Government relief packages: Pros, cons, and criteria for perfecting

Originally appeared on The Morning

By Dhananath Fernando

Last Monday (3), Finance Minister Basil Rajapaksa announced a relief package worth Rs. 229 billion. This package consists of a Rs. 5,000 allowance for government workers, 500 g wheat flour for estate communities per day, an increase in the purchasing price of paddy by Rs. 25 to Rs. 75 a kilogramme to assist farmers, a Rs. 1,000 increase for Samurdhi beneficiaries and an incentive scheme for home gardening. When evaluating relief packages, a long list of factors should be considered. One such factor is inflation. It is no secret that there is creeping inflation affecting the livelihoods of all cross sections of society. This is openly being expressed to politicians. Food inflation is at 22% and headline inflation is at 12%. 

This column has always highlighted the grave dangers of high inflation. We have been closely following these developments and our prediction has now been admitted by the Government. The sources for financing the Rs. 229 billion was not specified. The Finance Minister only mentioned that it would be utilised from the 2022 Budget while also mentioning that no tax will be increased. Both the budget numbers and their justification in the text were problematic. Inflation is the worst tax which hurts the poor more than middle income families. 

Given these circumstances, the available options are to cut down some of the already allocated capital expenditure or to borrow money from the Central Bank to finance this new expense. The former is happening already, as when the Government made reductions in capital expenditure as per the budget speech. Some were manifested through policy decisions such as halting construction activities for the next two years. Therefore, if there is a reduction in capital expenditure, it will have to come through cutting down budget lines allocated to areas such as highways, road development, education, and health care. 

Alternatively, we may have to finance this by borrowing more money from the Central Bank, continuing the dangerous policy of believing in Modern Monetary Theory. It will have a very high risk of starting a wage spiral and contributing further to inflation and the depreciation of our currency faster than we expect. Most of this (extra) money will be spent on imported goods. This increase of demand on imports will continue to dry up our limited foriegn reserves. 

In my view, the announcement will confuse investors and businesses, putting the credibility of the Finance Minister at risk. Presenting the Appropriation Bill, the Finance Minister used an anecdote to express how our economy is trapped between three competing challenges. The proposals of the budget such as to cut down expenditure by cutting down the fuel quota and extending the pension entitlement for 10 years for parliamentarians, was a positive signal. However, announcing a relief package completely opposing this may cause further business uncertainty. 

An ideal relief package 

While a relief package has its own pros and cons in politics and economics, it is worthwhile to explore how the relief package should be structured. As this column expressed multiple times, the only solution to overcome this crisis is through structural reforms. Structural reforms will be initially painful across the board, specially for low income earners. Pressure is already upon them with high inflation, and this demographic is being forced to make sacrifices to their food basket. 

The long-term solution for this problem is establishing a digital cash transfer system based on market prices. For example, a fisherman may consume a fair share of fuel to generate income and to contribute to the economy. But the consumption of fuel of a daily wage earning labourer is limited. So the fuel subsidy has to be targeted more towards the fisherman and less towards the labourer. A digital cash transfer to the bank account based on market prices of fuel is the most efficient way of undertaking this. If we try to keep the entire fuel price low through a non-targeted system, consumers who consume more and can afford market prices will automatically benefit as well. At the same time it may be an incentive for low fuel economic machines to be used when fuel prices are low across the board. A cash transfer will not only provide dignity for a person to consume based on their needs, but also provides freedom of choice to shift to alternatives.

Making it a cash transfer avoids political interference where beneficiaries need not worry about their political opinion in order to be entitled for the scheme. Governments can also save resources and be more efficient by adhering to the market forces of demand and supply.

The Samurdhi programme which is the main safety net in Sri Lanka is very poorly targeted and about half our households have become entitled to it. Additionally, about 25% of the Samurdhi fund is spent on administration costs. Therefore, a direct cash transfer can be more efficient than Samurdhi by saving administration costs. 

India administers a system called Adhar with a colour-coded system, where the value of the cash transfer is determined based on the level of poverty. In addition to being based on the poverty level, the option of managing the cash transfer in subsidies often varies with global prices of fuel and liquid petroleum gas. 

Unfortunately, the relief package which was announced did not have the depth necessary, and the targeting could have been better. If we look at the public service, it is usually overstaffed and worker category cardres who are entitled for overtime are maintained by the Sri Lankan Government. As a result, in addition to the basic pay, people simply sign up for overtime work without really having the need to commit for overtime. On multiple occasions many board chairpersons and senior officers have mentioned that they sign off on overtime for their staff assistants and chauffeurs, where in most cases, the total take-home pay is higher than that of the chairman or the senior officer. As such, providing a Rs. 5,000 allowance with non-existing resources would not really help to overcome the crisis. 

Sri Lanka should move towards a digital cash transfer system to strengthen our safety net. But simply strengthening the safety net won’t help the poor. Making imports competitive, bringing down tariffs on essentials and connecting with global value chains is of paramount importance in order to help the poor out of poverty. 

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.

It’s not about reserves – it’s about reforms

Originally appeared on The Morning

By Dhananath Fernando

We spent another year just debating so many economic issues without really getting anything substantial done. 

During the last few days, the debate has been around the official reserves position of the Central Bank of Sri Lanka (CBSL). So many questions have been raised on whether it can be used to service our debt or whether this is just a double account entry of the Chinese Yuan worth of $ 1.5 billion, which we secured many months ago. The reasonable answer is “we don’t know” until the CBSL makes the data available. The CBSL now says that our reserves are currently at $ 3.1 billion, but refuses to reveal the breakdown of how the country doubled its reserves. So much for transparency!

