This Selected Issues paper focuses on the fiscal position of Sri Lanka. The standard analysis shows that, prior to the adjustment announced in the 2002 budget, fiscal policy was clearly unsustainable, leading to a rising debt-to-GDP ratio. The paper looks at external debt and complements the analysis of the public debt dynamics. The baseline scenario shows that debt ratios decline significantly in the medium term, as a result of strong growth founded on renewed peace and political stability, far-reaching structural reforms, and stable macroeconomic conditions.

Abstract

This Selected Issues paper focuses on the fiscal position of Sri Lanka. The standard analysis shows that, prior to the adjustment announced in the 2002 budget, fiscal policy was clearly unsustainable, leading to a rising debt-to-GDP ratio. The paper looks at external debt and complements the analysis of the public debt dynamics. The baseline scenario shows that debt ratios decline significantly in the medium term, as a result of strong growth founded on renewed peace and political stability, far-reaching structural reforms, and stable macroeconomic conditions.

II. Fiscal Sustainability1

A. Introduction

1. Despite high deficits, fiscal policy in Sri Lanka has been sustainable in the past. The budget deficit has been traditionally high in Sri Lanka, averaging 10 percent of GDP since the mid-1980s. Despite this, Sri Lanka has managed to run a sustainable fiscal policy for a number of reasons. First, growth has been robust, with real GDP increasing at an average 4½ percent a year over the past two decades. Furthermore, debt service costs were low, as Sri Lanka accessed significant quantities of concessional foreign borrowing–accounting for around half of total debt-and also engaged in financial repression, keeping domestic debt costs low. For these reasons, Sri Lanka was able to run high primary deficits.

2. The sustainability of fiscal policy has become more important in the recent past. After encouraging signs of fiscal consolidation in the early 1990s and from 1997-1999, which helped reduce the debt-GDP ratio, fiscal consolidation was significantly reversed in 2000 and 2001, raising the concern that public debt could grow rapidly over the medium term. Public debt climbed to 104 percent of GDP in 2001, while interest payments-the largest component of the budget—rose to almost 7 percent of GDP. (Figure II.1).

Figure II.1.
Figure II.1.

Government Debt and Internet Payments, 1973-2001

(In percent of GDP)

Citation: IMF Staff Country Reports 2002, 208; 10.5089/9781451823516.002.A002

3. There are good reasons to believe that, absent consolidation, fiscal policy in Sri Lanka is no longer sustainable. While primary deficits remain high, the old safety valve of higher growth and low effective real interest rates on government debt may no longer apply, owing to a number of developments.

  • Prospects for GDP growth have dimmed. GDP contracted by about 1½ percent in 2001, the first time since independence. Moreover, with no clear signs that the U.S. economy will rebound quickly, growth in 2002 is expected to be below trend. In addition, there is a risk that slow implementation of growth-enhancing structural reforms could compromise medium-term growth prospects.

  • As part of government efforts to foster a more competitive financial sector, there has been a reduction in financial repression in recent years, such that an increasing share of new government debt attracts market-determined rates.

  • With Sri Lanka now considered a lower middle-income country, the likelihood is that the share of nonconcessional aid flows will increase over the medium term, further increasing the overall interest rate on public debt.

4. One possible counter argument is that large deficits may still be sustainable over the medium term, if the government relies on nondebt financing. Since the state sector is pervasive in Sri Lanka, asset sales could help sustain a high primary deficit over a considerable period. There is some precedent for this: in 1997, asset sales accounted for 2½ percent of GDP. On the other hand, sustainability will be adversely affected over the longer term by rising contingent liabilities associated with civil service pensions.

