• Sri Lanka’s crisis due to series of intentional and tragic policy mistakes
• Very significant corruption and vested interests drive decision-making
• Govt. lacks capability to design our own economic recovery plans
• Sri Lanka relies too heavily on IMF to tell us what the solutions are
• Treat domestic debt restructuring early so treatment can be mild
• Chinese assurance not critical for IMF board-level agreement
• Veering off democratic path is third crisis emerging in Sri Lanka

“We have a governance crisis that has led to an economic crisis and in trying to solve the economic crisis without solving the governance crisis, we are creating a crisis for our democracy as well,” asserted Verité Research Executive Director Dr. Nishan de Mel in an interview with The Sunday Morning, pointing out that Sri Lanka’s economic crisis was very much a symptom of a serious crisis in decision-making and governance due to incompetence and corruption. 

“Veering off and away from the democratic path is now the third crisis that’s emerging in Sri Lanka. So we have a governance crisis that has led to an economic crisis and in trying to solve the economic crisis without solving the governance crisis, we are creating a crisis for our democracy as well,” he warned.

Commenting on the role of the International Monetary Fund (IMF), he noted that the IMF was not attempting to ‘bail out’ Sri Lanka but offer interim assistance while facilitating confidence building amongst all parties, and attributed the delay in the programme getting off the ground to the lack of a well-formulated recovery plan from the side of the Government.

“We do not have the capability to design our own plans for economic recovery. We actually rely too heavily on the IMF to tell us what the solutions are. The IMF should not be deciding exactly how we are going to raise revenue, that’s the job of the Government. If the Government is saying it is doing it because the IMF said so, that means it has abdicated its fundamental responsibility of being the Government and actually farmed out the job of policymaking to a third party that doesn’t know as much about Sri Lanka and therefore will suggest policies that are likely to be not optimised for the country,” he added.

You recently tweeted that Sri Lanka’s economic crisis is actually a crisis of governance. Why do you say this?

 When we ask why Sri Lanka is in trouble, people have offered different explanations, often harking back to the long past. Those who see it as triggered by proximate events point to the global Covid environment in 2020 and 2021 and even later developments such as the Russia-Ukraine war. When you understand how the crisis of Sri Lanka came about, which we have analysed quite carefully, it is very clear that Sri Lanka’s crisis was avoidable. But it was not avoided. It was precipitated by a series of serious policy mistakes, which were also known to be mistakes when they were made.

It started with an unanalysed tax cut, where policymakers did not evaluate or understand the potential consequences. Then when the consequences emerged, where Sri Lanka lost access to global financial markets, policymakers enacted budgets that made the situation worse rather than better, causing credit ratings to fall even further. 

Despite not having a means to re-borrow, Sri Lanka also continued to deplete its reserves in repaying international debt – and watched wantonly the wiping out of foreign currency reserves. Even at the eleventh hour, despite repeated warnings from Sri Lanka and around the world, policymakers refused to stop foreign debt payments and chose to stop supplying essentials to the people of the country instead. These were intentional and tragic mistakes of policy that have pushed Sri Lanka to its most miserable economic plight as it celebrates 75 years of independence.

Sri Lanka’s growth this year is the worst in the world next to Ukraine, according to the World Bank. For next year too out of 148 countries, the World Bank projects Sri Lanka to have the largest negative growth in 2023. Sri Lanka is at the bottom of the pack in the world. Its problems are very much self-created.

While there were very unique and extraordinary mistakes made from the end of 2019 onwards, when I say that this is a crisis of governance, I am not referring only to that period. I am also referring to the structural aspects of economic policymaking that are very much entrenched in the system of governance. 

For instance, when Sri Lanka does a budget, it does not have a written analysis of the rationality of the budget proposal or even the reasonability of the projections. There is no document to show why the expected policies are going to yield the expected results. There is a lack of competence that envelops the entire system of financial decision-making and there is also very significant corruption and vested interests that direct this form of unaccountable decision-making, which is callous about the public interest. 

