Prof Athukorala: Sri Lanka and the IMF: Myth and Reality – Part 1

Originally appeared on The Daily FT.

By Prof. Prema-Chandra Athukorala

Read Sri Lanka and the IMF: Myth and Reality – Part 2 and Part 3

Sri Lanka is now in the midst of its worst macroeconomic crisis since independence. Whether to seek financial support from the International Monetary Fund (IMF) in managing the crisis is a hotly-debated issue in Sri Lankan policy circles. The debate is largely ideologically-driven: strongly-held, opposing views are expressed without facts.

The purpose of this paper is to demystify the debate by documenting and analysing Sri Lanka’s experience under IMF-supported macroeconomic adjustment programs, the economic circumstances that propelled the country to seek IMF support, and implications of these programmes for economic stabilisation and growth.

The discussion focuses on two key issues emphasised by the current political leadership and the Central Bank to justify their attempt to avert going to the IMF: IMF dictates policy reforms at the expense of national policy autonomy, and the conditions attached to IMF programs are harmful to national development. The paper primarily adopts an economist’s perspective, but where relevant economics is combined with politics in order to understand the vicissitudes of Sri Lanka-IMF relations.

The paper begins with a short introduction to the role of the IMF in economic stabilisation reforms in developing countries to provide the context for the ensuing analysis. The next section provides as analytical narrative of the history of Sri Lanka-IMF relations. The following section examines the impact of IMF programs on the Sri Lankan economy. The final section provides concluding remarks with a focus on the current debate on entering into an IMF programme.

The IMF and economic stabilisation

The IMF was set up in 1945 to provide member countries with bridging loans to help them get over balance of payments difficulties. A member’s access to the IMF’s financing is expressed in terms of tranches, equal to 25% of its quota of the IMF. The first four trenches (‘reserve’ tranches, in total up to 100% of its quota) can be accessed free of charge at the member’s own discretion.

The IMF also has other concessional credit facilities introduced to help member countries in the event of unforeseeable economic shocks: Compensatory Finance Facility (CFF), the Buffer Stock Financing Facility (BSFF), the Trust Fund and Subsidy Account (TFSA) financing, Supplemental Reserve Facility (SRF), Contingent Credit Lines (CCLs) and Emergency Assistance (EA).

When a country borrows beyond the reserve trenches or eligible concessional credit facilities, it has to agree on a reform package to overcome its problems that led to seek financial support. These lending programs are called structural adjustment (or stabilisation) programmes. The policy measures prescribed by the IMF relating to these lending programmes are known as ‘IMF conditionality’.

The main structural adjustment loan programme is the Stand-By Agreement (SBA) facility, introduced in 1952. The key objectives of SBAs are to rebuild the external reserves, strengthen the fiscal position, maintain monetary stability, and fortify the domestic financial system. The length of the typical SBA programme is 12 to 18 months and loans are to be repaid within a maximum of five years.

The other IMF stabilisation facilities are the Extended Fund Facility (EFF) (established in 1974); Structural Adjustment Facility (SAF) (1982) and later remained Enhanced Structural Adjustment Facility (ESAF), and Poverty Reduction and Growth facility (PRGF) introduced in 1999 in place of the ESAF specifically to help low-income countries. These programmes have been established to provide support to comprehensive structural adjustment programmes that include policies of the scope and character required to correct structural imbalances over an extended period. Normally the duration of these programmes varies from three to five years, and repayment is over four to 10 years from the date of drawing. 

Under the structural adjustment programmes, the IMF releases funds by quarterly credit tranches. The country has to observe the quarterly programme criteria at each test data. The interest rate comprises two components: the service charge and a ‘fixed margin’ (an annual interest rate). The service charge is calculated weekly, based on a Special Drawing Rights (SDR) rate (applicable to all borrowings from the IMF) and the fixed margin is applicable to loans up to 300% of the member’s IMF quota and a surcharge is applicable to loans beyond that limit. The interest rate is normally about one third of the average rate applicable to sovereign bonds issued by the typical developing country.

Unlike the other multilateral and bilateral lenders who lend to the government of the borrowing country, the IMF always lends funds to the central banks of the country. The IMF loans to the central bank are strictly for the purpose of building international reserves to meet external payments. Therefore, borrowing under IMF programmes does not have any direct impact on domestic money supply and hence on domestic inflation. 

Entering into an IMF supported programme also acts as a catalyst to generate additional international financial assistance in three ways (Bird and Rowlands 2007). First, having a macroeconomic adjustment programme with the IMF is often a prerequisite for obtaining World Bank adjustment loans. Second, as part of entering into a stabilisation programme, the IMF arranges aid consortia of donor countries to assist the given country, Most of the donor funds harnessed under these consortia are outright grants or long-term loans that carry low interest rates. Third, credibility of the reform program gained by entering into an IMF programme helps raising funds at competitive interest rates from private capital markets.

The core of an IMF stabilisation programme is a ‘letter of intent’ that contains ‘performance criteria’ (conditionality) agreed with the IMF. The performance criteria vary from case to case, but typically centre on four key variables: budget deficit, the rate at which domestic credit is created, interest rates for both depositors and borrowers, and the exchange rate. In recent decades, the IMF has begun to focus on domestic pricing policy for petroleum products, when the domestic prices are badly out of line with world prices. 

In the typical developing economy where the local capital market is weak and access to foreign credit is limited, domestic credit expansion is largely driven by the budget deficit. In IMF reform programs the major emphasis is, therefore, placed on fiscal reforms, cutting the budget deficit through both government revenue reform and rationalising government expenditure. (There is a saying that the acronym ‘IMF’ stands for ‘It’s Mostly Fiscal’!) 

A straightforward reduction of absorption (expenditure) is likely to entail a decline in total output and employment unless wages are exceptionally flexible and labour and capital is highly mobile among economic sectors. Therefore, exchange rate depreciation is recommended to make tradable goods (exports and imports competing goods) relatively more profitable compared to ‘non-tradables’ (mostly services and construction). The expansion of domestic tradable goods production relatively to non-tradable production is expected to help maintaining growth dynamism of the economy in face of policy-induced contraction in aggregate domestic absorption (Cooper 1992).

The decision to go to the IMF for assistance rests entirely with the IMF members. However, the relationship between the IMF and its developing-country members under stabilisation programmes has not always been smooth. Much of the disagreements hinge on judgements relating to conditionality attached to the lending programmes. While the principle of conditionality is not generally contested, often there are strong reservations on the part of members about the design and application of conditionality. The national officials are typically more optimistic than the IMF staff and the favourable developments they anticipate could imply less difficult action. 

On the other hand, in some cases, the national government’s discontent could also arise because, in setting conditions, the IMF staff has the tendency go beyond the basic framework. For instance, they could get into details of exactly what expenditures should be cut or what taxes should be raised to reduce the budget deficit, instead of leaving the responsibility for meeting the targets with the officials of the country concerned by taking into account country-specific political as well as economic considerations. 

Negotiating a stabilisation programme in a crisis context has the tendency to give the unwarranted impression that a country is rushing into action with a weak negotiating position vis-a-vis the IMF. The governments may resent IMF conditionality because of the loss of sovereignty implied and also because of a belief that the IMF’s objectives do not necessarily coincide with those of the national government. 

In such a context, naturally there is a tendency on the prat of the governments to make the IMF a scapegoat for (to hold the IMF responsibility for) politically unpopular decisions taken by them or for their own poor economic management. Indeed, such scapegoating often lead many to believe that the IMF forces countries to take politically disagreeable, and sometimes economically costly, action (Cooper 1992, Bird 2007).  

Sri Lanka and the IMF 

Sri Lanka (then ‘Ceylon’) became a member of the IMF (and the World Bank) on 29 August 1950. It accepted the obligation for liberalisation of the current account transaction under the IMF Article VIII in March 1994. 

