Sri Lanka - Economic Review

The World Bank have published their most recent Development Update on Sri Lanka.  In it, they explain the causes of the current economic crisis and provide an update on economic performance, before outlining priorities looking forward.

Without going into the details of the important welfare impacts of the crisis, which the World Bank have also assessed in the report, this note seeks to summarise the World Bank’s assessment of the economic situation.

Recent Economic Developments

In H1 2022, real GDP contracted by 4.8% YoY.  Agriculture and industry were weak, as a result of supply chain disruptions and a shortage of inputs, whilst services, which were supported by a gradual recovery in tourism, contracted more modestly.  The ban on agrochemicals, although it was removed in November, is expected to produce a significant short-term drop in yields and to impact severely the incomes of over a million small farmers.  Due to FX shortages, fertiliser remains in scarce supply.

Leading indicators for Q2 such as electricity sales (-9.2% YoY), cement consumption (-40% YoY), and the purchasing managers’ surveys suggest there is a significant deterioration in activity underway.  Exports, supported by textiles, are performing better.

Inflation, as measured by the Colombo CPI, rose by 64% YoY in August.  High commodity prices, the fertiliser ban, partial monetisation of the fiscal deficit and currency depreciation have all played their part.

Interest rates have risen sharply, including a 700 basis point rise in the policy rate in April 2022.  As real rates remain negative, however, further tightening in policy is warranted, according to the World Bank, which noted that 91D T-Bills were auctioned at over 30% in the primary market in August.

Financial sector stability is being severely tested.  Banks’ lending to the government slowed significantly in 2021, but they are significantly exposed to distressed SOEs, and have losses on their exposure to both (33% of total assets) as yet unrecognised.  There is also an acute shortage of foreign exchange.

In Q1, the banks’ reported NPL ratio was 8.4% and their reported capital adequacy ratio was 15.1%.  However, these do not reflect COVID-related forbearance measures or unaccounted losses on SOE and sovereign portfolios.

Despite a narrowing in the trade deficit in H1 2022, the current account is expected to have widened, with a decline in remittances more than offsetting a rise in tourism receipts.  The current account deficit may decline over the balance of the year, as imports fell by 25% YoY in June and July.  Nonetheless, a loss of market confidence has made it difficult to bring back export earnings and remittances to Sri Lanka, despite FX controls and mandatory repatriation and conversion rules which have imposed by the central bank.

In June 2022, net foreign assets in the banking system stood at USD -5.9bn.   The impact of the foreign exchange liquidity crisis is being felt across the economy, with sporadic shortages of fuel and energy, milk powder, wheat flour, intermediate goods used by industry, and even of imported medicines.

The government suspended external debt service payments in April 2022.   The incumbent president resigned on July 9^th.

At the end of May, the new administration announced several revenue mobilisation measures to reduce the fiscal deficit.  These included rises in the personal and corporate tax rates, and a reduction in allowances, and an increase in the standard VAT rate from 8% to 12%.

In September, Sri Lanka reached a Staff Level Agreement with the IMF for a 40-month Extended Fund Facility program of USD 2.9bn.  This is subject to IMF board approval.

According to the IMF’s statement, the agreement is “contingent on the implementation by the authorities of prior actions, and on receiving financing assurances from Sri Lanka’s official creditors and making a good faith effort to reach a collaborative agreement with private creditors.  Debt relief from Sri Lanka’s creditors and additional financing from multilateral partners will be required to help ensure debt sustainability and close financing gaps”.

The key elements of the programme involve:

• Raising fiscal revenue through tax reforms, targeting a primary surplus of 2.3% GDP by 2025
• Introducing cost-recovery pricing for fuel and electricity to minimise fiscal risks from SOEs
• Raising social spending
• Restoring price stability through data-driven monetary policy, fiscal consolidation, phasing out monetary financing, and stronger central bank autonomy
• Rebuilding foreign reserves through restoring a market-determined and flexible exchange rate
• Ensuring a healthy and adequately capitalised banking system; upgrading financial sector safety nets and regulatory standards with a revised Banking Act
• Reducing corruption vulnerabilities

 

The following is a link to the IMF’s press release announcing the staff level agreement:

https://www.imf.org/en/News/Articles/2022/09/01/pr22295-imf-reaches-staff-level-agreement-on-an-extended-fund-facility-arrangement-with-sri-lanka

In September 2022, Parliament passed an interim budget for the remainder of the year, which included further measures to reduce the fiscal deficit, trade and investment reforms, SOE reforms, reforms to several important legal frameworks, the establishment of a national debt management agency, and improvements to social welfare systems.

