In the midst of a fluctuating rupee, reducing inflation, and interest rates, Sri Lanka seems to be on the right track towards recovery. Exchange rate fluctuations are no surprise and I would submit that the fortunes of the Sri Lankan Rupee (LKR) during this period should not be used to judge the trajectory of the recovery. In this article, I intend to critique vital aspects of the current trajectory and will attempt to articulate the basis for my scepticism of the Government’s present course.
Sri Lanka’s economic woes have always originated from our fiscal equation; the State does not earn enough revenue and foreign exchange while it has also been spending or investing too much money on consumption and projects largely devoid of adequate returns.
Assuming a successful Domestic Debt Optimisation (DDO) with wide participation, Sri Lankans may enjoy short-term benefits in the form of a stronger LKR and lower interest rates; current market rates include a risk premium for the ongoing restructuring. Full details of the DDO will only become available in the coming days and weeks.
Paved with good intentions
At the very outset of the present Government’s tenure, upon the International Monetary Fund’s (IMF) urging, the administration gave assurances that Sri Lanka’s poor and vulnerable would be prioritised, that there would be a reinforcing of social protections and better targeting of cash transfers. The IMF report from March 2023 refers to the need “to shield vulnerable households from the impact of the crisis and macroeconomic adjustments… expand spending on social protection, supported by structural reforms to improve social safety nets, with improved coverage and targeting to those in need…”
However, in its April 2023 report, the World Bank noted that Sri Lanka’s poverty had already doubled; urban poverty has tripled: “The negative economic outlook for 2023 and 2024 and adverse effects of revenue-mobilisng reforms could worsen poverty projections… Mitigating these negative effects on the poor and vulnerable will remain critical during the adjustment.”
The IMF suggested that Sri Lanka “enhance Social Safety Nets (SSNs) to help cushion the poor and vulnerable from the impact of the economic crisis and policy adjustments”. It is time to acknowledge that the Government’s ‘critical’ cash transfers and social protections, central to the IMF’s own discourse, have not been effective and in many cases, failed completely.
Last week there were multiple reports of hundreds of beneficiaries gathering outside Samurdhi offices around the country only to find that their stipends have been cancelled and that they are no longer eligible. The IMF report also recognises the size of Sri Lanka’s public sector wage bill but still calls for “limited public sector salary and public pension payment increases to partially account for inflation during the programme within the programme’s primary balance targets.”
Organisations including the World Bank have noted that Sri Lanka’s investment in education and health are far below the benchmarks of peer group countries. The IMF states that “while expenditure rationalisation will contribute to fiscal consolidation, we will preserve spending on health, education, and social protection”. The word ‘preserve’ is used here to suggest that increasing such expenditures are beyond the available fiscal space. It is therefore implied that Sri Lanka will continue to underinvest in key areas of social spending for the foreseeable future.
An Asian Development Bank (ADB) report from 2019 noted that Sri Lanka was not generating adequate tax revenue relative to its GDP when compared with peer group nations. Sri Lanka also does not spend as much relative to income as those same peer group nations. Hence, notions of expenditure being the primary driver of the State’s fiscal crisis deserves further reflection.
The crisis was precipitated by the ‘Gota tax cuts’. Reports from the IMF, ADB, and World Bank have stressed that Sri Lanka needs to urgently generate revenue; it was no surprise that the Government reinstated and increased taxes across the board. The Inland Revenue Department (IRD) has performed admirably at generating revenue from those already within the tax net but we do not know whether the Government has been successful in widening the tax base.
What we do know:
- There has been no one-off tax on large corporates and conglomerates – those that received extraordinary windfalls from the Gota tax cuts.
- The top tax rate for a large corporate is roughly the same as the top tax rate for a high net worth individual; even pensioners are being taxed at rates above 25%.
- There is a high ratio of indirect to direct taxes, which fall disproportionately on the poor, thus regressive by definition.
- There is no separate bracket with a higher top marginal income tax rate for high earners and large corporates.
- Aside from a handful of selected sectors, there have been no significant cancellations of tax holidays and loopholes.
- Sri Lanka’s ratio of corporate tax revenue to GDP is at the lower end when compared with peer group countries.
What has the President prioritised instead? Simply put, his priorities have crystallised around suppressing dissent: (1) the unnecessarily violent crackdown at GGG (GotaGoGama), (2) the (continued) use of the Prevention of Terrorism Act (PTA) to remand activists, (3) the equally monstrous Anti-Terrorism Act, (4) High Security Zones Act, (5) committee to investigate threats to religious harmony, (6) Broadcasting Regulatory Commission Bill, (7) postponement of Local Government elections, and (8) interference with provincial governorships. These are all signs that the President has focused intensely on preserving power and establishing authority.
