Low-hanging fruit from a disastrous harvest

Originally appeared on The Morning.

By Dhananath Fernando

We all want quick fixes to reset the economy. Difficult times like these make quick fixes a vital necessity as patience amongst the public runs thin. However, when an economy grows to a level of high dysfunctionality – as ours unfortunately has – the availability of quick fixes is extremely limited. 

The first step towards economic recovery is for individuals to understand that given the nature of the current crisis, quick fixes simply do not exist. The process of economic recovery can be likened to the growth of a plant. A mere need for a quick harvest does not mean that what is sown can be reaped in just a few days – it takes its own time. All that we can do is to sow the right policy strategy. We will eventually reap what we sow; if we sow the wrong ideas and wrong policies we will have to reap painful outcomes in future, similarly to how we are currently reaping the pain of what we sowed many years ago. 

However, a few quick fixes can still be attempted. One such attempt can be made in the tourism sector. We all know that there is a shortage of fuel for transportation and hotels don’t have reliable electricity. It’s true that tourists consider the situation of the country before they visit, and we are far from presenting an ideal situation. That said, in economic terms what we can do is to provide incentives on the regulatory side for people to visit Sri Lanka. 

One possible measure is to provide an on-arrival short stay visa for selected countries, which will encourage and increase tourist arrivals. Merely maintaining existing regulations will not help in economic recovery as it does not attract tourism. At the same time, Sri Lanka’s aviation authorities charge very high prices for landing and other aviation related services. For example, an economy class flight from Singapore to Colombo costs Rs. 155,000, of which Rs. 35,000 (23%) is incurred in airport and Government taxes. If we reduce those charges, prices of air tickets to Colombo will come down. 

One business leader recently informed me that the price of a flight from Chennai to Colombo was significantly higher than a flight of the same distance and duration from Chennai to other airports in India. Despite the same travel class on the flight, the same quality of staff, and the same distance, the price is mainly driven up by levies and taxes charged when the border is crossed. Given this, bringing down our rates may mean that some audiences may consider visiting Sri Lanka. 

In my humble opinion, when foreign media questioned the Prime Minister on tourism, his answer should have been: “It is a difficult time for all of us, but even with all those difficulties we have the best beaches and the most amazing sunsets and Sri Lanka is still ranked very high on all travel magazines.” 

Nonetheless, we have to keep in mind that tourism alone will not be sufficient to turn our economy around. We made this mistake earlier and attempted to settle our sovereign debt through tourism receipts. Generally, about 80% of tourism income will go back as a USD outflow due to the consumption of imported items required to sustain tourism. At the moment, we have little going for us and this is just a suggestion that is scraping the bottom of the barrel. 

Moreover, we have to establish a unified bankruptcy law. It will take time, but it is needed urgently, and it’s important to start now. With the economic downturn, many organisations have had to downsize or wrap up their operations. This is the same sequence of events that has taken place in other countries that were facing similar crisis situations. 

In Sri Lanka, private limited companies have some cover on bankruptcy, but about 80% of the business establishments in Sri Lanka are Micro, Small, and Medium Enterprises (MSMEs). Most of these businesses are registered as proprietorships or as partnerships. When these enterprises are impacted, closing down the company is often the easiest and least painful option, as it helps the entrepreneurs move forward and get to the next phase of their lives quickly. If they have to spend a lot of time wrapping up their existing businesses that are not sustainable, it will slow down the economic recovery process, as a lot of valuable time, energy, money, and effort of capable people will be wasted on shutting down a company which is no longer viable. Therefore, an easy exit for businesses is as important as easy entry. Unfortunately, Sri Lanka’s labour laws do not support such an exit process and therefore, the process of exit is slowed. 

Finally, while accepting that there are no quick fixes to overcome the current crisis, we have to steel ourselves to go through the tough process of bridging reforms for markets to work. Markets work with credibility, a sound legal framework, and the rule of law. Given that the current situation has more to do with a question of credibility, legal reforms often go hand in hand with political reforms. Therefore, policymakers have to look at the reforms from a holistic point of view rather than just seeking out a quick fix. We are at the stage of sowing seeds for future reaping – if we don’t manage this situation well, we will reap a bad harvest once again.

The opinions expressed are the author’s own views. They may not necessarily reflect the views of the Advocata Institute or anyone affiliated with the institute.

Tackling poverty with competent policies

Originally appeared on The Morning.

By Dhananath Fernando

I learnt poverty through two sources. Firstly, I myself have experienced poverty. 

At university, a basic lunch was served for Rs. 20. It was just three curries, and often the only source of protein was a watery fish curry or half an egg. A watery chicken curry with saffron rice was only served on Fridays. It was a very basic meal. There was an option to get a re-serving for Rs. 5.

The re-serving provided only the curries (not the protein source) on the condition that you went with the unfinished plate. Students who couldn’t afford Rs. 20 for the full meal would wait until a friend finished their first round, borrow their unwashed plate, and join the line for just the Rs. 5 re-serving. At one point in my life I was one of those students. 

