Sri Lankan Railways : Cash vs Accrual Accounting

Editors Note:

In a conversation about our earlier piece on the Sri Lanka Railways on twitter, a question has been raised about the period of the accounts.  A twitter follower Nihal Ananda says that terming the final figures for losses for a particular year in the Sri Lanka Railways  reports as a loss for that period is misleading or wrong.  The data is directly from the SLR reports, which presents the data exactly as we have presented.  

Here is the response from the author of the piece,  Ravi Ratnasabapathy 

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1. The SL Railways prepares accounts on a “cash” as opposed the more common “accrual” basis.

2. In essence, the difference between cash-basis and accrual-basis systems is a matter of timing.

In the accrual method revenue is recorded when billed and expenses are recorded when consumed. Under the cash basis revenue is recorded when cash is received from customers, and expenses are recorded when cash is paid to suppliers and employees.
 
For example under accrual accounting sales on credit would recognised immediately on being billed, but in the cash method, only when the actual cash is received. Similarly for expenses, material purchased on credit will be accounted under the accrual method as soon as they are purchased but under the cash method, they would only be accounted for only when paid.

The timing difference between the two methods occurs because revenue recognition is delayed under the cash basis until customer payments arrive at the entity. Similarly, the recognition of expenses under the cash basis can be delayed until such time as a supplier invoice is paid. 

3. It has been pointed out that the railway prepares accounts on a cash basis and that fuel expense in 2014 (Rs.9,751m) is high because of an amount of Rs.5,000m being paid for bills due the previous year, the implication being that the figures quoted in the previous article are incorrect.

As explained above, the substantial difference between cash and accrual accounting is only timing. As far as the fuel is concerned, it only means that fuel expenses in previous years would have been lower (because fuel though used, had not been paid for-resulting in lower deficits) and that in the current year higher (when the bills were actually paid, resulting in a higher deficit).

4. With the exception of fuel the major item of income (ticket sales) and expense (personnel expenses) do actually take place on a cash basis. The fuel is purchased on credit and the amounts charged in 2014 reflect the impact of past purchases which had not been paid for. 
5. Thus it is possible to adjust for some of these timing differences and prepare a pro-forma account that perhaps reflects the annual deficit more correctly, which we have done.
6. The performance reports of the railway do disclose the actual fuel consumed during the year (as opposed what was paid for). These figures are found under the line “Fuel Usage” in the table above. We have carried out an illustrative exercise substituting the figures of fuel consumed for the fuel paid and arrived at an adjusted deficit for the period which is shown above.

This adjustment strips out the distortions in the fuel payments caused by settling the backlog of payments in 2014 and ceteris paribus, presents a better picture of the annual deficit.

As is evident, the railway still shows a significant deficit. The timing differences simply move the deficit between the various financial period but do not cause it to disappear. These deficits eventually need to be paid for by taxpayers.
 

Sri Lanka Railways: A snapshot of issues and ideas for improvement

Originally appeared on Daily News

By Ravi Ratnasabapthy

Several railway trade unions launched a lightning strike last Wednesday over salary anomalies. The strike was called off after four days but hundreds of thousands of commuters were stranded. Angry commuters took to the streets, some called for privatisation of the railways.

Sri Lanka faces a huge problem with public transport which is driving commuters to use private transport. A study by W.J. Weerawardana [1] estimates that 65% of the road space is used by 38% of the passengers; the increase in the use of private vehicles is the major cause of traffic congestion.

At rush hours and school times the traffic is almost at the point of gridlock. Parking is a also a problem. If even a half-decent public transport option were available many more commuters would use it

Standards of service at the railway are shoddy and reforms to railways must form a part of a larger plan to fix public transport. A summary of some key issues follows, with some ideas for improved services.

SLR Financials Table
  • The railways lost 6.7bn in 2016 (7.7bn in 2015). The railways appear to have been losing money since 1947 [2]. The expenditure of the railways exceeded costs by 10% in 1950 but by 1968 this had grown to 52.4%. The wages policy of the government and the policy limitations imposed by the government in the pricing of passenger and goods transport were factors that contributed to this situation [3]. This has not changed much: in 2016 costs exceeded revenues by 49.4% (2015: 45.09%) for broadly similar reasons.
  • Fares per kilometre range from 50 cents to a maximum of Rs.2.00 for 2nd and 3rd class travel. 1st class fares range from Rs.1.60-3.60 per kilometre.
  • Revenue does not cover even salaries. Salaries exceeded revenues by 31.89% in 2016 (28.9% in 2015).  
  • Only 42% of the trains run on time (39% in 2015). Delays exceeded 10 minutes for 43% of the trains (46% in 2015).
  • The assets of the railway or poorly utilised. Income from leases of railway land was Rs.119.58m in 2016. Lease arrears not collected amounted to Rs.1.8bn at end 2016 [4]. The Auditor General notes [5]: “Lands  about 12,000 acres in extent belong  to  the Department  of  Sri  Lanka Railways had remained idle for about 150 years without giving on lease or utilizing for another purpose”

COMMENT:

Fares are priced well below operating costs, the trains grimy and overcrowded. Maintaining rail fares at uneconomically low levels is politically attractive but has lead to the deterioration of the rolling stock and infrastructure due to a lack of funds for new investment.

There has been a steady increase in passenger numbers from just under 100m in 2011 to 136m in 2016, but the service does not appear to have been able to respond adequately to new demands for expanded services or improved quality.

Based on the current operating and cost structure fares would need to double to just to meet recurring expenses and rise still further if the capital expenditure is to financed.  The Government spent Rs.30bn on capital expenditure in 2015. (2014: Rs.34.6bn, 2013: Rs.20.2bn). While a significant fare increase is needed and may be accepted if accompanied by improved service, passengers cannot expect to pay for inefficiency. For example, the COPA [6] has questioned excess staff recruitment (of 1588) and payment of overtime in contravention of the Establishment Code.

Thus there is a need to restructure of operations to improve service quality and efficiency. In a lecture delivered last year at the Chartered Institute of Logistics & Transport, Dr Priyanka Seneviratne claimed SLR’s weaknesses stem mainly from lack of timely investment in fleet replacement, technology, and workforce development in the past. The Ministry of Internal Transport [7] confirms that 65% of the rolling stock is over 30-35 years old which increases the likelihood of breakdowns, increases maintenance costs and impairs service quality.

Dr Senevirate identified the following measures to enhance revenue:

  1. adjusting fares and tariffs to better reflect costs and improved services;
  2. leasing more real estate and advertising space at market prices, and
  3. partnering with the private sector to provide freight and ancillary services such as catering, courier, and real estate management.

The railway currently partners with the private sector to provide a luxury carriage on selected routes. This could be expanded to cover other routes or possibly even to a whole train, covering for example additional services at peak times to cater to office commuters. Service contracts where, for example, railway catering is contracted out could provide increased revenues and improve service. Operations of toilets, canteens could be handled in a similar manner. Idle land could also be redeveloped in partnership with private developers. 

The dilemma is ensuring that a public-private partnership is beneficial when corruption is endemic and state capacity is limited. The following principles are an outline of process that should be followed:

  1. Open bidding- public-private partnerships must be procured by competitive tendering.
  2. Public consultation: submission of the draft invitation to tender and the draft contract to public consultation, which should be advertised in the newspapers and in electronic media, informing the arguments for contracting a partnership, the scope and term of contract, its estimated value, setting a minimum period of thirty days for comments and suggestions.
  3. Capacity and institutional integrity in contract design. Some PPP contracts can be extremely complex and public officials may be overwhelmed. Capacity building within the public sector is essential. Setting up an independent PPP advisory unit within government staffed by competent people is advisable. Judicious use of external advisors may be necessary, depending on the nature of the contract.
  4.  Where possible standardising parts of the contract reduces conflict, enhances, predictability, minimises misspecification and reduces transaction costs. 
  5. Public disclosure of principal contract terms.
  6. Post implementation monitoring of contracts to ensure value is delivered.

Sri Lanka’s railways are a drain on the treasury. With tight budgetary constraints the Government will face increasing difficulties in allocating adequate resources to maintain, let alone develop, the railways.  The railway is an important component of transport infrastructure and improving its efficiency will contribute to the overall productivity of the economy.

Creating competition and private participation in the in the supply of services, utilisation of idle assets and supply of railway infrastructure could enhance efficiency and improve service. The Government should explore these options.


[1] Weerawardana W.J., Reduction of traffic congestion in Colombo city by improving public bus transport.

[2] Enhancing the Efficiency of the Sri Lanka Railways and its Contribution to Transportation, Sisira Kumara, Economic Review Aug/Sept 2011

[3] Ibid

[4] Auditor General’s Department, Annual Report 2016

[5] Report of the Auditor General on Head 306-Department of Sri Lanka Railways-Year 2015

[6] First Report of the Committee on Public Accounts (from 01.01.2016 to 07.04.2016).

[7] Ministry of Internal Transport, Performance Report 2014

Do we need more people in public service?

Originally appeared on The Daily FT

By Shyranthi Dhurairaj

Additional secretary National Policies and Economic Affairs, Mr Asanga Dayaratne announced recently that the government will be appointing 20 000 graduates as Development Officers (DO) this month. This decision was taken after interviewing 57 000 graduates who had graduated on or before 31st December 2016. Additionally, the Cabinet will recruit 7500 more graduates after the elections in August 2018 who will also be absorbed in as DO’s later. 

Why are these graduates being hired? It appears that this is a make-work programme. As per recent press reports, it appears there are no real vacancies to hire people but since these graduates are demanding jobs, jobs are being created by the state. The number of DO’s in Sri Lanka is 50 904 (2016 data). This new recruitment drive will increase the number by almost 40%. Such a sharp increase may mean other costs – they will need office space, furniture, computers and other facilities.

We may view this charitably, why not give the unemployed jobs? The question is who pays for this?

Sri Lanka’s budget is already overstretched, the country has run a persistent budget deficit, averaging over 7.7% of GDP since 1990. The deficit has been met partly by borrowing, which is why the debt-to-GDP ratio has averaged 89.1% during the same period, almost double that of our peer group. The recent increases in taxes, VAT, income tax and others were needed to bridge the deficit. If more people are to be recruited, the salary bill will rise and there will be a need for increases in taxation. It will not be immediate, the tax increases will come a little later, but eventually it will need to happen, just as the recent tax increases followed increments given to the public sector in 2015.

What is happening here?

The government is giving jobs to graduates, but then taxing people to pay for it. All that is happening is money is being transferred from the general public to newly-hired graduates. The graduates will be happy but the public who sympathise with their plight may not realise that the salaries of these people will eventually be paid by them.

People forget that they pay tax every time they go to the market. VAT, import duties add a lot to the cost of a shopping basket, or to a meal in a restaurant. 

Are people getting richer? No. Will the graduates who get jobs be better off by having the public pay for this?  What if the private sector creates jobs? Salaries would then be paid by businesses that hire people from the profits that they earn. The public will not be paying the salary bill. Instead the businesses will, from whatever they earn from their customers.

In fact there are many unfilled vacancies in the private sector. While the public-sector is overstaffing, there are 497 302 open vacancies in the private-sector. A local agricultural entrepreneur based in Polonnaruwa stated, “It is very difficult to find semi-skilled workers to operate our machinery, because their attitude is such that they would rather stay home until they get a government job”.

The problem is that the jobs available don’t meet the expectations of the graduates or that graduates lack the needed skills for these jobs currently open in the job market.

What the government could do is assess the skills demanded by the job market, and invest in retraining these graduates. The retraining will be a one-off cost but, the graduates will have a productive job – in places where they are actually needed and there are no long term costs burdened on the public.

Some graduates don’t like jobs in the private sector. An unemployed graduate from Ruhuna University stated, “I am a graduate from Ruhuna University. I’ve been unemployed for three years and is waiting for a government job. I am not interested in a job from the private sector, so I have never applied for one. Government jobs are secure and unlike private jobs, they provide a pension.”

What they, and the public must understand is that taxpayers cannot finance this anymore. There are many other problems that also burden taxpayers including losses in State-Owned Enterprises (SOEs).

To create better jobs, the Government can facilitate new investment; especially in new sectors by cutting red tape and improving the business environment. The sustainable way to better jobs is through new investment, not make-work programs.

Overstaffing infographic.png

Killing aspirations by regulating tuk-tuks

Originally appeared on The Daily FT

By Dhananath Fernando

What do regulations enforced after the 1st of August mean for tuk-tuks?

I live in Moratuwa, down Diggala road, a 2 km by-road from Keselwaata Junction on the Old Galle road. In my little hamlet, there are only two mini Lanka Ashok Leyland busses that operate in synchronization with the train time table from the Moratuwa Railway station to Diggala Road. Regardless of this inefficient bus operation, my saviors are an efficient and unique operation of tuk-tuks that cover a 2km radius from the railway station, enabling the commuting needs of the neighborhood. 

MAPPING OUT THE TUK-TUK OPERATION

In terms of the cost, the three wheelers engaged in this operation on this route only charge a ‘per passenger’ rate instead of a ‘per Km’ rate or a standard hire fare like almost all other tuk-tuks in the country. This means that each person has to only pay a fare of Rs.20 (despite the distance) and they take 3 passengers at a time in a single tuk. In simple words, it is a three-passenger bus system operating at every 10-minutes intervals. Their services are available until about 11.00 pm and I am very grateful to all the drivers operating their three-wheelers in the route and for providing us daily commuters with such an honorable and sustainable service.

You could even call me an over-satisfied customer as the journey is comfortable than the bus in many aspects. Seating facility, availability, frequency, reliability and ability to get off the vehicle right near the gate of my house are just a few advantages of this service. All this, is just Rs.5 higher than the bus fare (which is unreliable and mostly unavailable).

This is one, of the many services rendered by tuk-tuks that fail to reach mainstream newspaper headlines. Hence why it worries me of the adverse impacts that would overcome the industry when strict regulations are imposed by the “National Council for Road Safety” where they plan to regulate three-wheelers to have a meter with printed bills starting from the 1st of August, 2018. On the surface it looks like a step right direction as it seems to protect a consumer using this service, but in a practical world there would be many unintended consequences. Let’s analyse how these regulations would affect the tuk-tuk service in my area.

