Investing in Public Transport

Originally appeared on The Morning

By Dhananath Fernando

As a schoolboy, one promise that I remember being consistently made in Budget speeches was the development of the Marine Drive up to Moratuwa. But now, even in 2023, it has only been developed up to Dehiwala.

When the project was announced, I remember Sri Lankans celebrating. When the project was cancelled, we still celebrated. After leaving school, I often took the train to work, so I practically grew up with the Sri Lankan railway system and the Marine Drive. While the Marine Drive has progressed at a snail’s pace, the Sri Lankan Railway remains almost the same.

Later, when the Light Rail Transit (LRT) project was approved, there was renewed hope and celebrations. Consultants were hired and feasibility studies were done. TV commercials were aired on the impact it could create. However, following some back and forth, a new set of consultants were paid, who then cancelled the project. Again, we celebrated the cancellation, and now once again, we are in discussions to resume the project.

One does not need to be an economist to understand the importance of developing a solid public transport system which helps to improve efficiency, minimise pollution levels, and increase convenience for commuters.

As an initial incentive to get more commuters to consider using buses, the Government attempted to implement bus lanes. The provision of a dedicated lane for vehicles shuttling a large number of passengers would have reduced commute time and congestion, and also incentivised commuters to switch from private vehicles to public transport. Unfortunately, the actual adherence to bus lanes was short-lived; if you look at buses today, they move all over the lanes.

Further, there is a route permit system which effectively blocks the entrance of new players. This has created an oligopolistic market system, with a higher chance for cartelisation of the market. Additionally, the Government has imposed a price ceiling which stunts the space for innovation and value-added services.

For example, the 138 Kottawa-Pettah route – considered to be a route utilised by a significant proportion of the middle class – has no air-conditioned bus service. The lack of an efficient market system has led the players to not even be incentivised enough to employ air-conditioned buses.

The market system works when there are no entry and exit barriers and when room is created for innovation through the pricing mechanism to reflect the scarcity value of the product or service. In the current system, nothing is possible. And yet, modifying the public transport system is not a difficult task and will provide significant relief for the people.

One main problem in Sri Lanka for any type of investment is the ownership of land. Unfortunately, this is not an easy puzzle to resolve. There is no digitised land registry and more than 80% of land (including the forest cover) is owned by the Government – this land can be efficiently used for urban development.

Efficient public transportation with greater accessibility and affordability will create urban living hubs around it. One way to solve this puzzle is to start the digitisation of registration of lands in commercial areas within Colombo and Gampaha. Often, these projects tend to progress at a sluggish pace, falling significantly short of the required speed. The delays have not only driven up the cost but have also resulted in a loss of credibility.

Unfortunately, politicians often prioritise projects with short-term timelines, typically ranging from three to five years, as they require something tangible to showcase before the next election. Therefore, with the current governance structures, even these projects that are scheduled to take place would simply be an attempt to build political capital, instead of improving public transport in order to generate value for the people of Sri Lanka.

Debt restructuring: What’s next?

Originally appeared on The Morning

By Dhananath Fernando

Sri Lanka is passing through a crucial week in its history. The details of the final domestic debt restructuring are yet to be known, but we will soon come to know the final details. However, domestic debt restructuring won’t be the be-all and end-all that will confer the expected level of economic growth – we need reforms across the board for a growth trajectory. Progress can only be achieved through a comprehensive reform plan.

Domestic debt restructuring

No debt restructuring plan is easy. Debt restructuring itself is a very painful process. The ideal solution is to have a sound economy in order to avoid any type of debt restructuring, but we are far from such a scenario. The consequences of any type of debt restructuring would be broadly negative. It would only be positive compared to consequences of not undergoing debt restructuring.

When someone borrows money and later says that they cannot pay it back as promised, it is never a pleasant experience. Sri Lanka’s debt restructuring is no exception. The debt restructuring will have consequences at this stage; it is just a matter of who will bear the burden and whether the relief will be enough for Sri Lanka to at least settle the remainder of its debts.

