Vision for a Brighter Future in Sri Lanka



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Road to Realize ‘Mahinda Chintana Vision’


 


Continued from yesterday


Sirimal Abeyratne, University of Colombo, For Pathfinder, Colombo


Fiscal space for rising expenditure


A key issue emerging from the presidential election manifesto is the substantial increase in government expenditure within the next few years. In line with the proposed expansion in the role of the government, apparently the government expenditure is due to rise. In almost all the programmes highlighted in the manifesto such as the welfare and poverty alleviation, infrastructure and rural development, large-scale public investment projects, expansion of state-owned enterprises, reconstruction in the conflict-affected region and, assistance to production sectors, all reflect the potential increase in government expenditure. The expansion of the loss-making state-owned enterprises, including the public transport system and the railway also implies further ‘expansion in losses’ exerting pressure on the government budget.


What is not clear is, however, the way of rationalizing government expenditure and enhancing government revenue to facilitate the rising expenditure. Understandably, these proposals do not appear in an election manifesto, but reflects the magnitude of the challenges that the government has to face in coming to power.


Fiscal prudence: dismal performance


Over a long period of time, the fiscal management in Sri Lanka suffered from fundamental weaknesses due to higher current expenditure exceeding the government’s total revenue (Figure 3). This compelled the government to resort to the increased borrowings from both domestic and foreign sources, including the commercial borrowings from abroad. The Fiscal Management (Responsibility) Act of 2002 that was aimed at improving management, transparency and accountability of public finance, compelling the government to reduce the budget deficit to 5 per cent of GDP by 2006 became totally ineffective. The period 2004-2009 was marked by a sharp increase in current expenditure which has more than doubled from LKR 390 million to LKR 885 million. Even though the government succeeded in raising the tax revenue too, this had only a marginal impact on the revenue deficit which increased significantly in 2008 and 2009.


The economic recovery after its setback due to the global financial crisis and the resurgence of the North and East economies after the conclusion of the civil war will have a positive impact on the government revenue. But given the massive increase in government expenditure, this increase in revenue will be insufficient to meet the commitments. There is also little space available to generate indirect taxes because the rates are already high and the tax system is complicated. However, there is much scope for widening the tax base particularly in the case of direct taxes. But this requires political will and commitment to incorporate all citizens receiving income and holding wealth into a direct tax net.


On the expenditure side, there is also much scope for improving the productive use of government revenue. One explicit case is the annual losses and the accumulated debt of the public enterprises which drain part of government revenue as current transfers. According to the Annual Report 2008 of the Ministry of Finance and Planning (2008b: 140) highlights the major problems of commercial viability faced by 137 public enterprises: (a) heavy reliance on the government budget for recurrent expenditures, (b) heavy debts to the commercial banks – particularly the state banks, (c) unusual accumulation of inter-public enterprise debts and, (d) non-payment of dividends to the government. Even with an improvement in the commercial viability of public enterprises which is a process that derives long-term benefits, it is difficult to anticipate a substantial relief in the country’s short-term budgetary performance which is in serious disarray.


Besides the current losses and accumulated debts of the public enterprises, a key issue that is often disregarded is the fact that their commercial viability is due to aggravate over time. Naturally, the demand for services delivered by the public enterprises is on the rise so that the government needs to expand the output. In line with the expansion of the supply by the public enterprises, their losses and the debt burden will also increase.


Policy
dilemma


A major challenge that has to be faced in accommodating the forthcoming expenditure commitments as outlined in the presidential election manifesto is a policy dilemma rather than finding the ways of financing the rising budget deficit. The Technical Memorandum of Understanding between the Sri Lankan government and the International Monetary Fund (IMF) signed in July 2009 specifies the performance criteria in relation to fiscal targets, monetary targets, and external sector targets that Sri Lanka should achieve and maintain in relation to the IMF Stand-By Agreement. This programme included achieving the budget deficit to 5 per cent of GDP by 2011 from a target of 7 per cent of GDP in 2009 by improving the fiscal space.


The actual budgetary performance in 2009 is far behind the targets (Table 4). In fact, the initial budgetary estimates presented at the Budget Speech 2009 (Ministry of Finance and Planning 2008a) were even more restrictive than the linear targets set at the IMF Stand-By Arrangement. Even though the initial target for the budget deficit was 6.5 per cent of GDP, the actual performance reveals that it has increased to 9.7 per cent of GDP. The government revenue has declined in response to the tax revisions (both upward and downward), lower aggregate demand and dismal performance in most of the revenue-generating economic activities. The government expenditure (both recurrent and capital) has increased, resulting in an increase in the budget deficit reaching LKR 470 billion compared to the initial estimate of LKR 337 billion.


