Sri Lanka’s next leader faces a web of crises

By Dhananath Fernando

Originally appeared on the Morning

In two weeks, a newly-elected president and government will take charge of steering the country.

At the beginning of the forex crisis, we warned that an economic crisis often comes as a package of five interconnected crises.

Balance of payments crisis

A balance of payments crisis occurs when excessive borrowing from the central bank (money printing) leads to inflation. In countries like Sri Lanka, where the local currency is not a reserve currency and the economy relies heavily on imports, printing too much money increases the demand for goods and services – many of which are imported.

If exports, remittances, and Foreign Direct Investments (FDI) fail to keep up with this increased demand for imports, we run out of foreign exchange reserves, causing the currency to depreciate.

Debt crisis

When foreign currency reserves are depleted, the country struggles to meet its obligations to creditors. While borrowing from international markets might offer temporary relief, credit rating downgrades make this option limited, triggering a debt crisis. On 12 April 2022, Sri Lanka officially declared it could no longer service its debts, despite having the intention to do so.

Banking crisis

If local banks have provided significant loans to the government and the government defaults, a banking crisis can unfold. Sri Lanka narrowly avoided this scenario.

Humanitarian crisis

With debt defaults and depleted foreign reserves, imports become limited. Inflation makes basic necessities unaffordable for the poorest segments of society. In Sri Lanka, poverty numbers surged from three million to seven million, pushing more than 30% of the population below the poverty line.

Political crisis

When a government faces multiple crises such as these, political instability inevitably follows, as we have seen in Sri Lanka. The President was ousted, the Prime Minister and Finance Minister resigned, and an interim Government was formed.

Although the political crisis continues, it is only one phase in an ongoing cycle of instability, with the Presidential Election being a milestone in this process.

Current political landscape

The incumbent President has introduced significant relief measures, including raising public sector salaries, forgiving agricultural loans, and making other promises. However, if re-elected, he will struggle to deliver on these promises within the limited fiscal space, potentially leading to a deviation from the International Monetary Fund (IMF) programme.

Alternatively, he might be forced to raise taxes or borrow more, which would increase interest rates and add to the economic strain.

If another candidate is elected, they will face the same fiscal limitations and may have to reverse salary increases to maintain fiscal discipline.

In the case of a Samagi Jana Balawegaya (SJB) government, the challenges are compounded. The Economic Council within the SJB sends mixed signals about achieving revenue targets to support proposed expenditures. Additionally, the broad alliance of political factions under the SJB presents internal challenges, especially concerning sensitive reforms like State-Owned Enterprise (SOE) restructuring and maintaining Central Bank independence.

Not all factions have aligned views based on previous voting records and public statements. Managing these internal differences will be critical for an SJB government, especially in the context of carrying forward the relief measures introduced by the current President.

Similarly, in a National People’s Power (NPP) government, the same challenges apply. The NPP, primarily led by the Janatha Vimukthi Peramuna (JVP), advocates for a more State-led development approach, but many professionals in the party’s outer circle lean toward market-driven policies. This could lead to internal conflict, making reforms difficult to implement without alienating part of the party.

This situation resembles the ‘Yahapalana’ Government, where the President and Prime Minister held differing ideologies. As a result, governance became more about managing stakeholders than effective government operation.

If you recall, the Prime Minister made economic decisions through the Cabinet Committee on Economic Management (CCEM), which was later replaced by the National Economic Council appointed by then President Maithripala Sirisena. Stakeholder management within an NPP government could prove just as challenging.

On top of these internal struggles, Parliamentary and Provincial Council Elections are expected to follow, adding even more political promises that will further constrain the fiscal space. Reforms tend to slow down during election periods, making debt restructuring more difficult and putting the IMF programme and long-term debt sustainability at risk.

While we may see temporary relief from one or more of these crises, the interconnected nature of these issues means that one crisis could easily trigger the others. The risk factors remain extremely high, underscoring how difficult and sensitive sovereign debt restructuring and recovery can be. There is always a risk of setbacks before we see real progress.

The path forward

Whoever takes office, the best-case scenario involves continuing with reforms aimed at growing the economy, with all political parties supporting these efforts with transparency and accountability.

Stakeholder management will be crucial, but there is no other way to avoid the complete package of five crises. Economic growth, fiscal discipline, and political unity are essential if Sri Lanka is to emerge from this difficult period.

The thin line between gaining power and triggering crises

By Dhananath Fernando

Originally appeared on the Morning

The game has begun. The familiar auctioning of non-existent resources during election season is in full swing. Candidates are making various promises without considering the repercussions they will face whether they win or lose.

Candidates are likely contemplating two things: first, promise now, gain power, then deal with the aftermath of those promises. Secondly, if they know they’re not going to win, they might promise the impossible, thinking they won’t have to deal with the consequences. Neither of these approaches is without significant risks and either can lead to disastrous consequences.

Elections and governing a country go beyond mere promises and their execution; it’s about managing people’s expectations with available resources.

After the economic crisis, all indicators suggest we are slowly recovering, thanks to stringent measures. Interest rates have soared to record highs to curb inflation. Urban poverty has tripled, rural poverty has doubled, and the already impoverished estate sector has seen a 1.5-fold increase in poverty.

Apart from our parliamentarians, all citizens have compromised their wealth and earnings. The public has reluctantly understood that tough sacrifices are necessary.

Impossible promises

The promises being made now are simply impossible to deliver. One such promise is a 25-50% salary increase for Government employees. Even the last Budget’s cost of living allowance increment is yet to be fully implemented. According to the 2023 Budget, Government salaries and wages total approximately Rs. 939 billion. Therefore, a 25-50% increase would require an additional Rs. 230-460 billion next year.

Our annual revenue from Advance Personal Income Tax (APIT) is at most Rs. 160 billion. This means that the proposed salary hike would require almost 1.5 to three times APIT. Is the private sector ready to shoulder an additional 150-300% in tax or revenue hikes for these Government salary increases?

Just in July, the Government rejected a proposed Rs. 20,000 salary hike for State workers, stating that it would need an additional Rs. 275 billion, which would require increasing the Value-Added Tax (VAT) by 4% to proceed.

