FOR OFFICIAL USE ONLY Report No: PGD478 INTERNATIONAL DEVELOPMENT ASSOCIATION PROGRAM DOCUMENT FOR A PROPOSED CREDIT FROM THE PERFORMANCE-BASED ALLOCATION IN THE AMOUNT OF SDR 150,600,000 (EQUIVALENT TO US$200 MILLION) TO DEMOCRATIC SOCIALIST REPUBLIC OF SRI LANKA FOR THE Sri Lanka Second Resilience, Stability and Economic Turnaround Development Policy Operation August 15, 2024 Macroeconomics, Trade and Investment Finance, Competitiveness, and Innovation South Asia This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization. Democratic Socialist Republic of Sri Lanka GOVERNMENT FISCAL YEAR January, 1 – December, 31 CURRENCY EQUIVALENTS (Exchange Rate Effective as of July 31, 2024) Currency Unit = Sri Lankan Rupee (LKR) US$1.00 = LKR302.38 SDR1.00 = US$1.32842 ABBREVIATIONS AND ACRONYMS ADB Asian Development Bank JICA Japan International Cooperation Agency AIIB Asian Infrastructure Investment Bank LKR Sri Lankan Rupee AIP Agreement in Principle MoF Ministry of Finance AoA Articles of Association NCW National Commission on Women BOC Bank of Ceylon NDC Nationally Defined Contributions CBSL Central Bank of Sri Lanka NPLs Non-Performing Loans CIT Corporate Income Tax NTP National Tariff Policy CPF Country Partnership Framework PAL Port and Airport Levy CT Cash Transfer PA Prior Action DMO Debt Management Office PDM Public Debt Management DPO Development Policy Operation PB People’s Bank DPs Development Partners PFM Public Financial Management EFF Extended Fund Facility PPG Public and Publicly Guaranteed ELA Emergency Liquidity Assistance RAMIS Revenue Administration Management Information System FDI Foreign Direct Investment SDR Special Drawing Rights FHH Female Headed Households SOBs State-Owned Banks FLFP Female Labor Force Participation SOEs State-Owned Enterprises FX Foreign Exchange TA Technical Assistance GDP Gross Domestic Product TES Tax Expenditure Statement GFN Gross Financing Needs TRCSL Telecommunications Regulatory Commission of Sri Lanka GoSL Government of Sri Lanka USAID United States Agency for International Development HoCo Holding Company VAT Value Added Tax IDA International Development Association WBG World Bank Group IMF International Monetary Fund WBPS Welfare Benefits Payment Scheme IFC International Finance Corporation WE Women’s Empowerment IRD Inland Revenue Department y-o-y Year-on-year Regional Vice President: Martin Raiser Regional Director: Mathew A. Verghis Country Director: David Sislen Practice Manager: Saiyed Shabih Ali Mohib Task Team Leader(s): Richard Walker, Karina Baba The World Bank Sri Lanka Second Resilience, Stability and Economic Turnaround Development Policy Operation (P180549) DEMOCRATIC SOCIALIST REPUBLIC OF SRI LANKA Sri Lanka Second Resilience, Stability and Economic Turnaround Development Policy Operation TABLE OF CONTENTS SUMMARY OF PROPOSED FINANCING AND PROGRAM ...................................................................... i 1. INTRODUCTION AND COUNTRY CONTEXT ................................................................................. 1 2. MACROECONOMIC POLICY FRAMEWORK.................................................................................. 2 2.1. RECENT ECONOMIC DEVELOPMENTS ...........................................................................................2 2.2. MACROECONOMIC OUTLOOK AND DEBT SUSTAINABILITY..........................................................5 2.3. IMF RELATIONS .............................................................................................................................9 3. GOVERNMENT PROGRAM ........................................................................................................ 9 4. PROPOSED OPERATION .......................................................................................................... 10 4.1. LINK TO GOVERNMENT PROGRAM AND OPERATION DESCRIPTION .........................................10 4.2. PRIOR ACTIONS, RESULTS AND ANALYTICAL UNDERPINNINGS .................................................11 4.3. LINK TO CPF, OTHER BANK OPERATIONS AND THE WBG STRATEGY .........................................19 4.4. CONSULTATIONS AND COLLABORATION WITH DEVELOPMENT PARTNERS ..............................20 5. OTHER DESIGN AND APPRAISAL ISSUES .................................................................................. 20 5.1. POVERTY AND SOCIAL IMPACT ...................................................................................................20 5.2. ENVIRONMENTAL ASPECTS ........................................................................................................22 5.3. PFM, DISBURSEMENT AND AUDITING ASPECTS .........................................................................23 5.4. MONITORING, EVALUATION AND ACCOUNTABILITY .................................................................23 6. SUMMARY OF RISKS AND MITIGATION ................................................................................... 24 ANNEX 1: POLICY AND RESULTS MATRIX ........................................................................................ 26 ANNEX 2: FUND RELATIONS ANNEX ................................................................................................ 34 ANNEX 3: LETTER OF DEVELOPMENT POLICY................................................................................... 37 ANNEX 4: ENVIRONMENT AND POVERTY/SOCIAL ANALYSIS TABLE ................................................ 43 ANNEX 5: PARIS ALIGNMENT ASSESSMENT .................................................................................... 44 ANNEX 6: KEY CHANGES TO ORIGINAL POLICY MATRIX IN A PROGRAMMATIC SERIES..................... 47 The World Bank Sri Lanka Second Resilience, Stability and Economic Turnaround Development Policy Operation (P180549) The Credit was prepared by an IDA team consisting of Richard Walker (Senior Economist and TTL, ESAC1), Karina Baba (Senior Financial Sector Specialist and co-TTL, ESAF1), Joao Morgado (Young Professional, ESAC1), Shruti Lakhtakia (Economist, ESAC1), Udahiruni Atapattu (Research Analyst, ESAC1), Ximena Talero (Lead Counsel, LEGAS), Elsa Le Groumellec (Senior Counsel, LEGAS), Sachiko Morita (Senior Counsel, LEGAS), Gregory Smith (Lead Country Economist, Program Leader, ESADR), Tracey Plunkett (Contractor, SACSL), Sashikala Jeyaraj (Program Assistant, SACSL), Yasindu Amarasinghe (Team Assistant, SACSL), Puteri Watson (Senior Operations Officer, ESAC1), Leandro Secunho (Senior Debt Specialist, EMFMD), Sebastian Essl (Senior Economist, ESAC1), Cristian Lucas (Senior Economist, ESAC1), Miquel Dijkman (Lead Financial Sector Specialist, ESAF1), Antonia Menezes (Senior Financial Sector Specialist, EFNFI), Alexander Pankov (Lead Financial Sector Specialist, ESAF1), Tatsiana Kliatskova (Financial Sector Economist, ESAF1), Teuta Kacaniku (Lead Infrastructure Finance Specialist, IPGFG), Jemima T. Sy (Lead Public Private Partnerships Specialist, IPGPP), John Speakman (Consultant, ESAF1), Amila Dahanayake (Economist, ESAF1), Ivan Nimac (Lead Private Sector Specialist, ETIIC), Priyanka Kher (Senior Private Sector Development Specialist, ETIIC), Guillermo Arenas (Economist, ETIRI), Siddhartha Raja (Senior Digital Development Specialist, IDD06), Francesca Lamanna (Senior Economist, HSASP), Srinivas Varadan (Senior Social Protection Specialist, HSASP), Shalika Subasinghe (Consultant, HSASP), Patricia Fernandes (Lead Social Development Specialist, SSAS1), Kamani Jinadasa (Consultant, SSAS1), Nandini Krishnan (Lead Economist, ESAPV), Marta Schoch (Economist, ESAPV), Mohan Gopalakrishnan (Senior Financial Management Specialist, ESAG1), Anula Harasgama (Senior Financial Management Specialist, ESAG1), Enoka Wijegunawardene (Senior Financial Management Specialist, ESAG1), Mokshana Wijeyeratne (Senior Environmental Specialist, SSAEN), Nadeera Rajapakse (Environmental Specialist, SSAEN), Priyanka Dissanayake (Disaster Risk Management Specialist, SSACD), Aldo Defilippi (Consultant, SSACD), and Shanek Fernando (Social Development Specialist, SSAS1). The team gratefully acknowledges the support and guidance provided by David Sislen (Country Director, SACNP), Faris H. Hadad-Zervos (previous Country Director, SACNP), Mathew A. Verghis (Regional Director, ESADR), Shabih Ali Mohib (Practice Manager, ESAC1), Gabi Afram (Practice Manager, ESAF1), Gevorg Sargsyan (Country Manager, SACSL), Chiyo Kanda (previous Country Manager, SACSL), and Asela Dissanayake (Senior Operations Officer, SACSL). The team appreciates the close collaboration with the International Monetary Fund team for Sri Lanka, led by Peter Breuer (Division Chief) and Katsiaryna Svirydzenka (Deputy Division Chief). Finally, the team expresses its gratitude to the Government of the Democratic Socialist Republic of Sri Lanka for their cooperation in the preparation of this operation. The World Bank Sri Lanka Second Resilience, Stability and Economic Turnaround Development Policy Operation (P180549) @#&OPS~Doctype~OPS^dynamics@paddpfbasicinformation#doctemplate SUMMARY OF PROPOSED FINANCING AND PROGRAM BASIC INFORMATION Operation ID Programmatic If programmatic, position in series P180549 Yes 2nd in a series of 2 Proposed Development Objective(s) To support foundational reforms that restore macroeconomic stability and sustainability, mitigate the impact of current and future shocks on the poor and vulnerable, and support an inclusive and private-sector-led recovery and growth path. @#&OPS~Doctype~OPS^dynamics@padborrower#doctemplate Organizations Borrower: DEMOCRATIC SOCIALIST REPUBLIC OF SRI LANKA Ministry of Finance, Economic Stabilization and National Policies, Presidential Implementing Agency: Secretariat of Sri Lanka @#&OPS~Doctype~OPS^dynamics@padfinancingsummary#doctemplate PROJECT FINANCING DATA (US$, Millions) Maximizing Finance for Development Is this an MFD-Enabling Project (MFD-EP)? Yes Is this project Private Capital Enabling (PCE)? Yes SUMMARY Total Financing 200.00 DETAILS World Bank Group Financing International Development Association (IDA) 200.00 IDA Credit 200.00 i The World Bank Sri Lanka Second Resilience, Stability and Economic Turnaround Development Policy Operation (P180549) IDA Resources (US$, Millions) Guarantee Credit Amount Grant Amount SML Amount Total Amount Amount National Performance-Based 200.00 0.00 0.00 0.00 200.00 Allocations (PBA) Total 200.00 0.00 0.00 0.00 200.00 @#&OPS~Doctype~OPS^dynamics@padclimatechange#doctemplate PRACTICE AREA(S) Practice Area (Lead) Contributing Practice Areas Digital Development; Finance, Competitiveness and Macroeconomics, Trade and Investment Innovation; Social Sustainability and Inclusion; Social Protection & Jobs CLIMATE Climate Change and Disaster Screening Yes, it has been screened and the results are discussed in the Concept Document Explanation @#&OPS~Doctype~OPS^dynamics@padoverallrisk#doctemplate OVERALL RISK RATING Overall Risk ⚫ High ii The World Bank Sri Lanka Second Resilience, Stability and Economic Turnaround Development Policy Operation (P180549) RESULTS Indicator Name Baseline Current Target RI#1. Public Debt Management Office within the Ministry of Finance created, fully staffed and No (2022) No (June, 2024) Yes (2025) operational RI#2. (a) Total tax revenue-to-GDP (percent) (a) 7.3 (2022) (a) 9.8 (2023) (a) 12.0 (2025) (b) Use of electronic filing facilities for non-corporate (b) 23 (2021) (b) Not yet available (b) At least 70 (2025) tax declarations (percent) RI#3. Exposures to SOEs of total assets of: (a) 8.7 (Q2 2022) (a) 4.1 (Q1 2024) (a) 4.5 (2025) (a) the entire banking sector (percent), and (b) 20.9 (Q2 2022) (b) 8.4 (Q1 2024) (b) 10 (2025) (b) the two largest SOBs (percent) RI#4. CEB unbundling initiated through a Cabinet Reform to commence No (2023) Yes (2025) approved Transfer Plan in 2024 RI#5. Trade (imports and exports) as a share of GDP 41 (2021) 42.8 (2023) 45 (2025) (percent) RI#6. (a) Private investment in broadband networks (a) 0 (2022) (a) 100 (2025) (a) & (b) Reforms to facilitated (US$ million) (b) 8.8 (2022) (b) 12 (2025) commence in 2024 (b) Millions of people using broadband internet RI#7. (a) 1.82 million (June, (a) Beneficiaries of the new Welfare Benefits Payment (a) 0 (2022) 2024) (a) 2 million (2023- Scheme (WBPS) (number of households per year) 2025) (b) Coverage of the poorest 20 percent by cash transfer (b) 43 (2022) (b) Not available programs (percent) (b) 60 (2025) (c) Coverage of female headed household by the new (c) 0 (2022) (c) 252,348 (June, WBPS (number) 2024) (c) 400,000 (2025) RI#8. Reviews concluded on the infringement of Reform to commence women’s rights following National Commission on 0 (2023) 100 (2025) in 2024 Women’s procedures (proportion of reviews) iii The World Bank Sri Lanka Second Resilience, Stability and Economic Turnaround Development Policy Operation (P180549) IDA PROGRAM DOCUMENT FOR A PROPOSED CREDIT TO DEMOCRATIC SOCIALIST REPUBLIC OF SRI LANKA 1. INTRODUCTION AND COUNTRY CONTEXT 1. The Sri Lankan economy has stabilized from its worst economic crisis in modern history. After losing access to international financial markets in 2020, official reserves dropped precipitously in early 2022, and the forex liquidity constraint led to severe shortages of essential goods. The country suspended external debt servicing in April 2022, pending debt restructuring. The economy contracted by 9.5 percent between 2021 and 2023, and public and publicly guaranteed debt ballooned to 119.2 percent of Gross Domestic Product (GDP) in 2022 amid high inflation (46.4 percent, annual average in 2022) and a sharp currency depreciation (81.2 percent, y-o-y, 2022).1 Food insecurity and malnutrition increased, poverty doubled, and inequality widened. Roughly 60 percent of households faced a decline in income due to reduced work hours or job losses. As a response, the Government of Sri Lanka (GoSL) implemented domestic revenue enhancement policies, demand compression measures, and embarked on an ambitious structural reform plan to restore macroeconomic stability, help the poor cope with the economic shock, and address structural causes of the crisis. The implementation of structural reforms since mid-2022, including cost-reflective utility pricing and new revenue measures, helped restore stability as external and fiscal balances improved considerably. The country registered a primary surplus of 0.6 percent of GDP in 2023. As of end-June 2024, usable official foreign exchange reserves were US$4.2 billion2 (equivalent to 11-12 weeks of imports), and inflation declined to 1.7 percent. Domestic debt restructuring was completed in September 2023, and Memorandums of Understanding (MoUs) with official creditors and China Exim Bank were signed in June 2024. An agreement with a representative group of bondholders was reached in July 2024.3 GoSL’s reform plan has been supported by a 48-month US$3 billion equivalent International Monetary Fund (IMF) Extended Fund Facility (EFF) program, which was approved in March 2023. The second review of the EFF was completed on June 12, 2024. 2. The economy is expected to continue to stabilize in 2024. Growth is expected to turn positive this year and remain moderately positive over the medium term, limited by the scarring effects of the crisis, lower real incomes amid higher taxes, and high emigration of skilled workers. Risks remain though, as there is a narrow path to recovery, with limited buffers. Furthermore, the upcoming presidential and parliamentary elections could affect the pace of reform implementation, but there seems to be a broad commitment across the political spectrum to completing structural reforms and avoiding the policy mistakes of the past. Robust reform implementation before and after the elections is vital to build a stronger and more resilient economy, while effectively mitigating any negative impact of the reforms on the poor and vulnerable. 3. The proposed Development Policy Operation (DPO) – the second in a series of two operations – will provide US$200 million to support implementation of GoSL’s reform plan. The Program Development Objective (PDO) is to support foundational reforms that restore macroeconomic stability and sustainability, mitigate the impact of current and future shocks on the poor and vulnerable, and support an inclusive and private-sector-led recovery and growth path. This will be achieved through three pillars aimed at: (i) improving economic governance through better fiscal and debt management, improving tax policy and administration, and addressing financial sector risks; (ii) enhancing growth and competitiveness through regulatory reforms, institutional restructuring and increasing competition in core sectors (i.e., electricity and broadband), and reforms to the trade regime; and (iii) protecting the poor and vulnerable through the rolling out of a new Welfare Benefit Payment Scheme (WBPS) and reducing gender discrimination. The operation supports results areas in the World Bank’s Corporate Scorecard related to macroeconomic and fiscal management, protecting the 1 Calculated as the percentage difference between the end-December 2021 and end-December 2022 exchange rates. 2 Usable reserves exclude the Chinese currency swap in 2022-2023 due to conditions on usability. 3 Sri Lanka and the Ad-Hoc Group of Bondholders agreed on a proposal to restructure its International Sovereign Bonds (ISBs). This proposal is subject to review of consistency with debt sustainability targets and on the comparability of treatment with official creditors. Page 1 The World Bank Sri Lanka Second Resilience, Stability and Economic Turnaround Development Policy Operation (P180549) poorest, digital connectivity, and providing affordable and sustainable energy. 4. DPO2 is a key part of the Bank’s strategy, as outlined in the Sri Lanka Country Partnership Framework (CPF) FY24-FY274 and is being closely coordinated with other development partners (DPs). The DPO series has opened a constructive dialogue with GoSL to commit to important reforms that were not on the table earlier. This dialogue has helped GoSL to better articulate its vision for recovery and growth, and for the Bank to contribute to the design of the macro stabilization program and continue to support the structural reform agenda. The upstream policy interventions supported by this series are a precursor to better project specific investments that would support Sri Lanka’s recovery. Furthermore, the policy interventions build on the reforms from the first Resilience, Stability and Economic Turnaround (RESET) DPO (DPO1). DPO1 emphasized stabilization measures, whilst DPO2 looks to move the structural reform agenda forward. Both operations are calibrated with the IMF EFF and coordinated with the Asian Development Bank (ADB) and other DPs. Significant technical assistance (TA) and institutional capacity building is also being provided by the Bank and others to support the implementation and sustainability of reforms. 2. MACROECONOMIC POLICY FRAMEWORK 5. The macroeconomic policy framework is adequate for this operation.5 The macroeconomic policy mix is consistent with macro-fiscal stability, while the structural reform program supported by this operation, along with the IMF’s EFF, is helping to mitigate risks and sustain stability. The path to a sustainable economic recovery is narrow and contingent on adequate debt restructuring, continued implementation of structural reforms, and sufficient fiscal and external financing. The Sri Lankan economy stabilized in 2023, manifested in the better-than-expected fiscal and external sector outcomes, and disinflation. This was supported by a program of macro-critical reforms, including revenue-led fiscal consolidation, cost-reflective utility pricing, domestic debt restructuring, and the phase out of monetary financing. Debt is expected to become sustainable after the planned external debt restructuring is completed. Sustained fiscal-monetary- financial discipline and continued implementation of structural reforms are needed to restore a stronger and sustainable growth path. High gross financing and external financing needs and low buffers limit the economy’s ability to weather shocks. 2.1. RECENT ECONOMIC DEVELOPMENTS 6. The contraction of real GDP slowed from 7.3 percent in 2022 to 2.3 percent in 2023 (Table 1).6 For most of 2023, demand remained weak on account of lower disposable incomes, high borrowing costs, and depleted household buffers, while supply chain disruptions continued. Growth turned positive in Q3 2023 (after six quarters of decline) and remained so in Q4 2023 and Q1 2024, as agriculture expanded and the services sector grew, driven by the rebound in tourism. Industry continued to contract sharply in 2023 as construction, textiles, and mining slowed. However, high frequency indicators such as cement consumption, the purchasing manager’s index, and electricity sales to industries registered an uptick in activity in early 2024. Poverty continued to rise in 2023 for the fourth consecutive year to reach an estimated 25.9 percent (at US$3.65 per capita per day level, 2017 PPP), as households were affected by job and income losses, and the erosion of purchasing power. 7. Inflation, measured by the Colombo Consumer Price Index, moderated in 2023 and has continued to decline in 2024. Following a sharp spike to 69.8 percent (y-o-y) in September 2022, inflation decelerated to 4 percent in December 2023 and 1.7 percent in June 2024, supported by the large base effect, phasing out of monetary financing, appreciation 4 Report No. 182326-LK, discussed by the World Bank Board of Executive Directors on June 28, 2023. 5 The cut-off date for the data presented and analyzed in this section is July 5, 2024. CBSL further cut policy rates by 25 basis points on July 24, 2024. 6 Historical data on the real sector (including GDP) is taken from the Department of Census and Statistics. Historical data on inflation, interest rates, and the external sector is taken from CBSL. Historical data on the fiscal sector is taken from MOF. Page 2 The World Bank Sri Lanka Second Resilience, Stability and Economic Turnaround Development Policy Operation (P180549) of the Sri Lankan Rupee (LKR), and better supply conditions. This allowed the Central Bank of Sri Lanka (CBSL) to reduce policy rates by 700 basis points since June 2023, bringing rates to 8.5 percent (Standing Deposit Facility) and 9.5 percent (Standing Lending Facility) in May 2024. Alongside the completion of domestic debt restructuring in September 2023, monetary easing led to a fall in nominal interest rates, turning real interest rates positive and reducing borrowing costs. 