THE ADVERSE IMPACT OF REGULATIONS ON TUK-TUKS

If the tuks in my area were to adhere to new regulations and introduce a meter and a printed bill, they will no longer be able to charge a per passenger rate. Instead they have to charge a fare as per the standard meter rate. This results in someone like me, who initially only paid a Rs.20 for a one-way fare from the railway station to my house, now paying up to Rs.60 a ride, a price hike of 300%. Personally, I don’t think that I should bare this extra cost for the sake of receiving a standard fare rate and a printed bill. Eventually, this will result in me limiting my usage of tuk-tuks as a consumer. I know that the demand for tuks in my neighborhood would reduce and this isn’t a phenomena only limited to my area.

There is also a second possible outcome scenario of these regulations. The issue with regulations is the limited capabilities and downfalls of the government in terms of endorsing them. Most tuk-tuks will continue to operate as they do now, automatically creating a black market supply in tuk-tuk services. I am not arguing against regulations because of the inefficiencies in endorsing them, I am arguing against the case of regulations because regulations are not the best way to achieve the stated objectives; a standardized tuk-tuk fare across the country

UNLOCKING INNOVATION THROUGH COMPETITION, NOT REGULATION

Most Sri Lankan state institutions and politicians, across all parties, believe that state intervention and regulation is the only solution for public concerns as this. The practicality of regulations and its eventual reality does not agree. We often forget that the innovations made in the taxi services industry, like telephone call based taxi services such as “Budget Taxi”, “Fair Taxi” or taxi services utilizing the use of mobile phone and app technology, such as “Pick me” were not a result of regulation or strict control over the industry. These innovations were a result of minimum regulation and the presence of competition in the free market provision of tuk-tuk and taxi services. It was simply the freedom and space to innovate and serve customers and taxi drivers better to meet higher profit targets that drove these businesses to create such innovative solutions in the industry.

The world and markets evolve based on the needs of consumers and there needs to be market freedom to ensure innovative solutions to meet these needs. This is a fundamental in economics theory and not a concept of rocket science, or as some may call it, a “foreign conspiracy”.  

Additionally, according to the guidelines of the new regulations, every tuk-tuk must have a meter and should issue a printed receipt to the customer at the end of every ride. Does this mean that the many mobile app taxi services that generally provide an SMS receipt now require to provide a printed bill? When the entire world is going green, why an extra hassle for the driver to print a bill out at an extra cost?

As a passenger and a consumer there are services I expect a receipt for and there are services a receipt is not an expectation. If it is a household electronic item, I will definitely demand a receipt for warranty and returns purposes but from a taxi driver, the least I expect is a receipt. Rather I expect a safe and quick ride to my destination. This is not the first time the current government made attempts at regulating tuk-tuks. They imposed a minimum age ceiling for tuk-tuk drivers to be over 35 years of age. The justification behind this was apparently that three-wheelers contributed to the most number of road accidents of the recent past. However, as the data below shows, this was not the case.

     

 

 

LEAVE TUK-TUKS ALONE

Three-wheelers are not just merely a mode of transport. It means different things to those from different walks of life. For a rural commoner, it is an ambulance in a time of emergency. It is equivalent to a VIP Defender for an office worker, in a rush for his afternoon meeting. It is wedding car for a poor household. For entrepreneurs in urban and rural parts of the country, it is their mini lorry and companion. More than everything, it is an aspiration and product of pride for more than 1 million households in Sri Lanka. A poor man has to shoulder a tax of Rs. LKR 420,000 on a tuk-tuk. This tax, is then used to fund loss making state-owned enterprises; provide for the excess of government sector employee’s salaries and pensions; and a continuing list of unnecessary provisions. It is not rare to find tuk-tuks with logos of European cars pasted on its body. You’d see “Audi” to “BMW” stickers galore in some tuk-tuks. This sends a strong message to the rest of society. To a poor man, it is his BMW and his Audi. In other words, it is his aspiration and it is his world. Killing these aspirations with unnecessary regulations is never the solution, restructuring the service provided through competition and innovation, is.

Floors and Ceilings: State Intervention in the Dairy Industry

Originally appeared on Echelon

By Ravi Ratnasabapathy

Milking the consumer

The dairy industry has been promoted by the government with the objective of achieving self-sufficiency in milk products. The objective appears to be a moving target, with the most recent year for achievement being set to 2020. Currently, local production meets less than 40% of the total domestic milk requirement.

In 2015, local milk production was 374 million litres, a 12.1% increase from the previous year. In comparison, imports of milk and milk products grew 21.5%. Growth in imports of milk powder outstripped growth in local production over seven of the last ten years. Unfortunately, policy towards the dairy industry is a confused tangle of taxes and controls designed to achieve contradictory objectives. A bulk of the consumption takes the form of milk powder, most of which is imported. Local milk is mainly used for value-added products, and only surpluses are converted to milk powder. The policy is complicated because there are two administered prices in the value chain – a maximum retail price on powdered milk and a guaranteed farm gate price for liquid milk. Influencing the value chain and adding complexity are taxes on imports of milk powder. Milk powder prices are politically sensitive.

Policy is primarily geared towards the goal of protecting consumers, and interventions are made from time to time to set maximum retail prices. Farm gate prices of milk are mandated to encourage local production, with the objective of achieving self-sufficiency. Farm gate prices of local milk tend to be high; the cost of production of MILCO being the key determinant of price.

Farm Gate Price.png

According to the FAO:
“The farm gate milk price is largely determined by state-owned MILCO’s processing and marketing costs, both of which are reputed to be relatively high. The government uses the farm gate price as a political tool because it needs MILCO to cover its costs. The large private firms engaged in milk product manufacturing follow the purchasing prices offered by MILCO.”

Naturally, this increases the cost of the final domestic product. Between 2010 and 2016, farm gate prices doubled from Rs34 a litre to Rs70. International prices of powdered milk halved between 2014 and 2016, but Sri Lankan consumers did not benefit, as the controlled prices of imported powdered milk were only reduced by 16% from Rs386 to Rs325 for a 400g pack.

There is an inherent conflict between the maximum retail price, designed to protect the interests of consumers, and minimum farm gate prices, aimed at encouraging domestic production. The contradiction between a floor price on liquid milk and a price ceiling on powdered milk means that producers have an incentive to produce items not subject to price control such as liquid milk, flavoured milk, butter, cheese and yoghurt. However, as the input cost is high, they can only retail at high prices and are not competitive compared to imported products.

The government resolves this particular dilemma by imposing punitive taxes on imported dairy products: Rs880/kg on butter, Rs625/kg on yoghurt and around 140% on cheese. This raises the price of imports, enabling local producers to compete, but as this has the effect of raising overall prices it is detrimental to consumers.

In a further contradiction, the government also taxes the import of powdered milk, even while it imposes a maximum selling price. The tax is designed to earn revenue for the state. Importers of milk powder are squeezed between the tax (which raises costs) and the controlled price, which sets a ceiling at which the product retails. The taxes change, depending on world market prices. In the past, when world market prices dropped, tax rates were increased (while retail prices were unchanged) to earn revenue for the government. When world market prices increase, the importers lobby for revisions to the controlled price, and the government responds either by raising the controlled price, or if a price increase is deemed to be politically unfeasible, reducing the tax temporarily. After a recent reduction, the current tax (approximately 28% of the import price) is relatively low, but historically it was much higher: as much as Rs350/kg in 2014.

The ceiling on milk powder prices also creates problems for local liquid milk producers, as they are unable to convert any surplus liquid milk to powder at a profit. The local dairy industry focuses on value-added products due to better margins, but the market is too small to absorb the entirety of liquid milk produced. As excess milk cannot be stored for long in liquid form, it must either be converted to powder or disposed of. It appears that although high taxes on value-added products mean that local production is encouraged, the resulting high consumer prices restrict consumption growth. Whenever a surplus of liquid milk is collected, producers face the dilemma of either destroying it or converting it to powder, both options resulting in a loss.

The government is committed to raising domestic production and competitiveness, but structural impediments mean the cost of local production is high. Prof. Sivali Ranawana of the Faculty of Livestock, Fisheries and Nutrition of the Wayamba University has identified some of the reasons for the low productivity, including lack of quality pasture/forage, small farm holdings and the climate (which restricts the breeds that can be used).

MRP of 400g Milk Powder Pack.png

The best livestock, pure European breeds, can only be maintained in the hill country, and even in that region, there is a lack of forage of adequate quality. The FAO note that: “Animals are mostly fed on natural grasses available in common lands, such as roadsides, railway banks, fallow paddy fields, tank beds and other vacant lots, all maintained under rain-fed conditions.”

Although the good breeds in the upcountry have the potential to yield 20 litres of milk per day, a level achieved on some intensive farms; the average yield, even in the best climatic conditions, is only half this level.

According to the last comprehensive survey (conducted in 2008/9) by the Department of Animal Production and Health, average daily milk yields per cow were 10 litres in Nuwara Eliya, 5 litres in Kandy and 3 litres in Matale. Overall Sri Lanka’s cows produce a woeful average of 2 litres of milk per day. Given the problems facing the domestic dairy industry, it is not surprising that the costs of production are high. Government intervention in the dairy market is a game of political theatre. Price ceilings on milk powder placate the public, even while the government contributes to raise costs by taxing the input. Minimum farm gate prices please the dairyman, but squeeze value-added producers who then need protection from imports. Consumers are the ultimate losers, facing limited choice and high prices.

Kick-Starting FDI - Industrial Zones with a Twist

Originally appeared on Echelon

By Ravi Ratnasabapathy

Liberalising Sri Lanka’s economy is a controversial topic. Different groups have different views on what this means or how far it should go, but most people will agree that attracting FDI and boosting exports is a good thing. One way to reconcile differing interests is to revisit the old concept of industrial zones – but with a twist; privately-run zones that are managed by international zone developers. The success of Japanese and Thai industrial zone developers in Vietnam and Thailand offer a model that may be replicated in Sri Lanka. Japanese zone developers offer investors a complete solution – not just the physical infrastructure but all the soft services: from company incorporation, tax registration and advice on visas for expats to introducing accounting and law firms.

COMPREHENSIVE ‘HARD’ INFRASTRUCTURE
The ‘hard’ infrastructure goes beyond just the land, power, water and waste disposal that Sri Lanka’s zones currently offer. Japanese developers offer housing (flats for expats), clinics, schools, banks, shops and even a Japanese restaurant (or canteen offering Japanese food) – sometimes even a golf course. With regard to power, the developers either have special arrangements with the utility to guarantee continuous power (with engineers dedicated 24×7 to deal with issues) or have a private power producer as a tenant in the zone. For example, in the Amata Nakorn Industrial Estate in Thailand, the developer has group companies that provide power, water, natural gas, logistics and transportation services to clients within the zone.

What developers provide is a complete infrastructure and services model in which client companies can start operations almost on a plug-and-play basis

SUPPORT SERVICES
The developer also offers services: continuous support during factory construction, as well as ongoing operational support—logistics, customs, recruiting, banking, courier service, security guards and fire brigade. To deal with problems, they provide a 24-hour, 365-day helpdesk. They also disseminate information on changes in laws, wage levels, etc., and hold a monthly meeting with tenant firms to discuss any common issues. Critically, soft services are provided by Japanese staff (or fluent Japanese speakers who understand their business mindset). Japanese investors tend to be more risk-averse than others, and Japanese SMEs even more so. The advantage is that, if a zone is developed with the Japanese, the standards of service would be to such exacting levels that any other investor would find it a breeze.

Thus, what developers provide is a complete infrastructure and services model in which client companies can start operations almost on a plug-and-play basis.

GETTING LAND AND DEALING WITH RED TAPE
A recent paper on industrial zones and their link to economic growth notes that access to suitable land is one of the biggest problems faced by investors. Some 80% of the land is owned by the government, and difficulties in obtaining land combined with uncertainty over land policy (constantly changing tax rates, ownership restrictions) act as a deterrent.

Interviews with investors revealed that it was relatively common for FDI projects to be stalled or cancelled due to land disputes with the government; as a result, many investors report using middlemen to obtain approvals.

Likewise, smaller firms reported operating without a licence due to issues securing formal land approvals. Industrial zones offer easy access to land, which solves this problem. It is worth noting that Sri Lanka has not built any new zones since 2000 (although some are now underway), and all the existing 12 zones are full. The lack of land may as well account for low FDI flows. The other problem is red tape when obtaining approvals, unclear or contradictory rules, multiple agencies and delays. The current zones offer some blanket approvals: environmental and land clearance, electricity, water and telecoms. However, site, building plan, environmental protection license and certificate of conformity all need separate approval, though the EPZs do offer an expedited process.

Nevertheless, a further gamut of paperwork must go through the normal approval processes: preliminary investment clearance, work permit/visa, tax registration, import and export registration, import and export licence, rules of origin certificate, chemical materials approvals, and company registration.

There is room for further simplification or speeding of approvals, which the developer will need to work with the BOI to achieve. Even if the red tape is minimised, it will still be a problem. From an investor perspective, having the developer to guide them through an unfamiliar bureaucracy in a foreign language in a strange country is a huge plus.

The Japanese philosophy is to create the environment where the investor can focus on his business, leaving all the hassle to be sorted by the developer.

COMPETITIVE FISCAL INCENTIVES AND A STABLE POLICY ENVIRONMENT
Policies in Sri Lanka are driven by short-term political considerations. Ad-hoc changes in rules and tariffs cause uncertainty, deterring investors. An export zone can be better insulated from domestic policy upheavals as it has minimal local market impact.

Industrial zones in Thailand and Vietnam offer a complete waiver of all import tariffs and VAT, as well as time-bound income tax holidays. Currently, exporters in Sri Lanka are offered similar terms for raw materials but not for capital goods, placing Sri Lanka at a disadvantage.

While Vietnam and Thailand allow the import of all construction material in zones free of tax, Sri Lanka charges PAL, NBT and duty on capital goods. Worse, key construction materials are subject to high protective tariffs and are on a ‘negative’ list, meaning that they must be sourced from the local market, at a higher cost. This raises construction costs significantly, resulting in lower returns to investors.

Sri Lanka is only one among many destinations for FDI. To succeed, we have to make a competitive offering. A comparative analysis of the tax/tariff regime is needed with competing destinations to offer an attractive overall package to investors.

