Macro Scenarios in the Sri Lankan Economy during COVID-19

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hatchworks

15 min readApr 28, 2020

Hatch recently invited Deshal De Mel, Economist and Research Director at Verite Research to analyse the implications of the global COVID-19 pandemic on the Sri Lankan economy. De Mel who has experience across the public and private sector and in academia, obliged with the difficult task of forecasting whilst in the middle of a rapidly evolving scenario.

The webinar for this session can be found is here.

De Mel began by discussing the situation of the significant numbers of those most heavily hit initially, namely the approximately 2.9 million Sri Lankans working for daily wages and in informal production (excluding agricultural workers). These non-agricultural workers (such as mechanics, labourers and so on) are people who cannot “work from home”. Their income depends on attendance and who with their dependents are the most vulnerable in the current lockdown situation. Their situation cannot be compared with to similar people in other more developed countries where there are better social safety nets such as cash transfers during an emergency.

Real Economy- Employment

Overall De Mel classified sectors which would be affected in the short term (by the lockdown) and in the long term, which appear to be sectors that were already struggling after the 4/21 Easter Sunday attacks in Sri Lanka viz Textiles and Apparel, Construction and Mining, and Accommodation and F&B (mostly Tourism). However, obviously forecasts in all these areas would be very difficult until one has an idea about how long the virus is expected to remain.

External Sector/Current Account

De Mel then focused on Sri Lanka’s External Sector or Current Account which balances Sri Lanka’s major exports against its major imports and examined a short range of predictions covering anything from a 30% to 70% drop in net export values. This could be balanced favourably by a predicted 22.5% to 55.5% drop in the value of imports based mainly on lowered global oil prices. Settling on an average 50% drop on both sides there could still be an increase in the deficit up to around USD 720 M compared to 2019 — which would still be a change of less than 1% of GDP.

This could likely be further limited by the government choosing to curtail imports to support the Balance of Payments.

External Sector/Capital Account

For a number of years, as De Mel pointed out, Sri Lanka’s highest capital account outflows have been from foreign holdings of government securities such as Treasury Bills and Treasury Bonds, and a trend in withdrawals of funds had already begun last year in April reducing holdings by about LKR 60 Bn until March this year when it dropped by a similar about. A large part of such investments had already gone, so it won’t drive the rupee down much further on its own. What has pushed the rupee down before March is mostly foreign sales of govt securities, and investor sentiment itself (again based on uncertainties about global economies due to Covid19)

Policy Signals: Interest Rates

Sri Lanka’s Central Bank had already begun a fairly aggressive cycle of monetary loosening by reducing rates starting from January 2020 to push more liquidity into the economy and encourage borrowing and economic growth; a reduction in the Statutory Reserve Ratio followed, and in March interest rates dropped further to try to keep money in the economy and help companies to continue to function in this difficult time. A side effect of such policy, however, is that foreign portfolio investment in government securities accelerates withdrawals even further discouraged by low rates. Even with the aggressive attempt to lower interest rates, the market trend has been pushing against that — in other words to resist and hold market rates steady or even pushing them higher.

However, this started changing after March 23 with Govt announcements that captive funds such as EPF, ETF Bank of Ceylon and Peoples Bank would invest in the treasury market at rates of 7 or 7.5 % which artificially reduced interest rates quite sharply.

Deposit rates (the cost of funds for banks) had been trending upwards due to market pressures. These affect lending rates after a lag and therefore market rates were expected to rise (pre Covid19) policy actions and subdued credit demand will now affect it conversely and market interest rates are expected to remain low. Whereas pre-COVID, private sector demand for credit was recovering by January 2020 and was expected to increase, this too is likely to now continue to remain low which again will limit pressure on interest rates: It is very unlikely that companies will be willing or able to look at expansion and investment in capital.

Government revenues

Sri Lanka’s government revenue has been weak at 13.4% of GDP in comparison with the global median at 28.6% according to IMF statistics in 2018, which also limits government expenditure to be low comparatively at 18.6% in contrast to a global median of 30.7%. In effect the Sri Lankan government’s expenditure on areas like health (less than 2% compared to global averages of 5.9% according to WB figures 2017) education and public service delivery has been low due to weak revenue capacity. In this admittedly lackluster situation pre COVID, the government expected a deficit of around 7.5 % in 2020 (compared to a global median of 2% in 2018) meaning that we don’t have the fiscal space to spend on an emergency of this nature, in terms of spending on health, or livelihoods.

