Dhananath Fernando on State Owned Enterprises

Advocata COO spoke to newsfirst on State Owned Enterprises (SOEs) on the BizFirst program

Ravi Ratnasabapathy on Cabinet re-shuffle and the state of the economy

Advocata fellow Ravi Ratnasabapathy appeared on the Bizfirst program to discuss the recent cabinet reshuffle and the state of the economy in Sri Lanka.

Cheap footwear imports benefit ordinary Sri Lankans

Sri Lanka's footwear industry has written to the Director General of Customs requesting a crack down on illegal imports of footwear.

The industry claims that Sri Lanka is losing over US $112.5 million annually in foreign exchange as a result of cheap footwear imports from China and India. The industry estimates that the state should have gained revenue of around Rs. 9 billion if proper taxes had been paid on the import shoes

Local manufacturers are supposed to be on the verge of collapse as they cannot compete.

The industry has made repeated calls for protection following the reduction of duties on imported sports shoes in the 2011 budget. Successive governments since 2002 have introduced tariff barriers to protect the local footwear industry but some duties were reduced in 2011.

Shoe makers claim that illegal imports are mainly factory overruns, stock lots and inferior quality products and are available in the market for less than Rs. 750 which is below the minimum total custom tariff on footwear (CESS Rs. 600 +PAL + VAT and NBT). Consumers who were befuddled as to why shoes are so expensive in Sri Lanka now know why.

Yet, only last month the Minister of Industry and Commerce Rishad Bathiudeen, speaking at the Footwear & Leather Fair remarked that Sri Lanka's footwear and leather exports have increased by 28% in 2016. "Our footwear and leather exports in 2016 increased by 28% in comparison to 2015 revenues to $140 Million showing strong growth trends”.

It is clear that the problem is not as straightforward as the industry claims. The local shoe industry seems to succeed competing, at least on some level in the global market. If they compete abroad they should be able to compete in the domestic market, why is there a need for protection? 

Let us try to assess the relative benefits and costs of protecting the local shoe industry.

The industry maintains that letting consumers buy cheap imported shoes threatens the jobs of 40,000 people employed in the industry island wide.  The producers have requested that the duty structure that prevailing before 2011 be reintroduced. Duty on shoes was 30 per cent or Rs. 1000 per pair whichever was higher. Addition to duty, a CESS of Rs. 500 was levied per pair. 

This is a significant additional cost that consumers are burdened with. Additional costs will be a source of particular anguish to the parents of the four million children who attend school and whose shoes would need to be changed almost every year. All children have in common a constant need for new clothes and shoes as they grow. Kitting out youngsters for school can be expensive; those who participate in sports may require several different types of shoes, placing a heavy strain on family budgets.

The effect of import duties is to raise the price of both foreign products and domestic goods. These policies may “save” the 40,000 jobs in the industry, but only at the expense of the overall welfare of consumers. The annual shoe requirement locally is around 40 million pairs; a greater part of the population needs to pay higher prices on shoes in order to support the footwear industry.

Trade protection temporarily helps some producers, but it cannot do this without harming others. Who is affected by higher import duties? First consumers who either buy an imported shoe or a local shoe sold at a high price. Remember it is not just a case of an imported shoe being sold at a high price and consumers turning to local shoes instead. The purpose of the duty is to enable local products to be sold at higher prices (benefiting manufacturers) than would otherwise be possible.

Since they pay higher prices, consumers would have less money to spend on other goods, indirectly hurting various other trades. Due to high prices people will buy less; they will manage with broken or worn out shoes without replacement. Shoe traders and retailers, who sell imported shoes, will also suffer from reduced business.

Various arguments are put forth to support protectionism; to protect sunrise (infant) industries, sunset (declining) industries, strategic industries (energy, water, food etc.), save jobs or deter unfair competition.

When firms within certain industries call for protection, for whatever reason, policymakers must view the issue from the perspective of the consumers as well and weight the relative merits of the claim. Consumers do not form associations and lobby for their interests, unlike businesses, so Governments are under little pressure to look after consumer interests. Yet, in most instances the number of consumers far outweighs the number of producers or the number of jobs concerned. Often, the real goal of the industry is to gain security through the removal of competition.

Certainly, if duties are lowered, some workers in the footwear industry may lose their jobs and some or all of the firms may be forced to close by the foreign competition. The indsutry claims that 2000 cottage type businesses may have to close.

Workers will have to look for employment elsewhere. However, other job opportunities will be made available since the money that consumers previously had to pay for duties could be used to buy new products or services or consume more of already existing products and services. Employment is created in other sectors because resources will flow to areas that consumers consider being of highest value to them. 

It is rather ironic that while the industry focuses on opening markets abroad it is keen to keep the domestic market as protected as possible, in the interest of maximising exports and minimising "harmful" imports. It is fortunate that the export destinations for Sri Lanka's shoes are more open than Sri Lankas' home market.

In general, tariffs promote the production of items in which a nation is inefficient and deter other production lines in which the country has a comparative advantage. By reducing tariffs, things that could be produced more efficiently in one country would be made there and items that could be purchased less expensively abroad would be imported.

In the 1950’s, Britain attempted to protect its famed Lancashire textile industry through restraints on imports.  At best, this may have prolonged its decline, but it did nothing stop it.  Low-cost textiles were being made on a mass scale by foreign competitors.  Eventually the Britain’s textile industry moved to high added value luxury and designer products that sold at a premium in both domestic and foreign markets.  Some UK textile products have become world-beaters, without the need for subsidies or tariffs to protect the jobs they sustain.

Some of Sri Lanka’s shoe exporters are already competing effectively in the world market. Reducing import duties on shoes would benefit consumers and would spur the local industry to improve efficiency and towards greater innovation, to the long term advantage of all concerned.

A version of this article previously appeared in the Ceylon Daily News.

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Ravi Ratnasabapathy is a Fellow of the Advocata Institute and a management accountant by Training.

Should we have Socio-economic rights in the constitution in Sri Lanka?

A new Constitution is currently in the works and the question has arisen as to whether social and economic rights should be included as was the case with South Africa’s new constitution. No one doubts the importance of access to education, healthcare or shelter, but should these be included within the Constitution?

This was the subject of a talk delivered by Professor Pratap Bhanu Mehta, at a forum organised jointly by the Advocata Institute and Echelon Magazine.

Prof Mehta stated that the most important fact to keep in mind is that a constitution is a social contract among a particular group of people. It has to reflect the historical specificities of those people, their diverse goals, aspirations and identities. It needs to be legitimate in the eyes of the people who will be governed by that constitution.

We can all agree that it is good to have the best healthcare for all citizens, as equitably as possible; nobody would disagree with the need to disseminate education as widely as possible and few would disagree that some sensible labour legislation is necessary.

Will these goals be met by including socio economic rights in the constitution rather than leaving it to the normal hurly burly of representative politics?

Unfortunately, the comparative experience provides no clear answer, it depends on circumstances. There is also a paradox: it is precisely those countries that would have achieved these goals even in the absence of constitutionalising these rights that also do better when they do constitutionalise them.

State failure

Prof Mehta claimed that a part of the fascination with constitutionalising these rights comes from a feeling of deep state failure. Most countries that have achieved these goals, as in Scandinavia or advanced developed countries have done so without constitutionalising them. Therefore, the notion that constitutionalising these rights is a necessary condition for achieving them is false.

He stated, in the developing world there is pressure for constitutionalising these rights because it is believed that in the absence of a justiciable constitution right, the legislature, ministers, parliament, will not create the conditions to achieve these rights.

This context is very important. The discourse on rights in developing countries emerges from a history of state failure. We want to go to court because the legislature does not give us these rights. The paradox is that if we live in a country where the legislature does not deliver these rights, it is highly unlikely to do so even if constitutionalised as the state is unlikely to have the effective institutions to deliver these rights.

The problem is essentially one of governance and the idea that constitutionalising rights can substitute for broad governance reforms needs to be challenged.

The drafters of the Indian constitution drew a distinction between Fundamental Rights which are justiciable under the constitution and the Directive Principles of State Policy which are not. The Directive Principles contain the social and economic rights. While the Directive Principles imposed an obligation upon the State to strive to fulfill them, they are not justiciable rights and their non-compliance cannot be taken as a claim for enforcement against the State.

The rationale for this distinction is that in any society there are deep differences in opinion on economic matters, and a constitution should not prejudge these questions. We can all agree that better healthcare is a good idea, more education is a good idea, more health workers is a good idea, but we might disagree on the institutional architecture to deliver these rights.
Deep entrenchment of these rights in a constitution framework abridges that democratic and political discussion. The determination of the best solution should emerge from democratic politics and be open to iterative re-balancing, which will occur over time, depending on how the experience unfolds.

To illustrate, Prof Mehta took the example of workplace protection for workers. We may agree that increasing workers power vis a vis employers is a good thing, but we may disagree on the best solution to achieve that outcome.

If one’s economic analysis suggests that a form of social protection detaches income from employment; a minimum basic income, this may lead to a different view as to what the employer-employee relationship should be. From this viewpoint, giving people a minimum basic income may enhance workers bargaining power and may be a better way to achieve the desired outcome than by including stringent minimum wage instructions and placing the onus on the employer.

Thus, we may have two different models of enhancing workers bargaining power. How do we decide which is correct? This is something that should be subject to iterative learning. The danger with constitutionalising is that we may be setting in stone a solution that does not get very far because economic conditions are changing.

Interestingly, in India from the late 1970s the Supreme Court started expanding the guarantee of the Right to Life (a Fundamental Right) to include within it and recognise a whole gamut of social rights; the right to shelter, the right to health, education, right to environment, even a right to sleep.

Education bill

The question to ask is: how far has Indian governance improved as a result of the promulgation of these rights? Prof Mehta admitted that this was a complicated empirical question but his short answer is: only to a very limited extent.

The court pronounced the right to education and India now has a right to education bill as a result, but he claimed this bill was passed the day India’s enrolment in primary education had already reached its goal.

The right came after the fact, and focused largely on the input side of education rather than the output. He claimed that in fact learning outcomes have worsened after that right was promulgated. He said, similar problems existed with the right to environment. How does a country with the most progressive environment laws in the world end up with the filthiest air and the dirtiest water in the world?

Sri Lanka is regarded as one of the most important cases of human development success: it leads South Asia on many indicators, including, universal primary school enrollment, gender parity in school enrollment, under-five mortality, universal provision of reproductive health services, tuberculosis prevalence and death rates, and sanitation. All this, despite the absence of constitutionalised socio economic rights.

These achievements may be traced to enlightened policy and effective administration during the early decades after independence. Nepotism and corruption have rotted Sri Lanka’s public service, a disproportionate share of the budget is spent on defence and debt service, some of which has financed white elephant infrastructure.
Perhaps, these are the real issues to be tackled? 

Dr Wignaraja: Can Sri Lanka join Asian Supply chains?

by Dr Wignaraja on Daily Mirror

President Trump’s pledge to put America first during a global trade slowdown has sparked worries that the era of export-led growth has ended. Trade in Asia and globally has slowed since the 2008 global financial crisis but it is not the end of export-led growth. The real issue, however, is whether Sri Lanka can follow East Asia’s success in global supply chains amid slower trade growth and a likely rise in protectionism. Global supply chains refer to the geographical location of stages of production (design, production, marketing and service activities) in a cost-effective manner and linked by trade in intermediate inputs and final goods. For instance, the Toyota Prius—a hybrid electric mid-size hatchback car—for the US market was designed in Japan and is largely assembled there, but some parts and components are made in Southeast Asia and China. Supply chains exist in a wide range of manufacturing and services activities.  East Asia’s shift from a poor, less developed agricultural periphery to a wealthy global factory over the last half a century is an economic miracle. The extent of the region’s participation in global supply chains is significantly greater than elsewhere and has spurred East Asia’s global rise to the coveted “Factory Asia” league with the middle-income status for many economies.  In 2015, the developing economies in East Asia accounted for 34 percent of global supply chain trade with China making up 15 percent and Southeast Asia for 7 percent. This compares with 34 percent for the European Union, 10 percent for the United States and 5 percent for Japan.  However, South Asia is a relatively small player. India accounts for 1.7 percent of global supply chain trade and the rest of South Asia, including Sri Lanka, for 0.13 percent. Structural transformation and rising wages in China have encouraged an outward shift of labour-intensive segments of supply chains ranging from clothing to electronics. Sri Lanka has the potential to attract such supply chains from China. It is strategically located on the way to Europe, offers low wages with reasonable labour productivity and has a dynamic clothing industry. Close proximity to the large Indian market, which is a magnet for Chinese outward investment, is another advantage.  Smart business strategies and market-friendly national policies have supported East Asia’s achievement in supply chains. Being a big firm naturally creates advantages to participating in supply chains due to a larger scale of production, better access to technology from abroad and the ability to spend more on marketing.  It is crucial for small and medium-sized enterprises (SMEs) to work with large firms. Hence, smart business strategies, such as mergers, acquisitions and forming business alliances with multinationals or large local business houses are all rational approaches, as is investing in domestic technological capabilities to achieve international standards of price, quality and delivery. East Asia’s experience suggests that nimble SMEs can also join supply chains by locating to industrial clusters and reap the benefits of interdependence such as co-financing a training centre or a technical consultant to upgrade skills. Business associations can facilitate clustering by mitigating trust deficits to cooperation among SMEs and by coordinating collective actions for cluster formation. For instance, major industrial clusters are visible in Viet Nam near Ha Noi and Ho Chi Minh City, where large firms are surrounded by thousands of SME suppliers and subcontractors making garments, agricultural machinery and electronics goods. Turning to national policies in East Asia, modern cost-competitive infrastructure is crucial for supply chains. This means investing in world-class ports, roads to ports, logistics, electricity supply and information technology infrastructure. Maintaining open trade and investment regimes which encourage investment and transmit price signals to business are likewise important, as well as sound financial systems which emphasize competition among commercial banks and financial inclusion. High-quality, affordable technical and marketing support services and investing in education to develop skilled labour both help SMEs join supply chains. More controversial is the use of industrial policies in East Asia to target credit and subsidies to particular sectors or firms. Some oft-cited examples of failures include Korea’s heavy and chemical industry push, Malaysia’s national car project (the Proton) and China’s home-grown 3G mobile technology TD-SCDMA. More research is needed on good practices, as there is a high risk of government failure and cronyism associated with industrial policies. Joining supply chains will boost industrialization, jobs and incomes in Sri Lanka. There is no one-size-fits-all approach for Sri Lankan firms to join supply chains. Smart business strategies, facilitating business associations and market-friendly policies are all useful ingredients, while business and government collaboration is essential to tailor these ingredients to national circumstances. (Ganeshan Wignaraja is Advisor in the Economic Research and Regional Cooperation Department of the Asian Development Bank (ADB). The views expressed here are solely the author’s own and do not represent the position of the ADB. This is a guest article for the Ceylon Chamber of Commerce ‘Trade Intelligence for the Private Sector’ (TIPS) initiative that helps its member businesses be up-to-date on new developments in international trade. For more on the subject of this article, refer Production Networks and Enterprises in East Asia an edited volume by G. Wignaraja (2016)) 

In 2017, the government must deliver on Reforms

By Ravi Ratanasabapathy

First published on the Daily News

Sri Lanka's coalition Government has now been in office for two years; the new president was elected two years ago and the new coalition in Parliament was formed some eight months later. How has it fared, particularly in the sphere of economics?

