Reform or Perish. It’s not too late

Originally appeared on The Island, ColomboTelegraph and Groundviews

By K.D.D.B Vimanga and Naqiya Shiraz

The Sri Lankan economy faces a historical crisis.  The root causes are the twin deficits. First, the persistent fiscal deficit - the gap between government expenditure and income. Second, the external current account deficit - the gap between total exports and imports.  The problems have been festering for too long. Without urgent reforms, the crisis could easily morph into a full-blown debt crisis. 

Sovereign debt workouts are extremely painful for citizens. A mangled debt restructuring can perpetuate the sense of crisis for years or even decades. A return to normal economic activity may be delayed, credit market access frozen, trade finance unavailable.

With the global pandemic, these are unusual and difficult times. The next five years are going to be crucial for the country.  The problems can no longer be avoided and should be faced squarely. The journey ahead is going to be painful but the longer these are delayed the worse the problem becomes and the magnitude of the damage compounds. 

The State of the Economy 

The new government inherited a fragile economy, battered by the Easter attacks of 2019, the constitutional crisis of October 2018 and the worst drought in 40 years in 2017. With the pandemic in 2020 Sri Lanka’s economy shrank by 3.6% with all sectors of the economy contracting. 

Yet, the pandemic is not the sole cause - it only accelerated the decline of Sri Lanka’s economy that was weak to begin with.  The country has long been plagued by structural weaknesses, with growth rates in the last few years even below the average growth rate during the war. Mismanaged government expenditure coupled with a long term decline in revenue have characterised Sri Lanka’s fiscal policy. As of 2020 total tax as a percentage of GDP fell to just 8%, while recurrent expenditure increased. 

Borrowing to finance the persistent budget deficits is proving to be unsustainable. Total government debt rose to 101% of GDP in 2020 and has grown since. Sovereign downgrades have shut the country from international debt markets. The foreign reserves declined from US$ 7.6 bn in 2019 to US$ 5.7bn at the end of 2020 and to US$ 2.8 bn by July 2021. This level of reserves is equivalent to less than two months of imports. With future debt obligations also in need of financing, the situation is dire. 

The import restrictions placed to combat this foreign exchange crisis have failed to achieve their purpose and are doing more harm than good. imports rose 30% in the first half of  2021 compared to 2020 despite stringent restrictions.

The problem lies not in the trade policy but in loose fiscal and monetary policy that has increased demand pressures within the economy, drawing in imports and leading to the balance of payments crisis and consequently the depreciation of the currency.  

Measures by the Central Bank to address this by exchange rate controls and moral suasion have caused a shortage of foreign currency leading to a logjam in imports.

Fundamental and long-running macroeconomic problems were  intensified by the pandemic.Import restrictions, price and exchange controls do not address the real causes.

Treating symptoms instead of the underlying causes is a recipe for disaster.

The continuation of such policies will lead to the deterioration of the economy,  elevate scarcities, disadvantage the poor who are more vulnerable and in the long run lead to even higher prices and lower output due to lack of investment. 

Sri Lanka’s GDP growth over the last decade has been alternating between short periods of high growth and prolonged periods of low growth. This is a result of the state-led, inward-looking policies of the last decade.

A comprehensive reform agenda must be built around  five fundamental pillars:

i) fiscal consolidation - The need to manage government spending within available resources and to reduce debt are paramount. Revenue mobilization must improve but the control of expenditure cannot be ignored. Budgetary institutions must be strengthened and there must be reviews not only of the scale of spending but also the scope of Government.

 ii) Much of government expenditure is rigid - the bulk comprises salaries, pensions and interest so reducing these is a long term process. Reforming State Enterprises, especially in the energy sector and Sri Lankan Airlines is less difficult and could yield substantial savings. Continued operation of  inefficient and loss-making SOE’s is untenable under such tight fiscal conditions. Financing SOE’s from state bank borrowings and transfers from government reduces the funds available for vital and underfunded sectors such as healthcare and education. Excessive SOE debt also  weakens the financial sector and increases the contingent liabilities of the state. Therefore SOE reforms commencing with improving governance, transparency, establishing cost reflective pricing and privatisation are necessary. This can take a significant weight off the public finances and by fostering competition contribute to improvements in overall economic  productivity. 

iii) Tighten monetary policy and maintain exchange rate flexibility.  Immediate structural reforms include, Inflation targeting, ensuring the independence of the central bank by way of legislation and enabling the functioning of a flexible exchange rate regime. Further significant  attention has to be placed on the  financial sector stability with a cohesive financial sector consolidation plan, with special emphasis on restructuring of SOE debt. 

 iv) Supporting trade and investment. Sri Lanka cannot achieve economic growth without international trade which means linking to  global production sharing networks. Special focus has to be given to reducing Sri Lanka’s high rates of protection which creates a domestic market bias in the economy along with measures to improve trade facilitation and attract new export oriented FDI. 

Attempts to build local champions supported by high levels of protection have 

(a) diverted resources away from competitive businesses, 

(b) created a hostile environment for foreign investment, 

(c) been detrimental to consumer welfare,

(d) dragged down growth

v) Structural reforms to increase productivity and attract FDI - Productivity levels in Sri Lanka have not matched pace with the rest of the growing economies. The reforms mentioned above are extensively discussed in Advocata’s  latest publication “Framework for Economic Recovery”.

Sri Lanka  stumbled into the coronavirus crisis in bad shape,with weak finances; high debt and widening fiscal deficits. It no longer has the luxury to delay painful reforms. Failure to do so will not only jeopardize the economy; it could even spawn social and humanitarian crises.

Naqiya Shiraz is the Research Analyst at the Advocata Institute and can be contacted at naqiya@advocata.org.K.D.D.B. Vimanga is a Policy Analyst at the Advocata Institute. He can be contacted at kdvimanga@advocata.org.

The Advocata Institute is an Independent Public Policy Think Tank. Learn more about Advocata’s work at www.advocata.org. The opinions expressed are the author’s own views. They may not necessarily reflect the views of the Advocata Institute

The Government’s dangerous honey

Originally appeared on The Morning

By Dhananath Fernando

Minister of Finance Basil Rajapaksa, moving two important bills in Parliament, recited a poem in Sinhala literature, which is also a proverb, to explain the sorry state of our economy. He compared Sri Lanka’s economy to a man in the jungle trying to rescue himself from three life-threatening challenges.

Firstly, a furious wild elephant, similar to our mounting debt obligations. Secondly, to avoid the elephant, the man attempts to hide in a pit, but before he jumps into the pit, he realises that there is a cobra in it. So instead of jumping, the man then decides to hang onto the roots of a tree that lies above the pit as an alternative. The cobra in the bottom of the pit is similar to our Balance of Payment (BOP) crisis. Our importers and exporters are in big trouble, having difficulties opening Letters of Credit (LCs) due to forex shortages, and currency is depreciating rapidly with attempts to keep interest rates artificially low by policymakers.

Then the man realises that one root he is holding onto is the tail of a venomous reptile. He now cannot release his grip on the tail as the reptile will bite back. So, the adventure of running away from the elephant waiting at the edge of the pit now has two more severe life-threatening risks. The Finance Minister’s analogy reflects that trying to avoid one problem without a proper estimation and analysis has now opened us to more vulnerabilities while the previous challenges remain as they are.

As the story goes, one tree root the man is holding in his other hand is attached to a bee honey nest. So when he tightens his grip, bee honey keeps dripping, and so he decides to indulge in some bee honey. While the man has three life threats from the elephant, the cobra, and the other reptile, he decides to enjoy the dripping bee honey for a moment.

The Sri Lankan economic crisis is exactly the same. At a moment in history where urgent, hard, and serious economic reforms are required to overcome the crisis in the midst of the global pandemic, some alternative policies such as self-sufficiency, Modern Monetary Theory (MMT), and import substitution have become sweet bee honey for some policymakers who really do not understand the gravity of the crisis.

Unfortunately, just as the man who attempted to jump to a pitfall without properly analysing the situation, some economic measures with little analysis are cornering us for a brewing crisis.

Fixing USD at Rs. 203

Attempting to fix our exchange rate at Rs. 203 against the USD to avoid currency depreciation is one such activity. Simply, it is a price control on US dollars. Every good or service with an economic value is naturally obliged to a demand and supply matrix. In other terms, there is no alternative to fix the price of a currency without someone intervening in the excess or shortage.

In the forex market, the Central Bank does not have adequate forex to intervene in markets any longer, with the mounting debt obligations. So it is natural that $ 1 for Rs. 203 is a complete misguidance where there is no USD in the market at that price. The downside of trying to fix the USD at an artificially lower price is the encouragement it would provide on more importers to open LCs, adding more pressure on banks as well as the USD.

“Imports” are incentivised at a lower rate than the market rate for the USD. Exporters, on the other hand, are discouraged to bring forex as they get a far less market rate if they bring USD to the market. As a result, exporters hold the USD as long as possible and many exporters maximise their offshore accounts, as it is very cost-effective and hassle-free. As such, banks’ forex market has now further dried up, with both importers and exporters falling into trouble. It is the same predicament faced by the man who tried to avoid an elephant and came across two more additional troubles.

Additionally, another restriction has been imposed on more than 600 HS codes where the full amount has to be paid upfront to open the LC. This move will directly impact micro, small, and medium-sized businesses that depend on imports in those categories. Consumers will have to experience higher prices and black markets in most of these product categories, and the quality of life will be affected drastically.

Concerns expressed by investors on property rights over seizing rice stocks

Recent raids carried out on rice mills in Polonnaruwa will worsen Sri Lanka’s image as a destination for investors. As previously written in this column, it is the lack of competition, along with political support, that leads to the creation of cartels in the rice milling industry. However, seizing private property of an individual undermines investor confidence – no investor will consider Sri Lanka if there is a fear that the government will take over their property rights.

This was the same point made by the President when he was questioned by Indian media in his very first international media interview about the Hambantota Port. Though his supporters claimed that the Hambantota Port will be taken back by China, the President mentioned that if we were to do it, it would completely provide a wrong message for the investor community. According to media reports, the Government is initiating a very important Selendiva project for investors (Hilton Colombo, Grand Hyatt, etc). However, property rights concerns will seriously erode attracting quality investors for the Selendiva project.

At the same time, exactly like the proverb in the speech by the Finance Minister, while we are in serious trouble on multiple fronts, ideological groups seem to be defending their ideology rather than finding solutions with pragmatism. Ideological groups are the same as the man who is focusing on bee honey dripping, by forgetting that we are already in a very serious situation. The narration created on self-sufficiency and import substitution are just an example.

The Finance Minister has to be objective and pragmatic instead of falling into ideological traps. Otherwise, he will be a victim of his own analogy and the proverb of the man who multiplied the problem by irrational decision-making.

The opinions expressed are the author’s own views. They may not necessarily reflect the views of the Advocata Institute or anyone affiliated with the institute.

Closing the gate once the horse has bolted

Originally appeared on The Morning

By Dhananath Fernando

Can price controls rein in uncontrolled depreciation?

People are infuriated over the recent drastic price hikes on essential food items, and analysts and policymakers are attempting to make sense of what triggered this.

Some argue that the increasing global commodity prices are indeed the root cause of these local price hikes. In my opinion, however, global price hikes cannot be the sole reason. This conclusion is misleading as the domestic prices of these food items are higher than the percentage increase of global commodity prices adjusted for the depreciation of the Sri Lankan rupee (SLR).

Steep depreciation of the currency

It is no secret that the Government sought refuge in Modern Monetary Theory (MMT) in recent times. This has had a considerable impact on commodity prices due to the depreciation of the rupee. A depreciating rupee coupled with increasing commodity prices is certainly an ill-fated combination. Even though many economists alerted the Government of the risks MMT could pose, they fell on deaf ears.

When global market prices rise, it is inevitable that domestic markets adjust accordingly due to price signals. This means that people shift their consumption behaviours and patterns with price volatility. However, Sri Lanka’s essential commodity price hikes came suddenly and have given people no time to adjust their purchasing patterns.

As per Central Bank data, Sri Lanka’s food inflation is increasing. Advocata Institute’s Bath Curry Indicator, which tracks the weekly expenditure of a four-member household on rice and curry, found that prices increased by 45% on a YoY (Year-on-Year) basis in July and by 30% in August.

I’d like to conclude my argument by quoting Nobel Laureate Prof. Milton Friedman: “Inflation is always and everywhere a monetary phenomenon.”

Acute foreign exchange crisis exacerbated by MMT

The acute foreign exchange crisis we are in, too, is a major contributor to recent price hikes. Oversupply of money has drained our reserves and added additional pressure on the currency. For example, when the government provides Rs. 20,000 (which is beyond the government’s capacity) for low-income families, money will flow out of the system due to the purchase of imported goods. People will be inclined towards buying imported LP gas, lentils, sprats, and tin fish.

Further, maintaining a negative real interest rate, which is to keep interest rates artificially low by increasing money supply below the inflation rate, will motivate people to spend more money than to save. More spending equals more expenditure on imports, which will then exacerbate the country’s Balance of Payment (BOP) crisis.

Currently, banks have different exchange rates for different customers. The kerb market’s exchange rate for the US dollar is between Rs. 250 and Rs. 260.

If this trend continues, the country’s fuel prices, LP gas, milk powder, and many other commodity prices will continue to rise.

Price controls

The Government has announced strict price controls and has appointed a designated officer to curb hoarding by traders with the objective of decreasing essential commodity prices. Recent news reports claim that hoarded essential food items such as sugar have been confiscated from stores by the authorities.

However, price controls are proven to be ineffective and will lead to goods disappearing from markets, as a result creating black markets. Further, it is likely that price controls will result in importers stopping the importation of goods. The first lockdown saw an initial price control of Rs. 65 on lentils and a controlled price of Rs. 100 on tin fish. Later, the Government had to withdraw the price controls as it resulted in severe shortages, with traders halting imports and the sellers hesitating to trade at a loss. Price controls simply don’t work because the price structure is unique for each trader.

Competition is the only factor that drives prices down. For example, the cost structure of a trader who sells lentils in an air-conditioned shop and a trader who sells at the Sunday market is different. The price they mark is based on the cost, and consumers buy it based on the value they get. Price controls hamper the signalling mechanism, resulting in severe repercussions.

Why do traders hoard?

Even with increased raids by the Consumer Affairs Authority (CAA), traders continue to hoard. This behaviour is intricately linked with the foreign exchange crisis the country is in. The Central Bank introduced regulations stating that traders cannot buy US dollars for a future day (forward market) at the current exchange rate. Further, importers were requested to open Letters of Credit (LCs) for a 180-day credit period. As a result, importers brought essential commodities in agreement to pay the exchange rate to be in effect after 180 days. They brought the goods they already sold at a calculated exchange rate.

However, now the exchange rates are depreciating further. For example, when traders imported the consignments, our exchange rate was about Rs. 190. But with the currency depreciation, now they have to pay the current exchange rate as there is no forward market or interbank market in operation. This is pushing importers to hoard to secure stocks for the future. Importers will also be inclined to increase prices to cover their losses incurred due to exchange rate volatility.

All of these trickle down to the average consumer as higher prices on essential commodities. Higher prices, long queues for essential goods, and empty shelves are symptoms of wrong macroeconomic policies.

This column and many economists alerted the Government that it would come to this, and I am disappointed that the Government did not heed our advice.

The opinions expressed are the author’s own views. They may not necessarily reflect the views of the Advocata Institute or anyone affiliated with the institute.