In the proposed plan by the Central Bank of Sri Lanka (CBSL), it has been suggested the Central Bank, superannuation funds, and the holders of Sri Lanka sovereign bonds and other USD bond holders (issued under Sri Lankan Law) bear the burden of local debt. International sovereign bond holders and bilateral creditors are expected to primarily bear the burden of foreign debt.

Although technically it seems as if bond holders and other creditor segments bear the burden, the truth is that most of the burden has already been shared by people of Sri Lanka through inflation.

In the initial plan, the banking sector was excluded from the debt restructuring process. The CBSL has provided four broad reasons to justify this exclusion.

The banking sector pays about 48% taxes (after tax revisions) (30% corporate tax and 18% VAT on financial services) as opposed to previous taxes of 39% (24% corporate tax and 15% VAT on financial services)

The Non-Performing Loan (NPL) ratio of banks is on the rise (8.4% NPLs in 2022 Q2 to 13.3% in May 2023)

Banks are expected to be impacted by International Sovereign Bond (ISB) restructuring as well as Sri Lanka Development Bond (SLDB) restructuring (banks hold 17% in ISBs and SLDBs)

Many concessions and moratoriums were already provided during Covid, Easter attacks, and the economic crisis, where about Rs. 1.6 trillion worth of loans were under concessions, amounting to about 15% of total loans

The main question is whether the provided debt restructuring is adequate for Sri Lanka to reach its target of 13% Gross Financing Needs (GFNs), 2.5% primary surplus, and 95% of debt to GDP ratio by 2032.

If the restructuring is not adequate enough for us to settle our debts, we will likely have to undergo another restructuring. Most countries which have gone through sovereign debt restructuring have to go through two subsequent debt restructurings on average. We are yet to see the analysis by the CBSL on how to ensure that this restructuring plan is adequate for us to achieve targets.

Ideally, we should avoid any further debt restructuring, because further restructuring would be more difficult, economically and socially.

Impact on superannuation funds

With the proposed restructuring, the social conversation is on the impact on superannuation funds. The Government has assured a minimum of 12% until 2025 and a 9% interest until maturity for the EPF. This is projected to amount to an average of 9.1% in rate of returns.

However, we have to keep in mind that any interest rate needs to be compared to inflation. There is no value in getting a 9% interest rate if inflation is 12%. If so, the Central Bank has to ensure that inflation remains around 5% for the real interest to be 4%.

However, the key impact of the proposed debt optimisation plan on superannuation funds would be that as per the Government’s projections, the rate of return would be 9.1%, which is slightly lower (0.3%) than the current returns. This means that if the status quo continues (for instance with no DDO) at 9.4%, the rate of return will be 0.4% higher than if superannuation funds took part in DDO.

The EPF is a nearly Rs. 3 trillion fund where withdrawals per year are less than Rs. 150 billion. Its collection was approximately Rs. 170 billion in 2022 and generally there is a Rs. 30 billion surplus between collections and refunds every year. People can still withdraw the money and their balance will not be affected, instead, it will result in the forgoing of the additional returns the fund could have made.

Domestic debt restructuring to be considered with other reforms

This debt restructuring will only bring partial relief, even if we undertake the necessary reforms. Even if this debt restructuring is successful, our debt to GDP ratio will be 95% in 2032 as per predictions. That is still a very high number. Ideally, an emerging market like Sri Lanka should remain in the range of 60%.

Sri Lanka will only be able to emerge from this crisis if we move forward with State-Owned Enterprises (SOEs) reforms, monetary sector and monetary reforms, and trade reforms. For us to grow our economy, we have to engage in trade. Secondly, we have to avoid growing our debt further through unproductive SOEs. If we fail to fix the rest, we will most likely return to square one, with a much difficult context.

What we, the common people, can do is push our policymakers to allow the market system to operate and limit the size of the Government while pushing for key reforms.

