The risk of succumbing to a balance-of-payments crisis was effectively diminished by securing a three-year extended fund facility (EFF) worth $1.45 billion from the IMF in June.  In the first review, which was concluded in early November, the IMF judged the initial steps taken by the government to stabilize the economy as satisfactory, highlighted by lower inflation, a more favorable fiscal performance, and an improvement in the external accounts. The IMF also noted the continued uncomfortably low level of foreign exchange reserves and delays to structural reforms, and subsequently issued a debt sustainability analysis carrying rather severe warnings of the potential for a damaging bout of currency depreciation.

The government coalition made up of Prime Minister Ranil Wickremesinghe’s United National Party (UNP) and the faction of the Sri Lanka Freedom Party (SLFP) loyal to President Maithripala Sirisena managed to secure passage of value-added-tax (VAT) amendments demanded by the IMF, and won approval of a budget bill for 2017 that targets a narrowing of the headline budget deficit as a first step to reversing the unsustainable upward trajectory of the public-sector debt burden.

The government is also planning to implement a new Inland Revenue Act in 2017, along with the various reforms required to prune the budget that will help to dampen the risks to foreign investors seeking permanent macro-fiscal improvements. They include addressing the issues of financial management, the tax administration, and the inefficient, loss-making state-owned enterprises, including the national airline.

The government is counting on the budget measures to offset the negative fiscal impact of increases in both the public-sector wage bill and spending on subsidies, as well as the costs associated with the mostly non-concessional borrowing undertaken by the administration of former President Mahinda Rajapaksa to finance an expensive capital investment program. The deficit is projected to decrease to 4.6% of GDP in 2017, before gradually narrowing to 3.5% of GDP by 2020. The success of the deficit-reduction effort hinges on rapid economic growth, the closer targeting of spending increases, and the effectiveness of a simplified automated tax-payment system, which officials expect to boost the tax revenue-to-GDP ratio from 11.6% this year to 13.5% next year.

It remains an open question whether the political will is present to ensure faithful implementation of the reforms, in the absence of which Sri Lanka’s appeal as a frontier market—and its potential to move up the production chain and become a more serious portfolio option—could evaporate, particularly given the more enticing returns on offer elsewhere.  Likewise, Sri Lanka faces a risk of rapid capital outflows as the US Federal Reserve Board proceeds with plans to tighten monetary policy. In both cases, the stability of the governing coalition will be essential to limiting the damage.

The many contentious and unpopular choices required to fulfill the conditions for the IMF’s financial support will test the unity of the governing coalition, and the emergence of a new party formed as a vehicle for Rajapaksa’s return to power could also strain ties between the UNP and the Sirisena loyalists. Curiously, Rajapaksa has maintained his affiliation with the SLFP, rather than joining Sri Lanka People’s First, whose members include the former president’s brother, Basil Rajapaksa, and is headed by Gaminia Peiris, who served as minister of foreign affairs in the Rajapaksa administration.

It appears that the former president is keeping his powder dry until local and provincial elections make it possible to assess the new party’s potential as a third force.  There is some uncertainty about the timing of the elections, which were postponed by President Sirisena, as well as whether local elections will be staged under the existing electoral rules based on proportional representation (PR), or a new mixed system favored by the Sirisena faction.

The elections will also provide a test for the UNP, which has been troubled by tensions between the national leadership and the grassroots, mostly stemming from complaints by local leaders of a lack of accessibility on the part of officials higher up the political ladder. At the same time, UNP officials have been placed on the defensive by their coalition partners, who have responded to the threatened split of the SLFP by adopting a more antagonistic posture, presumably with the aim of showing their constituents that they remain capable of protecting their interests.

Publicly, the UNP claims it is unconcerned by the possibility of the Sirisena loyalists’ defection from the government, noting that with 106 of the 225 members of Parliament, the UNP-led United National Front for Good Governance (UNFGG) could form a majority coalition by striking a deal with the Tamil National Alliance (TNA), which controls 16 seats in the National Assembly. In private, however, there is some unease, not least owing to the fact that the end of the partnership with the SLFP would all but rule out any chance of achieving the two-thirds supermajority required to approve changes to the constitution. The UNP favors political devolution and a reduction in the executive powers of the president.

Although Wickremesinghe is open to permitting Sirisena to retain his present powers until the completion of his six-year term in 2021, the departure of the SLFP faction from the governing coalition would greatly weaken the president’s influence. With that in mind, the president has made overt appeals to Sinhalese nationalism, for example, by rescinding a colonial-era British order naming 19 Sinhalese involved in a rebellion two centuries ago as traitors.  Sirisena’s increased sensitivities to Sinhalese interests could also undermine the government’s pledge to the UN to carry out a thorough investigation of the alleged atrocities committed by the Sri Lankan military in the closing stages of the civil war against Tamil separatists. Little progress has been made to date in fulfilling the promise, which will be required if the country is to avoid a renewed descent into international isolation.

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