New electricity tariff structure leaves room for considerable improvement

Originally appeared on the Daily Mirror, Timesonline.lk

By the Resident Fellow of Advocata Institute

The recent revision of electricity tariffs is a step towards reducing the fiscal burden caused by the supply of electricity below its cost of production. While the new tariff structure is an improvement on the previous one, anomalies remain.

 In determining tariffs, there are three characteristics of electricity that must be noted:

I. Electricity is a commodity that is interchangeable, both in its generation and use. One megawatt hour (MWh) of electricity produced from coal or hydropower contains the same amount of energy. Different categories of users consume the same product.

II. It must be produced and used simultaneously. Electricity storage is still prohibitively expensive. Supply must meet demand exactly in the power grid.

III. The cost of supplying electricity fluctuates throughout the day, depending on the power generation mix, cost of fuels used, transmission costs and energy losses.

As electricity is a commodity, there should be no difference in the prices charged to different users. The tariff should also reflect the varying cost of supply, depending on the time of day and should as far as possible, balance the generation of electricity with its use. For sustainability, the tariff needs to be on a cost-recovery basis.

The new tariff addresses some of the shortcomings of the existing structure but there is still considerable room for improvement.

1. The proposed structure reduces the discrimination between different types of bulk supply customers.

For users below 42kVA, the different rates that were charged to hotels, government and general-purpose bulk supply, have been amalgamated into a single general-purpose tariff but a lower rate remains applicable to ‘industrial’ customers. However, it is positive that the differential between the general-purpose bulk supply and customers categorised as ‘industrial’ has decreased.

For larger bulk customers, it is welcome that the distinction between categories has been done away with and a single tariff, close to cost recovery and reflecting time of use, has been applied.

The Public Utilities Commission of Sri Lanka (PUCSL) consultation document states that the average cost of generation is Rs.32.87 but the tariff charged to low-use industrial users (Rs.20) and low-use general-purpose customers (Rs.25 for those below 180kWh) is both below cost.

The only justification for a discriminatory tariff is for a lifeline tariff for the poor. While the domestic users below 90kWh do receive a subsidised tariff, the domestic consumers, who exceed this, pay the highest tariff (Rs.50 for usage between 90-180kWh, Rs.75 above 180kWh), which is almost double that of all bulk users. Thus, high-use domestic consumers are subsidising industrial and commercial users.

Moreover, instead of increasing the rate for each block of use, the moment domestic customers exceed 60 units, the tariff increases from an average of Rs.9 to Rs.16. A customer, who consumes 59 units, will pay Rs.9 but one who consumes 61 units will pay Rs.16 per unit. This is unfair and can promote corruption in meter reading. In general, such cross subsidies are undesirable, as they can lead to inefficient resource allocation or have unintended consequences.

For example, the higher domestic tariff may serve as a disincentive for remote work. Remote or flexible work arrangements can reduce transport costs, congestion, energy use and for some, enable a better work/life balance. The government should be facilitating flexible work but the higher rates applicable to some domestic consumers may be a disincentive.

The PUCSL has an unusual definition of industry. It includes, ‘agriculture’, ‘forestry and fishing’, ‘mining and quarrying’, ‘manufacturing’, ‘electricity, gas, steam and air conditioning supply’, ‘water supply, sewerage and waste management. As a matter of principle, the producer should not make judgment on how the product is used or attempt to encourage or discourage particular activities through prices. If the government does wish to encourage particular industries, it is more efficient to do this through a transparent system of grants, rather than distorting prices.

Economic activity is increasingly complex and a value chain can involve many different sectors. For example, the tea industry involves agriculture, processing in factories, transport, warehousing, blending, financing, marketing and exports. Moreover, products are now more knowledge intensive, so a greater part of the value addition arises in non-production-oriented components of the value chain. With differential tariffs, parts of the same value chain may pay different prices for use of the same commodity.