The pre-election opportunity ECT presents the President

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

Originally appeared on The Morning

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By Dhananath Fernando and Shanaka Paththinigama

The East Container Terminal (ECT) has come into the limelight again.

Last week, a strike was ongoing by trade unions demanding to install gantry cranes, which were ordered a few years ago and which are now in the Colombo Port, at the ECT.

This was followed up with the Cabinet Spokesperson stating that it was “allowing the respective line Minister to conduct discussions at a diplomatic level on changing (the) Colombo Port Terminal deal with India and Japan”, according to Hellenic Shipping News Worldwide.

Subsequently, the Gantry Cranes were permitted to be unloaded and installed on the instructions of Prime Minister Mahinda Rajapaksa and the port workers decided to call off their strike on Thursday (2).

The fact of the matter is that the ECT is one absolute failure in terms of “getting things done”. Sri Lanka has been running it continuously and like many other economic issues, we have failed at getting our act together. This is despite being located at the heart of a strategic maritime route. Rather than taking advantage and converting the ECT to an operational level, we have lost a reasonable amount of credibility in the business world by opening the ECT for bidding and cancelling the bidding process on multiple occasions, thereby creating years of operational delays based on political favours. We hope, at least this time, Sri Lanka will be able to convert shop talk into actionable outcomes.

Understanding the shipping business

The shipping business is a technical subject and is very complicated. Ports are strategic geographical locations which are situated at the edge of oceans, seas, rivers, or lakes. These locations are then developed to provide facilities for the loading and unloading of cargo ships. The facilities provided for a port depends on the purpose for which the port is being used. A terminal refers to the set of facilities at a port where the loading and unloading of the cargo/container takes place. Terminals are named on the basis of the type of cargo that can be handled by it. Some of the most common types of terminals are container terminals, bulk cargo terminals, and LNG (liquefied natural gas) terminals.

Simply put, in one port, there are multiple terminals and the Port of Colombo has a few container terminals (CICT – Colombo International Container Terminal, JCT – Jaya Container Terminal, SAGT – South Asia Gateway Terminal, and UCT – Unity Container Terminal).

Global trade and most merchandise exports and imports account for a greater share of container terminals. The main factor that drives this business is efficiency and the networking ability to bring as many vessels as possible to the respective terminal. Simply put, when a ship enters the port/terminal how fast we can handle the containers and cargo (efficiency) and how networked we are to bring more vessels into the terminal are the two main determinants of making the business profitable.

Like most businesses, the price or the cost is a key determinant. To be profitable and bring the price down, over the years, shipping vessels have advanced to a point where there is capacity of more than 10,000 TEUs (20-foot equivalent units) in one vessel and those models (New Panamax – 12,500 TEUs | Triple E – 18,000 TEUs) have become popular with the development of global trade. These gigantic vessels can only be managed by deepwater ports which have a depth of more than 18 metres.

What’s all the fuss about the ECT?

There are two deepwater ports in the Colombo Port. One is CICT (85% owned by the China Merchant Port Holdings [for a period of 35 years, starting in 2013] and 15% by the Sri Lanka Ports Authority [SLPA] [owned by the Government]), which contributes to a higher share of the capacity and efficiency of the Colombo Port. The other deepwater terminal is the ECT. This is why the level of interest in this port is very high.

Geopolitical rivalries China, Japan, and India continue to seek operational ownership of the ECT through companies of their respective countries. The JCT (owned by the SLPA), SAGT (owned by John Keells Holdings – 42% , Mearsk – 26%, SLPA – 15%, A.P. Moller – 7%, Evergreen – 5%, and other investors – 5%), and UCT (owned by SLPA) are all shallow-water port terminals which can only handle smaller vessels (not economical compared to larger vessels) with about 10,000 TEUs capacity.

The ECT’s value is very high as it’s the only other deepwater terminal in the Port of Colombo except for CICT. As an additional benefit, it is located in the middle of the old port and the modern port, providing an added advantage for the movement of inter-terminal cargo, given its proximity to other terminals.

