Tough economic reforms like reducing debts of the petroleum, power agencies and other state enterprises, limiting foreign borrowings, cutting subsidies, curbing military spending and consulting the International Monetary Fund (IMF) in other policy issues are in store for Sri Lankans after the IMF approved its biggest-ever facility of $2.6 billion to the country.
The reforms could send prices up in petroleum, electricity and other essentials with the government agreeing to pass on to consumers any change in international prices without resorting to subsidies.
In one of the most ambitious economic reform programmes, the government in its Letter of Intent (LoI) to the IMF promised that if revenue falls, it “will take prompt action to contain other current expenditure—including on goods and services and transfers—or raise further revenue to safeguard the deficit target.” The LoI, released on the Central Bank website, said, government institutions had been ordered to maintain strict controls on budget and to justify all cost overruns. It said the Ceylon Petroleum Corporation (CPC) and the Ceylon Electricity Board (CEB), both saddled with the biggest debts in state enterprises through a combination of payments owed by other state firms and subsidized products, will break even by 2011.
The LoI, which opposition parties have been urging the government to release to the public, notes that if the global economy worsenes and hurts Sri Lanka’s exports, remittances and capital flows, the government will consult the Fund on an appropriate policy response. “It looks like the IMF will play an influential role in Sri Lanka’s economy contrary to what the government says,” an economist, who declined to be named, said.
The letter was jointly signed by Ranjith Siyambalapitiya, acting Minister of Finance and Planning and Central Bank Governor Ajith Nivard Cabraal. The Sunday Times reliably understands that the IMF wanted President Mahinda Rajapaksa as Minister of Finance to sign the letter. This was turned down and instead an acting appointment was provided to State Revenue Minister Siyambalapitiya to sign the letter.
An IMF statement on Friday announcing the approval of the $2.6 billion spoke of budget deficit cuts, reducing state spending and foreign exchange policy changes but provided only a small hint of the difficult reforms Sri Lanka has undertaken to make in the wake of the global financial crisis and rising costs due to high defence expenditure.
Even the Fund acknowledged that the reforms promised by Sri Lanka are ‘difficult’ measures. “The government’s programme will require difficult economic reform measures. Nevertheless, the government should take advantage of the opportunity created by the end of the conflict to ensure national reconciliation, restore macroeconomic stability, and promote strong and durable growth,” The IMF’s Deputy Managing Director and Acting Chairman Takatoshi Kato, said in a statement released by the Fund.
The most challenging of the targets is cutting the budget deficit to 5 % of GDP (gross domestic product) by 2011 from 7 % of GDP this year when, according to UNP Parliamentarian Kabir Hashim, the deficit in the first quarter this year itself is already 4% and set to reach 12 % by year’s end.
The United States, Britain and France which have opposed the loan request on the grounds of a poor human rights record by the government and inability to minimize civilian casualties during the recent fighting with the LTTE, did not object at Friday’s meeting but abstained during the vote, according to international media reports. The first time-ever political issues being raised in a loan that is normally considered on economic fundamentals saw the approval taking more than four months after the March 4 application.
While the foreign exchange crisis was acute in February, with reserves sufficient for a few weeks from a standard three months of imports, the situation has improved by July with $450 million coming into the reserves in the past two months.
Even with tough spending cuts, the budget deficit could only be reduced by around 9-10 % this year, concede Finance Ministry officials, who declined to be named. Dr Dushni Weerakoon from Colombos Institute of Policy Studies (IPS) said trying to maintain a 5% target by 2011 was a tough call and depended on how soon or to what extent donor aid was given for the massive Northeast reconstruction bill estimated at around $750 million.
“Maintaining these targets depends on how much the reconstruction is funded from outside and the extent to which the government can save on this expenditure,” she said.
But Central Bank Governor Cabraal asserted yesterday that the programme proposed by Sri Lanka was ‘do-able’. “This is what we suggested and we will follow it,” he said, adding that this year’s proposed budget deficit unfortunately went up to 7 % from 6.5 % due to the various economic stimulus packages offered to garments, tea and the finance and other sectors affected by the global crisis.
The IMF in a statement said its Executive Board approved a 20-month Stand-By Arrangement of US$ 2.6 billion to support the country's economic reform programme, and released immediately – in line with the usual practice– a sum of US$322.2 million. The remaining amount will be released in phases subject to quarterly reviews.
Dr Weerakoon from IPS pointed out that it was the standard IMF prescription of lower budget deficit, spending cuts and a flexible exchange. “Not much has changed.” She said, however, that the Fund should have been a little more flexible in the budget targets as Sri Lanka was recovering from a devastating war.
