Sri Lanka - Economic Restructuring Credit Project

Document of The World Bank FOR OFCIAL USE ONLY Report No. P-5271-CE REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL DEVELOPMENT ASSOCIATION TO THE EXECUTIVE DIRECTORS ON A PROPOSED DEVELOPMENT CREDIT OF SDR 68.3 MILLION TO THE DEMOCRATIC SOCIALIST REPUBLIC OF SRI LANKA FOR AN ECONOMIC RESTRUCTURING CREDIT April 6, 1990 TiUs document bas a resticted dtbution and may be used by recipient oly In te performance of teir offiel dtis Its oontents may not othwse be dbilosed witbout World Bank auhtiodn  CURRENCY EQUIVALENTS (Annual Averages) Sri Lanka Rupees per US11.00 1978 - Rs. 15.61 1979 - Rs. 15.57 1980 - Rs. 16.53 1981 - Rs. 19.25 1982 - Rs. 20.81 1983 - Rs. 23.53 1984 - Rs. 25.44 1985 - Rs. 27.16 1986 - Rs. 28.02 1987 - Rs. 29.44 1988 - Rs. 31.81 1989 - Rs. 36.04 PRINCIPAL ACRONYMS ARC - Administrative Reform Committee AsDB - Asian Development Bank CEB - Ceylon Electricity Board CEM - Country Economic Memorandum CFB - Central Freight Bureau CiT - Central Transport Board CUE - Cooperative Wholesale Establishment EPF - Employees' Provident Fund EPS - Employees' Pension Scheme FSP - Food Stamp Program GDP - Gross Domestic Product IC - Implementation Committee IPC - Industrial Policy cammittee -1DB - Janatha Estates Development Board JSP - Jana Saviya Program MDMP - Mid-Day Meal Program NSB - National Savings Bank PCs - Provincial Councils PD - Policy Division PEs - Public Enterprises PFP - Policy Framework Paper PIP - Public Investment Program PMB - Paddy Marketing Board PSC - Public Service Commission PTC - Presidential Tariff Commission RVDA - River Valley Development Authority SCC - Salaries and Cadres Commission SPC - State Plantations Corporation TA - Technical Assistance Fiscal Year January 1 to December 31  FOR OMCUIL USE ONLY TABLE OF CONTENTS Credit and Program Summary.................... . ...... .... i I. Sri Lanka's Development Stratety and Adiustment Issues ................ p.1 A. Background ............................................................... I B. Macro-Economic Imbalances ............. ................... . 2 C. The Size of the Public Sector and Its Use of Resources .......... 3 D. The Economic Impact of Civil Disturbances ....................... 8 II. Adlustment Efforts and Dialogue with the Bank and the IMF ............ 8 A. The 1988-90 Policy Framework ................. . ............... 8 B. Performance under the First-Year PFP-SAF (1988) . ......... 9 C. The 1989-92 Policy Framework ................................... . 10 III. The Proposed Economic Restructuring Credit .......................... 13 A. Stabilization and M acroeconomic Policies ........................ 14 B. Public Sector Rationalization ...................... 17 C. Private Sector Development ........................ .............. . 23 D. Poverty Alleviation ........................................29 E. Risks and Justification ...................... ................. 34 F. Administrative Arrangements and Financing Plan ........ ...... ..... 36 IV. Country Asptstance Strategy and World Bank Group Operations .......... 38 V. Country Relations with the DMF ...... .......... . 39 VI. Recommuendation ...................................... ....... ...... 40 Text Tables Table 1 Selected Macroeconomic Indicators, 1970-89 .................... 2 Table 2 Summary of Central Government Operations and Structure of Expenditures, 1981-90 . . 7 Table 3 PFP Macroeconomic Targets, 1989-92 . . 11 Table 4 The Price Effects of Adjustment and International Price Increases, 1987-90 .................... 31 Table 5 External Financing Requirements, 1990-91 (US$ million) ........ 36 This document has a restricted distribution and may be ud by recipients only in the performance of their official duties. Its contnts may not otherwise be discloed without World P'nck authorization.  Annex I Economic Indicators Table is Key Indicators, 1986-93.................. . 41 Table 2s Balance of Payments, 1980-93 ......................... 42 Amnex I1 Table 3: External Financing Requirements ...................... 43 Annex III Socio-Economic Data ................. ................ 44 Annex IV Government Employmeit and Pay Table 4s Public Sector Employment - 1987-1988 .......... 46 Table 5: Employment and Pay - Some International Comparisons.. 47 Table 6: Budgetary Savings from Retrenchment .................. 48 Annex V Draft Letter of Development Policy ....................... 49 Annex VI Policy Matrix .. ......................................... . 