Mangala’s economics

Despite many challenges Mangala Samaraweera took on some of the most important macroeconomic reforms during his two-year stint as Minister of Finance. Mangala was not a subject expert, but perhaps his best quality was to listen to the experts and formulate his judgment based on the technical advice that he received

When Mangala Samaraweera took over the Finance Ministry portfolio in May 2017 Sri Lanka was preparing to face some of its most challenging years in macroeconomic management. 

2018 was the year that the government had to make its highest ever domestic debt repayments (Rs. 922 billion in capital repayments of domestic debt. For context, in 2020 the domestic debt capital repayment was Rs. 456 billion). In 2019 Sri Lanka had to make its highest ever foreign debt repayments (Rs. 575 billion foreign capital repayments in 2019. In 2018 the foreign capital repayment was Rs. 315 billion and in 2020 it was Rs. 505 billion).

In addition to managing an economy where annual debt service payments (Rs. 2,022 billion in 2019) were higher than government revenue (Rs. 1,891 billion in 2019), in mid-2017 the country was in the midst of its worst drought in 40 years. Agricultural incomes had been decimated and the economy was also hurting from devastating floods in other parts of the country. 

The fragile coalition between President Maithripala Sirisena’s SLFP and Prime Minister Ranil Wickremesinghe’s UNF was also beginning to show the first signs of cracks as a two-year honeymoon period was over. Amidst these challenges Mangala’s time was largely focused on firefighting these critical issues. That did not stop him from taking on some of the most important macroeconomic reforms during his two-year stint as Minister of Finance.

Addressing Sri Lanka’s fiscal weakness

1996 was the year that Sri Lanka won the Cricket World Cup but it was also the last year that Sri Lanka had a government revenue to GDP ratio of over 20% (it was 20.1% that year and was consistently above 20% over many years prior to that). Since then revenue had declined dramatically, reaching a nadir of 11.6% in 2014. This was amongst the lowest government revenue performances in the world. 

Sri Lanka’s recent public expenditure ranging between 17% and 20% of GDP was not high by global standards. As of 2020 Sri Lanka’s government expenditure comprised largely non-discretionary spending including salaries and wages (6% of GDP), interest (6% of GDP), welfare and transfers (4% of GDP). Therefore there is very little room to meaningfully reduce expenditure in a practical manner.

The main causative factor behind Sri Lanka’s consistently high budget deficits was its weak revenue base. Sri Lanka also has an extremely regressive tax structure. As at 2017 approximately 82% of tax revenue was collected as taxes on goods and services and 18% as taxes on income and other direct taxes. Typically taxes on goods and services (indirect taxes) fall disproportionately on the poor. A family would pay the same tax on milk powder regardless of whether their household income is Rs. 50,000 or Rs. 500,000. This was how over 80% of Sri Lanka’s taxes have been collected. This reliance on taxes on goods and services has also contributed to driving up the cost of living as the tax component of prices continues to increase.

Mangala’s simple principle for taxation policy was that the government should wherever possible reduce upfront taxes and costs that disincentivise the commencement or establishment of business. However, once a business is established and profitable, it should pay its fair share in income taxes. This was the opposite to the reality at the time — Sri Lanka’s taxes had hitherto been front loaded into indirect taxes such as cess, PAL, NBT, and VAT — whereas income taxes are low and corporates enjoy a range of income tax holidays. As a result there is typically a high cost of entry into industry and limited competition among established players.

Taxes on incomes have been low for several reasons including open-ended tax holidays, weak collections reliant on self-declaration, and other leakages. The Inland Revenue Act of 2017 was drafted in order to address as many of these issues as possible. A few highlights of this landmark legislation;

1) Consolidation of rates — Income taxes on corporates were collapsed into three bands. A standard rate of 28% for most large businesses. A concessionary rate of 14% for exports, tourism, IT, education, and all SMEs. Accordingly the bulk of Sri Lanka’s businesses, SMEs defined as having turnover of less than Rs. 500 million per annum, were on a tax rate of 14% which is extremely low by any global standard. Finally a rate of 40% for industries engaged in alcohol/tobacco, and gaming.

2) Withholding taxes for services — The expansion of coverage of withholding taxes was a method to incentivise greater tax compliance. Withholding taxes on payments for services mandates withholding a percentage of corporate payments to professionals such as doctors, lawyers, and others. This withheld amount can be claimed back by the recipient when she files her annual taxes at the Inland Revenue Department, thus creating an incentive for professionals to file tax returns and declare income.

