Challenge of cost of construction

By Dhananath Fernando

Originally appeared on the Morning

Tourism is one of the key sectors driving Sri Lanka’s economic recovery. It has long been a pillar of the economy, yet few seem to fully grasp the basic economic logic required to elevate the industry to the next stage.

One critical component of the tourism value chain is lodging. The hospitality experience is largely built around where tourists stay – whether in a hotel, boutique property, or small guesthouse listed on platforms like Airbnb or Booking.com. 

Lodging often accounts for the largest share of total tourist expenditure and supports a wide range of ancillary services including restaurants, entertainment, and transport.

Lodging, however, is a capital-intensive industry. The investment is heavily front-loaded: before hosting the first guest, the property owner must invest significantly in construction, infrastructure, and setup. 

In Sri Lanka, the cost of construction is approximately 40% higher than in other countries in the region. This means that hoteliers need significantly more capital just to get started. To make matters worse, the cost of capital (i.e. borrowing costs) is relatively high and utilities like electricity are more expensive than in competing destinations.

These higher input costs drive up room rates, making Sri Lanka’s tourism product less competitive. Much of this is due to protectionist tariffs on essential construction materials such as cement, steel, tiles, bathroom fittings, and more. As a result, hoteliers pass these costs on to tourists.

Moreover, the hotel industry requires refurbishment every five years to maintain standards. The high cost of construction makes this cycle financially challenging and erodes competitiveness over time. Although Sri Lanka aims to attract high-spending tourists, price remains a key lever in travel decision-making and high costs significantly squeeze hotelier profit margins, especially for small and medium-sized establishments, which account for the majority of room inventory.

Labour and productivity challenges

Labour is another critical component of the hospitality equation. Typically, the industry recruits unskilled workers and trains them to deliver services. Wages are structured so that service charges make up a significant portion of employee income. 

However, if there is labour redundancy – more employees than needed – the service charge gets divided among more people, reducing individual earnings. This can lead to moonlighting and low productivity, as employees seek secondary sources of income.

Staff attrition is also common, with employees constantly on the lookout for better-paying opportunities. Productivity is measured through revenue per employee; fewer employees delivering the same service increases profitability and also boosts staff take-home pay via higher service charges.

A compelling case study is Cinnamon Red, presented by Hishan Singhawansa at the Advocata ‘Ignite Growth’ conference. He demonstrated how productivity improvements could increase revenue per employee. Cinnamon Red operates with an employee-to-room ratio of 0.75, compared to the industry average of 0.8-1.6, depending on hotel category (luxury vs. budget).

The hotel’s employee hours per occupied room are around five – roughly twice as productive as peers in the same category. As a result, revenue per employee is double that of competitors, and service charges are 1.6 times higher than other hotels and resorts. This shows that productivity gains translate into higher earnings for employees and better outcomes for businesses and consumers alike.

Cinnamon Red achieved this by removing unnecessary human intervention and embracing automation and self-service: self-check-in kiosks, vending machines, digital concierge services, and self-ordering systems. This transformation was part of a broader strategic repositioning, focused on multitasking and culture change.

The path forward for SL

If Sri Lanka is serious about transforming its tourism industry, reforms are essential. 

Key steps include:

  1. Reducing protectionist tariffs on construction materials to lower costs and improve competitiveness

  2. Improving labour productivity across the board, ensuring that skilled workers are retained and better rewarded

  3. Investing hotelier margins into delivering world-class experiences rather than simply covering high operating costs

There is also a need for a global tourism campaign, eased visa regulations, the removal of price floors for five-star hotels, and other policy changes, but none of this will matter unless we first understand the economic logic of tourism.

At the same time, we must recognise that tourism is highly vulnerable to external shocks. In recent years, Sri Lanka’s tourism sector has suffered due to:

  • The constitutional crisis in 2018

  • The Easter Sunday attacks in 2019

  • The Covid-19 pandemic (2020-2021)

  • The economic crisis in 2022

These events underscore the risk of over-reliance on a single sector. While tourism can be a powerful engine of growth, it should not be the sole driver of economic recovery. A balanced, diversified economy is essential for long-term resilience. 

Monthly employee earnings (LKR) vs. estimated living wage

(Source: Slides presented by Hishan Sinhawansa at the Advocata ‘Ignite Growth’ conference)

Tuk-tuk economy: Where algorithms meet asphalt

By Dhananath Fernando

Originally appeared on the Morning

In mainstream media, clashes between app-based ride-hailing taxis and traditional taxis are frequently reported, especially in tourist hotspots such as Kandy, Sigiriya, and even at the Bandaranaike International Airport. 

However, many Sri Lankans, including tuk-tuk drivers, do not fully understand the economic logic behind this. Often, the debate centres on high commissions taken by app companies or the notion that international ride-hailing platforms repatriate profits overseas.

At the ‘Ignite Growth Conference’ organised by the Advocata Institute, PickMe Founder Jiffry Zulfer shed light on the economic transformation driven by platforms like PickMe and its main competitor, Uber.

The core concept of ride-hailing apps is the ability to match demand and supply within a limited geographic radius in real-time. According to Zulfer, PickMe facilitates around 20 rides every second, striving to ensure that passengers always have a ride available and that drivers remain engaged and productive.

This matching of demand and supply has created significant market efficiency. On average, a driver using the app completes around 17 hires per day, compared to just 7-10 hires for a driver waiting at a tuk-tuk stand or roaming the streets. As a result, app-based drivers utilise their vehicles approximately 81% of the time, compared to just 39% for traditional drivers.

From an economic perspective, this availability of information – knowing who needs a ride and who can provide one – drives greater efficiency, not just for passengers and drivers, but for society at large as well. According to Zulfer, PickMe has covered over one billion passenger kilometres and now transports more people daily than Sri Lanka’s railway system.

Early investors in PickMe saw returns of up to 300 times their original investment, and it is likely the Government benefited as well, collecting around 30% in taxes. App-based drivers now earn on average 40% more than traditional taxi drivers, transforming the lives of 30-50% of tuk-tuk drivers in a population of 1.2 million tuk-tuk owners in Sri Lanka. 