Religious and charitable bodies continue to enjoy preferential treatment under the domestic tariff category but there is a small decrease in the discount offered to these bodies. High-use customers in this category should also be subject to a time of use (TOU)-based tariff. Advocata reiterates that there should be no price discrimination between users; at most there should be two categories, households and businesses.

2. It is welcome to note that the new tariff structure extends the TOU tariff to the agriculture subsector but this should be extended to smaller bulk users and made compulsory for the high-use domestic category. For customers using solar power on a net metering basis, the export and import tariffs should be based on TOU. A TOU-based tariff reflects the changing cost of generation across the day. Generation during peak hours relies more heavily on thermal power, which is more costly. Tariffs charged to customers should reflect this, so that the consumers are incentivised to shift demand to off-peak hours.

3. The new tariff maintains a lower rate for low-use domestic customers and it is welcome that the new structure applies marginal tariffs based on different slabs of usage. The previous system was inherently unfair to the consumer; the new tariff removes this anomaly.

4. The decision to charge for street lighting, which should be paid for by the local authorities, is welcome. Previously, as the Ceylon Electricity Board (CEB) did not charge for street lighting, the local authorities, which have control over when the lights are switched on and off, had no particular incentive to switch off street lights during day time. A lower rate for street lighting is justified because the major part of the use falls into off-peak hours.

5. It is regrettable that the PUCSL permitted the CEB to compel selected clients to pay for electricity in US dollars. This is a step towards forced dollarisation of payments and is precluded under Section 4 of Monetary Law Act No. 58 of 1949. The proposal is meant to address the current shortage of US dollars for importation of fuel for the energy sector. However, this would only divert resources from other alternative users and may not be the most efficient way of allocating the scarce foreign exchange in the country. It would be preferable to allow US dollars to flow into the banking sector (by removing any restrictions and requirements such as forced conversions and surrendering requirements) and for those funds to be allocated based on price (exchange rate).

The increase in the electricity tariff is unavoidable but will impose an additional burden on consumers. Therefore, it is imperative that this must be accompanied by increased transparency and efficiency

within the utility.

Consumers may expect to pay for higher world prices but cannot be expected to pay higher costs, due to inefficiency, waste or corruption. State enterprises need to be open and transparent in their affairs, particularly in procurement and where possible should operate in competitive markets.

As a first step, the CEB should provide a detailed breakdown on the components of its tariff:

• Energy costs: (Own generation costs and that paid to the private generation companies). This must be broken down into the fuel cost and the costs of operating the power stations, such as the manpower and maintenance costs as well as the capital cost of the stations.

• Network costs: This reflects the cost of transporting electricity through the power grid.

• Overhead: This is to recover the costs of central administration, billing and meter reading, data management, retail market systems as well as market development initiatives.

The opinions expressed are the authors’ own views. They may not necessarily reflect the views of the Advocata Institute.

The Port City We Need

Covered in the Daily Mirror, Daily FT, Daily News, The Morning, Lanka Business Online,

By Resident Fellows of the Advocata Institute

Better economic rules, not giveaways should be the focus of the new governance zone

Deng Xiaoping China’s great reform leader, faced a serious problem in the 1970s. Thousands of young Chinese were crossing to Hong Kong risking their lives. Rather than cracking down on the migrants, Deng sought to understand why they were migrating. Clearly the economic opportunities in Hong Kong were greater than in mainland China. Deng was also impressed by the rapid rise of the some asian economies, in particular the modernisation of Singapore.  Singaporeans, like the residents of Hongkong, were majority Chinese by descent and had even less natural resources. How did they achieve something that China couldn't?  

The answer was that these countries had better rules, better incentives, and a better economic governance system. Deng knew he needed to ‘reboot’ China with reforms that allowed markets to coordinate economic activity,  protect private property, and allow for Foreign Direct Investment: radical reforms in communist China at the time. He also knew that implementing these reforms in the entirety of the country would be a nonstarter. Entrenched interests who benefit from the status quo would fight to keep the existing order. To solve this, China demarcated the Shenzhen area as a special governance zone and implemented a new - more open - economic system. This was the start of the Special Economic Zones (SEZs) in China. It was promoted as a laboratory to experiment with market principles to serve “socialism”.  