79 Annex VII Conditions for Second Tranche Release . .. 87 Annex VIII Status of Bank Group Operations in Sri Lanka . . 90 HAP - IBiD 20879  (i) DEMOCRATIC SOCIALIST REPUBLIC OF SRI LANKA ECONOMIC RESTRUCTURING CREDIT Credit and Program Summary Borrower: Democratic Socialist Republic of Sri Lanka Amounts SDR 68.3 million (US$90 million equivalent) Cofinancing: The Government is discussing cofinanc_ng with several bilateral agencies Terms: IDA Credits Standard IDA Terms (40 years maturity) Description: The proposed ERC would support the Government's efforts aimed at stabilizing the economy and implementing structural reforms outlined in the second-year Policy Framework Paper discussed by the Committee of the Whole and by the IMF Board in October 1989, when a second-year SAF was also approved. in addition to addressing the country's serious internal and external imbalances, the focus of the ERC is on: (i) the public sector, its size, its claims on resources and the efficiency with which it uses such resources; (ii) the development of the private sector through improvements in the existing regulatory framework and incentive system and through transfer to the private sector of activities and assets now being managed by the public sector; and (iii) imroving the consumption levels of the poorest segments of society. Estimated Disbursements: Of the proposed credit of US$90 million, US$85 million equivalent would finance the foreign exchange cost of general imports; and US$5 million would finance a technical assistance program. The portion of the credit used to finance imports would be available for disbursement in two tranches. The first tranche of US$42.5 million equivalent would be available upon credit effectiveness; the second tranche of US$42.5 million, upon fulfillment of the second tranche release conditions (Annex VII), which is expected eight months after the release of the first tranche. The remaining US$5 million wculd be disbursed again. several programs to be administered by the Ministry of Policy Planning and Implementation. Appraisal Report: Not applicable. Map: IBRD 20879  REPORT AND RECOMMENDATION OF THE PRESIDENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED DEVELOPMENT CREDIT OF SDR 68.3 MILLION (US$90 MILLION EQUIVALENT) TO THE DEMOCRATIC SOCIALIST REPUBLIC 0F SRI LANKA 1. I submit the following report and recommendation on a proposed Economic Restructuring Credit (ERG) to the Democratic Socialist Republic of Sri Lanka for SDR 68.3 million (US$)O million equivalent) on standard IDA terms. 2. The proposed ERC would support the Government's efforts aimed at stabilizing the economy and implementing the structural reforms outlined in the second-year Policy Framework Paper (PFP) discussed by the Committee of the Whole and by the IMF Board in October 1989, when a second-year SAF was also approved. In addition to addressing the country's serious internal and external imbalances, the focus of the ERC is on: (i) the public sector, its size, its claims on resources and the efficiency with which it uses such resources; (ii) the development of the private sector through improvements in the existing regulatory framework and incentive system and through transfer to the private sector of activities and assets now being managed by the public sector; and (iii) improving the consumption levels of the poorest segments of society. 3. An economic memorandum on Sri Lanka (Report No. 8193-CE) was distributed to the Executive Directors on December 18, 1989. The report reviewed: recent economic developments and how they were influenced by Sri Lanka's political problems; the Government's recent stabilization program; and the role of aid in financing the balance of payments in 1990 and beyond to ensure the success of the new Government's economic program. I. Sri Lanka's Development Strategy and Adjustment Issues A. Background 4. Sri Lanka is well known for its achievements in the social areas, poor growth performance after Independence in 1948, and for implementing in 1977 one of the most radical liberalization efforts in the developing world. The country's unsatisfactory growth performance results from a development strategy which, for several decades prior to 1977, relied on inward looking industrialization and increasing government intervention in the economy. The net result of these policies was stagnation; rates of unemployment as high as 242 of the labor force during the 1970's; recurr ut balance of payments crises and foreign exchange shortages. Poor economic