Outlook positive for Sri Lanka's economy with further support from the IMF

By the time Sri Lanka reaches the end date of Vision 2025, its current mid-term development plan, it will have been nearly half a century since the country first embraced the ideas of market liberalisation in 1977. Sri Lanka is therefore now in a position to take the long view on liberalisation, having been one of the first post-colonial Asian countries to embark in this direction. However, the road to freeing the market has not always been easy, with advocates of a more protectionist, state-orientated stance still a powerful force in the nation. Nonetheless, the current government is strongly committed to widening the space taken by the private sector, boosting competitiveness within the international trading system and encouraging foreign investment.

IMF Facility

A recent supporting factor in this has been the three-year extended fund facility with the IMF, which – although suspended during the late 2018 political crisis and due to end in 2019 – was under new negotiations regarding a possible renewal at the beginning of the year. A raft of reforms undertaken by the government have been supported by the programme, which aims not only to control expenditure and boost revenue, but also to change the way government departments and state-owned enterprises (SOEs) function, involving measures such as the monitoring of spending through new IT systems and the boosting of transparency in contract bidding.

With the presidential and parliamentary elections scheduled for 2019 and 2020, respectively, managing the implementation of this programme well has become politically and economically crucial, as in the shorter term the strains of these changes may take a toll on many ordinary citizens.

Reform Goals

The IMF programme, which began in 2016, focused on a number of key reforms: advancing fiscal consolidation through building stronger supervisory and regulatory institutions, strengthening SOE governance and reducing their associated risks, modernising the monetary and exchange rate frameworks, and accelerating structural reforms.

These are in keeping with Vision 2025, which also identifies constraints on growth within the aforementioned areas. The development strategy highlights persistent fiscal deficits, uncompetitive exchange rates, declining government revenue collection, poor quality service delivery by many SOEs and major regulatory barriers created by dated land and labour laws. Meanwhile, trade is hampered by rigid and complex border taxation rules and inadequate infrastructure. Tackling these challenges is a daunting task, yet recent months have seen some important steps taken towards removing these constraints – despite slowing global growth, weather-related shocks and political uncertainty.

Spending & Taxes

On the fiscal policy side, consolidation has been under way, with the government able to report a small surplus in the primary balance in 2017, and the 2018 budget targeting a primary surplus of approximately 1% (see overview).

Revenue collection was first enhanced by the implementation of a value-added tax (VAT) rise, and then by the new Inland Revenue Act (IRA), which came into effect in April 2018, simplifying existing tax rules. Importantly, the implementation of the new, risk-based VAT administration involved the development of a new Revenue Administration Management Information System, rolled out for the IRA. Introduced with the assistance of the government of Singapore, the system helps eliminate irregularities and corruption in tax collection and management.

A similar breakthrough has been the introduction of a new public financial management IT system. Under this, government ministries have started to implement quarterly expenditure commitment ceilings, with a complete implementation targeted for September 2019. One cause of delay is the need to upgrade the existing IT infrastructure in these ministries, along with the training of staff used to facilitate cash-based expenditure models.

Further regulatory reform with a fiscal policy impact includes the Active Liability Management Act No. 8 of 2018, which the Central Bank of Sri Lanka (CBSL) is also pushing for in 2019. This gives the state the right to borrow sums up to LKR310bn ($2bn) for a range of purposes specified in the act, but with the overall aim of enabling a more proactive approach to re-financing public debt. Furthermore, a resolution was passed in early 2019 to raise LKR360bn ($2.3bn) for liability management purposes. The CBSL also announced intentions to reinforce its Medium-Term Debt Management Strategy to contain the exposure of the country to foreign exchange denominated loans in the year ahead. In terms of controlling government expenditure, a new cost-reflective fuel pricing formula was approved by the government in May 2018, to try and tackle the mounting losses incurred by subsidising fuel prices at the petrol pump.

Depreciation of the Sri Lankan rupee and rising oil prices meant that the cost of energy imports had risen significantly, up 28% year-on-year in January 2018 alone – notable because the country does not have any commercial domestic hydrocarbons resources. The formula should see fuel prices reflect market rates, with ad-hoc revisions. The IMF called for the introduction of a similar mechanism for electricity, which is subsidised for households and small businesses. This issue will likely see renewed demand, if the extended fund facility is resumed in 2019.

State Enterprises

One of the biggest challenges, however, remains reform of the SOEs, which dominate certain sectors, including banking, and fuel and electricity. There is no competitive neutrality scheme for SOEs in place, which distorts the playing field on some products and services when competing with private companies. Moreover, state institutions have been known to incur heavy losses. According to the IMF, SOE financial obligations amounted to approximately 11% of GDP in 2017.

One particular target for reform identified in the IMF programme is SriLankan Airlines. Media reports estimated the national carrier to be carrying outstanding loans and accumulated losses of $2bn as of early 2019, stemming from the previous administration’s severing of a management agreement with the Dubai-based Emirates back in 2008. Restructuring is thus a priority, with a panel convened by President Maithripala Sirisena concluding in January 2019 that the way forward was to find a foreign investor, rather than liquidation of the carrier. This is also likely to be the object of further discussion with the IMF, should its programme be restored, as previous attempts to find such a partner have so far proved fruitless.

The government and IMF reform programmes also stress the need for better governance at the SOEs. In a step forward, five of these entities released statements of corporate intent for the first time in 2017. Further moves to increase transparency are likely to be made in 2019, although progress has been slow.

Monetary Stability

On the monetary policy side, a move towards inflation targeting is under way, requiring upgrades to the legislative and regulatory framework of the CBSL. These changes have been drafted and are likely to be put to Parliament in 2019. The CBSL announced in January 2018 that it would be adopting a flexible inflation targeting (FIT) regime in 2020. Under FIT, the CBSL will periodically announce an inflation goal, then adjust rates accordingly.

In addition, the government passed a new Foreign Exchange Act, which took effect in November 2017. It modernised the existing framework passed in 1953, removing the criminalisation of deeds in violation of the act, with new rules on transactions made outside Sri Lanka, the opening and maintenance of foreign exchange accounts and other matters. The CBSL is working to bolster its foreign currency reserves, while operating a flexible exchange rate policy; although the upcoming loan repayment schedule has made a significant impact on this (see overview).

Year Ahead

Sri Lanka’s authorities are expecting the arrival in Colombo of an IMF delegation scheduled for February 2019, which will assess the government’s progress and decide whether to resume the postponed programme, although there was no update as of mid-February. Meanwhile, The political crisis in 2018 – which saw the final two instalments of the IMF facility suspended – is now over, yet the year ahead still poses some political risks. The fiscal tightening the programme requires has undoubtedly hit some hard, and was put forward as one reason that opposition candidates performed better than expected in the February 2018 local elections. With presidential elections mandated to take place in the short term, along with provincial council ballots, the urge to loosen policy may lead to the pace of reform slowing. Nonetheless, the overall objectives remain in view, with further economic liberalisation a major long-term goal of many politicians, firms and citizens.