Frontier Research’s review of Sri Lanka’s IMF Article 4 consultation post-announcement

By Frontier Research 

Executive Board’s discussion of the staff report on the Article IV consultations with Sri Lanka in December. The report itself is not public yet, but the press release provides a summary of the IMF’s assessment of Sri Lanka and what they would expect as part of a program.

Overall, this is within our expectations of what the IMF would expect, calling for significant changes in fiscal policy, a float of the rupee and hikes in interest rates. We have summarised the main points to address top-of-mind questions about it.

Q: Does the IMF think Sri Lanka’s public debt is unsustainable?

Yes, the IMF does state that Sri Lanka’s public debt has “risen to unsustainable levels” and that a “credible and coherent strategy” is required to restore macroeconomic stability and debt sustainability.

They expect central Government debt to have risen from 101.2% of GDP in 2020 to 107.2% in 2021 and further to 108.6% in 2022. Public debt (including public guaranteed debt and central bank liabilities) is expected to have risen from 110% in 2020 to 118.9% in 2021 and 119.9% in 2022.

The IMF staff projects that given the current policies, including a continuation of the Dec. 2019 tax cuts, the fiscal deficit will remain large during 2022-2026, raising public debt further over this period even beyond the already high 2022 level.

This indicates to us that negotiations for an IMF program will require Sri Lanka to pursue debt restructuring successfully with its creditors first, before the IMF can finalise a program and disburse assistance.

Q: What is the worst-case situation the IMF foresees?

 A dire situation is foreseen, with failure to meet external financing needs leading to significant contraction in imports and private credit growth unless fiscal and balance of payments financing needs are met, alongside possible monetary instability (read very high inflation and loss of trust in the rupee) if further central bank financing of the fiscal deficit continues.

Q:  What reforms are suggested?

 Exchange rate: The IMF highlighted that the official exchange rate has been effectively pegged to the dollar since April 2021 and that the debt servicing and current account deficit is driving FX shortage. This shortage is projected to dent GDP growth. 

Therefore, they recommend “a gradual return to a market-determined and flexible exchange rate to facilitate external adjustment and rebuild international reserves”. But this is based on their assumption of $ 2.2 billion in reserves by end-2022. 

Given the very low usable reserves at present, we think there is little room for an orderly and gradual LKR adjustment, so the official exchange rate has to be floated or at least significantly devalued ahead of an IMF program.

Monetary policy: Tighter policy is recommended to combat inflation, while phasing out the central bank’s direct financing of the fiscal deficit. This is similar to what we have seen with other countries like Pakistan, where significant rate hikes have been needed alongside amendments to central bank laws limiting deficit financing.

Fiscal: “Ambitious fiscal consolidation” is needed. To be driven by revenue measures including higher income tax and VAT rates, minimising tax exemptions and revenue administration reforms – essentially a return to the pre-Dec. 2019 status quo. 

But these should be complemented by expenditure rationalisation (read possible limits to expenditure increases) and a revamping of the fiscal rules (strict implementation of deficit targets). SOE reforms and adoption of proper energy pricing are also recommended.

Others: Critical ones are phasing out of import restrictions and gradual unwinding of capital flow restrictions.

Q: What do we make of these reforms?

 The immediate reforms that will need to be acted on even before an IMF program are the monetary tightening and adjustment of the exchange rate. We think the Government would also need to show some commitment to starting negotiations for a debt restructure ahead of a formal program. 

The Government might also need to present an interim budget with initial actions towards fiscal consolidation as part of IMF negotiations ahead of finalising a program and debt restructuring. The other reforms will take time and be part of the IMF program benchmarks, spread out over a period of time.

Overall, it is clear that the Article IV consultation report sets out the outline for negotiations on an IMF program and potential pre-conditions to be met by the Government before a program is finalised, including debt restructuring. With this, the IMF has set the platform for the Government to make a decision and act.