Understanding corruption: How Sri Lanka’s economic system favours a select few

By Dhananath Fernando

Originally appeared on the Morning

Dr. Sharmini Cooray, one of the Advisors to the Sri Lankan Government regarding the IMF, at the 73rd Oration at the Central Bank made an interesting comment, “Lots of Sri Lankans say nothing works in Sri Lanka. That’s not true. Things work well for a small group of people”. 

Unfortunately Sri Lankans do not understand how things are set up to work for a small group of people. The common narrative is that corrupt individuals created the system we are in today, but the stark reality is that the economic system has been set up in a way to incentivise corruption for individuals. Misdirected anger is then projected on individuals forgetting that the system itself creates the corrupt individuals. This is not to say that the individuals are completely absolved of responsibility, a part of the responsibility is on the individual, yet without fixing the system we cannot fix individuals. 

Below are a few examples of how the current system works for corruption.

Last week the President as the Minister of Finance issued a Gazette notification to increase the Special Commodity Levy (SCL) from Rs.0.25 (25 cents) per Kg to Rs.50 per Kg overnight. The problem here is twofold; it creates the possibility for corruption that incurs a cost to the consumer but also ensures that the government loses tax revenue. 

Information symmetry

Information symmetry or availability of information for all players in the market is very important. As the finance minister increases the tariff by almost 5000% if one importer gets to know of this decision before it is enacted he can easily import adequate stocks for about a year early at Rs. 25 cents per Kg before the festive season. The other players' prices now simply become uncompetitive because their 1Kg of sugar has to be at least higher than Rs. 49, given the tariff rate imposed overnight. As a result the small and medium sugar importers will be wiped out of  the market as they simply cannot compete where one or few players have already imported enough stocks at 25 cents tariff and now the rest have to import at Rs.50 per Kg tariff rate. That is how things are made to work only for a small group of people. One of the main criticisms for the Gotabhaya Rajapaksa Government was that the sugar scam was done in a similar manner. 

Most importantly the tariff increase on sugar will not generate revenue for the government because adequate sugar has been already imported. After about a year it is just a matter of another gazette notification to the finance minister to bring the tariff back to 25 cents and claiming that the relief has been provided to the betterment of the poor people. So ultimately a selected group of people are just getting benefited with the support of the politicians. The truth is the loss tariff revenue will be collected from the poverty stricken by increasing the indirect taxes such as VAT.  

This is one reason this column constantly highlighted the need for keeping a simple tariff structure with menial deviations among HS codes as well as over a period of time. This is just one way of how things are only getting worked out for a selected group of people. 

As a result the public builds a bad perception with a misunderstanding of markets that all businesses are run on the same operating system. The truth is the system affects other businesses very badly because of not having a level playing field. 

The solution is to change regulation where any tariff lines cannot be imposed just by the minister of finance. It ideally has to go through parliament and keep the tariffs on HS codes simple and consistent. The more we keep it complicated the more we incentivise corruption. 

The need for a competitive system has to be institutionalized. The best governance system is making sure competitiveness remains stable. We can only do that by removing laws empowering policy makers that further information asymmetry and provide more power to the people so the market system continues. 

Tax shenanigans 

Not only have we  increased SCL by 5000%, our VAT has also been increased by 3%. When we observe the VAT rate changes, the threshold changes over the last 5 years is very concerning. By doing so we have violated the tax principle of “Stability” by changing things often. When we make one mistake at the beginning, retroactively correcting it is not easy. The VAT increase may have come to compensate for the 20,000 salary hike for the 1.5 million government employees. To make things politically digestible, an attempt may be to increase the VAT before the budget as a press release and announce a big salary increase for government employees as victory. On top of it there vehicle permits and so many perks are the system of how things are making well for a small group of people.  

The simple truth is to make governance work, we have to make market works. Governance is the system of making markets work and making a level playing field. The moment we deviate from markets there is no way we can keep the governance going.  

What happened to our debt?

By Dhananath Fernando

Sri Lanka’s debt situation is still a mystery for some. During a panel discussion, I pointed out that Sri Lanka’s State Owned Enterprises (SOEs) have amassed a staggering 1.8 trillion in debt, all guaranteed by the Treasury and classified as ‘Public Debt’. One question from the audience was, “What did we do with the money we borrowed?” The simple answer is that money was borrowed primarily to service the interest on the initial loans Sri Lanka took out. Therefore,  despite borrowing substantial amounts, there is nothing tangible or visible to show for it, as a majority was essentially sunk into interest. 

To provide context, since 1999, approximately 74% of the increase in debt can be attributed to interest payments and currency depreciation. Interest payments accounted for a substantial 40% of the debt accumulated since the 1990’s, while the exchange rate depreciation contributed to 33%. 