However, we all have to admit that the economic solutions implemented to overcome the crisis haven’t really worked. Rather, they have thrown the lower and middle-class Sri Lankans from the frying pans to the fire. 

A self-sufficient economic model was proposed at the initial stages. Many economic experts including this column highlighted why a self-sufficient economic model is an expired concept in the 21st Century. Therefore, we must reiterate that the pursuit of self-sufficiency can completely isolate Sri Lanka from global supply chains. As a result, our trade balance will be adversely affected and will continue to be so, due to our lack of understanding of the simple balance of payments and the dependency of exports on imports. Further, there is the absence of incentive reforms.  

A policy of strict import controls and price controls was imposed with the objective of boosting local production, sidelining the market forces. The result was shortages and long lines even for essentials such as liquid petroleum gas and milk powder. Another argument was brought in that the import controls can create a trade surplus. The past two years have proven fair and square that the direction of our policies is completely wrong. In the period of January-October 2021 imports rose by 26.5% and the overall trade balance grew by 34% to $ 6,498 million. This is while the strong performance of exports increased by 22%. All this happened against the backdrop of attempting to keep the interest rates artificially low and keeping the US dollar artificially fixed at around Rs. 200. This is one main reason for our US dollar shortage. Simply, the excess demand created by a loose monetary policy is the reason for there being excess demand for imports. 

Afterwards, Modern Monetary Theory (MMT) was introduced as a panacea for all forex problems, claiming there is no connection between inflation and money supply. Today, inflation has risen to 11.5% fueling the balance of payment crisis to a boiling point. Instead of resolving the problem at its root, shortsighted measures were proposed such as tax amnesties and incentives for some US dollar savings without realising the basics – which is that investments are driven by the perception of trust, credibility, and policy consistency instead of ad hoc factors. People who believe in the efficacy of MMT for a small country with a non-international currency could be believing in the tooth fairy. 

Meanwhile, some considerable effort was also made by the Government in the right direction, but it was not adequate. Someone may call it a half-hearted attempt to overcome the scale of the crisis we are facing. The Deregulation Commission, appointed by His Excellency the President, proposed to do some land reforms and improve ease of doing business. Further price controls have been removed, except the price control on the US dollar and interest rates. 

With our inability to provide a clear direction, rating agencies questioned Sri Lanka’s debt sustainability multiple times and requested a credible plan which failed on many occasions. 

The new Governor presented a six-month roadmap, but in my view, the damage of the MMT, the self-sufficient economic model, and industrial policy logic had already been done by then. 

A discussion has always been up in the air regarding whether we should go to the International Monetary Fund (IMF). At the same time, the discussion was underway on whether we should re-profile and restructure our debt. 

In simple terms, that was the summary of economic policy in 2021. We were optimistic that tourism numbers will pick up and it’s a relief that the numbers indicate a positive trend. However, higher tourism increases our import components as well. Expansions, maintenance, and consumption by tourists result in a fair share of imports, so expecting the tourism revival as a panacea for our forex shortages is just another shortsighted dream similar to the MMT. 

In 2022, the outlook will remain the same or it will worsen unless we undertake economic reforms. Expecting a different result without reforms is mere wishful thinking. 

Whether we go to the IMF or not, the economic reforms have to be the starting point. The Government should initiate the reform agenda without waiting for anyone else. However, an IMF programme (always with the agreement of the Government), would be more credible to our lenders and potential FDI partners. Our present situation is not credible to both foreign and domestic investors. 

Below are a few suggestions we have to think through:

1. Establish independence of the CBSL and make sure that the exchange rate is competitive

2. Privatise loss-making state-owned enterprises and consolidate and privatise non-strategic SOE’s

3. A cash transfer system for poor people based on market prices to face the high cost of living during the reform period

4. A grand-scale deregulation of business regulations as per the report submitted to the President (by the Lalith Weerathunga and Krishan Balendra committee)

5. Lower tariff rates with Sri Lanka customs reforms to increase global trade and increase competitiveness

6. Freeze government sector recruitment and offer voluntary retirement schemes and minimise the government cadre

We have to provide a rapid response for this economic crisis without waiting until the last minute to come up with solutions. 

The reality is we are already too late – not by months but by a few decades. 

Rather than focusing on the official reserves position, we have to shift our gears towards reforms. No country ever overcame an economic crisis without any economic reforms.  

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.

Did we miss the opportunity to formulate ‘a non-traditional budget’?

Originally appeared on The Morning

By K.D.D.B Vimanga

A non-traditional budget was what the country needed. In general, budgets in Sri Lanka have mostly been giveaways to maintain political status quo or simply an outline of the Government’s plan for the economy, without taking into consideration current economic realities. As a result of numerous governments prioritising political gains over economic realities, the nation is currently experiencing severe economic consequences. These are manifested to the public in the form of steep price increases, shortages of essential goods, import restrictions, and much more. The macroeconomic consequences of this are fiscal and monetary instability, coupled with serious questions on Sri Lanka’s debt sustainability. A non-traditional budget would have indicated the broad policy direction and priorities of the Government with an understanding of where the economy is right now. The Budget would have prioritised macroeconomic stabilisation, taking into consideration the seriousness of the present economic crisis. Whether the budget proposals for 2022 achieve this remains a question.