The many reductions in taxes, targeted tax holidays, arbitrary tax eversals, etc. should not be seen simply as mistakes. More often than not, they are actions that are driven by vested interests that then cause Sri Lanka’s revenue to GDP to be among the lowest in the world. In most countries, when the economy grows, the revenue share to GDP grows with it. In Sri Lanka, it was the other way around.

These observations suggest that there is a capture of vested interests in which Sri Lanka’s economic policies are being formed. As long as that is the case, Sri Lanka cannot actually recover from the economic crisis. This is why I have said that the economic crisis is very much a symptom of a very serious crisis in decision-making and governance, both due to incompetence and corruption. Imagining that we can solve the economic crisis without solving the governance crisis would be an exercise in idle optimism.

Why is there such a delay in receiving IMF support despite constant Government assurances to the public in this regard?

 The delay is only in relation to the expectations that were set by the Government. But it’s not unusual for expectations to not materialise. An IMF Staff-Level Agreement (SLA) was anticipated in June, July, and August and it finally manifested in September. Setting unrealistic and overly-optimistic expectations is quite normal. 

In our regular macroeconomic briefing, since June [2022] we told our clients that it would be February/March 2023 when board-level agreement was likely to be achieved. The reason for our timeframe was because we saw the Government as lacking the dynamism and competence needed to proceed faster. 

The first step towards an IMF programme is to develop a plan to take the economy forward: you need to understand your numbers, you need to understand your policy options, and you need to build a path for economic recovery.

We know from history that when Sri Lanka gets into an IMF programme, it does not produce a plan of its own. Instead, the bureaucrats tend to rely too much on the IMF to come up with a plan, which they then try to negotiate. 

It is a serious governance problem that Sri Lanka does not design its own plans for economic recovery. Instead, like a failing business that wants a bank loan, but asks the credit officer at the bank to write its business plan, those tasked with running the country look to the IMF to tell them what to do. But the IMF, understandably, doesn’t have a good grip on what would work best in Sri Lanka – which is why IMF plans have not worked well in the past either. Sri Lanka has failed to complete seven out of the 16 IMF programmes in the last 66 years.

Essentially, the problem is that we don’t develop a plan of our own. Even now you will hear the Government say that it is raising taxes in a particular way because the IMF told it to do so. Now, that is not a sensible explanation. If the IMF provided analysis that showed it is the best way to raise tax revenue, it could make sense. Sri Lanka should develop policies on the best analysis that is available, not blindly carry out the suggestions of the IMF. The proper process is for Sri Lanka to provide the IMF with a plan and have it subjected to analysis and feedback from the IMF in order to improve it. The IMF would certainly welcome such a process.

If the Government is saying it is doing it because the IMF said so, that means it has abdicated its fundamental responsibility of being the Government and actually farmed out the job of policymaking to a third party that doesn’t know as much about Sri Lanka and therefore will suggest policies that are likely to be not optimised for the country. Turning around after that and blaming that third party is to add treachery to the act of abdication – and this is the governance crisis once again.

 Do you see a bailout happening in March?

 I think it would be incorrect to characterise the IMF assistance as a ‘bailout’. No one is offering Sri Lanka a free lunch at this stage. What everyone is trying to do is find a path for Sri Lanka to get back into a situation where the debt repayments are sustainable, alongside economic recovery and growth. The task of the IMF is to offer interim assistance while facilitating confidence building amongst all parties that Sri Lanka is implementing a plan that is going to lead to economic recovery and debt sustainability.

But in terms of timing, we do expect it to come by the end of February or March. However, saying that at this stage is also a statement of hope because we’ve really taken it to the wire. If we don’t pass this milestone by the end of March, we run the risk of it taking much longer because the analysis on debt sustainability and the economic projections will become quite dated and may need to be redone, if agreement is not achieved soon. 

What is the approach you recommend when tackling domestic debt restructuring?

 The question of domestic debt restructuring is as important as it is controversial. At the moment, Sri Lanka has only talked about restructuring its external debt and not its domestic debt.

