SL Government reaches peak in spending cuts, IMF says
The Sri Lankan Government appears to have reached its peak in spending cuts and now has to shift its attention more on increasing revenue, the Executive Board of the International Monetary Fund (IMF) said on Tuesday.
Issuing a statement on the conclusion of a IMF staff mission to Sri Lanka in May and the submission of its report to the Fund’s Executive Board, the report said, “Capacity in expenditure and commitment control has increased, enhancing the government’s ability to curtail spending to meet fiscal objectives. However, given sizeable investment needs, the staff was of the view that spending cuts may have reached their effective limit, and that the burden of adjustment needed to fall more squarely on increasing revenue”.
It said the government has remained solidly committed to fiscal consolidation and reduction of public debt as a mainstay of macroeconomic stability. In this context, and given rising economic growth, the mission saw the fiscal stance for 2014 as appropriate, but raised concern about the composition of further consolidation.
Excerpts of the report:
“Sri Lanka’s recent economic performance has been better than expected—particularly given some headwinds from chronic market turbulence and climatic shocks. While there remain weak spots in economic activity (such as agriculture, which has been negatively affected by recent drought), strong activity in traditional sectors such as garment manufacture, and new sectors such as tourism and services bode well for the near and medium-term outlook. This is complemented by a sustained reduction in headline and core inflation—bringing a new and welcome level of stability which has hopefully fed into a new set of public expectations regarding inflation. If Sri Lanka is to maintain current growth momentum and foster economic development and diversification, high and sustained levels of public spending on infrastructure and human capital will be essential. Tackling the issue of tax expenditures and broadening the tax base will be essential. The mission appreciated the steps taken thus far, but was of the view that the pace of reform in this area could reasonably be accelerated. There is also room, in the mission’s view, to take another look at the medium- and long-term strategy for debt reduction, and consider a more ambitious debt target (more strongly associated with reduced vulnerability) over a longer time horizon.
The current, supportive stance of monetary policy is appropriate given the decline in inflation and weak private credit growth. However, the overall picture is complex and requires close monitoring. On the one hand, with economic activity apparently on the rise and private credit (outside of pawning activity) beginning to show signs of recovery, the authorities should be ready to adjust rates as needed to ensure price stability—particularly given the long lags involved in monetary transmission. On the other hand, the current low inflation environment and the apparent change in inflation expectations offers an opportunity for a downward shift in the interest rate structure that might benefit the investment environment (and borrowing costs) over the medium term. Given the mix of signals, a cautious approach is warranted and the staff believes policy rates should remain on hold for the near term.
Exchange rates
The mission cautioned that the persistent stability of the rupee (vis-à-vis the US dollar) that has arisen as a side effect of foreign exchange absorption by the central bank since the fourth quarter of 2013 carries risks. First, it may create the perception that the rupee is implicitly fixed—a point supported by the shift in exchange rate classification from ‘managed float’ to ‘stabilised’ under the IMF’s Annual Report on Exchange Rate Arrangements. This perception could lead market participants and firms to hold un-hedged foreign exchange risk on their balance sheets. Second, should external balance continue to improve and inflation stay low, it could gradually lead to increasing currency misalignment. The central bank should thus be prepared to allow sufficient exchange rate flexibility to adjust to fundamental pressures, while limiting intervention to accumulation of reserves and smoothing short-term volatility.
Financial sector consolidation has potential benefits in the form of economies of scale, new products and services, and a greater resilience (via a stronger capital base) to shocks. The benefits of consolidation would likely be more rapid if fewer restrictions were placed on restructuring operations. Continued progress on corporate governance is also key. Close supervision during and after the consolidation process could also help avoid some of the pitfalls encountered by other countries in episodes of financial sector restructuring, such as excessive credit growth. Consolidation may also result in increased concentration and hinder effective competition if larger and state-owned banks continue to grow and dominate the banking sector.”