Sri Lanka's MSMES at a crossroad: How central bank policies led them towards a debt abyss

By Ranul Seneviratne

Micro, Small, and medium-sized enterprises (MSMEs) are the cornerstone of Sri Lanka's economy, contributing over 50% to the nation’s Gross Domestic Product (GDP) and employing a significant portion of the workforce. These micro, small, and medium enterprises (MSMEs) play a critical role not only in job creation but also in addressing gender disparities, with 25-35% of MSMEs being women-led, particularly in rural areas.

The vulnerabilities in Sri Lanka's policy framework became particularly evident during the economic crisis that unfolded between 2018 and 2023. Approximately 8.3% of MSMEs—equivalent to 108,100 businesses—ceased operations during this period, creating conditions that disproportionately harmed MSMEs, which are vital to Sri Lanka’s economic and social fabric.

This article comprises two separate sections:

PART 1 – We will look into the current landscape of Parate Executions in Sri Lanka and their impact on various stakeholders.

PART 2 – We will try to understand the root cause of this debt crisis seen among MSMEs and what chain of events resulted in the current predicament.

PART 1 - WHAT IS PARATE?

Parate execution, rooted in Roman Dutch Law, allows licensed commercial banks to sell mortgaged property without judicial oversight, based solely on a board resolution. This mechanism was incorporated into Sri Lanka’s Parate Law under the Recovery of Loans by Banks (Special Provisions) Act, No. 4 of 1990. The law enables banks to recover unpaid loans efficiently by auctioning mortgaged assets once debts exceed LKR 5 million and other recovery methods have been exhausted. Its non-judicial nature offers speed and flexibility, benefiting banks.

THE GOVERNMENT’S DECISION TO SUSPEND PARATE EXECUTIONS AND THE SUBSEQUENT LIFTING OF THE SUSPENSION

On November 28th, 2024, the Sri Lankan government took a decisive step by suspending Parate executions, aiming to offer temporary relief to struggling MSMEs amidst the nation’s ongoing economic challenges. This measure effectively paused the immediate seizure of assets by banks, providing businesses a window of opportunity to renegotiate debts and stabilize operations. While the move has been welcomed by many as a lifeline for SMEs, it has also ignited a broader debate about its long-term impact. The suspension highlights the delicate balancing act between safeguarding vital businesses and addressing the banking sector’s liquidity and stability, both critical to Sri Lanka’s economic recovery.

However, we at ADVOCATA believe that while it is important to safeguard MSMEs from possible bankruptcy, extending this suspension of Parate may actually be more harmful in the long run. Keeping in line with this view, the government of Sri Lanka also seems to have understood that extending Parate further would bring far more detrimental consequences to the economy. Hence, as a result, the government announced on December 18th that the suspension of Parate executions would be lifted in March 2025. We will now delve into how this decision affects key stakeholders in the economy, including businesses, banks, and the government, while examining its broader implications for financial stability and growth.

BUSINESSES

Analyzing the effects of lifting the suspension on Parate executions must be done with care. While it may seem that this decision could result in struggling MSMEs—a critical lifeline of the economy—shutting down, this assumption is not entirely accurate. Halting the immediate seizure of assets provides a window of opportunity for some companies to renegotiate their debts and stabilize operations, but only a few businesses will enjoy this benefit.

As of November 2023, the number of distressed businesses falling under the “Loans by Banks (Special Provisions) Act, No. 4 of 1990” was small. Banks had recovered only Rs. 38 billion through Parate executions on 557 individuals, accounting for just 2.7% of Stage 3 impaired loans and 0.4% of total loans provided—a modest contribution to resolving the bad debt crisis engulfing Sri Lanka’s MSMEs.

Prolonging the Parate suspension prevents the settlement or renegotiation of distressed debts. Lifting the suspension will help banks and authorities identify borrowers exploiting the “Parate suspension” to delay and avoid repayments despite being capable of fulfilling obligations, undermining repayment culture.

BANKS

For banks, lifting the suspension brings major benefits in the short run. Resuming debt repayments improves their balance sheets and asset quality, and provides opportunities to renegotiate with borrowers and restructure non-performing loans (NPLs). Conversely, the suspension prevented prompt recovery of assets tied to NPLs, increasing liquidity risks. The accumulation of unresolved bad loans weakens bank capital, limiting their ability to issue new loans.

The International Monetary Fund (IMF) has cautioned that prolonged suspensions could erode investor confidence and strain credit risk management. Allowing banks to reprocess property of distressed MSMEs who fail to respect debt obligations will reduce the current high-risk premiums charged when lending. However, this move may also encourage asset sales at low prices, increasing foreclosure costs and liquidity drain.

PART 2 – THE ROOT CAUSE OF THIS HIGH DEBT BURDEN AND MSME FAILURE

THE PROGRESS OF THE BUSINESS CYCLE

Sri Lanka’s current MSME sector crisis reflects the re-adjustment process following an artificial economic boom created by an abundance of easy money injected into the banking system. Classical Economists like Ludwig Von Mises and Friedrich A. Hayek explain this well in the “theory of money and economic fluctuations.”

At the start of a boom, cheap credit encourages borrowing. Entrepreneurs, optimistic about profits, take loans to fund production. This creates economic expansion but also drives up wages and production costs. Entrepreneurs take more loans, assuming investments will pay off. As borrowing increases, demand for loans outpaces supply, raising interest rates. Entrepreneurs then cut costs, lay off workers, and reduce operations. Excessive borrowing becomes unsustainable, leading to defaults. Non-Performing Loan (NPL) ratios in Sri Lanka hit 13.2% in September 2022 due to Stage 3 loans surging by 53.6%, reaching Rs. 1.3 trillion. The construction sector, notably affected, had a Gross Stage 3 Loans Ratio of 15.0%.

CENTRAL BANK’S ROLE IN THE CRISIS

Sri Lanka’s Central Bank’s monetary policy framework played a decisive role. Aggressive rate cuts and liquidity injections created a “deadly cocktail” that disproportionately harmed MSMEs. Mispricing interest rates incentivized unsustainable lending in low-productivity sectors. When conditions worsened, these sectors defaulted, driving up NPL ratios. The soft-pegged monetary system’s instability exacerbated the crisis.

INTEREST RATE MISPRICING AND SECTORAL VULNERABILITIES

Sri Lanka's elevated non-performing loan (NPL) ratios can be attributed to the mispricing or mis-targeting of interest rates, rooted in a fundamentally flawed central bank (CB) operational regime. The country operates under a highly unstable soft-pegged monetary system, which lacks a clear focus on either interest rate or exchange rate targeting. Instead, the CB attempts to achieve both, leading to policy errors and excess liquidity in the banking system.

When demand for imports increases, creating pressure on the rupee to depreciate, the CB intervenes in the forex market by selling dollars. This reduces the money supply, tightens short-term interest rates, and curbs excessive borrowing. However, to maintain artificially low policy rates, the CB prints money to replenish reserves, negating these effects.

For years, Sri Lankan policymakers have artificially suppressed interest rates, creating mispricing that incentivized lending at unsustainably low rates. This led to over-lending or mal-investment in low-productivity sectors like construction and certain types of MSMEs. When economic conditions worsened or monetary tightening occurred, these over-leveraged sectors faced defaults, exposing vulnerabilities and driving up NPL ratios.

INADEQUATE BANKRUPTCY LAWS

Sri Lanka’s outdated bankruptcy laws fail to address corporate distress effectively. Banks prefer quick recoveries through Parate execution over lengthy court processes. Other mechanisms like creditor compromises rarely succeed. In contrast, countries like the U.S. (Chapter 11) and India (IBC) offer frameworks prioritizing business recovery. Sri Lanka should adopt similar reforms to foster economic resilience and attract investment.

CONCLUSION

Sri Lanka’s MSME sector stands at a critical juncture, grappling with policy missteps, economic turbulence, and systemic weaknesses. While measures like suspending and later lifting Parate executions address immediate challenges, they underscore the need for structural reforms. Sustainable solutions require overhauling monetary and fiscal frameworks, reforming bankruptcy laws, and creating a transparent credit system. By fostering resilience and fair access to resources, Sri Lanka can transform its MSMEs into engines of recovery and sustainable development. The time to act is now.

for clarifications - ranul@advocata.org

Economics of tyre imports and import controls

By Dhananath Fernando

Originally appeared on the Morning

The recent discussion on restricting tyre imports to boost local production, with the stated objective of saving USD outflow from the country, requires closer examination. 

In Sri Lanka, import restrictions are often perceived as a measure to promote exports, but in reality, they have the opposite effect. Restricting imports discourages exports and reduces the productivity of local manufacturing. 

Moreover, this strategy burdens consumers with higher prices and fosters corruption among Government officials and politicians. Ultimately, it is a strategy with no winners, leaving everyone worse off in the long run.

A deep dive into the tyre market

Sri Lanka is a leading exporter of solid tyres, holding approximately 25% of the global market share. Solid tyres, used in heavy-duty vehicles like tractors and forklifts, represent a key segment of our exports. 

However, even as a global player in this industry, we rely on importing raw materials such as metal to remain competitive. Across all rubber products, Sri Lanka imports approximately $ 200 million worth of raw materials annually, as local rubber production is insufficient. In 2019, the total export value of rubber products was approximately $ 1 billion.

Typically, industries add about 30% value through their processes. In the case of pneumatic tyres, the current tariff structure includes a 20% general duty, a 10% Ports and Airport Development Levy (PAL), an 18% Value-Added Tax (VAT), a 25% or Rs. 330/kg Commodity Export Subsidy Scheme (CESS), and a 2.5% Social Security Contribution Levy (SSCL). 

The cumulative tax burden amounts to 75.5% on paper, but due to the cascading effect of VAT applied on top of other taxes, the effective rate is significantly higher.

Sri Lanka has approximately five million vehicles, including tuk-tuks and motorcycles, which are often referred to as a ‘poor man’s transport’. These high tariffs or import bans effectively double the price of tyres, placing a disproportionate burden on ordinary consumers. 

For instance, the tax relief provided by expanding the tax-free threshold from Rs. 100,000 to Rs. 150,000 results in a monthly saving of just Rs. 3,500 – an amount easily offset by the additional cost of a single tyre. 

High tyre costs also drive up transportation expenses across the board, including bus fares, tuk-tuk fares, and freight costs, cascading through the economy without any corresponding productivity improvements.

Moreover, the new generation of Electric Vehicles (EVs) requires specialised, high-quality tyres. Import restrictions could limit access to these products, reducing the efficiency and viability of EV adoption in Sri Lanka.

Supporting local production the right way

Does this mean local production should not be supported? Absolutely not. However, support should come in the form of reducing structural barriers rather than imposing tariff protections. 

For instance, the high cost of energy is a major driver of manufacturing expenses in Sri Lanka. Addressing this issue through energy sector reforms would make local products more competitive. Alternatively, the Government could share the risk by subsidising loan interest rates, enabling manufacturers to compete globally and focus on exports rather than relying on protectionist tariffs.

High tariffs only serve to make local production uncompetitive, forcing consumers to bear the cost of substandard products. Instead, removing barriers to business and fostering an export-oriented industrial strategy is the way forward.

The problem with CESS and import tariffs

The CESS was introduced by the Export Development Board (EDB) to encourage value-added exports and discourage raw material exports. Ironically, this tax on exports has been extended to imports, significantly inflating tariff burdens. Few people realise the original intent of the CESS and its unintended consequences on trade.

