FISCAL TALKING POINTS

Q&A WITH DR. KOSHY MATHAI

US Treasury Secretary Timothy Geithner described the IMF as an “indispensable institution at a critical time for the global economy” a few weeks ago. He was, in fact, hailing the appointment of the first woman to head the IMF since it was created at the end of
Word War II in Bretton Woods, saying that French Finance Minister Christine Lagarde’s “excep­tional talent and broad experience will provide invaluable leadership” to the Fund.

Less than three months before the 5 July appointment of Lagarde as the IMF’s Manag­­ing Director, its former chief Dominique Strauss-Kahn stressed the importance of surveillance. “We are in year one of the new multilateral surveillance of the Fund,” he reportedly told the IMF-World Bank Spring Meetings in Washington in mid April.

And as Singapore’s Finance Minister alluded at the sessions, risk identification and management are top fiscal priorities today. “It is connecting the dots [between risks] that is extremely important,” Tharman Shanmugaratnam, who chaired the ministerial meeting of the IMF’s policy-setting body, observed.

Amongst the risks identified in Washington at the time was that of a possible overheating in some dynamic emerging markets.

Here, in Sri Lanka, Dr. Koshy Mathai has been the institution’s Resident Represen­tative during a period in which the IMF has disbursed 1.75 billion dollars of its US$ 2.6 billion Stand-by Arrangement or SBA – a loan facility around which much of our island-nation’s fiscal balancing act has revolved. His take on Sri Lanka’s fiscal-policy direction is seemingly healthy.

Mathai says in the exclusive interview that follows that the Sri Lankan Government “has already taken important steps on many of these fronts, and I think it deserves a lot of credit for those policies”.

He adds that this “gives us optimism about Sri Lanka’s economic prospects, though of course we continue to try to do our job and also point out the risks we see”.

On the global platform, high food prices in particular and oil-price volatility have dominated economic concerns, together with the after effects of the earthquake in Japan, the ongoing unrest in the Arab world and global employment prospects that are nothing to write home about.

“We’ve seen something of a soft patch, but the global recovery is continuing,” says Mathai, in this interview – and he sees Asia leading the charge of emerging economies.

As for risks, he has “the debt crisis in peripheral European countries and the possible implications of disorderly sovereign and financial defaults”; the lack of “credible, medium-term fiscal consolidation plans in several countries”; and what he calls “easy monetary policy” in advanced economies at the top of the list.

And Mathai cautions: “A final, very different type of risk relates to emerging and developing economies, some of which may now be overheating and whose policies may need tightening.”

The SBA’s next review is slated for Septem­ber, ahead of which the IMF’s Mission Chief Brian Aitken visited Sri Lanka in mid June, asserting at a press conference that Sri Lanka’s macroeconomic landscape was in order but that there is room for improvement on the twin fronts of transparency and accountability.

So yes, Sri Lankans have their hands full if the dream of national development is to be fulfilled in its true sense. But in the meantime, it would seem that the fundamentals on which our forward plans lie are in working order.

Q: What is your assessment of the prevailing global economic environment? Do you, like many others, see Asia driving the recovery and how concerned are you about signs of sluggishness in the West and Japan?

A: We’ve seen something of a soft patch, but the global recovery is continuing. The IMF’s World Economic Outlook update in June put global GDP growth at 4.3 per cent this year. This relatively robust headline forecast, however, masks a great deal of variation, exactly as you suggest. The advanced economies – held back by a number of factors, including continuing weaknesses in the financial system, much-needed but still painful fiscal consolidation, high unemployment and of course some special factors like the earthquake in Japan – are expected to grow at just 2.2 per cent. Emerging and developing economies, in contrast, are projected to grow at 6.6 per cent; and emerging Asia is leading the charge, with China growing at 9.6 per cent and India at 8.2 per cent.

Around this baseline forecast, we see risks tilting to the downside – or in other words, it’s more likely that outcomes will be worse than the projections I’ve cited, rather than better. One key risk comes from the debt crisis in peripheral European countries and the possible implications of disorderly sovereign and financial defaults: contagion through various channels could threaten the recovery in Europe and indeed the rest of the world.

Another risk relates to the lack of credible, medium-term fiscal consolidation plans in several countries, including the US. This causes markets to worry, which could lead to increased risk premiums and borrowing costs. And in the extreme, this could force countries into hasty fiscal adjustments. Either way, the recovery could be harmed.

