President and Finance Minister Ranil Wickremesinghe is to present his maiden full budget for 2023 in Parliament this afternoon. A lone MP in Parliament representing the United National Party, he accepted the premiership in May 2022 when the incumbent Prime Minister Mahinda Rajapaksa resigned from the post after a popular struggle against his administration. He informed the Parliament and the nation that he accepted the position, when the others were reluctant, to rescue the country’s dying economy tapping onto his experiences as premier on five previous occasions.
Then, after two months in early July when President Gotabaya Rajapaksa fled the country and tendered resignation from overseas, Ranil was sworn in as Acting President in terms of the provisions of the Constitutions. Soon after that, his position was ratified in Parliament with 134 votes in his favour. He very quickly took over the mantle of the Government, appointed a PM from the ruling Sri Lanka Podujana Party or SLPP, formed a skeletal Cabinet from leading figures in SLPP, and invited the Opposition to join hands with him to rescue the economy as a government of emergency. When the response to this last request was in the negative, he filled the vacancies in the Cabinet with other members of SLPP, introduced an interim budget for the last three months of 2022, got an amendment to the Constitution passed in Parliament, proposed a wide tax hike, and continued with the work already begun to seek a bailout package from IMF.
There had been several preconditions imposed by IMF for such a bailout like increasing tax revenue, reforming state-owned enterprises, Central Bank refraining itself from funding the budget, tightening monetary policy, making the Central Bank independent, working towards the generation of a surplus of 2.3% in the primary account of the budget by 2025, and restructuring the unsustainable foreign debt. His Central Bank Governor and the Treasury Secretary had been working hard on meeting these goals and attained a certain level of progress except the foreign debt restructuring issue. Ranil very confidently told the Parliament last week that Sri Lanka could hope to finalise the IMF bailout by the end of 2022 with India and China participating actively in the debt restructuring program.
This is the background to the presentation of the Budget for 2023.
However, Sri Lanka’s economy is still not out of the woods as admitted by the Central Bank Governor recently. The major macroeconomic issues are looming over the country. On the foreign exchange side, the usable foreign reserves have now fallen to a virtually zero level. The country cannot move back to a safe import program of essential items and raw materials. The shock treatment introduced by way of banning a significant volume of imports is still continuing, killing the economy’s ability to make a quick turnaround. The official consumer price inflation is high at around 70% with the increase in food items going at above 85%. But when the overall inflation, with prices of investment goods and export goods inclusive, as measured by Stephen Hanke’s inflation dashboard, it is above 115% per annum.
The high food inflation has threatened the food security of both low income and middle-income consumers. The food security is defined as the affordability and availability of a nutritionally balanced diet and the increases in prices have reduced the affordability side. Compounding the food insecurity issue, there is a shortage as well as cost increases of essential medicines crippling the country’s healthcare system. This is a major humanitarian crisis, and it should be resolved as quickly as possible to prevent street riots by angry crowds. The real economic growth is in the negative region with an estimated economic shrinkage of the GDP by about 9% in 2022 followed by a further shrinkage of 4.5% in 2023.
The Central Bank expects a meagre economic recovery of about 1.5% in 2024 with a forecast of similar growth rates in the next 3-to-4-year time period. The Central Bank is working on an estimated nominal GDP of Rs. 24 trillion in 2022, up from Rs. 17 trillion in 2021. But when this is converted to dollar purchasing power by using the current exchange rate of Rs. 370 per dollar, its value falls to $ 65 billion in 2022 down from $ 85 billion in the previous year. What this means is that the economy will recede to the level which it had in 2011 with a per capita income of $ 3,000.
To kickstart the economy growing from this depth and make Sri Lanka a developed country by 2048 as envisaged by Ranil is really a challenge. As a result, with slowing economic growth, Sri Lanka will have to remain a lower middle-income country for some time. In fact, the Cabinet of Ministers recently decided that even being a lower middle-income country is too much for Sri Lanka because it cannot have access to cheap funding from friendly countries and multilateral financial institutions like Asian Development Bank, International Development Association, and the UN System. It decided to request the World Bank to consider Sri Lanka as a low-income poor country for the purpose of securing such highly concessional and cheap loans. This does not mean that Sri Lanka will be downgraded to a low-income country in practice. If accepted, it will be regarded as low-income country for extending cheap loans.
Apart from this, there are several other critical issues looming over the Budget 2023. The foreign debt restructuring program has hit a snarl at this late stage. What is being proposed to restructure is only the borrowing from commercial sources and from friendly countries by the central government which has been estimated to be at $ 33 billion by the Ministry of Finance. This is only a fraction of the total foreign debt of the country which stands at about $ 80 billion.
Even if the commercial and friendly country loans are successfully restructured, Sri Lanka has a major foreign debt repayment issue due to the lack of foreign exchange to repay other types of foreign debt obtained from international lending institutions like ADB or World Bank, borrowing by state-owned enterprises like CPC, CEB, Water Board, and SriLankan Airlines, borrowing by the Central Bank and the financial institutions, and the borrowing by the private sector.