Making matters worse, there are suggestions to amend VAT and many other tax rates by different candidates to align with their earlier pitches.

The danger of these promises is that whoever becomes the candidate who comes into power will need to fulfil all these promises, even those made by their competitors, which are unattainable.

The losing candidate, who will then be in the opposition, will always pressure the government to fulfil these unsustainable promises, raising public expectations for things that cannot be delivered. When expectations are unmet, it typically results in a political crisis, or if they try to fulfil what was promised and it is not economically viable, we will end up in an economic crisis.

That is why elections are not just about gaining power but also about managing people’s expectations.

Making promises responsibly

A salary hike for senior Government officials is necessary, but it is only feasible through a complete restructuring of the Government cadre and our military.

Currently, about 48% of our salary expenditure is for the defence sector, with about 32% going to the military. Restructuring the military is complicated and sensitive. A salary hike without restructuring will disincentivise staff who are expecting to leave, adding a massive burden on Government pensions and leading to a pension crisis.

With the new Central Bank of Sri Lanka (CBSL) Act, the Treasury cannot borrow money from the CBSL or print money. Therefore, if the Government borrows more from the market, interest rates will rise and the overall cost of capital will skyrocket.

The proposals to revise VAT are no different. VAT is a reasonable tax system because it only charges for the value added, unlike other indirect taxes like the Social Security Contribution Levy (SSCL), which has a cascading effect. VAT is easier to collect and it creates minimal distortions. Additionally, high-income earners contribute a higher amount of VAT as their consumption is greater.

The discussion about renegotiating the International Monetary Fund (IMF) agreement needs to be approached with caution. In every IMF review, it is clear that adjustments or shifts in timelines are made based on our performance.

However, trying to renegotiate the entire IMF agreement and its structural benchmarks could invite unnecessary complications. Not only Sri Lanka, but our bilateral partners including China, Japan, and India; multilaterals such as the Asian Development Bank (ADB) and Japan International Cooperation Agency (JICA); and our bondholders have all based their calculations on the existing IMF agreement.

It took over a year to negotiate our current terms. Another renegotiation would be time-consuming, and by the time we reach a settlement, the accumulated interest would be unbearable and market confidence would likely falter.

The damage our candidates are collectively doing is by making promises that cannot be delivered during this crucial time, and people’s expectations are a combination of all these. Whoever wins may have to deliver most of these pledges, which is not feasible. If the winner cannot deliver, a political crisis is certain, or if the winner tries to implement what was promised, another economic and social crisis is assured.

While people must vote carefully, candidates must make their promises responsibly; otherwise, they will start losing power from the very first day they receive it.

A new era or more turbulence?

By Dhananath Fernando

Originally appeared on the Morning

• The challenges facing Sri Lanka’s next president

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

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

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

Focus on economics and corruption

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

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

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

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

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

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

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

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

Limited options

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

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

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

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

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

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

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

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

Delaying elections threatens political and economic stability

By Dhananath Fernando

Originally appeared on the Morning

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

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

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

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

Uncertainty and economic growth

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

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

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

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

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

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

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

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

The solution: A common reform programme

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

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

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

Nearing debt negotiation deal amid economic uncertainty

By Dhananath Fernando

Originally appeared on the Morning

Sri Lanka is hopeful that we can reach a debt negotiation before the first half of the year. Many are focused on the potential for reductions in principal and interest rates or extensions of debt maturities.

According to a recent update from the Ministry of Finance, we are yet to finalise a settlement with our bondholders, although we are close to an agreement. The Internal Rate of Return (IRR) for the Sri Lankan Government’s proposal is about 9.7%, while the bondholders’ proposal is 11.51%. The total cash outflow according to the bondholder proposal for 2024-2028 is approximately $ 16.6 billion, compared to $ 14.7 billion for the Government’s proposal. Ideally, we should reach a settlement close to the Government’s proposal if all goes well.

Both the initial and revised proposals indicate that bondholders are reluctant to reduce the interest accrued during the suspension of debt repayments. In both proposals, there have been no haircuts on $ 1,678 million of accumulated interest. Only a 4% interest rate has been proposed for 2024-2028.

Bondholders have suggested a 28% reduction on existing bonds, reducing the total bond value from $ 12,550 million to $ 9,036 million. Both parties appreciate the depth of the haircut, particularly with respect to economic growth. These adjustments depend heavily on adhering to the International Monetary Fund’s (IMF) baseline projections. If we fail to achieve the necessary growth rates, we will receive a deeper concession, and vice versa.

Achieving the best debt restructuring plan for Sri Lanka is crucial and our future hinges on economic growth. The debt level must be compared with the size and growth of the economy because only growth can ensure our ability to repay our debt. Our debt sustainability can only be secured through high growth rates, not solely through the debt relief offered by bondholders.

Economic and governance reforms are essential for growth. Notably, bondholders have proposed an innovative idea called Governance-Linked Bonds (GLB), where Sri Lanka would receive an additional benefit of 50 basis points on two selected bonds, each worth $ 800 million, if we implement two key governance reforms – one qualitative and one quantitative. The quantitative target is to reach a 14% tax-to-GDP ratio in 2026 and 14.1% in 2027.

A list of qualitative targets primarily focuses on publishing procurement contracts and tax exemptions, both of which are included in the IMF Staff-Level Agreement. However, the governance linked bonds, according to the proposal, would only apply to two bonds maturing in 2034 and 2035, each worth about $ 800 million.

While GLBs are an excellent idea, it is questionable whether the incentive is sufficient to encourage a strong governance programme. The savings from a 50 basis point cut in interest for $ 1,600 million would be about $ 80 million. Given that our accumulated interest is also about $ 1,600 million, there is a risk that governments could easily deviate.

Nevertheless, GLBs would send a strong signal to the market that the Sri Lankan administration is committed to governance reforms, which would enhance confidence in Sri Lanka.

Sri Lanka’s real challenge is avoiding a second debt restructuring. We can only achieve this by taking necessary steps and reforms to grow the economy, not solely relying on debt restructuring agreements.