The zone developer not only develops but also markets the zone. The developer’s return is earned through rents and fees for ancillary services, so they have the incentive to ensure the zone is filled.

ATTRACTING INVESTORS
The zone developer not only develops but also markets the zone. The developer’s return is earned through rents and fees for ancillary services, so they have the incentive to ensure the zone is filled.

One of the problems faced by Sri Lanka is the lack of diversification in exports. Exports grow not only because of volumes, but also because of new products being added to the basket. Between 2000 and 2015, Sri Lanka added just 7 new products (worth $0.1 billion) to its export basket. In contrast, Thailand added 70 new products (worth $21.8 billion) and Vietnam 48 (worth $50.4 billion). The possibility of exporting related products within Sri Lanka’s existing export basket seems exhausted, so completely new sectors must be attracted. Attracting investment into a sector in which the country has little experience is difficult. Firms tend to cluster in close geographic proximity to each other to benefit from reduced transport costs, shared inputs and productivity spillovers due to learning and technology transfers. Getting a good anchor tenant who attracts a critical mass of related firms to move is important.

A well-connected zone manager already has relationships with potential investors and can encourage their clients from other countries to extend their production networks to Sri Lanka.

For example, the Thang Long Industrial Park (Vietnam) attracted Canon, which was followed by several dozen satellite Japanese businesses. Today, the park hosts 98 businesses, 78 of which are Japanese.

OWNERSHIP MODEL
There are many ownership options for industrial zones, public, private or JV, but the model best suited at the initial stage is a public/foreign joint venture. The government, represented by the BOI, provides the land and the private developer invests in the infrastructure. As the BOI has a stake in the venture, it has an incentive to make it work. The BOI works with the developer to secure all approvals and streamline the processes. The developer manages the zone, renting the properties and providing services, and the government takes a share of this.

The good news is that Sri Lanka is taking steps in the right direction. Currently, a logistics and industrial zone is being developed in Hambantota with Chinese investment, while Rojana Corporation of Thailand, a joint venture with Nippon Steel and Sumikin Bussan Corporation of Japan, is setting up an industrial zone in Kalutara. More must be done. As at September 2016, Vietnam had 220 zones in operation with a further 105 under construction. In Thailand, the central agency operates 9 estates, plus 39 more in conjunction with the private sector, while 50 more zones are entirely private owned and operated.

To work best, they should follow the full service model described above and offer a competitive fiscal package.

 

The kind of ‘liberals’ we are

Originally appeared on Daily FT

In an Op-ed published in the Daily FT recently, a group called ‘Avocado Collective’ provided a critique of a lecture by Prof. Razeen Sally organised by The Advocata Institute. Whilst much of it is a critique on the lecture, it casts aspersions on the motives of Advocata. We thought this was a good time to explain what the organisation is about and why we exist.

The Advocata Institute was set up in 2016 as an independent public policy think tank focusing on economic freedom. Sri Lanka’s public debate on economic policy has been dominated by those who believe that state intervention is the answer to all our problems. Advocata has sought to present an alternative view. 

Poor policy and governance are at the root of our problems. 

Take for example State-Owned Enterprises (SOEs), a major area of research for Advocata. The 55 largest State enterprises collectively lost Rs. 87 b in 2017, almost double the Rs. 43 b allocated to Samurdhi, the largest social welfare programme in the country. The losses of SriLankan Airlines alone were Rs. 28 b. 

The Auditor General has exposed billions of rupees in procurement corruption and mismanagement in the State and State enterprises. These losses are paid by taxpayers and, taxes are paid by everyone not just the rich. 

Last year alone, the Government raised Rs. 71 b by taxing food. This is partly responsible for the high cost of living in Sri Lanka. Is funding losses the best use of our tax money?

The country has some 200+ State enterprises but no comprehensive list is readily available. Procedurally, State enterprises must be incorporated by an Act of Parliament and be held accountable to Parliament. In Sri Lanka, all manner of entities are incorporated under the Companies Act with no debate in Parliament and minimal accountability.

Audited accounts of the 55 enterprises where more data is available are chronically late. When they are published, they frequently carry audit qualifications. Some – such as LakSathosa – have not submitted accounts from 2010. Poor accountability results in fraud. For example, the Auditor General reported a fraud of Rs. 15 b in rice procurement at LakSathosa. There are many others. 

We need to ask the question whether the running of a supermarket is the proper role of the Government. Or whether there are better ways of achieving the stated policy objectives of running LakSathosa. Similar questions can be asked about many other institutions, including the State Timber Corporation, which had its last two chairmen arrested under corruption charges. 

The State is engaged in economic activities that range from the strategic to the absurd. From hotels catering to tourists to firms claiming to convert polythene into diesel. What public interest do these enterprises serve?

Posing these questions is hardly a neoliberal conspiracy. It is only reasonable to assume a state that tries to do a limited, well defined set of things has a greater chance of success than a one that tries to do everything and failing at great cost to the people

This is particularly relevant since over several decades Sri Lanka’s once-effective public service has been broken. Some have even questioned the capacity of the State to deliver the most fundamental of public goods: the rule of law and a system of justice.

Is there a conspiracy in asking for sound money and low inflation? Is not keeping the cost of living low the most important safety net for the poor?

Protectionism is another problem. Sri Lankan consumers have to bear extraordinarily high prices due to high taxes. Protective tariffs are rampant in common consumer goods such as footwear, electronics and in vital industries like construction. These tariffs serve narrow political and business interests at the expense of all others. 

Tariff reform is naturally opposed by businesses who have a captive market. Their opposition to competition is at least understandable. What is more surprising is the opposition from groups such as the ‘Avocado Collective’ who perhaps inadvertently, find themselves siding with these groups, and indeed Donald Trump, on his views on trade. 

Sri Lanka faces multiple challenges including an unsustainable fiscal position characterised by persistent fiscal deficits and high levels of debt, particularly foreign commercial debt. Tightening global conditions could increase the cost of debt and make rolling over the Eurobonds maturing from 2019, more difficult. 

Uncertain property rights and trade restrictions deter investment, impairing job creation. The State has stepped in to fill the vacuum of jobs, it employs one in every 15 people, but the narrow tax base does not support the superstructure of the expenditure. Resorting to debt to fund recurrent expenditure is no longer sustainable.

The lack of opportunities and the cost of living cause many Sri Lankans to look overseas for advancement.

New challenges loom in health as the population ages while risks from climate change have increased. Is the education system geared to meet the needs of a knowledge economy? There are important questions to be raised on the priorities of public spending as well as the quality and effectiveness of spending. 

We believe that we need to rethink these issues and our objective is to bring alternative ideas for discussion since they are absent in the current discourse. We hold lectures and publish research and commentary, all of which, including videos of lectures are available online at advocata.org and our social media pages. Our public lectures have been open to all. 

We have always been open about our priorities. Our ideal Sri Lanka is one that is prosperous, open and free. A system that allows for maximum individual freedoms, particularly economic freedom. A country where anyone can succeed through hard work, personal responsibility and determination. 

Are these good things? How do we get there? There can be legitimate disagreement. Our role is to provide ideas, stimulate debate and offer practical solutions based on evidence, not to be the ultimate arbiter. 

Shooting down messengers is a spectator sport among Sri Lanka’s political elite. Constructing conspiracy theories is a fanciful, if entertaining, exercise practiced by those trying to de-legitimize real issues and will do little to move us forward.


By Fellows of the Advocata Institute in response to the article ‘What kind of liberals are these?’ published in the Daily FT, Friday 29 June. More information on Advocata is on www.advocata.org.

Politicians or technocrats?

Originally appeared on Echelon

By Ravi Ratnasabapathy

A layer of technocrats working with ministers can improve policy.

Sri Lanka’s long-suffering citizens face yet another election this month. Many are disappointed by the performance of the current government. The dreary parade of candidates for the upcoming election, actresses, singers and other sundry characters (mostly unsavoury), is uninspiring.

People yearn for technocrats, people with knowledge and skills, to come in and clean the house (similar to Plato’s ideal of a Philosopher King); but how can this be achieved?

Is the solution ‘qualifying criteria’ for politicians? The problem with electoral democracy is that such a thing is not possible; it would be seen as inherently unfair. Other countries also have their share of lunatics in the fray: South Korea created a blacklist to filter unsuitable candidates, an idea that is worth exploring, but a better solution is to have a layer of technocrats below the elected politicians. Technocracy should be in charge of day-to-day administration, to advise and guide politicians as to good, workable policy, and then implement it impartially. This is an attractive idea, but is it only wishful thinking? No; and in fact, independent Ceylon did in fact have this in the form of Civil Service, a body of people famed for intellect, independence and probity.

When we refer to a civil servant, it is not a crony who owes his appointment to some political master. A civil servant should be one selected on the basis of excellent academic credentials and a rigorous entrance exam. This ensures that only bright and intelligent people are brought into the service. This is then followed by a two-year period of internship (that was called a “cadetship”), where they learn the practical aspects of administration by working alongside senior colleagues. It is only after this process that they will be fit for the real administrative work in running a country.

Thus, the people entrusted with administration will have a minimum of three years of university study and two years of practical experience even before they start real work. Note that only the best of the graduates (based on their grades) were originally selected and subjected to a further rigorous examination, so there is reasonable certainty that the basic intake is of intelligent people whose minds have been trained to think. Invested with a further two years of on-the-job training, by the end of a total process of five years, we have the basic material on which an efficient system of administration may be built.

With no entry qualifications, minimal or zero education, and only the ability to appeal to the basest of popular sentiment, the politician, unchecked, is the most dangerous creature in which to vest the reins of power.

A civil servant should be one selected on the basis of excellent academic credentials and a rigorous entrance exam. This ensures that only bright and intelligent people are brought into the service

Yet, electoral democracy calls for persons to be elected by popular ballot, and the field should be open to all. How can these be reconciled? The technocrat must guide the politician, advise him (or her) on the options available and check their wildest impulses. But, if this is to work, the technocrat must not be beholden to the politician. The civil service must be independent and, most importantly, politically neutral.

Independence is ensured if politicians have no say in the appointment, dismissal, promotion, transfer, pay or other matters, which must be in the hands of an independent Civil Service Commission. The service must also be politically neutral and serve governments of different political hues equally. If the service is seen as impartial, then politicians have less incentive to interfere, contributing to its independence.

Civil servants should not engage in any political activity: they must not campaign for or against any party, nor misuse state resources or power for partisan purposes; nor should they shy away from carrying out their duties when a matter is politically controversial. Politicians have democratic legitimacy, while civil servants, as unelected officials, do not. Political neutrality is necessary to bring democratic legitimacy to technocrats, the scholar mandarins who influence and implement policy.

Politicians suggest broad policies; civil servants need to advise ministers as to how these can be implemented in a workable manner. Civil servants need to examine all options: Martin Donnelly, a senior UK civil servant, stated that civil servants should avoid having to answer the question “Why wasn’t I told about this?” by disclosing all potential outcomes that might take place at the outset.

He went on to say that civil servants should also “offer some advice that is not accepted to ensure a genuine fair hearing of all options that are within a government’s political direction”. If politicians’ views are not subject to scrutiny, they may miss the opportunity to consider changing them.

Politicians generally view things on a shorter time horizon; permanent civil servants, who have to work and live with the consequences of policy in the long term, naturally take a much more longer term view. Politicians want to make the big announcement at the right time, while civil servants are more apt to take the necessary time to examine all options, resource constraints and the scale of risks, even if that means taking longer. Such a system allows collective and personal experience to be drawn and built upon, safe policy debates to occur, and experts to be brought in for shorter or longer periods.

The minister does not have unbridled power, so hasty promises made at election time cannot be implemented ad-hoc: they are refined and adjusted in keeping with the constitution, the law and practical considerations. It is through this process that promises are turned into practical policy. Often, the relationship between the two will be tense; the inexperienced and idealistic politician will demand things that sound nice but may be unfair to some citizens (people outside his particular constituency), too expensive, unsustainable or otherwise impractical.

The comedy ‘Yes Minister/Yes Prime Minister’ is based on the tension between the well-meaning but bumbling minister and the crafty permanent secretary Sir Humphrey Appleby. Although the comedy portrays Sir Humphrey as being devious, he is performing a vital function in checking and tempering the enthusiasm of the minister.

The education, training and experience of the civil servant is thus essential in tempering policy. The politician is involved only at the larger policy level, and unless there are pressing problems to be resolved, has little to do with routine administration.

Belgium ran quite successfully for a better part of two years without a proper government (i.e. politicians), and could have carried on for much longer with no serious difficulty; its administration was functioning properly under its civil service.

Technocracy should be in charge of day-to-day administration, to advise and guide politicians as to good, workable policy, and then implement it impartially

These ideas are far from new or radical. They were first practised by the imperial Chinese, with the first formal exams being introduced in around 605AD. This was refined and expanded over a period of 1,300 years, until 1905. These bureaucrats, the Mandarins, were the scholar officials who ran the Chinese empire, at one time the greatest in the world. This system was adopted and further refined by the British, who in turn ran their empire on these lines. It is estimated that around 120,000 people were involved in running the British Empire, although only 4,000 were directly involved. Sri Lanka today boasts 1.3 million in public service, about 500,000 of who are in the military, leaving about 800,000 to run the civil administration.

It is also the system that was used in independent Ceylon, until 1962, when short-sighted politicians facing difficulties with implementing their various hare-brained schemes decided to abolish the civil service, starting the rot that leaves citizens today wondering whether to even cast their vote at all.

An important check on the politicians was removed; so now it is irrepressible politicians who hold the reins of power.

What is needed to try and restore this system? It is very difficult, but the first step would be the creation of a completely independent Public Services Commission, which would be responsible for the appointment, transfers and
promotion of all public servants.

Ministers should no longer control the fate of public servants.

The next step would be to change mindsets: Instil the values of the civil service code through training. A basic training to instil the core values of honesty, integrity, impartiality and objectivity should be carried out throughout the service. This must be followed up by more specific work to address skills gaps.

In general, training must focus more on senior ranks, if they are to set and demand higher standards of work from juniors.

Any policy or programme is only as good as its implementation. Given the abysmal quality of politicians, even getting policies right is a problem. Working to build an independent technocracy is essential to improve policymaking and its implementation.

