Economic ‘Aragalaya’ crucial for reform

Originally appeared on The Morning.

By Dhananath Fernando

SL economy has reached point of collapse; needs a total reset to recover

Every day on my way to work I walk past 5th Lane, the current Prime Minister’s residence. Last week, one of his security officers stopped me. He smiled and said, “Sir, we watch videos of Advocata Plus.” After a moment, he continued: “What is actually happening? How long will it take to recover?” I didn’t have a concrete answer. I couldn’t adequately answer him because our path to recovery depends on our course of action. 

The only certainty is the fact that it’s going to take time. Yet, to refrain from discouraging a hopeful individual, I smiled back, and said: “It’s a difficult time and recovery will be slow, but we will recover if people like the Prime Minister make the right decisions and policies.” His response was heavy with emotion, as his eyes brimmed with tears: “Our time is over. I thought we could make our children’s lives better, but now I can’t even provide my kids with what my parents provided me. It hurts, sir.”

The story of many Sri Lankans is no different. This is why we need a complete reset of our economy. The existing system, which we have inherited, cannot move forward any further – a point of collapse has been reached. The collapse has been painful and recovery takes time, but in order to ensure that we successfully overcome this collapsed system, an ‘Aragalaya’ for economic reform is absolutely crucial.

A question remains. What can we do to overcome and speed up our recovery? One common mistake many policymakers make is that they only see a fraction of the bigger picture. Reviving tourism, or getting remittances, or bridge financing is seen as a solution. However, these are just smaller concerns in a much larger problem. 

The core issue is that our economy is not competitive. Having existed as a closed economy for an extended period of time and losing our competitive edge has caused the Sri Lankan economy to lose its overall competitiveness. Many believe in the myth that our economy has been open since 1977, when in reality it has been closing down since the 1990s. One of the best indicators to measure this is through the comparison of our imports and exports to the size of our economy – both of which have been declining at a record pace since the 1990s. Exports are the indicator to measure our relevance in the global market and the declining trend in our exports means that we have become less relevant to global markets. 

Why is Sri Lanka losing competitive advantage? Firstly, the nation’s factor and product markets have not experienced any major reforms for decades – and in some cases for centuries. As Charles Darwin said in his Theory of Evolution, only those who adapt will remain. Sri Lanka did not adapt and thus became irrelevant. The country’s land market is virtually a closed market, with approximately 82% of the land owned by the Government, which causes one of the main factors of production to be hindered. 

Secondly, labour market reforms have not been implemented. Even in 1977 there were no labour market reforms. Hiring and firing employees is a very difficult process and stringent regulations on part-time work and flexible work hours are preventing Sri Lanka’s growth. On the supply side, productive labour remains glued to the Government sector, with very low salary scales despite having the potential of contributing to the economy in a far bigger capacity.  

Sri Lanka’s public sector employment, which was at 812,472 in 1994 (1), increased to 909,564 by 2002. By 2020, public sector employment was at 1,423,116 (2). The latest figures report 1.58 million public sector employees, making Sri Lanka home to one of the highest ratios of public sector employees in Asia (3).

The current economic crisis has brought the country’s public sector finances and savings to shame. With 54% inflation and more than 100% currency depreciation, EPF/ETF savings and the pensions of the public sector have been reduced to an amount that means little in comparison to skyrocketing living expenses. 

While the situation is unfortunate, it can be capitalised upon to enact public sector reforms. The first step would be to first freeze all recruitment and offer a retirement scheme to bring the employee numbers down. We can cut down the number of working days for public servants and consider different types of voluntary retirement schemes to hedge costs. There needs to be a prioritisation of public servants and the salaries of capable staff should be increased, with adequate training opportunities provided to enable further refinement of skills.

The current structure of public workers is not only negatively impacting their own lives, but also making the lives of the general public quite difficult. As a result, similar to the Prime Minister’s security personnel, most of us are unable to provide our children with what our parents provided for us. As such, public sector reforms have to occupy a core spot in the ‘Aragalaya’ to ensure economic reform. 

When suitable policies that can bring macroeconomic stability are implemented, the micro pieces will adjust accordingly. Thus far, the strategy has been micromanagement rather than macro stabilisation. However, when necessary Government policies attend to macromanagement, micromanagement will naturally be provided for by the private sector.

In the investment sector, labour and land have once again been key constraints, as the country lacks adequate land to provide investors. Zones managed by the Board of Investment (BOI) have run out of plots of land and getting new land for development has become a nightmare. Until the newly-appointed Minister of Investment Promotion offered a five-year visa for foreign investors, we did not even have a programme to attract talent and investment through our immigration system. 

If the macro policy is sound and a level playing field is created for all, then future generations will be better equipped to take care of themselves. One very important component of the ‘Aragalaya’ for economic reforms is our monetary policy, since without fixing our currency and the value of the notes we exchange, macro stabilisation will be a futile effort. 

References:

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.

Golden opportunity for energy market reform

Originally appeared on The Morning.

By Dhananath Fernando

Let markets work and adjust expectations

As children, most of you might have tried the trick of obscuring the vision of a bigger object by closing one eye. I used to try this with a lamp post, by moving the finger closer to the eye while closing the other eye, thereby making the lamp post disappear. As a child, there was a thrill in making the lamp post disappear with a minute object such as my finger. 

However, in reality, we know that a lamp post or a bigger object cannot be covered with a finger, due to factors such as volume and mass. Similarly, until we ran out of petrol, Sri Lanka also pretty much thought the finger could actually cover the lamp post – the finger in this case was import controls, which we all thought was the solution for a brewing Balance of Payments crisis. 

This column has been a consistent opponent of import controls since the beginning. It has been two years since we stopped importing vehicles. Some non-essential imports (as per the definition of policymakers) such as apples and other food items have also been halted. At one point in this debacle, the Government issued licences for imports, which threatened to create a new Licence Raj. 

We went as far as to kill the forward market and once even issued a regulation mandating a 100% cash requirement to open Letters of Credit (LCs), which were then required to be opened with a 90-180-day credit period. We did so much to reduce imports for so long, so why didn’t any of these policies bring their promised results and how did we run out of money even to import fuel and life-saving medicines? After all those remedies, why have we fallen to a state where the country is in a de facto lockdown – not because of Covid but due to a fuel shortage? 

Many still haven’t understood that imports were not the problem. By contrast, having no fuel imports has become a significant problem. Of course, at a time when we as a nation have hit rock bottom, imports will come to an automatic halt due to the unavailability of foreign exchange. But import controls have certainly not helped matters and have in fact worsened the problem. If we had a solid monetary policy, if we hadn’t maintained the exchange rate at artificial levels and if we maintained stability, this problem would not have arisen. 

It is in this context that the Cabinet has granted the opportunity for any oil producing country that can bring fuel to Sri Lanka to run the fuel distribution while the Government keeps control of the operations of the Sapugaskanda Refinery. 

Surprisingly, even the strong Ceylon Petroleum Corporation (CPC) unions remain silent. Previously, CPC unions were the first to mobilise on the streets when any policymaker dared to even broach the topic of opening up investment activity to the private sector for energy and fuel. Now, private investment has entered their territory and the signals of privatisation are all there, but silence still remains. It is obvious now to these unions and to the nation at large that the State cannot operate in such competitive sectors and that attempting to do so guarantees disaster. Unfortunately, we are presently living through such a disaster. 

While allowing the private sector to operate in the energy market is a good move, expecting the fuel problem to go away simply by allowing private companies to enter the Sri Lankan market is very short-sighted. For context, the reality of the fuel market is that fuel supply can only be secured by paying in US Dollars, but sales in Sri Lanka are transacted in LKR. Even if an investor enters the market with a USD investment, if they can’t convert their LKR into USD, there will be no strong business case unless they have some other business lines which have LKR and USD interests. Whoever invests in USD should be able to convert their sales to USD; otherwise this is not a sustainable long-term solution. 

One segment that has both USD and LKR interests is exporters. They earn USD from their exports and they need LKR for their local operations. If they can get a higher profit margin through fuel sales than through a USD conversion in the banking sector and if they have adequate volumes to run a fuel business, then there is a business case for these exporters to manage a fuel distribution operation. 

Alternatively, there has to be a separate financing arm for fuel, whereby anyone who has an interest in both USD and LKR can invest with an expectation of dividends. To do that, however, fuel pricing requires flexibility. Our present environment of price controls won’t work as fuel has far too many variable cost components and competitive margins. Therefore, one solution is to open the fuel business to anyone – including local exporters – to enter distribution and not necessarily to provide the opportunity only to oil producing nations.  

Allowing anyone to import fuel is the right decision at this moment, particularly as the big companies that can afford to purchase fuel at a premium either individually or through business collaborations will do so, thereby minimising the burden on the Government. The private sector, of course, will increase efficiency as well. 

Another group that has both USD and LKR interests is our overseas workforce that provides foreign remittances. If they can get higher margins than the conversion rate offered by Sri Lankan banks, they might be willing to channel their money into the business of importing essentials. That was the logic expounded by Daniel Alphonsus in his recent article on allowing anybody to undertake fuel imports, even through open accounts. 

The expectation is that the undiyal money presently parked offshore will be channelled to essential imports as the importers can now obtain LKR by selling fuel and other goods. But again, prices have to be flexible and competition will bring the market to a stable position. Currently, the black market price of a litre of petrol is over Rs. 1,500, whereas the official price is Rs. 400. This is no secret. Alphonsus argues that the same system existed during the war in the north and east – although there was no official supply, fuel was available even in small mom-and-pop stores at a price premium, often in small glass bottles. 

Markets are strong and they will always work. Of course, they may not work as per our expectations, but the reality is that our expectations should adjust according to the markets. Since we have completely run out of options, we have a golden opportunity for reform. It is possible that we may fail, but we have little to lose and are presently not doing anything other than going around the world with a begging bowl. That too will have to be continued for now, but expecting other countries to donate their taxpayer money to Sri Lanka after so much mismanagement and loss of credibility is idealistic thinking. It is the same as our thinking when we were children – that an object would disappear if we simply didn’t see it anymore.

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.

Cricket while the country burns?

Originally appeared on The Morning.

By Dhananath Fernando

In the mid 1990s, when Sri Lanka’s Cricket was performing extraordinarily well, there was an accusation that then President Chandrika Bandaranayake Kumarathunga was announcing unpopular policy decisions while public attention was on cricket. After Sri Lanka won a match, and while people are celebrating the next morning, the prices of items such as bread and LP gas are increased. There were even rumors that LTTE leaders had said “Sri Lankans remember any event only for two weeks”. Today, while public & media attention is focused on our historic cricket win against Australia, our policymakers seem to think that the attention diversion from cricket would save them from a historic Economic crisis. They are definitely wrong.

While IMF representatives are in Sri Lanka to explore the details of the programme, the drive for reforms among policy makers is extremely slow. Even more than 2 months after announcing the suspension of external debt, we have not yet provided any policy direction for stakeholders on reforms that we intend to follow to overcome the crisis.

So far, it seems like another round of political musical chairs without any genuine effort from policymakers to enact economic reforms. The school of thought that favored bringing political reforms hand in hand with Economic reforms is also now in question due to the situation with the 21st amendment. According to the Prime Minister, as per his recent speech in Parliament, we have to show our willingness for reforms to get the support of other countries. So what willingness has been indicated by our policy makers on any reforms? We have only been going to other countries and organizations with a begging bowl to find money for essentials on a weekly basis, and sadly that has become the new normal. We are at a very high risk of some level of social unrest with no reforms on the table and the poor leadership on display from our representatives. A short video clip uploaded by a journalist of a man in a fuel queue alerted me to the degree of risk we are in. The journalist asked about the impact of the economic crisis from this particular person in the queue. He said, with a very calm tone and patient body language, “I am a chauffeur and a father of 3 kids. I kindly request our leaders to not test the patience of fathers like me. The current protests & ‘Galle Face Green protests’ are broadly by youth. Not by fathers like me. Fathers like me do everything for our kids. We can’t see them suffering. When a father crosses the border of patience we don’t know where it will stop,” he said, with a measured tone and with a lot of depth.

While this column highlighted many preliminary reforms over the last two years, there are new reforms that we have to expedite given the severity of the crisis. As recent news stories have indicated, the debt restructuring in Sri Lanka seems likely to be very complicated and time consuming. In particular, the news that Hamilton Reserve Bank is suing Sri Lanka in American Federal courts indicates how complicated the situation could become. As per the report, they possess more than 25% of the July 2022 bond series and are requesting the full amount to be paid; they possess a share of the bond large enough to make them a ‘blocking minority’ which can block and delay the entire debt negotiating programme. The IMF, for their part, has indicated that they want to see a clear direction on debt restructuring if they were to support Sri Lanka. Bilateral partners such as China and Japan will also play a vital role in the entire process.

Given this situation and our slow approach to Economic reforms even after announcing debt restructuring, we will be left with a lot more debt to be paid. If we move at this pace, there is no doubt that we will have subsequent defaults even after restructuring, if we fail to boost economic growth. Therefore, the establishment of an independent debt office is extremely important. Our debt portfolio is diverse and expensive so highly skilled financial analysts should manage our debt in line with global trends. Following the dilution of our Civil Service, that level of skill is unfortunately not available in our public sector. Given the salary scale of the public sector we can’t expect talent with the calibre of skills of a fund manager to stay in the public sector. Simply put, a salary scale of LKR80,000 will not attract a fund manager who has to manage a few billion rupees worth of debts. Therefore, the independent public debt office should have a different salary scale (based on key performance indicators) and independent regulation if we are to have a sustainable problem for our debt crisis. We are where we are today due to our poor debt management. The “Common Minimum Programme” by the National Movement for Social Justice has indicated the same.

