IMF's latest view on capital flows: CFM and MPMs can be applied pre-emptively without surge in capital inflows

The IMF has updated its view on capital flows. Specifically, it now recommends that countries should have the option to pre-emptively curb debt flows to safeguard macroeconomic and financial stability. Excerpts from a blog post:

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Economies with large external debts can be vulnerable to financial crises and deep recessions when capital flows out. External liabilities are riskiest when they generate currency mismatches—when external debt is in foreign currency and is not offset by foreign currency assets or hedges. [...]Since the beginning of the pandemic many countries have spent to support the recovery, which has led to a build-up of their external debt. In some cases, the increase in debt in foreign currency was not offset by foreign currency assets or hedges. This creates new vulnerabilities in the event of a sudden loss of appetite for emerging market debt that could lead to severe financial distress in some markets.

In a review of its Institutional View on capital flows released today, the IMF said that countries should have more flexibility to introduce measures that fall within the intersection of two categories of tools: capital flow management measures (CFMs) and macroprudential measures (MPMs). [...]these measures, known as CFM/MPMs, can help countries to reduce capital inflows and thus mitigate risks to financial stability—not only when capital inflows surge, but at other times too. 

The main update is the addition of CFM/MPMs that can be applied pre-emptively, even when there is no surge in capital inflows, to the policy toolkit. [...]Pre-emptive CFM/MPMs to restrict inflows can mitigate risks from external debt. Yet they should not be used in a manner that leads to excessive distortions. Nor should they substitute for necessary macroeconomic and structural policies or be used to keep currencies excessively weak.

CFMs to restrict inflows might be appropriate for a limited period, the Institutional View said, when a surge in capital inflows constrains the policy space to address currency overvaluation and economic overheating. It said CFMs to restrict outflows might be useful when disruptive outflows risk causing a crisis. In turn, CFM/MPMs on inflows were considered useful only during surges of capital inflows, assuming that financial stability risks from inflows would arise mainly in that context.

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Preemptive CFM/MPMs on debt inflows (primarily in FX) may be useful in the presence of private sector debt stock vulnerabilities (primarily FX mismatches), which MPMs cannot sufficiently address. Those stock vulnerabilities may have accumulated during prior inflow surges or gradually over time without an inflow surge. Preemptive inflow CFM/MPMs should be targeted, transparent and, while potentially longer-lasting, temporary, being recalibrated or removed as the vulnerabilities that led to their adoption subside, or if an effective MPM (that is not designed to limit capital flows) becomes available.

In the context of capital inflow surges, inflow CFM/MPMs may be useful to address financial stability risks arising from the surge, and CFMs on inflows may be useful in the circumstances outlined in the Venn Diagram in Figure 2 (upper panel).

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Sri Lanka’s economic crisis and unsustainable public debt

The IMF’s latest 2021 Article IV Consultation report on Sri Lanka sheds light on the challenging public debt position and deteriorating macroeconomic indicators. Brief highlights from the report.

Macroeconomic mismanagement

Sri Lanka’s economic outlook is constrained by debt overhang, and large fiscal, current account and balance of payments deficits. Foreign exchange shortage and macroeconomic imbalances are negatively affecting GDP growth, which is expected to be below 3% through 2026. Inflation is expected to be above the target band of 4-6%. High external debt burden mean that international reserves remain inadequate to cover near-term debt service needs (forecast to be enough to cover only 1 month of imports of goods and services till 2026).

Fiscal consolidation with improvements in expenditure rationalization, budget formulation and execution, SOE reforms, cost-recovery energy pricing, and adherence to fiscal rule; and boosting income tax and VAT rates, minimizing exemptions, and revenue administration reforms to raise revenue are recommended. Monetary tightening to control inflation, phasing out of direct financing of budget deficit by the central bank, and a gradual transition to market-determined flexible exchange rate to facilitate external adjustment and to rebuild forex reserves are also recommended.

