Shaping Sri Lanka’s growth narrative

Originally appeared on The Morning

By Dhananath Fernando

Securing the second tranche from the International Monetary Fund (IMF) is an important step, especially to support our ability to successfully carry out the debt restructuring process. It is not just about the $ 330 million that this tranche brings; it is about the credibility it gives to the reform process and the confidence it instils in the international community, including bilateral and multilateral creditors. 

The moment we deviate from the IMF programme and allow our debt to remain unsustainable, we risk regressing to square one. However, we should not get our aims and priorities mixed up. Our aim is not to secure IMF tranches. We need to prioritise achieving deep and meaningful reforms. The IMF tranche will follow as a result. 

Ultimately, our goal should be to ensure that, in the future, we never find ourselves in a position where we need to turn to the IMF for assistance.

As this column has discussed many times, it is essential to recognise that the IMF can only stabilise the economy and facilitate credit access, which is a crucial element in our debt restructuring process. The responsibility to clear out the roadblocks that stand in the way of economic growth rests solely on our shoulders. We have to carry out reforms that go beyond the scope of the IMF programme. 

Three key reforms aiming to boost economic growth will be discussed below.

Reforms to attract more tourists 

Focusing on tourism can significantly contribute to the country’s economic recovery. In addition to bringing in foreign exchange, their spending in domestic markets contributes significantly to Government revenue through VAT. Instead of fixating on the number of inbound tourists, our focus should be on the number of nights a tourist stays in the hotel/country. Simplifying the entry process will attract more tourists, and more importantly, entice them to prolong their stay. 

In line with Daniel Alphonsus’ recent article, making the visa process more flexible for tourists is crucial. Our focus should not be on visa fees, but rather to encourage tourists to spend more. This allows local industries to capture the revenue and enhances Government revenue through VAT and various other forms of fees and indirect taxes.

Offering a two-year multiple-entry visa for citizens from countries with a per capita GDP four times higher than Sri Lanka’s is a strategic move to attract high-income tourists. Given our current fiscal situation, carrying out extensive global promotional campaigns are beyond our financial capacity. Therefore, our focus should shift to initiatives that can be implemented effectively with just a stroke of a pen.

Addressing labour force shortages 

Retaining skilled talent within Sri Lanka is a challenge faced by many industries, including blue chip companies. These labour shortages are anticipated to affect us from next year onwards, jeopardising the sustainability of existing businesses.

To address this issue and prevent businesses from relocating, it is essential to allow companies the flexibility to recruit from international markets. This approach is crucial to sustaining businesses and their supply chains. Permitting companies to hire skilled labour from outside Sri Lanka will not only alleviate pressure on the country’s labour market, but also offer advantages to consumers and businesses competing in global markets.

Further, it encourages the transfer of knowledge and skills, leading to improved productivity. For example, collaborating with professionals from countries like Japan could introduce advanced productivity management techniques, enhancing overall efficiency. Free movement of people is a crucial step in improving our productivity and driving the economic growth of the country.  

If relaxing labour market regulations proves too complicated, a pragmatic alternative is to permit foreign spouses of Sri Lankans to work in Sri Lanka. This measure could help in attracting more skilled workers, providing an incentive for Sri Lankans with families of mixed citizenship to return and settle here. Importantly, this reform won’t incur any costs for the Government; it simply involves changing existing regulations.

Industrial zones for private sector and simplifying tariffs  

For us to emerge from this crisis, our primary focus should be on global trade. The complicated tariff structure that is currently in place enables corruption and is a source of frustration for both exporters and importers. Simplifying the tariff structure into three to four tariff bands is essential to streamlining Government revenue administration. 

The existing high and complicated tariffs lead to massive leakages of tariff revenue. Moreover, these tariffs discourage imports, hampering productivity and burdening consumers. Implementing a straightforward tariff structure is imperative, removing para-tariffs such as CESS and PAL. Furthermore, we must ensure that the tariff structure for any HS Code is easy to compute and has minimal deviations.

A significant bottleneck in our system that hinders investments and export growth is the shortage of land for industrial activities. Currently, 95% of the land in Board of Investment (BOI) industrial zones in the Western Province is occupied. Investors are required to obtain approximately 17 approvals in order to set up operations and this process can take more than two years. 

Regrettably, the BOI has not initiated any development projects in the last 15 years. A viable solution that the Government should consider is utilising State-Owned Enterprise (SOE)-owned land and allowing the private sector to develop industrial zones on it. 

Private sector-run industrial zones can operate as a plug-and-play model, where the private sector attracts investors and secures the necessary approvals in advance. This approach does not require any Government investments; in fact, it can generate more revenue for the Government through leasing or selling the land for development. 

If Sri Lanka is genuinely committed to economic growth and recovery from the crisis, our primary focus should be on implementing these reforms rather than solely relying on the IMF.  While the IMF can provide us with short-term stability, it’s our responsibility as Sri Lankan citizens to shape our own growth narrative.

Restructuring SriLankan Airlines can help reduce our economic woes

Originally appeared on The Morning

By Anuka Ratnayake

There is much discussion on the precarious financial situation of the island’s National Carrier SriLankan Airlines. A month ago, Minister of Ports, Shipping, and Aviation Nimal Siripala de Silva revealed that “The only way to rescue the National Carrier is via urgent restructuring” [1].
The airline has racked up significant losses while its debt obligations have increased significantly with the depreciation of the currency. Getting rid of the airline will allow the Government to focus on its limited resources to strengthen social security nets and improve social infrastructure.
The argument regarding the airline has been muddied by emotion, for it is ultimately the people who pay for it and who have the right to ask if this is the best use of taxpayers’ money.
SriLankan Airlines’ Annual Report for 2020/’21 (latest available annual report) provides that the SriLankan Airlines Group recorded a loss of Rs. 49.7 billion. However, the Ministry of Finance in its latest Annual Report records that the loss (before tax) of SriLankan Airlines for the year 2021/’22 is Rs. 170.8 billion [2]. The accumulated loss amounts to Rs. 542.5 billion as at 31 March 2022. The National Carrier lost Rs. 248.4 billion in the first four months of 2022 due to the volatility in exchange rates [3].
The airline is in debt to the Bank of Ceylon and the People’s Bank to the tune of $ 380 million in 2022, while another $ 80 million loan has been obtained from the Bank of Ceylon by mortgaging shares of SriLankan Catering. The banks have extended support to the airline on the basis of letters of comfort issued by the Ministry of Finance.

Further, the airline has a debt payable on an international bond on a Government guarantee of $ 175 million. The guarantees extended by the Government to banks and bondholders represent additional potential losses of public funds. The group owes an arrears amount of $ 325 million to State-Owned Enterprises (SOEs) such as the Ceylon Petroleum Corporation (CPC), the Airport and Aviation Services (Sri Lanka) (AASL), and the Civil Aviation Authority of Sri Lanka (CAASL) [4].
The group’s current liabilities exceeded its current assets by Rs. 214.6 billion by 31 March 2021 and the total equity of the company as at reporting date has declined to a negative Rs. 281.5 billion.
The Auditor General’s report has continuously warned the company that “a material uncertainty exists that may cast significant doubt on the group’s ability to continue as a going concern” [5]. The Auditor General has relied on the Cabinet approval dated 7 February 2022 and the letter issued by the Secretary to the Treasury on 24 February 2022 confirming the support of the Government to the company to continue its operations as a “going concern”. In simpler terms, the SriLankan Airlines Group is technically insolvent and it continues to operate using taxpayer money.
The airline last reported a profit in 2008, under the management of Emirates. It has failed to report a profit in any year since then. The airline industry is known to be a high-risk, low profitability business.

Future losses and lessons learnt from India

The International Monetary Fund (IMF) has now reached a Staff-Level Agreement (SLA) with Sri Lanka to assist its economic recovery process. It was agreed that the IMF would provide an Extended Fund Facility (EFF) of $ 2.9 billion on a 48-month arrangement.
The total debt of SriLankan Airlines (just over $ 1 billion) is nearly one-third of the EFF. Sustaining further losses is an impossible task since the Government can no longer fund the airline. Covering future losses of the airline through tax increases is unacceptable given the dire economic conditions faced by the public.
Sri Lanka needs air connectivity, but this is best provided by privatising air services and not by operating an airline. A good example is the Air India privatisation which took place in the past year. The Indian National Carrier was sold to the Tata Group for the relatively small sum of INR 180 billion [6]. Prior to the sale of the airline, it was losing $ 3 million a day on average, which totaled to over $ 1 billion per year [7].
The rising aviation fuel prices and airport usage charges were not sustainable after the pandemic restricted air travel. Further, competition from low-cost carriers and the poor financial performance of the airline made things worse. Air India’s poor client orientation, lack of punctuality, obsolete productivity practises, and poor revenue generation techniques were among the reasons for its incompetency [8].
The impact of the Air India privatisation was discussed at a panel at the ReformNow Conference hosted by the Advocata Institute. The panellists stressed how the Tata Group had already begun the process of value addition through efficient customer care services, improving fleet productivity, and focusing on budget flights for the domestic market.