A third risk, also relating to financial stability, stems from the long period of easy monetary policy in advanced economies: this could be prompting an unhealthy ‘search for yield’ and re-leveraging, much as we saw in the run-up to the financial crisis.

And a final, very different type of risk relates to emerging and developing econo­mies, some of which may now be overheating and whose policies may need tightening.

Q: Could you compare and contrast the G-20 with the so-called ‘EMEs’ (Emerging Market Economies) in the context of growth potential in the medium term, and keeping in mind the impact of globalisation on their economies?

A: Well, there are some major EMEs within the G-20 itself, so I think maybe the better distinction is between advanced economies on the one hand, and emerging and developing economies on the other. As I mentioned earlier, there really is a marked difference in the growth prospects for these two groups. The US and Europe remain very important, but for the first time, it’s the emerging markets that are contributing the lion’s share of global growth. And we expect that to be true not just in the short run, but for a while.

Moreover, there are going to be significant changes in the composition of growth in different parts of the world. Much has been made of the so-called global rebalancing of demand after the crisis. The world used to have the Western consumer as its engine of demand – her consumption provided the impetus for exports from Asia and other markets. But now the Western consumer is retrenching, boosting her saving rate so as to rebuild wealth that was lost in the housing crash and the financial crisis.

As a result, many currently-export-dependent economies in Asia and elsewhere are going to have to start focusing more on domestic demand – both consumption and investment – to power their growth. We’ve seen some of this rebalancing taking place, but much less than there needs to be. Figuring out the policies that can facilitate this shift in the world economic order is a major priority.

Q: The flow of capital has, in a sense, become an emotive subject in the aftermath of the global financial crisis. How should EMEs and nations such as ours manage this – firstly, in attracting capital; and then absorbing or utilising such funds purposefully?

A: I think it’s important we don’t lose sight of the fact that foreign capital can be tremendously useful to many countries, as it supplements sometimes limited pools of domestic savings and facilitates productive investment and growth in recipient countries. But yes, sometimes you can have too much of a good thing.

International investors who ran away from everything but US Treasuries during the depths of the financial crisis have, since the middle of 2009, flooded back into emerging markets, including Sri Lanka. And we’ve seen how too-large and too-rapid inflows
can complicate monetary policy, lead to an undesirable appreciation of domestic currencies (with implications for export competitiveness) and potentially destabilise an economy.

A major analytical effort has gone on at the IMF and elsewhere during the past couple of years, to understand how countries should best respond to capital inflows. Of course, there’s a variety of different policy options, and the right mix depends very much on country circumstances, so I can’t give you a single prescription here.

But the kinds of tools policymakers have at their disposal include: simply allowing one’s currency to appreciate; intervening to purchase foreign currency; adjusting monetary policy; adjusting fiscal policy; and – what we might not have been so open to in the past, but now recognise as a legitimate part of the toolkit – introducing macro-prudential measures or even capital controls to stem the flows.

Q: What lessons are there for nations such as ours from the root causes of the worldwide financial and economic crises – and subsequently, the debt and monetary conundrums that have engulfed some nations in Europe, especially Greece and Ireland?

A: First and foremost, we’ve all learned just how important the linkages are between the financial sector and the real economy. After all, we’ve seen how problems in one particular segment of the housing finance market in the US spread through the financial system, caused the collapse of some of the most storied names on Wall Street and ultimately triggered the deepest worldwide recession since the Great Depression.

Related to that first lesson, we’ve also learned the importance of financial-sector reform – improved regulation, improved supervision, development of resolution mechanisms for systemically important finan­cial institutions, and a more comprehensive and regular assessment of the implementation of new standards.

A third lesson, I think, is the extent to which weak fiscal positions can threaten financial and economic stability. This is evident in some advanced economies, which as I said before, need to develop credible fiscal-consolidation plans, and it is also clearly visible in peripheral Europe, where the debt crisis is having substantial effects on both the financial sector and the real economy.

Related to this last point, there’s a fourth lesson, and that’s that socially inclusive policies are critical for preserving macroeconomic stability. We’re seeing that particularly in the Middle East and North Africa, where high youth unemployment has contributed to social tension and economic turmoil.  

If you will allow me to add a fifth and final lesson from the crisis, it would be that global policy cooperation is critically important. During the Great Depression, countries acted alone and implemented beggar-thy-neighbour policies that ended up making things worse for everyone. But in 2008/09, countries collaborated on stimulus packages, limiting the recession to just three quarters. Now, as the global economy recovers, policy cooperation needs to continue, to make the recovery sustainable and avoid some of the downside risks.