A large drop in tourist arrivals and contraction in manufacturing and services activity contracted real GDP by 3.6% in 2020. Temporary restriction on the use and importation of chemical fertilizer (which affects agricultural output) and the adverse effect of foreign exchange shortages and import restrictions on goods used in industrial activity will mute economic recovery, leading to just 3.6% growth in 2021. 

The 2019 tax cuts, the pandemic’s impact on revenue, and rising expenditures widened fiscal deficit to 12.8% of GDP in 2020 and 11.4% of GDP in 2021. Public debt shot up to 114% of GDP in 2020Q3 owing to large fiscal deficits and new sovereign guarantees to cover losses of Ceylon Petroleum Corporation (CPC). Public debt comprises central government debt, guaranteed debt and the CBSL’s foreign liabilities. 

The central bank (CBSL) has financed a part of large fiscal deficits. As the government’s net domestic financing requirements increased to about 12.3% of GDP in 2021, up from an average of 3.4% over 2010-19, the authorities temporarily introduced explicit interest rate caps for the primary market in mid-2020 with auction shortfalls covered by the central bank. Consequently, net credit to the government increased by 9% of GDP between March 2020 and November 2021. Banks’ claims on the government and SOEs is around 40% of total bank assets. The interest rate caps on treasury securities auctions were removed in August 2021. 

Exchange rate deprecation, supply shortages, increase in administered fuel and food prices (reflecting higher international prices), and a recovery in demand thanks to expansionary fiscal and monetary policies have overshot inflation to beyond the target band of 4-6%. Private sector wages and inflation expectations are on the rise. A rise in fuel prices and a recovery in imports demand amidst recovering tourism income and flat remittance inflows widened current account deficit, which is expected to be 3.1% of GDP in 2021. 

The CBSL fixed the official exchange rate at LKR 200-203 per US dollar since April 2021. It required surrendering of forex earnings through exports and converted remittances, and direct forex sales to cover essential imports. However, it led to sizable imbalances in spot and forward markets, forex hoarding, and severe dollar shortages for importers. Parallel market exchange rate is 20% higher than the fixed rate.

Foreign exchange reserves are critically low, reflecting pre-pandemic fiscal slippage, preexisting debt vulnerabilities, and the impact of the pandemic. Sri Lanka’s sovereign credit rating is CCC and lower, leading to loss of access to international capital markets to roll over maturing international sovereign bonds. Gross international reserves declined from $7.6 billion at end-2019 to $3.1 billion at end-2021 and then to $2.4 billion at end-January 2022. Net international reserves position is negative since November 2021.  

Note that Sri Lanka underwent an adjustment program with IMF (Extended Fund Facility) in 2016 due to unbalanced macroeconomic policies and difficult external environment. Prudent monetary policymaking, fiscal consolidation, income tax law, and an automatic fuel pricing mechanism were rolled out. However, the 2017 drought, the 2018 political crisis, and the 2019 terrorist attack created complications in EFF implementation. Fiscal consolidation was reversed in 2019, currency depreciated in 2018, and a real interest rate shock shot up public debt to GDP ratio from 84% in 2016 to 94% in 2019. Income tax and VAT rates were cut in 2019 (revenue losses exceeded 2% of GDP), automatic fuel pricing mechanism was discontinued, leading to high fiscal risks from SOE losses. 

Unsustainable public debt

The IMF considers that Sri Lanka’s public debt is unsustainable. Public debt and gross financing needs are estimated to reach 118.9% of GDP and 30.1% of GDP, respectively, in 2021. The country will have to undergo substantial adjustment for fiscal consolidation. External debt service is projected to remain around $7-8 billion over the medium-term. $1 billion international sovereign bonds are maturing in July 2022. Large debt overhang, and persistent fiscal and BOP financing shortfalls will constrain growth and jeopardize macroeconomic stability. Without permanent revenue measures and market access, the binding fiscal constraint will force the government to cut capital spending. Fiscal deficit will remain elevated above 9% of GDP, gross reserves will be critically low at around 1 month of imports over 2022-26, growth will stay below the potential (estimated in the range of 3.1-4.1% absent structural reforms) through 2026, and inflation will exceed the CBSL’s target band in 2022-24 and put pressure on exchange rates. 

