Supporting MSMEs requires more than parate suspension

By Dhananath Fernando

Originally appeared on the Morning

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Graph 1 

Economic sectors with high NPL ratios 

Graph 2 -

NPL ratio

A new era or more turbulence?

By Dhananath Fernando

Originally appeared on the Morning

• The challenges facing Sri Lanka’s next president

The Presidential Election has been announced. Ideally, by 22 September, there will be a new president with a new mandate from the people.

Sustaining power will be more difficult than winning the election. Generally, from the very first day after assuming office, things start to fall apart. This will be the first election after the ‘Aragalaya,’ and we do not know the ground reality.

The last power transition wasn’t smooth. While there was a democratic element in appointing the eighth President after the resignation of the former, that episode had many dark elements, including a massive economic contraction and impact on human lives.

Focus on economics and corruption

Previous elections had a national element, but this time the focus is completely on economics and corruption. The good news is that the path forward is well defined, including macro targets. The International Monetary Fund (IMF) Governance Diagnostic has provided the main reforms needed to curtail corruption, with timelines and responsible institutions. Most of these are non-controversial.

This time, all candidates will also have to declare their assets electronically. We, as the people, should demand that the Commission to Investigate Allegations of Bribery or Corruption (CIABOC) enforces this.

The new president must deliver on anti-corruption promises because the demands of the ‘Aragalaya’ have not been met yet. However, some promises, like recovering assets overseas, are not easy to execute. Therefore, delivering on the anti-corruption sentiment is challenging.

Delivering on the economic front is equally tough. After debt restructuring, our interest rates will likely remain high. When interest rates are high, the cost of capital is higher, slowing down investment.

For instance, buying a computer to automate manual work becomes difficult when money is hard to source due to high interest rates. As a result, our economy will not grow. If the economy is slow to grow, it invites another crisis. Simply put, if the economy doesn’t grow, our debt will not be sustainable.

In other words, if the economy is slow to grow, it indicates that we are heading towards another debt crisis. The next leader must ensure both growth and stability.

The second piece of good news is that we at least have an idea of what targets we need to achieve on the economic front. Our debt-to-GDP ratio must gradually come down to 95% and our revenue must increase by improving our tax net.

Many promises about increasing Government sector salaries and public sector expenditure are good, but will be difficult to keep.

Limited options

In this context, there are two limited options available to increase money and productivity.

The first is improving productivity in what we already do. Simply working harder and putting in more effort can help. For example, reducing the number of holidays by 10% should increase the economy’s momentum because people will work more. But this race cannot be won solely by working harder. We must also look into channels for improving productivity without capital investments.

One such area is opening up business ventures that change the business format. For example, app-based taxi companies have significantly improved the productivity of both passengers and drivers by connecting potential riders with drivers. Companies like Booking.com connect tourists looking for lodging with small-scale lodging options.

Changing the business model has increased income for many people, reduced expenditure for many, and decreased waiting times, increasing overall productivity. The new leader must leverage this productivity lever.

The second option is to reform State-Owned Enterprises (SOEs) to attract capital. Allowing SOEs to undergo privatisation and Public-Private Partnerships (PPPs) can attract capital through investments. Additionally, rather than incurring losses, private entities can generate revenue for the Government through taxes and improve productivity.

The third option is to release land to improve productivity and circulate capital. Providing land ownership to people allows them to use it as security to unleash capital from the banking system, improving productivity.

Beyond these three options, any president will have limited choices. Relying on geopolitical powers in a highly volatile geopolitical environment may also be unfeasible.

Therefore, the challenge for the new president extends beyond getting elected. The real challenge is navigating the period after the election, which will undoubtedly be tougher than getting elected.

Delaying elections threatens political and economic stability

By Dhananath Fernando

Originally appeared on the Morning

Whenever there is an election, there is always a conversation about delaying it. Already, Provincial Council Elections and Local Government Elections have been delayed. This was the case in 2004/2005 and again in 2019.

One rationale is that, having just achieved stability after a massive economic crisis, we need more time to complete some structural reforms and ensure political stability. On the flip side, how can we execute any reform without the mandate of the people? Operating without the people’s mandate means political stability is the first thing to go out the window.

After the resignation of the former President, the process of appointing a new President followed a democratic process. While it may not have been perfect, there was a democratic element involved. Political parties with a mandate from the people were able to contest, and the candidate who could command a majority of confidence through votes was given the responsibility to lead the country for the remaining term of the previous President.

Despite its flaws, this democratic element brought political stability, which led to economic stability. With the President’s support from Parliament, it was possible to enter into an agreement with the International Monetary Fund (IMF) and continue discussions with external and internal creditors for debt restructuring. The political stability that came through the democratic element in the power transition process made it possible to achieve some level of economic stability.

Uncertainty and economic growth

However, the same democratic process has clear guidelines on the expiry time of the mandate. If we do not follow this process, the system that brought stability will push us towards instability again.

Delaying or attempting to delay elections often prompts political parties and their supporters to demand elections, creating instability as people seek to test the mandate of the public. Delaying an election in the hope of completing unfinished reforms rarely works as planned.

Moreover, postponing elections increases uncertainty. Even holding an election carries some uncertainty, but postponing it intensifies this uncertainty. The biggest enemy of any economic development is uncertainty.

After debt restructuring, the only way out for the country is economic growth. According to agreements with bondholders, we start repaying our interest from September onwards. A year of uncertainty will hinder even the small growth potential we have.

For economic growth, we need investments, and in an uncertain economic environment, attracting investments will be difficult. Falling behind our growth targets due to political uncertainty will challenge our debt repayments and credit rating updates.

International support may not be as easy to secure if the legitimacy of the Government is questioned over a delayed national election. It is true that elections themselves have an element of uncertainty. Especially post-Presidential Elections, if Parliamentary Elections result in fragmented party compositions, we risk returning to a scenario similar to President Chandrika Bandaranaike Kumaratunga’s era, with a Coalition Government barely holding a majority.

Passing bills during a time when growth and structural reforms are needed could face resistance and pushback, leading to maintaining the status quo rather than shifting gears for growth and development.

Having a majority or even two-thirds power does not guarantee that all decisions will be right or fast. As we witnessed, a two-thirds majority Government was short-lived due to misguided economic policies. However, a diluted majority will also bring instability and frequent power changes, causing things to go back and forth.

The solution: A common reform programme

If we think about the country and the people, the only solution is a common minimum reform programme where parties agree on a baseline level of reforms. This ensures that regardless of who comes to power, progress continues. The common minimum programme can start with implementing the IMF Governance Diagnostic, which has recommended significant structural reforms for fiscal, monetary, anti-corruption, and State-Owned Enterprise (SOE) sectors.

If we can at least implement the IMF Governance Diagnostic Report as a common minimum programme, even in case of a drift, it will be slow. Delaying elections, however, will accelerate the drift and slow down existing reforms and growth.

The real challenge will be for whoever comes to power next. If the next government cannot drive economic growth through improving productivity, investment, and efficiency, another collapse is inevitable. A common agreement on reforms is required because the common people care less about who rules the country and more about how their future and standard of living will improve.

The dangers of the Online Safety Bill

By Dhananath Fernando

Originally appeared on the Morning

The Online Safety Bill is scheduled to be taken up for debate at its second reading in Parliament on 23 and 24 January. Unfortunately, this bill is going to make our current economic situation a bit more difficult in the short run and as well as the long run.  

The Asia Internet Coalition (AIC), where tech platform giants such as Google, Meta, and Amazon are partners, twice brought up the danger this bill could pose to the digital economy.  

Economy is beyond just supply and demand of rupees and cents. Economies are mainly the ideas that solve a problem of fellow humans and an exchange of those products and services with scarcity of resources. 

Problem-solving for humans comes with the freedom to think and with freedom of speech and dissemination of information. All attempts to restrict our freedom of expression, speech, and dissemination of information will backfire on the country and the economy. 

Sadly, the Online Safety Bill seems to be doing just that.

Self-censorship kills ideas for prosperity 

The bill has left significant room for vagueness in many clauses and definitions. According to the proposed bill, the commission appointed by the Constitutional Council has the powers to determine whether some facts are true or false and take follow-up actions. 

One example to showcase the impractical nature of this approach is the case of the Government decision on cremation of Covid-infected bodies, claiming that viruses could leak into the waterbed and cause contamination. This decision was highly debated on social media platforms and even scientists were divided on the decision. 

So if someone complains based on the Online Safety Bill, how does the committee decide on what is true and what is untrue when even scientists are unsure? Later the Government withdrew its decision and changed its initial stance. What was perceived as truth at one point was proved to be wrong at another point. What could have been the outcome if the Online Safety Bill had been enacted by then and if legal proceedings had been taken forward for those who commented for and against cremation of Covid deaths?

Looking at lessons from history, Galileo was killed for bringing an alternative view of the perceived truth on the shelving of the solar system. This act in this form takes us back to the repression faced by Galileo. It is severely problematic when the arbiter of ‘truths’ of fringe politics can also hand out punishments.

Generally when there is uncertainty, for their own safety, people engage in self-censorship. Self-censorship restricts the flow of ideas and minimises the ability of the economy to solve the problem. 

Let’s imagine that the Online Safety Bill had been enacted before 2021. During that time many analysts and economists on all social media platforms warned the Central Bank that excessive money printing could lead to inflation. The Central Bank was of the view that there was no relationship between money printing and inflation. So if the Central Bank complained to the Online Safety Commision on the opinions on the matter, most of the economists would have been punished by the bill by the time inflation was hitting 72%.

If the Central Bank says inflation has no relationship to money supply, there would have been no other way the commission could establish what was true or what was false at that point of time. The other possibility is that most of the economists would have self-censored knowing the repercussions of the bill, which could have caused greater harm to society.

If this bill creates a culture of self-censorship, our ability to hold the State accountable, ability to innovate, and ability to create would be quenched, leading to a stagnant economy. 

Impact on SMEs

The business models of tech giants are very cost effective. They do not have offices in every country, nor staff to monitor all content. Most of that is done through algorithms. They regulate harmful content through technology (algorithms) and very strict community guidelines are adhered to.

Anyone can read how comprehensive the guidelines of these tech platforms are on safety and trust and how effective they are on responding to these platforms’ community guidelines. Tech firms have refined algorithms to an extent that not a single photo falling under nudity can be found as the algorithm restricts them automatically. In that sense the tech companies have done a fantastic job compared to what a government tries to do with a bill in a market-based system.

Platforms such as TikTok are not only concerned about human rights but also about human safety, where drone shots with a risk of accidents are eliminated due to very high community standards.

If the Online Safety Bill becomes too much of a burden for these tech companies, with a response time of 24 hours for inquiries by the commision as per the bill, they will tune their algorithms to be very strict, which will have an impact on SME businesses run on social media. Simply, the competitors can complain on certain pages featuring products with various claims and pose an unnecessary burden to SMEs. 

Our tourism industry, where we have a long-tail SME sector, especially uses these platforms for room reservations. The reviews coming in the form of discrimination will fall under this and the booking sites will also fall under that purview, so they are likely to react to the online safety regulation, which will have an impact on our dollar-earning tourism industry.

The AIC has already twice highlighted its displeasure in diplomatic language, claiming as follows in a statement: “The proposed legislation, in its present form, poses significant challenges that, if not addressed comprehensively, could undermine the potential growth of Sri Lanka’s digital economy.”

Wrong signals to markets 

The Online Safety Bill also provides wrong signals to the market, including the International Monetary Fund (IMF) and our creditors. The IMF has provided a governance diagnostic where many other pieces of legislation, including the SOE Holding Company Act and Procurement Law, are among the top 16 priorities. Sadly our Government has brought a bill on Online Safety Bill, for which no stakeholder group which assisted Sri Lanka during the economic crisis has shown any interest other than highlighting its problematic nature, which ultimately impacts economic growth. 

Since actions speak louder than words, this will provide the wrong messaging to our creditors, bilateral and multilateral partners, and investors that our Government’s priority is not the economic crisis.

