Executive Summary of IMF Report from Consultation with Sri Lanka (February 2022)

The International Monetary Board holds bilateral discussions with its member nations annually under Article IV of its Article of Agreements. The discussions with Sri Lanka were concluded in February of 2022 and a report was submitted by IMF Executive Board and Staff.

The full 95-page report from the 2021 Article IV Consultation with Sri Lanka can be found here.

Below is an executive summary of excerpts from the report consistent with the original structure of the published report. Please be kind enough to note that I am not an Economist, and don’t have the formal academic qualifications to represent and/or recreate the original report. A review of the original report is highly encouraged.

Context & Key Issues

Sri Lanka was economically vulnerable prior to the onset of Covid-19 due to reasons including but not limited to the following:

1. Inadequate external buffers of capital (reserves outside of domestic assets)
2. Unsustainable public debt
3. Residual economic damage from the Easter attacks
4. Large tax cuts in late 2019 (to win the elections)
5. Real GDP contraction of 3.6% in 2020
6. Lockdowns necessitated by the onset of the pandemic

In 2020 and 2021, fiscal deficit exceeded the GDP by 10%

Public debt rose from 94% of GDP in 2019 to 119% of GDP in 2021.

Inflation is at 14% year-on-year as of January 2022, and is projected to remain double-digit in coming quarters.

The target band for inflation is 4% to 6% and is more than likely to be exceeded.

Fiscal deficit is projected to remain large over the period from 2022 to 2026, further raising public debt.

International reserves are expected to remain inadequate to facilitate non-priority imports, and to service sovereign debt.

The following downside risks have been identified as potentially being able to worsen the situation further:

1. Resurgence of the pandemic
2. Rising commodity prices (not sure how this is a risk, it’s more a reality)
3. Worse than expected agricultural production
4. Deterioration in bank asset quality (risks associated with repayments of debts given out by banks, especially loans under moratorium schemes)
5. Extreme weather events

Stronger than expected performance of the Tourism sector and inflow of FDIs are identified as risks with upside which may better the situation.

High-Level Priorities

1. Restoration of macro-economic stability
2. Achieving debt sustainability
3. Protection of vulnerable groups through social safety nets

Recommendations from the Executive Board

1. Fiscal consolidation (policy-level efforts to reduce Government borrowing and spending)
2. Increase of Income Tax and VAT (it was mentioned that the IMF noted the low tax-to-GDP ratio in the country and saw scope to increase taxation)
3. Minimization of tax exemptions
4. Reformations of revenue administration (tax collection)
5. Improvement of expenditure rationalization (spending to be done more rationally by the Government)
6. Reformation of state-owned enterprises (I’m assuming through privatization, restructuring, and/or PPEs)
7. Adoption of cost-recovery energy pricing (increase electricity prices to cover the costs of operating the Electricity Board)
8. Phasing out of Central Bank’s direct financing of budgetary deficits (limit Government spending on public services through Ministries funded by the Central Bank)
9. Gradual return to flexible, market-determined exchange rates by removing the peg to USD (this was already partially done, and the Dollar was floated but indicates that IMF has no plans to artificially control the rate)
10. Gradual unwind of capital-flow management (I don’t know what this means, if you do, please mention in the comments)
11. Increase in female participation in the workforce
12. Reduction of youth unemployment
13. Diversification of the economy (I assume they mean reducing the reliance on the Tourism sector to earn foreign exchange)

Staff Outlook

Sri Lanka is experiencing a combined balance of payments and sovereign debt crisis.

Public debt is structured unsustainably.

Gross foreign reserves are critically low, and insufficient to cover near-term debt servicing needs.

Efforts by Government to raise foreign exchange could provide temporary relief, but it is unclear how the large forex debt service obligations cant be met beyond 2022.

Although prospects for tourism have improved, near and medium-term growth outlook is clouded by macroeconomic imbalances.

Staff Recommendations

1. Strengthening Government revenue through VAT and Income tax by increasing rates and broadening the base (the tax brackets to be defined broader)
2. Energy pricing to be revised to reduce fiscal risk of loss-making state-owned enterprises
3. Adoption of a comprehensive strategy to restore debt sustainability
4. Market determination of exchange rates to be restored, maintaining flexibility (Dollar value to be determined through price discovery in the open market)
5. Social safety nets to be cast by increasing spending and widening coverage to protect vulnerable groups
6. Central Bank to closely monitor loans under moratorium schemes and identify vulnerabilities through stress testing (not sure what stress testing a loan means, please leave a comment if you know)
7. Adoption of the new banking act (I think this is what they’re talking about)
8. Liberalization of trade (this could mean a lot of things)
9. Implementation of a coherent investment promotion strategy
10. Reformation of state-owned enterprises and price controls (I think they mean privatization and removal of MRPs)

My Two Cents

I think most of what has been prescribed is self-explanatory. There’s a lot of emphasis on the Government needing to take accountability of its spending. I do want to mention that Government spending in Sri Lanka is not entirely devoted to election campaigns and corruption.

The reason we have had to continuously print more money and amplify our inflationary rates is because Sri Lanka follows a socialist model in facilitating free education and healthcare. Additionally, we also pay out a significant amount of pensions and have a large public sector workforce.

It’s not easy to take a side on the debate of privatization and liberalization of the economy, but it is being made clear that a lot of what Sri Lanka is used to writing off as Government expenditure is becoming unsustainable.

I also thought the comments on diversifying and liberalizing the economy were interesting. The shift to a knowledge-based economy is a paramount need at this point in time. We not only need higher earnings per capita, we also ideally need that earning to be made in foreign reserve currencies.

Participation of females in the workforce and employment of the youth were also recommendations that are right on the money. These things have gone unnoticed for far too long and need correction in the near term.

I do see further inflation and a rise in the value of the Dollar going forward. It seems like the IMF believes that vulnerable groups should be protected through social safety nets and the middle class should be made to absorb the brunt of the impact.

We are bound to see higher taxes, electricity charges, commodity prices, and Dollar rates. It’s going to be a rough few years and the recovery time horizon seems to be set for five years, as indicated by their comments.

It’ll be interesting and difficult in the coming years and Sri Lankans should brace for the full impact of a collapsing economy to fold under the weight of mismanaged debt and spending. Hopefully, we won’t see more of the same going forward.