Sri Lanka: From Don'ts to an example of Dos
Sri Lanka's recent economic woes and aahs offer important lessons for others in understanding both crisis creation and management. A development darling in South Asia, Sri Lanka's economic fabric looked highly fragile to external shocks because of pre-existing comorbidities from unhealthy policy diets. Sri Lanka subsequently turned around swallowing the bitter but unavoidable textbook orthodoxy on macroeconomic firefighting.
An acute balance of payments crisis forced Sri Lanka to preemptively default on over $50 billion foreign debt, triggering an unprecedented economic contraction with spiralling inflation. Gains in poverty reduction were reversed due to jobs and earnings losses across the economy. Many had begun to write Sri Lanka off as a case of economic development gone awry.
An ailing economy hit by cascading global shocks
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Pre-pandemic macroeconomic vulnerabilities and misguided policies under the guise of a "people-centric economy" in late 2019 left Sri Lanka with thin buffers. The pandemic followed by global supply chain disruptions, rate hikes, rise of the dollar and the Ukraine war pushed Sri Lanka into an economic abyss in 2022. Sri Lanka's GDP fell 7.8% in 2022 with year-on-year inflation rising to nearly 70% in September, debt rose to unsustainable levels, access to international capital markets closed, and foreign exchange reserves evaporated.
Macroeconomic policies and financial soundness regressed. The sharp acceleration in inflation in the first half of 2022 was driven primarily by monetary financing, administered price increases, the interaction of rupee depreciation and dollar shortages, and global commodity price surge. Inflation persisted due to the knock-on effects of price increases. Monetary financing to meet the rising fiscal obligations (Figure-1) inflamed the inflationary fire. The rupee-dollar rate depreciated by about 40% in 3 months from February 2022. Gross reserves decreased from $7.6 billion at the end of 2019 to $1.9 billion by end-March 2022. Non-performing loans in the banking sector increased from 7.6% at end-2021 to 11.9% in the last quarter of 2022.
Slides in cash dollar earnings tipped the economy off the cliff. The crisis unravelled as foreign exchange earnings from tourism and remittances collapsed and payment on account of fuel import bills soared. With reserves depleted, the authorities suspended external debt service on 12 April 2022, and formally defaulted on their international sovereign bonds on 18 May 2022. The consequent chaos and street unrest are still fresh in our memories. Deep-rooted public dissatisfaction created a vulnerable political and social environment. Severe shortages of food, fuel, cooking gas, and daily power cuts fuelled nationwide anti-government protests in March, May, and July 2022, followed by escalated violence leading to the resignations of top government officials including the President and the Prime Minister.
Reality reined in on policy
The Sri Lankan policy makers managed the crisis with exceptional measures, macroeconomic stabilisation and structural reforms based on a data-based diagnosis of the reality. Concrete economic stabilisation measures included significant monetary tightening, market-based exchange rate, fiscal consolidation, utility pricing reforms, and a privatisation program for commercial state-owned enterprises including Sri Lankan Airlines, Sri Lanka Telecom, and Sri Lanka Insurance.
Foreign exchange shortages triggered the tightening of import restrictions on non-essential goods from March 2022. A digital fuel rationing system was put in place to address fuel shortage to reduce queues at fuel stations. The adoption of monthly automatic price adjustment mechanisms for fuel and electricity in 2022 set up the framework for elimination of energy subsidies in 2023.
Fiscal consolidation was achieved through a combination of expenditure reduction and revenue increases. The primary fiscal deficit declined to 3.8% of GDP in 2022 from 5.7% in 2021. This was achieved by reducing the capital spending while making room for additional SSN spending and for transfers to the electricity board to cover its 2022 losses from below-cost electricity pricing. Revenue measures included strengthening personal income tax, corporate income tax, and VAT. Social safety nets (SSN) programs helped to partly mitigate the adverse impact of subsidy reduction and the employment effects of import controls on the poor.
The deficit reduction helped the government address fiscal financing shortfalls. The Central Bank of Sri Lanka (CBSL) downscaled monetary financing. Purchases of government securities in the primary market fell 3 times by January 2023 from the peak in June 2022.
