Market-driven solutions for climate resilience

By Dhananath Fernando

Originally appeared on the Morning

It is disheartening to see many areas and lives in Sri Lanka affected by severe weather conditions. The postponement of Advanced Level exams and the broader impact on human lives impose costs that cannot be measured in purely economic terms.

Unfortunately, in Sri Lanka, discussions on climate-related solutions tend to occur only during extreme events like floods or droughts. This article, admittedly, follows a similar trend.

The approach to solving natural disaster challenges in Sri Lanka has often been fragmented, relying heavily on the expertise of individual professions rather than adopting a holistic perspective. For instance, lawyers may frame the issue solely within a legal context, IT professionals may focus on technological solutions, and economists often emphasise financial and economic aspects. This siloed approach overlooks the need for an integrated strategy.

Additionally, many solutions in Sri Lanka depend heavily on Government intervention, creating inefficiencies due to limited governmental capacity and placing a burden on taxpayers. Unfortunately, market-driven solutions for climate and environmental challenges receive inadequate attention in public discourse. There are misconceptions that market-based systems are at odds with climate action, whereas, in reality, markets offer numerous innovative solutions.

Immediate vs. long-term solutions

In the short term, the Government must provide support to those affected by climate-related disasters. Generally, funds are allocated for this purpose in every national budget. However, for long-term solutions, incorporating climate risks into pricing mechanisms is crucial. The market system is not inherently complex; it simply needs to reflect the scarcity value of resources through proper pricing.

Currently, there is no effective way to associate climate risk with specific high-risk areas in Sri Lanka. If we had a digital land registry, we could assign risk values to lands based on factors such as flood, drought, or tsunami risks.

Similar to how platforms like Booking.com rate accommodations for cleanliness, food, and accessibility, land prices could reflect natural disaster risks. This would enable individuals to make informed decisions when selecting locations for agriculture or residence, ultimately reducing property damage and loss of life on a macro scale.

This approach could also encourage financial markets to extend quality credit for low-climate-risk properties within the existing collateral-driven credit system.

Infrastructure and investment prioritisation

The Government could prioritise infrastructure investments in canals and irrigation based on areas with the highest impact, rather than acting on an ad hoc basis. With risk data, disaster relief support could be incentive-based, aligning resources with identified risks.

The concept of property rights and reflective pricing for climate-resistant land can encourage optimal use and sustainable development. Ideally, integrating social safety net information and national identity cards would streamline rescue efforts and improve the efficiency of reaching the most affected people.

Catastrophe bonds

Catastrophe bonds (CAT bonds) represent another market-based solution. These bonds are typically issued through a Special Purpose Vehicle (SPV) by insurance companies to cover large-scale natural disaster risks.

Investors purchase CAT bonds, which provide funds to cover damages in the event of a disaster. If no disaster occurs during the bond’s term, investors receive higher returns. Returns and coupons vary depending on the type of natural disaster covered.

In the event of a catastrophe, investors may lose some or all of their capital. However, the relatively high returns reflect the associated risks. The issuance of CAT bonds also incentivises extensive research and investment in climate event analysis. Early identification of potential disasters not only minimises property damage but also saves lives by enabling timely alerts and evacuations.

With CAT bonds, investors have a financial incentive to invest in areas prone to climate risks, as they see potential returns. For investors, CAT bonds offer diversification opportunities and returns that are less affected by traditional stock market fluctuations or macroeconomic changes. Additionally, CAT bond returns are comparatively higher than those of other types of bonds.

The role of insurance and data

A mature insurance market can significantly mitigate climate risks. One of the main challenges for Sri Lanka’s insurance and capital markets is the lack of comprehensive data.

A digital land registry that integrates weather patterns and risk factors would enable insurance companies and banks to better assess investment risks for businesses and agriculture, in addition to considering the applicant’s credit history.

This would enhance the productivity of the financial sector and improve access to capital. Importantly, it would encourage businesses and agriculture to relocate to low-risk, high-productivity areas, enhancing overall efficiency.

Addressing climate challenges in Sri Lanka requires support from multilateral organisations, particularly for developing markets. However, it is crucial to avoid relying solely on Government interventions or over-regulating productive sectors.

By setting the right incentives and disincentives, and focusing on fundamental, long-term strategies, Sri Lanka can create sustainable solutions beyond ad hoc responses to climate events.

Price Regulation on Three-Wheelers and School Vans: A Recipe for Transport Troubles

By Gurubaran Ravi & Chanul Singharachchige

Price is fundamental in determining the manner in which market forces influence both patterns of demand and the chains of supply. Price is a manifestation of what economist Adam Smith termed the ‘invisible hand’ which naturally allocates scarce resources in accordance with the laws of supply and demand and requires near zero intervention. The question now lies: what happens when this unneeded intervention is implemented regardless? By manufacturing limitations around prices, the government disrupts the natural balance between supply and demand. With the government planning to introduce a series of price controls on the three wheelers , school and office transportation sector - upon which almost all of us rely - it is worth revisiting what the adverse consequences of such an act can and will look like, how they will most definitely exacerbate already existing problems, and finally, prevent the economy from finding its own equilibrium.

Essentially, price controls entail putting restrictions as to how high or low prices can be set for a certain good or service via ‘price ceilings’ and ‘price floors’ respectively. Conceptually speaking, the implementation of price controls is often for a given purpose, whether it be to control inflation or protect consumers, the government simply tries to artificially balance distortions within the market creating a great deal of uncertainty in the economy itself.

However, not all that is expected to come into fruition in theory can be seen in the outcomes found in objective reality. For example, despite the immediate benefits price controls may provide, they distort the natural dynamics of the market leading to unintended consequences such as supply shortages, the reduction in the quality of goods and services, and the prevalence of underground black markets. This tends to be because producers struggle to cover the costs associated with providing products at pre-established prices. The ultimate harm done to both consumers and producers through the implementation of such regulation - though often well-intentioned - outweighs any temporary benefits that may be reaped. 

Now, let us take a closer look at what the landscape of how the transport market for three wheelers in Sri Lanka looks like and behaves. Nowadays, three-wheelers, school vans, and office vans have become integral parts of the Sri Lankan transportation system - especially with the deterioration of the public transportation system. The three-wheeler segment comprises a significant portion of Sri Lanka’s transport sector with more than 300,000 three-wheelers in operation. These vehicles have made it possible for millions of people to have their means of private transport for daily use, particularly in rural areas and other hard-to-reach places. In the backdrop of an economic crisis, where operating costs become extremely high, the proposed price regulation policy is likely to jeopardize this important service. Such regulation could reduce the number of providers as the financial pressure on operators rises, the availability of transport decreases, and transport fares rise. This impact would be most severely experienced in regions where choices of public transport are already few, possibly leaving many with no affordable means of transport. 

The transport sector for three-wheelers is also mainly composed of individual operators, but recently a few companies like PickMe and Uber have utterly revolutionized Sri Lanka's transport market. They have managed to heighten efficiency, promote route optimization, and enhance service quality, whilst simultaneously providing alternate employment opportunities for a vast and diverse array of people. However, any proposed regulations that stifle the freedom with which price can move will inevitably disrupt the market dynamics fostered by these platforms. Experts warn that such constraints will undermine the flexibility and efficiency of the sector, distort supply and demand, and potentially reverse the benefits of market-based pricing models. This could lead to diminished levels of availability of service, hindrances in the pace of innovation within the industry, and a rollback of the advancements made in respect to meeting needs of consumers - particularly those of low-income earners. 

The free market fosters levels of competition that incentivize providers to one-up one another at every opportunity. In the service-based industries - such as transport - this is best accomplished through the provision of high quality services at as low a price as possible in order to attract consumers. Therefore, if price controls are implemented on the three-wheeler, school,  and office transportation sectors, they stifle the capacity as well as the incentives that providers have to improve levels of flexibility and provide a variety of options to consumers, particularly affecting low-income individuals. These price controls also significantly enlarge an industries’ reaction time - and hence inefficiency- when making adjustments in respect to pricing and supply when faced with fluctuations in economic conditions such as shifts in the levels of inflation or a fuel crisis. Experts in the field have shared similar concerns, emphasizing the fact that while these regulations may be passed in order to provide temporary relief to a select few, they risk the destabilization of the entire market and jeopardize the efficiency of the entire market system.

