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Economic and debt crisis: Act now to prevent prolonged economic recovery: Prof. Shanta Devarajan

02 Apr 2022

  • Economy will contract severely; inflation and poverty will increase if no action taken
  • IMF programme will build confidence in Sri Lanka and buy breathing space
  • Restructuring SOEs such as SriLankan Airlines, CPC, and CEB important
  • Sri Lanka should introduce policies that ensure rapid and inclusive economic growth
By Asiri Fernando Sri Lanka risks prolonging economic recovery by many years and further complicating the ongoing crisis, if we do not expedite a credible debt restructuring programme and introduce policies that ensure rapid and inclusive economic growth, former Director for Development Economics and Chief Economist of the World Bank for the South Asia region, Prof. Shanta Devarajan told The Sunday Morning. Sri Lanka is on the cusp of its first sovereign debt restructuring as most communities in the country struggle to get by. According to Prof. Devarajan, if Sri Lanka manages to enter a well-planned IMF programme of assistance, the island nation may regain access to capital markets within a short period and reduce the long-term impact of the economic crisis. The appointment of a credible financial advisory firm to negotiate with Sri Lanka’s creditors can lead to a ‘debt standstill,’ which would buy the country some breathing space to prioritise limited forex reserves for vital imports such as fuel, food, and pharmaceuticals. In an interview with The Sunday Morning, Prof. Shanta Devarajan – a professor of the practice of international development at Georgetown University’s Edmund A. Walsh School of Foreign Service – highlighted the importance of fiscal consolidation, improving State revenue, restructuring loss-making State-Owned Enterprises (SOEs), and monetary, exchange rate, and subsidy reforms, as Sri Lanka looks to regain her economic balance and move towards a path of recovery. Following are excerpts from the interview: What is your assessment of the current state of the Sri Lankan economy and do you see similarities to other countries that have undergone similar crises? The current state of the economy is terrible — just ask the people standing in line for petrol and cooking gas, facing power cuts of over 10 hours a day, shortages of pharmaceuticals and food, and skyrocketing prices. The country is both illiquid — not enough foreign exchange to buy imports and meet debt service payments — and insolvent — the total amount of public debt is so high that the Government will not earn enough revenue to pay it back. Other countries that have undergone similar crises include Lebanon, which had a disorderly default on its debt in 2022, after which GDP fell 20% and inflation rose to 100%. Another is Turkey, where thanks to the Central Bank’s lowering of interest rates in the midst of high debt and current account deficits, the currency depreciated by over 200%. What do you think will be the long-term impact of this crisis on the overall economy and the livelihoods of Sri Lankans? It depends on how the Government manages the crisis. If it fails to restructure its debt and ends up defaulting, the impact could be devastating. The economy would contract severely, inflation would soar, and poverty would increase sharply. It will take years for the country to resume growth. Such crises have long-term impacts — for example, undernourished children learn less in school and earn less as adults. Even worse, such crises lead to a breakdown of trust in the economy, which may take years, or even generations, to recover.  By contrast, if the Government is able to restructure the debt and agree on a programme with the IMF, the crisis will be short-lived. Other countries that have done this have regained access to capital markets in six to nine months. While many Sri Lankans will face hardship in the intervening months, the long-term effects may be minimal. You have highlighted the need for the Sri Lankan Government to expedite the appointment of a financial advisor as it lays the groundwork for debt restructuring. Can you explain what kind of financial advisor Sri Lanka should seek and what key factors should be taken into account when hiring a credible financial advisor/firm? The financial advisor helps the country negotiate a debt restructuring with its creditors. Sri Lanka should seek a financial advisor who is experienced in working with commercial and official creditors on the one hand, and understands the IMF and developing countries on the other. The advisor should be able to promote the country’s interest while reaching an agreement with the creditors. They should be credible to both the country and the capital markets. Can you explain the role of the financial advisor (once they are selected)? Once they are selected, the financial advisor can in the first instance negotiate a debt standstill. This is important because Sri Lanka has a billion-dollar debt payment coming due in July. The advisor can get this and other payments due over the next three months postponed. This will give Sri Lanka some breathing room to use foreign exchange to buy much-needed imports, such as fuel and food. Next, the financial advisor, drawing on some credible analysis of the sustainable debt of Sri Lanka (such as the IMF’s debt sustainability analysis), begins to negotiate with the creditors on how much of a ‘haircut’ they will take to make the country’s debt sustainable. The extent of the haircut the creditors are willing to take depends on how much fiscal consolidation the Sri Lankan Government can undertake, because the latter, along with an IMF programme, signals that the country is on track to achieving a sustainable debt. The Sri Lankan State has significant external and internal debt to service. Do you think Sri Lanka should seek to restructure both at the same time?  