After months of economic turbulence, Sri Lankan authorities reached a staff-level agreement with the IMF for a 4-year program worth USD $2.9 billion this September. At the height of Sri Lanka’s economic crisis, power outages lasted for more than 12 hours at a stretch, fuel queues lasted more than a week, and essential medicines were in short supply. All these factors caused the people to rise up in protest and force a change in one of Sri Lanka’s most powerful governments in recent times.
While Sri Lanka has moved past the peak of the crisis, it is still amid its worst economic situation in modern history. Sri Lanka is closer to stepping out of the hole it has dug for itself – though actually stepping out might still need some hard work on all sides. However, stepping out of crisis and moving towards a better future doesn’t require perfection, and Sri Lanka can likely achieve a lot without it.
Sri Lanka’s Historic Relationship with the IMF
Sri Lanka has been running fiscal deficits and current account deficits that have been financed by debt for decades. While there are many issues with how the global financial system relates to the sovereign debt markets of developing countries, it was Sri Lankan politicians – driven by winning the next election – that created a debt-driven consumption economy, who really put Sri Lanka into this mess. Their economic mismanagement has resulted in periodic cycles of economic downfall well before the 2022 crisis, with some level of balance of payments pressure occurring once every few years, starting from the early 1950s.
These continuous mistakes in Sri Lanka’s economic policy throughout its history define its current relationship with the IMF. The country’s macroeconomic crisis has been driven by high deficits – repeatedly approaching the IMF (16 times before 2022) but making just enough fiscal adjustment to stabilize the system then subsequently reversing track on fiscal reform and falling back into crisis. However, given the scale of this crisis, there is no way out besides engaging with the IMF. Nonetheless, the question remains: will this time be different?
What is the IMF asking of Sri Lanka?
A starting point to understand the IMF’s “advice” to Sri Lanka and what Sri Lanka will have to do to go along with this crisis might be considering the scenario of what Sri Lanka would need to do get out of the crisis if the IMF didn’t exist. Since Sri Lanka’s crisis stems from fiscal deficits and current account deficits financed through debt, the government would have to consider three factors: how to handle these budget deficits, how to handle the current account deficits, and how to renegotiate the current debt stock.
For Sri Lanka’s budget deficit, the biggest problem in recent years has been low revenue numbers – this has usually been what the IMF focuses on. The last three IMF programs, in addition to the upcoming one, have primarily focused on improving and increasing tax revenue. Sri Lanka’s revenue to GDP was one of the lowest in the world in 2021 following the 2019 tax cuts, where then-President Gotabaya Rajapaksa cut Sri Lanka’s taxes to critically low levels after his election.
The core of the IMF program will likely reverse such tax measures and implement a stronger tax regime.
The IMF has additional recommendations for Sri Lanka, which rank lower on the priority ladder but will remain critical parts of the program. On expenditure, the primary target is to ensure that any increases are only for absolute essentials. Given a more recent focus on welfare spending by the IMF, a key recommendation is that Sri Lanka increases social spending, especially welfare payments to the country’s poor, supported by multilateral agencies such as the World Bank. These go along with recommendations on monetary policy measures, including cutting down “money printing” or the monetization of the deficit and increasing the independence of the Central Bank of Sri Lanka.
Will this time be different? – Barriers to Effective Implementation
Sri Lanka’s interim budget for 2022 and recently presented budget for 2023 are likely to meet most of the IMF’s initial requirements on the domestic front to move ahead with a program. Any immediate delay is more likely to be on the debt negotiation side – especially if Sri Lanka’s bilateral creditors, primarily China and India, take longer to come to an initial understanding on moving forward. Moving ahead on this debt restructuring pathway and continuing to make progress will be critical, although very little on this line is in the government’s hands.
The primary barrier to Sri Lanka following through on its economic reforms continues to be domestic political pressures from a wide range of domestic actors. One such opposing view is that Sri Lanka’s two-party election cycles lend themselves to constant reversals of prudent economic policy in favor of election grabs. Another view is that corruption is a core factor, with the structure of the Sri Lankan economy lending itself to harmful economic policies that resist any internal change. The disconnect between policy and results also comes across, as socioeconomic pressures lend themselves to greater pressures to reverse policy. These views held by various societal actors can sometimes lead to weaker support for economic reform and lobbying for different solutions instead.
Most critiques of the proposed economic reforms are arguably justified. Sharp increases in taxation raise questions on accountability and corrupt patronage networks in government expenditure. Large adjustments in interest rates raise questions on the “health” of the underlying economy. A move away from debt-funded subsidies to more targeted welfare raises questions on the socioeconomic costs for those that slip through the net. Both the crisis and the reforms that can potentially solve the crisis can cause pain to many segments of society. How the government deals with this dichotomy will be a critical aspect that determines Sri Lanka’s future.
The reality for Sri Lanka’s pathway forward is likely imperfect policies for many of these factors, but good enough implementation to take Sri Lanka out of crisis. However, the government is continuing with these reforms despite such opposition point to a commitment towards changing the current economic trajectory – for now.
A “New Sri Lanka” is possible – but a “Somewhat Better Sri Lanka” is more likely
Expecting perfection from Sri Lanka’s government, especially one that has continuously failed to meet any standard of prudent and accountable policy making, is a flawed goal. While the breadth of this crisis and the lack of alternatives force better policymaking than before, the likelihood of effective implementation remains in question. However, Sri Lanka is not the only country that has faced such a crisis. Plenty of other countries have faced similar disasters before, and have overcome them following similar IMF-supported pathways.
For Sri Lanka, the path forward includes higher taxes, better welfare allocations, and a reduction in artificial control over the economy. These reforms may not result in an economic recovery that is as rapid, comprehensive, or inclusive as it can be, but they will nonetheless push the country toward progress. Undoubtedly, the country shouldn’t settle for but push for all it can and much more. However, a better country seems possible to reach even without it. That alone can give hope to a broken country.