SL's Extended Fund Facility arrangement with IMF: Mostly fiscal
By Dushni Weerakoon
The often repeated pun on the IMF's acronym satirically suggests that
it prescribes a tighter fiscal policy, whatever an economy's problem
might be. Indeed, lower budget deficits and higher government revenues
are central to Sri Lanka's latest US$ 1.5 billion loan from the IMF.
But, the economy's booms and busts of recent years - including the
current economic distress - go beyond merely the fiscal; much of it has
manifested in the monetary and exchange rate policy spheres.
It is hard, however, to get away from the argument that all roads
lead back to the fiscal quandary; the frequent devaluation of the rupee
for example, is a reflection in the monetary sphere of fundamental
imbalances in the real economy - production, consumption, and
investment. And fiscal policy is where the adjustments begin.
'Twin deficits'
The imbalances besetting the Sri Lankan economy produces 'twin
deficits': budget deficits that mean debt is piling up and current
account deficits that indicate overriding reliance on foreign capital
inflows.
At the heart of it, the imbalances mean a) national expenditure
exceeds national income; and b) production of tradable goods and
services is inadequate. So long as foreigners are willing to finance the
external current account deficit, the economy can muddle along.
But, if there is a reversal of such flows, as happened in 2015 (that
coincided with a sharp increase in fiscal imbalances), painful
adjustments have to be made.
A current account deficit can be addressed by either cutting national
expenditure or raising income. The latter cannot be increased
sufficiently in the short term as GDP growth typically increases
expenditures, and productivity improvements take time. Alternatively,
governments can attempt to switch resources to produce more tradable
goods and services.
This calls for a depreciation of the currency. But, a nominal
depreciation alone is insufficient; expenditures must also be reduced to
keep domestic cost increases at bay, and ensure that a real depreciation
of the currency takes place.
Curtail spending
Sri Lanka's IMF programme signed in June this year has built all
these elements into its framework - fiscal tightening, a soft inflation
target, and a flexible exchange rate regime. Within this framework, GDP
growth is expected to remain at a modest 5 % in the medium term, while
export earnings are forecast to grow steadily (Table 1). Clearly,
imbalances are to be addressed in the short term by 'switching
resources' (flexible exchange rate) rather than attempting to boost
national income.
For a real depreciation of the currency to occur, expenditure
(consumption or investment) must be reduced. Therefore, the government
and/or private sector (firms and households) must curtail spending. This
is being done by cuts in both current public spending as well as tax
increases.
The government's current expenditure is to reduce from 15.2 % of GDP
in 2015 to 13.9 % in 2016. Generous relief measures offered in 2015 will
take a cut in real rupee terms in 2016-17; household disposable incomes
will drop as fiscal expenditures on public sector salaries and wages,
expenditures on other civilian goods and services and transfers and
subsidies (of which nearly 80 per cent go to households) are squeezed
(Figure 1).
On the revenue side too, households' disposal incomes and firms'
profits will be impacted with projected increases in collection from VAT
and income taxes (Table 2). Not surprisingly, the overall macroeconomic
framework points to declining private savings as a share of GDP, while
private investment stagnates at 21.9 % of GDP in the coming years (see
Table 1).
Growth
While focusing on fiscal policy, the response of monetary authorities
will also be critical to the question of who bears the cost of
adjustment. If the rupee is not allowed to float freely, interest rates
will rise, increasing the cost of credit to firms and households, and
thereby reducing domestic expenditure.
The prudent option is to allow the rupee to move freely on underlying
economic fundamentals. Monetary policy can then be more stimulative to
support growth, discouraging savings and encouraging borrowing (as the
predicted savings-investment figures seem to suggest). Overall though,
there is little room to provide a fiscal and/or monetary policy stimulus
to accelerate growth in the near term, evident by the IMFs modest 5 %
medium term growth estimate.
It will draw the usual criticism that fiscal austerity leads to a
stagnant or shrinking economy, at least in the short run, and
exacerbates debt burdens needlessly. However, there is no realistic
alternative to fiscal tightening; Sri Lanka has pushed itself to a
corner, dragging public finances down with low tax receipts and
unaffordable spending sprees.
What the economy needs most today is a credible fiscal consolidation
plan that will restore macroeconomic stability and investor confidence
in the country. If the only means of getting there is inking an
agreement with the IMF, then it is incumbent on the government to
deliver on the terms swiftly. The loan amount, spread over three years,
is relatively small. In the circumstances, Sri Lanka needs to act early
and decisively to fully leverage the IMF deal as a confidence-restoring
measure in its efforts to attract investment flows, both local and
foreign.
The author is the Deputy Director of the Institute of Policy Studies
of Sri Lanka (IPS). To view the article online and comment, visit the
IPS blog 'Talking Economics'
- www.ips.lk/talkingeconomics |