Macroeconomic Stabilization as an Immediate Priority

The Sri Lankan economy contracted by an unprecedented 7.8 percent in 2022^a reflecting the magnitude of the crisis it faced during the year. All three sectors of the economy, namely, Agriculture, Industry, and Services, were severely affected in 2022, and the impact of corrective policy measures is also having a dampening effect on economic activity in the near term. While the recovery in some agricultural subsectors, the rebound in tourism and the gradual return of business confidence are expected to aid economic recovery, the economy is projected to contract by around 3 percent in 2023. Our authorities, while hoping for a faster recovery over the medium-term, understand that normalization of economic activity following a debt crisis could be slow. At the same time, the authorities realize that the immediate priority for the Sri Lankan economy is to stabilize the economy, which is a prerequisite for long-term growth. Accordingly, the stabilization program proposed by the authorities includes measures to ensure durable fiscal consolidation, restore public debt sustainability, restore price stability, rebuild external reserves, and safeguard financial stability, along with those aimed at strengthening social safety nets, addressing governance and corruption vulnerabilities, and implementing other structural reforms that would help unlock Sri Lanka’s growth potential.

Fiscal Developments and Policies

At 8.7 percent, 8.3 percent, and 8.4 percent of GDP in 2020, 2021 and 2022, respectively, Sri Lanka’s central government revenue collection is one of the lowest in the world. On the other hand, the rigid government expenditure, including wages and salaries, subsidies and transfers and interest payments, prevents any effective developmental activity without increasing the fiscal deficit and debt levels. To raise revenue collection to 15.0 percent of GDP by 2026, reduce the overall fiscal deficit to below 5.0 percent of GDP by 2025, and register a primary surplus of 2.3 percent of GDP by 2025, the government has introduced a series of decisive fiscal measures. In the near term, the primary balance is projected to improve to -0.7 percent of GDP in 2023 from -5.7 percent in 2021.

Key revenue measures implemented over the past few months include a) increasing the schedule of rates for marginal personal income tax (PIT), raising the top marginal rate, reducing tax-free threshold, and rationalizing incremental tax slabs, b) increasing the standard rate for corporate income tax (CIT), removing tax holidays as well as sector-specific CIT exemptions, and unifying the rate structure for CIT, c) reinstating the value added tax (VAT) rate at 15 percent from 8 percent, lowering the VAT registration threshold, and removing some VAT exemptions, d) reinstating the mandatory withholding tax, and e) increasing rates for excise tax on alcohol and tobacco products, and on fuel. Going forward, the government expects to further revamp the VAT system to minimize exemptions, speed up valid VAT refunds, and abolish the Simplified VAT system that has created distortions. In addition, in 2024, our authorities plan to implement automatic indexation of excise taxes to inflation. In 2025, the authorities plan to revamp the property tax system and introduce a wealth transfer tax. The above measures are expected to make Sri Lanka’s tax system more progressive, and gradually shift the focus of taxation from indirect to direct sources. The government has also embarked on revenue administration reforms to strengthen tax compliance, keeping in mind the relatively large size of the informal sector of the country. In order to enhance fiscal transparency, the government will document all tax expenditures provided under the Strategic Development Projects Act and the Board of Investment Act.

Expenditure containment measures would complement the government’s efforts towards fiscal consolidation. Measures have been introduced to reduce operational expenses of the government and increase accountability of spending. The government proposes to limit the expansion of the wage and public sector pension bill, while ruling out pay cuts. Public investment, which has declined to unsustainably low levels, is expected to be raised over the medium-term, with measures to enhance its efficiency and transparency. The government has also taken steps to reduce the stock of budget expenditure arrears to zero, while limiting the issuance of treasury guarantees, and these measures are encapsulated in the proposed program.

Expenditure rationalization is not expected to compromise spending on health, education, and social protection. The crisis has increased the incidence of poverty and reversed the gains achieved in recent decades. The poorest of the poor are the most affected by the crisis, and there is evidence that many others are falling into poverty because of reduced real incomes and loss of livelihoods. The ongoing social safety net reforms are expected to improve coverage and targeting, thereby supporting the poor and the vulnerable, particularly during the ongoing adjustment phase. The authorities, with the assistance from the World Bank and the Asian Development Bank (ADB), maintained social safety net spending at Rs. 142 billion (0.6 percent of GDP) in 2022, and the government has proposed a spending floor of Rs. 187 billion for 2023. The Welfare Benefits Board (WBB) is being operationalized as the key focal point for social safety nets, and a donor coordination system is being established to lead discussions on external financing.

