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

Originally appeared on The Morning

By Dhananath Fernando

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

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

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

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

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

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

Licensing process

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

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

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

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

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

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

Imports are not the problem

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

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

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

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

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

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

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

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

Fuelling reform

Originally appeared on The Morning

By Dhananath Fernando

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

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

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

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

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

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

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

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

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

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

Price controls worsen drug shortage

Originally appeared on The Morning

By Dhananath Fernando

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

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

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

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

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

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

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

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

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

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

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

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

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

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

References:

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

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

Government must resign itself to reforms – now

Originally appeared on The Morning

By Dhananath Fernando

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

References

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

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

The danger of being anchored in anti-competitive safety

Originally appeared on The Morning

By Dhananath Fernando

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

References:

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

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

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

Repay Foreign Debt or Finance Essential Imports

Originally appeared on Daily FT, Lanka Business Online and Groundviews

By Dr Roshan Perera and Dr. Sarath Rajapatirana

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

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

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

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

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

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

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

The consequences are clear. What will we choose?

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

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

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

National Single Window: Paving the way for paperless trade

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

By Mithara Fonseka and Kavishka Indraratna

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

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

A Background into the National Single Window

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

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

The Mutual Benefits of a NSW

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

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

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

Driving forces for implementation

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Poverty reduction needs to be prioritised with cohesive export-led growth policy framework

Originally appeared on The Daily FT

By Prof. Sirimevan Colombage

In Sri Lanka, around 40% of the population lives below the poverty line, according to expert opinion based on the survey data for 2016, in contrast to the official poverty ratio of only 4%. In the backdrop of the COVID-19 pandemic, the poverty ratio is likely to have reached nearly 50% of the population by now.

Adequate attention has not been given to poverty reduction in policy formulation agendas in recent times. 

An outward-looking trade policy aiming at export-led economic growth is imperative for poverty reduction, as evident from the fast-grown East Asian countries and emerging Asian economies such as Vietnam and Bangladesh. 

SL’s actual poverty 10 times bigger than official estimate

According to the Department of Census and Statistics (DCS), Sri Lanka’s headcount poverty index dramatically declined from 22.7% in 2002 to 4.1% in 2016, as per consumption approach. In computing this poverty index, DCS has used the National Poverty Line (NPL). 

The limitations of using the NPL for poverty estimation have been articulated in his incisive article by Wimal Nanayakkara, Senior Visiting Fellow at the Institute of Policy Studies (IPS) and former Director General of the Department of Census and Statistics. 

He suggests that the World Bank’s Global Poverty Line (GPL) is more appropriate for estimating the headcount index in keeping with international standards. The current NPL is based on the market values of an outdated basket of goods and services drawn from the Household Income and Expenditure Survey conducted by DCS way back in 2002. 

The World Bank’s poverty thresholds vary with the member country’s per capita Gross National Income (GNI). With her per capita GNI of $ 4,060, Sri Lanka reached the Upper-Middle Income Country (UMIC) status ($ 3,996 – $ 12,375) in July 2019, and hence, people who live below $ 5.5 daily income per person are poor based on GPL relevant to UMIC, according to Nanayakkara. 

Sri Lanka’s per capita GNI declined to $ 4,010 in 2019. As it was lower than the revised July 2020 UMIC classification ($ 4,046 - $ 12,535), Sri Lanka quickly slipped back to the Lower Middle-Income Country (LMIC) status ($ 1,036 - $ 4,045) along with Algeria and Sudan, as rightly predicted by Nanayakkara.  The applicable GPL for LMIC is $ 3.20. 

In terms of the GPL of $ 5.5, which is applicable for UMIC, Sri Lanka’s headcount poverty index for 2019 is as much as 40.4%, according to Nanayakkara. This can still be considered as the current poverty position of Sri Lanka, as her per capita GNI is still very close to the lower end of per capita GNI of UMIC, though she is now in LMIC category. 

Thus, the actual number of people living below the poverty line in Sri Lanka is about 10 times bigger than the mere 4.1% of population, as reflected in official statistics. 

Export-led growth for poverty reduction

It is essential to accelerate the rate of growth of Gross Domestic Product (GDP) to overcome poverty. The main ingredient for growth acceleration is foreign trade expansion which enables developing countries to gain market access, economies of scale, capital inflows, technology infusion, productivity improvements and efficiency. 

Open trade has been increasingly recognised as the key driver of employment creation and poverty reduction across the world in recent decades. Exports are critically important for economic growth, particularly for developing countries where domestic markets are small. Exports allow domestic producers to access international markets, and thereby to benefit from economies of scale. 

The world-wide evidence proves that those countries that achieved high export growth are the ones that enjoy high GDP growth and extensive poverty reduction. 

Sri Lanka’s backward technology and innovation

The formidable challenge currently faced by Sri Lanka is to raise her export growth at a rapid pace to achieve high GDP growth so as to reduce poverty. 

The country’s export sector, which is limited to a few low-tech products particularly apparels, has failed to graduate to high-tech and high value-added exports such as electronics and bio-technology products, unlike East Asian countries. This was due to the country’s backwardness in technology and innovation. 

In this regard, Foreign Direct Investment (FDI) can play a major role in fostering export growth by way of facilitating foreign capital inflows, technology infusion and foreign market access.

Trade opening and FDI inflows are found to be the major driving force behind the success stories of East Asian economies. More recent examples are India, China, Vietnam and Bangladesh. Outward-oriented economic strategies adopted in these countries, much later than Sri Lanka, led to foster export-led growth enabling millions of people to come out of poverty. 

Bangladesh: from a “basket case” to an economic powerhouse

Bangladesh is a good example to illustrate how prudent economic policies can turn a poor country, which was once branded as a “basket case”, into fastest growing economy in the Asian-Pacific region. It has become the new economic leader in South Asia with annual GDP growth rate over 6% in recent years, which was driven by the three star-performers – agriculture, garment exports and worker remittances. 

The key factor that fosters export-led growth in Bangladesh has been the liberal foreign investment regime by means of legal protection for foreign investment, generous fiscal incentives, concessions on machinery imports, unrestricted exit policy and full repatriation of dividends. 

Prudent fiscal management too was achieved in Bangladesh containing budget deficit to 3.5 - 4.0% of GDP. It helped to lessen inflationary pressures and to maintain exchange rate stability so as to facilitate the export drive. 