Q: Sri Lanka’s macroeconomic platform seems to be strengthening, but there is anxiety in some quarters that we continue to live on borrowed money. Are you concerned about our level of debt, which is around 40 billion dollars, or 85 per cent of GDP? Is this a necessary evil – and if it is, how about the burden it places on the next generation of economic managers?

A: There’s no doubt that the Government has a lot of debt, but the good news is that things are headed very much in the right direction. The fiscal deficit reached nearly 10 per cent of GDP in 2009, but it’s been decreasing since then. In 2010, it came in under eight per cent of GDP; and this year, it looks like we’re on track for 6.8 per cent, as targeted in the budget.

These reductions are the result of spending discipline as well as revenue increases stemming from the comprehensive tax reform passed in the 2011 budget. The Government announced in its 2011 Fiscal Management Report that it would aim to bring the deficit down further to 5.2 per cent of GDP by 2012 and to 4.8 per cent by 2013, and we think that these are credible and realistic goals. This would imply running a very small primary surplus, meaning that state revenue would slightly exceed expenditure excluding interest payments.

Now, in fact, there are many countries that have run substantially tighter fiscal policy than Sri Lanka is doing – for instance, I used to work in Turkey between 2005 and 2007, and a key part of that government’s economic strategy was running a primary surplus of some 6.5 per cent of GDP each year (yes, Turkish GDP was probably understated then, but the fiscal effort was nonetheless massive). Brazil made almost as big an effort, with a primary surplus of 4.5 per cent. Those policies were necessary to stabilise those economies, but they involved lots of sacrifices. In Turkey, for instance, the public-investment budget had to be frozen for many years in a row.

But in Sri Lanka’s case, a primary surplus maintained at just 0.2 per cent of GDP is more than enough to put the fiscal house in order. That’s essentially because the average rate of interest on Sri Lankan government debt is very low, which in turn is a result of two facts: a lot of the debt on the books is still concessional, even though Sri Lanka has recently graduated to middle-income status; and remaining outward capital controls keep domestic pools of savings like the EPF within the country, where they help to keep down yields on Treasury Bills and bonds. In sum, the numerator of the debt-to-GDP ratio grows rather slowly (at the rate of interest), while the denominator grows rather fast (at the economy’s growth rate). As long as the Government is able to avoid large primary deficits requiring it to issue lots of new debt, the debt-to-GDP ratio falls steadily. In fact, our calculations suggest that the ratio would get to the mid-60-per-cent range by 2015 – still too high, but a dramatic improvement in just a few years.

All of this is really important. In fact, it’s tough to overstate just how important fiscal discipline is for any economy, including Sri Lanka’s. At our headquarters in Washington, people like to joke that ‘IMF’ stands for ‘It’s Mostly Fiscal’, because fiscal problems have been at the root of so many economic crises across the world.

If a government runs a huge deficit, it has to be able to finance it – and that can mean only three things: printing money by the central bank, which tends to drive inflation and the cost of living up, hurting everybody in the economy but especially the poor; borrowing domestically, which tends to drive interest rates up, slowing investment, growth and job creation; and borrowing internationally, which exposes one to the whims of international investors, as Sri Lanka and many other countries learned during the global financial crisis.

None of these options is very attractive, which is why economists usually advocate keeping deficits low in the normal course of affairs. And that’s why we’re very encouraged by the fiscal policies the Government here has been implementing recently. Sri Lanka has had its share of fiscal problems in the past – and yes, the debt is too high right now – but assuming the authorities hew to the deficit-reduction path that they have laid out, the fiscal future is looking much better.

Q: On our TV programme Benchmark, in a pre-budget airing at the end of October last year, you quipped that “the IMF is a pessimistic institution” and that “worrying is almost our job!” So are you worried about where Sri Lanka is heading – and why or why not?

A: Our role across the world is indeed to raise warning flags, and to point out reasons for caution when others are emphasising only the positive. But in Sri Lanka, it’s tough not to be a cheerleader. This is an economy that somehow managed to grow at a steady five per cent during three decades of war. Now, with the war behind us and the prospects bright for increased domestic and foreign investment, it seems only logical that we’re set for a new phase of rapid growth.

