improved significantly. Although many of the changes, that have occurred, may be small by themselves, together they amount to a marked shift in emphasis in the Government's economic and fi- nancial policies--a shift towards policies designed to promote growth and away from almost exclusive concern with income distribution and welfare. As might be expected in any effort to achieve qualitative changes of such magnitude, there are import areas where improvements have lagged and where therefore difficult problems remain to be resolved. But on the whole progress has been such that the economy should be able in 1967, provided aid-giving countries are prepared to help, to move in many important respects out of the emergency phase, that characterized events so far, into the development phase. At this juncture, the present report attempts to take stock of the accomplish- ments, of the obstacles that have prevented faster economic growth, and of the essential problems that remain to be solved. 3. When this joint effort of Ceylon and aid-giving countries began, the economy had passed through nearly a decade during which most indicators of Government performance pointed downward. This trend has been halted and, in important aspects, reversed. Recourse to bank borrowing for financing the budget deficit has been considerably reduced to a level, where it no longer serves as the source of expanding domestic purchasing power far in excess of the growth of resources. Increases in current outlays of the Government have slowed down markedly, and the commitment to contain net food subsidies at the 1965/66 level offers the promise of holding the expansion of current expenditure to a rate which should provide increasing domestic resources for investment. On the revenue side, the effective income tax burden was reduced, and the incidence of taxation has begun to shift towards indirect taxes, i.e., towards consumption. Import programs, prepared in consultation with the Bank, have been established, and adhered to, with the objective of making as much exchange as possible available for productive uses.  -ii- 4. Progress has also been made more directly in laying the basis for accelerated economic growth. A planning ministry has been established which, though still suffering from a shortage of personnel, is competently staffed and is making its influence felt in rationalizing economic policies and improving the quality of investment. Agricultural development policy, which used to center, to the detriment of growth, on the construction of large irrigation works and costly settlement schemes, almost exclusively devoted to paddy, is being re-directed towards more productive ends, with respect to both the type of program and the emphasis given to other crops. In the field of public industry, action is being taken to make better use of existing invest- ment, and new proposals are more carefully screened, with emphasis being placed on the most urgent and promising investments. More scope has been given to private initiative, both domestic and foreign, in the development of manufac- turing industries. Furthermore, in order to help speed up the pace of domestic agricultural development, particularly in the production of subsidiary food- stuffs which are presently imported, sizeable tracts of public land have been leased to private interests for cultivation on a commercial scale. 5. All these are important advances which add up to a creditable performance on the part of the Government, and the fact that large obstacles still stand in the way of accelerating economic growth should not detract from these achiev ments. The most important among these obstacles appears to be the Government's continuing policy of holding down the cost of living by means of price con- trols and various ration schemes for items considered essential. As a result of this policy, there are now large areas in the economy of Ceylon where the price system is so distorted that it no longer serves as a meaningful indicator of scarcities, and where prices are too low to encourage local production. In some areas, the Government has attempted to overcome the disincentive effect by setting a higher producer price and by paying for the difference in the fornt of subsidies. However, this is obviously not a remedy that can be applied over a wide range of goods, and existing subsidies should be curtailed rather than expanded. Thus, the Government's policy towards consumer prices will have to be changed if growth is not to be stymied. Another area, where improvements have not yet gone far e nough is the use of public investment resources. H e se} there is still the tendency to start too many projects in too many parts of the country. As a result, scarce administratSv e technical and construction capacity tends to be dissipated, leading to long periods of construction before investment begins to yield productive returns. Improvements in these areas form an essential part of the program of action in the future, but their ab- sence so