Written by Nirupama Subramanian Courtesy The Indian Express

Former Governor, Central Bank of Sri Lanka, Dr Indrajit Coomaraswamy analyses the island nation’s economic crisis and the debt restructuring needed for IMF to release the $2.9 billion package. The session was moderated by Nirupama Subramanian, National Editor, Strategic Affairs.

On the Sri Lankan economy and status of the International Monetary Fund (IMF) bailout

The gross external reserve level is just under $1.8 billion but $1.4 billion of that is a swap arrangement with the People’s Bank of China, which is not very usable. You’ve got to have three months’ worth of import cover before you can draw on that, so the reusable reserves are only about $300 million. Of that about $100 million account for Special Drawing Rights Holdings with the IMF. A little bit of gold is left after the sale of some gold stocks that the Central bank had. So actually it’s about $300 million that exists, and that’s about a week’s high imports.

On the positive side, the queues for fuel and cooking gas have largely disappeared and the 10-12 hour power outages are now down to just one or two hours. Food supplies are available. Affordability is a significant challenge with food price inflation running over 90 per cent and our overall inflation close to 70 per cent but the rate at which inflation has been rising is coming down. The Central Bank governor is of the view that we are now near the peak of inflation.

Various measures, including the very aggressive tightening of monetary policy through an increase in the policy rates of the central bank by about 700 basis points, are beginning to take hold. As you know, monetary policy becomes effective after a transmission lag. There also is a combination of policy measures and administration on the ground. Import restrictions have banned everything except the most essential imports now. The currency depreciation, the interest rate increase, the tax increases – all of that is compressing demand and bringing down imports. A QR-based rationing system has been brought in for fuel, which has been working quite effectively. There is a better balance between the demand and the supply of essential goods.

Measures to reduce inflation have meant that the economy is expected to contract by over eight per cent. The IMF says 8.7 per cent, the World Bank says 9.4 per cent this year. In addition, the World Bank said in a recent report that the poverty ratio doubled between 2021 and 2022. About two-and-a-half million people have slipped below the poverty line and there are some protests even now but not at the scale we had earlier. So contraction of the economy and an increase in poverty levels are really longer-term challenges which have to be resolved. The government has to move from the IMF’s staff-level agreement to a full Extended Fund Facility (EFF) programme as fast as possible. For that, it has to present a debt restructuring package.

On debt restructuring talks with India, China and Japan

I want to acknowledge the tremendous assistance extended by the Indian Government and the Reserve Bank’s $ 4.8 billion emergency package which helped us tide over the crisis. The government has been saying that there has to be radio silence on the details of the debt restructuring but from the outside, I think one can say that progress has been made. Two things need to happen for the EFF. The official creditors, both bilateral and commercial, need to give an indication or reassurance of financing. They need to say they are willing to provide sufficient liquidity to Sri Lanka. Then the Executive Board of the IMF needs to consider the staff-level agreement and finalise it. This will trigger the money flow. Engagements are on between bilateral donor countries and the government of Sri Lanka. The government would like to have a common coordination platform to get the Paris club members, who are the traditional donor countries, the West plus Japan and the non-Paris club members, namely India and China. Then everybody knows what the government is offering everybody else and there is a far lesser chance of any suspicion.

We need revenue enhancement-based fiscal consolidation. The government has already introduced a number of fiscal measures to increase revenue and I think more are on the anvil in November when the next year’s budget is announced in Parliament. The World Bank, the Asian Development Bank and other donors are repurposing existing loans to strengthen social protection. We have to improve the targetting and design of the social cash transfer programmes. The Samurdhi programme is the main cash transfer programme but it is highly politicised. An academic has suggested a very good way of identifying the target group and that is to look at electricity consumption. About 98 per cent of households in Sri Lanka are linked to the National Grid. Like India, we need to get our digital ID going to transfer the money directly into the accounts of the beneficiaries so that the leakages can be reduced and administration costs brought down.

On the crisis of 2020 and the role of the Sri Lanka central bank

One is with the tax cuts and the very sharp reduction in revenue. The only way salaries and pensions could be paid was with the central bank essentially printing the money, and as you know if you print that much, you have inflation and some of the aggregate demand created by that excess money leaks into imports and puts pressure on the balance of payments and the currency.

That’s one line of instability which was associated with the central bank’s policy at that time. This is out of deficit financing or in common parlance money printing. Second, the alternate strategy adopted in 2020 and 2021, which drew heavily from the East Asian model, where the cost of funds was kept very low. But they were able to keep the cost of funds low by having very strong macro-economic fundamentals. Their budgets were in balance, their monetary policy was forward-looking and data-driven.

They were not artificially created by financial repression. If you drive the cost of funds down through financial repression, you end up essentially overheating the economy. So those were the two channels through which the central bank’s actions proved to be counterproductive – deficit financing and financial repression. But here it’s a positive role in protecting livelihoods and businesses during the pandemic because the government didn’t have the fiscal space to do it, so the Central Bank stepped in and played a very important role.

On Lanka being a ‘donor darling’  and its dependency on imports

Sri Lanka essentially had, like many countries in the global South from the 60s through the 70s, an inward-looking import substitution policy. This  resulted in Sri Lanka ending up with low investment growth and a high unemployment syndrome. In 1977, a new government came in and liberalised the economy but the country didn’t get the payoff it could have done for two reasons. The first was civil war, which meant that opportunities that would have come otherwise did not come Sri Lanka’s way. Second, the Sri Lankan polity was not able to function in a way that could avoid macro-economic stress. This stemmed from the government’s fiscal operations. In fact, Cambridge economist, Prof Joan Robinson, during her visit to Sri Lanka in 1969, said, You Ceylonese have eaten the fruit before you planted the tree.”

So this is what happened. We had a very consumption-oriented model which came out of a toxic combination of populist politics and an entrenched entitlement culture among the people. These two things fed off each other in a negative loop and dragged the country down. So the transformation of the economy didn’t take place even after the liberalisation in 1977.

Audience Questions

On China’s debt trap and clashing with India over assistance to Sri Lanka

The President and others have been clear that India is like family and China is a very good friend. So we need to deal with both countries and we need their support. One thing that has to be axiomatic in Sri Lanka’s foreign policy is that it has to be mindful of India’s strategic interests. The narrative on the Chinese debt trap is unfounded as it’s only ten per cent of the debt stock. We need to take advantage of  China’s capital but we must look for it in the form of equity.

On Indian investment opportunities

India gave funds to Sri Lanka as part of its Neighbourhood First” policy. Historically, we have had proximity forever. However, the infrastructure in both countries has tended to be very poor until recently, so the transaction cost of doing cross-border business has been high. Now with infrastructural improvements, that’s not a hurdle.  Also if India becomes a global hub for supply chains, there will be opportunities for other countries in the region as well. Sri Lanka is now trying to implement free trade agreements.