Reforms required, IMF or no IMF

Originally appeared on The Morning

By Dhananath Fernando

At Advocata’s first deep-dive session on Sri Lanka’s debt sustainability, Harvard Prof. Ricardo Hausmann emphasised on the importance of avoiding an economic crisis at all costs. As he is of Venezuelan origin, it is safe to assume Prof. Hausmann has first-hand experience of having to live through the realities of such a crisis. He warned that “an economic crisis comes slowly and then suddenly”.

Every week, the Central Bank attempts with various tools to subjugate the situation, but unfortunately the intensity of the wind seems difficult to change. The Energy Minister initiating discussions with the UAE to purchase fuel on a long-term credit period while restricting the country’s USD payments with a 5% ceiling on USD deposits indicates how hazardous things can be in future.

The Central Bank’s recent inflation numbers have indicated high food inflation. Now the last resort in sight is to approach the International Monetary Fund (IMF). Opinions on this are many.

In my view, emphasis should not be on the IMF. A credible plan to drive economic growth must take precedence. However, I don’t see such a plan in place as of now.

So let’s discuss solutions we can incorporate into a credible plan as the problem is clear.

Immediate policies

Cash transfer system for safety nets

Given the nature of the pandemic, it looks like we have to expect more lockdowns or limited travel in the immediate future. This will affect Sri Lanka’s MSME (micro, small, and medium-sized enterprise) sector and informal employment. At the moment, 99% of our establishments are MSMEs and more than 60% of our labour force is in the informal sector. MSMEs contribute more than 50% of our GDP. So any policy to stop spreading the virus through travel restrictions will undoubtedly affect our informal sector. We do not have a mechanism to protect them.

Samurdhi targeting and distribution through grama niladharis is extremely poor. Therefore, what governments often do is bring down prices of all food items, fuel, and other essentials across the board. This is direct intervention in the market in the form of subsidies. These subsidies end up in rich households due to their high consumption of commodities.

The solution is to introduce a cash transfer system to the vulnerable households. This will give them the freedom to choose what they want to spend on. The cash transfers can have multiple tiers based on the poverty levels. For example, when the global fuel prices are increasing, the cash transfer on fuel can be increased, but when prices decrease, the cash transfer can decrease proportionately. Simply, we have to introduce an agile digital safety net system in the future because market reforms are painful, especially for the poor.

Cutting down govt. expenditure and voluntary retirement scheme for govt. servants

A reason the Central Bank has to continue to follow Modern Monetary Theory (MMT) is the ballooning government expenditure. It is true our expenditure is somewhat on par with our regional peers, but our labour market is completely distorted by about 1.5 million people, and most of them are unproductive and dissatisfied with their work conditions. Undoubtedly, this is beyond our government’s afforbality, especially with pension payments and other expenses incurred utilising prime property across the island wasting most of our resources. Our state-owned enterprises (SOE) absorb a greater portion of our government revenue, their debt in state banks adding a serious risk to the stability of the banking system. So a freeze in the government sector is a must and we do not have any alternatives left.

Debt restructuring and debt conversion

We have to leave our current strategy of trying to manage debt with short-term swap agreements. The more we wait, the more the pain we have to go through. Debt conversion is a strategy that can be explored. We can consider a few debts to equity swaps similar to what we did with the Hambantota Port on identified unproductive assets. Debt restructuring or reprofiling is another option, which, however, requires serious effort. It will be an extremely costly process, where we will have to work with foreign legal firms and our creditors. This will have both positive and negative consequences.

Unlocking our land supply

Land is one of the main factors of production. It is unimaginable that 80% of land is owned by the government and only 3% of the land have clear titles, as per a World Bank study. Without having land ownership for its people, there is no opportunity for capital flow that can expand the entire business ecosystem. The Government has to prioritise creating a digital land registry instead of other unproductive alternatives.

Above are just a few recommendations for a credible recovery plan, whether we go to the IMF or not. The real problem is not whether we are going to the IMF or not. It is looking at what reforms we have to make on our own and how we are going to make these changes, which are required to drive economic growth.

Prof. Hausmann said that the big bad wolf comes slowly and suddenly. I hope we move much faster and get the reforms done before “the big bad wolf that comes slowly and suddenly” comes for us.

The opinions expressed are the author’s own views. They may not necessarily reflect the views of the Advocata Institute or anyone affiliated with the institute.

To Leave or to Stay? Years of bad economic policy are killing the aspirations of Sri Lanka’s youth

Originally appeared on The Island, Colombo Telegraph

By Sathya Karunarathne

Overseas migration for work or study, seems a popular option for Sri Lanka’s youth. Central Bank data shows that in 2019 alone the age group 25-29 recorded the highest number of departures abroad for skilled, semi-skilled, and unskilled employment. This age group also recorded the second-highest number of departures for professional, middle, and clerical level jobs. UNESCO’s Eurostat data collection on education for 2020 states that the total number of Sri Lankan students overseas is 24,118.

A significant segment of the youth population seem dissatisfied with the available opportunities and choices within Sri Lanka.The above numbers reflect their lack of faith in a better and safer society in the years to come. For decades this lack of opportunity was blamed on the war. However, even twelve years after the conclusion of the war little has changed.It is worthy to explore why.

How did we get here?

The island nation’s predicament was in the making for almost 70 years.Consecutive governments since independence have failed to successfully implement policies to deliver economic growth and better living standards.

Trade is the engine of growth but over the last fifteen years Sri Lanka has shied away from trade led growth. Although Sri Lanka was South Asia’s first to embark on economic liberalisation in 1977 and despite the relatively robust economic performance that resulted even during the war years, Sri Lanka began to move away from international trade and investment.

Starting in 2004 import tariffs were raised in an ad hoc fashion to finance a growing defence budget. By 2009 Sri Lanka had one of the world’s most complex import tax regimes made up of para tariffs, (taxes above custom duties) and customs duties. By 2009 the overall protection more than doubled from 13.4 percent to 27.9 percent. Sri Lanka’s import policies by this time were as protective as they had been 20 years ago. While Sri Lanka continued to miss the boat of economic globalisation our East Asian neighbours such as Vietnam and Thailand have risen to prosperity by successfully integrating with global value chains.

This was compounded by an increase in state spending and increased state involvement in the economy. Much of it is financed by debt. Sri Lanka’s state expenditure has ballooned. Due to excessive borrowing, the central government’s highest recurrent expenditure is on interest payments which were at 36 percent in 2020. The country boasts a bloated public sector. The Ministry of Finance states that 30 percent or the second largest of the central government’s recurrent expenditure is spent on salaries and wages. This amounted to a staggering 794.2 billion in 2020 an increase of 15.7 percent from 2019. The Economy Next reported in June that 86 percent of tax revenue went into salaries and pensions in 2020. Moreover, these salaries are only a part of the problem, much expenditure is wasted sustaining mismanagement, corruption, and negligence within some 527 SOEs whose cumulative losses outweigh profits.

Tax revenues have not kept pace with expenditure and the tax system is weighted towards indirect taxes. In 2020 of the share of Sri Lanka’s tax revenue only 22.1 percent was direct taxes with 77.9 percent being indirect. This is highly regressive as a large component of indirect taxes end up on goods and services consumed by the average Sri Lankan imposing a higher burden on low income earners.

Consecutive government’s reluctance to rectify these economic miscalculations through hard reforms have brought the island to a precarious state of high levels of accumulated debt with exponentially growing interest payments. The country now has a debt to GDP ratio of over 101 percent, while foreign reserves have declined to 2.8 billion- sufficient for less than two months of imports.Fitch ratings have estimated that Sri Lank’s foreign currency debt service obligations until 2026 amount to USD 29 billion. Sri Lanka’s debt is on an unsustainable path.

So what’s at stake for young

people in all this?

Sri Lanka’s youth sit helplessly as bungled policy results in the economy tanking, taking them further away from their aspirations, hopes and dreams. Labour force survey for the fourth quarter (Q4) of 2020 reported a startling youth unemployment (15-25 years) rate of 25.7 percent. In terms of education level, the highest unemployment rate is reported from the GCE A/L and above group. Although the labour force is educated their main source of employment remains in the informal sector. Nevertheless, skills gap and mismatches have been identified as a major obstacle preventing employment. For example, a 2019 survey estimated a shortage of 12,140 ICT graduates.A World Bank study recognised poor English language skills as another impediment.

In addition to this, COVID exacerbated Sri Lanka’s challenge of providing employment. Unemployment as a percentage of the total labour force increased from 4.5 percent to 5.2 percent between 2019 Q4 – 2020 Q4.19 This coupled with the country’s poor economic conditions will lead to more job losses in the coming months.For instance, with banks rationing letters of credit those employed in the import sector are in panic. Additionally, with prices of essential items increasing the demand for other products and services will decline as people are forced to deprive themselves of small luxuries such as ordering a meal from a restaurant to survive.This poses a threat to business operations and employment.

To curb the outflow of dollars the country has resorted to increased import restrictions.These unsustainable policy responses have robbed the Sri Lankan youth of the luxury to dream and to aspire. Purchasing a car and housing are two such aspirations that are slipping through the fingers of the average Sri Lankan. Vehicle Importers Association of Sri Lanka (VIASL) stated that the price of certain vehicles in the local market has increased by around Rs.10 million due to import restrictions.20 A 2017/2018 Wagon R which was sold at Rs.3.5 million is now being sold at Rs.6 million. Those building or repairing houses face difficulty as cement importers have limited the release of cement to the market due to partial suspension of imports and price controls resulting in severe shortages. This coupled with high tariffs on construction material will further contribute to making the construction of a house an illusion to the middle-class Sri Lankan.

Even the escape routes of Sri Lanka are closing. Students aspiring to leave the country for higher education fear banks may not issue dollars to finance their stay. Migrants are unable to take their savings with them meaning they face a much harder start in another country- last month the Central Bank issued a new order under the Foreign Exchange Act declaring limits on migration allowances26. Social media is swamped with infuriated complaints on price hikes and scarcity of essentials such as medicine in midst of a pandemic.

It is safe to conclude that young people have found themselves in a perilous socio economic fabric with looming uncertainty.

To leave or to stay?

If the government is to retain young people they must be provided with indications of stability and hope. Excessive reliance on import restrictions as a policy solution to the foreign exchange crisis at hand exhibits the government’s reluctance to implement painful but necessary reforms. Stability and hope lie in reforms the politicians are resistant to.

Increasing sources of government revenue, re-prioritising government expenditure, limiting intervention, relying on markets and recognizing the vitality of trade in a globalised economy is Sri Lanka’s road to prosperity. It will not be easy or painless, the accumulated policy mistakes of the past two decades require some very hard reforms but it is the only sustainable way out of the current mess.

Sri Lanka faces a serious crisis but it presents an opportunity to learn from the mistakes of the past and to rebuild the island’s institutions along with the hopes and dreams of the young.

Sathya Karunarathne is the Research Analyst at the Advocata Institute and can be contacted at sathya@advocata.org. Learn more about Advocata’s work at www.advocata.org. The opinions expressed are the author’s own views. They may not necessarily reflect the views of the Advocata Institute, or anyone affiliated with the institute.

Avoiding IMF won’t help us avoid austerity

Originally appeared on The Daily FT, Daily Mirror, Lanka Business Online, The Island, ColomboTelegraph

By Naqiya Shiraz and Rehana Thowfeek

Sri Lanka’s debt problems are  a topic of national conversation. Foreign reserves, already low at USD 4bn in May 2021 fell to USD 2.8bn after the most recent bond repayment of USD 1bn in July 2021 . The Government claims that the timely repayment of the bond is proof that doomsayers were wrong and that it indicates a robust economy. Is this correct?

While it is true that a default has been avoided thus far it does not necessarily mean that the economy is sound. The recent bond repayment comes at a cost: a foreign exchange squeeze. Bond holders are being repaid, but this means that foreign exchange that could otherwise have been used for imports are now being used to pay bond holders instead.

The government seems to be adamant in avoiding the bogeyman, the IMF, perhaps to avoid the tough medication an IMF program will bring. Yet avoiding the IMF does not mean we can escape the inevitable austerity that will follow. Austerity is in fact already upon us, in the form of restricted imports. The restrictions are denying essential inputs to the local economy and medicines and food to citizens. These restrictions work   in two ways:

1. The outright restrictions on imports

2. The shortages of foreign exchange in the market

The government has banned or restricted imports of what is termed “non-essential” items although the list includes goods like some clothing items, refrigerators and food items ( live fish, tomatoes for example). 

In addition, Central Bank’s attempts to control the rate of exchange have resulted in shortages of foreign exchange. The Central Bank has decreed an official rate of around 200/- but only limited amounts are being converted at these rates resulting in a shortage of hard currency.

 Banks are now rationing foreign exchange with the result that even items that are not banned are becoming unavailable.

“We cannot accommodate the requests for LCs so we have to ration them,” a banker said. “There is no regulation to say to ration them, but we are forced to do it.”

https://economynext.com/sri-lanka-rupee-forex-markets-in-pickle-as-lc-rationing-froths-83224/

The import restrictions were supposed to be restricted to luxury items but the currency shortage means that even medicine and some food items seem to be running short

While foreign bondholders will undoubtedly be pleased to have been repaid, local consumers and businesses must now suffer, making do without everyday products. The shortages in supply mean that prices rise: of whatever available imported products as well as local products. 

This affects not only consumers but also businesses. With banks being unable to open a Letter of Credit (LC’s), imports of intermediate goods, even exports by SME’s which have no access to BOI facilities are at risk. 

Unable to trade or operate due to lack of stocks or input material, import-dependent businesses are losing out. The net result is an overall decline in economic activity and welfare of all Sri Lankans. 

A person interviewed for this report explained the difficulty in obtaining asthma medication for his mother. He had to try 4 different pharmacies to get the required drugs.  He said that he believes larger stores have fewer stocks available as the volume of people going to them is much higher. 

Another respondent said chemotherapy drugs brought in from Europe were no longer available with only cheaper products from India, Bangladesh or Argentina being available. As he had no other choice he used the substitutes for part of his wife’s chemotherapy treatment but was worried about the quality and safety. 

The knock on effects of these are palpable. Prices of basic goods are increasing. Inflation in January 2019 according to the NCPI was 127 index points which increased to 146 in June 2021. That means prices have increased by 15% in little over two years as a whole. But prices of essential food prices have increased by a lot more. Food inflation particularly has dramatically increased by 25% (NCPI). According to the Advocata Institute’s Buth Curry Indicator, prices of food that would be consumed in a buth curry meal have increased by 45% from July 2020 to July 2021.

The effects don’t end there. Importers of seeds were complaining that their sales have dropped by 50% because of uncertainty over fertiliser imports. These importers bring in seeds that are not produced in Sri Lanka, for vegetables like beetroot and carrots. Sales have fallen as they are not being purchased by domestic farmers. Farmers are holding back from cultivating due to the uncertainty caused by the shortages of fertilizers needed for production. A consequence of this would be shortages and rising prices of fruits, vegetables and other produce in the coming months. This will not only affect farmers' incomes but also result in higher consumer prices. The government may have to resort to importing more food, thereby negating the impact of the fertilizer ban to begin with. Only recently, the cabinet approved the importation of 6000 metric tonnes of rice from Pakistan to manage the shortage in the market.

This fertiliser fiasco has affected the poor disproportionately. Larger businesses are able to stock up on fertilizer, but not everyone can afford to do that. It’s the small farmers that lose out on income. The incomes of these small farmers are in jeopardy. Coupled with the milk powder and gas shortage, prices of these essential commodities are forced to increase at an already difficult time. 

Economic policy affects the ordinary person in a society. These may be individual stories but they are certainly not one off situations. 

The fact of the matter is that the country is undergoing a self-imposed austerity program in the form of import restrictions and more recently a foreign currency shortage that has resulted in the rationing of even items that are not subject to control.  

