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

Originally appeared on The Daily FT.

By Prof. Prema-Chandra Athukorala

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

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

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

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

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

The IMF and economic stabilisation

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Sri Lanka and the IMF 

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

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

1964: Trotskyite Finance Minister seeking IMF support

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

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

1965-70: Four back-to-back SBAs

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

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

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

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

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

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

Originally appeared on The Daily FT

By Prof. Sirimevan Colombage

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

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

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

Tax Amnesty Bill

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

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

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

Benefits of tax amnesties debatable

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

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

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

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

 Types of tax amnesties

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

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

Objectives of tax amnesties

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

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

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

 Tax amnesty inadequate to recover revenue losses 

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

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

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

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

Tax amnesty discriminates against honest taxpayers

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

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

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

 Costs of tax amnesty offset benefits

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

 Policy alternatives

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

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

Abandoned tax reforms under EFF

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

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

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

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

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

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

Prof Colombage: Central Bank's V shape recovery projection unrealistic

Originally appeared on The Daily FT

By Prof. Sirimevan Colombage

There is an impending danger that delaying corrective policy decisions might push Sri Lanka towards an L-shaped recovery, prolonging the pandemic-led recession indefinitely

Sri Lanka’s economy contracted by 3.6% in terms of Gross Domestic Product (GDP) in 2020 in the aftermath of the outbreak of COVID-19 pandemic, recording the worst economic performance, as in the case of many countries. Industrial output declined by 6.9%, largely reflecting the adverse performance in apparel, manufacturing and construction. The services sector contracted by 1.5% due to the setback in tourism, transport and personal services. Agricultural production too fell by 2.4% in 2020.

In an effort to revive the economy and to mitigate the adverse impact of the pandemic on individuals and businesses, the Government has implemented a series of measures including health allocations, cash transfers and tax postponements.  These have been supplemented by the monetary easing policy adopted by the Central Bank since last year.

Despite such proactive measures, Sri Lanka is experiencing a prolonged economic recession due to the outbreak of the third wave of the pandemic. The economic recovery has become even more difficult due to the macroeconomic constraints faced by the country even before the pandemic. They include growth slowdown, high fiscal deficit, debt burden and balance of payments difficulties. 

 Alphabet of economic recovery

Questions have been raised across the world regarding the shape of the economic recovery from the COVID-19 pandemic applicable to different countries; whether it is V-shaped, U-shaped, W-shaped or L-shaped.

The best-case scenario is the V-shaped recovery in which the economy rebounds quickly after a sharp decline. In a U-shaped recovery, it takes months or years to revive economic activity. In a W-shaped recovery, the economy recovers quickly but falls into a second recession. Hence, it is known as a double-dip recession. 

The worst-case scenario is the L-shaped recovery in which the economy fails to recover in the foreseeable future.

Central Bank’s V-shaped projection unrealistic

As per the medium-term macroeconomic outlook presented in the Central Bank’s Annual Report-2020, the Sri Lankan economy is expected to rebound strongly in 2021 and sustain the high growth momentum over the medium term, buoyed by growth-oriented policy support. 

Accordingly, the economy is expected to achieve a V-shaped recovery with GDP growth jumping exorbitantly to 6.0% this year from the negative growth experienced last year, as shown in the chart. The growth momentum is projected to remain in the next five years accelerating the growth to 7.0% by 2025.

The Central Bank’s above projection seems to be over-optimistic, given the structural economic imbalances that have been prevailing in the country for a long time, leaving aside the adverse effects of the pandemic. This is clearly reflected by the fact that the economy was already on a downward path even before the pandemic. 

GDP growth averaged only 3.7% during the ‘Yahapalana’ regime of 2015-2019. The average growth rate was down to mere 3.1% in 2017-2019, the period immediately preceding the pandemic. 
Based on our time series projections as shown in the dotted line in the Chart, the annual GDP growth would not have been more than 2% from this year onwards, assuming there is no COVID-19 pandemic. The scenario appears even worse when a non-linear trend projection is applied, which indicates negative growth in the medium-term even without the pandemic. 

Thus, Sri Lanka’s economic downturn is deeply rooted in factors beyond the pandemic which call for immediate policy action.

As the pandemic has exacerbated the economic slowdown, it is highly unrealistic to anticipate a V-shaped economic recovery overtaking the pre-pandemic growth, as projected by the Central Bank.

SL’s poor growth record

Following the cessation of the war in 2009, the economy followed a high growth path supported by the revival of production activities in the north and east together with post-war reconstruction and infrastructure development. However, that construction-based economic recovery was short-lived due to the lack of sustainable growth strategies, fiscal imbalances and export setback. 

The weak economic performance has continued during the ‘Yahapalana’ regime during 2015-2019 in the absence of a coherent economic reform agenda aimed at export-led growth. 

SL lacks technology-driven growth

Economic growth achieved thus far has been driven by using more factors of production – capital and labour. Such growth is identified as ‘factor-driven growth’.  The economic slowdown immediately prior to the COVID-19 pandemic indicated that the economy could not grow any further solely depending on labour and capital inputs. 

In other words, Sri Lanka has reached the ‘Production Possibility Frontier’ (PPF), in economic terminology. Raising the output beyond PPF requires application of technology and innovation thus enabling the economy to materialise ‘technology and innovation-driven growth’. 
In the current global set up, technology and innovations based on human capital are the core growth drivers in many fast-growing countries, which have achieved the knowledge-economy status. Sri Lanka has been lagging behind in terms of knowledge economy indicators: economic and institutional status, education and skills development, Research and Development (R&D) and information and communication technology. 

Unless appropriate policy measures are adopted to fill such gaps targeting technology and innovation-driven growth without further delay, it would be impossible to revive the country’s economic growth hampered by the pandemic in the near future. 

Sri Lanka has lost numerous opportunities to achieve such growth in the post-liberalisation period mainly due to the politically-motivated decisions adopted by successive governments leaving aside economic priorities.

Import-dependent export growth 

A country’s long-run growth rate is constrained by its export capacity and import demand, according to the well-tested theory introduced by Prof. Anthony Thirlwall of University of Kent in 1979. It is known as ‘Thirlwall’s Law of ‘Balance of Payments – constrained economic growth’. The larger the trade surplus (exports minus imports), the faster the economic growth. 

In the long run, therefore, no country can grow faster than that rate consistent with balance of payments equilibrium on current account, unless it can continuously finance ever-growing deficits by foreign borrowing which, in general, is impossible, as evident from Sri Lanka’s experience. 

The country’s envisaged economic recovery largely depends on its ability to raise exports. The pandemic-hit export sector showed some resilience in the first quarter of this year recording a 12.6% increase in total export earnings; industrial exports rose by 7.9%, and agricultural exports by 31.0%. Nevertheless, the trade deficit expanded in the first quarter due to a 12% increase in import outlays. 

The Government has imposed import restrictions on a variety of goods since last year to ease the balance of payments difficulties. Given the high import content of domestic production, such restrictions have downside effects on the export sector as well as on overall economic growth. The recently-announced import ban on chemical fertiliser will adversely affect the agriculture sector, causing food security problems during the pandemic.

Thus, import controls are likely to prolong the pandemic-led recession, as per Thirlwall’s law. 

Selective import relaxation for lawmakers

Whilst import restrictions on some of the essential goods consumed by ordinary people (including turmeric) are in force, the Cabinet is reported to have given its nod to permit importation of luxury vehicles for MPs, reflecting the Government’s absolute insensitivity to the country’s fiscal and foreign exchange crisis amidst the pandemic.  

In contrast, New Zealand’s Prime Minister has said she and the ministers will offer a 20% pay cut lasting six months to show solidarity with those affected by the coronavirus outbreak, as the death toll continues to rise. 

CB’s frequent tinkering with export proceed conversion rules

Last week, the Central Bank once again revised the rules on repatriation of export proceeds, requiring 25% of the proceeds to be converted within 30 days after receiving such proceeds. 

The Monetary Board keeps its discretion to determine the specific export sectors or industries or individual exporters, who or which may be permitted to convert less than 25% of the total of the export proceeds received. This, however, will continue to be subject to not below 10% conversion of the export proceeds and received no later than 180 days from the date of shipment. 

Such discretionary rules introduced in a bid to salvage the country’s foreign exchange situation have severe detrimental effects on the export sector hit by the pandemic, as reiterated in this column earlier. 

