Sri Lanka - Country assistance strategy

Document of The World Bank FOR OFFICIAL USE ONLY Report No. 15633-CE MEMORANDUM AND RECOMMENDATION OF THE INTERNATIONAL DEVELOPMENT ASSOCIATION TO THE EXECUTIVE DIRECTORS ON A COUNTRY ASSISTANCE STRATEGY OF THE WORLD BANK GROUP FOR THE DEMOCRATIC SOCIALIST REPUBLIC OF SRI LANKA MAY 21, 1996 Country Operations Division Country Department I South Asia Region This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  CURRENCY EQUIVALENTS Sri Lanka Rupee (SLR) US$1.00 = SLR 54.30 (May 16, 1996) FISCAL YEAR (FY) July I - June 30 ACRONYMS AND ABBREVIATIONS ADB - Asian Development Bank BOO/BOT - Build Own Operate/Build Own Transfer CCF - Corporate Finance Services CEB - Ceylon Electricity Board CPPR - Country Portfolio and Performance Review ESW - Economic Sector Work FIAS - Foreign Investment Advisory Service GST - Goods and Services Tax IBRD - International Bank for Reconstruction and Development IDA - International Development Association IFC - International Finance Corporation IMF - International Monetary Fund JICA - Japan International Cooperation Agency LTTE - Liberation Tigers of Tamil Eelam LECO - Lanka Electricity Company MIGA - Multilateral Investment Guarantee Agency NEAP - National Environmental Action Plan NDC - National Development Committee NGO - Non-Governmental Organization OECF - Overseas Economic Cooperation Fund of Japan PER - Public Expenditure Review PFDP - Private Finance Development Project PSDIP - Private Sector Infrastructure Development Project UNDP - United Nations Development Programme UNP - United National Party  FOR OFFICIAL USE ONLY THE DEMOCRATIC SOCIALIST REPUBLIC OF SRI LANKA COUNTRY ASSISTANCE STRATEGY Contents A. POLITICAL OVERVIEW 1 B. RECENT ECONOMIC AND SOCIAL DEVELOPMENTS 2 Economic Developments 2 The External Environment 5 Social and Environmental Developments 6 C. SRI LANKA'S DEVELOPMENT GOALS AND CONSTRAINTS 8 Fiscal Reform 9 Enabling Environment for Accelerated Private Employment Growth 10 Capitalizing on Earlior Human Development Efforts 12 D. BANK GROUP'S ASSISTANCE STRATEGY 12 Improved Fiscal Discipline 13 Private Sector Development 13 Building Up Human Capital 16 Policy Dialogue 17 Performance and IDA Commitrent Scenarios 17 Portfolio Management 20 Aid Coordination 21 Role of Resident Mission and Decentralization 22 E. ISSUES FOR BOARD CONSIDERATION 23 AM{dsm6 Attadznont I - IDA Program Sceuariom - Base Case Attdmimet - IlDA Program Scenarios - High and Low Case Attadmit m - Reform Record Since the 1992 CAS Attachment IV - CPPR - Action Plan This document hu a reuted dirisbuton and may be used by recipients only in the perfrmmno of their |officW dude. Its ooatents mny not otherwin be diucloeed wilhout World Bank authorizaon. I  I  MEMORANDUM OF THE PRESIDENT OF THE INTERNATIONAL DEVELOPMENT ASSOCIATION TO THE EXECUTIVE DIRECTORS ON A COUNTRY ASSISTANCE STRATEGY OF THE WORLD BANK GROUP TO THE DEMOCRATIC SOCIALIST REPUBLIC OF SRI LANKA 1. Sri Lanka is a densely populated island nation of 18 million people off the southem tip of India. It is blessed with a diverse agricultural base, mountainous interior with a temperate climate where its famous tea is cultivated, and rich flora and fauna that add to its unique tourism assets. Since independence in 1948, the country has made impressive social gains despite its low per capita income of under $700, matching those of much more advanced economies in several areas. Its literacy and primary school enrollment are virtually universal, and the fertility rate is near replacement level. These accomplishments have been accompanied by an unbroken record of democracy, including elections leading to a peaceful change of government on several occasions. With this human resource base and natural endowments, Sri Lanka could have achieved the growth records of its East Asian neighbors had it not been for a history of ethnic conflict, political violence, and of stop-go economic policies, often associated with election cycles. 2. Sri Lanka has been on and off the economic reform path since 1977, when the first attempt was made to transform its inward-looking command economy. Growth has oscillated over the period since 1977 in response to halting reform attempts of successive governments. Since credible adjustment efforts resumed in 1989 under President Premadasa, economic growth has been more robust. The private sector has become the main engine of growth, helped by substantially reduced regulatory barriers and privatization. Today, the public sector no longer dominates manufacturing. However, the state still accounts for a quarter of total employment (civilian and military). It also owns more than 70 percent of all land, and intervenes heavily in agricultural trade and pricing. A. POLITICAL OVERVIEW 3. Ethnic conflict has dominated Sri Lanka's political landscape virtually since independence. From the start, nation-building was made more complex by inherited disparities between the majority Sinhalese and the minority Tamils, then seen as privileged in terms of access to higher education, civil service representation, and economic clout. Long-simmering Sinhalese resentment was exploited politically to detract from economic failures inherent in Sri Lanka's socialist model, most notably with a "Sinhala-only" language policy proclaimed in 1956. Ethnic divisions grew, with communal riots triggered by jobless youth further straining the country's social fabric. A bloody ethnic conflict with the Liberation Tigers of Tamil Eelam (LTTE) began in 1983, reaching major proportions in 1987. The conflict subsided following the India-Sri Lanka Peace Accord of July 1987 but escalated again in 1989. 4. Ending 17 uninterrupted years of power in the hands of the UNP, the charismatic and politically astute President Chandrika Kumaratunga won the election of August 1994 on a populist economic platfbrm and a promise of peace. She immediately initiated negotiations unconditionally, only to have the Tiger leadership unilaterally break off discussions and a truce, a move condemned by the international community. Fighting resumed with increased intensity. The government, committed to a negotiated peace, shifted to a policy of isolating the LTTE militarily as a precondition to renewed negotiations. From a military point of view, the offensive has been largely successful, with government troops now controlling most of the former rebel stronghold in the North, including Jaffna city and peninsula. With the govenmment's encouragement, the refugees who were displaced during the offensive are reportedly returning  2 to Jaffna, and the authorities have asked for donor emergency relief assistance for the North. There has, however, been no cease fire, and the Tigers are expected to continue to mount guerrilla attacks. The successful suicide bombings of several government installations, including the Central Bank in Colombo this January, show that the LTTE is able to strike at the vital nerve centers of the economy. 5. The military campaign against the Tigers has been accompanied by an offer of devolution of political power to regions. Under the proposed constitutional amendments, the rights of other (Moslem and Indian Tamil) minorities would also be protected. Approval requires a two-thirds majority in parliament followed by a referendum. Given the government's slim majority in parliament, both the timing of the votes and the outcome are uncertain. If approved, this political solution to the ethnic problem would have far reaching economic implications (see para. 26). 6. President Kumaratunga's administration faces a heavy agenda. It must complete its military offensive, salvage peace efforts, and rally support for a political solution. Reducing corruption is accorded high priority. And it is under pressure to deliver on its campaign promise of jobs and economic prosperity. After almost two years in office, the government has tempered the populist tendencies of its Peoples' Alliance coalition, affirmed a commitment to a market economy, and has made limited economic reforms. It has not, however, been able to prevent a deterioration in economic performance, partly because of the escalation in the military campaign. The government has taken a calculated risk that by concentrating its resources on the war, and its political capital on the campaign for peace and devolution, it can achieve the security which is the fundamental precondition for economic growth. It is gambling that it will be able to reverse any economic slippage and gamer support for market reforms once the war is over. The danger is that the war will drag on, delaying national consensus for reform and jeopardizing macroeconomic stability and longer-term economic and job growth. B. RECENT ECONOMIC AND SOCIAL DEVELOPMENTS Economic Developments 7. The Sri Lankan economy did well after 1989, spurred by the renewed adjustment efforts and private sector confidence. Efforts were made to reduce macroeconomic imbalances and create incentives for the private sector through privatization, trade, and external payment reforms. The rebound was broad- based, but with stronger growth in industry and services than in agriculture, and an unprecedented increase in domestic and foreign private investment. Real GDP rose by an average of 5.5 percent per annum during 1990-95, compared to 2.2 percent per annum over the preceding three years. Average domestic savings amounted to about 14 percent of GDP for the same time period, while national savings increased from 16 percent in 1990 to 18.5 percent in 1995. Underlying inflation has remained around 10 percent per annum during the past two years. Gross official reserves rose to more than 5 months of imports during 1993-94, fueled by strong export performance--especially in garments, an increase in remittances, and large inflows of foreign direct investment. This good economic performance, however, slackened in 1995. Table 1 shows recent trends in the Sri Lanka's key economic indicators.  