In essence, the biggest beneficiaries of this shift have been ordinary working-class drivers, passengers, investors, and the Government.

PickMe is now listed on the Colombo Stock Exchange, opening the door for broader public investment and shared benefits.

It is crucial to recognise that when demand and supply are allowed to interact freely, it creates a win-win outcome for all stakeholders, unlike Government-run businesses, which often favour one group at the expense of others.

Zulfer also categorised tuk-tuk drivers into three groups based on their engagement: a large segment contributes less than three hours per day, a second tier less than six hours, and only a minority works full-time (over eight hours) through the platform. Interestingly, more women are now joining the platform, unlocking new income opportunities and increasing female participation in the workforce.

The PickMe Founder further explained that when adjusting for inflation, ride prices had decreased, providing passengers with real financial benefits beyond mere convenience. At the time of launch, the app’s per-kilometre rate was Rs. 33, compared to the Rs. 40 charged by traditional meter taxis. This holds true across other ride-hailing platforms as well. 

Unfortunately, many policymakers still struggle to grasp the fundamental economic principles at play – how market forces, when allowed to operate freely, can uplift the average citizen.

Ride-hailing services have since expanded into motorbike transport, courier services, and food delivery. These platforms are now among the largest ‘restaurant’ operators in the country, despite not owning a single restaurant. 

The same model has given rise to the ‘dark kitchen’ phenomenon, enabling home-cooked meals and micro-businesses to reach a wide customer base. This has changed food habits, offered consumers more choice, and encouraged families to spend more time together with the convenience of food delivery.

Zulfer’s economic logic applies beyond transportation. It holds true for other network-based platforms like Booking.com, Airbnb, and others. The average person, especially those with entrepreneurial spirit, stands to benefit the most.

In Sri Lanka, the majority of room inventory is offered by micro and small-scale lodge owners. Online platforms have empowered them to tap into the tourism ecosystem and earn foreign income, something that was previously out of reach.

Understanding the economic logic of network-based industries is crucial for Sri Lanka’s growth. These platforms enhance productivity, generate opportunities, and create wealth. While foreign direct investment and trade policy are important, we must also pay attention to the power of networking demand and supply.

Imagine a world where the same happens to our entire public transport system. Things will not be perfect, but they definitely would be in a much better form than it is at the moment.  

By simply enabling the right environment – often by not interfering – governments can allow these industries to flourish, driving economic efficiency, opportunity, and prosperity for all.

Meeting pricing equilibrium during the fuel crisis

(Source: Slide presented by PickMe Founder Jiffry Zulfer at the ‘Ignite Growth Conference’)

From Sri Lanka to Singapore

By Dhananath Fernando

Originally appeared on the Morning

A 100-year journey or a 40-year leap?

For many Sri Lankans, one of the most common points of comparison is Singapore. We have heard time and again how Singapore once lagged behind Sri Lanka in terms of GDP per capita but eventually surpassed not only Sri Lanka but also many other developing nations worldwide. 

Given that both countries are in Asia and that Singapore once looked to Sri Lanka as an aspirational model, it is natural for Sri Lankans to frequently draw comparisons between the two.

Recently, at the Advocata Institute’s ‘Ignite Growth Conference,’ Central Bank of Sri Lanka Assistant Governor Dr. Chandranath Amarasekara presented a slide illustrating how long it would actually take for Sri Lanka to reach Singapore’s current GDP per capita under different growth scenarios.

Dr. Amarasekara projected the timeframe based on Sri Lanka’s GDP per capita growth at 3%, 5%, 6%, and 8% annually. For context, GDP per capita is a commonly used measure to gauge a country’s economic prosperity. Currently, Sri Lanka’s GDP per capita stands at approximately $ 3,800, while Singapore’s is around $ 84,000.

The calculation estimates the number of years it would take for Sri Lanka’s GDP per capita to grow from $ 3,800 to $ 84,000, assuming compound annual growth at different rates:

  • 3% growth rate: 105 years

  • 5% growth rate: 64 years

  • 6% growth rate: 54 years

  • 8% growth rate: 41 years

The challenge of comparing Singapore and SL

In my view, comparing Singapore and Sri Lanka directly is difficult because the two nations offer entirely different value propositions. Singapore is essentially a city state with a population of six million, whereas Sri Lanka is over 3.5 times larger in terms of population. 

The demographics, political landscapes, and economic structures are vastly different. However, from an economic perspective, an average Singaporean is 21 times wealthier than an average Sri Lankan.

To put it in simple terms:

  • Singapore, with just six million people, generates an economic output of $ 500 billion

  • Sri Lanka, with 21 million people, produces less than $ 90 billion

Learning from Singapore without copying 

While it may not be meaningful to copy Singapore’s model outright due to fundamental differences in culture and circumstances, there are key economic principles Sri Lanka can adopt.

A rock-solid monetary framework

One of Singapore’s greatest strengths is its monetary stability. The country’s financial system remains robust thanks to sound economic policies developed under visionary leaders like Goh Keng Swee.

A stable currency is crucial because wealth is stored in the form of money. For example, if a farmer produces 100 kg of rice and sells it for Rs. 20,000, depositing that money in a bank means converting his labour into a universally accepted currency. If inflation erodes the value of that currency over time, it discourages productivity. A monetary system that fails to preserve value will ultimately undermine economic progress.

Many admire Singapore’s modern infrastructure, but what they often overlook is the country’s strong monetary foundation. Interestingly, the same Dr. Goh who helped shape Singapore’s economy also advised Sri Lanka, but his recommendations were never fully implemented.

The right policy framework

While reaching Singapore’s current economic level may seem like a monumental task, the key lies in laying the right policy framework. If the right economic policies are put in place, progress will follow naturally. It is not about chasing Singapore’s end results but rather about focusing on the right processes to achieve sustainable growth.

Instead of fixating on when Sri Lanka will become like Singapore, we should prioritise fundamental economic reforms in areas like trade, investment, and labour policies. If we get these right, the rest will take care of itself.

