Non-negotiable reforms for election manifestos

By Dhananath Fernando

Originally appeared on the Morning

The year 2024 will be an election year. The general flow of events is that each political party and candidate will launch a manifesto of a grand-scale and present their plans for the people and the country. Most of these promises will not be implemented or will only be half implemented. In certain cases, the opposite of what was promised will be implemented. 

Most manifestos are presented in general terms with a target of 20 years ahead with little data. Many manifestos across all party lines are wish lists with no action plans.

In my view, this time there is a slight difference. 

Regardless of the party formation or whoever the presidential candidate will be, there are few reforms that are non-negotiable. Ideally, across all manifestos, there are five basic ideas which have to be the common denominator.

Strengthening social safety nets 

Following the worst economic crisis in Sri Lanka’s history and high inflation, about four million people have fallen below the poverty line. That puts seven million people under poverty. The recent Household Income and Expenditure Survey carried out by LIRNEasia and the World Bank indicates significant poverty levels and aftereffects of poverty due to the economic crisis. As a conscientious society, we need to take care of our poor people with the social safety net. 

The social safety net is not just an allowance. It is a system and a process of targeting the right people, providing an exit route, and with proper administration. The current Aswesuma programme is making some progress with World Bank assistance, but regardless of the political leader who comes to power, it is a non-negotiable condition that social safety nets have to be strengthened and improved. 

The current process has too many loopholes which have to be addressed and improved. Simplifying the process, providing the exit route, and monitoring and depoliticising has to be a continuous effort from the new leadership of the country.

SOE reforms 

Thus far, mandatory SOE reforms have been painfully slow. Many parties with vested interests are trying to delay it until the election. However, the continuation of SOE reforms is a must. 

Colossal losses, interference in the private sector, intervening in markets, creating an unfair playing field, and inefficiencies are a few reasons why SOEs played a pivotal role in Sri Lanka’s economic crisis. SOEs are vehicles of corruption and have diluted entrepreneurship and Foreign Direct Investments significantly. Without reforming SOEs, the future of Sri Lanka appears to be bleak. 

The principles announced by the SOE Restructuring Unit are in the right direction, but the SOE Act and reforms of the Ceylon Electricity Board, Ceylon Petroleum Corporation, and many other networking industries are a must. 

Anti-corruption and governance reforms

Execution of anti-corruption laws and governance reforms is another area which has no room for negotiation. The International Monetary Fund (IMF) Governance Diagnostic and many other locally-developed reports on governance provide direction on what needs to be done. 

Strengthening our Judiciary system, transparency and accountability in our tax system, removing tax exemptions, and repealing the Special Commodity Levy and the Strategic Development Act too falls under governance and anti-corruption reforms, as those acts provide the legal opportunity for corruption. 

There is a strong sentiment from people on the contribution of corruption to the crisis, so taking long-term measures regarding corruption is a must. Anti-corruption and governance reforms go beyond going after corrupt politicians. Rather, it is a system and framework for minimising government influence. Some reforms are complementary and reforming SOEs is also a key component of anti-corruption and governance reforms, as these SOEs play a vital role in corruption.

Following the IMF programme and debt restructuring 

Given the international financial architecture, we have no option other than sticking to the IMF programme. We can negotiate some of the actions that we have promised, but overall indicative targets and reforms have to be maintained. Otherwise, it will be yet another incomplete IMF programme and the debt restructuring process will be in jeopardy. 

Debt restructuring and the continuation of the IMF programme are very much interconnected. At the moment, external stakeholders are concerned about political instability and in fact, the IMF’s first review identifies the political risks for the continuation of the IMF programme. A commitment from any political leader on sticking to the programme will help Sri Lanka in rebuilding relationships with the world.  

Trade reforms and joining global supply chains 

We have to grow our economy to emerge from this crisis. Tax revisions make it likely that growth will slow down and the only solution to grow small island nations like Sri Lanka is through global trade. Our problems regarding global trade are mainly the problems in our own regulations and systems. 

We have to remove our para-tariffs and simplify the tariff structure for a few tariff lines. Not only will this help trade, but consumers will also have a greater choice of goods and services as well as competitive prices. 

On the other hand, the Government can improve the revenue from Customs since at the moment, the high tariffs are a main reason for revenue leakage in the form of corruption. Trade reforms are about growth, minimising corruption, encouraging exports, and assuring reasonable prices. Even at present, after very high taxes, there are levies such as the Special Commodity Levy, Ports and Airports Development Levy, and a huge array of taxes which hinder the competitive nature of our economy.

These five policies, in my view, are non-negotiable. If any administration deviates from them, it is very likely that we will fall back a few miles behind where we started. 

VAT: The good, the bad and the solutions

By Dhananath Fernando

Originally appeared on the Morning

The Value Added Tax (VAT) increase from 15% to 18% and the removal of about 95 items from the VAT exempted list to a VAT applicable list has raised concern among politicians and people alike. 

When taxes change too often, public confusion and erosion of tax revenue both have to be expected. VAT was once 8% in Sri Lanka and then revised to 12%. It was again increased to 15% and finally now to 18%. The VAT threshold was once at Rs. 12 million and later increased to Rs. 300 million. Currently it is at Rs. 80 million and expected to be reduced to Rs. 60 million. 

When the VAT threshold was increased to Rs. 300 million from Rs. 12 million, the number of individuals registered for VAT dropped to 8,000 from 28,000. Our policymakers are discussing expanding the tax base after diluting our tax base through our own inconsistent policies. 