3) From tax holidays to capital allowances — Sri Lanka has historically provided very generous tax holidays in order to attract investment. During the conflict period in particular this was needed in order to compensate the investor for the high risk undertaken in the outlay of capital. However there is a substantial fiscal cost of such tax holidays. In 2017 the annual cost of corporate income tax exemptions was Rs. 77 billion. The cost of tax exemptions on VAT was Rs. 135 billion. Together the cost of these tax exemptions accounted for 1.7% of GDP that year. The Inland Revenue Act introduced a capital allowances scheme where the investment in capital (depreciable assets) can be set off against future taxes. In effect, the investor would not pay income taxes until he has recovered the cost of investment. The larger the investment, the larger the tax break — but it avoids the open ended tax holidays enjoyed by several entities under the previous tax regime. The principle in play was that the government would minimise upfront taxes and costs faced by the investor — but once the investment is profitable, the investor must pay his fair share of income tax.

4) Introduction of capital gains taxes as wealth taxes — Globally taxation is increasingly shifting to wealth taxes from income taxes. Often the richest in society will gain not through direct income sources but through wealth increases such as through asset value growth. The IRA introduced a capital gains tax that is a first step towards addressing wealth taxes. It is a fairly minimal step with a 10% CGT on asset transaction gains and excludes financial market assets such as equity.

In general the new legislation intended to shift to a rule based tax structure, moving away from discretionary policy which leaves room for leakages and graft. The IRA had important positive impacts on tax collection. Even though the legislation came into effect in April 2018, the full impact of the legislation would only be seen in November 2019 when the 2019/20 filing is completed. The results were impressive. There was a 44% growth in income tax collection in 2019 in spite of major shocks to the economy, tax payers registered with the Inland Revenue Department in 2018 was 986,684 and by 2019 it had increased to 1,505,552. Most importantly, in 2019 the ratio of direct taxes to indirect taxes shifted to 75% to 25% from 83% to 17% in the previous year. Even though marginal, this was an improvement in Sri Lanka’s highly regressive tax structure.

Primary surpluses

One of Mangala’s key fiscal objectives at MoF was to achieve a primary surplus in the budget. Since independence, Sri Lanka had achieved a primary surplus only in 1954, 1955, and (marginally) in 1992. 

A primary surplus in the budget occurs when revenue exceeds expenditure minus interest cost. It is the measure of fiscal management that is truly within the control of the Minister of Finance since the past interest cost is payment for past sins. When a primary surplus is achieved it means the government’s revenue exceeds its non-interest expenditure. A primary deficit means the government has to borrow even to finance interest which is undesirable from a debt sustainability perspective. In 2017 Sri Lanka had a primary surplus of Rs. 2 billion and in 2018 Rs. 91 billion (0.6% of GDP).

2017 (5.5% of GDP) and 2018 (5.3% of GDP) also saw two of the lowest budget deficits in Sri Lanka’s recent past. In 2016 as well Sri Lanka limited its budget deficit to 5.3% and in 2013 the deficit was 5.4%. However prior to that the only time the budget deficit dipped below 5.3% was in 1977 (4.5% of GDP).

A critique of this achievement is that even though the government had primary surpluses in 2017 and 2018, and the overall debt to GDP decreased in 2017 (from 79% to 78% of GDP), debt to GDP increased to 84.2% in 2018. The reason behind the increase in debt to GDP in 2018 was because of the depreciation of the currency that year due to the global taper tantrum early in the year as the Federal Reserve raised interest rates and the constitutional crisis later that year. When currency weakens, the rupee value of external debt increases, causing the debt to GDP ratio to increase, in spite of the gains made in real fiscal management, which is what can be controlled by the Minister of Finance.

There is also a perception that the decline in GDP growth rates was due to enhanced government revenue measures. However, quarterly GDP growth from Q1 2015 to Q3 2018 averaged 4.3%. This was keeping in line with the average growth levels of 2013 (3.5%) and 2014 (5%). Just as the economy was recovering from the droughts of 2017, this momentum was lost due to the constitutional coup in October 2018 which dragged down Q4 2018 growth to 2.1%. The resulting capital flight and forex reserve sales to defend the rupee resulted in negative market liquidity and higher interest rates that carried on well into 2019, compounded by the Easter Sunday attacks, dragging down 2019 growth as well.

Fuel price reform

In early 2018 the hopes of shifting to a market based fuel price formula were fading. This was potentially a major reform given the significant fiscal burden created over the years due to mis-pricing of petrol and diesel and weak balance sheet management by CPC. These factors combined to result in CPC running up debts over Rs. 300 billion, mostly placed with the State banks, creating a high-risk fiscal combination. 

