Sri Lanka is fearing more economic instability in 2016, with little being done to fix the budget that went off the rails in 2015 and debt repayments looming, but several corrections have already occurred.
Is the situation as bad as in April 2015, when a rate cut added further instability to a credit system derailed by a revised budget in January with a 40% wage hike? In 2015, the budget deficit was planned at Rs499 billion. The revised number in the parliament was Rs670 billion – Rs750-800 billion may be more accurate.
Monthly tax revenues, which were Rs89 billion in January, rose to Rs145 billion in December. Surprisingly, in November and December, according to Treasury data, a revenue surplus of Rs15 and Rs5 billion rupees were seen. Of course, the October, November and December tax revenues are bloated with super gains taxes and car imports.
But even if monthly revenues were pushed up to Rs120 billion a month and not Rs140 billion, that is still a big improvement from January 2015. The rupee has depreciated sharply, so import and domestic taxes will go up as nominal prices increase.
For 2016, a deficit of Rs740 billion is projected with a public investment of Rs868 billion. This is probably an exaggeration, as over the past several years, with massive Chinese finance, Sri Lanka was able to invest only about Rs500 billion or less.
The good news is that there is no public sector salary increment this year or further increases in pensions. So this wage freeze type of action is a key ‘fiscal consolidation’ that will help finances limp back to some kind of stability. However, the rupee depreciation will increase the medicine and fertilizer bill.
[pullquote]One of the key reasons Sri Lanka’s tax revenues are not high enough is because energy taxes are not charged from the affluent, and state enterprises do not pay taxes or dividends[/pullquote]
Car imports have already fallen with credit restrictions and tax hikes. Credit will now shift more to non-car imports, which means areas where the tax take per dollar spent will be lower. That is bad news for the budget, but that is the type of weird policy Sri Lanka follows, and this column warned more than a year ago that politicians and bureaucrats will do this – as usual.
Hybrid and electric cars not bringing in as much ongoing taxes as conventional petrol engines or ones with super diesel are contributing less in initial import duties to build roads. Electric cars are a total tax loss. This is a typical green scam that allows rich people and businessmen to exploit the tax system like all renewable energy sources. Ironically, in Sri Lanka, electric cars are driven by coal. The new administration’s decision to tax them at higher levels was a good one, although the level of taxes should not be prohibitive. However, with many more new cars on the road – other than electric cars – fuel usage will go up, giving more opportunities to collect taxes.
Non-interventionist fuel pricing
This is where any fuel pricing formula must be carefully structured. There shouldn’t just be a formula; there should be a cost plus non-interventionist pricing. One of the key reasons Sri Lanka’s tax revenues are not high enough is because energy taxes are not charged from the affluent, and state enterprises do not pay taxes or dividends. Although electricity is heavily overpriced for bigger home users, that money does not show up as taxes either, but are frittered away in cross subsidies.
[pullquote]“The devaluation of a country’s currency has now become a regular means of restricting imports and expropriating foreign capital. It is one of the methods of economic nationalism.”
– Mises[/pullquote]
The so-called Yahapalana administration sharply cut kerosene prices. During the much maligned Mahinda Rajapaksa administration, the price of kerosene (which is basically jet fuel and more expensive to import than petrol and diesel) was raised because several large industries were the biggest consumers, as former Treasury Secretary P B Jayasundera pointed out. The charitable think it was a stupid move to bring down kerosene prices, but the uncharitable believe it was a calculated move to reward supporters of the former administration who have now wormed their way into the good books of the bigwigs in the current ruling party.
If Sri Lanka’s tax-to-GDP ratio is to move up, diesel – a carcinogenic substance – should be priced higher than petrol, and kerosene should be priced the highest with a 15% or 20% VAT. In some countries, road diesel is priced higher than agricultural diesel (farm equipment do not travel on public roads and damage them), but this is probably not practical in Sri Lanka and is a good way to recoup some of the subsidies given to agriculture.
Market pricing kerosene and diesel will also allow some taxes to be collected from the fisheries sector, which is are now not contributing much to the taxation system.
Value-added tax (VAT)
Ideally, Sri Lanka should raise VAT to 20% and get rid of all other problem taxes, and lower import duties. This is a good time to raise VAT, as global commodity prices are stable. In fact, instead of depreciating the rupee, VAT should have been raised to 20% across the board. That way, more revenue would have come in, and people’s savings and salaries would not have been damaged. But with a sharp increase in public sector wages, it was perhaps inevitable that the rupee was allowed to fall so that real wages are destroyed.
This is the ‘austerity’ that the poor and the private sector worker have to bear due to the profligacy and greed of the rulers and state workers. However, it is easy to do so in Sri Lanka since the urban intelligentsia – economists and analysts who are steeped in neo-mercantilism from soon after they are born – do not believe in the concept of sound money. Currency depreciation can always be blamed on external factors, not loose policy, and held out as being an advantage.