One of the key principles of taxation is stability, according to the Tax Foundation. The other principles are simplicity, transparency, and neutrality. When tax rates and thresholds are changed often, thIMFe markets and individuals react and tax revenue will erode. 

A complicated context 

Sri Lanka’s context is sadly more complicated than many other cases. We have given a commitment to the International Monetary Fund (IMF) on increasing our tax revenue because our interest costs are extremely high. Most of the interest is inherited due to bad financial management over the years and there is very little meaning in blaming each other. 

On one hand, the Government has no other option but to increase revenue through taxation. However, on the other hand, when taxes are increased the economy will contract. Growth, which is also a key requirement for us to emerge from the crisis, will be affected due to the lowered purchasing power of the people. When the economy contracts, tax revenue will also start to decline.  

Given the perennial weaknesses in our tax administration, the Government has selected the most convenient option of VAT to be increased, since it can be collected easily compared to other taxes. VAT is considered to be better compared to other taxes such as the Nation Building TAX (NBT) or the Social Security Levy (SSL), which are considered to be cascading taxes, where throughout the economic process one tax is applied on top of the other. 

This leads to a situation where the effective tax rate becomes very high, but with VAT, tax will only be applicable for the value added throughout the supply chain. Also, high income earners generally contribute a higher VAT in total as VAT is a consumption tax. People with higher incomes tend to consume more, so the more they spend, the more taxes the Government can recoup. 

The negative impact of VAT can be witnessed when it is applied to food items. The poorest of society gets adversely impacted, since their percentage of expenditure on food is very high compared to people who fall into higher income brackets. 

There will be considerable impact on the overall prices for the common people with the new VAT revisions. The price of petrol and diesel is expected to increase by about Rs. 50-60 (provided the other taxes are not changed and global fuel prices remain the same). LP Gas (12.5 kg cylinder) will increase by about Rs. 500-600. 

Prices of solar panels, electronic items, laptops, and mobile phones are expected to rise. This will also have an impact on inflation as well, but we need to keep in mind that inflation is always a monetary phenomenon. With high prices, people may consider cheaper alternatives and supply and demand will readjust, provided we keep our monetary policy right. 

Solutions 

A key solution to bringing down prices of food items is to remove the Special Commodity Levy (SCL) applied to these items. The SCL not only increases prices, but the provisions provided to the minister to impose and remove the SCL overnight opens significant room for corruption. The recent increase of the SCL on sugar to Rs. 50 from 25 cents is a good example of how an overnight gazette creates room for corruption and passes the burden to the people. 

Other taxes on food items including CESS, Ports and Airport Development Levy (PAL), and many other para-tariffs should be removed. There is a myth that productivity can be improved by imposing tariffs on domestic food items. If that is the case, our industries for milk, yoghurt, cheese, and many other food items have to be extremely productive and efficient. Instead of domestic product growth, we see the same producers ask the Government for further protection. 

Tax competitiveness as a framework 

 Moving forward, Sri Lanka has to look at tax competitiveness as a framework for thinking about taxes. In the global context, everything is about competitiveness, including the tax system. As an example, if corporate tax is 25% in competing markets in the region, we cannot increase the corporate tax to 30%, only considering the revenue requirement of the Government. 

At the same time, we cannot compromise our healthcare and education systems, which help to develop better skills through taxpayer money, by bringing taxes unnecessarily down and compromising our tax revenue. In a market system, competition and prices play a key role, and the same is applicable for taxes, FDIs, and many other variables. 

We have to first take the basic steps of improving tax administration. We then have to rationalise our expenditure and spend where we need to spend, thereafter raising revenue by being competitive. A VAT increase to increase Government revenue alone will not solve our macro instability. We have to ensure macro stability by being competitive in all aspects of the economy.  

Looming political and economic challenges ahead of elections

By Dhananath Fernando

Originally appeared on the Morning

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

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

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

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

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

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

Political risk

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

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

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

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

Risk of a second debt default

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

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

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

Solutions: A common minimum programme for reforms

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

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

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

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

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

Fiscal path amidst promises and uncertainties

By Dhananath Fernando

Originally appeared on the Morning

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

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

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

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

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

Scenario 1: Cutting down on capital expenditure

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

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

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

Scenario 2: High inflation

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

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

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

Scenario 3: Hike in interest rates

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

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

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

Solution

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

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

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

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

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

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

By Pravena Yogendra

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Navigating salary hikes amid the storm of inflation

By Dhananath Fernando

Originally appeared on the Morning

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

By Dhananath Fernando

Originally appeared on the Morning

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

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

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

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

Information symmetry

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

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

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

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

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

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

Tax shenanigans 

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

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

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

By Rehana Thowfeek

Originally appeared on Groundviews

Photo courtesy of EFE

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

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

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

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

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

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

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

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

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

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

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

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

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

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

What happened to our debt?

By Dhananath Fernando

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

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

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

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

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

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

Solution 

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

Shaping Sri Lanka’s growth narrative

Originally appeared on The Morning

By Dhananath Fernando

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

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

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

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

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

Reforms to attract more tourists 

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

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

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

Addressing labour force shortages 

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

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

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

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

Industrial zones for private sector and simplifying tariffs  

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

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

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

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

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

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

IPL and Sri Lankan economics

Originally appeared on the Morning

By Dhananath Fernando

For countries in the South Asian region, cricket is more of a religion than a sport. Sadly, in the same region, religion is more often a sport than an instrument for spiritual enlightenment. However, both scenarios can be understood using basic economic principles. The recent performance of Sri Lankan fast bowler Matheesha Pathirana, a member of the Chennai Super Kings, is a good example. 

