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Tuesday May 30th, 2023

Sri Lanka budget 2022: 9.8-pct of GDP deficit to be funded locally, repeats windfall taxes

ECONOMYNEXT – Sri Lanka is planning to finance a 9.8 percent of gross domestic product budget deficit or 1,807 billion rupees domestically and has continued a policy of deadly retrospective windfall taxes started by the failed 2015 administration in a budget for 2022.

The budget also returned to a cascading 2.5 percent turnover tax, whimsically calling it a ‘social security contribution’, in trying to reverse a policy error involving a steep valued added cut in 2019 to create what policy makers call a ‘production economy’ which is said to exist elsewhere.

The VAT cut devastated state finances and led to severe monetary instability, and an external crisis involving possible sovereign default as the central bank tried to keep rates down in the face of the deficit by printing money.

The tax cuts as well as the attempt to keep rates down despite the deficit has led to cascading policy errors involving import controls, exchange controls and forex surrender requirements as well as the seeking of credit lines for consumption imports which tend to push up external debt.

In 2021 revenues is estimated to have recovered 13.3 percent to 1,556 billion rupees from 1,373 billion rupees. However revenues are were still down from 1,890 billion in 2019 when the VAT framework was intact.

The overall deficit for 2021 had been revised up to 1,826 billion rupees or 11.1 percent of GDP in the budget.

Going by past experience the final deficit tends to go up from what is presented in the budget.

Current spending at 2,817 billion rupees in 2021 is estimated to have come down to 17.1 percent of GDP from 17.8 percent in 2020.

Current Expenditure

Sri Lanka’s current spending had ratcheted up to over 17 percent of GDP from 12.2 percent in 2014 when the disastrous ‘revenue based fiscal consolidation’ debacle started in 2015 throwing spending based consolidation out of the window hiking subsidies and salaries.

Politicians were led to believe by the International Monetary Fund among others, that there were large volumes of untaxed money just waiting to be plucked via ‘revenue based fiscal consolidation’.

Classical economist B R Shenoy has said ‘revenue based fiscal consolidation’ is a ‘statistical’ method of balancing budgets which is not founded on the political realities of democracies, and will devastate the private savings available for investment and future growth.

The budget for 2021 at least has made token gestures towards cutting spending, including a freeze on salaries except teachers who have agitated and won a 30 billion rupees pay rise.

Finance Minister Basil Rajapaksa also promised to enact legislation to stop supplementary estimates, or midway increases in spending which may legally block further salary hikes.

Rajapaksa, who of late has displayed a tendency to speak plainly of late said the public sector was an unbearable (uhu-lun-ner barry) burden on other sectors.


Sri Lanka public sector ‘unbearable burden’: Finance Minister

The public sector has been bloated by unemployed graduates in a policy driven by the Janatha Vimukthi Peramuna in 2004, and was latched on to the Sri Lanka Freedom Party led coalition and has been continued ever since.

Tax Policy Reversal

After severely undermining the Value Added Tax regime with the 2019 cuts, the current budget is trying to shore up revenues by resorting to a new cascading Social Security Contribution.

Sri Lanka tried to end cascading turnover taxes with the introduction of GST/Value added taxes in the mid 1990s, but bureaucrats keep bringing them back.

Cascading taxes tend to give high tax yields while adding to end prices and undermining export competitiveness.

The budget has also continued a policy started in 2015 of charging retrospective windfall taxes from large companies, calling it a ’25 percent surcharge’.

The 2015 budget as part of efforts to bridge the 100 day program heedless spending, brought it a windfall tax labeling it a ‘super gains tax’ starting a new deadly trend in regime uncertainty.

Several rent-seeking import substitution business had made actual windfalls in 2021, exploiting consumers under cover of import controls, analysts say.

Windfall taxes are now being shown to be a habit.

Other than the windfall tax, which is expected to destroy 100 billion rupees of investible capital in 2021, no other investment destroying income taxes have been increased.

However both taxes will go some way to bridge the deficit, which is required to help bring some stability to state finances and the external sector by reducing the corrective interest rates that is required in 2022 to prevent a monetary meltdown and default.

Domestically Financed

The 2022 budget is planning a 8.8 percent budget deficit or 1,658 billion rupees, down from an 1,826 billion rupee or 11.1 percent deficit in 2021 which is still not final.

The 2021 deficit was financed with 962 billion rupees in printed money of which 331 billion rupees was absorbed in a reserve money expansion and inflation and the rest went out in a balance of payments deficit.

According to revised estimated a deficit of 1,874 billion rupees or 11.4 percent of GDP was financed domestically with 48 billion rupees being repaid on a net basis on foreign borrowings.

In 2022, the finance ministry is expecting to repay 179 billion rupees in foreign borrowings pushing up the domestic borrowings 1,807 billion rupees, which is one percent of GDP higher than the 8.8 percent deficit.

The 9.8 percent number is under 10 percent, but Sri Lanka has a history of exceeding projected deficits.

The interest bill for 2022 is projected at 1,115 billion rupees up from 1,055 billion in 2021. Analysts expects 2022 to require higher interest rates to fix the external crisis and end money printing.

However there may be room to cut capital spending. It is also not clear whether the planned land sales are including in non-tax revenues and how it may help the budget.

