Recent IMF deal aims to realise Sri Lanka's economic potential through benchmarks and reforms

Sri Lanka’s deal with the IMF agreed upon in June 2016 could help the country open a new chapter of wide-ranging economic reform. While noting the country’s economic weaknesses that have been brought into focus in recent years, the fund also looked favourably upon Sri Lanka’s competitive advantages. From them, the country can stands to benefit in the longer term if it addresses structural shortcomings. Strengths include its human capital, infrastructure, strategic location and the benefits of investments in recent years – particularly in ports and transport networks.

Implementation of the tough measures laid out in the deal has proved challenging, but progress is being made as both parties appear committed to pushing ahead through 2017, with potentially significant benefits to the economy and investors.

Key Deal

On June 3 2016 the IMF’s executive board approved a 36-month extended fund facility with Sri Lanka, worth about $1.5bn. The deal aims to help the country meet its balance of payments requirements that emerged from external lenders, and ease pressures resulting from necessary macroeconomic readjustment. The IMF immediately released funds worth $168.1m on the inking of the arrangement, with the remainder of funds to be released in six tranches conditional on the findings of quarterly reviews of progress.

At the time of the deal, the IMF said that the funds would help Sri Lanka during this period of a difficult external environment, and provide the government with a window to push forward challenging structural reforms and fiscal consolidation to improve the economy’s performance and resilience in the longer term.

Reform Goals

The IMF programme outlines six pillars of reform that is necessary for Sri Lanka to meet its commitments and move closer to fulfilling its tremendous economic potential. These overlapping areas are: fiscal consolidation, revenue mobilisation (that is, enhancing the government’s income collection), public financial management reform, reform of state-owned entities (SOEs), a transition by the Central Bank of Sri Lanka (CBSL) to flexible inflation targeting and a flexible exchange rate regime, and reforms to trade and investment rules.

Upon confirmation of the agreement, Min Zhu, deputy managing director and acting chair of the IMF, highlighted the priorities of the programme, including reducing the fiscal deficit to 3.5% of GDP by 2020 through comprehensive tax reform, better control and oversight of government expenditure, and shifting SOEs to a more commercially-oriented operational basis. The fund also emphasised the importance of a “greater role for market forces” in the economy, and a more “outward orientation” in a market mindset that still bears the heavy legacy of decades of socialist-inspired efforts at self-sufficiency.

The fund sees the CBSL’s shift towards exchange rate flexibility as central to the process, and is supportive of boosting foreign exchange reserves as well as allowing the bank to focus on price stability – which is seen by the IMF as the main role of central banks. The IMF also focused on the need for “comprehensive trade reform” and “improvements in the investment environment” to help Sri Lanka lift and sustain its growth in the medium term and reduce further risks to its fiscal position.

Concrete Targets

With the overarching goals in mind, the IMF has set concrete targets for Sri Lanka. One such target is the deficit-to-GDP ratio and either further reducing or sustaining the 3.5% level over the medium term to ensure a continued reduction in the debt-to-GDP ratio – standing at 76% in 2015 – which should drop to 68% by 2020. To support this, the fund suggests an increase in the tax-to-GDP ratio from 10.1% to 15%. Regarding the country’s vulnerable foreign exchange reserves, the programme suggests increasing the central bank’s stock to the equivalent of five months of imports in the medium term.

Context

The IMF deal should be assessed in the context of Sri Lanka’s broader economic performance as well as with the ambitions of its new reformist government. While GDP growth was a respectable 4.8% in 2015, the construction sector contracted and manufacturing growth slowed as both public and private investment softened and world trade growth fell back.

Meanwhile, the fiscal deficit widened to a concerning 6.9% in 2015, with a revenue increase of 1.5% largely influenced by one-off measures and a rise in tax collections from a short-term spike in vehicle imports offset by a 2.1% increase in expenditure. Government outlay was pushed up by wage increases, rising interest payments, higher spending on goods and services, and the growth of income transfer schemes.

Sri Lanka’s vulnerabilities were also highlighted by a drop in the overall balance of payments, although the 2015 account deficit remained at 2.5%, the same level as 2014. Capital flows had a major impact on the balance of payments decline, with foreign investors exiting government securities, foreign direct investment falling, and externally-financed public and private projects being implemented slowly. The uncertain international environment and investor concern over domestic politics in a double election year had a significant bearing on these factors. They in turn exerted downward pressure on the Sri Lankan rupee, and caused volatility in the government bond markets.

Progress

In December 2016, following a review of Sri Lanka’s economic performance under the programme, the IMF agreed to release the second tranche of its funding package, totalling around $162.6m. The fund described the country’s progress as “broadly satisfactory”, highlighting greater macroeconomic and financial stability, improvements in the balance of payments, and an “encouraging” fiscal performance including the proposed 2017 budget, which would align government revenue and spending on a quarterly basis.

The IMF staff noted positive signs including an overall budget deficit of 2.7% in the first half of 2016, slightly below the maximum set by the programme, with tax revenue up a strong 20% in the first eight months of the year, though expenditure was marginally higher than expected, partly thanks to capital expenditure and higher-than-expected interest payments.

Tougher Talks

The release of the third tranche of funds is expected in June 2017, following tough talks with the IMF. While the tranche was set to be released in April, technical issues led to talks being prolonged. Ravi Karunanayake, then-minister of finance and current minister of foreign affairs, told local media that discussions included reforms to the Inland Revenue Act, and that the government was determined to ensure that citizens were not adversely affected by the programme. The fact that Sri Lanka fell short of targets for net foreign reserves in a March 2017 IMF review was another important point. The review noted progress towards an agreement on the release of the third funding tranche, but also highlighted ongoing challenges.

The economy maintained its strength in the second half of 2016, lifting full-year growth to 4.4%, though inflation also picked up to an annual average 4% due to a value-added tax increase and the supply-shock impact of drought on agriculture. The fund warned that prolonged drought could put further upward pressure on prices, as well as trim growth and affect the improvement of balance of payments.

The review noted that while efforts towards implementing revenue-raising measures as a basis for fiscal consolidation, as well as the introduction of statements of corporate intent for SOEs were impressive, it criticised patchy progress on implementing other reforms. The fund continues to urge the CBSL to remain vigilant in the face of rising inflation and credit growth, and suggested it continue to implement moves towards exchange rate flexibility. The IMF repeated encouragement of business environment improvements and SOE reform. With IMF funds still coming through the pipeline, in April 2017 the government started lining up a bond issue to raise up to $1.5bn from international markets. While the potential debt issue can be seen as a way to bolster funding if IMF cash is released more slowly, it is also partly due to the IMF deal in the first place, with international investors looking more favourably on Sri Lanka’s sovereign debt in the context of IMF support and ongoing fiscal tightening and reform.

Going Forward

Talks in April 2017 with the IMF and World Bank were more positive, with both bodies reaffirming their commitment to Sri Lanka’s reform programme. Karunanayake also outlined plans to strengthen the investment climate to make Sri Lanka a “gateway to Asia”, and said that the government was aiming to boost foreign reserves to $10bn by the end of 2017, from $6bn at end-2016. Much will hinge on the new Inland Revenue Act, which the government was struggling to finalise in spring 2017. Many believe the legislation will overhaul the country’s tax system, bringing it more in line with international practice. The IMF supports the act, which it hopes will broaden the tax base, minimise excess tax incentives, modernise regulation of cross-border transactions to tackle tax avoidance and reduce the current system’s complexity.