The basic principles of economics cannot be ignored in policymaking. By avoiding the IMF for fear of austerity measures, has resulted in more damaging self-imposed austerity. We need to ask ourselves how sustainable this really is in the long term. The longer we wait, more stringent austerity measures will be needed. 

Rehana Thowfeek is an economics researcher by profession. She has a MSc in Economics from the University of Warwick and a BSc in Mathematics and Economics from the University of London. She has worked previously for Sri Lanka-based think tanks; Verité Research and the Institute for Health Policy. At present she works for a US-based food technology company as a researcher. Naqiya Shiraz is the Research Analyst at the Advocata Institute and can be contacted at naqiya@advocata.org.

We too might lose everything

Originally appeared on The Morning

By Dhananath Fernando

I have a friend in Afghanistan. I met him about five years ago. He has been telling me how beautiful and resourceful Afghanistan is. After seeing the tragic stories in the media, I quickly reached out to him over email and checked his family’s wellbeing. He responded in just three words: “I lost everything.” His three-word response powerfully described the magnitude of what a crisis could look like.

Not only Afghanistan, Sri Lanka is also in a crisis. I have highlighted the enormity of our crisis through this column on many occasions. Many prominent economists have also alerted the subsequent governments on the same issue. Unfortunately, nothing has been done other than implementing short-term solutions. Our crisis can also lead us to Afghanistan’s predicament. “We will lose everything”, if we continue to go down this path.

It is not only terrorist activities or natural disasters that could lead to the loss of everything. An economic crisis can also pave the way to losing all our hard-earned money and dreams. Recovering from a crisis is not easy for a country like Sri Lanka, especially in the middle of a global pandemic. That is one reason why many experts have voiced the need to avoid such a crisis. Recovery is a difficult, long and painful process.

What we experience currently are signs of a potential economic crisis. People are already feeling the difficulties and it has been just overshadowed by the Delta variant. In simple words, like my friend in Afghanistan said, we are all at the risk of losing a significant amount of our wealth. Undoubtedly, the poor will be the most affected. Unlike during the 1970-1977 period, there is much to lose for people in a modern-day society with more complicated needs and wants. As well as huge debts of the private sector with multi-storey buildings, which may not be easily rented to pay off debts incurred for construction.

Shortages of some essential drugs have been reported. Minister of Energy Udaya Gammanpila urged the public to use the fossil fuel economy to save the foreign exchange for the importation of medicine and vaccines. Fuel imports are estimated to be about 25% of our import bill, according to the Minister’s statement. If this trend continues, it is likely that the Government will have to ration diesel and petrol. This will create a series of repercussions on people’s day-to-day living at unimaginable levels.

The existing USD crisis has already rationed the opening of Letters of Credit (LCs) and supply chains are already shrinking. The impact of this is that businesses will downsize or wind up and many people will lose their jobs. Our exports will drop and local suppliers of export business will face significant knock on effects.

Lower income and higher unemployment are breeding grounds for many illegal activities and extremist ideas to take root. Sri Lanka already has tension between different ethnic and religious groups. The eruption of one of these activities is the path for all of us to “lose everything we have”.

There are few notable events that took place over the last week which would provide an indication of the gravity of the crisis we are in.

At the time this article was written, a big conversation making rounds on social media was about the difficulties in proceeding with online payments in foreign currency, even for small amounts such as online subscriptions for digital platforms. Some banks have already announced an additional interest rate for USD payments. It is natural for banks to stop online payment as they have to prioritise their long-standing customers who need foreign exchange for their import and export businesses. At the same time, such actions will have a serious negative impact on all our online businesses and the digital economy.

In the meantime, the Central Bank increased the Standard Statutory Ratio (SRR) to 4% from 2%. This simply means that licensed commercial banks have to deposit Rs. 4 at the Central Bank for every Rs. 100 of savings they get, instead of the Rs. 2 rupees earlier. The impact would be that the banking system will have less money to lend for their customers, as they now have to deposit more money at the Central Bank. Also, the interest rates – both the Standing Lending Facility Rate (SLFR) and Standing Deposit Facility Rate – have increased by 50 basis points each to 5% and 6%, respectively. The outcome would be that this will incentivise people to deposit more money, spend less, and borrow less money with interest rates going upwards. However, this is taking place in a backdrop where low interest rates were leading to high demand for credit, which spills on to balance of payments.

We also received the first tranche of $ 50 million tranche of the Bangladesh swap facility of $ 250 million and our reserves are at a record low after settling nearly a $ 1 billion bullet payment last month. Avoiding going to traditional sources of credit like India, Malaysia, or Singapore shows the desperation of Sri Lanka.

The Sri Lankan rupee depreciated to 22-228 in kerb markets; prices have already been increased in some bakery products and the cost of living will go up, making people more poor.

In situations of this nature, it is natural for people to consider leaving the country, and what we saw in Afghanistan was one dimension of how humans react to such situations. The inability to do business, consume what we want, restrictions on the economy, or in simple words economic freedom, matter most to the people. When people realise their freedom, mainly in the economy, is shrinking in any form, they feel they are losing what they have and that the wealth they earned through years of hard work is starting to diminish.

So the obvious choice is to look for better places with freedom, respect, and dignity to start life over. Our dreams of a high-quality life are shrinking everyday and Covid-19 is just accelerating it. So like Afghanistan, Sri Lanka too is drifting towards an unprecedented economic crisis.

Solutions

There is no other solution than market-oriented reforms. Markets must be allowed to work and prices should indicate the scarcity of our resources. Before all that, we first need to have a credible plan on what we intend to do. With a credible plan, we can move towards action and raise money to keep our nose just above the water. When we have a plan, we can decide whether we want the IMF (International Monetary Fund) or someone else. But even without a plan, no one else can help or assist us to overcome the situation. However, the times are getting difficult and the clock is ticking faster. Before we lose all that we have, we need to fight back together in these difficult times which are about to come.

The opinions expressed are the author’s own views. They may not necessarily reflect the views of the Advocata Institute or anyone affiliated with the institute.

Markets: We can’t see them, but they exist

Originally appeared on The Morning

By Dhananath Fernando

When I was a kid, my father used to share stories about heroes, science, literature, and many more. I still remember the day he shared the story of Sir Issac Newton’s famous story of an apple falling from a tree, which made him think more and discovered the theory of gravitational forces. I wasn’t very impressed with the story. I questioned back as a kid: “If there is a force, why can’t we see it. Can’t we avoid gravity during the night? How can gravity act on a water surface and how can water flow if there is gravity?”

Later I realised, just because we can’t see it, that does not mean it doesn’t exist. It was because as a kid I simply did not understand the concept of gravity. The concept of “markets” is the same. It’s there and we all are part of it. When markets work well, we do not feel the existence of it. We only feel the existence of markets when we try to intervene in markets.

The current milk powder shortage and long lines to buy LP gas is a classic case of market interventions. While we have long lines for LP gas and milk powder, there are no lines to buy shampoo or soap or similar household products. In both cases, the market exists, but we just don’t see it.

Milk powder shortage

In the case of milk powder, supermarkets have rationed the quantity that can be purchased and most of the milk powder shelves are empty. There are many sides to the story. One side is that milk powder is not good for health, so we should move to liquid milk. There is further argument that Sri Lanka has to be self-sufficient in milk and produce all the milk it requires. As a result, Sri Lanka has always imposed high tariffs on powdered milk as well as imported milk, as high as 33.1%, as per the previous tariff calculations. This has been carried out with the objective of promoting local milk farmers and industry.

In Sri Lanka, there is a conspiracy theory for anything. The conspiracy theory is that milk powder companies create artificial shortages to cause inconvenience for the government and promote milk powder.

When we look at data and numbers, however, the story is different and it is multidimensional. First, global milk powder prices have been increasing significantly over the past few years. Since most of the milk powder is imported, when the global prices are increasing and when our currency is depreciating, there is no alternative to keeping prices constant. However, the Government and it’s main price regulating body, the Consumer Affairs Authority (CAA), are not allowing price increases by milk powder companies. They have at present imposed a price control – if you visit their website, the price controls can be seen.

Different brands and different pack sizes have specified prices. However, when global prices continue to increase constantly at one point, milk powder companies will reach a point where the losses of selling one pack of milk powder exceeds the loss of not selling a packet of milk powder at all.

At that point, obviously, the supply will be curtailed by the companies as no company can survive by making losses. So in a market system, the shortages start taking place. The long lines or shortages of any product category is the outcome of the market intervention in the form of price controls. (Source: https://www.globaldairytrade.info/en/product-results/)

This is basic economics which this column has explained many times.

The second argument is on the health concerns of milk powder. Many people are confused about why people do not consume liquid milk regardless of much propaganda by certain trade union groups and ideological groups.

The answer again lies in economics. In Sri Lanka, the domestic liquid milk demand is at about 700 million litres per annum, whereas our production is only 374 million litres per annum. Obviously, the balance has to be matched if we cannot produce it. On the flip side, our milk production is extremely unproductive. The average production by a milking cow is about 4.3 litres per day, whereas the world average is about 28 litres per day. In some countries like Israel, the productivity is about 40 litres per milking cow per day. Obviously, our productivity is very low to match the demand and we have been protecting the inefficiencies in the milk industry by imposing high tariff rates as high as 33.1%, as per the previous tariff calculations on milk-related products in importation.

When the global prices move up and when our currency is depreciating, when banks are going through a hard time to provide foreign exchange for importations, there is no way we can keep our prices constant in the milk powder market.

Only if we allow the prices to move up will the people who value milk powder at those prices will buy it, and there will be an incentive for other alternatives for milk powder to enter the market. So people can decide what they want and shift to alternatives. Even the promoters of liquid milk should now support a move to raise the prices of powdered milk, so that there is an incentive for increasing the supply of liquid milk in the market.

The case of LP gas

The liquefied petroleum (LP) gas market follows similar dimensions. Global gas prices have increased rapidly along with crude oil prices, and Sri Lanka has only two players. One is the government-owned operator and the other is the private sector operator. Private sector local businessmen cannot increase prices and they cannot import due to the US dollar shortage in the country. When we only have two players in the market and when one player is going out of the market due to price controls and US dollar shortages, the markets react naturally. It reacts in ways such as shortages, hoarding, or people who are storing more than what they want for future usage/panic-buying. So naturally, products will start disappearing at an accelerated rate. (Source: Saudi Aramco LPG prices per metric tonne)

The prices should move up and there is no doubt it would burden people with an increasing cost of living. But having long lines and making people inconvenienced during a global pandemic would cause more harm than a rise in the cost of living. As a result, the Government has finally decided to let the prices go up by Rs. 386 for the private sector player, but the actual value will be determined by the market.

Markets work whether we like it or not. Thinking that we can oversmart markets by price controls and regulations is no different to a man who tries to avoid gravity without realising the entire concept in the first place.

The opinions expressed are the author’s own views. They may not necessarily reflect the views of the Advocata Institute or anyone affiliated with the institute.

Hanky-panky under the blanket

Originally appeared on The Morning

By Dhananath Fernando

Who benefits from the licensing systems that come about with our blanket bans?

Recently I was thinking about why people do certain things and why they don’t. I realised there are things that have been banned but still, people do. Consumption of certain types of drugs is just an example. At the same time, there are things that are not banned,  but still, some people don’t use them. Smoking is a good example. It’s not banned but data shows that people are now less likely to smoke due to health reasons. Analysing human behaviour shows us that there are reasons to engage in some activities while reasons to avoid them. Undoubtedly knowledge, information, and many other factors influence and incentivise certain actions over others. However, there are certain activities, where the Government decides on behalf of the people, that such are either good or bad for the broader population and try to control the choices of people. Our ban on chemical fertiliser is one such instance out of many. 

Another round of discussions has erupted over whether the fertiliser ban is relaxed or not. In a recent statement, the Government reiterated that there are no changes in their policy announced earlier. This trend of banning product categories on the grounds that it is not good for society has been common over the past few years. Then-President Maithripala Sirisena proposed a ban on chainsaws and carpentry sheds as an attempt to protect forests. Another proposal was to ban glyphosate to maintain our soil structure and avoid unknown kidney diseases. Then recently another development was the banning of sachet packets, banning the importation of palm oil, numerous discussions to ban cattle slaughter, and now the blanket ban on the use and importation of chemical fertiliser. 

Whether these decisions were made based on grounds of scientific analysis or analysing data and economic principles, remains a serious question. These recent decisions will have serious consequences on economic activity, especially in the import sector. A key point to note is that these outright blanket bans have led to the proposition of issuing a license for the importation of the particular product category. 

Many policymakers as well as common Sri Lankans lack an understanding of the negative consequences of licensing. Having a licensing process, for example, to import chemical fertiliser will lead to an increase in prices, open avenues for corruption and bribery, activate informal black market activity, and allow inferior quality products to enter the market. This cost of maintaining a licensing regime will have to be borne by the general public. 

Any Sri Lankan who has attempted the construction of a house or shop or wall has to go through a process of getting the plan approved by the technical officer at the Local Government. It is a license or an approval that allows any individual to build any construction. Those who have gone through the system know how painful the process is. In the first place, meeting the technical officer is not easy. Secondly, regardless of how compliant the draft was, he/ she always has suggestions and changes. As a result many common people hand over the drafting process of the building to the technical officer himself so he can approve it. 

The economics behind this is that when anyone has an authoritative power to decide the “go” or “no-go” of a project the person who has the decision making power is naturally motivated to capitalise an incentive over the approval. On the other hand the person who wants approval is getting naturally motivated to incentivise the decision maker to provide the approval even compromising the quality and standard. The same dynamics work in every licensing process, including the licensing of imports. Examples of the licensing processes include the exercise department for alcohol shops, Sri Lanka Customs, passport office, driving license and Registry of Motor Vehicles (RMV). 

When we first impose a ban and secondly issue a licensing system it is a double whammy to the economy. By creating a blanket ban we are creating a scarcity of resources which is in demand. Then by issuing a licence we are making the utilisation of that scarce resource unproductive. Simply, the more we keep the discretionary authority the more we leave room for corruption and inefficiency. Secondly, the immediate  implementation of a licensing process can lead to increased scarcity, where fewer goods are available relative to the population. Therefore there can be market shortages putting thousands of people into hardship and inconvenience. Unfortunately in Sri Lanka’s case these interventions and restrictions have come into place when the market system was working perfectly well, especially for the benefit of the general consumer. This therefore needs much thought and reflection. 

If the intentions behind imposing a ban on a certain product category are correct, then logically, there cannot be a justifiable reason to allow a few people to import the particular product, especially if the product is harmful for human consumption in the first place. 

As an example, if palm oil is carcinogenic, the cancer-causing ability doesn’t disappear just because few people are importing it. Instead it could be higher as now the market system is completely broken down as a result of the ban and as a result of the license only a few players are able to import any substandard products due to the limited competition. Secondly, when a licensing system is in place it allows close associates and people connected with authority to be issued with licenses, reaping benefits at the cost of the general public. The flip side is that  these licenses are issued not on a competitive basis. So the room for the political authority to share profits with a person who is getting a licence is higher than operating in a competitive environment. 

In a market where different players compete to supply a product, the general consumer will benefit from lower prices. Now as a result of a license raj the majority will be made worse off as a few players connected to the political authority can keep prices higher.  

Allowing a few people to import essential compounds and organic fertiliser is not different in my view. This will end up in few people controlling the entire market causing very high prices for the farmers which will end up in very high prices on food for common people. 

Additionally, the politicians who would back the licensing process will defend the same importers of suppliers in any case of any malpractice or importation of any substandard products.  