Even if we secure a 30% haircut, our debt-to-GDP ratio in 2032 would still be approximately 95%. Over 50% of countries that have undergone a first debt restructuring have experienced a second. In Sri Lanka’s case, a second debt restructuring would be extremely painful for the population.

Moreover, our interest rates must remain high to meet the Government’s debt servicing requirements, attracting more funds. However, high interest rates discourage investment as people prefer to deposit their money in banks, leading to a low investment environment that could slow down growth. This slowdown would bring us back to the challenge of managing debt sustainability. This vicious cycle must be avoided.

Growth can only be achieved through improved productivity in a competitive environment, which arises when people are incentivised to perform. When the State dominates business and we try to manage everything independently, people do not become competitive.

Ultimately, growth is the only viable solution. Sadly, it is the only solution. Growth occurs when markets function effectively.

Steering clear of divisive politics and economic populism

By Dhananath Fernando

Originally appeared on the Morning

I was recently invited to moderate a session by the European Chamber of Commerce of Sri Lanka (ECCSL) on diversity, equity, and inclusion. Foreign Minister Ali Sabry was one of the Chief Guests and he shared two things we should not do, based on his experience over the past few years in managing a few key portfolios as the Minister of Justice, Finance, and Foreign Affairs.

The event focused on unleashing the power of diversity, equity, and inclusion for businesses in Sri Lanka. Keeping aside the political colours, Sabry’s message on the things Sri Lankans should not do is very apt given the current status of our affairs. These two exhortations were to never play divisive politics and never play with populist economic policies.

The final victim of divisive politics has been none other than our economy and our people. If Sri Lanka is serious about economic development, having a diverse culture is important, as highlighted by Prof. Ricardo Hausmann in his Harvard Growth Diagnostic study on Sri Lanka in 2016-2017. The economic theory behind it is that a diverse culture is capable of creating more combinations of ideas which translate to products, services, and exports.

He provided the example of Silicon Valley – most tech entrepreneurs in Silicon Valley are immigrants to the US, which is one reason a high degree of innovation takes place there. Unfortunately, in Sri Lanka, our politics is used to dilute this strength, which has led to where we are today. At one point, ethnic tensions led to mass migration and we are very slow to include all our ethnicities and religions in our culture.

The divisive politics is now at a level that goes beyond ethnicities. It is now ranged against certain countries, trade agreements, and imports from certain countries. Some good examples are the Suwa Seriya ambulance service and the trade agreement between India and Sri Lanka.

We almost rejected Suwa Seriya on the grounds that it was an Indian invasion and that Indian Intelligence services wanted to collect intelligence data through the ambulance service. This is a service primarily impacting the poorest of the poor and has now been recognised as one of the fastest services in the region by the World Bank.

Divisive politics is now beyond ethnicities and religions. We created the same tensions with trade agreements and claimed that the Free Trade Agreement (FTA) with Singapore would result in foreigners taking over our jobs. Instead, most Sri Lankans left the country for jobs overseas due to the economic crisis and we now beg people to visit us.

We also created similar tensions over the India-Sri Lanka Free Trade Agreement by claiming that the agreement would cause more imports to flow into Sri Lanka, worsening our trade balance. The data shows the exact opposite taking place.

We have a trade surplus with India under the FTA and our trade deficit with India comes from outside the FTA. However, comparing trade balances between countries is completely misleading, since what we need to keep in mind is the budget deficit rather than the trade deficit, because the budget deficit arising from Central Bank lending is what leads to a trade deficit.

At one point, by playing divisive politics, we wanted to boycott our Islamic community. We also wanted to boycott Indian products and chase away Chinese and Japanese investments. To make diversity a strength, we need to look beyond borders and capitalise on the strengths of all communities and all countries.

Minister Sabry’s second directive was to never play with populist economic policies. However, we repeatedly witness political parties engaging in populist politics. We are building resistance against the International Monetary Fund (IMF) programme without any alternative suggestions. Without the IMF programme, even 0.1% of debt relief is not possible. Many funds by many international partners like the Asian Development Bank (ADB), World Bank, and bilateral creditor will evaporate in seconds.

On the other hand, growth reforms are almost non-existent. Not a single State-Owned Enterprise (SOE) reform has been implemented yet and the SOE Bill has been shelved. On the growth front, a complicated tariff structure remains. The establishment of the Central Bank’s independence was the main reform we have undertaken and we can see the results. It is a pity that the Central Bank completely ignored the optics and raised its staff salaries, even at the risk of some policymakers requesting the reversal of the hard-earned reform of the bank’s independence.

While Minister Sabry has correctly understood what exactly should not be done, unfortunately, our politics remains divisive at a new level and populist economic policies have taken a new turn. We still have a long way to go.

The other side of parate execution suspension

By Dhananath Fernando

Originally appeared on the Morning

In India, there was a particular type of cobra that was causing havoc due to snake bites. People were protesting and social pressure was building. The then British Government had a brilliant idea to counter cobra bite-related deaths and bring down the reptiles’ population – it announced an incentive scheme for every dead cobra.

In essence, people in India were encouraged to kill cobras and hand over the animal’s dead body to established Government offices in India and collect cash in return. In the first few weeks, things worked out very well, but later the Government realised that the number of cobras being handed over was increasing exponentially.

Upon investigation, the Government realised that Indians had become somewhat entrepreneurial. They had started cobra breeding houses at homes and killing cobras as a means of revenue generation for the family. At one point, the Government withdrew the cash incentive system given the misuse of the entire scheme.

Since there was no incentive for people to maintain cobra breeding houses, they released the reptiles into the jungle. The cobra population then multiplied several fold more than what it was initially as a result of the same policy being implemented to reduce the cobra population. This is called the Cobra Effect.

The Government decision to suspend parate execution as a relief for Micro, Small, and Medium-sized Enterprises (MSMEs) is no different. It is true that MSMEs are going through a difficult time as a result of higher inflation, high interest rates, and economic contraction. It is necessary to protect the MSMEs as they comprise about 99% of business establishments and about 75% of employment in Sri Lanka.

