FOR OFFICIAL USE ONLY

Document of The World Bank

FOR OFFICIAL USE ONLY Public Disclosure Authorized

Report No. 25937-CE

INTEFWATIONAL DEVELOPMENT ASSOCIATION

PROGRAM DOCUMENT Public Disclosure Authorized FOR A

PROPOSED CREDIT

IN THE AMOUNT OF SDR 90.7 MILLION

(EQUIVALENT TO US$125 ILIILLION)

TO

DEMOCR4TIC SOCIALIST REPUBLIC OF SRILANKA Public Disclosure Authorized FOR A

FIRST REDUCTION SUPPORT CREDIT

May 21,2003

Poverty Reduction and Economic Management Region Public Disclosure Authorized

This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not be otherwise disclosed without World Bank authorization. CURRENCY EQUIVALENTS (as of May 21,2003)

US$l.OO = 97.19 Sri Lankan Rupees (SLR)

FISCAL YEAR

January 1-December 31

ABBREVIATIONS AND ACRONYMS

ADB = LTTE = Liberation Tigers of Tamil AMC = Asset Management Company Eelam BOC = Bank of Ceylon MDG = Millennium Development BO1 = Board of Investment Goals NPL = Non-performing Loan CAS = Country Assistance Strategy NSL = National Security Levy CBSL = Central Bank of PAA = Project Approving Agencies CDF = Comprehensive Development PEM = Public Expenditure Framework Management CEB = PER = Public Expenditure Review CFAA = Country Financial PERC = Public Enterprise Reform Accountability Assessment Commission CFSES = Consumer Finance and Socio- PRGF = and Economic Survey Growth Facility CPAR = Country Procurement PRS = Poverty Reduction Strategy Assessment Report PRSC = Poverty Reduction Support CPC = Ceylon Petroleum Credit Corporation PSDAC = Private Sector Development DCS = Department of Census and Adjustment Credit Statistics PUC = Public Utilities Commission DF = Development Forum RRR = Relief, Rehabilitation, and DHS = Demographic and Reconciliation Survey RSL = Regaining Sri Lanka DPR = Development Policy Review SBA = Stand-By Arrangement GDP = SLIC = Sri Lanka Insurance GST = Goods and Service Tax Corporation HIES = Household Income and SLT = Sri Lanka Telecom Expenditure Survey SOE = State-Owned Enterprise IDA = International Development TEWA = Termination of Employment Agency of Workmen Act IMF = International Monetary Fund UNF = United National Front IOC = Indian Oil Company VAT = Value Added Tax LDP = Letter of Development Policy

Vice President: Mieko Nishimizu Country Director: Peter Harrold Sector Director: Sadiq Ahmed Sector Manager Ijaz Nabi Task Leader: Tercan Baysan FOR OFFICIAL USE ONLY SRI LANKA PROPOSED POVERTY REDUCTION SUPPORT CREDIT I TABLE OF CONTENTS

PROGRAM SUMMARY ...... i

I. INTRODUCTION...... 1

11. SRI LANKA'S POVERTY REDUCTION STRATEGY (PRS) ...... 6

A. Sri Lanka's Poverty Reduction Strategy (PRS) and Development Agenda ...... 6 B. Progress to Date and Medium-Term Actions to Achieve the PRS Objectives ...... 7 C. Assessment of the PRS ...... 15 D. Medium-Term Economic Prospects and Framework ...... 16

111. THE PROPOSED CREDIT AND THE POLICY FRAMEWORK ...... 18

A. Rationale for and Overall Objectives of the Poverty Reduction Support Credit ...... 18 B. Design ...... 19 C. Objectives and Actions to be Supported Under the PRSC I...... 20 D. PRSC Triggers ...... 29

IV. LINKS WITH THE CAS ...... 34

V. PROGRAM IMPLEMENTATION AND SOCIAL IMPACT ...... 35

A. Implementation ...... 35 B. Social Impact Analysis ...... 36

VI. CREDIT AMOUNT, TRANCHING, AND DISBURSEMENT...... 37

VII. BENEFITS AND RISKS ...... 37

ATTACHMENTS Attachment 1: Letter of Development Policy

A"J3XES Annex I: Policy Matrix Annex II: Poverty Diagnostics and Policy in Sri Lanka Annex HI: Rural Sector Annex 1v: Public Financial Management and Accountability Annex V: Policy Matrix for the Poverty Reduction Strategy Reform Agenda and World Banmartners Programs of Support Annex Al: International Monetary Fund Press Release April: 18, 2003 Annex A2: At a Glance Annex B5: Social Indicators Annex B6: Key Economic Indicators Annex B7: Key Exposure Indicators

This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not be otherwise disclosed without World Bank authorization. LIST OF TABLES

Table 1 Poverty by Province: 1995196 ...... 3 Table 2 Key Macroeconomic Indicators: 1990-2001 ...... 4 Table 3 Medium-Term Macroeconomic Framework: 2002-2006 ...... 17 Table 4 Actions Supported Under PRSC Iand Triggers for PRSC I1...... 30

LIST OF BOXES

Box 1 Sri Lanka and the Millennium Development Goals (MDGs) ...... 2 Box 2 The Humanitarian Effects of the Conflict ...... 7 Box 3 Fiscal and External Debt Sustainability ...... 9 Box 4 Potential Sources of ...... 18 SRI LANKA

PROPOSED POVERTY REDUCTION SUPPORT CREDIT I

PROGRAM SUMMARY

Borrower: Democratic Socialist Republic of Sri Lanka

Amount: US$125 million equivalent; on standard IDA terms and conditions.

Description: Background: The principal objectives of the Government’s development and poverty reduction strategy include securing lasting peace, accelerating economic growth, and strengthening governance in the public sector. The Government has already embarked on a strong program of peace and reconciliation and a comprehensive set of structural reforms to promote private sector-led growth. Significant progress has been achieved in the peace front and in creating the conditions for accelerating economic growth on a sustainable basis.

The Proposed Operation: The proposed Poverty Reduction Support Credit (PRSC) is designed to support the implementation of Sri Lanka’s Poverty Reduction Strategy (PRS) as articulated in Regaining Sri Lanka: Vision and Strategy for Accelerated Development (which was discussed by the Board on April 1,2003). This operation, PRSC I,would be the first of a series of annual PRSCs within a rolling four-year horizon, overlapping with Sri Lanka’s PRS period. Consistent with the objectives and priorities of Sri Lanka’s PRS, the PRSCs would support reforms in two major areas: (i) accelerating economic growth and supporting private sector development; and (ii)strengthening governance in the public sector and improving the system.

Benefits: The proposed PRSC will help the Government to: (i)move forward with the structural reforms, create conditions for accelerating economic growth, and send a strong signal to the private sector; (ii)continue fiscal consolidation and also have some fiscal space for the priority PRS programs; and (iii)improve public sector governance, and strengthen institutional framework and capacity in the management of public resources. These developments would also lead to improvements in the poverty-focus of public expenditures.

Risks: There are several risks: (i)the derailment of the peace process; (ii)a substantial deterioration of external environment; (iii)potential for domestic political instability since Sri Lanka is going through a period of political “cohabitation”--a President from one party and a Government from another; and (iv) resistance by labor unions to some economic reforms. Risks are mitigated by the design of the credit and by the CAS triggers. Schedule of Disbursements: The proposed credit would be disbursed in July 2003.

Project ID No: PE-PO81718

INTERNATIONAL DEVELOPMENT ASSOCIATION PROGRAM DOCUMENT FOR A PROPOSED POVERTY REDUCTION SUPPORT CREDIT I TO SRI LANKA

I. INTRODUCTION

1. Sri Lanka entered 2003 with significantly improved prospects for establishing a lasting peace, recapturing missed opportunities, and for faster expansion in economic opportunities. The prolonged civil conflict of the last two decades and the postponement of the badly needed economic policy/institutional reforms had kept Sri Lanka in a state of continuous sociallpolitical crisis and economic difficulties. The country had to deal with the consequences of enormous human suffering from the 20 year civil conflict, depletion of , and below potential economic performance. Persistent and very large budget deficits have led to a huge public debt burden--now exceeding 100 percent of GDP--and a fragile fiscal situation.

2. Today, Sri Lanka has a great window of opportunity. The United National Front (UNF) Government that came to power in December 2001 with a mandate to secure peace and accelerate economic growth has already embarked on a bold program of peace/reconciliation and a comprehensive set of economic policy/institutional reforms to promote private sector-led growth. Since the beginning of 2002, significant progress has been achieved in the peace front with successive rounds of peace talks, creating a real sense of optimism for the first time. An initial program of relief, rehabilitation, and reconstruction in the conflict-affected North and East has already been launched with donor support to address priority needs. This is to be followed by more comprehensive programs of reconstruction based on the ongoing needs assessment. At the same time, with the 2002 Budget implementation and the 2003 Budget announcement, the new Government has clearly demonstrated its commitment to moving forward with the growth agenda and tackling the fiscal deficitldebt issue. The Bank and the International Monetary Fund’s (IMF) assessment is that the fiscal adjustment measures and comprehensive structural reforms that have been announced and being implemented are credible and substantial, and will continue in the medium-term in line with the Government’s vision for the country. This vision is articulated in “Regaining Sri Lanka: Vision and Strategy for Accelerated Development”, which maps the way forward in economic policy strategy and formulates Sri Lanka ’s Poverty Reduction Strategy (PRS).

3. Indeed, at the beginning of a new millennium, Sri Lanka is poised to compensate for the past underperformance and regain its place among its East Asian neighbors, its peers of the 1960s. These developments are already affecting the Bank’s level of engagement in Sri Lanka, and the new Country Assistance Strategy (CAS) has developed an appropriately formulated program of support. In support of its program of accelerated development and poverty reduction, the has requested a combined, three-year Poverty Reduction and Growth Facility (PRGF) and Extended Fund Facility (EFF) Arrangement from the IMF, and a four-year Poverty Reduction Support Credit (PRSC) from the Bank. The Joint Staff Assessment presented to the Board on April 1,2003 concluded that Sri Lanka’s PRS provides a sound basis for Bank and Fund concessional assistance. The proposed SDR 90.7 million (US$125 million equivalent) First Poverty Reduction Support Credit (PRSC I)would assist the Government implement policies and structural reforms that are consistent with and supportive of Sri Lanka’s PRS. While the amount of the proposed credit is US$15 million larger than the amount stated in the recent CAS, this is to help the Government respond to the immediate needs resulting from the devastating floods that were experienced in May 2003 and to ensure that efforts aimed at keeping the structural reform program on track are maintained in the aftermath of the floods.’ The PRSC would also

’ These floods are the worst experienced by Sri Lanka in the 47 years since Independence. The fiscal effects of this disaster have not been yet determined. Based on recent Bank data, the total cost of flood related damage may be in excess of US$50 million. complement the IMF’s PRGF-EFF arrangement, which was approved by the IMF’s Board on April 18, 2003.

4. This Program Document discusses Sri Lanka’s social context and recent economic performance. It then gives details of the objectives, the key thrusts, and policy measures included in the Government’s poverty reduction strategy. Medium-term prospects under a satisfactory implementation of the PRS are discussed. Finally, the Document elaborates the rationale, actions expected to be supported by the PRSC, and benefits and risks of the proposed operation.

Country Context

5. Social context. Sri Lanka has been a good performer among developing countries in terms of human resource development, promoting gender equality, and social mobilization. It was one of the first developing countries to understand the importance of investing in human resources by providing universal health and education coverage and promoting gender equality and social mobilization. As a result, Sri Lanka achieved human development outcomes as great as those of high income countries and surpassed almost all of the Millennium Development Goals (MDGs) at an early stage of its development process (see Box 1). The poor in Sri Lanka are relatively well-protected due to free and universal access to health and education services, large income transfer programs-i.e., Samurdhi--and substantial subsidy schemes. The early successes in human development outcomes undoubtedly result from these long- standing policies. But, there are weaknesses. While access to health and education services is well- distributed, quality--especially in poor areas--remains inadequate. Poor households also face shortfalls in access to other basic services--e.g., among the poorest households, only 38 percent have electricity, 55 percent safe sanitation and 61 percent safe drinking water. Access to English language and technical education--both in great demand--is also low in poor regions. Moreover, social protection programs have become highly politicized and poorly targeted--Samurdhi is presently available to over 50 percent of the population.

MillenniumDevelopment Goals Sri Lanka’s Position \a Reduce the proportion of people living in extreme poverty by Poverty incidence declined from 3 1 percent to 25 percent half between 1990 and 2015. between the mid-1980s and mid-1990s. Aim is to halve extreme poverty by 2010. Enroll all children in primary school by 2015. Net primary enrollment rates exceeded 100 percent in late 1990s. Make progress towards gender equality and empowering Gender equality achieved in primary, secondary, and even women by eliminating gender disparities in primary and tertiary levels. secondary school by 2015. Reduce infant and child mortality rates by two-thirds between Between the mid-1970s and late 1990s, infant mortality fell 1990 and 2015. from 44 to 15 per 1,000 live births; under-five mortality fell from 100 to 18. Reduce matemal mortality rates by three-quarters between Matemal mortality rate is 60 per 100,000 live births, on par 1990 and 2015. with middle income countries. Provide access for all who need reproductive health services Contraceptiveprevalence rate is high at 66 percent; poorest by 2015. country in the world to have achieved below replacement fertility; 95 percent of births attended by health staff. Implement national strategies for by Since 1994, two successive national environmental action 2005 to reverse the loss of environmental resources by 2015. plans have been developed and are presently under implementation. \a Excludes the conflict-affected North and East.

6. Poverty profile. Below potential and regionally unbalanced growth have kept Sri Lanka’s poverty reduction performance below potential as well. The findings of a recent Bank poverty assessment

2 study2 indicate that in the mid-1990s about one-fourth of Sri Lankans lived below the national poverty line. These figures reflect poverty incidence about twice that of Malaysia, Thailand, and the Republic of Korea, and, as such, constitute significant under-achievement, even if Sri Lanka has experienced some decline in the incidence of poverty since the mid-1990s. (A more detailed coverage of poverty diagnostics and policy in Sri Lanka is presented in Annex 11).

impediments, and infrastructure bottlenecks have also constrained Table 1: Poverty by Province, economic-social mobility and integration within the country. This I 1995196 I explains, to a great measure, the observed significant spatial disparities I Incidence of 1 in Sri Lanka’s poverty incidence and why poverty is predominantly Poverty (%) rural. Over 90 percent of the poor live in the rural sector (including the Province estate sector). For half of them, small-scale agriculture and wage labor Westem on farms and plantations provide the main source of income. The 2728 I poorest work in paddy production or in plantations. There are N.Westem 34 considerable variations in poverty incidence across different regions (see North Central 31 Table l),with the economically dynamic Western Province having Uva 31 Sabaragamuwa 32 relatively low poverty incidence, while the Uva, North Westem, and Note: Using lower poverty line of Southern provinces, for example, showing much higher incidence of Rs.792 per person per month; poverty. Although not covered in the poverty assessment due to data Source: Annex I1

8. Below potential economic growth. By developing country and South Asia standards, Sri Lanka’s annual average GDP growth rate of 5 percent (about 3.8 percent in per capita terms) in the 1990s appears respectable, especially against the backdrop of the civil conflict. The liberalization of the trade and foreign exchange regimes, privatization in the plantation and manufacturing sectors, enclave arrangements for export-oriented activities, and outward labor migration and their remittances appear to have contributed to this reasonably robust growth performance under difficult circumstances. With a population of about 18.7 million (in 2001) and growing at 1.2 percent annum, Sri Lanka’s per capita income was about US$830 in 2001. Notwithstanding this performance, however, Sri Lanka has not been able to achieve higher growth rates commensurate with its human and natural resource endowments and comparable to those attained by South East and East Asian countries which were at a similar stage of development in the 1960s.

9. In part, Sri Lanka’s below potential performance has been due to the prolonged civil conflict, which has caused not only major human suffering, but also diverted resources from high priority development programs, depleted physical and social capital, and made the challenging structural reforms more difficult to undertake. In recent years, the amount of defense spending exceeded the combined public sector spending on education and health--4.6 percent of GDP vs. 4.1 percent in 2000. However, a variety of important policy and structural barriers have also been important factors in stifling the development of the . Although Sri Lanka has made considerable progress in liberalizing its international trade policy since the late 1970s, its domestic economy has not been adequately liberalized. The public sector, with weakened governance and one of the highest per capita employment ratios in the developing world, dominates important parts of the economy, limiting the scope for private sector development, while highly inefficient public enterprises remain a major burden on the budget and the economy. Indeed, the domestic environment has remained constrained due to the policy

The World Bank, Sri Lanka: Poverty Assessment, June 26,2002, Report No. 22535-CE 3 distortions, including severe factor market rigidities, and other structural impediments. Highly inflexible labor laws, constraints to the finctioning of land markets and land administration systems, inadequate infrastructure, ineflcient financial intermediation, and serious bottlenecks in tertiary education all prevent Sri Lanka’s economy from performing at its potential, contribute to high cost of doing business and thus also adversely affect Sri Lanka’s international competitiveness. As a result, the private sector and the economy’s full growth potential have not been adequately harnessed, including in the rural areas where poverty is a major concern.

10. Recent political developments. Sri Lanka has had numerous elections recently--including Provincial Councils (April 1999), Presidential (December 1999), Parliamentary (October 2000 and December 2001) and local (March 2002). The (UNP)--traditionally supportive of economic liberalization--won a near majority in the 225-member legislature in the most recent parliamentary elections. With the support of allied parties, the UNP formed a Government with a two seat majority, returning to power after seven years in the opposition. Mr. Rani1 Wickremasinghe--Prime Minister from 1993-1994 and a cabinet minister from 1977-1993--was sworn in as Prime Minister on December 9, 2001. Following this, in the March 2002 local elections the UNP won all but one of the over 200 seats, hence, strengthening its mandate to pursue a lasting peace and economic reform agenda to accelerate economic growth.

11. Economic Developments. Large and sustained budget deficits--of around 7.5 to 11 percent of GDP-since the early 1990s have resulted in a fragilefiscal situation, facing the Government with a sign@cant deficit and debt reduction challenge (see Table 2). Even when grants treated as revenue, the budget deficit still remained at very high levels in the 1990s. Rising defense spending, significant increases in interest payments, large losses of state-owned enterprises (SOEs), and the sharp decline in budget revenues contributed to the growing budget deficits. The revenue performance has weakened by about 4 percentage points of GDP since 1995. The loss of tariff revenues from tariff exemptions and the tax concessions awarded to investors under the Board of Investment (BOI) regime have weakened the Table 2: Kev Macroeconomic Indicators: 1990-2001 1990 1993 1995 1996 1997 1998 1999 2000 2001 Annual GDP Growth (% change) 6.4 6.9 5.5 3.8 6.3 4.7 4.3 6.0 -1.4 Atlas GNP Per Capita (US$) 470 600 700 750 800 810 820 850 830 Annual Change in (Colombo) Consumer Price Index (% change) 21.5 11.7 7.7 15.9 9.6 9.4 4.7 6.2 14.2 InvestmenUGDPRatio 22.2 25.6 25.7 24.2 24.4 25.1 27.3 28.0 22.1 Domestic Savings/GDP Ratio 14.3 16.0 15.3 15.3 17.3 19.1 19.5 17.4 15.3 C/A Balance (excl. official transfers) as % of GDP -5.4 -5.3 -6.5 -4.9 -2.6 -1.4 -3.7 -6.7 -2.5 Overall BOP SurpluslDeficit (in US$mn.) 119 661 52 -68 163 37 -259 -522 220 Gross Off. Reserves (in months of imports of GNFS) 1.7 4.5 4.1 3.8 3.5 3.3 2.2 1.5 2.5 Extemal Debt Service Ratio (percent of exports of goods and services) 17.8 12.9 16.5 15.3 13.3 13.3 15.2 14.7 13.3 Govemment Revenue (% of GDP) 21.1 19.7 20.4 19.0 18.5 17.2 17.7 16.8 16.5 Govt. Current Expenditure (% of GDP) 22.3 20.5 23.5 22.8 20.8 19.6 18.7 20.2 21.4 Interest Payments (% of GDP) 6.4 6.0 6.2 6.4 6.2 5.4 5.6 5.7 6.7 Govt. Capital Expend. (% of GDP) 6.1 6.7 5.9 4.9 4.9 5.3 5.5 5.4 4.8 Budget Deficit (% of GDP) /1 -9.9 -8.7-10.1 -9.4 -7.9 -9.2 -7.5 -9.9 -10.9 Budget Deficit --including grants (% of GDP) -7.4 -7.1 -8.7 -8.4 -7.1 -8.5 -6.9 -9.5 10.5 Primary deficit -excluding grants (% of GDP) -3.5 -2.7 -3.9 -3.0 -1.7 -3.8 -1.9 -4.2 -4.1 Govemment Debt (% of GDP) 96.5 96.9 95.2 93.1 85.9 90.8 95.1 96.8 103.6 O/w Domestic Debt (% of GDP) 41.6 42.8 43.3 46.4 43.6 45.5 49.1 53.8 58.3 Govemment employment (‘000 persons) 649 - 738 752 762 790 822 857 864 Nominal Average Exchange Rate (Rs/US$) 40.0648.25 51.3 55.3 59.0 64.6 70.4 77.0 89.4 1/ Excluding grants and privatization proceeds. Sources: Central Bank of Sri Lanka; Department of Census and Statistics.

4 revenue base and collections. The introduction of the Goods and Services Tax (GST) in 1998 and the National Security Levy (NSL) in 2001, and their subsequent consolidation into a Value Added Tax (VAT) in August 2002 have not yet reversed this trend. The escalation of the conflict in the latter part of the decade, the expansion of government employment in recent years (over 13 percent during 1997-2001), and the delays in administered price adjustments compromised expenditure adjustments and further increased the budgetary burden of some SOEs. Heavy reliance on domestic deficit financing--averaging 75 percent of net financing needs since 1996--have made interest payments the largest expenditure item in the budget as the Government increased domestic borrowing significantly, especially in 2000 and 200 1 when the interest rates were also very high. Interest payments reached 6.7 percent of GDP and over 40 percent of tax revenue in 2001, crowding out important public expenditure categories, such as physical and social infrastructure; and to 7.4 percent of GDP in 2002. Increased domestic borrowing by the Government in turn pushed up real interest rates further in the late 1990s, thus adversely affecting private credit and investment.

12. The government debt climbed to over 100 percent of GDP in 2001, with 58 percent being higher cost domestic debt--which accounts for 90 percent of interest payments. Currently, interest payments, the salary/wage bill, defense spending, and subsidies/transfers account for most of the budgetary expenditures, leaving small amounts for capital expenditures (less than 5 percent of GDP out of a total spending of around 27 percent of GDP) and negligible amounts for non-wage repairdmaintenance.

13. Sri Lanka suffered significant economic setbacks in 2001. The switch to a floating exchange rate regime on January 23 was an important step to stem the loss of external reserves that had started in 2000. Still, given the import demand pressures and high oil prices, by March 31,2001, gross official reserves fell to under 2 months’ import financing needs. To improve fiscal balances, stabilize the exchange rate, and reverse reserve losses, the Government entered into a Stand-By Arrangement (SBA) with the IMF in April. However, adverse political and economic developments in the second half of the year derailed the program. The July 24th attack by the LTTE on the Colombo Airport and the events of September 1lth, a sluggish external demand for Sri Lanka’s exports, a prolonged drought, and the heightened political uncertainty produced a negative growth rate of 1.4 percent--the first contraction since independence in 1948. The rate of inflation rose by 8 percentage points to over 14 percent due to drought related price increases and the impact of the depreciation of Rupee. Defense spending overruns and fiscal laxity intensified in the run up to the December 2001 elections.

14. Economic recovery nraduallv resumed in 2002. Following the signing of a Memorandum of Understanding (MOU) between the Government and the Liberation Tigers of (LTTE) on February 23,2002, the Government presented a strong Budget in March 2002 which demonstrated a clear commitment to fiscal consolidation, structural reforms, and economic growth. On the fiscal front, a two- rate VAT system replaced the GST and the NSL; selective expenditure cuts were introduced (including a credible public sector hiring freeze); restrictions on FDI were further relaxed, and the deficit target was set at 8.5 percent of GDP. The higher budget deficit outcome of 8.9 percent is mainly due to the transitional revenue losses associated with the introduction of the VAT, the subsequent VAT exemptions granted to contain the VAT-related upward pressures on the cost of living, and a lower than projected GDP growth. These measures fostered investor confidence, boosted the stock market, and doubled capital inflows on a cumulative basis. The IMF released the last tranche under the SBA in September, and the gross official foreign reserve position improved to well over 2 months of imports. The Rupee remained broadly stable at around Rs.96 per US dollar. With the return of normal rains and the cessation of hostilities, GDP growth turned positive in the first half of 2002, reached 5.3 percent in the third quarter, and appears to have exceeded 3 percent for the year, reflecting largely domestic-oriented activity (particularly in services), since external demand remained sluggish. And the average rate of inflation appears to have fallen below 10 percent. The 2003 Budget presented on November 6,2002 reflects a continuity from the 2002 March initiatives.

5 11. SRI LANKA’S POVERTY REDUCTION STRATEGY (PRS)

A. Sri Lanka’s Poverty Reduction Strategy (PRS) and Development Agenda

15. Background. During the past four years, successive Governments have engaged in broad stakeholder consultations to reach consensus on a medium- to long-term strategy for faster and sustained and poverty reduction. The incidence and depth of poverty were widely discussed and the country’s approach to the problem was first elaborated in Connecting to Growth: Sri Lanka’s Poverty Reduction Strategy. The island-wide consultative process also mobilized views of key stakeholders on how to work together on relief and rehabilitation in the conflict-affected areas through the Framework for Reliej Rehabilitation, and Reconciliation (RRR). The results of these consensus-building consultations together with background assessments resulted in a well-developed draft of Sri Lanka’s Poverty Reduction Strategy (PRS), which development partners strongly endorsed at the June 2002 Development Forum (DF).

16. After its election in December 2001, the Government set about the task of defining its own economic program more precisely. This has resulted in the publication of The Future: Regaining Sri Lanka (RSL), which is a strong and aggressive proposal to remove the existing policy-induced and structural constraints that inhibit private sector activity, and change the role of the state. It is to be emphasized that RSL is fully consistent with the thrust of the earlier draft of the PRS, but with a much more accelerated and deeper implementation framework, and an elaborated monitoring and implementation mechanism. The PRS, which incorporates the policy framework elaborated in the RSL, was finalized in early January 2003 under the title Regaining Sri Lanka: Vision and Strategy for Accelerated Development. (The details of the consultative process, which started in May 1998, are elaborated in Part 11, Chapter 1 of the main text of the PRS and summarized in Annex 1 of Part 11). The final document defines the priorities for the country’s medium- and long-term term economic and social development agenda and charts a program of action for the country. This is also serving as the main framework for the formulation of the Bank‘s new Country Assistance Strategy for Sri Lanka (discussed at the Board on April 1,2003), for concessional assistance from the IMF as well, and for support from the bilateral donors.

17. Principal thrusts of Sri Lunka’s PRS. The PRS reflects afundamental change in the role of the state with a clear departure away from the unsustainable policies of “redistributiodtransfers ” to creating an enabling environment for faster economic growth and poverty reduction. Accordingly, the principal thrusts/objectives of PRS are already well-identified. In broad terms, these include: (i) securing lasting peace; (ii) building a supportive macroeconomic environment; (iii) accelerating economic growth, with the private sector leading the effort; (iv) investing in people; and, (v) strengthening “governance” in the public sector to enhance the development impact of public resources. 18. In line with the Millennium Development Goals (MDGs), the PRSP identifies the target of halving the number of poor by 2015 as the key objective that will guide the long-term strategy for poverty reduction. Within this framework, the other key targets that the PRSP sees as achievable in the medium- term include:

0 increasing the GDP growth rate to around 7 percent within next three-four years (and then increasing it further to near 10 percent in the second half of the current decade); 0 and creating a minimum of two million new jobs during the next several years for the currently unemployedunder-employed and the new entrants to the workforce; and 0 reducing the national headcount poverty index from 25 percent to 20 percent and the rural headcount poverty index from 27 percent to 22 percent by 2005.