Furthermore, this crisis will inevitably impact many private enterprises and a record number of businesses will go bankrupt. In a market system it is unavoidable that while some companies succeed, others will fail. Our legal framework should allow the failed firms a faster exit so entrepreneurs can bounce back with a new business or otherwise utilise their time productively. Investing their energy and money on something productive instead of on an already failed business will inevitably affect the overall productivity and efficiency of the economy. Unfortunately, Sri Lanka does not have unified bankruptcy laws. So when a company fails, exit is not easy. More money, time & energy has to be invested to manage a bankruptcy as a result. There are some exceptions laid out as provisions in the Companies Act, but for most micro, small and medium enterprises - which are sole properties and partnerships - the absence of a bankruptcy law will cause severe repercussions. Sri Lanka should proactively think of these issues before the situation gets out of control.

Our policymakers should realise that the hunger and anger of the common man has created a volatile and flammable situation. There is no way for cricket or any other diversion to stop the righteous fury of a hungry man, so it is imperative that we bring about Economic reforms before a spark ignites the entire situation and pushes us deeper into crisis.

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

The economics behind the fuel crisis

Originally appeared on The Morning.

By Dhananath Fernando

I recently overheard a conversation while taking public transport. The bus I was commuting in was moving at a snail’s pace across Dehiwala as people had blocked the road to show their displeasure over fuel shortages. The fuel queue was long, spanning over a few kilometres, consisting of mostly three-wheelers. The conversation started when a lady seated at the back lost her patience as some three-wheeler drivers tried to block the road. 

“Three-wheelers are a curse on our country,” she said. “Look how long the queue is and how undisciplined these tuk drivers are. They consume a lot of fuel and they just sit and waste their time browsing the internet on their phones while they are in the queue. All these drivers are a part of our labour force and they are part of the problem behind this fuel crisis. We should ban three-wheelers and develop public transport. The Sri Lanka Transport Board should field as many buses as possible. Why can’t they employ more trains at this time?” She had initiated the conversation with a gentleman seated next to her, who was also highlighting some solutions. 

Her opinion would be mirrored by many Sri Lankans if they were asked about the reasons behind the fuel crisis and economic crisis. While we all understand that it is the foreign exchange or USD shortage which led to this fuel crisis, the productive use of our limited fuel stocks has been in discussion for many months. People are now worried that once the latest fuel shipment is exhausted, Sri Lanka will completely run out of fuel as we are scraping the bottom of the barrel of the Indian credit line. 

We all have to admit that fuel has become an extremely scarce resource given the shortage of USD. Another side to the problem is that fuel importation and distribution is mainly done by the Ceylon Petroleum Corporation (CPC) and Lanka IOC (LIOC). Both these companies do not generate USD revenue. 

If we allow anyone to import fuel, then the exporters who have US Dollars will import fuel mainly for their usage for export output. The garment and rubber industries will import fuel on their own with their own US Dollars to run their generators and plants and pay the tax. 

It is far more convenient, efficient, and productive for them to depend on their own supply chains than depend on the inefficient CPC. When there are industries that can afford fuel imports at their own cost, there will be more fuel for common people through CPC and LIOC with the little forex and credit lines they secure. 

Daniel Alponsus has explained this in his recent blog in detail (1), where he further suggested removing price controls on fuel and allowing an open market account for fuel imports so the informal forex will automatically move towards essentials such as fuel while remittances will start flowing.

Before we come to the conclusion that three-wheelers are the problem (as per the conversation I overheard on my journey), we have to first ask why there are so many three-wheelers on the roads. The simple fact of the matter is that they are very efficient – they are lightweight, their fuel economy is about 30 km/litre, and they can transport one to three passengers per trip. By comparison, the fuel efficiency of a personal vehicle – depending on the weight and engine displacement – would on average be approximately one-third of the fuel efficiency of a three-wheeler. 

Secondly, three-wheelers are the main form of last-mile transport. They provide flexibility in labour markets, contributing to their popularity. The final and most significant reason for the large number of three-wheelers is the lack of sufficient public transport – both in terms of quantity and quality. If there was an option for anyone to become a service provider of public transport, most three-wheeler drivers would have become public transport drivers. 

At present, just because you have a bus doesn’t mean that you can field it on the road due to the route permit system. In many cases, the selling price of a route permit is a few times higher than the value of the bus even after a massive excise duty, sometimes above 100%, being imposed on the vehicle. 

Our policies have therefore discouraged many entrepreneurs from entering the market for public transport. In addition, we have strict price controls on bus fares, which limit the ability of service providers to differentiate their services at different price levels. 

For example, a young executive may be willing to leave his vehicle at home and shift to public transport if there is a transport service that provides internet service and a breakfast package. The executive can work while commuting and he can save on his breakfast preparation time at home. However, with the current controlled prices and route permit system, such niches with higher quality of service (and higher prices) cannot be fulfilled. 

So the main reason for the higher number of three-wheelers and more fuel combinations is the absence of market forces in the public transportation sector. The fuel crisis has been exacerbated by bad public policy in relation to public transport. This has compelled us to use 60% of our fuel imports, which is the highest single commodity type import in our import basket. 

The only encouragement provided for public transport was the bus lane priority system – now even that has unfortunately been abandoned. If we want to incentivise the buses for their fuel, another option is to subsidise their fuel based on mileage. This means the bus operators would buy fuel at the same price as a normal customer at the pump but they will obtain a subsidy based on mileage to avoid any leakages (i.e. resale of fuel on the secondary market at a premium) and provide incentive for drivers and consumers. 

Poor data availability and the lack of information systems acts as a bottleneck for such initiatives. However, if private mobile based services like PickMe or Uber can track mileage and location, there cannot be a reason why the same mechanism cannot be implemented for public transport.  

In the midst of rising fuel prices, Germany reduced public transport fares to encourage more people to commute through public transport. This is so that the fuel consumption of using individual vehicles would be lower. Unfortunately, Sri Lanka did otherwise. Our policymakers did not understand the economics and optics of the problem. Until we understand the dynamics of the situation, we will all simply listen to and believe conversations about three-wheelers being the issue without really understanding the fundamental problem.  

References:

  1. https://danielalphonsus.substack.com/p/solving-sri-lankas-fuel-crisis?s=w

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.

Don’t throw the baby out with the bathwater

Originally appeared on The Morning.

By Dhananath Fernando

While Sri Lankans have learned to accommodate daily blackouts by now, Sri Lanka’s power generation, or rather the lack thereof, has made headlines again. Minister of Power and Energy Kanchana Wijesekera’s amendments to the Electricity Act and trade union actions have created quite the chaos.

Sri Lanka’s power generation has always been political capital for politicians. During the Yahapalana Government, then President Maithripala Sirisena said he wouldn’t join the Cabinet until the Public Utilities Commission of Sri Lanka (PUCSL) and Ceylon Electricity Board (CEB) came to some resolution (1). The same administration saw CEB officials vehemently organising ‘bodhi poojas’ for the rain gods to avoid the horrors of extended power cuts. Recently, the CEB Chairman followed suit, stating: “When God gives rain and the Ceylon Petroleum Corporation (CPC) gives fuel, the CEB can provide electricity”(2).

In this context, the new Power and Energy Minister plans to amend the Electricity Act. The CEB Engineers’ Union has declared public resistance. The CEB enjoys a monopoly in transmission and maintenance of the grid and a greater control on power generation development and distribution. Therefore, as a trade union it has very high influence. This makes energy sector reforms very complicated. Achieving consensus between stakeholders is next to impossible. Given this monopoly and profit-making ability, reforms have taken a backseat. In this climate, the willingness of the Power and Energy Minister to prioritise reforms is commendable.

The Minister made a speech in Parliament highlighting the delays of renewable energy. In response, the Government suggested moving away from competitive bidding for renewable energy projects. While there is some degree of truth to delays occurring during the process of competitive bidding, the sustainable solution is not to completely do away with it. Under competitive bidding, the cost per unit of solar energy can drop drastically. Getting rid of competitive bidding would mean welcoming unsolicited renewable energy projects with much higher cost per unit. This cost will ultimately have to be borne by industries and consumers. In any trade, complete absence of competition means more rent seeking, inefficiencies, and corruption. 

A major reason for the delay of solar energy projects is the unavailability of land; 82% of Sri Lanka’s land is owned by the Government. Therefore, finding land for projects has become very difficult. The Government must prioritise clearing land for private investments. This applies to businesses across the board.

Secondly, making the policy and regulatory environment conducive to unsolicited proposals may not benefit the Government. This is because the current economic conditions are such that we do not have dollars to import material needed for renewable energy projects. Further, the cost of finance is also significantly high as our interest rates have skyrocketed. Without foreign exchange and high capital cost for any investor, development of renewable energy projects will take a backseat. Ultimately we will end up abolishing a competitive system with further delays and corruption.

The controversial wind power plants in Mannar should also be under the competitive bidding process. Failing this, Sri Lanka will not be able to reach market rates and will probably have to sell our energy generation for less than the market rate.

The solution is the unbundling of power generation, development, and distribution. Presently, whoever generates power has to contribute to the CEB grid. They have a monopoly in generation and development. Unbundling will divide these three segments and open some of it to the private sector. This will give people the choice to switch between any service provider based on the quality and reliability of the supply. Completely removing the competitive bidding process, without unbundling, will bring a double whammy on the cost. The prices of renewable energy will increase, while the CEB will continue to control the system through the grid. Thereby the Power and Energy Minister’s good intention to reform the energy sector may end up leading to a more negative condition with unintended consequences.

The Minister’s suggestion to connect the grid with India through a HVDC (High Voltage DC) cable is a sensible decision. One of the main challenges and restrictions for the expansion of renewable energy are demand and supply. Lack of management and access to a larger grid to sell and buy surplus or deficit of power too is an impediment. Connecting the Sri Lankan grid with India creates opportunities to overcome this issue. However, energy security precautions will have to be taken.

The suggestion of connecting the power grids of India and Sri Lanka was also made by Prof. Rohan Samarajiva in a report compiled under the chairmanship of former Governor of the Central Bank Dr. Indrajit Coomaraswamy, which was handed over to the President.

If Sri Lanka is to overcome the current energy crisis, reforms in the sector through unbundling and competitive bidding are necessary. Let’s be hopeful that our young Minister can make this crisis an opportunity to implement necessary reforms. 

References

(1) https://www.timesonline.lk/news/president-wont-attend-cabinet-meetings-until-ceb-pucsl-dispute-is-resolved/18-1082024

(2) https://www.newsfirst.lk/2022/03/31/when-god-gives-rain-and-cpc-gives-fuel-ceb-can-give-power-ceb-chairman/

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.

Low-hanging fruit from a disastrous harvest

Originally appeared on The Morning.

By Dhananath Fernando

We all want quick fixes to reset the economy. Difficult times like these make quick fixes a vital necessity as patience amongst the public runs thin. However, when an economy grows to a level of high dysfunctionality – as ours unfortunately has – the availability of quick fixes is extremely limited. 

The first step towards economic recovery is for individuals to understand that given the nature of the current crisis, quick fixes simply do not exist. The process of economic recovery can be likened to the growth of a plant. A mere need for a quick harvest does not mean that what is sown can be reaped in just a few days – it takes its own time. All that we can do is to sow the right policy strategy. We will eventually reap what we sow; if we sow the wrong ideas and wrong policies we will have to reap painful outcomes in future, similarly to how we are currently reaping the pain of what we sowed many years ago. 

However, a few quick fixes can still be attempted. One such attempt can be made in the tourism sector. We all know that there is a shortage of fuel for transportation and hotels don’t have reliable electricity. It’s true that tourists consider the situation of the country before they visit, and we are far from presenting an ideal situation. That said, in economic terms what we can do is to provide incentives on the regulatory side for people to visit Sri Lanka. 

One possible measure is to provide an on-arrival short stay visa for selected countries, which will encourage and increase tourist arrivals. Merely maintaining existing regulations will not help in economic recovery as it does not attract tourism. At the same time, Sri Lanka’s aviation authorities charge very high prices for landing and other aviation related services. For example, an economy class flight from Singapore to Colombo costs Rs. 155,000, of which Rs. 35,000 (23%) is incurred in airport and Government taxes. If we reduce those charges, prices of air tickets to Colombo will come down. 

One business leader recently informed me that the price of a flight from Chennai to Colombo was significantly higher than a flight of the same distance and duration from Chennai to other airports in India. Despite the same travel class on the flight, the same quality of staff, and the same distance, the price is mainly driven up by levies and taxes charged when the border is crossed. Given this, bringing down our rates may mean that some audiences may consider visiting Sri Lanka. 

In my humble opinion, when foreign media questioned the Prime Minister on tourism, his answer should have been: “It is a difficult time for all of us, but even with all those difficulties we have the best beaches and the most amazing sunsets and Sri Lanka is still ranked very high on all travel magazines.” 

