Cablegate: Sri Lanka: A Reform-Minded 2003 Budget

Published: Wed 27 Nov 2002 10:36 AM
This record is a partial extract of the original cable. The full text of the original cable is not available.
E.O. 12958: N/A
1. Summary: Indicating government commitment to fiscal
discipline and continued reforms, the 2003 GSL budget
concentrated on improving the macro economic situation through
measures to narrow the budget deficit and public debt while
increasing tax revenue. The fundamental weakness of the fiscal
situation remains, however; committed current expenditures
absorb all of government revenue, require heavy borrowings and
hold public investment below required levels. The budget
foresees an improved macro economic situation and lower interest
rates (stemming from a lower government deficit) together
boosting private investment. In addition, the budget proposed
to slightly expand tax holidays for investment and further
liberalize exchange controls. Significantly, there were no
populist measures. The budget was generally well received by
the business community; the opposition criticized it for a lack
of relief for the masses. It represents a credible first step
toward fiscal stability. End Summary
Reign in Macro Economic fundamentals
2. The Minister of Finance, K N Choksy, presenting the GSL
budget for FY 2003 to Parliament on November 6, said it aims to
undo the defects of the past and build prosperity for the
future. He said "our effort is to reform the economy in
parallel with the peace process" but warned that a spectacular
overnight recovery of the economy cannot be expected. He
recalled that in the past, the people have judged governments
and budgets by the number of flowery promises they make. He
asked that this government be judged by the results it delivers.
3. Under the United National Front (UNF) government, the
economy has already made a partial recovery from -1.3% dip in
2001. Growth is projected at 3% in 2002, increasing to 5.5% in
2003. Inflation has dropped from 14% in 2001 to about 9% in
2002. Considerable progress has been made in reducing the
budget deficit from 10.9% of GDP in 2001 to 8.9% of GDP in 2002,
which is just 0.4% off the IMF target. Deficit control,
however, has come at the cost of capital expenditure. The
current account deficit expanded to 4.3% of GDP in 2002 from a
planned 3.4%.
Deficit to drop to 7.5% in 2003
4. The government commitment to strengthening macro economic
fundamentals was manifested by moves to reduce government
spending and increase revenue. GSL hopes a new Fiscal
Management Law will ensure fiscal prudence and an Economic
Management Law will help ministries track economic reforms. The
2003 budget calls for total spending (and net lending) of Rs.
438 billion ($4.5 billion), or 24.6% of GDP. Revenues are
projected at Rs. 304 billion ($3.2 billion) or 17.1% of GDP,
implying a budget deficit of Rs. 134 billion ($1.4 billion), or
7.5% of GDP. The contraction in the deficit from last year's
levels, equivalent to about 1.4% of GDP, stems from both an
increase in revenue and a reduction in current expenditure. The
Government still runs a large current account deficit of 2.3% of
GDP. The overall deficit is to be financed through foreign
grants ($94 million), foreign borrowing ($260 million), domestic
financing ($906 million) and privatization receipts ($145
million). In the medium term, the government hopes to further
improve the fiscal situation by reducing the budget deficit to
5.6% of GDP by 2005.
Revenue to rise 16%; exemptions withdrawn
5. Revenue is forecast to increase by 16% in 2003 - a
reasonable target given the projected GDP growth of 5.5%,
inflation of 9% and a new, broad-based tax regime. The Value
Added Tax (VAT) introduced in August 2002 and import tariffs
were expanded to cover exempted goods and sectors. A 20% import
surcharge will remain through 2003, while a 0.1% debit tax on
bank transactions was extended to all types of bank accounts.
Certain other tax exemptions were withdrawn. The government
expects additional revenue of about Rs 12 billion from the
expanded tax regime. Furthermore, new taxes on annual vehicle
license fees, airline tickets and tourist hotels will fund the
development of roads, airports and tourism. Some of these taxes
have drawn criticism from affected persons and industries.
6. The budget announced the establishment of a revenue
authority to coordinate the functions of the various revenue
collecting agencies. In addition, tax administration is to
become more transparent and simplified. In order to widen the
tax net, the government offered an amnesty to defaulters and non-
taxpayers, with the intention of bringing them under a new tax
regime from April 2003.
Expenditure to come under control
7. On the expenditure front, GSL expects a contraction
equivalent to about 1.1% of GDP in 2003. Significantly, all of
this will arise from cuts in recurrent expenditure. Public
investment will rise from 4.6% of GDP in 2002 to 5.3% of GDP or
Rs 95 billion ($980 million), but will remain below the 6-7% of
GDP spent in 1998-2000 and below levels required for stronger
economic growth. Specific expenditure control measures in the
budget included strict budgetary controls, controls over defense
expenditure, public administration reforms and interest savings
on public debt. Otherwise the Government has little room for
expenditure management, especially with debt servicing running
ahead of total revenues. Interest payments will absorb 31% of
government expenditure (excluding repayments), public investment
(21%), defense (14%), welfare (5%), pensions (8%) and central
government salaries (6%). While defense expenditure has been
reduced by about 0.5% of GDP, it still remains one of the
largest spending items. Total defense spending (including
Police) is projected at Rs 63 billion (3.5% of GDP) in 2003
compared with 4% of GDP in 2002, 3.8% in 2001 and 5.7% in 2000.