Debunking protectionist arguments

Two common arguments are often made in favour of high import tariffs:

Infant industry argument: The idea is that new industries require time to establish themselves. However, the tyre industry in Sri Lanka dates back to the 1970s – well past its ‘infant’ stage. After more than half a century, it should be thriving without protectionist crutches.

Comparisons to India and the US: While India and the US impose some high tariffs, these nations have vastly different contexts. India, with a population of over a billion, and the US, with 300 million high-income consumers, can leverage economies of scale to make protectionism viable. Even in these countries, protectionism has shown its limits, and they increasingly focus on global competitiveness.

The tragedy of corruption through protectionism

Another significant downside of protectionism is its susceptibility to corruption. Sri Lanka has already witnessed scandals such as the sugar and garlic scams, where the Special Commodity Levy (SCL) was manipulated overnight through ministerial powers. 

Similarly, protectionist tariffs can be arbitrarily increased by corrupt officials, allowing certain companies to gain undue advantages. These benefits can even be funnelled into campaign financing, creating a vicious cycle of corruption.

The International Monetary Fund (IMF) Governance Diagnostic Report highlights the vulnerabilities associated with protectionism, emphasising how such policies open the door to corrupt practices. By simply raising tariffs, policymakers can distort market dynamics, favouring a few while imposing costs on the wider public. This undermines the principles of fair competition and good governance.

The misguided USD savings argument

The notion that import restrictions save USD is flawed. Imports are driven by the ability to borrow in LKR rather than by direct dollar demand. With an appreciating currency and improving reserves, Sri Lanka has imported more without destabilising its economy. Restricting tyre imports could inadvertently increase wear and tear of other spare parts, like shock absorbers and rubber bushes, leading to higher overall costs.

If Sri Lanka continues to pursue import bans as a strategy to develop industries, it risks destroying exports, raising the cost of living, and undermining local industries’ competitiveness. Instead, we should focus on removing barriers to business and enabling local manufacturers to compete globally. 

Protectionism not only creates losers but also fosters corruption, making it an unsustainable and counterproductive strategy. A competitive, export-driven approach benefits everyone, ensuring a prosperous future for the economy. 

Mapping Sri Lanka’s growth strategy

By Dhananath Fernando

Originally appeared on the Morning

With the final stage of Sri Lanka’s debt restructuring scheduled for next year, the focus must shift decisively towards economic growth. In this context, President Anura Kumara Dissanayake’s recent visit to India is particularly timely.

Over the past two years, Sri Lanka has been largely engaged in stabilisation efforts. Higher interest rates and increased taxes were central to this stabilisation agenda, which is fundamentally about avoiding bad decisions rather than actively pursuing the right ones.

Using a cricket analogy, stabilisation is like a No. 11 batsman in a Test match defending the wicket – the goal is simply to avoid getting out, not to score runs.

The next phase, however, demands a proactive growth strategy. Economic growth is less about avoiding pitfalls and more about taking the initiative and making bold moves. If stabilisation is about survival, growth is about thriving; it’s like playing a T20 match where you must play shots, protect your wicket, and actively score runs.

Connectivity represents a key area where Sri Lanka can catalyse growth. Connectivity to the Indian Ocean through maritime routes has been discussed for decades, but connectivity to India deserves equal, if not greater, attention.

India’s rapidly growing middle class presents significant economic opportunities for Sri Lanka. If we are serious about growth, enhancing connectivity with India is a necessity, not an option. Unfortunately, Sri Lanka has been slow to respond over the years. This time, we must be proactive and get the work done.

There are already Sri Lankan companies like Damro, MAS, and Brandix, as well as service-sector organisations, that have successfully expanded to India. The fear that Sri Lanka might be at a disadvantage due to its smaller market size is unfounded. In fact, the small size of our market is precisely why we need to integrate with the Indian market.

Among the proposals discussed during the President’s State visit to India, connectivity projects related to energy, transport, and trade stand out as the most crucial. These initiatives provide Sri Lanka access to a market of over one billion people.

Grid connectivity, for instance, has been a topic of discussion for decades but has yet to be realised. Such connectivity would reduce energy costs and create opportunities to export surplus energy, particularly solar power generated during the day.

With South Indian states experiencing peak energy demand during the day due to industrialisation, Sri Lanka could sell excess electricity and, conversely, purchase electricity during the evening when its own demand peaks. This business model would encourage renewable energy investments in Sri Lanka, given the potential to export to India.

Lower energy costs would benefit Sri Lankan industries, including tourism, by reducing production expenses and enhancing global competitiveness. Similarly, an underwater pipeline for petroleum products could significantly cut transportation costs by enabling direct access to South Indian refineries.

A proposed land bridge could also integrate a rail line, telecommunications cables, and grid connectivity, excluding petroleum pipelines, which are expected to connect to Trincomalee’s oil tanks. These connectivity projects will require years of development, substantial investment, and careful geopolitical considerations to avoid supply chain disruptions or tensions.

Economic connectivity with India, particularly in factor markets such as land, labour, capital, and entrepreneurship, would drastically reduce production costs and provide access to a larger market. Connecting to bigger markets is essential for economic growth, and India, as a neighbouring economic giant, offers a ready opportunity.

Concerns about independence and fears of interdependence are common among Sri Lankans, but history reveals that Sri Lanka’s culture, including Buddhism, has been profoundly influenced by India. Even today, India accounts for the largest number of tourists to Sri Lanka.

The Government of Sri Lanka must establish competitive investment policies to attract foreign investments with clear cost-benefit analyses. Reviewing joint statements from past State visits shows recurring references to connectivity projects such as the land bridge, Trincomalee oil tanks, and investments. What has been missing is the political will and proactive action to turn these plans into reality.

If Sri Lanka fails to capitalise on this opportunity for economic growth, a second default may become unavoidable, leading to yet another request for assistance from India. The stakes are too high for inaction.

Supporting MSMEs requires more than parate suspension

By Dhananath Fernando

Originally appeared on the Morning

The Government has decided to extend the suspension of parate law until 31 March 2025, aiming to support Micro, Small, and Medium-sized Enterprises (MSMEs) as they recover from the setbacks of the economic crisis.

Parate execution is a Roman-Dutch law that allows Licensed Commercial Banks (LCBs) to sell mortgaged property kept as collateral. The term ‘parate’ originates from Dutch and means ‘immediate’.

Under the Recovery of Loans by Banks (Special Provisions) Act No.4 of 1990, parate execution empowers banks to recover unpaid debts by selling assets without undergoing judicial processes.

The previous Government introduced the suspension and the current Government appears to be continuing the policy without fully recognising the potential harm it could cause to the MSME sector. While the suspension has been extended until March 2025, there is a high likelihood of further extensions being requested in subsequent months.

Data accessed up to November 2023 indicates that only 557 parate cases were executed in 2023 (although the MSME Chamber claims the actual figure is 1,140 cases). The total value of these executions was Rs. 38 billion, which represents just 0.4% of total loans and only 2.7% of total bad loans. Even if the number of cases were doubled, the overall value remains insignificant.

Based on these statistics, it is evident that the suspension of parate execution does little to support MSMEs, as the affected segment represents a very small portion of the sector.

MSMEs are the backbone of Sri Lanka’s economy, constituting 99% of business establishments and contributing to 75% of employment. Supporting MSMEs requires broader initiatives beyond suspending parate execution, which is essential for safeguarding depositors’ funds in the current financial framework.

Banks primarily lend using depositors’ money. Therefore, when loans go unpaid, banks face significant challenges in recovering funds to repay depositors. Parate execution has historically served as a legal safety mechanism for banks, albeit not an ideal solution.

On the flip side, when parate execution is suspended, it discourages the majority of borrowers who struggle to repay their loans on time. These borrowers, who represent the largest segment of customers, may question why they should meet their obligations when a smaller group is granted exemptions. 

This creates a moral hazard and could encourage new loan applicants to skip payments, knowing the repercussions for non-payment are minimal.

Furthermore, if depositors perceive that banks lack sufficient legal provisions to ensure the security of their funds, they may seek alternative channels for their savings and become increasingly reluctant to deposit money in banks. This could destabilise the financial system over time.

In the absence of parate execution, banks may take precautionary measures, such as tightening lending criteria, raising interest rates for riskier sectors, and prioritising lending to existing or prime customers. 

These steps could harm new entrants to the MSME sector, limiting their access to credit or burdening them with high interest rates, which reduces their competitiveness and stifles economic growth.

The Central Bank of Sri Lanka’s Financial Stability Review for 2024 highlights that while Non-Performing Loans (NPLs) are declining, the rate remains high at over 13% as of Q2 2024, with more than Rs. 1,200 billion classified as non-performing. 

Although the tourism sector is booming, industries like transportation and manufacturing continue to report significantly higher NPL ratios than the industry average.

In the long term, the Government needs to prioritise the introduction of bankruptcy laws, enabling struggling businesses to efficiently settle liabilities and pivot to new ventures without undue delays. Such a framework would balance the interests of borrowers, banks, and depositors more effectively.

The continuation of the suspension of parate execution risks undermining the banking sector, endangering depositors’ funds, and harming MSMEs by fostering higher interest rates and restricted access to credit. 

It is time for policymakers to consider alternatives that promote sustainable economic recovery while maintaining financial stability

Graph 1 

Economic sectors with high NPL ratios 

Graph 2 -

NPL ratio

Are plans to lift vehicle import ban truly wise?

By Dhananath Fernando

Originally appeared on the Morning

Many Sri Lankans, including myself, are products of a failed middle-class dream. We aspire to be doctors, lawyers, and accountants because that path seems to promise a reasonable house and a decent vehicle.

Yet, bad economics has turned us into a generation of frustrated, failed middle-class citizens. Among the middle class, one of the most debated topics is vehicle imports – a key symbol of socioeconomic aspirations – which has recently resurfaced as a contentious issue.

While the Government has not clarified its stance on vehicle imports, the economic consequences of restricting them are evident. A black market emerges and people are forced to pay exorbitantly high prices for second-hand vehicles that are 5-10 years old. The economic impact of such inflated vehicle prices often goes unrecognised.

When someone spends three times the vehicle’s actual value, they lose the ability to invest the same amount in other life priorities – building or expanding a home, starting a business, pursuing professional or children’s education, or supporting leisure and the arts. This ripple effect stifles personal aspirations and reduces income opportunities for micro, small, and medium-sized businesses.

While I strongly advocate for relaxing vehicle import restrictions (or any import restrictions), the reasoning often used to justify such relaxation is flawed. Many argue that importing vehicles would boost Government revenue through increased border taxes, especially given the International Monetary Fund’s (IMF) target of raising Sri Lanka’s revenue to 15% of GDP.

However, relying on border taxes for revenue sets a dangerous precedent, making our economy less competitive. This logic paves the way for protectionist measures like tariff hikes, a strategy that failed us during the 30-year war when high tariffs funded fiscal deficits but left our exports uncompetitive and fostered corruption.

Instead, the Government should focus on sunsetting unnecessary tax concessions, eliminating vehicle permit schemes for public servants, and broadening the tax net through investments in digitising the Inland Revenue Department.

The concerns: Currency depreciation and congestion

The two main arguments against vehicle imports are currency depreciation and increased congestion.