Despite the ECT having significant strategic value, consecutive governments have been just sitting on this, calling for bids and cancelling them, while competition is increasing every day – notably, the new Sagarala port development initiative by India, the construction of the Enayam Port in nearby Tamil Nadu, and also the Kerala Port, which is soon to be the world’s deepest multipurpose port.

With the agreement with SAGT due to expire in 2030 and with India developing their ports, the ECT has become a vital business asset as never before. Another deepwater port terminal operator adjacent to CICT will create more competition. However, the networking and other variables will matter to whoever gets the bid for the ECT.

At the same time, with the growth of global trade (not considering the effects of Covid-19), the Colombo Port is nearing full capacity of handling containers. The Port of Colombo moved to the top position of the Fastest Growing Port Index in the first half of 2018 by industry analyst Alphaliner and is one of the most connected ports in the entire world, handling about seven million TEUs in total. It is vital that the ECT is developed to maintain this growth.

Despite being situated in the centre of the Indian Ocean, and even though we are one of the most connected ports in the world, we are far from becoming a maritime hub. The root cause lies in our inability to be competitive and inadequacy to provide ancillary services such as logistics, bunkering, marine lubricants, fresh water supply, offshore supplies and ship chandelling, warehousing, and many more.

Our rules, regulations, and legal structures on the ownership of some shipping-related services and excessive government intervention, with the government acting as a player in the market and a regulator at the same time, has closed the space for private investment which could propel the Colombo Port to becoming a key global player.

Most experts have become weary of speaking about the same issues, while the opportunity of becoming a maritime hub in the Indian Ocean is slipping out of our hands.

Since the shipping business is based on efficiency and networking, the ECT has to be operated by a private operator and the Government should play a regulatory role and facilitate businesses by being the landlord of the port. This must be done while keeping the ownership of the port rather than trying to engage in the business and be a container terminal operator. Container terminal operation requires sizable capital investments. Private investments, which take the risk for the capital they invest, is the only possible way to create the right incentive structure and create the drive for efficiency and a very competitive business model.

Selecting a good terminal operator

After going back and forth, the previous Government signed a Memorandum of Co-operation (MoC) between Sri Lanka, India, and Japan. According to media reports, the current Government expects to discuss changes to the initial agreement, claiming that the previous deal was unfavourable for the country, and move to a new agreement.

At the same time, the SLPA unions claim that gantry cranes worth $ 25.7 million have been purchased for the development of the ECT, but concerns have been raised over the specifications of the cranes.

We really don’t know the truth

However, His Excellency the President, who received 6.9 million votes for a system change, should explore a method to select a proper operator. Undoubtedly, rather than handpicking operators based on introductions given by individuals, it has to be on a competitive bidding process, based on cost and pricing to ensure the competitiveness of the port with proper specifications. That’s the best system we can employ to find the most suited operator in a price-competitive industry.

Generally, Build-Operate-Transfer (BOT) agreements are provided with long tax holidays and the taxpayer has to be protected and prioritised as it is the people who gave the mandate for a system change.

At the same time, when the existing terminal operators bid for the project, their existing capacities and advantages need to be reflected in their pricing, investment, and proposal structure. The system change expected by the taxpayer, in this case, is to set up a system to ensure accountability and that things get done while getting the maximum benefit to the port and by establishing a level playing field for businesses and investors.

In countries like Sri Lanka where discussions revolve around high-value government transactions, there is a higher risk of such projects being influenced by many powerful businessmen and bureaucrats, leading to irregularities and corruption.

The President and the Government now have an opportunity to prove such assumptions wrong and set a prime example of how such a high-level transaction can be transparently managed. A single transaction with a conflict of interest can make a regime unpopular faster than anyone can expect. The Central Bank Bond irregularity is the most recent example.

On the verge of a crucial election and with the prospect of forming a fresh government, we hope Sri Lanka would move forward instead of dragging its feet on the ECT by ensuring and implementing a competitive bidding process (which will help avoid most of the geopolitical pressures) without getting sandwiched in between two global economic powers vying for regional dominance.