Matheesha Pathirana, a 20-year-old youngster from Sri Lanka, has become one of the star players of the Chennai Super Kings, a finalist in this year’s Indian Premier League (IPL). Recently, however, Matheesha failed to secure a slot on Sri Lanka’s T20 cricket team. 

Meritocracy is nothing but being competitive and allowing a framework for competitive people to receive a good share of the incentives. The Indian Premier League and the story of Matheesha teaches us a good lesson on incentives, freedom of choice, and the role of a government. 

Freedom of choice 

The IPL’s model is such that each team builds its player base through an auction. Simply, players have an incentive to remain competitive and maintain their performance to earn a good income. On the other hand, the team or the franchise has an advantage too, as they can earn a good income through sponsors by forming a competitive team to win the tournament. 

As a result of the competitive process, freedom of choice is allowed and resources are distributed based on a price value. The auction of players is a good example of a level playing field – it is such that the best of the best players get the opportunity, ultimately benefiting the quality of the game.

No interventions by regulator

Secondly, the Board of Control for Cricket in India (BCCI) does not field a team, as simultaneously regulating and competing will not be effective and will lead to a higher chance of failing at both functions. However, in Sri Lanka and many parts of the world, the government is engaged in both business and regulation. 

In our country, the Government is involved in almost all key industries, so the system is not incentivised to be competitive. The credibility and competitiveness of the IPL tournament is driven by the rules-based system, which is organised strictly to promote this while ensuring that a reasonable attempt is made to maintain the code of conduct and ethics of the game. 

Even though intervention is presently limited, many years ago a regional government intervened when Sri Lankan champion off-spinner Muralidaran played in Chennai. Nuwan Kulasekara faced a similar incident. Both are good examples of what could happen to the spirit of the game when governments intervene and harmony and reconciliation between communities do not exist. 

Although a functional framework is in place, it does not mean that accusations of gambling and match-fixing are not present. We need to understand that markets are not always perfect and while there can be deviations, we need to always focus on the most reasonable solution. 

Knowledge transfer to maximise competitiveness 

Markets honour the skill set, regardless of age, ethnicity, or any other barrier. The Chennai Super Kings has an experienced player in the 41-year-old former Indian Captain Dhoni as well as in the 20-year-old Matheesha who are on the same team – a common feature in most of the teams in the tournament. The IPL also allows foreign players to compete side by side with local players. 

In economic terms, this transfers a significant expertise between teams and their players while top-notch coaching staff with years of experience ensure maximum productivity and efficiency of the teams. 

Internationally driven 

Today, the IPL is not merely a game – it has now expanded into an industry earning billions in income by attracting many investors and brands as sponsors. It is in itself a large ecosystem with spillover effects on the Indian tourism industry, massively contributing to building the national brand name of India. 

Whoever wins the 16th IPL finals held on Friday (26) – whether it is the players or the Board of Control for Cricket in India – the Indian economy is the real winner. When markets are allowed to work, miracles can happen. This is the lesson Sri Lanka needs to learn.

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

New players in SL’s petroleum market

Originally appeared on The Morning

By Dhananath Fernando

I remember a litre of diesel being about Rs. 16 during my school years. I took the bus to school or sometimes, a very old Toyota van. When the bus or van stopped at the filling station, I would watch with curiosity how the filling station attendant pumped fuel.

The price was handwritten on the fuel dispenser in paint and the dispenser itself was visually similar to the emoji which appears when we type ‘gas’ on our mobile phones. The price and the number of litres indicated on the fuel dispenser was a manual system, where numbers moved up like an old cricket scoreboard. Restrooms at a filling station were rare. All fuel stations were operated mainly by the State-owned Ceylon Petroleum Corporation (CPC).

Today, the atmosphere at a filling station is quite different, with more sophisticated infrastructure such as digital fuel dispensers and digital payments methods. More payment options are available and some credit card companies offer discounts for fuel. Many fuel stations have restrooms and some even have mini super markets.

Currently, the market has two players – the CPC and the Lanka IOC. A new discussion is taking place about opening our market to three additional players. If memory serves right, when Lanka IOC entered the Sri Lankan market, the Chinese Government-owned Sinopec was offered access to enter the market as well.

However, at that moment in time, it did not want entry. Even though a two-player market is not perfect, it still brought a significant upgrade to the service and quality of filling stations. In this context, how should we view the entrance of more players into the fuel market?

First, a higher number of players is better than a lower number of players, because it increases the freedom of choice for people. It also downsizes risk. If one company fails, we have the other companies supplying fuel. During the economic crisis, the Indian-owned Lanka IOC provided services when our State-run CPC failed. As such, more players and a level playing field is a prerequisite to better and constant services.

Selection of players and importance of pricing ability

More players are healthier for a market system in an ideal situation, but the regulatory barriers have to be minimal. In an industry where capital expenditure is very high and a licensing process is involved, at the very least, the selection process has to be undertaken through a transparent and competitive bidding process.

Importantly, the new players should have price flexibility. In the last agreement with the Indian Oil Corporation (IOC), one condition was that IOC needs Government approval for any price revisions.

Think of an instance where the IOC experimented with a more environmentally-friendly fuel variant with a higher price – this cannot be sold in the Sri Lankan market until permission has been obtained from the Government. When private players are given the freedom to decide the price, they can come up with better solutions.

For instance, in certain countries there is a service where fuel can be delivered to homes, similar to food delivery. This is a valuable service for boat and generator users. When a supplier delivers fuel with safety measures, it cannot be sold at the usual price. In an environment with price controls, such augmented services will not emerge.