Currency depreciation

Currency depreciation is often wrongly attributed to imports. During the Covid-19 pandemic, Sri Lanka banned most imports, including essential medicines, yet the currency depreciated from Rs. 180 to Rs. 360. Before the ban, vehicle imports amounted to around $ 1 billion annually, while fuel imports, at $ 3 billion, should theoretically have had a greater impact on currency depreciation.

In reality, currency depreciation and reserve depletion occur when the Central Bank increases rupee supply by artificially lowering interest rates. When interest rates are kept low, borrowing becomes cheaper, prompting higher demand for credit – for vehicles, housing, and business expansion – which in turn drives up import demand. As a result, people demand more dollars from banks, leading to currency depreciation.

If the Central Bank refrains from artificially suppressing interest rates, banks will need to redirect credit for vehicle purchases from other sectors, naturally balancing the flow of rupees in the economy. Higher interest rates would curb excessive consumption, including vehicle purchases.

Unfortunately, the Central Bank has historically enabled excessive consumption by maintaining artificially low interest rates, which leads to higher import demand and ultimately depletes reserves as it attempts to defend the currency.

Thus, vehicle imports have little direct impact on currency depreciation or reserve depletion. Instead, the focus should be on managing interest rates to balance economic activity. That said, a phased approach to relaxing vehicle imports is advisable to avoid shocks to the economy. Notably, despite import relaxations, the Sri Lankan Rupee has appreciated by approximately 11%.

Congestion

Concerns about increased congestion due to vehicle imports are valid. However, the solution lies in improving public transportation. Significant investment in public transport infrastructure would reduce the demand for personal vehicles. Additionally, mechanisms for exporting used vehicles could help mitigate congestion.

Excessive taxes on vehicles will not develop public transport. On the contrary, such taxes exacerbate issues by suppressing aspirations, limiting personal choices, and further deteriorating the public transport system.

Developing public transport requires policy shifts, such as cancelling the restrictive route permit system, engaging the private sector, and relaxing price controls on bus fares. These reforms, not 300% vehicle taxes or outright bans, will address congestion effectively.

Way forward

Vehicle import restrictions and excessive taxes have far-reaching implications that go beyond economics, affecting aspirations and everyday lives.

While phasing out restrictions and ensuring fiscal discipline are essential, the Government must prioritise structural reforms and long-term solutions like public transport development and tax base expansion. Only then can we create an economy that balances growth, equity, and personal freedom.

Market-driven solutions for climate resilience

By Dhananath Fernando

Originally appeared on the Morning

It is disheartening to see many areas and lives in Sri Lanka affected by severe weather conditions. The postponement of Advanced Level exams and the broader impact on human lives impose costs that cannot be measured in purely economic terms.

Unfortunately, in Sri Lanka, discussions on climate-related solutions tend to occur only during extreme events like floods or droughts. This article, admittedly, follows a similar trend.

The approach to solving natural disaster challenges in Sri Lanka has often been fragmented, relying heavily on the expertise of individual professions rather than adopting a holistic perspective. For instance, lawyers may frame the issue solely within a legal context, IT professionals may focus on technological solutions, and economists often emphasise financial and economic aspects. This siloed approach overlooks the need for an integrated strategy.

Additionally, many solutions in Sri Lanka depend heavily on Government intervention, creating inefficiencies due to limited governmental capacity and placing a burden on taxpayers. Unfortunately, market-driven solutions for climate and environmental challenges receive inadequate attention in public discourse. There are misconceptions that market-based systems are at odds with climate action, whereas, in reality, markets offer numerous innovative solutions.

Immediate vs. long-term solutions

In the short term, the Government must provide support to those affected by climate-related disasters. Generally, funds are allocated for this purpose in every national budget. However, for long-term solutions, incorporating climate risks into pricing mechanisms is crucial. The market system is not inherently complex; it simply needs to reflect the scarcity value of resources through proper pricing.

Currently, there is no effective way to associate climate risk with specific high-risk areas in Sri Lanka. If we had a digital land registry, we could assign risk values to lands based on factors such as flood, drought, or tsunami risks.

Similar to how platforms like Booking.com rate accommodations for cleanliness, food, and accessibility, land prices could reflect natural disaster risks. This would enable individuals to make informed decisions when selecting locations for agriculture or residence, ultimately reducing property damage and loss of life on a macro scale.

This approach could also encourage financial markets to extend quality credit for low-climate-risk properties within the existing collateral-driven credit system.

Infrastructure and investment prioritisation

The Government could prioritise infrastructure investments in canals and irrigation based on areas with the highest impact, rather than acting on an ad hoc basis. With risk data, disaster relief support could be incentive-based, aligning resources with identified risks.

The concept of property rights and reflective pricing for climate-resistant land can encourage optimal use and sustainable development. Ideally, integrating social safety net information and national identity cards would streamline rescue efforts and improve the efficiency of reaching the most affected people.

Catastrophe bonds

Catastrophe bonds (CAT bonds) represent another market-based solution. These bonds are typically issued through a Special Purpose Vehicle (SPV) by insurance companies to cover large-scale natural disaster risks.

Investors purchase CAT bonds, which provide funds to cover damages in the event of a disaster. If no disaster occurs during the bond’s term, investors receive higher returns. Returns and coupons vary depending on the type of natural disaster covered.

In the event of a catastrophe, investors may lose some or all of their capital. However, the relatively high returns reflect the associated risks. The issuance of CAT bonds also incentivises extensive research and investment in climate event analysis. Early identification of potential disasters not only minimises property damage but also saves lives by enabling timely alerts and evacuations.

With CAT bonds, investors have a financial incentive to invest in areas prone to climate risks, as they see potential returns. For investors, CAT bonds offer diversification opportunities and returns that are less affected by traditional stock market fluctuations or macroeconomic changes. Additionally, CAT bond returns are comparatively higher than those of other types of bonds.

The role of insurance and data

A mature insurance market can significantly mitigate climate risks. One of the main challenges for Sri Lanka’s insurance and capital markets is the lack of comprehensive data.

A digital land registry that integrates weather patterns and risk factors would enable insurance companies and banks to better assess investment risks for businesses and agriculture, in addition to considering the applicant’s credit history.

This would enhance the productivity of the financial sector and improve access to capital. Importantly, it would encourage businesses and agriculture to relocate to low-risk, high-productivity areas, enhancing overall efficiency.

Addressing climate challenges in Sri Lanka requires support from multilateral organisations, particularly for developing markets. However, it is crucial to avoid relying solely on Government interventions or over-regulating productive sectors.

By setting the right incentives and disincentives, and focusing on fundamental, long-term strategies, Sri Lanka can create sustainable solutions beyond ad hoc responses to climate events.

Sri Lanka’s rice dilemma

By Dhananath Fernando

Originally appeared on the Morning

High rice prices, shortages of nadu rice, and the monthly importation of around 70,000 MT of rice have once again become key topics in national discussions.

As this column has highlighted previously, Sri Lanka’s per capita rice consumption is twice the global average. Yet, paradoxically, farmers remain poor and the market remains underdeveloped despite this significant consumption. The core issue lies in the complex and flawed economic dynamics governing the rice industry.

Low productivity and farmer incentives

One primary challenge is low paddy productivity. Farmers lack incentives to improve yields due to market dynamics. When production increases and supply exceeds demand, prices drop, negating any potential income gains for farmers.

Conversely, if yields fall, prices may rise, but the total crop volume decreases, leaving farmers with the same or even lower income. This discourages efforts to boost productivity, creating a cycle of stagnation and poverty.

Mismatch in rice varieties and market demand

Sri Lanka predominantly grows short-grain rice, while global demand favours long-grain varieties such as basmati and jasmine rice. Transitioning to long-grain cultivation presents challenges related to soil conditions and high production costs.

Moreover, the current pricing structure for rice does not reflect the true cost of production. Producing one kilogramme of rice requires approximately 2,400 litres of water, a resource for which farmers are not charged. Even accounting for a modest 20 LKR cents per litre, the true cost of rice would be significantly higher.

Market dynamics and oligopoly of millers

The paddy market is dominated by a few large-scale rice millers who have the financial capacity to purchase in bulk and maintain extensive storage facilities. Small and medium-scale millers often offer better prices but lack the scale to buy large quantities.

This oligopolistic structure limits competition and contributes to high consumer prices. While the Paddy Marketing Board has some storage capacity to intervene in the market, it is insufficient compared to the resources of large millers.

Implications of rice imports

Importing rice can benefit consumers by preventing shortages and stabilising prices. However, this strategy poses risks to small and medium-scale millers, who may struggle to secure sufficient paddy for milling if imported rice dominates the market.

The Government’s plan to import and distribute rice through State-run retailers, such as Sathosa, aims to control prices but introduces its own set of challenges.

Potential for corruption and market distortions

Government-led importation efforts create opportunities for corruption. The State must invest significant funds upfront and ensure that imported rice meets quality standards. Large-scale imports also raise the risk of mismanagement and unethical practices.

Additionally, limiting imported rice sales to Government outlets like Sathosa may inadvertently encourage private retailers to purchase and resell it at higher prices, undermining efforts to keep costs low for consumers. Imposing purchase limits at Sathosa could lead to long queues and inconvenience for shoppers.

Policy considerations and long-term solutions

There is no simple solution to Sri Lanka’s rice crisis. Addressing the issue requires long-term, multifaceted strategies.

Improving rice productivity and diversifying the buyer base beyond millers through strategic investments is essential. Establishing farmer associations with adequate storage facilities could enhance competition and stabilise the market. Allowing private sector rice imports without restrictive licensing could also promote fair competition and reduce corruption risks.

However, price controls or excessive Government intervention in the market are unlikely to resolve the underlying issues of consumer affordability or farmer poverty.

Ultimately, a sustainable solution involves balancing productivity improvements, market diversification, and transparent policies to ensure fair competition and equitable outcomes for all stakeholders in Sri Lanka’s rice industry.

Lanka’s fuel price tug of war: Who really pays the price?

By Dhananath Fernando

Originally appeared on the Morning

Fuel prices and fuel price revisions have always been a political football. Statements by various politicians on the taxes imposed on fuel and the scope for reducing fuel prices have come under renewed scrutiny with the 31 October price announcements.

Adding to the confusion, a statement by the Ceylon Petroleum Corporation (CPC) Chairman – that the CPC must compensate for the losses of other players if deviating from the price formula – has sparked fresh controversy. It’s essential to unpack these issues one at a time.

According to Central Bank data, we imported approximately $ 1.5 billion in refined petroleum and $ 0.5 billion in crude oil in the first half of the year. Assuming demand and prices remain steady, total fuel imports this year will be around $ 4 billion.

About 70% of fuel is consumed by the top 30% of high-income earners in Sri Lanka who can actually afford higher fuel prices. Naturally, energy consumption rises with income, as wealthier households use personal vehicles, high-energy appliances, and consume more overall. Only 30% of the total fuel is consumed by the remaining 70% of the population, which includes fishermen, public transport users, and service providers.

Thus, if we artificially lower fuel prices through a subsidy, it effectively subsidises the wealthiest families in Sri Lanka. While a low-tax regime might be ideal, given our fiscal situation and the International Monetary Fund (IMF) programme, Government revenue must increase to about 15% of GDP. Lowering fuel taxes would thus provide tax relief to the wealthiest 30% of households and incentivise excessive fuel consumption.