Nonetheless, we have to keep in mind that tourism alone will not be sufficient to turn our economy around. We made this mistake earlier and attempted to settle our sovereign debt through tourism receipts. Generally, about 80% of tourism income will go back as a USD outflow due to the consumption of imported items required to sustain tourism. At the moment, we have little going for us and this is just a suggestion that is scraping the bottom of the barrel. 

Moreover, we have to establish a unified bankruptcy law. It will take time, but it is needed urgently, and it’s important to start now. With the economic downturn, many organisations have had to downsize or wrap up their operations. This is the same sequence of events that has taken place in other countries that were facing similar crisis situations. 

In Sri Lanka, private limited companies have some cover on bankruptcy, but about 80% of the business establishments in Sri Lanka are Micro, Small, and Medium Enterprises (MSMEs). Most of these businesses are registered as proprietorships or as partnerships. When these enterprises are impacted, closing down the company is often the easiest and least painful option, as it helps the entrepreneurs move forward and get to the next phase of their lives quickly. If they have to spend a lot of time wrapping up their existing businesses that are not sustainable, it will slow down the economic recovery process, as a lot of valuable time, energy, money, and effort of capable people will be wasted on shutting down a company which is no longer viable. Therefore, an easy exit for businesses is as important as easy entry. Unfortunately, Sri Lanka’s labour laws do not support such an exit process and therefore, the process of exit is slowed. 

Finally, while accepting that there are no quick fixes to overcome the current crisis, we have to steel ourselves to go through the tough process of bridging reforms for markets to work. Markets work with credibility, a sound legal framework, and the rule of law. Given that the current situation has more to do with a question of credibility, legal reforms often go hand in hand with political reforms. Therefore, policymakers have to look at the reforms from a holistic point of view rather than just seeking out a quick fix. We are at the stage of sowing seeds for future reaping – if we don’t manage this situation well, we will reap a bad harvest once again.

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.

Tackling poverty with competent policies

Originally appeared on The Morning.

By Dhananath Fernando

I learnt poverty through two sources. Firstly, I myself have experienced poverty. 

At university, a basic lunch was served for Rs. 20. It was just three curries, and often the only source of protein was a watery fish curry or half an egg. A watery chicken curry with saffron rice was only served on Fridays. It was a very basic meal. There was an option to get a re-serving for Rs. 5.

The re-serving provided only the curries (not the protein source) on the condition that you went with the unfinished plate. Students who couldn’t afford Rs. 20 for the full meal would wait until a friend finished their first round, borrow their unwashed plate, and join the line for just the Rs. 5 re-serving. At one point in my life I was one of those students. 

That’s why this column has alerted the reader many times to the possibility of rising inflation due to Modern Monetary Theory (MMT). Money matters, and when inflation starts skyrocketing, basic essentials will be in short supply and the poor will suffer. 

Secondly, I learnt about poverty through my volunteer experience at CandleAid Lanka (1). CandleAid is a Government-approved humanitarian organisation founded by Captain Elmo Jayawardena. I have seen and heard so many stories of poverty and overcoming poverty from around the country during my interactions with CandleAid and Capt. Jayawardena. Out of all the stories, the story of Pahalagedara Jayathilaka is simply inspiring and reshaped my understanding of what poverty means for the poor.

Pahalagedara Jayathilaka was a crippled child who started his education in a borrowed wheelchair. His father had passed away from cancer when he was 10. Once, when narrating Jayathilaka’s story, Capt. Jayawardena said: “Jayathilaka’s best meals at university had been a cream bun or a fish bun.”

To cut a long story short, from the bottom of the poverty barrel, with the sheer determination and pure courage of his mother, Jayathilaka successfully entered the University of Moratuwa. He had come to Moratuwa with just his crutches and Rs. 1,000 in hand. Then CandleAid had provided him with an education sponsorship, through which he obtained superb results and a first class in Mechanical Engineering, and subsequently received a scholarship to the National University of Singapore (NUS). Today he is a Postdoctoral Researcher at the Department of Oncology of the University of Oxford (2).

In the terminology of economic research, there are many definitions of poverty, such as urban poverty and rural poverty, but the jargon of researchers is not sufficiently descriptive of the circumstances people find themselves in. When you are actually facing poverty, your decision-making processes, consequences, and outcomes in life are very different. 

For people in poverty, what matters the most is a fair opportunity to have a chance to succeed in life. It is an evolving process and it will never be an overnight miracle. 

They can overcome their circumstances if we establish the proper macroeconomic environment. That is what most of us forget; we forget the basics and try to target poverty without realising that macroeconomic instability causes poverty. 

I believe Pahalagedara Jayathilaka was unstoppable because he got a fair chance to compete as well as  support from a private charitable organisation. He was upskilled, an opportunity was created, and his fate was changed. 

The question during these unprecedented times is: how can we save our poor, and how can we support more people like Jayathilaka to create outstanding success stories? Of course, most people may not have stories as outstanding as Jayathilaka did, but they will at least gradually move above the poverty line and acquire a higher standard of living.

Before any suggestions are made, we need to understand that bringing down the inflation rate is the best way to help the poor. We created this problem of high inflation through bad monetary and fiscal policy, so bringing down inflation and creating stability through competent policy has to be the first priority. 

Furthermore, this column has often suggested the establishment of an efficient cash transfer system through the Government mechanism. While that is still an option, we all know how inefficient our Government apparatus is. 

The other option is to encourage private charitable organisations to help the poor. These organisations have good targeting systems and they have the capacity to reach people like Pahalagedara Jayathilaka and identify those who are truly in need. They are already doing a commendable service at a grassroots level, managing highly agile and impactful charitable projects to look after the poor. 

It would of course be the best case scenario if the Government can manage this, but our experience is that the Government’s management of all affairs is far below even our most basic expectations. 

Most charitable organisations have a far better reputation than the Government, and it is likely that expatriates will be more open to the idea of donating to these organisations than to the State to manage relief for the poor. This will bring in foreign exchange inflows, which will add further relief to our State coffers to manage essential imports.  

The best way to eradicate poverty is by creating wealth. To create wealth we need to first create opportunities, because the easiest tradeable good that the poor have is labour and human capital. We need to set up competitive processes to upskill our labour; poor people will gradually emerge from the poverty trap through the dignity of labour, and not by just becoming henchmen for a political party or by waiting in long queues to get a small cash subsidy or a handout.

A cash transfer system is a must. We should move as fast as possible on this matter. However, looking at how slowly things move with Government bureaucracy, it’s reasonable to assume that this will take time. 

Regardless, poor people cannot stay hungry for long. That is why we have to tackle inflation as public enemy number one and stop adding further inflationary pressures to our economy. Until we get the cash transfer system up and running, private charitable organisations should at least be approached or requested to come forward to utilise their network. They will be able to work faster than the Government and find and support many other Pahalagedara Jayathilakas who can excel. 

I still remember how Captain Jayawardena concluded his long story with a lot of emotion all those years ago. 

Every word I wrote about Jayathilaka is the absolute truth. Jayathilaka does not need colouring.

References:

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.

Salvaging the debt-ridden National Carrier

Originally appeared on The Morning.

By Dhananath Fernando

Privatising SriLankan Airlines is a hot topic once more, although this discussion is decades old now. Founded as Air Lanka in 1979, the airline was described by Singapore’s Lee Kuan Yew as “a glamour project, not of great value for developing Sri Lanka”. 

In 1998 Air Lanka signed a 10-year management contract with Dubai-based Emirates Airline for 40% of shares and provided the Emirates management the ability to make most of the management decisions. Air Lanka was rebranded as SriLankan Airlines. However, after 10 years, Emirates realised that the Sri Lankan Government was not going to renew the contract. 

According to SriLankan Airlines Annual Reports from 2008, the final year in which Emirates operated the airline, it made a profit of Rs. 4.4 billion. It was mentioned in some reports that this profit included insurance claims after the terrorist attacks on the Bandaranaike International Airport. 

Fig 1: Losses and Profits of Sri Lankan Airlines

However, since then, SriLankan Airlines has not made a single cent of profit. Cumulatively it has lost Rs. 372 billion since 2008. The airline made a loss of Rs. 44 billion in 2019, Rs. 47 billion in 2020, and Rs. 45 billion in 2021. Losses in 2019 were equivalent to 93% of the Samurdhi scheme’s budget – Samurdhi being the main social safety net in place to protect the poor. The losses were also equivalent to 84% and 90% of the Samurdhi budget in 2020 and 2021, respectively. These losses are equivalent to 17% of 2019’s health sector allocation in the National Budget. 

The problem is both clear and dire. We maintain a national airline at a substantial loss and ask the common people, many of whom don’t even possess a passport or haven’t even stepped on an aeroplane, to foot the bill. In other words, we are maintaining a failing  airline at the expense of the education and healthcare of our people. 

There are multiple reasons why SriLankan Airlines incurs losses. It is too politicised and many politicians and their relatives are not charged for extra baggage when they travel. Board appointments and recruitments have all been politically driven. Simply put, it is bad management. The general remedy for bad management is to replace it with good management so we can make the enterprise profitable. This has been the popular suggestion each time that the privatisation of SriLankan Airlines has been proposed. That is the exact thing we have been trying to do since we ended the management contract with Emirates. 

We have to ask ourselves why the outcome hasn’t changed even after the same remedy has been proposed and implemented repeatedly. Simply put, when you don’t invest sufficient money, time, or reputation into a business, no one has the ability to make it profitable. All the business leaders who have been appointed to lead the firm already have their own businesses, so it is obvious that SriLankan Airlines will become a secondary priority. 

Airlines are a very competitive business. Even privately-owned airlines are finding it difficult to compete and maximise profits, so how can we expect a State-owned and managed airline to do the same? There is a difference between a private company making a loss versus a State-owned company making a loss. A private company’s losses are borne by the private investors, who knowingly and consensually made the choice to invest their money in a potentially risky endeavour. But when public companies make losses, taxpayers have to pay and their money will be spent without their consent. How can this be justified, especially in a country like Sri Lanka where people suffer from a lack of basic needs, and when our healthcare, education, and social safety nets need significant improvement?

So what can be done about SriLankan Airlines? SriLankan Airlines’ business has few strategic units: The airline operation, catering, and the ground handling operation. Each section has some assets as well as liabilities. Overall, the airline has a lot of liabilities and debt. Most of the debt is guaranteed by the Treasury (part of it dollar denominated), which is part of the debt that is to be restructured as per the announcement on 12 April 2022.

Table: Debt guaranteed by Sri Lanka treasury for Sri Lankan Airlines

Accordingly, one option is that we ask strategic investors to pitch in to buy SriLankan outright. The bidding process has to be made transparent and competitive. The airline as a group is making colossal losses, so it is unlikely that we will be able to realise significant proceeds from the sale. As has been said, beggars can’t be choosers. 

Another option is for divisions like catering to be sold at concessionary rates to a potential buyer, again through a competitive bidding process, so that we don’t have to shoulder the burden of managing an operation while also closing any future window for corruption.

There is also the option to explore the feasibility of a similar kind of management contract or a Public-Private Partnership (PPP) similar to that which existed with Emirates. However, our airline is now in such a poor shape financially that the feasibility of a management contract is questionable. 

There are suggestions to list the airline on the Colombo Stock Exchange and allow investors to buy shares. Generally listings are successful when the company is doing well. At the moment, given the present economic conditions of the country and the historical performance of the entity, this may be challenging.   

Finding a strategic investor through a competitive bidding process is still a possibility given our connectivity with the main South Indian airports. Some Indian and international airlines may have an interest in expanding their network and will see a potential win-win situation. 

We have to begin the process of privatisation as it is obvious that we can’t run a business on taxpayer money at a time when the people are struggling for their basic survival. The citizens of Sri Lanka gave the management experts of all political parties and their close associates multiple opportunities over 14 years to turn the airline around and bore significant losses in return. Let us hope that policymakers will understand the gravity of the situation and that they will not allow such a huge drain on our coffers to continue unimpeded. 

For explanation of SLA losses for 4 years.

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.

Becoming the victim of one’s own policies

Originally appeared on The Morning.

By Dhananath Fernando

At a recent press conference, the Central Bank of Sri Lanka (CBSL) announced that importing goods through open accounts was going to be banned as a move to curb the money transfer through undiyal and hawala. In my view, this will have a negative impact on the supply of essential food items, drugs, and some raw materials. 

When a merchant imports goods, they can pay their supplier through a letter of credit. A letter of credit is simply a letter of guarantee by a bank or a financial institution to the supplier/seller that the correct amount will be paid in full on time. To open a letter of credit, the Sri Lankan importers should be able to buy foreign exchange or simply purchase US Dollars. But as we are all aware, all Sri Lankan banks have a drastic shortage of foreign exchange. The shortage is of such severity that we can’t import essentials, and in some cases even life saving drugs. 