3 Tabk 1: Key Economic Inicatom (%) Prel. 1960-94 1990 1991 1992 1993 1994 1995 Real GDP growth rate (per capita) 2.8 4.8 3.3 3.0 5.6 4.4 3.8 Consumer price index \a 8.2 21.5 12.2 11.4 11.7 8.4 7.9 Gross domestic investmentVGDP 20.1 21.9 22.6 24.6 25.6 26.0 24.2 Private investment/GDP 13.6 \e 13.3 13.1 17.6 17.7 18.4 15.9 Budgetdeficit/GDP\b 9.6 9.8 11.7 7.9 8.6 10.5 10.1 External current acc. deficit/GDP /c 7.2 \d 5.4 7.5 6.1 5.3 7.8 7.6 Gross national savings/GDP 12.9 16.5 15.0 18.5 20.3 18.2 16.6 Foreigndirectinvestinent,net(USSm) - 33.0 63.7 121.3 187.0 158.0 58.0 Portfolio investment, net (USSm) - 9.0 32.1 25.7 67.0 28.0 -2.0 al Period average Colombo consumer price index. bl Excluding grants and privatization proceeds. c/ Excluding official transfers. dl Period 1970-74. el Period 1980-94. Source: Central Bank of Sri Lanka, and Bank staff estimates. 8. Underpinning this economic performance are a number of important structural reforns, some of which were already begun by 1992 when the last CAS' was reviewed. The main reform priorities identified and recent action include: I incentivesforprivate sector investment have been liberalized. The investment regime has been considerably simplified and rationalized to eliminate the differential treatment among sectors and between foreign and domestic capital. Investment and foreign exchange controls have been dismantled: administrative constraints on foreigners investing in the Colombo Stock Exchange have been removed (1990) and all residents are allowed to open foreign currency accounts (1992). The corporate income tax rate declined from 50 percent in 1991 to 40 percent in 1993 and 35 percent in 1994. * The exchange and trade regime, except for agriculture, has been liberalized considerably. Full current account convertibility was established in early 1994, when Sri Lanka accepted the obligations under Article VIII of the IMF Articles of Agreement. Following reduction in the maximum tariff to 45 percent in 1993, the 1995 budget further reduced the maximum tariff to 35 percent, reduced the number of bands from four to three, and eliminated most exemptions and waivers.2 The 1995 budget announced further tariff reforms to be implemented in 1997 and 1998, with the objective of moving towards a unified tariff of 15 percent by 1998. Only a few non-agricultural items remain under license, mostly for reasons of health, security, public morals, or the environment. l President's Memorandum for Community Water Supply and Sanitation Project, November 16, 1992 (Report No. P-5777-CE). See Attachment m for a matrix account of progress since the 1992 CAS. 2 Automobiles, liquor and tobacco remain outside the 3 band structure.  4 * Tax holidays, which had proliferated with the stated objective of reducing high unemployment, were rationalized. Moreover, the government has announced that it will replace the turnover tax with a less distortionary value-added based goods and services tax (GST) in 1996, which is expected to be revenue neutral. * Notable progress is being made in privatization. Having started with the sale of small and medium-sized firms at the time of the last CAS, the government has widened its coverage to complex and large companies over the past year or two. These include the granting of 50 year leases for nine tea, rubber, and coconut plantations to private investors; the recent purchase of Colombo Gas by Shell (51 percent of the equity); and the purchase of Lanka Orient--which operates, inter alia, a duty-free shop at the airport--by Alpha Airports group (60 percent of the equity). In addition, a major electricity distribution company (LECO), Sri Lanka Telecommunications, and Air Lanka are being prepared for privatization. * Recent progress has been made in consolidating and targeting the social transferprograms for the poor. In 1995, the government consolidated the poorly targeted Food Stamps, Kerosene Stamps, and Mid-Day Meal programs (excluding the activities in North/East) into a single transfer program called Samurdhi ("prosperity"). Based on community-based screening, the Samurdhi program is intended to benefit the poorest 1.2 million households (compared with 1.5 million for the Food Stamps program) with an increased level of transfers to the poorest. Further consolidation of the social transfer programs is envisaged in 1996. 9. The 1994 election campaign, however, resulted in a deterioration in economic management. The Kumaratunga administration exacerbated this problem by introducing a number of populist measures during its early months in office. It increased the flour subsidy and added subsidies on fertilizer and kerosene. The economic problems have been compounded by the renewed fighting and increased defense expenditures. Defense spending has risen from 1 percent of GDP in the first half of the 1980s to 3.2 percent in 1990, and 5.1 percent in 1995. The overall budget deficit (before grants) widened from 7.9 percent of GDP in 1992 to 10.5 percent in 1994, as a result of excessive spending, and remained at about that level in 1995. These deficits were financed in part by captive sources of funds at below market interest rates. More importantly, they have entrenched adverse budgetary trends that have become difficult to reverse. This fiscal slippage and an accommodating monetary policy contributed to a growing external current account deficit, rising from 6 percent of GDP in 1992 to 8 percent in 1994. Indications are that the external current account improved somewhat in 1995 owing in part to lower imports following a sharp decline in investment. The overall balance of payments swung into deficit (US$70 million) in 1995 for the first time in over five years, resulting in a slight drop in gross official reserves from their high of 4.3 months of import coverage in 1994. 10. The 1996 budget contains no real fiscal adjustment. Indeed, the authorities have been quite candid in explaining that the civil war and the need to win political support for the devolution proposals must take precedence this year. Defense spending is budgeted to remain at about 5 percent of GDP in 1996.3 And only minor reforms in non-defense spending are planned. Thus, the underlying fiscal deficit is expected to be over 10 percent of GDP for a third year. Because of its access to high levels of concessional external financing , the government has, for the most part, been able to avoid printing money to finance the deficit. However, some 6.3 percent of GDP is being financed through domestic borrowing, crowding out private 3The authorities have promised that any increase beyond this level will be financed with a special emergency tax.  5 investment. The government expects to finance the remaining deficit with privatization proceeds, which were initially projected at 2.7 percent of GDP but are unlikely to fully materialize. 11. There has also been an erosion of investor confidence since early 1994. While the business community's initial uncertainties about the policy direction of the Kumaratunga government have been somewhat dispelled, investors remain uneasy about the government's commitment to continued reforms. This hesitance has been reinforced by the military build-up and terrorist attacks. Private investment has declined sharply, from 17.7 percent of GDP in 1993 to 15.7 percent in 1995, with a fall in foreign direct investment from US$187 million to US$58 mnillion over the same period. (The latter decline was mitigated by large foreign real estate projects that began in early 1994 and carried over into 1995.) Capital goods imports, another investment indicator, dropped 17.6 percent in 1995. And the Colombo market share index has dropped from 990 in January 1995 to 664 at year-end. 12. Sri Lanka has a close policy dialogue with the IMF but has had no formal agreement since the expiration of the third annual ESAF arrangement in July 1995. The last mid-term review was not completed because of slippage on the fiscal and structural fronts. The Bank and the Fund have jointly conveyed our concern with respect to the likely further erosion in fiscal discipline in 1996 and the diminishing scope for corrective measures in the face of a deteriorating financial situation. The government accepts the diagnosis of the Bank and Fund, but feels compelled to buy a bit more time in the hope of resolving the ethnic conflict. The authorities have, however, recently asked to resume serious discussion of a medium-term adjustment program to take effect following a winding down of the conflict and political action on the devolution proposals. The External Environment 13. Sri Lanka is rapidly becoming integrated into the world economy. Significant progress has been made in liberalizing the external trade and payments regime and in deregulating foreign investment. Sri Lanka's membership in the World Trade Organization has widened the framework for international market penetration. While the benefits of Sri Lanka's outward orientation are already evident, its export base remains narrow and vulnerable to external shocks. Improved productivity and export diversification-- within manufacturing, agribusiness, and services--are key to Sri Lanka's ability to withstand these shocks. But the greatest risks it faces are internal. The intensified conflict has already reduced foreign private investment and tourism receipts, exacerbating macroeconomic imbalances. 14. Exports. Exports have performed well recently, increasing from 30 percent of GDP in 1990 to 34 percent by 1994. Their composition has shifted over time from agriculture towards industry. Industrial exports accounted for 67 percent of total exports in 1994, while agriculture accounted for only 27 percent. However, exports have remained narrowly based on garments, textile, tea, rubber and gems. The share of rapidly expanding garments and textile in merchandise exports is close to 50 percent, with almost two- thirds destined for the United States. Garments are subject to quotas in main markets, including the United States and the European Union, but the Uruguay Round Agreement presents a good opportunity for growth with quotas to be eliminated by 2005. 