Aviation hub

Singapore’s aviation policy has been a key factor in the growth of Singapore’s Changi International Airport, where air transport contributed to nearly $ 20 billion of value added to the Singapore economy or about 6% of the Singapore GDP in 2011.
There is much public support for restructuring SriLankan Airlines due to its heavy burden on State coffers and thereby the taxpayers. However, rather than selling the airline alone, bundling the sale of the airline with the other business units such as SriLankan Catering and SriLankan Airlines Ground Handling would be attractive to investors. At the same time, the airport too can be included and marketed as an aviation package with a similar potential to the Changi International Airport.
A national carrier is a source of pride, but it is not a priority for a cash-strapped Government. The airline should be disposed of or even closed, and a liberal air services policy should be adopted instead.
This could boost growth and truly turn Sri Lanka into an aviation hub, freeing taxpayers’ money to be used for health, education, and other priorities.

References
1. https://www.ft.lk/top-story/Answering-aviation-Aragalaya/26-739243
2. https://www.treasury.gov.lk/api/file/a7a35d1a-556f-49b2-81e0-20294eb5a519
3. https://www.treasury.gov.lk/api/file/bc1e8eaf-91eb-4cb3-94e0-35d81f65a949
4. https://www.ft.lk/top-story/Answering-aviation-Aragalaya/26-739243
5. https://www.srilankan.com/pdf/annual-report/SriLankan_Airlines_Annual_Report_2020-21_English.pdf
6. https://www.indiatoday.in/business/story/explained-air-india-handover-government-to-tata-group-changes-1904217-2022-01-25
7. https://www.advocata.org/commentary-archives/2021/10/11/air-india-sold-privatise-srilankan-now
8. https://www.bbc.com/news/world-asia-india-60150531

Anuka Ratnayake is a Research Assistant at the Advocata Institute. She can be contacted at anuka.advocata@gmail.com. The Advocata Institute is an Independent Public Policy Think Tank. The opinions expressed are the authors’ own views. They may not necessarily reflect the views of the Advocata Institute.

Tackling poverty with competent policies

Originally appeared on The Morning.

By Dhananath Fernando

I learnt poverty through two sources. Firstly, I myself have experienced poverty. 

At university, a basic lunch was served for Rs. 20. It was just three curries, and often the only source of protein was a watery fish curry or half an egg. A watery chicken curry with saffron rice was only served on Fridays. It was a very basic meal. There was an option to get a re-serving for Rs. 5.

The re-serving provided only the curries (not the protein source) on the condition that you went with the unfinished plate. Students who couldn’t afford Rs. 20 for the full meal would wait until a friend finished their first round, borrow their unwashed plate, and join the line for just the Rs. 5 re-serving. At one point in my life I was one of those students. 

That’s why this column has alerted the reader many times to the possibility of rising inflation due to Modern Monetary Theory (MMT). Money matters, and when inflation starts skyrocketing, basic essentials will be in short supply and the poor will suffer. 

Secondly, I learnt about poverty through my volunteer experience at CandleAid Lanka (1). CandleAid is a Government-approved humanitarian organisation founded by Captain Elmo Jayawardena. I have seen and heard so many stories of poverty and overcoming poverty from around the country during my interactions with CandleAid and Capt. Jayawardena. Out of all the stories, the story of Pahalagedara Jayathilaka is simply inspiring and reshaped my understanding of what poverty means for the poor.

Pahalagedara Jayathilaka was a crippled child who started his education in a borrowed wheelchair. His father had passed away from cancer when he was 10. Once, when narrating Jayathilaka’s story, Capt. Jayawardena said: “Jayathilaka’s best meals at university had been a cream bun or a fish bun.”

To cut a long story short, from the bottom of the poverty barrel, with the sheer determination and pure courage of his mother, Jayathilaka successfully entered the University of Moratuwa. He had come to Moratuwa with just his crutches and Rs. 1,000 in hand. Then CandleAid had provided him with an education sponsorship, through which he obtained superb results and a first class in Mechanical Engineering, and subsequently received a scholarship to the National University of Singapore (NUS). Today he is a Postdoctoral Researcher at the Department of Oncology of the University of Oxford (2).

In the terminology of economic research, there are many definitions of poverty, such as urban poverty and rural poverty, but the jargon of researchers is not sufficiently descriptive of the circumstances people find themselves in. When you are actually facing poverty, your decision-making processes, consequences, and outcomes in life are very different. 

For people in poverty, what matters the most is a fair opportunity to have a chance to succeed in life. It is an evolving process and it will never be an overnight miracle. 

They can overcome their circumstances if we establish the proper macroeconomic environment. That is what most of us forget; we forget the basics and try to target poverty without realising that macroeconomic instability causes poverty. 

I believe Pahalagedara Jayathilaka was unstoppable because he got a fair chance to compete as well as  support from a private charitable organisation. He was upskilled, an opportunity was created, and his fate was changed. 

The question during these unprecedented times is: how can we save our poor, and how can we support more people like Jayathilaka to create outstanding success stories? Of course, most people may not have stories as outstanding as Jayathilaka did, but they will at least gradually move above the poverty line and acquire a higher standard of living.

Before any suggestions are made, we need to understand that bringing down the inflation rate is the best way to help the poor. We created this problem of high inflation through bad monetary and fiscal policy, so bringing down inflation and creating stability through competent policy has to be the first priority. 

Furthermore, this column has often suggested the establishment of an efficient cash transfer system through the Government mechanism. While that is still an option, we all know how inefficient our Government apparatus is. 

The other option is to encourage private charitable organisations to help the poor. These organisations have good targeting systems and they have the capacity to reach people like Pahalagedara Jayathilaka and identify those who are truly in need. They are already doing a commendable service at a grassroots level, managing highly agile and impactful charitable projects to look after the poor. 

It would of course be the best case scenario if the Government can manage this, but our experience is that the Government’s management of all affairs is far below even our most basic expectations. 

Most charitable organisations have a far better reputation than the Government, and it is likely that expatriates will be more open to the idea of donating to these organisations than to the State to manage relief for the poor. This will bring in foreign exchange inflows, which will add further relief to our State coffers to manage essential imports.  

The best way to eradicate poverty is by creating wealth. To create wealth we need to first create opportunities, because the easiest tradeable good that the poor have is labour and human capital. We need to set up competitive processes to upskill our labour; poor people will gradually emerge from the poverty trap through the dignity of labour, and not by just becoming henchmen for a political party or by waiting in long queues to get a small cash subsidy or a handout.

A cash transfer system is a must. We should move as fast as possible on this matter. However, looking at how slowly things move with Government bureaucracy, it’s reasonable to assume that this will take time. 

Regardless, poor people cannot stay hungry for long. That is why we have to tackle inflation as public enemy number one and stop adding further inflationary pressures to our economy. Until we get the cash transfer system up and running, private charitable organisations should at least be approached or requested to come forward to utilise their network. They will be able to work faster than the Government and find and support many other Pahalagedara Jayathilakas who can excel. 

I still remember how Captain Jayawardena concluded his long story with a lot of emotion all those years ago. 

Every word I wrote about Jayathilaka is the absolute truth. Jayathilaka does not need colouring.

References:

• https://www.ft.lk/News/some-call-it-courage-e28093-the-definition-is-inadequate/56-39233

• https://www.oncology.ox.ac.uk/team/jayathilake-pahala-gedara

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.

Salvaging the debt-ridden National Carrier

Originally appeared on The Morning.

By Dhananath Fernando

Privatising SriLankan Airlines is a hot topic once more, although this discussion is decades old now. Founded as Air Lanka in 1979, the airline was described by Singapore’s Lee Kuan Yew as “a glamour project, not of great value for developing Sri Lanka”. 

In 1998 Air Lanka signed a 10-year management contract with Dubai-based Emirates Airline for 40% of shares and provided the Emirates management the ability to make most of the management decisions. Air Lanka was rebranded as SriLankan Airlines. However, after 10 years, Emirates realised that the Sri Lankan Government was not going to renew the contract. 

According to SriLankan Airlines Annual Reports from 2008, the final year in which Emirates operated the airline, it made a profit of Rs. 4.4 billion. It was mentioned in some reports that this profit included insurance claims after the terrorist attacks on the Bandaranaike International Airport. 