Significantly, the budget did not contain any of the populist
measures typical of recent GSL budgets.
Public Debt
8. Due to heavy past borrowing to fund the war and unproductive
programs, Sri Lanka's public debt has increased to 105% of GDP,
prompting the government to accord high priority to bringing
debt under control. Debt servicing at Rs 326 billion (approx
$3.36 billion) is the largest expenditure item in the budget and
compares to total revenues of Rs 304 billion in 2003. The main
feature of the new debt management policy is to reduce short-
term debt instruments by replacing them with long-term bonds at
lower interest rates. A huge government overdraft from the
banking sector is also being eliminated. In addition, an
independent debt management office will be established in early
2003. These efforts, together with lower deficits, are expected
to gradually reduce public debt to 91.1% of GDP by end 2005.
Reforms to continue
9. The budget speech reiterated the government's commitment to
economic reforms covering a litany of areas - from welfare,
pensions and public administration to labor, land, power and
privatization. In addition, subsidies on a range of items from
wheat to petroleum and electricity have been already reduced.
The privatization program hopes to earn Rs 14 billion ($146
million) in 2003 through the sale of remaining Sri Lanka Telecom
shares and the opening of petroleum imports to the private
sector. In 2002, the government sold two sugar companies, a
bunkering company and minority stakes in 6 bus companies. The
sale of Sri Lanka Insurance corporation and a 15% stake in Sri
Lanka Telecom are underway. Total receipts are expected at Rs
21 billion ($219 million) in 2002.
Private sector
10. The Finance Minister stressed the importance of stimulating
growth and investment and increasing employment opportunities
outside the armed forces. The government hopes that the
combination of a recovering economy and a decline in public
sector borrowing from domestic banks will reduce inflation and
interest rates, spurring private sector activity. To boost
investment, the top corporate tax band was reduced from 35% to
30%, with half of the tax savings going into a skills
development fund. In addition, tax holidays were slightly
increased from 3 years to 5 years for exporting companies
located outside Colombo. The maximum tax holiday for large
infrastructure projects was also increased from 10 to 12 years.
Furthermore, joint public-private sector apex councils will
boost the tourism, garments, plantation, agribusiness, fishing
and jewelry industries.
11. The budget proposed mandatory credit ratings for financial
institutions and corporate debt instruments. Exchange control
liberalization will allow foreign companies to access rupee
credit facilities. Various other foreign exchange
liberalization measures will facilitate trade and investment:
import credit facilities up to 360 days, currency conversions to
settle loans, forward facilities up to 720 days and foreign
investment in debentures and government bonds.
North East rehabilitation not covered
12. The budget did not cover the rehabilitation of the north
and east devastated by war. The Government hopes to receive aid
from development partners for these activities at special donor
meetings, the first of which took place in Oslo on November 25.
A meeting in Tokyo in 2003 is to deal with medium term
assistance for the countrywide programs in the budget.
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Private sector welcomes the budget; opposition critical
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13. Private sector analysts and the business community have
praised the budget for its commitment to fiscal discipline and
reforms. But they have also pressed for practical measures to
implement new proposals and ensure accountability. Tax experts
and businessmen also commended tax administration proposals
aimed at simplifying the system. But they worry that expanded
taxation will lead to inflation and affect export
competitiveness. One of the most controversial has been the
extension of the VAT to the banking system, which analysts fear
could lead to increased interest costs. Another proposal to
charge a 15% tax on inward remittances was withdrawn due to
adverse effects on remittances of unskilled Sri Lankan workers
in the Middle East.
14. The opposition has criticized the budget for a lack of
relief for the working class and poor, as well as for not
funding major development projects. Some opposition politicians
have accused the government of simply following the dictates of
the World Bank and the IMF. Key government ministers defended
the budget moves, saying the country would incur more debt if
the people were to be given further economic relief. The stock
market reacted negatively to the budget especially due to
increased taxation on the key banking sector, which accounts for
44% of Colombo market capitalization. The budget was passed in
Parliament on November 14 with 129 votes for and 93 against.
15. This is the UNF's first full-year budget, its 2002 budget
having been delayed by elections until three months into this
year. It is a credible first step toward reversing the slide in
fiscal discipline that Sri Lanka has suffered in recent years.
But with a deficit target of 7.5% of GDP, the budget is neither
ambitious nor far-reaching in its reforms. This is no surprise
from a government that is pursuing a delicate peace process and
faces elections any time at the will of the President. Still,
if GSL sticks to this budget - or even comes close - it will be
well on its way to its modest medium-term goal of fiscal
stability in 2005.
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