By Uditha Jayasinghe
COLOMBO (Reuters) -The International Monetary Fund said its talks with crisis-hit Sri Lanka had been "constructive" on Thursday, raising hopes it would soon grant preliminary approval for a desperately needed financial support package.
Sri Lanka has had to shut schools and stop providing fuel to all but essential services this week after years of economic mismanagement have seen it run out of money.
"The discussions will continue virtually with a view to reaching a staff-level agreement on the Extended Fund Facility (EFF) arrangement in the near term," IMF said following 10 days of talks with Sri Lankan officials.
A staff agreement is a key step in IMF deals. To be finalised, the agreement needs approval from the IMF's Executive Board, but importantly for the process, it lays out the measures governments' need to take in return.
"Because public debt is assessed as unsustainable, Executive Board approval would require adequate financing assurances from Sri Lanka's creditors that debt sustainability will be restored," the IMF said.
Those assurances are likely to be highly sensitive in Sri Lanka.
Protests, some of them violent, in recent months have forced a number of key ministers to resign, leaving President Gotabaya Rajapaksa and Prime Minister Ranil Wickremesinghe struggling to stabilise the nation.
The country also owes at least $3.5 billion to China and other countries and global investment funds that have also lent tens of billions to Colombo want assurances that any debt relief they provide will be matched by Beijing.
Sri Lanka's international government bonds, which are already in default, slipped as much as 4.3 cents after the IMF's statement. The 2025 bond took the biggest tumble and hit a fresh record low at 32 cents in the dollar - a third of its face value.
"It is positive that we have seen this statement from the IMF so quickly," said Lutz Roehmeyer, a bondholder at Capitulum Asset Management in Berlin. "The quicker we get a deal... the faster financial aid can get to the country."
Analysts have cautioned that restructuring Sri Lanka's debt is still likely to be a protracted process.
The financial crisis is the worst in decades for the island of 22 million people, which has little money left to pay for essentials like food and fuel.
The IMF said in its post-meeting read out that the high fiscal deficit had to be reduced while ensuring adequate protection for the poor and vulnerable. Since revenue was weak, far-reaching tax reforms were urgently needed to achieve these objectives, it added.
"The statement indicates staff-level agreement will come in very soon and could activate bilateral and multilateral lenders to look at Sri Lanka positively," said Udeeshan Jonas, chief strategist at equity research firm CAL.
"IMF support will help Sri Lanka get commitments from creditors. The government has made a lot of progress on things which are generally supposed to be in favor of an IMF staff level agreement," he added.
The IMF said other challenges that needed addressing included containing rising inflation, attending to severe balance of payments pressures, reducing the country's vulnerability to corruption, and undertaking growth-enhancing reforms.
"Fuel shortage, a jump in inflation to 55% and central bank money printing shows that the economy will be in worst position for a debt restructuring, so that partly explains the fall on the bond prices," said Patrick Curran, senior economist at Tellimer.