5. The purpose of this paper is to analyze the sustainability of fiscal policy in Sri Lanka, both historically and looking forward. Using time series methods, we show that fiscal policy has been set in a sustainable fashion in the past. However, looking forward, we argue that recent fiscal policy is not sustainable, and that significant adjustment is required over the medium term. Moreover, the sustainability of fiscal policy can only be maintained if there is reasonably robust GDP growth. This makes clear the importance of rapid implementation of envisaged pro-growth structural reforms. Finally, we attempt to quantify the implicit tax arising from financial repression, and find that there has been a tendency for this tax to increase in periods of high deficits.

B. Basic Concepts and Literature Review

Tests Based on an Intertemporal Budget Constraint

6. Empirical tests of fiscal sustainability often focus on assessing whether fiscal policy has been set in a manner consistent with satisfying an intertemporal budget constraint. Chalk and Hemming (2000) give an overview of some of these tests. In this chapter we focus on using the test formulated by Bohn (1998) to evaluate fiscal sustainability. Unlike other tests, the Bohn test does not require any assumptions about interest rates, and is valid in economies with uncertainty. The Bohn test is based on estimating the following test equation:

st=ρdt+αzt+ϵt(1)

where st represents the primary surplus-GDP ratio, dt represents the debt-GDP ratio, Zt is a set of other determinants of the primary surplus (assumed to be stationary), and Єt is the error term. Bohn shows, under very general conditions, that fiscal policy is sustainable if st increases at least linearly with dt at high debt-GDP ratios. This ensures, that increases in the debt-GDP ratio are eventually reversed through primary surpluses. Thus the Bohn test is a test of whether ρ > 0 in the above test equation. However, Bohn also points out that there could be a concern that the linear relationship between st and dt in the test equation is actually an approximation to a nonlinear relation that is concave to the origin at high levels of the debt-GDP ratio. To investigate this possibility, he proposes the inclusion of a quadratic term (dtd¯)2, where d¯ is the mean value for dt, in the test equation. If the estimated second derivative of st with respect to dt is positive.

Tests Based on Sustainability Indicators

7. An alternative to testing whether the intertemporal budget constraint is satisfied is to devise indicators of how far fiscal policy has deviated from sustainability. In this case, a sustainable policy is often defined as one that does not lead to a marked increase in the debt-GDP ratio or decrease in the ratio of government net worth to GDP. Thus, Buiter (1985) calculates the permanent primary deficit required to keep the government net worth-GDP ratio constant over time, and suggests that the difference between this permanent deficit and the actual primary deficit can be used as a sustainability indicator. However, in most cases it is difficult to obtain data on government net worth. In contrast, Blanchard (1990) looks at sustainability from the point of view of policies required to keep the debt-GDP ratio stable, and derives a “primary gap indicator” based on the gap between the actual primary surplus and the sustainable primary surplus. Note that these two measures can lead to differing conclusions about sustainability. For example, an increased recourse to asset sales for financing a deficit would reduce the buildup of debt, but leave net worth unaffected.

8. For Sri Lanka we use the primary gap approach to derive the sustainable primary deficit. If the actual primary deficit exceeds this sustainable primary deficit, then the debt-GDP ratio is increasing, leading to unfavorable debt dynamics. We calculate the sustainable primary deficit each year and compare it with the actual primary deficit, which gives us a rough indicator of sustainability each year.

Previous Studies on Sri Lanka

9. Studies done for Sri Lanka have given mixed results. Carter (1995), using a sustainability indicator approach, found Sri Lankan fiscal policy to have been sustainable, primarily because of low interest rates on government debt. However, Cashin, Haque, Olekalns (1999), using time series methods, found that fiscal policy had been unsustainable.

C. Empirical Results for Sri Lanka

Sustainability Tests-Backward Looking

10. We use the Bohn test to answer the following question: historically, has Sri Lankan fiscal policy been conducted in an unsustainable fashion? Augmented Dickey-Fuller tests and Phillips-Perron tests, based on data from 1973-2001, were unable to reject the hypothesis of a unit root for both the debt-GDP and the primary surplus-GDP ratios. Thus, we conclude that they are nonstationary, and so the Bohn test becomes equivalent to a test for cointegration between the two variables. We use the Johansen cointegration test, which is the most widely used test for cointegration.