In the case of imports, if the buyer and the seller have mutual trust, a letter of credit is not mandatory. They can settle on a credit basis later on. The goods will be cleared on Documents against Payments (DP) or Documents against Acceptance (DA). Most importers and their buyers/suppliers have long-standing business relationships. They pay later either through different modes including hawala and undiyal. This is no secret. They pay an additional charge for hawala and undiyal to buy USD for a reason, which is simply that our banks don’t have sufficient dollars to facilitate imports even if the importer requests the opening of a letter of credit. Otherwise, no businessman would want to pay a higher price for forex if there were cheaper options available. Especially in the areas of food, medicine, essentials, and raw materials, these open account transactions are common. According to a recent news report, approximately $ 1.6-1.8 billion worth of transactions are done on open accounts every month. 

So what could happen when the Central Bank forces these importers to conduct transactions only through letters of credit? Simply put, they may not have any option other than to stop importing. Because banks don’t have USD, they can’t even import on open accounts to settle later. The Central Bank expects more USD to flow into formal channels since the demand for USD through undiyal and hawala is set to decline with the new regulation banning open accounts. Even if the Central Bank’s assumption is right, it won’t happen overnight. Given the uncertainty, importers will either hold or slow down the imports to observe the situation. It will take a few months to settle even if all USD inflows started flowing through official channels. What would happen to our essential food items, certain raw materials for businesses, and drugs during those long months? 

However, so far the Gazette notification has not been issued by the Central Bank, and we have to wait and observe the situation in the next few months.

It is not the first time the Central Bank has burnt its fingers by unnecessary attempts to control the market. 

First, the Central Bank imposed a 100% cash margin requirement on vehicle imports in 2018 and later vehicle importation was banned completely (1).

Later, the Central Bank’s 100% cash margin requirement on selected imports categorised as non-essentials was extended from vehicles to many other imports (2). This column questioned how an officer decides what is essential and what is not essential. A digital camera may not be considered an essential by a writer or a banker, but a camera is an essential to a wedding photographer whose livelihood depends on it. 

Then, the Central Bank stopped the forward purchasing market and only provided space to open letters of credit with a 180-day limit. 

It was then decided to artificially keep the currency at Rs. 200 per USD, and the undiyal and hawala market expanded dramatically.

All the main Key Performance Indicators (KPI) of the Central Bank have been eroded drastically during the same period in which these controls were imposed. Our inflation has increased to 29.8% and our food inflation has increased to almost 50%. Our currency has depreciated by more than 75% in a matter of a few months. Simply put, our Central Bank has fallen far short on all its key indicators regardless of back-to-back controls and interventions. Many new theories employed by CBSL economists, including Modern Monetary Theory, have backfired spectacularly and unfortunately it is the poor people who have to pay the ultimate price in hunger and inconvenience for the grave mistakes of the Central Bank and the Monetary Board.  

As a remedial action to these mistakes, our Central Bank has now made an attempt to ban open accounts and cripple the undiyal and hawala systems. 

In my humble opinion, this may potentially create shortages of essentials and inconvenience the traders and importers who have been supplying the essentials at a higher price. These merchants have been bearing the higher cost of the informal markets boosted by the Central Bank due to mistakes beyond their control made by policymakers. 

We have to first ask ourselves why an importer should bear a higher price on USD to import. Without fixing our monetary policy, there is no point passing the blame to the hawala and undiyal markets. They have existed for centuries in Sri Lanka and around the world because of their competitive and evolving nature. The buck stops with policymakers, and not with merchants or foriegn currency middlemen.

Quite frankly, it will accomplish very little to close the stable door after the horse has already bolted.  

References:

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.

Walking the talk on reforms: First step to Lankan recovery

Originally appeared on The Morning.

By Dhananath Fernando

Often we all see the world the way we want to see it, and not as it is. Sri Lanka’s economic crisis is also seen by many people through their own perception of reality. 

In previous years, we believed that self-sufficiency, State-led industrialisation, State-centred economic planning, and more recently, Modern Monetary Theory, were the way forward for our economy. The current crisis has shown that none of that has really helped us; by contrast, it has exacerbated a poor situation to where we are today.  

Next comes the question of overcoming the crisis. This has to be analysed with context; the most significant piece of context is that we are facing the worst situation we’ve been in since independence in 1948 – and it is only getting worse. 

There are some suggestions to increase industrialisation, improve exports and the trade balance, and incentivise Foriegn Direct Investments (FDIs). However, it is of no use to have lofty goals of industrialisation when we can hardly provide an uninterrupted electricity supply. 

Foreign investors are planning to leave. Investors are by no means considering entering the country. Thus, potential solutions have to be evaluated based on this context. Simply having a wishlist of suggestions with minimal viability will add very little value at this juncture. We need rational solutions to solve the crisis immediately, rather than policies that can only be enacted in times of relative normalcy. 

The Government needs to bring its finances into a sustainable state. Revenue must increase and expenditure should be reduced. Reducing the losses of State enterprises is a way to reduce the deficit without touching social expenditure.

With that in mind, here are a few suggestions for reform:

1. Privatise SriLankan Airlines

At a time when people are struggling to feed their families and when our official usable reserves are less than $ 200 million, there are very few upsides to running a fully State-owned airline making losses equivalent to the value of our entire Samurdhi scheme, which, despite its flaws, is the main social safety net in Sri Lanka. Privatisation will provide strong signals that we are serious about reforms. 

For the last 15 years, we have not made any profits on SriLankan Airlines. We can disclose all finances and ask for interested companies to buy it outright with assets and liabilities. Having a higher liability than assets is the main problem in this instance. With the suspension of debt repayment of State enterprises, Treasury guarantees for the State are on hold at the moment. 

Even if we need to pay a certain amount to the buyer to take it off our hands and sell it off with staff, it is much better than keeping the enterprise in-house and incurring colossal losses repeatedly. The new buyer can be given the responsibility of staff restructuring. We can follow the playbook through which Air India was sold outright by the Modi Government. Our airline is unfortunately no longer an asset but a liability to our national coffers. 

However, it is not only the National Airline that makes losses. There are many institutes that add little value to the public, make massive losses, and are a very high burden on the Treasury. Some of these public enterprises are classified as ‘strategic’ and others as ‘non-strategic,’ but two things they have in common is that, more often than not, they make substantial losses and have very limited transparency. 

There were some discussions to revive Sri Lankan Airlines by appointing business leaders with a profit motive, converting it to a budget airline, and appointing committees to reform and restructure. We have run out of time to even attempt these options. Unfortunately, hard times require hard decisions and we do not have the time, money, or options to avoid them. 

With interest rates and Treasury bill interest rates reaching above 20%, running loss-making enterprises on borrowed money will make our local debt increasingly unstable the more we delay reforms. Most importantly, we don’t need to wait for pressure from creditors or the International Monetary Fund (IMF) to kickstart reforms; we can begin them now.

2. Better utilisation of idle assets

Improving service efficiency and increasing revenue of railways through Public-Private Partnerships (PPP) have to be the way forward for better utilisation of idle assets. 

Sri Lanka Railways is categorised as a department of the Government, even though it is actually a State-Owned Enterprise. Sri Lanka Railways holds a considerable amount of State land which is used very unproductively. 

Fort Railway Station, Maradana Railway Station, and the surrounding land along the track between these two stations are prime examples. Major railway stations such as Kollupitiya, Wellawatte, and Bambalapitiya are all prime beachfront properties which are very poorly maintained and completely underutilised. Land prices in Colombo are extremely high. There are plenty of such examples under the Railways Department with zero or negative value addition to our economy. Sri Lanka Railways first has to be made a State-Owned Enterprise, and then the sector needs to be opened for private sector investment. 

In the past, some train compartments were operated by private players and it was a very successful and lucrative business model. If we eliminate the State railway monopoly and open up the time table, tracks, and properties to the private sector, we can cut down on our fuel consumption significantly, provide a convenient service to passengers, and even turn a loss-making liability into a revenue-generating asset.

Given the very high energy prices at present – which are only set to increase – many people need the option of efficient and robust public transit infrastructure. In any case, the majority of people in Sri Lanka cannot afford to purchase and operate personal vehicles, and trains have been the main source of transportation in areas where they are available.

It is also of paramount importance that the most vulnerable segments of the population benefit from a rehauled cash transfer system, which should cover the energy price component in public transport. Everyone, regardless of their socio-economic stratification, should be given a fair chance to compete in life. 

However, it should be emphasised that these two steps alone will not help overcome the crisis. However, it is a good start to get the wheels rolling on reforms. These reforms will provide an unambiguous signal to investors and the world that we are no longer a NATO (No Action, Talk Only) nation, but a nation that walks the talk.

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.

How protectionism killed Sri Lankan industry

Originally appeared on The Morning.

By Dhananath Fernando

Sri Lanka’s economic crisis was probably a crisis which was analysed (indeed over-analysed) and predicted from an early stage, but we failed to avoid it. We all knew that it was coming and therefore remedies were presented much earlier, but our policymakers simply turned a blind eye. They didn’t have the courage to face reality. Instead, they thought that wishful thinking would save Sri Lanka from the current crisis, and today, we have hit rock bottom. Unfortunately, we are just at the beginning of the crisis and have not even reached the recovery phase.  

It is important to reiterate that self-sufficiency, Modern Monetary Theory, industrial policy, protectionism, and import substitution failed yet again, and this time brought our people down on their knees. While we look towards solutions, we must also understand that it is not easy to rebuild an economy once it collapses. Recovery takes time, and recovery can only happen with the right set of policies.

There is one school of thought that argues that the lack of industrialisation is the reason for Sri Lanka’s balance of payments crisis. The main argument is that if we produced more to export, we would have had more USD revenue and this crisis would not have taken place. So the argument again comes back to import substitution, which involves banning imports or imposing higher tariffs on imports in order to produce locally. The argument is that this can save import expenditure while local manufacturing can scale up in order to focus on exports and bring export revenue. In the same theory, it is recommended that the government picks up which industries should be supported and which industries should not. This is simply going back to the same theory of the central planning model where a few officers decide which industries are good and which are bad. Often quoted examples for this are Japan, South Korea, and Vietnam. So today, let’s evaluate the strategy of industrialisation based on market principles. 

In simple terms, you become a good sailor by facing rough waters. Similarly the government selecting which industries to support and which industries to avoid will have consequences for all industries. Industrialisation should take place in a market system that optimally allocates all the available resources. If the government intervenes to assist one industry, it will have a knock-on effect on all other industries. Japan is indeed a classic example. The high-powered Japanese Ministry of Trade and Industry (MITI) recommended that Toyoda not produce cars. But he ignored their advice and today no explanations are required on Toyota’s success and competitiveness. In fact, in our apparel industry, big companies follow Toyoda’s example in the lean manufacturing techniques they pioneered. Rather than providing government support, price controls imposed by the Japanese Government impacted the automobile industry. So government intervention in the markets and industries is a sure recipe for failure. 

In Sri Lanka’s case, industries such as wall tiles, floor tiles, steel, aluminium, bathware, shoes, confectionery, and many others have been protected for decades. Have they become globally competitive due to protectionism and import substitution? In fact, import substitution is the worst we can do to develop exports because it creates an incentive to only produce for the local markets and discourages producers from producing for the global market given the tariff and non-tariff protection. Do our rubber, seafood, apparel, and electronic chips industries require any protection for them to be globally competitive? The simple answer is: no.  

In cricket terms, we can’t create a world class batsman by asking the bowlers to bowl loose deliveries. We can’t create a good bowler by asking the batsman to go soft on bowlers. Only in a competitive environment are heroes created. The protection is a sure way of killing the heroes and robbing poor consumers and exporters simultaneously. That is exactly what we have been doing for the last few decades. 

No export promotion can be done through import substitution; in fact, import substitution is killing our export potential. When the exporters have to pay more than 40% higher for construction materials, it is impossible for even our best performing exports to be competitive in global markets. 

If we observe the trade data, it is clear that our imports and exports are both declining as a percentage of GDP. In 2009, Sri Lanka had nine import taxes in addition to standard customs duties, and five of them are ‘para-tariffs’. Between 2004-2009, our total nominal protection doubled from 13.4% to 27.9%. Higher protectionism also indicates our continuous drop in both imports and exports.

Things got worse over time. The average effective rate of protection for manufacturing production increased from 47% to 63% from 2000 to 2015, and production for the domestic market was over 70% more profitable compared to production for exporting (World Bank, 2005; DCS, 2018). 

Accordingly, industrial policy and import substitution are contributory factors to where we are today with low exports and low productivity in the economy. 

In the history of industrialisation there are certain instances where some countries protected local industries, but in the success stories, protection had been given for a specified, strict time period or output and had a price-based structure.

Countries such as South Korea and Vietnam too became competitive not through import substitution but by allowing the markets to work. In a paper authored by Advocata Advisor Prof. Premachandra Athukorala, he quotes General Park Chung-Hee, who is considered the father of the Korean economic miracle: 

“The economic planning or long-range development programme must not be allowed to stifle creativity or spontaneity of private enterprises. We should utilise to the maximum extent the merit usually introduced by the price mechanism of free competition, thus avoiding the possible damages accompanying a monopoly system. There can be and will be no economic planning for the sake of planning itself.”

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.

Timescale confusions in solutions for the crisis

Originally appeared on the Daily FT

By Prof. Rohan Samarajiva

A few days after the tsunami, I was called to an expert meeting at Temple Trees by the then Prime Minister, Mahinda Rajapaksa. I was seated next to Arisen Ahubudu, the famous giver of names. He stated that we had lost too much territory, including Madagascar, and that we could not afford to lose more. He proposed building a wall around the country, using the traditional techniques used in protecting tank bunds, the ralepanawa. I was stunned that such a nice and well-meaning person could come out with such arrant nonsense. He had confused geological time with human time. 

