Debt Restructuring Can Be Painful But Better Than An Outright Default – Verite Research Director
By Rajiesh Seetharam
Sri Lanka’s Gross official reserves were estimated at US dollars 2.3 billion by end October 2021, which is less than six weeks imports coverage. Amidst challenging debt and forex crises, Sri Lankan Finance Minister Basil Rajapaksa presented Budget 2022 which imposes new taxes like the one off 25% Surcharge Tax on individuals or companies who have earned a taxable income over Rs 2,000 million for the year of assessment 2020/2021, 2.5% social security tax from companies above 120 million turnover and increase of VAT on financial services provided by commercial banks and financial institutions from 15% to 18%.
Ceylon FT spoke to Research Director of Verite Research Deshal de Mel to get his insights into Budget 2022 other macro economic issues facing Sri Lanka. De Mel recommended a proper debt restructuring programme similar to Ecuador in 2020, whereby Sri Lanka could advance at least 2 notches above in credit rating from its current levels, thus paving way to access global markets to rebuild reserves and address dollar liquidity issues.
Excerpts of the interview are as follows:
What is your opinion on new added taxes like super gains tax, social security tax, increase of VAT on financial service. In your view, what kind of impact will it cause to the Business Community, Exporters, and Investors?
A: Other than the Social Security Charge, the other major tax proposals (surcharge and VAT on financial services) are one-time taxes to be implemented only for 2022. Therefore, the new revenue measures do not provide a long-term, sustainable, solution to the structural issues relating to weak government revenue that has resulted in successive budget deficits. For 2023 again, there will have to be new taxes proposed to address revenue shortfalls.
This creates uncertainty for business and investors. The likely reason the government did not change VAT or corporate/personal income taxes was with a view to providing certainty and predictability for business and investors. However, by introducing one-off taxes such as the surcharge (which is also a retrospective tax), the outcome is in fact uncertainty and a lack of predictability of the future tax regime for business and investors.
A more sustainable solution would have been to reintroduce taxes such as PAYE and withholding tax on interest income. These tax measures can improve tax collection without increasing tax rates by improving the tax base. For example, as of end 2019, tax payers registered for PAYE amounted to 1.15 million, but by end 2020, tax payers registered for APIT/PAYE had declined to 0.66 million. A reduction of the VAT threshold from
Rs 300 million per annum would also significantly improve revenue collection by improving the tax base. As of end 2019, there were 28,914 entities registered to pay VAT, by end 2020, this had reduced to 8,152 entities. (These figures are from the Inland Revenue Department’s annual performance report 2020).
With regard to allocations to various sectors (Eg. Rs 270 billion on highways, Rs 82 billion on village development), what is your opinion. What other sectors need better allocation?
A: There is a Rs 931 bn (5% of GDP) allocation for capital expenditure. In almost every year, successive governments have overestimated capital expenditure and it is highly unlikely that this level of capital expenditure will materialise. Until prevailing fiscal challenges are addressed, it would have been more prudent to prioritise allocation of resources to immediate and urgent needs in sectors such as social protection, education, and healthcare given the current economic difficulties, than to sectors which provide a far longer term return such as physical infrastructure.
A more modest capital expenditure allocation would have also allowed the government to present a significantly lower budget deficit, which would be an important factor towards building confidence among global markets, which in turn is critical to rebuild external reserves and help address Sri Lanka’s foreign exchange challenges.
There are different views among economists on how to handle the forex and debt crises. Some economists suggest a debt restructuring programme with IMF assistance, while others prefer home grown solution. What is your opinion on how to handle the current debt and forex crises?
A: The long-term, sustainable path out of the current challenges in forex markets and external debt is for Sri Lanka to upgrade its credit ratings by at least two notches from the present CCC levels. This would allow not just the sovereign to raise financing to settle maturing external debt, but would also put the banking system in a better position to access dollar financing, which is critical to address prevailing dollar liquidity issues.
However, given the fact that Sri Lanka’s reserves as at end October was US$ 2.3 billion (less than six weeks import coverage) and liability maturities over the 12 months from September 2021 to August 2022 amount to US$ 6.7 billion (excluding maturing swaps which would increase this figure to over US$ 7.0 billion), Sri Lanka does not have sufficient time to upgrade its credit ratings to the extent required.
Therefore, the best option among available options is for Sri Lanka to restructure its external debt to create the space required to upgrade its credit ratings, which in turn requires the country to present a credible path of fiscal management, reducing budget deficits and restoring government revenue. Whilst restructuring debt is not a painless option, it is a far superior outcome to an outright default, which would shut Sri Lanka out of trade finance and capital markets for a prolonged period, causing irreparable damage to the economy.
Restructuring debt will no doubt cause disruptions and pain in the short term, however, a well managed restructuring such as Ecuador in 2020 can lead to a quick rerating of credit and the ability to access global markets to rebuild reserves and address dollar liquidity within a relatively short period of time. If Sri Lanka had taken steps to address credit ratings sooner, a restructuring could have been avoided, however, given the present gap between near term liabilities, available reserves, and known cash inflows, a restructuring becomes the most prudent option.
‘Publicfinance.lk’ a platform run by Verite Research noted that Central Bank’s net foreign assets has turned negative since 1995. How does it effect the overall economy? Please explain with your suggestions to overcome it.