15. Foreign Inflows. Capital inflows grew rapidly in the early 1990's, owing to a sharp increase in private inflows and continued high levels of workers remittances, more than offsetting the somewhat reduced level of official flows (Figure 1). Private foreign investment, both direct and portfolio investment, were particularly strong in 1993, but began dropping in 1994 because of the political uncertainties. Worker remittances doubled over five years to US$700 million (or 6 percent of GDP) in 1994 and remained at about that level in 1995. The increase in remittances reflects both the increasing number of Sri  6 Lankans employed in the Middle East and higher real interest rates being offered in Sri Lanka. However, official transfers (grant aid) fell from 2.7 percent of GDP in 1990 to 1.2 percent in 1994, largely due to weakened policy performance and aid implementation capacity, which affected aid disbursement levels. 16. The downward trend in direct foreign investment, which was observed in 1994 and accelerated in 1995, is explained in part by increased uncertainty associated with the intensification of the civil war and the direction of government policy. Successful implementation of the privatization program provides scope for additional inflows in the short run, but its more lasting benefit would be a boost to sagging private sector confidence-if shored up by peace and sound economic fundamentals. For Sri Lanka to attract growing private capital flows, the government needs to resolve the civil conflict and show strong resolve to address the fiscal imbalances and accelerate structural reforms. 1 Flgure 1: Balance of Payments Financing - 1990-95 9.0% 1 .. 8.0% | | 7.0% -- Private investment, net (DFI+Portf.) 6.0% - - M Private Creditors, 0 ~~~~~~~~~~~~~~~~~~gross (guar.+non- .. 5.0% guar.) - Official Creditors, 4.0% gross (bilat.+multilat.) 3.0Y. l l --Workers remittances 2.0%-- 1.0% * i 0.0% - I 1990 1991 1992 1993 1994 1995 Social and Environmental Developments 17. Sri Lanka has mnade substantial gains in reducing poverty since 1965. The distribution of consumption is also relatively egalitarian. But it is Sri Lanka's impressive social achievements that set it apart from all other low income countries (see Table 2). These include: * high life expectancy (72 years); * low infant mortality (19 per thousand live births); * a total fertility rate nearing replacement level; * virtually universal primary school enrollment, with enrollment rates for girls comparable to those for boys throughout the educational system; and * gender disparities in wage levels among the lowest in the world.  7 Tabk 2: Social Indicators - Sri Lanka's achievements at a glance- Sri Lanka Low-Income Economies \a Middle-Income Economics \a Population growth rate (%) \b 1.5 2.0 1.7 Life expectancy at birth, 1993 (years) 72 62 68 Adult illiteracy, 1993 (%) 12 41 17 Infantmortality rate, 1993\c 17 64 39 Primary education net enrollment rate, 100 68 \d 89 1989 (%) Memo: GNP per capita 1993 (USS) 600 380 2,480 a/ Weighted averages. bl 1980-93. cl Per live 1,000 births. d/Excluding China and India. Source: World DevelopmentReport 1995 and 1992, the World Bank. 18. But there are also areas of major concern. The education system is not geared to support the demands of a growing, modern economy. There is also an increase in the incidence of malaria, and of AIDs-even if well short of epidemic proportions. In addition, the changing pattern of diseases from an increasingly older population suggests the need for revised health care policies and greater private participation. 19. Despite the gains, there is still substantial poverty in the country. Some 22 percent of households are below the "one-dollar-a-day" poverty line. Poverty is concentrated in the rural areas, where almost four-fifths of the population lives. In rural areas, poverty is high among both agricultural and non- agricultural households. Most farm families are poor, surviving on less than two acres of land and deriving over 40 percent of their family income from off-farm sources. Although the most recent survey found little difference in the poverty incidence between the Tamils and the majority Sinhalese, the sample excluded the heavily Tamil North and East, where most of the fighting has occurred. Indian Tamils on the estates have a slightly lower incidence of poverty, but they also have the poorest social indicators, reflecting a lower level of services. 20. Unemployment has averaged over 12 percent during the 1990s. A substantial element of unemployment seems to be volt? itary, in that the attractiveness and security of civil service, public enterprise, and formal sector jobs motivate first-time job seekers to wait for the "right" job. Unemployment is concentrated among youth 15-29 (73 percent of the total), persons with at least a tenth grade education or more (53 percent), and women (50 percent). While over 75 percent of the unemployed remain in this state for more than one year, they are primarily first time job-seekers. The Kumaratunga Administration, like previous govemments, views job creation as both a political and economic imperative. This concem, magnified by the strained socio-political environment of the nation, explains in no small measure the struggle for consistency in economic management and the past recourse to soft policy options during periods of political uncertainty. 21. With access to education, health, and family planning services, Sri Lankan women are on average economically and socially better off than those in most other parts of the region. They have also taken advantage of job opportunities overseas and in the expanding garment manufacturing sector. Nonetheless, there are still notable gender disparities. Malnutrition is high among poor pregnant and lactating women, and all social indicators lag for Tamil women on the estates, as they do for men, and for poor Muslim  8 women. The civil conflict has caused social fragmentation and a disproportionate representation of single female-headed households among the poor. 22. Sri Lanka's rich natural resources and good public health are threatened by growing environmental damage. Land degradation and deforestation, coastal erosion, and loss of biodiversity are already problems. Restrictions on land use and ownership act as a disincentive to soil conservation other than on the plantations. Problems of urban and industrial pollution, while less severe than in many countries of comparable income, need to be addressed while they are still manageable. The rapid growth of the Colombo metropolitan area, which accounts for 20 percent of the population and the largest share of industry, has prompted mounting concern over the unmitigated effects of industrial pollution and urban congestion. Efforts are now underway to promote waste water treatmnent in industrial estates, but additional efforts are needed, both in regulation and use of economic instruments for pollution management. Measures are also needed to control coastal erosion and sedimentation, as well as coral reef destruction, caused by increasing urbanization and tourism. C. SRI LANKA'S DEVELOPMENT GOALS AND CONSTRAINTS 23. Sri Lanka aspires to eliminate poverty, while joining the ranks of the Newly Industrialized Countries. The vision of the Kumaratunga Administration is that of a peaceful Sri Lanka, in which the rapid economic growth of East Asia is combined with the country's traditional emphasis on social welfare and equity. The government recognizes that peace is essential for nation building--to restore the productive capacity of the North and East, sustain private sector confidence, realize the country's tourism potential, and reduce macroeconomic imbalances and release resources for productive uses. It has rightly placed peace, ancnored on substantive devolution to provincial governments and thereby to minorities, foremost on its agenda. 24. For the time being, the government has felt the need to put economic reform on the back bumer. But the longer it waits the more difficult it will be achieve the country's poverty and employment goals. Since poverty is not restricted to a small group or locale, broad-based growth at a higher and steady pace is needed to achieve a rapid decline in poverty. Too often in the past, Sri Lanka has looked to the public sector to create jobs. It mist now turn to the private sector for sustained job and output growth. But the fundamentals are not yet in place: the fiscal situation is worrisome, business confidence is eroding, and investments in human capital are deteriorating and need updating. Failure to act decisively on the economic front is not likely to lead to an immediate crisis. Rather, Sri Lanka would be mortgaging its future and missing the opportunity to follow its East Asian role models. 25. Sri Lanka seeks to complete its transition from the legacy of "Fabian" socialism to a market economy while reinforcing its deep commitment to social development. To do so, the government needs to focus on fiscal reform, the key to macroeconomic stability; improvements in the policy environment for private investment; and second-generation human resource investments. Success will depend on engaging stakeholders--including parliamentarians, business, labor, NGOs, and environmentalists--in the policy making process. The government has recently established a National Development Committee (NDC) to bring such groups together and prepare policy options and recommendations for the Cabinet. 