Such growth may happen almost automatically in the short run, as the economy recovers from the recent downturn and benefits from a honeymoon phase of increased activity and investment. But sustaining that growth will require a continued, strong policy framework.

First, and most basic, is keeping macroeconomic conditions stable – i.e. running sensible fiscal, monetary, financial, and external policies that keep inflation and interest rates low and stable and ensure that exchange rates move in a predictable fashion. If these basic variables are jumping all over the place, it’s tough for any business to plan, to make investments and to create jobs, and the quality of life of ordinary citizens is also directly affected.

But macro stability goes only part of the way – it’s a necessary but not sufficient condition for sustained growth. The Govern­ment also needs to promote Foreign Direct Investment by reducing red tape and enhancing the attractiveness of the overall climate for private-sector investors. It needs to continue to build up physical infrastructure. And it must also invest in human capital: Sri Lanka boasts a high literacy rate, but there are shortcomings with respect to the quantity and quality of university education, and deficiencies also in technical training. I often hear businesspeople complain that they can’t find middle-to-upper-level managers who can think laterally and drive their companies forward, and also that they can’t find appropriately skilled technical staff.

There are needs in the financial sector as well: participation in the stock market needs to be broadened; bank lending to the SME sector needs to be promoted, as does lending for long-term projects; and the corporate-debt market must be developed.

And although many Asian economies could focus less on exports, as I mentioned earlier, in the case of Sri Lanka we’d say that the priority is actually to rebuild exports, which have declined for most of the past 15 years – both as a share of world exports and as a share of GDP. Supportive policies could include the Comprehensive Economic Partner­ship Agreement (CEPA) with India and other frameworks to promote regional integration, in line with the Mahinda Chin­thana concept of developing Sri Lanka into a regional hub (exports are currently skewed toward the slow-growing West, but they need to be oriented increasingly toward neighbours like India and China, which are the new engines of global growth). Aside from regional integration, there’s a need to move toward higher value-added production – it seems to us a shame, for instance, that so much Ceylon Tea is currently exported in bulk form.

So these are some of the policy elements that we think are particularly important for sustaining growth in the medium to long run. I don’t think there’s anything revolutionary about anything I’ve just said – most people would mention similar factors – but whatever policy package is put together, it should be broadly discussed and supported by the country as a whole. As Henry Kissinger once said: “No … policy, no matter how ingenious, has any chance of success if it is born in the minds of a few and carried in the hearts of none.”

Now in fact, the Government has already taken important steps on many of these fronts, and I think it deserves a lot of credit for those policies. That gives us optimism about Sri Lanka’s economic prospects, though of course we continue to try to do our job and also point out the risks we see.

Q: The IMF recently called on the Sri Lankan Government to address transparency and good governance, rightly alluding to the “perception by the private sector that the business environment is not sufficiently transparent…”. Could you elaborate on this, especially in the light of the dire need for Sri Lanka to attract quality capital to meet its ambitious development goals?

A: First, let me emphasise the importance of raising investment in many countries in Asia, as part of the global rebalancing of demand that I talked about earlier, and in order to sustain growth. In our discussions here, in Sri Lanka, with foreign and local businesspeople, academics and others, one theme that has emerged is that some people perceive that there are mixed signals from the Government regarding the role of the private sector, and that there could be improvements in transparency and economic governance more broadly.

Some of these perceptions may actually be misperceptions, but as part of our cross-country research, we’re finding that these types of issues are very important, among other factors, to address in order to attract private investment.

It helps of course that the authorities here are very conscious of this. In this regard, the overall direction of policies – such as the tax reform, the BOI reform, and the comprehensive effort to reduce red tape and improve the ease of doing business – is certainly very positive and well-geared toward attracting much-needed investment. I am sure we can expect further positive steps in this direction.

Q: Moving on to the IMF’s US$ 2.6 billion Stand-by Arrangement or SBA (of which 1.75 billion dollars has now been released) – in a press conference  in April, following the release of the sixth tranche of US$ 218 million, you said that “there is no cause right now for a change in monetary policy, but it should be watched carefully…”. Can you explain this and also tell us where you stand today?

A: That was what I said back in April, and our mission chief Brian Aitken said much the same thing during his last visit to Colombo, in early June. We’ve heard people suggesting that the Central Bank of Sri Lanka (CBSL) should have been increasing interest rates a long time ago, just as many other central banks in the region have done, but we don’t agree with that assessment.

