SL’s path to debt sustainability remains knife-edged: IMF

• Following successful conclusion of 2nd review and Article 4 consultation, releases third tranche of $ 336 m more bringing total to $ 1 b under $ 3 b four-year EFF program
• Says performance under the program has been strong but economy is still vulnerable
• Insists sustaining the reform momentum and efforts to restructure debt are critical

The International Monetary Fund (IMF) on Wednesday said Sri Lanka’s economy is still vulnerable and the path to debt sustainability remains knife-edged hence the country need to sustain the reform momentum. 

It made this observation following the successful conclusion of the second review under the $ 3 billion Extended Fund Facility (EFF) program with Sri Lanka. This saw the release of SDR 254 million or $ 336 million to support Sri Lanka’s economic policies and reforms. This brings the total IMF financial support disbursed so far to SDR 762 million (about $ 1 billion). IMF’s Executive Board also concluded the 2024 Article IV Consultation with Sri Lanka.

“Performance under the program has been strong. All quantitative targets for end-December 2023 were met, except the indicative target on social spending. Most structural benchmarks due by end-April were either met or implemented with delay. Nevertheless, the economy is still vulnerable and the path to debt sustainability remains knife-edged. 

Sustaining the reform momentum and efforts to restructure debt are critical to put the economy on a path towards lasting recovery and debt sustainability,” said the IMF.

The EFF-supported program aims to restore Sri Lanka’s macroeconomic stability and debt sustainability, mitigate the economic impact on the poor and vulnerable, rebuild external buffers, safeguard financial sector stability, and strengthen governance and growth potential. The Article IV Consultation focused on wide-ranging reforms to restore macroeconomic stability and debt sustainability, maintain price stability, safeguard financial stability, rebuild external buffers, and implement growth-oriented structural reforms, including by strengthening governance.

IMF said signs of economic recovery are emerging. Real GDP expanded by 3% (y-o-y) in the second half of 2023. May 2024 inflation was 0.9% and gross international reserves increased to $ 5.5 billion by end-April 2024. The primary balance improved to a surplus with tax revenue increasing to 9.8% of GDP in 2023. Despite improvements in non‑performing loans, pockets of vulnerabilities remain in the banking sector.

The recovery remains gradual, and the medium-term growth potential hinges on appropriate policy settings. Growth is projected to recover moderately in 2024-25 given constrained bank credit and fiscal consolidation, while facing uncertainties around the debt restructuring and policy direction following the elections. Inflation is expected to temporarily increase due to one-off factors. The current account is expected to remain positive in 2024, driven by improved tourist arrivals and remittances. Domestic risks could arise from waning reform momentum, especially on revenue mobilisation. External risks are associated with intensified regional conflicts, commodity price volatility, and a global slowdown. Slow progress in debt restructuring could widen financing gaps.

Following the Executive Board’s discussion, IMF Deputy Managing Director and Acting Chair Kenji Okamura issued the following statement:

Sri Lanka’s performance under its Fund-supported program remains strong. All quantitative targets were met, except for the marginal shortfall of indicative target on social spending. Most structural benchmarks were either met or implemented with delay. Reforms and policy adjustment are bearing fruit. The economy is starting to recover, inflation remains low, revenue collection is improving, and reserves continue to accumulate. Despite these positive developments, the economy is still vulnerable and the path to debt sustainability remains knife-edged. Important vulnerabilities associated with the ongoing debt restructuring, revenue mobilisation, reserve accumulation, and banks’ ability to support the recovery continue to cloud the outlook. Strong reform efforts, adequate safeguards, and contingency planning help mitigate these risks.

To restore fiscal sustainability, sustained revenue mobilisation efforts, promptly finalising the debt restructuring in line with program targets, and protecting social and capital spending remain critical. Advancing public financial management will help enhance fiscal discipline, and strengthening the debt management framework is also needed.

Monetary policy should continue prioritising price stability, supported by a sustained commitment to refrain from monetary financing and safeguard central bank independence. Continued exchange rate flexibility and gradually phasing out the balance of payments measures remain critical to rebuild external buffers and facilitate external rebalancing.

Restoring bank capital adequacy and strengthening governance and oversight of state-owned banks are top priorities to revive credit growth and support economic recovery.

The authorities need to press ahead with their efforts to address structural challenges to unlock long-term potential. Key priorities include steadfast implementation of the governance reforms; further trade liberalisation to promote exports and foreign direct investment; labour reforms to upgrade skills and increase female labour force participation; and state-owned enterprise reforms to improve efficiency and fiscal transparency, contain fiscal risks, and promote a level playing field for the private sector.

Executive Directors commended the authorities’ strong performance under the Fund‑supported program, noting that reforms are bearing fruit. The economy has started to recover, inflation remains low, revenue collection is improving, and reserves continue to accumulate. Directors underscored, however, that important vulnerabilities and uncertainties remain, including with respect to the ongoing debt restructuring and the upcoming elections. Against this backdrop, they called on the authorities to continue strengthening macroeconomic policies to restore economic stability and debt sustainability and to sustain the reform momentum to promote long‑term inclusive growth.

Directors underscored that restoring fiscal sustainability requires additional revenue measures underpinning the 2025 Budget, further tax administration reforms, as well as limiting tax exemptions and making them more transparent. They called for protecting growth‑enhancing and social spending, and for improving the social safety net. Directors welcomed the submission of the new Public Financial Management bill to Parliament, which would strengthen fiscal discipline and establish a solid fiscal framework. They noted that further efforts to strengthen the debt management framework are also needed. Directors welcomed the progress on achieving cost‑recovery in energy pricing, noting its criticality for containing risks from state‑owned enterprises (SOEs).

Directors welcomed the progress made to advance debt restructuring to restore Sri Lanka’s debt sustainability. They called for a swift finalisation of the Memorandum of Understanding with the Official Creditor Committee and final agreements with the Export‑Import Bank of China. Directors stressed the importance of seeking comparable, transparent, and timely completion of restructurings with external private creditors consistent with program targets.

Directors emphasised that maintaining price stability remains the top priority for monetary policy, which requires anchoring inflation expectations, continuing to refrain from monetary financing, and the gradual unwinding of government security holdings as markets allow. They also stressed the importance of strengthening Central Bank independence. Directors underscored the need to continue building external buffers, while maintaining exchange rate flexibility to facilitate external rebalancing and preserve the credibility of the inflation targeting regime. They called for gradually phasing out the balance of payments measures.

Directors underscored the need to strengthen financial sector resilience to support the recovery. They called for swift completion of the restructuring of remaining domestic law, foreign currency loans and for adequate recapitalisation of commercial and state‑owned banks. Directors welcomed the enactment of the Banking Act amendments and emphasised the importance of their effective implementation to enhance supervision and the governance of State‑owned banks. They also called for further efforts to strengthen the anti‑money laundering and counter‑terrorism financing framework.

Directors stressed that pressing ahead with governance and structural reforms, supported by development partners and IMF capacity development, is crucial to unlock growth potential. They welcomed the publication of the authorities’ action plan on the key governance reforms recommended in the Governance Diagnostic Report and called for its steadfast implementation. Directors also recommended prioritising reforms to further liberalise trade, improve the investment climate and SOE efficiency, reduce gender gaps in the labour market, and mitigate climate vulnerabilities.