- Verité Research Executive Director Dr. Nishan de Mel on the Govt. and Central Bank’s management of the economy and the way out of the current crisis
Verité Research Executive Director Dr. Nishan De Mel Photo Pradeep Dambarage[/caption]
Dr. Nishan de Mel is an economist and the Executive Director of Verité Research. He has extensive academic, policy, and private sector experience and has taught and researched economics at the University of Oxford and Harvard University. The Morning spoke to Dr. de Mel on the Government and Central Bank’s economic management, the debt and foreign exchange situation, and his recommended path out of the current economic crisis.
The following are excerpts of the interview:
You have constantly criticised the corporate tax cuts the Government introduced in late 2019. However, the business community was heavily critical of the Yahapalana Government’s high corporate taxes from 2015 to 2019. Didn’t the business community, which has proven resilient through multiple crises, deserve some relief under a new Government?
What we were critical about were not the corporate tax cuts, specifically, but the whole tax reform that took place and the lack of analysis behind it. So, I’ll give you some examples. This change effectively took away the payee tax methodology. So it was not just the quantity of tax, but the method of taxation, and it reduced the personal income taxpayers by 40% and reduced the value-added tax (VAT) taxpayers by 70%. That’s a huge contraction of the tax base. Ironically, one year later, the Government announced a tax amnesty hoping to increase the tax base. So really, it is the lack of analysis on the consequences that resulted in the Government losing revenue by 25%. Since we run a budget deficit, a loss of government revenue just leads to future taxation, because the Government has to recover that money at some point. The missing analysis was really the problem and it has now had fairly negative consequences on the country. What Verité Research argues principally is that you shouldn’t be making momentous economic policy changes without an analysis of the consequences.
Are you not a believer in trickle-down economics or that corporate tax cuts encourage investments by companies, which in turn creates more jobs and stimulates the economy?
You know, I always move from belief to analysis. Neither a 100% corporate tax rate nor a 0% corporate tax rate is viable. So “what is the optimal level of taxation” is an analytical question. It’s not a belief question. So you have to have an analysis of what you say is the marginal propensity to invest based on a tax cut. What are companies likely to do? These are questions on which you need a lot of data and you need an analysis, and then you determine what the consequences are. So sometimes, increasing taxes has a better outcome and other times, decreasing has a better outcome. Sri Lanka already had a reasonably low tax rate on corporates compared to many developed countries. So it wasn’t that Sri Lanka was obviously too high in its taxation. That doesn’t mean the tax cuts would certainly not have had a successful impact, but that there should have been an analysis.
I’ll tell you the impact these tax cuts did have. The proper point of comparison might be 2018, because in 2019, the Easter attacks happened and there were all kinds of disruption. So if you compare 2020 with 2018, you find that local investment after the tax cut actually reduced by 4% of gross domestic product (GDP), down from 30% to 26%. That’s a Rs. 500 billion reduction in investment after the tax cut in a year that didn’t have any kind of calamity, like in 2019. Likewise, foreign direct investment reduced from 4% of GDP to 1% of GDP from 2018 to 2020 because even international investors make decisions looking at the sustainability of the economy. And when a tax cut effectively has the consequence of reducing the Government’s revenue by 25% it can immediately have a discouraging impact on investors, because they see the economy as moving into unsustainable territory.
Furthermore, corporates and businesses need, not only tax reductions, but also other aspects of the economy to be healthy. So for instance, if your tax reductions result in the Government having too little money and needing to finance itself by expanding money supply, that may have resulted in inflation; then that inflation consequence may be worse than the tax cut benefit. If the Government is struggling to pay its debt because the rating downgrades have shut us out of international financial markets, that is far worse for the private sector than if they had maintained the taxes and avoided a downgrade. So I wouldn’t be surprised if the private sector companies today are willing to say openly that they’re happy to accept the higher tax rate, if the Government runs a more sustainable and stable fiscal policy and monetary policy for the country.
When somebody criticises the economy, the Government responds by saying that the whole world is in crisis and therefore, Sri Lanka had no way of avoiding that impact. Do you agree?
Certainly, external shocks are consequential to a country like Sri Lanka, and Covid-19 had a huge external impact and consequences that are both positive and negative. A negative consequence was that for a period, mobility was restricted and trade became harder and more expensive. A positive consequence was that there was an enormous decoupling from China and a movement away from single sourcing. However, within this region, most countries have managed to increase their foreign reserves, not decrease them, like Sri Lanka has. Many countries have managed to increase their trade, especially in Asia and East Asia, outside of China. So we must not simply think of it as a blanket global problem, but must question why Sri Lanka hasn’t been able to emulate the successes of other countries in the region during this pandemic and manage it in the way that other countries have.
