Becoming the victim of one’s own policies

Originally appeared on The Morning.

By Dhananath Fernando

At a recent press conference, the Central Bank of Sri Lanka (CBSL) announced that importing goods through open accounts was going to be banned as a move to curb the money transfer through undiyal and hawala. In my view, this will have a negative impact on the supply of essential food items, drugs, and some raw materials. 

When a merchant imports goods, they can pay their supplier through a letter of credit. A letter of credit is simply a letter of guarantee by a bank or a financial institution to the supplier/seller that the correct amount will be paid in full on time. To open a letter of credit, the Sri Lankan importers should be able to buy foreign exchange or simply purchase US Dollars. But as we are all aware, all Sri Lankan banks have a drastic shortage of foreign exchange. The shortage is of such severity that we can’t import essentials, and in some cases even life saving drugs. 

In the case of imports, if the buyer and the seller have mutual trust, a letter of credit is not mandatory. They can settle on a credit basis later on. The goods will be cleared on Documents against Payments (DP) or Documents against Acceptance (DA). Most importers and their buyers/suppliers have long-standing business relationships. They pay later either through different modes including hawala and undiyal. This is no secret. They pay an additional charge for hawala and undiyal to buy USD for a reason, which is simply that our banks don’t have sufficient dollars to facilitate imports even if the importer requests the opening of a letter of credit. Otherwise, no businessman would want to pay a higher price for forex if there were cheaper options available. Especially in the areas of food, medicine, essentials, and raw materials, these open account transactions are common. According to a recent news report, approximately $ 1.6-1.8 billion worth of transactions are done on open accounts every month. 

So what could happen when the Central Bank forces these importers to conduct transactions only through letters of credit? Simply put, they may not have any option other than to stop importing. Because banks don’t have USD, they can’t even import on open accounts to settle later. The Central Bank expects more USD to flow into formal channels since the demand for USD through undiyal and hawala is set to decline with the new regulation banning open accounts. Even if the Central Bank’s assumption is right, it won’t happen overnight. Given the uncertainty, importers will either hold or slow down the imports to observe the situation. It will take a few months to settle even if all USD inflows started flowing through official channels. What would happen to our essential food items, certain raw materials for businesses, and drugs during those long months? 

However, so far the Gazette notification has not been issued by the Central Bank, and we have to wait and observe the situation in the next few months.

It is not the first time the Central Bank has burnt its fingers by unnecessary attempts to control the market. 

First, the Central Bank imposed a 100% cash margin requirement on vehicle imports in 2018 and later vehicle importation was banned completely (1).

Later, the Central Bank’s 100% cash margin requirement on selected imports categorised as non-essentials was extended from vehicles to many other imports (2). This column questioned how an officer decides what is essential and what is not essential. A digital camera may not be considered an essential by a writer or a banker, but a camera is an essential to a wedding photographer whose livelihood depends on it. 

Then, the Central Bank stopped the forward purchasing market and only provided space to open letters of credit with a 180-day limit. 

It was then decided to artificially keep the currency at Rs. 200 per USD, and the undiyal and hawala market expanded dramatically.

All the main Key Performance Indicators (KPI) of the Central Bank have been eroded drastically during the same period in which these controls were imposed. Our inflation has increased to 29.8% and our food inflation has increased to almost 50%. Our currency has depreciated by more than 75% in a matter of a few months. Simply put, our Central Bank has fallen far short on all its key indicators regardless of back-to-back controls and interventions. Many new theories employed by CBSL economists, including Modern Monetary Theory, have backfired spectacularly and unfortunately it is the poor people who have to pay the ultimate price in hunger and inconvenience for the grave mistakes of the Central Bank and the Monetary Board.  

As a remedial action to these mistakes, our Central Bank has now made an attempt to ban open accounts and cripple the undiyal and hawala systems. 

In my humble opinion, this may potentially create shortages of essentials and inconvenience the traders and importers who have been supplying the essentials at a higher price. These merchants have been bearing the higher cost of the informal markets boosted by the Central Bank due to mistakes beyond their control made by policymakers. 

We have to first ask ourselves why an importer should bear a higher price on USD to import. Without fixing our monetary policy, there is no point passing the blame to the hawala and undiyal markets. They have existed for centuries in Sri Lanka and around the world because of their competitive and evolving nature. The buck stops with policymakers, and not with merchants or foriegn currency middlemen.

Quite frankly, it will accomplish very little to close the stable door after the horse has already bolted.  

References:

• https://www.cbsl.gov.lk/en/node/4093

• https://www.cbsl.gov.lk/en/news/margin-deposit-requirement-of-importation-under-letter-of-credit
  

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.

Walking the talk on reforms: First step to Lankan recovery

Originally appeared on The Morning.

By Dhananath Fernando

Often we all see the world the way we want to see it, and not as it is. Sri Lanka’s economic crisis is also seen by many people through their own perception of reality. 

