Beyond profit margins and scandals

By Dhananath Fernando

Originally appeared on the Morning

Blaming imports and importers has long been ingrained in Sri Lankan culture, often seen as a root cause of the country’s economic issues. This perspective not only overlooks the fact that many importers are also exporters, but also fails to recognise that imports and exports are fundamentally interconnected components of the global trade system.

Despite this, it is crucial to acknowledge that not all imports are conducted ethically or transparently. Recent scandals, such as the sugar scam, misinvoicing, bribery, and procedural irregularities at Customs, highlight the darker aspects of importation. However, casting imports in a universally negative light and fostering resentment based on ideological reasons could prove to be more harmful than beneficial.

Recent investigative reports have revealed staggering profits made by importers on essential commodities like green gram, B-onions, and potatoes. Some profit margins have been reported as high as 280% when comparing the Cost, Insurance, and Freight (CIF) value to the market prices of these goods.

Before rushing to judgement on these profit margins, it is essential to delve deeper into the circumstances surrounding these imports. For example, the importation of green gram has been severely restricted since the onset of the Covid-19 pandemic, requiring special approval from the Ministry of Agriculture. As a result, the quantity of green gram imported in 2023 has been minimal.

Thus, comparing the CIF value at the port to market prices can be misleading, as it does not accurately reflect the profits made by importers. This situation raises questions about the high market prices for green gram, pointing to inefficiencies in local production rather than exorbitant profits by importers.

The scenario with undu, a staple food item, is similar. With a Rs. 300 import tariff, the market price for 1 kg of undu ranges between Rs. 1,500-1,700. This high cost is partly because importers cannot bring in undu without approval from the Ministry of Agriculture, despite the imposition of tariffs.

Allowing imports could potentially reduce the price of undu to around Rs. 700 per kg, even after tariffs. The restriction on undu imports exacerbates price inflation, making it unaffordable for many, particularly those in estate regions and the northeast, leading to food insecurity among vulnerable populations.

During the recent economic crisis and the consequent shortage of foreign exchange, many imports were facilitated through informal payment channels and ‘open papers’ in undiyal markets. This practice, aimed at evading high tariffs and taxes through under-invoicing, underscores the complexity of Sri Lanka’s tariff structure and the urgent need for its simplification.

The report by the Ways and Means Committee suggests that focusing solely on the cost of goods at the port does not provide a complete picture of the import value, especially considering the prevalence of informal payments. This approach to calculating profits, based solely on declared document values, overlooks additional costs borne by importers, thus distorting the perception of their profit margins.

Moreover, the perishability of essential food items, along with the significant costs associated with storage, wastage, and the impact of rising fuel and electricity prices, further complicates the economic landscape. These factors, combined with high inflation rates, have significantly influenced the cost structure of both the wholesale and retail markets, affecting pricing and profit margins.

The impact of export controls on certain commodities, such as B-onions by India, has also played a role in inflating global prices, illustrating the complex interplay of international trade policies and local market dynamics.

This situation underscores the phenomenon of unintended consequences in economic policy, where well-intentioned policies can lead to outcomes that are diametrically opposed to their original goals. Sri Lanka’s intricate tariff structure and monetary instability have inadvertently encouraged informal payment methods on one hand and escalated costs on the other, placing the poorest members of society in an increasingly precarious position.

While it is undeniable that practices like misinvoicing represent clear violations of the law and must be addressed through appropriate legal channels, attributing the entirety of Sri Lanka’s economic challenges to importers overlooks the broader systemic issues at play. Simplifying the tariff structure, as this column has long advocated, could lead to increased Government revenue and minimise systemic leakages, offering a more sustainable solution to the economic challenges faced by importers and consumers alike.

In conclusion, while illicit practices within the import sector must be rigorously tackled, the solution to Sri Lanka’s economic dilemmas lies not in vilifying importers but in addressing the complex policy and structural issues that underpin the nation’s trade dynamics. A comprehensive approach, focusing on policy reform, tariff simplification, and enhancing local production efficiencies, is essential for creating a more stable and equitable economic environment.

Non-negotiable reforms for election manifestos

By Dhananath Fernando

Originally appeared on the Morning

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

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

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

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

Strengthening social safety nets 

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

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

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

SOE reforms 

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

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

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

Anti-corruption and governance reforms

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

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

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

Following the IMF programme and debt restructuring 

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

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

Trade reforms and joining global supply chains 

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

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

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

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

VAT: The good, the bad and the solutions

By Dhananath Fernando

Originally appeared on the Morning

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

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

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

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

A complicated context 

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

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

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

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

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

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

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

Solutions 

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

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

Tax competitiveness as a framework 

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

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

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

Looming political and economic challenges ahead of elections

By Dhananath Fernando

Originally appeared on the Morning

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

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

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

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

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

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

Political risk

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

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

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

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

Risk of a second debt default

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

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

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

Solutions: A common minimum programme for reforms

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

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

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

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

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

Fiscal path amidst promises and uncertainties

By Dhananath Fernando

Originally appeared on the Morning

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

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

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

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

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

Scenario 1: Cutting down on capital expenditure

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

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

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

Scenario 2: High inflation

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

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

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

Scenario 3: Hike in interest rates

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

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

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

Solution

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

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

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

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

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

Why Prices are Slow to Fall Despite Easing Interest Rates, Inflation

Originally appeared on The Morning

By Dhananath Fernando

Inflation is gradually easing to the 20% range and the Central Bank has made the decision to reduce the interest rates by 2.5%. Additionally, the Sri Lankan Rupee is appreciating. In regular news stories, the media and people often ask the question, “Why, then, are prices still high?”