Govt. should not engage in petroleum business

While there will be three more players entering the market, this is a solution slightly removed from the best one. The new players have been provided the licence to import fuel and store and distribute fuel at fuel stations. However, petroleum product transmission, which is a high capital intensive service, is mainly owned by the Government.

Petroleum transmission services require pipes and other capital-heavy infrastructure to load, unload, and transfer fuel from the ship to the refinery or respective storage. Ideally, all players should invest in a petroleum transmission company such as the Ceylon Petroleum Storage Terminals, because it is a shared service which requires high capital investment in foreign exchange for infrastructure development.

Keeping such an important intermediary service in one Government institute is a big risk for the entire supply chain. One interruption in the intermediary service can control the outcome of the entire fuel market. When the Government engages in business, it will not be a level playing field and no investor would like to risk their money.

Burden of CPC on the Treasury

Another reason why the fuel market and the CPC require reforms is the colossal losses incurred just by maintaining its duopoly status. For the first eight months of 2023, the losses were more than Rs. 600 billion (Figure 1). For comparison, this figure is six times the expected revenue from PAYE (Pay As You Earn) tax from all workers, including petroleum workers.

The main reason for the significant loss is the deprecation in the currency, but even with that consideration, since 2015, only a marginal profit has been made in three years. CPC’s debt to the banking sector is close to Rs. 700 billion and of that, about Rs. 561 billion is guaranteed by the Treasury (Figure 2). The CPC’s negative equity of Rs. 334 billion indicates the magnitude of losses that have accumulated over time.Geopolitics at play

We need to understand the reasons why big companies are attempting to enter the Sri Lankan market. It is not with the main objective of simply supplying fuel to the 22 million market. Most likely, it is to access the shipping routes and the Bay of Bengal market spanning from India to Bangladesh.

On the other hand, another Expression of Interest has been called for an oil refinery in Hambantota as per news reports. Accordingly, the Chinese company will have an added advantage, with both access to the Hambantota Port and now the ability to import, store, and distribute fuel.

Geopolitics at play

We need to understand the reasons why big companies are attempting to enter the Sri Lankan market. It is not with the main objective of simply supplying fuel to the 22 million market. Most likely, it is to access the shipping routes and the Bay of Bengal market spanning from India to Bangladesh. 

On the other hand, another Expression of Interest has been called for an oil refinery in Hambantota as per news reports. Accordingly, the Chinese company will have an added advantage, with both access to the Hambantota Port and now the ability to import, store, and distribute fuel. 

While geopolitics will come into play,  the fundamentals remain the same. The Government should not engage in business and more players should be allowed to enter the market. Processes have to be competitive and transparent. The outcome of this will be that consumers will win and petroleum sector workers will have higher wages. 

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.

Figure 1

Source: CPC Annual Reports and Ministry of Finance Annual Reports

Figure 2 

Source: Annual Reports of the Ministry of Finance and the CBSL

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.

Why it takes so long to recover from an economic crisis

Originally appeared on The Morning

By Dhananath Fernando

I have been reflecting on the last few years of public policy and discussion, which I can broadly divide into three main chapters:

Chapter 1 – Denial

Chapter 2 – Realisation

Chapter 3 - Recovery

Chapter 1 – Denial

There was a time when even respected businessmen thought an economic crisis was a distant scenario. Many politicians, across all party lines, failed to consider a situation of 12-hour power cuts and long fuel lines, and viewed debt restructuring and accessing the International Monetary Fund (IMF) as taboo conversations.

We relied on a $ 3.6 billion bailout from an unknown Omani fund and thought China and the Port City would bail us out as a last resort. Some even thought the discovery of a sapphire cluster might be the breakthrough Sri Lanka needed. Sri Lankans believed we were a special nation with a magical power that would rescue us in some other way.

Despite our strategic location, beautiful weather, and natural beauty being undeniable assets, they do not guarantee a rescue from our own bad policies. Our denial was so strong that an international institution titled their report on the Sri Lankan economy as ‘Denial is Not a Strategy’.

Chapter 2 – Realisation

The moment of truth came, but we were too late to respond. None of our bailout expectations materialised and the international financial architecture found it difficult to save us. Our debt is unsustainable and the IMF requires a commitment from our creditors before providing us financial assistance.

We are struggling due to global geopolitics and our poor diplomatic service and lack of professionalism doesn’t allow us to be taken seriously. We hurt all our friendly nations as well as India, China, Japan, and the US. Islamic countries too were concerned and unhappy with us over different issues.

People only realised the depth of the crisis when medicine was in short supply and their loved ones considered leaving the country. Inflation skyrocketed, prices increased, and poverty affected about 30% of the population.

Chapter 3 – Recovery

The moment people realised the severity of the crisis, they started asking about when we would recover. The simple answer is that it takes a long time and now many of us understand why. Overcoming a crisis of this scale, which in itself is a combination of multiple crises, cannot be done easily.

Simultaneously, we face a balance of payment crisis, a debt crisis, a financial crisis, a humanitarian crisis, and a political crisis. The cost of delaying a response to the crisis and mismanagement has to be shared by us all, with mounting tax increases and high inflation pressure from the grassroots.

As a result, we can see constant protests and interruptions to public life, further worsening the situation. At the same time, this opens a new political space where any political party can make unrealistic promises and auction for votes. This vicious cycle is why recovery from the economic crisis takes a long time.

