World Bank lending has supported Sri Lanka’s development for several decades and its outstanding loan portfolio tops 2.4 billion dollars across 17 projects. However when Sri Lanka’s economic crisis hit the bank repurposed around 14% of its undisbursed loans to help pay for imports of LP gas and fertiliser.

Now that the immediate crisis is over and Sri Lanka has secured an Extended Fund Facility from the IMF, the World Bank is discussing a new country partnership strategy with the government, which will determine its lending priorities for the next four years. While the Bank’s experts are working out the details, its Country Director for Sri Lanka Faris Hadad-Zervos says there are three priorities it plans to support; better economic governance, regaining Sri Lanka’s competitive edge in the global markets and a social safety net that protects the most vulnerable people in the country. He recently joined Echelon for an interview.

Sri Lanka made the unusual request of the World Bank, that its economy be reclassified as an IDA or International Development Association eligible country. IDA is part of the World Bank that helps the poorest countries. This request has been granted. What does that mean, in practical terms?

Let me start by saying that it’s not an unusual request. In fact, it’s a timely request, and it was an essential request. Other countries have gone down the same path, Egypt, Indonesia and the Philippines are some examples, where they have reverse graduated and they’ve returned to a blended status which includes access to IDA and access to the IBRD (International Bank for Reconstruction and Development, a part of World Bank that lends to middle-income countries).

This is quite essential in times like this, where a country has lost access to the market for finance. So coming to IDA is an important step and will be critical in the medium term for the country.

Sri Lanka continues to be classified as a lower-middle-income country. However, there are other reasons why a country may be eligible for IDA reverse graduation, including macroeconomic instability, certain vulnerabilities and massive jumps in poverty. Unfortunately, Sri Lanka had ticked all those boxes despite continuing to be a lower middle-income status country.

IDA graduation implies that Sri Lanka can access different lending windows of the World Bank which offer more concessional funding that will help Sri Lanka achieve a degree of recovery for the time being.

Can you contrast IDA funding with what you call IBRD, which is typically what lower middle-income countries can access from the World Bank? What are the differences?

IDA and IBRD are different. But it’s interesting to note that it was only a few years ago that Sri Lanka graduated from blend status, which is initially from IDA, then to a combination of IDA-IBRD and then to full IBRD status.

If we discuss IDA, there have been countries, the Philippines, Egypt and Indonesia are examples. Once they’ve resolved challenges and gradually regained access to markets, they’ve returned to blend status and then would have returned to IBRD. That could potentially be the course for Sri Lanka.

Now that is, it’s more concessional in terms of fees for the credit. If you take into account the net present value, IDA credits are mostly grants. Also, the repayment time duration and the grace period are usually the main differences between IDA and IBRD.

IDA access also opens other windows, within and outside of IDA. Other countries have gained access to certain trust funds or other types of funds would become available to countries like Sri Lanka. During a period of crisis, it is the right time to access these.

Also, IBRD is a standard loan product, so it is assumed or assessed that a country is creditworthy and can access credit markets.

Sri Lanka’s economic crisis started when it lost access to global markets for credit. The World Bank typically funds a development programme of the government. You mentioned earlier that the World Bank is currently negotiating with the government for the next fouryear programme. You may also have views about what the priorities of Sri Lanka should be, given the challenges it faces both at home and in terms of accessing global markets for credit. Can you outline for us, from your point of view, what you think the priorities should be?

To assess what we think those priorities should be, we have to look at the past, at the causes of this crisis. It is in 2022, that there was a moratorium declared on certain debt repayments when the crisis actually hit. The result of this is actually not a year or two or three, it has been a series of years of less-than-perfect economic management. We’ve been looking at a steady erosion of competitiveness of the country, more restrictions on trade, on investment and the investment climate becoming steadily less competitive. Some fiscal policies were not reflective of the realities on the ground, and some of the lowest government revenue levels of any country in the world. So it was a combination and confluence of economic policies over time, which led to an erosion of the infrastructure and the ecosystem for investments and competitiveness.