From the point of view of the investor, this will also have a serious impact on attracting FDI and key players with the potential to transform our economy. For instance, one company which has shown interest in investing in Government shares of Sri Lanka Telecom is Jio, where a majority share is with Reliance Group in India. Meta, Google, Intel, and the Saudi Arabia Wealth Fund are a few other strategic partners and shareholders of Jio. Can we expect a tech company to provide a positive referral to its main shareholder in an investment decision when its own platforms are under risk through an Online Safety Bill in Sri Lanka?

This bill is beyond repair and just plastering over its shortcomings will not make it any better. If this goes through Parliament, the risks on freedom and signalling for investors will be quite negative. Importantly, in an environment where freedom does not prevail, economic growth and prosperity will fail drastically. The only solution left for this bill is to repeal it.

Price controls are not the way to bring down the price of chicken

By Pravena Yogendra

Originally appeared on Newswire, Lanka Business Online, the Morning and Daily News

Most HoReCa channels in Sri Lanka sell a packet of chicken rice and curry at a higher price than a comparative packet of fish rice and curry. The price of a portion of chicken rice and curry is ~30% more than that of a portion of fish rice and curry. This differential has remained over time, as this existed in the pre-crisis environment as well, albeit at low prices.

Is this because of a difference in production costs or due to undue policy intervention by the government?

Sri Lanka has a long history of implementing price controls dating back to the 1970s. In recent years, the government has implemented price controls on various essential goods, including food, fuel, and pharmaceuticals. While the resulting lower prices may have been popular among consumers, they have had significant unintended consequences on the economy.

Such price controls create distortions in the marketplace by interfering with the pricing mechanism, thereby preventing resources from being allocated efficiently. The government’s current effort to control the retail price of chicken is a case in point.

Chicken and eggs are the most affordable and culturally accepted meat source in Sri Lanka. The domestic poultry industry produces 240,000 MT of chicken per year, with current per capita consumption standing at 10.8 kg. 

The recent economic events, such as the forex shortage and the ban on chemical fertilizers, led to a series of events that artificially inflated chicken prices, making them expensive for regular consumption. As a result, the state felt the need to intervene by controlling the price of broiler chicken.  

However, these price controls have only been imposed on the organized/ formal market. Industry specialists classify the domestic chicken market into the formal/ organized market, which accounts for 60% of the market, and the informal/ wet market, accounting for the remaining 40%. Branded broiler chicken producers cater to the organized market, and small and medium-scale poultry farmers cater to the wet market.

The formal market comprises highly productive tax-paying private-sector poultry operators whose products are on par with international quality, health, and safety standards, presenting an excellent opportunity to expand into export markets. This is proven by the fact that these poultry operators supply to sectors that insist on high-quality standards, such as multinational hotels and restaurants operating domestically and abroad.

However, the pricing restrictions imposed on these more productive players have created a situation where the producers cannot pass on their increased production costs to consumers, resulting in them facing compressed profit margins. The short-term implication would be a lower placement of chicks, resulting in a contraction in production, leading to shortages in the market. The medium to long-term significance would be a decline in investments channeled into capacity expansion, which also reduces innovation and technological progress.  

 It is also important to note that since the wet market players form the larger part of the industry, they are the price setters; and the branded players must follow suit to maintain demand for their products. Wet market chicken prices are mainly determined by the price and availability of other protein substitutes. 

Taxation significantly impacts the retail price of chicken while the burden on fish is lower. Fish is VAT exempt. The major source of costs is labour and entrepreneurship with inputs such as fuel (kerosene) having low tax incidence. In comparison, chicken is subject to VAT, with most producers lying above the VAT threshold of LKR 80Mn. The major cost is the cost of feed which is subject to VAT. It is estimated that both direct and indirect taxes account for 19.6% of the retail price of chicken. The tax treatment between the two alternatives significantly impacts relative prices, disadvantaging chicken over fish. This non-equitable VAT treatment of the two substitutes is expected to be further exacerbated in January 2024 as VAT rates are set to increase by 3% to 18%. 

Although the state is focusing on controlling the final retail price of chicken, the real issue lies in inflated input costs. Poultry producer’s input costs have escalated due to the depreciation of the rupee, higher staff costs, and higher admin costs. However, manufacturers' main point of contention has been the feed cost.

Maize is the largest component of poultry feed, accounting for ~60% of weight and 45% of feed cost. Although nutritionists discovered that rice can be used as a 1 for 1 substitute for maize, its utilization for purposes other than human consumption remains highly regulated, resulting in minimal availability

Domestic maize prices are currently at abnormally high levels as maize production is still reeling from the after-effects of the fertilizer crisis.

Sri Lanka's annual maize requirement is ~500,000 MT, of which ~300,000 MT are produced domestically. Roughly ~210,000 MT are cultivated during the primary Maha season and another ~90,000 MT during the secondary Yala season. The yield on maize cultivation by smallholders is currently 1.5 tons per acre. However, industry experts believe that a yield of 2.5 tons per acre can be achieved if correct farming practices are deployed. A kg of maize currently retails at ~LKR 160. Pre-crisis, it used to retail at LKR 45.

Industry practitioners believe that several efforts can be undertaken to improve the productivity of domestic maize cultivation, thereby bringing costs down. A higher yield can be achieved if proper agricultural land is utilized. Currently, maize farming is conducted on encroached forest land. Due to red tape, the 17,000 hectares allocated by the Mahaweli scheme for agriculture remain largely unutilized.

Farmers can also yield more if maize fields are irrigated instead of rainfed. Experts also believe that the right farming practices are not undertaken as proper soil analysis and spraying are not performed.

Currently, maize can be imported from Pakistan at USD 250-260 per tonne, which works out to LKR 110 per kg, including a special commodity levy of LKR 25. The SCL is a contentious tax and was even highlighted in the recently issued IMF technical assistance report, citing corruption. 

The SCL is a seasonal, quantity tax imposed on certain essential commodities as a composite tax in lieu of other prevailing levies such as customs duty, VAT, EDB, CESS, Excise duty, PAL, and NBT. The SCL has come under fire as it is subjective and arbitrary, imposed at the discretion of the finance minister, creating uncertainty among industry stakeholders.

In the case of maize, seeds imported for the purpose of animal feed production have been subjected to SCL during lean production periods, to facilitate imports. When the SCL is not in effect, a general duty of 20%, CESS of 30%, VAT of 15%, and SSCL of 2.5% are imposed at the border. 

Therefore, not only does the SCL drive up the cost of chicken, but it also creates uncertainty due to the unpredictability and subjective nature of the tax

Maize continues to remain a controlled import that can only be imported by license holders. Licenses to import maize are issued by the import controller based on recommendations issued by the agricultural minister, who issues said recommendations based on his view of the industry’s maize requirement. 

Sri Lanka's organized players are second to none in the poultry breeding process- they have adopted international quality standards regarding feed conversion ratio, mortality rates, farm productivity, etc., putting them on par with foreign players. In addition to being highly efficient, the industry also contains sufficient productive capacity to be self-sufficient, thereby rendering the case for importation redundant.

The industry also maintains biosecurity standards and adheres to industry and farming best practice to ensure healthy, safe, and high-quality output that match the quality and certifications required by export markets. 

The government should step back from intervening in the market for both maize and broiler and allow the magic of the hidden hand to do the heavy lifting. Not only will this lead to more stable prices, but competition will drive further innovation and productivity improvements, leading to more production and lower prices.

Navigating salary hikes amid the storm of inflation

By Dhananath Fernando

Originally appeared on the Morning

Sri Lanka is currently going through a difficult period and this extends to Government sector employees as well. In light of these difficulties, there have been recent discussions centred around the possibility of a salary hike of Rs. 20,000 for Government sector employees in the upcoming Budget. While a salary increment is desirable, a more effective policy-level alternative could be maintaining a low inflation rate, which is more than equivalent to a salary increment across the board. 

The call for salary increments in the Government sector intensified following last year’s inflation, which exceeded 70%. Private sector salaries are just now adjusting to the new economic landscape. Inflation is a significantly more severe and burdensome tax on people, and unfortunately, we have been experiencing its effects over the last year or so.

Government employees are undeniably facing a challenging period, but it’s crucial not to overlook the fundamental cause of the high cost of living. The current cost of living crisis is the direct result of carrying out excessive money printing, as endorsed by the Modern Monetary Theory (MMT).

If the salaries of Government sector workers are increased by Rs. 20,000, a simple back-of-the-envelope calculation suggests that it will cost the Government an additional Rs. 360 billion (1.5 million Government employees x Rs. 20,0000 (increment) x 12 (months) = Rs. 360 billion). 

For the year 2023, the expected Government revenue from PAYE Tax is approximately Rs. 100 billion following the tax revision. Notably, the salary increment alone requires more than three times the amount of tax collected through PAYE Tax.

In 2022, the collection of VAT amounted to Rs. 464 billion. This proposed Government sector pay increase would equal more than 75% of the total VAT collection. Even with a more modest increment of Rs. 10,000, it would still be 1.5 times the PAYE Tax collection and one-third of VAT collection. 

An alternative approach to financing this salary increase is to borrow from the Central Bank. Since the new Central Bank Act imposes significant restrictions on borrowing, it is not entirely impossible, especially during the transition period. 

If the Government opts to borrow from the Central Bank to cover additional expenditure while artificially keeping interest rates low, a second round of high inflation becomes almost inevitable. On the other hand, if the Government borrows at market rates, it would result in an increase in interest rates, potentially slowing down economic growth and creating challenges for businesses. 

If the Government intends to pursue this path, it is advisable to let interest rates fluctuate rather than resorting to money printing and keeping interest rates artificially low. This is because, in the aftermath of a high inflation cycle, there was an inevitable need to raise interest rates to curb inflation. 

On the other hand, we need to keep in mind that the last inflation cycle pushed four million Sri Lankans below the poverty line, bringing the total number of people in poverty to seven million. This has forced many to reduce the number of meals or the size of their meals. The latest reports indicate a rise in malnutrition levels, particularly among infants. 

Given the limited resources, the Government should prioritise assistance for the truly vulnerable and allocate the limited resources to social safety nets. For the last two months, the new Aswesuma programme has faced delays in cash distribution due to various political and logistical challenges. By continuing to not prioritise social safety nets, the Government is inviting instability at the grassroots level. 

International partners and donor agencies have generously supported the establishment of these social safety nets by providing foreign exchange. Delaying and complicating the process may result in the perception that addressing the issue is of lower priority, potentially reducing the willingness of stakeholders to contribute further.

According to the Appropriation Bill tabled in Parliament, total Government expenditure is expected to exceed Rs. 6 trillion for the first time in history. A substantial portion, over Rs. 2.5 trillion, accounts for interest expense on loans. There is limited room for new expenditure items as we are already on an IMF programme and any deviations could have a direct impact on debt restructuring. 

High inflation, though currently low, has lasting negative effects from the previous year. This cost of living crisis, affecting all citizens, particularly hits those below the poverty line. Some of the potential solutions may be challenging and carry potential risks, so the Government must exercise caution in implementation to avoid exacerbating problems.

Understanding corruption: How Sri Lanka’s economic system favours a select few

By Dhananath Fernando

Originally appeared on the Morning

Dr. Sharmini Cooray, one of the Advisors to the Sri Lankan Government regarding the IMF, at the 73rd Oration at the Central Bank made an interesting comment, “Lots of Sri Lankans say nothing works in Sri Lanka. That’s not true. Things work well for a small group of people”. 

Unfortunately Sri Lankans do not understand how things are set up to work for a small group of people. The common narrative is that corrupt individuals created the system we are in today, but the stark reality is that the economic system has been set up in a way to incentivise corruption for individuals. Misdirected anger is then projected on individuals forgetting that the system itself creates the corrupt individuals. This is not to say that the individuals are completely absolved of responsibility, a part of the responsibility is on the individual, yet without fixing the system we cannot fix individuals. 