6 19. Re-orientation of public expenditures. Consistent with these objectives, the PRSP envisages gradual shifts in the allocation of public expenditures. Additional fiscal room that the ongoing fiscal consolidation (detailed below) will create is expected to allow for a deficit reduction of about 4.5 percent percentage points of GDP in four years, while also creating room for gradual increase in capital spending in education, health and infrastructure. The share of social sector capital expenditures would more than double to 2.2 percent of GDP by 2006 from its 2001 level. Similarly, the PRS includes strengthened public sector programs for --in agriculture, irrigation, rural electrification, connecting roads, and initiatives to promote community-based activities. B. Progress to Date and Medium-Term Actions to Achieve the PRS Objectives Securing Peace 20. Establishing a lasting peace is a top priority and it is a critical element of Sri Lanka’s poverty reduction strategy. Recognizing that ending the conflict and establishing peace will be a challenging and long process, the Government is pursuing a three-pronged approach to secure lasting peace consisting of (i)negotiating a political settlement; (ii)enacting constitutional reforms to fulfill the aspirations of all citizens; and (iii)expediting development in the conflict-affected areas. The Reliej Rehabilitation, and Reconciliation (RRR) process was initiated to address the basic needs of the people affected by the protracted conflict, to improve conditions for the resumption of economic activities, and to facilitate reconciliation among all ethnic groups. Between September 2002 and March 2003 six rounds of formal peace talks took place between the LTTE and Government. The talks were temporarily suspended in April, but it is anticipated that they will resume in the not too distant future. In the meantime, the Government is actively engaged with donors to mobilize financial support for immediate humanitarian and rehabilitation needs in the North and East. To this end, the Oslo Donor Conference was held on November 25,2002, in which development partners indicated pledges of about US$70 million for the North East Reconstruction Fund, for which the World Bank is the Administrator. This fund will be used for immediate humanitarian and reconstruction needs. A Conference on Reconstruction and Development of Sri Lanka is planned in Tokyo in June 2003, but it is not yet clear whether this will go ahead as currently planned. 21. Meeting the relief, rehabilitation, and reconstruction needs of the North and East. The two decade-old conflict has caused significant human suffering and physical damage (see Box 2). The full extent of the resulting relief, rehabilitation, reconstruction, and capacity building needs is being assessed and are expected to be substantial.

Box 2: The Humanitarian Effects of the Conflict

The conflict in Sri Lanka has led to loss of life, the displacement of persons belonging to all ethnic groups and the destruction of infrastructure, health care facilities and schools. Approximately 2.5 million persons lived in areas of direct military activity--65,000 people have been killed, 800,000 are intemally displaced, including 172,000 living in refugee camps and another 700,000 left the country. There are 30,000 war widows and an estimated 300,000 displaced children in the North-East where the school drop out rate is double the national average. The infant mortality rate in the North East is twice the national average, the matemal mortality rate is thrice the national average and 92% of deaths are reported from the region. There are an estimated 1.8 million landmines in the North--a per capita incidence comparable to Angola. The Bank’s Activities in the North East Since 1999, the Bank has been a leader in assisting development of the North East (NE). The NE Irrigated Agriculture Project (NEIAP; 1999) has been active in conflict-affected areas supporting community-driven efforts to rebuild economic activity and the 2001 Land Mine Action Project (a US$1 million Post Conflict Fund Grant administered by UNDP) has been supporting de-mining activities. In mid-2002, the Bank developed a three-phase strategy for comprehensive reconstruction support to the NE. In the first phase, we are redirecting, expediting, and scaling-up activities in the NE in those projects which focus on the entire country, but activities could not be carried out in the NE because of the conflict. Approximately US$15 million was identified through four projects. In the second phase, certain projects--with significant savings and/or where project components will not meet development objectives by closing--have been restructured to provide additional urgently needed support to the reconstruction efforts. US$3 1 million was identified in three operations and a restructuringpackage was approved by the Board on November 14,2002. In the third phase, a longer-term program to meet the development needs of the NE is being addressed in the context of the CAS. In addition, the Bank will administer the North East Reconstruction Fund (NERF)--the main vehicle for implementing humanitarian and rehabilitation programs in the NE.

7 This would mean that fiscal support needs associated with the peace process and the RRR efforts are likely to be significant as well. It is important that the population begins to see the gains from peace at an early stage and that resources are in place to permit resettlement to occur. Faced with the very tight budgetary situation, the Government has allocated budgetary resources amounting to only about 0.5 percent of GDP in 2003 for the RRR activities in the North East. However, the Government intends to prepare a “Supplementary Budget” on the basis of additional concessional assistance for the North and East. In this regard, the ongoing efforts to mobilize more concessional financial support to meet not only the immediate RRR needs but also the significant pent-up maintenance and investment needs in the conflict-affected region are important. As detailed in Box 2, the Bank has already expanded its support program for the North East. Other development partners are willing to increase their assistance to Sri Lanka in the short-term to support RRR programs, and it is expected that they will also participate in the medium- and longer-term reconstruction and development efforts under a successful peace process and effective implementation of Sri Lanka’s PRS. Building a Supportive Macroeconomic Environment

22. Creating the conditions for accelerating economic growth on a sustainable basis is a key priority as stressed in the PRS. Consistent with this objective, there is an acceleration in the pace of structural reforms aimed at: reforming factor markets, the commercial legal framework and the public sector; facilitating greater private sector participation in infrastructure; and reinvigorating the rural economy. At the same time, recognizing that macroeconomic stability is a sine qua non for sustained high economic growth, the PRS also places strong emphasis on fiscal sustainability and on strengthening the macroeconomic framework.

23. The Govemment is committed to continuinR fiscal consolidation and strengthening the macroeconomic framework. The medium-term objective is to reduce the budget deficit below 5 percent of GDP and the public debt to around 81 percent of GDP by 2006. Fiscal consolidation will continue through revenue as well as expenditure measures. On the revenue side, the tax revenue/GDP ratio is expected to increase by 2.7 percentage points during 2002-2005, mostly by extending VAT’s coverage to retail activities and by reducing VAT exemptions. The removal of tariff exemptions on imports and the introduction of a minimum import tariff rate are the other important source of improved tax buoyancy. Already, Section 17 of Board of Investment (BOI) Law was repealed, thereby eliminating BOI’s power to grant tax holidays/incentives outside the regular tax legislation. Also, the establishment of a unified tax authority is expected to improve tax collection in general. On the expenditure side, the target is to reduce the current expenditure/GDP ratio by 2.3 percentage point in four years. This is to be achieved through reductions (as a percent of GDP) in salaries/wages, defense spending, interest payments, and subsidiedtransfers, including the scaling down of the Samurdhi program through better targeting. The Government also intends to rely on grants and concessional donor assistance in meeting the financing needs of additional RRR activities in the North and East, thus maintaining fiscal discipline. In addition to the latter fiscal measures, some of the structural reforms initiated under the program, including the ongoing restructuring and privatization efforts in the SOE sector, will contribute to the fiscal consolidation and deficiddebt reduction effort. The acceleration of economic growth will, of course, enhance the budgetary revenue base and improve debt servicing capacity, thus strengthening fiscal sustainability (see Box 3).

24. There are, of course, some downside risks faced by the Government in strengthening fiscal balances and restoring fiscal sustainability in the medium-term. Internally, a resumption of hostilities, sustained drought and, externally, any sustained adverse impact of the post-Iraq War developments in the Middle-East on oil prices, tourism revenues, tea exports, and remittances could affect Sri Lanka’ s growth performance and external balances negatively, thus undermining the anticipated benefits of the ongoing fiscal consolidation and structural reform efforts.

8 I Box 3: Fiscal and External Debt Sustainability Fiscal policy/public debt sustainability. As noted earlier, under continued fiscal consolidation and structural reforms in the medium-term(detailed below), Sri Lanka’s fiscal policy will be sustainable, with the primary budget deficit falling and the public debt/GDP ratio declining (Table 3). Not unexpectedly, however, sensitivity analysis carried out by the IMF demonstrates that, even with strong fiscal adjustment, achieving a rising GDP growth rate from the very low 2001 levels is critical for securing fiscal sustainability. There are other risks to fiscal sustainability in the medium-term: the revenue measures may fail to be effective; concessional external financing may fall, leading to more non-concessional foreign borrowing; and capital spending may exceed prudent levels. External debt sustainability. Sri Lanka’s total external debt was US$9.7 billion at end-2001 (about 62 percent of GDP), with 85 percent of it being public/publicly guaranteed debt. Due to the high concessionality of the public debt, net present value of the external public debt was about 74 percent of the nominal stock. The medium-term macroeconomic scenario summarized in Table 3, with rising GDP growth and increasing concessional donor assistance, shows a declining external debt/GDP ratio. The latter is of course sensitive to GDP growth rate assumption. And the IMF’s sensitivity analyses indicate also that the external debt ratio shows reasonable robustness to temporary shocks to interest rates, growth, and the external current account, though a combination of these or a large depreciation of the Rupee could undermine sustainability.

25. To ensure that fiscal discipline is maintained and fiscal consolidation continues, legislative actions have been taken as well. The Fiscal Management (Responsibility) Act, enacted in January2003, requires regular mid-year and end-fiscal year ‘fiscal position’ reports. It also mandates a ‘Pre-election Budgetary Position’ report to discourage pre-election ‘hand-outs’. In addition, the Act sets a strict limit on borrowing from the Central Bank3and fixes the budget deficit target for 2006 at below 5 percent of GDP. Moreover, circulars were sent to the Secretaries of Ministries and Chairmen of the Boards of SOEs and Statutory Boards in May 2002, establishing strict time limits on the submission of annual accounts and performance reports; (these circulars also establish penalties for non-compliance). Strengthening fiscal balances will continue to reduce budget deficit and the public debt to sustainable levels.

Accelerating Private Sector-Led Economic Growth

26. Based on extensive assessments and actual experience, the liberalization of the domestic economy and strengthening of the enabling business environment are seen as key steps to fostering private sector-led growth. In this regard, there is a significant focus on reforming factor markets, which this proposed operation would support. Amendments are being made to the rigid labor laws to increase flexibility in the labor markets and thereby enhance labor mobility, productivity, and employment generation. The amendments seek to require the Labor Commissioner to apply new compensation formula to be published in a Gazette for job termination cases and expedite redundancy/labor dispute related hearings and determinations under a time-bound labor dispute settlement rule (details are in Section I11 below). Preparations are also underway to foster efficient use of rural (as well as urban) land by establishing clear property rights and modernizing institutional framework that would lead to efficient functioning of land markets. To this end, efforts are made to establish a legal framework to remove restrictions related to the sale, leasing, transfer, and mortgaging of the rural lands that have been distributed to farmers on grant basis under the Land Development Ordinance and Land Grants (Special Provisions) Act. Similarly, consideration is also being given to divest unutilized state-owned urban land both to raise resources and to promote efficient use of urban land. Legal and organizational reforms are also being developed to improve the land administration system through title registration (see Section I11 for details).

27. Thefinancial sector, which has been strengthened in the last two decades through improvements in the legal framework, still has considerable weaknesses which constrain efficient financial intermediation and private sector development. The sector is dominated by larger and less efficient state- owned institutions. And the state claims a large portion of financial resources--particularly of the long-

The latter can not exceed 10 percent of estimated government revenues 9 term funds--to finance the budget deficit, thus putting upward pressure on real interest rates and crowding out the private sector. The two state-owned commercial banks, Bank of Ceylon (BOC) and People’s Bank (PB), account for well over 50 percent of banking sector assets. Of the two, BOC has improved its performance recently and has lowered its NPL ratio (13.3 percent). However, People’s Bank is still a very weak bank with negative net worth and a very high NPL ratio (20 percent--and even higher under the international loan classification norms). Currently, there is an ongoing effort to restructure the state- owned banks. Since early 2002, Bank of Ceylon has been implementing a business plan to improve returns on assetdequity, reduce employee cost ratios, speed up the recovery of NPLs, and reduce the number of branches. Among various restructuring options recommended by a Bank-IMF team, two possibilities of commercializing the PB are now being considered; specially: (i)identifying suitable strategic investor to take over the PB; or (ii)breaking up the PB into a commercia2 bank and savings bank, and then finding a strategic investor to take over the commercial unit. In either case, an asset management company (AMC) will be established to deal with the collection of NPLs (see Section I11 for more details). To deepen the financial sector and improve financial intermediation, reforms have been and are being undertaken to increase private sector participation in the insurance and provident fund industry, and to strengthen the regulatory and supervisory framework for the banking and the capital marketsa4

28. Contractual savings are accounted for mainly by the two public provident funds for private sector employees, the Employees’ Provident Fund (EPF) and the Employees’ Trust Fund (ETF), and 10 insurance companies. In the insurance industry, the legal prohibition on private insurers and brokers was removed in 1986 with the amendment to the Insurance Control Act of 1962. Since then, seven private insurance companies have been authorized as well as 44 insurance brokers. The Sri Lanka Insurance Corporation (SLIC), which still dominates the market with about 55 percent of the industry’s assets, was privatized in April 2003. This action, together with the earlier privatization of the National Insurance Corporation (NIC), created an insurance sector that is 100 percent privately owned. The three largest private insurers next to the SLIC account for about 32 percent and two foreign controlled insurance companies 5 percent of the industry’s assets. Compulsory 15 percent reinsurance to NIC by other companies on their fire and marine insurance contracts was abolished with the enactment of the new Insurance Law in August 2000. Insurance companies are now free to reinsure with other domestic insurers or with foreign reinsurance companies. Foreign companies are allowed to operate in Sri Lanka in any form (branch, subsidiary, or joint venture) and restrictions on foreign ownership were fully relaxed. A new agency, the Insurance Board of Sri Lanka (IBSL), was established as an independent regulatory body in 2000.

29. There are also initiatives to make the provident funds more effective and safer instrument for old- age savings. The largest provident fund, EPF, has been allowed to invest in private sector securities and plans to introduce private management of the assets on a competitive basis, initially limited to a share of the portfolio and eventually expanded to the entire portfolio. Permitting some overseas investments in the medium-term could further increase portfolio diversification and performance. The Government has also decided to amalgamate the EPFBTF to improve the administration of these funds. A study will be launched in 2003 to review their current structure and business processes and formulate a plan for merging the two institutions, enhancing their administrative procedures and improving the collection of contributions and benefit payments.

30. To improve the enabling environment for private activity, steps have been initiated to move towards a unifodower and transparent system of corporate tax structure, and to modernize the legalhegulatory environment for market entry and exit by amending the Companies Act and enacting a bankruptcy legislation. Also, to strengthen the efficiency and effectiveness of tax administration and to facilitate the harmonization of tax treatment of the BO1and non-BO1 companies, preparations are being made to establish a modern, unified tax administration. The critical importance of liberalized trade policy

A detailed assessment of Sri Lanka’s financial sector is presented in: The World Bank and The InternationalMonetary Fund, Financial Sector Assessment Pronrum, Main FSAP Report (November, 2002). 10 for enhancing domestic competition and for increasing exports is stressed in the PRSP. Accordingly, the Government is committed to further reduce and rationalize tariff protection with a medium-term objective of reducing the number of tariff rates as well as the tariff dispersion for manufactured goods. The very high tariff protection currently afforded to agricultural products will also be lowered. The 40 percent import surcharge, introduced as a temporary revenue measure in 2001, was reduced to 20 percent in 2002, and the Government has indicated that it will be cut further to 10 percent in January 2004 and eliminated in January 2005.

3 1. Notwithstanding the successes with its privatization program so far in the agricultural and manufacturing sectors, Sri Lanka still has a significant number of large state-owned enterprises (SOEs) involved in many commercial activities, including utilities, transport, banking, petroleum, and the wholesale of basic commodities. Many of the SOEs and public departments producing goods and services have become unsustainable burdens on the public purse. Long delays in adjustments of administered prices and significant inefficiencies in SOE operations, particularly in the energy sector, have been a major drag on the economy and burden on the budget. The losses of SOEs equaled 1.5 percent of GDP in 2000, and the budgetary (recurrent and capital) transfers to SOEs amounted to 3 percent of GDP in 2001. SOEs have also been unable to deliver reliable and affordable goods and services demanded by citizens, particularly in utilities where the SOEs have enjoyed monopoly positions. To tackle the SOE sector problems and mobilize resources, there is commitment to continuing the privatizution program in most commercial a~tivities,~and the Government is in the process of restructuring some of the large SOEs in utilitiedinfrastructure to improve their efficiency/financial performance, as well as to introduceprivate sector participation in infrastructure.

32. Given the bitter experience of prolonged and frequent power cuts and the enormous losses of Ceylon Electricity Board (CEB) and Ceylon Petroleum Corporation (CPC), there is determination to continue reforms in the energy sector. In petroleum, the Government started implementing an automatic price adjustment formula in January 2002, which allows for monthly adjustments in petroleum and diesel prices according to changes in international prices (taking Singapore prices as reference). Steps are being taken to open the importation, distribution, and retail activities to the private sector. Some of the assets of CPC are being divested. The Indian Oil Company (IOC) has purchased 100 of the 300 filling stations owned by CPC; (currently, the private sector owns 600 filling stations). The IOC will also be free to supply all privately owned filling stations, thus ending CPC’s current monopoly over supplying all 900 gas stations. There are plans to spin off CPC’s infrastructure facilities (storage and distribution) and establish a separate (petroleum infrastructure) company in which a couple private companies would be allowed to purchase equity stake. Sri Lanka’s power sector has also faced serious difficulties in recent years, partly due to the ongoing structural problems and inefficiencies and partly due to external petroleum price shocks and the prolonged drought. In response, electricity tariffs were raised by 38 percent in April 2002, and a significant reform program has been initiated aimed at restructuring CEB and promoting increased private-sector participation in generation under a sound regulatory framework (see Section 111 for further details).

33. Znvi,poratine rural economy. About 80 percent of Sri Lanka’s population and 90 percent of the country’s poor live in rural areas. Despite its declining contribution to GDP (20 percent in 2000), the agricultural sector (including livestock and fisheries) remains vital for employment and income generation. Thus, fostering rapid rural development, particularly raising productivity and competitiveness in agriculture and non-farm rural sectors, is a critical element of achieving faster overall economic growth and poverty reduction in Sri Lanka. This is well recognized by the policy makers, and the PRS gives high priority to rural development. As noted earlier, measures are being taken to remove the key

5 Sri Lanka has had good experience with privatization of SOEs in the plantation sector and manufacturing industries. Its ongoing privatization program-expanded in 2002 by including Sri Lanka Insurance Corporation (SLIC) and additional public stakes in Sri Lanka Telecom (SLT)--is being managed by Public Enterprise Reform Commission (PERC). The program is on track. During the last 10 months, the Government sold: Pelwatte and Sevanagala Sugar Companies, Lanka Marine Services, 49 percent stake in Shell Gas Lanka, certain cluster bus companies, 12 percent of the publicly held shares of the SLT, and more recently 90 percent stake in SLIC (for over US$60 million). Among these, SLT and SLIC are the largest in terms of net asset value. 11 policy/institutional constraints to efficient and competitive rural sector, including the ongoing reforms in the labor and land markets. The other key elements of the strategy for promoting commercially oriented, efficient and productive agriculture include: (i)rationalizing the trade regime for agricultural outputs, inputs, and technology with the view to lowering the very high import protection rates and making the import tariff policy more predictable and transparent; (ii)gradually reducing public sector involvement in agricultural marketing; and (iii)supporting improvements in rural infrastructure--roads connecting to urban markets, rural electricity, water and sanitation, communications--to facilitate economic connectivity and integration (Annex I11 provides a more detailed background on the core issues of Sri Lanka’s agriculture and measures being undertaken).

Investing in People

34. Investing in human resource develoument. Improving access to quality education and basic health services is central to the PRS. Recognizing the backlog of needs in social services, the intention is to promote a growing private sector role in the provision of education and health services. This would allow public resources to be directed towards improving access and service quality in the poor areas. In education, the focus will be on: addressing regional inequities in the provision of quality basic education; improving the curricula in secondary education; and, in tertiary education, on enhancing the relevance of tertiary education in line with the market needs, increasing capacity by opening the tertiary education sector to the private sector, and reforming education finance. In the healthhutrition area, the principal strategic goals are to improve nutritional status of infants, children and pregnant women, prevention of non-communicable diseases, prevention and control of malaria and HIV/AIDS. In health care, the main focus will be on preventive programs, while the private sector will be encouraged to further develop the secondary and tertiary care private hospitals. Sri Lanka’ s long-standing strengths in social mobilization will be capitalized on to rely on community-based organizations to expand the provision of safe drinking water and sanitation services in rural areas under a sustainable system of tariff setting and maintenance. In urban areas, the private sector will be encouraged to play an increasing role in these activities.

35. Imvrovinn the welfare system. Basic assistance and income support through well-targeted safety net programs would still be required for some chronically poor and disadvantaged groups as well as those who may require a temporary cushion from shocks. The major welfare system of Sri Lanka--the Samurdhi program--as it has existed during recent years has suffered from flaws in design that has led to enormous mis-targeting, which have considerably reduced its impact. A sizable component (80 percent) of the Samurdhi program is a consumption grant in the form of food stamps to households. According to the findings of Bank’s recent Poverty Assessment study, the program misses about 40 percent of households ranked in the poorest quintile, while almost 44 percent of the total Samurdhi transfer budget is spent on households from the top 3 quintiles. Furthermore, targeting errors are not random, but rather reflect flaws in the design of the program (see Section I11 below and Annex I1for details). Because the program covers around half of the population, the impact of the program on the poor is limited by the generally small size of the transfer. Recognizing the above, the Welfare Reform Act was enacted in September 2002, with a view to firstly, rationalize all social welfare programs and, secondly, to de- politicize and improve the targeting efficiency of Samurdhi.

36. Gender. Addressing gender disparities in participation in the policy making processes, promoting gender equality in the labor force, and the protection of women’s rights are viewed as central to mainstreaming gender in anti-poverty efforts. In line with the Women’s Charter and the Women’s Manifesto, there are intentions to submit legislation that will reserve a certain percent of all seats in local and national elections for female candidates. A detailed analysis of gender bias in public services has been undertaken, and efforts are being strengthened to integrate gender into budgeting, personnel policies and program design. Other elements of the gender strategy, particularly those that address constraints faced by women in low-income households include: (i)increased emphasis on the protection of women’s rights in conformity with the U.N. Convention on the Elimination of All Forms of Discrimination Against Women (CEDAW); (ii)introduction of an employment policy to promote equal training and employment

12 opportunities for women and provide oversight on working conditions of Free Trade Zone workers, migrant women workers, and plantation workers; (iii)continued support for programs for women with a stronger emphasis on facilitating linkages between financial institutions, the private sector, and small female-headed ; (iv) greater support for victims of gender-based violence through Guidance and Counseling centers, legal support, easier access to law enforcement authorities and protective shelters; (v) increased emphasis to increase the role of women in decision making processes in community-based development initiatives and specific rehabilitation measures targeted at women and children affected by the civil conflict; and (vi) the introduction of gender sensitization programs. Improving Governance in the Public Sector

37. As envisioned in the PRS, there is commitment to reducing the state’s involvement in commercial activities and focusing its attention to the state’s primary activities and responsibilities in providing ‘public’ goods/services and using public resources effectively for poverty reduction.

38. Sri Lanka’s public administration was once the envy of the developing world, and its accomplishments in the years immediately after independence were impressive. However, its performance has degraded significantly over the past three decades. Stretching back to 1987, successive administrative reforms commissions have identified a host of problems resulting in a steady erosion in the quality of service delivery, but efforts to reverse this trend have been elusive. Yet recent decisions demonstrate that the current Government is willing to make tough choices in pursuit of its administrative reform agenda. To this end, a need is seen to reform public administration, improve the quality of public expenditure management, enhance transparency, accountability, and continue decentralization.

39. Civil service. The first challenge is ending the widespread politicization of the civil service. The abolition of an independent Public Service Commission (PSC) in 1972 is widely credited with being a pivotal turning point in the decline of meritocracy and the rise of patronage-based recruitment. In recognition of this problem, the 17” Amendment to the Constitution was recently passed, which seeks to reestablish an independent PSC. The new Commission members were appointed in late 2002, and the new PSC began operation in January 2003. To further strengthen meritocracy and competitiveness within the civil service, the PRS envisions adopting a policy of lateral recruitment and promotion for posts at the level of director and above, which will be placed on an open, competitive basis, with opportunities for both those in and out-of-government to apply. Clear and objective criteria and testing will be used to fill these posts.

40. Public administration. Another major issue concerns the duplication of functions and high degree of administrative fragmentation and balkanization. Sri Lanka has over 50 cabinet ministries-- while the global average is 16-and an unknown number of statutory boards and autonomous agencies. In addition, there are significant overlaps between various layers of government, such as the central and provincial levels, leading to massive redundancies and inefficiencies. This problem is being targeted along a number of dimensions. In March 2002, the Expenditure Reform Commission initiated a “zero based review” of public sector that will examine agency missions, objectives, programs, administrative structures and staffing with the goal of eliminating unnecessary functions and encouraging a consolidation of government departments and agencies to reduce overlap and duplication at all levels of the public service. The PRS stipulates that every public sector department will be required to submit proposals for consolidation of functions within and between relevant agencies and rationalize employee cadres over the next three years; it will also ensure that devolved functions are indeed undertaken by local governments. A fund will be established to finance one-off expenses arising from the consolidation and rationalization of functions within the public sector.

41. Employment and salaries. The problem of administrative fragmentation is linked to pronounced overstaffing. With a ratio of civil servants to per capital population of 3.6 per 100, Sri Lanka has one of the most overstaffed public sectors in the developing world. The final report of the Salaries Commission for 2002 estimates that as many as 30 percent of the civil service positions could be eliminated. This

13 problem is being addressed through a hiring freeze that by all accounts appears to be effective. Vacant posts have been abolished and the contracting out of various support services, such as drivers is being explored. A draft civil service pension bill has recently been sent to Parliament that will help control pension expenditure by creating a funded system for new recruits6 Finally, a major rightsizing exercise is being contemplated and the Bank has been approached for assistance in designing a Voluntary Retirement Scheme (VRS) for the civil service. So far the administration has successfully resisted pressure for an across-the-board increase in civil service salaries in the wake of the Salaries Commission report pending a rightsizing exercise.

42. Public expenditure management and financial accountability. There is a need to improve the quality of expenditure management institutions as the main instrument for the state's policy formulation and coordination. In light of the need to change the role of the state as stipulated in the context of the PRS, special attention will be given to medium-term, strategic budget policy formulation to attain: the goals of macroeconomic stability and debt reduction; ensure the effective allocation of resources between priority sectors; and strengthen the efficiency of expenditure programs.

43. The Government is following this path and has initiated improvements in the legal framework. In addition to the Fiscal Management Responsibility Act (discussed in paragraph 25), a revised Public Finance Act will be submitted to Parliament in the near-term, as a necessary prerequisite for sustainable improvements in the management of public finances. In the next phase, it is necessary to move into a more transparent and consultative budget formulation process through the preparation of a Medium Term Budget Framework (MTBF), which aims to link three essential elements, i.e., the macroeconomic framework, sector policies, and expenditure allocations.' Introduction of sectoral expenditure ceilings at the start of the 2004 budget preparation process, consistent with the MTBF, will be another important element for maintaining aggregate fiscal discipline and avoiding unrealistic and over-inflated budget submissions. Finally, there is a need to formulate an action plan to improve the monitoring of budget execution, involving both the Ministry of Finance and the Ministry of Policy Development and Implementation and gradually introduce a performance-orientation in budget management.

44. Overall publicfinancial management in Sri Lanka appears satisfactory, but a major effort is needed with respect to oversight aspects. Based on the recommendations of the recently completed Country Financial Accountability Assessment (CFAA), initiatives are being taken to strengthen public financial management and accountability by improving the independence of Department of the Auditor General, improving the legal framework for both internal and external audit, improving audit methodology, the transparency of public accounts and the responsiveness of the audit institutions to the Parliament and citizenry (see Section I11 below and Annex IV for details on public financial management). Similarly, the recommendations of the Country Procurement Assessment Report (CPAR)- -which calls for a simplification of the regulatory framework for procurement, possibly through a new procurement law--are being reviewed.

45. Transparency, accountabilitv and improved sewice deliverv. For the medium term, there is a need to reduce the culture of secrecy that surrounds the workings of the civil service and enhance the transparency through which public sector business is conducted. Towards this end, a variety of approaches are under consideration, ranging from annual departmental reports and consultation with stakeholders to 'access to information' legislation. As a part of its e-Lanka initiative, the Government is planning to use information technology and business process reengineering to streamline procedures and enhance service delivery. These measures will be combined with citizens charters, the development of "report cards" on government services by NGOs and civil society representatives, and other approaches to improve client orientation.

