Reforming Sri Lanka's Tax System: A Path to Fiscal Stability and Economic Growth

Originally appeared on Daily FT

By Dr Roshan Perera, Thashikala Mendis, Janani Wanigaratne

This article provides an insight on the Personal Income Tax structure in Sri Lanka as the second part of a series discussing potential tax reforms

Raising government revenue is critical for Sri Lanka to recover from the current economic crisis and create a more sustainable economic environment. However, taxes should be paid by those who can bear the burden. 

Personal Income Taxes (PIT) is an effective instrument in generating revenue as well as in reducing inequality through revenue redistribution.  In Sri Lanka, there has been a steady decline in revenue from PIT from 0.9% of GDP in 2000 to 0.2% of GDP in 2022. Revenue collection is  lower than that of even other low income economies. Furthermore, PIT tax revenue as a percentage of direct tax revenue declined from 40% in 2000 to 9.3% in 2022, although GDP per capita increased from USD 869 in 2000 to USD 3,474 in 2022. 

Advanced economies raise approximately 9% of GDP from PIT, while emerging economies and low income economies raise only 3.1% and 2.1% of GDP, respectively. (1)  Sri Lanka reports the  lowest contribution of PIT as a percentage of GDP in 2021, both among  advanced economies in Asia such as South Korea, as well as developing economies such as Bangladesh, Malaysia and Vietnam (See Figure 1).

Figure 1: Performance of Personal Income Tax Collection among Selected Countries

Source : IMF Data Library, OECD

Narrow Tax Base

The narrow tax base is one of the main reasons for Sri Lanka’s low PIT revenue performance. A narrow base not only limits revenue generation but it also makes revenue collection reliant on a small segment of the population. 

The number of income tax payers under the  Pay As You Earn (PAYE)/Advanced Personal Income Tax (APIT) Scheme (2) as a percentage of the total employed population shows  a relatively small proportion of the workforce contributing to income taxes (see Table 1). In 2019,  the proportion of tax paying employees was 33%. This proportion declined to less than 1% in 2021 due to abolishing of PAYE taxes with effect from 1st January 2020.  A voluntary APIT System was introduced with effect from April 1, 2020, where employees can opt in. This shift not only led to a revenue decline but also created monitoring gaps. With effect from January 1, 2023, it was mandated for employers to deduct APIT from employees' income, reverting to the original PAYE scheme.

(2 ) Note: PAYE/APIT is where employers deduct income tax on employment income of employees at the time of payment of remuneration.  PAYE was replaced by APIT with effect from April 2020. This measure of replacing PAYE with APIT essentially made PAYE optional. However, with effect from January 2023, deduction of Withholding Tax (WHT), Advanced Income Tax (AIT)  and APIT has been made mandatory.

Table 1: Employee Contribution to PIT

Source: IRD Performance Reports, Labour Force Survey

The large informal sector also contributes to the narrow tax base and low PIT performance. According to the Labor Force Survey (3) 2022,  the informal sector accounts for around 58% of total employment (see Table 1).  A large portion of the economy operating  outside formal regulation enables tax evasion and avoidance. Transforming the current informal self-employment system to a modern formal employee-employment system would be one way to improve tax revenue collection. 

Two alternative recommendations are proposed to capture informal economic activities into the tax net.  Establishing a universal online payments system would reduce cash transactions in the economy enabling better monitoring; and secondly, by introducing a unique digital identification system that connects tax accounts with income sources, bank accounts, motor vehicle and land registration etc. Authorities could cross check information provided in income tax returns as well as identify individuals who do not file returns. 

Tax Free Threshold and Tax slabs/Brackets

In the recent amendment to the Inland Revenue Act (4),  the tax free threshold for income was reduced from Rs.3 million per annum to Rs.1.2 million per annum. Further, the tax brackets were reduced  from Rs.3 mn to Rs.0.5 million.  Accordingly, the incremental tax rate for each additional Rs. 0.5 million of income was set at 6% (see Table 2).

Table 2:  Tax Threshold and Tax Brackets

Source :Inland  Revenue (Amendment) Act, No. 4 of  2023

Applying the current tax free threshold, income taxes are applicable to  approximately the top 15% of households where around  36% of total  income is concentrated (see figure 2) (5).

(5) Note This is based on the Household Income and Expenditure Survey 2019

Figure 2: Share of Income by Population 2019

Source : HIES Survey Annual Report 2019

According to the national poverty line (6) for  July 2023, the minimum monthly expenditure per person required to meet basic needs is Rs. 15,978. Hence, the total cost for a family of four is approximately Rs. 65,000 per month. Assuming salaries and wages remain unchanged at 2019 levels,  more than two-thirds of income is spent by households up to the 9th decile, (see Table 3).  Any additional financial burden including income taxes could further reduce the disposable income of households up to the 9th income decile. Hence, information on household income and expenditure patterns must be considered when setting income tax thresholds.

Table 3 :  Mean Household Expenditure as a % of Mean Household Income

Source : HIES Survey Annual Report 2019 (7)

Although the current tax system applies differential tax rates based on income brackets, an analysis of the effective tax rates paid within these brackets indicates a less than progressive tax system.  An individual crossing the tax free threshold of Rs.1.2 million per annum (equivalent to a monthly income of Rs. 100,000) pays an effectives tax rate of 1%, which gradually increases to 12% until the highest income bracket is reached at over Rs. 3.7 million (which is equivalent to a monthly income of Rs. 308,333). All the income levels above this income would be taxed at the highest nominal marginal rate of 36%.  However, after a particular income level the effective tax rate flattens (see Table 4). This implies that individuals in the highest income categories effectively pay less taxes. Expanding the income tax brackets would introduce more fairness and progressivity into the tax system.

Table 4 :  Effective Rate of Tax

Source :  Author’s Calculation

Figure 3: Personal Income Tax as a percentage of Annual Income

Source : Authors’ Calculation

The fairness of the tax system is further exacerbated as those whose main income sources are subject to capital gains are taxed at only 10% versus those whose income are subject to PIT who are taxed at a higher rate of 36%. 

As wages and salaries rise to keep up with inflation, individuals may find themselves earning more in nominal terms, but their purchasing power remains relatively unchanged.  Adjusting thresholds for inflation ensures that employees are not disproportionately burdened by bracket creep where taxpayers are pushed into higher brackets due to inflation. A proper rationale and scientific basis for determining thresholds, tax slabs, and tax rates is needed to increase revenue collection and ensure fairness in the tax system.Also, the proposed tax system should generate the estimated tax revenue by the end of the year.

Frequent ad hoc policy changes

Tax policy is frequently subjected to change, without proper economic rationale. For instance, the tax slabs for PIT have been revised 9 times while the tax free threshold was revised 5 times since 2000. Frequent and ad hoc policy changes complicate tax administration and reduce tax compliance.

Conclusion

The country has failed to meet  the first quarter targets for revenue under the IMF’s Extended Fund Facility Program. Raising government revenue will be critical to remaining within the program. Improving revenue collection from income taxes will be critical to achieving the revenue targets, while broadening the tax base will ensure the burden of taxation falls on the broadest shoulders.

Part one of the OPED series on Reforming Sri Lanka's Tax System: A Path to Macroeconomic Stability and Sustainable Economic Growth can be found here

Sri Lanka needs a bottom-up approach

Originally appeared on The Morning

By Dhananath Fernando

Regrettably, over the years, Sri Lanka's approach to development has primarily relied on aid and subsidies for its impoverished population. Many politicians have spoken about poverty, but they have often neglected to address its root causes. If our policies were centered on eradicating poverty rather than simply targeting the poor, our development framework could have evolved significantly.

As the adage goes, "there are no poor people, only poor places or countries." A recent report by LirneAsia revealed a startling increase in poverty numbers, rising from 3 million to 7 million people, pushing over 4 million individuals below the poverty line. If our long-standing strategies, such as fertilizer subsidies, Samurdhi, and fuel subsidies were on the right track, how did an economic crisis suddenly plunge 4 million Sri Lankans into poverty?

