Sri Lanka’s economic realities: What key indicators are telling us about the state of the economy?
Ballooning Debt
Generally, Government debt as a percent of GDP is used by investors to measure a country’s ability to make future payments on its debt, thus affecting the country’s borrowing costs and government bond yields.
When a state cannot or will not pay back even some of its loans — a sovereign debt default — it becomes harder to borrow or attract investment in future, opens up legal liabilities, and can have destabilizing knock-on effects. Those can include “capital flight and fiscal austerity”, according to IMF research.
Sri Lanka recorded a government debt equivalent to 86.80 percent of the country’s Gross Domestic Product in 2019.
IMF is forecasting Sri Lankan government debt to rise to 98.2 percent of GDP in 2020 which is in line with Central Bank of Sri Lanka’s estimates.
Sri Lankan Rupee’s steady decline
Sri Lanka recently imposed severe import controls due to its dual loosely anchored monetary framework involving ‘flexible’ exchange rate and ‘flexible’ inflation targeting which sent the rupee reeling in March and April 2020 as money was printed and the exchange rate was not defended. The monetary instability had earned the country a downgrade and raised concerns over servicing foreign debt.
Since independence in 1948 to1976 the country had the fixed exchange system with limited flexibility. However, since 1977 in which year the country adopted a flexible exchange rate system, the Rupee had been depreciating in the market steadily. The failure of the successive governments to arrest this development has been the worrying factor for many citizens from all walks of life.
The steady decline of SL Rupee value against the US Dollars over the past 20 years is shown in the below graph.
Fragile Balance of Payments
According to the best projections available, Sri Lanka’s balance of payments in the next five years will be highly fragile. As shown in the above graph, it is projected to have an obstinate current account deficit which has been augmented by an equally obstinate trade deficit. The current account in the balance of payments records on the receipt side, the flow of foreign exchange into Sri Lanka by way of exports, sale of services, income receipts and remittance into the country by Sri Lankans working abroad -significant number of Sri Lankan expatriates have returned home from abroad due to pandemic restrictions and global economic slump.
On the payments side, it has imports, purchase of services, payments on account of incomes earned by foreigners as dividends or interest and out-remittances made by Sri Lankans to entities outside the country. Any shortfall in the current account which is the case with Sri Lanka all the time will have to be filled by using the existing foreign exchange balances or borrowing abroad or attracting investments in to the share market or bond markets or getting foreigners to invest in Sri Lanka known as foreign direct investments (FDIs) or a combination of all these sources. Sri Lanka’s present situation is such that its insufficient foreign exchange balances cannot be used to repay external debt without detrimental effects.
Shrinking GDP
According to IMF, Sri Lanka’s gross domestic product could shrink 4.6 percent in 2020. If the pandemic is not brought under control and normalcy fail to return sooner — 2021 GDP will also be affected.
Tourism is a multi-faceted and interconnected industry with other sectors of the Sri Lankan economy. The industry has a strong backward and forward linkage, which is relatively higher than in many other industries of Sri Lankan economy. COVID-19 pandemic dramatically reshaping the world in which we live, with tumultuous economic and financial effects running alongside the public health emergency, it’s a no brainer to conclude that the battered tourism sector is one of the main causes for the miserable shrinking of the 2020 GDP. Further, there are no guarantees for a V-shape rebound in 2021.
Sliding Sovereign Credit Ratings
Sri Lanka is surely going through the most difficult economic downturn in its history today. In late September, Moody’s downgraded country’s sovereign rating by two notches from “B2” (high credit risk) to “Caa1” (very high credit risk), as the coronavirus pandemic compounded its economic woes. Sri Lanka’s Finance Ministry shot back stating that Moody’s ratings downgrade was unwarranted — a communique primarily aimed to appease foreign investors and international lending agencies. However, Moody’s expects government liquidity and external risks to intensify, as the government’s external debt service payments amount to approximately USD 4 billion (annually) between 2020 and 2025. These external debt service payments would continue to deplete already thin external buffers.
Sri Lanka credit ratings, according to main international rating agencies.
