SL slides down to 115 on Global Soft Power Index

Originally appeared on The Morning

By Dhananath Fernando

Global research outfit Brand Finance ranks countries by considering each country as a brand through the Global Soft Power Index. Sri Lanka’s brand results as a nation were released in partnership with the Sri Lanka Institute of Marketing (SLIM) last week and the country was ranked 115th out of 121 countries – a steep drop of 42 positions from ranking at 73 on the index in 2022.

Below us are Iraq, Laos, Trinidad, Uganda, Guatemala, and Zimbabwe. This survey was conducted globally with more than 11,000 samples. SLIM has to be appreciated for taking such an initiative at a very difficult time for Sri Lanka. A country’s perception and brand image are very important, especially when it comes to ‘Country of Origin’ status in global trade. The same matters in tourism and many other income-generating activities.

Brand strength of a country is determined under eight key themes and sub categories for each key pillar:

Business and trade

Governance

International relations

Culture and heritage

Media and communication

Education and science

People and values

Sustainable future

It is said that “perception is reality”. In simple terms, though we may feel that we do not deserve to be ranked 115th, outsiders do not perceive us positively. The reasons for our steep drop are quite obvious. It is more important to understand the drivers of positive perception according to the Brand Finance survey than to dwell on our ranking.

Out of the key drivers of reputation, a strong and stable economy is considered the most important driver for people. In a survey conducted within the index, it ranked very highly, with 8.9 points out of 10. The next driver, with 6.2 points, is having internationally admired leaders. Being politically stable and well-governed is ranked as the third most important attribute, while ease of doing business and sustainable cities for transport are ranked at fourth and fifth place respectively, based on importance.

Developing a nation’s brand

The expectations of people indicate that a dynamic economy and the ability to do business easily are the main drivers of pretty much everything else. If we, as Sri Lankans, are serious about building our brand, attracting FDIs, and bringing in tourists, there is no other choice than to undergo economic reforms.

The expectations indicate that most of the attributes that help develop a nation’s branding are influenced by the market and freedom. When a paternal government steps in, there is no ease of doing business for enterprises. When a government imposes high tariffs on imports, there is no efficient trade. When a government restricts movement of people and adds visa regulations, tourism cannot prosper. Countries which experience a higher degree of economic freedom also have credible country brands and soft power.

In Sri Lanka’s assessment, our worst ranking is for ‘international relations’. We have ranked 120 out of 121 countries. This comes as no surprise after our poor management of foreign relationships with all our key friends including India, China, Japan, the Middle East, and the US.

Our immaturity in managing the Indian Free Trade Agreement (FTA) and the East Container Terminal (India), managing the Port City and the fertiliser shipment (China), cancelling the Light Rail Transit Project (Japan), forced cremations of Muslims (the Middle East), and dealing with the Millennium Challenge Corporation (MCC) (the US) undeniably isolated us, pushing our reputation to a historic low.

Our diplomatic service is basically a meal ticket for unemployable relatives of politicians. It is imperative that a merit-based exam for diplomatic service be required in order to ensure our economic prosperity. Diplomacy is economic; a friendship built on doing business is much better than a business built on a friendship.

We have ranked relatively better on ‘culture and heritage,’ standing at 92 from among 121 nations. On ‘governance,’ we are ranked at 118 and on ‘business and trade’ we come in at 115.

Solutions

There are quick fixes, but building a brand is like raising a child. Values, ethics, and dynamism take time to instil. If we are to improve Sri Lanka’s brand, a comprehensive economic reform package is needed. Countries that recently picked up their ranking did it through reforms and allowing markets to work smoothly.

New Zealand had a reform plan in the 1980s while South Korea transformed through market-based reforms. Dubai was converted into a business hub, Vietnam was converted into an export-oriented economy, and so on. The common denominator is a concrete economic reform plan.

