• Govt. needs to undertake several structural reforms within the year
• Sri Lanka must also focus on structural reforms to unlock growth
• Limited capacity and political space may affect speed of reforms
• SL governments in particular have very short-term policy orientation
• CB independence strengthens House oversight over public finances
• With independence comes need for greater transparency, accountability
• More independent central banks deliver and maintain lower inflation

The securing of the International Monetary Fund (IMF) facility is only the beginning of a long and tough journey to moving the country towards a more sustainable growth path, asserted public policy specialist and Advocata Institute Senior Research Fellow Dr. Roshan Perera, in an interview with The Sunday Morning.

“The focus of the IMF programme in the near term is on macroeconomic stability and debt sustainability. There are five main pillars of this programme and monitoring the progress of these objectives is based on strict quantitative targets. Apart from this, there are several structural reforms the Government needs to undertake within the year to ensure the programme stays on course,” she pointed out.

Furthermore, this programme, unlike the last 16 programmes, entails a debt restructuring exercise to ensure Sri Lanka’s debt is brought to a sustainable level, Dr. Perera noted, adding that this was a more onerous task as it required the cooperation of many stakeholders – both domestic and foreign. 

“Achieving all this requires the Government to work simultaneously on multiple fronts. Limited capacity and political space may affect the speed at which reforms are undertaken. But the bottom line is unless these macroeconomic and structural reforms are carried out, Sri Lanka will likely be going back to the IMF for the 18th time,” she warned.

Commenting on the proposed Central Bank Act, Dr. Perera, who is a former Director of the Central Bank of Sri Lanka (CBSL), said: “I think we need to take a step back and understand the rationale for Central Bank independence. Unless the macroeconomic and structural reforms are pushed through, Sri Lanka will find itself in a similar situation in a few years.”

Following are excerpts of the interview:

Now that the IMF facility has been secured, what are the next steps the Government should take to ensure Sri Lanka’s economic recovery?

This is only the beginning of a long and tough journey to moving the country towards a more sustainable growth path. 

The focus of the IMF programme in the near term is on macroeconomic stability and debt sustainability. There are five main pillars of this programme: advancing fiscal consolidation and strengthening institutions, restoring price stability and rebuilding external reserves buffers, public debt sustainability, ensuring financial stability, and reducing corruption vulnerabilities. 

Monitoring the progress of these objectives is based on strict quantitative targets (performance criteria) on the Government’s primary fiscal balance, credit to the Government, and the net official international reserves, as well as indicative targets on Government tax revenue, social spending, costing of non-commercial obligations for fuel and electricity, and Treasury guarantees.

Apart from this, there are several structural reforms the Government needs to undertake within the year to ensure the programme stays on course.  

To be completed by Q2 2023: 

• Parliamentary approval of welfare benefit payment scheme (enhanced social safety nets)
• Cabinet approval of a comprehensive strategy to restructure the balance sheets of key State-Owned Enterprises (SOEs)
• Parliamentary approval of new anti-corruption legislation
• Parliamentary approval of the new Central Banking Act

To be completed by Q3 and Q4 2023: 

• Revamping the VAT system by removing almost all product specific VAT exemptions
• Submitting the Public Financial Management (PFM) Law to Parliament
• Parliamentary approval for the full revision of the Banking Act

But in addition, this programme (unlike the last 16 programmes) entails a debt restructuring exercise to ensure Sri Lanka’s debt is brought to a sustainable level. This is a more onerous task as it requires the cooperation of many stakeholders – both domestic and foreign. 

While the IMF programme at this point focuses on macroeconomic stabilisation and debt sustainability, the country needs to focus in parallel on undertaking structural reforms to unlock growth. This includes improving the business environment and boosting productivity and fostering competition by removing bureaucratic barriers, trade reform, labour market reform, and land reform, among other structural reforms. 