As per the latest budget submitted by the Prime Minister, who is also the finance minister, the 2021 budget deficit is targeted at 8.9% of GDP. It is interesting to note that the 2020 deficit is listed as 7.9 percent, which is controversial as it departs from the previous basis of accounting for the deficit. Wide budget deficits in the next few years are likely to require at least partial external financing. Declining sovereign ratings can substantially increase the cost of borrowing for the country in the international capital and bond markets. This will put further pressure on the already heavily indebted nation’s financial health.
Concluding Remarks
Now Sri Lanka is not the only indebted developing country that is struggling. Because of COVID-19, global economy is shrinking, and the pandemic control measures affect developing countries like Sri Lanka more acutely. However, Sri Lanka’s economic problems owe more to governance and socio-political factors than to the pandemic. Incurring more debt to service the existing foreign debt would keep the country in eternal debt trap.
A decade ago, as the developed world was struggling with the aftermath of the global financial crisis, Sri Lanka was cautiously optimistic of its economic future as the protracted war in the Island ended in May 2009. However, no one is proud of the wasted opportunities in terms of development goals and socio-economic stability of the country. Sooner or later Sri Lankan Government has to choose between servicing their lenders or helping their most vulnerable citizens, as the World Bank and the International Monetary Fund are warning that the tools to deal with a looming debt crisis aren’t up to the job.
Many Sri Lankans worry that their country is sliding into uncertainty and economic ruin. To stop that slide, the region and the wider world need to start paying attention now, rather than just lending more funds to service debts. Sri Lanka’s creditors should insist on cleaner and more transparent governance before agreeing to lend more funds and most importantly chronic bail-out. Authorities should steer clear from embarking on “white elephant” projects that make no economic sense in the interest of the wider population of the Island.
Sri Lankans may have to go through the severest economic hardships for the next three to four-year period. Sound economic management based on data and evolving global economic conditions could ease hardships. Fiscal and monetary policy that is driven by data and true economic realities on the ground rather than short sighted political motives would help Sri Lankans navigate in these pandemic-stricken local and global economic environments.
Update: November 28,2020
1. 2020 Appropriation Bill
In the latest budget, the Prime Minister Mahinda Rajapaksa fails to account for the accounting method. According to DailyMirror online published on 19 November 202 from Colombo, in the second reading of the 2020 Appropriation Bill, Prime Minister Mahinda Rajapaksa claimed that the budget deficit for 2019 increased to 9.6% of GDP. To evaluate this claim, FactCheck consulted annual reports from the Ministry of Finance (MoF).
The national accounting system in Sri Lanka uses the modified cash-based accounting method. Under this method of accounting, expenditure and revenue is only recognized when cash is paid or received: unspent budget allocations are cancelled at the end of the financial year.
According to the modified cash-based accounting method, the deficit in 2014 was 5.7% of the GDP and 6.8% of the GDP in 2019. The MoF Annual Report 2019 audited by the auditor general identifies unpaid claims not included in financial statements amounting to Rs. 243 billion (1.6% of GDP) in 2019. Similarly, in the auditor general’s report in 2014, he identifies unpaid claims of Rs. 190 billion (1.8% of GDP) not included in financial statements. With the inclusion of the unpaid claims, the deficit was 7.5% of the GDP in 2014 and 8.4% of the GDP in 2019.
It is incorrect to compare a value of 5.7% in 2014, which does not account for unpaid claims, against a figure of 8.4% in 2019, which accounts for unpaid claims. It is also inaccurate to calculate the budget deficit by considering unpaid claims in expenditure without applying the same basis to revenue.
2. Fitch Downgrades Sri Lanka
Rating Agency Fitch downgraded Sri Lanka’s sovereign debt to “CCC” on November 27, 2020. It expects Sri Lanka’s government debt-to-GDP ratio to increase to about 100% in 2020 from 86.8% in 2019, and to rise to around 116% in 2024.
This is in sharp contrast to Sri Lanka’s own targets, which see a reduction in debt-to-GDP to 75.5% in 2025, from an estimated 95.1% in 2020.
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