Anchoring retail fuel prices to the global market price (with adjustments for taxes, distribution costs, storage costs, finance costs, and profit margin) would help eliminate additions to the existing fiscal burden of CPC. When global prices rise, the domestic fuel price would rise, when global prices fall, the domestic price would fall. Even if the government chose not to increase retail prices in line with global price shifts, a transparent and publicly available formula would create more visibility on the fiscal costs of such a policy.

Like all challenging reforms, ideally the fuel price formula should have been introduced early in the political cycle, market prices were also trending upwards by 2018. In May 2018 the formula commenced implementation. On the 10th of every month the retail price of fuel will be adjusted to reflect the latest global fuel price (Singapore Platts was the anchor used). The timing could not have been worse, and communication could have been a lot better. Global fuel prices had started sky-rocketing from mid-June and peaked at over $ 80 per barrel in October from the $ 50 range leading up to May. Naturally the public associated the fuel price formula with rising prices at the pump. Had the formula been implemented a year prior, the public would have seen prices decline and stabilise prior to increasing. But alas, this was not to be, and the formula was scrapped by the new administration.

Trade liberalisation

As at end 2019 Sri Lanka’s rank in Trade Openness was 140th out of 141 in the Global Competitiveness Index. In spite of being the first country in South Asia to liberalise in 1977, Sri Lanka’s trade protection levels have increased over the last couple of decades. In the 5 years from 2014 to 2018, the average percentage of government revenue collected at the border was around 49%.

The increased layers of taxes on imports results in three key impediments;

i) These import taxes are a significant burden on consumers. The effective import tax rate of several basic consumption products from milk powder to biscuits goes up to 100%.

ii) Import taxes erode competitiveness as domestic firms receive significant protection from global competition leading to less incentive for innovation and dynamism and thus hinders long term productivity improvements — the true driver of economic growth.

iii) Several intermediate imports have high import taxes — including numerous construction materials. This drives up costs for all industries, eroding competitiveness of almost all Sri Lankan enterprise. It also makes Sri Lanka less attractive a destination for FDI.

In Sri Lanka a lot of border taxes take the form of paratariffs. The standard import duty is customs import duty (CID), however since CID is eliminated in Free Trade Agreements (FTAs) with India and Pakistan, successive Sri Lankan governments have added in layers of paratariffs such as cess and the Ports and Aviation Levy (PAL).

In the 2017 November Budget it was decided to commence the elimination of most of these paratariffs. Mangala championed this initiative since he recognised the potential positive implications it would have for the economy in the long term. Some of the Treasury officials were less enthusiastic, because there would naturally be a short-term revenue loss as a result of removing these tariffs and also because it would result in severe lobbying by protected industries, seeking to retain their walls of protection.

Whilst some in the ministry wanted to see tariffs eliminated almost entirely in a big bang reform move, it was necessary to allow time for domestic industry to adjust to this significant change. It was eventually decided that the best approach would be a five-year phase out of most paratariffs. This would make the revenue impact easier to absorb — revenue from PAL and cess amounted to around 1% of GDP. To start with though the 2017 November Budget would eliminate paratariffs on 1,200 or so of the least sensitive tariff lines. The impact would not be material, but Mangala felt it would be a robust signal — and also give additional time for industry to make adjustments to the envisaged operating environment. In the March 2019 Budget the next phase of para-tariffs was eliminated, and a Trade Adjustment Programme was introduced to provide budgetary support for domestic sector entities that face adverse adjustment costs due to exposure to greater global competition.

Welfare reform

Another important initiative of the Ministry of Finance under Mangala Samaraweera was the effort to streamline welfare payments. One of the first things Mangala asked me was how we can move away from a system of price controls on essential items to provide relief to the public. He understood that price controls are not sustainable since they are poorly targeted, they tend to result in shortages and erosion of quality when market prices exceed the administered price. And of course they are subject to constant abuse. He was very keen that we look at introducing a system where relief is provided to the needy through cash transfers — his favourite example was Bolsa Familia, Brazil’s cash transfer programme.

Of course this required a robust system of identification and targeting of those who are deserving of such support. This would apply not just to those who were of lower income levels, but also those with disabilities, the elderly and infirm, and those vulnerable to and victims of natural disasters. Sri Lanka’s existing system of welfare distribution, Samurdhi, was woefully inadequate in terms of targeting. Samurdhi had vast numbers of undeserving recipients who benefitted from the scheme and more worryingly, large numbers of deserving citizens who were excluded from the scheme. 