Analysing the Budget Speech makes it clear that the intention of the Budget was to be conscious of government expenditure. Is this consciousness sufficient? Especially at a time where the foreign debt service forecast for 2022 is an estimated $ 4,483.80 million? (1), when the state of the country’s foreign reserves stood at about $ 2.6 billion in September 2021 (1.7 months of imports [2]), and following which the net foreign assets have been negative in the months after. This very question of debt sustainability remains the elephant in the room. Yet, the Budget Speech failed to elaborate on specific measures that the Government hopes to utilise to meet this target. A budget that understands the present challenges would have presented a roadmap of actions to meet these outflows. The failure to do so highlights the failure to streamline the Budget to meet the seriousness of the present economic crisis.

A certain amount of credit must be given to the Government for refraining from making excessive government expenditure proposals. There is a slight increase in government total expenditure from the revised estimate of Rs. 3,387 billion for 2021 to Rs. 3,912 billion for 2022. This remains prudent in comparison to the Government’s total revenue from the revised estimate of Rs. 1,556 billion in 2021 to Rs. 2,284 billion (3). According to the figures provided by the Ministry of Finance, the budget deficit would see a reduction from Rs. 1,826 billion in 2021 to Rs. 1,628 billion in 2022. However, it should be noted that while the Budget Speech of 2021 promised a deficit of 9%, the revised estimate of the deficit has increased to 11.1% as per the Fiscal Management Report of 2022.

The budget deficit still remains unsustainably large for a country with a gross domestic product (GDP) of $ 80.7 billion in 2020 (4). The Budget tries to reduce government expenditure by proposing policies to reduce recurrent expenditure. These include reducing the fuel allowance provided to ministers and government officials by five litres per month, a 25% reduction in telephone expenses, and increasing the eligibility of MPs to receive a pension from five to 10 years. The magnitude of these cuts in government expenditure remains insignificant in contrast to the real need of the hour; especially when the Budget has made provisions to further expand the public sector, by offering permanent appointments to over 53,000 graduates which would drain a further Rs. 27,600 million from the exchequer. Such is counterintuitive to policies aimed at countering recurrent expenditure, and maintaining a bloated public sector is simply unaffordable with the current state of our public finances. Bold cuts to government expenditure would have reassured Sri Lanka’s creditors, donors, and lenders that we are serious about reforms while also making more resources and talent available to the private sector. Maintaining inflated departments with little or no productive output is a luxury we cannot afford anymore.

The continuation of financing this budget deficit through the domestic market borrowings will have a crowding out effect, especially as it will stunt credit available for the private sector and in return slow the country’s medium to long-term growth potential. Therefore, an ideal budget or a non-traditional budget would have prioritised fiscal consolidation. This includes setting a clear path to reduce the fiscal deficit to 5% by 2024. More efficient tax policy alternatives would have been reintroducing PAYE and withholding taxes and widening the tax base and spreading the tax burden to include a significant number of organisations that were given long tax breaks.

The Budget Speech highlighted three policies that, if implemented right, could direct the economy towards growth. The first being the acknowledgement that price controls have failed, and that market intervention creates uncertainties that affect consumers. This must be looked at with pragmatism, as the complete elimination of price controls including in the energy sector, can achieve better outcomes for the economy. The second being a policy focus to ensure a fair and competitive market. Recognising the role of the market economy and competition is a move in the right direction. This remains the only tried and tested solution to lower prices in the economy. The third policy that should be highlighted is the Finance Minister’s acknowledgement of a re-examination of the Samurdhi scheme. The scheme currently excludes some of the most vulnerable households and therefore, there is a need for tighter administration to ensure benefits accrue to those who need it most. The focus to streamline this initiative towards building entrepreneurship, fostering SMEs, and skill development is the right decision. However, for this to materialise, the Government needs to implement comprehensive reforms to improve ease of doing business and a comprehensive programme of digitalisation.

Addressing macroeconomic imbalances should have been a policy priority of the Budget. This includes addressing the fiscal deficit and the external current account deficit which have effects on the rest of the economy through interest rates and exchange rates. The Budget tries to address this issue by focusing on empowering local production. Prioritising self-sufficiency without opening the domestic market for competition is untenable. The Finance Minister’s speech outlined proposals to boost productivity, which are indeed pragmatic. Yet, one cannot increase productivity without improving competition. Focusing on improving national output has no economic impact without boosting domestic competition.

In the background, there was hope that the Government would start stabilising public finances, which would restore confidence. However, analysing the policy priorities of the Budget makes it clear that there has been little attempt to address the deficit and debt sustainability. Therefore, markets are unlikely to respond positively. At this juncture, Sri Lanka cannot afford to be complacent about our credit ratings. The Budget provided an ideal opportunity to provide a credible plan of action to get our credit ratings up. However, we seem to have missed this opportunity.

Measures to control public finances: spending, budget deficits, and debt 

Year after year, the budget proposals have highlighted large-scale policies that remain limited to budget speeches. However, the present economic storm makes no space for such complacency. Hard structural reforms will need to be implemented inevitably. The Budget could have been the starting point. However, it seems that this window has passed. Therefore, there is a conscious need to build consensus for the implementation of key structural reforms that achieve macroeconomic stabilisation and long-term economic growth. Without macroeconomic stability, there will be no growth. Furthermore, these reforms need to be institutionalised. One way of doing this is the adoption of a medium-term fiscal and monetary framework that gives confidence to donors, lenders, investors, and citizens. Having such a framework will act as a clear sign that the State is committed to fiscal prudence and monetary stability. A medium-term expenditure framework is a tool for establishing public expenditure programmes within a coherent multi-year economic and fiscal framework. 