Below are a few examples of how the current system works for corruption.

Last week the President as the Minister of Finance issued a Gazette notification to increase the Special Commodity Levy (SCL) from Rs.0.25 (25 cents) per Kg to Rs.50 per Kg overnight. The problem here is twofold; it creates the possibility for corruption that incurs a cost to the consumer but also ensures that the government loses tax revenue. 

Information symmetry

Information symmetry or availability of information for all players in the market is very important. As the finance minister increases the tariff by almost 5000% if one importer gets to know of this decision before it is enacted he can easily import adequate stocks for about a year early at Rs. 25 cents per Kg before the festive season. The other players' prices now simply become uncompetitive because their 1Kg of sugar has to be at least higher than Rs. 49, given the tariff rate imposed overnight. As a result the small and medium sugar importers will be wiped out of  the market as they simply cannot compete where one or few players have already imported enough stocks at 25 cents tariff and now the rest have to import at Rs.50 per Kg tariff rate. That is how things are made to work only for a small group of people. One of the main criticisms for the Gotabhaya Rajapaksa Government was that the sugar scam was done in a similar manner. 

Most importantly the tariff increase on sugar will not generate revenue for the government because adequate sugar has been already imported. After about a year it is just a matter of another gazette notification to the finance minister to bring the tariff back to 25 cents and claiming that the relief has been provided to the betterment of the poor people. So ultimately a selected group of people are just getting benefited with the support of the politicians. The truth is the loss tariff revenue will be collected from the poverty stricken by increasing the indirect taxes such as VAT.  

This is one reason this column constantly highlighted the need for keeping a simple tariff structure with menial deviations among HS codes as well as over a period of time. This is just one way of how things are only getting worked out for a selected group of people. 

As a result the public builds a bad perception with a misunderstanding of markets that all businesses are run on the same operating system. The truth is the system affects other businesses very badly because of not having a level playing field. 

The solution is to change regulation where any tariff lines cannot be imposed just by the minister of finance. It ideally has to go through parliament and keep the tariffs on HS codes simple and consistent. The more we keep it complicated the more we incentivise corruption. 

The need for a competitive system has to be institutionalized. The best governance system is making sure competitiveness remains stable. We can only do that by removing laws empowering policy makers that further information asymmetry and provide more power to the people so the market system continues. 

Tax shenanigans 

Not only have we  increased SCL by 5000%, our VAT has also been increased by 3%. When we observe the VAT rate changes, the threshold changes over the last 5 years is very concerning. By doing so we have violated the tax principle of “Stability” by changing things often. When we make one mistake at the beginning, retroactively correcting it is not easy. The VAT increase may have come to compensate for the 20,000 salary hike for the 1.5 million government employees. To make things politically digestible, an attempt may be to increase the VAT before the budget as a press release and announce a big salary increase for government employees as victory. On top of it there vehicle permits and so many perks are the system of how things are making well for a small group of people.  

The simple truth is to make governance work, we have to make market works. Governance is the system of making markets work and making a level playing field. The moment we deviate from markets there is no way we can keep the governance going.  

Can Sri Lanka’s Economic Revival Weather the Storm of a 2024 Election?

By Rehana Thowfeek

Originally appeared on Groundviews

Photo courtesy of EFE

By all estimates, Sri Lanka’s economy is expected to grow around 1.5% in 2024, making inroads into reversing the economic contraction the country experienced since 2020. Sri Lankan authorities have reached a staff level agreement with the IMF earlier this month and, pending executive board approval, Sri Lanka will receive the second tranche of $330 million soon.

Sri Lanka’s reserve position has improved somewhat from the record low levels it was once at – there are $3.5 million currently in reserves, which is sufficient to cover 2.6 months worth of imports, albeit still a worrisome situation. Tourism earnings and worker remittances are picking up and the cumulative trade deficit has narrowed in comparison to last year. Inflation is tapering at 0.8% in September (the base year has been revised to 2021), the result of the tight monetary policy stance taken by the Central Bank since April 2022.

Import restrictions brought in response to the dwindling foreign reserves are now being phased out with all but a few items still restricted. Due to the rapid decline in purchasing power experienced by the people in the past year, demand for imports may remain subdued but maybe offset by more favorable credit conditions. Policy rates have been further reduced and due to more favorable economic conditions banks are now showing greater willingness to lend in comparison to 2022, which bodes well for business revival.

The ability of Sri Lanka’s economy to redeem itself and firmly place itself on a path of inclusive and sustainable growth lies in how successfully the country can execute the necessary economic and governance reforms. Debt restructuring will ease the burden of external debt repayments in the medium term but eventually Sri Lanka will have to start servicing its external debts once again.

If Sri Lanka does not manage to adequately grow its economy to accommodate these payments with sufficient tax revenues and export earnings, the country risks slipping back into a situation similar to that experienced in 2021 and early 2022. The global situation is not favorable for economic recovery with many large economies undergoing recession and multiple wars being fought on different fronts.

The tourism industry shows signs of recovery but can be impeded by the labor migration. The tourism industry already faced issues with attracting labor, as it is not seen as an attractive or well-paying industry to work in. With workers either having left the industry to join other industries in the wake of the Easter attacks and the Covid impact or migrating to other countries due to the crisis, the industry will struggle to cater to the demand that it once managed to.

This calls for exploring the possibility of opening up the borders for foreign labor to work in Sri Lanka, which is a controversial issue to say the least. With mass migration, the country’s health sector is also in a bad state but opening up this sector to foreign labor is even more controversial than it would be to the tourism sector.

The importance of governance reforms cannot be overstated; addressing the governance failures that precipitated Sri Lanka’s economic decline over the past few decades is the only way to prevent reneging back into bad policy making. Checks and balances are important for a well-functioning economy and society. Since pockets have grown fat and powerful with lax governance structures for many decades, dismantling these systems that work in favor of a few and shaping them to work in favor of many is a difficult endeavor in the best of time.

Reforms to state owned enterprises are in the works, albeit at a slow pace. There are plans to pass the necessary laws to divest State Owned Enterprises (SOEs) and to set up a holding company to manage whatever SOEs remain. Reforms to SOE behemoths like the Ceylon Electricity Board are being tackled separately. The country’s flagship poverty program, Samurdhi, is being rehauled into a consolidated welfare program called Aswesuma with better targeting mechanisms, better entry criteria and exit clauses to make the program more effective. The new program also attempts to depoliticize welfare which hindered the effective function of its predecessor.

The budget, which can effectively signal the incumbent government’s commitment to reforms, is already off to a bad start. The government announced that public sector salaries would be increased. With no access to printed money from the Central Bank since the enactment of the new Central Bank Act nor access to foreign loans, the government has decided to increase VAT, perhaps to fund these salary increments.

The incumbent government has made no attempt to cut public sector expenditure and has instead opted to further increase its salary bill, which already swallows up a massive share of the tax revenue – 65% in 2022. This number is even higher when you add in the pensions bill. The government has fallen short of IMF targets on tax revenues in the recent review, so increasing expenditure further, especially just to pacify public sector workers in the light of elections, is utterly imprudent in the context.

Continuing to burden the general public with taxes to fund frivolous, unbridled expenses with no meaningful reform of public expenditure would serve as a harsh reminder to the people of Sri Lanka that the system change once demanded by the sea at Galle Face is yet to be seen, precipitating another wave of civil unrest.

It is not an understatement to say that the precarious stability that has been achieved hangs in the balance, and now with a looming election, the precarity worsens. There is no political consensus on the way forward which can solidify the reforms that the country ought to take – every possible reform is contested which does not bode well for the economy. The jostle is between the NPP, SJB, SLPP+UNP and other possible wildcards such as Dilith Jayaweera and Dhammika Perera, all of whom propose varying economic policies.

The resolution lies in a concerted effort towards comprehensive economic and governance reforms, fiscal prudence and a unified political will that transcends party divisions. The critical choices ahead will determine whether Sri Lanka can chart a stable, inclusive and sustainable economic course or succumb to the persistent vulnerabilities that always threaten its progress.

What happened to our debt?

By Dhananath Fernando

Sri Lanka’s debt situation is still a mystery for some. During a panel discussion, I pointed out that Sri Lanka’s State Owned Enterprises (SOEs) have amassed a staggering 1.8 trillion in debt, all guaranteed by the Treasury and classified as ‘Public Debt’. One question from the audience was, “What did we do with the money we borrowed?” The simple answer is that money was borrowed primarily to service the interest on the initial loans Sri Lanka took out. Therefore,  despite borrowing substantial amounts, there is nothing tangible or visible to show for it, as a majority was essentially sunk into interest. 

To provide context, since 1999, approximately 74% of the increase in debt can be attributed to interest payments and currency depreciation. Interest payments accounted for a substantial 40% of the debt accumulated since the 1990’s, while the exchange rate depreciation contributed to 33%. 

What Sri Lanka faced was a precarious combination in terms of borrowing and our monetary policy. Our expansionary monetary policy played a significant role in the depreciation of the currency over the years, exacerbating the situation further. Compounding this issue was the fact that approximately 50% of our borrowing was in foreign currency. As it is indicated in 2022, with Modern Monetary theory in play, the significant depreciation of the exchange rate since 2020 led to an accumulation of debt beyond our repayment capacity.

Printing more money artificially increases the demand for foreign exchange.  However, after depleting our reserves in an attempt to defend the currency, the only option left was to allow the currency to float, leading to a sharp depreciation. In the case for Sri Lanka, it was not just the currency depreciation; social unrest, debt default, and numerous other crises followed when the government resorted to borrowing from the Central Bank through money printing.

As at the end of June 2023, our total public debt has increased to USD 96.5 billion, with approximately 50% of it in domestic debt. The country’s public debt now stands at about 127.4% of GDP. Even if debt restructuring is successful after negotiations with the Paris Club and separate discussions with China, we only anticipate a reduction to 95% of GDP by 2032. 

Undoubtedly, expediting the debt restructuring process is crucial, especially given the unpredictable twists in geopolitics. While the tentative agreement with China Exim Bank to restructure the debt is a positive development for Sri Lanka, we must fast track negotiations with our other foreign creditors. Complicating matters, as we approach an election year, there is a significant risk of derailing the process as unfortunately, there is a lack of consensus among political parties regarding the economic stabilization program for the next few years. This further exacerbates the challenges Sri Lanka faces.

Solution 

If Sri Lanka is genuinely committed to resolving its debt crisis, a crucial step is to establish a consensus on public finance across the major political parties. At the very least, adherence to a single plan, such as the IMF program, is necessary. However, even the IMF program alone will be insufficient to take Sri Lanka to the next stage of economic stability. Therefore, there must be a fundamental agreement on specific reforms across party lines. For example, there exists a common minimum program in Parliament, shaped with contributions from the business community and organizations like Advocata. It is not too late to revisit and endorse this document. Committing to these agreed-upon reforms before political parties develop their individual manifestos in the coming years could provide a stable foundation for Sri Lanka's economic future.

Shaping Sri Lanka’s growth narrative

Originally appeared on The Morning

By Dhananath Fernando

Securing the second tranche from the International Monetary Fund (IMF) is an important step, especially to support our ability to successfully carry out the debt restructuring process. It is not just about the $ 330 million that this tranche brings; it is about the credibility it gives to the reform process and the confidence it instils in the international community, including bilateral and multilateral creditors. 

The moment we deviate from the IMF programme and allow our debt to remain unsustainable, we risk regressing to square one. However, we should not get our aims and priorities mixed up. Our aim is not to secure IMF tranches. We need to prioritise achieving deep and meaningful reforms. The IMF tranche will follow as a result. 

Ultimately, our goal should be to ensure that, in the future, we never find ourselves in a position where we need to turn to the IMF for assistance.

As this column has discussed many times, it is essential to recognise that the IMF can only stabilise the economy and facilitate credit access, which is a crucial element in our debt restructuring process. The responsibility to clear out the roadblocks that stand in the way of economic growth rests solely on our shoulders. We have to carry out reforms that go beyond the scope of the IMF programme. 

