Current state of Sri Lankan economy, according to Dhananath Fernando

The crisis was understood by Sri Lankans in terms of long power cuts, queues for fuel, and non-availability of an essential input in urban kitchen, cooking gas

Looking at big picture of economy

The science graduate turned economic analyst, Dhananath Fernando, CEO of the independent economics think-tank – Advocata Institute – in conversation with Kishani Alanki has presented a comprehensive objective analysis of the present state of the Sri Lankan economy (available at: https://youtu.be/OmF5bFVgsak?si=LJPvFb24xaStBPcK). This conversation attracted my attention because he had presented his view without fear, favour, or animosity. 

He is known for using simple examples to help ordinary laymen understand the meaning of complex economic issues. At the same time, he breaks those complex issues into different sub-parts which is the job of professional economists. Hence, his analyses are useful to ordinary people to understand what those economic issues are and to professional economists to think beyond what he has said. However, in any conversation in which parties involved must race against time, some facts can be missed out or get under-explained leaving a gap. I thought of amplifying and elaborating his conversation in a bid to fill this gap. 

Advice not heeded to

The background to his conversation is the economic crisis which Sri Lanka began to experience on all macro fronts. Though the trigger point was in early 2022, the seeds of the crisis had begun to germinate known to everyone except the top politicians and policymakers of the country. The latter group had stubbornly refused to seek external support to come out of the problem. When the State Minister of Finance, Ajith Nivard Cabraal, was appointed as Governor of the Central Bank in September 2021, I was asked by Dhananath Fernando in an interview with him what advice I would give to Cabraal to resolve Sri Lanka’s rapidly worsening economic crisis. I said that he should dismantle the inappropriate economic policy stubbornly pursued by Governor W.D. Lakshman to imprison the rupee at 200 per US dollar, function as the Governor of the nation’s central bank and not of politicians’, abolish Gotabaya Rajapaksa’s tax concessions and revert to the old system, and make a public announcement that he will propose to the Government to seek IMF assistance (available at: https://www.facebook.com/indrakumar.gunasekera.7/videos/546227996930672/?mibextid=zDhOQc). Had Cabraal listened to this piece of advice in September 2021, the trigger of the economic crisis in the following year could have been avoided. 

The crisis that grew from simmering to boiling point in 2022 was manifested on multiple fronts: debt overhang, rupee depreciation, rapid rise in the general price level, negative economic growth, ballooning of budget gaps, and a rise in unemployment and poverty levels. The Government first introduced some home-grown policies like the suspension of the servicing of foreign borrowing from commercial lenders and from individual foreign countries, clamping of exchange and import controls, control of the prices of some selected food items, and the rationed distribution of fuel. Then, it agreed with IMF to implement a selected economic reform program as a condition for receiving an extended fund facility of $ 2.9 billion to be disbursed from 2023 to 2027

IMF to the rescue

The crisis that grew from simmering to boiling point in 2022 was manifested on multiple fronts: debt overhang, rupee depreciation, rapid rise in the general price level, negative economic growth, ballooning of budget gaps, and a rise in unemployment and poverty levels. The Government first introduced some home-grown policies like the suspension of the servicing of foreign borrowing from commercial lenders and from individual foreign countries, clamping of exchange and import controls, control of the prices of some selected food items, and the rationed distribution of fuel. Then, it agreed with IMF to implement a selected economic reform program as a condition for receiving an extended fund facility of $ 2.9 billion to be disbursed from 2023 to 2027. 

At the time when Dhananath Fernando had this conversation with Alanki, IMF had conducted the first review of the progress of the program and the release of the second instalment amounting to $ 330 million was hanging on balance. Subsequently, IMF made an announcement that it had reached a staff-level agreement with Sri Lankan officials to make its recommendation to the Executive Board for the release of the instalment. But that was contingent on Sri Lanka meeting three crucial loan covenants involving the finalisation of the foreign debt restructuring, boosting of Government revenue to target levels, and working on the designed path of accumulation of foreign reserves by the Central Bank.