Fiscal deficit and debt burden

A crucial macroeconomic imbalance that impinges on Sri Lanka’s growth recovery is the fiscal deficit and the accumulating debt service payments. The budget deficit rose to 11.1% of GDP in 2020 and the available indicators show even a higher increase in the deficit over 13% of GDP this year. 

The continuation of the arbitrary tax cuts and the expenditure hikes already worsened the fiscal situation requiring frequent borrowings from domestic and foreign sources. Annual debt service payments amounting to around 150% of the Government revenue exert enormous pressure on budgetary management. 

While the Central Bank’s low interest rate policy helps to ease the domestic debt service burden, the depreciation of the rupee in recent weeks makes external debt service payments extremely costly. 

Overdependence on foreign loans and swaps

Instead of pursuing the Government to stick to a fiscal consolidation programme targeting a lower fiscal deficit so as to ease the debt burden, the Central Bank continues to rely on short-term foreign borrowings and swap arrangements. This is in addition to its accommodative monetary policy stance with regard to Government’s domestic borrowings.  

Last week, the Bangladesh Bank has agreed to provide a swap facility of $ 200 million. Sri Lanka received renminbi-denominated swap of $ 1.5 billion from China last month. In addition, the Republic of Korea last month agreed to provide concessional loans amounting to $ 500 million to finance the identified projects. 

More swap facilities are in the pipeline, according to the Finance Ministry sources, as reported in the media. 

Fresh debt-funded infrastructure projects 

Meanwhile, the Government is reported to have launched several major debt-funded infrastructure projects including highways a few days ago amidst the pandemic and severe external debt problems. Such borrowings will certainly aggravate the country’s staggering macroeconomic imbalances.

U- or L-shaped recovery for Sri Lanka?

In the backdrop of Sri Lanka’s growth slowdown even prior to the pandemic, the V-shaped recovery projected by the Central Bank is far from reality. 

Assuming a best possible scenario, hopefully the economy would revive after two to three years characterised by U-shaped recovery. The bottom of the U shape represents the extended period of the recession before recovery. 

A longer post-pandemic U-shaped recovery implies that the economy will take a number of years for recovery. First and foremost, the length of the economic recession depends on how long it takes to eradicate the coronavirus at the national and global levels.

Proactive policies are essential to correct the macroeconomic imbalances, specifically the fiscal deficit, bad debt dynamics and the balance of payments deficit so as to revive the Sri Lankan economy at least with U-shape recovery, which is considered to be the second-best option below V-shape recovery. 

There is an impending danger that delaying corrective policy decisions might push Sri Lanka towards an L-shaped recovery, prolonging the pandemic-led recession indefinitely. 

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

Daniel Alphonsus : A Crises Manifesto: Exorcising Hunger, Unemployment and Debt

Originally appeared on Echelon

By Daniel Alphonsus

An unprecedented crisis can only be met with comprehensive and deep reform. Bandages and tinctures will not do.

There are crises and there are crises. But the truly momentous calamities, those that set the stage for the decades that follow are few and far between. Surveying 20th century Sri Lankan history, two such events stand out – the Great Depression and the rice-queues of the 1970s. Those traumatic experiences dictated economy policy for the decades that followed. In the case of the Great Depression, rapid reductions in commodity prices, combined with a global credit crunch, ravaged Sri Lanka’s undiversified plantation economy. A consensus emerged for reducing Sri Lanka’s dependence on international markets.

The Ceylon Banking Commission report of 1934, in many ways the premier pre-independence analysis of Sri Lanka’s economy, observed, “Never before was the vulnerability of the economic structure of Ceylon more forcibly revealed than during this period. The three major products, namely, tea, rubber, and coconut, which between them account for over 90% of the wealth of the country, suffered seriously during the depression. The creed of economic self-sufficiency which became an article of faith in the economic policies of other countries spread to Ceylon as well.” Inspired by war-time planning and the Soviet command economy’s success in industrializing Russia, there was also widespread agreement that in the newly independent third world, governments, not firms, would be the motor of this historic transformation from global dependence to national independence.

Exhilaration soon gave way to enervation. The failure of import-substitution and appalling government record of running enterprises – including the critical plantation sector – paved the way for the open market reforms of 1977. The desperation was palpable. On election platforms, Sirima Bandaranaike accused J.R. Jayawardene of being in bed with the Americans, thinking that would dissuade voters from supporting him. But the ploy boomeranged. Voters, who just two or three decades ago were Asia’s second richest but now had to wait in queues for rice, voted with their stomachs. Their reasoning was simple, if J.R. is in bed with the Americans, then he will be able to secure relief from them.

Despite a quarter-century of the open market model coming to a sudden and unexpected halt in 2004, economically speaking, we are still the children of the 1977 revolution. This year may mark the twilight of that epoch, or at the very least a new chapter.

For Sri Lanka is facing an unprecedented economic crisis. It is a crisis of four tempests, whose sum is a raging storm that threatens to engulf the entire island in its dark thunderous deluge. They are:

1. Coronavirus: the global and domestic combined supply and demand shocks caused by the Coronavirus.

2. Original Sin: borrowing liberally from international capital markets in foreign currency, at high-interest rates and with low maturities for low-productivity construction and import consumption.

3. Negative Growth Shocks: the economic slowdown caused by floods, droughts, the constitutional coup and Easter Bombings.

4. Stalled Reform: with the exception of the new Inland Revenue Act, the failure to carry through any serious structural reform since 2004 has seen real growth fall.

As a result, we may be on the verge of Sri Lanka’s first sovereign default since Independence. Prior to the pandemic, though the trajectory was grim, there was still hope of avoiding that catastrophe. That hope is now waning fast. The origins of this crisis lie in the early years of this millennium. In 2004, the quarter-century long bipartisan consensus for reform stalled. In many cases – such as tariffs and privatizations – reform reversed. Due to time-lags the reforms of the late 90s and early 2000s continued to bear fruit for some years. But by the turn of the millennium, high-interest dollar debt increasingly became growth’s chief hand-maiden.

Post-2007 commercial borrowings from international capital markets rose rapidly from almost zero. This fueled a construction and consumption boom soon after the war’s end in 2009. Project loans were spent on empty airports and useless towers. Sovereign Bonds were issued to bridge the government’s ballooning budget deficit; caused by an unprecedently massive and swift expansion of the public sector.

Over the last few years, supported by an IMF programme, the government worked hard to reduce Sri Lanka’s debt-burden and dependence on international capital markets. Sri Lanka ran a non-trivial primary surplus for the first time in 2017, repeating that success in 2018 and upto November 2019 despite the coup and the Easter Bombing. But this alone was not enough.

In reality, the value of public debt rarely declines. What matters is reducing public debt relative to the size of public repayment capacity. In its simplest form, it’s about reducing the value of this equation:

This can be done in two ways. Reducing the value of the numerator, “Public Debt”. Or by increasing the value of the denominator, “Annual GDP”. In the last few years, Sri Lanka adopted a ‘fiscal consolidation’ approach which rightly attacked the numerator. But coalition dynamics and time-lags thwarted progress on the denominator, growth, which is more important. The new government reversed course significantly loosening fiscal policy. It implemented a sweeping range of tax cuts which drastically reduced government revenue. In the language of our equation, these tax-cuts increased the numerator. The wager – to describe the strategy charitably – was that rising public debt would be off-set by an even faster surge in GDP growth, thus reducing the relative value of public debt. That plan has clearly failed. Today, public debt is touching 95% of GDP. The true value, when one calculates all liabilities such as Treasury guarantees for invoices, is likely much higher.

As a result, markets seem to think Sri Lanka is at risk of defaulting for the first time in its history. Bond yields are in the double digits. Among emerging markets, only Argentina, Zambia and Lebanon have higher risk premiums on their debt. A default will be a further blow to an economy that has been ravaged by floods, coups, the Easter Bombings and COVID. The country will be shut off from international capital markets. It will not be able to finance the budget deficit. Inflation unless government spending is cut. Taken together, they could well lead us into an Argentine, Lebanese or Greek-style vicious cycle of default and political instability. An unprecedented crisis can only be met with comprehensive and deep reform. Bandages and tinctures will not do. As Italy has shown neither will attacking the numerator alone: decades of focusing on primary surpluses without structural reforms have only resulted in stagnation. Rather we need the second-round of 1977 type reforms that served Sri Lanka so well. There are many ways of thinking about such a reform programme. However, as the catalyst this time is likely to be a sovereign default, it is easier to label reforms as either an “attack on the numerator” or an “attack on the denominator”.

