Compounded crises: IMF the only way out

Originally appeared on The Morning.

By Dhananath Fernando

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

A cornucopia of crises: Refuge lies in reforms

Originally appeared on The Morning

By Dhananath Fernando

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Originally appeared on The Morning

By Dhananath Fernando

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

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

The moment of truth 

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

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

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

Debt restructuring cannot be mishandled

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

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

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

Sovereign debt restructuring 

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

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

Role of the IMF

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

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

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

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

A zero-sum game 

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

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

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

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

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

Replace blame game with reform game

Originally appeared on The Morning

By Dhananath Fernando

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Originally appeared on The Morning

By Dhananath Fernando

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

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

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

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

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

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

Licensing process

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

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

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

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

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

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

Imports are not the problem

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

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

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

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

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

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

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

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

Policy actions: Not quite enough

Originally appeared on Daily FT, Lanka Business Online and Groundviews

By Dr Roshan Perera and Dr. Sarath Rajapatirana

Key macroeconomic indicators signal an economic crisis

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

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

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

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

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

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

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

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

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

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

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

Recent policy actions not sufficient to stabilise the economy

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

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

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

• Incentivising foreign remittances and investments further

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

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

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

• Monetising the non-strategic and underutilised assets

• Postponing non-essential and non-urgent capital projects

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

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

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

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

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

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

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

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

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

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

References

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

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

Fuelling reform

Originally appeared on The Morning

By Dhananath Fernando

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

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

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

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

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

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

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

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

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

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

How can affordable electricity be assured 24x7?

Originally appeared on the Daily FT

By Prof. Rohan Samarajiva

The best way to understand the value of something is to experience life without it. These days, the Government is giving us a crash course on the value of reliable electricity supply. An unpleasant lesson, but nonetheless a learning opportunity.

If we probe the causes of load shedding, the learning can be deeper. Load shedding can be eliminated but at a cost. When hydropower declines due to periodic drought, the difference can be made up with generators running on imported fuel, the dollar price of which is determined by world market conditions. We can have 24x7 electricity, but not at an affordable price.

The Government created the immediate conditions for unreliable electricity supply through mismanagement of the country’s external debt. Today’s problems are not caused by delays in building additional generating capacity; they are caused by the lack of dollars to provide fuel for the existing generating plants. But there were deeper weaknesses in the organically developed system that must be understood.

With benchmark crude oil prices going over $ 100 per barrel, we must rethink our dependence on imported fossil fuels.

Reducing dependence on fossil fuels

Examination of the composition of our imports (Figure 1) shows that refined petroleum and crude oil taken together is the largest or second largest category of what is imported. It follows then that reducing the import of petroleum products would be an action that would satisfy many: those concerned about global warming will be made happy; those who want self-sufficiency would also be pleased. 

Petroleum imports are not used solely for electricity generation. But the way to reduce the consumption of petroleum products for transportation also involves electricity generated by renewables: buses and trains that are powered by electricity; lorries, cars, three-wheelers, and two-wheelers that are powered by electricity. Promoting electric vehicles makes no sense unless electricity comes from renewable sources. 

The significant increase in expenditure for fossil fuels starting in 2011 (Figure 2) appears correlated with the massive increase in the vehicle stock after the end of the conflict, leading to a doubling by 2014. Luckily, the biggest increase was in two wheelers, which do not take up a lot of road space and consume less fuel. 

Generating electricity from renewables does require some imported elements such as low-cost, efficient turbines and photo-voltaic panels but the costs and dependence is nowhere near that which exists with imported oil and natural gas. In fact, it may be possible even to export electricity at certain times of the day or even for months on end. But this will require substantial investment in the transmission grid.

Preconditions for increasing use of renewables

An economics commentator whose work I follow had expressed puzzlement at “demand for electricity is higher than supply” being given as a reason for load shedding. Others had expressed outrage at some Facebook posts that I had shared, which stated that solar and wind could not provide a complete solution to our energy woes. These responses by well-meaning and intelligent commentators made me realise the need for a better understanding of how the electricity is generated, transmitted, and distributed.

For all practical purposes using currently affordable technology, electricity must be treated as something that cannot be stored (but see discussion of pumped storage below). That means that it must be generated at the same time as people consume electricity by activating lights or appliances. Peak consumption in Sri Lanka (in the evening hours starting from around 6:30 p.m.) is around 2 or 2.5 times that of lowest use which is around 1000 MW. 

That necessitates a cheap source of baseload electricity that can be drawn upon throughout the day. In addition, we must have other sources that can be mobilised as demand increases. One would think that the major hydroelectric plants that have been built on the main rivers which generate cheap electricity that is unaffected by world market prices and the value of the rupee could serve as the source of baseload power. But there are constraints, such as competing demands from agriculture. The weather affects hydropower, as we are experiencing now. 

Therefore, planners in the past argued for coal as the ideal baseload for Sri Lanka. If Norochcholai does not keep breaking down and operates optimally, it can give 900 MW continuously whether or not the rains come. But it does break down, and it appears there have been irregularities in coal purchases. Coal, even if procured on long-term contracts at the lowest possible price, still must be paid for in dollars.

There are those who argue that Sri Lanka has plenty of wind and sun, and we can solve all problems by shifting to wind and sun. But the simple fact is that these are intermittent sources. Solar does not produce electricity when the sun does not shine and produces less when clouds cover the sun. Wind can produce throughout the day and night, but there are times when the wind dies down. It requires complex system controls to blend these intermittent sources into a centralised system designed for large, stable and controllable generators. 

Countries have incorporated massive amounts of intermittent renewable sources. In 2019, 47% of Denmark’s electricity came from wind. But they have a very sophisticated grid that is capable of handling intermittent power sources, and they use interconnections with other national systems to help balance the system. So, for example, when excess power is generated by the Danish wind turbines, it is used to pump water back up into reservoirs in Norway and Sweden (a method of storing electricity in the form of water known as pumped storage), which can then be run through turbines again to produce more electricity when needed. Yet with all that, Danish consumers pay more for electricity than their neighbours.

Similarly, if Sri Lanka is to increase the use of intermittent power sources, we will have to upgrade the grid and the system control centre’s software. Given the difficulties of synchronising the frequencies to one big plant such as Victoria, it may even be necessary to gradually convert the grid to direct current. If the Sri Lankan grid is connected via a high voltage direct current cable to the Southern Indian grid, the much larger combined system can absorb a greater amount of wind and solar power. 

Interconnecting does not mean that a country gives up on generating its own electricity. It simply means that marginal amounts of electricity will flow in either direction when it is advantageous to two (or more) systems. The fact that the peaks are different in the two systems can also be used to reduce the high costs incurred at peak.

It may be necessary to directly link revenues derived from regulated prices to those who make the substantial investments needed for the grid. This will almost necessarily require a restructuring of the current ungainly, unresponsive, and money-losing CEB in a manner that allows the transmission unit to be run efficiently. 

All these options require careful study in terms of costs, benefits and energy security. The relations between Denmark and its neighbours are such that all the parties can be confident about the contracts being respected and any disputes that arise being settled in a fair manner. We must ensure that the interconnection agreements with India have all these safeguards. The precedent of India’s interconnections with Bhutan shows that mutual interdependence is achievable in South Asia. The experience in Europe where interconnection, including over long distances across water, is growing rapidly even after Brexit, will have to be studied. 

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

Price controls worsen drug shortage

Originally appeared on The Morning

By Dhananath Fernando

Shortages have now become abundant and the new normal. We all know the reason: the foreign exchange shortage that is causing shortages of many essential and non-essential goods. Shortages have even affected our basic essentials, such as fuel and electricity.

We all know the solutions for the problems as well. Unfortunately, we have a shortage of policymakers who have the courage to enact the reforms to rescue our people from the commodity shortages. 

There are many contributing factors to potential shortages: supply chain disruptions, natural disasters, and many other externalities. However, in the Sri Lankan context, it is primarily price controls that are causing shortages. 

When there were price controls on tinned fish, there was a shortage of tinned fish. We had a controlled price for dhal, and dhal disappeared from the market. Cement prices were controlled and we experienced a cement shortage. The same has happened for US Dollars (USD). The Government controlled the price of USD, and the country has a shortage of USD. However, the USD problem is somewhat more complicated as price controls are just one of the reasons for the shortage. Controlling the price of the dollar has the worst effects of all the price controls as it has repercussions on all imports and exports.

As a result of the deteriorating situation, the Government removed price controls on most items which is commendable. It was clearly the right thing to do. Cement, milk powder, and many other commodities removed their price controls. But controls remained in a few very important categories: most significantly, USD and pharmaceuticals. The dollar shortage is worsening the shortages in all other industries and pharmaceutical shortages are creating a nightmare for many patients and their families. Even shortages of basic medicines such as the painkiller paracetamol have been reported. Although it was reported that the demand has increased by more than 200% due to Covid and Dengue, in a market system paracetamol cannot suffer shortages unless there is an economic issue (1).

One of my relatives has a rare type of pneumonia, and only one drug brand is effective in treating it. Since the disease is rare, only a small quantity of that particular drug was imported. Now with dollar shortages and delays in opening Letters of Credit (LCs), that particular drug is of less priority to the drug importer, as the same dollars could have been utilised to import more profitable drugs. 

On the other hand, there are price controls on some drugs and pharmaceuticals. As a result, when the prices have increased, no businesses would have the incentive to import them, as they would be engaging in a business where the cost is higher than the selling price (or where the profit margins are so razor-thin that investment is not justified).

Additionally, pharmaceutical prices and some active pharmaceutical ingredient prices have increased due to the pandemic and resulting supply chain interruptions. Simply maintaining rigid price controls doesn’t make economic sense and it only causes shortages in the market. It even makes the situation worse for local manufacturers, who find it difficult to source raw materials/ingredients. The State Pharmaceutical Corporation (SPC) can survive, because it’s a government institute, and it will receive preferential treatment from the State banks in opening LCs and will receive subsidies from the taxpayer. 