Just like I thought about why some people do certain things while others don’t, there are reasons why politicians prefer licensing. Simply the licensing process incentivises them and that is why they push for it regardless of the colour of the political flags they host. The current trend of setting up a licence raj which India had until the 1991 reforms and which were experimented in Sri Lanka in the 1970s is the surest way of making our entire country unproductive. 

However the ultimate loser of this game is the consumer and the farmer. Overall, Sri Lanka will lose while few politicians get some short term gains and the entire ecosystem feels the effects of instability. 

The opinions expressed are the author’s own views. They may not necessarily reflect the views of the Advocata Institute or anyone affiliated with the institute.

To get rich, reward the hardworking

Originally appeared on The Morning

By Dhananath Fernando

Market-oriented policy reforms needed

Bill Gates famously said: “If you are born poor it’s not your mistake, but if you die poor it’s your mistake.” I believe this statement is quite apt if applied to Sri Lanka’s economy. Our recent economic trajectory shows a deep struggle to maintain economic growth and reduce poverty. We also don’t have a strong record of building prosperity for Sri Lanka since Independence.

The reasons and solutions have been discussed consistently by many experts, most often analysed and even over-analysed. Some policymakers understand the problem but fail to implement solutions, while some neither comprehend nor implement known programmes. In worst cases, some fail to comprehend but instead implement policies that worsen the situation. Sri Lanka’s post-Independence failure is a result of a combination of the above scenarios. It is a sequence of half-hearted attempts for much-needed reforms.

Sri Lanka is reaching a crucial juncture in its history; of having to pay for the country’s past mistakes and struggling to keep up with global developments yet again. On a more optimistic note, this presents Sri Lanka with the opportunity to understand the pressing need and importance of implementing much-needed economic reforms. However, to much of our dismay, the current political discussion is solely concentrated on evaluating the symptoms of the problem and not on accelerating the process of implementing the solutions we desperately need.

There has always been a debate on the rankings provided by different rating agencies on our dwindling foreign reserves. Some argue that our little island nation can survive the current foreign debt crisis, given our cash inflow and outflow numbers. Others present the case on Sri Lanka’s poor debt management.

The policy discussion needs to move beyond this and expand its scope to discuss solutions. The most practical short-term solution available to Sri Lanka right now is to seek the International Monetary Fund’s (IMF’s) assistance. However, this is not to be confused with a “be-all and end-all” solution, as it is only a painkiller to provide temporary relief from the agony the country’s economy is in at the moment. Working with the IMF will give us the credibility needed to convince the rating agencies that we are serious about addressing our macroeconomic problems, slow growth, high debt, and twin deficits in the fiscal accounts and the Balance of Payments.

However, it is time Sri Lanka addresses the million-dollar question we’ve been avoiding for decades – the need to implement hard economic reforms. Today’s column discusses the desperate need for reforms from a market-oriented perspective.

Sri Lankan society can be broadly divided into four main subsections on a matrix of “working hard” and “getting wealthy/successful”. Getting wealthy or successful can be loosely defined as earning in proportion to the effort put in/risk they take.

Below are the four subsections that Sri Lankan society can be divided into:

1. Individuals who work hard and become prosperous

2. Individuals who work hard but don’t become prosperous

3. Individuals who do not work hard but become prosperous

4. Individuals who do not work hard and and do not become prosperous

If Sri Lanka wants to avoid the mistake of dying poor, Sri Lankans must work harder. Hard work takes place when the incentive structure works and people get rewarded for their hard work and the risks they take. That can only be done through the market. The market system allows prices to work. It’s not only a profit-making system but a profit and loss signalling system. This encourages people to utilise resources optimally.

It is vital that we allow the market to function independently if we are to fix the economic crisis at hand. Its proper function will ensure the prosperity of all Sri Lankans.

The more we delay reforms and preoccupy ourselves debating and evaluating the symptoms of the problem, the further away we get from the opportunity of setting the price mechanism right. This allows the sustenance of a system that rewards the non-hardworking over the hardworking. This will only encourage the latter to seek opportunities and prosperity outside of Sri Lanka.

While cartels and market manipulators thrive, the average Sri Lankan suffers from excessive regulations and red tape. Most micro, small, and medium enterprises (MSMEs) struggle to keep their heads above water. Their productivity is hampered with no return or reward for their hard work. The more we strengthen the cartels and market manipulators, the more we discourage the hard-working Sri Lankan. 

The quadrant of not becoming prosperous and not working hard could be a personal choice, but most often, when the incentive structures are not in place, people have no impetus to do the hard work. That is why our reforms have to be focused on improving competition and price mechanisms, as it would encourage people to work harder. 

Sadly, the policy discussion is not one of the myriad solutions we can adopt. It is solely concentrated on our short-term ability to pay our creditors.

If Sri Lanka intends on getting rich, the solution lies in market-based reforms.

The opinions expressed are the author’s own views. They may not necessarily reflect the views of the Advocata Institute or anyone affiliated with the institute.

Show me the money: a magic trick waiting to backfire

Originally appeared on The Morning

By Dhananath Fernando

Will the new tax amnesty really help us in the long run?

This is the humorous storyline of a video I watched some time ago by the famous Sinhala comedian duo “Podi malli and Chooti malli”. A father was very worried that his little son had swallowed a two rupee coin. The son and father struggled to get rid of the coin. Then the father patted the son’s back and asked him to vomit, but he couldn’t. 

A gentleman passing by saw this entire incident, and asked: “Can I help you?” Helpless, the father allowed him to take control of the situation. The stranger glared at the son and ordered him to give him the two rupee coin. Suddenly, the son threw up the two rupee coin. 

The father was very happy and surprised. He asked the stranger: “How did you do it and where do you work? Are you a doctor?” The stranger replied: “No, I work for the Inland Revenue Department”. 

This story is definitely not to underestimate our inland revenue officers. But given the proposed Tax Amnesty Bill, this discussion has come back into the limelight. It is not a secret that most current and retired Inland Revenue officers are taken care of by the payroll from small, medium, and even some large corporations, as tax advisors who always find smart ways to go through existing tax laws. So what are the pros and cons of the Tax Amnesty Bill and what would be the aftermath of the proposed Bill? 

The proposed Tax Amnesty Bill provides a wide range of benefits for tax evaders who haven’t abided by tax law. Accordingly, they can pay just a 1% nominal tax and disclose taxable income or assets, and become a legal taxpayer. 

On the plus side, the expectation of the Government is to increase its revenue, which is now required to finance government expenditure, given the extremely tight fiscal situation of our balance sheet. The Government expects to increase the tax base by providing this tax amnesty, and then improve government revenue in the coming years.

Secondly, the Government requires a sudden cash inflow to our economy to manage the expenditure on the fiscal side and a US dollar inflow to manage trade and our mounting debt repayments.

However, if we look at history, in 2002/2003, then-Finance Minister K.N. Choksy proposed a similar tax amnesty, which was reversed in 2004 again.

In recent history, on 2 April 2020, the current Governor of the Central Bank appealed to domestic and international well-wishers on behalf of the Sri Lankan Government to deposit foreign exchange into Sri Lankan banks, with an assurance that no questions would be asked on the financial trail of the funds. In the appeal, the Governor of the Central Bank mentioned that the money would be accepted without any hindrance from the Central Bank and the banking system, and would be exempt from exchange control regulations and taxes for three months from 2 April 2020 onwards. This request was made when our foreign currency earnings came to a standstill with the Covid lockdown last year. However, this did not bring the expected results. 

After spending more than one year without any sustainable solution, we are now back to square one with a similar proposal. In my opinion, this would further generate negative signals to our markets and international donors on multiple aspects. 

In the first place, no tax hikes or tax amnesties will work without a significant expenditure cut. Markets work based on information and signals. When we spend about $ 50 million on buying fighter jets, and when there was a heated discussion on parliamentarians importing duty-free vehicles, the signal system does not work right when we bring about revenue collection proposals. Simply put, markets won’t adjust, and people will not be willing to fasten their seatbelts.

During the pandemic, many companies had announced salary cuts, and the CEO was first to take the salary cut, at a higher percentage, before announcing salary cuts for staff and factory workers. Otherwise – it is not rocket science – resentment and resistance would build within. It may be only a little money we would save from a 15% salary cut for a CEO, opposed to the total savings from 10% Salary cuts for 2,000 workers. But the message has to be right – the policy is moving towards a purpose and the leadership is walking the talk. 

Secondly, on the market front, this move to grant amnesty would first discourage and discriminate against genuine taxpayers. It is true that there are only very few tax files opened in Sri Lanka, but the people who have made an effort to pay tax would be now thinking: “What is the point? Why do I pay taxes while the evaders get an amnesty?” 

This sentiment would have long term implications on eroding our tax revenue further. This would be a double-whammy if we do not get enough tax evaders joining the proposed scheme, because then we have given the wrong signals to the market. In this case, even genuine taxpayers will be discouraged, while at the same time we fail to collect adequate revenue from the tax amnesty.

Thirdly, though the Government has provided assurances that the information would be kept secret, even tax evaders are aware of the absence of proper institutions and transparency measures making it hard to assure confidentiality. This would increase the risk of getting the tax evaders exposed to certain corrupt politicians and causing future problems in terms of bribery to keep their names under the radar. 

Finally, and very importantly, the announced Tax Amnesty Bill and the recent announcement by the Central Bank Governor will again expose Sri Lanka to the grey list of the Financial Action Task Force (FATF), which Sri Lanka was delisted from only in 2019 October. The FATF is the global policy setter on anti-money laundering and countering the financing of terrorism. 

A delisting from the FATF grey list is a positive indication to the market to attract quality investments that look for a credible financial system. The delisting from the grey list was achieved through hard work by the Central Bank and its officials. So they should be the first to stand up against the threat of losing it again. 

At the same time, we have to be vigilant to not breach the codes of conduct and ethical guidelines of international donor agencies, as there is a high possibility of Sri Lanka having to knock on their door as a fallback option. 

So there is simply no magic formula for us like the story of the comedic duo, to just throw up the coins people have swallowed. It has to start from consolidating our expenditure and giving the right signals to the market if we are serious about raising government revenue. Otherwise, by trying to provide tax amnesties and implement unorthodox methods, we would only end up further exposed to unexpected risks.

The opinions expressed are the author’s own views. They may not necessarily reflect the views of the Advocata Institute or anyone affiliated with the institute.

Prof Colombage: Tax Amnesty Bill: A quick fix for budget gap?

Originally appeared on The Daily FT

By Prof. Sirimevan Colombage

Tax amnesties have the potential to encourage corruption and money laundering. They could weaken law enforcement in such grey areas, as income tax officers are prohibited to investigate the perpetrators of white-collar crimes who benefit from tax amnesties

The Ministry of Finance gazetted the Tax Amnesty Bill on 12 July in order to provide relief to tax defaulters who are prepared to voluntarily disclose their undisclosed taxable income or assets, against liability from investigation, prosecution and penalties under specified laws.

This Bill is introduced in the backdrop of the Government’s annual revenue loss of over Rs. 500 billion caused by the haphazard tax cuts implemented in 2020. The resulting budget deficit is largely funded by borrowings from the Central Bank and commercial banks, falling in line with the dubious Modern Monetary Theory (MMT), as explained in my last week’s FT column.

Tax Amnesty Bill

The new Tax Amnesty Bill provides a wide range of reliefs to tax evaders who had failed to disclose any taxable income or assets before March 2020. 

These reliefs include writing off penalties and interest, and permitting to invest the undisclosed taxable assets in financial instruments such as shares of a resident company, Treasury bills and bonds, debt securities issued by a company or to buy movable or immovable property in Sri Lanka. This facility will be effective after the commencement of the Act until 31 December 2021. The voluntary disclosures are subject to 1% nominal tax. 

Under the Bill, the Commissioner-General of Inland Revenue and other officers in the Department are bound to preserve absolute secrecy of the declarant’s identity and the content of the declaration. 

Benefits of tax amnesties debatable

Tax amnesties are used in developed and developing countries around the world to raise revenue collection and to improve tax compliance. In Sri Lanka, several tax amnesty laws were implemented beginning from 1964. 

While tax amnesties might serve as a quick fix to raise tax revenue during a fiscal crisis, their effectiveness in generating higher revenues in the medium and long term is found to be doubtful, as evident from the past experiences of tax amnesties operated in Sri Lanka and other countries. 

Tax amnesties have the potential to encourage corruption and money laundering. They could weaken law enforcement in such grey areas, as income tax officers are prohibited to investigate the perpetrators of white-collar crimes who benefit from tax amnesties. 

Investment attracted through a tax amnesty might leak out from the country once the tax evaders who made such investments decide to leave the financial market after cleaning their black money. Such tendencies would have adverse effects on the country’s money and capital markets.

 Types of tax amnesties

The word amnesty is originated from the Greek word ‘amnestia’. A tax amnesty can be defined as a package of concessions offered by a government to a specified group of taxpayers to exempt them from tax liability (including penalties and interest) relating to a previous period, and to relieve them from legal prosecution. Thus, tax amnesties usually involve both financial and legal concessions. 

Tax amnesties can be designed to cover all taxpayers, broad categories of tax payers (e.g. small taxpayers) or certain tax types (e.g. corporate income tax, personal income tax).

Objectives of tax amnesties

The fiscal authorities implementing a tax amnesty usually view it as an efficient tool to raise government tax revenue in both short and medium terms. In the short-term, amnesties can generate additional revenue from tax evaders. Such extra income in the short-term is most welcome during periods when a government faces a severe budget crisis due to revenue shortfalls and expenditure overruns, as in the case of the fiscal pressures faced by the Sri Lankan Government at present. 

In the medium term, a successful tax amnesty is expected to widen the tax base by bringing tax evaders into the tax net, and thereby to improve tax compliance.

Some tax amnesty measures have a wider scope than immediate revenue and tax compliance motives, aimed at broader objectives such as improving capital inflows and domestic investment. The new Tax Amnesty Bill falls into this category, as it provides facilities for tax invaders to invest in financial instruments, in addition to tax reliefs. 

 Tax amnesty inadequate to recover revenue losses 

Following the victory of the Presidential election in November 2019, the newly formed Government took steps to revise the Inland Revenue Act so as to provide a wide range of concessions to taxpayers, without considering their adverse consequences on fiscal and monetary stability. 

Accordingly, tax concessions were offered with respect to personal income tax rates, tax-free thresholds and tax slabs. Also, Pay-As-You-Earn (PAYE) tax on employment receipts, withholding Tax and Economic Service Charge were removed. Downward revisions were made to the Value Added Tax and Nation Building Tax to stimulate business activities.

As a result of those tax cuts, the total tax revenue fell by Rs. 518 billion from Rs. 1,735 billion in 2019 to Rs. 1,217 billion in 2020. This amounted to a loss of almost one third of the total tax revenue. It resulted in an expansion of the budget deficit by Rs. 229 billion from Rs. 1,439 billion in 2019 to Rs. 1,668 billion in 2020. Thus, the budget deficit rose from 9.6% of GDP in 2019 to 11.1% in 2020.

Income tax revenue alone fell by a whopping Rs. 160 billion from Rs. 428 billion in 2019 to Rs. 268 billion in 2020 due to the tax cuts. Such revenue loss cannot be recovered by the proposed tax amnesty. Even optimistically assuming a 10% increase in income tax revenue following this tax amnesty, the additional revenue generated would be only Rs. 43 billion, which is hardly sufficient to compensate for the policy-driven revenue loss.  

Tax amnesty discriminates against honest taxpayers

The short-term revenue mobilisation, which is often considered as the main benefit of tax amnesties, may be offset by various other factors. In particular, taxpayer compliance may decline after the amnesty due to the loss of credibility of the tax administration. The reason is that tax amnesty could be viewed as a weakness of tax administration. The regular taxpayers might see tax amnesty as a penalty for them and a reward for tax defaulters. 

