Mother land or other land?

Originally appeared on The Morning

By Dhananath Fernando

Economic crisis fueling migratory instability

Long queues to sort out passports and visas led many people to believe that Sri Lanka’s economic conditions were driving citizens away.

A survey by the Institute for Health Policy (IHP) conducted on 746 adults revealed that 27% of Sri Lankans are indeed willing to migrate if presented with the opportunity. According to the survey, 48% of those aged between 18-29 are considering migration, and 16% have started preparations to leave. The findings also revealed that 21% of those aged between 18-29 too have started preparations to leave. Further, 22% of women in the sample are considering migration, with 12% already having started preparations. There is no doubt that this survey is an indication of the critical situation Sri Lanka’s economy is faced with.

Sri Lankans have experienced the economic impact of various environmental hazards such as the tsunami, floods, landslides, and droughts. The economic impact of the ethnic conflict that lasted for 30 years and the impact of the Easter Sunday attacks on tourism were two other shocks that Sri Lanka has had to endure. However, the impact of an economic crisis is not felt overnight. The crisis we are in now has brewed at a slower pace and has hit us much faster than we expected. People often fail to understand the gravity of an economic crisis, and that in itself is rather dangerous.

The country is at a risk of losing more lives due to medicine shortages. Therefore, it is evident that measuring the impact of the crisis is quite difficult. However, this will indeed be felt in the form of increasingly poor quality of life and loss of hard-earned wealth across the board.

Economic crises physically manifest in the form of price hikes on essential items, shortages, and lower income levels. Shortages of LP gas, cement, and sugar is indeed an indication of the magnitude of the crisis we are in. Therefore, it is quite self-explanatory that people have increasingly felt the need to seek a better quality of life and opportunities outside Sri Lanka. Sri Lanka has experienced this before, during the ethnic conflict. Many people from the North and East fled to the West. These people didn’t leave Sri Lanka because they loved the country any less, they left because it was becoming increasingly hard to live here.

According to the aforementioned IHP survey, about 43% from the Northern Province desire to migrate, while 38% from Eastern Province desire to migrate. However, only about 2% have started preparations for migration in the Northern Province, indicating the gap between the desired action and resources.

The pressure is mounting up for the Government, and recently even his Excellency the President and the Prime Minister both admitted and highlighted the concern of youth migration. So, it is clear that the pressure felt at grassroot level is being noticed by the decision makers of the country. However, this is happening while the rising cost of living and worsening economic conditions are taking a hit at people’s consumption patterns.

The pressure is such that the Government is now considering IMF support, which they have been avoiding thus far.

All main indicators in our economy so far are not pointing towards any stronger recovery to overcome the crisis we are in.

In my view we are already too late. The only silver lining I see is the opportunity to restructure the economy. However, reforms in an environment which is unprepared for an economic overturn will be painful. It will take a longer time to recover, and it may have unintended consequences sociologically.

The Budget has pronounced some reform measures such as restructuring the public sector and reforming State Owned Enterprises. However, these reforms were contradicted by short sighted proposals to further recruit more than 50,000 government workers, etc.

One out of every two people expecting to emigrate and one out of four adults expecting to emigrate should not be taken lightly by the Government. It is a symptom of a bigger problem. Sri Lanka needs a credible plan to face the economic crisis we are in. Otherwise, those who have the capability and capacity to navigate through the storm will abandon the sinking ship or consider sailing to the land of Kangaroos through illegal means.

References

• http://ihp.lk/publications/docs/SLOTSReport20210ENG.pdf

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.

Ending the annual budget auction

Originally appeared on The Morning

By Dhananath Fernando

Budget 2022 must be the first step to getting the fundamentals right

As Lee Kuan Yew famously said: “Sri Lankan elections are an auction of non existing resources”. Over the years, our annual budget speech and promises have not been different. A long wish list of proposals skewed towards expenditure is read by the Minister of Finance. In between, some policy decisions and revenue proposals are pronounced 

A few weeks after a massive media focus, the budget is forgotten and everyone goes into deep slumber. This again gets the attention of next year’s budget. The same cycle follows, as some senior ministers fall asleep during the budget speech and wake up again for the traditional tea party generously sponsored by taxpayers. 

According to the analysis by Verite Research on PublicFinance.lk, of 34 proposals from 2020 (Verite has analyzed 34 selected proposals in the absence of a budget speech in 2020), only 4% were fully completed. On 50% of the proposals, information is not disclosed even to track whether the projects are progressing. Even in the 2019 Budget, only about 32% of the budget proposals were fulfilled. 

Most  financial analysts and financial sector professionals provide comprehensive coverages on the budget speech along with insights. Generally, it’s a time when vehicle owners and potential buyers get stressed. It is also commonly known that liquor and cigarette prices increase, and some relief packages in the form of subsidies for people get announced during the budget speech. So far, the budget speech is kind of a festival where people and businesses look for relief. That shows the level of government intervention that exists in Sri Lanka. In an ideal system where the market economy works, decisions cannot be surprises nor ad hoc, enabling people to have time to adjust and the price determining the allocation of resources. 

Traditionally, parliamentarians who support the government say that: “It’s the best budget post independence,” and the opposition says: “It’s the worst budget post independence,” as the microphones get directed by the media for comments on the budget.  

The budget this time is crucial for Sri Lanka. As per the numbers reported by authorities and independent analysts, it is clear we are short of money for detailed expenditure proposals and for daily operations.

86% of our tax revenue goes for salaries and pensions of state workers, and more than 100% of our revenue goes for our debt servicing. 

So as Lee Kuan Yew commented on our elections, most of the budget promises are just mere statements. It’s just a feel good statement or the auction of non-existent resources.  

This time it’s different because we are already inside the eye of the storm. This storm is the worst economic crisis post independence. 

Credit rating agencies have downgraded us, limiting our access to international finances, and we have about $ 22 billion of debt servicing for the next five years to be paid with just less than $ 2.5 billion in our reserves, as of 5 November 2021.

As we highlighted in this column post Budget 2021, it missed the elephant in the room, ignoring the debt crisis and the Covid-19 healthcare crisis. Even most of the business tycoons in most industries did not have the courage to point out that the last budget lacked the policy mechanisms of addressing the brewing economic crisis. Instead, they only looked inwards and failed to look beyond their interest without realising that we are on the same ship. There is very little meaning in demarcating our own territory when the entire ship is sinking.  

So we have arrived at a new cycle with a more serious situation, along with a further credit rating downgrade and more disincentives for exporters. The recent new rules on converting export proceedings will impact exports negatively. First, the exporters are paid a rate of Rs. 203 for each US dollar (USD) they bring, while the market rate is about Rs. 235 per USD. On the other hand, for importers, a USD was sold at Rs. 203 when the market rate is Rs. 235. So, we have fueled more imports and discouraged exports on exchange rate. Secondly, imposing controls on converting export proceedings will make life difficult for exporters to do business. Already exporters suffer from USD shortages and supply chain issues. Current policies just double the weight on their shoulders. 

There were heavy social media criticisms on the response by the Finance Minister on a budget related question. A journalist asked: “What benefits do you expect to announce for the people?”, to which he responded: “We may have to take from the people”. The reality is that the poor people who spend a higher percentage of their income on food have been greatly impacted by the increasing food prices caused due to the global commodity bubble. This has been made worse by the implementation of the Modern Monetary Theory implemented by our policy makers. So, taking from the poor will be difficult. At present they are mainly taxed through indirect taxes. 

Accordingly, this year’s budget has to be the first step to getting the fundamentals right. If we start auctioning non existent resources, this budget would lead us towards the direction of a looming crisis, making the situation even worse. 

Since the budget is now out, we can do an evaluation and make a judgement on the direction of the economy. 

(This article was written before the budget speech) 

Sources:

• CBSL, Annual Reports

• https://www.cbsl.gov.lk/sites/default/files/cbslweb_documents/statistics/wei/WEI_20211105_e.pdf

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.

Will Budget 2022 help reset Sri Lanka’s economy?

Originally appeared on Daily FT

By Dr. Roshan Perera

A budget sets out the government’s plan for the economy together with the financial resources required to achieve those plans. It also indicates the broad policy direction and priorities of the government. Any assessment of the Budget cannot be undertaken without an understanding of where the economy is right now. In other words, the Budget must be evaluated in the current economic context.

Looking at the key economic indicators, it is clear that the economy is at a critical juncture. The country suffered the sharpest decline in economic growth in 2020. Although growth is picking up, the economy is likely to remain below pre-pandemic levels. Inflation is rising due to external pressures from supply side disruptions and shortages in international markets. Domestically, financing of the Government’s budget through banking sources (Central Bank and commercial banks) is exerting upward pressure on prices. On the fiscal front, government revenue declined to historic lows due to the impact of sweeping tax policy changes as well as the slowdown in economic activity. Meanwhile, the Government has very little leeway on expenditure, as much of it goes to pay salaries of government servants and to make interest payments – all contractual obligations. The consequent widening fiscal deficit has been financed through increasing borrowings leading to higher debt levels and debt service payments. Downgrading of the sovereign by rating agencies has limited access to international capital markets, exacerbating issues in the macroeconomy. The current economic crisis is not due to the Covid-19 pandemic alone. Sri Lanka entered the pandemic with a slowing economy and a weak fiscal position; the result of years of poor economic policies undertaken by successive governments.

Budget 2022 was an opportunity for the country to reset and for the economy to move to a more sustainable growth path. With Sri Lanka losing access to capital markets and large debt service payments over the next few years, the urgent need was to restore fiscal credibility and strengthen market confidence. Because credibility of the fiscal strategy is vital for stabilising the macroeconomy and restoring the confidence of investors. Hence, the primary focus of the Budget 2022 should have been on correcting the twin deficits, i.e., the fiscal deficit and the external current account deficit, because of the spillover effects into the rest of the economy through interest rates and exchange rates.

According to the Medium-Term Fiscal Framework, the fiscal deficit is projected to decline to 8.8% in 2022 from 11.1% in 2021 (see Table 1 for details).

With minimal wiggle room on the expenditure front, the focus of fiscal consolidation is on revenue generation. Tax revenue is projected to increase by 50% in 2022 from the revised estimates for 2021. Given that actual revenue consistently falls short of estimates, how realistic these projections are is called into question. A major portion of the increase in tax collection in 2022 is expected from the introduction of several new taxes. In addition, the VAT rate on banks and financial service providers is proposed to be raised to 18% from 15% as a one-time increase. Collectively, these taxes are estimated to raise Rs. 304 billion, accounting for around 46% of the total projected increase in tax revenue in 2022 (See Table 2 for details).

As a comparison, the Interim Budget for 2015 introduced a super gains tax of 25% applicable on any company or individual with profits over Rs. 2 billion in the tax year 2013/14 as a one-off tax. The revenue collected from this tax was Rs. 50 billion. Furthermore, the social security contribution is similar to the Nation-Building Tax (NBT), which was a 2% tax on turnover imposed on entities with liable turnover in excess of Rs. 15 million per annum. In 2019, the NBT generated revenue of Rs. 70 billion before it was abolished in December 2019. With a higher turnover threshold and the current restrictions on imports, it will be challenging to raise the estimated revenue from the proposed social security contribution. In addition, the ability to raise the proposed revenue depends on how expeditiously required legislation can be presented to Parliament. Delays in passing legislation have hampered revenue collection in the past.

The question that needs to be asked is why introduce new taxes on a revenue administration that is already stretched when there is ample room to revise thresholds and rates on several existing taxes. This would have been much simpler to implement and would have required minimal amendments to existing legislation. In addition, taxes with retrospective effect, such as the surcharge tax, are not good signals for prospective investors.

The big question is whether the revenue estimates in Budget 2022 are based on reasonable projections. What if the proposed revenue collection does not materialise? Is there leeway to cut expenditure to match the revenue shortfall? If not, will this mean a widening budget deficit and additional borrowing? With minimal access to foreign financing sources, this will mean higher borrowing from domestic sources, particularly the banking sector. This will have economy-wide implications through higher domestic interest rates and crowding out resources from the private sector.

On the expenditure front, overall, there has not been a huge increase in total expenditure. However, the Ministry of Defence and Ministry of Public Security account for around 12% of total expenditure, while spending on health and education accounts for 6% and 4%, respectively, of the total. In terms of the composition of expenditure, salaries and wages comprise 34% of recurrent expenditure while interest payments account for 37%. While the Government has limited room to cut expenditure, making permanent another 53,000 graduate trainees may not provide the best signal in terms of the Government’s commitment to reversing the fiscal situation. Furthermore, the Budget for 2022 has reduced the allocation for subsidies and transfers. An important lesson from the pandemic was the need to build buffers during good times to be able to assist vulnerable households and micro and small and medium enterprises (MSMEs) who were disproportionately affected. Although the Budget proposes a one-off cash transfer to selected groups such as MSME entrepreneurs, school bus and van drivers, three-wheel drivers, and private bus drivers who were affected by the lockdowns, it does not address informal workers in other sectors of the economy who account for around 60% of the total workforce. Ad hoc cash transfers are not sufficient to address these issues. A more comprehensive social protection scheme is required to prevent vulnerable groups from falling into poverty due to unexpected events.

Macroeconomic stability also requires external sector stability. Large foreign debt service payments and dwindling foreign reserves have led to import controls and a tight rein on foreign exchange market. But a more sustainable solution to the external crisis is to encourage exports. The Budget refers to transforming the economy into an advanced manufacturing economy and encouraging exports to earn foreign exchange. This requires addressing the structural weaknesses in the economy hindering competitiveness and productivity. In this light, the question to ask is if spending priorities and policy measures announced in Budget 2022 address these bottlenecks. The Budget has allocated Rs. 5 billion for infrastructure for new product investment zones. In addition, the Budget refers to “…a special focus on expanding the IT sector and promoting BPOs and…a techno-entrepreneurship-driven economy”. However, the allocation for digitalisation is less than Rs. 5 billion. This is in comparison to the allocation for highways of around Rs. 270 billion and rural development programmes (Gama Samaga Pilisandara) of around Rs. 85 billion.

(The writer is a Senior Research Fellow at the Advocata Institute and a former Director of the Central Bank of Sri Lanka)

Did we miss the opportunity to formulate ‘a non-traditional budget’?

Originally appeared on The Morning

By K.D.D.B Vimanga

A non-traditional budget was what the country needed. In general, budgets in Sri Lanka have mostly been giveaways to maintain political status quo or simply an outline of the Government’s plan for the economy, without taking into consideration current economic realities. As a result of numerous governments prioritising political gains over economic realities, the nation is currently experiencing severe economic consequences. These are manifested to the public in the form of steep price increases, shortages of essential goods, import restrictions, and much more. The macroeconomic consequences of this are fiscal and monetary instability, coupled with serious questions on Sri Lanka’s debt sustainability. A non-traditional budget would have indicated the broad policy direction and priorities of the Government with an understanding of where the economy is right now. The Budget would have prioritised macroeconomic stabilisation, taking into consideration the seriousness of the present economic crisis. Whether the budget proposals for 2022 achieve this remains a question.

Analysing the Budget Speech makes it clear that the intention of the Budget was to be conscious of government expenditure. Is this consciousness sufficient? Especially at a time where the foreign debt service forecast for 2022 is an estimated $ 4,483.80 million? (1), when the state of the country’s foreign reserves stood at about $ 2.6 billion in September 2021 (1.7 months of imports [2]), and following which the net foreign assets have been negative in the months after. This very question of debt sustainability remains the elephant in the room. Yet, the Budget Speech failed to elaborate on specific measures that the Government hopes to utilise to meet this target. A budget that understands the present challenges would have presented a roadmap of actions to meet these outflows. The failure to do so highlights the failure to streamline the Budget to meet the seriousness of the present economic crisis.

A certain amount of credit must be given to the Government for refraining from making excessive government expenditure proposals. There is a slight increase in government total expenditure from the revised estimate of Rs. 3,387 billion for 2021 to Rs. 3,912 billion for 2022. This remains prudent in comparison to the Government’s total revenue from the revised estimate of Rs. 1,556 billion in 2021 to Rs. 2,284 billion (3). According to the figures provided by the Ministry of Finance, the budget deficit would see a reduction from Rs. 1,826 billion in 2021 to Rs. 1,628 billion in 2022. However, it should be noted that while the Budget Speech of 2021 promised a deficit of 9%, the revised estimate of the deficit has increased to 11.1% as per the Fiscal Management Report of 2022.