The ability to maintain strong international relationships and secure more aid has been considered a crucial qualification for candidates, during election cycles. Within the voting community, politicians offering the most substantial subsidy handouts are often perceived as popular leaders. While it is true that we need comprehensive international relationships in modern politics and must take care of our citizens, we must do so while keeping a development-oriented mindset at the core. Regrettably, development cannot rely solely on foreign aid, nor can we lift people out of poverty by offering aid exclusively to the poor.

This situation is not unique to Sri Lanka; it's a global phenomenon. No country has achieved development solely through aid programs. Instead, countries that have reached the development stage share strong institutions and reasonably functioning market systems as common denominators.

The primary focus of any government or political leader should revolve around two key conceptual frameworks:

1. Are we establishing institutions that promote a level playing field?

2. Are we encouraging a functioning market system?

Development is generally a bottom-up approach. People often know what's best for themselves better than politicians or leaders do. We simply need to provide them with opportunities in a competitive environment. Recently, I had the privilege of meeting a few small and medium-sized exporters. The entire system and processes seemed designed to hinder their export activities. Many exporters emphasized the difficulties they face when exporting in Sri Lanka, including challenges and harassment from government regulatory authorities, such as Sri Lanka Customs.

A prime example of our low export numbers is not only market access problems but the barriers within our own system that obstruct exports. One exporter from Kandy, specializing in vanilla exports, highlighted how customs consistently questioned HS codes and demanded repetitive documentation, causing him to spend more time on export processes than on developing his product and capacity. These challenges are consistent across the board for exporters, explaining why Sri Lanka's exports remain stagnant despite numerous committees, task forces, and chairpersons at the Export Development Boards.

Real change should start from the bottom by removing barriers for businesses and offering people the freedom to pursue their desired endeavors. Such reforms may not bring personal glory, as they empower individuals to make their own choices. In contrast, an aid-driven approach often results in leaders or countries seeking personal recognition through associated aid packages.

In Sri Lanka's case, we must remind ourselves that only we can make a difference and pull ourselves out of this crisis. While we need the support of international institutions like the International Monetary Fund and bilateral and multilateral creditors, they alone cannot rescue us from our predicament. It is only through economic reforms and the development of inclusive institutions that we can compete on a level playing field and extricate ourselves from this mess. Both small and large reforms are essential, and we must implement them swiftly and effectively.

SL’s tariff regime

Originally appeared on The Morning

By Dhananath Fernando

The Minister of Finance mentioned that “many surprises” would be contained in the Annual Budget for 2024. In economics, surprises are something we would want to avoid; the more surprises we get, the lower stability is. Frequent surprises are a sure way to push away investors and the business community. One surprise measure mentioned recently in Parliament was a tax on primary dealers in the bond markets as they were left out in the Domestic Debt Restructuring (DDR) process.

Just a few weeks ago, this column speculated about the likelihood of selective taxes, such as super gains tax or wealth tax, in the Annual Budget for 2024. If the reason to impose a special tax on primary dealers is the high profits they made as a result of being left out of the restructuring process, does this mean the Government is admitting it made a mistake by leaving them out of the debt restructuring processes? If so, we cannot correct it by imposing a tax, since two wrongs do not make a right.

A special tax on selected groups or industries is the opposite of tax holidays. The way we select industries or business categories for special taxes is the same way we select industries for tax holidays. Both are two sides of the same coin.

It is true that Government revenue is low compared to the size of our economy, but it is definitely not the fault of the businesses which made profits, unless their profits are exempted from taxes.

Sri Lanka’s corporate tax of 30% is a reasonably high rate. Even the UK increased its corporate tax to 25% in 2023 from 19%. Tax competitiveness is already low due to unreasonably high taxes and an unstable economic and political environment. Therefore, what is the rationale for charging a higher tax on a selected industry or a group if they already pay a corporate tax of 30%?

The unfortunate reality is that we cannot increase tax revenue simply by imposing selected taxes or by spontaneously increasing rates. This would bring the same consequences as our tariff structure.

The issue with the tariff structure in Sri Lanka is that we have imposed different taxes for different HS codes, making it very complicated. Some HS codes are charged a CESS and others are charged para-tariffs, creating considerable doubt as to which taxes are applicable when importing anything. This complexity in the tariff structure has resulted in a high level of corruption.

It is argued that bringing the tariff rates down and making it simple will improve tariff revenue. The same logic is applied for income tax and corporate taxes. The more complicated and more targeted special segments are, the more likely tax evasion is, and will eventually lead to our overall tax revenue further deteriorating.

In 2015 and 2021, a similar attempt was made to impose a singular super gains tax on companies earning over Rs. 2 billion. There were many instances where special taxes were imposed on the financial sector without any detailed analysis or impact analysis on overall tax principles.

Has it made our tax revenue better? The answer is an obvious no. Therefore, special taxes which may come as surprises for selected industries may not lead to the expected outcome. Instead, they will create more confusion in the market.

It is likely that the Government is targeting primary dealers due to the controversy that arose during the bond scam in 2015 and similar incidents, with suspicions of insider trading taking place afterwards.

If the reason for super profits is insider trading, the answer is a forensic audit and bringing the related parties to justice. The Government can start the process by releasing the full forensic audit report on the investigation of the presidential commission appointed for the bond scam.

Imposing a special tax to correct the super profits of insider trading may start a vicious cycle of unethical trading and business operations.

Investors will consider the occurrence of a similar circumstance if they make better profits – that they too will be liable for a special tax in addition to the corporate tax they pay.

More importantly, it dilutes the principles of an aspirational society. Assuming that someone should pay a higher tax simply because they made a profit is discriminatory and acts as a disincentive for generating wealth and profit. Those who made a higher profit are already paying a higher tax proportionately, compared to those who made less profit, at a rate of 30%.

Taxes have to be imposed based on principles of simplicity, transparency, neutrality, and stability. These are referred to as ‘principles’ because there is a rationale behind it. Statistics without principles and principles without statistics are both dangerous.

Reforming Sri Lanka's Tax System: A Path to Macroeconomic Stability and Sustainable Economic Growth

Originally appeared on The Morning

By Dr Roshan Perera, Thashikala Mendis, Janani Wanigaratne

This article provides an overview of the current tax system in Sri Lanka as part of a series discussing potential tax reforms.

Sri Lanka is recovering from the worst economic crisis in its history. Continuous high fiscal deficits due to insufficient government revenue to finance growing government expenditure has resulted in an unsustainable level of debt. This has hindered the government's ability to make capital investments and allocate sufficient funds for essential services such as education and healthcare. A large proportion of revenue (77.7% in 2022) goes to finance interest payments, It is also one of the largest items of recurrent expenditure accounting for 44.5% of recurrent expenditure in 2022.  In comparison expenditure on education, health and social protection (Samurdhi) accounted for only 9.3%, 7.9% and 3.4% of recurrent expenditure, respectively, in 2022.  

Getting back on a path of macroeconomic stability requires a significant boost in revenue.Revenue based fiscal consolidation is one of the key pillars of the stabilization program agreed with the International Monetary Fund (IMF).  The program sets a target of raising tax revenue to 14% of GDP (at the minimum) by 2026 through tax policy reforms and revenue administration reforms.

Taxation as a social contract

The main purpose of taxes is to provide funding for public services. Moreover, it redistributes income through transfer payments to low income households. Taxation is a classic example of the social contract between the citizens of a country and their government but also between citizens. This unwritten agreement influences the willingness of citizens to pay taxes in return for the services they receive from the government. Tax compliance rates in countries indicate a correlation between the payment of taxes and public service delivery. Dissatisfaction with public service delivery is found to be associated with low tax compliance. In Sri Lanka, the state is responsible for providing a wide range of public services such as education and healthcare.  However, the collection of taxes required to finance these public services is woefully inadequate. This could be due to lack of awareness of the role of citizens in the social contract or a lack of quality and availability of public services.  This leads to citizens abandoning public services in favour of the private provision of such services and being unwilling to pay for public services they  feel they don’t use. A robust tax system is necessary for a government to deliver high-quality public services to all its citizens.

