Sri Lanka's crisis will get worse, contingency planning for relief must start now

The country faces two crises - an economic crisis and a political crisis.

The government has lost its public legitimacy but the country’s system of presidentialism makes power sharing with opposition parties difficult resulting in a deadlock. Political dysfunction will delay a coherent response to the economic crisis. Structural reform is complicated by the many vested interests. Many politicians view reforms as a threat to their wealth and ambitions.

High food inflation, currency depreciation, production shortfalls and a collapsing economy mean many poor Sri Lankans face hunger. Higher global pries have made the problem acute. With the public finances in disarray there is limited scope for state assistance. The distribution of relief is hamstrung by the absence of a social registry. To avert a humanitarian crisis the country should work with the UN to structure a relief programme that can deliver basic necessities to people. Humanitarian aid for Sri Lanka will not solve the country’s fundamental problems, will help mitigate the impact on the poorest.

The Office for the Coordination of Humanitarian Affairs (OCHA) of the UN Secretariat is responsible for coordinating responses to emergencies. It does this through the Inter-Agency Standing Committee, whose members include the UN system entities most responsible for providing emergency relief.

Sri Lanka may be heading to what the OCHA calls a “slow-onset emergency” one that does not emerge from a single event but one that emerges gradually over time. In parallel to the work on the economy the Government should start talks with the OCHA to conduct a proper needs assessment to gauge the extent of the problem and to design a contingency plan that can be activated if the situation worsens.

The people are already suffering, a responsible government should be trying to prevent matters from getting any worse.

SRI LANKA IMF ARTICLE IV CONSULTATION MARCH 2022- HIGHLIGHTS

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.

Macro economic stabilisation

I noticed that this has become the subject of discussion so it thought it would be worth explaining what this entails.

In an open economy (ie one that has some degree of trade with the outside world), we can summarise the desirable economic goals as being the attainment of internal and external balance. Internal balance means a steady growth of the domestic economy consistent with a low unemployment rate. External balance is the achievement of a desired trade balance or desired international capital flows.

We assume that macroeconomic equilibrium requires equilibrium in three major sectors of the economy:

 • Goods market equilibrium. The quantity of goods and services supplied is equal to the quantity demanded. 

 • Money market equilibrium. The quantity of money supplied is equal to the quantity demanded. 

 • Balance of payments equilibrium. The current account deficit is equal to the capital account surplus, so that the official settlements definition of the balance of payments equals zero. 

These are all at the aggregate level. Production, Prices and the Balance of Payments are the three variables. Any fundamental imbalances will eventually be visible in these. If we witness volatility in exchange rates, inflation, interest rates or widespread shortages of goods these are all usually indicative of imbalances.

Keynes’s contribution to economic theory has been the central role he assigned to fiscal policy in stabilising output. Within the Keynesian framework, the fiscal deficit or a surplus is the most important balancing factor in the economy. This determines the levels of aggregate demand, income, prices, and eventually, in an open economy, of the balance of payments. 

The means by which a budget deficit is financed, whether by borrowing, taxes or money printing (Central Bank credit) will determine the way in which this impacts the economy.

Fiscal deficits can cause fluctuations in inflation, interest rates (through increased levels of government borrowing) and exchange rates (thorough the current account deficit). Higher public debt which accumulates due to persistent deficits may create uncertainty around future tax policy. In addition to crowding out, fluctuations in these key macroeconomic variables increases economic uncertainty causing businesses and individuals to defer investment decisions.

The connection between fiscal and current accounts deficits is sometimes obscure. The Keynesian view is that a rise in the budget deficit will increase domestic absorption via import expansion, causing a current account deficit. This view seems supported by empirical evidence for Sri Lanka; for example Saleh, Nair & Agalewatte (2005), Chowdhury and Saleh (2008). Perera and Liyanage (2011) find empirical evidence for long run relationships between twin deficits in Sri Lanka¹.

To explain the connection between the budget deficit and the balance of payments in simple terms see the figures below. Between 2019-2022 the government recruited an additional 250,000 people. Payments increased as follows:

                    2019        2020

Salaries from 686bn      794bn (up 108bn)

Pensions       228bn       258bn (up 30bn)

Subsidies      551bn        717bn 

In addition, public investment up from 631bn to 811bn.