The budget deficit still remains unsustainably large for a country with a gross domestic product (GDP) of $ 80.7 billion in 2020 (4). The Budget tries to reduce government expenditure by proposing policies to reduce recurrent expenditure. These include reducing the fuel allowance provided to ministers and government officials by five litres per month, a 25% reduction in telephone expenses, and increasing the eligibility of MPs to receive a pension from five to 10 years. The magnitude of these cuts in government expenditure remains insignificant in contrast to the real need of the hour; especially when the Budget has made provisions to further expand the public sector, by offering permanent appointments to over 53,000 graduates which would drain a further Rs. 27,600 million from the exchequer. Such is counterintuitive to policies aimed at countering recurrent expenditure, and maintaining a bloated public sector is simply unaffordable with the current state of our public finances. Bold cuts to government expenditure would have reassured Sri Lanka’s creditors, donors, and lenders that we are serious about reforms while also making more resources and talent available to the private sector. Maintaining inflated departments with little or no productive output is a luxury we cannot afford anymore.

The continuation of financing this budget deficit through the domestic market borrowings will have a crowding out effect, especially as it will stunt credit available for the private sector and in return slow the country’s medium to long-term growth potential. Therefore, an ideal budget or a non-traditional budget would have prioritised fiscal consolidation. This includes setting a clear path to reduce the fiscal deficit to 5% by 2024. More efficient tax policy alternatives would have been reintroducing PAYE and withholding taxes and widening the tax base and spreading the tax burden to include a significant number of organisations that were given long tax breaks.

The Budget Speech highlighted three policies that, if implemented right, could direct the economy towards growth. The first being the acknowledgement that price controls have failed, and that market intervention creates uncertainties that affect consumers. This must be looked at with pragmatism, as the complete elimination of price controls including in the energy sector, can achieve better outcomes for the economy. The second being a policy focus to ensure a fair and competitive market. Recognising the role of the market economy and competition is a move in the right direction. This remains the only tried and tested solution to lower prices in the economy. The third policy that should be highlighted is the Finance Minister’s acknowledgement of a re-examination of the Samurdhi scheme. The scheme currently excludes some of the most vulnerable households and therefore, there is a need for tighter administration to ensure benefits accrue to those who need it most. The focus to streamline this initiative towards building entrepreneurship, fostering SMEs, and skill development is the right decision. However, for this to materialise, the Government needs to implement comprehensive reforms to improve ease of doing business and a comprehensive programme of digitalisation.

Addressing macroeconomic imbalances should have been a policy priority of the Budget. This includes addressing the fiscal deficit and the external current account deficit which have effects on the rest of the economy through interest rates and exchange rates. The Budget tries to address this issue by focusing on empowering local production. Prioritising self-sufficiency without opening the domestic market for competition is untenable. The Finance Minister’s speech outlined proposals to boost productivity, which are indeed pragmatic. Yet, one cannot increase productivity without improving competition. Focusing on improving national output has no economic impact without boosting domestic competition.

In the background, there was hope that the Government would start stabilising public finances, which would restore confidence. However, analysing the policy priorities of the Budget makes it clear that there has been little attempt to address the deficit and debt sustainability. Therefore, markets are unlikely to respond positively. At this juncture, Sri Lanka cannot afford to be complacent about our credit ratings. The Budget provided an ideal opportunity to provide a credible plan of action to get our credit ratings up. However, we seem to have missed this opportunity.

Measures to control public finances: spending, budget deficits, and debt 

Year after year, the budget proposals have highlighted large-scale policies that remain limited to budget speeches. However, the present economic storm makes no space for such complacency. Hard structural reforms will need to be implemented inevitably. The Budget could have been the starting point. However, it seems that this window has passed. Therefore, there is a conscious need to build consensus for the implementation of key structural reforms that achieve macroeconomic stabilisation and long-term economic growth. Without macroeconomic stability, there will be no growth. Furthermore, these reforms need to be institutionalised. One way of doing this is the adoption of a medium-term fiscal and monetary framework that gives confidence to donors, lenders, investors, and citizens. Having such a framework will act as a clear sign that the State is committed to fiscal prudence and monetary stability. A medium-term expenditure framework is a tool for establishing public expenditure programmes within a coherent multi-year economic and fiscal framework. 

Other key structural reforms for macroeconomic stabilisation, as outlined in Advocata’s Framework for Economic Recovery, include public finance management and public sector reforms, state-owned enterprise reforms, enhancing monetary policy effectiveness and maintaining exchange rate flexibility, supporting trade and investment to strengthen external trade, land reform, improving ease of doing business, and bridging infrastructure gaps. The only salvation to Sri Lanka’s present economic crisis is such a comprehensive reform package that goes beyond a traditional budget.

References:

1. MOF annual report 2020

2. CBSL Recent Economic Developments: Highlights of 2021 and prospects for 2022

3. https://www.treasury.gov.lk/api/file/0c3639d9-cb0a-4f9d-b4f9-5571c2d16a8b

4. https://data.worldbank.org/indicator/NY.GDP.MKTP.CD?locations=LK

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

Is Wealth Tax the Solution to Sri Lanka’s Low Tax Revenue Collection

Originally appeared on Daily FT, Biz Adaderana , The Morning, Daily Mirror, The Island and Lanka Business Online

By Sathya Karunarathne

Successive governments have run fiscal deficits. Inadequate revenue collection and unrestrained government expenditure have worsened the country’s fiscal position.  

Tax revenue which averaged over 20% of GDP in 1990 has declined to under 10% of GDP in 2020. Ad hoc tax policy changes have significantly eroded the tax base. Weak tax administration has also contributed to the sharp decline in tax collection.

While tax revenue has contracted, government expenditure has ballooned over time. Today, government revenue is not sufficient even to meet its expenditure on salaries and wages and transfers and subsidies to households which include pension payments and social welfare payments such as Samurdhi.  

In this context, there are various proposals put forward to raise government revenue. One proposal is the reintroduction of the wealth tax.  

A wealth tax is expected to bridge the gap between the rich and the poor, achieving equality. This tax shifts the tax burden to affluent households, taxing an individual’s net wealth, which is the market value of total owned assets. Proponents of wealth taxation argue that this is a progressive system of taxation and is a more powerful tool in comparison to income, estate or corporate taxes as it addresses the issue of wealth concentration.  

Moreover, a tax should ideally satisfy basic characteristics of taxation: it should not be distortionary; it should be fair, and it should not be difficult to collect. 

The rationale for a wealth tax

One of the earliest proponents of the wealth tax for developing countries was Nicholas Kaldor.  Based on his recommendation, a wealth tax together with an income tax, expenditure tax and a gift tax were introduced in Sri Lanka in 1958. However, these new taxes yielded little revenue due to difficulties in determining the tax base and problems in administration.  Following the recommendation of the Tax Commission in 1990, the government abolished the wealth tax from the year of assessment 1992/1993.

Wealth taxes have mainly been implemented in European countries. In 1990, twelve countries in Europe had a wealth tax. Today, there are only three: Norway, Spain, and Switzerland.  Several non-European countries have also imposed wealth taxes from time to time including such as Argentina, Bangladesh, Colombia, India, Indonesia, Pakistan 

In recent times there has been renewed interest in wealth taxes. Presidential candidates in the US proposed various forms of a wealth tax. In the UK and France, there were proposals to impose “super taxes” on the rich. The primary justification was to address the increasing inequality in society.  

Issues with a wealth tax

Despite renewed interest in the wealth tax as a progressive tax based on equity, it scores poorly on the criteria of efficiency, and administrative feasibility.  

Many factors have justified the repeal of wealth taxes in OECD countries. The reasons cited are related to efficiency costs, risk of capital flight particularly in light of increased capital mobility and wealthy taxpayers' access to tax havens, failure to meet redistributive goals as a result of narrow tax bases, tax avoidance and evasion, high administrative and compliance costs compared to limited revenues (high cost yield ratio).  

To understand the efficiency costs of wealth taxes one can look at taxing a person’s wealth accumulated through savings. Despite the common consensus that taxing savings is an effective way to redistribute, a person’s saving decisions reveal little about their underlying lifetime resources and wellbeing. It only reveals their preference to consume tomorrow rather than today. Thereby a wealth tax imposes a tax on those who prefer to spend their money later as opposed to taxing the wealthy. Efficiency costs refer to the reduction of the welfare of the taxed individuals by more than $1 to generate $1 of revenue. Therefore, the efficiency cost of a wealth tax in terms of taxing savings is a reduction of  future consumption that can be bought with earnings, reducing incentive to work for those who prefer to consume the proceeds later and reducing incentive for young people to save for their retirement.

Capital flight is the possibility of holding assets outside of one's resident country without declaring them.As wealth taxes are imposed on residents it increases the risk of the wealthy

reallocating their assets to avoid taxation. Therefore a high tax burden encourages taxpayers to change their tax residence to a lower tax jurisdiction or tax havens.

Both income-generating and non-income generating assets are taxed under wealth taxation. They can include land, real estate, bank accounts, investment funds, intellectual or industrial property rights, bonds, shares, and even jewellery, vehicles, art and antiques. However, this tax base for wealth taxes has often been narrowed through exemptions. These exemptions have been justified most commonly on the grounds of social concerns such as the negative social implications of taxing  pension assets. Further liquidity issues (eg - farm assets), supporting entrepreneurship and investment (eg- business assets), avoiding valuation difficulties ( eg- artwork and jewellery) and preserving countries cultural heritage (eg - artwork and antiques) have also been cited as reasons for wealth tax reliefs. While some of these exemptions can be justified, they have led to the reduction of revenue raised from wealth taxes. They have also contributed to wealth taxes being less equitable as the wealthiest such as businesses benefit from these exemptions defeating the very purpose of imposing a wealth tax which is to meet its redistributive goals.

Narrow tax bases in wealth taxation often leads to tax avoidance and evasion opportunities. For example, Spain's 1994 wealth tax exemption for the shares of owner managers resulted in wealthy businesses reorganizing their activities to reap benefits of the exemption resulting in a significant erosion of the wealth tax base. 

Further, several other factors have also discouraged countries to sustain a wealth tax. They are namely, the difficulty in determining the tax base or what assets to be taxed, underreporting and undervaluation of assets, difficulty in measuring wealth taxes, distinguishing between individuals who are asset rich but cash poor, the constant need to value assets and audit returns increasing administrative and enforcement costs

Low revenue collection as well as the other reasons discussed have led to the abolishing of wealth taxes in most countries  (See Table 1 for details) . Tax revenue from individual net wealth taxes in 2016 ranged from only 0.2% of GDP in Spain to 1.0% of GDP in Switzerland. Sri Lanka’s experience with wealth taxation was no different with the tax yielding low revenue as reported by the 1990 Tax Commission.

Table 1: Implementation of Wealth Taxes in Selected Countries

Conclusion 

Taxing the wealth of the rich to generate income and to eliminate economic inequality sounds promising in terms of political debate. However, wealth taxes have failed to generate adequate revenue, failed to meet redistributive goals as a result of narrow tax bases, proven to have high administrative and enforcement costs, resulted in tax evasion and avoidance due to underreporting and undervaluation of assets, increased the risk of capital flight and access to tax havens and may have contributed to the reduction of investment and employment. 

Therefore, imposing a wealth tax may not be the ideal policy response to Sri Lanka’s low tax revenue, especially given the country’s previous experience with the tax yielding low revenue.

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.

Why Sri Lanka is poor, according to Bill Gates

Originally appeared on The Morning

By Dhananath Fernando

Bill Gates famously said: “My daughter won’t marry a poor man.” His definition of poor here is interesting. He explains that a person who wins $ 100 million is not wealthy: “He is simply a poor man with a lot of money. 90% of lottery winners eventually return to where they were before as they do not know how to recreate wealth.” “Wealth” is primarily the ability to create “wealth”, explained Bill Gates.

He further explained this with an example: “One day, a bank vigilante found a bag full of money, and delivered it to the bank manager. People called him an idiot, but in reality, this gentleman was just a rich man who had no money. A year later, the bank offered him a receptionist position, three years later he was in charge of clients and a decade later, he managed the regional branch of the bank. The bonuses of hundreds of employees he managed here were beyond the value he could have stolen.” Bill Gates concluded: “Wealth is a state of mind, my friend. That’s what I meant by ‘my daughter won’t marry a poor man’.”

Sri Lanka can learn from this story. A majority of Sri Lankans believe that the country is wealthy, given our resources. We have a sea of marine resources strategically located in the silk maritime route, natural harbours such as Trincomalee, a phosphate mine, and many more. However, as per Bill Gates’ definition, none of these resources create wealth. In economics, resources that cannot create and recreate wealth are no different to having no resources.

This is not endemic to Sri Lanka. Venezuela, which was the world’s fifth largest crude oil producer, is a poor and unstable country now. Afghanistan, which is also a very resourceful country in minerals and land, does not seem to have a very promising future. Nepal, which has the tallest mountains in the world with the potential to generate hydropower, often experiences blackouts. On the other hand, countries which do not have a rich history nor any resources – such as Singapore – found prosperity and wealth in a few generations. They simply knew the art of recreating wealth.

Sri Lanka has always prioritised sovereignty. However, we fail to comprehend that erosion of wealth is indeed erosion of sovereignty. Most of our scarce resources do not create any wealth, instead it consistently erodes existing wealth.

Many Sri Lankans and large scale businesses believe that the Government needs to provide them protection. This ideology has hindered our potential to keep up with global developments and has severely discouraged budding businesses and entrepreneurs. The businesses owned by the Government are managed by political appointees and government officials. They haven’t risked their money, nor do they know anything about business. As a result, they know very little about recreating wealth. There are no consequences to them if they were to lose large amounts of money.

The common denominator of the loss-making state owned enterprises is that they are allowed to manage a business without risking any money. Most trade union action also takes place in these very loss-making enterprises such as the Ceylon Electricity Board, the Ceylon Petroleum Corporation, and the Ceylon Transportation Board.

The state institutes that make profits also do not create any wealth. Like a man who steals money, they are just poor institutions with little to no profits. Most state institutes make profits either due to hampering competition or by monopolising the sector. For example, the two lottery boards are owned by the Government with no other lottery players in the market. Institutions like the Civil Aviation Authority are monopolies. The government milk supplier makes profits by hampering competition with higher effective tariff rates.

The role of the state should be to maintain safety nets for the poor. However, the state can’t even manage its core functions due to erosion of wealth. State owned airlines lose more money in eight months than the country’s annual budget for Samurdhi.

As per Bill Gates’ example, we are not creating wealth, but over the years we have made a habit of losing the wealth we have. As a result, we have now reached the bottom of poor economic management. The recent credit rating downgrade by Moody’s and Central Bank’s directive on exporters confirms the crisis we are in. As per the news reports, we have submitted documentation to secure $ 3.5 billion from Oman to sustain our fuel supply. This means the country’s future fuel supply is at a potential risk. This will discourage investors and foreign direct investments (FDIs). We already have LP gas and sugar shortages. Even if the price controls have been removed, there are no dollars to open and clear letters of credits for banks to operate. Our misperceptions in thinking that resources are indeed wealth, have made Sri Lanka what it is today.

Wealth is the ability to create wealth. Poverty is the state of thinking about money or resources as wealth without realising how to recreate wealth. Bill Gates was absolutely right.

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

A framework for economic recovery

Originally appeared on Daily FT

By Dr. Roshan Perera

A twin deficit problem

For much of its post-independence period Sri Lanka has been characterised by twin deficits: fiscal deficits and deficits in the external current account. What this implies is the country spends more than it earns and consumes more than it produces. The two deficits are linked because the deficit in the external current account reflects the sum of the deficit in private savings (where private investment is greater than private savings) and government dissaving (where government expenditure is greater than government revenue). If a government continues to consume more than it earns and/or domestic private savings are not sufficient to finance investment in the economy this is reflected in a widening of the deficit in the external current account. 

