Budget beyond numbers

Former Central Bank Deputy Governor W.A. Wijewardena - Pic by Daminda Harsha Perera

Ladies and gentlemen, when I was asked to speak at this forum, I was more than happy to accept. I’m a free man now with no obligations to anyone so I can speak whatever I like; because of this I accepted the invitation. 

Whenever a Budget is presented in Parliament, I always look at how the business sector would respond to the Budget. I always see the same thing year after year, that it is an “Investment-friendly, business-friendly, people-friendly Budget”. Now this year also I have seen the same response coming from the same business community. 

But of course I can understand the sentiments of the business community because about 400 years ago in 1681 when the French Finance Minister Jean-Baptise Colbert invited business leaders to the palace and he was so enthusiastic about making a turnaround in the French economy, he asked the business leaders, “What can I do from the Government for you?” The answer given by the business leaders was very sharp, they said in French: “Leave us alone.” 

So the particular statement made by the business leaders at that time became one of the core principles of economics, which simply asks the Government to leave us alone. Probably the sentiments expressed by the business leaders after every Budget is the way to say “leave us alone” today. 

 

Economic challenges 

Why I say so is we know we are in a Budget crisis. The Prime Minister in his economic policy statement has highlighted this and the Finance Minister in the Budget has highlighted it but still the private sector is doing well. So we don’t need a Government, we don’t need a Budget. What we need is for the Government to leave the private sector alone so without imposing any impeding barriers. 

The test is to see whether this Budget has taken some of the barriers out or imposed new barriers that would impede the growth of the private sector in the economy of this country. Some critical background, which has also been presented by the Prime Minister and Finance Minister, is that we are at the doorstep of an economic crisis. Of course if you read the Central Bank Annual Report you don’t see this but if you see the analysis done by independent analysts, it is clear.

We are in a foreign exchange, fiscal and economic crisis and therefore need to find solutions for that. We have a fragile external sector, everybody is worried about the Sri Lankan Rupee today, which is threatening to depreciate daily, and the Minister of Finance is worried the country does not have enough money to pay the debt. If we don’t have enough reserves, we are actually heading towards a bigger and unavoidable foreign exchange crisis in the country.

Then the other problem that we have is people in Sri Lanka think everything is an entitlement. A motor car is an entitlement, the Budget is an entitlement, and cost of living reduction by the Budget is an entitlement. We are living in an era of entitlement and this is what the Minister of Finance has to tackle when he presents the Budget. 

Then the low productivity and the high cost of production, the inefficient and unproductive infrastructure and simple technology-based manufacturing and this is the background within which the Minister of Finance has presented his Budget. So I think we have to congratulate him for undertaking this during a challenging time. 

 

Social market economy

The economic policy package presented by the Prime Minister and later the Budget is based on social market economy, which is a hybrid of market system and a facilitating government. This is a new concept for Sri Lanka but it is borrowed from Germany. 

In post-war Germany the leaders were scared of the rising communism in the East of Germany and the uncontrolled capitalist growth towards the West of Germany so they wanted a hybrid. So this same hybrid has now been adapted for Sri Lanka so we have a new ideal called the social-market economy and the Budget is based on that.

So this particular policy statement by the Prime Minister says it focuses on the creation of wealth through international trade because Sri Lanka does not have many resources; even though many people think we are resource rich, the only resource we have is human resources. Therefore growth would be done through the improvement of trade, specifically exports, which mean producing for a market bigger than the domestic economy. 

Then the development of human capital, introduction to technology advancement and innovations are the other ingredients along with removal of barriers, increasing competition for the private sector are the key pillars of the economic policy perceived by the Government. 

Finally, the policy statement addresses issues of environment, rising income gap, social security for the aged and safety nets for the vulnerable groups. So it’s a hybrid that puts the free market economy with the Government participating as a participating agent to address the social issues of the country.

The economic policy has several targets: one target is to discipline the Budget. The Prime Minister has very correctly said Sri Lanka had been living beyond its earnings. So what we mean by disciplining the Budget is that the Budget has to live within its income. 