(Source: ‘Ignite Growth Conference’ presentation by Dr. Chandranath Amarasekara)

Bracing for Trump’s tariff storm

By Dhananath Fernando

Originally appeared on the Morning

US President Donald Trump’s second term seems to be keeping all people around the world on their toes. The changes and policies, along with their implications, will be complicated, and we have to do our homework to gain an advantage or at least survive in this game.

The new Trump administration has suggested reciprocal tariffs, meaning the same tariff rates applied to each country that they charge for US products. 

Already, a 10% tariff is in effect for non-energy products from Canada and a 25% tariff on energy-related products from Canada. Additionally, a 25% tariff has been imposed on Mexican products, alongside an additional 10% tariff on Chinese products, bringing the total tariff on Chinese products to 21% (from around 11% previously).

SL’s opportunities and challenges

Before Sri Lanka gets affected by any reciprocal tariff, we first need to understand our total exports, including services. 

According to Harvard’s Atlas of Economic Complexity, we export about 21% to the United States. When it comes to apparel, about 40% of our apparel exports are destined for the US. 

Accordingly, the first line of impact for Sri Lanka would be potential consumption contraction in the US. With high tariffs even against Canada, China, and Mexico, as well as increased prices of essential products, the US consumer will likely reduce spending on non-essential items such as seasonal clothing. It is normal consumer behaviour to postpone purchasing decisions if expenditure on essentials like energy and rent increases.

The second line of impact has both positives and negatives. China and Mexico also supply apparel to the US. If relative prices of Sri Lankan apparel become lower following the 25% tariff for Mexico, we might gain an advantage. 

Similarly, we could become more competitive than China, which now faces an overall 21% tariff. Therefore, we must be cautious and prepared, recognising it is not just tariffs on Sri Lanka directly but also tariffs on others that can bring us opportunities or challenges.

The danger lies in the final stage if the US imposes reciprocal tariffs. The US would consider imposing the same tariffs for Harmonised System (HS) codes as the other trading country imposes on US products. 

There is discussion that the US might not only consider customs duties but also other tariff barriers and even non-tariff barriers. In that case, Port and Aviation Levy (PAL), Commodity Export Subsidy Scheme (CESS), Social Security Contribution Levy (SSCL), and Value-Added Tax (VAT) might be considered, according to some reports. 

This decision depends entirely on the Office of the US Trade Representative (USTR) defining ‘unfair trade practices.’ Media reports indicate that the USTR is expected to analyse all data and make a decision on reciprocal tariffs by 1 April.

We must recognise that Sri Lanka’s average tariff rates are significantly higher than those proposed by the US to China, Mexico, and Canada. A 25% tariff in Sri Lanka is considered low, as our effective tariff rates reach nearly 100%, and for vehicles with excise duties, it exceeds 200%. It is joked that even Trump would become confused if he learnt about Sri Lanka’s tariff structures and that he might learn a tough lesson from us.

In the context of reciprocal tariffs, price-sensitive product categories such as food, apparel, and rubber products may face higher prices in US markets. Ultimately, the real impact will depend on how other competing export markets are affected by US tariffs and non-tariff barriers and how these affect US consumption and global economic growth under new trade dynamics.

Meanwhile, Europe and other powerful countries are targeting the US with reciprocal tariffs, which could trigger global supply chains to consider relocation and create new incentive structures. This can present either an opportunity or a disaster for Sri Lanka.

Solutions

To attract new supply chains and assembly components, we must quickly work on basic factor market reforms. Having adequate land ready for industry and a flexible labour force with business consciousness is essential. Secondly, simplifying and lowering our tariff structure is critical, even though it might be somewhat late. 

Additionally, exploring exports towards East Asia and the Indian market is increasingly vital. Whether our US market shrinks or not, we should prepare to explore other markets, primarily India and East Asian countries. Strengthening foreign relationships, activating business chambers, and intensifying diplomatic missions to strengthen ties is necessary. 

Accelerating regional free trade agreements and conducting market sentiment research can help Sri Lankan entrepreneurs expand their exports. Fundamentally, economics never expires – even during trade wars or crises, strong economic fundamentals provide the best way to survive and thrive. We must move from hope to action.

Where did Sri Lanka export all products to in 2022?

Source: Harvard Atlas of Economic Complexity

Where did Sri Lanka export textiles to in 2022?

Source: Harvard Atlas of Economic Complexity

NPP’s maiden Budget

By Dhananath Fernando

Originally appeared on the Morning

The National People’s Power’s (NPP) maiden Budget will be presented to Parliament tomorrow (17). Ideally, a budget should not contain surprises – neither on the income front nor on the expenditure front. Government expenditure is the real tax burden on people; they ultimately bear the cost through taxes, inflation, or both.

Generally, a budget consists of two key components. The first is revenue and expenditure, while the second is the policy direction of the Government. This time, the business community is particularly focused on the latter, as it is evident that income and expenditure must align with the International Monetary Fund (IMF) programme.

Adhering to IMF targets 

The 2025 Budget has no alternative but to adhere to the parameters set by the IMF. While micro-level details and specific projects may change, key indicators such as gross financing needs, Government revenue-to-GDP ratio, primary balance, and debt-to-GDP ratio must be maintained as agreed under the IMF programme.

Additionally, the previous Government introduced new legislation under the economic transformation framework, covering many of the IMF’s targets. Achieving a Government revenue target of 15.1% of GDP will be a major challenge. Value-Added Tax (VAT), corporate tax, and income tax have already reached their upper limits, leaving limited scope for further increases. The Government is likely to bridge part of the revenue gap through vehicle importation.

When governments face revenue shortfalls, ad hoc taxes or sudden tax increases are common, often targeting sin industries such as tobacco and alcohol. However, the Budget must adhere to sound tax principles, ensuring simplicity, transparency, neutrality, and stability. 

The focus should be on simplifying the tax system and improving the efficiency of tax administration, as poor administration is as harmful as a bad tax system. Any unexpected changes in revenue policies could harm businesses, erode investor confidence, and slow down the economy. The best way to achieve the 15.1% revenue target is through efficiency measures and broadening the tax base.