How can we understand this through economics and determine what policies should be implemented to bring about maximum benefits for Sri Lankan citizens? Since everyone is a producer as well as a consumer, this affects all individuals.

Declining inflation doesn’t mean prices will drop

First, many hold the perception that inflation results in a direct increase in prices. The rate at which prices are rising, however, is what is actually known as inflation. It is the same as the acceleration of a vehicle; when we accelerate a vehicle, its speed increases. But once the vehicle is in motion, even without accelerating, it will move.

Declining inflation simply means that the speed at which prices are increasing has slowed down, but it does not mean that prices are actually decreasing. That is why inflation is considered the worst enemy of everyone, particularly the poor.

As Milton Friedman said: “Inflation is always a monetary phenomenon.” Another reason why we should not allow inflation to raise its head is because the remedial actions required to curb inflation come with their own costs and drawbacks.

To bring down inflation, interest rates must be increased. However, when interest rates increase, the economy shrinks, making the business environment more difficult to operate in. This is exactly what Sri Lanka is going through. When the business environment becomes difficult, social pressures tend to rise as well.

However, for certain essential items such as petroleum products, LP Gas, and some construction materials, prices have reduced due to currency appreciation. A common question, which is fair to raise, is how prices increase overnight when currency depreciates, but are very slow to adjust when currency appreciates.

When the media questions traders, a typical reason provided is that the stocks had been bought at a higher exchange rate, so the prices will be adjusted only with the next shipment. While there is some truth to this explanation, the absence of competition laws and a poor regulatory framework allows for price coordination and rent-seeking behaviour to also take place.

One reason for the lack of price coordination is the elimination of micro, small, and medium traders by government regulations themselves. If we recall the last few months, both the spot and forward markets were effectively not functioning due to Government regulations.

This prevented the opening of Letters of Credit (LCs) for a future date, based on the exchange rate at the time of reserving the USD. Additionally, there were regulations that stopped credit facilities for opening LCs. When banks do not provide credit facilities to open LCs, only large players who have the capacity to pay the full amount upfront are able to engage in the market.

Exchange rate appreciation and prices

This is precisely what happened in the case of sugar imports. When the forward exchange rate market was squashed, traders were unable to predict what the exchange rate would be by the time they had cleared the LCs at which point the imported sugar would have already been sold and the money collected.

Therefore, if the exchange rate depreciates significantly, the trader will incur a massive loss. While most of these regulations have now been reversed, many micro, small, and medium traders were wiped out from the market during the time these regulations were in place.

The limited players have made it easier for price coordination to occur to keep prices high even when the exchange rate strengthens. Similarly, the same circumstances were observed when price controls were imposed on poultry products. With price controls in place, layer chickens were sold out and it takes time for the market to reverse the effects. Sometimes, it is easier to just impose a quick regulation, but the recovery from that regulation can take years.

Regarding the exchange rate, until there is significant progress on debt restructuring, uncertainty remains. As a result, markets are reluctant to perform any adjustments. That is why, as a country, we need stable policies so that the business environment becomes favourable and even consumers do not have to worry about price fluctuations, as they will be adjusted in a systematic manner.

Price controls will not work

A common suggestion that is made to bring down prices is to impose price controls. People and the media are quick to jump on the decision to impose price controls, thinking it will bring the prices down.

However, it is important to understand that price controls do not necessarily lead to lower prices. Instead, they can have unintended consequences such as the emergence of black markets or complete shortages of goods.

We need to realise that the best-case scenario is to have both lower prices and sufficient availability of goods and services in the market. The second-best option would be to have goods available even at a higher price, as the non-availability of goods will cost consumers more in terms of finding alternatives for their needs. In such cases, the ultimate burden to the consumer is high due to the unavailability of goods.

That is why price controls are not a solution, as they do not effectively bring down prices and can create shortages.

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.

Current Food Inflation in Sri Lanka: Causes, Consequences and Way Forward

Originally appeared on the Morning

By Thilini Bandara

In recent times, rising food prices have become a global phenomenon owing to various factors including the Covid-19 pandemic, climate impacts, the Russia-Ukraine war and the downturn of the global economy. These have played a part in Sri Lanka recording the highest food inflation rate of 94.9% in September 2022 according to the Colombo Consumer Price Index—a rate which averaged at 9.39 per cent during 2009–2022. The World Bank's food security update highlights  Sri Lanka among the top 5 countries with the highest food price inflation in September 2022. This article explores the recent trends, causes and consequences of food inflation in the country. 

Fluctuation of food prices over time

Advocata Institute’s Bath Curry Indicator (BCI) tracks the monthly changes in the retail prices of a limited basket of goods normally consumed by Sri Lankans as per the 2016 Household Income and Expenditure Survey (HIES). 

Accordingly, the BCI supermarket prices recorded a 78% increase between September 2021 to 2022.  However, there is a slight decrease in prices on a month-on-month basis of 7.63% in September 2022 compared to August 2022. Further, when considering the BCI-Supermarket prices, it has recorded an 83.88% increase between August 2021 to August 2022 on a year-on-year basis, while showing a slight decline of 6.59% between September 2022 and August 2022. 

Table 1 depicts the price fluctuations in terms of BCI and BCI-Supermarket from 2019 to 2022.