However, whether the suspension of parate is really for MSMEs is a question; 557 parate executions have been undertaken as of November 2023. The total value of the parate executions was just Rs. 38 billion, which stands at just 0.4% of total loans and a mere 2.7% of total impaired loans. From the numbers, it is clear that most MSMEs have not been impacted by parate executions.

Effect on MSMEs

Parate is an execution power on the part of banks under the Recovery of Loans by Banks (Special Provisions) Act, No.4 of 1990, where lending banks can recover non-repaid debt by borrowers by selling assets without going through the judicial processes. In 1961, this power was only granted to People’s Bank and the Bank of Ceylon, and in 1985, the power was extended to regional rural development banks as well.

If MSMEs are not affected, what could be expected to happen when parate executions are suspended until December by the Government? This is likely to backfire on MSMEs given the nature of the banking industry, akin to the Cobra Effect.

Banks lend depositors money. Parate was a safeguard for depositors’ money in case someone was not repaying loans they had taken, giving banks a final resort to recover that money so they could honour the depositors.

Now with parate suspension, banks have a higher risk of not being able to recover the money from the loans extended, so they have to charge a higher risk premium when borrowing for anybody, including MSMEs. Therefore, if MSMEs want to borrow money now, they have to pay higher interest rates, which means further contraction of the economy at a time when it needs to grow.

Triple whammy

On the flip side, this will encourage borrowers to default as they now know the banks cannot execute parate even if they were to willfully default. Additionally, borrowers who are honouring their loan repayments with the greatest difficulty during this economic crisis will be discouraged, because their hard work in honouring the dues will not be rewarded. This does not mean that even the Rs. 38 billion through parate execution has to be understated, but it has to be addressed separately without changing a law which affects the entire banking sector.

The Government declared a Rs. 450 billion bank recapitalisation in Budget 2024 given the instability of the banking sector as losses and loans of State-Owned Enterprises (SOEs) have to be absorbed. On the other hand, licensed commercial banks including State banks are being exposed to sovereign debt restructuring, which is at its final stage. Accordingly, this is detrimental to the stability of the banking sector.

On the depositors’ end, they may be reluctant to deposit money as their risk is now higher on recovery.

Parate execution generally takes place at the last stage of recovery and must go through a court process. Suspension of parate without even consulting banks may provide wrong signals for the ongoing International Monetary Fund (IMF) review, since the IMF initially advised to conduct an assessment on the stability of the banks, although the context has now changed after a few months.

The Non-Performing Loan (NPL) ratios of banks are also on the rise, so banks basically face a triple whammy with this parate suspension – having to charge risk premiums, high NPL, exposure to sovereign default, and now difficulties in recovering money and incentives for not servicing existing loans.

However, the need to protect MSMEs is paramount, which requires a separate sequence of actions. Setting up a bank specifically to absorb bad loans, setting up bankruptcy laws, or moratoria on some of the bad loans under parate executions are options. Changing the entire parate system will indeed bring consequences similar to the Cobra Effect in India.

The dangers of the Online Safety Bill

By Dhananath Fernando

Originally appeared on the Morning

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

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

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

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

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

Self-censorship kills ideas for prosperity 

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

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

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

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

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

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

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

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

Impact on SMEs

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

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

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

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

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

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

Wrong signals to markets 

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

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

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

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

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.  

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.

Reforming the tax incentive structure in Sri Lanka

Originally appeared on Daily FT

By Roshan Perera, Thashikala Mendis, and Janani Wanigaratne

The second tranche of the International Monetary Fund’s (IMF) Extended Fund Facility (EFF) was delayed as the country failed to meet some of the program targets including the Government revenue target. This prompted the IMF in their latest review to reiterate the need to “strengthen tax administration, remove tax exemptions, and actively eliminate tax evasion” to ensure revenue is collected as per the program targets. This requires intense efforts by the Government if the country is to achieve sustainable macroeconomic stability.

Corporate Income Tax (CIT) in Sri Lanka has the potential to significantly contribute to Government revenue. However, CIT performance has been dismal with collection averaging around 1% of GDP over the last two decades although economic growth averaged around 4% during the corresponding period. It peaked at 1.9% in 2022 due to some one-off taxes.1 Compared to other countries in the region as well, CIT collection in Sri Lanka has been abysmally low (see Figure 1).

Further, CIT collection is concentrated in a few sectors in the economy. The 230 companies listed in the Colombo Stock Exchange (CSE) for financial year 2019/20 account for around 25% of total corporate income tax collection. However, financial services, food & beverages, and telecommunications account for a disproportionate share of taxes (see Figure 2). Sectors such as wholesale and retail trade, real estate and transportation which account for more than 25% of GDP, contribute less than 2% in CIT. Tax holidays and concessionary tax rates to selected sectors have eroded the CIT tax base, leading to lower CIT revenue collection. Ad hoc tax concessions complicate tax administration, distort resource allocation and provide opportunities for rent seeking and corruption.

Tax incentives

With the liberalisation of the economy in 1977 and the shift to a more export oriented development strategy, the Government sought to attract foreign direct investment (FDI) by offering attractive tax incentives, first under the GCEC Act No. 4 of 1978 and subsequently the Board of Investment (BOI) of Sri Lanka from 1992. Tax incentives were also offered under the Inland Revenue Act. The enactment of the Strategic Development Projects (SDP) Act, No. 14 of 2008 permitted the Minister in charge of investment the discretion to grant incentives to projects deemed of strategic importance with only subsequent ratification by Cabinet and Parliament.

The lack of clear criteria of what constitutes a “strategic development project” in the SDP Act and the discretion given to the Minister to decide on what constituted a “strategic” project led to generous tax holidays and incentives granted to projects that were not in any sense strategic (see Table 1 for a list of projects granted under the SDP Act). Furthermore, tax concessions under the Act have been awarded to projects that are not purely foreign funded, violating one of the core objectives of this Act, which is to attract foreign investment.

