Budget deficits and fiscal consolidation
IMF Staff recommends that, at a minimum, fiscal consolidation should achieve a primary balance of zero by 2024. The authorities’ objective of reaching a primary surplus by 2025 is close to this minimum path. Staff and the authorities agreed that fiscal consolidation should be primarily revenue based—Sri Lanka’s tax-to-GDP ratio is among the lowest in the world.
Commentary on Tax Holidays, Para-tariffs, and Budget 2022
Generous corporate and personal income tax (CIT and PIT) exemptions eroded the effectiveness of the 2017 Inland Revenue Act (IRA) and the widespread use of project-based tax holidays, the effectiveness of which remains questionable, has led to large revenue losses. The multitude of indirect taxes renders the tax system unpredictable and complex, while high para-tariffs hinder competitiveness and growth. The main tax measures of the 2022 Budget were undesirable: retroactive income taxes on the past taxable income undermine tax certainty, and turnover taxes are less efficient than the VAT due to a cascading of the tax burden along the supply chain.
Recommended Tax Reforms
The needed revenues should be mobilized from Corporate Income Tax, Personal Income Tax, and VAT, by raising rates, minimizing exemptions, and reinstating mandatory withholding requirements under the Inland Revenue Act.
Public Expenditure Management
Given limited fiscal space and the need for higher social safety net spending, some scaling-back of non-priority expenditure may be needed, accompanied by greater spending efficiency. An overarching strategy for managing the public wage bill is needed to reverse the recent increasing trend. Expenditure rationalization, however, is no substitute for revenue mobilization, given that Sri Lanka’s non-interest recurring expenditures are not out of line with its peers.
Commentary on Deficit Financing (Money Printing)
The CBSL should phase out its direct financing of budget deficits. Further monetary financing would aggravate inflation risks—staff’s analysis based on a battery of empirical results suggests that price increases are expected to catch up with money expansion over time in Sri Lanka. The CBSL’s plan and some initial steps taken to gradually unwind its large T-bill holdings are welcome and critical for fulfilling its price stability mandate. In doing so, the CBSL should coordinate with the MoF on a well-sequenced and time-bound exit strategy and clearly communicate that monetary budget financing should remain an extraordinary last-resort measure.
Fuel and Electricity Pricing
Automatic fuel and electricity pricing mechanisms should be adopted, under which retail prices are periodically adjusted in line with cost-recovery levels. This would pass changes in input costs through to consumers and eliminate energy subsidies which disproportionately benefit the rich rather than the poor. If energy subsidies are not eliminated, then they should be transparently remunerated through the budget within targeted fiscal deficits. Finally, an overarching strategy is needed to address high SOE debt and growing currency mismatches on energy SOEs’ balance sheets.
Recommendations on Interest Rates
With both headline and core inflation rapidly rising, the real policy interest rate (interest rate minus inflation) remains negative and well below its historical average of 21⁄2 percent per annum (over the past decade), suggesting a still highly accommodative stance. Near-term monetary policy tightening is thus warranted to ensure that the recent breach of the 4–6 percent inflation target band is only temporary.
Exchange Rate Management
To help rebalance supply and demand in the FX markets, moral suasion used to dissuade exchange rate movements should be phased out to allow the exchange rate to adjust to market conditions, as exercised before April 2021.
IMF assessment of Sri Lanka’s medium term GDP growth potential
Exogenous factors such as natural disasters, the 2018 political crisis, and the 2019 terrorist attack have not only caused large output losses for current periods but also may have left a long-lasting impact on growth potential by impeding factor accumulation and productivity growth. Sri Lanka’s medium-term growth potential is estimated to be around 3.1–4.1 percent at this juncture.
IMF views on Sri Lanka’s debt sustainability
In IMF staff’s view, Sri Lanka’s debt is unsustainable. Based on staff analysis, fiscal consolidation necessary to bring debt down to safe levels would require excessive adjustment over the coming years, pointing to a clear solvency problem. Rollover risk is very high. FX debt service needs of US$7 billion each year will require access to very large amounts of external financing at concessional rates and long maturities, sustained over many years.
Recommendations on Import Restrictions
Import of certain non-priority goods was suspended over 2020–21, and this is expected to have reduced the import bill by 2.4 percent of GDP, but such measures are detrimental to economic activity and the authorities should develop a schedule for them to be phased out. While the 2020 import restrictions focused on consumption goods, the majority of the 2021 restrictions fell on intermediate and capital goods, affecting agriculture, transport, and IT sectors.
Banking Sector Stability
Banks and Finance Companies appear to have preserved capital, profitability, and liquidity against the backdrop of healthy corporate earnings, with reported Non-Performing Loan (NPL) ratios relatively stable. Although the loan repayment moratoria and relaxed prudential requirements complicate the assessment of banks’ underlying asset quality, the share of loans under repayment moratoria has steadily declined from around 25 percent of total loans in mid-2020 to around 9 percent in August 2021, with banks actively working with their borrowers to restructure loans as needed.
Comments on Port City
The Colombo Port City project brings about an important opportunity for investment promotion and for testing growth-enhancing structural reforms. To maximize its benefits while minimizing associated risks, there is a need to ring-fence tax concessions, ensure compliance with international tax and AML/CFT (Anti Money Laundering and Countering Terrorist Financing) standards, and shield the domestic financial sector from offshore banking activities in the Port City.
The IMF Article IV consultation took place in mid-December 2021 and the report of the IMF staff assessment was published on March 25th 2022. Accordingly, some of the policy recommendations alluded to at the time of the Article IV consultation (for example interest rate increases and allowing gradual exchange rate adjustment) are already being implemented.