In the short run, what we can consider is implementing a free, six-month business and vacation visa plan for countries with twice the per capita GDP of Sri Lanka. This will allow us to earn much more through their spending in Sri Lanka. At present, we have nothing to lose, as they are not visiting Sri Lanka anyway.

The next step is to allow foreign spouses to work in Sri Lanka. As many people leave the country, at least some may consider staying back in these cases, especially those married to foreigners. They will bring their skill set, which enables better knowledge transfer. In some areas such as Galle, this synergy can already be observed in the tourism industry, despite bad regulations.

Thirdly, all tariffs should be brought under either a four-tier structure (0%, 5%, 10%, and 15%) or a higher tariff structure that is simple and unified so that it can incentivise trade. We need to keep our Central Bank independent and not intervene in the forex market in order to get the maximum benefits out of this. All these can be done with just a stroke of a pen at zero cost to the Government.

The brand ‘Sri Lanka’ can only be built by instilling the right values within the brand. A communications campaign may only dilute the brand when people realise we oversell ourselves by overpromising and under-delivering.

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.

Which reforms should take the spotlight after the IMF?

Originally appeared on The Morning

By Dhananath Fernando

According to news reports and a tweet by International Monetary Fund (IMF) Managing Director Kristalina Georgieva, Sri Lanka is likely to enter its 17th IMF programme since its membership began. We are yet to know the details of the programme, but we have an overview of key areas as per the press conference in September 2022, when we entered the Staff-Level Agreement. Out of the previous 16, we have only completed nine programmes and have given up in the midst of seven programmes without completion.

This time, things are slightly different, because on the previous 16 occasions our debt was sustainable, but this time it is not. Dropping out in the middle of the programme while we are under a debt restructuring plan will erode even the remaining confidence of investors and many other stakeholders.

There seems to be an overestimation that the IMF can fix all our problems. We have been trying to debunk this myth for a long time; the IMF cannot fix our economy. It is merely a lifeboat to make sure we don’t drown in our debt. Only we can fix our economy through economic reforms.

What the IMF can bring us is credibility. Credibility will provide us breathing space on a few fronts. It will provide room to negotiate debt with external creditors and enable us to obtain some relief before we start our debt repayments. This credibility will allow Sri Lanka to tap into more bilateral and multilateral funds to reactivate some of its economic activity.

It is imperative that we reform the economy and move forward with all this funding. Other countries that have gone through debt distress have fallen into a cycle of defaulting. We have to avoid this, which can only be done by creating a competitive economy.

A competitive economy can only be achieved through economic reforms and not in any other way. Most of these reforms are simple to understand but complicated to execute, as many of the beneficiaries of the current inefficiencies will be on the losing end. They will all have to work hard and compete in a market environment.

While there are many reforms to be undertaken, which will also be included in the IMF agreement in different forms, I would like to prioritise three key reforms.

Social safety nets to protect the poor

During an economic crisis, people are angry as well as hungry. Protecting the most vulnerable section of society has to be a priority. Ultimately, the objective of all economic principles we practise is to eradicate poverty.

Poverty eradication cannot be undertaken simply by distributing money to the poor. We can only eradicate poverty by opening up opportunities for the impoverished to engage in economic activity and expand their capacity to add productive value to society. During difficult times, they should have some support so they can worry less about basics and worry more about joining economic activities.

The current expenditure on our main social safety net programme – Samurdhi – is about Rs. 55.4 billion. This is peanuts compared to the losses of the Ceylon Petroleum Corporation (CPC) over eight months in 2022, which amounted to Rs. 632 billion. Most of the losses in petroleum caused by the Government’s fuel subsidy have benefitted 60% of the wealthiest families in the country.

Rather than entertaining the inefficiencies of the CPC and transferring fuel subsidies to those who can obviously afford it, the money should be channelled to the poor. This needs to be done by proper targeting and via cash transfers to their accounts, rather than in a material form.