Verité Research recently published an analysis of Sri Lanka’s debt stock and how it has grown. It showed that while the total debt stock increased by 42.8% during 2015 and 2019, at least 89.8% of that increase was due to the interest cost on accumulated past debt. How much of that responsibility lies with the previous Rajapaksa Government from 2005 to 2015?
See, this kind of analysis isn’t designed to start a blame game. What it shows is that Sri Lanka should worry not only about the amount of debt but the cost of debt too. So in 2007 and 2008, Sri Lanka graduated from being a low-income country to a middle-income country. That meant we lost access to concessional bilateral and multilateral financing. So the first international sovereign bonds (ISBs) were issued in 2007 but this money comes with a high interest cost. Actually, even the Exim Bank of China functions like a financial market player and lends at the same high rates. So when borrowing becomes more expensive and the depreciation cost is factored in, you have to worry about the returns on investment. If I’m borrowing at 6% and my depreciation is 4% or 5% annually, I need to have a return of more than 11% or 12% to justify that borrowing. What it does is make you a lot more concerned about whether you’re putting the money into the right things.
Last year, 71% of government revenue went into interest payments of outstanding debt. As far as I know, that is one of the highest interest cost-to-government revenue ratios in the world. Now that should ring alarm bells, because that was Lebanon’s ratio two years ago, and they ended up going into default. So we need more professional management of our debt. The 90% interest cost component in the increase of debt shows that this is what is driving our debt. There is an old saying in Japan; first the man takes the drink, then the drink takes the drink, then the drink takes the man. Debt can work like that. First, the country takes the debt, then the debt takes the debt, then the debt begins to take the country. We really have to avoid getting to that third stage. When the interest cost of debt is driving new debt, that is debt taking the debt, and that’s the time to take a step back before losing control of the situation.
You have claimed that expenditure in 2020 was relocated to 2019 by the Central Bank of Sri Lanka to make it look like the budget deficit was 11% in 2020, when in fact it was 14%. Is this legal, and if so, is it ethical?
The question of legality comes out of asking, are we acting according to the accounting standards that exist in the country? The Auditor General is quite clear that we violated the country’s accounting standards and therefore, it’s not correct. However, the financial laws don’t have a punishment mechanism for the Government violating reporting rules, but it certainly highlights that this is not the right number. It’s better to be correctly informed, than incorrectly informed. Poor information and poor understanding of the underlying reality can lead to poor decision making. An example is the Great Famine of China under Mao Zedong, and those who have analysed that period said that there was fundamentally an informational problem. Local units that were reporting agricultural production to the country’s centre reported slightly inflated numbers to make their units look good. When all of China reported slightly inflated numbers, at the centre they thought they had sufficient production to feed the nation, and the resultant famine killed dozens of millions of people. When you get into the habit of misreporting to make things look good, there’s a significant danger of getting your decision making also misinformed and misguided, and that is why we should be particularly concerned.
Are you saying that misreporting has become habitual, and if so, can people continue to rely on Central Bank data?
It is disappointing to see the Central Bank also provide this same number in its annual report as it was the Minister of Finance that misreported it. In its previous year’s annual report, the Central Bank had given the correct number but then revised it a year later without any change in the circumstances, but put a footnote to say it was put in by the Minister of Finance and denied responsibility. So I think the Central Bank was aware it was incorrect. The important thing is to urge policymakers and the system to get a right understanding to tell the truth, because when you don’t tell the truth to the Parliament and to the people, it erodes trust and confidence and that has enormous consequences on the country. The problem in misreporting happens more in the Budget. Over the past four to five years, Verité has predicted revenue and expenditure outcomes at the time of the Budget more accurately than the Budget. When a third party with limited access to data can make better forecasts on outcomes than the Government, it does mean that the Government forecasts are not as well done and not attempting to get to the truth adequately. That’s a disservice to parliamentarians who have to make decisions, to the public who are trying to understand the state of the economy, and ultimately to the economy because it leads to bad judgement and bad judgement leads to bad outcomes.
Central Bank Governor Ajith Nivard Cabraal has said that certain people have been predicting Sri Lanka will default in 2020, then in 2021, and now in 2022 but that the Government has managed to defy all these predictions. Do you think he was referring to you and Verité as well in that statement?