In the case of private companies, the importation of drugs and active pharmaceutical agents are conducted through long-term contracts. If LCs cannot be honoured or opened, both their professional business relationships and the reliability of supply will be affected. Sometimes with changes in credit periods, cost factors will change. This will occur particularly when there are doubts in the market on the exchange rate. In today’s Sri Lanka, where the kerb/black market rate is 20-30% higher than the rate offered by banks, the cost of imports is obviously going to be higher. 

Price controls on pharma are going to create shortages of the drugs that we depend on, as we have already experienced with products including tinned fish, dhal, milk powder, and cement. 

Due to shortages of USD and difficulties in opening LCs, even without price controls it will be difficult to avoid shortages. The main reason is that 2022’s entire global economy is connected through the dollar alone. In such a context, price controls are just going to make the problem worse. 

It is understandable from the Government’s point of view that allowing a sudden price increase of pharma products may not be politically feasible. But it may have a more significant political impact if the products are simply not available on the market. As with oil products, we could have aligned the prices slowly at regular intervals so that the price hikes would be more digestible for the average citizen and therefore less politically damaging. If we had enacted price revisions that aligned with global market prices we may not be where we are today. That is why the market system depends on the price mechanism – it is the thermometer which balances supply and demand. 

For a market system, competition comes before regulation. Imports and exports must work together at full capacity for prices to come down. Therefore, the regulatory framework has to be managed in a way that allows market forces to work. 

When the Board of Investment was positioned as a ‘One Stop Shop,’ there was a joke among the business community that “It’s one more stop” would be more apt. Similarly, the National Medicines Regulatory Authority (NMRA) – supposed to be the regulator of prices and quality of medicines and medical equipment – has simply added a severe burden to the process rather than making it easier. 

References:

• https://ceylontoday.lk/index.php/news/paracetamol-demand-up-275

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.

Government must resign itself to reforms – now

Originally appeared on The Morning

By Dhananath Fernando

My school Advanced Level biology teacher used to tell me how to study for exams. Her main advice was that the first step was to ‘make a decision to study’. I would think to myself, ‘Haven’t we all decided that we need to study?’ 

But she would explain the power of decision making, which applied everytime we make a decision – be it consciously or unconsciously – and mention life every time we had to make a decision: “Not making a decision is a decision. Thinking to ourselves to study later is also a decision. Studying now is a decision. Not studying is also a decision.” 

I realised that it’s all about the thousands of decisions that we make everyday. All of our destinations will be determined by such small decisions. What we are today is based on the decisions that we made in the past; what we will be tomorrow is based on decisions we make today.

The same lesson applies to our economic policy as well. It appears that our policymakers have made a decision to not make any decisions on the public policy front. Since the initial stages of Covid-19, multiple reports have been submitted by experts and the Government has even called for multiple reports on the current economic situation. There was an initial report by the Pathfinder Foundation which focused solely on the pandemic. Then a ‘Road Map for Economic Recovery’ was launched by the Advocata Institute. 

In fact, the President called for a deregulation report, which was chaired by Krishan Balendran and Lalith Weeratunga. Suggestions were handed over by the Delegation of German Industry and Commerce (1) to the Deregulation Committee. There were many other suggestions and ideas by many other stakeholders, including the Chamber of Commerce, on the brewing economic crisis. It was recently reported that the Pathfinder Foundation submitted another report to the Minister of Finance based on the findings of a tripartite discussion between experts from Sri Lanka, Japan, and India. 

After all these suggestions, the decision to delay reforms may have multiple reasons, of which which we can only guess. But keeping assumptions aside, the more we delay, the closer we get pinned to the wall with limited choices to escape from the crisis.

Economic reforms must always be looked at in a political context. Whether the present political power balance supports the reforms is a key question. While many are of the view that with a two-thirds majority reforms can be done, it seems otherwise. Reforms are going to be quite painful so it seems that policymakers are reluctant to push hard reforms, as they are scared that the citizens’ frustration during the reform period may dilute the political capital they enjoy.  Further, this may even cause them to lose the super-majority. 

Even the Minister of Finance has admitted that the State sector and State-Owned Enterprises (SOEs) are a massive burden to Government coffers; yet no State sector reform programme is even on the table. Politics is obviously the concern of the Government and State sector employees and their families are a massive voter bloc. Some of them would lose their jobs or would be pushed into mandatory retirement which would not help politics at the ground level. So reforms are put on the back burner and the Government continues to procrastinate. 

On the other front, the more that we delay reforms, the more the people get frustrated with disturbances to their regular day-to-day activities and businesses, including shortages of essentials such as LP gas, fuel, milk powder, cement, etc. The Government is stuck between a rock and a hard place – whether it carries out reforms or not, its popular support and political capital will be diluted either way. Therefore, my view is that it is better to bite the bullet and carry out reforms, as procrastination is just going to make things worse in the long run.

Another reason that reforms are delayed could be that the energy and focus of policymakers and politicians is spent mainly on fire-fighting day-to-day micro-problems. The situation is such that everyday has become a challenge for the Government to find US Dollars for importing basics and debt repayments.

Weather conditions impacting hydropower generation and global crude oil prices reaching nearly $ 100 a barrel are making our crisis worse. So far our policymakers’ strategy has been to completely depend on swaps. 

Over the last few weeks, India provided us with swaps and credit lines worth $ 1.5 billion and China with another Yuan 10 billion (approximately $ 1.5 b), of which basic information such as interest rates and payment conditionality has yet to be published. Interestingly, the total amount of swaps and credit lines are equivalent to six times the value of the MCC Grant, which created an extensive social discussion on the attached binding conditions which caused the President to appoint a committee to evaluate the grant agreement.

But our economic crisis is such that we are extremely desperate for foreign exchange. We had a presidential commission for a mere $ 480 million grant at a time when people had a deeper sensitivity to the potential conditions, whereas now we have decided to borrow six times more than that without any political party, media, or public figure having voiced their concerns. 

The decisions available at hand for all political parties are limited and difficult. It has come down to simply having the courage to implement reforms. Politics or party lines have become irrelevant as the prescription will not change regardless of the person in the driver’s seat.

Since 1977 and 1990 there has been no effort for any hard economic reforms, so many policymakers think that hard reforms will dilute their popularity. As a result, procrastination on reforms has become the norm. At the same time, the practice and knowhow of driving reforms have not been common. But the truth is that reforms will have less damage on political capital, while not undertaking reforms will have far more serious consequences. Stagnation won’t take us anywhere, but reforms will. 

References

1 https://srilanka.ahk.de/aktuelles/news-details/handover-of-report-on-the-simplification-of-existing-laws-and-regulations-in-sri-lanka

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

The danger of being anchored in anti-competitive safety

Originally appeared on The Morning

By Dhananath Fernando

The ‘what not to do’ guide for Sri Lanka’s economy from its shipping sector

Once I met a businessman in one of the world’s largest waterproofing corporations, based in the United States. He spoke to me about his humble beginnings. I asked him what his secret for success was. He replied “market system and competition” with confidence. 

He explained that an average person like him was able to create such a large business and social impact which provides employment for thousands of people in just one generation solely because of the market system and competition. “The market system made me an innovative, hard working and a progressive person. I didn’t care about my background. Without competition I could have been the same person as I was 20 years ago,” he said.

In life, hard work and commitment are the basic requirements of prosperity. What we need is a system that rewards hard work and free exchange, so the market system can create progression and prosperity. In any sector when competition is restricted, stagnation is unavoidable. That is one of the main reasons why, in any advanced market system, institutions are built to promote competition and restrict anti-competitive practises such as monopolisation. 

In Sri Lanka our total factor productivity is very low compared to our regional players, due to lack of competition and anti-competitive business practises. Sri Lanka is ranked at 84th in the Global Competitiveness Index (out of 140 economies) while we were ranked 52 in the same index in 2012; clearly, the situation is only becoming more dire.

The shipping industry is just one prominent example of how the lack of competition and anti-competitive trade practises have made Sri Lankan industry stagnant over the decades. While Sri Lanka boasts of its strategic location, our growth has been far below potential for many decades now. We have not only failed at capitalising on our naturally-gifted location but we are mired in debate and friction due to anti-competitive trade practises and attempts to monopolise the shipping industry and supporting services.

Most protected industries and cartels practise  anti-competitive behaviour after a certain period of time, due to stagnation and poor productivity. In a competitive environment, businesses focus more on future opportunities and productivity improvement, than on defending their own interests even if it means resorting to anti-competitive practises. As the American sporting legend Tom Brady famously said: “While the winners are focused on winning, the losers focus on the winners.”

Sri Lanka is quite unfortunate as even shipping, a main sector where we have the opportunity to open up for competition, has fallen victim to protectionist and anti-competitive practises. Minister Vasudeva Nanayakkara filed a public litigation case on the monopolisation of the shipping industry when he was a member of the Joint Opposition during the last regime. However, the lack of regulation to avoid anti-competitive practises will provide very limited space for ordinary citizens to become aware of the extent of the problem. 

Attempts to eliminate minimum investment requirements on shipping industry and freight forwarding with the objective of bringing more competition has failed over the years due to industry resistance. 

The result is shown in the numbers: Sri Lanka has about 750 local shipping, freight forwarding, and clearing agents, whereas Singapore has about 5,000 – despite commencing on its journey to becoming a maritime hub several years after us. Even in the case of the X-Press Pearl environmental disaster, we really did not have the basic ecosystem in place to combat an emergency because of our anti-competitive, inward-looking approach. 

Of course, shipping is not the only industry closed for competition, with anti-competitive behaviour. The acquisition of two of the largest tile manufacturers in Sri Lanka, which operate in an industry that is already highly protected (at one point with 107% total tariff protection), has also been a concern. The result has been the continuous suffering of consumers and the construction industry over the years, with basic housing becoming almost a dream for aspirational Sri Lankans. 

