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Wednesday March 29th, 2023

Sri Lanka debt unsustainable, should stop printing money, hike rates, taxes: IMF

ECONOMYNEXT – Sri Lanka’s public debt is unsustainable and the country should stop printing money, hike rates and taxes to prevent monetary instability from taking hold, the International Monetary Fund has warned.

Debt Unsustainable

The IMF Executive Directors after an annual article IV consultations said “the country faces mounting challenges, including public debt that has risen to unsustainable levels, low international reserves, and persistently large financing needs in the coming years.”

“Against this backdrop, they stressed the urgency of implementing a credible and coherent strategy to restore macroeconomic stability and debt sustainability, while protecting vulnerable groups and reducing poverty through strengthened, well-targeted social safety nets,” the statement said.

A country’s debt is usually deemed unsustainable based on a politically feasible monetary (interest rates) and fiscal (taxes and and spending cuts) framework, and requires debt re-structuring of some kind to keep interest rates at a manageable level.

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Sri Lanka 2020 deal talks hit a snag on debt sustainability: IMF spokesman

The current crisis may result in more monetary instability, the IMF said, after country cut taxes in 2019 and engaged record money printing to create a ‘production economy.’

“Unless the fiscal and balance-of-payments financing needs are met, the country could experience significant contractions in imports and private credit growth, or monetary instability in case of further central bank financing of fiscal deficits,” the IMF said.

Analysts had warned that under current monetary policy and deficits, with negative foreign assets of the central bank, Sri Lanka may lose control of reserve money and end up in market dollarization (Sri Lanka’s monetary meltdown will accelerate unless quick action is taken).

Printing Money

The IMF staff after annual Article IV consultations (report not published) said there had been a large amount of “central bank direct financing of the budget,” an euphemism for printing money.

Sri Lanka printed 1.2 trillion rupees in 2021, in part due to reserve appropriations and price controls on bond yield that led to auction failures.

However after October 2021 money is printed to sterilize reserve sales for imports to maintain a 200 rupee to the US dollar peg as well as a quasi-fiscal activity involving giving subsidies through printed money to expatriate workers.

Inflation has started to soar after two years of money printing which sent broad money up 40 percent in the period.

“Directors agreed that a tighter monetary policy stance is needed to contain rising inflationary pressures, while phasing out the central bank’s direct financing of budget deficits,” the IMF’s executive directors concurring with a staff assessment said.

Sri Lanka started to print money extensively in February 2020 to keep interest rates down, after cutting taxes in December 2019, ostensibly to kick start a ‘production economy,’ based on post-Keynesian principles.

In 2020 after a severe flexible exchange rate episode in March (a rapid shifting between pegged and floating regimes, with partial interventions that sends the rupee sliding) on top of tax cuts, new downgrades cut off Sri Lanka’s access to capital markets.

A downgrade also came in 2018 also after ‘flexible exchange rate’ episode. The downgrade via the flexible exchange rate and money printed to target ‘an output gap’ or a type of Keynesian stimulus, came despite a hike income and value added tax that brought the deficit now.

The IMF also urged tax hikes through both value added and income taxes.

IMF directors also called for the current 200 to the US dollar peg to be dropped in favour or a “gradual return to a market-determined and flexible exchange rate to facilitate external adjustment and rebuild international reserves.”

Monetary Reforms

Analysts and classical economists have called for reforms to central bank’s governing law to block non-rule based discretionary (flexible) policy and commit the agency to a rule of law involving one monetary anchor.

One option is a clean floating rate (no reserve building, no interventions in the fx market for imports or any other purpose) with a low inflation target not higher than 2 percent, (domestic anchor only) like most low inflation developed nations.

The second, more simpler option is a reserve building peg and no policy rate (unsterilized interventions) involving one external anchor, also known as a hard peg or curency, like Hong Kong and some East Asian nations to stop trade controls, exchange controls, currency collapses, high inflation and social unrest.

A third option is a similar arrangement with a wide policy corridor, and policy rate linked to the anchor currency – usually the Federal Reserves such as in the GCC areas and some other East Asian nations (currency-board-like-system), where the rate also changes.

A hard peg, which outlaws central bank financing of the budget, which led to the current crisis, is an automatic hard budget constraint. A hard peg – which Sri Lanka had from 1885 to 1950 would also stop the country from going to the IMF with external trouble.

Analysts have have pointed out that the ‘flexible exchange rate’ with dual anchors is a fancy name for an inconsistent, permanently depreciating crawling peg (or bbc peg) that has resulted in severe trade and exchange controls in Sri Lanka and elsewhere.