The specifics of debt restructuring are still a mystery to us. We don’t know how the restructuring will be carried out or the impact it will have on the banking industry. It is also unclear how the markets will respond.

Without domestic debt restructuring, even if we apply a 50% haircut on International Sovereign Bonds (ISBs) and Sri Lanka Development Bonds (SLDBs), our debt to GDP ratio after 10 years will be 136%, according to a Verité Research study published in October 2022. Cost of servicing new debt and the cost of rolling over previous debt at a high yield curve will not bring down our debt to GDP ratio.

Nevertheless, it is still possible for domestic debt to be restructured and banking recapitalisation is necessary. According to the same document, investments in Government securities, primarily Treasury bills and Treasury bonds, account for more than 30% of the interest revenue for the total banking industry.

Hence, changing the interest rates on these securities will affect the stability of banks. On the other hand, 82% of the money in the EPF and ETF has been put into Government securities.

As the required changes take place, no one will be happy, so people and opinion leaders will react in different ways. The changes will go back and forth and recovery will be prolonged. Elections will come and decision-making authorities will change and policy decisions will also go back and forth.

All this is why it takes so long to recover from an economic crisis.

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.

Our only saviour is reforms

Originally appeared on The Morning

By Dhananath Fernando

Whether we will be able to receive International Monetary Fund (IMF) Executive Board approval is now a topic of discussion even amongst the most economically-illiterate person. Let us first set the context.

The Sri Lankan Government and the IMF came to a Staff-Level Agreement in early September 2022. One of the key milestones we have to pass through is to get to some level of negotiation with our creditors. Our credit portfolio is diverse. We have multilateral senior creditors followed by bilateral creditors, including members of the Paris Club, mainly Japan.

On the other hand, there are two main creditors who are non-Paris Club members; India and China.

Paris Club members agree on equal treatment in debt restructuring. In simple words, all member countries of the Paris Club will be treated equally when it comes to restructuring. India has also agreed to assist Sri Lanka in the debt restructuring plan and has provided a letter to the IMF. However, according to the IMF, letters provided by China are not adequate. It has indicated a two-year moratorium, but given the financial needs expected by the IMF, Sri Lanka will not be on a sustainable debt path after a two-year moratorium alone.

Generally, credit assistance provided by multilateral donor agencies such as the World Bank and the Asian Development Bank is not restructured, provided it has been given with very long maturity periods and very low interest rates. Therefore, restructuring those loans has not been the practice. That is how the global financial architecture is designed, given their assistance in eradicating poverty and the IMF being the lender of last resort. 

However, over the last few years, there has been a request by private creditors, bondholders, and some stakeholders that the credit of multilateral donor agencies should also be restructured and China is one party that has made this request. Unfortunately, Sri Lanka is too negligible an economy to make that request or challenge the global financial architecture. .

Given the delays, there is now an emerging conversation on whether we have any other alternative options if the IMF agreement is further delayed. In fact, I asked this question at the meeting convened by the National Council Sub-Committee on identifying short- and medium-term programmes related to economic stabilisation, on whether alternative options were being considered in the likelihood of a delay. According to its Chair MP Patali Champika Ranawaka, the committee has not considered it, but he has an aim of being prepared for the worst-case scenario.  

As we have been saying over the years, we have come to this situation through our own policy errors and with our bad reputation, we do not have many choices in hand. Therefore, finding a solution without the IMF is a major challenge, but we, as a country, cannot avoid the consequences should this agreement get further delayed; social discussion is needed on what we can do to get it soon and on the available alternatives. 

Managing with what we have

One option is to drastically cut down our consumption, including essentials such as food and medicine, and face the situation with what we have. That option can trigger some level of social unrest because ‘a hungry man is an angry man’. 

Even at this level of consumption contraction, our poverty rate has increased above 30% according to a Parliament committee. Out of about five million households, about 1.7 million receive Samurdhi and another 1.1 million are on the waiting list. Of course, Samurdhi is not a good indication, as some people who should receive Samurdhi benefits are not recipients, while others who should not be in the programme are included. However, managing with what we have is one available option that comes with its own consequences. 

Moving ahead with debt restructuring without China?

The next option is to move ahead with debt restructuring without China. This option has a significant limitation because IMF confirmation is required even to restructure the debt of bilateral creditors. Without the IMF, it will be difficult to get Paris Club members and other stakeholders to a debt negotiation table. The more we delay and if China takes a very hard stance, which is likely, we have to request the IMF to move ahead with those who have agreed and hold China’s debt payments until we come to some level of agreement.

We have to understand China’s point of view and geopolitics as well. Our crisis has also become a tug of war between two economic powerhouses. On one hand, China does not want to align or agree with a US-led programme. On the other hand, the relief measures given to Sri Lanka have to be provided to all other countries making similar requests in future.

Pakistan and many African countries and emerging economies are expected to face debt distress in the coming years. China’s growth predictions are low, impacting global economic growth. Hence, the more we delay opening up Sri Lanka to geopolitical sensitivities, the more we will be pushed to align with certain superpowers. If we were to depend on China or India for continuous relief measures, it would be extremely difficult to avoid becoming a geopolitical pawn.

Possible reforms and opportunities 

In this context, it is clear that all available options (with the IMF or without the IMF), will result in extremely difficult times. However, in a crisis, there will be winners as well. Regardless of any of the aforementioned options, there are basic levels of reforms we have to undertake in any scenario. 