In previous years, we believed that self-sufficiency, State-led industrialisation, State-centred economic planning, and more recently, Modern Monetary Theory, were the way forward for our economy. The current crisis has shown that none of that has really helped us; by contrast, it has exacerbated a poor situation to where we are today.  

Next comes the question of overcoming the crisis. This has to be analysed with context; the most significant piece of context is that we are facing the worst situation we’ve been in since independence in 1948 – and it is only getting worse. 

There are some suggestions to increase industrialisation, improve exports and the trade balance, and incentivise Foriegn Direct Investments (FDIs). However, it is of no use to have lofty goals of industrialisation when we can hardly provide an uninterrupted electricity supply. 

Foreign investors are planning to leave. Investors are by no means considering entering the country. Thus, potential solutions have to be evaluated based on this context. Simply having a wishlist of suggestions with minimal viability will add very little value at this juncture. We need rational solutions to solve the crisis immediately, rather than policies that can only be enacted in times of relative normalcy. 

The Government needs to bring its finances into a sustainable state. Revenue must increase and expenditure should be reduced. Reducing the losses of State enterprises is a way to reduce the deficit without touching social expenditure.

With that in mind, here are a few suggestions for reform:

1. Privatise SriLankan Airlines

At a time when people are struggling to feed their families and when our official usable reserves are less than $ 200 million, there are very few upsides to running a fully State-owned airline making losses equivalent to the value of our entire Samurdhi scheme, which, despite its flaws, is the main social safety net in Sri Lanka. Privatisation will provide strong signals that we are serious about reforms. 

For the last 15 years, we have not made any profits on SriLankan Airlines. We can disclose all finances and ask for interested companies to buy it outright with assets and liabilities. Having a higher liability than assets is the main problem in this instance. With the suspension of debt repayment of State enterprises, Treasury guarantees for the State are on hold at the moment. 

Even if we need to pay a certain amount to the buyer to take it off our hands and sell it off with staff, it is much better than keeping the enterprise in-house and incurring colossal losses repeatedly. The new buyer can be given the responsibility of staff restructuring. We can follow the playbook through which Air India was sold outright by the Modi Government. Our airline is unfortunately no longer an asset but a liability to our national coffers. 

However, it is not only the National Airline that makes losses. There are many institutes that add little value to the public, make massive losses, and are a very high burden on the Treasury. Some of these public enterprises are classified as ‘strategic’ and others as ‘non-strategic,’ but two things they have in common is that, more often than not, they make substantial losses and have very limited transparency. 

There were some discussions to revive Sri Lankan Airlines by appointing business leaders with a profit motive, converting it to a budget airline, and appointing committees to reform and restructure. We have run out of time to even attempt these options. Unfortunately, hard times require hard decisions and we do not have the time, money, or options to avoid them. 

With interest rates and Treasury bill interest rates reaching above 20%, running loss-making enterprises on borrowed money will make our local debt increasingly unstable the more we delay reforms. Most importantly, we don’t need to wait for pressure from creditors or the International Monetary Fund (IMF) to kickstart reforms; we can begin them now.

2. Better utilisation of idle assets

Improving service efficiency and increasing revenue of railways through Public-Private Partnerships (PPP) have to be the way forward for better utilisation of idle assets. 

Sri Lanka Railways is categorised as a department of the Government, even though it is actually a State-Owned Enterprise. Sri Lanka Railways holds a considerable amount of State land which is used very unproductively. 

Fort Railway Station, Maradana Railway Station, and the surrounding land along the track between these two stations are prime examples. Major railway stations such as Kollupitiya, Wellawatte, and Bambalapitiya are all prime beachfront properties which are very poorly maintained and completely underutilised. Land prices in Colombo are extremely high. There are plenty of such examples under the Railways Department with zero or negative value addition to our economy. Sri Lanka Railways first has to be made a State-Owned Enterprise, and then the sector needs to be opened for private sector investment. 

In the past, some train compartments were operated by private players and it was a very successful and lucrative business model. If we eliminate the State railway monopoly and open up the time table, tracks, and properties to the private sector, we can cut down on our fuel consumption significantly, provide a convenient service to passengers, and even turn a loss-making liability into a revenue-generating asset.

Given the very high energy prices at present – which are only set to increase – many people need the option of efficient and robust public transit infrastructure. In any case, the majority of people in Sri Lanka cannot afford to purchase and operate personal vehicles, and trains have been the main source of transportation in areas where they are available.

It is also of paramount importance that the most vulnerable segments of the population benefit from a rehauled cash transfer system, which should cover the energy price component in public transport. Everyone, regardless of their socio-economic stratification, should be given a fair chance to compete in life. 

However, it should be emphasised that these two steps alone will not help overcome the crisis. However, it is a good start to get the wheels rolling on reforms. These reforms will provide an unambiguous signal to investors and the world that we are no longer a NATO (No Action, Talk Only) nation, but a nation that walks the talk.