Attacking the Numerator: Reducing Debt

Reducing public debt – ‘attacking the numerator’ – can be done in three ways. First, increasing taxes. Second, reducing expenditure. Third, selling assets. Sri Lanka will probably have to do all three.

Increasing Taxes: Property Taxes and Tax Loopholes

 It is well known that Sri Lanka has one of the lowest tax-to-GDP ratios in the world and has a regressive tax system. This year Sri Lanka’s tax-to-GDP ratio could rank among the lowest 15 countries in the world. However, in the midst of economic contraction raising taxes that reduce consumption and investment could catalyze growth shocks. One solution would be to tax savings, especially those savings that are not productive. The biggest example of such savings is land ownership. A Western Province property tax could raise substantial revenue and encourage efficient use of idle property. In the last decade property prices in Colombo rose by 300%, much of this windfall is the direct result of public infrastructure spending. Our tax system also has many loopholes. Consider the case of excise taxes on cigarettes. Estimates suggest the government could prevent over two hundred billion rupees of revenue leakage over the next decade by introducing a formula for cigarette prices. Similarly, the duty on beedi clearly points to political rather than economic considerations in excise taxation.

Reducing Expenditure: Too Many Men

Sri Lanka has a bloated public sector. From a revenue, productivity and ultimately security viewpoint the large size of the military is a challenge. Around 40% of government salary expenditure is spent on the military. The military, nearing 280 thousand men (compared to the British Army’s approximately 100,000), is holding back our most able men from productive employment. Transferring most of these men to reserves and offering subsidized labour to the export industry through an apprenticeship scheme would substantially improve public finance and propel growth. A similar story of job growth can be found in the public sector.

Selling Assets: Sell Enterprises

The government is poor at managing businesses. State-owned enterprises are renowned for their mismanagement, waste and corruption. The direct cost is colossal. But the indirect costs are even greater. Despite competition from Ports Authority run terminals, SAGT and China Merchant Holdings have played a key role in making Colombo one of the world’s great ports. Imagine if airports and air-services had been similarly open to competition and private enterprise; Sri Lanka could have become an aviation and air-sea hub, as well as a shipping-hub. There are countless other examples throughout our economy.

At this stage of economic development, there is little reason for the state to run enterprises. In fact, the state can increase the value of the assets it owns by selling enterprises without selling land per se. For example, state-owned hotels, container terminals and air terminals could be privatized without selling the land on which they operate. In other words, privatize the enterprises, not their land-holdings. The tax-payer would be significantly better off as the privatization proceeds can be used to settle debt. In addition lease values, for the land, will rise and the land-value will appreciate faster too.

From a productivity point of view, key targets for privatization could be Sri Lankan Airlines, Ratmalana Airport, Jaya Container Terminal and Unity Container Terminal. One simple method of doing this would be to place all SOEs operating in competitive industries in a holding company that has an explicit mandate to sell them within a set time-frame, failing which they are automatically listed on the Colombo Stock Exchange.

Attacking the Denominator: Productivity Growth

There is only one tried and tested way of going from third world to first in the space of a few decades: manufacturing exports. Sri Lanka successfully completed the first step of this process by the 1980s when it established apparel exports industry, which remains Sri Lanka’s only manufacturing export. In 1983, Sri Lanka was about to move up the value chain to semi-conductors, which would have led to South-East Asian and East Asian style growth. But Black July was engineered, and the semiconductor plants being built in Katunayake by Motorola and Harris Corporation were shipped-off to Penang. Similarly, we missed the wave of Japanese investment that was about to begin at that time.

Since then Sri Lanka hasn’t developed a major manufactured export. The challenge for Sri Lanka is to create new higher-productivity export industries. This is a complex task requiring government effort. But Sri Lanka has done it before. The tested strategy of the 1977 revolution is as follows. First, create investment zones where the usual constraints affecting investment can be managed. That is the genius of the Free Trade Zones. Second, make Sri Lanka’s exports competitive: reduce tariffs (a tax on imports is a tax on exports) and sign Free-Trade Agreements. Third, enable efficient factor allocation: remove regulatory constraints on agricultural production and update labour laws. Fourth, unleash the power of the developmental state by fast-tracking the MCC grant, designing clever export subsidies and most importantly completing land reform.

Investment Oases

The engines of Sri Lanka’s manufacturing exports are the Free Trade Zones. It is here that the apparel industry started. It is also the zones that were the cradle for the island’s solid-tyre export industry and they remain the primary site of all other manufactured exports. The reason for this is that zones make it much easier for an investor to open a factory. Land, electricity and water are available; regulatory permissions are already secured; customs officers and other government agencies are on hand. Over time an eco-system of trained labour and ancillary suppliers also develops. Despite being near capacity, Sri Lanka failed to build any new free trade zones between 2002 and 2017. So its no surprise to hear investors complain that access to land is the primary constraint for investment.

Almost all of Sri Lanka’s Free Trade Zones are managed by the BOI. One exception is the DFCC Bank run Linden Industrial Zone. The BOI run model worked well and was competitive in the 1980s. Today the world has moved on. In order to attract new investors in sectors outside apparel, Sri Lanka needs to allow international zone operators. For example, Sri Lanka should court a Chinese free trade zone operator, a Japanese free trade zone operator and a Singaporean one to establish facilities in Sri Lanka. These zone operators will then leverage the relationships they have with manufacturers in their countries and regions, doing the job successive governments have failed to do since the late 1980s.

The energies of Sri Lanka’s own private sector could also be unleashed in zone-management. MAS and Brandix run successful textile parks in Sri Lanka and India. There is no reason they couldn’t successfully run a zone in Sri Lanka. The failure is not the central government’s alone. As far as I know, no other province has done what the Wayamba Provincial Council did within a couple of years of the formation of a provincial government: establish not one but two province run industrial zones, at Heraliyawala and Dangaspitiya respectively. The Northern Province with its devolutionary fervour, combined with access to the KKS Port and Palaly Airport, should be particularly ashamed.

A pilot project could deploy under-utilized state land around Ratmalana to create an electronics free-trade zone. There is no better place in Sri Lanka due to proximity to a port, railway and airport, universities and technical schools and trained labour.

Export Competitiveness

But no one will build factories in Sri Lanka if input costs are high. In this era of global supply chains, one country rarely adds more than 20% to 30% of a product’s final value. Therefore, being able to import components and raw materials at the same prices as in competitor countries is vital. However, Sri Lanka has some of the highest effective tariff rates in the world. To make matters worse they are highly complex, creating ample room for discretion and thus delays and corruption. If Sri Lanka is to become the trading and manufacturing hub of the Indian Ocean, it will have to benchmark its tariffs against Dubai and Singapore. This is not new to Sri Lanka. In 1994 it has a simple three-band tariff structure. It is only after 2004 that Sri Lanka’s effective tariff rate sky-rocketed, primarily due to the cascading effects of CESS and PAL. Their abolition would be a very good start.

Similarly, during the 1977-2004 Sri Lanka’s real effective exchange rate was kept more or less constant. A weaker currency makes foreign goods dearer domestically and makes Sri Lankan goods cheaper on global markets. This helped ensure the competitiveness of exports and acted as an automatic, non-discretionary import substitution incentive. However, from 2004 onward the real effective exchange rate started creeping upwards, discouraging exports and encouraging imports. By 2017 Sri Lanka’s real effective exchange rate was 31% higher than in 2004.

Finally, Sri Lanka’s competitiveness is eroding because all its competitors are signing free trade agreements (FTAs). Sri Lanka must fast-track deeper goods and service trade integration with India, China and ASEAN. Most importantly, we need to become part of the two-major trade agreements the CPP11 and the RCEP. The constraints of space and time, robbed of the opportunity to discuss the importance of a new Customs Act, the implementation of the National Export Strategy or other reforms to facilitate cross-border trade. Suffice to say they too are essential.

Efficient Factor Allocation

Land, labour, capital; it is the development and allocation of these factors that determines the wealth of nations. Sri Lanka’s capital allocation is relatively efficient. Our challenge today is to ensure the efficient allocation of land and labour.