Table 1: Price fluctuation over time according to the BCI index

Causes of food inflation in Sri Lanka

At a glance, rising food prices can be attributed to disruptions in both global and local supply chains due to various factors that include the energy crisis, climate impacts, the pandemic and the Russia-Ukraine War. Additionally, domestic policy restrictions such as import bans of essential commodities, the rising cost of agricultural inputs, recent changes to agricultural policy, and the ban on chemical fertilisers and quick shift to organic fertilizer lowered agricultural production and heightened supply chain disruptions. 

Moreover, the expansionary monetary policy of the previous government through lowered interest rates and heightened money printing contributed to higher food inflation.

Additionally, due to the uncertainty surrounding imports entering the markets, traders must reassess their pricing decisions. This creates distortions in the marketplace and can lead to additional pressure on consumers. 

Consequences of food inflation

People living below the poverty line and middle-income groups with a fixed income are the most severely impacted by this high inflation. Food inflation rising rapidly in contrast to household incomes has widened the income gaps. It has further dealt a massive blow to the economic stability and well-being of the poor through poverty and malnutrition. A recent survey by the Sri Lankan Red Cross Society and the International Federal of Red Crescent Societies has revealed that 50% of households have reduced the intake of meat and fish, while 11% have completely dropped protein intake from their diets. Also, a survey conducted by WFP in September 2022, reveals that more than 1/3rd of Sri Lanka’s population is in food insecurity, while 79% of households are adopting food-based coping strategies to keep food on the table.  Moreover, the evidence revealed that even non-food expenditure such as education, housing, and health has lowered owing to rising food costs, which will lead to socioeconomic pressure.

Way forward

A recent report by the Food and Agriculture Organisation and the WFP highlights that the food security problem could be further heightened during the upcoming “maha” season between October 2022 - February 2023, if the country is unable to import sufficient amounts of rice and other food products to meet demand. In the absence of a sufficient supply of agricultural inputs such as fertilizers, pesticides, and other supplies, targeted assistance should be provided to farmers to increase domestic production and resilience of the agri-food systems. In fact, introducing incentive schemes, identifying special regions for off-season cultivation, implementing innovative food storage and preservation strategies, distributing farm inputs at subsidized rates, and promoting substitutes for imported items are some of the measures that can be implemented to address the food security problems. 

Targeted interventions should also be provided through social safety nets and humanitarian initiatives for low-income groups that are food insecure and require immediate assistance. Though funds for this have been already allocated from the 2022 interim budget, effective and efficient execution is required to identify the most vulnerable groups and provide them with the food assistance they require. 

References

Aneez, S. (2022). Crisis-hit Sri Lanka looks for foster parents to face malnutrition among children. Economynext. Available at: https://economynext.com/crisis-hit-sri-lanka-looks-for-foster-parents-to-face-malnutrition-among-children-101200/. [Accessed 17 October 2022]

CBSL. (2022). CCPI based headline inflation recorded at 69.8% on year-on-year basis in September 2022. CBSL. Available at: https://www.cbsl.gov.lk/sites/default/files/cbslweb_documents/press/pr/press_20220930_inflation_in_september_2022_ccpi_e.pdf. [Accessed 13 October 2022]

Economynext. (2022). Sri Lanka households drop meat from diet, slash drug doses as poverty worsens: survey. Available at: https://economynext.com/sri-lanka-households-drop-meat-from-diet-slash-drug-doses-as-poverty-worsens-survey-101259/.[Accessed 19 October, 2022]

FAO & WFP.(2022). FAO/WFP Crop & Food Security Assessment Mission (CFSAM) to the Democratic Socialist Republic of Sri Lanka. Rome: FAO & WFP. Available at: https://www.fao.org/3/cc1886en/cc1886en.pdf.[Accessed 17 October 2022]

OCHA. (2022). Food Security and Nutrition Crisis in Sri Lanka. OCHA. Available at: https://reliefweb.int/report/sri-lanka/food-security-and-nutrition-crisis-sri-lanka. [Accessed 17 October 2022]

Trading Economics. (2022). Sri Lanka Food Inflation. [online] Available at: https://tradingeconomics.com/sri-lanka/food-inflation. [Accessed 19 October 2022]

The World Bank. (2022). Food Security Update. The World Bank. Available at: Food-Security-Update-LXX-September-29-2022.pdf (worldbank.org). [Accessed 20 October 2022]

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.

Thilini Bandara is a Research Analyst at the Advocata Institute. She can be contacted at thilini@advocata.org. The Advocata Institute is an Independent Public Policy Think Tank. The opinions expressed are the authors’ own views. They may not necessarily reflect the views of the Advocata Institute.

A reformist mindset is crucial

Originally appeared on The Morning.

By Dhananath Fernando

On one side of the aisle, hopes have been raised with the election of a new President. Hopes abound that necessary and sorely needed economic reforms will now move forward. On the other side, yet another round of suspicion has arisen about whether politicians are yet again deceiving the common people. 

There is suspicion that the unaddressed sufferings of the people will be swept under the rug with another political plot. As I was trying to understand which side made the more compelling argument, I recollected my memories of a story related by my school Principal, the late Rev. Father Bonnie Fernandopulle. 

He asked his students: “Do you know the difference between a good kettle and a bad kettle? Both kettles serve the same purpose – boiling water. They both give the same whistle when water is boiling.” He paused before continuing: “Then what is the difference between a good kettle and a bad kettle?” 

After letting the students mull over it for a moment, he said: “Only time will tell which one is good and which one is bad. The good kettle will be durable and can be used for a longer time, while the bad kettle cannot be used for that long. Only time will tell which is which.” 

