• China’s two-year moratorium on debt should be theoretically enough for IMF
• SL economy still in a fragile state, it has stabilised from 2022 but still fragile
• On private creditors’ side, SL only needs to be open to talking at this stage
• Part of Govt. SOE restructuring may have to include some privatisation
• Govt. attempt to contain inflation through increasing policy rates effective
• Current tax regime needed to make SL a production-driven economy

Delays in securing ‘good assurances’ from bilateral creditors like China may not derail Sri Lanka’s prospective $ 2.9 billion Extended Fund Facility (EFF) from the International Monetary Fund (IMF), Economist Chayu Damsinghe told The Sunday Morning.

According to Damsinghe, the IMF is likely to work with China on the written assurances given by now and move ahead with the assistance programme as the international institution can ill afford not to support Sri Lanka.

In an interview with The Sunday Morning, Damsinghe, who is Product Head – Macroeconomic and Thematic Research at Frontier Research, pointed out that China had given Sri Lanka assurances more favourable than it had given other countries before, expressing confidence that the IMF-EFF would be approved soon. He warned however that Sri Lanka should not attempt to walk back key reforms, including on fiscal policy, as the repercussions may be felt earlier than expected, as well as complicate the debt restructuring process with agencies like the IMF.

He also called for greater transparency on State-Owned Enterprise (SOE) restructuring efforts and on State expenditure, to build trust and make painful changes more acceptable to the citizenry. He said that Sri Lanka could not afford to return to a situation where the top 10-20% of Sri Lankans pursued a debt-driven consumption pattern which was unsustainable.

Following are excerpts from the interview:

If China delays issuing the assurances that the IMF is seeking to clear the expected EFF, is there a possibility that IMF Board approval can get further delayed (beyond the second quarter of 2023)? And if it does, will some of the crisis faced last year return?

There is always a possibility that things can get delayed. But, from what I understand about China’s assurances, if what is reported is accurate, the said two-year moratorium on debt servicing should be theoretically enough for the IMF to meet the IMF’s lending policies. 

The question is about the language of the policy itself (IMF). The language has some ambiguity. It talks about some ‘good assurances’ and credible assurances, these are all judgemental terms, so this is when geopolitics comes into play. I am cautiously optimistic that the IMF-EFF will go through.

Of course, with the possibility of a delay, if things are pushed back beyond the second quarter, then that would be quite problematic for Sri Lanka. Sri Lanka’s economy is still in a fragile state. It has stabilised compared to 2022, but remains fragile. If anything were to go wrong, if there is a serious shock again, then things can deteriorate. One benefit we have now, coming in from the crisis of last year, is that we now have some systems in place to handle some of the shocks better and mitigate their impact.

Are the prospects of a haircut remote? What kind of debt moratorium do you think will come into effect if the debt restructuring goes through?

At the stage of the debt restructuring process, one does not need to agree to specific debt restructuring measures. At this point, especially from bilateral creditors, what is really needed to be agreed is that in line with the IMF programme, debt repayment will not start right now. That is essentially what needs to be agreed upon. The way that happens and what counts as a ‘credible level’ of promise remains to be seen. Also, that applies to bilateral creditors. On the private creditors’ side, we only need to be open to talking to them at this stage.

The details on what kind of restructuring will take place will likely be decided later on both for bilateral and private creditors. I think the general trend is that bilateral creditors don’t take reductions on their face value haircuts, so that is unlikely. I don’t think that is on the cards. 

What generally happens is that they (bilateral creditors) reduce their interest rates and re-profile their loans, so moratoriums and longer loan maturities are likely with the bilateral creditors. Of course, I think the private creditors will seek a haircut and may agree to a debt moratorium. On overall debt restructuring, what the present value terms are will need to be decided by the IMF and Sri Lanka.  

If China and the IMF cannot find common ground on SL debt restructuring, will the EEF fail to materialise? 

I think the chances of there being no IMF programme on the basis of China are remote. It is also not in the interest of the IMF to not give Sri Lanka an assistance programme at all, based only on China not giving adequate assurances. I don’t think the IMF would behave in this manner; if it does it may not look good for it as well. The IMF’s own policies will have language that allows it to lend to countries like Sri Lanka, even if a single creditor doesn’t commit. It has only once been used before, when Russia invaded Ukraine. 

I think that, sooner rather than later, they will come to some interim agreement. If these questions (about creditor commitment) remain down the road, say in 2024, then these delays may have an impact.

Can the IMF cut Sri Lanka loose due to Chinese reluctance to commit?

I don’t think China’s reluctance to commit itself is enough. Also, China giving this assurance to Sri Lanka is notable. With the assurances China is said to have given, it has given better assurances to Sri Lanka than it has given any other country before.

In the past, the kind of language the IMF has used in similar circumstances is that it has got a nod from China and proceeded. That is, they proceeded even without a formal written proposal so I think, from China’s side, what we are said to have got is progress. 

Where the IMF can cut Sri Lanka or anything similar is likely following the first or second review – if Sri Lanka walks back on some of the domestic policies which it has changed, policies like fiscal policy. If some of the domestic reforms are rolled back, there could be complications.