Fig 1: Losses and Profits of Sri Lankan Airlines

However, since then, SriLankan Airlines has not made a single cent of profit. Cumulatively it has lost Rs. 372 billion since 2008. The airline made a loss of Rs. 44 billion in 2019, Rs. 47 billion in 2020, and Rs. 45 billion in 2021. Losses in 2019 were equivalent to 93% of the Samurdhi scheme’s budget – Samurdhi being the main social safety net in place to protect the poor. The losses were also equivalent to 84% and 90% of the Samurdhi budget in 2020 and 2021, respectively. These losses are equivalent to 17% of 2019’s health sector allocation in the National Budget. 

The problem is both clear and dire. We maintain a national airline at a substantial loss and ask the common people, many of whom don’t even possess a passport or haven’t even stepped on an aeroplane, to foot the bill. In other words, we are maintaining a failing  airline at the expense of the education and healthcare of our people. 

There are multiple reasons why SriLankan Airlines incurs losses. It is too politicised and many politicians and their relatives are not charged for extra baggage when they travel. Board appointments and recruitments have all been politically driven. Simply put, it is bad management. The general remedy for bad management is to replace it with good management so we can make the enterprise profitable. This has been the popular suggestion each time that the privatisation of SriLankan Airlines has been proposed. That is the exact thing we have been trying to do since we ended the management contract with Emirates. 

We have to ask ourselves why the outcome hasn’t changed even after the same remedy has been proposed and implemented repeatedly. Simply put, when you don’t invest sufficient money, time, or reputation into a business, no one has the ability to make it profitable. All the business leaders who have been appointed to lead the firm already have their own businesses, so it is obvious that SriLankan Airlines will become a secondary priority. 

Airlines are a very competitive business. Even privately-owned airlines are finding it difficult to compete and maximise profits, so how can we expect a State-owned and managed airline to do the same? There is a difference between a private company making a loss versus a State-owned company making a loss. A private company’s losses are borne by the private investors, who knowingly and consensually made the choice to invest their money in a potentially risky endeavour. But when public companies make losses, taxpayers have to pay and their money will be spent without their consent. How can this be justified, especially in a country like Sri Lanka where people suffer from a lack of basic needs, and when our healthcare, education, and social safety nets need significant improvement?

So what can be done about SriLankan Airlines? SriLankan Airlines’ business has few strategic units: The airline operation, catering, and the ground handling operation. Each section has some assets as well as liabilities. Overall, the airline has a lot of liabilities and debt. Most of the debt is guaranteed by the Treasury (part of it dollar denominated), which is part of the debt that is to be restructured as per the announcement on 12 April 2022.

Table: Debt guaranteed by Sri Lanka treasury for Sri Lankan Airlines

Accordingly, one option is that we ask strategic investors to pitch in to buy SriLankan outright. The bidding process has to be made transparent and competitive. The airline as a group is making colossal losses, so it is unlikely that we will be able to realise significant proceeds from the sale. As has been said, beggars can’t be choosers. 

Another option is for divisions like catering to be sold at concessionary rates to a potential buyer, again through a competitive bidding process, so that we don’t have to shoulder the burden of managing an operation while also closing any future window for corruption.

There is also the option to explore the feasibility of a similar kind of management contract or a Public-Private Partnership (PPP) similar to that which existed with Emirates. However, our airline is now in such a poor shape financially that the feasibility of a management contract is questionable. 

There are suggestions to list the airline on the Colombo Stock Exchange and allow investors to buy shares. Generally listings are successful when the company is doing well. At the moment, given the present economic conditions of the country and the historical performance of the entity, this may be challenging.   

Finding a strategic investor through a competitive bidding process is still a possibility given our connectivity with the main South Indian airports. Some Indian and international airlines may have an interest in expanding their network and will see a potential win-win situation. 

We have to begin the process of privatisation as it is obvious that we can’t run a business on taxpayer money at a time when the people are struggling for their basic survival. The citizens of Sri Lanka gave the management experts of all political parties and their close associates multiple opportunities over 14 years to turn the airline around and bore significant losses in return. Let us hope that policymakers will understand the gravity of the situation and that they will not allow such a huge drain on our coffers to continue unimpeded. 

For explanation of SLA losses for 4 years.

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.

Sri Lanka’s unwieldy state sector: A growing burden?

Originally appeared on The Morning

By Dhananath Fernando

Recently a minister proudly proclaimed that the Government, for the last two years, has recruited approximately 45,000 new civil servants who have failed their Ordinary Level (O/L) examinations (of those who have studied up to the O/Ls). Comparing this to government recruitment of about 22,145 workers during the 2015-2019 Yahapalanaya regime, he explained that the present Government has recruited about 60,000 new workers for the state sector. 

While most ministers and parliamentarians see the recruitment numbers for the Government as an achievement from a business and economic point of view, the tail-heavy government cadre is one of the key reasons for Sri Lanka’s poor economic performance. 

We have more than 1.5 million state sector employees – a figure which has doubled since 2005. Their burden on the taxpayer is not a one-off expense, but one that is long term, as their pensions accumulate throughout the state sector and sometimes are even transferable to their spouses. 

The reasoning for increasing the size of the government cadre is part of a popular yet vicious cycle. For most politicians and political parties, job offers in the state sector are one way of establishing their political brand image for the next election – a priority over effectively managing taxpayer money. On the flip-side, for most of the unqualified voters the carrot for supporting the uneducated politicians is a government job opportunity with low work/productivity requirements and a tidy pension. 

When looking at the structure of the cadre, it is mostly chauffeurs, clerks, office assistants, and other unskilled/menial workers who have been recruited. Skilled jobs are very limited in the Government. As a result of high expenditure on the bottom-heavy structure of the Government, skilled job openings at the top cannot offer competitive salaries compared to the private sector. The outcome of this is that top-level jobs in the state are occupied by poorly skilled officers with low intellectual capacity. Furthermore, as a result of poor pay, top-level public officers have a significant incentive to engage in corrupt practices to remunerate themselves. One of the main reasons for white collar corruption across all ministries is the twin problem of offering non-competitive salaries and their natural result: poor leaders in top positions. Many ministry secretaries earn a salary that amounts to less than Rs. 100,000 per month. By contrast, it is likely that a high-skilled junior executive with an undergraduate degree would earn a better salary and enjoy a better work-life balance in the private sector. 

The recent statement by one of the ministers of the Government proves that the view inside the Government on state sector employment is divided. The Minister of Finance has stated that the state sector is becoming a significant burden for the Government (particularly due to mounting debt repayment concerns), and went on to propose an increase of the retirement age in the state sector to 65. 

Over-staffing of state workers is not inherent to one government. A viral social media video released during the last regime drew great controversy for that government, as it showed the then Minister of Housing (now Leader of the Opposition) interviewing candidates and directing his subordinates to choose workers for security and labourer jobs based on height. The aforementioned statement by a present minister about the Government hiring 45,000 candidates who failed their O/L examinations is purely an indicator that all governments subscribe to the same, flawed ideology – that expanding the state sector is a pathway to development. 

The salary scale for unskilled staff in government offices are in the range of Rs. 30,000-45,000 per month; as a result many of them simply stay in their offices needlessly (burning electricity generated on imported fuel) to claim a very high overtime income. Once, a chairman of a state authority mentioned (during a personal conversation) that he has to approve overtime pay for many drivers that is higher than the entire take-home salary package of the Chairman himself.

The situation is similar in many government institutions. Executive level state workers – who are not entitled to overtime pay – simply block every file and proposal and try to extort money out of the applicants. Alternatively, they may try to claim bills which are not spent on their other perks (e.g. travel expenses, fuel, etc.) and earn some extra money. 

This has always been the vicious cycle of state jobs. Now, the situation has deteriorated to the point that the Government is finding it difficult to keep even extremely important employees such as the directors and chairman of the Board of Investments (BOI), due to the pressure mounting from unskilled workers and trade unions over the salary hikes of the board. When the employment structure is unbalanced and too bottom-heavy, the final outcome is that the tail end takes control – with trade union activities and strikes completely disrupting all activities of citizens and the government alike. 

Attracting billion dollar investments is a highly skilled job which requires a specific sales mindset, credibility, intellectual power, and a business network to perform. Throughout the world, the work of investment bankers and high-level sales executives is very well compensated. Hence, it is doubtless that for investment promotions, Sri Lanka will require very highly skilled individuals. However, investors will not be attracted to Sri Lanka by merit of our talent alone; a regulatory framework that is conducive to business activities is also necessary to attract foreign direct investment inflows. In a bottom-heavy organisational structure, when salary increments are taken by the senior level staff or when top executives are recruited, bottom-level employees get concerned that their salaries will be affected by higher resource absorption by the senior level. This is the case in many institutions and public enterprises in Sri Lanka.  

