investment-banking-in-Sri-Lanka

A promising trinity of reforms

Sri Lanka’s stymied economic reforms agenda gets a major boost. But, will the country be able to make the most of it

October 31, 2017 | Echelon

Overshadowed by brinkmanship, Sri Lanka’s economy underwent some major reforms, two of which were new laws replacing outdated ones, and the third, an asset disposal. A surrounding mêlée clouded the importance of the legislative changes and the discussion of their long-term economic impact.

The new laws for income and consumption tax administration, and to liberalise foreign exchange transactions together with a billion dollar deal for the long-term lease of the Hambantota sea-port, may not alter the economic trajectory by themselves. However, they are a powerful signal to investors about the government’s resolve to confront its biggest challenges.

How firmly Sri Lanka will grasp the reforms, which have to be backed by regulations and government agencies able to implement those, may determine their success.

Dimantha Mathew, who heads investment bank First Capital’s equity and fixed income research, says these reforms will strengthen the government budget, which has been the main source of Sri Lanka’s instability. In a wide-ranging discussion about the country’s economic outlook, Mathew discussed the long-term outlook for the Sri Lankan economy.

Excerpts from the interview are as follows:

THREE TIMELY REFORMS

The first six months of 2017 was a tough period, we had floods, and on the reforms agenda, there was nothing to talk about after waiting two years for change. We went through a sovereign bond issue, and things started to get better. Three factors led to this. First, the Foreign Exchange Act was passed, followed by the Inland Revenue Act; the Hambantota Port deal was the third factor. Three key things that changed the whole dynamics of the economy, and without which the economy was heading for rough times.

I will start with the debt-to-GDP ratio. We forecast debt to reach 80% of GDP in 2017, up slightly from 79% last year. Now, however, with the three reforms within the last two months, we believe debt-to-GDP will decline going forward to around 77% in 2019. The decline doesn’t seem to be much because our GDP growth is slow. We previously expected the economy to grow 5% this year, but the first six months were bad and GDP grew only 3.9%. We’ve revised down our GDP growth forecast to 4.3% because of the floods. Three months after the floods, the economy still struggles because, unlike last year, nine districts were impacted this time. Consumer demand and buying power went off the system, so there was a crash in retail.

Usually, businesses believe it takes three months to recover from flooding of this magnitude, and for buying power to normalize. So, a part of the third quarter is also slightly affected. GDP growth will not kick-start with the reconstruction efforts and infrastructure development because floods impacted them too—construction had to stop for two to three weeks. The economy will slowly pick up from the third quarter, leading to higher growth in the fourth quarter, which is usually Sri Lanka’s biggest quarter. We could probably have 5% GDP growth. Also, when government revenue improves with the new Inland Revenue Act, the recurrent expenditure gap will be met, so additional borrowings will go into investment and capital expenditure. When that happens, there is more money spent on investments, which will regenerate the economy.

The three reforms will have a big impact going forward. For example, the foreign exchange act is very important for locals. If you take the biggest foreign exchange earners, it’s likely that most of them don’t bring all their foreign earnings into the country. This is because you can’t take it out of the country. If you bring in foreign earnings, it will belong to the government. When you liberalise laws so foreign exchange can be taken out of the country, money will start coming in, like in Singapore. If you want to be an economic hub for the region, you need to liberalise, mainly the outflows.

Right now, people have the right to invest their foreignexchange the wa y they want to, which means there is a high likelihood that more money will start coming in. Worker remittances are an important inflow for Sri Lanka. There’s been a gradual shift towards skilled labour, but remittances are not keeping pace with the amount of labour we export. So you really see the shift. Over the last three years, we’ve seen more skilled labour being exported to Southeast Asia, like Malaysia and South Korea, which has become a big labour export market for Sri Lanka.

Sri Lanka is slowly moving towards commercial borrowings, and repayments are due in 2019. We need to get our act together to attract foreign inflows with which to build sufficient reserves. Also, investors feel confident when they know they can freely take their money out, and then they will invest more. That’s why the foreign exchange bill is so important.

TAXING INCOME, NOT TRADE

The government has stepped up revenue collection over the last couple of years, and the new Inland Revenue Act will further strengthen that trend. For the first time, we’re coming closer to achieving the revenue figures estimated in the budget approved by parliament. Over the last 10-15 years, successive governments failed to reach the revenue targets they set out each year in the budget. The new act will bridge the gap between budgeted revenue and actual collection. The new act will also shift the government’s dependence away from indirect taxation to direct taxes.

Export growth is hindered because of high indirect taxes. To grow exports, we need imports. Most indirect taxes like VAT, PAL and NBT are charged on imports; so when government revenue is increased from these sources, it leads to balance of payments problems. The new act will shift the government’s revenue source from imports to collecting taxes from profits. The new act is not looking at asset classes like the previous law, but at sources of income instead, which will be taxed at the appropriate rate.

With that, you’re shifting the focus to direct taxes. In my view, it will be difficult to reduce the dependence on indirect taxes as much as the government would like, unless they start bringing down indirect taxes at the same time. According to the agreement with the IMF, the government has to abolish NBT. This is indicative of the commitment to bring down indirect taxes. If this happens, the poorer segments of the community will benefit, leading to a small buildup of consumer demand. Another precursor to reducing indirect taxes is lowering the telecom levy. I believe this is another tax that can be abolished going forward. The government will abolish five taxes every year going forward. We have 35 different taxes and that needs to be brought down to about 10 or less. This will simplify the tax system and reduce the tax burden as well. This is a regional trend. Even India went through one of its biggest tax reforms recently. So that’s where the region is moving to and we’re in line with the trend.

GROWTH SECTORS

Even though economic growth is slow, the reforms agenda is moving in the right direction, especially with the Inland Revenue Act. As a result, future real incomes will increase with expectations that inflation will be controlled at around 5-6%. We’ve been successful at keeping inflation at these levels over the last five years or so, except for short lapses. So, when you have this sort of conversion from indirect to direct taxation, real income starts moving up. This actually benefits higher-income groups, but t he middle income group even more. The middle income group is growing every year, and retail is starting to accelerate.