GP Short Notes

GP Short Notes # 653, 7 August 2022

Sri Lanka starts bailout talks with IMF
Ankit Singh

Sri Lanka: Colombo starts bailout talks with IMF

What happened? 
On 3 August, the newly elect prime minister in his first parliamentary speech after the ouster of Rajapaksa, declared that Sri Lanka will start bailout talks with IMF for a loan of USD 3 billion under the Extended Fund Facility program spanning over 4 years. The objective is to get support from financial support from IMF which would enable funds from friendly countries. He said: “We would submit this plan to the International Monetary Fund in the near future, and negotiate with the countries who provided loan assistance." 

The Prime Minister also discussed an interim budget to chart out the financial strategy to deal with debilitating forex reserves and fiscal deficit. He added that the power of the President will be curtailed through amendments and called for unity among political parties to work together in taking the nation out of the crises, on restructuring overseas debt to bring down public debt to less than 100 per cent of the GDP in 10 years (currently 140 per cent of the GDP).

What is the background?
First, the protests. Sri Lanka has been witnessing dissent, protests and demonstrations against the inability of the government to control inflation and afford fuel to run the nation. On a year on year on basis, inflation has increased by sixty per cent, currently hovering at fourteen per cent. The covid pandemic impacted the tourism industry of the nation and many people were rendered unemployed, creating harsh impacts of the rising inflation.

Second, the previous Prime Minister had declared in his political manifesto to introduce tax cuts to stimulate investment and diversification of the economy. The act, however, backfired and the government revenue further decreased while the fiscal deficit increased to above 10 per cent of the GDP. This directly impacted the stability of forex reserves to finance the imports while exports remained stagnant. The fiscal breathing space narrowed and debt commitments, which are a priority, became uncertain. The bailout talks if they succeed, will channelise the funds for Sri Lanka to continue with its commitments and liabilities. Sri Lanka currently owes USD 12 billion to bondholders, which cannot be defaulted at any risk.

Third, IMF’s concerns. In its recent Article IV staff report of March 2022, the IMF raised the issue of corruption in Colombo port city projects. The fiscal deficit will become a priority over infrastructure projects in Colombo and even Hambantota port city projects. A statement in Article IV said: “Unless the fiscal and balance-of-payments financing needs are met, the country could experience significant contractions in imports and private credit growth, or monetary instability in case of further central bank financing of fiscal deficits.”

Fourth, the socio-economic impacts of the crisis. Public services like education, health and food security have been impacted since the government announced a shutdown. The political and economic turmoil has wreaked havoc in Sri Lanka deeply on all social groups of the country. Nearly one in three parents in Sri Lanka have noticed negative changes in their children’s behaviour in the last 6 months as the country headed into economic collapse, according to a Save the Children survey conducted in June 2022. Soaring inflation, daily power cuts, and shortages of fuel, food and medicines have stretched families beyond their ability to cope. Therefore, the government had to venture for an immediate solution to the developing humanitarian crises in the nation.

What does it mean?
First, a bailout package will bring certain conditionalities and performance benchmarks from the IMF to guide the country out of its default tendencies. To restore debt and macro-economic sustainability, some structural reforms would be recommended by IMF. Likely reintroduction of taxes will increase revenue, a market-determined exchange rate system to make the local currency competitive and void of speculations and a more autonomous central bank will be the top demands and benchmarks from IMF.

Second, low-income countries and middle-income countries have sought financial help from IMF more frequently in the post-pandemic period. IMF has provided USD 250 billion through covid financial assistance and debt service relief.  From Asia, Pakistan, Bangladesh, Malaysia, Papua New Guinea, Uzbekistan and other central Asian states have sought financing facilities. In Africa, except for a few countries, almost all countries are engaged in some form of financing program. From Latin America, Argentina signed a debt deal worth USD 44 billion, the highest in the history of the IMF. Other than Argentina, Mexico, Honduras, Nicaragua, Peru, Chile and Bolivia have sought help from IMF in one way or another. The rally of developing economies for financing from IMF, a west backed institution is a symptom of the weakening discourse of secular development. It will lead to more free-falling economies which would like to hang between emerging powers rather than falling into the one basket.