Three key reforms aiming to boost economic growth will be discussed below.

Reforms to attract more tourists 

Focusing on tourism can significantly contribute to the country’s economic recovery. In addition to bringing in foreign exchange, their spending in domestic markets contributes significantly to Government revenue through VAT. Instead of fixating on the number of inbound tourists, our focus should be on the number of nights a tourist stays in the hotel/country. Simplifying the entry process will attract more tourists, and more importantly, entice them to prolong their stay. 

In line with Daniel Alphonsus’ recent article, making the visa process more flexible for tourists is crucial. Our focus should not be on visa fees, but rather to encourage tourists to spend more. This allows local industries to capture the revenue and enhances Government revenue through VAT and various other forms of fees and indirect taxes.

Offering a two-year multiple-entry visa for citizens from countries with a per capita GDP four times higher than Sri Lanka’s is a strategic move to attract high-income tourists. Given our current fiscal situation, carrying out extensive global promotional campaigns are beyond our financial capacity. Therefore, our focus should shift to initiatives that can be implemented effectively with just a stroke of a pen.

Addressing labour force shortages 

Retaining skilled talent within Sri Lanka is a challenge faced by many industries, including blue chip companies. These labour shortages are anticipated to affect us from next year onwards, jeopardising the sustainability of existing businesses.

To address this issue and prevent businesses from relocating, it is essential to allow companies the flexibility to recruit from international markets. This approach is crucial to sustaining businesses and their supply chains. Permitting companies to hire skilled labour from outside Sri Lanka will not only alleviate pressure on the country’s labour market, but also offer advantages to consumers and businesses competing in global markets.

Further, it encourages the transfer of knowledge and skills, leading to improved productivity. For example, collaborating with professionals from countries like Japan could introduce advanced productivity management techniques, enhancing overall efficiency. Free movement of people is a crucial step in improving our productivity and driving the economic growth of the country.  

If relaxing labour market regulations proves too complicated, a pragmatic alternative is to permit foreign spouses of Sri Lankans to work in Sri Lanka. This measure could help in attracting more skilled workers, providing an incentive for Sri Lankans with families of mixed citizenship to return and settle here. Importantly, this reform won’t incur any costs for the Government; it simply involves changing existing regulations.

Industrial zones for private sector and simplifying tariffs  

For us to emerge from this crisis, our primary focus should be on global trade. The complicated tariff structure that is currently in place enables corruption and is a source of frustration for both exporters and importers. Simplifying the tariff structure into three to four tariff bands is essential to streamlining Government revenue administration. 

The existing high and complicated tariffs lead to massive leakages of tariff revenue. Moreover, these tariffs discourage imports, hampering productivity and burdening consumers. Implementing a straightforward tariff structure is imperative, removing para-tariffs such as CESS and PAL. Furthermore, we must ensure that the tariff structure for any HS Code is easy to compute and has minimal deviations.

A significant bottleneck in our system that hinders investments and export growth is the shortage of land for industrial activities. Currently, 95% of the land in Board of Investment (BOI) industrial zones in the Western Province is occupied. Investors are required to obtain approximately 17 approvals in order to set up operations and this process can take more than two years. 

Regrettably, the BOI has not initiated any development projects in the last 15 years. A viable solution that the Government should consider is utilising State-Owned Enterprise (SOE)-owned land and allowing the private sector to develop industrial zones on it. 

Private sector-run industrial zones can operate as a plug-and-play model, where the private sector attracts investors and secures the necessary approvals in advance. This approach does not require any Government investments; in fact, it can generate more revenue for the Government through leasing or selling the land for development. 

If Sri Lanka is genuinely committed to economic growth and recovery from the crisis, our primary focus should be on implementing these reforms rather than solely relying on the IMF.  While the IMF can provide us with short-term stability, it’s our responsibility as Sri Lankan citizens to shape our own growth narrative.

Will Budget 2022 help reset Sri Lanka’s economy?

Originally appeared on Daily FT

By Dr. Roshan Perera

A budget sets out the government’s plan for the economy together with the financial resources required to achieve those plans. It also indicates the broad policy direction and priorities of the government. Any assessment of the Budget cannot be undertaken without an understanding of where the economy is right now. In other words, the Budget must be evaluated in the current economic context.

Looking at the key economic indicators, it is clear that the economy is at a critical juncture. The country suffered the sharpest decline in economic growth in 2020. Although growth is picking up, the economy is likely to remain below pre-pandemic levels. Inflation is rising due to external pressures from supply side disruptions and shortages in international markets. Domestically, financing of the Government’s budget through banking sources (Central Bank and commercial banks) is exerting upward pressure on prices. On the fiscal front, government revenue declined to historic lows due to the impact of sweeping tax policy changes as well as the slowdown in economic activity. Meanwhile, the Government has very little leeway on expenditure, as much of it goes to pay salaries of government servants and to make interest payments – all contractual obligations. The consequent widening fiscal deficit has been financed through increasing borrowings leading to higher debt levels and debt service payments. Downgrading of the sovereign by rating agencies has limited access to international capital markets, exacerbating issues in the macroeconomy. The current economic crisis is not due to the Covid-19 pandemic alone. Sri Lanka entered the pandemic with a slowing economy and a weak fiscal position; the result of years of poor economic policies undertaken by successive governments.

Budget 2022 was an opportunity for the country to reset and for the economy to move to a more sustainable growth path. With Sri Lanka losing access to capital markets and large debt service payments over the next few years, the urgent need was to restore fiscal credibility and strengthen market confidence. Because credibility of the fiscal strategy is vital for stabilising the macroeconomy and restoring the confidence of investors. Hence, the primary focus of the Budget 2022 should have been on correcting the twin deficits, i.e., the fiscal deficit and the external current account deficit, because of the spillover effects into the rest of the economy through interest rates and exchange rates.

According to the Medium-Term Fiscal Framework, the fiscal deficit is projected to decline to 8.8% in 2022 from 11.1% in 2021 (see Table 1 for details).

With minimal wiggle room on the expenditure front, the focus of fiscal consolidation is on revenue generation. Tax revenue is projected to increase by 50% in 2022 from the revised estimates for 2021. Given that actual revenue consistently falls short of estimates, how realistic these projections are is called into question. A major portion of the increase in tax collection in 2022 is expected from the introduction of several new taxes. In addition, the VAT rate on banks and financial service providers is proposed to be raised to 18% from 15% as a one-time increase. Collectively, these taxes are estimated to raise Rs. 304 billion, accounting for around 46% of the total projected increase in tax revenue in 2022 (See Table 2 for details).

As a comparison, the Interim Budget for 2015 introduced a super gains tax of 25% applicable on any company or individual with profits over Rs. 2 billion in the tax year 2013/14 as a one-off tax. The revenue collected from this tax was Rs. 50 billion. Furthermore, the social security contribution is similar to the Nation-Building Tax (NBT), which was a 2% tax on turnover imposed on entities with liable turnover in excess of Rs. 15 million per annum. In 2019, the NBT generated revenue of Rs. 70 billion before it was abolished in December 2019. With a higher turnover threshold and the current restrictions on imports, it will be challenging to raise the estimated revenue from the proposed social security contribution. In addition, the ability to raise the proposed revenue depends on how expeditiously required legislation can be presented to Parliament. Delays in passing legislation have hampered revenue collection in the past.

The question that needs to be asked is why introduce new taxes on a revenue administration that is already stretched when there is ample room to revise thresholds and rates on several existing taxes. This would have been much simpler to implement and would have required minimal amendments to existing legislation. In addition, taxes with retrospective effect, such as the surcharge tax, are not good signals for prospective investors.

The big question is whether the revenue estimates in Budget 2022 are based on reasonable projections. What if the proposed revenue collection does not materialise? Is there leeway to cut expenditure to match the revenue shortfall? If not, will this mean a widening budget deficit and additional borrowing? With minimal access to foreign financing sources, this will mean higher borrowing from domestic sources, particularly the banking sector. This will have economy-wide implications through higher domestic interest rates and crowding out resources from the private sector.

On the expenditure front, overall, there has not been a huge increase in total expenditure. However, the Ministry of Defence and Ministry of Public Security account for around 12% of total expenditure, while spending on health and education accounts for 6% and 4%, respectively, of the total. In terms of the composition of expenditure, salaries and wages comprise 34% of recurrent expenditure while interest payments account for 37%. While the Government has limited room to cut expenditure, making permanent another 53,000 graduate trainees may not provide the best signal in terms of the Government’s commitment to reversing the fiscal situation. Furthermore, the Budget for 2022 has reduced the allocation for subsidies and transfers. An important lesson from the pandemic was the need to build buffers during good times to be able to assist vulnerable households and micro and small and medium enterprises (MSMEs) who were disproportionately affected. Although the Budget proposes a one-off cash transfer to selected groups such as MSME entrepreneurs, school bus and van drivers, three-wheel drivers, and private bus drivers who were affected by the lockdowns, it does not address informal workers in other sectors of the economy who account for around 60% of the total workforce. Ad hoc cash transfers are not sufficient to address these issues. A more comprehensive social protection scheme is required to prevent vulnerable groups from falling into poverty due to unexpected events.

Macroeconomic stability also requires external sector stability. Large foreign debt service payments and dwindling foreign reserves have led to import controls and a tight rein on foreign exchange market. But a more sustainable solution to the external crisis is to encourage exports. The Budget refers to transforming the economy into an advanced manufacturing economy and encouraging exports to earn foreign exchange. This requires addressing the structural weaknesses in the economy hindering competitiveness and productivity. In this light, the question to ask is if spending priorities and policy measures announced in Budget 2022 address these bottlenecks. The Budget has allocated Rs. 5 billion for infrastructure for new product investment zones. In addition, the Budget refers to “…a special focus on expanding the IT sector and promoting BPOs and…a techno-entrepreneurship-driven economy”. However, the allocation for digitalisation is less than Rs. 5 billion. This is in comparison to the allocation for highways of around Rs. 270 billion and rural development programmes (Gama Samaga Pilisandara) of around Rs. 85 billion.

(The writer is a Senior Research Fellow at the Advocata Institute and a former Director of the Central Bank of Sri Lanka)

A framework for economic recovery

Originally appeared on Daily FT

By Dr. Roshan Perera

A twin deficit problem

For much of its post-independence period Sri Lanka has been characterised by twin deficits: fiscal deficits and deficits in the external current account. What this implies is the country spends more than it earns and consumes more than it produces. The two deficits are linked because the deficit in the external current account reflects the sum of the deficit in private savings (where private investment is greater than private savings) and government dissaving (where government expenditure is greater than government revenue). If a government continues to consume more than it earns and/or domestic private savings are not sufficient to finance investment in the economy this is reflected in a widening of the deficit in the external current account. 

If a country is running a deficit in the external current account deficit it is important to understand what is driving this deficit. If it is due to a deficit in private savings and investment that may not be such a bad thing because the shortfall is probably being financed through foreign direct investments (FDI) and in any case it is leading to an increase in the productive capacity of the economy. Thereby increasing future growth potential of the country. On the other hand, if the current account deficit is due to the government spending more than it earns, this would need to be financed through increased borrowings. And a country just like a household cannot continue to borrow indefinitely. There will come a day of reckoning. You will come to a point where you are not able to service your debt or you may be able to service your debt, but you won’t have the income to buy what you need to live (food, clothing, education, health etc).  It may come to a point where your creditors will stop lending to you. Or even if they do lend, they will charge you a very high interest rate which will only worsen your debt situation. So, what is true for a household is true for a country.  

Consequences of living beyond our means

Large deficits in the fiscal and external account have been financed through borrowings both from the domestic market (which has crowded out resources for the private sector) and external sources (which has led to an unsustainable level of foreign debt). Although in the short-term high government spending may stimulate economic growth in the medium to long term it acts as a drag on growth due to its impact on interest rates and the exchange rate. 