Slow recovery associated with low growth

When the question was posed to Dhananath as to where Sri Lanka stands now in its march toward recovery and ensuring economic growth, his answer was quick and straight. He said that some of the grave hardships like queues for fuel and cooking gas have eased, but the economy is not out of the woods. He said that one should look at the big picture to make the judgment. According to him, the crisis was understood by Sri Lankans in terms of long power cuts, queues for fuel, and non-availability of an essential input in urban kitchen, cooking gas. When these hardships are no longer to be seen, many might conclude that Sri Lanka does not have a crisis. But the big picture in the crisis is the same without a quick resolution. 

Sri Lanka still does not have sufficient foreign exchange balances to meet its requirements. When it will start repaying debt after it has been restructured, the higher foreign exchange outflow will be much more than the limited availability of inflows. Though Dhananath did not say it directly, what he implied was that the current stability in the exchange rate is not sustainable and it might start crashing at any time due to lack of a sufficient inflow of reign exchange reserves. The Government’s revenue performance is poor, and it cannot reduce the gap in the budget as planned. As a result, the central government debt is still ominously crushing the basic macroeconomy. 

He used a simple example to drive his point home. Suppose the economy is like a cake weighing 1 kg. The central government debt is 128% of that cake meaning the weight which the cake should bear now is 1.28 kg of debt. Hence, the economy getting crushed by the overwhelming weight of the central government debt cannot be avoided. Economic growth is still negative and even in the next few years it will grow at a very slow rate. He used another simple example to elaborate on his point. The cake has shrunk by 11% and its present weight is only about 900 g. If the economy grows by 3% in 2024, the size of the cake will only be 927 g, meaning that it has not returned to the previous level of the economy. Hence, this is not a situation where Sri Lankans can be complacent. 

Though the trigger point was in early 2022, the seeds of the crisis had begun to germinate known to everyone except the top politicians and policymakers of the country. The latter group had stubbornly refused to seek external support to come out of the problem

No more tax increases in a shrunk economy

Agreeing with Alanki, Dhananath said that in the underperforming economy of Sri Lanka, the Government cannot increase taxes anymore without damaging the economic spirits of people. He said that the belief that the tax revenue can be increased by increasing the tax rates is erroneous. That is because, after a high marginal tax rate, people will realise that the income that they get will be purposeless. Hence, they start withdrawing their labour from the existing levels, if it is the local economy, and leave for jobs in foreign countries, if they offer better prospects. Therefore, instead of tax revenue increasing, at high marginal rates, revenue will start falling. 

Even though Sri Lanka is still on the rising part of the Laffer Curve, any increase in the rate will not generate additional revenue due to the shrunk tax base arising from the shrinking economy. Hence, it will simply accelerate the current outflow of professionals from Sri Lanka seeking greener pastures elsewhere. Consequently, with the resulting depleted technical skills, the chances of recovering the slow-moving economy will further be dimmed. It is like the economy getting hit by a double whammy. Consequently, President Ranil Wickremesinghe is also poised to make the same mistake at a different level on IMF’s advice

Inapplicable Laffer Curve

This is the famous Laffer Curve Analysis named after the American economist Arthur Laffer. According to Laffer, when the tax rate is increased, it starts increasing the revenue at a decreasing rate, reaches a peak and then starts falling taking the shape of an upturned half-coconut shell. His observation was that if you are on the rising part of the curve, any increase in the rate will increase the revenue and vice versa. If you are in the falling side of the curve, any reduction in the rate will increase the tax revenue. If you do not appreciate this difference and adopt the wrong tax measure, you will end up with disastrous results. This was the mistake made by the President Gotabaya Rajapaksa when he cut the tax rates in December 2019. 

Sri Lanka was on the rising side of the curve and hence, when the taxes were cut, the country experienced a massive drop in the revenue. I warned Gotabaya Rajapaksa in December 2019 about the inapplicable use of the Laffer Curve Analysis for Sri Lanka and advised him that he should withdraw the disastrous tax cut immediately (available at: https://www.ft.lk/columns/Tax-cuts-Control-the-damage-before-the-unconventional-stimulus-backfires/4-691207). But this was not heeded to. Then, I renewed this call with Basil Rajapaksa when he became the Finance Minister in July 2021 which call falling on the deaf ears again (available at: https://www.ft.lk/columns/Challenge-before-the-new-Finance-Minister-Choice-between-pragmatism-and-dogmatic-ideals/4-720282). Even though Sri Lanka is still on the rising part of the Laffer Curve, any increase in the rate will not generate additional revenue due to the shrunk tax base arising from the shrinking economy. 