The results are astounding. In the past forty years Shenzhen has been transformed from a fishing town of less than 30,000 to the third largest city in China with a population of more than 12 million. By 2018, the economy of Shenzhen was $366 billion, four times that of Sri Lanka. 

In some ways, Deng’s problem is now Sri Lanka’s problem. To be sure, emigration out of Sri Lanka is not as severe as it was in 1970s China. Sri Lanka’s business environment is also not as bad as the Chinese system at that time. Yet market based reforms started in 1977 have all but stalled.  

Like China, in “mainland Sri Lanka” too an entrenched elite who benefit from the existing rules lobby to maintain the status quo. The result is that very little progress has been made over the last 15 years on reforms necessary to boost economic growth. After a brief post-war spurt between 2010-2012, economic growth slumped and has remained stagnant.

This is visible in Sri Lanka’s low scores on various rankings that measure the efficiency of the business environment. In the World Bank’s influential Ease of Doing Business report, Sri Lanka is ranked 99 out of 190 jurisdictions. The country has fallen behind regional peers like India, Bhutan and Nepal, having once been an early economic reformer in the region.  

Take the legal system, where Sri Lanka is one of the worst performers in the world. In contract enforcement, the World Bank ranks Sri Lanka 164 out of 190, taking on average nearly four years to enforce a contract. In Singapore, it takes just over five months. It's no wonder that foreign investors prefer easier destinations to deploy their capital. 

This is the logic for the Colombo Port City. Poor governance is a barrier to growth in many developing countries but implementing broad reform for better governance is extremely difficult. The idea is that by building special governance zones, governments could adopt completely new systems that overcome the problems that exist in the rest of the country. These zones would operate like “one stop shops” with pre-approvals and fast-tracked court systems, making doing business easier and hopefully attract foreign investment.  

Special zones are not new in Sri Lanka. Much of Sri Lanka’s export industry resides in the country’s dozen or so Free Trade Zones. Colombo Port City is different by virtue of being the first special zone developed by an international operator.  Unlike the FTZs, the focus is on white collar jobs and financial services instead of manufacturing exports. It also has a broader remit: the proposed legal structure lists seven laws that don't apply to Port City, and a further 14 that could be exempted in the area by the proposed oversight body. The Port City masterplan promises world class living facilities, entertainment, financial services, and business.

Yet Port City’s success, and indeed its importance to the country at large, will only depend on its ability to provide a superior economic governance system. To be a success Port City will need to guarantee greater economic freedoms to its investors, have an efficient legal system with clear and predictable laws. It needs to minimise discretion of the commissioners and have a fair and transparent regulatory structure. These are the critical features that have made several small cities like Hong Kong and Singapore prosper. 

This is the Port City we need. A better governance zone that can attract FDI, skilled people, spread knowhow, and serve as a lab for policy experiments. Get this right, and Port City could create positive spillover effects and expand economic opportunities for Sri Lankans. By learning from it’s successes, we can hope to scale some of the policies in the enclave to the rest of the country.

What of the Port City we will get? In the coming weeks, the country will debate whether the specific provisions in the Port City bill are prudent.  The supreme court is already hearing 19 petitions that challenge its constitutionality.  Like any project of this nature, there are also political and economic risks that need to be considered.  

Managing the geopolitical risk is going to be an enduring challenge in Sri Lanka. Here there are no easy answers, except professional management of our foreign affairs and dealings. Big picture thinking is needed instead of the current win/lose mindset and transactional diplomacy.

Another risk is in the domain of economic distortions. Unlike in Shenzhen which was conveniently located far from the commercial centres at the time, Port City is on the doorstep of Sri Lanka’s capital. After the operation of the Port City, life as a businessperson could be very different depending on which side of the Chaithya Road your business is situated. You may be competing for the same resources but face very different rules and taxes. The latter is a deeper malaise.

