Preparing for economic prosperity beyond the COVID-19 crisis

In many aspects, Sri Lanka has handled the crisis before it assumed pandemic proportions. Sri Lanka, arguably having the best public health service among developing countries, has taken a series of pre-emptive measures to stall the progress of COVID-19 in the country – Pic by Shehan Gunasekara

By Dr. Pradeep Perera

The COVID-19 pandemic hit the world when most countries including certain superpowers were least prepared to face the COVID-19 related health impacts and economic disruptions. 

The countries that have been depending on private sector provision of basic health services with less than universal health insurance coverage like USA are struggling to coordinate a centralised response to the pandemic. 

The severe austerity measures implemented after the global financial crisis in European countries with significant reduction in fiscal allocation to publicly financed health sector have badly exposed once famed public health services in European countries including NHS in the UK. 

The countries with significant power devolution to provinces, cities and local government units are finding it difficult to effectively implement a coordinated centralised response as the national governments in these countries do not exercise control over health services and police at local level. 

Sri Lanka’s response to COVID-19

In many aspects, Sri Lanka has handled the crisis before it assumed pandemic proportions. Sri Lanka, arguably having the best public health service among developing countries, has taken a series of pre-emptive measures to stall the progress of COVID-19 in the country. 

The strong leadership demonstrated by the government with decisive action and the commitment shown by the security and health sector officials set an example for many countries to follow. The dissolution of Parliament and Provincial Councils did not hamper the Government’s efforts and rather acted as a blessing as the officials were free to act in an apolitical manner without being pressurised by parochial political interests. 

Short-term – economic impacts of shutdown

The early shutdown of the country, strict enforcement of curfew, closure of the airport for arrivals from abroad including Sri Lankan nationals, designation of specific public hospitals to treat the COVID-19 patients, forced quarantine measures of recent arrivals from COVID-19 affected countries and individuals exposed to infected persons at Government expense and the recently started pre-emptive testing of asymptomatic individuals suspected of having contacts with confirmed COVID-19 cases have enabled the Government to keep the daily infections at single digit level. 

As the Government is contemplating the gradual lifting of restrictions, it is worthwhile to assess the likely economic cost of the preventive measures already taken, the economic impacts due to widespread pandemic situation outside the country and how Sri Lankan economy can be better positioned to recover from the recent shock. 

The short-term impacts to economic sectors that depend on the domestic market are likely to be limited to the reduced demand for goods and services during the curfew period. This include retail traders, industries making goods for domestic market and service providers to local population and farmers supplying vegetables and fruits for local consumption. The income loss to large number of people during the past month may affect the demand for these goods and services in next couple of months and the domestic consumption should recover within the next three months. 

Medium-term impacts on fiscal deficit and current account deficit

However, the external demand for certain goods and services exported by Sri Lanka is likely to be subdued for next 12 months as most of Sri Lanka’s trading partners are still badly affected by COVID-19. 

The tourism sector is likely to be badly affected and is unlikely to recover for some time as Sri Lanka cannot afford to allow unrestricted entry to tourists from affected countries. This includes some of the key tourist source markets such as UK, Germany, France, Italy and India. This would impact close to one million people depending on tourism and many businesses including large scale hotels, home stay service providers, inbound travel companies and shop owners selling artefacts and souvenirs to tourists. 

These are likely to go out of business and may be compelled to default on loans taken for business expansion. This would also have a significant impact to domestic demand for goods and service and overall GDP growth of the country in 2020 as tourism contributes to about 5% of the GDP. 

The apparel industry is likely to have a modest and limited impact due to the closure of shopping malls in USA and Europe and export order cancellations. The supply of material from China is likely to be restored from May after the disruptions experienced in February/March. 

If Sri Lanka’s apparel industry can make the necessary adjustments to meet the increased demand for personal protection equipment (PPE), Sri Lanka may even be able to achieve an increase in apparel exports in this year. The demand for rubber goods such as gloves for health sector is also likely to increase. The agriculture exports such as tea, coconut products, spices and sea food are not likely to be affected to a significant extent.

The COVID-19 related disruption has affected the global oil demand by about 20% and resulted in a steep reduction in oil prices. Notwithstanding the recent agreement between USA, Saudi Arabia and Russia to curtail the oil supply by 10 million barrels per day, the oil prices are likely to remain in the region of $ 35 per barrel compared to $ 55-$ 60 per barrel before the pandemic. This is likely to reduce the oil import expenditure of Sri Lanka by about $ 2 billion in 2020. 

However, the oil price reduction will have a significant impact on the economies of oil dependent Middle Eastern countries where significant number of Sri Lankan migrant workers are employed. There is likely to be reduction in remittances from Middle Eastern and European countries such as Italy due to the COVID-19 related impacts on likely loss of income of Sri Lankan migrant workers.