The current state of taxes in Sri Lanka

Sri Lanka’s tax revenue collection  has steadily declined from 19% of Gross Domestic Product (GDP) in 1990 to 7.3% in 2022. Although national income has increased over time with  GDP per capita rising from US $ 472 in 1990 to US $ 3,474 in 2022 there has not been a corresponding rise in tax collection (See figure 1).

Figure 1: Declining Tax to GDP

Source : Central Bank Annual Reports

Revenue collection in the country is also highly skewed, with 69.5% of tax revenue collected from indirect taxes. Undue reliance on indirect taxes is due to the large informal sector which is ‘difficult to tax’.  The direct to indirect tax ratio has consistently remained around 20:80 over time. Although direct taxes as a proportion of total tax has gradually increased from around 15% revenue in 2000 to 31.5% in 2022, as a percentage of GDP it has remained at a low level of around 2% for the last two decades, implying that it has not kept pace with the growth in the economy.

Figure 2: Composition of tax revenue

Source : Central Bank Annual Reports

The steady decline in revenue is due to inherent weaknesses in the tax system. One of the key issues is ad hoc policy changes relating to tax rates, thresholds, and exemptions, with little or no economic rationale. The frequency of these tax policy changes worsens the existing compliance issues as well as administrative issues. The resulting loss of government revenue, worsens income inequalities and reduces funds available for essential public services.

These concerns need to be addressed through comprehensive reforms in all 3 broad bases of tax, namely, (1) taxes on earnings such as personal and corporate income taxes; (2) taxes on what is purchased such as the value added taxes (VAT); and (3) taxes on what is owned such as land and property taxes. Identifying the issues in each of these taxes will be key to reforming the tax system and optimizing revenue collection which is vital for ensuring macroeconomic stability.

Conclusion

Building an effective fiscal social contract through taxation is as equally important as addressing the issues prevalent in the current tax system. It requires the government  to use the taxpayers’ money in a responsible and effective manner. Lack of transparency and accountability for the way a government uses the taxes it collects will make it very difficult for the government to convince its citizens to pay their taxes.  On the other hand, citizens are responsible for holding the government accountable and ensuring taxes are utilised for providing good quality public services for the benefit of society as a whole.

Bank interest rates: The A-Z

Originally appeared on The Morning

By Dhananath Fernando

As the Annual Budget approaches in November, there lies the risk of introducing price controls again. Budgets are usually like auctions of resources that don’t actually exist, often used by governments for publicity. In the 2015 Budget, there was a salary increase for Government workers and price controls were placed on items like hoppers and plain tea.

Budgets that come around election periods more often include giveaways and price controls, which cannot be maintained sustainably.

Meanwhile, the Central Bank, in a recent Monetary Policy meeting, hinted at controlling interest rates for certain banking services like pawning, credit cards, and pre-arranged temporary overdrafts.

The Central Bank appears to be in a tough spot, facing pressure from political authorities, the people, and other stakeholders. People and businesses are still struggling with the economic crisis, the aftermath of the Easter attacks, and the after-effects of Covid-19. People need loans (credit facilities and services) during this tough time. Unfortunately, the banking sector is slow to respond by lowering interest rates, even with the Central Bank’s new policies.

Recently, the Central Bank has been lowering interest rates – the Standard Lending Facility Rate and the Standard Deposit Facility Rate. The Statutory Reserve Ratio (SRR) has also been brought down by 2% and changes have been made, but this hasn’t led to a proportional decrease in lending rates by banks.

Unique situations for different banks

Some banks have responded more than others. For example, some banks charge higher interest rates for pawning (27% compared to 20% in other banks) and credit cards (33% compared to 28% in other banks). The same goes for personal loans (4% vs. 2%).

Let’s try to understand why some banks offer higher rates while others don’t.

Each bank’s lending and deposit portfolio is unique. Some banks generally have a higher percentage of Non-Performing Loans (NPLs). For them, bringing interest rates drastically down may be difficult. Since interest income is the key income for banks, if a particular bank has a higher NPL ratio, it would be difficult to adjust the interest rates.

On the other hand, with domestic debt restructuring, certain banks had higher exposure to Treasury bonds. Prior to debt restructuring, these banks faced higher risk, yet as they have been excluded from restructuring, this same exposure became a blessing later. For them there is greater room to adjust the interest rates while others may not have the same leeway.

Different banks have different types of loans. Some focus on small businesses, while others offer pawning. Pawning is safer because there is something valuable as collateral. Each bank’s situation is unique, and ideally in a market system people should switch to banks with lower rates, assuming everyone has the same information.

Options with consequences

However, these changes take time, especially when the country’s monetary system isn’t stable due to debt restructuring and weak economic policy. Also, due to instability, in most cases banks aren’t offering fixed interest rate loans anymore; most loans have flexible rates.

Mounting pressure on the Central Bank has left a few options, each with its own consequences. One option is offering special low-interest credit lines (e.g.: special credit lines with the support of the Asian Development Bank, etc.), like the Enterprise Sri Lanka loan scheme introduced before by former Finance Minister Mangala Samaraweera. This could lead to unintended consequences, like people using the loans for non-productive purposes.

For instance, many bank managers disbursed the loans to their existing customers, who basically settled their previous high-interest loans with the new loan at a concessional rate. Some loans were taken for consumption purposes, such as weddings and buying vehicles. There were reports that existing companies, including large companies, set up new entities just to obtain a loan to cover their previous debts. However, this is a solution that can be tested with the least impact within a strict monetary system, but unintended consequences should be expected.

Another option is the Central Bank artificially lowering rates by printing more money. This could worsen the economic situation, causing problems for the exchange rate and later on for inflation and the entire financial system.

Alternatively, the Central Bank could use its influence for the funds it manages (e.g.: Employees’ Provident Fund) and buy Government bonds at lower rates, attempting to push rates down. This also has downsides and is not advisable.

No simple solutions

When a country’s monetary system isn’t stable, these complex situations arise. This column has warned, time and time again, against the monetary instability caused by money printing that led to these situations.

Setting a cap on interest rates is like controlling prices, which isn’t a good idea. It could set a bad precedent and cause further problems. On the previous occasion the Central Bank controlled the exchange rate and forex repatriation, the Balance of Payments (BoP) crisis got worse. Though interest rate caps may have good intentions, the fallout could be tricky. In response, banks with portfolios that don’t support lower rates may reduce their lending, affecting people who need loans.

People who have credit needs may have to settle for further high interest options, making their situation worse on one side. More fake microfinance solutions with very high interest rates may emerge and people will have to depend on informal financial borrowing if the banks impose more restrictions on pawning and selected operations.

Social costs can be seen as there were multiple incidents of conflict in recovering debt and in extreme cases, even the loss of life. The experience over years has been for the Government to provide debt cancellation and relief for people by taking responsibility for the debt when people suffer from bad loans.

Unfortunately, there is no simple solution. The best approach is understanding the issue and its consequences before taking action.

Sri Lanka’s talent drain: From dreams to departures

Originally appeared on The Morning

By Dhananath Fernando

Every day, news stories emerge about skilled labour from Sri Lanka migrating out of the country. It’s not only doctors, engineers, bankers, and teachers who are leaving, but also individuals with institutional knowledge from small and medium enterprises.

This outflow of talent is undeniably going to adversely affect businesses next year. Many attribute this migration to the economic crisis, and often, the debate revolves around the ethical aspect of people leaving after benefiting from investments in education and healthcare funded by taxpayers.

The crisis we currently face is multidimensional. We are dealing with a Balance of Payments crisis, debt crisis, currency crisis, economic governance crisis, and a humanitarian crisis. Amidst all these crises, the issue of why people are leaving the country is primarily a crisis of an economy unable to accommodate its citizens’ dreams and aspirations.

Unfortunately, the dreams of many Sri Lankans, especially those with high-reaching aspirations, have consistently been at the receiving end of various Government policies over the years, even before the economic crisis truly struck. The economic crisis was merely the final blow that compelled people to make the decision to finally leave.