It was reported that about 3.7 million families have applied for the social safety net system, but unfortunately, the Government authorities have been on strike without having verified the families that have applied. Cash transfer systems should ideally be connected to inflation with a targeted time frame, so that those below the poverty line are incentivised for upskilling and to contribute to economic activity.

State-Owned Enterprises reforms

It is no secret that our State-Owned Enterprises (SOEs) are massive burdens to taxpayers with limited value being added to our economy. Therefore, selected SOEs should be privatised, which will improve the income levels of employees.

It cannot be emphasised enough that the privatisation process has to be transparent and should take place on a competitive basis. Politicians cannot be the facilitators of these transactions. There are some SOEs which can be opened up for Public-Private Partnerships (PPPs). Certain SOEs can be consolidated and others can be brought under a holding company.

Some of these SOEs are managed extremely poorly. Therefore, with the current liabilities, finding a buyer too seems next to impossible. As such, unfortunately, some of the debt may have to be absorbed by the Government, considering the stoppage of longer-term money leakage. We have to realise that the Government has no role in doing business. This has been proven many times globally and in Sri Lanka. Without SOE reforms, Sri Lanka simply has no future.

Trade reforms

In many forums where we converse about solutions for Sri Lanka’s economic crisis, a common refrain is that “Sri Lanka has to come out of this crisis”. A country of 22 million, which is almost the same population as the city of Mumbai, cannot grow by selling goods and services to its own citizens.

Sri Lanka’s market size is very small, so we have to sell to a global market. However, we cannot sell to a global market without being competitive. As such, imports are a big component in being competitive. What we need is a simple unified tariff structure; when things are simple, we can limit the room for corruption.

The complicated para-tariffs such as cess, PAL, and many other tariffs added one on top of the other have to ideally be within three main tiers. For instance, 5%, 10%, and 15% customs duty so that importers are clear on what to pay and can estimate in advance.

Monetary policy has to be fixed with trade reforms so that we will not face a currency crisis. It is true that the US Dollar is required for imports, but import demand is created by the Sri Lankan Rupee when the exchange rate is artificially low and money is added to the monetary system in the form of filling the deficit in Government expenditure and income.

When we fix this monetary policy, the currency will remain solid and exports will automatically start picking up with the stability in the market. The scarce US Dollar resources will be shared only for the prioritised needs through the pricing system.

In conclusion

If we can implement these three reforms within the next 12 months and maintain them for three years, we most likely will not require an IMF bailout for the 18th 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.

Feasibility of estimating economic recovery via LKR appreciation, CSE performance

Originally appeared on The Morning

By Dhananath Fernando

Sri Lankans base their assessment of the economy’s performance on two crucial factors. One is on the operations of the Colombo Stock Exchange (CSE) and the other is on the exchange rate – the appreciation or depreciation of the LKR to the USD.

However, neither are the right indicators to measure the performance of the economy. The companies listed on the CSE are insignificant compared to the number of business establishments in Sri Lanka.

Around 99% of the business establishments in Sri Lanka are Micro, Small, and Medium Enterprises (MSMEs) but they are not listed on the CSE. However, the MSME sector accounts for 75% of all employment. Large firms are responsible only for 25% of all employment, but not all large corporations are listed on the CSE.

For instance, MAS Holdings, which is one of Sri Lanka’s leading apparel manufacturers and employers in the sector, is not on the CSE. Moreover, just before the economic downturn in Sri Lanka, there was a bull run at the CSE. A performing economy is measured through the reduction of poverty and when the populace contributes to solving an economic problem.

The second popular measure to assess economic performance is the exchange rate. Recently, with the appreciation of the LKR, there is a sentiment that the economy is recovering. Previously, when the LKR was depreciating, the perception was that the economy was not doing so well.

Appreciation or depreciation of a currency has its own consequences, but connecting the exchange rate to performance of the entire economy is definitely not the right way to look at things.