However, it is impossible to turn a blind eye to the fact that there are certain factors that are crucial to these price controls. The government has to consider how it will be able to oversee and regulate thousands of independent operators across the country, especially in a sector that is as fragmented as the transport sector. The adoption of such regulations would likely require a high administrative cost, which would likely shift attention from other important sectors. Moreover, given the fact that the three-wheeler, school, and office transportation sectors are composed of many small participants, it remains doubtful whether such enforcement can be achieved in the first place. For instance, it may be hard to enforce compliance in rural regions and in urban regions with dissimilar levels of economic development. This may lead to a situation where only some or even a part of the controls are being implemented, thus aggravating and distorting the market more than it is at the moment. The efficiency of these measures is furthermore rather questionable, which leads to questions of whether or not these measures can be implemented without causing more problems than they are solving.

However, the three-wheeler, school, and office transportation sectors are far from the only sectors that have known the weight associated with the adverse consequences of price control implementation. It should be highlighted that LP gas, cement, bread, rice and eggs, have all been subject to similar limitations. These policies have frequently caused significant market distortions. In 2023, in order to combat a sharp rise in the prices of eggs, the Sri Lankan government made the decision to impose price controls on eggs. Despite this intervention aiming to resolve the dilemma, it instead devastated the industry and led to severe shortages in the supply chain with producers failing to sustain costs. The restrictions on LP gas and bread supplies appear to have influenced supply chain disruptions and market fluctuations. Moreover, there is news that cement may be the next to be affected by further price regulations, which will exacerbate the situation in the building and construction industry. Such stopgap regulations impair the normal functioning of free market economics, send misleading signals to actual price factors, and cause more instability in the economy, by providing only short-term relief while exacerbating long-term structural issues.

While the debate around price controls is critical, it raises a more significant question: The public transport system needs to be improved based on the government’s long-term vision of how it plans on fixing the system’s problems. While exercising the price control mechanism may give some relief to commuters and public transporters in the short run, it cannot address the structural issues that are inherent in the public transport system in Sri Lanka. The real solution is to create an integrated plan to upgrade public transport infrastructure and to improve service delivery so that the public transport system becomes the first choice of the transport user. In this regard, it would be possible for the government to ease the burden from the private transport sector, including three-wheelers and school vans, etc., and thereby develop a more balanced transport system. The provision of mass transit systems offers not only the purpose of decreasing reliance on private automobiles but also social justice, optimum resource utilization, and preservation of the earth.

On a more conclusive note, history teaches us a clear lesson: the fundamental importance of allowing prices to reflect supply and demand naturally simply cannot be understated and any intervention in this intricate relationship can have dire direct and indirect consequences.While interventions like price controls may provide temporary relief to a select few, they often just exacerbate already convoluted issues when considering the longer term.  A free market system is pivotal in order to maintain economic equilibrium where efficient resource allocation can be best fostered. In such a system, it is price that serves as the principle signal to guide both consumer and producer behavior. The self-regulating nature of this system not only promotes innovation and competition but helps mitigate market distortions that may arise from intervention or excess regulation.

Sri Lanka’s Productivity Push: Exploring Policy Pathways for the Proposed National Productivity Commission

By Tilani Jayawardhana

Why Does Productivity Matter for Sri Lanka?

Productivity is not just a technical measure of economic efficiency; it is fundamental to improving living standards, sustaining economic growth, and ensuring the long-term prosperity of society. Evaluating and enhancing the productive forces of the economy is crucial for informed policymaking, targeted investments, and achieving sustainable development. For Sri Lanka, focusing on productivity is key to overcoming economic challenges and realizing its potential in the global economy.

Sri Lanka should increase productivity across the economy if it wants to successfully compete in the global value chain. Improvement in productivity will reduce the costs and place the country in a better position to supply to the global markets at competitive prices. 

Productivity growth has to be a top priority of all the successive governments. Without productivity growth, the country’s production system, be it agriculture, industry, or services, will be displaced in the global system.  Therefore, the role of the NPC should be to ensure a data-driven approach to productivity in each sector, promote competition, and encourage international competitiveness. 

Sri Lanka’s productivity has to be built up through investments in physical capital stock, human capital and the diversity and dynamism of our industries. To ignite productivity growth, new business investment and workforce capabilities will need to improve in ways that respond to the changing shape and nature of the economy. Investments in physical capital are expected to continue to drive Sri Lanka’s productivity potential. International evidence shows that about two-thirds of labour productivity growth since the early 1970s has been due to capital deepening. This is because when the amount and quality of capital available to workers increases, they are generally able to produce more per hour worked. As the industrial mix changes, investment in growing industries and effective adoption of new technologies, including digital technologies, will be essential.

The productivity challenges and opportunities that we will face in the future will be different to what we have seen in the past. Improving productivity in the large and growing services sector will be increasingly important, as it will have an outsized impact on Sri Lanka’s overall productivity outcome. Country’s productivity agenda needs to respond to current economic circumstances and identify modern strategies to advance enduring policy goals.

Rationale in establishing the National Productivity Commission (NPC)

An economy’s ability to use labour, capital and other resources efficiently is the essence of productivity and it is when this efficiency increases a country’s economy would expand. In a bid to revive the country’s struggling economy, Sri Lanka has implemented a comprehensive economic reforms agenda. The government has initiated several key recovery strategies, with the establishment of a National Productivity Commission (NPC) being a flagship project under the Economic Transformation Bill. The proposed NPC is expected to help address the productivity enhancement needs of the domestic industrial sector as they are struggling to come out of the economic crisis and exposed to greater international competition. The government of Sri Lanka has taken this correct step forward and acknowledged that higher productivity growth has the advantage of raising average living standards by increasing GDP per capita. 

Productivity growth is an important aspect of economic and social development of a country. Moreover, increasing productivity enhances competitiveness, making it a crucial factor in attracting foreign investments and boosting international trade. Productivity drives economic growth and helps realize improved living standards. 

Though Sri Lanka’s output structure shows a shift to services (with an average share of 59.2% during 2016–2022) and away from agriculture (8.5%), a large share of the employed are still in agriculture (26.4%), where productivity is about 31% of the national average. Furthermore, its manufacturing sector—a sector widely regarded as one that can gainfully employ semiskilled workers—lags in labor productivity. Though Sri Lanka’s manufacturing labor productivity is one of South Asia’s highest, it is roughly half of that in the Philippines and Thailand, and about one-third of that in Malaysia and the People’s Republic of China (ADB Country Partnership Strategy: Sri Lanka, 2024–2028).

Sri Lanka's aging population presents a significant challenge to sustaining high economic growth, while boosting productivity is the key solution to overcoming this hurdle. Sri Lanka is “growing old” before becoming “rich” and thereby there is an urgent need in preparing for an aging society that will require increasing labor force participation and productivity of the workforce. Productivity improvements can offset the economic impacts of a shrinking workforce by enabling the remaining labor force to produce more. This is crucial for sustaining economic growth in the face of demographic challenges. Therefore, establishment of the NPC is a clear step forward in the correct direction. 

Overview of the Proposed NPC

The broad objective of the proposed NPC is to promote economic growth through increased productivity for the improvement of wellbeing of people in a sustainable manner. The NPC will be an independent body which is accountable to Parliament. 

The main duties and functions of the NPC shall be to: 

• Make recommendations to the relevant authorities based on evidence and comprehensive analysis in order to increase productivity and economic performance by; streamlining regulation of productivity, promoting healthy competition and contestable markets, catalysing structural transformation and encouraging international competitiveness

• Make recommendations to the Government on introducing a national competition policy and advise on subsequent revisions as needed from time to time

• Conduct public inquiries and evidence-based research on issues related to productivity, either in-house or contracted out, and disclose the methodologies used for such inquiry or research

• Carry out, performance, monitoring, evaluation and benchmarking on the productivity

• Report annually to Parliament on the productivity trends within the first four months of the following year

• Advocate on the need for productivity improvement 

Although the objectives of the NPC cover a wide range of responsibilities, from streamlining regulation to promoting competition and international competitiveness, this broad scope might dilute the focus and effectiveness of the NPC. It is important to narrow the focus to specific, high-impact areas initially, such as catalyzing structural transformation or enhancing international competitiveness. Clear prioritization of tasks could improve the efficiency and outcomes of the commission’s work. NPC’s work and policy orientation should address the country's on-going productivity issues, it also should carry a longer-term perspective in achieving the development goals of the country.

In addition, conducting inquiries and evidence-based research in-house might lead to biased outcomes, especially if the NPC faces political or administrative pressures. This issue can be resolved through the establishment of an independent research unit within the NPC with a clear mandate. 

NPC should Advocate for the development of standardized productivity metrics and benchmarks, perhaps aligned with international best practices to facilitate performance monitoring, evaluation and benchmarking. 