8. Vulnerabilities persist in the banking sector and credit growth has been weak. With the fall in interest rates, growth in credit to the private sector turned positive y-o-y for the first time in a year in February 2024 and increased to 4.1 percent (y-o-y) in April. Positive real interest rates have encouraged banks to increase lending, while the return towards pre-pandemic nominal interest rates, amid signs of stabilization, has stimulated credit demand in some sectors. Nonetheless, non-performing loans (NPLs) remained elevated at 12.8 percent in Q1 2024, compared to 11.6 percent in Q4 2022, reflecting continued pressures on borrowers’ repayment capacity. While banks’ capital adequacy ratios improved from 16.1 percent at end-2022 to 17.7 percent in Q1 2024 – primarily as a result of the credit contraction that took place in the first half of 2023 – some banks, especially state-owned banks (SOBs), experienced capital pressures due to the need to absorb losses on the FX component of the domestic debt restructuring, continued FX exposures to state-owned enterprises (SOEs), and under-reported and under-provisioned credit losses on banks’ private sector lending portfolio. Profitability remains weak,7 particularly in systemically important banks, due to pressures on net interest margins amidst subdued economic activity. 9. The current account recorded a surplus of 1.8 percent of GDP (US$1.6 billion) in 2023, compared to a deficit of 1.9 percent in 2022 (US$1.5 billion), boosted by strong remittance flows and tourism, amid weak imports. The improvement in the current account was mainly driven by a US$2.2 billion increase in remittances (to nearly US$6.0 billion). The merchandise trade deficit declined from US$5.2 billion in 2022 to US$4.9 billion in 2023, given the larger fall in expenditure on merchandise imports (by 8.1 percent (y-o-y) or US$1.5 billion), which also contributed to the improvement in the current account. The fall in the merchandise import bill was driven by liquidity shortages in the early part of 2023, administrative restrictions on imports (which remained in place for most of 2023), and sluggish demand emanating from the real sector contraction. Merchandise export receipts declined by 9.1 percent (y-o-y) or US$1.2 billion, given the contraction in textile and garment exports (as global growth slowed) and the appreciation of the rupee. Service exports performed strongly on the back of a tourism rebound. Although earnings from tourism increased 82 percent (y-o- y) to US$2.1 billion, they remained well below pre-COVID levels. The better-than-expected performance in tourism and remittances has continued in 2024, with monthly tourism revenues reaching a four-year high in February 2024. 10. The improvement in the current and financial accounts strengthened the external position in 2023 and into 2024. The continued external debt service suspension, the current account surplus, and substantial financing flows (including budget support of US$1.7 billion from the IMF and other multilaterals)8 helped the balance of payments to record a surplus of US$2.8 billion. Improved liquidity allowed the CBSL to build FX reserves.9 As a result, usable official FX reserves grew to US$4.2 billion (about 11-12 weeks of imports) by end-June 2024, compared to less than US$500 million in December 2022.10 Net foreign assets of the banking system also increased from US$-6.4 billion in April 2022 to US$-0.2 billion in April 2024.11 The exchange rate (LKR/US$) appreciated by 10.8 percent in 2023, and by another 5.6 percent in the first six months of 2024,12 amid improved FX liquidity.13 7 Return on equity was 10.6 percent at end-2023, compared to 10.4 percent at end-2022. 8 Total disbursement from bilateral and multilateral partners in 2023 was approximately US$2.6 billion. 9 The CBSL market purchases amounted to a net of US$1.9 billion in 2023 and US$1.8 billion in January-May 2024. 10 Excluding the US$1.4 billion swap between the authorities and the People’s Bank of China, which has conditions on usability. 11 Improved FX liquidity helped banks manage their FX net open positions after the domestic debt restructuring, by settling inflows and outflows internally, without using the interbank FX market in significant amounts. As a result, the FX market remains shallow with low turnover. 12 Calculated as the appreciation of the daily rate between January 1, 2024 and June 30, 2024. 13 Calculated using end of month exchange rates. Page 3 The World Bank Sri Lanka Second Resilience, Stability and Economic Turnaround Development Policy Operation (P180549) Table 1: Selected Economic and Financial Indicators (illustrative debt restructuring scenario)14 2022 2023 2024p 2025p 2026p 2027p Annual percentage change GDP (expenditure side, constant prices) (7.3) (2.3) 2.2 2.5 3.0 3.1 Private consumption (0.5) (1.6) 2.3 2.6 3.1 3.2 Government consumption 1.4 (5.4) (0.2) 0.6 1.7 1.8 Gross fixed capital formation (37.9) (7.9) 4.1 3.2 2.8 2.5 Exports 10.2 11.3 2.1 2.5 2.9 3.2 Imports (19.9) 5.1 3.2 2.7 2.3 2.2 GDP (production, constant prices) Agriculture (4.2) 2.6 1.5 1.5 1.5 1.5 Industry (16.0) (9.2) 2.6 2.7 2.9 3.0 Services (2.6) (0.2) 2.1 2.5 3.3 3.4 Share of GDP, unless otherwise stated External sector Exports of goods and services 21.0 20.5 20.9 21.8 22.4 22.5 Imports of goods and services 25.0 22.3 21.8 23.4 24.2 24.6 Remittances 4.9 7.1 6.9 7.5 7.8 7.8 Current account balance (1.9) 1.8 1.1 0.1 (0.2) (0.4) Net foreign direct investment 1.1 0.8 0.9 1.0 1.0 1.1 Official reserves (US$ million)* 464 2,972 6,279 7,700 9,048 10,337 Official reserves (months of imports) 0.3 2.1 4.2 4.8 5.3 5.7 Exchange rate (end of period, per US$) 363.1 323.9 Exchange rate depreciation (percent) 81.2 (10.8) Inflation GDP deflator (percent) 47.5 17.5 4.2 4.8 5.4 5.6 CPI (annual average, percent) 46.4 17.4 4.2 4.8 5.4 5.6 Share of GDP Public Sector Finances Total revenue 8.4 11.1 12.5 13.4 13.8 14.0 Total expenditures 18.6 19.4 19.7 19.0 18.6 18.8 Overall fiscal balance (10.2) (8.3) (7.2) (5.6) (4.8) (4.8) Primary balance (3.7) 0.6 0.5 2.1 2.3 2.3 Public and publicly guaranteed debt 119.2 110.8 108.3 109.3 107.0 104.5 Memorandum items Nominal GDP (LKR billion) 24,064 27,630 29,430 31,605 34,333 37,382 GDP (US$ billion) 77.1 84.4 93.4 92.3 94.8 99.2 Note: * Usable reserves exclude the Chinese currency swap in 2022-2023 due to conditions on usability. 2023 figures are provisional. Sources: Ministry of Finance, Central Bank of Sri Lanka (historical data) and World Bank staff calculations (projections). 11. The primary balance registered a surplus of 0.6 percent of GDP in 2023,15 owing to the implementation of new revenue measures and a reduction in primary expenditure. Total revenue and grants as a share of GDP increased from 8.4 percent in 2022 to 11.1 percent in 2023, driven by higher rates, lower thresholds, fewer exemptions on Value Added Tax (VAT) and personal and corporate income taxes, and the newly introduced Social Security Contribution Levy. Primary expenditures fell from 12.1 percent in 2022 to 10.5 percent of GDP in 2023 due to a lower wage bill and a sharp decline in net lending,16 despite an increase in welfare payments to help mitigate the impact of the crisis on the poor and vulnerable. However, the reduction of the overall deficit was limited by a sharp rise in interest payments, which increased from 6.5 14 The illustrative debt restructuring scenario reflects ongoing discussions on official and commercial external debt restructuring. It also incorporates the terms of the domestic debt restructuring – including the T-bond exchange with superannuation funds (84 percent participation), the T-bill exchange with the central bank, and the exchange of domestic foreign currency bonds into local currency bonds – that was completed in September 2023. 15 Compared to a primary deficit of 0.7 percent of GDP projected by the IMF EFF in March 2023. 16 Due to the repayment of a loan provided by the Treasury to the Ceylon Petroleum Corporation in 2022. Page 4 The World Bank Sri Lanka Second Resilience, Stability and Economic Turnaround Development Policy Operation (P180549) percent of GDP in 2022 to 8.9 percent of GDP, due to high domestic interest rates, especially in H1 2023.17 With limited access to external financing, 78 percent of the deficit was domestically financed. More than half of the debt stock in 2023 was domestic (Table 2). Table 2: Outstanding Debt Stock and Composition (end-2023) Debt Stock (end-2023) LKR million % of GDP Total PPG Debt 30,627,266 110.8 Domestic Debt 17,051,854 61.7 Treasury bills 4,017,035 14.5 Treasury bonds 12,002,337 43.4 Others 1,032,482 3.7 External Debt 11,644,094 42.1 Multilateral creditors 3,816,950 13.8 Bilateral creditors 3,540,275 12.8 Paris Club 1,451,382 5.3 Non-Paris Club 2,088,893 7.6 Commercial creditors 4,286,869 15.5 o.w. International Sovereign Bonds 4,110,125 14.9 Memo items Public guaranteed debt 1,931,317 7.0 Note: Domestic debt excludes stock of T-bills and T-bonds held by non-residents. Public guaranteed debt excludes Letters of Comfort issued by the Treasury. The split between bilateral and commercial creditors (including International Sovereign Bonds, Sri Lanka Development Bonds, foreign currency term financing facilities, non-resident investments in T-bills and T-bonds) is estimated. Sources: Ministry of Finance, Central Bank of Sri Lanka, and World Bank staff calculations (estimates). 2.2. MACROECONOMIC OUTLOOK AND DEBT SUSTAINABILITY 12. Economic growth is forecast to turn positive in 2024. The economy is expected to gradually recover in 2024, as private consumption picks up from a low base and investment growth turns positive after contracting by over 40 percent since 2021 (Table 1). However, slower global growth is expected to reduce demand for Sri Lanka’s goods exports, while higher taxes and lower real incomes will continue to dampen domestic demand. Improvements in supply conditions (such as imports of intermediary goods and better availability of foreign exchange) will support agricultural and industrial production, especially construction, as projects resume, or new ones begin. Going beyond 2024, the scarring effect of the crisis, emigration of skilled workers, and ongoing fiscal adjustment are expected to limit growth. The modest economic recovery will be insufficient to reverse welfare losses experienced during the crisis, and the poverty rate is estimated to remain above 22 percent until 2026. The new WBPS (supported by Prior Action 8 – PA#8) is expected to provide support to the poorest and most vulnerable. 13. Inflation is expected to trend towards and remain around the inflation target of 5 percent . Annual average inflation is expected to remain low in 2024 due to a stronger LKR, a favorable base effect, downward adjustments to electricity tariffs and energy prices, and curtailed monetary financing,18 despite the effects of recent revenue measures, including removal of VAT exemptions (supported by Performance and Policy Actions for Sri Lanka in FY24)19 and an increase in VAT rates. Over the medium-term, inflationary expectations are likely to stay muted as demand side pressures 17 Interest payments remained high – 79.9 percent of total revenue in 2023 – despite the suspension of external debt servicing, reflecting the significant increase in interest rates for government securities and impact of currency depreciation. 18 Monetary financing was phased out under the new Central Bank Act approved in July 2023. The CBSL has maintained zero primary market purchases of government securities under the IMF EFF. 19 Sri Lanka is required to implement Performance and Policy Actions as part of the Bank’s Sustainable Development Financing Policy. Page 5 The World Bank Sri Lanka Second Resilience, Stability and Economic Turnaround Development Policy Operation (P180549) remain weak. However, weather disruptions could impact food prices and electricity tariffs. 14. The current account is expected to remain benign in 2024-27, as tourism recovers towards pre-crisis levels, remittance inflows remain robust, and import growth remains sluggish. The merchandise trade deficit is expected to widen in 2024 due to an increase in the import bill, as the vehicle import restrictions are eased. However, rising tourism receipts and remittances are forecast to drive a current account surplus of 1.1 percent of GDP in 2024. Over the medium- term, a small current account deficit is expected, as imports recover with economic growth and higher levels of investment, which will be partially offset by an increase in exports (supported by PA#6) and continued strong performance of tourism and remittances.20 15. Despite signs of stabilization, financial sector risks will remain high as the strong nexus between the financial sector and sovereign persists in the short to medium-term. NPLs are expected to remain high, as private sector firms in select sectors continue to be challenged by the modest economic recovery and scarring effects of the crisis. The full and sustained recovery of the financial sector will depend on a successful debt restructuring and recapitalization of the financial sector and the pace of economic recovery, as well as the continued implementation of structural reforms, especially in the SOE and financial sectors (supported by PA#3, PA#4 and PA#5). Table 3: External Financing Needs and Sources (illustrative debt restructuring scenario) US$ million 2023 2024p 2025p 2026p 2027p Gross external financing requirement 710 (855) (1,967) (2,050) (1,693) Current Account 1,560 1,033 74 (208) (358) Balance on goods (4,901) (5,156) (5,799) (6,315) (6,991) Balance on services 3,405 4,242 4,373 4,574 4,869 Primary and secondary income, net 3,055 1,947 1,499 1,533 1,765 Amortization payments (including CBSL net) (849) (1,888) (2,041) (1,842) (1,335) Identified financing sources (2,438) (474) 835 917 1,053 Bilateral and multilateral loans 842 892 980 965 850 Other flows (716) 540 1,277 1,301 1,492 Change in reserves (2,245) (1,907) (1,421) (1,348) (1,289) Errors and omissions (318) Financing gap before IFI support (1,727) (1,329) (1,132) (1,133) (640) IFI support 1,727 1,329 1,132 1,133 640 IMF 682 679 682 683 340 Other IFIs 1,046 650 450 450 300 Shortfall (-) - - - - - Memo: Reserve path 2,972 6,279 7,700 9,048 10,337 Reserves (months of imports) 2.1 4.2 4.8 5.3 5.7 Note: * Reserve path excludes the Chinese currency swap in 2023 due to conditions on usability. 2023 figures are provisional. Other flows include FDI, trade financing and portfolio flows. Sources: Ministry of Finance, Central Bank of Sri Lanka (historical data) and World Bank staff calculations (projections). 16. While the external financing outlook has improved, financial flows from multilaterals and bilateral partners will remain critical for building external buffers. Foreign Direct Investment (FDI), trade finance, and other private flows, driven by positive investor sentiments, are expected to increase following debt restructuring and the implementation of structural reforms in trade and investment. However, the repayment of swap arrangements with the Reserve Bank of India, will exert pressure on the financial account, keeping external financing needs relatively high in the medium-term. In this context, inflows from the IMF and other multilateral partners are critical to build buffers in 2024 and beyond. 20Remittances increased from 4.9 percent of GDP in 2022 to 7.1 percent in 2023. On average, Sri Lanka received 8 percent of GDP in remittances in 2015-2020. Recent emigration numbers also support an increasing trend in remittances. Page 6 The World Bank Sri Lanka Second Resilience, Stability and Economic Turnaround Development Policy Operation (P180549) Additional inflows from bilateral lenders could also cushion the financial account once external debt restructuring is complete (Table 3). 17. New revenue measures and tightly controlled expenditure will contribute to fiscal sustainability. The fiscal balance is projected to improve in 2024, with further increases in revenue, and a reduced interest bill, despite new budgeted expenditure on bank recapitalization (Table 4). Revenues will increase largely due to VAT reforms (including removal of exemptions and a further increase in the VAT rate from 15 to 18 percent), increase in trade taxes as economic activity is revived, and improvements in tax administration (supported by PA#2).21 Beyond 2024, additional revenues (mainly from administration reforms and further removal of exemptions), tightly controlled recurrent expenditures, and reduced interest payments (as government’s domestic financing costs decline) will strengthen the primary and overall balances and create space for additional capital expenditures. Table 4: Key Fiscal Indicators (illustrative debt restructuring scenario) Share of GDP unless otherwise stated 2022 2023 2024p 2025p 2026p 2027p Total Revenue and Grants 8.4 11.1 12.5 13.4 13.8 14.0 Tax revenue 7.3 9.8 11.2 12.1 12.5 12.7 Income taxes 2.2 3.3 3.3 3.5 3.5 3.5 VAT 1.9 2.5 3.5 4.0 4.2 4.2 Excise taxes 1.4 1.7 1.7 1.7 1.7 1.7 Trade taxes 1.4 1.4 1.6 1.7 1.7 1.7 Others 0.3 0.9 1.1 1.2 1.4 1.6 Non-tax revenue 0.9 1.2 1.2 1.2 1.2 1.2 Grants 0.1 0.1 0.1 0.1 0.1 0.1 Total expenditure 18.6 19.4 19.7 19.0 18.6 18.8 Current expenditure 14.6 17.0 15.7 15.5 14.9 14.8 Salaries and wages 4.0 3.4 3.5 3.4 3.4 3.3 Transfer payments 3.4 3.6 3.5 3.6 3.6 3.6 Purchases of goods and services 0.8 1.1 1.0 0.8 0.8 0.8 Interest 6.5 8.9 7.7 7.6 7.1 7.1 Capital and net lending 4.0 2.4 2.4 3.5 3.7 4.0 Bank recapitalization 1.5 Primary balance (3.7) 0.6 0.5 2.1 2.3 2.3 Overall balance (10.2) (8.3) (7.2) (5.6) (4.8) (4.8) Net foreign financing 1.8 1.8 0.8 0.5 0.4 0.0 Net domestic financing 8.4 6.5 6.4 5.0 4.4 4.8 Total PPG debt 119.2 110.8 108.3 109.3 107.0 104.5 Interest (share of revenue) 77.8 79.9 62.0 56.9 51.2 50.5 Interest (share of expenditure) 35.0 45.8 39.3 40.2 38.0 37.6 Note: 2023 figures are provisional. Sources: Ministry of Finance, Central Bank of Sri Lanka (historical data) and World Bank staff calculations (projections). 18. Sri Lanka’s debt is expected to become sustainable after the planned debt restructuring is completed, although the debt stock and service costs will remain elevated. Applying the debt sustainability targets under the IMF EFF,22 the Bank’s market access Debt Sustainability Analysis shows that after peaking at 119.2 percent in 2022, public and publicly guaranteed (PPG) debt to GDP is projected to decline to 108.3 percent in 2024, 104.5 percent by 2027, and gradually decline towards 95 percent in the outer years (Table 5). Although the gross financing need (GFN) will remain high in the short run (on average, approximately 22.4 percent between 2024 and 2027), with reductions in outer years, the average GFN is projected to remain below the IMF EFF target (an average of 13 percent of GDP in 2027–32). It is important to note 21 Tax revenues provisionally increased 42 percent in the first two months of 2024, vis-à-vis the same period in 2023, driven by higher VAT collections. 22These debt targets are: (i) level of debt should decline below 95 percent of GDP by 2032; (ii) average GFN should remain below 13 percent of GDP in 2027–2032 and remain on a downward trajectory thereafter; and (iii) foreign exchange debt service should not exceed 4.5 percent of GDP in any year during 2027–32. Page 7 The World Bank Sri Lanka Second Resilience, Stability and Economic Turnaround Development Policy Operation (P180549) that the reduction in GFN in the outer years hinges on the ability to replace maturing T-bills with longer-term T-bonds, which is subject to the absorptive capacity of the domestic market and can be strengthened through better debt management (supported by PA#1). Due to the restructuring of commercial public debt, the foreign exchange share of annual public debt service is projected to remain well below the IMF EFF target of 4.5 percent of GDP. However, even after the debt restructuring, PPG debt stock is forecast to remain greater than 100 percent of GDP in 2027, with debt interest payments nearly half of revenue in 2027. Stress tests suggest that a real GDP or real exchange rate shock could adversely affect the path of debt reduction (Figures 1 and 2). Table 5: Debt Sustainability Analysis – illustrative debt restructuring scenario (in percent of GDP unless otherwise indicated) Actual Projections 2013-2021 2022 2023 2024 2025 2026 2027 2028 2029 Nominal gross public debt 84.7 119.2 110.8 108.3 109.3 107.0 104.5 102.6 100.7 Public gross financing needs 19.0 25.6 29.7 25.3 24.1 21.9 18.2 15.8 12.6 Real GDP growth (in percent) 3.1 -7.3 -2.3 2.2 2.5 3.0 3.1 3.1 3.1 Inflation (GDP deflator, in percent) 4.6 47.5 17.5 4.2 4.8 5.4 5.6 5.0 5.0 Nominal GDP growth (in percent) 7.8 36.6 14.8 6.5 7.4 8.6 8.9 8.3 8.3 Effective interest rate (in percent) 7.0 8.1 8.6 7.4 7.6 7.0 7.2 7.1 7.2 Actual Projections 2013-2021 2022 2023 2024 2025 2026 2027 2028 2029 cumulative Change in gross public sector debt 4.7 8.8 -8.3 -2.6 1.0 -2.3 -2.4 -2.0 -1.9 -10.2 Identified debt-creating flows 3.1 6.9 -12.9 0.4 -1.9 -3.9 -3.9 -3.4 -3.2 -15.9 Primary deficit 1.7 3.7 -0.6 -0.5 -2.1 -2.3 -2.3 -2.3 -2.3 -11.7 Primary (noninterest) revenue and grants 11.4 8.4 11.1 12.5 13.4 13.8 14.0 14.0 14.0 81.7 Primary (noninterest) expenditure 13.1 12.1 10.5 11.9 11.3 11.5 11.7 11.7 11.7 70.0 Automatic debt dynamics 1.3 3.2 -12.2 1.0 0.2 -1.6 -1.6 -1.1 -1.0 -4.2 Interest rate/growth differential -0.5 -23.1 -6.5 1.0 0.2 -1.6 -1.6 -1.1 -1.0 -4.2 Of which: real interest rate 1.6 -29.0 -8.9 3.2 2.7 1.4 1.4 1.9 2.0 12.7 Of which: real GDP growth -2.1 5.9 2.4 -2.3 -2.5 -3.1 -3.1 -3.0 -2.9 -16.8 Residual, including asset changes 1.7 1.9 4.5 -3.7 -0.1 0.0 0.0 -0.1 -0.1 -4.0 Note: 2023 figures are provisional. Source: Ministry of Finance, Central Bank of Sri Lanka (historical data) and World Bank staff calculations (projections). Figure 1: PPG debt scenarios Figure 2: Gross financing needs scenarios (Percent of GDP) (Percent of GDP) Source: World Bank Source: World Bank Page 8 The World Bank Sri Lanka Second Resilience, Stability and Economic Turnaround Development Policy Operation (P180549) 19. The macroeconomic framework is subject to high downside risks. A debt reduction plus sufficient financial support from international partners and the domestic market are needed to close the external financing gap for 2024-27, and for the economy to regain a sustainable macroeconomic trajectory. Given the likely parameters of external debt restructuring and available financing from international financial institutions and the domestic market, the path to fiscal and external sustainability remains narrow. Significant downside risks to the outlook, and implications for growth and poverty, include: (i) insufficiently deep external debt restructuring; (ii) lower-than-expected external or domestic financing, limited ability to replace maturing T-bills with longer-term T-bonds, or higher cost of financing due to high sovereign risk premiums; (iii) delay in or weaker than expected fiscal adjustment; (iv) a slowdown or reversal in macro- critical reforms in the run-up to and after the national elections; and (v) a deterioration of financial sector stability prior to bank recapitalization. On the upside, a faster recovery of tourism and larger remittance flows could raise the growth path and build additional fiscal and external buffers. A strong and sustained implementation of the structural reform program could boost confidence and attract fresh investment (supported by PA#6) and capital inflows. Restructuring and improvements in governance of SOEs will reduce related fiscal pressures and macro-fiscal risks (supported by PA#5).23 Finally, a pick-up in private sector credit growth (supported by PAs#3 and 4), and improvements in labor force participation, driven by an increase in female participation (supported by PA#9), could strengthen the economic recovery. 