Beyond profit margins and scandals

By Dhananath Fernando

Originally appeared on the Morning

Blaming imports and importers has long been ingrained in Sri Lankan culture, often seen as a root cause of the country’s economic issues. This perspective not only overlooks the fact that many importers are also exporters, but also fails to recognise that imports and exports are fundamentally interconnected components of the global trade system.

Despite this, it is crucial to acknowledge that not all imports are conducted ethically or transparently. Recent scandals, such as the sugar scam, misinvoicing, bribery, and procedural irregularities at Customs, highlight the darker aspects of importation. However, casting imports in a universally negative light and fostering resentment based on ideological reasons could prove to be more harmful than beneficial.

Recent investigative reports have revealed staggering profits made by importers on essential commodities like green gram, B-onions, and potatoes. Some profit margins have been reported as high as 280% when comparing the Cost, Insurance, and Freight (CIF) value to the market prices of these goods.

Before rushing to judgement on these profit margins, it is essential to delve deeper into the circumstances surrounding these imports. For example, the importation of green gram has been severely restricted since the onset of the Covid-19 pandemic, requiring special approval from the Ministry of Agriculture. As a result, the quantity of green gram imported in 2023 has been minimal.

Thus, comparing the CIF value at the port to market prices can be misleading, as it does not accurately reflect the profits made by importers. This situation raises questions about the high market prices for green gram, pointing to inefficiencies in local production rather than exorbitant profits by importers.

The scenario with undu, a staple food item, is similar. With a Rs. 300 import tariff, the market price for 1 kg of undu ranges between Rs. 1,500-1,700. This high cost is partly because importers cannot bring in undu without approval from the Ministry of Agriculture, despite the imposition of tariffs.

Allowing imports could potentially reduce the price of undu to around Rs. 700 per kg, even after tariffs. The restriction on undu imports exacerbates price inflation, making it unaffordable for many, particularly those in estate regions and the northeast, leading to food insecurity among vulnerable populations.

During the recent economic crisis and the consequent shortage of foreign exchange, many imports were facilitated through informal payment channels and ‘open papers’ in undiyal markets. This practice, aimed at evading high tariffs and taxes through under-invoicing, underscores the complexity of Sri Lanka’s tariff structure and the urgent need for its simplification.

The report by the Ways and Means Committee suggests that focusing solely on the cost of goods at the port does not provide a complete picture of the import value, especially considering the prevalence of informal payments. This approach to calculating profits, based solely on declared document values, overlooks additional costs borne by importers, thus distorting the perception of their profit margins.

Moreover, the perishability of essential food items, along with the significant costs associated with storage, wastage, and the impact of rising fuel and electricity prices, further complicates the economic landscape. These factors, combined with high inflation rates, have significantly influenced the cost structure of both the wholesale and retail markets, affecting pricing and profit margins.

The impact of export controls on certain commodities, such as B-onions by India, has also played a role in inflating global prices, illustrating the complex interplay of international trade policies and local market dynamics.

This situation underscores the phenomenon of unintended consequences in economic policy, where well-intentioned policies can lead to outcomes that are diametrically opposed to their original goals. Sri Lanka’s intricate tariff structure and monetary instability have inadvertently encouraged informal payment methods on one hand and escalated costs on the other, placing the poorest members of society in an increasingly precarious position.

While it is undeniable that practices like misinvoicing represent clear violations of the law and must be addressed through appropriate legal channels, attributing the entirety of Sri Lanka’s economic challenges to importers overlooks the broader systemic issues at play. Simplifying the tariff structure, as this column has long advocated, could lead to increased Government revenue and minimise systemic leakages, offering a more sustainable solution to the economic challenges faced by importers and consumers alike.

In conclusion, while illicit practices within the import sector must be rigorously tackled, the solution to Sri Lanka’s economic dilemmas lies not in vilifying importers but in addressing the complex policy and structural issues that underpin the nation’s trade dynamics. A comprehensive approach, focusing on policy reform, tariff simplification, and enhancing local production efficiencies, is essential for creating a more stable and equitable economic environment.

Non-negotiable reforms for election manifestos

By Dhananath Fernando

Originally appeared on the Morning

The year 2024 will be an election year. The general flow of events is that each political party and candidate will launch a manifesto of a grand-scale and present their plans for the people and the country. Most of these promises will not be implemented or will only be half implemented. In certain cases, the opposite of what was promised will be implemented. 

Most manifestos are presented in general terms with a target of 20 years ahead with little data. Many manifestos across all party lines are wish lists with no action plans.

In my view, this time there is a slight difference. 

Regardless of the party formation or whoever the presidential candidate will be, there are few reforms that are non-negotiable. Ideally, across all manifestos, there are five basic ideas which have to be the common denominator.

Strengthening social safety nets 

Following the worst economic crisis in Sri Lanka’s history and high inflation, about four million people have fallen below the poverty line. That puts seven million people under poverty. The recent Household Income and Expenditure Survey carried out by LIRNEasia and the World Bank indicates significant poverty levels and aftereffects of poverty due to the economic crisis. As a conscientious society, we need to take care of our poor people with the social safety net. 

The social safety net is not just an allowance. It is a system and a process of targeting the right people, providing an exit route, and with proper administration. The current Aswesuma programme is making some progress with World Bank assistance, but regardless of the political leader who comes to power, it is a non-negotiable condition that social safety nets have to be strengthened and improved. 

The current process has too many loopholes which have to be addressed and improved. Simplifying the process, providing the exit route, and monitoring and depoliticising has to be a continuous effort from the new leadership of the country.

SOE reforms 

Thus far, mandatory SOE reforms have been painfully slow. Many parties with vested interests are trying to delay it until the election. However, the continuation of SOE reforms is a must. 

Colossal losses, interference in the private sector, intervening in markets, creating an unfair playing field, and inefficiencies are a few reasons why SOEs played a pivotal role in Sri Lanka’s economic crisis. SOEs are vehicles of corruption and have diluted entrepreneurship and Foreign Direct Investments significantly. Without reforming SOEs, the future of Sri Lanka appears to be bleak. 

The principles announced by the SOE Restructuring Unit are in the right direction, but the SOE Act and reforms of the Ceylon Electricity Board, Ceylon Petroleum Corporation, and many other networking industries are a must. 

Anti-corruption and governance reforms

Execution of anti-corruption laws and governance reforms is another area which has no room for negotiation. The International Monetary Fund (IMF) Governance Diagnostic and many other locally-developed reports on governance provide direction on what needs to be done. 

Strengthening our Judiciary system, transparency and accountability in our tax system, removing tax exemptions, and repealing the Special Commodity Levy and the Strategic Development Act too falls under governance and anti-corruption reforms, as those acts provide the legal opportunity for corruption. 

There is a strong sentiment from people on the contribution of corruption to the crisis, so taking long-term measures regarding corruption is a must. Anti-corruption and governance reforms go beyond going after corrupt politicians. Rather, it is a system and framework for minimising government influence. Some reforms are complementary and reforming SOEs is also a key component of anti-corruption and governance reforms, as these SOEs play a vital role in corruption.

Following the IMF programme and debt restructuring 

Given the international financial architecture, we have no option other than sticking to the IMF programme. We can negotiate some of the actions that we have promised, but overall indicative targets and reforms have to be maintained. Otherwise, it will be yet another incomplete IMF programme and the debt restructuring process will be in jeopardy. 

Debt restructuring and the continuation of the IMF programme are very much interconnected. At the moment, external stakeholders are concerned about political instability and in fact, the IMF’s first review identifies the political risks for the continuation of the IMF programme. A commitment from any political leader on sticking to the programme will help Sri Lanka in rebuilding relationships with the world.  

Trade reforms and joining global supply chains 

We have to grow our economy to emerge from this crisis. Tax revisions make it likely that growth will slow down and the only solution to grow small island nations like Sri Lanka is through global trade. Our problems regarding global trade are mainly the problems in our own regulations and systems. 

We have to remove our para-tariffs and simplify the tariff structure for a few tariff lines. Not only will this help trade, but consumers will also have a greater choice of goods and services as well as competitive prices. 

On the other hand, the Government can improve the revenue from Customs since at the moment, the high tariffs are a main reason for revenue leakage in the form of corruption. Trade reforms are about growth, minimising corruption, encouraging exports, and assuring reasonable prices. Even at present, after very high taxes, there are levies such as the Special Commodity Levy, Ports and Airports Development Levy, and a huge array of taxes which hinder the competitive nature of our economy.

These five policies, in my view, are non-negotiable. If any administration deviates from them, it is very likely that we will fall back a few miles behind where we started. 

Borders & the Budget

Originally appeared on the Daily FT, Daily Mirror

By Daniel Alphonsus

Visa reform will boost tourism and reverse brain drain

Three million tourists are set to visit our shores next year. We will issue nearly as many online visas - millions too many. ETAs are a tourist's bane: rather than dreamy sun, sea and sand, the weary salaryman’s getaway begins with the tedium of forms. 

The tourist’s ayubowan to Sri Lanka begins with ferreting for flight details and credit cards. Warm-up complete, the ordeal begins in earnest: 20 clicks to navigate through the ETA form and countless key strokes to fill out the 27 form fields. Each question brings forth its own miseries, and sometimes mind-reading feats: “They’re asking me for my address in Sri Lanka. Hmm, does this mean my first address, my last address…but I haven’t even booked my hotel..dear, dear maybe I should book the Maldives instead. They’ve got a visa-on-arrival.” Followed, naturally, by web-pages reloading with unsaved data and vindictive payment gateways rejecting credit cards for arcane and esoteric reasons. Rather than a Small Miracle, they experience So Sri Lanka. 

This charade costs us millions of dollars every year. We are losing tens of thousands of tourists to our competitors.

Based on the three scenarios below, switching from ETA to visa-on-arrival à la the Maldives or Singapore should generate between $24 million to $145 million in additional tourism revenue.

The precise number is not especially relevant. The point is that these roughly right numbers are substantial enough to generate a robust prima facie case for experimenting with opening up visa-on-arrival and optimising the ETA experience

For workings click here.

Visas-on-arrival

Sri Lanka already operates visa-on-arrival for Singapore, Maldives and Seychelles citizens. In light of the tens of millions of dollars we’re losing in the absence of visas-on-arrival, very compelling reasons must be provided for not opening-up visa-on-arrival for citizens of our main tourism markets (such as the EU, China, Russia and UK). Plus those who have passed extensive checks in the process of traveling to other countries. For example, travelers holding multiple entry visas to the US can visit about 51 countries visa free. 

The burden of proof is therefore on those who say we ought not have a visa-on-arrival regime. All the more so because it appears that, even though not advertised, in a pinch, obtaining a visa-on-arrival is possible at BIA. Also note that airlines share passenger records with governments 24 hours before arrival. It takes seconds for our border agencies to check the relevant blacklists as they already have API integrations in place. The response time of an Interpol database query is half a second.

In addition, immigration department annual reports show that almost all rejections and deportations are from a handful of countries, mainly India. Other than a German and an Australian, no UK, EU, ASEAN or Australian national was rejected or deported in 2022. This suggests a risk-based, optimized approach is very much possible, and prudent.

Many of us have experienced this personally. We are more likely to tour Singapore because Sri Lankans enjoy visa-on-arrival. In fact, on average it only takes us 10 minsto enter Singapore. As shown in the picture above, for passport holders of 50+ countries, the experience is even more smooth. Using automated immigration gates, they clear border control in less than two minutes.

