Our depressing debt diagnosis

Originally appeared on The Morning

By Dhananath Fernando

Sri Lanka must understand how it got here before getting out of here

Last week, the Central Bank announced all export proceeds should be brought into the country within 180 days of shipment. Additionally, they stated that all exporters should convert 25% of their foreign currency earnings to LKR from the invoice value upon entry into the country. This was brought in just a few weeks after they restricted forward purchasing for importers. With these two moves, Sri Lanka’s debt sustainability has come under the spotlight once again. Recent reports from Standard Chartered Bank and Barclays Bank have also contributed to the discussion.

It is clear that the Government and the Central Bank are looking at the problem differently to how investors, financial markets, and other stakeholders perceive the problem. Indeed both sides share their opinion with good intentions of overcoming the current turbulent time. 

As per recent media reports and a press release by the Central Bank, their objective is to build non-borrowed foreign reserves in order to meet our debt commitments. The Government is looking at the problem as a cash inflow-outflow problem. Accordingly, the Government expects about $ 32-35 billion inflows, about $ 15 billion from exports, about another $ 7 billion from remittances, and about $ 1.5 billion from tourism, with foreign direct investments (FDIs) and other transfers, etc. filling the balance.

On the outflow side, the Government expects about $ 19 billion for imports and sovereign bond payments are about $ 2 billion every year, so the debt can easily be served without any problem according to the reports. It further states that total sovereign bonds are about $ 15 billion which is about 17% of total debt, and none of the other creditors have made any concern over our debt sustainability. Recently, the Governor made remarks that the Central Bank buys about $ 10 million per day to build up reserves so we can cover all debt commitments. According to his view, the outlook on exports, FDIs, tourism, and remittances looks positive with the vaccination drive. 

On the other hand, investors and other agencies are of the view that reprofiling debt with International Monetary Fund (IMF) support is the best solution at hand as our foreign reserves are eroding faster than expected. They see the problem as a solvency problem rather than a cash flow problem; that we need to buy time to bounce back with a lesser impact on the entire economy. It’s not that all reserves are liquid as some reserves are in gold and some IMF commitments and swap commitments are already included in the available reserves of about $ 5 billion. The question from the investors is: “If the cash flow is smooth, why does it continue to erode the reserves which are now at a historic low?” In this context we have to evaluate what we should do and what is possible to do.

Let’s get into the basics. In the debt discussion, we have all been debating on how we can settle the debt and how we can keep our noses above the water. But we should not forget the reasons that brought us to where we are today. We borrowed beyond our capacity at high interest rates and invested in projects which generate returns far less than our payment capacity. In other words, we borrowed at market rate and invested in non-tradable goods which did not generate any tradable return necessary to repay a part of the debt. Since we have failed to avoid the causes of the problem, now we have to pick the best possible escape route from the problem.

Secondly, in my view, we have to estimate the extent to which we can build up reserves by buying USD from the market given the current policy stance. The Government has committed to a policy to keep the interest rates unchanged and keep the exchange rate to USD in the Rs. 185 range. We need to understand that the USD inflow estimate of about $ 15 billion is not owned by the Government but by the exporters, and so are our remittances. The same applies for the imports where importers have to have money from the market to import the basics such as fuel, pharmaceuticals, etc. In this context, to build up the reserves, the Government has to buy USD from the market and that is how the Government can capture the USD available in the market from exporters. To do that, the incentive structures have to be there for exporters to sell more USD rather than save USD. Currently, the interest rates for USD are higher than interest rates for LKR accounts, so expecting a currency depreciation, the market perception is more skewed towards keeping their money in USD form. To overcome that incentive discrepancy, when the Government imposes a regulation to procure the USD earnings by exporters within 180 days and to convert 25% upon shipment, it is likely that the exporters under invoice consider options to park their money in offshore accounts, which will further erode our inflows. 

At the same time the regulation will impact some exporters who run on thin margins who have a portion of imports in their exports. On the other hand, the companies who have USD commitments and agreements with other companies now have to face extra pressure and loss on conversions due to this regulation. 

In my view, the sovereign debt problem has a broader dimension beyond just calculating cash flow. Because the Government owns the debt and because the USD cash flow is owned by private businesses and individuals, the Government requires a mechanism to capture it either by taxation or mopping up the liquidy from the market by tightening the systems by allowing the interest rates to move upwards. That will slow down the economy. The Government’s current strategy of buying their own Treasury bills and bonds, in other words printing money, will add constant and excessive pressure on imports through channels where the imports are open, though we have a import control policy. At the same time, it is highly likely that the excess liquidity will convert to credit with the economic recovery from Covid-19 and add pressure on inflation and cost of living. We have to keep in mind that while we build reserves by buying USD from the market, we might have to sell some of it again to keep the exchange rate stable. Changes in the exchange rate will affect our debt-to-GDP ratio.