Timescale confusions of a smaller magnitude are evident among many proposing solutions to our current multi-faceted crisis. 

Solutions to power cuts

We all experience the problem. Some of us understand the cause: no dollars to pay for fuel for the generators that make up for the shortfall from lower production from the hydro generators and Norochcholai. Even if we had the dollars, such fuel is priced in dollars and subject to price fluctuations that we cannot control. It is common sense that we should shift to electricity produced by renewable sources such as solar and wind. 

The problem is that under current market and technology conditions, both the distribution network (low voltage) and the transmission network (high voltage) are limited in how much solar- and wind-generated electricity they can accept. We can, and should, increase the use of electricity from renewable sources, but we need to upgrade the transmission network to be able to do so. Solar panels yield electricity when the sun is out (not at night and not when clouds pass over the panels); the wind will produce electricity even in evenings when our use is highest, but it is still intermittent. Batteries are not cost-effective yet.

Given the need to balance supply and demand of electricity in real-time caused by lack of cost-effective storage technologies, we need a large and modernised system in order to absorb more energy from these intermittent sources. We need to invest in upgrading the national grid and possibly connect to the large Indian grid. Feasibility studies must be done, and investment mobilised. It will take several years for the desired outcomes to be achieved. Increasing solar- and wind-based energy is not a viable solution for our immediate problems, though it is a solution in the long term. Within the applicable timescale, what we need are dollars for coal and diesel.

Promotion of manufacturing

Twin deficits, exacerbated by recent economic mismanagement, caused the crisis. More exports would have addressed the current-account deficit and may have helped with the fiscal deficit if the right tax policy was in place. Roughly $ 11 billion was earned from the export of goods such as apparel, tea, and value-added rubber products before the pandemic. Around $ 7 billion was claimed from service exports such as tourism, software and business process outsourcing. 

It is true that the East Asian Tigers and China took their people out of poverty through the production of goods for export. One has to ask why Sri Lanka (and to a significant extent, the rest of South Asia) failed to ramp up the production of goods for export, relying more heavily on service exports. One could even argue that the apparel industry is a service industry. A tailor who makes a suit out of material given to him is undoubtably a provider of services. The Sri Lankan apparel industry, which is the largest importer as well as the largest exporter, is doing what a tailor does, at scale. If it is manufacturing, it is manufacturing lite.

Until the market opening in 1978, the answer to the question of why we had no industries was that our private sector was weak and lacked capital. Therefore, the State went into manufacturing: steel, plywood, tyres, sugar, paper, shoes, cooking implements, etc. were all produced by fully State-owned enterprises under protection. They produced shoddy goods at high prices for the local market and lost enormous amounts of money. The plywood factory resulted in the clear-cutting of half of Sinharaja. After the market was opened to imports, they went out of business.

Since 1978, we have relied on private investors, with or without foreign partners, to manufacture for export (and for domestic use). They have tended to invest in sectors that did not rely too heavily on cheap energy (because our electricity prices were high, especially for industrial users). Except in the case of a few sectors such as apparel and rubber-based products, our producers failed to secure access to markets. Restrictive laws and para tariffs hindered local producers from getting integrated into global production networks, with very few exceptions. 

So, the industrialisation prescription as a solution to the crisis will take time and effort to implement. We would have to ensure reliable and low-cost energy (and other infrastructure services such as waste disposal), eliminate para-tariffs, and create the conditions for market access. The latter is the most challenging. 

Investors such as Michelin ensured market access for the solid tyres produced in Sri Lanka. The apparel industry also benefited in the early stages from foreign investors who facilitated market access. Attracting such investors and entering into trade agreements are needed for market access. But both take time. 

Industrialisation may be a good solution, but it is not for the Government to decide on manufacturing priorities. Because China has established itself as the factory to the world, countries such as ours must identify and exploit niches. Those best positioned for this are those with intimate knowledge of the markets, with skin in the game, namely private investors. The State must create the conditions and leave the actual investment decisions to such players. All this will occur on a timescale different from what is relevant to emerging from the present crisis.

Constitutional reforms

It has become evident that the hyper-presidential system created by the 1978 Constitution has failed to yield the promised benefits and has caused serious damage after the enactment of the 20th Amendment, which removed all the checks that were placed on the President by the 19th Amendment. For example, the Minister of Finance has stated that specific officials were responsible for the tax cuts that triggered the present crisis and the delay in debt restructuring. In the current system, the sole authority for those appointments was the President who must therefore be held accountable for the current crisis.

To address the demands of the protestors, the President must go. He must resign or be impeached. The former can take place immediately would allow the country to return to normal (if such a condition exists after the devastation wreaked by the President and his appointees). The time taken to impeach will be too long. 

The next best solution is to reduce the powers of the President. This would require a Constitutional amendment. An amendment that is approved by Cabinet can be completed within around six weeks. If it is moved as a private member’s motion, it could take more than six months, outside the timeframe needed to calm the country and get the debt restructuring done. The announcement that the Government is proposing the restoration of the 19th Amendment suggests a solution within the required timescale. Of course, it would be necessary to scrutinise the proposed amendment and ensure the President’s powers are meaningfully reduced immediately.

In innumerable discussions I have participated in, I hear proposals for Constitutional reform that pay no heed to the time factor. Some talk of a Constitution authored by the people, modelled on what is going on in Chile. The process began with an amendment to the Constitution and a referendum in 2020. This was followed by an election for a Constituent Assembly in April 2021. Its deliberations are ongoing. How realistic is this kind of process for the kinds of issues that have brought our people to the streets?

In these days of limited attention (and paper supplies), it would be useful if greater weight is given to the appropriateness of the proposed solutions for the time needed to solve the problems that beset us.

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.

Sri Lanka’s economy is entering a dangerous tailspin

Originally appeared on Daily Mirror

By Ravi Rathnasabapathy and Rehana Thowfeek

Sri Lanka has just entered the deepest economic crisis in its history. Shortages and rising prices that people face today are only the first inkling of what lies ahead. Unless decisive action is taken, it can go into a destructive tailspin. 

Downgrades and forex shortages mean foreign banks will only accept upfront payments for imports until credibility is restored. This means the country is now in a hand-to-mouth existence: imports are restricted to the quantum of foreign exchange inflows. These inflows are shrinking. 

Production of goods and services, for both exports and domestic consumption is contracting due to shortages of fuel, power and other inputs. Exporters are losing orders as overseas buyers, concerned about the inability to supply and missed deadlines are switching orders to other countries. Tourist numbers dwindle due to long power cuts, lack of fuel for transport and the closure of restaurants due to lack of gas. 

Lower exports lead to even lower foreign exchange receipts, which in turn limits production even further. With each cycle, the noose tightens further, until eventually most activity ceases. 

The shrinking supply of goods and services within the economy leads to increases in prices, as spending outpaces production. Businesses become unviable due to their inability to function at normal capacity and people lose their livelihoods. As activity shrinks, individuals and businesses alike find it difficult to repay their bank loans and the pressure shifts to the banking sector. This cycle continues until most economic activity grinds to a halt. As the country is pushed into a subsistence existence malnutrition and hunger become widespread.

The crippling effects of the inability to import are similar to that of being under international sanctions except that these have been self-inflicted. Now that the downward cycle has started, it is very difficult to stop as the forces of destruction gather momentum and speed. Until the appointment of the new governor last week, Sri Lanka was in free-fall. The best hope now is to arrest the descent and stabilise it at some point. The governor has taken only the first step on the path to stabilisation but much more needs to be done.

It is clear from the people’s protests that the public have lost confidence in the government. What people don’t realise is that multilateral agencies, international banks and rating agencies have also lost confidence. The government budgets the last two years were replete with errors: overestimated revenues, irreconcilable differences and unrealistic assumptions. Abrupt changes in polices and asinine statements by officials underlined these concerns; one international bank entitled its update “Denial is not a Strategy”. Even before the default many foreign banks refuse to accept letters of credit from Sri Lankan banks unless guaranteed by an international bank.    
A key benefit of an International Monetary Fund (IMF) programme is that it will restore confidence. The mere fact that the government budgets and forecasts are being reviewed by the IMF signals that they are based on realistic assumptions and reasonable estimates. Together with concrete steps towards repairing public finances it will restore some confidence among lenders and pave the way for bridge finance – to relieve some of the crippling shortages that are choking production and livelihoods.

Returning to growth is not impossible but this means addressing the structural issues within the economy, a matter that is all but impossible due to the thicket of vested interests that have grown during the past two decades.

Stabilisation – averting complete meltdown
The major cause of the disequilibrium in the economy was the excessive money printing carried out by the Central Bank since 2019. Money has been printed to finance government expenditure at an alarming rate. The huge increase in government spending results in strong demand for goods and services within the economy. High levels of demand feed into local products and services as well as for imports. Historically, whenever the government has run a large budget deficit financed by the Central Bank credit, it has always resulted in a current account deficit.
The first step to addressing the problem of money printing is to borrow from the domestic market, instead of the Central Bank. Given the enormous sums being borrowed, the government needs to offer a sufficiently high interest rate to attract the required quantum of funds. This is why rates have been raised sharply. Higher rates will reduce consumption by the private sector (which also reduces imports) but may also affect investment, so such high rates, while unavoidable to stabilise the present situation, cannot be maintained in the long term.

For rates to reduce, the levels of government borrowing must reduce. This means cutting the budget deficit. This will have to be approached in two ways: an increase in taxes and a reduction in expenditure.

Increases in personal taxes will reduce the government deficit and therefore the government borrowing requirement reducing the pressure on interest rates. Higher taxes can help curtail private consumption (including import consumption) but may also impact savings and therefore investment. Increases in corporate taxes could curtail investment.

To minimise the negative effect on investment, the government should not rely on taxes alone, expenditure must be cut but the recurrent expenditure is very rigid (mainly salaries, interest and pensions), so reducing capital expenditure is more feasible both politically and practically. Resistance will however be encountered due the corruption involved, especially in highway projects. Reducing the drain from state enterprises and the disposal of idle or underutilised assets are other avenues to close the deficit. Some trimming of unnecessary current government expenditures can increase available fiscal space for social transfers.

Since the majority of the government expenditure is spent on salaries, pensions and interest, a recruitment freeze and a freeze on increments will halt further expansion. All discretionary expenditure unless directly welfare-related must be frozen along with capital expenditure at least in the short term. All transfers and support to state-owned enterprises must cease.

The imbalances will be resolved due to a combination of factors: contraction of demand due to higher interest rates and higher prices which follow from the adjustment of prices to the realistic exchange rate. Prices will need to rise to the market-clearing rate, critically energy prices, which are dependent on the exchange rate. This, however, delivers a huge negative shock to the poor, so it must be cushioned with social transfers.

These are purely stabilisation measures. If carried out properly, this can restore the economy to its state in 2019 but at a higher price level, higher unemployment, lower levels of output and higher levels of poverty. Those in the middle and lower-income groups will be pushed further down the income spectrum: large sections of the middle class will find themselves poor and the poor will be left in abject poverty. Due to low levels of productivity growth will be stagnant at 1-2 percent.

Some of the destruction that has been wrought on businesses will be permanent. The rate of increase in prices will slow to tolerable levels but prices for the most part will not decline from the current high levels. Lower incomes and high prices lead to much lower living standards for most people. The low levels of productivity within the economy mean that prospects for escaping poverty remain poor but on the positive side, things will stop getting worse.
If people are to have some hope, then growth needs to be restored, which means addressing the problem of productivity.

Growth – Restoring prospects for recovery 
The people will have little prospects unless growth returns but growth is impossible unless the barriers that impede it are addressed. 

Sustained economic growth and productivity improvement are intricately linked. These are two sides of the same coin: a faster rate of economic growth cannot be maintained without productivity improvement. Higher productivity must be achieved in all sectors of economy, including the government, public sector and agriculture, where it is weakest.

At its simplest, productivity is a measure of an economy’s ability to produce outputs (goods and services) from a given set of inputs. The more productive the economy, the more value it is able to generate, either through more efficient allocation of inputs, greater productive efficiency in converting inputs into outputs or through innovation – coming up with new products and processes. Achieving sustained economic growth ultimately depends on an economy’s ability to increase its productivity over time, so improving productivity should be the key long-term goal of economic policy.

Many of the barriers to increased productivity are the result of policies and regulations of past governments. Misguided or poorly implemented measures to protect or encourage particular sectors have stifled the competitive forces that drive productivity resulting in higher costs of production. Competitive intensity is a key driver of productivity. It is only in a highly competitive business environment that firms have a strong incentive to adopt best-practice techniques, and technology and engage in innovative activity. This works in three main ways. 

First, within firms, competition acts as a disciplining device, placing pressure on the managers to become more efficient. Secondly, competition ensures that more productive firms increase their market share at the expense of the less productive. These low productivity firms may then exit the market, to be replaced by higher productivity firms. Thirdly and perhaps most importantly, competition drives firms to innovate, coming up with new products and processes, which can lead to step-changes in efficiency. Protectionism shields them from these competitive forces and eliminates a vital incentive, stunting long-term growth. 