Already stretched for revenue to cover even its debt obligations, the Port City may prove to be a leakage point of taxes for the State. Finally,  given its proximity to Colombo, there is a risk of capture of the regulatory framework of the same elite who have secured rents for themselves in the existing system. It’s no accident that successful SEZs tend to be away from the established power centres, such as Shenzhen was to Beijing. 

Only good rules, predictable policies, and oversight can overcome these challenges. A focus on better governance rather than tax breaks and giveaways would help keep the house in order.  

It would be better for the entire country to be governed by better rules and efficient systems that enhance ease of doing business. Given its size and scope, the Port City cannot perform miracles, but we can hope that Port City would be a catalyst in bringing about some of these changes to the country proper.

The project itself is an admission of failure in governance. Even when Sri Lankan leaders know what to do, a combination of backward ideology, political opportunism, vested interests, and lack of state capacity seem to hold back the vital growth oriented reforms. It is these reforms that are needed to expand economic opportunities for all Sri Lankans.  

The Port City can give the country a shortcut to attract foreign investments, provided it focuses on the right thing -- better economic governance.

The authors are resident fellows of the Advocata Institute, a free-market think tank based in Colombo. Learn more about Advocata’s work at www.advocata.org. The authors are grateful to the many useful conversations with the think tank’s advisors whose ideas helped this article.

Treasury and Central Bank should consider credit guarantees for COVID-19 distressed bank loans

Covered in the Daily Mirror, Daily FT

By Fellows of the Advocata Institute

Even though Sri Lanka’s economy has opened up, businesses are still recovering from the dual shock of the locally imposed curfew as well as the global fallback from the coronavirus. A vast majority of Sri Lankan businesses are in need of support if they are to survive the next few months. 

The need of the hour is for liquidity support and enhanced access to credit. However, banks find this situation to be challenging. They need to be able to finance the loans that are being demanded but they also need to have some guarantee that their loans will not go bad. 

Will Central Bank’s solution work?

In response to this problem, the Central Bank has announced a subsidised credit scheme for businesses. Through this, the Central Bank will be offering a facility of Rs.150 billion to licensed commercial banks (LCBs), at a concessionary rate of one per cent. LCBs, in turn, will be required to lend to businesses at a rate of 4 per cent. 

Put simply, the Central Bank is essentially offering commercial banks a credit line to solve their issue of a source of financing this new demand for loans.  

Assuming that the bank’s marginal cost would be around one per cent, it is left with a contribution of 2 per cent before provisioning. Lending to this segment of businesses will be risky as many of these borrowers are already leveraged and do not have spare collateral to pledge. 

Under distressed economic conditions, non-performing loans could increase significantly. While part of the non-performing loans could be partially recovered, the impairment cost or credit cost could be as high as 6 per cent.  

If the net contribution to the banks is 2 per cent after their direct cost, a potential 6 per cent credit cost per year would mean a pre-tax loss of 4 per cent per year, creating the need for a credit enhancement or guarantee. 

This credit line means that the Central Bank is printing money to meet this requirement, leading to a monetary expansion. The risk of increasing money supply in the current economic context is that the subsequent pressure on the exchange rate will result in a depreciation of the currency. 

Looking at Sri Lanka’s import bill, 19.8 per cent of our imports are consumption goods and 57 per cent of imports are intermediate goods for production. The share of investment imports is also higher than consumption goods at 23.1 per cent. The impact of a depreciating currency will be significant on the economy’s ability to recover and grow. 

There are additional risks associated with this solution. A key problem is that while banks are receiving newly minted money from the Central Bank to finance the loans, the bank and the depositors have to take the credit risk on the lending. The collapse of finance companies in recent years shows what happens when deposit taking institutions take on risks that they cannot bear. 

Bad loans of Sri Lanka’s banks have been rising since the currency crisis in 2018 and the Easter Sunday bombings. The banks are already burdened with the credit moratorium that was also given in early 2020. In the first quarter of 2020, bad loans had risen to 5.1 per cent, which is the highest since the third quarter of 2014.