far cannot be regarded as the chief obstacle to faster recovery during the past year. 6. Shortfalls in aid flows below earlier expectations were largely respon- sible for improvements in policies not being translated into economic recovery as quickly as one might have hoped. Resources, and in Ceylon at this stage this means primarily foreign exchange, are the means of translating decisions on policy and on investment into reality. Ceylon has not yet resources that would have provided the necessary room for maneuver. Substantial commitments of aid, totalling Rs. 435 million, were made. However, in 1966 at most Rs. 250 million of aid goods are likely to arrive. Moreover, a good part of this amount, particularly industrial raw materials and machinery, will arrive only towards the end of the year, so that their impact on supplies and on domestic production in 1966 will be small.  -iii- 7. Delays in the arrival of aid goods not only affected adversely the pace of economic improvement, but they also had repercussions on Ceylon's reserve position. At the same time, Ceylon once again was hit by a sharp drop in export prices, and coconut exports were considerably reduced by the effects of a prolonged period of drought. These factors caused export earn- ings in 1966 to fall Rs. 160 million, or 8.5%, below the 1965 level, and to fall short by Rs. 80 million of estimates made earlier in the year. As a result, reserves will probably decline by Rs. 110 million in 1966 and liquil reserves will once again be down to a level where they provide hardly any pro- tection against the contingency of payments running ahead of earnings even for a brief period. 8. As for 1967, export earnings will probably continue to suffer from de- clining terms of trade. They are thus unlikely to recover to the trend value estimated in earlier Bank reportsbut again fall short by roughly Rs. 80 million. Furthermore, net receipts from external financial assistance, in- cluding project and commodity aid as well as drawings on the IMF, will on the basis of agreements presently in force or in prospect amount to only Rs. 200 million, in contrast to twice that amount in 1966. This means unless new aid is provided, Ceylon will have available for imports in 1967 only Rs. 1,870 million. This would be Rs. 300 million, or about 15% less than was available in 1966. In fact, related to imports of non-food goods, the reduction in prospect is as much as one-third. Clearly imports at such a level would be incompatible with achieving the pace of growth which the Aid Group was initially set up to promote. M4oreover, all progress made so far in using the import program as an effective tool for remodeling the economy, would be lost if the import budget reverted to a position where it merely administered scarce imports of consumer goods. 9. The mission therefore examined, with officials of the Government of Ceylon, what would be the minimum need for imports of goods for productive purposes, i.e., of intermediate and capital goods, that would allow full utilization of existing productive capacity and permit new investment to be undertaken which seemed economically justified and within the capacity of the economy to carry out. It became qiite clear that these import require- ments would lead to an unmanageably large uncovered deficit in the balance of payments, if at the same time the import needs associated with the other economic and social ends of the Government-- e.g. stable prices, avoidance of temporary or scattered scarcities of basic consumer goods, execution of public programs as contained in the 1966/67 budget--were also to be met. The mission therefore explored with the Ceylon authorities where cuts could be made in the provisional estimates of import requirements for other than productive purposes. This involved a review of two principal areas. First, public expenditure proposals were scrutinized with a view to eliminating exchange outlays on items of lesser priority. Second, import needs of consumer goods wore examined with a view to identifying areas where total supply could be reduced without affecting basic needs or where,with some risk of temporary shortages, supply could be maintained with lower imports of finished products in anticipation of increased domestic production. In the process, roughly Rs. 220 million were cut from the provisional import budget.  -iv- 10. The result was an imrport program amounting to Rs. 2,245 million, before new project aid which is only marginally higher than estimated actual imports in 1966 of Rs. 2l129 million, but Rs. 375 million higher than Ceylon could afford on the basis of its own exchange earnings and aid presently in sight. It is an import program which would allow Ceylon to take a significant step forward in overcoming the emergency phase of its economic recovery, while it would hold down imports of finished consumer goods, including food. It is therefore, in a true sense, a policy instrument, designed to make good use of the scarcest good in the economy, namely foreign exchange. Moreover, the proposed import program has been approved, with minor modifications, by the Cabinet. 