It’s unlikely, although I can’t purport to know what’s in his mind. I think you have heard us at public events and you’ve seen our reports. Our fault in this case, unfortunately, is that we have been too optimistic. What we said was that the Government has enough money to pay debts in 2020 and 2021 and it’s only in 2022 that the Government is likely to run into trouble. And even there we had specific forecasts that said the Government can meet its obligations until it gets close to the end of 2022. In 2021, we expected reserves to be close to $ 2.8 billion on our base case, and optimistic cases even better.
Now, the actual usable reserves at the end of November, because there are also some unusable reserves that have been counted, was one month of imports – and that was our worst case scenario. So we have had to revise our cases downwards, not upwards, and I think the Central Bank Governor may have been referring to people who had to revise their forecasts upwards. It’s unfortunate and I’m sad about it, because we have always maintained that Sri Lanka knows how to step back from the brink, but we don’t always know how to avoid getting to the brink. The fact that we’ve been in 16 International Monetary Fund (IMF) programmes tells you that we get to the brink, and then we step back, and find a way forward. The Governor of the Central Bank himself did that quite successfully in 2009 with an IMF programme which was successfully implemented and during which time Sri Lanka saw a rating upgrade as well. So what has transpired, which is quite different to the past experiences, has been a surprise to us.
When an economist like you, who is held in high esteem, paints a bleak picture of the country’s economy, doesn’t it drive away foreign investors and alarm foreign governments? Doesn’t it then become a self-fulfilling prophecy?
This problem of self-fulfilling prophecies does exist in economics, and expectations can drive outcomes. Foreign direct investment (FDI) fell from $ 4 billion in 2018 to $ 1 billion in 2020. I don’t think that speaking the truth and providing numbers that are accurate should make people more pessimistic than they ought to be. People value credible, realistic estimates. It is when you lose trust and credibility and lose the ability to paint an accurate picture of the economy that people put a very high-risk premium on you and withhold their investments or ask for far higher returns on their investment. So all of us collectively, including the media, should become as accurate as we possibly can. But if people feel that everything that is being communicated is public relations and is set up to mislead you or to paint an overly optimistic picture, they start discounting the value of what you say. The value of independent commentators and independent media organisations is that we become a baseline of trust and thereby prevent confidence from sinking too low, because the more the Government misrepresents, the more they look for alternative sources of information.
The Central Bank always responds to sovereign rating downgrades by stating that the rating agencies acted too fast, with inaccurate information, or that they just ignore facts. Have the big three rating agencies been unfair to the Government and do they have a hidden agenda to destabilise Sri Lanka?
I think it’s important not to invent conspiracy theories just because we don’t like the messenger or the message. I could understand if there was a major power struggle between superpowers and one country claimed that rating agencies of the other country are biased and unfair to them. But it would be highly unlikely that global rating agencies, which are in competition with each other, act in concert to target a tiny little country like Sri Lanka. Plus, the rating agencies publish documents that provide an analytical basis for how they evaluate a country and these documents have the same structures and templates for all countries. They also provide the data and the facts that they rely on. So I think if one disagrees with a rating, one should be able to demonstrate that analytically by showing that they didn’t follow the same template as they did for an equivalent country, or that a particular piece of information was actually based on a wrong data point. If you can’t do that, it’s important to not simply dismiss them but to study the reports and take them seriously. All rating agencies are coming to the same verdict on Sri Lanka so the burden of proof lies on those who disagree to demonstrate why it is flawed.
Are these rating downgrades also due to a lack of engagement with the rating agencies or an unhealthy relationship?
I don’t think we need to have that assumption because the fundamentals already indicate that the rating downgrade is justified as reserves have come down.
The rupee being fixed at Rs. 203 to the dollar has deprived Sri Lanka of foreign exchange earnings, most notably with worker remittances.
If the rupee is floated where do you think it would end up, and would that solve this problem?
We have to understand why dollars are in short supply to fix the shortage of dollars. The price of the dollar to the rupee that you see in the unofficial market is the price that is based on demand and supply. There are two things that have happened in this situation to drive up the official price; one is that the supply has got constricted enormously because we are paying international debt and we are not able to refinance it in the same way. That’s why our reserves keep coming down. So the Government has taken the dollars that are coming in through exporters and others and has put it in the Central Bank, forced conversions at some levels, and has taken it out of the system to pay bondholders, without being able to replenish those dollars with new borrowings. This particular strategy has created an enormous shortage on that side. So you have to let the dollar be traded at a much higher rate. Now, when a price increase is expected, people could try to buy the dollars in advance and create an increase in demand. The shortage has given rise to both these problems. So providing a higher rate for the dollar is one way to solve the dollar crisis but I think that that should be part of a toolkit of solutions, not a single solution, because if you don’t solve the shortage problem, you keep driving up this problem of depreciation. The supply of dollars should be increased and then, as you stem the shortage, the depreciation pressure would also reduce.
