ECONOMYNEXT- Sri Lanka should avoid ambitious short term goals amid fiscal constraints and make long-term economic reforms for sustained gains to avoid economic instability, an economist said as the island slashed taxes, which was later followed by a rate cut.

“The only way that this short term risk can be managed is if the government sets very modest public investment targets, and sets a measured pace for recovery of the Sri Lankan economy, without going steaming ahead with very ambitious targets,” Dushni Weerakoon, Executive Director of the Institute of Policy Studies (IPS), delivering a lecture in the memory of Gamini Corea, a former civil servant and economist.

“We should avoid setting over ambitious targets for growth that can undermine macro stability and hinder debt sustainability, which can lead to a short-lived economic boom, which may bring us back to the kind of boom-bust cycles we’ve seen in the past.”

“In this constrained space, short term growth objectives have to be balanced with long-term solutions to ensure that there is some degree of confidence that we can get out of this.”

Sri Lanka has slashed direct taxes for a wide range of businesses, which would boost investments, jobs and growth by pushing up investible capital, but has also slashed value added tax from 15 to 08 percent, which will hit state revenues.

The central bank cut rates Friday, as domestic interest rates were edging up, indicating that the economy was beginning to pick up (private credit), or state credit pressure was beginning to build, or both.

Weerakoon said it was :not surprising that the government would use fiscal and monetary stimulus to provide an initial boost.

With falling tax revenues from the stimulus, the government has planned on better management of state-owned enterprises to balance the shortfall, but pressure is building up on promises to give thousands of state-sector jobs, Weerakoon said.

Long-term policies which will provide some assurance to investors are needed as Sri Lanka goes to international capital markets to rollover debt, Weerakoon said.

She said reforms are required to promote the countries export sector and ensure mounting debt is paid back sustainably with non-debt inflows.

Dilemma

Weerakoon said the Sri Lankan economy is now facing a dilemma, amid a peak debt repayment season.

Debt, of which half is foreign borrowings, has grown to 85 percent of gross domestic product (GDP), rising after 2015 as well, she said.

“The fact is we borrowed but didn’t plan on how to repay that debt,” Weerakoon said.

“The dilemma is that you need some degree of fiscal consolidation to get to some comfortable level of debt sustainability.”

“But, fiscal conslidation means we have to raise taxes, and cut spending.”

“However, growth has to pick up, and that calls for some loosening of fiscal policy, but that means debt outlook will worsen as well.”

Already, ratings agencies Moody’s and Fitch have cut the outlook for Sri Lanka’s sovereign rating, threatening to push up premiums for debt rollover the state plans to undertake in 2020.

Weerakoon said there is consensus among economists that growth is the best solution for debt, which the current government will focus on as its priority for the year.

She said while the corporate, personal and consumption tax cuts undertaken were the least harmful to the economy, the benefits will take some time to trickle down.

The main problem, Weerakoon said, was post-war Sri Lanka focusing on the non-tradable sector for growth, instead of export-oriented industries.

With an economy of just over 20 million consumers, Sri Lanka cannot sustain high growth for 10 to 15 years without generating demand for goods and services from larger markets, she said.

Initial growth following the war reached 7 percent, but has by now slowed down to 2 percent or under, she said.

“We’ve relied on construction, and mining. When that happens, then the economy is dependent on consumption for growth.”

“When taxes are raised, and the focus is on fiscal consolidation, consumption falls and there’s no easy option to recover.”

“If the economy is export oriented, then we can export the surplus.”

“Because our economy was dependent on domestic consumption, then reviving growth takes a little more time.”

“That requires a few more complex policy measures to be adopted.”

The short-term post-war boom being fuelled by construction meant revenues did not increase at the same pace as growth, challenging the country’s fiscal balances, Weerakon said.

Recent Fiscal Consolidation Welcome

While Sri Lanka, now an upper middle income country, has performed poorly against peer economies on public spending and debt, fiscal consolidation has improved in recent years, she said.

“The only indicator where we are better than Asia is on fiscal deficit. We have been conveging with the emerging markets and middle income average.”

