IMF report on Sri Lanka released

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Washington, DC – February 25, 2022: The Executive Board of the International Monetary Fund (IMF) has completed Article IV consultations1 with Sri Lanka.

Sri Lanka has been hit hard by COVID-19. On the eve of the pandemic, the country was highly vulnerable to external shocks due to inadequate external buffers and high risks to public debt sustainability, exacerbated by the Easter Sunday terrorist attacks in 2019 and major policy changes, including major tax cuts in late 2019.

Real GDP contracted by 3.6 percent in 2020 due to a loss of tourism revenue and necessary lockdown measures. Sri Lanka lost access to the international government bond market at the outbreak of the pandemic.

Authorities have taken a swift and wide-ranging set of emergency measures to address the impact of the pandemic, including macroeconomic policy stimulus, an increase in social safety net spending and loan repayment moratoriums for affected businesses. These measures were supplemented by a strong vaccination drive.

GDP growth is expected to have recovered to 3.6 percent by 2021, with mobility indicators largely back to pre-pandemic levels and tourist numbers starting to recover by the end of 2021.

Nevertheless, annual budget deficits exceeded 10 percent of GDP in 2020 and 2021, reflecting pre-pandemic tax cuts, weak revenue performance in the wake of the pandemic and spending measures to fight the pandemic. The limited availability of external financing to the government has led to much of the direct financing of the budget by the central bank.

Public debt is expected to have increased from 94 percent of GDP in 2019 to 119 percent of GDP in 2021. Large foreign exchange payments by the government and a larger current account deficit have led to a significant currency shortage in the economy.

The official exchange rate has been effectively pegged to the US dollar since April 2021.

The economic outlook is constrained by Sri Lanka’s indebtedness and continued large financing needs in the areas of finance and balance of payments. GDP growth is expected to be negatively impacted by the impact of the currency deficit and macroeconomic imbalances on economic activity and business confidence.

Inflation recently accelerated to 14 percent (y/y) in January 2022 and is expected to remain at double digits in the coming quarters, exceeding the target range of 4 to 6 percent as both supply and demand On the demand side, strong inflationary pressures have emerged since mid-2021. Under current policies and the authorities’ commitment to maintain tax cuts, the budget deficit is expected to remain large in the 2022-26 period, leading to a further increase in public debt in the medium term. Due to the continued burden of external debt service, international reserves would remain inadequate, despite the authorities’ continued efforts to secure foreign exchange financing from external sources.

The outlook is subject to significant uncertainties with downside risks. Unless finance and balance of payments financing needs are met, the country could face significant contraction in imports and private credit growth, or monetary instability in the event of further central bank financing of budget deficits. Additional downside risks include a resurgence of COVID-19, rising commodity prices, worse-than-expected agricultural production, a possible deterioration in bank asset quality and extreme weather events. Upside risks include a faster-than-expected tourism recovery and stronger-than-expected inflows of FDI.

Assessment Board of Directors

The Executive Directors praised the Sri Lankan authorities for the rapid policy response and successful vaccination campaign, which have cushioned the impact of the pandemic. Despite the ongoing economic recovery, administrators noted that the country faces mounting challenges, including public debt that has risen to unsustainable levels, low international reserves and continued high financing needs in the coming years.

Against this background, they emphasized the urgency of implementing a credible and coherent strategy to restore macroeconomic stability and debt sustainability, while protecting vulnerable groups and reducing poverty through reinforced, targeted social safety nets .

The directors stressed the need for ambitious fiscal consolidation based on high-quality revenue measures. They noted that Sri Lanka’s low tax-to-GDP ratio has scope for increasing income tax and VAT rates and minimizing exemptions, complemented by tax administration reform.

The Directors encouraged continuous improvements in expenditure rationalization, budget formulation and implementation and budget rule. They also encouraged authorities to reform state-owned enterprises and introduce cost-effective energy pricing.

Directors agreed that a tighter monetary policy stance is needed to contain mounting inflationary pressures while eliminating direct financing of budget deficits by the central bank. They also recommended a gradual return to a market-driven and flexible exchange rate to facilitate external adjustments and rebuild international reserves. The directors called on the authorities to phase out capital flow management measures if conditions permit.

Directors welcomed the policies that have helped mitigate the impact of the pandemic on the financial sector. Given the financial stability risks posed by the sovereign debt overhang and the nexus between state-owned banks, they recommended closely monitoring the quality of the underlying assets and identifying vulnerabilities through stress testing.

The directors welcomed the ongoing legislative reforms to strengthen the regulatory, supervisory and resolution frameworks.

The directors called for renewed efforts towards growth-enhancing structural reforms. They stressed the importance of increasing women’s employment and reducing youth unemployment.

Further efforts are needed to diversify the economy, phase out import restrictions and improve the business and investment environment in general. The directors also called for prudent management of the Colombo Port City project and continued efforts to strengthen governance and fight corruption. They noted the country’s vulnerability to climate change and welcomed efforts to increase resilience.

Read: IMF full report on Sri Lanka

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