There have been two quantitative targets set by the Prime Minister. One is to mainly reduce the currently high budget deficit to 3.5% by 2020 and have a dramatic transformation in the tax structure, which is highly skewed to indirect taxes today where we earn about 80% of revenue by indirect taxes and the balance 20% by direct taxes. The Prime Minister wants to change the structure so that we have a lower percentage of indirect taxes at 60% and increase direct taxation from 20% to 40%. 

The Budget also introduced economy-wide reforms that look at reducing loss making by State Owned Enterprises, amalgamating EPF and ETF and setting up a social security board which he calls the Pension Fund and then the removal of barriers to business, improving investment through low tax regimes and land ownership and protection of business and finally improving tourism, infrastructure and services. 

Now these are the targets of the new Government to be realised in the next five-year period. The Budget has to lay the foundation for the Government to facilitate attaining these targets. Therefore Budget 2016 has allocated more than Rs. 70 b for education and research. It has also proposed wide-ranging economic reforms and has undertaken to turn around the loss-making State-Owned Enterprises, develop roads and railway transportation, providing incentives for investments through better investment management, rationalising subsidies that has ballooned in the recent past, introducing new technology and national digital identity that is a novel thing for Sri Lanka.  

 

Numbers game 

Now when we look at the plus points of the Budget, in fact we can all be happy because the Government has laid the foundation for a sustainable economic growth over the next five-year period. Therefore I feel I can agree with the Chambers even though they have simply repeated what they said the previous year that the Budget is “business-friendly” and “economy-friendly.” 

But what matters is, what are these Budgets? Now you may recall George W. Bush, the former President of USA, when he was asked what a Budget was, said “it’s a document with lots of numbers,” and here also we find it is a document with lots of numbers presented at the time of presenting of the Budget but at the end of the year when we look at the Budget we miss all the budgetary targets. 

Unfortunately for Sri Lanka we don’t have an effective mechanism to monitor the Budget, the Parliament doesn’t do that, the business community, which is highly thrilled about the Budget, does not do that, the civil society organisations do not do it and the media is also silent on the missing of budgetary targets. Now of course I have given you the Interim Budget that was presented in January but this is valid for all the budgets that we have presented in Parliament since Independence. 

If you look at the Interim Budget of 2015, the revenue target was 13.6% of GDP but actual realisation, according to provisional data, was 13.1%; recurrent expenditure had been kept at 13.7% of GDP but we have overshot this at 14.6% of GDP. The deficit in the revenue account where the Government is making a saving, which we call dis-saving here because it’s a deficit, was targeted at a very small sum of Rs. 47 billion, which was 0.4% of GDP but the actual realisation is going to be about Rs. 180 b, which is 1.8% of GDP. 

The budget deficit is also planned at 4.4% of GDP but has grown to 6% of GDP but my data says it will be around 8% of GDP by the end of the year. But on one account we have done better because on capital expenditure we planned to spend Rs. 482 b but have ended up spending Rs. 517 b. Therefore as George Bush said budgets are just numbers and don’t rely on those numbers. Look at the qualitative things that they have proposed and whether those things stand to reasoning and help us in overcoming the current economic crisis that we are facing. 

 

Meeting policy goals 

One reaction from an independent economist is that it doesn’t comply with the policy goals of the Prime Minister. He wanted to reduce the budget deficit; therefore the foundation has to be laid in this Budget itself but as the Budget has been presented by the Finance Minister, the deficit is still at 6%, which is not different from previous years and we have done nothing to meet the 2020 target.

Then the Prime Minister wanted to reduce the share of indirect taxes from 80% to 60% but what has been done is an increase of indirect taxes to 86% in Budget 2016. At the same time we have reduced direct taxes from 20% to 14%. So Budget 2016 goes against the wishes of the Prime Minister. 

The reason for indirect taxes are to be reduced is because they are regressive. Indirect taxes impact the poor people more than rich people so that is why the Prime Minister wanted to reduce indirect taxes by 2020 so the richer people of the country should take the larger burden of financing the Government Budget. But what we have done in Budget 2016 is we have made even income tax regressive this year with a flat interest rate of 15% above a tax free threshold of Rs. 2.4 million per annum; what you have done is even the richest man in the country pays 15% and the poor man also pays 15%. It is regressive. 