New public service recruits will contribute 8 percent of their salaries to the fund, while the Govemment would contribute an additional 12 percent. ' Preparations are underway--with support from the ADB--to introduce a medium-term expenditure framework. In addition, annual Public Expenditure Analysis --to be carried out jointly with the Govemment and the IMF--is an important element of the Bank's assistance program. 14 46. Discussions are currently underway between the Bank and the Government for assistance with a host of governance related activities under the Economic Reform Technical Assistance Project (Cr.3722- LE) approved in December 2002. Areas under consideration include the design of a Voluntary Retirement Scheme (VRS) for the core civil service, including a legal, financial, economic, managerial and social assessment of the potential costs and benefits of such an approach. Particular attention would be devoted to ensuring the equity and cost-effectiveness of the scheme, as well as to avoiding problems of adverse selection (the best people leave the public sector) and moral hazard (staff who are let go re-enter the civil service or are brought back on contract). Other areas include the creation of a computerized Human Resource database that will strengthen establishment control and provide accurate, real-time information on the size and scope of the civil service, as well as streamlining personnel rules and regulations and rationalizing systems for recruitment, performance review, promotion, transfer and discipline. The Bank may also provide support for identifying opportunities for administrative rationalization through the merger andor elimination of ministries and departments; for outsourcing; and for developing a communication strategy to explain the need for public sector reform. Furthermore, the World Bank Institute (WBI) is helping to strengthen public accounts and parliamentary committees, focusing on the oversight role of Parliament in the public expenditure and financial management and PRS process.

47. Capacity to manage the environmental ConseQuences of development. Protection of its rich natural and environmental resources which support rural livelihoods, agricultural development and a tourism industry is critical for Sri Lanka’s economic growth. However, the country also has one of the highest population densities in the world (280 people per sq.km.) and efforts to improve living standards are creating heavy pressure on the natural environment. The elephant, an internationally recognized symbol of Sri Lanka, is losing its traditional habitats and human-elephant conflict is now a serious problem in several areas. To help deal with issues such as these, legislation is in place for the protection of coastal areas and natural reserves, and also for environmental impact assessment (EIA) of major development activities. The EL4 requirements of the Government are in line with international practice and generally consistent with the Bank‘s own policies8 and a six-year program of World Bank support to environmental capacity-building under the Environmental Action Project (closing in December 2003) has helped--along with support from other donors--in improving implementation of the requirements. Given also good public awareness and active NGOs, a solid basis now exists for a sound environmental management system to meet the challenges of accelerated private sector-led growth. To make this happen, the Government needs to continue strengthening its environmental management capacity. As a major step to increase the effectiveness of environmental regulation and enforcement and in line with broader decentralization process, the Government plans to devolve some key responsibilities of the Central Environmental Authority to the regional level.

C. Assessment of the PRS

48. As indicated in the BanWIMF Joint Staff Assessment (JSA), Sri Lanka’s Poverty Reduction Strategy is broadly appropriate for addressing the country’s current economic development and poverty reduction challenges and provides a sound foundation for the Bank‘s assistance. The PRS candidly lists the causes of poverty. Aside from the civil conflict, it correctly identifies the highly restrictive controlsh-egulations that have inhibited the functioning of the domestic factor markets and rural economy as principal causes of Sri Lanka’s below potential performance. It also acknowledges that the heavy involvement of the state in commercial activities has constrained private sector development and economic growth. Particularly important is the recognition that the policy of redistributiodtransfers pursued so far to reduce poverty has been ineffective. As mentioned, the PRS envisions a role for the state as that of (i)facilitator of an enabling environment for private sector-led growth; and (ii)creating

* A review has been carried out of the Government’s systems for addressing “safeguards” issues. The broad conclusions are that appropriate regulation is in place and functioning institutions exist. There are some weaknesses in implementation but significant capacity exists in both the public and private sector and recent major (non-Bank) investment projects have been subject to considerable public consultation and discussion. This review is in draft and currently being discussed with the Government. 15 opportunities for the poor to participate in the growth process. The latter is to be achieved through greater public expenditure devoted to human resource development and infrastructure. The PRS also calls for smaller and better targeted safety net programs. Given the large public debt and the tight fiscal situation, the PRS correctly indicates that the pace at which the reform agenda can be implemented depends on the fiscal space that can be created by economic growth, the restoration of peace, macroeconomic stability and concessional assistance.

49. This said, the JSA points out a number of areas in which the PRS could be strengthened; specifically: there is nothing with regard to institutionalizing a public sector tracking system; although there is a comprehensive picture of the patterns and determinants of poverty, further work is warranted to monitor and assess the impact of current and future fiscal policies on the poor; the poverty diagnostics for the North East is inadequate and needs to be improved; and there is a need to enhance institutional arrangements to coordinate monitoring and evaluation and promote incentives for its use in policy and budgetary decision-making.

50. These all underscore the tremendous capacity building needs in the country, especially as they relate to measuring, analyzing, monitoring and evaluating poverty reduction outcomes. It is recommended that the first annual progress report of the PRS include: (i)an update of the macroeconomic framework and prioritization of policies aligned to a detailed costing of the PRS agenda; (ii)addressing critical issues in the governance agenda, especially in civil service reform, transparency and decentralization; (iii)a selection of indicators and baselines to monitor PRS implementation and setting up an expenditure tracking system; (iv) a preliminary assessment of the impact of policies on the poor and disadvantaged groups; and (v) completing the poverty assessment and reconstruction needs of the North and East.

D. Medium-Term Economic Prospects and Framework

5 1. Looking ahead, Sri Lanka has a great opportunity to strengthen macroeconomic stability and achieve an economic performance commensurate with its human and natural resources. In tandem with the implementation of this credible reform program and the positive developments in the peace process, Sri Lanka’s medium-term prospects for higher GDP growth and sustained fiscal and external sustainability have improved recently. A healthy economic revival and higher economic growth should result from the sustained fiscal consolidation and successful implementation of the growth-focused structural reform program, along with improving investor sentiments. Also, the expected pick-up in reconstruction activities in the North-East and increasing trade between the North-East and the rest of the country, as well as improvements in the power supply, and recovery in agriculture and services should contribute to the anticipated stronger macroeconomic performance.

52. Thus, if peace holds and the stabilization and structural reform program stays on track, after a recovery in the GDP growth rate, Sri Lanka could achieve around 7 percent GDP growth with single digit inflation in the medium-term, as also projected by the PRS (see Table 3 and Box 4). Regarding the fiscal outlook, sustained implementation of the program, together with higher GDP growth, would lead to gradual reduction of the budget deficit and of the public debt towards sustainable levels. This would also create increasingly more fiscal space for high priority poverty programs.

53. As noted earlier (paragraph 24), there are downside risks to the robustness of Sri Lanka’s medium-term macroeconomic framework, given the tight fiscal situation, the fragile peace process, and the vulnerabilities to external shocks. A weak implementation of the budgetary revenue measures (detailed in paragraph 23) and/or a failure to withstand pressures to increase expenditures beyond prudent levels could undermine efforts to restore fiscal sustainability. A derailment in the peace process and/or a deterioration in the Middle East situation also constitute major downside risks to this medium-term outlook. However, as elaborated above, the Government is determined to maintained fiscal discipline 16 with the support of IMF’s three-year PRGF-EFF arrangement, under which fiscal and other macroeconomic developments will be closely monitored and contingency expenditureh-evenue measures would be put into effect in the event of shortfalls from fiscal targets. The medium-term macroeconomic program also includes a program of gradual reserve build-up as a cushion against external shocks. And, as elaborated in Section VI1 below, mitigating measuredprograms are being put in place to reduce risks of a derailment in the peace process.

Table 3: Medium-Term Macroeconomic Framework: 2002-2006 (In percent of GDP or as noted) 2002la 2003 2004 2005 2006 Annual GDP Growth (% change) 3.3 5.5 6.5 6.8 7.0 Average inflation (% change) 9.6 8.9 7.0 6.0 5.0 Gross investment 22.3 24.2 26.3 27.9 29.0 National Savings 20.3 20.8 22.1 23.7 25.3 CJA Balance (incl. official transfers) -1.8 -3.3 -4.1 -4.1 -3.6 Overall BOP Surplus or Deficit 1.5 0.1 0.4 0.5 0.9 Gross official reserves less Asian Clearing Union balance (US$ billions) 1.6 2.0 2.4 2.9 3.3 Gross Off. Reserves (months of imports of goods and services) 2.4 2.7 3.1 3.3 3.5 Total external debt 59.6 59.2 58.1 51.1 55.3 Government Revenue 16.5 16.9 17.9 18.7 19.1 Govt. Current Expenditure 20.8 19.2 17.9 16.8 16.2 Interest Payments 7.4 1.3 6.6 5.9 5.5 Govt. Capital Expend 4.6 5.2 6.2 6.9 7.2 Budget Deficit -excluding grants -8.9 -7.5 -6.3 -5.1 -4.3 Budget Deficit -including grants -8.5 -7.1 -5.7 -4.5 -3.7 primary deficit--excluding grants -1.4 -0.2 0.3 0.8 1.2 Net external financing 0.1 2.1 3.0 3.2 2.7 Grants 0.4 0.4 0.6 0.6 0.6 Government Debt 103.8 99.6 94.5 89.1 83.8 O/w Domestic Debt 60.0 56.7 52.2 47.1 42.7 Additional external financing needs (US $ billions) 0.42 0.42 0.42 0.31 Oil price ( US$ per barrel) 24.9 28.0 23.5 22.0 20.5 Source: Ministry of Finance and Central Bank of Sri Lanka; and the IMF a: Provisional.

54. Resource requirements. During the next several years Sri Lanka will need substantial financial resources to continue implementing its comprehensive economic reform program, undertake the priority PRS programs, help support the acceleration of economic growth and investment, and increase official reserves to prudent levels (Table 3). Preliminary estimates indicate that during 2003-2006, Sri Lanka’s additional external financing needs would average about US$0.4 billion a year (in the range 1.3-2.3 percent of GDP annually). In view of the strength of the stabilization and structural reform program and demonstrated commitment to reforms, as well as the successful peace process, new concessional assistance from donors is likely to meet the external financing gap in the medium-term. The IMF is expected to provide about US$560 million under the PRGF-EFF arrangement, and the Asian Development Bank’s (ADB) total support would be about US$400 million (with US$200 million in balance of payments support), and the bilateral donors--particularly Japan, U.S.A., Germany, and Kuwaiti and Saudi Funds--are likely to contribute about US$70 million annually in program support.

17 Box 4: Potential Sources of Economic Growth Supply-side. In the short- to medium-term, Sri Lanka’s prospects for strong economic recovery and higher growth are good. Already the economy is experiencing increasingly strong recovery from the dismal level recorded in 2001, but this is not unexpected. The cessation of hostilities and strongly positive developments in the peace process have created a post-conflict spurt in economic activity that is generally observed in similar situations. In addition, the improved political environment, the retum of normal rains, the increased power supply, the improving macroeconomic situation, and the (credible) ongoing structural reform program all appear to have also boosted the recovery of domestic economic activity, particularly in services. Reconstructionactivities and economic revival in the North-East will boost overall growth performance. Agricultural production is expected to retum to its trend levels in the near-term, and then pick up further in the medium-term with the removal of policy distractions in input, output, and technology markets, the adoption of a more stable trade regime in agriculture, and the reform of land and labor markets (see Annex I11 for a detailed coverage of the core agricultural issues and on the ongoing/future measures to address these).

The ongoing structural reforms--in the factor markets, economically sound energy pricing, further import tariff rationalization, the enabling commercial legal environment, steps towards lower and uniform income taxation, restructuring/privatization in the SOE sector, and public sector--as well as improvements in infrastructure should contribute towards more efficient resource allocation and lead to productivity gains. These developments should have deep and lasting effects on the resource allocation efficiency and productivity in the economy, lowering production costs, enhancing domestic competition and intemational competitiveness, and encouraging private investment. As elaborated in the PRS, in the medium-term, aside from agriculture, service sectors (tourism,, wholesale/retail trade, transport, particularly port activities), construction, offsfarm rural activities, and manufacturing industries are expected to show stronger growth performance, with improved productivity and rising private (and complementary public) investment. Small and medium-scale enterprises (SMEs), which account for about 90 percent of industrial establishments and 70 percent of employment in the manufacturing, would benefit from improved business environment and be induced by structural reforms to increase their scale of operation and employment levels. There are also expected to be significant spill-over effects on productivity and efficiency from the expansion of IT industriedactivities, which are themselves expected to be important growth areas.

Demand-side. On the demand-side, higher economic growth would be supported by an expanding household consumption demand, increasing private investment as well as rising public investment in social and physical infrastructure, which would be supported by donor assistance. It is expected that the investment/GDP ratio would increase by over six percentage points of GDP during the next four years. Helped by diversification and productivity gains, merchandise exports are also expected to expand, despite some (moderate) setback that might be caused by the removal of the MFA quotas.

Adjustment to the removal of MFA quotas. Exports of garmentskextiles account for more than 50 percent of Sri Lanka’s merchandise exports. And the share in manufacturing value-added of the latter two categories, together with the leather products, is about 40 percent, and they account for just over 5 percent of GDP. The elimination of the MFA quotas by 2005 might lower Sri Lanka’s garmenthextile exports as China and other large competitors such as India expand their exports. However, the adverse impact on Sri Lanka is likely to be moderate given that most of the exports are carried out by 10-11 large companies which have already started taking steps to further enhance their competitiveness. Also, most medium-size firms are expected to merge to improve their readiness for the post-quotaperiod. However, small, mostly sub-contractingfirms are likely to be adversely affected.

In view of the critical importance of the apparels production and exports, the Govemment recently created a committee with a mandate to assess the likely impact of the removal of garmenthextile quotas and develop a strategy to contain the adverse impacts. The committee has made recommendations to enhance competitiveness through worker training, development of industry infrastructure, and the adoption of modem technology. The ongoing structural reforms should also help in the reduction of production costs.

111. THE PROPOSED CREDIT AND THE POLICY FRAMEWORK

A. Rationale for and Overall Objectives of the Poverty Reduction Support Credit (PRSC)

55. The proposed PRSC recognizes the importance of country-owned policies and is derived from the PRS, based on the CAS, and underpinned by appropriate structural, social, fiduciary, and environmental analysis. Specifically, the PRSC would: (i)support Sri Lanka in implementing priority structural reforms; (ii)help finance the public expenditure program and facilitate shifts in the poverty-orientation of public expenditures, by creating urgently needed fiscal space for priority pro-poor social and infrastructure expenditure programs at a time when fiscal adjustment in 2003 alone is necessitating significant reduction in budget deficit; (iii)complement the IMF’s PRGF program in supporting

18 continued fiscal consolidation and reduction in the budget deficit; and (iv) help fill external financing gap in 2003 and subsequent three years.

56. IMF’s Parallel Poverty Reduction and Growth Facility (PRGF). The PRSC would complement the IMF’s PRGF-Extended Fund Facility (EFF) arrangement. The latter will help towards Sri Lanka’s macroeconomic stability and growth objectives by supporting the Government’s ongoing and planned actions to: (i)strengthen public finances; (ii)reform the financial sector and public enterprises; and (iii) strengthen macroeconomic policy instruments/institutions.

57. As highlighted earlier, in implementing Sri Lanka’s PRS, there will be major challenges to: (i) maintain a prudent fiscal policy stance and a sound overall macroeconomic framework, particularly given the country’s enormous public debt burden and very limited fiscal space; (ii)manage and respond to the heightened aspirations for greater employment and higher income opportunities, given the last two decades of missed opportunities and pent-up demand; and also to (iii)create adequate fiscal room for the PRSP’s priority socialhnfrastructure programs and for relief and reconstruction in the North and East, as well as in all other hitherto disadvantaged regions of the country. Given these country circumstances, for the PRS to be successfully implemented, increased financial and other support from donors would be needed, as noted earlier.

B. Design

58. The proposed program for PRSC Iis a part of an integrated, four-year program involving a series of four operations that would provide financial support on an annual basis to help implementation of the PRS program and enhance poverty-orientation of public expenditures (see the Policy Matrix in Annex I). While paying attention to the complementarities within the whole PRS program and coordinating with the IMF’s PRGF-EFF operation, the proposed credit will support the implementation of the key structural reforms in areas where the Bank has been involved for some time in terms assessments and policy dialogue. Specific areas include: the factor and energy markets; the rural sector; the welfare system; and governance in the public sector, including the public expenditure management, public financial accountability, and environmental management. Progress in the implementation of the PRS will be monitored, including the shifts in the poverty focus of public expenditures, and appropriate triggers will be relied on to initiate subsequent phases of the PRSC program.

59. The time horizon of the proposed PRSC series overlaps with the PRSP and CAS periods. This first credit, PRSC I,would support the continuation and, in some cases, launching of structural reforms in the key areas, including public actions that will create flexibility and foster efficiency in the labor and land markets, strengthen the financial market, reform the power sector, and strengthen governance in the public sector as cited above. The emphasis on factor markets is consistent with the PRS priorities and with the long-standing view shared by the Government, the private sector, researchers, and donors that Sri Lanka could achieve higher growth by addressing the policy-induced constraints to private sector activity, including the rigidities in labor and land markets, inefficiencies resulting from public sector presencehterventions in the banking and energy sectors. It is envisaged that the PRSC I1would follow in 2004 and PRSC I11 in 2005. They would continue supporting the ongoing and new structural reforms and their implementation. PRSC I1and PRSC I11 would also expand the program’s coverage of the ongoing reform initiatives, particularly in the area of Sri Lanka’ s over-extended and inefficient welfare system, and in the policy/institutional environment critical to reinvigorating the rural economy on which 80 percent of the population rely for their livelihoods, including 90 percent of the country’s poor. The findings of the Development Policy Review (DPR) that is planned for FY04 will help determine additional reform areas to support for the PRSC-IV in 2006.

60. It is important to note that over the last 12 months the Government, in consultation with the IMF and World Bank, has undertaken major steps towards restoring fiscal sustainability and structural reforms to improve investment environment and promote economic growth. These reforms, detailed in the

19 Government's Letter of Development Policy (see Attachment l),provide the track record to underpin PRSC I;(some of these bold reform actions were summarized above in Section 11, and they are also presented in Table 4 below). As discussed below, PRSC Iwould support these public actions in the cited areas.

61. Subsequent PRSCs will depend on: (i)satisfactory progress--to be monitored through agreed performance indicators--in the implementation of the reform measures already put in place; (ii)specific prior actions and Board triggers in each of the key areas covered such that irreversible progress/commitment is demonstrated; and on (iii)continued satisfactory macroeconomic framework as assessed under the PRGF-EFF arrangement. To help in the formulation and implementation of the structural reforms as well as with the ongoing efforts to strengthen public expenditure management and fiduciary mechanisms, technical support is being (and will be) provided under the Bank's Economic Reform Technical Assistance Credit, which is under implementation.

C. Objectives and Actions to be Supported Under the PRSC I

62. The PRSC I--as well as the subsequent PRSCs--is structured around two principal components consistent with the objectives of the PRS:

0 Accelerating economic growth and supporting private sector development; and 0 strengthening governance in the public sector and improving the welfare system.

63. These two components aim to enhance the effectiveness of the overall strategy for poverty reduction. The first component reflects thefundamental importance Sri Lanka is giving to the promotion of strong private-sector led growth in its economic development and poverty reduction strategy. And the second component aims to help address the key weaknesses in the public administration (described in the above section) and public expenditure management (PEM). The latter is also recognized as a top priority challenge, which sees improved institutional capacity for effective policy formulation and PEM as essential prerequisites for the successful implementation of the PRS. This would enable the public sector to assume its changing role effectively as a facilitator of private sector-led growth and creator of opportunities for the poor.

64. There is a long-standing and broad consensus among the public sector, the private sector, donors, and the observershesearchers that Sri Lunka's economy could grow faster and generate higher employment if the existingfactor market distortions and power sector inefficiencies are addressed effectively.' Indeed, various private sector groups have been all along complaining about the highly restrictive labodland markets and the inefficiencies in the commercial banking and power sectors caused by public sector interference and the dominance of SOEs. The chambers of commerce and industries have been asking for reforms in the factors markets and in the enabling business environment to foster private sector development and investment." The PRS has correctly identified these areas as the priority reform areas in pursuit of private sector-led growth. The Bank fully agrees with these reform priorities. Accordingly, within the context of an integrated medium-term program and consistent with the PRS priorities, PRSC Ias well as subsequent PRSCs would support public actions that have been recently undertaken and those future follow-up actions that will be undertaken to reform the factor markets (labor, land, and financial), the power sector, the enabling business environment, and the rural economy. Under the second component, the key actions that are to be supported include reforms: in the welfare system, in the public administration (civil service) and institutional dimensions of public expenditure management, and in public financial management/accountability and fiduciary capacity.

Detailed assessments are available in references given in paragraph 103 below, loFor example, see: The Ceylon Chamber of Commerce, Budnet Prouosals (various years); Letters of the Ceylon Chamber of Commerce to the Government, dated April 30,2002 and June 10,2002. 20 65. Expected medium-term ‘outcomes’. The four-year PRSC program would contribute towards the achievement of the key PRS outcomes expected in the medium-term. Specifically, these include:

0 Gradual increase in the annual GDP growth rate to around 7 percent by 2006, two percentage point higher than that achieved in the 1990s under conflict conditions. o Key intermediate outcomes: increased labor and land productivity; increased efficiency and stability of the financial system; increase in the investment/GDP ratio, with expansion in both private and government investment; better targeted public expenditures; and rising employment.

0 Decrease in the national (headcount) poverty incidence from around 25 percent (lower national poverty line) to below 20 percent by 2005; (similarly, decrease in the incidence from 27 percent to below 22 percent).

Monitoring indicators for the above medium-term outcomes include: poverty measures; aggregate and sectoral growth rates; fiscal and debt outturns; real wages and employment trends. (For a detailed coverage of the medium-term ‘outcomes’ and monitoring indicators, see Annex Iwhich presents the four-year PRSC Policy Matrix).

Objective 1: Accelerating Economic Growth and Supporting Private Sector Development

Labor Market

66. Issues. A well functioning labor market is a pre-requisite for economic growth and poverty reduction. As assessed and analyzed in detail in Sri Lanka: A Fresh Look at Unemplovment (see paragraph 103), the labor market in Sri Lanka suffers from considerable segmentation, which is reflected in the large wage premium provided in the ‘formal’ sector and in public sector jobs. These wage differentials are artificial and result from a policy environment that provides protection to certain segments of the labor market, including: (i)the formal labor market, which benefits from very stringent job security regulations; (ii)certain product markets that are protected by tariffs; and (iii)the public sector that offers preferential employment and pay treatment. Sri Lankan workers in the protected sectors earn between 34-100 percent more than those in unprotected sectors, with the premium being highest in the public sector. In the public sector, despite job security and a generous pension system, employees in the lower levels enjoy the largest premiums due to public sector pay policies, which tend to be shaped by high salary increases recommended by the ‘Salaries Commissions’.

67. With respect to the formal sector, which covers firms with 15 or more employees, Sri Lanka has had one of the most stringent job security regulations in the world, restricting and segmenting the country’s labor market. There is ample evidence that this rather rigid and outdated labor legislation (and the resulting high unit labor costs in the formal sector) has discouraged domestidforeign private investment, inhibited the graduation of small enterprises from the informal private sector, and constrained employment generation. Jobs in the formal labor market are subject to collective bargaining. Tripartite ‘Wage Boards’, consisting of delegates from the major labor unions, private employers, and the Commissioner of Labor, set minimum wages for each skill level by sector. Interference by politicians in the collective bargaining process and in wage board decisions have encouraged labor unions to develop political affiliation over the years and to take militant agendas. Today, Sri Lanka has a large number of small trade unions with considerable leverage.

68. Currently, employers cannot easily adjust their work force to normal business cycles due to the restrictions enshrined in the Termination of Employment of Workmen Act (TEWA-1971) and the ZndustriaE Disputes Act (1950). The TEWA applies to private sector firms with 15 or more employees. Under the TEWA, the termination of any worker’s service is only possible with prior written consent of the Commissioner of Labor or the employee concerned. The Commissioner has the discretion to accept

21 or reject a firm’s application to terminate an employee and, moreover, has the prerogative to determine the exact compensation to be paid. The process is non-transparent, as neither the act nor any other regulation defines the minimum compensation that a laid-off worker is entitled to. Each application for lay-off is considered individually which has led to discrepant awards. In addition, the dispute resolution process takes several months and sometimes even years, during which time the firm has to continue paying the salary of its redundant worker.

69. This legislation has discouraged small firms from expanding. A 1995 survey of rural industries showed that 97 percent employed less than 15 workers implying that of scale in both agriculture and industry were probably not realized. Firms with 15 or more employees have become reluctant to hire additional workers and instead preferred to employ contractual workers who have no protection under the law. Thus, the law protects about 1 million formal workers, but has failed to protect over 7 million contractual or casual workers. It has also prompted businesses to close down completely to avoid carrying costs indefinitely instead of merely downsizing or forced them to accept larger losses in business downturns.” The response to this in the past has been to rely on public sector employment at increasing costs and create enclaves such as the free trade zones that circumvent local labor laws.

70. Labor market reforms. In the medium- and longer-term, there is a desire to establish a flexible and efficient labor market by eliminating the causes of segmentation in the labor market--Le., by reforming the civil service pay, pension, and hiring policies, and by tackling the long-standing issue of the inflexible labor legislation. In the near-term, the main focus is on the latter. The Factories Ordinance has been amended to liberalize the practice for overtime, especially for female workers, in line with international norms. In order to limit the Labor Commissioner’s role and discretion in labor disputes the so called ‘4-3-2’ formula has recently been introduced. Under this formula, a 4-month limit has been established to settle a labor tribunal case, a 3-month limit for an arbitration case, and a 2-month limit to decide on appropriate remuneration for a terminated worker. It is important that these arrangements are confirmed by legislative changes (see below). These legislative amendments will liberalize the labor market and reduce the involvement of the Labor Commissioner. However, workers who are paid less than the minimum or who believe that they were laid off for reasons other than redundancy can appeal their case with the Labor Tribunal. The latter’s role will, therefore, be changed to settling grievances instead of determining whether there was a genuine business downturn or not. At the same time, to provide cushion against loss of income, an unemploymentprotection and retraining scheme, which is being formulated with the help of the International Labor Organization (LO), will also be introduced. However, in view of the very tight fiscal situation, there is a need to minimize the burden of any such scheme on the budget. Financial Market

71. Issues. As noted earlier, in Sri Lanka, the existing weaknesses in the financial sector have constrained private sector development and therefore growth and poverty reduction. Financial intermediation is inefficient as evidenced by high intermediation spreads and the narrow range of financial instruments. A large portion of long-term funds finances the budget deficit, implying significant crowding out of the private sector.

72. Some reforms in the financial sector have been implemented. These include improved financial disclosure through the adoption of international accounting and auditing standards in banking and capital markets. The ability of banks to recover loans has been strengthened by parate execution powers, which allow banks to recover loan collaterals without resorting to the courts. Measures to improve the regulatory, supervisory and institutional infrastructure have helped to establish a world-class stock market in Colombo. Despite progress to date, the financial system is shallow, with the asset side concentrated in immobilized government securities (38 percent), and the liabilities side in bank deposits (33 percent).

In the post-September 11 period, the occupancy rates of the hotels fell to as low as 20-22 percent in Colombo for an extended period, yet the TEWA prevented them from laying off workers. 22 Government borrowing dominates the financial markets, while savers invest mainly in bank deposits. The sector is inefficient, especially in the state-owned segment. The level of non-performing assets is high and increased in 2001 due to the recession. These inefficiencies have been at the expense of both depositors and borrowers. The private sector has taken advantage of the protection afforded by the inefficiency of the state-owned sector, and has preferred to enjoy high intermediation spreads rather than compete for market share.

73. Commercial banking sector and the state-owned banks. A core problem relates to the weaker performance and continued dominance of the sector by the two state commercial banks (SCBs). The SCBs have lacked the type of internal governance and self discipline that stockholders, boards of directors, and management provide in private institutions. External governance and discipline from the market competition is also weak owing to the SCBs’ dominance. Past governments have tried but largely failed to improve the health and efficiency of the SCBs by recapitalizing them, and setting targets and monitoring their performance more closely. They continue to hold weak portfolios despite two asset cleanup operations in 1993 and 1996.

74. Financial sector reforms. Building on the recent reforms, the key medium- and longer-term objective in the financial sector is to improve financial intermediation by reducing the state’s intervention and dominance, promoting increasing private sector participation in the sector (including in the insurance and pension fund industry), and by strengthening the regulatory and supervisory framework for banking and the capital markets. To this end, the current and near-term priority focus is on improving the performance of the commercial banking sub-sector, particularly by addressing the issue of the SCBs. Some steps have recently been undertaken to improve their operating performance and financial position. To strengthen corporate governance and management, the boards of both banks were revamped to include representatives from the private sector, and the boards were made more independent. In addition, recently recruited expatriates and private sector bankers have been appointed to key management positions. Other actions include: (i)increasing the minimum capital adequacy requirement for banks from 9 to 10 percent effective from January 1,2003; (ii)withdrawing the sovereign guarantees for lending to SOEs; and (iii) public announcement of the plan to commercialize the People’s Bank (PB). Both state banks are committed to their restructuring programs submitted to the Government in September 2001 that will reduce their size and regional scope, streamline their operations, and strengthen their portfolios.