According to the current regulation, the Consumer Affairs Authority (CAA) Act No. 09 of 2003 (which was brought after repealing the Fair Trading Commision [FTC] Act of 1987) is expected to promote competition. Unfortunately, the Act only sets price controls on selected consumer goods instead of truly promoting competition. They raid small mom-and-pop shops for selling goods at rates higher than the set prices, and cast a blind eye on all other anti-competitive behaviour. It should be noted, however, that the CAA is hindered by its limited purview on the Investigation of existence of monopolies, mergers and acquisitions, and anti-competitive practises. 

The previous FTC Act of 1987 had a broader purview to investigate anti-competitive trade practises (compared to current CAA) including agreements to limit production, refusal to prevent  predatory pricing, vertical agreements, and cartels. But the Fair Trade Commision Act lacked implementation guidelines and specific distinction between public and private sectors (1). Anti-competitive practises need to always be analysed with State-Owned Enterprises (SOEs) as most monopolies and anti-competitive practises are SOE driven.

Additionally, the provisions for the appointment and removal of members to the FTC, as well as the way the Act was implemented, raised concerns of the departure from competitive policy at the FTC (2).

A good example of the shortcomings of the FTC is the merger of Glaxo-Wellcome and SmithKline Beecham. FTC considered that it was beyond their purview as it was an international merger. In relation to unfair trade practises, the oft-cited case is that of Ceylon Oxygen Ltd. Ceylon Oxygen had held a dominant market position since 1936 in Sri Lanka. When a new firm named Industrial Gases (Pvt) Ltd. entered the market in 1993, it was alleged that Ceylon Oxygen behaved in predatory manner by reducing the deposit fee on canisters and decreasing maintenance charges, and made discriminatory discounts as well as discriminatory rebates. 

FTC identified  three anti-competitive practices of Ceylon Oxygen, namely, predatory pricing, discriminatory rebates, and excluding dealing. However, when the case went up to the Appeals Court, it was held that the FTC had no jurisdiction to investigate such practises over the case and therefore did not recognise these practises as preventing competition.

Though the FTC had its own shortcomings, the subsequent CAA Act has a far more limited purview. Simply put, Sri Lanka’s business environment and ecosystem are  set on all fronts to avoid competition and promote anti-competitive behaviour, while our prosperity completely depends on the opposite. 

Competition is very important to Micro-, Small- and Medium-Sized Enterprises. They are the first to adapt and grow due to flexibility and agility in a competitive environment. That is the reason the world-class waterproofing businessman whom I had met thanked competition and the market system for his success and the success of his business. 

If Sri Lanka is serious about achieving the status of a high income country, we can only get there by improving our productivity (total factor productivity) and certainly not through debt accumulation. Trade and competition policies play a pivotal role in this journey of reform and our policymakers should focus on implementing high-impact policies to promote competition and avoid anti-competitive behaviours. Unfortunately, the current focus has been on prices and market intervention.

Sri Lanka has a large number of talented young people who could become as successful as the waterproofing businessman I met. If we establish a market system and a competitive environment, then nothing will stand in the way of our youth reaching the top and Sri Lanka will become a far better and more prosperous nation than it is today.

References:

(1)  ​​Trade and Competition Policies: Their implications for productivity Growth in Sri Lanka by Dr.Sarath Rajapathirana

(2)  Thurairtnam (2006), Malathi Knight Jones (2002)

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.

No true independence without economic freedom?

Originally appeared on The Morning

By Dhananath Fernando

This is a story I’ve heard, the validity of which I am not too sure about. The story goes that post India’s independence in 1947 the then Indian Prime Minister Jawaharlal Nehru was visiting villages to celebrate the newly attained freedom. However, the Prime Minister was slapped by an old man who emerged from the crowd, stating that he had lost his three sons and wife to the war. “Is this the freedom you brought to India?’” he asked the Prime Minister. 

The old gentleman’s question contained a great deal of emotions and obviously it went beyond a matter of political freedom. Income and wealth wise it was not sustainable and India as a country was very poor then, even more than it is today, and quality of life was deteriorating. 

After thinking for a little while Prime Minister Nehru provided a thought-provoking answer: “Now a senior citizen of India like you can slap the Prime Minister. That’s the freedom we brought to Bharat.” 

While Nehru’s answer was more relevant in the context of political freedom, the same story remains valid even in the context of economic freedom. Every citizen prefers to live in a society and an economy where they are free to make their own choices and have the freedom of choice when it comes to economic matters. As a result, countries that experience a higher degree of economic freedom have a higher GDP per capita. 

Graph 1 – Per capita GDP of least free countries and most free countries 

Graph 2 – Economic freedom and the income share of poorest 10% 

Indeed, economic freedom and political freedom usually go hand in hand, especially in attracting investments, skills, and capital. 

Currently, Sri Lanka is celebrating its 74th Independence anniversary. We must ask ourselves, how economically free are we, really? 

According to the Economic Freedom of the World Index in 2019 Sri Lanka ranked 92nd out of 165 countries and in most of the indicators our performance has been constantly poor.

Economic Freedom of the World Index evaluates countries on five main parameters. Our performance is extremely poor in International Trade. Being an Island located in one of the main maritime routes, we have been ranked 146 out of 165 countries which really reflects our constant policy flaws over the years. Our inward looking anti-trade bias policies have brought Sri Lanka to where it is today. 

Our ranking is equally bad in Regulation. Our score is 6.9 out of 10 and our rank is 110. Sri Lanka has too many regulations for micro, small, and medium enterprises and a fairly large licensing system. In fact, in the inaugural 72nd speech on Independence Day, the President pledged to remove unnecessary regulation. He appointed a deregulation commission headed by Lalith Weerathunga and Krishan Balendran, and we are awaiting the implementation of the recommendations. 

Soundness of Money is another important parameter evaluated by the Economic Freedom of the World Index. This considers the standard deviation of inflation and how strong the currency will be. So, the property in cash form will not be diluted over sudden currency depreciation. Sri Lanka ranks 103 with a score of  8.2 on this measure. The above numbers are from 2019 when we had single digit inflation. Now our year-on-year (YoY) headline inflation is 14% and food inflation is 25%. Therefore, on a sound money front our ranking obviously cannot be performing well. 

In the pillar of Legal System and Property Rights our ranking is 85th out of 165 countries with a  score of 5.1. This is an area we need urgent attention, and some reforms such as digitising our judiciary system is commendable. However, we have a lot to improve, especially regarding the time taken to resolve a case. As the Minister of Justice once said, an average criminal case takes about 10 years and a land case takes more than 20 years, which is a serious bottleneck in our investment system. Investors impart extra attention in doing their due diligence on matters of the judiciary system, as rule of law and independence of the judiciary are one of the fundamentals of democracy. 

On the pillar of Size of the Government as per 2019 data we were doing reasonably well. We ranked 17th out of 165 countries with a score of 8.28. However, our scores seem to be skewed due to low taxes and not actually because the size of our government is limited. We have 1.5 million State workers and in most of the industries State Owned Enterprises have a fairly large footprint with government intervention. 

Ultimately, after celebrating independence for 74 years, our economic freedom is deteriorating overall. Most Sri Lankans apply for visas and make attempts to get permanent residency in countries that are economically free. Hong Kong, Singapore, New Zealand, Switzerland, Australia, the US, and Denmark are the countries at the top of the list. Rather than blaming Sri Lankans who plan to migrate permanently, we should focus on changing our policies to become a country with more economic freedom, and ensure that the same Sri Lankans who are looking to leave as well as others around the world will find Sri Lanka an attractive place to live and work. 

As Jawaharlal Nehru responded to the old gentleman on freedom in 1947, if we start our reforms and bring economic freedom to Sri Lanka, our leaders too can tell our youth and boast of how they made Sri lanka an economically attractive country. 

Reference:

https://www.cbsl.gov.lk/sites/default/files/cbslweb_documents/press/pr/press_20220131_inflation_in_january_2022_ccpi_e.pdf

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

Cycling to work in Colombo is easier said than done

Originally appeared on The Morning

By Dhananath Fernando

A new proposal is under discussion to encourage travelling to work by bicycle. No doubt any policymaker who pays a trip to Europe may observe many people commuting to work by bicycle and on foot. So it is normal for anyone to think “if Europeans can do it, why can’t we?”

Some may even believe that countries in Europe have become developed nations because of behaviour involving “a healthier way of life”; commuting to work by bicycles and using electronic vehicles to reduce pollution.

That line of thought is no different to thinking that the work of Usain Bolt, the Olympic Gold Medallist is easy – running 100 metres in about 10 seconds while accumulating millions of dollars in wealth. All this while many other people cannot come close to accumulating the same amount of wealth even by working throughout their lifetime. 

But what many fail to realise is that Bolt had to put about 20 years or more of training to run that 100 metre in 10 seconds under Olympic game conditions. Similarly, most of the outcomes are a result of a series of policies which go hand in hand with culture, geography, and many other economic factors. 

There is no doubt that cycling is good for health and it will help reduce emissions as well. But if policymakers are deeply interested in encouraging people to cycle to work, it has a lot to do with Sri Lanka’s land, housing, and tariffs on construction materials policy rather than being purely based on cycling. 

You may ask how ‘cycling to work’ is connected to housing, construction tariffs, and land policy? 

It goes without saying that people can cycle to work when they reside at a reasonable distance from their workplaces. When many of the members of the workforce live far away from their workplace, they have to have a convenient mode of transportation not only for reporting to work but also for other personal needs. Given the poor public transportation and lack of interest in developing public transportation, the reasonable option available for the middle class is to have their own vehicle. 

As Sri Lanka became a middle-income country, many could afford a vehicle even at very high border taxes, which are as high as above 100%. So for the average middle class, the available reasonable choice is to reside far from the city limits (main cities such as Colombo, Gampaha, Kandy, and Galle) and commute in their personal vehicles.