The operation of multiple tax jurisdictions has led to an overlap of tax incentives, obscuring the process of monitoring the overall benefits and costs of tax incentives provided. Lack of transparency and well-defined criteria as well as poor evaluation of projects has led to the granting of tax incentives without proper justification, leading to large revenue losses.

Transparency, availability and accessibility of information regarding companies that have received tax incentives, especially under the BOI Act, are limited3. In light of this, the IMF diagnostic report has highlighted the need for a more transparent data sharing protocol.

The case of Port City

More recently the Colombo Port City Economic Commission Act, No. 11 of 2021 was given the authority to grant tax incentives within the Port City.

The CPC Act grants incentives to businesses that are identified as strategically important. Extraordinary Gazette 2343/604 lists several industries as strategically important. Even though the Act provides a descriptive definition of a business of strategic importance, the rationalisation for these industries to be selected for special incentives is unclear. Especially as some of these industries already exist in Sri Lanka, which puts them at a disadvantage. Moreover, under section (4) subregulation (3) of the Extraordinary gazette 2343/60, one of the criteria for granting incentives is the ability of the business to demonstrate to the Port City Commission the potential contribution to Sri Lanka’s economy and social development by fostering innovation, knowledge transfer, technology transfer, research and development. This criteria is vague and subjective, thus allowing the Commission to grant incentives at its discretion.

Granting incentives often leads to differential tax treatment creating an unlevel playing field. While an entity in an already established industry within the country located within the CPC is provided generous tax incentives, the firm located outside is subject to the normal taxes operating in the rest of the country. Such differential treatment could create labour market distortions, as the employees in the Port City benefit from tax exemptions.

Sri Lanka has not been able to attract Foreign Direct Investments (FDIs) despite the plethora of incentives offered. It is questionable whether we can expect different results by applying the same failed strategy with the Colombo Port City. For instance, out of 74 land plots, only 6 were leased so far, and even those have not yet materialised.

To improve the performance of CIT, reforming the existing incentive structure is critical.

Improving investment environment

Evidence suggests that tax incentives are not the most important factor attracting FDI. Rather investors prioritise factors such as macroeconomic stability, access to skilled labour, and quality infrastructure facilities when making investment decisions. Therefore, shifting focus from relying on tax incentives to creating a favourable macroeconomic environment and policy consistency while providing the necessary resources and infrastructure will be more important to attracting investments. This will reduce distortions in the economy while ensuring the Government’s revenue base is protected.

Renegotiating tax incentives

Given the weak fiscal position of the country and the debt restructuring exercise being carried out at present, a similar exercise to renegotiate existing tax incentives may be warranted. Rationalising existing tax incentives would widen the tax base and enable lowering corporate tax rates.

Centralising tax incentives

If tax incentives are to be granted it should be done by a centralised authority. This authority should be able provide justification for granting special tax incentives by carrying out a cost benefit analysis. Clear objectives and proper criteria for granting incentives should be established and the authority held accountable for monitoring the progress of the investments to ensure the objectives of the investment are fulfilled. Failure to meet the objectives should lead to an immediate cancellation of the incentives granted. To ensure transparency, all incentives granted should require Cabinet and Parliamentary approval and information on incentives granted made publicly available through gazette notices. Sunset clauses will ensure that incentives have a limited timeframe and are periodically reviewed.

Conducting tax expenditure analysis

Tax expenditure refers to concessions such as tax exemptions, deductions, concessionary tax rates, etc. granted to specific industries or entities. While typically a government budget provides estimates of government revenue, tax expenditures are rarely reported. However, given the generous tax incentives offered it is vital to ensure the costs and benefits of tax expenditures are properly accounted for. Conducting regular tax expenditure analysis will enable comprehensive cost benefit analysis to evaluate the potential revenue loss and the expected economic benefits of tax incentives. Moreover, it is essential to carry out regular assessments to ascertain whether the revenue loss resulting from tax exemptions is justified by the employment, GDP contribution, and economic impact of these projects.

Global Minimum Tax 5

When tax incentives and holidays are granted, it should be ensured that their rates are not lower than the rate recommended by the Global Minimum Tax (GMT). This is an agreement introduced by the OECD/G20 in October 2021, with the purpose of establishing a minimum tax rate of 15% for large multinational companies. It allows countries with taxable parent companies of Multinational Enterprises (MNE) to impose a top-up tax on the profits of any foreign subsidiary that pays an effective rate less than 15%. It also allows the host country where the MNE subsidiary carries out its activities to charge a top-up tax rate on subsidiaries, if the home country of the parent company imposes a CIT rate less than 15%. So even if the countries are free to grant tax holidays and incentives with a CIT rate lower than 15%, the agreement grants the taxing rights to either the FDI exporting countries or the countries in which the MNE subsidiaries are operated. Therefore the MNEs would not be benefitted by lower rates as they will be taxed by either country.

The countries that do not adopt this GMT rule would lose out on tax income as the other countries will adjust their domestic tax rules to top up undertaxed profits. This proposal has already been strongly backed by 130 countries. Unfortunately, Sri Lanka was one of the nine countries that did not agree to this proposal.

The country is struggling to meet its revenue targets. The potential of CIT as a significant source of revenue has not been not fully exploited. A plethora of tax incentives granted under numerous agencies have seriously eroded the tax base. Reversing these trends are vital for restoring fiscal sustainability and enabling the Government to promote sustainable and inclusive growth.

Footnotes:

1This is due to the imposition of a retrospective one-time surcharge tax of 25% on individuals, companies, and partnerships with a taxable income exceeding 2 billion for the 2020/2021 tax assessment year.

2Based on the taxes paid by around 230 listed companies on the Colombo Stock Exchange in 2019/2020.

3Information on projects granted under the SDP Act are publicly available through gazette notices which are mandatory. This is unlike projects granted incentives under the BOI Act which are not publicly available. An RTI filed to extract this information was also not responded to by the relevant authority.

4http://documents.gov.lk/files/egz/2023/8/2343-60_E.pdf

5World Bank, 2023, “Can the global minimum tax agreement reduce tax breaks in East Asia?” https://blogs.worldbank.org/developmenttalk/can-global-minimum-tax-agreement-reduce-tax-breaks-east-asia#:~:text=In%20October%202021%2C%20the%20G20,to%20be%20implemented%20in%202024.

