Sri Lanka is finally on board with the IMF: What’s next?
Sri Lanka is finally on board with the IMF: what’s next?
WRITTEN BY NASHALIE DE SILVA AND THILINA PANDUWAWALA
17 April 2023
On 20 March 2023, Sri Lanka finally gained the IMF Executive Board’s approval for its long-awaited USD 2.9 billion Extended Fund Facility. After months of power cuts, lengthy fuel queues, and sweeping protests in 2022, the IMF Staff-Level Agreement reached in September 2022 offered Sri Lanka’s withering economy some hope for recovery. More than six months down the line and several reforms later, Sri Lanka’s IMF-approved debt restructuring programme remains a focal point for what lies ahead. Can Sri Lanka achieve reform targets, obtain sufficient debt relief, and appease its creditors at the same time? This remains a key question for the island nation.
The battle for financing assurances
Crucial to the IMF's approval of a debt restructuring is that the major bilateral creditors pledge adequate financing and agree to temporarily accept that Sri Lanka is in arrears on its debt repayments. China’s participation was critical as Sri Lanka’s largest bilateral creditor, yet this involved significant delays as China continues to develop its approach to debt restructuring across a number of Belt and Road Initiative (BRI) borrowers. Having rushed to Sri Lanka’s aid in early 2022 with emergency financing, India was also the first to provide financing assurances in January 2023, followed by the Paris Club. China’s financing assurances have been slower to materialise.
China had been Sri Lanka’s main bilateral financier before 2022, providing USD 2.3 billion in balance of payment support loans via the China Development Bank (CDB) between 2018 and 2021, and an RMB 10 billion (about USD 1.5 billion) currency swap from China’s central bank in December 2021. While these provided some breathing room, especially during the COVID-19 pandemic, they also allowed the Sri Lankan government to avoid IMF programme-led reforms in 2020 and 2021. Instead, the Sri Lankan government indulged in a disastrous tax cut in November 2019, which reversed fiscal reforms undertaken during the previous IMF programme (2016-2019). China did not follow India’s lead of providing large-scale emergency financing to Sri Lanka in 2022, though it did add to the inflow of small-scale aid supporting the country.
It will be crucial to communicate the need for these tough reforms to voters and ensure that they benefit from the economic recovery.
Given the decrease in Chinese financing in 2022, there was concern about Sri Lanka’s slow progress towards a debt restructuring process and that it would lead to delays in accessing the IMF programme. The increasing tensions between China, the USA, and multilateral institutions heightened concerns. Therefore, it was not surprising when the first financing assurance letter from the Export-Import Bank of China, which offered a two-year moratorium on debt repayments, was deemed insubstantial to finalise IMF Board Approval. However, in early March 2023, China offered a second letter which appears to have retained the two-year moratorium but provided language aligning better with the IMF Debt Sustainability Analysis' (DSA) parameters and official arrears policy. On 20 March, less than two weeks after the news, Sri Lanka’s Extended Fund Facility programme was formally secured.
What now?
The IMF Staff Report and the Sri Lankan government’s Letter of Intent that accompanied the IMF’s approval set out the benchmarks and targets that Sri Lanka will need to meet. Aside from expectations for moderating inflation and the reforms to increase government revenue, a major focus surrounds the progress towards tackling Sri Lanka’s unsustainable public debt, which saw an increase to 128 per cent of GDP in 2022. In general, the IMF considers a country’s public debt to be sustainable “if the government is able to meet all its current and future payment obligations without exceptional financial assistance or going into default”. The IMF envisages that the debt ratio should be brought down to 95 per cent by 2032. According to some, this gradual reduction in debt levels is unambitious and even insufficient to guarantee Sri Lanka’s future debt sustainability. This still leaves Sri Lanka needing to implement tough reforms and expedite negotiations with creditors by meeting their preferences for equity of treatment. Thus, the IMF Board Approval is just another step on the difficult road ahead for Sri Lanka.
China will undoubtedly remain a major player in Sri Lanka’s debt negotiations, holding an estimated 19.6 per cent of Sri Lanka’s debt at the end of 2021, which is further complicated by the designation of most China Development Bank debt as commercial lending. Given the limited debt relief provided to Ecuador last year, there is continued uncertainty on what amount of debt relief and Net Present Value (NPV) reduction in debt Chinese creditors are willing to accept. Likewise, despite China’s continuous calls for wider participation in debt restructuring, including by multilaterals, Sri Lanka’s latest creditor presentation confirmed that multilateral organisations would be left out of the mix. The extent to which China and other major creditors agree to maturity extensions and rate adjustments to provide debt relief to Sri Lanka’s economy will be a key factor that determines the momentum of recovery.
Alarm bells out of Zambia
Furthermore, Zambia’s debt restructuring process, which has reached somewhat of a stalemate, seems deeply concerning for what could lie in store for Sri Lanka. Despite receiving IMF Board Approval in August 2022 after financing assurances from major bilateral creditors, Zambia has effectively been stuck in debt restructuring. The creditors have been unable to agree on converting the financing assurances into actual debt relief, hindering the country’s ability to pass the first review of the IMF programme and get the next tranche. The fear is that Sri Lanka will follow the same path, despite the government’s intention to complete debt restructuring by the September 2023 first review timeline.
However, significant differences set the two cases apart. While Zambia’s Debt Sustainability Analysis (DSA) is low-income country based, Sri Lanka is classified as a market-access country for DSA purposes. It is also assessed in fiscal terms instead of through external debt targets, which gives Sri Lanka more leeway in restructuring its external debt. Therefore, a key metric outside of debt restructuring for Sri Lanka is its ability to sustain tough revenue measures in order to raise government tax revenues and rationalise expenditure.
A long and tedious road
Although international headlines have moved away from Sri Lanka’s economic crisis, the path to recovery is still a long one. Apart from the debt restructuring process, Sri Lanka will have to meet the various benchmarks and targets set out by the IMF to unlock continued disbursements and remain in the good books of all creditors — private, multilateral, and bilateral. With the current package being Sri Lanka’s seventeenth time approaching the IMF, the island nation is no stranger to backpedalling on its reform efforts — especially when elections are nearing, and the political implications of fiscal consolidation push the voters towards populist politics.
It is precisely these voters who took to the streets last year to pressure the previous government to correct its disastrous course. The technocrats who now lead the reform process and debt restructuring negotiations were appointed to their positions only after violent protests outside former President Gotabhaya Rajapaksa’s private home on the night of 31 March 2022. It will be crucial to communicate the need for these tough reforms to voters and ensure that they benefit from the economic recovery. This explains why in addition to fundamental economic reforms, the IMF programme has benchmarks for reforms related to anti-corruption and governance improvements.
DISCLAIMER: All views expressed are those of the writer and do not necessarily represent that of the 9DASHLINE.com platform.
Author biographies
Nashalie De Silva is Senior Product Lead and Thilina Panduwawala is Head of Economic Research at Frontier Research, a macro-advisory firm based in and focused on Sri Lanka. The article reflects the opinions and analysis of the authors and not those of the institutions they are affiliated with. Image credit: Flickr/Nazly Ahmed.