Sri Lanka did not recourse to IMF financing throughout the 1950s, given the healthy external reserve position built up during the Second Word War, which was subsequently buttressed by the Korean War commodity boom (1950-51) and the tea boom (1954-55). The country obtained IMF finance for the first time in 1961, and then in 1962, within the reserve trenches. 

1964: Trotskyite Finance Minister seeking IMF support

Sri Lanka’s first attempt to borrow from the IMF under an SBA was by the Sri Lanka Freedom Party (SLFP) and Lanka Sama Samaja Party (LSSP) Coalition Government in 1964. By that time import restriction and capital controls had been carried out to the maximum and it was becoming increasingly difficult to introduce further restrictions without damaging the economy (Corea 1971). Because of the nationalisation of the foreign-owned gas and petroleum outlets in 1961, Sri Lanka became the first country against which the US Government invoked the Hickenlooper Amendment requiring the suspension of US aid to countries expropriating US property without compensation (Olson 1977). Following this, the international aid community virtually isolated Sri Lanka.

The pragmatic Trotskyite Finance Minister, Dr. N.M. Perera (NM) decided to approach the IMF. In September 1964, at the Annual Meetings of the IMF and the World Bank held in Tokyo, the Sri Lankan team led by NM consulted the IMF on the possibility of obtaining financial support under an SBA. The Government was defeated in the Parliament before the negotiations ended. However, according to a statement made by Dudley Senanayake (the Opposition Leader) at a parliamentary debate, the negotiation with the IMF failed well before because NM was not prepared to touch the politically-sensitive subsidy on rice (Hansard Vol 73, No. 13, 1767 c. 2898).

1965-70: Four back-to-back SBAs

During 1965-1970, the right-of-the-centre United National Party (UNP) Government obtained IMF financial support under four SBAs. The IMF conditionality of the Letters of Intent of these SBAs reflected the very nature of the mainstream development thinking at the time, which favoured import-substitution industrialisation with the Government directly playing a major role. 

Redressing the fiscal imbalance by rationalising expenditure, in particular reducing subsidies was the key focus. Reforming State-Owned Enterprises was not part of conditionality even though converting their losses had already become a big drain on the Government budget. Under the third SBA signed in May 1968, a Foreign Exchange Entitlement Certificate Scheme (FFECS), a dual exchange rate systems, designed to provide incentives to sleeted ‘non-traditional’ exports and to lift quantitative restrictions on selected imports at a premium above the official exchange rate (initially set at 44%). Other than this, there was no emphasis by the IMF on unshackling the economy from import restrictions and other direct Government intervention in the economy.

An important development in the policy scene during this period, which has not received only scant attention in the post-independence development history of Sri Lanka, is a failed attempt by J.R. Jayewardene (JR), the then Minister of State and Deputy Prime Minister, to seek IMF support for a major liberalisation reform. At the time the economy was in the doldrums because of the closed-economy polices pursued by the country from the late 1950s. JR ‘regarded the crisis as an opportunity to embark on a radical change in economic policies that would amount to a departure from the dirigiste policies’ (de Silva and Wriggins 1998, p168). 

He approached B. R. Shenoy, the Indian liberal economist (who had taught at the Ceylon University College in the late 1940s) for advice. Shenoy responded with a comprehensive policy blueprint for unshackling the economy (Shenoy 1966). JR presented the Shenoy report to the Cabinet but there was little chance of being adopted the radical reform package given the political adjustments and realignments within the multi-party Cabinet. He had to wait until the UNP’s election victory under his leadership in 1977 to implement the proposed reforms. 

(Prof. Prema-Chandra Athukorala is a Fellow of the Academy of the Social Sciences of Australia, an Emeritus Professor of Economics at Australian National University and an Advisor for Advocata Institute and can be reached via Prema-chandra.athukorala@anu.edu.au)

Prof Colombage: Tax Amnesty Bill: A quick fix for budget gap?

Originally appeared on The Daily FT

By Prof. Sirimevan Colombage

Tax amnesties have the potential to encourage corruption and money laundering. They could weaken law enforcement in such grey areas, as income tax officers are prohibited to investigate the perpetrators of white-collar crimes who benefit from tax amnesties

The Ministry of Finance gazetted the Tax Amnesty Bill on 12 July in order to provide relief to tax defaulters who are prepared to voluntarily disclose their undisclosed taxable income or assets, against liability from investigation, prosecution and penalties under specified laws.

This Bill is introduced in the backdrop of the Government’s annual revenue loss of over Rs. 500 billion caused by the haphazard tax cuts implemented in 2020. The resulting budget deficit is largely funded by borrowings from the Central Bank and commercial banks, falling in line with the dubious Modern Monetary Theory (MMT), as explained in my last week’s FT column.

Tax Amnesty Bill

The new Tax Amnesty Bill provides a wide range of reliefs to tax evaders who had failed to disclose any taxable income or assets before March 2020. 

These reliefs include writing off penalties and interest, and permitting to invest the undisclosed taxable assets in financial instruments such as shares of a resident company, Treasury bills and bonds, debt securities issued by a company or to buy movable or immovable property in Sri Lanka. This facility will be effective after the commencement of the Act until 31 December 2021. The voluntary disclosures are subject to 1% nominal tax. 

Under the Bill, the Commissioner-General of Inland Revenue and other officers in the Department are bound to preserve absolute secrecy of the declarant’s identity and the content of the declaration. 

Benefits of tax amnesties debatable

Tax amnesties are used in developed and developing countries around the world to raise revenue collection and to improve tax compliance. In Sri Lanka, several tax amnesty laws were implemented beginning from 1964. 

While tax amnesties might serve as a quick fix to raise tax revenue during a fiscal crisis, their effectiveness in generating higher revenues in the medium and long term is found to be doubtful, as evident from the past experiences of tax amnesties operated in Sri Lanka and other countries. 

Tax amnesties have the potential to encourage corruption and money laundering. They could weaken law enforcement in such grey areas, as income tax officers are prohibited to investigate the perpetrators of white-collar crimes who benefit from tax amnesties. 

Investment attracted through a tax amnesty might leak out from the country once the tax evaders who made such investments decide to leave the financial market after cleaning their black money. Such tendencies would have adverse effects on the country’s money and capital markets.

 Types of tax amnesties

The word amnesty is originated from the Greek word ‘amnestia’. A tax amnesty can be defined as a package of concessions offered by a government to a specified group of taxpayers to exempt them from tax liability (including penalties and interest) relating to a previous period, and to relieve them from legal prosecution. Thus, tax amnesties usually involve both financial and legal concessions. 

Tax amnesties can be designed to cover all taxpayers, broad categories of tax payers (e.g. small taxpayers) or certain tax types (e.g. corporate income tax, personal income tax).

Objectives of tax amnesties

The fiscal authorities implementing a tax amnesty usually view it as an efficient tool to raise government tax revenue in both short and medium terms. In the short-term, amnesties can generate additional revenue from tax evaders. Such extra income in the short-term is most welcome during periods when a government faces a severe budget crisis due to revenue shortfalls and expenditure overruns, as in the case of the fiscal pressures faced by the Sri Lankan Government at present. 

In the medium term, a successful tax amnesty is expected to widen the tax base by bringing tax evaders into the tax net, and thereby to improve tax compliance.

Some tax amnesty measures have a wider scope than immediate revenue and tax compliance motives, aimed at broader objectives such as improving capital inflows and domestic investment. The new Tax Amnesty Bill falls into this category, as it provides facilities for tax invaders to invest in financial instruments, in addition to tax reliefs. 

 Tax amnesty inadequate to recover revenue losses 

Following the victory of the Presidential election in November 2019, the newly formed Government took steps to revise the Inland Revenue Act so as to provide a wide range of concessions to taxpayers, without considering their adverse consequences on fiscal and monetary stability. 