What I feel is that the foundation that has been laid by Budget 2016 is not in line with what the Prime Minister announced in the Economic Policy Statement and I wish the Finance Minister was present to hear this.  

 

Drawbacks of an EXIM Bank 

Then there are other drawbacks. There is a new proposal to set up an Import Export Bank or EXIM Bank. This has been a demand by some interested groups for many years because India, China and many other countries have EXIM Banks. They ask ‘if other countries can have it, why not us?’ The reason is that Sri Lanka’s export structure is still short-term stock; an EXIM Bank is needed or would be useful only when we move from the current export structure to medium-term exports – at that time an EXIM Bank would be useful. 

If there is indeed a need for an EXIM Bank, my view is let the private sector set it up, not the Government, because the Government has already burnt its fingers by getting into private banking. Now you may be aware that the funds of the EPF and ETF and others were used by the Government to buy the bigger shares in leading commercial banks and the Government got the power to appoint directors and chairmen and influence lending activities. So instead of exiting the current involvement with private banks, the Government is going to set up another bank. 

The reason I say this adventure is not viable for Sri Lanka is because this was done in the past. We set up an institution called the National Enterprise Bank, thinking that what is needed by Sri Lanka is banking facilities for its small and medium industries. The bank was placed under the Ministry of Industries and within one year it was bankrupt. Then we converted the World Bank funding infrastructure projects into another bank called Lankaputhra to fund the infrastructure activities of the country. But then the bank gave 85% of its loans to a new airline called Mihin Air and when Mihin Air became bankrupt, Lankaputhra Bank also went bankrupt.

So what the Treasury did without going before Parliament, which has to oversee public finance of the country, it stealthily took over the losses of Lankaputhra Bank and forced the Lankaputhra Bank to absorb the National Enterprise Bank. So it was a marriage between two sick people: the husband is sick, the wife is sick, therefore the output is also sick. Right now instead of dissolving these two banks the Finance Minister has suggested that Lankaputhra Bank should be amalgamated with the Regional Development Bank, which is doing reasonably well. So what you are doing is adding a sick wife to a little vibrant husband, again the output may not be good. So what is the use of having another State Bank?

If the Government and the private sector are so interested in an EXIM Bank, then let the private sector have this bank. Let them finance it, let them capitalise it. Because what happens when the Government gets into this banking business, eventually if the bank is in trouble the taxpayers’ money will have to be used to recapitalise it and we know taxpayers’ money has more important things to do than recapitalising bankrupt commercial banks. 

Mahapola University 

Then there is another proposal to set up a new university called the Mahapola University, just to pay tribute to a former leading personality, Lalith Athulathmudali, who started this breakthrough Mahapola scholarship policy. We have to honour him; there is no question about it. But when you set up universities in Sri Lanka, that has to be done in line with the national higher education policy, not by ad hoc plans to honour one man or another man.

If there is a genuine need to pay tribute to the late Lalith Athulathmudali, establish a Chair in Law in one of the Law Faculties of the existing universities in his name or convert the current Law Faculty of the Colombo University into a Law School and we can name it after Lalith Athulathmudali.

The current problems of the higher education sector will not be resolved by adding another university to the country. The current problem in higher education is consolidating the existing university system and improving its quality and getting academics to do more research so we can implement and realise this complex economic system the Prime Minister wants to have in the country. 

 

Taxing electric cars 

Another contradiction in Government policy is increasing duty of electric cars from 5% to 50%. This is despite the whole thrust of the Government being to establish an environmentally-friendly road transportation business.

I can remember when hybrid cars were entering the market, the former Treasury Secretary was advised that with hybrid cars in the end we would have a lot of batteries that would flood the country and we won’t know how to dispose of them. This prompted him to increase taxes on hybrid cars. Similarly I have heard that the country will be flooded by electric cars, but the world is moving away from traditional combustible engine to environmentally-friendly cars. So we are moving backwards. 

 

Banking disasters 

Then there are two disastrous project proposals in the Budget related to the banking sector. One thing is the banking sector taxes have increased, branding them along with tobacco, gaming and casino; taxes for the latter are called “sin taxes” because we want to stop them from expanding. For the first time banking has been branded as a sinful activity and they have raised taxes from 15% to 30%. 