Increasing competition means opening the country to investment and trade, reducing the tariffs and regulatory impediments to both. This can help reduce consumer prices and prices of inputs. Import competition spurs local businesses to greater efficiency. With sound macroeconomic policies in place imports can flow in freely.

Within the government, productivity must be addressed through the process of privatisation of commercial activities that could be more productively undertaken by the private sector and the closing down of non-viable state-owned entities, reforming the legal foundations of the economy and substantially increasing the efficiency in critical government functions. For example, increasing the efficiency in the areas of tax and custom procedures and reducing trade and regulatory barriers to enhance competitiveness, digitisation and better systems that improve efficiency and ease of doing business.

Policymakers have no idea of how grave this crisis is or how bad things could get. It is a classic debt and balance of payments crisis, which, if mishandled, can result in a complete meltdown of the economy. The government has appointed, at long last, competent officials in the governor and the treasury secretary aided by a solid team in Indrajith Coomaraswamy, Shanta Devarajan and Sharmini Cooray. They must have unwavering support from the executive and legislature. All political parties need to work together towards resolving the political deadlock and restoring political stability to ensure economic change can be achieved without delay. 

Compounded crises: IMF the only way out

Originally appeared on The Morning.

By Dhananath Fernando

Economic crises are difficult to solve. In the case of a natural disaster, we know that it will come to an end at some point. We just have to manage for a short period until everything settles. By contrast, economic crises are different. They generally come in a package of five separate but intertwined crises if not managed well. It is clearly best to avoid crises, but when the crisis hits, and if we fail to manage it, the situation becomes significantly worse. Sri Lanka, unfortunately, seems to be managing the situation badly. 

What we are currently experiencing is the balance of payments crisis. Simply put, we don’t have sufficient US Dollars to import essentials, including fuel and medicine. As a result, the lifestyle that we used to live cannot be sustained as long as these conditions prevail. 

The second crisis just around the corner is the debt crisis. We have a $ 1 billion payment to be paid on 25 July and our usable reserves amount to only about $ 150 million. It has clearly come to the point where restructuring debt is unavoidable. Debt restructuring will be a painful process for creditors and debtors equally. This will have an unavoidable impact on the local economy. Additionally, the debt restructuring can be done with an IMF programme. The IMF is the only organisation that can bring credibility to a country that has proved that “it is not good for money”.

The critical question is, how is Sri Lanka going to finance its trade until we negotiate with the IMF and have an agreed-upon programme of restructuring debt? If we had sufficient reserves, we would at least have had a backup option, but we all know reserves are not built for day-to-day imports but for an emergency situation like Covid-19. The other option is to get support from bilateral partners until we finalise the negotiations. Even for that to take place, generally an IMF programme is essential as they need to have some assurance that the money will be utilised to import essentials but not to bail-out any bond holders. Hence it is essential to enter into an IMF programme as early as possible, rather than beating around the bush. 

In an ideal scenario, as a country we should have moved forward with reforms before going to the IMF seeking funds and advice. Indeed, if we had carried out these reforms at the right time, then we would not have needed to go to the IMF. But if we are not doing things correctly, it’s sensible to go to the IMF, not only because of the money, but for credibility and discipline. The current situation is that we are already late – and the clock is ticking. There are massive shortages nationwide, which have the potential to get worse. The Government is yet to be clear about whether we intend to have an IMF programme and even as this article is being written, the country did not even have a finance minister to initiate any such discussions.

The third crisis of the package is the financial crisis. Particularly in the process of debt restructuring, some of these bonds are held by domestic banks. So restructuring will affect the local financial system. Furthermore, most of the local banks have extended credit guarantees for State-Owned Enterprises (SOEs) and it is likely that their debt will also be required to be restructured. So the impact on the financial sector can trigger a third crisis.

As these triple crises bear down, the political capital enjoyed by the Government will undoubtedly wear away. As a result, political instability will start kicking in. Especially in a country like Sri Lanka, where most essential services like fuel, electricity, and water are provided by the Government, the moment interruptions start, public resistance increases at a higher rate. In the Sri Lankan case, the political crisis has overtaken the debt crisis and the financial crisis. We are in the middle of a political and balance of payment crises and the other two crises are just a matter of time. 

The final crisis in the package is the humanitarian crisis. Especially if we fail to secure some funding lines without also delaying IMF negotiations, there is a risk of extended power cuts and further deterioration of living conditions. This can trigger a humanitarian crisis. If we drift to a disorderly default, as the Financial Times reports, “Disorderly default is the same as civil war.”

Already there are stories in the news about shortages of medicine and medical equipment and postponement of surgeries, all of which impact the humanitarian needs of the people. So urgent action is needed! However, Sri Lanka is in a complete state of dysfunction; there is no solid Government or cabinet ministers to make decisions, while public resistance keeps mounting. 

The nature of an economic crisis is that one crisis will keep instigating another and it’s not going to just go away. It takes a lot of time to overcome after things go out of control. 

We are very far behind and we need someone who really understands the depth of reforms needed and the work plan we have to adhere to. The general optimistic sentiment of ‘this shall too pass’ really won’t work here. We have expected the same to happen for a long time but it really hasn’t happened. 

Before we move to reforms, we need to keep in mind, for future reference, the cost of bad economic policy. Self-sufficiency, protectionism, intervening in markets, and ad hoc policy decisions are a recipe for a disaster and sadly we are facing one now.

We have to immediately increase interest rates and remove all surrender requirements by the Central Bank. In an economic crisis, dimensions are different. We have to immediately go to the IMF with a short- and medium-term plan with political consensus on implementation for the next five to eight years.

The problem and the solutions are already known. We need credibility, commitment to undertake reforms, and competence for execution of reforms to overcome. 

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 cornucopia of crises: Refuge lies in reforms

Originally appeared on The Morning

By Dhananath Fernando

Many people call me and ask what the economic crisis looks like and how they should feel about it. I always say to them, “The economic crisis is like a long night where you can’t fall asleep even when you are sleepy. At the same time, you don’t know when the sun will rise and the night will be over. You are sleepy and tired but still you can’t fall asleep.” 

This economic crisis is the same; the future is becoming uncertain and we are not sure what will happen. As Prof. Riccardo Hausmann said at an Advocata session in September 2020, “An economic crisis comes slowly, and then suddenly.”

The nature of any economic crisis is that it often comes with many other crises. Currently we are suffering from a balance of payments crisis. Simply, it means we do not have enough foreign exchange to buy essentials such as fuel, food, energy, power, and other products that we need to survive on a day-to-day basis.

The second phase is generally the interruptions of services. For example, at present with long power outages, our telecom sector is in trouble; cell towers may not be able to provide the same voice call clarity, service, and internet services as in a normal environment. So every economic activity connected to the internet is going to be affected and the jobs and income will be affected. Many young people who are internet freelance workers will lose their income and the country will erode more foreign exchange inflows.

Another example is if vehicle battery manufacturers cannot get necessary packaging material. After a few months, there will be a vehicle  battery shortage which will impact all vehicles which use batteries to start their engines. All that is just the impact to the common man due to the BOP crisis.

The second crisis is the brewing debt crisis. At the moment the debt crisis has been overtaken by shortages and long lines. But with a $1 billion payment due in July the debt crisis is knocking at our door. We haven’t made any announcements to warn our creditors yet, so the impact of debt restructuring will be felt by our entire financial sector as well as all State Owned Enterprises with credit guarantees provided by banks. 

Economics is always connected with politics. With a BOP crisis combined with a debt crisis impacting the fiscal  sector is affecting the entire political structure. This problem is at a much deeper level where whoever and whenever in power will not be able to have quick fixes. Most of the solutions are painful and already we all have become victims of the pain of shortages of basic essentials such as fuel and electricity. 

However still we can attempt to do a few quick fixes but the actual solutions are with deep economic reforms, which this column has advocated for a long time.

We have to increase the interest rates and remove all forex surrender requirements by the commercial banks to the Central Bank. At the moment interest rates are too low compared to inflation. In simple terms our inflation is at about 17%. Our interest rates are at 7-8%. So if someone deposits money at a bank, the value of the money will fall at 17% and the interest rate is only 8% so the net loss would be 9%-10%. As a result, people are more encouraged to spend money than save. When people spend money, the demand for imports is going to increase regardless of some import controls or licensing schemes.

If you inquire from businesses, generally they have high demand but the problem is they can’t supply because of supply chain interruptions due to lack of foreign exchange. So interest rates have to increase to a viable level to stabilise the economy and minimise pressure on inflation. If an economy is functioning well, we can keep the interest rates low by making it easy to access capital. But in the middle of a forex crisis we can’t afford to keep interest rates low. 

One reason for the LKR to continuously depreciate is the low interest rates. The second reason is the surrender requirement of 50% from the commercial banks to the Central Bank. The simple meaning of this is that all banks have to sell 50% of their USD income to the Central Bank at a lower rate/price. So banks may only have 50% of the balance in the market to give it to the importers and everyone who is asking for foreign exchange. As a result the exchange rate is constantly increasing and people who have foreign exchange are holding it, expecting rates to go up further. 

The final outcome is that there is a massive shortage of USD in the banking system and the black market forex trades have been highly active. It was reported that the Central Bank had suspended the licence of one money exchanger. The prevailing system will most likely exacerbate the problem and forex shortages will further increase. 

We have to immediately clear many grey areas in our stance and policy. Then a clear direction has to be provided on the stance of whether we should approach the IMF or not. Since the IMF’s Article IV report states our debt is unsustainable, it is clear that we have to restructure our debt if we were to get into any IMF programme. Until then only technical advice can be accessed. Even in our debt restructuring, we haven’t been very clear and our messaging has been so weak for markets to make any concrete decisions. Not providing clarity on these critical areas is going to extend the crisis.

The dark night of the economic crisis will last longer than we think if we move at this speed and we may even run out of candles due to the unavailability of naphtha which is a petroleum product. The solution is reforming now! 

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.

Debt restructuring: A foreign language Sri Lanka needs to grasp very fast

Originally appeared on The Morning

By Dhananath Fernando

“Life is a foreign language and all men mispronounce it,” American journalist Christopher Morley said once. To Sri Lankan policymakers across all governments ‘economic policy’ has been similar to a foreign language that has been mispronounced, too many times too often. We have not only mispronounced but we have gone beyond, making conclusions and creating misperceptions and myths based on our misunderstanding of economic policy. 

Advocata and many economic experts raised the sustainability of Sri Lanka’s debt just after Covid and a Deep Dive Session was conducted providing an in-depth analysis on debt in September 2020 (1). Very early on, Advocata recommended that the economic reforms were a must to avoid any debt restructuring and we should do everything possible to solve the problem immediately. International rating agencies alerted on the same and many policymakers were in denial or silence about these alerts. In fact, CITI bank issued a report titled ‘Denial is not a strategy’ and credit rating was constantly downgraded. 

The moment of truth 

However, the moment of truth has arrived and the senior officials have indicated that the Government is expecting a sovereign debt restructuring. There is very little meaning in complaining and we all have to face the reality. 

Presently, debt restructuring is indeed a foreign language to us and this time we can’t make the mistake of mispronouncing it. This is because we haven’t done it before as a country and it is a very technical subject that needs specialised help. 

A paper published by (2), Lee Buchheit, Guillaume Chabert, Chanda DeLong and Jeromin Zettelmeyer says: “All sovereign debt workouts are painful for the debtor country, its citizens, its creditors and its official sector sponsors. If mishandled, a sovereign debt workout can be incandescently painful. A mangled debt restructuring can perpetuate the sense of crisis for years, sometimes even for decades.”

Debt restructuring cannot be mishandled

Simply, Sri Lanka cannot allow debt restructuring to be mishandled. As this column has mentioned over and over again, without reforms based on the market system and restructuring the economy, mere debt restructuring won’t solve our chronic problems. Debt restructuring without making structural economic reforms can lead the way for another restructuring of debt if it is not done successfully. A failed restructuring can also cause a disorderly default. 

The consequences of this are that economic activity and growth will slow down and be delayed. Mishandled debt restructuring leads to instability in the financial system, leading to declining Foreign Direct Investments (FDIs) and many other chronic economic problems. There are instances of sovereign debt crises leading to political crises, banking crises, and even to the extent of humanitarian crises. So understanding the depth and gravity of managing the debt restructuring professionally and transparently is just the first leg to a very long journey. 

The first step is appointing financial and legal advisors for the restructuring process and it is very important to make the selection process transparent and get the assistance of financial sector experts and an established parliamentary committee of all parties. Simply, we have to have top-notch financial advisors and legal advisors on our side. Already, according to Reuters, the bondholders are in discussion with one of the top legal firms on the restructuring process. Same as debt repayments, after the restructuring process commences, future governments will also have to carry the burden and process forward. 

Sovereign debt restructuring 

Sovereign debt restructuring can fail in a few ways. If the restructuring process takes too long to execute, and if it fails to provide sufficient debt relief, or if the creditors perceive the process as excessive and confiscatory, then the markets will hold a grudge that can affect future market access to the sovereign. 

In any sovereign debt restructuring, the debtor is the central player. In a corporate or individual debt restructuring, there will be a bankruptcy code (in many countries) to be used in restructuring under the supervision of courts. But in a sovereign debt restructuring, there is no bankruptcy code and debt relief can only be obtained with the creditors’ consent. 