Optimize the ETA process

Some tourists may still prefer to secure an ETA before arrival. Therefore, we should do our best to ensure the application is seamless. Currently it is not. Of the 27 fields requested on the ETA, about 20 can be found in passenger record details airlines share with immigration authorities. They are redundant. Questions on the ETA should be limited to around seven fields. The amount of information gathered should be commensurate with the risk: those from high risk countries could be subject to additional questions.

Eliminate the ETA fee

Credit card payments are often an even greater source of friction. Tourists need to pay $20 via credit card for an ETA. This deters potential tourists; it's another step in the journey and credit card payments often fail. So much so, the our embassy in Germany issued the following notice:

“On Arrival Visa at the Port of Entry to Sri Lanka: submit visa application and payment at Colombo International Airport. A fee of USD 60 will be charged for this service. Please observe that this option of obtaining a visa is available only for German passport holders, who have tried to obtain a visa via the ETA-system www.eta.gov.lk, but failed due to not being able to pay the fees with credit card.” 

It's not only card friction that is the problem. Many Chinese citizens no longer own cards and use Alipay instead.

Wiser countries like Singapore understand that reducing friction encourages more tourists to arrive, and thereby spend more. Which is why they don’t charge tourists a fee.

*Note the ETA fee is $20 for SAARC and $50 for other nationalities. $40 is a rough weighted average. For workings click here.

Based on the rough estimates above, if the ETA fee or friction puts off even three percent of tourists, then Sri Lanka stands to unequivocally benefit from eliminating the ETA fee. The exchequer will be worse off for now. But the Treasury still recoups some of the lost visa fees by higher VAT revenue directly, and indirectly via higher income tax from tourism sector firms and employees. (1)

Brain Gain

Since Independence Sri Lanka has lost or chased away lakhs of skilled workers. Many middle class families can proudly count at least one doctor, accountant and engineer (among many other species of the middle bourgeoisie) among their relations overseas. Between 2005 and 2015, the BOI estimated that around 20% of STEM graduates left the country every year. With COVID and the economic crisis, emigration was particularly acute the last few years. But it's not new. Skilled emigration is a chronic problem we’ve faced for decades.

(2 ) This report offers a rigorous treatment of the topic from the 1970s.

We desperately need to reverse brain drain. Of course, the central challenge is building a Sri Lanka in which Sri Lankans want to stay. But that is beyond the scope of this article. Here we shall only discuss how we can make it easier for skilled talents to come, and contribute. 

Some readers may be perplexed that even a handful of skilled non-Sri Lankans want to live and work on our island. But we live in a nomadic, connected and occasionally romantic age. These rare souls exist. 

We must do everything in our power to welcome and encourage them. Above all, by simply removing barriers to them legally working here. For the path to prosperity is paved by productivity growth. Therefore, it makes absolutely no sense for us to create barriers for skilled migration. It is the opposite of what smart countries do - especially via human capital theft aka points-based migration. There are three main ways foreign talent raises Sri Lanka’s productivity, growth and thereby prosperity. Foreign talent:

1. Adds human capital: whenever someone who has higher productivity than the average Sri lankan worker moves to Sri Lanka, they raise Sri Lanka’s average productivity directly. We already have huge talent shortages in key sectors like IT. 

2. Upgrades existing human capital: foreign talent, directly or by osmosis, teaches their skills to others.  

3. Increases existing human capital productivity: the whole is often greater than the sum of its parts. Skilled talent enables others to be more productive. For example, having access to a pediatric neurosurgeon makes all pediatricians more productive as knowledge is shared from expert to generalist. Alternatively, having a Japanese team-member makes the whole team more effective when working with Japanese clients. 

Per capita GDP is a good proxy for average worker productivity. Therefore, if someone from a richer country moves to a poorer country, then the average productivity of the poorer country will improve. How do we do this? The Harvard Centre for International Development has some ideas from which I borrow liberally. 

The fastest way for Sri Lanka to have brain gain to compensate for some of the brain drain is to:

Offer a two-year visa-on-arrival for those from countries that are 4x richer than Sri Lanka

1. Offer a two-year renewable visa-on-arrival for citizens or permanent residents of countries which have per capita incomes at least four times that of Sri Lanka. (3)

2. Amend the Citizenship Act such that any person who has at least two Sri Lankan grandparents is eligible for citizenship. ()4 

3. Regularize employment of all foreign spouses of Sri Lankan nationals, including a path to permanent residency and citizenship. (5) 

The first of these measures can be implemented by the stroke of the minister’s pen.(6) Sri Lanka’s immigration act provides for broad ministerial discretion. The minister is empowered to make entry regulations for visas upto five years in length. He or she can implement Point A above without requiring primary legislation.

We have little to lose, and all to gain. Try these measures for a year, try them for a few countries. Then roll-back or amend accordingly. Sri Lanka has a long history of policy-instability, but we should not confuse the many cases of foolish equivocation with genuine experimentation. That is what this budget should propose: bold measures to breakthrough our malaise and initiate the process of transitioning from stabilisation to recovery.

(1) As this article is solely on matters related to the immigration act, I’m not going to discuss this in detail. But it's worth noting that levying a flat (dis)embarkation levy is also a deterrent against short-haul traffic. Instead, the airports authority should price the levy based on the distance between Sri Lanka and the origin/destination airport.

 (2) Diaspora remittances do little to compensate: Sri Lankans remit more from the Maldives than Australia.

(3) For those that ask why a per capita GDP based criterion rather than points-based criteria, my answer is simple. A points-based system inherently involves discretion, and in the context of our state (in)capacity and corruption, will result in friction (countless people will not bother applying with all the documents that will be required), many false positives (as the assessors of points, e.g. a degree certificate’s legitimacy, will be corrupt) and false negatives (because those with skills we want may not have the right paper to demonstrate it). Considering this range of incentive problems and Type I/II errors, a very conservative threshold like the 4x per capita GDP one suggested is most optimal.

(4) For further details on this point and the next point, see page 14 of this study on Sri Lanka’s immigration framework.

(5) Reaching consensus in Parliament on this point should be easy. Sajith Premadasa’s manifesto promises dual citizenship after three years of residence for foreign spouses of Sri Lankans. See page 39.

 (6) Soon, one hopes, his or her digital signature. In fact, the President should announce that he will only sign documents via a digital signature from 31 December 2023 onward.

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.

Reforming Sri Lanka's Tax System: A Path to Fiscal Stability and Economic Growth

Originally appeared on Daily FT

By Dr Roshan Perera, Thashikala Mendis, Janani Wanigaratne

This article provides an insight on the Personal Income Tax structure in Sri Lanka as the second part of a series discussing potential tax reforms

Raising government revenue is critical for Sri Lanka to recover from the current economic crisis and create a more sustainable economic environment. However, taxes should be paid by those who can bear the burden. 

Personal Income Taxes (PIT) is an effective instrument in generating revenue as well as in reducing inequality through revenue redistribution.  In Sri Lanka, there has been a steady decline in revenue from PIT from 0.9% of GDP in 2000 to 0.2% of GDP in 2022. Revenue collection is  lower than that of even other low income economies. Furthermore, PIT tax revenue as a percentage of direct tax revenue declined from 40% in 2000 to 9.3% in 2022, although GDP per capita increased from USD 869 in 2000 to USD 3,474 in 2022. 

Advanced economies raise approximately 9% of GDP from PIT, while emerging economies and low income economies raise only 3.1% and 2.1% of GDP, respectively. (1)  Sri Lanka reports the  lowest contribution of PIT as a percentage of GDP in 2021, both among  advanced economies in Asia such as South Korea, as well as developing economies such as Bangladesh, Malaysia and Vietnam (See Figure 1).

Figure 1: Performance of Personal Income Tax Collection among Selected Countries

Source : IMF Data Library, OECD

Narrow Tax Base

The narrow tax base is one of the main reasons for Sri Lanka’s low PIT revenue performance. A narrow base not only limits revenue generation but it also makes revenue collection reliant on a small segment of the population. 

The number of income tax payers under the  Pay As You Earn (PAYE)/Advanced Personal Income Tax (APIT) Scheme (2) as a percentage of the total employed population shows  a relatively small proportion of the workforce contributing to income taxes (see Table 1). In 2019,  the proportion of tax paying employees was 33%. This proportion declined to less than 1% in 2021 due to abolishing of PAYE taxes with effect from 1st January 2020.  A voluntary APIT System was introduced with effect from April 1, 2020, where employees can opt in. This shift not only led to a revenue decline but also created monitoring gaps. With effect from January 1, 2023, it was mandated for employers to deduct APIT from employees' income, reverting to the original PAYE scheme.

(2 ) Note: PAYE/APIT is where employers deduct income tax on employment income of employees at the time of payment of remuneration.  PAYE was replaced by APIT with effect from April 2020. This measure of replacing PAYE with APIT essentially made PAYE optional. However, with effect from January 2023, deduction of Withholding Tax (WHT), Advanced Income Tax (AIT)  and APIT has been made mandatory.

Table 1: Employee Contribution to PIT

Source: IRD Performance Reports, Labour Force Survey

The large informal sector also contributes to the narrow tax base and low PIT performance. According to the Labor Force Survey (3) 2022,  the informal sector accounts for around 58% of total employment (see Table 1).  A large portion of the economy operating  outside formal regulation enables tax evasion and avoidance. Transforming the current informal self-employment system to a modern formal employee-employment system would be one way to improve tax revenue collection. 

Two alternative recommendations are proposed to capture informal economic activities into the tax net.  Establishing a universal online payments system would reduce cash transactions in the economy enabling better monitoring; and secondly, by introducing a unique digital identification system that connects tax accounts with income sources, bank accounts, motor vehicle and land registration etc. Authorities could cross check information provided in income tax returns as well as identify individuals who do not file returns. 

Tax Free Threshold and Tax slabs/Brackets

In the recent amendment to the Inland Revenue Act (4),  the tax free threshold for income was reduced from Rs.3 million per annum to Rs.1.2 million per annum. Further, the tax brackets were reduced  from Rs.3 mn to Rs.0.5 million.  Accordingly, the incremental tax rate for each additional Rs. 0.5 million of income was set at 6% (see Table 2).

Table 2:  Tax Threshold and Tax Brackets

Source :Inland  Revenue (Amendment) Act, No. 4 of  2023

Applying the current tax free threshold, income taxes are applicable to  approximately the top 15% of households where around  36% of total  income is concentrated (see figure 2) (5).

(5) Note This is based on the Household Income and Expenditure Survey 2019

Figure 2: Share of Income by Population 2019

Source : HIES Survey Annual Report 2019

According to the national poverty line (6) for  July 2023, the minimum monthly expenditure per person required to meet basic needs is Rs. 15,978. Hence, the total cost for a family of four is approximately Rs. 65,000 per month. Assuming salaries and wages remain unchanged at 2019 levels,  more than two-thirds of income is spent by households up to the 9th decile, (see Table 3).  Any additional financial burden including income taxes could further reduce the disposable income of households up to the 9th income decile. Hence, information on household income and expenditure patterns must be considered when setting income tax thresholds.

Table 3 :  Mean Household Expenditure as a % of Mean Household Income

Source : HIES Survey Annual Report 2019 (7)

Although the current tax system applies differential tax rates based on income brackets, an analysis of the effective tax rates paid within these brackets indicates a less than progressive tax system.  An individual crossing the tax free threshold of Rs.1.2 million per annum (equivalent to a monthly income of Rs. 100,000) pays an effectives tax rate of 1%, which gradually increases to 12% until the highest income bracket is reached at over Rs. 3.7 million (which is equivalent to a monthly income of Rs. 308,333). All the income levels above this income would be taxed at the highest nominal marginal rate of 36%.  However, after a particular income level the effective tax rate flattens (see Table 4). This implies that individuals in the highest income categories effectively pay less taxes. Expanding the income tax brackets would introduce more fairness and progressivity into the tax system.