It is also important to have within the NPC mandate to promote public advocacy and engagement. The mandate to advocate for productivity improvement is broad, and without a clear strategy, these efforts might not reach the right audience or create the desired impact. Development of a targeted communication and advocacy strategy that includes specific campaigns for different sectors, public education initiatives, and collaboration with media and civil society to raise awareness should be taken into consideration.

Concerns on the proposed NPC and some policy recommendations

• The process of appointing the chairman and five members to the NPC is under presidential authority, which raises concerns about potential political interference and the practicality of the level of independence of the commission. Even if the commission operates under an independent entity, the inherent structure would not warrant it to operate at arm’s-length from politicians and other public agencies. 

• The two core features of the NPC has to be its transparency and its economy-wide perspective. The commission’s activities should encompass all levels of government and all sectors of the economy, with the core values of independence, transparency and community-wide perspective, including social and environmental aspects. 

• The NPC should have permanent staff that has the capacity to evaluate all aspects of the public sector operational activities with special emphasis on macroeconomics and competition policy. Their work should be overseen by independent commissioners appointed for a fixed term. 

• The NPC must be geared to contributing by providing quality, independent advice and information to the government, and on the communication of ideas and analysis. - The commission ideally should be an agency of the Government of Sri Lanka, located within the
  Treasury portfolio, covering all levels of government and encompass all sectors of the economy, as well as social and environmental issues 

• National performance monitoring system has to be based on the Total Factor Productivity (TFP). TFP is referred to as the productivity measure involving all factors of production. Most often productivity measurement is based on Partial Factor Productivity, where one or more outputs are measured relative to one particular input (eg. Labour productivity is a ratio of output to labour input). Therefore, unlike labour productivity (or capital productivity), which considers only the labour input (or capital input), TFP is a comprehensive measure of productivity. TFP is usually calculated as the ratio of the total output to the combined inputs of labor and capital. Partial productivity measures are widely used as they are simple to calculate. However, partial factor productivity should be interpreted with caution.  

Regulatory Power of the NPC.The NPC’s mandate to "streamline regulation" and "promote healthy competition" might be limited if the commission does not have sufficient authority to enforce its recommendations. Without enforcement powers, the NPC could become merely an advisory body, with its recommendations being ignored or delayed by the government.

How Trade Restrictions are Inflating Urban Housing Costs in Sri Lanka

By Ashanthi Abayasekara and Yasmin Raji

A glance at Colombo’s (and suburban) housing prices will quickly establish that buying or renting a house is expensive for a vast majority of Sri Lankans. Advocata Institute in a study found that 70% of Sri Lankans cannot afford to own even a basic 500 square foot house in their lifetime. But what is driving up urban housing prices making house ownership unaffordable?

A recent study by Advocata Institute on the ‘Impact of Anti-Competitive Practices in the Construction Industry on Affordable Housing in Urban Sri Lanka’, reveals that urban housing prices are inflated partly due to restrictive trade policies and anti-competitive practices in the markets for housing construction materials.

The study examined the tiles, cement, and aluminum markets, all essential inputs in urban housing construction. These industries were found to be highly concentrated, with few firms involved. Barriers to entry are high due to substantial capital requirements and the need for economies of scale, which new entrants cannot afford. Additionally, market players benefit from significant trade protection through high import tariffs, cementing the dominance of domestic players.

In the case of domestically produced cement, the raw material used in the production of cement, clinker, has been subjected to a cumulative tariff ranging between 16% and 25% from 2014 to 2022. In comparison, importers of bulk and bag cement—the direct competitors of domestic manufacturers—have faced an additional para tariff of CESS consistently over the same period, ranging between 8% and 14%. This put cumulative tariffs for bulk and bag importers significantly higher than for clinker importers, ranging between 27.5% - 38.5% and 26% - 32.5% for bulk and bag cement importers respectively..

Figure 1: Changes to quantity of cement imported, prices, and tariff structures

A similar situation can be observed in the tile market, where imported tiles have been subjected to a total tariff rate ranging between 79% and 89.5% from 2013 to 2022 while tile raw materials were only subjected to a VAT of 8%. This discrepancy in tariff rates creates an uneven playing field, giving domestic manufacturers an unfair advantage over their importing counterparts. 

In addition to the high border tariffs, quantity restrictions have also been utilized to curtail imports. This was predominantly observed in the sweeping import restrictions imposed in April 2020 owing to the foreign exchange shortage prevailing at the time. This saw the quantity of bag cement imported reducing by 65% and tiles reducing by 87%. While most of these restrictions were placed as an attempt to conserve foreign exchange during the forex crisis, the inconsistent way in which these policies have been implemented has disproportionately benefited the larger domestic players in the markets. 

Apart from its implications on the producers and importers of construction materials, the high border tariffs coupled with import suspensions (protectionist trade policies) have resulted in a limited supply of construction materials available for customers, not only limiting their choices but more importantly, driving up the prices of goods exponentially. For example, high tariffs and import restrictions in the tile market led to customers being subjected to price increases of 93%-123% by August 2022 compared to April 2020. Customers also reported waiting times of over a year to receive the goods. 

So how does all of this impact housing affordability? With rising prices of construction materials due to these protectionist trade policies and the lack of competition in the domestic market, the cost of constructing a house has also seen a significant increase over the years, making it unaffordable to a vast majority of Sri Lankans. 

Given these impacts on necessities like housing, the corrective action would be to abolish tariffs altogether as soon as possible, and boost competition in construction material materials. However, due to Sri Lanka’s constrained fiscal space, reducing tariffs and removing trade restrictions should be done gradually. This approach will steadily increase the import of these goods, boost their supply, gradually drive down prices, and ultimately minimize housing affordability issues.

A new era or more turbulence?

By Dhananath Fernando

Originally appeared on the Morning

• The challenges facing Sri Lanka’s next president

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

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

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

Focus on economics and corruption

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

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

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

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

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

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

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

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

Limited options

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

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

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

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

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

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

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

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

Delaying elections threatens political and economic stability

By Dhananath Fernando

Originally appeared on the Morning

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

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

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

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

Uncertainty and economic growth

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

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

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

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

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

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

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

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

The solution: A common reform programme

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

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

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

Bouquets and brickbats for Economic Transformation Bill

By Dhananath Fernando

Originally appeared on the Morning

We all agree that Sri Lanka’s economy requires transformation. Can we transform an economy solely through an Economic Transformation Bill? No. Can we do it without a bill, without a proper legal framework and institutional structure? Again, the answer is a definite no.

Overall, the bill essentially unbundles the Board of Investment (BOI) into three main parts: establishing a powerful Economic Commission to decide and drive investment strategy at a national level, improving the investment climate for investors, and setting up Invest Sri Lanka to attract investors.

The current zones managed under the BOI have been transferred to a new organisation, with options for establishing industrial zones in collaboration with the private sector. This aims to resolve land issues and improve facilities for investors. The new institution is focused purely on trade agreements and economic integration with global supply chains.

A Productivity Commission, modelled after Australia’s, is proposed to enhance market efficiency and prevent anti-competitive practices. Lastly, a type of Government think tank is proposed to provide research services and analytics on trade and investment.

The bill also appears to compile six ideas into one comprehensive piece of legislation. Incorporating debt-to-GDP ratio targets, export-to-GDP ratio targets, and gross financing needs expectations seems to be another objective, as outlined in the preamble.

Risk of political interference

On the flip side, the appointment of members for the Economic Commission and other institutions falls directly under the president’s purview. In instances where the president is also the minister of finance, significant economic powers are concentrated in the hands of a single individual. Given that the majority of members can be appointed by the president, there is a significant risk of political interference in the business and investment climate.

We can set up numerous institutions, but real reform and transformation occur not when the bill is passed but rather when capable individuals drive real change. If we have flawed provisions for the appointment of members to the Economic Commission and other institutions, allowing for political interference, we risk creating another ineffective BOI.

Ideally, appointments should be nominated or approved by the Constitutional Council (CC). Additionally, representation from professional bodies such as the Institute of Chartered Accountants of Sri Lanka (CA Sri Lanka) could ensure adherence to ethical standards.

Steps in the right direction

The new bill proposes six key institutions:

Economic Commission (EC)

Invest Sri Lanka (Invest SL)

Zones Sri Lanka (Zones SL)

National Productivity Commission (NPC)

Office for International Trade (OIT)

Sri Lanka Institute of Economics and International Trade (SIEIT)

The idea of establishing a separate entity to manage investment zones is a step in the right direction. A 2018 study by the Harvard Center for International Development revealed that 95% of BOI investment zones were occupied and investors had identified land availability as a constraint.