Export-led growth has enabled Bangladesh to reduce poverty from 40% of the population to 14%. In parallel, there have been substantial improvements in social indicators – infant mortality, maternal mortality, undernourishment, school education and adult literacy

Phases of foreign trade regimes

Sri Lanka has oscillated between inward-looking and outward-looking trade policies from time to time since Independence, and therefore, failed to sustain steady export-led growth path so as to bring down poverty levels. 

Perhaps, such policy changes can be conceptualised by using the theoretical framework developed by the US National Bureau of Economic Research (NBER) in its series of studies on trade liberalisation under the direction of Anne Krueger and Jagdish Bhagwati in 1978. They divided a country’s liberalisation process into five phases from trade controls to liberalisation, as shown in the Table.

The NBER studies, drawn from the experiences from different trade regimes in a number of countries including India, Ghana, the Philippines, South Korea and Chile provided ample evidence on the benefits of trade liberalisation.

Sri Lanka’s trade liberalisation under stress

In 1977, Sri Lanka moved from Phase II (NBER classification) of stringent trade and exchange control controls to Phase III marking the initial stages of trade and exchange liberalisation. The liberalisation process had been intensified since then.

In 1994, the Sri Lankan Government accepted the obligations under Article VIII of the Articles of Agreement of the International Monetary Fund (IMF). Accordingly, all restrictions on current account transactions of the balance of payments (BOP) were removed and the Sri Lankan Rupee was allowed to be freely convertible for such transactions. This shift to Phase V (NBER classification) was a major step towards trade liberalisation. 

However, the momentum of liberalisation was short-lived as various types of controls had to be imposed frequently due to the ethnic conflict, balance of payments difficulties, macroeconomic instability and external trade shocks. Thus, the country reverts back to Phases I and II from time to time.

Recent import controls

The country’s BOP situation has worsened since last year due to the COVID-19 pandemic which has adversely affected the export and tourism sectors. The external payments problems have been compounded by foreign debt commitments which amount to $ 6 billion this year. The rise in global market prices of crude oil and other commodities has further pressurised the BOP situation. The likely decline in worker remittances will further enhance the BOP deficit. 

In the backdrop of BOP difficulties, the Government has imposed import controls on a number of “non-essential” goods since last year. These include motor vehicles and various other consumer durables.

These import controls have adverse implications for economic activity, GDP growth and poverty reduction. 

Debt sustainability risks ignored through swaps  

The Government was able to secure $ 1.5 billion swap from the People’s Bank of China last week to meet immediate BOP needs. It is reported that the Government is negotiating with India to obtain another $1.1 billion under swap facility, debt freezing arrangement and development aid.

These swap facilities are temporary solutions to overcome BOP difficulties, and hence, deeper policy adjustments are essential to address the disarrays in macroeconomic fundamentals, particularly debt sustainability risks.   

Keeping IMF at distance

Overwhelmed by the Chinese swap, State Minister Ajith Nivard Cabraal claims that the Government can manage without IMF assistance. In fact, the challenge is to resolve the macroeconomic imbalances, rather than stubbornly refusing to go to IMF. 

Malaysia, which had strong macroeconomic fundamentals during the Asian financial crisis, could afford to refuse bailout from IMF. 

Sri Lanka’s case is totally different with her high budget deficit, unsustainable debt commitments, balance of payments difficulties, slow economic growth and more than anything else, acute poverty. 

It is ideal that if these deep-rooted problems can be resolved by ourselves without seeking anybody’s assistance, leaving aside the IMF.

IMF’s conditionality requires correction of macroeconomic fundamentals with stipulated deadlines. We ourselves can make these corrections without obliging to IMF. It is not happening that way, and therefore, swaps which do not impose any corrective measures, are the easy way out for the authorities to evade the much-needed policy reforms. 

So, the macroeconomic disarrays will remain unresolved forever exerting disastrous effects on the country’s economic growth. As a result, the poor who represent about one half of the population will continue to suffer without having basic human needs met. 

Outward-looking strategy imperative for poverty reduction

The current restrictive trade policy measures, which are based on the inward-looking approach, have been imposed to tackle the BOP difficulties. However, they are detrimental to export-led growth and poverty reduction.  

Hence, a cohesive export-led growth policy framework is essential to address the socioeconomic problems faced by nearly 50% of the population living below the poverty line. Poverty reduction, which is almost ignored in the current economic policy formulation, should be an explicit target of any future growth strategy. 

(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)

Can the ECT buoy the Colombo Port?

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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Sri Lanka’s location at the midpoint of international trade routes, positioned at the centre of the Indian Ocean, is a fact that we probably know by heart. But what’s important is the question whether we are exploiting this position. Our ports and good policy decisions are the tools that allow us to change geography into tangible benefits. The performance of the Colombo Port has been exemplary. It recently handled its seven millionth container and was ranked the fastest-growing port in 2018. However, with the Colombo Port operating at approximately an 80% capacity, this growth and the benefits it brings have an expiration date.

What is the ideal role of the government in the shipping industry?
The government should most definitely not be both a player and a regulator. Right now, the Government plays both roles, and the potential for a conflict of interest is enormous. It also means that it is increasingly difficult for competitive neutrality to be maintained. However, the government should not be completely removed from the industry. The role of the government lies solely in being a landlord and regulator, for if the Colombo Port is to grow while remaining efficient and profitable, regulation is required to address anti-competitive practices, monitor performance, and enforce standards. Of course, when advocating for government regulation, one wants to steer clear of the miles of red tape that the government is fond of. A caveat of this argument is that a balance be struck, so that regulation does not stifle innovation or investment.

What makes economic sense?
Establishing the hard and soft infrastructure a port requires is a capital and time-intensive task. There also needs to be strong commitment, which the Government lacks. Colombo International Container Terminal (CICT), which is a joint venture between China Merchants Port Holdings Company Ltd. and the Sri Lanka Ports Authority (SLPA), signed a BOT agreement in 2011. The terminal was operational by 2013. In comparison, the construction of the breakwater for the Jaya Container Terminal (JCT) run by the SLPA took four years, from 2008 to 2012. CICT developed an entire terminal in less time than it took the SLPA to construct the breakwater for its existing terminal.

Lack of direction and consensus from decision makers in government have resulted in the East Container Terminal (ECT) – a strategically important terminal remaining unused and idle. It is clear that the Government needs to step aside and allow the private sector to come in. This is evidenced by the performance of the South Asia Gateway Terminal (SAGT), which is operated on a BOT basis with the Government of Sri Lanka and a consortium of local and international establishments, which was awarded the “Best Terminal in the Indian Subcontinent Region” for the third consecutive year in 2019 and won the “Best Transhipment Hub Port Terminal of the year” at the Global Ports Forum.

