Never waste a crisis: Govt. hopes to restore macroeconomic stability
Sri Lanka economy: Top experts’ report tabled in parliament; outlines the path ahead
Krishnamoorthy Subramaniam is Executive Director for Sri Lanka and Chandranath Amerasekera, is the Alternative Executive Director for Sri Lanka with the International Monetary Fund.
Their report on Sri Lanka’s economy is among the documents tabled in Parliament by President Ranil Wickremesinghe last Tuesday. They were part of the communications with the International Monetary Fund (IMF). Here are edited excerpts:
Our authorities extend their sincere gratitude to all nations – particularly to India for leading the way – for providing the necessary financing assurances and required support, thereby enabling staff to submit Sri Lanka’s request for a 48-month Extended Arrangement under the Extended Fund Facility (EFF), with access to Fund resources of approximately US$ 3 billion (395 percent of quota), to the Executive Board for its consideration. The authorities express hope that the implementation of the economic program supported by the EFF will bring about much-needed stability to the Sri Lankan economy, paving the way for longer-term sustained and inclusive growth in Sri Lanka.
In 2022, Sri Lanka experienced the worst socio-economic and political crisis in its post-independent history. Although fiscal and monetary policy stimuli helped a rebound of the economy from time to time over the past few years, events that unfolded since 2018, including the constitutional crisis in 2018, the Easter Sunday terrorist attacks in 2019, and the COVID-19 pandemic thereafter, considerably weakened the Sri Lankan economy. The situation was exacerbated by grave policy missteps that included unsustainable direct and indirect tax cuts, continued monetary financing of fiscal deficits at suppressed interest rates, a prolonged period of low-interest rates that caused excessive monetary expansion and balance of payments pressures, flawed pricing policies for petroleum products, electricity and other public utilities, an ill-timed ban on chemical fertilizer, and the defense of the exchange rate at the expense of the country’s foreign exchange reserves.
Sri Lanka had lost access to the conventional international financial markets with the onset of the pandemic, and had exhausted all fiscal, monetary, external sector and financial sector buffers by early 2022. Rising inflation and shortages of essentials, including basic food items, pharmaceutical supplies, cooking gas and domestic petroleum products, together with long power cuts, resulted in a collapse of business confidence, severely affected the ongoing recovery in tourism, and most importantly, triggered widespread public protests of an unprecedented scale that resulted in a change of key positions of the government over the next few months.
The government expressed its desire for close IMF engagement and made a request for a Fund-supported stabilization program. The government also announced a debt service standstill in April 2022, as almost all usable foreign exchange reserves of the country had been exhausted. The government commenced introducing necessary stabilization measures broadly in line with the recommendations of the 2021 Article IV consultations and introduced additional measures to address the shortages of essentials with the assistance of friendly nations. In this regard, the authorities extend their special thanks to India for stepping in during the country’s hour-of-need and providing emergency financing through multiple channels, at a time of extreme uncertainties surrounding the recovery of such financing – a rare act of kindness by any standard.
The government also embarked on discussions with creditors to seek support for an IMF-backed program to regain debt sustainability and restore macroeconomic stability. Following intense negotiations, the authorities reached a Staff-Level Agreement (SLA) with the Fund on September 1, 2022, and while meeting the prerequisites needed for program approval. The delay in obtaining the approval for the EFF and the unpopular, yet essential, reform measures have caused some tensions in Sri Lanka in the past few weeks. However, our authorities, with a deep sense of conviction and ownership, reiterate their resolve to carry out the necessary reforms and take steps to institutionalize reforms in order to prevent any return to populist and unsustainable policies that would be detrimental to the country’s progress in the long run.
The Sri Lankan economy contracted by an unprecedented 7.8 percent in 2022, reflecting the magnitude of the crisis it faced during the year. All three sectors of the economy, namely, Agriculture, Industry, and Services, were severely affected in 2022, and the impact of corrective policy measures is also having a dampening effect on economic activity in the near term. While the recovery in some agricultural subsectors, the rebound in tourism and the gradual return of business confidence are expected to aid economic recovery, the economy is projected to contract by around 3 percent in 2023.