75. In the context of restructuring the two SCBs, it is important to acknowledge their differences. The PB is a very weak institution with a negative net worth and inadequate capital adequacy. Until recently it had relied on a ‘letter of comfort’ from the Ministry of Finance to continue its operations. The letter of comfort has recently been withdrawn and the Government has announced its intention to commercialize the PB. The Bank of Ceylon (BOC), on the other hand, is relatively well positioned with a capital adequacy of over 13 percent, rising revenues and pre-tax profits. The BOC has also adequately provided for anticipated loan losses well above the industry standard. This situation has led the Government to support BOC’s continued operations, while insisting that the bank continue its efforts aimed at improving its performance in line with the agreed performance targets and schedule.

76. In view of the PB’s very high non-pet$orming loans and negative net worth, and given that any new large re-capitalization would impose a significant burden on the population, the Government correctly treats the commercialization of the PB as an urgent priority. As a lasting solution with a minimum impact on the budget, the commercialization of the PB will be carried out with a view to identifying a strategic investor to take over it as a single unit (first preference--Option 1) or, if this option does not materialize, by splitting the PB into a commercial bank and a savings bank and then seeking strategic investor to take over the commercial unit (Option 2) in the first quarter of 2004. Under either option, an asset management company (AMC) will be established to enable the SCBs to deal with their NpLs. As a whole, this task will require proper due diligence and an open and transparent process to prepare the PB for commercialization. To these ends, steps have recently been initiated. These measures are regarded as substantive so as to make the process of commercializing the PB irreversible, justifying

23 support under the proposed PRSC. At the same time, there is also an ongoing effort to increase the coverage, sustainability, and benefit adequacy of pensiodprovident fund systems. This initiative would also be supported under the PRSC program.

Land Market

77. Issues. Well functioning land markets are important for poverty alleviation as they: (i)provide land holders with greater control over land management and thus promote efficient land use and facilitate associated investment and productivity growth in agriculture and other enterprises; (ii)enable mobilization of lands for enterprises and infrastructure; and (iii)are preconditions to active mortgage markets, credit mobilization and related financial sector development.

78. In Sri Lanka, regulatory and policy reform in land administration and land policy could unleash the potential of the private sector and reduce poverty. In addition to limited access to public services and technology, the rural poor in particular has faced constraints from nonfunctioning land markets.” As a result, a majority of Sri Lankan farmers use natural resources inefficiently and are trapped in small-scale, unproductive agriculture (see Annex I11 for details on rural development). Land market constraints result in sub-optimal land use.

79. The land tenure pattern in Sri Lanka is highly complex. The majority of land in Sri Lanka is state owned, but allocated to and farmed by private farmers under varying grants and permits, most of which allow private use and inheritance but restrict lease, sale, subdivision, and mortgaging. An additional, smaller portion of land was affected by the Land Reform Act 1970, which nationalized private land holdings in excess of 50 acres and redistributed them to small-holder tenants in perpetuity. The Act placed a ceiling of 5 acres on tenant farms. As a result of restrictions on land transactions, those households who would want to move to other sectors or areas with better growth prospects would have to leave without any compensation for their land, and thus even farmers with non-viable holdings are trapped in agriculture.

80. Private land owners face similar constraints. Most private land records are in the form of a deeds registration system, which records transactions and serves as evidence only in support of proving titling to land. A prudent purchaser of land must undertake a cumbersome search of all past deeds concerning a particular parcel in the system (having to go back to records over a 30-year period), and often vital documents are missing.l3 The multiplicity of inheritance and customary land laws reflecting the island’s multi-ethnic character (Kandyan, , Moslem, and Roman-Dutch Law) further complicates land tenure and affects gender equity. Private lands are also affected by land use restrictions, such as the Paddy Lands Act which does not allow paddy land to be used for non-paddy cultivation without government permission and restricts the ability of the owner to lease the land to a tenant. In combination, all these factors impede the efficient use of land. The urban land market is also affected by inappropriate government restrictions and ownership.

8 1. Land market reforms. One element of a long-term solution to these challenges is the removal of the restrictions on transactions by conversion of grants and permits to fully marketable freehold deeds or titles. Another element is a nation-wide conversion to a registration of title system. In contrast to the deed system, under a title system the parcel is registered, with transactions thereafter registered against the parcel. A title system facilitates boundary dispute resolution, accuracy, transparency and accessibility of records, willingness of lenders to provide financing, and efficient land transactions.

I2This includes lack of secure property rights, high transaction costs in land sales and other administrative services, inability to use land as collateral, and little control over land management. l3In Sri Lanka, the parcel and boundary information for private lands is held in ofices of private surveyors and may not be readily available. Land transactions thus often involve significant cash and opportunity costs for clients. Furthermore, the deeds may not agree with the facts on the ground and disputes are common. In the case of a dispute, settlement times for land cases in courts usually take more than ten years, and lack of affordability limits the access of poor land holders including women-headed households to dispute resolution. 24 82. The strategy to tackle these challenges includes removing restrictions related to the sale, lease, transfer, sub-division and mortgage of state land that are currently held under grants and permits. Regarding these lands in rural areas under the Land Development Ordinance and Land Grants (Special Provisions) Act, a Draft ‘Land Ownership Law’ is being prepared, which will likely be sent to Parliament in the first half of 2003. The latter is intended to provide a legal framework for converting grant lands to freeholds, thus establishing private ownership and clear property rights and removing the above cited restrictions. However, the draft has some drawbacks in that in its current form it could lead to an inefficient, non-transparent process of conversion without clear and appropriate decision making criteria. It is not obvious that the current design of the process would adequately help vulnerable land holders, including women, to have freedom of choice and to make informed choices. In view of the critical importance of converting grant lands to freeholds for achieving higher productivity in agriculture, efforts to establish and implement an efficient, transparent, and appropriate process of land conversion would be supported under the PRSC program (see Table 4 below).

83. Similar issues are also being addressed on urban land. With the support of the Economic Reform Technical Assistance Project, a consultancy has been initiated on organizational arrangements for disposition of unutilized urban land owned by the state. It will be important for these arrangements to take into consideration international experience and potential governance, social, economic, fiscal, and environmental impacts. Once defined and agreed, the establishment of these arrangements could be supported through the PRSC program (see Table 4 below). In recognition of restrictions affecting urban lands, the Government has expressed its intention-in the Regaining Sri Lanka document--to amend the legal and regulatory frameworks affecting rent, condominium ownership, housing finance repayment and debt recovery, local authority approvals, etc.

84. Additional analysis and stakeholder consultations on both urban and rural land policies should enable the development of a more complete policy reform agenda for land by late 2004. Key elements of these reforms may be supported under later phases of the PRSC program (see Annex I).

85. Another institutional change under consideration is to restructure and group all agencies dealing with land administration (e.g., the Survey Department, the Land Settlement Department, the Registrar General’s Department, and the Commissioner of Lands Department) under a single Ministry to reduce the administrative burden. An important first step in July 2002 was the appointment of the Registrar General of Lands as the Registrar General of Title. An Institutional Review Study by a consultant was completed in December 2002 which the Government is currently considering, with the intention of reaching agreement in 2003 on a follow-up plan for specific organizational reform actions (see Annex I).An amended version of the Registration of Title is in the process of being developed, which would also be supported under the PRSC program (see Table 4 below). It will be important to ensure clarity, completeness, legal soundness, and overall quality of these amendments. In July 2002, the Survey Act was enacted, which takes into consideration land titling requirements. In the meantime, the Bank is simultaneously providing support on land market development through a separate Land Titling and Related Services Project, which, inter alia, is laying the institutional and operational foundation for a socially inclusive, efficient, and transparent process of converting existing land records into registered titles.

Power Sector 86. Issues. The power sector in Sri Lanka is dominated by the vertically integrated state owned Ceylon Electricity Board (CEB). Recently, a prolonged drought forced the CEB to rely more on expensive emergency thermal generation from its own and private sources. However, due to the political considerations, the CEB was unable to pass through cost increases to the consumers in 2001. This has worsened CEB’s already weak financial situation, which is a result of weak managerial capacity, inefficiency, and a lack of accountability. The CEB incurred a RslO billion loss in 2001 and might have

l4 Including provisions for co-ownership, which is an important gender consideration.

25 faced another Rs6 billion loss in 2002. It has a long-term debt of about Rs42 billion owed to the Treasury (plus Rs6 billion in debt service arrears) and short term liabilities owed to state banks of Rs15 billion. Electricity tariffs were increased by an average rate of 38 percent in April 2002 and effective measures have been taken to reduce CEB’s receivables. In recognition of the structural nature of the problems affecting the power sector, a comprehensive power sector reform process is underway with support by the ADB through a Power Sector Adjustment Operation.

87. The power sector reform process--supported by the Electricity Reform Bill enacted in October 2002--envisages the unbundling of the power sector into separate generation, transmission, and distribution companies with the transmission company acting as the single buyer of electricity from generators. According to the schedule agreed with the ADB, unboundling of the CEB will be completed by October 2003 and the successor companies will be formed. This restructuring process is seen as a necessary step to introduce private sector participation in small and medium-scale hydro generation, and it is expected that the successor entities of the CEB would enjoy better incentives, reduced political interference, and face accountability. The Public Utilities Commission (PUC) Act was enacted to set up the multi-sector infrastructure regulatory agency Public Utilities Commission of Sri Lanka (PUCSL), having regulatory powers over the Electricity Reform Act. The PUCSL will be responsible for pricing (retail and bulk tariffs), licensing, and other regulatory functions. The latter’s independence is statutorily guaranteed, and it is expected that the new industry structure, coupled with the regulatory oversight of the PUCSL, will facilitate more competition with increased private sector participation. This would also result in reduced fiscal burden by the sector on public finances and free up resources from the banking system.

Objective 2: Strengthening Governance in the Public Sector and Improving the Welfare System

Governance in the Public Sector

88. Civil service and administrative reform. A major cause of the progressive degradation in social services over the past 25 years is the decline in the quality of public administration. Problems have included: an increase in politicization and patronage-based recruitment; a major expansion in the size of the civil service that has lowered its productivity and increased the burden of the wage bill; excessive administrative fragmentation and balkanization; and a lack of transparency and client-focus. A number of efforts have recently been initiated to address these concerns (which are discussed in paragraphs 37-41 above).

89. Public expendilure management--issues. Until recently, because of the fiscal pressures from the civil conflict, expenditure control has been shaky and the other two objectives--allocating resources in conformity with government policies, and creating the conditions for sound operational management-- neglected altogether. There is therefore a need for a substantial and durable improvement in public expenditure programming, budgeting, and financial management and accountability. Some technical progress in public financial management in Sri Lanka has been made starting in late 2001, and the dialogue with donors, including the Bank has intensified. As noted earlier, the various building blocks for a comprehensive diagnosis are now available from technical assistance by other donors, and from the Bank’s recently-completed Country Financial Accountability Assessment (CFAA), Country Procurement Assessment Report (CPAR), and the institutional chapter of the ongoing PER exercise.

90. Reforms. In the area of administrative reform, there is movement on two fronts. First, a number of important steps have been taken to stop the decline of the public service, with particular emphasis upon the twin goals of ending political interference and restoring meritocracy in recruitment and containing the growth of the wage bill. At the same time, analytic work has been initiated that will facilitate its ability to advance the reform agenda in the months ahead. With the assistance of the Bank and other donors, this effort is unfolding along several dimensions, including: (i)the development of a comprehensive, authoritative, web-based organizational chart for the public sector as a whole, which will provide support

26 for the broader rationalization effort; (ii)the development of a pay and employment model that will allow the analysis of various rightsizing scenarios; (iii)careful analysis of issues of establishment control to ensure that unauthorized recruitment is not taking place and prevent re-entry in the event of a rightsizing exercise; and (iv) the provision of consultancy support for exploring various rightsizing options such as a VRS. A variety of other initiatives, ranging from streamlining guidelines for personnel management to developing an integrated computerized human resource database, are also underway.

9 1. It is well recognized that public expenditure management needs to be strengthened for better development and poverty outcomes. To this end, with donor support a process is currently ongoing to improve the public accounts system, strengthening expenditure planninghudgeting processes as well as expenditure execution, monitoringkontrol, and oversight mechanisms. Recently, the Government has prepared a draft Public Finance Act (PFA) and distributed for review and comments. After it is further refined and strengthened, the enacted PFA will fill the important gaps that exit in Sri Lanka on the basic legal framework for budgeting, public expenditure management, and financial accountability.

92. Public financial management and accountability. As noted earlier, a Country Financial Accountability Assessment (CFAA) was carried out. The report is in draft stage and is being discussed with the Government. The analytical work carried out under the CFAA and other diagnostic studies note that the framework for public financial accountability in Sri Lanka is generally sound and firmly rooted on the principles of the Westminster model of governance. The study observes that the primary accountability institutions and organizations, though long established, have not evolved with time (see Annex IV for further details). This has reduced the effectives of these institutions, resulting in less than adequate assurance that public funds are used for the purposes intended. The CFAA findings indicate that institutional reforms (in the form of legislations and changes to rules and procedures of public financial management in the government system) alone cannot bring about a sustained improvement in the effectiveness of public financial accountability in Sri Lanka. The report emphasizes the need to: (i) mobilize stakeholders within and outside the public sector (i.e., legislators, Auditor General, and the media); and (ii)supplement institutional reform measures with capacity building programs.

93. Reforms. In recent months, several important initiatives have been taken by the Government, legislators, and the Auditor General to: (i)improve the quality and timeliness of financial reporting on the use of public funds; (ii)modernize the public financial accountability framework; and (iii)improve oversight by the Treasury of state owned enterprises. A stakeholder seminar is proposed to be held in June, 2003 to finalize the draft CFAA report and the Action Plan.

94. The CFAA draft report recommends an action plan of key institutional reforms and long-term capacity building programs encompassing institutions such as: (i)the parliamentary committees responsible for financial oversight; (ii)Auditor General’s department responsible for public audit; (iii) public financial management in the public sector; and (iv) the media for facilitating access to public financial information. PRSC I,11, and I11 would support the implementation of many of these key reforms and capacity building programs (see Annex Iand Table 4 below for further details).

95. Environmental Management - Issues. The basic principles and elements for good environmental management are in place but a number of important issues remain to be addressed. Over the last 10 years of experience with Environmental Impact Assessment (EN) in Sri Lanka, the weakest link has been the Project Approving Agencies (PAA) system where a line ministry’s role in clearance of the EL4 may lead to conflict of interest. A critical review of the PAA system, its effectiveness, long term sustainability and alternative approaches is needed. In addition, while project specific environmental impact assessments are conducted reasonably well, the broad policies and programs implemented by the Government can have serious unanticipated environmental consequences. This concern needs to be addressed, perhaps through promotion of increased use of strategic and sectoral environmental assessments (SEA) for policies and programs. As in most countries, the main concerns are related not to the EL4 regulations but to the weak implementation of the procedures. Therefore, continued strengthening

27 is required of Central Environmental Authority (CEA) capacity and commitment to monitor the implementation of the mitigation measures recommended by the EIA. The Government views CEA decentralization to the regions as one of the key responses to the problem. It is anticipated that the regional offices will be a better positioned to license local-scale activities in their areas and to monitor implementation.

96. Reforms. Recently, the Government has made an important decision to establish several regional offices which will assume a number of responsibilities currently assigned to CEA. Programs to build environmental management capacity have been conducted in a few selected provinces on a pilot basis. Key issues that still need to be addressed include clear allocation of roles and responsibilities between the CEA and the regional offices, and the most effective way to ensure sufficient capacity in the regional offices to carry out these responsibilities effectively. Furthermore, the Government expressed strong interest in a pilot initiative to harmonize environmental assessment and clearance procedures for all donor-supported projects in Sri Lanka, consistent with upgrading in parallel country’s own policies and procedures, in support of the decentralization process. Identification of some key gaps by a recent review and computerization of the licensing process initiated under the existing World Bank environment project provides a very helpful start for further improvement. The next steps include adjusting the respective policies, regulations and procedures and raising capacity of the central and regional agencies to implement the upgraded procedures. A set of these policy and capacity building initiatives will be supported by PRSC Ithrough IV.

The Welfare System

97. The existing welfare system. During recent years, the welfare system of Sri Lanka of which, the Samurdhi program is the most significant component--has suffered from serious design flaws that have led to considerable mis-targeting. An evaluation of Samurdhi suggests that its targeted food-stamp program, which constitutes 80 percent of the total program budget, misses about 40 percent of households ranked in the poorest quintile, while almost 44 percent of the total budget is spent on households from the top 3 quintiles. Qualitative results suggest that political factors, including party affiliation or voting preferences influence allocation of Samurdhi grants. Large-scale leakage of benefits has led to the program covering as much as half of the population--far above the poverty rate, estimated at less than 25 percent--with the result that the benefits are spread too thinly and the small size of transfers has little impact on poverty (see Annex I1for further details).

98. Reforms initiated. Responding to the need for reform, the new Welfare Benefit Act was enacted by the Parliament in September 2002 to rationalize the legal and institutional framework of all social welfare programs, and to improve the targeting performance of the Samurdhi food-stamp program in particular: On the governance side, the Act mandates an independent Welfare Benefits Board and lower level Selection Committees to set eligibility criteria, validate entry and exit into the program, and redress appeals. On the technical aspect of identifying beneficiaries, the Act envisages setting objective criteria for the selection of beneficiaries, based on easily observable and measurable characteristics of households, with a longer term objective of integrating the criteria to cover all welfare programs in the country. Given that available evidence suggests that the systemic problems of Samurdhi are mainly a result of politicization of the process of identifying beneficiaries, the changes ensconced in the Act represent significant steps. If implemented effectively, these are likely to enhance objectivity and transparency, thereby minimizing the scope for political interference in the selection process and increasing targeting efficiency. The improved system will be implemented by June 2004.

99. Zmplementation of reforms. To oversee implementation of reforms in accordance with the Act, a Steering Committee has been set up under the initiative of the Ministry of Finance, constituting of senior officials members from key departments. At the request of the Government, the Bank, in collaboration with an international consultant with extensive experience in implementing similar programs (and supported through the Economic Reform Technical Assistance Project), has been engaged in providing

28 assistance on the operational, technical and institutional aspects of implementing a strategy for piloting the new system. A detailed work program incorporating the key steps towards conducting a pilot exercise has been developed and is currently being implemented by a core team in Sri Lanka under supervision of the Steering Committee, with inputs from Bank staff as necessary. The broad contours of this work program, as a pre-requisite for the pilot, involve statistical exercises to develop the means-testing formula and simulations for various financiavpayment scenarios, operational work for organizing logistics and training, and software development to create the appropriate Management Information System (MIS)/database. The statistical exercises are near completion and the steering committee is going to make decisions on the means-testing formula, the application form, and the timeline of the pilot (see Annex I for further details the specific actions to be supported under the PRSC program and their timeline).

D. PRSC Triggers

100. While the PRSC is designed to support the overall implementation of a broad set of reforms summarized in the medium-term policy matrix (Annex I),there are number of core actions the implementation of which will trigger board presentation. All the prior actions for presenting the PRSC I to Board have already been undertaken. These are presented in the second column of Table 4, together with all the other key reform actions that have been undertaken by the Government and that are also supported under the PRSC I.The triggers for PRSC I1are summarized in the third column of Table 4. The triggers for PRSC I1are indicative and will be further refined as we go along.

29

e, i .-F

- .. sa...... a. i (ci m IV. LINKS WITH THE CAS

101. Country assistance context. The 2003 CAS is based on the PRS and the economic strategy vision described in Regaining Sri Lanka: Vision and Strategy for Accelerated Development. It focuses on the three PRS themes: peace, growth, and equity. Accordingly, the CAS’ objectives are to: (i)support the peace objective by helping in the reconstruction and capacity building activities in the North-East; (ii) support structural reforms aimed at removing constraints to private sector activity and to higher sustainable economic growth, including in the rural sector; and (iii)help enhance equity in terms of access to and quality of public services.

102. In line with the emerging needs of Sri Lanka and the thrusts of the new CAS, this Program Document seeks approval by the Executive Directors of the first Poverty Reduction Support Credit (PRSC I)for Sri Lanka. The proposed operation is an integral part of the Bank’s strategy to support the implementation of Sri Lanka’s Poverty Reduction Strategy (PRS) and, as elaborated above, the PRSC I program would focus on supporting the economic growth and governance agenda. The entire PRSC program would overlap with the PRS period, supporting the progress in the implementation of the PRS in an integrated manner and in the Bank’s focus areas.

103. AAA strategy. Several major pieces of analytical work have been carried out over the last several years, all of which help underpin the proposed PRSC program (FigureUAnnex I).Work by the Bank includes: A Review of Trends and Policies in the Social Sectors (1998); A Fresh Look at Unemployment (1999); Recauturinn Missed Ouuortunities (2000); Country Financial Accountability Assessment (CFAA, 2002); Country Procurement Assessment Review (CPAR, 2003); Financial Sector Assessment Program (FSAP; 2002 with the IMF); Sri Lanka: Promoting Anricultural and Rural Non-farm Sector Growth: A Policy Note (2002); the recently completed chapter on the Institutional Aspects of Public Expenditure Management of the ongoing Public Expenditure Review (PER), which is being carried out jointly with the Government and the IMF. Work by other institutions includes the background work related to ADB’s technical assistance in support of strengthening public sector financial management in Sri Lanka; and IMF staff reports associated with the SBA and Article IV consultation and the PRGF-EFF arrangement. In addition, the Household Income and Expenditure Surveys (HIES) of 1985/86 to 1995196 have been fully analyzed over the past year. A Sri Lanka Zntegrated Survey (SLIS) was launched in all provinces of the country in 1999/00 and its analysis completed in 2001. On the basis of these analyses, a Poverty Assessment report was completed by the Bank in 2002.

104. To ensure that this four-year program of budgetary support is underpinned by a satisfactory public expenditure management system, technical support will be provided in reforming the fiduciary framework and strengthening the public expenditure management system in planning/budgeting, execution, and expenditure monitoring/control. As discussed above, this support will be based on the findings of the recently completed CFAA, CPAR, and of the background paper on the institutional dimensions of public expenditure management. There is an ongoing dialogue on public expenditure allocations issues--both at aggregate and sectoral levels. This joint effort will continue in the medium- term through a continuous program of annual public expenditure review (PER) work, each year focusing on a relevant theme and producing results to feed into the living PRS. This will reinforce the support being provided by the ADB in this area. As formulated in the CAS, the AAA activities planned over the next four years will continue to provide a basis to fine-tune subsequent PRSCs. The annual PER analysis--to be carried out jointly with the Govemment--will support the ongoing efforts aimed at strengthening public expenditure management and poverty-focus of public expenditures. Other key analytical activities include Social Assessment of the Conflict-Affected Areas (FY03-FY04), DPR (FY04), Investment Climate Survey (FY03-FY04), Poverty Update (FY05), and Update on Rural Development Issues (FY06) (see Figure 1 in Annex Iand Annex V for more details).

105. Lending strategy. Under the new CAS, the FY03-FY06 base case lending program consists of about four projects per year for a total of US$SOO million of IDA resources. While this lending amount is

34 significantly higher than the amount approved during the last CAS period, such an increase is based on a dramatic change both in the peace prospects and the economic policy framework and is merely a restoration of a “normal” lending program for Sri Lanka in line with its IDA allocations. In each year, the lending program would be anchored in a PRSC providing program support to the implementation of the PRS. It is envisaged that the four PRSCs might account for close to half of the total four-year lending program. This would be complemented by two to four investmenVsectora1operations per year to support key program in focus areas, including HIV/AIDs, community water, rural poverty reduction, sector wide programs in health and education, capacity building and infrastructure rehabilitation in the North-East, and information technology (see Annex IV for details). Given the scope of the humanitarian and other impacts of the prolonged civil conflict in Sri Lanka, the country qualifies for IDA grants for a limited period of time--i.e., FY03 and FY04. In FY03, the IDA grant amount--over and above that approved in December 2002 for the National HIV/AIDs Prevention Project--will be US$55 million and used to finance the community water project.

106. Coordination with the ZMF. As noted earlier, the PRSC will complement the IMF’s PRGF-EFF arrangement, which will support fiscal consolidation and some of the structural reform efforts. The two institutions will continue their ongoing coordination to ensure that the PRSC and PRGF programs are consistent and reinforce each other. During the recent missions on the Poverty Reduction Strategy (PRS), the IMF review of the Standby Arrangement, and discussions on the PRGF program, Bank staff worked closely with IMF staff in order to ensure a coordinated approach in support of Sri Lanka’s macroeconomic stabilization and structural reform efforts. Bank and Fund staff also worked closely in providing background technical support in the formulation of the PRS and prepared the Joint Staff Assessment (JSA). A joint Bank-Fund Financial Sector Assessment Program (FSAP) was completed in 2002, and at the Government’s request, a joint Bank-Fund mission followed-up on FSAP’s recommendations regarding the restructuring of the state-owned banks. The latter mission provided recommendations for an orderly restructuring of People’s Bank.

107. Coordination with other donors. In implementing its country assistance strategy, the Bank is also collaborating closely with the ADB, the Japan Bank for International Cooperation (JBIC), and other donors. Coordination and partnership with JBIC and ADB are especially critical, given that their assistance complements that of the Bank, providing opportunities for parallel or joint financing. Coordination is strengthened by systematic sharing of information and finding ways to reinforce each other’s programs and policy dialogue. The ADB’s Private Sector Development Program Loan and the Power Sector Adjustment Credit and the Bank‘s PRSC deliver consistent messages and support consistent reform directions toward a more market-based system. In the financial sector, the Bank focuses on the banking sector and pension funds, while the ADB focuses on capital market development and SME finance. The ADB is also supporting ongoing efforts to strengthen public expenditure management, which complement the Bank‘s work on civil service and administrative reform issues. JBIC’s involvement in financing infrastructure is complemented by the Bank through support to policy reforms that can enhance the outcomes of these projects for the country. The Bank is working closely with the ADB and other donors on environmental management capacity and this collaboration will be used to begin a process of harmonization, based around strengthening the Government’s own environmental assessment systems. (See Annex V for details of donor support in Sri Lanka).

V. PROGRAM IMPLEMENTATIONAND SOCIAL IMPACT

A. Implementation

108. Committees have been established in twelve broad PRS areas, each with a steering committee responsible for managing and monitoring the overall implementation of the PRS. Staff from the Ministry of Policy Development and Implementation (MPDI) and from the National Planning Department (NPD) will support the steering committees. Also a monitoring team, led by the National Operations Room (NOR) of the MPDI, with officials from the NPD, the External Resources Department, the Department of

35 Census and Statistics, and the Central Bank, and representatives from the private sectors, academichesearch institutions, NGOs, and donor agencies, will be established. The specific liaison and implementation arrangements between the PRSPRSC programs will be finalized during the appraisal mission.

B. Social Impact Analysis

109. Monitoring and evaluation (M&E) is an essential part of improving and fine-tuning policies geared towards poverty reduction. Sri Lanka’s PRSP highlights the overall plans for M&E, including preparations underway to strengthen monitoring capacity and to fill quantitative and qualitative information gaps (for the details of support under the PRSC program, see Annex I).The M&E framework contains five critical components, which will also address the needs of a Poverty and Social Impact Analysis (PSIA) of policy reforms:

0 Rationalize the existing surveys, like the Household Income and Expenditure Survey (HIES) and Consumer Finance and Socio-economic Survey (CFSES)--which are included in the M&E framework outlined by the PRSP--to regularize their periodicity, synchronize their timing, and strengthen some modules (especially in the area of human development) to track indicators related to quality of services.

0 Introduce a mechanism to track the poverty and social impact of policy changes. For the aforementioned welfare reform, two components are currently being discussed: (i)a Poverty Map to identify geographic areas of isolation and poverty, which will aid targeting of poverty programs in general; and (ii)an in-built monitoring system of the welfare program to track improvements in indicators of poverty that will help with identifying movement of beneficiaries in and out of the program. To monitor the impact of broader policy measures that are likely to have varying effects across heterogeneous groups--e.g., changes in land and labor policies--the existing HIES may provide some answers, along some basic dimensions of poverty. Additionally, other components of the existing M&E framework--e.g., the Labor Force surveys and the Demographic and Health Survey (DHS)--could be tailored to address the impact of specific policies. (However, it will be important to increase the frequency--currently once every 5 years--of both the HIES and the DHS).

0 With the peace accord and post-conflict reconstruction efforts, an opportunity now arises for understanding poverty in the North-East. The HIES and other surveys will need to be representative of this region, and the current HIES on the ground appears to have accomplished this goal.

0 An integral part of poverty monitoring and impact is also the participatory component to assess access and consumer satisfaction issues. The PRS acknowledges the importance of this and proposes a broad-based monitoring team that will need to be regularized.

