• Advocata’s framework for economic recovery 

By Imesh Ranasinghe  We are 18 months into the pandemic but the policymakers are yet to announce a proper programme to save Sri Lanka from the economic crisis it is currently facing now. Although many policymakers blame the Covid-19 pandemic for the current economic situation, by now many have realised the pandemic just unveiled the curtain behind which all the troubles of Sri Lanka’s economic system were kept hidden.  Colombo-based think tank Advocata Institute, on 14 September unveiled a Framework it has prepared for Sri Lanka’s Economic Recovery. The report was prepared by Advocata Institute Senior Research Fellow and Central Bank of Sri Lanka (CBSL) former employee Dr. Roshan Perera.  Presenting the report, she said that for consumers and producers to be able to make long-term decisions there needs to be stability in the economy and highlighted what is really meant by stability.  She said stability means an economy that is growing at a steady and sustainable rate where the inflation rate should be at a level and does not have a material bearing on the decision-making agents of the economy.  Also, the economy should be resilient to both internal and external shocks as there is always an element of uncertainty. Our economic system is buffeted by various shocks, so in order to achieve this, an economy needs to have stability both internal and external.  Dr. Perera said internal stability is where the economy is producing goods and services in line with the resources in the economy, basically an economy operating at its optimal level which neither generates a higher level of inflation or deflation.  While external stability is where the demand for foreign goods is basically matched by foreign inflows and as a result current account balance can be financed in an orderly manner. She added that the external current account balance of a country is calculated by adding up private savings and Government savings.  “So basically if a government continues to consume more than it earns or domestic private savings are not sufficient to finance the investments in the economy, this would be reflected in a widening of our current account deficit,” she said.  After addressing the imbalances through this in the external sector, she said it is required to address the fundamental imbalances in the economy such as addressing the forex deficit or addressing savings rates.  “We can’t simply address the symptoms which may be high imports, we have to address the fundamental reasons for this external current account deficit,” Dr. Perera said.  When considering Sri Lanka in the last few decades, she stressed that the country has been running on deficits on its external current account balance and in the absence of sufficient domestic savings the country basically has to depend on foreign savings to bridge this current account deficit.  In order to do that she said, the country needs to get foreign inflows through FDIs but as Sri Lanka has a poor track record in getting FDIs, the country had to basically borrow from abroad.  She pointed out that over the years since the start of this century Sri Lanka’s borrowings which were mainly multilateral and bilateral changed to financial market borrowing and through international sovereign bonds which were at higher rates and less grace period. While many of the bilateral and multilateral borrowings were concessionary finances.  “This has made the debt service payments really balloon over time,” she said.  According to the estimates by the Ministry of Finance from 2021 up to 2026, Sri Lanka has around $ 25 billion foreign debt obligations which have not taken into account foreign currency-denominated debt, Sri Lanka Development Bonds, and ISBs that are held domestically, which has increased in the recent times quite significantly.  She said that with low inflows due to the pandemic, negative investor sentiment, and ratings downgrade, servicing these debts have been a challenge. “But these are contractual obligations, there will be serious repercussions if a country defaults on its debt,” she added.  Since the start of the pandemic the country’s foreign reserves have gone through a steady drawdown by the end of July 2021, the foreign reserves declined to $ 2.8 billion which was the import cover of 1.8 months and was increased to $ 3.5 billion in August due to various receipts of the IMF Special Drawing Rights (SDR) allocations and swap with Bangladesh.  What needs to be done?  According to Dr. Perera’s report, primarily Sri Lanka needs to address its macroeconomic imbalances and need to correct its fiscal deficit and the external current account deficit because these have spillover effects into the rest of the economy through the interest rates and exchange rates.  “Secondly, we need to have growth because you need to create jobs and people need to have income, we need to improve our competitiveness and we need to improve our productivity, for that we require various structural reforms. And finally, we need to build up buffers to strengthen the resilience of the economy to shocks in order to be able to question the economy and strengthen the various sectors of the economy. We will be able to build these buffers to help us cushion the economy when we face shocks,” she explained.  However, she said in addressing macroeconomic imbalances, similar recommendations could be found in any programme implemented to address the same issue in any country over the past few decades.  But she added in Sri Lanka that although recommendations were given, successive governments have not followed through on it for ensuring long-term macroeconomic stability and sustained economic growth.  Also, she said that in all the previous stabilisation process programmes, although debt has been highlighted as a concern the programme has sought to address it through fairly strict fiscal consolidation programmes.  “But this time it’s different,” she added.  The report had identified several areas that need attention to address macroeconomic imbalances namely, 

• Debt restructuring
• Revenue-centered fiscal consolidation
• Public finance management and public sector reform
• State-owned enterprise reform 
• Enhancing monetary policy effectiveness and maintaining exchange rate flexibility 
• Supporting trade and investment to strengthen external sustainability 

