Sri Lanka Brief Update: IMF Bail Out – Conditions and Expectations

1. The IMF’s transparency policy allows for the deletion of market-sensitive information and premature disclosure of the authorities’ policy intentions in published staff reports and other documents. IMF Country Report on Sri Lanka No. 2023/116. – 01 

2. Between 1965 and 2019 Sri Lanka has signed 16 agreements with the International Monetary Fund (IMF), out of which seven were terminated without completing. On March 20 the IMF Board approved a 48-month extended arrangement under the Extended Fund Facility (EFF) of SDR 2.286 billion (about US$3 billion) to support Sri Lanka’s economic policies and reforms. IMF report

3. The objectives of the EFF-supported program are to restore macroeconomic stability and debt sustainability, safeguarding financial stability, and stepping up structural reforms to unlock Sri Lanka’s growth potential. All program measures are mindful of the need to protect the most vulnerable and improving governance. Close collaboration between Sri Lanka and all its creditors will be critical to expedite a debt treatment that will restore debt sustainability consistent with program parameters. IMF Country Report on Sri Lanka No. 2023/116. – Pg 01

4. Risks to program implementation are exceptionally high, given the complex debt restructuring process, unfavorable external environment, elevated risks of persistently high inflation, and challenging political and social situation. Given Sri Lanka’s weak track record of reform implementation, the program runs significant risks of slippages regarding fiscal consolidation, revenue mobilization, and reserves build up.  – ibid Pg 2

5. Real GDP is projected to contract by 8.7 percent in 2022 and 3 percent in 2023, before a moderate expansion by 1.5 percent in 2024 and gradual convergence towards the growth potential of around 3 percent over the medium term. ibid Pg 09

6. Large uncertainty and downside risks remain. Downside risks should be mitigated by restoring confidence and macroeconomic stability, addressing key corruption vulnerabilities, and Sri Lanka: Cross-country Comparison of Real GDP Growthboosting potential growth through structural reforms. Contingency planning for additional policy actions is also critical.

External risks associated with intensification of regional conflicts, supply disruptions, and renewed surge in global commodity prices could induce further exchange rate depreciation and runaway inflation. A global growth slowdown, further exacerbated by systemic financial vulnerabilities, could weigh on exports and the recovery.

Domestic risks could arise from renewed social unrest and political instability triggered by public dissatisfaction arising from reform fatigue and alleged corruption. Sri Lanka’s weak track record for reform poses an additional risk. Given elevated upside inflationary pressure, the risk of persistently high inflation is significant. – ibid Pg 10

7. The program aims to strengthen the social safety nets (SSN) to help cushion the impact of the economic crisis on the poor and vulnerable. The ambitious fiscal consolidation should protect SSN spending. In addition, Sri Lanka’s SSN programs have suffered from poor adequacy, coverage, and targeting. A World Bank study found that, in 2019, only 13 SVAT is a parallel system for exporters and other firms whose sales are mostly VAT exempt to avoid paying VAT on their inputs, adding complexity to the VAT system. 38 percent of the poorest income quintile received targeted cash transfers under the Samurdhi program, while 12 percent of the richest income quintile received the transfers. – ibid Pg 13

8. As the market regains confidence, the authorities will need to refrain from market intervention and allow exchange rates to adjust freely to changing fundamentals with due regard to potential disorderly market conditions and adverse balance sheet effects. ibid Pg 23

9. The poverty rate is estimated to have doubled and inequalities have widened over the past two years. Based on the $3.65 per day poverty line, which is the international threshold for lower middle-income countries, the World Bank estimated that poverty increased from the pre-pandemic rate of 11.3 percent to 25.6 percent in 2022 (World Bank, 2022). Moreover, existing inequalities have widened, as the World Bank report shows that consumption in 2022 would have declined by 9.5 percent among the bottom 40 percent of the population, compared to a decline of 7.1 percent for the top 60 percent. The Gini index is projected to increase from 37.7 in 2019 to 39.9 in 2022 (World Bank, 2022). ibid Pg 73

10. Beyond the energy pricing reforms, SOE reforms will include: (i) Cabinet approval of a comprehensive strategy to restructure the balance sheets of the CPC, CEB, the Road Development Authority, and Sri Lankan Airlines by June 2023 (structural benchmark); (ii) prompt publication of audited financial statements for all 52 major SOEs. – ibid Pg 16.

11. To restore price stability and limit fiscal dominance in the future, the new CBA will prohibit monetary financing. Specifically, the CBSL will be prohibited from (i) purchasing securities issued by the government or any other public entity in the primary market, and (ii) directly or indirectly granting credits to the government or any public entities. ibid Pg 81

12. Strengthening Sri Lanka’s governance and anti-corruption framework is crucial to restore and sustain long-run economic, social, and political stability. Given governance weaknesses in several state functions and a high level of corruption, a reform agenda should be developed to combat corruption.

The new anti-corruption law is currently being reviewed by a government review committee before submission to the Parliament; it is expected to be enacted by June 2023. The draft law provides for:

(i) the creation of an anti-corruption commission vested with the authority to initiate investigations on its own accord; (ii) asset declaration requirements for public officers in accordance with the G-20 High-Level Principles on asset disclosure by public officials, including coverage of officials and reporting standards; (iii) a strengthened conflict of interest system that clearly establishes standards and procedures to avoid private influence on public decisions; (iv) the creation of a centralized system to receive, manage, verify asset and conflict declarations; and (v) dissemination of asset declarations to the public.-  ibid Pg 83

13. IMF’s Governance Diagnostic (GD) mission will provide a comprehensive assessment of Sri Lanka’s governance weaknesses and corruption vulnerabilities.

• Objective. At the request from the authorities, GD will examine the severity of corruption in Sri Lanka and identify key governance weaknesses and corruption vulnerabilities that are macroeconomically critical. It will also assess the adequacy of the anti-corruption framework and policies given the nature of corruption vulnerabilities and international commitments. GD does not aim to identify corrupt institutions, individuals, or transactions. ibid Pg 82

14. To ensure full compliance with United Nations Convention against Corruption (UNCAC), the authorities plan to introduce an additional bill by March 2024 that covers comprehensive asset recovery provisions with technical assistance from the IMF. Asset recovery provisions, as required by UNCAC, include measures to identify, trace, freeze return and dispose foreign assets upon conviction. Moreover, the new anti-corruption law should clearly delineate a transparent and merit-based process for the selection of independent commission members as required by UNCAC. – Ibid Pg 83

15. The authorities’ capacity to implement an ambitious fiscal adjustment and wide-ranging structural reforms will be tested against reform fatigue and already high social discontent. –ibid Pg 33

Next Update: IMF Bail Out- Challenges, Loopholes and Weaknesses