Feature - Sri Lanka’s economic malaise

By Ruchira Gunawardana

Busting the Myths 

A popular piece of criticism levelled at Sri Lanka’s current economic leadership is that ‘the IMF is not the answer’ and the reforms the incumbent administration is implementing are all wrong, ill-conceived and ill-thought-of. Such people, usually — and ironically therefore — are economists with PhD’s in various fields of Economics; yet they derive some sort of delight in ‘bashing the IMF’; vehemently preaching their doctrine that IMF reforms have never yielded positive results and Sri Lanka is blindly following a path towards imminent doom.

This disinformation campaign must stop; by setting the record straight, these allegations will be addressed and all the misinformation being sowed will be clarified. 

1. IMF and Austerity 

Some economists argue that it is not just futile but also damaging to continue the ongoing austerity measures closely intertwined with the International Monetary Fund (IMF)-Extended Fund Facility (EFF) programme. On the contrary, with or without the IMF’s assistance, austerity measures are an absolute necessity to firmly anchor inflation — and by extension — inflation expectations. Why? Because, the Sri Lankan economy has operated on a persistent inflationary gap, whereby economic injections are greater than economic leakages; and in such a scenario, the only natural response for the economy would be to increase prices in order to choke off that excess aggregate demand (AD). This basically means that inflation is needed to keep AD in check. As many are already aware, Sri Lanka was tending towards hyperinflation in 2022, with September’s figure peaking at almost 70%. To control this situation and salvage an economy from meltdown, austerity measures such as a doubling of taxes, phasing out subsidies, and cost-reflective pricing for utilities such as electricity and energy were enacted. This thereby compressed AD to more reasonable levels by putting a lid on the excessive growth in economic agents’ demand and stopping the economy from over-heating. Now, the benefits of such austerity measures can be clearly seen, with the inflation rate (CCPI) dropping to 6.3% in July — the first time the inflation rate hit single-digits after 19 months. Essentially, the inflation rate has reduced because injections are more in line with leakages, hence closing the inflationary gap; the need for further inflation to restore balance in the economy is much reduced because AD has fallen to a more reasonable, natural level — and this was thanks to the austerity measures, or else AD would have kept increasing unnaturally, thus widening the inflationary gap. Regardless of how painful or heartless this may seem, it is the economic reality; bear in mind that inflation is worse (terrible troika of uncertainty in the macro-environment, erosion of purchasing power, widening of inequalities), so austerity was the only alternative to prevent AD growing out of control and hence bring down inflation.

In any case, the adverse impact on the poor and vulnerable emanating from the fiscal reform process will be set off through welfare payments and social security programmes, for which the IMF has mandated a minimum spending floor. Sri Lanka has a long history of living beyond its means for decades, evidenced by both internal and external accounts — internally because government expenditure exceeding government revenue, and externally because import expenditure superseding export revenue. In addition, Sri Lanka has one of the lowest revenue-to-GDP ratios in the world — about 8.5% according to the most recent figures; it is apparent that a nation cannot be sustained for long with such a precarious level of government revenue. The only way Sri Lanka can bring lasting macroeconomic stability and not go to the IMF for the 18th time is by upholding balance in its internal and external accounts. It is foolish to bash the IMF, since the IMF actually advocates for removing these unsustainable macroeconomic imbalances, which is ideally what Sri Lanka must be doing, instead of running twin-deficits (budget deficit + current account deficit). As long as this continues, Sri Lanka will sooner or later find itself in yet another economic crisis and knock on the IMF’s door for the 18th time. Why did we have to go to the IMF for the 17th time? Because, we lived beyond our means, filled the financing gap with costly debt — and so failed to keep up to our commitments to the IMF. On the previous 16 occasions of IMF assistance, Sri Lanka’s economic leadership backed down on economic reforms at the earliest sign of stability, and later went on to reverse much of the progress thus made. In essence, this is a crisis of our own making and the result of severe economic mismanagement.

Argentina has bleak economic prospects, with its inflation among the world’s fastest and the only G20 economy to contract by a significant percentage this year, because it has failed to move its economy towards an equilibrium, with widespread distortions and imbalances; if Sri Lanka is to avoid becoming the IMF’s largest debtor (Argentina), it must plug the hole in its budget and current account — not through more debt, but through reforms that make the transition inclusive and sustainable.

What many of these critics forget is that the number one reason Sri Lanka is in this malaise is because of a chronic fiscal imbalance: when government expenditure is almost double that of revenue, the government resorted to taking on more debt to finance its expenditure, and the excess AD resulting from an under-taxed populace fed into imports; this led to the current unsustainable debt burden.