26. To date, the government has given relatively little attention to the economic aspects of devolution. T.he authorities appear to believe that the extent, nature, and timing of devolution is essentially a political matter, and that the fiscal and financial questions can be worked out later. In fact, international experience, as well as Sri Lanka's own experience with more limited devolution in 1987, suggest that economic issues are critical. Greater thought needs to be given to the mix of revenue and expenditure powers to be  9 delegated to the regions, and the effect of this on accountability in the use of funds. Whether or not the proposals presently before the parliament are approved, the solution to Sri Lanka's ethnic conflict is expected to involve some form of greater devolution to the regions. For this reason, it is extremely important to assess the far-reaching fiscal impact of devolution. Also, given the limited institutional capacity at the regional and local levels, attention needs to be given to the effect of devolution on the quality of services. Fiscal Reform 27. Sri Lanka needs to move quickly toward a more sustainable fiscal deficit. Analytical work is underway in the context of a public expenditure review (PER) to define the precise level which would be most appropriate. All agree, however, that a sustainable deficit must be much lower than the current 10 percent. In recent years, the government has financed the fiscal deficit in part through forced placement of pension fund resources in jow interest government securities, thus crowding out private investment. The budget has also benefited from ample foreign aid which can no longer be taken for granted. While defense spending at 5 percent of GDP dominates the budget, there are serious structural problems in the non- defense share of the budget. The legacy of past years of large deficits has resulted in a debt service burden of 5.8 percent of GDP. In recent years, civil service salaries and poorly targeted transfer programs and subsidies have been protected at the expense of operations and maintenance and needed public investrnent- which has ranged between 7 and 8 percent in recent years. While structural measures like the promised GST are needed to enhance revenue buoyancy and efficiency, revenues themselves, at 20 percent of GDP, are already reasonably high for the country's per capita income. 28. The major opportunities to restructure current expenditures are: restraining the wage and pension bill (7.6 percent of GDP); reducing transfers to public enterprises (4-5 percent of GDP including off- budget deficit financing) through prioritizing or restructuring loss makers like the Railways and the Water Board; and curtailing the cost of the generous entitlements and subsidies (3.4 percent of GDP) through consolidation and improved targeting to the poor. Although all these measures would produce medium- term gains in efficiency, the greatest fiscal savings would come from reducing entitlements and subsidies (2 percent of GDP). 29. Govermment has been a growing source of employment, especially for teachers, and, as a by- product, has reinforced young people's desire to wait for such jobs. Since a misguided attempt at civil service reform in the early 1990s, public employment has again increased and now totals over 800,000. Another attempt to prune the civil service, and redirect job seekers to the private sector, is warranted. Civil service reform at the federal level needs to be coordinated with devolution plans to guard against uncontrolled hiring and spending at the regional level. 30. Sri Lanka's large array of safety nets are both costly and poorly targeted. They typically have transferred resources, albeit modest, to a large fraction of the population above the poverty line and inadequate sums to the very poor. The steps taken in 1995 to consolidate some of these programs are a step in the right direction, but subsidies on fertilizer and flour and other transfer payments remain a significant budgetary burden, totaling about 11 percent of total public expenditures. The government needs to follow through with its planned further consolidation and better targeting of the transfer programs. The regressive bread subsidy, which was cut in half in late 1995, needs to be eliminated. And the recently reintroduced fertilizer subsidy should be removed.  10 Enabling Environment for Accelerated Private Employment Growth 31. Sri Lanka's success in attracting foreign private investment, its export orientation, and responsiveness of the economy to market-oriented reformns bode well for the country's future. It is still a distance away from its East Asian cousins in terms of the policy environment and infrastructure support for rapid, sustained economic expansion. Although textile, garment, and leather product exports have grown rapidly, they tend to be at the low value-added end of the market for these products. Much of the financial sector is still a captive of the state and thus unable to provide fuel for a growing private sector. And recent performance in agriculture, which still accounts for almost one-quarter of GDP, has been weak. To get at the sources of these problems, further fundamental policy changes are required. The unfinished reform agenda includes: addressing key structural weaknesses in agriculture; * deepening financial sector reform; * easing infrastructure constraints; * removing labor market rigidities; and * protecting the environment. 32. AgriculturalPolicies. Increased agricultural output is needed to boost overall economic growth and to reduce poverty, which is concentrated in rural areas. The transfer to private management of the tea and rubber estates begun just before the last CAS in 1992, and the effective privatization of the plantation companies under long-term leases in 1995 are expected to improve the profitability and international competitiveness of this important segment of agriculture. Less has been accomplished in the non-plantation sector. Government policies motivated by food self-sufficiency goals continue to discourage increased productivity and diversification. The government intervenes in both input and output markets. Rice producers benefit from protection against imports, as well as subsidies on fertilizer and water. Faced with restrictions on land sales and buoyant demand for off-farm rural labor, farmers have little incentive to shift into higher value crops or sell their land to more entrepreneurial farmers. To unlock this stagnation, the government needs to liberalize input prices, land markets, water ownership and maintenance, fertilizer distribution, and marketing of paddy, chilies, onions and potatoes. Also needed are long-term credit, with no future repayment amnesties. Sri Lanka does not yet have a political consensus for major agricultural reforms. Indeed, the government has recently embarked on a program to field new agricultural field ("AMA") staff who could well increase intervention in input markets. There is, however, increased debate within the country on agricultural issues, as well as growing recognition that basic changes are needed to increase exports and reduce rural poverty. Another encouraging development is the governnent's recent willingness in principle to restructure the giant irrigation and power authority (Mahaweli) through privatization or commercialization of revenue-rming units, transfer of public service functions to local or national line agencies, and tumover to farmer organizations the responsibility for operation and mainitenance of field distribution canals. 33. Financial Sector Reform. Progress on financial sector reforrns since the last CAS has been disappointing. Competitive treasury bill auctions were introduced in 1993, and the second (remaining) state-owned development finance institution has been privatized. First steps have been taken to privatize the state-owned insurance companies and redirect contractual savings towards private investment. But government dominance of the banking system continues to prevent efficient financial intermediation. Since the mid-1980s, domestic financing of the government has preempted a large share of gross national savings, crowding out the private sector and driving up interest rates. Compulsory placement of contractual savings from public institutions (e.g., pension funds, insurance companies) with the government has compounded  11 the problem. The two state-owned banks (Bank of Ceylon and People's Bank) together account for 60 percent of assets and liabilities, although their market share has been declining. Despite a bail-out in 1993, they remain plagued by directed lending, a high cost structure, inadequate provision for bad debts, and underfunded pension obligations. Private banks, while growing, have taken advantage of the state banks' need for high margins, further taxing the private sector. To attract private investment, the government must send a clear message that the financial sector is there to serve investors rather than to tax them. It must expedite on-going reforms--such as development of viable bond markets and granting of investment autonomy to the contractual savings institutions--and begin privatizing the insurance companies and the state banks. Such efforts must be accompanied by stronger Central Bank supervision. 34. Easing Infrastructure Constraints. Sri Lanka's infrastructure lags behind that of several of its Asian neighbors. The public utilities and transport agencies suffer in varying degrees from weak operational and financial management, an inadequate capital base, and a backlog in maintenance. Most threatening to continued export growth are a looming power crisis, which has caused frequent supply interruptions this spring. Since the last CAS, and especially during the past year, the government has come to recognize that the private sector must play a significant role in relieving these bottlenecks to growth and employment. It has taken or is about to take a number of steps to attract private resources and management through private ownership, BOO/BOT arrangements, and both restructuring and privatization of utilities. A first BOT arrangement for the KHD power plant (in which IFC is involved) was recently agreed, and a memorandum of understanding has been issued to a foreign consortium for expansion of one quay at the Colombo port. The Government also intends to prepare a port development strategy to increase Sri Lanka's competitiveness in containerized trans-shipment, restructure and commercialize port management, and increase private sector participation in investment and operations. 