Rather than having the BOI run industrial zones, there are many private sector players who can provide better services to investors. Zones SL should collaborate with the private sector to open new zones, providing infrastructure as landlords rather than managing the zones themselves.

The Productivity Commission is another positive policy step, provided it is implemented correctly. Its role should be to ensure a data-driven approach to productivity in each sector, promote competition, and encourage international competitiveness.

The commission should work with industry experts, as productivity expertise varies by sector. Australia’s experience with its Productivity Commission demonstrates the importance of maintaining focus on competition and avoiding mission drift, as seen with the Consumer Affairs Authority, which has deviated from its original purpose.

The OIT aims to address the lack of capacity in trade negotiations. The bill’s overall concept targets structural issues that hinder exports and Foreign Direct Investments (FDIs). However, it does not guarantee the intentions of politicians or ensure that everything will improve after the passage of the bill. The appointment process and selection of competent individuals for committees are crucial.

Implementation challenges

The key challenge for Sri Lanka will be execution. A large government with poor capacity is likely to result in political appointees populating these commissions, given the current appointment structure and salary scales. There is little incentive for qualified individuals to join at the current salaries offered.

Moreover, the Government lacks the capacity to offer higher salaries, and doing so for one segment could lead to demands for salary increases across the board or protests during a politically sensitive period. Phased reforms to reduce the State’s workforce are necessary to improve State capacity and manage these institutions effectively.

When the BOI was established, it was intended to be a one-stop shop for investors. However, it has become another bureaucratic hurdle. We risk repeating this mistake with all six proposed institutions if the wrong individuals are appointed. Conceptually, the policy is in the right direction, but its success depends on the implementation and the people driving it.

Nearing debt negotiation deal amid economic uncertainty

By Dhananath Fernando

Originally appeared on the Morning

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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.

Unveiling the true culprit behind economic woes

By Dhananath Fernando

Originally appeared on the Morning

Sri Lankans have a very negative view of imports, which are often portrayed on TV as the problem behind the economic crisis. Not only politicians, but also those who have opinions on our economy subscribe to the idea that imports are the problem.

Our politicians’ favourite pastime is to blame imports and impose various tariffs or ban imports. Banning imports also makes for a very pro-Sri Lankan image, because a common excuse provided is that high imports are damaging to local industries. Accordingly, the banning of imports has been portrayed as a measure to help develop local industries.

A favourite area when it comes to cutting down imports is food imports. Often, media headlines and politicians comment aggressively, even quoting figures on the value of food imported. The middle class, upper middle class, and wealthiest of society often make the argument of needing to save valuable foreign exchange by cutting down food imports.

However, when we consider the data, it indicates the exact opposite. The middle class, upper middle class, and the wealthiest are the ones who consume the most amount of imports in the form of fuel, mainly through personal vehicles and as energy. About 27% of our imports in January was fuel. Fuel is the largest component of our import basket as a single commodity.

What we have imported as food is less than 11% of our total imports. Non-food consumer goods are just 8% of our total imports. Most pharmaceutical products and medicines for patients fall under the non-food consumer goods category, which are primarily consumed by the most vulnerable people in society.

Imported food items are also consumed by the most vulnerable sections of society. Food items such as canned fish, maize, green gram, lentils, black gram, sprats, b-onions, potatoes, and wheat flour are critical food items for the poorest of the poor.

Firstly, these can be stored without a refrigerator, which saves their energy cost. Secondly, they are easily available and affordable compared to many other items of food they consume. Therefore, the request of politicians and academics to cut back on these food items, which comprise less than 11% of our total imports, is nearly impossible to fulfil, and reducing these imports further is tantamount to asking the poor to live in hunger and their children to suffer from malnutrition.

Thirty-seven percent of our import basket comprises intermediate goods, besides food. These are goods required for exports and to produce many things without interrupting the supply chain. For instance while our main export is apparels, our main import is also apparels. Therefore, asking to reduce apparel sector imports amounts to reducing our valuable exports.

In reality, while there persists a belief that imports have to be reduced, it is not the solution it is touted to be. If we have to cut down on food imports, it will lead to increased malnutrition, hunger levels, or food costs for Sri Lankans.

Ways of reducing imports

If we want to bring down our imports, cutting down on fuel is one way to consider. A World Bank study revealed that 70% of the fuel is consumed by the wealthiest 30% of society. Therefore, it only makes sense to maintain fuel prices at market price.

As indicated in the graphs, there is a correlation between high fuel prices and fuel imports. Our fuel imports have decreased when prices are high as people use it sparingly. Compared to January 2023, our fuel imports had declined by about $ 100 million per month by January this year. With the expansion of the economy, this number is expected to slowly grow. Prices can bring imports down without import bans or tariffs.

Another way to reduce fuel imports is by improving public transport. Most of our fuel is wasted in traffic jams as a result of our poor public transportation infrastructure. If we invest in public transport, not only will it reduce fuel imports, but it will also uplift many Sri Lankans and provide significant relief in terms of their purchasing power. Many middle class Sri Lankans pay a 200% tariff to buy a second-hand vehicle at an interest rate of above 12% because they have no other choice but to commute.

Saving foreign exchange

Sri Lanka has been offered many grants, including for the Light Rail Transit (LRT) project, which we turned down on numerous occasions, leading to geopolitical tensions. When people spend less money on commuting and waste less time in traffic congestion, it will not only improve productivity but also their purchasing power, creating many jobs and generating income.

It is an inalienable truth that we need more food imports with different varieties of protein sources for the benefit of the impoverished. Foreign exchange has to be earned through exports, tourism, and remittances.

Saving foreign exchange is a function of the monetary policy or the supply of the Sri Lankan Rupee to the financial system rather than a function of imports and exports. When the rupee becomes expensive, the US Dollar demand decreases automatically because people buy the latter using rupees that they could have used in an alternative manner.

Asking the public to cut down on food imports, which are mainly consumed by the poor, at the expense of allowing the use of more fuel-driven vehicles cannot be justified and borders on cruelty.

Steering clear of divisive politics and economic populism

By Dhananath Fernando

Originally appeared on the Morning

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

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

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

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

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

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

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

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

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

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

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

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

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

The other side of parate execution suspension

By Dhananath Fernando

Originally appeared on the Morning

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

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

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

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

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

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

Effect on MSMEs

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

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

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

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

Triple whammy

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

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

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

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

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

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

Why focusing on trade is paramount

By Dhananath Fernando

Originally appeared on the Morning

If you were to ask the average Sri Lankan what Sri Lanka’s economic problems are, you are most likely to hear three answers. The most common and popular answer would be corruption, a likely second would be high imports, and some may even say there is a lack of exports.

This article will address the second and third answers.

Contrary to popular belief, many Sri Lankans are unaware that our imports are declining compared to the size of our economy. Many make the mistake of checking the total value of imports and claiming that our imports are increasing.

That is correct, but import value can increase for many reasons. It could be due to a significant price fluctuation of certain imported commodities (fuel), a consumption hype due to a growing population over the years, or many other reasons.

Accordingly, imports and exports both have to be evaluated in comparison to the size of the economy – commonly known as the Gross Domestic Product (GDP). It is the same as considering a person’s weight relative to their height and age: weight as an absolute number has no meaning without comparing it with height and age.

Since the 1990s, Sri Lanka’s imports as well as exports have been declining compared to our economy. In recent years, exports have increased because our economy contracted steeply with the economic crisis while our exports remained fairly constant.

This indicates that the claim of our imports being a problem is a complete myth and misleading. Instead, our problem is that our imports are low because our exports are low. We need to export more so we can import more of the things that are being produced competitively and efficiently in other parts of the world.

For instance, let us consider the example of food items. There are many food items with a high range of protein sources and variety that food insecure people can afford, which face a high tariff rate in order to discourage consumption. The final victims of this process are the poorest people in the country who cannot afford a variety of food.

The impoverished spending more on food means they are left with little money to spend on non-food items such as education and health. Therefore, discouragement of imports through tariffs will affect the poor.

Another common myth in Sri Lanka is that Free Trade Agreements (FTAs) increase imports while drying out our USD reserves. Sri Lanka hasn’t signed many FTAs to begin with. Even when we analyse the data, trade primarily takes place outside FTAs.