In 2025, the authorities plan to revamp the property tax system and introduce a wealth transfer tax. The above measures are expected to make Sri Lanka’s tax system more progressive, and gradually shift the focus of taxation from indirect to direct sources. The government has also embarked on revenue administration reforms to strengthen tax compliance, keeping in mind the relatively large size of the informal sector of the country. In order to enhance fiscal transparency, the government will document all tax expenditures provided under the Strategic Development Projects Act and the Board of Investment Act.
Expenditure rationalization is not expected to compromise spending on health, education, and social protection. The crisis has increased the incidence of poverty and reversed the gains achieved in recent decades. The poorest of the poor are the most affected by the crisis, and there is evidence that many others are falling into poverty because of reduced real incomes and loss of livelihoods. The ongoing social safety net reforms are expected to improve coverage and targeting, thereby supporting the poor and the vulnerable, particularly during the ongoing adjustment phase.
Measures are being introduced to mitigate fiscal risks arising from state-owned business enterprises (SOBEs) and to reform the SOBE sector. Fuel and electricity prices have been adjusted in line with international market prices, and regular formula-based price revision mechanisms have been introduced. Such measures are expected to depoliticize pricing of energy and other public utilities, while eliminating the spillover effects of mispricing on the fiscal and financial sectors. A comprehensive strategy to reform the key SOBEs is expected to be introduced by mid-2023.
The government expects to strengthen the framework for SOBE borrowing by limiting such borrowing to commercially viable activities and preventing foreign currency borrowing by non-financial SOBEs without adequate sources of foreign currency revenue. The government will transparently remunerate any subsidies and quasi-fiscal activities of SOBEs through government transfers.
A new Public Financial Management (PFM) law is expected to be in place from 2024, thereby introducing binding fiscal rules, including a legally binding government debt ceiling. The PFM law is also expected to establish the legal definitions for public debt and government deficit, clarify the budget formulation process, specify the responsibilities of the Ministry of Finance and spending units, establish information and accountability requirements, and introduce stricter guidelines on issuing treasury guarantees.
Inflation, Monetary Developments and Monetary Policy Inflation (Colombo Consumer Price Index (CCPI) based, year-on-year) accelerated from 5.7
percent in September 2021 to 69.8 percent in September 2022, i.e., over a space of merely one year. Causes for this acceleration included the depreciation of the Sri Lanka rupee, disruptions to domestic food production, global fuel and food price shocks, price revisions of domestic fuel, electricity, and cooking gas supplies along with the associated increases in other prices, and unsustainable monetary financing of the fiscal deficits that de-anchored inflation expectations. Inflation has decelerated thereafter in response to policy tightening, measuring 50.6 percent in February 2023.
A sharper deceleration is projected over the next few months. Monthly inflation has hovered within a range of - 0.7 percent and 0.5 percent over the past five months, indicating that high year-on-year inflation recorded at present is due to legacy effects than due to ongoing inflationary pressures. The policy interest rate corridor of the Central Bank of Sri Lanka (CBSL) was increased from 5.00-6.00 percent at end 2021 to 15.50-16.50 percent by March 2023, with a decisive seven percentage-point hike in April 2022. The latest monetary policy adjustment in March 2023 was carried out after much deliberation between the Fund staff and the CBSL. The CBSL remains committed to a data-driven monetary policymaking process and is confident of bringing down inflation to single digit levels by end 2023, and subsequently to the target range of 4-6 percent by 2024.
The enactment of the new Central Bank bill will also assist in firmly anchoring inflation expectations by prohibiting monetary financing, introducing institutional reforms that would enhance the independence of the CBSL, institutionalizing the flexible inflation targeting monetary policy framework with exchange rate flexibility, and increasing accountability of the CBSL in relation to price stability.
