by Sanath Nanayakkare
The majority of external obligations in the recent past were financed by sources such as the Central Bank of Sri Lanka or through monetary financing, but fiscal consolidation through improved revenue as well as rationalization of expenditure deemed needed in such circumstances were hard to come by, RAA Jayalath, Deputy Governor of the Central Bank of Sri Lanka, said recently.
He said this during a high-level seminar organized on the theme “Dealing with the current foreign exchange crisis in Sri Lanka: lessons learned from global experience”.
“Thus, a large amount of monetary financing by the Central Bank led to worsening inflation and exchange rates,” he observed.
He went on to say: “In this environment, the tax cuts introduced in 2019-20 with a reduction in the VAT threshold was a painful policy, in my view. The full impact of such a tax cut was higher than Rs. 600 billion and some put it at Rs. money circulating in the economy supporting medium to long-term growth. The combination of additional pandemic-induced spending and limited resource mobilization had widened the fiscal deficit. Tax cuts, low interest rates Interest and high liquidity created increased demand for imports.In addition to this, the pandemic dampened tourism-related income, which was the fifth largest inflow that had normalized after the Sunday attack of P Easter in 2019. Pandemic-related mobility restrictions around the world have boosted remittances through banking channels. However, this was short-lived as mobility increased after successful vaccination programs, following which the pattern of fund flow changed. This has been exacerbated by the fixing of the exchange rate at levels of Rs.200”.
“Tourism brought in $4.4 billion – 5.6% of GDP in 2019 – and it was reduced to 0.8% in 2020. Then the government decided to ban the import of agrochemicals in April 2021 for health reasons and to promote eco-friendly sustainable agriculture.. Although the transition to organic farming seemed like a sustainable eco-friendly step, the sudden change was like a ready time bomb. Whatever the rationale, sudden transmission was extremely problematic due to the lack of organic farming infrastructure, dependence on imported agrochemicals and lack of access to modern farming techniques.…….This has disrupted the economy’s self-sufficiency in rice production, necessitating imports of rice using scarce foreign exchange reserves The country’s external economic performance deteriorated and the challenge cit of the current account fell from 1.14 billion in January 2022 to 0.13 in January 2021.”
“When you look at the current crisis in Sri Lanka, we cannot forget the legacy that the country has carried. Since independence, Sri Lanka has been a double-deficit country except for a few years. The number of times the country has requested assistance from the IMF in its post-independence history shows the frequency of the challenges it has faced. Today we are requesting support from the global lending agency for the 17th time.
“The country’s trade account was constantly in deficit. Import expenditure was almost double exports. In the current account, it showed some relief mainly due to remittances from migrant workers. But this was insufficient to cover the double deficit. The majority of the country’s foreign exchange inflows did not come from non-debt-creating flows like FDI, but from additional borrowing. In addition to this balanced budget, the state budget was continuously in deficit. And it was growing due to ever-increasing commitments from the government sector. Thus, the balance of the country’s primary account – the state budget before deducting debt service expenditures – was in deficit except for a few years.
“Government revenue as a percentage of GDP has been constantly decreasing since the 1980s, except in 2015 and 2016. Tax revenue decreased until 2015 and recorded some increase in 2017/2018. But the budget deficit was significant. In 2019, it was around 9.6% and rose to 11.1% in 2020 and 2021, so fiscal and balance of payments (BOP) issues were consistently at the heart of Sri Lanka’s macroeconomic performance. In addition, the government’s continued heavy borrowing to fill the budget deficit over the years has led monetary policy and exchange rate management to have limited effectiveness in managing the fallout from financing the fiscal gap. Following the global financial crisis and the presence of low interest rates in the developed market, Sri Lanka significantly shifted its strategy towards borrowing from foreign markets, exposing the country to global credit cycles. So, although we have witnessed rapid economic growth, the majority of them came from borrowed funds and, at the same time, they were mainly invested in non-tradable sectors or sectors with low income generation.
“This was reflected in the trade balance which was unhealthy and deteriorating. The other factor that led to the rapid change in our debt composition was when we moved to commercial borrowing, particularly after losing access to concessional borrowing. Since we achieved middle-income country status in early 2000, most of our borrowing has been commercial borrowing. We did not have access to low-cost loans from multilateral organizations. And as concessional lending declined, the economy increasingly turned to commercial lending, primarily through international sovereign bonds (ISBs) and other bank and foreign borrowings. While the level of domestic/public debt has remained broadly stable, external debt has become primarily the engine of the Sri Lankan economy.
“The external debt to GDP ratio has risen from 30% in 2014 to over 50% in 2020. Although Sri Lanka’s external debt to GDP ratio has witnessed a significant reduction over the past two decades, the change in the high level of external debt has made the economy more vulnerable to a currency crisis in recent years. Therefore, in 2021, the economy recorded net repayments to foreign creditors; therefore, the entire budget deficit was financed by domestic financing. It was a kind of domestication of external bonds,” the deputy governor said.