The Sri Lankan economy has demonstrated significant downside risks and vulnerability to economic shocks even before the onset of COVID-19. The IMF has identified high level of public debt (i.e. 90% of GDP including government guaranteed loans of SOEs), high level of foreign currency denominated debt including both public and private sector external debt (i.e. 59% % of the GDP in 2018 ), persistently high twin deficits of high budget deficit ( i.e. over 5% during last 10 years) and current account deficit close to 3% of the GDP during past 5 years and high external financing requirement of over $ 5 billion compared to gross international reserves during 2020-2024 period. The COVID-19 is likely to further exacerbate the highly vulnerable fiscal and external financing situation of Sri Lankan economy. 

The tax reduction announced in January 2020 and the Government’s proposal to employ large number of unemployed youth and graduates will also have a significant impact on the fiscal deficit even without considering the COVID-19 induced impacts. 

The anti-COVID-19 measures have lowered the economic activities during the past six weeks and would further reduce the fiscal revenues. The recently-announced import restrictions will also reduce the import tax revenues. On the other hand, the government expenditure will increase due to additional expenditure incurred on anti-COVID-19 efforts including cash payouts to affected people. There could be savings on capital expenditure as construction activities have been disrupted in the past six weeks. 

The Export Development Board (EDB) has estimated that the exports of goods and services will drop by $ 7 billion in 2020. After adjusting for the import content of exports, the net impact is likely to be lower than this amount. The current account deficit of Sri Lanka’s balance of payment (i.e. this captures the deficit of export and import of goods and services, remittances, tourist receipts and foreign payments by Sri Lankans) is likely to increase to $ 6 billion-$ 7.5 billion compared to current account deficit of $ 3 billion. 

The external financing requirement for 2020 is likely to increase from $ 5 billion (i.e. the requirement before the COVID-19 onset) to $ 7.5 billion to $ 8 billion. It is likely Sri Lanka will have to restrict the foreign exchange outflows (i.e. current account transfers) and impose certain controls over the discretionary imports to maintain the current account deficit and external financing requirement at a manageable level. 

Government response to mitigate impacts

While many countries have announced fiscal stimulus packages of 5%-10% of GDP, this level of Government intervention is not an option available to the Sri Lankan Government. Given the extremely limited fiscal space due to high level of public sector indebtedness and already high fiscal deficit, the Government must judiciously utilise the available limited fiscal resources to restore the economic activities. It would be imperative to prune all unnecessary expenditure while targeting the fiscal subsidies to affected sectors. 

The Government has announced series of debt payment moratoriums and it is expected that the banks would provide these concessions to the affected businesses. The debt payment moratoriums will affect the interest income of banks while banks must bear the funding cost of these loans in the form interest payments on deposits. If the commercial banks are forced to bear the cost of bailout of affected businesses, the viability of banking sector in Sri Lanka will be badly affected and this will have long term implications on future growth prospects of the country. 

While the Central Bank can provide liquidity and bring down the interest rates to lower the impact on banks, a more sustainable option is for the Government to provide targeted subsidies to temporary affected businesses to keep them afloat. This should be restricted to businesses that was viable prior to the COVID-19 onset and these businesses have good prospects of turnaround within the next 12 months. 

There would be another set of businesses that were struggling to make loan payments even before the COVID-19 crisis with little prospects for turnaround. These businesses need to be liquidated in an orderly manner and banks should be allowed to recover the dues to the extent possible. This strategy will minimise the fiscal cost while maintaining the financial health of banking sector to support the future economic growth. 

The increase in fiscal deficit due to COVID-19 would have to be funded to the maximum extent possible using noninflationary sources (i.e. without resorting to central bank funding of the fiscal deficit). If long-term concessionary financing can be mobilised by external official lenders that need to be tapped to the maximum extent possible. 

The Government needs to negotiate a moratorium on scheduled debt repayment for 2020 -21 with external official lenders to reduce the external financing gap and off-set the expected increase in current account deficit of balance of payment. This may require reaching an understanding with international lenders like IMF on future economic strategy and a trajectory for bringing down the Sri Lanka’s twin deficits (i.e. fiscal and current account) and the public debt to a sustainable level.

Once the immediate issue of bridging the fiscal deficit and current account deficit are addressed, Sri Lanka has to embark on a long-term economic revival strategy with less dependency on foreign borrowings. This will require far-reaching structural reforms to the economy, export diversification strategy and attracting Foreign Direct Investments to both manufacturing and service sectors. The skill base of Sri Lankan youth should be developed to enable them to effectively participate in the dynamic global economy and some of the restrictive labour and employment practices may have to be relaxed. A strong political will and a visionary leadership is required to take certain decisions which may not be very popular. 

[The author has PhD Degree from Imperial College London UK in energy economics and has been working with multilateral development banks (IFC, The World Bank and Asian Development Bank) and for over 20 years. At present he is heading ADB’s energy sector operations in India. The views expressed are the personal opinion of the author and do not represent the views of ADB.]