Recreating something that was built over a century, but destroyed within a couple of decades, will not be easy, but it’s the only way forward. Leave it to degenerate further and we will be left with a situation where it grinds to a complete halt, under its own sloth and inertia.

Bringing sanity to public finances

Originally appeared on Echelon

By Ravi Ratnasabapathy

Ad-Hoc policies have created unsustainable long-term spending commitments. A medium-term expenditure framework can discipline policymaking.

Sri Lanka has experienced a large and persistent budget deficit, averaging over 7.7% of GDP since 1990. The deficit has been met partly by borrowing, which is why the debt-to-GDP ratio has averaged 89.1% during the same period, almost double that of our peer group. The government has attempted to close the deficit through painful and unpopular tax increases; but amid the rising cost of living, public patience for this has already worn thin.

With elections looming and the popularity of the government sinking, there is a danger they will revert to giveaways without considering the impact this will have in the longer term. Giving jobs or salary increases to state workers is a popular short-term gimmick, but involves long-term commitments: salary payments over the life of the employee, often followed by a pension. With 1,358,589 people already on the State payroll and a further 600,000 drawing pensions, this is no longer sustainable. Salaries and pensions alone consume half of government revenue.

The accumulated ills of various shortsighted measures have taken the country to the brink of default. There is an unprecedented ballooning of foreign debt repayments over 2018-22 amounting to a massive $14.9 billion. To put this in context, the current IMF facility is only $1.5 billion.

The maturing debt is too large to be repaid, so must be rolled over, which means we need to borrow to repay. In order to do so, we must maintain investor confidence. Failure to do so will lead to higher borrowing costs – something we cannot afford. Moody’s ranks Sri Lanka among the countries most exposed to an interest rate shock. Interest payments already consume around 36% of government revenue, an increase in rates will put severe pressure on the budget.

The accumulated ills of various shortsighted measures have taken the country to the brink of default. There is an unprecedented ballooning of foreign debt repayments over 2018-22 amounting to a massive $14.9 billion

Moody’s warns, “Persistently high government liquidity and external vulnerability risks continue to pressure Sri Lanka’s credit profile, and specifically measures to build reserves and smooth the profile of external payments may be insufficient to stem imminent government liquidity and balance of payments pressures starting in 2019, when large international debt repayments come due and Sri Lanka’s three-year International Monetary Fund Extended Fund Facility programme concludes."

This is why the Finance Ministry has pushed through unpopular tax hikes and increased fuel prices. Foreign lenders will look at the country’s finances to assess its ability to repay; so in the short term, there is no sensible alternative but to collect more taxes. The real problem, however, is not tax but runaway spending; over 2000-16, total spending grew at a compounded annual rate of 12% (from Rs335,822 million to Rs2,333,883 million), with the deficit following suit (Rs119,396 million to Rs640,326 million). Foreign financing of the deficit grew from Rs495 million to Rs429,130 million in the same period. It is government spending not taxation that ultimately determines the total burden of government activity on the private sector. Although spending may be financed by borrowing or printing money (instead of taxes), all government spending is ultimately a call on resources that have alternative uses, or involves transfers from one group of society to another.

Debt is simply taxation postponed, with interest added. Money printing can tide over in the short term, but ultimately results in inflation and currency depreciation. The need, therefore, is to reign in expenditure, which must start with a proper plan.

Large businesses routinely plan for 3-5 years, but the government relies on an annual budget, which is produced by a bottom-up approach – i.e. the various departments submit their estimates of expected expenditure, which are then amended and collated centrally. Planning and policy is geared to the annual budget cycle, and little attempt is made to prioritize spending.

Debt Balloon and Yawning Deficit.png

Planning must move away from annual budgets to a Medium-Term Expenditure Framework (MTEF), three-to-five year rolling plans, the important features of which are as follows:

  • Extends the timeframe of budgeting from 1 year to 3-5 years.
  • Projects the future cost of existing programmes and approved policy changes (baseline).
  • Establishes hard spending limits – fiscal targets (i.e. deficit or total spending).
  • Establishes a procedure for proposing any new policy initiatives.
  • Rolls the MTEF forward each year, adding a year at the end.

The Treasury can work backwards from revenue, assuming no changes in the tax structure and the deficit target to arrive at the overall spending limit. Matching this with projected costs of current programmes will indicate if there is space available in the budget for new policy initiatives. Fiscal space is the difference between baseline projections and the government’s spending target; if there is no space, no new programmes can be accommodated, unless some existing programmes are cut.

The overall spending limit is a ‘hard’ limit, but within the overall limit, reallocation can take place. This forces the Cabinet to consider spending priorities – where should limited resources be allocated? The Cabinet can determine soft ceilings for ministries that need to ‘win’ competitively on the basis of plans submitted.

Although spending may be financed by borrowing or printing money (instead of taxes), all government spending is ultimately a call on resources that have alternative uses, or involves transfers from one group of society to another

The Treasury needs to reward credible plans, so those that provide performance measures, specify outcomes, outputs and costs should receive more funding. Performance measures help make the case for budget allocation and enable monitoring of programmes. Performance measures are based on the following parameters:

  • Inputs: Measures the resources used to provide government services, such as personnel, operating expenses and capital.
  • Activities or output: Measures what an agency does, the number of applications processed, the number of passengers carried and kilometers of roads paved.
  • Efficiency: Measures the cost per unit of activity such as cost per patient, cost per student or cost per child vaccination.
  • Outcome: Measures how well objectives are met. These are usually the ends of government such as safety, health or educational improvement.

Expenditures must be driven by policy priorities, but disciplined by budget realities, which means sudden and unplanned announcements cannot be made. The result is greater policy predictability, a focus on outcomes, priorities and expenditure management.

Conceptually, this is simple, but implementing it in practice is a daunting task involving a lot of political negotiation (to get ministers to agree to spending limits) and administrative work in estimating future costs, revenues and measuring performance.

The trickiest political negotiation involved is in allocating the spending limit according to priorities. This exercise is the most important – with an annual incremental budget, no one is forced to question the ‘base cost.’ With a hard spending limit to be allocated among departments, questions on priorities come to the fore. The other obstacle is weak capacity within the government, both the bureaucracy and among ministers, which means that external technical support is needed to implement this, which is fortunately available through donor programmes.

Bridging the deficit.png

More than 16 African countries have adopted an MTEF, with Ghana and Malawi pioneering it in 1996. Since then, other countries in the region have followed. Implementing may be done in stages, starting with key spending units. In Malawi, the deficit contracted from 15% of GDP in 1994/5 to 5% by 1998/9, partly due to the MTEF. According to the World Bank (2013), by the end of 2008, more than two-thirds of all countries had adopted an MTEF. To work, the MTEF must become the government’s budget process and control the details of spending. Expenditure limits are agreed to by incoming governments giving intra-party policy consistency.

Properly planned expenditure means little need for periodic, ad hoc adjustments to taxes, which are witnessed at every budget, and even in between budgets through gazette notifications. Unexpected tax changes wreck havoc with the plans of businesses and households alike. Greater visibility will increase overall levels of confidence among lenders and investors.

When an MTEF is implemented well, public expenditure is limited by the availability of resources, budget allocations reflect spending priorities, and public goods and services are delivered cost-effectively. MTEFs, therefore, offer the prospect of achieving the three high-level objectives of public expenditure management: aggregate fiscal discipline, allocative efficiency and technical efficiency. Reaching this is an incremental process, but with good technical support, it is possible. The earlier this is adopted, the better.

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.

In dealing with disaster, the state has a critical role

By Ravi Ratnasabapathy

Originally appeared on the DailyNews

Sri Lanka braces itself for yet another round of floods; the third in as many years. As floods and droughts become regular occurrences, how should the nation respond?

The impact of this year’s floods is not yet known but likely to be heavy. In May 2017 floods and landslides affected 15 of the 25 districts of Sri Lanka. The drought in 2016 and 2017 affected 1,927,069 people across 17 districts, many of them poor.

“Approximately 12 per cent of those affected were poor, nearly twice the national average of 6.7 per cent. In the case of the landslides, this is because the 11 affected Divisional Secretary (DS) Divisions tend to be poorer than the national average. Those affected by the floods overall were also disproportionately poor, with an estimated poverty rate of 8.7 per cent.” (World Bank)

If the poor are disproportionately affected by natural disasters it has a negative impact on poverty and therefore has the highest level of priority for policymakers.

Little can be done about the weather but proper risk management can minimise its impact. The Government needs to move from the unplanned and ad-hoc reaction when disaster strikes to a proactive, systematic management of risk, something that may be illustrated by the example of Chile.

The earthquake that rocked Chile in 2010, one of the largest in history that wiped out roughly 18% of the country’s GDP – a massive impact. (The impact Sri Lanka’s 2017 floods was only 0.4% of GDP.) Yet Chile demonstrated a miraculous recovery. Most countries that suffer catastrophes of that magnitude take years or even decades to recover. Chile did it quickly, how did it do so?

Several factors contributed overall to the low casualty rate and rapid recovery.

The Government had decided to prioritise the role it played in managing disasters. First, in minimising damage, because of its history with natural disasters, Chile’s Government had developed a strong building code and ensured it was properly enforced. In particular, Chile had a law that held building owners accountable for losses in a building they built for 10 years. Furthermore, while not legally required, almost all homeowners in Chile had earthquake insurance because banks required it in order to get a loan to buy a house.

Second, the disaster response had been well-planned- the number of fires after the earthquake was limited due to the immediate shut down the electricity grid and the local emergency response was very effective. The third factor was education: the overall high level of knowledge about earthquakes and tsunamis by much of the population that helped them respond more appropriately after the event.

After the disaster, any government faces the question of how reconstruction will be paid for. Did Chile wait for aid to arrive? No.

Following the quake, because of the sheer size of the disaster, Chile was compelled to increase taxes temporarily. But the policies that ensured that a large part of the homeowner market was insured paid off – it minimised the amount the Government needed to finance. Together these contained the financial ramifications from the earthquake and put Chile quickly on the road to recovery.

Although Sri Lanka never experienced anything like the devastation in Chile, natural disasters in Sri Lanka take a heavy toll on resources and people. Apart from the human cost they disrupt agricultural output (which may affect exports) and increase food inflation. The contraction of economic activity negatively impacts government revenue while simultaneously creating new budget pressures in the form of disaster relief. In the four months of 2017, the government reportedly incurred LKR 1,397 million for the provision of disaster relief (World Bank).

How can risk be managed?

Small risks may be managed by households and slightly larger ones at the level of the community but for largest risks governments have a critical role, providing an enabling environment for shared action and responsibility and channelling direct support to vulnerable people.

The problem needs to be tackled across three fronts:

1. Preventive measures that minimise the impact of disasters.

2. Early warning systems and evacuation plans that allow people to leave disaster zones to safer areas.

3. Managing the financial risks from natural disasters.

Preventive measures

1. Floodplain zoning

A flood zoning authority must be created and floodplains (the water channel, flood channel and low land susceptible to floods) must be surveyed. The survey forms the basis of establishing floodplain zones, including delineation of the areas subject to flooding and classification of land with reference to the relative risk of flood.

Specific activities and uses (settlement and economic) in designated areas should be subject to administrative permits and building/land use codes. Eg. Building and design standards must protect against inundation. Restrictions and prohibitions should be based on risk assessments.

 

 

The public should be made aware of the dangers of floods and the need to restrict use.

Information about restrictions on construction in flood areas should be easily accessible and information about risk assessments should be easily understood, for example, clear flood maps and, where appropriate, information based on geographic information systems (GIS) should be distributed. Mandatory disclosures of risk could be included for property transfer or rental in areas of risk.

2. Conservation of wetlands

Wetlands are natural sponges that trap and slowly release surface water, rain, groundwater and flood waters. They are important in both flood and drought management so as far as possible natural wetlands and retention areas in the river basin should be conserved, and where possible restored or expanded.

3. Modifying the flood flow: Engineering measures

Diversions, reservoirs, channelisation (increasing the capacity of the channel), bank protection (to prevent bank erosion), dams and floodplain restoration (creating washlands that can safely take overflows) will play a role in minimising impact. Engineering measures must be in harmony with the landscape and nature conservation. A holistic approach covering the whole river basin is needed as localised flood protection measures can have negative effects both downstream and upstream.

Early warning systems and education

Forecasting and early warning systems should be established and guidelines issued on how populations are to act during floods.

Education on measures that can be taken at the level of individual households to either limit the damage when flooding occurs or prevent inundation is needed, eg. elevation of structures, elevated curb stones to prevent water entry from smaller events, reinforcement of foundations to avoid structural damage, moving building contents (and particularly electrical installations) above flood water levels (either temporarily or permanently), dry flood proofing to make areas below flood water levels watertight and temporary or permanent flood walls (ranging from sandbags to free-standing concrete barriers).

Forecasts and related information must be easily accessible and real-time media coverage ensured.

Managing financial risks of natural disasters

The GoSL exposure to disaster risk is through the costs of relief/recovery, reconstruction of public assets, compensation and (re)insurance schemes that provide coverage for disasters.

Several tools are available:

i. Insurance, GoSL already has some cover with the National Insurance Trust Fund but premia can be reduced through risk reduction – eg. land-use planning, flood defences etc. which will also support private insurance, which can top-up overall compensation.

ii. Risk pooling - insurance coverage for a pool (or its full portfolio) of Government assets. Insurance arrangements that cover a broader pool of assets facing more diversified risks can have cost advantages over insuring the assets in a flood zone.

iii. Multi-country pooling (done by several Pacific, Caribbean, African nations) provide small countries with improved access to international insurance markets based on their ability to merge a set of (less) correlated risks.

iv. Catastrophe bonds: bonds where the principal or interest payments are delayed or lost to investors in the event of a disaster.

v. Contingent credit lines with multilateral development agencies can bridge short-term shortfalls.

These are some possible options, careful assessment of the relative costs and benefits of different approaches is necessary. Once zoning is complete, the Government could lead the way in the relocation of some public assets away from areas of risk.

Rethinking agricultural policy

Agriculture is being affected by social, economic and environmental pressures. Current policies which encourage domestic agriculture need to be reviewed in the light of changing the climate, society- fewer people wish to take up agriculture, labour shortages and pressures on land use.