Yes, headline inflation rose to 9.8 per cent on a 12-month basis in April, before dropping to 8.8 per cent in May, but we think this is mostly driven by supply shocks – the flooding we experienced earlier this year drove some food prices up, and rises in the international prices of petroleum and other commodities have also had an impact domestically.

Economists generally think that monetary policy, which is a demand-management tool, shouldn’t immediately respond to supply shocks. No central bank, after all, can control food or fuel prices directly. Tightening monetary policy can at best reduce general price pressures, but this comes at the cost of slowing down the economy and dampening job creation. Right now, we don’t think that would be the right thing to do.

The general view among economists is that it’s only when supply shocks start to spill over into the demand side of the economy that monetary policy should be adjusted. So, for instance, if we start to see people’s expectations of inflation moving up sharply, or if workers across different sectors respond to those higher inflation expectations by pressing for large wage demands that in turn cause manufacturers to raise prices of general goods and services, then we might start to get worried. If we see signs of the economy’s overheating – bursting at the seams with factories running at full capacity, shortages of material and labour developing in many sectors, real-estate prices shooting through the roof, banks lending irresponsibly, etc. – then we would say the Central Bank should respond.

But we’re not seeing such signals just yet. Core inflation remains in the mid-single digits. There are labour shortages in certain sectors, but they seem more structural than cyclical in nature. The property market is quite subdued. And while credit is certainly growing very rapidly, that’s happening from a very low base – recall for how long credit was shrinking from one month to the next.

So we don’t see a need for monetary-policy tightening just now. But conditions can change fast, and central banks always have to be vigilant. No doubt, the CBSL will be keeping a careful look out for the warning signs and will be ready to act as needed.

Q: You also said at this press conference that a team from the IMF would be discussing liquidity management with our monetary authorities. How are these deliberations proceeding and are you satisfied with the Central Bank’s recent actions to manage excess liquidity?

A: Well, we’re always having this kind of technical discussion with our counterparts, and I’m sure that will continue. And this is actually a really important topic.

Excess rupee liquidity in the system is a lot lower than it was earlier, but it’s still high –  meaning that banks not only have enough money to cover their nightly reserve requirements, but they also  have quite a bit extra. With those extra funds at hand, one might worry that the banks can increase their lending even further, pushing the economy to overheat, boosting inflation and possibly exposing themselves to too much risk, as those new loans could go sour.

Moreover, in the presence of excess liquidity, some monetary-policy tools may become less effective – an interest rate hike, for instance, may fail to put the brakes on the economy as it normally would do, since banks would still have the wherewithal to continue lending.

Against this background, we fully supported the CBSL’s move to increase the statutory reserve ratio from seven to eight per cent. This basically meant that the banks are required to keep a little more of their deposits on hand, rather than being allowed to lend those monies freely onward. It thus directly reduced the excess rupee liquidity in the system, and by a substantial amount – close to Rs. 20 billion.

Now where is this excess liquidity coming from?

It’s almost all a result of the CBSL’s foreign-exchange intervention. Since 2009, there has been a large net inflow of dollars into Sri Lanka – imports were subdued for a long time, while remittances continued to be strong and a lot of foreign capital came in to make portfolio investments in assets like Treasury Bills and bonds.

The Central Bank stepped into the market regularly to purchase those dollars, selling rupees in exchange. The purchase of dollars meant that the CBSL’s foreign-exchange reserves were rebuilt, and the injection of new rupees into the system stemmed the appreciation of the Sri Lankan Rupee that would otherwise have resulted from so many new dollars chasing after the existing pool of domestic currency. That same injection of new rupees, however, also meant a build-up of excess liquidity.

Earlier, the CBSL was able to sterilise its intervention effectively – it engaged in longer-term open-market operations, lending Treasuries to the market, issuing its own CBSL securities at times and engaging in FX swaps, all to mop up excess rupees. But more recently, it has become difficult in the market to mop up those rupees on a term basis. The excess rupee liquidity is instead sterilised on an overnight basis, but the problem is that bank credit officers still view such funds, which are locked up for only one night, as available for lending, and the same concerns about excess liquidity that I mentioned earlier still apply.

In some months during the first half of the year, we’ve seen CBSL sales of dollars, and that has been a principal driver behind the reduction in excess rupee liquidity. The problem is certainly less acute than it was in the past. But as the Central Bank continues to accumulate reserves in the future, as we think it should (at least at a moderate pace), excess liquidity may increase again.