Land

Many cite East Asia’s successful land reform as the key to their economic prosperity. Studwell’s How Asia Works is perhaps the most persuasive and readable account. There is much to commend in this analysis. Granting freehold land to families already farming it will increase agricultural productivity. This is true of Sri Lanka too. One critical land reform, that can be implemented quickly, will be to make small-holders of the existing tea-estate workers. This will improve productivity, as the principal-agent problem will be solved. In addition, with freehold rights, they will have every incentive to replant and improve the land. Access to credit will not be an issue; the land itself will act as collateral.

As for the RPCs, the factories and land equal to the value of their remaining leaseterm can be transferred to them freehold. They can then offer extension services and an out-grower model to the new small-holders. In a similar vein, there is absolutely no good reason for the continuation of the Paddy Lands Act, especially in the wet-zone. In fact, some of the land in the wet-zone restricted by the Paddy Lands Act was never paddy land in the first place. This law is a major barrier to more productive use of land for high-value export crops, such as spices.

Having got land out of the way, we can move on to labour. Sri Lanka’s labour laws have created a de facto caste system of a few highly protected insiders and a sea of completely unprotected informal workers. In fact, the failure to make labour law more flexible is an important reason why over a million Sri Lankans work in the hazardous conditions of the Gulf. It is better to have some protection for many, than a great deal of protection for a few. Especially as labour law is a major constraint to growth. The downsides of more flexible labour laws can be effectively managed through a targeted social security net, such as in the Danish Flexisecurity model, which combines high levels of labour market flexibility with generous social safety nets, such as solid unemployment insurance.

The Developmental State

Finally, Sri Lanka needs to restructure its state to facilitate rather than hamper development. The first is a question of a simply accepting reality. What credibility does a country have when it refuses the largest grant in its history (MCC), while going-cap in hand asking for debt moratoria from its creditors?

Second, the state-owned enterprises in natural monopoly sectors, such as railways and power-lines need to be depoliticized and forced to be efficient. Depoliticization can be significantly achieved by simply passing a new law. The law can require that the appointment of directors of all State-Owned Enterprises be subject to the approval of a Constitutional Council appointed nominating board, with clear ‘fit-and-proper’ criteria. A similar mechanism is already in place for banks.

Furthermore, efficiency can be improved by introducing competition, resolving conflicts-of-interest and raising transparency. Sri Lanka’s competition law does not cover state-owned-enterprises: this allows public sector monopolies to enjoy rents at the expense of citizens. That needs to go. It is also absurd, for example, that the Sri Lanka Ports Authority is owner, operator and regulator of port terminals. The public sector is rife with such conflicts-of-interest which appear designed to breed corruption and mismanagement.

These are the key changes, but information matters too. As they are owned by the tax-payer, SOEs should have greater disclosure requirements than firms listed on the Colombo Stock Exchange. But a start would be to simply require SOEs to follow all CSE disclosure requirements, this can be done by law or by requiring SOEs to list their debt on the CSE. Or both.

There are also government departments that need to be made into SOEs. The railways are the most important example. If the railways were able to borrow money, which they could if they were an SOE, they could then finance the electrification and double-tracking through the development of land the CGR owns around railway stations.

Way Forward

The real economic policy statements in Sri Lanka are not budgets but IMF programmes. Budgets are often nothing more than promises of bread and the certainty of circuses. They bear little reality to actual revenue and expenditure, much the less actual economic management. As such the crescendo of this crisis, and thus opportunity, will be the inevitable IMF programme. It is almost certain that Sri Lanka will enter into its 17th IMF programme later this year or early in 2021. Sri Lanka has been in IMF devil-dances for much of its post-independence history. We have failed to undertake the reforms needed to grow and to protect our sovereignty. The IMF kapuralas have also failed to require front-loading reforms: allowing Sri Lanka to get away with cosmetic compliance rather than really restructuring the economy.

With COVID, the IMF is also overextended; perversely this improves its bargaining position. As a result, this programme can be a water-shed that combines both fiscal consolidation and export-driven productivity growth. It must be a landmark programme with a single objective: to be the last programme the IMF has with Sri Lanka. Then, as in 1977, Sri Lanka may just pull-off a Phoenix-like rise from the ashes. If not, then the demons of hunger, unemployment and debt-collectors will follow.

(Daniel Alphonsus was an advisor at Sri Lanka’s Finance Ministry. He also worked at Sri Lanka’s Foreign Ministry and at Verite Research. Daniel read philosophy, politics and economics at Balliol College, Oxford and public policy at the Harvard Kennedy School where he was a Fulbright Scholar.)

Back to the Basics: Achieving our FDI targets?

In this weekly column on The Sunday Morning Business titled “The Coordination Problem”, the scholars and fellows associated with Advocata attempt to explore issues around economics, public policy, the institutions that govern them and their impact on our lives and society.

Originally appeared on The Morning

By Aneetha Warusavitarana

As we enter the middle of February, Sri Lanka does not appear to have a clear plan in place for foreign direct investment (FDI) for 2020. Last year, the Government set a target to attract Rs. 3 billion in FDI by the end of the year; this however did not come to pass. After the Easter Sunday attacks, the Government downgraded the target to Rs. 1.5 billion, reflecting the drop in investor confidence following the terror attacks.

Attracting FDI should be a priority for Sri Lanka right now. As a region, growth in South Asia has slowed down, and we are no longer the fastest growing region in the world. In Sri Lanka, we will have to face challenging economic realities; the tax cuts introduced as a stimulus for the economy may or may not pan out as expected, and it is likely that government expenditure will continue to rise in the lead-up to parliamentary elections.

Our recent graduation to upper middle-income status has also shed light on the living standards of many in the country. The poverty line for upper middle-income countries is far higher than the official poverty line used in Sri Lanka. When the country’s poverty numbers are recalculated for the new poverty line of $ 5.5 per day, our poverty rate skyrockets from a respectable 4% to a horrifying 40%. Of course, this number should not be taken at face value; a little under half of our population did not suddenly plunge into poverty at the point of our transition to upper middle-income, and living standards are similar to what they were last year. However, it is a good indicator of how far we have to go as a country for Sri Lankans to have economic realities associated with upper middle-income countries.

Economic growth

The solution to our woes is of course economic growth; the catch is that growth appears to be quite elusive at this point, with GDP growth for 2020 estimated to be 3.7%. The country is also a little strapped for cash with debt repayments and uncertainty as to what our tax revenue will look like. What Sri Lanka needs at this point is FDI.

Attracting FDI into Sri Lanka should be a priority for the Sri Lankan Government, not simply because it is a source of foreign exchange for the country, but because the benefits of FDI go far beyond that of increasing inward capital flows. FDI is a link to international markets that Sri Lanka would otherwise have limited access to, and with that link comes the transfer of knowledge, skills, and knowhow. Entry into global value chains through FDI forces firms to improve productivity and increase competitiveness. The World Bank succinctly captures the benefits of FDI for high-growth firms in developing countries by identifying two main channels: (a) Contractual linkages between foreign and local firms that promote the formal transmission of knowledge and practices that may help domestic suppliers upgrade their technical and quality standards, and (b) the demonstration effect, where domestic firms imitate foreign technologies or managerial practices.

The investors’ side

Sri Lanka has to go far beyond setting targets for FDI if we are to attract it in the numbers that we need. We need to understand what investors are looking for, and then ensure that Sri Lanka has met that criteria. The World Bank’s Global Investment Competitiveness Survey is a tool that can help governments design policy and prioritise reform that investors will recognise and value. The survey captures 754 interviews with executives of multinational corporations (MNCs) that have invested in developing countries, and identifies the determinants to attracting FDI.

When speaking about FDI in Sri Lanka, focus is often solely on attracting FDI, with great effort being expended to answer the question of how to get investors to see Sri Lanka as a lucrative destination for investment. This is of course important, but we need to go beyond this if we are to retain FDI, and see the investment grow. One of the top five findings from the survey was that more than a third of investors reinvest all of their profits into the host country. This means that investors will be looking for policies in the host country that will help them grow their business, and not just policies to facilitate their initial setup.

Another key finding from the survey was the importance of having economic stability and a transparent, predictable policy regime. Three-quarters of investors have experienced disruptions in their operations as a result of political turmoil. A quarter of these investors then either cancelled or withdrew their investment.

Next steps

Achieving long-term policy stability is not an easy task; it will require considerable political will and commitment to long-term growth over a quick short-term win. Focus has to move beyond quick-fix investment incentives. The report highlights that incentives are not the most important determinant for a potential investor, according to the survey. They rank fourth in importance, below transparent governance, investment protection guarantees, and ease of establishing a business. Of course, this is not to say that incentives should be removed wholesale. They are a criterion, but possibly not the most important one.