Further, in terms of domestic political posturing, I don’t think reversals like some claim are possible without some quick repercussions. In the past, we could reverse them and it may have taken a few years to feel the repercussions. However, at present, if there is a reversal, the repercussions may be felt in months.

Creditors, ISB holders have recommended domestic debt restructuring. How will this affect an already-vulnerable banking sector?

Firstly, we need to recognise what domestic debt means, especially because I think the private creditors have communicated domestic debt as ‘debt held under domestic law’. This is not necessarily debt held on domestic currency. Debt held by SOEs, SDBs, and others may be included. SOE debt is guaranteed by the State, so it may also indirectly affect the Government’s balance sheet. 

It is not clear how much sway the ISB creditors hold over the IMF. At present there is a shift internationally towards making the debt restructuring powers debtor friendly.

I think the Government should be aware of the risks of restructuring domestic debt. It is a risky thing, so be aware of the cost. Also, I think there should be some thought given to domestic debt being restructured – if domestic debt is restructured, who will lend to the Government domestically? Do the costs outweigh the benefits?

While the Government has said it will move to reform the SOE sector, little has been done about it. What do you think should be done as a priority?

From what I understand, part of the restructuring may have to include some privatisation.

However, many of the SOEs are laden with debt, billions of rupees of debt. SriLankan Airlines is a good example; I think they have been looking to sell it, but have been unable to find a buyer. The fact that they couldn’t find a buyer also tells us something about the complexity of what is in hand. Also, if there are buyers – who wants to buy an SOE with massive debt for a dirt cheap price? We need to ask ourselves if those are the kind of partners you want operating the SOE. 

As a priority, I think there is a need for some transparency, especially as there is a trust deficit with State enterprises. It is also important for the public to accept these reforms. For example, with the CEB, there is a restructuring process ongoing, the Government has indicated that it wants to ‘unbundle’ the CEB. There was a committee appointed and a report prepared with recommendations, but that report is not public. Of course, there are parts you can’t publish due to commercial reasons, but the rest can be revealed. Such action will build confidence and also show how difficult this process is. 

Also, we need to analyse what the best time to sell is, even for profit-making SOEs. What I mean is, today may be a good time to sell the SOE politically, but it may not be the best market to sell in.

One possibility is that we can move to form a Special Purpose Vehicle (SPV) that can take some of these profit-making SOEs together and then you privatise or sell the SPV. This could help to insulate from some of the risks present.

Do you think the Government’s attempt to contain inflation through the increase of policy rates is effective? 

The short answer is, yes, I think so. However, in the Sri Lankan context, how the mechanism works is complex. How I see it working in Sri Lanka is that our inflation, outside specific supply factors like a harvest going wrong, might be driven along by depreciation.

Arguably, more critical for Sri Lanka is that when interest rates are low and you have money going into the banking sector and the economy, you have the ability to borrow money, borrow rupees, and buy dollars for whatever import you need. That private sector credit route is critical given the depreciation in Sri Lanka. I think by having interest rates be higher, that route is essentially choked off. The high interest rates affect that. Part of the debt crisis is spending a lot on consumption; that is what led to the debt-driven consumption pattern.

Do you think the Government got the tax bracket on Personal Income Tax (PIT) right with the current tax policy? If not, why? 

I think there are different adjustments; be it the bracket being Rs. 40,000 instead of Rs. 50,000, small adjustments like that. I don’t think it will affect the overall macroeconomic story of the taxes.

I think a really low tax, for example 0.1% or 1% for everyone, be it rich or poor, may have helped to get more people into the tax net and into a culture of paying tax. It may not have a great economic benefit in the short term, but it will have a social benefit. That is a long-term approach.

This tax regime for the top 10-20%, it is painful; it’s tight and restrictive. My view is that people will struggle to adjust to that change. Mind you, they adjusted to changes before and their spending patterns adjusted along with that. However, with the current tax regime, though it may be painful, if you want Sri Lanka to be a production-driven economy and not a consumption-driven one or a debt-driven one, that pain is going to be part of that story. 

If Sri Lanka is really keen on moving towards an export-oriented economy, I think tight taxes are a part of the story and that may mean painful reductions in quality of life for the top 10-20%, but it cannot be avoided. It’s not possible to have the top 10-20% have their consumption continuing to push higher, if we want to move towards a production economy.

Earlier, more than 50% of the country’s expenditure was done by the top 10-20%. Given the scale of inflation we have suffered, I am sure that figure (50%) has worsened. Sri Lanka can’t afford to let that pattern continue. It also pushes depreciation, so even if you’re not paying for that (through a direct tax), there is a high chance you’re paying for it through other prices. 

Again, the Government can encourage people (to pay taxes) if it is transparent on State expenditure and justifies expenditure priorities. It helps with acceptance and compliance.

Do you think the policy rates should be brought down at the next monetary policy review?

I don’t see how reducing policy rates can help at this stage, because they are 14.5% or 15.5%, whereas Treasury bill rates are 25%. The problem is not the 14.5%, the problem is the 25%. That is partly inflation driven and partly fear of debt restructuring, so I don’t think that cutting policy rates helps those factors or brings them down in a sustainable way. I think that if you are going to bring rates down, liquidity injections, like the CBSL is likely doing, is a better option.