Table 4 :  Effective Rate of Tax

Source :  Author’s Calculation

Figure 3: Personal Income Tax as a percentage of Annual Income

Source : Authors’ Calculation

The fairness of the tax system is further exacerbated as those whose main income sources are subject to capital gains are taxed at only 10% versus those whose income are subject to PIT who are taxed at a higher rate of 36%. 

As wages and salaries rise to keep up with inflation, individuals may find themselves earning more in nominal terms, but their purchasing power remains relatively unchanged.  Adjusting thresholds for inflation ensures that employees are not disproportionately burdened by bracket creep where taxpayers are pushed into higher brackets due to inflation. A proper rationale and scientific basis for determining thresholds, tax slabs, and tax rates is needed to increase revenue collection and ensure fairness in the tax system.Also, the proposed tax system should generate the estimated tax revenue by the end of the year.

Frequent ad hoc policy changes

Tax policy is frequently subjected to change, without proper economic rationale. For instance, the tax slabs for PIT have been revised 9 times while the tax free threshold was revised 5 times since 2000. Frequent and ad hoc policy changes complicate tax administration and reduce tax compliance.

Conclusion

The country has failed to meet  the first quarter targets for revenue under the IMF’s Extended Fund Facility Program. Raising government revenue will be critical to remaining within the program. Improving revenue collection from income taxes will be critical to achieving the revenue targets, while broadening the tax base will ensure the burden of taxation falls on the broadest shoulders.

Part one of the OPED series on Reforming Sri Lanka's Tax System: A Path to Macroeconomic Stability and Sustainable Economic Growth can be found here

Sri Lanka needs a bottom-up approach

Originally appeared on The Morning

By Dhananath Fernando

Regrettably, over the years, Sri Lanka's approach to development has primarily relied on aid and subsidies for its impoverished population. Many politicians have spoken about poverty, but they have often neglected to address its root causes. If our policies were centered on eradicating poverty rather than simply targeting the poor, our development framework could have evolved significantly.

As the adage goes, "there are no poor people, only poor places or countries." A recent report by LirneAsia revealed a startling increase in poverty numbers, rising from 3 million to 7 million people, pushing over 4 million individuals below the poverty line. If our long-standing strategies, such as fertilizer subsidies, Samurdhi, and fuel subsidies were on the right track, how did an economic crisis suddenly plunge 4 million Sri Lankans into poverty?

The ability to maintain strong international relationships and secure more aid has been considered a crucial qualification for candidates, during election cycles. Within the voting community, politicians offering the most substantial subsidy handouts are often perceived as popular leaders. While it is true that we need comprehensive international relationships in modern politics and must take care of our citizens, we must do so while keeping a development-oriented mindset at the core. Regrettably, development cannot rely solely on foreign aid, nor can we lift people out of poverty by offering aid exclusively to the poor.

This situation is not unique to Sri Lanka; it's a global phenomenon. No country has achieved development solely through aid programs. Instead, countries that have reached the development stage share strong institutions and reasonably functioning market systems as common denominators.

The primary focus of any government or political leader should revolve around two key conceptual frameworks:

1. Are we establishing institutions that promote a level playing field?

2. Are we encouraging a functioning market system?

Development is generally a bottom-up approach. People often know what's best for themselves better than politicians or leaders do. We simply need to provide them with opportunities in a competitive environment. Recently, I had the privilege of meeting a few small and medium-sized exporters. The entire system and processes seemed designed to hinder their export activities. Many exporters emphasized the difficulties they face when exporting in Sri Lanka, including challenges and harassment from government regulatory authorities, such as Sri Lanka Customs.

A prime example of our low export numbers is not only market access problems but the barriers within our own system that obstruct exports. One exporter from Kandy, specializing in vanilla exports, highlighted how customs consistently questioned HS codes and demanded repetitive documentation, causing him to spend more time on export processes than on developing his product and capacity. These challenges are consistent across the board for exporters, explaining why Sri Lanka's exports remain stagnant despite numerous committees, task forces, and chairpersons at the Export Development Boards.

Real change should start from the bottom by removing barriers for businesses and offering people the freedom to pursue their desired endeavors. Such reforms may not bring personal glory, as they empower individuals to make their own choices. In contrast, an aid-driven approach often results in leaders or countries seeking personal recognition through associated aid packages.

In Sri Lanka's case, we must remind ourselves that only we can make a difference and pull ourselves out of this crisis. While we need the support of international institutions like the International Monetary Fund and bilateral and multilateral creditors, they alone cannot rescue us from our predicament. It is only through economic reforms and the development of inclusive institutions that we can compete on a level playing field and extricate ourselves from this mess. Both small and large reforms are essential, and we must implement them swiftly and effectively.

SL’s tariff regime

Originally appeared on The Morning

By Dhananath Fernando

The Minister of Finance mentioned that “many surprises” would be contained in the Annual Budget for 2024. In economics, surprises are something we would want to avoid; the more surprises we get, the lower stability is. Frequent surprises are a sure way to push away investors and the business community. One surprise measure mentioned recently in Parliament was a tax on primary dealers in the bond markets as they were left out in the Domestic Debt Restructuring (DDR) process.

Just a few weeks ago, this column speculated about the likelihood of selective taxes, such as super gains tax or wealth tax, in the Annual Budget for 2024. If the reason to impose a special tax on primary dealers is the high profits they made as a result of being left out of the restructuring process, does this mean the Government is admitting it made a mistake by leaving them out of the debt restructuring processes? If so, we cannot correct it by imposing a tax, since two wrongs do not make a right.

A special tax on selected groups or industries is the opposite of tax holidays. The way we select industries or business categories for special taxes is the same way we select industries for tax holidays. Both are two sides of the same coin.

It is true that Government revenue is low compared to the size of our economy, but it is definitely not the fault of the businesses which made profits, unless their profits are exempted from taxes.

Sri Lanka’s corporate tax of 30% is a reasonably high rate. Even the UK increased its corporate tax to 25% in 2023 from 19%. Tax competitiveness is already low due to unreasonably high taxes and an unstable economic and political environment. Therefore, what is the rationale for charging a higher tax on a selected industry or a group if they already pay a corporate tax of 30%?

The unfortunate reality is that we cannot increase tax revenue simply by imposing selected taxes or by spontaneously increasing rates. This would bring the same consequences as our tariff structure.

The issue with the tariff structure in Sri Lanka is that we have imposed different taxes for different HS codes, making it very complicated. Some HS codes are charged a CESS and others are charged para-tariffs, creating considerable doubt as to which taxes are applicable when importing anything. This complexity in the tariff structure has resulted in a high level of corruption.

It is argued that bringing the tariff rates down and making it simple will improve tariff revenue. The same logic is applied for income tax and corporate taxes. The more complicated and more targeted special segments are, the more likely tax evasion is, and will eventually lead to our overall tax revenue further deteriorating.

In 2015 and 2021, a similar attempt was made to impose a singular super gains tax on companies earning over Rs. 2 billion. There were many instances where special taxes were imposed on the financial sector without any detailed analysis or impact analysis on overall tax principles.

Has it made our tax revenue better? The answer is an obvious no. Therefore, special taxes which may come as surprises for selected industries may not lead to the expected outcome. Instead, they will create more confusion in the market.

It is likely that the Government is targeting primary dealers due to the controversy that arose during the bond scam in 2015 and similar incidents, with suspicions of insider trading taking place afterwards.

If the reason for super profits is insider trading, the answer is a forensic audit and bringing the related parties to justice. The Government can start the process by releasing the full forensic audit report on the investigation of the presidential commission appointed for the bond scam.

Imposing a special tax to correct the super profits of insider trading may start a vicious cycle of unethical trading and business operations.

Investors will consider the occurrence of a similar circumstance if they make better profits – that they too will be liable for a special tax in addition to the corporate tax they pay.

More importantly, it dilutes the principles of an aspirational society. Assuming that someone should pay a higher tax simply because they made a profit is discriminatory and acts as a disincentive for generating wealth and profit. Those who made a higher profit are already paying a higher tax proportionately, compared to those who made less profit, at a rate of 30%.

Taxes have to be imposed based on principles of simplicity, transparency, neutrality, and stability. These are referred to as ‘principles’ because there is a rationale behind it. Statistics without principles and principles without statistics are both dangerous.

Reforming Sri Lanka's Tax System: A Path to Macroeconomic Stability and Sustainable Economic Growth

Originally appeared on The Morning

By Dr Roshan Perera, Thashikala Mendis, Janani Wanigaratne

This article provides an overview of the current tax system in Sri Lanka as part of a series discussing potential tax reforms.

Sri Lanka is recovering from the worst economic crisis in its history. Continuous high fiscal deficits due to insufficient government revenue to finance growing government expenditure has resulted in an unsustainable level of debt. This has hindered the government's ability to make capital investments and allocate sufficient funds for essential services such as education and healthcare. A large proportion of revenue (77.7% in 2022) goes to finance interest payments, It is also one of the largest items of recurrent expenditure accounting for 44.5% of recurrent expenditure in 2022.  In comparison expenditure on education, health and social protection (Samurdhi) accounted for only 9.3%, 7.9% and 3.4% of recurrent expenditure, respectively, in 2022.  

Getting back on a path of macroeconomic stability requires a significant boost in revenue.Revenue based fiscal consolidation is one of the key pillars of the stabilization program agreed with the International Monetary Fund (IMF).  The program sets a target of raising tax revenue to 14% of GDP (at the minimum) by 2026 through tax policy reforms and revenue administration reforms.

Taxation as a social contract

The main purpose of taxes is to provide funding for public services. Moreover, it redistributes income through transfer payments to low income households. Taxation is a classic example of the social contract between the citizens of a country and their government but also between citizens. This unwritten agreement influences the willingness of citizens to pay taxes in return for the services they receive from the government. Tax compliance rates in countries indicate a correlation between the payment of taxes and public service delivery. Dissatisfaction with public service delivery is found to be associated with low tax compliance. In Sri Lanka, the state is responsible for providing a wide range of public services such as education and healthcare.  However, the collection of taxes required to finance these public services is woefully inadequate. This could be due to lack of awareness of the role of citizens in the social contract or a lack of quality and availability of public services.  This leads to citizens abandoning public services in favour of the private provision of such services and being unwilling to pay for public services they  feel they don’t use. A robust tax system is necessary for a government to deliver high-quality public services to all its citizens.

The current state of taxes in Sri Lanka

Sri Lanka’s tax revenue collection  has steadily declined from 19% of Gross Domestic Product (GDP) in 1990 to 7.3% in 2022. Although national income has increased over time with  GDP per capita rising from US $ 472 in 1990 to US $ 3,474 in 2022 there has not been a corresponding rise in tax collection (See figure 1).

Figure 1: Declining Tax to GDP

Source : Central Bank Annual Reports

Revenue collection in the country is also highly skewed, with 69.5% of tax revenue collected from indirect taxes. Undue reliance on indirect taxes is due to the large informal sector which is ‘difficult to tax’.  The direct to indirect tax ratio has consistently remained around 20:80 over time. Although direct taxes as a proportion of total tax has gradually increased from around 15% revenue in 2000 to 31.5% in 2022, as a percentage of GDP it has remained at a low level of around 2% for the last two decades, implying that it has not kept pace with the growth in the economy.

