Economic Stimulus: is Sri Lanka overextended?
Sri Lanka is doing everything to revive a dormant economy. First came the sweeping tax cuts to funnel cash into the hands of consumers and businesses. Then, the Central Bank lowering key lending rates to drive up credit growth. A debt moratorium on small business loans quickly followed. The economic stimulus package is an unprecedented one for its sheer depth and scope. Two bank executives and an economist, who is also a board member of a listed bank, weighed in on the stimulus’ impact at a recent investment forum organised by investment bank First Capital.
OVEREXTENDED FISCAL STIMULUS
To begin with, the sweeping tax cuts announced by the new government after the November 2019 presidential elections were probably too much. The fiscal stimulus was a major shift from the trajectory of the previous government. The logic for reducing taxes was to encourage corporates to invest and put more money into the hands of individuals so that they can spend.
The economy had experienced several shocks beginning with the constitutional crisis in 2018 and the Easter Sunday terrorist attacks the following year. Suppressed consumption showed signs of recovering towards the end of 2019. The smallest stimulus would have had the desired impact in terms of driving consumption, but the outcome now is a larger tax stimulus than what was necessary.
Avoiding significant fiscal slippage is difficult considering Sri Lanka’s recurrent expenditure structure. Cutting expenditure is quite limited. In 2018, interest payments, public sector salaries and transfers including pensions totalled to just under Rs2 trillion; tax revenue was slightly lower than that and considering the recent tax cuts, estimated between 2-3% of GDP, the fiscal deficit will be significant.
With cutting recurrent expenses a limited option, we could see a delay in capital intensive infrastructure projects, or there could be a shift with the private sector taking on more development projects through PPPs. Investors will worry about fiscal slippages and the rating downgrade risk will worry investors. This government, and successive governments, must be sensitive to what global markets expect.
I don’t have answers, but I expect the next budget will have some clarity on managing the deficit over the next 2-3 years. It will be critical for the government to embark on structural reforms early while they still enjoy some political capital.
AFTER ELECTIONS, A CRITICAL BUDGET
The Rs500 billion question: Can the economic stimulus fund itself?
The general election in April 2020 is expected to deliver a stable government, but the real test comes when it presents the budget in November.
The question everyone’s asking is will the economic stimulus package pay for itself? In 2018, the government spent Rs500 billion as interest payments on treasury bonds alone: that’s equal to the revenue loss from the tax cuts, estimates credit rating agency ICRA Lanka.
The success of the fiscal stimulus will depend on the economy recovering to post 4% growth by end-2020.
DEBT MORATORIUM UNLIKELY TO DENT BANKS
Dilshan Rodrigo says he enjoys holidaying out of town with his family. Once bustling seaside resorts are now deserted, the aftermath of the Easter Sunday bombings which shocked the world. “The economy is hurting. Small businesses are the first to suffer from an economic shock,” says Rodrigo, Chief Operating Officer at Hatton National Bank Plc. Less than a year before, a constitutional crisis in October 2019 brought the economy to a standstill. There’s a compelling reason to support small businesses for a new government looking to revive the economy. According to the debt moratorium scheme introduced in January 2020, small businesses don’t have to make capital repayments but must pay interest. Banks must also defer legal recoveries during the moratorium period. Hatton National has a significant SME portfolio making up 25% of its total loan book and Rodrigo is confident the ‘SME Revival Scheme’ will have little impact on bank earnings and regulatory limits on capital and liquidity. “The scheme is well thought out. Banks will fare better in 2020 because of the tax concessions but an economic revival where GDP grows 4% plus is critical for us”.
MINDING THE SHORT TERM RISKS
Nandika Buddhipala, CFO at Commercial Bank of Ceylon Plc argues that the economic stimulus poorly managed could lead to economic shocks
The fiscal stimulus and small business debt moratorium particularly target the construction sector which has driven economic growth in the past. Construction has a long gestation period before realising returns, so we are unlikely to see an immediate impact from the economic stimulus measures.
Boosting consumption can uplift the economy, but if it leads to import growth the medium-term sustainability of the economy is at risk should the trade deficit expand and currency falls. These risks may emerge even in the short term.
Dynamic banking regulation
Bank earnings took a huge hit adjusting for new IFRS-9 bad loan provisioning rules. Across Europe, banks could spread the adjustment over several years. In Sri Lanka, we had to absorb it all at once. Regulations ensure banks build necessary strengths during good times, but our regulatory structures should be dynamic enough to respond effectively during economic downturns as well.