What would these people have done with their salaries? They would have spent a proportion (the marginal propensity to consume or MPC) and saved some. Of what was spent, some would be on local goods, some of it on imported goods. Even some of the local goods (for example local biscuits) would include imported inputs - from the board/plastic used in the packaging to the wheat and sugar in the ingredients. The marginal propensity to import is as important a determinant of the results of a fiscal expansion as the MPC. This is how the budget deficit connects to the current account deficit. This phenomenon is sometimes termed the twin deficit hypothesis. Pay more salaries = larger deficit, cut taxes = larger deficit; do both and deficit becomes very large. Current account deficit follows suite.

Sri Lanka's ongoing crisis bears all the hallmarks of a serious disequilibrium, addressing this means revisiting the causes; closing the deficit and controlling the money supply. This causes a sharp contraction in the economy and hardship on the population which needs to be managed as far as possible, foreign grants and assistance in the form of food and humanitarian supplies would be one option for example.

The alternative to painful stabilisation is to continue to proceed on this path until it ends in a meltdown. 

1Staff StudieS Central Bank of Sri lanka (2011) [online] Available at: https://www.cbsl.gov.lk/sites/default/files/cbslweb_documents/statistics/otherpub/StaffStudies_Vol_41_2011-min.pdf [Accessed 14 Jan. 2022].

  

Elephants and Poya thoughts

It is the Navam Full Moon Poya Day today. I saw decorated elephants walking around the park yesterday, in preparation for the ‘Pereheras’ today. Elephants in Yala have also been in the news, jeep drivers have been feeding wild elephants in the park and the elephants have turned aggressive during 'musth'. These are but signs of the times but since elephants are newsworthy I found this old news report rather amusing:

On May 28, 1873 the New York Times published an article called “White Elephants”

that starts with the following paragraph

When a Siamese despot takes a grudge against one of his poorer subjects,

and determines on his ruin, he does not cut off the delinquent’s head and

confiscate his property. On the contrary, he makes him a present – he sends

him the handsomest and healthiest white elephant he can find. The luckless

recipient knows at once that his fate is sealed. He knows that the beast

will eat him out of house and home without the possibility, on his part, of

resistance. He cannot sell or give away the fatal gift, for no one would accept

it, and the attempt to get rid of it even would be direct treason and sacrilege.

He sits down with Oriental resignation to submit to the inevitable, and the

white elephant devours his substance.

On the LLRC Report

This is something that I stumbled across while cleaning out some old folders. It was written sometime in 2012 when the LLRC report was first published. 

The Jathika Hela Urumaya, a partner of the Government has criticised the Lessons Learned and Reconciliation Committee report, for, amongst other things, exceeding their mandate. While this writer has little sympathy in general with the positions of the JHU it is necessary in this instance to admit that they do have a point. To reproduce the rather vague mandate of the LLRC :

• To inquire and report on the following matters that may have taken place during the period between 21st February, 2002 and 19th May, 2009, namely ;
• The facts and circumstances which led to the failure of the ceasefire agreement operationalized on 21st February, 2002 and the sequence of events that followed thereafter up to the 19th of May, 2009.
• Whether any person, group or institution directly or indirectly bear responsibility in this regard;
• The lessons we would learn from those events and their attendant concern, in order to ensure that there will be no recurrence;
• The methodology whereby restitution to any person affected by those events or their dependants or their heirs, can be affected;
• The institutional administrative and legislative measured which need to be taken in order or prevent any recurrence of such concerns in the future, and to promote further national unity and the reconciliation among all communities, and to make any such other recommendations with reference to any of the matters that have been inquired into under the terms of the Warrant.

The Commission's mandate is restricted primarily to inquiring into the reasons for the failure of the ceasefire, who was responsible and what lessons can be learned. There is a small catch-all clause at the end: to recommend measures to promote national unity and any other recommendations with reference to the matters that have been inquired into.

Into this relatively minor clause the commission has stuffed a lot of recommendations, indeed almost everything of value in the report falls under this category, hence the JHU's annoyance that the commission has missed its primary purpose.

What exactly was that purpose? Was it really to learn lessons on the failure of a ceasefire?

To begin with, it took the Government a whole year after the end of the conflict to decide that it was necessary to set up a commission to inquire into the causes of the failure of the ceasefire, by then a largely irrelevant matter. Commissions of inquiry take many months to do their work (the report was published two and a half years after the end of the fighting) so if they were serious about learning lessons what took them so long to appoint the commission?

