Following our series on Sri Lanka’s economic crisis, we take a look at what the IMF can do for us, and how we need to step up — by reforming taxes, legislature, and policies
@May 19, 2022
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Story by Umesh Moramudali Edited by Aisha Nazim Translated by Mohammed Fairooz & Nishadi Gunatilake
- Sri Lanka is going through a round of technical negotiations with the IMF
- Finalizing the IMF program will take at least three months - Central Bank Chief
- IMF programme is not merely about money, but credibility
- Credibility is important to get loans and finance imports - to help prevent power cuts, fuel shortages
- IMF lending comes with conditions mostly focusing on economic reforms
While chaos and political turmoil are widespread, Sri Lanka’s officials from the Central Bank and the Ministry of Finance are having rounds of technical negotiations to finalise the country’s 17th programme with the International Monetary Fund (IMF).
What kind of support does the IMF provide?
In our previous analysis, we outlined the root causes of Sri Lanka’s economic woes and why seeking IMF assistance was inevitable. The country is struggling to finance essential imports while being burdened with debt restructuring negotiations.
Against this backdrop, the IMF’s support is crucial for several reasons. A common misconception is that biggest form of support extended by the IMF is to provide foreign currency (USD) to resolve the dollar shortage. This is not so.
The most important support at this juncture is the assistance and credibility IMF provides for debt restructuring negotiations, which will help us borrow from other lenders.
Entering into an IMF programme will help establish Sri Lanka’s credibility regarding its commitments to repay debt, and move towards financial discipline. This will assist the country to finalize debt restructuring negotiations quickly and obtain financial support from countries and multilateral entities such as The World Bank.
Does this mean Sri Lanka doesn’t get a dollar loan from the IMF this time?
No, Sri Lanka will get a dollar loan from the IMF as a part of the program. However, the difference this time is that a dollar loan will not be enough to save our crippled economy.
The Governor of the Central Bank of Sri Lanka (CBSL) indicated that Sri Lanka is anticipating obtaining an Extended Fund Facility (EFF) from the IMF. This loan facility is provided throughout a few years in a few instalments. For example, Sri Lanka obtained an EFF of USD 1.5 billion in 2016 and money was disbursed in five tranches — or instalments.
However, an EFF is not an immediate solution for not having sufficient foreign currency reserves to import essential items. As it stands, Sri Lanka needs to figure out a way to borrow dollars immediately to import essential goods for next month. Obtaining money through an EFF takes a few months; that too is provided in tranches over the upcoming months across a span of three years. Therefore, an EFF does not resolve the country’s burning need — which is quick cash.
But can the IMF provide quick cash in some way or the other?
The IMF has a loan facility termed as Rapid Financing Instrument (RFI) which provides urgent financial assistance to countries that faces Balance Of Payment (BOP) issues. This facility is provided for countries that are significantly affected by a big economic shock such as natural disasters, global shocks, or conflict. An RFI is provided without a country entering into a fully-fledged IMF programme. Therefore, it can be obtained within a short period of time (a month or two). In 2020 May, IMF provided an RFI of USD 488 million to Bangladesh considering the adverse impact of the COVID-19 pandemic on Bangladesh's economy. More than 12 countries received RFIs in response to the pandemic.
However, Sri Lanka was too stubborn to request an RFI during the early pandemic period. Throughout 2020 and 2021, the country maintained a strict stance not to seek IMF support. After taking the decision to seek the IMF’s assistance at the back of a sovereign default, Sri Lanka requested an RFI as the country’s forex reserves approached zero. However, the request came too late. Media reports stated that Sri Lanka did not get a positive response for RFI requests as country’s debt level is unsustainable and the country lacked a comprehensive fiscal plan. This meant, as of now, the IMF will not provide quick cash for Sri Lanka.
How long until we can get the loan?
At this point, it is quite likely that Sri Lanka will not receive any quick cash from the IMF, as the RFI is unlikely. That means IMF support to Sri Lanka will be provided in the form of EFF. Currently, it is difficult to say how much money will be provided to Sri Lanka via EFF. In 2016, Sri Lanka entered an EFF program under which approximately USD 1.5 billion in seven tranches. While the exact amount of an IMF loan is hard to predict right now, the Central Bank of Sri Lanka (CBSL) Governor hinted that Sri Lanka would have the potential to obtain a loan worth 400% of the country’s IMF quota which is approximately USD 03 billion.
However, finalising the IMF program will take approximately three more months if political stability is restored.
What are the IMF’s ‘conditions and reforms’?
When a country enters a programme with the IMF, they agree to carry out certain changes in its economic policy. These conditions aim at resolving the Balance Of Payment (BOP) crises and addressing the root causes of the country’s economic woes. Such conditions also ensure that the borrowing country practices financial discipline, to ensure that loans are repaid on time.
Structural reforms refer to changes in regulations, institutions, and legislature. In the context of developing countries, such reforms aim to address structural problems such as low tax revenue, high budget deficit, weak export performances, massive losses of State Owned Enterprises (SOEs) and many others. Any country entering into a fully-fledged, long-term IMF program is required to indicate the structural reforms expected to be carried out, when the letter of intent is sent to the IMF.
What policy changes are likely to take place along with implementing the proposed IMF programme?