Hence, an amnesty may create disincentive in the form of moral hazard among law abiding tax payers not to pay taxes. If people expect further rounds of tax amnesties in the future, then they will feel tax evasion would be profitable. As a result, the number of tax evaders will rise causing deterioration of tax compliance. 

Repeated tax amnesties would result in revenue losses due to reduced compliance. This might lead to a vicious circle which would necessitate more and more generous and frequent tax amnesties to widen the tax net.

 Costs of tax amnesty offset benefits

The direct cost of administering the amnesty, which includes administrative resources and advertising, might offset the additional revenue collected through the amnesty. Also, the foregone tax revenue on account of waived penalties and interest levies might be quite high. Hence, the net benefit of tax amnesty would be marginal, if not negative. 

 Policy alternatives

Notwithstanding the benefits of tax amnesties, there are various other alternative policy strategies that can be used to enhance revenue mobilisation in both the short and medium terms. In contrast to tax amnesties, such alternative strategies are geared to deal with the root cause of the fiscal gap, namely weak tax compliance. 

In general, low tax compliance is due to (a) weak tax administration, (2) weak legal system or enforcement of the law, and (c) poor tax policy characterised by complexities, regressive taxes and high taxes. 

Abandoned tax reforms under EFF

The above-mentioned weaknesses have been prevalent in the tax system of Sri Lanka for many decades. An attempt was made to overcome such weaknesses through the tax reforms that were to be implemented under the now abandoned Extended Fund Facility (EFF) arrangement with the International Monetary Fund (IMF) for the period, 2016-2019. 

Accordingly, administrative improvements were initiated in the Inland Revenue Department (IRD) and Customs Department. The new Inland Revenue Act was launched in 2018, and IRD continued its outreach strategy to ensure that the new tax rules and incentives are clearly understood by taxpayers. 

Specific improvements in electronic database and surveillance systems were introduced to enhance income tax and Value Added Tax (VAT) revenue mobilisation. Steps were also to be taken to enhance capacity building in IRD including training programmes for the staff.  Most of such tax reforms were abandoned due to the suspension of the EFF prematurely in 2019.

Low tax compliance could be better addressed by such far-reaching improvements in tax administration, rather than favouring corrupt tax defaulters vis-à-vis law-abiding taxpayers through tax amnesties. It is widely recognised that tax amnesties could induce corruption and money laundering. 

Therefore, tax reforms that go beyond tax amnesties are essential to overcome the structural weaknesses of Sri Lanka’s tax policy and administration.

(Prof. Sirimevan Colombage is Emeritus Professor in Economics at the Open University of Sri Lanka and Senior Visiting Fellow of the Advocata Institute. He is a former Director of Statistics of the Central Bank of Sri Lanka, and reachable through sscol@ou.ac.lk)

Coming out a winner

Originally appeared on The Morning

By Dhananath Fernando

Can the Finance Minister come out on top of this crisis?

There are winners and losers for every crisis. The new Finance Minister can definitely be a winner if he understands the problem and tackles the economic crisis upfront. He can become a success story if he does the right thing at the right time. Kumar Sangakkara in his Colin Cowdrey lecture said “In cricket, timing is everything”. It is the same for an economy. Sri Lanka is at the doorstep of an unprecedented economic crisis since independence. Both the Government and opposition have expressed views on this matter. However, if we fail to act now and make the right decisions, it is most likely that the crisis will fail us fair and square. 

So today I am looking at discussing the possible solutions the new Finance Minister has at hand to overcome the situation. 

First, we have to understand that we are already in a crisis. Importers and exporters are having obvious difficulties opening letters of credit (LCs) and people are buying gold to reduce the impact of currency depreciation and inflation on their money. Under these circumstances there is very little rationale in creating a picture that things are rosy. Our supply chains are also under severe turbulence due to adhoc Government interventions. This is further affecting our export capabilities. In our debt servicing, we have resorted to borrowing more with short term liquidity tools such as swaps and short term borrowings to repay our creditors. 

Understanding the problem 

As this column always highlighted, our economic problems are beyond debt serving and opening LCs. Those are just symptoms of the problem. Our economy is like a diabetic patient who has been living on high sugar with no exercise with a bad lifestyle for more than a few decades. Now the patient is in a coma and completely unconscious. This is a serious situation where we need some strong medication and a lifestyle change. Just a few pills of Vitamin C is not going to be sufficient to bring the patient back to some sort of normalcy. 

The patient is diabetic because of a high inflow of sugar. Similarly, our economy is in the present crisis because of excessive Government expenditure on non-available resources. Simply, we do not have money to pay approximately 1.5 million Government workers, run an airline which costs about Rs. 24 billion just for four months which is almost half of our Samurdhi allocation for the year. We further do not have resources to run a petroleum corporation with losses of more than Rs. 100 billion, while continuing to depend on subsidised prices. Comparatively, the losses of the CPC are twice as high as our Samurdhi allocation which is an essential safety net for the country. 

Secondly, we do not have the right institutions to manage economic governance. For example the debt numbers are parked all over SOEs (State Owned Enterprises). Such is the cost of mismanagement. 

Thirdly, our economy is significantly unproductive. All our factor markets (Labour, Land, Capital) are completely inefficient with excessive regulation and protectionism coupled with rent seeking. As a result, in most industries our incentive structures are largely inefficient. Just take our judicial system. All stakeholders are incentivised to postpone the cases rather than reaching resolution quickly. Across other sectors the situation is the same or worse. 

Short-term solutions 

Like with the diabetic patient who is in a coma, in order to become better there has to be a  lifestyle change. However before all that the patient has to be given immediate care to come out of the coma. This involves hospitalised care and the immediate medical treatment in order for the patient to be properly conscious. It is the same with our economy. At present no one is willing to lend us money as we haven’t proved that we are good for our money. Markets are not lending to us. Even the countries we have good relationships with and our decades-old international organisations are requesting some sort of an assurance to work with us. The only organisation who can provide some credibility and assistance is the IMF (International Monetary Fund). The IMF is not an alien body. Sri Lanka is a member of the IMF, and since the next day we formed our Central Bank and our Governor and the Minister of Finance, who are the representatives of this global body. The IMF has no magic formula but the Governor and the Finance Minister have to agree on an economic programme to establish transparency, accountability and make immediate but necessary adjustments. Simply, they will ask us to take measures to increase revenue and reduce expenditure.  However, what is important is to make sure that the programme implemented by us is  good enough and well disciplined and effective in order to prevent us going to the IMF again. We have gone to the IMF 16 times since we became a member of the IMF. 

Secondly, in the short-term we have to let the price system work in the energy markets. Import of oil is our largest import and this needs to be priced properly. The market economy is nothing complex but is simply allowing the price system to work. There cannot be any magic formula for us to keep prices lower when the world market pieces are rising. Therefore allowing market prices to work will allocate the optimum utility for our resources. 

Thirdly, we have to freeze Government recruitments and even offer a scheme for unproductive workers to leave which may help in some level to control expenditure. Currently 86 cents of every 1 rupee collected is taken away by the Government employees as their salaries. Needless to mention that it is not sustainable. 

Medium-term solutions 

Implementing the above will give us some short term breathing space and prevent a full blown crisis. Same as the diabetes patient who was in a coma now became a little conscious. Then we have to make sure the patient does not go back to his old habits. So in the medium term setting up the right institutions for management of SOEs and restructuring and privatising some SOEs are of paramount importance. 

At the same time allowing the price system to work requires strengthening our safety nets. The current Samurdhi programme is our main safety net programme which is a politically driven list. Those who deserve the Samurdhi are not in the list while those who have moved out of poverty are still in the list. So we have to have a digital Samurdhi system where cash transfers are prioritised. When market prices change there will be additional allowances added based on the price change and when prices go downwards those benefits will come down proportionately. So even the poorest in the society are given an opportunity to catch up and contribute back to the society and markets. 

In the meantime deregulation of our factor markets as well as our product markets have to continue. The President appointed a commission to look into this and create a collective effort on deregulation of existing bureaucratic structures, regulations and  proceedings. 

By implementing these reforms the image and reputation of the country will be improved. As a result there will be a significant inflow of FDI. 

Long-term solutions 

Longer term solutions are similar to getting the diabetic patient to a healthy lifestyle. In the long run we have to provide a solution for our lands. Simply a digital land registry and transferring Government-owned land for productive use must be prioritised. Giving proper land titles will infuse more capital into the market and make our precious land more productive. 

Similarly, our judiciary system has to be digitised and the resolving cases and contract enforcement has to be strengthened. Currently needless to mention our court system is very unproductive and inefficiency is rewarded. 

In the meantime there has to be a better governance structure within the Central Bank to protect our currency. If we fail in our monetary policy the rest of the policies will fall apart. 

Above are just a few recommendations. Given the nature of our problem there has to be strong medication. Serious economic reform along with making structural economic changes have to take place. Without reforms the chances of an economic recovery is unforeseeable. If the finance minister becomes a reformer, then all Sri Lankans will succeed and emerge victorious, when coming out of this crisis.

The opinions expressed are the author’s own views. They may not necessarily reflect the views of the Advocata Institute or anyone affiliated with the institute.

Losing GSP: End of the world or life goes on?

Originally appeared on The Morning

By Dhananath Fernando

A new conversation has begun over the GSP+ concession in Sri Lanka, with the European Parliament adopting a recent resolution on Sri Lanka. Diverse views have been expressed regarding the economy and our exports. 

One school of thought has been that the economic impact would be serious, as this is expected to directly impact our apparel exports, which form a quite sizable portion of our export basket to the EU.

Another school of thought that has been popularised is that it will have a very limited impact, as Sri Lanka is going to lose the GSP+ facility anyway if we are able to upgrade to the status of an upper middle income country. Some statistics illustrate that even after resuming the GSP+ concessions in 2017, our exports to the EU have not changed significantly over the last few years.

So the question is: How do we look at this in terms of economics? 

What is GSP+?

The Generalised Scheme of Preferences (GSP) of the EU is a trade arrangement that allows developing countries to pay lower or no duties on their exports to the EU. This programme helps vulnerable countries with access to markets to reduce poverty, improve governance, and move towards development. GSP+ is a special component of the same programme that provides duty-free access to beneficiary countries for over 7,200 product categories (HS codes). The beneficiary countries have to, in turn, agree to international conventions on human rights, good governance, labour rights, and the environment. 

Sri Lanka was a beneficiary of the GSP+ scheme since its inception in July 2005, and then lost the concession in August 2010. We regained the concession scheme in August 2017. 

When we look at the statistics after we received the  GSP+ concession in 2005, there was a big improvement in our exports. The end of the 30-year war and the boom of the post-war business environment too contributed to this improvement. 

However, even with the suspension of GSP+ in 2010, our exports to the EU increased, although the rate of exports slowed down. Before the suspension of GSP+, from 2005-2010, our share of exports to the EU increased from 28% to 38%. 

On the other hand, even after securing the GSP+ again in 2017, our exports to the EU recorded slow growth, seeing about a $ 250 million increase from 2017-2019. This can be traced back to the fundamental fact that even with or without GSP+, our exports will remain unchallenged. 

Looking at the problem from an economic point of view

As economists, we have to evaluate a few other variables before we jump to conclusions. One is the growth of our total exports. We can observe our total exports have not been growing by much over the last decade. The reality is that compared to our GDP growth, our exports are declining. 

So from an economic point of view, it reiterates the fact that the challenges to our exports are no longer from outside, they come from inside. Our Customs processes and barriers for international trade remain at a level that even a trade concession will not bring any positive impact to increase our exports. 

One the other hand, we have to consider the income levels and consumption patterns of the EU to see whether our exports have become irrelevant in that market. Markets change very fast, and if we do not adapt, trade concessions won’t help much. 

The diversification of our export basket has not materialised, and our exports have not been competitive in the global market. As a result, our total export growth and export growth for non-EU countries has also remained stagnant. 

Whether our competitors have become better 

We have to evaluate if other countries in the region, with GSP+, have increased the competition faced by our exports. According to European Commission data from 2019, Pakistan and Sri Lanka are the only two countries in Asia with GSP+. However, labour-intensive markets such as Philippines, Armenia, and Mongolia in the region too have received the GSP+ concession. So it is likely that over the years, the competition has increased, while our approach has remained the same, meaning we maintain the same export basket with higher protection and a lack of competition. 

On the other hand there is a discussion within Bangladesh to acquire the GSP+ concession, according to The Daily Star. This may not only increase competition for Sri Lanka, but also open an alternative for existing local companies who have business in Bangladesh. They will consider moving to Bangladesh and increase capacity there. Thus, evaluation of the GSP+ has to consider all the facts and market dimensions. We should also have a strategy to increase our exports without GSP+ when we upgrade to middle income country status.

At the same time, we need to understand that markets are driven by information and sentiments. If the EU suspends our GSP+ claims on the basis of human rights, good governance, and environmental mishaps, it is very likely that other markets and investors will also be driven by that decision, which will affect our investments and the country’s reputation. Additionally, Sri Lankan exporters are currently benefitting from concessions, and losing GSP+ will have a negative effect on them.

Solutions

The solution to improve our exports is to create competition. The development of exports has to be tapped from the import end. Trade is a two-way street, and we are in a world where every nation is linked in an interconnected global supply chain. They all manufacture parts and components and assemble those parts and components to create the final product. From an end-to-end total manufacturing process, the world has moved to an assembly of parts and components to keep the economies of scale and make it affordable for most of the citizens in the world. 

The solution is to integrate into the global production and supply chain network. To do that we have to unilaterally embrace the price-driven market system. Price is the best way to ensure allocation of resources. So that is definitely the best solution for Sri Lanka – but at the same time, we should remember our economic situation and retain the existing concessions that are currently benefitting our exporters.

The opinions expressed are the author’s own views. They may not necessarily reflect the views of the Advocata Institute or anyone affiliated with the institute.

Knocked down by policies made under the influence

Originally appeared on The Morning

By Dhananath Fernando

I recall quite a humorous story. One night two friends under the influence of alcohol were attempting to cross the road. They saw two headlights in the distance and assumed they were from two speeding motorcycles. With determination to display their fearlessness to the motorcyclists, the two friends decided to stand in the middle of the road so the two bikes could pass them on either side. However, it turned out that the headlights were from a speeding four-wheel vehicle and the two friends were badly injured. Being too drunk to make sense of what had just happened, the two went on to assume that there had been a third motorcyclist in the middle that they failed to see. 

Sri Lanka’s policy makers’ approach to the dire economic condition we are in is quite similar to the assumptions of the two drunk friends. With the optimistic expectation that two harmless motorcycles would pass us by, we run the risk of being badly hit by one big vehicle. 

Last week the Cabinet approved the proposal for Sri Lankan companies registered under the Company Act No.7 of 2007, Licensed Banks, and Savings Banks to raise money overseas and invest in Sri Lankan Sovereign Bonds and Sri Lanka Development Bonds. Foreign exchange remittances have been further extended by another six months. Since last week, banks have been rationing their clients on opening up letters of credits (LCs). 

So let’s evaluate the potential impact of these actions. We have been trying too many options over the last two years and we have to ask ourselves why nothing is working. The simple reason is markets don’t believe we are worthy of money. That is why regardless of decisions at every week’s cabinet meeting the forex market is still in peril. Our solutions don’t seem to address the problem of being worthy of money. 

When we allow private companies to raise money offshore and allow investment in Sovereign Bonds and SLDB, we are incentivising non-financing companies to enter into the radar of finance companies. That will dilute the focus of the existing business operations of the non-finance companies. Also it would indicate a wrong signal to the market that we are stretching ourselves too much without taking necessary actions. 