Accordingly, tax concessions were offered with respect to personal income tax rates, tax-free thresholds and tax slabs. Also, Pay-As-You-Earn (PAYE) tax on employment receipts, withholding Tax and Economic Service Charge were removed. Downward revisions were made to the Value Added Tax and Nation Building Tax to stimulate business activities.

As a result of those tax cuts, the total tax revenue fell by Rs. 518 billion from Rs. 1,735 billion in 2019 to Rs. 1,217 billion in 2020. This amounted to a loss of almost one third of the total tax revenue. It resulted in an expansion of the budget deficit by Rs. 229 billion from Rs. 1,439 billion in 2019 to Rs. 1,668 billion in 2020. Thus, the budget deficit rose from 9.6% of GDP in 2019 to 11.1% in 2020.

Income tax revenue alone fell by a whopping Rs. 160 billion from Rs. 428 billion in 2019 to Rs. 268 billion in 2020 due to the tax cuts. Such revenue loss cannot be recovered by the proposed tax amnesty. Even optimistically assuming a 10% increase in income tax revenue following this tax amnesty, the additional revenue generated would be only Rs. 43 billion, which is hardly sufficient to compensate for the policy-driven revenue loss.  

Tax amnesty discriminates against honest taxpayers

The short-term revenue mobilisation, which is often considered as the main benefit of tax amnesties, may be offset by various other factors. In particular, taxpayer compliance may decline after the amnesty due to the loss of credibility of the tax administration. The reason is that tax amnesty could be viewed as a weakness of tax administration. The regular taxpayers might see tax amnesty as a penalty for them and a reward for tax defaulters. 

Hence, an amnesty may create disincentive in the form of moral hazard among law abiding tax payers not to pay taxes. If people expect further rounds of tax amnesties in the future, then they will feel tax evasion would be profitable. As a result, the number of tax evaders will rise causing deterioration of tax compliance. 

Repeated tax amnesties would result in revenue losses due to reduced compliance. This might lead to a vicious circle which would necessitate more and more generous and frequent tax amnesties to widen the tax net.

 Costs of tax amnesty offset benefits

The direct cost of administering the amnesty, which includes administrative resources and advertising, might offset the additional revenue collected through the amnesty. Also, the foregone tax revenue on account of waived penalties and interest levies might be quite high. Hence, the net benefit of tax amnesty would be marginal, if not negative. 

 Policy alternatives

Notwithstanding the benefits of tax amnesties, there are various other alternative policy strategies that can be used to enhance revenue mobilisation in both the short and medium terms. In contrast to tax amnesties, such alternative strategies are geared to deal with the root cause of the fiscal gap, namely weak tax compliance. 

In general, low tax compliance is due to (a) weak tax administration, (2) weak legal system or enforcement of the law, and (c) poor tax policy characterised by complexities, regressive taxes and high taxes. 

Abandoned tax reforms under EFF

The above-mentioned weaknesses have been prevalent in the tax system of Sri Lanka for many decades. An attempt was made to overcome such weaknesses through the tax reforms that were to be implemented under the now abandoned Extended Fund Facility (EFF) arrangement with the International Monetary Fund (IMF) for the period, 2016-2019. 

Accordingly, administrative improvements were initiated in the Inland Revenue Department (IRD) and Customs Department. The new Inland Revenue Act was launched in 2018, and IRD continued its outreach strategy to ensure that the new tax rules and incentives are clearly understood by taxpayers. 

Specific improvements in electronic database and surveillance systems were introduced to enhance income tax and Value Added Tax (VAT) revenue mobilisation. Steps were also to be taken to enhance capacity building in IRD including training programmes for the staff.  Most of such tax reforms were abandoned due to the suspension of the EFF prematurely in 2019.

Low tax compliance could be better addressed by such far-reaching improvements in tax administration, rather than favouring corrupt tax defaulters vis-à-vis law-abiding taxpayers through tax amnesties. It is widely recognised that tax amnesties could induce corruption and money laundering. 

Therefore, tax reforms that go beyond tax amnesties are essential to overcome the structural weaknesses of Sri Lanka’s tax policy and administration.

(Prof. Sirimevan Colombage is Emeritus Professor in Economics at the Open University of Sri Lanka and Senior Visiting Fellow of the Advocata Institute. He is a former Director of Statistics of the Central Bank of Sri Lanka, and reachable through sscol@ou.ac.lk)

Prof Colombage: Central Bank's V shape recovery projection unrealistic

Originally appeared on The Daily FT

By Prof. Sirimevan Colombage

There is an impending danger that delaying corrective policy decisions might push Sri Lanka towards an L-shaped recovery, prolonging the pandemic-led recession indefinitely

Sri Lanka’s economy contracted by 3.6% in terms of Gross Domestic Product (GDP) in 2020 in the aftermath of the outbreak of COVID-19 pandemic, recording the worst economic performance, as in the case of many countries. Industrial output declined by 6.9%, largely reflecting the adverse performance in apparel, manufacturing and construction. The services sector contracted by 1.5% due to the setback in tourism, transport and personal services. Agricultural production too fell by 2.4% in 2020.

In an effort to revive the economy and to mitigate the adverse impact of the pandemic on individuals and businesses, the Government has implemented a series of measures including health allocations, cash transfers and tax postponements.  These have been supplemented by the monetary easing policy adopted by the Central Bank since last year.

Despite such proactive measures, Sri Lanka is experiencing a prolonged economic recession due to the outbreak of the third wave of the pandemic. The economic recovery has become even more difficult due to the macroeconomic constraints faced by the country even before the pandemic. They include growth slowdown, high fiscal deficit, debt burden and balance of payments difficulties. 

 Alphabet of economic recovery

Questions have been raised across the world regarding the shape of the economic recovery from the COVID-19 pandemic applicable to different countries; whether it is V-shaped, U-shaped, W-shaped or L-shaped.

The best-case scenario is the V-shaped recovery in which the economy rebounds quickly after a sharp decline. In a U-shaped recovery, it takes months or years to revive economic activity. In a W-shaped recovery, the economy recovers quickly but falls into a second recession. Hence, it is known as a double-dip recession. 

The worst-case scenario is the L-shaped recovery in which the economy fails to recover in the foreseeable future.

Central Bank’s V-shaped projection unrealistic

As per the medium-term macroeconomic outlook presented in the Central Bank’s Annual Report-2020, the Sri Lankan economy is expected to rebound strongly in 2021 and sustain the high growth momentum over the medium term, buoyed by growth-oriented policy support. 

Accordingly, the economy is expected to achieve a V-shaped recovery with GDP growth jumping exorbitantly to 6.0% this year from the negative growth experienced last year, as shown in the chart. The growth momentum is projected to remain in the next five years accelerating the growth to 7.0% by 2025.

The Central Bank’s above projection seems to be over-optimistic, given the structural economic imbalances that have been prevailing in the country for a long time, leaving aside the adverse effects of the pandemic. This is clearly reflected by the fact that the economy was already on a downward path even before the pandemic. 

GDP growth averaged only 3.7% during the ‘Yahapalana’ regime of 2015-2019. The average growth rate was down to mere 3.1% in 2017-2019, the period immediately preceding the pandemic. 
Based on our time series projections as shown in the dotted line in the Chart, the annual GDP growth would not have been more than 2% from this year onwards, assuming there is no COVID-19 pandemic. The scenario appears even worse when a non-linear trend projection is applied, which indicates negative growth in the medium-term even without the pandemic. 

Thus, Sri Lanka’s economic downturn is deeply rooted in factors beyond the pandemic which call for immediate policy action.

As the pandemic has exacerbated the economic slowdown, it is highly unrealistic to anticipate a V-shaped economic recovery overtaking the pre-pandemic growth, as projected by the Central Bank.