The answer to this is not to shy away from reserve accumulation. Rather, it’s to come up with monetary-policy tools that address the situation directly.

Q: Inflation has been in single digits for quite sometime and borrowing rates are now relatively low. Are you confident that this stability can be maintained?

A: We think the CBSL has been running monetary policy very competently, and the reduction in inflation and interest rates is a result of that. We never know what external shocks are around the corner, but underlying inflation trends seem to be under control. With continued prudent monetary and fiscal policies, we would expect to see inflation and interest rates both falling further over time.

Regarding interest rates, I would note that deposit rates are actually quite low – adjusted for inflation, they are often actually negative, and this is not a good incentive for saving. So I would hope that we see real deposit rates moving into positive territory while lending rates fall. That kind of compression of net interest margins may require not just sound macroeconomic policies, but also some structural improvements to the efficiency of the banking sector.

Q: There is an ongoing debate, especially amongst our exporters and importers, about the value of our currency – and whether or not the Central Bank should intervene to peg it. What is your take on this and where would you like to see the rupee heading in the medium term?

A: We firmly believe that Sri Lanka’s flexible exchange-rate regime is appropriate and that there should be no peg. Of course, a central bank can never be totally hands off – it’s sensible to intervene in order to avoid disorderly movements in the exchange rate that could harm the economy. But econo­mists generally would say that sustained intervention in one direction or the other to keep exchange rates either above or below the levels suggested by fundamentals should be avoided.

Soon after the end of the war, we saw a long period when the rupee was virtually fixed against the dollar. Since then, we’ve seen some flexibility in one direction, with the rupee appreciating. And given the amount of foreign currency flowing into the economy, there’s little wonder that we should have seen stable or appreciating exchange rates over this period.

Going forward though, rising imports and high oil prices could imply smaller balance-of-payments surpluses or even deficits; and in such a scenario, it would be important to illustrate to markets that the rupee is flexible in both directions. This would also encourage the development of forward markets in foreign exchange and discourage short-term, speculative capital inflows, which Sri Lanka doesn’t need.

As for where the rupee should be headed in the medium term, let me just say that I learned a long time ago not to try to predict currency movements! Economists have statistical models that try to explain the appropriate levels for exchange rates, but the results of those models are sometimes difficult to assess, particularly in a world of large capital flows. In the IMF programme here, in Sri Lanka, rather than looking at the price side of things – that is, the exchange rate – we have focused on the quantity side (i.e. the level of reserves at the Central Bank).

Reserves are certainly not a problem for Sri Lanka. In fact, the build-up of reserves over the past two years has been a resounding success, far in excess of what we initially expected – and that’s not just because of foreign borrowings. Nonetheless, reserves are not high compared to levels seen in many other EMEs, and there is probably some scope for at least modest further accumulation. So in the programme, the Central Bank commits to achieving such accumulation and the exchange rate is allowed to adjust however it needs to, in support of that reserves target.

Q: How do you view Sri Lanka’s investment prospects, especially in the light of our image abroad and the stiff competition there now is for quality FDIs? (The shortfall versus target in the last two years has been significant – net inflows have been less than two per cent of GDP)

A: FDI has clearly been a weak point for Sri Lanka. Last year, it amounted to just over one per cent of GDP, and this year we’re targeting an increase to two per cent. By contrast, FDI in Vietnam accounts for eight per cent of GDP!

Now, historically, Sri Lanka was struggling under the burden of the war, and it was naturally difficult to attract international investors here. But things have now changed fundamentally, and I think prospects for increases in both FDI and domestic investment are strong. We’re already seeing a pick-up in investment, and with further efforts to reduce red tape, make the BOI more of a facilitator and improve the overall investment climate, I hope we’ll see even more improvement in the investment numbers.

Q: How important is the diaspora to Sri Lanka’s development ambitions? What measures should be taken to entice expatriates to invest substantially in their homeland – especially in the war-torn north and east – and perhaps return home (and reverse the brain drain)? What can we learn from the Indian experience?

A: This is a really important question, but I’m not sure that I have a good answer. There’s no doubt that a lot of talented (and rich!) people of Sri Lankan origin live outside this country, and getting them to invest in and come back to their home country would be fantastic. That’s especially so because many of these emigrants come from the north and east, which of course face particular challenges.

