Addressing Sri Lanka’s macroeconomic challenges

By Utsav Kumar and Dushni Weerakoon

Sri Lanka is widely recognised for its rapid development progress—as shown by various development indicators—but underperformance on growth. The country’s growth slowed to 3.2% in 2018. So what is holding back growth? As with many countries, there is no single answer for Sri Lanka. But it is worth homing in on one of them, namely, macroeconomic vulnerabilities. 

During 2018, Sri Lanka’s currency depreciated by nearly 20%.Meanwhile, there was a net outflow from government treasuries of$990 million and foreign reserves fell to $6.9 billion by the end of the year. Moreover, despite the introduction of several reforms to improve the fundamentals of the economy, the country remains vulnerable to external and domestic shocks, and more needs to be done, especially to avoid policy reversals. Lookingback, exchange rate and reserves came under pressure in 2015, 2012,2009, 2004, and 2001.This raises the question: why does Sri Lanka repeatedly face these macro pressures, and how can it break this cycle?

A new Asian Development Bank (ADB) working paper looks at Sri Lanka’s macroeconomic performance over nearly five decades and makes the following points.

First, macroeconomic pressures have punctuated Sri Lanka’s economic history at various times. In fact, Sri Lanka is a classic twin deficit economy, with persistent deficits in the current and fiscal accounts. This signals fundamental economic imbalances, in which national expenditure exceeds national income, and production of tradablesis inadequate.These deficits have manifested themselves in recurring balance of paymentscrises, and have led Sri Lanka to turn to the International Monetary Fund (IMF) periodically.Sri Lanka entered its first arrangement with the IMF in June 1965, and since then has been in another 14 programs, the latest being in 2016.  

Second, at the heart of the country’s macroeconomic performance isfiscal policy, since high deficits and government borrowing constrain the effectiveness of monetary policy and exchange rate management. There are various reasons for a continued weak fiscal situation. These include a steady decline in thetax-to-gross domestic product (GDP) ratios from 19% in 1990 to 10% in 2014 (with improvements being recorded since then), rigidities in the expenditure structurethat constrain the quality of spending, a history of populist public spending programs, a large public sector, and weak performance of state-owned enterprises (SOEs).

Third, as fiscal deficits persisted and nominal debt increased, Sri Lanka turned increasingly to foreign commercial borrowing for deficit financing. As at end-2017—the latest year for which official data are available—nearly 43% of central Government foreign debt is from foreign commercial sources as opposed to 5% in 2005. In the face of a growing external debt portfolio, keeping the exchange rate fixed or within a narrow band was an attractive proposition. However, the capital account wasde facto quite open, given that restrictions were removed on inflows and exchangecontrols governing capital outflows relaxed. The Central Bankthus attempted to set interest rates andtarget the exchange rate within a “predetermined” band simultaneously, with adverse consequences for macroeconomic stability. Of late, the Central Bank has let the exchange rate move more freely.

Last,lack of policy continuity can lead to the conditionsthat generated macroeconomic pressuresto resurface, andundermineinvestorsentiment. Take the example of the Fiscal Responsibility Management Act, which has seen slippages and relaxation of conditions over the years since it was first introduced in 2003. Sri Lanka was one of the first countries in South Asia to liberalise its trade regime, but theintroduction of para-tariffs in the previous decade created an anti-export bias.Another example is the lack of progress on SOE reforms, after they were first initiated in late 1980s and early 1990s.

The policy recipe to address persistent twin deficits and recurring balance of paymentscrisesfor Sri Lanka hasn’t changed much over the years. However, it is worth repeating for a couple of reasons.

Given there is an elevated share of foreign commercial sources in central Government foreign debt, the tenure of foreign commercial borrowing is typically shorter than the borrowing from multilateral and bilateral sources. The latter offer phased repayments over a long period, as opposed to large “bullet” payments on maturity for commercial borrowing. This has increased the need to maintain a sufficient buffer of foreign exchange reserves. 

Sri Lanka missed the bus in the late 1980s, when global manufacturers were looking at Asia to set up manufacturing bases. In hindsight, Sri Lanka also missed a critical opportunity to partake in what later became “hyperglobalisation” through global value chain trade. Today, Sri Lanka needs to generate new sources of sustained growth. To do so, Sri Lanka will have to continue efforts to shift from debt-fuelled, consumption-driven growth to export-led private sector growth. 

Measures to put the fiscal house in order, such as strengthening tax administration, improving public financial management, expenditure rationalisation in discretionary spending, improving the performance of SOEs,are only one part of the policy prescription. Deeper structural reforms will be required to attract hard currency. These include, addressing constraints to export growth and in attracting foreign direct investment, reforms in factor markets, and reforming the trade facilitation regime. These are well recognised in the government’s Vision 2025and steps have been taken to introduce reforms. However, there is still a long way to go.

To avoid past outcomes, there is a need to build a consensus on some of the key reforms in order to shield them from the electoral cycle and ensure their continuance. As a small-open economy, it is imperative that Sri Lanka addresses the policy constraints to growth in order to fully exploit its opportunities.

Writers Utsav Kumar is Senior Country Economist at the Asian Development Bank and Dushni Weerakoon is the Executive Director of the Institute of Policy Studies. The OpEddraws upon on a new ADB working paper titled “Sri Lanka’s Macroeconomic Challenges: A Tale of Two Deficits” (by Dushni Weerakoon, Utsav Kumar, and Roselle Dime). The working paper can be accessed via http://dx.doi.org/10.22617/WPS190024-2