Figure 2: Composition of tax revenue

Source : Central Bank Annual Reports

The steady decline in revenue is due to inherent weaknesses in the tax system. One of the key issues is ad hoc policy changes relating to tax rates, thresholds, and exemptions, with little or no economic rationale. The frequency of these tax policy changes worsens the existing compliance issues as well as administrative issues. The resulting loss of government revenue, worsens income inequalities and reduces funds available for essential public services.

These concerns need to be addressed through comprehensive reforms in all 3 broad bases of tax, namely, (1) taxes on earnings such as personal and corporate income taxes; (2) taxes on what is purchased such as the value added taxes (VAT); and (3) taxes on what is owned such as land and property taxes. Identifying the issues in each of these taxes will be key to reforming the tax system and optimizing revenue collection which is vital for ensuring macroeconomic stability.

Conclusion

Building an effective fiscal social contract through taxation is as equally important as addressing the issues prevalent in the current tax system. It requires the government  to use the taxpayers’ money in a responsible and effective manner. Lack of transparency and accountability for the way a government uses the taxes it collects will make it very difficult for the government to convince its citizens to pay their taxes.  On the other hand, citizens are responsible for holding the government accountable and ensuring taxes are utilised for providing good quality public services for the benefit of society as a whole.

Bank interest rates: The A-Z

Originally appeared on The Morning

By Dhananath Fernando

As the Annual Budget approaches in November, there lies the risk of introducing price controls again. Budgets are usually like auctions of resources that don’t actually exist, often used by governments for publicity. In the 2015 Budget, there was a salary increase for Government workers and price controls were placed on items like hoppers and plain tea.

Budgets that come around election periods more often include giveaways and price controls, which cannot be maintained sustainably.

Meanwhile, the Central Bank, in a recent Monetary Policy meeting, hinted at controlling interest rates for certain banking services like pawning, credit cards, and pre-arranged temporary overdrafts.

The Central Bank appears to be in a tough spot, facing pressure from political authorities, the people, and other stakeholders. People and businesses are still struggling with the economic crisis, the aftermath of the Easter attacks, and the after-effects of Covid-19. People need loans (credit facilities and services) during this tough time. Unfortunately, the banking sector is slow to respond by lowering interest rates, even with the Central Bank’s new policies.

Recently, the Central Bank has been lowering interest rates – the Standard Lending Facility Rate and the Standard Deposit Facility Rate. The Statutory Reserve Ratio (SRR) has also been brought down by 2% and changes have been made, but this hasn’t led to a proportional decrease in lending rates by banks.

Unique situations for different banks

Some banks have responded more than others. For example, some banks charge higher interest rates for pawning (27% compared to 20% in other banks) and credit cards (33% compared to 28% in other banks). The same goes for personal loans (4% vs. 2%).

Let’s try to understand why some banks offer higher rates while others don’t.

Each bank’s lending and deposit portfolio is unique. Some banks generally have a higher percentage of Non-Performing Loans (NPLs). For them, bringing interest rates drastically down may be difficult. Since interest income is the key income for banks, if a particular bank has a higher NPL ratio, it would be difficult to adjust the interest rates.

On the other hand, with domestic debt restructuring, certain banks had higher exposure to Treasury bonds. Prior to debt restructuring, these banks faced higher risk, yet as they have been excluded from restructuring, this same exposure became a blessing later. For them there is greater room to adjust the interest rates while others may not have the same leeway.

Different banks have different types of loans. Some focus on small businesses, while others offer pawning. Pawning is safer because there is something valuable as collateral. Each bank’s situation is unique, and ideally in a market system people should switch to banks with lower rates, assuming everyone has the same information.

Options with consequences

However, these changes take time, especially when the country’s monetary system isn’t stable due to debt restructuring and weak economic policy. Also, due to instability, in most cases banks aren’t offering fixed interest rate loans anymore; most loans have flexible rates.

Mounting pressure on the Central Bank has left a few options, each with its own consequences. One option is offering special low-interest credit lines (e.g.: special credit lines with the support of the Asian Development Bank, etc.), like the Enterprise Sri Lanka loan scheme introduced before by former Finance Minister Mangala Samaraweera. This could lead to unintended consequences, like people using the loans for non-productive purposes.

For instance, many bank managers disbursed the loans to their existing customers, who basically settled their previous high-interest loans with the new loan at a concessional rate. Some loans were taken for consumption purposes, such as weddings and buying vehicles. There were reports that existing companies, including large companies, set up new entities just to obtain a loan to cover their previous debts. However, this is a solution that can be tested with the least impact within a strict monetary system, but unintended consequences should be expected.

Another option is the Central Bank artificially lowering rates by printing more money. This could worsen the economic situation, causing problems for the exchange rate and later on for inflation and the entire financial system.

Alternatively, the Central Bank could use its influence for the funds it manages (e.g.: Employees’ Provident Fund) and buy Government bonds at lower rates, attempting to push rates down. This also has downsides and is not advisable.

No simple solutions

When a country’s monetary system isn’t stable, these complex situations arise. This column has warned, time and time again, against the monetary instability caused by money printing that led to these situations.

Setting a cap on interest rates is like controlling prices, which isn’t a good idea. It could set a bad precedent and cause further problems. On the previous occasion the Central Bank controlled the exchange rate and forex repatriation, the Balance of Payments (BoP) crisis got worse. Though interest rate caps may have good intentions, the fallout could be tricky. In response, banks with portfolios that don’t support lower rates may reduce their lending, affecting people who need loans.

People who have credit needs may have to settle for further high interest options, making their situation worse on one side. More fake microfinance solutions with very high interest rates may emerge and people will have to depend on informal financial borrowing if the banks impose more restrictions on pawning and selected operations.

Social costs can be seen as there were multiple incidents of conflict in recovering debt and in extreme cases, even the loss of life. The experience over years has been for the Government to provide debt cancellation and relief for people by taking responsibility for the debt when people suffer from bad loans.

Unfortunately, there is no simple solution. The best approach is understanding the issue and its consequences before taking action.

Sri Lanka’s talent drain: From dreams to departures

Originally appeared on The Morning

By Dhananath Fernando

Every day, news stories emerge about skilled labour from Sri Lanka migrating out of the country. It’s not only doctors, engineers, bankers, and teachers who are leaving, but also individuals with institutional knowledge from small and medium enterprises.

This outflow of talent is undeniably going to adversely affect businesses next year. Many attribute this migration to the economic crisis, and often, the debate revolves around the ethical aspect of people leaving after benefiting from investments in education and healthcare funded by taxpayers.

The crisis we currently face is multidimensional. We are dealing with a Balance of Payments crisis, debt crisis, currency crisis, economic governance crisis, and a humanitarian crisis. Amidst all these crises, the issue of why people are leaving the country is primarily a crisis of an economy unable to accommodate its citizens’ dreams and aspirations.

Unfortunately, the dreams of many Sri Lankans, especially those with high-reaching aspirations, have consistently been at the receiving end of various Government policies over the years, even before the economic crisis truly struck. The economic crisis was merely the final blow that compelled people to make the decision to finally leave.

If you recall, many political campaigns targeted youth and professionals with visuals of young people buying vehicles, enjoying family life, having access to better schools, and other attributes of a middle-income lifestyle. In fact, during the Yahapalana Government, the then Finance Minister Mangala Samaraweera understood the needs of the youth and introduced special loan schemes aimed at them under his flagship project ‘Enterprise Sri Lanka’.

High tariff rates

However, our policies over the years have largely stifled the aspirations of an aspirational society. If you take a stroll in urban areas, it becomes apparent that there are many unfinished houses. Often, you can see rusting steel bars protruding from concrete beams and the primary use of the slabs seems to be for drying clothes.

Many people are unaware that the dream of owning a decent house in Sri Lanka has been hindered by very high tariff rates on steel, tiles, bathware, and practically all construction material. People’s right to access reasonably-priced construction materials has been obstructed, resulting in our construction costs being higher than other countries in the region.

Additionally, people pay interest rates of 14-18% on their housing loans due to the extra 40% cost they incur. Consequently, the funds people could have invested into building their second floor have already been spent on the ground floor. This situation affects masons, carpenters, architects, designers, and the entire supply chain, crushing their dreams as well.

Further, certain products imported to the country incur effective tariff rates of over 100%. Sadly, the Government doesn’t even generate significant revenue from these high tariffs, as they are so exorbitant that importing at an effective tariff of over 100% makes no sense. This form of corruption is hidden, as certain individuals benefit from maintaining high tariffs for personal gain, while consumers suffer. The significant reason for professionals considering migration, despite the hardships, is the crisis of shattered aspirations, which the Aragalaya represented.

This type of corruption is challenging to capture, but in people’s minds, the notion that a few people are stealing their dreams holds true when they understand how tariff rates have diminished their quality of life.

Subpar transport system

Another major factor affecting people’s lives is transportation. Our public transport service is abysmal due to a lack of market openness and market restrictions through a permit system. State-owned train services are not only unprofitable but also fall far below average service levels. Thus, for the middle class, the logical choice is to purchase a personal vehicle.

However, personal vehicles are also subject to tariffs of over 100%. Remarkably, the Sri Lankan Government earns a greater profit margin than the automobile manufacturers themselves by imposing tariffs exceeding 100% of the vehicle’s value. Essentially, this means buyers are paying a value of more than double the price of the vehicle.

The extra cost is often funded by borrowing through vehicle leases, incurring interest rates of over 14% on top of everything else. Further, they pay an additional Rs. 50-70 for every litre of fuel, and the cycle continues with spare parts, revenue licences, etc.

For professionals, their aspirations are once again ignored, making it unsurprising that people consider migrating. The Government’s solution to the vehicle issue over the years has been a vehicle permit system which has exacerbated the problem rather than solving it.

Crisis of unrealised dreams

In summary, the migration of people represents a crisis of unrealised dreams, with the economic crisis serving as a significant trigger.

The solution lies in allowing the private sector to recruit skilled individuals from other markets and establishing a scheme that permits skill migration into Sri Lanka. This approach would help fill vacancies, promote knowledge transfer, and stabilise the business environment.

If Sri Lankans can migrate overseas and compete in Toronto, New York, London, Dubai, and Stockholm, they can undoubtedly compete with anyone else in Sri Lanka. Knowledge transfer would be enhanced and salaries would increase over time, even for local staff.

Given that we have already shattered people’s dreams, we shouldn’t obstruct the remaining dreams of those considering staying in Sri Lanka. The best way to retain them is by ensuring the sustainability of the remaining business ecosystem. But to ensure the ability to realise the dreams of an aspirational society, the cause of the problem must be fixed at the root.

A facelift for the railway

Originally appeared on The Morning

By Dhananath Fernando

I am a frequent train traveller, whether it’s a short or long distance journey. Often, I book railway tickets from Colombo to Anuradhapura, especially for my mother when she goes to attend religious observances. Many years ago, the process of booking train tickets used to be quite complicated, requiring a visit to the station. However, things have changed over the years. Nowadays, we have the option of booking train tickets online or through our mobile phones.

I usually make the booking by calling my mobile service provider and providing the National Identity Card (NIC) details of the passenger. The fare is then directly charged to my mobile phone. If I am booking for multiple passengers, I need to provide the NIC numbers for all of them. While this method is convenient in some ways, I did have a few concerns.

