An Emergency Economic Stabilization Plan

Photo courtesy of The Economic Times

INDEPENDENT ECONOMISTS- 04/08/2022

Sri Lanka is at a very dangerous juncture with usable reserves that have dropped to about $150 million. Acute shortages of essentials ranging from fuel to medicine have become prevalent.

Rising public discontent amidst increasing prices and shortages has led to large protests all across the country, which is unable to import essential fuel without the help of credit lines from bilateral partners. As the crisis reaches such depths the government and the administration have failed to come up with a credible economic plan capable of taking  Sri Lanka out of a fully blown out economic collapse.

At such a crucial juncture, a group of independent economists have launched an emergency plan of action with the aim of stopping further collapse of the economy and to stabilize over the medium term. They say that macroeconomics risks will continue to worsen if immediate action is not taken.

Sri Lanka has run dangerously low on foreign reserves and faces the specter of a ‘disorderly default’ on its debt obligations. Although a default may cause legal complications in debt restructuring negotiations and reputational damage for the future, much of the economic consequences of a sovereign default are already here.

The economists that an agreement with the IMF can establish market confidence and help unlock bridge financing.

Macroeconomic risks are worsening

The economic crisis in Sri Lanka is spinning out of control.

• Sri Lanka has run dangerously low on foreign reserves, and faces the specter of a ‘disorderly default’ on its debt obligations. Although a default may cause legal complications in debt restructuring negotiations and reputational damage for the future, much of the economic consequences of a sovereign default are already here.
• The country is already locked out of International debt markets and is unable to refinance its maturing debt or its current account deficit. The result is an acute shortage of foreign exchange that has led to power outages,shortages of cooking gas, fuel, medicine and other basic necessities.
• With headline inflation based in CCPI at 18.7% and food inflation at 30.2% as of March 2022. Sri Lankans are seeing the cost of goods spiraling upwards and the value of their savings diminishing rapidly.
• Spiraling costs and wage demands are making it difficult to do business in particular for small and medium sized firms who are struggling to survive.
• Long run policy errors have become concentrated to a point that make daily life very difficult. Most Sri Lankans are now facing more than 10 hours of power cuts, with no end in sight.
• This discontent is fueling protests, as the authorities have thus far failed to put forward a credible plan to tackle the economic crisis. The economy is collapsing and people’s livelihoods are being destroyed, the immediate objective should be to stem further collapse.
• This document is an attempt to provide an emergency action plan to focus the attention of Parliamentarians, activists, and civil society to take urgent steps to stem the economic decline.
• The immediate priority is to stop things from getting worse and implementing policy changes that provide stability in the medium term.

Stop things from getting worse and begin stabilization

Sri Lanka has run out of foreign reserves and its debt is no longer sustainable. All independent analysis point to an inability to meet debt repayments even leading up to the international sovereign bond of $1 billion maturing in July 2022.

• Ill-conceived decisions to use scarce foreign reserves and the overreliance on short term credit lines such as swaps have caused extreme damage to the domestic economy. This has aggravated the current shortages and pain felt by all Sri Lankans.
• Sri Lanka also runs the risk of runaway inflation. Immediate action is necessary to stop prices spiraling out of control and to stop the value of the rupee diminishing rapidly.
• The short term objective is to stop the worsening situation by entering into negotiations with our creditors and building confidence in the currency and the economy overall.

The following actions will help mitigate the situation and must be executed immediately:

Action	Rationale
1. Immediately appoint professional financial and legal advisors for debt restructuring.	Advisors will commence the external debt restructuring process.
2.  Advisors to seek creditors’           consent for immediate standstill or external debt repayments.	Arrests the outflows from reserves and preserves foreign exchange to pay for critical requirements of the economy (fuel, food, pharmaceuticals). Creditors will likely expect some visibility on progress in negotiations with the IMF in order to agree to a standstill.
3.  Expedite negotiations with the IMF.	A staff level agreement with the IMF can establish market confidence and help unlock bridge financing. In order for the IMF to provide financial assistance to a country with unsustainable debt, IMF financing may proceed before a debt restructuring is completed if the member has taken credible steps towards completing the debt restructuring process in a way that will achieve debt sustainability.
4.  Negotiate bridge financing with bilateral and multilateral partners.	Bridge financing will provide some inflows to reserves and help build up foreign exchange to stabilize the economy. Early harvest in IMF negotiations may provide an opportunity to negotiate additional credit lines with bilateral partners to secure energy in the near term. Reaching out to the World Bank, ADB, Governments of Japan, China, and India immediately can establish the groundwork to drawdown such financing as soon as an IMF staff level agreement is in place. This can be utilized both for meeting essential imports as well as budget support for necessary social protection for the most vulnerable.
5.  Appeal for emergency humanitarian Aid from donor countries and organizations.	Appeal for humanitarian aid and emergency funds to help the most vulnerable population groups until bridge financing and other medium term avenues can be opened up.
6.  Increase policy interest rates to establish positive benchmark real interest rates.	Helps control credit flows and import demand, controlling inflation expectations and helping establish macroeconomic stability.
7.  Rationalize non-essential government expenditure and free up substantial fiscal space to provide support to vulnerable population groups.	Reprioritize capital expenditure on long term projects such as roads and highways as well as non-essential program expenditure across all ministries to create fiscal space for immediate priorities of social protection to vulnerable populations. Freeze public sector recruitment altogether, and freeze  salary increases for minimum 3 years. Imposition of hard budget constraints on SOEs by ceasing all non-essential capital and current transfers to SOEs.
8.  Provide cash transfers to vulnerable sections of the population.	Enhance targeting to capture hitherto excluded populations and ensure graduation of long term beneficiaries. Transfers should be in the form of cash transfers directly to bank accounts or using mobile money. Lessons from the poor-targeting and delivery of Covid-era welfare payments should not be repeated when designing this program. Work already done to improve targeting and efficacy of social safety nets can be utilized for this purpose.
9.  Enhance government revenue .	Mobilize revenue by restoring VAT rates and exemptions and Inland Revenue Act provisions from pre-2019. Reintroduce PAYE and Withholding Taxes to improve cashflows to the Treasury.
10. Gradually unwind Central Bank domestic balance sheet in a sequenced manner.	The Central Bank holds Rs. 1,730 billion government securities in its balance sheet and provides around Rs. 700 billion in market liquidity through the overnight-window SLF. The CB must take steps to gradually unwind its government securities holdings in a carefully sequenced manner alongside market interest rate increases and foreign inflows. This would help anchor longer term price stability in the market.
11. Introduce market-based pricing mechanism for the energy sector.	Implement transparent automatic market based energy pricing and provide a legislative framework to create sustainability. The poorer sections of society that will be affected by price volatility need to be  compensated using social protection mechanisms discussed in 8.
12. Protect banking sector stability by avoiding domestic debt restructure.	The IMF’s article IV consultation indicates that Sri Lanka’s banks have preserved capital, liquidity, and earnings amidst the pandemic. Whilst banks have the capital buffers to withstand an external debt restructuring, a substantive domestic debt restructuring should be avoided by Sri Lanka’s negotiators. If domestic restructuring must take place, there are tried and tested tools to ensure systemic stability. For instance, domestic debt treatment could be limited to reprofiling, along with some regulatory forbearance, in order to minimize negative impacts on financial sector stability (similar to Jamaica in 2010).

Urgent legislative reforms for medium term economic stability 

We recommend the following priority legislative reforms to build medium term economic stability and restore credibility and confidence in the governance of public finances and monetary policy.

However, to be effective, these changes require broader changes in the governance structure such as strengthening the independence of the judiciary, rule of law and the necessary checks and balances for each branch of government. This would inevitably mean constitutional reform that addresses these issues in order for these legal changes to serve their intended purpose.

Law	Rationale
Monetary Law Act	Present to parliament the Monetary Law Act that was drafted in 2018/19. The legislation brings discipline to deficit financing (money printing), builds institutional independence of CB, and creates the legislative framework for inflation targeting.
Fiscal Management Responsibility Act	Tighten fiscal rules by modernizing Sri Lanka’s Fiscal Management Responsibility Act (2003) to address the prevailing fiscal numbers. Clearly define escape clauses (justified deviations from rules) and path to recovery, along with accountability measures. Explore potential for including supermajority requirements to amend certain provisions of the legislation.
Customs Act	Introduce customs law reforms such as enhanced risk based investigations, reform of customs officers rewards schemes and rationalize penalties to address perverse incentives. Other reforms including advanced rulings (improves predictability), appeals process, and other measures to comply fully with WTO Trade Facilitation Agreement. The already drafted Customs Act can be utilized for this purpose.

Forging a national consensus on key economic reform areas

• The main risk facing Sri Lanka in the coming weeks and months ahead is the fallout of the current political instability on the efforts at macro stabilization. Political and policy stability is a necessary condition for economic stabilization measures to succeed.
• During the fiscal adjustment, budget cuts need to be prioritized in a way that doesn’t further burden vulnerable households already crippled by the current conditions. Any attempt to push through the reform program without a clear and compelling articulation of the rationale, urgency, and expected outcomes, will be unwise.
• Ensuring that an agreement with the IMF can be eked out with political consensus and as wide public acceptance as possible, is crucial. Political parties must come together to agree on a common minimum program to steer the economy out of the current crisis and towards macroeconomic stability.
• This consensus can then be extended to, and reinforced by, business chambers and think tanks.

The independent economists who are signatories to the document are Aneetha Warusavitarana, Anushka Wijesinha, Asanka Wijesinghe, Chayu Damsinghe, Daniel Alphonsus, Deshal de Mel, Naqiya Shiraz, Rehana Thowfeek, Shiran Fernando, Thilina Panduwawala and Umesh Moramudali.