That’s why this column has alerted the reader many times to the possibility of rising inflation due to Modern Monetary Theory (MMT). Money matters, and when inflation starts skyrocketing, basic essentials will be in short supply and the poor will suffer. 

Secondly, I learnt about poverty through my volunteer experience at CandleAid Lanka (1). CandleAid is a Government-approved humanitarian organisation founded by Captain Elmo Jayawardena. I have seen and heard so many stories of poverty and overcoming poverty from around the country during my interactions with CandleAid and Capt. Jayawardena. Out of all the stories, the story of Pahalagedara Jayathilaka is simply inspiring and reshaped my understanding of what poverty means for the poor.

Pahalagedara Jayathilaka was a crippled child who started his education in a borrowed wheelchair. His father had passed away from cancer when he was 10. Once, when narrating Jayathilaka’s story, Capt. Jayawardena said: “Jayathilaka’s best meals at university had been a cream bun or a fish bun.”

To cut a long story short, from the bottom of the poverty barrel, with the sheer determination and pure courage of his mother, Jayathilaka successfully entered the University of Moratuwa. He had come to Moratuwa with just his crutches and Rs. 1,000 in hand. Then CandleAid had provided him with an education sponsorship, through which he obtained superb results and a first class in Mechanical Engineering, and subsequently received a scholarship to the National University of Singapore (NUS). Today he is a Postdoctoral Researcher at the Department of Oncology of the University of Oxford (2).

In the terminology of economic research, there are many definitions of poverty, such as urban poverty and rural poverty, but the jargon of researchers is not sufficiently descriptive of the circumstances people find themselves in. When you are actually facing poverty, your decision-making processes, consequences, and outcomes in life are very different. 

For people in poverty, what matters the most is a fair opportunity to have a chance to succeed in life. It is an evolving process and it will never be an overnight miracle. 

They can overcome their circumstances if we establish the proper macroeconomic environment. That is what most of us forget; we forget the basics and try to target poverty without realising that macroeconomic instability causes poverty. 

I believe Pahalagedara Jayathilaka was unstoppable because he got a fair chance to compete as well as  support from a private charitable organisation. He was upskilled, an opportunity was created, and his fate was changed. 

The question during these unprecedented times is: how can we save our poor, and how can we support more people like Jayathilaka to create outstanding success stories? Of course, most people may not have stories as outstanding as Jayathilaka did, but they will at least gradually move above the poverty line and acquire a higher standard of living.

Before any suggestions are made, we need to understand that bringing down the inflation rate is the best way to help the poor. We created this problem of high inflation through bad monetary and fiscal policy, so bringing down inflation and creating stability through competent policy has to be the first priority. 

Furthermore, this column has often suggested the establishment of an efficient cash transfer system through the Government mechanism. While that is still an option, we all know how inefficient our Government apparatus is. 

The other option is to encourage private charitable organisations to help the poor. These organisations have good targeting systems and they have the capacity to reach people like Pahalagedara Jayathilaka and identify those who are truly in need. They are already doing a commendable service at a grassroots level, managing highly agile and impactful charitable projects to look after the poor. 

It would of course be the best case scenario if the Government can manage this, but our experience is that the Government’s management of all affairs is far below even our most basic expectations. 

Most charitable organisations have a far better reputation than the Government, and it is likely that expatriates will be more open to the idea of donating to these organisations than to the State to manage relief for the poor. This will bring in foreign exchange inflows, which will add further relief to our State coffers to manage essential imports.  

The best way to eradicate poverty is by creating wealth. To create wealth we need to first create opportunities, because the easiest tradeable good that the poor have is labour and human capital. We need to set up competitive processes to upskill our labour; poor people will gradually emerge from the poverty trap through the dignity of labour, and not by just becoming henchmen for a political party or by waiting in long queues to get a small cash subsidy or a handout.

A cash transfer system is a must. We should move as fast as possible on this matter. However, looking at how slowly things move with Government bureaucracy, it’s reasonable to assume that this will take time. 

Regardless, poor people cannot stay hungry for long. That is why we have to tackle inflation as public enemy number one and stop adding further inflationary pressures to our economy. Until we get the cash transfer system up and running, private charitable organisations should at least be approached or requested to come forward to utilise their network. They will be able to work faster than the Government and find and support many other Pahalagedara Jayathilakas who can excel. 

I still remember how Captain Jayawardena concluded his long story with a lot of emotion all those years ago. 

Every word I wrote about Jayathilaka is the absolute truth. Jayathilaka does not need colouring.

References:

• https://www.ft.lk/News/some-call-it-courage-e28093-the-definition-is-inadequate/56-39233

• https://www.oncology.ox.ac.uk/team/jayathilake-pahala-gedara

The opinions expressed are the author’s own views. They may not necessarily reflect the views of the Advocata Institute or anyone affiliated with the institute.