Policies that encourage risky production choices in flood zones or increase vulnerability to droughts and floods should be avoided. Allocation of water rights should reflect sustainable use and will help mitigate the impact of droughts. The Government must understand the impact that disasters have on poverty and recognise the proper role it must play in managing these risks. Ad-hoc responses grab headlines but working strategically to minimise long-term risks-a harder and thankless task, is the way to go.

The author is a resident fellow at the Advocata Institute.

Sri Lanka can create jobs, boost exports, by moving brains: Hausmann

  Harvard University’s Center for International Development Director Prof. Ricardo Hausmann

Harvard University’s Center for International Development Director Prof. Ricardo Hausmann

Many advanced nations from Singapore to the US have open policies that allow people to migrate easily bringing knowledge and skills to transform economies and create new jobs, a top Harvard economist said.

Allowing brains to move brings skills in faster, and tends to have a multiplier effect in jobs and economic activity, Ricardo Hausmann, from the University of Harvard, told a seminar organised by Colombo-based Advocata Institute.

In the US, every foreign-born Science, Technology, Engineering and Mathematics (STEM) graduate was found to help create 2.61 additional jobs, Hausemann said.

Technology is not limited to tools and codes/routines/procedures. These can all be easily transferred. What is difficult to transfer is tacit knowledge, knowledge embedded in the human mind through experience. Tacit knowledge includes insights, intuition and personal wisdom gained through experience. This is know-how and something that is difficult to extract and codify.

Know-how takes a long time to acquire, like becoming a skilled surgeon or an anaesthetist. To carry out a successful operation both were needed. 

Producing complex goods requires different types of know-how which a single person simply did not have. In simple agriculture of a different age, a single farmer knew how to grow seed, cultivate, breed and look after buffaloes, make or repair his plough and produce his fertiliser.

But in modern agriculture where genetically engineered seeds, combined harvesters and fertiliser were used, he simply did not have the knowledge. An advanced society possessed a lot of know-how, but it was in the minds of many different people. 

  Harvard University’s Center for International Development Director Prof. Ricardo Hausmann with Moderator JB Securities CEO Murtaza Jefferjee Pix by Ruwan Walpola

Harvard University’s Center for International Development Director Prof. Ricardo Hausmann with Moderator JB Securities CEO Murtaza Jefferjee Pix by Ruwan Walpola

 

Scrabble theory


To produce a good, a team of people had to come together, like making a word out of different letters when playing scrabble. While some letters may be available, others were not.

“So if you are missing a letter, the other letters would become less valuable. So you would give a lot to have this other letter.

“I like to say that an anaesthetist working on his own is not much better than a bad economics lecturer. The only thing he does is put people to sleep.”

“So if you bring different skills, you can make more things. They are complements, not substitutes. There are enormous benefits in different people working together.”

“In some sense the secret of development is to get more letters and express them in different words and longer words.”

He says it is difficult to move know-how into brains. Author Malcom Gladwell had claimed that it took 10,000 hours (about 14 years) to learn, practice and acquire a world class skill.

“So how do you move know-how? How do you get more know-how to Sri Lanka? We know it is difficult to put know-how to brains,” Hausmann says.

“It is much easier to move brains. It is a fundamental intuition.”
 

Moving brains


Brains moved through migration, foreign direct investment and diaspora networks, when people who had originally migrated out, came back.

Moving brains allowed a geographical region to move into entirely new products and keep boost productivity in established sectors, he said.

In Sri Lanka, Camso-Loadstar, now a global solid rubber tyre company was founded by a foreign national teaming up with a local partner.

US car companies Ford, GM and Chrysler were founded by people who worked for Oldsmobile. Oldsmobile was founded by a German who worked for Daimler-Benz.

Silicon Valley founded by 10 people who were hired from AT &T Bell Labs in New Jersey to Shockley Semiconductor. Eight broke away to form Fairchild Semiconductor. 

Ex-Fairchild workers then founded a number of other companies including Intel. About 57% of Silicon Valley workers are now foreign born, 25% were out of state.

“Only 18% were born in California, even though it has a population of 40 million, twice as big as Sri Lanka,” Hausmann said. “Silicon Valley would not exist if it was based on locally grown talent.”

Hausmann himself is originally from Venezuela.

Sri Lanka’s IT sector is small and not growing as fast as countries that had easier access to foreign talent.

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Wage differential
 

Wages were found to be lower in Sri Lanka than in India, he says. 

However IT wages are higher than in other sectors in the island. IT graduates could find work easily suggesting that skills were in short supply.

Sri Lanka a net was exporter STEM workers, Hausmann says. About 23% of engineering and science graduates and 20% of computer science graduates leave the country to work abroad each year he says.

The low inflow of foreign workers does not compensate for outflow, he says.

Apparel manufacture in Bangladesh was pioneered by a Desh Garments in 1977, in a joint venture with Daewoo, who took 126 workers of various disciplines to train in their country. By 1988 ex-Desh workers had set up 56 companies.

Foreigners who move tended to create more jobs though the common perception was that they ‘stole’ jobs.

In Singapore now 45% of the population was foreign born, “People say we want to be like Singapore,” Hauseman said. “But they would not have gotten where they were with only home grown ‘letters’. They had to attract ‘letters’.

The foreign born population of Hong Kong was 40%, he said.

 

Stealing jobs or creating jobs?
 

It was not just obviously technological degree holders that transformed countries, he said.

Albania, an ex-communist state had at one seen large scale migration into Greece. 

When the Great Recession credit bubble broke, hitting the Greece’s deficit spending government and its economy, large numbers returned boosting Albania’s workforce 5%. The people who went to Greece were supposedly low skilled.

The standard argument goes that, if the workforce increased unemployment would rise 5%. Or wages would fall.

“Well, unemployment went down and wages went up,” Hausmann said. “And why? The people who returned were not the same people that had left in terms of know-how they possessed.”

Agricultural workers for example had worked in green houses. 

“They built green houses and hired neighbours,” he says. “And there was a boom in tomatoes and other agricultural exports.”

Panama had seen a spectacular boom in services, which was very skill intensive.

The country had built special economic zones with tax holidays. The country wanted to attract international headquarters. 

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Horrible immigration laws
 

But investors who wanted to come, wanted exemption from immigration laws.

“So Panama has a horrible immigration policy as bad as that of Sri Lanka,” Hausmann says.

“They had closed the door on immigration but they opened two windows. People came in through the windows.

“So foreigners came in and there was a boom in construction and everything else and wages of Panamanians skyrocketed,” he says.

Still only 4.7% of the population is foreign born in Panama.

“It is one foreigner in 27. Not like one is 7 in the US, or one it two in Singapore,” he says. “And everybody complaints about that. 

“It doesn’t matter what level of migration is. Australians are at 27% migration and they think it is too high. Panamanians are at 4.7% migration and they think it is too high. 

“Sri Lankans are at 0.1% migration and they think it is too high.”

Sri Lanka could grow fast with immigration law reform, he says. 

Though board of investment companies were allowed to bring some foreign workers, their spouses are not allowed to work. 

Typically professionally qualified people married qualified people.

They also cannot choose a different job after they come. 

There was no path to permanent residency or citizenship. It was much more difficult for a non-BOI firm to access foreign talent. 


Approving vs Attracting Talent
 

Hausmann’s team had done a comparative study reviewing immigration laws of Hong Kong, Singapore, Indonesia, Thailand and Vietnam. They had also looked at Saudi Arabia.

The more economically advanced have sophisticated immigration systems that have moved from being systems that strictly authorised the entry of foreign workers, talent, and capital, to systems that promote their entry, he says.

They had a wide variety of visas for skilled, semi-skilled, trainees, managers and entrepreneurs. There were talent visas.

He says immigration reform should be part of an overall effort to draw talent, foreign direct investment and export diversification. 

More visa categories should be created. If here is a path to residency more skilled workers will come. 

He says immigration reform is a ‘low hanging fruit’ that can be implemented easily unlike infrastructure which needs lots of money. 

“Sri Lanka may have the talent and the people for the current economy, but does it have the talent and the people for the economy it wants to have?” Hausmann says.

“To get there, Sri Lanka will need to open up for more inflow of foreign know-how the way all prosperous countries have done already. This means more FDI, more return diaspora and higher inflow of foreign workers.”

Sri Lanka is ‘weird’ he say because there is no path to citizenship unlike countries that have become prosperous fast.

Analysts say Sri Lanka’s immigration laws are even ‘weirder’ than people realise.

Solving Sri Lanka’s growth conundrum: lessons from East Asia

Originally appeared on Echelon

By Ravi Ratnasabapathy

Sri Lanka’s economy has lagged its potential for decades. Even nine years after the end of the war, growth remains elusive. Something is wrong, but what? Sri Lanka, like other developing countries, experienced short spurts of growth, but nothing like sustained growth over decades that took place in East Asia.

Between 1965 and 1993, the high-performing countries of East Asia (HPEA) – Hong Kong, Singapore, Taiwan and South Korea – broke the mould of history: they brought about, within a single generation, a process of socioeconomic development that took the advanced economies of Western Europe centuries to achieve. Malaysia, Thailand and Indonesia also experienced rapid progress, although not to the same extent as the others. These nations used a range of policies, from hands-off to highly interventionist, so no single “East Asian model” exists, but economic openness, macroeconomic stability and flexible labour markets were common factors that provided the enabling environment for growth.

DRIVERS OF GROWTH
There is a general agreement that the two principal drivers were as follows:
(a) rapid capital accumulation, both human and physical
(b) superior allocation of physical and human resources among various sectors of the economy

High levels of investment created jobs, which together with ongoing investments in education, improved skills and enabled workers to move into new industries as they opened up.

OPENNESS TO TRADE
Sri Lanka’s educational standards, like India and the Philippines, exceeded those of East Asia in the 1950s. The difference was the environment in which investments in education took place: an openness to trade. While Sri Lanka, India and the Philippines adopted a path of self-sufficiency, closing themselves to outside influences, the rest of East Asia opened up.

After an early phase of import substitution, the miracle economies embarked on a strategy of outward orientation from the 1960s. This outward orientation was reflected in their lowering of tariff rates and export taxes, the removal of quantitative restrictions on trade and reduced barriers to international investment flows (ADB, 1997).

FDI brought new production techniques, quality control and access to external markets. It created competitive pressure on local firms to acquire new skills. An important spillover effect was the demonstration effect to domestic firms regarding feasibility in terms of production and quality, thus heightening demand for new technology and sophisticated skills by local firms. This created a virtuous cycle of accumulation and assimilation: rapid acquisition of new technology went hand in hand with the formation of new skills, some of which took place outside schools; on-the-job-training, informal acquisition of knowledge and learning by doing. Some innovations originated on the shop-floor.

Growing levels of income, in turn, increased both private and public investment in education including, specifically, higher education, and science and technology. The outcome is reflected in the rising shares of exports and imports as a proportion of these economies.

Trade and regulatory barriers make Sri Lanka unattractive for investment, which means lower levels of technology transfer and, in turn, productivity; a cycle that needs to be broken

MACROECONOMIC STABILITY, FISCAL PRUDENCE AND DEBT
Exceptional macroeconomic management created the stable environment essential for private investment. Fiscal prudence is key to macroeconomic stability. Balanced budgets lead to low inflation, low interest rates and stable exchange rates. Some countries did run small deficits: between 1961 and 1996, South Korean deficits averaged 0.86% of GDP, Thailand (0.79%), Indonesia (1.09%) and Malaysia (4.04%), but nothing like Sri Lanka’s deficits, which averaged 8.2%.

Countries that did run deficits financed them prudently, avoiding money printing, which causes inflation and currency depreciation, unlike Sri Lanka.

TECHNOLOGY AND PRODUCTIVITY
East Asia’s extraordinary growth was not only due to superior accumulation of physical and human capital, but also to better allocation of capital. The more easily accessible resources in an economy can move from lower to higher productivity activities, the greater the overall productivity.

Lower-income countries are less developed not only because they have less physical and human capital per worker than developed economies, but more importantly, because firms use their tangible input of labour, capital and raw materials less efficiently – and without combining them with sufficient complementary, knowledge-intensive intangible assets (Dutz & O’Connell, 2013).

Sustainable economic growth is based on productivity growth.

Productivity growth in Sri Lanka increased following reforms in 1977/78, but slowed steadily between 1988 and 1997 mainly due to slower adoption of technology (Bandara and Karunaratne). In an open world, there is always competition from low-wage economies that compete on cost. Established players may start with low wages, but must move up the value chain, redesigning and improving their production systems to increase competitiveness.

Competitive pressure forces firms to improve, restructure or close. Inefficient firms being closed or taken over (by more efficient ones) is not harmful, but increases overall productivity, a process termed “creative destruction”. In common, East Asia did not have high levels of labour protection, making it easier to downsize or close businesses.

Instead of minimum wages or job protection, governments focused on job generation, boosting demand for workers, resulting in rising employment levels, which was followed by market- and productivity-driven increases in wages. Low inflation meant workers experienced real increases in living standards, unlike in Sri Lanka where inflation erodes wage increases.

Resource allocation is also dependent on prices and regulation, prices for energy, raw materials, and indeed all factors of production including labour and capital. For example, mispricing energy may change the relative competitiveness of certain industries, and subsidised credit could end up propping up inefficient firms. Despite some limited intervention, all HPEAs kept price distortions within reasonable bounds. Regulations can create rigidity that impedes optimal resource allocation (e.g. Paddy Lands Act prevents alternative use of land).

SELECTIVE INTERVENTION
Many HPEAs practised intervention to foster development, with variable results. Where guided by political considerations, such as Malaysia’s efforts at heavy industrialisation in the 1980s and Indonesia’s high-tech industrialisation in the 1990s, they did not succeed. (Jumo 2001).

Where selective interventions succeeded, they did so because of three essential prerequisites. First, they addressed problems in the functioning of markets. Second, they took place within the context of good, fundamental policies. Third, their success depended on the ability of governments to establish and monitor appropriate economic-performance criteria related to the interventions (World Bank, 1993). A technocratic bureaucracy, insulated from political pressure with capacity to conceive and implement the policy designs, is essential. This requirement, and the fact that the WTO rules now bar some of these policies, means that this has limited application for Sri Lanka. The World Bank concludes that “the market-oriented aspects of East Asia’s policies can be recommended with few reservations, but the more institutionally demanding aspects, such as contest-based interventions, have not been successfully used in other settings” (World Bank,1993).