11. Because of the effect on Ceylon's export earnings of expected further declines in export prices and of lower exports of coconut products--resulting from drought, and because of Ceylon's inability to continue drawing on its exchange reserves as it did in 1966, the import program can only be carried out if new commodity aid in the amount of roughly $80 million is made avail- able for disbursement in 1967. Not all of this aid may need to come from aid- giving countries as the IMF may be able to make a contribution under its compensatory financing scheme. However, to the requirement of commodity aid will have to be added a commitment of about $30 million for projects which seem economically justified and could be fully prepared in 1967, although it is unlikely that disbursements during thefirs t year will be large. 12. Altogether, this is unquestionably a large request for new aid for 1967. When the estimated spill-over of aid from 1966 is added, total aid disbursements required in 1967 would amount roughly to $130 million. This would bring total financial assistance received from members of the Aid Group and the IMF to about $210 million in the two-year period 1966-1967. Yet no evaluation of Ceylon's aid requirements can overlook the fact that of this total assistance of $210 million, including the request for 1967, only about 70%, or about $75 million a year, would represent genuine additions to Ceylon's exchange resources. The remainder would merely compensate for the decline in export earnings below the 1965 level, resulting from the decline in export prices and the effect of a prolonged drought on exports of coconut products. In any case, it is clear that unless the aid requestedfor 1967 is forthcoming, Ceylon has little chance of devoting sufficient resources to development--which has been the objective of her efforts to improve performance.  CHAPTER I THE ECONOMY OF CEYLON IN 1966 - PROGRESS AND PROBLEMS Introduction 1. The economy of Ceylon during the present decade has been charac- terized by the stagnation of real incomes per head of population, a severe foreign exchange shortage and a decline both in relative and abso- lute terms, in private investment. The economy has traditionally been based on export agriculture, particularly tea production and to a lesser extent rubber and coconuts. Falling prices of these commodities have meant that, in the last few years, expanding Ceylonese production has resulted only in fairly constant foreign exchange receipts. The adjust- ment to the new situation where a proportionately greater amount of local demand for goods and services would have to be met by local production created great difficulties in the sensitive political environment of Ceylon. The situation was made worse by the fact that increased govern- ment expenditures were met by expansionary financing which gave rise to heavy consumer demand relative to the fairly low controlled prices at which many key consumer goods were being sold. In order to meet the problem of shortages of items of mass consumption, the roughly constant amount of available foreign exchange was re-distributed between its various uses, with the private sector being particularly restricted in the amounts of machinery and raw materials it could obtain. 2. This difficult problem was further aggravated by the government's policy of income re-distribution. High expenditures for social purposes were supplemented by large subsidies to consumers for the purchase of basic food items. These were met by heavy progressive taxation, high rates of company taxation, and high import and export duties. The effect of this was to re-distribute a fairly constant total real income from investment to consumption. This procedure once started tended to be self- perpetuating. As investment was reduced, income grew more slowly; and, in order to ensure at least constant if not increased per capita con- sumption for a rapidly growing population, it was necessary to re- distribute income away from investment still further. Political pres- sures led also to a vast expansion of the public sector financed not so much by reducing private consumption as by channeling private savings into the financing of government expenditure. The nadir of the whole situation was reached in early 1965 when the new Government found itself faced with a foreign exchange crisis which could only be managed through destructive cuts in imports of investment goods which did not even permit the adequate maintenance of existing capital.  -2- Resources and Their Utilization (Current market prices; Rs. million) 1961 1962 1963 1964 1965 Resources GDP 6748 6909 7050 7537 7781 Imports 1972 2070 2031 2102 2057 Total 8720 8979 9081 9639 9838 Utilization Consumption 5766 5978 6181 6719 6833 Investment 1047 1030 999 982 924 Exports 1907 1971 1903 1937 2081 Total 8720 8979 9081 9639 9838 3. It was in this context that a meeting of aid-giving countries was convened in mid-1965. It was hoped that an inflow of commodity aid would -oermit the government room for maneuver sufficient to allow for some liberalizing of imports for investment purposes, and contribute, together with measures on the home front on the part of the Government, to a reversal of the trend. 