When I was young and growing up not far away in the region, Sri Lanka was known for the best garment products, and if you got Sri Lankan clothes or textiles, you were regarded as quite fortunate. To see that this market competitiveness has eroded over time is unfortunate.

So, when you look at that, and policies, like the loose monetary policy over time and excessive borrowing, it’s not surprising that we’re in this situation. It only required one or two crises. Unfortunately, Sri Lanka went through several; the Easter Sunday bombings, a terrible event, Covid and we look at the recent war in Ukraine. When you teeter on the brink, and walk on the cliff, three steady blows of wind will push you over. I think that’s what we are seeing.

So if you agree with me that was the nature of the problem the solution must necessarily be largely the inverse of that. Addressing economic governance will be essential for stabilizing Sri Lanka, and also necessary for achieving balance of payments stability and financial stability.

What is the infrastructure for economic governance, economic decision-making and transparency of decision-making, and the ability to decide on fiscal and monetary policy? What is that? Do all branches of government have a chance to explore what the debt levels of the country are? Those levels of transparency, that level of economic governance needs to be reset.

The other is a return to competitiveness and a productive foreign investment climate in the country, and make the private sector the driver of the economy. Thirdly, the one that underpins all of this, is to ensure that no one is left behind and that social protection systems are transparent, efficient, and long-term.

That to me is the trinity of things that need to be addressed, not only in terms of immediate recovery but a return to a new and reset growth path for the country.

How do you make better economic governance possible, and make transparency possible, through a lending programme from the World Bank?

There’s a wide slew of things and I have to say that the government has begun and we have to give credit where credit’s due, to address many of these. One is addressing the fiscal imbalances that exist in the country, and this is absolutely essential.

But looking forward, let us look at the decisions, the systems, the architecture for decision making, and policies in terms of revenue generation, expenditure management, and macrofiscal management; how are decisions made?

The other is the debt levels, which is the architecture for the overall debt structure to be assessed by the legislature. So transparency in numbers is critical. The other very important one is the nexus between the financial sector to the sovereign. If the government can continue to borrow from the financial sector, without a degree of checks and balances and some guardrails, this becomes a problem. It not only creates a vulnerability problem for the economy, but it also crowds out private-sector borrowing. So that’s on economic governance.

On the return to competitiveness and the foreign investment climate; this harkens to my Middle Eastern roots. Sri Lanka was once known as Serendip, a legendary country famous for its commerce and trade. I dare to say it is in the Sri Lankan genes, and it’s nothing short of dismal that Sri Lanka is losing and has been losing competitiveness due to excessive restrictions on imports and exports, excessive bureaucracy, and all things that discourage the private sector, from coming to conduct business here and to export outside. We need to return to competitiveness.

Sri Lanka is a large and beautiful island nation, but it exists in the rest of the world. Like any other country, it has to trade freely and rely on the entrepreneurship of its people.

The last item is social protection. As we’re doing one, and two here, we need to make sure that three, which are the poor and vulnerable, don’t suffer, and they have a safety net to protect them. Now you have existing safety nets, they’re largely inefficient, and a large chunk of it is going to those who perhaps should not be receiving the safety nets. That means those who should be receiving it are unable to enter. So a revision is something the government has begun to do in earnest.

We have observed that the goal is to revamp the entire system towards an integrated social protection system that is transparent, adaptable, and can respond to crises and shocks, and where the process by which people are selected and validated is clear, transparent, automated, and allows those who deserve to be there.

Do you foresee the World Bank supporting the creation of a new social safety net that encompasses everything that you talked about?

Yes. The government has begun the work. The World Bank already has a social protection project and as we move forward, and we’re going ahead with our country partnership framework, which we hope to present for discussion and the guidance of our board of directors in May, we will also present a strategy that addresses these as a project that addresses the government’s reform agenda along the trinity of pillars that I mentioned earlier: economic governance, trade and competitiveness, and social protection. We will also be involved in another project led by the government, and they have begun doing significant transformational work, to revamp the social protection system. We will support that as well.