When a government borrows continuously from the domestic market it crowds out resources from the private sector and drives up interest rates. Thus, making it unviable for a firm to borrow because the cost of borrowing is higher than the return it could earn from investing. In addition, when a country has a large external debt, it attempts to fix the currency to stabilize the debt stock. But this could result in an overvalued exchange rate which leads to an anti-export bias and an import bias which further worsens the trade deficit and external finances. This is contrary to what an economy like Sri Lanka with a small market (both in terms of size and per capita income) needs. As expanding trade is the only sustainable path to faster growth and employment generation. 

The availability of concessional financing from multilateral and bilateral donors enabled the country to run fiscal and external deficits over many decades. Although access to low-cost financing ended when the country graduated to middle-income status, we didn’t change our spending patterns to suit our income. Instead, we sought alternative sources of financing, borrowing from financial markets and commercial sources at high interest rates and with shorter repayment periods. Consequently, by 2016, the share of foreign debt from non-concessional sources rose to over 50%. This has enormously increased debt service payments. Today, Sri Lanka has one of the highest levels of government debt in its history and its debt service payments are one of the highest in the world (absorbing 72% of government revenue in 2020). This has led to both domestic and external resources being diverted to servicing past debt to the detriment of future growth. 

Policy Priorities

Advocata Institutes’ recent report “A Framework for Economic Recovery” propose several policies to address macroeconomic imbalances and structural reforms for sustainable and inclusive growth. 

Firstly we need to address the macroeconomic imbalances in the economy. Primarily, correcting the twin deficits because they have spillover effects into the rest of the economy through interest rates and exchange rates. Priority should be given to fixing the tax system. Tax revenue which was over 20% of GDP in the 1990s has plummeted to 8% in 2020 and is likely to fall further in 2021. Expanding the tax base and improving tax administration are key to reversing the long-term downward trend in government revenue. Currently the personal income tax threshold in Sri Lanka is more than four times its per capita GDP and even higher than the tax threshold in countries with per capita incomes that are several times that of Sri Lanka, such as Singapore and Australia. A high tax threshold removes a significant portion of the working population that can contribute to tax revenue. Tax exemptions for businesses should be rationalised and the granting of exemptions centralised under one authority.  Evidence suggests that sweeping tax exemptions are not the most important factor in attracting investments and foregoing this tax revenue is not sustainable in the long term. 

With declining tax revenue collection, the government faces severe resource constraints. Expenditure on contractual obligations interest payments, salaries and wages and pension payments) has come at the cost of spending on building human capital (health and education). This needs to be reversed. Serious attention needs to be paid in the budget to rationalising the public sector and strengthening budgetary oversight mechanisms so that the government is held accountable for how they use the resources entrusted to them.

Secondly, we need to stimulate economic growth and improve the country’s competitiveness. Sri Lanka has experienced very volatile growth rates and in recent times spurts of debt fuelled economic growth. But this growth has neither been inclusive nor sustainable. We need to generate growth that is both inclusive (benefits all our citizens) and sustainable (growth that does not jeopardise future generations). The budget needs to address the structural weaknesses in the economy hindering productivity driven growth. Some policies that we discuss in our report are: (1) improving the business environment by reducing regulatory barriers which are needed to attract foreign direct investment. Sri Lanka lags its peers in the areas of doing business and competitiveness; (2) unlocking access to land which has been identified as a major bottleneck for investment; (3) creating a flexible labour market and raising labour force participation. There are a plethora of legislation governing labour in SL which act as a serious impediment for job creation. Further, Sri Lanka has a rapidly aging population and is no longer benefitting from a demographic dividend. However, it has access to a large untapped source of female labour. Encouraging greater female participation in the labour force requires removal of legislation restricting employment of female workers and improved provision of services such as childcare and safe transport; (4) addressing infrastructure gaps to enhance productivity and efficiency of the factors of production. We need to invest in infrastructure that has high social and economic returns. This requires better processes for project appraisal and selection, better management of risks which otherwise could lead to cost overruns and project delays and greater accountability to reduce waste and corruption.

Finally, the budget needs to build buffers to strengthen the resilience of the economy to shocks. 

Households have been disproportionately affected by the ongoing pandemic because they lack the buffers to cushion them from economic shocks. Workers, particularly in the informal sector, have lost jobs due to the impact of lockdowns and the closure of borders. Although the government provided some relief to households affected by the pandemic by way of income transfers, the lack of fiscal space constrained the government’s ability to adequately respond to the crisis. In addition, Sri Lanka’s existing social protection scheme has significant coverage gaps. Establishing a universal social safety net and reducing targeting errors will ensure that those who need support receive it when they need it most. 

Micro, small, and medium enterprises (MSMEs) play a vital role in the Sri Lankan economy. This sector was severely affected by measures taken to contain the spread of the virus, such as travel bans, lockdowns and social distancing. To mitigate the impact of the pandemic, the government and the Central Bank introduced various emergency liquidity support programs, debt moratoriums and extension of credit at concessionary interest rates. These schemes may have prevented some firms from bankruptcy. However, the inability of the government to continue providing such relief given the prolonged nature of the pandemic and fiscal constraints requires other measures to be put in place to deal with such situations. Given the size of this sector and its importance to the economy, ensuring the solvency of these firms as well as increasing their productivity is paramount to Sri Lanka’s long term economic growth prospects. Many firms will emerge from this pandemic with seriously impaired balance sheets. Firms that are not resilient, uncompetitive, or heavily indebted will probably fold due the crisis. To reduce the adverse economic impact of ad hoc closures, the government must ensure access to an effective bankruptcy regime. Such a mechanism will strengthen economic resilience, while incentivising firms to prioritise strategies to repair balance sheets in the medium term before they reach bankruptcy.  

(The writer is a Senior Research Fellow at the Advocata Institute and a former Director of the Central Bank of Sri Lanka)

Budget 2022: Macroeconomic stabilisation and structural reforms for inclusive and sustainable growth

Originally appeared on The Morning.

By Dr. Roshan Perera

Years of profligate living finally caught up with us. Sri Lanka, for much of its post-Independence period, has been living beyond its means: We have been spending more than we earn and consuming more than we produce. Our extravagant lifestyle was made possible by the availability of concessional financing from multilateral and bilateral donors. This ended once we graduated to a middle-income country. But we didn’t change our spending patterns to match our income. Instead, we sought alternative sources of financing. We borrowed from financial markets and commercial sources at high interest rates and with shorter repayment periods.

Consequently, by 2016, the share of foreign debt from non-concessional sources rose to over 50%. This had an enormous impact on our debt service payments. Today, Sri Lanka has one of the highest levels of government debt in its history and its debt service payments are one of the highest in the world (absorbing 72% of government revenue in 2020). This led to both domestic and external resources being diverted to servicing past debt to the detriment of future growth.

According to current estimates, Sri Lanka has around $ 26 billion in foreign debt obligations due between now and 2026. Sovereign rating downgrades made rolling over this debt challenging. But these are contractual obligations and there could be serious repercussions if a country defaults on its debt. Due to the decline in foreign inflows owing to the pandemic, the Government resorted to short-term measures such as bilateral swaps to shore up foreign reserves. However, there was a steady drawdown of the country’s foreign reserves to meet these debt obligations. Foreign reserves, as at end-September 2021, declined to $ 2.5 billion (which was equivalent to 1.5 months of import cover). Foreign currency obligations falling due within the next 12 months amount to around $ 7 billion. The current level of foreign reserves is grossly inadequate to service the Government’s debt.

Furthermore, using a country’s foreign reserves to pay debt obligations is not a good strategy in the long term. Foreign reserves play an important role in an economy – by providing a buffer against possible external shocks, smoothing temporary fluctuations in the exchange rate, and providing confidence to foreign investors.

With limited access to foreign financing, the Government is relying more on domestic sources to bridge the fiscal deficit. To keep interest costs low, domestic interest rates have been suppressed, which has effectively dried up the market for government securities. This has led to debt monetisation, with the Central Bank of Sri Lanka (CBSL) purchasing a major share of government securities issued in the primary auction. However, there are costs involved with this strategy, as high monetary growth leads to high inflation. It also undermines the independence of the CBSL and hinders its use of its key monetary policy instrument, the interest rate, to manage inflation.

So, what needs to be done? Advocata Institutes’ recent report titled “A Framework for Economic Recovery” proposes several policies to address macroeconomic imbalances and structural reforms for sustainable and inclusive growth. These policies are not new. If you examine macro stabilisation programmes that have been implemented in this country (or in other countries that have faced similar economic issues), you would broadly find similar recommendations. This does not mean the recommendations made in the past were wrong – but rather that successive governments did not follow through on the reforms needed to ensure long-term macroeconomic stability and sustained economic growth.

This time is different in one aspect. Sri Lanka has lost access to financial markets due to its rating downgrade. Hence, it is not able to easily refinance its foreign debt. In previous stabilisation programmes, although debt sustainability was a major concern, it was addressed through a fiscal consolidation programme. This alone may not be sufficient in the current context. The country may need to engage in a pre-emptive debt restructuring exercise to prevent default. A wilful default could disrupt access to future financing, reduce investor confidence, affect credit ratings, and have a negative impact on the reputation of the country. However, debt restructuring is a complex process and securing a deal that is acceptable to a majority of creditors is fraught with difficulty, as there are many stakeholders involved, and conflicts of interest are inevitable, hence the need to engage with an institution such as the International Monetary Fund (IMF) in the negotiation process.

The focus of Budget 2022 should be to address the macroeconomic imbalances in the economy. Primarily, correcting the twin deficits, i.e. the fiscal deficit and the external current account deficit, because these have spillover effects into the rest of the economy through interest rates and exchange rates. Priority should be given to fixing the tax system. Tax revenue, which was over 20% of gross domestic product (GDP) in the 1990s, has plummeted to 8% in 2020 and is likely to fall further in 2021. Expanding the tax base and improving tax administration are key to reversing the long-term downward trend in government revenue.

Currently, the income tax threshold in Sri Lanka is more than four times its per capita GDP and even higher than the tax threshold in countries with per capita incomes that are several times that of Sri Lanka, such as Singapore and Australia. A high tax threshold removes a significant portion of the working population that can contribute to tax revenue. Tax exemptions should be rationalised and the granting of exemptions centralised under one authority. Evidence suggests that sweeping tax exemptions is not the most important factor in attracting investments, and foregoing this tax revenue is not sustainable in the long term. With declining tax revenue collection, the Government faces severe resource constraints.  Expenditure on contractual obligations (interest payments, salaries and wages, and pension payments) has come at the cost of spending on building human capital (health and education). This needs to be reversed. Serious attention needs to be paid in the budget to rationalising the public sector and strengthening budgetary oversight mechanisms so that the Government is held accountable for how they use the resources entrusted to them.

Secondly, we need to stimulate economic growth and improve the country’s competitiveness. Sri Lanka has experienced very volatile growth rates and in recent times, sudden spurts of debt-fuelled economic growth. But this growth has neither been inclusive nor sustainable. We need to generate growth that is both inclusive (benefits all our citizens) and sustainable (growth that does not jeopardise future generations). The budget needs to address the structural weaknesses in the economy hindering productivity-driven growth. Some policies that we discuss in our report are:

1. Improving the business environment by reducing regulatory barriers, which is needed to attract foreign direct investment (FDI). Sri Lanka lags behind its peers in the areas of doing business and competitiveness

2. Unlocking access to land that has been identified as a major bottleneck for investment

3. Creating a flexible labour market and raising labour force participation. There are a plethora of legislation governing labour in Sri Lanka which act as a serious impediment for job creation. Furthermore, Sri Lanka has a rapidly ageing population and is no longer benefitting from a demographic dividend. However, it has access to a large untapped source of female labour. Encouraging greater female participation in the labour force requires removal of legislation restricting employment of female workers and improved infrastructure such as childcare and safe transport services

4. Addressing infrastructure gaps to enhance productivity and efficiency of the factors of production. We need to invest in infrastructure that has high social and economic returns. This requires better processes for project appraisal and selection, better management of risks which otherwise could lead to cost overruns and project delays, and greater accountability to reduce waste and corruption.