To put things in proper perspective we must appreciate the unique political moment in which the new administration operates. The change of regime was a shock and expectations soared; perhaps to levels that were unrealistic. The disappointment has now set in as the coalition Government, made up of disparate parties with different agendas unexpectedly propelled to power has grappled with a Gordian knot of issues.

Economic liberalism, good governance, ethnic reconciliation and a sensible foreign policy were expected to materialise overnight. While significant strides have been made they have fallen short of public expectations.

Careful handling

On the economic front in particular expectations have proved to be far too high. The Government has treaded very cautiously, shying away from tackling unpopular reforms and unravelling the web of protectionist regulation that grew up around many sectors of the economy under the 'import substitution' label.

Part of the problem has been in the communication, the public were not aware of the precarious state of the finances that the new Government inherited.

The IMF, in its review in September 2014, noted that "public debt and debt service remain high by international comparison, reserves are limited, tax revenues are low, and medium-term sustainability depends heavily on continued growth and a positive external environment." In 2014 the debt/GDP ratio stood at 75% and debt service costs accounted for 90% of Government revenue. Interest cost alone amounted to 37% of Government revenue.

Despite the bleak economic situation, prompted by forthcoming parliamentary elections in August 2015, the new Government announced a wave of populist measures -increases in salaries, subsidies and reduced fuel costs, amongst others.

These were probably necessary to win the election. Flush from electoral victory the new regime may not even have realised the full depth of the problem they were dealing with: there were periodic news reports announcing various apparently unrecorded liabilities being unearthed during their first few months in office. Unfortunately having won the election, the Government was unable to roll back any of the giveaways or make any headway in reducing the size of the state. Politically expedient but economically unsustainable the resulting fiscal, balance of payments crisis and IMF bailout were inevitable.

Tough measures followed in the budget of November 2016. Personal and corporate income taxes were increased along with VAT and taxes on alcohol and tobacco. Though unpopular these should provide the macro-economic stability within which the Government can embark on a serious programme of reforms. The time for proper reform is now upon us. Eminent economist, Professor Razeen Sally warned that Sri Lanka is in a period of dangerous policy drift and that the window of opportunity for economic was narrowing and that Sri Lanka should not 'miss the bus'.

What needs to be done?

Now that the tax rates have been raised to a level where the fiscal deficit is under control for the moment, it must be secured for the medium term. This means that the State must keep its expenditure under control; no more populist unfunded giveaways, a freeze on recruitment and a general economy drive eschewing extravagance, the elimination corruption and waste through increased transparency and open processes.

This must be followed by measures to start trimming the state. There is some public support for privatisation in a few sectors at least. The government should push ahead with these and list the entities on the stock exchange. The formula used in privatisation during the1980's: sale of a majority stake, a public listing for 20% of the shares with 10% of the equity given free to employees proved to be both popular and successful. It will also give a boost to the flagging stock market and send an important signal to investors that Sri Lanka is ready for business.

Improving the business climate

Some measures have already been announced, which is welcome, but more needs to be done. There is still a need to cut red tape: business regulations must be simplified, the number of approvals for investment minimised and these should be processed by a genuine one-stop-shop rather than a multitude of ministries, and despatched in a matter of days and weeks rather than months. Digitisation and reducing bureaucratic discretion are the way to go.

This in turn will lay the foundation for the big reform which is to reorient policy towards FDI and exports. The trade and FDI regime needs to be liberalised: import tariffs minimised, customs procedures simplified, non- tariff barriers to imports such as quotas/licensing arrangements should be abolished as far as practicable.

If implemented properly, the reforms should take Sri Lanka back on a path of sustainable growth resulting in improved livelihoods for its citizens.

The overall conclusion on the economy over the past two years is similar to contemplating a glass; half full or half empty, depending on perspective. The government has the opportunity to change this perspective to one of near full, provided the moment is seized and a reform programme moves ahead without delay.

What would President-Elect Trump mean for Sri Lanka and Asia?

By D.A Jayamanne
First Published in Daily News

Foreign policy analysts are scrambling to understand the potential impact of a Trump Presidency on Asia and other regions. Not only did Trump ran an unconventional campaign, his campaign themes challenged years of bipartisan consensus on U.S. engagement and leadership in the world. “We will no longer surrender this country to the false song of globalism” said the now President-elect Trump in a landmark speech on foreign policy back in April. He went on to say that a top policy goal in a Trump administration would be to “end the era of [global] nation-building and create a new foreign policy”.

Throughout the campaign Trump was sharply critical of U.S. interventions overseas, especially the war in Iraq, interventions in Libya, even challenging U.S. commitments towards NATO and other U.S. allies.

We don’t know how much of Trump’s rhetoric will translate into policy” says Frank Lavin, a former U.S. ambassador to Singapore and a U.S - Asia expert.

“We don’t to what extent this was just campaign talk or how deep and heartfelt this view is”. Speaking in the online podcast series for Advocata Institute, a Colombo-based think tank, Lavin went on to explain that President elect Trump’s key cabinet positions might provide the first clues as to how the president-elect might govern.

“The eyes of the world would be on him as he selects the key cabinet positions of Secretary of State, Defence and Treasury” says Lavin, “How orthodox are some of these selections; Is he picking from the mainstream currents of U.S. policy engagement, where there is generally a consensus on U.S. leadership in the world, or is he picking more outliers?”. Even then, there could be some ebb and flow warns Lavin, and that it’s wise to adopt a “wait and see” approach until President Trump takes office and gets about his business.

So far, Trump has made several picks that gives hope to the more mainstream sections of the U.S. policy establishment.

This has included picking ex Trump critics such as Louisiana governor Nikki Haley, as the new U.S. Ambassador to the United Nations. More surprisingly, it is reported that the president-elect is seriously considering former governor Mitt Romney for the key position of Secretary of State, the U.S. equivalent of foreign minister.

Romney was a fierce critic of Trump’s candidacy and remained bitterly opposed to his campaign till the end. All picks must go through a hearing process before being confirmed.

“Every president wants to put their stamp on the office” comments Lavin, “but I would say there’s there tend to be a lot more continuity in U.S. foreign policy than there is change. Even though President Trump comes into office as a ‘change candidate’. Certainly, some changes may be afoot. Broadly speaking however, United States is the same country and we have the same challenges, our national interests are still the same, so we are probably talking about what kind of weight we are giving to certain foreign policy goals, rather than seeing radical changes to those goals”.

This may be particularly true in the case of U.S. policy towards Middle-powers and smaller countries that doesn’t have a strong policy dimension according to Lavin. These relationships are mostly friendly and revolves around classical diplomacy.

More is known however about Trump’s apprehensions towards multilateral Trade deals. Trump last week doubled down on a campaign pledge to scrap the Trans-Pacific Partnership (TPP), a Free Trade deal that involved 12 pacific rim countries including Japan, Canada, Australia and America.

“The TPP would have allowed the U.S. to set the architecture for the Asian region and help determine the kind of trade relations that benefit all parties.” says Frank Lavin, who served as the U.S. under secretary for International Trade from 2005-2007. “If the U.S. is not going to set that architecture, then what we are allowing is for other parties to do it. Some might do it with the U.S. in mind, others might do it to exclude America”.

According to analysts, one of the foreign policy objectives of the TPP was to create trading bloc that counter balances China’s dominant exporting power. American politicians often complain about China’s mercantilist attitudes towards trade. Lavin agrees.

“China can be mercantilist in trade. They do have national champions they promote, and use industrial policy to favor those champions”. But part of the solution is to work more with countries that do play by the rules says Lavin, and this is where the TPP would have been useful according to the former diplomat, who now heads an e-commerce company based in China.

So how does all of this impact Sri Lanka? On trade, the scrapping of the TPP would mean that Sri Lanka is saved from potential risks arising from being excluded in the agreement.

A study by the IPS estimated that Sri Lanka could stand to lose around $40 million worth of exports by being excluded from the TPP. For his part, Trump says that instead of the TPP, he will negotiate “fair, bilateral trade deals” indicating perhaps that a potential U.S. - Sri Lanka bilateral trade agreement may not totally be off the table.

On general foreign relations, things are much murkier. Sri Lanka’s relationship globally is dominated by the alleged human rights abuses during the conflict years and the commitments the country had made to the international community.

Whilst Trump’s campaign rhetoric certainly point to a more non interventionist foreign policy agenda for America, it is unlikely that the entire machinery of U.S. diplomacy be overturned.

As ambassador Lavin explains, critical clues will in be who Trump chooses as his key advisors on foreign affairs, and after that, we’ll just have to wait and see.

See the full podcast with Ambassador Frank Lavin.

Former U.S. Diplomat and Advocata Institute advisor Frank Lavin speaks about President elect Donald Trump and the impact his presidency might have on Asia.

On the Budget 2017 : Towards better economic and Fiscal Policy

The Daily News published  parts of Advocata's statement on the Sri Lankan naitonal Budget 2017.

The immediate policy priority should be to restore emphasis on exports: Liberalise the trade and investment framework to attract FDI.

Public sector reforms to cut costs are vital. While tax increases may be unavoidable, the additional burden on the public must be minimised: Reforms for the public sector to reduce its size, cut corruption and improve efficiency are essential.

The current tax structure is incoherent and chaotic. It must be reviewed and policy grounded on sound fiscal and tax principles including fiscal adequacy, administrative feasibility, simplicity, transparency and stability.

Despite a significant improvement in the first half of the year, meeting Sri Lanka’s budget deficit for 2016 will be challenging. A significant amount of fiscal consolidation will still be needed over the next few years if the government is to achieve its stated goal of reducing the budget deficit to 3.5% of GDP by 2020 or indeed meet its commitments to the International Monetary Fund (IMF), which is likely to create considerable uncertainty over the likelihood of further tax increases.

Given the difficult environment and ambitious targets, the government may be tempted to resort to ad hoc, short-term measures to deal with fiscal crises as they arise, creating a volatile business environment, eroding confidence and leading to a lack of predictability in revenue targets. This, in turn, results in further ‘quick fixes’.

This is a vicious cycle that must be broken if consistency and predictability is to be restored to the tax system. This is possible if the government adopts a framework of evidence-based policymaking, and we urge that this be done as a matter of priority.

Making policy that is based on evidence is not easy, but it is possible to draw on the experience of countries such as the UK, which have adopted such an approach. Frameworks that governments can follow to build and support a system of evidence-based policymaking are available, and the government should seek specialised assistance to implement a structured approach. This will help ensure consistency and predictability in policy, improving business confidence.

Policy making must be an ongoing process, and consultation and assessment should not be limited to a period a few weeks before the budget. Poorly researched policy may cause unintended consequences and result in policy reversals. While all suggestions must be considered, many are likely to come from sectors seeking privileges. These must be carefully researched, subjected to wider consultation and adopted only if overall benefits to society outweigh costs. Some of the complexity and anomalies in the tax code may be traced to the accommodation of various special interest groups.

In achieving its fiscal targets, the government cannot limit its focus to raising taxes. Breaking from the pattern of the past, equal or even greater emphasis must be placed on the reduction of expenditure, reviewing not only the scale of spending but also the scope of the government.

An economy drive eschewing extravagance, the elimination of corruption and waste through increased transparency, and open processes must necessarily form a part of this exercise. Sri Lanka’s leaders frequently cite the example of Singapore. Fiscal prudence has been a hallmark of Singapore’s governing philosophy and successful management of the economy – an ethos that must become a watchword for Sri Lanka’s rulers. The Singapore Civil Service’s “Cut Waste Panel” and “Economy Drive” offer useful practical lessons in managing costs and could be adapted for Sri Lanka.

The tax system must be simplified, widening the base and increasing compliance. The finance minister’s commitment to this is laudable. The remainder of this submission seeks to outline a few key issues and offer avenues for the administration to explore. We believe these ideas are worthy of careful study and could yield outcomes that will assist in stimulating growth, reducing the budget deficit, and simplifying and rationalising the tax system.

Rethink the development strategy

Restore policy emphasis on exports

Lacking a large domestic market and possessing few natural resources, exports offer the best opportunity for rapid development.

Successful integration of the manufacturing sector into global production networks has played a key role in employment generation and poverty reduction in China and other high-performing East Asian countries.

The market-oriented policy reforms of 1977/8 were based on this rationale and served the country well, resulting in a notable diversification of the commodity composition of Sri Lanka’s exports and a consistent improvement in share of world manufacturing exports until the late 1990’s.

