Sri Lanka has to watch inflation, bank credit, tax revenues, keep monetary policy tight and avoid guaranteeing bank forex borrowings and instead create an environment for foreign direct investments, the International Monetary Fund has said.
The executive board of the IMF in a review of Sri Lanka’s economy said Sri Lanka’s economy was facing key challenges of slowing growth and high inflation and gave a nod for post program monitoring.
The IMF has finished a 2.5 billion US dollar bailout last year which rescued the country from two balance of payments crises, brought about by contradictory exchange rate and monetary policies.
IMF director cautioned against easing of monetary policy in the near term, and said the exchange rate should not be defended aggressively.
“Exchange rate flexibility should be maintained to cushion external shocks, while deeper markets and a gradual move toward a flexible inflation targeting regime would strengthen inflation control,” IMF’s executive directors said in a public information notice.
Sri Lanka has an unstable soft-pegged exchange rate where the Central Bank intervenes in the foreign exchange market to maintain a rate and also has a policy interest rate, which is targeted by printing money, a contradictory policy mix.
A policy rate requires the exchange rate to weaken when fresh money is injected to the banking system either to finance the government budget deficit or to off-set the effects of foreign exchange sales on interest rates.
To prevent balance of payments crises from developing from contradictory policy the monetary authority either has to allow rates to go up in the short term when the peg is defended aggressively or allow the exchange rate to weaken by keeping it flexible.
Since the end of the last balance of payments crisis, the Central Bank has kept exchange rate ‘flexible’ though it had prevented its appreciation from capital inflows.
Last year Sri Lanka’s budget deficit had been kept at 6.5 percent of gross domestic produce – a quarter percent above target – partly by carrying over payments to the next year and cutting capital expenditure, while tax revenues were weak.
The IMF said value added tax exemptions should be reduced and fully extended to wholesale and retail trade and reduce tax holidays. At the moment only large supermarkets owned by private citizens pay VAT while state ones do not pay taxes.
The IMF said state energy enterprise losses have been cut and said a recent power tariff hike would help. But an automatic price adjustment formula backed by measures to safeguard the poorest should be put in place.
Energy subsidies accommodated by printed money, is one of the principle triggers for Sri Lanka’s currency depreciation.
The IMF said authorities were trying to cut current expenses, which they welcomed. Last year revenue to GDP had fallen to 13 percent and it should be increased.
Other analysts have cautioned that in the past taxes collected from the people had been busted on current spending, especially the expansion of a state worker cadre, handouts to politically powerful special interest groups and mis-managed state enterprises.
Capital expenditure has always been fully funded with debt for several decades, even when revenues were close to 20 percent of GDP with no surplus in the current account of the budget since 1987.
The IMF said foreign reserves should also be built up saying they were “relatively low by most metrics, and encouraged strengthening the reserve position as circumstances permit.
Sri Lanka was warned against encouraging excessive foreign borrowings and was encouraged to boost foreign direct investments. Attempts to give forex guarantees to banks to borrow abroad may hurt monetary stability and economic stability in the future, IMF directors said.
“They cautioned that government guarantees for foreign currency borrowing by banks, if introduced, could undermine exchange rate flexibility, create contingent liabilities, and raise debt sustainability risks,” the public information notice said.
“Directors noted the long-term deterioration of the export-to-GDP ratio and growing reliance on debt for current account deficit financing.”
Instead of more debt, IMF directors called on authorities for “further improvements in the business climate to attract foreign direct investment.”
Sri Lanka has resumed expropriating private property and there are increasing concerns over deteriorating rule of law.
Sri Lanka should also boost free trade, which they said would also boost exports.
Free trade allows costs of inputs to fall, including labour, as workers find living expenses lower and drives capital into exports rather than tariff protected inefficient businesses.
Critics say trade protection kicks off a vicious downward spiral of generating profiteering businesses that invest increasingly large volumes of capital in ‘domestic production’ which are not efficient or of sufficient quality to export.
They in turn raise living costs for the poorest wage earners by forcing them to pay higher than global prices for what they buy, especially for those in remaining export industries, increasing export weakness through wage pressure.
Export industries then call for exchange rate depreciation to remain in business by cutting the real wages of workers.
The IMF said the banking sector “appears sound” and said there was progress in strengthening regulation, but called for vigilance following recent high credit growth.