11. Test results indicate significant evidence of cointegration between the debt-GDP ratio and the primary surplus-GDP ratio. The estimated cointegrating vector (at 5 percent significance level) is given by

st=0.17dt0.17(6)

Thus, we can conclude that for Sri Lanka st responds in linear fashion to dt. Moreover, an examination of cointegration between st, dt, and (dtd¯)2 indicated that the second derivative of st with respect to dt is nonnegative2. Hence we conclude that fiscal policy appears to have been conducted in a sustainable fashion in Sri Lanka over the sample period.

Sustainability Evaluation-Forward Looking

12. Here we use the primary gap approach to evaluate whether the current fiscal position is sustainable. The methodology is to compare a baseline scenario based on no adjustment with a medium term adjustment scenario, and subject the latter to a sequence of stress tests. Figure II.2 shows the debt-GDP ratio under each scenario, while Figure II.3 looks at the difference between actual primary surplus and that required for sustainability.

Figure II.2.
Figure II.2.

Debt-GDP Ratio Under Different Scentario

Citation: IMF Staff Country Reports 2002, 208; 10.5089/9781451823516.002.A002

Figure II.3.
Figure II.3.

Fiscal Sustainability Under Different Scentarios

Citation: IMF Staff Country Reports 2002, 208; 10.5089/9781451823516.002.A002

13. Sri Lanka has some clear advantages with regard to the structure of its public debt. Although the current high debt-GDP ratio immediately suggests sustainability to be a major issue, Sri Lanka has the distinct advantage of owing around half of this debt stock to foreigners on highly concessional terms. The average nominal interest rate on foreign debt is around 2 percent. Moreover, over 64 percent of outstanding domestic debt at end-2001 was owed to public sector or publicly controlled institutions, thus moderating the risk of creditors forcing drastic changes in fiscal policy by a refusal to rollover debt. Even so, there is clear evidence that, absent serious fiscal consolidation, current fiscal policy is unsustainable.

No Adjustment Scenario

14. The no-reform scenario assumes that policies in 2001 are maintained in the medium-term (Table II.1). No fundamental tax policy or tax administration reforms are undertaken, and the revenue-GDP ratio does not increase. Likewise, the ratios of primary current spending and capital spending to GDP are maintained. In this case, the share of total expenditure in GDP rises substantially, as interest costs rise from 7 percent of GDP in 2001 to 11½ percent of GDP by 2006. Accordingly, the deficit increases to 15½ percent of GDP by 2006; as in the past, most of this is financed domestically. The increased domestic financing requirements lead to a higher average interest rate on domestic debt (13½ percent). We assume that growth rebounds only, to a relatively low medium-term rate of 3½ percent.

Table II.1.

No Adjustment Scenario

(In percent of GDP)

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Sources: Data provided by the authorities; and Fund staff projections.

15. This scenario is clearly unsustainable. The ratio of debt-to-GDP rises from 104 percent of GDP in 2001 to 127 percent of GDP by 2006, with domestic debt rising from half to two thirds of the total (Figure II.2). The primary deficit stays constant at around 4 percent of GDP, whereas, toward the end of the period, primary surpluses would be required to achieve sustainability. The gap between the actual and required primary deficit is therefore positive and increasing (Figure II.3). Other investigations (not presented) indicate that even if the authorities managed to keep the overall deficit at the 2001 level of 11 percent of GDP, it still would not be sustainable. Thus, serious consolidation is required to bring fiscal policy back to a sustainable path.