Salvaging the debt-ridden National Carrier

Originally appeared on The Morning.

By Dhananath Fernando

Privatising SriLankan Airlines is a hot topic once more, although this discussion is decades old now. Founded as Air Lanka in 1979, the airline was described by Singapore’s Lee Kuan Yew as “a glamour project, not of great value for developing Sri Lanka”. 

In 1998 Air Lanka signed a 10-year management contract with Dubai-based Emirates Airline for 40% of shares and provided the Emirates management the ability to make most of the management decisions. Air Lanka was rebranded as SriLankan Airlines. However, after 10 years, Emirates realised that the Sri Lankan Government was not going to renew the contract. 

According to SriLankan Airlines Annual Reports from 2008, the final year in which Emirates operated the airline, it made a profit of Rs. 4.4 billion. It was mentioned in some reports that this profit included insurance claims after the terrorist attacks on the Bandaranaike International Airport. 

Fig 1: Losses and Profits of Sri Lankan Airlines

However, since then, SriLankan Airlines has not made a single cent of profit. Cumulatively it has lost Rs. 372 billion since 2008. The airline made a loss of Rs. 44 billion in 2019, Rs. 47 billion in 2020, and Rs. 45 billion in 2021. Losses in 2019 were equivalent to 93% of the Samurdhi scheme’s budget – Samurdhi being the main social safety net in place to protect the poor. The losses were also equivalent to 84% and 90% of the Samurdhi budget in 2020 and 2021, respectively. These losses are equivalent to 17% of 2019’s health sector allocation in the National Budget. 

The problem is both clear and dire. We maintain a national airline at a substantial loss and ask the common people, many of whom don’t even possess a passport or haven’t even stepped on an aeroplane, to foot the bill. In other words, we are maintaining a failing  airline at the expense of the education and healthcare of our people. 

There are multiple reasons why SriLankan Airlines incurs losses. It is too politicised and many politicians and their relatives are not charged for extra baggage when they travel. Board appointments and recruitments have all been politically driven. Simply put, it is bad management. The general remedy for bad management is to replace it with good management so we can make the enterprise profitable. This has been the popular suggestion each time that the privatisation of SriLankan Airlines has been proposed. That is the exact thing we have been trying to do since we ended the management contract with Emirates. 

We have to ask ourselves why the outcome hasn’t changed even after the same remedy has been proposed and implemented repeatedly. Simply put, when you don’t invest sufficient money, time, or reputation into a business, no one has the ability to make it profitable. All the business leaders who have been appointed to lead the firm already have their own businesses, so it is obvious that SriLankan Airlines will become a secondary priority. 

Airlines are a very competitive business. Even privately-owned airlines are finding it difficult to compete and maximise profits, so how can we expect a State-owned and managed airline to do the same? There is a difference between a private company making a loss versus a State-owned company making a loss. A private company’s losses are borne by the private investors, who knowingly and consensually made the choice to invest their money in a potentially risky endeavour. But when public companies make losses, taxpayers have to pay and their money will be spent without their consent. How can this be justified, especially in a country like Sri Lanka where people suffer from a lack of basic needs, and when our healthcare, education, and social safety nets need significant improvement?

So what can be done about SriLankan Airlines? SriLankan Airlines’ business has few strategic units: The airline operation, catering, and the ground handling operation. Each section has some assets as well as liabilities. Overall, the airline has a lot of liabilities and debt. Most of the debt is guaranteed by the Treasury (part of it dollar denominated), which is part of the debt that is to be restructured as per the announcement on 12 April 2022.

Table: Debt guaranteed by Sri Lanka treasury for Sri Lankan Airlines

Accordingly, one option is that we ask strategic investors to pitch in to buy SriLankan outright. The bidding process has to be made transparent and competitive. The airline as a group is making colossal losses, so it is unlikely that we will be able to realise significant proceeds from the sale. As has been said, beggars can’t be choosers. 

Another option is for divisions like catering to be sold at concessionary rates to a potential buyer, again through a competitive bidding process, so that we don’t have to shoulder the burden of managing an operation while also closing any future window for corruption.

There is also the option to explore the feasibility of a similar kind of management contract or a Public-Private Partnership (PPP) similar to that which existed with Emirates. However, our airline is now in such a poor shape financially that the feasibility of a management contract is questionable. 

There are suggestions to list the airline on the Colombo Stock Exchange and allow investors to buy shares. Generally listings are successful when the company is doing well. At the moment, given the present economic conditions of the country and the historical performance of the entity, this may be challenging.   

Finding a strategic investor through a competitive bidding process is still a possibility given our connectivity with the main South Indian airports. Some Indian and international airlines may have an interest in expanding their network and will see a potential win-win situation. 