The cure and the cause
If we can be very precise for a moment, to clarify Sri Lanka’s most significant structural economic weakness, it is our persistent Balance of Payments (BOP) crisis. We simply do not export enough and we are far too import dependent; as a result we spend far more foreign currency than we earn and have been borrowing to fill this gap for decades, with no policy alternatives installed by the political class and the bureaucracy.
This is not opinion or conjecture. In my May 2022 article for ‘The Morning After’ titled ‘Picking Up the Ladder,’ I discussed Sri Lanka’s lack of industrialisation. By all meaningful measures – Manufacturing Value Added (MVA) as a percentage of GDP, Competitive Performance Index (CPI), and high-technology exports – Sri Lanka’s export sector lags far behind the success stories of the Asian century: Japan, Singapore, South Korea, Hong Kong, Vietnam, Taiwan, etc.
The United Nations Development Programme (UNDP) report of August 2022 gives a similar critique: “The successive governments of independent Sri Lanka largely failed to match welfare orientation with a coherent strategy to find new sources of growth through structural diversification of the economy, refurbishing existing export industries or diversifying into new areas in either agriculture or industry…”
Whatever we think of the evolution of Sri Lanka’s economic challenges, the solutions remain static. Policy suggests that Sri Lanka must integrate with global supply chains to become part of international trade flows. We have already noted that Sri Lanka has an underdeveloped industrial and manufacturing base, so we do not manufacture many high-technology items or complex components. We also understand that the global free trade regime is a ‘race to the bottom’ where countries compete on costs; how do we compete on cost with market pricing or ‘cost-reflective’ pricing for energy and transport? How does Sri Lankan labour compete on cost with the rest of Asia?
Sri Lanka’s post-war development story was driven partly by the construction boom, which has had unintended consequences. Primarily, it shifted focus away from tradeable sectors; Sri Lankan manufacturing failed to diversify on account of cost dynamics and a lack of incentives.
The UNDP report also notes that “the complementarity between macroeconomic management and trade liberalisation required for maintaining competitiveness of tradeable production in the liberalised economy was missing”. If the UNDP has understood that Sri Lanka is globally uncompetitive in tradeable production and given that Sri Lanka has an objectively and comparatively underdeveloped manufacturing and industrial base, what then is Sri Lanka’s role in free trade?
This is the complexity of the task that this Government and many before it have failed to acknowledge. In truth, Sri Lanka has to start somewhere, but only from a point at which policy is cognisant of the need to ensure Sri Lanka gains more in the long-term than simply the short-term benefits of foreign currency flows and economic activity. Longer-term, Sri Lanka has to utilise official policy and unofficial practice to ensure technology transfers that can then be translated into higher-value industries locally, benefiting Sri Lankan businesses and its entrepreneurial sector in the long-term.
Chinese manufacturing and industrial ingenuity is the result of significant technology transfers from global corporations, both through official and unofficial channels, what’s called ‘Forced Technology Transfer’; foreign firms are required to provide regulators, joint venture partners, and other market participants with technical information of technology, intellectual property such as algorithms and software code, research analyses, structural designs, etc. Sri Lanka cannot perhaps utilise official channels that are too stringent, however policymakers must be aware of what we are trying to achieve from specific types of Foreign Direct Investment (FDI).
Sri Lanka is currently focusing on tourism and worker remittances to plug the forex gap in the meantime. Yet if we continue to incentivise these sectors at the expense of industry, we end up over-valuing the LKR in the global market, making our industrial exports less competitive, a phenomenon in economics called ‘Dutch disease’.
It is thus clear that the present Wickremesinghe Government will fail in the same way that previous versions did; it does not have a clear focus on the core challenge for Sri Lanka’s economy: diversifying its export sector to rectify the BOP imbalance. At no time has any Ranil Wickremesinghe-led government taken tangible steps to develop and implement a modern industrial policy, despite Wickremesinghe himself being a former Minister of Industry (1989-’93).
Global capital is the new smoking
It is also necessary to underline the very specific genesis of Sri Lanka’s debt crisis and note the current President’s tenure as Prime Minister of the Yahapalana regime. In a March 2023 article titled ‘Chaos and Collateral,’ I considered the effects of the dramatic increase in Sri Lanka’s borrowings through International Sovereign Bonds (ISBs) during the Yahapalana regime.
