Sri Lanka arriving at an agreement with its external creditors and completing the debt restructuring before the upcoming elections poses a greater risk to the economy, said Associate Professor of Economics at Oberlin College USA, Prof. Udara Peiris in an interview with The Daily Morning Business, as securing a deal now, “without widespread cross-party support, could lead to future uncertainties and hinder Sri Lanka’s access to international capital markets.”
He said that under the current International Monetary Fund (IMF) projections and policies, Sri Lanka's GDP per capita will lag behind those of India and Bangladesh by 2032 and to reverse this trend, Sri Lanka needs to improve female labour force participation, increase exports, and enhance governance.
Also, he added that higher dollar reserves are not a cause for celebration but a reflection that the Government struggles to directly tax citizens to gather the necessary foreign currency for external payments.
According to him, the Central Bank's practice of accumulating reserves acts as a form of indirect taxation as by acquiring dollars, CBSL fuels inflation in rupees.
Prof. Periris said that to match Singapore's wealth level by 2053, Sri Lanka would need to increase its per capita income nearly 80 times, “an unrealistic target given the current economic strategy,” as It highlights Sri Lanka's difficult path to keep up with more rapidly advancing economies.
Following are excerpts from the Interview:
What are your thoughts on Sri Lanka's current macroeconomic conditions since the crisis year 2022?
Sri Lanka is grappling with two distinct crises: a short-term financial crisis and a long-term governance crisis.
The short-term crisis is a textbook example of the perils of money-financed deficit spending with a fixed exchange rate. During the Covid-19 pandemic, the monetary base increased from 670 billion rupees at the end of 2019 to 1 trillion rupees by the end of 2021 to support expanded government spending. This then triggered a capital outflow, and the exchange rate collapsed. Fortunately, the Central Bank of Sri Lanka has since effectively addressed this by stabilising the monetary base. Government rupee debt ballooned during the pandemic and posed a risk to the ability to control money growth. Early in the crisis, alongside Verite Research, I emphasised the need for restructuring domestic debt to maintain financial stability (see ‘The Desirability of Domestic Debt Restructuring’ published in October 2022). The eventual application of our proposal by the Government termed Domestic Debt Optimisation, has successfully minimised the reliance on new money creation to manage government debt, leading to lower interest rates as we had forecasted. Additionally, foreign reserves have improved, thanks to a post-Covid global surge in tourism, particularly tourist arrivals from Russia.
The more severe, long-term crisis stems from decades of mismanagement and poor governance, which go beyond typical election-cycle accusations of corruption. The core issue is a lack of accountability from public institutions to citizens and taxpayers. This often manifests in nepotism and a lack of rigorous economic analysis in policymaking. Many budget items are based on little or no analysis that is available for public scrutiny. The focus should not solely be on which policies or parties are better but on developing transparent policies grounded in solid economic analysis.
The solutions proposed, such as those in IMF programmes, are a step in the right direction. For instance, increasing government revenue is crucial, but the method matters. For example, raising taxes through VAT can disproportionately affect poorer citizens who spend a higher percentage of their income on consumption. A more equitable approach would be broadening the tax base and spreading the tax burden evenly among citizens. Regarding the restructuring of domestic debt, our initial proposal called for a broad-based restructuring impacting all holders of government debt. However, in the implementation of Domestic Debt Optimisation, there was a tax only on pension funds, which was essentially a high wealth tax on future pensioners without any such tax on financial investors. This policy reflects the fundamental governance issues that must be addressed for genuine recovery and long-term stability.
Should Sri Lanka rethink its tax structure? especially the extensive use of indirect taxes to gain more revenue. and the PAYE tax? Also, Sri Lanka is planning on gradually removing para-tariff in 5 years, how challenging will it be for the Government to get rid of it which they have heavily depended on in the past years, how can the Government substitute for it?
One fundamental aspect of Sri Lanka's long-term crisis is its unclear and inconsistent tax policy. The country has relied heavily on indirect taxes for decades, with exchange rate policies being particularly problematic. The Central Bank's practice of accumulating reserves acts as a form of indirect taxation—by acquiring dollars, it fuels inflation in rupees. Higher dollar reserves are not a cause for celebration but a reflection that the government struggles to directly tax citizens to gather the necessary foreign currency for external payments.