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Sri Lanka rupee at 296.75/297.25 to dollar at open, bond yields steady

ECONOMYNEXT – Sri Lanka’s rupee opened at 297 /297.50 against the US dollar in the spot market on Monday, while bond yields were steady, dealers said.

The rupee closed at 296.75 /297.25 to the US dollar on Monday after opening around 296.50 /297.50 rupees.

A bond maturing on 01.09.2027 was quoted at 26.50/75 percent steady from Friday’s close at 26.50/65 percent.

Sri Lanka’s rupee is appreciating amid negative private credit which has reduced outflows after the central bank hiked rates and stopped printing money. (Colombo/ May 29/2023)

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Sri Lanka rupee appreciation squeezes exporters

ECONOMYNEXT – Sri Lanka’s recent appreciation is starting to squeeze apparel exporters as their domestic costs including wages and energy, were hiked over recent months, when the rupee fell steeply, an industry official said.

Companies had raised salaries and emoluments at rates averaging 25 percent for workers while transport costs have also gone up but not has come down, Yohan Lawrence Director General of the Join Apparel Association Forum said.

Apparel factories in particular also provide transport and some meals for workers.

Electricity prices have also been hiked, based on the rupee which was weaker. A tariff cut is expected from June after the rupee appreciated and imported fuel prices fell.

Sri Lanka’s rupee collapsed in 2022 from 200 to 360 to the US dollar as interest rates were suppressed with liquidity injections and a failed attempt was made to float the rupee with surrender requirement in place.

From the second half of 2022, with higher interest rates and negative private credit, the central bank has avoided printing money under conditions which are generally accepted to be difficult, and is broadly running deflationary open market operations, triggering a balance of payments surplus and putting the rupee under upward pressure.

Central bank net credit to government which was 3,302 billion rupees in September in 2022, was down to 3,209 billion rupees by March 2023, part of which was due to rollovers, analysts say.

Market pricing of fuel and electricity by the Ministry of Energy and also spending controls and tax hikes buy have also helped contain domestic credit.

Sri Lanka also has mandatory conversion rules, imposed on exporters, which is a concern for exporters.

“We believe rupee should be at its natural level, but with forced conversions you won’t get the correct picture,” Lawrence said.

Sri Lanka has to release a plan to remove import controls, exchange controls and other restrictions imposed in the period where policy rates were suppressed with liquidity injections (so-called multiple currency practices and capital flow measures) by June under the IMF program.

Apparel exporters have also seen orders fall amid tighter conditions in Western markets.

The central bank has to peg (intervene actively in forex markets and create money) to meet reserve targets under an IMF program and cannot free float (avoid creating money through international operations) the rupee.

The newly created money has generally been absorbed in an overnight liquidity shortage.

There have also been foreign purchases of rupee Treasuries. Amid a contraction in credit, the inflows also do not turn into imports fast as the money if the money is spent.

By making purchases a little below what is allowed by the contraction in domestic credit, the rupee can be allowed to appreciate, analysts say.

The central bank has so far allowed the rupee to appreciate to around 300 to the US dollar from 360 levels under a transparent guidance peg up to February.

Except after the 2008/2009 currency crisis, Sri Lanka’s central bank has not previously allowed to the rupee to appreciate under IMF programs where the first year in particular sees balance of payments surpluses, before private credit and domestic investments picks up again.

One of the considerations used by third world central banks are Real Effective Exchange Rate indices.

The REER of the Sri Lanka rupee based on a basket of currencies calculated by the central bank was 61.12 points in February before the rupee was allowed to appreciate by lifting a surrender rule.

In March the index went up to 69.55 points, but remained steeply below 100. Real effective exchange rates are calculated also taking into account inflation in counterpart trading nations.

Sri Lanka’s inflation index had hardly risen since September amid rupee gains. Falling food prices can help contain pressure for further wage hikes, analysts say. (Colombo/May30/2023)

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Sri Lanka forum to discuss central bank independence vs sound money

ECONOMYNEXT – Central bank independence and sound money will be under discussion at a public event organized by the Sri Lanka chapter of the Bastiat Society today, May 30, as island is recovering from the worst episode of monetary instability since independence.

The forum will feature Lawrence H White, Professor of Economics at George Mason University in the US, and W A Wijewardene, former Deputy Central Bank Governor, of the Central Bank of Sri Lanka.

“The discussion will compare the current system against alternative systems and explore the relationship between such banking systems and sound money,” the organizers said.

White specializes in the theory and history of banking and money. He is the author of “The Clash of Economic Ideas” (2012), “The Theory of Monetary Institutions” (1999), “Free Banking in Britain” (2nd ed., 1995), and “Competition and Currency” (1989).

Wijewardene has been speaking on central bank independence in Sri Lanka long before it became a topic of wider discussion, but also on accountability.

In April, a Central Bank Independence and Other Matters, which includes a collection of his orations on the subject over the years as well a recent development was published.

The discussion comes as independent central banks in the West have created the worst inflation since the 1970s and early 1980s and are apparently unaccountable to parliaments and the public.

The early 1980s also saw the first wave of external debt crises in so-called soft-pegged countries in Latin America and Eastern Europe in particular as the US and UK tightened policy to end the Great Inflation.

The discussion will be held at 7.00 pm at the Lakmahal Community Library and those interested can register online, the organizers said. (Colombo/May30/2023)

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