In the next 12-month period, the debt repayment obligations of the country as estimated by the Central Bank will amount to $ 5 billion. When the Central Bank’s obligation to pay the outstanding amount due to Asian Clearing Union at $ 1.9 billion is also included, this goes up significantly to $ 6.9 billion. Sri Lanka does not have foreign exchange to meet these obligations.
Apart from this, China which holds about 52% of the total bilateral loans by the central government has become a holdout lender in the country’s debt restructuring exercise. Sri Lanka should meet in London, known as the London Club, to negotiate its commercial loans and in Paris, known as Paris Club, to do the same for bilateral loans. China is a member of neither club. And its policy has been not to follow the normal debt restructuring that involves foregoing a part of the principal or interest or both – known as offering a haircut – but giving a new loan to the borrower to repay the old debt and restart it as new one in the books of the borrower, known as refinancing. If Sri Lanka’s other creditors find that arrangement unacceptable, the negotiations will come to a halt and so would the IMF bailout and its associated other benefits. That was why IMF, World Bank and other creditors have repeatedly warned the Sri Lanka Government that it should immediately get China on board in the restructuring exercise. I have in this column mentioned earlier that it will be a test of Ranil’s diplomatic skills to get China on board as expected.
Then, there are two other critical issues relating to debt and foreign exchange issues which will hamper his budget 2023. One is that the Treasury is not only empty but also overdrawn as far as the liquid funds are concerned. In terms of the Constitution, the Government operates through a cash flow account known as the Consolidated Fund. All the receipt of the Government through taxation, non-tax revenue, grants, and loan proceeds are credited to this account as resources. Then, expenses as approved by Parliament are debited to this account. Since these receipts and expenses are tallied in the budget, the Consolidated Fund should balance itself except for small surpluses or deficits that may occur due to the non-synchronisation of the flows. But over the time, they should be naturally eliminated.
But what is being experienced by the Sri Lanka Government is that the deficit in the Fund is rising month after month forcing the Treasury to finance it through temporary overdraft facilities obtained from the two state banks and a provisional advance from the Central Bank equal to 10% of the estimated revenue for the year. As such, the deficit which had been around Rs. 100 billion a few years back has now ballooned to nearly Rs. 1 trillion. With the Government revenue falling short of the estimates and the expenditure overdoing, the overdrawn state of the Fund is rising. The biggest challenge of the Budget 2023 is to eliminate this overdrawn position and make a new start with regard to budgeting of the country. That requires Ranil to use the current revenue to reduce the two overdraft balances from the two state banks that amounted to Rs. 840 billion at end-2021. With the expected meagre income level in 2023, this is an impossible task.
The other critical issue is the negative net foreign reserve position of the Central Bank. The Bank always had a net positive position with regard to its foreign reserves but from May 2021, they fell into the negative region first by small amounts but then in leaps and bounds in every passing month. Since action was not taken to correct it at that time, it began to grow from around a shortfall of about $ 25 million at the beginning to $ 4,500 million as at end of September 2022. Since the Bank has reported its gross foreign reserves at about $ 1,700 million, the total foreign exchange liabilities of the Bank can be estimated at $ 6,200 million.
This does not mean that the Central Bank’s overall position depicts a state of bankruptcy since it has a positive balance of domestic assets, in the form of loans given to Government and to commercial banks. But regarding its foreign involvements, it is a state of bankruptcy. Unless the Budget 2023 takes action to correct it immediately, the problem will be compounded in the period to come with no available facilities for correction. The Central Bank of the Philippines underwent such a trouble in 1993 and eventually was liquidated paving the way for the establishment of a new central bank with support from IMF, Government of Japan, and the US Treasury. This state of affairs within the Central Bank will not be viewed kindly by outside creditors.
Then, there is this domestic debt restructuring issue which is also peeping over the Budget of 2023. Previously, Sri Lanka’s domestic debt was not unsustainable and therefore, the issue did not arise. However, a debt unsustainability is a situation where a country can repay its debt and pay interest only by resorting to extraordinary measures and it is not left with an option except defaulting it. As long as the Government can borrow money from the market to service its domestic debt, its debt is sustainable. However, if it is unable to borrow from the market the entirety of its fund requirements and it must borrow from the Central Bank and the banking sector to finance it, its debt is unsustainable.
The Central Bank’s new management is trying its best to avoid this possibility by increasing interest rates and eliminating the new lending to the Government. But with increases in interest rates from 12% to 30% plus, the current success rate is not encouraging. If the foreign creditors ask for a domestic debt restructuring as well, it will be a death blow to the country’s financial system.
The Budget 2023 should address all these issues. With that only RW can show that his magic wand will be working.
A version of this article originally published in Daily FT