Another issue in the Budget is that banks have been prohibited from undertaking leasing businesses and there is a history about this. You may recall that when the Western world was hit by the Great Depression, the US Government got the wisdom that the depression was due to banks engaging themselves in non-core activities. So in 1934 a special law called ‘Glass-Steagall Act’ was passed in the US, prohibiting commercial banks from undertaking investment banking. 

But the effect of the Act was disastrous for the US banking industry because banks are free enterprise ventures. Whenever there is a profit opportunity they will move into that so what the US banks did was set up subsidiaries in Europe, especially in London, and very freely undertook investment banking. So that is the birth of the Eurocurrency banking system outside the USA. But the mistake was realised by former President Bill Clinton and in 1998 this Act was repealed. Today in 2016 we are bringing back this repealed Act to Sri Lanka. 

Anyone who knows about leasing knows that leasing comes as a package of a loan. If you want to get part of your financial facility from a commercial bank and the leasing facility from another leasing company, you are moving from one institution to another. Because of this you have to provide banking under one roof. Now here we are asking the borrowers to get the financing facility from the commercial bank and get the leasing component from another company. Because the Budget itself has encouraged Sri Lankans to move into construction and invest abroad, they will have to get large-scale equipment under leasing and for that purpose I don’t think current leasing companies have the capacity. They do not have the resources base, nor do they have the technical knowledge, and they cannot manage it. This is another anomaly we have introduced in Budget 2016. 

 

Guarantees for finance  

The second anomaly is getting the Central Bank to guarantee all the deposits of all the finance companies in the country. I think is quite funny and something I have never seen. The Central Bank is the regulator. The very same regulator is also providing money, which is not something that happens elsewhere in the world.

But of course we have a deposit guarantee scheme where banks are also paying premium and both banks and finance companies have access to this insurance. But it is the company that has to take responsibility for bad management because they are paying the premium. But what is proposed in the Budget is for Central Bank to guarantee 100% of the deposits, which is not a small sum. As at the end of 2014 the total deposits of license finance companies amounted to Rs. 415 billion but the Central Bank has a capital base of only Rs. 82 billion. 

I think the Finance Minister will have the Central Bank becoming bankrupt before any of these finance companies become bankrupt. This is the hard message I have to deliver today because in my view the Finance Minister has either been ill-advised or misinformed. If the Central Bank does not have the capital, how can it guarantee deposits? The only way is to open the vault of the Central Bank and ask finance companies to appropriate the money in the vault. Everyone would love this. Then it can be said the Government has the responsibility to guarantee deposits but it cannot do this because the Government is already committed under the National Savings Bank (NSB) all deposits, which comes to about Rs.500b. 

So when we add the finance companies to NSB deposits, the Government will become bankrupt as tax revenue is only about Rs. 1.5 billion. So we must start thinking why this kind of policy has been brought in. These are bailout plans while the current trend in the world today is bail-in plans. We must encourage these institutions to bear the cost rather than the taxpayer and when we do so it sets a bad precedent and economists call it the “moral hazard” issue.

In simple terms you may remember a Rinso washing powder advertisement where the husband and children play a game of football and deliberately jump into mud and the poor mother has to clean the clothes after they come back home. Now this is what we mean by moral hazard because when someone else takes the responsibility for your own misbehaviour, there is no incentive to work cautiously and do your best. So what happens when the Central Bank guarantees these deposits is eventually it gives a license to the present owners of finance companies to run them badly, increase the probability of failing them and pass the cost on to the Central Bank and when this happens remember it is we who pay because printing of money increases inflation in the country. 

In addition, the Budget also proposes a cap on deposits for finance companies but by giving a guarantee you are encouraging depositors to remove their money from conventional banks and deposit them in finance companies. So this is a contradictory policy. I think this is something the Government will have to reconsider because if this happens the Central Bank will become bankrupt and it will also create lots of Rinso mothers in the country. So this is my reading of the Budget. It has good sides as well as bad sides but I hope the authorities will be able to make corrections to the Budget and come up with a proper budgetary statement. Thank you very much!