We have to begin the process of privatisation as it is obvious that we can’t run a business on taxpayer money at a time when the people are struggling for their basic survival. The citizens of Sri Lanka gave the management experts of all political parties and their close associates multiple opportunities over 14 years to turn the airline around and bore significant losses in return. Let us hope that policymakers will understand the gravity of the situation and that they will not allow such a huge drain on our coffers to continue unimpeded. 

For explanation of SLA losses for 4 years.

The opinions expressed are the author’s own views. They may not necessarily reflect the views of the Advocata Institute or anyone affiliated with the institute.

Becoming the victim of one’s own policies

Originally appeared on The Morning.

By Dhananath Fernando

At a recent press conference, the Central Bank of Sri Lanka (CBSL) announced that importing goods through open accounts was going to be banned as a move to curb the money transfer through undiyal and hawala. In my view, this will have a negative impact on the supply of essential food items, drugs, and some raw materials. 

When a merchant imports goods, they can pay their supplier through a letter of credit. A letter of credit is simply a letter of guarantee by a bank or a financial institution to the supplier/seller that the correct amount will be paid in full on time. To open a letter of credit, the Sri Lankan importers should be able to buy foreign exchange or simply purchase US Dollars. But as we are all aware, all Sri Lankan banks have a drastic shortage of foreign exchange. The shortage is of such severity that we can’t import essentials, and in some cases even life saving drugs. 

In the case of imports, if the buyer and the seller have mutual trust, a letter of credit is not mandatory. They can settle on a credit basis later on. The goods will be cleared on Documents against Payments (DP) or Documents against Acceptance (DA). Most importers and their buyers/suppliers have long-standing business relationships. They pay later either through different modes including hawala and undiyal. This is no secret. They pay an additional charge for hawala and undiyal to buy USD for a reason, which is simply that our banks don’t have sufficient dollars to facilitate imports even if the importer requests the opening of a letter of credit. Otherwise, no businessman would want to pay a higher price for forex if there were cheaper options available. Especially in the areas of food, medicine, essentials, and raw materials, these open account transactions are common. According to a recent news report, approximately $ 1.6-1.8 billion worth of transactions are done on open accounts every month. 

So what could happen when the Central Bank forces these importers to conduct transactions only through letters of credit? Simply put, they may not have any option other than to stop importing. Because banks don’t have USD, they can’t even import on open accounts to settle later. The Central Bank expects more USD to flow into formal channels since the demand for USD through undiyal and hawala is set to decline with the new regulation banning open accounts. Even if the Central Bank’s assumption is right, it won’t happen overnight. Given the uncertainty, importers will either hold or slow down the imports to observe the situation. It will take a few months to settle even if all USD inflows started flowing through official channels. What would happen to our essential food items, certain raw materials for businesses, and drugs during those long months? 

However, so far the Gazette notification has not been issued by the Central Bank, and we have to wait and observe the situation in the next few months.

It is not the first time the Central Bank has burnt its fingers by unnecessary attempts to control the market. 

First, the Central Bank imposed a 100% cash margin requirement on vehicle imports in 2018 and later vehicle importation was banned completely (1).

Later, the Central Bank’s 100% cash margin requirement on selected imports categorised as non-essentials was extended from vehicles to many other imports (2). This column questioned how an officer decides what is essential and what is not essential. A digital camera may not be considered an essential by a writer or a banker, but a camera is an essential to a wedding photographer whose livelihood depends on it. 

Then, the Central Bank stopped the forward purchasing market and only provided space to open letters of credit with a 180-day limit. 

It was then decided to artificially keep the currency at Rs. 200 per USD, and the undiyal and hawala market expanded dramatically.

All the main Key Performance Indicators (KPI) of the Central Bank have been eroded drastically during the same period in which these controls were imposed. Our inflation has increased to 29.8% and our food inflation has increased to almost 50%. Our currency has depreciated by more than 75% in a matter of a few months. Simply put, our Central Bank has fallen far short on all its key indicators regardless of back-to-back controls and interventions. Many new theories employed by CBSL economists, including Modern Monetary Theory, have backfired spectacularly and unfortunately it is the poor people who have to pay the ultimate price in hunger and inconvenience for the grave mistakes of the Central Bank and the Monetary Board.  

As a remedial action to these mistakes, our Central Bank has now made an attempt to ban open accounts and cripple the undiyal and hawala systems. 

In my humble opinion, this may potentially create shortages of essentials and inconvenience the traders and importers who have been supplying the essentials at a higher price. These merchants have been bearing the higher cost of the informal markets boosted by the Central Bank due to mistakes beyond their control made by policymakers. 

We have to first ask ourselves why an importer should bear a higher price on USD to import. Without fixing our monetary policy, there is no point passing the blame to the hawala and undiyal markets. They have existed for centuries in Sri Lanka and around the world because of their competitive and evolving nature. The buck stops with policymakers, and not with merchants or foriegn currency middlemen.

Quite frankly, it will accomplish very little to close the stable door after the horse has already bolted.  