2.3. IMF RELATIONS 20. The second review of the IMF EFF program was completed on June 12, 2024. The 48-month EFF program of SDR 2.286 billion (approximately US$3 billion) was approved in March 2023. The EFF aims to restore macroeconomic stability and debt sustainability, safeguard financial stability, enhance governance, and step-up structural reforms to unlock Sri Lanka’s growth potential. With the completion of the second review, Sri Lanka received an additional tranche of SDR254 million (about US$336 million), bringing the total IMF financial support disbursed to-date under the EFF to SDR762 million (about US$1 billion). The reforms included in the RESET DPO series have been closely calibrated and sequenced with the EFF. These include complementarities in areas such as debt management, public financial management, tax administration, social protection, and the energy and financial sectors. 3. GOVERNMENT PROGRAM 21. The GoSL’s reform priority is to consolidate economic stabilization and revive growth through structural reforms and debt restructuring under the following key pillars: (i) a primarily revenue-based fiscal consolidation, accompanied by institutional reforms and cost-recovery based energy pricing; (ii) a stronger social safety net; (iii) debt restructuring aimed at restoring public debt sustainability; (iv) a multi-pronged strategy to restore price stability and rebuild international reserves under greater exchange rate flexibility; (v) policies to safeguard financial stability; (vi) focused reforms to address governance and corruption issues; and (vii) broader structural reforms to enhance Sri Lanka’s growth potential. Several of these reforms have been initiated and implemented through the 2022 Interim Budget, 2023 and 2024 Budget’s, and EFF Memorandum of Economic and Financial Policies, including new revenue measures and a social welfare payment program (Aswesuma); the reform of SOEs; cost-reflective pricing of utilities; important legal frameworks such as the new Central Bank, Public Financial Management (PFM), Public Debt Management (PDM) and economic reform laws, and legislation to uphold gender equality principles and empower women. 22. The support provided by the RESET DPO series is an important contributor to the success of GoSL’s program. The first pillar includes measures to address several governance failures which contributed to the crisis and strengthen 23Strong progress has been made in the power sector reforms, supported by PA#5. The implementation of cost-recovery energy pricing is underway. The Electricity Act of July 2024 aims to enhance sector performance through regulatory reform and the restructuring of energy SOEs, thereby promoting efficiency and transparency. Additionally, government is addressing SOE risks through broader reforms, including better management, increased competition, and reduced reliance on state borrowing. The new PDM Act (June 2024, supported by PA#2) and new PFM Act (July 2024) will further strengthen SOE governance and fiscal discipline. Efforts to shift state-owned banks away from SOE lending and improve their governance, along with CBSL requirements to reduce aggregate SOE exposures in the banking sector by 2030, also support these improvements. However, macro-fiscal risks, stemming from SOEs, will prevail and continued monitoring is required. Page 9 The World Bank Sri Lanka Second Resilience, Stability and Economic Turnaround Development Policy Operation (P180549) institutional arrangements to help stabilize the economy and ensure the sustainability of the reforms. The second pillar includes measures to increase the competitiveness and outward orientation of the economy by levelling the playing field and opening space for new entrants in core markets and reducing barriers to international trade. The third pillar seeks to help the poorest and most vulnerable through the economic adjustment, and support women to participate more fully and equally in Sri Lanka’s recovery. The DPO series is an appropriate response to Sri Lanka’s current context, given that stabilization policies and structural reforms are critical for macroeconomic stability and to support a growth orientated recovery. Similar to the EFF, the use of budget support has helped provide needed foreign exchange quickly to keep social services going, finance critical imports, and boost confidence in the economy. 4. PROPOSED OPERATION 4.1. LINK TO GOVERNMENT PROGRAM AND OPERATION DESCRIPTION 23. The program development objective (PDO) is to support foundational reforms that restore macroeconomic stability and sustainability, mitigate the impact of current and future shocks on the poor and vulnerable, and support an inclusive and private-sector-led recovery and growth path. The proposed operation is the second and last of the RESET programmatic series initiated in 2023. 24. The RESET series supports GoSL’s reform plan to stabilize the economy and foster sustainable growth through three pillars: (i) improving economic governance through better fiscal and debt management, improving tax policy and administration, and addressing financial sector risks; (ii) enhancing growth and competitiveness through regulatory reforms, institutional restructuring and increasing competition in core sectors (i.e., electricity and broadband), and reforms to the trade regime; and (iii) protecting the poor and vulnerable through the rolling out of a new WBPS and reducing gender discrimination. 25. The proposed operation is aligned with the goals of the Paris Agreement (see Annex 5). First, the operation is consistent with Sri Lanka’s climate commitments including the Nationally Determined Contribution (NDC),24 the National Adaptation Plan (2016-2025),25 and the Climate Prosperity Plan.26 As part of its 2021 NDCs, Sri Lanka has committed to reducing greenhouse gas (GHG) emissions by 14.5 percent by 2030. Second, no prior actions (PAs) for the proposed DPO will likely cause a significant increase in GHG emissions to impede Sri Lanka’s planned low-carbon development path, nor will they inhibit the development of the country’s adaptation measures. The National Tariff Policy (NTP) and new Electricity Act will operate in compliance with the National Environment Act (NEA) and other laws pertaining to environmental management and conservation and could be a gateway to promoting better mitigation and adaptation technologies. Specifically, the Electricity Act will help reduce GHG emissions by encouraging investments in renewable energy and enhancing grid resilience through decentralization. Further, the structural reforms supported through the DPO, which aim to improve economic governance (Pillar 1), enhance growth and competitiveness (Pillar 2), and better protect the poor and vulnerable (Pillar 3), will contribute to economic stabilization and growth. The improved economic conditions and business environment will attract foreign investments, boosting economic growth and employment while helping to accelerate climate adaptation and reduce GHG emissions as the country transitions towards net negative emissions. This influx of investments is needed for financing adaptation needs, as these cannot be met solely through public investments. Overall, the country's policy, legal, and regulatory framework for managing potential environmental consequences from the PAs is considered adequate, with further strengthening expected upon completion of the NEA amendment process. 24 Nationally Determined Contributions, Ministry of Mahaweli Development and Environment Sri Lanka, 2016. Available at https://lpr.adb.org/sites/default/files/resource/415/sri-lanka-nationally-determined-contributions.pdf.pdf 25 Ibid 26 Sri Lanka Climate Prosperity Plan: Preliminary Report. Available at https://unfccc.int/sites/default/files/resource/SriLanka_LTLEDS.pdf Page 10 The World Bank Sri Lanka Second Resilience, Stability and Economic Turnaround Development Policy Operation (P180549) 26. The design of the operation builds on lessons from previous DPOs in Sri Lanka and the region.27 First, a programmatic approach was proposed, as the implementation of the reform program will take several years. Second, to fully achieve expected outcomes, Parliamentary approval of legislation and, where appropriate, the issuance of implementing regulations were set as the targets of DPO2 reforms. Third, to ensure government ownership and implementation, this operation is closely coordinated by a team in the Office of the President, Ministry of Finance (MoF) and CBSL. Finally, to mitigate the risk of reform reversals, the Bank has engaged with local think-tanks, political parties across the political spectrum, and with the public on reform design and implementation. As a result, the Bank and other DPs are working closely with GoSL to ensure that these areas have the commitment and resources needed to ensure the success and sustainability of the DPO2 reforms. 4.2. PRIOR ACTIONS, RESULTS AND ANALYTICAL UNDERPINNINGS Pillar I: Improving Economic Governance 27. This pillar includes measures to both address governance problems that contributed to the economic crisis and ensure better governance to support a stronger recovery. Specific PAs focus on policies to strengthen debt management, improve tax administration, and reduce systemic risks in the financial sector. Strengthening the governance framework, institutional structures and coordination in these macro-critical areas is essential for Sri Lanka’s medium to long-term macroeconomic stabilization and development path. As discussed in Annex 6, changes to the original triggers include: (i) not requiring certain implementing regulations and reporting requirements (i.e., PA#1 and PA#2); and (ii) revising PA language to strengthen or adjust the legal instrument or scope of the action (i.e., PA#2 and PA#4). These changes do not have a material impact on the strength of the pillar. The pillar’s measures closely complement the EFF program. Reform objective 1: improve fiscal and debt management DPO2 PA#1: To improve debt management, Sri Lanka has enacted a new Public Debt Management (PDM) law, as evidenced by publication in the Official Gazette of the certified Public Debt Management Act No. 33 of 2024. 28. Rationale & Policy Content: The current debt management legal and institutional framework is fragmented, which constrained consolidated strategic planning and led to the accumulation of debt with suboptimal transparency and limited considerations of cost and risk. The new PDM law clearly defines MoF’s borrowing authority and the Public Debt Management Office (PDMO) as the single entity to manage public debt. The law aims to ensure improved debt transparency by defining PDMO’s debt recording responsibilities, including the minimum content and publication timeframe of key reports. Moreover, general guidelines for the granting of sovereign guarantees and on-lending are defined, including the requirement for a credit risk assessment of borrowers before the approval of the potential transaction. In order to ensure robust initial implementation of the PDM law, the establishment of the PDMO and regulations for the granting of sovereign guarantees and on-lending will be proposed as Performance and Policy Actions (under the Sustainable Development Financing Policy) for Sri Lanka in FY25. 29. Expected results: By streamlining and consolidating debt related legislation and creating a dedicated debt management office, Sri Lanka will ensure that debt management decisions are coordinated under the guidelines of a Medium-Term Debt Management Strategy and an Annual Borrowing Plan, which will prevent fragmented external and domestic borrowing decisions. An ultimate result of this reform is the creation of a strong institutional structure for borrowing decisions that maintains public debt at sustainable levels and contributes to macroeconomic stability. In addition, more rigorous requirements for granting state guarantees will help contain the exposure of the financial sector, especially SOBs, to problematic SOEs, which has been a source of instability in the sector. 27This includes the Catastrophe Deferred Drawdown Option in 2014, Competitiveness, Transparency and Fiscal Sustainability DPO in 2016, and the first Resilience, Stability and Economic Turnaround (RESET) DPO in 2023. Page 11 The World Bank Sri Lanka Second Resilience, Stability and Economic Turnaround Development Policy Operation (P180549) Reform objective 2: improve governance of tax administration DPO2 PA#2: To strengthen governance of tax administration and its enforcement capability: (i) MoF has specified the type, scope, frequency and manner of 3rd party data to be shared by the relevant counterparts under the Inland Revenue Act as evidenced by publication in the Official Gazette No. 2376/25-2024 of the regulation issued by MOF and letter dated July 2, 2024 issued from the Secretary General of Parliament to the Presidential Secretariat confirming its approval; (ii) IRD has introduced risk management guidelines on categorization of risks associated to tax administration as evidenced by the issuance by the IRD Commissioner General of the Risk Management Guide-2023; and (iii) MoF has issued a Tax Expenditures Statement (TES) estimating revenue foregone for all the major taxes, as evidenced by publication of the TES dated March 31, 2024, on the MoF website. 30. Rationale & Policy Content: Tax administration reforms to strengthen tax compliance and enforcement are critical to support the revenue-based fiscal adjustment and, ultimately, broaden the tax base. Currently, IRD obtains third party information through MoUs with agencies such as banks and property registration authorities in local government, but compliance is weak. The current system of tax audits, led by a single jurisdictional field officer with limited information, is vulnerable to discretion in the selection of cases. Furthermore, the volume of tax expenditures is large (approximately 50 percent of 2022 tax revenue), but neither the criteria for the attribution of tax incentives nor the amount of foregone revenue is regularly published, limiting transparency. The first component of PA#2 creates a legal obligation for financial institutions and government departments to share taxpayer transaction-level information with IRD in a systematic and time-bound manner (building on the related reform, PA#2, in DPO1). Component two then introduces an improved risk- based audit selection system based on this information (including the formation of a Risk Management Committee and Risk Management Unit, and a broad definition and categorization of risks). The third component of PA#2 supports government’s efforts to increase transparency through the publication of a Tax Expenditures Statement (TES), which will also be mandatory under the new PFM Act, as part of the Annual Budget package. The TES provides estimates of the revenue foregone from tax incentives, including disaggregated estimates for income taxes, VAT and customs duties. 31. Expected results: PA#2 is expected to measurably improve tax collection through better compliance and reporting, more tax returns being filed, better targeted tax audits, and more information being available to verify tax compliance. Third-party data reporting will help identify transactions with liability for taxation and hence provide useful inputs for compliance risk management. The Annual TES will calculate revenue foregone from tax incentives and will clearly identify and quantify the composition of such tax expenditures to better inform policy decision-making. Reform objective 3: safeguard financial sector stability and restore the flow of credit to the private sector DPO2 PA#3: To reduce systemic risks, strengthen financial sector stability, and enhance the enabling environment for corporate non-performing loan (NPL) resolution CBSL has stipulated: (i) tightened prudential limits for the maximum exposures that banks can have vis-à-vis single borrowers and to a group of connected borrowers, including SOEs, as evidenced by CBSL Directive No. 01 of 2024 (“Large Exposures of Licensed Banks”) dated March 25, 2024 and published on the CBSL’s website; and (ii) enhanced requirements for banks when reviving distressed but viable business and a standardized workout process in accordance with international best practices as evidenced by CBSL Circular No. 02 of 2024 (“ Guidelines for the Establishment of Business Revival Units in Licensed Banks”) dated March 28, 2024 and published on CBSL’s website. 32. Rationale & Policy Content: The financial sector is excessively exposed to financially distressed SOEs, owing to the existing regulatory framework, which have enabled SOBs to perpetuate the flow of funds to the para-statal sector. Concentration risk in the banking sector is also high due to large exposures in certain sectors and large private sector borrowers. The rewriting of the regulation on single borrower exposure limits aims to address these weaknesses and lay the foundations for a robust, more inclusive financial sector that is more effective in channeling resources to meet the financial demands of the real economy. In parallel, Sri Lanka lacks an adequate legal and regulatory framework to provide opportunities to distressed, but potentially viable, borrowers to restructure their debt and continue to operate – an important goal in light of the recent crisis. The amendments to Circular No. 1 of 2022 seek to enhance the operational Page 12 The World Bank Sri Lanka Second Resilience, Stability and Economic Turnaround Development Policy Operation (P180549) effectiveness of commercial banks’ business revival units in rehabilitating distressed companies by setting out prudent policies in terms of borrower eligibility and loan restructuring practices. In addition, the amended Circular includes enabling clauses for multi-creditor, corporate workouts,28 aimed at coordinating and encouraging the voluntary restructuring of loans to large, distressed corporates. 33. Expected results: PA#3 is expected to contribute to the stabilization of the financial sector and its repurposing from a financing tool for the state and SOEs to providing funding for the broader economy. In addition to reducing concentration risks, the PA will contribute to economic recovery by facilitating relief to viable businesses under distress. The measures are expected to contribute to a significant lowering in lending volumes to SOEs from 8.5 percent of total banking assets and 21 percent of SOBs assets in 2022 to 4.5 and 10 percent by 2025, respectively.29 The lower exposure to SOEs will contribute to the stabilization of the banking sector and release liquidity to support an inclusive private-sector- led recovery. It will also facilitate the SOE restructuring process through a hardening of the budget constraint. DPO2 PA#4: To enhance banking sector stability and performance, Sri Lanka has initiated the restructuring process for state-owned Bank of Ceylon (BOC) and People’s Bank (PB) as evidenced by Cabinet Paper No. 24/0695/604/078 approving improved governance arrangements and strategic direction for both banks. 