IMF report on Sri Lanka published

Washington, DC – February 25, 2022: The Executive Board of the International Monetary Fund (IMF) concluded the Article IV1 consultation with Sri Lanka.

Sri Lanka has been hit hard by COVID-19. On the eve of the pandemic, the country was highly vulnerable to external shocks due to inadequate external buffers and high risks to public debt sustainability, exacerbated by the 2019 Easter Sunday terrorist attacks and major policy changes. , including big tax cuts at the end of 2019.

Real GDP contracted by 3.6% in 2020, due to the loss of tourism revenue and the necessary lockdown measures. Sri Lanka lost access to the international sovereign bond market at the start of the pandemic.

The authorities implemented a rapid and comprehensive set of relief measures to deal with the impact of the pandemic, including macroeconomic policy stimulus, an increase in social safety net spending and loan payment moratoriums for affected companies. These measures were complemented by a strong vaccination campaign.

GDP growth is forecast to recover to 3.6% in 2021, with mobility indicators largely back to their pre-pandemic levels and tourist arrivals beginning to recover by the end of 2021.

However, annual fiscal deficits exceeded 10 percent of GDP in 2020 and 2021, due to pre-pandemic tax cuts, weak revenue performance in the wake of the pandemic, and spending measures to combat the pandemic. . The limited availability of external financing to the government has resulted in a large amount of direct financing of the budget by the central bank.

Public debt is projected to have risen from 94% of GDP in 2019 to 119% of GDP in 2021. Large foreign exchange (FX) debt service payments by the government and a larger current account deficit have led to a significant shortage of foreign exchange in the economy.

The official exchange rate has been effectively pegged to the US dollar since April 2021.

The economic outlook is constrained by Sri Lanka’s over-indebtedness, as well as persistently large balance of payments and fiscal financing needs. GDP growth is expected to be negatively affected by the impact of foreign exchange shortages and macroeconomic imbalances on economic activities and business confidence.

Inflation recently accelerated to 14% (yoy) in January 2022 and is expected to remain in double digits in the coming quarters, exceeding the 4-6% target band, as strong inflationary pressures have built up both on the supply and demand side. from mid-2021. Based on current policies and the authorities’ commitment to preserve tax cuts, the fiscal deficit is expected to remain large between 2022 and 2026, further increasing public debt in the medium term. Due to the persistent burden of external debt service, international reserves would remain inadequate, despite continued efforts by the authorities to secure foreign exchange financing from external sources.

The outlook is subject to large uncertainties with downside risks. Unless fiscal and balance of payments financing needs are met, the country could experience significant contractions in imports and private credit growth, or currency instability if the central bank continues to finance fiscal deficits. Other downside risks include a resurgence of COVID-19, rising commodity prices, worse-than-expected agricultural production, possible deterioration in bank asset quality, and extreme weather events. Upside risks include a faster-than-expected tourism recovery and stronger-than-projected FDI inflows.

Executive Board Evaluation

The Executive Directors commended the Sri Lankan authorities for the prompt political response and successful vaccination campaign, which have cushioned the impact of the pandemic. Despite the ongoing economic recovery, Directors noted that the country faces mounting challenges, including public debt that has risen to unsustainable levels, low international reserves, and persistently large financing needs in the coming years.

In this context, they emphasized the urgency of implementing a credible and coherent strategy to restore macroeconomic stability and debt sustainability, while protecting vulnerable groups and reducing poverty through strengthened and well-targeted social safety nets.

Directors emphasized the need for ambitious fiscal consolidation based on high-quality revenue measures. Noting Sri Lanka’s low tax-to-GDP ratio, they saw room to increase income tax and VAT rates and minimize exemptions, complemented by revenue administration reform.

Directors encouraged continued improvements in spending rationalization, budget formulation and execution, and the fiscal rule. They also encouraged the authorities to reform state-owned companies and adopt cost-recovery energy prices.

Directors agreed that a tighter monetary policy stance is needed to contain rising inflationary pressures, while direct financing of budget deficits by the central bank is phased out. They also recommended a gradual return to a flexible, market-determined exchange rate to facilitate external adjustment and rebuild international reserves. Directors called on the authorities to gradually withdraw capital flow management measures as conditions allow.

Directors welcomed the policy actions that helped mitigate the impact of the pandemic on the financial sector. Noting the risks to financial stability stemming from excess public debt and the sovereign-bank nexus, they recommended close monitoring of underlying asset quality and identification of vulnerabilities through stress testing.

Directors welcomed ongoing legislative reforms to strengthen regulatory, supervisory, and resolution frameworks.

Directors called for renewed efforts on structural reforms that improve growth. They emphasized the importance of increasing female participation in the labor force and reducing youth unemployment.

More efforts are needed to diversify the economy, phase out import restrictions, and improve the business and investment climate in general. Directors also called for prudent management of the Colombo port city project and continued efforts to strengthen governance and combat corruption. They noted the country’s vulnerability to climate change and welcomed efforts to build resilience.

Read : Full IMF report on Sri Lanka

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