World Bank and other multilateral creditors typically don’t agree to take haircuts or agree to reprofile debt owed to you. But can Sri Lanka afford, at this point, to continue servicing what it owes the multilateral creditors such as the World Bank?

To be clear, payments to multilateral development banks continue in accordance with international agreements. Sri Lanka continues to be in good standing with the MDBs (Multilateral Development Banks) and those debts were not part of the moratorium. It was essential for that debt to not be part of the moratorium because the World Bank and other multilateral development banks continued to have a substantial portfolio in Sri Lanka. In the case of the World Bank, we have roughly 17 projects worth $2.4 billion, and those existed even before the crisis.

So it was critical and essential for us to continue receiving payments on these MDB loans so that we could continue to dispense resources as they were needed.

As you know, the World Bank was the first institution in Sri Lanka, in the midst of the crisis around April-May 2022, to repurpose $325 million very quickly towards social protection payments, LP gas imports and fertiliser imports for the Yala and the Maha seasons.

Moreover, we are a bank that is owned by all the countries. We’re a bank that uses our resources and our credit rating, which is quite impressive and stable to extend concessional financing to countries like Sri Lanka, in different parts of the world. If we are unable to secure our credit rating, then the level of concessional financing to the world goes down.

Thus, it is not an easy answer to give; payment to the MDBs or not because whatever happens will have a butterfly effect and an impact on other countries that are in equal need.

We’ve heard that the multilateral creditors, including the World Bank, will support Sri Lanka, with total lending over the next few years exceeding or equal to about 7 billion US dollars. Can you outline for us what the plan is as far as the World Bank is concerned?

Let me begin by saying that we at the World Bank are very pleased with the recent board approval of the IMF’s EFF programme which is an important step on what I hope will be a journey out of the crisis, towards a sustainable recovery and growth.

Our engagement is part of the support by the international community and it will complement and supplement other multilateral and bilateral institutions like the IMF, ADB, and others. To ensure that we continue to coordinate, we have a platform that is currently chaired by the World Bank but will be a rotating chairmanship among the MDBs in Sri Lanka. Focusing on recovery and longterm growth is our responsibility under our mandate.

In the process of addressing the recovery, we start putting the building blocks in place, led by the government and the people of Sri Lanka towards a growth that is green, resilient and inclusive. Insofar as we’re doing that in our joint engagement; we will focus on these three areas; support the government as it resets the Sri Lankan economy, addressing competitiveness, economic governance, and social protection. We will also focus specifically on the revamp of the social protection system, which is going to be so critical for the country. We have to do it once and we have to do it right so that we can mitigate the pain in the future.

Last but not least, we will also be focusing on the financial sector, which is a very important part of the trinity here. There we look at mechanisms to ensure the continued stability of the sector to make sure that the rules and the guardrails for the sector, are such that the banks are safe and adequately covered. The IFC, which is the International Finance Corporation, the private sector arm of the World Bank, will continue to engage. They’re looking at the financial sector, and other areas such as the tourism sector.

When you look at how bank loan classifications under IFRS 9, the stage two and three loans have reached very high levels. How can potentially the World Bank and multilateral lenders help in this regard? Short of capitalising the banks yourself, I don’t know whether that’s on the agenda. How can you help?

The banking sector is absolutely the lifeline, and I believe it requires attention. I should also add that it is being addressed. The health of the financial sector has been a focus of our engagement with our colleagues, from the IMF, the ADB, and numerous other bilateral institutions, since day one.

We could debate this topic indefinitely because there are so many different facets to it, but one aspect that is crucial to consider is the institutions’ overall health. This is where you have to look at even the mechanism by which asset quality is being assessed. So you need to look at the system and how to revamp the system, not only looking at the banks but what is the governance ecosystem in which the banks live. Do the banks have adequate protection, separation and guardrails from the government to prevent future excessive borrowing or limits on that? So that money could be used by the private sector and entrepreneurs.