34. Rationale & Policy Content: The recent crisis revealed that Sri Lanka’s two largest SOBs (holding 40 percent of total banking assets) have unsustainable business models and serious governance weaknesses. The long-standing practice of using Bank of Ceylon (BoC) and People’s Bank (PB) to finance public debt and loss-making SOEs has resulted in substantial losses, as confirmed by the independent Asset Quality Review (AQR) completed in 2023. While the risk of systemic banking crisis has receded, the authorities need to implement a comprehensive restructuring strategy for large SOBs to enable these systemically important financial institutions to support the economic recovery and to prevent the reoccurrence of problems caused by the bank-sovereign nexus going forward. To this end, the GoSL (as the owner) is committed to overhaul the business models of BoC and PB away from financing the budget and SOEs, towards financing the private sector and with a particular focus on segments underserved by private banks. The GoSL has also committed to ensuring the regulatory capital compliance of both banks, including through budget transfers in 2024.30 Critically, GoSL has decided to upgrade the corporate governance requirements for SOBs in line with international good practice, including reconstituting the Board of Directors with a majority of independent members (including the chairperson) and strengthening the risk management functions. In parallel, the CBSL (as the regulator) instructed BoC and PB to prepare detailed, time-bound recapitalization plans, reflecting the findings from the AQR and the impacts from SOE and sovereign debt restructuring.31 This is being supported by the IMF EFF (as a structural benchmark) and through Bank TA. 35. Expected results: The ongoing restructuring should turn BoC and PB into well-managed commercial entities that are fully compliant with CBSL’s tightened prudential requirements. Together with PA#3 measures and other sector reforms 28 Workout is a type of restructuring procedure to address the financial distress of an enterprise. Workouts are rarely compulsory frameworks, as they are meant to encourage informal restructurings, with central banks typically playing a strong role in exerting moral suasion to encourage banks to use the workout schemes and/or a Framework Agreement, which can be negotiated at the outset contractually binding banks to use the scheme during loan restructurings. The Sri Lanka Banks’ Association is currently considering the second model and developing a Framework Agreement, with assistance from the World Bank. 29 The Directive No 1 of 2024 on Large Exposures will enter into force in January 2026, with a three-year transition period. This transitional arrangement is required as the two largest SOBs have sizable legacy loans and the capacity of the financial system to absorb excess exposures by other borrowers is constrained in the short- term. Despite these factors, banks have already started reducing their large exposures, including on instruction of the CBSL, in anticipation of the new requirements. Stronger independence and enforcement powers of CBSL should ensure the effective implementation of the regulation, especially with regards to SOE exposures. A longer transition period for the reduction of aggregate exposures to SOEs mitigates the risk of financing constrains of SOEs in the short-term. 30 The 2024 National Budget includes an allocation of LKR 450 billion to support recapitalization of banks. The amount was informed by the AQRs conducted under the supervision of the CBSL, which were based on strict assumptions and less favorable macroeconomic conditions. 31 The recapitalization plans are at the final stage of preparation, pending the restructuring of the FX debt of Ceylon Petroleum Corporation. Broader efforts to support the restructuring of SOBs have been supported by stronger provisions of the recently enacted CBSL Act, Banking (Special Provisions) Act (supported under DPO1), Banking (Amendment) Act, which have strengthened the independence, as well as enforcement powers and tools of CBSL that can be used to ensure the continuity of restructuring efforts. Page 13 The World Bank Sri Lanka Second Resilience, Stability and Economic Turnaround Development Policy Operation (P180549) (including Banking Law amendments supported under IMF EFF), the SOB reforms will help safeguard banking sector stability, reduce the bank-sovereign nexus, and reactivate credit flows to support a stronger private sector-led recovery. Pillar II: Enhancing Growth and Competitiveness 36. The second pillar includes measures to increase competition and mobilize private capital in core markets (i.e., electricity and broadband) through regulatory reform and SOE restructuring, and to improve export competitiveness through reforms to the trade regime. A fragmented and inward-oriented trade regime, as well as dominant positions of loss-making SOEs in core markets are binding constraints to export competitiveness and growth. The reforms under this pillar are essential for improving the cost and quality of goods and services, opening opportunities for private sector investment and, ultimately, Sri Lanka’s medium to long-term competitiveness and growth performance. As discussed in Annex 6, changes to the original triggers include: (i) removing legislation that could not be enacted prior to the presidential and parliamentary elections as further political consensus is required to ensure broad support for the reforms or mitigate the risk of reform reversal (i.e., PA#5 and PA#6); and (ii) including new legislation in the prior actions that is deemed critical to advance reforms seeking to increase competition in core markets (i.e. PA#5 and PA#7). These changes do not have material impact the achievement of the development objective of the operation. Reform objective 4: improve power sector performance through regulatory reform and SOE restructuring DPO2 PA#5: To ensure a more effective, efficient and financially and commercially sustainable power sector, Sri Lanka has enacted a new Electricity Act, as evidenced by publication in the Official Gazette of the certified Sri Lanka Electricity Act No. 36 of 2024. 37. Rationale: Power sector restructuring is critical to macro-stability and a core pillar of the SOE reform effort. It is required to address several challenges. At the outset, this includes decreasing the occurrence of load shedding and blackouts, reducing the burden currently posed on the financial sector (especially SOBs), while bringing more transparency, accountability, and better governance to the power sector. Moving forward the sector needs to attract new investments, promote transparency and competition, and diversify generation through decarbonization and achieving the country’s renewable energy goals. At the same time, the independence of the Regulator over licensing and tariff decision making needs to be maintained. The power sector has been dominated by a single integrated utility, the Ceylon Electricity Board (CEB), which holds four of the five distribution licenses – the transmission, bulk supply, and operations licenses, and a generation license covering about 65 percent of generating capacity in the country. The 2009 Sri Lanka Electricity Act established the Public Utilities Commission of Sri Lanka (PUCSL) to regulate the electricity industry. However, until the outbreak of the economic crisis, CEB showed little responsiveness to regulatory initiatives, constraining PUCSL’s ability to regulate the industry efficiently. The new cost-reflective tariff methodology, introduced in 2022, has halted the recurrent losses incurred by CEB and paved the way for the entry of new market players. Nevertheless, the successful restructuring of the power sector will ultimately require more comprehensive reforms, including transitioning to open access for the grid, and a more competitive electricity market where a government owned entity is not the single off taker for all electricity generated. The latter would also reduce the need for sovereign guarantees. Unbundling of CEB into separately incorporated and managed entities is one of the first steps towards this transition. 38. Policy Content: The new Electricity Act substantially advances these goals, as well as the objectives of the SOE Reform Policy Paper (supported by PA#5 in DPO1) in a core market.32 The Act mandates the unbundling of CEB into multiple, separate generating companies, a separate network system operator, a separate national transmission network service provider, and multiple, separate distribution companies. With certain exceptions (e.g., the hydro company, the network system operator), these new entities can become wholly or partially owned by private investors, thus enabling 32 The objectives of the SOE Policy are to open markets and improve the enabling environment for increased private participation; to improve the quality, price and accessibility of goods and services provided to all citizens; and to reduce the fiscal burden of SOEs. The Policy is grounded on principles of professional management, robust governance and transparency mechanisms, financial sustainability, and the unbundling of regulator and operator functions. Page 14 The World Bank Sri Lanka Second Resilience, Stability and Economic Turnaround Development Policy Operation (P180549) more investments. The Act opens the market by mandating open and non-discriminatory access to the power grid, requiring competitive procurement for new generation and transmission, and strengthening the Regulator’s decision- making authority over licensing and tariff setting. The Act mandates cost-based principles for tariffs (including reasonable return on investments) to promote the financial viability of the sector and requires the preparation and periodic review of a national electricity policy, a national tariff policy, and an annual power procurement plan. The Act also establishes a path to a competitive wholesale electricity market. Through these steps, new entrants, investors and lenders will gain greater visibility into the sector and risks can be identified and mitigated. More rigorous competition in procurement, supply and sector participation will ultimately benefit electricity consumers. These follow-on reforms will be supported by technical assistance in coordination with development partners, including with ADB. 39. Expected Results: PA#5 is expected to improve transparency, openness, competition, and accountability in the sector, which in turn will promote financial stability, new investments and new entrants, greater system reliability, and progress towards climate change and decarbonization goals. At the onset, this includes finalization of a Transfer Plan by 2025 for the unbundling of CEB. Reform objective 5: reduce trade policy uncertainty and increase competitiveness DPO2 PA#6: To increase access to imported inputs and capital goods and encourage export orientation, Sri Lanka has through MoF, approved a National Tariff Policy (NTP) that commits to a predictable path of reduction of import duty protection over a four-year period as evidenced by minutes of the meeting of the Cabinet Paper No. 24/1072/604/114 approving the NTP. 40. Rationale & Policy Content: Sri Lanka has become a significantly more inward-orientated economy since the turn of the century with serious implications for the balance of payments. Over the 2000-2023 period, the share of trade to GDP more than halved from 88 to 43 percent and that of exports to GDP from 39 to 18 percent. The inward turn has been caused by a steady real appreciation of the exchange rate and a surge in import barriers. High rates of tariff protection disincentivize exports as firms prefer to sell domestically instead of exporting, while high tariffs on intermediate inputs and capital goods reduce investment, increase production costs and negatively affect the ability of exporters to compete in foreign markets. The ad-hoc introduction and constant revision of para-tariffs adds to policy complexity and uncertainty, distorting long term investment plans of firms and acts as a drag to private sector investment. The new National Tariff Policy (NTP) lays out a framework to reduce import duties and tariff complexity, phase out import duty exemptions, and continue the process to eliminate para-tariffs. Given current fiscal constraints, the tariff rationalization will aim at being close to revenue neutral, by gradually reducing tariffs on intermediate inputs and capital goods first and making up for those reductions by reducing import tax exemptions. 41. Expected results: The Cabinet decision requires the NTP to be gazetted. As such, the government has committed to gazette the NTP as a part of the 2025 Budget process. Implementation of the NTP is expected to boost investment by reducing the cost of importing capital goods (given lower tariffs) and lowering the hesitancy of firms to invest (given more certainty on future tariff policy changes). The NTP is also expected to enhance export competitiveness by improving access to imported inputs and capital goods for exporters, and increasing incentives to export by reducing the anti-export bias inherent in the high tariffs that currently protect domestically produced goods. The increased outward orientation of the economy is expected to increase the share of trade to GDP by approximately 5 percent over 2021-25, and contribute to the reduction of external imbalances and stronger economic growth. Page 15 The World Bank Sri Lanka Second Resilience, Stability and Economic Turnaround Development Policy Operation (P180549) Reform objective 6: mobilize private capital and competition in the broadband market DPO2 PA#7: To expand access to affordable broadband services, facilitate private capital and develop competitive markets, Sri Lanka has: (i) enacted amendments to the Sri Lanka Telecommunications Act No. 25 as evidenced by publication in the Official Gazette of the certified Sri Lanka Telecommunications (Amendment) Act No.39 of 2024; and (ii) issued implementing regulations for the adoption of a sector specific competition regulation framework as evidenced by Rules made by the TRCSL and published in the Official Gazette. 42. Rationale & Policy Content: Sri Lanka’s digital sector is relatively advanced in the region, yet prices of high-quality broadband services are unaffordable to a large part of the population while more than half of households lack access to the fiber optic network altogether. Limited levels of competition in Sri Lanka’s broadband market have curtailed investment and innovation. The legal framework is outdated, limiting the ability of the regulator to adopt necessary global standard practices to promote competition. The amendments to the Telecommunications Act (which have been more than a decade in the offing), and the introduction of regulations related to competition will strengthen the ability of the regulatory agency (TRCSL) to define and implement regulations in a predictable and transparent manner. Competition is critically important in telecoms markets, as it drives innovation and technological advancement, encourages private investment, leads to more competitive pricing, and encourages wider coverage, including among rural or underserved areas or communities, thereby reducing the digital divide. 43. Expected results: The updated regulatory framework will strengthen the ability of TRCSL to: (i) reduce entry barriers to telecommunications markets, (ii) increase competitive pressure to help keep prices low and promote innovation in technology and services, and (iii) align Sri Lanka’s regulatory regime with international good practices, potentially attracting investment. This framework is expected to facilitate additional private investments worth at least US$100 million over 2022-2025 to provide affordable and high-quality broadband connectivity. Such investments are anticipated to increase broadband access from 8.8 million people in 2022 to 12 million in 2025, contributing to the growth of the digital economy. Pillar III: Protecting the Poor and Vulnerable 44. The third pillar seeks to strengthen the social protection system and reduce gender discrimination. This will involve improving the governance, effectiveness, and efficiency of the country’s social protection system, to help the poor and vulnerable cope better with the price-adjustments resulting from the macro-fiscal reforms implemented in the aftermath of the economic crisis as well as with future shocks, including those related to climate change. Furthermore, a stronger legal framework will be created to effectively address gender discrimination by stipulating and safeguarding the social, economic and political rights of women. Whilst Unified Labor Legislation (ULL) is being prepared to comprehensively overhaul archaic labor legislation, including discrimination based on gender, the new Women’s Empowerment (WE) Act and establishment of a National Commission on Women (NCW) constitute important intermediate steps. The WE Act directly prohibits discrimination based on gender in employment and promotes revision of laws and procedures to ensure equal salaries between men and women engaged in employment with equal value. As discussed in Annex 6, changes to the original triggers include: (i) removing regulations that need significantly more consultations and potentially larger legislative adjustments (i.e., PA#8); and (ii) the introduction of foundational legislation to address women empowerment and gender inequalities (i.e., PA#9). These changes do not have a material impact on the achievement of the development objectives of the operation. Reform objective 7: strengthen social protection institutions, delivery systems, and targeting DPO2 PA#8: To ensure increased impact and sustainability of the social protection system, Sri Lanka has issued regulations authorizing implementation of the periodic recertification of WBPS beneficiaries as evidenced by an amendment to the Welfare Benefit Payment (Selection of Persons Eligible to Receive Payments) Regulations No. 1 of 2022 issued by the Minister of Finance Page 16 The World Bank Sri Lanka Second Resilience, Stability and Economic Turnaround Development Policy Operation (P180549) and published in Extra Ordinary Gazette No. 2382/02 dated April 29, 2024 and letter dated June 7, 2024 issued by the Secretary General of Parliament to the Presidential Secretariat confirming approval by Parliament of such amendment. 45. Rationale & Policy Content: The economic crisis and structural reforms have had a significant negative impact on the poor and vulnerable (poverty doubled from 13.1 to 25 percent in 2022). The social protection system was ill-equipped to respond to these challenges effectively due to multiple weaknesses, including: (i) inadequacy of cash transfer (CT) benefits; (ii) poor coverage of the poor and vulnerable;33 and (iii) limited system capacity to respond to crises. Social assistance reforms were initiated under DPO1 with the introduction of Aswesuma and a new social registry. However, given the poverty and vulnerability situation of families evolve constantly, their eligibility for poverty targeted programs will need to be regularly reassessed. PA#8 will ensure that families’ situations are updated regularly by conducting a recertification for all families periodically, such that those that are still deemed poor will continue to receive benefits, while others who have moved out of poverty will graduate from the program and their benefits cease. 46. Expected results: PA#8 is expected to improve the targeting of Aswesuma by mandating the regular means testing of beneficiary families. This measure is expected to mitigate the impact of current and future shocks on the poor and vulnerable by improving the coverage of the poorest 20 percent by cash transfer programs (i.e., from 43 to 60 percent over 2022-25) and of female headed households34 by Aswesuma (i.e., from 0 to 20 percent over 2022-25). Reform objective 8: reduce discrimination on the grounds of gender and remove barriers to female labor force participation (FLFP) DPO2 PA#9: To reduce legal discrimination on the grounds of gender – including gender discrimination in the labor market – and enable the enforcement of Sri Lanka’s obligations under the Convention on the Elimination of all Forms of Discrimination Against Women (CEDAW), Sri Lanka has enacted the Women Empowerment (WE) Act as evidenced by publication in the Official Gazette of the certified Women Empowerment Act, No. 37 of 2024. 47. Rationale & Policy Content: Sri Lanka exhibits large gender gaps in FLFP (32 percent compared to 71 percent for men in 2022). While the reasons for these gender gaps are complex, Sri Lanka’s current legal framework, which includes many explicit restrictions on women’s employment, is a contributing factor. For example, the Employment of Women, Young Persons and Children Act (1956) requires employers to get written sanction for women to work after 10pm, and no woman can be employed for more than ten days per month of night work. Furthermore, the Shop and Office Employees Act (1954) restricts the number of working hours for female employees and their ability to work at night in specific sectors. The WE Act aims to reduce legal discrimination on the grounds of gender in several key areas of social, economic and political participation. It is an important intermediate step while further labor legislation reforms are pursued through the ULL. By establishing a framework to enforce the implementation in Sri Lanka of CEDAW, the WE Act includes specific clauses around addressing inequalities in women’s economic participation and discrimination in the workforce. This includes ensuring women’s equal rights to the same employment opportunities and remuneration as men. For example, the WE Act allows the relevant Minister to adopt regulations necessary to reduce gender based discrimination in the workplace, whilst the NCW will monitor the implementation of anti-discriminatory measures in state institutions, non- state entities and the private sector. Importantly, the Act includes a provision to allow the NCW to investigate reported discriminatory employment practices, enabling women to obtain redress against such practices. 