If a country is running a deficit in the external current account deficit it is important to understand what is driving this deficit. If it is due to a deficit in private savings and investment that may not be such a bad thing because the shortfall is probably being financed through foreign direct investments (FDI) and in any case it is leading to an increase in the productive capacity of the economy. Thereby increasing future growth potential of the country. On the other hand, if the current account deficit is due to the government spending more than it earns, this would need to be financed through increased borrowings. And a country just like a household cannot continue to borrow indefinitely. There will come a day of reckoning. You will come to a point where you are not able to service your debt or you may be able to service your debt, but you won’t have the income to buy what you need to live (food, clothing, education, health etc).  It may come to a point where your creditors will stop lending to you. Or even if they do lend, they will charge you a very high interest rate which will only worsen your debt situation. So, what is true for a household is true for a country.  

Consequences of living beyond our means

Large deficits in the fiscal and external account have been financed through borrowings both from the domestic market (which has crowded out resources for the private sector) and external sources (which has led to an unsustainable level of foreign debt). Although in the short-term high government spending may stimulate economic growth in the medium to long term it acts as a drag on growth due to its impact on interest rates and the exchange rate. 

When a government borrows continuously from the domestic market it crowds out resources from the private sector and drives up interest rates. Thus, making it unviable for a firm to borrow because the cost of borrowing is higher than the return it could earn from investing. In addition, when a country has a large external debt, it attempts to fix the currency to stabilize the debt stock. But this could result in an overvalued exchange rate which leads to an anti-export bias and an import bias which further worsens the trade deficit and external finances. This is contrary to what an economy like Sri Lanka with a small market (both in terms of size and per capita income) needs. As expanding trade is the only sustainable path to faster growth and employment generation. 

The availability of concessional financing from multilateral and bilateral donors enabled the country to run fiscal and external deficits over many decades. Although access to low-cost financing ended when the country graduated to middle-income status, we didn’t change our spending patterns to suit our income. Instead, we sought alternative sources of financing, borrowing from financial markets and commercial sources at high interest rates and with shorter repayment periods. Consequently, by 2016, the share of foreign debt from non-concessional sources rose to over 50%. This has enormously increased debt service payments. Today, Sri Lanka has one of the highest levels of government debt in its history and its debt service payments are one of the highest in the world (absorbing 72% of government revenue in 2020). This has led to both domestic and external resources being diverted to servicing past debt to the detriment of future growth. 

Policy Priorities

Advocata Institutes’ recent report “A Framework for Economic Recovery” propose several policies to address macroeconomic imbalances and structural reforms for sustainable and inclusive growth. 

Firstly we need to address the macroeconomic imbalances in the economy. Primarily, correcting the twin deficits because they have spillover effects into the rest of the economy through interest rates and exchange rates. Priority should be given to fixing the tax system. Tax revenue which was over 20% of GDP in the 1990s has plummeted to 8% in 2020 and is likely to fall further in 2021. Expanding the tax base and improving tax administration are key to reversing the long-term downward trend in government revenue. Currently the personal income tax threshold in Sri Lanka is more than four times its per capita GDP and even higher than the tax threshold in countries with per capita incomes that are several times that of Sri Lanka, such as Singapore and Australia. A high tax threshold removes a significant portion of the working population that can contribute to tax revenue. Tax exemptions for businesses should be rationalised and the granting of exemptions centralised under one authority.  Evidence suggests that sweeping tax exemptions are not the most important factor in attracting investments and foregoing this tax revenue is not sustainable in the long term. 

With declining tax revenue collection, the government faces severe resource constraints. Expenditure on contractual obligations interest payments, salaries and wages and pension payments) has come at the cost of spending on building human capital (health and education). This needs to be reversed. Serious attention needs to be paid in the budget to rationalising the public sector and strengthening budgetary oversight mechanisms so that the government is held accountable for how they use the resources entrusted to them.

Secondly, we need to stimulate economic growth and improve the country’s competitiveness. Sri Lanka has experienced very volatile growth rates and in recent times spurts of debt fuelled economic growth. But this growth has neither been inclusive nor sustainable. We need to generate growth that is both inclusive (benefits all our citizens) and sustainable (growth that does not jeopardise future generations). The budget needs to address the structural weaknesses in the economy hindering productivity driven growth. Some policies that we discuss in our report are: (1) improving the business environment by reducing regulatory barriers which are needed to attract foreign direct investment. Sri Lanka lags its peers in the areas of doing business and competitiveness; (2) unlocking access to land which has been identified as a major bottleneck for investment; (3) creating a flexible labour market and raising labour force participation. There are a plethora of legislation governing labour in SL which act as a serious impediment for job creation. Further, Sri Lanka has a rapidly aging population and is no longer benefitting from a demographic dividend. However, it has access to a large untapped source of female labour. Encouraging greater female participation in the labour force requires removal of legislation restricting employment of female workers and improved provision of services such as childcare and safe transport; (4) addressing infrastructure gaps to enhance productivity and efficiency of the factors of production. We need to invest in infrastructure that has high social and economic returns. This requires better processes for project appraisal and selection, better management of risks which otherwise could lead to cost overruns and project delays and greater accountability to reduce waste and corruption.

Finally, the budget needs to build buffers to strengthen the resilience of the economy to shocks. 

Households have been disproportionately affected by the ongoing pandemic because they lack the buffers to cushion them from economic shocks. Workers, particularly in the informal sector, have lost jobs due to the impact of lockdowns and the closure of borders. Although the government provided some relief to households affected by the pandemic by way of income transfers, the lack of fiscal space constrained the government’s ability to adequately respond to the crisis. In addition, Sri Lanka’s existing social protection scheme has significant coverage gaps. Establishing a universal social safety net and reducing targeting errors will ensure that those who need support receive it when they need it most. 

Micro, small, and medium enterprises (MSMEs) play a vital role in the Sri Lankan economy. This sector was severely affected by measures taken to contain the spread of the virus, such as travel bans, lockdowns and social distancing. To mitigate the impact of the pandemic, the government and the Central Bank introduced various emergency liquidity support programs, debt moratoriums and extension of credit at concessionary interest rates. These schemes may have prevented some firms from bankruptcy. However, the inability of the government to continue providing such relief given the prolonged nature of the pandemic and fiscal constraints requires other measures to be put in place to deal with such situations. Given the size of this sector and its importance to the economy, ensuring the solvency of these firms as well as increasing their productivity is paramount to Sri Lanka’s long term economic growth prospects. Many firms will emerge from this pandemic with seriously impaired balance sheets. Firms that are not resilient, uncompetitive, or heavily indebted will probably fold due the crisis. To reduce the adverse economic impact of ad hoc closures, the government must ensure access to an effective bankruptcy regime. Such a mechanism will strengthen economic resilience, while incentivising firms to prioritise strategies to repair balance sheets in the medium term before they reach bankruptcy.  

(The writer is a Senior Research Fellow at the Advocata Institute and a former Director of the Central Bank of Sri Lanka)

Crisis is here, reforms must be too

Originally appeared on The Morning

By Dhananath Fernando

Providing a definition for an economic crisis is a difficult task. Especially for a country like ours, which has had an ever present economic crisis, since independence. Realising the depth of the crisis is too difficult when we don’t know the real potential outside. This is because we have normalised our economic difficulties. As a result a transition from one phase of the crisis to another phase is celebrated as a victory. In certain instances due to lack of understanding, deepening the economic crisis too has been celebrated as a move towards economic prosperity without realisation of the reality. 

Our comparison has always been “how we did in the past” or “how the previous governments had done it”. As a result we have become accustomed to having very low levels of expectations. This is also a result of  a lack of exposure to where we really want to be and without realising our potential. 

The current economic crisis is just a good reflection of where we all stand including our policy-makers. Many of us consider that having adequate USD (foreign currency) to settle our foreign debts is the point of getting over the line from our economic hardships. Basically, the ability to pay debts is perceived as prosperity.  As a result we have added enormous pressure on all our businesses to celebrate a fake victory. At this backdrop we keep implementing the wrong policies, such as import restrictions without realising that we are deepening our economic crisis by adding extra burden on their raw material importation. We have reached a stage where we look for credit lines to secure our fuel imports mainly from Oman, India, and the Middle East. 

At the rate crude oil prices are increasing, without a significant reduction in consumption, credit lines will increase the amount of bi-lateral debt. It is also most likely that our bi-lateral partners would ask for a condition to join an IMF programme, if they are to lend to us in the future. This is because the individual countries who we borrow money from, need an assurance of our solvency. On the flip side, our bilateral partners too need to take precautionary measures to minimise the risk of lending to us, or else it would cause political unrest in their respective countries. There will be questions raised as to why a bi-lateral loan was provided to a country with a low credit rating. Some of Sri Lanka’s potential borrowers are beneficiaries of different forms of IMF assistance. The recent Bangladesh swap facility is a good example. Bangladesh received a $ 732 million disbursement from the IMF to address the Covid-19 pandemic, following which they have agreed to provide us with a $ 250 million swap facility in tranches. 

Adding fuel to fire is the lack of reforms. The failure to do so is like not using the tools in our tool box. So, existing hardships will prevail or worsen, and complaints on delays on clearing shipments haven’t been addressed as yet and the USD shortages still continue at banks. Further, the lack of decisive action being taken is risking the stability of our banking sector. As a result we have downscaled our capacity and expectations to a greater extent and everyone has gone to a survival mode and comparing an era of survival with another era of survival while the human race and societies have taken great strides on developing the entire society as a whole. 

The current control of the USD has now started to affect our remittances. Our remittances are declining significantly even with the nature of the pandemic we had earlier. Increasing remittances was a key goal of our policy-makers. In fact remittances were encouraged by agreeing to offer a slightly higher exchange rate for remittances to cover up the loss of revenue from tourism. It is not rocket science to figure out why our remittances are in decline, when the kerb market offers a rate about 20-30% higher than the rate fixed by the Central Bank of Sri Lanka. At the same time, when imports are restricted people are motivated to get goods directly, at a reasonable price from overseas travellers, instead of transferring foreign currency to Sri Lanka and bearing the exchange rate loss. 

The most recent statement by the Central Bank, the six-month road map, places a bigger weight on the generation of foreign exchange through investments in national assets such as the West Container Terminal, power plants and development projects. That is a positive sign that our underutilised assets are now being looked at for revenue generation. But in terms of the tools that we have used, are they sufficient? Most likely not. However we will have to wait for a few weeks to make an estimation on the effectiveness of these tools and measures. 

On the other hand, investments such as the WCT and other infrastructure development carry a larger import component. Even in tourism about 80% of the revenue consists of imported content. Unfortunately there are no shortcuts for a deepening economic crisis brewing for decades. We are already in a crisis for too long and we are cornering ourselves. The impact for common people would be to sacrifice their quality of life. That is to let go of what they consumed before and give way even to the little convenience we had. 

Solution 

The solution to overcome the problem are economic reforms. We reiterate often on reforms because there is no other solution. They are the only solution. Budget 2022 is a golden opportunity to direct the country towards economic reforms. Merely reading numbers that allocate money on expenditure that we cannot afford, will take us nowhere. 

The policy direction has to be on allowing the markets to operate based on prices instead of excessive regulation or promoting a culture of banning. The price signalling system will optimise the resources allocation. Markets and investments will receive a positive signalling that Sri Lanka is open for change. Only an optimisation of resource allocation and getting our economic fundamentals right can take us out from this crisis. Otherwise, Sri Lanka will remain where it has been in the past into the foreseeable future. Reforms provide the only road 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.

Will India’s cobra bite Sri Lanka’s cattle?

Originally appeared on The Morning

By Dhananath Fernando

• A ban on cattle slaughter could create a herd of new problems

Not long ago, India had a serious issue with snakes. Many people died, as a result of being bitten by a specific species of cobras. As a remedy to this problem the government of the day, proposed a cash reward system. A bounty was made available for every dead cobra. It appeared to be a good solution at the initial stage but later on the government realised the cobra numbers are increasing though people redeem cobras. Later on the government realised that entrepreneurial Indians were now breeding cobras as an income stream and they maintain breeding houses of the same type of cobras. As a result the government suddenly stopped the cash incentive system. Then the breeders did not have any financial incentive to keep them at their breeding houses. As a result they just released the cobras to an open environment which rapidly increased the cobra population and the problem became worse than ever before. This is called the “cobra effect”, where you bring a solution with good intentions but the outcome is a series of negative consequences far worse than the original problem. This is a story all Sri Lankan policy-makers should keep in mind, especially the ones who keep proposing the banning of cattle slaughter. Every ban so far has backfired economically as well as politically. The only bans which haven’t backfired are the ones which haven’t been implemented.

The former president proposed a ban of carpentry sheds and chainsaws in a move to protect the environment which didn’t get implemented. Then a ban on glyphosate was proposed. Recently, in addition to many import bans, a ban on sachets and a ban on chemical fertiliser have been proposed. The impact of these bans have been like a boomerang, making colossal losses to our economy, the livelihoods of the people and the political capital of the government which could have been invested to implement much needed macroeconomic reforms.

The cattle slaughter ban is most likely going to bring similar consequences. The biggest impact being farmers having the burden to maintain animals past their productive prime. This will significantly impact the productivity of the dairy industry. In the very likes of the cobra effect in India. Undoubtedly the policy is implemented with good intentions but merely having good intentions isn’t sufficient to the harms and consequences of these actions. Our politicians cannot just run away from these bad consequences without taking responsibility, just because their intentions are good. Governing Sri Lanka is not like the high school prefects checking for the uncombed hair or the bags of fellow students. We are a democratic country where the actions of policies determine the well being of people’s lives. Just to mention “we did it with good intentions without realising the bad consequences” is not an acceptable excuse at all.

With the ban on cattle slaughter, and the topic gaining national attention, it is sufficient for milk farmers to accelerate the selling process of cattle for slaughter. This will be fueled by the fear that they will lose out by holding on to cows in future. In the meantime our dairy industry which is finding it difficult to manage even with very high tariff protection will find it further difficult to sustain. This will greatly affect national milk production and the livelihoods of dairy farmers.

In the liquid milk industry, the output of the cow depends on the feed, temperature and protection from infections. Better the feed and lower the temperature (which avoids sweating of the cow) increases the output. Sri Lankan dairy farmers are already finding it very difficult to provide better feed for cows. According to data, in 2019 Sri Lanka had about 323,490 milking cows but the average output is about four to five litres a day where the global average is about 28 litres per day. In countries like Israel the output per day is as high as 40 litres.

It is a clear indication of how difficult it is for our farmers to provide adequate water and food for milking cows. So after a certain period most farmers recover money by selling it for meat. Otherwise economically it doesn’t make sense to keep them at home just feeding. Another aspect that must be explored is the impact on natural forests. Most of Sri Lanka’s forest reserves are facing dangers by cattle farms, especially in villages bordering sanctuaries. Cattle farmers let the cows enter protected sanctuaries for feed which then affects the natural vegetation of herbivorous animals such as elephants. This too is one contributory factor for human-elephant conflict where elephants come out of forest areas looking for food as a result of depleting vegetation.

On the other hand the male cattle or bulls will have a very short life span as maintaining a bull without the ability to sell doesn’t make economic sense. So illegal cattle slaughtering will increase. Already Sri Lanka’s domestic liquid milk supply is about 373 million litres and the local demand is almost twice that, which is 700 million litres. So the milk powder imports will most likely go up and employment will be affected. According to the EDB (Export Development Board) data, there are about five large companies, 10 medium-scale companies, and more than 1,000 small enterprises and seven tanneries that produce 25 tonnes of leather daily which brings in about $ 550 million worth of foreign exchange annually. This decision to stop the slaughter of cattle will have a significant impact on these livelihoods and Sri Lanka’s foreign exchange revenue will take a hit, especially at a time where we are desperately in need of foreign exchange.

Keeping money matters aside, from an animal cruelty perspective, this regulation will discourage farmers to take care of their cattle and keep them well-fed. This decision will further distort the incentives to provide proper protection and shelter for cows due to a lack of financial incentives. This is best illustrated by the situation in India. A similar policy decision by the Indian government on banning the slaughter of cattle has been one factor leading to vehicle traffic, in some areas due to the overpopulation of cows and cows inhabiting roads. In some cases the government has had to spend extra resources, building cow care centres as many cows were being mistreated.

In policy decisions “good intentions” is not the litmus test to decide which policy should get the priority. It is the cost benefit analysis, causes consequences analysis and factual and evidence-based research that should decide the implementation of a policy. Intentions are important but bad consequences such as the “cobra effect” can only be avoided by sensible well thought economic thinking.

