The International Monetary Fund’s 17th support package for Sri Lanka has come with severe conditions. That may be for the good of the future of the country which — at the time of its independence in 1948 — was the strongest economy in South Asia, and is now the only one to have defaulted on an IMF loan. Talal Rafi and Viola Fur analyse the details.    

Sri Lanka is currently in its 17th International Monetary Fund (IMF) Program and its first IMF Program as a defaulted nation, having walked out of almost half of the previous 16 Programs showing a lack of discipline in following through on critical changes required or asked for by them. In 2019, the new government — led by the Rajapaksas who won by a big margin — introduced a large tax reduction which was one of the populist promises made by them in their election manifesto. These tax reductions resulted in a large fiscal deficit which led the credit-rating agencies to downgrade Sri Lanka which in turn resulted in them losing access to capital markets.

Other policy errors like trying to transform the country into an organic nation in 24 hours, excessive monetary financing, exchange rate control and not reaching out to the IMF lead to a humiliating default in 2022. If it was not for India’s support with US$4 billion in 2022, Sri Lanka could have descended into chaos.

 Positive aspects

The IMF Program has its positive aspects, in particular with bringing fiscal discipline. Sri Lanka has had governance issues and a lack of long-term planning since its independence in 1948. In fact, at the time, Sri Lanka had one of the best economies in Asia and was the first nation in South Asia to open its economy.

First, the IMF Program brings fiscal responsibility. Sri Lanka has only had a primary budget surplus 5 times in the last 75 years. Even when interest payments are removed, Sri Lanka still has not been able to balance its budget for 70 out of its past 75 years, showing lack of fiscal discipline.

The IMF Program requires Sri Lanka to have a primary budget surplus of 2.3 per cent, focused as it is on revenue-based fiscal consolidation since government revenue fell below 8 per cent of Gross Domestic Product (GDP) in 2022. The IMF program aims to bring revenue up to 15 per cent of GDP by 2025, which is a reasonable target. So, the government has raised its Value Added Taxes (VAT) and brought back the Pay-as-you-Earn Tax which was abolished in 2019. And it is also trying to broaden its tax base for personal income tax and corporate taxation.

Sri Lanka’s debt to GDP stood at 128 per cent in 2022, now down to 115 per cent; the IMF target is to bring it to 95 per cent by 2032, and to reduce gross financing needs which was at 35 per cent of GDP in 2022 to 13 per cent by 2027. This also includes reducing external gross financing needs to 4.5 per cent of GDP. The country is still in the process of negotiating its debt with China and other international bondholders with them showing interest in macro-linked bonds. A large haircut and steady economic growth in the medium to long term is essential for Sri Lanka to achieve debt sustainability.

Second, independence of the Central Bank of Sri Lanka is critical. The Central Bank of Sri Lanka Act No. 16 of 2023 which was passed last year as advocated by the IMF gives the Central Bank greater independence, asserting that price stability is the core objective of the Central Bank with financial stability being the secondary objective. The Central Bank is prevented from monetary financing of the Treasury as it cannot purchase government securities from the primary market and it can give credit only to government-owned financial institutions when financial system instability is to be thwarted. Since bankruptcy in 2022, the Central Bank has steadily built its reserves. The Sri Lankan rupee — which was pegged to the US$ at Sri Lanka Rupees (LKR) 203 before the default— was floated. This has resulted in more worker remittances and export earnings coming into Sri Lanka through formal channels helping the current account balance.

Last, the IMF has identified corruption vulnerabilities as a key issue. Sri Lanka became the first country in Asia to have a governance diagnostic (by the IMF) which highlighted key areas in Sri Lanka that needed to be improved. Improving the government’s ability to oversee asset declarations of government officials, strengthening the legal framework in public finance management, creating transparency in public procurement, improved tax policies, mechanisms for better coordination among government institutions and greater protection of property rights were some of the key points mentioned in the IMF governance diagnostic assessment.

Areas for Improvement

Two aspects of the IMF Extended Fund Facility (EFF) merit further improvement, namely social protection policy and the political consensus forged around it.

First, the IMF program’s primary objective is to advance revenue-based fiscal consolidation and reforms to social safety nets to ‘cushion the impact of the economic crisis on the poor and vulnerable’. Indeed, devaluations — such as what Sri Lanka experienced after floating the LKR in 2022 — are known to have a disproportionate impact on lower income groups, as the consumption of tradable goods, whose prices spike due to devaluation, represents a higher share of their income. The EFF is therefore correct to place emphasis on the distributional consequences of economic reforms. Yet social protection policies have yet to be meaningfully strengthened since the 2022 crisis. Social protection programs like Samurdhi, the largest in Sri Lanka, do not capture an estimated 50 per cent of those living in poverty. Other programs, such as Aswesuma, could improve through better targeting and additional funding. The IMF should continue to strongly emphasise the implementation of policies designed to mitigate the distributional effects of necessary economic reforms.

Second, with Presidential and parliamentary elections scheduled to take place later in 2024, the future of the EFF is uncertain. Opinion polls in April 2024 indicate that incumbent President Ranil Wickremesinghe trails far behind the two frontrunners, both of whom have, to varying extents, called for a renegotiation of the EFF Program. This lack of political consensus is concerning, as it could engender policy volatility on critical economic reform areas. (The IMF had to, of course, negotiate the terms of the EFF with the sitting President Wickremesinghe and his government.) Yet the failure to meaningfully liaise with members of the Opposition in a democratic nation could compromise the longevity of the reforms already underway. The IMF stands to benefit from broadening the range of stakeholders it speaks to during important visits.

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The latest IMF Program in Sri Lanka has led to the implementation of critical reforms, particularly in fiscal policy, independence of the Central Bank, and governance. To build on these results, the IMF should strengthen its emphasis on larger and better social protection programs and liaise with a broader range of political stakeholders to ensure the EFF’s resiliency, whatever the electoral outcomes may be.

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Banner image © Lucas Favre, 2017, Unsplash.

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