Over 50% of recurrent expenditure towards interest payments

Sri Lanka has little control over its expenditure, with over 50% of spending allocated to interest payments. In 2023, approximately 90% of tax revenue was spent on interest payments. 

Currently, Sri Lanka has one of the highest interest payment-to-revenue ratios in the world, raising concerns about the possibility of a second debt restructuring. Post-debt restructuring, the Government has minimal room for fiscal adjustments.

While Government employees and various sectors may expect relief packages, the reality is that there is no fiscal space to accommodate such demands. It is true that salary structures for senior Government positions need improvement to attract the right talent, but this can only be achieved by restructuring the lower levels of the public service, which absorb the bulk of the salary bill.

Another solution is to drive economic growth and increase labour force participation, reducing the proportion of Government employees relative to the total workforce. Blanket salary increments are difficult to implement without compromising capital expenditure, which is crucial for long-term development. 

Currently, 20% of recurrent expenditure is allocated to salaries and wages, while pensions account for approximately 8%. Given this context, expecting significant relief packages is unrealistic, and any attempt to provide them could lead to long-term economic instability.

Investment should prioritise healthcare, education, social protection

Government spending should prioritise critical sectors such as healthcare, education, and talent development. However, expenditure in these areas – including the ‘Aswesuma’ social safety net – was lower than expected last year. 

The IMF has pointed out that Sri Lanka did not fully allocate the funds intended for ‘Aswesuma,’ which serves as the primary social safety net for the country. Ensuring proper allocation to these essential sectors is crucial.

Focus should be on structural reforms

Rather than solely focusing on balancing income and expenditure, the Government should use the Budget as an opportunity to set a clear policy direction. 

Key areas requiring structural reforms include land policies, labour laws, the export sector, and energy markets. These reforms are fundamental to Sri Lanka’s economic growth, as the country’s challenges are largely structural rather than issue-specific.

We will have to wait until tomorrow to see the extent to which the Government seizes this opportunity. Instead of expecting widespread relief measures, the public should push for meaningful policy reforms – an essential step for securing Sri Lanka’s future

(Sources: CBSL, Advocata Research)

(Sources: CBSL, MOF Annual Report, Advocata Research)

The power of know-how over industry selection

By Dhananath Fernando

Originally appeared on the Morning

In most of our export strategies, the starting point has been the Government deciding which industries should drive exports – some of these decisions are data-driven. 

Accordingly, we examine current export figures and sometimes focus on expanding existing product segments. Secondly, we target additional industries with the expectation that exports can be boosted. While both approaches seem logical at first glance, we need to understand the broader framework of how to grow exports effectively.

Most of the time, we perceive exports as industry-specific, but in reality, exports are about know-how. Know-how becomes a product, and know-how makes a product competitive. However, know-how is not just knowledge – it is sometimes tangible, existing in tools, but more often, it is intangible. 

It is akin to Lasith Malinga’s bowling action and his ability to deliver pinpoint yorkers. We can analyse Malinga’s technique, attempt to replicate his action, and even learn from his strategies through interviews or YouTube videos. Yet, even with all this information, it is extremely difficult to replicate his unique skill set. 

Malinga possesses tangible components such as his slinging action, run-up, and release style, which can be considered tools. He also has knowledge that he shares through various platforms. However, his true know-how – what makes him exceptional – remains elusive, even to himself. 

This difficulty in transferring know-how is likely why the Mumbai Indians recruited Malinga both as a player and later as a coach in the Indian Premier League. If we consider Malinga as a product, he is export-competitive and his value lies in a combination of factors, primarily his unique know-how.

When a country seeks to expand exports, the know-how ecosystem is what determines success or failure. Our apparel manufacturers, for example, possess specialised knowledge that enables them to produce garments at the lowest cost while maintaining high quality. 

Initially, their products were relatively simple, but over time, they evolved in complexity. The industry experimented with various approaches – ethical garment production, lean manufacturing, and women’s empowerment – learning from both successes and failures to refine a sustainable model.

Today, Sri Lanka’s apparel exports are not merely about physical products but also the know-how that allows us to compete globally. Know-how thrives within an ecosystem that supports industries. 

For this to develop, the Government must provide entrepreneurs and businesses with the freedom to access and test resources – what economists refer to as factor markets. Land, labour, and capital must be available with minimal restrictions on a level playing field. 

This is why licensing requirements can be detrimental to exports; they obstruct access to essential resources, thereby stalling know-how development. For instance, if land acquisition is difficult, apparel firms may struggle to operate or innovate. Similarly, excessive labour regulations can increase operational costs, making products uncompetitive and disrupting the know-how ecosystem. Such obstacles discourage exports.

Another common discussion on boosting exports revolves around diversifying the export basket. To understand how diversification occurs, we can refer to Harvard’s Center for International Development, where Prof. Ricardo Hausmann uses the analogy of monkeys and trees in a forest.

In a forest, monkeys do not leap from one end to the other; they move from branch to branch. Similarly, export diversification does not occur in giant leaps but through adjacent product categories. Existing exporters and individuals within the know-how ecosystem expand into related fields. 

For instance, if we excel in gemstone exports, an adjacent category would be jewellery. This is why Government intervention in selecting export industries with large targets is often ineffective – diversification and expansion naturally occur within adjacent categories.

In making more complex products for export, Prof. Hausmann employs an economic theory likening diversification to a Scrabble board. If we have only three letters, our word combinations are limited. However, with four letters, the number of possible words increases exponentially. 

Therefore, minimising restrictions on factor markets – such as land and labour – enables more access to ‘letters,’ allowing for greater diversification.

Additionally, some ‘letters’ contribute significantly to forming words, like the letter ‘A,’ which is more versatile than a letter like ‘Z’. Similarly, removing barriers to factor markets increases the potential for new export combinations.

In Sri Lanka, our export strategy has traditionally relied on the Government selecting industries for growth. While this approach may work to some extent, if we seek rapid export expansion – like Vietnam – we must focus on the framework rather than forcefully pushing selected industries.

In today’s global economy, no country manufactures all its products on its own. Most nations produce parts, components, and assemblies, relying on international trade to complete final products. If we fail to open our economy to trade, our export ambitions will remain unfulfilled. Trade enhances competitiveness and provides access to multiple ‘letters’ at optimal costs.