References:

• https://www.cbsl.gov.lk/en/node/4093

• https://www.cbsl.gov.lk/en/news/margin-deposit-requirement-of-importation-under-letter-of-credit
  

The opinions expressed are the author’s own views. They may not necessarily reflect the views of the Advocata Institute or anyone affiliated with the institute.

Walking the talk on reforms: First step to Lankan recovery

Originally appeared on The Morning.

By Dhananath Fernando

Often we all see the world the way we want to see it, and not as it is. Sri Lanka’s economic crisis is also seen by many people through their own perception of reality. 

In previous years, we believed that self-sufficiency, State-led industrialisation, State-centred economic planning, and more recently, Modern Monetary Theory, were the way forward for our economy. The current crisis has shown that none of that has really helped us; by contrast, it has exacerbated a poor situation to where we are today.  

Next comes the question of overcoming the crisis. This has to be analysed with context; the most significant piece of context is that we are facing the worst situation we’ve been in since independence in 1948 – and it is only getting worse. 

There are some suggestions to increase industrialisation, improve exports and the trade balance, and incentivise Foriegn Direct Investments (FDIs). However, it is of no use to have lofty goals of industrialisation when we can hardly provide an uninterrupted electricity supply. 

Foreign investors are planning to leave. Investors are by no means considering entering the country. Thus, potential solutions have to be evaluated based on this context. Simply having a wishlist of suggestions with minimal viability will add very little value at this juncture. We need rational solutions to solve the crisis immediately, rather than policies that can only be enacted in times of relative normalcy. 

The Government needs to bring its finances into a sustainable state. Revenue must increase and expenditure should be reduced. Reducing the losses of State enterprises is a way to reduce the deficit without touching social expenditure.

With that in mind, here are a few suggestions for reform:

1. Privatise SriLankan Airlines

At a time when people are struggling to feed their families and when our official usable reserves are less than $ 200 million, there are very few upsides to running a fully State-owned airline making losses equivalent to the value of our entire Samurdhi scheme, which, despite its flaws, is the main social safety net in Sri Lanka. Privatisation will provide strong signals that we are serious about reforms. 

For the last 15 years, we have not made any profits on SriLankan Airlines. We can disclose all finances and ask for interested companies to buy it outright with assets and liabilities. Having a higher liability than assets is the main problem in this instance. With the suspension of debt repayment of State enterprises, Treasury guarantees for the State are on hold at the moment. 

Even if we need to pay a certain amount to the buyer to take it off our hands and sell it off with staff, it is much better than keeping the enterprise in-house and incurring colossal losses repeatedly. The new buyer can be given the responsibility of staff restructuring. We can follow the playbook through which Air India was sold outright by the Modi Government. Our airline is unfortunately no longer an asset but a liability to our national coffers. 

However, it is not only the National Airline that makes losses. There are many institutes that add little value to the public, make massive losses, and are a very high burden on the Treasury. Some of these public enterprises are classified as ‘strategic’ and others as ‘non-strategic,’ but two things they have in common is that, more often than not, they make substantial losses and have very limited transparency. 

There were some discussions to revive Sri Lankan Airlines by appointing business leaders with a profit motive, converting it to a budget airline, and appointing committees to reform and restructure. We have run out of time to even attempt these options. Unfortunately, hard times require hard decisions and we do not have the time, money, or options to avoid them. 

With interest rates and Treasury bill interest rates reaching above 20%, running loss-making enterprises on borrowed money will make our local debt increasingly unstable the more we delay reforms. Most importantly, we don’t need to wait for pressure from creditors or the International Monetary Fund (IMF) to kickstart reforms; we can begin them now.

2. Better utilisation of idle assets

Improving service efficiency and increasing revenue of railways through Public-Private Partnerships (PPP) have to be the way forward for better utilisation of idle assets. 

Sri Lanka Railways is categorised as a department of the Government, even though it is actually a State-Owned Enterprise. Sri Lanka Railways holds a considerable amount of State land which is used very unproductively. 

Fort Railway Station, Maradana Railway Station, and the surrounding land along the track between these two stations are prime examples. Major railway stations such as Kollupitiya, Wellawatte, and Bambalapitiya are all prime beachfront properties which are very poorly maintained and completely underutilised. Land prices in Colombo are extremely high. There are plenty of such examples under the Railways Department with zero or negative value addition to our economy. Sri Lanka Railways first has to be made a State-Owned Enterprise, and then the sector needs to be opened for private sector investment. 

In the past, some train compartments were operated by private players and it was a very successful and lucrative business model. If we eliminate the State railway monopoly and open up the time table, tracks, and properties to the private sector, we can cut down on our fuel consumption significantly, provide a convenient service to passengers, and even turn a loss-making liability into a revenue-generating asset.

Given the very high energy prices at present – which are only set to increase – many people need the option of efficient and robust public transit infrastructure. In any case, the majority of people in Sri Lanka cannot afford to purchase and operate personal vehicles, and trains have been the main source of transportation in areas where they are available.