If you recall, many political campaigns targeted youth and professionals with visuals of young people buying vehicles, enjoying family life, having access to better schools, and other attributes of a middle-income lifestyle. In fact, during the Yahapalana Government, the then Finance Minister Mangala Samaraweera understood the needs of the youth and introduced special loan schemes aimed at them under his flagship project ‘Enterprise Sri Lanka’.

High tariff rates

However, our policies over the years have largely stifled the aspirations of an aspirational society. If you take a stroll in urban areas, it becomes apparent that there are many unfinished houses. Often, you can see rusting steel bars protruding from concrete beams and the primary use of the slabs seems to be for drying clothes.

Many people are unaware that the dream of owning a decent house in Sri Lanka has been hindered by very high tariff rates on steel, tiles, bathware, and practically all construction material. People’s right to access reasonably-priced construction materials has been obstructed, resulting in our construction costs being higher than other countries in the region.

Additionally, people pay interest rates of 14-18% on their housing loans due to the extra 40% cost they incur. Consequently, the funds people could have invested into building their second floor have already been spent on the ground floor. This situation affects masons, carpenters, architects, designers, and the entire supply chain, crushing their dreams as well.

Further, certain products imported to the country incur effective tariff rates of over 100%. Sadly, the Government doesn’t even generate significant revenue from these high tariffs, as they are so exorbitant that importing at an effective tariff of over 100% makes no sense. This form of corruption is hidden, as certain individuals benefit from maintaining high tariffs for personal gain, while consumers suffer. The significant reason for professionals considering migration, despite the hardships, is the crisis of shattered aspirations, which the Aragalaya represented.

This type of corruption is challenging to capture, but in people’s minds, the notion that a few people are stealing their dreams holds true when they understand how tariff rates have diminished their quality of life.

Subpar transport system

Another major factor affecting people’s lives is transportation. Our public transport service is abysmal due to a lack of market openness and market restrictions through a permit system. State-owned train services are not only unprofitable but also fall far below average service levels. Thus, for the middle class, the logical choice is to purchase a personal vehicle.

However, personal vehicles are also subject to tariffs of over 100%. Remarkably, the Sri Lankan Government earns a greater profit margin than the automobile manufacturers themselves by imposing tariffs exceeding 100% of the vehicle’s value. Essentially, this means buyers are paying a value of more than double the price of the vehicle.

The extra cost is often funded by borrowing through vehicle leases, incurring interest rates of over 14% on top of everything else. Further, they pay an additional Rs. 50-70 for every litre of fuel, and the cycle continues with spare parts, revenue licences, etc.

For professionals, their aspirations are once again ignored, making it unsurprising that people consider migrating. The Government’s solution to the vehicle issue over the years has been a vehicle permit system which has exacerbated the problem rather than solving it.

Crisis of unrealised dreams

In summary, the migration of people represents a crisis of unrealised dreams, with the economic crisis serving as a significant trigger.

The solution lies in allowing the private sector to recruit skilled individuals from other markets and establishing a scheme that permits skill migration into Sri Lanka. This approach would help fill vacancies, promote knowledge transfer, and stabilise the business environment.

If Sri Lankans can migrate overseas and compete in Toronto, New York, London, Dubai, and Stockholm, they can undoubtedly compete with anyone else in Sri Lanka. Knowledge transfer would be enhanced and salaries would increase over time, even for local staff.

Given that we have already shattered people’s dreams, we shouldn’t obstruct the remaining dreams of those considering staying in Sri Lanka. The best way to retain them is by ensuring the sustainability of the remaining business ecosystem. But to ensure the ability to realise the dreams of an aspirational society, the cause of the problem must be fixed at the root.

A facelift for the railway

Originally appeared on The Morning

By Dhananath Fernando

I am a frequent train traveller, whether it’s a short or long distance journey. Often, I book railway tickets from Colombo to Anuradhapura, especially for my mother when she goes to attend religious observances. Many years ago, the process of booking train tickets used to be quite complicated, requiring a visit to the station. However, things have changed over the years. Nowadays, we have the option of booking train tickets online or through our mobile phones.

I usually make the booking by calling my mobile service provider and providing the National Identity Card (NIC) details of the passenger. The fare is then directly charged to my mobile phone. If I am booking for multiple passengers, I need to provide the NIC numbers for all of them. While this method is convenient in some ways, I did have a few concerns.

Despite booking the ticket over the phone, the passenger still needs to physically collect the ticket from a designated counter by presenting their NIC. This seems to defeat the purpose of online/phone booking, as the passenger ultimately has to go and get a physical ticket. The only advantage is that I can ensure that a seat is available before all seats are taken.

Another concern is that online/phone ticket booking opens just two weeks before the departure date. This means that if my mother is travelling on a Sunday and returning on a Tuesday, I need to call on a Saturday two weeks prior for the departure ticket and then again the following Monday for the return ticket. If I wait until Monday to book both tickets, there is a high chance that the Sunday train tickets may be sold out.

Recently, I had the chance to speak with a senior officer from Sri Lanka Railways, who shed light on some of these concerns and suggested ways the railway sector could be transformed. The officer explained that passengers were required to collect tickets in person because the railway ticket inspectors lacked QR-code scanners as well as funding for this investment. Essentially, the requirement to collect the tickets physically stems from the inability to verify the authenticity of online tickets. However, mobile phones could easily scan QR codes, similar to what is done at fuel stations in Sri Lanka.

The limitation of ticket schedules opening only two weeks before departure aims to prevent early bookings that may lead to ticket resales at higher prices, which can disadvantage regular travellers. However, in my view, no business can ask for a better deal than the payment of a service months before even providing it. A ticket shortage also indicates an incapacity to supply services for certain routes on the rail routes that have excess demand.

Another concern I had was why we could not rent out prime railway properties, such as the land owned by Sri Lanka Railways, for development. Regarding this, the officer pointed out that according to the Sri Lanka Railways Authority Act, properties under the railway could only be rented for five years, discouraging larger investments.

This highlights the need for ‘property rights’ to attract investors and promote property development. A key pillar of a market system is ‘property rights’ and most railway stations situated in prime locations are poorly maintained due to a lack of investment. Offering long-term leases to investors could provide funds for essential improvements, including implementing QR code readers for ticket checking.

Developing Sri Lanka’s railway system is not just about receiving train compartments from other countries. Nor is it about having QR codes or simply developing railway stations. We must address pricing incentives for road and train travel while maintaining the benefits for passengers at the core. A customer-centred approach and the right investments are crucial for meeting their expectations. That is why when markets are allowed to develop with space for specialisation, it solves people’s problems.

A master strategy for railway development should aim to fulfil people’s commuting needs. Economics plays a role at both micro and macro levels, emphasising the need to get the economics right for meaningful progress in our railway system.

Fixing policy failures in trade and tariff

Originally appeared on The Morning

By Dhananath Fernando

In Sri Lanka, we have often faced the consequences of two types of failures – ones of those who acted without proper thought and ones of those who had great ideas but never put them into action. This holds true for many of the policies we have implemented, especially when it comes to trade and tariff structures.

Recently, there was a parliamentary discussion on wheat flour prices. While global flour prices have decreased, Sri Lanka’s wheat prices have remained high. Common sense tells us that if prices are not adjusting accordingly, there must be some market intervention or manipulation. We need to return to first principles to better understand this.

The price of any resource represents its scarcity value. Increasing prices indicate a higher scarcity value, while decreasing prices suggest declining scarcity. Wheat flour prices in Sri Lanka have been wielded as a political tool over the years, making them a matter of great significance, particularly for vulnerable communities, such as those in the estate sector. As wheat flour serves as a primary carbohydrate source for many due to income limitations, its price carries immense importance.

In the past, the Government managed wheat flour distribution at heavily subsidised rates, similar to the situation with petroleum products, due to its political value. During the time of President J.R. Jayewardene, wheat flour was imported under the PL 480 agreement and many subsidies were granted under this programme. When Chandrika Bandaranaike Kumaratunga assumed power, she promised to provide a loaf of bread for Rs. 3.50, highlighting the significant political importance attached to the pricing of wheat flour.

Later, a monopoly licence was granted to one company to convert wheat grains into flour. This would have been acceptable if, simultaneously, wheat flour imports were also permitted. However, the Government imposed high tariffs on wheat flour imports while keeping tariffs for wheat grains significantly lower.

