Regulating prices: From price mandates to more competition

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

By Thiloka Yapa

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

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

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

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

Price regulation and its impact 

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

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

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

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

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

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

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

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

What can be done?

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

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

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

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

4.  Consumer Affairs Authority Act No. 09 of 2003 

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

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

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

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

When price controls get out of control

Originally appeared on The Morning

By Dhananath Fernando

• Price controls lead to shortages and distort markets

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

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

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

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

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

How can the distorted rice market be rectified? 

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

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

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

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

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

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

Originally appeared on The Daily FT.

By Prof. Prema-Chandra Athukorala

IMF programmes and economic performance

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Concluding remarks: Seeking or rejecting IMF support

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

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

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

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

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

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

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

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

Originally appeared on The Daily FT.

By Prof. Prema-Chandra Athukorala

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

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

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

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

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

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

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

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

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

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

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

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

1977-’88: The first wave of liberalisation reforms 

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

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

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

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

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

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

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

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

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

1988-2005: The second-wave reforms

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

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

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

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

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

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

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

1995-2009: The period of escalating civil war

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

The post-civil war era

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

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

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

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

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

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

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

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

Originally appeared on The Daily FT.

By Prof. Prema-Chandra Athukorala

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

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

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

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

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

The IMF and economic stabilisation

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Sri Lanka and the IMF 

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

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

1964: Trotskyite Finance Minister seeking IMF support

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

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

1965-70: Four back-to-back SBAs

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

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

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

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

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

Losing by focusing on the winners

Originally appeared on The Morning

By Dhananath Fernando

• Winners focus on winning and losers focus on winners.

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

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

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

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

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

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

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

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

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

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

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

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

Underneath the underwear patriotism

Originally appeared on The Morning

By Dhananath Fernando

• Can Sri Lanka become self-sufficient in undergarments?

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

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

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

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

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

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

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

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

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

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

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

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

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

Reform or Perish. It’s not too late

Originally appeared on The Island, ColomboTelegraph and Groundviews

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

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

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

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

The State of the Economy 

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

(a) diverted resources away from competitive businesses, 

(b) created a hostile environment for foreign investment, 

(c) been detrimental to consumer welfare,

(d) dragged down growth

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

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

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

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

The Government’s dangerous honey

Originally appeared on The Morning

By Dhananath Fernando

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

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

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

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

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

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

Fixing USD at Rs. 203

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

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

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

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

Concerns expressed by investors on property rights over seizing rice stocks

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

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

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

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

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

Closing the gate once the horse has bolted

Originally appeared on The Morning

By Dhananath Fernando

Can price controls rein in uncontrolled depreciation?

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

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

Steep depreciation of the currency

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

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

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

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

Acute foreign exchange crisis exacerbated by MMT

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

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

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

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

Price controls

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

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

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

Why do traders hoard?

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

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

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

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

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

Reforms required, IMF or no IMF

Originally appeared on The Morning

By Dhananath Fernando

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

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

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

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

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

Immediate policies

Cash transfer system for safety nets

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

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

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

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

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

Debt restructuring and debt conversion

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

Unlocking our land supply

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

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

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

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

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

Originally appeared on The Island, Colombo Telegraph

By Sathya Karunarathne

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

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

How did we get here?

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

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

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

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

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

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

So what’s at stake for young

people in all this?

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

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

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

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

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

To leave or to stay?

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

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

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

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

Avoiding IMF won’t help us avoid austerity

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

By Naqiya Shiraz and Rehana Thowfeek

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

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

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

1. The outright restrictions on imports

2. The shortages of foreign exchange in the market

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

We too might lose everything

Originally appeared on The Morning

By Dhananath Fernando

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Solutions

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

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

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

Originally appeared on The Morning

By Dhananath Fernando

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

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

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

Milk powder shortage

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

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

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

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

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

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

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

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

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

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

The case of LP gas

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

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

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

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

Hanky-panky under the blanket

Originally appeared on The Morning

By Dhananath Fernando

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

To get rich, reward the hardworking

Originally appeared on The Morning

By Dhananath Fernando

Market-oriented policy reforms needed

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

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

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

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

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

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

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

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

1. Individuals who work hard and become prosperous

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

3. Individuals who do not work hard but become prosperous

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

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

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

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

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

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

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

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

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

Show me the money: a magic trick waiting to backfire

Originally appeared on The Morning

By Dhananath Fernando

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Originally appeared on The Daily FT

By Prof. Sirimevan Colombage

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

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

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

Tax Amnesty Bill

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

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

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

Benefits of tax amnesties debatable

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

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

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

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

 Types of tax amnesties

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

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

Objectives of tax amnesties

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

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

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

 Tax amnesty inadequate to recover revenue losses 

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

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

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

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

Tax amnesty discriminates against honest taxpayers

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

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

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

 Costs of tax amnesty offset benefits

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

 Policy alternatives

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

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

Abandoned tax reforms under EFF

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

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

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

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

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

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

Coming out a winner

Originally appeared on The Morning

By Dhananath Fernando

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

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

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

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

Understanding the problem 

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

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

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

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

Short-term solutions 

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

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

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

Medium-term solutions 

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

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

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

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

Long-term solutions 

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

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

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

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

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