Sri Lanka’s state sector is, without a doubt, too large and expensive for us to maintain. It’s exploding to a level beyond our control. If we fail to implement reforms as fast as possible, the situation would be disastrous for both the state sector as well as the private sector. The best solution for our current problems is economic reforms. The idea that the state can maintain its public capital by simply hiring more workers is a myth. Without reform, we will soon lose both our solvent economy and our politicians’ credibility and political capital. 

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.

Keeping track of our state enterprises

Originally appeared on the Daily News

By Aneetha Warusavitarana

The Sri Lankan government is currently in a rather confused state of having lost track of the number of state enterprises it runs.

While the Ministry of Finance tracks the financials of 55 key SOEs, the government does not have an official number for the enterprises it runs. The Annual Report of the Ministry of Finance states that there are 400 and this is true to a certain extent. In the Advocata Institute’s 2019 report on the state of state enterprises, it has identified 424 principal SOEs, 84 subsidiary SOEs and 19 sub-subsidiary SOEs; bringing the total to a shocking 527 entities.

While it is bewildering that the government runs a minimum of 527 entities, the losses sustained by these enterprises are a greater cause for concern. When looking at the financials of the 55 strategic SOEs (which account for only 10.4% of the 527), the cumulative losses for the period of 2006 – 2017 amount to a massive Rs. 795 billion.

Reform promises

Apparently, the government has taken note of this. Reform has been promised by a variety of politicians at pivotal political moments. The election manifesto of President Maithripala Sirisena stated,

“I will implement a plan corresponding to Singapore’s Thamasek model to regularise the Management of State owned strategic institutions and sectors such as state banks, the harbour, energy, water supply, airports and transport.”

This is essentially a good starting point. Under the Singaporean Temasek model, one holding company is responsible for countries’ public enterprises. This is a model that has worked, with variations being adopted in other countries.

The Indonesian variation of the model has one holding company for each sector – given that Sri Lanka is a much smaller country it is possible that we could manage with one holding company.

The benefits of adopting this model lie in the accountability it creates. Having a holding company creates distance from the government and its SOEs, reducing chances for political intervention. It’s important to note that the Prime Minister has also expressed his support for this model, which meant the policy had buy-in from both sides of then unity government. While the Temasek model is a step in the right direction, if we want our SOEs to be efficient, privatisation is where the final solution lies.

On that note, the ‘privatisation of state-owned enterprises’ was mentioned early in the 2016 budget speech. The speech highlighted the loss-making nature of SOEs and the negative impact this it had on the budget. The solution mentioned was the use of ‘corrective measures’ to transform SOEs into commercially viable enterprises.

The methods recommended were selective, market-based pricing mechanisms for public utilities, rationalising of recruitment and exploring public-private-partnership opportunities.

The budget speech of 2017 also stated that steps would be taken to make SOEs viable business entities through cost reflective pricing structures and operational autonomy.

It went further, committing to the listing of non-strategic enterprises such as the Hyatt, Grand Oriental Hotel, Waters Edge, West Coast, Manthai Salt, Hambantota Salt and Hilton. The rationale was that the money raised could be used for debt repayment. Notably, both the budget speech of 2018 and 2019 were silent on the topic of SOE reform.

Working under the assumption that these promises were made in good faith, there is the question of why reform never materialises. It is possible that we have been trying to run before we can walk. While SOE losses have to stemmed, it may be better to have smaller, digestible phases of reform than a large reform agenda which will never move beyond a statement or speech.

Reform is vital, but should realistic

A key point highlighted in the recent IMF staff report was the losses sustained by state owned enterprises. Three main SOEs; the Ceylon Petroleum Corporation (CPC), the Ceylon Electricity Board (CEB) and SriLankan Airlines have recorded a combined loss of 1.3 per cent of GDP in 2018, compared to 0.5 per cent of GDP in 2017. The report also puts the financial obligations of non-financial SOEs at 11.8% of GDP.

Given rising losses and the urgent requirement for some level of action to be taken, it may be that the government should focus on smaller, more achievable reform that lies within the realm of political possibility. In Advocata’s 2019 report on the state of state enterprises, a few key reforms were identified.

These reforms were chosen because they are politically feasible and because they will have a targeted impact on the root causes behind SOE losses. Two of the main reforms are detailed below.

1. Conduct a survey of all state-owned enterprises: it is impossible for the government to regulate or monitor these entities, when the government is uncertain of the scope of its responsibility. Once the survey is completed, the government can institute basic reporting procedures.

2. Strengthen COPE, COPA and the Auditor General’s Department: these institutions are the main source of accountability for state-owned enterprises and as such should be given a mandate which allows them to take sufficient action.

Once these steps are taken, the government could expand its reform agenda to encompass the OECD principles of corporate governance, which include clearly defining the state’s role as an owner, establishing an effective legal and regulatory framework for SOEs, ensuring transparency and disclosure, while emphasizing the state’s responsibility to stakeholders. In short, the OECD guidelines will nudge SOEs towards a path of transparency and efficiency.

However, in the short term, the first two reforms mentioned above remain crucial.

The COPE reports

Originally appeared on Echelon

By Ravi Ratnasabapathy

The Parliamentary Committee on Public Accounts (COPE) reports on state enterprises

The COPE, a key oversight committee, is by its own admission under-resourced. It lacks staff, particularly for audit and legal support. They also lack IT systems and, apparently, even a proper office. Despite these limitations and the fact that the reports are not comprehensive, they have examined a limited number of issues in a few institutions. These reports are a devastating critique of the state of governance, underlining the need for a re-think in the role of the government.

Excerpts from the reports are as follows:

SRI LANKA PORTS AUTHORITY: RS 5.8 BILLION TO CONSTRUCT SURIYAWEWA CRICKET STADIUM

As per the Auditor General’s report on the SLPA (2016):
“The Authority had conducted the architectural and construction activities of the international cricket stadium in Suriyawewa on behalf of the institute of Sri Lanka Cricket. According to the contract agreement entered into between the contractor and the Authority on the said construction, a sum totalling Rs5,838 million, inclusive of the interest amounting to Rs2,881 million, had remained payable to the contractor by the Authority up to 31 December 2016 in respect of the said constructions made under the variation order (emphasis added) of the contract for construction of the Hambanthota Harbour.”

Note: A variation order is an alteration to the scope of works in a construction contract in the form of an addition, substitution or omission from the original scope of works. While these are not unusual in large projects, it is bizarre to treat work on an entirely new and unrelated project as a variation in a port construction contract.

“Despite the non-availability of any verification that the said sum would be borne either by the Treasury or the institute of Sri Lanka Cricket, the sum had been accounted in the financial statements of the Authority as being receivable from a Government institution, but the receipt of that sum remained doubtful”(ibid).

Separately, the third COPE report observes that Sri Lanka Cricket owes the State Engineering Corporationan amount of Rs818 million on 7 projects as at 31.12.2015.

PEOPLE’S BANK DUD LOAN

1. NON-PERFORMING LOANS AT RS395 MILLION – KANDY CITY CENTRE
An overdraft facility of Rs245 million and a long-term loan facility of Rs150 million were granted to a customer for a construction named Kandy City Centre on 30 January 2009 and 27 January 2009, respectively. However, these loans were classified as non-performing loans after 3 months. Though the customer agreed to pay the loan in installments of Rs1 million per month, it was decided to offset the loan against the monthly rent to be paid on behalf of the People’s Bank branch housed at Kandy City Center.

However, even if the customer repaid the loan in monthly installments of Rs1 million each, the bank would have to wait for 62 years to recover the outstanding amount. The chairman stated that several such unsystematic transactions had been done.

Note: As per CBSL guidelines, ‘Credit facilities repayable in monthly installments: when 3 consecutive installments, principal and/or interest, have not been paid’ are to be classified as non-performing loans.

The loan granted in January 2009 was classified as non-performing within three months of disbursement, which indicates that there was no attempt at repayment. Subsequent to COPE recommendations, Rs20 million had been recovered. Legal action had been instituted, but the defendants did not appear in courts when the case was called on 1 December 2016.

Credit approval in a bank should go through multiple levels of authority – the branch manager, credit officer, credit committees, board committees and risk management committees – depending on the size of the loan. A loan in excess of Rs100 million would typically require approval at the highest levels. The chairman’s comment of ‘unsystematic transactions’ seems to indicate serious control weaknesses, further examples follow.