What Sri Lanka faced was a precarious combination in terms of borrowing and our monetary policy. Our expansionary monetary policy played a significant role in the depreciation of the currency over the years, exacerbating the situation further. Compounding this issue was the fact that approximately 50% of our borrowing was in foreign currency. As it is indicated in 2022, with Modern Monetary theory in play, the significant depreciation of the exchange rate since 2020 led to an accumulation of debt beyond our repayment capacity.

Printing more money artificially increases the demand for foreign exchange.  However, after depleting our reserves in an attempt to defend the currency, the only option left was to allow the currency to float, leading to a sharp depreciation. In the case for Sri Lanka, it was not just the currency depreciation; social unrest, debt default, and numerous other crises followed when the government resorted to borrowing from the Central Bank through money printing.

As at the end of June 2023, our total public debt has increased to USD 96.5 billion, with approximately 50% of it in domestic debt. The country’s public debt now stands at about 127.4% of GDP. Even if debt restructuring is successful after negotiations with the Paris Club and separate discussions with China, we only anticipate a reduction to 95% of GDP by 2032. 

Undoubtedly, expediting the debt restructuring process is crucial, especially given the unpredictable twists in geopolitics. While the tentative agreement with China Exim Bank to restructure the debt is a positive development for Sri Lanka, we must fast track negotiations with our other foreign creditors. Complicating matters, as we approach an election year, there is a significant risk of derailing the process as unfortunately, there is a lack of consensus among political parties regarding the economic stabilization program for the next few years. This further exacerbates the challenges Sri Lanka faces.

Solution 

If Sri Lanka is genuinely committed to resolving its debt crisis, a crucial step is to establish a consensus on public finance across the major political parties. At the very least, adherence to a single plan, such as the IMF program, is necessary. However, even the IMF program alone will be insufficient to take Sri Lanka to the next stage of economic stability. Therefore, there must be a fundamental agreement on specific reforms across party lines. For example, there exists a common minimum program in Parliament, shaped with contributions from the business community and organizations like Advocata. It is not too late to revisit and endorse this document. Committing to these agreed-upon reforms before political parties develop their individual manifestos in the coming years could provide a stable foundation for Sri Lanka's economic future.

Partial privatisation: A happy middle ground?

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

Originally appeared on The Morning

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By Sumhiya Sallay

Reforming Sri Lanka’s state-owned enterprises has been part of the new Government’s policy agenda. With 527 SOEs, Sri Lanka has an excessive number of state-owned enterprises. Financial reporting of these enterprises has been low, and the Ministry of Finance has published the financials of only 54 of these state-owned enterprises, which have been classified as “strategic”. The losses of these 54 are staggering enough; in 2018, they made a net loss of Rs. 26 billion, thus making it clear that reform in this sector is badly needed.

The Government has committed itself to transforming them into profitable entities; a committee has been appointed to hire technocrats onto the boards of these state enterprises, and the committee has called for applications. While this is commendable, the reform agenda appears to end here; the next step of privatising some of the loss-making, non-strategic state enterprises has been taken off the table. This is made abundantly clear in the Government’s National Policy Framework, which states that it will enact laws to stop the privatisation of state enterprises.

If privatisation is off the table, what can be done?

The three main state enterprises – Ceylon Petroleum Corporation (CPC), Ceylon Electricity Board (CEB), and SriLankan Airlines – recorded a combined loss of 1.3% of GDP in 2018, compared to 0.5% of GDP in 2017. Given that the expected revenue loss from the recent tax cuts is an estimated 2% of GDP, it is clear that turning our state enterprises around would go a long way towards achieving the fiscal targets set by the Government.

If the Government has taken the option of privatisation off the table, but wants to actively transform state enterprises into profit-making entities, the option of private management should not be dismissed in the same breath as privatisation. Private management of state enterprises would essentially be partial privatisation. In this scenario, the Government would share ownership of the enterprise with a private company, and the management of the enterprise would be transferred to the private company. In the case of strategic enterprises, the Government could retain majority shareholding.

A government’s primary responsibilities towards its country and people should not be the management of business enterprises; the government has a responsibility to uphold the rule of law, ensure national security, and protect the rights of its citizens, and the management – or in this case the mismanagement – of state enterprises should not make the list. A government is the entity that sets the rules of the game; it details out the laws and regulations that govern businesses. When a government also enters the playing field, there is an inherent conflict of interest that occurs. Even if the government remains impartial, it does not have the necessary incentives in place to run a business successfully.

However, when a private entity manages a business, they would look at increased profits as the business is under their sole control, and any losses they make or issues they face would be their responsibility. The incentive is to minimise losses and make the business more productive. A private entity managing state enterprises would absolve the Government of having to invest in loss-making public enterprises and reduce government borrowing.

Further, private management would bring down fiscal and administrative pressure of state-owned entities and remove the huge weight of having to manage state enterprises off the Government’s shoulders. This encourages the Government to work towards providing increased quality of living for the people through effective governance, rather than spending so much of its time and money on managing businesses.

