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FINANCIAL CHRONICLE™ » DAILY CHRONICLE™ » After three successful events, now back to hard economic choices

After three successful events, now back to hard economic choices

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Director - Equity Analytics
Director - Equity Analytics
Sri Lankans were treated to three successful events, one after the other, during the last two weeks.

Satisfying IMF to conclude SBA
The first was the successful completion of the Stand-By-Arrangement or SBA, which Sri Lanka entered with the International Monetary Fund or IMF in mid-2009 when the country had been hit by a massive external sector crisis.

Against the rising oil prices in the international markets and an adverse global economy, the country had run a huge trade deficit amounting to $ 6 billion in 2008 causing an unaffordable deficit in the current account of the balance of payments amounting to $ 3.9 billion, almost 10 per cent of Gross Domestic Product or GDP of that year.

Since the foreign exchange inflows by way of borrowings and foreign investments were not sufficient to meet this deficit, the end result was a deficit in the overall balance of the balance of payments to the extent of $ 1.4 billion or 3.4 per cent of GDP. The country’s net foreign reserves fell by that amount.

In early part of 2009, the authorities tried to fix the problem by getting into temporary borrowings from friendly central banks under swap arrangements and seeking the assistance of Sri Lanka’s Diaspora to supply the country with foreign exchange without much success.

When the foreign reserves started to fall drastically driving the country to a critical situation, it was the SBA with IMF that rescued the country. With SBA and the winning of the long drawn ethnic war conclusively toward the middle of 2009, the tides began to turn in favour of Sri Lanka resulting in an improvement in the external sector of the country.

However, after drawing a few instalments of the SBA, known in IMF terminology as tranches, the country was not able to proceed further with it to draw the last two tranches creating doubts in the minds of the international community whether the country would be able to conclude the SBA as it had promised earlier. Now, those doubts have been cleared with the drawing of the final tranche in July, this year.

Borrowing more to repay past loans and finance the Budget
The second was the country’s success at borrowing $ 1 billion from the world’s commercial markets by issuing Sri Lanka’s sovereign bonds to foreign investors. This measure which had been announced in the Budget of 2012 was needed to repay the principal of a similar sovereign bond issue made by Sri Lanka amounting to $ 500 million in 2007 and part finance the expenditure programmes of the government during the year.

Again the odds were against the country because of the brewing of another external sector crisis and the downgrading of the country’s credit position from positive to stable by international credit rating agencies.

When the country was making preparations for the issue of the sovereign bonds, it was hit once again by being classified as a high risk banking sector country by one of the rating agencies, namely, Standard and Poor’s, in its annual banking industry country risk assessment or BICRA. Yet, monies were a plenty in the global markets seeking investment outlets and therefore a lot of interest was shown by prospective investors in Sri Lanka’s sovereign bonds.

As a result, Sri Lanka was able to attract funds for the sovereign bonds at an average interest rate of 5.85 per cent, as against the previously announced indicative interest rate of 6.15 per cent for Sri Lanka’s bonds which are rated below the investment grade and, hence, commonly known as ‘junk bonds’.

Going for an Extended Fund Facility
The third was the announcement by the Central Bank that it would go for an Extended Fund Facility or EFF with the IMF in order to continue to strengthen its macroeconomic fundamentals and the shaky external sector in the next few years. EFF is a facility which a member country can get from IMF when it faces serious balance of payments problems due to structural weaknesses in its economy requiring long periods for implementation of a successful corrective programme.

EFF is basically for a three-year period with option to go for a four-year EFF in extremely vulnerable cases, but could be repaid within four-and-a-half to 10 years, longer than the repayment period of SBAs that is limited to three and a quarter to five years. But the most important fact about EFF is that the IMF should be satisfied that the member country should be able and willing to implement deep and sustained structural reforms in order to get out of its deep balance of payments problems.