Rev. Fr. Fernandopulle repeatedly advised students to be good kettles and make decisions that could stand the test of time. His message can also be applied to the spheres of politics and reforms. Within these spheres, too, the test of the time is the best test to administer before arriving at hasty conclusions.

Political instability 

Since 2018, back-to-back political instability has too often been present in the key decision-making positions. The 2018 constitutional coup and 2019 Easter attacks kick-started a sequence of events fraught with political instability. Then the country was sent into lockdown as Covid numbers surged. 

Since then, after the country was reopened, we have so far had five finance ministers, three prime ministers, and two presidents in the very short period of time of two-and-a-half years. Since 2019, even the Central Bank has had three governors.

To make any headway in reforms, a government should be allowed to remain in place for at least two or three years to ensure that some progress is made. The first 100 days are the main reform window. Any government can capitalise on the first 100 days if it has done its homework and if it has a competent team and reforms ready to execute at short notice. 

To stay in power for two to three years, the initial reforms have to have some impact and people should have some level of hope that things are improving. The common people should also have some level of confidence that the people in charge are moving the country in the right direction. To achieve this, we need a written action plan to give confidence to all stakeholders, including the International Monetary Fund (IMF), and even for all political parties to reach a consensus and work together. 

So it is of paramount importance that we obtain some level of consensus on a programme of reforms. Otherwise, we will just waste time going back and forth appointing more ministers and cabinets every fortnight while reforms come to a complete standstill. 

A reform programme 

Putting forth a reform programme in a document is the very first step on the path to achieving consensus. 

Surprisingly, no political party has taken the initiative or led discussions on a commonly-agreeable work plan. What political parties have put forward are long manifesto type documents which lack an actionable plan. Those documents often have drawn-out explanations of the problem and broader solutions with executions that are vague.

The National Movement for Social Justice (NMSJ) has compiled a common minimum programme evaluating reform ideas from multiple parties and organisations (the author was a part of the process). 

In a recent tweet, Samagi Jana Balawegaya (SJB) MP Dr. Harsha de Silva mentioned that they have created a reform plan based on NMSJ proposals. According to his tweet, the team, which was supported by Dullas Alahapperuma and included Dr. Nalaka Godahewa and Prof. Charitha Herath, had agreed on the proposals. All that happened before the parliamentary presidential race, but nonetheless the reform plan remains valid. 

NMSJ documents have been endorsed by economists and business leaders, so a sensible starting point could be to move ahead with the plan and get the consensus of all parties, forging ahead with the reform pathway. Let me remind you that we are already very late to start reforms at all.  

Unfortunately, we do not have many options other than performing economic reforms if we are serious about overcoming this crisis. If we want to settle for not executing any reforms, we will have to settle for becoming a failed state in the coming years. 

Reform communications 

The second step of any successful reform package is the communication of reforms. 

Reform communication is less about running an expensive media campaign and airing catchy commercials, and is instead more about explaining clearly and simply the change that will be wrought on the system and ensuring transparency. Transparency and actually executing actions are the biggest tool of communication. It provides signals to both markets and individuals. 

For example, if we start the process of privatising SriLankan Airlines, the tender process has to be competitive so that it communicates to investors, the local community, and international financial institutions that the urge for change has come from within. Then when we actually go about enacting privatisation, it will clearly communicate the message that we are open for private investments, which assures private property and competitiveness. 

In the world of reforms, actions are the strongest tool of communication. The second most important tool is ensuring transparency and explaining reforms in simple language for people to understand their impacts and how they will help us emerge from the crisis.

Institutions for executing reforms

Another key piece of the puzzle is having necessary institutions and capacity to carry forward reforms. 

For instance, there is a process and an engagement strategy we need to follow to privatise a State enterprise. The strategy and the execution requires skilled manpower, networking capabilities, negotiation power, and transaction management. Only a strong institutional structure will bring transparency and seriousness to our reform programme. 

The new Government or any governments expected to be formed in future should realise that reforms are the only way out. Economic reforms are both a science and an art. A key challenge for the new Government is that it is running out of time. 

As my Principal mentioned, the sooner people realise which kettle is which, the better for the nation. If people realise the kettle is bad, it is natural that people will take to the streets and protest will gain momentum, where forceful control will have little effect than to push things completely out of control. 

Only time will tell us whether the new Government is serious about reforms. That will decide whether Sri Lanka will become a tiger economy or a failed state.

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.

Any government’s biggest enemy is INFLATION

Originally appeared on The Morning.

By Dhananath Fernando

Friedrich Hayek famously said, “I do not think it is an exaggeration to say history is largely a history of inflation, usually inflation is engineered by governments for the gain of governments.” While there are many reasons for the ‘Aragalaya’ to advance and develop as a movement, the economic context for movements such as the ‘Aragalaya’ taking off should not be underestimated. 

Those who remember our recent history will recall a similar ‘Aragalaya’ in 2001-2002 called ‘#JanabalaAragalaya’. During that time as well, Sri Lanka’s currency depreciated significantly and cost of living was on the rise. In fact, every time Sri Lanka’s currency depreciated and inflation started soaring, we would see similar kinds of people’s protests rising to prominence. 

Inflation leads to crisis

Today we are going through one of the largest crises in our history and the people’s resistance has been reflective of what we are going through. That is why it is said that the biggest enemy of any government is not the opposition, but inflation. 

Unfortunately, many governments and central banks around the world have not realised this truth and have created inflation by lending their respective governments money without any control; they followed reckless monetary policies without understanding the gravity of their actions.

