Link to full report.
Key highlights:
1. Debt rollover risk is very high. Staff projects FX debt service to reach around US$7 billion in 2022, including the US$1 billion ISBs maturing in July 2022, against critically low gross reserves and the lack of market access.
2. Sri Lanka has started experiencing a debt and BoP crisis where sizable and persistent FX inflows are urgently needed to avoid depletion of gross reserves. The large uncertainties around how to close fiscal and BoP financing gaps—which would persist for years absent policy changes—render macroeconomic forecasting extremely challenging. The illustrative scenario below aims to describe the authorities’ current policies while making optimistic assumptions that the financing gaps are closed through asset sales and new—currently unidentified and uncertain—external financing from bilateral strategic partners at reasonable costs.
a. The primary deficit would decline to 2.8 percent of GDP in 2022 as envisaged in the Budget, despite substantial risks.
b. The current account deficit would narrow gradually over the medium-term, as tourism slowly recovers.
c. A severe debt overhang, heightened macro imbalances, prolonged FX shortages, and the cut in government capital spending would erode business and public confidence and deter investment, productivity growth, and confidence in the currency. Accordingly, growth would weaken to 2.6 percent in 2022—amid the lingering impact of the chemical fertilizer ban and supply shortages —and stay below potential (estimated in the range of 3.1-4.1 percent absent structural reforms, through 2026.
3. Risks around this scenario are clearly tilted to the downside. Should the unidentified external financing not be forthcoming, the country could experience a disorderly adjustment through severe import compression and potentially external arrears in the near-term. Relying on domestic sources to fill the fiscal financing gaps, as intended by the authorities, would either suffocate private credit growth or require further monetary financing of the fiscal deficit, which can undermine monetary stability. Confidence in the currency and the financial sector could erode under such a downside scenario, leading to an even worse macroeconomic outcome, severely affecting life and livelihood of many segments of the population, and risking intensifying social discontent.
4. The authorities have presented plans to tackle the crisis but these are unlikely to put the economy back on a stable and sustainable path. The authorities are following a 6-month Roadmap announced by the CBSL in October 2021, which aims to address near-term FX shortages by raising new financing from government-to-government loans and currency swaps with foreign central banks, expediting state asset sales, and tightening export surrender requirements. In this regard, new bilateral support by India totaling US$1.4 billion, comprising a central bank currency swap, a credit line for fuel imports, and deferment of clearing Sri Lanka’s balance at the Asian Clearing Union, has recently been secured. However, even if these inflows could provide some breathing space in the short term, it remains unclear how the large FX debt service obligations this year and beyond can be met.
5. To avert a full-fledged BoP and debt crisis, there is an urgent need for implementing a credible and coherent strategy to restore fiscal and debt sustainability and regain macroeconomic stability, covering both the near and medium term. Staff recommends a comprehensive set of policies with specific measures, comprising:
a. Implementing revenue-based fiscal consolidation and tightening monetary policy; moving away from an unsustainable de-facto exchange rate peg and restoring a market-determined exchange rate, while containing the risk of disorderly exchange rate movements; and mitigating adverse impacts of the macroeconomic adjustments on vulnerable groups by strengthening social safety nets. Institution building reforms, such as revamping the fiscal rule, would help ensure the credibility of the strategy
b. Developing a comprehensive strategy to restore debt sustainability. The development of such a strategy is the prerogative of the authorities, and the Fund always advises members to stay current on their debt obligations to the extent possible. This said, in staff’s view, fiscal consolidation and macroeconomic policy adjustments alone cannot restore Sri Lanka’s debt sustainability.
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