Percentage change in TEU handling from 2016 to 2017 (Source: Ministry of Ports and Shipping, Performance Report (2017), compiled by the Advocata Institute)

When comparing the success of the different terminals, the same conclusion can be drawn. Looking at the comparison of the number of Twenty-foot Equivalent Units (TEUs) handled by the terminals from 2016 to 2017, the CICT is the best performer. Interestingly, while both SAGT and CICT have enjoyed an increase of 10.9% and 19.3% in TEU for 2017, JCT has witnessed a 4.3% drop. The privately-operated terminals outperforming the SLPA Jaya Terminal speaks volumes.

“Seaports are interfaces between several modes of transport, and thus they are centers for combined transport … they are multi-functional markets and industrial areas where goods are not only in transit, but they are also sorted, manufactured and distributed. As a matter of fact, seaports are multi-dimensional systems, which must be integrated within logistic chains to fulfill properly their functions.”

— United Nations Conference on Trade and Development

Ripple effects of private ownership

This definition by the United Nations Conference on Trade and Development succinctly describes the importance of ports and port infrastructure, and accurately shows how ports cannot work in silos. They are an integral component in a wider network of business, infrastructure, supply chains and employment. If we want profitable and efficient ports, we need similarly performing ancillary services.

Ancillary services and ports enjoy a symbiotic relationship. On one hand, ancillary services are series of economic activities which provide services and create employment; which are dependent on the port. On the other hand, the port benefits from efficient ancillary services as they make the port and its terminals more attractive to clients and boosts its own performance.

Ancillary services include logistics, bunkering, marine lubricants, freshwater supply, off shore supplies and ship chandelling, warehousing and many more. These services, and their ability to grow is affected by the general functioning of the port, and therefore is affected by the ownership of the terminals.

For a port to survive, ancillary services need to constantly innovate and remain productive. There is no need for this article to expound on how the government is not the place to go to when in search of innovation. This is clearly the forte of the private sector. This is backed up by the fact that so far, private ownership of terminals and profitability go hand in hand. In short, if profitable and productive terminal creates a well-functioning port, allowing ancillary services to grow; then we should be looking to the private sector for investment and not the government.

What is happening with the ECT?

As mentioned above, the Colombo Port is fast growing. However, if you were to look at the Colombo Port from one of the many high rises in the Fort area, spotting the East Container Terminal would not be difficult – it’s the only terminal with nothing happening. No cranes, no ships, no activity.

The East Container Terminal is not significant simply for its disuse. Compared to the West Terminal, it is situated in the middle of the new port and the old port of Colombo. This gives it an advantage as it is closer to all other terminals and moves inter-terminal cargo a smaller distance. This gives it an important edge as inter-terminal cargo is an important component of transshipment. The depth of the ECT, at 18m allows it to handle container shipments, adding to its value. In short, the ECT has a clear operational advantage.

It is evident that the country has lost out in this scenario. In a port that is as fast growing as the Colombo port, the decision makers of this country have, for a variety of reasons, not developed the ECT. The Sri Lankan government has taken many stances over the years. It both invited expressions of interest and business proposals for the development of the ECT and cancelled tenders, insistent that the ECT will be run by the Sri Lanka Ports Authority – sending mixed signals to interested parties, and effectively ensuring that investors are reticent, and development of the port has stalled.

Politics have dictated the government’s decisions on the ECT, and the result is that the country has lost out. In shipping the government has an important role to play in regulation and ensuring standards are adhered to, but it cannot be both a player and a regulator. The performance of the JCT in comparison to the private terminals makes it clear that government is not as effective as the private sector, it should limit itself to the task of regulation. In conclusion, the ECT should be opened for private ownership as soon as possible, following the precedent set by the BOT models of the CICT and SAGT.

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Aneetha Warusavitarana is a Research Analyst at the Advocata Institute. Advocata is an independent policy think tank based in Colombo, Sri Lanka. They conduct research, provide commentary, and hold events to promote sound policy ideas compatible with a free society in Sri Lanka. She can be contacted at aneetha@advocata.org or @AneethaW on twitter .

SL is running out of input-led ‘perspiration’ growth: Sally

Originally appeared on Daily FT

Shortages of labour, land and an ageing population mean that Sri Lanka’s opportunities for rapid catch-up growth are diminishing and institutional transformation is needed for innovation and output-led growth, a top economist has said.

The first stage of growth involves a poor country catching up with more advanced economies, using inputs like cheap labour and land, involving ‘perspiration’. 

“Once you become middle-income, especially the upper middle income categories, your growth rate inevitably slows down; this model no longer works,” said Razeen Sally, the Associate Professor of the Lew Kwan Yew School of Public Policy in Singapore.

“We are already seeing that in Sri Lanka. The population begins to age. You have less availability of labour - particularly cheap labour. Capital becomes more expensive. Wasting capital becomes more obvious, land becomes scarcer.”

Sally was speaking at an event in Colombo on ‘Asian capitalism and what it means for Sri Lanka’ organised by the Advocata Institute, a free market think tank and Echelon, a business magazine.

Inspiration vs. perspiration

When a country exhausts catch-up growth, a second stage involving innovation, which economist Paul Krugman called ‘inspiration’ or output-led growth, was needed.

“Now you have to use your brains much more, less your sweat or brawn,” Sally said.

Output-led growth requires liberal institutions and a different type of entrepreneurial capitalism.

Economists and thinkers had defined free enterprise and capitalism in different ways.

Economist Adam Smith believed that if people had freedom to produce and consume, with secure property rights, then the market economy would flourish with increased specialisation driving efficiency. 

“Specialisation goes deeper and if you do it across borders with freer trade, it goes wider.”

This was ‘Smithian’ growth. It was not about technology as such and describes the catch-up phase.

Friedrich List, a German, wrote his ‘National System of Political Economy’ against the economics of freedom of Smith. 

While Smith believed in free trade and removing state blockages to entrepreneurship, List advocated state support for business through protectionism and a variety of state interventions for young and upcoming countries like Germany to catch up with a leader like Britain.

“And that is an argument for state intervention and industrial policy, particularly to support infant industry - so-called - that has been used in countries like Japan, South Korea and Taiwan,” Sally said. “And that argument finds it echoes here in Sri Lanka.”

Marx in turn had an apocalyptic vision, that capitalism would destroy itself while Weber had an almost religious view. 

Joseph Schumpeter, an Austrian finance minister and banker who became a professor at Harvard University and one of the top economist theorists of the 20th Century, observed another pattern.

