By D Fernando –

Sri Lanka’s shaky public finances are about to receive another blow from the fallout of the coronavirus. The first and most crucial aspect of an epidemic is always the human cost, but the spread of the virus has important repercussions for the economy. 

Studies indicate that epidemic disease impacts on a country’s economy through several channels, including the health, transportation, agricultural and tourism sectors. As borders are closed and global markets slow trade is impacted, so exports suffer.

Sri Lanka’s tourism is badly hit and the order books of some of the key exporters are reported to be empty for the next quarter. As international supply chains contract exports may remain constrained, even when markets re-open as components and raw materials may remain in short supply. The supply chain impact will affect even domestic producers as imported raw materials run short. Agriculture depends on imported fertiliser, pesticides, planting materials and chemicals. Local factories source raw materials, components and spare parts from overseas and may be unable to work at full capacity.

As cashflow dries up and debts mount, many businesses will close. During the global financial crisis of 2008/10, an estimated 90,000 Sri Lankans lost their jobs [1] due to downsizing amongst manufacturing firms, especially in the apparel sector. The impact of the current crisis will be worse because the financial crisis was confined to advanced countries. Developing countries were affected due to the loss of export markets but their domestic markets were unaffected. This pandemic is affecting both developed and developing countries.  

The upshot of this is that growth will slow and may even turn negative in 2020. The budget deficit will take a double hit from falling revenues and increased expenditure. Lower levels of activity mean lower levels of tax collection. As sales and imports decline, the collection of VAT and import taxes will decline. As business profits fall, income tax collection will fall. Meanwhile government spending on health (from testing kits to hospital costs) and relief measures will rise in response to the epidemic. The budget deficit will thus widen and the government will need to borrow more.

Even if public finances were robust, this would pose a significant challenge but Sri Lanka’s finances, sickly to begin with were weakened by recent tax cuts. The fallout it difficult to estimate but a recap of the principal issues is useful to assess the available policy options.    

Sri Lanka obtained an IMF facility of US$1.5bn in June 2016. This is the 16^th instance when it turned to the IMF since joining the fund in 1950 an indication of the systemic and long-running nature of the underlying problems. The overall objective of the recent IMF programme was to “reverse a two-decade decline in tax revenues and put public finances on a sustainable medium-term footing”[2]. The programme aimed to increase government revenue to reduce the budget deficit and therefore the public debt (as deficits fall, the need to borrow reduces). 

In the popular imagination IMF programmes are associated with austerity: cutting government expenditure which negatively impacts social and welfare spending. The reduction in expenditure closes the budget deficit at the expense of the welfare programmes. Sri Lanka did the opposite: increasing taxes to cover the deficit. Expenditure was left untouched and in fact continued to increase.

Unfortunately, the bulk of government revenue comes through the form of consumption taxes particularly VAT, so much of the burden of increased tax fell on the general public anyway, provoking intense displeasure. Income taxes were also increased, angering the business community. The government thus succeeded in antagonising a remarkably diverse set of constituents and became exceedingly unpopular.

Public finances did improve somewhat but were never very strong. With the attacks in April 2019 things started to slip again.  The IMF review in November 2019 noted that “the fiscal targets are no longer within reach, due to the significant revenue shortfalls”[3].

Following the Presidential election of November 2019 the government announced sweeping tax cuts in December. Given the unpopularity of the tax increases responding to public frustration could hardly be faulted but the breadth of the cuts was astonishing. Corporate income tax was reduced from 28% to 24%,  VAT was halved from 15% to 8%;  withholding tax, nation building tax and economic service charge were scrapped.[4] The objective was to kickstart a floundering economy but the cost –around a quarter of government revenues or 3-4% of GDP destabilised public finances.

On 7^th February 2020 the IMF noted that: “Preliminary data indicate that the primary surplus target under the program supported by the Extended Fund Facility (EFF) was missed by a sizable margin in 2019 with a recorded deficit of 0.3 percent of GDP, due to weak revenue performance and expenditure overruns”[5]. According to the fund, Sri Lanka’s 2020 budget deficit could rise to 7.9% of GDP the highest since 2015, although this is still optimistic since it did not factor in the impact of the pandemic. The reported deficit for 2019 was 6.5% but according to the Ministry of Finance “the actual budget deficit for 2019 should have been over 8 per cent” as around Rs.367bn of expenditure remained unpaid and unaccounted at the year end[6]. 