2. NON-PERFORMING LOANS GRANTED BY JA-ELA BRANCH AT RS619 MILLION
The Ja-ela Bank branch had granted three loan facilities and three overdraft facilities to a customer, his spouse and an enterprise; and subsequently, these loans were categorized as non-performing.

I. At the date of 12.11.2013, the outstanding balance of Rs619,867,345 of the three overdraft facilities and one loan facility could not be recovered.

II. The chairman stated that legal action has been taken to recover more than 60% of the loans that had been granted in an unsystematic manner and discussions are being held with regard to the remaining portion of the loans.

Note: Subsequent follow-up by COPE indicates that the husband and wife were directors in a company engaged in property development. Loans had been obtained in the names of the individual directors and the company. The unsettled balance of these loans was Rs197 million and the interest to be collected was Rs503 million, making the sum total due to the bank Rs700 million by September 2016.

AIRPORT AND AVIATION SERVICES

1. Rs. 7 MILLION FOR THE CONSTRUCTION OF KATARAGAMA HOLIDAY RESORT
Rs7 million had been paid to a private party in 2002 to purchase land to construct this holiday resort. Thereafter, the Kataragama Divisional Secretariat informed that the land belongs to the government and that it had been obtained on a 30-year lease from January 2008 for an annual lease of Rs460,000. However, the sum of Rs7 million paid to a private party had not been recovered.

Note: Following the COPE report, legal action had been instituted in the Gampaha District court for recovery of the Rs7 million. The question as to why the title was not properly checked prior to purchase remains unanswered.

2. AIRPORT AND AVIATION SERVICES LIMITED: RS248 MILLION PAID ON A CONTRACT SIGNED FOR RS27 MILLION TO DEVELOP AN ERP SYSTEM. THE PROJECT WAS NOT COMPLETED.
The contract had been awarded to a private company for Rs27,464,632 (without VAT) in June 2012 for the implementation of the project within 8 months. The company had paid a sum of Rs248,600,000 (without VAT) to the contractor and the period of the contract had been extended on four occasions. Though over four years have lapsed since the awarding of the contract, the contractor had failed to carry out the contract properly. The work of this institution has currently been suspended and it has submitted an appeal.

SRI LANKA TOURISM DEVELOPMENT AUTHORITY

1. SPENT A TOTAL OF RS113 MILLION ON FOUR OCCASIONS FOR WORK THAT WAS NOT CARRIED OUT
A sum of Rs11 million out of Rs29 million had been received for renovating 30 rooms of a holiday bungalow belonging to the Authority had been for work not done and overpaid taxes. According to the report obtained by the Authority from ICTAD, a loss of nearly Rs5 million has been incurred. Steps had not been taken to recover that amount from the contractor or the officer who approved the payment.

A sum of Rs3.2 million had been paid to suppliers based on three letters, which the suppliers had produced stating that they had provided dozers to construct the Kalpitiya Mohottuwasama Jetty. This payment had been made without a certificate of fixing work hours according to the daily meter reading by an officer of the authority.

Even though the Kalpitiya integrated Tourism project commenced in 2008 on an estimated cost of Rs5.5 billion in order to construct holiday resorts with 4,000 rooms and infrastructures facilities to be completed within 5 years, not a single room had been constructed despite an expenditure of Rs88.7 million at December 2014.

2. PAID RS7.3 MILLION AS PART OF THE INTEREST OF A LOAN OBTAINED BY A PRIVATE HOTEL
Four hotels had been selected close to the Hambantota International Cricket Stadium (which was selected to host cricket matches for the 2011 Cricket World Cup), to develop accommodation facilities.

It was revealed that this sum of Rs7.3 million, a portion of the 4% interest of a loan obtained by the Peacock Beach Hotel from the Bank of Ceylon, had been paid out of the Tourism Development Fund on a number of occasions. According to the documents furnished to this committee, the approval of the minister in charge had not been obtained to make the payments.

Note: A letter appended to the COPE report provides some explanation of the circumstances of this payment. It indicates that the four hotels had to be upgraded to four-star status in order to host the 2011 World Cup matches. The hotels had apparently informed the SLTDA that there was no commercial viability to the exercise and requested that the government subsidise the interest cost on the loans required to finance the upgrade.

The cost of upgrade for three hotels is indicated as being “Rs414 million”. The upgrade cost of the fourth hotel was apparently not available. The letter was written by the Director General of the SLTDA and addressed to the Secretary of the Ministry of Tourism had been copied to the Bank of Ceylon, People’s Bank and Hatton National Bank. The interest rates on the loans were supposed to be 12% and the SLTDA was supposed to pay 4% as a subsidy. Based on these figures, the subsidy for the three hotels would amount to Rs16.5 million annually, assuming loans to the values indicated were granted. It is not known if this was the case and if further liabilities exist.

NATIONAL WATER SUPPLY AND DRAINAGE BOARD

There was a cost escalation of 338% in 11 water supply projects that were funded by a bank loan of Rs54 billion. The board has received an unsolicited foreign-funded project, and work has commenced without a contract. Strangely, the NWSDB has been appointed as a sub-contractor on the project by the main contractor, to the value of $64 million (it appears that the unsolicited proposal was accepted by the NWSDB and the work has later been sub-contracted to the NWSDB itself).

Lanka Mineral Sands Ltd. spends money on tasks that are contrary to the objectives of the company – Beach Park The company’s welfare funds have been utilized for the construction of roads and buildings in various other areas in contravention to the objectives of the institution. Information pertaining to spending Rs40 million for the construction of the Hambantota Beach Park and spending money for making improvements to the Devinuwara Maha Devale have come to light.

A veil of incorporation or a shroud of secrecy?

Originally appeared on Echelon

By Ravi Ratnasabapathy

SOEs incorporates under the companies act

State-owned Enterprises (SOEs) in Sri Lanka come in a bewildering variety of forms, ranging from departments, authorities, boards and state corporations, to limited companies. The traditional forms are the first four, which are usually created by a special act of parliament. The advantage of this is that it creates direct accountability of the SOE to the parliament.

When SOEs are formed through acts of parliament, they are subject to the stringent financial and administrative regulations of the state and are obligated to report to the parliament.

The Companies Act is intended for use by private businesses and the principal accountability is to shareholders. There is no obligation under the Act to comply with the regulatory and accountability mechanisms that govern state entities.

The Auditor General reports that, unless the majority of shares are owned by the government, even the audit of limited companies is beyond their purview. Therefore, the recent trend for increasing numbers of SOEs to be incorporated under the Companies Act instead of by an act of parliament is unusual. A list of 452 state entities includes 149 incorporated as limited companies, a fact that the Auditor General (AG) has drawn attention to in his Annual Report of 2016:
“In recent years, it was observed that a considerable number of limited liability companies have been incorporated under the Companies Act by certain Public Enterprises and the universities even sometimes without the approval of the Cabinet of Ministers.”

Another trend is the evolution of complex corporate structures within SOEs, some having multiple subsidiaries and associate companies. The list includes 100 subsidiaries and 19 sub-subsidiaries. Is there a rationale for this? A perusal of the COPE and Auditor General’s reports reveals some systemic problems (examples are highlighted in the boxed sections).

Even within the private sector, complex corporate structures present governance challenges as risks can lie undetected within subsidiaries/associates. These risks, if left unchecked, can expose the group to significant liabilities, and the same is true for SOEs. Vigilance of subsidiary activity is essential for risk management and compliance, but as the AG notes:
“However, it was observed that most of the Public Corporations do not exercise their controlling power over the subsidiaries although their members constitute the majority of the Board of Directors” (Auditor General, Annual Report, 2016)

A classic example is the Ceylon Electricity Board, which has some 22 associate companies, subsidiaries and sub-subsidiaries. Such structures are difficult to penetrate, obscure transparency and leave room for corruption.

The subsidiaries may provide goods and services to other companies within the group via transfer pricing arrangements instead of open tendering. When the directors or key management of these companies are also employees or associates of the parent body, it gives rise to serious conflicts of interests that are difficult to avoid; a point highlighted by the first COPE report.

The failure to disclose details of related party transactions (with subsidiaries) was one of the reasons that compelled the AG to qualify the audit opinion on the financial statements of Ceylon Electricity Board for 2013.

The Ceylon Electricity Board had eight contracts with LTL Project (Pvt) Ltd , a related party to build transmission lines and strengthen infrastructure. The value of four contracts amounted to Rs5.9 billion; the values of the others were not disclosed in the report. Contrast this with the governance of listed companies. Local listed companies are now required to have a Related Party Transactions Review Committee made up of independent directors who must review and report on related party transactions to the Board. The CEB has failed to disclose details even to its auditors! In some cases, it appears that complex group structures have evolved to conceal transactions, hide assets, divert revenue streams or simply enrich connected parties; the very reason such structures are also encountered in instances of money laundering. Some selected examples appear below.