Yes, Sri Lanka should restructure its public debt, both external and internal. Both types of debt, if excessive, can threaten the economy’s stability. What would the debt restructuring process involve? What are the key steps? The debt restructuring process involves a programme of fiscal consolidation and monetary tightening by the Government and negotiation with creditors on a reduction or reproduction of debt service payments. The fiscal consolidation includes increases in tax revenues (which are among the lowest in the world) and cuts in expenditures, especially losses from SOEs and fuel and electricity subsidies. Monetary tightening means interest rates will increase. With both of these in place, the exchange rate regime can be made more flexible. On the negotiation with creditors, one set would be with commercial creditors, including the holders of International Sovereign Bonds (ISBs) and Sri Lanka Development Bonds (SLDBs). In the case of other would-be official creditors, for the ‘traditional’ bilateral partners such as the US, Europe, and Japan, there is an established process called the Paris Club for such negotiations. In Sri Lanka’s case, it will have to also negotiate with non-traditional partners such as India and China. In your opinion, what proposals can Sri Lanka take to the IMF when it negotiates an assistance programme?  There are five major proposals that Sri Lanka can take to the IMF: (i) an increase in the VAT rate and a lowering of thresholds for both the VAT and income tax; (ii) restructuring of the SOEs such as SriLankan Airlines, CPC, and CEB to reduce losses to the Treasury (and risks to public banks); (iii) reduction in subsidies in fuel and electricity, combined with a cash transfer targeted to the bottom 40% of the income distribution (this is to cushion the poor from the increase in fuel and electricity prices); (iv) an increase in interest rates and slowing of money supply growth; and (v) a more flexible exchange rate regime. Should the Sri Lankan Government seek parliamentary approval for the proposals it plans to take forward to the IMF? If any of the policy changes described above require parliamentary approval, then the Government should take those proposals to Parliament. But some of them, such as interest rate increases, do not require parliamentary approval. How will the credibility of the IMF help Sri Lanka to better negotiate with its creditors? The IMF’s debt sustainability analysis is widely seen as an objective piece of analysis using the most rigorous analytical techniques. Therefore, the DSA can help to ‘anchor’ the negotiations between Sri Lanka and its creditors. Do you think Sri Lanka will be able to negotiate a ‘breathing space’ from its creditors with IMF assistance and a financial advisor? If so, how long will it buy Sri Lanka? The financial advisor can help negotiate breathing space by seeking a debt standstill over the next few months. In the meantime, Sri Lanka will need more foreign exchange to buy imports. The country can try to get ‘bridge financing’ from friendly bilateral partners such as India and Japan. In some cases, these partners will give the bridge financing only if the country is in discussions with the IMF on a programme. In this sense, the IMF also helps the country get some breathing space. Sri Lanka has requested to restructure bilateral debt from India and China. Do you think Sri Lanka should continue to pursue the bilateral requests outside the IMF/financial advisor’s involvement? All creditors want to make sure that they get treated more or less equally. Negotiating with all the creditors together provides some assurance of this. So it is better to restructure bilateral debt with India and China alongside the negotiations with the other creditors. One way of doing this is the Common Framework proposed by the G20 countries. While it is meant for low-income countries, there is a possibility that a lower-middle-income country like Sri Lanka could be included. What type of fiscal and structural reforms do you think Sri Lanka needs to embark on in the short- to medium-term to build confidence among creditors, the IMF, and potential investors? The tax increases, SOE restructuring, subsidy reform, and monetary and exchange rate reforms mentioned earlier will go a long way to building confidence among creditors, the IMF and investors. In the longer term, Sri Lanka can undertake reforms to increase the productivity of agriculture, rationalise the civil service, and improve the business climate. In a recent interview you stated that an IMF programme may open new sources of funding for Sri Lanka. Can you explain what those sources are and what type of framework Sri Lanka should follow when seeking funding from them? An IMF programme will open up funding from three sources: the IMF itself, which could be up to a billion dollars a year for three years; the World Bank and Asian Development Bank, which can provide budget support based on structural reforms that enhance inclusive growth; and bilateral partners who will respond with investment when confidence in the economy increases. What long-term policies do you think Sri Lanka should introduce to ensure better fiscal policy making and avoid debt default in the future? In the long term, Sri Lanka should introduce policies that ensure rapid and inclusive economic growth. This includes boosting agricultural productivity (which may involve relaxing some of the regulations of the sector), rationalising the civil service (because it crowds out private sector growth), stimulating business investment, especially in the services sectors, and allowing greater migration of skilled workers into the country.     


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