The Underlying Causes of the Crisis

Although the Sri Lankan economy has been subject to several exogenous shocks since 2017 – the 2018 political crisis, the 2019 bombings, as well as the pandemic and a concomitant collapse in tourism – the World Bank is clear that it was showing signs of clear structural weakness before COVID struck.

Sri Lanka has one of the lowest tax/GDP ratios in the world, reflecting a decline from 24% in 1978 to 12.6% in 2018.   Although expenditures have not been high, interest costs reached 30% of total expenditure and 72% of revenue in 2021.

Years of fiscal indiscipline and a reliance on relatively short-term, foreign currency denominated commercial debt have led to high public debt and debt service.  Public and publicly-guaranteed debt rose from 78.6% GDP in 2017 to 109.7% GDP in 2021.

Sri Lanka has become more inward-looking since the turn of the century, with the ratio of trade to GDP falling from 88% in 2000 to 39% in 2020.  The World Bank estimates the gap between actual and potential exports to be USD 10bn annually, almost as high as the current level of merchant exports.  The causes have been an overvalued exchange rate, and frictions that increase the costs trading.  These include import duties that are among the highest in the world, multiple para-tariffs etc.

Further macroeconomic imbalances have been caused by continued monetisation of fiscal deficits and episodes of loose monetary policy.

Looking Forward

According to the World Bank, the current crisis is not a temporary liquidity shock that can be resolved by external financing support from outside.  It requires deep and permanent structural reforms in the following areas especially:

• Measures principally to raise fiscal revenues, but also to reduce low priority expenditures, to produce the primary surplus agreed with the IMF. Focus areas for revenue mobilisation are higher rates for corporate and personal income taxes, and VAT, reduced exemptions and, importantly, ensuring a greater contribution from high income earners.   These should be supported by administrative reforms (e-filing of returns, mandatory withholding and reporting of PAYE, capital gains etc.)
• Debt restructuring. Projected gross financing needs for 2022 were about 30% of GDP, among the highest in emerging markets.
• SOE reforms. The losses of Ceylon Petroleum, Ceylon Electricity Board and Sri Lankan Airlines rose to 4% GDP in the first four months of 2022. Balance sheets need restructuring, but steps are also needed to eliminate below-cost recovery utility pricing, and to reduce operational inefficiencies.
• Tighter and more consistent monetary policy to contain inflationary pressures. The gradual restoration of a market-determined and flexible exchange rate to facilitate external adjustments and to rebuild international reserves.
• Careful management of the financial sector, given heightened public-sector exposure and the effect of currency depreciation on their balance sheets.

In its baseline forecasts, the World Bank predicts a 9.2% contraction in real GDP in 2022 and a further 4.2% contraction in 2023, resulting from a shortage of FX liquidity, job and income losses, and supply side constraints on production.

Despite expected further tightening in monetary policy, inflation will likely stay elevated in 2023 because of currency depreciation, high commodity prices and continued monetisation of the fiscal deficit.

The fiscal deficit is expected gradually to decline, assuming further consolidation measures are announced in the 2023 budget.

Significant import compression is expected to lead to an improvement in the current account.  The recovery in remittances will depend on how soon confidence in the currency and economy is restored.

The World Bank’s forecasts are summarised in the following table:

To read the World Bank’s full report, please use the following link to its website:

https://www.worldbank.org/en/country/srilanka

In early November, the IMF produced a report highlighting issues in the tax system and suggesting policy reform options.   The report also discusses the consequences for the money supply and inflation of the central bank’s financing of the fiscal deficit, and the impact of the pandemic on the informal sector.

This report may be found using the following link:

https://www.imf.org/en/Countries/LKA