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“Our country is facing a severe foreign exchange crisis. Data from the Central Bank shows that the country’s net foreign exchange reserves are close to zero, which means almost all of its reserves are borrowed.”

The significance of this statement to Parliament by Mr. Basil Rajapaksa, the Finance Minister, on September 7, lay not on the announcement of this well-known economic predicament, but its admission, by the new Finance Minister.

No rosy picture

Unlike the rosy pictures painted by some other ministers, who have continued to say that the problem of inadequate foreign reserves would be resolved soon by foreign inflows, this statement recognises the critical state of the country’s foreign reserves and implies the need to resolve it.

Problem recognised

Recognising the seriousness of the problem is an essential first step towards finding solutions. However, the country’s external financial vulnerability can be resolved only with a new vision that adopts essential economic reforms. The persistent deficits in the trade and balance of payments are a result of inappropriate monetary, fiscal and trade policies.

Not COVID

While COVID aggravated the external financial difficulties due to loss of tourist earnings, on the one hand, and increased expenditure, on the other, the parlous state of the external finances was brought about by structural deficiencies and inappropriate fiscal and monetary policies.

Resolving problem

The resolution of the problem requires economic policy reforms. International assistance from whatever source is an essential and immediate need, but such palliatives, though critically important, will not resolve the fundamental disequilibria in the economy.

Fiscal imbalance

As the Finance Minister himself noted in his September 7 speech to Parliament, Government finances are in a parlous state with revenues falling and expenditure continuing to rise. The correction of this fiscal imbalance is vital for economic stability.

Fiscal consolidation

Large fiscal deficits affect all parts of the economy adversely. Reducing the fiscal deficit or fiscal consolidation, requires a twin strategy of reducing government expenditure and increasing Government revenue.

The possibility of reducing Government expenditure is limited owing to rigidities in government expenditure. The bulk of government expenditure is on salaries and pensions, debt servicing costs and losses of state owned enterprises (SOEs). However prudence in public expenditure, reforming SOEs to reduce losses and not undertaking unproductive large capital expenditure are essential to curtail expenditure.

Revenue

The enhancement of revenue is most important. As the Finance Minister noted many of the main sources of revenue have dried up. He told the House: “Due to COVID-19, the Government’s revenue for this year has fallen between 1500 and 1600 billion rupees from the estimated amount.”

These shortfalls included, import duties on cars and other “non-essential imports” and petrol, excise duties on liquor and the tax relief on income tax in the last budget.

Monetary policy

Monetary expansion has been an underlying cause of economic destabilisation. Now that it is clearly evident that the monetary policies espoused by the Government have brought about inflation and external financial instability, it is prudent to abandon it and follow a restrained monetary policy.

Trade reforms

Several eminent economists specialising in international trade have pointed out that reforms in trade policies are vital to enhance the country’s exports. At a recent webinar organised by the Advocata Institute, Dr. SarathRajapatirana, former Head of the World Bank’s Trade Division, Dr. Dayaratna Silva, former Sri Lankan Ambassador to the World Trade Organisation (WTO} and Emeritus Professor of Economics of the Australian National University (ANU), Dr. Prema-chandraAthukorala, emphasised the need for trade reforms to expand the country’s exports by making them competitive in the world market.

Para tariffs

“Countries that have grown fast, especially in East Asia, have understood the importance of trade reforms,” Dr. SarathRajapatirana said.

The first step, he said, of such a reform agenda should be to simplify taxes at the border by removing para tariffs. These are fees and charges in addition to import duties that have been imposed. He advocated a single uniform tariff of 15 percent for all imports.

Exports: GDP

Dr. Rajapatirana pointed out that Sri Lanka’s trade as a percentage of GDP has been low compared to Thailand and Vietnam because we have not exploited our opportunity to trade as we have high tariff rates compared to other developing countries.

Furthermore, although tariffs play a role in protecting domestic infant industries, if tariffs are too high, they can become anti-competitive. Dr. Rajapatirana observed that recent import restrictions, such as banning a wide range of consumer goods from April 2020, have further worsened Sri Lanka’s growth potential and put Sri Lanka at odds with WTO rules.

World Trade Organisation (WTO)

Dr. Dayaratna Silva elaborated on the severe consequences for Sri Lanka’s economy if such import restrictions continue. There is a possibility of tariff retaliation.

“Prolonged import controls are not consistent with the WTO, and it is high time it is redressed,”he said.

He also warned that such forms of retaliation could have a significant negative effect on our imports, thereby worsening our existing foreign exchange and balance of payment crisis.

“My worry is the long-term industrial development of the country because of these restrictions and inefficiently allocated resources as a result,” he added.

European Union

Ambassador Denis Chaibi, Head of the European Union Delegation to Sri Lanka and the Maldives commented on the importance of adhering to global rules on trade.

“The European Union tries to have a rule-based order. When a country does not follow those rules, the rule-based structure is affected. Without trade, Sri Lanka’s prospects are not good,” he explained.

Trade sanctions by the EU would be a disaster.

Value chains

“No country in the world now produces goods from the beginning to end within their geographic boundaries. Countries specialise in different components within the production value chain. Made in the country X label has become invalid,´Prof.Prema-chandraAthukorala, Emeritus Professor of Economics at the Australian National University (ANU), who is an authority on global production networks, explained.

Comparative advantage

Prof. Athukorala underscored the importance of a country to “identify her comparative advantage within the production network.”

He emphasised that Sri Lanka cannot achieve economic growth without joining global production networks through trade.

Import controls

He concluded by commenting on recent developments of import controls.

“Sselective intervention, without disturbing the incentive structure of the country as a policy, is going to be a recipe for disaster,” he said.

Summing up

Foreign assistance is critically important to overcome the current external financial crisis. From whatever source such assistance is obtained, it is only a palliative. The long run economic stability and growth of the country is dependent on adopting a policy framework that is conducive to export competitiveness.

Import substation policies have failed to improve the trade balance, on the one hand, and onthe other hand, created scarcities of essentials and deprived industries of raw materials. The liberalisation of trade to ensure international trade competitiveness is the way forward.

Although such reforms in trade policy are necessary, they are insufficient. Comprehensive changes in monetary and fiscal policies are imperative. Fiscal reforms that progressively move towards fiscal consolidation are vital for the stability and growth of the economy.

In conclusion

The recognition that the country is in an economic crisis is only a first step. The courage to change failed policies and adopt comprehensive economic reforms is imperative.

Will the Government have the political courage and resolve to adopt such reforms?

Is it not opportune for all political parties to unite in a national effort to rescue the country?