If we leave aside for the moment the government accountability mechanisms and simply view SOEs as businesses, how good is their governance record? The critical tests for a private company are the auditors’ report and timely publication of reports. An analysis in the COPE report of 2014 showed that, of 46 institutions that were reviewed, only 15% had unqualified or clean audit reports. A full 75% of reports were qualified, while 4% were disclaimers of opinion and 6% failed to submit accounts. Things were not much better in 2017. The AG notes that, of 218 entities reviewed, only 80 (36%) received ‘clean’ audit opinions.

These are shocking revelations and the problems appear to be systemic. The complex structures created under the Companies Act seem to provide a shroud of secrecy that hampers oversight and enables systematic corruption. A select list of examples is listed here. The government should shine some light on the dark corners of these SOEs, first by compiling a full list of entities and second by implementing basic regular reporting structures to establish a minimum degree of control.

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Electricity Piracy

THE ARBITRARY NATURE OF THE SUBSIDIARY AND SUB-SUBSIDIARY COMPANIES OPERATING UNDER THE CEYLON ELECTRICITY BOARD AND THEIR LACK OF RESPONSIBILITIES TO THE BOARD

The Committee on Public Enterprises undertook a study on the members of the Boards of Directors of 20 subsidiary companies operating under the Ceylon Electricity Board and observed that the same person represents the Boards of Directors of many of those companies.

For example, the Committee observed that the chairman of the Ceylon Electricity Board is a member of Boards of Directors of 6 subsidiary companies, which enables him to take different positions in regard to the same issue, thus jeopardizing the main aim of the Board to provide electricity to the consumers at an affordable price. The following traits of the subsidiary companies operating under the Ceylon Electricity Board were identified: Taking steps to retain a majority of dividends in those companies The Ceylon Electricity Board has no control over those companies. It was observed that the meetings of the Board of Directors of those companies are not represented by an official of the ministry or the Treasury. Those institutions are informed only of matters of specific importance Even though the Ceylon Electricity Board holds a majority of shares of these companies, they are reluctant to be responsible to the Board.

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At Arm’s Length?

PEOPLE’S BANK: CONSTRUCTION WORK WORTH RS1.9 BILLION BY SUB-SUBSIDIARIES

The People’s Leasing Property Development Company, a sub-subsidiary company of People’s Bank that was established through the People’s Leasing Finance Company, has made 13 construction works worth Rs1.96 billion.

An unusual payment of Rs11,000 per square foot, exceeding the ordinary payment of Rs6,000 per square feet, was made in the case of these construction works. Further procurement processes have not been followed, and a Bill of Quantities has not been prepared.

The chairman has stated that a decision has been taken not to award construction contracts to this company at the moment and to carry out construction work by People’s Bank itself.

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Unauthorised Formation Of Subsidiaries To Perform Services For The Group?

THE FOLLOWING FOUR PRIVATE COMPANIES WERE FORM ED UNDER THE ROAD DEVELOPMENT AUTHORITY:

1. Maganeguma Emulsion Production Company (Pvt.) Limited
2. Maganeguma Consultancy and Project Management Services Company (Pvt.) Limited
3. Maganeguma Road Construction Equipment Company (Pvt.) Limited
4. Expressway Transport (Pvt.) Company

“It was discovered that neither the ministry nor the authority possessed any information regarding the methodology that had been adopted in establishing the aforesaid companies as per the decision taken by the Cabinet. It was further discovered that share certificates and records of minutes were not available, and that annual general meetings had not been conducted.”

COPE requested a report from the Attorney General around all matters related to the ownership of these four companies, on the matters that should be examined at ministry level and on the significant matters that should be examined in a criminal investigation. (COPE Report, 2014)

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Dud Number

SRI LANKA TELECOM’S RS108 MILLION ACQUISITION OF SKY NETWORK LTDv

“Even though Sri Lanka Telecom had purchased 75% of shares of Sky network Ltd. for Rs108 million to obtain the frequency required for the continuation of service related to WiMax technology, the company had been closed down after a couple of years with no adequate business activities done on the ground that the technology had become obsolete. The transaction looks suspicious as the said company, which had been formed in 2006, had carried out no business activities other than retaining a frequency until it was purchased by SLT in 2008. It was also revealed that Rs10,468,000 had been paid as director fees during the period in which the company did not function and the person who had been paid as such had happened to be a director at Sky network Ltd”. (Page ix) (COPE Report 2014)

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Wholesale No Transparency

REFUSAL TO SUBMIT ACCOUNTS OF SUBSIDIARIES TO AUDITORS

“It was revealed that account details of C.W.E. Construction and C.W.E. Securities had not been submitted to the Auditor General despite reminders being sent and replies to only 13 out of the 26 audits queries had been submitted to the Auditor General.” (3rd COPE report p7). COPE also notes an instance of selected employees drawing two sets of salaries, from CWE and its subsidiaries (p10).

Monster monopolies

In this weekly column on The Sunday Morning Business titled “The Coordination Problem”, the scholars and fellows associated with Advocata attempt to explore issues around economics, public policy, the institutions that govern them and their impact on our lives and society.

Originally appeared on The Morning

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By Dilshani N Ranawaka

Rukshani, is a small business owner running her own grocery store. Her peak hours of business are when everyone gets back home from their jobs around 7-8pm after working in Colombo. Unfortunately, she has been struggling to make ends meet as of late, due to power cuts that are also scheduled in her area around the same time as her peak hours. With just candles lit during these hours, refrigerators and coolers switched off, it adds an additional cost for her to operate her business.

Thilina, who works in Colombo faces a challenge of getting back home as the workers of the Railway Authority have decided to go on strike asking for a pay raise. Even though trains are over-crowded, they are unfortunately the fastest way of commuting back and forth. Alternatively, Thilina has to resort to the next best solution in his capacity; buses, which incurs an additional cost to reach home.

How is that Rukshani and Thilina have no say over the situation? Why does Rukshani have to suffer losses during the peak hours of her business and why should Thilina have to look for alternative transportation for something they are capable of paying, but somehow is beyond their control?

Trains and electricity are two vital services for the day to day functioning of the country. Why do these authorities continue to function when they are failing to provide reliable and efficient services to their customers who pay for these services? They have a monopoly over this service, hence they exploit it.

As of 2017, Sri Lanka Railway (SLR) sums up for Rs. 7.5 billion in losses. The Central Electricity Board (CEB) projects of Rs. 89 billion in losses for 2019. An island-wide poll by Sparkwinn Research, commissioned by Advocata Institute indicates that 81% of the sampled population are not satisfied with the performance of the State Owned Enterprises (SOEs). As the numbers have spoken, people are clearly not in favour of having these underperforming SOEs.

Would a private institute still run under these terrible, burdening losses?

The issue mainly starts with the monopolistic control over services complemented with organized trade unions within these public institutions. The fact that these services do not have competition, offers a fundamental background for wage increases and other demands that usually result in strikes which influences the entire population.

The initiation of these services dates back to the years when the private sector had inadequate resources to facilitate these services. In such conditions, the government established these entities for the benefit of the population. However, due to the monopolistic nature of these establishments, workers were able to unionize forcing the government to lose control over these institutions.

To add on to the burden of failures, is the fact that all these are controlled and heavily subsidized by the government. The lack of incentives to improve their efficiency and productivity are therefore felt heavily by the government.

There are common practices of addressing the issues on monopolies of the economy. Incentivizing merger policies, regulating and controlling the quality of these monopolies and price caps are some of the methods developed countries use to provide better services.

The “P” word; “privatization” is a taboo in Sri Lanka, although it is commonly agreed that the process of privatization paves the way towards an answer to address these issues that burden the entire economy.

“Privatization” in Sri Lanka is identified as “transferring an institute from public ownership towards private ownership”. This is only one such form of privatisation and is known as a “complete privatization”.  However, there exists various forms of privatizations such as transferring assets, Public-Private Partnerships and franchising.

Path towards privatization

The process of privatization should be methodological. Montreal Review (an independent online magazine) identifies few principals that would lead to an efficient privatization process.

1. The purpose of privatisation

2. The need to review different methods of privatisation

3. The extent of the privatisation

4. Recognising constraints

5. Finding a buyer

6. Implementing an investor friendly environment to attract investors

How the United Kingdom excelled in their privatization process of trains and telecom are case studies which could be replicated in Sri Lanka. The United States government remained in control of quality control and maintaining standards while the operations were handled by private sectors. On the other hand, the United States had successfully privatised industries with natural monopolies such as water and electricity supply by the privatization of operations with the government remaining in control of providing the role of maintaining standards while removing excess burden on the budgets.