SL’s poor growth record

Following the cessation of the war in 2009, the economy followed a high growth path supported by the revival of production activities in the north and east together with post-war reconstruction and infrastructure development. However, that construction-based economic recovery was short-lived due to the lack of sustainable growth strategies, fiscal imbalances and export setback. 

The weak economic performance has continued during the ‘Yahapalana’ regime during 2015-2019 in the absence of a coherent economic reform agenda aimed at export-led growth. 

SL lacks technology-driven growth

Economic growth achieved thus far has been driven by using more factors of production – capital and labour. Such growth is identified as ‘factor-driven growth’.  The economic slowdown immediately prior to the COVID-19 pandemic indicated that the economy could not grow any further solely depending on labour and capital inputs. 

In other words, Sri Lanka has reached the ‘Production Possibility Frontier’ (PPF), in economic terminology. Raising the output beyond PPF requires application of technology and innovation thus enabling the economy to materialise ‘technology and innovation-driven growth’. 
In the current global set up, technology and innovations based on human capital are the core growth drivers in many fast-growing countries, which have achieved the knowledge-economy status. Sri Lanka has been lagging behind in terms of knowledge economy indicators: economic and institutional status, education and skills development, Research and Development (R&D) and information and communication technology. 

Unless appropriate policy measures are adopted to fill such gaps targeting technology and innovation-driven growth without further delay, it would be impossible to revive the country’s economic growth hampered by the pandemic in the near future. 

Sri Lanka has lost numerous opportunities to achieve such growth in the post-liberalisation period mainly due to the politically-motivated decisions adopted by successive governments leaving aside economic priorities.

Import-dependent export growth 

A country’s long-run growth rate is constrained by its export capacity and import demand, according to the well-tested theory introduced by Prof. Anthony Thirlwall of University of Kent in 1979. It is known as ‘Thirlwall’s Law of ‘Balance of Payments – constrained economic growth’. The larger the trade surplus (exports minus imports), the faster the economic growth. 

In the long run, therefore, no country can grow faster than that rate consistent with balance of payments equilibrium on current account, unless it can continuously finance ever-growing deficits by foreign borrowing which, in general, is impossible, as evident from Sri Lanka’s experience. 

The country’s envisaged economic recovery largely depends on its ability to raise exports. The pandemic-hit export sector showed some resilience in the first quarter of this year recording a 12.6% increase in total export earnings; industrial exports rose by 7.9%, and agricultural exports by 31.0%. Nevertheless, the trade deficit expanded in the first quarter due to a 12% increase in import outlays. 

The Government has imposed import restrictions on a variety of goods since last year to ease the balance of payments difficulties. Given the high import content of domestic production, such restrictions have downside effects on the export sector as well as on overall economic growth. The recently-announced import ban on chemical fertiliser will adversely affect the agriculture sector, causing food security problems during the pandemic.

Thus, import controls are likely to prolong the pandemic-led recession, as per Thirlwall’s law. 

Selective import relaxation for lawmakers

Whilst import restrictions on some of the essential goods consumed by ordinary people (including turmeric) are in force, the Cabinet is reported to have given its nod to permit importation of luxury vehicles for MPs, reflecting the Government’s absolute insensitivity to the country’s fiscal and foreign exchange crisis amidst the pandemic.  

In contrast, New Zealand’s Prime Minister has said she and the ministers will offer a 20% pay cut lasting six months to show solidarity with those affected by the coronavirus outbreak, as the death toll continues to rise. 

CB’s frequent tinkering with export proceed conversion rules

Last week, the Central Bank once again revised the rules on repatriation of export proceeds, requiring 25% of the proceeds to be converted within 30 days after receiving such proceeds. 

The Monetary Board keeps its discretion to determine the specific export sectors or industries or individual exporters, who or which may be permitted to convert less than 25% of the total of the export proceeds received. This, however, will continue to be subject to not below 10% conversion of the export proceeds and received no later than 180 days from the date of shipment. 

Such discretionary rules introduced in a bid to salvage the country’s foreign exchange situation have severe detrimental effects on the export sector hit by the pandemic, as reiterated in this column earlier. 

Fiscal deficit and debt burden

A crucial macroeconomic imbalance that impinges on Sri Lanka’s growth recovery is the fiscal deficit and the accumulating debt service payments. The budget deficit rose to 11.1% of GDP in 2020 and the available indicators show even a higher increase in the deficit over 13% of GDP this year. 

The continuation of the arbitrary tax cuts and the expenditure hikes already worsened the fiscal situation requiring frequent borrowings from domestic and foreign sources. Annual debt service payments amounting to around 150% of the Government revenue exert enormous pressure on budgetary management. 

While the Central Bank’s low interest rate policy helps to ease the domestic debt service burden, the depreciation of the rupee in recent weeks makes external debt service payments extremely costly. 

Overdependence on foreign loans and swaps

Instead of pursuing the Government to stick to a fiscal consolidation programme targeting a lower fiscal deficit so as to ease the debt burden, the Central Bank continues to rely on short-term foreign borrowings and swap arrangements. This is in addition to its accommodative monetary policy stance with regard to Government’s domestic borrowings.  

Last week, the Bangladesh Bank has agreed to provide a swap facility of $ 200 million. Sri Lanka received renminbi-denominated swap of $ 1.5 billion from China last month. In addition, the Republic of Korea last month agreed to provide concessional loans amounting to $ 500 million to finance the identified projects. 

More swap facilities are in the pipeline, according to the Finance Ministry sources, as reported in the media. 

Fresh debt-funded infrastructure projects 

Meanwhile, the Government is reported to have launched several major debt-funded infrastructure projects including highways a few days ago amidst the pandemic and severe external debt problems. Such borrowings will certainly aggravate the country’s staggering macroeconomic imbalances.

U- or L-shaped recovery for Sri Lanka?

In the backdrop of Sri Lanka’s growth slowdown even prior to the pandemic, the V-shaped recovery projected by the Central Bank is far from reality. 

Assuming a best possible scenario, hopefully the economy would revive after two to three years characterised by U-shaped recovery. The bottom of the U shape represents the extended period of the recession before recovery. 

A longer post-pandemic U-shaped recovery implies that the economy will take a number of years for recovery. First and foremost, the length of the economic recession depends on how long it takes to eradicate the coronavirus at the national and global levels.

Proactive policies are essential to correct the macroeconomic imbalances, specifically the fiscal deficit, bad debt dynamics and the balance of payments deficit so as to revive the Sri Lankan economy at least with U-shape recovery, which is considered to be the second-best option below V-shape recovery. 

There is an impending danger that delaying corrective policy decisions might push Sri Lanka towards an L-shaped recovery, prolonging the pandemic-led recession indefinitely. 

(Prof. Sirimevan Colombage is Emeritus Professor in Economics at the Open University of Sri Lanka and Senior Visiting Fellow of the Advocata Institute. He is a former Director of Statistics of the Central Bank of Sri Lanka, and reachable through sscol@ou.ac.lk)

Daniel Alphonsus : A Crises Manifesto: Exorcising Hunger, Unemployment and Debt

Originally appeared on Echelon

By Daniel Alphonsus

An unprecedented crisis can only be met with comprehensive and deep reform. Bandages and tinctures will not do.

There are crises and there are crises. But the truly momentous calamities, those that set the stage for the decades that follow are few and far between. Surveying 20th century Sri Lankan history, two such events stand out – the Great Depression and the rice-queues of the 1970s. Those traumatic experiences dictated economy policy for the decades that followed. In the case of the Great Depression, rapid reductions in commodity prices, combined with a global credit crunch, ravaged Sri Lanka’s undiversified plantation economy. A consensus emerged for reducing Sri Lanka’s dependence on international markets.