This created a lopsided tariff structure that discouraged wheat flour imports, favouring the two companies already engaged in wheat grain to flour conversion. According to the numbers quoted in Parliament, the import tariff for wheat grains is Rs. 3 and the import tariff for wheat flour is about Rs. 35. With this tariff structure, wheat flour importers cannot compete in the market as the tariff rate on flour is about 10 times higher than the tariff on wheat grains.

Additionally, the Government’s practice of issuing licences to selected wheat flour importers has often led to corruption. This combination of higher tariffs, licences, and limited competition has resulted in an advantageous situation for the two domestic companies currently operating in the market, but it has hindered fair market dynamics.

Similar issues exist in the fuel importation process. The tariff on crude oil is lower than that on refined fuel. The crude oil refinery in Sri Lanka, donated by Iran long ago, operates with low efficiency, giving an advantage to inefficient fuel refining processes. This inefficiency in the refining process can impact fuel prices, potentially leading to higher costs for consumers.

In Parliament, the proposed solutions appeared more disastrous than the problem itself. One suggestion involved imposing a special tax on specific companies. However, targeting individual companies with such taxes would be viewed unfavourably by investors. Companies need to be encouraged to make profits through healthy competition and efficiency, rather than through tariff protection and government policies that create problems for all in the long run.

An ideal solution would involve a uniform tariff rate and only a few tariff slabs for all imports, thereby eliminating room for tariff manipulation. Such a system would also minimise corruption at Customs and other government authorities, as importers would find it more economical to pay the standard tariff rates than to resort to corrupt practices.

Let us remember the wisdom of John Charles Salak: “Failures are divided into two classes: those who thought and never did, and those who did and never thought.” We must strive for well-thought-out policies and meaningful actions to foster a fair and prosperous Sri Lanka for all.

Addressing the land problem

Originally appeared on The Morning

By Dhananath Fernando

Decades ago, when tasked with writing an essay about my country, I emphasised its vast potential for production, ranging from agriculture to technology. Since then, Sri Lanka’s need to produce and export goods has been incessantly highlighted in panel discussions, TV debates, and interviews.

However, the real challenge lies not in recognising this need but in understanding why we remain lethargic when it comes to production. While the blame often falls on corrupt politicians and misused public funds, the economic reasons behind our sluggishness go deeper.

In our Grade 9 lessons, we were introduced to the main factors of production: land, labour, capital, and entrepreneurship. Have we ever considered the current status of these factors in Sri Lanka, which are essential for fostering production?

Let’s begin with land. Whether local or foreign, any investor will attest to the difficulty of securing a plot of land for production. Around 95% of the Board of Investment (BOI) zones in the Western Province are already occupied and the BOI has struggled to establish new zones for the past 15 years.

Initiating any production venture typically requires an average of 16 approvals, paving the way for corruption. Investors seek land that is ready for swift set-up and operation, as delays translate to significant costs. They need land equipped with electricity, water, telecom, waste management, and other essential services to minimise the time between investment and production.

Image Credit: JB Securities

Regrettably, the absence of available land turns our aspirations for a production-based economy into mere talk, without any tangible action. Approximately 82% of the land in Sri Lanka is State-owned, encompassing forest reserves and sanctuaries, while only 18% remains in private hands. Resolving land issues is a cumbersome process due to physical documentations that are prone to tearing and misplacement.

Poor utilisation of land by SOEs

State-Owned Enterprises (SOEs) occupy most of our land, and their utilisation has been rather poor. For instance, Sri Lanka Railways monopolises a stretch of land without exploring additional opportunities like real estate development. The Marine Drive land stretch, which offers beautiful sunset views, remains underutilised, discouraging tourists from visiting after 7.30 p.m. due to inadequate street lighting and lack of economic activity.

Private ownership of the railway could have not only transformed that stretch, but also attracted more tourists. SOEs are reluctant to relinquish land, leaving it to the discretion of the respective minister. While occasional rentals or long-term leases may occur, the full potential of the land cannot be unlocked without ownership.

In the present set-up, banks won’t grant loans without land titles and investors won’t risk their entire capital without a proper land base to support their technological advancements. Small-scale, scattered lands are available, but large-scale productions require sizeable plots with appropriate infrastructure. Unfortunately, the Government is losing substantial revenue in taxes and rents due to the underutilisation of land.

Addressing the land problem is imperative for attracting investments and Foreign Direct Investments (FDIs), as highlighted in the Harvard CID team study on Sri Lanka. In the global competition for investors, the land issue remains a key concern for potential stakeholders, as indicated by the World Bank Enterprise Survey.

Image Credit: JB Securities

Solutions

A potential short-term solution involves the Government acquiring land from SOEs that have development potential, converting them into BOI zones, and opening private industrial parks. Private companies can then develop industrial zones and present diverse value propositions to attract investors.

This arrangement would enable the Government to earn revenue through taxes and leasing fees while ensuring efficient land usage. Nonetheless, this is a temporary fix, and we must remain focused on real, long-term solutions.

Looking ahead, the establishment of a digital land registry with accessible and searchable documentation would streamline transactions and promote transparency. Although this vision may appear distant, it should not deter us from pursuing lasting solutions for Sri Lanka’s economic growth.

Rough seas make good sailors: Embracing competition in trade

Originally appeared on The Morning

By Dhananath Fernando

When I first started my career, my boss shared two valuable pieces of advice with me. “There are only two ways to secure a promotion,” he said. “First, you can develop your subordinates to replace you, allowing you to move up the career ladder. Second, you can help your boss get a promotion, positioning yourself to take their place.” 

The essence of his advice was that the key to advancing in one’s career lay in competitiveness. By being competitive, we not only benefit ourselves but also contribute to the entire ecosystem. This principle forms the basis of global trade. Unfortunately, for a long time, Sri Lankans have had a different perspective. We believed that imposing higher tariffs or even banning certain imports would make us competitive. This notion is akin to arguing against hiring smarter individuals to make existing employees more competitive.

For a considerable period, Sri Lankans have embraced this flawed argument at a national level without understanding its fundamental flaw. Many Government policy documents emphasise making local industries competitive through import controls, even using terms like ‘import substitution’.

If this argument were true, why were there no industries developed during the time when most imports remained banned? Even after the recent lifting of some import restrictions, a significant number of imports, including vehicles, still remain on the restricted list. In 2020, imports such as vehicles and turmeric were banned. 

After three years, have we witnessed any local industries becoming globally competitive and gaining market share? By restricting imports of tyres and vehicles, we did not witness the establishment of vehicle or tyre manufacturing for export markets in Sri Lanka. Instead, those who were already competitive in the global market for tyres and rubber continued to thrive, while some competitive players became uncompetitive due to import controls.

There is no formula for becoming competitive by avoiding competition. Just as the saying goes, “rough seas make good sailors”; it is competition that makes any local industry globally competitive.

Another common misconception in Sri Lanka is the belief that we are already an open economy. The truth is that we have become a more closed economy compared to the 1990s and possibly even more closed than in the 1970s. Our imports and exports are constantly declining in relation to our GDP. Instead of becoming a trading hub, we have isolated ourselves over the years, distancing from global economic integration.

Yet another popular argument gaining traction is the need to develop more industries to boost exports. Occasionally, this argument is used to advocate for import restrictions, suggesting that industries can be developed without external competition. In Sri Lanka, the main obstacle to industrial development lies in concerns related to the main factors of production: land, labour, and capital.

Most land slots in the Board of Investment (BOI) zones are already occupied, making it nearly impossible for new investors to secure a plot of land with access to electricity, water, and waste management. Land and property rights are fundamental for unlocking capital. Banks are hesitant to extend credit facilities without land as collateral. Such distortions in factor markets are the reasons behind the poor industrialisation we currently observe.

A commonly cited example for industrialisation is Vietnam, with some falsely claiming that Vietnam became an export hub by avoiding competition. The truth is quite the opposite. If we compare the Free Trade Agreements (FTAs) signed by Vietnam, Sri Lanka, and Thailand, Vietnam has actively embraced Foreign Direct Investment (FDI) and competition, allowing the private sector to drive export development. It was not achieved through a State-led policy of developing industries; rather, industries flourished as a result of market forces.