Role of the IMF

In sovereign debt restructuring, there is a role for the International Monetary Fund (IMF). It first conducts a Debt Sustainability Analysis (DSA). However, the decision whether the debt has to be restructured or not is a decision by the sovereign country and the IMF provides technical assistance. 

Funds can be provided by the IMF to overcome the balance of payment crisis with an agreeable reform programme based on the status of debt sustainability and access to financial markets. 

In Sri Lanka’s case, the debt sustainability report is still due but the indication of the Government on a debt restructuring programme indicates that our debt is not sustainable. This was one of the main discussion points at the recently-held All Party Conference between the former Prime Minister and the current Minister of Finance.

In the case of Sri Lanka, the debt restructuring adjustment can only be determined after a detailed analysis of our entire debt stock. This included the repayment clauses of recently-taken swaps from friendly nations and the payment postponements of the Asia Clearing Unit (ACU) and even the foreign-denominated debt taken by State-Owned Enterprises (SOEs). The tools available are either to extend the maturity, adjust the agreed interest rate (coupon clipping), reduce the debt stock or principal amount (haircut), or a mix and match of selected options of the above tools.

A zero-sum game 

Debt restructuring is a zero-sum game and any creditor class will first try to make their case as a special creditor category and avoid the restructuring. If it fails, the creditors will try to expand the net number of creditors as much as possible and share the pain with everybody. The pain of debt adjustment on one party is distributed. 

In the restructuring process, any country will try to avoid restructuring of local debt as it could cause stress on the local banking and financial system. In Sri Lanka’s case, some ISB holders are local banks so the restructuring will be a little complicated as even if the external debt is restructured, then there may be an impact on local banks with high exposure to sovereign bonds. 

Sri Lanka’s creditor profiles are slightly diverse. In the bilateral creditors class, we have Paris club member countries (Japan) and non-Paris club member countries (India, China) where the Paris club operates on six principles that guide its work. So it is important that we come to a consensus at the negotiation table with Paris club members and non-Paris club members. Commercial creditors and sovereign bondholders too have to negotiate similar restructuring agreements. International Sovereign Bonds are governed by London Law or New York State Law, which makes our debt restructuring case a ‘foreign language’ to us. 

We are already on the path for debt restructuring but it is vital that all parties and Sri Lankans understand to an extent the depth of the restructuring and professionalism, transparency, and maturity required during the restructuring process. We can’t let the restructuring be handled and treated with a kid’s glove mentality. We have to do structural economic reforms with debt restructuring. Life may be a foreign language where all men mispronounce it,  but if we mishandle the debt restructuring, the lives of many men and women will be at risk.

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.

Replace blame game with reform game

Originally appeared on The Morning

By Dhananath Fernando

In Buddhism, there is an anecdote on treating a seriously injured patient: “When a man gets injured with a poisoned arrow, there is no time to investigate from which direction the arrow came and who sent the arrow. The sensible decision is to urgently treat the patient before the situation becomes serious.” Our economy is at such a critical stage that we have no time to point fingers at each other. We have to enact reforms as soon as possible, particularly to protect our most vulnerable and impoverished citizens.

With the currency flotation and the rapid and sustained LKR depreciation, the wellbeing and survival of less well-off Sri Lankans has become a serious question.

Those who have little knowledge of economics have started complaining that the currency depreciation is at fault, forgetting or not knowing what led to the currency depreciation.

As this column has highlighted for the last few years, our inappropriate policy decisions have led to the rapid depreciation in the first place. Maintaining low interest rates, continuous expansionary monetary policies (money printing), poor management of public finances, and compromising government income has caused a balance of payment crisis (commonly known as a lack of USD/foreign currency) to the extent that we now cannot even afford to import essential goods such as food items, gas and oil. Since the Central Bank can no longer artificially raise the value of the currency by spending reserves (due to very low level of reserves), the banks were asked to manage the exchange rate based on their forex demand and supply.

Simply put, a currency float is where we allow markets to determine the exchange rate to obtain the market value of a currency. However our ‘floating currency’ was not a true float as the Central Bank had regulations for banks to sell 25% of their forex and regulations on exporters to convert their forex proceedings within a stipulated time. Such regulations will not encourage forex inflows and will create excess demand by more importers who attempt to buy forex due to uncertainty. Further, the absence of a proper reform plan from the Government of Sri Lanka (GoSL) simply kept the markets more uncertain and led to firms and individuals holding on to their forex currency. As a result, the currency depreciated, since the more we maintain a situation of uncertainty, the greater the pressure on the currency.

So, what can we do to solve the problem of higher cost of living, particularly for poorer people? When the currency depreciates, people in sectors of the economy that are particularly sensitive to price hikes, including taxi drivers, fishermen, poor households that use LP gas, etc. are affected. The sensitivity to price hikes is higher the more those sectors and people are closer to the poverty line. Simply put, the people who stay just above the poverty line risk falling below and pressure on daily survival for many will continue to increase.

To avoid inflationary pressures we have to increase interest rates further. In economies which are functioning dynamically and smoothly, the interest rates are kept at low levels. But in a country where we have done a significant amount of money printing, keeping the interest rate low is going to worsen the balance of payment crisis. When interest rates are kept low, access to money will be easier, so people will try to consume more, which will add more pressure on forex outflows.

While interest rates are increased, we have to immediately revamp the welfare system and create a new social security network with proper targeting. That is one of the main reforms we need to implement in order to overcome the economic crisis. In fact, we should have had a better social security system in place before we floated the currency, but our situation was so critical that we cannot manipulate our currency further.

There are too many people in the current Samurdhi programme who don’t deserve to be in the system, and the programme has become extremely political. The withdrawal pattern shows that some of the Samurdhi recipients withdraw money only once or twice a year as a nice bonus during the New Year season or during the Christmas season. At the same time, there are a lot of genuinely vulnerable people outside the Samurdhi programme who actually deserve to partake.

Abolishing an existing programme and setting up a new programme in a short time may also not be very easy as there may be resistance from within. Particularly with politically connected beneficiaries, resistance may mount up against any new programme that better targets recipients. Secondly, the social security benefit should be adjusted based on market prices. For example, when the global market prices increase, the allowance should increase accordingly and when the prices come down, the allowance should also come down. At the same time, there should be an exit mechanism from the programme. The objective of a social safety net is to provide a fair opportunity for poor people to work hard and rejoin the economy as productive members of society. If the social security safety net is not adjusted for market prices, it is very likely that undeserving people will join the programme and resources will be wasted.

The next question is where we are going to find money, as our Government is already tight for cash. Our budget deficit is ballooning. One option is to perform more quantitative easing (money printing) and find money to run the programme, but obviously, it would add more to inflationary pressures. So that option is out. The second available option for financing is to do away with loss-making State-Owned Enterprises (SOEs). The allocation for Samurdhi (and pension entitlements of farmers and fishermen) is about Rs. 50 billion combined. About 25% of this is administration costs. The losses of Sri Lankan Airlines alone in 2020 was Rs. 47.2 billion. So clearly we have to save money by letting go of some of the SOEs which are colossal loss-makers with minimum value addition, to save our poorer citizens during this challenging time. We have many such SOEs which individually make losses that are many times the budget of the Samurdhi programme. The other option is to adjust the tax system to increase revenue. Mainly taxes such as VAT can easily be amended. This is why all the reforms have to take place simultaneously with good coordination, as simply conducting reforms in isolation may only bring resistance and non-action.

Another option that we can consider is a Universal Basic Income (UBI) model where we cut down all subsidies provided for utilities and other sectors and have an allowance for every citizen for their survival. However, we have to make sure that all other subsidies are eliminated if we move to UBI, as we definitely can’t afford to maintain both.

Sri Lanka’s situation is getting worse by the day and our survival is dependent on our ability to find solutions. Procrastination will only worsen the situation. Even though it is already late, it is imperative to begin reforms now.

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.

Import controls: Didn’t work in 2020, won’t work in 2022

Originally appeared on The Morning

By Dhananath Fernando

When I was a university student in my final year, I did an internship at one of the leading garment companies in Sri Lanka. My internship stipend was Rs. 5,500 per month, and I worked in Nittambuwa. 

On the weekly payday, it was a tradition that I would bring a small, affordable treat home. Of course, in those days the value of Rs. 5,500 and the purchasing power of the rupee was better than it is today. When my bus reached Pettah station (my interchange for the next bus to my home in Moratuwa), I would walk through the local market. What I could afford to buy from my stipend were fruits like apples, oranges, and grapes that were sold on the market sidewalks, and I would purchase a few of each variety. 

I recalled those days when I heard that the Government would be imposing licensing requirements for the import of 367 products, including apples and oranges. It occurred to me that many of the small traders who used to sell me those fruits would probably go out of business. Furthermore, the consumers who enjoyed affordable sources of fruit may lose access too.

There appears to be a widespread misconception that fruits like apples and oranges are only consumed by the wealthy elite. If they were only consumed by wealthy people, they of course would not be sold on the Pettah pavements and at central bus stands in Colombo and across the country.

The fundamental logic that is important to understand is that we cannot categorise any product as ‘essential’ or ‘non-essential’ in the first place. Different products are essential to different people based on a multitude of factors. 

A particular type of fruit like apples may not be essential to me, as I prefer to eat mangoes instead of apples. But from the perspective of an entrepreneur who was making apple juice or apple vinegar in Sri Lanka, apples cannot be substituted with mangoes. It is very likely that they will go out of business. 

Licensing process

According to the new regulations, the importers of 367 product categories have to obtain a licence for importation. Imposing such a licensing process will undoubtedly lead to corruption.  This move will ultimately only allow people in well-connected elite circles with contacts amongst Customs officers and politicians to obtain the import licences. The small-scale importer will be hit the hardest.

All big industries that require a licence have been taken over by politically-connected individuals. For example, private buses require a licence or a route permit. As the route permit is more expensive than the vehicle itself, buses tend to be poorly maintained, which puts passengers and other road users at risk.

The need for a licence to sell liquor is another example: most of the liquor licences of any given electorate tend to be owned by ruling and Opposition MPs, their family members, or allies.

Similarly, licences for Ceylon Petroleum Corporation-owned filling stations and State-owned LP gas distribution (and many other industries that require licences) have been completely overtaken by politically-connected individuals and most areas have minimal competition as a result.

Even obtaining the licence or approval that is required for basic house construction is a very cumbersome process and is greatly influenced by bribery and corruption.

Furthermore, the prices of many of the newly-affected products will go up. The few people who have the licence will have controlling power over the pricing and will effectively monopolise the industry. 

Imports are not the problem

To think that imports are the cause of the present USD shortage is a completely inaccurate diagnosis of Sri Lanka’s economic situation. 

As the Advocata Institute has explained many times, higher rates of imports have been caused by a reckless monetary policy, including quantitative easing and low-interest rates. Our imports have been declining as a percentage of GDP for the last 30 years, as have our exports. Therefore, thinking that imports are the fundamental problem is a complete misconception.

However, the Government and the Central Bank have recently been taking measures which are steps in the right direction. Increasing interest rates and floating the currency are appropriate in the current context, given the balance of payment crisis the country is undergoing. 

Ideally, interest rates have to be low and the currency has to be strong, but both can happen with time by allowing market forces to work. It is clear that the value of the currency cannot be maintained by forceful intervention. 

However, currency depreciation and higher interest rates will affect citizens in multiple ways. Depreciating the currency will cause inflation rates, which is about 14.2% (CPI, January 2022), and prices of most essentials and non-essentials to spike dramatically. 

Increasing interest rates will encourage people to save more than they spend, so the cost of capital will be high and the economy will be slowed down. Hence, growth will be low. It’s a choice between two equally-difficult options.

Our policymakers should understand that imports are not the problem. The real problem is that we haven’t carried out any reforms to improve the productivity and efficiency of the economy. Until the Government identifies the existence of a problem and takes the necessary actions to rectify it, we will not be able to overcome 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.

Policy actions: Not quite enough

Originally appeared on Daily FT, Lanka Business Online and Groundviews

By Dr Roshan Perera and Dr. Sarath Rajapatirana

Key macroeconomic indicators signal an economic crisis

A reading of key macroeconomic indicators reveals the extent of the economic crisis Sri Lanka is faced with. Indicators in all four sectors of the economy (i.e., the real sector, fiscal sector, external sector, and monetary sector), have been at their worst level in recent years, and in some cases, at levels never before seen in the post-independence history of this country. 

Growth was negative in 2020 and continued in the negative territory in the third quarter of 2021. This was obviously partly due to the pandemic as well as the measures taken to curtail its spread. However, growth in Sri Lanka continued to remain subdued while other countries in Asia were firmly on a path to recovery. Macroeconomic instability will continue to negatively impact investor sentiment and growth prospects in 2022. This will be further exacerbated by the impact of the war in Ukraine, as the region accounts for a large share of tourist arrivals and is one of the key destinations for Sri Lanka’s tea exports.

Inflation as measured by the CCPI has reached double digits (15.1% YoY in February 2022). These levels were last seen only during the last stages of the civil war. Many countries around the world have also been experiencing an uptick in inflation due to higher commodity prices, especially energy prices and supply side issues due to pent up demand with the opening of countries.