Imperative to adhere to fuel formula

Instead of being swayed by popular demands to reduce fuel prices, especially with rising tensions in the Middle East, the Government should first review its balance sheet to ensure adequate revenue with minimal market distortions to achieve debt sustainability.

If the Government aims to lower fuel prices for the public transport and fisheries sectors, the best approach would be a direct cash transfer rather than lowering all fuel prices, which would mitigate the impact of high fuel prices on essential goods and services.

It is imperative that we stick with the fuel formula and strengthen it if necessary. Unfortunately, there is limited information regarding the recent controversy over agreements between fuel suppliers on price revisions. If, as the Chairman claims, there is a clause to compensate private players for losses, this would be unreasonable if true.

In the absence of the full report, the only available information is a post on X from the former Minister of Power and Energy, who claims the CPC only pays the difference when the Government provides a subsidy or other mechanism to deviate from the price formula. In fairness to private players, if only the CPC receives a fuel subsidy, it creates an unlevel playing field, as petrol and diesel would be cheaper at CPC stations than at private ones.

Although the subsidy benefits consumers, it primarily benefits the wealthiest 30%, and rising demand could drastically increase the total subsidy cost for the Government. Therefore, a fuel subsidy is not advisable, as it essentially transfers Treasury funds to the wealthiest households in Sri Lanka.

Another issue has arisen: one supplier has reportedly requested about Rs. 82 million as compensation for deviations from the fuel price formula. It is difficult to assess this claim fully, as the original documents are not publicly available, but if true, it raises questions about whether recent price revisions adhered to the formula.

In particular, price adjustments before and after the elections require examination. Data on whether the September and October price revisions complied with the formula has also not been published; making this information available would reduce information asymmetry, essential for a functioning market economy.

Providing consumers with the best price

A further question is whether only a Government-owned CPC can reduce prices, and why prices are not decreasing with private players like Lanka IOC, Sinopec, RM Parks, and United Petroleum in the market.

The answer is not straightforward. The CPC is already heavily in debt, with high financing costs that must be covered. Moreover, prior to the latest revision, Sinopec’s diesel prices were actually lower than others, illustrating how competition can bring prices down.

However, prices depend on global crude and refined oil rates, and sometimes on the efficiency of refineries. When a price formula is in place in a small market, players often charge similar prices, but more competitors could introduce value propositions, including price variations based on global fluctuations.

For example, Lanka IOC offered an environmentally friendly fuel at a higher price, while Sinopec sold diesel at a lower price. To remain competitive, each player must offer something unique, which may not always be a lower price but can include quality or convenience.

The final point is that the new administration has requested a flat dealer margin instead of a percentage tied to global fuel prices, which is a positive move. Dealer costs are mainly influenced by inflation rather than global prices. The purpose of the price formula is to account for both variable and fixed costs to prevent losses and provide consumers with the best price.

In a market system, the consumer is at the centre. To prioritise consumer needs, we must ensure multiple players and transparency in pricing to minimise information asymmetry. Publishing the final fuel price revision calculations for the past two months and the full price revision agreement with private players would be a constructive first step.

Central Bank Defends Liquidity Injections Amid “Money Printing” Controversy

By Dhananath Fernando

Originally appeared on Ada Derana Business

A fresh controversy has erupted following reports that Sri Lanka’s Central Bank (CBSL) injected nearly 100 billion rupees into the banking system by October 25. Given that money printing was the major cause of the country’s financial crisis, this news has sparked considerable attention. CBSL has defended its actions, arguing that these liquidity injections do not equate to money printing.

What is the CBSL’s Argument?

CBSL asserts that these liquidity injections were necessary to address persistent imbalances among banks. Despite an overall surplus of funds in the banking system, this liquidity is unevenly distributed. Foreign banks operating in Sri Lanka hold significant liquidity surpluses but remain cautious about interbank lending due to strict risk management guidelines. As Sri Lanka’s sovereign rating is still ‘Default, this limits their exposure to local financial institutions. As a result, foreign banks deposit excess rupees with the Central Bank rather than in the interbank market.

While this was a serious problem in the midst of the crisis things have improved since: interbank call market (clean or unbacked) trading volumes, once as low as zero 1-2 billion rupees daily, has now returned to Rs10bn to Rs20bn (averaged 10 billion last month). Repo volumes (backed by T-bills) are back around 30 to 70 billion rupees, which is higher than pre-crisis levels.

Notably, auction data shows the central bank offering more than what banks bid for, with some banks bidding close to the deposit rate, indicating a willingness to lose bids—yet CBSL still provided new funds.

Given the much healthier interbank volumes, the CBSL should avoid undermining the working of the interbank market. The CBSL should be the last resort for a bank facing a liquidity crunch, not the first.

The Core Issue: Temporary vs. Longer-Term Impact

The debate centers on whether these injections are temporary or enduring. If CBSL swiftly withdraws the new money by selling Treasury bills or foreign exchange, the money supply remains stable. However, if these short-term purchases are repeatedly rolled over, the increase in money supply could become more long-term. Critics warn that this scenario is no different from lending money to the government, potentially triggering balance of payments problems and inflation, thus jeopardising the ongoing economic recovery.

A Matter of Terminology

CBSL’s reluctance to label this as “money printing” is essentially terminological. Regardless of whether the funds are lent to banks or the government, the impact on the money supply is fundamentally the same. Therefore, interventions must uphold the principle of currency stability, given the grave consequences of unchecked money creation.

Acknowledging CBSL’s Efforts

It is It is important to acknowledge that since September 2022, the CBSL has done an admirable job in restoring monetary stability. The critical task now is to maintain this hard-won stability. These points are presented to promote a healthy academic debate on an issue of great importance, not to cast blame on any specific entity or person.

Potential Alternative Strategies

What alternatives could CBSL have considered?

Purchase Foreign Exchange from Banks: Where balance of payments conditions permit, CBSL could continue the practice of buying foreign exchange, injecting rupees but reducing foreign currency in the If the injected rupees were later used for imports, CBSL could sell foreign exchange back, maintaining balance and avoiding exchange rate issues.

Use the Standing Lending Facility: Lending at the Standing Lending Facility Rate of 9.25% would ensure banks only borrow for urgent liquidity needs. As this penal rate is higher than the interbank rate, it discourages long-term dependency and helps avoid a lasting increase in the reserve money supply.

Reduce the Standing Deposit Facility Rate: If the CBSL wishes to lower rates, it could reduce the rate on deposits held at the Central Bank, which would encourage banks to lend more in the interbank market. However, this would also lower overall interest rates and must be carefully managed. To support reserve accumulation, interest rates need to remain at an appropriate level to curb credit and keep imports in check.

The Balancing Act

CBSL faces the difficult task of supporting the banking sector while safeguarding monetary stability. Any intervention must be carefully weighed to mitigate risks such as inflation and currency destabilisation.

Fuel deal without bidding sparks fears of economic instability

By Dhananath Fernando

Originally appeared on the Morning

On Wednesday (16), a daily newspaper reported that the new Government was planning to strike a fuel supply deal between the Ceylon Petroleum Corporation (CPC) and the Ceylon Electricity Board (CEB) for power generation.

Following this report, there was significant discussion on social media questioning why the Government would deviate from the competitive bidding process (a few Government representatives have personally informed us over the phone that the facts in the news story are incorrect and that the Government plans to clarify details through a press conference).

If the news is true, it would mean that the CEB would no longer engage in competitive bidding when purchasing fuel from the CPC. Fuel purchases, including hydrocarbons like naphtha and heavy fuel oil, are key input costs in electricity generation.

Regardless of the news story’s accuracy, the main concern for businesses is that bypassing the competitive bidding process in fuel procurement could lead to significant risks for CPC and CEB financial stability with corruption vulnerabilities. If the CPC and CEB start incurring losses or attempt to cover up losses by increasing tariffs, it could destabilise the economy.

To put this into perspective, the CPC’s revenue for 2023 was approximately Rs. 1,300 billion and the CEB’s about Rs. 679 billion. In comparison, Sri Lanka’s total tax revenue, including Value-Added Tax (VAT) for 2023, was around Rs. 3,000 billion.

Together, these two institutions manage a cash inflow that amounts to nearly two-thirds of the country’s total tax revenue. Even a minor financial misstep could result in a major crisis for the Government, leading to a complete economic collapse.

Avoiding the competitive bidding process creates a vulnerability to corruption. Competition is a crucial tool for preventing corruption, as it automatically introduces checks and balances through price signals on the supplier side. Without competitive bidding, any corruption within the CPC or CEB would likely manifest as significant financial losses in their balance sheets. Unlike other institutions, losses at the CPC and CEB have massive spillover effects, as has been seen under successive governments.

Typically, the CPC sells naphtha – a byproduct of its refinery – at a price higher than the market rate to the CEB. This is one way the CPC tries to offset its own inefficiencies or cover losses when the Government mandates fuel sales below production cost. However, when the CPC charges more for naphtha, electricity generation becomes more expensive, prompting the CEB to seek tariff increases.

On top of this, the CEB often delays payments to the CPC when it experiences losses, which forces the latter to borrow money from banks at high interest rates. These costs, in turn, are passed on to consumers, affecting industries across the board – from rice mills to poultry farms and even hotel operations, as energy costs are a major expense (CEB tariff hikes impact the water bill and many other industries, including through increasing inflation).

The CPC also sells jet fuel to SriLankan Airlines at inflated prices, similar to how it overcharges the CEB for naphtha. Jet fuel is a significant cost for the aviation industry and the high prices can push airlines into losses. When the CPC, CEB, and SriLankan Airlines all incur losses, they ultimately turn to the Treasury for bailouts.

It is no secret that the Treasury’s budget deficit has remained massive for years, compared to the country’s GDP. Consequently, the Government then turns to State-owned banks like the Bank of Ceylon (BOC) and People’s Bank (PB) to cover the losses. In many cases, the Government provides Treasury guarantees, sometimes even in US Dollars, for fuel purchases.

These banks, in turn, are forced to lend depositors’ money to these institutions, often at a high risk due to the prime lending rates. Ultimately, the financial mismanagement of the CPC and CEB trickles down to depositors’ hard-earned savings.

In the last Budget, the Government allocated Rs. 450 billion, equivalent to three years of Advance Personal Income Tax (APIT, previously the Pay-As-You-Earn [PAYE] tax), to recapitalise the banking sector, mainly with State banks. In addition, the Government absorbed $ 510 million into the Treasury to address losses at SriLankan Airlines, largely caused by the CPC’s inflated prices.

If the CPC indeed moves away from competitive bidding, it is a clear signal of poor governance and a warning of future economic hardship, potentially affecting depositors’ savings. When the CPC and CEB incur losses, the Government typically has to either increase the prices of electricity and fuel beyond what is set by price formulas or continue providing subsidies – both of which lead to higher taxes or interference with key economic indicators, thus creating political pressure.

This cycle has been ongoing for years, which is why the business community and others are deeply concerned about the CPC leaving the competitive bidding process. If the news is false, we can be relieved. But it is essential to understand the grave risks of abandoning competitive bidding, as it extends far beyond corruption; it threatens to bring about complete financial instability.