The question is why people reside so far away from city limits. It is mainly because housing is not affordable within city limits. Unaffordability of housing is due to two main reasons. First, about 82% of the land in Sri Lanka is owned by the Government, including prime properties within city limits. So land prices are very high due to the Government holding land for completely unproductive enterprises. 

A simple walk around Colombo would bring to view a number of  single-storeyed State buildings where the space is utilised in a very unproductive manner due to poor city planning and excessive regulation. 

Secondly, our cost of construction is very high due to tariffs and paratariffs. Hence, the cost of productive land usage housing schemes such as apartments have become only affordable to the elite and not the middle class. Our floor tiles, wall tiles, cement, steel, construction, aluminium, electrical material and a long list of other materials are more expensive than the global market prices. This is due to very high tariff rates that do not generate much revenue for the Government but only benefit a few protectionist industries, which is called ‘rent’ in economic terms. On housing projects there is a regulation which stipulates that every apartment should have a parking space.

A young professional who uses mobile app-based taxi services or lives at a walking distance to their office does not necessarily need to pay for the land, bearing the construction cost for a 300 Sq.Ft. parking slot in an 800 Sq.Ft. apartment. It is such regulations that drive the housing prices within city limits and minimise choice for the consumer.

As a result we have very few vertical housing schemes that are affordable to the working middle class located within city limits. Young professionals who could easily settle in a two-bedroom apartment within walking or cycling distance to their workplace now have to buy unproductively utilised and expensive land far away from the city, along with a vehicle to commute to work.

If the middle class has housing options within city limits, they would be the happiest to settle in Colombo. They can save their hard-earned money on an apartment property which is a transferable asset rather than purchasing five-year-old low quality reconditioned vehicles which are subject to a tariff of more than 100% to commute to the workplace, burning fuel in the congested and traffic-riddled city streets. 

When middle-class aspirational Sri Lankans can afford to reside in the city where they will be able to use a bike instead of a reconditioned vehicle to commute to work, it is then that we will achieve the objective of saving fuel and minimising emissions and valuable foreign exchange, thus increasing productivity across the board. 

A few years ago the Colombo Mayor and Dutch Ambassador also promoted cycling on weekends. It just became a typical Colombo event and now we hardly see people cycling in Colombo. Often cyclists in Colombo are lottery sellers selling a dream of a fortune to the working middle class and aspirational Sri Lankans, where they can buy a house if they have the luck on a State-issued lottery ticket.

Additionally, we have to remember that there are regions in Europe where it’s less humid than Sri Lanka, so cycling to work is easier than in a tropical country.

If our policymakers really want to see a city of cyclists, they have to start working on our land policy, housing, and tariffs on construction. If we set those policies right, many more developments will be achieved rather than just producing cycling professionals within city limits. 

The Government will need to consider enforcing traffic laws and providing cycling space to enable safe and easy cycling to and from work. 

Reference:

• https://www.newswire.lk/2022/01/26/proposal-to-travel-by-bicycles-to-work/

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.

Special Goods and Services Tax: Issues and Concerns

Originally appeared on Ceylon Today, Daily FT, The Island

By Dr Roshan Perera & Naqiya Shiraz

I. Background

The new bill titled ‘Special Goods and Services Tax’ was published by gazette dated 07 January 2022. (1) The Special Goods and Services Tax (SGST) was originally proposed in Budget speech 2021 but was not implemented. It has once again been presented in Budget 2022. The SGST aims to consolidate taxes on manufacturing and importing cigarettes, liquor, vehicles and assembly parts, while also consolidating taxes on telecommunication and betting and gaming (see table 1 for existing taxes on these products and table 2 for taxes consolidated into the SGST as per the schedule in the gazette). The rationale for this new tax as per the bill is “...to promote self-compliance in the payment of taxes in order to ensure greater efficiency in relation to the collection and administration on such taxes by avoiding the complexities associated with the application and administration of a multiple tax regime on specified goods and services.”

Given the multiplicity of taxes and the complexity of the current tax system as a whole, rationalising taxes is necessary to improve collection. However, whether the proposed SGST simplifies the tax system while ensuring revenue neutrality or even improving revenue collection, needs to be carefully examined.

The SGST Bill is silent on the treatment of the existing VAT on these goods and services. However, according to the Value Added Tax (Amendment) Bill also gazetted on 07 January 2022,(2) liquor, cigarettes and motor vehicles will be exempted from VAT while telecommunications and betting and gaming services will still be subject to VAT. 

While the gazetted Bill sets out some of the features of the proposed SGST there are many important areas not covered in the Bill.  These are expected to be gazetted as and when required by the Minister in charge. 

II. Issues & Concerns

The motivation behind SGST is the simplification of the tax system. Although the objective of introducing the SGST is to improve efficiency by reducing the complexity of the tax system there are many issues and concerns with this proposed tax.

1. Revenue

Tax revenue which was 13% of GDP in 2010, declined to 8% in 2020.  Ad hoc policy changes and weak administration contributed to the decline in tax revenue collection.  This continuous decline in tax revenue has led to widening fiscal deficits and increasing debt. One of the main reasons for the current macroeconomic crisis is low tax revenue collection. Hence, any change to the existing tax system should be with the primary objective of raising more revenue.  

According to the budget speech the SGST is estimated to bring in an additional Rs. 50 billion in revenue in 2022. (3) Revenue from taxes proposed to be consolidated under the SGST has significantly declined over the past 3 years. Given the already difficult macroeconomic environment, along with ad hoc tax policy changes raising the additional revenue estimated at Rs. 50 billion seems a difficult task. 

2. Tax Base and Rate

For the SGST to raise taxes in excess of what is already being collected through the existing taxes, the rate and the base for the SGST needs to be carefully and methodically calculated. Further, the existing taxes have different bases of taxation. For instance the basis of taxation of motor vehicles is both on an ad valorem (4) basis and a quantity basis while the basis of taxation of cigarettes and liquor is quantity. (5) In light of this, the basis of taxation on which SGST is applied becomes an issue. Having different bases and different rates for various goods and services would complicate the implementation of the tax These issues need to be carefully considered to ensure the new tax is revenue neutral or be able to enhance revenue collection.

3. Efficiency

One possible revenue benefit of this proposal is the inability to claim input tax credits on the sectors exempted from VAT. However, the issue is the cascading effect that would result where there would be a tax on tax with the end consumer paying taxes on already paid taxes. If the idea was to raise additional revenue by limiting tax credits, it would have been simpler to raise the tax rates on the existing taxes rather than introduce a new tax. 

4. Administration

According to the bill, SGST  will now be collected through a new unit set up under the General Treasury where a Designated Officer (DO) will be in charge of the administration, collection and accountability of the tax. The existing revenue collection agencies, such as the Inland Revenue Department (IRD) or the Excise Department will not be primarily responsible for the collection of this tax. By removing the  IRD and Excise Department, a parallel bureaucracy will be created, at a time when public spending needs to be carefully managed. The General Treasury also has no previous experience and expertise in direct revenue collection. Weak administration is one of the key reasons for the low tax collection and success of this tax would depend on the strength of its administration. 

In addition to the above-mentioned concerns, as per the Bill the minister in charge of the SGST has been vested with the power to set the rates, the base and grant exemptions. Accordingly, Parliamentary oversight over fiscal matters is weakened under this proposed Bill. 

It could also lead to a time lag between the gazetting and implementing of changes to the SGST (such as the rate, base etc) and obtaining Parliamentary approval for those changes.

5. Dispute resolution 

The SGST Bill also focuses on the dispute resolution mechanism. Under the present tax system,  with the enactment of the Tax Appeals Commission Act, No. 23 in 2011 the Tax Appeals Commission has the “responsibility of hearing all appeals in respect of matters relating to imposition of any tax, levy or duty”.(6) The most recent amendment to the Tax Appeal Commissions act (2013) (7)  seeks to address the large number (495) of cases pending before the Tax Appeals Commission (8) by increasing the number of panels to hear the appeals. 

Under the proposed SGST disputes will be handled through the court of appeal. However, the time period by which specific actions need to be taken is not provided in the bill. In addition, disputes have to be taken to the court of appeal.  Hence, the entire process will be more time consuming. This could result in revenue lags and difficulties in revenue estimation until disputes are resolved.

Additionally, in the case that no valid appeal has been lodged within 14 days, any remaining payments would be considered to be in default. Thereafter, the responsibility is shifted to the Commissioner-General of the IRD to recover the dues. Given the IRD is completely removed from the normal collection process, the rationale for bringing defaults under the IRD is not clear.

III. Policy Recommendations

As discussed, the SGST Bill has several limitations and much of this is due to the ambiguities in the Bill.  

• If the tax is implemented, the rate and basis of taxation need to be revenue-neutral to ensure tax collection is maximised and administrative costs minimised.

• The rates, basis of taxation, exemptions etc should be specified in the Bill, as done in most other Acts. This would avoid the power for discretionary changes to the tax being placed in the hands of the minister in charge. 

• Given the already weak tax administration, it would be more sensible to strengthen the existing revenue collecting agencies and address the weaknesses in the existing system without creating a parallel bureaucracy.

• In the case where VAT is consolidated into the proposed GST, the issue of cascading effect of input tax credits needs to be addressed. This is relevant particularly in the case of capital expenditure. 

Given the critical state of revenue collection in the country, the question to ask is whether this is the best time to introduce a new tax. Focus should be on fixing issues in the existing tax system to ensure revenue is maximised.  The VAT is the least distortionary tax and it is the easiest to administer. Given these features, it can be a very efficient revenue generator for a country. Therefore instead of introducing a new tax, capitalising on systems that are already in place and amending the VAT rate, threshold and exemptions may be a more practical solution to the revenue problem that the country is currently facing. 