performance was the main reason for the reorientation in policies in 1977, when the trade regime was liberalized and government interferences in the functioning of markets were substantially reduced. The economy responded well generating new sources of economic activity and export earnings. At 5-7Z per year during '1978-85, GDP growth reached an unprecedented high level and unemployment declined to 122 in the early 1980's. 5. Since the mid-1980's, however, slow growth, macro-economic imbalances, and high unemployment have re-emerged as serious problems. There are three reasons for this recent deterioration in economic performance: (i) the macro- economic policies pursued since 1977 led to unsustainably large deficits in the  -2- external and internal accounts; (ii) the Government did not carry the break with the pre-1977 development strategy beyond the liberalization of trade, financial markets, and prices, i.e. it did not reduce the size of the public sector nor did it address the root causes for its inefficiency; and (iii) the outbreak of the ethnic conflict in 1983 in the North and East of the Island, compounded by the resurgence of terrorism in the South after a Peace Accord was signed with India in July 1987, put heavy pressures on the budget and has been responsible for drastic losses in output, and reduced foreign investment and tourism. B. Macro-Economic Imbalances 6. Macro-economic problems emerging after 1977 have to do with several inter- related factors: ti) the excessive size of the public sector, which employs over 20S of the country's labor force (i.e., 1.25 million people out of a labor force of about 6 million); (ii) the relatively high levels of assistance from the aid comxunity to support the 1977 liberalization of the economy (with commitments at about 152 of GDP in the late 1970's and 112 in the 1980's) enabling the Government to undertake overly ambitious expenditure programs which crowded out the private sector; (iii) the country's access to international capital markets after 1977 and its ability to borrow on commercial terms until 1984; and (iv) the Government's reluctance to adjust the exchange rate for fear of exacerbating inflation. These factors throughout the 1980's led to large deficits in the current and fiscal accounts; high debt service ratios; critically low levels of foreign exchange reserves and inflation rates which are relatively high by South Asian standards. Table 1: SELECTED MACROECONOMIC INDICATORS, 1970-1089 1970-7 1978482 10988-89 1986 1987 1988 1989 GOP growth rat. (X per year) 8.1 6.2 8.4 4.8 1.5 2.7 2.0 Inflation rat. (X per yar) C.8 16.6 11.' 9.1 10.2 15.0 11.6 Debt Service Ratio p/ 14.8 18.5 19 21.7 28.1 24.9 21.5 A. Of GOP Nationa 1avings 10.8 14.? I 14.2 15.5 14.4 12.2 Foreign Savings 5.8 12.8 8.6 9.5 7.8 8.7 8.8 Domstic Investment 16.1 27.5 24.2 28.7 28.8 28.1 21.0 of which Public 8.6 15.8 13.2 14.1 12.4 13.7 11.0 Governamnt Revenues 17.9 20.4 20.9 21.5 21.4 19.8 21.1 Total Expenditures 27.8 87.5 88.0 88.0 82.5 84.8 33.8 Deicit 9.4 17.1 12. 2 11.4 11.1 15.0 12.0 Domestic Financing 4.2 8.0 5.8 5.1 5.8 9.4 6.8 Export b/ 26.7 81.5 25.8 28.8 25.2 25.6 26.4 Import k/ 29.4 46.8 86.4 84.7 85.7 35.9 36.7 ource: Central Bonk Of Sri Lanka a/ X of current account receipts, I.e., including workers' remittance. M/ Goods and non-factor services. 7. Far from reducing the role of government in the economy, the 1977 liberalization program increased it. The availability of external finance both  from donors and commercial sources led the Government to expand its investment program. Current expenditures rose both as a result of increased public sector employment and of public corporations in need of budgetary support after they were exposed to market forces and international coutpetition. As total government expenditures soared, so did fiscal deficits in spite of Sri Lanka's relatively high tax-GDP ratio which gradually increased from a historical 16-17? of GDP to slightly over 202 of GDP in the mid-1980's. The fiscal deficit for the period of 1978-1987 averaged 14t of GDP, about half of which was financed by grants and concessional loans and the other half by domestic borrowing. At close to one- half of national savings, this level of domescic borrowing has been the main cause for relatively high real interest rates. On average, commercial lending rates have been at about 101 per year in real terms in recent years. 