Sri Lanka’s fiscal future - A tightrope for growth
Where macroeconomic stabilization is not enough
(Most of this remains personal opinion, though the facts and figures of the past are very much driven by work at Frontier Research. Outside of those, thoughts given here are very much my own and don't reflect Frontier which doesn't do this sort of policy thoughts. What I’m explaining is also an oversimplification, so please bear with this.)
As Sri Lanka continues its gradual recovery from the worst of 2022, some aspects of the economy are now starting to look towards a stronger recovery in the future - though many others are still crawling along. What choices the government makes on the fiscal front will likely be a key part of how this story turns out. Although I’m writing this on the eve of the budget for 2024, I will focus far more on the overall future of the fiscal trajectory and largely leave the impending budget aside for later.
Sri Lanka’s fiscal past - Growth financed through borrowing
It is largely undeniable that the root cause of Sri Lanka’s crisis stemmed from fiscal mismanagement. Of course, views may differ on whether this was revenue-related (which is largely consensus but has a few detractors), expenditure-related (which is more commonly held in urban centres than outside), or more driven by theft-corruption (general economic consensus is that this was not the case, but it is a powerful and attractive argument nevertheless for many across the country). I will touch on the theft-corruption angle later, but outside of this, the key message is that as long as these fiscal issues remain, it will mean the government’s ability to directly push growth is limited.
However, these fiscal constraints aren’t new. Sri Lanka has had weak and falling revenue for ages and our government sector employment numbers have been rising for ages. But despite this, GDP grew at a compound rate of around 5.2% from 1958 to 2021. Though these are not absolutely stellar numbers, they still account for a pretty decent level of growth. We can break this period down into many more, but I will refrain from doing so too much to keep this piece a bit short. I will just note that if we take the 2001 to 2018 period, growth is even faster, compounding at around 5.8%. There are always issues with comparing growth rates across such a long period, especially given how hazy GDP as an indicator is, but the broad message should still remain - Sri Lanka managed to see at least decent growth despite fiscal issues.
How was this done? Overall, through borrowing to hide the fiscal issue or at least, to side-step it. This was from varied sources, but we can simplify it down to being primarily from the CBSL (money printing) and external borrowing, and secondarily from local (relatively) captive sources of capital. These essentially meant that although domestic fiscal conditions should have necessitated fiscal consolidation, successive governments were able to avoid this reality by borrowing to fund growth. The rise in growth since the late 80s along with falling revenues as a % of GDP is a great indicator of this. I won’t place all the data here, but may follow up later with some of this.
Constrained fiscal space - How can growth be financed?
One key difference that shapes Sri Lanka’s post-crisis fiscal environment, is that both the primary sources of financing are significantly lower than in the past. Given the new CBSL Act, “money printing” won’t be possible unless there are circumstances that cause the Act to change (which would need a strong majority in Parliament that wants to print money). Given the default, raising large amount of external finance will also be constrained for a while. Here, global liquidity conditions matter even more than local in a way, since tight global conditions would mean costlier and fewer funding coming into Sri Lanka.
This leaves local sources alone to finance the government’s deficit - which is where the government is moving towards a primary surplus (though the overall balance remains in deficit, and is currently being increasingly rolled over causing a rise in interest). The current framework for the primary surplus is that through revenue growth and expenditure rationalization. Although there can be different views on HOW the balance between revenue and expenditure can be handled, and what measures are best within each, I don’t think there’s much disagreement on whether SOME measures are needed.
The issue with whatever measure is taken, is that it will constrain that growth pathway we saw in the past, because the mechanism to sidestep that growth constraints are likely going to be limited. Tax measures would constrain consumption, expenditure measures would do the same. Tax measures can additionally constrain production and investment in the economy as well. External borrowing and money printing could theoretically have mitigated some of the growth impacts of these, but as we have seen they have their own costs - arguably worse. Of course, the alternative of taking no measures would very likely be worse too in that huge deficits remaining unfunded would likely necessitate either sharp inflation to reduce the value of these deficits or outright default. In all of these outcomes, weak growth leads to weaker quality of life, weaker health and education outcomes, and weaker upward mobility than in the past. This is, of course, heightened for the poorest but not at all limited to that level. The fact that this is a relative change (things are still growing and improving, but at a weaker level, and it will take time to reach pre-crisis levels) is quite likely to lead to high levels of dissatisfaction at varied levels of society.
What this is likely to mean, is that the “costs” that are being felt by the economy and society are unlikely to be purely temporary, and that society is likely to have to face higher costs than in pre-crisis Sri Lanka for much longer.
Avoiding a growth trap - are there any options?
Given these constraints and the need to try and address these, the only real way to “boost growth” seems to be financing from abroad. What form this takes, whether it is tourism, remittances, foreign investment, foreign inflows into our securities, or even “repatriation of stolen money” is not particularly important in my view - since I feel they all fall into the same few traps.