The idea of partial privatisation, initially, may be a challenge to implement, but in the long run, it would result in highly effective results. This would also mean that there would be less political influence on the management of state enterprises.

It has worked before, so why dismiss it?

Looking back at partial privatisation in Sri Lanka, a significant achievement has been the liberalisation of the telecommunications industry. This was implemented in order to provide better services for customers through competition and industry development through private sector participation. Both customers and society as a whole benefited from it as there was a reduction in call charges (tariffs), improved telecommunications in rural areas, decrease in equipment costs, industry profit growth, increased government revenue, etc. This example of partial privatisation shows us the benefits not only the Government but also the people would gain. Taking into account these loss-making state entities and the debt repayments the Treasury will have to make over the next few years, the option of partial privatisation by the Government should be seriously considered.

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Addressing Sri Lanka’s debt: How to move forward

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

Originally appeared on The Morning

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By Sumhiya Sallay

Sri Lanka’s debt-to-GDP ratio is at a staggering 82.9% as of 2018, an increase from 76.9% in 2017. While the Ministry of Finance projects that these ratios will decline in the future, achieving these targets is of the utmost importance.

With a new Government in place, the country can expect to see new projects and policies introduced as the Government works on achieving their campaign promises. It is crucial that our loan commitments are a constant point of reference in this postelection period, where policies and projects that would shape Sri Lanka for the next four years are being evaluated and decided upon.

Our new title of upper middle-income country recognises the economic growth we have witnessed as a country. The challenge that lies ahead is sustaining this growth and clearing this hurdle of debt.

What can we do about our debt?

Total government debt is currently 82.9% of GDP, with the total debt service amounting to 14.5% of GDP. Government revenue as of 2018 was Rs. 1,920 billion, while government expenditure was Rs. 2,693 billion. The shortfall is clear, the Government has to borrow and borrow extensively to keep the country running. To elaborate further, the amount of money spent on debt servicing in 2018 amounted to 108.8% of government revenue. What is more alarming is the fact that the revenue-to-GDP ratio of Sri Lanka is one of the lowest in the world, and with the fast-growing emerging market economy, this brings much concern.

Bringing our debt-to-GDP ratio down will be challenging. The country will have to commit to a clear and stable monetary policy and maintain investor confidence. If these conditions are coupled with nominal growth in the economy, the result would be a fall in our debt-to-GDP ratio.

Of course, this is easier said than done, and borrowing from Peter to pay Paul is not a solution in and of itself. This needs to be accompanied with strong fiscal policy to ensure that the country gets a better grip on its finances.

Addressing expenditure

Given the recent tax cuts, it is clear that the country will have to balance this decrease in tax revenue with a corresponding decrease in government expenditure. The question is: How does a government manage their debt, taxes, and expenditure in a way that allows for economic growth while avoiding prohibitive rates of taxation?

Simply, some compromises have to be made and a delicate balance struck.

In order to achieve this balance, it is vital that we move away from ad hoc policymaking and the Government plans and works within a medium-term policy framework. In other words, the country needs to adopt a well-planned medium-term expenditure framework. This would mean that the Government would be able to plan projects and programmes taking into account a three-year resource envelope and fiscal obligations aligned with the allocated annual budget which would provide productive financial outcomes. This encourages the fiscal management of the Government’s revenue and expenditures, and thus helps control debt.

A medium-term expenditure framework (MTEF) sets out a rigid budget plan within which the Cabinet and central agencies ensure fiscal discipline when allocating public resources. This approach would set fiscal targets and allocate resources for strategic priorities within these targets, thus forming the basis of national priorities and expenditure prioritisation.

The MTEF aims to improve inter and intra-sectoral resource allocation by effectively prioritising all expenditures according to the Government’s socioeconomic programmes and committing towards allocating resources to only the most important projects.

This approach would monitor current expenditure estimates of policies and programmes and form a reference point for the upcoming years’ budgets. A MTEF would pave the way for policy and funding changes and thereby give time for ministries and agency managers to adjust and make better plans for their operations.

While following a MTEF is important, the Government could look at economic policies that would need adjustments to allow the country to repay loans, such as diversifying the labour market, supporting micro to macro businesses, re-regulating SOE finances, etc.

The Government could also create a policy environment that would encourage investment. While there are clear strategies that could be followed to manage our debt, this should be at the top of the new Government’s agenda, and our debt situation should guide policies on expenditure, borrowings, and taxation.

The Ministry of Finance projects that the country’s debt-to-GDP ratio will decline in the coming years, with an expected drop to 72% of GDP in 2022, but this is wholly dependent on Sri Lanka putting in place and adhering to a sustainable fiscal policy. Sri Lanka has an opportunity to overcome this challenge and it is vital that we grab this opportunity and adopt necessary policies.

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