In Latin America such dual anchor regimes with reserve collecting flexible regimes, lead to severe currency collapses and repeated defaults including when there is a budget surplus, when the the US Fed starts to tightens monetary policy.

The IMF also called for current exchange controls to be lifted. IMF directors said Sri Lanka “to gradually unwind capital flow management measures as conditions permit.”

The exchange controls and liquidity injections had triggered parallel exchange rate or around 245 to 250 to the US dollar.

Bad weather and a resurgence of Covid-19 could also compound economic woes contribute and raise bad loans.

IMF Concludes 2021 Article IV Consultation with Sri Lanka

Washington, DC – March 2, 2022: The Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation1 with Sri Lanka on February 25, 2022.

Sri Lanka has been hit hard by COVID-19. On the eve of the pandemic, the country was highly vulnerable to external shocks owing to inadequate external buffers and high risks to public debt sustainability, exacerbated by the Easter Sunday terrorist attacks in 2019 and major policy changes including large tax cuts at late 2019. Real GDP contracted by 3.6 percent in 2020, due to a loss of tourism receipts and necessary lockdown measures. Sri Lanka lost access to international sovereign bond market at the onset of the pandemic.

The authorities deployed a prompt and broad-based set of relief measures to cope with the impact of the pandemic, including macroeconomic policy stimulus, an increase in social safety net spending, and loan repayment moratoria for affected businesses. These measures were complemented by a strong vaccination drive. GDP growth is projected to have recovered to 3.6 percent in 2021, with mobility indicators largely back to their pre-pandemic levels and tourist arrivals starting to recover in late 2021.

Nonetheless, annual fiscal deficits exceeded 10 percent of GDP in 2020 and 2021, due to the pre-pandemic tax cuts, weak revenue performance in the wake of the pandemic, and expenditure measures to combat the pandemic. Limited availability of external financing for the government has resulted in a large amount of central bank direct financing of the budget. Public debt2 is projected to have risen from 94 percent of GDP in 2019 to 119 percent of GDP in 2021. Large foreign exchange (FX) debt service payments by the government and a wider current account deficit have led to a significant FX shortage in the economy. The official exchange rate has been effectively pegged to the U.S. dollar since April 2021.

The economic outlook is constrained by Sri Lanka’s debt overhang as well as persistently large fiscal and balance-of-payments financing needs. GDP growth is projected to be negatively affected by the impact of the FX shortage and macroeconomic imbalances on economic activities and business confidence. Inflation recently accelerated to 14 percent (y/y) in January 20223 and is projected to remain double-digit in the coming quarters, exceeding the target band of 4–6 percent, as strong inflationary pressures have built up from both supply and demand sides since mid-2021. Under current policies and the authorities’ commitment to preserve the tax cuts, fiscal deficit is projected to remain large over 2022–26, raising public debt further over the medium term. Due to persistent external debt service burden,

International reserves would remain inadequate, despite the authorities’ ongoing efforts to secure FX financing from external sources.

The outlook is subject to large uncertainties with risks tilted to the downside. Unless the fiscal and balance-of-payments financing needs are met, the country could experience significant contractions in imports and private credit growth, or monetary instability in case of further central bank financing of fiscal deficits. Additional downside risks include a COVID-19 resurgence, rising commodity prices, worse-than-expected agricultural production, a potential deterioration in banks’ asset quality, and extreme weather events. Upside risks include a faster-than-expected tourism recovery and stronger-than-projected FDI inflows.
Executive Board Assessment

Executive Directors commended the Sri Lankan authorities for the prompt policy response and successful vaccination drive, which have cushioned the impact of the pandemic. Despite the ongoing economic recovery, Directors noted that the country faces mounting challenges, including public debt that has risen to unsustainable levels, low international reserves, and persistently large financing needs in the coming years. Against this backdrop, they stressed the urgency of implementing a credible and coherent strategy to restore macroeconomic stability and debt sustainability, while protecting vulnerable groups and reducing poverty through strengthened, well-targeted social safety nets.

Directors emphasized the need for an ambitious fiscal consolidation that is based on high-quality revenue measures. Noting Sri Lanka’s low tax-to-GDP ratio, they saw scope for raising income tax and VAT rates and minimizing exemptions, complemented with revenue administration reform. Directors encouraged continued improvements to expenditure rationalization, budget formulation and execution, and the fiscal rule. They also encouraged the authorities to reform state-owned enterprises and adopt cost-recovery energy pricing.

