Will Budget 2022 help reset Sri Lanka’s economy?

Originally appeared on Daily FT

By Dr. Roshan Perera

A budget sets out the government’s plan for the economy together with the financial resources required to achieve those plans. It also indicates the broad policy direction and priorities of the government. Any assessment of the Budget cannot be undertaken without an understanding of where the economy is right now. In other words, the Budget must be evaluated in the current economic context.

Looking at the key economic indicators, it is clear that the economy is at a critical juncture. The country suffered the sharpest decline in economic growth in 2020. Although growth is picking up, the economy is likely to remain below pre-pandemic levels. Inflation is rising due to external pressures from supply side disruptions and shortages in international markets. Domestically, financing of the Government’s budget through banking sources (Central Bank and commercial banks) is exerting upward pressure on prices. On the fiscal front, government revenue declined to historic lows due to the impact of sweeping tax policy changes as well as the slowdown in economic activity. Meanwhile, the Government has very little leeway on expenditure, as much of it goes to pay salaries of government servants and to make interest payments – all contractual obligations. The consequent widening fiscal deficit has been financed through increasing borrowings leading to higher debt levels and debt service payments. Downgrading of the sovereign by rating agencies has limited access to international capital markets, exacerbating issues in the macroeconomy. The current economic crisis is not due to the Covid-19 pandemic alone. Sri Lanka entered the pandemic with a slowing economy and a weak fiscal position; the result of years of poor economic policies undertaken by successive governments.

Budget 2022 was an opportunity for the country to reset and for the economy to move to a more sustainable growth path. With Sri Lanka losing access to capital markets and large debt service payments over the next few years, the urgent need was to restore fiscal credibility and strengthen market confidence. Because credibility of the fiscal strategy is vital for stabilising the macroeconomy and restoring the confidence of investors. Hence, the primary focus of the Budget 2022 should have been on correcting the twin deficits, i.e., the fiscal deficit and the external current account deficit, because of the spillover effects into the rest of the economy through interest rates and exchange rates.

According to the Medium-Term Fiscal Framework, the fiscal deficit is projected to decline to 8.8% in 2022 from 11.1% in 2021 (see Table 1 for details).

With minimal wiggle room on the expenditure front, the focus of fiscal consolidation is on revenue generation. Tax revenue is projected to increase by 50% in 2022 from the revised estimates for 2021. Given that actual revenue consistently falls short of estimates, how realistic these projections are is called into question. A major portion of the increase in tax collection in 2022 is expected from the introduction of several new taxes. In addition, the VAT rate on banks and financial service providers is proposed to be raised to 18% from 15% as a one-time increase. Collectively, these taxes are estimated to raise Rs. 304 billion, accounting for around 46% of the total projected increase in tax revenue in 2022 (See Table 2 for details).

As a comparison, the Interim Budget for 2015 introduced a super gains tax of 25% applicable on any company or individual with profits over Rs. 2 billion in the tax year 2013/14 as a one-off tax. The revenue collected from this tax was Rs. 50 billion. Furthermore, the social security contribution is similar to the Nation-Building Tax (NBT), which was a 2% tax on turnover imposed on entities with liable turnover in excess of Rs. 15 million per annum. In 2019, the NBT generated revenue of Rs. 70 billion before it was abolished in December 2019. With a higher turnover threshold and the current restrictions on imports, it will be challenging to raise the estimated revenue from the proposed social security contribution. In addition, the ability to raise the proposed revenue depends on how expeditiously required legislation can be presented to Parliament. Delays in passing legislation have hampered revenue collection in the past.

The question that needs to be asked is why introduce new taxes on a revenue administration that is already stretched when there is ample room to revise thresholds and rates on several existing taxes. This would have been much simpler to implement and would have required minimal amendments to existing legislation. In addition, taxes with retrospective effect, such as the surcharge tax, are not good signals for prospective investors.

The big question is whether the revenue estimates in Budget 2022 are based on reasonable projections. What if the proposed revenue collection does not materialise? Is there leeway to cut expenditure to match the revenue shortfall? If not, will this mean a widening budget deficit and additional borrowing? With minimal access to foreign financing sources, this will mean higher borrowing from domestic sources, particularly the banking sector. This will have economy-wide implications through higher domestic interest rates and crowding out resources from the private sector.