Foreign Direct Investments (FDIs) are another crucial element in this equation. FDIs bring in individuals with specialised know-how, much like acquiring a player of Malinga’s calibre. They also introduce advanced technology, enabling the creation of more ‘letters’ and exponentially increasing the potential for new products over time.

If Sri Lanka is serious about exports, we need to focus on the process and the journey. We hope that the upcoming Budget will establish key milestones to guide us in the right direction.

Rice Under Siege: Story Of How Price Controls And Tariffs Broke Sri Lanka’s Staple Supply Chain

By Ranul Seneviratne Trainee Research Analyst - Advocata Institute.

A LESSON FROM HISTORY AND THEIR RIPPLE EFFECTS ON SRI LANKA'S RICE SUPPLIERS

Sri Lanka’s rice market is crumbling under the weight of contradictory government policies. Price controls and import tariffs have created an artificial scarcity of rice, pushing millions into hunger and malnutrition. Instead of addressing the core issues, policymakers keep repeating the same mistakes done in the past. At this point one has to question its intended purpose and effectiveness, is this the best way to ensure the welfare of the people? History, not economics, offers insight. First noted centuries ago, during Emperor Diocletian (A.D. 284 - A.D. 305) of Rome, whose attempt to cap prices of several goods, including that of wheat, by imposing the death penalty led to fleeing traders, vanishing supplies, and widespread starvation. This scheme of price controls created so much chaos that the Romans didn’t try it again for the next 1,600 years. Despite their goal of lowering costs for consumers, price controls often cause unintended consequences. At least the Romans learned from their mistakes. Sri Lankans however now face the consequences of rice shortages caused by the most recent imposition of price controls which took place on the 7th of December, 2024, this being a brain child of the Consumer Affairs Authority (CAA) a state agency responsible for the task. These shortages are worsened by the natural dip in production during the drier Yala season (May–September) and increased demand during the December tourism peak. Despite this, the government has set price caps for rice:

  • Nadu rice: Rs. 225 (wholesale), Rs. 230 (retail)

  • Imported Nadu: Rs 210 (wholesale), Rs 220 (retail)

  • Samba rice: Rs. 235 (wholesale), Rs. 240 (retail)

  • Keeri Samba: Rs. 255 (wholesale), Rs. 260 (retail)

Simultaneously, a Rs. 65/kg import tariff has made imported rice 50% more expensive, worsening malnutrition and contradicting the goal of lowering prices through price caps. This tariff is still in place at present. Sri Lanka first imposed this Special Commodity Levy (SCL) of Rs. 65/kg all the way back in October of 2021. However, at present there is a debate within the government on whether to remove this. This mix of policies defies economic logic and creates harmful market distortions.

RICE MILLERS, WHOLESALERS, AND RETAILERS

Prices guide resource allocation and reflect scarcity, but price controls disrupt this mechanism, leading to misallocation and shortages. Sri Lanka’s rice millers faced losses under these caps when forced to sell below cost. For instance, back in mid December producing 1kg of Nadu rice costs Rs. 235, while the wholesale cap is Rs. 225, resulting in a loss of Rs. 10 per kg. This had compelled millers to halt production, worsening shortages. Wholesalers and retailers face similar challenges. Even at present as we speak “Red Raw Rice” is still in shortage as the CAA slapped a price cap at Rs 220 and created black markets where it was sold at around Rs 310 as recently as the 3rd week of last month. Sri Lanka's deputy minister of agriculture just a few days back said that -“Sri Lanka has red rice stocks but they are only sold after 5.00 pm when the Consumer Affairs Authority officials go home after their days work”  

According to Araliya Rice Sri Lanka's largest rice grain miller the cost breakdown of producing 1 kg of White Nadu Rice was as follows back in December of last year. This will help us understand why there was a shortage in most types of rice as sellers could not cover their costs at the price cap set by the government. However one must remember that these costs have slightly come down as Sri Lanka has experienced deflation in the last few months.

Cost Breakdown for 1kg of White Nadu Rice:

  • Paddy purchase (farm gate price): Rs. 122

  • Storage: Rs. 38

  • Conversion: Rs. 37

  • Other costs: Rs. 38
    Total: Rs. 235

Back in December large-scale millers were paying above the government’s current minimum guaranteed price for paddy. Which is set at Rs 120 for Nadu, however most paddy farmers are saying that the cost to produce 1 kg of rice is around Rs 117 making the Rs 120 purchase price not sufficient to meet their costs. However, fast forward to January, most farmers in areas like Anuradhapura and Polonnaruwa complain that the price they receive is between Rs 95 - 100. Farmers say this is the price seen just prior to the government announcing the minimum price of Rs 120. This drop in farm gate prices could probably be due to collusive practices large scale millers engage just before paddy is harvested in the Maha season. 

Meanwhile, a Rs. 65/kg import tax pushes imported rice prices far above global levels. For example, imported Nadu rice retails at the price range of Rs. 220 - 225 (with a Rs. 215 landing cost), compared to Rs. 140-150 without the tax, the price at which it retails in India for example. Retaining this tax during shortages exacerbates malnutrition as it makes rice increasingly unaffordable. The following table shows the difference in prices between different rice varieties and also shows the difference in prices of  imported or locally produced varieties as of the 3rd week of January 2025 taken from the Department of Census and statistics.  

As you can see even with a Rs 65/kg import tariff imported rice varieties are quite significantly cheaper, hence retaining taxes and exacerbating malnutrition among children is a cardinal sin being committed by the government. 

IS IT THE "GREED" OF RICE MILLERS THAT IS CAUSING ALL THIS?

Sri Lanka's rice milling market operates as an oligopoly, with a few large players like Araliya and New Rathna controlling around 35% of the market however there are reports that this has increased to around 60% today, alongside many small-scale millers concentrated in Marandagahamula. Historically, large millers have exploited their dominance through anti-competitive practices; using their storage capacity and purchasing power, they manipulate prices by flooding the market during harvests to lower paddy prices and then create artificial scarcities to keep rice prices high.