35. Improving Labor Market Flexibility. Restrictive labor laws and above market wages in unionized firms jeopardize Sri Lanka's intemational competitiveness and deter private investment. Strong private and public sector labor unions linked to political parties have traditionally resisted privatization. While recent successful privatizations have defused the situation somewhat, resistance is still strong. The Government is attempting to widen the compact with labor unions, while tackling the rigidities of existing labor legislation. An NDC subcommittee on labor-management relations, composed of govenmment, business, and labor representatives, is considering amendments to the Employment Act which would protect the rights of workers to organize legally in private companies while giving employers more flexibility to adjust to market conditions. 36. Environmental Protection. Sri Lanka is determined not to sacrifice its natural environment or the quality of urban life as it pursues private-sector led growth. Environmental concems are widespread in the general public because of the high level of education and inclusion of environment in the curriculum. Sri Lanka was one of the first countries to develop a National Environmental Action Progran (NEAP) and establish specialized environmental agencies. However, weak and overlapping institutions have hamnpered NEAP implementation. Enforcement capacity is limited. Aid donors have been eager to finance environmental activities, but too often the projects have been driven by the financing and have lacked sufficient ewnership and sustainability. Overall, although progress has been limited since the last CAS, the government is anxious to improve environmental ma:aagement and better direct and coordinate donor assistance for environmental projects. Recognizing the difficulty of administrative enforcement, the government also intends to rely more on economic incentives.  12 Capitalizing on Earlier Human Development Efforts 37. Sri Lanka's intemational competitiveness is closely linked to the caliber of its labor force. Despite the impressive social indicators, there are signs of a deterioration in the quality of services, as well as growing questions about sustainability. More efficient health and education delivery systems are needed to eradicate the remaining large pockets of poverty and maintain a competitive edge. Sri Lanka also needs to begin addressing "second generation" issues more typical of middle-income countries. Growing demand for higher education has become an increasing burden for already over-stretched resources, and an aging population is creating pressures for more high cost tertiary care. Welfare payments to the very poor need to be replaced with credit and other tools to enable them to participate in the growing economy. 38. Major quality issues in education include insufficient support expenditures; excessive recruitment of unqualified teachers; growing spending on university education and lack of cost recovery which could crowd out priority expenditures on general education. Graduates lack the basic skills needed by private sector employers, in part because English language instruction has deteriorated. A stronger emphasis on English training is essential for a society with a growing technological and international orientation. It could also help attenuate ethnic tensions. 39. The main challenge in the health sector is posed by the aging demographics and resulting revised epidemiological profile. The historically strong public health system is not sustainable at current costs. The need for efficiency gains .fird a redirection of basic services, combined with the recent strong growth in private health services, calls for a thorough policy review in the sector. This should be followed by a reallocation of public health sector resources to refocus on basic services with maximum public health impact. 40. Until recently, Sri Lanka's NGOs were engaged primarily in religious and welfare activities. Reflecting a deep civic sense of social responsibility, the government was seen as the main source of social services and safety nets for the poor. Gradually, in the last few years, a number of NGOs--including the largest, Sarvodaya--have moved into income generating activities and provision of social services; and some have been quite effective. With the injection of added donor funding, including from IDA (para. 56), numerous new NGOs have sprung up, many lacking in experience. Moreover, their geographic distribution tends to be skewed away from the areas of greatest need. Both the previous and current governments have had suspicions about NGOs political motives. The current government's relations with NGOs have been further complicated by its having hired, under its new Samurdhi program, large numbers of unemployed youth to help poor villagers improve their lives. Although it is too soon to measure the impact of this program, it is likely to be more positive if the workers can cooperate with the NGOs already working in the villages. On a broader scale, the government and the NGOs need to strengthen their dialogue in an effort to reinforce and complement each other's efforts. D. BANK GROUP'S ASSISTANCE STRATEGY 41. The Bank Group's strategy is designed to help Sri Lanka realize its dream of economic growth and poverty reduction comparable to that of its more prosperous East Asian neighbors. In view of the uncertainties about peace prospects and the political dynamics of economic reform, the IDA's strategy emphasizes flexibility combined with the maintenance of longer-term continuity. In the short-run, IDA will try to minimize policy slippage and exploit opportunities for immediate progress. At the same time, we will urge the government to move steadily ahead on fundamental economic reforms, even in the face of possible faltering peace and devolution initiatives and terrorist activity. In the event of a peace agreement, the Bank expects to coordinate a large multi-donor reconstruction effort (paras. 63-65).  13 42. We cannot and should not do it all. IDA currently ranks third in aid funding in Sri Lanka, well below Japan and the Asian Development Bank (ADB). However, we are considered by both the government and our development partners to be particularly strong in policy reform and dialogue, and both Japan and the ADE are generally supportive of our policy work and regularly cofinance our operations. To strengthen this partnership, we will direct t]le Bank Group's resources where we can make the biggest difference in a cost-effective manner. We will focus on the sectors/subsectors that require the most attention, in which there is strong government commitment to sectoral reform, and where the dialogue already shows signs of paying off. As such, we will support the government's efforts to improve fiscal discipline, promote sustainable private-sector led growth, and address second generation human resource issues. Within these sectors, we will undertake policy-based economic and sector work, complemented by selective lending operations to reinforce reform. In some areas, like infrastructure, we envisage setting out the policy framework for financing primarily by Japan, through public sector agencies, and by the private sector. Improved Fiscal Discipline 43. The IMF and IDA have both supported revenue and expenditure reforms of the government. The IMF, with technical assistance support from IDA, has assisted the government in preparing to adopt and implement the GST in 1996. IDA has financed preparation of a preshipment inspection scheme to facilitate duty compliance and reduce domestic leakage from export promotion schemes. IDA is currently devoting more of its attention to expenditures, where both the need for reform and the potential for backsliding are greater. Along with the Fund, we have stressed the need to eliminate the election-motivated bread subsidy, and restructure the safety net system to improve poverty targeting while containing costs (paras. 27-30). Much of the dialogue relates to structural budgetary reforms. IDA's PERs and sector studies indicate scope for civil service restructuring, higher operations and maintenance expenditures- offset by increased user charges, more rapid reduction in losses of public enterprises through accelerated privatization, and efficiency gains from reform of large public enterprises such as the Railways and the Ceylon Electricity Board (CEB). The proposed IDA-financed Teacher Training and Redeployment Project (para. 54) will help the government limit the hiring of teachers--who currently comprise 40 percent of the civil service wage bill. IDA would also consider support for a major expenditure restructuring program, in the context of considerably improved fiscal management. 