On March 20, the International Monetary Fund approved a $2.9 billion Extended Fund Facility (EFF) arrangement to support Sri Lanka as it addresses its ongoing economic crisis. The 48-month extended arrangement will provide a much-needed injection of capital to fund essential imports and provide policy space for the Sri Lankan government to stimulate economic growth and facilitate structural reforms. Furthermore, President Ranil Wickremesinghe has announced that the approval of this loan will enable the government to access over $7 billion in overall funding from other multilateral creditors and restore the confidence of stakeholders in Sri Lanka.
It is the 17th time in its history that Sri Lanka has required an IMF financing program. What is in the IMF’s new EFF program, and what are the structural challenges that it requires the Sri Lankan government to address?
What Is the Extended Fund Facility of the IMF?
The EFF provides financial assistance to countries facing short-term balance of payments issues that require longer-term structural changes to address. The EFF programs typically have long-term engagement and allow for a longer-term repayment period, which aims to maintain policy space and enable the recipient government to implement structural reforms.
The EFF arrangement comes with strict conditionalities for economic reform. The official press release from the IMF executive board announcing the Sri Lankan EFF stated, “Ambitious revenue-based fiscal consolidation is necessary for restoring fiscal and debt sustainability.”
The IMF demands that the Sri Lankan government reform its tax mechanisms and manage expenditure to tackle persistent budget deficits and bring spending in line with income. The IMF also urged the government to continue its implementation of progressive tax reforms while introducing stronger safety nets to protect the poorest and most vulnerable in society.
The IMF requires close collaboration between Sri Lanka and its creditors to “restore debt sustainability consistent with program parameters.” This will ensure that the government mobilizes the funds for essential purchases and investments rather than to service short-term, unsustainable debt. The approval of the IMF program was subject to assurance from bilateral creditors, which the Sri Lankan government has now received, and this should initiate debt restructuring negotiations between Sri Lanka and its major creditors.
Sri Lanka’s Structural Reforms
The IMF statement identifies the main structural challenges that the Sri Lanka government must address to ensure macroeconomic stability for the country. These are broadly summarized under four main headings.
The previous government implemented significant tax cuts while simultaneously increasing public expenditure. This increased the size of Sri Lanka’s budget deficit and required higher external financing to bridge the gap between revenue and spending. However, this increased the debt burden and deteriorated Sri Lanka’s balance of payments position as it continued to service its debt obligations with more debt. This led to an eventual default when a lack of foreign reserves meant servicing obligatory debt repayments became unsustainable.
The Sri Lankan economy also heavily relies on indirect taxation as a driver of government revenues; indirect taxes are taxes levied on goods and services rather than income or profits. These come primarily as value-added taxes (VAT) and tariffs. Indirect taxes compose over 80 percent of government tax revenue in Sri Lanka, whereas income taxes, such as PAYE, contribute very little to government revenue.
Indirect taxation is particularly regressive because the taxes are captured by the price of goods and services. Therefore, consumers pay the same tax on goods regardless of their income, meaning that the poorest in society spend a greater proportion of their income on taxes than wealthier consumers.
The IMF has urged the Sri Lanka government to continue with current fiscal reforms but also demands stronger social safety nets to protect the poorest in society. A more progressive tax system will begin shifting the balance away from indirect taxation and creating fairer and more sustainable sources of government revenue.
However, it is vital that the government recognize the short-term implications of this tax restructuring as it imposes further burdens on the poorest households in society during a time of soaring energy and food prices. The IMF statement addresses the need for social safety nets but a greater emphasis is required to ensure that the benefits of the EFF program reach those struggling most with the economic crisis.
Public Financial and Expenditure Management
Tax structures and public financial and expenditure management overlap significantly with respect to structural reforms. The overarching aim of this reform is that the government must only spend within its means. Public expenditure must align with domestic tax revenues and a sustainable level of foreign borrowing. This will create a longer-term fiscal balance to ensure that public spending is sustainable so that there is continuous funding for essential imports and public investments.
The tax reforms must be accompanied with debt restructuring agreements with Sri Lanka’s bilateral, multilateral, and private creditors to ensure that the IMF funds promote economic growth rather than merely satisfying external debt obligations. The government received assurances from its three main bilateral creditors, China, India, and Japan, who agreed to support Sri Lanka’s economic recovery in line with the IMF program. If Sri Lanka is able to renegotiate their debt repayment schedule, this will create the fiscal space needed to fund public investments and pursue other structural reforms that have longer-term benefits for the Sri Lankan economy.
The Energy Sector
Because Sri Lanka does not have significant natural resource endowments, the island relies heavily on fuel imports from abroad. Therefore, energy prices in Sri Lanka are dictated by the interaction between supply and demand in the commodity markets. In the wake of the Russian invasion of Ukraine, coal and oil prices soared and Sri Lanka faced rising energy costs to maintain its fuel supply. Because the global commodity markets trade predominantly in U.S. dollars, the Sri Lankan government began depleting foreign exchange reserves at an unsustainable rate to maintain fuel imports and electricity supply for the island. Eventually this became unsustainable and a fall in resource imports led to electricity shortages and national fuel rationing.
The energy crisis exposed Sri Lanka’s overdependence on volatile global commodity markets. Around two-thirds of Sri Lanka’s national energy supply comes from fuel imports, which makes the nation particularly vulnerable to exogenous economic shocks. Sri Lanka must diversify its energy sector to ensure that fuel is affordable for citizens and to insulate the economy from the volatility of global energy prices. Energy diversification requires significant investments in domestic renewable energy infrastructure to shift the balance towards greater energy autonomy; this will protect Sri Lankan consumers from future commodity price shocks and preserve foreign exchange reserves for other essential imports.
Anti-Corruption Legislation and Strong Governance
The IMF has also called upon the government to tackle endemic corruption. The governance diagnostic mission will guide Sri Lanka to create a more comprehensive anti-corruption agenda and promote government reform that tackles corruption at its core. The IMF’s governance policy aims to “promote more systematic, effective, candid, and even-handed engagement with member countries regarding governance vulnerabilities – including corruption – that are critical to macroeconomic performance.”
What Next for Sri Lanka?
Ahead of the first IMF review in six months, Sri Lanka must begin debt restructuring discussions with bilateral and private creditors. Sri Lanka received support guarantees from China, India, and Japan prior to the IMF program approval, and the government aims to announce its debt restructuring strategy in April.
The IMF program will catalyze further external funding from other multilateral organizations and inject more capital into the Sri Lankan economy. Additional capital will fund essential imports, public investments and replenish foreign exchange reserves.
At the same time, the Sri Lanka government must ensure that strong social safety nets are established to protect the poorest households from the austerity measures imposed by IMF conditionalities. Priorities must include food, medicine and fuel security and efficient public services.
A version of this article was previously published by the Lakshman Kadirgamar Institute of International Relations and Strategic Studies (LKI).