I think that part of this involvement of non-resident Sri Lankans will happen naturally. As the economy here continues to grow, as new opportunities come up and as wages rise, it’s inevitable that Sri Lankans abroad will think about bringing their money or even themselves back. And I guess the strong remittance figures are evidence that some of this is happening already.

About 10 years ago, I worked on the IMF’s team for Zambia, and I was struck by how many Indians I found living there – indeed, the first sign I saw on coming out of the Lusaka airport read: ‘Zambia Malayalee Cultural Association Welcomes You’ – which of course made me, as someone who was born in Kerala, feel right at home!

I was told that many Indian professionals had arrived in the 1970s, when the Indian economy was stagnant but copper-rich Zambia was booming. But what Indian professional today would go to Zambia, when the Indian economy has become so dynamic? And how many of those long-time Zambia residents are now thinking of a return to India?

An IMF colleague of mine who studied at IIT tells me a similar story – that while 30 years ago, almost all IIT graduates aspired to go to Silicon Valley, most of them today want to stay in India. As opportunities arise, people will want to stay, and that same idea applies to Sri Lanka.

Aside from this natural evolution, there may also be scope for special measures to attract investment from non-resident Sri Lankans. And as you’ve said, there may very well be lessons Sri Lanka can learn in this respect from India, which has had a lot of success in catering to and mobilising funds from the so-called NRIs.

Q: Sri Lanka’s aspirations to create BPO and KPO hubs centre on our credentials – e.g. literacy levels, language skills, a high number of professionals, amongst others. Are we making the most of our potential, do you think? What more must we do to make inroads into what is undoubtedly a lucrative business arena? On the other hand, are there any negative connotations in following this path?

A: Well, as I mentioned earlier, I think that literacy is only part of the story. Business leaders I talk to tell me that they need people with English skills, with IT skills and with creative-thinking skills; and for that, we need an additional emphasis on training and higher education. As you say, there is huge potential in the BPO/KPO area – and we don’t need to think only of call centres, but can envisage more advanced functions as well.

India attracts so much of this worldwide business, and if even a little bit of that work can come to Sri Lanka instead, or can be subcontracted from Indian firms to their Sri Lankan counterparts, it would be a huge bonus for the economy. Here again, I must emphasise the importance of the CEPA with India. India is a massive growth engine, and if we can tie our wagon to that engine, we’re bound to go places.

There have certainly been problems with the free-trade agreement that’s been in place between India and Sri Lanka for over a decade, but we should work to fix those problems rather than throwing the idea of CEPA out entirely.

Q: How does the IMF view ailing but essential state institutions such the CEB and CPC? Are you convinced (based on recent pronouncements that it is no longer in the red) that the former is experiencing a turnaround? As for the latter (which continues to absorb massive losses), what, if anything, can and must be done?

A:  As in many countries, our monitoring of the fiscal position focuses on the central government, but the performance of state enterprises is also a key part of the overall fiscal stance. That’s why the IMF programme includes a benchmark that the CEB and CPC should break even, on a combined basis, by 2011.

Now as you’ve said, the CEB is doing a lot better and is in fact profitable. As we understand it, this is largely a function of the heavy rains earlier this year: the same rains that caused such destructive flooding also filled the tanks and have facilitated a substantial shift in the mix of electricity generation from expensive thermal plants to cheap hydropower. This provides temporary assistance to CEB’s financial performance.

In the long run, however, the key is the addition of cheaper sources of generation. The current mix of plants, some of which run on very expensive fuels like diesel, has very high average costs of generation – in fact, several rupees per unit higher than the average selling price. But with the addition of new coal-powered plants and new hydro capacity (Norochcholai, Sampur, Upper Kotmale, etc.), average generation costs are set to fall over the next few years, and this should set the stage for profitable operations going forward.

For CPC, we understand that the bulk of its past losses have stemmed from the sale of subsidised furnace oil to the electricity sector. CPC too has thus benefited from the rains, as the volume of those subsidised sales has now fallen, and it will similarly benefit from the shift in the CEB’s generation mix over the next few years.

Beyond this, there are operational efficiencies to be gained at both enterprises, I’m sure, and I believe the two managements are trying to implement measures in that direction.

Q: LMD-commissioned Nielsen polls in recent times suggest that businesspeople are now concerned about poverty. What more must the Government do to reduce the proportion (over 15 per cent are thought to be living on less than two dollars a day) of people who continue to live below the international poverty line?