8. Together with the commodity boom of the late 1970's, the government-led expansion in aggregate demand exacerbated inflation. Because of an insufficiently flexible exchange rate, inflation led in turn to a gradual appreciation of the real exchange rate in the first half of the 1980's. This appreciation impeded a more vigorous development and diversification of the export sector and contributed to a current account deficit which averaged 16? of GDP in 1980-82--with a gradual decline to around 102 of GDP thereafter. As part of this deficit was financed through commercial borrowing up until 1984, debt service ratios increased from 14? of exports if goods and services in 1978 to 302 in 1988. Commercial debt reached one-third of the country's medium- and long-term debt by the mid-1980's, although, by end-1988, it had declined to 202, i.e. US$850 million out of US$4.5 billion. Thus, the good growth performance after liberalization can be explained by a once-and-for-all gain in efficiency that followed eliminating many of the market distortions prevailing before 1977, complemented by an expansionary fiscal policy. How'ver, as a large share of the country's resources was diverted from the private se7:tor and absorbed in public expenditure programs with disappointing returns to the economy, this growth could not be sustained. C. The Size of the Public Sector and Its Use of Resources 9. Concentration and inefficient use of a large share of the country's economic resources in the public sector has been one of the main obstacles to achieving more rapid economic growth. Evidence of this iss (i) in public sector enterprises which have grown at much lower rates than their counterparts in the private sector; and (ii) in the large number of wasteful central government expenditure programs. Public Enterprises. 10. In spite of a decade of liberalization, public sector enterprises still are an important segment of the economy. The state owns about 130 public enterprises (PEs) in all sectors. They employ over 600,000 people (of which 400,000 in state-owned tea and rubber estates), i.e. over 10? of the labor force. Excluding utilities and transportation (i.e. including PEs in agriculture, industry, and financial sector), they account for 8 of the GDP. Most of these enterprises are a legacy of the pre-1977 period when through nationalization or outright creation of new enterprises the state grew to become the largest entrepreneur in the economy. With the growth of the private sector after 1977,  -4- however, the inefficiency of PEs became evident. Public manufacturing enterprises' output stagnated while that of the private sector grew by over 10X per year. Three-quarters of the growth in the country's tea output since 1977 came from the private sector even though the latter owns only half of the land under tea. A similar pattern can be observed in all the sectors where the private sector has been allowed to enter: e.g. bus transportation; insurance; banking and marketing of agricultural inputs and products. There is a question as .o whether the PEs' poor growth performance is the result of less investment than their covaterparts in the private sector, or less efficient use of resources. While investment data for the entirety of the public enterprise sector are not available, information for the most significant PEs indicates that their poor growth performance is the result of a less efficient use of resources rather than less investment per se. The public sector enterprises' inefficiency is mostly the result of the mutually inconsistent functions Pfs' managers are expected to fulfill: to provide employment, to reduce the cost of living, to substitute for imports with little attention paid to economic efficiency, and to comply with rules and regulations suited for bureaucratic processes but not for comercially oriented ones. 11. To offset, at least partly, the cost of such a system, PEs have been granted privileges in terms of protection against foreign and domestic competition, monopolistic and monopsonistic privileges, access to the budget or government credit guarantees. The economic cost of PEs' mismanagement is thus not entirely captured in the budget. The direct cost to the budget has been as high as 1-2Z of GDP in mid-1980's but it has been declining more recently as (i) certain public enterprises financed their losses by building up arrears with their suppliers (e.g. the Central Transport Board in 1989): (ii) a few underwent restructuring processes which included sales of assets and improvements in management (e.g. Air Lanka and the Ceylon Shipping Corporation); and (iii) others financed their losses through the banking system (e.g. -he State owned tea and rubber estates in 1988 ani 1989). Central Government Expenditure. 