0 Finally, and perhaps most crucial, are the institutional arrangements to coordinate the M&E system and promote incentives for its use in policy and budgetary decision-making. An immediate objective would be to enhance capacity of the Department of Census and Statistics (DCS) to be able to conduct the HIES at intervals of 2-3 years (currently, two agencies--the DCS and the Central Bank--alternate in fielding two similar surveys, which is both inefficient and introduce comparability problems). Our policy dialogue so far has been to present this concern and move beyond it towards a decision. Two options can be considered: (i)a single household survey conducted by a single authority, Le., DCS, to collect incomekonsumption data and expand the survey to include more social indicators, akin to an LSMS (the preferred option); and (ii) continue to have two surveys, but coordinate them in terms of timing, expanding one of them (for example, CFSES) to include broader social indicators--one model could be the Sri Lanka Integrated Survey (SLIS) conducted in 1999-2000. Once clarity is achieved on the institutional arrangements and survey plans, it will facilitate rationalizing of the poverty monitoring system

36 and will improve capacity and prospects for developing a multipurpose household surveys (like the LSMS) to aid the deepening of the diagnostics and monitoring of poverty.

VI. CREDIT AMOUNT, TRANCHING, AND DISBURSEMENT

110. Borrower and Credit amount. The borrower is the Democratic Socialist Republic of Stri Lanka. The proposed PRSC Iis SDR 90.7 million (US$l25 million equivalent) and would be released in one tranche, expected in July 2003. The credit would be on standard IDA terms--a 40 year maturity, including a 10-year grace period.

111. Disbursement, procurement, andfinancial management. The Credit will follow the Bank‘s simplified disbursement procedures for adjustment operations. The Government will open and maintain a Deposit Account with the Central Bank of Sri Lanka (CBSL) into which the proceeds of the Credit will be disbursed. Disbursement will not be linked to any specific purchases and no procurement requirements will be needed. Disbursements from the Deposit Account will follow normal Government policies and procedures. The proceeds will not be used to finance expenditures excluded under Schedule 1 of the Development Credit Agreement. The CBSL, on behalf of the Government, will maintain an appropriate accounting system in accordance with generally acceptable accounting principles. It will provide the required information on the receipt and use of the Credit funds in a format agreed at negotiations.

112. Central Bank Safeguards Assessment. The IMF conducted a Stage Two Safeguard Assessment in July, 2001. It determined that while a number of measures have been initiated to strengthen the CBSL, there are significant vulnerabilities that need to be addressed. To address these vulnerabilities, the assessment recommended: (i)the adoption of stronger external audit mechanisms under the oversight of an Audit Committee; (ii)implementation of International Accounting Standards; and (iii)appropriate review and control procedures over data submitted to IMF. The CBSL has made good progress in implementing these recommendations and its 2002 accounts (on full IAS basis) have been audited by Ernst and Young, New Zealand.

VII. BENEFITS AND RISKS

113. Benefits. By focusing on economy-wide policy and institutional issues likefactor markets and broad public sector reform, as well as on the rural sector that is critically important for poverty reduction, the proposed PRSC is expected to help implementation of the poverty reduction program in several ways. First, it will help the Government’s implementation of important structural reforms, boosting investor confidence. Second, in the short- to medium-term, the credit will support fiscal consolidation and help create conditions for accelerating economic growth by providing quick-disbursing assistance at a time when economic recovery is still slow and there is a very tight budget situation. Third, the credit will support poverty reduction not only by creating fiscal space, but also through improvements in the poverty-focus of public expenditure programs. The credit will facilitate the latter also by inducing and supporting analytical work (annual PER analysis, the introduction of rolling Medium-Term Expenditure Framework (MTEF), better costing of PRSP programs, incidence analysis in social sectors and poverty incidence updates). Finally, the credit will help the poor by supporting the strengthening of the institutional framework and capacity in the management of public resources.

114. Risks. The overall PRSC program faces several risks:

0 Peace process. A resumption of hostilities and the derailment of the peace process, which could worsen the precarious fiscal situation, slow down economic activity, hurt business confidence, and postpone the implementation of the PRS program.

0 Politics under a cohabitation government. Sri Lanka is going through ‘‘cohabitation’’--a President from one party and a Government from another--for the first time. The President has

37 the constitutional power to dismiss the Government and call elections. Such an event could obviously disrupt both the peace process and economic reforms. The President has stated that she would not dismiss the Government as long they continue to command the confidence of Parliament. Nevertheless, this remains a risk for this operation.

0 Opposition to reforms. Stronger reactions/opposition to some reforms, such as bank privatization, or if the reforms were seen as a threat to the peace process, the Government might slow down its efforts.

0 ExtemaE. Sri Lanka remains a country with heavy external dependence. If the situation in the Middle East were to deteriorate further, the economy might be hurt due to likely decline in international tourism and tea exports, a slower recovery in the global economy, and sustained high oil prices, just at the time the Sri Lankan economy is recovering. Inflows of workers’ remittance might also be affected in the short- to medium-term.

115. Of these risks the first two are the most critical. This is therefore a relatively risky strategy. It is intentionally so, because of the historic moment at which Sri Lanka finds itself. The Government and indeed the LTTE are themselves being very bold and taking enormous risks with respect to their own political futures, for the sake of a better future for the people of Sri Lanka. It seems only reasonable that the Bank should also be prepared to accept the risks of this strategy so long as the two parties remain committed to achieving peace and laying the foundation for a renewed attack on poverty. It is therefore a strategy that has high risks, but potentially very high rewards in a country that for too long has been performing below its full potential. Sri Lanka now has the opportunity finally to break out of the conflict and follow a path of sustained progress for all its people. The World Bank Group can make a substantial contribution to this process.

116. To handle these risks, several mitigation strategies are being adopted. First, with Bank support, a major communications program is being developed to present and explain the reform program to the population. This should reduce resistance to the reforms. In addition, a major program of technical assistance for the reform process has been approved--Le., the Economic Reform Technical Assistance Project--which should boost implementation capacity. Both the IMF and the Bank will also provide support to strengthen the monitoring and evaluation capacity building effort.

117. The political risks are harder to mitigate, but should be tractable so long as the Government retains the confidence of Parliament. The successful implementation of the reform program and successful negotiation of the peace process are the best guarantees of this. With regard to the peace process, there is every indication of strong commitment from both sides and the best prospect to supporting this is an early demonstration of the benefits of peace. Thus, the Bank--along with other development partners--will provide early support for reconstruction efforts as part of the strategy. Finally, the external shocks require that foreign reserves be built up as quickly as possible.

38 ATTACHMENTS

Attachment 1 Page I of 12

Fax Telex

@Dcd q.mo emo nsry PN. 19" May,2003 My No. Date

Mr. James D. Wolfensohn, President, International Development Association, 1818 H Street, NW, Washington DC 20433

Dear Mr. Wolfensohn,

LETTER OF DEVELOPMENT POLICY

The Government of Sri Lanka, at a critical time .in its history, has launched an econo&c program which aims to reduce poverty by creating an enabling environment for inclusive private sector led growth and to consolidate the peace process by relief, rehabilitation, and reconstruction efforts. This far-reaching strategy is laid out in Regaining Sri Lanka: Vision and Strategy for Accelerated Development - our Poverty Reduction Strategy Paper (PRSP). On behalf of the Government of Sri Lanka, Iam writing to request the First Poverty Reduction Support Credit (PRSC) of US$ 110 million in support of our PRSP.

The attached Letter of Development Policy (LDP) sets out the actions that Government will undertake over the medium term to implement this strategy, focusing on measures that will increase the efficiency of factor markets and energy supply, establish a safe and sound financial system, support rural development, improve targeting of welfare programs, enhance environmental management capacity, and strengthen the effectiveness of Government services and public expenditure.

Section 111 of the LDP incorporates the actions considered critical for the success of our reform program together with the timelines for the completion of these actions. Section IV incorporates the actions that will be completed within the next year to demonstrate our commitment to the reform program. The remaining actions represent our vision of the on going process and our best current estimate of actions that will be camed out during the subsequent two years.

Yours sincerely,

K.N. Choksy,P.C., M.P. Minister of Finance

Attachment 1 Page 2 of 12 MAY1gTH2003 GOVERNMENT OF SRI LANKA LETTER OF DEVELOPMENT POLICY

I. INTRODUCTIONAND STRATEGIC CONTEXT

Background

01. The Government of Sri Lanka is in a process to reverse the legacy of two decades of painful and costly conflict and enter into a new phase of economic development. The Government’s commitment towards a negotiated settlement of the conflict and the progress being made including relief, rehabilitation and reconstruction efforts have raised expectations throughout the country and the international community that lasting peace may finally be within reach. In recognition that peace and inclusive economic growth are closely linked, we have developed a comprehensive Poverty Reduction Strategy (PRS) which is articulated in our Poverty Reduction Strategy paper (PRSP) titled “Regaining Sri Lanka: Vision and Strategy for Accelerated Development.” This strategy is the outcome of a four year extensive consultative process and it focuses on strengthening the basis for competitive, private sector-led growth through fiscal consolidation and far-reaching structural reforms.

02. Despite achieving very high social development indicators early in its development, poverty in Sri Lanka remains high. The findings of the recent World Bank Poverty Assessment indicate that in the mid- 1990s about one fourth of Sri Lankans lived below the national poverty line. The inclusion of data from the North and East would make this situation worse. Thus, to address this problem, our PRS represents a departure from erstwhile policies of transfers and redistribution to a strategy that aims at fostering growth,and widening opportunities for the poor.

03. In the last three decades Sri Lanka performed below its potential in economic growth, especially relative to its East Asian neighbors who were its peers in the 1960s. Though a 5 percent average annual growth recorded in the 1990s is respectable given that the country was entangled with a serious conflict, it is not commensurate with Sri Lanka’s human and natural resource endowment. This has largely been the result of the continued dominance of the public sector in commercial activities, distortions in the labour, land, and credit markets, poor connectivity to the rural economy, as well as an onerous regulatory and legal framework constraining competitive private sector participation in key industries. Although after the initial phase of the economic liberalisation in 1977, the country’s economic policy environment was strengthened further through subsequent reforms, momentum of reforms had slowed-down and more fundamental reforms were not implemented, as economic management became complicated with the escalation of the conflict and lack of political will. As a result, important distortions and barriers to productivity growth remained, making Sri Lanka relatively less attractive to foreign investment and not so friendly to competitive private sector participation.

04. When the present Government took office after the General Election in December 2001, the country was in the midst of a serious economic contraction mainly caused by escalating military conflict, deteriorating fiscal accounts and weak external environment. The Stand-By Agreement (SBA) launched in April 2001 had got derailed. The real GDP declined in 2001 for the first time since independence. Public debt climbed to over 105 percent of GDP, while interest payments reached 7% percent of GDP. Interest payments on public debt, wages, defense expenditure, and transfers to households and SOEs absorb about 95 percent of government revenue, leaving minimal fiscal space for investment in physical and social infrastructure. The peace process and the economic policies of the government have now provided a new lease of life to an ailing economy. The Government has already taken strong measures to foster an enabling environment for private sector-led growth and job creation. The immediate priority was to restore macro- economic stability. We moved quickly to curtail defense expenditure, broadened the tax base, imposed a Attachment 1 Page 3 of 12 hiring freeze in the public sector, and introduced several urgent structural reforms. With these, the stabilization program was brought back on track, and as a broad endorsement of our economic program, the IMF released the remaining tranches under the SBA in April and September 2002.

Recent Economic Performance and Medium-Term Prospects

05. The measures adopted by the Government are paying off and setting the stage for improved medium-term prospects. In 2002, the economy recovered and the macroeconomic situation improved. Despite weak external demand, the economy grew by 4 percent in 2002, with a significant recovery of domestic economic activity in the second half, reflecting the normalization of the security situation and improved consumer and business confidence. Inflation declined to 9% percent in 2002 from 14 percent in 2001. The external current account deficit declined reflecting improved services receipts, including from tourism, and higher remittances. The capital account showed higher FDI. Gross official reserves rose to US$1.5 billion (2% months of import cover) while the rupee remained stable at around Rs96/US$. We believe that full implementation of the reform program will further brighten medium-term prospects for Sri Lanka, specifically in terms of raising real GDP growth and reducing the fiscal deficit and public debt.

06. In 2002, the fiscal deficit was reduced by 2 percentage points of GDP to 8.9 per cent of GDP (despite losses associated with the transition from the GST/NSL to a simplified two-rate VAT system) through restraint on expenditure. The 2003 Budget presented in November, 2002 reflects our continued commitment to fiscal consolidation and structural reforms. The fiscal adjustments and the decline in inflation allowed interest rates to be cut by 300 basis points since January 2002, setting the stage for an expansion of private sector credit and investment. These measures have fostered investor confidence, boosted the stock market considerably, and doubled capital inflows.

07. We expect these positive developments in the Sri Lanka economy to continue as the reform program advances. Economic growth in 2003 is projected at 5% percent and inflation to decline to 7 percent by end- 2003. Gross reserves are targeted to increase to US$2 billion. We are aiming for a medium-term growth rate of 6% percent over 2003-06 and sustained high growth rate of 8-10 percent in the long-run. The inflation rate is expected to fall to 5 percent, and gross official reserves to rise to cover 3 months of imports by 2006.

08. The Government of Sri Lanka has already taken steps to secure the availability of external financial resources to facilitate faster growth. Reconstruction related imports alone are likely to raise the current account deficit to 4 percent of GDP. Moreover, preliminary estimates indicate that during 2003-06, annual external financing needs would average about US$400 million. Bilateral donors, particularly Japan, U.S., Germany, Kuwait, and Saudi Arabia, are likely to contribute about $70 million in program support. In support of our three-year Poverty Reduction and Growth Facility (PRGF) and EFF arrangements (EFF) approved in April 2003, the IMF has committed US$567 million equivalent to 100 per cent of our quota. Of this US$ 369 million is provided under the concessional PRGF and the balance US$ 198 million is provided under EFF. In 2003, we expect US$161 million to be disbursed under PRGFEFF program. The Asian Development Bank’s total financial support during 2003-06 would be US$ 400 million, with a program component of US$200 million. About US$60 million is expected to be disbursed as program support by the ADB in 2003. Under its new Country Assistance Strategy, the World Bank’s base case lending program consists of about four projects per year for a total of US$800 million of IDA resources over the Bank’s FY03-FY06. The proposed PRSC I,equivalent to US$110 million, is part of the World Bank’s strategy to support Sri Lanka’s PRS.

09. This Letter of Development Policy next describes in broad terms our Government’s medium-term structural reform program that underpins Sri Lanka’s PRS, outlining the issues and strategies. It then presents the structural reform agenda for the major areas of the PRSC. Attachment 1 Page 4 of 12 11. THE NATIONALSTRATEGY FOR ACCELERATEDDEVELOPMENT

Regaining Sri Lanka

10. Regaining Sri Lanka-our Poverty Reduction Strategy Paper-brings together complementary elements of the Government’s economic program to achieve inclusive growth and lasting stability. This comprehensive strategy is the result of a far-reaching stakeholder consultation dating back to the drafting of the Poverty Framework (PF) in 1998. The consultations with line ministries, donors, NGOKBO network, private sector representatives, trade unions, government agencies, and research organizations continued until it was finalized in January 2003. Within this extended discussion period, we have reached understandings on the broad areas that will be supported by the World Bank, the IMF, the ADB, and other bilateral and multilateral donor partners,

11. The PRS reflects a fundamental change in the role of the state to creating an enabling environment for faster economic growth and poverty reduction. The principal elements of the Government’s PRS include:

0 Securing lasting peace 0 Strengthening a supportive macroeconomic environment 0 Reducing conflict-related poverty 0 Creating opportunities for pro-poor growth 0 Investing in people 0 Empowering the poor and strengthening governance 0 Implementing an effective monitoring and evaluation system 0 12. In line with the Millennium Development Goals (MDGs), the PRSP identifies the target of halving the number of poor by 2015 as the key objective that will guide the Government’s long-term strategy for poverty reduction. Within this framework, the other key targets that the PRSP envisages in the medium- term include:

0 Increasing annual real GDP growth to around 6% percent within next three to four years (and then increasing it further to nearly 8-10 percent in the second half of the current decade; 0 Creating a minimum two million new jobs during the on-coming few years for the currently unemployedunder-employed as well as new entrants to the workforce; and 0 Reducing the national headcount poverty index from 25 to 20 percent and the rural headcount poverty index from 27 to 22 percent by 2005. Progress in Economic Reforms

13. We give below the specifics of the Government’s economic program to further strengthen macro- economic stability and to place Sri Lanka on a path of self-sustaining high growth, employment creation and poverty reduction in the medium-term.

14. Restoring Fiscal Sustainability and reducing pressure on interest rates. Our aim is to make further progress towards strong fiscal consolidation and low inflation as envisaged in the IMF-supported three year PRGFLEW program. To bring public debt to a manageable level, the program aims to reduce the fiscal deficit by 1% percent, on average, per year through 2006. To achieve this, we plan to raise revenues by 2% percent of GDP by 2006, through broadening the tax base, rationalizing tax incentives, and improving tax administration. We have already extended the VAT to the financial sector, extended the debit tax from current accounts to savings accounts, imposed duties on most exempt imports and reduced defense expenditures. We also reduced the top income tax rate to 30 per cent from 35 per cent. The revenue augmenting and expenditure cutting measures in 2003 are expected to reduce the fiscal deficit to 7% percent of GDP. While this includes about % per cent of GDP for post-conflict spending in the North-East, we feel Attachment 1 Page 5 of 12 that we should be able to accommodate another ?h per cent of GDP for additional reconstruction and rehabilitation expenditures be financed out of mainly additional donor funding, without bringing in undue macro-economic pressures. Significant progress has already been made in other areas of fiscal and quasi- fiscal consolidation:

The Fiscal Management Responsibility Act No. 3 of 2003 was enacted in January 2003. The Act sets a medium-term fiscal deficit path and ceiling on maximum level of public debt. It also mandates pre- election budget reports to discourage pre-election handouts. By 2006, the Act stipulates a ceiling on public debt at 85 percent of GDP and the budget deficit at 5 percent of GDP. Tax Incentive Scheme was harmonized in 2002 for both BO1registered companies and those that come under the Inland Revenue Authority. A Welfare Reform Act was enacted in September 2002, setting transparent eligibility and exit criteria. A computerized applicant scoring system for the Samurdhi cash benefit scheme is being installed with World Bank assistance. A contributory pension scheme for all new public officers was approved by the Parliament in January 2003 and is being implemented. A project manager and team entrusted with responsibility for setting up a Revenue Authority have been appointed, to strengthen tax collection and provide better service. The draft legislation is under preparation. Key public enterprises (CPC, CWE, and CEB) will limit their bank borrowing. The existing freeze on hiring civil servants, with limited exceptions and abolition of redundant vacant positions, continues. The progress in reducing the deficit has already led to lower need for domestic financing. As a result, in combination with a sound monetary policy, inflation has been reduced enabling nominal interest rates to be lowered significantly-- prime lending rates now stand at 11.5 percent and Treasury Bill yields of 9.5 percent compared with the beginning of last year.

15. Labour Market Reforms. A well functioning labour market is a prerequisite for economic growth. For workers covered under the Termination of Employment of Workman Act (TEWA) of 1971, i.e., employees of enterprises with more than 15 workers, Sri Lanka has had one of the most stringent job security regulations in the world, restricting and segmenting the country’s labour market and discouraging the expansion of employment and foreign direct investment. Furthermore, labour disputes litigated under the Industrial Disputes Act of 1950 through a low-capacity system were costly, lengthy, fraught with ad hoc discretionary rulings. Hence, the Government seeks to foster market flexibility through the adoption of labour reforms, including the revision of legal provisions on redundancy compensation, time- bound resolution of labour disputes, and assistance for workers options for voluntary retirement to find appropriate employment. In this regard, the Government has already undertaken the following actions: e Amendments to TEWA and the Industrial Disputes Acts were enacted in January 2003. Accordingly, a maximum time frame for settlement of labour disputes has been set and the Labour Commissioner is required to use the termination compensation formula to be published in the Government gazette. The formula will be in line with international practices. . e The Factories (Amendment) Act No. 19 of 2002 enacted to harmonize labour legislation with international practice. e The first of 17 proposed country-wide Job Information Centers (Jobs Net) has been set up. The centers will help potential employers connect with job seekers. e The Government with the assistance of LOis considering various designs and funding options for an Unemployment Benefit (UB) scheme that would provide appropriate short-term income support for retired workers. However, in view of the tight fiscal space, we are keen to minimize the fiscal burden of any such scheme on the budget. Attachment 1 Page 6 of 12 16. Land Market Reforms. Land market reforms are an important element of the Government’s strategy to increase productivity in the rural agricultural economy. The majority of land in Sri Lanka is owned by the state, but farmed by private farmers under various tenure agreements with restrictions on sale, lease, and collateralization. The land grants under the Land Development Ordinance (LDO) and Land Grants (Special Provision) Act constitute a large portion of small-scale paddy lands that are held by private farmers in this manner. Granting farmers clear titles for their land, thus giving them independent control over land management and access to collateralized credit, is the Government’s priority action in the land market reform program. In addition, the existing land administration system is based on a deed registration system, which reduces the efficiency of land transactions, tenure security, and land market choices. In this connection, we have already undertaken the following actions:

0 The Government is preparing a draft Land Ownership Law to convert land grants under the LDO Act and the Land Grants (Special Provisions) Act to freehold lands to facilitate marketable freehold or leasehold titles. This law is expected to be presented to Parliament in July 2003. 0 The Survey Act No. 17 of 2002 was passed taking into account the land titling requirements. 0 The Government is preparing amendments to the Registration of Title Act No. 210f 1998 to improve its efficiency and coverage. 0 A pilot land titling program is being implemented to develop operational methods and manuals, and formulate a 1egaVpolicy and organizational framework for a long-term land titling administration.

17. Power Sector Reforms. In recognition of major structural weaknesses the Government has embarked on a comprehensive power sector reform program. The vertically integrated Ceylon Electricity Board (CEB) has Rs 42 billion in long-term debt plus Rs 6 billion in debt service arrears owed to the Treasury, and Rs15 billion in short-term debt owed to state banks. Excessive reliance on hydropower has resulted in power cuts and widespread disruptions to industry whenever drought conditions prevail. Reliance on expensive thermal energy (e.g. under drought conditions) and unwillingness to pass on increased costs to consumers have further deteriorated CEB’s already weak financial situation-the cumulative result of past poor governance, weak managerial capacity, inefficiencies, and lack of accountability. To address these structural weaknesses and with the support of the ADB through a Power Sector Adjustment Operation, the Government has already undertaken the following actions:

0 The average electricity tariff rate was increased by 38 percent in April 2002 to contain further accumulation of CEB losses. 0 Unbundled the CEB, as provided for under the Electricity Reform Act of 2002, by October 2003. This restructuring is seen as an essential step to increase efficiency, accountability, and minimize outside interference. 0 The Electricity Reforms Bill was passed in Parliament in December 2002, paving the way for its restructuring. 0 The Public Utilities Commission (PUC) Bill to set up a multi-sector infrastructure regulatory agency, having regulatory power over public utilities including electricity, was passed in Parliament in December 2002 and the regulatory body to cover electricity sector was established in December 2002. 0 A financial recovery plan to restore the viability of CEB’s successor entities and to settle its short-term debt is being formulated.

18. Financial Sector Reforms. The Government of Sri Lanka is committed to strengthen the performance of the financial sector to help improve its contribution to private sector-led growth and development. The inefficiencies in the banking sector are underlined by high intermediation spreads and narrow range of financial instruments. The high level of non-performing loans (NPL) in the dominant state banks-especially in People’s Bank (PB)-continue to mount at considerable expense to the public and the fiscal budget. Despite two re-capitalizations in 1993 and 1996, People’s Bank again has a negative net worth due to inadequate governance structures (reflected in past political interference in credit decisions). In view of PB’s high level of NPLs and the high fiscal burden of any recapitalization, the Government is treating the Attachment 1 Page 7 of 12 restructuring of PB as an urgent priority. Curtailing government borrowing from the banking system is also a pre-requisite to foster competition among banks on the lending side-fiscal consolidation will complement specific financial sector reforms. We have already undertaken the following actions:

We have publicly announced our intent to restructure the PB. The People’s Bank Restructuring Committee was appointed in January 2003 to oversee its reforms. The process to hire the services of a financial adviser to assist the restructuring of PB has been initiated. The World Bank-funded Economic Reforms Technical Assistance (ERTA) project is supporting this effort. The adviser will formulate appropriate options for restructuring. The options being considered for reform are to commercialize it as a single entity or after separating it into viable sub-units in an open and transparent process. This would be in full accordance with the Banking Act. Amendments to the Monetary Law Act were enacted in Parliament to provide the CBSL more control over its monetary instruments and strengthen its role as the commercial bank regulator and supervisor. To strengthen the integrity of the banking system, the minimum Capital Adequacy Ratio (CAR) was raised to 10 percent for all domestic banking units from January 1, 2003 and on a consolidated basis on all domestic and foreign banking units effective December 31, 2003. Amendments to the Securities Commission Act, which increase the regulatory scope of the agency to a broad range of financial institutions, were passed by Parliament in January 2003. To increase market penetration and efficiency of the insurance industry, the state owned Sri Lanka Insurance Corporation (SLIC) was privatized.

19. Other Structural Reforms. The program for reform and liberalization of external trade, launched in 1977, left untouched many important distortions and barriers to productivity growth across the economy. These lingering obstacles have made Sri Lanka relatively less attractive to foreign investment and unfriendly to competitive private sector participation. To address these issues, the Government of Sri Lanka is already acting on a wide range of structural reforms:

0 Further Twelve percent of Government shares of Sri Lanka Telecom (SLT) were sold through an POin December 2002. 0 To enhance competition in the telecommunications sector, access to international gateways was liberalized in January 2003. The Govemment has initiated the process of sale of the Colombo Hilton Hotel and the retail operations of the Cooperative Wholesale Establishment (CWE) in 2003. 0 The Petroleum Products Special Provisions Act was adopted and made effective in August 2002 to provide private sector participation in the import, export, sale, supply, and distribution of petroleum products. 0 The Government intends to unbundle the Ceylon Petroleum Corporation (CPC) into three competitive distribution units plus a common use facility with a view to introduce a competition in this sector. Part of CPC has already been divested. Investing in People

20. Education Sector. Sri Lanka enjoys impressive basic education attainment, on which the PRSP aims to build on, to attain 100 percent secondary enrollment by 2010 (net primary enrollment rates already exceeded 100 percent in late 1990s). However, the quality of education and returns to education in the job market remain low. For example, only 5 percent of students were exposed to computers in 2000 (a low penetration level even compared to countries with comparable income). A considerable disconnect exists between the skills the market demands and the skills the system supplies. A larger role for the private sector and the local community in the provision of flexible, high quality education services is envisioned for those who are relatively well off, enabling the Government to focus its resources on improving access and service Attachment 1 Page 8 of 12 quality in poor communities. Towards this end, the Government of Sri Lanka is already acting on a wide range of structural reforms, including:

0 Continuing its liberal licensing policy for private schools.

0 Further accelerating teacher training. 0 Augmenting existing basic facilities in rural schools. 0 Further improving the quality of tertiary education and enhancing market relevance.

21. Health Sector. Notwithstanding its overall good performance since independence-having achieved standards in many indicators already-the health care system faces several major challenges, including a resurgence of malaria and high levels of undernourishment and anemia among pregnant and lactating mothers. The following are included among the actions that we intend to undertake to improve the performance of the health sector:

0 Continuing the improvement of the nutrition levels for infants, children, and pregnant women, to ensure prevention of disease and productive lifestyles. 0 Continuing the implementation of prevention and control programs for malaria and HIV/AIDS. 0 Capitalizing on Sri Lanka’s long standing strengths in social mobilization to expand the provision of safe drinking water and sanitation services. In urban areas, the private sector will be encouraged to play an increasing role in these activities.

22. Social Safety Net. The Government recognizes that basic assistance and income support through a well-targeted safety net program is still required for some chronically poor and disadvantaged groups, as well as people who may require a temporary cushion from shocks. According to the World Bank’s Poverty Assessment, the Samurdhi program does not assist some 40 percent of the poorest quintile. In this connection, the Government has already undertaken the following actions:

0 Enacting the Welfare Benefits Act in September 2002 with a view to de-politicizing the process and better targeting the beneficiaries. 0 Formulating clear eligibility and exit criteria (this is being carried out with World Bank assistance).