Constant change vs. equilibrium

In contrast to standard neo-classical economics which is about a stable equilibrium, Schumpeter’s economic system is highly dynamic. Capitalist economies are constantly changing. Everything is being disrupted and re-created. It is disruptive innovation which has parallels to Anichcha in Buddhism, which means impermanence. It is about constant change the central agent of which is the entrepreneur. 

“What Schumpeter’s entrepreneur basically does is beg, borrow or steal ideas and turn them into marketable, profitable products - goods and services,” Sally said.

“So you take inventions, and rarely is the inventor the innovator and turn them into innovations. An invention is a new idea. And an innovation is turning that into something for the mass market, which makes profits, which generates investment, which creates jobs and livelihoods.

“Most of the really big ideas of the past like gun powder, the printing press and algebra had come from China and the Middle East. But they were not innovated in China and the Middle East,” said Sally. 

“They were innovated in Europe by European entrepreneurs in the commercial revolution and subsequent agriculture-industrial revolutions that Europe had but China and the Middle East did not. That is a genuine puzzle.”

Creative destruction

Schumpeter talks about “perennial gales of creative destruction” which is at the heart of his capitalist economic system. 

“So capitalism is not about stable equilibrium, but about creative destruction,” Sally said. “New entrepreneurs swarm around new ideas, inventions. And they turn them into innovations at crucial junctures, in the process destroying old incumbent industries.”

IBM was disrupted by Microsoft and Apple, who will in turn be destroyed by different technologies from more nimble firms. If the system is open enough, this kind of creative destruction will happen.

“In other words we cannot have prospering capitalism without this kind of disruption, which can be socially very disruptive,” Sally said. “This can upend politics, society and indeed the world.”

In poor Asia there was room for catch up growth but the opportunities dwindle as countries become richer so they must move to Schumpeterian growth, which means improving productivity.

Schumpeterian growth

“You want to improve the efficiency of your inputs, particularly your land, labour and capital. So it is not the quantity or mass of them but the quality or efficiency.”

Malaysia, Thailand and China had an urgent need for innovation-led growth. Middle Asian countries were seeing conditions similar to Japan in the 1970s and South Korea in the 1980s, when they exhausted the catch-up period. 

The Asian re-emergence of the last century was based on imitating the West, which was fine in the catch-up phase. Sally said in the first phase, it was possible to grow with weak institutions and rule of law and even corruption.  But the changes needed to go forward does not happen automatically.

“You need to be open to international trade,” Sally said. “It is crucial. You need to improve labour markets, primary and secondary education, you need to improve hard infrastructure.

“Friedrich List would argue that you also need industrial policy. The reality is that results are mixed. Asian Tiger countries have used a combination of policies from the Adam Smith and Friedrich list textbook, but not from the Schumpeterian textbook.”

Liberal institutions and complex reforms

“But when you come to that second stage, when you really need to boost your factors of production, your overall productivity and innovation, not only do you need to get your basics right, you need to improve the quality of your institutions,” Sally says.

“You need to improve the quality of your financial system including regulations, education, skills,  better public administration, a more efficient judiciary and legal system, a tax system and bankruptcy procedures, going well beyond the basics.”

The World Bank’s Ease of Doing Business Index was a reflection of how good the business climate and institutions were. Only Singapore, Hong Kong and Korea were in the global top 10. Taiwan was 15. All are part of rich Asia. For middle and poorer Asia to join this club their institutions must be as good but Sally says improving financial systems, legal systems and educations systems is politically difficult and complicated.

“Improving institutions depends on politics,” Sally said. “So I have my doubts about Asia being successful in the future as it has in the past.” 

There was a growing belief that China’s ‘Mao and Markets’ system, where a few people at the top made decisions, may allow it to overtake the West. But doubts remained whether real innovation could take place. Sally says there were questions whether people in the top would really give up the power and rents that can be earned in an autocracy.

Sally says innovation is happening in Asia, especially in the digital space. Young people in Asia are adopting digital technologies quickly. In China, a number of tech companies were emerging. The venture capital market in China for tech was now worth $ 60 billion a year, the same as the US.

China was now promoting some state and private tech firms aggressively in a type of industrial policy. But less efficient state firms were a drag. There was also a crony private sector. Productivity growth was slowing.

Power shift

Meanwhile, the so-called Pax America which provided a relative stable geopolitical environment which allowed Asia to grow was changing, Sally said. There was a possibility of a Chinese-led ‘Pax Sinica’ emerging under different rules.

The US had maintained the peace in Asia and prevented China, India and Japan from getting into a major war with each other. After 9/11, the US became increasingly fixated on the problems in the Middle East. Obama was reluctant to intervene in Asia and Trump, a ‘gut isolationist’, is even less engaged. Another possibility was a power vacuum, which could lead to a major conflict. Meanwhile, it was not a foregone conclusion that the US would continue to pull back and a Pax Sinica will come.

Meanwhile, Sri Lanka had not initiated the major reforms required and was coming increasingly under China. Sri Lanka’s current administration had initially got the basics wrong and had to go to the IMF. It was now sticking to a broad program agreed with the IMF in getting some of the basics right.

But no major reforms had taken place in land, the banking system or education. The reform window was closing and perhaps had already closed, he said.

Advocata's submission for the Budget 2017

Echelon Magazine, Sri Lanka's premier business magazine published excerpts of Advocata Institute's Budget submission for 2017

THINK TANK ADVOCATA IS PROPOSING LOWER TRADE TAXES AND TRIMMING PUBLIC SECTOR EXPENDITURE IN ITS RECOMMENDATIONS FOR BUDGET 2017 PRESENTED TO THE MINISTRY OF FINANCE AND PLANNING

Summary recommendations
1. The immediate policy priority should be to restore emphasis on exports: Liberalise the trade and investment framework to attract FDI.

2. Public sector reforms to cut costs are vital. While tax increases may be unavoidable, the additional burden on the public must be minimised: Reforms for the public sector to reduce its size, cut corruption and improve efficiency are essential.

3. The current tax structure is incoherent and chaotic. It must be reviewed and policy grounded on sound fiscal and tax principles including fiscal adequacy, administrative feasibility, simplicity, transparency and stability.

Despite a significant improvement in the first half of the year, meeting Sri Lanka’s budget deficit for 2016 will be challenging. A significant amount of fiscal consolidation will still be needed over the next few years if the government is to achieve its stated goal of reducing the budget deficit to 3.5% of GDP by 2020 or indeed meet its commitments to the International Monetary Fund (IMF), which is likely to create considerable uncertainty over the likelihood of further tax increases.

