At the time of the Budget 2021 presentation, the Sri Lankan economy faced two major challenges, according to economist and Research Director of Verité Research Deshal de Mel. The first is the economic shrinkage witnessed in the wake of the pandemic with agencies such as the IMF projecting a contraction of 4.6 percent for 2020.

“These estimates were released before the second wave of infections so the country is expected to experience a fairly sharp contraction in economic activity,” de Mel asserted.

This challenge is not specific to Sri Lanka and is expected to affect several nations, which he noted would have broad ramifications in terms of unemployment and business sustainability.

The second challenge relates to Sri Lanka’s external debt, which de Mel points out will be maturing in the coming years.

He explains: “Around US$ 20 billion of debt must be serviced and in the current environment with a widening fiscal deficit and sense of risk aversion among global markets towards some frontier economies, how Sri Lanka positions itself to meet those liabilities is its second critical challenge.”

“There is a need for Sri Lanka to shore up reserves to service the liabilities coming up in the next two years,” he pointed out, noting: “Middle income countries typically borrow funds from global bond markets for a regular inflow of reserves to be able to refinance maturing liabilities.”

De Mel continued: “However, in the case of Sri Lanka, its expanding budget deficit has led to concerns among global rating agencies and investment banks about the country’s ability to tap into global markets to refinance its debt.”

Moreover, with the nation’s external debt rising to double digits, it has limited access to global bond markets. “Markets were expecting a path to fiscal sustainability that will enable Sri Lanka to regain access to these sources of funds,” de Mel stated.

He elaborated: “As such, it remains to be seen whether global markets respond favourably to this budget and steps will have to be taken in the coming months to reassure them that the country still has a credible path to sustainability, enabling it to refinance its debt going forward.”

In his view, it would not be surprising if Sri Lanka records a higher fiscal deficit for 2020 as there is a need for governments to step in with fiscal stimulus to compensate for the contraction in private economic activity.

Against this backdrop, de Mel believes that the government’s ability to achieve its inflation target of five percent will depend on whether the Central Bank of Sri Lanka continues to finance the fiscal deficit as it did last year. Additionally, he feels the budget could have addressed the pandemic through broader allocations, stressing the need for funds or actions that require expenditure to expand the country’s vaccination and testing capacities, and robust quarantine facilities among others.

According to de Mel, Sri Lanka has typically looked to finance deficits by balancing domestic and foreign sources, which has been used to maintain interest rates. However, the budget appears to place greater emphasis on domestic financing, which would entail higher borrowing requirements in terms of domestic Treasury bill and bond auctions, he asserted.

“We expect a kick-start to economic recovery and private sector demand for credit in parallel with the government’s borrowing requirements in 2021, which means there will be pressure for interest rates to pick up,” he said.

Summarising his views on the budget, de Mel said it addresses the challenge of providing fiscal stimulus to address the decline in private sector activity.

“Where the budget falls short is addressing the external debt management challenge as a credible path for fiscal consolidation in the medium term has not been set out, as well as measures to enhance revenue to reduce the budget deficit to around five percent in five years,” he concluded.