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Presidential promises and business registrations

In this weekly column on The Sunday Morning Business titled “The Coordination Problem”, the scholars and fellows associated with Advocata attempt to explore issues around economics, public policy, the institutions that govern them and their impact on our lives and society.

Originally appeared on The Morning

By Aneetha Warusavitarana

On Independence Day, the presidential address touched on several topics, ranging from public administration and corruption to eradicating poverty in the country. Reforming the current system in order to promote an environment where Sri Lankans could thrive and prosper was a promise made – a large part of which was economic freedom. While the President veered clear of more controversial topics, this focus on reform was promising.

“Outdated laws, regulations, taxes, and charges that prevent people from freely undertaking self-employment, traditional industries, or businesses need to be revised swiftly. We will work towards removing unnecessary restrictions imposed on the public to better ensure their right to live freely.”

If the Government follows through on this commitment, it would require a considerable amount of work. While significant changes were introduced to the tax system of the country with relative ease, legal and regulatory change will be more difficult to come by. We have a host of outdated laws, and one industry is often governed by several acts – creating considerable confusion.

For instance, the coconut industry is governed by the Coconut Products Ordinance, the Coconut Fibre Act, and the Coconut Development Act. Each of these Acts address different aspects of the coconut industry, from the export of products to land use. Legal reform is notoriously time and labour intensive, and we are unlikely to see legal reform, unless it is driven by clear political will. Regulatory change is easier to bring about, and is a good starting point for the improvement of Sri Lanka’s business environment.

Small businesses

Last October, the Advocata Institute commissioned an islandwide survey of micro and small entrepreneurs, covering 1,500 respondents. The aim was to better understand the legal and regulatory barriers that these enterprises face. Sri Lanka has seen successful reform in the area of business registration, with the country moving up on the Ease of Doing Business index. The impact these reforms have had on small businesses was reflected in the survey findings, with 67% of respondents stating that they had registered their businesses. When this number was broken down further, we found that rates of registration did not fluctuate drastically between micro and small enterprises, with 66% of micro and 76% of small enterprises having registered their business.

While these numbers are promising, there is still room for improvement. Bringing businesses into the formal sector gives them opportunity and access to finance, knowledge, and markets that they are excluded from when they exist in the informal sector.

However, businesses have good reasons for being hesitant to formalise. In cases where the cost and time associated with registration are too high, it may make more sense for businesses to postpone registration until they are more established. Excessive regulation is also a key factor; when numerous documents and approvals are required, the costs associated with registration rise and act as a deterrent to formalisation.

Barriers

Among the unregistered businesses, only around one-third had tried to register their business at any point. The survey results indicate that this group of individuals may not necessarily have prohibitive barriers that prevent them from registering their businesses, as they have rarely gone beyond getting information from a municipal council or divisional secretariat, have prepared documents halfway, or have simply asked friends about the process or checked the website. This could indicate that there needs to be better information provided at divisional secretariats or municipal councils, or assistance provided to help these individuals register their businesses. It could also simply be a lack of interest in pursuing registration at this point in time.

One reason provided as to why they have not registered their businesses, which appears to be a more concrete barrier, is the issue of space and the requirement for a rent agreement. When these unregistered enterprises were asked if they were aware of the documents required for registration, 65% of respondents were aware that a name registration certificate was required and 61% were aware that grama niladari approval was required. Only 48% were aware that a rent agreement was required for the premises.

Requirements

The need for a rent agreement or copy of a deed at the point of registering the name of the business, while appropriate for a larger business, is less so in the case of these small and micro enterprises. A majority of the micro and small enterprises interviewed in the survey do not have a designated office space. 42% of small enterprises and 48% of micro enterprises operate from residential premises. If they are the owners of the premises, then the process is slightly simpler – the original deed and a notarised copy are required. If not, the original rent agreement and a notarised copy are required. At face value, this requirement may seem inconsequential. However, it does appear to be unnecessary and poses another hurdle for entrepreneurs.

A rent agreement or a deed is not necessarily a requirement for registering a business across the world. Looking at the case of New Zealand, it is only required that a company director enters in a valid address which will be cross checked against the New Zealand Post Database to ensure that the address is accurate. In the case of Hong Kong, registering a business only requires an incorporation form, a copy of the articles of association, and a notice to the business registration office. New Zealand and Hong Kong are in the top three most economically free countries in the world, and set a precedent that we could all follow.

Way forward

97% of micro businesses and 85% of small businesses surveyed register their business as sole proprietorships, with only 3% of the businesses surveyed registering themselves as partnerships, and 2% registering themselves as private limited companies.

Given this, removing the requirement of a rent agreement or deed for this type of registration could be a viable solution. The process of registration of private limited companies has been eased through the Government’s e-RoC portal, and reform should now focus on easing the process for our smaller businesses.

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Achieving export target through National Export Strategy

In this weekly column on The Sunday Morning Business titled “The Coordination Problem”, the scholars and fellows associated with Advocata attempt to explore issues around economics, public policy, the institutions that govern them and their impact on our lives and society.

Originally appeared on The Morning

By Aneetha Warusavitarana

After a series of tax cuts and promises of expenditure tightening, the Government has now turned its focus onto export growth. It is perhaps about time this area was given some attention, especially as it presents the Government with an avenue from which much-needed foreign exchange can enter the economy.

Minister of Industrial Export and Investment Promotion, and Tourism and Civil Aviation Prasanna Ranatunga has emphasised on the Government’s target of $ 18.5 billion in export revenue. In a welcome move, and breaking precedence, the Government has decided to continue with the National Export Strategy (NES) created during the tenure of the previous Government, a step that bodes well for policy consistency in the country.

The export narrative presented in the Government’s manifesto was one that focused on boosting domestic production for exports and carrying out import substitution. It identified that high tariffs on the imported inputs to stifle domestic production and economic growth, and committed to reduce tariffs on raw materials and intermediate goods.

Achievable targets?

Even though the policy consistency is promising, we still need to meet this target of $ 18.5 billion in export revenue. The question that remains is whether the Government has taken the steps to make this target a reality. The NES has a clearly laid out plan of action for the six key focus areas identified. However, we cannot think of creating export growth without a holistic look at the country’s trade position. Our location is often the first thing that comes to mind when one thinks of international trade, but we have done little to reap any benefits from being the “Pearl of the Indian Ocean”. The recently released (human) Freedom in the World report tracks countries’ freedom to trade, among several other indicators. While Sri Lanka is still fairly low in overall rankings for human freedom, placing at 110/162, we perform poorly on the indicator “Freedom to Trade Internationally”, especially on the sub-indicators on tariffs and regulatory trade barriers, where we score 6.3 and 5.2 out of 10, respectively .

Some of the recent tax reforms have reduced taxes at the border as well, but Sri Lanka’s tariff system remains convoluted and opaque; even once this hurdle is cleared, the bureaucracy has to be contended with. Speaking of export growth is all well and good, but exports are simply one component of a strong international trade regime. If Sri Lanka does not have a foundation that supports and incentivises international trade, we are unlikely to witness export growth of this nature. Implementing some reforms mentioned in the Government’s manifesto, especially those on the lowering of tariffs, would be a strong first step.

A quick-fix solution?

While the NES has identified six focus areas for innovation and export diversification, it also places emphasis on easing regulations and improving Sri Lankan exporters’ ability to diversify, innovate, and comply with international standards. The Government would have to commit to creating a predictable and transparent environment for exporters, bringing down the costs of conducting business in Sri Lanka, improving the export competitiveness of domestic firms, and reforming some of our more archaic laws. Reform in the Customs Department is at the heart of this. There have been some preliminary steps in this direction, notably the launch of the Automated System for Customs Data (ASYCUDA), but there is much more to be done. Reforming the Customs Ordinance is vital; the NES states that a new Customs Act, which is in line with international standards for trade facilitation, has been drafted. However, it has not progressed beyond this stage.

These are not easy reforms to implement, and they are far from a quick-fix solution. They do, however, promise to create meaningful change that can translate into the export growth the Government is targeting.

Sri Lanka, left out of South Asia?