Given the difficult environment and ambitious targets, the government may be tempted to resort to ad hoc, short-term measures to deal with fiscal crises as they arise, creating a volatile business environment, eroding confidence and leading to a lack of predictability in revenue targets. This, in turn, results in further ‘quick fixes’.

This is a vicious cycle that must be broken if consistency and predictability is to be restored to the tax system. This is possible if the government adopts a framework of evidence-based policymaking, and we urge that this be done as a matter of priority.

Making policy that is based on evidence is not easy, but it is possible to draw on the experience of countries such as the UK, which have adopted such an approach. Frameworks that governments can follow to build and support a system of evidence-based policymaking are available, and the government should seek specialised assistance to implement a structured approach. This will help ensure consistency and predictability in policy, improving business confidence.

Policy making must be an ongoing process, and consultation and assessment should not be limited to a period a few weeks before the budget. Poorly researched policy may cause unintended consequences and result in policy reversals. While all suggestions must be considered, many are likely to come from sectors seeking privileges. These must be carefully researched, subjected to wider consultation and adopted only if overall benefits to society outweigh costs. Some of the complexity and anomalies in the tax code may be traced to the accommodation of various special interest groups.

In achieving its fiscal targets, the government cannot limit its focus to raising taxes. Breaking from the pattern of the past, equal or even greater emphasis must be placed on the reduction of expenditure, reviewing not only the scale of spending but also the scope of the government.

An economy drive eschewing extravagance, the elimination of corruption and waste through increased transparency, and open processes must necessarily form a part of this exercise. Sri Lanka’s leaders frequently cite the example of Singapore. Fiscal prudence has been a hallmark of Singapore’s governing philosophy and successful management of the economy – an ethos that must become a watchword for Sri Lanka’s rulers. The Singapore Civil Service’s “Cut Waste Panel” and “Economy Drive” offer useful practical lessons in managing costs and could be adapted for Sri Lanka.

The tax system must be simplified, widening the base and increasing compliance. The finance minister’s commitment to this is laudable. The remainder of this submission seeks to outline a few key issues and offer avenues for the administration to explore. We believe these ideas are worthy of careful study and could yield outcomes that will assist in stimulating growth, reducing the budget deficit, and simplifying and rationalising the tax system.

RETHINK THE DEVELOPMENT STRATEGY
Restore policy emphasis on exports

Lacking a large domestic market and possessing few natural resources, exports offer the best opportunity for rapid development.

Successful integration of the manufacturing sector into global production networks has played a key role in employment generation and poverty reduction in China and other high-performing East Asian countries.

The market-oriented policy reforms of 1977/8 were based on this rationale and served the country well, resulting in a notable diversification of the commodity composition of Sri Lanka’s exports and a consistent improvement in share of world manufacturing exports until the late 1990’s.

However, protectionist pressures began to build in 2001, and from 2004, the relatively open trade policies of the past were explicitly and systematically reversed. A policy paper by the World Bank titled “Increase in Protectionism and Its Impact on Sri Lanka’s Performance in Global Markets” shows that, today, through the proliferation of a variety of para-tariffs, Sri Lanka’s tariff policies are just as protective as they had been more than 20 years earlier.

The present protectionist import tax structure has serious costs for Sri Lanka’s economic welfare and growth; Sri Lanka’s exports relative to GDP have declined, as has its share of world exports. Sri Lanka has fallen significantly behind its competitors. Vietnam, which was on par with Sri Lankan exports in 1990 with $2 billion per annum, today exports $162 billion versus Sri Lanka’s $10.5 billion.

A bulk of Vietnam’s exports is driven by foreign investment and a globally competitive agriculture sector that emerged in the wake of a liberalisation drive that moved away from ‘self-sufficiency’. FDI firms account for 71% of Vietnam’s and 44% of China’s exports. The lesson is clear: To boost growth and create productive employment, Sri Lanka should cut barriers to trade and investment, and focus on attracting export-oriented FDI.

The most important reforms needed are listed as follows:

1.Trade policy reforms: Move from the present chaotic tariff structure towards a transparent, uniform tariff structure
• Unify the existing Customs duty and the plethora of para-tariffs (PAL, VAT, CESS, Customs Surcharge) into a single Customs duty at the individual Customs code level, and then reduce Customs duties across the board to a uniform nominal rate of 15%. Moving towards a low, uniform tariff structure has the potential to increase tariff revenues. This would speed up Customs clearance and reduce the potential for corruption as it reduces the discretion of Customs officials and makes the trade regime predictable.
• On the export side, remove all cess as it reduces the effective price received by exporters, and thereby discourages exports. There is no evidence to suggest that these cesses promote local downstream processing of primary products that are now exported in ‘raw’ (unprocessed) form.
• Join the Information Technology Agreement of the WTO to create free trade in electronics, which will attract FDI to this sector.

2. Foreign direct investment reforms
• Restore the role of the Board of Investment as the ‘one-stop shop’ for investment approval/promotion (as envisaged in the BOI charter). This requires repealing the Revival of Underperforming Enterprises and Underutilized Assets Act (2011) and the Strategic Development Projects Act (2011), or passing new legislation to supersede these two acts.
• It is, of course, necessary to rationalise the fiscal incentives offered to investors, but there is a strong case for providing export-oriented foreign investors with time-bound tax holidays and investment tax allowances beyond the tax holiday period. There is evidence that tax incentives play an important role in influencing location decisions of export-oriented (efficiency-seeking) FDI, especially where competing countries still offer them, provided of course that the other preconditions are ‘reasonably’ met. (The evidence used in recent policy reports by the World Bank to argue against tax incentives comes from studies that have not made a distinction between ‘market seeking’ and ‘export-oriented’ FDI). Removing all tax incentives, while other negatives continue to weigh on the overall competitiveness in investment and trade, may be counterproductive.
• Sri Lanka has to improve property rights to draw investment. The guarantee against nationalisation of foreign assets without compensation provided under the Article 157 of the present Constitution needs to be maintained under the ongoing constitutional reforms.
• Avoid the current practice of ‘domestic value added’ [which is defined as per unit of domestic retained value (wages + profit + domestically procured intermediate inputs) as a percentage of growth output] as an evaluation criteria in approving investment projects.

The very nature of the ongoing process of global production sharing (production fragmentation) is that per unit value added of production plants located in a given country within vertically integrated global industries (such as electronics and electrical goods) is usually very thin. The contribution of such production to domestic output (GDP) depends on the volume factor and the ability to produce for the vast global market, not on per unit value added.