On the expenditure front, overall, there has not been a huge increase in total expenditure. However, the Ministry of Defence and Ministry of Public Security account for around 12% of total expenditure, while spending on health and education accounts for 6% and 4%, respectively, of the total. In terms of the composition of expenditure, salaries and wages comprise 34% of recurrent expenditure while interest payments account for 37%. While the Government has limited room to cut expenditure, making permanent another 53,000 graduate trainees may not provide the best signal in terms of the Government’s commitment to reversing the fiscal situation. Furthermore, the Budget for 2022 has reduced the allocation for subsidies and transfers. An important lesson from the pandemic was the need to build buffers during good times to be able to assist vulnerable households and micro and small and medium enterprises (MSMEs) who were disproportionately affected. Although the Budget proposes a one-off cash transfer to selected groups such as MSME entrepreneurs, school bus and van drivers, three-wheel drivers, and private bus drivers who were affected by the lockdowns, it does not address informal workers in other sectors of the economy who account for around 60% of the total workforce. Ad hoc cash transfers are not sufficient to address these issues. A more comprehensive social protection scheme is required to prevent vulnerable groups from falling into poverty due to unexpected events.

Macroeconomic stability also requires external sector stability. Large foreign debt service payments and dwindling foreign reserves have led to import controls and a tight rein on foreign exchange market. But a more sustainable solution to the external crisis is to encourage exports. The Budget refers to transforming the economy into an advanced manufacturing economy and encouraging exports to earn foreign exchange. This requires addressing the structural weaknesses in the economy hindering competitiveness and productivity. In this light, the question to ask is if spending priorities and policy measures announced in Budget 2022 address these bottlenecks. The Budget has allocated Rs. 5 billion for infrastructure for new product investment zones. In addition, the Budget refers to “…a special focus on expanding the IT sector and promoting BPOs and…a techno-entrepreneurship-driven economy”. However, the allocation for digitalisation is less than Rs. 5 billion. This is in comparison to the allocation for highways of around Rs. 270 billion and rural development programmes (Gama Samaga Pilisandara) of around Rs. 85 billion.

(The writer is a Senior Research Fellow at the Advocata Institute and a former Director of the Central Bank of Sri Lanka)

A framework for economic recovery

Originally appeared on Daily FT

By Dr. Roshan Perera

A twin deficit problem

For much of its post-independence period Sri Lanka has been characterised by twin deficits: fiscal deficits and deficits in the external current account. What this implies is the country spends more than it earns and consumes more than it produces. The two deficits are linked because the deficit in the external current account reflects the sum of the deficit in private savings (where private investment is greater than private savings) and government dissaving (where government expenditure is greater than government revenue). If a government continues to consume more than it earns and/or domestic private savings are not sufficient to finance investment in the economy this is reflected in a widening of the deficit in the external current account. 

If a country is running a deficit in the external current account deficit it is important to understand what is driving this deficit. If it is due to a deficit in private savings and investment that may not be such a bad thing because the shortfall is probably being financed through foreign direct investments (FDI) and in any case it is leading to an increase in the productive capacity of the economy. Thereby increasing future growth potential of the country. On the other hand, if the current account deficit is due to the government spending more than it earns, this would need to be financed through increased borrowings. And a country just like a household cannot continue to borrow indefinitely. There will come a day of reckoning. You will come to a point where you are not able to service your debt or you may be able to service your debt, but you won’t have the income to buy what you need to live (food, clothing, education, health etc).  It may come to a point where your creditors will stop lending to you. Or even if they do lend, they will charge you a very high interest rate which will only worsen your debt situation. So, what is true for a household is true for a country.  

Consequences of living beyond our means

Large deficits in the fiscal and external account have been financed through borrowings both from the domestic market (which has crowded out resources for the private sector) and external sources (which has led to an unsustainable level of foreign debt). Although in the short-term high government spending may stimulate economic growth in the medium to long term it acts as a drag on growth due to its impact on interest rates and the exchange rate. 

When a government borrows continuously from the domestic market it crowds out resources from the private sector and drives up interest rates. Thus, making it unviable for a firm to borrow because the cost of borrowing is higher than the return it could earn from investing. In addition, when a country has a large external debt, it attempts to fix the currency to stabilize the debt stock. But this could result in an overvalued exchange rate which leads to an anti-export bias and an import bias which further worsens the trade deficit and external finances. This is contrary to what an economy like Sri Lanka with a small market (both in terms of size and per capita income) needs. As expanding trade is the only sustainable path to faster growth and employment generation. 

The availability of concessional financing from multilateral and bilateral donors enabled the country to run fiscal and external deficits over many decades. Although access to low-cost financing ended when the country graduated to middle-income status, we didn’t change our spending patterns to suit our income. Instead, we sought alternative sources of financing, borrowing from financial markets and commercial sources at high interest rates and with shorter repayment periods. Consequently, by 2016, the share of foreign debt from non-concessional sources rose to over 50%. This has enormously increased debt service payments. Today, Sri Lanka has one of the highest levels of government debt in its history and its debt service payments are one of the highest in the world (absorbing 72% of government revenue in 2020). This has led to both domestic and external resources being diverted to servicing past debt to the detriment of future growth. 