Critics have claimed that the commission was purely set up to forestall an international inquiry and its timing, a month before the formation of the UN Secretary General's Panel of Experts supports this view. Thus we have a commission that was set up to defer an international inquiry (which it did not) given a vague mandate to inquire into a matter that was largely irrelevant. If the Government does not appear to be serious about the commission, should anyone else be?

It is a difficult question. The commission heard a lot of useful testimony which they have reproduced at length. It can provide a useful starting point for some discussions on matters post-war, which seems to be the consensus amongst the Government's critics. What then of the Government's position?

We have seen plenty of pictures of the President reading the report at leisure, dressed in a sarong and seated in a planters chair, but we are yet to hear if the Government is pleased or displeased and what, if any, recommendations they intend implementing. The report was released two months ago and while various parties including foreign Government's have stated their positions the official view on the report can only be guessed at.

The official news website of the Government carries a detailed road map of Monetary and Fiscal Policies for 2012 and beyond, there is clearly pressure on the finances but nothing on the LLRC. The Defence Secretary warned last week, at some length, that the country is surrounded by enemies, within and without. Some lessons it appears, are yet to be learned.

Some thoughts on public finance and debt

 Sri Lanka is now entering the jaws of a debt crisis. The issues were present for decades but started to crystallise over the past two years. Sri Lanka’s debt rating was downgraded several times and commentators warned of the problem but all these were brushed off. Now that some of the symptoms are becoming evident the debate is hotting up. The problem is not easy to grasp, how should we think about this?

The simplest way to think about public debt is to consider it as postponed taxation. The Government wants to spend money but instead of raising this money through taxes it borrows the money. Raising taxes is politically challenging, citizens will start to ask questions as to why taxes are being raised. After some time if the benefits that were promised when taxes were raised are not visible further questions can arise.

Those in power, especially those who court public popularity are tempted to look for simpler ways to fund spending. Debt is an attractive solution – we can spend now and worry about repayment later. For the public, few questions arise when borrowing takes place – they feel no immediate impact from this exercise and depending on how the money is spent, may even see some benefit from it.

What happens when the debt has to be repaid? As long as a Government maintains its credibility with financial institutions it is always possible to roll it over. Governments can then opt to raise new debt to repay the old debt. The public still feels no impact, the good times continue, the Government keeps spending and no one is worried. 

As the debt accumulates, so does the interest on the debt so Governments borrow again, not only to repay the principal amounts due but also the interest. Things keep snowballing and everybody; Governments and citizens remain blissfully unconcerned until a point is reached when the debt levels get to a stage where the lenders start to worry about getting repaid. When that happens, the party stops and citizens awaken to a rude shock.

When lenders stop refinancing a Government’s debt it is then confronted with the problem it has postponed and may even have forgotten – how to repay the debt. Recall that debt is postponed taxation.

The Government should have been raising taxes over the years to repay the debt it was taking but for convenience it chose not to. After years, even decades of indulgence it is now forced to confront the problem repaying everything within a short space of time.

Government revenue that should have been raised over many years or decades must now be raised within a few years. This is the austerity that accompanies a debt crisis. Governments must cut expenditure or raise taxes sharply. Had this been done over the long periods that the debt was accumulating there would be far less pressure, but when it has to be raised within a short period of time it creates a huge shock.

It is important to note that while the debt crisis is single debilitating event, the problems are those that have accumulated over a long time. None of this is recalled when the crisis breaks, the public eye is focused only on the aftermath, not the causes.

In a crisis countries call on the IMF to help. The benefit of having the IMF is that by underwriting a Government’s plans it lends credibility to the restructuring. Recall that the reason the Government is confronted with a debt crisis in the first place is because the lenders have lost confidence in the Government and refuse to lend it any more. Thus the IMF becomes necessary for an orderly restructuring process.

Depending on how bad the situation is the IMF can also lend money to the Government, these funds can help the Government tide over the immediate problem and reduce the pain of the adjustment. The IMF money provides a cushion which allows a longer period over which expenditure can be cut and/or taxes raised. 

People tend to associate the IMF with the austerity measures that become necessary when the debt problem crystallises and they are blamed for the problems. The fact is even without the IMF the Government would still be faced with the same problem of raising taxes or cutting expenditure.

This, in a nutshell is the problem that Sri Lanka faces. The country has borrowed to meet its recurrent expenditure (including interest payments) as well as infrastructure. The infrastructure projects have not yielded an adequate enough return to finance the debts, which is why it becomes a burden on the taxpayer. 

Now that the crisis is breaking there is little that can be done except manage it sensibly with a view to minimising the damage. Postponing the problem will only make it worse.