However, protectionist pressures began to build in 2001, and from 2004, the relatively open trade policies of the past were explicitly and systematically reversed. A policy paper by the World Bank titled “Increase in Protectionism and Its Impact on Sri Lanka’s Performance in Global Markets” shows that, today, through the proliferation of a variety of para-tariffs, Sri Lanka’s tariff policies are just as protective as they had been more than 20 years earlier.

The present protectionist import tax structure has serious costs for Sri Lanka’s economic welfare and growth; Sri Lanka’s exports relative to GDP have declined, as has its share of world exports. Sri Lanka has fallen significantly behind its competitors. Vietnam, which was on par with Sri Lankan exports in 1990 with $2 billion per annum, today exports $162 billion versus Sri Lanka’s $10.5 billion.

A bulk of Vietnam’s exports is driven by foreign investment and a globally competitive agriculture sector that emerged in the wake of a liberalisation drive that moved away from ‘self-sufficiency’. FDI firms account for 71% of Vietnam’s and 44% of China’s exports. The lesson is clear: To boost growth and create productive employment, Sri Lanka should cut barriers to trade and investment, and focus on attracting export-oriented FDI.

The most important reforms needed are listed as follows:

1. Trade policy reforms: Move from the present chaotic tariff structure towards a transparent, uniform tariff structure

• Unify the existing Customs duty and the plethora of para-tariffs (PAL, VAT, CESS, Customs Surcharge) into a single Customs duty at the individual Customs code level, and then reduce Customs duties across the board to a uniform nominal rate of 15%. Moving towards a low, uniform tariff structure has the potential to increase tariff revenues. This would speed up Customs clearance and reduce the potential for corruption as it reduces the discretion of Customs officials and makes the trade regime predictable.

• On the export side, remove all cess as it reduces the effective price received by exporters, and thereby discourages exports. There is no evidence to suggest that these cesses promote local downstream processing of primary products that are now exported in ‘raw’ (unprocessed) form.

• Join the Information Technology Agreement of the WTO to create free trade in electronics, which will attract FDI to this sector.

2. Foreign direct investment reforms

• Restore the role of the Board of Investment as the ‘one-stop shop’ for investment approval/promotion (as envisaged in the BOI charter). This requires repealing the Revival of Underperforming Enterprises and Underutilized Assets Act (2011) and the Strategic Development Projects Act (2011), or passing new legislation to supersede these two acts.

• It is, of course, necessary to rationalise the fiscal incentives offered to investors, but there is a strong case for providing export-oriented foreign investors with time-bound tax holidays and investment tax allowances beyond the tax holiday period.

There is evidence that tax incentives play an important role in influencing location decisions of export-oriented (efficiency-seeking) FDI, especially where competing countries still offer them, provided of course that the other preconditions are ‘reasonably’ met. (The evidence used in recent policy reports by the World Bank to argue against tax incentives comes from studies that have not made a distinction between ‘market seeking’ and ‘export-oriented’ FDI). Removing all tax incentives, while other negatives continue to weigh on the overall competitiveness in investment and trade, may be counterproductive.

• Sri Lanka has to improve property rights to draw investment. The guarantee against nationalisation of foreign assets without compensation provided under the Article 157 of the present Constitution needs to be maintained under the ongoing constitutional reforms.

• Avoid the current practice of ‘domestic value added’ [which is defined as per unit of domestic retained value (wages + profit + domestically procured intermediate inputs) as a percentage of growth output] as an evaluation criteria in approving investment projects. 

Advocata's submission for the Budget 2017

Echelon Magazine, Sri Lanka's premier business magazine published excerpts of Advocata Institute's Budget submission for 2017

THINK TANK ADVOCATA IS PROPOSING LOWER TRADE TAXES AND TRIMMING PUBLIC SECTOR EXPENDITURE IN ITS RECOMMENDATIONS FOR BUDGET 2017 PRESENTED TO THE MINISTRY OF FINANCE AND PLANNING

Summary recommendations
1. The immediate policy priority should be to restore emphasis on exports: Liberalise the trade and investment framework to attract FDI.

2. Public sector reforms to cut costs are vital. While tax increases may be unavoidable, the additional burden on the public must be minimised: Reforms for the public sector to reduce its size, cut corruption and improve efficiency are essential.

3. The current tax structure is incoherent and chaotic. It must be reviewed and policy grounded on sound fiscal and tax principles including fiscal adequacy, administrative feasibility, simplicity, transparency and stability.

Despite a significant improvement in the first half of the year, meeting Sri Lanka’s budget deficit for 2016 will be challenging. A significant amount of fiscal consolidation will still be needed over the next few years if the government is to achieve its stated goal of reducing the budget deficit to 3.5% of GDP by 2020 or indeed meet its commitments to the International Monetary Fund (IMF), which is likely to create considerable uncertainty over the likelihood of further tax increases.

Given the difficult environment and ambitious targets, the government may be tempted to resort to ad hoc, short-term measures to deal with fiscal crises as they arise, creating a volatile business environment, eroding confidence and leading to a lack of predictability in revenue targets. This, in turn, results in further ‘quick fixes’.

This is a vicious cycle that must be broken if consistency and predictability is to be restored to the tax system. This is possible if the government adopts a framework of evidence-based policymaking, and we urge that this be done as a matter of priority.

Making policy that is based on evidence is not easy, but it is possible to draw on the experience of countries such as the UK, which have adopted such an approach. Frameworks that governments can follow to build and support a system of evidence-based policymaking are available, and the government should seek specialised assistance to implement a structured approach. This will help ensure consistency and predictability in policy, improving business confidence.

Policy making must be an ongoing process, and consultation and assessment should not be limited to a period a few weeks before the budget. Poorly researched policy may cause unintended consequences and result in policy reversals. While all suggestions must be considered, many are likely to come from sectors seeking privileges. These must be carefully researched, subjected to wider consultation and adopted only if overall benefits to society outweigh costs. Some of the complexity and anomalies in the tax code may be traced to the accommodation of various special interest groups.

In achieving its fiscal targets, the government cannot limit its focus to raising taxes. Breaking from the pattern of the past, equal or even greater emphasis must be placed on the reduction of expenditure, reviewing not only the scale of spending but also the scope of the government.

An economy drive eschewing extravagance, the elimination of corruption and waste through increased transparency, and open processes must necessarily form a part of this exercise. Sri Lanka’s leaders frequently cite the example of Singapore. Fiscal prudence has been a hallmark of Singapore’s governing philosophy and successful management of the economy – an ethos that must become a watchword for Sri Lanka’s rulers. The Singapore Civil Service’s “Cut Waste Panel” and “Economy Drive” offer useful practical lessons in managing costs and could be adapted for Sri Lanka.

The tax system must be simplified, widening the base and increasing compliance. The finance minister’s commitment to this is laudable. The remainder of this submission seeks to outline a few key issues and offer avenues for the administration to explore. We believe these ideas are worthy of careful study and could yield outcomes that will assist in stimulating growth, reducing the budget deficit, and simplifying and rationalising the tax system.

RETHINK THE DEVELOPMENT STRATEGY
Restore policy emphasis on exports

Lacking a large domestic market and possessing few natural resources, exports offer the best opportunity for rapid development.

Successful integration of the manufacturing sector into global production networks has played a key role in employment generation and poverty reduction in China and other high-performing East Asian countries.

The market-oriented policy reforms of 1977/8 were based on this rationale and served the country well, resulting in a notable diversification of the commodity composition of Sri Lanka’s exports and a consistent improvement in share of world manufacturing exports until the late 1990’s.

However, protectionist pressures began to build in 2001, and from 2004, the relatively open trade policies of the past were explicitly and systematically reversed. A policy paper by the World Bank titled “Increase in Protectionism and Its Impact on Sri Lanka’s Performance in Global Markets” shows that, today, through the proliferation of a variety of para-tariffs, Sri Lanka’s tariff policies are just as protective as they had been more than 20 years earlier.

The present protectionist import tax structure has serious costs for Sri Lanka’s economic welfare and growth; Sri Lanka’s exports relative to GDP have declined, as has its share of world exports. Sri Lanka has fallen significantly behind its competitors. Vietnam, which was on par with Sri Lankan exports in 1990 with $2 billion per annum, today exports $162 billion versus Sri Lanka’s $10.5 billion.

A bulk of Vietnam’s exports is driven by foreign investment and a globally competitive agriculture sector that emerged in the wake of a liberalisation drive that moved away from ‘self-sufficiency’. FDI firms account for 71% of Vietnam’s and 44% of China’s exports. The lesson is clear: To boost growth and create productive employment, Sri Lanka should cut barriers to trade and investment, and focus on attracting export-oriented FDI.

The most important reforms needed are listed as follows:

1.Trade policy reforms: Move from the present chaotic tariff structure towards a transparent, uniform tariff structure
• Unify the existing Customs duty and the plethora of para-tariffs (PAL, VAT, CESS, Customs Surcharge) into a single Customs duty at the individual Customs code level, and then reduce Customs duties across the board to a uniform nominal rate of 15%. Moving towards a low, uniform tariff structure has the potential to increase tariff revenues. This would speed up Customs clearance and reduce the potential for corruption as it reduces the discretion of Customs officials and makes the trade regime predictable.
• On the export side, remove all cess as it reduces the effective price received by exporters, and thereby discourages exports. There is no evidence to suggest that these cesses promote local downstream processing of primary products that are now exported in ‘raw’ (unprocessed) form.
• Join the Information Technology Agreement of the WTO to create free trade in electronics, which will attract FDI to this sector.

2. Foreign direct investment reforms
• Restore the role of the Board of Investment as the ‘one-stop shop’ for investment approval/promotion (as envisaged in the BOI charter). This requires repealing the Revival of Underperforming Enterprises and Underutilized Assets Act (2011) and the Strategic Development Projects Act (2011), or passing new legislation to supersede these two acts.
• It is, of course, necessary to rationalise the fiscal incentives offered to investors, but there is a strong case for providing export-oriented foreign investors with time-bound tax holidays and investment tax allowances beyond the tax holiday period. There is evidence that tax incentives play an important role in influencing location decisions of export-oriented (efficiency-seeking) FDI, especially where competing countries still offer them, provided of course that the other preconditions are ‘reasonably’ met. (The evidence used in recent policy reports by the World Bank to argue against tax incentives comes from studies that have not made a distinction between ‘market seeking’ and ‘export-oriented’ FDI). Removing all tax incentives, while other negatives continue to weigh on the overall competitiveness in investment and trade, may be counterproductive.
• Sri Lanka has to improve property rights to draw investment. The guarantee against nationalisation of foreign assets without compensation provided under the Article 157 of the present Constitution needs to be maintained under the ongoing constitutional reforms.
• Avoid the current practice of ‘domestic value added’ [which is defined as per unit of domestic retained value (wages + profit + domestically procured intermediate inputs) as a percentage of growth output] as an evaluation criteria in approving investment projects.

The very nature of the ongoing process of global production sharing (production fragmentation) is that per unit value added of production plants located in a given country within vertically integrated global industries (such as electronics and electrical goods) is usually very thin. The contribution of such production to domestic output (GDP) depends on the volume factor and the ability to produce for the vast global market, not on per unit value added.

In some traditional industries that use diffused technology (such as garments, footwear, travel goods), there is opportunity to increase per unit value added by forging backward linkages, but this is a time-dependent process and depends on export volume expansion. In the garment industry, per unit value added was around 20% at the beginning, but is now over 60%. Backward-linked knitted textile production and other ancillary input industries (hangers, buttons, labels, packaging material) have emerged as the volume of export expanded, creating sizeable demand for such inputs.

3. Macroeconomic policy
Trade, investment and labour market reforms need to be accompanied/complemented by macroeconomic policies to regain international competitiveness of the economy. Relying solely on nominal exchange rate depreciation for this purpose is not advisable, given the massive build-up of foreign-currency denominated government debt. Also, given the increased exposure of the economy to global capital markets, large abrupt changes in the exchange rate could shatter investor confidence, triggering capital outflows.

What is required is a comprehensive policy package encompassing some exchange rate flexibility and fiscal consolidation, which requires both rationalisation of expenditure and widening of the revenue base.

The current import-substitution policy retards growth and hurts consumers.

The present policy stance and import tax structure have drawn capital, labour and land to high cost, and highly protected import substitution farming and agricultural processing activities with low or negative economic rates of return. Sri Lanka’s food prices are higher than in the region due to high tariffs imposed to achieve self-sufficiency, hurting the poor and possibly contributing to malnutrition particularly of poor children. At a time when the government is burdening people with higher taxes, it is imperative that attempts be made to reduce food costs; revising this policy could contribute significantly to lowering the cost of living.

An example of this policy is rapid growth of maize and soybean cultivation over the last 10 years. These are not traditional crops and were not cultivated on any scale prior to 1998. These are used primarily as raw materials for the production of animal feed. Subjected to heavy protective tariffs, the cost of these locally produced crops are far in excess of world prices and directly related to the high cost of local poultry products. Instead of reviewing a flawed agricultural policy, the government has reacted to high retail prices of poultry by introducing price controls.

The policy of protecting the local sugar industry has had a similar impact and should also be subjected to review. The protective policy toward wheat imports has resulted in increased retail prices of bread, despite a collapse of world wheat prices by 50% since 2013.

The above highlights just a few key issues; there are many others. The government needs to study the impact of its trade and agricultural policies on consumer prices, and review its policies to maximise benefits to society as a whole. The ill effects of poor agricultural policy are not limited to higher prices, and their unintended consequences may extend to the human-elephant conflict and the recent spread of chronic kidney disease. The review of policy needs to be holistic.

PUBLIC SECTOR REFORM

Cumulative public debt and the high budget deficit have been key drivers of macroeconomic instability in Sri Lanka. Higher government borrowing not only wreaks havoc in the government’s finances, but also crowds-out private investment by pushing up interest rates. Sri Lanka also operates a “Mega State” apparatus, with a massive public sector, unproductive/loss-making state enterprises and an oversized peacetime military that further diminishes the fiscal position.

