Responding to Sri Lanka’s economic crisis

Sri Lanka’s balance of payments is in dire straits. The country’s mounting foreign and domestic public debt, a huge fiscal deficit and a severe foreign exchange shortfall have led to potentially calamitous economic circumstances. 

Sri Lanka has not yet secured the means to meet its upcoming foreign loan repayments — US$ 4.5 billion is due over the next year, to be followed by another US$ 4 billion in the subsequent year.

Credit rating agencies Fitch and Standard and Poor’s downgraded Sri Lanka’s international sovereign rating in early 2016 in light of its rising fiscal deficit and foreign debt — the highest among Asia’s emerging markets — compounded by sluggish growth prospects.

Non-concessional commercial loans
While excessive public debt has been accruing over generations, the debt trap that the country is experiencing today is principally due to non-concessional commercial loans taken out between 2009 and 2014 by the previous government, led by Mahinda Rajapaksa. The loans, which went towards infrastructure development projects, roughly doubled the country’s external debt.

The current administration, led by President Maithripala Sirisena and Prime Minister Ranil Wickremesinghe, manifestly worsened the country’s fiscal conditions in 2015. Outstanding domestic debts rose by over 12 percent due to excessive government spending and foreign debt had increased by 25 per cent by the end of that year, albeit primarily to finance the previous government’s loans.

Sri Lanka’s foreign currency earnings and reserves are insufficient to meet its external financing requirements. The depletion in reserves is a consequence of large foreign capital outflows, reduced exports due to the global economic downturn, and falling remittances from migrant workers employed in the distressed Middle East region.

As temporary measures to avert a foreign exchange crisis, the government initiated a US$1.5 billion currency swap with the Reserve Bank of India and a US$1 billion currency swap with the Central Bank of China in March. Sri Lanka’s Central Bank also plans to raise up to US$3 billion through the issuance of international sovereign bonds this year.

Sri Lanka has resorted to extended foreign borrowing to counteract the rising fiscal deficit and strengthen foreign reserves. An IMF loan of US$1.5 billion has been granted on a 36-month Extended Fund Facility program, subject to formal approval by the IMF’s Executive Board in June. The Governor of the Central Bank of Sri Lanka has said that the country hopes to obtain an additional US$5 billion in loans from other sources, including the World Bank and the Asian Development Bank, once the IMF loan — a mark of international confidence is in effect.

Agreeing to tough conditions

The IMF loan has come only as the Sri Lankan government has agreed to tough conditions, including restrictions on budget deficit sizes and tax-to-GDP ratio requirements. The government has since proposed a range of structural changes to its fiscal policy. On 8 March, emergency tax measures were announced.

The changes include widening the tax base by increasing corporate income tax, increasing value-added tax (VAT), reintroducing income tax on capital gains, and removing certain previous exemptions on VAT and the Nation Building Tax (a consumption tax introduced in 2009 to fund security forces and rebuild infrastructure damaged by terrorism and war). 

A Share Transaction Levy was reimposed on all share transactions. The government also shared its plans to introduce a carbon tax on vehicles with the IMF delegation in mid-April.

Two primary aims of the Sri Lankan government are to attract foreign direct investment and encourage the private sector to invest more. However, the government’s sudden changes to the budget — including unplanned and ad hoc tax policy changes — have dented investor sentiment, causing capital outflows. These post-budget policy changes have led to a state of economic uncertainty. Predictability and consistency in economic policy are key to a positive business and investment environment.

Downward economic momentum is expected in the short-term as the proposed higher taxes will negatively affect low- and middle-income consumers, small- and medium-sized enterprises, and organizations importing raw and intermediate materials (which include those in the already ailing export sector). 

While it is necessary to increase tax revenue to meet growing public debt and stabilize the economy, higher tax rates discourage business and investment and reduce consumption, leading to less growth. With more than half of the registered tax payers in Sri Lanka known to be evading taxes, the country should focus instead on developing an efficient and comprehensive tax collection mechanism.

Privatizing SOEs

To reduce public debt, the government is looking to privatize state-owned enterprises (SOEs) that are currently running at a loss. These SOEs account for more than 80 per cent of domestic debt. Sri Lanka has invited Chinese companies and others to invest in these SOEs, proposing a debt-equity swap. Chinese companies have not yet responded to these proposals.

Despite the deterioration in its balance of payments, Sri Lanka showed positive growth momentum last year. 

There is hope for an economic turnaround in the medium term, following the IMF loan. As an emerging market, Sri Lanka has many lucrative areas for investment, including the booming tourism sector, construction and infrastructure development.

That said, some commentators believe the country lacks a clear sense of direction on economic policy and suspect that the government may not be able to effectively manage the widening balance of payments gap. This scepticism stems from the fragmented political landscape marked by the tense alliance between arch political rivals, the right-leaning United National Party and a segment of the more socialist Sri Lanka Freedom Party. 

The unpredictable economic management of the Ministry of Finance adds to this cautionary mood.
Such a coalition causes paralysis and a lack of debate around policy implementation. The gloomy short-term economic forecast is bound to test the strength of this coalition. In managing painful economic reforms, the government’s hard work is only beginning. 

(Courtesy East Asia Forum)

By Iromi Dharmawardhane

(Iromi Dharmawardhane is Research Associate at the Institute of South Asian Studies (ISAS) at the National University of Singapore)