CONCLUSION
East Asia’s success was based on set complementary factors that worked in concert. Economic openness is critical, but must go with macroeconomic stability, low price distortions, and a conducive regulatory environment that encourages investment and permits efficient allocation of resources. Sri Lanka retreated from a policy of openness since 2000, raising tariff and regulatory barriers, resulting in a sharp contraction in exports as a share of GDP, which fell from a high of 33.3% to about 12.7% in 2016. Total nominal protection doubled from 13.4% to 27.9% between 2004 and 2009 (Pursell 2011).

Tariffs and policies favour import substitution in agriculture and industry. Domestic industries have thrived, but at the expense of productivity. Low productivity growth means wages rise slowly, but high tariffs from food and household products translate to high costs of living. This prompts workers to seek high wages (which deters some investments) or better paying jobs overseas. Worker remittances support families, propping up consumption and local industries. Trade and regulatory barriers make Sri Lanka unattractive for investment, which means lower levels of technology transfer and, in turn, productivity; a cycle that needs to be broken.

No single “East Asian model” exists, but economic openness, macroeconomic stability and flexible labour markets were common factors that provided the enabling environment for growth of East Asia

KEY RECOMMENDATIONS
1. Trade and commercial policy liberalisation
2. Macroeconomic reforms
3. Investment and regulatory reform Trade reforms

Eliminating the anti-export bias of import protection (resulting in exports being less profitable than domestic sales, propped up by high protection) encourages trade and investment in exports. This overcomes limitations of the domestic market and creates the competitive pressures that drive productivity. This works through three channels.

First, it lowers prices, benefiting consumers by increasing purchasing power (pro-competitive effect); second, it forces less competitive firms out of the market, reallocating resources to more competitive ones (selection effect); finally, it induces innovation to improve productivity (innovation effect). Higher productivity growth produces not just one-off price reductions, but a sequence of reductions over time, increasingly benefiting present and future consumers.

Macroeconomic reforms
There is acceptance on the need for fiscal consolidation and balancing budgets, but adopting a Medium-Term Expenditure Framework; an annual, rolling three year-expenditure plan that sets expenditure priorities; and hard budget constraints increase predictability and credibility of commitment to macroeconomic stability. Creating externally imposed constraints on Central Bank operations based on commitments to the IMF or, more radically, by adopting the German Bundesbank Law as done in some East European nations will enhance this further.

Investment and Regulatory reforms
Broad-based regulatory reform must include agriculture, which contributes about 8.7% of GDP, but absorbs 28% employment. Reforms to seed, planting material and land policy to increase productivity are needed. Incentives should promote the adoption of technology (greenhouses, drip irrigation) and mechanisation. Withdraw price and marketing interventions. Divert expenditures to provision of agricultural insurance, finance, irrigation infrastructure and R&D.

In East Asia, agriculture productivity improvements released labour to work in non-farm employment, and reduced food prices helped increase the value of real incomes (ADB 1997).

Encourage private provision of tertiary education to meet the evolving skills needs of an outward-oriented economy. The impact of policy reforms will be enhanced by investments to eliminate infrastructure bottlenecks. Investments must be characterised by transparency, efficiency and quality, and privately financed to minimise budget strain. These are merely the outline of a large reform process to ease investment and trade. Post-war, the economy experienced a brief spurt of debt-fueled reconstruction and infrastructure-driven growth, but this petered out. Apart from questionable improvements to productivity, it is a path that is closed to a heavily indebted government.

East Asia grew in different circumstances, but openness and trade underpinned by decent macroeconomic fundamentals still offer opportunities for growth, as demonstrated by later reformers like Vietnam. It is the path Sri Lanka should return to.

 


References
1. ADB (Asian Development Bank). 1997. Emerging Asia: Changes and Challenges. Manila.
2. Productivity, Innovation and Growth in Sri Lanka, An Empirical Investigation, Mark A. Dutz Stephen D. O’Connell, World Bank 2013
3. An empirical analysis of Sri Lanka’s Manufacturing Productivity slow-down, Bandara, Yapa M. W. Y. and Karunaratne, Neil D. (2010) An empirical analysis of Sri Lanka’s Manufacturing Productivity slow-down. Journal of Asian Economics
4. Jumo, K. 2001. “Rethinking the Role of Government Policy in Southeast Asia.” In Joseph E. Stiglitz and Shahid Yusuf, eds., Rethinking the East Asian Miracle. Oxford, U.K.: Oxford University Press.
5. The East Asian Miracle, Economic Growth and Public Policy, World Bank 1993.
6. Pursell, Garry and F.M.Z. Ahsan (2011), ‘Sri Lanka’s Trade Policies: Back to Protectionism’, Australia South Asia Research Centre Working Paper 2011/03, Canberra: Australian National University
7. Growth and Poverty: Lessons from the East Asian Miracle Revisited, M. G. Quibria, 2002.
8. Giammario Impullitti and Omar Licandro. 2018.We may be underestimating the gains from globalisation. [ONLINE] Available at:http://blogs.lse.ac.uk/businessreview/2018/03/09/we-may-b-underestimating-the-gains-from-globalisation/. [Accessed 10 April 2018].

Tax Spiral and Government Spending

By Ravi Ratnasabapathy

The new Inland Revenue Act replaces the existing income tax law and comes into effect from April 1, 2018. It’s stated aim is to simplify and modernise the existing code and it does take some steps towards this.

Sources of income have been consolidated and some exemptions removed but it also introduces new complexities with regard to deduction of certain business expenses including interest and repairs. It aims to reduce tax holidays, which is positive; tax holidays go against the principle of equal treatment but the aim to increase direct taxes is questionable. Indirect taxes affect consumption and spending but direct taxes affect savings and investment.

Nevertheless the Government is expected to collect more tax with the burden falling heavily on businesses and higher income earners.

This column will focus mainly on the larger issues from a macro perspective rather than a detailed analysis of tax rates.

Taxation is required to fund government spending but the system must based on sound principles: simplicity, certainty and stability. Simplification reduces costs of administration and brings greater clarity. The government’s pressing need for revenue means that taxes should focus primarily on this aspect; using taxes to regulate activity (eg. bank lending, leases etc.) should be avoided.

Tax transactions

Taxes designed purely to raise revenue are more likely to be simple, as the only design constraints are neutrality and efficiency. The number of taxes and the number of tax rules should be minimised.

Uncertainty can arise at any stage – when identifying tax transactions, valuing them and applying tax law to them. (eg. conflicts between the Inland Revenue and Foreign Exchange Act, uncertainty over application of capital gains tax to old apartments). For this reason it is preferable to alter rates on existing taxes rather than introducing new taxes or changing the basis of application. Ad-hoc tinkering outside the annual budget should be avoided. Retrospective legislation is particularly devastating and its use should be discontinued.

Stability is connected to certainty. ‘Certainty’ is knowing the answer to a given question; stability is about whether the current answer will still be correct in few years’ time. For taxpayers, stability enables better planning and efficient compliance.

People can budget household income more accurately and businesses can make long term investment decisions in confidence. Businesses would far prefer to operate in a slightly more imperfect system than in one where incremental improvements are made every year. Stability also enables more efficient administration; changes in returns, processes or mechanisms of collection create difficulties for the Inland Revenue.

A stable tax system requires greater predictability in expenditure. Unfortunately too much spending is driven by short-term expediency and is often disconnected from policy making, planning and budgets. A medium term expenditure framework incorporating fiscal sustainability and space is essential.

Inflation and currency depreciation

Fiscal Sustainability considers the fiscal balance, evolution of public debt, capacity of the government to finance its budget (borrowing etc.) requirements, refinance maturing debt and fiscal risks. Fiscal Space refers to additional expenditure needed to promote development or stimulate growth.

While taxes are important, it is government spending rather than taxation that ultimately determines the total burden of government activity on the private sector. Although spending may also be financed by borrowing or printing money, all government spending is ultimately a call on resources that have alternative uses or involves transfers from one group in society to another. If a government borrows money, this has to be financed at the time of borrowing and then serviced by future generations of taxpayers with interest. Money printing causes inflation and currency depreciation.

Thus far the Government has focused on achieving fiscal consolidation through revenue enhancing measures. This must change, the level and composition of public expenditure must be reviewed for efficiency. Between 2005-17 total spending quadrupled (from Rs. 584,783 m to Rs. 2,645,300 m). This level of growth in expenditure is difficult to sustain and threatens macroeconomic stability, which is necessary for growth.

The Government needs to conduct a comprehensive review of spending, evaluating the quality and efficiency with a view to reducing waste, inefficiency and improving outcomes. Expenditure needs to be prioritised within a frame of a medium term expenditure plan. There is much scope for further simplification and rationalisation of the overall tax system including para tariffs and excise duties.

People are worried that the rates of tax may increase-quite understandably so. They must pose the next logical question: What does the government do with the money that they collect? Is the public getting value for the money being spent-does the much vaunted public health and education system deliver value? If so why do so many go to private hospitals or fee-paying schools. For the richer sections, lead by the ministers themselves, even the local private hospitals and schools are not good enough - they must go overseas. Why?

Unless the public holds the government accountable for its expenditure we will see a never ending spiral of spending and taxes.

This article originally appeared on the Daily News

 

The COPE Report findings: we need to rethink the role of the State

By Ravi Ratnasabapathy

The last report from The Committee of Public Enterprises (COPE) released in 2016, highlights the government waste.  In this article we highlight some of the worst excesses.  

The Government is entrusted with billions of rupees of public funds, collected from the people. It has a duty to account for them and use them in accordance with the wishes of Parliament, without excess, extravagance or waste.  

Ensuring the money is properly used is the responsibility of Parliament which works through two  Committees, the Committee on Public Accounts (COPA) and the Committee on Public Enterprises. COPA scrutinises the Government, its Ministries, Departments, Provincial Councils and Local Authorities while COPE scrutinises public corporations and business undertakings.   

Summarised are some findings of the 1st COPE report. The COPE, by its own admission, is under-resourced. It lacks staff particularly for audit and legal support. They also lack IT systems and apparently, even a proper office.

Despite these limitations and the fact that the reports are not comprehensive-they have examined a limited number issues in a few institutions, they are a devastating critique on the state of governance. This is only the tip of a very large iceberg and underlines the need for a drastic re-think in the role of government.

A few highlights are presented below.     

The Committee on Public Enterprises

First Report
(For the period from 26th of January 2016 to 08th of April 2016)

Purchase and issue of substandard drugs

  1. Imported pharmaceuticals not properly tested due to lack of lack of laboratory facilities. Drugs later found to be substandard are issued to patients owing to the delays in testing samples prior to the distribution of the same.

  2. Drugs worth Rs250m had been identified for destruction in 2014 & 20 15but only Rs.214.6m were actually destroyed.

  3. Substandard drugs worth Rs.199m purchased between 1996-2014 for sale through Osu Sala outlets.

  4. Substandard drugs worth Rs.1bn purchased between 2011-14, the majority (Rs.867m) for distribution free through the public health system.

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Ceylon Electricity Board

Lack of accountability 20 subsidiaries incorporated under the Companies Act  

The CEB holds a 63% stake in Lanka Transformers Ltd, which in turn has stakes ranging from 50%-100% in 15 of other companies. The CEB also has stakes of 50%-100% in 5 other companies.

  1. LTL and its subsidiaries refused to submit details of operation to the COPE, despite the fact that the CEB effectively owns more than 50% of the shares. They claim to be private companies and need not report to parliament. The accounts of 14 were later submitted 16.3.2016

  2. The subsidiary companies have paid dividends worth Rs.14bn to LTL. The CEB should have received 7.1bn as its share but only Rs.6.9bn was received.

Authors Note: LTL supplies services and products to the CEB. Values and terms of contracts are not known.

Payment of salaries and allowances outside standard procedures  

  1. A sum of Rs. 849 million had been spent to pay 39 allowances of various types to employees without the approval of the Cabinet of Ministers of the Treasury.

  2. Establishing a new salary scale known as “E – scale” for engineers with effect from 01st of January 2015 and making payments in accordance with that without the recommendations of the salaries and Cadre Commission.


Janatha Estate Development Board

  1. Land leased at low rates

Land belong to the JEDB in Vauxhall street had been undervalued and given on long leases of 25,30 or 50 years upon  a cabinet decision.

Click image to enlarge

    2. Unpaid EPF and ETF dues for the period 2011-2015 amounting to Rs.323m (including surcharges).

    3. Operations Loss of the JEDB

2011           2012          2013         2014
Rs.258m    Rs.199m   Rs.501m   Rs.169m


Land Reclamation Commission

1. Information with pertinence to the lands belonging to the Commission not been updated.

Action has not been taken to formulate a register of lands and to maintain it updated.

2. Special Projects for which lease agreements have not been signed

i. 280 acres of Monarakelewatta had been leased out to a private company under 30 year lease in February 2011 without any approval from the subject minister and Rs.1 million has been paid as advances but lease rent had not been recovered for the period from 2011-2016

ii. Out of 12 acres of the Kumbalgoda estate, 06 acres have been leased out to a private Export Crop Project in an illegitimate manner.

iii. Leasing out a plot of land with an extent of approximately 2 hectares of Arkediyawatta in Badulla District. The amount in arrears to be recovered is around one million and without the approval of the Council a loan of Rs.17.5 million has been obtained keeping this land as a security and no action been taken by the Council with pertinence to this matter.

iv. 06 acres of Industrial Zone, Leylandwatta, Homagama has been given to Rosell Bathware Ltd company under 50 year lease and lease rent not been properly recovered.


Elkaduwa Plantation Company LTD

1. Leasing out the Nellaolla estate

i. Leasing out an extent of 125hectares of the Nellaolla estate which consist of 358 hectares to Agri Squad company and the balance forcibly acquired by the residents of the area.

ii. A person as a sub lessee of the Agri Squad Company possessing the estate in an unauthorized manner.

2. Leasing out a factory owned by the company

Leasing out a factory owned by the company to the institution by the name of Pride Tea, the particular institution has completely defaulted paying lease rent to the company and also defaulting the payment due for tea leaves with a value of Rs.30 million provided by the company.


