by C. A. Chandraprema Courtesy The Island

That Sri Lanka was unable to persuade the international credit markets to roll over the USD one billion sovereign bond that matured earlier this month was an ominous sign that no one should ignore. The last resort of the government was to order the three largest state owned banks to borrow the money from the international market but that, too, failed and the government was constrained to pay the debt out of the existing reserves. Last year, after accepting the position of Prime Minister at President Sirisena’s invitation, former President Mahinda Rajapaksa made an impassioned televised appeal to the people saying that fresh elections and a new government (headed by him) would be the last chance to prevent Sri Lanka from becoming another Greece. The hoped-for general election never took place and the hope-for renewal was dashed with the restoration of the UNP to power.

The failure to raise money on the international markets seems to indicate that the former president’s prediction is coming true. According to reports appearing in the financial press, the total repayment of foreign loans this year will be USD 5.9 billion with USD 2.6 billon being due just in the first three months of this year. Against this backdrop, The Sunday Island spoke to the former Central Bank Governor Ajith Nivard Cabraal about the unfolding situation.

Q.    The Central Bank Governor admitted that the three state banks had not been able to raise the one-billion-USD loan to pay off foreign debt. What are the implications of the three state banks being unable to raise that money? All of us were under the impression that the state banks were invincible and that they had a better reputation than the government that owns them.

A.    There’s no appetite for Sri Lankan paper. The state-run banks are fairly advanced banks and there would have been no worry about giving money to those banks because they are fairly liquid. But because of the government’s exposure to the credit markets, the appetite of the investors was not there even to lend to the state banks. Now, the government will have to get bilateral loans like swaps from India or loans from China in order to balance their numbers. They have serious difficulty in raising funds because people know that they are already exposed fairly strongly in forex borrowings and they have something in the region of about 35 billion USD up from about 23 billion USD at the end of President Rajapaksa’s tenure in power. So they have borrowed 50% more than the accumulated debt outstanding at the end of the Rajapaksa government and it is coming at a huge cost because the rupee has depreciated by about Rs. 54 per dollar. The government has to spend 184 rupees to buy dollars either from the market or the Central Bank. That money in turn has to be raised by the government through taxes or through further borrowing. The government is in a very unenviable position.

Q. The country gets its ratings and the various banks get their own ratings from the same credit rating agencies. If the bank is viable one would think that the international investors would not worry too much about being able to recover their money.

A. All the banks would be having ratings which will be the same or below the sovereign. No institution in a country can have a rating that is better than what the sovereign has. That is why the sovereign rating is so important. Those days I used to explain this to the banks and all the banks used to help us to maintain the ratings by doing certain things properly because they all knew that if the country rating drops, they will all suffer. Their borrowing rates will all increase if the country rating drops. So they helped us to improve the ratings by being disciplined and improving their own governance structures and helping us to maintain the currency – they knew that their rating was dependent upon the country rating.

Q. This government has been borrowing money in foreign currency to a much greater extent than the Rajapaksa government. So much so that a one billion Dollar sovereign bond now looks like small change.

A. They have been borrowing at a rate. Last week the Central Bank took on treasury bills to the tune of Rs 90 billion. That’s a case of printing money. Because there is no money to pay the salaries, no money to pay the debt. Even to buy the dollars, you have to have the rupees. So they have now become reckless. I am frightened to even think about the situation now.

