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.

Feasibility of estimating economic recovery via LKR appreciation, CSE performance

Originally appeared on The Morning

By Dhananath Fernando

Sri Lankans base their assessment of the economy’s performance on two crucial factors. One is on the operations of the Colombo Stock Exchange (CSE) and the other is on the exchange rate – the appreciation or depreciation of the LKR to the USD.

However, neither are the right indicators to measure the performance of the economy. The companies listed on the CSE are insignificant compared to the number of business establishments in Sri Lanka.

Around 99% of the business establishments in Sri Lanka are Micro, Small, and Medium Enterprises (MSMEs) but they are not listed on the CSE. However, the MSME sector accounts for 75% of all employment. Large firms are responsible only for 25% of all employment, but not all large corporations are listed on the CSE.

For instance, MAS Holdings, which is one of Sri Lanka’s leading apparel manufacturers and employers in the sector, is not on the CSE. Moreover, just before the economic downturn in Sri Lanka, there was a bull run at the CSE. A performing economy is measured through the reduction of poverty and when the populace contributes to solving an economic problem.

The second popular measure to assess economic performance is the exchange rate. Recently, with the appreciation of the LKR, there is a sentiment that the economy is recovering. Previously, when the LKR was depreciating, the perception was that the economy was not doing so well.

Appreciation or depreciation of a currency has its own consequences, but connecting the exchange rate to performance of the entire economy is definitely not the right way to look at things.

There were few reasons behind the recent appreciation of the LKR. Nevertheless, the exchange rate is simply the price we pay to buy USD. Like for many other commodities and services, the price of USD is determined through demand and supply. Suppliers of USD are mainly exporters, service exporters, remittances, foreign grants, and tourism. Main buyers are importers, the Central Bank, service importers, etc.

If you are wondering how the Central Bank becomes a buyer of USD, that is one way reserves are built. Until the last week of February, the Central Bank had a direction for all commercial banks to surrender 25% of their USD flows from exporters. That limit has now been reduced to 15%, which means that banks will have an additional 10% of USD than they did before, so the availability of USD in the market is slightly higher. Further, over the last few months, the Central Bank has been the main buyer of USD/forex and as a result our reserve levels have improved slightly.

The International Finance Corporation (IFC) also approved a $ 400 million facility to support Sri Lanka to purchase essential items, so the inflows to the market are likely to increase. As a result of high supply and constant demand, the exchange rate has come down slightly.

Another reason is that the Central Bank increased the middle spot rate for banks to Rs. 5 from Rs. 2.50 last week. In simpler terms, previously, the Central Bank had provided a direction on the price of the USD. It is similar to a price control but slightly more flexible. As a result, banks can now provide better rates so that forex sellers are willing to supply.

As the economy contracted by 7.1% in the first nine months of 2022 and the World Bank projects a further 4.2% contraction for 2023, demand for imports has been low. On top of this, most imports are restricted. Additionally, tourism is slowly picking up and with many Sri Lankans migrating for work, it helps to recover remittances to an extent.

We need to realise that none of the above changes are reforms. They are just dynamics in the market. These little fluctuations are not an indication to measure whether we are moving in the right direction.

Reforms mean establishing a dynamic market and creating a suitable environment as soon as possible given the gravity of our crisis. When reforms are implemented, the exchange rate will become predictable rather than subject to speculation.

Reforms involve systems design and thinking, so that the system works even when a new person takes over. It is important not to mix up market changes and reforms. Markets will always fluctuate based on the availability and scarcity of resources, but reforms are about creating an environment for markets to work. Even the forex market optimises the use of resources.

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

Is a Currency Board solution to depreciating rupee?

Originally appeared on Daily News

By Ravi Ratnasabapathy

Sri Lanka’s rupee depreciated rapidly over the last month. The Government has claimed the problem is mainly due to global pressures and has reacted with a series of import restrictions on vehicles, consumer durables and perfumes. Bankers report that similar controls were imposed in 2009 during another episode of devaluation.

Currency instability has been a recurring phenomenon in Sri Lanka.Money is the medium of exchange, and a sound, widely accepted currency promotes trade. Trade was vital to ancient Rome which introduced a uniform currency throughout their empire. Historically, the use of money arose due to the inconveniences of barter. Money serves three fundamental purposes:

1. It is the medium of exchange: Money is used for trading goods and services. In the absence of money trade could only take place through the cumbersome process of barter.

