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Sri Lanka’s economy has been on a period of adjustment, burdened by significant debt repayments and fiscal imbalances. Addressing the fundamental issues in the economy so far has required a devaluation in the rupee, obtaining support from the IMF and raising interest rates. However, while these measures have helped keep these problems in check, bringing the economy into a more sustainable path will require prudent fiscal measures, i.e. increasing revenues and reducing the fiscal deficit.

What’s wrong with the Sri Lankan economy?
In   the simplest definition the problem stems from economic imbalances, or more specifically, deficits. These deficits are often exacerbated by loose fiscal and monetary policy. While low rates lead to increased consumption and increased imports worsening the external deficit (Balance of payments) increased government expenditure expand the fiscal deficit.

The deficits need to be addressed through local and foreign borrowings which in turn lead to mounting levels of debt repayments every year. Every once in a while the economy faces a situation where these deficits and debt repayments are difficult to be tackled with and thus require a slowdown in both private and public consumption. This adjustment comes in the form of increased interest rates and/or depreciation in the rupee.
In the current cycle of adjustment, we have seen the rupee depreciating about 9% against the US dollar since the Central Bank’s (CBSL) decision to float the currency in September last year. And following the two policy rate hikes by the CBSL this year interest rates have adjusted upwards significantly so far.

Have measures taken so far worked?
The measures have helped relieve pressure in the economy to a certain extent. The IMF credit facility has taken off some of the pressure on external finances. The improvement in investor sentiment in light of the IMF agreement helped in accessing international markets for foreign funds at favourable costs. While effects of interest rate hikes are yet to be seen, the rupee depreciation and other restrictive measures put in place have helped reduce the level of imports in to the country this year.

Why aren’t these measures enough?
Unlike in past cycles where these measures helped address macroeconomic imbalances, this time the economy is faced with significant levels of debt repayments which have been building up over the recent years. In 2015 alone, foreign debt outflows (without interest) amounted to USD 4.6bn. This is about four times higher than debt repayments seen in the last adjustment cycle in 2011 when the economy faced similar issues.

According to CBSL data, from November this year to July 2017 there’s about USD 3.9bn in foreign debt outflows (including interest). These foreign debt repayments together with local repayments are bound to put significant pressure on government finances in 2017.

What will exacerbate the situation further next year are global market conditions. For the past couple of years, emerging economies like Sri Lanka benefitted from the low interest rate policies of developed economies. The low interest rate environment made it easier to access foreign financing at low cost (foreign loans, sovereign bonds, etc.). However, this is expected to change next year with the US resuming its rate hike cycle (following the hike done in December 2015). The resultant rising interest rate environment in global markets would make it difficult for Sri Lanka to access foreign financing at favourable rates. This would make rolling over debt repayments difficult.

Weak exports growth is another concern that will add to the pressure this time around. Even though imports have been declining throughout the year, continued weakness in exports growth has kept deficits from contracting. If global demand fails to improve, the weak exports trend is likely to continue into next year increasing pressure on external balances.

This is why an improvement in fiscal performance will be crucial in 2017. If the government fails to rein in revenues and avoid populist expenses, an  expanding   fiscal deficit would mean even more pressure on borrowings. Then in its place, further upward adjustment in rates and depreciation in the rupee will be required to reduce external deficits and relieve pressure on the economy. This will in turn translate into lower consumption and slowdown in growth.

The bottom line
Fiscal measures will be key in determining how long the current period of economic adjustment will last. If the government delivers on prudent fiscal policies and take steps towards fiscal consolidation the economy will likely fall into a more stable path and pressure will be taken off on interest rates and the rupee. In this context, the key focus is government’s budget proposals for 2017; how prudent they are and how effective their delivery will be in easing pressure on the economy.

(Ashini Samarasinghe works as a Research Economist at Frontier Research. Views and opinions expressed in the article reflect her individual views)