12. Central government expenditure account for about 33-342 of GDP with current expenditures at 20Z of GDP in recent years and capital expenditures at 13-14Z. About half of current expenditures are for civil servants' pensions, wages and overheads (about one-third of that amount being for defense) while the other hal' is approximately equally divided between interest on the government's debt and other transfers to households, public corporations and other levels of government. In addition to the transfers required to support public enterprises, public expenditure programs have suffered from three other problems. The first is the high cost of the civil administration. Compared to other countries of its size and level of development, Sri Lanka's civil administration is exceptionally large. It employs 650,000 people in 24 central ministries overseeing 130 departments and 86 decentralized units of government reporting to central ministries (500,000 in the central ministries and 150,000 in the 86 decentralized units). Excluding police, armed forces and pensions of retired civil servants, the cost of the country's civil administration is over 6Z of GDP, of which wages accounted for two-thirds and overheads for the remaining one- third.  -5- 13. The President appointed an Administrative Reforms Comittee (ARC) in 1986 to review the government's administrative structure (then with over 40 ministries), staffing, and compensation policies. The ARC concluded that: (i) the number of ministries should be reduced to 16; (ii) staff Pt the lc.ver level was overpaid and underpaid at the higher level; and (iii) overstaffing was a pervasive problem throughout the public sector. Excluding the armed forces. police, health and education personnel, the ARC estimated that some 20Z of staff could be retrenched without any impact on the quality or level of government services rendered. This figure does not include, however, those employed in decentralized units of government for which an assessment of overstaffing still needs to be made (see para. 49) 14. Transfers and Subsidies. The second problem with central governs.ent expenditure is the large number of mis-targeted transfers to households. The oldest and largest of these programs (1.3? of GDP in 1989) is the Food Stamp Program (FSP). Since its inception in 1979, the FSP has suffered from a serious mis-targeting problem as about half of the population (8 million people in 1988) was enrolled in the program instead of the 600,000-700,000 families who should have been the target group according to recent household surveys. The mis- targeting of FSP was accentuated as of January 1989 when the value of the food stamps was doubled and the number of beneficiaries increased to 8.5 million. Two other transfers programs were announced during 1988 in the run-up to elections and have rendered the problem of inefficient and costly transfer programs much more serious than before: the Mid-Day Meal Program and the Jana Saviya Program (JSP) or people's strength in Sinhalese. The mid-day meal is a program designed to provide one lunch a day to all children enrolled in primary or secondary schools. Despite costing close to 12 of GDP, it fails to improve the country's nutritional status significantly. Pre-school children, the ones most nutritionally at risk, do not benefit from the program while a large number of children who because of their age or income level of their families are not nutritionally at risk, do benefit. The costs of meeting the nutritional needs of pre-school children would be only a fraction of the cost of the mid-day meal. 15. As originally envisaged, the JSP consisted of a monthly payment of Rs 2,500 (i.e. about US$63 at today's exchange rate) for two years to all eligible families. About Rs 1,500 was to be paid in coupons enabling beneficiaries to purchase basic consumption items, mainly food, and Rs 1,000--the so called 'investment component"--was to be deposited in a savings account. The accumulated amount would be released after the two-year period as a grant to families having formulated a viable investment project--which could range from purchasing livestock to developing a micro-enterprise. Crucial to determining the cost of the prop-am is the number of eligible families. When the Government announced the program during the 1988 election campaign, eligible families were all those