However, given the extensive amount of State Owned Enterprises (SOEs), an initial step towards privatization could be to list down possible institutions or even better, towards creating an index which could be a measurement towards qualifying for privatization process.

Can we breakdown these natural monopolies? Are monopolies simply an excuse that gives the governors the luxury of political lobbying? Something to think about.

“The very term “public consumption products” is an absurd one. Every good is useful “to the public”, and almost every good may be considered “necessary”. Any designation of a few industries as “public utilities or services” is completely arbitrary and unjustified”  - Murray Rothbard, a prestigious American Economist.

In state business, the agency problem is on steriods

Originally appeared on Echelon

By Ravi Ratnasabapathy

Inefficiency in state enterprises is a common, if not universal, problem. Citizens are often frustrated by poor service at public institutions. Public hospitals are free, but how many senior executives use them? When holidaying overseas, Sri Lankans will use the railway, but when was the last time they rode on Sri Lanka’s subsidised railway?

Where there is a choice – private hospitals or cars – people may escape poor state services by using alternatives; but the poor aren’t as fortunate.

However, there is no escape from the cost of inefficiency. Inefficiency and waste in state enterprises must eventually be paid for, either by high prices (needed to cover all the waste) or higher taxes. Why is this common in Sri Lanka, but less so in developed countries? The issue is with governance, specifically the problem of agency.

The principal-agent problem is common to any enterprise, private or public, not directly managed by its owners. When an owner manages a business, the interests of the business and the owner are perfectly aligned. When the owner hires a manager to run the business, problems arise if the interests of the manager conflict with that of the owner.

“When an owner manages a business, the interests of the business and the owner are perfectly aligned. When the owner hires a manager to run the business, problems arise if the interests of the manager conflict with that of the owner”

The problem with state enterprises is that, apart from the standard agency costs of a business, they also suffer political costs. We will come to this presently, but in effect, two sets of costs must be managed for a state enterprise to function effectively, so the regime of governance needs to be much stronger than for private entities. In Sri Lanka, the governance regime is a lot weaker, leading to underperformance and abuse.

DEFINING THE PROBLEM OF AGENCY
Shareholders, the ultimate owners of a company, as principals, elect the management to act and take decisions on their behalf. Managers are supposed to employ the resources of the business in a manner that will maximize shareholder wealth. The manager’s best interest, however, is to divert these resources to enhance their personal status (through perquisites such as chauffeured limousines, business class travel) and maximise their own wealth (through excessive pay or corruption).

An example may be seen in recent news reports of a payment of Rs75 million paid to senior managers of People’s Bank and allegedly excessive payments to the top management of SriLankan Airlines. According to a COPE report, the ETF has paid incentives amounting to Rs74.8 million and bonuses of Rs44.5 million, contrary to treasury circulars. Another instance is Hunter and Company PLC, where the auditors were dismissed when they insisted that disclosure was necessary with regard to a bungalow that was being used by key management personnel. Later, a shareholder of the company moved to convene an EGM to call for an explanation from Hunters’ directors with regard to the “disappearance of a Rs2.5 million cheque in favour of a Mr Mahesh Gajanayake and about directors’ remuneration over and above the limit set out in the company’s Article 107”.

The reduction of agency costs is regarded as the essential function of company law and corporate governance.

THE PROBLEM IN STATE ENTERPRISES: POLITICAL AND AGENCY COSTS
State ownership creates its own agency problems, which are caused by the separation of politicians and bureaucrats who oversee SOEs from “the citizens” on whose behalf the enterprises are ostensibly owned. This creates an extra level of agency.

SOEs are ultimately owned by citizens, but run by managers, who are controlled by politicians. Politicians determine or otherwise influence the appointment of key management and must hold the managers accountable.

Unlike shareholders, politicians have not invested their own money in the business. As they have no stake, there is no particular interest in ensuring that it is well run. Politicians, however, have incentives to direct SOEs to achieve economically inefficient objectives for political purposes, giving rise to political costs. These may be benign, if policies enhance social welfare, even if they fail to maximize shareholder value, but most often they are malign, favouring political allies at the expense of public welfare.

The real owners, the citizens, have no voice and little interest in how the business is run.

CITIZENS AS SHAREHOLDERS: THE COLLECTIVE ACTION PROBLEM
Citizens are the ultimate “owners”, but cannot exert any meaningful oversight as:
(a) they have no legal standing as owners; and
(b) the fragmented nature of the “ownership” creates a collective action problem: no one citizen, even ones who are seriously interested, has an incentive to bear the costs required to monitor the managers.

Oversight is costly, as time and effort must be spent monitoring performance if malpractice is to be detected, a task made more difficult as citizens lack ready access to information. As no direct rewards accrue to a diligent citizen from such action, there is little incentive to expend the effort to do so; they will depend on politicians for this. As discussed previously, politicians have no incentives to do so.

The main mechanisms to address these two layers of agency costs are general corporate laws on the one hand, and general political and legal institutions on the other; but for reasons discussed later, they are weak.

Therefore, the performance of state-owned enterprises (SOEs) suffer from both political costs (i.e. costs associated with the control of firms by politicians who have political goals that differ from economic efficiency) and agency costs (i.e. costs resulting from managerial pursuit of private benefits at the expense of the firm), leading to chronic inefficiency and underperformance.

THE AGENCY PROBLEM: A DISTINCTION BETWEEN PRIVATE AND PUBLIC
As observed above, the agency problem is present in all corporate entities, but it is important to note a fundamental distinction between private shareholders and citizens.

Investors in private companies take a risk when they put money down, but it is one taken of their own volition. Shareholders subscribe voluntarily to shares; they are not compelled to invest.

Generally, people only invest in private companies if they know and trust the management. If the business does not perform to expectations, they will earn a lower return. If it fails, the shareholders will lose, but it is their own money, voluntarily invested, that is lost.

With SOEs, the important difference is that, unlike in a company where willing investors are taking conscious decisions, the investment in an SOE is by citizens who contribute involuntarily and unwittingly. Taxation is compulsory, and in the form of indirect taxation, all citizens contribute to SOEs.

In the most extreme case, if shareholders are disgusted and can find no remedy, they still enjoy a final option: exit. They may sell their shares. For citizens, unless they choose to migrate, there is no exit option.

Businesses must risk their own money when they go into trade, but governments risk other people’s money. If a business does not earn a profit, the owner will need to keep infusing funds, and this provides a powerful incentive to improve efficiency. If the owner is incapable of improving the business and is unable to infuse more funds, a mismanaged business will eventually close.

SOEs in Sri Lanka, however, enjoy implicit state guarantees and funding via state banks, which undermines even the threat of bankruptcy as a source of managerial discipline. The continuous accumulation of losses is only possible because of this factor. An example is SriLankan Airlines, which has accumulated losses of $1 billion and a negative net worth, but continues to operate with funding from state banks. For context, the current IMF facility (stand-by arrangement) is $1.5 billion.

THE PROBLEM OF AGENCY WITHIN THE POLITICAL CONTEXT OF SRI LANKA
As citizens lack the interest or wherewithal to monitor SOEs, efficiency is entirely dependent on the system of governance. Distorted incentives and weakened mechanisms present structural challenges to efficiency.

“Investors in private companies take a risk when they put money down, but it is one taken of their own volition. The investment in an SOE is by citizens who contribute involuntarily and unwittingly.”

• Patronage
  Politics in Sri Lanka is based on patronage. Ministers face pressures from constituents for jobs or favours. State sector jobs are especially prized for status and security. Politicians believe that granting jobs is a necessary condition for re-election. In general, lawmakers and ministers in Sri Lanka across party lines and ideological divides view SOEs as providing avenues to create employment.

  SOEs incorporated as limited liability companies enjoy greater autonomy in the management of their affairs, allowing the minister to bypass treasury or budget restrictions placed on recruitment. In the case of state banks, it is possible for the minister to exercise patronage by directing lending on preferred terms to selected constituents.

  This leads to problems of over-staffing. The more staff are hired, the greater the potential votes, leading to the chronic over-staffing evident in many SOEs. The allied problem is nepotism – the recruitment of people based on relationships instead of ability. Recruiting unsuitable candidates weakens the general level of competence within the SOE, which adversely impacts performance.

  Therefore, patronage is particularly harmful as it has a dual impact on performance; the hiring of excess staff adds to unnecessary costs, while nepotism leads to diminished efficiency.