Another currency crisis hit in 2011-2012, which led to the build-up of pressure on then President Mahinda Rajapaksa. Later, in 2016-2017, yet another currency crisis took place, with pressure mounting against the Yahapalana Government in connection with the Bond scam. Since 2019, Modern Monetary Theory (MMT)-led money printing has undoubtedly been one of the main reasons for the crisis we are experiencing today. 

When countries that do not possess a global reserve currency as the national currency add money to their economy, that money will generally chase behind imports, which require foreign exchange. If the country allows the currency to fluctuate automatically, the prices of imports will increase and demand will drop without any forex shortages. But if a country is trying to control the exchange rate using its reserves, unless it has a mechanism to continuously build reserves, at some point it will encounter forex shortages followed by steep currency depreciation. 

Perfect storm 

Sri Lanka has often faced this same problem, which is also the reason we always face currency crises. The present crisis is of historic proportions, as it is accompanied by a perfect storm of so many other policy errors, along with deteriorating global conditions. 

Since 2008, we have had the option of borrowing from markets. We complicated our problem by borrowing money at high interest rates to build our reserves as well as to keep the exchange rate controlled and artificially high. 

Ultimately, we have lost control of everything, and now we have a USD shortage which has led to many shortages of essentials. Since we have borrowed money from international markets, we are now experiencing a debt crisis. Further, due to our own banks investing in sovereign bonds, the stability of our financial system is in question. 

The graph shows the currency depreciation since 1970. We can observe what has happened in recent years to understand and validate Freidrich Hayek’s statement that history is a history of inflation. 

Solutions 

The first part of the solution is for all future and potential leaders and governments to understand that one of the main potential enemies of the country is the inflation they themselves have the power to create. On the other hand, central banks should understand that their excessive lending to governments can lead the country to absolute chaos and instability.

Therefore, regulation has to come forward for inflation targeting and to have a limitation on lending capacity of central banks to governments to ensure stability in our financial system. 

The already-drafted Monetary Law Act is a good starting point for the new government and finance minister and getting it approved with necessary amendments and inflation targeting is an easy win that will establish and indicate the direction of monetary stability. When inflation starts moving upwards, bringing it down is not an easy task, so we should make sure to keep it in check before it takes control and sends every other aspect out of control. 

Sri Lanka is at a crossroads, where we undoubtedly need a sequence of reforms. If we implement the reforms that are required, we have the potential to become a tiger economy, but if we continue to behave with old habits and allow inflation to take us over with our bad monetary policy, we will become a failed state. 

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

Sri Lanka’s economy is entering a dangerous tailspin

Originally appeared on Daily Mirror

By Ravi Rathnasabapathy and Rehana Thowfeek

Sri Lanka has just entered the deepest economic crisis in its history. Shortages and rising prices that people face today are only the first inkling of what lies ahead. Unless decisive action is taken, it can go into a destructive tailspin. 

Downgrades and forex shortages mean foreign banks will only accept upfront payments for imports until credibility is restored. This means the country is now in a hand-to-mouth existence: imports are restricted to the quantum of foreign exchange inflows. These inflows are shrinking. 

Production of goods and services, for both exports and domestic consumption is contracting due to shortages of fuel, power and other inputs. Exporters are losing orders as overseas buyers, concerned about the inability to supply and missed deadlines are switching orders to other countries. Tourist numbers dwindle due to long power cuts, lack of fuel for transport and the closure of restaurants due to lack of gas. 

Lower exports lead to even lower foreign exchange receipts, which in turn limits production even further. With each cycle, the noose tightens further, until eventually most activity ceases. 

The shrinking supply of goods and services within the economy leads to increases in prices, as spending outpaces production. Businesses become unviable due to their inability to function at normal capacity and people lose their livelihoods. As activity shrinks, individuals and businesses alike find it difficult to repay their bank loans and the pressure shifts to the banking sector. This cycle continues until most economic activity grinds to a halt. As the country is pushed into a subsistence existence malnutrition and hunger become widespread.

The crippling effects of the inability to import are similar to that of being under international sanctions except that these have been self-inflicted. Now that the downward cycle has started, it is very difficult to stop as the forces of destruction gather momentum and speed. Until the appointment of the new governor last week, Sri Lanka was in free-fall. The best hope now is to arrest the descent and stabilise it at some point. The governor has taken only the first step on the path to stabilisation but much more needs to be done.

It is clear from the people’s protests that the public have lost confidence in the government. What people don’t realise is that multilateral agencies, international banks and rating agencies have also lost confidence. The government budgets the last two years were replete with errors: overestimated revenues, irreconcilable differences and unrealistic assumptions. Abrupt changes in polices and asinine statements by officials underlined these concerns; one international bank entitled its update “Denial is not a Strategy”. Even before the default many foreign banks refuse to accept letters of credit from Sri Lankan banks unless guaranteed by an international bank.    
A key benefit of an International Monetary Fund (IMF) programme is that it will restore confidence. The mere fact that the government budgets and forecasts are being reviewed by the IMF signals that they are based on realistic assumptions and reasonable estimates. Together with concrete steps towards repairing public finances it will restore some confidence among lenders and pave the way for bridge finance – to relieve some of the crippling shortages that are choking production and livelihoods.

Returning to growth is not impossible but this means addressing the structural issues within the economy, a matter that is all but impossible due to the thicket of vested interests that have grown during the past two decades.

