Steering clear of divisive politics and economic populism

By Dhananath Fernando

Originally appeared on the Morning

I was recently invited to moderate a session by the European Chamber of Commerce of Sri Lanka (ECCSL) on diversity, equity, and inclusion. Foreign Minister Ali Sabry was one of the Chief Guests and he shared two things we should not do, based on his experience over the past few years in managing a few key portfolios as the Minister of Justice, Finance, and Foreign Affairs.

The event focused on unleashing the power of diversity, equity, and inclusion for businesses in Sri Lanka. Keeping aside the political colours, Sabry’s message on the things Sri Lankans should not do is very apt given the current status of our affairs. These two exhortations were to never play divisive politics and never play with populist economic policies.

The final victim of divisive politics has been none other than our economy and our people. If Sri Lanka is serious about economic development, having a diverse culture is important, as highlighted by Prof. Ricardo Hausmann in his Harvard Growth Diagnostic study on Sri Lanka in 2016-2017. The economic theory behind it is that a diverse culture is capable of creating more combinations of ideas which translate to products, services, and exports.

He provided the example of Silicon Valley – most tech entrepreneurs in Silicon Valley are immigrants to the US, which is one reason a high degree of innovation takes place there. Unfortunately, in Sri Lanka, our politics is used to dilute this strength, which has led to where we are today. At one point, ethnic tensions led to mass migration and we are very slow to include all our ethnicities and religions in our culture.

The divisive politics is now at a level that goes beyond ethnicities. It is now ranged against certain countries, trade agreements, and imports from certain countries. Some good examples are the Suwa Seriya ambulance service and the trade agreement between India and Sri Lanka.

We almost rejected Suwa Seriya on the grounds that it was an Indian invasion and that Indian Intelligence services wanted to collect intelligence data through the ambulance service. This is a service primarily impacting the poorest of the poor and has now been recognised as one of the fastest services in the region by the World Bank.

Divisive politics is now beyond ethnicities and religions. We created the same tensions with trade agreements and claimed that the Free Trade Agreement (FTA) with Singapore would result in foreigners taking over our jobs. Instead, most Sri Lankans left the country for jobs overseas due to the economic crisis and we now beg people to visit us.

We also created similar tensions over the India-Sri Lanka Free Trade Agreement by claiming that the agreement would cause more imports to flow into Sri Lanka, worsening our trade balance. The data shows the exact opposite taking place.

We have a trade surplus with India under the FTA and our trade deficit with India comes from outside the FTA. However, comparing trade balances between countries is completely misleading, since what we need to keep in mind is the budget deficit rather than the trade deficit, because the budget deficit arising from Central Bank lending is what leads to a trade deficit.

At one point, by playing divisive politics, we wanted to boycott our Islamic community. We also wanted to boycott Indian products and chase away Chinese and Japanese investments. To make diversity a strength, we need to look beyond borders and capitalise on the strengths of all communities and all countries.

Minister Sabry’s second directive was to never play with populist economic policies. However, we repeatedly witness political parties engaging in populist politics. We are building resistance against the International Monetary Fund (IMF) programme without any alternative suggestions. Without the IMF programme, even 0.1% of debt relief is not possible. Many funds by many international partners like the Asian Development Bank (ADB), World Bank, and bilateral creditor will evaporate in seconds.

On the other hand, growth reforms are almost non-existent. Not a single State-Owned Enterprise (SOE) reform has been implemented yet and the SOE Bill has been shelved. On the growth front, a complicated tariff structure remains. The establishment of the Central Bank’s independence was the main reform we have undertaken and we can see the results. It is a pity that the Central Bank completely ignored the optics and raised its staff salaries, even at the risk of some policymakers requesting the reversal of the hard-earned reform of the bank’s independence.

While Minister Sabry has correctly understood what exactly should not be done, unfortunately, our politics remains divisive at a new level and populist economic policies have taken a new turn. We still have a long way to go.

