The inconclusive IMF review and challenges ahead for Sri Lanka

The Central Bank’s funding of the Government budget is highly undesirable since such funding would be in the form of creating seed money – known as base money or reserve money – that would generate money supply increases in multiple terms. The resultant inflation would then put pressure for the exchange rate to depreciate as inflation acts as a tax on exports and an incentive for imports. This will in turn further worsen the fiscal situation trapping the country in a vicious cycle of getting into further economic crises

An inconclusive IMF staff review

An IMF staff mission headed by Jaewoo Lee to make the second review of Sri Lanka’s progress with respect to its obligations under the ongoing three-year Extended Fund Facility or EFF has completed its mission and issued a press statement (available at: http://www.imf.org/en/News/Articles/2017/03/07/PR1775-Sri%20Lanka-IMF-Staff-Concludes-Visit-to-Discuss-Progress-of-Economic-Reform-Program). 

The statement is not significantly different from the statement issued after the first review conducted in September 2016 by a similar mission also headed by Jaewoo Lee (available at: http://www.imf.org/en/News/Articles/2016/09/23/PR16422). Both have admitted that the staff of IMF had done its best to reach a staff level agreement with the officials of the Government. But no confirmation has been made about an agreement being reached between the parties implying that the review outcomes have been inconclusive.

Plans for continued discussions with high-ups at IMF

Hence, discussions would continue, as the press statements say, with the higher ups of the Fund by the Sri Lankan team – usuallymade up of the Minister of Finance and the Governor of the Central Bank – when they attend the subsequent annual meetings of the Fund and the World Bank. The planned discussions with respect to the first review had been successful and IMF’s Executive Board had finally approved of the release of the second tranche of EFF amounting to $ 162.6 million in November 2016 (available at: http://www.imf.org/en/News/Articles/2016/11/18/PR16515-Sri-Lanka-IMF-Completes-First-Review-of-the-Extended-Arrangement-Under-the-EFF). 

Is Sri Lanka a chronic failure in keeping to its promises?

In the press statement announcing the approval of the release of the second tranche, IMF’s Deputy Managing Director Tao Zhang had expressed the satisfaction about the progress made by Sri Lanka despite the challenging circumstances within as well as outside the country. Thus, by all means, the Fund had expected Sri Lankan authorities to continue to maintain this satisfactory progress during the balance period of the EFF arrangement.

Hence, the inconclusive staff level discussions and the postponement of the final decision to subsequent meetings to be held by the side of the Spring Meetings to be held in coming April is a testimony of the country’s failure to implement the reform program promised to IMF under the EFF arrangement.

IMF’s bailout of Sri Lanka in mid 2016

Sri Lanka availed itself of the EFF under reference in June 2016 when the country had been faced with a severe external sector crisis, exacerbated by a looming economic crisis that had crippled the lifeline of its economy. According to the observations of the Fund (available at: http://www.imf.org/external/np/sec/pr/2016/pr16262.htm) the crisis had reflected in all the macroeconomic fronts of the country. 

Economic growth had slowed down and been below the country’s potential for growth. The fiscal sector had been chronically in deficit, despite the increase in Government revenue to 13.1% of GDP in 2015 due to one-off tax measures and higher import duty collections from the surge in vehicle imports. The balance of payments or BOP had significantly deteriorated due to large scale capital outflows and lower foreign direct investments. The Sri Lanka rupee was under continuous pressure for depreciation due to poor BOP conditions. 

Though price inflation in the economy had been low in the past few years up to mid 2016, there was the threat of inflation raising its ugly head once again because of the high growth in the monetary base, money supply and the private sector credit utilisation. Surely, inflation began to rise again worsening the prevailing macroeconomic crisis. It generated a second round of macroeconomic imbalances on all fronts: slowed-down economic growth, worsened fiscal situation and continued pressure for exchange rate to depreciate. Thus, Sri Lanka’s track record since the approval of EFF has not been satisfactory.

Opportunity given to Sri Lanka to reset its macroeconomic policies

But IMF, according to Fund’s Deputy Managing Director at that time, Min Zhu, expected a lot from Sri Lanka. It surmised that the planned EFF would give an opportunity for Sri Lanka’s Government to “reset macroeconomic policies, address key vulnerabilities, boost (foreign) reserves and support stability and resilience” of the economy. In other words, EFF was to rescue Sri Lanka’s economy from the depth to which it had fallen. Given the enormity of the crisis, this was an urgent need to be supported by an economy-wide reform programme.

