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Sri Lanka misses IMF fiscal target with ‘flexible exchange rate’; new deal on way

BLAST EFFECT: Easter Sunday blasts by Islamist extremists generated widespread sympathy in the West giving Sri Lanka breathing space to follow better policy – if it wants to.

ECONOMYNEXT – Sri Lanka has missed targets in a deal with the International Monetary Fund as it operated controversial ‘flexible exchange rate’ with contradictory policy for most in 2018, but a new deal was on and the country was hit Islamist bomb blasts.

Sri Lanka’s central bank started to print money and generated excess liquidity through multiple lender of last resort windows in March/April and July/August 2018 despite having a forex reserve target, leading to a collapse of the currency from 153 to 182 to the US dollar.

Although tight liquidity after triggering currency pressure prevented a total Indonesia or Argentina style meltdown, analysts say trade restrictions and a credit contraction led to a fall in revenues and an output shock, which led to missing targets.

Tight liquidity during crises also tends to contain inflation. The program has a high inflation target of over 7 percent, allowing wide discretion for loose policy.

Printing money generates a deficit in the balance of payments with excess demand, as well as spooking foreign investors, importers and exporters, automatically leading to a fall in forex reserves and missing any IMF forex reserve targets.

However the IMF said a reserve target has been met for June. During the first half of 2019 analysts have noted that monetary and exchange policy has been consistent.

Renewed monetary instability began after July 2019, when fresh injections began.

As Sri Lanka was recovering from the currency collapse, in April 2019 on Easter Sunday, several churches and hotels in Sri Lanka were hit by Islamist bomb attacks, for which Islamic-state, a pan-nationalist group, claimed responsibility, generating widespread sympathy in the West.

Though Sri Lanka had missed targets in the program a new deal has been reached, pending prior actions, the IMF said.

“The team reached understandings at the staff level with the Sri Lankan authorities on the sixth review of the EFF-supported program,” IMF Mission chief to Sri Lanka Manuela Goretti said in a statement.

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“The authorities are taking steps to complete all the pending actions and structural benchmarks for this review over the next few weeks.”

“The team welcomed the authorities’ efforts to normalize the security situation in the country after the tragic terrorist attacks in April and mitigate the impact of the shock on the economy.”

The monetary instability from the pursuit of a ‘flexible exchange rate’ where interest rates and exchange rates are targeted simultaneously came despite political difficult tax hikes and market pricing of fuel.

“While the program targets agreed at the time of the fifth review are no longer within reach, the authorities are committed to achieve a primary fiscal surplus of 0.2 percent of GDP in 2019, through implementation of remaining revenue measures in the 2019 budget and prudent expenditure management,” the IMF said in a statement.

The IMF program had a performance criteria for a long-running primary deficit.

The petroleum utility also borrowed dollars running losses in excess of 100 billion rupees, despite having a price formula for reasons which are not clear, raising questions whether agency was mis-used in a failed bid to control the exchange rate through mercantilist means.

In the first quarter of 2019, some CPC debt from SOEs had been repaid.

Critics had pointed out that the collapse of the currency in 2018 and unhedged forex risks taken on by the Ceylon Petroleum Corporation had wiped out any gains from tax hikes as dollar debt expanded taking away any gains from ‘revenue based fiscal consolidation’.

However after October 2018, when President Maithripala Sirisena triggered a political crisis by violating the constitution, analysts say the central bank was put in a difficult position and had managed as best as it could.

Analysts and warned at the inception of the program given Sri Lanka’s past tendency to print money and generate currency pressure even within IMF deals, missing reserve targets, the central bank should have been restrained with tight ceilings on domestic assets.

The monetary instability and credit contraction coupled with bomb blasts cut growth to 1.6 percent in the June 2018 quarter.

IMF said it expected growth of 2.7 percent in 2019, improving to 3.5 percent in 2020.

The IMF urged Sri Lanka to pass changes to a monetary law, amid concerns that the law may give more room for bureaucratic discretion to generate monetary instability though contradictory money and exchange policies.

Concerns are also rising that the new law will also help the central bank avoid inflation targeting with genuine float by getting legal authority to practice discretionary ‘flexible’ inflation targeting with a highly unstable soft-peg with little or no credibility.

Sri Lanka has to peg (buy dollars and inject base money) to meet IMF reserve targets and insistence by IMF among others, that there has to be a ‘reserve buffer’.

Analysts who have tried to decipher the policy behind the ‘flexible exchange rate’ have identified the latest reincarnation as having a convertibility undertaking of delaying interventions until there is a ‘disorderly fall’ but buying dollars at market rates with no ‘disorderly gain’, especially from the Treasury.

Base money injected from dollar purchase are also kept as excess liquidity for a extended periods of time but, any liquidity contraction from defence after the disorderly fall is injected overnight, making for hopelessly skewed policy that pushes the currency down even when credit is weak.

Concern has been raised particular on the way the central bank switches from a peg (buying dollars) to floating with excess liquidity intact, though a float helps end contradictory policy.

However the IMF said it supported the ‘flexible exchange rate’.

“The mission supported the Central Bank of Sri Lanka (CBSL)’s prudent and data-dependent monetary policy approach and their renewed commitment to strengthen reserve buffers in line with program understandings,” the statement said.

“The CBSL should continue to allow for exchange rate flexibility and limit FX intervention to smooth excess volatility, in the event pressures from tighter global financial conditions were to intensify.”