These ‘deep and sustained structural reforms’ normally include disciplining the budget, reforming the state enterprises, adopting a market based flexible exchange rate policy, tightening monetary controls as necessary and removing the impediments for investment, trade flows and continued high economic growth.
The total amount which a country can borrow from IMF under EFF is sufficiently large, going up to 200 per cent of the member country’s share in IMF known in its terminology as the ‘quota’ annually and up to 600 per cent of the quota as the full amount. In exceptional dire necessities, even this can be exceeded.

Given Sri Lanka’s current quota of SDR 413.4 million, Sri Lanka is eligible to borrow under EFF a total of SDR 2.5 billion or $ 3.8 billion from the IMF over the next three years. The interest rates are very much lower than the market interest rates and fixed at IMF’s rate of charge plus a number of margins. Given the current rate of charge of 1.08 per cent, the total payment rate by a country cannot be more than four per cent per annum as compared to the Sri Lanka’s sovereign bond rate of 5.85 per cent which it got for its latest sovereign bond issue.

Commitment to fix the structural weaknesses
The announcement by the Central Bank that it would go for an EFF is a frank admission of the presence of structural weaknesses in its economy and its willingness to implement a deep and sustained reform programme to get out of such weaknesses.

The Sri Lankan authorities have informed IMF that EFF will help the country to “prioritise macroeconomic and financial stability and growth through prudent monetary and fiscal policies, while also addressing pressing concerns such as State enterprise performance, revenue administration, and public financial management”. This is good news for better economic governance and transparency.

Now Sri Lanka has expressed its willingness to go through a deep structural reform programme, it has to make a number of hard economic choices for the benefit of long-term sustainability and growth.
Hard economic choices before the nation

The first choice it has to make relates to its overconsumption beyond its ability during the whole of its post-independence period.

The overconsumption has been manifested in its government sector which has expanded dramatically in the recent few years.

Disciplining the Budget
As the data presented in the midyear fiscal position report published by the Ministry of Finance in June, 2012 reveal, the Government’s finances in the first four months of the year indicate a growing crisis in bridging the gap between the revenue and expenditure.

According to these data, there have been an underperformance of the revenue and an overshooting of consumption expenditure of the government as against its budgeted numbers. This writer commented on this fact in a previous My View published under this series as follows.

The erosion of the revenue base
“The revenue of the Government, according to the Midyear Report, has increased from Rs. 285 billion in the first four months of 2011 to Rs. 306 billion during the corresponding four months of 2012. This is an increase of seven per cent and, hence, an achievement. However, when compared with a pro-rated budget of Rs. 369 billion for the first four months, the revenue performance has fallen short by some 17 per cent in this period. Consequently, as a ratio of GDP, when pro-rated, it amounts to a mere 12.1 per cent in 2012. The comparative numbers in 2010 and 2011 were 14.6 per cent and 14.3 per cent respectively. This is clearly a sign of the erosion of the revenue base of the Government.”

Consuming beyond means
“The Government’s consumption expenditure, technically known as the recurrent expenditure, too has shown a similar pattern. Compared with the outcome in the first four months of 2011, it has increased dramatically by 24 per cent from Rs. 360 billion to Rs. 445 billion. But, compared with a pro-rated budget that had planned a consumption expenditure of just Rs. 369 billion, there has been a marked overshooting of the government’s consumption expenditure by 21 per cent. The Sri Lankan Government is therefore a massive unrestrained consumer who cannot plan its consumption expenditure according to an announced expenditure plan.

Economists call this ‘fiscal slippage’ and such a slippage is not a sign of good budgeting.”

The Government is a dis-saver
“This has caused irreparable implications for the Government’s planned savings, known as the current or revenue account balance, during 2012. The Sri Lankan Government has been a spender on consumption more than its revenue in the last few decades and in the Budget of 2012, it had been announced that such overspending would be brought down to a minimum level of just little less than Rs. 2 billion for the whole year.

“However, in the first four months, such overspending has been Rs. 140 billion, much higher than the total overspending of Rs. 75 billion made by the Government in the whole of 2011. What this means is that the Government has been borrowing money (or printing money or doing both) to meet its consumption
expenditure and if it goes on without a restraint, the year might end up with a huge gap in its revenue account.