It is true the sovereign nations have the legitimate power to print money, but ultimately what consecutive governments consumed by taking debt has to be paid in real terms by earning it real value, and there is no shortcut for it. Very importantly, while the debate is on as to what route we need to take, we should not forget the reason that brought us here.

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

Why is the President being ‘landed’ with this request?

Originally appeared on The Morning

By Dhananath Fernando

A digital land registry could help our rural masses 

The “Gama Samaga Pilisadarak” is the President’s most recent engagement programme. Positives and negatives of the programme have both been openly discussed on mainstream and social media. As per media reports, the programme is structured in such a way that officials of key ministries, such as Land, Education, and Road Development, visit villages with the President. 

People are then requested to put forward their problems before this entourage of officials. They try to solve the problems at the location itself, directing the state officials to act faster. The President mentioned that following such a course of action has helped build local infrastructure and helps him understand people’s problems better. 

On the contrary, on social media, views have been expressed on forest destruction concerning areas where the President has been visiting, and describing this as an attempt to prioritise development at the expense of our green cover. 

The objective of today’s column is not to provide a commentary on “Gama Samaga Pilisadarak”, but an effort to put things into perspective regarding the most common concerns people have been putting before Sri Lanka’s First Citizen. Secondly, we aim to explore why the very same issues are being repeated in most of the villages. In my understanding, the problems presented to the President are just symptoms of a bigger problem, and it looks like the solutions instantly provided by the officials are just temporary solutions without understanding the problem at its root. 

Most frequent requests made to the President, as have been telecast in the news, are requests for land to conduct agricultural activities. The fundamental question is why solving issues surrounding land has become a common-priority request, as we saw on television, with people screaming and pleading the President to get their land matters solved.

As indicated multiple times in this column, about 80% of Sri Lanka’s land is owned by the Government. Out of that, about 30% is our forest cover. As a tiny island, land is obviously a limited resource in economic terms. Therefore, if we fail to optimise the utilisation of land, all the natural beauty and biodiversity we brag about is most likely to fade away from us. 

Creating land, like what we did with the Port City, is extremely expensive and environmentally costly. The problem lies in the fact that most of the land our farmers cutivate is only under a licence, and they do not have a title. As a result, the farmer has to visit the Divisional Secretariat to obtain a license, renew the license, or even to obtain approval to change the crop they cultivate. 

Smaller and smaller portions

Most of these lands our farmers cultivate are provided under different land and agricultural projects. Over generations when the original land is divided among family members, the land plot becomes smaller and smaller.

For example, look at what happens when the original land of five acres is provided to a farmer, which in turn is divided among his four children. This will get subdivided after the next generation. Now, instead of five acres, only about 25 perches of land will now be available, and this has limited scope for agriculture. As a result of these smaller land plots over generations, industrialisation or commercialisation of cultivating lands is unfeasible.

Employing technology and machinery to increase productivity on a 25-perch land plot is not feasible. As a result, people ask for more lands from the Government, or encroach on forest cover to do their farming.

On the other hand, these lands do not have titles. So farmers are unable to optimise the maximum usage of the land using technology, because they have no source for capital. They don’t have other assets to use as collateral to access finance, nor are the banks willing to provide them loans without any valid collateral.

As a result, the land problem has become a vicious cycle. These circumstances have led to a scenario where a combination of factors continue to make our farmers poorer and our agriculture unproductive, while trapping our farmers in informal loans and creating severe social concerns such as suicide. There is the additional issue of contributing to the loss of our forest cover and destroying our biodiversity. 

If we look at countries that are in deep poverty, one of the common denominators is that the people of those countries do not have their land and property rights. There is no magical formula for an economy to take off without establishing property rights for their citizens. 

The President expressed his displeasure at rumours circulating on social media on the destruction of forest cover, but until we provide a permanent solution to this problem, we will lose out on every front. The President will have to hear the same complaint at every location he visits.

On top of that, the Government has decided to stop all agricultural imports for the next four years, as per reports by The Morning. This will most likely worsen the situation. Food prices will go up, and more farmers will attempt to do agriculture by practicing their unproductive farming methods. 

The rising prices will punish all our poor consumers already suffering from the high cost of living. At the same time, our tourism will suffer, as it needs some imported agricultural products to prepare the cuisine. However, it is understandable that balancing such a dilemma when foreign reserves are depleting is going to be a serious challenge.  

What is the solution?

The President has a greater opportunity to capitalise on this matter economically as well as politically. We have to have a digital system and a digital land registry. As soon as the “digital land registry” is spelled out, many associate it to the three-letter “MCC” agreement. That is now gone, and there is very little value in debating it now. 