48. Expected results: The passage of the WE Bill represents a significant policy commitment to promote gender equality – including in the workplace. Reforms supported by the PA are expected to contribute to lowering barriers for women’s access to formal employment. The establishment of the NCW will create a mechanism for the investigation of infringements to women’s rights in the workplace and the application of appropriate redress measures. Such a mechanism 33 Only 43 percent of households in the poorest income quintile received CTs in 2019, while about 12 percent in the richest quintile received CTs. 34 A large share of female headed households fall in the poorest quintile of the population. Page 17 The World Bank Sri Lanka Second Resilience, Stability and Economic Turnaround Development Policy Operation (P180549) is expected to contribute to higher FLFP, mitigating the impact of shocks on poor and vulnerable households (including female headed ones) and contributing to higher economic growth. Table 6: DPF Prior Actions and Analytical Underpinnings Prior Actions Analytical Underpinnings Pillar 1: Improving Economic Governance Summary of Findings: The legal and institutional framework for debt management is fragmented and lacks consolidated strategic planning, which contributed to the accumulation of debt, fragmented debt recording, and suboptimal debt transparency. CBSL Prior action #1 current debt management functions are also conducive to potential conflicts of interest. • Sri Lanka Debt Management Performance Assessment, World Bank (2022). • Sri Lanka Debt Management Reform Plan, World Bank & IMF (2023). Summary of Findings: Tax administration in Sri Lanka is well below basic TADAT standards, including third-party data sharing, risk- based audit selection, and compliance risk management. Furthermore, as of March 2023, MOF did not monitor and report on the annual cost of tax expenditures. Prior action #2 • Sri Lanka Tax Administration Diagnostic Assessment Tool (TADAT, 2023). • World Bank technical note on tax policy and administration issues in Sri Lanka (2023). IMF technical reports on Revenue-Raising Tax Policy Reform Options (2022), Diagnostic Assessment of IRD RAMIS (2023), and Guiding the Development of Tax Administration Reform (2023). Summary of Findings: Prior to 2024, the prevailing regulation on single borrower limits enabled banks to bankroll financially weak SOEs, leading to the buildup of at-risk SOE exposures. Deficiencies in the operational effectiveness of banks’ business revival units in rehabilitating distressed, but salvageable companies pose significant risks to the economy. Prior action #3 • World Bank TA note comparing pre-existing single borrower regulation with international Basel Committee standards. • World Bank bank-level data analysis to determine feasible transition plan for phasing in the new, tighter requirements on exposure to single or connected borrowers (notably SOEs). • Technical consultations with CBSL and the banking community on business revival units and corporate workouts. Summary of Findings: The long-standing practice of using BoC and PB to finance public debt and loss-making SOEs resulted in substantial losses. Recapitalizing both SOBs and upgrading their corporate governance is necessary to prevent the reoccurrence of Prior action #4 similar problems going forward. • BOC and PB Independent Asset Quality Reviews (2023). • World Bank technical assessment of Sri Lanka’s state-owned banks (2023). Pillar 2: Enhancing Growth and Competitiveness Summary of Findings: The power sector faces key governance weaknesses at a corporate and sector level; a lack of market discipline and price and cost distortions; and systematically poor financial management and performance, which has significant fiscal and economic costs. To address these challenges, comprehensive reforms are needed, together with targeted measures, such as Prior action #5 increasing the share of renewable energy and introducing competitive and transparent methods of procurement. • Rethinking Power Sector Reforms in the Developing World; World Bank publication (2020). • Ministerial Committee Report on Power Sector Reforms (October 2022). • CEB Diagnostic Assessment and Debt Restructuring Options; World Bank technical advisory support (June 2023). Summary of Findings: High tariffs reduce competition, productivity and export orientation in Sri Lanka. The use of para-tariffs exacerbates the sheltering of the domestic market from competition, distorting long-term business plans of firms. • World Bank Note on Sri Lanka’s Export Potential and on Sri Lanka’s Export Competitiveness (2022). Prior action #6 • Fernandes at. al. Sri Lanka import tariffs and firm exports (2023). • World Bank Note on Import Tariffs and Tax Exemptions (2023). • World Bank Note on Impact Assessment of Sri Lanka’s Free Trade Agreements (2023). Summary of Findings: The legal framework is outdated, limiting the ability of the regulator to adopt necessary global standard practices to promote competition. Prior action #7 • World Bank Note on Priority Reforms for Competition and Innovation in Telecommunications in Sri Lanka (2023). • World Bank Advisory Services to the Government on the National Digital Economy Strategy 2030 (2023-2024). Page 18 The World Bank Sri Lanka Second Resilience, Stability and Economic Turnaround Development Policy Operation (P180549) Pillar 3: Protecting the Poor and Vulnerable Summary of Findings: The social protection system was ill-equipped to respond to the challenges posed by the crisis given the: (i) inadequacy of CT benefits; (ii) poor coverage of the poor and vulnerable; and (iii) limited system capacity to respond to crises. Prior action #8 • Sri Lanka Development Update (October 2022). • World Bank, Fiscal Incidence Analysis (2023). Summary of Findings: Sri Lanka’s current legal framework includes explicit restrictions on women’s employment, contributing to a large gender gap in labor force participation. For example, the Employment of Women, Young Persons and Children Act (1956) mandates that no woman can be employed for more than ten days per month of night work. • Solotaroff, Jennifer L., George Joseph, Anne T. Kuriakose, and Jayati Sethi. Getting to Work: Unlocking Women’s Potential in Sri Lanka’s Labor Force (2020). Prior action #9 • Women, Business and the Law. Washington, DC: World Bank. Sri Lanka Profile: Assessment of Gender Gaps in Laws and Policies in Sri Lanka (2023-2024). • South Asia Gender Innovation Lab, Sri Lanka, Maldives and Nepal Gender Platform and Poverty and Equity Global Practice. Fostering Gender Inclusion: Understanding the Potential Impact of Sri Lanka’s Proposed Employment Act on Gender Equality in the Labor Market. Poverty and Social Impact Analysis (2024). 4.3. LINK TO CPF, OTHER BANK OPERATIONS AND THE WBG STRATEGY 49. The DPO2 is an integral part of the Sri Lanka CPF FY24-FY27 and WBG’s crisis response in the country. The CPF supports measures to restore economic stability and build a stronger foundation for green, resilient, and inclusive development and recovery, while protecting the poor and vulnerable. In this context, the proposed operation focuses on economic governance, growth and competitiveness, social protection and gender equality reforms. In particular, the supported reforms are strongly aligned with High-Level Outcome 1 of the CPF (Economic Stabilization and Private Sector Job Creation) and all three related objectives (Fiscal and Debt Sustainability, Economic Inclusion and Investment Climate, and Resilience and Efficiency of the Financial Sector). DPO2 also contributes to the objective of strengthening the social protection system under High-Level Outcome 2 (Protected and Enhanced Human and Natural Capital). Despite the reform progress supported by DPO1 and DPO2 in the RESET series, further effort and time is required to complete and sustain the reforms. The World Bank’s engagement in this regard will be considered during the upcoming CPF’s Performance and Learning Review. 50. The proposed operation complements the ongoing portfolio and recent projects that have been approved to support implementation and maximize impact. IPF operations and TA programs will accompany the implementation of the DPO across all the pillars. PAs#1 and #2 are supported by a Bank executed TA under the EU/AFD funded grant for strengthening Public Financial Management, and the ongoing Public Finance Review (P501002). The financial sector actions in PAs#3 and #4 complement the Sri Lanka Financial Sector Safety Net Project (P180861) – which aims to strengthen the financial and institutional capacity of the Sri Lankan financial sector safety net – and will be supported by the Sri Lanka Financial Sector Program (P502167), as well as TA under the Sri Lanka Maldives Post COVID-19 Competitiveness Recovery Program (P175642). TA is also being provided to the trade reforms (PA#6) through this latter program. The Bank is supporting the ongoing power sector reforms (PA#5) through TA under the Sustainable Energy Support Project (P175305), and is currently preparing a new operation, Sri Lanka Energy Transition Program (P505052), to facilitate investment in the expansion of RE. Advisory support to the Ministry of Technology and the TRCSL is being provided under the Digital for Grid in Maldives, Nepal, and Sri Lanka TA (P177824), with support from the Digital Development Partnership, to implement the reforms under PA#7. PA#8 is supported by the new Social Protection Project (P178973). Advisory support and technical assistance are being provided to strengthen the legislative framework upholding women’s rights, including the legislation supported by PA#9, through the Maldives, Nepal, Sri Lanka Gender and Social Inclusion Platform (P179463). Page 19 The World Bank Sri Lanka Second Resilience, Stability and Economic Turnaround Development Policy Operation (P180549) 4.4. CONSULTATIONS AND COLLABORATION WITH DEVELOPMENT PARTNERS 51. The authorities have stepped up communication efforts, using a range of consultation mechanisms. Under the leadership of the President’s Office, the GoSL has been communicating key elements of the reform program, including the importance of increasing taxes, maintaining financial sector stability, SOE and trade reforms, and protecting the poor and vulnerable. Relevant analytical work conducted by the Bank has been made available to support these communication efforts. The preparation of the PAs has also been supported by a combination of media outreach, consultation meetings, issuance of industry papers, engagement with Parliamentary committees, among others. In particular, with support from the Bank, the GoSL implemented a comprehensive communications campaign for PA#8, which included robust citizen engagement. Traditional and social media channels have been used widely to ensure that information on Aswesuma is disclosed island wide. Community groups and Civil Society Organizations (CSOs) have been consulted on challenges and constraints faced in the implementation of Aswesuma to draw lessons and strengthen implementation. A Grievance Redress Mechanism (GRM) has been established and the related capacities of the Divisional Secretariat (DS) staff, supporting Aswesuma implementation, are being strengthened to effectively respond to queries and grievances. 52. The Bank is partnering with a Colombo-based thinktank, to support citizen engagement and facilitate a wider understanding of the PAs in the public domain. Based on a stakeholder mapping, conducted jointly with representatives from academia and media, and using narratives and messages targeted at specific groups, outreach activities are being implemented to build the public’s understanding of the importance of the reforms. These include focus group discussions, townhall events across the country, and messaging through traditional and social media. A main event in May 2024 then amplified the messages about the importance of the actions, which is expected to function as a catalyst for further public discussion. The overarching objectives of this citizen engagement exercise are to build the policy literacy of local partners and the public around DPO2 reforms and try to establish coalitions of support for the government’s reform plan. 53. DPs are working closely together to identify priorities and opportunities for coordination. An MDB+ Coordination Platform, with participation from ADB, AIIB, IMF, JICA, USAID and the Bank, coordinates on the complementarity and sequencing of macro- and growth-critical TA, policy advisory support, and budget support. The Bank continues to work closely with the IMF during the EFF program and RESET DPO series, and the reforms supported by this operation are carefully sequenced and calibrated with the EFF reforms. The Bank also continues to work with ADB on the energy sector to support effective implementation of related reforms. The Bank hosts briefings with DPs to present analysis, share experiences with TA, discuss priority reforms, and understand the ongoing and potential role of the wider DP community. Finally, the Bank has shared the stakeholder mapping, narratives and messages developed for the communication outreach with DPs to encourage consistency in public messaging. 5. OTHER DESIGN AND APPRAISAL ISSUES 5.1. POVERTY AND SOCIAL IMPACT 54. The overall impact on poverty is expected to be neutral to positive but risks from an uncertain macro and political outlook remain. Under Pillar I, measures to increase transparency and enhance revenue mobilization (PA#1-2) can have positive impacts, if better tax compliance from higher-income individuals mobilizes resources which are redirected to pro-poor public spending.35 Institutional-strengthening and transparency-enhancing measures to support financial sector stability (PA#3-4) are expected to be neutral.36 Under Pillar II, reforms to the electricity sector (PA#5) may have a negative impact on poverty depending on whether adequate compensation mechanisms exist and how future tariff 35 While PA#2 and continued TA will contribute to better compliance, the likelihood of future budget allocations towards pro-poor spending cannot be assessed given macroeconomic and political uncertainties, as well as an ongoing process to strengthen institutions to ensure proper targeting. 36 They could have positive indirect effects in the long run by lowering SOB’s exposures to loss-making SOEs and reducing crowding out effects for the private sector (i.e., SOBs would have more space to lend to the private sector, including in a more inclusive manner). In addition, positive impacts could arise via indirect effects if relief to viable businesses in distress were to re-start job creation. Page 20 The World Bank Sri Lanka Second Resilience, Stability and Economic Turnaround Development Policy Operation (P180549) increases compare to the recovery in real household incomes. Tariff reforms (PA#6) are expected to alleviate the tax burden among poor households and have a marginal positive impact on poverty reduction. Measures to support the telecommunications sector (PA#7) are expected to have a neutral to positive impact (though marginal) provided that increased competition will lead to lower tariffs.37 Under Pillar III, the positive impacts on poverty and inequality are expected to be driven by reforms to the social protection system (PA#8) and by less gender discrimination that could translate into higher FLFP (PA#9). These positive impacts depend on the continued political commitment to social protection and gender equality reforms, and a recovery in the labor market following the initial signs of macroeconomic stabilization and better economic growth. 55. Reforms to the electricity sector (PA#5) may have a negative impact on poverty via: (i) tariff revisions that disproportionally burden poor households in the absence of appropriate compensation mechanisms and with further real income erosion, and (ii) potential employment losses due to CEB restructuring. Future regular electricity tariff revisions could have a poverty-increasing effect in the absence of appropriate mitigation measures or a stable recovery in the real value of households’ incomes. Increases in electricity tariffs and a shift towards cost-recovery contributed to overall price increases and loss of purchasing power during the crisis, and are estimated to have increased poverty by 1.9 percentage points between 2022 and 2023.38 While there was an immediate negative impact of the transition to cost- reflective electricity pricing, additional impacts are likely to be lower compared to this one-off adjustment. In addition, the likely economic recovery, combined with better management of the energy sector, and strengthening of Aswesuma and other social protection programs (a more equitable way to allocate resources than electricity subsidies), will help mitigate these negative impacts. Additional impacts on poverty could come from employment losses due to the restructuring of CEB. A further assessment of these impacts depends on details of appropriate severance packages, which are part of the 12-month restructuring plan for CEB. Moreover, the impact on employment will also depend on the availability of alternate job opportunities in the private sector.39 While SOE employees face better employment conditions, the real value of their wages has contracted in recent years, making them more vulnerable to shocks.40 Better targeted social protection systems could offset some of these impacts and indirect positive spillovers could come from better management of the sector. 56. Objective and transparent criteria used for re-certification of Aswesuma beneficiaries are likely to have an equity-enhancing effect, although this has not yet been quantified (PA#8). Regular re-certification processes aim to keep programs well-targeted by reassessing the socioeconomic conditions of beneficiaries. The continued use of objective criteria for this assessment is key to ensuring sustained positive implementation of Aswesuma. Risks of limited poverty- targeting performance of government cash transfers remain and can be addressed by evaluating the coverage and targeting effectiveness of Aswesuma. To conduct this assessment, a nationally representative survey, measuring monetary poverty and Aswesuma beneficiary status, is planned for 2025 at the latest. Further, the Welfare Benefits Act of 2002 requires the implementation of effective communication, community engagement, and grievance redress services. As discussed in paragraph 51, this is being put in place. 37 Telecommunication expenses (telephone or internet charges) account for a small share of households’ expenditure budget (1.7 p ercent on average in 2019). Households in the poorest decile spend less (1.4 percent) than richest households (2 percents) on these services. 38 Electricity subsidies accounted for 4.2 percent of income for households in the poorest decile against only 0.5 percent for those in the richest. Hence, subsidy removal would have had a larger negative impact on the poor even before the crisis. At the same time, 63 percent of spending on electricity subsidies reached households in the top 60 percent. Redirecting these resources to better-targeted support for the poor is a more equitable and efficient way to allocate resources. Yet, overnight subsidy removal and tariff revisions implemented at the peak of the crisis contributed to large welfare losses. It is estimated that poor households would have had to cut their electricity consumption by four times to reach the value of pre-crisis levels of energy consumption – which could have led to a deterioration of welfare under several dimensions. 39 This will depend on the recovery of labor force participation, which has declined from 52.3 percent to 48.8 percent between 2019 and 2023. 40 These employees are better-off, better educated and more likely to live in richer provinces than the average employed population. Yet, their real value of wages has contracted by 29 percent between 2019 and 2022. Page 21 The World Bank Sri Lanka Second Resilience, Stability and Economic Turnaround Development Policy Operation (P180549) 57. The WE Bill (PA#9) is expected to help level the playing field for women and contribute to increasing FLFP, provided that the higher cost of hiring women is compensated for by higher overall productivity and post-crisis recovery in labor demand.41 The Bill will enforce their rights in line with CEDAW on: (i) equality before the law, (ii) right to health and education, (iii) equality in matters related to marriage and family relations, (iii) nationality rights, and (iv) political, economic and cultural rights. Specifically, the Bill will help to enforce women’s rights to have the same employment opportunities as men, the right to equal remuneration and treatment, and the right to equal benefits and protections. The assessment of the impact on women assumes that the higher potential costs of hiring women are compensated for by higher overall productivity and post-crisis recovery in labor demand. Higher FLFP could also lead to higher earnings among women and reduce gender inequality. The positive impact is expected to primarily affect women in the formal sector, making up 39 percent of the total female employment in Sri Lanka. While women in this category are better educated and earn more than peers employed in the informal sector,42 they earn 18 percent less on average per year than their male counterparts. This gap accrues to men working more hours and having greater flexibility in deployment due to fewer or less stringent restrictions on overtime and night-time work, especially in the services sector.43 Several factors can, however, limit the realization of these benefits, including: (i) a large informal sector where legislation does not apply, (ii) conservative social norms around female employment, (iii) labor market factors, including a delayed recovery in job demand, especially in urban areas, combined with higher costs of hiring women (e.g., transport), and (iv) inadequate non- legislative actions to support higher FLFP (e.g., improved safety and childcare services, and safer transportation options).44 58. The Corporate Commitment on Gender is being supported by the RESET DPO series. Firstly, the DPO2 reforms are expected to help enforce women’s economic, social, and political rights – including rights to employment and to equal remuneration. The legislative reforms to be introduced through the WE Bill are intended to contribute to closing gender gaps in FLFP by creating a mechanism to review and seek redress for instances of discrimination in employment based on gender. Progress towards enforcing women’s equal right to employment and equal remuneration will be tracked through results indicator (RI) #8, which will monitor the conclusion on reviews into the infringement of women’s employment rights. Secondly, social protection reforms under DPO2 will continue to prioritize access by female-headed households (FHH) to social welfare benefits. FHH are disproportionately represented among the poor (with poverty rates among FHH estimated to have increased from 11.3 percent in 2019 to 25.6 percent in 2022)45 and were, therefore, prioritized for enrolment in Aswesuma under DPO1. Currently, the Welfare Benefits Board (WBB) is collecting data on access by FHH to these benefits to track progress and inform potential corrective action in targeting FHH. The latest estimated coverage (June, 2024) of FHHs by the new WBPS is 14 percent. For DPO2, a 20 percent or 400,000 households target (RI#7) will be maintained to ensure adequate coverage of these households in the second year of Aswesuma implementation. 