“Asian countries have been loosening fiscal policies, but that isn’t of much help because in the important indicator of public debt we are twice the average of emerging markets and middle income Asian countries.”

Although Sri Lanka has missed its consolidation targets by a large margin, the trend has so far been in a positive direction, Weerakoon said.

“There was a primary surplus. A primary surplus is the first step to stabilize debt.”

“So, steps have been taken in the right direction.”

“But if there’s slow growth, taxes will fall. Lower growth also means debt ratios can worsen.”

Weerakoon said ideally fiscal austerity is best undertaken when economic growth is high, but Sri Lanka has a history of engaging in pro-cyclical policies.

Tax cuts may not work

The IPS head said the new tax cuts promote equity and social justice, but the government may not see the desired results in a timely manner.

“Tax cuts can boost growth by encouraging consumption and investment, but it takes time.”

“Tax reductions may not always pass through as well.”

Inland Revenue Department officials have admitted that retailers may keep margins high and not pass on the tax benefits to consumers, to recoup lost margins when the rupee collapsed in 2018.

The government is also hoping the stimulus-induced growth in consumption and income to in turn lead to higher tax revenues.

“Tax revisions can stimulate growth but there’s no guarantee that revenues will pick up, at least in the short run,” Weerakoon said.

She also said if reducing income inequality is an objective, higher public spending would be key. Higher spending has more immediate multiplier effects on the economy, Weerakoon said.

However, in the current constrained fiscal space, it is critical to set modest public investment targets, she said.

Weerakoon said in Sri Lanka, tax policies are usually driven by politics and have very little to do with economics.

Investors too may be looking for indicators other than tax levels to consider bringing money to Sri Lanka, she said.

The new Inland Revenue Act enforced since 2017 has cut down many incentives, but the present government is bringing back a law which would give tax holidays to foreign investors.

The benefits of tax cuts for investors may be debated, although many developing economies still maintain such practices, Weerakoon said.

“Incentives are subject to abuse. Efficiency seeking investors would look for a sound investor environment,” she said.

Weerakoon said incentives could be justified if they promote desirable results, such as regional development and investments into high-tech and most desirable sectors.

Key Reforms Required

Investor friendly reforms are required to bring in non-debt inflows to boost low foreign reserves and service debt and create export industries, Weerakoon said.

Another area where reforms are required are on trade, since current import controls also hurt export competitiveness, she said.

“However, in this climate when there is backlash against pushing the trade agenda forward, any trade reforms to revive growth will take a bit of time.”

Pushing younger generations to enroll in more science, technology, engineering and mathematics (STEM) subjects will also pay dividends in the long-run with higher productivity, she said.

“But STEM education levels are quite low in terms of enrollment, and in terms of spending on education, upper middle income countries spend around 4.6 percent of GDP. Sri Lanka spends 1.8 percent.”

“With that kind of skill biased technological change, inequalities can also widen,” she said.

Reforms are also needed to mitigate an ageing workforce, she said.

An ageing population would increase the burden on the country’s health and social security spending, at a time when coverage for the elderly is already below desired levels, Weerakoon said.

“We will see fewer earner and tax payers as the dependency ratio climbs,” she said.

“Theory suggests people will adjust their consumption and save more. but if you look at savings patterns of Sri Lankans, I don’t think that is quite happening.”

Luck may run out

Weerakoon said over the past several decades, Sri Lankan has had the comfort of concessionary funding and bailout packages to manage its mistakes.

However, as an upper middle income country, concessionary funding is less accessible, with non-concessionary loans now making up 55 percent of the total, she said.

With persistant economic deficits leading to economic instability, the IMF has bailed out Sri Lanka on 15 occassions in 52 years, Weerakoon said.

“Seventy percent of our time has been under one IMF program or the other.”

“The deep reforms never took hold. In time our luck might run out.”

Weerakoon said Sri Lanka’s challenges are becoming complex as its income levels rise.

“Graduating to upper middle income was the easy part. Starting frow a low base, we can quickly get to 4,000 per capita.”

“Getting to 12,000 per capita is the harder bit,” she said.

“Out of 101 middle income countries in 1960, only 13 have made it to high income.” (Colombo/Feb03/2020)