4. Successive World Bank missions in 1965 and 1966 discussed with the Government the economic impasse of Ceylon and possible lines along which the economy might be moved forward. From these analyses and discussions emerged a pattern of action which rested on joint efforts being made by the Government and the donors. On the part of the Government, action was required in four directions: (a) to curtail the growth of monetary demand so as to keep it in line with the supply of locally produced and imported goods; (b) to reduce as much as feasible the growth of consump- tion expenditure, particularly on imported goods, so as to minimize the absorption of local and foreign resources by consumption and thus to reverse the trend towards a declining investment rate; (c) to raise the volume and improve the pattern and quality of investment and related developmental expenditures so as to accelerate the rate of growth of output and to improve the balance of payments; (d) as one of the principal means of achieving the objectives listed under (b) and (c), to adopt import pro- grams which made rersaableuse of the exchange resources available. On the part of the donors, what was called for was a level of aid flows which was sufficient, within the framework of agreed import programs, to provide the room for maneuver required for making more exchange resources avail- able for productive purposes pari passu with the changes effected by the Government in the use of resources, because at least for the next few years lack of foreign exchange was considered the principal constraint to achieving more rapid growth.  -3- 5. This is the third successive report analyzing the progress and problems of the economy of Ceylon. As will be discussed in the following sections, there has been notable progress, since the first of these reports was written in mid-1965, in most directions where progress was considered essential for overall improvement of the economy. One aspect of developments during the last eighteen months is particularly encour- aging. This is the imporvement that has taken place in the institutional framework and psychological atmosphere in which economic policy is operating in Ceylon. For the performance of Ceylon's esonomy, these facets are perhaps even more important than specific acticns because in the long run they will largely determine the quality of economic policy and condition the response of the ecoioxmy. Yet progress and problems in this area tend to be overlooked in an appraisal of performance because they are less visible than the results of specific actions. The Problem of Savings 6. Among the causes of Ceylon's unsatisfactory record of economic growth and chronic financial disequilibrium in the past, the inadequency of savings was identified as one of the crucial weaknesses. Ceylon's savings performance was judged inadequate not so much by comparison with that of other countries with similar per-capita incomes. In fact, such comparisons for any one year showed Ceylon's performance to be reasonably good. Yet there were two disturbing aspects of savings in Ceylon. First, judged by the productive return in terms of growth from the investment into which these savings were transformed, a much higher proportion of income needed to be saved and invested in order to achieve a satisfactory rate of growth. Secondly, for the past decade or so, the share of income saved declined. Clearly, continuation of this trend was not com- patible with any sustained effort to accelerate growth. In 'Large part, the causes of this deteriorating savings performance were beyond Ceylon's control. Declining terms of trade ate up a large part of the slow growth that occurred in real product, as is apparent in the following table: Growth in Real Product and Real Income (Rs. million) 1960 1961 1962 1963 1964 1965 Real Product 212 174 232 127 289 136 Loss through declining terms of trade -11 -14o +69 -160 -74 +7 Real Income 201 34 301 -33 215 143 Source: Appendix Table III In other words, declines in the terms of trade absorbed over one- fourth of the growth in real product during this period, so that real income grew by only 2.3% a year while real product rose by 3.1%.  Such losses were bound to affect savings, particularly as they hit the incomes of the plantation sector which is Ceylon's largest potential source of savings. 