But over the next four years, the President can prioritise the digital land registry, which will mark forest cover on the cadastral survey system with GPS coordinates. It will increase Government efficiency drastically, release the dead capital of land among farmers, and investments will start kicking off. Most of the back-end work has been done, and cases for the need for a digital land registry have been developed. 

The question is: how are we going to find money to implement the survey and purchase the technology? We have to seek out multilateral donor agencies, or a potential bilateral loan, to secure the funding, as this will create massive economic potential. Setting up a digital land registry will be significantly impactful, rather than just developing a road or incurring another massive capital expenditure. 

This is an action which will move us upwards in the Ease of Doing Business Index, and build investor confidence. At the same time this will fall perfectly in line with the President’s manifesto of “Vistas of Prosperity and Splendor” under a digitised economy. 

The ripple effect will trickle down to smaller cases at courthouses, as well as to micro and small business enterprises when the project unfolds. 

Since there have already been many land deed programmes such as “Jayabhoomi” and “Swarnabhoomi”, this will not be a simple and easy project. Having the simple digital infrastructure ready is the first step to address these issues, both at present and in the long term. 

The main opposition comes from lawyers, as they are the main beneficiaries of delayed court proceedings. If the President focuses on this single reform, it will not only be the best-ever environmental conservation reform to protect our green cover, but also a historic economic reform to unlock our dead capital, and reactivate capital markets and agriculture. Most importantly, it will be a big relief for our farmers and fellow Sri Lankans.

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

Growth, productivity and competition: Time to shift gears

Originally appeared on Echelon

By Ravi Ratnasabapathy

The Sri Lankan economy has been running, metaphorically speaking, in second gear. It’s time to shift up if we want standards of living to improve.

What determines the ‘standard of living’? Economists measure it in terms of the value of goods and services; when this grows, living standards improve.

Resources – land, labour and capital – and the extent to which they can be harnessed for productive purposes through entrepreneurship are the building blocks of the economy: what people use to produce goods and services. Having a large resource endowment, like oil, is an advantage. Sri Lanka has restarted efforts in oil exploration. In any case, it is better not to pin all our hopes of development on a chance oil strike.

So far, our development has been conventional. Like other poor countries, Sri Lanka has brought previously idle factors of production – land, labour and capital – into productive use.

Post-war, the integration of the North and the East expanded its limited pool of resources. This stage of growth is termed input-led, and is determined by the amount of input that a country can muster.

Once a country reaches middle-income status, especially upper-middle income levels, marginal returns to resources diminish and growth slows. The country also runs out of resources to bring into production: available land gets used, labour is fully employed, the population ages and incremental returns of capital slow down. The growth model is exhausted, so the economy stagnates. The production possibility frontier is reached. Sri Lanka is approaching this stage, as there is not a lot more stuff that can be thrown into our economic ‘pie’.

Sri Lankans today are, on average, much better off than their grandparents were. Some have become very wealthy, but there are still too many people who are relatively poor. The rich will be content, but less so the poor. If the population grows, living standards will fall, unless growth of the economy exceeds that of the population. Now, we face a conundrum. The total value of goods and services must increase, but such idle ‘factors’ are no longer available. The limits of its input have been reached.

From this point, the way to grow is through ‘productivity’. In economic terms, productivity depends on both the value of a nation’s products and services, measured by the prices they can command in open markets, and the efficiency with which they can be produced. It is the overall increase in value that makes high wages possible.

“Once a country reaches middle-income status, especially upper-middle income levels, marginal returns to resources diminish and growth slows”

Productivity matters at all stages of growth, but its importance increases as the production possibility frontier is reached. The New York Times columnist Paul Krugman said, “Productivity isn’t everything, but in the long run, it is almost everything. A country’s ability to improve its standard of living over time depends almost entirely on its ability to raise its output per worker.”

The challenge for a middle-income country such as Sri Lanka is how to create the conditions for rapid and sustained productivity growth. Rich economies produce, consume and invest in entirely different goods and services than poor economies. Economies typically move from primary products such as agriculture into manufacturing and services. This structural transformation—the movement of labour from low-productivity to high-productivity sectors—depends on the demand for labour in high-productivity sectors, and the supply of labour from low-productivity sectors. A multitude of factors affect this, but it is broadly driven by investment in more productive sectors and a regulatory regime that facilitates the movement of labour and other resources.

While new investment is important, export-oriented investment is especially important in smaller countries. According to an IMF working paper titled ‘Economic Benefits of Export Diversification in Small States’ (McIntyre et al, April 2018), “Openness to trade provides small states the chance to overcome the limitations of size through access to larger markets and opportunities to achieve economies of scale in production. Moreover, openness to foreign investment generally promotes long run growth through knowledge and technology transfers from foreign to domestic firms.”

