• Crisis is a great opportunity to make sure we never go bankrupt again
• Structural reforms key or SL will be back to square one in a few years
• DDO is definitely not a fair deal, but the best option out of bad options
• Concluding the external debt restructuring should be the key priority
• Greater economic integration with India key for SL’s economic prospects 
• The IMF programme is tough because Sri Lanka’s situation is critical
• Not Govt.’s job to manage and operate biz with commercial interests
• Gaining support for long-term structural reforms will be biggest challenge

“Not many countries in the world can recover the way Sri Lanka has in a year after declaring bankruptcy,” asserted Economist Talal Rafi in an interview with The Sunday Morning, emphasising on the importance of speedy structural reforms to ensure the country never goes bankrupt again.

“Structural reforms like Central Bank independence, SOE reforms, liberalisation of trade, and land and labour law reforms are essential or we will be back to square one in a few years,” he warned.

Speaking on the Government’s Domestic Debt Optimisation (DDO) plan, Rafi asserted that it was definitely not a fair deal, but pointed out that it was “the best option out of a lot of bad options”. 

In the course of the interview, Rafi also spoke on key steps the Government should take to strengthen the economy, the International Monetary Fund (IMF) Extended Fund Facility (EFF), State-Owned Enterprise (SOE) reforms, challenges ahead for Sri Lanka, protecting the most vulnerable segments of society, ensuring people’s buy-in in moving towards recovery, and better governance.

Following are excerpts:

It’s been a year since the former President vacated office and the current President took over. How do you view the developments over the last year on the economic front?

Not many countries in the world can recover the way Sri Lanka has in a year after declaring bankruptcy. 

Sri Lanka was at its absolute rock bottom last year with inflation at over 70% and heading into hyperinflation. Market interest rates were around 30% and there was a fear of food shortages last year. We are definitely not out of the woods, but compared to last year, the economy has stabilised. Inflation is expected to hit single digits soon, the Central Bank cut policy rates by 200 basis points earlier this month and another cut is expected soon. 

My concern is on structural reforms not taking off fast enough as this crisis is a great opportunity to make sure we never go bankrupt again. Structural reforms like Central Bank independence, SOE reforms, liberalisation of trade, and land and labour law reforms are essential or we will be back to square one in a few years. 

What are your views on the Government’s DDO plan, in terms of pros and cons?

DDO is definitely not a fair deal, but, in my opinion, it is the best option out of a lot of bad options. But as DDO was a condition of the International Sovereign Bond (ISB) holders, it is a good move to go ahead. If not, the external debt restructuring can get stalled. The positive is that the banking sector has been excluded from the DDO. 

Ireland had a banking crisis which led to an economic crisis. Ireland’s banking crisis started when Non-Performing Loans (NPLs) hit double digits but in Sri Lanka, NPLs have gone even higher to 13%. Putting further pressure on the banking sector would be risky as financial sector stability is crucial for macroeconomic stability and for any economic growth going forward. Given that 36% of bank profits come from Government securities, any coupon cut can affect banks and a hit on banks can cause disruptions to economic activities and loss of business confidence. 

Banks pay higher taxes and also banks will be affected by the restructuring of ISBs and Sri Lanka Development Bonds (SLDBs) as well, so it is not like the banks are untouched by the overall debt restructuring. Let us also not forget that banks had given moratoriums, including concessions, which amount to around 15% of their total loans. 

But the unfair part is that the Employees’ Provident Fund (EPF) had to shoulder a larger portion of the DDO than would have been needed if the DDO was done equitably. Superannuation funds had already lost almost half of their value due to inflation. 

What are the key steps the Government should take in the near term to strengthen the economy, regain confidence, and attract Foreign Direct Investment (FDI)?

Firstly, concluding the external debt restructuring should be the key priority. On average, a country restructures its debt twice after a default in the first 10 years, so restructuring debt to ensure debt is sustainable is crucial. 

