Economic Policies in an Election Year: Some Inconvenient Arithmetic - Part I

With the prospect of elections this year, political parties are gearing up their rhetoric and policy promises to an electorate worn out by two years of economic crisis on top of the hardship imposed by two years of a global pandemic. Reckless policies in 2020-21 forced Sri Lanka to declare a debt default, drove inflation to a peak of over 70 percent in September 2022, and contracted the GDP by over a cumulative 11 percent in 2022-23. The CBSL has since succeeded in stabilizing inflation at low single digits and building up international reserves while embarking on a programme to strengthen a banking system battered by the preceding economic shocks. Output is showing signs of recovery, with growth turning slightly positive in the third quarter of 2023, and tourism picking up. Sri Lanka has reached a debt restructuring agreement in principle with official bilateral creditors and good faith discussions with international bond holders are proceeding. With these signs of a long-awaited turnaround, it may be tempting to believe that the reforms are largely done and policies can be relaxed.  
Declaring a premature victory has been Sri Lanka’s playbook and must not be repeated, especially in this election year and its aftermath. During previous economic difficulties, we did not implement difficult structural and governance reforms once some degree of macroeconomic stabilization was achieved. This stop-and-go policymaking and fiscal indiscipline resulted in a high government debt ratio even before the pandemic (70-90 percent of the GDP in most years during 1980-2019). But this time really is different because our starting point — with a debt default and a public debt ratio of 126 percent of the GDP — is so much worse.  

What Will Sri Lanka’s Debt Restructuring Deliver?

The basis for all international debt restructuring, including Sri Lanka’s is the IMF’s Debt Sustainability Analysis (DSA). Based on the IMF’s macroeconomic assumptions and policies agreed under the government’s IMF-supported programme, the DSA projects the country’s debt and debt service over the coming decade and beyond. After taking into account the maximum fiscal adjustment that the IMF judges the country can realistically sustain, it shows the amount of debt relief that creditors must provide to make the country’s debt sustainable. In Sri Lanka’s case, the government is required to run a surplus of 2.3 percent of GDP on its primary fiscal balance (i.e. the fiscal balance excluding interest payments) every year from 2025, until at least 2035. The DSA sets out the following criteria that a debt restructuring plan must meet:  
Public debt to decline from 126 percent of the GDP at end-2022 to below 95 percent of the GDP by end-2032.  
The government’s gross financing needs (i.e. the financing needed to cover the primary fiscal deficit and debt service obligations) to decline from 35 percent of the GDP in 2022 to an average below 13 percent of the GDP during 2027-2032.  
Foreign currency debt service to decline from 9 percent of the GDP in 2022 to below an annual ceiling of 4.5 percent of the GDP during 2027-2032.  
Debt relief should be sufficient to close Sri Lanka’s external financing gap, projected at some US$ 17 billion during 2022-27.  
Even with a successful debt restructuring plan, there is no margin for policy errors or delays
The DSA shows that even after debt restructuring, Sri Lanka will be vulnerable to debt distress and face a tight fiscal situation over the next decade.   
Consider:  

Public debt would decline only gradually, staying above 100 percent of the GDP even in 2027-28, and reaching the still very high level of 95 percent of the GDP by 2032 (above the pre-pandemic debt ratio of 89 percent of the GDP as at end-2019). To put this debt level in perspective, the general government debt to GDP ratio for emerging markets and developing countries (comparators for Sri Lanka) averaged 64 percent of GDP world-wide and 73 percent of GDP in Asia, as at end 2022.  
· Sri Lanka has to undertake further fiscal adjustment to increase its primary fiscal balance from a (estimated) deficit of 0.7 percent of the GDP in 2023 to a surplus of 2.3 percent of the GDP by 2025, and then maintain that surplus over at least the next decade. As Table 1 shows, we have to do much fiscal adjustments over the next two years as we did in 2023. What is more, we cannot relax after that: this primary surplus has to be maintained for the foreseeable future.   
Tax revenue, which increased by 2 percentage points of the GDP in 2023, must rise by an additional 3 percentage points of the GDP in 2024 and by a further 2 percentage points of the GDP in 2025. That is, from the current 9.2 percent of the GDP to at least 14 percent of the GDP by 2025. This tax effort must also be maintained over at least the next decade. And if anyone wonders why this is necessary, it is worth noting that even with such a significant tax effort, interest payments would take up an average of 45 percent of the tax revenue by 2027-28 (the end of the IMF-supported programme) — still likely one of the highest interest payments to tax revenue ratios in the world.  
With interest payments taking up so much of government revenue, there would be very little room to increase non-interest spending. The fiscal projections underlying the DSA show non-interest spending rising from the current, tight, 11 percent of the GDP to only 13 percent of the GDP by 2027-28. If we don’t succeed in raising tax revenue to 14 percent of the GDP, a correspondingly larger share of tax revenue would be gobbled up by interest payments, leaving a smaller share for non-interest spending — such as on healthcare, education, and poverty alleviation.  
These considerations are not a matter of ideology. They are a matter of arithmetic. Sri Lanka’s tight fiscal situation and vulnerability to another bout of debt distress will remain whatever political ideology one espouses and whether or not we have an IMF-supported programme. (It would be considerably worse without the IMF). Policy reversals — like lowering taxes — or delays in implementing structural reforms will only make matters worse. If political parties want a better outcome, they need to adopt policies that will deliver it.   
Part II of this article will offer some suggestions.  

Dr. Sharmini Coorey is a former Department Director of the International Monetary Fund (IMF) and currently a member of the Presidential Advisory Group on Multilateral Engagement and Debt Sustainability advising the Government of Sri Lanka. Her experience at the IMF includes surveillance and programme work in Africa, Asia, Europe, and the Western Hemisphere as well as fund policy work. She holds a Ph.D. and bachelor’s degrees in Economics from Harvard University.