ECONOMYNEXT – Sri Lanka is fearing more economic instability in 2016 with little being done to fix budget that went off the rails in 2015 with 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 de-railed by a revised budget in January with 40 percent wage hike?

In 2015 the budget deficit was planned at 499 billion rupees. The revised number in the parliament was 670 billion rupees. May be 750 to 800 billion may be may be more accurate finally.

Monthly tax revenues which were 89,651 billion in January rose to 145 billion rupees in November.

Surprisingly in October and November according to Treasury data revenue surpluses of 15 and 05 billion rupees were seen. Of course the September, October, November, tax revenues are bloated with retrospective super gains taxes and car imports.

But even if monthly revenues were pushed up to 120 billion a month and not 140 billion rupees, that is also a big improvement from January. The rupee has been depreciated sharply, so import and domestic taxes will go up with the nominal prices going up.

For 2016, a deficit of 740 billion rupees is projected with public investment of 868 billion rupees. This is probably an exaggeration, since over the past several year with massive Chinese finance Sri Lanka was able to invest only about 500 billion rupees or less.

The good news is 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.

Car imports have already fallen with credit restrictions and tax hikes. Credit will now shift more to non-car imports, this means to areas where the tax take per dollar spent will be lower when imports are generated.

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 the politicians and bureaucrats will do this – as usual.

The hybrid and electric cars, not bring in as much on going taxes as conventional petrol engines or ones with super diesel, after contributing less in initial import duties to build the roads.

Electric cars are a total tax loss. This is a typical green scam that allow rich people and rich businessmen to exploit the tax system like all renewable energy sources. Ironically in Sri Lanka electric cars are driven by coal due to the high thermal generation of power. The decision to tax them at a higher level was a good one, though the level of taxes should not be prohibitive.

Now with many more new cars on the road – other than electric cars – fuel usage will go up, giving more opportunities to collect taxes.

To get the benefit of all the new cars on the road, fuel pricing and taxation will be key. This is an area that not enough attention has been paid to.

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 between different types of fuel.

One of the key reasons Sri Lanka’s tax revenues are not high enough is because energy taxes are not charged properly and state enterprises do not pay taxes or dividends.

Though electricity is heavily over-priced for bigger home users, that money does not show up as taxes either, but are frittered away in cross-subsidies.

The so-called Yahapalana administration also sharply cut kerosene prices in an interventionist move. During the much maligned Mahinda Rajapaksa administration, the kerosene price (which is basically jet fuel and is 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 that 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 percent 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 it is a good way to recoup some of the subsidies given to agriculture by taxing all fuels.

Market pricing kerosene and diesel will also allow some taxes to be collected from the fishery sector, who are now not contributing much to taxation system.

VAT

Ideally Sri Lanka should raise value added tax to 20 percent and get rid of all the other problem taxes and also 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 percent across the board.

That way more revenue would have come and people’s savings and salaries would have not been damaged with money printing and currency depreciation. 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.

‘Currency depreciation austerity’ which falls disproportionally on wage earners and those with meagre financial savings like pensioners.

However it is easy to bust the currency and get away 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 be conveniently and deceptively blamed on external factors, not on domestic loose policy and also held out as being an advantage, based on Western false doctrine that emerged in the 1930s.

"The days are gone in which most persons in authority considered stability of foreign exchange rates to be an advantage," explained Ludwig von Mises, philosopher and economist in 1944.

"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 excuses 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 had to depreciate when IMF research – based on the same econometrics that over-valuation 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.

Taxes like NBT on energy can hurt export competitiveness.

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 permit this kind of deception 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 of banks. 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 to those countries.

The 50 basis point rate hike, though coming too late is a good move and has gone some way to reduce the damage done by a 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 and climbing.

At higher deposit rates more resources will be generated for lending and investment by curbing consumption.

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 balance of payments crisis and the country goes into an economic crash due to the drastic measures that are needed to correct runaway credit and consumption.

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 through money printing.

This shows how important it is to defend the peg when money is printed. When reserves are lost only authorities wake up. But if the currency is depreciated loose policy will continue for some time at the expense of an impoverishment of an entire population.

Though 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 and will take too long to explain in this column.

Currency depreciation also scares away foreign lenders and prevents them from rolling away debt. This is an idea that everyone can easily understand.

Depreciation

In Sri Lanka because interest rates increases are delayed, there is usually a credit collapse and a currency collapse during the correction period. When both happens, 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 close to 110 to the US dollar.

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 as they had before.

Sri Lanka 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. The ‘J curve’ is a vicious false doctrine similar to the ‘Phillips curve’ which had allowed rulers and central bankers to print money, destroy currencies and claim it as a great victory despite the mayhem it causes on both the poor and the rich.

There however can be ‘J curve’ like behaviour when a currency collapse is triggered by a global hard landing. In many countries currencies collapse because economies in developing countries go through internal problems which causes currency movements.

A credit slowdown in the US for example may cause the US dollar to go up along with a domestic economic crunch which hurts import demand (2009). In that case regardless of whether the currency of an export country was devalued or not, exports will fall and then pick up when the importing developed nations stabilize.

Exports from Hong Kong fell and picked up later in the wake of global recession, but there was no currency deprecation like in other Asian countries.

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 real salaries of workers are destroyed and they can pay workers less and make more profits. Alternatively they can also try to win a bigger market share based on slave salaries.

In Sri Lanka this advantage no longer hold because, when there are slave salaries at home, they go to the Middle East where surprisingly salaries are higher, but working conditions may be worse.

In Sri Lanka there is an additional incentive to ask for devaluation. That is because utilities prices (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 which will generate further calls for devaluation) is another reason to adjust energy and water prices every month or every three months with a hefty value added tax included.

Feedback and queries: bellwetherECN@gmail.com

This column is based on ‘The Price Signal by Bellwether‘ published in the March 2016 issue of the Echelon Magazine. It was published before revisions were proposed to the 2016 budget. To read Bellwether columns as soon as they are published, subscribe to Echelon Magazine at this link. The i-tunes app can be downloaded from here.