The sale of the Central Bank’s gold holdings was widely criticised, but the Central Bank in a press release said that the share of gold holdings in the reserve may change from time to time to serve the reserve management needs of the Central Bank and that the gold holdings could be replenished in future. Do you agree with this policy?
I agree with the statement. The portfolio mix that you maintain your reserves in should be based on optimising the returns to your reserves. So if I hold it in dollars, I may get a high interest rate in dollars; if I hold it in gold and gold is appreciating, then my effective return is higher and gold can be converted to dollars as well. So the judgement must be made on optimising the return to your reserve portfolio. Now, the fact that it is true doesn’t mean that this particular action was based on optimisation, because the worry is that the gold reserves were sold simply to get liquidity and because we were cash-strapped. The moment something has to be done because you’re cash-strapped and liquidity-constrained, rather than because you’re optimising your returns, it is not a suboptimal outcome. The real question is, was it the optimal time to sell our gold, which would be when we expect gold prices to have peaked in some way or the returns to have increased, making it more advantageous to switch the portfolio from gold to cash. I don’t know whether there was an assessment on that, but we don’t want to criticise it because at this stage, we are not able to make that estimation.
The Government appears to be hopeful that the earnings from the sale of state-owned land to foreign investors could rescue Sri Lanka from the current economic situation, and dozens of lands have already been earmarked for lease. Would land in Sri Lanka be attractive to foreign investors if the economy is in crisis?
So unlike the gold question, I have a more critical view of the sale of assets in the country. I’m not principally for or against selling assets, but if you are selling assets, you have to optimise your returns, and to optimise returns, you have to evaluate your assets, conduct proper valuations, engage in the process of competitive bidding, and structure the assets in a way that is optimal for sale and value realisation, both in the short term and long term. It’s fair to say that there doesn’t appear to be that process in place. I mean, having no competitive bidding is a guaranteed way of losing value. We have carried out lots of assessments on mega infrastructure projects. When the country is in crisis, foreign investors have already placed very high-risk premiums on the country. When you do a fire sale under these circumstances, international investors will look for higher returns, which means lower costs to enter the market. You want to engage in a sale when confidence is high and the risk premiums are low, because then you get a higher price for the same return.
Since the Government has ruled out restructuring debt, especially ISB debt, what is the solution available to Sri Lanka?
So this ruling out the restructuring of ISB debt, we must not take it as a given. The Government and the Central Bank Governor himself, a month before joining an IMF programme in 2009, said very publicly, and on record, that he would not enter into an IMF programme. Which means he was probably already in negotiation with the IMF at the time of that statement because the programme was finalised soon after. What is best for the country at this time is to share the pain that the country is feeling with as wide a base as possible. The shortage of dollars is causing pain and that is because the creditors are being paid on time and in full. It’s leading to inflation, fire sales, and taking away future money and future benefits for the country.
So we are causing pain not only to today’s economy, but the future economy as well. We borrow at a much higher-risk premium than, for example, the US, because of the associated risk. Now, when the risk materialises, the investors should face some consequences. That is the law of the market. You can’t rescue the rich from the consequences of the risks they have taken to make money. That’s inappropriate in any system. Countries share the risk with the creditors all the time and creditors know that that is how the global financial system works. So I think sharing the pain is the way out without letting people in Sri Lanka take all the pain. It’s not even worthwhile because all it means is that the economy gets into greater trouble and the problem snowballs.
Won’t restructuring hurt our credibility with investors and make it extremely difficult for us to attract investors in future?
If you had an investment grade rating and you went into a restructure, then there’s quite a large consequence, because your ratings will come right down to just above the default level. However, when you have a “CC” rating, your credibility is already gone. Actually, it went one or two years ago. In 2020, we lost access to financial markets. I mean, the secondary market return yields tell you the rates at which people will lend to us, which means we are already blacklisted. So the markets are expecting us to restructure because if not, our ratings will fall again. It’s the best path to recover your ratings and there are many examples – Ukraine, Ecuador, Argentina, all in the last few years. I use Ecuador as a particularly easy example to understand because when their rating fell to “CCC”, they actually negotiated and within six months got back to “B-” after restructuring. So restructuring is really the best path to regaining credibility, because as long as you continue to lose your reserves, there is no path to credibility.