Secondly, the Government needs to focus on improving ease of doing business and reducing red tape. Many investors prefer faster approvals and shorter setting up time to tax incentives. In Sri Lanka, the only thing offered to many investors is tax incentives. In the US, the state of California has one of the highest tax rates in the US, yet many US companies are set up in California, showing that tax exemptions are not the most important incentive for a business but rather a conducive business environment. 

Lastly, 70% of global trade involves supplying global value chains. Sri Lanka is not part of this vibrant trade and the key reason is because we are one of the most protected economies in the world. Also, Sri Lanka only has three Free Trade Agreements (FTAs). Vietnam opened its economy after us and has over a dozen FTAs. 

Sri Lanka’s economy is less than $ 80 billion and many global large-scale investors will not be interested in investing to cater solely for the Sri Lankan market. More FTAs will help Sri Lanka attract investments so goods and services made in Sri Lanka using FDI can be exported to other countries using Sri Lanka as a manufacturing base.

Sri Lanka has the perfect location with the oil-rich Gulf nations to its west, the vibrant ASEAN nations to its east, and a fast-growing India to its north. India is set to become a $ 10 trillion economy by 2040 if it maintains its growth so Sri Lanka is strategically positioned to capitalise on this. Greater economic integration with India is key for Sri Lanka’s economic prospects going forward. 

How do you view the IMF EFF and the challenges it poses for the people?

Sri Lanka is an example of what will happen to a country if the IMF is not there at the peak of its economic crisis. If we had gone to the IMF in 2020 as many experts advised, we would have averted the worst effects of the economic crisis.

One thing I would like to state is that we went to the IMF because we had no other choice. If not for India, Sri Lanka would have deteriorated into a nightmare situation last year. With reserves at near zero in April last year and a mountain of external debt, support from India was vital in keeping the economy afloat.

Some like to criticise the IMF, but if not for the IMF, what other choices did we have? The IMF’s role is to bring macroeconomic stability, which I believe it has brought about to some extent. 

Sri Lanka will take some time to recover before we can look for rapid growth. There are certain segments that criticise the IMF for not focusing immediately on Sri Lanka’s rapid economic growth, which is ridiculous as Sri Lanka needs to stabilise first. The effects of the structural reforms needed will take time to kick in and will not produce results immediately.

The IMF programme is tough and that is because Sri Lanka’s situation is critical. The IMF requires a primary budget surplus of 2.3% while we have a primary budget deficit of 3.7%. This requires fiscal consolidation of 6% in two years, which is a daunting task. But at the same time, these are things the Government has to do.

Sri Lanka has only had a primary budget surplus four times in 75 years. So even excluding interest payments, Sri Lanka was not able to balance its budget for 71 out of the past 75 years, which shows the utter lack of financial discipline. 

Populist policies such as subsidies, a bloated public sector, and monetary financing (money printing) are key reasons why Sri Lanka is bankrupt today, so the IMF programme is addressing all this. If Sri Lankans can complete the IMF programme requirements, we can be on the right path.

India did the right reforms in 1991 and never went to the IMF again, so let us do the necessary structural reforms and, hopefully, we will never need to go to the IMF again.

What are your thoughts on the ongoing SOE reform process and what are the other key reforms that need to be implemented?

It is not the job of the Government to manage and operate businesses with commercial interests in my opinion. Any SOE which has commercial interests and can be privatised should be privatised.

In 2021, the loss of SriLankan Airlines was over 1% of the GDP while the social security net floor set by the IMF programme is 0.6% of GDP. If SriLankan Airlines can be privatised, social security spending can be doubled and that is just speaking of one SOE’s loss.

There is a massive opportunity cost with the Government trying to run loss-making SOEs. This money can be instead spent on education, health, and infrastructure. In 2021, 86% of State revenue went to paying salaries and pensions of State employees. This is highly unsustainable. Then where do we find money for infrastructure, education, and health?

The most common criticism of privatisation is that private owners will price the products in their way. But liberalising the industry, making sure there is competition, and bringing in the required regulations can offset this. 

