Columns - The Sunday Times Economic Analysis

At least now, the CB admits it’s a loan

By the Economist

The first instalment of relief for the country’s balance of payments is expected shortly. According to the Central Bank of Sri Lanka the negotiations for the stand-by facility of US$ 1.9 billion, “which has been sought by the Central Bank of Sri Lanka from the IMF”, has according to the Central Bank, “now reached an advanced level of finalization.” Agreement has been reached with the IMF and the facility is due to be approved by the IMF Board shortly.

It is interesting that the Central Bank admits that it sought the loan. Earlier we were told the IMF was waiting to give a loan. Still earlier we were told we did not really want it. What we were doing was akin to not looking a gift horse in the mouth. Admittedly, the IMF had plenty of resources they may have been keen to disburse among countries in trouble due to the global recession. This was a change as it had little opportunities to lend before as few countries were in need during the boom years. That does not imply that they were eagerly waiting to lend to the Republic of Sri Lanka that was in trouble.

Sri Lanka’s relationship with the IMF was strained for some time. Economic advisors of the government were averse to borrowing from the Breton Woods institution as they did not want to comply with IMF conditions that would be imposed. Ultimately the IMF saw no reason to hold office here and left a few years ago.

The government’s alternate strategy was to borrow from commercial sources and seek facilities from friendly governments. This averted a balance of payments crisis for some time, but the heavy outflow of debt repayments combined with a massive trade deficit in 2008 led to a serious erosion of foreign exchange. Even when the emerging crisis was clear, there was a denial of it and an expectation that funds from friendly countries would enable the country to tide over the crisis without depending on an IMF facility.

The conditions imposed by the IMF under its Article IV provisions were the other issue. There were many pronouncements by officials as well as ministers that Sri Lanka would not comply with any conditions imposed by the IMF. Everyone other than those in high office and ministers in the government knew that “conditionalities”, as the IMF lingo calls conditions, were mandatory. The granting of the loan would no doubt be heralded as one received without any conditions. In fact some of the important conditions have already been met. However the IMF is willing to join with the government to give the impression that no conditions were imposed. Such is the new IMF diplomacy, deceit and so called transparency.

If truth be told, Sri Lanka complied with the conditions even before the loan was approved. The most obvious one was the free float of the Rupee without intervention by the Central Bank so that the currency would find its realistic level. This is why the Rupee depreciated from around Rs. 112 to the US$ to over Rs. 121 per dollar. This depreciation may continue depending on market conditions. Therefore one of the most important conditions has already been met.

There was an expectation that import controls may be put in place again. In fact a large margin of funds had to be deposited for certain imports. This condition that was imposed several months ago was withdrawn as it was unacceptable to the IMF. So these restrictions were removed as if it was due to an improvement in the balance of payments. On the other hand, there was a need to curtail imports. The IMF remedy of higher duties was imposed on some basic items of imports, as these were the items that were likely to result in lesser expenditure on imports. Many items of consumption will now increase in price due to the depreciation and higher duties.

There can be no doubt that the IMF would require the fiscal deficit to be brought down. This would take time. Promises given by the government are not likely to be taken seriously on this aspect. Therefore it is understood that the loan amount would be released in tranches or instalments, with the first instalment being around US$ 600 million. The rest of the money would be dependent on ‘good financial behaviour’ by the government.

What is little appreciated in Sri Lanka is that conditions relating to fiscal discipline are vital for the country’s economic good health. Cutting down unnecessary and unproductive expenditure is vital for economic stabilization in the short run and economic growth in the long run. Whether such conditions are imposed by the IMF or not, they are essential pre-requisites for the country to achieve economic and financial stability. It is the continuing fiscal deficits of over 7 percent for many years that has placed the country in this crisis. In 2008 the fiscal deficit reached 7.8 percent of GDP. It is these persistent fiscal deficits that have resulted in 90 percent of government revenue being spent on servicing of debt and thereby leaving no funds for essential economic and social services.

The potential danger is that the government would, after receiving the first instalment, change its mind on the conditions imposed and get back to its own policies that will aggravate problems in the fullness of time. Then it is not merely a matter of not receiving the rest of the funds from the IMF but the continued licence to mismanage the economy that is hazardous. Additionally we may once again resort to high cost commercial borrowing that would place a severe strain on future balance of payments.

The crisis the country reached was an opportunity to reassess its policies and take corrective actions. It appears that the government’s economic advisers are unacquainted with the economic logic for the IMF’s recommendations. The IMF does not now impose conditions that are a violation of a country’s economic sovereignty even when such recommendations are good economic policies. The current prescriptions are fairly simple, cut cost and government expenditure to be more in line with government revenue, adopt an exchange rate that limits imports and encourages exports and ensure that the rate of inflation does not rise above those of your competitors. Must we drift into a further crisis to put our house in order?

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