The policy dilemma arises from the contradiction between the government’s political commitment and the economic commitment. The government’s wish is to expand the public expenditure as it did during the past few years and as committed in the presidential election manifesto. However, this political commitment is constrained by the economic commitment to achieve fiscal discipline as agreed under the IMF Stand-By Arrangement. With the approval of the IMF Stand-By Arrangement, Sri Lanka narrowly escaped from a serious macroeconomic crisis. This was primarily led by the portfolio capital inflows based on an improved investor confidence over the anticipated macroeconomic performance and the higher returns on investment in financial assets of Sri Lanka (Abeyratne 2010). If there is any change in investor confidence, including that of the IMF stance, is likely to reverse the external finance position. The fiscal disarray that is due to arise is a key factor underlying this possibility, posing a major challenge to the government.


Achieving the Vision of Prosperity


The preceding analysis reveals the key issues related to the mission of achieving the economic vision as outlined in the presidential election manifesto. Given the end of the political conflict and the recovery of the global economic downturn, the Sri Lankan economy is looking forward to take off by sustaining a higher growth momentum. This requires Sri Lanka to be competitive in the Asian region by integrating more with the global economy, by establishing an investment-friendly policy and regulatory environment, by sustaining macroeconomic stability and, by performing a facilitating role efficiently by the government. However, the programme of actions outline in the manifesto appears to be weak and contradictory in guiding the economy towards its vision of prosperity.


The presidential election manifesto through its valuable concept of a ‘global hub’, sets the tone of greater integration with the global economy and, for that matter the need for greater investment by the private sector, both local and foreign. A global hub requires strong connectivity with the rest of the world and, the connectivity requires liberalization and facilitation. However, the manifesto portrays a contradictory programme of actions, outlined in the context of the government’s re-directed development strategy and the re-defined policy framework adopted in the past few years.


It is noteworthy that the Sri Lankan economy even in the midst of a prolonged political conflict was able to sustain a moderate rate of growth during the past three decades. In spite of the severe infrastructure constraint of the country, this is a commendable achievement based primarily on the policy reform process, though lopsided and incomplete. Therefore, the achievement of the vision of economic prosperity requires a bold reform process in the key areas of policy management. Without this initiative, even the anticipated post-war economic spurt for which the previous policy reform process itself had already prepared the groundwork will be short-lived.


Key areas of reform


Development strategy


Entrepreneurship development is primarily a natural process in the policy regime itself with correct incentives. When the incentive structure is distorted mostly by government involvement, the types of economic activities emerged are not sustainable and not competitive without government assistance. The result is that the government has to spend more resources for securing little benefit to the society. Rapid expansion in industry and service sectors will absorb the surplus labour in the domestic agriculture sector, deriving economic benefits to the rural sector as well.


i. The policy measures adopted should not discriminate among production sectors, because they tend to discourage potential expansionary sectors, potential investments and potential entrepreneurship development. This also applies to the discriminative treatment between local and foreign investment.


ii. At the initial stage of economic take-off, foreign investment plays a major role by bridging the savings gap and, catering the global markets. As foreign investors seek good economic fundamentals and regulatory mechanisms more than the special incentives, the policy focus should be on creating a business-friendly environment.


iii. Agriculture sector should be competitive to stand against competitive imports and to cater the international markets ensuring rising income in the sector. The structural weaknesses in the sector such as land-holding system, land-utilization pattern, and the issues of property rights need to resolved, at least gradually.


iv. Since the domestic market is too small to take the economy too far, the prime focus of the development strategy should be on international market in general and, export promotion in particular. This is consistent with the action plan for creating a global hub in Sri Lanka.


v. The main focus of the government should be on reducing the cost of production in the economy and, improving competition and competitiveness. The problems in these areas usually emerge through government intervention, regulatory mechanisms, infrastructure bottlenecks, market rigidities as well as lack of human resources.


vi. The government can also expand the potential for private investment and public-private partnerships in public investment projects such as highways, railways, ports and airports, power generation and other. This will expedite the investment promotion and reduce the burden on the government budget.