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.

How protectionism killed Sri Lankan industry

Originally appeared on The Morning.

By Dhananath Fernando

Sri Lanka’s economic crisis was probably a crisis which was analysed (indeed over-analysed) and predicted from an early stage, but we failed to avoid it. We all knew that it was coming and therefore remedies were presented much earlier, but our policymakers simply turned a blind eye. They didn’t have the courage to face reality. Instead, they thought that wishful thinking would save Sri Lanka from the current crisis, and today, we have hit rock bottom. Unfortunately, we are just at the beginning of the crisis and have not even reached the recovery phase.  

It is important to reiterate that self-sufficiency, Modern Monetary Theory, industrial policy, protectionism, and import substitution failed yet again, and this time brought our people down on their knees. While we look towards solutions, we must also understand that it is not easy to rebuild an economy once it collapses. Recovery takes time, and recovery can only happen with the right set of policies.

There is one school of thought that argues that the lack of industrialisation is the reason for Sri Lanka’s balance of payments crisis. The main argument is that if we produced more to export, we would have had more USD revenue and this crisis would not have taken place. So the argument again comes back to import substitution, which involves banning imports or imposing higher tariffs on imports in order to produce locally. The argument is that this can save import expenditure while local manufacturing can scale up in order to focus on exports and bring export revenue. In the same theory, it is recommended that the government picks up which industries should be supported and which industries should not. This is simply going back to the same theory of the central planning model where a few officers decide which industries are good and which are bad. Often quoted examples for this are Japan, South Korea, and Vietnam. So today, let’s evaluate the strategy of industrialisation based on market principles. 

In simple terms, you become a good sailor by facing rough waters. Similarly the government selecting which industries to support and which industries to avoid will have consequences for all industries. Industrialisation should take place in a market system that optimally allocates all the available resources. If the government intervenes to assist one industry, it will have a knock-on effect on all other industries. Japan is indeed a classic example. The high-powered Japanese Ministry of Trade and Industry (MITI) recommended that Toyoda not produce cars. But he ignored their advice and today no explanations are required on Toyota’s success and competitiveness. In fact, in our apparel industry, big companies follow Toyoda’s example in the lean manufacturing techniques they pioneered. Rather than providing government support, price controls imposed by the Japanese Government impacted the automobile industry. So government intervention in the markets and industries is a sure recipe for failure. 

In Sri Lanka’s case, industries such as wall tiles, floor tiles, steel, aluminium, bathware, shoes, confectionery, and many others have been protected for decades. Have they become globally competitive due to protectionism and import substitution? In fact, import substitution is the worst we can do to develop exports because it creates an incentive to only produce for the local markets and discourages producers from producing for the global market given the tariff and non-tariff protection. Do our rubber, seafood, apparel, and electronic chips industries require any protection for them to be globally competitive? The simple answer is: no.  

In cricket terms, we can’t create a world class batsman by asking the bowlers to bowl loose deliveries. We can’t create a good bowler by asking the batsman to go soft on bowlers. Only in a competitive environment are heroes created. The protection is a sure way of killing the heroes and robbing poor consumers and exporters simultaneously. That is exactly what we have been doing for the last few decades. 

No export promotion can be done through import substitution; in fact, import substitution is killing our export potential. When the exporters have to pay more than 40% higher for construction materials, it is impossible for even our best performing exports to be competitive in global markets. 

If we observe the trade data, it is clear that our imports and exports are both declining as a percentage of GDP. In 2009, Sri Lanka had nine import taxes in addition to standard customs duties, and five of them are ‘para-tariffs’. Between 2004-2009, our total nominal protection doubled from 13.4% to 27.9%. Higher protectionism also indicates our continuous drop in both imports and exports.

Things got worse over time. The average effective rate of protection for manufacturing production increased from 47% to 63% from 2000 to 2015, and production for the domestic market was over 70% more profitable compared to production for exporting (World Bank, 2005; DCS, 2018). 

Accordingly, industrial policy and import substitution are contributory factors to where we are today with low exports and low productivity in the economy. 

In the history of industrialisation there are certain instances where some countries protected local industries, but in the success stories, protection had been given for a specified, strict time period or output and had a price-based structure.

Countries such as South Korea and Vietnam too became competitive not through import substitution but by allowing the markets to work. In a paper authored by Advocata Advisor Prof. Premachandra Athukorala, he quotes General Park Chung-Hee, who is considered the father of the Korean economic miracle: 

“The economic planning or long-range development programme must not be allowed to stifle creativity or spontaneity of private enterprises. We should utilise to the maximum extent the merit usually introduced by the price mechanism of free competition, thus avoiding the possible damages accompanying a monopoly system. There can be and will be no economic planning for the sake of planning itself.”

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.