Let us evaluate the Indo-Sri Lanka Free Trade Agreement (ISFTA). Imports are declining or stagnant from India to Sri Lanka under the ISFTA and we have undertaken more exports than imports under the agreement. However, more trade has taken place outside the ISFTA.

One potential reason for this could be the cost for companies to comply with the ISFTA and the complicated nature of FTAs. However, we have done more exports than imports under the ISFTA, indicating that trade agreements are not necessarily conspiracies by other countries to push their products but that Sri Lanka has done well in exports under FTAs in absolute numbers. As such, the claim that trade agreements push imports and discourage exports is also misleading and the data fails to support the claim.

Even if we check the numbers for the Pakistan-Sri Lanka Free Trade Agreement (PSFTA), we export more under the FTA in absolute numbers than we import. However, compared to our GDP, our trade is very weak, which is one of the main constraints to our economic growth.

Our barriers to trade are beyond trade agreements. Most barriers are internally driven by Sri Lanka Customs, the complicated tariff structure, necessary regulatory barriers, and related to ease of doing business. Blaming FTAs or imports for our economic crisis is meaningless. Instead, our growth potential lies in when we import and export and simplifying the tariff structure unilaterally is the first intervention to minimise corruption and boost trade.

Joining global trade will not only make our country wealthier but position us strongly in Indo-Pacific geopolitics.

As it was famously said: “When goods and services don’t cross borders, soldiers will.”

(Special thank you to Advocata Institute Research Analyst Araliya Weerakoon)

Why are we poor?

By Ravi Ratnasabapathy

Originally appeared on the Daily FT

Economists tell us that Sri Lanka’s economy has stabilised but what does this mean if so many are struggling?

To economists stability means that the imbalances in the economy have been resolved. The symptoms of the imbalances appear as rising prices, shortages of foreign exchange and goods. These have indeed disappeared but what does it mean to ordinary people? It only means that the rate at which people were being impoverished has slowed. We were crashing down the mountainside but the fall has been broken, if only temporarily. This is no mean achievement but obviously people expect much better.

People enjoyed a particular standard of living in 2020 but three short years later find themselves pauperised and cannot fathom why. What caused this steep decline in living standards? Corruption, poor governance and weak public finances are blamed but these were prevalent for decades. Why did the effects of these pass unnoticed for so long and how did they suddenly manifest?

The fact is that while these are connected to the problem they are not the immediate causes. To understand the causes of poverty today we must understand what changed between 2020 and 2023.

Two distinct causes of poverty today

There are two distinct causes but for the sake of clarity they must be dealt with separately.

Between December 2019 and August 20221 the Central Bank printed huge volumes of money – net Central Bank credit to Government grew 10-fold; from 363 billion to 3,162 billion. The end result of the increase in the supply of money is the fall in its value. This is reflected in rising prices and depreciation of the rupee in the foreign exchange market.

The Government at the time tried to mask the symptoms of the problem by imposing price controls; the exchange rate for the rupee was fixed at Rs. 200 along with the prices of many other goods. The result was scarcities – of foreign exchange and of goods which were visible in the long queues and in power cuts. As the printing continued, the Government imposed ever tighter import and price controls until eventually economic activity ground to a near halt. People were either standing in queues or sitting in the dark. Work in factories and offices stopped because of the unavailability of materials, the inability to transport staff or products and the lack of power.

To resolve this problem the only option was to allow interest rates to rise to slow the credit growth that was fuelling excess demand. A partial devaluation was initially attempted without a significant rate increase but this failed and forex shortages persisted. The corner was turned only when rates were hiked significantly and a peg re-established at 360.

As the rupee fell all prices rose. Price controls had to be removed, most importantly on energy – fuel, electricity and cooking gas to reflect the diminished value of the currency. This explains the sudden increase in prices of both goods and services.

Unfortunately while prices rose people’s incomes and savings did not. People’s living standards are measured not by their income but by what that income can procure. When the value of money falls living standards fall.

Effects of currency debasement are permanent

How is this to be reversed? The tragedy is that the effects of currency debasement are permanent. Complete reversal requires that stock money to shrink back to the level it was in 2019 – this would lead to a massive increase in interest rates; much higher than present. The consequences of this would be widespread business collapse and an economic contraction that would impose even more suffering.

What should be done? The debasement of the currency can only happen through the Central Bank. It must be prevented by rules from ever doing so again.

People mistakenly think that the Central Bank should try to keep interest rates low but the only way in which this can be done is (a) if the Government reduces its volume of borrowing, the sheer size of which puts significant upward pressure on rates or (b) if the Central Bank keeps increasing the supply money (money printing) which lowers rates. It is difficult to reduce Government spending in the short term, therefore the borrowing will have to continue. This means the only avenue to lower interest rates is money printing which ultimately impoverishes all.

The Central Bank should not engage in activist monetary policy to stimulate the economy. It must not finance the Government’s budget deficit and in its role as provider of liquidity to the banking sector it must not become a banking intermediary. Liquidity to the interbank market needs to be purely temporary, based on market rates with an added premium to prevent moral hazard. Central Bank intermediation is in some way a substitute for interbank markets and therefore the relative level of costs between the two is crucial.

If the value of the rupee holds it will allow people to try and restore what has been lost. People need to start all over again and through their own efforts try to rebuild their lives.

Second reason for increase in poverty – increase in taxes

The second reason for the increase in poverty is the increase in taxes. People who have already suffered terribly because of currency debasement now face another blow when the Government appropriates even more of their income and raises the prices of goods through sales based taxes. The Government is fixing the problems in its own finances but doing so by passing the buck on to the people.

In the short-term some increases in taxes were unavoidable because of the rigidity in Government spending – the bulk of which is salaries, pensions and interest. These must be reduced but this takes time. However there is no excuse for making no attempt to cut costs. For example, the high prices of electricity and fuel include the extra costs caused by corruption in fuel purchases, inflated power purchase costs, excess payroll and inefficiency.

Corruption and waste become relevant to the problem of impoverishment when their costs are transferred to citizens through increased taxes, higher prices and poorer quality of services provided by the Government. The use of debt and more moderate levels of money printing allowed the Government to conceal the real burden of its spending from people for decades.

The public blames the general increases in prices that result from money printing on “profiteering” by traders. Increases in debt have no immediate impact, it is only when it has to be repaid are the consequences felt at which point the lenders are blamed.

Citizens who voted repeatedly for corrupt populists have awoken from slumber as the costs of past profligacy have finally become apparent.

Ability of the Government to disguise the real burden of its activities

Because of the ability of the Government to disguise the real burden of its activities, in the context of corruption citizens need to have a singular focus on all economic activities of the Government. It is Government spending rather than taxation that ultimately determines the total burden of Government activity on the private sector. The critical question citizens must ask is how far does Government activity and spending actually improve the lives of citizens?

The IMF program is trying to reduce the Government’s deficit and debt – but the approach they have taken is to simply increase taxes rather than doing so concurrently with cutting expenditure. There seems to be unquestioned acceptance of the level of public spending, regardless of its quality or nature.

Tax morale – citizens’ willingness to pay taxes – depends on the trust they have in the Government and the quality of services they receive. In the modern world a state must earn the right to collect tax. To do so it must treat its citizens fairly. It must be responsive and seen to be addressing needs and improving services. The lack of this was evident in the protests of 2022.

The Sri Lankan State fails in the provision of the most fundamental of public goods – those that cannot be provided by private markets: the rule of law and a functioning system of justice. While some useful services are provided in health and education, quality is poor. The spending on private tuition, private schools and private healthcare is a testament to this. Corruption is rampant. For example, COPE reports show the State Pharmaceuticals Corporation has repeatedly procured substandard drugs2, dud software3 and failed to follow strictures imposed by COPE4.

Promises of jobs are a vote-winner. Elections have been won, jobs have been created but only now have the public been presented with the bill. A large proportion of taxes are in effect sustaining the patronage system that enables the election of corrupt politicians.

Voters must realise that there are no easy or painless solutions. After a crisis such as this, countries may experience ‘a lost decade’ before output reaches its pre-crisis level. Populists who promise quick solutions without proper diagnosis or are unable to locate the sources of the problem could easily tip the country back into crisis

Identify the villains in this tragedy

People need to identify clearly the villains in this tragedy; the Central Bank and mis-spending by the Government. Public outrage is justified but unless the sources of the problem; the Central Bank and Government spending are correctly identified, they may well be duped again.

That the rate of impoverishment has slowed will not satisfy the public but do they realise the fragility of this meagre achievement? Politicians are eager to promise quick and painless solutions. The electorate can expect to be subjected to “death by slogan” over the election cycle. A fairer society. End corruption. A brighter future.