Then how is the regulator assessing the asset quality of the banks? Those are areas that we will be looking at with others, looking at the legal and regulatory infrastructure. The other one, which I’m very confident about, is having adequate deposit insurance for the banking sector. So depositors feel that their funds are not at risk. I am comfortable that there will be an engagement in the future which will prevent any other impacts of the crisis.

Do you agree that Sri Lanka has a large government? Will reforming the state’s size and SOEs figure significantly in the World Bank’s proposed country partnership strategy?

What the World Bank looks for is to support sustainable development. In that, we look at revenues versus expenditures and, fiscal policy.

Let me first concentrate on the revenue side and compare Sri Lanka to other nations. The revenue generation in terms of the rates and the base was very low. In fact, I believe it was among the lowest in the world. So that’s a key priority; the revenue side.

On the expenditure side, this is a decision left to the government. Policies are an equilibrium between economic, sociological and political economy. These are for the sovereign to take. We are focusing on it from the numbers. What the numbers say is, there needs to be fiscal balance.

As per the agreements with creditors, the reform agenda requires that there is a greater balance to reduce the fiscal deficit. We see that there’s a reduction already this year to return debt-to-GDP. So decisions have to be made. But it is not for the bank to make those. This is a sovereign decision.

Now on SOEs, it goes without saying SOEs can always be made more efficient. It is a fact that some of them represent a considerable fiscal demand on the economy. Restructuring and optimization of SOEs are very important. The way I look at it is, how can they deliver, first and foremost to the people, and can they deliver resources to the government.

The Sri Lankan government borrows heavily from the market. You suggested this isn’t a practice that is sustainable or healthy from a macro-fiscal point of view, and from a financial sector health point of view. How does a country go about addressing this? What sort of safeguards need to be put in place for there to be less crowding out? And if you can also address how it might be unwound, now that it has gone so far?

There is plenty of international experience on this and the first step is to put together legal and regulatory guardrails. This is one of the key pillars of our support, which the government has asked us to undertake, and which is a key pillar of our future financial and policy support.

There are a lot of technical details we won’t go into but the issue is there has to be a guardrail, there have to be checks and balances. So that this doesn’t become too severe and create liabilities and vulnerability for the banking sector moving forward.

Is it likely to take the form of a GDPrelated measure of how much the government can borrow from the banking sector or the market?

I think we are still in the process. That is fairly a technical item and frankly, I would defer to my technical colleagues who would look at it in great detail.

We are seeing a lot of things, including the recent central bank act; which seeks, first and foremost, to inject a healthy level of independence. At another level, it is also strengthening the prudential capacity. Over time, there will be work towards having rules and regulations to compel and mandate interaction between the central bank, the sovereign as well as the financial sector. Within that, it’s a combination of things, prudential regulation, legal regulation, SOEs and how SOEs are governed and the financial sector.

Sri Lankans feeling the pressure of the economic crisis are a little impatient for results. How does a government sell difficult reforms when the psyche of the population is that they have had enough of the crisis?

I think they have the right to be impatient and frustrated. This has been going on for a while, the result of a year or two of action, and this is the result of years of ossification of systems of governance. My humble advice is that the government adequately articulates the reform path to everyone, that it is coordinated and they consult.

To conclude, is there anything you want to add?

From the side of the World Bank, we continue to be fully committed to the people and the government of Sri Lanka. We have been here for years and we shall be here for a while. I think now there is perhaps light at the end of the tunnel, but we are not out of the tunnel yet.

What is essential right now, we stay the course of critical reforms. This is an area that supersedes any other consideration. There is only one path of reform moving forward. We hope everybody will fall in line. I think the three Cs are critical here in terms of the reform agenda; communication, coordination and consultation. If those three Cs are met, then I am very optimistic.