The Ceylon Banking Commission report of 1934, in many ways the premier pre-independence analysis of Sri Lanka’s economy, observed, “Never before was the vulnerability of the economic structure of Ceylon more forcibly revealed than during this period. The three major products, namely, tea, rubber, and coconut, which between them account for over 90% of the wealth of the country, suffered seriously during the depression. The creed of economic self-sufficiency which became an article of faith in the economic policies of other countries spread to Ceylon as well.” Inspired by war-time planning and the Soviet command economy’s success in industrializing Russia, there was also widespread agreement that in the newly independent third world, governments, not firms, would be the motor of this historic transformation from global dependence to national independence.

Exhilaration soon gave way to enervation. The failure of import-substitution and appalling government record of running enterprises – including the critical plantation sector – paved the way for the open market reforms of 1977. The desperation was palpable. On election platforms, Sirima Bandaranaike accused J.R. Jayawardene of being in bed with the Americans, thinking that would dissuade voters from supporting him. But the ploy boomeranged. Voters, who just two or three decades ago were Asia’s second richest but now had to wait in queues for rice, voted with their stomachs. Their reasoning was simple, if J.R. is in bed with the Americans, then he will be able to secure relief from them.

Despite a quarter-century of the open market model coming to a sudden and unexpected halt in 2004, economically speaking, we are still the children of the 1977 revolution. This year may mark the twilight of that epoch, or at the very least a new chapter.

For Sri Lanka is facing an unprecedented economic crisis. It is a crisis of four tempests, whose sum is a raging storm that threatens to engulf the entire island in its dark thunderous deluge. They are:

1. Coronavirus: the global and domestic combined supply and demand shocks caused by the Coronavirus.

2. Original Sin: borrowing liberally from international capital markets in foreign currency, at high-interest rates and with low maturities for low-productivity construction and import consumption.

3. Negative Growth Shocks: the economic slowdown caused by floods, droughts, the constitutional coup and Easter Bombings.

4. Stalled Reform: with the exception of the new Inland Revenue Act, the failure to carry through any serious structural reform since 2004 has seen real growth fall.

As a result, we may be on the verge of Sri Lanka’s first sovereign default since Independence. Prior to the pandemic, though the trajectory was grim, there was still hope of avoiding that catastrophe. That hope is now waning fast. The origins of this crisis lie in the early years of this millennium. In 2004, the quarter-century long bipartisan consensus for reform stalled. In many cases – such as tariffs and privatizations – reform reversed. Due to time-lags the reforms of the late 90s and early 2000s continued to bear fruit for some years. But by the turn of the millennium, high-interest dollar debt increasingly became growth’s chief hand-maiden.

Post-2007 commercial borrowings from international capital markets rose rapidly from almost zero. This fueled a construction and consumption boom soon after the war’s end in 2009. Project loans were spent on empty airports and useless towers. Sovereign Bonds were issued to bridge the government’s ballooning budget deficit; caused by an unprecedently massive and swift expansion of the public sector.

Over the last few years, supported by an IMF programme, the government worked hard to reduce Sri Lanka’s debt-burden and dependence on international capital markets. Sri Lanka ran a non-trivial primary surplus for the first time in 2017, repeating that success in 2018 and upto November 2019 despite the coup and the Easter Bombing. But this alone was not enough.

In reality, the value of public debt rarely declines. What matters is reducing public debt relative to the size of public repayment capacity. In its simplest form, it’s about reducing the value of this equation:

This can be done in two ways. Reducing the value of the numerator, “Public Debt”. Or by increasing the value of the denominator, “Annual GDP”. In the last few years, Sri Lanka adopted a ‘fiscal consolidation’ approach which rightly attacked the numerator. But coalition dynamics and time-lags thwarted progress on the denominator, growth, which is more important. The new government reversed course significantly loosening fiscal policy. It implemented a sweeping range of tax cuts which drastically reduced government revenue. In the language of our equation, these tax-cuts increased the numerator. The wager – to describe the strategy charitably – was that rising public debt would be off-set by an even faster surge in GDP growth, thus reducing the relative value of public debt. That plan has clearly failed. Today, public debt is touching 95% of GDP. The true value, when one calculates all liabilities such as Treasury guarantees for invoices, is likely much higher.

As a result, markets seem to think Sri Lanka is at risk of defaulting for the first time in its history. Bond yields are in the double digits. Among emerging markets, only Argentina, Zambia and Lebanon have higher risk premiums on their debt. A default will be a further blow to an economy that has been ravaged by floods, coups, the Easter Bombings and COVID. The country will be shut off from international capital markets. It will not be able to finance the budget deficit. Inflation unless government spending is cut. Taken together, they could well lead us into an Argentine, Lebanese or Greek-style vicious cycle of default and political instability. An unprecedented crisis can only be met with comprehensive and deep reform. Bandages and tinctures will not do. As Italy has shown neither will attacking the numerator alone: decades of focusing on primary surpluses without structural reforms have only resulted in stagnation. Rather we need the second-round of 1977 type reforms that served Sri Lanka so well. There are many ways of thinking about such a reform programme. However, as the catalyst this time is likely to be a sovereign default, it is easier to label reforms as either an “attack on the numerator” or an “attack on the denominator”.

Attacking the Numerator: Reducing Debt

Reducing public debt – ‘attacking the numerator’ – can be done in three ways. First, increasing taxes. Second, reducing expenditure. Third, selling assets. Sri Lanka will probably have to do all three.

Increasing Taxes: Property Taxes and Tax Loopholes

 It is well known that Sri Lanka has one of the lowest tax-to-GDP ratios in the world and has a regressive tax system. This year Sri Lanka’s tax-to-GDP ratio could rank among the lowest 15 countries in the world. However, in the midst of economic contraction raising taxes that reduce consumption and investment could catalyze growth shocks. One solution would be to tax savings, especially those savings that are not productive. The biggest example of such savings is land ownership. A Western Province property tax could raise substantial revenue and encourage efficient use of idle property. In the last decade property prices in Colombo rose by 300%, much of this windfall is the direct result of public infrastructure spending. Our tax system also has many loopholes. Consider the case of excise taxes on cigarettes. Estimates suggest the government could prevent over two hundred billion rupees of revenue leakage over the next decade by introducing a formula for cigarette prices. Similarly, the duty on beedi clearly points to political rather than economic considerations in excise taxation.

Reducing Expenditure: Too Many Men

Sri Lanka has a bloated public sector. From a revenue, productivity and ultimately security viewpoint the large size of the military is a challenge. Around 40% of government salary expenditure is spent on the military. The military, nearing 280 thousand men (compared to the British Army’s approximately 100,000), is holding back our most able men from productive employment. Transferring most of these men to reserves and offering subsidized labour to the export industry through an apprenticeship scheme would substantially improve public finance and propel growth. A similar story of job growth can be found in the public sector.

Selling Assets: Sell Enterprises

The government is poor at managing businesses. State-owned enterprises are renowned for their mismanagement, waste and corruption. The direct cost is colossal. But the indirect costs are even greater. Despite competition from Ports Authority run terminals, SAGT and China Merchant Holdings have played a key role in making Colombo one of the world’s great ports. Imagine if airports and air-services had been similarly open to competition and private enterprise; Sri Lanka could have become an aviation and air-sea hub, as well as a shipping-hub. There are countless other examples throughout our economy.

At this stage of economic development, there is little reason for the state to run enterprises. In fact, the state can increase the value of the assets it owns by selling enterprises without selling land per se. For example, state-owned hotels, container terminals and air terminals could be privatized without selling the land on which they operate. In other words, privatize the enterprises, not their land-holdings. The tax-payer would be significantly better off as the privatization proceeds can be used to settle debt. In addition lease values, for the land, will rise and the land-value will appreciate faster too.