It is also of paramount importance that the most vulnerable segments of the population benefit from a rehauled cash transfer system, which should cover the energy price component in public transport. Everyone, regardless of their socio-economic stratification, should be given a fair chance to compete in life. 

However, it should be emphasised that these two steps alone will not help overcome the crisis. However, it is a good start to get the wheels rolling on reforms. These reforms will provide an unambiguous signal to investors and the world that we are no longer a NATO (No Action, Talk Only) nation, but a nation that walks the talk.

The opinions expressed are the author’s own views. They may not necessarily reflect the views of the Advocata Institute or anyone affiliated with the institute.

How protectionism killed Sri Lankan industry

Originally appeared on The Morning.

By Dhananath Fernando

Sri Lanka’s economic crisis was probably a crisis which was analysed (indeed over-analysed) and predicted from an early stage, but we failed to avoid it. We all knew that it was coming and therefore remedies were presented much earlier, but our policymakers simply turned a blind eye. They didn’t have the courage to face reality. Instead, they thought that wishful thinking would save Sri Lanka from the current crisis, and today, we have hit rock bottom. Unfortunately, we are just at the beginning of the crisis and have not even reached the recovery phase.  

It is important to reiterate that self-sufficiency, Modern Monetary Theory, industrial policy, protectionism, and import substitution failed yet again, and this time brought our people down on their knees. While we look towards solutions, we must also understand that it is not easy to rebuild an economy once it collapses. Recovery takes time, and recovery can only happen with the right set of policies.

There is one school of thought that argues that the lack of industrialisation is the reason for Sri Lanka’s balance of payments crisis. The main argument is that if we produced more to export, we would have had more USD revenue and this crisis would not have taken place. So the argument again comes back to import substitution, which involves banning imports or imposing higher tariffs on imports in order to produce locally. The argument is that this can save import expenditure while local manufacturing can scale up in order to focus on exports and bring export revenue. In the same theory, it is recommended that the government picks up which industries should be supported and which industries should not. This is simply going back to the same theory of the central planning model where a few officers decide which industries are good and which are bad. Often quoted examples for this are Japan, South Korea, and Vietnam. So today, let’s evaluate the strategy of industrialisation based on market principles. 

In simple terms, you become a good sailor by facing rough waters. Similarly the government selecting which industries to support and which industries to avoid will have consequences for all industries. Industrialisation should take place in a market system that optimally allocates all the available resources. If the government intervenes to assist one industry, it will have a knock-on effect on all other industries. Japan is indeed a classic example. The high-powered Japanese Ministry of Trade and Industry (MITI) recommended that Toyoda not produce cars. But he ignored their advice and today no explanations are required on Toyota’s success and competitiveness. In fact, in our apparel industry, big companies follow Toyoda’s example in the lean manufacturing techniques they pioneered. Rather than providing government support, price controls imposed by the Japanese Government impacted the automobile industry. So government intervention in the markets and industries is a sure recipe for failure. 

In Sri Lanka’s case, industries such as wall tiles, floor tiles, steel, aluminium, bathware, shoes, confectionery, and many others have been protected for decades. Have they become globally competitive due to protectionism and import substitution? In fact, import substitution is the worst we can do to develop exports because it creates an incentive to only produce for the local markets and discourages producers from producing for the global market given the tariff and non-tariff protection. Do our rubber, seafood, apparel, and electronic chips industries require any protection for them to be globally competitive? The simple answer is: no.  

In cricket terms, we can’t create a world class batsman by asking the bowlers to bowl loose deliveries. We can’t create a good bowler by asking the batsman to go soft on bowlers. Only in a competitive environment are heroes created. The protection is a sure way of killing the heroes and robbing poor consumers and exporters simultaneously. That is exactly what we have been doing for the last few decades. 

No export promotion can be done through import substitution; in fact, import substitution is killing our export potential. When the exporters have to pay more than 40% higher for construction materials, it is impossible for even our best performing exports to be competitive in global markets. 

If we observe the trade data, it is clear that our imports and exports are both declining as a percentage of GDP. In 2009, Sri Lanka had nine import taxes in addition to standard customs duties, and five of them are ‘para-tariffs’. Between 2004-2009, our total nominal protection doubled from 13.4% to 27.9%. Higher protectionism also indicates our continuous drop in both imports and exports.

Things got worse over time. The average effective rate of protection for manufacturing production increased from 47% to 63% from 2000 to 2015, and production for the domestic market was over 70% more profitable compared to production for exporting (World Bank, 2005; DCS, 2018). 

Accordingly, industrial policy and import substitution are contributory factors to where we are today with low exports and low productivity in the economy. 

In the history of industrialisation there are certain instances where some countries protected local industries, but in the success stories, protection had been given for a specified, strict time period or output and had a price-based structure.