You can basically compare this to the macro version of a low wage earning bread winner who has very little saved money in his till, and is also not creditworthy enough to borrow cash to support his family’s basic expenditure on utilities or an ambulance in the case of a natural disaster during which he needs hospitalisation. The situation becomes more problematic if you look at how the government has typically collected revenue:

This is from 2018 when we last had a full year’s data.

This shows that almost half the government’s income (revenue) is from import taxes, and one third is from taxes on consumption, including taxation of cigarettes and alcohol. Only a fifth is from income tax. Revenue will be further eroded by recent policy measures reducing imports –in addition to the direct changes to taxes which were announced in December 2019, eg reduction of VAT, reduction of import taxes, removing NBT, which together severely erode the country’s capacity to collect domestic revenue, even though reduced imports is supportive from a Balance of Payments point of view. In conclusion, with last year’s policy changes and this year’s COVID effect, government revenues will drop even further than the already low levels, thereby impacting government expenditure and public finance.

If you look at the Vote on Account presented Oct. 2019 (above) projected government expenditures will definitely increase post COVID, and revenues will drop, resulting in a deficit (borrowing requirement) reaching into maybe double digits in 2020 with COVID being factored in. De Mel points out that this puts Sri Lanka in a very weak position in terms of public finance and for a country where the public debt to GDP is already more than 85%, running a predicted 10 % (or more) budget deficit is going to be viewed poorly by global actors, who will again lose confidence. Again due to the emergency the government will need to borrow more to fund the spending needed, but there is also a constitutional challenge because to legally raise the borrowing limit, Parliament has to be recalled. The government has no authority to increase borrowing without Parliamentary approval and there will be doubts as to whether additional borrowing post-April 30th is legal which is problematic in that foreign creditors would be concerned about the legality of external debt repayments. In short, the President can draw on the Consolidated fund but there is no allowance there to raise the borrowing limit.

Liquidity injections

There are few options the government has and critical expenditure on lives and livelihoods has to be funded, so since there is no Parliamentary approval for increased borrowing, the Central Bank has been buying Government securities. This is in effect printing money: around LKR 170Bn has been injected into the economy this way in the latter half of March 2020. This is around 1% of GDP and so it is significant. In the short run, this will not have a significant inflationary effect due to demand weakness, but it would contribute to the currency weakness through adverse sentiment.

External Debt

Sri Lanka has already a significant external debt problem, with more than 54% of total govt debt is in foreign currency. From an already weak position, we will now face a further shock with declines in income from tourism and manufactured exports. External debt repayments will also be more challenging due to the weakened fiscal condition. Keep in mind that global markets were already risk-averse and investors were already leaning towards safer investments such as cash, gold and govt bonds in advanced economies. It will be difficult to refinance external debt obligations.

In 2020 Sri Lanka has maturing external debt of about USD 6Bn of which at least USD 4.5Bn is sovereign debt i.e government debt issued in a foreign currency, to be funded out of reserves of USD 7.9Bn available in Feb 2020- this leaves very little space on reserves.- as we need to also fund general imports with a buffer of about 3 to 4 months worth. So overall from a debt repayment perspective Sri Lanka’s space on reserves is very limited.

Maturity on External debt on the rise

In 2019 repayments of external debt were equivalent to 78% of foreign reserves (USD 7.6Bn/Dec 2019). With the lack of reserve space, Sri Lanka has to keep refinancing from global markets each year to roll-over debt. Sri Lanka does not have the reserve space and the external earning capacity to be able to fund these repayment obligations each year using domestic resources so it has to keep on being rolled over. De Mel says: We are very reliant on global markets and whether they are willing to lend to us. The unfortunate thing is that in the current context global markets themselves are in a very unfavourable situation with risk appetite being low.

When you look at the yield on Sri Lanka’s Sovereign Bond Issues for example an alarming figure is the Secondary market yield on the bond maturing Oct 20 — its a dollar yield at 91.93% the implication being that it will be very difficult for Sri Lanka to raise the money needed to refinance our debt, given the current environment; and this is reflected in our risk premium too.