Q. What about this theory that if the interest rate is right, no matter what your prospects, there will be lenders?

A. That’s not true. There is a certain elasticity with regard to the interest rates. If the borrower is fairly sound and if a good return is offered there will be lenders. But all those decisions will be on the basis that the repayment capacity of the borrower will be sound.  If there is a doubt about the borrower’s ability to repay, like what this government has now done by increasing the debt to GDP ratio, and the interest rates and so on, there is now a serious worry in the minds of investors whether this government will be able to repay. When that happens, however much you may increase interest rates, that’s not going to work because many investors will be getting wary about lending money. If there is a good chance of losing all their money they will not be interested in an additional 1% or 2%. If you hear that a borrower is indiscriminately raising interest rates in order to borrow, the lenders get a little suspicious. Already Sri Lankan bonds are trading above seven percent and close to 8%.  That’s a huge interest rate. In comparison, the US interest rate is about 2%. When that happens the investors become wary. Raising interest rates may be helpful because there are some people who take that risk. But they will do so with some trepidation. There will come a time when people will say that even at the high interest rate, they will not invest any more money in Sri Lankan bonds. That’s where the crunch occurs. Then you cannot roll over debt. That is what happened with this 1 billion Dollars. In normal circumstances, if Sri Lanka had been well managed, an investor would have subscribed to the new bonds which could have been used to retire the old bonds. What happened was that the government could not find any takers for the new bonds. The government couldn’t find takers for the state owned banks’ issue of bonds also. Then the government was constrained to repay the bond that was maturing with the resources that it already had. They used the reserves and proudly announced that the reserves were being used to retire the maturing bonds. This was an acknowledgement that they were unable to raise new money to pay the maturing bond. The Central Bank Governor was saying what is obvious to all the investors. He was only stating the fact.

Q. What would have been the change in the dynamics if a new government had been in power now? The same mountain of debt would have remained.

A. The people would have at least have known that there was a stable new government with new policies which will hold out some hope. Now there is no chance and hopelessness has set in. You saw the way the stock market reacted when Mahinda Rajapaksa became the Prime Minister. They welcomed the declaration of a general election. Now their hopes have been dashed and they think that they will be saddled with this government for the next one and a half years which means the economy will continue to deteriorate. People have been telling me how much their businesses are struggling. A fertilizer company said they had not been paid for 11 months. The government has ordered a subsidy and the difference between the actual sale price and the cost has to come from the government.  These people have already imported the fertilizer and have paid for all that. So they are on the brink. All the construction companies that have been building roads and bridges have not been paid.  The government is not able to make any payment. The decline in the stock market reflects the situation in the economy. At the end of 2014, the stock market capitalization was 3,105 billion rupees which in US dollar terms was 23.7 billion. By the end of 2015, the market capitalisation had gone down to 2938 billion Rupees which was 20.4 billion Dollars. By the end of 2016, it had further deteriorated to 2745 billion Rupees which works out to 18.2 billion USD. In 2017, there was a marginal improvement with the market capitalization increasing to 2899 billion Rupees which worked out to 19 billion USD. However at the end of 2018, it was Rs. 2839 billion which amounts to 15.5 billion USD. So the 23.7 billion USD at the time MR left office has now come down by 8.2 billion USD. One third of the entire value of our companies has been lost.

A showdown with the IMF?

When a staff team from the IMF led by Manuela Goretti visited Colombo during in mid-September 2018 to hold discussions on the fifth review of the program supported by a three-year Extended Fund Facility, the message they gave the government was clear. The IMF  knew fully well that Sri Lanka was going to enter an election year in 2019 and that there could be the provincial council elections first and the presidential elections by the end of the year and they obviously knew how fearful this government was of losing. They also knew that there was the likelihood of the government resorting to giving handouts to win elections. Yet the message they gave was clear. The team that came to Sri Lanka in September spoke of among other things ‘further fiscal consolidation’ which in IMF jargon means increasing taxes and reducing government expenditure so as to reduce the budget deficit.

To achieve that objective, they stressed that ‘the focus should remain on implementing the new Inland Revenue Act and other tax policy measures’ and spoke of the need to ‘strengthen tax compliance’. The IMF team which was in Sri Lanka for nearly two weeks, also commended the successful implementation of the fuel pricing formula and encouraged the introduction of an automatic pricing mechanism for electricity. They also spoke of how critical it was to have a ‘clear commitment to exchange rate flexibility’ which means to allow the rupee to depreciate until it finds its natural level. It need hardly be said that none of the measures recommended by the IMF will endear the government to the people during an election year. Even in their fourth review under the Extended Fund Facility programme in June 2018, they were very clear about the course of action they were recommending.