The first trap is that although the topline numbers for all of these are “inflows”, the actual effect is rarely as straightforward. Inflows that result in direct growth of individual incomes (tourism and remittances) have a direct impact on the amount of imports that are consumed - leading to a new outflow that coincides with the new inflow. Foreign investment and inflows also have an outflow baked in - projects often have direct import requirements, and both investments and inflows have an obvious repatriation need. This is not to say that none of these inflows matter and they are negative. They are still positive in that it allows consumption-led growth to some extent AND it doesn’t require new debt to finance this. Rather, it is to say we can’t consider these purely as “free money” and that there ARE costs, sometimes quite immediate, that moderate their positivity. Even if it allows some “new growth” to happen, whether it is enough to finance the “existing growth” is a question I don’t think gets a full-hearted yes.
The second trap is more subtle, and relates to the external finances more. Sri Lanka will still have external debt payments to make after the restructuring is complete, which will mean a need for USD to be generated to pay these off. This requires an obvious thing to happen - for our USD income to grow faster than our USD expenditures. However, a key problem with inflows alone is that they can cause the LKR to stay strong and even appreciate (though in the short term, the CBSL’s desire to grow reserves can absorb these inflows and delay what I’m explaining below). Why is this a problem? This means that the incentive towards growth of the export sector (through decreasing the income on exports), the key USD income earner, will be severely constrained leading to weak export growth (I personally feel this is the key reason for weak export growth in Sri Lanka, a relatively controlled exchange rate). Additionally, the incentive towards growth of the import sector (through decreasing the price of imports), the key USD expenditure, will be strongly supported. These two factors can combine to create a situation where Sri Lanka has a constant deficit in the USD trade balance, hence leading to a net outflow of USD. Combining with our debt repayment need, this will mean one of two things - either we need to borrow more to meet these two deficits (trade and debt), or we act to constrain the economy again and improve the trade balance - what happened in 2022 for example.
To me, this means a whole bunch of factors that add a huge amount of complexity. None of this means that a particular inflow is bad or a particular outflow is good. The balance between these factors will vary in all sorts of ways. For some, one balance will be really good while it will be completely different for another. On the whole, however, it seems difficult for me to argue that one approach is purely completely better than the others in the short-term. Of course, I do still believe that in the long-term, even short-term pain will be worth it and will lead to a great outcome, but the question is whether we then actually reach the long-term.
The tightrope to walk on - How can a government handle all of this?
What all of this means, is that there are no easy answers for the government. If it chooses to prioritize growth, it will need to finance it one way or the other and the lack of reasonable options can lead to further issues. If it chooses to prioritize stabilization, it will need to deal with the real and perceived impacts of lower growth. So far, it has had a benefit that the costs of 2022 were so high that stabilization measures were still an “improvement” on growth, but this dividend is fast fading.
All this is very much part of the fiscal future of the country. The social impacts of lower growth can’t be ignored nor can the social impacts of debt-financed growth. It is not just something that matters outside of economics, or something that affects the economics, but in my view is a part of the economic trajectory as well. Both from the socioeconomic as well as the political angle, each approach will have detractors and supporters. Their incentives, lobbying, support, and narratives will be a core part of what shapes the economic story in my view. They cannot be excluded from the economic equation and considered separate.
A future that includes SOME pain doesn’t seem particularly easy to avoid for me, whatever the path taken, though the shape and colour of this might be. This pain is likely going to cause further instability that affects the macroeconomic story at some point, whether it is in 2024, 2025, or beyond (I don’t mean public unrest, but varied social, political, and even economic responses that prevent a particular macroeconomic pathway). For me, this means that economic stabilization cannot be limited to the macroeconomic indicators, but must also extend to other aspects as well.
This is not to say that we must “sacrifice” the macroeconomic performance for the other aspects - stabilization measures that ignore the macroeconomic reality are doomed to fail. Rather, it is that reasons that cause non-economic instability must also be addressed directly and indirectly. These are, of course, not just public responses. Stabilizing not just the social impacts on wider society, but the political responses of lobbying groups, political parties, external actors and even ideological narratives will be a core part of Sri Lanka’s future. All of this stems from the fiscal pathway and the constraints coming from it, and will likely need measures from that pathway as well - essentially that macroeconomic measures that ignore the wider stabilization needs are also doomed to fail.
Will Sri Lanka go down this road? It is difficult to say, but there seems to be rising multi-partisan consensus on the need of the purely macroeconomic stabilization pathway at the least. Political parties are of course, only one part of the picture, with small and large businesses, the media, and even average citizens all having the ability to influence, at varied levels, the amount of stability and instability in the system. My hope, however, is that any emerging political consensus also leads to political parties taking measures that ensure that other forms of instability are also addressed across society, and particularly that they won’t be pushed to add instability into the system. In the long-term, I think the economy and society will adjust, I struggle to think of countries where it hasn’t. However, I think there is space to make things less painful in the short-term as well, and that we all have a part to play here.