Scrambled supply: How maize, markets and policy cracked egg prices

By Dhananath Fernando

Originally appeared on the Morning

Just after the election, social media chatter quickly shifted to egg prices, which had dropped by about Rs. 10. Many speculated that a kickback had ended, causing the price drop. However, a few days later, the prices shot up again by Rs. 10 and memes started circulating, joking that now the hens were taking the kickback.

But there is a deeper story behind egg prices and the poultry industry in Sri Lanka. The primary cost in poultry is the cost of feed, with maize being the main ingredient, making up about 60% of the feed by weight. The cost of maize accounts for around 45-60% of the total cost of poultry production.

In Sri Lanka’s poultry market, 40% is through wet markets while 60% is through formal markets, which maintain high standards to supply to hotel chains. At one point, we were even exporting poultry products to the Maldives.

When it comes to eggs, however, the cost factors are front-loaded. Layer chickens must be imported and raised to maturity, which takes longer than broiler chickens. The cost of feeding these layer chickens, especially with maize prices being so high, significantly increases production costs.

After the economic crisis, inflation caused maize prices to soar from Rs. 45 to Rs. 165 per kg, pushing up poultry product prices. Our local maize market, which is the main cost driver for the poultry industry, is tricky.

While Sri Lanka requires about 500,000 MT of maize annually, we only produce 300,000 MT, leaving a shortfall of 200,000 MT, which is imported through a licensing process. This system creates a cartel of importers, driving up maize prices and, consequently, chicken and egg prices.

Maize imports are also heavily taxed, including Ports and Airport Development Levy (PAL), Value-Added Tax (VAT), and Customs duty, further increasing costs. Meanwhile, local maize production is inefficient, yielding only about 1.5 MT per hectare compared to the global average of 2.5 MT per hectare. This low productivity forces farmers to encroach on forests to increase their yield, creating environmental challenges.

In response to the crisis, the Government imposed price controls on eggs. Since farmers had already invested in layer chickens, they were unable to maintain them under the price controls and ended up selling the chickens for meat. This led to a reduction in egg production, driving prices higher.

In the formal market, producers with thin profit margins halted capacity improvements, keeping production stagnant. As a result, we were unable to expand exports, as there was no capital to fund growth. The combination of price controls, maize import licensing, and high tariffs led to low production and high prices.

Eventually, the Government resorted to importing eggs from India. This highlights how distortions in the maize market, coupled with tariffs and inefficient agriculture, have hurt Sri Lanka’s poultry industry.

Despite all the costs, including shipping, insurance, and handling, the cost of an imported egg is still cheaper than locally produced eggs, mainly due to irregularities in the maize market.

Over time, the market began to stabilise. The drop in egg prices right after the election was likely due to lower demand during election week, especially from eateries and bakeries. As eggs are perishable, the surplus likely drove prices down. However, as soon as prices fell, people began buying more than usual, which quickly drove demand back up and prices along with it.

While it’s possible that some farmers and wholesalers may have hoarded eggs, the primary reason for high egg prices lies in Government interference in the maize market and price controls. The well-intentioned move to make protein more affordable through price controls has had the opposite effect – something that happens with many policy decisions.

The new Government must focus on making decisions based on data, facts, and economics, not just good intentions. In economics, good intentions don’t guarantee good outcomes.

The first 200 days: Can the new government lead or will it be overtaken?

By Dhananath Fernando

Originally appeared on the Morning

• Sri Lanka’s new Government faces critical early decisions

The first 100-200 days are critical for any new government. Being prepared to assume power is essential because if a government expects to prepare after getting to power, it risks being overtaken by circumstances.

This is particularly true in a country like Sri Lanka, where uncertainty is the only constant. Governments here face numerous internal and external shocks, and there is little time to prepare or adjust once in power. When a new president or government takes charge, it is akin to boarding a fast-moving train.

Many previous governments have been reactive, merely responding to crises rather than controlling the situation. If a new government fails to take command, the situation will inevitably take control of it.

During his second term, President Mahinda Rajapaksa’s Government was overtaken by corruption and inefficiency before it could address core issues. The ‘Yahapalana’ Government came to power unprepared, only drafting its Vision 2025 plan after a Cabinet reshuffle, including changes to the Ministry of Finance. By then, its primary mandate for rule of law, good governance, and economic transformation had already faded.

President Gotabaya Rajapaksa’s Government faced the unexpected Covid-19 pandemic. While somewhat prepared, its policies were misaligned with sound economic principles. The more policies it implemented, the more unpopular it became, given the delicate balance between economics and politics.

Learning from these past lessons, one hopes the current Government avoids the same mistakes. Its challenge is navigating back-to-back elections. While elections may strengthen the Government’s political power, delaying essential economic reforms could be disastrous for a fragile economy like Sri Lanka’s. Delays in reforms could take years to recover from, and in the meantime, other pressing issues may spiral out of control.

While the plan for economic stability continues, economic growth reforms are equally vital. According to the National People’s Power (NPP) manifesto, simplifying the tariff structure is a good starting point. A simplified tariff would not only boost growth and competition but also reduce corruption, benefiting consumers by lowering prices. The Government should see an increase in revenue as informal money leaks caused by a complex tariff system decline.

However, timing is crucial, and reforms need to be implemented quickly within the first 100-200 days. Simplifying the tariff structure will see resistance from trade unions and stakeholders benefiting from the corrupt system. The best way to minimise resistance is to act early. Some local companies, which profit from targeting only the domestic market, may resist the changes, as will officials who have benefitted from the complexity of the system.

The second key reform the new Government should prioritise is anti-corruption. In fact, it received a strong mandate for this. While addressing corrupt politicians and officials is important, the Government also needs to reduce the potential for future corruption by adjusting or removing certain regulations.

Even if the Government is not entirely prepared to tackle corruption vulnerabilities, the International Monetary Fund (IMF) Governance Diagnostic is ready with specific actions, responsible divisions, and timelines. By committing to this framework, Sri Lanka can also secure financial and technical support from bilateral and multilateral sources. More importantly, it would significantly reduce the country’s corruption vulnerabilities.

The Government must also avoid certain pitfalls. Delaying economic growth reforms in favour of focusing solely on anti-corruption would be a mistake. Both reforms need to move forward simultaneously, and the Government must be proactive rather than reactive.

Another mistake to avoid is the overuse of relief packages and price controls. When governments fail to deliver on promises, they often impose price controls as a last resort, covering everything from eggs and milk powder to hotel rooms. While intended to protect consumers, price controls often lead to unintended consequences. If the controlled price is lower than production costs, sellers lose the incentive to sell, creating black markets.

We hope the Government can maintain stability, grow the economy, and continue its anti-corruption drive in parallel. Failing to do so will only lead to further losses for all.

Why we won’t be able to find the thieves after the election

By Dhananath Fernando

Originally appeared on the Morning

If you ask the average person the reason for our economic crisis, they would probably say one word: ‘corruption’. The idea of corruption was hyped so much that it became the main theme of the people’s movement – the ‘Aragalaya’. 

However, the truth is a little different. This doesn’t mean there hasn’t been corruption; it means corruption is more of a symptom than the root cause. Corruption is like a fever, while the real infection lies elsewhere. The problem is, we don’t fully understand how corruption occurred, and if we don’t know that, it’s unlikely that we can fix it either. 

Even when we look at the election manifestos of political parties, they talk about eliminating corruption, but corruption isn’t the main focus. Instead, they place more emphasis on proposals for exports, business environment reforms, social safety nets, and debt restructuring.

Why don’t we know?

The way many Sri Lankans calculate corruption is simple: they take the total value of loans we have taken over the years, compare it with the asset value of infrastructure projects, and conclude that the difference equals corruption. 

However, most of the money we borrowed was not for infrastructure. In fact, since 2010, about 47% of the loans were taken just to pay interest. Another 26% of the debt increase came from currency depreciation. This means that from 2010 to 2023, about 72% of the total loans was used for interest payments and dealing with currency depreciation. 

Therefore, comparing the value of infrastructure projects to the total debt doesn’t give a clear picture of corruption because we have been borrowing mostly in order to pay interest. As a result, the debt keeps growing and we remain stuck in the same place.

Does that mean there’s no corruption?

This doesn’t mean there has been no corruption. It simply means we don’t fully understand how it took place. As a result, the solutions proposed for corruption only address the symptoms, not the root cause. 

Corruption has taken place during procurement. Most of the projects we conducted have been priced far above their actual value. 

For example, a project that should have cost $ 1 million was priced at $ 3 million. We then borrowed money at high interest rates for that inflated amount. The project is completed, but we’re still paying interest on an inflated value and the interest keeps snowballing. Now, we’re borrowing more just to pay the interest, which only pushes the total debt higher.

How to fix it

This problem needs to be fixed at the beginning, not at the end. Most anti-corruption methods focus on the aftermath – finding thieves and recovering stolen money. Of course, we should recover stolen money and hold people accountable for misuse of public funds. But on a policy level, the real need is for transparency in procurement and competitive bidding. 

Digital procurement systems and a proper procurement law can take us to the next stage. Otherwise, it’s akin to closing the stable door after the horse has bolted. Without competitive bidding, we may never even know the true value of projects or how much was stolen. Recovering stolen money becomes incredibly difficult if we don’t know the amount or the method used to steal it.

The solution is upfront disclosure of the values of large infrastructure projects, as well as clear financing methods and guidelines.

The graph shows the impact of State-Owned Enterprise (SOE) losses on debt. The contributions of Ceylon Petroleum Corporation (CPC) and SriLankan Airlines to the debt are clear; in 2024, we will see more debt from SriLankan Airlines, the National Water Supply and Drainage Board (NWSDB), and other entities.

Simply put, we borrowed too much at high interest rates with short maturities for infrastructure projects that didn’t generate enough revenue to even cover the interest payments. As a result, the interest compounded and we have been continuously borrowing to pay off that growing interest, leaving the debt in place and forcing us to keep borrowing.

Albert Einstein put it wisely when he said: “Compound interest is the eighth wonder of the world. He who understands it, earns it; he who doesn’t, pays it.”

Price Regulation on Three-Wheelers and School Vans: A Recipe for Transport Troubles

By Gurubaran Ravi & Chanul Singharachchige

Price is fundamental in determining the manner in which market forces influence both patterns of demand and the chains of supply. Price is a manifestation of what economist Adam Smith termed the ‘invisible hand’ which naturally allocates scarce resources in accordance with the laws of supply and demand and requires near zero intervention. The question now lies: what happens when this unneeded intervention is implemented regardless? By manufacturing limitations around prices, the government disrupts the natural balance between supply and demand. With the government planning to introduce a series of price controls on the three wheelers , school and office transportation sector - upon which almost all of us rely - it is worth revisiting what the adverse consequences of such an act can and will look like, how they will most definitely exacerbate already existing problems, and finally, prevent the economy from finding its own equilibrium.

Essentially, price controls entail putting restrictions as to how high or low prices can be set for a certain good or service via ‘price ceilings’ and ‘price floors’ respectively. Conceptually speaking, the implementation of price controls is often for a given purpose, whether it be to control inflation or protect consumers, the government simply tries to artificially balance distortions within the market creating a great deal of uncertainty in the economy itself.

