IMF Extended Fund Facility: Sri Lanka's Economic Recovery: Opportunities and Challenges

To help Sri Lanka deal with its present economic crisis, the International Monetary Fund (IMF) has authorized an Extended Fund Facility (EFF) arrangement worth $2.9 billion. The 48-month extended agreement is anticipated to give key imports the much-needed financial assistance they require, as well as give the Sri Lankan government the policy freedom it needs to encourage economic development and carry out structural reforms. The approval of the loan is also anticipated to restore stakeholder trust in Sri Lanka and release more than $7 billion in finance from other multilateral creditors.

This is the 17th time Sri Lanka has needed a funding package from the IMF. What is the new IMF EFF program's scope, and what structural issues does the Sri Lankan government need to resolve?

Extended Fund Facility of the IMF

The International Monetary Fund (IMF) provides financial assistance through the Extended Fund Facility (EFF) to nations that are experiencing short-term balance of payment problems that require more extensive structural reforms. These initiatives feature a payback duration that enables the maintenance of policy space and the implementation of structural reforms and are intended for longer-term participation. The EFF seeks to support recipient governments financially while simultaneously enabling them to carry out fundamental changes for long-term stability.

Recent negotiations between the Sri Lankan government and the International Monetary Fund (IMF) resulted in an Extended Fund Facility (EFF) agreement, which is subject to stringent requirements for economic reform. To address ongoing budget deficits and get spending in line with revenue, the IMF has asked that the Sri Lankan government alter its tax policies and oversee expenditures. Moreover, the government has to keep enacting fair tax changes and strengthen safety nets for the most vulnerable and underprivileged members of society.

In order to guarantee macroeconomic stability for the nation, the IMF has also outlined the primary structural concerns that the Sri Lankan government must solve, which are roughly categorized under four key areas. They include effective tax administration, management of public finances and expenditures, the energy industry, anti-corruption laws, and strong governance.

As the taxes are absorbed by the cost of products and services, Sri Lanka's economy significantly relies on indirect taxation, which is extremely regressive. In order to safeguard the most vulnerable members of society, the IMF has advised the Sri Lankan government to maintain its present economic reforms while simultaneously calling for greater social safety nets. A more progressive tax structure will start to move the balance away from indirect taxes and provide more equitable and long-lasting sources of funding for the government revenue.

A Plan for Reviving Sri Lanka's Economy

To guarantee longer-term fiscal balance, the government must spend within its means, match public spending to domestic tax receipts, and maintain a manageable amount of foreign borrowing. To make sure that the IMF funds foster economic growth rather than just meet external debt commitments, debt restructuring agreements with Sri Lanka's bilateral, multilateral, and private creditors must be implemented with tax measures.

a)      The Role of Taxes in Sri Lanka's Fiscal Policy's Problems

Public spending soared despite there were considerable tax cuts under the previous administration. Due to this, Sri Lanka's budget deficit increased, forcing the government to rely increasingly on outside funding to close the funding gap between revenues and expenses. The country's debt load rose as a result, and its balance of payments situation deteriorated. Due to its inability to service its debt commitments with further debt, Sri Lanka finally declared default when there were not enough foreign reserves to support mandatory debt repayments.

The government of Sri Lanka mainly relies on indirect taxes, which entails taxing products and services rather than income or profits. Value-added taxes (VAT) and tariffs, which account for more than 80% of government tax income, are principally included in this. In contrast, a small portion of government revenue comes from income taxes like PAYE. As the taxes are included in the pricing of goods and services, this sort of taxation is very regressive. Due to the fact that customers pay the same tax rate on goods regardless of their income, the poorest members of society pay a higher percentage of their income in taxes than consumers from wealthier backgrounds.

The IMF has encouraged the Sri Lankan government to carry out its ongoing economic reforms and strengthen social safety nets to safeguard the most disadvantaged members of society. A more progressive tax structure can lessen the need for indirect taxes, resulting in more equitable and long-lasting sources of governmental funding.

The administration must, however, be aware of the immediate effects of this tax restructure. The most vulnerable households in society can experience additional hardships in a period of rising energy and food prices. Although social safety nets are acknowledged in the IMF statement, greater care must be taken to make sure that those who are suffering the most during the economic crisis receive the advantages of the EFF program.

b)      The Intersection of Taxation and Public Spending Reform

With regard to structural reforms, there are considerable overlaps between the administration of public finances and expenditures and tax systems. This reform's main objective is to limit government spending to what it can reasonably afford. Governmental spending must be in line with domestic tax receipts and a manageable amount of borrowing from abroad. This will provide a longer-term fiscal balance to guarantee that government expenditure is manageable so that ongoing money for necessary imports and public investments is available.

To make sure that the IMF monies stimulate economic growth rather than just paying foreign debt commitments, the tax changes must be complemented by debt restructuring agreements with Sri Lanka's bilateral, multilateral, and private creditors. The country's three largest bilateral creditors, China, India, and Japan, gave the government guarantees that they will help Sri Lanka's economic recovery in accordance with the IMF program. If Sri Lanka is successful in renegotiating their debt repayment plan, this would free up the necessary financial resources to support public investments and pursue other structural changes that will be advantageous to the Sri Lankan economy in the long run.

 c)       Energy Crisis in Sri Lanka: Need for Diversification

Sri Lanka is significantly dependent on gasoline imports from overseas because the country lacks considerable natural resource endowments. As a result, the relationship between supply and demand on the commodities markets determines energy prices in Sri Lanka. Once Russia invaded Ukraine, energy costs increased, making it more expensive for Sri Lanka to maintain its fuel supply. The Sri Lankan government started exhausting its foreign exchange reserves at an unsustainable rate to maintain fuel imports and the island's supply of power since the world's commodities markets mostly trade in U.S. dollars. This eventually proved unsustainable, and a decrease in resource imports resulted in national fuel restrictions and electrical shortages.

Sri Lanka's over reliance on uncertain international commodities markets was made clear by the energy crisis. Petroleum imports supply about two thirds of Sri Lanka's energy needs, rendering the country very sensitive to shocks to the global economy. To guarantee that fuel is affordable for the general population and to protect the economy from the volatile nature of global energy prices, Sri Lanka has to diversify its energy industry. In order to tilt the scales in favor of enhanced energy independence and protect Sri Lanka's consumers from possible shocks in commodity prices, energy diversification calls for significant investments in local renewable energy infrastructure. Also, by making these investments, foreign exchange reserves can be preserved for other necessary purchases.

d)      Building Strong Institutions: The Fight Against Corruption

The IMF has encouraged the Sri Lankan government to address the prevalent problem of corruption. The governance diagnostic mission will offer recommendations for creating a thorough anti-corruption plan and carrying out governmental changes in order to combat corruption at its source. With regard to governance concerns, such as corruption, which are essential to macroeconomic stability, the IMF's governance strategy aims to promote more equal and open interaction with member nations.

Looking forward

Sri Lanka has to begin negotiating debt restructuring with bilateral and private creditors in advance of the first IMF assessment in six months. Support has already been committed by China, India, and Japan, and the government plans to reveal its debt restructuring plan in April.

The IMF program will also draw more foreign assistance from other international institutions, boosting the amount of money flowing into the Sri Lankan economy. With this money, vital imports, public investments, and the replenishment of foreign exchange reserves will be supported.

To protect the poorest households from the effects of IMF conditions, the Sri Lankan government must prioritize the creation of robust social safety nets. The primary goal should be to provide the security of food, medicine, and fuel as well as effective public services.