Achieving all this requires the Government to work simultaneously on multiple fronts. Limited capacity and political space may affect the speed at which reforms are undertaken. But the bottom line is unless these macroeconomic and structural reforms are carried out, Sri Lanka will likely be going back to the IMF for the 18th time. 

Is the Government’s approach to the debt restructuring plan feasible in terms of meeting the April deadline set by the IMF?

The objectives of debt restructuring are to put Sri Lanka’s debt on a sustainable path and to restore market access for the country. The IMF programme hopes to achieve these overall objectives by:

• Reducing public debt below 95% of GDP by 2032 (public debt was 128.1% at end 2022)
• Reducing the Government’s annual Gross Financing Needs (GFN) to an average of 13% between 2027-2032 (the GFN of the Government was 34.5% in 2022) 
• Reducing the Government’s annual debt servicing in foreign currency to a maximum of 4.5% of GDP every year in 2027-’32 (the debt servicing in foreign currency was 9.6% of GDP in 2022). 

In order to achieve these targets, the Government needs to engage both domestic and external creditors to modify the terms of the existing debt contracts in terms of coupon adjustments, maturity extensions, and haircuts on the principal. 

The Government is expected to announce the coverage and parameters of both the external and domestic debt operations by end April 2023 and complete the Domestic Debt Optimisation (DDO) exercise by May 2023 and the external debt restructuring by September 2023. 

This appears to be an ambitious timeline given the experience of other countries that have undertaken a similar exercise. For instance, Ghana took around two months to come to an agreement with 85% of its domestic creditors. This excluded pension funds. 

In the case of banks, although it was a ‘voluntary’ exercise, they were ‘incentivised’ to participate in the Domestic Debt Exchange (DDE) by increasing the risk weight to 100% on old bonds as opposed to 0% on the newly-issued bonds and excluding non-participating banks from the Ghana Financial Stability Fund, which was set up to provide liquidity support.

In the case of Sri Lanka, the authorities announced that in the case of Treasury bills, of the Rs. 4.1 trillion outstanding, only Rs. 2.6 trillion ($ 7.1 billion) held by the Central Bank would be restructured. This accounts for more than 50% of the assets of the Central Bank, which will have implications for the liquidity and solvency of the Central Bank.

Of the total outstanding Treasury bonds of Rs. 8.7 trillion ($ 24 billion), superannuation funds hold around 43%. If they are excluded from DDO, the burden of restructuring will fall on banks that hold around 44.5% (Rs. 3.9 trillion) of the outstanding stock of Treasury bonds.

This will have implications for financial stability given that banks have already been affected by multiple shocks and the continuing contraction of the economy. This may require regulatory forbearance from the regulator on capital requirements, but is also an opportunity for consolidation within the financial sector. 

Hence, the extent of the domestic debt restructuring would depend on the extent of recapitalisation it would entail as well as the impact on financial stability [i]. Who bears a greater share of the restructuring cost will depend on the economic and financial costs of the different options.

Will the proposed Central Bank Act yield the expected results? Shouldn’t the focus be on preventing political interference over ensuring independence?

I think we need to take a step back and understand the rationale for Central Bank independence.

At the beginning I said that unless macroeconomic and structural reforms are pushed through, Sri Lanka will find itself in a similar situation in a few years. Ensuring these reforms are undertaken requires political commitment but also an independent bureaucracy that is able to make the right decisions and carry them out. This requires a stronger institutional framework for policymaking. 

Governments in general and in Sri Lanka in particular have very short-term policy orientation – they operate from one election cycle to the next. These policies may make the public happy in the short run, but they fail to deliver the long-term goals for the country. Adopting a rule-based policy framework as opposed to a discretionary policy framework is able to overcome this time inconsistency problem of policymaking.

In the case of a central bank, independence insulates monetary policy from short-term political considerations, which otherwise leads to boom-bust cycles and time-inconsistent policies. 