In some traditional industries that use diffused technology (such as garments, footwear, travel goods), there is opportunity to increase per unit value added by forging backward linkages, but this is a time-dependent process and depends on export volume expansion. In the garment industry, per unit value added was around 20% at the beginning, but is now over 60%. Backward-linked knitted textile production and other ancillary input industries (hangers, buttons, labels, packaging material) have emerged as the volume of export expanded, creating sizeable demand for such inputs.

3. Macroeconomic policy
Trade, investment and labour market reforms need to be accompanied/complemented by macroeconomic policies to regain international competitiveness of the economy. Relying solely on nominal exchange rate depreciation for this purpose is not advisable, given the massive build-up of foreign-currency denominated government debt. Also, given the increased exposure of the economy to global capital markets, large abrupt changes in the exchange rate could shatter investor confidence, triggering capital outflows.

What is required is a comprehensive policy package encompassing some exchange rate flexibility and fiscal consolidation, which requires both rationalisation of expenditure and widening of the revenue base.

The current import-substitution policy retards growth and hurts consumers.

The present policy stance and import tax structure have drawn capital, labour and land to high cost, and highly protected import substitution farming and agricultural processing activities with low or negative economic rates of return. Sri Lanka’s food prices are higher than in the region due to high tariffs imposed to achieve self-sufficiency, hurting the poor and possibly contributing to malnutrition particularly of poor children. At a time when the government is burdening people with higher taxes, it is imperative that attempts be made to reduce food costs; revising this policy could contribute significantly to lowering the cost of living.

An example of this policy is rapid growth of maize and soybean cultivation over the last 10 years. These are not traditional crops and were not cultivated on any scale prior to 1998. These are used primarily as raw materials for the production of animal feed. Subjected to heavy protective tariffs, the cost of these locally produced crops are far in excess of world prices and directly related to the high cost of local poultry products. Instead of reviewing a flawed agricultural policy, the government has reacted to high retail prices of poultry by introducing price controls.

The policy of protecting the local sugar industry has had a similar impact and should also be subjected to review. The protective policy toward wheat imports has resulted in increased retail prices of bread, despite a collapse of world wheat prices by 50% since 2013.

The above highlights just a few key issues; there are many others. The government needs to study the impact of its trade and agricultural policies on consumer prices, and review its policies to maximise benefits to society as a whole. The ill effects of poor agricultural policy are not limited to higher prices, and their unintended consequences may extend to the human-elephant conflict and the recent spread of chronic kidney disease. The review of policy needs to be holistic.

PUBLIC SECTOR REFORM

Cumulative public debt and the high budget deficit have been key drivers of macroeconomic instability in Sri Lanka. Higher government borrowing not only wreaks havoc in the government’s finances, but also crowds-out private investment by pushing up interest rates. Sri Lanka also operates a “Mega State” apparatus, with a massive public sector, unproductive/loss-making state enterprises and an oversized peacetime military that further diminishes the fiscal position.

The massive increase in public sector employees starting from about 850,000 in 2005 to around 1.27 million by 2016 also has knock-on effects on the political economy, with both major parties now having to pay homage to this large voting bloc by promising unfunded and unsustainable goodies such as salary increases and other benefits – what analysts term ‘an auction of non-existent resources’ – at each election.

While most commentators emphasize enlarging the tax net to address fiscal imbalances, Advocata believes that reducing the size and scope of the state is more pressing. While political space for reforms may be limited, public opinion is increasingly skeptical of loss-making state enterprises, which is an argument reformists in government could use.

Advocata urges policymakers to look into following avenues of reform:

Addressing the debt burden

The government’s debt/GDP ratio is 75%. Debt service costs (interest and capital) accounted for 90% of government revenue in 2014. The previous year’s debt service cost actually exceeded revenue; the ratio in 2013 was a whopping 102%. Interest cost alone amounted to 37% of government revenue in 2014.

Sri Lanka regularly runs a primary (before interest payments) budget deficit, which means recurring expenditure is being funded by debt, a situation that is clearly unsustainable. Sri Lanka’s debt ratios bear some uncomfortable parallels with those of Greece, just before the outbreak of the debt crisis.

Restructuring the debt to extend its maturity and reduce interest rates could provide some relief, but disposing of unproductive state assets and using the proceeds to reduce debt is a more permanent solution and we offer a few ideas below.

Reforming SOEs

Disposing of loss-making and unproductive state-owned enterprises (SOEs) is a way of easing the debt burden and preventing further deterioration of the fiscal position. The outstanding SOE debt to banks is at Rs757 billion, more than four times what the government spent on health services in 2015. Some SOEs have accumulated so much debt that even privatisation may not be possible. These could simply be shut down with generous severance payments to employees, which will be cheaper in the long run.

Reform of SOEs need not be limited to loss-making enterprises. SOE’s often employ significant resources in terms of labour, land and other factors of production, which could be better utilised. Conducting a comprehensive productivity study would allow the government to determine which ones to shut down, which ones to privatise and which ones could be held under ownership at a government holding company in the model of Singapore’s Temasek Holdings.

Reactivating “Dead Capital”: State-held land

The Land Reform Commission was vested with about 987,000 acres, some of which could be used for more productive purposes. Additionally, government ministries, schools and other facilities occupy prime real estate blocks in major cities like Colombo, which greatly outweighs their economic value.

As an initial step, accounting of property rents at market values would allow the government to get an accurate sense of the value of the dead capital that the government is occupying, which could be put to more productive use. The Colombo Dutch Hospital project and the clearing of the Army headquarters for commercial activity are examples of how dead capital in government-held land could be activated for more productive use. The government should draw up a Land Asset Sales Programme, an orderly and coordinated programme to dispose of surplus or underutilised land. The proceeds from these sales should be used to reduce national debt. The sales programme must be run in an open and transparent manner by an independent body free of political influence to minimise corruption.

Public-private partnerships for infrastructure

Converting existing infrastructure such as highways into Public-Private Partnerships could raise funds to pay down the loans that were used to finance them. Operational rights could be auctioned in a transparent manner to private investors. New infrastructure projects should be on the basis of a Build Own and Operate (BOO) model or Build Operate and Transfer (BOT) model, which has been used successfully all over the world to finance infrastructure projects.

Restoration of the National Procurement Agency (NPA)

The NPA was established in 2004 to streamline procurement, reduce waste and corruption, and ensure better transparency and governance by centralising procurement under an independent body. The agency was believed to have been effective, which lead to it being shut down, allegedly for political reasons, in 2007. Its operation should be revived and its independence guaranteed.