From a productivity point of view, key targets for privatization could be Sri Lankan Airlines, Ratmalana Airport, Jaya Container Terminal and Unity Container Terminal. One simple method of doing this would be to place all SOEs operating in competitive industries in a holding company that has an explicit mandate to sell them within a set time-frame, failing which they are automatically listed on the Colombo Stock Exchange.

Attacking the Denominator: Productivity Growth

There is only one tried and tested way of going from third world to first in the space of a few decades: manufacturing exports. Sri Lanka successfully completed the first step of this process by the 1980s when it established apparel exports industry, which remains Sri Lanka’s only manufacturing export. In 1983, Sri Lanka was about to move up the value chain to semi-conductors, which would have led to South-East Asian and East Asian style growth. But Black July was engineered, and the semiconductor plants being built in Katunayake by Motorola and Harris Corporation were shipped-off to Penang. Similarly, we missed the wave of Japanese investment that was about to begin at that time.

Since then Sri Lanka hasn’t developed a major manufactured export. The challenge for Sri Lanka is to create new higher-productivity export industries. This is a complex task requiring government effort. But Sri Lanka has done it before. The tested strategy of the 1977 revolution is as follows. First, create investment zones where the usual constraints affecting investment can be managed. That is the genius of the Free Trade Zones. Second, make Sri Lanka’s exports competitive: reduce tariffs (a tax on imports is a tax on exports) and sign Free-Trade Agreements. Third, enable efficient factor allocation: remove regulatory constraints on agricultural production and update labour laws. Fourth, unleash the power of the developmental state by fast-tracking the MCC grant, designing clever export subsidies and most importantly completing land reform.

Investment Oases

The engines of Sri Lanka’s manufacturing exports are the Free Trade Zones. It is here that the apparel industry started. It is also the zones that were the cradle for the island’s solid-tyre export industry and they remain the primary site of all other manufactured exports. The reason for this is that zones make it much easier for an investor to open a factory. Land, electricity and water are available; regulatory permissions are already secured; customs officers and other government agencies are on hand. Over time an eco-system of trained labour and ancillary suppliers also develops. Despite being near capacity, Sri Lanka failed to build any new free trade zones between 2002 and 2017. So its no surprise to hear investors complain that access to land is the primary constraint for investment.

Almost all of Sri Lanka’s Free Trade Zones are managed by the BOI. One exception is the DFCC Bank run Linden Industrial Zone. The BOI run model worked well and was competitive in the 1980s. Today the world has moved on. In order to attract new investors in sectors outside apparel, Sri Lanka needs to allow international zone operators. For example, Sri Lanka should court a Chinese free trade zone operator, a Japanese free trade zone operator and a Singaporean one to establish facilities in Sri Lanka. These zone operators will then leverage the relationships they have with manufacturers in their countries and regions, doing the job successive governments have failed to do since the late 1980s.

The energies of Sri Lanka’s own private sector could also be unleashed in zone-management. MAS and Brandix run successful textile parks in Sri Lanka and India. There is no reason they couldn’t successfully run a zone in Sri Lanka. The failure is not the central government’s alone. As far as I know, no other province has done what the Wayamba Provincial Council did within a couple of years of the formation of a provincial government: establish not one but two province run industrial zones, at Heraliyawala and Dangaspitiya respectively. The Northern Province with its devolutionary fervour, combined with access to the KKS Port and Palaly Airport, should be particularly ashamed.

A pilot project could deploy under-utilized state land around Ratmalana to create an electronics free-trade zone. There is no better place in Sri Lanka due to proximity to a port, railway and airport, universities and technical schools and trained labour.

Export Competitiveness

But no one will build factories in Sri Lanka if input costs are high. In this era of global supply chains, one country rarely adds more than 20% to 30% of a product’s final value. Therefore, being able to import components and raw materials at the same prices as in competitor countries is vital. However, Sri Lanka has some of the highest effective tariff rates in the world. To make matters worse they are highly complex, creating ample room for discretion and thus delays and corruption. If Sri Lanka is to become the trading and manufacturing hub of the Indian Ocean, it will have to benchmark its tariffs against Dubai and Singapore. This is not new to Sri Lanka. In 1994 it has a simple three-band tariff structure. It is only after 2004 that Sri Lanka’s effective tariff rate sky-rocketed, primarily due to the cascading effects of CESS and PAL. Their abolition would be a very good start.

Similarly, during the 1977-2004 Sri Lanka’s real effective exchange rate was kept more or less constant. A weaker currency makes foreign goods dearer domestically and makes Sri Lankan goods cheaper on global markets. This helped ensure the competitiveness of exports and acted as an automatic, non-discretionary import substitution incentive. However, from 2004 onward the real effective exchange rate started creeping upwards, discouraging exports and encouraging imports. By 2017 Sri Lanka’s real effective exchange rate was 31% higher than in 2004.

Finally, Sri Lanka’s competitiveness is eroding because all its competitors are signing free trade agreements (FTAs). Sri Lanka must fast-track deeper goods and service trade integration with India, China and ASEAN. Most importantly, we need to become part of the two-major trade agreements the CPP11 and the RCEP. The constraints of space and time, robbed of the opportunity to discuss the importance of a new Customs Act, the implementation of the National Export Strategy or other reforms to facilitate cross-border trade. Suffice to say they too are essential.

Efficient Factor Allocation

Land, labour, capital; it is the development and allocation of these factors that determines the wealth of nations. Sri Lanka’s capital allocation is relatively efficient. Our challenge today is to ensure the efficient allocation of land and labour.

Land

Many cite East Asia’s successful land reform as the key to their economic prosperity. Studwell’s How Asia Works is perhaps the most persuasive and readable account. There is much to commend in this analysis. Granting freehold land to families already farming it will increase agricultural productivity. This is true of Sri Lanka too. One critical land reform, that can be implemented quickly, will be to make small-holders of the existing tea-estate workers. This will improve productivity, as the principal-agent problem will be solved. In addition, with freehold rights, they will have every incentive to replant and improve the land. Access to credit will not be an issue; the land itself will act as collateral.

As for the RPCs, the factories and land equal to the value of their remaining leaseterm can be transferred to them freehold. They can then offer extension services and an out-grower model to the new small-holders. In a similar vein, there is absolutely no good reason for the continuation of the Paddy Lands Act, especially in the wet-zone. In fact, some of the land in the wet-zone restricted by the Paddy Lands Act was never paddy land in the first place. This law is a major barrier to more productive use of land for high-value export crops, such as spices.

Having got land out of the way, we can move on to labour. Sri Lanka’s labour laws have created a de facto caste system of a few highly protected insiders and a sea of completely unprotected informal workers. In fact, the failure to make labour law more flexible is an important reason why over a million Sri Lankans work in the hazardous conditions of the Gulf. It is better to have some protection for many, than a great deal of protection for a few. Especially as labour law is a major constraint to growth. The downsides of more flexible labour laws can be effectively managed through a targeted social security net, such as in the Danish Flexisecurity model, which combines high levels of labour market flexibility with generous social safety nets, such as solid unemployment insurance.

The Developmental State

Finally, Sri Lanka needs to restructure its state to facilitate rather than hamper development. The first is a question of a simply accepting reality. What credibility does a country have when it refuses the largest grant in its history (MCC), while going-cap in hand asking for debt moratoria from its creditors?

Second, the state-owned enterprises in natural monopoly sectors, such as railways and power-lines need to be depoliticized and forced to be efficient. Depoliticization can be significantly achieved by simply passing a new law. The law can require that the appointment of directors of all State-Owned Enterprises be subject to the approval of a Constitutional Council appointed nominating board, with clear ‘fit-and-proper’ criteria. A similar mechanism is already in place for banks.