The World Bank provided technical support in designing such a targeting mechanism and after a lot of work the new targeting criteria was finally gazetted in June 2019. The mechanism consisted of objective, verifiable criteria including education levels, housing conditions, income, electricity consumption, assets, and illnesses. If fully implemented this mechanism of targeting, combined with the use of digital payment systems, would have enabled a transparent and efficient scheme of providing welfare to those who most deserved it, without resorting to the economic inefficiencies of indiscriminate price controls. Unfortunately this initiative too did not make it beyond the election cycle.

Monetary policy legislation

Another potentially game changing reform was the new Monetary Law Act. This legislation was champion by the Central Bank under Indrajit Coomaraswamy, and Mangala supported it to the hilt, even at the tail-end of the political cycle. 

The MLA was designed to provide greater independence to the Central Bank, coupled with accountability measures for the Monetary Board. It would create disciplines around deficit financing (money printing) and establish the legal framework for inflation targeting. These measures would have imposed limitations on some of the most problematic interactions between the monetary and fiscal authorities, that have over the years led to Sri Lanka’s fiscal profligacy, deficit financing, all resulting in ballooning debt and monetary instability. 

Mangala was not a subject expert, but perhaps his best quality was to listen to the experts and formulate his judgment based on the technical advice that he received. The new Monetary Law Act also did not see the light of day.

2018 constitutional coup

It had been a very heavy few weeks in the lead up to the 2019 Budget to be presented in early November 2018. The 26th of October was a Friday. The Active Liability Management Bill, a landmark piece of legislation that would allow Sri Lanka to buy back or otherwise manage its lumpy liabilities to smoothen out its repayment obligations, was passed in Parliament in the afternoon. This piece of legislation had faced stiff opposition by President Sirisena. 

We had finished the final draft of the Budget speech and had sent it for the final technical annotations. The end of a long week and several long months. As I drove out of the Treasury building at around 6 p.m. I noticed barricades being hurriedly stacked up near the Presidential Secretariat. I didn’t pay much attention and carried on to catch up with some friends.

About 45 minutes in everyone was getting messages, stating that Mahinda Rajapaksa was being sworn in as Prime Minister at the Presidential Secretariat. The initial reaction was disbelief since that act would in itself be unconstitutional. I made a couple of phone calls and it was clear something extraordinary was going on so I rushed back to the Treasury. Most of the staff was gone by this time but the Minister and a couple of the private staff were still around. Nobody could quite believe what was going on. 

Having thought things through Mangala wanted to send out a tweet at 8:30 p.m. saying, “The appointment of @PresRajapaksa as the Prime Minister is unconstitutional and illegal. This is an anti-democratic coup #LKA.” I asked him if he was sure he wanted to use the word coup. It was a strong word and would have important ramifications. He thought for a few seconds and replied in the affirmative, saying that a coup was exactly what was going on.

The economy took a beating over the subsequent two months. Foreign investors took flight and exited their positions in GoSL rupee-denominated Treasury securities. Rs. 75 billion worth of foreign investments in government securities was sold in just two months, creating massive pressure on the currency, causing the rupee to crash from 172/$ to Rs. 182/$ between October and December 2018. The currency was already weak due to the taper tantrum in the early part of the year which hammered all emerging economies. When capital flows started reversing in Q4 and other emerging economies saw a recovery, Sri Lanka was in the midst of the coup and associated capital flight.

During this time the government sold $ 1 billion worth of reserves in just one month as reserves declined from $ 7.9 billion to $ 6.9 billion. These were valuable reserves the government had been building up in preparation for the substantial external debt repayments in 2019. More importantly Sri Lanka’s credit rating was downgraded by all three rating agencies in November 2018. On 30 November 2018 the yield on the January 2019 ISB had reached 10.7% from 5.6% on 26th October. This meant that Sri Lanka was effectively locked out of global capital markets on the cusp of having to settle over $ 5.3 billion in debt repayments in 2019, including a $ 500 million ISB in early January 2019. It was heart-breaking for Mangala watching this unfold from the sidelines given all the efforts that he had and the team had taken to keep the economy stable to meet the 2019 debt repayments amidst the global bond market volatility in 2018.