Countries such as South Korea and Vietnam too became competitive not through import substitution but by allowing the markets to work. In a paper authored by Advocata Advisor Prof. Premachandra Athukorala, he quotes General Park Chung-Hee, who is considered the father of the Korean economic miracle: 

“The economic planning or long-range development programme must not be allowed to stifle creativity or spontaneity of private enterprises. We should utilise to the maximum extent the merit usually introduced by the price mechanism of free competition, thus avoiding the possible damages accompanying a monopoly system. There can be and will be no economic planning for the sake of planning itself.”

The opinions expressed are the author’s own views. They may not necessarily reflect the views of the Advocata Institute or anyone affiliated with the institute.

Compounded crises: IMF the only way out

Originally appeared on The Morning.

By Dhananath Fernando

Economic crises are difficult to solve. In the case of a natural disaster, we know that it will come to an end at some point. We just have to manage for a short period until everything settles. By contrast, economic crises are different. They generally come in a package of five separate but intertwined crises if not managed well. It is clearly best to avoid crises, but when the crisis hits, and if we fail to manage it, the situation becomes significantly worse. Sri Lanka, unfortunately, seems to be managing the situation badly. 

What we are currently experiencing is the balance of payments crisis. Simply put, we don’t have sufficient US Dollars to import essentials, including fuel and medicine. As a result, the lifestyle that we used to live cannot be sustained as long as these conditions prevail. 

The second crisis just around the corner is the debt crisis. We have a $ 1 billion payment to be paid on 25 July and our usable reserves amount to only about $ 150 million. It has clearly come to the point where restructuring debt is unavoidable. Debt restructuring will be a painful process for creditors and debtors equally. This will have an unavoidable impact on the local economy. Additionally, the debt restructuring can be done with an IMF programme. The IMF is the only organisation that can bring credibility to a country that has proved that “it is not good for money”.

The critical question is, how is Sri Lanka going to finance its trade until we negotiate with the IMF and have an agreed-upon programme of restructuring debt? If we had sufficient reserves, we would at least have had a backup option, but we all know reserves are not built for day-to-day imports but for an emergency situation like Covid-19. The other option is to get support from bilateral partners until we finalise the negotiations. Even for that to take place, generally an IMF programme is essential as they need to have some assurance that the money will be utilised to import essentials but not to bail-out any bond holders. Hence it is essential to enter into an IMF programme as early as possible, rather than beating around the bush. 

In an ideal scenario, as a country we should have moved forward with reforms before going to the IMF seeking funds and advice. Indeed, if we had carried out these reforms at the right time, then we would not have needed to go to the IMF. But if we are not doing things correctly, it’s sensible to go to the IMF, not only because of the money, but for credibility and discipline. The current situation is that we are already late – and the clock is ticking. There are massive shortages nationwide, which have the potential to get worse. The Government is yet to be clear about whether we intend to have an IMF programme and even as this article is being written, the country did not even have a finance minister to initiate any such discussions.

The third crisis of the package is the financial crisis. Particularly in the process of debt restructuring, some of these bonds are held by domestic banks. So restructuring will affect the local financial system. Furthermore, most of the local banks have extended credit guarantees for State-Owned Enterprises (SOEs) and it is likely that their debt will also be required to be restructured. So the impact on the financial sector can trigger a third crisis.

As these triple crises bear down, the political capital enjoyed by the Government will undoubtedly wear away. As a result, political instability will start kicking in. Especially in a country like Sri Lanka, where most essential services like fuel, electricity, and water are provided by the Government, the moment interruptions start, public resistance increases at a higher rate. In the Sri Lankan case, the political crisis has overtaken the debt crisis and the financial crisis. We are in the middle of a political and balance of payment crises and the other two crises are just a matter of time. 

The final crisis in the package is the humanitarian crisis. Especially if we fail to secure some funding lines without also delaying IMF negotiations, there is a risk of extended power cuts and further deterioration of living conditions. This can trigger a humanitarian crisis. If we drift to a disorderly default, as the Financial Times reports, “Disorderly default is the same as civil war.”

Already there are stories in the news about shortages of medicine and medical equipment and postponement of surgeries, all of which impact the humanitarian needs of the people. So urgent action is needed! However, Sri Lanka is in a complete state of dysfunction; there is no solid Government or cabinet ministers to make decisions, while public resistance keeps mounting. 

The nature of an economic crisis is that one crisis will keep instigating another and it’s not going to just go away. It takes a lot of time to overcome after things go out of control. 

We are very far behind and we need someone who really understands the depth of reforms needed and the work plan we have to adhere to. The general optimistic sentiment of ‘this shall too pass’ really won’t work here. We have expected the same to happen for a long time but it really hasn’t happened. 

Before we move to reforms, we need to keep in mind, for future reference, the cost of bad economic policy. Self-sufficiency, protectionism, intervening in markets, and ad hoc policy decisions are a recipe for a disaster and sadly we are facing one now.