(Roshan Perera is a Senior Research Fellow at Advocata Institute. She can be contacted via roshananne@gmail.com. Thashikala Mendis is a Data Analyst at Advocata Institute. She can be contacted via thashikala@advocata.org. Janani Wanigaratne is a Research Consultant at Advocata Institute. She can be contacted via janani.advocata@gmail.com.

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

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.

Why was the IMF Tranche Delayed?

Originally appeared on The Morning

By Dhananath Fernando

There is some uncertainty in the market regarding the reasons for the delay in the IMF's second tranche. The simple reason is that although we have made some progress, given the depth of the crisis, our speed of reforms is inadequate for a swift recovery, particularly in revenue collection.

A shortfall in revenue collection, expected to be about 15% compared to initial projections by the year end, has been cited as a key reason. Secondly, until we finalize debt restructuring, especially external debt restructuring, the risk factors remain high in achieving our desired debt-to-GDP ratio. Even after the expected debt restructuring, in 10 years, our debt-to-GDP ratio will still be above 90% according to estimates.

Thirdly, the Central Bank's reserve collection has slowed down. Consequently, with our macroeconomic indicators sending mixed signals, it can not be assured that the economic recovery is still on the right path. Furthermore, at the press briefing held on the 27th of September IMF officials reiterated that more work needs to be done to sustain the reform momentum.

It is crucial to identify the reasons for the delay in reforms. Our framework for driving reforms is not well-established. The current structure, where the President acts in the capacity of the Minister of Finance, appoints committees, and delegates tasks, is flawed. Some tasks are interconnected, and the entire drive must come from the Finance Minister alone.

Further, these two roles can have contradictory interests. The Finance Minister holds an unpopular job, requiring revenue increases through taxation and expenditure reduction. Conversely, when the President, a politician expecting re-election, occupies the role, there's a natural tendency to make popular decisions, deviating from essential reforms.

Our reform process is highly complicated, demanding direct involvement of the Finance Minister in debt negotiations with external creditors in several categories, namely multilateral, bilateral, and private creditors. This task alone is equivalent to a few full-time jobs. Additionally, structural reforms are expected to focus on State-Owned Enterprises, where considerable trade union influence will come into play with appointments made by fellow cabinet ministers. Thus, driving such unpopular yet critical reforms becomes nearly impossible, especially when the finance minister is also the President or vice versa. More importantly, for key appointments such as the Central Bank Monetary Board and Governance Board, the President nominates with the Minister of Finance's approval and the Constitutional Council's endorsement. When the President and the Finance Minister are the same, the objective of checks and balances significantly diminishes.

In the case of India's reforms in the 1990s, it was Dr. Manmohan Singh who spearheaded reforms. He had Dr. Montek Singh Alhuwalia as the Chairman of the National Planning Committee to drive reforms. With his experience working with the IMF and a keen understanding of the Indian perspective, the reforms initiated in the 1990s continue to fuel India's growth, making it one of the countries with the highest economic growth rate.

The IMF Governance Diagnosis report, subsequently released, provided numerous recommendations out of which approximately 16 recommendations have been prioritized, mainly focusing on governance and transparency.

One reason this column advocates moving beyond IMF reforms is that corruption cannot be curtailed solely through governance structures. The size of the government must be limited in conjunction with effective governance structures. Aligning governance structures with the vast expanse of the government is nearly impossible.

Furthermore, the IMF primarily brings stability; the responsibility for growth lies in our hands. We must unlock our growth potential through necessary reforms, extending beyond the IMF program. This underscores the urgency of accelerating comprehensive reforms and establishing a dedicated team to drive these changes. Regrettably, what we observe is mere enactment of legislation without robust mechanisms to execute and ensure continuity of the process, and this leading to delays in the IMF's second tranche.

Sri Lanka needs a bottom-up approach

Originally appeared on The Morning

By Dhananath Fernando

Regrettably, over the years, Sri Lanka's approach to development has primarily relied on aid and subsidies for its impoverished population. Many politicians have spoken about poverty, but they have often neglected to address its root causes. If our policies were centered on eradicating poverty rather than simply targeting the poor, our development framework could have evolved significantly.

As the adage goes, "there are no poor people, only poor places or countries." A recent report by LirneAsia revealed a startling increase in poverty numbers, rising from 3 million to 7 million people, pushing over 4 million individuals below the poverty line. If our long-standing strategies, such as fertilizer subsidies, Samurdhi, and fuel subsidies were on the right track, how did an economic crisis suddenly plunge 4 million Sri Lankans into poverty?

The ability to maintain strong international relationships and secure more aid has been considered a crucial qualification for candidates, during election cycles. Within the voting community, politicians offering the most substantial subsidy handouts are often perceived as popular leaders. While it is true that we need comprehensive international relationships in modern politics and must take care of our citizens, we must do so while keeping a development-oriented mindset at the core. Regrettably, development cannot rely solely on foreign aid, nor can we lift people out of poverty by offering aid exclusively to the poor.

This situation is not unique to Sri Lanka; it's a global phenomenon. No country has achieved development solely through aid programs. Instead, countries that have reached the development stage share strong institutions and reasonably functioning market systems as common denominators.

The primary focus of any government or political leader should revolve around two key conceptual frameworks:

1. Are we establishing institutions that promote a level playing field?

2. Are we encouraging a functioning market system?

Development is generally a bottom-up approach. People often know what's best for themselves better than politicians or leaders do. We simply need to provide them with opportunities in a competitive environment. Recently, I had the privilege of meeting a few small and medium-sized exporters. The entire system and processes seemed designed to hinder their export activities. Many exporters emphasized the difficulties they face when exporting in Sri Lanka, including challenges and harassment from government regulatory authorities, such as Sri Lanka Customs.