Policy Priorities

Advocata Institutes’ recent report “A Framework for Economic Recovery” propose several policies to address macroeconomic imbalances and structural reforms for sustainable and inclusive growth. 

Firstly we need to address the macroeconomic imbalances in the economy. Primarily, correcting the twin deficits because they have spillover effects into the rest of the economy through interest rates and exchange rates. Priority should be given to fixing the tax system. Tax revenue which was over 20% of GDP in the 1990s has plummeted to 8% in 2020 and is likely to fall further in 2021. Expanding the tax base and improving tax administration are key to reversing the long-term downward trend in government revenue. Currently the personal income tax threshold in Sri Lanka is more than four times its per capita GDP and even higher than the tax threshold in countries with per capita incomes that are several times that of Sri Lanka, such as Singapore and Australia. A high tax threshold removes a significant portion of the working population that can contribute to tax revenue. Tax exemptions for businesses should be rationalised and the granting of exemptions centralised under one authority.  Evidence suggests that sweeping tax exemptions are not the most important factor in attracting investments and foregoing this tax revenue is not sustainable in the long term. 

With declining tax revenue collection, the government faces severe resource constraints. Expenditure on contractual obligations interest payments, salaries and wages and pension payments) has come at the cost of spending on building human capital (health and education). This needs to be reversed. Serious attention needs to be paid in the budget to rationalising the public sector and strengthening budgetary oversight mechanisms so that the government is held accountable for how they use the resources entrusted to them.

Secondly, we need to stimulate economic growth and improve the country’s competitiveness. Sri Lanka has experienced very volatile growth rates and in recent times spurts of debt fuelled economic growth. But this growth has neither been inclusive nor sustainable. We need to generate growth that is both inclusive (benefits all our citizens) and sustainable (growth that does not jeopardise future generations). The budget needs to address the structural weaknesses in the economy hindering productivity driven growth. Some policies that we discuss in our report are: (1) improving the business environment by reducing regulatory barriers which are needed to attract foreign direct investment. Sri Lanka lags its peers in the areas of doing business and competitiveness; (2) unlocking access to land which has been identified as a major bottleneck for investment; (3) creating a flexible labour market and raising labour force participation. There are a plethora of legislation governing labour in SL which act as a serious impediment for job creation. Further, Sri Lanka has a rapidly aging population and is no longer benefitting from a demographic dividend. However, it has access to a large untapped source of female labour. Encouraging greater female participation in the labour force requires removal of legislation restricting employment of female workers and improved provision of services such as childcare and safe transport; (4) addressing infrastructure gaps to enhance productivity and efficiency of the factors of production. We need to invest in infrastructure that has high social and economic returns. This requires better processes for project appraisal and selection, better management of risks which otherwise could lead to cost overruns and project delays and greater accountability to reduce waste and corruption.

Finally, the budget needs to build buffers to strengthen the resilience of the economy to shocks. 

Households have been disproportionately affected by the ongoing pandemic because they lack the buffers to cushion them from economic shocks. Workers, particularly in the informal sector, have lost jobs due to the impact of lockdowns and the closure of borders. Although the government provided some relief to households affected by the pandemic by way of income transfers, the lack of fiscal space constrained the government’s ability to adequately respond to the crisis. In addition, Sri Lanka’s existing social protection scheme has significant coverage gaps. Establishing a universal social safety net and reducing targeting errors will ensure that those who need support receive it when they need it most. 

Micro, small, and medium enterprises (MSMEs) play a vital role in the Sri Lankan economy. This sector was severely affected by measures taken to contain the spread of the virus, such as travel bans, lockdowns and social distancing. To mitigate the impact of the pandemic, the government and the Central Bank introduced various emergency liquidity support programs, debt moratoriums and extension of credit at concessionary interest rates. These schemes may have prevented some firms from bankruptcy. However, the inability of the government to continue providing such relief given the prolonged nature of the pandemic and fiscal constraints requires other measures to be put in place to deal with such situations. Given the size of this sector and its importance to the economy, ensuring the solvency of these firms as well as increasing their productivity is paramount to Sri Lanka’s long term economic growth prospects. Many firms will emerge from this pandemic with seriously impaired balance sheets. Firms that are not resilient, uncompetitive, or heavily indebted will probably fold due the crisis. To reduce the adverse economic impact of ad hoc closures, the government must ensure access to an effective bankruptcy regime. Such a mechanism will strengthen economic resilience, while incentivising firms to prioritise strategies to repair balance sheets in the medium term before they reach bankruptcy.  