Apart from addressing these ground-level barriers to export growth, another avenue that can be explored is free trade agreements, and the Sri Lanka Export Development Board (SLEDB) has brought its attention here. Under the India-Sri Lanka Free Trade Agreement (FTA), we have seen the country reaping the benefits of international trade. Sri Lanka’s exports to India have grown faster than India’s exports to Sri Lanka, and Sri Lanka has experienced diversification in the goods it exports to India, with a shift from agricultural products like cloves and areca nuts to boats and ships.

The case is the same when considering the impact GSP+ (Generalised Scheme of Preferences) has created on the economy. Trade agreements are far from a “quick fix”, with trade negotiations being notoriously drawn out, and a source of strong opposition in Sri Lanka. The last agreement we signed was the first one in a decade, and the Government should take care to ensure a lapse of that length does not repeat itself.

Even though South Asia has been replaced by East Asia and the Pacific as the fastest-growing region in the world, the potential in this region is significant and should be leveraged for our benefit. While the world watches on as Brexit takes place, the Asian region is heading in a more promising direction. The Regional Comprehensive Economic Partnership (RCEP) has 15 participating countries in the Asia-Pacific region and includes almost one-third of the world’s population and global domestic product. This is an ambitious target, but we should at the very least explore bilateral trade agreements with our neighbours, and give our export industries easier access to these markets.

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Reducing govt. spending with 100,000 new jobs?

In this weekly column on The Sunday Morning Business titled “The Coordination Problem”, the scholars and fellows associated with Advocata attempt to explore issues around economics, public policy, the institutions that govern them and their impact on our lives and society.

Originally appeared on The Morning

By Aneetha Warusavitarana

From unannounced inspections of government offices to broader commitments to bring the public service to its former glory, the catchphrase for our new Government is efficiency. In the case of some policy measures, the Government has stood by their statements,and has taken steps to curtail the excesses and inefficiencies of the State. The most recent step towards achieving this was highlighted by a presidential circular which limited the allowances and official vehicles of chairpersons, while also directing state entities to reduce unnecessary expenditure, and create a 25% saving from their approved budgets. While it remains to be seen if these cuts in state expenditure will materialise, the sentiment can be applauded.

Efficiency in the public sector combined with a reduction of government spending plays a bigger role for the Government, and goes beyond the objective of providing quality services to the public. It is common knowledge that while we are now upper middle-income, the country has to face some challenging economic realities. There are significant debt repayments that have to be made, and the projected growth rate for the economy is not promising at 3.5%.

Recent tax cuts have raised concerns that the drop in government revenue will exacerbate the problem rather than improve it. Sri Lanka has been downgraded by two major credit rating agencies; Standard and Poor’s (S&P) and Fitch Ratings, both of which have stated the tax cuts and an expectation that fiscal consolidation will be left on the wayside as one of their rationales behind the downgrading.

Countering these claims, the Government has argued that the tax cuts will provide a much-needed stimulus to the economy, and will trigger economic growth. It also argues that the loss in revenue will be offset by a reduction in public expenditure as excesses of the State are curtailed and spending is prioritised. Efficiency is a key component in the Government’s argument that the country’s macroeconomic status will be a promising one in the coming years.

100,000 jobs we can’t afford

With parliamentary elections around the corner, the pressure to secure a majority is mounting, and the Government has announced that it will provide 100,000 jobs in the government sector – a surefire way to secure votes. This increase in government jobs is in contradiction to its aim to reduce government expenditure; these new entrants into the government service have been promised a salary of Rs. 35,000, creating an increase in government expenditure that we can ill afford. Salaries already constitute the second largest source of government expenditure, and this has long-term implications as pension commitments grow.

The provision of these jobs is part of the work carried out by the Multi-Purpose Development Task Force. The objective of this task force is to empower families that are eligible for Samurdhi benefits, but do not receive it. The programme will absorb unskilled individuals who have either low levels of formal education or no formal education at all. These individuals will be recruited to fill vacancies that do not require specific qualifications at schools, hospitals, and other state institutions. Candidates will also be absorbed into sectors of masonry, carpentry, agriculture, fisheries, and forest conservation, with training provided.

Confusingly, the Government expects to reduce annual expenditure on agri-product imports by Rs. 2 billion through this employment scheme. Even if this increase in employment will boost agricultural productivity to a level in which the country saves on imports, this saving will not entirely offset the increase in expenditure on salaries.

Even though the objective of economic empowerment is commendable, there are once again questions that need to be raised. Targeting of families for Samurdhi benefits is notoriously poor, and there is no guarantee that the Government will be able to target individuals for this scheme any better. There are better and more effective ways to create meaningful economic empowerment – investing in vocational training programmes tailored to labour market gaps in the private sector would, for instance, be a workable alternative to handing out jobs.

Bloated government service and corruption

While this increase in government jobs is not in line with promises to continue fiscal consolidation, there are also more worrying consequences to this decision. The Government has promised to crackdown on the corruption that runs rampant in the government sector, but beyond that by increasing the size of the state sector, the Government is increasing opportunity for corruption. In instances where a country’s institutions are weak, self-interested individuals have greater opportunities to engage in rent-seeking behaviour.

Additionally, at this point in time, the Government should be focused on placing limits on the government service – greater numbers most rarely result in increased efficiency, and leaving efficiency aside, this is a step that the Treasury can ill afford.

Given that efficiency in the public sector and limited government expenditure are part of the Government’s plan to turn around the economy, as well as ensure economic stability if not growth, these hires are not only short-sighted, but are also economically damaging.

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An island of potential?

In this weekly column on The Sunday Morning Business titled “The Coordination Problem”, the scholars and fellows associated with Advocata attempt to explore issues around economics, public policy, the institutions that govern them and their impact on our lives and society.

Originally appeared on The Morning

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By Aneetha Warusavitarana

Micro, small, and medium-sized enterprises (MSMEs)are constantly a part of policy discussions. They are described as the backbone of the economy, an important source of employment, and drivers of innovation and change. Successive governments have identified these enterprises as a focus for government help and have acted on this. We have seen a variety of loan schemes especially targeted at these enterprises under a variety of different names. More recently, we have witnessed the Government introducing a credit support scheme for small and medium enterprises (SMEs) in an attempt to assist struggling businesses.

But what do we know about our micro and small enterprises?

When one thinks of a micro or small entrepreneur, what comes to mind is the grocery at the corner of your road the vadai cart at Galle Face or the small tailoring business you run to for a last-minute adjustment. While Sri Lanka’s “start-up” ecosystem is growing, and we are witnessing an increase in tech start-ups and other innovative microenterprises, this is a fairly accurate description of what Sri Lanka’s micro and small entrepreneurs look like.

In October 2019, as part of a larger research project, the Advocata Institute commissioned an islandwide survey of 1,500 micro and small entrepreneurs across the sectors of industry, services, and trade. The purpose of the study was to understand and identify the barriers that these enterprises face during the course of setting up and running their businesses. Apart from the focus on barriers and obstacles, the survey also looked into the motivations and expectations of these entrepreneurs to understand why they decided to strike out on their own and where they see their business in the future.

Why do Sri Lankans start their own businesses?

A majority of these entrepreneurs were motivated by a desire to run their own business and try out a new idea, a need to support their family, or a belief that they could make more money working for themselves than for someone else. When asked, 43% of women cited a need to support their family as a driving factor behind their decision, compared with 28% of men. Among men, a desire to run their own business was the most common reason provided, with 40% stating so. Only 12% of the respondents started their own business because they couldn’t find employment elsewhere and only 11% because they had no other means of survival.

While this paints a picture of people driven by a desire to strike out on their own and take risks, those in lower socioeconomic classes were more likely to start a business for reasons of survival – because they lost a previous job, couldn’t find work elsewhere, or simply needed to support their family.

Across the island, entrepreneurs were overwhelmingly positive about the future of their business, with 91% certain that they can make their business a success. Interestingly, when asked if offered a salaried position as an alternative, only 15% said they would close their business and take up the position, while 67% stated that they would not take up the position and the remaining 18% were uncertain. Given the opportunity, only 15% would leave Sri Lanka to work abroad, with 60% disagreeing with that statement. It is clear that our entrepreneurs have a rosier outlook on the business climate than most economic pundits, and have a determination to make their business a success.

What stands in their way?

When asked how their business has performed over the last two years, although their outlook was positive, 40% of entrepreneurs said performance has been alright, but could do better. 32% ranked their performance as either poor or very poor, while only 28% perceived their business performance to be good or very good.