The CBSL increased the policy rates by 950 basis points in three steps during April 2022-March 2023 (Figure-2). The interest rates on deposit and lending products of financial institutions and yields on government securities increased considerably, correcting anomalies that prevailed in the market interest rate structure. Elevated interest rates attracted more deposits into the banking system. Domestic credit expansion slowed. Credit to the private sector contracted for twelve consecutive months since June 2022. The year-on-year growth of broad money decelerated to 3.4% by end May 2023.
Central bank autonomy, strengthened by enacting the new Central Bank Act with critical improvements over the previous Monetary Law, proved handy in correcting policy behaviour. The new Act prioritised price stability as the primary objective of monetary policy and financial stability as the other objective. It prevents any form of government representation or participation on the Governing Board or Monetary Policy Board. It also prohibits the CBSL from providing monetary financing and purchasing treasury securities from the primary market.
The autonomy provided under the law was exercised, as emphasised by the CBSL Governor Dr P Nandalal Weerasinghe in the Fourteenth South Asia Economic Summit organised by the Centre for Policy Dialogue in Dhaka. CBSL's macro-forecasting models have begun to play a more prominent role in informing data-dependent policy decisions, paving the way for in-depth analysis of forward-looking inflation dynamics to enhance policy communication and insulate policy from political pressure.
Markets were eventually allowed to set the exchange rate. The CBSL's market guidance confined daily exchange rate movements within a predefined band around the weighted average interbank spot rate of the previous trading day. This limited excessive volatility temporarily but kept the exchange rate effectively pegged amidst foreign exchange shortages. The CBSL dropped the guidance in March 2023.
Results have begun to come
Contrary to float fear mongers, the exchange rate stabilised (Figure-3). The LKR-USD rate hovered between 320-330 in September-October 2023. A current account surplus, new external financing and other non-debt creating inflows, and sovereign debt relief supported the cause. The CBSL even purchased foreign exchange to rebuild international reserves.
Inflation is down from a peak of 70% in September 2022 to a miraculous 1.3% in September 2023. Shortages of essentials have eased. Foreign reserves and liquidity started seeing the light at the end of the tunnel with improved current and financial accounts inflows. Usable foreign reserves increased to US$2.4 billion by end-July 2023 (equivalent to over 1.5 months of imports of goods and services).
The improvements in the Balance of Payments conditions allowed relaxing import restrictions gradually in June and July 2023. Earnings from tourism in January-August 2023 ($1.3 billion) exceeded the earnings in all of 2022 ($1.14 billion). Same goes for the $3.9 billion remittances in January-August 2023 exceeding the $3.8 billion received in all of 2022.
The IMF program is so far on track. In March 2023, the IMF approved a 48-month Extended Fund Facility of approximately US$3 billion to support the government's reform program, followed by budget support from other development partners. IMF's First Review concluded in October found program performance at end-June satisfactory.
Not entirely out of the woods yet
Premature monetary loosening could reignite inflation and exchange rate pressures. The economy contracted by 7.9% in the first half of 2023. In response, CBSL began to loosen monetary policy as inflation decelerated. Policy rates were cut by 250 basis points in June 2023 and by a further 200 basis points in July. The Statutory Reserve Requirement (SRR) was also reduced by 200 basis points in August 2023. Yes, the hiking cycle may be getting nearer to an end across emerging and developed markets, but loosening risks reversal of stabilisation gains.
Sri Lanka is not back to pre crisis rates of poverty. Accelerating the reform momentum and strengthening accountability will shape the extent to which the recovery maintains the balance between stability and inclusive growth. NPLs increased to 13.7% in the 2nd quarter of 2023. Fiscal indiscipline, loose monetary policy, meddling with the setting of exchange rates, and trade restrictions can rise from the ashes before you know it when the guards are down.
The Sri Lankan fall and subsequent recovery show how macro instability haunts when taken for granted, the necessity of having market based flexible interest and exchange rates to absorb shocks, the limits of stabilisation measures in preventing contraction and the attendant costs needing structural responses. Policies, good or bad, never happen in a socio-political vacuum. They find a way to strike back under populist guises if prosperity from good policies is not shared, and the costs of stabilisation fall disproportionately on those least able to bear it.
Zahid Hussain is a former lead economist of the World Bank, Dhaka Office