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 according to a government’s will

Originally appeared on The Morning

By Dhananath Fernando

• Cost of living and the freedom of choice

Jeewan Thondaman, the political leader representing the estate electorate in Sri Lanka, was questioned recently on what development means for the estate sector. He said: “One politician visits the estates and says he built five houses and another one says he built 10. Merely building houses is not development.”

Then the TV anchor probed him on what development really is. “Giving the opportunity for people to build their own house in a land they own, as per their preference and aspirations, is development,” he replied. He went on to say that “if politicians build houses for the estate sector, regardless of the number of houses built, estates would never be developed”.

Politics aside, the young politician’s views on choice are highly commendable. Most often, people do not realise the importance of the ability to choose from a wide range of options. Especially in countries like Sri Lanka, we expect all things to be provided by the government. We like to eat what the government tells us to eat, we want to get educated on what the government says is good for us, we strive to get a job from the government as they see fit, etc.

The ability to choose is often tested in terms of marriage and relationships. Imagine if the government decided to select partners for us. We can all picture what chaos it would be. Similarly, when the government decides which food we should eat, which fertiliser we should use, and which job we should do, the results are not that different.

Availability of a range of options and increasing choices as much as possible is one key parameter on consumer convenience. The same concept works for essential commodities as well at a time when the national conversation is on rising food prices.

Let’s first understand the reason for rising food prices.

The recent food price hikes are caused by multiple reasons. One is rising global food prices and commodity prices with economies opening up after lockdowns. As a result, a barrel of Brent Crude oil, which was priced at about $ 42, is now at $ 83. So, a fuel price hike can be expected, which will, in turn, have a knock-on effect on many consumer goods.

Sri Lankans will be affected more significantly due to the Sri Lankan rupee depreciating in comparison to the US dollar. Excessive printing of money under Modern Monetary Theory (MMT) has further contributed to the depreciation of the currency. As this column highlighted many times, excessive printing of money, which increases the money supply, will also increase the demand for imports. A lot of the money printed will be used to purchase imported goods, which will worsen the balance of payment (BOP) crisis. A worsening BOP crisis will also increase the shortage of USD, thus increasing the price for a US dollar in LKR terms, or the exchange rate.

An increasing exchange rate will cause the prices of all imported goods to increase as the market adjusts, and keeping the exchange rate fixed without really having sufficient US dollars doesn’t make any sense. Simply, we have imposed a price control on the USD, which has created shortages just as with milk powder and liquified petroleum (LP) gas. Price controls also led to shortages.

If the Central Bank has unlimited USD supply, we can keep the exchange rate without fluctuations, but as per official data, our reserves are at a historically low level. So the Government and also our people are in a very unfortunate situation without having adequate tools to arrest the rising prices.

In a situation like this, some recommendations have been floated, such as increasing wages or Lanka Sathosa distributing essential goods.

On the question of increasing wages, the private sector has to have increased profits and revenue if they were to consider a salary hike. The government sector, which is about 18% of our labour force, cannot have a salary hike without further borrowing from the Central Bank. If the Central Bank further borrows on behalf of the Government, the prices will further increase. So, the only way to overcome this is to fasten our seatbelts and make sacrifices on our real consumption.

Sathosa has no other magic formula to reduce the prices unless a subsidy or budgetary support is provided, and obviously someone has to bear that cost of such a subsidy. Removing price controls is indeed a move in the right direction, but ensuring the market has enough competition across sections is also important in bringing down prices.

One good example is the wheat flour market, where there are only two players in the market. There is a very high tariff on imported milled wheat instead of raw wheat. So this acts as an entry barrier for other industry players to enter the market. As a result of such a lack of competition, the two existing players set the market price and the barriers to entry allow ample space for rent-seeking activities.

It’s the same for cement and industries like LP gas. In most cases, these industries are protected from competition. Protection from competition is directly undermining consumer choice. If Sri Lanka is serious about bringing down prices, our only solution is competition and expanding consumer choice.

At present, though, it seems that sacrificing consumption will be the only option we have and it will not be easy, specifically for the poor, where a higher percentage of income goes for purchasing food. This is going to be a truly difficult time period for such families. So the only option available is increasing the range of options available by increasing competition. Then, people can adjust their choices so that they have room to explore alternatives without experiencing the effect of higher prices. The only way to do it is to remove all barriers to market entry in order to pick the supply side up and iron out market distortions.

Different households will adjust in different ways to price hikes. For example, some households will reduce the quantity of milk powder used per cup. Some households may decide that only kids should be fed with milk powder and adults give up milk powder and shift to plain tea. Some families may adjust with frequency. Instead of having milk tea seven days a week, some will skip two to three days based on their affordability. Some families or businesses who have a higher degree of dependence on milk powder will use the same quantity, but they will reduce their entertainment expenses or other expenditure categories to keep the milk powder consumption going.

In simple terms, each household and individual, based on their circumstances, can decide what is the best choice for them. So even when making “sacrifices in consumption”, the freedom to choose is vital. With people making choices, there will be new market opportunities where suppliers will consider more options to supply alternatives to the  market and capture a different market segment.

Freedom of choice matters both in hard times and good. It is a fundamental pillar in a market system where people have the option of adjusting for higher prices by managing the cost of living to a certain extent. Competition in the market is what fuels the choice for consumers. Sri Lanka has to set the fundamentals right. For example, we cannot develop the estate sector by just building houses. We need to provide them the opportunity and choice to build a house as per their preference. This can only be done by allowing the market forces to work and establishing freedom of choice for people. While the importance of having the freedom to make individual choices is fundamental, the Central Bank can ensure that the rate of money supply increase is limited by using monetary policy. Finally, MMT does not work as it is claimed by those innocent of simple monetary economics. As our currency is not an internationally accepted currency, money printing by the Central Bank leads to inflation.

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.

Budget 2022: Macroeconomic stabilisation and structural reforms for inclusive and sustainable growth

Originally appeared on The Morning.

By Dr. Roshan Perera

Years of profligate living finally caught up with us. Sri Lanka, for much of its post-Independence period, has been living beyond its means: We have been spending more than we earn and consuming more than we produce. Our extravagant lifestyle was made possible by the availability of concessional financing from multilateral and bilateral donors. This ended once we graduated to a middle-income country. But we didn’t change our spending patterns to match our income. Instead, we sought alternative sources of financing. We borrowed from financial markets and commercial sources at high interest rates and with shorter repayment periods.

Consequently, by 2016, the share of foreign debt from non-concessional sources rose to over 50%. This had an enormous impact on our debt service payments. Today, Sri Lanka has one of the highest levels of government debt in its history and its debt service payments are one of the highest in the world (absorbing 72% of government revenue in 2020). This led to both domestic and external resources being diverted to servicing past debt to the detriment of future growth.

According to current estimates, Sri Lanka has around $ 26 billion in foreign debt obligations due between now and 2026. Sovereign rating downgrades made rolling over this debt challenging. But these are contractual obligations and there could be serious repercussions if a country defaults on its debt. Due to the decline in foreign inflows owing to the pandemic, the Government resorted to short-term measures such as bilateral swaps to shore up foreign reserves. However, there was a steady drawdown of the country’s foreign reserves to meet these debt obligations. Foreign reserves, as at end-September 2021, declined to $ 2.5 billion (which was equivalent to 1.5 months of import cover). Foreign currency obligations falling due within the next 12 months amount to around $ 7 billion. The current level of foreign reserves is grossly inadequate to service the Government’s debt.

Furthermore, using a country’s foreign reserves to pay debt obligations is not a good strategy in the long term. Foreign reserves play an important role in an economy – by providing a buffer against possible external shocks, smoothing temporary fluctuations in the exchange rate, and providing confidence to foreign investors.

With limited access to foreign financing, the Government is relying more on domestic sources to bridge the fiscal deficit. To keep interest costs low, domestic interest rates have been suppressed, which has effectively dried up the market for government securities. This has led to debt monetisation, with the Central Bank of Sri Lanka (CBSL) purchasing a major share of government securities issued in the primary auction. However, there are costs involved with this strategy, as high monetary growth leads to high inflation. It also undermines the independence of the CBSL and hinders its use of its key monetary policy instrument, the interest rate, to manage inflation.

So, what needs to be done? Advocata Institutes’ recent report titled “A Framework for Economic Recovery” proposes several policies to address macroeconomic imbalances and structural reforms for sustainable and inclusive growth. These policies are not new. If you examine macro stabilisation programmes that have been implemented in this country (or in other countries that have faced similar economic issues), you would broadly find similar recommendations. This does not mean the recommendations made in the past were wrong – but rather that successive governments did not follow through on the reforms needed to ensure long-term macroeconomic stability and sustained economic growth.

This time is different in one aspect. Sri Lanka has lost access to financial markets due to its rating downgrade. Hence, it is not able to easily refinance its foreign debt. In previous stabilisation programmes, although debt sustainability was a major concern, it was addressed through a fiscal consolidation programme. This alone may not be sufficient in the current context. The country may need to engage in a pre-emptive debt restructuring exercise to prevent default. A wilful default could disrupt access to future financing, reduce investor confidence, affect credit ratings, and have a negative impact on the reputation of the country. However, debt restructuring is a complex process and securing a deal that is acceptable to a majority of creditors is fraught with difficulty, as there are many stakeholders involved, and conflicts of interest are inevitable, hence the need to engage with an institution such as the International Monetary Fund (IMF) in the negotiation process.

The focus of Budget 2022 should be to address the macroeconomic imbalances in the economy. Primarily, correcting the twin deficits, i.e. the fiscal deficit and the external current account deficit, because these have spillover effects into the rest of the economy through interest rates and exchange rates. Priority should be given to fixing the tax system. Tax revenue, which was over 20% of gross domestic product (GDP) in the 1990s, has plummeted to 8% in 2020 and is likely to fall further in 2021. Expanding the tax base and improving tax administration are key to reversing the long-term downward trend in government revenue.

Currently, the income tax threshold in Sri Lanka is more than four times its per capita GDP and even higher than the tax threshold in countries with per capita incomes that are several times that of Sri Lanka, such as Singapore and Australia. A high tax threshold removes a significant portion of the working population that can contribute to tax revenue. Tax exemptions should be rationalised and the granting of exemptions centralised under one authority. Evidence suggests that sweeping tax exemptions is not the most important factor in attracting investments, and foregoing this tax revenue is not sustainable in the long term. With declining tax revenue collection, the Government faces severe resource constraints.  Expenditure on contractual obligations (interest payments, salaries and wages, and pension payments) has come at the cost of spending on building human capital (health and education). This needs to be reversed. Serious attention needs to be paid in the budget to rationalising the public sector and strengthening budgetary oversight mechanisms so that the Government is held accountable for how they use the resources entrusted to them.

Secondly, we need to stimulate economic growth and improve the country’s competitiveness. Sri Lanka has experienced very volatile growth rates and in recent times, sudden spurts of debt-fuelled economic growth. But this growth has neither been inclusive nor sustainable. We need to generate growth that is both inclusive (benefits all our citizens) and sustainable (growth that does not jeopardise future generations). The budget needs to address the structural weaknesses in the economy hindering productivity-driven growth. Some policies that we discuss in our report are:

1. Improving the business environment by reducing regulatory barriers, which is needed to attract foreign direct investment (FDI). Sri Lanka lags behind its peers in the areas of doing business and competitiveness

2. Unlocking access to land that has been identified as a major bottleneck for investment

3. Creating a flexible labour market and raising labour force participation. There are a plethora of legislation governing labour in Sri Lanka which act as a serious impediment for job creation. Furthermore, Sri Lanka has a rapidly ageing population and is no longer benefitting from a demographic dividend. However, it has access to a large untapped source of female labour. Encouraging greater female participation in the labour force requires removal of legislation restricting employment of female workers and improved infrastructure such as childcare and safe transport services

4. Addressing infrastructure gaps to enhance productivity and efficiency of the factors of production. We need to invest in infrastructure that has high social and economic returns. This requires better processes for project appraisal and selection, better management of risks which otherwise could lead to cost overruns and project delays, and greater accountability to reduce waste and corruption.

Finally, the budget needs to build buffers to strengthen the resilience of the economy to shocks. Households have been disproportionately affected by the ongoing pandemic because they lack the buffers to cushion them from economic shocks. Workers, particularly in the informal sector, have lost jobs due to the impact of lockdowns and the closure of borders. Although the Government provided some relief to households affected by the pandemic by way of income transfers, the lack of fiscal space constrained the Government’s ability to adequately respond to the crisis.

In addition, Sri Lanka’s existing social protection scheme has significant coverage gaps and needs to be extended to include informal sector employees, daily wage earners, and self-employed workers. Ad hoc payments are not sufficient to keep people from falling into poverty. Urgent action is needed to establish a universal social safety net and reduce targeting errors to ensure those who need support receive it when they need it most.

Micro, small, and medium-scale enterprises (MSMEs) play a vital role in the Sri Lankan economy, accounting for over half of Sri Lanka’s GDP and over 90% of total enterprises and 45% of employment in the non-agriculture sector. This sector was severely affected by measures taken to contain the spread of the virus, such as travel bans, lockdowns, and social distancing. To mitigate the impact of the pandemic, the Government and CBSL introduced various emergency liquidity support programmes, debt moratoriums, and extension of facilities at concessionary interest rates. While these schemes may have prevented some firms from bankruptcy, the Government is unable to continue providing such relief, given the prolonged nature of the pandemic and the fiscal constraints it faces.

However, given the size of this sector and its importance to the economy, ensuring the solvency of these firms as well as increasing their productivity is paramount to Sri Lanka’s long-term economic growth prospects. As the pandemic continues to affect economic activity, many firms will emerge with serious impact on their balance sheets. Therefore, as economies transition to normalcy, it is important to repair balance sheets by reducing unsustainable debt and rebuilding cash reserves. Firms that are not resilient, are uncompetitive, or are heavily indebted will collapse during such crises. To reduce the adverse economic impact of ad hoc closures in the most productive manner, the Government must ensure access to an effective bankruptcy regime. Such a mechanism will strengthen economic resilience, while incentivising firms to prioritise strategies to repair balance sheets in the medium term before they reach bankruptcy.

In conclusion, the key focus of policymakers should be on addressing macroeconomic imbalances. Priority should be given to correcting the twin deficits, i.e. the fiscal deficit and the external current account deficit, stimulating economic growth, and improving competitiveness while building buffers to strengthen the resilience of the economy to shocks.

(The writer is a Senior Research Fellow at the Advocata Institute and a former Director of the Central Bank of Sri Lanka)

Air India sold; privatise SriLankan now

Originally appeared on the Daily FT

By Prof. Rohan Samarajiva

Privatisation should not take into account the nationality of the purchaser, but that a foreign acquisition would, on balance, yield a more sustainable solution

Air India, which was losing $ 3 million a day on average (over $ 1 billion per year) has been sold for what amounts to loose change for a conglomerate the size of Tata Sons: $ 400 million plus the assumption of $ 2 billion out of the massive debts in excess of $ 8 billion accumulated by the state-owned carrier over the years.

But this is a good deal for the people of India. It is one that we in Sri Lanka should study and emulate.

Air India, founded by the Tatas in 1932, was expropriated by the state a few years after independence. It, and Indian Airlines which was merged with it a few years back, had the backing of the state, unlimited financing, and monopoly rights in both the domestic and international segments. Yet, service was awful, and profits were rare. 

As the market was opened to competition, first in the domestic segment and then in the international, the two state-owned airlines failed to meet the challenge. Even today, Air India is smaller than IndiGo, an airline which commenced operations in 2005.

The greatest benefit to the public is the avoidance of subsidising the airline. The government will still have to deal with the remaining debts of the company but at least the liabilities will not keep growing. And if the Tatas manage to turn it around, the government will receive tax revenues.

100% sale

It took the Modi government four years to get to this point in the sale. But in fact, various Indian governments have been trying to do something about this bleeding sore for much longer. Earlier attempts failed because the government was trying to keep an ownership stake and the ability to interfere in management. 

In 1998, the Kumaratunge government sold only 40% of the money-losing and inefficient Air Lanka for $ 70 million. It bundled the sale with a 10-year management contract to Emirates. But given the crudity of how the letter and spirit of the management contract was violated by the government in a fit of pique, it was unlikely that any new investor/manager would trust the government of Sri Lanka to keep its word.