The massive increase in public sector employees starting from about 850,000 in 2005 to around 1.27 million by 2016 also has knock-on effects on the political economy, with both major parties now having to pay homage to this large voting bloc by promising unfunded and unsustainable goodies such as salary increases and other benefits – what analysts term ‘an auction of non-existent resources’ – at each election.

While most commentators emphasize enlarging the tax net to address fiscal imbalances, Advocata believes that reducing the size and scope of the state is more pressing. While political space for reforms may be limited, public opinion is increasingly skeptical of loss-making state enterprises, which is an argument reformists in government could use.

Advocata urges policymakers to look into following avenues of reform:

Addressing the debt burden

The government’s debt/GDP ratio is 75%. Debt service costs (interest and capital) accounted for 90% of government revenue in 2014. The previous year’s debt service cost actually exceeded revenue; the ratio in 2013 was a whopping 102%. Interest cost alone amounted to 37% of government revenue in 2014.

Sri Lanka regularly runs a primary (before interest payments) budget deficit, which means recurring expenditure is being funded by debt, a situation that is clearly unsustainable. Sri Lanka’s debt ratios bear some uncomfortable parallels with those of Greece, just before the outbreak of the debt crisis.

Restructuring the debt to extend its maturity and reduce interest rates could provide some relief, but disposing of unproductive state assets and using the proceeds to reduce debt is a more permanent solution and we offer a few ideas below.

Reforming SOEs

Disposing of loss-making and unproductive state-owned enterprises (SOEs) is a way of easing the debt burden and preventing further deterioration of the fiscal position. The outstanding SOE debt to banks is at Rs757 billion, more than four times what the government spent on health services in 2015. Some SOEs have accumulated so much debt that even privatisation may not be possible. These could simply be shut down with generous severance payments to employees, which will be cheaper in the long run.

Reform of SOEs need not be limited to loss-making enterprises. SOE’s often employ significant resources in terms of labour, land and other factors of production, which could be better utilised. Conducting a comprehensive productivity study would allow the government to determine which ones to shut down, which ones to privatise and which ones could be held under ownership at a government holding company in the model of Singapore’s Temasek Holdings.

Reactivating “Dead Capital”: State-held land

The Land Reform Commission was vested with about 987,000 acres, some of which could be used for more productive purposes. Additionally, government ministries, schools and other facilities occupy prime real estate blocks in major cities like Colombo, which greatly outweighs their economic value.

As an initial step, accounting of property rents at market values would allow the government to get an accurate sense of the value of the dead capital that the government is occupying, which could be put to more productive use. The Colombo Dutch Hospital project and the clearing of the Army headquarters for commercial activity are examples of how dead capital in government-held land could be activated for more productive use. The government should draw up a Land Asset Sales Programme, an orderly and coordinated programme to dispose of surplus or underutilised land. The proceeds from these sales should be used to reduce national debt. The sales programme must be run in an open and transparent manner by an independent body free of political influence to minimise corruption.

Public-private partnerships for infrastructure

Converting existing infrastructure such as highways into Public-Private Partnerships could raise funds to pay down the loans that were used to finance them. Operational rights could be auctioned in a transparent manner to private investors. New infrastructure projects should be on the basis of a Build Own and Operate (BOO) model or Build Operate and Transfer (BOT) model, which has been used successfully all over the world to finance infrastructure projects.

Restoration of the National Procurement Agency (NPA)

The NPA was established in 2004 to streamline procurement, reduce waste and corruption, and ensure better transparency and governance by centralising procurement under an independent body. The agency was believed to have been effective, which lead to it being shut down, allegedly for political reasons, in 2007. Its operation should be revived and its independence guaranteed.

The defence budget

Spending on defence has grown from around Rs144 billion in 2009 to an estimated Rs306 billion in 2016, a massive increase in a time of peace. Due to the politically charged nature of the expenditure, this has been the ‘elephant in the room’. While acknowledging that immediate demobilisation or salary cuts are not feasible, continuous growth in defence expenditure seven years after the end of the war is something that requires questioning.

It is one of the largest items of expenditure, and discussion of this subject must no longer be avoided. Cutbacks in capital expenditure and hardware are necessary. More generally, a national plan to downsize the military should serve the long-term interest of all communities in Sri Lanka.

Voluntary retirement schemes

The state currently employs over a million people and an additional estimated 220,000 workers employed in SOEs. Some analysts put the figures much higher. In total, the public sector accounts for about 15% of the total labour force.

The public sector pensions and salaries bill for 2015 was Rs717 billion, representing 49% of government revenue. The weight of the wage and pension bill has crowded out priority expenditure in education, health and essential infrastructure, and even operational expenditure necessary to enable employees’ effective functioning. Not only do the salaries and entitlements of these workers burden the fiscal position of the government, it also mops up scarce labour from the private sector. By this account, Sri Lanka probably has the largest state sector in the world.

The dependence on excess labour also means that state agencies become reluctant to invest in new technologies or procedures in fear of backlash or simply not knowing where to allocate the labour.

Reforms in this area are not going to be easy, as the 2002 UNP government discovered to its peril. However, the current levels of state sector cadre places a massive strain on the fiscal position.

The government should commission a report on the labour requirement for the state sector. While attrition and a hiring freeze are preferred methods of cadre management, for some sectors and institutions, Voluntary Retirement Schemes (VRS) may be possible. To manage pension liabilities, a new contributory pension scheme should replace the current defined benefit scheme for any new recruits to the public service.

Reform of energy utilities

Sri Lanka’s energy utilities are a source of macroeconomic instability, and reforms to the sector are long overdue. While detailed studies for longer-term reforms must be undertaken as an interim measure, re-introducing the pricing formula for fuel and extending the formula to electricity will prevent large imbalances from building up. For the electricity sector, an immediate move to daylight saving time could reduce night peak load demand by as much as a third, with consequent reduction in thermal energy generation. In Sri Lanka, the discussion is private participation in electricity centres around fixed contract IPPs. In many other countries, however, this model is now considered outdated, the world has moved on to integrated energy markets. A study by the Pathfinder Foundation carried out in 2007 provides a useful starting point for ideas on moving to energy markets.

THE TAX SYSTEM

Recent budget statements by successive governments, including the present one, have not been in keeping with sound principles of taxation. While recognising the unique political moment in which the new administration operates and the politically expedient measures that were taken to create that political moment, continuing to ignore principles of fiscal discipline can only lead to further imbalances.

The following principles serve a guide to sound tax and fiscal policy:

Fiscal adequacy
The overarching objective should be that sources of revenue, taken as a whole, should be sufficient to meet the demands of public expenditure. Revenue should be elastic or capable of expanding or contracting annually in response to variations in public expenditure. Most crucially, any new benefit or relief measures offered must be fully funded. Government finances are in a dire state, they should not be made worse; ill-conceived proposals in the past have contributed to the structural weakness of the fiscal position.

The adoption of a medium-term budget framework to prioritise, present and manage both revenue and expenditure over a multiyear framework is desirable. It can help demonstrate the impact of current and proposed policies over the course of several years, and ultimately achieve better control over public expenditure.

Rules in the Fiscal Management (Responsibility) Act may be tightened to reinstate budget discipline, and ensure fiscal responsibility and debt sustainability.

Simplicity, administrative feasibility and transparency
Tax laws should be capable of convenient, just and effective administration. Tax codes should be easy for taxpayers to comply with and for governments to administer and enforce. It is far simpler to adjust rates to existing taxes than bring in new types of taxes.

Any changes needed to the tax code should be made with careful consideration of established practices and open hearings. Each tax in the system should be clear and plain to the taxpayer. Disguising tax burdens in complex structures to deceive the public, the preferred approach by politicians in the past, should be avoided. Simplicity will close loopholes for tax evasion, reduce the scope for corruption and minimise administrative costs.

Neutrality
By and large, taxes should neither encourage nor discourage personal or business decisions. The purpose of taxes is to raise needed revenue, not to favour or punish specific industries, activities and products. Minimising tax preferences broadens the tax base, so the government can raise sufficient revenue with lower rates.

Stability
Taxpayers deserve consistency and predictability in the tax code. Governments should avoid enacting temporary tax laws, including tax holidays, amnesties and retrospective changes. The periodic revision of taxes via gazette notifications should be avoided. Put simply, a good tax policy promotes economic growth by focusing on raising revenue in the least distortive manner possible.

Sin taxes need re-thinking

While our proposals are mostly concerned with broad issues of policy, we have made an exception for ‘sin taxes’ because of their importance to the exchequer.

‘Sinful’ items such as alcohol and tobacco have traditionally been taxed heavily and are the second-largest source of tax revenue for the state. A review of these policies could develop their effectiveness and improve collection. The present government, continuing the practices of the past, has now raised taxation to prohibitive levels. This may be counterproductive because, while high taxes do deter consumption, excess taxation may drive consumers to dangerous illicit substances, and support a thriving illegal alcohol and cigarette industry.

The link between higher taxes and substance abuse is that the use of highly hazardous home brews concocted from medicinal drugs, cosmetics and pharmaceuticals also need to be examined.

Both in Sri Lanka and even in developed countries, it is a tendency for lower income groups to consume cigarettes. In Sri Lanka, there is an additional tendency for lower income groups to consume cottage industry products and items like beedies. Further research needs to be done on the link between education and awareness as opposed to the assumption that cigarette and alcohol consumption is merely a function of affordability or a broader lifestyle/environment and an awareness issue.

High taxes on cigarettes have lead to a massive increase in the lightly taxed Beedi industry, as well as expansion in illegal cigarettes. Customs statistics indicate that beedi volumes have risen from 1.1 billion sticks in 2007 to 3.2 billion sticks in 2013, while cigarette volumes declined from 4.6 billion sticks in 2007 to 4.0 billion during the same period.

Studies carried out by the Institute of Policy Studies make a case for rethinking alcohol taxes, principally to move to a structure of taxation by volume, which will increase state revenues while modifying consumption habits.

The government needs to reconsider its policies for the taxation of both alcohol and tobacco in light of all available evidence. Recent experiences in India and Pakistan highlight the problems with outright prohibition.

On PM's economic statement: most important is to liberalize trade and investment

By Ravi Ratanasabapathy

The article first appeared on the Daily News

The Prime Minister’s statement on the economy to parliament on October 27 struck many a right note and has the ingredients to take the country to the goal of doubling per capita income by 2025.

Most important was the promise of reforms to liberalise trade and investment, to attract foreign investment and restore emphasis on exports.

It is important that the sentiments expressed in the Prime Minister’s statement must follow with practical yet bold economic policy reform. A detailed policy document has been promised and would hopefully contain the necessary implementation plans.

The rest of this brief note is aimed at understanding the policy pronouncements in the context of Sri Lanka’s political and socio-economic priorities.

Improving the business and investment climate

The statement promises a lot: simplifying the process of registering a business, getting construction permits, electricity connections and bank credit, registering property, protecting minority investors, the payment of taxes, trading across borders, the enforcement of contracts, the resolution of insolvency and reforming labour laws.

The Prime Minister’s target to bring Sri Lanka into the top 70 countries in the World Bank’s Doing Business Index by 2020 is welcome. Sri Lanka currently languishes at 110 in the index amongst 185 countries and its position has actually dropped by one place under the current administration. Policy reform to increase the ease of doing business is uncontentious and will draw broad political support from across the spectrum.

However the government must be bolder. Whilst ease of doing business has improved in the last few years, Sri Lanka can do much more to expand general economic freedom in the economy. The Fraser Institute, which publishes the annual index of economic freedom ranked Sri Lanka 111 among 160 countries. The index now ranks countries in the region like Nepal higher in terms of economic freedom than Sri Lanka with India only just behind. Beyond just looking at ease of doing business, Sri Lanka should also focus on other aspects of economic freedom including removing of outdated and arbitrary regulation, reversing recent follies such as Soviet-style price controls and truly living up to the promises of liberalising international trade and investment. In this vein, the proposed establishment of a single window for investment approval in the Prime Minister’s speech is a welcome move.

Sri Lanka can emulate, and where necessary adapt, the best practice policies from other countries such as New Zealand and Australia which rank highly in terms of economic freedom

Trade liberalisation: repeal of the Export and Import Control Act

The Government promises to repeal this archaic piece of legislation and replace it with new legislation based on that of Singapore. If implemented in the true spirit of Singapore’s legislation, this would be extremely positive.

Singapore is generally regarded as a free port and the Government only restricts the import of goods seen as posing a threat to health, security, safety and social decency. Around 99% of imports to Singapore are duty-free.

The policy statement makes reference to “a low tax regime”, the lessons from East Asia and other parts of the world is that the tariff regime needs to be low and uniform. This minimises loopholes, corruption and simplifies customs processing. A low uniform rate of duty eliminates disputes with classification and enables documents to be processed on a self-declared basis (with customs only focusing on misstatements of price and quantities) which results in faster, simpler clearing of goods.

While sentiments to keep a low tax regimes are laudable, a commitment for a low uniform tariff policy should be the goal.

State enterprise reforms and financing of infrastructure

The proposed debt/equity swaps of the Mattala Airport and the Hambantota mark an important step towards reducing the Government’s debt burden. The Government should also convert other infrastructure projects such as the highways into PPP projects by auctioning operational rights.

The statement promises investment in infrastructure in logistics to improve connectivity to global supply chains. Whilst we all welcome investments in critical infrastructure, all new projects should be implemented through public private partnerships to prevent further accumulation of public debt.

The report published by the Advocata Institute on “The State of State Enterprises in 2015” shows that the state has over 245 enterprises in its books, of which only a small number actually reported their financial position. The proposed formation of a Public Commercial Enterprise Board to manage SOEs and the creation a Public Wealth Trust, a centralised body to hold the shares in SOEs is therefore timely. Hopefully these mechanisms may prove to be the first step in imposing accepted reporting practices and better management of State enterprises. Sri Lanka can learn from Singapore’s state enterprise holding company Temasek and other experiences around the world.

Additionally, the listing of the shares of SOE’s on the Stock Exchange would also impose discipline in reporting and is something the Government should explore. Minority stakes could be offered to the public which would raise revenue to the state, allow public participation in SOE’s and broad-base the CSE; even while the majority stake is still controlled by the Government.