Despite booking the ticket over the phone, the passenger still needs to physically collect the ticket from a designated counter by presenting their NIC. This seems to defeat the purpose of online/phone booking, as the passenger ultimately has to go and get a physical ticket. The only advantage is that I can ensure that a seat is available before all seats are taken.

Another concern is that online/phone ticket booking opens just two weeks before the departure date. This means that if my mother is travelling on a Sunday and returning on a Tuesday, I need to call on a Saturday two weeks prior for the departure ticket and then again the following Monday for the return ticket. If I wait until Monday to book both tickets, there is a high chance that the Sunday train tickets may be sold out.

Recently, I had the chance to speak with a senior officer from Sri Lanka Railways, who shed light on some of these concerns and suggested ways the railway sector could be transformed. The officer explained that passengers were required to collect tickets in person because the railway ticket inspectors lacked QR-code scanners as well as funding for this investment. Essentially, the requirement to collect the tickets physically stems from the inability to verify the authenticity of online tickets. However, mobile phones could easily scan QR codes, similar to what is done at fuel stations in Sri Lanka.

The limitation of ticket schedules opening only two weeks before departure aims to prevent early bookings that may lead to ticket resales at higher prices, which can disadvantage regular travellers. However, in my view, no business can ask for a better deal than the payment of a service months before even providing it. A ticket shortage also indicates an incapacity to supply services for certain routes on the rail routes that have excess demand.

Another concern I had was why we could not rent out prime railway properties, such as the land owned by Sri Lanka Railways, for development. Regarding this, the officer pointed out that according to the Sri Lanka Railways Authority Act, properties under the railway could only be rented for five years, discouraging larger investments.

This highlights the need for ‘property rights’ to attract investors and promote property development. A key pillar of a market system is ‘property rights’ and most railway stations situated in prime locations are poorly maintained due to a lack of investment. Offering long-term leases to investors could provide funds for essential improvements, including implementing QR code readers for ticket checking.

Developing Sri Lanka’s railway system is not just about receiving train compartments from other countries. Nor is it about having QR codes or simply developing railway stations. We must address pricing incentives for road and train travel while maintaining the benefits for passengers at the core. A customer-centred approach and the right investments are crucial for meeting their expectations. That is why when markets are allowed to develop with space for specialisation, it solves people’s problems.

A master strategy for railway development should aim to fulfil people’s commuting needs. Economics plays a role at both micro and macro levels, emphasising the need to get the economics right for meaningful progress in our railway system.

Fixing policy failures in trade and tariff

Originally appeared on The Morning

By Dhananath Fernando

In Sri Lanka, we have often faced the consequences of two types of failures – ones of those who acted without proper thought and ones of those who had great ideas but never put them into action. This holds true for many of the policies we have implemented, especially when it comes to trade and tariff structures.

Recently, there was a parliamentary discussion on wheat flour prices. While global flour prices have decreased, Sri Lanka’s wheat prices have remained high. Common sense tells us that if prices are not adjusting accordingly, there must be some market intervention or manipulation. We need to return to first principles to better understand this.

The price of any resource represents its scarcity value. Increasing prices indicate a higher scarcity value, while decreasing prices suggest declining scarcity. Wheat flour prices in Sri Lanka have been wielded as a political tool over the years, making them a matter of great significance, particularly for vulnerable communities, such as those in the estate sector. As wheat flour serves as a primary carbohydrate source for many due to income limitations, its price carries immense importance.

In the past, the Government managed wheat flour distribution at heavily subsidised rates, similar to the situation with petroleum products, due to its political value. During the time of President J.R. Jayewardene, wheat flour was imported under the PL 480 agreement and many subsidies were granted under this programme. When Chandrika Bandaranaike Kumaratunga assumed power, she promised to provide a loaf of bread for Rs. 3.50, highlighting the significant political importance attached to the pricing of wheat flour.

Later, a monopoly licence was granted to one company to convert wheat grains into flour. This would have been acceptable if, simultaneously, wheat flour imports were also permitted. However, the Government imposed high tariffs on wheat flour imports while keeping tariffs for wheat grains significantly lower.

This created a lopsided tariff structure that discouraged wheat flour imports, favouring the two companies already engaged in wheat grain to flour conversion. According to the numbers quoted in Parliament, the import tariff for wheat grains is Rs. 3 and the import tariff for wheat flour is about Rs. 35. With this tariff structure, wheat flour importers cannot compete in the market as the tariff rate on flour is about 10 times higher than the tariff on wheat grains.

Additionally, the Government’s practice of issuing licences to selected wheat flour importers has often led to corruption. This combination of higher tariffs, licences, and limited competition has resulted in an advantageous situation for the two domestic companies currently operating in the market, but it has hindered fair market dynamics.

Similar issues exist in the fuel importation process. The tariff on crude oil is lower than that on refined fuel. The crude oil refinery in Sri Lanka, donated by Iran long ago, operates with low efficiency, giving an advantage to inefficient fuel refining processes. This inefficiency in the refining process can impact fuel prices, potentially leading to higher costs for consumers.

In Parliament, the proposed solutions appeared more disastrous than the problem itself. One suggestion involved imposing a special tax on specific companies. However, targeting individual companies with such taxes would be viewed unfavourably by investors. Companies need to be encouraged to make profits through healthy competition and efficiency, rather than through tariff protection and government policies that create problems for all in the long run.

An ideal solution would involve a uniform tariff rate and only a few tariff slabs for all imports, thereby eliminating room for tariff manipulation. Such a system would also minimise corruption at Customs and other government authorities, as importers would find it more economical to pay the standard tariff rates than to resort to corrupt practices.

Let us remember the wisdom of John Charles Salak: “Failures are divided into two classes: those who thought and never did, and those who did and never thought.” We must strive for well-thought-out policies and meaningful actions to foster a fair and prosperous Sri Lanka for all.

Addressing the land problem

Originally appeared on The Morning

By Dhananath Fernando

Decades ago, when tasked with writing an essay about my country, I emphasised its vast potential for production, ranging from agriculture to technology. Since then, Sri Lanka’s need to produce and export goods has been incessantly highlighted in panel discussions, TV debates, and interviews.

However, the real challenge lies not in recognising this need but in understanding why we remain lethargic when it comes to production. While the blame often falls on corrupt politicians and misused public funds, the economic reasons behind our sluggishness go deeper.

In our Grade 9 lessons, we were introduced to the main factors of production: land, labour, capital, and entrepreneurship. Have we ever considered the current status of these factors in Sri Lanka, which are essential for fostering production?

Let’s begin with land. Whether local or foreign, any investor will attest to the difficulty of securing a plot of land for production. Around 95% of the Board of Investment (BOI) zones in the Western Province are already occupied and the BOI has struggled to establish new zones for the past 15 years.

Initiating any production venture typically requires an average of 16 approvals, paving the way for corruption. Investors seek land that is ready for swift set-up and operation, as delays translate to significant costs. They need land equipped with electricity, water, telecom, waste management, and other essential services to minimise the time between investment and production.

Image Credit: JB Securities

Regrettably, the absence of available land turns our aspirations for a production-based economy into mere talk, without any tangible action. Approximately 82% of the land in Sri Lanka is State-owned, encompassing forest reserves and sanctuaries, while only 18% remains in private hands. Resolving land issues is a cumbersome process due to physical documentations that are prone to tearing and misplacement.

Poor utilisation of land by SOEs

State-Owned Enterprises (SOEs) occupy most of our land, and their utilisation has been rather poor. For instance, Sri Lanka Railways monopolises a stretch of land without exploring additional opportunities like real estate development. The Marine Drive land stretch, which offers beautiful sunset views, remains underutilised, discouraging tourists from visiting after 7.30 p.m. due to inadequate street lighting and lack of economic activity.

Private ownership of the railway could have not only transformed that stretch, but also attracted more tourists. SOEs are reluctant to relinquish land, leaving it to the discretion of the respective minister. While occasional rentals or long-term leases may occur, the full potential of the land cannot be unlocked without ownership.

In the present set-up, banks won’t grant loans without land titles and investors won’t risk their entire capital without a proper land base to support their technological advancements. Small-scale, scattered lands are available, but large-scale productions require sizeable plots with appropriate infrastructure. Unfortunately, the Government is losing substantial revenue in taxes and rents due to the underutilisation of land.

Addressing the land problem is imperative for attracting investments and Foreign Direct Investments (FDIs), as highlighted in the Harvard CID team study on Sri Lanka. In the global competition for investors, the land issue remains a key concern for potential stakeholders, as indicated by the World Bank Enterprise Survey.

Image Credit: JB Securities

Solutions

A potential short-term solution involves the Government acquiring land from SOEs that have development potential, converting them into BOI zones, and opening private industrial parks. Private companies can then develop industrial zones and present diverse value propositions to attract investors.

This arrangement would enable the Government to earn revenue through taxes and leasing fees while ensuring efficient land usage. Nonetheless, this is a temporary fix, and we must remain focused on real, long-term solutions.

Looking ahead, the establishment of a digital land registry with accessible and searchable documentation would streamline transactions and promote transparency. Although this vision may appear distant, it should not deter us from pursuing lasting solutions for Sri Lanka’s economic growth.

Rough seas make good sailors: Embracing competition in trade

Originally appeared on The Morning

By Dhananath Fernando

When I first started my career, my boss shared two valuable pieces of advice with me. “There are only two ways to secure a promotion,” he said. “First, you can develop your subordinates to replace you, allowing you to move up the career ladder. Second, you can help your boss get a promotion, positioning yourself to take their place.” 

The essence of his advice was that the key to advancing in one’s career lay in competitiveness. By being competitive, we not only benefit ourselves but also contribute to the entire ecosystem. This principle forms the basis of global trade. Unfortunately, for a long time, Sri Lankans have had a different perspective. We believed that imposing higher tariffs or even banning certain imports would make us competitive. This notion is akin to arguing against hiring smarter individuals to make existing employees more competitive.

For a considerable period, Sri Lankans have embraced this flawed argument at a national level without understanding its fundamental flaw. Many Government policy documents emphasise making local industries competitive through import controls, even using terms like ‘import substitution’.

If this argument were true, why were there no industries developed during the time when most imports remained banned? Even after the recent lifting of some import restrictions, a significant number of imports, including vehicles, still remain on the restricted list. In 2020, imports such as vehicles and turmeric were banned. 

After three years, have we witnessed any local industries becoming globally competitive and gaining market share? By restricting imports of tyres and vehicles, we did not witness the establishment of vehicle or tyre manufacturing for export markets in Sri Lanka. Instead, those who were already competitive in the global market for tyres and rubber continued to thrive, while some competitive players became uncompetitive due to import controls.

There is no formula for becoming competitive by avoiding competition. Just as the saying goes, “rough seas make good sailors”; it is competition that makes any local industry globally competitive.

Another common misconception in Sri Lanka is the belief that we are already an open economy. The truth is that we have become a more closed economy compared to the 1990s and possibly even more closed than in the 1970s. Our imports and exports are constantly declining in relation to our GDP. Instead of becoming a trading hub, we have isolated ourselves over the years, distancing from global economic integration.

Yet another popular argument gaining traction is the need to develop more industries to boost exports. Occasionally, this argument is used to advocate for import restrictions, suggesting that industries can be developed without external competition. In Sri Lanka, the main obstacle to industrial development lies in concerns related to the main factors of production: land, labour, and capital.

Most land slots in the Board of Investment (BOI) zones are already occupied, making it nearly impossible for new investors to secure a plot of land with access to electricity, water, and waste management. Land and property rights are fundamental for unlocking capital. Banks are hesitant to extend credit facilities without land as collateral. Such distortions in factor markets are the reasons behind the poor industrialisation we currently observe.