Other options are Public-Private Partnerships (PPPs), where the Government can share ownership with the private sector but where the enterprise will be managed by the private sector.

SOEs being left as they are will be detrimental to economic development. SOEs cannot compete as approvals take months to go through the hierarchy, while in the private sector approvals are obtained within weeks. Boards of SOEs are mostly political appointments and there is the problem of overstaffing. Even if an SOE is restructured and the number of people working is reduced, another government in future can easily increase the number of employees. 

Privatisation of SOEs with commercial interests like hotels is a must as privatisation is tougher to reverse. SOEs also have a spillover effect. Most SOEs running at a loss borrow heavily from State banks, resulting in a crowding out effect for private sector borrowing. 

What are the main challenges you see for Sri Lanka in the months ahead?

Gaining support for the long-term structural reforms will be the biggest challenge. If structural reforms are not implemented, Sri Lanka will be back in a similar economic crisis before 2030 is my prediction.

External debt restructuring will be another challenge. The global economic downturn and the increasing geopolitical tensions between world powers will be key factors in the near term for Sri Lanka. The country is heavily reliant on the apparel industry and the fall in demand in Western countries will be a major challenge. 

Due to the crisis, people in Sri Lanka moving below the poverty line has increased dramatically and making sure they are able to survive until the economy recovers is crucial.

The Government projections for the future are at odds with those expressed by most independent economists. What is your stance? Will the economy grow in the year ahead?

The global economic prospects are not looking quite good with slower growth in the US, EU, and China so the export sectors may be affected. The economy is expected to grow next year, as predicted by the IMF and the Central Bank. 

Inflation is set to hit single digits soon and we are expecting another policy rate cut by the Central Bank. With lower interest rates, lower inflation, and the removal of import restrictions, the economy will be in a better position to show growth.

What measures should the Government take to protect the most vulnerable segments of society? 

The Government should move away from subsidies and rather focus on direct cash transfers. Let me explain; about 75% of Government taxes come from indirect taxes rather than from direct taxation (which is more targeted towards the rich).

For example, indirect taxation results in the poorer segments paying similar amounts compared to the rich when purchasing many items. When petrol was subsidised, someone driving a land cruiser in Colombo was pumping large amounts of subsidised petrol, which is mostly paid for by the poorer segments. This is not fair. Direct cash transfers should be done. 

There are many gaps in the Samurdhi system which should be addressed. For instance, many in the list should not be there and many who should be on the list are not there. Administration costs itself take up 40% of the Samurdhi budget. A new transparent system is needed as recommended by the IMF and the Government is working on this with the World Bank. Hopefully, the deserving segments will get the benefits needed under the new system.

How can the people’s buy-in be ensured in moving towards recovery?

Better communication and making sure the people know what is happening and why certain unpopular decisions are being made are important. If the people understand why certain decisions are being made and how they play in the greater interest of the country, then reforms will be much easier to implement.

It is the people who are being called on to make the biggest sacrifices; they are paying for politicians’ policy failures and deliberate acts of harm, with decisions that impact millions being made without expert input or blatantly ignoring expert advice. How can we ensure better governance and that we don’t hit rock bottom once again?

My message to the people is that they get what they vote for. Rather than being swayed by populist policies and charismatic leaders, voters should carefully scrutinise the policies put forward by political candidates. 

Another important factor is to ensure strong independent institutions that can act as safeguards in preventing policy errors and protecting the best interests of the country. For example, former British Prime Minister Liz Truss last year tried to give the UK a massive tax cut similar to what Sri Lanka got in 2019. This would have badly damaged the UK economy, but, luckily for the British people, the UK had strong institutions that prevented this policy misstep.

Unfortunately, in 2019, Sri Lanka did not have such strong institutions to prevent the 2019 tax cuts, which led to Sri Lanka losing access to international capital markets following a rating downgrade which precipitated the economic crisis.