Dr. Roshan Perera, Senior Research Fellow, Advocata Institute and former Director, Central Bank of Sri Lanka.

Naqiya Shiraz is a Research Analyst at the Advocata Institute.

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.

References:

1. http://documents.gov.lk/files/bill/2022/1/162-2022_E.pdf

2. http://documents.gov.lk/files/bill/2022/1/163-2022_E.pdf

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

4. A value based tax base of ad-valorem refers to a rate of tax, where revenue will increase if the value of tax base increases. 
   A quantity based tax base is a tax imposed on a per unit quantity of the product.

5. https://www.treasury.gov.lk/api/file/304e2f2f-f215-40ad-b613-4d7cc3427178

6. https://www.treasury.gov.lk/api/file/4028b5a0-f166-4f1d-a076-299e32200212
   http://www.cabinetoffice.gov.lk/cab/index.php?option=com_content&view=article&id=16&Itemid=49&lang=en&dID=10210

Borrowing from Peter to pay Paul

Originally appeared on The Morning

By Dhananath Fernando

There’s a childhood memory engraved in my mind, of an incident with a fellow schoolmate concerning an act of borrowing. Back then, we borrowed money from each other constantly to eat sweets and junk food and buy video game gadgets. A particular friend of mine had the habit of borrowing a little money every week and settling the same again after a week’s time right on schedule. After a few weeks, I realised he borrowed the same amount of money from another friend as well. 

Like a well-planned roster, he proceeds to settle his debt with the other friend in a week’s time. One day my frequently borrowing friend did not settle my money as he promised. When I confronted him on the matter, he plainly stated that he settled the amount owed to me with the money he borrowed from my other friend and vice versa. At this one instance, the other friend had refused to lend money to my frequently borrowing friend so he was unable to settle with me. 

But what was particularly amusing was what he said after. “What I have been borrowing and settling for the past few weeks is money from the two of you to each other. So to resolve the matter, the two of you must settle with each other because it’s your money. Not mine.” 

Sri Lanka’s debt servicing is a much more complex version of what my classmate did; we settle our creditors by borrowing from someone else. Most sovereign countries do the same. However, this can only be done when someone agrees to give us money. Similar to the incident with my friend, the moment people refuse to lend us money, the cycle starts collapsing. That is exactly what happened to Sri Lanka. As a result, the country has lost its credit rating by international rating agencies and has thereby lost market access. 

The current strategy we follow is requesting lifelines from our bi-lateral partners as a form of assistance. As a result, in just five days, India threw in about $ 1.4 billion worth of credit lines and swaps to secure our fuel, medicine, essential supplies, and debt repayments. 

Initially, China provided us with a swap of 10 billion Yuan as a back-up, which the Central Bank absorbed as reserves according to their data. 

At the same time with some of the bi-lateral partners, our relationship has not been professional. We cancelled the LRT project with Japan, which is our main bilateral creditor as well as the main funder for one of our main multilateral partners, the Asian Development Bank (ADB). To make matters worse, we keep the trade channels such as vehicles and spare parts closed, which is precisely where the bilateral relationships can be strengthened. 

Our mismanagement of bilateral relations is reflected, even with China. Recent events, such as our shortsighted handling of diplomatic relations over the fertiliser issue, with China blacklisting a state bank for not honouring payments, illustrates this issue. 

Economically and geopolitically, we have lost market access for borrowing on one hand, and on the other, we have somewhat tarnished the relationship with our friends at a time when we need their assistance the most. So far, we have been very lucky to still have their continuous support regardless of the setbacks even though the fault is on our end entirely. As a recommendation, the Government should not take the silence of some bilateral partners lightly, but work double-time to restore trust and understanding in business and trade. 

The current strategy of paying our International Sovereign Bonds through bilateral swaps and depending on credit lines for essentials will eventually come at a geopolitical expense. We become more vulnerable with our past track record of working with our bilateral partners. 

In this context, the Central Bank increased policy rates by 50 basis points, a policy move in the right direction. However, this comes – unfortunately – too late to stop the inflationary pressure constantly building, probably due to the faulty use of Modern Monetary Theory, which we have been following for some time now. The policy rate revisions will encourage people to save more money instead of spending more. This will somewhat ease the pressure, but at the same time slow the economy down. But we can’t afford to accelerate the economy with a historic balance of payment crisis which was already exacerbated by a price control on US Dollars (USD) in an attempt to encourage imports and discourage exports. 

Surprisingly, policymakers have not taken any reforms to overcome the situation, believing that debt servicing through borrowed money will solve the problem. Very high hopes have been kept on tourism but the same thing that happened to remittances will happen to tourism when we try to keep the exchange rate very low. We encourage people to keep the USD in grey markets so people will become further reluctant to sell their hard-earned USD to the Central Bank. 

At the same time, we need to understand tourism also increases the consumption of the economy where, with USD inflows, there will be a fair share of USD outflows concurrently. Thus, keeping all our eggs in the basket of tourism would not be advisable at all. If policymakers recall, at the beginning of the pandemic, remittances were at a record high. With mounting debt, our policymakers replied that our solutions remained in our remittances, which today are in decline due to our own policy failures. In this context, there are certain areas for restructuring that policymakers have to consider if they were to come out of the crisis: 

1. Restructuring of our social security net. A market pricing-based digital cash transfer system with better targeting than Samurdhi is recommended to provide poor people the opportunity to keep their noses above the water to navigate through the economic reform period

2. Restructuring and Reforms on the State sector and State-owned enterprises are a must. Listing the debt of State-owned enterprises, privatisations, consolidations and outright sale of some of the assets owned by State-owned enterprises is required for the private sector, including land. Government care has to be limited through a reasonable voluntary retirement scheme

3. Restructuring and Reforming in our Central Bank .The current tools of excessive interventions by the Central Bank on interest rates, exchange rates and every part of monetary policy has to be refined

4. Restructuring and reforming our tax system and tariff system is a must. Currently, our income and corporate tax systems are too complicated and it has to be simplified if policy makers are interested in increasing revenue. The complicated tariff structure has to be simplified with three tariff bands. Bringing down tariffs will also help the Government increase the revenue and boost trade

5. Restructuring and reforming our production structures for it to be aligned with global production and supply chains is vital to increase export revenue. At the same time, a deregulation drive has to be initiated to ensure conducive business environment for locals and foreigners

6. If our debt is unsustainable, we have to consider a restructuring of debt, but with the above-mentioned reforms. Attempting to do a debt restructuring without a solid commitment to reform will worsen the problem and debt restructuring could become a frequent event causing us to lose our credibility and market access if we fail to do the necessary reforms

All these ideas are not new and not a first mention in this column. These have been repeatedly spoken of by countless economic experts. It is simply that the call to action rate is very low. Policymakers whose job is to change policies and get things done. Not to behave like my classmate – paying debts with borrowed money, wiping their hands clean, and shifting the responsibility elsewhere at the last minute.

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.

Sri Lanka Railway railed with strikes and losses; Time to reform?

Originally appeared on The Morning.

By Anuka Ratnayake and Aaditha Edirisinghe

On 13 January 2022, the Station Masters’ Union launched a 24-hour token strike cancelling over 200 scheduled trips. As a result, commuters heading back home from Colombo, long distance travellers, tourists (both local and foreign) were all inconvenienced and left stranded in stations partway through their journey. Angry commuters attacked the train bound to Batticaloa when it passed the Kekirawa Station. This public outrage at the services provided by Sri Lanka Railway (SLR) is nothing new. However, little has been done to reform or restructure amidst public disappointment and escalating losses.

Why should the Railway be reformed? 

Operating as a Government institution under the Ministry of Transport, SLR is the country’s primary alternative mode of public transport to the often congested road network. Underpricing of railway fares along with systemic issues including mismanagement and poor governance have led to recurring annual losses. Despite budgetary support, the railway has recorded an accumulated loss of Rs. 46.7 billion in the years 2015-20. 

As with many transportation networks globally, the impact of Covid-19 has made SLR’s financial position increasingly precarious; with revenues down, losses amounted to over Rs.10 billion in 2020 alone. The widening chasm between the revenue raised and expenditure incurred, stood at a staggering Rs. 22 billion in 2018, as per official records. This has led to the dependence on Government bailouts. The Treasury spent a grand total of Rs. 48.7 billion in 2020, of which around Rs. 14 billion was for recurrent expenditure such as salaries, subsidies and grants. 

Sri Lanka Railway has an exceedingly large workforce with very active trade unions and an extensive bureaucracy. According to the official statistics of 2019, SLR has 14,207 employees. The total personal emoluments incurred for the same year was Rs. 9.8 billion, which was up by Rs. 809 million compared to 2018.

Due to the overstaffing issue, work duplication is often seen at SLR and is a serious issue affecting efficiency. Union actions are a burden on the operations of SLR, as observed during the last week of December 2021 and on 13 January 2022. 

In an interview conducted in January 2022, the Station Masters’ Association Chairman Sumedha Someratne claimed that as a result of the strikes in December, SLR incurred a loss as high as Rs. 20 million per day although the Railway General Manager quoted a much lower figure. 

A major reason for SLR’s budgetary reliance is the lack of cost reflective pricing. As of now, for a trip between 51-100 km, the fare per kilometre is around Rs. 3.30 for first class seats and Rs. 1 for third class seats. This underpricing has led to a reduction in the availability of funds to cover operational costs, resulting in the lack of finance for maintenance and repairs; by 2017, 65% of SLR’s locomotives were over 30 years old. 

The Urban Transport Master Plan 2014 identified several irregularities of the condition of the railway. A few noteworthy issues were the malfunctionings in the signalling system along with the deformation of rails and irregularities in alignment, which caused delays and sudden cancellation of trains. This poses a threat to passenger safety and is increasingly dangerous during inclement weather conditions. 

