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Sri Lanka would need hard reforms under an IMF program after elections: analysts

ECONOMYNEXT – Sri Lanka needs hard reforms under an International Monetary Fund program from a stable government after elections to restore investor confidence and provide a stable policy environment for companies to operate, analysts said.

Sri Lanka Podujana Party of President Gotabaya Rajapaksa is widely expected to win upcoming parliamentary polls in August with insiders pushing for a two thirds majority.

Two thirds majorities from 1978 however had brought constitutional changes that fostered illiberal arbitrary rule and undermining of the judiciary and general rule of law, critics say.

Policy Formulation

In the last five years infighting between Prime Minister Ranil Wickremesinghe and President Maithripala Sirisena led to conflicts and there was general policy fright and paralysis with the administration unable to even do a build-operate-transfer deal for Colombo port or a natural gas or coal plant, they say let alone privatization.

“We need to have one strong party ruling the country, whatever the party,” Sanjeewa Fernando, Executive Director Research at CT CLSA Securities, a Colombo-based brokerage told an online forum organized by Sri Lanka’s Echelon Magazine.

“The key here is that we need to have proper policy stability and then there has to be a government to take decisions. It is after that they only if they prefer they can go for hard reforms.

“This is what has been told by the IMF and other institutions that Sri Lanka needs to adopt hard reforms. But we have not done that. I think it’s high time, we have to use this environment to do these things.

“I think this is a good time to do tough reforms which will help Sri Lanka’s economy go to a better state.”

A new IMF facility is expected after a new government is formed.

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Instability

Sri Lanka started 2020 reversing value added tax reforms involving raising rates and broadening the base that was achieved under a previous IMF program under a so-called ‘fiscal stimulus’. The taxes were slashed without passing them in parliament.

The lack of a stable legal or tax framework as well as expropriation and price controls which chip away and private property rights is called ‘regime uncertainty’ by classical economists.

Sri Lanka is now under import controls adding another sudden economic control with the aid of a law that was used in the 1970s to close the economy and achieve 20 percent unemployment.

An exceptional level of uncertainty is also brought by a so-called midnight gazette where taxes are slammed while the citizenry is sleeping using another process that evolved in the 1970s.

The IMF program itself, which was started after a currency collapse from liquidity injections in 2015, failed to bring monetary stability and the currency collapsed in between the program in 2018, plunging the country into stagflation.

A ‘debt moratorium’ was also imposed on the banking sector. From late January policy rates were cut, despite the budget deficit expected to rise after the tax cuts, just as the credit system was starting to recover.

Under so-called ‘flexible exchange rate’ and ‘flexible inflation targeting’ Sri Lanka’s rupee had collapsed from 151 to 185 to the US dollar since April 2018, after collapsing from 131 to 153 from 2015 to 2018 worsening losses in state enterprises and nullifying price reforms in petroleum.

SOE

Lower tax revenues from the stimulus, Covid-19 and import controls may drive the deficit to as much as 9 to 11 percent of gross domestic product analysts said.

The government spending has been cut in the first quarter, Lakshani Fernando – Vice President at Asia Securities said. Increasing taxes was also a problem at this time with the economy set to contract in 2020.

“SOE has to be one of the key priorities,” Lakshani Fernando – Vice President at Asia.” I think this is one of the things they will focus on.

Indirect privatization could also be on the agenda.

“In the next year there is a high likelihood that we will look at privatizations,” Head of Research at First Capital, an investment house said.

“Already the government has started this Temasek model type company called Selendiva. They already have a structure, 51 percent going to the government. There is likelihood that they will raise money through that area.

“That will obviously have foreign investment coming in. That may not be the traditional foreign investment.”

Tax Hikes

The government however is now taxing petroleum heavily to get some revenues.

When value added taxes were slashed by the current cabinet, policy makers were expecting to get more money out of growth rather than the rate.

An increase in taxes was needed but the question was its impact on an economy already hit by Coronavirus, Asia Securities’ Fernando said.

“We are looking at slow economic activity,” Fernando said. “If on top of that the government tightens fiscal policy by increasing those taxes, it is going to be a bigger impact, but I honestly think that has to be done at this point.

Overall there are some hard decisions to be made.”

“What I feel is there could be an additional form of taxes coming in,” Udeeshan Jonas – Chief Strategist at Capital Alliance said.

“It might not be VAT as such; it may be another indirect tax. Given that the government wants to control import duties, it may be another tax on non-essentials.”

He said the value added tax cut had not increased spending of the consumer as prices were not reduced, but it helped firms.

IMF Program

Nikita Tissera – Head of Research at Bartleet Religare Securities, said the IMF program could be a catalyst for hard reforms, but there have also been other cases.

Tissera said improving the profits of SOEs, higher direct taxes could be options.

He said Nigeria – an oil exporter with chronic monetary instability – had gone against IMF recommendations over the last three years, and foreign capital was controlled.

“Despite the IMF warning them very severely on the east of capital movement, they did not do it and Nigeria still got the facility they wanted,” Tissera said.

“So I don’t know at this time bang in the middle of the pandemic how pressing the IMF would be to press reforms on us, linked to their help.

An IMF program will help improve investor confidence. With Sri Lanka’s sovereign bonds trading at a discount, the country has been pushed out of the bond market and will have to pay a billion dollar maturing bond out of reserves.

Analysts said the likelihood of a default was low, may be around 5 to 10 percent.

An IMF program would to address the problem of debt sustainability, persons familiar with the issue say.

At the moment fresh budget support loans from other multilateral loans are also in abeyance until and IMF program addresses the issue with a credible fiscal plan.

With a highly unstable soft-peg Sri Lanka is a serial IMF customer. Since the soft-peg was created the central bank has had 16 programs with the IMF. Necessarily not a single had reformed the soft-peg. (Colombo/July25/2020)