Dr Dushni Weerakoon, Executive Director Of The Institute Of Policy Studies and Dr Indrajit Coomaraswamy, former governor of the Central Bank Of Sri Lanka, weighed in on Sri Lanka’s unfolding debt crisis, a possible IMF program, debt restructuring, priority of reforms and approach, and outlook for inflation, currency, and interest rates at a CT CLSA securities online investor forum on IMF: order of priorities for reforms held on 23 march 2022. Excerpts of their comments from the forum are as follows:
SEQUENTIONING ECONOMIC REFORMS
Dr Weerakoon: The most critical for Sri Lanka in terms of the economic outlook is to gain some sense of macroeconomic stability. And on that front, we no longer can afford sequential reforms, and I think we must work on several fronts, simultaneously. And critically coordinated action on three fronts is essential; the monetary policy front, the exchange rate front, and the fiscal front.
We’ve sort of entered a monetary policy tightening cycle. We have seen the central bank adopt a market-driven exchange rate. But underpinning this, we are missing the fiscal side. And as long as we neglect that, the progress we’ve made on the monetary and exchange rate front will not get us to stability. If the Central Bank continues to provide direct financing for fiscal expenditures, it will only add pressure on monetary policy and the exchange rate. So the simultaneous alignment of actions on all three fronts is critical.
The reason, I think, we have been slow on the fiscal front is that it is the most difficult. However, fiscal reforms will be at the front and centre of the IMF programme. Even in their recent communique, you can see that the IMF is calling for an ambitious adjustment on the fiscal side. And that’s not easy because it means that we are in a severe economic downturn, resulting in further pain. Things are going to get much tougher before it starts to improve. So the fiscal adjustment will require us to raise taxes on the revenue side and freeze expenditures and curtail subsidies on the expenditure side.
Let’s not forget that these kinds of reforms are easier for an incoming government when their popularity is at its peak. However, considering where we are in the election cycle, the government must communicate and package these reforms, keeping in mind that we have to also ensure that these economic hardships don’t spill over into any kind of social unrest and instability on the socio-economic front.
Now, the clearest way for them to do that is to ask for greater sacrifices from those who are more able to pay, so restructuring the tax side must be done to ensure that the richer segments of the Sri Lankan population bear a greater burden of that tax adjustment. On the expenditure side, a large chunk of spending that the government can control to some extent is public sector wages and salaries. I don’t think we have any option but to call for a freeze on public sector salaries and wages until we come out of the worst of the crisis.
As we try to push on as much as possible through the fiscal side, we need to have targeted social sector spending and social safety nets. The poorer segments of the population, including the bulk of the workforce, don’t have social security or pensions. They are in the informal sector earning daily wages. They are the most vulnerable to economic shocks and disproportionately impacted by the Covid outbreak.
So packaging that fiscal reforms programme with a clear central message that we are aware of the equity concerns is the only way of ensuring that any such reform programme sticks, and we can see it through to the end.
If there is going to be the sequencing of reforms from there, you can bring in the other elements, such as state-owned enterprises reforms, but that will probably be part of the IMF conditions. There are other structural reforms, like labour and land reforms, but we should probably avoid overloading the reforms programme because there’s only so much that you can do. So stay focused on the most important reforms. And for me, that is on the macro stabilization front.
Dr Coomaraswamy: Fiscal reform is the most difficult thing to do. But we cannot have a situation where revenue is less than 9% of GDP and expenditures at 19%. We can’t have three-four consecutive years of double-digit fiscal deficits. You can see what has happened to the Central Bank treasury bill holdings, it cannot continue to print money and get away with it, and we are beginning to see the consequences of that in terms of inflation.
And the pressure on our imports continues. Despite putting in place various controls, imports are still at an extremely high level. So you can’t get away from doing some fiscal reforms. It’s tough, but that is the first thing we need to do. But fiscal reform has to be at the front and centre of any attempt to overcome the economic problem. And this is not a new problem. We’ve had this for years. Government fiscal operations have been the main source of instability for decades now. But it is far more acute.
We haven’t had double-digit fiscal deficits for three years or so. Either way, it’s just not feasible to sustain deficits without causing major macroeconomic imbalances. So we have to begin to start putting it right. It probably will take a few years to address the problem fully. But we have to make a start. And it’s extremely important. Parallelly, we need to have a much more robust social safety net. I think cash transfers are the way to go. And we’ll have to find the money for that. Hopefully, we can get some external assistance to do it, because otherwise, I don’t think it would be possible to maintain social stability while one undertakes these reforms.