There were few reasons behind the recent appreciation of the LKR. Nevertheless, the exchange rate is simply the price we pay to buy USD. Like for many other commodities and services, the price of USD is determined through demand and supply. Suppliers of USD are mainly exporters, service exporters, remittances, foreign grants, and tourism. Main buyers are importers, the Central Bank, service importers, etc.

If you are wondering how the Central Bank becomes a buyer of USD, that is one way reserves are built. Until the last week of February, the Central Bank had a direction for all commercial banks to surrender 25% of their USD flows from exporters. That limit has now been reduced to 15%, which means that banks will have an additional 10% of USD than they did before, so the availability of USD in the market is slightly higher. Further, over the last few months, the Central Bank has been the main buyer of USD/forex and as a result our reserve levels have improved slightly.

The International Finance Corporation (IFC) also approved a $ 400 million facility to support Sri Lanka to purchase essential items, so the inflows to the market are likely to increase. As a result of high supply and constant demand, the exchange rate has come down slightly.

Another reason is that the Central Bank increased the middle spot rate for banks to Rs. 5 from Rs. 2.50 last week. In simpler terms, previously, the Central Bank had provided a direction on the price of the USD. It is similar to a price control but slightly more flexible. As a result, banks can now provide better rates so that forex sellers are willing to supply.

As the economy contracted by 7.1% in the first nine months of 2022 and the World Bank projects a further 4.2% contraction for 2023, demand for imports has been low. On top of this, most imports are restricted. Additionally, tourism is slowly picking up and with many Sri Lankans migrating for work, it helps to recover remittances to an extent.

We need to realise that none of the above changes are reforms. They are just dynamics in the market. These little fluctuations are not an indication to measure whether we are moving in the right direction.

Reforms mean establishing a dynamic market and creating a suitable environment as soon as possible given the gravity of our crisis. When reforms are implemented, the exchange rate will become predictable rather than subject to speculation.

Reforms involve systems design and thinking, so that the system works even when a new person takes over. It is important not to mix up market changes and reforms. Markets will always fluctuate based on the availability and scarcity of resources, but reforms are about creating an environment for markets to work. Even the forex market optimises the use of resources.

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.

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)

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.)

Growth, productivity and competition: Time to shift gears

Originally appeared on Echelon

By Ravi Ratnasabapathy

The Sri Lankan economy has been running, metaphorically speaking, in second gear. It’s time to shift up if we want standards of living to improve.

What determines the ‘standard of living’? Economists measure it in terms of the value of goods and services; when this grows, living standards improve.

Resources – land, labour and capital – and the extent to which they can be harnessed for productive purposes through entrepreneurship are the building blocks of the economy: what people use to produce goods and services. Having a large resource endowment, like oil, is an advantage. Sri Lanka has restarted efforts in oil exploration. In any case, it is better not to pin all our hopes of development on a chance oil strike.

So far, our development has been conventional. Like other poor countries, Sri Lanka has brought previously idle factors of production – land, labour and capital – into productive use.

Post-war, the integration of the North and the East expanded its limited pool of resources. This stage of growth is termed input-led, and is determined by the amount of input that a country can muster.

Once a country reaches middle-income status, especially upper-middle income levels, marginal returns to resources diminish and growth slows. The country also runs out of resources to bring into production: available land gets used, labour is fully employed, the population ages and incremental returns of capital slow down. The growth model is exhausted, so the economy stagnates. The production possibility frontier is reached. Sri Lanka is approaching this stage, as there is not a lot more stuff that can be thrown into our economic ‘pie’.

Sri Lankans today are, on average, much better off than their grandparents were. Some have become very wealthy, but there are still too many people who are relatively poor. The rich will be content, but less so the poor. If the population grows, living standards will fall, unless growth of the economy exceeds that of the population. Now, we face a conundrum. The total value of goods and services must increase, but such idle ‘factors’ are no longer available. The limits of its input have been reached.

From this point, the way to grow is through ‘productivity’. In economic terms, productivity depends on both the value of a nation’s products and services, measured by the prices they can command in open markets, and the efficiency with which they can be produced. It is the overall increase in value that makes high wages possible.