Stabilisation – averting complete meltdown
The major cause of the disequilibrium in the economy was the excessive money printing carried out by the Central Bank since 2019. Money has been printed to finance government expenditure at an alarming rate. The huge increase in government spending results in strong demand for goods and services within the economy. High levels of demand feed into local products and services as well as for imports. Historically, whenever the government has run a large budget deficit financed by the Central Bank credit, it has always resulted in a current account deficit.
The first step to addressing the problem of money printing is to borrow from the domestic market, instead of the Central Bank. Given the enormous sums being borrowed, the government needs to offer a sufficiently high interest rate to attract the required quantum of funds. This is why rates have been raised sharply. Higher rates will reduce consumption by the private sector (which also reduces imports) but may also affect investment, so such high rates, while unavoidable to stabilise the present situation, cannot be maintained in the long term.

For rates to reduce, the levels of government borrowing must reduce. This means cutting the budget deficit. This will have to be approached in two ways: an increase in taxes and a reduction in expenditure.

Increases in personal taxes will reduce the government deficit and therefore the government borrowing requirement reducing the pressure on interest rates. Higher taxes can help curtail private consumption (including import consumption) but may also impact savings and therefore investment. Increases in corporate taxes could curtail investment.

To minimise the negative effect on investment, the government should not rely on taxes alone, expenditure must be cut but the recurrent expenditure is very rigid (mainly salaries, interest and pensions), so reducing capital expenditure is more feasible both politically and practically. Resistance will however be encountered due the corruption involved, especially in highway projects. Reducing the drain from state enterprises and the disposal of idle or underutilised assets are other avenues to close the deficit. Some trimming of unnecessary current government expenditures can increase available fiscal space for social transfers.

Since the majority of the government expenditure is spent on salaries, pensions and interest, a recruitment freeze and a freeze on increments will halt further expansion. All discretionary expenditure unless directly welfare-related must be frozen along with capital expenditure at least in the short term. All transfers and support to state-owned enterprises must cease.

The imbalances will be resolved due to a combination of factors: contraction of demand due to higher interest rates and higher prices which follow from the adjustment of prices to the realistic exchange rate. Prices will need to rise to the market-clearing rate, critically energy prices, which are dependent on the exchange rate. This, however, delivers a huge negative shock to the poor, so it must be cushioned with social transfers.

These are purely stabilisation measures. If carried out properly, this can restore the economy to its state in 2019 but at a higher price level, higher unemployment, lower levels of output and higher levels of poverty. Those in the middle and lower-income groups will be pushed further down the income spectrum: large sections of the middle class will find themselves poor and the poor will be left in abject poverty. Due to low levels of productivity growth will be stagnant at 1-2 percent.

Some of the destruction that has been wrought on businesses will be permanent. The rate of increase in prices will slow to tolerable levels but prices for the most part will not decline from the current high levels. Lower incomes and high prices lead to much lower living standards for most people. The low levels of productivity within the economy mean that prospects for escaping poverty remain poor but on the positive side, things will stop getting worse.
If people are to have some hope, then growth needs to be restored, which means addressing the problem of productivity.

Growth – Restoring prospects for recovery 
The people will have little prospects unless growth returns but growth is impossible unless the barriers that impede it are addressed. 

Sustained economic growth and productivity improvement are intricately linked. These are two sides of the same coin: a faster rate of economic growth cannot be maintained without productivity improvement. Higher productivity must be achieved in all sectors of economy, including the government, public sector and agriculture, where it is weakest.

At its simplest, productivity is a measure of an economy’s ability to produce outputs (goods and services) from a given set of inputs. The more productive the economy, the more value it is able to generate, either through more efficient allocation of inputs, greater productive efficiency in converting inputs into outputs or through innovation – coming up with new products and processes. Achieving sustained economic growth ultimately depends on an economy’s ability to increase its productivity over time, so improving productivity should be the key long-term goal of economic policy.

Many of the barriers to increased productivity are the result of policies and regulations of past governments. Misguided or poorly implemented measures to protect or encourage particular sectors have stifled the competitive forces that drive productivity resulting in higher costs of production. Competitive intensity is a key driver of productivity. It is only in a highly competitive business environment that firms have a strong incentive to adopt best-practice techniques, and technology and engage in innovative activity. This works in three main ways. 

First, within firms, competition acts as a disciplining device, placing pressure on the managers to become more efficient. Secondly, competition ensures that more productive firms increase their market share at the expense of the less productive. These low productivity firms may then exit the market, to be replaced by higher productivity firms. Thirdly and perhaps most importantly, competition drives firms to innovate, coming up with new products and processes, which can lead to step-changes in efficiency. Protectionism shields them from these competitive forces and eliminates a vital incentive, stunting long-term growth. 

Increasing competition means opening the country to investment and trade, reducing the tariffs and regulatory impediments to both. This can help reduce consumer prices and prices of inputs. Import competition spurs local businesses to greater efficiency. With sound macroeconomic policies in place imports can flow in freely.

Within the government, productivity must be addressed through the process of privatisation of commercial activities that could be more productively undertaken by the private sector and the closing down of non-viable state-owned entities, reforming the legal foundations of the economy and substantially increasing the efficiency in critical government functions. For example, increasing the efficiency in the areas of tax and custom procedures and reducing trade and regulatory barriers to enhance competitiveness, digitisation and better systems that improve efficiency and ease of doing business.