Back in the 1990s or even in the following decade, state-owned airlines were seen as having value. But over time, the environment has changed, and they are beginning to look less like marquee investments and more like collections of landing slots and aircraft. With the present transaction, more attention is being paid to Air India’s Heathrow landing slots than the value of its brand or the prestige of being a flag carrier. The airline business is a regulated activity vulnerable to state interference and coercion. Even having 100% ownership is not going to protect an airline with the major presence in a national market from the caprice of a head of state annoyed that his entourage did not all get seats in business class. But it is better than having thieves foisted on the airline as managers. The thievery engaged in by SriLankan management is now in the public record, thanks to the Airbus investigation. 

For how much?

Even when Emirates was remitting dividends to Treasury, the airline itself was not profitable (though it was not haemorrhaging money like after Emirates departed); the real money makers were catering and ground handling, which were monopolies. The considerable pressures that will be exerted to bundle these activities along with the airline to show a less cringeworthy sale price should be resisted. 

Once we get rid of the money-guzzling airline, action should be taken to provide the best possible services to all airlines without discrimination through optimal use of the tools of competition: competition for the market and competition in the market.

The Government can save face by manipulating the debt component of the sale, as has been demonstrated in India. Because the government of India is absorbing more of the debt than the stated sale price of $ 2.4 billion or the actual cash component of $ 400 million, an uncharitable observer could even claim that the Modi government is giving away an airline for nothing. But that disregards how much is saved by not having the white elephant in government hands: more than $ 1 billion a year.

With SriLankan, the avoided losses to Treasury would be Rs. 99 million a day, the average per day loss incurred by the airline in 2018, 2019 and 2020. The less abnormal years of 2018 and 2019 were included lest it be said that no general claims could be made from losses in a pandemic year. Rs. 99 million ($ 0.5 million a day) is quite a bit lower than Air India’s $ 3 million a day benchmark. But it must be remembered that most things in India are around 50 times the size of Sri Lanka, whereas the daily loss is only six times. 

But still, not losing Rs. 36 billion per year ($ 180 million) a year would be nice. That’s close to one fourth of what the Government spent on pensions in 2020. In times like this, every billion matters.

But it should be Sri Lankan

Once I was on a TV talk show with JVP leader, making headway with the argument that the taxes paid on potatoes and milk powder by a housewife in Siyambalanduwa should not be spent on subsidising SriLankan Airlines. He conceded that such subsidies were wrong and that the government appeared incapable of running an airline. But he said, why do we have to sell it to foreigners? Why cannot some good Sri Lankan capitalists take it over and run it professionally? 

So shocked was I by this ceding of ground that I was unable to properly respond, which I will do now. My first response would have been to say that from a Marxian perspective the nationality of the capitalist makes no difference. Exploitation is no less objectionable because the capitalist carries the same passport as the exploited. But then, perhaps Marxism is no longer relevant, this being three decades after the fall of the Berlin Wall and all that. 

As a consumer why would I care about anything other than the price-quality bundle offered by the airlines offering service to the destinations I wished to travel to? If one of the airlines happened to be a lossmaker like Air India or SriLankan, subsidised by other people’s tax dollars, that would be even better for me as a consumer. 

But then, it could be argued that this was a form of predatory pricing, whereby even efficient airlines were driven to rack and ruin because they have to match the artificially low prices of the state-subsidised carriers. As a consumer I would not care, but perhaps as a policy maker I may. The remedy for this would be some form of inter-state agreement not to offer subsidies, as there exists in the European Union.

But this would be a digression, because the whole point of privatising to a foreign or domestic investor would be to get away from subsidising the flying rich. If the investor believed he would not be bailed out, he would run the business in a responsible manner, offering reasonable prices and withdrawing from ruinous competition where such popped up. The only danger would be the state (or the Cardinal through the state) exerting pressure not to withdraw from unprofitable routes, something SriLankan is very familiar with.

Who would be able to better resist such pressures, a domestic or a foreign investor? The answer being the latter, I would conclude that privatisation should not take into account the nationality of the purchaser, but that a foreign acquisition would, on balance, yield a more sustainable solution.

Rohan Samarajiva is founding Chair of LIRNEasia, an ICT policy and regulation think tank active across emerging Asia and the Pacific. He was CEO from 2004 to 2012. He is also an advisor to the Advocata Institute.

When ‘national assets’ become ‘national liabilities’

Originally appeared on The Morning

By Dhananath Fernando

• Understanding the Trinco Oil Tank Farm controversy

Robert Kysokai, the author of the book “Rich Dad Poor Dad”, defines the difference between an asset and a liability quite simply. According to Mr. Kysokai, who is a management guru, anything which creates a cash flow is an asset and anything that dries the cash flow is a liability. If someone buys a car to be rented out to a taxi service, then it is an asset, because it can create cash flow and generate income. It can cover the expenses of the car from the income it creates by being used as a taxi. But if someone buys the same car to commute to work, it’s a liability, because it dries the existing cash flow from a different cash inflow, as the buyer has to incur regular cost for fuel, insurance, running costs, etc.

The lack of understanding of this simple concept has cost Sri Lanka a few generations of delayed development, with the recent fiasco surrounding the Trincomalee Oil Tank Farm story being a prime example of this.

The discussion surrounding the Trinco Oil Tank Farm is a good case study to explore the question as to whether the resources we have as a country are actually “national assets” or “national liabilities”. In most cases, holding onto national resources has gone on to create “breeding grounds for corruption and crime”, thereby becoming national liabilities.

The Trincomalee Oil Tanks were developed by the British, using labour from British territories in Africa between 1924 and 1930 – almost a century ago. The project plan was to develop 102 oil tanks. Tank number 100 was not developed and tank number 91 was destroyed due to an aeroplane accident. The tanks were constructed with inch-thick steel and protected with foot-thick concrete rings. The objective of setting up the tanks in Trincomalee was to make the  Trincomalee Port a naval hub in the region. This could be utilised for trade and military usage. The Trincomalee Port was one of the main natural deep-water ports where big vessels can be docked easily. So the vision behind setting up an oil tank farm in Trincomalee was mainly to set up an ecosystem for naval operations and bunkering operations.

In the meantime, in the 1970s, Sri Lanka introduced a policy of nationalisation and self-sufficiency. As a result, the properties of foreign energy companies that were in operation were asked to leave our shores, with the government monopolising the energy market.

Singapore took this as an opportunity and embraced all oil companies that left our shores. They were, in fact, welcomed with open arms. Provisions were made for them to invest and provide the freedom to take their profits off if they wanted. But instead of taking the profits off, investors invested them back into Singapore and made Singapore a dominant trading hub in the region, while also making it a maritime centre. Sri Lanka lost a great opportunity. This loss is signified  by the difference in the GDP per capita of the two countries. In approximate figures, Sri Lanka’s per capita GDP is $ 4,000 while Singapore’s per capita GDP is $ 60,000.

Rather than utilising the resources of oil tanks as an asset by working with foreign investors, the government taking over the energy market converted the asset into a liability. As a result, taxpayers have to keep supporting the colossal loss-making Ceylon Petroleum Corporation (CPC), which was a creation of this monopolising energy markets.

Since the nationalisation and self-sufficiency attempts in the 1970s, only about 15 oil tanks were used by CPC and their subsidiary, Ceylon Petroleum Storage Terminals (CPST) Ltd., till 2002, when Indian Oil Company bought one third of CPST’s shares. Then, the 15 tanks were leased out on a 35-year lease agreement to India for development. The Liberation Tigers of Tamil Eelam (LTTE) war too obstructed the optimum usage of the tanks. Each tank in the  Trincomalee Oil Tank Farm has a storage capacity of about 12,000 MT per tank, which accounts for about 1.2 million MT of storage in the entire facility. The recently built Muthurajawela Oil Tank Facility, built with a $ 72 million loan from China’s Exim Bank (total investment was $ 157 million), can only store upto about 250,000 MT. So the capacity of the Trincomalee Oil Tanks is far more substantial.

However, according to the shipping  industry expert Mr.Rohan Masakorala, the  LTTE problem would never  have taken off if the foriegn oil companies were allowed to operate in Trincomalee. According to him their entire eastern coastal belt would have been developed as much as Colombo, if we had allowed the foreign capital and technology to flow in,  especially in the Energy Market.

In 2018, the then Minister of Petroleum had discussions on a joint development project with India for 15 oil tanks out of the remaining 85 tanks. Again, another political monsoon started and nothing took off. So for nearly a century, we really didn’t use the Trincomalee Oil Tanks, although we still claim it as a “national asset”. Refurbishment of Phase I of the Trincomalee Oil Tanks requires a few billion dollars of capital. It also requires technology beyond our shores, and having an international partner is the only way to operationalise it.

Again in February, the current Minister of Petroleum announced that Sri Lanka is going to take over all oil tanks. Now there is a national interest on these oil tanks as a result of the Indian Foreign Secretary’s visit. The simple reality is that the 100 oil tanks which we failed to do anything with for 100 years, which occupies valuable land stretching 850 acres, are not really assets at present, from an economic perspective. They are simply liabilities, and in our case, they are even more than liabilities.

The only solution we have is to open our resources for foreign investments, if Sri Lanka is really serious about coming out from this economic downturn. Trincomalee has the potential to become a revenue-earning asset. The emerging Bay of Bengal economy is just opposite the Trincomalee Port. Chennai, Bangladesh, Visakhapatnam, and Thailand are countries and cities with large populations, with bigger markets where Trincomalee has the capacity to trade with and become a naval point for much larger economies. Currently, the trade volume we do at the Trincomalee Port is very limited, and the Prima factory and the cement plant are the only players presently using these facilities.

We have to think about Trincomalee as a whole and see the bigger picture than just seeing a fraction of it. The development of Trincomalee can be further extended with tourism up to our southern beach belt.

National assets are the ones that generate cash flows, regardless of ownership, and national liabilities dry up our cash flow. From an economic perspective, what we really celebrate as “national assets” and what we really try to hold for ourselves are “national liabilities”.

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.

Regulating prices: From price mandates to more competition

Originally appeared on Daily FT, Lanka Business Online, Colombo Telegraph, Ceylon Today and the Morning

By Thiloka Yapa

As price controls ultimately lead to instability in the system, a surer way to achieve stability and growth is to allow markets to flow freely and responsibly

The Government recently removed the maximum retail price (MRP) on rice with a decision to import a buffer stock of rice to prevent any shortages.1 This is an important step in the right direction. Opening up the market for more competition will reduce the market power of the alleged oligopoly of large-scale rice mill owners. While the removal of the MRP is commendable, the Government’s action on this front has been anything but consistent. Despite the frequent use of price controls and their appeal to politicians, economists are generally opposed to them, except perhaps for very brief periods during emergencies. While the pandemic is undoubtedly an emergency, Sri Lanka’s current economic problems are largely due to poor policies. 

Although the politicians who impose them may be motivated by good intentions, they are counterproductive, often leading to higher prices and damaging the market. 

The Parliament recently passed an amendment to the Consumer Affairs Authority Act which increases fines on traders who do not follow the MRP issued by the Consumer Affairs Authority (CAA).2 Raising the penalties seems to indicate that the Government intends to impose controls more strictly. The reason that some of the ill-effects of price controls were not experienced is because they were not strictly enforced. Previous research by Advocata Institute revealed that only larger producers and the larger retailers in the formal sector adhered to them; in the informal markets and among smaller retailers these were routinely ignored so the shortages and black markets associated with price controls were not widespread.3 Strict enforcement and larger fines could see products disappearing from shelves as traders find it no longer profitable to engage in the trade of the controlled commodities.  

Price regulation and its impact 

Price controls are administered through the Consumer Affairs Authority Act which has the power to regulate prices.4

Under Section 10(1)(b)(ii) of the Act, the authority, in protection of the consumer, can call retailers and wholesale traders to register their stocks and warehouses with the CAA. Moreover, under Section 18, the Minister in consultation with the CAA is empowered to specify any good or service, as essential to the life of the community, by way of gazette notification. Manufacturers and traders are restricted from increasing prices without the prior written approval of the CAA. A period of 30 days is provided for the authority to examine the application for any price revision and convey the decision to the applicant company. 

This Section permits the CAA to make decisions on behalf of traders in the market, whenever it regards a product to be ‘essential’. Further, under Section 20(5), the Authority can fix the maximum price above which goods and services cannot be sold. It was under this section that the recent MRP for sugar, rice and LP Gas was imposed. 

This regulation could be a barrier against market competition, as it may deter the entry of new firms and discourage innovation which curtails competition. Competition plays a vital role in a market economy. It incentivises firms to challenge each other, create new markets and expand existing markets. While this leads efficient firms to enter and grow, inefficient firms shrink and exit. Firms innovate, leading to lower prices and enhance consumer choices. While the objective of the Consumer Affairs Authority Act No. 9 of 2003 in itself is to promote competition and protect consumers, the impact of the provisions which allow the authority to regulate prices lead to the exact opposite, resulting in high prices and less choice for consumers.

Prices play a key role in a market economy. It is a signal, wrapped in an incentive. Change in prices incentivise individuals to respond; either by consuming less of a product, or shifting to alternatives. Price controls distort these signals. Since the Government defines market prices when controls are imposed, it forces the market to function based on the imposed price. As producers and consumers respond to controls, they produce an excess supply when the prices are set high or increase the demand when prices are set low. This leads to wastage and shortages, exacerbating the fundamental economic problem that the controls expect to solve. 

A 2018 report on price controls by the Advocata Institute revealed that price controls have limited value in controlling the cost of goods, particularly in the consumer market due to weak enforcement.5 The report highlighted other ill-effects: traders surveyed have admitted to the problem of low-quality goods being brought into the market, meaning that quality suffers as a result. As traders are under pressure to comply, they resort to importing substandard products to supply at prices close to the controlled price.

The enforcement of ad-hoc controls also adds up to the costs of suppliers, as these regulations distort their cost structures. This was the case when the Government slashed the Special Commodity Levy on sugar, big onions, dhal and canned fish in November last year, imposing an MRP on these commodities.6 The sellers who were impacted, opposed the MRP and continued their sale at high prices, claiming they would incur massive losses since the stocks were purchased before tax revisions, at a much higher price. 

Price controls also result in policy uncertainty. This is a situation where there is ambiguity in the stability of future rules and regulations. While entrepreneurs in the market will then keep attempting to predict what regulators would do in the future, this comes at the expense of consumers, who would have otherwise been the main-focus of these businesses.7

What can be done?

Sri Lanka urgently needs to rethink government interventions that increase the costs of competing. At a recent discussion hosted by the Advocata Institute, the newly-appointed Governor emphasised the importance of growth and stability. He stated that the lack of stability would lead to uncertainty. As price controls ultimately lead to instability in the system, a surer way to achieve stability and growth is to allow markets to flow freely and responsibly. For this to happen, as one major reform, Sri Lanka needs to amend the sections in the Consumer Affairs Authority Act that permits the authority to regulate market prices. In doing so, it is also worthy to review Sections 34 to Section 38 in the Act, which aims to promote competition and revisit the mandate of the CAA. 

1.  Ruwani Fonseka, ‘Alagiyawanna explains removal of MRP on rice’, The Morning, September 28, 2021 https://www.themorning.lk/alagiyawanna-explains-removal-of-mrp-on-rice/ (accessed September 29, 2021)

2. Parliament of Sri Lanka, ‘Hon. Speaker endorses the certificate on the Consumer Affairs Authority (Amendment) Bill’, Parliament of Sri Lanka. September 23, 2021, https://parliament.lk/en/news-en/view/2263 (accessed September 25, 2021)

3. Advocata Institute, ‘Price Controls in Sri Lanka-Political Theatre’( Sri Lanka: Advocata Institute, 2018), 24 https://www.research.advocata.org/wp-content/uploads/2018/10/Price-Controls-in-Srilanka-Book.pdf (accessed September 25, 2021)

4.  Consumer Affairs Authority Act No. 09 of 2003 

5. Advocata Institute, ‘Price Controls in Sri Lanka-Political Theatre’( Sri Lanka: Advocata Institute, 2018), 9 https://www.research.advocata.org/wp-content/uploads/2018/10/Price-Controls-in-Srilanka-Book.pdf (accessed September 25, 2021) 

6. ‘Revised taxes, MRP complicate commodities market’, The Sunday Times, November 22, 2020 https://www.sundaytimes.lk/201122/business-times/revised-taxes-mrp-complicate-commodities-market-423077.html (accessed September 30, 2021)

7. Institute of Economic Affairs, ‘Flaws and Ceilings: Price Controls and the damage they cause’ (London: London Publishing Partnership, 2015) quoted in Advocata Institute, ‘Price Controls in Sri Lanka-Political Theatre’( Sri Lanka: Advocata Institute, 2018), 43 https://www.research.advocata.org/wp-content/uploads/2018/10/Price-Controls-in-Srilanka-Book.pdf (accessed September 25, 2021)
   
   ‘රටේ ආර්ථිකය හා අපේ හෙට දවස’ YouTube video, posted by “Advocata Plus,” September 25, 2021, https://www.youtube.com/watch?v=8JvWQWn7cHw (accessed September 25, 2021)
   

Thiloka Yapa is the Research Analyst at the Advocata Institute and can be contacted at thiloka@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.