Adjustment Scenario

16. The second scenario assumes that substantial pro-growth structural reforms and strong fiscal adjustment take place from 2002, based on the announced budget (Table II.2). The government implements high quality tax policy reforms, and embarks on a major overhaul of tax administration, causing the revenue-GDP ratio to rise steadily from 16½ percent in 2001 to 20¼ percent by 2006 back to about the average revenue ratio over the past 15 years. Much of the improvement in revenue can be traced to the administrative gains arising from the establishment of a unified revenue authority in 2003, as well as a dramatic simplification of the tax system through the introduction of a broad based VAT and the phasing out of tax exemptions.

Table II.2.

Adjustment Scenario

(In percent of GDP)

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Sources: Data provided by the authorities; and Fund staff projections.

17. Adjustment also takes place on the expenditure side. Recurrent spending is compressed as both wages and transfers are kept in check, leading to the expenditure-GDP ratio falling by 3¼ percent of GDP between 2001-06. This scenario assumes civil service reform and wage increases not in excess of inflation; a review of public expenditure to weed out inefficiencies, redundancies, and overlapping responsibilities; the streamlining and improved targeting of subsidies to households; a continuation of the peace process leading to security-related expenditure declining to 3 percent of GDP in the medium-term; and a withdrawal of the state from large areas of the economy, reducing the need for subsidies to public corporations. Reflecting important infrastructure needs, but not building in the potential costs of reconstruction in the north and east, capital expenditure is assumed to rise to 7½ percent of GDP in the medium term.

18. Strong adjustment under this scenario leads to the overall deficit falling from 11 percent in 2001 to 4 percent by 2006. The primary balance switches from deficit to surplus in 2004. At the same time, net domestic financing falls from 8¼ percent of GDP in 2001 to 1¾ percent of GDP at the end of the period. The reduction in domestic financing pressure leads to interests rates on domestic debt falling to 10 percent. The structural and fiscal reform agenda puts Sri Lanka on a higher growth trajectory, with growth reaching 6½ percent by the end of the period.

19. This scenario is clearly sustainable, with a falling debt-GDP ratio (both domestic and foreign) and a large negative gap between the actual and sustainable fiscal deficits. The total debt-GDP ratio declines by nearly 20 percentage points of GDP over this period.

Stress Tests

20. The conclusion about the adjustment scenario is contingent on a number of favorable assumptions. To check robustness, we now subject this scenario to a number of stress tests, to see how the conclusions change if one of the assumptions does not hold. Key risks examined include: low growth; inability to implement revenue reform; a fall in external financing; recourse to nonconcessional foreign loans; and higher capital spending.

  • Our initial stress test assumes that growth is low, a mere 1 percent in the medium term (Table II.3). This causes the debt-GDP ratio to rise to 117 percent of GDP by 2006, instead of falling back to 84 percent of GDP. Although the tax policy and administration reforms go ahead in this scenario, the weak economy is assumed to allow revenue to increase to only I8½ percent of GDP by 2006, 1½ percentage points of GDP lower than under the baseline. With interest rates exceeding the growth rate, interest payments increase as a share of GDP; combined with weaker revenue, the deficit only falls to 9 percent of GDP by 2006. Thus, one key conclusion is that the sustainability of the reform scenario depends crucially on a return to solid growth rates in the medium term. If growth does not resume, then fiscal policy will become unsustainable, even with tax reform and expenditure adjustment.

Table II.3.

Stress Test I-Low Growth

(In percent of GDP)

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Sources: Data provided by the authorities; and Fund staff projections.
  • The second stress test assumes that Sri Lanka faces severe external financing constraints (Table II.4). Here, external financing does not materialize as envisioned, and the ratio of net external financing to GDP remains at just over 1½ percent in the medium term, the same as in 2001. This scenario also assumes that privatization is suspended and no grants are received. In this case, domestic sources finance a greater share of the deficit, leading to significantly higher interest rates on domestic debt (15 percent). No change is assumed in interest rates for foreign debt. As a result, interest costs rise dramatically to 9½ percent of GDP by 2006. Accordingly, slower overall adjustment is observed, with the deficit falling to 7¼ percent over this period. Nonetheless, this shock alone does not imperil sustainability as we have defined it; the debt-GDP ratio falls gradually over time. However, it remains at over 100 percent of GDP by 2006, suggesting sustainability hangs on a knife-edge. Also, this is a partial equilibrium analysis: a realistic scenario would be to lower growth rates in the face of such high domestic interest rates.

