IMF has published the ‘Article IV staff report on Sri Lanka’.
IMF recommendations include – Revenue-based fiscal consolidation, Flexible exchange rate, Strengthening Social safety nets,
Developing a comprehensive strategy to restore debt sustainability, reforms on strengthening VAT and income taxes, through rate increases and base broadening measures.
COVID-19 severely hit the economy, causing a loss of tourism receipts and necessitating several strict lockdowns. Pre-pandemic tax cuts and the impact of COVID-19 led to fiscal deficits larger than 10 percent of GDP in 2020 and 2021 and a rapid increase in public debt to 119 percent of GDP in 2021. Sri Lanka’s access to international capital markets was lost in 2020, prompting a decline of international reserves to critically low levels and large-scale direct lending to the government by the Central Bank of Sri Lanka (CBSL). External debt repayments and a widening current account deficit have led to foreign exchange (FX) shortages, while the official exchange rate has been de facto fixed since April 2021. Inflation is on the rise, reaching double digits in December 2021, reflecting imported inflation, supply shocks, and a pickup in domestic demand amid loose monetary policy.
Download IMF Full Report – the Article IV staff report on Sri Lanka
Major policy changes since late 2019 exacerbated the pre-pandemic vulnerabilities.
The new government following the Presidential and Parliamentary elections (in November 2019 and August 2020, respectively), headed by President Rajapaksa of the Sri Lanka Podujana Peramuna party, pledged to develop a people-centric economy through tax policy changes to promote production and reduce the cost of living. In this context, income tax and VAT were cut in late 2019, with estimated revenue losses exceeding 2 percent of GDP. The automatic fuel pricing mechanism was discontinued, raising fiscal risks from state-owned enterprise losses. The plans to upgrade legislation relating to central bank independence and the fiscal rules were suspended. These policy changes, while aimed at promoting growth and employment, further eroded fiscal space, increased Sri Lanka’s vulnerability to shocks, and halted institution building reforms.
To restore macroeconomic stability and debt sustainability, implementing a credible and coherent strategy covering both the near and medium term is needed. Staff recommends a comprehensive set of policies with specific measures:
• Substantial revenue-based fiscal consolidation. Reforms should focus on strengthening VAT and income taxes, through rate increases and base broadening measures. Fiscal adjustment should be accompanied by energy pricing reforms to reduce fiscal risks from lossmaking public enterprises. Institution building reforms, such as revamping the fiscal rule, would help ensure the credibility of the strategy.
• Developing a comprehensive strategy to restore debt sustainability.
• Near-term monetary policy tightening to ensure that the recent breach of the inflation target band is only temporary. Recent welcome steps to gradually unwind the CBSL’s large treasury bill holdings should continue through close coordination with the Ministry of Finance.
• Gradually restoring a market-determined and flexible exchange rate. To avoid disorderly movements in the exchange rate, the transition should be carefully sequenced and implemented as part of a comprehensive macroeconomic adjustment package.
• Social safety nets should be strengthened, by increasing spending, widening coverage, and improving targeting, to mitigate the adverse impacts of macroeconomic adjustment on vulnerable groups.