Sri Lanka gradually returns to macroeconomic stability, but risks remain
Sri Lanka
gradually returns
to macroeconomic
stability, buT RISKS
REMAIN
WRITTEN BY ANJALI HEWAPATHAGE AND THILINA PANDUWAWALA
25 September 2023
With the approval of the IMF’s Extended Fund Facility (EFF) coming through in March 2023, the memory of last year’s acute crisis seems to be washing out gradually in the minds of Sri Lankans. Since April 2023, a major factor affecting economic and financial sector sentiment has been the potential impact of the government’s proposed domestic debt restructuring (DDR) process, which was deemed essential to reduce the high domestic debt servicing costs of the government.
Domestic interest rates stayed high over the previous months partly because of the uncertainty regarding the DDR process and the potential losses it could cause to domestic creditors. In late June, the government announced the final DDR proposal after much delay. It predominantly covered the domestic rupee debt held by the central bank and superannuation retirement funds, removing most concerns about the stability of the domestic banking system and losses to private sector bond investors.
With the reduction of uncertainties on the DDR that were attached to interest rates, the central bank was able to shift to a stance of monetary easing from June 2023 onwards. Partially helped by moderation from a high base in the previous year, inflation (year-on-year) fell to 4 per cent in August 2023, from 64.3 per cent recorded in August 2022. Given this, the Central Bank of Sri Lanka opted to cut the benchmark policy rates and reduce the statutory reserve requirement for banks, in a bid to stimulate economic growth.
Emerging signs point to a measured and gradual economic recovery. Growth in lending to the private sector has turned positive in June 2023 with the gradual unwinding of tight monetary conditions. Furthermore, import restrictions on nearly 600 goods were removed and qualms about fresh foreign exchange troubles eased, with the rupee appreciating against the dollar. The influx of tourists rebounded strongly, with the highest number of inbound tourist arrivals since before the onset of COVID-19 (as recorded in July 2023). Inward remittances have also recovered significantly.
It may be true that Sri Lanka is on a path of economic recovery, but, despite the ambition and compliance to continue growth, it might prove challenging as risk factors play out both locally and globally.
While the economy finds some respite from the troubles it saw last year, it must meet several ambitious revenue and expenditure targets, as part of its agreement with the IMF. With the first review of the programme concluding in late September 2023, it is crucial to achieve these targets to unlock the next two tranches of fund disbursements due in 2024.
Ambitious fiscal targets to achieve
Sri Lanka had one of the lowest tax revenue to GDP ratios in the world in 2022 (around 8 per cent); the IMF’s targets aim to raise this to 10 per cent by the end of 2023. The government has raised tax rates, eliminated tax exemptions, and re-introduced pay-as-you-earn (PAYE) and withholding taxes, which contributed to tax revenue growing by nearly 50 per cent in the first half of 2023. Nonetheless, tax revenue has to accelerate further to meet the targets laid out by the IMF.
Although tax revenue growth is expected to continue into 2024, seamless revenue collection from the property/wealth tax (expected to be implemented by 2025) is debatable due to the limited capacity and infrastructure of Sri Lanka’s tax collection authorities. Despite the government keeping non-interest spending controlled, interest expenditures have nearly doubled due to the high-interest rates that prevailed in the first half of the year.
Sri Lanka expects to receive approximately USD 1.8 billion in funding from multilateral organisations like the Asian Development Bank, IMF, and the World Bank in 2023 and USD 1.5 billion in 2024, which can be used for budgetary support, instead of the country solely relying on domestic financing. This funding is also essential to rebuild the country’s foreign exchange reserves, which grew from USD 1.8 billion in May 2022 to USD 3.8 billion by July 2023, and are expected to increase further to USD 5.4 billion by the end of 2024.