Table II.4.

Stress-Test II-External Financing Constraints

(In percent of GDP)

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Sources: Data provided by the authorities; and Fund staff projections.
  • Another stress test relates to higher foreign interest rates. This scenario assumes that Sri Lanka’s foreign debt becomes increasingly less concessional over time, as would be the case if Sri Lanka opted for nonconcessional foreign borrowing (Table II.5). Specifically, the average interest rate on foreign debt rises gradually in the medium term, from 2 percent in 2001 to 7 percent by 2006. As a result, instead of falling to 5¼ percent of GDP, the interest bill rises to 7¾ percent of GDP by 2006. We assume that this is accommodated in the form of slower adjustment; accordingly, the deficit now falls to only 6½ percent of GDP in the medium term. Absent any further effects from this shock, sustainability is not directly endangered. Again, this test assumes that the high growth trajectory can be maintained.

Table II.5.

Stress Test III-Increasingly Non-Concessional Foreign Debt

(In percent of GDP)

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Sources: Data provided by the authorities; and Fund staff projections.
  • A fourth stress test assumes that capital spending increases to around 9 percent in the medium term, to finance reconstruction in the north and east, and possibly to provide for the recapitalization of Peoples Bank (Table II.6). No other assumptions are changed. As a result, the deficit only declines to 5¾ percent, instead of 4 percent, by 2006. Sustainability is not endangered, although debt falls at a slower pace, reaching 89½ percent of GDP by 2006, 5 percent of GDP above the baseline.

Table II.6.

Stress Test IV-Higher Capital Spending

(In percent of GDP)

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Sources: Data provided by the authorities; and Fund staff projections.
  • Finally, we assume that there is no tax reform. While the government commits to fiscal adjustment, it does not implement any further tax policy or administration reforms. Thus, there are no efficiency gains from tax simplification, from broadening the base, or from re-organizing the agents of tax administration. All other assumptions are maintained. As in the no-reform scenario, the revenue-GDP ratio remains constant in the medium-term (Table II.7). Along with the higher trajectory of interest payments, lower revenue implies a deficit of 9¼ percent of GDP by 2006. Again, growth is assumed to be unaffected. Technically, fiscal sustainability is not endangered, although the debt-GDP ratio barely declines, and is a full 16 percentage points of GDP more than what it would have been in the presence of revenue reform.

Table II.7.

Stress Test V-No Revenue Reform

(In percent of GDP)

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Sources: Data provided by the authorities; and Fund staff projections.

D. Implicit Tax from Financial Repression

21. As has been the case with other developing countries, Sri Lanka has taken advantage of financial repression to reduce the cost of government debt. This has included issuing debt in the form of rupee loans at below market rates, and restricting pension and other social security funds to investing largely in government paper, thus creating a large pool of funds which could be tapped at lower rates.

22. A substantial, albeit declining, proportion of Sri Lanka’s domestic debt is made up of nonmarket debt instruments. By 2001, rupee securities accounted for around 36 percent of total domestic debt, down from a peak of 62 percent in 1997. Toward the end of the decade, the authorities moved toward more market based instruments, reducing their reliance on rupee securities.

23. Most of these securities are held by provident funds, chiefly the Employees’ Provident Fund (EPF).3 Investment options are heavily restricted; as a result, the portfolios of the provident funds are dominated by rupee securities, with a miniscule amount of treasury bills, and an increasing proportion of treasury bonds in recent years.4 As a result of this policy, these funds offered very low returns on their investments; the average after tax real rate of return over the past 3 decades was only around ¼ percent. In effect, this amounts to an implicit tax on pension income of all workers who are not in the civil service.