US treasury Yields have come down, in terms of risky assets like Sri Lankan debt, premiums have gone a lot higher. The refinancing risk was illustrated on the 30th of March when the Central Bank auctioned for USD220M worth of Sri Lanka development bonds: The auction was undersubscribed and only 119.9M was accepted. SLDBs are dollar refinancing from Sri Lankan banks and Sri Lankan banks’ FCD holdings of dollars indicating the kind of difficulties we are likely to face going into market in a global environment as well.

Policy Options/Recommendations

We have a large informal economy and the main worry is how to support the very vulnerable for example daily wage workers who will have seriously lower income if lockdowns continue, in an economy which has very little “fiscal space” in contrast with advanced economies. We just won’t be able to give direct cash assistance or livelihood support to so many people. So the Govt will have to re-examine alternatives aside from a complete lockdown, maybe for example providing shelter for the most vulnerable people (including the immunocompromised and an ageing population close on 12.5% of the whole, which already poses significant socio-economic challenges) and then gradually opening up the economy step-by-step. Striking a balance is going to be critical, particularly since it is a developing country with a large informal sector.

The Central Bank has already taken timely steps In terms of businesses and small industries: they provided liquidity through loan moratoriums (that’s a concession where you don’t have to start repayments at once), so companies can survive through this critical stage. More important than stimulus in the short term is to provide liquidity and support just to keep companies afloat, to not collapse or lay off workers until the crisis can be overcome.

De Mel stressed that what has been done in term of morotorums and liquidity has been helpful. He also suggested the government gives partial capital guarantees and funding into subsidies as well because currently a lot of the credit risk is being passed on entirely to banks: Sri Lankan banks are already faced with weakening credit quality in the last couple of years and forcing banks to take on even more risk has macroeconomic ramifications whose effects will be felt a long time after the virus dies out. It was suggested to source this from external donors lines of credit.

More recommendations to help businesses

Govt encouraging landlords to offer concessionary rental charges for the next 3 months to be recouped in the following year
Differing EPF/ETF contributions for the next 3 months to be recovered over the next 12 months
Concessionary Electricity Charges to be offered by the CEB in view of the fact that global fuel prices are down by almost half

Whatever the government does in fiscal spending should be used to support the most vulnerable, and to boost the health sector, in capital requirements such as PPEs, ventilators and enhanced testing capacity so as to facilitate the shift from a curfew to a less limited lockdown so people can go back to work. These measures are going to cause a significant expansion in government spending and parliamentary approval is needed to raise the borrowing limit and to allocate public finances towards these services. For that, the Government has to either rescind the Gazette of 2nd March 2020 or implement article 40 Subsection 7 of the Constitution that allows Parliament to be recalled to pass these emergency allocations,

To deal with the debt situation, since we have 6 billion in liabilities vs 7.9 bn in reserves Sri Lanka will certainly have to try to seek some forbearance on at least our multilateral and bilateral liabilities maturing this year- this is to create some space to settle the USD 1 Bn ISB maturing in Oct 2020. (The IMF and the WB have also called for this) The last thing we want to do is allow Sri Lanka to default in our market-based borrowing.

Reserve Cushions

Sri Lanka’s reserve situation -meaning the reserve assets of the country which are used to balance payments, hold the currency and maintain confidence in a country- is very tricky.

It is impossible to raise global market funding in the prevailing environment. We will have to look at some support from the IMF, and there are two main policy options available to help restore confidence in Sri Lanka in global markets :

Rapid financing instrument providing urgent Balance of Payments assistance of up to USD 1Bn in reserve support which can be repaid in 3.5- 5 years
A Stand- by arrangement. Up to USD 3.45n can be frontloaded similarly repayable in anything from 3.5 to 5 years.
On an optimistic note, De Mel also listed some sectors which will come out strong through the present challenges:

Telecommunications
E-Commerce
Logistics
Fin-Tech/Payments
Export Manufacturing- taking advantage of supply chain realignment as well as
Any technology supporting any of the above

Q&A

Q. Could you clarify further about fiscal support that countries can give the business community?

Countries sometimes implement sizable measures up to 10 % of GDP, but this level of spending is not realistic for Sri Lanka. There should be some increases in the areas mentioned eg, provision of liquidity and concessionary debt to provide short term support.

