A delayed response by the Sri Lankan authorities to fiscal indiscipline and risky commercial borrowing led to unsustainable levels of public debt and allowed the crisis to spread to all key sectors of the economy. A slow debt restructuring process, limited external financing support, and the scarring effects of the economic contraction could prolong the country’s current financial crisis.
According to the World Bank Sri Lanka Development Update a restrictive trade regime, weak investment climate, episodes of loose monetary policy and an administered exchange rate had contributed to external imbalances. ‘This fiscal indiscipline, driven primarily by low revenue collections, had led to high fiscal deficits and large gross financing needs’, states the Bank. ‘Combined with these pre-existing fiscal imbalances, the tax cuts in 2019 contributed to a rapid growth in debt to unsustainable levels. The situation worsened after credit rating downgrades which led to Sri Lanka losing access to international financial markets in 2020’, it said.
The International Monetary Fund and Sri Lankan authorities reached a staff-level agreement in September this year for a bailout of US$2.9 billion. For this 48 month extended Fund Facility to come to fruition, financing assurances from official creditors to restore debt sustainability and making a good faith effort to reach a collaborative agreement with private creditors will be crucial.
The Update reveals the economy was already showing signs of weakness before the COVID-19 pandemic. Former President Gotabaya Rajapaksa often pinned the economic downturn which gained momentum during his tenure, to the pandemic.
The World Bank says there is significant uncertainty with Sri Lanka’s outlook because of the fluid political situation and heightened fiscal, external, and financial sector imbalances. It predicts a significant economic contraction in 2022 and 2023 with economic recovery thereafter depending on progress with fiscal consolidation, debt restructuring, and growth enhancing structural reforms.
‘The fiscal deficit is expected to gradually fall over the medium-term due to consolidation efforts and the current account deficit is expected to decline due to import compression. Nevertheless, additional resources will be needed in 2023 and beyond to close the external financing gap’.
The World Bank’s recommendation for Sri Lanka to emerge from the current economic crisis and improve long-term growth prospects is to enhance fiscal and debt sustainability and implement growth enhancing structural reforms. ‘These measures need to be accompanied by tighter and more consistent monetary policy to contain inflationary pressures. The financial sector needs to be carefully managed, given heightened exposure to government and State-Owned Enterprises (SOEs) debt. A gradual restoration of a marketdetermined and flexible exchange rate is required to facilitate external adjustments and rebuild international reserves’.
Despite tightened monetary policy, inflation is likely to stay elevated. Mitigating the impacts on the poor and vulnerable will remain critical during the adjustment period.
The international episodes of other countries with similar experiences suggest that unless root causes are addressed and the political leadership has firm resolve, these crises will tend to reoccur.
SL WORLD BANK UPDATE – OCT 2022u