Farmers, constrained by limited storage and credit, are forced to sell during harvests, enabling this cycle. Cartels and exclusive agreements further restrict competition. However, the current level of prices are a result of multiple factors, including protectionist import tariffs, a dry Yala season, flooding-induced supply disruptions, and price control uncertainties. These uncertainties encourage millers to sell rice at higher prices now, fearing future losses.

By late 2024, rice stocks began depleting, and millers limited daily releases to stretch supplies until the Maha harvest. Small-scale millers, lacking proper climate-controlled storage, often run out of stock, leaving larger millers with market dominance and full control over supply. Despite public concerns, the Consumer Affairs Authority (CAA) back in December said that millers aren’t really hoarding excessively and that they are maintaining the bare minimum required to keep mills running  until the next harvest season(present Maha Season). 

Protectionist policies, including a Rs. 65 per kilo import levy prevented imports from filling supply gaps. Basic economics suggests rising prices should increase supply, but restrictive policies enable large millers to curtail supply further, benefiting at the consumer's expense. Allowing low-tariff imports could help stabilize the market, ensure sufficient supply, and protect consumers from inflated prices.

ARE LARGE SCALE MILLER’S HOARDERS? 

Large-scale rice millers in Sri Lanka are often criticized for hoarding, while this may arise in certain instances this is not the case at present and it is wrong to generalize it as a recurrent phenomenon. At present too, even the CAA has acknowledged the fact that the current shortages are not due to millers hoarding. Furthermore, large scale millers also bring significant benefits to consumers. These millers have improved rice quality using advanced technologies. They have built huge processing plants to convert the paddy into rice, built huge temperature-controlled silos to preserve its moisture content and keep it fresh, there is also a huge cost for all of this. Thanks to these innovations and investments we are able to consume uniform, impurity-free grains with minimal breakage, meeting our demands for high-quality, safe, and consistent rice.

Despite their contributions, large-scale millers face challenges, including rising input costs and inflation. The price of a 5 kg rice bag increased significantly from Rs. 20 in 2019 to Rs. 50 in 2024. Millers also deal with cash flow pressures as they must pay farmers upfront while selling on credit, a unique practice in the industry.

If rice millers are engaging in anti-competitive behavior, it is the result of policy mishaps like protectionist tariffs and import controls which have enabled such rent-seeking behavior, distorting the market and fostering a "rice millers mafia." Removing protectionist tariffs and allowing imports would force competitive pricing, enhancing both quality and quantity. 

 IMPACT ON CONSUMERS

Price controls and tariffs harm consumers by creating shortages that leave many unable to purchase rice, leading to hunger and reduced access to essential goods. Price controls prevent the market from adjusting to natural supply reductions, while import tariffs compound the problem by making alternatives unaffordable. Consumers unable to afford rice cannot switch to substitutes like wheat if those are also taxed, worsening food insecurity. Additionally, importers struggle to provide quality rice due to high tariffs and price controls, leading to low-quality imports. In Sri Lanka, the Rs 65/kg tariff makes rice significantly more expensive, with taxes accounting for 50% of the cost. Removing this tax could improve rice affordability and quality while allowing market forces to stabilize supply and prices naturally, ensuring better outcomes for consumers and farmers alike.

DOES SRI LANKA NEED TO BECOME SELF-SUFFICIENT IN RICE TO ENSURE FOOD SECURITY.

Self-sufficiency or Autarky is a very narrow-minded view point only fitting for a utopian world. Self-sufficiency does not guarantee food security nor will it end malnutrition among the population. Rather a country's goal has to be in pursuing to become export competitive in rice or for that matter anything else. To achieve this, it must be able to produce high quality varieties of rice at far higher yields than seen presently in Sri Lanka. It must also produce it at the lowest possible opportunity cost of production, if unable to, then “Trade economics” tells us that you are far better off importing it from another country. Countries like Vietnam and Thailand are export competitive in rice, self -sufficiency is not their goal. But in-order to achieve this all forms of protectionist policies like import tariffs have to be dismantled. Firstly, because it would be impossible to produce high quality rice without being able to import high quality fertilizer or advanced machinery needed for growing and harvesting paddy. Secondly, by protecting inefficient farmers export competitiveness can never be achieved as foreign competition is needed to learn and grow better quality rice. To give a comparison of how efficient farmers are in countries like Thailand, the “Farmgate” price for rough rice is around 60 to 70 percent cheaper than in Sri Lanka. For example, farmgate prices of paddy with 15 percent moisture (dried paddy) was 8,900 to 10,200 baht per ton, which works out to around 75 to 86 rupees a kilogram, In Vietnam the farmgate prices are around 8,000 dong or about Rs. 94 per kilogram.  While in Sri Lanka it is at Rs 120 (Gov. announced price) making it probably the highest farmgate price for rice in Asia and perhaps even the world, showing the scale of export competitiveness achieved in countries like Thailand and Vietnam.  

On the other hand a major reason for farmers being so poor and the industry being so inefficient in Sri Lanka is due to the fact that we have too many farmers growing rice thanks to decades of protectionist policies. According to data from the Department of Agrarian Development, Sri Lanka has over 1 million paddy farmers which is around 12% of the total labour force. Whilst a staggering 25% of our labour force is engaged in agriculture, generating only around $ 2.6 billion in export revenue, countries like the Netherlands exported around  $ 132 billion in 2024 with just 185 000 farmers engaged in agriculture, which was just 1.91% of Netherlands total labour force. Hence the problem very clearly is an over supply of labour in the industry, which is keeping millions trapped in eternal poverty and hence in order to reduce this number the country must liberalize the sector and allow inefficient farmers to switch to more productive sectors of the economy. A second reason for the high levels of poverty seen among farmers is due to the fact that farmers in Sri Lanka don’t own the land they grow the crop on, rather it is either owned by the state or most are tenant farmers that pay a rent to farm on those lands. As a result farmers are unable to obtain credit as they have no collateral to show to banks. Furthermore average farm sizes of around 1 hectare are too small in Sri Lanka and as a result it provides very little incentive for farmers to invest in high end technologies to improve farm productivity as they are unable to recover the cost. Comparatively on average a farmer in the Netherlands holds and owns around 41 hectares of land if one equates the output to a traditional farm since the Netherlands has vertical farm technology.  