7. However, this basic difficulty of maintaining and possibly increasing savings in the face of declining terms of trade was greatly aggravated by the financial policies of the Government. These were directed largely towards re-distributing incomes in favor of the lower income groups, particularly in the forms of direct subsidies of consumption and the provision of an expanding range of services free of charge or below cost. Financing these various pro- grams resulted in taxation being pushed more and more deeply into areas where potential private savings were appropriated and used to finance current Government outlays. In addition, despite more or less stagnating public capital outlays, large deficits, equivalent to nearly 5% of GNP at the peak, remained to be financed by bank credit, thus swelling purchasing power, creating additional demand for goods and resulting in pressures on imports. 8. The immediate task, therefore, lay in improved performance of the public sector, specifically in taking action in three directions: to reduce the inflationary deficits in order to contain the increases in total demand in the economy; to raise public savings, primarily by containing the rate of expansion of current outlays and by improving the profitability of public enterprises and corporations; to encourage private savings by selecti-e tax reductions. The following table gives a rough indication of the results so far achieved: A prox. 1959/60 - 1963/64 1964/65 1965766 Revenue Average rate of increase 6% 9% 2% Current Expenditure Average rate of increase 7% 6% 4% Current Surplus Annual average (Rs. mill.) 55 8h 51 Capital Expenditure Annual average (Rs. mill.) 520 580 573 Cash Deficit Annual average (Rs. mill.) 440 443 496 Expansionary Deficit Financing Annual average (Rs. mill.) 200 43 83 Source: Appendix Table VI. 9. The most noticeable achievement of the past two years has been the sharp reduction in expansionary deficit financing, as compared to the past. The outturn in 1965/66 did not match the performance in 1964/65, but this should not cause undue concern. First, the expansionary deficit in 1964/65 was exceptionally small because food subsidies were sharply reduced that year by the poor rice crop. Secondly, in 1965/66 revenue fell short of estimates be- cause unexpectedly export prices fell in the last quarter of the fiscal year and delays in the arrival of aid goods reduced collections from import duties. Thirdly, the amount of expansionary deficit financing remained within the ceiling agreed upon with the IMF. Taking these factors into consideration, the Government's performance in this area has been good and helped towards bring- ing demand more nearly in line with resources.  -5- 10. Moreover, other elements in the monetary situation strengthened this improvement in the conduct of the Government's financial affairs. Largely because of a strong rise in private time and savings deposits, net private credit increased only marginally. As a result, net domestic credit in September 1966, was only 13% above the level reached two years earlier. In contrast, the rate of expansion was 24h p.a. in the preceding five yeaws. The rate of expansion picked up in 1966. This reflected the higher deficit resulting from the factors mentioned above and was further increased by the shortfall below expectations in the accumulation of counterpart funds arising out of delays in aid goods. These developments are depicted in the following table: Changes in Factors Affecting Money Supply (Rs. Million) Annual Average September 30 1960-1964 1965 1966 (est.) Net Credit to Government 189 34 114 Net Credit to Public Corporations n.a. 13 26 Net Credit to Private Sector 19 -112 36 Subtotal 20 -65 176 Exchange Reserves -93 145 -209 Other Items (net) -31 46 36 Money Supply 8T 126 3 Source: Appendix Table XII. Expansionary deficit in table on previous page is not identical with net credit to Government because of differences in coverage and leads and lags in recording. 11. It is encouraging to note that the improvement in the Government's financial position was not brought about largely by further increases in revenue along the pattern of the past, i.e., by the Government appropri- ating an ever increasing share in the national product, particularly through pushing further and further into potential private savings. In fact, the improvement was achieved mainly through containing the expansion of current outlays. In this respect, the results obtained in 1965/66 are all the more gratifying since they were achieved in the face of a large increase in food subsidies which, reflecting the better rice harvest and higher world market prices for rice, accounted for roughly 60% of the total increase in current outlays. Looked at another way, it is, of course, disappointing that this increase in the food subsidy once again spoiled what would otherwise have been an excellent performance in containing current expenditures. In the light of this experience, the Government's decision to contain the net food subsidy at the 1965/66 level of roughly Rs. 300 million in 1966/67 and future years is all the more welcome. Given the political background sur- rounding the food subsidy, this was clearly a most important decision and should help the Government  -6- Improve upon the record of the past two years in keeping current expenditures in check in favor of channeling more resources into investment. 