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Country Strategy and Program Update 2003-2005: Sri Lanka

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I. Current Development Trends and Issues

A. Recent Political and Social Developments

1. The new Government, led by the United National Front, came to office in December 2001 and gives high priority to a political settlement to the civil conflict, which has plagued the country for the past two decades. The Norwegian Government is acting as a facilitator between the Sri Lanka Government and Liberation Tigers of Tamil Eelam (LTTE). In February 2002, the Government and LTTE formally agreed to cease hostilities, restore normalcy to the country, and provide an environment for direct talks between the two parties. The agreement contains several milestones for confidence-building measures for a permanent solution for peace, including the reopening of the A9 highway from Kandy to Jaffna after 12 years in April 2002. The agreement also calls for unimpeded flow of nonmilitary goods and essential items to and from LTTE controlled areas in the north and east. The Sri Lanka Monitoring Mission, led by Norway and consisting of members from the Nordic countries and Sri Lanka, has been set up to monitor the compliance of the terms and conditions of the agreement. Although the ongoing peace process may remain fragile, its progress has raised hopes for sociopolitical and economic stability. Formal talks between the Government and LTTE is expected to commence soon.

2. Sri Lanka has made good progress toward achieving the millennium development goals and targets (Appendix 1, Tables A1.1) despite the prolonged civil conflict. However, official statistics generally exclude the north and east. In 1997, the gross enrolment rate reached over 100% in primary education and 75% in secondary education, with limited gender disparity (Appendix 1, Tables A1.2 and A1.3). Child and maternal mortality rates also improved to levels comparable to middle-income countries. Population with access to safe water and sanitation increased to 83%. While official poverty incidence was reduced to 27% in 1995, poverty incidence is estimated to have remained at about 40% after including the north and east.¹

B. Economic Assessment and Outlook

3. Sri Lanka suffered a 1.4% contraction of gross domestic product (GDP) in 2001 (Appendix 1, Table A1.4) due in part to external factors such as falling export demand from the global slowdown and poor agricultural yields from the continuing drought.² The LTTE attack on the country’s only international airport caused tourism and shipping to plummet in the last half of the year, and power cuts of up to 8 hours daily harmed production. Political instability in 2001—with the dissolution of Parliament and subsequent elections—further damaged the ailing macroeconomy, reflected most directly in the unsustainable fiscal deficit (including foreign grants and privatization proceeds) of nearly 10% of GDP. This substantially constrains the Government’s development resources and undermines future economic growth prospects, apart from crowding out private investment. The paralysis in decision making caused capital expenditures (excluding net lending) to decline to less than 5% of GDP and impaired even counterpart funding for foreign-financed projects.

4. The Government’s first budget, announced on 22 March 2002, focuses on bringing back fiscal discipline with a deficit target of 8.5% of GDP, excluding privatization proceeds and foreign grants, mainly through revenue reforms. Further consolidation is likely in the 2003 budget, as the Government plans to review all public expenditures and set spending ceilings according to a medium-term budget framework. However, as externally financed projects have been given priority, counterpart funding is not likely to be a problem.

5. Looking ahead, the Government articulated the beginning of its reform agenda in the 2002 budget speech. The budget recognizes the heavy burden of state-owned enterprise (SOE) losses on the economy, particularly the crowding out of private investment in light of the accumulated fiscal deficits. In the energy sector, the reform efforts included a transparent automatic price adjustment formula for petroleum products and an average 35% increase in power tariffs. The Government is fully committed to rationalizing and simplifying the tax system, and the Asian Development Bank (ADB) is supporting the reforms.³ The new budget provides the framework for advancing them. The Government is also committed to pursuing labor law reforms, with legislation amended to provide (i) time limits within which labor tribunals and arbitration panels must hear and decide on labor disputes and (ii) a schedule of specified compensation payable to workers when they are terminated.

6. The ADB outlook for Sri Lanka in 2002 suggests a mild recovery, with GDP growing by 3.5%. Tourism and shipping are slowly returning to their previous levels, and the improving global economy is raising export demand. Power cuts have been eliminated, albeit at a substantial cost, through the installation of emergency generation plants, and because the drought has eased. The ceasefire is also providing some needed stability.

C. Implications for the Country Strategy and Program

7. The effectiveness of the Government’s plans for economic recovery will largely depend on the progress of the peace process. Cessation of hostilities and continued peace would help to keep defense expenditures in check and help the Government achieve its ambitious fiscal targets. A permanent agreement between the Government and LTTE would allow higher levels of rehabilitation work in the north and east to commence. The ceasefire agreement represents only the first step in forging a lasting peace in the country, which will pave the way for substantial reconstruction and rehabilitation operations in the north and east. Along with other development partners, ADB will need to respond adequately to the changed situation. ADB had, however, already taken a major initiative in 2001 to initiate such operations.⁴ ADB will continue to assess the feasibility and timing of a larger rehabilitation effort, but as peace has still not been achieved and a stable postconflict environment is still being created, ADB will work with the Government and other major development partners to prepare a postconflict rehabilitation plan for the north and east.

8. The 2002 budget speech announced the Government’s commitment to undertake reforms to put the country on a path to sustainable growth. The reforms have generally been in line with the ongoing policy dialogue in the infrastructure and finance sectors and may even be accelerated. ADB will continue to support the Government’s reform agenda through the lending and nonlending pipeline. However, in the changed sociopolitical and economic context and brighter prospects for an end to the civil conflict, ADB needs to reassess its strategic and operational priorities and assistance program. ADB will thus initiate work on a new country strategy and program (CSP) in late 2002 for completion in 2003. The CSP will be prepared in close consultation and cooperation with the Government and development partners and stakeholders.

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