5.2. ENVIRONMENTAL ASPECTS 59. Policy actions under the DPO2 are not expected to have significant direct negative impacts on Sri Lanka’s environment, forests and natural resources.46 Reforms under DPO2 could lead to potentially positive environmental outcomes as a result of better fiscal discipline, economic stability and support to the poor. Increased broadband access (PA#7) can lead to reduced carbon emissions and promote efficient use of resources. Power sector reforms (PA#5) are expected to lead to greater efficiency, accountability, and compliance with environmental and social policies. The reforms 41 Based on a Poverty and Social Impact Analysis of a proposed labor law reform to promote greater gender equality in the workplace, conducted by the South Asia Gender Innovation Lab, Sri Lanka, Maldives and Nepal Gender Platform and Poverty and Equity Global Practice. 42 In 2022, average yearly earnings for women in formal wage employment was LKR557,514, roughly 40 percent more than employed women. 43 Hourly wages in the formal sector show no gender gap, despite higher costs of hiring women due to restrictive laws. This implies women may be more productive or possess specific skills. The impact of legislative changes on women's employment depends on whether the increased costs are offset by the previously limited flexibility. 44 Labor force participation in urban areas decreased from 50.2 percent in 2019 to 45.2 percent in Q32023 and from 34.5 to 32.0 percent among women. Sri Lanka scores worse than regional peers on legal indicators related to safety, pay, and childcare (Women, Business and the Law database, World Bank). 45 The poverty rate among male headed households is estimated to have increased from 11.3 percent to 21.9 percent between 2019 and 2022. Estimates are based on 2019 Household Income and Expenditure Survey (HIES) data and World Bank’s team microsimulations. 46 The assessment is based on past sector analysis and the World Bank team’s judgement. Page 22 The World Bank Sri Lanka Second Resilience, Stability and Economic Turnaround Development Policy Operation (P180549) also aim to reduce reliance on thermal power plants and increase RE as a source of power, indicating a positive trend towards reducing air pollution and, thus, improving air quality and health. However, negative impacts may arise mainly with RE siting (wind, solar) and end of life waste management. The NTP (PA#6) and associated lowering of tariffs and import restrictions over time could be a gateway to promoting environmentally sound technologies. The country has a well-established environmental legal and institutional structure, including a strong Environmental Impact Assessment framework and import control regulations and surveillance systems, to protect and manage environmental risks. The Bank is supporting the GoSL to improve its E&S risk management capacity under ESF’s country systems strengthening initiative. 5.3. PFM, DISBURSEMENT AND AUDITING ASPECTS 60. The PFM framework and formal mechanisms and rules for financial accountability are generally sound. Strengths include: (i) a budget preparation process that ensures adequate time for preparation, approval and publication, (ii) a relatively robust accounting system, and (iii) timely annual audited financial statements. Government’s budget is publicly available, both in print and on an external website. The audit mandate is wide, covering financial, compliance and performance aspects. Despite the above strengths, the PFM framework has several areas that require improvement. GoSL is committed to addressing gaps in the PFM framework, including through the 21st amendment to the Constitution and strengthening of Public Investment Management. Some of these initiatives are being supported by DPs such as JICA, IMF, the United Nations Development Programme, and the Bank through a Multi-Donor Trust Fund. Prepared with support from the Bank and IMF, a new PFM Bill is currently going through Parliament and is expected to be enacted in the next few months. ADB is currently preparing a new policy-based operation with a strong PFM component. 61. An IMF Safeguards Assessment in 2023 showed that CBSL has a relatively strong safeguards framework, especially in the external audit and financial reporting areas. CBSL’s internal control environment is anchored in a strong compliance culture, however some functions require continued modernization, including through an expanded scope for financial risk management. Therefore, no additional fiduciary arrangements, such as dedicated foreign or local currency bank accounts subject to audits, need to be put in place. 62. Disbursement and audit arrangements. The GoSL has requested a DPO as the lending instrument. The first operation included US$500 million disbursed in two tranches. The second operation of [US$200] million will be available for disbursement following the completion of the PAs and upon effectiveness of the operation after Board approval. Following submission of an authorized signatory letter and a request for withdrawal, the Bank may disburse the DPO proceeds into an US$ account that forms part of the GoSL’s official forex reserves held by CBSL. The GoSL, through MoF, may then use the proceeds to: (i) make foreign currency payments; (ii) transfer amounts to a local currency bank account of the GoSL, which is then used for budget expenditures; or (iii) undertake a combination of these approaches. The GoSL will confirm, within 30 days, receipt of proceeds, their credit in the treasury account, and availability to finance budget expenditures as stated in the Financing Agreement (FA). Once the funds enter the GoSL’s reserves and the budget, they will be commingled with other GoSL funds. Thereafter, the Bank will not require the use of these funds to be tracked. However, the GoSL will not use the DPO proceeds to pay for excluded expenditures. If any portion of the credit is used to finance excluded expenditures, the Bank shall require a refund of the amount. 5.4. MONITORING, EVALUATION AND ACCOUNTABILITY 63. The Presidential Secretariat and MoF are responsible for overall oversight and implementation of the operation, in collaboration with several other agencies.47 The Presidential Secretariat chairs inter-ministerial and agency meetings to oversee the progress of key reforms regularly and make swift decisions to resolve bottlenecks that require high level interventions. The Presidential Secretariat is supported by a technical team responsible for following up on reform 47 CBSL, Ministry of Power and Energy, Ministry of Technology, Telecommunications Regulatory Commission of Sri Lanka, Ministry of Women, Child Affairs and Social Empowerment. Page 23 The World Bank Sri Lanka Second Resilience, Stability and Economic Turnaround Development Policy Operation (P180549) implementation. Through these meetings and follow up, ministries and agencies will be held responsible for the progress of individual reform measures and will also be able to escalate bottlenecks that require political or inter-ministerial decisions. The Bank will monitor the status of implementation through quarterly implementation support missions and tracking of results indicators. This will be augmented by regular engagement of Bank staff implementing TA and investment operations to support the program's reforms. Throughout the program period, GoSL will be responsible for providing information to the Bank, according to an agreed data monitoring template and within specified time limits, to assess the adequacy of the macroeconomic framework and implementation of the policy reform framework. 64. Grievance Redress. Communities and individuals who believe that they are adversely affected by specific country policies supported as Prior Actions or tranche release conditions under a World Bank Development Policy Financing may submit complaints to the responsible country authorities, appropriate local/national grievance mechanisms, or the Bank’s Grievance Redress Service (GRS). The GRS ensures that complaints received are promptly reviewed in order to address pertinent concerns. Project affected communities and individuals may submit their complaint to the Bank’s independent Accountability Mechanism (AM). The AM houses the Inspection Panel, which determines whether harm occurred, or could occur, as a result of Bank non-compliance with its policies and procedures, and the Dispute Resolution Service, which provides communities and borrowers with the opportunity to address complaints through dispute resolution. Complaints may be submitted at any time after concerns have been brought directly to the World Bank’s attention, and Bank Management has been given an opportunity to respond. For information on how to submit complaints to the World Bank’s corporate Grievance Redress Service (GRS), please visit http://www.worldbank.org/GRS. For information on how to submit complaints to the Bank’s Accountability Mechanism, please visit https://accountability.worldbank.org. 6. SUMMARY OF RISKS AND MITIGATION 65. The overall residual risk rating for the operation is high. Table 7 presents the residual risk ratings by category. With the exception of Technical, Fiduciary and Environment and Social risks, all other risk categories are rated substantial or high to the achievement of the PDO. A description of these risks and mitigation measures are provided below. 66. Political and governance risks are high. These risks are inherently high, as the political environment remains fluid in the run-up to the 2024 presidential elections. In addition, the economic adjustment has imposed a heavy burden on the population. The political leadership has stated that it is, however, committed to completing the IMF program and implementing reforms supported by DPO2. The completion of reforms and the IMF program is also supported by a broad consensus among a core group of Parliamentarians across parties, senior government officials, and civil society, which would help mitigate the risks. However, residual risks remain high given the uncertainty introduced by the elections and a potential change in government, which may undermine continuity and/or ownership of reforms. 67. Macroeconomic risks are high. These risks are inherently high given that the economic path to recovery remains narrow, and insufficient fiscal and external buffers render Sri Lanka highly vulnerable to shocks. There are, however, prospects that these risks can be mitigated. The EFF’s second review was concluded. There has been strong progress on the debt restructuring, with final and initial agreements reached with official and external commercial creditors, respectively. Upside potential could materialize from strong and sustained implementation of structural reforms, which would boost confidence and attract fresh capital inflows, as well as better than expected recovery in remittances and tourism. Despite these mitigation measures – notably better debt management, tax administration and financial sector stability (all supported by this operation) – the residual macroeconomic risks remain high. 68. Sector strategies and policies risks are substantial. Sector risks are inherently high since sector strategies, policies, funding for relevant sector organizations, and governance arrangements have been prone to ad hoc changes and there is a history of policy reversals (for example, in trade, investment and SOE policies). Fiscal risks might impact the adequacy and predictability of funding to support needed sector interventions. Ongoing and planned sector reforms supported by Page 24 The World Bank Sri Lanka Second Resilience, Stability and Economic Turnaround Development Policy Operation (P180549) the DPO2 and other DPs are expected to strengthen the institutional and legal frameworks, as well regulatory and oversight bodies. The approval of laws, combined with support to implementing regulations, should help reduce the risk of reversals. With these mitigation actions, the residual risks fall to substantial. 69. Institutional capacity for implementation and sustainability risks are substantial. The inherent risks are high, given the high complexity and ambition of the reforms, which requires strong coordination, as well as adequate resources and skills. The historical record of effective policy implementation and inter-ministerial coordination is weak and is constrained by enduring capacity gaps, which are aggravated by the drain of talent triggered by the crisis. A consolidated multi-year reform program is yet to be released (likely after the elections), and the government will probably continue to rely on external assistance for the implementation of reforms. Ongoing and planned assistance by DPs, through TA, capacity building and financing, reduce the residual risk to substantial. The Bank will continue to work closely with other DPs and sustain the dialogue (e.g., through the MDB+ Platform) to support and sequence the reform agenda and, ultimately, prevent any reform reversal. 70. Stakeholder risks are substantial. These risks are inherently high. A Political Economy Analysis undertaken by the Bank highlighted risks associated with resistance from vested interests (in the government and private sector), as well as polarized public opinion around certain reforms (related to SOEs, openness of the economy, and social protection), which may compromise policies or weaken and delay implementation of reforms. These risks will be mitigated by sustained TA and support from DPs. For example, the Bank is supporting efforts to scale up strategic communications, and it will also review the outcomes of periodic phone surveys that aim to capture citizen awareness and perceptions of the fairness of key reforms. These surveys will inform additional communication and outreach efforts by the government. Furthermore, a better targeted, stronger and more shock responsive WBPS will ensure the poorest and most vulnerable are supported during the adjustment period. With these mitigation actions, the residual risks fall to substantial. Table 7: Summary Risk Ratings @#&OPS~Doctype~OPS^dynamics@padrisk#doctemplate Risk Categories Rating 1. Political and Governance ⚫ High 2. Macroeconomic ⚫ High 3. Sector Strategies and Policies ⚫ Substantial 4. Technical Design of Project or Program ⚫ Moderate 5. Institutional Capacity for Implementation and Sustainability ⚫ Substantial 6. Fiduciary ⚫ Moderate 7. Environment and Social ⚫ Moderate 8. Stakeholders ⚫ Substantial 9. Other ⚫ Overall ⚫ High Page 25 The World Bank Sri Lanka Second Resilience, Stability and Economic Turnaround Development Policy Operation(P180549) ANNEX 1: POLICY AND RESULTS MATRIX DETAILED RESULTS FRAMEWORK Prior Actions Results Prior Actions under DPO1 Prior Actions under DPO2 Indicator Name Baseline Target Pillar 1: Improving Economic Governance Prior Action #1. To strengthen domestic revenue mobilization, the Recipient has: (i) removed sector specific concessionary corporate income tax rates, as evidenced by publication in the Recipient’s official gazette of the Inland Revenue (Amendment) Act, No. 45 of 2022 as certified by the Speaker of Parliament; Prior Action #1. To improve debt management, Results Indicator #1: Public Debt and (ii) increased the fuel excise duty, as Sri Lanka has enacted a new Public Debt Management Office within the evidenced by (a) publication in the Recipient’s Management (PDM) law, as evidenced by Ministry of Finance created, fully No (2022) Yes (2025) official gazette on December 31, 2022, of the publication in the Official Gazette of the certified staffed and operational. order (the “Order”) issued by the Minister of Public Debt Management Act No. 33 of 2024. Finance under the Excise (Special Provisions) Act, No. 13 of 1989, and (b) letter dated May 23, 2023, issued by the Secretary General to the Parliament to the Minister of Finance confirming approval by Parliament of such Order. Prior Action #2. To strengthen governance of Prior Action #2. To strengthen governance of Results Indicator #2: tax administration and its enforcement tax administration and its enforcement (a) 7.3 (2022) (a) Total tax revenue-to-GDP (a) 12.0 (2025) capability, the Recipient has enacted capability: (i) MoF has specified the type, scope, amendments to the Inland Revenue Act frequency and manner of 3rd party data to be (percent)48 (b) 23 (2021) 48The World Bank’s macroeconomic framework shows an increase in tax revenue-to-GDP ratio by 4.7 percentage points, from 7.3 percent in 2021 to 12.0 percent by 2025, as a result of the full package of tax reforms implemented. Page 26 The World Bank Sri Lanka Second Resilience, Stability and Economic Turnaround Development Policy Operation(P180549) Prior Actions Results requiring: (i) financial institutions, government shared by the relevant counterparts under the (b) Use of electronic filing facilities for (b) At least 70 procurement departments, stock exchange, Inland Revenue Act as evidenced by publication non-corporate tax declarations (2025) registrar of companies, motor vehicle authority, in the Official Gazette No. 2376/25-2024 of the (percent) 49 and land registrar to submit taxpayer regulation issued by MOF and letter dated July transaction information at the individual level to 2, 2024 issued from the Secretary General of the IRD in a systematic and time-bound manner; Parliament to the Presidential Secretariat and (ii) non-corporate taxpayers to file their confirming its approval; (ii) IRD has introduced income tax returns through an electronic risk management guidelines on categorization system (e-filing of income tax returns), as of risks associated to tax administration as evidenced by publication in the Recipient’s evidenced by the issuance by the IRD official gazette of the Inland Revenue Commissioner General of the Risk Management (Amendment) Act, No. 4 of 2023 as certified by Guide-2023; and (iii) MoF has issued a Tax the Speaker of Parliament. Expenditures Statement (TES) estimating revenue foregone for all the major taxes, as evidenced by publication of the TES dated March 31, 2024, on the MoF website. Prior Action #3. To reduce systemic risks in the Prior Action #3. To reduce systemic risks, financial sector: (i) the CBSL’s Monetary Board strengthen financial sector stability, and has approved an ELA framework that articulates enhance the enabling environment for the CBSL’s policies and operational and corporate non-performing loan (NPL) resolution Results Indicator #3. Exposures to procedural modalities for ELA provision to CBSL has stipulated: (i) tightened prudential SOEs of total assets of:50 (a) 8.7 (Q2 (a) 4.5 (2025) liquidity-distressed but solvent banks, as limits for the maximum exposures that banks (a) the entire banking sector 2022) evidenced by a certified extract of the minutes can have vis-à-vis single borrowers and to a (percent), and of the meeting of the Monetary Board group of connected borrowers, including SOEs, (b) the two largest SOBs (percent) (b) 20.9(Q2 approving and attaching the ELA framework; as evidenced by CBSL Directive No. 01 of 2024 (b) 10 (2025) 2022) and (ii) Cabinet has approved the establishment (“Large Exposures of Licensed Banks”) dated of a financial sector crisis management March 25, 2024 and published on the CBSL’s committee that sets out crisis management website; and (ii) enhanced requirements for 49 In 2021, the weighted average of non-corporate taxpayers filing electronic returns was 23 percent, leading to a score of “D” in the indicator for POA 4-14 in the TADAT Assessment made by the Joint IMF- World Bank-ADB team in January 2023. To move to a score of “B” for electronic filing of returns, at least 70 percent of declarations are to be filed electronically by non-corporate taxpayers by 2025. 50 This has been informed by the Bank’s ongoing technical work on overhauling the regulation of the single borrower exposure lim it. This work is underpinned by a bank-level data analysis aimed to ensure that banks will be able to meet the new, tighter requirements that are currently being designed. Banks’ total exposure to SOEs is one of the key areas that the new regulation seeks to contain. This indicator is also supported by PA#1 (as stricter requirements for state guarantees should limit the excessive buildup of SOE exposures in the financial sector), PA#4 (the strengthening of business models and corporate governance of SOBs should move them away from SOE lending), and PA#5 (the restructuring of the energy sector, which represents a large SOE exposure in the financial sector). Page 27 The World Bank Sri Lanka Second Resilience, Stability and Economic Turnaround Development Policy Operation(P180549) Prior Actions Results responsibilities and provides an institutional banks when reviving distressed but viable basis for CBSL–MoF policy coordination, as business and a standardized workout process in evidenced by minutes of the meeting of the accordance with international best practices as Cabinet approving the establishment of the evidenced by CBSL Circular No. 02 of 2024 financial sector crisis management committee. (“Guidelines for the Establishment of Business Revival Units in Licensed Banks”) dated March 28, 2024 and published on CBSL’s website. Prior Action #4. To maintain stability and Prior Action #4. To enhance banking sector confidence in the banking system, the Minister stability and performance, Sri Lanka has of Finance has submitted to Parliament the initiated the restructuring process for state- Banking (Special Provisions) Bill aimed at owned Bank of Ceylon (BOC) and People’s Bank strengthening the deposit insurance and (PB) as evidenced by Cabinet Paper No. problem bank resolution framework, as 24/0695/604/078 approving improved evidenced by (a) minutes of the meeting of the governance arrangements and strategic Cabinet held on May 2, 2023 (Cabinet paper No direction for both banks. 