Meanwhile the rating agencies Fitch [7] and S&P [8]downgraded the outlook on Sri Lanka’s debt to ‘negative’ from ‘stable’.

Sri Lanka’s already wobbly public finances must now cope with the added economic shock of the coronavirus.  This is why weighing the relative costs of a lockdown or a curfew is so important, we need to see which will do the least damage because the system cannot withstand much more stress. 

China went for a near total lockdown and preliminary data emerging is frightening. The Economist reported that:

 “The jaw-droppingly bad economic data coming out of China hint at what could be in store for the rest of the world. In the first two months of 2020 all major indicators were deeply negative: industrial production fell by 13.5% year-on-year, retail sales by 20.5% and fixed-asset investment by 24.5%. GDP may have declined by as much as 10% year-on-year in the first quarter of 2020. The last time China reported an economic contraction was more than four decades ago, at the end of the Cultural Revolution.”[9]

How much of the economic shock in China is due to the disease itself and how much is due to the extreme measures put in place is impossible to say. China’s economy is robust and can recover from such a shock. This is unfortunately not the case for Sri Lanka.  

The biggest headache for the government will be managing the foreign debt. The Central Bank’s freshly minted medium term debt strategy is based on assumptions that no longer hold: 5 percent GDP growth over the medium term, inflation of 5 percent and a budget deficit of 3.5 percent. With the medium term strategy in ruins can the government rollover the maturing debt? 

Gross reserves stood at US$7.9bn [10] equivalent to 4.6 months of imports at February 2020. External debt repayments are around US$5.6 bn in 2020. This has been partially refinanced by a US$500m loan [11] from China which has supposedly promised a further US$700m. The country will be looking to raise a further US$2-2.5bn at least if it intends to repay this year’s debt while maintaining  a minimum  reserve of three months imports.  

With its public finances in shambles, the IMF programme derailed and inevitable debt downgrades expected from rating agencies it is impossible to return to the market. A new IMF programme will restore some confidence but that would mean a return to painful tightening. Appealing for further bailouts is thus the most attractive option.

Pakistan has called for debt relief and dozens of African countries have followed suite. The call has been supported by the World Bank and the International Monetary Fund (IMF)[12]. Unfortunately this call is for the poorest countries: those with a per capita annual income of less than $1,175. Sri Lanka is much richer than this and does not qualify but lacking too many other options this may be worth considering.

Some commentators have even suggested that the government should simply default[13]. While this may appear simple, it is risky and even restructuring of commercial debt-deferring or reducing repayments is viewed by the markets as a default event, which means it will be difficult to return to the markets for a while. It is also delivers a shock to the economy with declines in GDP, investment, and private sector credit being common. The financial sector may be affected leading to bank failures.

An IMF study in 2002 covering restructurings by Russia, Ukraine, Ecuador and Pakistan in 1998-2000 showed as a result of the restructuring:

 “The decline of real income and financing was transmitted to domestic demand. Confidence plummeted and private investment was curtailed sharply. Private consumption followed, albeit with a lag, as for a while households drew down their available savings. Public consumption was also scaled down reflecting efforts to consolidate public finances. Despite exchange controls, exchange rates depreciated sharply reflecting the shortage of foreign funds resulting from capital flight. The domestic demand contraction and import substitution helped improve current accounts. The exchange rate depreciation passed quickly to prices and inflation surged. Wages lagged, inflation wiped out the value of deposits, unemployment rose, and households suffered significant real income losses.” [14]

Sri Lanka is thus finds itself in a tricky position with very little room to manoeuvre.  

It is important to note that these problems are not due to the pandemic alone, although it does have a significant impact. The pandemic has only precipitated the policy weaknesses that were building up over decades into a single giant shock. This was also the case in the countries in the IMF study referred above where following a relatively short history of access to international capital markets, the macroeconomic situation was destabilised by domestic policy shortcomings and exogenous shocks: Weak oil prices for Russia and Ecuador, international sanctions following nuclear testing for Pakistan, the El-Niño effect for Ecuador, Russia’s turmoil for Ukraine, in addition to an unfavorable external environment after the Asian crisis.

Bailouts may seem attractive but it is only a temporary measure, postponing the issues for a later date. Politicians and citizens who have been living in a state of denial must wake up to the grim realities. Given the risks even the IMF may be preferable to a debt restructure but whatever the outcome unless the fundamental structural problems are addressed, these problems will recur.