A prime example of our low export numbers is not only market access problems but the barriers within our own system that obstruct exports. One exporter from Kandy, specializing in vanilla exports, highlighted how customs consistently questioned HS codes and demanded repetitive documentation, causing him to spend more time on export processes than on developing his product and capacity. These challenges are consistent across the board for exporters, explaining why Sri Lanka's exports remain stagnant despite numerous committees, task forces, and chairpersons at the Export Development Boards.

Real change should start from the bottom by removing barriers for businesses and offering people the freedom to pursue their desired endeavors. Such reforms may not bring personal glory, as they empower individuals to make their own choices. In contrast, an aid-driven approach often results in leaders or countries seeking personal recognition through associated aid packages.

In Sri Lanka's case, we must remind ourselves that only we can make a difference and pull ourselves out of this crisis. While we need the support of international institutions like the International Monetary Fund and bilateral and multilateral creditors, they alone cannot rescue us from our predicament. It is only through economic reforms and the development of inclusive institutions that we can compete on a level playing field and extricate ourselves from this mess. Both small and large reforms are essential, and we must implement them swiftly and effectively.

Reforms: The need of the hour

Originally appeared on The Morning

By Dhananath Fernando

Former Governor of Anambra State in Nigeria Peter Obi once wisely said: “No country can progress if its politics is more profitable than its industries. In a country where those in government are richer than the entrepreneurs, they manufacture poverty.”

This is quite relevant to the Sri Lankan scenario. If so, we have been manufacturing poverty over the years and the key tool used for it by politicians is weak governance structures. Even if we apply the best economic policy in the world, it would mean nothing in a society without governance.

The current reforms which are being discussed should also give equal weight to governance. Among the key reforms that have been discussed in Parliament, governance reforms should be given paramount importance. Suggested reforms related to the Central Bank, State-Owned Enterprises (SOEs), social safety nets, and reforms on trade accounts are key components.

Governance reforms and CBSL independence

In the current set-up where the President is also the Finance Minister, there is a possibility of diluting governance structures. Both tasks are quite challenging and attempting to facilitate both will likely result in nothing, especially during an economic downturn. When reforming the Central Bank of Sri Lanka (CBSL), in order to ensure its independence, appointment of positions should come through the Constitutional Council.

Conversely, if the integrity of the Constitutional Council is diluted, the process of appointment of members to both the Monetary and Governance Boards of the Central Bank will not be channelled through proper checks and balances. This lack of governance structures in the CBSL leaves room for diluted appointments, particularly at a time when there is a need for a dynamic and credible Central Bank.

Governance reforms for SOEs

State-Owned Enterprise reforms require a governance structure with depth. At the moment, the SOE Restructuring Unit has called for proposals for transaction partners, but the selection of the partners should be managed with transparency.

One way to ensure transparency is to avoid information asymmetry by providing access to information to potential interested partners of SOEs. Unsolicited proposals should be avoided and competitive bidding processes have to be adhered to. While we can consider privatisation of some entities, it is important that we implement governance structures for the remaining SOEs.

Governance structures on procurement have to be in the forefront. In a nutshell, SOE reforms have to be driven by governance reforms. Otherwise, one bad transaction can drive public confidence down and lead Sri Lanka back to square one. Managing as well as reforming SOEs has provided a window of corruption for politicians.

As Peter Obi said, one tool for politicians to become richer than the industries itself has been either to appoint their henchmen to maintain corruption, while sometimes they try to make profits when the reforms take place. Both have to be avoided and can only be minimised through governance reforms.

Governance reforms for social safety nets

Another set of key reforms which requires a deeper governance structure are the reforms related to social safety nets. It is no secret that the existing Samurdhi programme has been politically driven and poorly targeted. However, a new scheme has been gazetted and people have been asked to apply for the new social safety net.

Ideally, the new selection has to be verified again through a third party organisation where political intervention is at a minimum. The selection of these third party organisations have to be made through a transparent procurement process. Otherwise, the same political biases on selecting the most vulnerable people will prevail.

We have to keep in mind that every reform or every move provides a window for politicians to profit more than entrepreneurs. That is the very reason why we need to limit Government involvement and bring in governance structures. Only solid governance structures and people’s solidarity with governance structures can stop politics from becoming more profitable than industries.

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.

IMF Programme #17: takes two to tango

Originally appeared on the Daily FT, Ada derana, Groundviews

By Daniel Alphonsus

On Sri Lanka’s reform-regress-run to the IMF crisis cycle

Countries never learn from others’ mistakes, they only learn from their own. Sri Lanka is an exception: we don’t even learn from our folly. Apparently neither does the IMF. Sri Lanka’s 17th IMF programme is set to be approved on March 20th. Is it welcome? Yes. Will it break Sri Lanka’s reform-regress-run to the IMF crisis cycle? Probably not. 

All reforms undertaken over the past half-year to win IMF board approval are reversible. None of them constitute entrenched changes in economic policy or governance. We are building our recovery on the shakiest of foundations. The fuel and electricity price ‘formulae’, tax plus interest rate increases and greater exchange rate flexibility can all be altered, more or less, at the stroke of a pen.  

This is not surprising. Sri Lanka has a chequered history of cosmetic compliance: ticking the boxes of virtue and sensibility via international undertakings during desperate times, and then reverting to business-as-usual once crisis abates. We have good reason to think that, this time too, the future will rhyme with this past. Undoubtedly, post IMF board approval, some reforms less easy to rewind will come to pass - the new Central Bank Act being the most notable. 

But the IMF’s bargaining power peaks prior to board approval. That is the decisive point in this process. It is the pivotal moment for any attempt to use this crisis to build the foundations required for breaking the crisis cycle and going from third-world to first. If the most contentious and critical reforms are not pushed through prior to board approval, there is good reason to think they will not come to pass. Remember that of its 16 programmes thus far, Sri Lanka’s has only completed two extended / structural programmes. The remainder are either relatively insignificant standby-facilities or derailed extended programmes

Considering the unprecedented nature of the current crisis, this is a colossal missed opportunity. As argued in a prequel article, Programme 17 could have and should have broken this cycle. Public opinion was desperate, the government commanded a super-majority in Parliament and the IMF held all the aces. The distinction between what is desirable and what is feasible had, almost overnight, dissolved. The cry for fuel and electricity was so piercing and loud that a comprehensive and deep programme permitting profound economic restructuring was possible for the first time since 1977. 