You have seen on our website a paper published by the Sri Lanka Economic Policy Group, which is hosted by Verité and comprises several prominent economists. This particular paper was authored by an economist at Oberlin College in the US, Professor Udara Peiris.

The paper that we developed shows that the current agreement and the current targets for debt restructuring are not likely to deliver a sustainable pathway for economic recovery and debt management for Sri Lanka unless interest rates (yield curves) on local debt can be brought down by over 10%.

We don’t see a path for reducing interest rates adequately, given the high risk in the Sri Lankan economy and the lack of confidence that people have in financial management. The Government is currently facing a risk premium of over 12% in auctions of its debt in the local money market. 

Interest rates are also high because the Government has a huge borrowing appetite simply to pay back money that has already been borrowed. That is a vicious cycle. The estimated total interest payment by the Government in 2023 is at 7.2% of GDP. That’s unprecedented.

The only way to get back on a lower interest rate path is for the Government to reduce its demand for borrowing. The way to do that minimally is by reprofiling domestic debt. That means postponing the capital repayments on maturing Government bonds.

How will that happen?

 That pathway is to reduce risk and reduce demand on local debt with a quick mild reprofiling. When you reduce demand, you reduce price, which is interest rate, and thereby bring a lower interest cost, which can then make the debt path sustainable and less risky. The analytical view taken in the paper is that without a pathway to substantially reduce interest rates, to around 2019 levels, regaining debt sustainability doesn’t play out as per the current plans of the Government. 

We have not only published the paper, but have also published the math behind the paper; the data in Excel sheets, the calculations, and the functions, all of which can be downloaded and evaluated. The IMF’s debt sustainability analysis is unpublished at the moment, so we are unable to compare and see what assumptions the IMF has made that are different to what is in this paper. 

I think it is very important that we work on transparent analysis that everyone can see and agree on. The IMF should also increase its commitment to transparency; it should be possible to replicate the IMF analysis, understand its assumptions, and subject it to analytical scrutiny.

If you understand what the Central Bank is saying in public and in press statements, it seems to be saying that domestic restructuring is currently not on the cards, but when you read the credit assurance letters that have come in, what you also understand is that it’s not off the cards either, that it could be on the cards if Sri Lanka does not manage to enact a certain pathway of economic recovery. 

In this case of domestic debt restructuring for Sri Lanka, the old adage holds; that a stitch in time saves nine. What this paper is showing is that if you wait until it becomes inevitable to restructure domestic debt, it will be harder and more painful. Then you may not be able to just reprofile your debt; you may have to cut coupons, you may have to cut capital. It’s like any problem; if you have cancer or a wound, if you allow it to fester, then you have a much more difficult surgery in the future. But if you treat it early, you might actually be able to treat it without too much pain. 

Our view currently, based on the paper we have published, is that domestic debt restructuring should be treated early, and in such a way that the treatment can be relatively mild and more easily managed. We have a pathway for that. But if you allow it to fester and wait till it is inevitable, then it may be a lot more damaging for the economy. 

How do you view global assurances on debt restructuring, hot on the heels of India’s expressed support, and do you see other creditors coming on board as well? 

 I think we have now got letters of assurance from all the parties – India, China, and the Paris Club as well as the private creditors – to help Sri Lanka restructure its debt. To a great extent, these letters are adequate in terms of the technical requirements for the IMF to provide board approval.

I think, as you can see in public, the main discussion is around whether the assurance by China is adequate. However, from a technical perspective, the Chinese assurance is not critical for IMF board-level agreement because the required level of agreement exists even without China.

China has not given assurances that are equivalent to the other bilateral lenders; it has initially suggested that it will suspend or accept a moratorium on the debt payments of 2022 and 2023. 

This is just the starting point of the debt restructuring; the IMF Board agreement doesn’t end debt restructuring. It just moves it forward with more confidence. I think it should be possible to agree that when we get to the end of that process, all bilateral official creditors will be treated equally. The assurances do not need to be equal at the start in order to ensure equal treatment at the end. Therefore, I think holding on to the principle of equal treatment at the end ought to be enough for the moment, and we must try and persuade the IMF to proceed with board-level agreement on that basis.