Directors agreed that a tighter monetary policy stance is needed to contain rising inflationary pressures, while phasing out the central bank’s direct financing of budget deficits. They also recommended a gradual return to a market-determined and flexible exchange rate to facilitate external adjustment and rebuild international reserves. Directors called on the authorities to gradually unwind capital flow management measures as conditions permit.

Directors welcomed the policy actions that helped mitigate the impact of the pandemic on the financial sector. Noting financial stability risks from the public debt overhang and sovereign-bank nexus, they recommended close monitoring of underlying asset quality and identifying vulnerabilities through stress testing. Directors welcomed ongoing legislative reforms to strengthen the regulatory, supervisory, and resolution frameworks.

Directors called for renewed efforts on growth-enhancing structural reforms. They stressed the importance of increasing female labor force participation and reducing youth unemployment. Further efforts are needed to diversify the economy, phase out import restrictions, and improve the business and investment climate in general. Directors also called for a prudent management of the Colombo Port City project, and continued efforts to strengthen governance and fight corruption. They noted the country’s vulnerability to climate change and welcomed efforts to increase resilience.

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Sri Lanka stocks recover with banking and finance sectors leading the way

Stock Market. Free public domain CC0 image.

ECONOMYNEXT – Sri Lanka’s stocks edged up on Wednesday recovering from the two-day loss, with banking and finance sectors pushing up the market as buying interest returned for the day, easing selling pressure, brokers said.

The main All Share Price Index (ASPI) closed up 0.42 percent or 39.03 points to 9,272.43.

The market was on a downward trend since last week as investors are adopting a wait-and-see approach until more clarity is given regarding local debt restructuring after the International Monetary Fund approved the extended loan facility.

“Buying interest has renewed and selling pressures are wearing off,” Ranjan Ranatunga of First Capital Holdings said.

Shares at Lanka IOC was gaining during the following week on the news that the Sri Lanka cabinet has granted approval for three oil companies from China, the United States, and Australia in collaboration with Shell Pl to lease 150 fuel stations for each company to operate in the local market.

However, sudden price revision of fuel by the Energy Ministry has hit the shares dragging it down, analysts said.

A crossing was seen by Horana Plantations, with a 51 percent stake change coming into play, the crossing had generated 700 million rupees from the total turnover, Ranatunga said.

The market saw a net foreign inflow of 32.8 million rupees, and the total offshore inflows recorded so far in 2023 are 3.3 billion rupees.

The most liquid index, S&P SL20, closed 0.64 percent or 16.95 points up at 2,673.25.

The market saw a turnover of 1.4 billion on Wednesday, below this year’s daily average of 1.8 billion rupees.

Top gainers were Sampath Bank, Vallibel One and DFCC Bank.(Colombo/March29/2023)

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Rupee closes weaker at 328.50/329.50 against the US dollar, Bond yields steady

ECONOMYNEXT – Sri Lanka’s treasury bond yields were down and the rupee closed weaker in the spot market on Wednesday following an undersubscribed treasury bill auction, dealers said.

A 01.07.2025 bond closed at 31.25/30 percent on Tuesday, steady from 31.20/60 percent on Tuesday.

A 15.09.2027 bond closed at 28.25/29.00 percent, unchanged from Tuesday.

A one-year bill closed at 24.00/30 percent, down from 24.25/25.00 percent.

Sri Lanka rupee closed at 328.50/329.50 rupees against the US dollar weakened, from 325/328 rupees from a day earlier. (Colombo/ March29/2023)

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Sri Lanka tuk tuk, bus fares to be cut on lower fuel prices

CROWDED: An overloaded bus in a suburb of Colombo, leaning sideways with passengers clinging to foot boards.

ECONOMYNEXT – Sri Lanka’s bus fares will be cut from 12.9 percent from midnight onwards, a public transport regulator said while tuk tuk drivers said they are cutting their free market fares with immediate effect.

“The minimum rate will be cut to 30 rupees from tonight,” Lasantha Alagiyawana acting Transport Minister told reporters Wednesday. 

The minimum bus fare was previously 35 rupees. 

Three wheeler association President, Lalith Dharamsena said the first kilometer is charged from 100 rupees and 80 rupees for the second kilometer.

The price of Petrol 92 Octane will be slashed by 15 percent or 60 rupees to 340, Petrol 95 Octane 95 will be reduced by 26.5 percent or 135 rupees to 375, Auto Diesel by 19.8 percent or 80 rupees to 325, and kerosene by 3.3 percent or 10 rupees to 295.

Wijesekera said on President Ranil Wickremesinghe’s advice and in line with the price formula agreed with the International Monetary Fund (IMF), the prices will be reduced from midnight today. (Colombo/Mar29/2023) 

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