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

Blaming the banks: Why a credit guarantee is better

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

Originally appeared on The Morning

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By Dhananath Fernando

The Central Bank of Sri Lanka (CBSL) is in the spotlight yet again. Questions have been raised as to whether the CBSL and the banking system have been provided sufficient facilitation to contain the health crisis (that has been contained successfully at the moment) which led to an economic crisis.

The Government announced a series of economic relief packages since the beginning of the Covid-19 pandemic, including a Rs. 5,000 allowance for the most vulnerable sections of society and for the rescheduling of leases and loan facilities. Currently, the discussion is not on what the relief measures are, but rather on how we can execute them in the right way or whether we have better alternatives.

First, let’s understand the context. The CBSL offered a Rs. 50 billion refinancing facility in March, which was then increased to Rs. 150 billion in June. By the time the second scheme was announced, Rs. 27.5 billion of the original Rs. 50 billion had been given out. The CBSL offered the Rs. 150 billion credit facility to licensed commercial banks (LCBs) at 1% interest where the banks have to provide 4% interest to their customers affected by Covid-19.

Additionally, the CBSL brought the Statutory Reserve Ratio (SRR) to 2% from 4%, increasing liquidity (availability of money) in the market. The deposit that needs to be kept at the CBSL by banks as a percentage of total deposits is called the SRR. This means that when a customer deposits Rs. 100 in any LCB, the respective LCB has to deposit Rs. 2 to the CBSL which will not be paid any interest. Earlier, the banks had to deposit Rs. 4 and now it has been brought down to Rs. 2. As a result of this decision, out of the total deposits of all LCBs in Sri Lanka, 2% has been released to the market. That is depositors’ money.

The process of getting a working capital loan for a business is as follows: The businesses can apply for working capital loans from their respective LCBs and upon their approval, they send the application to the CBSL and the CBSL provides the money from the credit line they established, which is Rs. 150 billion. The CBSL provides money to LCBs at 1% and they give the loan to customers at 4%. The main question is how the CBSL got Rs. 150 billion in the first place. That was through money printing or money creation.

Additionally, banks now have more money from the reduction of the SRR, which can be used for other investments, to provide credit facilities, or as a deposit at the CBSL to earn an interest. The CBSL offers a 5.5% interest to LCBs parking excess money at the CBSL, which is called the Standing Deposit Facility Rate (SDFR). The CBSL has a similar facility where LCBs can borrow money if they run short of money, which is called the Standing Lending Facility Rate (SLFR) which is at 6.5%. A few challenges we may face in the future in this context are outlined below.

Challenge 1 – refinancing previous loans

When a loan scheme is available at a 4% concessionary rate, there can be instances when unnecessary loans will be applied for, to settle previous loans which have been taken at a higher interest rate. In the overall system, it may indicate that the CBSL and other banks have provided adequate loans under the newly established credit facility for Covid-19, but the ground reality may be that many businesses who have a solid working relationship with banks and bank managers will refinance their previous facilities.

The same has been experienced in large-scale loans under the previous Government’s Enterprise Sri Lanka loan scheme. It was reported that some established companies incorporated new companies just on paper to get the concessionary loan to refinance previous facilities. It was alleged that the majority of politically connected individuals received the loans and in most cases, the loans were canvassed to known businesses by bank managers themselves, avoiding customers who truly had financial needs. For bank managers, it is safer to provide a loan to a known business entity with a track record and good relationship, rather than taking a risk in a challenging business environment and risking underperformance in bank manager/branch key performance indicators (KPIs).

Challenge 2 – risk of market distortions and increasing expenses in CBSL

Since the CBSL pays 5.5% on deposits by the LCBs, banks have a higher incentive to simply earn a 5.5% interest with minimal administration cost, rather than providing a loan facility at 4% for the customers with a 3% interest margin, which also requires a significant amount of administration work. The banks will most likely park the excess money they received from the SRR cut and deposit it at the CBSL. This would increase the interest expenses for the CBSL. LCBs may also consider investing the excess money in bonds and other investment instruments which may distort those markets as well.