The other side of parate execution suspension

By Dhananath Fernando

Originally appeared on the Morning

In India, there was a particular type of cobra that was causing havoc due to snake bites. People were protesting and social pressure was building. The then British Government had a brilliant idea to counter cobra bite-related deaths and bring down the reptiles’ population – it announced an incentive scheme for every dead cobra.

In essence, people in India were encouraged to kill cobras and hand over the animal’s dead body to established Government offices in India and collect cash in return. In the first few weeks, things worked out very well, but later the Government realised that the number of cobras being handed over was increasing exponentially.

Upon investigation, the Government realised that Indians had become somewhat entrepreneurial. They had started cobra breeding houses at homes and killing cobras as a means of revenue generation for the family. At one point, the Government withdrew the cash incentive system given the misuse of the entire scheme.

Since there was no incentive for people to maintain cobra breeding houses, they released the reptiles into the jungle. The cobra population then multiplied several fold more than what it was initially as a result of the same policy being implemented to reduce the cobra population. This is called the Cobra Effect.

The Government decision to suspend parate execution as a relief for Micro, Small, and Medium-sized Enterprises (MSMEs) is no different. It is true that MSMEs are going through a difficult time as a result of higher inflation, high interest rates, and economic contraction. It is necessary to protect the MSMEs as they comprise about 99% of business establishments and about 75% of employment in Sri Lanka.

However, whether the suspension of parate is really for MSMEs is a question; 557 parate executions have been undertaken as of November 2023. The total value of the parate executions was just Rs. 38 billion, which stands at just 0.4% of total loans and a mere 2.7% of total impaired loans. From the numbers, it is clear that most MSMEs have not been impacted by parate executions.

Effect on MSMEs

Parate is an execution power on the part of banks under the Recovery of Loans by Banks (Special Provisions) Act, No.4 of 1990, where lending banks can recover non-repaid debt by borrowers by selling assets without going through the judicial processes. In 1961, this power was only granted to People’s Bank and the Bank of Ceylon, and in 1985, the power was extended to regional rural development banks as well.

If MSMEs are not affected, what could be expected to happen when parate executions are suspended until December by the Government? This is likely to backfire on MSMEs given the nature of the banking industry, akin to the Cobra Effect.

Banks lend depositors money. Parate was a safeguard for depositors’ money in case someone was not repaying loans they had taken, giving banks a final resort to recover that money so they could honour the depositors.

Now with parate suspension, banks have a higher risk of not being able to recover the money from the loans extended, so they have to charge a higher risk premium when borrowing for anybody, including MSMEs. Therefore, if MSMEs want to borrow money now, they have to pay higher interest rates, which means further contraction of the economy at a time when it needs to grow.

Triple whammy

On the flip side, this will encourage borrowers to default as they now know the banks cannot execute parate even if they were to willfully default. Additionally, borrowers who are honouring their loan repayments with the greatest difficulty during this economic crisis will be discouraged, because their hard work in honouring the dues will not be rewarded. This does not mean that even the Rs. 38 billion through parate execution has to be understated, but it has to be addressed separately without changing a law which affects the entire banking sector.

The Government declared a Rs. 450 billion bank recapitalisation in Budget 2024 given the instability of the banking sector as losses and loans of State-Owned Enterprises (SOEs) have to be absorbed. On the other hand, licensed commercial banks including State banks are being exposed to sovereign debt restructuring, which is at its final stage. Accordingly, this is detrimental to the stability of the banking sector.

On the depositors’ end, they may be reluctant to deposit money as their risk is now higher on recovery.

Parate execution generally takes place at the last stage of recovery and must go through a court process. Suspension of parate without even consulting banks may provide wrong signals for the ongoing International Monetary Fund (IMF) review, since the IMF initially advised to conduct an assessment on the stability of the banks, although the context has now changed after a few months.

The Non-Performing Loan (NPL) ratios of banks are also on the rise, so banks basically face a triple whammy with this parate suspension – having to charge risk premiums, high NPL, exposure to sovereign default, and now difficulties in recovering money and incentives for not servicing existing loans.