CONCLUSION

Price controls, aimed at easing consumer burdens, often result in shortages, black markets, and harm  farmers and producers. Coupled with import tariffs, these contradictory policies deepened the crisis. The crisis seen in Sri Lanka's rice markets is an example of such government overreach and shows the negative effects of price controls and import tariffs that seem to be a recurrent phenomenon. 

To solve this crisis markets and prices must be allowed to function naturally. The following simple steps must be followed to come out of this man-made crisis. 

  1. Remove price controls

  2. Remove import tariffs and licensing and allow rice to

Overcoming structural barriers to achieve export growth

By Dhananath Fernando

Originally appeared on the Morning

Sri Lanka has been trying to solve its export puzzle for a long time, with a new export target set at $ 36 billion by 2030. 

As of November 2024, the country had approximately $ 11.6 billion in merchandise exports and $ 3.1 billion in services exports, totalling around $ 16 billion. Over the next five years, exports are expected to double, requiring an annual compounded growth rate of approximately 14%.

Many policymakers define Sri Lanka’s export challenge as a lack of diversity in the export basket, limited access to international markets, or insufficient value addition. While these factors are valid, the core issue is that Sri Lanka is not competitive. 

This lack of competitiveness is not due to an inherent incapability but rather the result of policies and structural inefficiencies that have rendered the country uncompetitive. Often, this fundamental issue is misdiagnosed as a lack of targeting, leading to constant shifts in focus towards different sectors or products every three years without addressing the root causes of uncompetitiveness.

Addressing competitiveness 

Addressing public policy challenges is inherently complex, as solutions impact various stakeholders, making change management difficult. 

One of the primary mistakes governments and policymakers make is attempting to target specific sectors for export growth. Instead, focus should be placed on sectors where Sri Lanka has a competitive advantage. 

The only way to determine competitiveness is through practical application – by actively engaging in export activities rather than relying solely on theoretical projections. In the modern economy, competitive advantage extends beyond specific products to elements such as design, lead times, and supply chain efficiencies – factors that may not be immediately evident to a single decision-maker.

The global trade landscape is shifting from finished products to parts and components within value chains. However, when the Government plans around traditional industry categories, it often overlooks this evolving reality. 

For any product or component to be manufactured competitively, key resources – land, labour, capital, and entrepreneurship – must be accessible and efficient. Sri Lanka’s export underperformance, poor diversification, and lack of market access stem largely from bottlenecks in these factor markets. 

When essential factors of production do not function effectively, innovation stagnates, restricting export diversification and the development of components for various products, including value-added goods. 

If businesses can achieve higher margins through value addition, they would naturally do so. If they choose to export raw materials instead, it suggests the presence of barriers, misaligned incentives, or a competitive disadvantage in value-added production.

To illustrate this, consider the hypothetical case of exporting iron ore. A country rich in iron ore but burdened with high energy costs will find exporting raw ore more advantageous than converting it into steel. Conversely, a country with lower energy costs, proximity to industrial zones, and high steel demand will have a competitive advantage in steel production. 

This principle applies across all industries – cost structures, infrastructure, and resource availability dictate competitiveness.

A complex problem   

Compounding the problem is the interconnected nature of these issues. Solving one aspect alone will not fix the broader export challenge. 

In Sri Lanka’s case, high energy costs place any export industry at a price disadvantage. Subsidising energy is often proposed as a solution, but ultimately, taxpayers bear the cost. 

Similarly, labour costs remain high due to regulatory barriers. For instance, if a major tech company wanted to relocate its regional office to Sri Lanka, the country lacks an adequate pool of IT graduates. Addressing this would require either allowing foreign professionals to work in Sri Lanka or significantly upskilling the local workforce.

Export development also requires capital and entrepreneurship. Capital can be acquired through debt or equity, but debt financing is currently not a viable option for Sri Lanka. Equity investment remains possible, but attracting such investment necessitates improving Sri Lanka’s investment climate. This highlights the urgent need for reforms within the Board of Investment (BOI). 

Additionally, facilitating foreign entrepreneurs’ ability to enter Sri Lanka – through streamlined visa processes and work permits – is essential. The Department of Immigration and Emigration must play a role in this.

For capital to flow, investors require developed lands with ready-to-use infrastructure, minimising lead time and operational delays. Without addressing these factor market inefficiencies, traditional export strategies will continue to fail. The global export market is now highly fragmented, with the future lying in the production of components and participation in global value chains rather than focusing solely on finished products.

Ultimately, the export sector is too complex for any single individual or institution to plan entirely. It is an organic, competitive field where businesses strive to add value through quality and cost efficiency. 

The role of the Government should be to facilitate this process by removing barriers and creating an environment conducive to competition. If the right conditions are in place, export growth will naturally follow and Sri Lanka will achieve its ambitious targets.

Why economic reality matters more than honesty

By Dhananath Fernando

Originally appeared on the Morning

At least once a week, we find ourselves blaming corruption and criticising how corrupt our current and former leaders are.

Blaming dishonesty and corruption often suggests that honesty alone could solve all our problems. Honesty, integrity, and transparency are universal values that we must all uphold. However, these values alone cannot guarantee success, especially if we lack an understanding of economics and how the world truly works.

The world operates on incentives. People naturally prioritise their self-interest, even when their actions seem altruistic. A common mistake is believing that policies based on good intentions will always lead to good outcomes.

However, in economics and public policy, success is measured by consequences, not intentions. A well-meaning policy, even when created by an honest person, can have disastrous outcomes. Good intentions alone are not an excuse for poor results in economics.

Take the example of the rice, coconut, and egg markets in Sri Lanka. In the case of rice, many believe that a mafia of rice millers hoarding stocks is the root cause of the problem. To address this, price controls were imposed with the honest intention of lowering prices. Instead, this led to shortages in the rice market and the creation of a black market.

When rice imports were allowed, the landing cost was around Rs. 130 per kilo. It was assumed that traders would add a profit margin if the imports were sold without price controls, so a tariff of Rs. 65 was imposed to limit their earnings.