Hence, it will simply accelerate the current outflow of professionals from Sri Lanka seeking greener pastures elsewhere. Consequently, with the resulting depleted technical skills, the chances of recovering the slow-moving economy will further be dimmed. It is like the economy getting hit by a double whammy. Consequently, President Ranil Wickremesinghe is also poised to make the same mistake at a different level on IMF’s advice.

Perilous state of fiscal sector

How should the Government, then, manage its finances? Dhananath said that one avenue available is the reform of the loss-making State-owned enterprises of SOEs to make them profitable. It is a medium to long-term goal and hence, its results will not be felt immediately. But it is a policy which should be pursued by the Government with vigour, rigour, and commitment. That is because it will in the medium to long-term plug the draining of public resources to meet their losses. Hence, what can the Wickremesinghe administration put into practice immediately to cope with the burgeoning gap in the public finances? IMF advises the Government to increase the revenue which is known as ‘revenue-based fiscal consolidation’ in finance circles. But it has come to its peak and no more increases in revenue is possible to meet the present budget gaps. 

What should be done is to use a hybrid in which both revenue and expenditure cutting will play an equal role. Dhananath did not talk about it because he was not asked. But the sane fiscal policy to be adopted is the placing of the expenditure side of the budget on a strict expenditure cut immediately. The proposed net expenditure plan for 2024 which the Parliament should approve along with the passing of the Budget 2024 amounts to Rs. 6.53 trillion, up by 12% over the net expenditure of Rs. 5.85 trillion in 2023. 

With an inflation rate of near zero, this is an unaffordable increase in the real net expenditure of the Government. It is also 20% of the estimated GDP of the year. If the planned budget deficit is 9%, it will amount to Rs. 2.9 trillion requiring the Government to raise Rs. 3.6 trillion or 11% of GDP as revenue. This is an ambitious target of increasing the revenue from the current level of Rs. 2.7 trillion. Hence, the Government has no choice but to tighten its belts to the maximum level possible in the years to come.

When the question was posed to Dhananath as to where Sri Lanka stands now in its march toward recovery and ensuring economic growth, his answer was quick and straight. He said that some of the grave hardships like queues for fuel and cooking gas have eased, but the economy is not out of the woods. He said that one should look at the big picture to make the judgment. According to him, the crisis was understood by Sri Lankans in terms of long power cuts, queues for fuel, and non-availability of an essential input in urban kitchen, cooking gas. When these hardships are no longer to be seen, many might conclude that Sri Lanka does not have a crisis. But the big picture in the crisis is the same without a quick resolution

Debunking myth of lowering inflation

The Central Bank through its extremely tight monetary policy has brought down the inflation rate from about 70% a year ago to less than 2% in September. This is a remarkable achievement, and it has been hailed by many, including the IMF, as a success story. Dhananath revealed the myth behind this success story by distinguishing between the cost of living and inflation rate. We can amplify his position with relevant numbers. 

The cost of living is the increase in the consumer budget of a typical Sri Lankan family of nearly four people. This was Rs. 91,880 in January 2021. This has accelerated to Rs. 175,491 by September 2023. Though the inflation rate is down to less than 2%, a family still faces an increased cost on consumption goods that reduces its welfare level. This is without the increase in the prices of investment goods that has affected the livelihood of people. Again, the reduced income levels over the increase in the consumption goods is a double whammy affecting the people. Though the reduction in inflation rate is good for the Central Bank as an indicator for its monetary policy, it is not a valid argument for measuring the welfare level of people if their income has not correspondingly increased.

Example set by interviewee and interviewer 

There is another important observation about the interviewee and the interviewer. Dhananath maintained his sober composure throughout the interview even when some embarrassing questions were raised. He did not get angry and call names for the interviewer as it always happens with respect to interviews with political authorities in the country. Interviewer Alanki did not jump in between answers and act as an obstacle for giving a full answer. They both are examples for others.

(The writer, a former Deputy Governor of the Central Bank of Sri Lanka, can be reached at [email protected].)