23/0832/604/086) approving the submission to Parliament of the Banking (Special Provisions) Bill, and (b) “order paper” of Parliament for May 23, 2023, evidencing submission of the respective Bill to Parliament. DPO1 Second Tranche Release Condition: Sri Lanka has enacted the Banking (Special Provisions) Act aimed at strengthening the deposit insurance and problem bank resolution framework. Pillar 2: Enhancing Growth and Competitiveness Prior Action #5. To improve the commercial Prior Action #5. To ensure a more effective, performance, financial transparency, and efficient and financially and commercially Results Indicator #4. CEB private-sector participation in the SOE sector, sustainable power sector, Sri Lanka has enacted unbundling initiated through a No (2023) Yes (2025) the Recipient has: (i) approved the SOE Reform a new Electricity Act, as evidenced by Cabinet approved Transfer Plan Policy Paper, as evidenced by the minutes of the publication in the Official Gazette of the meeting of the Cabinet held on May 15, 2023 Page 28 The World Bank Sri Lanka Second Resilience, Stability and Economic Turnaround Development Policy Operation(P180549) Prior Actions Results (Cabinet paper No. 23/0858/604/090) certified Sri Lanka Electricity Act No. 36 of 2024. approving and attaching the respective policy paper; and (ii) re-assigned the operational control of selected SOEs to the Ministry of Finance, as evidenced by the publication in the official gazette of the respective transfer decision made by HE the President under Article 44 of the Sri Lankan Constitution. Prior Action #6. To simplify the tariff structure, Prior Action #6. To increase access to imported the Recipient has adopted: (i) order issued by inputs and capital goods and encourage export the Minister of Investment Promotion under the orientation, Sri Lanka has through MoF, Sri Lanka Export Development Act No. 40 of approved a National Tariff Policy (NTP) that 1979 implementing the phasing out over a commits to a predictable path of reduction of period of 3 years of the Export Development import duty protection over a four-year period Board Cess by reducing the Cess by 33 percent as evidenced by minutes of the meeting of the from April 1, 2023, as evidenced by (a) the Cabinet Paper No. 24/1072/604/114 approving publication in the Recipient’s official gazette of the NTP. the relevant order, and (b) letter dated May 9, 2023, issued by the Secretary General to the Results Indicator #5. Trade Parliament to the Ministry of Finance (imports and exports) as a share of 41 (2021) 45 (2025) confirming approval by Parliament of the order GDP (percent)51 issued by the Minister of Investment Promotion, and; (ii) order issued by the Minister of Finance under Section 03 of the Ports and Airport Development Levy Act No. 18 of 2011 to phase out PAL over a period of five (5) years commencing from 2023 and exempt PAL applicable on 20 percent of tariff items as phase I from April 4, 2023, as evidenced by (a) the publication in the Recipient’s official gazette of the relevant order, and (b) letter dated May 9, 51This PA entails reducing uncertainty around the import duty structure through the phasing out the para-tariffs. The trigger entails adding predictability through the implementation of a National Tariff Policy. Both actions will lead to the reduction of trade costs, an increase in the export orientation of the country, and an increase in trade as a share of GDP. Page 29 The World Bank Sri Lanka Second Resilience, Stability and Economic Turnaround Development Policy Operation(P180549) Prior Actions Results 2023, issued by the Secretary General to the Parliament to the Ministry of Finance confirming approval by Parliament of the order issued by the Minister of Finance. Prior Action #7. To expand access to affordable broadband services, facilitate private capital and develop competitive markets, Sri Lanka has: (i) enacted amendments to the Sri Lanka Results indicator #6. Telecommunications Act No. 25 as evidenced by 0 (2022) 100 (2025) (a) Private investment in broadband publication in the Official Gazette of the N/A networks facilitated (US$ million)52 certified Sri Lanka Telecommunications (b) Millions of people using (Amendment) Act No.39 of 2024; and (ii) issued 8.8 (2022) 12 (2025) implementing regulations for the adoption of a broadband internet sector specific competition regulation framework as evidenced by Rules made by the TRCSL and published in the Official Gazette. Pillar 3: Protecting the Poor and the Vulnerable Prior Action #7. To enhance social protection, Prior Action #8. To ensure increased impact and the Recipient has: (i) adopted the FY23 Budget sustainability of the social protection system, Sri Results Indicator #7. for a new welfare benefit payment scheme Lanka has issued regulations authorizing (a) Beneficiaries of the new Welfare (a) 0 (2022) targeted at low-income and vulnerable implementation of the periodic recertification (a) 2 million Benefits Payment Scheme (WBPS) households in the amount of LKR187 billion, as of WBPS beneficiaries as evidenced by an (2023-2025) (number of households per year) evidenced by (a) Appropriations Act, No. 43 of amendment to the Welfare Benefit Payment 2022, (b) minutes of the meeting of the Cabinet (Selection of Persons Eligible to Receive (b) Coverage of the poorest 20 (b) 43 (2022) held on 2023.01.16 (Cabinet paper No. Payments) Regulations No. 1 of 2022 issued by (b) 60 (2025) 23/0101/604/008), and (c) letter dated May 9, the Minister of Finance and published in Extra percent by cash transfer programs 2023 (reference BD/CBP/02/01/02/2023) from Ordinary Gazette No. 2382/02 dated April 29, (percent) the Director General National Budget to the 2024 and letter dated June 7, 2024 issued by Secretary to the President confirming allocated the Secretary General of Parliament to the (c) 0 (2022) 52 The Bank has estimated that US$1.3 billion in investment would be needed to ensure universal access to basic broadband. The target of US$100 million reflects the timing and the risks of the investments that will follow a rising curve over time, but outside of the window that tracks the DPO results. Page 30 The World Bank Sri Lanka Second Resilience, Stability and Economic Turnaround Development Policy Operation(P180549) Prior Actions Results budgetary provisions; and (ii) issued a gazette Presidential Secretariat confirming approval by (c) Coverage of female headed (c) 400,000 notification by the Minister of Finance under Parliament of such amendment. household by the new WBPS (2025) Article 9 of the Welfare Benefit Act No. 24 of (number) 2002 for a new welfare benefit payment scheme, as evidenced by (a) the publication in the Recipient’s official gazette of the notification issued by the Minister of Finance, and (b) letter dated May 12, 2023, issued by the Secretary General to the Parliament to the Ministry of Finance confirming approval by Parliament of the notification issued by the Minister of Finance. Prior Action #9. To reduce legal discrimination on the grounds of gender – including gender discrimination in the labor market – and enable the enforcement of Sri Lanka’s obligations Results Indicator #8. Reviews under the Convention on the Elimination of all concluded on the infringement of N/A Forms of Discrimination Against Women women’s rights following National 0 (2023) 100 (2025) (CEDAW), Sri Lanka has enacted the Women Commission on Women’s procedures Empowerment (WE) Act as evidenced by (proportion of reviews) publication in the Official Gazette of the certified Women Empowerment Act, No. 37 of 2024. Page 31 The World Bank Sri Lanka Second Resilience, Stability and Economic Turnaround Development Policy Operation(P180549) @#&OPS~Doctype~OPS^dynamics@paddpfannexpolicyandresult#doctemplate RESULTS INDICATORS BY PILLAR Baseline Closing Period Improving Economic Governance Public Debt Management Office within the Ministry of Finance created, fully staffed and operational (Yes/No) Dec/2022 Dec/2025 No Yes Total tax revenue-to-GDP (percent) (Percentage) Dec/2022 Dec/2025 7.30 12.00 Use of electronic filing facilities for non-corporate tax declarations (percent) (Percentage) Dec/2021 Dec/2025 23 > 70 Exposures to SOEs of total assets of the banking sector (percent) (Percentage) Jun/2022 Dec/2025 8.70 4.50 Exposures to SOEs of total assets of two largest state-owned banks (percent) (Percentage) Jun/2022 Dec/2025 20.90 10 Enhancing Growth and Competitiveness Trade (imports and exports) as a share of GDP (percent) (Percentage) Dec/2021 Dec/2025 41 45 Private investment in broadband networks facilitated (US$ million) (Amount(USD)) Dec/2022 Dec/2025 0 100 Millions of people using broadband internet (Number) Dec/2022 Dec/2025 8.80 12 CEB unbundling initiated through a Cabinet approved Transfer Plan (Yes/No) Jul/2024 Dec/2025 Page 32 The World Bank Sri Lanka Second Resilience, Stability and Economic Turnaround Development Policy Operation(P180549) No Yes Protecting the Poor and Vulnerable Beneficiaries of the new Welfare Benefits Payment Scheme (WBPS) (number of households per year) (Number) Dec/2022 Dec/2025 0 2,000,000 Coverage of the poorest 20 percent by cash transfer programs (percent) (Percentage) Dec/2022 Dec/2025 43 60 Coverage of female headed household by the new WBPS (Number) Dec/2022 Dec/2025 0 400,000 Reviews concluded on the infringement of women’s rights following National Commission on Women’s procedures (proportion of re views) (Percentage) Dec/2023 Dec/2025 0 100 Page 33 The World Bank Sri Lanka Second Resilience, Stability and Economic Turnaround Development Policy Operation (P180549) ANNEX 2: FUND RELATIONS ANNEX IMF Executive Board Concludes 2024 Article IV Consultation with Sri Lanka and Completes the Second Review Under the Extended Fund Facility June 12, 2024 • The IMF Executive Board completed the 2024 Article IV Consultation and Second Review under the 48-month Extended Fund Facility with Sri Lanka, providing the country with immediate access to SDR 254 million (about US $336 million) to support its economic policies and reforms. • Performance under the program has been strong. All quantitative targets for end-December 2023 were met, except the indicative target on social spending. Most structural benchmarks due by end-April 2024 were either met or implemented with delay. Nevertheless, the economy is still vulnerable and the path to debt sustainability remains knife-edged. Sustaining the reform momentum and efforts to restructure debt are critical to put the economy on a path towards lasting recovery and debt sustainability. • The Article IV Consultation focused on wide-ranging reforms to restore macroeconomic stability and debt sustainability, maintain price stability, safeguard financial stability, rebuild external buffers, and implement growth- oriented structural reforms, including by strengthening governance. Washington, DC: The Executive Board of the International Monetary Fund (IMF) completed the second review under the 48-month Extended Fund Facility (EFF) Arrangement, allowing the authorities to draw SDR 254 million (about US$336 million). This brings the total IMF financial support disbursed so far to SDR 762 million (about US$1 billion). The Executive Board also concluded the 2024 Article IV Consultation with Sri Lanka. The EFF arrangement for Sri Lanka was approved by the Executive Board on March 20, 2023 (see Press Release No. 23/79) in an amount of SDR 2.286 billion (395 percent of quota or about US$3 billion. The first review of the EFF was completed by the Executive Board on December 12, 2023 with disbursements of SDR 254 million (about US$337 million; see Press Release No. 23/439). The EFF-supported program aims to restore Sri Lanka’s macroeconomic stability and debt sustainability, mitigate the economic impact on the poor and vulnerable, rebuild external buffers, safeguard financial sector stability, and strengthen governance and growth potential. Signs of economic recovery are emerging. Real GDP expanded by 3 percent (y-o-y) in the second half of 2023. May 2024 inflation was 0.9 percent and gross international reserves increased to US$5.5 billion by end-April 2024. The primary balance improved to a surplus with tax revenue increasing to 9.8 percent of GDP in 2023. Despite improvements in non-performing loans, pockets of vulnerabilities remain in the banking sector. The recovery remains gradual, and the medium-term growth potential hinges on appropriate policy settings. Growth is projected to recover moderately in 2024-25 given constrained bank credit and fiscal consolidation, while facing uncertainties around the debt restructuring and policy direction following the elections. Inflation is expected to temporarily increase due to one-off factors. The current account is expected to remain positive in 2024, driven by improved tourist arrivals and remittances. Domestic risks could arise from waning reform momentum, especially on Page 34 The World Bank Sri Lanka Second Resilience, Stability and Economic Turnaround Development Policy Operation (P180549) revenue mobilization. External risks are associated with intensified regional conflicts, commodity price volatility, and a global slowdown. Slow progress in debt restructuring could widen financing gaps. Following the Executive Board’s discussion, Mr. Kenji Okamura, Deputy Managing Director and Acting Chair, issued the following statement: “Sri Lanka’s performance under its Fund-supported program remains strong. All quantitative targets were met, except for the marginal shortfall of indicative target on social spending. Most structural benchmarks were either met or implemented with delay. Reforms and policy adjustment are bearing fruit. The economy is starting to recover, inflation remains low, revenue collection is improving, and reserves continue to accumulate. Despite these positive developments, the economy is still vulnerable and the path to debt sustainability remains knife-edged. Important vulnerabilities associated with the ongoing debt restructuring, revenue mobilization, reserve accumulation, and banks’ ability to support the recovery continue to cloud the outlook. Strong reform efforts, adequate safeguards, and contingency planning help mitigate these risks. “To restore fiscal sustainability, sustained revenue mobilization efforts, promptly finalizing the debt restructuring in line with program targets, and protecting social and capital spending remain critical. Advancing public financial management will help enhance fiscal discipline, and strengthening the debt management framework is also needed. “Monetary policy should continue prioritizing price stability, supported by a sustained commitment to refrain from monetary financing and safeguard central bank independence. Continued exchange rate flexibility and gradually phasing out the balance of payments measures remain critical to rebuild external buffers and facilitate external rebalancing. “Restoring bank capital adequacy and strengthening governance and oversight of state-owned banks are top priorities to revive credit growth and support economic recovery. “The authorities need to press ahead with their efforts to address structural challenges to unlock long-term potential. Key priorities include steadfast implementation of the governance reforms; further trade liberalization to promote exports and foreign direct investment; labor reforms to upgrade skills and increase female labor force participation; and state- owned enterprise reforms to improve efficiency and fiscal transparency, contain fiscal risks, and promote a level playing field for the private sector. Executive Board Assessment Executive Directors commended the authorities’ strong performance under the Fund supported program, noting that reforms are bearing fruit. The economy has started to recover, inflation remains low, revenue collection is improving, and reserves continue to accumulate. Directors underscored, however, that important vulnerabilities and uncertainties remain, including with respect to the ongoing debt restructuring and the upcoming elections. Against this backdrop, they called on the authorities to continue strengthening macroeconomic policies to restore economic stability and debt sustainability and to sustain the reform momentum to promote long term inclusive growth. Directors underscored that restoring fiscal sustainability requires additional revenue measures underpinning the 2025 Budget, further tax administration reforms, as well as limiting tax exemptions and making them more transparent. They called for protecting growth enhancing and social spending, and for improving the social safety net. Directors welcomed the submission of the new Public Financial Management bill to Parliament, which would strengthen fiscal discipline and establish a solid fiscal framework. They noted that further efforts to strengthen the debt management framework are also Page 35 The World Bank Sri Lanka Second Resilience, Stability and Economic Turnaround Development Policy Operation (P180549) needed. Directors welcomed the progress on achieving cost-recovery in energy pricing, noting its criticality for containing risks from state-owned enterprises (SOEs). Directors welcomed the progress made to advance debt restructuring to restore Sri Lanka’s debt sustainability. They called for a swift finalization of the Memorandum of Understanding with the Official Creditor Committee and final agreements with the Export-Import Bank of China. Directors stressed the importance of seeking comparable, transparent, and timely completion of restructurings with external private creditors consistent with program targets. Directors emphasized that maintaining price stability remains the top priority for monetary policy, which requires anchoring inflation expectations, continuing to refrain from monetary financing, and the gradual unwinding of government security holdings as markets allow. They also stressed the importance of strengthening central bank independence. Directors underscored the need to continue building external buffers, while maintaining exchange rate flexibility to facilitate external rebalancing and preserve the credibility of the inflation targeting regime. They called for gradually phasing out the balance of payments measures. Directors underscored the need to strengthen financial sector resilience to support the recovery. They called for swift completion of the restructuring of remaining domestic law, foreign currency loans and for adequate recapitalization of commercial and state-owned banks. Directors welcomed the enactment of the Banking Act amendments and emphasized the importance of their effective implementation to enhance supervision and the governance of state-owned banks. They also called for further efforts to strengthen the anti-money laundering and counterterrorism financing framework. Directors stressed that pressing ahead with governance and structural reforms, supported by development partners and IMF capacity development, is crucial to unlock growth potential. They welcomed the publication of the authorities’ action plan on the key governance reforms recommended in the Governance Diagnostic Report and called for its steadfast implementation. Directors also recommended prioritizing reforms to further liberalize trade, improve the investment climate and SOE efficiency, reduce gender gaps in the labor market, and mitigate climate vulnerabilities. IMF Communications Department MEDIA RELATIONS PRESS OFFICER: HUONG LAN 'PINKY' VU PHONE: +1 202 623-7100 EMAIL: MEDIA@IMF.ORG Page 36 The World Bank Sri Lanka Second Resilience, Stability and Economic Turnaround Development Policy Operation (P180549) ANNEX 3: LETTER OF DEVELOPMENT POLICY Page 37 The World Bank Sri Lanka Second Resilience, Stability and Economic Turnaround Development Policy Operation (P180549) Page 38 The World Bank Sri Lanka Second Resilience, Stability and Economic Turnaround Development Policy Operation (P180549) Page 39 The World Bank Sri Lanka Second Resilience, Stability and Economic Turnaround Development Policy Operation (P180549) Page 40 The World Bank Sri Lanka Second Resilience, Stability and Economic Turnaround Development Policy Operation (P180549) Page 41 The World Bank Sri Lanka Second Resilience, Stability and Economic Turnaround Development Policy Operation (P180549) Page 42 The World Bank Sri Lanka Second Resilience, Stability and Economic Turnaround Development Policy Operation (P180549) ANNEX 4: ENVIRONMENT AND POVERTY/SOCIAL ANALYSIS TABLE Significant poverty, social or Significant positive or negative Prior Actions distributional effects positive or environment effects negative Pillar 1: Improving Economic Governance Prior action #1 No No Prior action #2 No No Prior action #3 No No Prior action #4 No No Pillar 2: Enhancing Growth and Competitiveness Prior action #5 No Yes, negative Prior action #6 No No Prior action #7 No No Pillar 3: Protecting the Poor and Vulnerable Prior action #8 No Yes, positive Prior action #9 No Yes, positive Page 43 The World Bank Sri Lanka Second Resilience, Stability and Economic Turnaround Development Policy Operation (P180549) ANNEX 5: PARIS ALIGNMENT ASSESSMENT Program Development Objective: The Program Development Objective is to support foundational reforms that restore macroeconomic stability and sustainability, mitigate the impact of current and future shocks on the poor and vulnerable, and support an inclusive and private-sector-led recovery and growth path. Step 1: Considering our climate Answer: Yes analysis, is the operation consistent Explanation: The DPO is consistent with Sri Lanka’s climate commitments, with the country’s climate including the NDC, National Adaptation Plan (2016-2025), and Climate commitments, including the NDC, Prosperity Plan 2022. Overall, all PAs align with the Paris Agreement, with none NAP, LTS, and other relevant likely to cause a significant increase in GHG emissions. Assessments of strategies? individual PAs are provided below for additional clarity. Mitigation goals: assessing and reducing the risks All PAs in this operation are assessed as unlikely to cause significant increases in GHG emissions. PA5, PA6, and PA9 are also assessed as likely to contribute to reduced emissions that warrant further elaboration and are therefore detailed below. Pillar 1: Improving Economic Governance Conclusion for PAs under Pillar 1: The PAs under Pillar 1 are aligned for mitigation goals, as it meets the criteria for Step 2. Further consideration of Step 3 is not necessary. Pillar 2: Enhancing Growth and Competitiveness Prior Action 5: To ensure a more effective, efficient and financially and commercially sustainable power sector, Sri Lanka has enacted a new