[1] Daily News 9 Jul 2009. Over 180 countries adopt Global Jobs Pact. [ONLINE] Available at: http://archives.dailynews.lk/2009/07/09/bus10.asp. [Accessed 29 March 2020].

[2] MF.3 June 2016. IMF Executive Board Approves Three-Year US$1.5 Billion Extended Arrangement under EFF for Sri Lanka. [ONLINE] Available at: https://www.imf.org/en/News/Articles/2015/09/14/01/49/pr16262. [Accessed 29 March 2020].

[3] IMF. 4 Nov 2019. Sixth Review Under the Extended Arrangement Under the Extended Fund Facility and Requests for Waiver of Nonobservance and Modification of Performance Criterion-Press Release; Staff Report; and Statement by the Executive Director for Sri Lanka. [ONLINE] Available at: https://www.imf.org/en/Publications/CR/Issues/2019/11/04/Sri-Lanka-Sixth-Review-Under-the-Extended-Arrangement-Under-the-Extended-Fund-Facility-and-48787. [Accessed 29 March 2020].

[4] Ministry of Finance, Economic and Policy Development. 23 Mar 2020. Pre Election Budgetary Position Report. [ONLINE] Available at: http://treasury.gov.lk/documents/10181/829992/Pre-Election+Budgetary+Position+Report-2020-20200323-2/d489aa0a-edb8-47e4-bab0-af51b68d2132. [Accessed 29 March 2020].

[5] IMF. 7 Feb 2020. IMF Staff Concludes Visit to Sri Lanka. [ONLINE] Available at: https://www.imf.org/en/News/Articles/2020/02/07/pr2042-sri-lanka-imf-staff-concludes-visit-to-sri-lanka. [Accessed 29 March 2020].

[6] Ministry of Finance, Economic and Policy Development. 23 Mar 2020. Pre Election Budgetary Position Report. [ONLINE] Available at: http://treasury.gov.lk/documents/10181/829992/Pre-Election+Budgetary+Position+Report-2020-20200323-2/d489aa0a-edb8-47e4-bab0-af51b68d2132. [Accessed 29 March 2020].

[7] Economynext, 19 Dec 2019. Sri Lanka sovereign rating outlook downgraded to ‘negative’ by Fitch over tax cuts. [ONLINE] Available at: https://economynext.com/sri-lanka-sovereign-rating-outlook-downgraded-to-negative-by-fitch-over-tax-cuts-36605/. [Accessed 29 March 2020].

[8] Economynext. 14 Jan 2020. Sri Lanka credit outlook downgraded to negative on tax cuts by Standard and Poor’s. [ONLINE] Available at: https://economynext.com/sri-lanka-credit-outlook-downgraded-to-negative-on-tax-cuts-by-standard-and-poors-40118/. [Accessed 29 March 2020].

[9] The Economist. 19 Mar 2020. Governments are spending big to keep the world economy from getting dangerously sick. [ONLINE] Available at: https://www.economist.com/briefing/2020/03/19/governments-are-spending-big-to-keep-the-world-economy-from-getting-dangerously-sick. [Accessed 29 March 2020].

[10] Adaderana Biz. 12 Mar 2020. Sri Lanka official reserves increase to US$ 7.9bn in February 2020. [ONLINE] Available at: http://bizenglish.adaderana.lk/sri-lanka-official-reserves-increase-to-us-7-9bn-in-february-2020/. [Accessed 29 March 2020]

[11] ColomboPage. 18 Mar 2020. China grants US$ 500 million concessionary loan to Sri Lanka to fight coronavirus pandemic. [ONLINE] Available at: http://www.colombopage.com/archive_20A/Mar18_1584548120CH.php. [Accessed 29 March 2020

[12] Euromoney. 26 Mar 2020. Debt relief for Africa as coronavirus Covid-19 crisis intensifies [ONLINE] Available at: https://www.euromoney.com/article/b1kxnyc2th4x6d/debt-relief-for-africa-as-coronavirus-covid-19-crisis-intensifies. [Accessed 29 March 2020].

[13] Ceylon Today. 10 Jan 2020. Sovereign debt: Why not default?. [ONLINE] Available at: https://ceylontoday.lk/print-more/49288. [Accessed 29 March 2020]

[14] IMF. 21 Feb 2002. Sovereign Debt Restructurings and the Domestic Economy Experience in Four Recent Cases. [ONLINE] Available at: https://www.imf.org/external/NP/pdr/sdrm/2002/022102.pdf. [Accessed 29 March 2020].