  A COPE report highlights how the State Engineering Corporation recruited 4,512 employees when the available vacancies were only 41. The problem is pervasive. The Secretary to the Treasury Dr. Samaratunga noted that recruitments to SOEs take place without the approval of the Management Services Department of the Treasury. “All SOEs across the government—public corporations, statutory boards or government-owned companies—have effected recruitment without proper approval of the management services”.

• Corruption
  Corruption is endemic in Sri Lanka’s political system. The root of the problem lies in campaign finance. Changes in the 1978 constitution removed limits on campaign spending and the need to disclose sources of funding. This has led to a massive increase in spending with candidates seeking to outspend each other in order to win. Those who succeed come into office having either made major investments or incurred significant debts, usually a combination of both. This creates an in-built incentive for corruption. In the absence of strong governance mechanisms, it is hardly surprising if MPs do not succumb to temptation. spending a good deal of their time in office either recovering election spending or raising funds for their re-election campaign. This explains the scramble for positions in the government, which allows control over resources. The greater autonomy of SOEs makes them particularly tempting targets.

“Greater efficiency can only be expected through better governance, which requires addressing fundamental weaknesses in the political system and adopting a comprehensive system of corporate governance for state enterprises”

LACK OF A COMPREHENSIVE SOE CORPORATE GOVERNANCE FRAMEWORK
The Secretary to the Treasury has noted that SOEs have a “general lack of governance practices, lack of accountability mechanisms, issues associated with lack of clear policy and legal frameworks, and weak supervisory roles played by the management and board of directors”.

Many countries have adopted comprehensive corporate governance practices to strengthen the governing bodies that oversee and control (shareholders or owner meetings, board and management, internal monitoring structures), while defining clear rules of engagement between the different actors, as well as increasing transparency and accountability towards stakeholders.

These are lacking in Sri Lanka, and the overall system of governance still seems inadequate to hold SOEs to account.

Conclusion
Perverse incentives and weak governance greatly increase political and agency costs of state-owned enterprises. It is, therefore, not surprising that a study by Lalithsiri Gunaruwan found that “inefficiency is a common feature in all Sri Lankan SOEs, across all organisational categories”. Greater efficiency can only be expected through better governance, which requires addressing the fundamental weaknesses in the political system and adopting a comprehensive system of corporate governance for state enterprises.

SOEs in Sri Lanka : Beyond "Profit & Losses"

The state has a long history of involvement in the economy in Sri Lanka; state ownership of utilities dates back to the colonial era. Post-independence experiments with socialism saw the expansion of the state into many new areas of business. Despite some reforms in the 1977-2005 era, state enterprises still account for a significant share of the economy.

The 2005-2015 period saw a halt to the privatisation process and a renewed wave of expansion in state businesses. Between 2009 and 2014 the number of SOEs grew from 107 to 245 while the number employed grew from 140,500 to a staggering 261,683.

Although the Department of Public Enterprises is supposed to improve governance in Public Enterprises (Commercial Corporations, Government Owned Companies and Statutory Boards), by its own admission only 55 SOEs come under its purview. The last available performance report (2014) indicates the 55 SOEs that were considered strategically important obtained budgetary support of Rs.126bn and treasury guarantees of Rs.47.6bn that year. Bank borrowings by these SOEs stood at Rs.471.2bn as at end 2014.

The size of the SOEs and the breadth of their activity make it an important determinant of the overall productivity of the economy. Consequently, the governance of SOEs will be critical to ensure their positive contribution to a country’s overall economic efficiency and competitiveness.

Ensuring that whether held nationally, regionally or locally – the state’s investments to actually deliver the societal outcomes desired is extremely difficult due to certain inherent problems.

1) Governments are run by politicians, not businessmen. Politicians can only make political decisions, not economic ones and these decisions will tend to be focused on short term publicity and benefits, ignoring long term consequences. An example is the launch of a company called Polipto Lanka to convert rubber and polythene waste to diesel. It was launched in 2009 amidst much fanfare but despite regular grants from the treasury it is yet to show any commercial results or even demonstrate that the process is economically feasible. Coincidentally, the launch took place a week before a general election. Polipto Lanka receives regular budget support from the Treasury; support for the last three years amounting to Rs.120m.

2) Governments use other people’s money; businesses must risk their own money. If a business does not earn a profit, the owner will need to keep infusing funds and this provides a powerful incentive to improve efficiency. The general public, whose money is effectively at risk in a state venture do not have the wherewithal or knowledge to hold managers or politicians to account. Politicians would prefer to postpone hard decisions than risk personal unpopularity, which is why state enterprises can keep running losses year after year.

The Janatha Estates Development Board (JEDB) and Sri Lanka State Plantation Corporation (SLSPC) have not reported a profit in the last five years, Mihin Lanka has barely made a profit since its inception, yet they continue to operate, the losses being paid by taxpayers because politicians will not risk bad publicity that may follow any attempts to reform them.

The Director General of Public Enterprises admitted as much in his report of 2009:

"We have found some boards take affairs of the enterprise very lightly regardless of their strategic importance even in a situation where PE [Public Enterprise] faces very difficult time. Since there is

no formal procedure to hold the chairman and the board of directors accountable, for their weak performance or unacceptable practices, some boards act with sheer indifference in discharging their responsibility."

3) State enterprises tend to be monopolies or restrict competition from the private sector. A business that faces no competition will find it easier to report profits. Where state businesses face competition the Government may grant SOEs preferential tax or other benefits that hinder the ability of the private sector to compete, causing deterioration in service or increasing costs to consumers. A few years ago VAT was imposed on large supermarkets but LakSathosa was exempted from this. The previously unprofitable LakSathosa started to make profits, while the efficient local supermarkets were penalised.

SOEs which operate as monopolies may not deliver an adequate level of service or charge excessive prices, which may lower the productivity/efficiency of the wider economy.

When Telecom was in state hands, obtaining a telephone connection, essential for business was a luxury that required a wait of several years. Thanks to liberalisation of phone connections, now they are available over the counter but businesses still struggle to obtain power connections and may have to invest in standby generators due to unreliability.

Energy costs (fuel and electricity) do not reflect the decline in global oil prices partly due to inefficiencies within the CPC/CEB (Ceylon Petroleum Corporation/ Ceylon Electricity Board), impacting on the competitiveness of business.

Inefficiencies in the state managed port terminals are a drag on trade but fortunately throughput at the privately managed SAGT (South Asia Gateway Terminal) Queen Elizabeth Quay is far greater and a boon to business.

The SAGT terminal has been ranked number one for terminal productivity in South Asia by the Journal of Commerce in the USA and ranked number four in the world. Because of the faster turnaround time ships prefer to dock at Queen Elizabeth Quay where it operates.

SOEs, especially those that lose money, are partly funded by banks. When a large chunk of bank lending is directed towards SOEs, the private sector will find it harder to obtain funds and higher interest rates could lead to a phenomenon referred to as "crowding out".

4) Governments cannot boost overall employment by hiring workers to the state sector. Giving people state-sector jobs may appear to create employment but this causes a problem because each new position brings with it a tax obligation that imposes a burden on the private sector, where wealth is generated and taxes paid. Effectively, since the salary of a public-sector employee reduces the amount of funds available to private employers, a job created in the public sector causes an offsetting loss in the private sector.

5) State-owned enterprises may enjoy hidden subsidies in a variety of forms including preferential borrowing costs, lower rents or taxes. Thus the actual costs will be higher than reported in the accounts and very difficult to quantify without detailed analysis. For example, imagine if ministries or SOEs had to pay market rents for the space in Government buildings that they utilise. Few would occupy the highly-valued areas they do now and would probably occupy less office space.

Indeed there is a massive opportunity cost of state- owned property in that they do not generate a net tax income for the state. If these properties were utilised by the private sector they would generate taxes as well as rents. Secondly, government office buildings in city centres create additional congestion. Given the current state of information technology, most government offices could and should be moved far from city centres. Hence, it is clear that the problems with SOEs are not limited to losses; their inefficiencies also can be a serious drag on the wider economy.

A more worrying issue is that the public is unaware of the full extent of the problem. The Treasury and other bodies that are supposed to monitor SOEs do so only partially and by all accounts ineffectively. Hence the question is - how much of public resources are being drained away in this financial black hole? The tax payers and citizens surely deserve better.

At a minimum, the Government needs to publish regular, comprehensive performance report giving the investments, outstanding debts and profits/losses of all SOEs. The question of reform needs to be urgently addressed and privatisation should remain an option.

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A version of this article originally appeared in “The State of State Enterprises in Sri Lanka” Report as well as The Island.