However, in Sri Lanka, an extremely loose monetary policy due to excessive money printing by the Central Bank of Sri Lanka (CBSL) to finance the Government’s deficit has pushed inflation to double digit levels. Further, core inflation – which excludes food and energy – had risen to 10.9% by February 2022, reflecting the demand pressures in the economy. Food inflation has risen even faster, with the year on change reaching 25.7% in February 2022. The recent outbreak of war in Ukraine sharply increased energy prices, with Brent crude oil prices rising to over $ 100 in March 2022 – levels last seen in late 2014.  With domestic fuel prices adjusting to higher international prices, inflation is likely to increase even further.

Meanwhile, the fiscal sector continues to deteriorate. Ad hoc tax changes made at end-2019 resulted in tax revenue declining by around Rs. 500-600 billion in both 2020 and 2021. This decline will continue in 2022 unless measures are taken to reverse this trend. Consequently, tax revenue collection has fallen to the lowest level in history (8% of GDP). This has led to widening fiscal deficits and interest payments absorbing more than 70% of Government revenue.

The significant contraction in revenue with no adjustment to Government expenditure increased the fiscal deficit to 11.1% of GDP in 2020. This is likely to have increased further in 2021. A deficit of this size was last witnessed in 2009 (9.9% of GDP) and 2001 (10/4% of GDP). The sharp decline in revenue and the worsening fiscal position led to international rating agencies downgrading the sovereign, effectively locking Sri Lanka from international capital markets. Hence, the Government resorted to domestic sources to finance the widening fiscal deficit. However, with a cap on interest rates, it fell on the CBSL to do the heavy lifting.

Consequently, money supply rose to unprecedented levels, mainly driven by credit to the Government from CBSL, as the net foreign assets (NFA) of CBSL turned negative for the first time ever. Net Credit to the Government (NCG) in 2021 increased by Rs. 1.454 billion (38.2% YoY) with CBSL being the main provider of credit. Credit to the private sector increased by only Rs. 810 billion (13.1% YoY) during the same period.

The extent of the monetisation of the fiscal deficit is seen by the sharp increase in CBSL’s holdings of Government securities from Rs. 75 billion at end 2019 to Rs. 1,417 billion at end 2021. This has further increased to Rs. 1,529 billion by 11 March 2022. By artificially suppressing interest rates to keep Government borrowing costs low, the CBSL was forced to purchase Government securities not taken up in the primary market. This had increased reserve money (base money) by 35% (YoY) in 2021. The increase in base money would have been even higher if not for the decline in CBSL’s NFA to a negative Rs. 386 billion due to the use of foreign reserves for debt service payments and to support the ‘fixed’ exchange rate.

On the external front, the Government’s large foreign debt repayments and its inability to tap foreign capital markets due to the sovereign downgrade led to the use of foreign reserves for debt service payments. Consequently, the country’s official foreign reserves fell to precarious levels. To address the imbalance in the external sector, the Government restricted imports of many goods. The CBSL also imposed a 100% margin requirement on importation of selected “non-essential” goods.

Notwithstanding these import controls, the trade deficit (the difference between exports and imports) widened in 2021. In addition, in September 2021, CBSL fixed the exchange rate within a band of Rs. 200 to 203 per US Dollar and instructed banks to carry out transactions within this narrow band. Since demand for US Dollars outstripped supply at this “fixed” rate, a black market developed.

On 7 March 2022, when CBSL allowed “greater flexibility” of the exchange rate, the US Dollar was trading at around Rs. 260-270 in the black market. The large deviation between the official exchange rate and the black-market rate led to a significant decline in foreign inflows. Workers’ remittances, which hitherto helped cushion Sri Lanka’s trade deficit, had declined by 23% to $ 5.5 billion in 2021, with the decline continuing in 2022.

Recent policy actions not sufficient to stabilise the economy

To address the deteriorating macroeconomic environment on 4 March 2022, the CBSL revised its policy rates by 100 basis points, thereby raising the Standing Deposit Facility Rate (SDFR) to 6.50% and the Standing Lending Facility Rate (SLFR) to 7.50%. In the same monetary policy announcement, CBSL as the Economic and Financial Advisor, proposed several policy measures to be taken by the Government to address the current economic situation, such as;

  • Introducing measures to discourage non-essential and non-urgent imports urgently

  • Increasing fuel prices and electricity tariffs immediately, to reflect the cost

  • Incentivising foreign remittances and investments further

  • Implementing energy conservation measures, while accelerating the move towards renewable energy

  • Increasing government revenue through suitable tax increases on a sustained basis

  • Mobilising foreign financing and non-debt forex inflows on an urgent basis

  • Monetising the non-strategic and underutilised assets

  • Postponing non-essential and non-urgent capital projects

However, a few days after this announcement on 7 March, CBSL permitted “greater flexibility in the exchange rate”. Although the CBSL indicated that it was of the view that transactions in the foreign exchange market should be conducted at not higher than Rs. 230 per US Dollar, by 11 March, the US Dollar was trading at Rs. 265/275.

This was partly due to confusion in the market with parallel announcements being made by the Cabinet regarding increasing the incentive payment to Rs. 38 per US Dollar from the current rate of Rs. 10 per US Dollar for repatriations by migrant workers. Maintaining the exchange rate at these levels would require further policy action while restoring the confidence of migrant workers to use formal channels for their remittances.

While the monetary policy tightening cycle has commenced more needs to be done as inflation and inflation expectations remain elevated. The last time inflation was at these levels in 2009, policy interest rates were at 10.50% (SDFR)/12.00% (SLFR) and the 91-day Treasury bill rate was close to 16%. Higher interest rates are also necessary to maintain the interest rate differential given the Federal Reserve Bank of the US has signalled it will continue to raise interest rates to address “surging inflation”. The difference between the current policy interest rates and market interest rates also provides an arbitrage opportunity for investors to make supernormal profits. This opportunity is higher given the large liquidity deficit in the overnight market, which stood at Rs. 704 billion as at 11 March 2022.

Tackling inflation also requires bringing down aggregate demand in the economy. Excessive money printing by CBSL has increased currency in circulation by Rs. 290 billion (59%) from end 2019 to end 2021. The large tax cuts in 2019 have left around Rs. 1 billion in the hands of individuals and businesses. In addition, although workers remittances did not come through formal channels, there was a thriving informal system known as the ‘Hawala’ or ‘Undiyal’ system, by which remittances came into the economy. The increase in cash in the economy has elevated demand for both domestic and imported commodities, thus exerting upward pressure on domestic prices and increasing demand for foreign exchange to support higher imports.

Suppressing imports, particularly of cars, has also left money in the hands of dealers. This excess money in the system is likely to have driven the boom in the stock market and pushed up land prices and the market for second-hand vehicles. The higher money supply in the economy has thus driven speculative activities rather than being channelled into growth-enhancing economic activities. Addressing the build-up of aggregate demand pressures requires, in addition to further tightening of monetary policy, raising taxes and curtailing the monetisation of the deficit through CBSL financing.

Further, the exchange rate should be the mechanism through which imports are discouraged and exports incentivised. Imports in 2021 increased by 28.5% from 2020. However, the increase from 2019 was only 3.5%. Further, the main increases were in medicines, fuel, textiles, base metals, machinery and equipment, and building materials.

Allowing the market mechanism to determine prices would be the most efficient way to ensure that goods get allocated to their highest use. This is particularly important in the case of fuel, which is priced significantly below cost. Interference in the market mechanism leads to shortages and the development of a black market. There are plenty of examples in the recent past that amply demonstrate the impact of administrative price controls on the availability and quality of goods in the market. In addition, controlling the price or supply of commodities leads to a transfer of “profit” to those who control the market while taxing consumers in terms of time and effort expended to source goods.

Sri Lanka faces twin problems of an internal imbalance with high domestic inflation and an external imbalance with external outflows well in excess of inflows (in other words, a deficit in the balance of payments). The root cause of the twin problems is the Government continuing to run fiscal deficits and financing these deficits through high-cost external borrowing and monetary expansion. Addressing these issues requires policy action on several fronts. However, first, a debt restructuring programme needs to be put in place to give the country some breathing space to stabilise the macroeconomy and to implement growth enhancing reforms. 

A comprehensive macroeconomic stabilisation programme and overall economic reform agenda will impact key economic variables; some desirable and some not so. Low-income groups will be particularly affected by these policy adjustments. Hence, attention needs to be paid to ensure an adequate safety net to protect the most vulnerable in society from the fall out of policy adjustments.

The current Samurdhi programme is woefully lacking in terms of adequacy and targeting. There needs to be a more comprehensive social protection scheme. The additional cost of the programme could be funded through savings from the fuel subsidy (which currently disproportionately benefits richer households), reversing the tax cuts and reallocating Government expenditure (1).

References

  1. Tackling the COVID-19 economic crisis in Sri Lanka: Providing universal, lifecycle social protection transfers to protect lives and bolster economic recovery, UNICEF Sri Lanka Working Paper, June 2020

Dr. Roshan Perera, Senior Research Fellow, Advocata Institute and former Director, Central Bank of Sri Lanka.The opinions expressed are the author’s own views. They may not necessarily reflect the views of the Advocata Institute, or anyone affiliated with the institute.

Fuelling reform

Originally appeared on The Morning

By Dhananath Fernando

Fuel shortages have become abundant. The implications of these shortages need no lengthy explanations. They will affect all of us: from a multinational company to the average man on the street, every action we take in life will be disturbed. The electrical grid is already experiencing multi-hour, island-wide blackouts and the situation could escalate to include water supply and many other utilities, for which the knock-on effect will be very severe. 

There were serious discussions in Parliament about the possibility of revising fuel prices. In fact, the CBSL Governor himself has requested that prices be increased. When fuel prices are increased, it may (to an extent) reduce the demand for fuel. But fuel is such an essential commodity that even when prices are increased, the drop in demand may be low. But when fuel prices are increased, people will have to spend more money on fuel and related products, hence there will be less money being spent on non-fuel imports. As the non-fuel imports come down, the balance of payments will come closer to equilibrium, reducing the extent of that crisis. Ultimately, that’s the fundamental feature of a market system.

Fuel price revisions have never been popular in Sri Lanka, as historically, revisions have always led to price increases. When the former Finance Minister late Mangala Samaraweera announced the price formula along with his team including the present Finance Ministry Secretary Dr. S.R. Attygalle, many people did not see the fuel pricing formula positively. 

In my opinion, the optics and launching the formula were also quite bad in the context of a political economy. The formula was introduced at a time when global crude oil prices were increasing, so many people thought the price formula was just an attempt – or an excuse – to increase the price rather than the proper market mechanism. At launch the officials were laughing and it was launched as V1+V2+V3 = V4 and it was captured in the media and popular rhetoric that policymakers were having fun by increasing the burden on poor people. So while the decision to implement the formula was appropriate, the marketing and getting the public on board with market-based pricing could have been better. Later on, with elections getting closer, adherence to the price formula was not maintained. But market-based pricing of fuel is definitely a need for the ailing Sri Lankan economy. 

It is crystal clear that we are unable to sell fuel at lower prices than the cost of production and distribution without incurring heavy losses and debts. The Ceylon Petroleum Corporation (CPC) makes a loss of Rs. 46.80 per for every litre of diesel even after receiving a duty waiver of Rs. 25. For petrol following a duty waiver of Rs. 45 the CPC makes a loss of about Rs. 18. 37. 

After the fuel shortage became prevalent, the common excuse trotted out by policymakers is that they don’t have dollars to buy fuel. In my view, this is misleading. While it is true that we do not have dollars to buy fuel at the soft-peg rate of approximately Rs. 200 per USD, we may have USD to buy fuel at the market rate of about Rs. 250-260 per dollar. Interestingly, we do not need the assistance of the International Monetary Fund (IMF) to make these little changes with a big impact. Increasing domestic fuel prices may reduce the losses of CPC, but it will not solve the underlying problems causing shortages. Currently our Government makes two main losses on every litre of petrol or diesel: first, it suffers an operational loss on subsidised fuel and secondly, it suffers an exchange rate loss.

While the main reason for the current crisis is shortage of USD, it should be noted that the energy market dynamics are also very weak. It’s a duopoly market with over 80% share for the State-owned CPC, one of the biggest loss-making State-owned enterprises in the nation. As per sales for 2020 of diesel, because of the duty waiver alone, the Government is losing out on about Rs. 30 billion in revenue for petrol and about Rs. 98 billion for diesel. 

It is simply not worth making such losses, making life inconvenient for consumers while also losing political capital at the same time. There is no winner when the State tries to keep fuel prices low. Claiming that our prices are low doesn’t really matter when we have no fuel available at all! So although it is not a popular decision, the right and rational decision is to determine the price based on market forces. Also, the entry barriers have to be reduced or eliminated to allow other players to enter the market. Singapore, a smaller country with a population less than a quarter of Sri Lanka’s, has more fuel and energy suppliers, ensuring price and supply stability.

Rather than merely providing excuses as to why we do not have USD to buy fuel, the Government can identify the price at which it can make the USD available for our fuel imports. Long-term reforms are the only solution for this problem. Emerging from our economic strife is determined by when we start our reforms programme. It’s better for everyone that we start sooner than later. 

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.

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