If banks collapse, the government may end up having to bail them out with capital injections. At the moment, Sri Lanka’s banking system is fairly sound and given the indications that bad loans will rise, all efforts must be made to keep banks stable.

Further complications

As highlighted by former Central Bank Deputy Governor and senior economist W.A. Wijewardene, the issue with excess liquidity already in the system, the problem is not about liquidity but the fear of default. According to Wijewardene, this fear of default could be tackled by a comprehensive credit guarantee scheme and smoothing out banks’ internal credit approval systems. 

Instead of using the CRIB reports for rejecting loans, a rating system could be used to eliminate the worst ones. If treasury guarantees are available, it may not be necessary to create new money and endanger the balance payments. Banks may be willing to make loans from their own deposits if there is a guarantee. 

There is also a moral hazard associated with this decision. This crisis hit at a time where there was significant pre-existing distress in the economy, there is the possibility that this financing will be utilised to keep ‘zombie entries’ alive. Additionally, this would prevent resources from being allocated to productive and efficient firms. What is needed is quick support for viable companies to get their business going. Steeply subsidised credit may induce businesses to go after loans that are not needed and refinance other loans, which are at higher rates. Or whenever they have the cash, the incentive will be to settle the higher cost loan than the low-cost one, inviting default or delays. The artificially low rate of interest of 4 per cent for working capital also may create other distortions. 

A working solution 

Given a challenging environment, if the authorities want to direct banks to give loans, the government will have to share the risk. Ideally, the credit risk should be split three ways between the government, multi-laterals and banks, to ensure that they have skin in the game. The worst-case scenario would see the banks with a potential zero profit from this scheme and not the alternative of sustaining heavy losses, incentivising the banks to lend.

Guarantees could also be structured to give high credit cover to smaller firms and lower amounts to large firms, as it may not be necessary to give all borrowers the same amount of credit cover. 

For instance, loans up to a million rupees for very small firms could be covered by a 100 per cent guarantee, loans from 1 to 10 million by a 90 per cent guarantee, from 10 to 20 million, 75 per cent and loans above 20 million to 50 per cent or a similar suitable share of risk. Of course, this solution is not devoid of risk. This would allow the LCBs to meet the demand for the loans, with the guarantee offered by the government.  

Sri Lanka has to shift away from passive tests, to active, voluntary and targeted testing as curfews are lifted

Covered in Economy Next and the Daily News

By Fellows of the Advocata Institute

Voluntary testing, random testing of people in high-risk areas will increase the chance of asymptomatic index cases and members of clusters being discovered.

In dealing with the COVID-19 pandemic, Sri Lanka has been aggressively contact-tracing and later testing contacts of index cases that have turned up showing symptoms. Contact tracers in the health service and military have done a commendable job.

Initially, Sri Lanka did not test contacts of index cases as soon as they were quarantined and also did not test quarantined persons before release. But these are gaps that have now been closed.

In addition, tight curfews have been placed in the country for weeks, for any exposed person that the contact tracers had missed, including anyone who came to the country before March 19 when the airport was closed, to develop symptoms and come to the hospital.

Several large clusters including the Bandaranaike Pura cluster relating to an index case that returned from India on March 12, as well as the cluster from a case found in Suduwella Ja-Ela during curfew shows that the strategy was useful.

Source: Ministry of Health, Sri Lanka; Ministry of Health, Vietnam

Current Testing Strategy is Dependent on Symptomatic Cases

The current contact tracing strategy has a serious flaw in that it is too dependent on symptomatic cases and there is no way to detect an infected index case that is asymptomatic.

The best practice adopted in the countries with the most success is to trace at least three levels of contacts (F1, F2, F3) of an index case (F0). If there are confirmed cases at any given level, the next level is traced, quarantined and tested.

The longer the delay in discovering the index patient, the higher the chance that the disease has spread to multiple levels. Each level expands exponentially, therefore time is of the essence.