12. Progress in the performance of Government corporations and enter- prises has been mixed. The position with respect to industrial corporations is discussed in greater detail in the following chapter. What needs to be noted here is that, altogether, industrial corporations in 1965 in- creased their profit by about 25% over 1964, and that a further increase is likely in 1966. lIowever, despite this improvement, the net return on capital employed was only 3.3% in 1965. Moreover, these figures give too favorable a picture, because they reflect in part the inclusion of new trading activities, part of which were previously carried out by the private sector. This is not to detract from the fact that, as noted in the next chapter, much great efforts than in the past are now being made to improve the operations of these corporations and that the Government has undertaken to establish more realistic pricing policies, all of which should begin to make itself felt in 1967. 13. In contrast, little has been done so far to improve the position of the Government enterprises. A notable exception is the telephone services in Colombo. There, upon completion of an improvement program, rates were raised by 50%. It should also be noted that operations of the Port of Colombo were improved to such an extent that substantial surcharges which had been previously imposed, were lifted. However, nothing was done to reduce the large drain on the budget of the railways, while two Large enterprises suffered considerable set-backs. The Ceylon Transport Board, which runs Ceylon's bus system, experienced a large reduction of its current surplus in 1965/66, as improvements in service were not accom- panied by any fare increase, and may run at a loss in 1966/67 unless fares are raised. The Port Cargo Corporation blemished its achievements in quicker handling of ships by hiring a large number of additional workers which will further add to its over-staffing problem and result either in higher losses or an increase in rates which already are excessively high. 14. There are also some significant changes underway on the income side of Government finances which should be noted. Most important among them is probably the shift in the incidence of taxation towards indirect taxes, i.e., taxes falling on consumption. This is the combined effect of reductions in -'ffeative incorhe',tax burden--lower nominal rates and the introduction of a savings relief scheme--and additional indirect taxes. These measures reduced the share of total revenue from income and similar taxes from an average of 18.5% in 1959/60 - 1963/64 to 16% in 1965/66, while the contribution from indirect taxes rose from 55.6 to 59%. This shift would have been even more pronounced, had not the wide response to the amnesty for tax evaders contributed roughly Rs. 35 million, or 12%, to collections from income tax. Mloreover, this shift should gain further momentum as private investment, which is encouraged by various tax in- centives, expands--which it should as more exchange becomes available. It should also be noted in this context that the Government has set up a Tax Commission to investigate the adequacy of the present tax system, particularly with a view to determining what changes seem necessary to en- courage private saving and investment. The Commission recently began its hearings.  -7- 15. In this connection, a further comment needs to be made about the amnesty. An amnesty was first offered in 1964/65. It met with some success, but was generally regarded as unsatisfactory in relation to the large amount of illicit wealth believed to have been accumulated over the years from undeclared incomes. Therefore, the amnesty was repeated in 1965/66 and, since it was reinforced by strengthening the investigative branch of the tax collecting agency, produced declarations totaling some Rs. 120 million. The most important benefit from this successful measure is not so much in the revenue collected. It lies rather in clearing the business atmosphere and in giving large amounts of previously "'hot" money access to legitimate transactions. To appreciate the significance of this step, it should be noted that under the regulations pertaining to investment in approved fields, where approval carries with it sub- stantial tax benefits, undeclared incomes are vrtually barred from economically useful investment and are, therefore, driven into unproduc- tive fields such as real estate. It is expected,therefore, that the amnesty will make an important contribution towards channeling domestic funds into areas where they will help expand Ceylon's productive base. i6. To sum up, it seems that in the areas of saving and general financial policies the Government's performance so far has been, on the whole, creditable. The impact of this improvement on the performance of the economy in 1966 is as yet difficult to ascertain. While the expansion of demand, particularly for consumer goods, was no doubt