RESTRUCTURING DEBT
Dr Coomaraswamy: I think we have left it so late. In my view, this was inevitable from about two years ago; you could see it coming after the government slashed taxes and lost Rs500-600 billion in revenue.
It was clear that we would get to this point at some point, over time, and you could see external reserves haemorrhaging to settle the external debt. But we’ve left it to the point where now I think it’s going to be very difficult to achieve sustainability without some kind of haircut. It’s a complicated process.
Multilateral loans from the World Bank, ADB and IMF are classified as senior debt and we should not touch those for restructuring because if we get into arrears on that debt, those institutions could stop all operations and cease disbursing existing loans. Nobody expects you to restructure multilateral debt, creditors want equality of treatment, but they are quite accepting of excluding multilateral debt. So you take that to one side.
Then you have bilateral debt, and you have commercial debt. Bilateral debt has two categories: The West plus Japan, which are part of the Paris Club. And you can negotiate with them collectively at the Paris Club. On the other hand, you have China and India that are not in the Paris Club.
However, there is a G20 common framework that has been used for low-income countries. Given our circumstances, one possibility is to see whether we can be given this G20 common framework as a means of negotiating with China and India, which are important creditors. Otherwise, the creditor group in the Paris Club only includes the OECD countries. So, that’s something we should try and work on. But even if we don’t, we would need to work separately with China and India because the creditors want the quality of treatment. We need to be able to convince all our creditors to give the same treatment.
Then we have the commercial debt. We will have to negotiate collectively with creditor committees, and they are already beginning to form. Some of them have hired me to meet legal consultants. So it’s going to be a complicated process, and it will take some time.
But this is a road that has been travelled by several countries already. So we don’t have to reinvent the wheel. There is a lot of experience. And there are financial advisors. We need to appoint a financial advisor and a legal adviser upfront, to help us through this process, which is complicated and long-drawn. We also need to convince some of our non-Paris Club creditors to come into the fold (Paris Club), notably China and India. So, it’s going to be difficult. But it’s a well-traversed path by several countries. We cannot escape a haircut at this point, and with our debt repayments over 12 months at over $6 billion.
DEBT RESTRUCTURING: THE CONSEQUENCES
Dr Weerakoon: There are significant financial system risks and life is complicated enough as it is for us to tackle external debt. Restructuring external debt is a path governments are reluctant to tread if you look at the number of countries in debt distress that have gone through restructuring. It’s a handful, and that is because there are associated risks that countries have to manage.
So in terms of what these costs of restructuring debt might be, first is that you run the risk of getting bogged down in a prolonged negotiating process, with the threat of legal action hanging over your head. Some people talk about Argentina’s experience with debt restructuring, but we are talking about something entirely different today. The creditor landscape has changed so much since the 80s and 90s when Latin America went through its debt crisis. Commercial banks were the biggest creditors along with a handful of advanced countries and some of the multilateral institutions.
But today, if you take Sri Lanka, for instance, and we’re not alone in this, the creditor landscape is dominated by private creditors of dispersed bondholders mostly based in the US. And then we have the bilateral creditors like China, India and Japan, and limited multilateral creditors.
Now, the first order of things is that we have to bring together disparate groups of creditors together and get them to agree on what is called equality of treatment because creditor A will not want us to get more debt.
relief from them compared to creditor B. The geopolitics of this entire debt restructuring with US-based investors, China, India, and Japan, also weighs heavily on whether the risks of getting bogged down in negotiations are much less for country A versus country B.
The second risk involves the bond investors themselves. We need to know whether the bonds that Sri Lanka has issued have common agreement clauses where a majority of bondholders can bind the minority. If not, then you run the risk of certain bondholders holding out. They can go to court and drag you through a very embarrassing process where when you try to re-enter international capital markets, if you have not satisfied all your investors, when you try to issue fresh bonds, it can become rather difficult at that point.
So, for all of these reasons, when you look at, for instance, the recent debt restructures of Ecuador and Argentina, which are serial defaulters, it’s much easier to bring these credit committees together and get all these players around one table because they’ve defaulted before, everyone is interested in avoiding a repeat.