Board of the Sri Jayawardanapua Hospital

Payment of consultants fees

Note: Although this is a state hospital it also runs a paying ward. These payments of fees appear to be over and above the normal remuneration to staff.

  1. 50% of the total income charged from the patients of the paying wards have been paid as professional fees to the doctors and staff of the hospital. PAYE tax has not been deducted on the payment. Unpaid PAYE tax for 2014 and 2015 amounted to Rs.74.7m

Purchase of anesthetic equipment

  1. Four anaesthetic machines had been purchased at a cost of Rs. 29.9m without following a proper procurement process. The purchase of the equipment had apparently gone ahead despite an offer from the Australian Government to provide these free of charge.

  2. The purchase of the equipment had been justified on the basis of three existing machines being defective. No technical evaluation of  is available to support this and no proper procedure was followed for disposal. The Committee was later informed that he disposed equipment had been  given to the Negombo, Kalutara and Monaragala hospitals.

Expired stock

Drugs and other worth Rs.5.1m had been purchased for the Neurosurgical Unit in February 2012.

80% of the stock valued at Rs.4.1m had not been used and expired.


National Secretariat for Elders

Deducting Rs. 100/- without the concurrence of the Ministry of Finance from the elders’ allowance of Rs 2,000 paid to elders as per a budget proposal

The budget for 2015 proposed a monthly payment of Rs.2000/- for elders over the age of 70. Ministry of Social Empowerment and Welfare, the relevant line ministry by way of circular No. 1/2016 has ordered that Rs.100/- be deducted from each payment and the money be retained at the secretariat to set up a welfare fund.

The money is being deducted in spite of the opposition of the management of the secretariat and without the approval of the Ministry of Finance

Note: The Secretariat has issued ID cards for 10,978 elders, although the plan had been to issue 40,000 cards. Assuming the monthly allowance of Rs.2000 was paid only to those registered the monthly payment would amount  to Rs21m and the amount retained for the ‘welfare fund’ would be Rs1m per month.


Bank of Ceylon

Continuous losses at the overseas branch in London. Although the branch in the Seychelles I snow profitable operations are high risk as 62% of the total deposits are owned by only 03 customers.

 

The task ahead for the Government

Originally appeared on Echelon

The Yahapalanaya Government is unpopular, as borne out by the results of recent local government elections. They were elected amid great expectations of change: people wanted better governance, lower corruption, more freedom; in sum, a better life. They have failed, dismally. It is uncertain which party will eventually form a government, but whatever party needs to pay heed to the concerns of the people.

What is the problem?

Sri Lanka’s macroeconomic fundamentals are improving, but to ordinary people, this is meaningless; what matters is how it benefits them: better jobs, higher salaries, lower cost of living. To comprehend the problems of the common man, we must view them from that perspective. Between 2015 and mid-2017, the government imposed a huge burden on the public; the combined impact of tax increases (VAT, PAL) and the currency depreciation added almost  25% to the cost of imported items. This is excluding increases in duty or the impact of extending VAT to previously untaxed items such as healthcare, alcohol and telecommunication; factoring these in would increase the impact even further.

How many average citizens were fortunate enough to receive a 25% increase in income during this period? Anyone who did not would probably face lower living standards.

To add to these self-inflicted woes is the impact of the drought and floods in both 2016 and 2017. Affected people, particularly in rural areas, lost livelihoods and income. With crops wiped out, urban people experienced soaring prices of coconuts and vegetables. When the cost of living rises, the government gets the blame, even when, in this instance, it’s not at fault. The impact is evident in consumer spending; one only needs to glance at the published accounts of companies such as Nestlé and Elephant House. Nestlé reported a 5.3% decline in turnover in the half year ended June 2017, while Elephant House reported a 5% decline in the quarter to June 2017. These are both food companies; noodles, malted milk, ice cream and sausages are hardly luxuries. Yet, overall sales revenues have declined; the fact that people have cut back on simple things like this illustrates the depth of the problem.

When people cutting back on basics are confronted by the spectacle of egregious corruption of ministers living in ostentatious luxury and driving around in convoys of vehicles each of which costs more than the house of a common man, the frustration boils over. The government cannot expect to tax punitively, spend lavishly on themselves, and expect the public to grin and bear. How should the government react? In the short term, some relief that does not upset fiscal stability, and reforms to promote growth in the longer term.

 

The First Step: A clear message of austerity starting from the top

The government must show, publicly, that they are concerned about waste, corruption and inefficiency. Mere words will no longer suffice, deeds must follow. A visible cutback in luxury and waste must be led from the top: this means no new vehicles, no fancy offices, fewer overseas jaunts, no large entourage of security/staff. It must be visible. Even if the impact on cutting back on ministers’ privileges yields comparatively small savings, they need to be seen to be tightening their belts to win public support.

They should launch an economy drive eschewing extravagance, and eliminating corruption and waste through increased transparency and open processes. 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. When faced with a crisis, Singapore set up a “Cut Waste Panel”, headed by members from the public and private sectors, to receive suggestions from the public on where the government can cut waste, remove frills and make savings in the delivery of public services. The minister could set up a similar panel and, in addition to suggestions from the public, actively seek other opportunities to reduce costs.Properly executed, with real results, this will help restore credibility.

 

The Second Step: For quick relief, cut protective tariffs

Sri Lanka has a high cost of living, partly due to taxes. The taxes are of two types – protective taxes to benefit local industries and revenue-generating taxes. Protective taxes bring minimal revenue to the government and can be cut immediately, with little impact on the budget deficit.

Local industries have lobbied for protective tariffs on imports, which benefit them by raising the price of imports. These earn little revenue for the state, but increase consumer prices. For example, the import of wheat flour is taxed, ostensibly to support paddy farmers but in reality to protect local wheat millers. Wheat flour is effectively taxed at around 85%, while wheat grain is taxed at around 23%. Local wheat millers pocket the difference.

The net result is high prices of bread. Wheat flour retails in Malaysia for half the price it does in Sri Lanka. Cutting the tax on wheat flour could reduce bread prices significantly, and thereby the cost of living.

This is not an isolated example, it is prevalent across many food items and sectors from building materials (construction costs in Sri Lanka are estimated to be 40-60% higher than in the region) to toiletries (shampoo is taxed at rates between 100% and 200%), to shoes. Local industries create a few thousand jobs to protect these, and millions of consumers pay higher prices. A much larger population loses, while a small group gains, which means negative results on overall welfare. If these taxes are cut, they will bring immediate and significant relief to people, with little pressure on public finances.

 

The Third Step: Resist giveaways, maintain macro stability, facilitate investment

As a result of increased taxes, the primary balance of the budget (all expenses before interest) showed a surplus as at November, the first in 63 years. This means that government revenue meets current expenditure without the need to borrow. This must be maintained to prevent debt from growing, so there is no room for panicked giveaways.

The temptation for salary increases or subsidies must be resisted at all cost: it will buy short-term popularity, but destabilise the budget in the long term. Indeed, it was the public sector salary increase in 2015 that ultimately forced the government to increase taxes. The government initially financed the increased salary bill in 2015 by printing money, the impact of which came later in the form of currency depreciation. Forced to contemplate either further currency depreciation or tax increases to pay for salary hikes, they chose the latter and the currency stabilised. The cost of increased salaries for 1.3 million public servants was ultimately borne by 20 million people. A minority experienced an increase in welfare, but ultimately the vast majority suffered.

Politicians and the public must understand that a government has no resources of its own to distribute, and what it can distribute is ultimately only what it can collect in taxes. Short-term giveaways will simply repeat this destructive cycle.

The solution to jobs is not to grant public sector salary increases or recruit more into service, but to enable new investment that will create new jobs and increase demand for workers, which will lead to higher salaries. A simple illustration of this is the sudden increase in demand for workers in Colombo hotels following the opening of Shangri-La Colombo – city hotels are competing actively, and overall salaries in the sector have risen. To do this, they need to facilitate investment by simplifying regulations and removing tariff barriers, while maintaining policy stability. A limited domestic market means the path to growth is through exports, not protected, import-substituting local businesses.

 

The Fourth Step: Pruning of debt, reducing expenditure

Around 50% of government revenue is spent on salaries and pensions, and a further 36% on interest. With 86% of revenue eaten up with these two items, the country is effectively borrowing to consume, and debt keeps growing. A primary surplus on the budget means that fresh debt is not needed for current expenditure (although it may be needed for capital expenditure). If expenditure is cut, then the surplus will grow and more debt repaid, leading to long-term reductions in interest. Fortunately, there is plenty of scope for this: simply, cut waste and reduce corruption. A key area is State-Owned Enterprises (SOEs), which have become little more than vehicles for corruption.

Corruption is endemic and deep-rooted, and can only be controlled at the source – government procurement. Politicians love to spend other people’s money, whether on capital expenditure or in procurement of ministries and state enterprises. The Auditor General (AG) has revealed a Rs15 billion scam in rice imports by Lak Sathosa – purportedly imported to reduce the cost of living, but in reality, for the purpose of making money. The AG also revealed a Rs4 billion scam in coal imports.

Spending presents opportunities for theft; the less the government spends, the less politicians can steal. Scaling back state involvement in economic activity will automatically lead to a reduction in corruption in absolute terms, even if the proportion stolen never changes.

Recall that the high taxes are what angered people, the taxes that fund government spending. Control spending to keep taxes low. There needs to be a comprehensive review of spending, reviewing, not only the scale of spending, but also the scope of government. The government should not expend any further funds expanding SOEs; these should be restructured to cut waste and losses. As many as possible should be sold or closed down. Privatisation can have a fourfold benefit:
a) raise revenue that may be used to repay debt,
b) obviate the need to fund losses (in the case of loss-making entities),
c) reduce opportunities for corruption, and
d) open new opportunities for private sector participation in the economy.

For whatever procurement that does take place, open and transparent processes must become the norm. Infrastructure can either be developed privately or in partnership with the government to minimise additional borrowing. Where corruption is detected, action must be taken, starting from within the government’s own ranks.

Conclusion
There are no quick and easy solutions, but measures described above will bring some immediate relief, while setting the foundation for sustainable growth. Enough benefits will flow to ensure re-election of whichever party implements this in full by 2020. There will be stiff opposition by politicians and businesses who benefit, but they are a minority. The vast majority, particularly the poor, will benefit.

#Lka70. Independent. Not free.

  Photo Credit : Nazly Ahmed

Photo Credit : Nazly Ahmed

By Ravi Ratnasabapathy 

Sri Lanka achieved ‘independence’ seventy years ago. What does this mean? What we achieved was self-government – the ability to elect our own rulers; but as a society did we become freer? We are no longer administered by rulers appointed from afar but is the citizenry free?

Representative, constitutional democracy is the best means known for keeping rulers accountable. Contrary to popular belief its real benefit is in removing bad leaders, not in choosing good ones.

To get elected politicians may lie or may make meaningless appeals to emotion, only a handful truly understand the problems or have real intent on solving them. Citizens have to sift truth and assess ability with minimal information. There is no way to know how a politician will perform once elected.

As a system for choosing leaders, it fares poorly but citizens can remove the really bad ones. This is the most important, maybe even the only real check that citizens have on power.

Thus while democracy is an improvement on colonialism, it does have its limits. Power remains in the hands of fallible human beings but at least the bad can be booted out. It is a good way to make a few big decisions-once elected the politician has little concern with the citizen until the next election-but it is best to leave smaller ones in the hands of citizens themselves.

What matters in daily life is personal freedom.

The Government intervenes heavily in the economy, its motives driven by corruption and the protection of special interests. They benefit a few to the detriment of the many. Fiscal prudence must be restored and cuts made to the size and scope of Government spending. This regime was elected on mandate of good governance, so they should use the mandate to restore the personal freedom of the citizenry in all spheres of life

Freedom is about not being limited by in ones actions by threats, coercion or interference of others – specifically, other individuals or institutions, such as government or religious bodies. The only good reason to interfere with people’s freedom is to prevent them doing or threatening actual harm to others.

Freedom is guaranteed by laws that restrain the power to interfere in people’s lives. The role of Government is to uphold the rule of law. As Francisco de Paula Santander (1792-1840), Colombian soldier and statesman said “Weapons have given you independence. Laws will give you freedom”.

Colonial laws

Sri Lanka has no bill of rights and we inherited some colonial laws that intrude into personal freedom.

For example, articles 365 and 365A of the Penal Code are widely considered to criminalise homosexuality and are used to arrest, detain, harass, intimidate, blackmail and shame. The Vagrant’s Ordinance is used to harass, arrest and detain sex-workers, and is also used to criminalise the poor, mentally ill, disabled and other vulnerable people. Abortion is illegal except to save the life of the mother. Half the population, women, are discriminated in the Thesawalami, Kandyan and Muslim laws.

These are questions of morals, customs and ethics, things that concern individual citizens. It is individuals who must tussle with these issues, not the law. In any case the law should apply equally to everyone, regardless of gender, race, religion or language.

We may well detest other people’s morality, religion, political views or lifestyle. We may worry that they are harming their health but these are not valid reasons to interfere in the lives of others. Minors should be protected but consenting adults should be left in peace.

Any regulation should focus on limiting public harm, not protecting morality. Strict laws on drunk driving, prohibition on sale of alcohol to minors or limiting public smoking may make sense but the recent foray of state policy, through punitive taxation and restrictive laws to stop the consumption of alcohol and tobacco is wrong.

There are licenses and taxes that most countries impose but they must be reasonable. The fact that some people disapprove of something is no reason to restrain others. The goal of taxation should be the raising of revenue, not punishment.

It is a fact that individuals disagree on things. What is the interest of one is not necessarily of the other. When one is called to give up some freedom for society what happens in reality is the sacrifice of one set of interests to another, there is no real common interest.

Self interest of politicians, officials

When the state makes laws, a choice will be made over many conflicting sets of interests-a choice in which only one side can win. The process of lawmaking is tainted by the self- interest of politicians, officials and lobbyists. It can lead to minority groups being exploited and their liberties curbed.

Therefore the passing of laws, especially those that curb rights should only be resorted to only when strictly necessary. Calls to curb or ban activities must be viewed sceptically. For example, why is horse racing banned in Sri Lanka? This may not be an important example but the problem is ‘mission-creep’ restrictions start innocuously but then keep expanding.