While the initial investments in ISBs began in the late 2000s, it would increase steadily, reaching as high as 35% of total external debt. ISBs are not project/asset specific, meaning less transparency on the allocation of funds. Bonds are also tradeable and their prices subject to regular analyses by rating agencies; negative outlooks affect their yields (returns), making refinancing (rollover) more expensive.
Sri Lanka’s dependency on global financial capital flows is not unique but its management, utilisation, and allocation of borrowings have been uniquely terrible; the failure to restrict its ISB investment quantum to a manageable proportion of the total external debt portfolio deserves special mention.
In many ways, the global financial system that enables entities including states to borrow astronomical amounts of money and to have these funds flow across borders with little to no regulation necessarily produces an addiction to such financial flows.
If a state can mitigate risks and manage its finances with any degree of diligence and even a small measure of forward planning, some countries might well survive with an underdeveloped industrial base and under-diversified foreign exchange streams. Such economies are dependent on forex cash flows from tourism and services which are more vulnerable to external shocks; this is the insidious nature of the addiction to global financial capital.
In the 1995 Review of International Political Economy Eric Helleiner makes an impassioned critique of the age of unencumbered capital, the era of free, cross-border movement of capital with all the required protections granted to it; free, protected, and deregulated in a manner that workers will never experience.
Helleiner points out that “many accounts of the globalisation of financial markets over the past three decades explain it as a product of unstoppable technological and market forces…” and instead emphasises “the behaviour of states… in encouraging and permitting the process. States are shown to have supported financial globalisation in three ways: (1) granting freedom to market actors through liberalisation initiatives, (2) preventing major international financial crises, and (3) choosing not to implement more effective controls on financial movements”.
Helleiner’s research found that states “embraced” the trend of globalisation throughout the post-World War II period because of “a competitive deregulation dynamic, political difficulties associated with the implementation of more effective capital controls, the… domestic prominence of neoliberal advocates and internationally-oriented corporate interests”.
Helleiner stresses that the globalisation of capital since the ’60s is “one of the most spectacular developments in the postwar global political economy”. Cross-border movements of private capital went from near zero to “where they now dwarf international trade flows”.
Shared identity and a grand social bargain
I have previously discussed the work of Harvard University’s Professor of International Affairs John Ruggie. In a foreword for the Fair Labour Association’s 2006 Annual Report, Ruggie states that “‘market rationality’ has never been a sufficient basis for social solidarity and human community”; he posits that previous eras of globalisation have collapsed and that “markets erode traditional standards and relationships much quicker than they give rise to new ones”.
This is central to the opposition to globalised finance and neoliberalism; the erosion of a specific set of values based around ‘human community’ as a driver of policy priorities. When markets erode social systems and traditional relationships and there is no useful replacement to fill this gap, “tensions emerge that often breed undesirable measures of social protection, such as protectionism, anti-immigration policies, or even extreme forms of nationalism, xenophobia, and anti-modernism… However much they differed, national socialism, fascism in Italy, and the communist revolution in their own ways all sought to assert social control over market relations that were seen to be out of control.”
Ruggie further contends that communities and societies need to “draw on… shared identity as citizens… in constructing the grand social bargains represented by the New Deal, social democracy, the social market economy…” and reminds us of a time when social safety nets for the most vulnerable “was seen as an extension of the concept of citizenship into the economic and social realms”.
This “grand social bargain” is missing in the present Sri Lankan context. The negotiations are one-sided, there is no representation for the most vulnerable, and instead these are the people from whom the current structure hopes to extract the most.
As I stated at the outset, the current President has a history of economic policy orthodoxy which has failed to create a focused, dynamic, globally competitive export-oriented industrial base.
Instead, the President’s record includes further entrenching Sri Lanka in the system of financial capital that disincentivises export-oriented industrialisation. This is evident even today as the Wickremesinghe Government still has no industrial policy and even removed tax concessions for major export sectors in an environment of increased energy costs; ingredients that are tailor-made to dramatically reduce the competitiveness and value proposition of Sri Lankan-made products. This is the exact opposite of the route Sri Lanka should be taking.
The President’s policy orthodoxy, displayed over decades, has contributed significantly to the structural weaknesses in our economy and hastened Sri Lanka’s economic collapse. It is now contributing towards extending Sri Lanka’s policy inertia and stagnation at the very moment when we can least afford it.
(The writer has over a decade of experience in the banking sector after completing a degree in accounting and finance. He has completed a Masters in International Relations and is currently reading for a PhD at the University of Colombo. He is also a freelance presenter, writer, and researcher and can be contacted via email: kusumw@gmail.com and Twitter: @kusumw)