Sri Lankan govt has made commendable progress toward restoring debt sustainability – IMF

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The International Monetary Fund (IMF) has said that the Sri Lankan government has made commendable progress toward restoring debt sustainability, building up financial reserves, reducing inflation, and safeguarding financial stability.

Moving forward, the Fund said,  it’s important to stay focused on improving governance and protecting the poor.

The Bretton Woods Institution ealier indicated that the longstanding structural weaknesses were elevated by several shocks, which ultimately plunged the country into an economic crisis. Poor governance, a restrictive trade regime, a weak investment climate, episodes of loose monetary policy, and an administered exchange rate contributed to macroeconomic imbalances.

Fiscal indiscipline led to high fiscal deficits and large gross financing needs, which, together with risky commercial borrowing, elevated debt vulnerabilities. Ill-timed tax cuts in 2019 further eroded weak fiscal buffers and led to a rapid growth in debt to unsustainable levels.

As Sri Lanka lost access to international financial markets in 2020 and official reserves dropped precipitously thereafter, the forex liquidity constraint ultimately led to severe shortages of essential goods in 2022.

The country announced an external debt service suspension in April 2022, pending debt restructuring. Amid the crisis, half a million jobs were lost, food insecurity and malnutrition increased, poverty doubled, and inequality widened.

The government is implementing structural reforms to regain macroeconomic stability and a sustainable growth path, including cost-reflective utility pricing, revenue-enhancing measures, and trade, investment, state-owned enterprise, and social protection reforms. Key legislation is being enacted on monetary policy, debt, and public financial management.

In March 2023, the IMF approved a 48-month Extended Fund Facility of approximately US$3 billion to support the government’s reform program, which was followed by budget support from development partners, including the World Bank. Debt restructuring discussions with external creditors are ongoing. The Parliament approved a domestic debt restructuring strategy in July 2023, which excluded financial sector held government securities issued under domestic law.

The economy contracted by 7.8 percent in 2022 and 7.9 percent in the first half of 2023. Construction, manufacturing, real estate, and financial services suffered the most amid shrinking private credit, shortages of inputs, and supply chain disruptions, worsening the negative welfare impacts of income contractions and job losses registered in 2022.

Headline inflation, measured by the Colombo Consumer Price Index, peaked at 69.8 percent in September 2022 and subsequently declined sharply to 4 percent in August 2023 from a high base amid subdued demand. Decelerating inflation was beneficial for households’ welfare, and helped limit further increases in food insecurity and malnutrition, especially among poor households.

The central bank began to loosen monetary policy as inflation decelerated. Policy rates were cut by 250 basis points in June 2023 and by a further 200 basis points in July, bringing the Standing Deposit Facility rate down to 11 percent and the Standing Lending Facility rate to 12 percent. Supported by policy rate cuts and better clarity on domestic debt restructuring, the 91-day T-bill rates fell below 20 percent in July 2023 (for the first time since April 2022).

Between January and July 2023, the merchandise trade deficit contracted by US$1 billion, driven by import restrictions and subdued import demand (primarily for intermediate and investment goods), despite the reduction in exports driven by weak global demand. Foreign exchange liquidity pressures are easing due to the absence of large debt service payments, strong remittance flows, and improved tourism earnings, leading to an accumulation of usable foreign reserves to US$2.4 billion by end-July 2023 (equivalent to 5-6 weeks of imports of goods and services). Stronger remittance flows contributed to higher non-labor income, although it also reflected an increase in emigration since the start of the crisis. After depreciating by 81 percent against the US Dollar in 2022, the currency (LKR) appreciated by 11 percent from January to August of 2023.

The overall fiscal deficit increased in the first four months of 2023, driven by a sharp rise in interest payments, despite higher total revenues and, consequently, a near closing of the primary deficit. While some of the necessary fiscal reforms, including new revenue measures, have improved overall progressivity, indirect taxes, and rising energy prices are placing a disproportionate burden on the poor and vulnerable. Unless mitigated with targeted measures, the removal of energy subsidies could lead to further poverty increases.