• Economy will contract over the next 2 years, some have lost a decade
• Shortages will lead to a drop in output and export contraction
• Monopolies are bad for consumers, need 3 players in energy sector
• SOE losses can be reduced if prices are determined by market forces
• Price-based subsidies must be converted to cash transfers

By Asiri Fernando How Sri Lanka responds to the ongoing crisis will define if the country breaks or emerges stronger, Colombo-based think tank Advocata Institute Chairperson and JB Securities Ltd. CEO Murtaza Jafferjee told The Sunday Morning. Sri Lanka’s economy may contract for several years, and unless robust economic and governance reforms are enacted, rebuilding trust and spurring growth may remain a challenge. A debt restructuring plan may be ready by the end of the year. According to Jafferjee, Sri Lanka needs to focus on moving towards becoming a social market economy that leaves no one behind. He also advocates for a more streamlined tax system and for State-Owned Enterprises (SOEs) to be reformed. In an interview with The Sunday Morning, the veteran investment professional and Chartered Financial Analyst said that public officials who played a role in exacerbating the economic crisis needed to be held accountable. Following are excerpts of the interview: Sri Lanka has come to a standstill due to the ongoing power, fuel, and LPG shortages. In your opinion, what can the Government do to improve the supply of such essentials? The only way to solve shortages is through a pricing mechanism for energy. Although energy prices have been rising precipitously due to a structural shortage in supply owing to under-investment globally, which was further accentuated by the conflict in Ukraine, our problem was further compounded by a shortage of US Dollars. Either the currency has to further depreciate (second best option) or energy prices have to go up further to dampen demand. Although fuel prices are now determined monthly through a cost formula, the level of taxation on fuel has been one of the lowest over the past decade; taxes on petrol and diesel only account for 14% and 9% of retail prices respectively due to duty discounts of around Rs. 25 per litre. Global prices have collapsed this week, let’s hope policymakers opt to recover some of the taxes that have been forgone before they decide to reduce retail prices. If power and fuel shortages continue, can Sri Lanka sustain the improved export volume it achieved last year? Energy is an essential input for transportation and production. Shortages will lead to a drop in output, hence a contraction in exports. The Government has said that it is ready to allow new players into the energy market to kickstart supply. What can the Government do to facilitate private sector entry to the energy sector and how can the process be made transparent? We already unbundled the sector 20 years ago by permitting the Lanka Indian Oil Company (LIOC) to enter the market. The initial plan was to make our market a three player one – unfortunately the 2002-’04 Government could not complete its task. We need three players. Common user facilities in terms of storage and distribution are under Ceylon Petroleum and Storage Terminals Ltd. (CPSTL), permitting easy entry for a new player. The initial plan had set aside a quantum of fuel stations from the Ceylon Petroleum Corporation (CPC) pool, which was then merged back – we need to reverse this. The aviation sector is the sole preserve of CPC; monopolies are bad for consumers. Policymakers can transfer the storage and refuelling infrastructure into a common user facility and permit new entrants. SOEs and the subsidies regimes have contributed to the current economic crisis. The Government has shown its willingness to privatise some of the loss-making SOEs. How can such SOEs be privatised effectively? We got into this mess by misallocating resources through fixed prices. Policymakers tried to achieve distributional objectives (affordability for the poor) through price-based subsidies (bad idea) – for example, the top 30% of households consume 70% of fuel. If prices are determined by market forces, these large losses by SOEs, especially Ceylon Electricity Board (CEB) and CPC, will be reduced. We must also introduce competition to sectors that were the sole preserve of SOEs like aviation fuel, electricity distribution, etc. by unbundling.  Another reason for poor performance of SOEs is they are attached to ministries and thus become an instrument of the respective minister to exercise his or her political largesse (a.k.a. jobs for the boys). Further, there are inherent conflicts for the ministry as the policymaker, the regulator, and the asset operator. Take the case of the Sri Lanka Ports Authority (SLPA) that comes under the Shipping Ministry – in the case of the Colombo Port, SLPA is the landlord port, it owns and operates JCT, has 15% share in their key competitor terminals CICT, SAGT, and the new West Terminal. This arrangement is riddled with conflicts; many of the objectives of each of these entities conflict with each other. Ideally the commercial SOEs should not be gazetted under the Ministry but should be moved into a conglomerate-like entity that looks at these businesses as investments with the sole objective of improving performance through improved governance and capital allocation. This is what has been done in Singapore through Temasek Foundation and in Malaysia through Khazanah Nasional Berhad. The ministers then have to focus on policy and we need competent and independent regulators. What do you think will be the short- to medium-term impact of the crisis on the Sri Lankan economy? The economy will contract over the next two years. In many instances, countries that have faced our predicament experienced a lost decade. In your opinion, how will this crisis affect Sri Lanka in the long term? We will either become a failed state or become a tiger economy. There are yet elements within our system trying to ensure the former will happen. I am, for my part, through my work at the Advocata Institute, working toward the latter. This is a very difficult task for vested interests who have a lot to lose with the second outcome. In short, we need to open up to the world, move towards a