44. Both IDA and the Fund have urged the government to give early attention to the fiscal and financial aspects of devolution. An IDA-financed expert visited Sri Lanka to discuss relevant lessons from international experience with the authorities, and devolution issues will be included in the PER. IDA stands ready to provide additional assistance of this sort when the government feels it would be useful. Private Sector Development 45. The Bank Group provides a complementary mix of support for private sector development. IDA addresses the institutional and policy framework for private investment and for public investment in infrastructure, while IFC helps stimulate a supply response. IFC and IDA staff have recently cooperated in the preparation of a Private Sector Assessment (FY95) to establish a common basis for action. Given the potential for foreign investment, the Foreign Investment Advisory Service (FIAS) has assisted the Government in redrafting foreign investment guidelines, preparing an investment promotion strategy, and restructuring of Board of Investments into a more effective promotion agency. IFC seeks to match foreign sponsors to local entrepreneurs while providing comfort to the foreign investors. In view of the dynamism of small businesses in Sri Lanka, IFC is exploring ways to provide an efficient mechanism to finance small  14 and medium-scale industrial investments. Although Sri Lanka has been a member of MIGA since 1988, no mvestors have yet sought coverage from the Agency. MIGA has, however, received several Preliminary Applications for Guarantee of eligible investments valued at approximately $200 million. MIGA expects to take a more active role in Sri Lanka in the future, especially by encouraging foreign investment in privatization and infrastructure. 46. A number of the reforms discussed above to reduce regulation and trade restrictions and commence privatization were supported by two IDA-financed adjustment credits approved in FY904 and related Policy Framework Papers. In the context of our economic dialogue, IDA is pressing the government to complete the reform agenda and send steady and clear messages to the private sector. As a country poised for 'take- off', Sri Lanka can benefit from IDA's international experience and assistance in addressing the key requirements for private sector growth: * diversification and productivity growth in the agricultural sector; * deepening of the financial sector; * private sector investments in infrastructure, and * environmental safeguards. 47. In agriculture, IDA and government views broadly coincide on the main constraints to diversification and productivity growth. An ESW study, Non-Plantation Crop Sector Policy Alternatives (FY96), has increased understanding of the changes needed for improved agricultural performance and poverty alleviation in rural areas. Yet there is not an agreed, comprehensive strategy for reform across a broad front in the agricultural sector. We have opened the dialogue to reach such a strategy for meaningful reform in the context of preparing an Agricultural Sector Investment Credit. In the meantime, we have agreed on an action plan for a proposed Mahaweli Restructuring Project (para. 32). Building on the recommendations of IDA's Tree Crops Strategy Paper, and the government's new interest in privatizing estates, IFC is actively exploring investment opportunities in agr;business, particularly plantations. 48. The govermment appreciates the importance of increasing competition in thefinancial sector, but it has been reluctant to commence privatizing the state-owned banks because of fear of resistance from the banking sector unions. IDA stands ready to help when the government feels ready to cede management control and part or all of the ownership of the larger Bank of Ceylon to private investors. The ongoing Private Finance Development Project (PFDP) is already supporting the asset valuation and other preparation required for privatizing insurance companies. It is also helping strengthen Central Bank supervision. Follow-up assistance would be conditioned on the privatization of the insurance sector and at least one of the two state-owned banks. In the meantime, IDA will undertake ESW to help prepare a sequenced financial sector reform strategy. We are also exploring assistance for judicial and regulatory reform to further improve the environment for private investment. 49. IFC's support for capital markets complements IDA's assistance in the financial sector. The Corporation is currently exploring the possibility of setting up a private sector commercial bank and is active in a mutual fund and an insurance company. IFC is currently appraising a project with Lanka Orix Leasing Company, where dollar denominated leases will be extended to Sri Lankan exporting companies for machinery and equipment purchases. It has also helped securitize Orix's receivables. 4See Implementation Comnpletion Report (No. 14986) for Economic Restructuring Credit (Cr. no. 2128-CE) and Public Manufacturing Enterprise Credit (Cr. no. 2185-CE).  15 50. Both IDA and IFC regard energy and infrastructure as priority areas. Given domestic resource constraints and the interest of the ADB and OECF in financing such investments, however, IDA intends to be extremely selective in lending to these sectors. We will focus on removal of capacity constraints in ports, power generation, telecommunications, and possibly urban water and sanitation through development of a regulatory framework for private investments and the unbundling of monopolies to facilitate privatization and promote efficiency. IDA support for reforms in the telecommunications sector has already stimulated private investment and interest. IDA is also helping prepare a transport strategy which would transform the sector from a state-dominated one into an efficient public-private partnership. This strategy would provide the framework for private investment and donor support for transport. 51. At the same time, IDA will remain strongly placed to assist in the development of infrastructure projects through the proposed Private Sector Infrastructure Development Project (PSIDP) which is being presented with this CAS. PSIDP will serve as a catalyst for large new private investments by providing long-term debt financing and strengthening Sri Lankan capability in project finance. IFC also plans to explore infrastructure projects, particularly in ports, power and transport, and in some cases in cooperation with PSIDP. IFC will present to the Board shortly Sri Lanka's first BOT power project investment, the 50 MW Asia Private Power. IFC is now positioning itself for a role in the planned private-led Colombo port expansion; and it is exploring investment opportunities in the restructured telecommunications sector.5 IFC is also interested in participating in private sector infrastructure investments involving privatization of utilities. 52. Both IFC and IDA have been much encouraged by the recent progress inprivatization. IDA is providing technical assistance to the Public Enterprise Restructuring Commission, which is developing a solid track record in privatization. IFC welcomes the opportunity to discuss areas for IFC assistance in privatization programs when the political climate improves. IFC's Corporate Finance Services (CCF) will work to identify and develop potential privatization, restructuring, and joint-venture opportunities in those sectors that are of mutual interest to the government and the CCF. 53. The Bank Group's work in Sri Lanka reinforces the government's conviction that growth must not be at the expense of the natural environment or the quality of urban life. A proposed IDA-financed Environmental Action project would help strengthen the institutions engaged in setting environmental policy, monitoring and enforcing regulations, and preparing environmental impact assessments. The project would help update the NEAP and bolster the capacity of the line sector agencies to build environmental considerations into their planning and project development. And it would explore macroeconomic and sector policy incentives to protect the environment. IDA has worked closely with a number of NGOs in preparing a proposed Energy Services project which will support village hydropower, solar power, and other forms of alternative energy. IDA assistance will also help address urban environmental problems. The ongoing Colombo Environmental Improvement project is assisting with sanitary landfill, control of waste-water pollution, and industrial pollution control; the PFDP is also establishing an industrial pollution control and abatement fund. A proposed Clean Settlements project would support community-based provision of water and sanitation services in Colombo's shanty areas. In addition, preparation of a National Biodiversity Action Plan would be supported under a proposed Global Environment Facility (GEF) Conservation of Medicinal Plants Project. 5Telecommunications Regulation and Public Enterprise Report Technical Assistance Project, approved March 1, 1996  16 Building Up Human Capital 54. Excellent collaboration exists between the government and IDA in education. The Government's National Education Policy, adopted in Parliament in August 1995, drew heavily on the Education Sector Strategy Report undertaken by IDA with Sri Lankan teams. It pointed out, inter alia, that the heavy recruitmnent of untrained university graduates has contributed to the deterioration in quality. The proposed Teacher Training and Deployment project being discussed with this CAS would limit the hiring of new teachers, improve their qualifications, and redeploy them to areas of greatest need. Within the framework of the Sri Lanka National Education Policy, a follow-on project will also address other system shortcomings, including an outdated curriculum, weak management, and insufficient cooperation with the private sector. IDA also plans to do a study of education finance, including the appropriate public/private mix. 55. IDA has found it more difficult to establish a productive policy dialogue in health, in part because of the understandable pride of the Sri Lankan medical establishment in the country's past achievements. However, with the emergence of new issues (para. 39) and budget constraints, the government has turned to IDA for help in addressing the most pressing problems. Thus, drawing upon experience-under a recent IDA-financed health and family planning project, we hope to assist the government in addressing key public issues, including cost-effective prevention of STD/HIV/AIDS and malaria. This proposed Health Services project would include a community-based nutrition program that is targeted to mothers and children, including those on the estates--where the rate of malnutrition is double the national average. NGOs and volunteers would help execute this component. The project would also strengthen the institutional capacity for policy analysis and planning in the health sector. Future assistance beyond this project will depend on the progress of the policy dialogue. In the meantime, IFC is looking into the possibility of financing a private hospital in Colombo. 