The recent announcements regarding the closure and amalgamation of Mihin Lanka into SriLankan Airlines is encouraging but the previously announced partial privatisation of the debt-ridden airline has not yet materialised.

The proposed Public Enterprise Commercial Board should be given a wide mandate to restructure and reform SOE’s including assessing the strategic need for such enterprises, the closure of unviable enterprises and to privatise enterprises where there’s enough commercial interest. The new structure will hopefully be just the first step on the long road to improve overall accountability and governance of these state enterprises.

It is unlikely a one size fits all solution would work for reforming all state enterprises in what would inevitably become a politically charged issue. However the public appetite for bold reform in this area is high with the realisation that the cumulative losses over the last ten years amongst the 55 strategically important enterprises amounted to Rs.636 billion.

Some areas of concern: SME’s rural agriculture

Several proposals including the one to expand SME finance through quantitative targets enforced by the Central Bank must be viewed with caution. Dirigiste lending to push bank exposure further to higher-risk sectors may boomerang on lenders, especially public sector banks, resulting in losses. Any difficulties SME’s may face with access to credit need to be examined carefully and appropriate solutions developed in consultation with financiers.

The establishment of rural modernisation boards and agricultural marketing boards will need to be examined more closely. No details are available so the exact role of these bodies is not clear but the current flawed agricultural policies have pushed up food prices for consumers. Sri Lanka’s food prices are the highest in the region and the priority should be to lower the cost of living through appropriate reforms to the sector.

Apart from a few areas of doubt the overall economic statement is broadly in the right direction and if properly implemented could boost growth and improve the welfare and prosperity of Sri Lankans. The government however has a demonstrable problem with policy inconsistency over the last few years, even amongst its own ministries and between Ministers of the same party. Whilst some diversity of opinion is expected from a coalition government, some of the policies enacted in the recent past have run counter to this and other broad policy pronouncement from the Prime Minister.

These broad ideas will hopefully pass the implementation test and we await the publication of the detailed strategy document.

The writer is a Fellow of the Advocata Institute, a fee-market think tank based in Colombo. www.advocata.org

While Sri Lanka slept Georgia was awake!

The article originally appeared on the Daily Mirror 

Georgia, a former Soviet state, has lessons for Sri Lanka on political will and economic reform.
If Georgia was a book, then it is surely is one of many pages. Her pages would be full of    Caucasus Mountain villages and places like Vardzia, a cave monastery dating back to the 12th century, and the Black Sea beaches. What is in it for us as a nation lies a few pages after: the visionary political and economic reforms done in Georgia during 2004 and 2012. 

Being a country at the intersection of Asia and Europe with a 4.4 million population, Georgia offers many lessons to Sri Lanka, where politicians struggle to drive the country forward after nearly seven decades of independence.

With the fall of the Soviet Union in 1991, the Republic of Georgia had a long walk through darkness until it finally saw the light at the end of the tunnel in 2004. In the 1990s, Georgia was torn apart by a civil war. The country was taken over by corrupt interests. In 2003 however, Georgians fought back. Peaceful protests after a disputed election saw the ouster of President Eduard Shevardnadze and the end of Soviet-backed rule. In the climatic end of the saga, demonstrators stormed a session in parliament with red roses in hand. Georgians remember this as the ‘Rose Revolution’. In the following presidential and parliamentary elections, reformist leader Mikheil Saakashvili came into power kick starting what many analysts consider a small economic miracle in Georgia. 

The story has many parallels to Sri Lanka.  Today, we have ended our own military conflict of 30 years, yet the future still seems fractured. Hopes for rapid economic reforms to take Sri Lanka to the next level have quickly evaporated. Instead, the government seems to be embroiled in one political crisis after the other. Unlike the Georgian politicians, instead of seizing the momentum of Sri Lanka’s own political revolution, the Sri Lankan leaders could end up squandering the reform movement.   

Most economists agree that greater economic freedom has a strong correlation with greater prosperity of a country.  Table 1 shows a simple comparison how Georgia, which came to be born a mere 25 years ago, overtook Sri Lanka in such a short span of time. 

The Heritage Foundation is one organisation that measures the level of economic freedom in a country. The comparison is telling: (See Table 1) 
As per the index of economic freedom by Heritage Foundation, the way Georgia has progressed is clear. It is not rocket science. We need the necessary reforms for business freedom, trade freedom and investment freedom. 

How Georgia did it
Contrary to popular belief, we must come to understand that most politicians in the world have little intention to make a country or its people genuinely prosperous. Governments are distracted and politicians have a short-term single-minded goal -- the next election. Even those who come into politics with good intentions eventually succumb to the temptation to look after themselves, their future generations and ensure their supporters have a big enough slice of the cake. They have centralized power, racked up the country’s debt and siphoned off benefits for themselves. This is the experience of our post-independence democracy. 

Changing political incentives is not easy but Georgia offers a great example. After the Rose Revolution, instead of expanding the power of the state, they limited its power. This provided more freedom and responsibility for their people to make their own lives better as citizens. 

By 2003, Georgia was drowning deep in corruption, sliding fast down a slippery slope when the Rose Revolution took place. 
Rose Revolution leader Mikheil Saakashvili became President in 2004. He was re-elected in 2008 and in the eight-year tenure of Saakshvili, his reform agenda changed the course of progress of Georgia.

Tax reduction
These are some of the actions taken: simplified and reduced the number of taxes applicable to six from 20 taxes; reduced the rates of taxation. (Income, value-added tax (VAT), corporate, excise, customs and property tax were the only taxes applicable. All the other taxes were abolished). 

Significant reductions were made in tax rates across the board: for income taxes, VAT, profits and customs duties. A new system was introduced to pay taxes online and many tax clauses were brought in to eradicate widespread tax avoidance and evasion by companies. The ultimate outcome was that tax income collection increased sixfold within six years despite the reduction in rates. 

The unfortunate truth in Sri Lanka is that the few income taxpayers who contribute to the economy are being penalized by the Inland Revenue and the government tries to regulate their industries on top of that. The result speaks for itself as for the bad policy of the government does prove they are not capable of re-correction to this rudderless course. In comparison, our tax revenue is going down relative to gross domestic product (GDP) every year and this is all due to the mediocre tax structure we have in Sri Lanka.  

Reduce size and footprint of state
    The number of government agencies was reduced along with the number of government employees. The salary scales of the remaining employees on the state payroll were increased, which led to productivity improvements in the government sector. 
    The police force was totally reformed, which carries important lessons for Sri Lanka. Trust in the police increased from zero to 80 percent. Under the previous system, the police conspired with criminals and corruption had overtaken the system. What the Georgians simply did was cutting down the cadre and increasing the salary of the remaining staff.
 

Cutting down heavy-handed regulations
Eight hundred permits and licences were abolished and state and land properties, such as sea ports and airports, were privatized. New regulations introduced to hire and fire employees easily resulted in lower rates of unemployment and higher pay in Georgia. 

In Sri Lanka, our government sector keeps expanding and everyone gets disappointed as no one gets paid as per their expectations. Our productivity goes down and unfortunately, the entire government sector has become a slave house of politicians regardless of the colour of the flags they hold. 

 Our education system continues to teach us to dream small and aim for stability than going for growth and stand on our feet. So we have become a nation of complacent people with colourless and meaningless criticisms. 
 Adopting international standards to remove layers of regulation. In Georgia, the Organisation for Economic Cooperation and Development’s (OECD) standards for pharmaceuticals, food, consumer products and services were fully adopted and welcomed. No special permits were required for the OECD-approved goods and services to enter Georgia. The banks also welcomed this decision, as it made their operations easier. 
Anyone who had a Schengen visa or a tourist from a country, which had a GDP per capita twice that of Georgia’s, could freely enter Georgia. 
 

Industrial development and liberalization
 The prices were liberalized in the power sector and power production and distributions were privatized. Priority was given to foreign direct investment. Private hydropower plants were constructed and fast-flowing rivers from high mountains created electricity, which was exported to almost twice the quantum that was imported before. 
 The export sector was totally revamped. This needed to be done as Russia banned the Georgian imports in 2006. The country improved all the products to compete in the international market. Wines, fruit, mineral water and such became high-quality exports through internal competition among traders. Within four years, Georgia’s export revenue exceeded to of what it was before the Russian imports ban. 
 While Sri Lankan politicians exhausted their voters by providing excuses for the GSP Plus and the ban on fish imports by the European Union (EU) and many other superficial reasons, Georgia had the courage to open up its markets and start small.
 

Economic Liberty Act
 To ensure the sustainability of the economic growth, the Georgian parliament passed the Economic Liberty Act. The law restricted creation of new taxes and required the government to maintain the government debt at 60 percent of GDP, government expenditure to be 30 percent of GDP and budget deficit not to exceed 3 percent of GDP. During the tenure of Saakashvili, the GDP per capita increased by 300 percent to reach US $ 3300. 
Sri Lanka has a Fiscal Responsibility Act, which could be strengthened by the inclusion of provisions similar to that of Georgia. The need is clear: just to compare the figures of Sri Lanka Forbes reported on September 30, that the Sri Lankan government’s debt to GDP stands for 75 percent and 94 percent of all government revenue is currently directed to debt repayment. The budget deficit is at 6.1 percent as per GDP in the first quarter of 2016.  
 

Georgia after 2012
In 2012, an opposition coalition, which was founded just six months before the election, defeated Saakashvili’s party and Bidzina Ivanishvili, the wealthiest man in Georgia, became Prime Minister.
Two weeks prior to the election, a video showing violence against prisoners was aired on an opposition-run television channel. It was the cause of public outcry that resulted in strong opposition votes. 
In 2014, Georgia established a free trade agreement with the EU. Following its intent to become an EU member state, Georgia had been introducing European standards to many of its industries. 

With a more populist political party at the helm, Georgia’s economy grew by 3.4 percent in 2013, 4.6 percent in 2014 and 2.8 percent in 2015. The inflation rate reached 4.9 percent in 2015 and the value of the Georgian lari declined by 30 percent. 

As of 2016, Georgia’s external debt has reached US $ 15 billion, six billion of which is government debt. The debt is equal to 43.3 percent of GDP. Since 2012, Georgia has been borrowing US $ 220 million every year from the World Bank. It borrowed US $ 290 million in 2016. As a result, its budget deficit has reached 11 percent of GDP. The most rapidly growing industry in its economy is tourism. Georgia’s tourism industry is now accountable for 23.5 percent of GDP, 20 percent of employment and 36 percent of its exports.
The lesson learnt from where Georgia heading after 2012 is that economic reform is an ongoing process. It is said ‘success fails like nothing’ and surely economic reforms are not a once and for all solution. Once a country is taken to a certain level through necessary economic reforms, it needs to continue progressing with the global economic trends and the expectations of the people of the country. From Sri Lanka’s point of view, we haven’t made any major reforms in our economy. Before we move on to the sustenance phase, we need to pass the start up phase.
 

Lessons for Sri Lanka and way forward 
To overcome the current crisis, Sri Lanka has many things to do but if we try to do all of them, it would be next to impossible. It was said by Mathma Ghandhi, “Actions express priorities.”
A proper economic plan    

First, a proper economic plan needs to be tabled by the government for the remaining years of this parliamentary term clearly mentioning the short-term reforms and the reforms need to be implemented within the next generation. So the president and prime minister will be more focused rather than appearing as comedians in front of the public bringing up ad hoc policy recommendations and making purely unnecessary statements, where the public feel they need to punish themselves from toxic stingray tails for wasting time in polling booths. 
Simplified tax system 

 A new system of simplified taxation needs to be introduced. Importantly, the system has to be a simple tax system that provides convenience. Rather than increasing the tax rates, it is vitally important to broaden the tax base and make the collection efficient, so that the increasing tax income will not be a mammoth task as it is now.
Liberalize trade and foreign investment

Rather than focusing on mega projects, which need to create new markets, the first step would be joining the global value chain in established industries. The business regulations need to be simplified and the number of approvals for a project needs to be cut down. In addition, unnecessary permits need to be abolished.  
“Breathes there a man whose soul so dead, who never to himself has said, this is my country, my native land,” said Sir Walter Scott.  
At Advocata, we stand for what we believe, and although many give up after losing the battle, we press on toward winning the war and fighting for genuine change to take mother Lanka to where she deserves to be.
We invite the so-called economic gurus and pundits who voted for allocating Rs.1180 million to upgrade their super luxury vehicles in the Cabinet to get up from just warming their seats and do something because this time it is not from the frying pan into the fire but from the frying pan into the microwave, where there is no point of return.

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Dhananath Fernando is the Chief Operating Officer of Advocata Institute.

The government aims to regulate e-commerce. It shouldn't.

A version of this article appeared on  Daily News

The Sri Lankan government reportedly intends bringing legislation to regulate e-commerce businesses operating in the country. The Finance Minister was quoted as saying “They (e-commerce operators) are just operating here. Where is the regulation for that? We will make them bring money earned there back to the country.” If this were enacted it is quite likely that Uber, Agoda and Booking.com; the businesses which have earned the ire of the Tourist Hotels Association of Sri Lanka (THASL) and the Rent-A-Car Association would pull out. These associations have lobbied for regulation.

Sri Lanka’s domestic market is small and the volume of e-commerce is smaller still. For a global company the hassle of incorporating a local office, opening bank accounts and grappling with the local administration would not be worthwhile. They would almost certainly leave.

The Hotels and Rent-a- car association have not made a clear case for their position. Consumers however would be left worse off facing higher prices and more limited choice.

Tourist arrivals

The informal tourist sector is now the fastest growing segment of the market, catering to as much as 40 percent of the tourist arrivals to the country. Internet booking engines are the lifeblood of the sector; small guesthouses depend almost entirely on them to reach their clientele.

