IMF hints at necessity for debt restructuring programme

• Says fiscal consolidation and macroeconomic policy adjustments alone unlikely to restore country’s debt sustainability
• Expresses scepticism on the success of six-month Road Map presented by CB in last October
• Doubts ability to implement  broad revenue-based fiscal consolidation programme with govt.’s insistence on preserving 2019 tax reforms

Hinting the necessity of a possible debt restructuring programme, the International Monetary Fund (IMF) has underlined that a strategy consisting of fiscal consolidation and macroeconomic policy adjustments alone is unlikely to restore the country’s debt sustainability given the significantly large external and fiscal financing gaps in short to medium term.

“To avert a full-fledged BoP and debt crisis, there is an urgent need for implementing acredible and coherent strategy to restore fiscal and debt sustainability and regain macroeconomic stability, covering both the near and medium term. The development of such a strategy is the prerogative of the authorities, and the Fund always advises members to stay current on their debt obligations to the extent possible. This said, in staff’s view, fiscal consolidation and macroeconomic policy adjustments alone cannot restore Sri Lanka’s debt sustainability,” the IMF stated in its Staff report on Sri Lanka released last Friday. 

According to multilateral lender, Sri Lanka’s fiscal financing gap, which is estimated at US$ 3.13 billion in 2022, is projected to double to US$ 6.1 billion by 2025 under the current trajectory. 

Similarly, external financing gap, which is estimated at US$ 2.7 billion, is projected to peak to US$ 3.15 billion by 2025, while gross international reserves to remain at US$ 2.2-2.5 billion range over the period with import coverage of one month.

IMF cautioned that the country’s debt overhang and persistent fiscal and BoP financing would constrain growth and jeopardize macroeconomic stability in both the near and medium term. 

“A severe debt overhang, heightened macro imbalances, prolonged FX shortages, and the cut in government capital spending would erode business and public confidence and deter investment, productivity growth, and confidence in the currency,” it noted.

Accordingly, the country’s GDP growth is projected to weaken to 2.6 percent in 2022 amid the lingering impact of the chemical fertiliser ban and supply shortages and projected to remain below potential growth of 3.1-4.1 percent (in the absence of structural reforms) through 2026.

The IMF staff was also doubtful of the success of 6-month roadmap announced by the Central Bank (CB) back in October last year, which aims to address near-term FX shortages by raising new financing from government-to-government loans and currency swaps with foreign central banks, expediting State asset sales, and tightening export surrender requirements.

“….even if these inflows could provide some breathing space in the short term, it remains unclear how the large FX debt service obligations this year and beyond can be met,” it noted.

The Fund warned that the country would be in risk of a disorderly default on its external debt, which would lead to catastrophic economic and social consequence.

“Should the unidentified external financing not be forthcoming, the country could experience a disorderly adjustment through severe import compression and potentially external arrears in the near-term. 

Relying on domestic sources to fill the fiscal financing gaps, as intended by the authorities, would either suffocate private credit growth or require further monetary financing of the fiscal deficit, which can undermine monetary stability. Confidence in the currency and the financial sector could erode under such a downside scenario, leading to an even worse macroeconomic outcome, severely affecting life and livelihood of many segments of the population, and risking intensifying social discontent,” it elaborated.

Although, the government and the IMF have agreed on a revenue-based fiscal consolidation with the country’s tax-to-GDP ratio remaining among the lowest in the world, the IMF doubts the ability to implement a broad revenue-based fiscal consolidation programme amid the government’s insistence on preserving the 2019 tax reforms.
“...it is unclear how the authorities’ revenue goals can be achieved, as they commit to preserving the 2019 tax reforms, which introduced large PIT, CIT and VAT rate cuts and exemption increases. 

Moreover, the revenue measures in the 2022 budget are overwhelmingly one-off, whereas the January 2022 package is likely to increase wage and pension spending permanently,” it added.

IMF stressed that such a programme must focus on raising rates of CIT, PIT and VAT while minimising exemptions, and reinstating mandatory withholding requirements under the IRA.

“This would ensure efficient revenue mobilisation and larger contributions from high-income earners while avoiding overburdening the poor,” it noted.

Along with a broad revenue-based fiscal consolidation programme, the IMF has recommended growth-enhancing structural reforms, including increasing female-labour force participation, reducing youth unemployment, liberalising trade, developing a wide-reaching and coherent investment promotion strategy, and reforming price controls and State-owned Enterprises (SOEs) while continuing with efforts to strengthen governance and reduce corruption vulnerabilities.

Commenting on foreign exchange policies, IMF remarked that import restrictions are hindering trade and growth while distorting markets. However, it acknowledged that capital flow management (CFM) measures might be required to contain forex outflows in the short-term.

“That said, the CFMs should not be a substitute for warranted macroeconomic adjustment,” the IMF added.