(The writer is a Senior Research Fellow at the Advocata Institute and a former Director of the Central Bank of Sri Lanka)

Budget 2022: Macroeconomic stabilisation and structural reforms for inclusive and sustainable growth

Originally appeared on The Morning.

By Dr. Roshan Perera

Years of profligate living finally caught up with us. Sri Lanka, for much of its post-Independence period, has been living beyond its means: We have been spending more than we earn and consuming more than we produce. Our extravagant lifestyle was made possible by the availability of concessional financing from multilateral and bilateral donors. This ended once we graduated to a middle-income country. But we didn’t change our spending patterns to match our income. Instead, we sought alternative sources of financing. We borrowed from financial markets and commercial sources at high interest rates and with shorter repayment periods.

Consequently, by 2016, the share of foreign debt from non-concessional sources rose to over 50%. This had an enormous impact on our debt service payments. Today, Sri Lanka has one of the highest levels of government debt in its history and its debt service payments are one of the highest in the world (absorbing 72% of government revenue in 2020). This led to both domestic and external resources being diverted to servicing past debt to the detriment of future growth.

According to current estimates, Sri Lanka has around $ 26 billion in foreign debt obligations due between now and 2026. Sovereign rating downgrades made rolling over this debt challenging. But these are contractual obligations and there could be serious repercussions if a country defaults on its debt. Due to the decline in foreign inflows owing to the pandemic, the Government resorted to short-term measures such as bilateral swaps to shore up foreign reserves. However, there was a steady drawdown of the country’s foreign reserves to meet these debt obligations. Foreign reserves, as at end-September 2021, declined to $ 2.5 billion (which was equivalent to 1.5 months of import cover). Foreign currency obligations falling due within the next 12 months amount to around $ 7 billion. The current level of foreign reserves is grossly inadequate to service the Government’s debt.

Furthermore, using a country’s foreign reserves to pay debt obligations is not a good strategy in the long term. Foreign reserves play an important role in an economy – by providing a buffer against possible external shocks, smoothing temporary fluctuations in the exchange rate, and providing confidence to foreign investors.

With limited access to foreign financing, the Government is relying more on domestic sources to bridge the fiscal deficit. To keep interest costs low, domestic interest rates have been suppressed, which has effectively dried up the market for government securities. This has led to debt monetisation, with the Central Bank of Sri Lanka (CBSL) purchasing a major share of government securities issued in the primary auction. However, there are costs involved with this strategy, as high monetary growth leads to high inflation. It also undermines the independence of the CBSL and hinders its use of its key monetary policy instrument, the interest rate, to manage inflation.

So, what needs to be done? Advocata Institutes’ recent report titled “A Framework for Economic Recovery” proposes several policies to address macroeconomic imbalances and structural reforms for sustainable and inclusive growth. These policies are not new. If you examine macro stabilisation programmes that have been implemented in this country (or in other countries that have faced similar economic issues), you would broadly find similar recommendations. This does not mean the recommendations made in the past were wrong – but rather that successive governments did not follow through on the reforms needed to ensure long-term macroeconomic stability and sustained economic growth.

This time is different in one aspect. Sri Lanka has lost access to financial markets due to its rating downgrade. Hence, it is not able to easily refinance its foreign debt. In previous stabilisation programmes, although debt sustainability was a major concern, it was addressed through a fiscal consolidation programme. This alone may not be sufficient in the current context. The country may need to engage in a pre-emptive debt restructuring exercise to prevent default. A wilful default could disrupt access to future financing, reduce investor confidence, affect credit ratings, and have a negative impact on the reputation of the country. However, debt restructuring is a complex process and securing a deal that is acceptable to a majority of creditors is fraught with difficulty, as there are many stakeholders involved, and conflicts of interest are inevitable, hence the need to engage with an institution such as the International Monetary Fund (IMF) in the negotiation process.

The focus of Budget 2022 should be to address the macroeconomic imbalances in the economy. Primarily, correcting the twin deficits, i.e. the fiscal deficit and the external current account deficit, because these have spillover effects into the rest of the economy through interest rates and exchange rates. Priority should be given to fixing the tax system. Tax revenue, which was over 20% of gross domestic product (GDP) in the 1990s, has plummeted to 8% in 2020 and is likely to fall further in 2021. Expanding the tax base and improving tax administration are key to reversing the long-term downward trend in government revenue.