As the economy deteriorated into December it became clear that the adverse impacts of the coup would be long lasting. Due to the sales of $ 1 billion worth of reserves by the Central Bank, liquidity in the domestic rupee market also reduced dramatically. The market was short Rs. 100 billion in the overnight money markets and this pushed up domestic interest rates dramatically as well. Prior to the coup, the one-year Treasury bill was in single digits at 9.5% as at end September 2018, having been at 10.5% when Mangala became Finance Minister. During the coup interest rates shot up to 11.25% by mid-December. The market was Rs. 100 billion liquid short till at least April 2019, keeping interest rates elevated and hurting economic growth significantly in 2019. The high interest cost added to Sri Lanka’s debt concerns as well by driving up the cost of domestic debt.

Managing external debt in 2019

When the Supreme Court verdict came through on 13 December and Mangala returned as Finance Minister, there was a lot of work to be done. Firstly there was no year-end budget to authorise payments for 2019, and Sri Lanka had lost access to global capital markets to finance the country’s highest foreign debt repayments in 2019. A quick vote on account was passed by end December, and the next step was to somehow regain access to global capital markets to make sure we can refinance debt repayments. It was unfortunately too late for the January 2019 bond which we had to settle out of the already diminished reserves. 

Soon afterwards Mangala led a team to Washington to meet with the IMF and reinstate and renegotiate Sri Lanka’s programme. In spite of Mangala losing his suitcase and D.C. being having a snow day as soon as we arrived, the team met with Christine Lagarde and the technical team led by Manuela Goretti, and after some tough negotiations we were able to set the programme back on track with some important concessions. The external goodwill towards Sri Lanka was palpable, and there was nobody better than Mangala to leverage this to the country’s best advantage.

Over the next two months Mangala had to put together a delayed Budget for 2019. This was a particularly tough Budget since it was an election year and there were expectations of additional concessions, but at the same time it was critical that the fiscal position would inspire the confidence of global capital markets in order to regain access to external financing. Mangala’s last Budget was able to meet both criteria. 

The March 2019 Budget included programmes such as Gampereliya, a rural infrastructure programme which was seen as a means of providing targeted fiscal impetus to improve cash circulation at the rural level, whilst investing in productive infrastructure leveraging on rural value chains. The enhanced Enterprise Sri Lanka programme was a means of reducing cost of capital, one of the key impediments to SMEs in the country. This was a strategy to provide a targeted reduction in interest rates to productive investments without a general reduction in interest rates. A general reduction in interest rates at the time would have led to an acceleration of capital flight post-coup, and would have further de-stabilised an already volatile external sector. Mangala had some other wonderful ideas in that Budget, including providing scholarships for the best performing Advanced Level students to study at any top global university that they qualify for admission.

The Budget was also able to satisfy global markets and Sri Lanka regained access to global capital markets. Immediately as the Budget was passed, the Central Bank led the process of raising the required International Sovereign Bonds (ISBs) to settle the upcoming debt payments in 2019. However, whilst settling the immediate debt, Mangala and Indrajit Coomaraswamy were also cognisant of the fact that leading into two election years (2019 Presidential and 2020 Parliamentary), Sri Lanka may face risks in retaining global capital market access to finance debt repayments in 2020 and 2021. Accordingly, Mangala and Indrajit made a conscious decision to raise an additional $ 2.4 billion dollars’ worth of ISBs in mid-2019 to build up reserves to $ 7.6 billion by end 2019 to tide over a volatile couple of years ahead. 

Whilst today many politicians criticise the previous Government’s International Sovereign Bond strategy, it is the reserves built through the $ 4.4 billion ISBs raised in 2019 that have been used to settle Sri Lanka’s external debts in 2020 and 2021. Sri Lanka would have already defaulted if not for Mangala and Indrajit’s decision in mid-2019.

True patriot

There are of course many things that I’m sure Mangala wishes went differently. He wanted to update and upgrade legislation for Customs and Excise — to reduce subjectivity, discretion, and shift to a more rules based framework for both pieces of legislation. He wanted to do move faster on trade reform but the political economy of late stage reform made such intentions difficult to fulfil. He was also keen to invest more in education, health, and reconciliation. He wanted to bring in legislation to address microfinance and informal finance related household indebtedness. There was a lot more than could be done within an interrupted two-year tenure.

I and many others will miss Mangala not so much for his achievements and efforts as Finance Minister. Nor for his work towards reconciliation from the Sudu Nelum movement to date, for his work in liberalisation of the telecom sector in the late 1990s, for his work with the UDA in Colombo’s initial beautification. I will miss a human being of immense courage, who stood for what is right regardless of societal or political compulsions. A man of integrity, conviction, and humility. A patriot in the true sense of the word.

(The writer is an economist and served as Economic Advisor to the late Mangala Samaraweera during his tenure as Finance Minister.)