State-Owned Enterprise (SOE) reforms must be at the forefront. Without this, we have no future. One good opportunity is to capture the drive within the Indian market. Even if Sri Lanka does nothing, there will be spillover effects from India. The Indian economy, especially the North Indian economy, is growing very fast and we have to connect to their market. If we had played our cards right, we could have become a good connection point for trade between India and China. Instead, we made enemies all over. However, there is still potential. 

The more we delay reforms, it will further exacerbate the problem. As such, reforms are the only saviour in any scenario. It is sad to see how we are distancing ourselves from reforms, with political developments triggering another round of economic and political uncertainty which will lead to social uncertainty. Let us hope reforms move forward fast. 

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.

Sri Lanka’s biggest insecurity: Fear of competition

Originally appeared on The Morning.

By Dhananath Fernando

If we were to take some collective responsibility for the sad state of our country and attribute it to any cause, I believe it is due to our ‘fear of competition’. 

From top to bottom, Sri Lankans have been fearful of competing. Over a period of time, we have become very reluctant to compete and our fear has grown into incompetence. The fear of competition syndrome is spread across all sections of society, from the top executives to people below the poverty line. 

Sadly, as a country, we have not understood the meaning of ‘competition’. In our vocabulary, competition is where winners are selected and losers are ridiculed. However, competition is actually where the winner and the loser both win – when the winner wins, the loser also wins. How can this be?

A winner is defined as an individual who takes the leap to utilise the resources available to their maximum potential. Even in a 100 m race, the winner is the person who covers the distance within the shortest time span.

The recipe for the title of a winner is determined by the effort endured by any individual to go that extra mile and maximise the resources available. Once that formula is found, even the loser can use the formula of the winning person without wasting their resources further. Losers can ask the winners to run on their behalf next time so that the losers can better use their skills elsewhere.

This is how we all use so many consumable goods. Let us take computers as an example: most of us have lost the race of manufacturing computers while many have not even tried. But someone found the computer formula, so now we can all use the winning formula, which helps many of us save our valuable resources. Thus, losers have also benefited. This is why competition makes winners win and losers also win. It is much more than simply picking a winner – it is about the allocation of resources.  

In the Sri Lankan context, the fear of competition is what mainly led to the misallocation of resources. From top to bottom, not only are Sri Lankans fearful, but we also instigate fear in others. 

It was recently reported that a driver who was providing a taxi service using a mobile app had been threatened by some other drivers who were not using the app-based taxi service. The threat had taken place while the service was being provided to foreigners. The underlying reason for this is the fear of competing with mobile app-based technology.  

Fear of competing with private medical schools

While our tuk-tuk drivers have fear of competition regarding app-based solutions, our doctors have a fear of competition regarding private medical schools. They do not want someone capable with a better service in the market because they are fearful that someone else will overtake them. 

Fear of competition in furniture manufacturing 

Our furniture manufacturers are fearful of competing with other furniture manufacturers in the region. Not only are they fearful, they even ask the Government to support some of these industries with taxpayer money.

Fear of competition in the construction industry

Our bathware and tile manufacturers are reluctant to compete with the same category of products overseas. As a result, our cost of construction is about 25-40% higher than the region due to our widespread fear of competition. Most of our construction materials have a tariff of nearly 100% to avoid competition. Even the private sector is suffering from the fear of competition, which is one of the main reasons Sri Lanka lacks big industries and innovation in the system.

University students’ and the labour force’s fear of competition 

Our university students and teachers do not want to compete with international students. As a result, resistance is high against the entrance of any type of private university to the market. Rankings of our universities and colleges have been deteriorating over the years, but we still remain reluctant to compete. Not only do university students want to avoid competition, but they also want to be dependent on the Government.

Our Government servants and entire labour force are fearful that if we open the job market, foreigners with better skills will replace them. Although we are not competitive, we want to maintain our stake.

Across the board, Sri Lankans are deeply fearful of competing with the world. We lack the courage to admit the truth that our competitors can produce high quality products with high efficiency and productivity. If we are so afraid to compete with the world, there is little reason to claim that we have to improve exports. Exporting would mean competing with the world on an uneven playing field with different tariffs imposed in different regions.

Hasn’t our fear of competition not only made the country worse, but also contributed greatly to our economic crisis? Not just politicians, but all Sri Lankans have promoted fear among our fellow citizens. There are no innovations, inventions, or new technologies without competition. That is the sad truth. We have unfortunately become victims of our own actions.

For once, we should admit that we are the problem without absolving ourselves and instead blaming our political elites. While the poor decision-making of politicians is definitely a problem, if we are reluctant to compete, they can easily say that they simply represented our worldview and opinion.

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

A flawed independence

Originally appeared on The Morning.

By Dhananath Fernando

Over the years, our definition of ‘freedom’ has become full of flaws. We took freedom for granted and we lost both our freedom and independence. Even though we gained independence in 1948 from Great Britain, we have no understanding of what real freedom is. 

We fail to understand that freedom comes at the cost of hard work, courage, respect, the ability to cooperate, and being competitive with the world. There is an ecosystem we should have built if we really want to be free. We did not build that ecosystem, so over the 75 years of independence, we question ourselves and argue back, asking, “Are we really free?”

Prof. Amal Kumarage in a recent tweet has asked this question very eloquently on independence and freedom.

“I’m confused as to what’s happening on 4 February in #SriLanka. Is it: 

1. A fake celebration of a real independence, 

2. A real celebration of a fake independence, or 

3. A fake celebration of a fake independence?”

Freedom is an alluring subject to many as people in general summarise freedom to being liberated to have an easy life, getting things free of charge. Over time, as the dire need for freedom kept rising, the wrong seeds of freedom grew by encapsulating and manipulating the idea of freedom to a level where people truly believed that we are entitled to many benefits even though we lack the resources. 