Desperate people may clutch at any alternative assuming that things cannot get any worse but they are gravely mistaken. Politicians who do not grasp the problem may trigger another spiral. Criticism of the current approach is needed but people should look for politicians who offer realistic alternatives. How should voters evaluate alternatives?

To avoid another crisis it is vital to maintain monetary stability and fiscal prudence. Serious politicians must commit to both. Ambitious manifestos must be seen to translate into pragmatic programs within the fiscal constraint. The British tradition of access talks: pre-election talks between opposition politicians and civil servants helps prepare the opposition for Government. They need to decide on policy priorities and the mechanics of delivery. Those who have done their homework will demonstrate familiarity with the public finances5.

Some talk of billions in stolen assets and imply that all it takes is to recover this and all will be well. Have they examined the complexity of the legal proceedings in the recovery of stolen assets? The international record of successful of stolen asset recovery is poor. The Stolen Asset Recovery (StAR) Initiative – a partnership between the World Bank and the United Nations Office on Drugs and Crime (UNODC) has over 15 years recovered a total of around $ 1.9 billion6. The most successful has been the Philippines which recovered more than $ 1 billion over 21 years. This is a tidy sum but do those who tout this as a solution understand the gargantuan size of the Government expenditure?

Public salaries and wages cost Rs. 956.2 billion in 20227. For year of 365 days that works out to Rs. 2.62 billion per day. Subsidies cost another 1,020 billion or Rs. 2.23 billion per day. Including interest total recurrent expenditure runs at Rs. 9.64 billion a day.

The sum total recovered under the StAR over 15 years would only cover the public sector salaries for a little over seven months; total recurrent expenditure for only two. In any case can a realistic budget be built on such an uncertain stream of revenues? Can the rich pay for this all? How many billionaires and millionaires does the Government need to find to sustain spending at a rate of Rs. 9.6 billion per day?

Government spending

Government spending can create the opportunities for corruption; affecting not just the level of public expenditure, but also its composition, favouring projects that allow the collection bribes.

If the misspending in the public sector were reduced greatly then the tax burden could be reduced. Salaries and pensions for the 1.5 million employees of public sector and the 672,0008 pensioners made up 36% of recurrent spending in 2022 (interest took up 44%). This is an ongoing expense that needs to be paid. Are the citizens receiving valuable public services in return?

In 2016 there were 230,525 teachers and around 62,000 in the health service. The problem is with the million others in employment. The number in public employment stood at 812,472 in 19949 but is now estimated at 1.5 m10. Was there a proportionate increase in the quality of services that people received?

Voters must realise that there are no easy or painless solutions. After a crisis such as this, countries may experience ‘a lost decade’ before output reaches its pre-crisis level. Populists who promise quick solutions without proper diagnosis or are unable to locate the sources of the problem could easily tip the country back into crisis.

Footnotes:

1 Sri Lanka: Macroeconomic Developments in Charts, First Quarter 2023, p34 https://www.cbsl.gov.lk/sites/default/files/cbslweb_documents/statistics/mecpac/Chart_Pack_Q1_2023_e1.pdf

2 See reports: https://www.advocata.org/commentary-archives/2019/11/5/coping-with-latest-cope-report; https://www.dailymirror.lk/breaking-news/Fraud-corruption-rampant-at-SPC-GMOF/108-276243;

3 https://readme.lk/spc-has-paid-lkr-644-million-for-software-that-doesnt-work/

4 https://www.news.lk/news/political-current-affairs/item/26077-govt-agencies-failure-to-act-on-cope-recommendations

5 The Institute for Government, a think tank offers a useful guide: https://www.instituteforgovernment.org.uk/sites/default/files/2024-01/preparing-for-government.pdf

6 https://star.worldbank.org/blog/fifteen-years-star

7 Ministry of Finance Annual Report 2022, p109, https://www.treasury.gov.lk/api/file/39a16e61-7659-476b-8f18-d969c7a69733

8 https://www.parliament.lk/uploads/documents/paperspresented/1662013778004147.pdf

9 “Census Of The Public And Semi-Government Sector Employment 1994”. 1994. Statistics.Gov.Lk. http://www.

statistics.gov.lk/PublicEmployment/StaticalInformation/census_reports/CensusOfPublicAndSemiGovernmentSectorEmployment-1994FinalReport.

10 https://economynext.com/crisis-hit-sri-lanka-finally-starts-to-deal-with-bloated-public-sector-96277/

(The views expressed in this article are those of the writer and do not reflect the views of organisations he is affiliated to.)

High tariffs on basic food items: A blow to the struggling masses

By Dhananath Fernando

Originally appeared on the Morning

Last week it was reported that the Government has again imposed high tariffs (Special Commodity Levy) on some food items such as cowpea, finger millet, undu, maize, and a few others. At a time when seven million people are below the poverty line, tariffs on food items are a crime. Imposing tariffs on such food items is not done just to increase Government revenue.

The tariff on undu has increased to Rs. 300 from Rs. 200 per kg. For finger millet and other items, it has increased from Rs. 70 to Rs. 300. How much can a Government earn from a population of 22 million by imposing a Rs. 300 tariff on finger millet and cowpea?

According to the Ministry of Agriculture, the per annum demand for cowpea in Sri Lanka is 15,000 MT, while the demand for finger millet stands at 10,000 MT. Even if we import the entire demand for finger millet and cowpea, the amount the Government can earn as tariff is about Rs. 7.5 billion for the entire year.

This is a negligible amount compared to our expenditure. The expenditure for the President is about Rs. 5.8 billion as per the Budget estimate for 2024. It is clear that the increase of the Special Commodity Levy (SCL) for food items will have an impact beyond taxes, because at this tariff rate no one will import finger millet or cowpea.

However, it means that the consumer will lose the opportunity to purchase cowpea, undu, and finger millet for Rs. 300 less than what is available in the market. How can we justify people paying an additional Rs. 300 when seven million people – one-third of our country – live in poverty?

This general justification is that this tariff is imposed to protect local manufacturing of finger millet, cowpea, and maize. Even if this is true, what is the justification in terms of consumers when they no longer have access to affordable food items?

Given existing lifestyle changes, products such as undu, cowpea, and finger millet are mainly consumed not by the wealthiest section of the society but the poorest. Diabetes patients, pregnant mothers, estate workers, people in the north and east are the primary consumers of these food items.

It doesn’t stop there. High prices on maize will impact the entire food supply chain as maize is one of the main expenditures of the poultry industry. About 40% of the cost of poultry is on food, primarily driven by maize. This indicates that the cost of main protein sources such as chicken and eggs will increase.

The cost of chicken and eggs in turn impacts the costs of the bakery industry and all food items at restaurants and eateries.

Accordingly, the net impact on the entire food supply chain due to this ad hoc Special Commodity Levy is much greater than what we see at the surface level. Although it is not ideal, if the Government really wishes to protect finger millet, cowpea, and maize farmers, it can give a direct subsidy of Rs. 7.5 billion, based on the productivity and efficiency of farms.

This would mean that at least those who push for better cultivation methods receive an incentive to ensure a better harvest, rather than asking consumers to shoulder a flat price hike for all food items at a time when they are struggling to put three meals on the table per day. People are facing excessive burdens due to inflation and the high tax rate in order to pay for the mistakes of our policymakers.

The second argument against the high SCL on imported food items concerns saving foreign exchange. Firstly, we cannot save foreign exchange through higher tariffs because the demand for imports is determined by the money supply within the economy. People buy forex to import by spending the rupees they earn. When they buy forex in rupees, they have to reduce their consumption by some other means.

If we can save forex simply through higher tariffs and import controls, we have to question how we ran out of forex when import controls, in place since Covid, existed until very recently.

We even controlled some of our pharmaceutical imports but we were still unable to save forex. Foreign exchange cannot be saved by import controls or high tariffs.

Secondly, 40% of our imports is fuel. If we really want to cut down on our imports, we must reduce fuel imports, which this column has recommended multiple times, suggesting a market system for public transport. By imposing a Special Commodity Levy on food, we are simply asking the poorest of the poor to face starvation while providing the opportunity for rent-seeking behaviour of a few crony elites.

Whether in socialism or in capitalism or with the argument of saving foreign exchange, how can we justify a Special Commodity Levy of Rs. 300 on basic food items when one out of every three fellow Sri Lankans are forced to skip a meal due to poverty?