Policymakers have no idea of how grave this crisis is or how bad things could get. It is a classic debt and balance of payments crisis, which, if mishandled, can result in a complete meltdown of the economy. The government has appointed, at long last, competent officials in the governor and the treasury secretary aided by a solid team in Indrajith Coomaraswamy, Shanta Devarajan and Sharmini Cooray. They must have unwavering support from the executive and legislature. All political parties need to work together towards resolving the political deadlock and restoring political stability to ensure economic change can be achieved without delay. 

Policy actions: Not quite enough

Originally appeared on Daily FT, Lanka Business Online and Groundviews

By Dr Roshan Perera and Dr. Sarath Rajapatirana

Key macroeconomic indicators signal an economic crisis

A reading of key macroeconomic indicators reveals the extent of the economic crisis Sri Lanka is faced with. Indicators in all four sectors of the economy (i.e., the real sector, fiscal sector, external sector, and monetary sector), have been at their worst level in recent years, and in some cases, at levels never before seen in the post-independence history of this country. 

Growth was negative in 2020 and continued in the negative territory in the third quarter of 2021. This was obviously partly due to the pandemic as well as the measures taken to curtail its spread. However, growth in Sri Lanka continued to remain subdued while other countries in Asia were firmly on a path to recovery. Macroeconomic instability will continue to negatively impact investor sentiment and growth prospects in 2022. This will be further exacerbated by the impact of the war in Ukraine, as the region accounts for a large share of tourist arrivals and is one of the key destinations for Sri Lanka’s tea exports.

Inflation as measured by the CCPI has reached double digits (15.1% YoY in February 2022). These levels were last seen only during the last stages of the civil war. Many countries around the world have also been experiencing an uptick in inflation due to higher commodity prices, especially energy prices and supply side issues due to pent up demand with the opening of countries.

However, in Sri Lanka, an extremely loose monetary policy due to excessive money printing by the Central Bank of Sri Lanka (CBSL) to finance the Government’s deficit has pushed inflation to double digit levels. Further, core inflation – which excludes food and energy – had risen to 10.9% by February 2022, reflecting the demand pressures in the economy. Food inflation has risen even faster, with the year on change reaching 25.7% in February 2022. The recent outbreak of war in Ukraine sharply increased energy prices, with Brent crude oil prices rising to over $ 100 in March 2022 – levels last seen in late 2014.  With domestic fuel prices adjusting to higher international prices, inflation is likely to increase even further.

Meanwhile, the fiscal sector continues to deteriorate. Ad hoc tax changes made at end-2019 resulted in tax revenue declining by around Rs. 500-600 billion in both 2020 and 2021. This decline will continue in 2022 unless measures are taken to reverse this trend. Consequently, tax revenue collection has fallen to the lowest level in history (8% of GDP). This has led to widening fiscal deficits and interest payments absorbing more than 70% of Government revenue.

The significant contraction in revenue with no adjustment to Government expenditure increased the fiscal deficit to 11.1% of GDP in 2020. This is likely to have increased further in 2021. A deficit of this size was last witnessed in 2009 (9.9% of GDP) and 2001 (10/4% of GDP). The sharp decline in revenue and the worsening fiscal position led to international rating agencies downgrading the sovereign, effectively locking Sri Lanka from international capital markets. Hence, the Government resorted to domestic sources to finance the widening fiscal deficit. However, with a cap on interest rates, it fell on the CBSL to do the heavy lifting.

Consequently, money supply rose to unprecedented levels, mainly driven by credit to the Government from CBSL, as the net foreign assets (NFA) of CBSL turned negative for the first time ever. Net Credit to the Government (NCG) in 2021 increased by Rs. 1.454 billion (38.2% YoY) with CBSL being the main provider of credit. Credit to the private sector increased by only Rs. 810 billion (13.1% YoY) during the same period.

The extent of the monetisation of the fiscal deficit is seen by the sharp increase in CBSL’s holdings of Government securities from Rs. 75 billion at end 2019 to Rs. 1,417 billion at end 2021. This has further increased to Rs. 1,529 billion by 11 March 2022. By artificially suppressing interest rates to keep Government borrowing costs low, the CBSL was forced to purchase Government securities not taken up in the primary market. This had increased reserve money (base money) by 35% (YoY) in 2021. The increase in base money would have been even higher if not for the decline in CBSL’s NFA to a negative Rs. 386 billion due to the use of foreign reserves for debt service payments and to support the ‘fixed’ exchange rate.

On the external front, the Government’s large foreign debt repayments and its inability to tap foreign capital markets due to the sovereign downgrade led to the use of foreign reserves for debt service payments. Consequently, the country’s official foreign reserves fell to precarious levels. To address the imbalance in the external sector, the Government restricted imports of many goods. The CBSL also imposed a 100% margin requirement on importation of selected “non-essential” goods.

Notwithstanding these import controls, the trade deficit (the difference between exports and imports) widened in 2021. In addition, in September 2021, CBSL fixed the exchange rate within a band of Rs. 200 to 203 per US Dollar and instructed banks to carry out transactions within this narrow band. Since demand for US Dollars outstripped supply at this “fixed” rate, a black market developed.

On 7 March 2022, when CBSL allowed “greater flexibility” of the exchange rate, the US Dollar was trading at around Rs. 260-270 in the black market. The large deviation between the official exchange rate and the black-market rate led to a significant decline in foreign inflows. Workers’ remittances, which hitherto helped cushion Sri Lanka’s trade deficit, had declined by 23% to $ 5.5 billion in 2021, with the decline continuing in 2022.