Conditionalities of previous IMF programs with Sri Lanka and the most recent IMF staff report on Sri Lanka released in 2022 implies structural reforms that are likely to be implemented alongside an IMF program. The policy recommendations of the IMF staff report insist on carrying out reforms to increase tax revenue, develop a strategy towards debt sustainability, tighten monetary policy, resorting to flexible exchange regime, reform SOEs, strengthen social safety nets, and reform price controls.
|Policy recommendation||Potential outcome|
Increase tax revenue
Increase income tax rates, reduce income tax thresholds, increase VAT rate and reduce VAT threshold
Strategy for debt sustainability
Setting up an independent debt office
Tightened monetary policy
Continuation of high interest rate
Flexible exchange rate regime
No fixed exchange rates
Listing minority stakes of some SOEs in the stock market, SOEs become more transparent, restructure Sri Lankan Airlines
Strengthen the Social Safety Net
Samurdhi becomes more targeted welfare
Reform price controls
Cost-based fuel pricing formula, Electricity pricing formula, electricity bill increase
Central bank independence
Repeal Monetary Law Act and pass the Central Bank bill to reduce political intervention in CBSL
Relaxing import restrictions
Source : Author constructed based on IMF reports and news reports
One of the major and immediate policy reforms in light of an IMF program is tax changes aiming at increasing tax revenue. Increasing revenue will be achieved by expanding the tax base and increasing tax rates. This means that more people and businesses will have to pay taxes, including existing taxpayers. This will result in the reintroduction of Pay As You Earn (PAYE) tax, reimposing Withholding Tax (WHT) on rent income, interest income, and other earnings such as consultancy fees more than Rs. 50,000. In essence, individuals and companies who earn enough will have to pay tax. These taxes will not affect the poorer people of the community.
Given the very low tax ratio of Sri Lanka, it is likely that changes to the Value Added Tax (VAT) will be introduced in the upcoming months. VAT rate is likely to increase slightly with a significant reduction of VAT threshold.
VAT rate is a percentage, currently set at 08%, and it will go up. The threshold determines how many companies/business pays tax - ex : if the threshold is 05 million, businesses that has annual sales of more than 05 million will pay, while those earning below this won’t. By reducing the threshold, you can get more businesses to pay VAT.
It is likely that a VAT increase and threshold reduction will be accompanied by a reduction in customs duties and para-tariffs; such as the Port and Airport Levy (PAL). Historical evidence suggests that the IMF’s approach has been to focus more on VAT while phasing out para-tariffs such as PAL. This will ensure that there won’t be a discernible increase of prices for essentials due to changes in VAT.
Part of the IMF recommendation is to introduce cost-based formulas for fuel, electricity, and water. This means electricity charges will go up for most people. The CBSL governor also emphasized on the need to revise electricity prices to reduce the losses of the Ceylon Electricity Board (CEB). The same principle will apply to the water charges as well, resulting in increased water bills.
The IMF strongly advocates for controlling inflation through higher interest rates. CBSL already doubled the policy rates. This resulted in a significant increase of interest rates. Lending rates of a number of commercial banks exceeded 20%. As inflation remains high, interest rates are unlikely to come down in the near term when there is an IMF program.
What about cuts for free health and education?
There is a misconception that entering an IMF programme will result in spending cuts in Sri Lanka’s education and health sectors. However, this wasn’t recommended to the Sri Lankan government in the last two IMF programmes we entered, nor in the IMF staff reports. In reports as recent as 2019, the IMF emphasised on the need to prioritise government spending on education, health and social safety nets; especially during the pandemic.
Sri Lanka’s budget deficit is largely because of a lack of revenue. With this in mind, most IMF recommendations focus on reducing the budget deficit through increasing revenue. This is often referred to as revenue-based consolidation. This means it is highly unlikely that IMF program results in cuts in education and health spending.
The way forward
The IMF programme is just one component of Sri Lanka’s recovery from the worst economic crisis in the country’s post-independence history, and this alone will not resolve our economic crisis.
Most reforms suggested by the IMF are reforms that Sri Lanka was supposed to carry out to save the economy. The country’s inability to carry out reforms or sustain reform efforts were major causes of our current crisis.
Once the economy is stabilized, one can debate long-term policy plans. For that, we must first survive.
|Type of Tax||Tax changes|
Personal Income Tax
Highest tax rate was decreased to 18% from 24%. Six band structure of 4,8,12,16,20 and 24 percent was replaced with 6,12,18 three band structure. Income tax exemptions were granted to profit or income generated through agriculture, Information Technology (IT) and enabling services and few other sources.
Corporate Income Tax
Standard tax rate was reduced from 28% to 24%
Income tax rate applicable for manufacturing industry was reduced to 18% from 28%
Pay As You Earn (PAYE) tax
The tax was abolished, and an Advanced Personal Income Tax scheme was introduced
Withholding Tax (WHT)
Remove WHT on interest, rent and other services
Economic Service Charge (ESC)
Value Added Tax (VAT)
VAT rate was reduced to 8% from 15%
To increase the threshold for registration of VAT to Rs. 300 million per annum from Rs. 12 million per annum.
Ports and Airports Development Levy (PAL)
Standard rate was increased to 10% from 7.5%