Electricity Act. Step M2.1: Is the PA likely to cause Answer: No a significant increase in GHG Explanation: As part of NDC commitments, the country will transition from a emissions? fossil fuel-based power system to a renewable energy one. This will contribute to GHG reductions, while adding more capacity to meet the growing demand. The Act and its supporting measures will also bring more transparency in the sector, enable a smooth transition into financial sustainability, and promote investments in renewable energy. Prior Action 6: To increase access to imported inputs and capital goods and encourage export orientation, Sri Lanka has through MoF, approved a National Tariff Policy (NTP) that commits to a predictable path of reduction of import duty protection over a four-year period. Step M2.1: Is the PA likely to cause Answer: No a significant increase in GHG Explanation: The reduction of tariffs will likely increase imports of more emissions? environmentally friendly goods. This shift will incentivize exporters and domestic producers to adopt advanced, less polluting technologies, which can lead to lower GHG emissions. Conclusion for PAs under Pillar 2: The PAs under Pillar 2 are aligned for mitigation goals, as they meet the criteria for Step 2. Further consideration of Step 3 is not necessary. Pillar 3: Protecting the Poor and Vulnerable Prior Action 9: To reduce legal discrimination on the grounds of gender – including gender discrimination in the labor market – and enable the enforcement of Sri Lanka’s obligations under the Convention on the Elimination of all Forms of Discrimination Against Women (CEDAW), Sri Lanka has enacted the Women Empowerment (WE) Act as evidenced by publication in the official gazette of the certified Women Empowerment Act, No. 37 of 2024. Page 44 The World Bank Sri Lanka Second Resilience, Stability and Economic Turnaround Development Policy Operation (P180549) Step M2.1: Is the PA likely to cause Answer: No a significant increase in GHG Explanation: Legal discrimination in the labor force based on gender is a emissions? contributor to the large gender gaps exhibited in labor force participation. By implementing legal and institutional frameworks that address the existing restrictions, an enabling environment is created for women to enter the labor force. The resultant increases in standards of living will reduce the need for negative livelihood strategies and coping mechanisms used to provide for basic needs, which frequently include measures which are damaging to the environment. Conclusion for PAs under Pillar 3: The PAs under Pillar 3 are aligned for mitigation goals, as it meets the criteria for Step 2. Further consideration of Step 3 is not necessary. Adaptation and resilience goals: assessing and managing the risks All PAs supported by the operation are assessed as not likely to be impacted by current or future physical climate risk, given that the objectives are related to enhancement or improvement of policy, institutional and regulatory frameworks. PA5, PA7, PA8, and PA9 are assessed as likely to contribute positively to adaptation and resilience goals that warrant further elaboration and are therefore detailed below. Pillar 1: Improving Economic Governance Conclusion for PAs under Pillar 1: The PAs under Pillar 1 are aligned for adaptation and resilience goals. Pillar 2: Enhancing Growth and Competitiveness Prior Action 5: To ensure a more effective, efficient and financially and commercially sustainable power sector, Sri Lanka has enacted a new Electricity Act. Step A2: Are risks from climate Answer: No hazards likely to have an adverse Explanation: The PA will incentivize investments in renewable energy, which effect on the PA’s contribution to could result in reduced vulnerability to extreme weather events, enhanced grid the Development Objective(s)? resilience through decentralization, and a diversified energy mix to stabilize supply. Together, these factors could collectively result in an adaptive energy infrastructure capable of withstanding and recovering from the effects of climate change. Prior Action 7: To expand access to affordable broadband services, facilitate private capital and develop competitive markets, Sri Lanka has: (i) enacted amendments to the Sri Lanka Telecommunications Act No. 25; and (ii) issued implementing regulations for the adoption of a sector specific competition regulation framework. Step A2: Are risks from climate Answer: No hazards likely to have an adverse Explanation: Expanding access to affordable broadband effect on the PA’s contribution to aligns with the country's NAP priority to develop robust and resilient network- the Development Objective(s)? based communication and internet alert systems. These systems enable authorities to issue early warning alerts and timely seasonal and medium-term weather forecasts, including information on water availability. This is crucial for delivering warnings to last-mile vulnerable communities. This PA is therefore expected to contribute positively to increased climate resilience in Sri Lanka. Conclusion for PAs under Pillar 2: Pillar 2 PAs are aligned for adaptation and resilience goals. Pillar 3: Protecting the Poor and Vulnerable Prior Action 8: To ensure increased impact and sustainability of the social protection system, Sri Lanka has issued regulations authorizing implementation of the periodic recertification of WBPS beneficiaries. Page 45 The World Bank Sri Lanka Second Resilience, Stability and Economic Turnaround Development Policy Operation (P180549) Step A2: Are risks from climate Answer: No hazards likely to have an adverse Explanation: Better targeted social protection systems will aid households, effect on the PA’s contribution to particularly those vulnerable to climate-induced food insecurity, by building the Development Objective(s)? resilience through savings and enhanced food consumption via cash transfers, with higher amounts directed to the most vulnerable groups. These systems are scalable in coverage, value, and conditions to provide post-shock support in climate emergencies, mitigating impacts and preventing harmful coping strategies. The financial systems, digital payments, and social registry transparency improved by the PA will enable rapid assistance during climate shocks. Prior Action 9: To reduce legal discrimination on the grounds of gender – including gender discrimination in the labor market – and enable the enforcement of Sri Lanka’s obligations under the Convention on the Elimination of all Forms of Discrimination Against Women (CEDAW), Sri Lanka has enacted the Women Empowerment (WE) Act. Step A2: Are risks from climate Answer: No hazards likely to have an adverse Explanation: Women are particularly vulnerable to the impacts of climate change effect on the PA’s contribution to due to their often-limited access to necessary adaptation resources, especially the Development Objective(s)? those with constrained economic means. By creating a mechanism to help enforce women´s economic, social and political rights ‘including the right to employment and equal remuneration’ the Bill may increase employment opportunities for women in emerging sectors. Their resilience to shocks, including those induced by climate change, is also expected to improve, thereby enhancing climate change adaptation efforts. Conclusion for PAs under Pillar 3: The PAs under Pillar 3 are aligned for adaptation and resilience goals. Overall Conclusion of Paris Alignment Assessment: All prior actions of the proposed program are aligned with the mitigation, adaptation, and resilience goals of the Paris Agreement. Page 46 The World Bank Sri Lanka Second Resilience, Stability and Economic Turnaround Development Policy Operation (P180549) ANNEX 6: KEY CHANGES TO ORIGINAL POLICY MATRIX IN A PROGRAMMATIC SERIES Triggers for DPO2 – Original Language Prior Actions for DPO2 – Updated language Justification for the change in language Pillar 1: Improving Economic Governance Trigger #1. To improve debt management, Sri Lanka, has Prior Action #1. To improve debt management, Sri Lanka has Issuance of regulations for the establishment of the PDMO and granting enacted a new Public Debt Management Law, established a enacted a new Public Debt Management (PDM) law, as evidenced of sovereign guarantees and on-lending is dropped from PA#1. Their single Debt Management Office (DMO), and issued rules and by publication in the Official Gazette of the certified Public Debt issuance could only be initiated once the PDM law was enacted. Given regulations for the granting of sovereign guarantees and on- Management Act No. 33 of 2024. delays in the enactment of the PDM Law, this issuance will only occur in lending. the latter part of 2024. To ensure robust initial implementation of the PDM Law, issuance of these regulations will be proposed as Performance and Policy Actions (under the Sustainable Development Financing Policy) for Sri Lanka in FY25. This will allow us to move ahead with these important reforms sequentially. Trigger #2. To enhance the quality of tax audits and tax Prior Action #2. To strengthen governance of tax administration and transparency, (i) the IRD has issued notified tax forms for its enforcement capability: (i) MoF has specified the type, scope, (i) The reference to the issuance and notification of tax forms for reporting information and receives data from third parties into frequency and manner of 3rd party data to be shared by the reporting information has been replaced by issuance of regulations their RAMIS risk system and has published the first annual relevant counterparts under the Inland Revenue Act as evidenced since the term "tax forms" did not clearly specify the legal rank of the report on compliance of tax audits using their centralized risk- by publication in the Official Gazette No. 2376/25-2024 of the norm. Also, the publication of the first annual report on compliance of based systems; and (ii) Sri Lanka, through MoF, has issued a regulation issued by MOF and letter dated July 2, 2024 issued from tax audits using centralized risk-based systems has been replaced by statement of tax expenditures that estimates revenue the Secretary General of Parliament to the Presidential Secretariat issuance of IRD internal guidelines for the utilization of third-party data foregone on tax exemptions and tax reductions for all the confirming its approval; (ii) IRD has introduced risk management in risk-based audit selection, because audit results data would not be major taxes. guidelines on categorization of risks associated to tax available until later in 2024. Receipt of data from third parties into the administration as evidenced by the issuance by the IRD RAMIS risk system has been dropped because the new regulation only Commissioner General of the Risk Management Guide-2023; and enters into force on July 1, 2024, and the integration of RAMIS with the (iii) MoF has issued a Tax Expenditures Statement (TES) estimating IT systems of other agencies is still being developed. revenue foregone for all the major taxes, as evidenced by publication of the TES dated March 31, 2024, on the MoF website. Trigger #3. To reduce systemic risks, strengthen financial Prior Action #3. To reduce systemic risks, strengthen financial (i) The new CBSL Act replaces the CBSL’s Monetary Board with the sector stability, and enhance the enabling environment for sector stability, and enhance the enabling environment for Governing Board as the key decision-making body. corporate NPL resolution, (i) the CBSL’s Monetary Board has corporate non-performing loan (NPL) resolution CBSL has approved a revised regulation that stipulates prudential limits stipulated: (i) tightened prudential limits for the maximum for the maximum exposures that banks can have vis-à-vis exposures that banks can have vis-à-vis single borrowers and to a single borrowers and to a group of connected borrowers, group of connected borrowers, including SOEs, as evidenced by including SOEs, and (ii) the CBSL has issued an amendment to CBSL Directive No. 01 of 2024 (“Large Exposures of Licensed Banks”) Circular No.1 of 2022, providing for the revival of viable dated March 25, 2024 and published on the CBSL’s website; and (ii) enhanced requirements for banks when reviving distressed but Page 47 The World Bank Sri Lanka Second Resilience, Stability and Economic Turnaround Development Policy Operation (P180549) businesses through a standardized workout process in viable business and a standardized workout process in accordance accordance with international best practices. with international best practices as evidenced by CBSL Circular No. 02 of 2024 (“Guidelines for the Establishment of Business Revival Units in Licensed Banks”) dated March 28, 2024 and published on CBSL’s website. Trigger #4. To enhance banking sector stability and Prior Action #4. To enhance banking sector stability and PA#4 builds on the original trigger for DPO2, by clarifying that the performance, the CBSL and MoF have endorsed, and SOB’s performance, Sri Lanka has initiated the restructuring process for restructuring process will initially focus on the two large SOBs and will Boards of Directors have adopted, time-bound restructuring state-owned Bank of Ceylon (BOC) and People’s Bank (PB) as be initiated through complementary policy actions by GoSL (the owner) plans based on comprehensive diagnostic audits conducted by evidenced by Cabinet Paper No. 24/0695/604/078 approving to strengthen corporate governance and risk management, as well as a reputable third-party entity. improved governance arrangements and strategic direction for both the strategic direction for both banks. The GoSL has already committed banks. to the recapitalization of the two SOBs. However, more time is needed for the banks to approve recapitalization plans, in agreement with MOF and CBSL. As this reform is a structural benchmark for the IMF EFF, there is a high degree of comfort that the government will undertake this reform after due consultations and with due diligence. Pillar 2: Enhancing Growth and Competitiveness Trigger #5. To establish the objectives of the SOE reform Prior Action #5. To ensure a more effective, efficient and financially There is strong support across the political spectrum for improvements program, institutional and governance arrangements – and commercially sustainable power sector, Sri Lanka has enacted a in management and corporate governance of SOEs, but there is ongoing including the guiding principles of the HoCo, transparent new Electricity Act, as evidenced by publication in the Official debate about the overall approach to private participation. Given the divestment procedures, and use of divestment proceeds – and Gazette of the certified Sri Lanka Electricity Act No. 36 of 2024. increasing lack of clarity on the broader SOE reform path and additional expand the coverage of the program: (i) the Cabinet has issued time needed for consensus building (especially on the broader regulations to implement a new SOE Reform Act; (ii) the institutional model and approach to private participation), PA#5 has Ministry of Finance has revised the Articles of Association for been changed to the enactment of the new Electricity Act, given the the HoCo to be consistent with the new SOE law; and (iii) the stronger support for the ongoing energy sector regulatory reforms and President has gazetted the operational control of a further set restructuring of CEB – a key macro/fiscal critical SOE. The new Act and of SOEs to the Ministry of Finance. broader sector restructuring – supported by Bank TA – aims to: (a) promote competition in the power sector through the introduction of open access, (b) establish wholesale power markets, and (c) set out a revised institutional and market framework to, inter alia, unbundle and restructure CEB. These objectives will make a meaningful contribution to the implementation of the SOE Reform Policy in a core sector where the Bank is heavily involved. The Bank will, however, continue its policy dialogue and support to the broader SOE agenda through other instruments and sector interventions (e.g., IFC transaction advisory and Bank support to the SOB reforms). Trigger #6. To address the regulatory and policy obstacles to Prior Action #6. To increase access to imported inputs and capital (i) In February 2024, GoSL decided to be more ambitious and expand increase private investment and encourage export goods and encourage export orientation, Sri Lanka has through the scope of a unified Investment Law by consolidating five bills into a orientation, Sri Lanka has: (i) through the Board of Investment MoF, approved a National Tariff Policy (NTP) that commits to a new Economic Transformation (ET) Bill. The latter included the Page 48 The World Bank Sri Lanka Second Resilience, Stability and Economic Turnaround Development Policy Operation (P180549) (BOI), issued the implementation regulations for a new unified predictable path of reduction of import duty protection over a four- Investment chapter, which had been supported by the Bank as part of Investment Law, and (ii) through the MoF, issued a National year period as evidenced by minutes of the meeting of the Cabinet the original PA#6. Given the government’s decision to pass a more Tariff Policy that commits to a predictable path of reduction of Paper No. 24/1072/604/114 approving the NTP. ambitious Bill, additional time was required for its preparation and import duty protection over a four-year period. consultations, thereby leaving insufficient time to finalize the Parliamentary process within the DPO2 timeline. Thus, this part of PA#6 has been dropped. However, the Bank will continue to support government’s reforms to enhance the investment environment through technical assistance. Trigger #7. To expand access to affordable broadband Prior Action #7. To expand access to affordable broadband services, (i) GoSL legal analysis recommended the amendment of the services, Sri Lanka has, (i) through the Ministry of Technology facilitate private capital and develop competitive markets, Sri Lanka Telecommunications Act to clarify the powers of TRCSL to define and (MoT), issued an open access and infrastructure sharing policy has: (i) enacted amendments to the Sri Lanka Telecommunications implement the proposed regulations. The amendment removed the for broadband networks; and following [orders] issued by the Act No. 25 as evidenced by publication in the Official Gazette of the need for a MoT policy, thereby also strengthening the PA. MoT, (ii) through the Telecommunications Regulatory certified Sri Lanka Telecommunications (Amendment) Act No.39 of (ii) added to respond to the market evolution since 2022 and provide a Commission of Sri Lanka (TRCSL), established implementing 2024; and (ii) issued implementing regulations for the adoption of a regulatory framework for all ex-ante and ex-post remedies. However, the regulations on spectrum assignment and sharing of infrastructure regulations and procedures, through an open and consultative sector specific competition regulation framework as evidenced by were dropped as following the approval of the amendment to the Act, process, to support competitive markets through (a) sharing of Rules made by the TRCSL and published in the Official Gazette. changes to the regulations entail Cabinet approval, rather than issuance telecom-ready infrastructure; and (b) competitive assignment by TRCSL. Therefore, these sub-components are no longer aligned with of radio spectrum for wireless broadband services. DPO2 timelines. Pillar 3: Protecting the Poor and Vulnerable Trigger #8. To ensure increased impact and sustainability of Prior Action #8. To ensure increased impact and sustainability of the (i) This has been dropped as a Cabinet decision is insufficient to mandate the social protection system, Sri Lanka has, through its Cabinet social protection system, Sri Lanka has issued regulations that poverty-targeted programs use the social registry developed for of Ministers, (i) mandated that poverty-targeted programs use authorizing implementation of the periodic recertification of WBPS the new WBPS. There are several poverty targeted programs, some the social registry developed for the new welfare benefit beneficiaries as evidenced by an amendment to the Welfare Benefit under different pieces of legislation, which means significant legal payment scheme; (ii) approved and adopted regulations for Payment (Selection of Persons Eligible to Receive Payments) and/or regulatory changes to bring the original Trigger into effect. This recertification of welfare program beneficiaries. Regulations No. 1 of 2022 issued by the Minister of Finance and cannot happen within the DPO2 timeline. However, as discussed in the published in Extra Ordinary Gazette No. 2382/02 dated April 29, LDP, the government is committed to move this forward, and the Bank 2024 and letter dated June 7, 2024 issued by the Secretary General will continue to provide relevant support. of Parliament to the Presidential Secretariat confirming approval by (ii) Parliamentary approval has replaced Cabinet approval, which Parliament of such amendment. significantly strengthens the PA. Trigger #9. To reduce gender discrimination in the labor Prior Action #9. To reduce legal discrimination on the grounds of The original scope of the reform has been expanded to support the market; (i) legal restrictions against women working flexible gender – including gender discrimination in the labor market – and enactment of the WE Bill, which seeks to reduce legal discrimination in hours and at night are removed through the amendment of enable the enforcement of Sri Lanka’s obligations under the the workforce and beyond on the grounds of gender. This, therefore, the Shop and Office Employees Act No. 19 of 1954 in line with Convention on the Elimination of all Forms of Discrimination Against considerably strengthens the PA. the non-discriminatory principles outlined in the Gender Women (CEDAW), Sri Lanka has enacted the Women Empowerment Equality Bill; and (ii) implementing regulations for labor (WE) Act as evidenced by publication in the Official Gazette of the compliance audits are revised to include checks on new certified Women Empowerment Act, No. 37 of 2024. legislation. Page 49