Other key structural reforms for macroeconomic stabilisation, as outlined in Advocata’s Framework for Economic Recovery, include public finance management and public sector reforms, state-owned enterprise reforms, enhancing monetary policy effectiveness and maintaining exchange rate flexibility, supporting trade and investment to strengthen external trade, land reform, improving ease of doing business, and bridging infrastructure gaps. The only salvation to Sri Lanka’s present economic crisis is such a comprehensive reform package that goes beyond a traditional budget.

References:

1. MOF annual report 2020

2. CBSL Recent Economic Developments: Highlights of 2021 and prospects for 2022

3. https://www.treasury.gov.lk/api/file/0c3639d9-cb0a-4f9d-b4f9-5571c2d16a8b

4. https://data.worldbank.org/indicator/NY.GDP.MKTP.CD?locations=LK

K.D.D.B. Vimanga is a Policy Analyst at the Advocata Institute. He can be contacted at kdvimanga@advocata.org.

The Advocata Institute is an Independent Public Policy Think Tank. Learn more about Advocata’s work at www.advocata.org. The opinions expressed are the author’s own views. They may not necessarily reflect the views of the Advocata Institute

Living according to a government’s will

Originally appeared on The Morning

By Dhananath Fernando

• Cost of living and the freedom of choice

Jeewan Thondaman, the political leader representing the estate electorate in Sri Lanka, was questioned recently on what development means for the estate sector. He said: “One politician visits the estates and says he built five houses and another one says he built 10. Merely building houses is not development.”

Then the TV anchor probed him on what development really is. “Giving the opportunity for people to build their own house in a land they own, as per their preference and aspirations, is development,” he replied. He went on to say that “if politicians build houses for the estate sector, regardless of the number of houses built, estates would never be developed”.

Politics aside, the young politician’s views on choice are highly commendable. Most often, people do not realise the importance of the ability to choose from a wide range of options. Especially in countries like Sri Lanka, we expect all things to be provided by the government. We like to eat what the government tells us to eat, we want to get educated on what the government says is good for us, we strive to get a job from the government as they see fit, etc.

The ability to choose is often tested in terms of marriage and relationships. Imagine if the government decided to select partners for us. We can all picture what chaos it would be. Similarly, when the government decides which food we should eat, which fertiliser we should use, and which job we should do, the results are not that different.

Availability of a range of options and increasing choices as much as possible is one key parameter on consumer convenience. The same concept works for essential commodities as well at a time when the national conversation is on rising food prices.

Let’s first understand the reason for rising food prices.

The recent food price hikes are caused by multiple reasons. One is rising global food prices and commodity prices with economies opening up after lockdowns. As a result, a barrel of Brent Crude oil, which was priced at about $ 42, is now at $ 83. So, a fuel price hike can be expected, which will, in turn, have a knock-on effect on many consumer goods.

Sri Lankans will be affected more significantly due to the Sri Lankan rupee depreciating in comparison to the US dollar. Excessive printing of money under Modern Monetary Theory (MMT) has further contributed to the depreciation of the currency. As this column highlighted many times, excessive printing of money, which increases the money supply, will also increase the demand for imports. A lot of the money printed will be used to purchase imported goods, which will worsen the balance of payment (BOP) crisis. A worsening BOP crisis will also increase the shortage of USD, thus increasing the price for a US dollar in LKR terms, or the exchange rate.

An increasing exchange rate will cause the prices of all imported goods to increase as the market adjusts, and keeping the exchange rate fixed without really having sufficient US dollars doesn’t make any sense. Simply, we have imposed a price control on the USD, which has created shortages just as with milk powder and liquified petroleum (LP) gas. Price controls also led to shortages.

If the Central Bank has unlimited USD supply, we can keep the exchange rate without fluctuations, but as per official data, our reserves are at a historically low level. So the Government and also our people are in a very unfortunate situation without having adequate tools to arrest the rising prices.

In a situation like this, some recommendations have been floated, such as increasing wages or Lanka Sathosa distributing essential goods.

On the question of increasing wages, the private sector has to have increased profits and revenue if they were to consider a salary hike. The government sector, which is about 18% of our labour force, cannot have a salary hike without further borrowing from the Central Bank. If the Central Bank further borrows on behalf of the Government, the prices will further increase. So, the only way to overcome this is to fasten our seatbelts and make sacrifices on our real consumption.

Sathosa has no other magic formula to reduce the prices unless a subsidy or budgetary support is provided, and obviously someone has to bear that cost of such a subsidy. Removing price controls is indeed a move in the right direction, but ensuring the market has enough competition across sections is also important in bringing down prices.

One good example is the wheat flour market, where there are only two players in the market. There is a very high tariff on imported milled wheat instead of raw wheat. So this acts as an entry barrier for other industry players to enter the market. As a result of such a lack of competition, the two existing players set the market price and the barriers to entry allow ample space for rent-seeking activities.

It’s the same for cement and industries like LP gas. In most cases, these industries are protected from competition. Protection from competition is directly undermining consumer choice. If Sri Lanka is serious about bringing down prices, our only solution is competition and expanding consumer choice.

At present, though, it seems that sacrificing consumption will be the only option we have and it will not be easy, specifically for the poor, where a higher percentage of income goes for purchasing food. This is going to be a truly difficult time period for such families. So the only option available is increasing the range of options available by increasing competition. Then, people can adjust their choices so that they have room to explore alternatives without experiencing the effect of higher prices. The only way to do it is to remove all barriers to market entry in order to pick the supply side up and iron out market distortions.