Furthermore, efficiency can be improved by introducing competition, resolving conflicts-of-interest and raising transparency. Sri Lanka’s competition law does not cover state-owned-enterprises: this allows public sector monopolies to enjoy rents at the expense of citizens. That needs to go. It is also absurd, for example, that the Sri Lanka Ports Authority is owner, operator and regulator of port terminals. The public sector is rife with such conflicts-of-interest which appear designed to breed corruption and mismanagement.

These are the key changes, but information matters too. As they are owned by the tax-payer, SOEs should have greater disclosure requirements than firms listed on the Colombo Stock Exchange. But a start would be to simply require SOEs to follow all CSE disclosure requirements, this can be done by law or by requiring SOEs to list their debt on the CSE. Or both.

There are also government departments that need to be made into SOEs. The railways are the most important example. If the railways were able to borrow money, which they could if they were an SOE, they could then finance the electrification and double-tracking through the development of land the CGR owns around railway stations.

Way Forward

The real economic policy statements in Sri Lanka are not budgets but IMF programmes. Budgets are often nothing more than promises of bread and the certainty of circuses. They bear little reality to actual revenue and expenditure, much the less actual economic management. As such the crescendo of this crisis, and thus opportunity, will be the inevitable IMF programme. It is almost certain that Sri Lanka will enter into its 17th IMF programme later this year or early in 2021. Sri Lanka has been in IMF devil-dances for much of its post-independence history. We have failed to undertake the reforms needed to grow and to protect our sovereignty. The IMF kapuralas have also failed to require front-loading reforms: allowing Sri Lanka to get away with cosmetic compliance rather than really restructuring the economy.

With COVID, the IMF is also overextended; perversely this improves its bargaining position. As a result, this programme can be a water-shed that combines both fiscal consolidation and export-driven productivity growth. It must be a landmark programme with a single objective: to be the last programme the IMF has with Sri Lanka. Then, as in 1977, Sri Lanka may just pull-off a Phoenix-like rise from the ashes. If not, then the demons of hunger, unemployment and debt-collectors will follow.

(Daniel Alphonsus was an advisor at Sri Lanka’s Finance Ministry. He also worked at Sri Lanka’s Foreign Ministry and at Verite Research. Daniel read philosophy, politics and economics at Balliol College, Oxford and public policy at the Harvard Kennedy School where he was a Fulbright Scholar.)

Sri Lanka’s economy must follow Vietnam

In this weekly column on The Sunday Morning Business titled “The Coordination Problem”, the scholars and fellows associated with Advocata attempt to explore issues around economics, public policy, the institutions that govern them and their impact on our lives and society.

Originally appeared on The Morning

---

By Dhananath Fernando

With the appointment of the Cabinet of Ministers and state ministers, the real game has started. Now the challenge is transforming an ailing economy to a competitive economy within a short period of time. There are many debates among the public on the division of ministerial portfolios. However in reality, bigger economic challenges and a need to manage foreign affairs will outweigh all micro debates put together.

Problems at hand

The problems in our economy have been discussed extensively. We all know that we are burdened with short and long-term severe economic ailments. We have to literally unlearn, undo, and pay for the sin of economic mismanagement of over 40 years within the next four years. As a matter of fact, $ 4 billion is required each year for debt servicing in the coming four years. Just to put things in context, per year we need four times the value of the Hambantota Port deal to just keep our noses above water. We have to do it for four years provided that there are no major negative shocks in the global and local economy. The poor public finances management combined with deteriorating government income are just additional issues we have to deal with. Sri Lanka managed to contain Covid-19 well compared to our neighbours, but with New Zealand going back to a lockdown and many Sri Lankans working abroad planning to return within the next few months, there is an indication that the risk of a sudden uptick in COVID cases is still high.

Reading the mandate

In this context, people have provided a two-thirds majority for “Saubhagya Dakma”, the manifesto of His Excellency the President. Though it is a reasonable assumption to read this election victory as the citizenry’s overwhelming support of the manifesto, I believe it is also a voice of tiredness and displeasure by all Sri Lankans against the economic and political system that we marinated in for decades. This message can be put simply as a voice calling for a complete revamp of the existing system. In other words, making a competitive, efficient, productive, and sustainable system for a progressive Sri Lanka. The underlying voice is that Sri Lankans are not happy with where we are, although the same Sri Lankans are responsible for electing all governments in the past. It may also be read as a serious betrayal of people’s expectations and under-delivery in performance. A clear mandate was provided in November last year before COVID-19 and it has been re-assured post-COVID with another mandate. Since the world has come to a new equilibrium post-COVID on the economic front, it is important to keep an up-to-date pragmatic approach with the underlying principle of making our economy competitive, efficient, relevant to global markets, and productive.

Role model Vietnam

Through a pragmatic and dynamic approach, one country that has done exceptionally well, not only in the containment of Covid-19 but also in economic management, is Vietnam. Sri Lanka has many lessons to learn from Vietnam if we are serious about transforming our economy! Till 30 July no deaths were reported in Vietnam due to Covid-19 infections, despite Vietnam sharing a border with China and having a population of 95 million. However, over the last few days, according to data, there is a sudden uptick in cases and 16 deaths have been reported. This is also a reminder that Covid-19 management is a continuous battle that must be forged until the world comes up with a vaccine or sustainable solution. By 1986 Vietnam had suffered two wars and their economy and social condition was in shambles. Vietnam won the war with the US but the victory meant very little to overcome economic hardships. Making things worse, they had to fight another battle with Cambodia while it was believed that Cambodia was supported by China. After two crippling wars, Vietnam had lost about 1-3 million young people. Basically, at this point, Vietnam was worse off than Sri Lanka right after the war.

The post-war “Doi Moi” programme transformed Vietnam and put them back on the map in just 10 years. Vietnam managed to pick the right policy mix through the Doi Moi programme and managed to establish a strong economic foundation, stronger than our post-war reforms. This doesn’t mean that Vietnam has solved all their problems, but they have been able to create a strong economy which can withstand a global pandemic. About 97% of their population have health coverage and so far it looks like Vietnam is one of the biggest survivors of the Covid-19 pandemic. They were only able to do this as a result of the business and trade-friendly economic programme they introduced in the early 1990s.

Vietnam started labour-intensive productions similarly to Bangladesh and Sri Lanka, but unlike Sri Lanka, they managed to move on to more technologically advanced product categories. Although Vietnam is somewhat behind us in raw numbers, they are far ahead in the journey of being the next economic miracle in Asia.

How they did it

Simply, they carried out reforms to improve the competitiveness of the Vietnamese economy. Tariffs at the border were lowered to improve the competitiveness of Vietnamese products. The Government limited its role to that of a facilitator and the private sector and foreign direct investment were given the opportunity to lead the economy. Global co-operation was embraced and Vietnam signed 10 very well negotiated free trade agreements. Though I am not a strong proponent of free trade agreements and I believe in unilateral trade facilitation, Vietnam has signalled how serious they are on trade through their consistent collaboration with other markets.

With the Doi Moi programme, they first managed to get one main investor, Nokia, and then built confidence in capital markets. As a result, other investors rallied around the main investment and diversified rapidly. Today, Vietnam has become the China of China. Vietnam has good trade relations with both China and the US and have become the largest beneficiary of trade tensions between these two global economic giants. Due to trade tensions between the US and China, most Chinese-manufactured products were transhipped through Vietnam. On the other hand, most US-allied countries looked at a business-conducive market outside China to diversify their factories and Vietnam had the right ingredients for investments. While most other regional markets, including Sri Lanka, were trapped in labour-intensive industries, Vietnam had already moved to high-tech and advanced product categories through global co-operation.

Samsung shifted its smartphone production to Vietnam, Apple is reported to manufacture its Airpods in Vietnam, and Google plans to shift its smartphone production from China to Vietnam. As a result of co-operation with these global companies, homegrown Vietnamese companies are now emerging, showing competitive potential in global markets. A good lesson for Sri Lanka on understanding the recipe to improve local production is that local production can be improved only if we produce goods and services on a globally competitive scale. Vietnam has proven this.