Competition is the driving force behind trade growth. There is no formula for improving trade by moving away from competition. Just as rough seas make good sailors, it is through competition that our trade can truly thrive.

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.

Competition: The way forward

Originally appeared on The Morning

By Dhananath Fernando

The recent conversation on taxi services at the Bandaranaike International Airport brought back memories of one of the times I travelled overseas as a youth. The Colombo-Katunayake Highway construction was not yet completed and I had just finished university.

I did not have the means to hire a vehicle to travel from Moratuwa to Katunayake in order to catch a flight, nor did Sri Lanka have the infrastructure or many affordable choices for a poor boy like me to reach the airport quickly at a reasonable cost. There was no PickMe nor Uber, and neither did I have a smartphone.

I left home early with my borrowed luggage from a friend and came to the Moratuwa Railway Station. I took the train from there to Pettah. From Pettah, I took an air-conditioned bus, paying extra to keep my luggage in the front of the bus and took a tuk from the bus depot to the airport departure terminal. I think the time I took to travel from home to the airport was just about 30 minutes less than the travel time of my flight.

All that I went through was due to unaffordability as well as the unavailability of affordable choices to travel. If there had been proper modes of public transport available connecting trains and airports, the lives of people like me, who could not afford a taxi to the airport, could have been easier. In the context of the availability of choices, we have to evaluate whether to allow mobile app-based and registered taxi services at the airport.

It is obvious why registered taxi services at the airport charge a higher rate. Their reasons to charge a higher rate include the cost to operate at the airport by paying rent for their operating offices and keeping an adequate fleet of vehicles. Further, their cost also includes licence fees and bribes that they have to pay to obtain the licence to operate at the airport.

However, their business model has been challenged by a more technologically-advanced operation where customers can choose the type of vehicle they want and are given the ability to check the rate for the journey prior to booking the taxi. This offers many more options including safety measures, such as the ability to contact the driver after the ride in case something is left behind after long hours of travel time.

While the operation of registered taxi services is perfectly reasonable, preventing someone else with an alternative solution from entering the market will make the lives of people more difficult. In a competitive world, competition should be encouraged.

The solutions suggested by our policymakers are absurd. Certain policymakers have wished to prevent the operation of mobile app-based taxi services at the airport. Others have suggested that the airport registered taxis should also register with mobile app-based taxi services. While the second option is somewhat reasonable, a business model being rendered uncompetitive due to the development of technology is not a problem for policymakers in the first place. Imagine bullock cart owners claiming that they are being impacted by engine-driven vehicles?

Simply, this is the evolution of the world and we have to adapt or we will lose in the market. Unfortunately, airport-based taxi services are becoming uncompetitive and more importantly, customers do not see any value in their services. If a customer sees the comparative value of one service being better than the other, they should be given the opportunity to make a choice based on the available options. This service should be valid even for customers whose hotel travel is coordinated directly.

Once we look beyond this and decide to connect our airport to multimodal transportation systems (such as connecting railways and highway buses to the airport), the airport-registered vehicles as well as Uber and PickMe taxis will witness an impact on the number of hires they receive.

Will policymakers delay connecting the airport to multimodal transport systems merely in order to protect our taxi services and drivers, overlooking affordable options for consumers?

In most airports around the world, the terminals are connected to some form of public transport while any type of taxi service is allowed. In fact, the infrastructure and signage enables mobile app-based taxis and other taxi services to pick up and drop off passengers at specific points. All modifications have been undertaken to make the lives of travellers easy, affordable, and safe, instead of protecting a group of politically-affiliated rent-seekers.

The manner in which our policymakers treat this issue is a good indication of how the majority’s choices have been compromised for political reasons, for the benefit of a few who are unproductive and uncompetitive.

This norm is not only seen in this particular scenario, but everywhere in our economy, including the State sector. Similar to how registered taxi drivers are objecting to mobile app-based taxi services, the Ceylon Petroleum Corporation wishes to keep other private companies out of the market. Some tile and bathroom fitting manufacturers wish for import bans on tiles and bathroom fittings, simply for their own benefit, as do aluminium manufacturers.

Things are the same in politics. They are all basically asking Sri Lankans and tourists who arrive in the country to take long journeys, wasting a lot of their precious time and call it a ‘beautiful life in the paradise island or Asia’s little miracle’.

‘So Sri Lanka’; is it actually a miracle?

Why Prices are Slow to Fall Despite Easing Interest Rates, Inflation

Originally appeared on The Morning

By Dhananath Fernando

Inflation is gradually easing to the 20% range and the Central Bank has made the decision to reduce the interest rates by 2.5%. Additionally, the Sri Lankan Rupee is appreciating. In regular news stories, the media and people often ask the question, “Why, then, are prices still high?”

How can we understand this through economics and determine what policies should be implemented to bring about maximum benefits for Sri Lankan citizens? Since everyone is a producer as well as a consumer, this affects all individuals.

Declining inflation doesn’t mean prices will drop

First, many hold the perception that inflation results in a direct increase in prices. The rate at which prices are rising, however, is what is actually known as inflation. It is the same as the acceleration of a vehicle; when we accelerate a vehicle, its speed increases. But once the vehicle is in motion, even without accelerating, it will move.

Declining inflation simply means that the speed at which prices are increasing has slowed down, but it does not mean that prices are actually decreasing. That is why inflation is considered the worst enemy of everyone, particularly the poor.

As Milton Friedman said: “Inflation is always a monetary phenomenon.” Another reason why we should not allow inflation to raise its head is because the remedial actions required to curb inflation come with their own costs and drawbacks.

To bring down inflation, interest rates must be increased. However, when interest rates increase, the economy shrinks, making the business environment more difficult to operate in. This is exactly what Sri Lanka is going through. When the business environment becomes difficult, social pressures tend to rise as well.

However, for certain essential items such as petroleum products, LP Gas, and some construction materials, prices have reduced due to currency appreciation. A common question, which is fair to raise, is how prices increase overnight when currency depreciates, but are very slow to adjust when currency appreciates.

When the media questions traders, a typical reason provided is that the stocks had been bought at a higher exchange rate, so the prices will be adjusted only with the next shipment. While there is some truth to this explanation, the absence of competition laws and a poor regulatory framework allows for price coordination and rent-seeking behaviour to also take place.

One reason for the lack of price coordination is the elimination of micro, small, and medium traders by government regulations themselves. If we recall the last few months, both the spot and forward markets were effectively not functioning due to Government regulations.

This prevented the opening of Letters of Credit (LCs) for a future date, based on the exchange rate at the time of reserving the USD. Additionally, there were regulations that stopped credit facilities for opening LCs. When banks do not provide credit facilities to open LCs, only large players who have the capacity to pay the full amount upfront are able to engage in the market.

Exchange rate appreciation and prices

This is precisely what happened in the case of sugar imports. When the forward exchange rate market was squashed, traders were unable to predict what the exchange rate would be by the time they had cleared the LCs at which point the imported sugar would have already been sold and the money collected.

Therefore, if the exchange rate depreciates significantly, the trader will incur a massive loss. While most of these regulations have now been reversed, many micro, small, and medium traders were wiped out from the market during the time these regulations were in place.

The limited players have made it easier for price coordination to occur to keep prices high even when the exchange rate strengthens. Similarly, the same circumstances were observed when price controls were imposed on poultry products. With price controls in place, layer chickens were sold out and it takes time for the market to reverse the effects. Sometimes, it is easier to just impose a quick regulation, but the recovery from that regulation can take years.

Regarding the exchange rate, until there is significant progress on debt restructuring, uncertainty remains. As a result, markets are reluctant to perform any adjustments. That is why, as a country, we need stable policies so that the business environment becomes favourable and even consumers do not have to worry about price fluctuations, as they will be adjusted in a systematic manner.

Price controls will not work

A common suggestion that is made to bring down prices is to impose price controls. People and the media are quick to jump on the decision to impose price controls, thinking it will bring the prices down.