When price controls get out of control

Originally appeared on The Morning

By Dhananath Fernando

• Price controls lead to shortages and distort markets

Why has Sri Lanka’s economy remained stagnant? This is not a difficult puzzle to solve. It is simply because Sri Lanka has repeated the same failed policies ignoring “economic fundamentals”. This is evident now more so than ever by the number of “price controls” imposed by the Government. Even an amateur student of economics would know that price controls distort markets creating black markets. Black markets mean reduced quality of goods and services and shortages. The recent conundrum of a few rice millers declaring rice prices and the Government having to withdraw price controls is the best example of the failure of this policy measure. The lack of economic analysis behind such policies have not only diluted the Government’s political capital but also have created shortages of rice in the market. 

It is no secret that the entire economic system has been damaged by the implementation of price controls. The real impact, like in the case of rice, is much more severe than what we see on the surface. 

A retired army officer was appointed to ensure the supply of essential food items. He raided a few rice mills, warehouses, sugar storages, and other essential commodities as per media reports to ensure the supply of essential food items. However, the recent withdrawal of price controls on rice is an indication of the failure of such short-sighted policies. Shortages sprouted, markets reacted and prices have increased further. These miscalculated policies have also led to the dilution of investor confidence by providing all the wrong signals to investors. Heavy Government intervention in businesses and private property, confiscating stocks and storages discourage investors. 

Markets work on the principles of demand and supply. It is a series of coordinated actions and reactions. These happen as a result of people working for the benefit of each other when allocating scarce resources which have alternative uses. Allowing this system to function can achieve the best outcomes for everyone, especially the consumers. Controlling the price by means of force is counterproductive. This will leave a bitter taste for both the consumer and producer as well as the Government. 

The political theatre of price controls is not new to Sri Lanka. It goes back to the 1970’s. Since then Sri Lanka has had a habit of imposing, relaxing and reimposing price controls. We have been in the same vicious cycle for decades. The previous Yahapalana Government imposed price controls on hoppers, tea, and milk tea. The current Government imposed price controls on another long list of goods including lentils and tinned fish. Even today, our USD has a price control of Rs. 203 per dollar. As a result there is a serious shortage of USD in the market. What is evident is that all items which have price controls imposed, experience some level of shortage or market distortions. 

How can the distorted rice market be rectified? 

The distortion of our rice and paddy market ultimately boils down to poor productivity along with excessive political and Governmental interference in the industry. The contribution of the agricultural sector to the country’s GDP is 8% with about 24% of the country’s labour force in agriculture. This is a good indicator to highlight how unproductive the sector is. Additionally, analysis shows that our pricing of one kilogramme of rice is completely irrational. According to research, paddy is a water guzzler that consumes about 2400 litres of water for transpiration. Further, 1200 litres is required to produce one kilogramme of rice. At the moment we do not charge for water needed for paddy cultivation. Most of the water provided is subsidized by taxpayer money. Additionally we provide fertiliser at a subsidised rate (organic or chemical). The subsidy is included in the price of paddy and rice. One of the main factors of production which is land is also not calculated in the cost of production as most of the cultivated land is owned by the Government. 

If we were to calculate the price of water, land and fertiliser, the cost of production of rice in Sri Lanka is extremely high. So if Sri Lanka is serious about rectifying the problem of rice, all these issues must be addressed. Attempting to control the price which is the final indication of resource allocation is not the solution. Failure to address the real bottlenecks at the root of the issue will exacerbate problems faced by the paddy farmer as well as the consumer. 

Importation of rice is not a popular topic in Sri Lanka for many reasons including the current forex crisis. One way to address the market manipulation by rice millers and provide consumers affordable prices is to let the market system work. That includes allowing the importation of rice by private businesses. Unlocking land for our farmers too is important to increase their productivity by using low cost methods of farming. At the moment since the land is owned by the Government, capital infusion and technological development that could be done is limited. Farmers cannot take a loan from the bank or do any technological advancement using the land as collateral. Farmers have very limited options and they are trapped in a vicious debt cycle while continuing to resort to unproductive methods of farming on land they do not own. 

Until Sri Lanka comprehends the problem, our solutions will be mere performative political theatre. Without evidenced-based public policies and a good understanding of economics, price controls will be imposed and reversed overnight, leaving the consumer, producer and the Government with a foul taste.

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 Athukorala: Sri Lanka and the IMF: Myth and reality – Part 3

Originally appeared on The Daily FT.

By Prof. Prema-Chandra Athukorala

IMF programmes and economic performance

There are two ways to evaluate the impact of IMF stabilisation programmes: (a) counterfactual evaluation: comparing outcome with what would have happened without the programmes; and (b) comparing results to objectives: evaluate performance against the benchmarks imposed by the policy-makers. 

It is not possible to apply the first approach to assess the impact of IMF programmes using data for a single country simply because there is no suitable counterfactual (situation in the absence of the programme) for assessing how the country would have fared without the programmes. This approach can be applied with ‘proxy’ counterfactuals only in multi-country comparative analyses (Goldstein and Montiel 1986, Barro and Lee 2005, Easterly 2005, Vreeland 2003). We apply here the second methodology, using economic growth (measured by annual growth rate of real GDP) as the key performance criterion.

In Table 2, the average growth rate of the Sri Lankan economy during the years under IMF programmes (‘programme years’) is compared with that of the entire period (1965-2019) and years without IMF programs (excluding the ‘pandemic’ year of 2020). The growth rate in all programme years (4.91) is 0.42 higher compared to that of the non-programme years (4.49). When the programmes years are separated into years under fully-implemented programmes (proposes under with the entire committed fund was disbursed by the IMF) and partially implemented programmes, the growth impact of the fully implemented programmes is found to notably higher, as one would expect (5.16%). 

Note that doing the period under study (1965-2009), all non-programme years are preceded by programme years: the period stars with the first IMF programme in1965. Therefore, lower growth rates in the non-programme years reported in Table 2 shows that, on average, the positive growth impact of the programs has not percolated beyond the programme years. The average growth rate during the non-programme years is 4.49 compared to 5.16 during the average growth rate during the fully-implemented programmes. 

This simple comparison of growth rates ignores the possibility that the growth impact of reforms could have shaped by exogenous shocks such as the two JVP uprisings (in 1971 and during 1988-89), escalation of the separatist war, and changes in the terms of trade. Also, the economy has the natural tendency to grow over time at a certain rate regardless of reforms. Moreover, the degree of openness of the economy to foreign trade could impact on the nature of the adjustment process in the economy (Arpac and Bird 2009). The real issue is whether the IMF programmes have produced better growth performance after allowing for these other factors.

We undertook an econometric analysis to delineate the impact of IMF programmes after controlling for these influences. The results indicate that average growth rate is 1.26 percentage points higher using the 33 years under all programmes compared to the non-programme years. This estimated growth impact is however statistically significant only at 20% (that is, there is a 20% probability that this estimate is likely due to chance). By contrast, for the 25 years of completely fully-disbursed programmes, the growth rate is 1.45 percentage points higher compared to the non-programme years and incomplete programme years are taken together. This estimate is statistically significant at the one-percent level (that is, there is only one percent probability that this growth impact is likely due to chance).

In sum, the results of the econometric analysis is consistent with what we observed in the simple data tabulation (Table 2). This estimated growth impact is all the more impressive when we take into account what the econometricians call the possible ‘negative selection bias’. A country normally approaches the IMF at a time of macroeconomic distress. It would not, therefore, be surprising if we had found no statistically significant association or even a negative association between programme participation and economic growth (Easterly 2005). 

It is clear from this evidence that the growth outcome during the IMF programme years has been respectable. But, have the programmes been successful in rectifying macroeconomic imbalances of the economy to set the stage for sustainable growth? This is an important issue because the very purpose of IMF stabilisation programmes is to achieve ‘adjustment with growth’. 

Addressing this issue requires an in-depth analysis of individual programmes, paying attention to the programme objectives, problems cropped up in the implementation process, and the impact of the programmes on the overall incentive structure of the economy. However some tentative inferences can be made by comparing the relevant macroeconomic variable across years of the fully-disbursed programmes and non-programme years. The relevant data are summarised in Table 3. 

The data clearly indicate the catalytic effect of the programmes on net capital inflows to the country. During the programme years, net capital inflows relative to GDP was 1.4 percentage points higher compared to the non-programme years (or the level of net capital inflows was about 32% higher than during the non-program years). Increase in capital flows seems to have helped maintaining imports and government expenditure at relatively higher levels. However, there is no evidence of net capital inflows augmenting domestic investment: investment as a percentage of GDP is strikingly similar between programme years and non-programme years.

There is some evidence of improvement in the country’s international competitiveness (measured by the real exchange rate change), but this has not persisted beyond the programme years.

Government revenue was notably higher during the programme years, with an increase in tax revenue making a significant contribution to the increase. However, this was overwhelmed by the Government’s failure to contain Government expenditure. The difference of the magnitudes of excess domestic demand (which is equal to the sign reversed value of net capital inflows), current account deficit and the budget deficit during programme years and non-programme years are striking similar. 

This pattern suggests that domestic excess demand, which is driven by the failure to contain the budget deficit, is the prime driver of the failure of the reform programmes to contain the external imbalance (widening current account deficit). The current account deficit during the programme years is 50% larger compared to that in the non-programme years (4.8% compared to 3.2% of GDP).

The date relating to the domestic imbalance (domestic expenditure over income) of the economy and the overall Government budget balance are depicted in Figure 1. Note that the domestic imbalance is by definition equal to the current account balance (the external imbalance), after allowing for changes in foreign reserves and valuation effect on foreign assets resulting from exchange rate changes. The figure therefore vividly demonstrates that the explanation of the persistent external imbalance of the economy is deeply rooted in the failure of fiscal management. The widening budget deficit that propels domestic excess demand has been an endemic structural feature of the economy, notwithstanding repetitive recourse to IMF adjustment programmes during the period under study.

Concluding remarks: Seeking or rejecting IMF support

There is no evidence to suggest that the IMF has been a determining hand in shaping economic stabilisation reforms in Sri Lanka. In all 16 stabilisation programmes supported by the IMF during 1965-2020, the decision to go to the IMF has been dictated by the country’s own failure to keep the macroeconomic house in order. There is no evidence to suggest that the IMF insisted on implementing a stereotyped policy package in all ‘crisis’ cases. Moreover, governments in both ideological camps have gone to the IMF in times of need.

The Sri Lanka-IMF relationship during the UF movement during 1970-77 indicates that there is room to enter into an IMF programme even for a national government with an incompatible ideological position provided it agrees with the IMF on the importance of achieving macroeconomic stabilisation. During the right-of-the centre UNP regimes of 1977-’94, the IMF supported trade liberalisation, but subject to its standard conditionality relating to macroeconomic stability. In hindsight, one could surmise that the outcome of the liberalisation reforms would have been much more impressive had the Government followed IMF-World Bank advice (and Shenoy’s advocacy) for combining trade and investment liberalisation with macroeconomic stabilisation. 

There is convincing evidence that the growth rate of the economy was significantly higher during the years of fully-implemented IMF stabilisation programmes. However, the long-standing fundamental macroeconomic disequilibria of the country has persisted despite the repetitive reliance on IMF programmes. This simply reflect policy failures of the country to use the breathing space provided by the programmes to undertake the required structural adjustment reforms: the ‘repetitive client status’ of the country does not, therefore, make a case for rejecting IMF support. 

Borrowing from the IMF is much cheaper than raising funds through sovereign bond issues and borrowing from other commercial sources. Unlike other donors, the IMF always lend funds to the Central Bank of the country strictly for meeting external payments. Therefore, IMF programmes do not have a direct impact on the domestic money supply and hence domestic inflation. More importantly, entering into an IMF programme acts as a catalyst to generate additional financial assistance. 

Other international financial institutions such as the World Bank and the Asian Development Bank, and individual donor nations find comfort to lend to Sri Lanka as the lending risks are reduced given the financial discipline that an IMF programme instils. Financial credibility achieved by entering into an IMF programme also helps raising funds at competitive interest rates from private capital markets.

Delaying the inevitability of approaching the IMF can be costly in the form of more stringent conditionality. The IMF team visited Sri Lanka in February 2020 to meet with the new administration and discuss its policy agenda has pre-warned about Sri Lanka’s formidable macroeconomic adjustment challenges: ‘Ambitious structural and institutional reforms are needed to anchor policy priorities, buttress competition and foster inclusive growth. Fiscal prudence remain critical to support macro-economic stability and market confidence, amid high level of debt refinancing needed. Given risks to debt sustainability over the medium term, renewed effort to advance fiscal consolidation is essential for macroeconomic stability.’ [https://www.imf.org/en/News/Articles/2020/02/07/pr2042-sri-lanka-imf-staff-concludes-visit-to-sri-lanka]

(Prof. Prema-Chandra Athukorala is a Fellow of the Academy of the Social Sciences of Australia, an Emeritus Professor of Economics at Australian National University and an Advisor for Advocata Institute and can be reached via Prema-chandra.athukorala@anu.edu.au)

Prof Athukorala: Sri Lanka and the IMF: Myth and reality – Part 2

Originally appeared on The Daily FT.

By Prof. Prema-Chandra Athukorala

Since 1965 Sri Lanka has been a ‘repetitive client’ of the IMF. The country has entered into 16 economic stabilisation programmes during 1965-2000. Macroeconomic management of the country has been under IMF programmes for approximately 33 years of the 55-year period.

1970-’75: Trotskyite Finance Minister seeking IMF support again

The United Front coalition (UF) came into power in 1970 promising to ‘to lay the foundation for an irrevocable transition to the economy to a socialist one’ (Perera 1970a, p. 4-5). The development strategy of the new Government envisaged combining ‘outward looking development with the right mixture of internal policies and approaches to domestic resource mobilisation which prove to be socially acceptable’ (Perera 1970b, p. 176).

By 1970, Sri Lanka’s repayment obligations to the IMF had become an important factor that contributed to high level of capital amortisation because of repetitive recourse to borrowing in the second half of the 1960s (Central Bank Annual Report 1971, p. 194). NM, the Finance Minister, started negotiation for a fifth SBA with IMF within months of the new Government coming into power. In his 1970 Budget Speech he argued that “we cannot brush aside and completely ignore these international institutions; we can repudiate their terms only if we are prepared to face the far-reaching distortions” (Perera 1970).

The initial discussions were held in June 1970 in Colombo with D.S. Savkar, Assistant Director, West Asia Division of the IMF. NM attended and addressed the IMF-World Bank annual conference in Copenhagen in September 1970 and persuaded the IMF Managing Directors Paul Schweitzer to visit Colombo on 20 October 1970. Final discussion were held in Washington DC in December 1970. In the negotiations, NM was assisted by a strong team of technocrats including W. Tennekoon (Central Bank Governor), M. Rajendra (Secretary to the Treasury) and H.A. de S. Gunasekera (Permanent Secretary, Ministry of Planning and Employment).

The IMF was firmly of the view that the imbalance of payments can only be set right by a further devaluation of the Rupee. The Finance Minister opposed to the idea because of the perceived inflationary impact it would have and managed to convince the IMF team that the Government had the capacity to reduce the budget deficit by taking firm actions to reduce the budget deficit, promoting domestic saving, relaxing credit controls, encouraging exports and pursuing a vigorous programme of import substitution. The IMF approved a SBA of $ 25.6 million on 17 May 1971. To facilitate the implementation of the SBA, the IMF enlisted assistance of the World Bank and some downer countries for an aid programme.