In the meantime, measures are being introduced to mitigate fiscal risks arising from state-owned business enterprises (SOBEs) and to reform the SOBE sector. Fuel and electricity prices have been adjusted in line with international market prices, and regular formula-based price revision mechanisms have been introduced. Such measures are expected to depoliticize pricing of energy and other public utilities, while eliminating the spillover effects of mispricing on the fiscal and financial sectors. A comprehensive strategy to reform the key SOBEs is expected to be introduced by mid-2023. The government expects to strengthen the framework for SOBE borrowing by limiting such borrowing to commercially viable activities and preventing foreign currency borrowing by non-financial SOBEs without adequate sources of foreign currency revenue. The government will transparently remunerate any subsidies and quasi-fiscal activities of SOBEs through government transfers.

A new Public Financial Management (PFM) law is expected to be in place from 2024, thereby introducing binding fiscal rules, including a legally binding government debt ceiling. The PFM law is also expected to establish the legal definitions for public debt and government deficit, clarify the budget formulation process, specify the responsibilities of the Ministry of Finance and spending units, establish information and accountability requirements, and introduce stricter guidelines on issuing treasury guarantees.

Inflation, Monetary Developments and Monetary Policy

Inflation (Colombo Consumer Price Index (CCPI) based, year-on-year) accelerated from 5.7 percent in September 2021 to 69.8 percent in September 2022, i.e., over a space of merely one year. Causes for this acceleration included the depreciation of the Sri Lanka rupee, disruptions to domestic food production, global fuel and food price shocks, price revisions of domestic fuel, electricity, and cooking gas supplies along with the associated increases in other prices, and unsustainable monetary financing of the fiscal deficits that de-anchored inflation expectations. Inflation has decelerated thereafter in response to policy tightening, measuring 50.6 percent in February 2023. A sharper deceleration is projected over the next few months. Monthly inflation has hovered within a range of -0.7 percent and 0.5 percent over the past five months, indicating that high year-on-year inflation recorded at present is due to legacy effects than due to ongoing inflationary pressures.

The policy interest rate corridor of the Central Bank of Sri Lanka (CBSL) was increased from 5.00-6.00 percent at end 2021 to 15.50-16.50 percent by March 2023, with a decisive seven percentage-point hike in April 2022. The latest monetary policy adjustment in March 2023 was carried out after much deliberation between the Fund staff and the CBSL. The CBSL remains committed to a data-driven monetary policymaking process, and is confident of bringing down inflation to single digit levels by end 2023, and subsequently to the target range of 4-6 percent by 2024.

Most market interest rates increased, with the prime lending rate and yields on Sri Lanka Rupee denominated Government securities peaking at 29.67 percent and 33.14 percent, respectively. The year-on-year growth of credit to the private sector by commercial banks decelerated from 20.3 percent in April 2022 to 6.2 percent at end 2022. Credit to the private sector, after adjusting its foreign currency-denominated component for exchange rate depreciation, contracted by 3.3 in 2022. Credit to small and medium scale enterprise (SME) sector contracted by 8.3 percent in 2022. In the absence of required foreign financing flows to the government, domestic financing has continued to expand. Within domestic financing, financing by the CBSL still accounts for a significant portion. Monetary financing of the fiscal deficit shall be prohibited under the new Central Bank bill that is expected to be enacted by end-April 2023, while further safeguards are proposed under the program for the interim period. Borrowing requirements of SOBEs are expected to decline notably, due to the introduction of cost-recovery based pricing mechanisms.

The enactment of the new Central Bank bill will also assist in firmly anchoring inflation expectations by prohibiting monetary financing, introducing institutional reforms that would enhance the independence of the CBSL, institutionalizing the flexible inflation targeting monetary policy framework with exchange rate flexibility, and increasing accountability of the CBSL in relation to price stability.