However, it is important to understand that price controls do not necessarily lead to lower prices. Instead, they can have unintended consequences such as the emergence of black markets or complete shortages of goods.

We need to realise that the best-case scenario is to have both lower prices and sufficient availability of goods and services in the market. The second-best option would be to have goods available even at a higher price, as the non-availability of goods will cost consumers more in terms of finding alternatives for their needs. In such cases, the ultimate burden to the consumer is high due to the unavailability of goods.

That is why price controls are not a solution, as they do not effectively bring down prices and can create shortages.

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.

Economic lessons from ‘The Voice’

Originally appeared on The Morning

By Dhananath Fernando

The global reality TV platform ‘The Voice Sri Lanka’ Season 2 concluded a few weeks ago, with  Rameesh Sashinka, fondly known as ‘Ramiya,’ emerging as the winner. Ramiya comes from a very humble background in Aluthgama and works at the beach, providing services such as surfing for tourists. 

In vernacular terms and according to Ramiya, he is a ‘welle kolla’ or a beach boy, who walked away as the winner of ‘The Voice Sri Lanka’ despite getting eliminated in the knockout rounds. His journey serves as an example of how a functioning market system can lift people out of poverty even in a short period of time.

‘The Voice’ is structured around freedom of choice. In the first round called the ‘blind auditions,’ coaches have the ability to select singers by pressing a button and turning their chair. Generally, talented singers get at least three out of the four chairs to turn, but in Ramiya’s case, only coach Umariya turned around. 

In economic terms, coach Umariya provided Ramiya with market access so that he could test himself in a competitive environment. According to the rules of the competition, if multiple coaches show interest, the singer has a choice of selecting a coach based on their preference. 

A market system works on competition and having diverse choices makes the market more competitive. Market access is very important and licensing schemes that restrict market entry can hinder people such as Ramiya. 

Imagine a situation where Ramiya had to obtain a licence from the Government to prove his talent and a certificate from his Grama Niladhari to prove his skill. Ramiya would have still been in the queue trying to obtain the necessary certificates. As important as minimal regulation and market access is, a competitive regulatory framework with transparency by the organisers is a must.   

In the third round, Ramiya was eliminated. ‘The Voice’ platform has an option for eliminated contestants to make a comeback through a new coach. Coach Supun, who was the fifth coach, picked Ramiya to be a part of his team. 

In economic terms, this is called a safety net. In a competitive market system there cannot be only winners – winning and losing are two sides of the same coin. In order to have a resilient economy, society should have measures in place to support and protect those who experience setbacks. That safety net is the encouragement for them to bounce back and win. That is why our Government should have better focus on building robust social safety nets. 

It is important to recognise Ramiya’s competition strategy as well. He focused on a specific genre of music, but he was very skillful in bringing diversity within his chosen genre. The economic lesson for us is that every nation’s economy is quite different from the next and no one can excel in everything. However, within our competitive environment, we can add diversity and capitalise on our strengths. 

Ramiya, the humble man from the Aluthgama beach, competed on a global platform and brought songs by the likes of Freddie Silva and Upali Kannangara to a global stage by singing in our vernacular. The lesson is that Sri Lankans have the potential to succeed on a global platform and we should not be fearful to compete. Instead, we should embrace the competition as we are capable of winning. There is no point in hiding when we have the capability of winning as Sri Lankans.  

On the other hand, even Ramiya’s most loyal fanbase knows he is not the most talented person in the competition. What he brings is a unique messaging and entertainment to fill the market gap. From an economic and financial perspective, he offers value for money or value for the time people spend on entertainment. He brings a breath of fresh air when he performs. This is a concept that we as Sri Lankans have failed to understand. Our focus has always been on the lowest price, while overlooking value for money.

Let’s take train services as an example. As the Government was able to offer the lowest price, we decided to keep the train service under State control. However, it does not measure up when you compare it in terms of providing value for money. The railway service is plagued by poor quality and delays. It is far better to have a well-functioning train service, even at a higher price, compared to a poorly functioning one.   

In many reality TV programmes, unfortunately, winners fail to succeed in their careers later on. The reason can also be explained through economics. In economics, real wealth is not just money; it is the ability to recreate wealth, the science of making two bucks out of one. 

Songs being sung by the contestants in reality shows are mainly composed by established artists in the field. The original songs have the chemistry or the logic of recreating wealth. If a person who is selected as a winner fails to figure out the science of recreating the same entertainment value, very often they will fail. That is why lottery winners often become poorer than they were, because they do not know how to recreate wealth. 

The reality is that markets exist, whether we like it or not. Markets are not always perfect and they cannot solve all the problems in the world. However, it is the most reasonable solution we have at hand to take our people out of poverty. 

In ‘The Voice’ Season 1, the winner was Harith Wijeratne, a medical doctor. Now, the winner is a beach boy (with all due respect) from Aluthgama. When markets work, it rewards the most competitive person who maximises limited resources. Markets respect diversity (in the quarter-finals of ‘The Voice,’ Ramiya had an intro rap for the song he sang). 

This is another great economic fable from the Sri Lankan community and Ramiya is the one who is presenting it to reality. 

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.

On the 75th Independence, time to re-plug to the world economy

Originally appeared on the Daily FT

By Anuka Rathnayake & Thilini Banadara

As Sri Lanka is inaugurating its political independence of 75 years on 4 February, the burning issue the public is struggling to grapple with, in the recent past, is the worst economic slump. Many factors have contributed to the current economic crisis but protectionism and trade barriers are main elements that have further depleted the economy, shaping it as uncompetitive and inward-looking.

Even though Sri Lanka was known as a fairly open economy, the dynamics of trade has changed since 2004. The planned reduction of tariffs into a single band had been abandoned by the end of 1990s.  Since about 2005, Sri Lankan trade policy has been characterised by a protectionist approach. 

The Government was involved in economic decision making and policies related to import substitution were much more prominent. As highlighted in the Trade Policy Review of Sri Lanka by the World Trade Organisation in 2010, the average tariff protection increased . In fact, it can be noted as frequent and ad hoc changes in tariff structure. The trend in protectionist policies resulted in a fall of exports as depicted by the ratio of exports to GDP . 

In 2009, by the time peace was restored, Sri Lanka had nine para tariffs applicable for imports  in addition to the standard customs duties, of which , five were ‘para-tariffs’: taxes which are only applied to imports and there is no domestic equivalent. Adding  to whatever protection is provided to domestic production by customs duties, with such para tariffs being in place, the protectionism became even more complicated. 

A systematic comparison of Sri Lanka’s tariff structure at November 2002, January 2004, 2009 and January 2011 suggests that the total protection rate notably increased between 2004 and 2009 . 

The ensuing years were followed by many ad hoc and duty exceptions and case-by-case adjustment of duties on many imports which directly compete with domestic production. By 2015, the average effective rate of protection for manufacturing production had increased by 16%.

This trend is well depicted through the Trade Openness indicator as given in Figure 1. The degree of openness is measured by the actual size of registered imports and exports of an economy. In other words, it suggests how free or restricted a country is in its relations with the rest of the world. 

Since 2004 onwards there has been a decline in the trade openness of Sri Lanka and this trend continued up until 2010. By 2015 with an increased rate of protection, the trade openness deteriorated to 36.6%. 

Since 2019, Sri Lanka has been pushing many import controls creating disruptions in the market. This tendency resulted in further decline of trade openness 32.2% in 2020. It is similar to the trade openness during 1970 - 1976 when the liberalisation policies were reversed and the economy had high regulations. The trade policy was more aligned towards import substitution.

Trade restrictions 

Sri Lankan businesses face a variety of trade restrictions exacerbated by the economic crisis. Accordingly, such conditions that impact the price, quality, quantity, or timeliness of product delivery but are outside the direct control of the exporter or importer. 

Both the importing country’s border and the border of the exporting country have been parallelly imposed with restrictions. Even though a number of Free Trade Agreements have reduced external trade barriers and expanded access to markets, Sri Lanka has kept its borders closed by enacting internal trade restrictions.