Different households will adjust in different ways to price hikes. For example, some households will reduce the quantity of milk powder used per cup. Some households may decide that only kids should be fed with milk powder and adults give up milk powder and shift to plain tea. Some families may adjust with frequency. Instead of having milk tea seven days a week, some will skip two to three days based on their affordability. Some families or businesses who have a higher degree of dependence on milk powder will use the same quantity, but they will reduce their entertainment expenses or other expenditure categories to keep the milk powder consumption going.

In simple terms, each household and individual, based on their circumstances, can decide what is the best choice for them. So even when making “sacrifices in consumption”, the freedom to choose is vital. With people making choices, there will be new market opportunities where suppliers will consider more options to supply alternatives to the  market and capture a different market segment.

Freedom of choice matters both in hard times and good. It is a fundamental pillar in a market system where people have the option of adjusting for higher prices by managing the cost of living to a certain extent. Competition in the market is what fuels the choice for consumers. Sri Lanka has to set the fundamentals right. For example, we cannot develop the estate sector by just building houses. We need to provide them the opportunity and choice to build a house as per their preference. This can only be done by allowing the market forces to work and establishing freedom of choice for people. While the importance of having the freedom to make individual choices is fundamental, the Central Bank can ensure that the rate of money supply increase is limited by using monetary policy. Finally, MMT does not work as it is claimed by those innocent of simple monetary economics. As our currency is not an internationally accepted currency, money printing by the Central Bank leads to inflation.

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.

Reform or Perish. It’s not too late

Originally appeared on The Island, ColomboTelegraph and Groundviews

By K.D.D.B Vimanga and Naqiya Shiraz

The Sri Lankan economy faces a historical crisis.  The root causes are the twin deficits. First, the persistent fiscal deficit - the gap between government expenditure and income. Second, the external current account deficit - the gap between total exports and imports.  The problems have been festering for too long. Without urgent reforms, the crisis could easily morph into a full-blown debt crisis. 

Sovereign debt workouts are extremely painful for citizens. A mangled debt restructuring can perpetuate the sense of crisis for years or even decades. A return to normal economic activity may be delayed, credit market access frozen, trade finance unavailable.

With the global pandemic, these are unusual and difficult times. The next five years are going to be crucial for the country.  The problems can no longer be avoided and should be faced squarely. The journey ahead is going to be painful but the longer these are delayed the worse the problem becomes and the magnitude of the damage compounds. 

The State of the Economy 

The new government inherited a fragile economy, battered by the Easter attacks of 2019, the constitutional crisis of October 2018 and the worst drought in 40 years in 2017. With the pandemic in 2020 Sri Lanka’s economy shrank by 3.6% with all sectors of the economy contracting. 

Yet, the pandemic is not the sole cause - it only accelerated the decline of Sri Lanka’s economy that was weak to begin with.  The country has long been plagued by structural weaknesses, with growth rates in the last few years even below the average growth rate during the war. Mismanaged government expenditure coupled with a long term decline in revenue have characterised Sri Lanka’s fiscal policy. As of 2020 total tax as a percentage of GDP fell to just 8%, while recurrent expenditure increased. 

Borrowing to finance the persistent budget deficits is proving to be unsustainable. Total government debt rose to 101% of GDP in 2020 and has grown since. Sovereign downgrades have shut the country from international debt markets. The foreign reserves declined from US$ 7.6 bn in 2019 to US$ 5.7bn at the end of 2020 and to US$ 2.8 bn by July 2021. This level of reserves is equivalent to less than two months of imports. With future debt obligations also in need of financing, the situation is dire. 

The import restrictions placed to combat this foreign exchange crisis have failed to achieve their purpose and are doing more harm than good. imports rose 30% in the first half of  2021 compared to 2020 despite stringent restrictions.

The problem lies not in the trade policy but in loose fiscal and monetary policy that has increased demand pressures within the economy, drawing in imports and leading to the balance of payments crisis and consequently the depreciation of the currency.  

Measures by the Central Bank to address this by exchange rate controls and moral suasion have caused a shortage of foreign currency leading to a logjam in imports.

Fundamental and long-running macroeconomic problems were  intensified by the pandemic.Import restrictions, price and exchange controls do not address the real causes.

Treating symptoms instead of the underlying causes is a recipe for disaster.

The continuation of such policies will lead to the deterioration of the economy,  elevate scarcities, disadvantage the poor who are more vulnerable and in the long run lead to even higher prices and lower output due to lack of investment. 

Sri Lanka’s GDP growth over the last decade has been alternating between short periods of high growth and prolonged periods of low growth. This is a result of the state-led, inward-looking policies of the last decade.

A comprehensive reform agenda must be built around  five fundamental pillars:

i) fiscal consolidation - The need to manage government spending within available resources and to reduce debt are paramount. Revenue mobilization must improve but the control of expenditure cannot be ignored. Budgetary institutions must be strengthened and there must be reviews not only of the scale of spending but also the scope of Government.

 ii) Much of government expenditure is rigid - the bulk comprises salaries, pensions and interest so reducing these is a long term process. Reforming State Enterprises, especially in the energy sector and Sri Lankan Airlines is less difficult and could yield substantial savings. Continued operation of  inefficient and loss-making SOE’s is untenable under such tight fiscal conditions. Financing SOE’s from state bank borrowings and transfers from government reduces the funds available for vital and underfunded sectors such as healthcare and education. Excessive SOE debt also  weakens the financial sector and increases the contingent liabilities of the state. Therefore SOE reforms commencing with improving governance, transparency, establishing cost reflective pricing and privatisation are necessary. This can take a significant weight off the public finances and by fostering competition contribute to improvements in overall economic  productivity. 