Reform recommendations 

Given that Sri Lanka is facing an economic crisis, the treasury cannot afford to shield SLR from the adverse repercussions of its inefficient operations. Immediate reforms are needed to get SLR back on track. 

Since most of SLR’s issues stem from its inability to raise sufficient revenues, the implementation of a cost-reflective fare structure should be prioritised. However, standing in the way of such price reform are the cheap fares of public bus service, the primary substitute to rail transport.

Therefore, for the price revision to be viable SLR should look into improving the quality of service to justify higher prices while reducing costs to be more competitive. 

Furthermore, to offset some costs SLR can focus on the profitable use of its vast asset base, such as its 13,000 acres of land which can be capitalised for this purpose. In 2017, it was reported that nearly 15% of land owned by SLR was leased to 6,400 users. Yet it has been unable to collect Rs. 1.46 billion in lease revenue from the users of the land owned by the department. Better management of real estate would bring in massive revenues to the Railway Department, which can be used to finance repairs and maintenance. 

Moreover, the Railway Department can focus on improving freight transportation, a lucrative and profitable source of revenue generation. According to the Asian Development Bank, by 2017, the freight transportation service market share of Sri Lanka Railway had eroded to less than 1%. The lack of necessary transportation and containerisation equipment limits the freight business to goods such as cement and petroleum. In the interest of expanding the freight service with the available resources; tracks which are reserved for passenger transportation during the daytime can be utilised under a night schedule. 

Furthermore, portions of SLR’s underutilised land can be used profitably for freight-related logistics services which will also bring in much-needed revenue to the loss-making institution.  

To bridge the prevailing investment gap at SLR, public private partnerships (PPPs) should be encouraged for operations and maintenance. A major bottleneck in SLR’s ability to deliver a consistent service is the outdated and malfunctioning infrastructure it owns, such as signalling and tracks. Investments in this respect will allow SLR to provide the public a consistent service while accumulating a sustained influx of cash. 

Colossal losses of state-owned institutions such as the Sri Lanka Railway is a burden on the state coffers, and ultimately the taxpayer. The Government’s increasing reliance on debt to keep such institutions afloat is compromising the economic future of Sri Lanka. Thus it is the need of the hour to begin reforming and restructuring potential cash cows such as Sri Lanka Railway. If reformed, Sri Lanka Railway would undoubtedly be a pillar of Sri Lanka’s transport infrastructure, contributing to the overall productivity of the economy.

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

Debt restructuring: Between a rock and a hard place?

Originally appeared on The Morning

By Dhananath Fernando

According to news sources, the President has requested the Chinese Foreign Minister to assist Sri Lanka in restructuring our debt. The Finance Minister too has indicated to Japan and India, our long-standing bilateral partners, the need for more assistance to overcome the economic crisis Sri Lanka is going through. 

In a recent press conference, the Central Bank of Sri Lanka (CBSL) Governor also mentioned that discussions for a new loan from China to restructure our debt is underway. 

However, it seems that the President and the CBSL Governor have given the term ‘restructuring’ two different meanings. One as run by the Global Times, the Chinese Communist Party-run newspaper, which said: “After President Rajapaksa’s request to restructure debt, Song Wei, a research fellow at the Chinese Academy of International Trade and Economic Cooperation stated that interest-free loans offered by the Chinese Government are applicable for debt relief while the concessional loans raised through the market cannot be written off.” 

However, as measures for debt restructuring, the CBSL Governor suggested taking more swap agreements, paying International Sovereign Bonds (ISBs) and bilaterally skewing our debt profile from market borrowing. Considering all this, we are yet to know what would be the final decision.

In Sri Lanka’s external debt profile as at the end of 2020, about 57% was borrowed from financial markets (34% from ISBs and 8% from China Exim Bank). 

In my view, we cannot evaluate debt restructuring without really understanding the problem. The issue at hand is that Sri Lanka borrowed money in US Dollar terms with a short maturity at high-interest rates and invested in assets on non-revenue generating non-tradable assets. As a result, we had to borrow money at even higher interest rates to service the interest of previous debts which has snowballed to a point where Sri Lanka has lost access to capital markets.

So the choices are not between ‘good’ vs. ‘bad’. The choices are between ‘worse’ vs. still ‘worse’. That is why it is called an economic crisis. Either measure will result in a catastrophic impact on the people of Sri Lanka. So in this context let us evaluate debt restructuring. 

The objective of any debt restructuring is to avoid a similar situation in the future and ensure sovereign debt sustainability. So a debt restructuring plan without an economic reform plan to improve competition, trade, and efficiency of the economy will not bring us any sustainable solution. Rather, it will worsen the situation. 

Secondly, debt restructuring is also a very difficult process for a country like Sri Lanka with a limited resource base. Countries such as Argentina and Ecuador defaulted but they have large reserve bases including oil to get back on a path of recovery. But Sri Lanka is a small $ 82 billion economy with no experience on debt restructuring.

Debt restructuring is not an easy process given Sri Lanka’s debt profile. Usually, senior creditors such as the International Monetary Fund (IMF), the World Bank, and the Asian Development Bank (ADB) are unlikely to restructure debt as it is provided at a concessional rate and with a longer maturity period. In restructuring multilateral debt, generally, a new programme would be introduced to recover the previous debt. 

Restructuring bilateral debt is complicated. The debt of Paris Club members has to be negotiated at the Paris Club. Australia, Austria, Belgium, Brazil, Canada, Denmark, Finland, France, Germany, Ireland, Israel, Italy, Japan, South Korea, the Netherlands, Norway, Russia, Spain, Sweden, Switzerland, the UK, and the US are the members of Paris Club. So any bilateral debt restructuring from the above nations have to be at the Paris Club. According to data, 10% of our creditors are members of the Paris Club, with Japan being the main bilateral creditor for Sri Lanka.

Our debts with China and India, who are not Paris Club partners, have to be negotiated outside the Paris Club. Generally, any bilateral creditor would not agree to single-handedly bear the entire restructuring loss of one particular country. They will request other partners to assist. Even in the case of China, according to NewsIn Asia, Long Xingchun, a senior research fellow at the Academy of Regional and Global Governance of the Beijing Foreign Studies University, stated that restructuring loans with China alone is insufficient to help the island nation tide over its difficulty, which needs a package plan with other involved parties.

The geopolitical situation in Sri Lanka will give way to more geopolitical externalities in debt restructuring with bilateral partners. But it seems we have to move towards that direction as we have very limited alternatives at hand. 

Additionally, bilateral partners will also request to share the debt burden with commercial creditors including ISB holders. This is because in debt restructuring, the main objective is to distribute the loss as much as possible. 

Restructuring commercial debt has to be dealt with by international law and it is somewhat an expensive and time-consuming process to reach a consensus with all creditors. According to global debt restructuring expert Prof. Lee Buchheit, it can take about nine months to a few years based on the profile of the debt. 

In debt restructuring, there are four parameters generally considered. 

1. Reducing debt stock or principal amount commonly known as haircuts

2. Adjusting the interest rates to be paid or coupon rates commonly known as coupon adjustment

3. Extending the repayment or maturity period

4. Mix and match of all above

The general practice is creditors ask to conduct a debt sustainability study of the country before deciding the adjustment or deciding which parameters of restructuring are to be used. The only credible organisation to conduct an independent study is the IMF, and that is why in most of the debt restructuring processes, the countries are under the IMF programme. In Sri Lanka’s case, in the event of a restructuring as our President requested, we have to disclose all debt including the debt owed by the State-Owned Enterprises because the restructuring burden will be calculated across the board. 

Creditors are generally very reluctant to restructure debt especially when it is due to financial mismanagement. In case of a natural disaster or a negative externality, the negotiation would be easier compared to a situation concerning economic mismanagement. 

So the available choices for Sri Lanka are very limited and every choice may have its own set of consequences. Reserves are declining and people often complain about shortages of essentials and interruption of utilities. Businesses are complaining about the inconvenience of working with banks due to difficulties in opening Letters of Credit (LCs). Creditors and investors are embroiled in suspicion and confusion with constant credit rating downgrades. Debt restructuring will be complicated and an open Sri Lanka for geopolitical sensitivities will affect political stability. 

The choices at hand are difficult. This column has continuously highlighted the need for reforms since the beginning of the pandemic with full knowledge that delays will limit the alternatives. We need to shift gears and move forward with hard reforms before people become hard on reforms. 

References:

• https://newsin.asia/china-to-revise-lankan-loans-repayment-schedules/

• https://newsin.asia/china-to-revise-lankan-loans-repayment-schedules/

• https://www.youtube.com/watch?v=I1hezyj2YxA&list=WL&index=1&t=7182s

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.

Government relief packages: Pros, cons, and criteria for perfecting

Originally appeared on The Morning

By Dhananath Fernando

Last Monday (3), Finance Minister Basil Rajapaksa announced a relief package worth Rs. 229 billion. This package consists of a Rs. 5,000 allowance for government workers, 500 g wheat flour for estate communities per day, an increase in the purchasing price of paddy by Rs. 25 to Rs. 75 a kilogramme to assist farmers, a Rs. 1,000 increase for Samurdhi beneficiaries and an incentive scheme for home gardening. When evaluating relief packages, a long list of factors should be considered. One such factor is inflation. It is no secret that there is creeping inflation affecting the livelihoods of all cross sections of society. This is openly being expressed to politicians. Food inflation is at 22% and headline inflation is at 12%. 

This column has always highlighted the grave dangers of high inflation. We have been closely following these developments and our prediction has now been admitted by the Government. The sources for financing the Rs. 229 billion was not specified. The Finance Minister only mentioned that it would be utilised from the 2022 Budget while also mentioning that no tax will be increased. Both the budget numbers and their justification in the text were problematic. Inflation is the worst tax which hurts the poor more than middle income families. 