China Plus One strategy

With Covid-19, ideologies on self-sufficiency are resurfacing, but the reality is that the world has decided to diversify its supply chain. China is the factory of the entire world, but due to rising labour charges even before Covid-19, companies were considering moving out of China. However, given the large infrastructure and business ecosystem and the availability of a range of skills (low-level skills to high-level, specialised skills) in one market, China is still competitive. But now companies are moving to a “China Plus One” strategy – meaning they keep their supply chain in China while investing in another Plus One market as a contingency. Again, Vietnam became the ideal location given the close proximity to China and more than that, its business-conducive environment. Sri Lanka too can get few investments if we play our cards right with big-ticket investors using a China Plus One strategy.

Lessons and solutions

Sri Lanka needs to unlearn from the era of producing everything on our own. That is history. Now the world is in a place where they produce only parts and components and have moved on to assembly. Sri Lanka needs to get onto this boat and begin producing parts and components and that too, competitively. Just producing products for the sake of producing them is not the way to boost local production. Like Vietnam did, first, you get the know-how and play with world-class players on your own soil which will produce results. This will not only improve our share in global markets but also improve local production. I hope the new Government and the respective ministers will understand the dynamics and capitalise on this wave. I wish them all the strength and vision to build a resilient economy and wish Sri Lanka’s economy will stand the test of time.

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.

New government must ‘unlearn’

In this weekly column on The Sunday Morning Business titled “The Coordination Problem”, the scholars and fellows associated with Advocata attempt to explore issues around economics, public policy, the institutions that govern them and their impact on our lives and society.

Originally appeared on The Morning

---

By Dhananath Fernando

The election is over and a strong and secure mandate has been provided to President Gotabaya Rajapaksa and the Government. The President has already announced that the new Parliament will be convened on 20 August and I congratulate all the members who will represent our citizenry in this Parliament. It is certainly going to define a new era for Sri Lanka if the newly elected members take it seriously.

Regardless of which party won or the composition of the government, Sri Lanka’s challenges were always going to remain unchanged. A new government cannot create a new Sri Lanka unless the government takes a new approach and starts to unlearn and undo the wrongs we’ve been committing for decades. 

Challenge 1: A severe economic recession 

The official data released by the Census and Statistics Department just the day before the election indicated a 1.6% negative economic growth (economic contraction) in real terms in the first quarter (January-March). Considering the depreciation of the Sri Lankan rupee, in US dollar (USD) terms, it is approximately a 5% contraction of the economy in the first quarter. Sri Lanka took strict social distancing measures towards the end of March, so we have to expect further economic contraction in the second and third quarters. The new government’s biggest challenge would be realigning the economy. 

According to the Export Development Board (EDB), exports have been picking up almost on par with last year’s exports, which is a big relief. A potential reason behind the recovery in exports could be the fact that India and a few competing countries have failed to manage Covid-19. As a result, some degree of production has been parked in Sri Lanka even though our cost factors are high. In the long run, we should be able to keep those orders on our shores by offering competitive prices. Otherwise, once those markets (India, Philippines, etc.) open and bounce back to normal, we will have to fall back to square one.

The EDB has expressed concern about the apparel sector’s ability in securing orders after August. Therefore, the new government has to get prepared early by starting negotiations with the International Monetary Fund (IMF) as soon as the new Parliament is summoned. Our neighbouring countries such as Nepal, the Maldives, Bangladesh, and Pakistan have already managed to secure IMF bailout programmes to overcome the brewing global economic crisis. 

Challenge 2: Trust, cohesiveness, and diversity

Over the last few decades, Sri Lanka has had emotional wounds which haven’t recovered yet. Over the years “suspicion of others’ religious and ethnic identity” has taken root amongst our fellow Sri Lankans and petty politics have ignited these fears in order to polarise Sri Lanka.

All political parties created suspicion between each other for their political advantage. Now, the very same suspicion has become the main bottleneck for us to move forward towards economic development.

In my view, this paranoia of suspecting each other is one reason why Sri Lanka is lagging in economic development when compared to other competitive East Asian countries. For more than 30 years, our Sinhalese and Tamils were suspicious of each other and did not respect our diversity. This led to the creation of the LTTE, who also capitalised on these fears while all of us became victims and losers.

If you remember, thereafter tensions were created between religious groups for converting people to a different religion for financial incentives. The wounds are not yet fully healed between the North and South, and new tensions have erupted between Muslims, Catholics, and Buddhists.

Our suspicions go beyond that. Businessmen have been labelled as a group of people with an “only for profit” motive (“businesskaaraya”), regardless of the service and assistance they provide to our economy. Private enterprises have always been attacked for playing a villain’s role over the years. As a result, all our young graduates keep expecting government jobs.

Now, we are in a situation where our revenue is not adequate to pay the salaries, pensions, and social security expenses of the government. Going a step further, we have created suspicion on foreigners and foreign investors with the famous term “foreign conspiracy”, while completely disregarding diversity. Every white-skinned person has been labelled a threat for an invasion rather than an opportunity to explore opportunities for co-operation globally.

We are where we are now as a collective result of all these domestic perspectives. We all unanimously agree that we have played far below our potential and that we are a deeply divided nation.

We are further divided on political ideology, so much so that we kill each other and damage each other’s property. The new government has the challenge of undoing and unlearning these practices. “Suspicion” is the seed that can crack any relationship, friendship, partnership, or co-operation. Even in Buddhism, “suspicion” is considered an emotion to be treated with extra caution.

Sri Lanka’s strength is its diversity. Starting from our biodiversity, diversity in weather and cultural and architectural diversity have always been our edge. Our exports need to be diversified, our economy has to be diversified, and our Sri Lankan mindset and experiences need to be diversified.

How can we create diversity without respecting diversity between people and all Sri Lankans? One of the main challenges for the new government will be establishing diversity and bringing everyone together in heart and in practice rather than spending years on documenting regulations and strategies. All political parties need to co-operate with the new government, as Sri Lanka is wounded beyond her threshold of tolerance. 

Challenge 3: Establishing competitiveness

Making Sri Lanka an economically advanced nation can only be part of a broader strategy, which is dependent on making our economy competitive. To establish competitiveness we need to increase our productivity and efficiency. The game is like winning the World Cup, where the only way to do it is to play well and play better than all the other teams. The same applies to our economy. There are multiple ways to improve productivity and efficiency. We need to think on a global scale and produce in relation to global markets while joining the Fourth Industrial Revolution. That is the next challenge for the newly elected government. 

The recent reality TV programme performed by teenagers which is getting popular across the world is one good example of the miracles as a result of competition and a competitive environment.

Young Sri Lankan teenagers proved that Sri Lanka can compete. Some of the young artists have not only challenged local original musicians but also western original musicians in their vocals and musical capacity. Some have been compared in foreign media for their performance and this is an indication that the younger generation is ready to compete and they have the fire to compete on the global stage.

Another event that made headlines was Sri Lanka’s national debating team becoming the runner-up in the World Schools Debating Championship by debating in a language which is not their mother tongue – another good example of the benefits of competition and why Sri Lanka can compete on a global level if we pick our strengths right and create a competitive environment.

The new government should push Sri Lankans to work hard for free exchange and create an environment of opportunities for any individual to be successful regardless of religion, ethnicity, caste, or creed. Sri Lanka has been practising to avoid competition and be isolated from the world – the complete opposite.

The new government has the challenge of undoing and unlearning most of what we have been doing over the years. I wish all the courage to His Excellency the President, the new government, and the new Minister of Finance and all the strength to bring in the hard reforms and to put Sri Lanka back on the map.

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.