Budget tourists, who form the majority of visitors to guesthouses cannot afford the prices of star-class hotel. Close the booking engine and we close the door to the budget tourists who will head off to India or Southeast Asia spelling certain doom to the 8,000 plus small guesthouses scattered across the country. Some mid-range tourists will choose to pay the higher rates at hotels and still come but many will not.

The beauty of allowing small guesthouses to flourish is to broaden the income earning opportunities for people with a minimal investment. Householders rent out extra rooms in their own houses, with a little refurbishment; upgrading the toilets, installing hot water and perhaps airconditioning. The money earned goes direct to the hands of local families. Further, budget tourists will patronise local shops and restaurants, offering an easy path to improved living standards.

Mark P. Hampton is Senior Lecturer in Tourism Management at the University of Kent, notes that:

My own research in Indonesia, Vietnam, Thailand and Malaysia since the mid-1990s shows that as backpackers tend to consume local products (food, coffee, beer, cigarettes etc), stay in small guest houses, and use locally owned ground transport, more of their expenditure is retained in-country than in conventional mass tourism.

Economic leakages from backpacker tourism are also significantly less than for conventional (foreign-owned) tourism, since backpacker businesses are usually locally owned and profits tend to be retained within the developing country rather than flowing overseas to international hotel groups.

Traveller reviews

Depriving these people of opportunities to better themselves in order to benefit large-scale hotels seems perverse. The booking engines do charge the guest houses a fee but the bulk of what is spent by tourists is retained locally.

What about maintaining minimum standards?

In the pre-internet era there was a problem of standards. How does a visitor know what to expect? This is the origin of the star ratings in hotels, a means to indicate standard.

This is no longer a problem. Booking engines work on the basis of traveller reviews. Visitors post their ratings of the places they stay, those that receive poor ratings are less likely to be patronised. Essentially, standards are enforced by the visitors themselves which is why this model has been so successful.

Previously the hotel industry successfully lobbied for the imposition of minimum room rates and there have been recent attempts to restrict short-lets on apartments which were seen as a threat by the hotels. Now they seek to restrict the informal sector.

Hotels in Sri Lanka need to understand that tourism is a global industry; their competition is not only domestic it is regional: from Malaysia, Thailand and Indonesia. A good number of hotels in these countries offer lower rates than the average in Sri Lanka and overall travel costs are rated to be much cheaper, as comments from tourists on the popular TripAdvisor website testify:

“There is no question whatsoever that Thailand is much cheaper than Sri Lanka and with higher quality. On average, all things being equal, Thai hotels are half the price of those in Sri Lanka and there are lots to choose from especially in the low price category.” or

“Sri Lanka is a compact island offering beautiful vistas, cultural, historical and religious sites, beach and river activities, hiking . . . all year round, taking into account the weather patterns. With ten days and proper planning, you could see and do a lot. Compared to Malaysia and Thailand many of the things you might want to do are more expensive.”

Business-friendly destination

The Sunday Times reported that when a Singapore hospitality expert asked in 2014 for a package tour of Sri Lanka, the offering was similar to that she had experienced 10-15 years ago. “It was no different. I have been visiting Sri Lanka for many years and the package was the same as 10-15 years ago. Attempting to cripple the competition locally will not improve the position of Sri Lanka’s hotels regionally and will be the detriment to the wider tourism industry.

It may also be detrimental to local Tech Startup ecosystem in general as Sri Lanka will come to seen as a place with backward and uninviting regulations at a stage the country’s tech community is desperately trying to position it as a place of innovation and attract investors. Instead of lobbying for strangling regulation the lobby groups need to reexamine their value proposition and adapt. On the government’s part, it should stay out of an industry where the average regulator and legislator has minimal understanding. Cumbersome rules will reduce Sri Lanka’s attractiveness as a forward looking business-friendly destination for FDI.

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Ravi Ratnasabapathy is a Fellow of the Advocata Institute.

Razeen Sally : Open up shipping and Tea to competition

If the outlined measures are implemented, two prominent sectors will be opened up to international competition: shipping and tea

Read the full article originally appeared on Financial Times

Sri Lanka desperately needs a new global economic strategy as part of a broader strategy for national renewal. It needs a decisive shift to markets and globalisation. A prospering, globalised market economy is the sturdiest foundation for a genuinely open society – for constitutional liberalism, the rule of law, ethnic peace and balanced international relations. Without it, all else fails. It has to be among the Government’s top priorities. The good news is that Sri Lanka has its most golden opportunity to achieve its long-advertised potential since the victory of the UNP in June 1977. 

But no economic reforms have materialised since the change of government last year. As I argued in my last Daily FT column, there should be four economic priorities for the remainder of this Government’s term: 1) “first do no harm” – no more senseless public sector salary hikes, price controls and ad hoc taxes; 2) fiscal stability, especially through tax and expenditure reforms; 3) improving the domestic business climate; and 4) trade and FDI liberalisation. They are all connected. Together they would greatly strengthen Sri Lanka’s competitiveness for higher productivity, growth and prosperity. Here I focus on the last component – a new trade policy.

Deshal de Mel answers your questions on the Sri Lankan economy

The economist Deshal de Mel who delivered Advocata's inaugural lecture on our series on How to fix Sri Lanka's economy. Participated in a lively Q&A session after the lecture moderated by Shiran Fernando.  However, we couldn't cover all the questions. Deshal was kind enough to answer some of the questions left on slido.com via his blog.  Here is a reproduction of Deshal's blog post.

1) Would the Port City, now being positioned as a Financial City, help the Sri Lankan economy?

The Port City has potential to help position Colombo as a modern city that is an attractive destination for global professionals to live, work, and visit. However, the viability of this depends on the type of investments that come in, the management of the environment, the management of infrastructure (sewage, drainage, marine and shore environment) and the related regulatory policy. The feasibility of a Financial City would depend on the evolution of the financial market in Sri Lanka. At present our financial market is not very sophisticated – it remains highly regulated with significant interventions in foreign exchange, lending practices, ownership etc.

There is a suggestion that the Financial City would be positioned as an off-shore financial market, with different regulations including visa requirements and so on. However, if this is completely separate from the rest of the economy, the resultant benefits for the local economy may be limited to some employment creation and spill-over spending effects.

2) How would Brexit and a Donald Trump victory in the US election affect Sri Lanka? Particularly the apparel industry, which employs a lot of women.

Early indications are that the main impact of Brexit are through the weaker GBP and resultant constraints on UK importers of Sri Lankan apparel. This effect is likely to continue and may affect other Euro area countries as well if the viability of the European integration project gets further undermined. The weaker GBP will also affect tourist arrivals from the UK this winter season.

The effect of a Trump victory on the other hand is almost impossible to analyse given the difficulty in predicting his policy positions and the possible gap between campaign rhetoric and policy reality. Nonetheless, whoever comes into power in the US will necessarily have to take into account the sharp anti-establishment voter sentiment, and there are likely to be rollbacks in economic liberalism, particularly with regard to cross border movement of labour, both in the US and Europe and in setbacks to progress of international trade agreements. A weakening of trade institutions will be further detrimental to global trade and to countries like Sri Lanka which need trade for growth.

3) Given the VAT set back, how challenging would it be to meet the fiscal deficit targets in the IMF program? What are the implications if the government does not pursue the IMF agenda?

There has been an improvement in fiscal performance in the first 4 months of 2016, with revenue growth of 20% and budget deficit declining by 14%. Nonetheless, these figures remain below budgeted targets with revenue falling short by 13% and budget deficit being 34% higher than planned. Tax revenue continues to rely heavily on indirect taxes and particularly import based taxes. With economic growth expected to moderate in 2016, there will be challenges in achieving the envisaged fiscal targets, which amplifies the urgency of reform of the inland revenue department to optimize use of information technology in revenue collection, simplifying tax payment processes and simplifying the tax system, and minimizing room for discretion in tax related decisions by officials.
A failure to meet the IMF targets may result in a delay or holding back of tranches of the IMF loan. This would lead to an erosion of confidence in the Sri Lankan economy among global investors – which in turn would impede Sri Lanka’s ability to raise funds to meet short term external payment obligations.

4) What can the government do to drive SME’s, start-ups?

Continued focus on the simplification of business processes and reduction in costs of setting up and operating a business is the best way a government can support SMEs and startups. In addition, a government has a role in encouraging the development of conducive networks and ecosystems that bring small time businesses in contact with sources of finance, distribution channels and markets, knowledge, and technology.

5) How much are policy changes/reversals affecting Sri Lanka’s economy? How much would clearer communication of policies by the government help its acceptance by the public and thus implementation?

Regular reversals of economic policy decisions and conflicting messaging on economic issues from the government is very harmful to the business and investment climate. It becomes very difficult to plan commercial activities such as new investment or business expansion when the policy environment is uncertain. Ideally a government should have a clear three to five year policy framework with only incremental changes in the interim to respond to external developments. Unfortunately Sri Lanka’s recent experience has been the opposite, with even short term policy frameworks such as the budget, being regularly changed in response to stakeholder reactions. A more inclusive approach to policy making, taking into account stakeholder views prior to implementation, would be a way to deliver more sustainable and implementable policies.

6) Are apartment/real estate developments drawing out liquidity in the market?

Investment in apartments and real estate is just one source of demand for credit in the market. Considering 2015 statistics, out of private sector credit of 3.4 trillion, personal housing (construction, repairs, purchasing etc) accounted for 10.8%. Anecdotal evidence however does indicate that a lot of real estate investments have been on cash basis – and this is difficult to capture in statistical form.

Overall loan growth in the economy has been strong for the last 20 months or so – with private sector credit and borrowings by the government being significant. Steps have been taken in 2016 to curb this credit growth, including the recent policy rate hike by the Central Bank in June.

7) What is the likelihood of Sri Lanka being able to diversify its economic growth outside the Western Province? What steps can be taken to grow the rural economy?

Steps have been taken to improve transport infrastructure in parts of the country outside the western province. More needs to be done to reduce transport costs, particularly to the central, eastern, and northern parts of the country in order to improve connectivity with the larger local markets in the western province and access to global markets through the port and airport. In addition to expressways, investment in domestic airports will be an important driver of connectivity. However transport connectivity is not the only factor that determines attractiveness of investment in rural regions. Investment in health and education services are important factors in retaining management talent and other white collar skills in these regions, whilst also developing home grown talent from the regions themselves.

8) Has Sri Lanka’s peace dividend materialized?

Sri Lanka enjoyed strong economic growth in the years immediately after the war. However, growth was concentrated in a few narrow sectors such as construction, domestic trading, domestic transportation, financial services and so on. This growth was also contingent on fairly accommodative monetary policy, which had to come to an end in 2012 as the economy began to overheat. A more sustainable growth path would be one which has more diversified growth sources, including a more substantial share of external growth drivers through the export of goods and services. Thus far tourism and logistics related industries are the most promising sectors on the horizon to help this diversification of growth factors to enable a more sustained peace dividend.

9) In the context of privatization and other divestment of state assets – what happens to those who have no other source of livelihood?

A structural change in an economy where resources shift from uncompetitive sectors to competitive ones is necessarily a change which entails dislocations in the labour market. Workers in those industries which are uncompetitive will need to develop skills to cater to the new industries that do emerge in their place. This is never an easy and trouble free process – and there is a role of the state in the provision of such training facilities and temporary safety nets to support livelihoods of those who do lose jobs. To minimize the time of transitions, it is essential to proactively drive the FDI attraction process to create new jobs in the new, more competitive sectors of the economy.

10) What measures could be taken to enable citizens/interest groups to communicate issues to the government instead of resorting to disruptive strikes?

A more inclusive approach to policy making can be constructive here – particularly through greater consultations prior to significant policy changes. The communication needs to be two-way, with the government clearly articulating the reasons behind such policy changes and making best endeavours to take into account the reasonable concerns of citizen groups. In today’s context technology can be used in a much more effective way to obtain citizen feedback on policy and to address concerns through more effective communication. Policy reform will always lead to winners and losers, and the effective management of the losers from the process is crucial to ensuring the longevity of the reform process.

11) Can Sri Lanka contribute to value addition in India’s economic sectors?

Sri Lanka already is contributing to value addition in India’s economic sectors through Sri Lankan investments in logistics, apparel, and leisure, among others, in the Indian economy. However, further value could be created by better integration of supply chains between the two countries, enabling more efficient manufacturing, taking advantage of comparative advantages and Sri Lanka’s natural logistical/locational strengths.

12) Do you think the government is giving enough weight towards entrepot trading?

Steps have been taking towards creating an enabling environment for entrepot trading by the enactment of the Commercial Hub Regulation Act of 2013. This creates bonded zones in 6 locations in the country that are free of customs duties and processes, enabling activities such as entrepot trade and other logistics/warehousing related businesses. However more needs to be done to promote this to improve uptake – such as proactively approaching multinationals to set up their warehousing/distribution operations in Sri Lanka, catering to their buyers in the Indian sub-continent and beyond.

13) Can Sri Lanka pursue sustainability whilst also focusing on growth in manufacturing?

Considering global trends in manufacturing, Sri Lankan manufacturers will necessarily have to engrain sustainability in their operational processes. This is necessary both in terms of streamlining operational costs and optimizing efficiency, and also in terms of marketability of products, which is increasingly influenced by sustainability factors.

14) How far away are we from default in our foreign debt? Is the relationship with China adding to this debt burden?

With the IMF programme brining some confidence and the new Central Bank Governor bringing credibility to Sri Lanka’s economic policy making machinery, Sri Lanka’s ability to borrow from global markets has returned, at least for now. Therefore, the country will likely be able to roll-over its near term debt obligations, barring a significant risk event in the global market, or a reversal of these recent domestic policy measures. The long term sustainability of debt remains contingent on Sri Lanka’s ability to anchor meaningful fiscal consolidation through sustained revenue improvements and rationalization of government expenditure. It is also necessary to develop external inflows through greater exports of goods and services, and FDI.