The IMF concludes that Sri Lanka cannot refinance its debt in an orderly manner and its current fiscal policies are unsustainable. Public debt will increase to 125.3% of GDP in 2026 and interest payments will remain above 70% of tax revenue. Fiscal financing needs exceed the domestic financial system’s capacity. Sovereign spreads have increased the international rating agencies have downgraded its bonds to CCC or lower. The CBSL provided 3.5% of GDP in direct financing in 2020 and around 5% of GDP in the first three quarters of 2021. Meanwhile, contingent liabilities of SOEs could materialize soon. CEB and CPC’s balance sheets remain highly exposed to currency fluctuations. Their operational losses are going to increase if retail prices are not reflective of cost. Sri Lankan Airlines is already in distress. Excessive adjustment is required to take fiscal consolidation to a level that will make debt sustainable but is unlikely (primary deficit has to come down from 4.9% of GDP in 2021 to 2.8% of GDP in 2022 and then 1.8% of GDP in 2026 under the baseline scenario).

The IMF recommends implementation of a credible and coherent strategy to restore fiscal and debt sustainability and regain macroeconomic stability over the medium-term. Specifically,

1) Revenue-focused fiscal consolidation, tight monetary policy, transitioning to a market-determined exchange rate, mitigating adverse impact of macroeconomic adjustments on vulnerable groups by strengthening social safety nets, revamping fiscal rule, etc.

• Fiscal consolidation should achieve a primary balance of zero by 2024. 
• Strengthen corporate and personal income tax (CIT and PIT) by minimizing exemptions, raising rates, and reinstating mandatory withholding requirements under the Inland Revenue Act 2017. Multitude indirect taxes renders tax system unpredictable and complex, and high para-tariffs hinder competitiveness and growth. 
• Shift towards risk-based compliance management, strengthen large-taxpayer unit, and digitize revenue administration. Strengthen Customs and Excise Departments. 
• Expenditure rationalization by scaling-back of non-priority expenditure, greater spending efficiency, and an overarching strategy to manage public wage bill are also helpful, but higher revenue mobilization is more critical. 
• Cost-recovery based energy pricing is needed to mitigate fiscal risks from SOEs. Retail fuel and electricity prices are set below cost-recovery levels on discretionary basis, resulting in high debt overhang of CPC and CEB and restricting new investment. Automatic fuel and electricity pricing mechanism are recommended. An overarching strategy is needed to address high SOE debt and growing currency mismatches on energy SOEs’ balance sheets.
• Improvements in budget formulation and execution procedures are needed to support fiscal consolidation. Revenues should not be overestimated and interest payments underestimated to provide unrealistic assessment of resource availability. Expenditure arrears are high due to weak internal reporting and commitment control mechanisms. Strengthen the Macro-Fiscal Unit at MOF and adopt the GFSM 2014 fiscal reporting standards. Current fiscal rule should be revamped in line with international best practice to anchor fiscal sustainability.

2) A comprehensive strategy to restore debt sustainability. The IMF notes that fiscal consolidation and macroeconomic policy adjustments alone cannot restore Sri Lanka’s debt sustainability. 

3) Preserve hard-earned price stability and restore a market-based exchange rate.