Beyond these, the IMF also recommended that Sri Lanka’s state-owned enterprises (SOEs) undergo reforms. Crucial to minimising fiscal expenditure is cutting the losses that the state-run petroleum electricity firms had made due to below-cost pricing. Effectively, the government has adopted cost-reflective energy reforms. Going further, progress is also being made on the privatisation of other loss-making SOEs. The first leg of these privatisations is expected to advance further by the fourth quarter of 2023. Petroleum sector liberalisations are already underway, with Sinopec set to start operations in Sri Lanka by late September. Australia's United Petroleum and US firm RM Parks, in collaboration with Shell, are the two other companies that have received approval to set up operations in Sri Lanka.
However, risks remain
It may be true that Sri Lanka is on a path of economic recovery, but, despite the ambition and compliance to continue growth, it might prove challenging as risk factors play out both locally and globally.
While the country is on track to achieve the targets set by the IMF to a large degree in 2023, the government’s IMF-backed reform agenda has been met with some resistance. Activists have protested the inclusion of superannuation funds in the debt restructuring perimeter, privatisations of SOEs, and the additional burden placed on the people with higher tax rates and higher costs of living. Delays in executing reforms in the run-up to expected national elections by late 2024 may hinder further progress.
A lagging economic recovery entails serious implications for the financial sector. Lending to the private sector saw a contraction for twelve consecutive months from June 2022 to May 2023, as high-interest rates and taxes curtailed the demand for loans from banks. Evidently, non-performing loans and advances in the banking sector reached an all-time high of 12 per cent earlier in the year. If the economic recovery takes longer than anticipated, or if economic risks exacerbate and disrupt the recovery process, higher non-performing loans will impact the banking sector’s profitability and eat into the sector’s capital bases. In turn, they will be constrained in their ability to lend to support economic growth.
Beyond this, external factors have the potential to interfere with the economy’s recovery. Climate dynamics are expected to take centre stage going forward in terms of external risk factors. The El Niño phenomenon (a weather phenomenon that causes increases in surface water temperatures) is expected to cause dryness and lower rainfall levels across the South Asian region. Drought conditions would warrant higher thermal power requirements, pushing up crude oil imports, as hydroelectric power generation capacity reduces. Additionally, locally prevailing drought conditions would impact agricultural harvests, contributing to higher food prices.
The consequences of last year’s acute crisis and ongoing burdens have been felt most harshly by low-income households. According to a recent survey, Sri Lanka’s population has grappled with gradually intensifying economic volatility since 2019, with around 7 million people living in poverty by 2023. Food insecurity acutely affects around 10,000 households, with rising climate risks set to amplify the difficulties that low-income households in Sri Lanka face. While expenditures on social safety nets have increased, the actualisation of these benefits by the poor has been disproportionate. Effective flowthrough of social welfare spending to the targeted beneficiaries also remains imperative in kickstarting the country’s economic recovery at the grassroots levels.
It is still uncertain how the risk factors highlighted above will play out, and to what degree they will impact the Sri Lankan economy. Staying firmly on the course of the IMF programme is particularly important since Sri Lanka will have rising external debt repayments from 2024 onwards — depending on the final external debt restructuring deal. The ability to raise external financing outside of the inflows from multilateral organisations will be needed to ensure restructured debt repayments can be met while rebuilding foreign exchange reserves.
Without growth recovery in the near term to clearly transmit the gains of the ongoing reforms to a wider portion of society, political changes following the upcoming elections risk derailing an IMF programme-based reform path beyond 2024. In the next few years, Sri Lanka will need to walk a tightrope, balancing both the need to support economic growth and to maintain macroeconomic stability.
DISCLAIMER: All views expressed are those of the writer and do not necessarily represent that of the 9DASHLINE.com platform.
Author biographies
Anjali Hewapathage is a Product Lead and Thilina Panduwawala is the Head of Economic Research at Frontier Research, a Colombo-based macro-advisory firm focused on Sri Lanka. The article reflects the opinions and analysis of the authors and not those of the institutions they are affiliated with. Image credit: Wikimedia.