All these cabinet decisions and daily developments are a clear indication of the seriousness of the problem which we should not underestimate or misinterpret like the two friends did. 

Allowing banks to ration Letters of Credit (LCs) is also an indication that the Government has prioritised Sovereign Debt settlements over conducting trade. This is a result of the shortage in the Forex or foreign currency. As a result banks have to ration LCs and obviously they will provide priority to their long standing best customers. That means some of the customers who may have a forex requirement will not have the ability to access finance and they will run out of business. Some may be export industries who depend on imports. 

For example if we look at tea exports, some polythene films, packaging material, printing material are imported. As a result of the rationing process in banks, some of the exporters will not be able to keep their supply chains stable without the ability to open letters of credit. When the supply chain starts breaking down companies have to wind up or downsize their operation. The nature of the modern economy is that different  parts and components are produced and assembled all over the world, this is why we need to understand the importance of the global supply chain network. When we are kept outside of that chain, survival in a competitive environment is impossible. 

In simple terms banks have asked to ration and prioritise their customers. The next step for us would be to prioritise whether we settle our creditors or continue our trade operations. In my view we can ask our creditors to wait for sometime but we can’t ask our businesses to wait. They are already bleeding with back-to-back shocks from the Easter Sunday attacks to Covid-19. If we ask our businesses to wait, it is very unlikely they will be able to survive, especially in light of worsening market restrictions. 

At that point, choices will be very limited. So the solution is to prove to the markets that we are good for money and do it as fast as possible. Over the last decades we really haven’t proved that we are good for money. To do that as this column always advocated we have to make hard economic reforms. There was a time that we could have gone to markets and said that we will do reforms on our own. That window is closed now. When we go out and say the same thing now, no one trusts us now. So now we have to have an additional partner who can bring credibility and hold us accountable and help us put our own house in order. So far in the current set up it’s the IMF who can do it. Otherwise we have to get into a geopolitical game which is too risky to play. 

There are rumours of a cabinet reshuffle and a new minister on Economic Development and Management. Their task would be a gigantic one. However, we should reevaluate the context and do the right thing, unlike the drunkard friends who misread a vehicle as a motorbike. If we misread the situation and context we will be not different from friends who got knocked by a car but thought it was a rider without his headlights.

The opinions expressed are the author’s own views. They may not necessarily reflect the views of the Advocata Institute or anyone affiliated with the institute.

Living the same economic year 73 times

Originally appeared on The Morning

By Dhananath Fernando

Both the Government and the Opposition are in agreement that Sri Lanka’s ailing economy is at peril. A few weeks ago, the Minister of Energy admitted that buying fuel has become a challenging task with import payments only being settled after nine months. These same sentiments were echoed by the former Prime Minister when he was recently sworn in as a Member of Parliament. However, the diagnosis of the problem at hand and building an action plan to address it is continuing at a snail’s pace.

The problem has reached a level where letters of credit (LCs) are opened on a rationed basis and some importers have claimed that private banks do not facilitate foreign currency for their imports. On the other hand, forex dealers have been barred from quoting above Rs. 200 for the dollar.

This will simply create more forex shortages as people who have USD now would not sell it to the Government as it does not reflect the market value. Instead, people may consider parking money outside or keep it in USD terms considering the devaluation of the Sri Lankan rupee in real terms. Owing to the Central Bank regulation, even though the USD rate is less than Rs. 200, in the open market the rates are much higher.

Shortages in foreign exchange is not a recent phenomenon. The Minister of Trade mentioned at Parliament that the current foreign exchange crisis is the worst ever in history. However, our solution for the problem so far has been “not proposing any solution”.

We are doing the same thing over and over again and expecting different results. If we rewind back to 16 June 2020, the President criticised the Central Bank for not extending their support and not utilising the tools to revive the economy.

In February this year, the State Minister of Finance mentioned that the fears of debt sustainability have no grounds as we expect $ 32 billion of inflows and total International Sovereign Bonds (ISBs). He went on to say that the country’s outstanding debt is only about 16% and annual debt servicing of $ 4 billion is manageable compared to $ 32 billion of inflows.

Depending on the same figures, the President in November last year assured debt sustainability after a credit rating downgrade by Fitch.

However, the forex crisis pops up again and the frequency of the problem is getting higher. Earlier imports were controlled and then exporters were requested to convert 25% of their earnings on an immediate basis. However, regardless of strict measures and stringent regulations being imposed, the results have been the same or are getting worse.

Now even the members of the ruling party have started to admit the forex challenge at hand.

Earlier, the Leader of the House said answering a question posted by a journalist that the Government has enough money to take up mega development projects. However, last week, the Minister of Trade and the Minister of Energy were open about how difficult the situation is.

It is an indication that things are getting challenging. On the flip side, it’s a positive indication. At least, everyone is getting to realise the gravity of the problem in the first place. Until recently, there was denial of the fact that there is even a crisis to begin with. A Citi Bank report in December last year was titled “Denial is not a strategy”. This shows that even our international stakeholders were aware that we as a country have been denying the problem rather than providing a solution.

According to the current Government, the previous Government is mainly responsible for the economic crisis at hand as growth numbers were low and the debt numbers were high at the point of the transition. According to the main Opposition, this Government’s tax cut programme introduced in December 2019 and poor Covid management are the main reasons for where we are now. In politics that is how things are. It is always someone else that is responsible for the problem.

The common belief is that bad politics is leading to bad economics as the politicians lack understanding of economic policy and the inherent corruption. While there is some truth to it, often bad economics leads to bad politics.

It is unavoidable that bad economics fuel political storms. If we look at the defeat of the previous Government, it was too led by bad economics. Policies by the two Heads of State were in two different directions. The very first interim budget was stretching the government balance sheet beyond our capacity with massive pay increases for government employees. A proper economic plan was absent and by the time the V2025 policy formulation was done which was poorly implemented, it was too late to come back to a growth trajectory. The Cabinet Committee on Economic Management (CCEM) was dissolved and a National Economic Council (NEC) was appointed and later even the NEC was dissolved. The same policy contradiction on the top led to a constitutional crisis and a vacuum in national security ended up in a terrorist attack that could have been prevented. The Easter attacks were a big negative shock to our entire economy.

As a result of this sequence of events, the then ruling party, United National Party (UNP), was divided into two and the then Prime Minister had to experience a historic defeat in the last general election, which was just 10 months ago with a roaring two-thirds majority for the current ruling party.

It seems back-to-back economic decisions by the current administration are repeating the same mistake of the previous administration and another political crisis spiral is brewing.

Growing import bans, not implementing a proper economic reform agenda, and inward-looking policies of self-sufficiency combined with Modern Monetary Theory (MMT) has created instability in the entire financial system leading to a historic balance of payment crisis. Politically, it has opened a window for the same Prime Minister who was defeated just 10 months ago and has challenged the Government on economic and Covid management. So we are back again on the vicious cycle of bad economics leading to bad politics. The irony is that bad economics not only leads to bad politics but also has a serious negative effect on the quality of life and poverty of all Sri Lankans. Unfortunately, we as a nation have become victims of this vicious cycle. Robin Sharma popularly said: “Don’t spend the same year 75 times and call it a life.” There is no doubt that here in Sri Lanka, we have been doing exactly that for the past 73 years since Independence.

The opinions expressed are the author’s own views. They may not necessarily reflect the views of the Advocata Institute or anyone affiliated with the institute.

Rich man plays, poor man pays

Originally appeared on The Morning

By Dhananath Fernando

How we end up footing the bill for Government price controls

Purchasing alcohol was an expensive endeavour back in college. I remember the total alcohol bill being shared equally amongst those who drink and those who don’t. Sri Lanka’s fuel pricing mechanism is quite similar to this. The subsidised prices are a blessing for direct users of fuel who can afford it. The majority, who are secondary users, end up paying for the subsidy indirectly. Sri Lanka’s fuel problem is quite complex. If we are to overcome this issue it is vital that policymakers understand the concept of “markets” and “prices”. 

It is important that Sri Lanka integrates with global markets and continues to allow fuel imports. This costs the Government approximately about $ 3.5 billion per annum. Global fuel prices fluctuate based on market conditions, and it is crucial to understand why prices fluctuate and the indicators of these fluctuations. Some oil deposits in the world are located such that their extraction process is relatively easy and less costly. Some others are very costly to extract. The Middle East and the OPEC (Organisation of the Petroleum Exporting Countries) are reputed for their oil reserves, whereas the extraction of oil is comparatively more costly in areas like Alberta, Canada. Global oil prices are determined based on this ability of countries to supply to the global market. Political, economic, and climatic developments, and changes in these countries have a direct impact on global oil prices.

So what does the “price” increase communicate? It communicates to the consumer the scarcity of that particular resource within the particular time frame. So increases in global oil “prices” is an indication to consumers that fuel is becoming a scarce resource, and we have to use it optimally. It is also an indication to producers that they can earn more by producing more. This narrows down to the basics of supply and demand. Price is an indicator of scarcity. The “market economy” is not complicated, it is merely allowing the “price system” to work. This allows prices to indicate what should be done. Price is not just a number or a sum a consumer pays. Final retail prices are an accumulation of labour costs, material costs, scarcity, externalities, and factors of production. This is fundamentally why we must not intervene in the market price mechanism.

Sri Lanka has always ignored market principles. The island nation has been trying to artificially keep fuel prices constant despite the continuous fluctuations of global prices. We have failed to understand that such fabricated interventions to either inflate or deflate prices will only result in ceasing to keep up with global indications on whether the resource is scarce or not.

Sri Lanka’s fiscal discipline and stability has always been connected to fuel and the Ceylon Petroleum Corporation (CPC). As a result of fuel price changes, there are significant knock-on effects on all utilities, including electricity and water. CPC provides fuel at a lower price to the Ceylon Electricity Board (CEB), which is one of the main sources for electricity generation. As a result, the pricing of electricity is also now not indicative of scarcity. The CPC, which buys fuel at higher prices and sells it lower, now owes significant debts to most of the state banks. 

The debt incurred is in US dollar terms. A delay in payment or a default may adversely affect the entire financial system. The heavy impact this would have on the banking sector will consequently impact the Central Bank of Sri Lanka (CBSL). It is no secret that the CBSL bails out the CPC and CEB through Treasury Bills, or by printing money. Therefore it is clear that by intervening, we have successfully exposed the entire financial system to deep peril.

The current Minister of Energy said the banks have informed the  CPC Chairman that they do not have foreign currency to pay for fuel imports. This was informed to the Secretary of the Treasury, who then summoned all the heads of banks, who collectively assured the payments for fuel imports. He further stated that the CBSL said it cannot offer any reserves, given the country’s economic woes. It is perplexing to say that the problem is really this severe. It is clear that intervention in the price system has caused a massive domino effect beyond comprehension. 

According to a World Bank report, the biggest beneficiary of subsidised fuel prices are the highest echelons of society. “The non-poor are the largest consumers of fuel and electricity (the top 30% of society consumes 70% of fuel. This is well ahead of direct and indirect consumption of fuel by the bottom 40% through public transport). The administered fuel prices are an effective subsidy to the non-poor funded indirectly by fiscal resources,” stated the World Bank in its Development Update for Sri Lanka in November 2017.

I see no difference in this fuel pricing phenomenon and how the final alcohol bill was shared amongst those who drink and those who don’t in my college days. The poor are bearing the burden of fuel subsidies so the rich can buy fuel for much cheaper. The weighed-down poor only consume fuel in the form of transport, electricity, and other secondary forms. We have to understand that the losses of the CPC have to be paid by someone. Currently, that someone is constituted by both the rich and the poor. 

One important aspect is that the Government also collects revenue through the consumption of fuel. Changes made to the duty waiver have caused enormous losses to the Government. Giving cash subsidies to the poorest section of society could have been a much better strategy than tampering with duty waivers and underpricing fuel, ignoring market signals.

According to the calculations shown in Figure 1, the recent price changes do not reflect market prices of diesel, as illustrated in Figure 2.

What is the solution?

The first solution lies in addressing the problem. As of now, Sri Lanka’s fuel prices fail to indicate scarcity, hampering the independent function of market prices. One way of doing this is by setting up a transparent mechanism and changing the prices to reflect market prices. It may be a price formula or a process where transparency is assured. 

Such a step will incentivise better resource allocation. Consumers will be able to shift between alternative choices and manage their decisions based on price signals. The previous administration introduced a pricing formula that was very poorly administered. The method of calculation was not properly communicated. 

I recall a time when elections were approaching, with a simultaneous spike in global oil prices underway. However, Sri Lanka’s oil prices remained the same. The same was seen when global prices reduced during the first lockdown, and the local consumer was deprived of the deflation. 

One common misperception on this strategy was voiced politically as: “Why do we need a Government if the prices are going to change according to the world market prices?” Simply because we are now experiencing the consequences of such control by the Government. As The Morning reported, the fuel fund has a negative Rs. 26 billion and there are many discrepancies over the numbers in numerous reports. 

Another common misperception is that based on the price changes of fuel, we are going to allow bus fares and other connected prices to change daily. It may be daily changes or it can be changes over a month or a quarter, and there are so many ways we can structure it based on market forces. We have all forgotten that we deal with so many daily price fluctuations. Vegetable prices, Gold prices, stock market prices, and even the prices we pay as interest for Treasury Bills and Bonds change everyday. Price changes for a reason: they communicate the market conditions, which is the ultimate objective of “price”, and allowing the markets to work. 

It is true that this price hike has an impact on the poor. The Government can consider direct cash transfers. The cost of cash transfers will be lower than the losses we collectively incur from the CPC, CEB, and other fuel-dependent state institutions. The current price hike is just another temporary solution; it does not fix the problem. 

Increasing the share collected by everyone at my university party does not change the unfair division of the cost. Likewise, a price increase without setting up a market system and price signals to operate won’t solve Sri Lanka’s fuel and economic crisis.Purchasing alcohol was an expensive endeavour back in college. I remember the total alcohol bill being shared equally amongst those who drink and those who don’t. Sri Lanka’s fuel pricing mechanism is quite similar to this. The subsidised prices are a blessing for direct users of fuel who can afford it. The majority, who are secondary users, end up paying for the subsidy indirectly. Sri Lanka’s fuel problem is quite complex. If we are to overcome this issue it is vital that policymakers understand the concept of “markets” and “prices”. 

It is important that Sri Lanka integrates with global markets and continues to allow fuel imports. This costs the Government approximately about $ 3.5 billion per annum. Global fuel prices fluctuate based on market conditions, and it is crucial to understand why prices fluctuate and the indicators of these fluctuations. Some oil deposits in the world are located such that their extraction process is relatively easy and less costly. Some others are very costly to extract. The Middle East and the OPEC (Organisation of the Petroleum Exporting Countries) are reputed for their oil reserves, whereas the extraction of oil is comparatively more costly in areas like Alberta, Canada. Global oil prices are determined based on this ability of countries to supply to the global market. Political, economic, and climatic developments, and changes in these countries have a direct impact on global oil prices.

So what does the “price” increase communicate? It communicates to the consumer the scarcity of that particular resource within the particular time frame. So increases in global oil “prices” is an indication to consumers that fuel is becoming a scarce resource, and we have to use it optimally. It is also an indication to producers that they can earn more by producing more. This narrows down to the basics of supply and demand. Price is an indicator of scarcity. The “market economy” is not complicated, it is merely allowing the “price system” to work. This allows prices to indicate what should be done. Price is not just a number or a sum a consumer pays. Final retail prices are an accumulation of labour costs, material costs, scarcity, externalities, and factors of production. This is fundamentally why we must not intervene in the market price mechanism.