However, the productivity of the domestic market cannot be neglected and the spur to this is competition. In ‘Building the Microeconomic Foundations of Prosperity: Findings from the Business Competitiveness Index’, Porter says, “Purely local industries also matter for competitiveness because their productivity has a major influence on the cost of living and the cost of doing business, not to mention their level of wages. The productivity of the entire economy matters for the standard of living, not just the traded goods sector.”

Open and vigorous competition in the local market will see the least efficient firms exiting the market, while market shares are reallocated from less efficient to more efficient firms, which causes overall productivity to rise. Porter also states, “Productivity is the goal, not whether firms operating in the country are domestic or foreign owned. What matters most is not ownership, but the nature and productivity of the companies’ activities in a particular country.”

The government has a two-fold role to play in this structural transformation; it must facilitate the increase in productivity and help manage the costs. Many elements are involved. Investment is needed, especially in new areas, so prudent fiscal and monetary policy is a precondition.

Investors seek low transaction costs and high certainty, and these characteristics are best secured by institutions (judiciary, public administration, the financial system, regulatory agencies). High-quality laws, courts and bureaucracy increase efficiency. Stable, accessible and clear laws; limited discretion (bureaucratic/ministerial); low corruption; and consistent/ impartial court rulings increase predictability. All these influence investments in physical and human capital, technology, and the organisation of production.

The importance of exports has already been stressed, but we cannot rely on garments and tourism; diversification is needed for much faster growth. In 2000, export revenue of both Vietnam and Sri Lanka was around $2 billion. In 2017, Sri Lanka’s exports reached $11.4 billion, but Vietnam achieved $162 billion. Over the period 2000-14, Vietnam added 48 new products to its export basket with a per capita value of $545, while Sri Lanka added seven, with a per capita value of $5. Moving to higher-value sectors will support higher wages in exports.

In the domestic market, the weakest sector is agriculture, which absorbs about 28% of the workforce but contributes only 8% to GDP. Policy to speed up the modernisation of agriculture – helping producers acquire scale, invest in food processing, encourage crop diversification and improve productivity (mechanisation, drip irrigation, greenhouses, quality seeds etc) – is needed. Land policy needs review, and support for R&D must replace subsidies and price guarantees. Reforms to provide tenants and smallholders proper ownership or tenure could inject dynamism to agriculture. It requires careful study and needs to be geared to local circumstances, but the experience of Korea and Taiwan are worthy of study: “Land reforms in the Republic of Korea and Taipei, China, also led to rapid structural transformation in three ways. First, the land reforms led to increased incomes among poor farmers in the two countries, who could then invest some of the income in the schooling of their children. [The increase in agricultural productivity in Taipei, China, was particularly striking, with yields of traditional crops such as rice and sugar increasing by half, and that of fruits and vegetables doubling (Studwell 2013).] This led to the availability of a skilled workforce in the Republic of Korea and Taipei, China, necessary for rapid export-oriented industrialization. Second, increased incomes in rural areas led to an expansion of the domestic market in the manufacturing sector, fostering rapid industrialization. Third, the more egalitarian land distribution provided a stable political environment, which allowed the political leaders of the two countries to concentrate their attention on rapid industrialization.” (Ban, Mun, and Perkins 1980; Putzel 2000; Studwell 2013).

Trade liberalisation is needed to promote competition and improve efficiency in the domestic market. Tariffs or subsidies may be replaced by supporting the adoption of new technology and R&D, and enhancing worker skills.

Improving the quality of the factors will improve productivity: infrastructure to improve physical capital, and education to improve human capital.

“The richer sections of society may not see a need for reforms, but if broad-based growth is not maintained, the destructive ethnic tensions of the past could resurface”

The process of reallocation is disruptive, it involves changes in the size and make-up of an economy, and the distribution of activity and resources among firms and industries. Some sectors will
shrink, or even disappear, and new ones will appear. Firms will close or downsize, while others set up or expand. Some workers may find it difficult to transition, so there is a need for income support for displaced workers and to foster reintegration through training and job search assistance. The focus should be on protecting the worker, not the job.

Sri Lanka’s economy has undergone some structural changes since 1960. According to ‘The Sri Lankan Economy.

Charting A New Course (ADB 2017), “The share of agriculturehas shrunk quite rapidly, from about 30% of GDP to a little over 10%. Industry has expanded from about 20% of GDP in 1960 to over 30% by 2015.” Post-war reconstruction helped boost growth, but this has petered out.

The richer sections of society may not see a need for reforms, but if broad-based growth is not maintained, the destructive ethnic tensions of the past could resurface. Improving living standards is the surest way to avoid a return to our troubled past.