56. IDA's strategy to reduce poverty recognizes the special features of this problem in Sri Lanka, including its persistence despite strong social indicators and its concentration in the rural areas (para. 19). IDA's assistance focuses on creating jobs and raising rural incomes by improving the environment for private sector growth, particularly in agriculture. Since female participation in the labor market is relatively high, women should also benefit from job growth. Given the political importance of employment, as well as its central role in relieving poverty, IDA also plans to do ESW, in collaboration with the government, on labor markets and policies, including their impact on the poor and on women. Building on the Poverty Assessment completed in FY95, we also plan to explore the impact on poverty of ethnic variations in access to social services and employment opportunities. The findings will enable the government and IDA to anticipate the effect of these issues in designing policies and projects to reduce poverty. In the meantime, a number of IDA-financed ongoing and proposed projects include components-- e.g., in health, commnunity water supply, and nutrition--targeted on the poor, especially women. To reach the poorest groups, an IDA-financed Poverty Alleviation project approved in FY91 supports NGO activities in credit, civil works, and nutrition. The government and IDA have gained useful experience under this project, which initially had a number of problems and was adversely affected by the political transition. Future support in this area will depend on continued progress in resolving remaining problems, as well in targeting safety net programs. A possible second project would also draw upon the findings of the Poverty Assessment Report completed in FY95.  17 Policy Dialogue 57. The government values highly IDA's presence as a catalyst for reform and other donor support. The availability of financial resources from other donors, and potentially from the private sector, makes our analytical work and policy advice especially important. The policy reform agenda is grounded in the selective ESW tasks specified above and the consensus their discussion and dissemination engender. In addition, the Bank and the government have jointly prepared a comprehensive reform agenda, "Sri Lanka in the Year 2000", which provides a foundation for the policy dialogue. The government intends to use this document to enhance debate with interested parties on econoric policy issues. Annual joint IDA/government PERs will facilitate discussion of the quality and composition of public expenditures and public sector reform. Periodic economic updates for use by the government and the donors will'highlight policy alternatives. Selective comprehensive analytic studies (e.g., on the transport and irrigation sectors), will be shorter than in the past, and more policy-focused. Officials and stakeholders will participate at all stages of drafting, and dissemination and discussion with officials and, as appropriate, NGOs, the private sector, and academicians will be a primary objective. These will be supplemented by frequent short policy notes, drawing upon international experience as well as lessons from and analytical work on Sri Lanka. In addition, the Bank is supporting a variety of seminars and informal gatherings to expose policy makers and interested members of the business, academic, and NGO communities to new ideas. Some of these will be organized under the auspices of National Development Council, which IDA plans to assist. An important objective is to build a consensus for reform by encouraging people to rethink the role of the state in promoting job-creating economic growth and reducing poverty. Performance and IDA Commitment Scenarios 58. Risks and PotentiaL Sri Lanka stands at a critical juncture. If the government's strategy for peace is successful and it has the political confidence to resume reforms, the country has a good chance of achieving rapid, broad-based growth. On the other hand, if defense expenditures continue many months longer at their current level or higher and/or the LTTE succeeds in destabilizing the economy, the prospects for growth and poverty alleviation could suffer a major set-back. A further risk is that even if the government succeeds in containing the war, it may fail to build a sufficient consensus to accelerate economic reformns. The matrix scenarios in Attachments I and II reflect this wide range in possible outcomes and our difficulty in assigning probability weights to each. They represent an attempt to help position the country for a post-conflict "take-off' while recognizing the strong downside risks and the need to use IDA resources and services efficiently. 59. The Base Case. This most likely scenario (Attachment I) assumes continued fighting in the North- East at a somewhat reduced level, but with the possibility of additional suicide bombings in Colombo. Because of uncertainty as to how forcefully the government will move on the economic front under these circumstances, we have defined the base case as a range bounded by a high and a low set of performance benchmarks. Sri Lanka is currently at the low end of the band, primarily because of the deterioration in fiscal performance. To reach the high end of the base case band, the government will need to make significant improvements in fiscal management and resume meaningful structural reform. The macro projections that correspond to the high end of the base case are discussed in Box 1.  18 . . . . .. . .. . . . .. .. . .. .. . . . . .. . The acr prjectonspreente inAnnx Clillstrte w t.o.l be. .....pe.....ted... at.th.....end .o the base ease They showthe efibet of a gradual but steady reduction nihe overall ~~~~~~~...........d........by........ percent Of GD? per num This would improve public savings from a n live ............... . er....t.o.........to.. p~~aitIv~ I pere ... ..........er..0..h.........1 vmefomreucd hetan fitli snbsidies ari defense expnditures; beter targeted ncome transfrs; lower int..st.e..ense..o ........ the civil ervice (prticularl no new tacher recuitment);completin ta...d.tai... ...h.u ..e.ve......e loss; continued pwgrcsa in financial iberah~~~~~~~~~~ation~~ regulation and supervision and impr..........e..nt .........or Wgislatiea ~ ~ ~ ~ ~~....... and in............................ Oiven these assumptions,~~~~.............. ..d...fav.rble.e..er .. ...rnmntcositet.it.t.....sg ba in19~~~~~~~~~~~~~~~~~~~S........... w Under these assuniptions~~~~~~ external ~~~inanieing requirements would increase somewhat .................b..t US$1 billion in 1995 to US$1 ~~~~~-L6 billion in the year 2000k with the current aceount de~~~~~~~eit a...r...i....... 5.6 p~~rcent of GDP~~~ or US$900 million during the period 1997-2000. External financing of this magnit............d. should be ibxtbconiing if adjustment is resumed as projected. The overall balance of payments should once~~~~~~~~~........ again become positive, as private capital if lows recover from their l9~~~~5 low with improving private . confidence. Ptivatization proceeds will be an unportant source of e~~~~~~~~~~~teni~~il ~naneing Official aid transfers.... asswne contnued coznnitments at aout the levl ~,frc~entyears ~ztd ome improveent in aid tiliz.t..n 60. During discussion of his GAS in draft with th authorities, they assure us. that.they.intended.t make odes refrms urin theremanderof tis yar ad emark n th othr hih en.bas.cas measures folloing a diminutin in fightingand political ction on the evolution.propsals..We.urge themto akepropt ctio toimpoveecoomi pefraceadblte .rvt setr.ofiec. We... argued that, rather tan jeopardize a peac accord, .such .reform woul boost economic growth and. employment, and hence enhance prospects for lasting peace....... We.made..clear.that...DA would respond to the. pace of reform, matching financial and non-lending services to performance. Explicit triggers and~~~~~~~~~~~~~~~~~~~~~~~.................... performance benchmarks .. ar.ie.i.tahmn..Thyseif.h.isa.eeneadexedtr measures, overall budge deii targets... an.srutualmasre.i.pivtzaio,.grcutre.te.innca sector, and human resources at.... eihe.ed.f.h.bnd.Te.as.as......ledngprgrm.ane from low verag of bout S$70 illin a yar toa hig aveage o US$10 milion.Aboutthre operations a year are envisaged at the high end. At the low end, fewer operations would be processed~~~~~~................ because of weak macroeconomic performance and failure to meet sector policy conditions....Assuming.a favorable environment~. . for .private investment, .F plas.o.xpndit.prtolo.o.sx.roe.s.ndinenif its business promotion efforts, focusing on ~~~~~~ proisngexor.sctrs(turim,ceamcs.grmnt,.oo procesing and. fiheries. M.. has.. received ....a.number. of.prelminary.pplicatons.w..h.coul m aterialize..... in t e n x e r o w ...... ................. ............. . ........... 61 ......... Low....Case.... Failure.to.tem.the.curent.fisca deeroato could.precipitte.the.low.cas (Attachment II)... ..While.. this.. would..be..most..likely..in..the.event ..of.further...escalation...of.the..war ..and ..spreading.  19 violence, it could also occur if the current level of spending is maintained without adequate compensatory fiscal measures. Other factors which would lead to the low case would include entirely stalled or reversed structural reforms and deteriorating portfolio management. This case is not sustainable in the medium and long term. Under such circumstances, IDA would approve one or two operations a year, for an average annual total of about US$50 million. The program would focus on preservation of Sri Lanka's long-term development potential through investment to improve the quality of the education system and the environment. Non-lending services would be maintained at a reduced level to keep alive the dialogue on reforms. 