The inconclusive IMF review and

challenges ahead for Sri Lanka

Monday, 13 March 2017

The Central Banks funding of the Government budget is

highly undesirable since such funding would be in the
form of creating seed money known as base money or
reserve money that would generate money supply
increases in multiple terms. The resultant inflation would
then put pressure for the exchange rate to depreciate as
inflation acts as a tax on exports and an incentive for
imports. This will in turn further worsen the fiscal
situation trapping the country in a vicious cycle of getting
into further economic crises
An inconclusive IMF staff review

An IMF staff mission headed by Jaewoo Lee to make the second

review of Sri Lankas progress with respect to its obligations under
the ongoing three-year Extended Fund Facility or EFF has
completed its mission and issued a press statement (available at:
http://www.imf.org/en/News/Articles/2017/03/07/PR1775-Sri
%20Lanka-IMF-Staff-Concludes-Visit-to-Discuss-Progress-of-
Economic-Reform-Program).

The statement is not significantly different from the statement

issued after the first review conducted in September 2016 by a
similar mission also headed by Jaewoo Lee (available at:
http://www.imf.org/en/News/Articles/2016/09/23/PR16422). Both
have admitted that the staff of IMF had done its best to reach a
staff level agreement with the officials of the Government. But no
confirmation has been made about an agreement being reached
between the parties implying that the review outcomes have
been inconclusive.
Plans for continued discussions with high-ups at IMF

Hence, discussions would continue, as the press statements say,

with the higher ups of the Fund by the Sri Lankan team
usuallymade up of the Minister of Finance and the Governor of the
Central Bank when they attend the subsequent annual meetings
of the Fund and the World Bank. The planned discussions with
respect to the first review had been successful and IMFs
Executive Board had finally approved of the release of the second
tranche of EFF amounting to $ 162.6 million in November 2016
(available at:
http://www.imf.org/en/News/Articles/2016/11/18/PR16515-Sri-
Lanka-IMF-Completes-First-Review-of-the-Extended-Arrangement-
Under-the-EFF).
Is Sri Lanka a chronic failure in keeping to its promises?

In the press statement announcing the approval of the release of

the second tranche, IMFs Deputy Managing Director Tao Zhang
had expressed the satisfaction about the progress made by Sri
Lanka despite the challenging circumstances within as well as
outside the country. Thus, by all means, the Fund had expected
Sri Lankan authorities to continue to maintain this satisfactory
progress during the balance period of the EFF arrangement.

Hence, the inconclusive staff level discussions and the

postponement of the final decision to subsequent meetings to be
held by the side of the Spring Meetings to be held in coming April
is a testimony of the countrys failure to implement the reform
program promised to IMF under the EFF arrangement.
IMFs bailout of Sri Lanka in mid 2016

Sri Lanka availed itself of the EFF under reference in June 2016
when the country had been faced with a severe external sector
crisis, exacerbated by a looming economic crisis that had crippled
the lifeline of its economy. According to the observations of the
Fund (available at:
http://www.imf.org/external/np/sec/pr/2016/pr16262.htm) the
crisis had reflected in all the macroeconomic fronts of the country.

Economic growth had slowed down and been below the countrys
potential for growth. The fiscal sector had been chronically in
deficit, despite the increase in Government revenue to 13.1% of
GDP in 2015 due to one-off tax measures and higher import duty
collections from the surge in vehicle imports. The balance of
payments or BOP had significantly deteriorated due to large scale
capital outflows and lower foreign direct investments. The Sri
Lanka rupee was under continuous pressure for depreciation due
to poor BOP conditions.
Though price inflation in the economy had been low in the past
few years up to mid 2016, there was the threat of inflation raising
its ugly head once again because of the high growth in the
monetary base, money supply and the private sector credit
utilisation. Surely, inflation began to rise again worsening the
prevailing macroeconomic crisis. It generated a second round of
macroeconomic imbalances on all fronts: slowed-down economic
growth, worsened fiscal situation and continued pressure for
exchange rate to depreciate. Thus, Sri Lankas track record since
the approval of EFF has not been satisfactory.
Opportunity given to Sri Lanka to reset its macroeconomic
policies

But IMF, according to Funds Deputy Managing Director at that

time, Min Zhu, expected a lot from Sri Lanka. It surmised that the
planned EFF would give an opportunity for Sri Lankas
Government to reset macroeconomic policies, address key
vulnerabilities, boost (foreign) reserves and support stability and
resilience of the economy. In other words, EFF was to rescue Sri
Lankas economy from the depth to which it had fallen. Given the
enormity of the crisis, this was an urgent need to be supported by
an economy-wide reform programme.
 Disciplining the budget is the key

According to Min Zhu, disciplining the Government budget

known as fiscal consolidation was the key to the entire reform
programme. Fiscal consolidation means the Governments taking
charge of the budget rather than the budget taking charge of the
Government.