Moreover, even if some of the required reforms come to fruition over Programme 17’s next few reviews - it will still be a missed opportunity. Reform takes time, effort and energy. These are scarce resources. As major structural reforms - such as the central bank act, fiscal rules, privatisations and labour market reforms - were not completed as prior actions, it means the first few reviews will be focussed on them. This will leave little room for some of the more complex long-term reforms; especially in land, the public service and regulatory policy (e.g. competition policy). 

Of course, we are a sovereign state, so primary responsibility for this failure lies in our own polity. But we find little hope in ourselves. As weary and jaded citizens we tend to assume inertia, or worse, on our side as a given. Which is why this article is about the IMF’s failure. 

What could the IMF had done differently? Especially considering its familiarity with Buenos Aires, it should know that it takes two to tango. As Keynes famously said of the IMF and World Bank; the Bank’s a fund, and the Fund’s a bank. Considering the creditor-borrower relationship between the IMF and Sri Lanka; as a creditor the IMF should bear some responsibility for the failure of so many programmes over such a long period of time. The IMF’s own kapuralas have conceived of programme conditionality as a form of collateral. The IMF ought demand more conditionality as collateral prior to lending. This, of course, requires review of past country programmes and, as we all know, economic history and country expertise are not exactly first-rank priorities at the Fund. 

Anyone involved in economic policy-making in Sri Lanka, the IMF included of course, knows that much of the technical work was already done. When the staff-level agreement was signed in September last year, there was a great deal of reform that just required political will and nothing else. Cabinet had approved an earlier version of the new central bank bill during the last days of the Samaraweera ministry. Placing energy price formulas on a statutory footing shouldn’t take more than a day’s drafting. Fiscal rules legislation was already in a relatively advanced stage. Non-legislative measures could also have been mandated - the state could readily have divested its stakes in Sri Lanka Telecom and Lanka Hospitals. These firms are already listed with established valuations. Considering the 200 days between the staff-level agreement in September and board approval now, we had more than enough time to list the major state banks and Sri Lanka Insurance; maybe even privatize the East, Jaya and Unity container terminals. After all, for better or worse, remember the plantations were effectively privatized within fourty-eight hours. These delays are all the more astonishing due to the hypocrisy of asking for favours from our creditors while refusing to sell underperforming assets. 

Primary balance vs growth 

Considering the political cost of market pricing energy and increasing taxes, from a political point of view, there is tremendous incentive for the political leadership to undertake structural reform in return for less pain. Sri Lanka’s future debt sustainability (or lack thereof) is a function of current and future (a) government revenue, (b) government expenditure and (c) GDP growth. By raising Sri Lanka’s growth potential, both the IMF and long-term creditors could and should have been willing to trade-off revenue and expenditure targets for entrenched, high quality structural reform. The one percent rate hike - which the central bank opposed - just before placing Sri Lanka on the board agenda illustrates this well. Clearly, this temporary, one-off one percent increase in interest rates was considered decisive for obtaining board approval. Why then was not actually passing the central bank bill in Parliament - which is likely to shape inflation rates for decades? Note that in my view, the IMF’s bargaining power at this juncture could be so strong that a trade-off between primary balance linked targets and structural reforms may not exist. The IMF may have been able to demand both. That is the IMF could have had the cake, eaten the cake and called it a letter of intent. 

Primary balance today vs primary balance tomorrow

Even if one does not buy the argument of reducing the primary balance target today in exchange for growth tomorrow, two strategies superior to the status quo could have been pursued. 

First, instead of trading off the primary balance versus growth, we could have exchanged a primary balance improvement today for a larger primary balance improvement tomorrow. The IMF could have permitted reducing the primary balance target today in exchange for entrenched reforms that result in a paradigm shift in Sri Lanka’s primary balance trajectory for the future. For example, coming back to the central bank bill, through greater depoliticization and limitations on central bank funding of government deficits, this landmark reform is likely to change Sri Lanka’s medium to long term primary balance trajectory. The ‘net present value’ of this change in primary balance terms - even when discounted for the probability of it being unenforced - is likely to be greater than a few percentage point changes in the primary balance today. 

Optimizing this trade-off would also have the added benefit of placing less pain on the public and reducing the extent of contractionary policy amidst Sri Lanka’s worst economic crisis in decades. 

Second, there are some measures that can improve the primary balance today, and tomorrow. A good example is the sale of shares in state banks. The sale of minority stakes in BOC and People’s Bank will raise money for the exchequer, boosting the primary surplus. However, especially if the banks are listed, it will also make it more difficult for the state banks to permit the government to create enormous contingent liabilities via loans to the CEB and CPC, resulting in a healthier future primary balance. 

Overdiscounting the future

The argument often made in response is that the IMF cannot tradeoff the certainty of hitting quantitative targets today, in return for structural reforms whose fruits may not materialize tomorrow. This view is misguided. First, deep understanding of context enables a reasonably good assessment of the probabilities of a structural reform producing a desired outcome - enabling the computation of rough expected values. For example, we know that once a privatization takes place it is unlikely to be easily undone. Second, even after first discounting on the basis of probabilities, a second round of discounting can take place to compensate - to some degree - for the uncertainty inherent in structural reform.

Bailamos
There are two dancers in this toxic tango. They both need to take stock of the past, break with it and dance a new dance. Introspection is a good start. The IMF and our government should get together and commission a review of all past programmes to inform the design and implementation of the current programme. In the meantime, the priority should be to ensure as many structural reforms as possible are pushed through prior to the first review. If we are able to use entrenched, high-quality structural reform to credibly improve Sri Lanka’s medium term growth and primary balance trajectory, we should be able to avoid some of the short-term pain and contraction that we would otherwise experience. Then, maybe instead of toxic tango, we can look forward to a solid baila session. With the President, as he did with Iranganie Serasinghe, accompanying the IMF’s managing director for a round of kaffirhina. After all, compared to austerity, structural reform is a sumhiri pane.

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.