iii) Tighten monetary policy and maintain exchange rate flexibility.  Immediate structural reforms include, Inflation targeting, ensuring the independence of the central bank by way of legislation and enabling the functioning of a flexible exchange rate regime. Further significant  attention has to be placed on the  financial sector stability with a cohesive financial sector consolidation plan, with special emphasis on restructuring of SOE debt. 

 iv) Supporting trade and investment. Sri Lanka cannot achieve economic growth without international trade which means linking to  global production sharing networks. Special focus has to be given to reducing Sri Lanka’s high rates of protection which creates a domestic market bias in the economy along with measures to improve trade facilitation and attract new export oriented FDI. 

Attempts to build local champions supported by high levels of protection have 

(a) diverted resources away from competitive businesses, 

(b) created a hostile environment for foreign investment, 

(c) been detrimental to consumer welfare,

(d) dragged down growth

v) Structural reforms to increase productivity and attract FDI - Productivity levels in Sri Lanka have not matched pace with the rest of the growing economies. The reforms mentioned above are extensively discussed in Advocata’s  latest publication “Framework for Economic Recovery”.

Sri Lanka  stumbled into the coronavirus crisis in bad shape,with weak finances; high debt and widening fiscal deficits. It no longer has the luxury to delay painful reforms. Failure to do so will not only jeopardize the economy; it could even spawn social and humanitarian crises.

Naqiya Shiraz is the Research Analyst at the Advocata Institute and can be contacted at naqiya@advocata.org.K.D.D.B. Vimanga is a Policy Analyst at the Advocata Institute. He can be contacted at kdvimanga@advocata.org.

The Advocata Institute is an Independent Public Policy Think Tank. Learn more about Advocata’s work at www.advocata.org. The opinions expressed are the author’s own views. They may not necessarily reflect the views of the Advocata Institute

The Government’s dangerous honey

Originally appeared on The Morning

By Dhananath Fernando

Minister of Finance Basil Rajapaksa, moving two important bills in Parliament, recited a poem in Sinhala literature, which is also a proverb, to explain the sorry state of our economy. He compared Sri Lanka’s economy to a man in the jungle trying to rescue himself from three life-threatening challenges.

Firstly, a furious wild elephant, similar to our mounting debt obligations. Secondly, to avoid the elephant, the man attempts to hide in a pit, but before he jumps into the pit, he realises that there is a cobra in it. So instead of jumping, the man then decides to hang onto the roots of a tree that lies above the pit as an alternative. The cobra in the bottom of the pit is similar to our Balance of Payment (BOP) crisis. Our importers and exporters are in big trouble, having difficulties opening Letters of Credit (LCs) due to forex shortages, and currency is depreciating rapidly with attempts to keep interest rates artificially low by policymakers.

Then the man realises that one root he is holding onto is the tail of a venomous reptile. He now cannot release his grip on the tail as the reptile will bite back. So, the adventure of running away from the elephant waiting at the edge of the pit now has two more severe life-threatening risks. The Finance Minister’s analogy reflects that trying to avoid one problem without a proper estimation and analysis has now opened us to more vulnerabilities while the previous challenges remain as they are.

As the story goes, one tree root the man is holding in his other hand is attached to a bee honey nest. So when he tightens his grip, bee honey keeps dripping, and so he decides to indulge in some bee honey. While the man has three life threats from the elephant, the cobra, and the other reptile, he decides to enjoy the dripping bee honey for a moment.

The Sri Lankan economic crisis is exactly the same. At a moment in history where urgent, hard, and serious economic reforms are required to overcome the crisis in the midst of the global pandemic, some alternative policies such as self-sufficiency, Modern Monetary Theory (MMT), and import substitution have become sweet bee honey for some policymakers who really do not understand the gravity of the crisis.

Unfortunately, just as the man who attempted to jump to a pitfall without properly analysing the situation, some economic measures with little analysis are cornering us for a brewing crisis.

Fixing USD at Rs. 203

Attempting to fix our exchange rate at Rs. 203 against the USD to avoid currency depreciation is one such activity. Simply, it is a price control on US dollars. Every good or service with an economic value is naturally obliged to a demand and supply matrix. In other terms, there is no alternative to fix the price of a currency without someone intervening in the excess or shortage.

In the forex market, the Central Bank does not have adequate forex to intervene in markets any longer, with the mounting debt obligations. So it is natural that $ 1 for Rs. 203 is a complete misguidance where there is no USD in the market at that price. The downside of trying to fix the USD at an artificially lower price is the encouragement it would provide on more importers to open LCs, adding more pressure on banks as well as the USD.

“Imports” are incentivised at a lower rate than the market rate for the USD. Exporters, on the other hand, are discouraged to bring forex as they get a far less market rate if they bring USD to the market. As a result, exporters hold the USD as long as possible and many exporters maximise their offshore accounts, as it is very cost-effective and hassle-free. As such, banks’ forex market has now further dried up, with both importers and exporters falling into trouble. It is the same predicament faced by the man who tried to avoid an elephant and came across two more additional troubles.

Additionally, another restriction has been imposed on more than 600 HS codes where the full amount has to be paid upfront to open the LC. This move will directly impact micro, small, and medium-sized businesses that depend on imports in those categories. Consumers will have to experience higher prices and black markets in most of these product categories, and the quality of life will be affected drastically.