“Once a country reaches middle-income status, especially upper-middle income levels, marginal returns to resources diminish and growth slows”

Productivity matters at all stages of growth, but its importance increases as the production possibility frontier is reached. The New York Times columnist Paul Krugman said, “Productivity isn’t everything, but in the long run, it is almost everything. A country’s ability to improve its standard of living over time depends almost entirely on its ability to raise its output per worker.”

The challenge for a middle-income country such as Sri Lanka is how to create the conditions for rapid and sustained productivity growth. Rich economies produce, consume and invest in entirely different goods and services than poor economies. Economies typically move from primary products such as agriculture into manufacturing and services. This structural transformation—the movement of labour from low-productivity to high-productivity sectors—depends on the demand for labour in high-productivity sectors, and the supply of labour from low-productivity sectors. A multitude of factors affect this, but it is broadly driven by investment in more productive sectors and a regulatory regime that facilitates the movement of labour and other resources.

While new investment is important, export-oriented investment is especially important in smaller countries. According to an IMF working paper titled ‘Economic Benefits of Export Diversification in Small States’ (McIntyre et al, April 2018), “Openness to trade provides small states the chance to overcome the limitations of size through access to larger markets and opportunities to achieve economies of scale in production. Moreover, openness to foreign investment generally promotes long run growth through knowledge and technology transfers from foreign to domestic firms.”

However, the productivity of the domestic market cannot be neglected and the spur to this is competition. In ‘Building the Microeconomic Foundations of Prosperity: Findings from the Business Competitiveness Index’, Porter says, “Purely local industries also matter for competitiveness because their productivity has a major influence on the cost of living and the cost of doing business, not to mention their level of wages. The productivity of the entire economy matters for the standard of living, not just the traded goods sector.”

Open and vigorous competition in the local market will see the least efficient firms exiting the market, while market shares are reallocated from less efficient to more efficient firms, which causes overall productivity to rise. Porter also states, “Productivity is the goal, not whether firms operating in the country are domestic or foreign owned. What matters most is not ownership, but the nature and productivity of the companies’ activities in a particular country.”

The government has a two-fold role to play in this structural transformation; it must facilitate the increase in productivity and help manage the costs. Many elements are involved. Investment is needed, especially in new areas, so prudent fiscal and monetary policy is a precondition.

Investors seek low transaction costs and high certainty, and these characteristics are best secured by institutions (judiciary, public administration, the financial system, regulatory agencies). High-quality laws, courts and bureaucracy increase efficiency. Stable, accessible and clear laws; limited discretion (bureaucratic/ministerial); low corruption; and consistent/ impartial court rulings increase predictability. All these influence investments in physical and human capital, technology, and the organisation of production.

The importance of exports has already been stressed, but we cannot rely on garments and tourism; diversification is needed for much faster growth. In 2000, export revenue of both Vietnam and Sri Lanka was around $2 billion. In 2017, Sri Lanka’s exports reached $11.4 billion, but Vietnam achieved $162 billion. Over the period 2000-14, Vietnam added 48 new products to its export basket with a per capita value of $545, while Sri Lanka added seven, with a per capita value of $5. Moving to higher-value sectors will support higher wages in exports.

