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Verite shows how Lanka can achieve Sustainable Debt Dynamics

Published on The Island

Verité Research, a private think tank that provides strategic analysis for Asia, hosted the online discussion Steering out of the Debt Crisis: Recipe for Budget 2022 on Oct 14. The event was anchored around addressing Sri Lanka’s debt and USD liquidity crisis, and featured presentations by Executive Director, Nishan de Mel, Research Director, Deshal de Mel, and Analyst Anushan Kapilan. An expert panel included Dr. Shantayanan Devaranjan (Georgetown University), Dr. Nandalal Weerasinghe (former Senior Deputy Governor – CBSL) and Dr. Mick Moore (Institute of Development Studies – UK).

A press release issued by the think tank said: Verité Research presented analysis pertaining to debt management and fiscal measures, including specific proposals to increase government revenue and improve the allocation of expenditure.

The Verité Research analysis showed that Sri Lanka can achieve sustainable debt dynamics by meeting two conditions with regard to its domestic debt, and two further conditions with regard to its foreign debt. The presentation explained that, despite some challenges, achieving these conditions was feasible for Sri Lanka – provided policy-makers choose to do so.

The main challenges arise from poorly formulated fiscal/budget measures, coupled with the pandemic-induced setbacks which have resulted in successive downgrades of Sri Lanka’s credit ratings. As a result, Sri Lanka has been locked out of global capital markets, and rapidly depleted its foreign reserves, as it has continued to pay back foreign bondholders, at the expense of negative feedback on the local economy.

The Verité Research analysis showed that the worst is yet to come. Sri Lanka’s foreign reserve would be completely depleted by the end of 2022 if no surprise inflows materialise, and even if they did, the crisis would simply re-emerge in 2023. This means that even if Sri Lanka can claim to be technically solvent, it does not have the liquidity to sustainably pay back its foreign debt until the country credit rating is improved by at least two notches.

The current path of repaying debt offers a high return to bondholders at the expense of huge pain to domestic businesses and consumers, and makes the credit rating outlook even more precarious. The solution is to share the pain with bondholders by pre-emptively restructuring the debt. This can improve the foreign reserve position more quickly, and thereby improve the country’s credit rating more quickly as well. This alternative path is less painful to the local economy, offers a faster recovery, with a higher probability of success. It is a better path for the Sri Lankan economy than repaying foreign bondholders in full, even if it were able to do so.

A clear distinction needs to be made between a forced restructuring which would occur if a country were to default in a disorderly way without negotiating with creditors, and an orderly pre-emptive restructuring of debt following negotiations with creditors. The sooner Sri Lanka moves to an orderly pre-emptive debt restructure, the easier it would be to do so, and the more favourable it would be for the Sri Lankan economy. Delaying the decision is damaging and can result in outcomes that are highly disruptive.

Currently the primary deficit is at 7.4% of GDP. At the current GDP growth rate of a little under 4% (predicted by Verité Research), it is necessary to reduce the primary deficit to around 2% of GDP or less to help stabilise the debt.

The Verité Research analysis showed that in the base case scenario with no policy changes, the debt to GDP Ratio would increase to 123.08% by 2025, however with prudent fiscal measures it can be kept down to 108.8% by 2025.

The fiscal measures proposed included the reduction of the personal income threshold to LKR 1 Mn per Annum; the reintroduction of PAYE with a threshold of LKR 1.5Mn; reintroduction of WHT on interest income; increasing the VAT rate to 10% in 2022 and to 12% in 2023; reducing the VAT free thresholds from LKR 300 Mn to LKR 150 Mn in 2022; simplifying the corporate tax regime to a three-tier regime; and increasing the total taxes on cigarettes and alcohol in line with increases in inflation and GDP according to a tobacco taxation formula introduced in the 2019 budget.

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Last modified: October 30, 2023

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