Delay is costly for everyone, not only for Sri Lanka, but also for the official creditors and private creditors and I don’t think it is advisable to delay the process on the basis of difficulties in getting perfect alignment between creditors at this stage. 

What are your expectations of the Government as Sri Lanka seeks to navigate and emerge from this crisis? Do you see the right attitude?

 I started this discussion with you by pointing out that governance was at the heart of the crisis and I think, in coming out of the crisis, we must understand that governance is also at the heart of the solution to the crisis. Sri Lanka can no longer afford to do a temporary patchwork solution, because even debt restructuring is not the end of the road. 

The only reason that Sri Lanka absolutely needs to restructure its debt is because it wants to be able to build confidence for investors, go back to financial markets, and have a smooth pathway to investment and economic growth.

Now, if we do not get to that level of confidence, then the economic pathway ahead is still going to be rough and I think we cannot get to a better path if we are unable to fix our Government.

I’ll give you a simple example. The Government passed a budget at the end of last year which had all the right targets (as agreed with the IMF), but the wrong plans and policies to achieve those targets. Our current analysis shows – and we will publish them soon with some refinement – that revenue targets are going to be missed by about 10%. 

Once you set up a budget in which it is clear even from an analysis at a very early stage that the targets are going to be missed, then you know that governance is a problem. The targets are not going to be missed because of things that will happen in the future. It’s because of policies that are being designed that are not commensurate with the targets that are there.

I’ll give you a simple example. The Government anticipates in the Budget to raise excise tax revenue from cigarettes, to between Rs. 137-140 billion. The policies it has passed are going to get the Government only Rs. 90 billion; it is going to miss the target by Rs. 50 billion.

There are multiple such examples where when we do the math on the policies that the Government has passed, the Budget fails to compute. This comes back to the problem of vested interests dominating the decisions of the Government. Another example is where the Government has introduced withholding tax at only 5% – that’s a huge mistake. Instead it has increased PAYE tax, which is much less productive and causes much wider public discontent.

It is irresponsible and reckless to blame the IMF for such a poor design of taxes. The tax plan can be agreed with the IMF, but it should be a plan that the Government owns and believes is the best for Sri Lanka. The fact that the Government doesn’t have such a plan and blames the IMF for the plan that society thinks is reckless and improperly designed suggests that governance is seriously out of alignment.

Here’s another problem that’s coming out of alignment – as people recognise that policies have been badly done and the Government keeps trying to pile up compensating tariffs like increasing electricity tariffs, for instance, and does so, it’s also now beginning to dismantle democracy in Sri Lanka.

We had a dismantled governance that was dismantling the economy, which is now dismantling our democracy. There are three independent commissions now under attack by the Government – the Public Utilities Commission, the Election Commission, and the Human Rights Commission. I have never seen a point in Sri Lanka’s history when the democratic structures have been under attack in this particular way. We have, of course, seen governments pass constitutions that got rid of the commissions altogether – that was worse. 

To have these commissions and have them under attack in this way, in a public way, means that good people are now afraid to serve on independent commissions and the whole understanding of democracy, that the Government listens to people, that it allows independent evaluation of its policies, is under attack at the moment. This, I think, is extremely dangerous for Sri Lanka because we have a President who has effectively come into power with what can properly be called a constitutional coup, in the sense that it is constitutionally valid, except that it lacks democratic legitimacy or popular support.

In that context, I think the Government must be doubly concerned about respecting its obligations, to listen and to respond to public sentiment, and not place under attack the democratic structures that are in the country. 

That Sri Lanka is now veering off away from the democratic path is now the third crisis that’s emerging in the country, consequential to the economic crisis. So we have a governance crisis that has led to an economic crisis and in trying to solve the economic crisis without solving the governance crisis, we are creating a crisis for our democracy as well.