In the domestic market, the weakest sector is agriculture, which absorbs about 28% of the workforce but contributes only 8% to GDP. Policy to speed up the modernisation of agriculture – helping producers acquire scale, invest in food processing, encourage crop diversification and improve productivity (mechanisation, drip irrigation, greenhouses, quality seeds etc) – is needed. Land policy needs review, and support for R&D must replace subsidies and price guarantees. Reforms to provide tenants and smallholders proper ownership or tenure could inject dynamism to agriculture. It requires careful study and needs to be geared to local circumstances, but the experience of Korea and Taiwan are worthy of study: “Land reforms in the Republic of Korea and Taipei, China, also led to rapid structural transformation in three ways. First, the land reforms led to increased incomes among poor farmers in the two countries, who could then invest some of the income in the schooling of their children. [The increase in agricultural productivity in Taipei, China, was particularly striking, with yields of traditional crops such as rice and sugar increasing by half, and that of fruits and vegetables doubling (Studwell 2013).] This led to the availability of a skilled workforce in the Republic of Korea and Taipei, China, necessary for rapid export-oriented industrialization. Second, increased incomes in rural areas led to an expansion of the domestic market in the manufacturing sector, fostering rapid industrialization. Third, the more egalitarian land distribution provided a stable political environment, which allowed the political leaders of the two countries to concentrate their attention on rapid industrialization.” (Ban, Mun, and Perkins 1980; Putzel 2000; Studwell 2013).

Trade liberalisation is needed to promote competition and improve efficiency in the domestic market. Tariffs or subsidies may be replaced by supporting the adoption of new technology and R&D, and enhancing worker skills.

Improving the quality of the factors will improve productivity: infrastructure to improve physical capital, and education to improve human capital.

“The richer sections of society may not see a need for reforms, but if broad-based growth is not maintained, the destructive ethnic tensions of the past could resurface”

The process of reallocation is disruptive, it involves changes in the size and make-up of an economy, and the distribution of activity and resources among firms and industries. Some sectors will
shrink, or even disappear, and new ones will appear. Firms will close or downsize, while others set up or expand. Some workers may find it difficult to transition, so there is a need for income support for displaced workers and to foster reintegration through training and job search assistance. The focus should be on protecting the worker, not the job.

Sri Lanka’s economy has undergone some structural changes since 1960. According to ‘The Sri Lankan Economy.

Charting A New Course (ADB 2017), “The share of agriculturehas shrunk quite rapidly, from about 30% of GDP to a little over 10%. Industry has expanded from about 20% of GDP in 1960 to over 30% by 2015.” Post-war reconstruction helped boost growth, but this has petered out.

The richer sections of society may not see a need for reforms, but if broad-based growth is not maintained, the destructive ethnic tensions of the past could resurface. Improving living standards is the surest way to avoid a return to our troubled past.

Economic Recovery in the North: Moving From Aid to Entrepreneurship

By Anushka Wijesinha

This article originally appeared in the Daily Mirror on 27 May 2015.

Last week, Sri Lanka marked the six-year anniversary since the end of the armed conflict in May 2009. In the aftermath of the war, there was an impressive reconstruction and public infrastructure effort, with around 10% of all budget expenditures during 2009-2013 being spent directly on reconstruction in the Northern and Eastern Provinces. Two large ‘Marshall Plan’-type programmes – Uthuru Vasanthaya in the North and Neganahira Navodaya in the East – aimed to kick-start growth through an infrastructure and public works drive. The major connective infrastructure in these provinces – roads, bridges, fishery harbours, etc. – are now of a standard rivaling many other parts of the country. However, the shift from reconstruction, to true economic recovery through industrialization, job creation, and entrepreneurship, has been much slower – particularly in the North. While this article does not take a comprehensive look at all the reasons for this, it points to some key issues that need attention by donors, public officials and the private sector.

Post-war Economic Dynamics

It is clear that the post-war growth spurt is having a tangible effect on the Northern economy, particularly in key cities like Jaffna and Vavuniya. Consumption has picked up sharply, and a lot of the big brands from the South – in consumer electronics and agricultural equipment – are now operating here. There is even a branch of the Colombo-based men’s hair salon, La Passion!. Meanwhile, years of donor interventions have also distorted economic incentives. A local civil society leader I met with on a recent visit remarked that, “A hand-out mentality has been rooted in, and there is a need to promote entrepreneurial effort”. The steady inflow of foreign remittances is also having an economic effect in Jaffna, skewing the incentives to work. Young people who would otherwise be joining the labour force seeking employment are opting to stay out and live off remittance income instead. Locals complain of sharp rises in alcoholism and drug abuse among youth. But the picture is not the same across the peninsula. In Point Pedro, for instance, young people are keen to look for jobs and eager to see new industrial activities start up.