Contact tracers wait for index cases to show up in the hospital with symptoms to find the contact levels to kickstart the tracing process.

Authorities also wanted to get all index cases to state hospitals where they are able to exercise tight control and prevent further spread.

In a situation where tight curfew is imposed, this may be acceptable as the exponential expansion of new levels of contacts is stopped and the cluster is localized to where people can move around in houses close by.

However, it will not be the case when the curfew is lifted.

High-Risk Groups during Curfew and After

Even during curfew, there are several high-risk groups that may get infected. These are delivery personnel, postmen, drivers and cleaners of vehicles, as well as medical staff and cleaning staff at hospitals.

Once curfew is lifted, the front office staff of any institution including airports, quarantine workers, cleaning staff, people working in economic centres, and drivers may be exposed to higher risks.

Those in driving/delivery related jobs, in particular, would also be in a position to spread the disease faster and to a greater area.

After curfew is lifted the government could sample test people in high-risk areas.

These include front office staff of hotels or any company, cleaning staff, transport and delivery personnel, restaurant/supermarket workers, taxi, truck, and other vehicle drivers and sex workers.

Voluntary and private random testing

Sri Lanka has imposed a price control on PCR testing. This price control does not account for the costs of personal protective equipment, the cost of medical staff, and the safe disposal of medical waste.

If the concerns of authorities are that hospitals could get infected, testing and sample collections could be done outside of private hospitals.

Removing the price control would allow competition to drive the cost down, and would allow the private sector to expand testing capacity.

Opportunities should be provided for companies to negotiate bulk discounts and multiple validated testing points should be allowed. Companies and employees could be encouraged to share the cost.

To reduce the cost on the government, opportunities should be provided for voluntary testing and testing at the cost of the employer; especially for front office staff and sample testing of factory workers.

This way any index cases that have slipped through the net and any second contacts of index cases who have since recovered could be discovered.

Under the current testing strategy, there is zero chance of an asymptomatic person being discovered by authorities. Since the growth of a cluster is exponential, time is of the essence.

People may require a test for a variety of reasons.

Any individual who does not have symptoms but may feel that he/she was exposed due to going to a crowded place or any other high-risk location, that they have COVID-19 should have an opportunity to get a PCR test from at his or her own expense, preferably through a drive-through system.

Any individual who has to look after an elderly person or visit an elderly person may have a need for a test.

Many countries, including Korea, are already asking for pre-flight tests from foreign visitors. The current state testing regime there is no opportunity for anyone to get a test.

Drawing from the process adopted in countries like the UAE, results could be sent by text messages and other online methods. The same could be shared with authorities to construct a live map without burdening the public sector.

Sri Lanka’s weak public finances will exacerbate economic shocks from COVID-19

Covered in the Daily News and published in the Daily FT, Lanka Business Online and LMD

By Fellows of the Advocata Institute

The country will have to borrow heavily and go in for a new IMF program

Sri Lanka’s shaky public finances are about to receive another blow from the fallout of COVID-19. The most crucial aspect of a pandemic is always the human cost, but the spread of the virus has important repercussions for the economy. Studies indicate that pandemic impacts a country's economy through several channels, including the health, transportation, agricultural and tourism sectors. As borders are closed and global markets slow; trade is impacted, so exports suffer.

Sri Lanka’s already-battered tourism industry will be further hit  and the order books of some of the key exporters will suffer in the next quarter.  As international supply chains contract exports may remain constrained, even when markets reopen as components and raw materials may remain in short supply. The supply chain impact will affect even domestic producers as imported raw materials run short. Agriculture depends on imported fertiliser, pesticides, planting materials and chemicals. Local factories source raw materials, components and spare parts from overseas and may be unable to work at full capacity.   