Finally, the budget needs to build buffers to strengthen the resilience of the economy to shocks. Households have been disproportionately affected by the ongoing pandemic because they lack the buffers to cushion them from economic shocks. Workers, particularly in the informal sector, have lost jobs due to the impact of lockdowns and the closure of borders. Although the Government provided some relief to households affected by the pandemic by way of income transfers, the lack of fiscal space constrained the Government’s ability to adequately respond to the crisis.

In addition, Sri Lanka’s existing social protection scheme has significant coverage gaps and needs to be extended to include informal sector employees, daily wage earners, and self-employed workers. Ad hoc payments are not sufficient to keep people from falling into poverty. Urgent action is needed to establish a universal social safety net and reduce targeting errors to ensure those who need support receive it when they need it most.

Micro, small, and medium-scale enterprises (MSMEs) play a vital role in the Sri Lankan economy, accounting for over half of Sri Lanka’s GDP and over 90% of total enterprises and 45% of employment in the non-agriculture sector. This sector was severely affected by measures taken to contain the spread of the virus, such as travel bans, lockdowns, and social distancing. To mitigate the impact of the pandemic, the Government and CBSL introduced various emergency liquidity support programmes, debt moratoriums, and extension of facilities at concessionary interest rates. While these schemes may have prevented some firms from bankruptcy, the Government is unable to continue providing such relief, given the prolonged nature of the pandemic and the fiscal constraints it faces.

However, given the size of this sector and its importance to the economy, ensuring the solvency of these firms as well as increasing their productivity is paramount to Sri Lanka’s long-term economic growth prospects. As the pandemic continues to affect economic activity, many firms will emerge with serious impact on their balance sheets. Therefore, as economies transition to normalcy, it is important to repair balance sheets by reducing unsustainable debt and rebuilding cash reserves. Firms that are not resilient, are uncompetitive, or are heavily indebted will collapse during such crises. To reduce the adverse economic impact of ad hoc closures in the most productive manner, the Government must ensure access to an effective bankruptcy regime. Such a mechanism will strengthen economic resilience, while incentivising firms to prioritise strategies to repair balance sheets in the medium term before they reach bankruptcy.

In conclusion, the key focus of policymakers should be on addressing macroeconomic imbalances. Priority should be given to correcting the twin deficits, i.e. the fiscal deficit and the external current account deficit, stimulating economic growth, and improving competitiveness while building buffers to strengthen the resilience of the economy to shocks.

(The writer is a Senior Research Fellow at the Advocata Institute and a former Director of the Central Bank of Sri Lanka)

When ‘national assets’ become ‘national liabilities’

Originally appeared on The Morning

By Dhananath Fernando

• Understanding the Trinco Oil Tank Farm controversy

Robert Kysokai, the author of the book “Rich Dad Poor Dad”, defines the difference between an asset and a liability quite simply. According to Mr. Kysokai, who is a management guru, anything which creates a cash flow is an asset and anything that dries the cash flow is a liability. If someone buys a car to be rented out to a taxi service, then it is an asset, because it can create cash flow and generate income. It can cover the expenses of the car from the income it creates by being used as a taxi. But if someone buys the same car to commute to work, it’s a liability, because it dries the existing cash flow from a different cash inflow, as the buyer has to incur regular cost for fuel, insurance, running costs, etc.

The lack of understanding of this simple concept has cost Sri Lanka a few generations of delayed development, with the recent fiasco surrounding the Trincomalee Oil Tank Farm story being a prime example of this.

The discussion surrounding the Trinco Oil Tank Farm is a good case study to explore the question as to whether the resources we have as a country are actually “national assets” or “national liabilities”. In most cases, holding onto national resources has gone on to create “breeding grounds for corruption and crime”, thereby becoming national liabilities.

The Trincomalee Oil Tanks were developed by the British, using labour from British territories in Africa between 1924 and 1930 – almost a century ago. The project plan was to develop 102 oil tanks. Tank number 100 was not developed and tank number 91 was destroyed due to an aeroplane accident. The tanks were constructed with inch-thick steel and protected with foot-thick concrete rings. The objective of setting up the tanks in Trincomalee was to make the  Trincomalee Port a naval hub in the region. This could be utilised for trade and military usage. The Trincomalee Port was one of the main natural deep-water ports where big vessels can be docked easily. So the vision behind setting up an oil tank farm in Trincomalee was mainly to set up an ecosystem for naval operations and bunkering operations.

In the meantime, in the 1970s, Sri Lanka introduced a policy of nationalisation and self-sufficiency. As a result, the properties of foreign energy companies that were in operation were asked to leave our shores, with the government monopolising the energy market.

Singapore took this as an opportunity and embraced all oil companies that left our shores. They were, in fact, welcomed with open arms. Provisions were made for them to invest and provide the freedom to take their profits off if they wanted. But instead of taking the profits off, investors invested them back into Singapore and made Singapore a dominant trading hub in the region, while also making it a maritime centre. Sri Lanka lost a great opportunity. This loss is signified  by the difference in the GDP per capita of the two countries. In approximate figures, Sri Lanka’s per capita GDP is $ 4,000 while Singapore’s per capita GDP is $ 60,000.

Rather than utilising the resources of oil tanks as an asset by working with foreign investors, the government taking over the energy market converted the asset into a liability. As a result, taxpayers have to keep supporting the colossal loss-making Ceylon Petroleum Corporation (CPC), which was a creation of this monopolising energy markets.

Since the nationalisation and self-sufficiency attempts in the 1970s, only about 15 oil tanks were used by CPC and their subsidiary, Ceylon Petroleum Storage Terminals (CPST) Ltd., till 2002, when Indian Oil Company bought one third of CPST’s shares. Then, the 15 tanks were leased out on a 35-year lease agreement to India for development. The Liberation Tigers of Tamil Eelam (LTTE) war too obstructed the optimum usage of the tanks. Each tank in the  Trincomalee Oil Tank Farm has a storage capacity of about 12,000 MT per tank, which accounts for about 1.2 million MT of storage in the entire facility. The recently built Muthurajawela Oil Tank Facility, built with a $ 72 million loan from China’s Exim Bank (total investment was $ 157 million), can only store upto about 250,000 MT. So the capacity of the Trincomalee Oil Tanks is far more substantial.

However, according to the shipping  industry expert Mr.Rohan Masakorala, the  LTTE problem would never  have taken off if the foriegn oil companies were allowed to operate in Trincomalee. According to him their entire eastern coastal belt would have been developed as much as Colombo, if we had allowed the foreign capital and technology to flow in,  especially in the Energy Market.

In 2018, the then Minister of Petroleum had discussions on a joint development project with India for 15 oil tanks out of the remaining 85 tanks. Again, another political monsoon started and nothing took off. So for nearly a century, we really didn’t use the Trincomalee Oil Tanks, although we still claim it as a “national asset”. Refurbishment of Phase I of the Trincomalee Oil Tanks requires a few billion dollars of capital. It also requires technology beyond our shores, and having an international partner is the only way to operationalise it.

Again in February, the current Minister of Petroleum announced that Sri Lanka is going to take over all oil tanks. Now there is a national interest on these oil tanks as a result of the Indian Foreign Secretary’s visit. The simple reality is that the 100 oil tanks which we failed to do anything with for 100 years, which occupies valuable land stretching 850 acres, are not really assets at present, from an economic perspective. They are simply liabilities, and in our case, they are even more than liabilities.

The only solution we have is to open our resources for foreign investments, if Sri Lanka is really serious about coming out from this economic downturn. Trincomalee has the potential to become a revenue-earning asset. The emerging Bay of Bengal economy is just opposite the Trincomalee Port. Chennai, Bangladesh, Visakhapatnam, and Thailand are countries and cities with large populations, with bigger markets where Trincomalee has the capacity to trade with and become a naval point for much larger economies. Currently, the trade volume we do at the Trincomalee Port is very limited, and the Prima factory and the cement plant are the only players presently using these facilities.

We have to think about Trincomalee as a whole and see the bigger picture than just seeing a fraction of it. The development of Trincomalee can be further extended with tourism up to our southern beach belt.

National assets are the ones that generate cash flows, regardless of ownership, and national liabilities dry up our cash flow. From an economic perspective, what we really celebrate as “national assets” and what we really try to hold for ourselves are “national liabilities”.

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.

When price controls get out of control

Originally appeared on The Morning

By Dhananath Fernando

• Price controls lead to shortages and distort markets

Why has Sri Lanka’s economy remained stagnant? This is not a difficult puzzle to solve. It is simply because Sri Lanka has repeated the same failed policies ignoring “economic fundamentals”. This is evident now more so than ever by the number of “price controls” imposed by the Government. Even an amateur student of economics would know that price controls distort markets creating black markets. Black markets mean reduced quality of goods and services and shortages. The recent conundrum of a few rice millers declaring rice prices and the Government having to withdraw price controls is the best example of the failure of this policy measure. The lack of economic analysis behind such policies have not only diluted the Government’s political capital but also have created shortages of rice in the market. 

It is no secret that the entire economic system has been damaged by the implementation of price controls. The real impact, like in the case of rice, is much more severe than what we see on the surface. 

A retired army officer was appointed to ensure the supply of essential food items. He raided a few rice mills, warehouses, sugar storages, and other essential commodities as per media reports to ensure the supply of essential food items. However, the recent withdrawal of price controls on rice is an indication of the failure of such short-sighted policies. Shortages sprouted, markets reacted and prices have increased further. These miscalculated policies have also led to the dilution of investor confidence by providing all the wrong signals to investors. Heavy Government intervention in businesses and private property, confiscating stocks and storages discourage investors. 

Markets work on the principles of demand and supply. It is a series of coordinated actions and reactions. These happen as a result of people working for the benefit of each other when allocating scarce resources which have alternative uses. Allowing this system to function can achieve the best outcomes for everyone, especially the consumers. Controlling the price by means of force is counterproductive. This will leave a bitter taste for both the consumer and producer as well as the Government. 

The political theatre of price controls is not new to Sri Lanka. It goes back to the 1970’s. Since then Sri Lanka has had a habit of imposing, relaxing and reimposing price controls. We have been in the same vicious cycle for decades. The previous Yahapalana Government imposed price controls on hoppers, tea, and milk tea. The current Government imposed price controls on another long list of goods including lentils and tinned fish. Even today, our USD has a price control of Rs. 203 per dollar. As a result there is a serious shortage of USD in the market. What is evident is that all items which have price controls imposed, experience some level of shortage or market distortions. 

How can the distorted rice market be rectified? 

The distortion of our rice and paddy market ultimately boils down to poor productivity along with excessive political and Governmental interference in the industry. The contribution of the agricultural sector to the country’s GDP is 8% with about 24% of the country’s labour force in agriculture. This is a good indicator to highlight how unproductive the sector is. Additionally, analysis shows that our pricing of one kilogramme of rice is completely irrational. According to research, paddy is a water guzzler that consumes about 2400 litres of water for transpiration. Further, 1200 litres is required to produce one kilogramme of rice. At the moment we do not charge for water needed for paddy cultivation. Most of the water provided is subsidized by taxpayer money. Additionally we provide fertiliser at a subsidised rate (organic or chemical). The subsidy is included in the price of paddy and rice. One of the main factors of production which is land is also not calculated in the cost of production as most of the cultivated land is owned by the Government. 

If we were to calculate the price of water, land and fertiliser, the cost of production of rice in Sri Lanka is extremely high. So if Sri Lanka is serious about rectifying the problem of rice, all these issues must be addressed. Attempting to control the price which is the final indication of resource allocation is not the solution. Failure to address the real bottlenecks at the root of the issue will exacerbate problems faced by the paddy farmer as well as the consumer. 