This, however, resulted in consumers paying an additional Rs. 65 per kilo at a time when approximately 25% of the population lives below the poverty line. This demonstrates how well-intentioned policies can backfire when basic economic principles, like how price controls create shortages and tariffs burden the poor, are ignored.

A classic example of unintended consequences is the subsidy for kerosene. The subsidy was introduced to provide an affordable fuel source for poor households. At the refinery level, kerosene is a byproduct closely related to jet fuel.

The subsidy made kerosene so cheap that it created excessive demand, prompting industries to convert boilers and heat-generating systems to run on kerosene. Even tuk-tuks and long-distance buses began mixing kerosene with fuel to cut costs and boost performance. Once again, good intentions resulted in undesirable consequences.

The maize market provides a similar example. To encourage local maize farmers, a licensing system and high tariffs were introduced. This policy led to inflated maize prices, which significantly impacted the poultry industry since maize is a primary ingredient in animal feed.

As feed costs soared, chicken and egg prices increased, driving up the cost of bakery items. At a time when 25% of the population lives in poverty, the policy intended to protect maize farmers ended up raising food prices for everyone, disproportionately affecting the poor.

Even in the coconut market, the story is no different. Coconut imports are prohibited, forcing domestic production to meet all demands, including those for coconut oil and other byproducts. If imports of specific varieties were allowed, the prime coconuts could be reserved for export, potentially increasing export revenue.

While transparency, honesty, and integrity are essential values, they are not substitutes for sound economic principles. Economics operates on incentives and consequences. In public policy, we must focus on outcomes rather than intentions. That’s why, in economics, honesty alone is not enough – it must be accompanied by an understanding of how systems work.

Rethinking tax policy in Sri Lanka

By Dhananath Fernando

Originally appeared on the Morning

  • The case for adhering to tax principles

Many Sri Lankan budget speeches are essentially discussions on Government expenditure. Revenue proposals are often introduced piecemeal before the budget and frequently fail to align with basic principles of taxation. 

Under the current International Monetary Fund (IMF) programme, Sri Lanka has committed to achieving a revenue target of 15% of Gross Domestic Product (GDP) by 2025, increasing to 15.5% by 2026. Additionally, a primary balance target of 2.3% in 2025 must be met and maintained. 

While we have already exceeded the primary balance target, this achievement has come at the cost of cutting capital expenditure, which will likely impede long-term growth.

Tax revenue has met targets, primarily through record-high import tariffs collected at the border by Sri Lanka Customs, amounting to Rs. 1,500 billion. However, relying on such high border tariffs impacts both the cost of living and the cost of raw materials, adversely affecting exports and local production.

The need for adhering to tax principles

It is crucial that the Government prioritises adherence to fundamental principles of taxation when implementing revenue measures. Over-reliance on border taxes is not a sustainable strategy for achieving a higher tax-to-GDP ratio.

Why border taxes are problematic

Generating revenue through border taxes disproportionately affects importers, as they incur significant costs upfront, even before generating profits. In contrast, profit-based taxes are levied only after profits are realised, making them less burdensome from a cash flow perspective. The time value of money amplifies the impact of upfront border tariffs on profitability.

Sri Lanka’s import basket comprises approximately 80% intermediate and capital goods, with only 20% being consumer goods. Tariffs on these critical imports drive up production costs, ultimately increasing the price of exports and even domestic goods. For example, the Rs. 65 tariff on rice accounts for about 50% of its production cost, leading to a nationwide increase in meal costs by approximately the same margin.

A tax base built on three pillars

Globally, taxes are traditionally levied on three bases:

What you earn (e.g. income tax, corporate tax)

What you buy (e.g. Value-Added Tax, or VAT)

What you own (e.g. property tax)

Principles for an effective tax system

Simplicity: Taxes must be simple for taxpayers to understand and for authorities to collect and enforce. Overly complex tax structures with numerous thresholds lead to lower compliance, reduced revenue, and enforcement challenges. A standard and straightforward tax system is key to maximising efficiency and minimising leakage.

Transparency: Transparency in taxation fosters trust and reduces opportunities for corruption. For instance, Sri Lanka’s import tariff system, based on Harmonised System (HS) codes, lacks transparency due to its cascading structure. Similarly, ambiguities in income tax policies create doubts and complications. Transparency is especially critical for tariffs, which, even when necessary, must be clear and predictable.

Neutrality: Taxes should not create winners and losers by favouring or penalising specific industries, products, or sectors. For example, in 2015, Sri Lanka imposed taxes on profits from the previous year, undermining the fairness of the system. The primary purpose of taxation is revenue generation, not market distortion. Lowering tax rates can expand the tax base, ultimately increasing revenue and minimising evasion.

Stability: Tax rates should remain consistent over time to provide predictability for taxpayers. Frequent changes to tax rates, such as the numerous adjustments to VAT in Sri Lanka, create uncertainty, open avenues for corruption, and undermine economic stability. Temporary taxes and tax holidays should also be avoided to maintain consistency and fairness.

Taxes on property: A case for caution

Among all forms of taxation, taxes on property ownership are particularly burdensome. This is because taxpayers often have to forgo another revenue source to meet their property tax obligations. 

If a property generates income, that income is already taxed under income tax laws. Imposing an additional property tax not only constitutes double taxation but also discourages wealth creation. Such policies can deter investment and economic growth, undermining broader development objectives

Balancing revenue generation and expenditure

Sri Lanka urgently needs to increase tax revenue due to its high expenditure, particularly on interest payments, which account for approximately 50% of total expenditure. This is not repayment of debt but merely the cost of servicing bad debt. While room for expenditure cuts is limited due to the predominance of recurrent spending, hard restructuring is necessary to reduce this burden.

Although the Government has achieved a primary surplus by reducing capital expenditure, this strategy will have adverse long-term effects on growth. Therefore, adhering to fundamental tax principles is critical to improving Government revenue sustainably without jeopardising the country’s economic prospects.

Source: CBSL, Advocata research 

Source: CBSL, Advocata research 

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.

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