Internal trade restrictions can be identified in terms of broader categories such as; 

1. Monetary and regulatory barriers, 

2. Procedural barriers, 

3. Service barriers,

4. Technical barriers and 

5. Market barriers 

Currently a number of monetary and regulatory barriers exert pressure on Sri Lankan businesses, while lowering the country’s competitiveness on international trade. Such barriers include complex tariff structures, quotas, import restrictions, excessive duties or levies and export and import licenses. 

Both exporters and importers encounter ineffective, unpredictable, and less transparent procedures throughout the entire trade process. This is mostly the result of poor coordination between agencies and excessive bureaucracy (red tape) among Government employees.

Additionally, the distribution and financial services channels are two areas where existing enterprises face significant service obstacles, which slows down the final stage of clearance.  Shedding further light on the obstacles placed, the technological obstacles  have a negative impact on the export competitiveness of local enterprises because of their limited technical and financial resources. Besides the market constraints like price controls are a significant obstacle because they are unrealistic in a setting of shifting global markets and fluctuating currencies.

Impact of trade restrictions

Over the years, the country has experienced a number of adverse effects due to trade restrictions. Net economic losses in the wider economy have increased as this restricts competition. Shrinking volumes of exports and imports have negatively affected domestic production. Consumers are left with limited choice of products while they experience increased prices. 

Trade restrictions impact the macroeconomy with a fall in employment opportunities mainly due to the deterrents on domestic and foreign investment. Limitations on land, labour and capital have disincentivised investors from competitive export industries to protected industries and inefficient import substitution. Reduction in economic activity has increased the economic woes among people.  

Restrictions on trade have put a significant number of businesses in a precarious position.  Starting with street vendors, small and medium scale enterprises who depended on imported raw materials to the larger apparel and construction industries; all the businesses are finding it a challenge to continue their business. 

Way towards trade freedom

The way to greater freedom of trade is to reformulate the existing monetary policies and laws in order to enhance trade freedom and provide more opportunities for local enterprises to engage in trade. Also in the current context, easing import restrictions and reducing taxes or levies on imports and exports would be crucial.  Additionally, it is important to remove unnecessary Government red tape or bureaucracy wherever possible to make customs processes more simple, effective, clear, predictable and timely. This will help to cut down on processing times at the border and make the movement of goods cheaper, faster and more efficient.

Paving way to greater freedom to Trade - the ability to exchange goods and services openly, creates greater opportunities for Sri Lankans to achieve greater economic prosperity. It opens many avenues towards competition, innovation and economies of scale. The beneficiaries of open trade are the Sri Lankan citizens and businesses who will benefit from lower prices and greater choice.  

Freedom to trade will ensure the economic freedom by which the fundamental rights of an individual to make their economic decisions will enhance. The true meaning of independence will only be assured through greater economic freedom. 

Source : Central Bank of Sri Lanka 

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

Golden opportunity for energy market reform

Originally appeared on The Morning.

By Dhananath Fernando

Let markets work and adjust expectations

As children, most of you might have tried the trick of obscuring the vision of a bigger object by closing one eye. I used to try this with a lamp post, by moving the finger closer to the eye while closing the other eye, thereby making the lamp post disappear. As a child, there was a thrill in making the lamp post disappear with a minute object such as my finger. 

However, in reality, we know that a lamp post or a bigger object cannot be covered with a finger, due to factors such as volume and mass. Similarly, until we ran out of petrol, Sri Lanka also pretty much thought the finger could actually cover the lamp post – the finger in this case was import controls, which we all thought was the solution for a brewing Balance of Payments crisis. 

This column has been a consistent opponent of import controls since the beginning. It has been two years since we stopped importing vehicles. Some non-essential imports (as per the definition of policymakers) such as apples and other food items have also been halted. At one point in this debacle, the Government issued licences for imports, which threatened to create a new Licence Raj. 

We went as far as to kill the forward market and once even issued a regulation mandating a 100% cash requirement to open Letters of Credit (LCs), which were then required to be opened with a 90-180-day credit period. We did so much to reduce imports for so long, so why didn’t any of these policies bring their promised results and how did we run out of money even to import fuel and life-saving medicines? After all those remedies, why have we fallen to a state where the country is in a de facto lockdown – not because of Covid but due to a fuel shortage? 

Many still haven’t understood that imports were not the problem. By contrast, having no fuel imports has become a significant problem. Of course, at a time when we as a nation have hit rock bottom, imports will come to an automatic halt due to the unavailability of foreign exchange. But import controls have certainly not helped matters and have in fact worsened the problem. If we had a solid monetary policy, if we hadn’t maintained the exchange rate at artificial levels and if we maintained stability, this problem would not have arisen. 

It is in this context that the Cabinet has granted the opportunity for any oil producing country that can bring fuel to Sri Lanka to run the fuel distribution while the Government keeps control of the operations of the Sapugaskanda Refinery. 

Surprisingly, even the strong Ceylon Petroleum Corporation (CPC) unions remain silent. Previously, CPC unions were the first to mobilise on the streets when any policymaker dared to even broach the topic of opening up investment activity to the private sector for energy and fuel. Now, private investment has entered their territory and the signals of privatisation are all there, but silence still remains. It is obvious now to these unions and to the nation at large that the State cannot operate in such competitive sectors and that attempting to do so guarantees disaster. Unfortunately, we are presently living through such a disaster. 

While allowing the private sector to operate in the energy market is a good move, expecting the fuel problem to go away simply by allowing private companies to enter the Sri Lankan market is very short-sighted. For context, the reality of the fuel market is that fuel supply can only be secured by paying in US Dollars, but sales in Sri Lanka are transacted in LKR. Even if an investor enters the market with a USD investment, if they can’t convert their LKR into USD, there will be no strong business case unless they have some other business lines which have LKR and USD interests. Whoever invests in USD should be able to convert their sales to USD; otherwise this is not a sustainable long-term solution. 

One segment that has both USD and LKR interests is exporters. They earn USD from their exports and they need LKR for their local operations. If they can get a higher profit margin through fuel sales than through a USD conversion in the banking sector and if they have adequate volumes to run a fuel business, then there is a business case for these exporters to manage a fuel distribution operation. 

Alternatively, there has to be a separate financing arm for fuel, whereby anyone who has an interest in both USD and LKR can invest with an expectation of dividends. To do that, however, fuel pricing requires flexibility. Our present environment of price controls won’t work as fuel has far too many variable cost components and competitive margins. Therefore, one solution is to open the fuel business to anyone – including local exporters – to enter distribution and not necessarily to provide the opportunity only to oil producing nations.  

Allowing anyone to import fuel is the right decision at this moment, particularly as the big companies that can afford to purchase fuel at a premium either individually or through business collaborations will do so, thereby minimising the burden on the Government. The private sector, of course, will increase efficiency as well. 

Another group that has both USD and LKR interests is our overseas workforce that provides foreign remittances. If they can get higher margins than the conversion rate offered by Sri Lankan banks, they might be willing to channel their money into the business of importing essentials. That was the logic expounded by Daniel Alphonsus in his recent article on allowing anybody to undertake fuel imports, even through open accounts. 

The expectation is that the undiyal money presently parked offshore will be channelled to essential imports as the importers can now obtain LKR by selling fuel and other goods. But again, prices have to be flexible and competition will bring the market to a stable position. Currently, the black market price of a litre of petrol is over Rs. 1,500, whereas the official price is Rs. 400. This is no secret. Alphonsus argues that the same system existed during the war in the north and east – although there was no official supply, fuel was available even in small mom-and-pop stores at a price premium, often in small glass bottles. 

Markets are strong and they will always work. Of course, they may not work as per our expectations, but the reality is that our expectations should adjust according to the markets. Since we have completely run out of options, we have a golden opportunity for reform. It is possible that we may fail, but we have little to lose and are presently not doing anything other than going around the world with a begging bowl. That too will have to be continued for now, but expecting other countries to donate their taxpayer money to Sri Lanka after so much mismanagement and loss of credibility is idealistic thinking. It is the same as our thinking when we were children – that an object would disappear if we simply didn’t see it anymore.

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.