Sri Lanka’s central bank has gone to the IMF 16 times since it was created in 1950 as contradictory policy led to currency troubles. The currency troubles then generated trade restrictions and low growth.

Burkina Faso’s monetary authority has gone to the IMF 9 times. Ethiopia’s central bank has gone to the IMF 5 times.

The full statement is reproduced below:

International Monetary Fund
Washington, D.C. 20431 USA

We welcome the authorities’ commitment to fiscal discipline and institutional reforms to anchor debt sustainability, while providing space to support the ongoing recovery and social goals.

• The new Central Bank Act will be a landmark reform in the roadmap towards flexible inflation targeting, strengthening the Central Bank of Sri Lanka’s mandate, governance, accountability, and transparency, in line with international best practice.

• Trade and investment liberalization, SOE reforms, and stepped-up anti-corruption efforts will be important to bolster Sri Lanka’s competitiveness and medium-term growth.

A staff team from the International Monetary Fund (IMF) led by Manuela Goretti visited Colombo during September 10-25, 2019 to conduct the sixth review under Sri Lanka’s economic reform program supported by a four-year Extended Fund Facility (EFF) arrangement. At the end of the visit, Ms. Goretti made the following statement:

“The team reached understandings at the staff level with the Sri Lankan authorities on the sixth review of the EFF-supported program. The authorities are taking steps to complete all the pending actions and structural benchmarks for this review over the next few weeks.

“The team welcomed the authorities’ efforts to normalize the security situation in the country after the tragic terrorist attacks in April and mitigate the impact of the shock on the economy. Real GDP growth was revised to 2.7 percent in 2019 and is projected to improve to 3.5 percent in 2020, as tourist arrivals and related activities gradually recover. Inflation is expected to remain stable at around 4.5 percent during 2019-20.

Despite the recent fall in tourist arrivals and remittances, the current account balance is projected to improve to 2.6 percent of GDP in 2019 on the back of lower imports and stronger exports supported by the exchange rate correction in late 2018.

“Sustaining prudent policies and implementing institutional reforms remain critical to preserve macroeconomic stability, given the weak global outlook and Sri Lanka’s sizable public debt.

“The protracted impact of the 2018 political crisis and the Easter attacks are significantly impacting fiscal performance. The end-June fiscal target was missed by a large margin, due to frontloading of spending from the clearing of arrears and externally-financed capital projects carried over from 2018 as well as a sharp fall in indirect revenues following the terrorist attacks.

While the program targets agreed at the time of the fifth review are no longer within reach, the authorities are committed to achieve a primary fiscal surplus of 0.2 percent of GDP in 2019, through implementation of remaining revenue measures in the 2019 budget and prudent expenditure management.

“The mission welcomed the authorities’ commitment to advance revenue-based fiscal consolidation in 2020 and over the medium term to preserve the gains achieved under the program, put the high public debt on a downward path, and provide space for better-targeted social and capital spending.

Sustained efforts are needed to mobilize revenues, by broadening the tax base and enforcing compliance, and strengthen spending efficiency. To anchor public debt sustainability, the mission welcomed the authorities’ plans to revamp fiscal rules and establish an independent public debt management agency over the medium term, in line with international best practice.

Improving the financial performance of SriLankan Airlines and advancing energy sector reforms, including by tackling cost inefficiencies and subsidies in the electricity sector, remain critical steps to reduce fiscal risks.

“The mission supported the Central Bank of Sri Lanka (CBSL)’s prudent and data-dependent monetary policy approach and their renewed commitment to strengthen reserve buffers in line with program understandings.

The CBSL should continue to allow for exchange rate flexibility and limit FX intervention to smooth excess volatility, in the event pressures from tighter global financial conditions were to intensify.

The new Central Bank Act will be a landmark reform in the roadmap towards flexible inflation targeting by strengthening the CBSL’s mandate, governance, accountability, and transparency, in line with international best practice.

“The CBSL adopted temporary measures to support the tourism sector and ease credit conditions in the aftermath of the terrorist attacks, including a debt service moratorium and caps on bank interest rates. These exceptional measures should be lifted as soon as credit conditions stabilize to avoid distortions to the financial system, amid weaker credit quality and falling profitability. The mission welcomed the ongoing efforts to strengthen the regulatory and supervisory regime for banks and non-bank financial institutions.

The CBSL’s plans to enhance the macroprudential policy framework and stress testing capabilities and to upgrade the contingency framework would also contribute to financial stability. The authorities have made progress in strengthening the Anti-Money Laundering and Countering the Financing of Terrorism regime.

“The mission welcomed the authorities’ ongoing plans to bolster competitiveness and medium-term growth by gradually liberalizing the trade and investment regimes, while addressing any potential revenue impact. These plans would need to be supported by an unwavering commitment to strengthen governance and transparency, notably in state-owned enterprises, and tackle corruption as well as stepped-up efforts to promote women’s economic empowerment and targeting social transfers to those who need it the most.”

The team met with Prime Minister Wickremesinghe, Minister of Finance Samaraweera, State Minister of Finance Wickramaratne, Governor of the Central Bank of Sri Lanka Coomaraswamy, Secretary to the Treasury Samaratunga, Senior Deputy Governor Weerasinghe, other public officials, representatives of the Parliamentary Opposition, business community, civil society, and international partners. (Colombo/Sep25/2019- Updated 10:05, Sep25/2017)

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