Currently, the income tax threshold in Sri Lanka is more than four times its per capita GDP and even higher than the tax threshold in countries with per capita incomes that are several times that of Sri Lanka, such as Singapore and Australia. A high tax threshold removes a significant portion of the working population that can contribute to tax revenue. Tax exemptions should be rationalised and the granting of exemptions centralised under one authority. Evidence suggests that sweeping tax exemptions is not the most important factor in attracting investments, and foregoing this tax revenue is not sustainable in the long term. With declining tax revenue collection, the Government faces severe resource constraints.  Expenditure on contractual obligations (interest payments, salaries and wages, and pension payments) has come at the cost of spending on building human capital (health and education). This needs to be reversed. Serious attention needs to be paid in the budget to rationalising the public sector and strengthening budgetary oversight mechanisms so that the Government is held accountable for how they use the resources entrusted to them.

Secondly, we need to stimulate economic growth and improve the country’s competitiveness. Sri Lanka has experienced very volatile growth rates and in recent times, sudden spurts of debt-fuelled economic growth. But this growth has neither been inclusive nor sustainable. We need to generate growth that is both inclusive (benefits all our citizens) and sustainable (growth that does not jeopardise future generations). The budget needs to address the structural weaknesses in the economy hindering productivity-driven growth. Some policies that we discuss in our report are:

1. Improving the business environment by reducing regulatory barriers, which is needed to attract foreign direct investment (FDI). Sri Lanka lags behind its peers in the areas of doing business and competitiveness

2. Unlocking access to land that has been identified as a major bottleneck for investment

3. Creating a flexible labour market and raising labour force participation. There are a plethora of legislation governing labour in Sri Lanka which act as a serious impediment for job creation. Furthermore, Sri Lanka has a rapidly ageing population and is no longer benefitting from a demographic dividend. However, it has access to a large untapped source of female labour. Encouraging greater female participation in the labour force requires removal of legislation restricting employment of female workers and improved infrastructure such as childcare and safe transport services

4. Addressing infrastructure gaps to enhance productivity and efficiency of the factors of production. We need to invest in infrastructure that has high social and economic returns. This requires better processes for project appraisal and selection, better management of risks which otherwise could lead to cost overruns and project delays, and greater accountability to reduce waste and corruption.

Finally, the budget needs to build buffers to strengthen the resilience of the economy to shocks. Households have been disproportionately affected by the ongoing pandemic because they lack the buffers to cushion them from economic shocks. Workers, particularly in the informal sector, have lost jobs due to the impact of lockdowns and the closure of borders. Although the Government provided some relief to households affected by the pandemic by way of income transfers, the lack of fiscal space constrained the Government’s ability to adequately respond to the crisis.

In addition, Sri Lanka’s existing social protection scheme has significant coverage gaps and needs to be extended to include informal sector employees, daily wage earners, and self-employed workers. Ad hoc payments are not sufficient to keep people from falling into poverty. Urgent action is needed to establish a universal social safety net and reduce targeting errors to ensure those who need support receive it when they need it most.

Micro, small, and medium-scale enterprises (MSMEs) play a vital role in the Sri Lankan economy, accounting for over half of Sri Lanka’s GDP and over 90% of total enterprises and 45% of employment in the non-agriculture sector. This sector was severely affected by measures taken to contain the spread of the virus, such as travel bans, lockdowns, and social distancing. To mitigate the impact of the pandemic, the Government and CBSL introduced various emergency liquidity support programmes, debt moratoriums, and extension of facilities at concessionary interest rates. While these schemes may have prevented some firms from bankruptcy, the Government is unable to continue providing such relief, given the prolonged nature of the pandemic and the fiscal constraints it faces.

However, given the size of this sector and its importance to the economy, ensuring the solvency of these firms as well as increasing their productivity is paramount to Sri Lanka’s long-term economic growth prospects. As the pandemic continues to affect economic activity, many firms will emerge with serious impact on their balance sheets. Therefore, as economies transition to normalcy, it is important to repair balance sheets by reducing unsustainable debt and rebuilding cash reserves. Firms that are not resilient, are uncompetitive, or are heavily indebted will collapse during such crises. To reduce the adverse economic impact of ad hoc closures in the most productive manner, the Government must ensure access to an effective bankruptcy regime. Such a mechanism will strengthen economic resilience, while incentivising firms to prioritise strategies to repair balance sheets in the medium term before they reach bankruptcy.

In conclusion, the key focus of policymakers should be on addressing macroeconomic imbalances. Priority should be given to correcting the twin deficits, i.e. the fiscal deficit and the external current account deficit, stimulating economic growth, and improving competitiveness while building buffers to strengthen the resilience of the economy to shocks.

(The writer is a Senior Research Fellow at the Advocata Institute and a former Director of the Central Bank of Sri Lanka)