After signing the SBA, NM emphatically defended his decision to go to the IMF in the Parliament: ‘effort to put its own house in order was not the result of IMF advice but was the obvious thing to do in the national interest’ (Hansard, Vol 91, November 10, 1971, cc 2621-2633).

The worsening balance of payment situation in the wake of the oil price increase in 1973 compelled the Government to negotiate another SBA. In preparation for negotiations the Government came up with some ‘sweeteners’ for the IMF: the rupee was re-linked to the pound sterling from the US$ when the pound was floated on 23 June 1972 resulting in an indirect devaluation of the rupee by about 7%.; in November 1972 the FEECs rate was increased from 45% to 65% with an expansion of the import coverage of FEEC scheme to nearly 75%, and the food subsidy bill was cut substantially on its own initiative. The negotiations took two years and a personal visit by the Finance Minister to the IMF before signing the agreement to the tune of $ 29.6 m on 30 April 1974.

Sri Lanka obtained only the first instalment ($ 8.5 m) under this SBA. The IMF withheld the balance because the Government failed to adhere to the ceiling imposed on domestic credit. Perhaps the Government was not under pressure to stick to IMF conditionality in that year because of the availability of ‘easy’ IMF finance under the newly-introduced Oil Facility (SDR 34 million) and the Compensatory Finance Facility (SDR 7.0).

The Government approached the IMF for another SBA in 1975. However, the discussions floundered allegedly on account of the Government’s reluctance to cut further subsidies as required by the IMF (Kappagoda and Paine 1981, p74).

The UF Government made considerable progress towards macroeconomic adjustment with the help of the IMF programmes. Both the annual debt servicing burden and the term structure of external debt significantly improved. However, as Kappagoda and Paine (1981) have convincingly argued, ‘the payment adjustment [cut in domestic absorption] proceeded faster than was warranted’ (p. 100).

The adjustment burden primarily felt on imports with serious adverse effects on the economy’s medium term prospects and consumer wellbeing. The groundswell of unhappiness of the electorate paved the way for the UNP to return to power with a landslide majority in June 1977.

1977-’88: The first wave of liberalisation reforms 

The widely-held view in the Sri Lankan policy circles is that the regime shift opened up the opportunity for the IMF to dictate ‘neo-liberal’ reform in Sri Lanka (Gunasinghe 1986, Lakshman 1985, Davis 2015). Lakshman (1985, p. 22), in particular, claims that ‘the determining hand of the IMF-WB group in shaping and implementing of the ‘open economy’ is abundantly clear’. This claim could not be further from reality.

Major reforms such as trade liberalisation and exchange rate depreciation and the opening up of the economy to foreign direct investment were, in fact, undertaken by the new Government in the ‘honeymoon’ period following the massive election victory, based on the recommendations of the Shenoy report. When the Government adopted pro-market policies for its own reasons, the IMF became an important partner of development policy, but, of course, subject to its standard conditionality.

As already noted, the balance of payments position was in relatively better shape at the time compared to the first half of the decade. There was also promising sign of massive concessionary capital inflows from the major donor nations in support of the economic opening by the new Government. Immediately after the new Government was formed, the Finance Minister, Ronnie de Mel made a one-month visit to a number of Western countries to seek aid and returned with promising pledges. In 1978, aid disbursements alone were sufficient to cover the current account deficit (Central Bank Annual Report 1978). There was no urgent need for approaching the IMF for balance of payments support alone. It seems that the Government choose to go to the IMF to gain credibility to the reform process. 

The Government presented a proposal for a $ 427 m under a SBA. However, in the absence of a well-prepared medium-term stabilisation programme, and because the Government’s disagreement with the IMF to phase out subsidies, the IMF approved a SBA of only $ 122 plus $ 50.3 million as a supplement from the IMF Trust Fund in 1978. Immediately after approving the SBA, the IMF opened a representative office in Colombo to work closely with the Government in monitoring the reforms. In January 1979, the IMF approved $ 317.2 m EFF programme to support structural adjustment reforms during the three-year period of 1979-’81.

The relationship between the Government and the IMF, however, began to come under strain from 1981 because of a significant disagreement relating to the policy priorities of the Government (Rajapatirana 2017). The Government swiftly implemented the Shenoy recommendations for economic opening, but it overlooked Shenoy’s recommendations for macroeconomic stabilisation, which was an integral part of the proposed overall reform package. It decided to accelerate the implementation of the Mahaweli Development Project (collapsing the original implementation period of 30 years to eight years), side by side with the liberalisation reforms. 

The IMF (and the World Bank) became concerned about the inconsistency between the objective of structural adjustment in the economy under liberalisation reforms and the inevitable macroeconomic instability resulting from the massive investment programme (Levy 1998, Athukorala and Jayasuriya 1991). 

Apart from the macroeconomic instability, there were also genuine concerns regarding the viability of the $ 664 m project: A study of the project financed by the World Bank in 1981 recommended a slower rate of implementation than what the Government envisaged to avoid possible cost blow-up. The study also expressed concern that donors had made aid commitments for the project without properly evaluating the project’s costs. 

In September 1983, the IMF approved another SBA of $ 105 m (as opposed to the Government’s request for $ 221 m). However, the IMF terminated the agreement after only half of the agreed amount was disbursed, over concerns about macroeconomic instability caused by the massive Mahaweli investment programme. The World Bank also withheld disbursement of allocations under a Structural Adjustment Loan (SAL) ($ 70 m) because of the Government’s dispute with the IMF. According to a confidential letter to the Ministry of Finance and Planning (leaked to Lanka Guardian), David Hopper, the Vice President of the South Asia Programme, emphatically stated that ‘the precondition for all Bank structural adjustment activities is an agreement with the IMF’ (Jayalath 1990). 

Ronnie de Mel, the Finance Minister, described the nature of the Sri Lanka-IMF relationship during this period as follows: ‘We have had discussions, intricate discussions, debates, long negotiations and many quarrels. We have had suspensions. We have had estrangements. It has been, in short, love-hate type relationship. It has been something like the relationship between Elizabeth Taylor and Richard Burton’ (Hansard, Vol. 22, No. 12, March 18, 1983, C 1768).

1988-2005: The second-wave reforms

The economic boom following the 1977 reforms mainly concentrated in the first three years (1978-81) when the economy grew at an average annual rate of 6.6%. In the ensuing years of the decade, liberalisation reforms were overtaken by the commitment to major infrastructure projects. The process of structural adjustment in the economy was hampered by the failure to complete implementation of the reform agenda, in particular labour market reforms and State enterprise reforms, and the adverse impact of the investment boom on tradable goods production in the economy because of the appreciation of the real exchange rate (Moore 1990, Dunham and Kelegama 1997).

Added to this was the economic disruption caused by the escalation of the separatist war from 1983 and JVP uprising in the south during 1987-’89. By the end of the 1980s, the Sri Lankan economy had come close to a foreign exchange crisis, with low foreign exchange reserves, massive security related Government expenses, and a misaligned exchange rate that propelled significant capital flight and under repatriation of export proceeds (IMF 2001). 

In this volatile economic climate, the UNP Government under the new leadership of President Premadasa embarked on the ‘second wave’ liberalisation reforms (Dunham and Kelegama 1995). The IMF supported the reforms under a Structural Adjustment Facility (SAF) of $ 209 m) and an Extended Structural Adjustment Facility (ESAF) of $ 478.6 m. Reforms included devaluation of the rupee against the US$ by 34% between mid-1989 and the end of 1993, further liberalisation of financial and commodity markets, revamping of the operations of the Board of Investment (BOI) with a one-stop-shop for investment approval process, privatisation of some State-Owned Enterprises (under an innovative politically-friendly label, ‘peopalisation’) and a poverty alleviation programme. 

Dunham and Kelegama (1995, p. 187) have characterised the second-wave reforms as an illustration of how ‘strong leadership proved critical in ... reforms, in a country where the state is not strong, and is neither cohesive nor disciplined, in organisational rearms’. 

The vigour of second-wave reforms was lost because of the tragic death of the President, but there was no back sliding from reform because economic outcomes had been impressive enough to make economic liberalisation by-partition policy (Kumaranatunge 2004). 

The new SLFP-led Coalition Government continued with trade liberalisation and privatisation of State enterprises. During 2001-2002 the Government received financial support for reforms under a SBA of $ 256.8 m. In releasing funds under the SBA the IMF was sympathetic to the difficulties faced by the Government in meeting conditionality because of the exigencies of the accelerating civil war. 

For instance, the IMF showed flexibility to extend the agreement to 19 September 2002 on a lapse-of-time basis to allow the completion of the final review and granted a waiver for the non-compliance of performance criteria and released the agreed amount, because non-compliance was largely due to factors beyond the control of the Sri Lankan authorities (escalating ethnic conflict and oil price hike). 

1995-2009: The period of escalating civil war

During the period from collapse of peace talks between the LTTE and Government in 1995 until 2009, the reform process was hampered by the escalating civil war. In 2003, the IMF approved a three-year PRGF to the amount of $ 392.7 m and an additional EFF in tune of $ 210.8 m over the period 2003-’06. Both programmes lapsed after the withdrawal of the first instalments.

The post-civil war era

Following the ending of the civil war in July 2009, the IMF approved the largest ever programme loan (SBA of $ 2.6 b) for Sri Lanka. The quarterly performance criteria (QPCs) related to the standard macroeconomic stabilisation measures. 

The Government’s poor record of revenue mobilisation, in particular continued decline in the tax revenue-to-GDP ratio, and the budgetary burden of supporting loss-making public enterprises, and the backsliding on trade liberalisation came up in the negotiations but did not become part of the conditionality. This was presumably because the IMF wanted to provide the Government with policy autonomy in restoring the economy after the three-decade civil war.

In June 2016 the Government entered into a three-year EFF ($ 1.5 b) with the IMF. The EFF aimed to harness an additional $ 650 m in other multilateral and bilateral loans of about $ 2.2 b (over and above the existing financing arrangements). The stated objective of the programme was to help the new Government restore macroeconomic stability and resilience of the economy to facilitate sustainable and equitable economic growth (IMF 2016). 

The programme focussed on reforms to tax policy and tax administration with a focus on increasing direct tax collection, fiscal policy management, and State enterprise reforms to achieve fiscal consolidation while providing fiscal space for the Government’s key social and development spending programmes. Fiscal consideration reforms were to combine with flexible monetary targeting under a flexible exchange rate regime, reforms in the trade and investment regime, and rebuilding foreign exchange reserves. 

The reforms undertaken by the Government under the programme during 2016-’19 included a major revision to the value added and income tax systems and introducing a new building tax and rationalising the customs duty structure (Coomaraswami 2017). On 13 May 2019 the IMF Executive Board approved an extension of the EFF until June 2020 with rephrasing of remaining disbursements to complete the reform agenda. However, the implementation of the programme abruptly ended with the change of government in early 2020.

To sum up, since 1965 Sri Lanka has been a ‘repetitive client’ of the IMF. The country has entered into 16 economic stabilisation programmes during 1965-2000. Macroeconomic management of the country has been under IMF programmes for approximately 33 years of the 55-year period. The IMF fully disturbed agreed funds under 12 (approximately covering 25 years) of these 17 agreements. The conditionality attached to the agreements has notably varied over time depending on shifts in the development thinking of the IMF and macroeconomic conditions and the underlying political developments of the country.

(Prof. Prema-Chandra Athukorala is a Fellow of the Academy of the Social Sciences of Australia, an Emeritus Professor of Economics at Australian National University and an Advisor for Advocata Institute and can be reached via Prema-chandra.athukorala@anu.edu.au)

Prof Athukorala: Sri Lanka and the IMF: Myth and Reality – Part 1

Originally appeared on The Daily FT.

By Prof. Prema-Chandra Athukorala

Read Sri Lanka and the IMF: Myth and Reality – Part 2 and Part 3

Sri Lanka is now in the midst of its worst macroeconomic crisis since independence. Whether to seek financial support from the International Monetary Fund (IMF) in managing the crisis is a hotly-debated issue in Sri Lankan policy circles. The debate is largely ideologically-driven: strongly-held, opposing views are expressed without facts.

The purpose of this paper is to demystify the debate by documenting and analysing Sri Lanka’s experience under IMF-supported macroeconomic adjustment programs, the economic circumstances that propelled the country to seek IMF support, and implications of these programmes for economic stabilisation and growth.

The discussion focuses on two key issues emphasised by the current political leadership and the Central Bank to justify their attempt to avert going to the IMF: IMF dictates policy reforms at the expense of national policy autonomy, and the conditions attached to IMF programs are harmful to national development. The paper primarily adopts an economist’s perspective, but where relevant economics is combined with politics in order to understand the vicissitudes of Sri Lanka-IMF relations.

The paper begins with a short introduction to the role of the IMF in economic stabilisation reforms in developing countries to provide the context for the ensuing analysis. The next section provides as analytical narrative of the history of Sri Lanka-IMF relations. The following section examines the impact of IMF programs on the Sri Lankan economy. The final section provides concluding remarks with a focus on the current debate on entering into an IMF programme.

The IMF and economic stabilisation

The IMF was set up in 1945 to provide member countries with bridging loans to help them get over balance of payments difficulties. A member’s access to the IMF’s financing is expressed in terms of tranches, equal to 25% of its quota of the IMF. The first four trenches (‘reserve’ tranches, in total up to 100% of its quota) can be accessed free of charge at the member’s own discretion.

The IMF also has other concessional credit facilities introduced to help member countries in the event of unforeseeable economic shocks: Compensatory Finance Facility (CFF), the Buffer Stock Financing Facility (BSFF), the Trust Fund and Subsidy Account (TFSA) financing, Supplemental Reserve Facility (SRF), Contingent Credit Lines (CCLs) and Emergency Assistance (EA).

When a country borrows beyond the reserve trenches or eligible concessional credit facilities, it has to agree on a reform package to overcome its problems that led to seek financial support. These lending programs are called structural adjustment (or stabilisation) programmes. The policy measures prescribed by the IMF relating to these lending programmes are known as ‘IMF conditionality’.

The main structural adjustment loan programme is the Stand-By Agreement (SBA) facility, introduced in 1952. The key objectives of SBAs are to rebuild the external reserves, strengthen the fiscal position, maintain monetary stability, and fortify the domestic financial system. The length of the typical SBA programme is 12 to 18 months and loans are to be repaid within a maximum of five years.

The other IMF stabilisation facilities are the Extended Fund Facility (EFF) (established in 1974); Structural Adjustment Facility (SAF) (1982) and later remained Enhanced Structural Adjustment Facility (ESAF), and Poverty Reduction and Growth facility (PRGF) introduced in 1999 in place of the ESAF specifically to help low-income countries. These programmes have been established to provide support to comprehensive structural adjustment programmes that include policies of the scope and character required to correct structural imbalances over an extended period. Normally the duration of these programmes varies from three to five years, and repayment is over four to 10 years from the date of drawing. 

Under the structural adjustment programmes, the IMF releases funds by quarterly credit tranches. The country has to observe the quarterly programme criteria at each test data. The interest rate comprises two components: the service charge and a ‘fixed margin’ (an annual interest rate). The service charge is calculated weekly, based on a Special Drawing Rights (SDR) rate (applicable to all borrowings from the IMF) and the fixed margin is applicable to loans up to 300% of the member’s IMF quota and a surcharge is applicable to loans beyond that limit. The interest rate is normally about one third of the average rate applicable to sovereign bonds issued by the typical developing country.

Unlike the other multilateral and bilateral lenders who lend to the government of the borrowing country, the IMF always lends funds to the central banks of the country. The IMF loans to the central bank are strictly for the purpose of building international reserves to meet external payments. Therefore, borrowing under IMF programmes does not have any direct impact on domestic money supply and hence on domestic inflation. 

Entering into an IMF supported programme also acts as a catalyst to generate additional international financial assistance in three ways (Bird and Rowlands 2007). First, having a macroeconomic adjustment programme with the IMF is often a prerequisite for obtaining World Bank adjustment loans. Second, as part of entering into a stabilisation programme, the IMF arranges aid consortia of donor countries to assist the given country, Most of the donor funds harnessed under these consortia are outright grants or long-term loans that carry low interest rates. Third, credibility of the reform program gained by entering into an IMF programme helps raising funds at competitive interest rates from private capital markets.