Sri Lanka has always ignored market principles. The island nation has been trying to artificially keep fuel prices constant despite the continuous fluctuations of global prices. We have failed to understand that such fabricated interventions to either inflate or deflate prices will only result in ceasing to keep up with global indications on whether the resource is scarce or not.

Sri Lanka’s fiscal discipline and stability has always been connected to fuel and the Ceylon Petroleum Corporation (CPC). As a result of fuel price changes, there are significant knock-on effects on all utilities, including electricity and water. CPC provides fuel at a lower price to the Ceylon Electricity Board (CEB), which is one of the main sources for electricity generation. As a result, the pricing of electricity is also now not indicative of scarcity. The CPC, which buys fuel at higher prices and sells it lower, now owes significant debts to most of the state banks. 

The debt incurred is in US dollar terms. A delay in payment or a default may adversely affect the entire financial system. The heavy impact this would have on the banking sector will consequently impact the Central Bank of Sri Lanka (CBSL). It is no secret that the CBSL bails out the CPC and CEB through Treasury Bills, or by printing money. Therefore it is clear that by intervening, we have successfully exposed the entire financial system to deep peril.

The current Minister of Energy said the banks have informed the  CPC Chairman that they do not have foreign currency to pay for fuel imports. This was informed to the Secretary of the Treasury, who then summoned all the heads of banks, who collectively assured the payments for fuel imports. He further stated that the CBSL said it cannot offer any reserves, given the country’s economic woes. It is perplexing to say that the problem is really this severe. It is clear that intervention in the price system has caused a massive domino effect beyond comprehension. 

According to a World Bank report, the biggest beneficiary of subsidised fuel prices are the highest echelons of society. “The non-poor are the largest consumers of fuel and electricity (the top 30% of society consumes 70% of fuel. This is well ahead of direct and indirect consumption of fuel by the bottom 40% through public transport). The administered fuel prices are an effective subsidy to the non-poor funded indirectly by fiscal resources,” stated the World Bank in its Development Update for Sri Lanka in November 2017.

I see no difference in this fuel pricing phenomenon and how the final alcohol bill was shared amongst those who drink and those who don’t in my college days. The poor are bearing the burden of fuel subsidies so the rich can buy fuel for much cheaper. The weighed-down poor only consume fuel in the form of transport, electricity, and other secondary forms. We have to understand that the losses of the CPC have to be paid by someone. Currently, that someone is constituted by both the rich and the poor. 

One important aspect is that the Government also collects revenue through the consumption of fuel. Changes made to the duty waiver have caused enormous losses to the Government. Giving cash subsidies to the poorest section of society could have been a much better strategy than tampering with duty waivers and underpricing fuel, ignoring market signals.

According to the calculations shown in Figure 1, the recent price changes do not reflect market prices of diesel, as illustrated in Figure 2.

What is the solution?

The first solution lies in addressing the problem. As of now, Sri Lanka’s fuel prices fail to indicate scarcity, hampering the independent function of market prices. One way of doing this is by setting up a transparent mechanism and changing the prices to reflect market prices. It may be a price formula or a process where transparency is assured. 

Such a step will incentivise better resource allocation. Consumers will be able to shift between alternative choices and manage their decisions based on price signals. The previous administration introduced a pricing formula that was very poorly administered. The method of calculation was not properly communicated. 

I recall a time when elections were approaching, with a simultaneous spike in global oil prices underway. However, Sri Lanka’s oil prices remained the same. The same was seen when global prices reduced during the first lockdown, and the local consumer was deprived of the deflation. 

One common misperception on this strategy was voiced politically as: “Why do we need a Government if the prices are going to change according to the world market prices?” Simply because we are now experiencing the consequences of such control by the Government. As The Morning reported, the fuel fund has a negative Rs. 26 billion and there are many discrepancies over the numbers in numerous reports. 

Another common misperception is that based on the price changes of fuel, we are going to allow bus fares and other connected prices to change daily. It may be daily changes or it can be changes over a month or a quarter, and there are so many ways we can structure it based on market forces. We have all forgotten that we deal with so many daily price fluctuations. Vegetable prices, Gold prices, stock market prices, and even the prices we pay as interest for Treasury Bills and Bonds change everyday. Price changes for a reason: they communicate the market conditions, which is the ultimate objective of “price”, and allowing the markets to work. 

It is true that this price hike has an impact on the poor. The Government can consider direct cash transfers. The cost of cash transfers will be lower than the losses we collectively incur from the CPC, CEB, and other fuel-dependent state institutions. The current price hike is just another temporary solution; it does not fix the problem. 

Increasing the share collected by everyone at my university party does not change the unfair division of the cost. Likewise, a price increase without setting up a market system and price signals to operate won’t solve Sri Lanka’s fuel and economic crisis.Purchasing alcohol was an expensive endeavour back in college. I remember the total alcohol bill being shared equally amongst those who drink and those who don’t. Sri Lanka’s fuel pricing mechanism is quite similar to this. The subsidised prices are a blessing for direct users of fuel who can afford it. The majority, who are secondary users, end up paying for the subsidy indirectly. Sri Lanka’s fuel problem is quite complex. If we are to overcome this issue it is vital that policymakers understand the concept of “markets” and “prices”. 

It is important that Sri Lanka integrates with global markets and continues to allow fuel imports. This costs the Government approximately about $ 3.5 billion per annum. Global fuel prices fluctuate based on market conditions, and it is crucial to understand why prices fluctuate and the indicators of these fluctuations. Some oil deposits in the world are located such that their extraction process is relatively easy and less costly. Some others are very costly to extract. The Middle East and the OPEC (Organisation of the Petroleum Exporting Countries) are reputed for their oil reserves, whereas the extraction of oil is comparatively more costly in areas like Alberta, Canada. Global oil prices are determined based on this ability of countries to supply to the global market. Political, economic, and climatic developments, and changes in these countries have a direct impact on global oil prices.

So what does the “price” increase communicate? It communicates to the consumer the scarcity of that particular resource within the particular time frame. So increases in global oil “prices” is an indication to consumers that fuel is becoming a scarce resource, and we have to use it optimally. It is also an indication to producers that they can earn more by producing more. This narrows down to the basics of supply and demand. Price is an indicator of scarcity. The “market economy” is not complicated, it is merely allowing the “price system” to work. This allows prices to indicate what should be done. Price is not just a number or a sum a consumer pays. Final retail prices are an accumulation of labour costs, material costs, scarcity, externalities, and factors of production. This is fundamentally why we must not intervene in the market price mechanism.

Sri Lanka has always ignored market principles. The island nation has been trying to artificially keep fuel prices constant despite the continuous fluctuations of global prices. We have failed to understand that such fabricated interventions to either inflate or deflate prices will only result in ceasing to keep up with global indications on whether the resource is scarce or not.

Sri Lanka’s fiscal discipline and stability has always been connected to fuel and the Ceylon Petroleum Corporation (CPC). As a result of fuel price changes, there are significant knock-on effects on all utilities, including electricity and water. CPC provides fuel at a lower price to the Ceylon Electricity Board (CEB), which is one of the main sources for electricity generation. As a result, the pricing of electricity is also now not indicative of scarcity. The CPC, which buys fuel at higher prices and sells it lower, now owes significant debts to most of the state banks. 

The debt incurred is in US dollar terms. A delay in payment or a default may adversely affect the entire financial system. The heavy impact this would have on the banking sector will consequently impact the Central Bank of Sri Lanka (CBSL). It is no secret that the CBSL bails out the CPC and CEB through Treasury Bills, or by printing money. Therefore it is clear that by intervening, we have successfully exposed the entire financial system to deep peril.

The current Minister of Energy said the banks have informed the  CPC Chairman that they do not have foreign currency to pay for fuel imports. This was informed to the Secretary of the Treasury, who then summoned all the heads of banks, who collectively assured the payments for fuel imports. He further stated that the CBSL said it cannot offer any reserves, given the country’s economic woes. It is perplexing to say that the problem is really this severe. It is clear that intervention in the price system has caused a massive domino effect beyond comprehension. 

According to a World Bank report, the biggest beneficiary of subsidised fuel prices are the highest echelons of society. “The non-poor are the largest consumers of fuel and electricity (the top 30% of society consumes 70% of fuel. This is well ahead of direct and indirect consumption of fuel by the bottom 40% through public transport). The administered fuel prices are an effective subsidy to the non-poor funded indirectly by fiscal resources,” stated the World Bank in its Development Update for Sri Lanka in November 2017.

I see no difference in this fuel pricing phenomenon and how the final alcohol bill was shared amongst those who drink and those who don’t in my college days. The poor are bearing the burden of fuel subsidies so the rich can buy fuel for much cheaper. The weighed-down poor only consume fuel in the form of transport, electricity, and other secondary forms. We have to understand that the losses of the CPC have to be paid by someone. Currently, that someone is constituted by both the rich and the poor. 

One important aspect is that the Government also collects revenue through the consumption of fuel. Changes made to the duty waiver have caused enormous losses to the Government. Giving cash subsidies to the poorest section of society could have been a much better strategy than tampering with duty waivers and underpricing fuel, ignoring market signals.

According to the calculations shown in Figure 1, the recent price changes do not reflect market prices of diesel, as illustrated in Figure 2.

What is the solution?

The first solution lies in addressing the problem. As of now, Sri Lanka’s fuel prices fail to indicate scarcity, hampering the independent function of market prices. One way of doing this is by setting up a transparent mechanism and changing the prices to reflect market prices. It may be a price formula or a process where transparency is assured. 

Such a step will incentivise better resource allocation. Consumers will be able to shift between alternative choices and manage their decisions based on price signals. The previous administration introduced a pricing formula that was very poorly administered. The method of calculation was not properly communicated. 

I recall a time when elections were approaching, with a simultaneous spike in global oil prices underway. However, Sri Lanka’s oil prices remained the same. The same was seen when global prices reduced during the first lockdown, and the local consumer was deprived of the deflation. 

One common misperception on this strategy was voiced politically as: “Why do we need a Government if the prices are going to change according to the world market prices?” Simply because we are now experiencing the consequences of such control by the Government. As The Morning reported, the fuel fund has a negative Rs. 26 billion and there are many discrepancies over the numbers in numerous reports. 

Another common misperception is that based on the price changes of fuel, we are going to allow bus fares and other connected prices to change daily. It may be daily changes or it can be changes over a month or a quarter, and there are so many ways we can structure it based on market forces. We have all forgotten that we deal with so many daily price fluctuations. Vegetable prices, Gold prices, stock market prices, and even the prices we pay as interest for Treasury Bills and Bonds change everyday. Price changes for a reason: they communicate the market conditions, which is the ultimate objective of “price”, and allowing the markets to work. 

It is true that this price hike has an impact on the poor. The Government can consider direct cash transfers. The cost of cash transfers will be lower than the losses we collectively incur from the CPC, CEB, and other fuel-dependent state institutions. The current price hike is just another temporary solution; it does not fix the problem. 

Increasing the share collected by everyone at my university party does not change the unfair division of the cost. Likewise, a price increase without setting up a market system and price signals to operate won’t solve Sri Lanka’s fuel and economic crisis.

The opinions expressed are the author’s own views. They may not necessarily reflect the views of the Advocata Institute or anyone affiliated with the institute.

The bottomless pot of Sri Lankan monetary policy

Originally appeared on The Morning

By Dhananath Fernando

A student asked their teacher: “What’s the most amazing, incredible thing in the world?” The teacher responded: “The most incredible thing in the world is that we see people leave all around us, but we never think it’s going to be us. It’s an everyday experience, that people known to us and loved ones leave us. Even experiencing it every day, our mind can’t think that we would also be one of them. Isn’t that incredible?”

Sometimes, it is the most obvious things that we fail to understand. Sri Lanka’s monetary policy definitely falls into this category of things. We see it and experience it every day, but still fail to understand or notice the big elephant in the room. 

The monetary policy is the set of rules under which a monopoly state agency produces paper money. The public is forced to use the money because the government has given it a monopoly and arrests anyone who keeps large volumes of foreign money. There are also restrictions on keeping deposits in foreign money to protect against inflating and depreciating money.

Good central banks will produce stable, low-inflation money. Bad central banks will produce large volumes of money, which generates high inflation and also results in foreign exchange shortages and depreciation.

Some people who run central banks try to avoid printing excess money, if they believe that high inflation and currency depreciation is bad. But sometimes, the Finance Ministry will pressure them to print money to finance the deficit or keep interest rates down.

And central banks will be forced to follow the orders of politicians. To avoid this kind of pressure, which is called fiscal dominance monetary policy, central banks ask for independence from the Finance Ministry.

But there are other activist central banks that will try to push growth on their own by printing money and artificially pushing interest rates down. Such banks will create monetary instability regardless of whether they are given independence or not. 

Some countries have solved this problem by putting controls on their central bank so that its officials are unable to print excess money, whatever their ideology or economic beliefs are. To do this, it is necessary to reduce discretion and bring them under the rule of law.

One such law is a strict inflation targeting law of around 2%. To target inflation, however, it is necessary to have a pure floating exchange rate.

Countries with central banks that create the most trouble or instability usually have pegged exchange rates. They are usually called soft-pegged exchange rate regimes.

The simplest way to restrain them is to fix the exchange and take away their ability to manipulate the interest rate by prohibiting the purchase of domestic securities. This is done by a currency board law which results in a fully credible peg or a fixed exchange rate.

The exchange rate can also be fixed to a great extent by having a wide policy corridor and managing the ability to control short-term interest rates on a daily basis.

The more discretion that is given to the central bank, the more tools they will use to inject liquidity to manipulate interest rates and then create instability. 

A third way is to dollarise. That is to allow foreign currency issued by a better central bank – such as one that is restrained by an inflation targeting law, or a currency board law – to be used in the country. It can be extended to allow multiple foreign currencies to be used as well.

Then, there cannot be any Balance of Payments crises anymore. This is what the Colombo Port City has done. It will be a multiple currency area.

The Central Bank’s recent strategy has to be evaluated with its policies over the last few months and in recent weeks. Below are a few decisions taken over the last few weeks:

1. Over the last week, the Central Bank urged the private sector to borrow foreign currency offshore funding and promised to give a zero-cost swap facility. Put simply, this means private firms are encouraged to borrow money in foreign currencies and “sell” it to the Central Bank for rupees. The Central Bank gives them the foreign currency back at the same exchange rate they sold it at a specified future date – say, one year, at the exact same rate. However, if the rupee rates are very low, it is doubtful whether this will be a very profitable activity. Companies that could borrow in foreign currencies can invest in Sri Lanka Development Bonds and government securities which are denominated in US dollars

2. In another news story, Sri Lanka requested and received a $ 200 million swap facility from Bangladesh. Interestingly, the IMF (International Monetary Fund) approved a $ 732 million facility for Bangladesh in May 2020 as emergency assistance to address the Covid-19 pandemic

3. In another move, the Finance Ministry has raised the limit on borrowing through treasury guarantees to 15% of GDP (gross domestic product) from 10% of GDP. This will allow the Government to borrow more off the balance sheet through state-owned enterprises and spend it through those enterprises. So the loans taken through treasury guarantees will not come under central government debt. Central government debt is already at 101% compared to our GDP, so space is limited for the Central Bank to borrow. The Bangladeshi Central Bank has also asked for a treasury guarantee, according to reports in newspapers in that country

When evaluating all these moves, it is clear that Sri Lanka is drifting towards a very hard situation on raising foreign exchange, as it has been highlighted in this column as well by many experts during the last 12 months. 