Given these circumstances, the available options are to cut down some of the already allocated capital expenditure or to borrow money from the Central Bank to finance this new expense. The former is happening already, as when the Government made reductions in capital expenditure as per the budget speech. Some were manifested through policy decisions such as halting construction activities for the next two years. Therefore, if there is a reduction in capital expenditure, it will have to come through cutting down budget lines allocated to areas such as highways, road development, education, and health care. 

Alternatively, we may have to finance this by borrowing more money from the Central Bank, continuing the dangerous policy of believing in Modern Monetary Theory. It will have a very high risk of starting a wage spiral and contributing further to inflation and the depreciation of our currency faster than we expect. Most of this (extra) money will be spent on imported goods. This increase of demand on imports will continue to dry up our limited foriegn reserves. 

In my view, the announcement will confuse investors and businesses, putting the credibility of the Finance Minister at risk. Presenting the Appropriation Bill, the Finance Minister used an anecdote to express how our economy is trapped between three competing challenges. The proposals of the budget such as to cut down expenditure by cutting down the fuel quota and extending the pension entitlement for 10 years for parliamentarians, was a positive signal. However, announcing a relief package completely opposing this may cause further business uncertainty. 

An ideal relief package 

While a relief package has its own pros and cons in politics and economics, it is worthwhile to explore how the relief package should be structured. As this column expressed multiple times, the only solution to overcome this crisis is through structural reforms. Structural reforms will be initially painful across the board, specially for low income earners. Pressure is already upon them with high inflation, and this demographic is being forced to make sacrifices to their food basket. 

The long-term solution for this problem is establishing a digital cash transfer system based on market prices. For example, a fisherman may consume a fair share of fuel to generate income and to contribute to the economy. But the consumption of fuel of a daily wage earning labourer is limited. So the fuel subsidy has to be targeted more towards the fisherman and less towards the labourer. A digital cash transfer to the bank account based on market prices of fuel is the most efficient way of undertaking this. If we try to keep the entire fuel price low through a non-targeted system, consumers who consume more and can afford market prices will automatically benefit as well. At the same time it may be an incentive for low fuel economic machines to be used when fuel prices are low across the board. A cash transfer will not only provide dignity for a person to consume based on their needs, but also provides freedom of choice to shift to alternatives.

Making it a cash transfer avoids political interference where beneficiaries need not worry about their political opinion in order to be entitled for the scheme. Governments can also save resources and be more efficient by adhering to the market forces of demand and supply.

The Samurdhi programme which is the main safety net in Sri Lanka is very poorly targeted and about half our households have become entitled to it. Additionally, about 25% of the Samurdhi fund is spent on administration costs. Therefore, a direct cash transfer can be more efficient than Samurdhi by saving administration costs. 

India administers a system called Adhar with a colour-coded system, where the value of the cash transfer is determined based on the level of poverty. In addition to being based on the poverty level, the option of managing the cash transfer in subsidies often varies with global prices of fuel and liquid petroleum gas. 

Unfortunately, the relief package which was announced did not have the depth necessary, and the targeting could have been better. If we look at the public service, it is usually overstaffed and worker category cardres who are entitled for overtime are maintained by the Sri Lankan Government. As a result, in addition to the basic pay, people simply sign up for overtime work without really having the need to commit for overtime. On multiple occasions many board chairpersons and senior officers have mentioned that they sign off on overtime for their staff assistants and chauffeurs, where in most cases, the total take-home pay is higher than that of the chairman or the senior officer. As such, providing a Rs. 5,000 allowance with non-existing resources would not really help to overcome the crisis. 

Sri Lanka should move towards a digital cash transfer system to strengthen our safety net. But simply strengthening the safety net won’t help the poor. Making imports competitive, bringing down tariffs on essentials and connecting with global value chains is of paramount importance in order to help the poor out of poverty. 

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.

Repay Foreign Debt or Finance Essential Imports

Originally appeared on Daily FT, Lanka Business Online and Groundviews

By Dr Roshan Perera and Dr. Sarath Rajapatirana

The available foreign reserves of the country can be used to either repay foreign creditors or to finance imports of essential goods and services required by its citizens. This is the dilemma facing Sri Lanka today. Repaying the full value of the bond using the limited foreign reserves available would provide a windfall gain to those currently holding these bonds. But it will be at great cost to the citizens of the country who will face shortages of essentials like food, medicine, and fuel. 

In these circumstances, it is in the best interest of all its citizens, for the government to defer payment of the US dollar 500 million International Sovereign Bond (ISB) coming due on 18 January 2022, until the economy can fully recover and rebuild. 

Just as an individual with co-morbidities is more vulnerable to develop severe illness if infected with COVID-19 and more to likely require hospitalisation and even treatment in an ICU, Sri Lanka was vulnerable to economic shocks long before COVID-19 struck. The country was already facing several macroeconomic challenges. Muted economic growth. An untenable fiscal position. Although a tough consolidation programme was put in place to bring government finances to a more sustainable path, sweeping tax changes implemented at the end of 2019 reversed this process, with adverse consequences to government revenue collection. Weak external sector due to high foreign debt repayments and inadequate foreign reserves to service these debts. COVID-19 only exacerbated these macroeconomic challenges. And like a patient who gets over the worst of COVID-19 has a long road to recovery; the economy of Sri Lanka faces many challenges to get back on track. 

The onset of COVID-19 in early 2020, only worsened an already grim macroeconomic situation. The country lost the confidence of international markets, and the ability of the sovereign to rollover its external debt became difficult if not impossible. In these circumstances, there was a solid argument for a sovereign debt restructuring. But the response from the government and the Central Bank of Sri Lanka (CBSL) was a firm “No”. The argument was that Sri Lanka never defaulted on its debt and it was not going to do so now. The official position was also that the government had a ‘plan’ to repay its debt and hence there was no reason to engage in a debt restructuring exercise. However, Sri Lanka faced high debt sustainability risks: the debt to GDP ratio at 110% was one of the highest historically and interest payments to government revenue at over 70% was one of the highest in the world. 

Table 1: Summary of External Sector Performance Q1 – 2017 to 2021 ($mn)

Therefore, it is in the best interest of the country and its citizens for the government to defer payment on its debt and use its limited foreign reserves to ensure uninterrupted supply of essential imports. But this requires a plan. To minimise the cost to the economy, the government must immediately engage its creditors in a debt restructuring exercise. This will require a debt sustainability analysis (DSA) by a credible agency to identify the resources required for debt relief and the economic adjustment needed to put the country back on a sustainable path. This will be critical to bring creditors to the negotiating table and provide them comfort that the country is able and willing to repay its debt obligations in the future. 

The cost of not restructuring is much higher. A non-negotiated default (if and when the country runs out of options to service its debt) would lead to a greater loss of output, loss of access to financing or high cost of future borrowing for the sovereign. It could even spill over to the domestic banking sector, triggering a banking or financial crisis. 

The consequences are clear. What will we choose?

Dr. Roshan Perera, Senior Research Fellow, Advocata Institute and former Director, Central Bank of Sri Lanka.

Dr. Sarath Rajapatirana, Chair, Academic Programme, Advocata Institute and former Economic Adviser at the World Bank. He was the Director and the main author of the 1987 World Development Report on Trade and Industrialisation.

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.

National Single Window: Paving the way for paperless trade

Originally appeared on Daily FT, The Morning, the Island, and Lanka Business Online

By Mithara Fonseka and Kavishka Indraratna

In 2016, Sri Lanka ratified its Trade Facilitation Agreement (TFA) with the WTO and in 2017 a Secretariat was established for the National Trade Facilitation Committee to drive much needed trade reforms in the country. Currently, the rate of Sri Lanka’s implementation commitments under TFA stands at 34.9% with a timeframe ranging from 2017-2030. Reforms include the Trade Information Portal, streamlining customs processes and revamping the systems for post-clearance audit. However, progress of one of the key reforms, the National Single Window (NSW), has been stalled. Deviating from the initial time frame of completing the Single Window in December 2022, the target date has been delayed to 2030. The NSW, a globally recognised trading portal, acts as a one-stop shop for exporters and importers where customs documents, permits, registrations and other information can be submitted online at once. The definition of a Single Window, as provided by the UN/CEFACT Recommendation No. 33, is as follows: “A Single Window is defined as a facility that allows parties involved in trade and transport to lodge standardized information and documents with a single entry point to fulfil all import, export, and transit-related regulatory requirements. If information is electronic, then individual data elements should only be submitted once”. Putting such a reform on the back-burner will only delay Sri Lanka’s transition to a system of streamlined, paperless trade processes and therefore acts as an impediment to local and foreign investment.

Why should Sri Lanka implement a NSW?
Sri Lanka has been underperforming in global trade rankings, where we sometimes rank in the bottom 50 countries. According to the Ease of Doing Business in 2020, in the trading across borders pillar, Sri Lanka ranks 96 out of 190 economies. While several of Sri Lanka’s indicators perform better than the South Asian average, there is significant room for improvement. When comparing with OECD standards, Sri Lanka takes 72 hours for border compliance regarding imports and 48 hours for export documentary compliance whereas the OECD average stands at 8.5 and 2.3 hours respectively. Lengthy customs procedures and multiple inspections impede efficiency. Meanwhile, we ranked 94 out of 160 countries under World’s Bank 2018 Logistics Performance index and 103 out of 136 for the World Economic Forum’s 2016 Enabling Trade index. Notably, one of the indicators from the Enabling Trade Index, the customs services index, which considers factors such as clearance of shipments via electronic data interchange and the separation of physical release of goods from fiscal control, we rank 116 out of 117 countries. A lack of transparency, inter-agency coordination and lengthy cumbersome processes contribute to Sri Lanka’s poor trade environment. An average trade transaction can involve over 30 different agencies and upto 200 data elements, a lot of which have to be repeated. There is thus an evident need to streamline trade processes through digitisation, creating a business friendly environment that supports small businesses as well as foreign investors.