The drive down the tunnel of distorted versions of freedom led to many ethnic and religious turns over the years, believing that freedom is restricting someone else’s freedom for the betterment of someone else.

This is similar to a situation where a child learns the wrong values or habits without realising they are wrong and instead thinking they are right. After 75 years of practising the wrong values and ethics, we now have an operating system which we try to sustain with unsustainable resources. That is a brief summary of insights on our 75 years of independence.    

During that journey of 75 years, we have failed to understand the damage done by the existing system to our competitiveness and productivity. We simply became irrelevant in the world over a period of time. By deciding not to compete with the world, we decided to sacrifice our freedom. 

Our decision to not compete with the world mainly came through our economic policy. We simply misread the world and future of the world. In a world of sharing resources and collaborating for each other’s benefit and independence, we thought that real freedom is the ability to produce everything on our own. 

We supported the narrative of ‘self sufficiency’ when the world actually moved away from self sufficiency to interdependence. As per the Fraser Institute’s Economic Freedom of the World Index, Sri Lanka has been ranked at the 138th position out of 165 countries based on our ‘Freedom to Trade Internationally’. Though we claim we are an open economy, the facts say otherwise. In terms of our openness, we are at one of our lowest points.

My father used to say: “If you think you are the smartest person on the street, it is time to change the street.” This is because an uncompetitive environment does not support growth. Without growth, no wealth will be created nor will there be freedom or independence.

When we isolate ourselves from global trade, we avoid competition. Avoiding competition means we are out of touch with the real needs and wants of people. Not only that, we try to become dependent on the world without contributing anything to the world or to its maximum utility of resources. Being open to competition is what keeps us all competitive and relevant.

Real freedom is the freedom to compete and be competitive in a global landscape. Even when we are one of the closed economies in the world, we are open for global competition. Our IT, apparel, tea, and rubber sectors and even unskilled labour that contribute with remittances are competing at a global level. 

When we are really competitive it provides us the tools and freedom to change the direction of our fellow human beings and to support humanity. That comes only through the freedom to trade. That is the real freedom we should all aspire to. We are far from this and we are moving further away, but at least it is important to keep the idea alive so that one day someone can move towards it. 

A fake celebration of a real independence, 

A real celebration of a fake independence, or

A fake celebration of a fake independence? 

According to Prof. Kumarage, it is difficult to judge what we are actually trying to do this year, but we should aspire to have real freedom and this real freedom comes at the cost of hard work, free exchange, and free trade by being relevant and competitive in relation to the world.

Source : Central Bank of Sri Lanka

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

A well-told lie is worth a thousand facts

Originally appeared on The Morning.

By Dhananath Fernando

Sri Lanka has always been consistent about two things. First, finding a villain to blame for incidents that have taken place in the past for Sri Lanka’s performance. Second, waiting for a hero to rescue us all with magical powers without making sure the systems and markets work. 

We always fail to evaluate reasons and economic context and understand the behaviour of people from an economic angle. A recent example is politicians claiming the economic crisis was a result of the Aragalaya and blaming the people who protested against the hardships they were going through, without realising that the economic crisis is what led to the Aragalaya.  

In a new turn, fingers have now been pointed at exporters, claiming that they have not brought money back into the country and accusing them of being part of the problem. In my view, the figures mentioned in relation to claims that exporters have parked funds outside are unrealistic. Some Sri Lankan companies have scaled their operations very successfully around the world, which has been done legally. For instance, there are energy investments in Bangladesh and Senegal and manufacturing plants in Africa and neighbouring India. Even our IT sector is expanding to the Middle East and to different regions around the globe using legally owned foreign exchange. 

This is obviously illegal and remedial action needs to be taken, but what is more important is to understand why it happens. We need to understand the reasons behind this and understand the reality with a solution-oriented framework. In most cases, the enemy is within, though we try to find the enemy outside. 

In my view, there are three main factors that influence such malpractices

Market intervention by the Central Bank

When central banks infuse more money into the system to maintain artificial interest rates, the exchange rate comes under pressure or the currency depreciates. The fear of currency collapse makes people withdraw money or avoid bringing money into the country.

Not only exporters, but even Sri Lankans who were sending remittances stopped sending their money through the banking system. Instead, they sent money through unofficial means at a depreciated exchange rate. When domestic prices are rising due to money printing or import controls, their families back home naturally need more money to buy goods.

However, exporters cannot keep unlimited amounts of money outside the country. Exporters need money to run their local operations, so they have to convert their export proceedings and get Sri Lankan Rupees to run the operation. When interest rates are kept artificially low, there is an incentive to borrow domestically and delay the conversion of dollars into rupees. 

However there is a limit to what exporters can borrow. Even if they borrow domestically, it cannot contribute to a foreign exchange shortage unless the Central Bank printed money to maintain an artificially low policy rate through discount windows or reverse repo operations.

If banks give extra loans to exporters, they have to cut down on other loans (to housebuilders, for example) or they have to pay higher rates and get deposits and reduce the consumption of their customers. Banks do not have to reduce other credit if the interest rate is maintained artificially through the injection of new money.

The policy of the Central Bank has simply created a highly unstable financial situation and it is human behaviour to protect one’s hard-earned money, so they will obviously keep their money outside. Understanding this should not require any financial expertise; even basic logic is enough. This is understood by our unskilled workforce contributing to our economy through remittances. 