• Monetary policy tightening is warranted in the near-term to ensure price stability. Private sector wages and inflation expectations are rising, and public sector wage increases are exerting price pressures. 
• CBSL should phase out its direct financing of budget deficits to lower inflation risks. 
• Returning to a market-determined and flexible exchange rate will facilitate external adjustment. This should be carefully sequenced and implemented as a part of a comprehensive macroeconomic adjustment package. This will help in inflation targeting as well.
• External position is weaker than the level implied by medium-term fundamentals and desirable policies. External debt vulnerabilities are high, and the level of reserves remain precariously low. A strong growth-friendly fiscal consolidation, debt sustainability, prudent monetary policy accompanied by exchange rate flexibility, boosting forex reserves to adequate level, structural reforms to boost export capacity and to encourage FDI are helpful.

4) Ensure financial sector stability. Debt overhang and persistent fiscal and BOP financing shortfalls post significant financial stability risks. 

• Sovereign-bank nexus is strong due to the banks’ large exposure to the government and SOEs. Large public borrowing needs could constrain banks’ lending to the private sector and affect growth prospect.
• Sovereign rating downgrades have constrained banks’ access to external financing and import credit.
• Unwinding pandemic related relief measures, monitoring of quality of loans, proactively identifying vulnerabilities through stress testing, and maintaining restrictions on bank profit distribution to ensure capital adequacy are helpful.

5) Strengthen social safety nets in view of needed macroeconomic adjustments. 

• Sri Lanka spends around 0.4% of GDP in social safety nets. There is scope for improving coverage and targeting, but revenue mobilization is critical for creating fiscal space needed for higher social safety net spending. 
• Growth-enhancing structural reforms are needed, especially promoting female labor force participation, creating job opportunities for youth, reducing trade barriers, and improving investment climate. 

Post pandemic economic recovery in Nepal

It was published in The Kathmandu Post, 14 March 2022.

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Medium-term economic recovery

A course correction beyond the band-aid nature of policy reaction is warranted.

The weaknesses of the economy, masked by pandemic-related fiscal and monetary relief measures and regulatory forbearances, are starting to unravel. Economic growth is persistently below target, the budget deficit is large and widening, public debt is increasing sharply, current account and balance of payments deficit are growing, and foreign exchange reserves are falling. The overall macroeconomic situation and growth outlook are not encouraging. A course correction beyond the band-aid nature of policy reaction is warranted to ensure the country has the available resources to finance the investment needed for medium-term economic recovery.

Deteriorating situation

The economy contracted by an estimated 2.1 percent in fiscal 2019-20, the first contraction in over four decades, as demand, supply and health shocks disrupted economic activities. A sharp and considerable economic rebound is unlikely due to a setback in agricultural output, especially a shortage of chemical fertilisers, and the continued deceleration of remittances that affect households’ purchasing power. Gross domestic product (GDP) growth may hover around 5 percent as base effect (which refers to the tendency of achieving an arithmetically high rate of growth when starting from a very low base) dissipates, and remittances decelerate (which constrains aggregate demand).

The state of public finance is also not encouraging given the large and growing fiscal deficit, which refers to expenditure net lending minus total receipts. Federal receipt, which includes foreign grants, is estimated to reach 23.7 percent of GDP this fiscal, but federal expenditure is estimated to top 34.8 percent of GDP, of which recurrent expenses account for 65 percent. Despite expenditure and revenue shortfalls relative to budget targets, the deficit will likely be over 6 percent of GDP. Note that the spending pattern has not changed much with capital spending absorption capacity still low, and over 50 percent of actual capital spending bunched in the last quarter, raising concerns over the quality of assets and fiduciary risks. It was just 16 percent of the budget estimate in the first seven months of this fiscal.

Capital spending is beset with structural weaknesses (low project readiness, weak contract management, and high staff turnover), allocative inefficiency (ad hoc allocation, lack of adherence to medium-term framework, and weak project pipeline), and bureaucratic delays (political interference at operational and management levels, weak intra- and inter-ministry coordination, and maze of approvals). Meanwhile, outstanding public debt has nearly doubled in a matter of just five years, reaching 40.7 percent of GDP in 2020-21.

