The Executive Board of the International Monetary Fund (IMF) has determined that Sri Lanka’s economic future looks bleak with public debt at unsustainable levels, low international reserves and still large financing needs in the coming years. future.
In this context, the Executive Board of the IMF stressed the urgency of implementing a credible and coherent strategy to restore macroeconomic stability and debt sustainability, while protecting vulnerable groups and reducing poverty through strengthened and well-targeted social safety nets.
In a press release issued today, the IMF’s Executive Board said it concluded the Article IV consultation with Sri Lanka on February 25, 2022.
The IMF said that on the eve of the pandemic, the country was highly vulnerable to external shocks due to insufficient external reserves and high risks to public debt sustainability, exacerbated by the Easter Sunday terrorist attacks in 2019. and major political changes, including significant tax cuts at the end of 2019. Real GDP contracted by 3.6% in 2020, due to a loss in tourism receipts and necessary containment measures. Sri Lanka lost access to the international sovereign bond market at the start of the pandemic.
The authorities rolled out a rapid and widespread set of relief measures to deal with the impact of the pandemic, including a macroeconomic stimulus policy, increased spending on social safety nets and moratoriums on loan repayments for businesses affected. These measures were supplemented by a strong vaccination campaign. GDP growth is expected to return to 3.6% in 2021 as mobility indicators largely return to pre-pandemic levels and tourist arrivals start to recover by the end of 2021.
Nevertheless, annual budget deficits exceeded 10% of GDP in 2020 and 2021, due to pre-pandemic tax cuts, weak revenue performance in the wake of the pandemic, and spending measures to combat the pandemic. The limited availability of external financing for the government has led to significant direct financing of the budget by the central bank. Public debt is expected to decline from 94% of GDP in 2019 to 119% of GDP in 2021. Large foreign currency (FX) debt service payments by the government and a wider current account deficit have led to a significant shortage of currencies in the economy. . The official exchange rate has been effectively pegged to the US dollar since April 2021.
The economic outlook is limited by Sri Lanka’s over-indebtedness as well as by still significant fiscal and balance of payments financing needs. GDP growth is expected to be negatively affected by the impact of currency shortages and macroeconomic imbalances on economic activities and business confidence. Inflation recently accelerated to 14% (y/y) in January 2022 and is expected to remain in double digits over the coming quarters, exceeding the target range of 4-6%, as strong inflationary pressures have built up both on the supply side and on the demand side. since mid-2021. Under current policies and the authorities’ commitment to preserve tax cuts, the fiscal deficit is expected to remain large over 2022–26, which will further increase public debt over the medium term. Due to the persistent external debt service burden, international reserves would remain insufficient, despite the authorities’ continued efforts to secure foreign currency financing from external sources.
The outlook is subject to great uncertainties with downside risks. Unless fiscal and balance of payments financing needs are met, the country could experience significant contractions in imports and private credit growth, or monetary instability if additional fiscal deficits are financed by the country. central bank. Other downside risks include a resurgence of COVID-19, rising commodity prices, worse-than-expected agricultural production, potential deterioration in bank asset quality, and extreme weather events. Upside risks include a faster-than-expected tourism recovery and stronger-than-expected FDI inflows.
Directors commended the Sri Lankan authorities for the rapid political response and the success of the vaccination campaign, which cushioned the impact of the pandemic. Despite the ongoing economic recovery, Directors noted that the country faces growing challenges, including public debt that has reached unsustainable levels, low international reserves and still large financing needs in the years to come. In this context, they stressed the urgency of implementing a credible and coherent strategy to restore macroeconomic stability and debt sustainability, while protecting vulnerable groups and reducing poverty through strengthened social safety nets. and well targeted.
Directors stressed the need for ambitious fiscal consolidation based on high-quality revenue measures. Noting Sri Lanka’s low tax-to-GDP ratio, they saw scope for raising income tax and VAT rates and minimizing exemptions, complemented by tax administration reform. Directors encourage continued improvements in expenditure rationalization, budget formulation and execution, and the fiscal rule. They also encouraged the authorities to reform public enterprises and adopt cost-recovery energy pricing.
Directors agreed that tighter monetary policy is needed to contain rising inflationary pressures, while phasing out direct central bank financing of fiscal deficits. They also recommended a gradual return to a flexible, market-determined exchange rate to facilitate external adjustment and rebuild international reserves. Directors called on the authorities to phase out capital flow management measures when conditions permit.
Directors welcomed the policy measures that have helped to mitigate the impact of the pandemic on the financial sector. Noting risks to financial stability related to public over-indebtedness and the sovereign-bank nexus, they recommended close monitoring of the quality of underlying assets and identification of vulnerabilities through stress testing. Directors welcomed ongoing legislative reforms aimed at strengthening regulatory, supervisory and resolution frameworks.
Directors called for renewed efforts on growth-enhancing structural reforms. They stressed the importance of increasing women’s participation in the labor market and reducing youth unemployment. Further efforts are needed to diversify the economy, gradually eliminate import restrictions and improve the business and investment climate in general. Directors also called for careful management of the Colombo Port City project and continued efforts to strengthen governance and fight corruption. They noted the country’s vulnerability to climate change and welcomed efforts to increase resilience. (Colombo Official Gazette)