Importation of rice is not a popular topic in Sri Lanka for many reasons including the current forex crisis. One way to address the market manipulation by rice millers and provide consumers affordable prices is to let the market system work. That includes allowing the importation of rice by private businesses. Unlocking land for our farmers too is important to increase their productivity by using low cost methods of farming. At the moment since the land is owned by the Government, capital infusion and technological development that could be done is limited. Farmers cannot take a loan from the bank or do any technological advancement using the land as collateral. Farmers have very limited options and they are trapped in a vicious debt cycle while continuing to resort to unproductive methods of farming on land they do not own. 

Until Sri Lanka comprehends the problem, our solutions will be mere performative political theatre. Without evidenced-based public policies and a good understanding of economics, price controls will be imposed and reversed overnight, leaving the consumer, producer and the Government with a foul taste.

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.

Losing by focusing on the winners

Originally appeared on The Morning

By Dhananath Fernando

• Winners focus on winning and losers focus on winners.

“Winners focus on winning and losers focus on winners”, I recalled this statement when I saw different headlines on Sri Lanka’s budget for the fiscal year 2022. As per media reports, the Government expects three main policy proposals in the upcoming budget. These include the development of local industries, expansion of infrastructure development, and having an expansionary monetary policy. 

Speculations too have highlighted continued import restrictions as a strategy to develop local industries. This is what reminded me of the saying that losers focus on winners while winners focus on winning. 

In a hundred metre race the most rational thing to do is to focus on one’s timing and speed as opposed to focusing on obstructing fellow athletes. Similarly in economics and business if one wants to develop local industries one must increase productivity and efficiency rather than resorting to import restrictions. 

One reason many justify import controls as a strategy for the development of local industries is the lack of knowledge rather than a strong ideological stance. Sri Lanka has had a trade deficit for a long time, which is “value of imports – value of exports”. Therefore, many Sri Lankans generally believe that by reducing imports the trade deficit can be reduced. 

The same argument applies when people assume that we have to spend foreign exchange earned from exports when importing. People believe that producing locally will save foreign exchange due to the reduced need for imports. As a result, there is growing animosity against imports across all products and services. People believe that this will leave local industries better off. This thought process has led Sri Lanka to become a nation full of people who detest imports. But they forget that local industries depend significantly on raw materials and parts. 

This idea is not endemic to Sri Lanka but can also be found in some other parts of the world. So there is a global belief that having complete import controls can help homegrown local innovation regardless of its severe economic consequences. However the reality is far different. Banning imports would do more harm for local businesses than good. It can significantly impact the production and manufacturing potential of the economy. However, we will only be able to arrive at a reasonable conclusion once the budget is presented. 

One of the main arguments provided by proponents of import controls, is the belief that Micro and Small Enterprises (MSMEs) cannot compete with large-scale global brands. However, the truth is different. In Sri Lanka, the apparel sector especially consists of quite a number of MSMEs. They produce goods at the standards acceptable to international markets. These target markets are far different from the domestic market. Therefore they actually compete internationally and are capable of doing so because they are able to maintain productivity. Therefore the best way to empower small enterprises is by helping them improve productivity and allowing them to compete. 

Another common belief is that some developed countries too have import controls or higher tariffs. Ardent believers of import substitution present these examples to defend their case. A common example provided was the import duty and tariff rates in India and South Korea in comparison to Sri Lanka’s, claiming that our tariff rates are much lower. However the truth is that Sri Lanka has a complicated system of para tariffs. These are additional tariffs on custom duties (CESS and PAL). Para tariffs increase the effective rate of protectionism, which is the overall protection levied at the border on imports. Sri Lanka’s effective rate of protection is much higher than other countries in the region. Once again, this exhibits Sri Lanka’s obsession with winners and the lack of attention given to winning. In addition, many new winners in trade have appreciated the importance of neutral policies that give similar incentives for export production as well as import substitution production.  

Another common argument is that the similar practices by the west at the initial trajectory on their development and the extent to which they protected their industries is often provided by proponents who believe banning imports is a strategy for local industry development. South Korea and Japan have been provided as an example often on how they banned car imports which made the boom of brands like Toyota and Hyundai is a common story. If that argument is true then countries like North Korea have to be most prosperous as they have very serious import restrictions. 

Second, for the country and the market size of Sri Lanka to get economies of scale, we need to produce bigger volumes beyond our shores. So competition is inevitable. Just because one country has succeeded at doing it doesn’t make sense for us to repeat without understanding geography, demography, and geopolitics. Thirdly if we look at the brands that have really done well those are the ones who have been opened for competition. In the case of Japan, the Ministry of Trade and Industry recommended to Toyota Founder Kiichiro Toyoda, not to produce cars in the first place and the rest of the Toyota brand is just history. 

We are all in agreement that the local industries should prosper and have to be productive. But thinking that the import bans as a strategy for local industry development is not in the right direction. It would set a bad example for people to just target winners instead of winning and ultimately the entire country will be a net loser. We have to become a country of thinking about winning rather than a country of focusing on winners and the budget 2022 should lay a broader strategy to achieve this objective. 

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.

Underneath the underwear patriotism

Originally appeared on The Morning

By Dhananath Fernando

• Can Sri Lanka become self-sufficient in undergarments?

My father had a very hard time with me when he accompanied me for haircuts when I was a kid. I’d ask him “Who cuts the hair of the barber?”. He’d say “It has to be another barber!”. Then I’d argue back saying “If the barber can give haircuts to everybody, why can’t he cut his own hair?”. Then my argument continued. Do the doctors go to doctors when they are sick or do they check themselves by their own stethoscope and decide their own medication? The same goes for surgeons. When a surgeon has to go through surgery can they do it on their own or do they have to go for another surgeon? When I look back, though I am not very proud of my arguments as a kid, the recent comments on the economics of undergarments on “Why Sri Lanka cannot produce all undergarments we require locally?” took me back to my childhood. 

A big social media discussion driven by political rhetoric, with little to no understanding of basic economics, was popular last week. Some argued that Sri Lankans will not have enough undergarments with the new direction by the Central Bank of Sri Lanka (CBSL) for licensed commercial banks (LCBs). The direction was to deposit 100% of the invoice value to open a letter of credit and halting credit facilities for LC’s for 623 HS codes including men and women undergarments. 

The opposite argument was there are enough local undergarment brands in Sri Lanka and anyone can buy it from Pamunuwa. There were some arguments going to the extent that “Sathosa” can provide undergarments in case of any shortages. Many argued that if Sri Lanka can export and stitch for world-class brands such as Victoria’s Secret, VS PINK, GAP Body, and Calvin Klein, how come we can’t produce to meet local demand? 

The argument went to the extent of some proponents mentioning that we have to ban everything we can produce in Sri Lanka to solve our foreign exchange crisis. 

First, let’s understand the reason behind the circular direction by the CBSL. A cluster of 623 HS codes are now required to deposit 100% of the value upfront. Additionally LCBs are not permitted to provide credit facilities, to open LC’s for the purposes of importing the mentioned 623 HS code line items. So simply it is not a tariff barrier, but the real objective is to discourage imports, in order to minimise the demand for foreign exchange used for imports, given the forex shortage we have presently. When the supply is suppressed, in this case on undergarments which is an essential product category the prices will automatically go up. That higher prices may impact consumer behaviour. 

Secondly, the question is why can’t we produce undergarments for Sri Lankans if we produce for Victoria’s Secret? Obviously, we can produce but economically or business-wise it doesn’t make any sense for the producer to produce a low-value, low-priced product for a 22 million market. Especially when the existing competency is at producing a world-class high-value, high-priced product for a market of a few billion people. In terms of margin as well as volume, the obvious pick is to produce for a bigger market. If we ask our manufacturers to produce for the local market as well, most likely they will have to shut down most of their factories, and obviously, Sri Lanka’s export numbers will drop drastically. When the capacity is there to produce high-value goods with significant value additions, why should a business consider producing a low-value product for a smaller volume. So pondering whether we can produce undergarments to our own markets by restricting imports, is the same as my childhood argument of asking the surgeon to get his own surgery done. So producing undergarments for the local market just because we produce for Victoria’s Secrets doesn’t have any rationale. On the other hand, if the current garment manufacturing plants are pushed to produce for the local market, the resources such as labour, land and capital have to be taken from the same resource pool. This can make exports expensive and make Sri Lankan exports uncompetitive. 

At the same time, export garments are stitched under branding regulations and contractual standards with strict customer audits where even a rejected garment is not allowed to be released to the local market. The companies have signed intellectual property agreements on individual designs and premium quality raw material is imported from Hong Kong, China and different parts of the world to make the product of superior quality. 

The same argument is there for tea. Often people complain that though Sri Lanka produces Ceylon tea, the tea available at the retail market is not as good as export quality. Obviously, just like the high value branded undergarments, there are high quality teas in Sri Lanka which many can’t afford given our purchasing power. As a result we have to settle for something affordable and the market is offering a product which is affordable for an average Sri Lankan consumer. Obviously a country of nearly a per capita $ 4000 income cannot afford to drink expensive silver tea three times a day. It is same for undergarments that markets offer a range of products where anyone can pick based on their affordability and personal preference. Those who could afford Victoria’s Secret and Tommy Hilfiger can go for it and those who can’t have the freedom to select from a range of undergarment brands and even unbranded categories based on their affordability. What is important is to make sure the choice is available so people can pick what fits them the best. 

Especially in a category like undergarments, it is the last thing that people will check – whether it is imported or locally manufactured. Perfect fit for the body, hygiene factors, sanitation factors, comfortability, affordability and even emotional attachment for the brand are very prominent in the product category at point of purchase. So it is essential that Sri Lankans have the freedom of choice to select what undergarments they feel comfortable with. Some people obviously may have a preference for local brands based on their criterion of selection. 

At the same time it doesn’t mean that local players shouldn’t produce garments for the local market. In a level playing field some businesses can produce for the local market and importing also needs to be allowed for their production as well. 

With the deepening of the US dollar shortage there are economic misperceptions built around imports. Banning imports is deemed to be the only way to develop local industries. Obviously we all know by hating something; we cannot achieve anything and the only way to achieve it is by competing. It is understandable that we face a foreign exchange shortage but obviously trying to produce undergarments for the local market by cutting imports will worsen the situation rather than solving it. 

Thinking that we should produce all undergarments we require locally as we produce for Victoria’s Secret is the same as my childhood thought that the barber should get his own haircut done and the surgeon should do his own surgery.

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.

The Government’s dangerous honey

Originally appeared on The Morning

By Dhananath Fernando

Minister of Finance Basil Rajapaksa, moving two important bills in Parliament, recited a poem in Sinhala literature, which is also a proverb, to explain the sorry state of our economy. He compared Sri Lanka’s economy to a man in the jungle trying to rescue himself from three life-threatening challenges.

Firstly, a furious wild elephant, similar to our mounting debt obligations. Secondly, to avoid the elephant, the man attempts to hide in a pit, but before he jumps into the pit, he realises that there is a cobra in it. So instead of jumping, the man then decides to hang onto the roots of a tree that lies above the pit as an alternative. The cobra in the bottom of the pit is similar to our Balance of Payment (BOP) crisis. Our importers and exporters are in big trouble, having difficulties opening Letters of Credit (LCs) due to forex shortages, and currency is depreciating rapidly with attempts to keep interest rates artificially low by policymakers.

Then the man realises that one root he is holding onto is the tail of a venomous reptile. He now cannot release his grip on the tail as the reptile will bite back. So, the adventure of running away from the elephant waiting at the edge of the pit now has two more severe life-threatening risks. The Finance Minister’s analogy reflects that trying to avoid one problem without a proper estimation and analysis has now opened us to more vulnerabilities while the previous challenges remain as they are.

As the story goes, one tree root the man is holding in his other hand is attached to a bee honey nest. So when he tightens his grip, bee honey keeps dripping, and so he decides to indulge in some bee honey. While the man has three life threats from the elephant, the cobra, and the other reptile, he decides to enjoy the dripping bee honey for a moment.

