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.