A:  This is a key issue. It speaks directly to the welfare of the people and unless the entire population benefits from economic growth, support for the policies that foster that growth may weaken. But even though it’s a key issue, I must admit that poverty reduction is an area where the IMF doesn’t really have any special competence. As you know, our mandate is more in the area of short-term macroeconomic stabilisation, and I’m not sure I’m going to be able to speak with much authority on specific policies to address poverty.

What I can say though, is that even the basic macroeconomic stabilisation that we advocate helps the poor – studies have shown that the poor are often those disproportionately affected by macroeconomic volatility, high inflation and interest rates, etc. And there’s no doubt that we need economic growth – while I have strong personal views about the need for redistributive policies in any society, redistribution alone cannot be the answer. Consider the experience of China, where millions upon millions of people have been pulled out of poverty as overall economic growth has charged ahead, and contrast it to earlier examples in other countries where governments focused purely on redistribution and had far less success in poverty reduction.

Indeed, the recent Commission on Growth and Development, chaired by the Nobel prize-winning economist Michael Spence, found that every case of a nation’s rising out of poverty involved a period of strong and sustained growth. That said, growth must be achieved in a sensitive manner, and the presence of well-targeted social safety nets to protect the poor is critically important.

Q: What in particular would the IMF expect when next year’s fiscal budget is presented in November? Would you desire more significant reforms vis-à-vis streamlining the remaining (and many) ‘nuisance taxes’ that continue to make life a misery for Sri Lankans?

A: I think the main thing we’re looking for is a further reduction in the deficit, in line with the path laid out in the Fiscal Manage­ment Report. Underscoring the Govern­ment’s commitment to fiscal discipline year after year not only strengthens the fiscal position, but also gives a very clear and positive signal of policy consistency to markets.  As for taxes, the tax reform passed last year was great; but of course there’s more room for simplification, and additional measures to strengthen tax administration would also be desirable.

Q: Still on the topic of taxation and budgets, where do you stand on whether our focus should be on direct or indirect taxes – and why?

A: I’m not sure I really see this as a big topic of debate. Most countries have a mix of both types – direct taxes like the income tax, as well as indirect taxes like the VAT, excises and customs duties. I think it’s a stylised fact that many South Asian countries, including Sri Lanka, tend to rely more heavily on indirect taxes, and that’s largely because of difficulties with the administration of, and compliance with, income taxes. In our view, there’s a need for more of a balance.

But as tax-administration capacity builds up, so too will compliance with income taxes. And that may be also convenient for a government, as it provides another tool with which a society’s income-distribution objectives may be addressed.

Q: Finally, and in your assessment of the big picture, where does Sri Lanka’s future lie and what sensitivities are there in the economic and political milieu we now live in? And after the IMF’s SBA runs out – what on earth do we do thereafter?

A: As much as I’d like to think that the IMF programme is the be-all and end-all of the Sri Lankan economy, I know that that’s definitely not the case! IMF programmes play a certain role in bolstering market confidence and helping governments to commit to strong policies and build reserves during difficult periods. They’re not meant to be a permanent feature of the landscape. The fact that our programme has continued for two years, through six formal Board reviews already, is a sign of success – it means that macroeconomic indicators and government policies are generally strong.

The programme is scheduled to end early next year, but while the lending may stop, the constructive policy dialogue that we’ve engaged in with the authorities will not. IMF teams will continue to visit periodically and exchange views with government counterparts on economic developments and policy responses.

People will have seen the Government’s commitment to deficit reduction, sensible monetary and financial policy, and prudent external-sector management. If these had just been IMF policies, I might have worried that things would change when the programme ends.

But since, throughout, they’ve been policies very much driven and owned by the  authorities themselves, I don’t expect any major changes, and I think the markets will remain confident.

Sri Lanka has huge opportunities ahead of it, and this is really an exciting time to be here in the country. If strong policies can be maintained over the next few decades – a tall order, no doubt – a fundamental economic transformation could take place.

My mother grew up in Malaysia, and her side of the family is settled there, so I’ve been to that country many times over the years.

Kuala Lumpur today is almost unrecognisable as the same city that I used to visit as a kid in the 1970s. And while some observers talk about Malaysia now having fallen into a ‘middle-income trap’, there’s no denying the massive progress that that country achieved in terms of raising its people’s living standards over a comparatively short period. I very much hope we’ll see the same thing happening here.

– LMD

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