Now, the most common debt restructuring for both Argentina and Ecuador was maturity extensions and interest rate adjustment, they did not go into the haircut of touching the principal. In some sense, in a situation like we are in now, it is in the interest of both bondholders and governments to try and get these negotiations done sooner. And maturity extensions and interest rate adjustments are easier to negotiate. But that doesn’t mean that you have resolved your debt restructuring problems. It may be that in four or five years it catches up with you. So all of these risks have to be weighed against the benefits.
The benefits are enormous. We all know as economists that when you have a large public debt overhang, that’s the main inhibitor of long term economic growth. Once you go through some sustained debt sustainability process, then it frees up fiscal space to support economic recovery. But the creditor landscape is such that all of these pros and cons need to be weighed, and governments need to decide on the cost benefits of this process. I’m not entirely sure that Sri Lanka has decided on debt restructuring.
The danger for Sri Lanka is on the inflationary front that we may now start to see wage increases coming across the board
But, if we go to the IMF, fiscal consolidation may include debt sustainability as part of the conditions, then what would happen is once a staff-level agreement is signed, we should already have done all the debt sustainability analysis, bringing all these layers together to arrive at some consensus. If we fail to do that, then even the IMF Executive Board’s approval of your programme gets delayed.
Dr Coomaraswamy: In terms of IMF support, the IMF standard operating procedures dictate that they cannot transact with countries where they deem debt to be unsustainable. So, until we have a program that addresses that, they won’t be able to transact with us, they won’t be able to support us. It is a Catch 22 situation: we can’t have an IMF programme without debt restructuring, and it is extremely difficult to do that restructuring without an IMF programme.
I must say my colleagues in the Central Bank did come up with a plan. The medium-term debt management strategy, which was published in April 2019, had three pillars, gradually reducing the dependence on external debt because if you suddenly stop it, you have the kind of rollover problem we have experienced in the last couple of years, and you have to start using reserves to settle your debt.
The gradual reduction in dependence on external debt, increasing the average term to maturity, and not undertaking any debt of fewer than 12 months were the three pillars. It sets out how that debt was to be managed. And the Active Liability Management Act was designed to increase the tools available to the Central Bank for liability management. So those were the pillars of the debt management strategy. But borrowing from abroad was not an end in itself.
The Central Bank as the advisor and the agent to the government, debt management made it very clear that borrowing money was to buy time for the government to reduce the primary deficit and get into a primary surplus on the budget by reducing the borrowing requirement and increasing non-debt inflows, like exports, remittances, and FDIs.
INFLATION AND EXCHANGE RATE
Dr Weerakoon: If you look at inflation pressure, I tend to think that it is still more of supply-side inflation related to the agriculture sector disruptions, as well as the exchange rate devaluation and all of these things, are feeding in, we have not yet come to a point that I feel its demand-pull inflation because there is no feelgood factor for people to go on a spending binge, even at the time that we had no interest rates.
In that scenario, monetary policy tightening is signalling intentions, what I think central bankers might call forward guidance. If you look at our monetary policy right now, the policy rates are way short of what’s reflected in market interest rates. So there’s a large gap there to be bridged.
Now, the danger for Sri Lanka is on the inflationary front that we may now start to see wage increases coming across the board. And once this wage-price spiral becomes entrenched, the Central Bank will have to be very proactive and address it and try to nip it in the bud. So, the current monetary policy tightening that we’ve seen has still a long way to go.
I see interest rates will probably keep edging up, and if the wage spiral starts kicking in, then interest rates will have to be raised a little more. Now, the issue is, if interest rates go up, what happens to growth? Let’s not forget that we are at the bottom of recovery from a huge economic shock and we need to see some positive growth. To kill growth to achieve macroeconomic stability is something that needs to be carefully considered to be able to balance both with limited tools and fiscal space at our disposal.
Going forward, I expect interest rates will keep going up. An inflationary outlook suggests that is not going to ease off. My take on the exchange rate is overshooting does happen when you have held on to a rate and you’ve suddenly let go. There is high speculative behaviour out there. But there is also a lack of confidence to pull the exchange rate back. The risk here on the currency is very high. We will struggle to build reserves back to about $8 billion that’s needed to bring about some degree of confidence and stability on the exchange rate front. So to me, it was a bit of a very calculated risk that the Central Bank let the exchange rate go overnight after holding it back so long without allowing it to gradually depreciate. We have to focus our attention primarily on stabilising the exchange rate right now because the volatility means that investors will hold off where there is a great deal of uncertainty.