SL’s economic recovery will hinge on unwavering commitment to reforms: CB says

The expected near term recovery of Sri Lanka’s economy is fraught with many challenges due to the unprecedented scale of the crisis that the economy is facing and uncertainties on several fronts which may require swift policy actions as circumstances evolve, the Central Bank said this week.

It said the economy is set to recover in the latter part of 2023 given the progress go far in the IMF bailout programme and debt restructuring negotiations. This is also in addition to the reforms that have already been undertaken and those that are to be implemented in the period ahead.

However, in the report titled “Recent Economic Developments: Highlights of 2022 and Prospects for 2023”, the banking regulator said that these developments would hinge on policymakers’ unwavering commitment to implementing policy reforms in a timely, holistic, and efficacious manner while ensuring that such commitment remains unhampered by political and election cycles.

“This is imperative to prevent any oscillations of national policies in the crucial period ahead in order to strengthen the economy’s resilience to external shocks, thereby ensuring its unwavering progress over the medium term,” it said.

The report said:

The Sri Lankan economy, which faced extreme headwinds and heightened uncertainties during the first half of 2022, has shown signs of stability in the second half of the year thus far, helped by the myriad of multifaceted policy interventions undertaken to steer the economy to transition towards a path of stable and sustainable growth over the medium term. Although the economy was on a recovery path subsequent to the abating of the COVID-19 pandemic, its progress was muted by the culmination of the entrenched twin deficits in the government budget and external current account.

Hence, the growth momentum observed towards the end of 2021 dissipated rapidly and the real economy fell into a contraction during the first half of 2022, driven by the spillover effects of the unprecedented economic crisis felt across several sectors, owing to fuel shortages, power outages, widespread scarcity of key imported raw materials and other essentials, and the soaring cost of production, among other factors. The steady rise in inflation to historically high levels since the beginning of the year has hollowed out household purchasing power.

This anomalous rise in inflation stemmed from domestic and global supply side disruptions, the undertaking of long overdue adjustments in administrative prices, the sharp depreciation of the Sri Lanka rupee against the USD, and the release of pent-up demand pressures emanating from the lagged impact of monetary accommodation in the recent past.

Moreover, the expansionary fiscal policy with the low tax regime introduced in late 2019 fuelled inflation, not only by directly enhancing aggregate demand but also by necessitating monetary financing to bridge the expanding budget deficit amidst the lack of access to international capital markets following the rating downgrades. The monetary tightening efforts, which commenced in August 2021, accelerated thus far in 2022 to avoid possible de-anchoring of inflationary expectations and arrest lingering demand driven pressures.

During the year, servicing of external debt became increasingly challenging, given the lack of access to international markets due to consecutive sovereign downgrades and the bunching of large foreign debt service payments amidst lacklustre foreign exchange inflows.

The Government also opted to seek financial assistance from the IMF by way of an EFF arrangement. However, the overstretched fiscal position, which is already weighed down by soaring levels of debt, offered little fiscal leeway to undertake measures that could catalyse the economic recovery process. The external sector also continued to grapple with heightened challenges amidst the dearth of liquidity in the domestic foreign exchange market.

Tourism earnings recorded some turnaround, while workers’ remittances remained subdued despite recording some revival in recent months.

The engagement with the IMF on a macroeconomic adjustment programme progressed on many fronts, with a staff level agreement for an EFF being reached in early September 2022. The debt restructuring process has also reached an advanced stage.

The IMF-EFF programme will provide an opportunity to embark on much needed and long neglected structural adjustments in a more structured and timely manner, which will be instrumental in shaping the economy to progress on a trajectory of greater stability and sustained growth.

In the midst of significant economic challenges on the domestic front, the economy will also have to grapple with global uncertainties emanating from monetary policy tightening measures adopted by major central banks in response to surging inflation, the spillover effects of geopolitical tensions and thereby a looming global recession, which will make the external environment less conducive for economic recovery.