On one side, it involves increasing revenue and cutting down

unnecessary expenditure while increasing productivity related
ones. The latter ones include expenditure on education, research
and development, healthcare services and essential infrastructure
facilities like roads, power-plants, improvements in
communication facilities, etc.

On another, with improved revenue and expenditure conditions,

fiscal consolidation aims at generating savings in the budget
that is, keeping its consumption expenditure known as recurrent
expenditure below the revenue levels and reducing the overall
budget deficit to an affordable level. The latter target brings out
another beneficial improvement in the form of keeping a check on
the growth of overall public debt levels.
Fiscal indiscipline is the source of all ailments

There is a good reason for the Fund to consider fiscal

consolidation as the key to economic reforms aiming at restoring
macroeconomic stability in the country. That is because it is the
undisciplined budgets that would create all macroeconomic
troubles for a country. When the budget has no resources to
maintain the Governments expenditure programmes, it has to
borrow funds increasing public debt levels or get the Central Bank
to print money and make available to the Government to finance
its extravagant expenditure programmes.

The first would deny the private sector the needed resources to
expand its economic activities. That in turn will reduce the
countrys economic growth potential.

The Central Banks funding of the Government budget is highly

undesirable since such funding would be in the form of creating
seed money known as base money or reserve money that
would generate money supply increases in multiple terms.

The resultant inflation would then put pressure for the exchange
rate to depreciate as inflation acts as a tax on exports and an
incentive for imports. This will in turn further worsen the fiscal
situation trapping the country in a vicious cycle of getting into
further economic crises.

Hence, the budget consolidation should be the topmost priority of

any Government seeking to introduce economic reforms to come
out of an economic crisis.
Sri Lankas promised six-pronged reform program

Thus, of the six-pronged reform programme pledged by the

Government to IMF when it sought EFF from the Fund, the first
four aimed at generating a permanent fiscal consolidation, while
the last two would give Sri Lankan entrepreneurs more
international access to foreign markets, on one hand, and compel
the Central Bank to maintain price as well as exchange rate
stability, on the other.

The reform programmes relating to fiscal consolidation are as

follows:
Fiscal consolidation

First, the Government had promised to lower the budget deficit

bringing it to a level of 3.5% of GDP by 2020. This would in turn
check on the growth of public debt, improve investor confidence
and with reduced Government borrowings, make available a
larger volume of credit funds to the private sector.
Increase revenue

Second, a higher level of Government revenue has been targeted.

For this purpose, tax system would be simplified, on one hand,
and the tax net would be broadened, on the other. It would in turn
improve transparency and equity in taxation. Transparency is
ensured, because in a simplified tax system, every citizen would
know what and how he would be paying as taxes. Equity is
ensured, because since everyone liable for paying taxes is now in
the net and therefore, tax burdens are not imposed on a selected
number of people.

With increased revenue, the Government would be able to

allocate more funds for productive infrastructure developments
and spend more on education, research and development and
healthcare services, commonly known as human capital
development.
Improve fiscal management

Third, public financial management would be strengthened in

order to keep expenditures on target and eliminate waste of
funds. Such an improved financial management by the
Government would make budgets transparent by allowing more
data on the budgets to be released to the public domain. It would
also help the Government to report on the revenues that have
been lost due to tax exemptions and tax holidays and analyse the
risks arising from state owned enterprises and fiscal operations by
provincial councils, local governments and statutory boards.
Reform State-Owned Enterprises

Fourth, a pledge has been given by the Government to reform

State-Owned Enterprises so that the loss-making ones will not be
a burden to the taxpayers, while others will contribute more to
the Government coffers. Financial independence would be given
to state owned enterprises but they would be required to function
under well defined financial rules so that they would be
accountable for their actions. Such autonomy will help them to
improve their commercial viability.
Making monetary policy more effective through inflation
targeting

In the case of the monetary policy reforms, the Government will

allow the Central Bank to keep inflation low, which is a must for
ensuring long term investments and prevent pressure for the
exchange rate to depreciate. The Central Bank would change from
the present system of monetary policy under which it targets to
control money supply to keep inflation down to a system where it
would target the inflation directly.