A Background into the National Single Window

In 1989, the Government of Singapore introduced the world’s first NSW, known as Tradenet. It took two years for the model to become operational and has now become one of the most advanced models in the world. Since then, many countries have adopted similar models and a NSW has become a critical tool in facilitating efficient and paperless trade. The annual survey conducted by The United Nations on trade facilitation identified that almost 74% of countries surveyed in the Asia Pacific region have to some extent engaged in creating a NSW (this includes countries which are only in the pilot stage). While a NSW is universally known for promoting the transition from paper-based to electronic customs processing, each window developed by a country is unique and varies according to the context of the country. For example, in Chile and Malaysia, the NSW enables traders to submit their export and import declarations, manifests and their trade-related documents to customs authorities electronically. In Korea and Hong Kong, private sector participants including banks, customs brokers, insurance companies and freight forwarders are also connected through the portal.

Single entry, single submission, standardized documents and data, sharing of information (information dissemination), centralised risk management, coordination of agencies and stakeholders, analytical capability and electronic payment facilities are some of the key functions included in a Single Window. In Sri Lanka, the World Bank did several studies on the NSW, identifying different operational models, best practices and a final blueprint document was given to the government and Sri Lanka Customs (SLC) in July 2019. However, since then, there has been no news of progress. While many countries including Sri Lanka are keen to emulate Singapore’s pioneering model, a lack of clear targets and timelines deteriorate the chances of implementing such a system.

The Mutual Benefits of a NSW

Businesses in countries without an integrated trade system find it difficult to compete in the international arena given the time and money spent to simply get clearance. Streamlining the entire process from start to finish in a manner that’s comprehensive and transparent, sans bureaucracy has a number of positive effects for traders. It was estimated that Singapore’s TradeNet saved its traders around US$1 billion per year. Korea’s uTradeHub allowed its business community to save approximately US$ 818.9 million. These were savings from the use of e-documents, automated administrative work and information storage and retrieval with the use of ICT. A Single Window automatically simplifies the compliance requirements traders face. In Mozambique traders benefited from faster clearance times, where through the NSW, the time was reduced from 3 days to a few hours. Meanwhile, Thailand’s NSW transformed the customs clearance turnaround time (measured as per declaration) to 95% in 5 minutes. Using a single portal has enabled traders to avoid visiting multiple agencies and simply submit an application at their convenience from any location. NSW has supported businesses through the removal of unnecessary costs, time and red tape, factors which tend to act as key deterrents to small businesses as well as foreign enterprises. 

The NSW system has similarly provided noteworthy cost-savings for government entities involved in trade. Singapore Customs, has claimed that for every US$1 earned in customs revenue, it only spends 1 cent, implying a profit margin of 9,900%.  In Hong Kong, trade facilitation measures have provided them with HK$1.3 billion in annual savings. The NSW has also reduced revenue leakages which may arise through transit. For example, Mozambique is a transit country to Swaziland, South Africa, Zimbabwe, Zambia and Malawi. By expanding their NSW to include value added services such as GPS tracking of consignments in transit, automatic detection of breaches in consignment and deviation from assigned transit corridors the NSW prevents revenue leakages and the opportunity for corruption, maximising revenue collection. The NSW has further led to productivity and efficiency improvements. A Single Window has enabled authorities to handle a larger volume of applications with much more ease. Mozambique, which used to face infrastructural weaknesses, through the implementation of its single window, is able to handle roughly 1,500 custom declarations per day.  Shifting to paperless customs processes would reduce costs for inventory and assist in improved resource allocation as personnel would not be required for trivial and mundane tasks such as preparation and cross checking of numerous documents. In totality, a fully digitised system provides government agencies with the means to do away with inefficiencies that hold back the speed of document processing, approval, communication and inspection stages. Further contributing to efficency, a NSW has also facilitated the dissemination of data through multiple agencies ranging from border control authorities, freight forwarders, customs brokers, shipping agents, banks and so on. As a result, there is improved inter-agency coordination and increased transparency.

Apart from a substantial increase in government revenue, the NSW will contribute to an improved business environment in Sri Lanka. The domino effects include an upward movement in the country’s global rankings, incentives for FDI and local business as well as a global recognition. 

Driving forces for implementation

While the NSW on the surface seems like an IT-based innovation, it is rather a platform for inter-agency and private sector collaboration. As the NSW is a system which requires involvement from government, the private sector and the transport community, it is crucial to ensure inter-agency collaboration. Ensuring public-private sector participation, introducing mandates and a steering committee to oversee implementation is crucial in developing such a system. The system as a whole is one that constantly evolves with no end stage. It requires continuous maintenance, support, and enhancement. This should be supplemented by the appropriate legislation, disclosure and publishing, backed by training and airtight data security policies. Thus governance of the NSW needs to be executed appropriately so that new technologies, techniques and new modes of trade can be leveraged. In best performing nations, a Single Window is not considered a single system but rather “a combination of trade-related platforms that serve various trade communities and modalities”. This has enabled leading countries such as Singapore and Hong Kong to facilitate seamless trade by building an environment of interoperable trade systems.

1. WTO, Trade facilitation Agreement Database, https://tfadatabase.org/members/sri-lanka , Accessed January 6, 2022.

2. WTO, Trade facilitation Agreement Database,10.4-Single Window, https://tfadatabase.org/members/sri-lanka/technical-assistance-projects/article-10-4

3. United Nations, UN/CEFACT, ‘Recommendation and Guidelines on establishing a Single Window: to enhance the efficient exchange of information between trade and government, Recommendation No.33, (2005), https://unece.org/fileadmin/DAM/cefact/recommendations/rec33/rec33_trd352e.pdf Accessed January 6, 2022.

4. World Bank Group, ‘Doing Business 2020’, Economy Profile Sri Lanka, Comparing Business Regulation in 190 Economies,(2020), https://www.doingbusiness.org/content/dam/doingBusiness/country/s/sri-lanka/LKA.pdf Accessed January 6, 2022.

5. World Bank Group, ‘Doing Business 2020’, Economy Profile Sri Lanka, Comparing Business Regulation in 190 Economies,(2020), https://www.doingbusiness.org/content/dam/doingBusiness/country/s/sri-lanka/LKA.pdf Accessed January 6, 2022.

6. World Bank Group, ‘Logistics Performance Index 2018’, (2018), https://lpi.worldbank.org/international/scorecard/radar/254/C/LKA/2018#chartarea Accessed January 6, 2022.

7. World Economic Forum,’The Global Enabling Trade Report 2016, Enabling Trade Rankings’, (2016) https://reports.weforum.org/global-enabling-trade-report-2016/enabling-trade-rankings/#series=CUSTSERVIND

8. World Economic Forum, ‘Enabling Trade Index 2016’, (2016) https://www3.weforum.org/docs/WEF_GETR_2016_report.pdf Accessed January 6, 2022.

9. World Economic Forum, ‘The Global Enabling Trade Report 2016, Enabling Trade Rankings’, https://reports.weforum.org/global-enabling-trade-report-2016/enabling-trade-rankings/#series=CUSTSERVIND Accessed January 6, 2022.

10. Johns, M. “Trade facilitation reform in Sri Lanka can drive a change in culture”, World Bank Blogs, 2017

    https://blogs.worldbank.org/endpovertyinsouthasia/trade-facilitation-reform-sri-lanka-can-drive-change-culture Accessed January 6, 2022.

11. UN ESCAP,’Digital and Sustainable Trade Facilitation in Asia and the Pacific 2021’, (2021)
      https://www.unescap.org/sites/default/d8files/knowledge-products/UNTF%20Report.pdf Accessed January 6, 2022.

12. UN ESCAP,’Single Window Planning and Implementation Guide’,

    https://www.unescap.org/sites/default/d8files/5%20-%201.%20Introduction_0.pdf Accessed January 6, 2022.

13. UN ESCAP, ’Single Window Planning and Implementation Guide’

     https://www.unescap.org/sites/default/d8files/5%20-%201.%20Introduction_0.pdf Accessed January 6, 2022.

14. UN ESCAP, ‘Single Window for Trade Facilitation: Regional Best Practices and Future Development’ https://www.unescap.org/sites/default/files/Regional%20Best%20Practices%20of%20Single%20Windows_updated.pdf, Accessed January 6, 2022.

15.  UNECE, ‘Trade Facilitation Implementation Guide, Singapore case study’, https://unece.org/fileadmin/DAM/cefact/single_window/sw_cases/Download/Singapore.pdf Accessed January 6, 2022.

16. United Nations ESCAP, ‘Single Window Implementation: Benefits and Key Success Factors’, (2012), https://unnext.unescap.org/sites/default/files/switajik-sangwon.pdf Accessed January 6, 2022.

17. UNECE, ‘Trade Facilitation Guide, Single Window Implementation in Mozambique’,
    https://tfig.unece.org/cases/Mozambique.pdf Accessed January 6, 2022.

18. UNECE,Trade Facilitation Implementation Guide, Interagency Collaboration for Single Window    Implementation:Thailand’s Experience, https://tfig.unece.org/cases/Thailand.pdf Accessed January 6, 2022.

19. United Nations, Single Window Planning and Implementation Guide, (2012) https://www.unescap.org/sites/default/files/0%20-%20Full%20Report_5.pdf Accessed January 6, 2022.

20. United Nations, ESCAP, Single Window Implementation: Benefits and Key Success Factors

     https://unnext.unescap.org/sites/default/files/switajik-sangwon.pdf Accessed January 6, 2022.

21. UNECE, ‘Trade Facilitation Guide, Single Window Implementation in Mozambique’,   
        https://tfig.unece.org/cases/Mozambique.pdf Accessed January 6, 2022.

22. United Nations, ESCAP, Single Window for Trade Facilitation:Regional Best Practices and Future  
    Development, (2018),  https://www.unescap.org/sites/default/files/Regional%20Best%20Practices%20of%20Single%20Windows_updated.pdf Accessed January 6, 2022.
    

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.