Disciplining the budget is the key

According to Min Zhu, disciplining the Government budget – known as fiscal consolidation – was the key to the entire reform programme. Fiscal consolidation means the Government’s taking charge of the budget rather than the budget taking charge of the Government. 

On one side, it involves increasing revenue and cutting down unnecessary expenditure while increasing productivity related ones. The latter ones include expenditure on education, research and development, healthcare services and essential infrastructure facilities like roads, power-plants, improvements in communication facilities, etc. 

On another, with improved revenue and expenditure conditions, fiscal consolidation aims at generating savings in the budget – that is, keeping its consumption expenditure known as recurrent expenditure below the revenue levels –  and reducing  the overall budget deficit to an affordable level. The latter target brings out another beneficial improvement in the form of keeping a check on the growth of overall public debt levels.

Fiscal indiscipline is the source of all ailments

There is a good reason for the Fund to consider fiscal consolidation as the key to economic reforms aiming at restoring macroeconomic stability in the country. That is because it is the undisciplined budgets that would create all macroeconomic troubles for a country. When the budget has no resources to maintain the Government’s expenditure programmes, it has to borrow funds increasing public debt levels or get the Central Bank to print money and make available to the Government to finance its extravagant expenditure programmes.

The first would deny the private sector the needed resources to expand its economic activities. That in turn will reduce the country’s economic growth potential. 

The Central Bank’s funding of the Government budget is highly undesirable since such funding would be in the form of creating seed money – known as base money or reserve money – that would generate money supply increases in multiple terms. 

The resultant inflation would then put pressure for the exchange rate to depreciate as inflation acts as a tax on exports and an incentive for imports. This will in turn further worsen the fiscal situation trapping the country in a vicious cycle of getting into further economic crises. 

Hence, the budget consolidation should be the topmost priority of any Government seeking to introduce economic reforms to come out of an economic crisis.

Sri Lanka’s promised six-pronged reform program

Thus, of the six-pronged reform programme pledged by the Government to IMF when it sought EFF from the Fund, the first four aimed at generating a permanent fiscal consolidation, while the last two would give Sri Lankan entrepreneurs more international access to foreign markets, on one hand, and compel the Central Bank to maintain price as well as exchange rate stability, on the other.

The reform programmes relating to fiscal consolidation are as follows:

Fiscal consolidation

First, the Government had promised to lower the budget deficit bringing it to a level of 3.5% of GDP by 2020. This would in turn check on the growth of public debt, improve investor confidence and with reduced Government borrowings, make available a larger volume of credit funds to the private sector. 

Increase revenue

Second, a higher level of Government revenue has been targeted. For this purpose, tax system would be simplified, on one hand, and the tax net would be broadened, on the other. It would in turn improve transparency and equity in taxation. Transparency is ensured, because in a simplified tax system, every citizen would know what and how he would be paying as taxes. Equity is ensured, because since everyone liable for paying taxes is now in the net and therefore, tax burdens are not imposed on a selected number of people. 

With increased revenue, the Government would be able to allocate more funds for productive infrastructure developments and spend more on education, research and development and healthcare services, commonly known as human capital development.

Improve fiscal management

Third, public financial management would be strengthened in order to keep expenditures on target and eliminate waste of funds. Such an improved financial management by the Government would make budgets transparent by allowing more data on the budgets to be released to the public domain. It would also help the Government to report on the revenues that have been lost due to tax exemptions and tax holidays and analyse the risks arising from state owned enterprises and fiscal operations by provincial councils, local governments and statutory boards. 

Reform State-Owned Enterprises

Fourth, a pledge has been given by the Government to reform State-Owned Enterprises so that the loss-making ones will not be a burden to the taxpayers, while others will contribute more to the Government coffers. Financial independence would be given to state owned enterprises but they would be required to function under well defined financial rules so that they would be accountable for their actions. Such autonomy will help them to improve their commercial viability. 

