A tricky time

Sri Lanka will have to learn what it is like to be caught between a rock and a hard place in the coming months as the Government navigates a tricky situation between providing stimulus for the economy while working towards fiscal sustainability. Budget 2021, which has been billed as something that will provide stimulus, will still find it difficult to turn around an economy staggering under slow growth, COVID-19 impact, large deficits and high debt.

A World Bank report released on Wednesday warns the budget deficit will expand to 11% of GDP and the economy will contract by 6.7% in 2020, worsening debt refinancing prospects next year. The latest South Asian Outlook report titled ‘Beaten or Broken? Informality and COVID-19’ released in Washington by the World Bank paints a bleak picture of Sri Lanka’s challenges. Recalling that the country was facing fiscal and growth challenges well before the virus hit, it reiterated that the global pandemic remained the biggest risk to Sri Lanka’s growth prospects. 

COVID-19 will also have an impact on Sri Lanka’s poverty line, driving down both earnings and consumption. The report projected that Sri Lanka’s growth is expected to contract by a worrying 6.7% in 2020 before managing a modest recovery of 3.3% in 2021. 

Private consumption is also expected to reduce by 6.7%, exports 34.8%, imports 29.2% and capital investment by 15.1%. In terms of growth the industry sector is estimated to contract by 6.1% and services by 6.3% with only agriculture growing by 1%.

Refinancing requirements will be high, with annual foreign exchange debt service requirements estimated at 7%-8% of GDP over 2020-2022. The fiscal deficit is projected to expand further to over 11% of GDP in 2020, driving an increase in debt levels.

Inflation is expected to remain anchored at 4.9% and the current account balance is projected to be 2.2% of GDP by year end, helped largely by restricted imports and a sizeable reduction in Sri Lanka’s fuel bill. More worrying is that debt as a percentage of GDP will grow to 102% and the primary balance will grow to 4.3% of GDP from 0.8% in 2019.  

Perhaps the most worrying aspect is that this combination of circumstances is expected to drive up unemployment and poverty. Even though the Government gave Rs. 5,000 in two instalments earlier in the year these handouts were seen as not being targeted enough and therefore their impact limited. The Government’s plans to provide employment for 60,000 graduates and 100,000 people from low income backgrounds while creating further fiscal hardship will not be enough to counter larger social and economic ills worsened by COVID-19.

Therefore the Government should keep the big picture in mind when formulating the upcoming Budget and work to boost public finances as a matter of priority. Unless serious and longstanding reforms are introduced quickly Sri Lanka will lack the market credibility to keep borrowing at competitive rates in 2021 and beyond. It is therefore imperative that policies are created to reduce the Budget deficit to at least mid-single digit levels as soon as possible and unnecessary expenditure is pruned through reforming State-Owned Enterprises (SOEs).

For this year Sri Lanka can use import restrictions and funds saved from cheaper oil prices to prop up its dwindling reserves, but if the economy is to thrive, imports will have to restart eventually. At that point Sri Lanka will need a backup plan more robust than import substitution.