A commonly cited example for industrialisation is Vietnam, with some falsely claiming that Vietnam became an export hub by avoiding competition. The truth is quite the opposite. If we compare the Free Trade Agreements (FTAs) signed by Vietnam, Sri Lanka, and Thailand, Vietnam has actively embraced Foreign Direct Investment (FDI) and competition, allowing the private sector to drive export development. It was not achieved through a State-led policy of developing industries; rather, industries flourished as a result of market forces.

Competition is the driving force behind trade growth. There is no formula for improving trade by moving away from competition. Just as rough seas make good sailors, it is through competition that our trade can truly thrive.

Contemporary Issues in Agri-Food Supply Chain in Sri Lanka

Originally appeared on the Morning

By Thilini Bandara and Niumi Amarasekara

Introduction

In the current context of food insecurity, building a resilient agri-food supply chain is crucial for Sri Lanka. The agri-food supply chains are a set of activities involved in a “farm to fork'' sequence including farming, processing, testing, packaging, warehousing, transportation, distribution, and marketing. So far, the supply chains have been providing mass quantities of food for the country’s growing population. However, the supply chains are plagued by a number of issues stemming from within and outside the supply chain. Hence this article sheds light on various inefficiencies prevalent in the agri-food supply chain and  the way forward to establish a more resilient supply chain.

Overview of agri-food supply chain in Sri Lanka

Agri-food sector plays a major role in the Sri Lankan economy. It is a key source of food supplies which comprises a complex system of supply chains involving farmers, distributors, processing firms, wholesalers, retailers, and consumers.

Figure 01: Flow of agri-food supply chain

Issues in the agri-food supply chain sector

The country has been experiencing inefficiencies within its agriculture sector due to various issues stemming from within the supply chain.  For instance, Sri Lanka  annually loses 270,000 metric tons of fruits and vegetables along the supply chain, which are estimated to cost around Rs. 20 billion. This accounts for 30-40% of the total agri-food production in the country.One of the key causes of this is the lack of integration between supply and demand . For instance, farmers cultivate their lands without having a scientific understanding of future needs and in the absence of a national-level cultivation strategy to fulfill local demand. This leads to an overproduction of certain crops, which ultimately results in considerable losses for farmers.

Nevertheless, high food miles set along the supply chain also causes a high degree of inefficiency. For instance, when commodities from different parts of the country reach the main economic centers , only to be redistributed, it can cause high cost and further damage to the produce. Also maladaptation of post harvest handling practices at various stages of the supply chain further lead to high wastage and inefficiencies.

Apart from that, a number of additional factors (eg: information asymmetry, limited supply of inputs, lack of infrastructure and support facilities, poor agricultural policies, import restrictions, and price controls, etc.) also hinder the smooth operation of supply chains. Finally, these can lead to significant pricing disparities of the commodities across the island.

Source: Weekly prices, Hector Kobbekaduwa Research & Training Institute

In order to analyze the pricing disparities of Raw Rice (white) across the island, the average of weekly prices were obtained from the Hector Kobbekaduwa Agrarian Research and Training Institute for four weeks from 6th of January 2023 to 2nd of February 2023 of 10 districts across Sri Lanka. Colombo was taken as the base district and the percentage changes were calculated to identify whether there is a significant difference in the prices of each district against Colombo.

Due to lower average retail pricing than Colombo's average retail price, it can be seen from the calculations that in certain paddy production areas like Ampara, Hambantota, and Matara have greater percentage changes of 13.2%, 10.2%, and 9.97% against Colombo respectively. In comparison to Colombo; Anuradhapura, Polonnaruwa, and Kurunegala also have relatively lower average retail prices. The common reason behind this is that food supply to Colombo varies between types of commodities and does not depend on the closest production areas. The variations in distance and transport costs are reflected in the price disparities in Colombo. Apart from that, some other reasons for the price disparities across the island could be possibly due to complex interactions between supply and demand, income variation, uneven population distribution, price controls and the price of close substitutes.

Way forward

In light of the aforementioned issues, continuous development and tailor made policies should be introduced to establish a more resilient agri-food supply chain. Hence below are a few recommendations that can be introduced to the system.

• Establish post harvest handling hubs across main cities of the island to improve the efficiency of the sector

• Farmers/ supply chain actors to be more vigilant on proper post harvest handling techniques to minimize losses

• Utilize railway system as a cost effective source of transportation

• Promote the use of digital marketing platforms to connect different actors across the supply chain

• Integrate these platforms with financial services such as online payments, credit-based transactions, and loan facilities through banks 

• Enhance collaboration among different actors across the supply chain to reduce cost and increase efficiency (eg: promote forward and backward integration via business partnerships)

• Encourage private sector participants to invest in modern technologies along the supply chain to reduce losses

• Encourage innovations/processes that can improve the efficiency and reduce losses along the supply chain
  

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.

IMF Programme #17: takes two to tango

Originally appeared on the Daily FT, Ada derana, Groundviews

By Daniel Alphonsus

On Sri Lanka’s reform-regress-run to the IMF crisis cycle

Countries never learn from others’ mistakes, they only learn from their own. Sri Lanka is an exception: we don’t even learn from our folly. Apparently neither does the IMF. Sri Lanka’s 17th IMF programme is set to be approved on March 20th. Is it welcome? Yes. Will it break Sri Lanka’s reform-regress-run to the IMF crisis cycle? Probably not. 

All reforms undertaken over the past half-year to win IMF board approval are reversible. None of them constitute entrenched changes in economic policy or governance. We are building our recovery on the shakiest of foundations. The fuel and electricity price ‘formulae’, tax plus interest rate increases and greater exchange rate flexibility can all be altered, more or less, at the stroke of a pen.  

This is not surprising. Sri Lanka has a chequered history of cosmetic compliance: ticking the boxes of virtue and sensibility via international undertakings during desperate times, and then reverting to business-as-usual once crisis abates. We have good reason to think that, this time too, the future will rhyme with this past. Undoubtedly, post IMF board approval, some reforms less easy to rewind will come to pass - the new Central Bank Act being the most notable. 

But the IMF’s bargaining power peaks prior to board approval. That is the decisive point in this process. It is the pivotal moment for any attempt to use this crisis to build the foundations required for breaking the crisis cycle and going from third-world to first. If the most contentious and critical reforms are not pushed through prior to board approval, there is good reason to think they will not come to pass. Remember that of its 16 programmes thus far, Sri Lanka’s has only completed two extended / structural programmes. The remainder are either relatively insignificant standby-facilities or derailed extended programmes

Considering the unprecedented nature of the current crisis, this is a colossal missed opportunity. As argued in a prequel article, Programme 17 could have and should have broken this cycle. Public opinion was desperate, the government commanded a super-majority in Parliament and the IMF held all the aces. The distinction between what is desirable and what is feasible had, almost overnight, dissolved. The cry for fuel and electricity was so piercing and loud that a comprehensive and deep programme permitting profound economic restructuring was possible for the first time since 1977. 

Moreover, even if some of the required reforms come to fruition over Programme 17’s next few reviews - it will still be a missed opportunity. Reform takes time, effort and energy. These are scarce resources. As major structural reforms - such as the central bank act, fiscal rules, privatisations and labour market reforms - were not completed as prior actions, it means the first few reviews will be focussed on them. This will leave little room for some of the more complex long-term reforms; especially in land, the public service and regulatory policy (e.g. competition policy). 

Of course, we are a sovereign state, so primary responsibility for this failure lies in our own polity. But we find little hope in ourselves. As weary and jaded citizens we tend to assume inertia, or worse, on our side as a given. Which is why this article is about the IMF’s failure. 

What could the IMF had done differently? Especially considering its familiarity with Buenos Aires, it should know that it takes two to tango. As Keynes famously said of the IMF and World Bank; the Bank’s a fund, and the Fund’s a bank. Considering the creditor-borrower relationship between the IMF and Sri Lanka; as a creditor the IMF should bear some responsibility for the failure of so many programmes over such a long period of time. The IMF’s own kapuralas have conceived of programme conditionality as a form of collateral. The IMF ought demand more conditionality as collateral prior to lending. This, of course, requires review of past country programmes and, as we all know, economic history and country expertise are not exactly first-rank priorities at the Fund. 

Anyone involved in economic policy-making in Sri Lanka, the IMF included of course, knows that much of the technical work was already done. When the staff-level agreement was signed in September last year, there was a great deal of reform that just required political will and nothing else. Cabinet had approved an earlier version of the new central bank bill during the last days of the Samaraweera ministry. Placing energy price formulas on a statutory footing shouldn’t take more than a day’s drafting. Fiscal rules legislation was already in a relatively advanced stage. Non-legislative measures could also have been mandated - the state could readily have divested its stakes in Sri Lanka Telecom and Lanka Hospitals. These firms are already listed with established valuations. Considering the 200 days between the staff-level agreement in September and board approval now, we had more than enough time to list the major state banks and Sri Lanka Insurance; maybe even privatize the East, Jaya and Unity container terminals. After all, for better or worse, remember the plantations were effectively privatized within fourty-eight hours. These delays are all the more astonishing due to the hypocrisy of asking for favours from our creditors while refusing to sell underperforming assets. 

Primary balance vs growth 

Considering the political cost of market pricing energy and increasing taxes, from a political point of view, there is tremendous incentive for the political leadership to undertake structural reform in return for less pain. Sri Lanka’s future debt sustainability (or lack thereof) is a function of current and future (a) government revenue, (b) government expenditure and (c) GDP growth. By raising Sri Lanka’s growth potential, both the IMF and long-term creditors could and should have been willing to trade-off revenue and expenditure targets for entrenched, high quality structural reform. The one percent rate hike - which the central bank opposed - just before placing Sri Lanka on the board agenda illustrates this well. Clearly, this temporary, one-off one percent increase in interest rates was considered decisive for obtaining board approval. Why then was not actually passing the central bank bill in Parliament - which is likely to shape inflation rates for decades? Note that in my view, the IMF’s bargaining power at this juncture could be so strong that a trade-off between primary balance linked targets and structural reforms may not exist. The IMF may have been able to demand both. That is the IMF could have had the cake, eaten the cake and called it a letter of intent. 

Primary balance today vs primary balance tomorrow

Even if one does not buy the argument of reducing the primary balance target today in exchange for growth tomorrow, two strategies superior to the status quo could have been pursued. 

First, instead of trading off the primary balance versus growth, we could have exchanged a primary balance improvement today for a larger primary balance improvement tomorrow. The IMF could have permitted reducing the primary balance target today in exchange for entrenched reforms that result in a paradigm shift in Sri Lanka’s primary balance trajectory for the future. For example, coming back to the central bank bill, through greater depoliticization and limitations on central bank funding of government deficits, this landmark reform is likely to change Sri Lanka’s medium to long term primary balance trajectory. The ‘net present value’ of this change in primary balance terms - even when discounted for the probability of it being unenforced - is likely to be greater than a few percentage point changes in the primary balance today. 

Optimizing this trade-off would also have the added benefit of placing less pain on the public and reducing the extent of contractionary policy amidst Sri Lanka’s worst economic crisis in decades. 

Second, there are some measures that can improve the primary balance today, and tomorrow. A good example is the sale of shares in state banks. The sale of minority stakes in BOC and People’s Bank will raise money for the exchequer, boosting the primary surplus. However, especially if the banks are listed, it will also make it more difficult for the state banks to permit the government to create enormous contingent liabilities via loans to the CEB and CPC, resulting in a healthier future primary balance. 