The core of an IMF stabilisation programme is a ‘letter of intent’ that contains ‘performance criteria’ (conditionality) agreed with the IMF. The performance criteria vary from case to case, but typically centre on four key variables: budget deficit, the rate at which domestic credit is created, interest rates for both depositors and borrowers, and the exchange rate. In recent decades, the IMF has begun to focus on domestic pricing policy for petroleum products, when the domestic prices are badly out of line with world prices. 

In the typical developing economy where the local capital market is weak and access to foreign credit is limited, domestic credit expansion is largely driven by the budget deficit. In IMF reform programs the major emphasis is, therefore, placed on fiscal reforms, cutting the budget deficit through both government revenue reform and rationalising government expenditure. (There is a saying that the acronym ‘IMF’ stands for ‘It’s Mostly Fiscal’!) 

A straightforward reduction of absorption (expenditure) is likely to entail a decline in total output and employment unless wages are exceptionally flexible and labour and capital is highly mobile among economic sectors. Therefore, exchange rate depreciation is recommended to make tradable goods (exports and imports competing goods) relatively more profitable compared to ‘non-tradables’ (mostly services and construction). The expansion of domestic tradable goods production relatively to non-tradable production is expected to help maintaining growth dynamism of the economy in face of policy-induced contraction in aggregate domestic absorption (Cooper 1992).

The decision to go to the IMF for assistance rests entirely with the IMF members. However, the relationship between the IMF and its developing-country members under stabilisation programmes has not always been smooth. Much of the disagreements hinge on judgements relating to conditionality attached to the lending programmes. While the principle of conditionality is not generally contested, often there are strong reservations on the part of members about the design and application of conditionality. The national officials are typically more optimistic than the IMF staff and the favourable developments they anticipate could imply less difficult action. 

On the other hand, in some cases, the national government’s discontent could also arise because, in setting conditions, the IMF staff has the tendency go beyond the basic framework. For instance, they could get into details of exactly what expenditures should be cut or what taxes should be raised to reduce the budget deficit, instead of leaving the responsibility for meeting the targets with the officials of the country concerned by taking into account country-specific political as well as economic considerations. 

Negotiating a stabilisation programme in a crisis context has the tendency to give the unwarranted impression that a country is rushing into action with a weak negotiating position vis-a-vis the IMF. The governments may resent IMF conditionality because of the loss of sovereignty implied and also because of a belief that the IMF’s objectives do not necessarily coincide with those of the national government. 

In such a context, naturally there is a tendency on the prat of the governments to make the IMF a scapegoat for (to hold the IMF responsibility for) politically unpopular decisions taken by them or for their own poor economic management. Indeed, such scapegoating often lead many to believe that the IMF forces countries to take politically disagreeable, and sometimes economically costly, action (Cooper 1992, Bird 2007).  

Sri Lanka and the IMF 

Sri Lanka (then ‘Ceylon’) became a member of the IMF (and the World Bank) on 29 August 1950. It accepted the obligation for liberalisation of the current account transaction under the IMF Article VIII in March 1994. 

Sri Lanka did not recourse to IMF financing throughout the 1950s, given the healthy external reserve position built up during the Second Word War, which was subsequently buttressed by the Korean War commodity boom (1950-51) and the tea boom (1954-55). The country obtained IMF finance for the first time in 1961, and then in 1962, within the reserve trenches. 

1964: Trotskyite Finance Minister seeking IMF support

Sri Lanka’s first attempt to borrow from the IMF under an SBA was by the Sri Lanka Freedom Party (SLFP) and Lanka Sama Samaja Party (LSSP) Coalition Government in 1964. By that time import restriction and capital controls had been carried out to the maximum and it was becoming increasingly difficult to introduce further restrictions without damaging the economy (Corea 1971). Because of the nationalisation of the foreign-owned gas and petroleum outlets in 1961, Sri Lanka became the first country against which the US Government invoked the Hickenlooper Amendment requiring the suspension of US aid to countries expropriating US property without compensation (Olson 1977). Following this, the international aid community virtually isolated Sri Lanka.

The pragmatic Trotskyite Finance Minister, Dr. N.M. Perera (NM) decided to approach the IMF. In September 1964, at the Annual Meetings of the IMF and the World Bank held in Tokyo, the Sri Lankan team led by NM consulted the IMF on the possibility of obtaining financial support under an SBA. The Government was defeated in the Parliament before the negotiations ended. However, according to a statement made by Dudley Senanayake (the Opposition Leader) at a parliamentary debate, the negotiation with the IMF failed well before because NM was not prepared to touch the politically-sensitive subsidy on rice (Hansard Vol 73, No. 13, 1767 c. 2898).

1965-70: Four back-to-back SBAs

During 1965-1970, the right-of-the-centre United National Party (UNP) Government obtained IMF financial support under four SBAs. The IMF conditionality of the Letters of Intent of these SBAs reflected the very nature of the mainstream development thinking at the time, which favoured import-substitution industrialisation with the Government directly playing a major role. 

Redressing the fiscal imbalance by rationalising expenditure, in particular reducing subsidies was the key focus. Reforming State-Owned Enterprises was not part of conditionality even though converting their losses had already become a big drain on the Government budget. Under the third SBA signed in May 1968, a Foreign Exchange Entitlement Certificate Scheme (FFECS), a dual exchange rate systems, designed to provide incentives to sleeted ‘non-traditional’ exports and to lift quantitative restrictions on selected imports at a premium above the official exchange rate (initially set at 44%). Other than this, there was no emphasis by the IMF on unshackling the economy from import restrictions and other direct Government intervention in the economy.

An important development in the policy scene during this period, which has not received only scant attention in the post-independence development history of Sri Lanka, is a failed attempt by J.R. Jayewardene (JR), the then Minister of State and Deputy Prime Minister, to seek IMF support for a major liberalisation reform. At the time the economy was in the doldrums because of the closed-economy polices pursued by the country from the late 1950s. JR ‘regarded the crisis as an opportunity to embark on a radical change in economic policies that would amount to a departure from the dirigiste policies’ (de Silva and Wriggins 1998, p168). 

He approached B. R. Shenoy, the Indian liberal economist (who had taught at the Ceylon University College in the late 1940s) for advice. Shenoy responded with a comprehensive policy blueprint for unshackling the economy (Shenoy 1966). JR presented the Shenoy report to the Cabinet but there was little chance of being adopted the radical reform package given the political adjustments and realignments within the multi-party Cabinet. He had to wait until the UNP’s election victory under his leadership in 1977 to implement the proposed reforms. 

(Prof. Prema-Chandra Athukorala is a Fellow of the Academy of the Social Sciences of Australia, an Emeritus Professor of Economics at Australian National University and an Advisor for Advocata Institute and can be reached via Prema-chandra.athukorala@anu.edu.au)

Losing by focusing on the winners

Originally appeared on The Morning

By Dhananath Fernando

• Winners focus on winning and losers focus on winners.

“Winners focus on winning and losers focus on winners”, I recalled this statement when I saw different headlines on Sri Lanka’s budget for the fiscal year 2022. As per media reports, the Government expects three main policy proposals in the upcoming budget. These include the development of local industries, expansion of infrastructure development, and having an expansionary monetary policy. 

Speculations too have highlighted continued import restrictions as a strategy to develop local industries. This is what reminded me of the saying that losers focus on winners while winners focus on winning. 

In a hundred metre race the most rational thing to do is to focus on one’s timing and speed as opposed to focusing on obstructing fellow athletes. Similarly in economics and business if one wants to develop local industries one must increase productivity and efficiency rather than resorting to import restrictions. 

One reason many justify import controls as a strategy for the development of local industries is the lack of knowledge rather than a strong ideological stance. Sri Lanka has had a trade deficit for a long time, which is “value of imports – value of exports”. Therefore, many Sri Lankans generally believe that by reducing imports the trade deficit can be reduced. 

The same argument applies when people assume that we have to spend foreign exchange earned from exports when importing. People believe that producing locally will save foreign exchange due to the reduced need for imports. As a result, there is growing animosity against imports across all products and services. People believe that this will leave local industries better off. This thought process has led Sri Lanka to become a nation full of people who detest imports. But they forget that local industries depend significantly on raw materials and parts. 

This idea is not endemic to Sri Lanka but can also be found in some other parts of the world. So there is a global belief that having complete import controls can help homegrown local innovation regardless of its severe economic consequences. However the reality is far different. Banning imports would do more harm for local businesses than good. It can significantly impact the production and manufacturing potential of the economy. However, we will only be able to arrive at a reasonable conclusion once the budget is presented. 

One of the main arguments provided by proponents of import controls, is the belief that Micro and Small Enterprises (MSMEs) cannot compete with large-scale global brands. However, the truth is different. In Sri Lanka, the apparel sector especially consists of quite a number of MSMEs. They produce goods at the standards acceptable to international markets. These target markets are far different from the domestic market. Therefore they actually compete internationally and are capable of doing so because they are able to maintain productivity. Therefore the best way to empower small enterprises is by helping them improve productivity and allowing them to compete. 

Another common belief is that some developed countries too have import controls or higher tariffs. Ardent believers of import substitution present these examples to defend their case. A common example provided was the import duty and tariff rates in India and South Korea in comparison to Sri Lanka’s, claiming that our tariff rates are much lower. However the truth is that Sri Lanka has a complicated system of para tariffs. These are additional tariffs on custom duties (CESS and PAL). Para tariffs increase the effective rate of protectionism, which is the overall protection levied at the border on imports. Sri Lanka’s effective rate of protection is much higher than other countries in the region. Once again, this exhibits Sri Lanka’s obsession with winners and the lack of attention given to winning. In addition, many new winners in trade have appreciated the importance of neutral policies that give similar incentives for export production as well as import substitution production.  

Another common argument is that the similar practices by the west at the initial trajectory on their development and the extent to which they protected their industries is often provided by proponents who believe banning imports is a strategy for local industry development. South Korea and Japan have been provided as an example often on how they banned car imports which made the boom of brands like Toyota and Hyundai is a common story. If that argument is true then countries like North Korea have to be most prosperous as they have very serious import restrictions. 

Second, for the country and the market size of Sri Lanka to get economies of scale, we need to produce bigger volumes beyond our shores. So competition is inevitable. Just because one country has succeeded at doing it doesn’t make sense for us to repeat without understanding geography, demography, and geopolitics. Thirdly if we look at the brands that have really done well those are the ones who have been opened for competition. In the case of Japan, the Ministry of Trade and Industry recommended to Toyota Founder Kiichiro Toyoda, not to produce cars in the first place and the rest of the Toyota brand is just history. 

We are all in agreement that the local industries should prosper and have to be productive. But thinking that the import bans as a strategy for local industry development is not in the right direction. It would set a bad example for people to just target winners instead of winning and ultimately the entire country will be a net loser. We have to become a country of thinking about winning rather than a country of focusing on winners and the budget 2022 should lay a broader strategy to achieve this objective. 

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.

Underneath the underwear patriotism

Originally appeared on The Morning

By Dhananath Fernando

• Can Sri Lanka become self-sufficient in undergarments?

My father had a very hard time with me when he accompanied me for haircuts when I was a kid. I’d ask him “Who cuts the hair of the barber?”. He’d say “It has to be another barber!”. Then I’d argue back saying “If the barber can give haircuts to everybody, why can’t he cut his own hair?”. Then my argument continued. Do the doctors go to doctors when they are sick or do they check themselves by their own stethoscope and decide their own medication? The same goes for surgeons. When a surgeon has to go through surgery can they do it on their own or do they have to go for another surgeon? When I look back, though I am not very proud of my arguments as a kid, the recent comments on the economics of undergarments on “Why Sri Lanka cannot produce all undergarments we require locally?” took me back to my childhood. 

A big social media discussion driven by political rhetoric, with little to no understanding of basic economics, was popular last week. Some argued that Sri Lankans will not have enough undergarments with the new direction by the Central Bank of Sri Lanka (CBSL) for licensed commercial banks (LCBs). The direction was to deposit 100% of the invoice value to open a letter of credit and halting credit facilities for LC’s for 623 HS codes including men and women undergarments. 

The opposite argument was there are enough local undergarment brands in Sri Lanka and anyone can buy it from Pamunuwa. There were some arguments going to the extent that “Sathosa” can provide undergarments in case of any shortages. Many argued that if Sri Lanka can export and stitch for world-class brands such as Victoria’s Secret, VS PINK, GAP Body, and Calvin Klein, how come we can’t produce to meet local demand? 

The argument went to the extent of some proponents mentioning that we have to ban everything we can produce in Sri Lanka to solve our foreign exchange crisis. 

First, let’s understand the reason behind the circular direction by the CBSL. A cluster of 623 HS codes are now required to deposit 100% of the value upfront. Additionally LCBs are not permitted to provide credit facilities, to open LC’s for the purposes of importing the mentioned 623 HS code line items. So simply it is not a tariff barrier, but the real objective is to discourage imports, in order to minimise the demand for foreign exchange used for imports, given the forex shortage we have presently. When the supply is suppressed, in this case on undergarments which is an essential product category the prices will automatically go up. That higher prices may impact consumer behaviour. 

Secondly, the question is why can’t we produce undergarments for Sri Lankans if we produce for Victoria’s Secret? Obviously, we can produce but economically or business-wise it doesn’t make any sense for the producer to produce a low-value, low-priced product for a 22 million market. Especially when the existing competency is at producing a world-class high-value, high-priced product for a market of a few billion people. In terms of margin as well as volume, the obvious pick is to produce for a bigger market. If we ask our manufacturers to produce for the local market as well, most likely they will have to shut down most of their factories, and obviously, Sri Lanka’s export numbers will drop drastically. When the capacity is there to produce high-value goods with significant value additions, why should a business consider producing a low-value product for a smaller volume. So pondering whether we can produce undergarments to our own markets by restricting imports, is the same as my childhood argument of asking the surgeon to get his own surgery done. So producing undergarments for the local market just because we produce for Victoria’s Secrets doesn’t have any rationale. On the other hand, if the current garment manufacturing plants are pushed to produce for the local market, the resources such as labour, land and capital have to be taken from the same resource pool. This can make exports expensive and make Sri Lankan exports uncompetitive. 

At the same time, export garments are stitched under branding regulations and contractual standards with strict customer audits where even a rejected garment is not allowed to be released to the local market. The companies have signed intellectual property agreements on individual designs and premium quality raw material is imported from Hong Kong, China and different parts of the world to make the product of superior quality. 

The same argument is there for tea. Often people complain that though Sri Lanka produces Ceylon tea, the tea available at the retail market is not as good as export quality. Obviously, just like the high value branded undergarments, there are high quality teas in Sri Lanka which many can’t afford given our purchasing power. As a result we have to settle for something affordable and the market is offering a product which is affordable for an average Sri Lankan consumer. Obviously a country of nearly a per capita $ 4000 income cannot afford to drink expensive silver tea three times a day. It is same for undergarments that markets offer a range of products where anyone can pick based on their affordability and personal preference. Those who could afford Victoria’s Secret and Tommy Hilfiger can go for it and those who can’t have the freedom to select from a range of undergarment brands and even unbranded categories based on their affordability. What is important is to make sure the choice is available so people can pick what fits them the best. 

Especially in a category like undergarments, it is the last thing that people will check – whether it is imported or locally manufactured. Perfect fit for the body, hygiene factors, sanitation factors, comfortability, affordability and even emotional attachment for the brand are very prominent in the product category at point of purchase. So it is essential that Sri Lankans have the freedom of choice to select what undergarments they feel comfortable with. Some people obviously may have a preference for local brands based on their criterion of selection. 

At the same time it doesn’t mean that local players shouldn’t produce garments for the local market. In a level playing field some businesses can produce for the local market and importing also needs to be allowed for their production as well. 

With the deepening of the US dollar shortage there are economic misperceptions built around imports. Banning imports is deemed to be the only way to develop local industries. Obviously we all know by hating something; we cannot achieve anything and the only way to achieve it is by competing. It is understandable that we face a foreign exchange shortage but obviously trying to produce undergarments for the local market by cutting imports will worsen the situation rather than solving it. 

Thinking that we should produce all undergarments we require locally as we produce for Victoria’s Secret is the same as my childhood thought that the barber should get his own haircut done and the surgeon should do his own surgery.

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.