However, not all that is expected to come into fruition in theory can be seen in the outcomes found in objective reality. For example, despite the immediate benefits price controls may provide, they distort the natural dynamics of the market leading to unintended consequences such as supply shortages, the reduction in the quality of goods and services, and the prevalence of underground black markets. This tends to be because producers struggle to cover the costs associated with providing products at pre-established prices. The ultimate harm done to both consumers and producers through the implementation of such regulation - though often well-intentioned - outweighs any temporary benefits that may be reaped. 

Now, let us take a closer look at what the landscape of how the transport market for three wheelers in Sri Lanka looks like and behaves. Nowadays, three-wheelers, school vans, and office vans have become integral parts of the Sri Lankan transportation system - especially with the deterioration of the public transportation system. The three-wheeler segment comprises a significant portion of Sri Lanka’s transport sector with more than 300,000 three-wheelers in operation. These vehicles have made it possible for millions of people to have their means of private transport for daily use, particularly in rural areas and other hard-to-reach places. In the backdrop of an economic crisis, where operating costs become extremely high, the proposed price regulation policy is likely to jeopardize this important service. Such regulation could reduce the number of providers as the financial pressure on operators rises, the availability of transport decreases, and transport fares rise. This impact would be most severely experienced in regions where choices of public transport are already few, possibly leaving many with no affordable means of transport. 

The transport sector for three-wheelers is also mainly composed of individual operators, but recently a few companies like PickMe and Uber have utterly revolutionized Sri Lanka's transport market. They have managed to heighten efficiency, promote route optimization, and enhance service quality, whilst simultaneously providing alternate employment opportunities for a vast and diverse array of people. However, any proposed regulations that stifle the freedom with which price can move will inevitably disrupt the market dynamics fostered by these platforms. Experts warn that such constraints will undermine the flexibility and efficiency of the sector, distort supply and demand, and potentially reverse the benefits of market-based pricing models. This could lead to diminished levels of availability of service, hindrances in the pace of innovation within the industry, and a rollback of the advancements made in respect to meeting needs of consumers - particularly those of low-income earners. 

The free market fosters levels of competition that incentivize providers to one-up one another at every opportunity. In the service-based industries - such as transport - this is best accomplished through the provision of high quality services at as low a price as possible in order to attract consumers. Therefore, if price controls are implemented on the three-wheeler, school,  and office transportation sectors, they stifle the capacity as well as the incentives that providers have to improve levels of flexibility and provide a variety of options to consumers, particularly affecting low-income individuals. These price controls also significantly enlarge an industries’ reaction time - and hence inefficiency- when making adjustments in respect to pricing and supply when faced with fluctuations in economic conditions such as shifts in the levels of inflation or a fuel crisis. Experts in the field have shared similar concerns, emphasizing the fact that while these regulations may be passed in order to provide temporary relief to a select few, they risk the destabilization of the entire market and jeopardize the efficiency of the entire market system.

However, it is impossible to turn a blind eye to the fact that there are certain factors that are crucial to these price controls. The government has to consider how it will be able to oversee and regulate thousands of independent operators across the country, especially in a sector that is as fragmented as the transport sector. The adoption of such regulations would likely require a high administrative cost, which would likely shift attention from other important sectors. Moreover, given the fact that the three-wheeler, school, and office transportation sectors are composed of many small participants, it remains doubtful whether such enforcement can be achieved in the first place. For instance, it may be hard to enforce compliance in rural regions and in urban regions with dissimilar levels of economic development. This may lead to a situation where only some or even a part of the controls are being implemented, thus aggravating and distorting the market more than it is at the moment. The efficiency of these measures is furthermore rather questionable, which leads to questions of whether or not these measures can be implemented without causing more problems than they are solving.

However, the three-wheeler, school, and office transportation sectors are far from the only sectors that have known the weight associated with the adverse consequences of price control implementation. It should be highlighted that LP gas, cement, bread, rice and eggs, have all been subject to similar limitations. These policies have frequently caused significant market distortions. In 2023, in order to combat a sharp rise in the prices of eggs, the Sri Lankan government made the decision to impose price controls on eggs. Despite this intervention aiming to resolve the dilemma, it instead devastated the industry and led to severe shortages in the supply chain with producers failing to sustain costs. The restrictions on LP gas and bread supplies appear to have influenced supply chain disruptions and market fluctuations. Moreover, there is news that cement may be the next to be affected by further price regulations, which will exacerbate the situation in the building and construction industry. Such stopgap regulations impair the normal functioning of free market economics, send misleading signals to actual price factors, and cause more instability in the economy, by providing only short-term relief while exacerbating long-term structural issues.

While the debate around price controls is critical, it raises a more significant question: The public transport system needs to be improved based on the government’s long-term vision of how it plans on fixing the system’s problems. While exercising the price control mechanism may give some relief to commuters and public transporters in the short run, it cannot address the structural issues that are inherent in the public transport system in Sri Lanka. The real solution is to create an integrated plan to upgrade public transport infrastructure and to improve service delivery so that the public transport system becomes the first choice of the transport user. In this regard, it would be possible for the government to ease the burden from the private transport sector, including three-wheelers and school vans, etc., and thereby develop a more balanced transport system. The provision of mass transit systems offers not only the purpose of decreasing reliance on private automobiles but also social justice, optimum resource utilization, and preservation of the earth.

On a more conclusive note, history teaches us a clear lesson: the fundamental importance of allowing prices to reflect supply and demand naturally simply cannot be understated and any intervention in this intricate relationship can have dire direct and indirect consequences.While interventions like price controls may provide temporary relief to a select few, they often just exacerbate already convoluted issues when considering the longer term.  A free market system is pivotal in order to maintain economic equilibrium where efficient resource allocation can be best fostered. In such a system, it is price that serves as the principle signal to guide both consumer and producer behavior. The self-regulating nature of this system not only promotes innovation and competition but helps mitigate market distortions that may arise from intervention or excess regulation.

Sri Lanka’s Productivity Push: Exploring Policy Pathways for the Proposed National Productivity Commission

By Tilani Jayawardhana

Why Does Productivity Matter for Sri Lanka?

Productivity is not just a technical measure of economic efficiency; it is fundamental to improving living standards, sustaining economic growth, and ensuring the long-term prosperity of society. Evaluating and enhancing the productive forces of the economy is crucial for informed policymaking, targeted investments, and achieving sustainable development. For Sri Lanka, focusing on productivity is key to overcoming economic challenges and realizing its potential in the global economy.

Sri Lanka should increase productivity across the economy if it wants to successfully compete in the global value chain. Improvement in productivity will reduce the costs and place the country in a better position to supply to the global markets at competitive prices. 

Productivity growth has to be a top priority of all the successive governments. Without productivity growth, the country’s production system, be it agriculture, industry, or services, will be displaced in the global system.  Therefore, the role of the NPC should be to ensure a data-driven approach to productivity in each sector, promote competition, and encourage international competitiveness. 

Sri Lanka’s productivity has to be built up through investments in physical capital stock, human capital and the diversity and dynamism of our industries. To ignite productivity growth, new business investment and workforce capabilities will need to improve in ways that respond to the changing shape and nature of the economy. Investments in physical capital are expected to continue to drive Sri Lanka’s productivity potential. International evidence shows that about two-thirds of labour productivity growth since the early 1970s has been due to capital deepening. This is because when the amount and quality of capital available to workers increases, they are generally able to produce more per hour worked. As the industrial mix changes, investment in growing industries and effective adoption of new technologies, including digital technologies, will be essential.

The productivity challenges and opportunities that we will face in the future will be different to what we have seen in the past. Improving productivity in the large and growing services sector will be increasingly important, as it will have an outsized impact on Sri Lanka’s overall productivity outcome. Country’s productivity agenda needs to respond to current economic circumstances and identify modern strategies to advance enduring policy goals.

Rationale in establishing the National Productivity Commission (NPC)

An economy’s ability to use labour, capital and other resources efficiently is the essence of productivity and it is when this efficiency increases a country’s economy would expand. In a bid to revive the country’s struggling economy, Sri Lanka has implemented a comprehensive economic reforms agenda. The government has initiated several key recovery strategies, with the establishment of a National Productivity Commission (NPC) being a flagship project under the Economic Transformation Bill. The proposed NPC is expected to help address the productivity enhancement needs of the domestic industrial sector as they are struggling to come out of the economic crisis and exposed to greater international competition. The government of Sri Lanka has taken this correct step forward and acknowledged that higher productivity growth has the advantage of raising average living standards by increasing GDP per capita. 

Productivity growth is an important aspect of economic and social development of a country. Moreover, increasing productivity enhances competitiveness, making it a crucial factor in attracting foreign investments and boosting international trade. Productivity drives economic growth and helps realize improved living standards. 

Though Sri Lanka’s output structure shows a shift to services (with an average share of 59.2% during 2016–2022) and away from agriculture (8.5%), a large share of the employed are still in agriculture (26.4%), where productivity is about 31% of the national average. Furthermore, its manufacturing sector—a sector widely regarded as one that can gainfully employ semiskilled workers—lags in labor productivity. Though Sri Lanka’s manufacturing labor productivity is one of South Asia’s highest, it is roughly half of that in the Philippines and Thailand, and about one-third of that in Malaysia and the People’s Republic of China (ADB Country Partnership Strategy: Sri Lanka, 2024–2028).

Sri Lanka's aging population presents a significant challenge to sustaining high economic growth, while boosting productivity is the key solution to overcoming this hurdle. Sri Lanka is “growing old” before becoming “rich” and thereby there is an urgent need in preparing for an aging society that will require increasing labor force participation and productivity of the workforce. Productivity improvements can offset the economic impacts of a shrinking workforce by enabling the remaining labor force to produce more. This is crucial for sustaining economic growth in the face of demographic challenges. Therefore, establishment of the NPC is a clear step forward in the correct direction. 

Overview of the Proposed NPC

The broad objective of the proposed NPC is to promote economic growth through increased productivity for the improvement of wellbeing of people in a sustainable manner. The NPC will be an independent body which is accountable to Parliament. 

The main duties and functions of the NPC shall be to: 

• Make recommendations to the relevant authorities based on evidence and comprehensive analysis in order to increase productivity and economic performance by; streamlining regulation of productivity, promoting healthy competition and contestable markets, catalysing structural transformation and encouraging international competitiveness

• Make recommendations to the Government on introducing a national competition policy and advise on subsequent revisions as needed from time to time

• Conduct public inquiries and evidence-based research on issues related to productivity, either in-house or contracted out, and disclose the methodologies used for such inquiry or research

• Carry out, performance, monitoring, evaluation and benchmarking on the productivity

• Report annually to Parliament on the productivity trends within the first four months of the following year

• Advocate on the need for productivity improvement 

Although the objectives of the NPC cover a wide range of responsibilities, from streamlining regulation to promoting competition and international competitiveness, this broad scope might dilute the focus and effectiveness of the NPC. It is important to narrow the focus to specific, high-impact areas initially, such as catalyzing structural transformation or enhancing international competitiveness. Clear prioritization of tasks could improve the efficiency and outcomes of the commission’s work. NPC’s work and policy orientation should address the country's on-going productivity issues, it also should carry a longer-term perspective in achieving the development goals of the country.

In addition, conducting inquiries and evidence-based research in-house might lead to biased outcomes, especially if the NPC faces political or administrative pressures. This issue can be resolved through the establishment of an independent research unit within the NPC with a clear mandate. 

NPC should Advocate for the development of standardized productivity metrics and benchmarks, perhaps aligned with international best practices to facilitate performance monitoring, evaluation and benchmarking. 