Overdiscounting the future

The argument often made in response is that the IMF cannot tradeoff the certainty of hitting quantitative targets today, in return for structural reforms whose fruits may not materialize tomorrow. This view is misguided. First, deep understanding of context enables a reasonably good assessment of the probabilities of a structural reform producing a desired outcome - enabling the computation of rough expected values. For example, we know that once a privatization takes place it is unlikely to be easily undone. Second, even after first discounting on the basis of probabilities, a second round of discounting can take place to compensate - to some degree - for the uncertainty inherent in structural reform.

Bailamos
There are two dancers in this toxic tango. They both need to take stock of the past, break with it and dance a new dance. Introspection is a good start. The IMF and our government should get together and commission a review of all past programmes to inform the design and implementation of the current programme. In the meantime, the priority should be to ensure as many structural reforms as possible are pushed through prior to the first review. If we are able to use entrenched, high-quality structural reform to credibly improve Sri Lanka’s medium term growth and primary balance trajectory, we should be able to avoid some of the short-term pain and contraction that we would otherwise experience. Then, maybe instead of toxic tango, we can look forward to a solid baila session. With the President, as he did with Iranganie Serasinghe, accompanying the IMF’s managing director for a round of kaffirhina. After all, compared to austerity, structural reform is a sumhiri pane.

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.

Why it takes so long to recover from an economic crisis

Originally appeared on The Morning

By Dhananath Fernando

I have been reflecting on the last few years of public policy and discussion, which I can broadly divide into three main chapters:

Chapter 1 – Denial

Chapter 2 – Realisation

Chapter 3 - Recovery

Chapter 1 – Denial

There was a time when even respected businessmen thought an economic crisis was a distant scenario. Many politicians, across all party lines, failed to consider a situation of 12-hour power cuts and long fuel lines, and viewed debt restructuring and accessing the International Monetary Fund (IMF) as taboo conversations.

We relied on a $ 3.6 billion bailout from an unknown Omani fund and thought China and the Port City would bail us out as a last resort. Some even thought the discovery of a sapphire cluster might be the breakthrough Sri Lanka needed. Sri Lankans believed we were a special nation with a magical power that would rescue us in some other way.

Despite our strategic location, beautiful weather, and natural beauty being undeniable assets, they do not guarantee a rescue from our own bad policies. Our denial was so strong that an international institution titled their report on the Sri Lankan economy as ‘Denial is Not a Strategy’.

Chapter 2 – Realisation

The moment of truth came, but we were too late to respond. None of our bailout expectations materialised and the international financial architecture found it difficult to save us. Our debt is unsustainable and the IMF requires a commitment from our creditors before providing us financial assistance.

We are struggling due to global geopolitics and our poor diplomatic service and lack of professionalism doesn’t allow us to be taken seriously. We hurt all our friendly nations as well as India, China, Japan, and the US. Islamic countries too were concerned and unhappy with us over different issues.

People only realised the depth of the crisis when medicine was in short supply and their loved ones considered leaving the country. Inflation skyrocketed, prices increased, and poverty affected about 30% of the population.

Chapter 3 – Recovery

The moment people realised the severity of the crisis, they started asking about when we would recover. The simple answer is that it takes a long time and now many of us understand why. Overcoming a crisis of this scale, which in itself is a combination of multiple crises, cannot be done easily.

Simultaneously, we face a balance of payment crisis, a debt crisis, a financial crisis, a humanitarian crisis, and a political crisis. The cost of delaying a response to the crisis and mismanagement has to be shared by us all, with mounting tax increases and high inflation pressure from the grassroots.

As a result, we can see constant protests and interruptions to public life, further worsening the situation. At the same time, this opens a new political space where any political party can make unrealistic promises and auction for votes. This vicious cycle is why recovery from the economic crisis takes a long time.

The specifics of debt restructuring are still a mystery to us. We don’t know how the restructuring will be carried out or the impact it will have on the banking industry. It is also unclear how the markets will respond.

Without domestic debt restructuring, even if we apply a 50% haircut on International Sovereign Bonds (ISBs) and Sri Lanka Development Bonds (SLDBs), our debt to GDP ratio after 10 years will be 136%, according to a Verité Research study published in October 2022. Cost of servicing new debt and the cost of rolling over previous debt at a high yield curve will not bring down our debt to GDP ratio.

Nevertheless, it is still possible for domestic debt to be restructured and banking recapitalisation is necessary. According to the same document, investments in Government securities, primarily Treasury bills and Treasury bonds, account for more than 30% of the interest revenue for the total banking industry.

Hence, changing the interest rates on these securities will affect the stability of banks. On the other hand, 82% of the money in the EPF and ETF has been put into Government securities.

As the required changes take place, no one will be happy, so people and opinion leaders will react in different ways. The changes will go back and forth and recovery will be prolonged. Elections will come and decision-making authorities will change and policy decisions will also go back and forth.

All this is why it takes so long to recover from an economic crisis.

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.

Our only saviour is reforms

Originally appeared on The Morning

By Dhananath Fernando

Whether we will be able to receive International Monetary Fund (IMF) Executive Board approval is now a topic of discussion even amongst the most economically-illiterate person. Let us first set the context.

The Sri Lankan Government and the IMF came to a Staff-Level Agreement in early September 2022. One of the key milestones we have to pass through is to get to some level of negotiation with our creditors. Our credit portfolio is diverse. We have multilateral senior creditors followed by bilateral creditors, including members of the Paris Club, mainly Japan.

On the other hand, there are two main creditors who are non-Paris Club members; India and China.

Paris Club members agree on equal treatment in debt restructuring. In simple words, all member countries of the Paris Club will be treated equally when it comes to restructuring. India has also agreed to assist Sri Lanka in the debt restructuring plan and has provided a letter to the IMF. However, according to the IMF, letters provided by China are not adequate. It has indicated a two-year moratorium, but given the financial needs expected by the IMF, Sri Lanka will not be on a sustainable debt path after a two-year moratorium alone.

Generally, credit assistance provided by multilateral donor agencies such as the World Bank and the Asian Development Bank is not restructured, provided it has been given with very long maturity periods and very low interest rates. Therefore, restructuring those loans has not been the practice. That is how the global financial architecture is designed, given their assistance in eradicating poverty and the IMF being the lender of last resort. 

However, over the last few years, there has been a request by private creditors, bondholders, and some stakeholders that the credit of multilateral donor agencies should also be restructured and China is one party that has made this request. Unfortunately, Sri Lanka is too negligible an economy to make that request or challenge the global financial architecture. .

Given the delays, there is now an emerging conversation on whether we have any other alternative options if the IMF agreement is further delayed. In fact, I asked this question at the meeting convened by the National Council Sub-Committee on identifying short- and medium-term programmes related to economic stabilisation, on whether alternative options were being considered in the likelihood of a delay. According to its Chair MP Patali Champika Ranawaka, the committee has not considered it, but he has an aim of being prepared for the worst-case scenario.  

As we have been saying over the years, we have come to this situation through our own policy errors and with our bad reputation, we do not have many choices in hand. Therefore, finding a solution without the IMF is a major challenge, but we, as a country, cannot avoid the consequences should this agreement get further delayed; social discussion is needed on what we can do to get it soon and on the available alternatives. 

Managing with what we have

One option is to drastically cut down our consumption, including essentials such as food and medicine, and face the situation with what we have. That option can trigger some level of social unrest because ‘a hungry man is an angry man’. 

Even at this level of consumption contraction, our poverty rate has increased above 30% according to a Parliament committee. Out of about five million households, about 1.7 million receive Samurdhi and another 1.1 million are on the waiting list. Of course, Samurdhi is not a good indication, as some people who should receive Samurdhi benefits are not recipients, while others who should not be in the programme are included. However, managing with what we have is one available option that comes with its own consequences. 

Moving ahead with debt restructuring without China?

The next option is to move ahead with debt restructuring without China. This option has a significant limitation because IMF confirmation is required even to restructure the debt of bilateral creditors. Without the IMF, it will be difficult to get Paris Club members and other stakeholders to a debt negotiation table. The more we delay and if China takes a very hard stance, which is likely, we have to request the IMF to move ahead with those who have agreed and hold China’s debt payments until we come to some level of agreement.

We have to understand China’s point of view and geopolitics as well. Our crisis has also become a tug of war between two economic powerhouses. On one hand, China does not want to align or agree with a US-led programme. On the other hand, the relief measures given to Sri Lanka have to be provided to all other countries making similar requests in future.

Pakistan and many African countries and emerging economies are expected to face debt distress in the coming years. China’s growth predictions are low, impacting global economic growth. Hence, the more we delay opening up Sri Lanka to geopolitical sensitivities, the more we will be pushed to align with certain superpowers. If we were to depend on China or India for continuous relief measures, it would be extremely difficult to avoid becoming a geopolitical pawn.

Possible reforms and opportunities 

In this context, it is clear that all available options (with the IMF or without the IMF), will result in extremely difficult times. However, in a crisis, there will be winners as well. Regardless of any of the aforementioned options, there are basic levels of reforms we have to undertake in any scenario. 

State-Owned Enterprise (SOE) reforms must be at the forefront. Without this, we have no future. One good opportunity is to capture the drive within the Indian market. Even if Sri Lanka does nothing, there will be spillover effects from India. The Indian economy, especially the North Indian economy, is growing very fast and we have to connect to their market. If we had played our cards right, we could have become a good connection point for trade between India and China. Instead, we made enemies all over. However, there is still potential. 

The more we delay reforms, it will further exacerbate the problem. As such, reforms are the only saviour in any scenario. It is sad to see how we are distancing ourselves from reforms, with political developments triggering another round of economic and political uncertainty which will lead to social uncertainty. Let us hope reforms move forward fast. 

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 biggest insecurity: Fear of competition

Originally appeared on The Morning.

By Dhananath Fernando

If we were to take some collective responsibility for the sad state of our country and attribute it to any cause, I believe it is due to our ‘fear of competition’. 

From top to bottom, Sri Lankans have been fearful of competing. Over a period of time, we have become very reluctant to compete and our fear has grown into incompetence. The fear of competition syndrome is spread across all sections of society, from the top executives to people below the poverty line. 

Sadly, as a country, we have not understood the meaning of ‘competition’. In our vocabulary, competition is where winners are selected and losers are ridiculed. However, competition is actually where the winner and the loser both win – when the winner wins, the loser also wins. How can this be?

A winner is defined as an individual who takes the leap to utilise the resources available to their maximum potential. Even in a 100 m race, the winner is the person who covers the distance within the shortest time span.

The recipe for the title of a winner is determined by the effort endured by any individual to go that extra mile and maximise the resources available. Once that formula is found, even the loser can use the formula of the winning person without wasting their resources further. Losers can ask the winners to run on their behalf next time so that the losers can better use their skills elsewhere.

This is how we all use so many consumable goods. Let us take computers as an example: most of us have lost the race of manufacturing computers while many have not even tried. But someone found the computer formula, so now we can all use the winning formula, which helps many of us save our valuable resources. Thus, losers have also benefited. This is why competition makes winners win and losers also win. It is much more than simply picking a winner – it is about the allocation of resources.  

In the Sri Lankan context, the fear of competition is what mainly led to the misallocation of resources. From top to bottom, not only are Sri Lankans fearful, but we also instigate fear in others. 

It was recently reported that a driver who was providing a taxi service using a mobile app had been threatened by some other drivers who were not using the app-based taxi service. The threat had taken place while the service was being provided to foreigners. The underlying reason for this is the fear of competing with mobile app-based technology.  