How to address macroeconomic imbalances  Talking about Sri Lanka’s debt issue, Dr. Perera said that the country has several options when it comes to handling debt. “It can do nothing and carry on as it is doing at present, utilising whatever foreign inflows it gets to service its debt but will come at the cost of the rest of the economy and there is a limit to this strategy.”  Also, she said the country can default, with the depleted foreign reserves and the Government running out of options to finance its foreign debt service obligations there is a strong possibility of default.  “Although the Government currently maintains that it will meet its obligations, depleting or using our foreign reserves and prioritising debt service payments over facilitating productive economic activity can be detrimental to the future of the economy,” she added.  She said the other option the Government has adopted is debt monetisation, where the Government has attempted to monetise the debt but it has challenges because it has undermined the independence of the CBSL and thus led to high inflation.  According to her report, the Government can also resort to financial repression because the Government is trying to convert its foreign debt to domestic debt but it’s also artificially suppressing the domestic interest rates to keep borrowing costs low.  However, she said these will have serious implications for domestic savings and ultimately lead to misallocation of resources.  The final two options are the Government could do debt conversions such as debt to equity swaps and debt restructuring.  She pointed out although debt restructuring is a very complex process and securing a deal that will be acceptable to most creditors will not be an easy task as there are many stakeholders involved and conflict of interests, it is something Sri Lanka needs to engage in with an internationally accepted institution such as the IMF.  Further, she said when considering fiscal consolidation, which is one of the primary reasons for macroeconomic instability, it has to be revenue-centered.  She added that there has been a serious erosion in Government revenue and it has had serious implications for macroeconomic stability.  Moreover, she said that Sri Lanka needs to have a comprehensive review of the tax system.  The last review of the tax system was done in 2009 under the chairmanship of former CBSL Governor W.D. Lakshman, whose recommendations were never implemented holistically.  Other things required for a revenue-centered fiscal consolidation include reducing excessive reliance on indirect taxes and rationalising tax incentives by strengthening tax administration through facilitating compliance and effective monitoring.  When it comes to public finance management, she said that contractual obligations such as payment of salaries, pensions, and interest payments account for a large share of Government revenue.  Moreover, she added that with the Government facing these severe resource constraints the increase in expenditure is an opportunity cost where one requires to cut down on expenditure on other things like building human capital and  physical capital.  Other options under public finance management in the report require rationalising the public sector, improving the targeting of subsidies and transfers, strengthening fiscal rules to constrain discretionary spending and strengthening budgetary institutions (as they should be well financed, have individuals with the necessary expertise, be transparent, independent and held accountable).  According to Dr. Perera, state-owned enterprises (SOEs) are a major source of inefficiency and continuing to maintain these inefficient SOEs through transfers of government, once again reduces the funds available to other vital sectors of the economy or underfunded sectors.  This could be reformed by strengthening governance by implementing measures to improve corporate governance mechanisms and highlighting KPIs.  Other such reforms include improving transparency, cost-reflective pricing, and restructuring and divestment (this needs to be undertaken within a strong institutional framework and with an overall objective of improving competition).  She said since much of the losses of these SOEs largely fall on the banks, this has implications for macroeconomic and financial sector stability, hence it requires immediate reforming.  “What has happened is because of fiscal dominance it has adversely affected the independence of the monetary policy, basically the CBSL has been called upon to finance the Government due to the widening fiscal deficits and the challenges faced by the Government in raising foreign financing,” she said, highlighting the need to enhance monetary policy effectiveness.  The report states inflation targets, independent central banks, and financial sector stability as reforms that are required to enhance monetary policy effectiveness.  Financial sector stability is required as worsening of current conditions can pave the way for a full-blown banking sector crisis with serious consequences for the country.  In addition, Dr. Perera said that this rapid increase in monetary expansion is also exerting pressure on foreign reserves and the exchange rate.  “But maintaining the exchange rate stable to cushion the impact on foreign debt service payments should not be the policy priority, so what we want to stress is, the CBSL needs to focus on its priority, it needs to keep a lid on inflation and maintain a flexible exchange rate,” she said.  For the external sector and the trade sector, Sri Lanka needs policies to support trade and investments such as global production networks, trade return and improving trade facilitation.  Economic growth  Just as a country needs macroeconomic stability it also needs economic growth,. and according to Dr Perera, Sri Lanka’s growth has been extremely volatile over the last two decades.  She noted that there has been periods of accelerated growth due to several reasons such as political economy reasons, where governments before elections go on a spending spree mainly with the purpose of winning votes rather than really raising the productive capacity of the economy to ensure growth in the medium term.  “And we have also seen this debt-driven infrastructure spending particularly after the civil war, but these growth spurts have been very short-lived and have not been productivity-led growth,” she added.  Secondly, she noted that high growth has only been seen in certain sectors of the economy, which is referred to as the non-tradable sectors such as the construction industry, real estate, trading, financial services, etc.  “Agriculture and manufacturing have grown at a much slower rate, and this is largely a function of the incentive structures in the economy,” she said.  The report talks about structural reforms for sustainable and inclusive growth, in which reforms such as improving the business environment to attract investors and increasing access to land, which has been identified as a binding constraint for economic growth.  Other reforms include creating flexible labour markets and raising female labour force participation, building human capital, and bridging the infrastructure gap.