containedp considerable pressure on exchange resources remained. However, this was to be expected in a situation where the other line of attack on the general problem of disequilibrium-- i.e., increases in imports--was delayed in making itself felt. Moreover, the shortage of foreign exchange was part- icularly acute with respect to investment and is likely to have been such as to frustrate efforts to translate a higher level of savings into increased investment in 1966. This is certainly true of private industrial investment which has a high foreign exchange component and for which highly inadequate exchange resources were available. It is less true with respect to investment in other fields, particularly domestic agriculture. There,some increase in investment has probably occurred, particularly on land leased for commercial use.The question is whether even more investment could have been channeled into areas with a smaller exchange content. In the short span of one or two years, this is improbable. But it is important for the future to ensure, mainly by allowing domestic prices of g6ods in scarce supply to rise, a proper composition of investment which reflects the relative scarcity of exchange and prevents this scarcity from imposing an unduly low ceiling on investment intentions that can be realized. To find a solution to this problem, will, in the future, be at least equally important as continuing the effort to raise the level of domestic savings. 17. In the narrower field of savings, too, difficult problems remain to be solved. Most immediately, the 1966/67 budget raises the possibility of a set-back in the effort to raise public savings and to reduce deficit financing through bank creditv- The following table shows the 1966/67 budget, as compared with the p'rovisional estimate of the out-turn of 1965/66 (in Rs. million):  1965/66 1966/67 Revenue 1,789 1,998 Current Expenditure 1,747 1,857 Current Surplus 51 141 Capital Expenditure 573 767 Cash Deficit (adjusted) 496 574 Financing: Non-expansionary 413 516 Expansionary 83 58 Source: Appendix Table VI. There are serious doubts about the realism of the revenue estimate. The basis for this projection is the large expected increase in collections from import duties, reflecting much higher imports, which cannot be realized. Nor do current projections of export volumes and prices permit an estimated rise of 20% in export duties. The budget contained Rs. 100 million in new revenue proposals, but against this must be set lower likely collections from income taxes next year when the amnesty will not boost the final figure, and also the fact that various once-and-for all items in miscellaneous receipts will not recur. As against this, the latest revised estimates for excise duties and the turnover tax in 1965/66 suggest that projections for these might well be too low. 18. On balance, it seems highly unlikely that revenue will increase by more than Rs. 100 million, including Rs. 25 million from the higher price of flour to offset the expected increase in losses from subsidies on other foods. This means that the current surplus in 1966/67 would be less than last year's, if current expenditure estimates are realized, as is probab]e because supple- mentary appropriations are, as in previous years, likely to offset any short- fall that might occur against the original budget. Moreover, any s.zeable rise in capital outlays could be financed only through bank credit, which would be very undesirable in view of the large increase in non-expansionary borrowing from domestic and foreign sources (including counterpart funds) already included in the estimates. This prospect is clearly unsatisfactory, and remedial action will have to be taken, particularly on current outlays where appropriations provide for an increase of 6%, disregarding food sub- sidies, and where the aim should probably be to limit expansion to 4%. This would be in line with the Government's declared policy as outlined in the next chapter, and would raise the prospective current surplus to around Rs. 75 million, which, being equivalent to about 1% of GNP, would be the minimum one should expect. 19. Moreover, it should not be too difficult to achieve such a reduction. The cuts in foreign exchange outlays of Govennment Departments, as suggested in the import Program for 1967, would suffice with respect to the original budget. If supplementary provisions are considered, room would have to be made by further reductions elsewhere. Again, this should not be impossible, particularly if a start were made in a thorough review of all present ex- penditure programs with a view to reducing or eliminating all outlays which do not serve eoonomic or social ends of high priority. In fact, such a review would seem to be urgen-tly required in any case if the Government is to adhere i.n a meaningful w-kay to its annouiieed intention to limit the ex- pansion of current out] a-ys to 4% a j ar. :Ar-oss-the-board limitations on out- lays may be an unavoidable short-tezoa uall