More importantly, what can be done to prevent it from recurring? Following the crisis of 2008 the EU put a framework for economic governance consisting of three pillars; monitoring, prevention, correction.       

“The European Union’s economic governance framework aims to monitor, prevent, and correct problematic economic trends that could weaken national economies or negatively affect other EU countries.”

The key areas that need to be monitored are the budget deficit and the means by which it is financed – either debt or money creation by the Central Bank. 

In the EU the monitoring of member states public finances is done by the European Commission, the preventive measures are found in the Stability and Growth Pact (which sets budget targets) and the corrective mechanism is the Excessive Budget Procedure/Excessive Imbalance Procedure. The EBT requires member states that run excessive budget deficits of more than 3% of GDP, or which fail to reduce their excessive debts (above 60% of GDP) at a sufficient pace to follow a particular set of rules to correct the problems.

Oversight

For Sri Lanka the monitoring would need to be done by Parliament and its oversight committees, the Committee on Public Accounts (COPA) and the Committee on Public Enterprises (COPE). The scrutiny of finances is carried out by the Auditor General (AG). These key bodies need to be independent and competent. Both suffer from a lack of capacity which needs to be addressed separately from the institutional reforms. The mandate of the AG should be modeled on the National Audit Office of the UK.

Sri Lanka requires rules to control

a) the budget deficit,

b) levels of debt,

c) money creation by the Central Bank.

The foundation for (a) is available in the Fiscal Responsibility Act of 2002. This needs to be strengthened along with the adoption of Medium Term Expenditure Frameworks for spending (the EU works with Medium Term Budget objectives). These would replace the annual budget process. Some amendments to the Central Bank Act and operating procedures will be required.

The social consequences of an economic crisis.

How does an economic crisis affect ordinary people? It is a difficult question to answer because it depends on many variables including the strength of the financial sector and the state of public finances. While it is difficult to draw exact parallels from other crises because initial conditions may have been different examining some of the broader channels through which a crisis me be transmitted is useful. An ADB paper on the Asian Financial crisis identifies five main channels of transmission; prices, labour markets, assets, credit and the government budget.

The initial blow tends to be on the currency and the sudden depreciation of the currency leads to price increases in imported goods or those locally produced that carry high import content although the degree of price inflation depends partly on the level of government intervention.

This disrupts trade and investment and leads to contraction of GDP, which translates to a lower demand for labour leading to increased unemployment and under employment. "Reduced demand for labor is reflected in business failures or retrenchment, wage cuts, shorter work hours, or fewer employee benefits."

"Besides reduced employment earnings, many households bear the loss of lifetime savings due to banking failures or of asset values owing to the collapse of stock and real estate markets. Diminished collateral for loans and high interest rates constrict access to credit for investment or consumption. This then forces household to resort to the informal credit market that imposes punitive interest rates".

Inflation also eats away the real value of savings, as the quantity of goods that a given sum of money can acquire diminishes.

The downturn also leads to lower government revenues while a good deal of public expenditure has to be devoted to restructuring financial institutions and debt servicing. "Normally efforts are made to maintain previous spending levels in such basic social services as education and health, but lower real spending in these areas is often inevitable".

Increases in poverty, malnutrition and hunger are possible. A paper by M Ramesh (on the impacts of the Asian Financial crisis) notes: 

"In Indonesia, underemployment rose from around one-third of the labor force in 1996 to around one-half in 1998. In Thailand, underemployment rose from 1.7% in 1998 to 3.6% in 1999" 

"The effects of the crisis were aggravated by increases in consumer prices, especially food prices. Indonesia was most affected, with food prices rising by 81% in 1998 and by 25% in the following year . In Malaysia and Thailand, food prices increased by 9% and 10% respectively in 1998, although there was little increase the following year. "

"The economic slowdown and increased unemployment were accompanied by increased poverty. Based on national poverty lines (which vary considerably in terms of how they are calculated and, hence, must be treated with care), between 1996 and 1998, the poverty rate nearly doubled in Indonesia (from 11.3 to 20.3%) and South Korea (from 9.6 to 19.2%; World Bank, 2000: 116). The increase was less dramatic in Malaysia (from 8.2 to 10.4%) and Thailand (from 11.4 to 12.9%) over the same period, but still significant."

Analysts and rating agencies have warned that a crisis may be approaching; a useful panel discussion on this is available here. It is not something that should be dismissed lightly.