We have to ask ourselves: “With so many reactive and stringent measures such as import controls, why are we struggling to fix this problem?” That is where we have to recall the story of the student and the teacher. Sometimes it’s the most obvious thing that we fail to understand. That is, our monetary policy. That is, demand and supply of money. Our Central Bank has been supplying money following MMT (Modern Monetary Theory) utilising the space of low inflation. It is true the inflation is low, but the excess money we print will chase behind imports. It is the same as trying to fill a pot without a bottom. 

Let’s consider a simple example. Even if I grow all the food items that I require in my backyard, the moment I switch on a light at my home, I am spending on imports in the form of fuel for electricity. The moment I switch on my internet router, which consumes electricity, it is the consumption of imports. The moment we build flyovers, highways, and even a simple act of giving away 1 kg of dhal to an affected family mean we are spending on imports. So the only way to cut imports, if we really want to, is by minimising our consumption. 

Or else, we have to increase taxes. The Government has clearly stated that they do not intend to increase taxes. Even increasing taxes will not be a solution without fixing government expenditure, however. Currently, 86 cents of every rupee of tax collected is spent on government employees.

So to minimise consumption, the Central Bank has to absorb money from the system by selling the treasury bills they have rather than buying it from the market. When the Central Bank buys treasury bills, we call it money printing or quantitative easing. The more money we inject into the system, the more we spend, and we will spend more on imports. That is the Balance of Payments crisis we face at the moment, and that is why so many hard and well-intentioned efforts by the Central Bank haven’t seen the expected results materialising. 

Many are of the view that reactivating tourism and attracting higher foreign direct investments (FDIs) will be a permanent solution for this problem. Increased numbers in tourism and FDI will help to ease the situation, but it is not the permanent solution. There have been grand expectations expressed at the recent Sri Lanka Investment Forum to bring the per capita GDP to $ 8,000 by 2030 and a list of very aspirational goals. All the outputs are welcome, but without fixing our monetary policy and failing to understand the most obvious reason why we are failing, Sri Lanka will remain where it is today for the next decade. We must remind ourselves of the story of the teacher and the student on how we have failed to understand the obvious realities and realise that current policies have failed while trying to fix all the other issues in the periphery. Monetary stability is not everything, but without monetary stability, everything is nothing

The opinions expressed are the author’s own views. They may not necessarily reflect the views of the Advocata Institute or anyone affiliated with the institute.

MV X-Press Pearl: lack of preparedness fanned the flames

Originally appeared on The Morning

By Dhananath Fernando

There have been many sentiments expressed on social media that Sri Lanka did not have luck in the recent past. Adverse weather, a third wave of Covid-19, and the sinking ship are just the most recent incidents from a much longer list. I was reminded of the meaning of luck when I was watching a documentary on Hollywood star Will Smith. Smith recalled his father’s advice on his successful career from his humble beginnings. “There is nothing called luck. Even if there is anything called ‘luck’ it is where opportunity meets preparedness.” Smith recalled how his father used to call him at 3 a.m. after seeing his box office numbers.

When I think about Sri Lanka; it is true we really haven’t had any luck for the last decade, but I believe it is simply because we haven’t been prepared. So when the opportunity comes or even when a crisis occurs, we are not prepared. The delay in preparing our policies costs us each time.

Reforms in the shipping and maritime industry is one such area of policy reform that we have postponed for too long. With the X-Press Pearl sinking near the “Pearl of the Indian Ocean” in our territorial waters, it is clear that the economics and our policy of a maritime hub have to be re-evaluated.

One may be surprised at the connection I am implying between a fire in a feeder vessel and the country’s shipping and marine policy, and one may even wonder what economics has to do with it. Whilst it is true that there is no recipe or economic model to douse a fire, economic policy can create an economic ecosystem where we have many firefighters, technology, and partners capable of dismantling an emergency of this scale or even at a bigger scale. If we did have such a policy, it could have presented may options, which in turn could have helped us avoid such a catastrophe for the economy, our invaluable marine environment, and our pristine beaches. 

How good policy could have helped

An incident like an emergency fire and an event of this scale and the ability to avoid it will undoubtedly have numerous variables. It is a rare incident. There are thousands of feeder vessels and mainliners passing our Colombo Harbour and Sri Lanka ranks 24th on the list of “Best Container Terminals” in the world, so how is it that we did not have a system in place to fight a fire? This is a question we have to ask ourselves as a nation aspiring to become the centre of the Silk Route.

The adverse monsoonal weather and the Indian fire brigade vessels taking about two to three days to arrive, have fuelled discussions surrounding “luck”. However, something that should be explored immediately is why Sri Lanka did not have sufficient auxiliary services such as maritime fire brigade services, especially in a backdrop where the Port of Colombo is a regional transhipment hub.  

It is not a question of our commitment to overcome this particular emergency but about the absence of policy to bring in technology and international businesses to arrest the situation. Undoubtedly, it is one out of many alternatives. There are incidents where even with superior technology, ships have been sunk into deep depths.

The economic argument brings in the question of what alternatives could have been available to us to control the fire and avoid damage to marine life. The Sri Lanka Port Authority Fire Brigade and Sri Lanka Air Force did their best to stop the fire at its initial stages. In one reel of footage it was clear the officer in a helicopter was throwing some chemicals from bags to douse the fire. While their efforts are appreciated, in the modern world, there are more advanced helicopters, aircraft, and vessels for fire-fighting, and our Air Force helicopters or Navy vessels are not crafted to fight a fire of that scale. In the industry of shipping there are more and more companies that provide such facilities. The shipping industry is an ecosystem and container transhipment is just a one tiny part of it. 

It is easy to point fingers at the Government and ask why it can’t have such high-tech vessels and aircraft to combat fires at sea. The answer is simply that it is not the Government’s responsibility to douse fires nor does our Government have the money to make such massive investments. But it is the policymakers’ responsibility to create a business environment in the shipping industry where such supportive services can be established within our country. 

There are many reasons why such companies do not establish their businesses in Sri Lanka. One main reason is that there is no reason for smaller, supportive businesses to enter the Sri Lankan market when none of the bigger shipping companies or principals are based in Sri Lanka. Then, we have to ask the question why the main shipping companies or giant players are not entering the Sri Lankan market. The reason is there is a law that 51% of the ownership of the company has to be kept with a local agency. There is no reason for a globally reputed big shipping company to enter Sri Lanka by offering 51% of the ownership to a local company where there are many better options available in the region and globally.

As a result of Sri Lanka not transforming to a maritime hub because it is sticking to its archaic laws, none of the advanced technologies or support services that exist in the industry will enter Sri Lanka, and we will have the same discussion even in five years unless the reforms are made. 

Our snail’s pace movement in a dynamic industry has driven Sri Lanka away from becoming a maritime hub and we have become just a port with high container transhipment volumes – which is also now coming to a saturation with delays in operationalising the East and West Container Terminals. The lobbying against reforming these laws is very high, as there are many beneficiaries in the current system. Policymakers who attempted to do the reforms have failed or are set to fail. 

There has been another discussion on getting a reasonable insurance claim for the damages caused to our marine environment through this recent incident. Some policymakers even mentioned that the claim will be supported to overcome national financial difficulties. However, we have to re-evaluate whether our policymakers have enacted the supporting legislations on global conventions under the International Maritime Organisation, in our Parliament. Since the ship is still within our territorial waters, it is the domestic legal framework that the shipping company has to abide by. But without the necessary legal framework in place to become a maritime hub, facing such incidents in Sri Lanka with the big insurance companies and their experienced lawyers will be challenging. They will always find legal reasons to escape from paying compensation, the same as our motor insurance companies. Ultimately, poor Sri Lankan taxpayers have to bear the entire loss that will be caused to our pristine beaches, marine environment, fisheries sector, tourism sector, and all industries and livelihoods connected to the incident.

Many Sri Lankans are of the view that during the incident, luck was not on our side. If Will Smith’s father was right, it is true that Sri Lankans did not have the luck of combating the fire; it was that the opportunity in the form of the fire met our lack of preparedness for decades in the shipping and maritime industry. The rest is history.

The opinions expressed are the author’s own views. They may not necessarily reflect the views of the Advocata Institute or anyone affiliated with the institute.

We have a COVID education crisis; do not turn it into a catastrophe

Originally appeared on The Daily FT

By Dr. Sujata Gamage

We may recover from the health impact or the economic impact, but the impact of lost years of education for children or children lost to the system due to dropping out will present a COVID education catastrophe with long-term implications

Schools have been closed for more than 16 months. News of school closures and brief re-openings have dominated the news. Success at holding examinations gives us a false sense of achievement. The Minister of Education has been heard to say that online education is continuing despite school closings. Such statements show a complete lack of understanding of the ground situation.

At the ground level, yes, teachers have been reaching out to students as best as they can. According to a survey carried out by the Education Forum Sri Lanka in November 2020, almost all teachers have used social media such as WhatsApp to reach out to their students, but they have been able to connect to only 45% of the students on average. Of those only ~5% were reached via software such as Zoom or Teams which give a real-time online education experience. Even for the 45% total who were contacted by schools, the mode of education is really a repeat of the usual chalk-talk education, but now in distance mode. The objective is to ‘cover’ the syllabus.

However, more important than covering the syllabus is having the school contact each child to inquire after his/her situation. We all know that it is difficult for children to be trapped inside. But in addition, not every home is a safe place for children. Domestic disputes affect the kids. These disputes can turn violent. In some homes, children are abused. Some disadvantaged children who receive school lunches could go hungry when schools are closed. 

 Warnings by experts

At a recent policy dialogue by the Education Forum Sri Lanka, Dr. Tara de Mel warned that we may recover from the health impact or the economic impact, but the impact of lost years of education for children or children lost to the system due to dropping out will present a COVID education catastrophe with long-term implications. She made a plea for short-term remedies to reach out to each child, and for planning NOW to reopen schools as soon as the present third COVID-19 wave subsides. 

Weerasinghe, the Director of Education responsible for the Vavuniya South Education Division, echoed Dr. de Mel’s sentiments saying that the Vavuniya South division he represents has a diverse community from farmers in the interior to fishermen in the coastal areas, and children of such communities were difficult to contact. These children may have dropped out of education altogether.

Weerasinghe further said that during the lockdowns in 2020 rural schools gained somewhat on urban schools presumably because the small rural schools were able to work under the radar to bring children to school under health guidelines of local medical authorities. That is not possible now because the Ministry of Education has issued an all-encompassing closure of schools. Weerasinghe questioned the logic of applying equality of policies to a widely diverse set of schools. 

For example, policies regarding school openings are made with crowded urban schools with students from across the country in mind, when smaller schools serving a contained community could well stay open. We need school-based solutions, he emphasised. Further he noted that we need to give pride of place to teachers and expect them to take responsibility for the education of children under their charge and supporting the teachers to do their job.

Renuka Peiris, former Director of Health and Nutrition at the Ministry of Education, noted that children are now expected to learn in a home environment which is quite different from the school environment. To compensate, they need to be given a timetable appropriate for self-study in a home setting and teachers need access to model lessons. 

The teacher-student interactions should be tracked randomly to make sure that teachers are adapting well to the new mode. The focus in distance education is only on educational achievement and the three national examinations. Is that the objective of education, she asked?

There was consensus that there must be equal emphasis on student educational achievements, their social-emotional learning, and their health and well-being. In distance education the focus has entirely been on transmitting educational content, missing all three purposes of education.

Decentralising education management

Regarding decentralising education management allowing schools to make decisions about opening or closing of schools, Renuka Herath said that by statute the Director General of Health is the ultimate authority for all decisions related to a pandemic, but that power is delegated to Medical Officers of Health (MoH) at divisional level. At the school level, the principal may make the decisions in consultation with the MoH for the area, if power to make such a decision is delegated to the school level by the Ministry of Education. 

There is indeed a circular from the Ministry that authorises schools to just that (Circular 2020/15) but when the ministry decides that all schools, say in the Western Province, should be closed, school-based committees cannot override such a directive. The Ministry of Education should make decisions on school opening or closing with sensitivity to children attending smaller schools serving small communities.

Time to act

Taking the ground reality into consideration, the Education Forum Sri Lanka has called upon the Ministry of Education and Provincial Departments of Education to recognise and act on the following without delay:

1. Content delivered over TV, WhatsApp or in print form is not education: The archaic transmission mode of education practiced in the Sri Lankan education system came to the fore during COVID-19. Teachers sent PDF files over WhatsApp to parents with smartphones, clogging their phones and forcing them to get pages and pages of notes printed. Learning happens not in transmission but in the engagement of the child with the content under the guidance of a teacher. Teachers need only send instructions to use existing textbooks and workbooks which should have been made available free to students at the beginning of the year.

2. Parents cannot replace teachers. Schools are responsible for keeping home-bound students engaged 7:30 a.m. to 1:30 p.m. on designated school days: A bi-weekly self-learning plan should be provided for each child and a teacher should follow-up with him/her at least once a day. Ninety six per cent of households in Sri Lanka have access to a mobile phone. Teleconferencing is possible with analogue phones. There is a teacher for every 16 students on average. There is no excuse for not reaching out to every child.

3. A reduced curriculum covering the essential learning outcomes in language and math, for example should be provided and teachers given the freedom to integrate learning outcomes in other subjects. The Academic Council of Bhutan, for example The Royal Education Council of Bhutan, for example, released an Education in Emergency (EiE) Prioritised and Adapted Curriculum as early as July 2020. National Institute of Education Sri Lanka has already identified ELC for primary education. 

4. Diagnostic tests to identify the “learning lags” in essential competencies should be made for Grades 5 onwards for use by students for self-assessment or by teachers for keeping track. These can be developed and administered by Provincial, Zonal or Divisional directorate level.

5. Modalities for engaging in learning should be entrusted to schools, with supervision by closest authority and subject to schools covering essential competencies: On average only 50% of students engage ‘online’ learning. If the curriculum is reduced, teachers can use the time saved to reach out to those unreached using offline methods suitable for each locality.

6. School attendance committees at GND Level should be reactivated to monitor and support home-bound children: Children’s anxieties and mental health issues, abusive homes, poor nutrition are other critical issues. Regulation 1005/5 of 1997 mandated School Attendance Committees comprising principals, school development society representatives, and education health, and welfare authorities in each GND to keep track of families with school-age children. These committees should be reactivated immediately. 

7. Decisions regarding school opening/closures should be delegated to authorities as close as possible to the affected communities: Schools in low-risk areas should be allowed to keep open. Even in high-risk areas, principals, and teachers in consultation with relevant committees can decide on appropriate school re-opening schedules and isolation modalities. Strategic plans for a more permanent way of keeping schools open should be developed with vaccinations and testing underpinning such plans. 

8. Teachers are frontline workers. They should receive priority in vaccination: When health-care-workers are considered as frontline workers deserving immediate vaccination, the same should follow for teachers considering the repercussions of school closures across the society and the economy. 

9. Personnel and students in schools in high-risk areas should be tested regularly: A cost-effective testing system should be designed so that teachers and students are tested regularly. If a student or a teacher is tested positive, individual classrooms or groups of students should be isolated, instead of closing the entire school. 

10. Blended learning should be adopted as the norm when schools are in session so that teachers and students can transition smoothly to home-based learning during an emergency. Best-practices in this regard can be sourced from countries which have already adopted this kind of learning.

Dr Sujata Gamage is a Senior Research Fellow at LIRNEasia, a regional think tank based in Colombo, Sri Lanka. She specializes in planning, evaluation and capacity building in education, ICT in education, research and research networks, and public sector performance using data analytics, institutional research, scoping studies, systematic reviews, statistical methods and simulations. She is also an advisor to the Advocata Institute.