23. Gender Dimensions. Addressing gender disparities in participation in policy-making processes, promoting gender equality in the labour force, and the protection of women’s rights are viewed by the Govemment of Sri Lanka as central to main streaming gender in anti-poverty efforts. In this connection, the following actions are under preparation or have already been undertaken:

0 In line with the Women’s Charter and the Women’s Manifesto, the Government proposes formulating amendments to the election laws in consultation with the political parties represented in the Parliament to enable adequate representation of women in the nominations to the legislative organs of the Government. 0 A detailed analysis of gender bias in public services has been undertaken, and efforts are being strengthened to integrate gender into budgeting, personnel policies and program design.

24. Empowerment of Communities. The Government of Sri Lanka believes that empowerment of local communities and civil society to play a greater role in the management of their day to day affairs is central to the battle against poverty. The results of the Community Driven Development (CDD) pilot initiative currently undertaken in the Mahaweli area show that the CDD approach is powerful and could be used in rural and agricultural development efforts, as well as in the management of Sri Lanka’s fragile natural resource base. The CDD pilot projects are generating useful results, inculcating notions of demand driven systems, cost sharing, and empowerment in poorer segments of society. Building on the positive experience of the pilots already underway, the Government is planning the following actions: Attachment 1 Page 9 of 12 In the medium term, the CDD approach will be extended to 5 districts in the Southern Province, and over the longer term the program will be scaled up to the entire country. 0 The Government intends to continue its collaborations with NGOs to implement programs to assist the disabled, the elderly, the orphaned, and other vulnerable segments of society. Strengthening Governance in the Public Sector

25. Governance and Civil Service Reforms. The Government of Sri Lanka is committed to carrying out substantial public sector governance and civil service reforms. Sri Lanka has one of the largest public service cadres in the world on a per capita basis. The public sector suffers from tremendous overstaffing, poor service delivery, duplicate institutions, administrative fragmentation, and inadequate decentralization. The poor bear a disproportionate share of the cost of sub-standard governance. In addition, bottlenecks in critical government functions amount to additional costs and delays for commercial activity. Although Sri Lanka has a history of a relatively professional civil service cadre, it has seen a gradual decline into politicization and patronage, since the abolition of the Independent Public Services Commission (PSC) in 1972. In the near term, we will focus on creating a more streamlined, efficient, decentralized, and accountable public administration. We are also aware that administrative reforms need to be complemented by sound public expenditure management. The recently completed World Bank Country Procurement Assessment Report (CPAR) and Country Financial Accountability Assessment (CFAA), as well as the ongoing Public Expenditure Review (PER), will form the basis for our comprehensive expenditure management system. Progress has already been made in reforming this critical interface between the Government and the population:

The 17th Amendment to the Constitution reestablishing an independent PSC was passed in Parliament. The new PSC began operations in January 2003. Submitted a Bill to Parliament for a fully funded pension system for new recruits to the public sector. The Expenditure Reform Commission initiated a “zero-based” review of Government agency structures, functions, and staffing in March 2002 with the goal of encouraging consolidation of Government functions and eliminating duplications. An across-the-board civil service hiring freeze with limited exceptions has been in effect since last year. An Administrative Reforms Committee chaired by the Secretary to the Prime Minister has been constituted to provide policy advice and help coordinate the public sector program.. Consultations are underway to finalize a draft Public Finance Act to provide the legal basis for budgeting, public expenditure management, and financial accountability. Initiated strengthening capacity for environmental management through computerized procedures, environmental licensing, and decentralizing the central environmental agency by creating regional offices.

Strengthening Outcomes Monitoring and Evaluation

26. We have known for a long time what steps are needed to improve economic performance, but often these steps were not taken due to the absence of an effective implementation mechanism. The Government has now introduced a number of Steering Committees with extensive private sector participation, to drive the reform process. There are 18 functioning Steering Committees already meeting to iron out the priority actions in the reform program in their respective areas. Technical Assistance for the Committees is being provided through the World Bank’s Economic Reforms Technical Assistance Project (ERTA). The Steering Committees report to and are coordinated by the Program Management Committee (PMC) within the Ministry of Policy Development and Implementation (MPDI). The progress of the Steering Committees is reported by the PMC to the Economic Policy Committee (EPC) chaired by the Prime Minister and represented by key members of the cabinet, MPDI, and Ministry of Finance. Attachment 1 Page 10 of I2 27. Monitoring and evaluation (M&E) is an integral part of improving and fine-tuning policies geared towards poverty reduction. Sri Lanka's PRSP highlights the overall plans for M&E, including preparations to strengthen monitoring capacity and to fill quantitative and qualitative information gaps. Plans to improve M&E already include:

Rationalizing/synchronizing the Household Income and Expenditure Survey (HIES), Consumer Finance and Socio-Economic Survey (CFSES). Completing a poverty map to identify geographic pockets of poverty. Introducing a mechanism to track the poverty and social impact of policy changes. Integrating/analyzing North-East poverty data Building capacity in the Department of Census and Statistics (DCS) to be able to conduct the HIES at intervals of 2-3 years Introducing continuous stakeholder consultation in M&E efforts. Implementation of this overall framework will also address the needs of a Poverty and Social Impact Assessment (PSIA) of policy reforms.

111. THE STRUCTURAL REFORM AGENDA FOR 2003 UNDER THE PRSC 1 PROGRAM

28. The Government of Sri Lanka understands that while the proposed PRSC Iis designed to support the overall implementation of a broad set of reforms organized around the country's PRSP, there is a number of core actions we need to undertake which will trigger presentation of the project to the Board of Directors of the World Bank. Our understanding of these prior actions for PRSC Iis summarized below.

Labour Market. The Government of Sri Lanka will define and adopt in the Government Gazette a minimum compensation formula for terminated workers covered under the Termination of Employment of Workmen Act (TEWA) and the Industrial Disputes Act, to make the costs associated with job terminations transparent and predictable.

The Government will make gazette announcement of the effectiveness date of the amendments in the labour legislation and the compensation formula by 20" May 2003. Appropriate and necessary action shall be taken to ensure that these amendments and the compensation formula are implemented by no later than 3lStDecember 2003.

Land Market. We commit to developing and adopting a process to convert restricted grants under the Land Development Ordinance (LDO) and the Land Grants (Special Provisions) Act to full private ownership in a manner that will ensure rapid and cost effective conversion with the involvement of District Secretaries. The Land Ownership Act and its regulations will allow the conversion of grants to freehold lands, including those which were sub-divided or mortgaged.

Financid Sector. As part of the structural reform agenda under the PRSC I, we will initiate the commercialization of People's Bank. We have already publicly announced the plan to restructure the People's Bank and appointed a Bank Restructuring Committee to oversee its commercialization. We will complete the short-listing of financial advisors by 20" May, 2003.

Power Sector: To advance key reforms and lay the foundations for further reforms in the power sector, the Government of Sri Lanka will send the names of Commissioners of PUCSL to the Constitutional Council by 20" May, 2003.

Strengthening Govemance in the Public Sector. As part of the structural reform agenda, the Ministry of Finance is financing the draft Public Finance for presentation to the Economic Policy Committee of the Cabinet by 20fi May, 2003. Attachment 1 Page I1 of 12 Iv. THE STRUCTURAL REFORM AGENDAFOR 2004 AND BEYOND

29. The Government recognizes that the current program of reforms is just the start of implementation of “Regaining Sri Lanka”, our Poverty Reduction Strategy. The core reforms that we have launched - in areas such as labour, land and the financial sector - will move to full implementation in the coming period, and the way forward in these areas is already well known. There are other areas whose implementation we intend to initiate in 200314 and thereafter. However, these actions are indicative only and would be refined as implementation of the program advances. The priority reform areas are summarized below.

Core reform areas:

Labour Market. The Government of Sri Lanka will implement the amendments to the labour legislation not later than 31” December 2003.

Land Market. As part of the reform agenda supported by the Government: (a) submit to Parliament the Land Ownership Bill, (b) finalize administrative plan for the conversion of restricted land grants to full private ownership; and (c) submit to Parliament an amended version of the Registration of Title Act.

Financial Sector. As part of the proposed reform program, we will: (a) implement the commercialization program of the People’s Bank (PB); (b) in the event commercialization does not materialize, ensure that the commercial unit will not engage in activities which will result in fiscal burden on the Government and the savings unit will only be confined to deposit mobilization, and funds mobilize will be used to purchase securities issued or guaranteed by the government or other low risk assets; (c) present to Parliament a new Banking Act, a new Monetary Law Act, and debt recovery Laws, as mutually agreed by the Government and the Bank; and (d) present to Parliament a Superannuation Funds Regulatory Bill.

Power Sector, To address key structural reform issues in the sector, the Government will initiate implementation of reforms through the Public Utilities Commission Act.

Indicative reform areas:

Rural Development. As part of its program for rural development outlined in the Regaining Sri Lanka document, the Government will (a) implement the reform program granting full ownership rights to rural land under the Land Ownership Act; (b) issue the associated regulations and procedures on the Seed Act which has been passed by the Parliament, including the revised quarantine rules and regulations that are in line with international standards; (c) finalize the National Water Policy, submit to Parliament the draft National Water Act, and subsequently issue the associated regulations and procedures; (d) continue steps to mobilize public-private partnerships in agricultural research and extension; and (e) continue the irrigation sector reform program, including increasing water user participation in systems management.

Welfare System. Within the context of our comprehensive program to reform the welfare system, we will: (a) develop a new application form to collect information on potential applicants in the pilot exercise to be undertaken; (b) conduct pilot exercise for targeting around 50,000 households; and (c) enroll a subgroup of the households selected from the target pilot as potential beneficiaries.

Strengthening Governance in the Public Sector. To address major issues of governance in the public sector, the Government will: (a) send to Parliament the Public Finance Act; (b) a Medium Term Budget Framework (MTBF), specifying amongst other things, the estimates of expenditure for priority areas will be completed in October 2003.(c) implement civil service reforms, including (i)maintaining the existing hiring freeze with limited exceptions (ii)an initial consolidation and/or elimination of redundant functions, departments, and agencies and, (iii)the creation of a surplus labour cell for staff redeployment, and/or voluntary retirement . Attachment 1 Page 12 of 12 Strengthening Outcomes Monitoring and Evaluation. Under the program supported by the proposed PRSC 11, we will (a) complete the informatioddata needs assessment for monitoring poverty and social indicators in the North and the East, areas which have not been covered by household surveys for over a decade; and (b) develop a poverty information base to enable better targeting of our poverty programs.

While our government is determined to make steady progress as planned, with the satisfactory implementation of our macro-economic and structural reform program we would be in a better position to clearly specify the policy content of the 2005-2006 programs, in line with the broad strategy in Regaining Sri Lanka.

ANNEXES eL E & *YL Y

&I

3 B i R I

rh h . .. . TT uior I

Annex I1 Page I of 9 ANNEX I1

Poverty Diagnostics and Policy in Sri Lanka

1. Poverty is multidimensional - encompassing material as well as human deprivation. In the case of Sri Lanka, continued commitment of public policy to investment in the social sectors has led to the country achieving by far the highest level of human development in South Asia, and higher than even that of some wealthier countries. Moreover, a focus on gender equality and the education of women have been permanent features of Sri Lanka’s social policies.

2. Economic development, however, has lagged consistently behind social development. The lack of success in reducing income poverty is apparent when contrasted with that of East Asian countries that were at comparable levels of development only a few decades ago. In the 1960s, Sri Lanka’s income per capita was comparable to that of Malaysia, the Republic of Korea, and Thailand. By the end of the twentieth century, income in Sri Lanka was less than half that of Thailand, one-fourth that of Malaysia, and just one-tenth that of the Republic of Korea. A significant cause for slow poverty reduction is below potential economic growth. Per capita GDP growth in Sri Lanka averaged 3.8 percent during the 1990s. Also, between 1990-91 and 1995-96, inequality (as measured by in consumption) remained almost unchanged. Modest growth, combined with no redistribution in favor of the poor resulted in stagnation in poverty rates during the 1990s, over the years for which data are available.

Poverty Trends and Patterns in Sri Lanka 3. Data Sources, and Methodology. The analysis of poverty in Sri Lanka during the 1990s draws primarily from three national household consumption surveys: two rounds of Household Income and Expenditure Surveys (HIES) conducted by the Department of Census and Statistics (DCS) in 1990-91 and 1995-96, and one round of Consumer Finance and Socio-Economic Survey (CFSES) by the Central Bank, in 1996-97. All three defined the poverty line in terms of the estimated cost (per capita) of a minimum food and non-food consumption bundle.’ In addition, the Sri Lanka Integrated Survey (SLIS), conducted in 1999-2000, provides important insights into the socio-economic characteristics of poverty.

4. Available data can thus tell the story only till the mid-90s, since no nationally representative household survey measuring consumption is available since 1996-97. Moreover, due to the difficult situation in the conflict areas of the North and the East, all the surveys have been unable to include representative samples of these areas - an omission that leaves the picture on poverty somewhat incomplete. In this context, it is important to note that an ongoing round of the HIES, expected to be completed in mid-2003, will not only address the question of what has happened to poverty since the mid-90s, but is also likely to provide measures that are inclusive of the North and the East.

5. Poverty Trends. Poverty in Sri Lanka has declined since independence, with a number of studies revealing a significant decline between 1953 and 1985.’ The declining trend has continued since the mid- 1980s, but slowed during the early 1990s. Data from HIES suggest that absolute poverty increased significantly between 1990/91 and 1995/96, i.e., from 20 to 25 percent, according to the lower poverty line (Table l).3In making these comparisons however, one must bear in mind that in 1996 the economy was hit by several shocks - including a prolonged drought and the escalation of the conflict, which negatively affected business confidence, tourism, and foreign investment. Economic growth was just 3.8

’ The HIES used a lower poverty line of Rs. 791 and a higher poverty line of Rs. 950 while the CFSES used a Rs. 860 and Rs. 1,032 per person per month respectively, to estimate the incidence of consumption poverty. The lower poverty line used by the DCS surveys was also used by the Poverty Assessment (World Bank, 2001). These are estimates based on a local (reference) consumption poverty threshold of 2,500 calories and 53 grams of protein per day and male adult (20-39 years) equivalent, at 1995-96 prices. *These studies included World Bank (1995). The results using a “high’ and a “low” poverty line can be interpreted to mean that most of those living below the lower poverty line are victims of chronic poverty, while those living between the lower and higher poverty lines are vulnerable to transitory poverty. Annex I1 Page 2 of 9 percent, with agriculture falling by 5 percent and paddy production declining 27 percent. The economy rebounded to grow 6.4 percent in 1997.4

6. The 1996197 estimates from the CFSES Table 1: Poverty Headcounts (a)- 1990/91 to 1996/97 estimate the head count index at 19 percent according to the lower poverty line - which may reflect recovery from the “bad year” of 1995-96. However, such a comparison is difficult to make’ since the HzEs and CFSESfindingsfor 1.1 Source: HIES 1990/91 and 1995/96 (DCS), CFSES those years were not strictly comparable. 1996/97 (CB)

7. Regional Disparities: Looking across provinces, poverty is found to be low and has declined rapidly in the Western Province (Figure l),in sharp contrast to poor provinces like Uva and Sabaragamuwa. There are large, growing disparities in the incidence of poverty across regions. While Western Province, where the capital city, 75 percent of manufacturing and most services are located, has a headcount index of 14 percent, more than 1 out of 3 people in poor provinces like Uva, North Western and Sabaragamuwa are poor. For the rest of Sri Lanka for which data is available - most of which is rural and coastal, where small-scale or plantation agriculture and fisheries remain the main economic activities - poverty and isolation are high.

Figure 1: Trends in the Incidence of Poverty in Sri Lanka, by Province, 1985/86-1995/96

45 40 35 30 25 20 15 10 5 0

1985/8@ 1990/901995/96

A decomposition of changes in the Foster, Greer, and Thorbecke measures of poverty reveals that between 1990191 and 1995/96, lack of consumption growth largely explains the rise in poverty. Favorable redistribution offset the lack of consumption growth in the urban sector. In the rural and estate sectors, both growth and redistribution effects were adverse (Gunewardena 2000). Annex I1 Page 3 of 9 8. In general, the more urbanized a province, the less poor it is. Westem, Central and Southern Provinces, Table 2: Poverty by Province, 1995196 which together contribute 80 percent of the total urban Province Incidence of Poverty (%) population - are also the ones with lowest poverty levels Index Contribution (Table 2). Conversely, the least urbanized provinces of Westem 14 17 Central 28 17 Uva and North Westem Provinces - which together Southem 27 16 contribute 13 percent of the total urban population - also N.Westem 34 18 have the highest poverty levels (Table 2). The district North Central 31 8 level figures also exhibit similar correlation between Uva 37 11 Sabaragamuwa 32 14 urbanization and poverty incidence. Nore: Using lower poverty line of Rs.792 per person per month; Source: HIES 1995796 9. Sectoral Composition of Poverty. Poverty is lower and has unambiguously declined in the urban sector, where manufacturing and services are concentrated, in sharp contrast to the rural and estate sectors (Figures 2a, 2b & 2c). More than 90 percent of all poor people in Sri Lanka live in rural or estate areas (88 and 4 percent respectively). Average rural consumption is about two-thirds of urban consumption. Estate households are among the poorest in Sri Lanka, with per capita consumption of only about half that in the urban sector. If the higher poverty line is used, the estate sector becomes the poorest sector (poverty headcount rises to 45 percent), which would suggest that “borderline” poverty - that indicates vulnerability - is most prevalent in the estate sector. Poverty in the estates is often related to remoteness of the estates, which restricts the geographic mobility of estate workers and access to public services. Language barriers (most estate workers speak only Tamil) and discrimination further curtail their ability to integrate themselves into the Sri Lankan economy and society by finding jobs outside the estate ~ector.~

Figures- 2a, 2b, 2c: Trends in the Incidence of Poverty,-- by Sector, 1985186 to 1995196

Urban Sector Rural Sector Estate Sector

40 - 40 - 40 -

35 - 35 - 30 - 30 - 25 - ::I25 - 3L7 20 - 22 21 15 15 15 15 10 - 10 12 5- 5- v 51 0- 0- 0 I 0 1 1985186 1990191 1995196

The available data do not show a close link between poverty and unemployment, with only 5 percent of principal income earners in poor families being unemployeda6The sectors with the highest levels of poverty are agriculture, and mining and quarrying (Table 3). Moreover, a breakdown of poverty by occupational category reveals that farmers have the highest incidence of poverty (52 percent). The level of poverty among production workers is also quite high (45 percent), reflecting the fact that most of them have low skills and are engaged in providing low-value goods and services to small, low-income, informal markets.

’The closed nature of the labor market in the estate sector is discussed in Korale (1988). The 1995/96 HIES found that 34 percent of the individuals in households where the principal income eamer was unemployed were poor, compared to 40 percent of individuals in households where the principal income eamer was employed. Annex I1 Page 4 of 9

10. Since more than 40 percent of Table 3: Incidence of Povertv bv EmDlovment Sector principal income earners in poor households Sector Index* (%) Contribution** (%) are employed in agriculture (Table 3), and Agriculture 51 42 the poorest households rely on agriculture Mining and Quarrying 59 2 for more than half of their income (earned either as small-scale farmers or wage Manufacturing 36 11 laborers), the performance of the agricultural Construction 44 I sector would have a strong impact on Wholesale and Retail 30 9 poverty. Official statistics on agricultural Transportation 26 4 value-added show high volatility from year Finance 10 0.4 to year, and an annual average growth rate Communications 23 10 of about 2 percent between 1990 and 1999 Unclassified 61 10 and just 1 percent during 1990-98. UnemployeUNon-labor 28 5 Force Participants Non-Income Dimensions of Poverty

11. Ethnicity & Gender. With the exception of Indian Tamils (often referred to as estate Tamils), the majority of whom are poor, the incidence of poverty varies little across ethnic groups. Aggregate consumption is lowest among Tamils living on estates, for whom inequality is also the lowest among all ethnic groups, indicating that the majority of households are homogeneously poor. Individuals in households headed by women are about as likely to be poor as those living in households headed by men, regardless of the level at which the poverty line is set, indicating no direct relationship between consumption poverty and gender.

12. Lack of Access to Infrastructure. The poor, especially those living in rural areas and estates, have significantly less access to basic infrastructure than wealthier households. Only a fraction of poor families in 1999/2000 had access to safe cooking fuel (2 percent), electricity (38 percent), safe sanitation (55 percent) and clean drinking water (61 percent) (Table 4). Limited access to these resources reduces their living standards, and by affecting their human development, inhibits their future ability to climb out of poverty.

13. Outside of the conflict areas, economic welfare and living conditions are worst for households living on estates, most of whom are Tamils. Along with the lowest consumption levels in Sri Lanka, they also have the worst basic living conditions. Access to safe cooking fuel (3 percent), electricity (43 percent), and sanitation facilities (60 percent) are well below levels in other sectors. Travel time in estate areas to community level facilities, like main roads, banks, post offices and markets are about twice that in rural areas, indicating the remoteness of communities located deep inside large estates. Living conditions are difficult in other rural areas too, with access to clean sanitation, good drinking water, electricity, and safe cooking fuel much more limited than in urban areas. Travel time to facilities such as main roads, banks, post offices, and markets is about twice that of urban areas, due chiefly to longer travel distances and more limited transportation. Annex I1 Page 5 of 9 Table 4: Average Consumption and Access to Basic Infrastructure Services by Consumption Quintile and Sector 199912000 Monthly avg. Access to I“/. Values) consumption per Safe drinking water Latrine Safe sanitation Safe cooking fuel Electricity capita (SL Rs)

Consumption quintile Poorest 821 61 84 55 2 38 Second 1,211 74 85 67 5 49 Third 1,537 78 89 75 8 60 Fourth 1,986 82 90 82 22 67 Richest 3,860 89 94 89 51 82 Sector Urban 2,809 97 94 91 51 84 Rural 1,816 74 88 72 14 57 Estate 1,449 72 76 60 3 43 Moor 2,061 91 81 79 23 78 Note: A household has access to “safe drinking water” if it obtains its drinking water from protected well, public tap, tube well, tap within unit, and tap outside unit). A household has access to “safe sanitation” if the type of latrine it uses is either water seal or flush toilet. A household has access to “safe cooking fuel” if it uses either gas or electricity for cooking. Source: World Bank, based on 199912000 Sri Lanka Integrated Survey.

14. Education and Health Status of the Poor. Sri Lanka’s achievements in education and health have been remarkable. Less than 10 percent of the population is illiterate, and 100 percent of children are enrolled in school. These strong social indicators have improved the , even of households below the poverty line. While poverty is highest among individuals whose principal income earner has no schooling, such households make up only 8 percent of the poor, a percentage only slightly higher than their share in the total population (5 percent) (Gunewardena 2000). Households with principal earners who have just primary schooling account for the highest share (35 percent) of the poor, followed by those with lower secondary schooling (26 percent). Almost 90 percent of the total poor come from households whose principal income eamer has left school at some stage prior to the GCE OL’

15. Although education is free, there are some indications that the quality of education provided to the poor is inferior to that provided to richer households. Class sizes - a measurable indicator of education quality - are considerably higher in rural areas and estates than in urban areas. Language of instruction is also likely to be important. A primary education in Tamil, for instance, is likely to yield lower market returns than one in Sinhalese or English. Basic analysis reveals a strong correlation between district-level poverty incidence and English - an observation that calls for further research on the relationship between language of instruction and returns to education.*

16. On health, , though not associated exclusively with poverty, is generally regarded as a good indicator. Between 1993 and 2000, the prevalence of stunting among children (under 5 years) fell from 23.8 to 13.5 percent; that of wasting from 15.5 to 14 percent, and that of underweight children from 37.7 to 29.4 percent.’ The percentage of children born with low birth weight (an indicator of maternal health) has also declined from 19.7 to 16.6 percent.”

These numbers are computed using the higher poverty line, from the HIES (1995-96). See Poverty Assessment (World Bank, 2002) for detailed statistics on these issues. Department of Census and Statistics (ZOOO), Demographic and Health Survey. loAlailima, Patricia (2001), op cit. Annex I1 Page 6 of 9

17. The Poverty Assessment (2001) finds no Table 6: Health Indicators by Sector, 1999/2000 consistent differences in the long term (stunting) Sector % of children % of children % of children or short-term (wasting) nutritional indicators of underweight* stunted** wasted *** Urban 16 26 20 across children in Sri Lanka consumption groups Rural 24 29 21 according to data from the SLIS (1999/2000). Estate 42 31 31 There are significant differences, however, Total 24 29 21 across ethnic groups and sectors of residence, * underweight is defined as weight for age below 2 standard with nutritional outcomes of estate children deviations from the age and gender specific mean; **stunting is being inferiorto thoseof the rest of the country defined as height for age below 2 standard deviations from the age and gender specific mean; ***wasting is defined as weight 6)' A recent study identified poor caring for height below 2 standard deviations from the age and gender and feeding practices, and poverty-related specific mean factors, such as lack of access to adequate food Source: World Bank, based on 1999/2000 Sri Lanka Integrated and housing, safe water and sanitation, and Survey; calculations from three quarters. maternal undernutrition as the key causes of child malnutrition. l1

Poverty and Deprivation in the North and East 18. Part of Sri Lanka's difficulties in raising incomes and reducing poverty can be traced to the civil war, which has gone on for the last two decades. While the humanitarian, social and economic impact of the war was felt most directly by populations in the North and East and the areas bordering it, the economic, social, and psychological repercussions extend far beyond the theatre of battle. The Commissioner General of Essential Services has estimated that the number of persons internally displaced on account of war is around 600,000 (roughly one-third of the population in the conflict areas). UNHCR estimates that one-third to half of all homes have been damaged or destroyed in the Province. One out of every 12 households in the North reported a member killed as a result of the conflict; among the poorest households, it was one in seven.

19. Expenditures on the war effort, which consumed about 5 percent of GDP in recent years, crowded out a vast range of pro-growth and pro-poor public services. The instability brought about by the war also reduced investment and job creation. The 1999 annual report of the Central Bank of Sri Lanka estimates that the conflict reduced Sri Lanka's economic growth by about 2-3 percentage points a year. According to Ministry of Planning estimates, the size of the economy of the Northem Province shrank from US$350 million to US$250 million between 1990 and 1995.

20. The poor tended to bear a disproportionate share of the costs of the war. Available sources indicate high levels of wasting and stunting among children and very poor nutritional status of women. A survey of 515 households and 702 children carried out in Trincomalee district found that 27 percent of children under 5 were stunted, 26 percent were wasted, and 50 percent were underweight." Households in the conflict areas were also severely affected in terms of their ability to obtain a secure 1i~elihood.l~ Among the worst affected groups were households that were displaced, sometimes repeatedly, as a result of conflict. Data from the SLIS indicates that one of the most common reasons for changing the place of residence in the North East is the war, and that nearly all households that moved due to the war suffered loss of property - productive assets (agricultural equipment, livestock, shops, and mills), and sometimes even land they had cultivated before being displaced.

" Marga Institute (1998), RETA Study on Reduction of Child Mulnutririon. The prevalence of maternal malnutrition is indicated by the fact that some 36 per cent of women are anemic and the average weight gain during pregnancy is as low as 7.5 kg compared to the minimum requirement of 10 kg. Data from the 1999-2000 SLIS, which must be treated with caution since it is not representative for the entire region, suggests that foreign remittances and labor income from abroad acted to some extent as mitigating factors, ensuring minimum consumption levels in the Northeast. l3See Shanmugaratnam (1999) Annex I1 Page 7 of 9 21. There is unfortunately no official estimate of poverty and human deprivation in the Northeast as conditions there have been too difficult to conduct representative household surveys during the past two decades. This crucial information gap is likely to be addressed by the current HIES, which is expected to collect representative data from the conflict region. Such data will reveal more precisely the extent and characteristics of the considerable challenge faced by the government in the region.

22. Recent progress in achieving peace in the North-East provides much cause for optimism. The Government and the LTTE have announced a cessation of the hostilities, and a permanent ceasefire in February, 2002 - to date, the longest ceasefire to hold. Life has resumed its normalcy, with restrictions and embargos being removed, roads re-opened, and military having vacated schools and other public buildings. There is also a concrete plan, agreed upon by all sides, for post-conflict reconstruction, as well as the future federal structure for governance in the country.

Policy Imperatives 23. The diagnostics of poverty briefly presented above suggest some important areas for poverty reduction, and these are broadly consistent with those in the PRSP. Although Sri Lanka has largely achieved the Millennium Development Goals on human development, it still faces the challenge of reducing the proportion of its population living in poverty (currently about 25% of the population). Below some key areas of focus for achieving this are highlighted. Notably, some elements of the specific reform agenda would need to be monitored to assess impact on poverty and on disadvantaged groups like ethnic minorities, estate population, and women. In what follows, we also highlight ways in which the Poverty and Social Impact Analysis (PSIA) of these policies can be integrated into the broader M&E framework.

