Modern Monetary Theory, excessive money printing, curbing imports, arranging swaps, and even going before the IMF to contain an economic disaster is like lashing out at the many heads of a hydra. They soon grow back!

IMF or no IMF, Sri Lanka needs policy credibility and stability to woo the right kind of investors, those who would bring FDI that can drive productive segments of the economy, the Institute of Policy Studies (IPS) suggests.

Current fiscal and monetary policy is failing to reassure foreign investors, let alone citizens.

Sri Lanka’s structural macroeconomic problems are well known: it cannot sustain its debt; the public sector is bloated; export growth is lower than imports; it has few FDIs in productive sectors of the economy; and, it consistently runs twin deficits. Over the decades, Sri Lanka has tried to deal with its economic problems like aiming for a hydra’s heads. Chopping them off can bring respite, but it is brief. The heads grow back, and the bite is more menacing than before. Sri Lanks has gone before the IMF 16 times in the last 70 years, so clearly, even structural reforms under an IMF programme live short lives (please see graph).

With reserves in hand to cover barely two months of imports, the forex market will conOnly cohesive and strategic policymaking can deliver the debt-laden country out of chaos tinue to face volatility and instability until a steady stream of capital inflows emerge, beyond short-term swaps. Sri Lanka needs a strategic approach to policymaking to attract FDIs that can bring productivity gains for long term growth.

Since early 2020, Sri Lanka had printed billions of rupees in the wake of the unfolding coronavirus pandemic. In August 2021, the Central Bank raised policy rates, signalling a possible course correction. But none of it will help.

According to the IPS, advanced economies (AEs) amassed debt to 120% of GDP on average by the end of 2020. Emerging markets economies (EMEs) trailed some distance at 65% of GDP.

“Some countries are better at managing the inherent risks and conflicts of interest involved in this exercise. AEs have an advantage as issuers of reserve currencies with global demand and historically lower interest rates,” the IPS said in an August 2020 blog post.

On the other hand, emerging market economies (EMEs) with limited exposure to foreign currency-denominated debt holding comfortable stockpiles of reserves are less exposed to disruptive tail events, it said. Such countries can reduce their debt ratios by maintaining nominal GDP growth above the average interest rates on their debt. EMEs can then run modest primary deficits and still have a stable or falling debt-to-GDP ratio, the IPS contends.

Sri Lanka is not an AE, neither is it a typical EME.

Its debt metrics point to high vulnerabilities. It has a high debt-to-GDP ratio of 101% of GDP, the IPS says. It is also overexposed to foreign currency-denominated debt and has a hefty foreign debt repayment schedule. Under these conditions, the threat from exercising monetary sovereignty was always self-evident. A depreciating currency notwithstanding distortionary controls on imports and capital flows worsens debt vulnerabilities.

According to the IPS, if the exchange rate depreciates, it increases the real value of outstanding debt relative to the size of the economy, even if interest rates remain modest. Further, shocks like COVID-19 raise risk premia and marginal borrowing costs can rise suddenly and sharply, thus cutting countries abruptly out of financial markets.

The Central Bank tightened policy rates in August, signalling to the market that interest rates could rise. The IPS argues that if debt servicing interest rate costs are pushed persistently above the economic growth rate, the debt burden will grow steadily, even in the absence of new borrowing, a context sometimes called a debt spiral.

Higher interest rates may not attract foreign capital given the risk premia on the currency as depreciating pressure deepens. One option is to raise tax income, but this is a slippery slope for policymakers. Attracting FDI is another solution, but Sri Lanka needs to be smart about this.

“For a successful outcome, productivity gains to drive long-term growth, the type of FDI matters,” IPS contends. The more desirable is efficiency-seeking FDI, but this is also harder to attract. “For now, a policy environment of import curbs and capital controls is more likely to see strategic-seeking infrastructure-led FDI. The latter runs the risk of switching resources to non-tradable sectors – reducing the availability of external financing over the longer term – and the prospect of a short-lived growth burst as before in the post-war years. Crucially too, the sole reliance on FDI leaves Sri Lanka at the mercy of developments beyond its control”.

Effective policy strategies that instill and maintain credibility is crucial to winning FDIs that matter. “Indeed, this is all the more important as Sri Lanka appears to be firmly against an International Monetary Fund (IMF) bailout,” the IPS argues.

IMF support will hardly solve Sri Lanka’s problems. Loan amounts are small, and the IMF no longer has much sway on debt relief because private institutional investors and China hold much of the debt. However, an IMF programme may be beneficial because it can firm up sovereign credit ratings and revive investor sentiments.

“But investor sentiments can also improve if governments put forward and implement credible policy strategies,” the IPS points out. The Central Bank’s move to tighten policy rates will not do that.

The Central Bank’s policy rate adjustment to anchor expectations, for instance, will not stick if direct financing of fiscal spending is to continue under yield control measures. Instead, market convictions on the credibility of the policy mix will drive economic fundamentals. As Sri Lanka readies to transition out of pandemic-related emergency support, some notion of fiscal and debt sustainability to anchor confidence should be the priority in Budget 2022 preparations, the IPS says.