Regulatory framework


The regulatory framework and the bureaucratic system of a country is a key determinant of the cost of business, investment promotion and, entrepreneurship development. Apparently, a fast growth of the economy creates increasing demand for simple and clear regulations and, for efficient public service. At the same time, the public institutions need to be demand-driven in order to improve their service delivery and sustainability. This is also an area where there has been an inadequate reform process in the past.


i. Public enterprises require greater autonomy to operate on the basis of economic and management principles because the issue in question is not the ownership, but the management. The government institutions dealing with public administration should also have a greater autonomy and an incentive structure to operate on demand-driven basis.


ii. Regulatory mechanisms and bureaucratic procedures need to be simplified and rationalized in order to reduce the opportunity costs and transaction costs of doing business. The reforms in these areas will improve the international competitiveness of the Sri Lankan economy which would lead to a realization of the concept of a global hub in naval, aviation, commerce, energy and knowledge.


iii. Rule of law is the key to manage a free market economy, as its enforcement prevents someone’s action affecting economic freedom of another and even the entire society. The weaknesses in the enforcement of the rule of law has so far paved the way for deep-rooted economic chaos and sources of corruption which become more and more difficult to be corrected.


Macroeconomic order


The maintenance of macroeconomic order and its long-term sustainability is a basic requirement to achieve rapid growth. The deterioration of the macroeconomic fundamentals are reflected primarily through the price stability, budgetary position and the balance of payments position. As far as the budgetary position is concerned, the government should be committed itself to achieving both fiscal and monetary discipline. As the investors seek an adequate profit margin, increased share value, investment safety and, sustainable return, the macroeconomic stability and its long term sustainability are key determinants of the country’s investment competitiveness.


i. The budgetary position needs to be improved on both revenue and expenditure sides aiming at a manageable budget deficit. On the revenue side, indirect tax system has to be simplified avoiding complex procedures of numerous taxes. Tax base needs to be widened by incorporating all income-earners and wealth-owners.


ii. On the expenditure side, wasteful and unproductive expenditure patterns should be reviewed to improve the cost-effectiveness, transparency and accountability of the government expenditure. The re-structuring of public enterprises and other public institutions with greater management autonomy will also improve the fiscal position of the government.


iii. The government’s fiscal discipline assists the monetary authorities to maintain monetary discipline as well. With this the average interest rates should be lower and stable and, should respond to market forces rather than to the interventionist measures.


iv. The exchange rate should also be stable, but flexible as it should also respond to the market forces rather than to unnecessary manipulations. This requires increasing foreign exchange inflows based more on export expansion than on anything else.


Policy reforms in a country should be a long-term dynamic process to ensure the dynamism of the economic environment. As all the countries in the region are eager to adopt policy reforms, Sri Lanka should not be left behind due to the loss of competitiveness. However, the policy reversals and ad hoc changes guided by short-term objectives can undermine the long-term predictability of the policy regime, affecting investment promotion. The governments may change, but the policy environment should be stable ensuring its greater degree of predictability in order to achieve a rapid growth within the next few decades.


References


Abeyratne, S. (2010), "Gala Time in Rainy Days: Macroeconomic Implications of the Financial Inflows to Sri Lanka in 2009", Economic Review, 35(9 & 10), Colombo: People’s Bank


Abeyratne, S. (2009), The Economic and Social Impact of the Global Financial Crisis in Sri Lanka, Colombo: UNDP Regional Centre for Asia Pacific


Abeyratne, S. (2006), "Small and Medium Enterprises in Sri Lanka: Integrating the SME Sector with the Market" in W. Gooneratne and S. Hirashima (eds), Small and Medium Enterprise Development in SAARC Countries: Challenges and Policy Reforms, Colombo: Center for Development Studies


Business Standard (2008), "Government to ease investment norms in higher education", Business Standard, July 26, India


CBSL (various issues), Annual Report, Colombo: Central Bank of Sri Lanka


Herath, P. (2009), "Property Rights and Capital Formation: A Requisite for Economic Growth and Development of Sri Lanka", Economic Review, 35(7 & 8), Colombo: People’s Bank


Ministry of Finance and Planning (2010), Pre-Election Budgetary Position Report 2010, Colombo


Ministry of Finance and Planning (2009), Mid Year Fiscal Position Report 2009, Colombo


Ministry of Finance and Planning (2008a), Budget Speech 2009, Colombo


Ministry of Finance and Planning (2008b), Annual Report 2008, Colombo


Snodgrass, D. (1999), "The Economic Development of Sri Lanka: A Tale of Missed Opportunities" in R.I. Rotberg (ed), Creating Peace in Sri Lanka: Civil War and Reconciliation, Washington DC: Brookings Institution Press


UNCTAD (2009), World Investment Report 2009, New York and Geneva: United Nations Conference on Trade and Development


UNTWO (2009), World Tourism Barometer: Interim Update (September), United Nations World Tourism Organization, Web site: www.unwto.org


US Energy Information Administration (2006), Singapore Energy Data, Statistics and Analysis (July), Web site: http://www.eia.doe.gov/emeu/cabs/Singapore


Concluded


 
 
 
 
 
 
 
 
 
 
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