However, the need to protect MSMEs is paramount, which requires a separate sequence of actions. Setting up a bank specifically to absorb bad loans, setting up bankruptcy laws, or moratoria on some of the bad loans under parate executions are options. Changing the entire parate system will indeed bring consequences similar to the Cobra Effect in India.

Looming political and economic challenges ahead of elections

By Dhananath Fernando

Originally appeared on the Morning

“We know what should be done to get the country on the right track, but we don’t know how to get power back after implementing the policies.” This is a popular statement I hear often when I meet quite a few politicians. The truth is that politicians do not know how to get back power because it’s not an attractive solution.

The popular policies that bring politicians into power are the very same that inspire their ousting at the very next election cycle. People hardly object to good policies unless the same politicians instigate false propaganda. The Right to Information (RTI) Act was just one such instance.

As an election is due next year, it is vital to understand and remember our priorities, otherwise our politicians are likely to take a wrong turn and pass the buck back to the people.

In an election year, the behaviour of any political party is to completely abandon rational economic reforms and play to populist narratives that result in outcomes that are the complete opposite, with the motive of coming to power.

Bringing down fuel prices and announcing other types of subsidies are common tactics. This is harmful, especially when those benefits cannot be financed sustainably, or in some situations, brought into life in the first place.

Even if it does not retain power, the newly-elected government will have a tough time preventing plans that have already been put in place and enacting better policies.

Political risk

In the current context, we run a very high risk of our politicians bringing us back to square one; i.e. another economic crisis. This, given the fact that 2024 is set to be an election year, is a recipe for disaster.

All political parties will shift their focus to slowly becoming more populist rather than being driven by objectivity. Therefore, the real risk is going back to another debt restructuring if we fail to grow the economy and our exports.

There are many politicians who do not understand the gravity of the need for reforms. Regardless of which party or coalition comes to power, there are fundamental issues that need to be addressed.

The process is more or less the same as handing over a house with structural issues from one tenant (government) to the other. The new tenant cannot function because neither the previous tenant nor the owner (people) is willing to fix the fundamental problems.

Risk of a second debt default

Given the unstable political environment coupled with a country already going through debt restructuring, the risks of a second debt default are astronomically high. As we are still struggling with finalising the first debt restructuring, adding a second one into the mix will leave us in dire straits.

The second one will undoubtedly be harder, especially given the significant increase in interest rates and being unable to print money with the new Central Bank Act. If we fail to raise money through markets in order to roll over debt and if we are not open to increasing interest rates, the only option we will be left with is to default again. At that point, most likely there will be pressure once again to amend the newly-enacted Central Bank Act to allow money printing.

Of course, that would be an inflationary measure and we will be back at square one with a balance of payments crisis, debt crisis, humanitarian crisis, and likely a banking crisis too.

Solutions: A common minimum programme for reforms

Reforms are easier in the first 100 days of any government. If we fail to enact reforms within the first 100 days, more often than not, no reforms will take place. Failing to undertake reforms in 100 days means a cost of a five-year delay plus many bad policy decisions in the middle, which are costly and difficult to reverse.

Ideally, if key political parties come to an agreement before an election on selected reforms and execute them regardless of who comes into power, it will at least ensure some stability for Sri Lanka. There are many ideas that all political parties have in common.

Regarding State-Owned Enterprise reforms, there is no political party that says the Government should run an airline. Even National People’s Power Economic Advisor Dr. Anil Jayantha, in an interview with Advocata, noted that they did not believe the Government should do any business with hotels.

Accordingly, there are many other similar areas where we can arrive at an agreement with little difficulty. Therefore, regardless of who wins elections, people can win and sustain some of the economic reforms.

The truth is that reforms are inevitable if Sri Lanka needs to move forward and for any political party to sustain its power. Implementing bad policies, especially considering the status of our country, will make it very difficult to sustain power, because then we will be setting the standard for a new normal in economics and politics.

Fiscal path amidst promises and uncertainties

By Dhananath Fernando

Originally appeared on the Morning

Starting from the second week of November, every minute in Parliament will be focused on the national Budget. Fortunately or unfortunately, many of the promises outlined in the Budget are unlikely to be implemented or fulfilled.