Making monetary policy more effective through inflation targeting

In the case of the monetary policy reforms, the Government will allow the Central Bank to keep inflation low, which is a must for ensuring long term investments and prevent pressure for the exchange rate to depreciate. The Central Bank would change from the present system of monetary policy under which it targets to control money supply to keep inflation down to a system where it would target the inflation directly. 

In the present monetary policy management, the Central Bank is seeking to influence the ultimate target of establishing an inflation free world and through that, a stable nominal income, by controlling some intermediate targets like base money, credit levels and money supply. The empirical evidence shows that this system is far from satisfactory in attaining an inflation free world. 

Hence, in an inflation targeting system, the Central Bank would announce an inflation target at the beginning of the year, come to an agreement with the Government to maintain that target and stick to it by adopting appropriate interest rate and credit policies. 

In these reforms, the Central Bank would allow the exchange rate to be more flexible in terms of the market requirements. For instance, if the country’s competitiveness has been eroded by higher inflation in the domestic economy than in trading-partner countries, the Central Bank would allow the exchange rate to depreciate in the market till the country’s real exchange rates are stable. 

Taxing imports at high rates

With regard to market access reforms, the Government has pledged to support the maintenance of a facilitating trade and investment environment. These reforms include reducing import duties that have been introduced to give unnecessary protection to domestic industries, expand export opportunities, improve competitiveness and ensure integration to the global markets, specifically integration to global supply chains.

In the case of Sri Lanka, the average import duties are at a very low level at 4-5%. But, due to a number of cascading taxes like VAT, Excise Duties, Port and Airport Levy, Nation Building Tax and so on imposed on imports, the average taxes on imports amount to about a fourth of the total imports of the country, thereby making them the largest contributors to the Government coffers. This has made import duties an iniquitous form of taxation. The Government had pledged to abolish these multilevel taxes. But it would reduce the Government revenue and negate the presently boasted claims that the Ministry of Finance has improved its revenue base. 

But these high taxes on imports have generated an unintended side benefit too. That is, contrary to the popular belief that rupee depreciation would increase the Government’s foreign debt repayment liabilities, at the present level of Government’s foreign debt repayments which stand at about $ 3.0 billion per annum, the Government emerges as a net gainer in rupee depreciation. For instance, the depreciation of the exchange rate by one rupee will bring an additional amount of revenue of Rs. 4.5 billion to the Government; but its debt repayment obligations increase only by Rs. 3 billion.

However, this is a gain only at the moment. However, the Government would become a loser when the debt repayment obligations would rise significantly in the future on the basis of the current high external sector borrowings by the Government.

Take the patient out of ICU through an effective reform program

What has been revealed in the second review is that except some marginal improvements in Government revenues, all other reform programmes are yet to be started. This is not a good sign for Sri Lanka’s economy. The postponement of reforms will make the life of those in power comfortable today; but it would transfer the sick and hospitalised economy of Sri Lanka to the intensive care unit or ICU. Sri Lanka’s economy had been transferred to ICU from time to time in the past and on all those occasions, outside agencies like IMF were brought in to help the country to take the patient out of ICU. 

The treatments prescribed are bitter and cannot be sold to the electorate easily. Hence, midway through, the reform programs are abandoned and political leaders emerge as heroes who do not yield to the pressures coming from international lenders. Some of the senior Cabinet ministers have already begun to play this hero’s role.

What they have forgotten is that reform programs are their own and they are needed for the economy to move along a sustainable growth path. This truth is also kept away from the public making them vulnerable to disinformation being spread by other interest groups. 

Hence, the chronic sickness of the economy becomes acute day by day threatening the life of the patient. But Sri Lankans and their political leaders continue to go on taking pride in small gains they make from time to time. At the same time, what they do not notice is that the rest of the world is moving forward in leaps and bounds leaving Sri Lanka far behind. 

Hence, the choice before the Sri Lanka’s political leadership today is crucial for the future of the country. They should introduce the needed reform programs of their own, as was done by Britain’s David Cameron administration in 2010, instead of waiting for an outside lending agency like IMF to point it out to them. Reforms should be undertaken in its true spirit and not as a duty. In the past, Sri Lanka was successful in window-dressing its attainments and winning tranches. But, the country’s leadership should realise that this strategy would not help them to come out of the present economic crisis. 

 

(W.A. Wijewardena, a former Deputy Governor of the Central Bank of Sri Lanka, can be reached at [email protected].)