As cashflow dries up and debts mount, many businesses will find it difficult to cope. During the global financial crisis of 2008/10, an estimated 90,000 Sri Lankans lost their jobs due to downsizing amongst manufacturing firms, especially in the apparel sector. The impact of the current crisis has the potential to be worse because unlike the financial crisis, this pandemic is not confined to advanced countries. Developing countries were affected due to the loss of export markets but their domestic markets were unaffected. This pandemic is affecting both developed and developing countries.  Daily wage-earners will see their already uncertain incomes further dampened. Small businesses will be among the hardest hit.  

This would mean that growth will slow further. The budget deficit will take a double hit from falling revenues and increased expenditure. Lower levels of activity mean lower levels of tax collection. As sales and imports decline, the collection of VAT and import taxes will decline. As business profits fall, income tax collection will fall. Meanwhile, government spending on health (from testing kits to hospital costs) and relief measures will rise in response to the pandemic. The budget deficit will thus widen and the government will need to borrow more.  Sri Lanka’s interest bill this year alone will be Rs 1 trillion.

Even if public finances were robust, this would pose a significant challenge, but Sri Lanka’s finances --  sickly to begin with -- were weakened by recent tax cuts. The fallout is difficult to estimate but a recap of the principal issues is useful to assess the available policy options.    

Sri Lanka obtained an IMF facility of US$1.5bn in June 2016. This is the 16th instance when it turned to the IMF since joining the fund in 1950 - an indication of the systemic and long-running nature of the underlying problems. The overall objective of the recent IMF programme was to “reverse a two-decade decline in tax revenues and put public finances on a sustainable medium-term footing”. The programme aimed to increase government revenue to reduce the budget deficit and therefore the public debt (as deficits fall, the need to borrow reduces). 

In the popular imagination, IMF programmes are associated with austerity: cutting government expenditure which negatively impacts social and welfare spending. The reduction in expenditure closes the budget deficit at the expense of the welfare programmes. Under the previous ‘Yahapalana’ regime, Sri Lanka did the opposite: increasing taxes to cover the deficit. Expenditure was left untouched and in fact, continued to increase.

Unfortunately, the bulk of government revenue comes through the form of consumption taxes particularly VAT, so much of the burden of increased tax fell on the general public anyway, provoking intense displeasure. Income taxes were also increased, angering the business community. The government thus succeeded in antagonising a remarkably diverse set of constituents and became exceedingly unpopular.

Public finances did improve somewhat but were never very strong. With the attacks in April 2019 things started to slip again.  The IMF review in November 2019 noted that “the fiscal targets are no longer within reach, due to the significant revenue shortfalls”.

Following the Presidential election of November 2019, the new government announced sweeping tax cuts in December. Given the unpopularity of the tax increases, responding to public frustration could hardly be faulted,  but the breadth of the cuts was astonishing. Corporate income tax was reduced from 28% to 24%,  VAT was halved from 15% to 8% with a high vat-free threshold;  withholding tax, nation building tax and economic service charge were scrapped. The objective was to kickstart a floundering economy but the cost –around a quarter of government revenues or 3-4% of GDP destabilised public finances.

On 7th February 2020, the IMF noted that: “Preliminary data indicate that the primary surplus target under the program supported by the Extended Fund Facility (EFF) was missed by a sizable margin in 2019 with a recorded deficit of 0.3 percent of GDP, due to weak revenue performance and expenditure overruns”. According to the fund, Sri Lanka’s 2020 budget deficit could rise to 7.9% of GDP, the highest since 2015. Given the pandemic,  this will look optimistic. The reported deficit for 2019 was 6.5% but according to the Ministry of Finance “the actual budget deficit for 2019 should have been over 8 per cent” as around Rs.367bn of expenditure remained unpaid and unaccounted at the year end. 

Meanwhile the rating agencies Fitch and S&P downgraded the outlook on Sri Lanka’s debt to ‘negative’ from ‘stable’.   Sri Lanka’s already wobbly public finances must now cope with the added economic shock of COVID-19. 

Dealing with the public health emergency and the associated human cost should be top of mind for policymakers. Yet clear-eyed economic thinking will be equally important and will have a direct bearing on the human cost, particularly for our society’s most vulnerable.  This is why weighing the relative costs of a lockdown or a complete curfew is important. 