Whilst Sri Lanka has seen greater borrowings from China during the last decade, the feasibility of such loan repayments is more to do with the choice of project, which is the role of the Sri Lankan government, than the choice of lender. Sri Lanka has had positive outcomes from the Chinese relationship such as the extension to the Colombo South Harbour’s new deep water terminal, as well as less positive outcomes such as the Mattala Airport – therefore it is a question of how Sri Lanka chooses to utilize the investments from China in an optimal manner.

15) Considering your titillating presentation, with the government swaying left and right on issues, do you see the two coming together instead of being unhooked?

It is important for a government to keep abreast of all policy issues, speak in a unified voice and avoid lingering doubts. This will help provide optimal support to Sri Lankan enterprise, big or small.

16) What’s your outlook on interest rates?

Interest rates have already increased significantly in the first half of 2016 and with the rate hike by the Central Bank in July, I would expect interest rates (particularly the benchmark bond yields) to have peaked by now and remain around these levels through the rest of the year. Credit growth is likely to moderate in the second half of the year and thus ease liquidity pressures in the market and recovery of foreign investment in LKR treasuries will also help stabilize interest rates.

17) Today’s firms are underpaying workers and earning excess profits. Why doesn’t competition cause market prices of goods and services to decline?

Perfect competition would cause prices to find equilibrium at a level where supply equates to demand. However, in most cases, particularly in developing economies, markets have several imperfections and do not result in optimally competitive environments. Governments in such cases need to take steps to mitigate such market failure, be it through effective competition policy to prevent formation of monopolies and oligopolies, or by supporting improvements in information to reduce information asymmetries.
In Sri Lanka’s case however a lot of the high and sticky prices are due to high taxation or administered prices, that do not allow the price level to settle at a true market rate. This is the case for several agricultural products and protected domestic industries.

18) Do you think rehabilitation, reconciliation and reconstruction bolster the economy?

Rehabilitation, reconciliation, and reconstruction are important elements in sustaining peace in the country, and this in turn is crucial to ensuring economic stability and creating an environment that encourages long term investment. The relationship works both ways, since the expansion of economic opportunity in turn is important to create livelihoods for those in post-war provinces, which again is an essential component of normalization.

20) Why hasn’t protectionism of infant industries and uncompetitive industries been removed?

One of the main reasons is very effective and strong lobbying of successive governments by the industries concerned. A second reason is the fact that there hasn’t been significant investment in new sectors which creates alternative employment opportunities for those employed in such protected industries. Another reason is that a reduction of trade tariffs on such industries would have a negative impact on government revenue, which is particularly problematic in a situation where 50% of government revenue is based on import based taxes.

21) Is a reduction of agricultural subsidies and protection practical? Or is it only sound in theory?

The removal of protection cannot be implemented overnight. Several pre-requisites need to be fulfilled in preparation for this, namely; 1) a robust network of well targeted safety nets to provide cushion for those affected by labour market dislocation, 2) investment in skill development/re-training activities to engrain the relevant capabilities to enable workers to shift to new industries, 3) Pro-actively drive FDI in higher value agriculture – particularly targeting global companies that implement higher technology based agriculture catering to global export markets. This entire process takes time but it has to start somewhere, to enable the economy to gradually shift from low productivity, low wage activities, to higher productivity, more remunerative activities.

23) Should there be a change in the government’s incentives towards developing the economy, as opposed to the prevailing incentive of getting re-elected at the next election?

Government incentives are driven by voter demands. If voters demand state jobs, domestic industry protection, subsidies, and so on, that is what the government is incentivized to provide. Voters need to understand the true costs of these activities, particularly in a different fiscal and financial paradigm to what Sri Lanka has been accustomed to until the last 6 or 7 years. The government and policy makers (by and large) know what is required but will continue to pander to voter demands until voters make more educated demands of their government.

24) Africa has astonishing stories of creativity and innovation. Are we as a nation far less creativity oriented and more interested in imports and consumption?

Sri Lanka’s education system has been an exam-centric one, which trains students to acquire and retain knowledge and use it to pass an exam. A lot more can be done to inculcate skills such as creativity, problem solving, analysis – this requires an overhaul of the curriculum and teaching methods. It is these skills that are needed to build an innovation centric culture. We do have pockets of excellent creativity and innovation, but these are success stories despite the education system, not because of it. By re-orienting our education practices, such successes can be made the norm and not the exception.

25) Which industries can be built to a level that would be able to produce competitive exportable products and services?

It is difficult to predict which sectors can thrive in an economy. For instance, it is unlikely that someone could have predicted that Sri Lanka would be the global market leader in solid tyre exports, and fly fishing rods. From a policy perspective, I believe it is better to be sector agnostic, and to focus on creating an environment in which the best investments could thrive. Sri Lanka is likely to succeed in niches which are inherently tough to predict – but will have requirements such as skilled labour, good logistical processes, good access to global markets, and robust physical infrastructure – these are the areas a government should focus its attention.

26) Is SOE privatization likely to take place?

Privatization may not happen in the same manner in which it occurred in the 1990s and early 2000s – but I would expect the divestment of stakes of public companies in a manner similar to what happened with SLT. The viability of this process requires excellent communication with the industry stakeholders (unions, employees), the general public, and also ensuring a healthy competitive market in which the industry operates.

27) Is it feasible to abolish VAT and replace it with a BTT of around 7 to 8%

I would argue that the VAT is a superior tax to BTT since it taxes value addition and minimizes tax duplication. A lot of work has gone into developing VAT to the level we are at today, so I think it should be persevered with and continue to focus on improving collection and minimizing leakage.

Reuben Abraham : SEZs could help drive development in the provinces

The CEO of the IDFC institute and Advocata adviser Dr Reuben Abraham says  that special zones that allows for rules of the economy to be experimented with may provide the way for rapid regional development in places like Hambantota and the North and East of Sri Lanka.  He was speaking to Advocata Institute's inaugural podcast series titled Advocata Radio.

Following are excerpts from the podcast as published on the Daily Mirror.

Dr Reuben Abraham is the CEO of IDFC Institute, a mumbai based think and do tank working on the political economy of public policy and reform. He is also part of a number of influential think tanks and Institutes around the world including New York University, Legatum Institute and Council for Foreign relations. Dr Abraham spoke to Advocata Institute’s monthly podcast on the challenge of urbanization in the developing world as well as ideas on how to think about Sri Lanka’s megapolis plans. 

Q You said your institute works on the political economy of public policy, explain to us what that is.

Our underlying premise for that is most of what is to be done is either well known or with enough smart people in this room it’s quite easy to figure out. The problem with public policy, often times is that we just don’t know how to implement, how to execute what we know. So in that sense we are trying to shift the focus away from a technical discussion of public policy to a political economy discussion on public policy. A shift away from the ‘WHAT’ of public policy to the ‘HOW’ of public policy.  For each instance you have to take a completely different approach based on your analysis of political economy of a given situation. So where are the benefits? Who loses? You need to figure that out.

Q:We are currently at a stage in the world, where roughly half the population is living in urban settings. We are seeing rapid urbanization taking place particularly in our region and in China. What are the key issues to consider, when we think of urbanization?

I think it’s important to look at the long run trends. If you look at 10 000 years’ worth of history you will discover very quickly that mankind has primarily been a rural species. Now in 2007/2008 something dramatic happened which a lot of attention was paid to mainly that the world became over 50% urban. And for the majority of history up until about 1800 the percentage of people living in urban areas was basically 3% or less. And now since 2007/ 2008 it has gone over 50% and it is expected to climb to about 80%. This is the trajectory we are on. We are basically marking the movement of the species from being a primarily rural species to a primarily urban species. The real challenge here for all our countries is that almost all the urbanization you are going to see in the next 30-40 years is going to be in developing countries but, very specifically in south Asia, China and Africa. That is challenge number one and challenge number two is that is the time frame you have because this is not a reversible process. It’s not like you can command people to go back into the villages because many people from the Chinese onwards  have tried that but it has never worked. It is basically an irreversible of humanity’s journey of being a rural species to an urban species and there is a limited window in which something could be done.

That is why there is urgency and that is why all of our countries need to pay way more attention to this problem than they have and if they don’t look at it from a historical point of perspective you have to look at it from a job-generation and poverty reduction standpoint. 

Ultimately all non-agricultural jobs are generated in cities and productivity growth of any economy demands that people will move out of agriculture and into other sectors and all of the jobs in those sectors are almost entirely created in cities. Cities are where poverty goes away. If you look at the most recent numbers out of China you would see that less than 2% of china’s urban population is actually poor. Which means that almost all of China’s poverty is now rural.   

Q: There is also the complaint that rural development is getting ignored in all this talk of urbanization. How would you respond to that? 

I’m not a huge believer in this sharp dichotomy between rural and urban because, what you typically see is that when a country grows is that they begin to fold into each other. Keep in mind the fact that when I say urban I don’t mean Colombo or Bombay I mean depending on the definition you use could be as little as 5000 agglomerating together. The key is you need economies of scope, economies of scale and economies of agglomeration. Those are created at these sort of population levels, that’s the primary argument. In many ways rural development to a very large extent depends on urban development so, I don’t necessarily see the dichotomy between the two. I think if you develop your urban areas then by definition you also develop your rural areas.

Q: Sri Lanka is pursuing this grand idea of a western province megapolis, but when we talk about urbanization in Sri Lanka we tend to talk about physical infrastructure development, transport, and zoning and not enough is spoken about the overall rules of the economy which has an impact on urbanization. What would your advice be for Sri Lanka’s megapolis plans?

Yes this is a classic problem not necessarily in Sri Lanka, its everywhere. When we talk about urbanization we are talking about the urbanization of people not the urbanization of places that is where the central dichotomy lies.

However, the underlying logic of the the Western province megapolis is a fairly decent one simply because close to 70% of global GDP just comes from about 40 urban mega regions of the world.  Mega regions are areas that have more than 100 billion dollars of GDP. The biggest mega region in the world still remains in North Eastern corridor of the United States which is the Boston to Washington corridor going through New York and the tri-state areas through to Silicon Valley, the eastern seaboard of China all of these are examples of large urban clusters. I suspect that this is the underlying logic of what is going on in Sri Lanka.

I think the problem in all of this is people are making an assumption that the rules don’t matter. That somehow in Boston all you needed to do was basically create an announce of policy that you were going to generate this huge corridor between Boston and Washington and suddenly economic activity would take off. That is not the point, the point is actually you need the change of rules in the first place.

This is an argument that I’ve always made when people talk about smart cities using Singapore as a paragon for instance. But how did Singapore get to be a prosperous place or how did Switzerland get to be a prosperous place before the advent of the internet. Clearly it has nothing to do with the internet, obviously technology helps but, it is not the reason why something happened. Something happened because the rules were fundamentally changed. Coming up with a megapolis idea absent of changing the rules is not going to help any. There needs to be a change in the rules.

If one thinks about is as a special zone where one can basically change the rules then that idea has more legs, though if that is the model the government wants to follow I would argue that Colombo is exactly the wrong place to try it in because there are massive interests already in Colombo who are going to oppose every change of rules that any ruling entity can come up with.

Sri Lanka is experimenting with in a limited way with a special zone for rules change with Colombo Port City, at the doorstep of Colombo.   Why wouldn’t Colombo be a good starting point?

Let’s use the analogy of software operating systems in computers. What we are basically talking about is that say Windows NT is a broken OS and say a Solaris is much better and a much more robust software - it’s a much better Operating System.  The easy way out here is to replace the broken software with a better piece of software.

But Anybody who has worked in an office knows just convincing people in a department - let alone a city - to move from what they are familiar with to an unfamiliar operating system is a very hard task.

So changing  the operating system has to necessarily have two conditions in my opinion. First is they have to have meaningful scale, it cannot be done at village level, it has to be done at least at city level. The change that you get is meaningful that is number one.

Number two is the unit that you’ve picked, whatever scale that you’ve picked it has to have the political economy that works in your favor. For instance if you look at the Chinese example keep in mind the fact that the easy solution for the Chinese would have been to import the operating system of Hong Kong and reboot the entire country. That was clearly not feasible even in a commanding and controlled economy like China.

Keep in mind they did not try to change the rules in Beijing or Shanghai. Instead of that what Deng Xiaoping and his colleagues decided to do was that, they found this little town on the pearl river delta called Shenzhen and they demarcated a certain area and they changed the rules there. And then once Shenzhen became successful the rest of the country wanted the same rule change.

Q: This is about Special Economic Zones or Free Economic Zones. Port City is billed as a place where a Dubai Financial centre style arrangement is going to be experimented on.  But if you want a city outside of Colombo, we do have an opportunity in Hambantota, where lot of unused infrastructure already exist.  

I don’t think the Dubai financial center is the right example to pick simply because, there is not enough scale there. Of course Dubai can afford to do it because it’s a city on it’s own. So it does not have to worry about the massive spillovers that can get generated from a big city etc. but, if you are talking about countries with those concerns then I would certainly argue that the scale has to be bigger.

Perhaps Hambantota is a good model to look at assuming that there is genuine thought given to wholesale reform and not just have it as a tax give away. That is the other problem you see in a lot of these other places that a lot of the reform tends to be in the form of tax give away which is I will give you all these concessions if you come here.

And I don’t think that’s right model to use. Paul Romer the NYU economist has an extraordinary two part test to test whether something is a concession or a reform and suspect that you can subject Hambantota port project to exactly the same test. The first part of the test is can you basically give this immortality what I mean by this is that, the reform that you have undertaken there , does it need to be a time bound reform or can it basically be given immortality, can it be given to run forever.

For instance a 10 year tax holiday is by definition a simple concession it’s not a reform, it’s not genuine reform. The second test is geographical which the reform that you’re trying out, or the little change of rules that you’re trying out, does it need to be restricted to this particular area that you’re trying out in or can it be expanded to the rest of the country? And if it turns out that you need to restrict it to just that area then chances are it’s a concession and it’s not a reform. Whereas if it could be taken to the whole of Sri Lanka then it’s clearly a reform.