External Sector Developments

Sri Lanka faced severe balance of payments pressures over the past few years, with catastrophic effects in 2022. The Easter Sunday attacks, the COVID-pandemic and the uncertainties in 2022 significantly affected earnings from tourism. Worker remittances declined considerably in 2021 and 2022. While merchandise exports remained resilient, the expectation of an imminent exchange rate depreciation increased imports in late 2021, resulting in a large trade deficit of US$ 8.1 billion in 2021, despite the imposition of import controls. After Sri Lanka lost access to the international conventional capital market, flows to the financial account dried up. This loss, combined with sizable debt service payments that were made until mid-April 2022, caused a significant loss of gross official reserves (GOR) in 2020, 2021 and 2022, and exhausted the usable reserves.

The sharp depreciation of the Sri Lanka Rupee in early 2022, the tight monetary policy stance, decline in real incomes and purchasing power, and tighter controls on imports resulted in a narrower trade deficit of US$ 5.2 billion in 2022. Worker remittances are on an upward trend while tourist arrivals have also begun to show signs of sustained recovery.^b The stability of the foreign exchange market also benefitted from the debt service standstill that is in place and the capital flow measures (CFM), as well as the quota system for fuel distribution. With positive sentiments in the domestic foreign exchange market rising, the CBSL eliminated the guidance given to the market on the exchange rate and allowed the exchange rate to be determined by market forces. Thus far in 2023, the CBSL has been able to purchase over US$ 950 million on a net basis towards building up reserves, while the Sri Lanka Rupee has appreciated by around 11 percent against the US$ during this period, reflecting improving market sentiments in anticipation of the Executive Board approval of the EFF.

The CBSL remains committed to a flexible exchange rate policy that is consistent with the flexible inflation targeting framework, and to building up reserves through regular intervention in the domestic foreign exchange market as envisaged in the program. The authorities have also requested temporary approval of the remaining exchange restrictions and multiple currency practices until a sustainable outcome in the foreign exchange market is achieved.

Financial Sector Developments and Stability

The impact of the economic crisis had severe implications on the financial system through various channels. Subdued economic activity, reduced disposable income, and lack of demand for credit resulted in a deceleration in asset growth in the banking sector and a deterioration in the asset quality and profitability of the sector in 2022. The rest of the regulated financial sector is also experiencing similar developments. Amidst these risks, the government and the CBSL remain committed to ensuring the stability of the financial system by addressing any vulnerabilities in the system. The authorities are mindful of the significant impact on financial sector activity arising from the macroeconomic stabilization measures that have been put in place, as ensuring financial system stability is vitally important in facilitating economic recovery and for effective monetary policy transmission.

A comprehensive diagnostic exercise is ongoing for a group of banks covering more than 70 percent of domestically-owned bank assets. The asset quality review component of this diagnostic is expected to be concluded by April 2023. The CBSL will develop a roadmap for financial sector restructuring and recapitalization by July 2023. The asset quality review is expected to be extended to a larger group of banks accounting for an additional 20 percent of domestically-owned banking assets, and this exercise is expected to be completed in August 2023.

The CBSL’s crisis management powers and the framework for financial sector supervision are being strengthened through appropriate legislation that is to be enacted this year. The CBSL has already updated its framework for Emergency Liquidity Assistance for banks. In addition, a coordinating committee will be appointed to ensure the effectively management of risks to financial stability, with representation of the financial sector regulators and the Ministry of Finance. The new Central Bank Act will also establish the CBSL’s authority for macroprudential regulation and supervision, supporting the maintenance of financial system stability.

The authorities are continuing to strengthen the country’s AML/CFT framework. These efforts include legislative reforms to further align the existing framework with international standards. Envisaged amendments to the Companies Act will address the only remaining non-compliant aspect of the FATF 40 recommendations.

Restoring Public Debt Sustainability

Given the depth of Sri Lanka’s debt problem, fiscal consolidation efforts led by the series of significant revenue measures outlined in Paragraph 7 above alone are insufficient to ensure a return of the public debt to a more sustainable level. In line with the IMF’s debt sustainability analysis (DSA) and program parameters, a) the ratio of public debt to GDP needs to be reduced from around 128 percent in 2022 to below 95 percent over a 10-year period, and b) the central government’s annual gross financing needs and its annual debt service in foreign currency need to be reduced. Achieving these outcomes requires the assistance of the creditor community. For this purpose, the government has engaged with all creditors in a transparent manner and has also hired legal and financial advisors.