The defence budget

Spending on defence has grown from around Rs144 billion in 2009 to an estimated Rs306 billion in 2016, a massive increase in a time of peace. Due to the politically charged nature of the expenditure, this has been the ‘elephant in the room’. While acknowledging that immediate demobilisation or salary cuts are not feasible, continuous growth in defence expenditure seven years after the end of the war is something that requires questioning.

It is one of the largest items of expenditure, and discussion of this subject must no longer be avoided. Cutbacks in capital expenditure and hardware are necessary. More generally, a national plan to downsize the military should serve the long-term interest of all communities in Sri Lanka.

Voluntary retirement schemes

The state currently employs over a million people and an additional estimated 220,000 workers employed in SOEs. Some analysts put the figures much higher. In total, the public sector accounts for about 15% of the total labour force.

The public sector pensions and salaries bill for 2015 was Rs717 billion, representing 49% of government revenue. The weight of the wage and pension bill has crowded out priority expenditure in education, health and essential infrastructure, and even operational expenditure necessary to enable employees’ effective functioning. Not only do the salaries and entitlements of these workers burden the fiscal position of the government, it also mops up scarce labour from the private sector. By this account, Sri Lanka probably has the largest state sector in the world.

The dependence on excess labour also means that state agencies become reluctant to invest in new technologies or procedures in fear of backlash or simply not knowing where to allocate the labour.

Reforms in this area are not going to be easy, as the 2002 UNP government discovered to its peril. However, the current levels of state sector cadre places a massive strain on the fiscal position.

The government should commission a report on the labour requirement for the state sector. While attrition and a hiring freeze are preferred methods of cadre management, for some sectors and institutions, Voluntary Retirement Schemes (VRS) may be possible. To manage pension liabilities, a new contributory pension scheme should replace the current defined benefit scheme for any new recruits to the public service.

Reform of energy utilities

Sri Lanka’s energy utilities are a source of macroeconomic instability, and reforms to the sector are long overdue. While detailed studies for longer-term reforms must be undertaken as an interim measure, re-introducing the pricing formula for fuel and extending the formula to electricity will prevent large imbalances from building up. For the electricity sector, an immediate move to daylight saving time could reduce night peak load demand by as much as a third, with consequent reduction in thermal energy generation. In Sri Lanka, the discussion is private participation in electricity centres around fixed contract IPPs. In many other countries, however, this model is now considered outdated, the world has moved on to integrated energy markets. A study by the Pathfinder Foundation carried out in 2007 provides a useful starting point for ideas on moving to energy markets.

THE TAX SYSTEM

Recent budget statements by successive governments, including the present one, have not been in keeping with sound principles of taxation. While recognising the unique political moment in which the new administration operates and the politically expedient measures that were taken to create that political moment, continuing to ignore principles of fiscal discipline can only lead to further imbalances.

The following principles serve a guide to sound tax and fiscal policy:

Fiscal adequacy
The overarching objective should be that sources of revenue, taken as a whole, should be sufficient to meet the demands of public expenditure. Revenue should be elastic or capable of expanding or contracting annually in response to variations in public expenditure. Most crucially, any new benefit or relief measures offered must be fully funded. Government finances are in a dire state, they should not be made worse; ill-conceived proposals in the past have contributed to the structural weakness of the fiscal position.

The adoption of a medium-term budget framework to prioritise, present and manage both revenue and expenditure over a multiyear framework is desirable. It can help demonstrate the impact of current and proposed policies over the course of several years, and ultimately achieve better control over public expenditure.

Rules in the Fiscal Management (Responsibility) Act may be tightened to reinstate budget discipline, and ensure fiscal responsibility and debt sustainability.

Simplicity, administrative feasibility and transparency
Tax laws should be capable of convenient, just and effective administration. Tax codes should be easy for taxpayers to comply with and for governments to administer and enforce. It is far simpler to adjust rates to existing taxes than bring in new types of taxes.

Any changes needed to the tax code should be made with careful consideration of established practices and open hearings. Each tax in the system should be clear and plain to the taxpayer. Disguising tax burdens in complex structures to deceive the public, the preferred approach by politicians in the past, should be avoided. Simplicity will close loopholes for tax evasion, reduce the scope for corruption and minimise administrative costs.

Neutrality
By and large, taxes should neither encourage nor discourage personal or business decisions. The purpose of taxes is to raise needed revenue, not to favour or punish specific industries, activities and products. Minimising tax preferences broadens the tax base, so the government can raise sufficient revenue with lower rates.

Stability
Taxpayers deserve consistency and predictability in the tax code. Governments should avoid enacting temporary tax laws, including tax holidays, amnesties and retrospective changes. The periodic revision of taxes via gazette notifications should be avoided. Put simply, a good tax policy promotes economic growth by focusing on raising revenue in the least distortive manner possible.

Sin taxes need re-thinking

While our proposals are mostly concerned with broad issues of policy, we have made an exception for ‘sin taxes’ because of their importance to the exchequer.

‘Sinful’ items such as alcohol and tobacco have traditionally been taxed heavily and are the second-largest source of tax revenue for the state. A review of these policies could develop their effectiveness and improve collection. The present government, continuing the practices of the past, has now raised taxation to prohibitive levels. This may be counterproductive because, while high taxes do deter consumption, excess taxation may drive consumers to dangerous illicit substances, and support a thriving illegal alcohol and cigarette industry.

The link between higher taxes and substance abuse is that the use of highly hazardous home brews concocted from medicinal drugs, cosmetics and pharmaceuticals also need to be examined.

Both in Sri Lanka and even in developed countries, it is a tendency for lower income groups to consume cigarettes. In Sri Lanka, there is an additional tendency for lower income groups to consume cottage industry products and items like beedies. Further research needs to be done on the link between education and awareness as opposed to the assumption that cigarette and alcohol consumption is merely a function of affordability or a broader lifestyle/environment and an awareness issue.

High taxes on cigarettes have lead to a massive increase in the lightly taxed Beedi industry, as well as expansion in illegal cigarettes. Customs statistics indicate that beedi volumes have risen from 1.1 billion sticks in 2007 to 3.2 billion sticks in 2013, while cigarette volumes declined from 4.6 billion sticks in 2007 to 4.0 billion during the same period.

Studies carried out by the Institute of Policy Studies make a case for rethinking alcohol taxes, principally to move to a structure of taxation by volume, which will increase state revenues while modifying consumption habits.