The reasons they provided ranged from high competition, unsupportive government policies, and the Easter Sunday terror attacks to a lack of market access and business networks and an excess of regulations and restrictions. The question of what is holding our small and micro entrepreneurs back is one we tried to explore in greater depth through the survey. Sourcing finance, low sales, and difficulties in finding space were the most common problems cited.

How do we help these businesses?

Finance is often where governments intervene, with an aim to help or assist these enterprises. Under the credit support scheme introduced by the Government, performing and non-performing loans of up to Rs. 300 million are eligible for a capital moratorium, but interest payments will continue to be charged.

While this scheme provides relief for small and medium entrepreneurs, it does address the issue that these entities struggle to find access to finance. Focusing on how this problem could be eased, and how information could be better disseminated on options available, may be a better angle to take.

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New year, same Sri Lanka?

In this weekly column on The Sunday Morning Business titled “The Coordination Problem”, the scholars and fellows associated with Advocata attempt to explore issues around economics, public policy, the institutions that govern them and their impact on our lives and society.

Originally appeared on The Morning

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By Aneetha Warusavitarana

We entered 2019 on the back of a constitutional crisis, with the anticipation and uncertainty that accompanies any year which entails a presidential election. It is safe to say that a lot has happened in the year 2019. The country was devastated by the Easter Sunday bombings and had to slowly piece itself back together. The presidential election came and went and the country has a new President and Prime Minister. In a few short months, the general election will be held and the new Parliament will be voted in. It is a difficult year to take stock of and summarise, but looking forward, what can we expect for 2020? More importantly, what should we be expecting and how do we hold our Government to account?

Are we going to see an economic turnaround?

The country has witnessed quite a drastic turnaround with the introduction of a slew of tax cuts by the President within days of being appointed. The intention of these tax cuts is to ease tax burdens and provide a stimulus to the economy. However, the resulting drop in revenue has been estimated to be 2% of GDP. The Government has taken a few steps to counter this by raising excise duties and the Ports and Airports Development Levy. It has also committed to tightening government spending in the upcoming months, as it aims to maintain the budget deficit below 4%. Regardless, the Government appears quite ambitious in its goals for 2020, with economic growth targeted to double this year. The outlook presented by the Government is one that is fiercely positive.

Others are more sceptical. Sri Lanka’s sovereign credit rating has been downgraded to “negative” by Fitch Ratings, with the tax cuts cited as one reason for this drop. They also expect to see government debt increase in the medium term and argue that the tax increases will not be sufficient to counter the cuts that have been made. The increase in excise duty, for instance, will only cover 10% of the revenue lost by the VAT reduction. They do acknowledge that future policy steps could mitigate these concerns and while they expect the budget deficit to widen by 1.5% of GDP, they expect to see an increase in GDP growth by 3.5% in 2020 as well.

What does all of this mean to the individual?

Projections and policy statements are all well and good, but these numbers and percentages take time to translate into anything meaningful to an individual. The recent increase in the prices of vegetables has a greater impact to the voter than what is outlined in the paragraphs above. Sri Lanka’s graduation to upper middle-income status has not necessarily been felt by all Sri Lankans. According to the Household Income and Expenditure Survey (HIES), the mean household income per month is Rs. 52,979. An individual’s mean income per month is Rs. 33,894. An increase in these numbers would be something meaningful. The opportunity to work in decent employment and see an increase in wages is probably what would improve the living standards in this country.

The Government has however tried a different tack with this problem. Following in the steps of innumerous governments before them, they have promised to increase hires into the government service. In a novel twist, the Government has promised to employ 100,000 individuals, selected from families that are recipients of the Samurdhi benefit. The rationale appears to be to give jobs to those most vulnerable. While this is a worthy sentiment, the implications of this policy should be seriously considered. Despite the change in Samurdhi allowance from Rs. 3,500 to a salary worth Rs. 35,000 for each individual, this policy measure further expands the state which already accounts for roughly 14% of the labour force in the country. Salary payments are a substantial component of government expenditure, only coming second to interest payments on our loans.

As the Government appears to embed itself deeper into our economy and takes on such significant policies, it is important to remember that the brunt of their oversight increases the burden on taxpayers. Although it may not feel like it, macroeconomics do shape our everyday lives and if the Government is unable to continue on a path of fiscal consolidation with careful expenditure management, the impact will be borne by us.

New Year’s resolutions

At this point, it is difficult to predict where the country is headed. Given that the parliamentary elections are around the corner, it is possible that some ambitious policies like the moratorium on small and medium enterprise loans and the increase in government hires are simply to garner public favour. Policy direction may change towards the middle of the year. Regardless, there are a few things to consider and a few facts that are unlikely to change: We have debt repayments to make, and unless the Government wishes to default, there should be careful fiscal management to ensure that we are able to meet these commitments. The country is in dire need of economic growth. We need to attract investment and kickstart the economy. Sri Lanka needs to plan beyond four years if we are to escape the dreaded economic boogeyman: The middle-income trap.

A big part of achieving this is holding the Government accountable. In present times more than ever, this is vital. Sri Lankans, like all people, are not fond of paying taxes – a fact reflected in our low rates of collection. We do however pay them, in various forms and in varying degrees. This money that we hand over to the Government is what partly funds policy decisions, giving us the right to demand accountability and transparency. As we close off an action-packed decade and open this new chapter, it is crucial that we stay committed to ensuring that we get the future we were promised, and the future we deserve.

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What do we know about the MCC agreement?

In this weekly column on The Sunday Morning Business titled “The Coordination Problem”, the scholars and fellows associated with Advocata attempt to explore issues around economics, public policy, the institutions that govern them and their impact on our lives and society.

Originally appeared on The Morning

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By Aneetha Warusavitarana

Late last month, in a major breakthrough, Sri Lanka’s Cabinet of Ministers approved the implementation of the $ 480 million Millennium Challenge Corporation (MCC) grant and released the final draft of the grant agreement to the public for review.

The agreement has indeed been at the heart of heated debate and political scuffle in recent months, with the President refusing to approve the agreement before the end of his term, a fundamental rights (FR) petition against the signing of the agreement being filed in the Supreme Court, and even a protest fast being staged earlier in the week.

But with the agreement out in the public with continued avenues for negotiation, Cabinet appraisal, and the Attorney General’s (AG) stamp of approval, what does Sri Lanka have left to be concerned about?

Who is the MCC and what do they do?

The MCC was created by US Congress in 2004 and is an independent US foreign aid agency. Since its inception, the MCC has signed 37 compacts with 29 countries, with an expected benefit to approximately 175 million people. These countries have to meet stringent eligibility criteria in order to qualify for an MCC grant, as funding is dependent on governments demonstrating that they are committed to democracy, investing in their citizens, and economic freedom.

The MCC describes its selection process as “competitive”, with a clear selection process through which recipient countries are chosen. Using the World Bank’s classification of countries based on per capita income, candidate countries are selected. From here, country selection criteria and methodology are published, and performance on these indicators is assessed and published in a scorecard.

It is based on these country scorecards, the opportunity to reduce poverty and generate growth in a country, and the availability of funds that a final decision is taken.

Additionally, the MCC places emphasis on the work being country-led, meaning that the Government of Sri Lanka identifies its growth priorities and develops MCC proposals accordingly. Sri Lanka began negotiations with the MCC in 2004 and was selected by the organisation as eligible to develop a compact in 2016. Sri Lanka’s project proposals for the compact were submitted to the MCC Board in November 2017 and the Sri Lanka compact was approved by the MCC Board in April 2019.

However, the agreement has been on hold ever since. As the organisation traditionally only funds low and lower middle-income countries, Sri Lanka’s recent graduation to upper middle-income status has now put its eligibility for the MCC grant into jeopardy, unless the agreement is signed prior to 2020 as the country does not feature on the organisation’s 2020 scorecard.

What does the grant fund?

The main points of contention centre on the question: Where is the money going and what does this funding mean? According to the publicly available draft agreement, the MCC is providing this grant to address two of Sri Lanka’s “binding constraints” to economic growth: (a) inadequate transport logistics infrastructure and planning and (b) lack of access to land for agriculture, the services sector, and industrial investors.

These are constraints identified through a comprehensive constraints analysis conducted by the Government of Sri Lanka and the MCC, in partnership with Harvard University’s Centre for International Development.

