Originally appeared in the Daily FT, Ada Derana Biz, Sunday Observer
Advocata Institute submitted a letter to all members of Parliament on Monday 3 May, on the proposed Colombo Port City Economic Commission Bill. The letter was addressed to all MPs, highlighting the potential opportunity the Port City project presents and observations on how to maximise the economic opportunities.
The full letter can be read on www.advocata.org. The recommendations and observations are summarised below.
1. The case for Special Economic Zones in Sri Lanka
Special Economic Zones (SEZs) have been a tool employed around the world by bringing in positive value addition to an economy. More broadly, SEZs are places that have all the facilities that firms need to thrive. SEZs can play an important role in creating the right conditions for industrial success. This might include suitable land plots, hard infrastructure, and site-specific policies or clearances. Moreover, firms in SEZs can benefit from each other’s proximity – they can be each other’s suppliers and customers – thereby making a strong case for Sri Lanka to utilise SEZs to achieve economic growth.
If implemented with the right policies and a globally accepted regulatory framework, the Colombo Port City has the potential to emulate some of the successful financial centres in the region and become a driver of growth that Sri Lanka needs.
However, the success of an SEZ can only be determined by evaluating the linkages generated within the local economy. In order to become successful, Port City should facilitate positive spillovers in technology and know-how that enable the local economy to enhance productivity.
In order to become truly effective, given the thicket of red tape in Sri Lanka, SEZs require a certain degree of discretionary powers. The provision of such powers allows SEZs to operate independently and achieve productive targets without having to deal with tedious and time-consuming processes that hobble businesses in the rest of the country. This is why SEZs can effectively accelerate economic growth while also being an incentive for Foreign Direct Investments.
2. The issues with tax concessions
Taxes are the most important source of revenue for the Government. However, in 2020, tax revenue fell to 8.1% of GDP, exacerbating an already precarious fiscal situation. With a history of fiscal deficits, the compounding effects of debt financing has snowballed into serious concerns regarding debt sustainability.
The tax concessions as provided for in the Bill can create distortions within the economy while seriously impairing fiscal sustainability. Businesses located within the Port City will benefit from the agglomeration effects of being in the Port City and having access to world-class infrastructure. Therefore an investment in the Port City should yield a much higher return, thus not requiring further fiscal incentives. Research also suggests that the effectiveness of tax incentives in attracting foreign investment is low. Having only a marginal impact in attracting FDI compared to other factors.
While recognising the need to be competitive vis-à-vis other zones, the provisions to provide tax relief over and above the tax concessions already provided for under the Inland Revenue Act No. 24 of 2017 will further compromise the progressivity of the tax system and affect competitive neutrality.
There are, however, instances when fiscal incentives (tax credits, grants, etc.) may be warranted, for example, where private returns are below the cost of capital but social returns (positive externalities) can be generated. However, the existing Inland Revenue Act provides for such incentives – we recommend that the power to grant fiscal incentives be retained within the Ministry of Finance.
3. Considerations on financial regulation
Developing a fully-fledged OFC (Offshore Financial Centre) requires the relaxation of capital controls to permit free movement of capital, improving the ability to compete globally. However, given Sri Lanka’s current status of debt sustainability, sovereign rating downgrade, and foreign exchange crisis, it may not be the most appropriate time to set up an OFC. Stringent foreign exchange controls in place as of now may not allow the relaxation of capital controls.
The success of a financial centre depends on the confidence and trust that it evokes in investors and customers. The key to building this trust and confidence is dependent on two factors. First, the governance structure in place, i.e., the laws, rules and regulations governing financial products and services. Second, the way in which the regulatory authority/ies apply and enforce the regulations. Further, these regulations must conform to international best practices set out by institutions such as the Basel Committee on Banking Supervision (BCBS) and Financial Action Taskforce (FATF) recommendations on anti-money laundering and combatting the financing of terrorism and proliferation (AML/CFT), to ensure global acceptance. Any attempts to circumvent these standards could have adverse impacts on financial institutions operating in the rest of the country as well.
There is, however, a case for moving from a rules-based financial regulation, as is currently in place, to a more principle-based financial regulation. Such a move encourages financial innovation and facilitates the expansion of financial services in a dynamic global environment. There is also a case for unified regulation of financial services (a single omnibus legislation which has been adopted by other financial centres). The Bill only refers to regulation of banks and capital market institutions. It is silent on whether insurance companies would be allowed to operate within this jurisdiction and who would regulate that sector. It is of vital importance that this issue be addressed if the Port City is to be operated as an OFC.
According to the draft Bill, licensing (Section 42(4)) and regulating (Section 45) for offshore banking businesses is done by the Commission with the concurrence of the Monetary Board under the Banking Act No.30 of 1988. However, as per the Bill, the examination of such entities would be undertaken by a “competent authority” appointed by the Port City Commission (Section 49), and the Monetary Board may only call for information and reports from these entities through the Commission (Section 51). But the Bill is silent on the expertise and experience of those who would be appointed by the Commission to undertake the examination of these entities. Our recommendation is that until a separate financial regulatory framework for the OFC is set up in the Port City, and until persons with the necessary capabilities are recruited, the existing regulators must undertake both the regulation and supervision of financial institutions set up within the Port City.
Advocata also call upon members of Parliament to make an addition to clause 5, as subsection (k) reading “Uphold laws and regulations on anti-money laundering and terrorism financing” in light of the above mentioned AML/CFT issues.
4. The need for flexible labour regulations
The Colombo Port City expects to operate as a service-oriented SEZ that propels Sri Lanka to be a major trading and services hub within the Indian Ocean. It hopes to attract top-notch IT, financial service firms and types of businesses and economic activity that will be highly innovative. In order for such firms to thrive and grow, a labour environment that accommodates failure, mistakes and high rates of experimentation is crucial.
This requires a flexible labour market with low redundancy and restructuring costs that promotes swift adaptability to market changes. Prioritising labour solutions over capital will result in job creation that will ultimately benefit the country. However, the labour regulations in operation in Sri Lanka does not facilitate the same.
Unemployment is a social problem, the burden of which must not be borne by the employers alone. Hence, we recommend the establishment of an Unemployment Insurance Scheme similar to EPF and ETF funds to compliment flexible labour regulations.
5. Recommendations on Parliamentary oversight and accountability
At present, the Bill states that the Commission should submit to the President or Minister in Charge an annual report setting out the status of operations, income and expenditure of the Commission. Alongside this, it also provides for the audit of accounts of the Commission. However, as the main parliamentary oversight mechanisms in place to examine the activities of the government bodies responsible for public accounts and public enterprises are the COPA and the COPE, we recommend that the Port City Commission be made accountable to these committees.
In relation to the composition of the Commission, it is our recommendation that the Secretary to the Treasury be appointed as an ex-officio to the Commission since this would allow for fiscal accountability.
Parliament should also consider the provision of including a mechanism for staggered appointments to the committee would ensure institutional stability, preserve institutional memory and political representation. In line with the international governance standards, Parliament should also consider having a minimum quota for women’s representation in the Commission.
The Advocata Institute recommends the consideration of the reforms outlined above to achieve maximum economic outcomes.