enrolled in NFSP, a principle that would have required over 20? of GDP per year to finance the program. As it became clear that this amount of resources could not be mobilized and as discussions with the IMF and the Bank on a second-year PFP progressed, the program was reformulated several times. The 1989 budget included Rs 6.8 billion (31 of the GDP) for the JSP of which only Rs 0.9 billion was actually spent while the 1990 budget includes Rs 4.4 billion (1.5? of the GDP). In spite of its cost, the JSP is not an effective anti- poverty program because of loose selection criteria, benefits which create strong  -6- disinccAtives to work and are unrelated to the beneficiaries' income, and its failure to address the roots of poverty. 16. Historically, the most important subsidies (0.5? of GDP) in the budget are for fertilizer use; the National Savings Bank (NSB) and sugar production. The subsidy on fertilizer was entirely eliminated as of January 1, 1990 after being in effec;t for almost three decades. Previous Governments have been of the view that the fertilizer subsidy is an important determinant of rice production and thus farmer's income. As in many other countries, however, most of the fertilizer subsidy accrues to better-off farmers, i.e. those with the largest plots and access to irrigation. The need for the NSB subsidy stems from an important share of its assets being locked in long-term government securities purchased in the 1960's and 1970's, paying interest rates of 5-6X while interest psid on savings deposits are more than twice this level. As these low yielding government securities maturea, the NSB subsidy has been gradually reduced from an annual Rs 500 million in the early 1980's (US$21 million in 1983) to Rs 230 million (US$6 million) in 1989-90; it is expected that the need for the subsidy will disappear completely in the early 1990's. Finally, the subsidy for sugar is to compensate domestic producers who cannot compete with sugar imports, in spite of an extremely high tariff (see para. 37). 17. A number of important subsidies became effective in 1989 without any provision in the budget. The most significant one is the subsidy on wheat. As the price of imported wheat rose and the government decided not to increase the price of wheat flour accordingly, the Food Comnissioner (in charge of food distribution to the cooperatives and other private and official outlets) experienced losses close to Rs 2.1 billion (0.9Z of GDP). In the case of rice, mostly imported by the state-owned Cooperative Wholesale Establishment (CWE), the subsidy (0.2? of GDP) has been financed by the commercial banking system and profits from other CWE activities. In the case of the Ceylon Transport Board where losses reached about Rs 800 million, 0.3Z of GDP, while the budgetary allocation was only Rs 150 million, the unbudgeted subsidy was financed through arrears to the Employees Provident Fund; and zo suppliers such as the Ceylon Petroleum Corporation and the Tyre Corporation, both state enterprises. 18. Public Investment Program (PIP). The third problem with central government expenditures are public investment projects which do not provide adequate returns to the economy. Since liberalization in 1977, Sri Lanka has had public investment at levels as high as 12-13? of GDP on the average, with peaks at over 15? of GDP in the early 1980's. The 1988 Country Economic Memorandum (CEM) on Sri Lanka contains a detailed analysis of the main public expenditure programs and, more particularly, of the PIP. A major conclusion was that many of the capital investment projects begun in the early 1980's were unproductive but by now most of them were either completed or discontinued. Another conclusion of the CEM was, however, that insufficient funds were allocated for (a) maintenance programs, particularly for irrigation and roads; (b) the development of the transport infrastructure; and (c) the development and maintenance of the health and education sectors.  Table 2: SUMMARY OF CENTRAL GOVERNMENT OPERATIONS AND STRUCTURE OF EXPENDITURES 1981-90 (N of GOP) 1981 1982 1988 1984 198S 1986 1987 1988 1989 Budga Current Expeniture 17.2 18.5 18.1 16.0 20.1 18.9 20.1 20.? 22.6 2 22.3 Goods and servies 6.1 6.6 6.8 6.0 10.0 8.4 0.4 9.a 9.7 9.9. 9.2 Slaries and wao" 4.2 4.6 4.0 8.6 4.2 4.5 4.1 4.5 5.0 C.1 n.s Oter goods & servies 1.9 2.0 2.5 2.' 5.8 4.0 6.3 4.8 4.8 4.7 n.S. Intrest Paymets 4.4 5.1 5.4 4.4 4.6 4.9 S.2 5.6 5.4 C.8 7.0 Foreign 0.8 0.9 1.0 1.1 1.2 1.2 1.8 1.8 1.6 1.8 1.2 Domestic 8.6 4.