Moreover, para-tariffs require reevaluation. Such tariffs distort the relative prices of imports, which in turn can skew investment decisions domestically. When the relative prices faced by Sri Lankans diverge from those in other countries, it hampers the economy's ability to compete globally. In other words, taxes on imports hurt export competitiveness. Most of these taxes should be removed, except perhaps in areas critical to national security. Instead of relying on indirect taxation, the focus should shift towards taxes linked to value creation/addition.
A crucial step towards improving this situation is the electronic registration of taxpayers and the electronic recording of economic transactions, particularly financial ones, with the tax authority. It is encouraging that the government is taking the IMF recommendation on this seriously, and I hope to see its implementation soon.
Sri Lanka is yet to sign a deal with creditors while other reforms such as SOE restructuring are still remaining, what sort of risk will these have if they drag on beyond the elections in 2024?
In my view, an agreement with creditors reached before the upcoming election poses a greater risk to the economy. I believe a genuine deal with creditors should not and cannot be finalised before the year-end elections. The newly elected government will have a fresh mandate from the voters, encompassing how to handle external debt and reforms for State-owned enterprises (SOE). Securing a deal now, without widespread cross-party support, could lead to future uncertainties and hinder Sri Lanka’s access to international capital markets.
Post-election, the new government’s first task will be to negotiate a deal with creditors. This timing will ensure that the agreement reflects the electoral mandate, thereby offering more stability and credibility to the agreement. Creditors will be able to negotiate confidently, knowing that the agreement will likely be respected and maintained over multiple years, rather than just for a few months.
Does the current IMF programme have room for adjustments? If so, what could be some of those adjustments? Also, Post debt restructuring, what should be the priorities the government should focus on to ensure they don't go into another restructuring?
In a recent analysis published under the title, ‘Poorer than India and Bangladesh: Where is IMF program taking Sri Lanka?’, I examined data from the IMF and the Sri Lankan Government. My findings suggest that by 2032, under the current IMF projections and policies, Sri Lanka's GDP per capita will lag behind those of India and Bangladesh. To reverse this trend, it is essential for Sri Lanka to improve female labour force participation, increase exports, and enhance governance.
GDP per capita is an essential indicator of a country's economic health, reflecting the average income per person and is particularly valuable for comparing different-sized economies. Presently, Sri Lanka's GDP per capita exceeds those of India and Bangladesh. However, IMF projections indicate that if Sri Lanka continues on its existing trajectory, it will be overtaken by India and Bangladesh. By 2028, per capita incomes in Vietnam and the Philippines are projected to increase by 35% and 25% respectively, surpassing that of Sri Lanka. The challenge of closing this gap is formidable. For example, to match Singapore's wealth level by 2053, Sri Lanka would need to increase its per capita income nearly 80 times, an unrealistic target given the current economic strategy. It highlights Sri Lanka's difficult path to keep up with more rapidly advancing economies.
Sri Lanka urgently needs to implement structural reforms to achieve growth rates higher than the IMF's projections. There are suggestions that Sri Lanka could achieve an 8% GDP growth rate, well above the IMF's forecast of 3.1%. However, historical data shows that only two oil-exporting nations that defaulted on their debts — Nigeria and Côte d'Ivoire — have achieved such growth, with most others achieving between 2% and 6%. For non-oil exporting countries, the average growth was slightly above the IMF's projection for Sri Lanka at 3.4%. This modest improvement requires significant structural changes beyond simple fiscal austerity measures like tax hikes and spending reductions. Nishan de Mel of Verité Research has identified three key areas for fostering growth in Sri Lanka: enhancing women's economic empowerment, increasing regional trade integration, and improving governance.
Countries that grow faster than 3.4% typically show stronger economic fundamentals than Sri Lanka. For instance, their female labour force participation rates average 55%, and their exports as a percentage of GDP stand at 43%. In contrast, Sri Lanka's female labour force participation is only 30%, and exports account for merely 20% of GDP.
According to the Worldwide Governance Indicators from the World Bank, countries that default on their debts usually see a decline in metrics like Government Effectiveness and Control of Corruption. Yet, countries maintaining higher growth rates tend to see a smaller decline in these areas. In essence, countries focusing on improving governmental efficiency and reducing corruption are more likely to achieve rapid economic growth.