Supporting Industrialization

Atchuvely Industrial Zone is one such activity. This estate, which had been derelict and shut down during war, has now been revamped by UNOPS with funding from the Indian government. Twenty-five acres are now ready for occupation, but the inflow of investment has been rather slow. When I visited here earlier this year, I met with the owners of the few factories that have commenced operations, including a manufacturer of hardware items and a recycled paper producer. Several factories have received American donor support for their equipment and machinery, but are having difficulty finding the local skilled labour required to install and operate these machines. I also noticed that while several other projects had been given approval, the slots allocated to them were empty. Many local entrepreneurs are having difficulties with obtaining project finance to set up. This must be tackled, and local bank branches must play a better role in financing enterprise growth here. There is plenty of opportunity for, and interest among, indigenous entrepreneurs to expand into Atchuvely, professionalize their operations, expand and employ more people.

Beyond Donor Aid to Accessing Better Markets

In the immediate post-war period, there has been a high dependence on day labour for income – manual labour on farms and civil works projects. But the availability of work is often uncertain, leaving people vulnerable to fluctuations in income. Donor projects have identified this and attempted to support income diversification. These projects have funded training centers for job training and livelihood development and gifted people and households machinery and equipment. But during recent visits to the North, I witnessed in several instances where these facilities lay abandoned. I observed how successive rounds of donor projects have “gifted” assets to people, but paid little attention to help them make productive use of these assets. While these have been built and gifted with all the right intentions, there has been less focus on ensuring that these can sustainably support entrepreneurship. Little attention has been paid to helping them access markets. One local government official in the North remarked to me, “Many NGOs are providing training for people to produce various things in Kilinochchi and Mullaitivu, but the peoples marketing knowledge is weak and so they cannot sell what they make.”

From ‘Cow-Dropping’ to ‘Dairy Entrepreneurship’

Diary projects have similar problems. A colleague I was travelling with jokingly called this the “cow-dropping syndrome”. So many donors have “dropped” free cows on families and hoped that this would improve livelihoods and incomes. Yet, little attention had been paid to help them become ‘dairy entrepreneurs’ instead; helping them maintain healthy animals, improve milk quality, and link up to stable markets and lucrative value chains. In some cases, women of female-headed households who received free cows had simply sold them off, either because they did not have a way of plugging in to a profitable milk supply chain, or even because it became too expensive to maintain owning them (feed, veterinary costs, etc), in the absence of sustainable revenue generation. Amidst this, however, a project by Cargills and Tetra Laval, was different. Supported by GIZ, they built up a group of dairy entrepreneurs who now regularly supplying large volumes of milk at better prices, to the national supply chain. With advice from Tetra Laval’s global ‘Food for Development’ programme, Cargills has been able to learn best practices in dairy farming and milk production. This in turn has boosted Northern dairy farmer’s knowledge in maintaining better milk production. Similar efforts by ILO’s LEED project have also adopted an integrated approach, where local producer groups are closely linked to national value chains.

Next Phase

More of these approaches are needed to boost entrepreneurship to support the growth of indigenous enterprises here, not just support an influx of brands from Colombo. Helping micro-producers link up with supply chains can certainly boost incomes in the North. It is already six years on, and once the dust settles on donor support it is entrepreneurship of the people that will boost the Northern economy more sustainably. The next phase of economic recovery must shift from ‘aid’ to ‘entrepreneurship’.

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Anushka Wijesinha is a development economist and a consultant to a host of governmental and non-governmental organizations in Sri Lanka.  He has previously worked at Institute for Policy Studies, The World Bank and the presidential commision on taxation.  His writings on economics are found on his blog -- The curionomist.  You can follow him on Twitter @anushwij