To address these constraints, the MCC will be funding two main projects – the transport project focuses on improving traffic management, improving the road network along the Central Ring Road for better connectivity between the Western Province and peripheral provinces, and the modernisation of the public bus system.

The land project focuses on creating a parcel fabric map and inventory of state lands, digitising the deeds registry, facilitating the ongoing work to move Sri Lanka from a deed registration system to a title registration system, digitising key valuation information for properties in targeted districts, and establishing land policy councils to support the Government’s work on land policy and legislation.

The agreement states the projects are expected to benefit approximately 11 million individuals over a 20-year period – around half of Sri Lanka’s total population.

Why are people against the MCC agreement?

There have been two main arguments levelled against this agreement. The first is that the land project will mean that land owned by the Sri Lankan Government will be available for purchase to the American Government.

The second argument is that the MCC agreement is an attempt to undermine Sri Lanka’s national security. While both of these claims have been denied by MCC Resident Country Director Jenner Edelman, an air of suspicion still remains.

Indeed, Sri Lanka is commonly cited as a case study of debt-trap diplomacy in the region and there is merit to the argument that the Government should be vigilant in reviewing the terms and conditions of future development agreements.

However, upon review of the publicly available resources of information, the MCC grant does not involve the lease or transfer of ownership of any Sri Lankan land and does not require Sri Lanka to pay back any of the grant amount, as long as the agreement is not explicitly violated.

This is a standard safeguard that is characteristic of international aid agreements used to ensure that the grant money is used exclusively to achieve the goals of the compact and does not fall into the wrong hands.

Other concerns pertaining to the construction of a physical economic corridor, connections to SOFA and ACSA agreements, acquisition of Sri Lankan land by the US Government, undervalued land transactions, establishment of US colonies and/or army bases, construction of electric fences, and destruction of the local environment have also been confirmed as baseless upon review of the agreement.

The document clearly stipulates that the Sri Lankan Government has “principal responsibility for overseeing and managing the implementation” of the projects, and a signed legal opinion from the AG of Sri Lanka must be acquired before the agreement is entered into force.

Even after the agreement has been signed, Sri Lanka still has the option to modify the agreement, provided that these modifications do not exceed the allocated funding allowance or extend the grant term of five years.

The agreement will also not come into force until it has been submitted to and enacted by the Parliament of Sri Lanka, providing ample safeguards to ensure all relevant stakeholders are involved in the approval process. Concerns around the failure to submit the agreement to Parliament prior to its signing have been deemed unreasonable by Minister of Finance Mangala Samaraweera, who stated that Parliament cannot debate an unsigned document.

The argument of the Opposition that the agreement should be put on hold until after the election also presents serious risks of losing the grant altogether, due to Sri Lanka’s recent graduation into upper middle-income status.

While it is important for Sri Lanka to consider all of the implications associated with enforcing the MCC compact, it is equally important to consider the benefits that could be lost if the Government continues putting off approving the agreement any longer.

At no cost to Sri Lanka’s Treasury, the compact presents a rare opportunity for Sri Lanka to address some of its most prominent infrastructure issues and binding impediments to growth. With a current public debt-to-GDP ratio of 82.9%, the Treasury cannot afford to address these issues on its own, and grants like the MCC are only going to become harder to come by with Sri Lanka’s new income status. Regardless of which government comes into power over the next year, Sri Lanka should not let this opportunity slip away.

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What good is a handbook that’s not followed?

In this weekly column on The Sunday Morning Business titled “The Coordination Problem”, the scholars and fellows associated with Advocata attempt to explore issues around economics, public policy, the institutions that govern them and their impact on our lives and society.

Originally appeared on The Morning

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By Aneetha Warusavitarana

State-owned enterprises (SOE) are infamous for their losses. According to the 2018 Ministry of Finance Annual Report, the main 54 SOEs made a net loss last year, amounting to Rs. 26,070 million. With the Committee on Public Enterprises being opened up to the media, coverage of both losses and mismanagement of SOEs has flooded newspapers.

It is abundantly clear that the plethora of SOEs in the Government are unable to function without a constant stream of funds from the Treasury. In 2018, budgetary support for recurrent expenditure of the main 54 SOEs came to a total of Rs. 58,519 million.

The chart below lists the five state-owned enterprises which receive the greatest quantity of Treasury Guarantees, just one example of the money that flows out of the Treasury to sustain these entities. When it is Sri Lankan taxpayers’ money that keeps these entities above board, the question of the hour is why isn’t there better management?

What is the Government’s approach to governing SOEs?

Extensive work has been done on international and regional case studies of good governance for SOEs. Restructuring and partial privatisation of inefficient SOEs have been proposed, while some SOEs could be lined up for complete privatisation. While organisations such as the Organisation for Economic Co-operation and Development (OECD) and World Bank have provided clear guidelines for governance and improved management of SOEs, so has the Sri Lankan Government.

The Committee on Public Enterprises (COPE) is a well-known government mechanism established to hold SOEs to account. The committee is empowered to publish reports which evaluate selected SOEs – investigating hiring irregularities and issues in procurement, and auditing their finances. The reports are usually a hair-raising read, speaking of special employment grades created with high-wage allocations of money that simply cannot be accounted for, and situations that can only be described as odd – for instance, why was the Sri Lanka Ports Authority building a cricket stadium in Sooriyawewa?

In 2018, the National Human Resources Development Council (NHRDC), with the Institute of Chartered Accountants (CA) launched a “Handbook on Good Governance for Chairmen and Directors of Public Enterprises”. This handbook was meant to act as a guide for Sri Lankan SOEs, placing emphasis on the fact that as SOEs run on the money and resources of the Sri Lankan people, and as such, it is important that there is proper management. The handbook is comprehensive – detailing the frequency of board meetings, responsibilities of key officials, and emphasising the need for regular financial reporting.

The handbook places responsibility for financial discipline in the public sector, including public enterprises, with the Minister of Finance, and the General Treasury is able to act on the Minister’s behalf. The duties of the boards of these SOEs are also detailed on, and ensuring proper accountability by maintaining records and books of accounts are one of the many responsibilities which fall on the board. The chief financial officers are responsible for accounting and budgetary control systems.

On the point of monitoring and evaluation, the handbook is clear. It calls for monthly reporting in the form of performance statements, operating statements, cash flow statements, liquidity position and borrowing, procurement of material value, statement on human resources, as well as a separate performance review if the entity is a commercial corporation or a government-owned company.

The reality: Turning a blind eye to good governance

While the COPE and the handbook on good governance are two mechanisms put in place by the Government to ensure good governance of SOEs, the reality of how our SOEs are run is vastly different. The Ministry of Finance has identified 54 “Strategic State-Owned Enterprises” – the profits and losses of these entities are monitored by the Ministry of Finance, and are published in its Annual Report. However, this is where any structured financial reporting from SOEs ends. In 2017, only 28 of the 54 strategic SOEs have submitted annual reports to the Ministry of Finance. Advocata’s report on the “State of State-Owned Enterprises: Systemic Misgovernance” identifies a total of 527 SOEs, including the plethora of subsidiaries and sub-subsidiaries that exist. On the other hand, the Ministry of Finance Annual Report 2018 only mentions a total of 422 enterprises, and does not publish their financial statements. In this context of minimal oversight, there is no wonder that the losses incurred by these entities are this high.

The next step: Dissolution

A key recommendation that has been presented in response to the losses incurred by SOEs is privatisation, or at least partial privatisation. It could be implemented on a case-by-case basis, evaluating entities on both their performance and the type of service that is provided, which would be one way for the Government to stem the losses that pour out of the Treasury. While calls for privatisation have often elicited an unfavourable response, it is interesting that the handbook published jointly by the NHRDC and CA has a section on criteria for dissolution of SOEs. To quote from the handbook: “Dissolution of a public enterprise would arise under the following circumstances:

(a) When objectives for which the enterprise was created have been achieved and continuation is no longer required

(b) On the basis of policy directions of the Treasury/Government

(c) When the enterprise is faced with losses and liquidity problems or is not viable due to other reasons

(d) Merger or amalgamation with other enterprises.”

The question that remains is why is the Government continuing to run these enterprises, despite the losses that they incur? The losses, corruption, and clear practices of political patronage make it clear that by not taking action, the Government is actively choosing to mismanage the funds and resources of the people, for personal gain. It’s high time some of these recommendations, guidelines, and committee reports were actioned.

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