That is the test one would basically use and I actually think there is another candidate for this sort of special zone in Sri Lanka which I haven’t heard been debated at all which is the northern provinces. Because the Northern provinces badly and desperately need economic development so the government can be seen as making a huge concession towards the people in the north who have been suffering for quite some time and so on. Then use this change of rules in the Northern area and use the proximity to India as a catalyst to basically drive the change. In my opinion that is an extraordinary possibility that I don’t see much conversation about. Obviously I don’t know the internal political economy situation well enough to comment but, it would seem to me at least as a technical point it’s something that should be discussed.

Q: Related to this, economist Paul Romer introduced the idea of Charter cities, where he advocated a wholesale import of a rule set. He argued that if potential foreign investors could have rules that they can trust that would be the driving force of investment?

On charter cities one needs to be very careful on how one thinks about it. If you are a small country then it becomes easier to make the first argument that Paul was making which was the argument that an external sovereign will guarantee the rules of the country. Which is an easier sell if you are a small and very poor country. 

But for most countries I think it becomes much harder to invoke this idea of outsourcing sovereignty to a third entity. Therefore I think a much better solution would be to employ a domestic version of the charter which pretty much what I’m describing.

To create these zones inside of a country guaranteed by the sovereign of the country. It’s basically the difference from a Hong Kong and a Shenzhen. Basically Hong Kong had an external sovereign guaranteeing the rules of the game and Shenzhen had internal sovereign guaranteeing the rules of the game. I think the right approach is to have the Shenzhen model which is to have an internal sovereign guaranteeing the rules of the game.

Q: What is your sense of Sri Lanka’s place in the global development community. Sri Lanka has long being talked up as a place with enormous potential, yet FDIs doesn't seem to come through to the levels expected.  Are we expecting things  too much, too fast?

Not really, I mean you are right keep in mind the fact that when Lee Kuwan Yew took over Singapore, Sri Lanka was the model and he wanted Singapore to be like Sri Lanka. There is no question that Sri Lanka has lost an enormous amount of time while trying to figure it’s internal politics out.

Sri Lanka doesn’t register much in the international development community for two reasons. One is it’s too small and the other is it’s too rich. Its that very interesting combination because if Sri Lanka was actually very poor then a lot of people would take notice but, Sri Lanka is not very poor. Sri Lanka is well into middle income territory. I think it’s the combination of lacking size to be of interest to big investors

These are disadvantages that exist there is nothing you can do about it. But, I think the way to think about it is if Singapore being a backwater swamp that nobody wanted, could turn itself around to what it is today, I don’t see why Sri Lanka should be any different.

I think it’s fundamentally a question of the rules and I think it’s a lot easier to change the rules in Sri Lanka than say, in India. One must pay a lot of attention to changing the rules how to change the rules.

In the ‘How question’ I think these ideas around the western mega polis, special zones around the Hambantota area and even the idea I threw out which was the Northern & Eastern territories of Sri Lanka also should be considered because those are the ways in which you could change the rules because I suspect changing the rules in all of Sri Lanka is going to be a lot harder.                       

This article is part of a series of interviews with Public Policy experts hosted by Advocata Institute, a public policy think tank based in Colombo.  The longer version of these interviews are available in podcast form on www.advocata.org/radio

Brexit: Self determination or self destruction?

By Christopher Lingle

The article originally appeared on dailymirror.lk 4th July 2016

The Brexit issue induced many people to engage in hyperbolic promises to encourage a Leave vote or excessive doom-and-gloom warning to inspire a Remain vote. This habit survived beyond the reports of the final results. For their part, the “Remainders” responded with an orgy of teeth-gnashing and finger-pointing to disparage those that had the cheek to vote: UK Out of EU. But let’s begin at the beginning, with first principles; and; if you will, with self-determination being a natural right based on human liberty and dignity. In terms of separating from others, people are entitled to act as individuals (migration), couples (divorce) or as members of a group with shared identity (Brexit).

This is contestable. Even while some European Union (EU) officials admitted it must be more responsive to citizens, opponents of the Leave option insisted ordinary voters should not decide such an important issue! In sum, these views would have the EU become more democratic but individual countries would become less so. Next, let’s engage some of the interpretations of the motives of theBrexit vote.

One narrative is that those resisting continuing expansion of power in the hands of EU institutions are xenophobes or racists. Another narrative is of disaffected masses that are protesting some of the negative impacts of globalization. This is often joined with another assertion that this is or should be an expression of outrage against increasing income inequality.

All of these narratives have an element of truth or they would not gain traction. But assertions that citizens’ disaffection is about grievances arising from destabilizing forces of globalization or income inequality should be viewed with great caution.

Indeed, there is strong evidence that what has been occurring is the outcome of political decisions that have had economic consequences. As such, the underlying cause is a failure of political governance. Naturally, those that supported or implemented the EU policy are either ignorant of their (unintended?) consequences or seek to deflect the blame away from themselves. In short, forces that prefer more government interventions in economic and social life are raising false narratives to deflect blame from problems arising from their own actions.

In this reading, the troubling rise of populism around the world must be interpreted as widespread disaffection with “politics as usual”. Brexit is but a part of a global “peasants’ revolt”, relying upon ballots rather than pitchforks, against the policies and judgments of the political elite -- the Establishment.

This apparently unseemly rise of nationalism and populism is not a random or spontaneous development. It can be traced to the expansion of state control and power that has marginalized individuals while promoting economic interests of special interests, including trade unions.

Indeed, these developments reveal the internal, fatal contradictions of representative democracy that may be approaching its logical end. We have reached a global “Weimar moment” whereby the detachment of the political elite from their citizens is driving them into the arms of dark nationalist, protectionist forces.

Political elites

Political elites have used democracy as a cover to insert their ideologies or their special interests (monopoly privileges or political correctness issues). In turn, citizens have found that their life outcomes and daily lives have become increasingly dominated by arbitrary political forces. In the case of the EU, it is primarily a “social democratic” construct. As in the case of Brexit, earlier votes that went against the agenda of the political establishment to expand the EU prerogatives and actions were met with howls of elitist disdain. The assertion was that the unwashed masses got it wrong and must vote again.

This happened when the Danes rejected the Maastricht Treaty (1992). After being obliged to vote again they accepted it, but the voters later refused to join the euro-zone as did Swedish voters.

As for the Irish voters, they rejected the Nice Treaty (2001) and the Lisbon Treaty (2008), but were compelled to vote again until delivering the correct answer. When French and Dutch voters turned down the EU Constitution (2005), their responses were ignored, as in the case of rejection by Greek voters of the terms of the euro bailout (2015).

In all events, the eventual outcome is uncertain. In the UK, it could lead to greater openness and increased exchanges with the rest of the world without the suffocating bureaucratic interferences from Brussels. Or it could collapse into an internecine nativism. It might also be the death knell for the cohesion of the UK as the Scots may choose independence.

Interpreting what Brexit means for financial markets or the UK economy involves a great many possible permutations so that no one can pretend to speak authoritatively. One thing is sure and is confirmed by the events of the first week after the vote, it is the case that uncertainty will often lead to increased market volatility.

For their part, ‘Remainers’ painted such an apocalyptic future for Brexit that they are largely to blame for the market turmoil. Now they have already begun scrambling to walk back their predictions to calm troubled waters and anxious markets.

In the long term, Brexit can be positive for the UK. But it will require that British leaders allow free trade with the lifting of obstructive EU regulations. As it is, London is very likely to remain the premier destination for investment capital in Europe for a very long time.

As for the EU, it as though a soldier has been shot and the bullet has passed through with death being imminent, though the soldier be unaware. Since neither the British nor EU elites thought that the Leave vote would succeed, their lack of insights makes them unable to address the grievances raised against them. One wonders how they would respond to the question as to whether the central institutions of the modern EU — the Schengen area and the euro — make the continent more stable or less?  

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Christopher Lingle is adjunct professor of economics at Universidad Francisco Marroquin (Guatemala) and Research Associate at the Centre for Civil Society (Delhi). He is also a senior visiting fellow at the Advocata Institute.

Ignore the outrage, Sri Lankans want to work in Beyonce’s garment factory

By Ravi Ratnasabapathy

The article originally appeared on Capx.co 3rd June 2016

Last week, the Sun newspaper in the UK claimed that a factory in Sri Lanka that produces a line of clothing for a popular singer Beyonce is using sweatshop ‘slaves’. The report attracted little interest in Sri Lanka, partly because attention was more focused on the devastating floods that hit the island. But perhaps the report also failed to make waves because it simply did not ring true; the mainstream apparel factories in Sri Lanka are seen as responsible and respected employers in the formal sector.

Since the original Sun article, several international media outlets such as Quartz andVice have published pieces amplifying the story. Whilst some commentators have aired dissenting views, a local perspective may be useful.

The Sun report claims that the basic monthly salary of 18,500 Sri Lankan Rupees received by a seamstress at the factory that produces Beyonce’s Ivy Park clothing line amounts to slave labour. It goes on to claim that the workers earn just £4.30 a day, and then informs its readers what the equivalent (Rs. 902) could be spent on:

A McDonald’s meal: Rs. 650 (£3.07)
A pint of beer: Rs. 200 (94p)
A litre of milk: Rs. 150 (71p)
A pair of Levi jeans: Rs. 3,900 (£18.41).

This might shock readers in the UK, but none of that is what low-income people in Sri Lanka buy. They buy powdered milk (much cheaper), they rarely eat western style fast food (McDonald’s, in particular is several times the cost of a low-end Sri Lankan meal), alcohol is deliberately kept expensive through high taxes, and they are highly unlikely to buy Levi jeans – a local equivalent would cost a third of the price (or less).

A more realistic comparison of living costs is given by Sri Lanka’s National Consumer Price Index (NCPI) based on data from the Household Income and Expenditure Survey (HIES). Based on the March 2016 NCPI, a household (of 3.9 members) would typically spend just Rs. 35,356.96 (£168) per month on all their living expenses.

Let’s look purely at food costs. The World Food Programme Cost of Diet, a method to model the cost of a theoretical, simulated food basket which satisfies all nutritional requirements of a household, estimates that the cost of a nutritious diet for the model Sri Lankan household of five (parents and three children) varies from Rs. 12,208 per month in the Northern Province to Rs.15,371 in the Western Province.

Sri Lanka is not a rich country and wages are low but so are living costs. The Official Poverty line at national level for April 2016 is Rs. 3,943 per person, according to the Department of Census and Statistics.

A nurse in a government hospital would start on a salary of Rs. 15,620, and once promoted would receive Rs. 21,660. Salaries for teachers in the government service is similar, ranging from Rs.13,410 to Rs. 15,540. Like the apparel industry, both professions predominantly attract young women, although nurses naturally require a much higher level of education. 

Set against the everyday realities of ordinary Sri Lankans, the basic wages of a sewing operator of Rs.18,500 seem more reasonable. Basic wages also do not include overtime and other benefits afforded to garment workers which could push their earnings well over Rs.20,000, at times going as far as Rs.30,000.

To be sure, these wages are still low and the job is demanding. The workers are undoubtedly poor and life will not be easy, but they are better off than some of their neighbours who eke out an existence in subsistence agriculture, work as maids, or are simply unemployed.

Until the country opened up to trade and investment in 1977, almost a quarter of the labour force lacked jobs. Things have improved since then. According to official figures, around 25% of the labour force is employed overseas as migrant workers, mostly in the Middle East, and many of them women. Women account for half the migrant worker population, the majority of whom work as house maids where conditions can be dangerous. There are cases where workers have been abused, unpaid or not paid as agreed and imprisoned in their countries of employment.

Claims have also been made that Sri Lanka has weak labour protections, when in fact Sri Lanka has comprehensive labour laws. In addition to regulations on hours worked, holidays, overtime and child labour, all employees are also entitled to statutory provident fund contributions by the employer amounting to 15% of their basic pay, which they can withdraw on retirement. Employees with a service in excess of five years are also entitled to statutory gratuity payments if they leave. In addition most of these factories, such as the one producing Beyonce’s Ivy Park range, provide transport, free meals and other welfare and incentive bonus programs.

These benefits do not extend to workers in the informal sector or those who are self-employed, which is where sewing operators are most likely to find work outside apparel factories.

The garment industry has rescued millions of people from poverty all over East Asia; it is labour intensive and provides many relatively low-skilled jobs that are easily learned and transferred, thus ideal for countries at an early stage of development. It forms a stepping-stone to more sophisticated industries and services.

The global development of the industry took place in three waves. The ILO reports that:

“During the first wave of production, the Republic of Korea, Singapore, the territory of Hong Kong and Taiwan achieved excellent results within their own borders, but then began to cut down production and invest heavily in other least-cost countries. As a result, between 1985 and 1990, the production of the Philippines, Indonesia, Thailand and Malaysia increased greatly and led the world market in exports.

These countries have in turn begun to invest or redistribute part of their production to a third wave of countries such as Bangladesh, Pakistan, Sri Lanka and more recently Laos, Nepal and Vietnam.”

Sri Lanka’s industry started off in the 1970s and has evolved significantly since. It is no longer is it seen as a ‘cheap’ destination but as a ‘quality’ supplier.

The call for better wages by activists based on rich country comparatives is misleading and dangerous. If followed through by the imposition of boycotts in favour of significantly higher minimum wages, it could endanger the very people they intend to help.

Concerned Westerners interested in doing some real good for workers in Sri Lanka and elsewhere should instead lobby their governments to cut tariffs on garment imports.

The greater the demand for clothing from Sri Lanka, the more factories there will be for Sri Lankans to work in. As the choice of jobs increases, salaries will rise and lifestyles will improve. The competition will push employers to increase productivity and the economy will grow. The children of these workers, better fed, clothed and educated than their parents were, will have better opportunities, perhaps even in white-collar jobs.

The Sun, quotes one of the workers interviewed as saying “We had to come and work here because our father could not afford to feed us and there are no jobs there”. The garment industry is the main source of income for many economically marginalised households in rural areas.

If the jobs in the factory became unviable, what would they return to?

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Ravi Ratnasabapathy is a management accountant by training and a fellow at the Advocata Institute.

SOEs in Sri Lanka : Beyond "Profit & Losses"

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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