The government needs to reconsider its policies for the taxation of both alcohol and tobacco in light of all available evidence. Recent experiences in India and Pakistan highlight the problems with outright prohibition.

On PM's economic statement: most important is to liberalize trade and investment

By Ravi Ratanasabapathy

The article first appeared on the Daily News

The Prime Minister’s statement on the economy to parliament on October 27 struck many a right note and has the ingredients to take the country to the goal of doubling per capita income by 2025.

Most important was the promise of reforms to liberalise trade and investment, to attract foreign investment and restore emphasis on exports.

It is important that the sentiments expressed in the Prime Minister’s statement must follow with practical yet bold economic policy reform. A detailed policy document has been promised and would hopefully contain the necessary implementation plans.

The rest of this brief note is aimed at understanding the policy pronouncements in the context of Sri Lanka’s political and socio-economic priorities.

Improving the business and investment climate

The statement promises a lot: simplifying the process of registering a business, getting construction permits, electricity connections and bank credit, registering property, protecting minority investors, the payment of taxes, trading across borders, the enforcement of contracts, the resolution of insolvency and reforming labour laws.

The Prime Minister’s target to bring Sri Lanka into the top 70 countries in the World Bank’s Doing Business Index by 2020 is welcome. Sri Lanka currently languishes at 110 in the index amongst 185 countries and its position has actually dropped by one place under the current administration. Policy reform to increase the ease of doing business is uncontentious and will draw broad political support from across the spectrum.

However the government must be bolder. Whilst ease of doing business has improved in the last few years, Sri Lanka can do much more to expand general economic freedom in the economy. The Fraser Institute, which publishes the annual index of economic freedom ranked Sri Lanka 111 among 160 countries. The index now ranks countries in the region like Nepal higher in terms of economic freedom than Sri Lanka with India only just behind. Beyond just looking at ease of doing business, Sri Lanka should also focus on other aspects of economic freedom including removing of outdated and arbitrary regulation, reversing recent follies such as Soviet-style price controls and truly living up to the promises of liberalising international trade and investment. In this vein, the proposed establishment of a single window for investment approval in the Prime Minister’s speech is a welcome move.

Sri Lanka can emulate, and where necessary adapt, the best practice policies from other countries such as New Zealand and Australia which rank highly in terms of economic freedom

Trade liberalisation: repeal of the Export and Import Control Act

The Government promises to repeal this archaic piece of legislation and replace it with new legislation based on that of Singapore. If implemented in the true spirit of Singapore’s legislation, this would be extremely positive.

Singapore is generally regarded as a free port and the Government only restricts the import of goods seen as posing a threat to health, security, safety and social decency. Around 99% of imports to Singapore are duty-free.

The policy statement makes reference to “a low tax regime”, the lessons from East Asia and other parts of the world is that the tariff regime needs to be low and uniform. This minimises loopholes, corruption and simplifies customs processing. A low uniform rate of duty eliminates disputes with classification and enables documents to be processed on a self-declared basis (with customs only focusing on misstatements of price and quantities) which results in faster, simpler clearing of goods.

While sentiments to keep a low tax regimes are laudable, a commitment for a low uniform tariff policy should be the goal.

State enterprise reforms and financing of infrastructure

The proposed debt/equity swaps of the Mattala Airport and the Hambantota mark an important step towards reducing the Government’s debt burden. The Government should also convert other infrastructure projects such as the highways into PPP projects by auctioning operational rights.

The statement promises investment in infrastructure in logistics to improve connectivity to global supply chains. Whilst we all welcome investments in critical infrastructure, all new projects should be implemented through public private partnerships to prevent further accumulation of public debt.

The report published by the Advocata Institute on “The State of State Enterprises in 2015” shows that the state has over 245 enterprises in its books, of which only a small number actually reported their financial position. The proposed formation of a Public Commercial Enterprise Board to manage SOEs and the creation a Public Wealth Trust, a centralised body to hold the shares in SOEs is therefore timely. Hopefully these mechanisms may prove to be the first step in imposing accepted reporting practices and better management of State enterprises. Sri Lanka can learn from Singapore’s state enterprise holding company Temasek and other experiences around the world.

Additionally, the listing of the shares of SOE’s on the Stock Exchange would also impose discipline in reporting and is something the Government should explore. Minority stakes could be offered to the public which would raise revenue to the state, allow public participation in SOE’s and broad-base the CSE; even while the majority stake is still controlled by the Government.

The recent announcements regarding the closure and amalgamation of Mihin Lanka into SriLankan Airlines is encouraging but the previously announced partial privatisation of the debt-ridden airline has not yet materialised.

The proposed Public Enterprise Commercial Board should be given a wide mandate to restructure and reform SOE’s including assessing the strategic need for such enterprises, the closure of unviable enterprises and to privatise enterprises where there’s enough commercial interest. The new structure will hopefully be just the first step on the long road to improve overall accountability and governance of these state enterprises.

It is unlikely a one size fits all solution would work for reforming all state enterprises in what would inevitably become a politically charged issue. However the public appetite for bold reform in this area is high with the realisation that the cumulative losses over the last ten years amongst the 55 strategically important enterprises amounted to Rs.636 billion.

Some areas of concern: SME’s rural agriculture

Several proposals including the one to expand SME finance through quantitative targets enforced by the Central Bank must be viewed with caution. Dirigiste lending to push bank exposure further to higher-risk sectors may boomerang on lenders, especially public sector banks, resulting in losses. Any difficulties SME’s may face with access to credit need to be examined carefully and appropriate solutions developed in consultation with financiers.

The establishment of rural modernisation boards and agricultural marketing boards will need to be examined more closely. No details are available so the exact role of these bodies is not clear but the current flawed agricultural policies have pushed up food prices for consumers. Sri Lanka’s food prices are the highest in the region and the priority should be to lower the cost of living through appropriate reforms to the sector.

Apart from a few areas of doubt the overall economic statement is broadly in the right direction and if properly implemented could boost growth and improve the welfare and prosperity of Sri Lankans. The government however has a demonstrable problem with policy inconsistency over the last few years, even amongst its own ministries and between Ministers of the same party. Whilst some diversity of opinion is expected from a coalition government, some of the policies enacted in the recent past have run counter to this and other broad policy pronouncement from the Prime Minister.

These broad ideas will hopefully pass the implementation test and we await the publication of the detailed strategy document.

The writer is a Fellow of the Advocata Institute, a fee-market think tank based in Colombo. www.advocata.org