market economy – ideally a social market economy that leaves no one behind, and rely on productivity growth rather than factor accumulation to drive growth. The key driver of a market economy is competition; this is what creates a virtuous cycle of wealth creation by forcing productivity improvements and innovation – consumers benefit via lower prices and better quality. What are the short-term measures that can be taken to mitigate the impact of the crisis, in particular the shortage of forex? Our crisis is due to macro instability caused by excessively loose monetary and fiscal policy. It’s not a supply problem but too much demand that created it. The IMF programme will fix it. Will the monetary policies adopted by the Central Bank of Sri Lanka thus far continue to stabilise the rupee depreciation if the current status quo continues? They will have to further increase policy rates although the market has already reacted expecting a change – three-month Treasury bills were last issued at 28%. Do you think Sri Lanka has taken adequate steps thus far to improve fiscal consolidation? What further steps can be taken? Fiscal consolidation will have to come mainly through revenue measures, not expenditure, for the latter is sticky. Our tax to GDP is below 8%, we need to get it above 14% over the next four years. One can tax what one earns, what one buys, and what one owns. In the first case the majority will have to come through corporate taxation. We need a flat rate of taxes for everyone – no concessions – and rescind all tax holidays. If anyone is exempted or offered concessions, it comes at a cost to the people who pay corporate taxes, for they will have to pay more. The only case for tax concessions or holidays is if a business creates very high returns to society but private returns are below their cost of capital – very few of those who are enjoying concessions pass this test. Tax credits are a better fiscal policy instrument than concessions based on lower rates. In the case of a tax credit, it is a defined sum which can then be set off against one’s taxes – there is greater transparency as to how much the benefit is and it’s capped at this figure. For example, there is a case for tax credits for training people, which is tough for private companies to do because there is no bind on employees from leaving. If these people remain in the country, the Government can recover its tax credit expense with the expectation that a better skilled individual will earn higher income, hence be able to pay higher taxes. VAT is the best way to tax what we buy. All paratariffs, like CESS and PAL, must be done away with and we have to move to a single rate of VAT over a larger base – this is the least distortionary tax. A middle-income country like ourselves should target collecting around 6% of GDP through VAT – remove exclusions and reduce the revenue threshold to Rs. 30 million from Rs. 120 million. Local governments can fund themselves through rates and taxes – the assessment values have to be revised to reflect current land prices. The crisis has affected low-income communities disproportionately. What do you think should be done to improve the social safety net to ensure vulnerable communities have access to essential food items and services? Wherever possible, convert price-based subsidies to cash transfers. In 2021 we only spent Rs. 55 billion on Samurdhi; this figure has to double or triple. This can be easily paid for by removing all existing subsidies on energy, fertiliser, etc. The IMF is expected to push for expanding the tax network of Sri Lanka. Do you think this will include the inclusion of low-income earners and if so, wouldn’t such a move be counterproductive? Low-income earners are below the income tax threshold; they will pay some taxes through indirect taxes, especially on tobacco and alcohol. However, 51% of national income accrues to the top 20% of households, so they should pay 65% of the total taxes. How long will it take to produce a debt restructuring plan? We must do it with the help of our financial and legal advisors. If we execute it well, perhaps before the end of the year. Ironically, the holdouts on some of the Euro Bonds (ISBs) settlements may be locals who have investments through offshore accounts. One needs to investigate whose money is behind Hamilton Reserve Bank (HRB). Going by the court case, HRB’s entire exposure is only in the July 2022 bond; this goes against the principle of prudence in investing, so it seems like assurances were given on payment by somebody in authority. Do you think the legal action started by Hamilton Reserve Bank will have an impact on Sri Lanka’s debt restructuring plans and the negotiation with the IMF? HRB’s court case is based on it as holders of the July 2022 bond – this bond has a single-limbed Collective Action Clause (CAC), which requires only 25% of the said bond to have a blocking position. Many of the other bonds have a double-limbed CAC – the second limb is 50% of all issued bonds. They can block a resolution of the July 2022 bond but cannot block the others. Hw important are governance reforms to ensure Sri Lanka rebuilds credibility and enters a path to recovery? Very important. External creditors will not agree to a haircut if they are not convinced that we are good for the rest of the money. We will become a failed state if we don’t reform. This is the 17th time we are going to the IMF; this should be the last. Do you think there should be a process to hold public officials, elected and appointed, accountable for their role in worsening the crisis through introducing poor policies and mismanagement? An entire generation has lost its wealth; we will also have old-age poverty. Accountability is a must; justice must be served through the court system, not through vigilantes. I am not a lawyer, but I hope the Judiciary and some of the best legal minds in the country work on this. We know who’s responsible, starting with the gang of four [former Governor of the Central Bank Ajith Nivard Cabraal, former Presidential Secretary Dr. P.B. Jayasundera, former Treasury Secretary S.R. Attygalle, and former Governor of the CBSL Prof. W.D. Lakshman], but a successful prosecution is a much harder endeavour because the laws are not explicit.