Fear of competing with private medical schools

While our tuk-tuk drivers have fear of competition regarding app-based solutions, our doctors have a fear of competition regarding private medical schools. They do not want someone capable with a better service in the market because they are fearful that someone else will overtake them. 

Fear of competition in furniture manufacturing 

Our furniture manufacturers are fearful of competing with other furniture manufacturers in the region. Not only are they fearful, they even ask the Government to support some of these industries with taxpayer money.

Fear of competition in the construction industry

Our bathware and tile manufacturers are reluctant to compete with the same category of products overseas. As a result, our cost of construction is about 25-40% higher than the region due to our widespread fear of competition. Most of our construction materials have a tariff of nearly 100% to avoid competition. Even the private sector is suffering from the fear of competition, which is one of the main reasons Sri Lanka lacks big industries and innovation in the system.

University students’ and the labour force’s fear of competition 

Our university students and teachers do not want to compete with international students. As a result, resistance is high against the entrance of any type of private university to the market. Rankings of our universities and colleges have been deteriorating over the years, but we still remain reluctant to compete. Not only do university students want to avoid competition, but they also want to be dependent on the Government.

Our Government servants and entire labour force are fearful that if we open the job market, foreigners with better skills will replace them. Although we are not competitive, we want to maintain our stake.

Across the board, Sri Lankans are deeply fearful of competing with the world. We lack the courage to admit the truth that our competitors can produce high quality products with high efficiency and productivity. If we are so afraid to compete with the world, there is little reason to claim that we have to improve exports. Exporting would mean competing with the world on an uneven playing field with different tariffs imposed in different regions.

Hasn’t our fear of competition not only made the country worse, but also contributed greatly to our economic crisis? Not just politicians, but all Sri Lankans have promoted fear among our fellow citizens. There are no innovations, inventions, or new technologies without competition. That is the sad truth. We have unfortunately become victims of our own actions.

For once, we should admit that we are the problem without absolving ourselves and instead blaming our political elites. While the poor decision-making of politicians is definitely a problem, if we are reluctant to compete, they can easily say that they simply represented our worldview and opinion.

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.

A flawed independence

Originally appeared on The Morning.

By Dhananath Fernando

Over the years, our definition of ‘freedom’ has become full of flaws. We took freedom for granted and we lost both our freedom and independence. Even though we gained independence in 1948 from Great Britain, we have no understanding of what real freedom is. 

We fail to understand that freedom comes at the cost of hard work, courage, respect, the ability to cooperate, and being competitive with the world. There is an ecosystem we should have built if we really want to be free. We did not build that ecosystem, so over the 75 years of independence, we question ourselves and argue back, asking, “Are we really free?”

Prof. Amal Kumarage in a recent tweet has asked this question very eloquently on independence and freedom.

“I’m confused as to what’s happening on 4 February in #SriLanka. Is it: 

1. A fake celebration of a real independence, 

2. A real celebration of a fake independence, or 

3. A fake celebration of a fake independence?”

Freedom is an alluring subject to many as people in general summarise freedom to being liberated to have an easy life, getting things free of charge. Over time, as the dire need for freedom kept rising, the wrong seeds of freedom grew by encapsulating and manipulating the idea of freedom to a level where people truly believed that we are entitled to many benefits even though we lack the resources. 

The drive down the tunnel of distorted versions of freedom led to many ethnic and religious turns over the years, believing that freedom is restricting someone else’s freedom for the betterment of someone else.

This is similar to a situation where a child learns the wrong values or habits without realising they are wrong and instead thinking they are right. After 75 years of practising the wrong values and ethics, we now have an operating system which we try to sustain with unsustainable resources. That is a brief summary of insights on our 75 years of independence.    

During that journey of 75 years, we have failed to understand the damage done by the existing system to our competitiveness and productivity. We simply became irrelevant in the world over a period of time. By deciding not to compete with the world, we decided to sacrifice our freedom. 

Our decision to not compete with the world mainly came through our economic policy. We simply misread the world and future of the world. In a world of sharing resources and collaborating for each other’s benefit and independence, we thought that real freedom is the ability to produce everything on our own. 

We supported the narrative of ‘self sufficiency’ when the world actually moved away from self sufficiency to interdependence. As per the Fraser Institute’s Economic Freedom of the World Index, Sri Lanka has been ranked at the 138th position out of 165 countries based on our ‘Freedom to Trade Internationally’. Though we claim we are an open economy, the facts say otherwise. In terms of our openness, we are at one of our lowest points.

My father used to say: “If you think you are the smartest person on the street, it is time to change the street.” This is because an uncompetitive environment does not support growth. Without growth, no wealth will be created nor will there be freedom or independence.

When we isolate ourselves from global trade, we avoid competition. Avoiding competition means we are out of touch with the real needs and wants of people. Not only that, we try to become dependent on the world without contributing anything to the world or to its maximum utility of resources. Being open to competition is what keeps us all competitive and relevant.

Real freedom is the freedom to compete and be competitive in a global landscape. Even when we are one of the closed economies in the world, we are open for global competition. Our IT, apparel, tea, and rubber sectors and even unskilled labour that contribute with remittances are competing at a global level. 

When we are really competitive it provides us the tools and freedom to change the direction of our fellow human beings and to support humanity. That comes only through the freedom to trade. That is the real freedom we should all aspire to. We are far from this and we are moving further away, but at least it is important to keep the idea alive so that one day someone can move towards it. 

A fake celebration of a real independence, 

A real celebration of a fake independence, or

A fake celebration of a fake independence? 

According to Prof. Kumarage, it is difficult to judge what we are actually trying to do this year, but we should aspire to have real freedom and this real freedom comes at the cost of hard work, free exchange, and free trade by being relevant and competitive in relation to the world.

Source : Central Bank of Sri Lanka

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.

On the 75th Independence, time to re-plug to the world economy

Originally appeared on the Daily FT

By Anuka Rathnayake & Thilini Banadara

As Sri Lanka is inaugurating its political independence of 75 years on 4 February, the burning issue the public is struggling to grapple with, in the recent past, is the worst economic slump. Many factors have contributed to the current economic crisis but protectionism and trade barriers are main elements that have further depleted the economy, shaping it as uncompetitive and inward-looking.

Even though Sri Lanka was known as a fairly open economy, the dynamics of trade has changed since 2004. The planned reduction of tariffs into a single band had been abandoned by the end of 1990s.  Since about 2005, Sri Lankan trade policy has been characterised by a protectionist approach. 

The Government was involved in economic decision making and policies related to import substitution were much more prominent. As highlighted in the Trade Policy Review of Sri Lanka by the World Trade Organisation in 2010, the average tariff protection increased . In fact, it can be noted as frequent and ad hoc changes in tariff structure. The trend in protectionist policies resulted in a fall of exports as depicted by the ratio of exports to GDP . 

In 2009, by the time peace was restored, Sri Lanka had nine para tariffs applicable for imports  in addition to the standard customs duties, of which , five were ‘para-tariffs’: taxes which are only applied to imports and there is no domestic equivalent. Adding  to whatever protection is provided to domestic production by customs duties, with such para tariffs being in place, the protectionism became even more complicated. 

A systematic comparison of Sri Lanka’s tariff structure at November 2002, January 2004, 2009 and January 2011 suggests that the total protection rate notably increased between 2004 and 2009 . 

The ensuing years were followed by many ad hoc and duty exceptions and case-by-case adjustment of duties on many imports which directly compete with domestic production. By 2015, the average effective rate of protection for manufacturing production had increased by 16%.

This trend is well depicted through the Trade Openness indicator as given in Figure 1. The degree of openness is measured by the actual size of registered imports and exports of an economy. In other words, it suggests how free or restricted a country is in its relations with the rest of the world. 

Since 2004 onwards there has been a decline in the trade openness of Sri Lanka and this trend continued up until 2010. By 2015 with an increased rate of protection, the trade openness deteriorated to 36.6%. 

Since 2019, Sri Lanka has been pushing many import controls creating disruptions in the market. This tendency resulted in further decline of trade openness 32.2% in 2020. It is similar to the trade openness during 1970 - 1976 when the liberalisation policies were reversed and the economy had high regulations. The trade policy was more aligned towards import substitution.

Trade restrictions 

Sri Lankan businesses face a variety of trade restrictions exacerbated by the economic crisis. Accordingly, such conditions that impact the price, quality, quantity, or timeliness of product delivery but are outside the direct control of the exporter or importer. 

Both the importing country’s border and the border of the exporting country have been parallelly imposed with restrictions. Even though a number of Free Trade Agreements have reduced external trade barriers and expanded access to markets, Sri Lanka has kept its borders closed by enacting internal trade restrictions.

Internal trade restrictions can be identified in terms of broader categories such as; 

1. Monetary and regulatory barriers, 

2. Procedural barriers, 

3. Service barriers,

4. Technical barriers and 

5. Market barriers 

Currently a number of monetary and regulatory barriers exert pressure on Sri Lankan businesses, while lowering the country’s competitiveness on international trade. Such barriers include complex tariff structures, quotas, import restrictions, excessive duties or levies and export and import licenses. 

Both exporters and importers encounter ineffective, unpredictable, and less transparent procedures throughout the entire trade process. This is mostly the result of poor coordination between agencies and excessive bureaucracy (red tape) among Government employees.

Additionally, the distribution and financial services channels are two areas where existing enterprises face significant service obstacles, which slows down the final stage of clearance.  Shedding further light on the obstacles placed, the technological obstacles  have a negative impact on the export competitiveness of local enterprises because of their limited technical and financial resources. Besides the market constraints like price controls are a significant obstacle because they are unrealistic in a setting of shifting global markets and fluctuating currencies.

Impact of trade restrictions

Over the years, the country has experienced a number of adverse effects due to trade restrictions. Net economic losses in the wider economy have increased as this restricts competition. Shrinking volumes of exports and imports have negatively affected domestic production. Consumers are left with limited choice of products while they experience increased prices. 

Trade restrictions impact the macroeconomy with a fall in employment opportunities mainly due to the deterrents on domestic and foreign investment. Limitations on land, labour and capital have disincentivised investors from competitive export industries to protected industries and inefficient import substitution. Reduction in economic activity has increased the economic woes among people.  

Restrictions on trade have put a significant number of businesses in a precarious position.  Starting with street vendors, small and medium scale enterprises who depended on imported raw materials to the larger apparel and construction industries; all the businesses are finding it a challenge to continue their business. 

Way towards trade freedom

The way to greater freedom of trade is to reformulate the existing monetary policies and laws in order to enhance trade freedom and provide more opportunities for local enterprises to engage in trade. Also in the current context, easing import restrictions and reducing taxes or levies on imports and exports would be crucial.  Additionally, it is important to remove unnecessary Government red tape or bureaucracy wherever possible to make customs processes more simple, effective, clear, predictable and timely. This will help to cut down on processing times at the border and make the movement of goods cheaper, faster and more efficient.

Paving way to greater freedom to Trade - the ability to exchange goods and services openly, creates greater opportunities for Sri Lankans to achieve greater economic prosperity. It opens many avenues towards competition, innovation and economies of scale. The beneficiaries of open trade are the Sri Lankan citizens and businesses who will benefit from lower prices and greater choice.  

Freedom to trade will ensure the economic freedom by which the fundamental rights of an individual to make their economic decisions will enhance. The true meaning of independence will only be assured through greater economic freedom. 

Source : Central Bank of Sri Lanka 

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.