Sri Lanka’s expenditure is not high by international standards — at less than 20% of GDP; this meant that revenue-based fiscal consolidation was the right path to take. Of course, government spending has deep-rooted flaws because it is channelled into unproductive and wasteful things, but this cannot be corrected overnight and requires extensive analysis (the State-owned Enterprise Reform process is ongoing); it is the quality of the expenditure that matters — and governance reforms are needed to adequately address this issue.
 

2. ‘IMF-forced reforms’ and claims of an over-reliance on the IMF

Another common criticism is that Sri Lanka is being pushed into following these ‘one-size-fits-all’, ‘general’ reforms that are ‘forced’ by the IMF and that other countries such as South Korea and Vietnam had their own plans even as they continued on an IMF programme.

This critique is oblivious and ignorant to the fact that IMF policies are never general; they are specifically, carefully tailored to the needs of the country and give due consideration to the different dynamics of countries. This is evidenced by the IMF undertaking an in-depth governance diagnostic on Sri Lanka, which is the first country in Asia to undergo such an analysis — future policies of the IMF and multilateral development banks (MDBs) will be tailored specifically to take into account these differences and the political economy situation.

Also, it was Sri Lanka that reached out to the IMF in early 2022 and invited them to send a delegation to Sri Lanka and reach a deal on a program swiftly — it was never the IMF that forced its policies on Sri Lanka.

A frequent misconception that some people have about the current EFF is that it’s an ‘IMF-programme’; but in reality, it is actually an IMF-endorsed programme because the IMF Executive Board has accepted Sri Lanka’s Letter of Intent — written by Sri Lanka’s Minister of Finance and the Governor of the Central Bank of Sri Lanka to the IMF Managing Director — and it is this that forms the entire four-year EFF.

Basically, this is Sri Lanka’s comprehensive economic programme supported by the IMF and endorsed by the IMF — it is not something that the IMF conjured and forced upon the Sri Lankan authorities. Furthermore, comparing Sri Lanka to South Korea in 1997 is highly misleading, because South Korea went to the IMF as a result of a banking sector crisis that engulfed most of South East and East Asia and later spilled over into the real economy. Sri Lanka’s economic malaise is vastly different to what South Korea underwent because South Korea’s financial crisis didn’t originate from a fiscal imbalance, unlike in Sri Lanka.

Moreover, some economists argue that Sri Lanka lacks its own strategy to develop exports, support SMEs and become an internationally competitive economy. What these people fail to recognise is that Sri Lanka is currently in a crisis, and although circumstances have stabilised somewhat recently, there is still much more to go in terms of regaining complete macroeconomic stability and debt sustainability; in lieu of all these large, overwhelming issues, it would be idiotic for the government to focus just on economic growth and development because it doesn’t happen overnight — economic growth and development will follow after Sri Lanka regains macroeconomic stability and debt sustainability.

The chronic, burning problems of the economy must be addressed and sorted first. Of course, the government has already committed to the IMF that structural reforms will be implemented, and the World Bank too is focusing on improving the trade and investment climate in its latest Country Partnership Framework — so arguing that the government should do just these instead of addressing urgent issues such as fiscal reform and debt restructuring is merely fallacious and capricious.
 

3. ‘Going to the IMF was not necessary’

Unfortunately, even some economists claim that Sri Lanka seeking the IMF’s assistance was not required and that Sri Lanka doesn’t need the IMF. However, they seem to ignore the fact that Sri Lanka officially defaulted on its debt in April 2022, and when a nation defaults on its debt, it cannot just ignore it and focus on ‘increasing exports, supporting SMEs’ — it has to restructure its debt, by way of maturity extensions, interest rate reductions, and haircuts.

Now, the globally accepted route to do this is to seek assistance from the IMF, which will prepare a Debt Sustainability Analysis (DSA) that will contain the methodology and extent of debt relief required to regain debt sustainability. It is this DSA that forms the overarching point of negotiations with creditors of the defaulted country — this is the international financial architecture, and Sri Lanka must conform to this, otherwise remain ‘junk rated’ by rating agencies such as Fitch Ratings for eternity, which will obviously gravely damage Sri Lanka’s economic potential. Even if there were not a debt crisis, a Balance of Payment (BoP) crisis is there, and no right-minded international investor would invest in a country in the midst of an economic meltdown with crippling shortages, 13 hour power cuts, sky-high inflation, drastic currency depreciation, and widespread social instability.

This meant that there was no way the external financing gaps could have been closed through foreign investment. As such, it was indisputably essential to reach out to the IMF and gain its endorsement for Sri Lanka’s economic policies which would therefore instill international confidence in Sri Lanka’s economic prospects. Hence, going to the IMF and following through Sri Lanka’s IMF-endorsed policies to restore macroeconomic and debt sustainability is incontestable.