The sharp depreciation of the Sri Lanka Rupee in early 2022, the tight monetary policy stance, decline in real incomes and purchasing power, and tighter controls on imports resulted in a narrower trade deficit of US$ 5.2 billion in 2022. Worker remittances are on an upward trend while tourist arrivals have also begun to show signs of sustained recovery. The stability of the foreign exchange market also benefitted from the debt service standstill that is in place and the capital flow measures (CFM), as well as the quota system for fuel distribution. With positive sentiments in the domestic foreign exchange market rising, the CBSL eliminated the guidance given to the market on the exchange rate and allowed the exchange rate to be determined by market forces. Thus far in 2023, the CBSL has been able to purchase over US$ 950 million on a net basis towards building up reserves, while the Sri Lanka Rupee has appreciated by around 11 percent against the US$ during this period, reflecting improving market sentiments in anticipation of the Executive Board approval of the EFF.
The CBSL remains committed to a flexible exchange rate policy that is consistent with the flexible inflation targeting framework, and to building up reserves through regular intervention in the domestic foreign exchange market as envisaged in the program. The authorities have also requested temporary approval of the remaining exchange restrictions and multiple currency practices until a sustainable outcome in the foreign exchange market is achieved.
The government is appreciative of the specific and credible financing assurances from India, the Paris Club, Hungary, and China, as well as the consent of other official bilateral creditors to Fund financing to Sri Lanka notwithstanding the arrears. The authorities also appreciate the cooperation of external commercial creditors in this regard.
The government reiterates its commitment to a debt resolution consistent with the IMF program parameters and stands ready to use additional safeguard mechanisms to ensure comparable treatment, as appropriate. In this regard, the authorities have issued a Presidential letter addressed to all bilateral official creditors a) assuring transparency on any debt treatment terms that are agreed with any creditor or group of creditors, before being formalized, b) committing not to resume debt service to any creditor unless that creditor agrees on a comprehensive debt treatment in line with IMFsupported program parameters and the comparability of treatment principle, and c) reiterating commitment to a comparable treatment of all external creditors, with a view to ensuring all-round equitable burden sharing for all restructured debts. An announcement on the coverage and parameters of debt operations is expected to be made before endApril 2023.
Concluding remarks
The Sri Lankan government recognizes that the approval of the EFF alone is insufficient to resolve the issues the country is currently facing. While the delay in seeking Fund assistance is regretted, due to various reasons, it has taken a period of 12 months, as well as extraordinary efforts from all stakeholders, to design an appropriate stabilization program, complete the prerequisites, coordinate with creditors, and secure the necessary financing assurances, before reaching the current stage of Executive Board approval. The government hopes that the next steps in finalizing debt treatment would be faster, as further delays could lengthen the Sri Lanka’s economic recovery process.
The government has benefitted from the close engagement with the Fund during the past year, particularly through policy discussions and technical assistance in the areas of fiscal reforms, financial sector reforms, and institutional reforms through necessary legislative changes. The government also expects that the approval of the EFF will lead to notable catalytic effects to mobilize
support from the World Bank, ADB and other bilateral and multilateral development partners, as well as to rebuild confidence in the economy as the reform program progresses. The government is aware of the serious downside risks that the economy is facing and is determined to decisively address these under the IMF-supported economic program.
Recognizing the fact that a major reason for the country’s lack of continued progress is the deficiency in implementing the identified essential reforms, our authorities express their willingness to learn from countries that
have faced similar crises and recovered through the timely implementation of successful reform programs. In essence, in the spirit of the motto “never waste a crisis,” our authorities are determined to use the current crisis and the IMF-supported reform program as an opportunity to durably address
Sri Lanka’s institutional weaknesses and ensure macroeconomic stability and sustainability, going forward.
Following the Executive Board approval, our authorities also propose to present the IMF-supported economic program to Parliament for discussion and to mobilize the necessary consensus for the successful implementation of the program.