It is also important to have within the NPC mandate to promote public advocacy and engagement. The mandate to advocate for productivity improvement is broad, and without a clear strategy, these efforts might not reach the right audience or create the desired impact. Development of a targeted communication and advocacy strategy that includes specific campaigns for different sectors, public education initiatives, and collaboration with media and civil society to raise awareness should be taken into consideration.

Concerns on the proposed NPC and some policy recommendations

• The process of appointing the chairman and five members to the NPC is under presidential authority, which raises concerns about potential political interference and the practicality of the level of independence of the commission. Even if the commission operates under an independent entity, the inherent structure would not warrant it to operate at arm’s-length from politicians and other public agencies. 

• The two core features of the NPC has to be its transparency and its economy-wide perspective. The commission’s activities should encompass all levels of government and all sectors of the economy, with the core values of independence, transparency and community-wide perspective, including social and environmental aspects. 

• The NPC should have permanent staff that has the capacity to evaluate all aspects of the public sector operational activities with special emphasis on macroeconomics and competition policy. Their work should be overseen by independent commissioners appointed for a fixed term. 

• The NPC must be geared to contributing by providing quality, independent advice and information to the government, and on the communication of ideas and analysis. - The commission ideally should be an agency of the Government of Sri Lanka, located within the
  Treasury portfolio, covering all levels of government and encompass all sectors of the economy, as well as social and environmental issues 

• National performance monitoring system has to be based on the Total Factor Productivity (TFP). TFP is referred to as the productivity measure involving all factors of production. Most often productivity measurement is based on Partial Factor Productivity, where one or more outputs are measured relative to one particular input (eg. Labour productivity is a ratio of output to labour input). Therefore, unlike labour productivity (or capital productivity), which considers only the labour input (or capital input), TFP is a comprehensive measure of productivity. TFP is usually calculated as the ratio of the total output to the combined inputs of labor and capital. Partial productivity measures are widely used as they are simple to calculate. However, partial factor productivity should be interpreted with caution.  

Regulatory Power of the NPC.The NPC’s mandate to "streamline regulation" and "promote healthy competition" might be limited if the commission does not have sufficient authority to enforce its recommendations. Without enforcement powers, the NPC could become merely an advisory body, with its recommendations being ignored or delayed by the government.

Sri Lanka’s next leader faces a web of crises

By Dhananath Fernando

Originally appeared on the Morning

In two weeks, a newly-elected president and government will take charge of steering the country.

At the beginning of the forex crisis, we warned that an economic crisis often comes as a package of five interconnected crises.

Balance of payments crisis

A balance of payments crisis occurs when excessive borrowing from the central bank (money printing) leads to inflation. In countries like Sri Lanka, where the local currency is not a reserve currency and the economy relies heavily on imports, printing too much money increases the demand for goods and services – many of which are imported.

If exports, remittances, and Foreign Direct Investments (FDI) fail to keep up with this increased demand for imports, we run out of foreign exchange reserves, causing the currency to depreciate.

Debt crisis

When foreign currency reserves are depleted, the country struggles to meet its obligations to creditors. While borrowing from international markets might offer temporary relief, credit rating downgrades make this option limited, triggering a debt crisis. On 12 April 2022, Sri Lanka officially declared it could no longer service its debts, despite having the intention to do so.

Banking crisis

If local banks have provided significant loans to the government and the government defaults, a banking crisis can unfold. Sri Lanka narrowly avoided this scenario.

Humanitarian crisis

With debt defaults and depleted foreign reserves, imports become limited. Inflation makes basic necessities unaffordable for the poorest segments of society. In Sri Lanka, poverty numbers surged from three million to seven million, pushing more than 30% of the population below the poverty line.

Political crisis

When a government faces multiple crises such as these, political instability inevitably follows, as we have seen in Sri Lanka. The President was ousted, the Prime Minister and Finance Minister resigned, and an interim Government was formed.

Although the political crisis continues, it is only one phase in an ongoing cycle of instability, with the Presidential Election being a milestone in this process.

Current political landscape

The incumbent President has introduced significant relief measures, including raising public sector salaries, forgiving agricultural loans, and making other promises. However, if re-elected, he will struggle to deliver on these promises within the limited fiscal space, potentially leading to a deviation from the International Monetary Fund (IMF) programme.

Alternatively, he might be forced to raise taxes or borrow more, which would increase interest rates and add to the economic strain.

If another candidate is elected, they will face the same fiscal limitations and may have to reverse salary increases to maintain fiscal discipline.

In the case of a Samagi Jana Balawegaya (SJB) government, the challenges are compounded. The Economic Council within the SJB sends mixed signals about achieving revenue targets to support proposed expenditures. Additionally, the broad alliance of political factions under the SJB presents internal challenges, especially concerning sensitive reforms like State-Owned Enterprise (SOE) restructuring and maintaining Central Bank independence.

Not all factions have aligned views based on previous voting records and public statements. Managing these internal differences will be critical for an SJB government, especially in the context of carrying forward the relief measures introduced by the current President.

Similarly, in a National People’s Power (NPP) government, the same challenges apply. The NPP, primarily led by the Janatha Vimukthi Peramuna (JVP), advocates for a more State-led development approach, but many professionals in the party’s outer circle lean toward market-driven policies. This could lead to internal conflict, making reforms difficult to implement without alienating part of the party.

This situation resembles the ‘Yahapalana’ Government, where the President and Prime Minister held differing ideologies. As a result, governance became more about managing stakeholders than effective government operation.

If you recall, the Prime Minister made economic decisions through the Cabinet Committee on Economic Management (CCEM), which was later replaced by the National Economic Council appointed by then President Maithripala Sirisena. Stakeholder management within an NPP government could prove just as challenging.

On top of these internal struggles, Parliamentary and Provincial Council Elections are expected to follow, adding even more political promises that will further constrain the fiscal space. Reforms tend to slow down during election periods, making debt restructuring more difficult and putting the IMF programme and long-term debt sustainability at risk.

While we may see temporary relief from one or more of these crises, the interconnected nature of these issues means that one crisis could easily trigger the others. The risk factors remain extremely high, underscoring how difficult and sensitive sovereign debt restructuring and recovery can be. There is always a risk of setbacks before we see real progress.

The path forward

Whoever takes office, the best-case scenario involves continuing with reforms aimed at growing the economy, with all political parties supporting these efforts with transparency and accountability.

Stakeholder management will be crucial, but there is no other way to avoid the complete package of five crises. Economic growth, fiscal discipline, and political unity are essential if Sri Lanka is to emerge from this difficult period.

The thin line between gaining power and triggering crises

By Dhananath Fernando

Originally appeared on the Morning

The game has begun. The familiar auctioning of non-existent resources during election season is in full swing. Candidates are making various promises without considering the repercussions they will face whether they win or lose.

Candidates are likely contemplating two things: first, promise now, gain power, then deal with the aftermath of those promises. Secondly, if they know they’re not going to win, they might promise the impossible, thinking they won’t have to deal with the consequences. Neither of these approaches is without significant risks and either can lead to disastrous consequences.

Elections and governing a country go beyond mere promises and their execution; it’s about managing people’s expectations with available resources.

After the economic crisis, all indicators suggest we are slowly recovering, thanks to stringent measures. Interest rates have soared to record highs to curb inflation. Urban poverty has tripled, rural poverty has doubled, and the already impoverished estate sector has seen a 1.5-fold increase in poverty.

Apart from our parliamentarians, all citizens have compromised their wealth and earnings. The public has reluctantly understood that tough sacrifices are necessary.

Impossible promises

The promises being made now are simply impossible to deliver. One such promise is a 25-50% salary increase for Government employees. Even the last Budget’s cost of living allowance increment is yet to be fully implemented. According to the 2023 Budget, Government salaries and wages total approximately Rs. 939 billion. Therefore, a 25-50% increase would require an additional Rs. 230-460 billion next year.

Our annual revenue from Advance Personal Income Tax (APIT) is at most Rs. 160 billion. This means that the proposed salary hike would require almost 1.5 to three times APIT. Is the private sector ready to shoulder an additional 150-300% in tax or revenue hikes for these Government salary increases?

Just in July, the Government rejected a proposed Rs. 20,000 salary hike for State workers, stating that it would need an additional Rs. 275 billion, which would require increasing the Value-Added Tax (VAT) by 4% to proceed.

Making matters worse, there are suggestions to amend VAT and many other tax rates by different candidates to align with their earlier pitches.

The danger of these promises is that whoever becomes the candidate who comes into power will need to fulfil all these promises, even those made by their competitors, which are unattainable.

The losing candidate, who will then be in the opposition, will always pressure the government to fulfil these unsustainable promises, raising public expectations for things that cannot be delivered. When expectations are unmet, it typically results in a political crisis, or if they try to fulfil what was promised and it is not economically viable, we will end up in an economic crisis.

That is why elections are not just about gaining power but also about managing people’s expectations.

Making promises responsibly

A salary hike for senior Government officials is necessary, but it is only feasible through a complete restructuring of the Government cadre and our military.

Currently, about 48% of our salary expenditure is for the defence sector, with about 32% going to the military. Restructuring the military is complicated and sensitive. A salary hike without restructuring will disincentivise staff who are expecting to leave, adding a massive burden on Government pensions and leading to a pension crisis.

With the new Central Bank of Sri Lanka (CBSL) Act, the Treasury cannot borrow money from the CBSL or print money. Therefore, if the Government borrows more from the market, interest rates will rise and the overall cost of capital will skyrocket.

The proposals to revise VAT are no different. VAT is a reasonable tax system because it only charges for the value added, unlike other indirect taxes like the Social Security Contribution Levy (SSCL), which has a cascading effect. VAT is easier to collect and it creates minimal distortions. Additionally, high-income earners contribute a higher amount of VAT as their consumption is greater.

The discussion about renegotiating the International Monetary Fund (IMF) agreement needs to be approached with caution. In every IMF review, it is clear that adjustments or shifts in timelines are made based on our performance.

However, trying to renegotiate the entire IMF agreement and its structural benchmarks could invite unnecessary complications. Not only Sri Lanka, but our bilateral partners including China, Japan, and India; multilaterals such as the Asian Development Bank (ADB) and Japan International Cooperation Agency (JICA); and our bondholders have all based their calculations on the existing IMF agreement.

It took over a year to negotiate our current terms. Another renegotiation would be time-consuming, and by the time we reach a settlement, the accumulated interest would be unbearable and market confidence would likely falter.

The damage our candidates are collectively doing is by making promises that cannot be delivered during this crucial time, and people’s expectations are a combination of all these. Whoever wins may have to deliver most of these pledges, which is not feasible. If the winner cannot deliver, a political crisis is certain, or if the winner tries to implement what was promised, another economic and social crisis is assured.

While people must vote carefully, candidates must make their promises responsibly; otherwise, they will start losing power from the very first day they receive it.

The State’s business is no business at all

By Dhananath Fernando

Originally appeared on the Morning

We can’t judge a book by its cover, but in the Sri Lankan Presidential Election, we can certainly gauge many people’s futures based on what is said about State-Owned Enterprise (SOE) reforms.

The simple truth is that we can only progress with SOE reforms. These reforms are rare and even mentioning them on a political stage requires courage. However, the fact remains that there is no future without SOE reforms.