“The days are gone in which most persons in authority considered the stability of foreign exchange rates to be an advantage,” explained Ludwig von Mises, a philosopher and economist, in 1944.
“The devaluation of a country’s currency has now become a regular means of restricting imports and expropriating foreign capital. It is one of the methods of economic nationalism.”
These ideas were reinforced during the post-World War II Bretton Woods system when soft-pegs made currency collapses inevitable, and all kinds of ideas based on econometrics such as ‘overvalued’ currencies were given as the excuse for the sudden epidemic of devaluations by the ideological backers of soft-pegs. In fact, it is amusing to see so many intelligent people claiming that the rupee was ‘overvalued’ and having to depreciate when IMF research – based on the same econometrics that overvaluation is supposedly calculated – showed no such thing.
Charging a high level of VAT from fuel and electricity has another advantage. It allows exporters to recoup the taxes and be export competitive. In fact, adjusting electricity prices every month (or every three months) and allowing competition in fuel pricing will help keep the exchange rate stable, like in Singapore.
The VAT invoice should be given to all customers. At the moment, ordinary people are not given VAT invoices, which hides the burden on the state. This is important for democracy. The manipulation of billing software and accounting books permits this kind of deception, which has also encouraged VAT fraud by forcing businesses to have two sets of books.
Monetary policy
It was bad move to raise the statutory reserve ratio. That constraints growth, making the credit system inefficient, without giving any benefit. If Sri Lanka has to grow, SRR should be brought down.
Sri Lanka should learn from Hong Kong and Singapore instead of paying lip service only.
The 50 basis point rate hike, although coming too late, is a good move and has gone some way to reduce the damage done by the rate cut in April 2015. Fortunately, from around the third quarter, banks have been raising deposit rates. Bank deposit rates are now up about 200 basis points. At higher deposit rates, more resources will be generated for lending and investment by curbing consumption.
[pullquote]In Sri Lanka, there is a peculiar idea among central bankers that raising rates is the end of the world; it is not so[/pullquote]
In Sri Lanka, there is a peculiar idea among central bankers that raising rates is the end of the world; it is not so. Economic growth will continue on the tightening cycle as well. What happens in Sri Lanka is that the tightening cycle is delayed and credit growth generates, and the balance of payments crisis and the country goes into a hard landing.
Deposit rates went up because, by defending the dollar peg (unsterilized forex sales), liquidity was killed and the system tightened, despite fresh liquidity being injected. This shows how important it is to defend the peg when money is printed. Only when reserves are lost do authorities wake up. But if the currency is depreciated, loose policy will continue for some time.
Although there have been many warnings about impending foreign debt repayments, if the monetary policy is right, any foreign debt can be repaid by curbing an equivalent volume of domestic credit. The inability to repay foreign loans comes up when the Central Bank buys treasury bills and pushes domestic credit to unsustainable levels.
This is an idea that most people find difficult to grasp.
Currency depreciation also scares away foreign lenders and prevents them from rolling over debt. This is an idea that everyone can easily understand.
Depreciation
In Sri Lanka, because rate rises are delayed, there is usually a credit or currency collapse. When both happen, domestic disposable income is badly hit. If there is only a credit slowdown and no currency collapse, the recovery would be faster. In 2009, that is what happened. The rupee fell to 118, but when credit slowed, it was allowed to come back to earlier levels.
In the old days, especially in times of commodity exports, a currency collapse led to an ‘export surplus’, as the domestic population was made destitute and could no longer consume. We had a similar effect in 2012 and, in fact, it probably helped the last administration lose power.
Old timers also talk of the ‘J’ curve, which later research shows, does not seem to apply in many countries.
However, there can be J curve like behaviour when a currency collapse occurs due to a global monetary problem. In many countries, currencies collapse because economies in developing countries go through internal problems that cause currency movements.
A credit slowdown in the US, for example, may cause the US dollar to go up, along with a domestic economic crunch that hurts import demand (2009). In that case, regardless of whether the currency of an export country is devalued or not, exports will fall and then pick up when the importing developed nation stabilizes.
But export promoters in any case will try to use such effects to prove a J curve and call for devaluation.
Exporters like devaluation because their real salaries are destroyed, and they can pay workers less and make more profits. Alternatively, they can try to win a bigger market share based on slave salaries. In Sri Lanka, there is an additional incentive to ask for devaluation. That is because utility prices (like energy and water) also do not move with the currency.
Already, because many exporters are borrowing in dollars, they are no longer as strident as they were in calling for devaluation. To block calls for devaluation (and generate spurious J curves that will generate further calls for devaluation) is another reason to adjust energy and water prices every month or every three months with a hefty VAT included.