The pace of poverty reduction in Sri Lanka will benefit enormously from achieving higher growth rates. This entails restoring fiscal sustainability, removal of factor market rigidities, improvements in infrastructure like the road network, and investing in its maintenance and sustainability; improving the quality of human development services; enhancing the development impact of public sector governance; and reforming regulatory structures to improve the climate for private investment. Policy and institutional reforms to address each of these areas--some of which are supported under the PRSC program--are expected to be successfully implemented, given that peace has been secured. Moreover, continuity and predictability of policies may be enhanced as a result of the recently negotiated peace accord.

Since poverty is largely rural, a special effort is essential for creating growth opportunities in the rural sector. Low labor productivity in agriculture has been identified to be a major factor behind persistent rural poverty. Current trends in economic transformation show a gradual shift of labor to the non-agricultural sector, which, however, has not led to higher productivity of those who remain in agriculture. Yields of major crops have either fallen, or been volatile. A dominant constraint to raising productivity appears to be excessive government intervention in agricultural commodity and factor markets. These include restrictive land policies (with state ownership of near 80 percent of all land) which limits efficient land use and allocation; regulations that limit technology imports; commodity price interventions; a continuing emphasis on input and credit subsidies, at the expense of more productive public investments on infrastructure and extension services; and unpredictable trade policies. The Government has initiated steps towards redressing many of these issues, as elaborated in the main text. While it is expected that the proposed reforms articulated in the PRSP involving liberalization of the commodity and land and other factor markets will enhance productivity and incomes in the rural sector, it will be important to examine how these reforms will impact different sections of the rural sector, including the estates where deep pockets of poverty reside. For growth to result in substantial poverty reduction, it must translate into employment, particularly among the youth and those who have education of high school level and above. The magnitude of Annex I1 Page 8 of 9 the problem is apparent from statistics - in 1997/98, 30 percent in the age group of 19-25 years, and 24 percent among those with GCE (A-Level) qualifications were unemployed. This suggests the need for more appropriate skills training in secondary and higher education, provided that growth does translate into job creation. A human development strategy must therefore focus on quality of services delivered, coupled with deregulation of restrictive policies that distort incentives in the labor market. Of particular importance would be to track how the deregulation of the labor market differentially impact employment and wages across groups, including the poor and disadvantaged. For example, it will be especially important to see whether these reforms reduce the gender differential in wages, and increase employment opportunities for those in isolated areas. Existing studies appear to suggest that such policies will tend to have a positive impact for most groups.

0 Direct interventions to address poverty and human deprivation is also a priority, to ensure equitable distribution of the benefits of growth. While universal access to education and health services has been a significant achievement of Sri Lanka, quality of services for the poor, especially in education, remains an issue. Immediate attention is also warranted in areas of child and maternal nutrition, deficiencies in which lead to long-term impairments in learning and development. This would also entail improving access to basic infrastructure, like sanitation and safe water, as well as to community level facilities, particularly in rural and estate areas.

0 Basic assistance and income support through well-targeted safety net programs would still be required for some chronically poor and disadvantaged groups as well as people who may require a temporary cushion from shocks. The major Welfare system of Sri Lanka - the Samurdhi program - as it has existed during recent years has suffered from flaws in design that has led to enormous mis- targeting, which have considerably reduced its impact. o The main component of the Samurdhi program (comprising about 80 percent of the total program budget) is a consumption grant in the form of food stamps to households. An evaluation of the program suggests that the program misses about 40 percent of households ranked in the poorest quintile, while almost 44 percent of the total Samurdhi transfer budget is spent on households from the top 3 quintiles. Furthermore, targeting errors are not random, but rather reflect flaws in the design of the program. Qualitative results suggest that ethnic status, and party affiliation or voting preferences influence allocation of Samurdhi grants. Because the program covers around half of the population (to the extent of 2 million households), the impact of the program on the poor is limited by the generally small size of the transfer. o Recognizing the above, the Government of Sri Lanka (GoSL) has enacted the Welfare Benefits Act, with a view to firstly, rationalize all social welfare programs and secondly, to de-politicize and improve the targeting efficiency of Samurdhi in particular. This involves setting up an independent Board and lower level Selection Committees to set eligibility criteria, validate entry and exit into the program, and credibly redress complaints. The reform process also involves setting objective criteria for selection of beneficiaries of Samurdhi through means-testing, credible enforcement of these criteria on the ground, and the concomitant development of a complete database of beneficiaries to track entry into and exit from the program. Through these reforms, the government aims to achieve depoliticization and rationalization of the selection process in Samurdhi cash transfers, which will in turn lead more efficient targeting and lower rates of exclusion of deserving beneficiaries. By concentrating available resources among those who need it the most at a certain point of time, the impact of the program as a social protection against shocks will be enhanced. In the longer run, the entire welfare system, comprising of a large number of smaller programs in addition to Samurdhi, are envisaged to be integrated into the system. Technical support to devise an objective set of criteria for selection into the program is being provided by the World Bank. Full implementation of the reformed structure is tentatively expected by July, 2003. Annex I1 Page 9 of 9 Monitoring and Evaluation (M&E) is an intrinsic part of improving and fine-tuning policies geared towards poverty-reduction. The PRSP highlights the overall plans for M&E by GoSL. The M&E framework will entail 5 critical components, which will also address the needs of a Poverty and Social Impact Analysis (PSIA) of policy reforms. o Rationalize the existing surveys, like the HIES and CFSES - which are included in the M&E framework outlined by the PRSP - to regularize their periodicity, synchronize their timing, and strengthen some modules (especially in the area of human development) to track indicators related to quality of services. o Introduce a mechanism to track the poverty and social impact of policy changes. For the aforementioned Welfare reform, two components are currently being discussed: (i)a Poverty Map to identify geographic areas of isolation and poverty, which will aid targeting of poverty programs in general, (ii)an in-built monitoring system of the Welfare program to track improvements in indicators of poverty that will help with identifying movement of beneficiaries in and out of the program. To monitor the impact of broader policy measures that are likely to have varying effects across heterogeneous groups, like land and labor policies, the existing HIES may provide some answers, along some basic dimensions of poverty. Additionally, other components of the existing M&E framework, like the Labor Force surveys and the Demographic and Health Survey could be tailored to address the impact of specific policies. The concern here is to do with the frequency (currently once every 5 years) of both the HIES and the DHS. o With the peace accord and post-conflict reconstruction efforts, an opportunity now arises for understanding poverty in the North-East. A special study of this region is currently being undertaken by the World Bank. The HIES and other surveys will need to be representative of this region, and the current HIES on the ground appears to have accomplished this goal. o An integral part of poverty monitoring and impact is also the Participatory component to assess access and consumer satisfaction issues. While the PRSP acknowledges its importance, regularizing this component remains an outstanding concern. o Finally, and perhaps most crucial, is the institutional arrangements to coordinate the M&E system and promote incentives for its use in policy and budgetary decision-making. An immediate concern would be to enhance capacity of the DCS to be able to conduct the HIES at intervals of 2-3 years (currently, two agencies - the DCS and the Central Bank - alternate in fielding two similar surveys, which is both inefficient and raise problems with comparability). Once the DCS is empowered with sole responsibility, it will facilitate rationalizing of the poverty monitoring system along the dimensions described above, and will improve capacity and prospects for developing a multipurpose household surveys (like the LSMS) to aid the deepening of the diagnostics and monitoring of poverty.

Annex I11 Page 1 of 5 ANNEX I11 Rural Sector

Introduction 1. About 80 percent of Sri Lanka’s population and 90 percent of the country’s poor live in rural and estate areas. More than half of the rural poor are dependent on small-scale agriculture and wage labor on farms and plantations as the main source of their income Thus, sespite its declining contribution to GDP (20% in 2000), the agricultural sector (including livestock and fisheries) remains vital for employment and income generation. Directly employing about 40% of the total labor force in the country, the agricultural sector also contributes to employment generation indirectly, as agro-based industries’ account for about 65% of employment the industrial sector (including firms with 5 or more employees). Thus, fostering more rapid rural development, particularly raising the productivity and competitiveness, and accelerating the growth of the agricultural and rural non-farm sectors, are critical elements to achieving faster overall economic growth, and hence, poverty reduction in Sri Lanka. More rapid growth in the agricultural and rural non-fann sectors will both directly and indirectly contribute to generating greater opportunities for employment and income growth in rural areas. In addition, by contributing to increased rural incomes, this will build a strong foundation for consumer demand in rural areas, which could in turn would stimulate growth in other economic sectors.

Constraints to Agricultural and Rural Non-Farm Growth 2. Since 1996, the Government of Sri Lanka adopted several policy measures aimed at hastening agricultural growth. Intended to assist the agricultural sector to shift from low-value to high-value production, the measures also aimed at improving productivity and international competitiveness so as to put the sector on a higher growth trajectory. The policy reforms included various private sector investment incentive schemes (e.g. concessionary credit, duty waivers and tax holidays on new investments), increasing trade, seed distribution and commodity market liberalization, including the closure of the Paddy Marketing Board. The anticipated supply and agricultural growth response, however, has been slow to materialize. 3. A number of other existing government policies, however, undermined progress toward the government’s goals. Among the hindrances are unpredictable trade policies; highly restrictive quarantine regulations; delays in passing key seed and phyto-sanitary regulations, which limit technology access; commodity price interventions; restrictive land policies; and poorly functioning water delivery systems. The combined effect of these measures was the creation of a complex and multi-dimensional maze of obstacles, which ultimately dampened agricultural productivity growth, hindered diversification and reduced opportunities for raising agricultural incomes. Further, they contributed to raising operating costs, reducing agricultural profitability, increasing price and market risks, diminishing competitiveness; and - overall -- discouraging productivity-enhancing investments and private-sector participation. A continuing emphasis on input subsidies with limited short-term impact (e.g. fertilizer, water, seeds) also diverted scarce public resources away from critical productivity- and efficiency-enhancing investments (rural roads, electricity, markets, research and extension) that could have had a more lasting impact on growth. Even where limited investments have been made in some sectors (e.g. irrigation, roads, research and extension), inadequate emphasis and funding for operations and maintenance has sapped their potential. 4. Although the more rapid development of the rural non-farm sector is critical to raising and sustaining agricultural and rural growth, a number of policy and structural impediments hinder necessary progress. The non-farm sector is increasing in importance to rural households as a source of income -- about 56% of the total by 1999-2000. An analysis of the composition of rural non-farm incomes reveals,

’ Agro-industries include: (i) food, beverage and tobacco; (ii) textile, wearing apparel and leather; and (iii) wood, wood products and fumiture. Cited data are from the Department of Census and Statistics. Annex I11 Page 2 of 5 however, that the more income-vulnerable households (bottom 40% in rural expenditure quintiles) depend in the main on lower-paying and distinctly less secure, casual, non-agricultural wage labor. Macro- economic and trade policies, labor rules, and government intervention marketing, however, hinder more rapid growth of the rural non-farm sector. Some of the more severe impediments include macro-policy that raises the cost of capital locally, unpredictable trade policies that increase price uncertainty and thus eventual return on investments, highly restrictive labor regulations, government participation in marketing and distribution, disorganized production and marketing systems which make regular sourcing of local commodities of standard quantity and quality difficult, and inadequacies in rural infrastructure and services. By impeding more rapid agricultural sector growth, these factors also contribute to slowing rural non-farm sector growth Elaborating a Long term Vision and Strategy 5. Formulating and implementing a rural development strategy that builds on synergies in the agricultural and non-farm sectors is a critical step toward enabling Sri Lanka to achieve rapid economic development and poverty reduction in the fastest possible time. Such an integrated rural development framework is critical because measures to promote more rapid growth and increased productivity in the agricultural sector can complement those that would also sustain growth in the non-farm sector. Global experience shows that because of strong forward and backward linkages, the development of the agricultural and non-farm sectors are highly interdependent. Developing a rural development strategy and putting it into practice, however, would be a challenging task due to the large number of Central Ministries and provincial governments that would need to be involved. The GoSL’s program to formulate a Poverty Reduction Strategy would be a critical vehicle for completing such a task. 6. A redefinition of the appropriate roles for the public and private sectors must be an integral component of this new overall strategy. In the short to medium term, reforms would need to focus on two major areas: (i)fostering the appropriate policy and regulatory environment and moving institutional reform of public institutions to encourage increased private sector participation and investments and permit factor mobility; and (ii)strengthening rural infrastructure and services, with increased emphasis on operation and maintenance of physical assets to ensure their longer term performance. 7. Improving the policy and regulatory environment in the agricultural sector would require the adoption of policies to ease access to improved technologies, create a more transparent and stable trade policy regime, allow full and transferable ownership rights to land, and ensure the sustainable use of water would be key to promoting increased productivity and incomes. Critical to promoting growth in the non-farm sector (and indirectly to the agricultural sector) would be adopting policies to speed up currently lagging private sector participation and investments in the sector. This includes rationalizing currently restrictive labor regulation and phasing out government involvement in activities that could be efficiently performed by the private sector (e.g. retail distribution, marketing).

Enhancing Agricultural Productivity Growth

8. National Aericultural Stratepv and Policv. To meet 2lst-century challenges, Sri Lanka needs to formulate an updated National Agricultural Strategy and Policy, consistent with its rural development srtategy. An essential component of the National Agricultural Strategy will be a new balance in the roles of the public and private sectors in agricultural research and extension. Improving the effectiveness of both systems will give farmers greater access to improved agricultural technologies and market support services. 9. Quarantine Policv and Regulations, The streamlining and modernization of the national quarantine system is urgently needed to ensure that it effectively filters out harmful pests and diseases but does not bar entry to improved technologies. The costs of Sri Lanka’s highly restrictive quarantine regulations have been rising relative to its benefits in recent years. Necessary reforms include the regular and accurate updating of the “Host Index of Plant Diseases in Sri Lanka” and the list of prohibited and restricted plants and planting materials. Once revised, the new quarantine regulations should be Annex I11 Page 3 of 5 publicized domestically and internationally through awareness campaigns to inform current and potential domestic and foreign private sector investors in the seedplanting materials sector. In modernizing quarantine policies, the government can draw on a breadth of international experience. 10. Seed Policv. In partnership with the private sector, the government should quickly finalize and enact the seed industry regulations and procedures that have been pending for several years. These regulations derive from the National Seed Policy and National Seed Act, approved in 1996 and 1998 respectively. Establishing the rules of the game in seed marketing and distribution would be critical to encouraging private-sector participation and investments, and thus to expanding the markets for different kinds of improved seeds. In addition, the government should privatize the remaining government seed farms. Experience with the two earlier privatizations of government seed farms (Hingurakgoda and Pelwehera seed farms) resulted in greater productive use of these assets, including the near doubling of seed (e.g. paddy) output (CIC Agribusiness 2002). If needed, the government could sub-contract private firms to fill the seed requirements of various government programs. 11. Plant Variety Protection Legislation. Enacting intellectual property rights protection for seeds and planting material is a crucial move in encouraging private-sector research and development (R&D). In the absence of legislation protecting the results of private-sector R&D, very little such local investment has occurred. Without plant-variety protection, owners of the intellectual property inherent in many of those seeds have little incentive to bring them into Sri Lanka, adapt them to local conditions, and market them to farmers. International experience confirms the multiple benefits from adopting more liberalized yet environmentally prudent technology policies. 12. Trade Policv. To induce more private investments in agriculture, agro-industry and storage, reduce within-year price fluctuations, and improve food security, the government will need to resist the pressure to continue seasonal altering of tariff rates. Over the short-to-medium term, the Government needs to commit to reducing tariff protection gradually for various agricultural commodities. This reform will reduce the bias in favor of particular crops (e.g. rice, potatoes, chillies, onions) and thus allow improved domestic resource allocation and reduce the taxation of consumers who are made to pay above- world-market prices. With the removal of price distortions, cropping patterns could adjust to follow changing economic incentives, including shifting from low-value and low-productivity activities (such as rice production) toward commercial production of alternative higher-value crops. To minimize the adjustment cost associated with tariff reforms, other critical policy changes will have to match the phased tariff reductions with measures to lift the constraints on domestic, commodity and factor (land, seeds, technology and water) markets and to improve rural infrastructure. These complementary actions will help ensure that farmers have the freedom and the capacity to alter their resource-use decisions to meet the changing needs of the market. 13. Land Policv and Land Administration. The government’s recent decision to grant agricultural households, who have received LDO land full ownership rights, will bring considerable benefits to these families. Experience worldwide has shown that more secure property rights benefit farmers and help improve their productivity by (i)improving households’ security of tenure and thus their ability (and readiness) to make investments; (ii)providing better access to credit; and (iii)reducing the transaction costs associated with land transfers. To ensure the effective implementation of this policy, a nationwide awareness and communications campaign would be a crucial means of informing all eligible beneficiaries not only about the implications of these new ownership rights, but also the corresponding procedures involved in formalizing these rights, to ensure that lack of information about the program does not disadvantage beneficiary households. Consistent with granting farmers full ownership rights, the government should also, as an integral component of implementing this provision, remove the minimum- size restrictions on farm land. 14. In view of the government’s priority commitment to foster a shift from low-value to high-value agriculture, it would be critical remove the provision requiring farmers to obtain the permission of the Commissioner of Agrarian Services to shift to other crops in designated paddy lands. It is necessary, accordingly, to revise the Agrarian Services Development Act, No. 46 of 2000. Annex I11 Page 4 of 5 15. The government’s program to phase in a shift from a deeds to a title registration system is also a vital step in ensuring the more efficient functioning of land markets. Especially in light of land- policy reforms, a title system is needed to facilitate boundary dispute resolution, improve transparency and accessibility of records, boost the willingness of lenders to provide financing, and ensure efficient land sales, leases, subdivisions, and other transactions. International experience validates the importance of establishing appropriate institutional mechanisms to administer land rights effectively. The experience from Thailand, where the Government has been carrying out a very effective long-term program for land titling, suggests that, in order to be effective, such institutions need to be legally valid, authoritative and complete, accessible and cost-effective, and institutionally as well as financially sustainable. Over the short-to-medium term, additional key actions are required to ensure the effectiveness of Sri Lanka’s land administration system. They include: (i)establishing the legal, regulatory, and procedural framework for efficient, effective and sustainable land titling and title registration; (ii)completing the restructuring and streamlining of land administration agencies to promote efficiency, transparency, coordination and cost effectiveness; and (iii)developing a common information technology strategy including data management for all relevant agencies in order to make information on land tenure, land use, and land capability transparent and accessible. 16. Water Policv. Building consensus and adopting a National Water Policy is essential to any strategic vision for the sustainable development, management and use of water resources. Key elements of the policy would be: (i)promoting the shift from supply-driven goals to comprehensive planning, allocation and management within a river-basin framework; (ii)formulating an appropriate legal and regulatory framework and reprioritizing expenditures to support such a shift; and (iii)reforming institutional structures and procedures, building on increased participatory management of systems, to improve the management of water resources in Sri Lanka. This policy would direct the priorities for investment and institutional reforms required to maximize returns on public and private investments over the longer term. The policy would provide the framework for redefining the roles of water-related departments to achieve more efficient, sustainable, and equitable inter-sectoral allocation of scarce water resources (surface and groundwater) among competing users (e.g. agriculture, residential, industrial). Conducting broad-based communication campaigns to discuss critical and sensitive issues, while educating stakeholders to the extent possible on lessons from international experience would be essential to successful implementation. 17. There is an urgent need to improve the delivery of surface irrigation services. This would contribute both to raising the productivity of existing crop areas and to facilitating the diversification by farmers to higher-value crops that require improved access and reliability of irrigation water supply. Effective action will necessitate: (i)prioritization of expenditures from a primary focus on the creation of new assets, to demand-driven investments in rehabilitation and maintenance of existing infrastructure; (ii) fostering greater user participation in managing systems and recovering costs, so as to ensure longer term financial and fiscal sustainability of operations of surface irrigation systems; and (iii)re-orientating and restructuring existing water institutions to ensure efficient and client-oriented operations and improve coordination. 18. Reintroducing water fees -- at a minimum to cover O&M expenditures in surface irrigation -- will be critical for several reasons. It will promote more efficient water use by reducing incentives for farmers to use water to excess. Raising the necessary financial resources will also enable the appropriate execution of O&M activities and thus ensure the longer term sustainability of surface irrigation systems and eliminate the costly current pattern of rehabilitating systems in almost 5-6 year cycles. Additionally, water fees could reduce the large fiscal burden of operating irrigation systems and contribute to the improved fiscal health of the country. To make their reintroduction acceptable, however, requires matching improvements in the quality of delivery of irrigation services, for which institutional reform of water agencies is a prerequisite. Annex I11 Page 5 of 5 Strengthening Rural Non-Farm Sector Growth

19. Labor Regulations. The recent Government proposal to amend the Industrial Disputes Act and Termination of Employment Act should give a major boost to improving incentives for private sector investments in the non-farm sector overall. Its rapid adoption will be critical. 20. Commoditv Marketing Policies. Reorienting the government’ s role in the marketing system would be critical to encouraging greater private sector involvement and investments. In particular, the highly subsidized retailing operations of the Cooperative Wholesale Establishment (CWE) crowd out and undercut private sector involvement in the domestic market. The government announced in January 2002 its intention to float a separate company to handle CWE’s current retailing activities and to hand over its management to the private sector. The government should take the next bold step towards privatization. Selling these assets would not only remove the crowding-out effect, but would free up fiscal resources for other activities. In the immediate term, the government should hold off adding new commodities and services to CWE’s retailing activities. Should the government wish to assist low-income households, using more-targeted measures such as food stamps is far more efficient than being directly involved in retailing. Strengthening Rural Infrastructure 21. There is an urgent need to improve rural infrastructure beyond the Western Province. Improved access and quality of rural infrastructure would contribute not only to raising the quality of rural life, but also to the successful implementation of government development plans for the modernization of agriculture and improving the investment climate for rural industries and services. Regression analysis using the SLIS 1999-2000 data shows access to rural infrastructure in addition to land owned, the size of the household, and education, are significant determinants of household participation in rural non-farm activities. It shows that lack of access to roads (the distance from the nearest main road) is negatively correlated with the probability of participating in non-farm employment. Participatory planning and implementation of rural infrastructure projects, which involves government and targeted users, would be valuable to ensure the appropriateness of investments undertaken. 22. Rural Roads. Accelerating rural growth will require increased investments in roads (rural roads and highways) while ensuring improved operations and maintenance of systems created. Notably, studies (Fen, Hazell, and Thorat 1999) have shown that additional government expenditures on roads have a large impact on poverty reduction as well as a significant impact on agricultural productivity growth. 23. Rural markets. There is a need to increase publidprivate investments in rural markets to reduce marketing costs and improve agricultural competitiveness. Existing markets are poorly situated, equipped, and maintained. The high cost of domestic marketing raises the costs of agricultural inputs for farmers and the costs of agricultural outputs for consumers and agro-processors. 24. Achieving more rapid and sustainable poverty-reducing agricultural and rural non-farm sector growth will require a coherent and coordinated plan of actions by several ministries on several fronts as discussed above. This will not be easy. However, only when such an integrated package is introduced is it likely that Sri Lanka will see economic growth that will alleviate poverty and not leave any significant groups behind.

Annex IV Page 1 of 4 ANNEX IV

Public Financial Management and Accountability

1. The recent Country Financial Accountability Assessment (CFAA) study indicates that the will to reform both at the political and bureaucratic levels is evident and strong. According to the findings of the analytical work, the strengths of the system include:

A constitution that explicitly identifies the role of the parliament for control and oversight of public funds and the well-established committees of parliament, namely, the Committee on Public Accounts (COPA) and Committee on Public Enterprises (COPE) for this purpose. In line with this, the parliament approves the annual estimates and allocations are confirmed in the Annual Appropriation Acts. Thereafter, any variations that increase the approved estimates will need to be reviewed and approved by parliament as supplementary estimates.

0 The long established position of the Auditor General and clear segregation of the public accounting and audit functions (since 1907). The functional independence of the auditor general is explicitly provided for in the constitution and is secure. A very detailed and clear framework for financial management and internal control procedures to be followed by the government in expending and reporting on the raising and use of public funds.

Core Issues:

2. The draft CFAA report identifies five priority public financial accountability institutions which need urgent reforms--legislative scrutiny, public audit, public financial management framework, access to information, and financial management at the sub-national level. The proposed PRSC will support reforms and capacity building measures in four priority areas to address the deficiencies discussed below:

4 Legislative Control: Parliamentary control of the public purse is assessed to be ineffective and not meeting the expectations set in the Constitution. The key issue is that the hearings of the two parliamentary committees concerned with financial oversight - Committee on Public Enterprises (COPE) and Committee on Public Accounts (COPA) are not open and transparent to the public. In addition, the secretariat that supports the two parliamentary committees is inadequately resourced and is not able to provide the necessary technical advice to the members who themselves lack exposure and experience. Consequently, committee deliberations tend to focus on minor matters, there are inordinate delays in review of audit reports, and hardly any follow-up on recommendations.

4 Public Sector Financial Management: The diagnostic work indicates that the public financial accountability framework of the government is archaic, focuses on input control, lacks legal enforceability, and does not clarify accountability relationships for sound financial management in the public sector. Further, government oversight of state owned enterprises and government owned companies is assessed to be weak because of the absence of organizational (in terms of staff and resources) and institutional mechanisms within the government for their effective supervision. The fiduciary implication is that even though funds might be accounted for (given the emphasis on expenditure controls), there is a risk that it may not be possible to satisfactorily ascertain whether they are being used for the intended purposes. In addition, delays in releasing financial information of the government and the present form and content of such information make it difficult for interested public to assess the financial condition of the state.

4 Public Audit: The public audit function does not currently meet the standards implied in Article 153 of the Constitution and those expected of the auditing profession, and consequently, its impact on financial accountability is below its potential. Quality, relevance, and timeliness of audit information are Annex IV Page 2 of 4 inadequate to promote timely and meaningful deliberations in the parliament. Key issue is the lack of financial and administrative independence of the Auditor General (AG) and the lack of capacity in the department.

+ Public Access to Information: Public access to financial information of the government and state run organizations is very limited in Sri Lanka. A combination of the governance culture that derives from colonial times, and the absence of supportive legislations for encouraging active disclosure, have contributed to this situation.

Reform Strategv and Expected Results:

3. To address the above concerns, the government, legislature, and the Auditor General have already taken some actions and have agreed to implement the remaining recommendations made in the CFAA study. By the end of the three-year PRSC period, Sri Lanka expects to achieve the following:

Revised procedures of parliament to allow for greater transparency in COPE and COPA hearings. Substantial progress in implementation of the capacity building plan for the parliamentary secretariat serving the COPE and COPA. Enactment and implementation of the Public Finance Act. Annual audited accounts of most state-owned enterprises and government agencies tabled in parliament within 5-months of the end of the fiscal year. Preparation of Year 2003 annual accounts of the government in the revised format. Pilot the ‘Code of Best Practice’ guidelines in 6 selected state-owned enterprises. Establishment of the State Holding company with 5 pilot government-owned companies under its purview. Setting up of a professional body for public sector accountants. Finalization of Audit legislation and its submission to parliament. Substantial completion of the implementation of the institutional development plan for the office of the Auditor General. Availability of annual reports of government agencies in the web site of Ministry of Finance and Planning. Finalization of the rights to information legislation and its submission to parliament.

a. Actions Taken:

A senior government official has been assigned the responsibility for overseeing implementation of public financial accountability reforms.

The parliament, under the guidance of the Speaker of the house, has initiated a review of the parliamentary procedures and the Parliamentary Powers and Privileges Act to explore ways and means to promote greater transparency of the committee hearings. The two parliamentary committees, namely, the standing orders committee and the media committee, are reviewing these procedures with a view to also getting the media more involved. In the interim, progressive initiatives have been taken by the committees to address issues relating to performance of entities. Recently, the COPE has closely scrutinized several loss making and financially distressed state owned enterprises (e.g. Ceylon Electricity Board) by regularly summoning them to parliament to query on their current performance.

The Ministry of Finance has initiated efforts to modernize the public financial accountability framework that governs financial management in ministries, departments, and state owned enterprises. A draft Public Finance Act has been prepared (repealing the provisions in the Public Finance Act of 1971) with a view to provide legal enforceability and greater clarity to Annex IV Page 3 of 4 the roles and responsibilities of government agencies and officials for financial management. The PFA Act addresses issues such as: clarity in the roles and responsibilities of chief accounting and accounting officers; measures to be taken when a directive, having financial implications, is issued by an executive authority to an accounting officer; limits on the number of supplementary estimates that can be submitted to parliament in a year; time limits for rendering accounts for audit (i.e. 3 months); format, contents and minimum disclosure requirements of annual financial statements; roles and responsibilities of internal audit departments; requirement for establishing and the role of audit committees in reviewing internal, external and parliamentary reports of the agency; procedure for issuing government guarantees; and penalties for non-compliance with all of the above.