Concerns expressed by investors on property rights over seizing rice stocks

Recent raids carried out on rice mills in Polonnaruwa will worsen Sri Lanka’s image as a destination for investors. As previously written in this column, it is the lack of competition, along with political support, that leads to the creation of cartels in the rice milling industry. However, seizing private property of an individual undermines investor confidence – no investor will consider Sri Lanka if there is a fear that the government will take over their property rights.

This was the same point made by the President when he was questioned by Indian media in his very first international media interview about the Hambantota Port. Though his supporters claimed that the Hambantota Port will be taken back by China, the President mentioned that if we were to do it, it would completely provide a wrong message for the investor community. According to media reports, the Government is initiating a very important Selendiva project for investors (Hilton Colombo, Grand Hyatt, etc). However, property rights concerns will seriously erode attracting quality investors for the Selendiva project.

At the same time, exactly like the proverb in the speech by the Finance Minister, while we are in serious trouble on multiple fronts, ideological groups seem to be defending their ideology rather than finding solutions with pragmatism. Ideological groups are the same as the man who is focusing on bee honey dripping, by forgetting that we are already in a very serious situation. The narration created on self-sufficiency and import substitution are just an example.

The Finance Minister has to be objective and pragmatic instead of falling into ideological traps. Otherwise, he will be a victim of his own analogy and the proverb of the man who multiplied the problem by irrational decision-making.

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.

Closing the gate once the horse has bolted

Originally appeared on The Morning

By Dhananath Fernando

Can price controls rein in uncontrolled depreciation?

People are infuriated over the recent drastic price hikes on essential food items, and analysts and policymakers are attempting to make sense of what triggered this.

Some argue that the increasing global commodity prices are indeed the root cause of these local price hikes. In my opinion, however, global price hikes cannot be the sole reason. This conclusion is misleading as the domestic prices of these food items are higher than the percentage increase of global commodity prices adjusted for the depreciation of the Sri Lankan rupee (SLR).

Steep depreciation of the currency

It is no secret that the Government sought refuge in Modern Monetary Theory (MMT) in recent times. This has had a considerable impact on commodity prices due to the depreciation of the rupee. A depreciating rupee coupled with increasing commodity prices is certainly an ill-fated combination. Even though many economists alerted the Government of the risks MMT could pose, they fell on deaf ears.

When global market prices rise, it is inevitable that domestic markets adjust accordingly due to price signals. This means that people shift their consumption behaviours and patterns with price volatility. However, Sri Lanka’s essential commodity price hikes came suddenly and have given people no time to adjust their purchasing patterns.

As per Central Bank data, Sri Lanka’s food inflation is increasing. Advocata Institute’s Bath Curry Indicator, which tracks the weekly expenditure of a four-member household on rice and curry, found that prices increased by 45% on a YoY (Year-on-Year) basis in July and by 30% in August.

I’d like to conclude my argument by quoting Nobel Laureate Prof. Milton Friedman: “Inflation is always and everywhere a monetary phenomenon.”

Acute foreign exchange crisis exacerbated by MMT

The acute foreign exchange crisis we are in, too, is a major contributor to recent price hikes. Oversupply of money has drained our reserves and added additional pressure on the currency. For example, when the government provides Rs. 20,000 (which is beyond the government’s capacity) for low-income families, money will flow out of the system due to the purchase of imported goods. People will be inclined towards buying imported LP gas, lentils, sprats, and tin fish.

Further, maintaining a negative real interest rate, which is to keep interest rates artificially low by increasing money supply below the inflation rate, will motivate people to spend more money than to save. More spending equals more expenditure on imports, which will then exacerbate the country’s Balance of Payment (BOP) crisis.

Currently, banks have different exchange rates for different customers. The kerb market’s exchange rate for the US dollar is between Rs. 250 and Rs. 260.

If this trend continues, the country’s fuel prices, LP gas, milk powder, and many other commodity prices will continue to rise.

Price controls

The Government has announced strict price controls and has appointed a designated officer to curb hoarding by traders with the objective of decreasing essential commodity prices. Recent news reports claim that hoarded essential food items such as sugar have been confiscated from stores by the authorities.

However, price controls are proven to be ineffective and will lead to goods disappearing from markets, as a result creating black markets. Further, it is likely that price controls will result in importers stopping the importation of goods. The first lockdown saw an initial price control of Rs. 65 on lentils and a controlled price of Rs. 100 on tin fish. Later, the Government had to withdraw the price controls as it resulted in severe shortages, with traders halting imports and the sellers hesitating to trade at a loss. Price controls simply don’t work because the price structure is unique for each trader.

Competition is the only factor that drives prices down. For example, the cost structure of a trader who sells lentils in an air-conditioned shop and a trader who sells at the Sunday market is different. The price they mark is based on the cost, and consumers buy it based on the value they get. Price controls hamper the signalling mechanism, resulting in severe repercussions.

Why do traders hoard?

Even with increased raids by the Consumer Affairs Authority (CAA), traders continue to hoard. This behaviour is intricately linked with the foreign exchange crisis the country is in. The Central Bank introduced regulations stating that traders cannot buy US dollars for a future day (forward market) at the current exchange rate. Further, importers were requested to open Letters of Credit (LCs) for a 180-day credit period. As a result, importers brought essential commodities in agreement to pay the exchange rate to be in effect after 180 days. They brought the goods they already sold at a calculated exchange rate.