“When the Government uses money in such huge volumes for consumption, it is left with no sufficient money to finance the much needed infrastructure projects unless it borrows from foreign commercial sources. But such borrowings will add to the already swelling foreign commercial borrowings by the Government. In 2004, commercial and non-concessionary borrowings were just less than five per cent of total foreign borrowings of the country. In 2011, it had swelled to 43 per cent of the total foreign borrowings.”

The adverse implication of cutting capital expenditure
“As it is, if the Government continues to spend on consumption without restraint, the deficit in the revenue account is to shoot to well over five per cent of GDP in 2012. With a planned capital expenditure programme of 6.5 per cent in the year, the overall budget deficit is to shoot to above 11 per cent, again well above the planned deficit of 6.2 per cent in the Budget 2012. Or in the alternative, if Sri Lanka plans to remain within the original budget targets, it has to cut its capital expenditure drastically as it had done on previous occasions to give way for unrestrained consumption expenditure. This has adverse implications on Sri Lanka’s future economic growth prospects.”

“A fiscal crisis is, therefore, brewing in Sri Lanka requiring policy authorities to take adequate remedial measures without any delay. That requires the Government of Sri Lanka to go for a massive ‘belt-tightening’ programme, known as ‘austerity measures,’ to avoid the impending crisis. This is what Sri Lanka has communicated to IMF when it has said that it is willing to address “pressing concerns such as state enterprise performance, revenue administration, and public financial management.”

Fix the loss-making public enterprises too
The performance of the key State sector enterprises has been worse in the recent few years.
A salient feature of key public enterprises in Sri Lanka has been, with the exception of state sector banks, gaping operating losses in them as reported by both the Central Bank and the Ministry of Finance in their Annual Reports.

As mentioned above, operating losses are an underestimate of the true loss positions of these enterprises. Yet, they point to a direction toward which they have been moving in the recent past.

According to the Central Bank, in 2011, CEB has incurred an operating loss of Rs. 26 billion, CPC Rs. 94 billion, CTB Rs. 4 billion, Railways Rs. 4 billion, SriLankan Airlines Rs. 19 billion and Mihin Air Rs. 455 million. Only the Ports Authority and the Water Board have been able to record modest operating surpluses in 2011.

These gaping holes in the key public enterprises have been a recurring feature throughout and it prompted the Minister of Finance in 2005 Dr. Sarath Amunugama to refer to four of such loss making public enterprises, namely, CPC, CEB, CTB and Railways, as monsters because they were eating up public funds which could have been used for more productive purposes; but since then, as revealed above, Sri Lanka has added many more to the list of those monsters and year after year the list appears to be expanding without limit.

Public enterprises becoming a burden to taxpayers
When public enterprises lose money year after year, their capital gets eroded. After the total accumulated losses exceed the capital, their net worth becomes negative. If a private company has a negative net worth, it is no more a going concern and under the country’s Companies Law has to be closed down.
Yet, in the case of public enterprises, such a course of action is not taken since the authorities are committed to continuing with a system of loss making public enterprises. Hence, eventually, those enterprises have to be rescued by the tax payers by financing their losses either through direct government grants or by assuming their liabilities to state banks by issuing Government bonds to such banks. Either way, it is a burden to the budget and eventually to the country’s tax payers.

Avoid getting into a debt trap
Since the Government has its own financial problems, it cannot finance public enterprises or its expanded public sector without borrowing, first from the local market and then from the international markets. The vicious cycle which this financing method would create is the need for borrowing more for the payment of interest and the principal of these loans, as was the case with the recent issue of the sovereign bonds by Sri Lanka. This cannot be continued without getting into a serious economic and debt crisis in later times even with an EFF from IMF.

So the hard economic choice which Sri Lanka has to make today for the benefit of posterity is to voluntarily shrink itself by cutting down its expenditure programmes, prioritising economic goals and implementing a successful and effective ‘belt-tightening programme’ also known as ‘austerity measures’.

There is no any other alternative available for Sri Lanka today.
(W.A. Wijewardena can be reached at

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