At the same time, items that are not in the Budget may be implemented midway through the year, based on the direction of the wind. Things are especially likely to take a completely different turn in an election year.

A key criticism against this Budget is that the revenue proposals to cover up the expenditure proposals are not adequately mentioned. A revenue of Rs. 4,100 billion is expected for an expenditure of Rs. 6,900 billion. It’s akin to wanting to spend Rs. 69 while only having Rs. 41 in hand. The challenge is that we are uncertain as to how we will earn even Rs. 41.

An earlier proposal to increase VAT by 3% and remove the exemptions on VAT can be seen as a measure to increase revenue. There are a few proposals to increase the tax base, which is a step in the right direction, such as the requirement of a Tax Identification Number (TIN) for opening a current account, obtaining a building licence, and for revenue licences for vehicles.

The question that arises is what would happen if we fail to generate even the expected revenue and I think there are three scenarios that can occur if we fail to achieve the revenue targets in the middle of the year.

Scenario 1: Cutting down on capital expenditure

Approximately Rs. 1,200 billion has been allocated for capital expenditure in the 2024 Budget. This includes some proposals such as a new airport and building a few universities. So we will likely have to rechannel some of the capital expenditure to recurrent expenditure if we fail to generate revenue.

What is important to note is that, compared to last year, capital expenditure makes up a lower percentage of total expenditure. So in a context of starting with an already lower capital expenditure base, cutting capital expenditure from key areas of growth such as health or education further will maim our growth in the long run.

Slower growth is also not favourable for Sri Lanka because the need of the moment is growth. Only growth will increase our tax revenue and create more employment opportunities and business opportunities.

Scenario 2: High inflation

The second scenario would be the Government exploring the opportunity to get finances from the Central Bank to bridge the deficit. With the new Central Bank Act, the space for doing this is very low, but if past experiences hold true, anything is possible. There is a transition period of about 18 months and we should not underestimate the crafty nature of our politicians to find legal loopholes.

If the Budget deficit is being financed through the Central Bank (money printing), further increases in cost of living and high inflation are unavoidable. It will also drain our forex reserves and build additional pressure on our currency and likely end up with a currency depreciation after a few months’ cycle: a cycle not so distant in memory.

The Central Bank financing this Budget deficit will also challenge the sustainability of the IMF programme. As the next year is an election year, politicians will mainly think about the elections before the economy, despite promises made. While the new Central Bank Act tries to stop this from taking place, the possibility cannot be ruled out fully.

Scenario 3: Hike in interest rates

The third scenario is where the Government borrows money from the market to bridge the gap and allow interest rates to move. This will not cause inflation as the Budget deficit is not being financed through the Central Bank, but the cost of money will go up (interest rates moving up).

When the cost of money goes up, growth will contract. When this happens, businesses start winding-up operations and expansions become difficult. Also, banks will lend more money to the Government at higher interest rates, slowing down credit for the private sector.

When the economy slows down there may be an impact on the tax revenue on one side. On the other side, with limited growth, achieving debt sustainability will be challenging.

Solution

In order to prevent these scenarios from taking place, it is imperative that we reduce wasteful expenditure. The key solution is to focus on reforming State-Owned Enterprises (SOE). SOE reforms can increase revenue, cut down expenditure, bring down our debt, and attract foreign investments.

The bank recapitalisation of Rs. 450 billion, mentioned in the Budget, is due to the debt owed by two SOEs that have losses which amount to Rs. 1,800 billion. The taxpayer is now expected to pay the bill. It amounts to about Rs. 20,000 per citizen from taxpayer money for bank recapitalisation. That is a staggering Rs. 80,000 per household of four members.

Boosting tourism is also another option. While there is a fund for tourism promotions which has to be utilised well for building our brand image, it will all be in vain if we do not do things as simple as removing regulatory barriers to tourism.

The final bird in our hand as a solution is the Colombo Port City. We have to accelerate the process and attract investments.

If we play our cards right, we can at least move a step ahead in 2024.