The prospects for Sri Lanka securing the International Monetary Fund (IMF) $2.9 billion Extended Fund Facility (EFF) bailout, which hinged upon written financing assurances from its three major bilateral creditors China, Japan and India, appear to be propitious.
India was the first of Sri Lanka’s creditors to officially back its debt restructuring programme. In early February financing assurances were provided by the Paris Group, of which Japan is a member, to support the IMF’s approval of the EFF. The delay in securing the IMF package was due to Beijing, which has the biggest share of Sri Lanka’s debt. China has been reluctant to enter into the agreement, in part because debt restructuring talks with Sri Lanka could become a precedent for its other failing borrowers.
Although 10% is owed to China, combined with the borrowings from Chinese banks, especially EXIM Bank of China and the China Development Bank, the percentage of Chinese-held debt is close to 19.6%. Even though the quantum of the loan is not large, and provides limited provision of liquidity, given the dire situation that Sri Lanka finds itself in, the IMF package might impart a measure of stability. Since 2022, India has become the largest bilateral lender to Sri Lanka.
A year ago, Sri Lanka plunged into its worst financial crisis ever, rudely shattering its popular perception as a more progressive, prosperous and democratic South Asian country. Since the angry mass mobilisation in the form of the ‘aragalaya (struggle)’ protests, Sri Lanka is yet to emerge from the economic and political volatility and social upheaval.
Historically, Sri Lanka has had a problem of twin deficits, an internal fiscal deficit underlined by a severe balance of payment deficit. The situation came in March 2022 when reserves fell to $1.9 billion. On March 7, 2022, the regulator of the banking system announced the devaluation of the national currency with immediate effect, and the Sri Lanka Rupee (LKR) rate fell to a record historic low of Rs 230 against the US Dollar; by April, LKR was 365 to a dollar. On April 12, Colombo announced that it will be defaulting on its external debt of $51 billion. By mid-July, President Gotabaya Rajapaksa fled the country and resigned from abroad.
Nevertheless, the old political elite, perhaps best epitomised by the current President Ranil Wickremesinghe, has managed to hold on to power without popular support or legitimacy. Urgent humanitarian issues continue to grip the nation and progress on economic relief and democratic change is imperceptible.
Economic mismanagement which had been going on for years blew up because of policy decisions like the abrupt ban on fertilisers and shift to all-organic agriculture. Foreign debt was spent on vain projects which had almost no rate of return. Colombo was paying more than two-thirds of its revenue as interest for the heavy borrowing from the international market in the last decade.
Given the shortage of foreign exchange, import controls were introduced into the economy which led to a sharp contraction, more so because Sri Lanka is heavily dependent on the import of intermediate goods. However, the underlying affliction is the high rates of corruption and rent-seeking in Sri Lanka embedded in its economic decision making. Inflation is at about 60% and nearly 33% of all Sri Lankans are experiencing food insecurity. Anyone with any measure of resources is desperate to get out of the country.
The Sri Lankan crisis was a type of “liquidity trap” in which people were accumulating wealth but were not ready to spend it. Poverty and inflation led to a rise in expenditure on public utilities like electricity, and fuel. On the other hand, rising debt of foreign banks mainly from the IMF may lead to further rise in income tax, corporate tax, etc.
The IMF may push USD into the economy amid the weakening of the LKR that ends in the complete surrender of the Sri Lankan economy. Sri Lanka’s debt crisis is so intractable that more than 182 economists and development experts, including Jayati Ghosh, have called for total debt forgiveness for the country
The IMF agreement signed in September had pushed for greater liberalisation, committing the government to a range of reforms. Foremost in the key elements of the EFF arrangement is the IMF’s push for making the personal income tax more progressive and broadening the tax base. The arrangement entails ending subsidies by introducing “cost recovery-based” pricing for fuel and electricity. In February, the government hiked electricity prices by 66%, following an increase in prices by 75% last year.
Under the IMF agreement, the central bank will buy dollars, prevent an appreciation of the currency and build reserves, amid slower domestic credit. This week, the central bank completely lifted a surrender rule and a guidance peg, allowing the rupee to go up and has bought more than $300 million.
Sri Lanka has gone to the IMF 16 times in the past after triggering monetary instability. It does not operate an inflation-targeting framework as it does not have a clean float, leading to sovereign default after currency crises. It has been pursuing a flexible exchange rate which tends to be unstable and permanently depreciating.
Post 2022 economic crisis, the focus has been on easing currency pressure and money printing. A draft bill to legalise an inflation-targeting regime and prevent monetary financing of the budget deficit (money printing) has been tabled. The Central Bank Act will effectively allow officials to modify the monetary policy, exchange rate policy and growth policy to attain a specific yearly inflation rate. Fears of domestic debt restructuring have inadvertently pushed up interest rates, helping reduce credit.
The IMF agreement also seeks to reduce corruption vulnerability through fiscal transparency and the introduction of a stronger anti-corruption legal framework. An ambitious state-enterprise restructuring move, through the sale of 14 state firms is being initiated and primed to raise $4.5 billion. An Indian private firm has been keen on the loss-making Sri Lankan Airlines which recently defaulted on its $175 million government-guaranteed bond. This is easier said than done in a country where the outlook of society is largely “statist,” and a bulk of state revenues is spent on salaries to public servants.
Will Wickramasinghe implement unpopular decisions?
Presidential elections are due to take place in September 2024. In the interregnum, much depends on whether Wickremasinghe tries to cushion people from the effects of the economic restructuring with an eye on the election, or pursues a radical restructuring of the economy.
Despite becoming President through a constitutional mandate, Wickremasinghe lacks the political legitimacy to lead the government. Aware of his unpopularity, his government was reluctant to provide LKS 10 bn needed to fund the local elections, forcing the Supreme Court to intervene.
In a bold policy address, Wickremesinghe has underlined the need to fully implement the 13th Amendment to the Constitution to grant political autonomy to the minority Tamils in the country. In his address to parliament in February, he said, “Remember, I’m not here to be popular. I want to rebuild this nation from the crisis situation it has fallen. Yes, I’m ready to make unpopular decisions for the sake of the nation.” Given the deep fault lines based on ethnicity, religion and class within Sri Lankan government structures and its polity, how this devolution of power will play out is deeply suspect.
The IMF-induced reforms have had the effect of aggravating inflation. Individual incomes above LKR 125,000 per month are subjected to a tax rate starting at 6%. Protestors from this income bracket are threatening to trade union action against the ‘regressive’ tax regime, indicating a new phase of politicisation among previously affluent sections of society.
The government has demonstrated little inclination to hold accountable any of those who have been accused of large-scale corruption. The crackdown on protests has persisted, with police continuing to arrest activists and protesters. While the crisis has to be examined in the context of debt and wealth accumulation, what’s concerning for Sri Lanka is the sharp increase in poverty. It remains to be seen whether this is transitory or will there be segments which remain trapped in poverty in the long term.
Vaishali Basu Sharma is an analyst of strategic and economic affairs.