In fact, in their June 2018 fourth review report they drew attention to the fact that ‘political uncertainty in the run-up to the 2019–20 elections could slow reforms’. And they stressed that ‘sustained reform momentum is critical’. They observed that “public debt remains high and external buffers low against standard metrics, leaving the economy vulnerable to shocks, while limited export diversification and FDI suggest that the country’s growth potential has yet to be realized through structural reforms. Political uncertainty has increased following the opposition’s victory in the February 2018 local elections and two cabinet reshuffles. While the Prime Minister passed a no-confidence vote in April 01 there is an elevated risk that the political window for enacting major reforms will narrow in the run-up to the presidential and parliamentary elections scheduled for late 2019 and 2020, respectively. To secure the hard-won gains under the program and support inclusive and sustained growth, the reform momentum needs to accelerate, buttressed by strong policy frameworks and institutions”.

That seems to indicate that the IMF wants the reform programme to continue and would take a very dim view of any derailment due to political reasons. The IMF observed, “Gross public debt is projected at 83.7 percent of GDP in 2018, well-above peer emerging markets. This is in the context of sizable gross financing needs of around 18.6 percent of GDP in 2018 and international bond redemptions in 2019-22. Going forward, sustained fiscal efforts to reach an overall deficit of 3.5 percent of GDP by 2020 are expected to lower the debt ratio to 80 percent of GDP by 2020 and, under unchanged policies, to 73 percent by 2023, reducing the risk of debt distress.”

“The large and inefficient SOE sector (state owned enterprises) continues to pose substantial fiscal risks. SOEs’ financial obligations, estimated at 11 percent of GDP in 2017, consist mainly of project loans, short term bank loans linked to fuel subsidies, and aircraft lease commitments. SOEs have engaged in quasi-fiscal operations such as supplying energy at subsidized prices and funding infrastructure projects, with their debt absorbed by the government in times of difficulties. Lack of transparency, including delays in publishing audited financial statements, has raised concerns over undisclosed liabilities.”

“Staff welcomed important progress with energy pricing reforms…While energy prices reforms are fully implemented, the authorities committed to recognize the quasi-fiscal cost of fuel and electricity NCOs as central government expenditure to prevent further buildup of contingent liabilities.”

“A number of tax policy measures have been implemented to improve revenue performance.  As an initial step towards rationalizing tax incentives, the Cabinet suspended the Board of Investment Act in May 2016, annulling its capacity to grant tax exemptions and other forms of preferential treatment and instead concentrating these powers in the Ministry of Finance, which has ultimate oversight of tax policy. The VAT amendment enacted in November 2016 raised the VAT rate from 11 percent to 15 percent and broadened the VAT base by eliminating exemptions for telecommunication and private healthcare, excluding diagnostic tests, dialysis and services provided by the Outpatient Department (OPD), while the VAT continues to apply to wholesale and retail trade…Budget 2018 envisaged to broaden the VAT base further by eliminating exemptions on items including yarn, fabrics, industrial racks, electronic goods, and airplanes and parts, which are expected to yield about 0.2 percent of GDP in revenues.”

“On the personal and corporate income tax side, an important policy milestone was reached with the legislation of the Inland Revenue Act (IRA) which came into force on April 1st, 2018. The Act creates a predictable, stable, and transparent income tax system. Notable features include: removal of tax exemptions to broaden the tax base… introduction of a capital gains tax on immovable property; increased taxes on dividends and interest income; and a transparent set of investment-based tax incentives. Looking ahead to Budget 2019 and recognizing the need for about 1 percent of GDP in additional revenue, we plan to focus on our policy efforts to broaden the base of income tax and VAT and rationalize excise taxes.”(!)

Given the fact that what the IMF has in mind for Sri Lanka in 2019 and the needs of the government in an election year, some commentators have been predicting a showdown between the IMF and the SL government to take place in 2019. Given the fact that we are already finding ti difficult to raise money in the international markets, that will be the final nail in the coffin and the former president’s warning about becoming another Greece will come true. The government is in a bind. There are signs that it is only too well aware of the predicament it is in. This is probably why all talk of holding the provincial council elections have ceased. It seems to be only the Opposition that is interested in having the provincial council elections. Not holding the provincial council elections will give this government some breathing space until October this year. Thereafter they will have to device some was to avoid holding the presidential elections as well if they are to continue along the path they seem to have chosen for themselves.