62. High Case. There is also a chance that the government will accelerate the reform process significantly. The likelihood of this high case (Attachment II) is considered low at present. It could become a more realistic scenario, however, if the government were to strengthen its majority in general elections, most probably following approval of the devolution referendum, as part of a political settlement of the conflict. GDP would grow by 6 percent per annum or more, and total investment would rise to 28 percent of GDP by the year 2000, with rapid growth of agriculture, export crops, and export-oriented manufacturing. Fiscal improvement could be dampened initially by reconstruction needs but this investment would further accelerate growth. In this case, we would plan a program of four to five operations per year averaging US$175 million annually, depending on progress in reform of the agricultural and financial sectors, as well as reconstruction needs in the North-East. Under this scenario, additional support would be provided for agriculture, the financial sector, and human resource development including through an adjustment credit. Non-lending services would be increased to help implement the reforms and strengthen the regulatory framework for the private investment and other donor support which would be expected to materialize. As the high case approached, the Bank Group would undertake a complete review of the assistance strategy, including Sri Lanka's eligibility for IBRD lending, and report back to the Board. 63. Reconstruction of the North and East. With peace, reconstruction of the North and East would be feasible, and additional donor support could be expected. IDA--along with the UNDP--would take the lead in coordinating such assistance. IDA would view its advisory and aid coordination role as just as important as its financing. In response to recent developments in the Jaffna area, we have begun to meet regularly with the authorities, other donors, and humanitarian agencies to discuss plans to reestablish economic activity in the North-East and prepare for permanent reconstruction. 64. Although IDA's project assistance has not reached the conflict area, we have devoted non-lending services to preparing for the eventual resumption of activities, starting with reconstruction. Much of the economic and sector work underway for the nation as a whole would apply for the conflict area, once peace comes. Along with the government and donors, we helped develop a framework at the time of the 1994- 1995 truce. This framework remains relevant, although some changes would be needed to reflect subsequent events as well as recent experience in other country post-conflict situations. The main objective of such a reconstruction plan would be to allow the population, including returning refugees, to benefit as quickly as possible from the economic opportunities that they have missed over the last ten years. A broad-brush estimate of rehabilitation and reconstruction needs suggests that a program of about US$1 billion, executed over five years, would be required to reintegrate the North and East into the economy. The program would need to be phased with an eye to harmonizing it with the absorptive capacity of the public investment program and overall macroeconomic balances. The program would need to be sensitive to the ethnic issues involved in resettlement and provision of infrastructure and services, including the possible jealousy of residents of other areas.  20 65. The donor group envisages a three stage plan. Phase one consists of small but visible gestures-- such as generators and rebuilding the Jaffna hospital. The government has already begun such an emergency relief program and has called for donor assistance, including food. Phase two would begin following a peace agreement; it would be a two-year effort to rebuild physical infrastructure and public services, resettle refugees, and resume economic activity in the area. The third phase, in which we would expect to play a major role, would be a five-year effort to provide the larger infrastructure and incentives for private investment. Although we will not update the earlier assessment of needs in a formal sense until there is a cease-fire, we are remaining alert to developments as they unfold and are in close coordination with the Government and donors in planning. Sri Lanka's conflict is one where the normal capabilities of Government have not been destroyed beyond a relatively small and well-defined area. So at least the basic government institutional framnework for reconstruction is present. As soon as conditions warranted, the Bank would call a special donor meeting to enlist support. We would also chair a core donor group, comprised of the UNDP, the ADB, and Japan, which would seek to maximize the complementarity of various donors' contributions. In the first instance, IDA could assist by deploying resources under ongoing credits--including those in poverty alleviation and rural infrastructure--to the North. We would also assist in building administrative capacity in the war-affected area. While a reconstruction project could be accommodated under the base case, additional IDA resources might be needed if peace were followed by substantial economic reforms. 66. IBRD Creditworthiness and IDA Eligibility. Even in the high case, Sri Lanka is not likely to exceed the IDA operational cut off for the medium-term. Because of the country's political risks and its precarious fiscal position, it is not currently considered creditworthy for IBRD lending. In the event of peace and policy performance in line with the high case, we would review Sri Lanka's creditworthiness for IBRD lending. In anticipation of such a review, we will track the following benchmarks: * macroeconomic performance (e.g., public savings, monetary, fiscal and exchange rate management); * structural reform progress (public expenditure rationalization, trade reform and economic deregulation); and - growth of exports, especially non-traditional ones Portfolio Management 67. After successive years of decline, and following a major restructuring effort, performance of the Sri Lanka portfolio experienced a sharp turnaround in 1995. This result is explained in no small part by the efforts of the government, sensitized by the donors on the need to improve aid utilization. The issue has been elevated to the Cabinet, which now conducts periodic reviews and ensures that "core" public investment projects are not shortchanged in the face of fiscal pressures. The improved portfolio management reflects a three-pronged joint IDA-government effort: Through supervision and other portfolio management activities, such as Country Portfolio and Performance Reviews (CPPRs) and PERs, we are addressing both the project-specific and systemic or country-wide implementation issues, including procurement delays, erratic counterpart funding, and slow staffing of project personnel; project mid-term reviews are now conducted for all projects. The 1994 CPPR Action Plan (Attachment IV) has been closely monitored by the Resident Mission and a Mid-term Review was held jointly in Colombo with other major donors; and  21 We are restructuring/closing non-performing projects in order to complete, over the next 12 months, the clean-up of the portfolio that began two years ago; in some cases, this effort has been accompanied by aggressive cancellations of balances that are unlikely to be used. All 14 projects listed in the Action Plan were closed or had cancellations as planned, and US$88 million was canceled from nine projects compared to the agreed US$45 million. * Every effort is being made to assure ownership of new projects by involving stakeholders, provinces (as appropriate), and other beneficiaries in planning and execution; planned implementation periods are limited strictly to five years; and project launches are standard to ensure timely start-up. 68. The Bank's standard bidding documents were introduced for intemational competitive bidding following a three-day taskforce workshop in early 1995; and standard documents are being prepared for local bidding. There has been modest improvement in the timeliness and quality of audits, and the use of private auditors has increased. The disbursement ratio of IDA's Sri Lanka portfolio increased to 17.5 percent in FY95 from a low of 10.4 percent in FY93 and 11.3 percent in FY94 and is projected to reach over 20 percent in FY96, compared to a Bank average currently at 18.5 percent. To some extent, this dramatic improvement in the ratio reflects the fact that the undisbursed balance has declined as a result of low new IDA lending over the past three years. But the quantitative improvement have been matched by qualitative ones as well (Box 2). Eighty percent of ongoing projects are rated satisfactory. For the 31 projects that exited the Sri Lanka portfolio during FY80-95, the net "disconnect" (discrepancy in the staff ratings of project development impact and the assessment of the Project Completion Reports by OED) was 12.9 percent, compared to the Bank-wide net "disconnect" of 18.2 percent for the same period. 69. While the progress is real, problems remain--most notably delays experienced in high profile procurement decisions in such sectors as telecommunications and power. The next CPPR, planned for early FY97, will focus on further streamlining procurement procedures. We expect to be joined in this effort by the OECF and the ADB who share our concern about continuing procurement delays. ,.,.,~~ ~ ~~~~~~~~~~~~~~~~~~~~~~~. . .. .. .. ..... .............. ~~~~~~~~~~~~~~~~~~~~~. . x s .... ..i..: B~A~2~ PRTFOIO MNAGE(N. TR4OUD.EAAP .L I .... ... $