Prioritising SOE bill over OSA: A shift in economic direction

By Dhananath Fernando

Originally appeared on the Morning

While the Government has prioritised the Online Safety Act (OSA), which is extremely negative for our economy, there are other bills in the line-up which are expected to get through. One such bill is on the State-Owned Enterprise (SOE) holding company.

The SOE Restructuring Unit (SOERU) has outlined the principles of SOE reforms, which are in the right direction, but the Government’s prioritisation of bringing the OSA is definitely in the wrong direction.

Key principles

While the bill on the SOE holding company is yet to be released, the SOERU has outlined nine key principles on which they expect to base the SOE reforms. In the first principle it admits the Government has no role in commercial activities except for three instances.

(1) If there is a concern on national security, the Government can engage in business.

(2) If there will be no private participation in certain industries given the size of our market, the Government can engage in business. For instance, if we open the rural bus routes for the private sector, there may be a possibility that, given the nature of the low population density, no private bus operator will be interested in entering the market. While it can be to an extent addressed through allowing to charge a higher price and the Government providing a direct cash subsidy to the citizens in the rural area, there can be practical challenges. In that case the SOERU principals have left the space for the Government to enter business.

(3) If the service from the Government is essential in nature but if the regulatory mechanisms are weak for competition, where there is opportunity for market exploitation by the private sector, the Government can be in the business.

While the three areas are logically right, we have to wait for the final bill to see how exactly this has been worded. The danger is that governments are so powerful that even in the above three areas, it can leave a lot of room to keep a lot of existing SOEs under the government of the day if the political ideology is to keep SOEs, claiming it is under national security.

In the Right to Information (RTI) Act, there is provision that the authority can decline to disclose the requested information if it threatens national security. For most RTI requests, many Government institutions have been responding that the information cannot be disclosed due to national security reasons. Therefore, defining national security or the process of deciding how an organisation or industry comes under national security is important.

Unless the Government can always build a logical stand, even institutions like the Cashew Corporation will have to be under the Government as it can impact national security.

On the second condition, that in the absence of a private player due to limitation of the market size or another criterion for a service that is essential in nature, the guidelines have to be developed in the case of what could be a new player wanting to join the industry later.

For example, it could be an industry with high capital investment and low market penetration, making Sri Lanka unattractive at the beginning due to the market size. As a result the Government can be in that business as the service is in the nature of being essential.

But over the years as technology and other parameters develop, at one point there may be new players interested in joining the industry. At that point, a natural resistance may occur from the SOEs over a new entrant being in the market as they will lose their monopoly status. The same happened when Lanka IOC entered the market and still there is some resistance to the entrance of Sinopec and other players in the energy market.

Deciding what an essential service is also requires a framework. Otherwise, when a government wants to be in a business, it can easily announce that industry as an essential service and enter the business, bringing forth various reasons.

All of the above are beyond the scope of the SOE law, but we need to keep in mind that these are the loopholes governments always have when ideological stances are different. Even if the new bill passes, we should not underestimate the skills of policymakers in finding the loopholes.

Other principles

The fourth principle of the SOE holding company is to bring all SOEs under one registration format. At the moment, different SOEs have different structures with a very high degree of complexity. For instance, the railway is a commercial activity and runs as the ‘Railway Department,’ while the Ceylon Electric Board runs as a board under an act. Meanwhile, Lanka Hospitals is a hospital but operates as a private limited company. Therefore bringing them all under one registration is vital when we set up the SOE holding company.

The fifth principle mainly focuses on the governance of SOEs as the SOE reform process is a longhaul game. The SOE holding company and the subsidiaries are required to adhere to Colombo Stock Exchange guidelines. This includes releasing quarterly financial statements and the board of directors being required to conform to the Code of Best Practice on Corporate Governance.

The other principles in the list are on unbundling the regulator and the operator in certain industries. There are industries run by the Government where the Government is a player as well as a regulator at the same time.

Overall the SOERU’s principles to base the SOE holding company is in the right direction, although there is always room for politicians to exploit the principles.

It is sad to see the pushing back of such important SOE holding company legislation over the draconian Online Safety Act.

Housing affordability in Sri Lanka: The looming crisis and need for multifaceted approach

By Advocata Institute

Originally appeared on the Daily FT

Sri Lanka is at a crossroads, confronting with a mounting crisis in housing affordability that demands immediate and comprehensive attention. The complexity of this challenge is underscored by the stark disparities between the escalating housing demand and the sluggish pace of housing supply growth. Data derived from the 2012 Census of Population and Housing Survey paints a stark reality: housing demand has surged by 11.9%, reaching 5,875,009 units from 2012 to 2022. In contrast, housing supply has lagged, with an increase of only 9.5% to 5,685,151 units. This glaring gap which is approximately 3.23% of housing units (189,858) raises a red flag, necessitating urgent and effective policy interventions.

Delving deeper into the district-wise dynamics exposes the severity of the issue. Colombo, as a critical urban hub, experienced a 10% surge in housing demand, reaching 635,385 units in 2022. However, the corresponding supply increase was a mere 7.4%, resulting in a substantial shortfall of approximately 26,978 units. This scarcity not only exerts upward pressure on house prices but fundamentally challenges the broader affordability of housing, impacting citizens across various socioeconomic strata.

Challenges

At the heart of this crisis lies a multifaceted challenge. Urbanisation, population growth, and evolving societal needs have outpaced the pace at which housing supply is expanding. A legacy of historical housing policies, coupled with limited private sector participation, has left the Government shouldering the bulk of responsibility. The absence of a robust regulatory framework and streamlined approval processes further impedes the swift execution of housing projects. This perfect storm of factors has led to a housing deficit that reverberates across the nation.

To this, in the housing landscape in Sri Lanka, a disconcerting reality emerges from the statistics. Out of the 6,094,115 families, a fraction grapples with precarious living conditions, with 0.73% residing in cadjan/palmyrah houses, 4.56% in temporary structures, and 6.35% inhabiting partly constructed houses. The prevalence of households not yet plastered stands at 13.79%, while 7.25% have roofs consisting of galvanised sheets. Alarmingly, 3.55% represent homeless-landless families, and 0.49% temporarily dwell in quarters for job requirements. Another 2.74% of families are categorised as homeless yet possess a block of land, and 1.31% are temporarily living on rent while maintaining a permanent residence elsewhere. Additionally, 8.39% face challenges with proper water supply, 2.97% lack adequate access to roads, 3.19% lack proper sanitation facilities, and 2.74% are without electricity. These realities underscore the multifaceted challenges faced by a significant portion of the population in securing decent and dignified housing.

Housing demand, a pivotal component, is linked to demographic trends, housing finance accessibility and cost, and Government policies encompassing taxation and subsidies. The precarious nature of property rights, particularly insecure tenure, has the potential to hinder investments in housing. Conversely, housing supply is contingent upon factors such as land availability, robust infrastructure, construction material costs, and market efficiency. The interplay of consumer, producer, and Government behaviour further shapes the delicate equilibrium of demand and supply in the housing sector. Government policies, notably those governing land use and building regulations, wield significant influence over housing construction, subsequently impacting the supply of affordable housing.

Multifaceted approach

To navigate this housing affordability crisis, a multifaceted approach is imperative. Reforming housing policies is imperative for the Government, necessitating an alignment with contemporary needs and fostering adaptability to evolving trends. Priority should be given to strategic reforms that emphasise affordable housing development in both urban and rural areas. Facilitating collaboration between the public and private sectors emerges as a key solution to bridge the housing gap. Incentivising private developers to partake in affordable housing projects, coupled with supportive measures like infrastructure and regulatory facilitation, can yield significant positive outcomes. A pivotal aspect involves strengthening the role and capacity of the National Housing Development Authority (NHDA). This entails regular leadership by the NHDA in conducting comprehensive housing needs assessments that encompass qualitative dimensions. Securing adequate funding, autonomy, and an unwavering commitment to improving living standards within NHDA are indispensable components of this multifaceted strategy.

Housing affordability is not just an economic metric; it's a barometer of societal well-being. A secure, affordable home is the bedrock upon which individuals build their lives. It impacts education, healthcare, and overall community prosperity. Failure to address this crisis risks leaving a lasting scar on the nation's social fabric.

The absence of a cohesive, long-term housing policy focused on low-income housing has significantly contributed to the limited construction of affordable houses. Historically, the Government's housing initiatives, especially in the past two decades, primarily aimed at clearing slums for land development rather than addressing affordable housing concerns directly (The World Bank 2012). Resolving housing policy issues is crucial, and it's equally vital to address market failures in land, building materials, and the construction industry to enhance housing affordability (World Bank 1993).