Recent policy actions not sufficient to stabilise the economy

To address the deteriorating macroeconomic environment on 4 March 2022, the CBSL revised its policy rates by 100 basis points, thereby raising the Standing Deposit Facility Rate (SDFR) to 6.50% and the Standing Lending Facility Rate (SLFR) to 7.50%. In the same monetary policy announcement, CBSL as the Economic and Financial Advisor, proposed several policy measures to be taken by the Government to address the current economic situation, such as;

• Introducing measures to discourage non-essential and non-urgent imports urgently

• Increasing fuel prices and electricity tariffs immediately, to reflect the cost

• Incentivising foreign remittances and investments further

• Implementing energy conservation measures, while accelerating the move towards renewable energy

• Increasing government revenue through suitable tax increases on a sustained basis

• Mobilising foreign financing and non-debt forex inflows on an urgent basis

• Monetising the non-strategic and underutilised assets

• Postponing non-essential and non-urgent capital projects

However, a few days after this announcement on 7 March, CBSL permitted “greater flexibility in the exchange rate”. Although the CBSL indicated that it was of the view that transactions in the foreign exchange market should be conducted at not higher than Rs. 230 per US Dollar, by 11 March, the US Dollar was trading at Rs. 265/275.

This was partly due to confusion in the market with parallel announcements being made by the Cabinet regarding increasing the incentive payment to Rs. 38 per US Dollar from the current rate of Rs. 10 per US Dollar for repatriations by migrant workers. Maintaining the exchange rate at these levels would require further policy action while restoring the confidence of migrant workers to use formal channels for their remittances.

While the monetary policy tightening cycle has commenced more needs to be done as inflation and inflation expectations remain elevated. The last time inflation was at these levels in 2009, policy interest rates were at 10.50% (SDFR)/12.00% (SLFR) and the 91-day Treasury bill rate was close to 16%. Higher interest rates are also necessary to maintain the interest rate differential given the Federal Reserve Bank of the US has signalled it will continue to raise interest rates to address “surging inflation”. The difference between the current policy interest rates and market interest rates also provides an arbitrage opportunity for investors to make supernormal profits. This opportunity is higher given the large liquidity deficit in the overnight market, which stood at Rs. 704 billion as at 11 March 2022.

Tackling inflation also requires bringing down aggregate demand in the economy. Excessive money printing by CBSL has increased currency in circulation by Rs. 290 billion (59%) from end 2019 to end 2021. The large tax cuts in 2019 have left around Rs. 1 billion in the hands of individuals and businesses. In addition, although workers remittances did not come through formal channels, there was a thriving informal system known as the ‘Hawala’ or ‘Undiyal’ system, by which remittances came into the economy. The increase in cash in the economy has elevated demand for both domestic and imported commodities, thus exerting upward pressure on domestic prices and increasing demand for foreign exchange to support higher imports.

Suppressing imports, particularly of cars, has also left money in the hands of dealers. This excess money in the system is likely to have driven the boom in the stock market and pushed up land prices and the market for second-hand vehicles. The higher money supply in the economy has thus driven speculative activities rather than being channelled into growth-enhancing economic activities. Addressing the build-up of aggregate demand pressures requires, in addition to further tightening of monetary policy, raising taxes and curtailing the monetisation of the deficit through CBSL financing.

Further, the exchange rate should be the mechanism through which imports are discouraged and exports incentivised. Imports in 2021 increased by 28.5% from 2020. However, the increase from 2019 was only 3.5%. Further, the main increases were in medicines, fuel, textiles, base metals, machinery and equipment, and building materials.

Allowing the market mechanism to determine prices would be the most efficient way to ensure that goods get allocated to their highest use. This is particularly important in the case of fuel, which is priced significantly below cost. Interference in the market mechanism leads to shortages and the development of a black market. There are plenty of examples in the recent past that amply demonstrate the impact of administrative price controls on the availability and quality of goods in the market. In addition, controlling the price or supply of commodities leads to a transfer of “profit” to those who control the market while taxing consumers in terms of time and effort expended to source goods.

Sri Lanka faces twin problems of an internal imbalance with high domestic inflation and an external imbalance with external outflows well in excess of inflows (in other words, a deficit in the balance of payments). The root cause of the twin problems is the Government continuing to run fiscal deficits and financing these deficits through high-cost external borrowing and monetary expansion. Addressing these issues requires policy action on several fronts. However, first, a debt restructuring programme needs to be put in place to give the country some breathing space to stabilise the macroeconomy and to implement growth enhancing reforms. 

A comprehensive macroeconomic stabilisation programme and overall economic reform agenda will impact key economic variables; some desirable and some not so. Low-income groups will be particularly affected by these policy adjustments. Hence, attention needs to be paid to ensure an adequate safety net to protect the most vulnerable in society from the fall out of policy adjustments.

The current Samurdhi programme is woefully lacking in terms of adequacy and targeting. There needs to be a more comprehensive social protection scheme. The additional cost of the programme could be funded through savings from the fuel subsidy (which currently disproportionately benefits richer households), reversing the tax cuts and reallocating Government expenditure (1).

References

1. Tackling the COVID-19 economic crisis in Sri Lanka: Providing universal, lifecycle social protection transfers to protect lives and bolster economic recovery, UNICEF Sri Lanka Working Paper, June 2020

Dr. Roshan Perera, Senior Research Fellow, Advocata Institute and former Director, Central Bank of Sri Lanka.The opinions expressed are the author’s own views. They may not necessarily reflect the views of the Advocata Institute, or anyone affiliated with the institute.