We have to immediately increase interest rates and remove all surrender requirements by the Central Bank. In an economic crisis, dimensions are different. We have to immediately go to the IMF with a short- and medium-term plan with political consensus on implementation for the next five to eight years.

The problem and the solutions are already known. We need credibility, commitment to undertake reforms, and competence for execution of reforms to overcome. 

The opinions expressed are the author’s own views. They may not necessarily reflect the views of the Advocata Institute or anyone affiliated with the institute.

A cornucopia of crises: Refuge lies in reforms

Originally appeared on The Morning

By Dhananath Fernando

Many people call me and ask what the economic crisis looks like and how they should feel about it. I always say to them, “The economic crisis is like a long night where you can’t fall asleep even when you are sleepy. At the same time, you don’t know when the sun will rise and the night will be over. You are sleepy and tired but still you can’t fall asleep.” 

This economic crisis is the same; the future is becoming uncertain and we are not sure what will happen. As Prof. Riccardo Hausmann said at an Advocata session in September 2020, “An economic crisis comes slowly, and then suddenly.”

The nature of any economic crisis is that it often comes with many other crises. Currently we are suffering from a balance of payments crisis. Simply, it means we do not have enough foreign exchange to buy essentials such as fuel, food, energy, power, and other products that we need to survive on a day-to-day basis.

The second phase is generally the interruptions of services. For example, at present with long power outages, our telecom sector is in trouble; cell towers may not be able to provide the same voice call clarity, service, and internet services as in a normal environment. So every economic activity connected to the internet is going to be affected and the jobs and income will be affected. Many young people who are internet freelance workers will lose their income and the country will erode more foreign exchange inflows.

Another example is if vehicle battery manufacturers cannot get necessary packaging material. After a few months, there will be a vehicle  battery shortage which will impact all vehicles which use batteries to start their engines. All that is just the impact to the common man due to the BOP crisis.

The second crisis is the brewing debt crisis. At the moment the debt crisis has been overtaken by shortages and long lines. But with a $1 billion payment due in July the debt crisis is knocking at our door. We haven’t made any announcements to warn our creditors yet, so the impact of debt restructuring will be felt by our entire financial sector as well as all State Owned Enterprises with credit guarantees provided by banks. 

Economics is always connected with politics. With a BOP crisis combined with a debt crisis impacting the fiscal  sector is affecting the entire political structure. This problem is at a much deeper level where whoever and whenever in power will not be able to have quick fixes. Most of the solutions are painful and already we all have become victims of the pain of shortages of basic essentials such as fuel and electricity. 

However still we can attempt to do a few quick fixes but the actual solutions are with deep economic reforms, which this column has advocated for a long time.

We have to increase the interest rates and remove all forex surrender requirements by the commercial banks to the Central Bank. At the moment interest rates are too low compared to inflation. In simple terms our inflation is at about 17%. Our interest rates are at 7-8%. So if someone deposits money at a bank, the value of the money will fall at 17% and the interest rate is only 8% so the net loss would be 9%-10%. As a result, people are more encouraged to spend money than save. When people spend money, the demand for imports is going to increase regardless of some import controls or licensing schemes.

If you inquire from businesses, generally they have high demand but the problem is they can’t supply because of supply chain interruptions due to lack of foreign exchange. So interest rates have to increase to a viable level to stabilise the economy and minimise pressure on inflation. If an economy is functioning well, we can keep the interest rates low by making it easy to access capital. But in the middle of a forex crisis we can’t afford to keep interest rates low. 

One reason for the LKR to continuously depreciate is the low interest rates. The second reason is the surrender requirement of 50% from the commercial banks to the Central Bank. The simple meaning of this is that all banks have to sell 50% of their USD income to the Central Bank at a lower rate/price. So banks may only have 50% of the balance in the market to give it to the importers and everyone who is asking for foreign exchange. As a result the exchange rate is constantly increasing and people who have foreign exchange are holding it, expecting rates to go up further. 

The final outcome is that there is a massive shortage of USD in the banking system and the black market forex trades have been highly active. It was reported that the Central Bank had suspended the licence of one money exchanger. The prevailing system will most likely exacerbate the problem and forex shortages will further increase. 

We have to immediately clear many grey areas in our stance and policy. Then a clear direction has to be provided on the stance of whether we should approach the IMF or not. Since the IMF’s Article IV report states our debt is unsustainable, it is clear that we have to restructure our debt if we were to get into any IMF programme. Until then only technical advice can be accessed. Even in our debt restructuring, we haven’t been very clear and our messaging has been so weak for markets to make any concrete decisions. Not providing clarity on these critical areas is going to extend the crisis.

The dark night of the economic crisis will last longer than we think if we move at this speed and we may even run out of candles due to the unavailability of naphtha which is a petroleum product. The solution is reforming now! 

The opinions expressed are the author’s own views. They may not necessarily reflect the views of the Advocata Institute or anyone affiliated with the institute.