The government has now re-established the department for public enterprises in the Ministry of Finance for improved oversight of state owned enterprises. This department will provide the Ministry of Finance with dedicated staff and resources to review performance of state owned enterprises, and to follow-up on improvement recommendations. In addition, a corporate governance unit has also been set-up in this department for implementing the ‘Code of Best Practice’ in selected state owned enterprises. This ‘Code of Best Practice’ developed with ADB assistance prescribes six principles to be followed and provides guidelines for their practical implementation. The principles encompass: (i)disclosure and transparency requirements, (ii)duties and responsibilities of the board members, (iii) ownership functions of the government and its relationship with the enterprise, (iv) conduct of annual general meetings, (v) public interest and accountability to stakeholders, and (vi) performance related incentive payments, where applicable. This code will be piloted initially in 11 selected public enterprises. National Review Committees (under the purview of the Department of Public Enterprises) have been established to review annual reports of critical state-owned enterprises, recommend follow-up actions, and submit reports to the cabinet. This is an interim measure to closely supervise critical state owned enterprises, until such time sufficient capacity is built in COPE.

A diagnostic study has been carried out with ADB assistance to revise the format for the presentation of the consolidated government accounts to move towards accrual accounting and to prepare reports in full compliance with PSAS by mid 2007. The government has issued a new treasury circular instructing all government agencies and state-owned enterprises to submit audited accounts within 5-months to reduce the elapsed time after end of fiscal year end from 10 to 5 months. b. Actions underway/proposed

The internal control practices (as specified in the Financial Regulations) are being modernized and revised as Financial Guidelines which will have legal enforceability once the PFA is enacted. The strengthened legal framework, together with the initiatives mentioned below, will help improve overall financial management in the government.

To improve oversight of government-owned companies, a State Holding company (following the model in Singapore) is to be created. Initially, shares owned by five selected government companies (currently the shareholder is the secretary to the Treasury) including the two most controversial companies- Sri Lankan Airlines and Sri Lanka Telecom will be transferred to the proposed State Holding company which will have sufficient resources, professional staff, and a more focused approach to manage the investments in these companies. Annex IV Page 4 of 4 0 As part of revision of the format of government financial statements (under the ADB assisted study) to migrate to full accrual by 2007, the following measures are planned:

o In the immediate term (i.e. by March 2004), produce government financial statements on cash basis of accounting based on a new format that is easily understandable and will clearly show domestic and off-shore debt and interest payments, deficit and borrowing requirements for the year, and an operating statement that shows current and previous year actual revenue collection and expenditure. o In the medium term, adopt a modified accrual basis of accounting starting with recognition of assets, and thereafter, liabilities, including commitments, guarantees, contingent liabilities and accounts payableheceivable (present target - mid 2005) o In the long term, move towards full accrual accounting to prepare government financial statements in compliance with IPSAS (present target - mid 2007)

0 Steps are being taken to publish the government annual accounts on the Internet, thereby, reducing delays in making them available in the public domain. The year 2002 accounts of government agencies are expected to be published in the Ministry of finance website starting from June 2003.

0 To upgrade, the capacity of public sector accountants, a professional body for public sector accountants (The Chartered Institute of Public Finance Accountants) is being established. This institute will conduct pre and in-service training for its members and also formulate public sector accounting standards.

0 The government and the Auditor General’s department have agreed to draft a new legislation for public audit (to provide for greater independence from executive control and to further clarify the role and scope of his work) and to formulate an institutional development plan for building capacity of the department. m B

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Annex AI Page I of 4 ANNEX AI

EXTERNAL RELATIONS DEPARTMENT

Press Release No. 03/54 Intemational Monetary Fund FOR IMMEDIATE RELEASE Washington, D.C. 20431 USA April 18, 2003

IMF Approves US$567 Million in PRGFEFF Credit Arrangements for Sri Lanka

The Executive Board of the Intemational Monetary Fund (IMF) today approved three-year arrangements under the Poverty Reduction and Growth Facility and Extended Fund Facility amounting to SDR 413.4 million (about US$567 million) for Sri Lanka, which will support the government’s economic program for 2003-06. Of this amount, SDR 269 million (about US$369 million) is available under the PRGF, and SDR 144.4 million (about US$198 million) is available under the Extended Fund Facility (EFF). The decision will enable Sri Lanka to draw SDR 59.06 million (about US$81 million) from the IMF immediately.

The PRGF is the IMF’s concessional facility for low-income countries. It is intended that PRGF- supported programs are based on country-owned poverty reduction strategies adopted in a participatory process involving civil society and development partners and articulated in a Poverty Reduction Strategy Paper (PRSP). This is intended to ensure that PRGF-supported programs are consistent with a comprehensive framework for macroeconomic, structural, and social policies to foster growth and reduce poverty. PRGF loans carry an annual interest rate of 0.5 percent and are repayable over 10 years with a 5 %-year grace period on principal payments. The EFF is an IMF financing facility that supports medium- term programs that seek to overcome balance of payments difficulties stemming from macroeconomic imbalances and structural problems. The repayment terms are 10 years with a 4%-year grace period.

In commenting on the Executive Board’s decision, Shigemitsu Sugisaki, Deputy Managing Director and Acting Chairman, made the following statement: Annex AI Page 2 of 4 “Sri Lanka today stands at a pivotal point in its history. Over the past 20 years, a long civil conflict has beleaguered the country, which not only disrupted economic activity, but also hampered the sustained implementation of economic reforms. The current environment, in which peace negotiations are progressing well and economic activity is picking up, provides an excellent opportunity for Sri Lanka to implement deeper economic reforms and put the economy on a path of sustained high growth. The PRGF- EFF supported program aims to accelerate economic growth and reduce poverty through private-sector led development, in line with the authorities’ Poverty Reduction Strategy Paper and building on steps taken under the IMF’s Stand-By Arrangement that was completed in September 2002. Key elements of the program are fiscal consolidation; reforming the financial sector, public enterprises, labor market regulations, and the trade regime; and strengthening macroeconomic policy instruments and institutions. Sri Lanka’s PRSP is a satisfactory policy framework to increase growth and reduce poverty.

“The program’s focus on fiscal consolidation is appropriate in light of the public debt burden. It is also necessary to ensure that adequate resources are available to meet priority spending needs and to free resources for private sector expansion. Thus, the program emphasizes increasing revenue by broadening the tax base and strengthening tax administration as well as reorienting expenditure towards social, infrastructure, and post-conflict needs.

“Sustaining high growth depends critically on implementing the program’s structural reforms. The progress made in reforming the electricity and petroleum sectors, restructuring state-owned enterprises, and strengthening the banking sector is commendable. However, further reforms are needed in financial sector, public enterprises, labor markets, and the trade regime.

“The govemment’s attention to reducing conflict-related and rural poverty is well placed. The implementation of plans to strengthen rural infrastructure and improve access of the poor to quality education and health services are appropriate and necessary steps. In the area of welfare reforms, the new focus on depoliticization and targeting of Samurdhi benefits is commendable and should be strongly implemented.

“To fully realize the program’s medium-term objectives for growth and poverty reduction, lasting peace is necessary. The authorities are fully committed to the program and have embarked on difficult reforms, while making strong efforts to preserve public support for the peace process. At the same time, continued donor financing is required to support reforms and reconstruction, as well as the momentum of the peace process”, said Mr. Sugisaki.

Annex

Recent Economic Developments

After declining in 2001, the economy recovered last year. Following a series of exogenous shocks in the second half of 2001-the global slowdown, an attack on Colombo airport, and a severe drought, GDP for the year fell by 1% percent, the first decline in several decades. A robust expansion in domestic demand and tourism underpinned the rebound in 2002, as progress toward peace revived business and consumer confidence. GDP growth for 2002 is likely to reach 4 percent. However, the recovery is yet to be broad based, with lingering weaknesses in private investment and exports of goods. Inflation slowed down, due, in part, to better weather conditions, with the 12-month rate dipping below 8 percent in March 2003.

Strong inflows of remittances and tourism receipts helped gross official reserves to rise from $1.2 billion (December 2001) to $1.6 billion (March 2003) covering 2% months of imports. The rupee remained broadly stable in real effective terms. Annex AI Page 3 of 4 Monetary policy balanced the need to support the economic recovery with restraining inflation. The decline in inflation allowed the Central Bank of Sri Lanka (CBSL) to cut rep0 rates by 300 basis points since January 2002. As a result, other lending rates also declined and helped the recovery of private-sector credit.

The fiscal deficit for 2002 is estimated at 9 percent of GDP-2 percent of GDP lower than in 2001-but higher than the budget target of 8% percent of GDP. This outcome reflected a revenue shortfall of around 1percent of GDP, partly offset by spending cuts of about ?4percent of GDP. The lower revenue was due to a combination of weaker-than-expected imports, a large number of exemptions granted when the GST was replaced with the VAT, and lower nontax revenue, in part, reflecting a restructuring in payments from the electricity company (CEB) to the budget. The cuts in expenditure reflected reduced capital spending (due to low project-implementation rates) and somewhat lower current spending.

Reforms were advanced in several areas. Following the enactment of the Electricity Reform Bill in December 2002, the unbundling of the state electricity company (CEB) is proceeding on schedule, while Ceylon Petroleum Corporation (CPC) reforms are progressing in step with the liberalization of the petroleum sector. A 12 percent stake in Sri Lanka Telecom (SLT) was sold in December 2002 and the privatization of Sri Lanka Insurance Corporation (SLIC) was completed in early April 2003. Several amendments to the labor laws were passed by Parliament in January 2003. A Fiscal Management Responsibility Act (FMRA) came into force in December 2002, while a Welfare Benefit Law was enacted in September to reform the welfare system.

Program Summary

The government’s economic program supported by the combined PRGF-EFF arrangements, is based on their medium-term economic and Poverty Reduction Straten Paper (PRSP)-Regaining Sri Lanka-that was finalized in January 2003.

Under the PRGF-EFF supported program, the ongoing economic recovery is expected to gain further momentum this year, with GDP growth projected to rise to 5% percent. A resumption of delayed private investment projects, a substantial increase in public investment, higher tourism, and a return to normal weather underpin the projection. Inflation is expected to slow to 7 percent by end-year. The current account deficit is likely to rise to 3% percent of GDP, as an export rebound is more than offset by higher imports related to increased activity and reconstruction needs. Gross reserves are targeted to reach $1.9 billion (2% months of imports) by end-2003.

In line with the PRSP, growth is expected to average 6% percent over the medium term. This reflects both higher productivity and capital accumulation, reflecting labor market and financial sector reforms, and strong public and private investment. In the absence of major external shocks, prudent monetary policy and normal monsoons should help inflation decline to 4% percent by 2006. With substantial reconstruction and investment imports, the current account deficit is likely to rise to 4% percent of GDP by 2004, before falling to 3% percent of GDP by 2006. Reasonably strong capital inflows should help gross official reserves to rise to $3 billion (3% months of imports).

The program’ fiscal strategy aims to restore fiscal sustainability, while ensuring that adequate resources are available for priority spending and post conflict needs. Public debt now stands at 104 percent of GDP, while interest payments amount to 7% percent of GDP, raising serious sustainability concerns. To bring the level of debt to a manageable level, the program aims to reduce the fiscal deficit by 1% percent of GDP per year, on average, over the medium term, bringing it down to 4% percent of GDP by 2006.

Achieving these objectives will require revenue to be raised and expenditure rationalized and reoriented to priority needs. The aim is to increase revenue by broadening the tax base-through rationalizing tax Annex AI Page 4 of 4 exemptions and incentives-and by strengthening tax administration-in part, by establishing an efficient revenue authority. The program envisages capital spending to rise over the medium term, while continued savings in welfare, reflecting better targeting of beneficiaries, is expected to allow a near doubling of capital expenditures in health and education. A medium-term expenditure framework (MTEF) is planned to be established by mid-2003 to better reorient expenditure towards social and post-conflict needs. Financing of the budget is programmed to be increasingly shifted away from expensive debt to concessional donor funds.

The flexible exchange rate regime has served the economy well and will be continued. Thus, market interventions will be limited to smooth short-term volatility or meet the reserves target in line with the monetary program. Monetary policy will continue to be guided by the need to support economic recovery, while restraining inflation.

The structural reform agenda of the program will focus on the following aspects of the PRSP:

0 Financial sector reform-particularly restructuringthe Peoples Bank

0 Improvement in tax administration-including steps to establish a Revenue Authority

0 Restructuring of public corporations-particularly the electricity and petroleum monopolies.

0 Implementing labor market and trade reforms.

For questions, please contact Mr. Jahangir Aziz (Mission Chief on Sri Lanka, ext. 37693) or Mr. Lamin Leigh (Desk Economist, ext 36518), Division 9, Asia and Pacific Department, IMF. Annex A2 Page I of 2 ANNEX A2 At A Glance

Lower- POVERTY and SOCIAL Sri South middle- Lanka Asia income Development diamond' 2001 Population, mid-year (millions) 19.6 1,380 2,164 Life expectancy GNI per capita (Atlas method, US$) 830 450 1,240 GNI (Atlas method, US$ billions) 16.3 61 6 2,677 - Average annual growth, 1995-01 Population (%) 1.3 1.9 1.o Labor force (%) 2.2 2.4 1.2 Most recent estimate (latest year available, 1995-01) capita enroilment Poverty p7 of population below national poverfy line) 25 Urban population (% of total population) 23 28 46 Life expectancy at birth (years) 73 62 69 1 Infant mortality (per 1,000 live births) 15 73 33 Child malnutrition I"/.of children under 5) 33 49 11 Access to improved water source Access to an improved water source p7 of population) 83 87 80 Illiteracy (% ofpopulation age 15) 8 44 15 Gross primary enrollment (77 of school-age population) 111 101 107 - Sri Lanka Male 112 109 107 Lower-middle-incomegroup Female 110 93 107

KEY ECONOMIC RATIOS and LONG-TERM TRENDS 1981 1991 2000 2001 Economic ratios' GDP (US$ billions) 4.4 9.0 16.3 15.7 Gross domestic investmenUGDP 27.8 22.9 28.1 22.0 Trade Exports of goods and serviceslGDP 30.5 28.2 39.7 37.0 Gross domestic savings/GDP 11.7 13.9 17.2 15.3 Gross national savingsiGDP 17.8 17.1 21.4 19.5 Current account balance/GDP -10.0 -5.8 -6.5 -1.7 Interest payments/GDP 1.1 1.4 1.3 1.3 Total debUGDP 50.6 73.1 55.3 54.4 Total debt service/expotts 13.7 10.0 9.7 Present value of debt/GDP 42.8 - Present value of debUexports 89.6 Indebtedness 1981-91 1991-01 2000 2001 2001-05 (average annual growth) GDP 3.9 4.9 6.0 -1.4 5.6 Sri Lanka GDP per capita 2.4 3.6 4.3 -2.9 4.4 Lower-middle-incomegroup Exports of goods and services 4.9 6.9 18.0 -6.5 2.4

STRUCTURE of the ECONOMY 1981 1991 2000 2001 Growth of investment and GDP (%) (% of GDP) Agriculture 27.7 26.8 195 19.5 1"- Industry 280 256 27.5 26.7 ' lo I Manufacturing 16.2 148 16.9 158 o Services 44.3 47 7 530 538 1 96 97 98 99 00 01 Private consumption 80.9 76.3 72 4 ' 201 I General government consumption 74 98 104 ;:.?1 = =-GDI -GDP Imports of goods and services 46 5 372 505 437

1981-91 1991-01 2ooo 2o01 Growth of exports and imports (x) (average annual growth) Agriculture 20 17 Industry 49 65 Manufacturing 65 74 Services 44 56 Private consumption 3.5 4 1 General government consumption 6 6 8.1 Gross domestic investment 07 55 100 -171 Exports *imports Imports of goods and services 34 78 149 -101

Note 2001 data are preliminary estimates Debt Data is from the World Bank Global Development Finance Database * The diamonds show four key indicators in the country (in bold) compared with its income-group average If data are missing, the diamond will be incomplete Aiuiex A2 Page 2 of 2

Sri Lanka

PRICES and GOVERNMENT FINANCE 1981 1991 2000 2001 Inflation (%) Domestic prices (% change) 2o T Consumer prices 12 2 6.2 14 2 15 Implicit GDP deflator 20 9 106 6.2 13 2 10 Government finance 5 (?A of GDP, inciudes current grants) 0 I Current revenue 22 6 17.2 169 96 97 98 99 00 01 Current budget balance 01 -3.0 -4 5 ...... GDP deflator =+-CPI Overall surpiusldeficit (including grants) -12 4 -9 5 -9.5 -105

TRADE 1981 1991 2000 2001 Export and import levels (US$ mill.) (US$ miiiions; Total exports (fob) 1,987 5,522 4,817 8 000 Tea 432 700 690 7:000 7 Other agricultural goods 261 442 330 I Manufactures 804 2,962 2,543 Total impotis (cif) 1,694 2,894 7,320 5,974 Food 485 693 654 Fuel and energy 234 901 731 Capital goods 720 1,737 1,081 95 96 97 98 99 00 01 Export price index (1995=100) 151 140 Import price index (1995=iOO) 132 125 Ea Exports s Imports Terms of trade (1995=100) 115 112 I BALANCE of PAYMENTS 1981 1991 2000 2001 Current account balance to GDP (%) (US$ miiirons) c Exports of goods and services 2,534 6,475 6,183 Imports of goods and services 2,054 3,345 8,235 7,135 Resource balance -81 1 -1,760 -952 Net income -96 -1 80 -305 -260 Net current transfers 363 469 998 960 Current account balance -442 -521 -1,066 -272 Financing items (net) 404 942 447 542 Changes in net reserves 38 -421 61 9 -270 Memo: Reserves including gold (US$ mi//ions) 704 91 5 1,187 Conversion rate (DEC, /oca//US$) 19 2 41 4 77.0 89.4

EXTERNAL DEBT and RESOURCE FLOWS 1981 1991 2000 2001 (US.$ miiiions) Composition of 2001 debt (US$ mill.) Total debt outstanding and disbursed 2,235 6,580 9,019 8,529 A8 iBRD 29 76 13 8 IDA 126 1,058 1,610 1,570 Total debt service 21 2 41 6 777 71 6 IBRD 4 15 7 5 IDA 1 11 31 39 Composition of net resource flows Official grants 178 173 109 94 Official creditors 163 563 154 184 Private creditors 182 36 133 71 Foreign direct investment 49 63 176 172 Portfolio equity 0 32 -45 -1 1 World Bank program Commitments 159 242 18 37 A - IBRD E - Bilateral Disbursements 28 187 47 39 B - IDA D .Other multilateral F - Pnvate Principal repayments 2 12 24 31 C. IMF G -Short-term Net flows 26 174 23 8 Interest payments 3 14 14 13 Net transfers 23 161 10 -5

Development Economics 5120103 Annex B5 Page 1 of 1

ANNEX B5 Social Indicators As of 1/31/2003

Latest single year Same regionlincome group Lower- South middle- 1970-75 1980-85 1994-00 Asia income POPULATION Total population, mid-year (millions) 13.5 15.8 19.4 1,355.1 2,047.6 Growth rate (% annual average for period) 1.5 1.4 1.3 1.9 1.1 Urban population (% of population) 22.0 21 .I 23.6 28.4 42.0 Total fertility rate (births per woman) 3.9 2.9 2.1 3.3 2.1 POVERTY (“A of population) National headcount index 25.0 Urban headcount index Rural headcount index INCOME GNI per capita (US$) 31 0 380 850 440 1,130 Consumer price index (1995=100) 12 34 154 142 146 Food price index (1995=100) 34 159 INCOME/CONSUMPTION DISTRIBUTION Gini index 34.4 Lowest quintile (% of income or consumption) 8.0 Highest quintile (% of income or consumption) 42.8 SOCIAL INDICATORS Public expenditure Health (% of GDP) 1.7 0.9 2.3 Education (% of GDP) 2.7 2.6 3.4 3.0 4.6 Social security and welfare (% of GDP) 6.1 3.0 2.9 Net primary school enrollment rate (“A of age group) Total 102 91 Male 101 91 Female 103 91 Access to an improved water source (‘A of population) Total 83 87 80 Urban 91 92 95 Rural 80 85 69 Immunization rate (“A under 12 months) 20 95 53 89 DPT 70 99 57 89 Child malnutrition (% under 5 years) 33 49 11 Life expectancy at birth (Years) Total 66 69 73 62 69 Male 65 67 71 62 67 Female 68 71 76 63 72 Mortality Infant (per 1,000 live births) 44 25 15 73 33 Under 5 (per 1,000 live births) 100 48 18 96 41 Adult (15-59) Male (per 1,000 population) 21 4 200 161 227 192 Female (per 1,000 population) 196 152 92 21 2 125 Maternal (per 100,000 live births) 60 Births attended by skilled health staff (%) 65 85 95

Note: 0 or 0.0 means zero or less than half the unit shown. Net enrollment ratios exceeding 100 indicate discrepancies between the estimates of school-age population and reported enrollment data. 2002 World Development Indicators CD-ROM, World Bank

Annex B6 Page 1 of 2

ANNEX B6 Key Economic Indicators As of 512012003

Actual Estimate Projected Indicator 1998 1999 2000 2001 2002 2003 2004 2005 2006 National accounts (as % of GDP) Gross domestic producta 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 Agriculture 21.1 20.7 19.5 19.5 19.3 18.7 18.0 17.2 16.5 Industry 27.5 27.3 27.5 26.7 27.0 26.8 26.8 26.8 26.8 Services 51.4 52.1 53.0 53.8 56.0 54.5 55.2 55.5 0.0 Total consumption 80.9 80.5 82.6 84.7 84.7 84.0 82.0 80.3 78.3 Gross domestic fixed investment 25.1 27.3 28.0 22.1 22.3 24.2 26.3 27.9 29.0 Government investment 3.3 3.2 3.3 3.0 3.5 4.7 5.7 6.3 6.6 Private investment 21.8 24.1 24.7 19.0 18.9 19.2 20.6 21.7 22.6

Exports (GNFS)b 36.2 35.5 39.7 37.0 35.9 36.8 38.1 38.2 39.1 Imports (GNFS) 42.2 43.3 50.5 43.7 43.0 44.7 46.4 46.5 46.6 Gross domestic savings 19.1 19.5 17.4 15.3 15.3 16.0 18.0 19.7 21.7 Gross national savings 23.4 23.5 21.4 19.5 20.3 20.8 22.1 23.7 25.3 Memorandum items Gross domestic product 15795 15657 16305 15669 16301 17527 19111 20871 22849 (US$ million at current prices) GNI per capita (US$, Atlas method) 810 820 850 830 820 860 920 1000 1080 Real annual growth rates (%, calculated from 1982 prices) Gross domestic product at market prices 4.7 4.3 6.0 -1.4 3.3 5.5 6.5 6.8 7.0 Gross domestic income 9.6 3.6 3.6 -0.3 12.9 5.9 8.5 8.4 8.1 Real annual per capita growth rates (%, calculated from 1982 prices) Gross domestic product at market prices 3.5 2.8 4.3 -2.9 1.6 4.3 5.4 5.9 6.1 Total consumption 5.7 3.8 3.3 -1.1 3.4 3.6 5.0 5.6 4.4 Private consumption 5.7 3.8 2.7 16.9 3.1 3.9 5.7 6.0 4.3 Balance of Payments (US$ millions) EXPO~~S(GNFS)~ 5712 5578 6475 61 83 5856 6449 7280 7972 8939 Merchandise FOB 4798 4610 5522 481 7 4793 5310 6052 6633 7483 Imports (GNFS)~ 6659 6800 8235 7135 701 1 7826 8860 9695 10654 Merchandise FOB 5889 5980 7320 5974 6097 6834 7736 8450 9280 Resource balance -947 -1222 -1760 -952 -1 I55 -1377 -1 580 -1723 -171 5 Net current transfers 900 912 998 960 1008 1052 1098 1137 1172 Current account balance -227 -564 -1066 -272 -399 -590 -793 -905 -872 Net private foreign direct investment 193 177 176 172 233 380 312 351 354 Long-term loans (net) 398 397 297 354 358 599 765 81 6 767 Official 376 155 154 184 407 505 307 178 91 Private 22 242 143 170 -49 95 457 638 676 Other capital (net, inci errors & ommissions) -1 35 -351 -26 16 42 104 105 117 111 Change in reserves' -229 340 619 -270 -234 -493 -389 -380 -360 Memorandum items Resource balance ("A of GDP) -6.0 -7.8 -10.8 -6.1 -7.1 -7.9 -8.3 -8.3 -7.5 Real annual growth rates (YR82 prices) Merchandise exports (FOB) 13.2 4.5 9.8 2.4 -3.0 3.9 8.4 4.2 10.6 Merchandise imports (CIF) 9.9 3.7 13.7 1.3 3.6 8.1 13.9 9.7 9.4 Annex B6 Page 2 of 2

Key Economic Indicators (Continued)

Actual Estimate Projected Indicator 1998 1999 2000 2001 2002 2003 2004 2005 2006

Public finance (as % of GDP at market prices)d Current revenues 17.2 17.7 16.8 16.5 16.5 16.9 17.9 18.7 19.1 Current expenditures 19.6 18.7 20.2 21.4 20.8 19.2 17.9 16.8 16.2 Current account surplus (+) or deficit (-) -2.4 -1.0 -3.4 -4.9 -4.3 -2.4 0.0 1.9 2.9 Capital expenditure 5.3 5.5 5.4 4.8 4.6 5.2 6.2 6.9 7.2 Foreign financing 1.7 0.7 0.7 1.6 0.1 2.1 3.0 3.2 2.7

Monetary indicators MZGDP 37.1 38.7 38.5 39.2 40.1 40.1 40.1 40.1 40.1 Growth of M2 (%) 13.2 13.4 12.8 13.6 15.0 13.5 14.0 13.2 12.4

Price indices( YR82 400) Merchandise export price index 91.4 84.0 91.7 78.1 80.1 85.3 89.7 94.3 96.2 Merchandise import price index 94.7 97.0 108.2 87.1 76.5 79.3 78.9 78.5 78.9 Merchandise terms of trade index 96.4 86.6 84.7 89.6 104.7 107.6 113.8 120.1 122.0 Real exchange rate (USs/LCU)" 126.2 117.4 124.7 122.2 119.5

Consumer price index (% change) 9.4 4.7 6.2 14.2 9.6 8.9 7.0 6.0 5.0 GDP deflator (% change) 9.2 4.2 6.2 13.2 9.3 8.9 7.0 6.0 5.0 a. GDP at factor cost. b. "GNFS" denotes "goods and nonfactor services." c. Includes use of IMF resources. d. Consolidated central government. e. "LCU" denotes "local currency units." An increase in US$/LCU denotes appreciation. Amex Bl Page 1 of I

ANNEX B7 Key Exposure Indicators As of 5/20/2003

Actual Estimate Projected Indicator 1999 2000 2001 2002 2003 2004 2005 2006

Total debt outstanding &disbursed (TDO) (US$millions) a 9732 9019 8529 8961 9599 10392 1 1263 1 1994

Net disbursements (US$millions) a 788 -714 -490 432 638 793 871 731

Total debt service (TDS) (US$millions) a 738 777 716 674 850 737 772 901

Debt and debt service indicators ("70) TDOIXGS 143.1 115.8 115.2 125.9 123.0 119.0 118.6 114.0 TDO/G D P 62.2 55.3 54.4 59.6 58.7 58.2 57.7 55.6 TDS/XGS 10.8 10.0 9.7 9.5 10.9 8.4 8.1 8.6

IBRD exposure indicators (%) IBRD DS/public DS 1.3 1.o 0.9 0.9 0.3 0.3 0.2 0.0 Preferred creditor DS/public 27.1 24.2 28.3 27.9 23.1 30.8 29.3 29.6 DS (%) IBRD DSIXGS 0.1 0.1 0.1 0.1 0.0 0.0 0.0 0.0 IBRD TDO (USSmillions) 19.7 13.3 8.3 4.0 2.0 1.o 0.0 0.0 Share of IBRD portfolio (%) 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 IDA TDO (UsSmil1ion.s) 1652 1610 1570 1597 1720 1822 1923 2022

IFC (US$millions) Loans 50 Equity and quasi-equity e 18

MlGA Gross outstanding guarantees (US$millions) ' 47 34 17 17

Note: Debt data are from the World Bank Global Development Finance Database and may differ from Text Tables 1 and 2 that are based on IMF sources. a. Includes public and publicly guaranteed debt, private nonguaranteed, use of IMF credits and net short-term capital. b, "XGS" denotes exports of goods and services, including workers' remittances. c. Preferred creditors are defined as IBRD, IDA, the regional multilateral development banks, the IMF, and the Bank for International Settlements. d, Includes present value of guarantees. e. Includes equity and quasi-equity types of both loan and equity instruments. f. 2003 is as of end second quarter FY03.