Q. What about the interest that will add to the debt repayments in the case of these fiscal relief packages/ in particular in the SME sector could governments consider grants rather than loans?

It will be tough to provide grants for such a large range of sectors and the number of companies that will require such. The best option would be concessionary working capital loans as has been done, with as long a grace period as possible and staggered repayments.

Q. Given the limited capacity of the government to provide stimulus, what kind of recovery can be expected in Sri Lanka, a U shape, a V or an L?

V shape may be too optimistic, it would be closer to a U shape. The overall impact on the economy will certainly outlast the virus.

Q What are the implications of using the EPF to stimulate the economy and what is the legal procedure?

There are some practical difficulties because most EPF funds are invested in Treasury Bills and Treasury Bonds, and divesting around 20% of the holdings on government securities would have significant implications on govt borrowing, on market interest rates and can be quite disruptive. Needs serious consideration.

Q, How far are we from becoming the next Venezuela?

There are options for getting back on track and addressing government revenue, not based on continuing to print money and a downward spiral. There is still enough in our control that we can avoid.

Q. Can the Govt borrow on bank profits and offer tax concessions to repay the borrowing?

I’m not sure how that would work out. Banks need to reinvest their profits into their capital and continue to lend and keep the economy going. If bank profits are significantly eroded their ability to lend is affected

Q Do you think the government is looking at liberalisation of trade in future, will that help foster economic recovery. Will the government look at this as an opportunity to lift regulatory barriers etc?

We will first have to shift away from the significant constraints currently faced. Govt has imposed a lot of measures on restricting imports and that is being done to protect reserves given the payment dynamics predicted for the next few months. But it doesn’t have the capacity to restrict imports for very long, a)because they are required inputs for lots of manufacturing and exports. Again when tourism recovers you will need to have imports coming in to support that sector. And 50% of government revenue is collected at the border. So it is difficult to continue this level of restriction of imports beyond a few months. They will have to revert to a more normalised import structure at that point. However, liberalisation beyond that is also unlikely at this stage due to the government ideologies which are basically supportive of domestic industries and in favour of domestic production.

Q. What are your thoughts on the impact on infrastructure development given the contraction of fiscal space

It will be difficult for the government to drive capex on infrastructure this year. They will have to rely lot more on private participation in infrastructure development. PPB Models have been spoken about and might have to take precedence in this context where the government has very limited space to drive finance or infrastructure on its own. On labour market flexibility I don’t think that is going to be feasible — the government will be reluctant to have anything that will allow companies to lay off people.

Q A question was brought up about possible though unlikely collapse of the banking sector, what can we do to hedge against such an extreme scenario?

In terms of capitalization, banks are still ok. Sri Lanka's banks are mostly capitalized above the requirements so there doesn’t need to be so much concern about such a collapse. My concern is more about credit quality and the fact that non-performing loans have gone up in the last couple of years- that might decrease further once the moratoriums are over you will still see companies that are struggling to recover from the implications of COVID. We have been having serious shocks each year since 2017- it was first the worst drought in 40 years, then in 2018 we had the debilitating constitutional crisis, in 2019 it was the Easter Attacks, and now this. Many companies have been continuously struggling to get past these shocks.

Credit quality will deteriorate even further in the coming few months after moratoriums which is of concern for banks as it reduces the ability to churn capital and to act as intermediary…

In terms of deposit safety, I don’t think that is of concern.

Q. How should the context of the engagement of development banks change in this scenario ?

There is a need for investment in long term projects in true venture capital model type of financing and there is space for that. If we can have a development bank that functions well and does that effectively its great. Unfortunately more recent experiments eg regional development banks have not been a really good use of taxpayer money. So it depends on the government structures and how well managed those are.

Q What about the potential of innovation through horizontal mergers?

Disruptions always bring about innovation, you can find companies that need to have capital infusions in order to survive, so yes it does make sense. At the same time in this period of uncertainty, it probably makes sense to wait a bit and see how things pan out in the coming months before making quick decisions.