In order to facilitate transparent negotiations on debt treatment, the government, in consultation with Fund staff, has reclassified certain debts that were previously included in SOBE balance sheets and recognized them as central government debt. A comprehensive Public Debt Summary^c and a Quarterly Bulletin of Public Debt and Debt Service^d are now in the public domain, with the most up-to-date information.

The government is appreciative of the specific and credible financing assurances from India, the Paris Club, Hungary, and China, as well as the consent of other official bilateral creditors to Fund financing to Sri Lanka notwithstanding the arrears. The authorities also appreciate the cooperation of external commercial creditors in this regard. The government reiterates its commitment to a debt resolution consistent with the IMF program parameters and stands ready to use additional safeguard mechanisms to ensure comparable treatment, as appropriate. In this regard, the authorities have issued a Presidential letter addressed to all bilateral official creditors a) assuring transparency on any debt treatment terms that are agreed with any creditor or group of creditors, before being formalized, b) committing not to resume debt service to any creditor unless that creditor agrees on a comprehensive debt treatment in line with IMF-supported program parameters and the comparability of treatment principle, and c) reiterating commitment to a comparable treatment of all external creditors, with a view to ensuring all-round equitable burden sharing for all restructured debts.^e An announcement on the coverage and parameters of debt operations is expected to be made before end-April 2023.

Reforms to Facilitate Long-Term Growth and Sustainability

While the program components outlined above would strengthen macroeconomic fundamentals and place Sri Lanka on a stronger footing for sustained growth and development, the government will continue to facilitate growth-supportive reforms to address long-identified barriers to sustained high growth. These include reforms to improve the investment climate of the country, trade liberalization and export diversification, and reforms to address deficiencies in the labor market and other factor markets to improve the overall productivity in the economy. The government is working with the World Bank, ADB and other development partners on implementing these reforms. Being an island economy susceptible to climate shocks, climate change adaptation and mitigation also remain key areas of reform towards achieving long-term growth and sustainability. As the stabilization phase of the IMF-supported program progresses, greater focus would be directed to such structural reforms.

The government considers its efforts to reduce corruption vulnerabilities as a critical component of the reform program. In this regard, the Fund has been invited to conduct a governance diagnostic of Sri Lanka’s anti-corruption framework. The government is committed to supporting the diagnostic exercise, publishing the report by end-September 2023, and implementing the identified reforms under the EFF. The government will work with the IMF to strengthen legislation and enhance compliance in line with international best practices. Efforts to digitalize revenue administration, procurement processes and other government services are also expected to reduce opportunities for corruption.

Concluding remarks

The Sri Lankan government recognizes that the approval of the EFF alone is insufficient to resolve the issues the country is currently facing. While the delay in seeking Fund assistance is regretted, due to various reasons, it has taken a period of 12 months, as well as extraordinary efforts from all stakeholders, to design an appropriate stabilization program, complete the prerequisites, coordinate with creditors, and secure the necessary financing assurances, before reaching the current stage of Executive Board approval. The government hopes that the next steps in finalizing debt treatment would be faster, as further delays could lengthen the Sri Lanka’s economic recovery process.

The government has benefitted from the close engagement with the Fund during the past year, particularly through policy discussions and technical assistance in the areas of fiscal reforms, financial sector reforms, and institutional reforms through necessary legislative changes. The government also expects that the approval of the EFF will lead to notable catalytic effects to mobilize support from the World Bank, ADB and other bilateral and multilateral development partners, as well as to rebuild confidence in the economy as the reform program progresses.

The government is aware of the serious downside risks that the economy is facing and is determined to decisively address these under the IMF-supported economic program. Recognizing the fact that a major reason for the country’s lack of continued progress is the deficiency in implementing the identified essential reforms, our authorities express their willingness to learn from countries that have faced similar crises and recovered through the timely implementation of successful reform programs. In essence, in the spirit of the motto “never waste a crisis,” our authorities are determined to use the current crisis and the IMF-supported reform program as an opportunity to durably address Sri Lanka’s institutional weaknesses and ensure macroeconomic stability and sustainability, going forward.

Following the Executive Board approval, our authorities also propose to present the IMF-supported economic program to the Parliament for discussion and to mobilize the necessary consensus for the successful implementation of the program.