24. The size of this implicit tax can be measured by comparing the return on rupee securities with a compatible market interest rate in a particular year. The 364-day treasury bill rate is chosen as such a comparator, given that treasury bonds were only introduced in the last few years. Table II.8 shows that in every year except one in the last decade, the treasury bill rate was higher than the rupee security rate, sometimes substantially. Multiplying the interest rate differential by the quantity of rupee securities held by the provident funds gives an estimate of the implicit tax.

Table II.8.

Financial Repression Tax

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Sources: Central Bank of Sri Lanka Annual Report; and Fund staff calculations.

25. Captive source funding tends to assume a larger role in periods where the deficit is high. From 1991 to 1996-with fiscal deficits averaging 9¾ percent of GDP-the implicit tax averaged 0.3 percent of GDP. However, by 1999 fiscal adjustment had reduced the deficit to 7½ percent of GDP, and the implicit tax fell sharply, as the gap between interest rates on rupee securities and market-based instruments narrowed. The gap was actually negative in 1997, and miniscule in 1998 and 1999 as the authorities made a concerted effort to switch to market based debt instruments. In 2000 and 2001, however, fiscal slippage led to a deficits averaging 10½ percent of GDP, causing the implicit tax rate on provident funds to jump to over 0.6 percent of GDP in 2001. A large increase in domestic interest rates was not reflected in rupee security returns, and the gap widened again.

26. In conclusion, there is a temptation to resort to nonmarket financing whenever interest rates are high. By holding debt service costs down, financial repression can bolster fiscal sustainability. The disadvantages of this policy are manifold: aside from the costly distortions it creates, resorting to financial repression for fiscal policy purposes is both nontransparent and inequitable.5

E. Concluding Remarks

27. This paper has examined the sustainability of Sri Lankan fiscal policy using both backward- and forward-looking frameworks. In general, we find that fiscal policy was conducted in a sustainable fashion in the past, as the government was able to run large primary deficits because of high growth and low real effective yields on government debt.

28. Looking to the future, strong medium term adjustment is needed for fiscal policy to be sustainable. Failure to adjust implies a rising deficit with mushrooming interest payments. The results are highly sensitive to assumptions about growth-even strong adjustment can lead to a rising debt-GDP ratio if growth remains low. This demonstrates the importance of early implementation of the envisaged pro-growth structural reforms outlined in the budget. In addition, fiscal adjustment should be carried out in a manner that promotes growth (see, for example, Gupta et al (2002)) rather than cutting capital spending. Although none of the other scenarios appear to directly endanger sustainability, any combination could cause problems, especially if they adversely affect medium-term growth. Also, as the government moves toward market-determined securities the implicit tax on financial repression will decline substantially, and need to be compensated for by lower deficits.

References

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1

Prepared by Anthony Annett (FAD) and Daniel Kanda (APD).

2

Here we abstract from conceptual difficulties associated with taking deviations around the mean of a nonstationary variable. In any case, it is plausible to assume that the debt-GDP ratio for Sri Lanka is bounded, so this should not pose a serious problem.

3

The EPF covers all private sector and public corporation and statutory board employees, is funded by employee and employer contributions (8 percent and 12 percent respectively), and pays out a lump sum upon retirement. Participation is compulsory and there is no cap on contributions as income increases.

4

In terms of numbers, the provident funds held Rs 3.1 billion in treasury bills (2 percent of the total), Rs 64.8 billion in treasury bonds (28 percent of the total), and Rs 183.5 billion in rupee securities (63 percent of the total) at end-2001.

5

Private sector employees are already taxed heavily, while public sector workers are not liable for income tax and receive pension benefits directly from the consolidated fund.

Sri Lanka: Selected Issues and Statistical Appendix
Author: International Monetary Fund