The Sri Lankan economic crisis is exactly the same. At a moment in history where urgent, hard, and serious economic reforms are required to overcome the crisis in the midst of the global pandemic, some alternative policies such as self-sufficiency, Modern Monetary Theory (MMT), and import substitution have become sweet bee honey for some policymakers who really do not understand the gravity of the crisis.

Unfortunately, just as the man who attempted to jump to a pitfall without properly analysing the situation, some economic measures with little analysis are cornering us for a brewing crisis.

Fixing USD at Rs. 203

Attempting to fix our exchange rate at Rs. 203 against the USD to avoid currency depreciation is one such activity. Simply, it is a price control on US dollars. Every good or service with an economic value is naturally obliged to a demand and supply matrix. In other terms, there is no alternative to fix the price of a currency without someone intervening in the excess or shortage.

In the forex market, the Central Bank does not have adequate forex to intervene in markets any longer, with the mounting debt obligations. So it is natural that $ 1 for Rs. 203 is a complete misguidance where there is no USD in the market at that price. The downside of trying to fix the USD at an artificially lower price is the encouragement it would provide on more importers to open LCs, adding more pressure on banks as well as the USD.

“Imports” are incentivised at a lower rate than the market rate for the USD. Exporters, on the other hand, are discouraged to bring forex as they get a far less market rate if they bring USD to the market. As a result, exporters hold the USD as long as possible and many exporters maximise their offshore accounts, as it is very cost-effective and hassle-free. As such, banks’ forex market has now further dried up, with both importers and exporters falling into trouble. It is the same predicament faced by the man who tried to avoid an elephant and came across two more additional troubles.

Additionally, another restriction has been imposed on more than 600 HS codes where the full amount has to be paid upfront to open the LC. This move will directly impact micro, small, and medium-sized businesses that depend on imports in those categories. Consumers will have to experience higher prices and black markets in most of these product categories, and the quality of life will be affected drastically.

Concerns expressed by investors on property rights over seizing rice stocks

Recent raids carried out on rice mills in Polonnaruwa will worsen Sri Lanka’s image as a destination for investors. As previously written in this column, it is the lack of competition, along with political support, that leads to the creation of cartels in the rice milling industry. However, seizing private property of an individual undermines investor confidence – no investor will consider Sri Lanka if there is a fear that the government will take over their property rights.

This was the same point made by the President when he was questioned by Indian media in his very first international media interview about the Hambantota Port. Though his supporters claimed that the Hambantota Port will be taken back by China, the President mentioned that if we were to do it, it would completely provide a wrong message for the investor community. According to media reports, the Government is initiating a very important Selendiva project for investors (Hilton Colombo, Grand Hyatt, etc). However, property rights concerns will seriously erode attracting quality investors for the Selendiva project.

At the same time, exactly like the proverb in the speech by the Finance Minister, while we are in serious trouble on multiple fronts, ideological groups seem to be defending their ideology rather than finding solutions with pragmatism. Ideological groups are the same as the man who is focusing on bee honey dripping, by forgetting that we are already in a very serious situation. The narration created on self-sufficiency and import substitution are just an example.

The Finance Minister has to be objective and pragmatic instead of falling into ideological traps. Otherwise, he will be a victim of his own analogy and the proverb of the man who multiplied the problem by irrational decision-making.

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.

Closing the gate once the horse has bolted

Originally appeared on The Morning

By Dhananath Fernando

Can price controls rein in uncontrolled depreciation?

People are infuriated over the recent drastic price hikes on essential food items, and analysts and policymakers are attempting to make sense of what triggered this.

Some argue that the increasing global commodity prices are indeed the root cause of these local price hikes. In my opinion, however, global price hikes cannot be the sole reason. This conclusion is misleading as the domestic prices of these food items are higher than the percentage increase of global commodity prices adjusted for the depreciation of the Sri Lankan rupee (SLR).

Steep depreciation of the currency

It is no secret that the Government sought refuge in Modern Monetary Theory (MMT) in recent times. This has had a considerable impact on commodity prices due to the depreciation of the rupee. A depreciating rupee coupled with increasing commodity prices is certainly an ill-fated combination. Even though many economists alerted the Government of the risks MMT could pose, they fell on deaf ears.

When global market prices rise, it is inevitable that domestic markets adjust accordingly due to price signals. This means that people shift their consumption behaviours and patterns with price volatility. However, Sri Lanka’s essential commodity price hikes came suddenly and have given people no time to adjust their purchasing patterns.

As per Central Bank data, Sri Lanka’s food inflation is increasing. Advocata Institute’s Bath Curry Indicator, which tracks the weekly expenditure of a four-member household on rice and curry, found that prices increased by 45% on a YoY (Year-on-Year) basis in July and by 30% in August.

I’d like to conclude my argument by quoting Nobel Laureate Prof. Milton Friedman: “Inflation is always and everywhere a monetary phenomenon.”

Acute foreign exchange crisis exacerbated by MMT

The acute foreign exchange crisis we are in, too, is a major contributor to recent price hikes. Oversupply of money has drained our reserves and added additional pressure on the currency. For example, when the government provides Rs. 20,000 (which is beyond the government’s capacity) for low-income families, money will flow out of the system due to the purchase of imported goods. People will be inclined towards buying imported LP gas, lentils, sprats, and tin fish.

Further, maintaining a negative real interest rate, which is to keep interest rates artificially low by increasing money supply below the inflation rate, will motivate people to spend more money than to save. More spending equals more expenditure on imports, which will then exacerbate the country’s Balance of Payment (BOP) crisis.

Currently, banks have different exchange rates for different customers. The kerb market’s exchange rate for the US dollar is between Rs. 250 and Rs. 260.

If this trend continues, the country’s fuel prices, LP gas, milk powder, and many other commodity prices will continue to rise.

Price controls

The Government has announced strict price controls and has appointed a designated officer to curb hoarding by traders with the objective of decreasing essential commodity prices. Recent news reports claim that hoarded essential food items such as sugar have been confiscated from stores by the authorities.

However, price controls are proven to be ineffective and will lead to goods disappearing from markets, as a result creating black markets. Further, it is likely that price controls will result in importers stopping the importation of goods. The first lockdown saw an initial price control of Rs. 65 on lentils and a controlled price of Rs. 100 on tin fish. Later, the Government had to withdraw the price controls as it resulted in severe shortages, with traders halting imports and the sellers hesitating to trade at a loss. Price controls simply don’t work because the price structure is unique for each trader.

Competition is the only factor that drives prices down. For example, the cost structure of a trader who sells lentils in an air-conditioned shop and a trader who sells at the Sunday market is different. The price they mark is based on the cost, and consumers buy it based on the value they get. Price controls hamper the signalling mechanism, resulting in severe repercussions.

Why do traders hoard?

Even with increased raids by the Consumer Affairs Authority (CAA), traders continue to hoard. This behaviour is intricately linked with the foreign exchange crisis the country is in. The Central Bank introduced regulations stating that traders cannot buy US dollars for a future day (forward market) at the current exchange rate. Further, importers were requested to open Letters of Credit (LCs) for a 180-day credit period. As a result, importers brought essential commodities in agreement to pay the exchange rate to be in effect after 180 days. They brought the goods they already sold at a calculated exchange rate.

However, now the exchange rates are depreciating further. For example, when traders imported the consignments, our exchange rate was about Rs. 190. But with the currency depreciation, now they have to pay the current exchange rate as there is no forward market or interbank market in operation. This is pushing importers to hoard to secure stocks for the future. Importers will also be inclined to increase prices to cover their losses incurred due to exchange rate volatility.

All of these trickle down to the average consumer as higher prices on essential commodities. Higher prices, long queues for essential goods, and empty shelves are symptoms of wrong macroeconomic policies.

This column and many economists alerted the Government that it would come to this, and I am disappointed that the Government did not heed our advice.

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.

Reforms required, IMF or no IMF

Originally appeared on The Morning

By Dhananath Fernando

At Advocata’s first deep-dive session on Sri Lanka’s debt sustainability, Harvard Prof. Ricardo Hausmann emphasised on the importance of avoiding an economic crisis at all costs. As he is of Venezuelan origin, it is safe to assume Prof. Hausmann has first-hand experience of having to live through the realities of such a crisis. He warned that “an economic crisis comes slowly and then suddenly”.

Every week, the Central Bank attempts with various tools to subjugate the situation, but unfortunately the intensity of the wind seems difficult to change. The Energy Minister initiating discussions with the UAE to purchase fuel on a long-term credit period while restricting the country’s USD payments with a 5% ceiling on USD deposits indicates how hazardous things can be in future.

The Central Bank’s recent inflation numbers have indicated high food inflation. Now the last resort in sight is to approach the International Monetary Fund (IMF). Opinions on this are many.

In my view, emphasis should not be on the IMF. A credible plan to drive economic growth must take precedence. However, I don’t see such a plan in place as of now.

So let’s discuss solutions we can incorporate into a credible plan as the problem is clear.

Immediate policies

Cash transfer system for safety nets

Given the nature of the pandemic, it looks like we have to expect more lockdowns or limited travel in the immediate future. This will affect Sri Lanka’s MSME (micro, small, and medium-sized enterprise) sector and informal employment. At the moment, 99% of our establishments are MSMEs and more than 60% of our labour force is in the informal sector. MSMEs contribute more than 50% of our GDP. So any policy to stop spreading the virus through travel restrictions will undoubtedly affect our informal sector. We do not have a mechanism to protect them.

Samurdhi targeting and distribution through grama niladharis is extremely poor. Therefore, what governments often do is bring down prices of all food items, fuel, and other essentials across the board. This is direct intervention in the market in the form of subsidies. These subsidies end up in rich households due to their high consumption of commodities.

The solution is to introduce a cash transfer system to the vulnerable households. This will give them the freedom to choose what they want to spend on. The cash transfers can have multiple tiers based on the poverty levels. For example, when the global fuel prices are increasing, the cash transfer on fuel can be increased, but when prices decrease, the cash transfer can decrease proportionately. Simply, we have to introduce an agile digital safety net system in the future because market reforms are painful, especially for the poor.

Cutting down govt. expenditure and voluntary retirement scheme for govt. servants

A reason the Central Bank has to continue to follow Modern Monetary Theory (MMT) is the ballooning government expenditure. It is true our expenditure is somewhat on par with our regional peers, but our labour market is completely distorted by about 1.5 million people, and most of them are unproductive and dissatisfied with their work conditions. Undoubtedly, this is beyond our government’s afforbality, especially with pension payments and other expenses incurred utilising prime property across the island wasting most of our resources. Our state-owned enterprises (SOE) absorb a greater portion of our government revenue, their debt in state banks adding a serious risk to the stability of the banking system. So a freeze in the government sector is a must and we do not have any alternatives left.

Debt restructuring and debt conversion

We have to leave our current strategy of trying to manage debt with short-term swap agreements. The more we wait, the more the pain we have to go through. Debt conversion is a strategy that can be explored. We can consider a few debts to equity swaps similar to what we did with the Hambantota Port on identified unproductive assets. Debt restructuring or reprofiling is another option, which, however, requires serious effort. It will be an extremely costly process, where we will have to work with foreign legal firms and our creditors. This will have both positive and negative consequences.

Unlocking our land supply

Land is one of the main factors of production. It is unimaginable that 80% of land is owned by the government and only 3% of the land have clear titles, as per a World Bank study. Without having land ownership for its people, there is no opportunity for capital flow that can expand the entire business ecosystem. The Government has to prioritise creating a digital land registry instead of other unproductive alternatives.

Above are just a few recommendations for a credible recovery plan, whether we go to the IMF or not. The real problem is not whether we are going to the IMF or not. It is looking at what reforms we have to make on our own and how we are going to make these changes, which are required to drive economic growth.

Prof. Hausmann said that the big bad wolf comes slowly and suddenly. I hope we move much faster and get the reforms done before “the big bad wolf that comes slowly and suddenly” comes for us.

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.