However, now the exchange rates are depreciating further. For example, when traders imported the consignments, our exchange rate was about Rs. 190. But with the currency depreciation, now they have to pay the current exchange rate as there is no forward market or interbank market in operation. This is pushing importers to hoard to secure stocks for the future. Importers will also be inclined to increase prices to cover their losses incurred due to exchange rate volatility.

All of these trickle down to the average consumer as higher prices on essential commodities. Higher prices, long queues for essential goods, and empty shelves are symptoms of wrong macroeconomic policies.

This column and many economists alerted the Government that it would come to this, and I am disappointed that the Government did not heed our advice.

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.

Living the same economic year 73 times

Originally appeared on The Morning

By Dhananath Fernando

Both the Government and the Opposition are in agreement that Sri Lanka’s ailing economy is at peril. A few weeks ago, the Minister of Energy admitted that buying fuel has become a challenging task with import payments only being settled after nine months. These same sentiments were echoed by the former Prime Minister when he was recently sworn in as a Member of Parliament. However, the diagnosis of the problem at hand and building an action plan to address it is continuing at a snail’s pace.

The problem has reached a level where letters of credit (LCs) are opened on a rationed basis and some importers have claimed that private banks do not facilitate foreign currency for their imports. On the other hand, forex dealers have been barred from quoting above Rs. 200 for the dollar.

This will simply create more forex shortages as people who have USD now would not sell it to the Government as it does not reflect the market value. Instead, people may consider parking money outside or keep it in USD terms considering the devaluation of the Sri Lankan rupee in real terms. Owing to the Central Bank regulation, even though the USD rate is less than Rs. 200, in the open market the rates are much higher.

Shortages in foreign exchange is not a recent phenomenon. The Minister of Trade mentioned at Parliament that the current foreign exchange crisis is the worst ever in history. However, our solution for the problem so far has been “not proposing any solution”.

We are doing the same thing over and over again and expecting different results. If we rewind back to 16 June 2020, the President criticised the Central Bank for not extending their support and not utilising the tools to revive the economy.

In February this year, the State Minister of Finance mentioned that the fears of debt sustainability have no grounds as we expect $ 32 billion of inflows and total International Sovereign Bonds (ISBs). He went on to say that the country’s outstanding debt is only about 16% and annual debt servicing of $ 4 billion is manageable compared to $ 32 billion of inflows.

Depending on the same figures, the President in November last year assured debt sustainability after a credit rating downgrade by Fitch.

However, the forex crisis pops up again and the frequency of the problem is getting higher. Earlier imports were controlled and then exporters were requested to convert 25% of their earnings on an immediate basis. However, regardless of strict measures and stringent regulations being imposed, the results have been the same or are getting worse.

Now even the members of the ruling party have started to admit the forex challenge at hand.

Earlier, the Leader of the House said answering a question posted by a journalist that the Government has enough money to take up mega development projects. However, last week, the Minister of Trade and the Minister of Energy were open about how difficult the situation is.

It is an indication that things are getting challenging. On the flip side, it’s a positive indication. At least, everyone is getting to realise the gravity of the problem in the first place. Until recently, there was denial of the fact that there is even a crisis to begin with. A Citi Bank report in December last year was titled “Denial is not a strategy”. This shows that even our international stakeholders were aware that we as a country have been denying the problem rather than providing a solution.

According to the current Government, the previous Government is mainly responsible for the economic crisis at hand as growth numbers were low and the debt numbers were high at the point of the transition. According to the main Opposition, this Government’s tax cut programme introduced in December 2019 and poor Covid management are the main reasons for where we are now. In politics that is how things are. It is always someone else that is responsible for the problem.

The common belief is that bad politics is leading to bad economics as the politicians lack understanding of economic policy and the inherent corruption. While there is some truth to it, often bad economics leads to bad politics.

It is unavoidable that bad economics fuel political storms. If we look at the defeat of the previous Government, it was too led by bad economics. Policies by the two Heads of State were in two different directions. The very first interim budget was stretching the government balance sheet beyond our capacity with massive pay increases for government employees. A proper economic plan was absent and by the time the V2025 policy formulation was done which was poorly implemented, it was too late to come back to a growth trajectory. The Cabinet Committee on Economic Management (CCEM) was dissolved and a National Economic Council (NEC) was appointed and later even the NEC was dissolved. The same policy contradiction on the top led to a constitutional crisis and a vacuum in national security ended up in a terrorist attack that could have been prevented. The Easter attacks were a big negative shock to our entire economy.

As a result of this sequence of events, the then ruling party, United National Party (UNP), was divided into two and the then Prime Minister had to experience a historic defeat in the last general election, which was just 10 months ago with a roaring two-thirds majority for the current ruling party.

It seems back-to-back economic decisions by the current administration are repeating the same mistake of the previous administration and another political crisis spiral is brewing.

Growing import bans, not implementing a proper economic reform agenda, and inward-looking policies of self-sufficiency combined with Modern Monetary Theory (MMT) has created instability in the entire financial system leading to a historic balance of payment crisis. Politically, it has opened a window for the same Prime Minister who was defeated just 10 months ago and has challenged the Government on economic and Covid management. So we are back again on the vicious cycle of bad economics leading to bad politics. The irony is that bad economics not only leads to bad politics but also has a serious negative effect on the quality of life and poverty of all Sri Lankans. Unfortunately, we as a nation have become victims of this vicious cycle. Robin Sharma popularly said: “Don’t spend the same year 75 times and call it a life.” There is no doubt that here in Sri Lanka, we have been doing exactly that for the past 73 years since Independence.

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.