In the present monetary policy management, the Central Bank is

seeking to influence the ultimate target of establishing an
inflation free world and through that, a stable nominal income, by
controlling some intermediate targets like base money, credit
levels and money supply. The empirical evidence shows that this
system is far from satisfactory in attaining an inflation free world.

Hence, in an inflation targeting system, the Central Bank would

announce an inflation target at the beginning of the year, come to
an agreement with the Government to maintain that target and
stick to it by adopting appropriate interest rate and credit policies.

In these reforms, the Central Bank would allow the exchange rate
to be more flexible in terms of the market requirements. For
instance, if the countrys competitiveness has been eroded by
higher inflation in the domestic economy than in trading-partner
countries, the Central Bank would allow the exchange rate to
depreciate in the market till the countrys real exchange rates are
stable.
Taxing imports at high rates

With regard to market access reforms, the Government has

pledged to support the maintenance of a facilitating trade and
investment environment. These reforms include reducing import
duties that have been introduced to give unnecessary protection
to domestic industries, expand export opportunities, improve
competitiveness and ensure integration to the global markets,
specifically integration to global supply chains.

In the case of Sri Lanka, the average import duties are at a very
low level at 4-5%. But, due to a number of cascading taxes like
VAT, Excise Duties, Port and Airport Levy, Nation Building Tax and
so on imposed on imports, the average taxes on imports amount
to about a fourth of the total imports of the country, thereby
making them the largest contributors to the Government coffers.
This has made import duties an iniquitous form of taxation. The
Government had pledged to abolish these multilevel taxes. But it
would reduce the Government revenue and negate the presently
boasted claims that the Ministry of Finance has improved its
revenue base.

But these high taxes on imports have generated an unintended

side benefit too. That is, contrary to the popular belief that rupee
depreciation would increase the Governments foreign debt
repayment liabilities, at the present level of Governments foreign
debt repayments which stand at about $ 3.0 billion per annum,
the Government emerges as a net gainer in rupee depreciation.
For instance, the depreciation of the exchange rate by one rupee
will bring an additional amount of revenue of Rs. 4.5 billion to the
Government; but its debt repayment obligations increase only by
Rs. 3 billion.

However, this is a gain only at the moment. However, the

Government would become a loser when the debt repayment
obligations would rise significantly in the future on the basis of
the current high external sector borrowings by the Government.
Take the patient out of ICU through an effective reform
program

What has been revealed in the second review is that except some
marginal improvements in Government revenues, all other reform
programmes are yet to be started. This is not a good sign for Sri
Lankas economy. The postponement of reforms will make the life
of those in power comfortable today; but it would transfer the sick
and hospitalised economy of Sri Lanka to the intensive care unit
or ICU. Sri Lankas economy had been transferred to ICU from
time to time in the past and on all those occasions, outside
agencies like IMF were brought in to help the country to take the
patient out of ICU.

The treatments prescribed are bitter and cannot be sold to the

electorate easily. Hence, midway through, the reform programs
are abandoned and political leaders emerge as heroes who do not
yield to the pressures coming from international lenders. Some of
the senior Cabinet ministers have already begun to play this
heros role.

What they have forgotten is that reform programs are their own
and they are needed for the economy to move along a
sustainable growth path. This truth is also kept away from the
public making them vulnerable to disinformation being spread by
other interest groups.

Hence, the chronic sickness of the economy becomes acute day

by day threatening the life of the patient. But Sri Lankans and
their political leaders continue to go on taking pride in small gains
they make from time to time. At the same time, what they do not
notice is that the rest of the world is moving forward in leaps and
bounds leaving Sri Lanka far behind.

Hence, the choice before the Sri Lankas political leadership today
is crucial for the future of the country. They should introduce the
needed reform programs of their own, as was done by Britains
David Cameron administration in 2010, instead of waiting for an
outside lending agency like IMF to point it out to them. Reforms
should be undertaken in its true spirit and not as a duty. In the
past, Sri Lanka was successful in window-dressing its attainments
and winning tranches. But, the countrys leadership should realise
that this strategy would not help them to come out of the present
economic crisis.
(W.A. Wijewardena, a former Deputy Governor of the
Central Bank of Sri Lanka, can be reached at
waw1949@gmail.com.)
Posted by Thavam