To enhance the business environment, the Government should transition from being the sole provider of housing to creating a legislative, administrative, and policy framework that fosters a competitive market. Direct Government involvement in construction, coupled with regulatory roles, may lead to conflicts of interest. Instead, policies should incentivise private entities to engage in affordable housing construction. This involves eliminating protectionist measures like import tariffs, para-tariffs, and addressing concentration issues in building materials industries.

Addressing institutional failures is paramount. Multiple agencies with overlapping functions create bottlenecks, hindering policy development and project execution for adequate and affordable housing. Streamlining these agencies, ensuring coordination, and establishing a robust regulatory framework are necessary. Regulatory issues, such as land availability and titling problems, are major barriers. Unlocking Government-owned land for housing projects, improving titling processes, and digitizing land registries can facilitate development and clear ownership, enabling better access to finance.

Provision of infrastructure and support services is crucial. Government investment in public services like water, sanitation, and public transportation can unlock regions for housing development. Improving the efficiency and productivity of the construction industry, potentially through standardised housing units and prefabrication, would significantly reduce construction costs.

Reducing the cost of borrowing and enhancing financing options for low-income households is a challenge. Mortgage guarantees, encouragement for banks to access low-cost wholesale funding, and addressing issues related to land titling and borrower risk can enhance access to affordable financing. Additionally, focusing on the underdeveloped incremental housing finance market can cater to the unique needs of low-income households.

Improving data availability is essential for effective planning. Establishing a centralized mechanism to collect, analyse, and disseminate recent housing data is crucial for long-term planning and achieving sector and economic objectives. Conducting regular surveys and censuses will provide up-to-date insights into the state of the housing sector in Sri Lanka.

In conclusion, addressing these multifaceted challenges requires a holistic and well-coordinated approach involving comprehensive policy reforms, market enhancements, and improvements in data collection and analysis mechanisms.

Middle class caught in housing dilemma

By Dhananath Fernando

Originally appeared on the Morning

The system in Sri Lanka often categorises many individuals in the middle class as products of failure, not because they have failed themselves, but because the system has failed them. An evident sign of this failure emerges when individuals strive to afford a house, as the decision to build or buy a basic house in Sri Lanka frequently forces them to sacrifice many other life choices due to the exorbitant cost of construction.

Dr. Roshan Perera and Dr. Malathy Knight of the Advocata Institute recently authored a research report revealing that property prices in Colombo exceed the same income-to-property ratio found in New York, Tokyo, Beijing, and London.

The exorbitant cost of construction primarily stems from the steep prices of raw materials in Sri Lanka. For instance, a tonne of cement costs about $ 114 in Sri Lanka, compared to $ 53 in Thailand. Similarly, the cost of a tonne of steel in Sri Lanka is around $ 760, in contrast to $ 561 in Singapore.

Factors behind high costs

Two main factors force consumers to pay higher prices. First, Sri Lankans encounter restricted access to construction materials at lower prices due to import restrictions or tariff barriers, even when Free Trade Agreements (FTAs) are in place, as most construction items remain on the negative list. A negative list refers to an exclusion clause in an FTA that prevents an item from being imported.

Second, the high tariffs or import protection for construction materials are often justified under the narrative of ‘saving dollars’ or ‘preserving valuable foreign exchange’. However, the truth lies in the high cost structures of local manufacturers, making them unable to compete if import bans or tariffs are reduced.

For example, the total tariffs on tiles were approximately 83% in 2021, with para-tariffs such as CESS and PAL making up about 50%. High energy prices in Sri Lanka contribute to the high costs for local companies, and importing tiles may actually reduce foreign exchange expenditure due to energy savings.

Far-reaching impact

The high cost of construction for the middle class results in sacrificing many life choices, including higher education, education for children, investments, and wealth creation. This challenge becomes even more pronounced when faced with an interest rate of 10% for housing loans or business expansion.

The impact of the high cost of construction extends beyond housing to the tourism sector. Hotels require refurbishment approximately every five years to remain competitive, and with high construction costs, room rates tend to be high. This puts a strain on hoteliers, including small and medium-scale hotels, making them less competitive with markets like Thailand or the Maldives.

According to research, a 500 sq ft house can only be affordable for Sri Lankans in the 70th income percentile, while a 1,000 sq ft house is attainable only for those in the 75th income percentile, highlighting the underlying tragedy of the high cost of construction. Many construction inputs in the market exhibit characteristics of monopolies or oligopolies.

The solution to reduce construction costs involves first removing construction materials from the negative list and eliminating imposed para-tariffs. This competitive market approach will lead to lower prices, benefiting consumers. As a result, aspirational Sri Lankans will have more space in life for better choices, rather than spending their entire lives paying off housing loans. When the middle class has more choices in life, their decisions become a source of income for many other industries, fostering economic growth.

Economic freedom for true independence

By Dhananath Fernando

Originally appeared on the Morning

For the last 76 years, we Sri Lankans have looked at different ways of making Sri Lanka a wealthier and developed country. A popular refrain during every Independence Day celebration week has been that “when we got independence, we were only second to Japan”. Another quote bragged about how good we were, as “Singapore was behind us and they took Sri Lanka as their model for development”. 

Unfortunately, much of Sri Lanka’s independence has only been ceremonial, not real. We have still failed to capture the science of equitable wealth creation, which only comes with economic freedom. Economic freedom leads to true and meaningful independence. All countries in the region, including Singapore and Japan, overtook us by establishing the elements of economic freedom at various degrees rather than simply taking Sri Lanka as an example.  

Science of wealth creation 

Wealth creation is science, not magic. It has always been a function of maximising the use of limited resources and increasing productivity. Both can be done when individuals have better incentives to create wealth. For individuals to create wealth, their rights over property have to be secure. The government should ensure that the property of people belongs to them. 

The government should allow individuals to do business and create wealth instead of trying to intervene in markets and pricing. Further, a government poking its fingers in and preferential treatments in a sector serve to discourage individuals from being in the same business. 

Wealth can also be created when raw materials are competitive in price and good in quality. Having a variety of choices in a competitive market system is paramount. The simplest way of creating a competitive environment is by opening up for international trade. 

Regulatory barriers have to be minimal. This does not mean the government plays no part in regulation. The government can adopt a regulatory function without intervening in the market to ensure that the competition and competitive nature of the industries are protected. 

Lastly, all transactions in the modern world take place in a fiat currency. Simply put, we store all our production as individuals in a form of a paper called money. The monopoly of money belongs to the government and when it does not protect the value of the money, it amounts to theft of the hard work and production of an individual. 

The science of wealth creation is simply establishing these five principles. This has been statistically proven by the Economic Freedom of the World Index by the Fraser Institute. 

Over the decades, it has monitored these five indicators and data have shown the relationship and causation between wealth creation. 

The per capita GDP of countries with the highest level of economic freedom is on average about $ 48,000 while for countries with the lowest level of economic freedom the per capita GDP averages at $ 6,300. 

Even if we consider the standard of living amongst the poorest 10% of the population in the countries with higher economic freedom, the income distribution among the poorest 10% is eight times higher than in countries with very low economic freedom. 

Sri Lanka falls under the third quartile, meaning that our performance in economic freedom is not that great. We have ranked 116 out of 165 countries. 

Science of economic freedom

In modern times, many people consider happiness as a function of wealth, freedom, and independence. When we look at the data on economic freedom, it is clear that countries with higher ratings indicate a higher score on the UN World Happiness Index as well. 

Even if we look at poverty numbers, the countries with higher economic freedom obviously have low poverty rates compared to countries with low economic freedom. 

Over the last 76 years, the science of economic freedom is something we have failed to utilise. One reason this column has always advocated for reforms of State-Owned Enterprises (SOEs) is because a limited government improves the economic freedom of people, which leads to creating wealth. People having ownership and rights over land is another reform we require to improve the property rights indicated in economic freedom, which will also lead the process of wealth creation.   

On this independence day, our prime focus has to be on creating wealth. We can create wealth by establishing economic freedom. When we have wealth and economic freedom, we become independent. That is when we leave the trap of poverty, our standards of living improve, and we provide value for the globe. 

Happy Independence Day, Sri Lanka.

The dangers of the Online Safety Bill

By Dhananath Fernando

Originally appeared on the Morning

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

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

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

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

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

Self-censorship kills ideas for prosperity 

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

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

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

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

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

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

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

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

Impact on SMEs

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

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

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

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

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

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

Wrong signals to markets 

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

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

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

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