Central Bank independence refers to instrument independence, not goal independence. That is, while the goal of monetary policy (inflation target) is set together with the Government, the conduct of monetary policy should be free from Government control. In other words, the Central Bank should be able to use its instrument (interest rate) to achieve the goal that has been set by the Government (inflation target). 

However, since the Central Bank of Sri Lanka also undertakes agency functions for the Government such as debt management and managing the Employees’ Provident Fund (the largest provident fund in the country), there are likely to be conflicts with the primary objective of domestic price stability. Hence these functions need to be taken out of the CBSL if it is to focus on its primary mandate. 

One of the main obstacles to the Central Bank achieving its primary objective has been the monetisation of the Government’s deficit through the purchases of Government securities. In the proposed Central Bank Act, purchase of Government securities from the primary market is prohibited (Section 86). This is an essential element for the independence of the CBSL. 

Monetising the deficit allows governments free rein over the printing press without having to go to Parliament for approval. Giving the Central Bank independence in fact strengthens parliamentary oversight over public finances rather than diminishing it. 

However, with independence comes the need for greater transparency and accountability. “…If you’re independent, it’s vital that people can understand what you are doing. If you are independent and you tell the general public ‘It’s none of your business,’ independence will be taken away from you, sooner or later” – former Governor of Swedish Riksbank Stefan Ingves.

Greater independence requires greater parliamentary oversight. Many countries require the governor of the central bank to explain to parliament or a parliamentary committee the rationale behind every monetary policy decision. It also entails better communication with the general public on the policies undertaken. 

One of the main sources of independence is through the appointment of the governor and the members of the boards. Excluding the secretary of Finance from the Monetary Policy Board was to ensure monetary policy decisions were made independent of the Government. However, in the proposed bill, the minister in charge of Finance is responsible for a majority of appointments to the boards. This could dilute the independence of the institution.

The consequences of not achieving the set targets are not specified in the proposed bill other than requiring the Central Bank to explain to the minister in charge of Finance, and in some cases Parliament, the reasons for deviations from the target. 

This was a major failure of the Fiscal Management Responsibility Act. Despite continuous breaches of fiscal targets, no one was held responsible because there was no accountability mechanism built into the act.

Finally, the CBSL cannot achieve its objectives and overall macroeconomic stability will not be possible without fiscal discipline. Sri Lanka enacted a Fiscal Management Responsibility Act No.3 of 2003 (amended in 2013, 2016, 2021) with several fiscal rules, but enforcement was weak. Fiscal rules need to be integrated into government budgets and medium-term fiscal frameworks [ii]. Some countries have included correction mechanisms which specify a path to return to the fiscal rule following a deviation. It also requires better oversight by Parliament.

The proposed Budget Office in Parliament can play the role of an independent nonpartisan entity that can provide fiscal oversight by assessing fiscal plans, evaluating budget forecasts, costing Government budget proposals, and monitoring adherence to fiscal rules. But this entity must be given operational independence, have the technical capacity, and have access to timely information to carry out an independent analysis.

For a rules-based framework to work, it requires political commitment. But the overall benefits to the citizens of the country in terms of improving overall welfare are considerable. 

There is empirical evidence to support that more independent central banks deliver and maintain lower inflation compared to less independent central banks. Countries with less independent central banks tend to run higher budget deficits since monetary financing is easier politically compared to raising taxes and hence end up with higher public debt and economic crises. 

Footnotes

[i] Grigorian, David A., 2023. ‘Restructuring Domestic Sovereign Debt: An Analytical Illustration,’ IMF Working Paper 23/24, Washington, DC.

[ii] Study in 2021, ‘Fiscal Rules and Fiscal Councils Recent Trends and Performance During the Covid-19 Pandemic’ prepared by Hamid R. Davoodi, Alexandra Fotiou, Paul Elger, Daniel Garcia-Macia, Xuehui Han, Andresa Lagerborg, W. Raphael Lam, and Paulo Medas (IMF Working Paper WP/22/11)