To return to the matter of exporters, the margins are low in trading businesses and export quantities have to keep moving; a business cannot run without money. We have to reevaluate the numbers and it is unlikely that more than 10% of the proceedings will be repatriated, which is a figure that leans more towards the higher side. Even that is profits or value created by exporters. 

If the money comes, the exporter will use it and it will trigger demand. If money is not brought back, it will not become imports and instead becomes a private foreign reserve. While it may contribute to higher interest rates, this type of activity will simply reduce imports and not create forex shortages.

There were claims that some exporters sent goods to Singapore or Dubai and re-sold the goods to third countries while keeping some money there. 

We need to understand why people try to keep money outside the country. Who wants to bring money into an unstable country? Dubai and Singapore do not have central banks that print money and people not only import and export freely, they can also freely send capital in and out.

Sri Lanka, on the other hand, has exchange controls. Again, this is due to money printed to keep interest rates artificially low, which is exerting pressure on the exchange rate. Economists call this the impossible trinity of monetary policy objectives. A central bank cannot hold an exchange rate and allow the free flow of capital if it also prints money to control interest rates.

Exchange controls can be seen as a tool used to delay interest rates. It is worthwhile to recall the scale of Central Bank interventions and controls during this crisis. The Central Bank places price controls on Treasury bills and printed money. Exchange controls were also tightened further instead of correcting interest rates and stopping money printing.

The Treasury placed import controls on hundreds of items. The Central Bank increased margins for Letters of Credit (LCs). Moreover, forward markets for foreign exchange were killed, putting importers at risk and also damaging businesses that had hedged their imported input costs. Exporters were forced to convert their dollars early, which created problems for some exporters who had been in the habit of giving credit to customers to win business from competitors.

Additionally, forced conversion rules were imposed on service receipts. Some service workers and those others who used to bring these to the country and save them in foreign exchange accounts then kept their money abroad. Unlike goods exporters, service exporters have larger margins.

By this time, banks were facing a capital outflow and were unable to renew their credit lines and in some cases dollar-rupee swaps. Forced dollar conversions reduced dollar liquidity and brought these closer to default.

There are also concerns as to whether it is a violation of property rights for banks to force account holders to convert dollars without their consent. Foreign exchange controls are in any case a violation of property rights.

This very column previously warned of the potential drying up of forex with such market interventions. In simple terms, in a context where LKR is not hard pegged to the USD with floating interest rates or if there are no floating rates, all additional money supplied to the financial system to keep rates down evaporates in the form of imports, even with under-invoicing.

Trade barriers – High and complicated tariff structure 

Making tariff structures complicated is an incentive for corruption. The level of corruption that takes place at customs is no secret and the more complicated the system becomes, the more room for corruption. Simply, when the cost of corruption is lower than the legal procedure, the incentives are in place for corruption. 

This column has on many occasions recommended a simple tariff structure with three bands so that paying import tariffs becomes easier than taking on the cost of corruption. This was proved by Prof. Premachandra Athukorala in a practical research he undertook, where bringing down the tariffs by half on selected HS codes ensured that the Government income from those particular imported items doubled. Too many restrictions and intervention are the genesis of black markets and corruption. One of the easiest ways to minimise corruption at Sri Lanka Customs is to make our tariff structure simple, low, and consistent. 

Poor business environment 

Overall, Sri Lanka’s business environment is extremely poor. We have to ask ourselves why our own people leave the country and why they are reluctant to bring their money into the country. The answer is not complicated; we may act rationally or emotionally at times, but when it comes to money, we all tend to make rational decisions, especially when there is a tangible cost or benefit associated with it. 

It is obvious that people consider all alternative options to protect their hard-earned money. This is one reason remittances were not sent through official channels. Family members still received the money and imports still took place, but without going through the official channels. Any imports paid for with unofficial funds – such as open account imports – reduce the demand for dollars from exports.

Now that the Central Bank has raised rates and reduced money printing, leading to reduced exchange rates, people are sending their money through official channels. This shows that most people prefer to send their money through official and legal channels if a stable and consistent system is available.

It has been a while since Standard and Poor’s, Fitch Ratings, and many other international agencies warned about Sri Lanka’s worsening economic crisis. As such, our economic environment was extremely poor, which was why people did not feel that it was safe to bring their money into the country. The same happened even in Africa – with the crisis in Zimbabwe, many had bank accounts in Cape Town to protect the value of their money. 

Final thoughts 

One has to be careful about harassing exporters. Exporters, especially subsidiaries of foreign countries, have other countries to operate in. 

Under-invoicing exports is wrong, as it will reduce profits within the country. This is a tax fraud. However, reducing profits cannot contribute to forex shortages since any money that is not spent in the country will also reduce imports.

Sri Lanka wishes to be a hub for South Asia. It wishes to become a place where companies set up regional headquarters. If currency instability and exchange controls exist, these will not be set up in this country. Moreover, there are also rules on transfer pricing. 

If Sri Lanka possessed monetary stability, if there were no exchange controls, and if its tax rates were reasonable – the US has been pushing for a global corporate tax rate of 15% – companies would not try to take profits to safer places.

Exporters and importers have been harassed over the years. Framing exporters as the reason for the crisis instead of solving our own problems will simply make the situation worse. 

Can we really put the entire weight of the economic crisis on our exporters, forgetting the bond scam, Easter attacks, droughts, Covid-19, borrowing money at very high interest in USD, and investing in unproductive projects? The enemy is within, but we are always looking for a culprit outside. In politics, sometimes a well-told lie is worth a thousand facts.    

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.