The biggest headache for the government will be managing foreign debt. The Central Bank’s freshly minted medium term debt strategy is based on assumptions that no longer hold -- 5 percent GDP growth over the medium term, inflation of 5 percent and a budget deficit of 3.5 percent. With the medium term strategy in ruins can the government rollover the maturing debt? 

Gross reserves stood at US$7.9bn equivalent to 4.6 months of imports in February 2020. External debt repayments are around US$5.6 bn in 2020. This has been partially refinanced by a US$500m loan from China which has reportedly promised a further US$700m. The country will be looking to raise a further US$2-2.5bn at least if it intends to repay this year’s debt while maintaining a minimum reserve of three months imports.  

With its public finances in shambles, the IMF programme derailed and inevitable debt downgrades expected from rating agencies it is impossible to return to the market to borrow. The yields on Sri Lanka’s sovereign bonds maturing this year have spiked.  At the time of writing, investors were asking for a 101 percent increment on the current yield, bonds maturing next year are at 44%. A new IMF programme will restore confidence to the markets but that would mean a return to painful tightening. Appealing for further bailouts is thus the most attractive option.

Sri Lanka is among the countries that have called for debt relief. The call has been supported by the World Bank and the International Monetary Fund (IMF). Although the call is for the poorest of countries,  there are signs that these organizations will consider countries recently transitioned into upper middle income category like Sri Lanka. Some commentators have even suggested that the government should simply default.  While this may appear simple, it is risky and even restructuring of commercial debt: deferring or reducing repayments is viewed by the markets as a default event, which means it will be difficult to return to the markets for a while. It also delivers a shock to the economy with declines in GDP, investment, and private sector credit being common. The financial sector may be affected leading to bank failures.

An IMF study in 2002 covering restructurings by Russia, Ukraine, Ecuador and Pakistan in 1998-2000 showed as a result of the restructuring:

 “The decline of real income and financing was transmitted to domestic demand. Confidence plummeted and private investment was curtailed sharply. Private consumption followed, albeit with a lag, as for a while households drew down their available savings. Public consumption was also scaled down reflecting efforts to consolidate public finances. Despite exchange controls, exchange rates depreciated sharply reflecting the shortage of foreign funds resulting from capital flight. The domestic demand contraction and import substitution helped improve current accounts. The exchange rate depreciation passed quickly to prices and inflation surged. Wages lagged, inflation wiped out the value of deposits, unemployment rose, and households suffered significant real income losses.”

Sri Lanka thus finds itself in a tricky position with little room to manoeuvre.  These problems are not due to COVID-19 alone, although it has made matters much worse.  The pandemic has only precipitated the policy weaknesses that were building up over decades into a single giant shock encompassing growth, fiscal and external sectors at the same time. 

This was also the case in the countries in the IMF study referred above where following a relatively short history of access to international capital markets, the macroeconomic situation was destabilised by domestic policy shortcomings and exogenous shocks: weak oil prices for Russia and Ecuador, international sanctions following nuclear testing for Pakistan, the El-Niño effect for Ecuador, Russia’s turmoil for Ukraine, in addition to an unfavourable external environment after the Asian crisis.

In the short-term bailouts will be necessary,  but it is only a temporary measure, postponing the issues for a later but not too distant date. Whilst further bi-lateral loans from China are a possibility,  given the global nature of the COVID-19 crisis, further bi-lateral aid may not be a realistic option. With it’s $1 trillion lending capacity, an IMF program provides perhaps the only realistic option to access further borrowing.  

Politicians and citizens who have been living in a state of denial must wake up to the grim realities. Pre-election bravado and long touted conspiracy theories must give away to level-headed thinking and negotiations with global financial institutions. Economic management should be done in consultation with all other statutory agencies that are empowered to play a role. 

Mistakes could be costly and run the risk of turning the COVID-19 outbreak from a severe public health crisis into a devastating economic crisis.