The positive side to this is that since banks park their liquidity back in the CBSL, the risk of inflation due to excess liquidity is somewhat minimised, but it will not bring the expected economic revival post-COVID-19. The non-performing loan (NPL) percentage has already increased to 5.1% as business recovery was very slow even before the Covid-19 pandemic, due to the Easter Sunday attacks. Similar concessionary loan facilities were provided to businesses impacted by the Easter attacks and it is highly likely that NPLs will increase.

As a result, banks may have a natural reluctance to provide facilities as they have a lucrative and stable option available without risking depositors’ money. The CBSL may push banks to provide loans as much as possible due to the lack of a correct incentive structure, which will lead to an impact on the stability of the banking sector and result in loans not reaching the right target audience.

Challenge 3 – pressure on LKR compared to USD and foreign currencies

By the time the CBSL announced the SRR cut and the Rs. 150 billion credit line, there was about Rs. 223 billion excess money in the financial system. The problem was not a lack of money (liquidity) in the financial system but the reluctance of banks to absorb risk to provide the facility to the impacted customers. At the same time, the mechanism of dispatching loans was not efficient and all banks were just depending on the Credit Information Bureau of Sri Lanka (CRIB) without having a risk-based credit assessment system to determine the borrowers’ ability to settle the loans and offering different interest rates based on the risk assessment. Additionally, the delays in banks’ internal approvals may not be supportive, given the urgent need of facilities and higher demand.

Now, as a result of excess liquidity, inflation may increase and the Sri Lankan rupee (LKR) will face further pressure to depreciate, leading us towards a Balance of Payments (BOP) crisis. Bringing the SDFR and SLFR down will bring down all interest rates in the market which will result in more money (liquidity) in the market, adding further pressure on the LKR.

In summary, the reluctance of banks to take the risk to provide loans in a challenging environment by risking depositors’ money is the problem, not the lack of liquidity in the market.

A workable solution

It is challenging to find an ideal solution for very complicated problems as our economic fundamentals have not been good for decades. Most variables are interconnected so we have to make a compromise in one of the areas. As the problem is not the lack of money supply, but rather the banks’ reluctance to take risks with regard to loan recovery, a credit guarantee by the Government could have been the first line of solution. That would minimise the risk taken by the banks without adding excess liquidity to the market and distorting other market sentiments.

Ideally, the Government credit guarantee has to be backed by a foreign funding line (USD funds) and this column has been promoting the idea of a bilateral loan with a neighbouring country or active engagement with the International Monetary Funday (IMF) for a fund facility, given the international sovereign bond settlements starting from October. The government guarantee can be provided on an agreed ratio where small loans are fully guaranteed by the Government and for bigger loans, the bank and the Government share the risk, where early instalments first cover the risk of the bank and their depositors.

One bottleneck for the Government in providing a credit guarantees scheme is the past mistakes made with our state-owned enterprises (SOEs). Multiple back-to-back credit guarantees have been provided to colossal loss-making SOEs like SriLankan Airlines, Ceylon Petroleum Corporation (CPC), and the Ceylon Electricity Board (CEB). Successive governments turned to these last resorts very early to fund completely unnecessary operations and now, faced with a real crisis, we have run out of solutions.

However, in a recent interview, Dr. Nandalal Weerasinghe mentioned that the Treasury wanted to create money and support businesses instead of providing a government credit guarantee. The reasons for these instructions are yet to be clarified by the Treasury. However, Dr. Weerasinghe has alerted the potential risk of excessive money printing on banking sector stability.

When the Easter Sunday attacks impacted the economy, we never expected a global-level pandemic of this scale. The lesson is that we should not underestimate the possibility of similar pandemics and market disruptions with climate change and a dynamic global environment in the future. I sincerely hope that there will be no calamities for the next few years as there is a lot we all have been hoping to achieve for decades.

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