2. Unit of account: Money is the common standard for measuring relative worth of goods and services.

3. Store of value: It is the means by which wealth is stored. Without money people would need to store their wealth as goods, which is cumbersome and expensive.

Money oils the wheels of trade; it is obvious that it performs its functions best when its value is stable. If the value of money fluctuates widely it undermines it’s fundamental purpose. A simplistic example drives this point home.

Imagine being contacted by a broker about a 2,500-square-foot house, only to visit and find a house half the size. The prospective buyer would have very little trust in the broker. This is purely hypothetical given that a foot is a foot. Since its definition is unchanging, 2,500 square feet means the same today as it did 20 years ago.

Whatever the level of trust buyers have in their brokers, square footage will never be a factor; that is, unless the length of the foot is allowed to “float,” and its length declines. Suddenly, 2,500 square feet could very well mean 1,500 square feet in real terms, and trust in brokers will plummet.

This illustrates the effect of an unstable currency. Sound money has underpinned the growth of Singapore and Hong Kong. What lessons do these hold for Sri Lanka?

Hong Kong has a Currency Board, which means all currency issued in the territory must be at least 100 per cent backed by foreign reserves. Singapore’s monetary policy, although no longer a fixed board (which it once was) retains the key characteristics of a currency board. A currency board is similar to a fully backed gold standard.

As the currency is fully backed by hard reserves it is freely convertible and immune from depreciation. The exchange rate can remain fixed but in practice many countries that run currency board arrangements allow a small fluctuation in the exchange rate to reflect trading conditions. The exchange rate may also be revised periodically, to ensure it remains consistent with the underlying fundamentals of the economy; which is what Singapore does.

The currency board guarantees the convertibility between the local currency and foreign currency at the foreign exchange rate in the currency board system. The local currency is linked with the foreign currency by the guarantee of convertibility and the fixed exchange rate. Therefore, the confidence in the local currency is linked with that in the foreign currency by the currency board arrangement, and the local currency acquires the properties of the foreign currency with respect to the basic functions of the money.

The Currency Board cannot create money, except when actual reserves are available nor can it lend money to the Government, usually described as printing money (or, euphemistically, quantitative easing).

Since the Government cannot borrow from the Central Bank (a source of ‘easy’ money) it must rely on taxes or debt to finance spending, which imposes a degree of fiscal discipline. This in turn results in low inflation. As the money supply also changes only with movements in reserves, interest rates remain fairly stable and are generally low.

Currency board systems assure convertibility, instill macroeconomic discipline limiting budget deficits and inflation, provide a mechanism that guarantees adjustment of balance-of-payments deficits, and thus create confidence in the country’s monetary system,

In other words; the perfect way to impose discipline when grappling with difficult financial problems.

For this reason Currency Boards were adopted in several East European countries when transitioning from Communism. The transition from communism caused severe monetary shocks in Eastern Europe. To manage the transition several countries including Estonia, Lithuania and Bulgaria implemented currency boards with great success; inflation declined and economic growth picked up.

IMF studies show that historically, countries with currency board arrangements have experienced lower inflation and higher growth than those with other regimes. The lower level of inflation is explained partly by the greater monetary discipline imposed but also by the greater level of confidence engendered by adopting the Board.

Note that a Board is not a simple exchange rate peg (which is what Sri Lanka had pre-1977) the requirement for the currency to be fully “backed” by reserves, the restriction on lending to the state and a long-term commitment to the system usually enshrined in law are crucial differences that underwrite the stability of the currency.

To date no currency board has had to be abandoned as a result of a crisis. The Asian currency crises of 1997 provided a severe test: all currencies of SE Asia depreciated rapidly except those of Hong Kong and Singapore. The worst affected was the Indonesian rupiah which dropped from $1=Rp2,400 to $1=Rp14,500, the Thai Bhat fell more than 50% and the currencies of South Korea, the Philippines and Malaysia were all battered.

Alone amongst its neighbours, the Hong Kong Dollar was unaffected, despite repeated speculative attacks. Although Singapore allowed its currency to depreciate by around 20%, to adjust to the relative weakness of its trading partners during the crisis, it was a matter of choice by policy makers rather than an event forced on them by circumstances.

Currency boards were once the norm. Invented by the British they provided the stability that allowed foreign trade to flourish throughout the Empire. With the decline of the Empire the boards were gradually dismantled by the newly independent states, except in a few places such as Singapore and Hong Kong.

Adopting a Currency Board would address Sri Lanka chronic currency problems and provide the platform for long term growth.