Given the resistance by political leaders, this column is another attempt to reiterate why the State should not engage in business and how State involvement in business impacts all citizens.

Why should the State not do business?

The role of the State is not to do business but to ensure the rule of law. As the saying goes, “When you do something, you are not doing something else.” When the State engages in business, it neglects its primary duty – upholding the rule of law, which is its core mandate.

Another reason the State should not do business is that it has a unique way of participating in every business as a mandatory shareholder through the tax system. Every corporation is required to pay 30% of its profit to the State, which is essentially the Government’s share.

Additionally, businesses must pay an 18% tax based on their income. This means that the Government collects more than 50% of the profit value without doing anything. Since the Government is already collecting money from all businesses, there is no need for it to engage in business directly.

Why sell profit-making SOEs?

A common argument against privatisation is, ‘why sell profit-making SOEs?” The answer is that the State has no role in business, and even if these enterprises are making a profit, those profits must be evaluated against the value of the assets.

For instance, the Sri Lanka Cashew Corporation has an asset base of about Rs. 500 million, but its annual profit is only around Rs. 14 million. This translates to roughly Rs. 1 million per month. Does it make sense to run a business that generates just Rs. 1 million in profit after tying up resources worth Rs. 500 million?

If we had Rs. 500 million, even the safest investment, such as a fixed deposit at a 6% interest rate, would yield about Rs. 30 million per year, which is more than double the profit of the Cashew Corporation. Just because an enterprise is making a profit doesn’t justify the State continuing to run it if we can’t maximise the return on those assets.

What about the SOEs of Vietnam and South Korea?

Like Sri Lanka, both South Korea and Vietnam had significant SOEs in the 1960s due to limited private capital. As private capital slowly developed, both countries began reforming their SOEs. These reforms included privatisations and gradual government withdrawal through corporatisation.

In Vietnam, there were about 5,600 SOEs in 2001, which was reduced to 3,200 by 2010 through various reform packages under the Doi Moi reforms. By 2016, the number of SOEs had further decreased to 2,600, thanks to reforms including Public-Private Partnerships (PPPs) and corporatisation.

Vietcombank, which was a 100% State-owned bank, was listed on the Ho Chi Minh Stock Exchange as part of a pilot project in 1990. The State’s ownership was reduced by 75%, with 15% of the shares sold to Japan’s Mizuho Bank. Similarly, Petrolimex, a petroleum company in Vietnam, sold 9% of its shares to JX Nippon Oil & Energy on the Ho Chi Minh Stock Exchange.

In South Korea, Korea Telecom (KT) was fully privatised by listing it on the Korean Stock Exchange, New York Stock Exchange, and London Stock Exchange. The Korea Electric Power Corporation was also opened to private investors by listing on the Korean Stock Exchange in 1989 and the New York Stock Exchange in 1999. Other companies, like Pohang Iron and Steel Company, Korea Exchange Bank, and Korea Tobacco & Ginseng Corporation, also underwent reforms to allow private sector participation.

Vietnam attracted Nokia as a key investor for economic growth, while South Korea grew with Samsung and other electronics companies. If Sri Lanka wants to progress, we need to bring in world-class operators that can run these enterprises efficiently, rather than have the Government manage them.

Benefits of SOE reforms

SOE reforms offer a package of four solutions to our problems.

First, they boost Government revenue, as efficiently-run companies will generate higher profits, allowing the Government to increase its revenue.

Second, SOEs have significantly contributed to our sovereign debt, and reforming them can help reduce the national debt.

Third, Sri Lanka requires Foreign Direct Investment, and SOE reforms can serve as a channel to attract such investments.

Fourth, SOE reforms can help cut down Government expenditure, as these enterprises currently contribute to massive Government losses.

SOE reforms require political will because incorporating them into a manifesto is unlikely to attract votes; in fact, it may deter traditional voters. However, the moment of truth will come, and ultimately, we all have to face it – it’s just a matter of time.

Why public transport should be the real campaign promise

By Dhananath Fernando

Originally appeared on the Morning

All political parties want to make promises during the election to attract their voter base.

Some politicians in the Opposition provide material benefits such as roofing sheets, sarees, and mobile phones. Additionally, the ruling party often announces salary hikes for Government servants, special interest rates for retirees, fuel cost reductions, and fertiliser subsidies, expecting to provide relief for voters and secure their votes in return.

The biggest benefit voters can receive from politicians and their manifestos is the improvement of the public transport system. A solid mechanism to improve public transport is more beneficial compared to all other promises combined.

However, the way most politicians are opting to provide relief for the problem of commuting is by removing the vehicle import ban. Removing the ban is necessary because our vehicle stock has not been renewed for the last 4-5 years. However, vehicle imports will not solve the problem of public transportation. Not many politicians or parties understand that our economy and many of the other struggles related to the cost of living are connected to the problem of commuting.

Given the poor status of our public transport system, every middle-class family living in suburban areas within a 20-30 km radius of Colombo wants to travel in their own vehicle. To own a personal vehicle, a middle-income family pays about 150-200% in tariffs on imported vehicles. Simply put, this means that middle-class people pay twice the value of a car, often with a vehicle loan taken at about 12-14% interest.

The solution many middle-class families choose to solve their commuting problem comes at a significant cost to their living expenses and lifestyle. As a result, they end up spending two to three times the value of a vehicle at high-interest rates, cutting down on other potential expenditure, such as higher education or investing in a business.

When the middle class cuts down on spending, many other industries that could have benefited from middle-class expenditure are negatively impacted.

Moreover, as middle-class citizens purchase personal vehicles to solve their commuting problems, the roads become overcrowded. Our average speed during peak hours is dropping below 20 km/h. By spending a fortune on a car at a very high-interest rate, we spend valuable time on the road.

During peak hours, residents from the stretch of Moratuwa, Wattala, Pelawatta, Battaramulla, Maharagama, Kottawa, and Homagama take at least one hour to enter Colombo and another hour to return home. Spending two hours a day commuting means that if a person works for 22 days per month for 12 months, they spend about 22 full days (24-hour days) on the road. This translates to spending at least one month out of 12 on daily commuting. We are spending a month in the most expensive and uncomfortable way possible.

Politicians need to understand the need for a solid public transport system, which will not only provide relief for people but also improve our productivity manifold and boost economic growth and investments.

How can we fix it?

Many political parties make only broad statements, but none specify how to solve the problem. An often-tried solution is buying extra buses from India for the Sri Lanka Transport Board (SLTB) or purchasing new train engines or compartments from India. Despite trying this approach for over two decades, the situation remains the same.

Recent data reveals that after Covid-19, the number of bus routes has declined. One notable bus route that disappeared in Colombo was route number 155, which operated from Mount Lavinia to Mattakkuliya.

While the problem is complicated, the first step to solving it is to encourage people to commute to the city using public transport rather than personal vehicles. Therefore, we need to prioritise high-passenger capacity vehicles in traffic lanes. The priority lane system for buses was a step in the right direction, but the condition of the buses remains very poor. Bus owners are already complaining that high costs and a lack of labour are causing them to leave the industry.

The framework for the solution is to provide a public transport option that is less expensive than travelling by personal vehicle and allows for faster commuting with the same level of comfort as a personal vehicle. In terms of buses, the option is to allow more air-conditioned buses and permit them to charge a higher price.

However, the route permit system must be abolished or replaced with a new mechanism where supply and demand can be matched. With the current route permit system, even if there are many passengers on a particular route, no new buses can be introduced. With controlled pricing, service providers have no incentive to improve their services. Therefore, allowing players to enter with different price points is the first requirement.

Secondly, we can consider high-level options such as a Light Rail Transit (LRT) system, where we can tap into bilateral and multilateral funds.

In terms of trains, private investment must also be allowed. For instance, railway stations across the island are generally located at points where real estate values are the highest. With amendments to the Railways Authority Act, private investments can be tapped to generate alternative revenue models for these stations. Additionally, railway tracks, compartments, and operations can be unbundled, allowing different players to enter each segment rather than running it as a State-run, loss-making monopoly.

Solutions for public transport do not lie solely in Government investments. They lie in making regulatory changes that can unleash the potential of capital, allowing players to enter the market according to demand, and making regulatory changes that offer the public more choices.

Let’s hope that the manifestos of political parties will address the above issues in the upcoming Presidential and General Elections.

Economics 101: A lesson for presidential candidates

By Dhananath Fernando

Originally appeared on the Morning

The story of how Singapore wanted to emulate Sri Lanka and how Sri Lanka later aspired to be like Singapore is widely known. This narrative has been discussed at many forums and political rallies.

Less known, however, is that Dr. Goh Keng Swee, the architect of Singapore’s financial system, advised the Sri Lankan Government and the then President in the 1980s. He clearly outlined what needed to be done and what should be monitored in our economy. Unfortunately, we did not heed Dr. Goh’s advice. He was then the Deputy Prime Minister of Singapore.

What Dr. Goh recommended remains relevant for whoever is elected as the new president on 22 September. His focus was mainly on the financial architecture of the country because he knew that without stability in the financial system, other achievements would be impossible. As it is famously said, ‘Stability is not everything, but without stability, everything is nothing.’

Dr. Goh’s first advice to the President was to monitor the Central Bank of Sri Lanka’s (CBSL) Government securities holdings, which essentially means the money printed by the CBSL. He noted that should the Government continue to print more money beyond the rate of economic growth, it would be a sign of significant trouble and unsustainability.

Evaluating Sri Lanka’s data since 2020, this issue is evident. The Government’s total securities holdings, which were about Rs. 400 billion in June 2020, rose to about Rs. 1,500 billion in September 2021 and exploded to almost Rs. 3,000 billion by June 2022.

Dr. Goh explained that excessive money printing indicated three things: first, the government is spending more than it can afford. Second, it cannot afford to borrow and spend because borrowing from the market will raise interest rates. Thus, excessive printing means spending beyond our borrowing capacity at market interest rates. Third, it points to leakages in revenue.

Essentially, a government that prints too much money fails in all three areas. Therefore, the new president must avoid money printing at all costs. Although the new CBSL Act imposes limitations, the bank can still add excessive money when buying US Dollar reserves while collecting reserves for upcoming debt repayments.

The second metric Dr. Goh advised monitoring was the CBSL’s reserve levels; how the bank accumulates or depletes reserves signals financial stability.

The third indicator to monitor was the exchange rate, which should be observed alongside reserves and money printing. If reserves are depleting while the exchange rate remains stable, it means the currency is being defended at the expense of reserves. Conversely, if the exchange rate depreciates without reserve depletion, it might indicate influencing forex demand by printing more money.

Dr. Goh’s last two parameters were the consumer price index and the cost of construction materials. Printing too much money leads to inflation, raising consumer prices. If the cost of construction materials is high, it indicates slow development. Economic growth involves building and investing, mainly in the construction sector.

It is unfortunate that the Cabinet recently approved an increase in the cess on cement clinker, which will raise cement prices and open room for corruption. Higher cement prices slow down the economy. When construction costs rise, people cut back on other expenditures, shrinking the overall economic cycle and slowing the economy when growth is most needed.

Dr. Goh’s advice to then President J.R. Jayewardene remains valid for the new president, whoever that may be. The real victory lies not just in electing a president through a massive political campaign, but campaigning for an economic programme that can rescue us from the ongoing crisis.