If freedom is to be restricted it should be up to those who want to do so to show why this is both necessary and sufficiently beneficial to warrant it. Election success does not license the winning majority to treat other people exactly as it chooses.

The philosopher John Locke listed life, liberty and property as basic freedoms: people have a right to live, to do as they please (provided they do not infringe the equal right of others) and to enjoy all that they own.

Locke’s concept of property was not limited to land, he claimed people had property in their own lives, bodies and labour. They deserved to own the things that they had spent personal effort in creating and ownership should be secure under the law.

Sri Lanka’s emergency regulations and the Prevention of Terrorism Act granted the authorities sweeping powers of search, arrest, and detention, which have led to arbitrary detention, torture, and enforced disappearances. The Government has been widely criticised for abuses against political opponents and innocents, particularly minorities who claim to have been targeted purely on suspicion.

These laws remain even nine years after the end of the war. For at least some, the right to life could be under threat. The right to property has also been under attack.

Land, houses and businesses were expropriated by law. Laws were passed limiting what property citizens could own and how they could use it. For example, land classified as paddy land can only be used for paddy, not other crops or purposes. Restrictions apply to the sale of tea, rubber and coconut land. Never mind that people may no longer want to farm or have other needs, such as housing. The colonials also confiscated land but there is no need to repeat the error.

Land reforms

Whether the exercise even benefited society is doubtful, certainly Sri Lanka never became rich as a result.

Land reforms, ostensibly to help the poor, weakened a fundamental pillar of freedom-the right to hold what we own. Once personal property is no longer sacrosanct a precedent is set for future abuse: witness the complaints of the poor evicted from their homes in Colombo or the plight of some of the displaced in the conflict zone, denied access to their land. Laws enacted to reengineer society for the betterment of the weak have created the conditions for their oppression.

Money, lawfully earned cannot be used as we wish. Exchange Controls, introduced in 1953, later expanded and later partially reversed dictate how we spend our own money. At one time it was impossible to travel abroad, spend on overseas education or buy anything imported unless deemed “essential” by the state. Thankfully some rules have been relaxed but try sending money to relatives overseas (for medical or other reasons) or remit the proceeds of property sales and we face obstacles. Are these trivial issues? Perhaps, but even so why? Colonial Ceylon had no restrictions but independent Sri Lanka does. Problems of mismanagement of finances by the Government translate to restrictions on citizens.

If citizens, even if displaced or poor, feel their rights are infringed they should be able to seek justice through the courts. Few seem to try. The system of justice has corroded. The courts exist and the police exist but are they independent enough to uphold and enforce the law? Can an ordinary person hope to win in court against a politician?

A new regime is in power, when they celebrate independence they must reflect on the state of personal freedom.

The purpose of Government should be to expand freedom, not restrict it.

New constitution

A new constitution can help protect natural justice: enshrine the due process of the legal system, ensure equal treatment; and define a personal sphere into which legislation and officialdom can never intrude.

They must recognise that people’s beliefs, lifestyle or morals vary. There is no common agreement on what is acceptable, unacceptable, tolerable or intolerable. As long as no harm is done to others the state should not intervene in such matters, legislation that permits this should be rolled back.

The independence and integrity of the system of justice must be restored.

The Government intervenes heavily in the economy, its motives driven by corruption and the protection of special interests. They benefit a few to the detriment of the many. Fiscal prudence must be restored and cuts made to the size and scope of Government spending.

This regime was elected on mandate of good governance, so they should use the mandate to restore the personal freedom of the citizenry in all spheres of life.

Ravi Ratnasabapathy is a resident fellow at the Advocata Institute.  

After Independence : Reform or Revolution

Originally appeared on FT.LK

It could have been better. Much, much, better. But it was not a disaster. That, in summary, is the story of our country since 1948, when we received independence as a collateral effect of the Indian independence struggle. The atrophying of British military power as a result of the World Wars also contributed.

Institutions

At the top of our society, the institutions appeared strong when we became free from British rule. For example, many talk about how independent our courts were and how we squandered that legacy in recent decades, especially after the appointment of Sarath Nanda Silva as Chief Justice. 

There is no doubt that a strong and efficient judicial system that dispenses justice without fear or favour (and undue delay) is an essential pre-condition for wealth creation and the building of a good society. But there was little depth to what was good about our legal system. Who the litigant was still mattered in Magistrate’s Courts and District Courts.

Fairness in the superior courts was underwritten by the presence of a few truly independent judges, especially those from the Burgher community. Not them alone, but their presence made most of the judge behave better. But after 1956, the Burghers were made to feel unwelcome and departed for Australia. Our institutions gradually deteriorated.

Believing that an independent and professional administrative service was a barrier to their efforts to serve the people, our political class, inspired and led by the socialist parties, subjugated it to their will. Comparison of those at the upper levels of the administrative and foreign services of India and Sri Lanka shows how much damage has been caused. 

Economy

The British did not bequeath us a dynamic economy. It was, as many in my age group learned in school, based on the export of tea, rubber and coconut. Little value addition was done. Most government revenues came from taxing foreign trade. Reliance on commodity exports made the economy vulnerable to economic cycles. In 1952, a dramatic fall in rubber prices by over 30% because of the end of the Korean War led to the Rubber-Rice Pact with China, not some kind of grand gesture of non-alignment.

But today, we are less dependent on commodities. Service exports (if we include remittances from those who work abroad, technically a form of trade in services) yielded Rs. 14.3 billion in 2016, higher than the $ 10.3 billion earned from goods exports, of which agriculture and mining comprised on 23%, according to the 2016 Annual Report of the Central Bank. 

Remittances, which none other than the families that generate them appear to be proud of, brought in $ 7.2 billion. Contrary to entrenched perception, more men than women are now engaged in this form of service export and the proportion of skilled workers is increasing. Tourism was the biggest source of conventional service earnings, yielding $ 3.5 billion. Most of our rubber now goes out in the form of value-added tyres, gloves and such. It is second only to apparel among industrial exports. 

Our economy has diversified and is less vulnerable to external forces than at independence. But the momentum achieved in increasing and diversifying exports was lost as a result of the insular policies of the past decade. Lack of attention to exports and the right kinds of foreign investment has led to greater dependence on borrowing, no longer available at concessional rates, leading to a different form of vulnerability that has to be carefully managed.

Human development

 But from the perspective of citizens, life has actually improved, contrary to those who claim otherwise. Few people know or remember how life was for the citizen back then. These days, we have the Human Development Index (HDI) which was developed by the famed Pakistani economist Mahbub ul Haq. 

“People are the real wealth of a nation,” Haq wrote. “The basic objective of development is to create an enabling environment for people to enjoy long, healthy and creative lives. This may appear to be a simple truth. But it is often forgotten in the immediate concern with the accumulation of commodities and financial wealth.”

However, the HDI which was devised in 1990 does not allow comparison between 1948 and now. Life expectancy is a cruder, but easier to understand, indicator that does.

A male child born in Sri Lanka in 1945-47 could expect to live 46.8 years. A female could expect live 44.7 years, two years less. The life expectancy predictions in 2015 were 72 years for a male and 78 for a female (six years longer), according to the WHO. 

Behind these huge increases are significant achievements in healthcare, housing, education and even working conditions. Obviously, life expectancy could not improve for women if many of them would die at childbirth like they did at the time of independence. If polio, malaria, filariasis and various infectious diseases had not been eliminated with considerable effort and if the housing stock had not been improved, it’s unlikely that that life expectancy for everyone would have gone up by this much. And without people’s incomes and education improving, they could not have stayed alive for that long. 

Revolution or reform?

Those who draw a picture of a country in dire straits tend to do so as part of advocacy of radical change. But in the centenary year of the Russian Revolution, it would be wise to exercise caution with regard to prescriptions of revolution. Revolutionary movements in the 20th Century killed millions worldwide and thousands right here. Reform may be messy. The results may be sub-optimal as has been the case in Sri Lanka. But they carry less risk of unintended consequences. Reforms demand more from us as citizens than the mouthing of grandiose slogans. The less-than-ideal pace of economic growth does call for remedial action. Should it be the replacement of the current crop of political leaders with those promising revolutionary change? Or should it be the hard work of exerting pressure on political leaders and officials through instruments such as the Right to Information Law?


Rohan Samarajiva is the chair of Lirneasia and an advisor to Advocata Institute.

High construction costs: Do price controls on cement help?

Originally appeared on Echelon

AN INTERVENTION-EAGER STATE NEGLECTS ITS REGULATORY ROLE

The president of Sri Lanka’s Chamber of Construction Industry has complained that construction costs in Sri Lanka are higher than in the region. Players in the tourism industry have claimed that high construction costs inhibit capacity expansion in the tourism industry. Why are construction costs so high? The government imposes price controls on cement, an important factor in construction, supposedly to keep costs low; but is this working?

Price controls distort markets, causing shortages and creating black markets. But, these obvious market distortions are not visible in cement. This may be because of industry involvement in setting prices, which are based on cost estimates provided by manufacturers. This seems likely, given that cement prices in Sri Lanka are higher than in the region. According to the JUBM & Arcadis Construction Cost Handbook (2017), the cost of ordinary Portland cement in Malaysia is between RM19 and RM20 per 50kg bag, which is about Rs715-750. The cost in Indonesia is around Rs845. The regulated price in Sri Lanka is Rs870-930 per bag.

Naturally, producers would be quite happy to supply a product if the price was set high enough and no shortages would occur.

Promoting competition and allowing markets to work properly are the best ways to lower prices, but in 2013, the government imposed a new restriction that curtails competition. The number of cement plants that may be operated in a port was limited to one per port. If a new factory is to be set up, priority has to be given to existing operators in the port. This limits new investment and competition, and prevents prices from falling.

If price controls were removed, the price of cement would probably fall, as it would give cheaper imports the opportunity to compete on price

QUALITY

If price controls were removed, the price of cement would probably fall, as it would give cheaper imports the opportunity to compete on price. Would this affect quality?

The local cement industry has complained of low-quality (and low-cost) cement imports in the past. This is a problem because consumers cannot detect poor quality. Substandard cement on construction work is a serious matter, as the consequences may manifest after construction is completed.

This issue needs to be addressed through a comprehensive building code, which is lacking. A proper code is needed for consumer protection and public safety. Although old regulations such as the Factories Ordinance exist, these are not up-to-date and enforcement is weak. A standard Code of Practice to regulate and enforce design, construction and compliance requirements is necessary.

While a uniform code is absent, a multiplicity of approvals exists: at provincial, district, pradesheeyasabaha, urban and municipal level. These become even more complex given several central agencies such as the Urban Development Authority (UDA), the Sri Lanka Land Reclamation and Development Corporation, and the Department of Agrarian Development. This leads to overlaps of authority, conflicts of instructions, contradictory regulations and compliance loopholes.

There is a lot of red tape, but it does not improve safety or ensure quality. The government needs to replace these old regulations with a single comprehensive code, legally enforceable, covering all classes of buildings and including safety, structural stability and accessibility.

Along with a code, building contractors and architects should be licensed and carry professional indemnity insurance. The objective of licensing is to ensure that work is done by people who are conversant with the standard (which should carry statutory force), and conduct their duties competently and professionally.

In the event of any failure in buildings, they may lose their license to practice. This is apart from any action taken in courts. The insurance ensures that consumers can receive compensation for shoddy work. The code is self-enforcing; if there is a failure, they will not be able to practice, which gives the incentive to ensure quality.

Specialist licenses should be necessary for more complex work, including the following:
(a) Piling work
(b) Ground support and stabilization work
(c) Site investigation work
(d) Structural steel work
(e) Pre-cast concrete work
(f ) In-situ post-tensioning work

 

OVERALL CONSTRUCTION COSTS

Cement is only one part of the construction cost; policy with regard to other construction materials significantly increases costs.

The government imposes high taxes on many imported construction materials to protect domestic industries. These include steel bars and rods (taxed at 89.66%), ceramic tiles (107.6%), and sanitarywear (72.4%). Aluminium extrusions, granite, electrical fittings, furniture and carpets are also heavily taxed. This results in high overall construction costs.

For example, steel costs around $723/mt in Sri Lanka, but only $500/mt in Thailand and $470/mt in China. By some estimates, the construction cost of an average (non-luxury) high-rise apartment block in Sri Lanka may be as much as 60% above that of Thailand or Malaysia due to these protective taxes, despite Sri Lanka’s lower labour costs.

The policy is a muddle of ad-hoc interventions. Contrast this with the UK government, which in partnership with the industry has developed a strategy to improve the performance of the construction sector by 2025. Objectives include lowering costs: a 33% reduction in the initial construction of a new building and the whole life cost of built assets, a 50% reduction in the overall time from inception to completion of a construction, and a 50% reduction in greenhouse gases. The UK industry is focused on reducing costs through efficiency, better methodology, technology and innovation.

Apart from protective taxes, the lack of scale among contractors, low labour productivity, outmoded methods and long delays in approvals also contribute to high overall costs

The focus is on overall cost reduction, and not trying to protect local producers of construction material.

Apart from protective taxes, the lack of scale among contractors, low labour productivity, outmoded methods and long delays in approvals also contribute to high overall costs.

Improvements in these areas will also reduce costs. Ordinary citizens are unable to afford housing, while the government intervenes to protect the industry.According to a report by Jones Lang LaSalle (2014): “High project development costs, coupled with the high borrowing costs for housing loans, have breached affordable limits and restricted home buying prospects for Sri Lanka.

Based on our understanding from the affordability assessment, only the top income-earning resident Sri Lankans can buy homes in Colombo. Residents with limited income are forced to opt for properties that are at least 20-25km away from city limits.”

 

CONCLUSION

Price controls for cement are clearly not helping to reduce construction costs. Restrictions on competition deter investment and contribute to raise, rather than lower, cement prices. Other interventions to protect the local industry have resulted in raising overall construction costs.

While the State is eager to intervene in unnecessary areas, it has neglected its role as a regulator. Although in most circumstances the best protection is the common sense of an individual consumer, in instances where technical knowledge is needed to detect poor quality, there is a case for regulation, particularly if public safety is involved.

The government should stop controlling the price of cement, and focus on drawing up and enforcing a proper building code. To lower costs, taxes on construction materials must be reduced and competition facilitated