A: The negative net foreign assets position of the monetary authority is another symptom of the weakening foreign exchange position and dollar liquidity challenges faced in the economy. Net foreign assets of the monetary authority refers to the difference between gross official reserves (US$ 2.3 billion as at end October) and liabilities associated with reserves (for example swaps and liabilities incurred with the IMF). A negative net asset position occurs when gross reserves decline to a level below these reserve related liabilities.
The ramifications of this position are seen in the real economy. When reserves decline and the sovereign does not have access to global capital markets to refinance maturing debt, the government has to choose between the use of reserves to settle maturing external debt at the expense of releasing sufficient reserves to enable the banking system to pay for imports, including essential commodities and services (overseas education, IT services, credit card payments).
The immediate solution is to regain access to global capital markets to replenish reserves. The longer term solution is to invest in non-debt creating inflows (exports of goods and services, tourism, remittances) – however, the long-term solutions can not materialise in time to address the immediate challenges.
Recently, Verite Research released a study on how cigarettes should be taxed. Budget 2022 states that Cigarette prices would be increased. Does the price increase match with your research study recommendation?
A: The budget speech says cigarette prices would increase by Rs 5 per stick, however, it does not say how much of this price increase is due to tax increases and how much is due to price adjustments by the company. What the budget speech does not say is that there is also a substantial reduction in taxation (close to 50% reduction in tax) on one type of cigarette.
Having such a large divergence between prices of different types of cigarettes will naturally cause substitution from highly taxed cigarettes to lower taxed cigarettes, which could reduce overall effective tax rates on cigarettes. Ideally cigarette taxes should be indexed to income growth (nominal GDP growth) where taxes across all categories of cigarettes are increased at the same rate keeping in line with affordability.
Verite Research has been tracking budget for a few years. How accurate are the budget figures this time? What is your recommendation to improve accuracy of the budget and to see that budget proposals are implemented?
A: Budget Promises, a dashboard on publicfinance.lk tracks implementation of budget proposals across several years. Typically, when there is greater visibility over progress of implementation, there are better outcomes in implementation. In recent years the Budget Promises tracker indicates that transparency or willingness to share information on progress by the executive arm of government has diminished.
It is critical that Parliament, which has control of and responsibility for public finance according to the Constitution, should demand greater visibility over progress of the implementation of budget proposals. Often times a reason for weak progress in implementation of budget proposals is the lack of a rigorous analysis prior to presenting proposals in the budget speech. Parliament could insist that every budget proposal is accompanied by a three-page cost benefit analysis that identifies implementation risks and mitigating actions. This could help ensure that implementation bottlenecks are thought through and addressed beforehand, allowing for a smoother implementation path.
Any comments on inflation?
A: Inflation has been on an increasing trend in Sri Lanka and globally. The most recent data for October indicates that CCPI inflation has reached 7.6%, which is above the stated comfort level of the Central Bank of 4%-6%. There are many factors that have contributed to this. Global supply chain disruptions combined with rapid global demand recovery amidst accommodative global monetary and fiscal policy have contributed to a spike in global commodity prices from food and energy to electronics and building materials.
Sri Lanka being a price taker in global markets has also seen an increase in the cost of imported commodities and imported inputs. At the same time, Sri Lanka’s more unique forex liquidity shortfalls have contributed to additional domestic supply chain disruptions affecting intermediate and consumer goods, which have exacerbated price increases domestically. Therefore, inflation in Sri Lanka can for the most part be explained by supply side factors. However, monetary authorities should be vigilant of the possibility of ‘transitionary’ supply driven inflation translating into behavioural changes (wage adjustments and longer term cost adjustments) that would result in permanent inflation.
The warning signs are emerging as core inflation (inflation excluding volatile items such as food and fuel – a proxy for demand-driven inflation) reached 6.3% in October, well above the Central Bank’s stated comfort levels. Management of inflation expectations is crucial towards this end, and monetary policy would need to take a proactive approach towards addressing this, keeping in mind monetary policy time lags.
General theory or understanding is that stock market is a reflection of the economy. While the country is facing debt and forex crises, rising inflation, shortages of essential commodities, the Stock Market is rising. What is your view?
A: The behaviour of equity markets is not entirely surprising in the current environment. The low interest rates and high levels of rupee liquidity that have prevailed since early 2020 until quite recently, are generally supportive of equity markets since fixed income returns are diminished. Furthermore, equity market investments are used by investors as a tool to mitigate against some of the shocks mentioned. Equity investments are a hedge against inflation since it is expected that price increases would eventually be reflected in nominal earnings and prices of domestic counters.
Most importantly, a few stocks have accounted for the bulk of the recent appreciation of the ASPI and these counters are clear hedges against currency depreciation (companies with dollar earnings) and counters with high levels of dollar assets which will reflect in rupee earnings and stock valuation when the currency depreciates.
Therefore, whilst the equity market is not necessarily a reflection of underlying economic conditions, investors sometimes use the equity market as a hedge against significant risks such as inflation and currency depreciation (Merval, the Argentine stock exchange, has been among the world’s best performing even amidst successive defaults). Prudent investors would of course be cognizant of the fundamental macroeconomic risks and long-term implications for equity market valuations and would adopt appropriate mitigatory investment strategies.