The financial sector is also not in good standing. An aggressive increase in credit relative to deposits, which has fallen in tandem with the deceleration of remittances, has contributed to a chronic liquidity crisis. The liquidity situation used to be periodic in the past, that is it fluctuated in line with capital spending. However, it has been persistent in recent years, implying structural weaknesses and increased vulnerabilities in the financial sector. The outsized real estate and housing bubbles and the bullish stock market are not in sync with the macroeconomic fundamentals. It could pose a significant challenge after pandemic-related regulatory forbearances and relief measures are withdrawn. The elevated inflationary pressure, primarily due to supply disruption, rise in fuel and commodity prices, and Nepali rupee depreciation, will worsen the matter.

The external sector is in bad shape. The current account deficit in the first six months of this fiscal year is already higher than the whole of the last fiscal year. This is mainly due to the widening trade deficit and deceleration of remittances, which is not expected to recover soon. Consequently, the balance of payments is negative and foreign exchange reserves are falling steadily. Now, foreign exchange reserves are sufficient to cover 6.6 months of merchandise and services imports. It was about 14 months of import cover in mid-July 2016. Given the currency peg with the Indian rupee, vulnerability to natural disasters and the need for an additional buffer for remittances and tourism-related vulnerabilities, the optimal level of reserves is estimated to be 5.5 months of prospective import of goods and services.

Medium-term priority

Economic recovery will only be strong and sustained if medium-term priority is reoriented to reduce reliance on exogenous factors to support growth, poverty and inequality reduction, revenue mobilisation, and financial and external sector stability. For instance, the pattern and intensity of monsoon rainfall largely dictate agricultural output in the absence of reliable supply of farm inputs such as year-round irrigation, timely availability of chemical fertilisers, cheaper access to finance, and connectivity to link farmgate and retail markets, and farmers and consumers. Similarly, remittance income largely dictates consumption, especially private consumption, accounting for 90 percent of total consumption and demand in services and industrial sectors. This is neither resilient nor sustainable. Policy effort should be directed towards reorienting the sources of growth to more reliable factors through investment in physical infrastructure and human capital development, private sector development, and public sector reforms. These are essential to boost aggregate output and productivity.

Creating fiscal space required to boost spending on physical infrastructure and human capital development in the public sector is essential. This can be done through expenditure management and/or higher revenue mobilisation. Reduction of recurrent spending through expenditure consolidation or by plugging in leakages (for instance, in the distribution of allowances, unnecessary recruitment, and mundane charges), enhancing budget transparency and policy direction, accounting for fiscal risks and liabilities, and decreasing fiscal burden due to loan and share investment in non-performing public enterprises are some of the areas that require urgent attention for expenditure management. Since raising taxes is not ideal given the already high rates, efforts should be redirected at enhancing revenue administration, including reducing tax expenditures (subsidies, rebates, concessions), broadening the tax base, and divesting the government’s share in public enterprises and the monetisation of their assets. These will be helpful to create the fiscal space needed to finance medium-term recovery and promote competitive and cooperative federalism.

Similarly, financial sector volatility and vulnerabilities need to be curbed by using macroprudential tools. Credit growth needs to be consistent with deposit growth, asset-liability mismatch minimised, sectoral bubbles contained, and evergreening of troubled assets discouraged. These contribute to high volatility of liquidity and hence unpredictable interest rates. The current monetary policy and financial sector architecture do not adequately stop the misallocation of resources to sectors that do not contribute much to boosting domestic economic activities and job creation.

Another priority area should be private sector development to boost competitiveness and unshackle the economy from the grip of sectoral cartels and crony capitalists that distort factor and product markets. A holistic review of policies, rules and regulations is needed to get a clear picture of why investment is not increasing as expected despite the slew of legal changes enacted in the last five years. This review should also answer why special economic zones remain vacant and what needs to be done, the possibility of providing relatively cheaper electricity to businesses to boost cost competitiveness of industrial and services sectors, and the effectiveness of Investment Board Nepal in promoting investment and public-private partnership.