IMF conditions are normally difficult to maintain. According to economist Dr Muttukrishna Sarvananthan, Sri Lanka has a poor record of fulfilling the Fund’s fiscal and monetary policy recommendations. In 2001, the standby credit facility was discontinued after the disbursement of the first tranche primarily due to non-fulfillment of the agreed policy reforms and failure to attain the set targets, he said.
UNP Parliamentarian Hashim said some of the policies the IMF wanted the government to pursue are policies the UNP tried to implement in 2001 (which were tough). “To bring down the deficit, it will have to increase taxes and reduce expenditure. In what areas will they reduce expenditure? On whom will taxes be increased?”
The IMF statement said the government plans to increase revenue, reduce tax benefits and enforce cuts in military and other expenditures. Recently, government authorities have been saying that plans are afoot to increase the army to 300,000 personnel from a current 200,000, adding to government expenditure. Tax revenue has also been falling but the newly-appointed Tax Commission is expected to come up with plans to raise revenue and broaden the tax base.
The LoI said the government would limit foreign borrowings to less than US$1.75 billion during the course of the 20-month facility while stating that subsidies to the CPC and the CEB will be targeted to vulnerable groups and ‘transparently reflected in the government budget’.
The government also told the IMF that it was committed to developing a plan to address outstanding debts between the key state-owned enterprises. “The plan, which we intend to finalize by end- December 2009, will clearly identify all elements of circular debt including the identification and reconciliation of debts owed and due among the two largest state owned enterprises and a mechanism and timeframe for settling these debts. The Ministry of Finance will monitor and coordinate this exercise,” it said..
Key highlights of the Letter of Intent (LoI):
- Reduce Government budget deficit to 5 percent of GDP by 2011 consistent with target under the Fiscal Responsibility Act,
- Continue with flexibility in the exchange rate (as announced in October 2008) while building up reserves to at least 3 ½ months of imports by the end of the program period
-*Phase out temporary taxes, including import surcharges, as new revenue measures yield results.
- Government committed to increasing tax revenue by at least 2 percent of GDP by 2011 with measures to broaden the revenue base, significantly, reduce tax exemptions, and further improve tax enforcement.
- If revenue falls, the government will take prompt action to contain other current expenditure—including on goods and services and transfers—or raise further revenue to safeguard the deficit target. However, any additional expenditure as a result of higher than expected external grants from our development partners will be accommodated within the programme.
- Directives issued to Government institutions to maintain strict controls on budget and to justify all cost overruns.
- Steps taken to limit the length and the scope of tax exemptions granted under the Board of Investment (BOI) Act and the Inland Revenue Act with the intention of broadening the tax base. Tax holidays will not be extended after they expire.
- To keep financing consistent with the Government’s goals of ensuring the public debt sustainability, borrowings to be limited to less than US$1,750 million during the course of the programme. The Central Bank will work with the Ministry of Finance to improve its management of the Government’s cash flow.
- Improvements to the cost structure of the CEB will be realized by shifting toward lower cost electricity generation. With respect to the CPC, increases in international oil prices to be passed onto consumers by raising the domestic price of petrol. Necessary measures to bring these enterprises to break even by 2011. Any subsidies will be targeted to vulnerable groups and transparently reflected in the Government budget.
- Government committed to developing a plan to address outstanding debts between the key state-owned enterprises. The plan, which we intend to finalize by end- December 2009, will clearly identify all elements of circular debt including the identification and reconciliation of debts owed and due among the two largest state owned enterprises and a mechanism and timeframe for settling these debts. The Ministry of Finance will monitor and coordinate this exercise
- Needed funds (for government expenditure) will be found both through savings in military spending beginning with the 2010 budget, and external financing in the form of concessional loans and grants from our development partners.
- DPS ---The immediate priority is addressing the humanitarian needs of the estimated 280,000 internally displaced persons (IDPs). The government aims to resettle 70-80 percent of IDPs by the end of the year. The resettlement plan involves restoring basic services including water, electricity, health services, and education, and the development of economic and social infrastructure in consultation with local officialsand communities in the affected areas.
- Redeployment of certain categories of military personnel for demining and provision of basic infrastructure, and any external grants from our development partners. About two percent of the projected government spending will be used for the provision of humanitarian assistance and the resettlement of displaced persons. -*On risk and contingencies like unexpected economic slowdown in trading partner countries which would slow export growth further, a fall in remittances inflows, and capital outflows, the Government to adjust its policies, in close consultation with IMF staff, to ensure the achievement of a sustainable external position by the end of the programme period. In the event of a potentially disruptive movement in the nominal exchange rate against the U.S. dollar in either direction, the authorities will consult with Fund staff on the appropriate policy response.
- Given the expected slowdown in economic activity and potential rise in non-performing loans, the Central Bank will instruct all banks to have adequate capital to cover future losses in line with international best practice in loss recognition.