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Economy

Sri Lanka's VAT fiasco adds pressure, makes budget crucial

A man walks passed Sri Lanka's old parliament building now in the shadows of new high rise buildings coming up to change Colombo's skyline in the growing post-war economy. (Photo by Marwaan Macan-Markar)

COLOMBO -- Sri Lanka's finance ministers strike at midnight, while the country sleeps. The public wakes up to the shocking news in the Gazette, the government journal that prints official decrees, of price increases in selected goods following overnight tax increases.

President Maithripala Sirisena's administration last resorted to the "midnight gazette," as the local media describe this sly maneuver, on Aug. 19. The issue that justified its action? The imposition of a tax on imported large onions from India to protect local farmers producing smaller onions.

Sirisena's coalition administration -- which came to power following a surprise win in the January 2015 presidential election -- is not shy of using this sleight of hand, despite widespread criticism. On May 2, it used the midnight gazette to increase value added tax from 11% to 15%. A backlash led by opposition parliamentarians followed, focusing on protests that the government was reducing the role of the legislature to rubber-stamping taxes that had already been imposed.

The uproar led to a landmark ruling in early August by the Supreme Court, in a case filed by an opposition lawmaker and two Buddhist monks that accused the government of not following due process. The suit claimed the VAT hike was illegal because parliament was not consulted before the new rates were enforced. The judges agreed, freezing the process until the government follows the required process: a debate in parliament, followed by a vote.

The government accepted the ruling, but has created uncertainty about its intentions by failing to say when it will present a VAT bill to parliament. Business leaders are waiting for signs from the finance ministry, which is currently preparing a budget to be presented in mid-November. Some details of the VAT strategy have emerged, including a rise in the revenue threshold for retailers from 33,000 Sri Lankan rupees ($225) a day to 138,000 rupees, which will exempt many small traders. There is also a growing list of goods and services that will likely be exempt.

The delay in finalizing the new VAT rates spells trouble, however, as the ruling National Unity Government seeks to implement a deal agreed with the International Monetary Fund for a $1.5 billion loan intended to help the administration to cope with a growing fiscal deficit, soaring foreign debt and a big trade imbalance.

In June, the IMF approved the payment of a first tranche of $168 million, with the remainder available in six instalments over a three-year span, subject to quarterly reviews. However, the deal is contingent on radical changes in Sri Lanka's finances that are causing strains in the government, a coalition formed by former rivals Sirisena and Prime Minister Ranil Wickremesinghe. The two men hail from parties that are traditional rivals.

Jaewoo Lee, leader of an International Monetray Fund team to Sri Lanka, speaks at a press conference on Sep 23 at the Central Bank in Colombo. (Photo by Marwaan Macan-Markar)

The strings attached to the IMF package include a hike in VAT to raise government revenues, and reform of more than 200 loss-making state-owned enterprises -- including Sri Lankan Airlines, the national carrier -- which are together reported to have accumulated $15 billion in debt. Colombo-based banking sources say the figure could be higher, since the previous government allowed some loans by local banks to be kept off the SOEs' books.

The IMF says that Sri Lanka's gross domestic product could grow by a relatively healthy 5% in 2016, compared with 4.8% in the previous year, helping to create room for fiscal and economic reforms. But it has also warned that the government must fulfil its commitments if the three-year Extended Fund Facility is to continue in place.

"It is important that the government expedites the legislative process of implementing the value added tax amendments that are needed to support revenue targets for 2016 and 2017," Jaewoo Lee, head of an IMF delegation, said in late September, at the end of a two-week visit to the South Asian island. "If the VAT [change] is not implemented in a timely manner, we will have to postpone the review," Lee said.

Dependent on remittances

The government can ill afford an IMF snub. The economy is heavily dependent on remittances from migrant workers in the Middle East and other corners of Asia to balance its external payments. Average annual exports of between $10 billion and $11 billion, largely from garments and tea, lag well behind annual imports of $18 billion. Annual remittances from Sri Lankan workers overseas amount to about $7 billion. Foreign direct investment fell below $1 billion in 2015.

Fitch, a global ratings agency, downgraded Sri Lanka's long-term foreign debt credit rating from BB- to B+ on Feb. 29, ahead of the government's request for IMF assistance, noting that the country faced "increased refinancing risks on account of high upcoming external debt maturities." Fitch added that the country's "external liquidity position remains strained, reflecting pressure on foreign reserves." Moody's, another ratings agency, downgraded the Sri Lankan economy from "stable" to "negative" in June -- a move that took the government by surprise, since it came in the wake of the IMF agreement.

The downgrades followed a serious deterioration in Sri Lanka's fiscal situation in 2015, with the budget deficit hitting 7.4% and public debt rising to 76% of GDP, from 70.7% in December 2014. "As of end-2015, there was also an estimated 1.36 trillion rupees (11% of GDP) in additional government and state enterprise liabilities," the IMF added in a mid-2016 assessment.

Some of the country's financial problems were inherited by the coalition government, which had to start paying off loans raised by the previous administration of President Mahinda Rajapaksa. The previous administration significantly expanded the public sector, building up public sector debt and nationalizing some profitable companies. Some of the its projects ended up as white elephants, including a barely used $209 million international airport built in a forest in Rajapaksa's constituency.

China was a key funder of Rajapaksa's infrastructure spending, through loans totaling nearly $5 billion, many at commercial interest rates. "China was the only country willing to write the big checks, so the (Rajapaksa) government had no choice," said a senior Colombo-based commercial banker.

However, other problems faced by the Sirisena administration have been self-inflicted. Soon after Sirisena's unexpected presidential election victory, the administration gave salary increases to about 1.3 million public sector workers -- adding 2 percentage points to the budget deficit. This was clearly to ensure their support in a parliamentary election in August 2015, which his coalition won.

"Fiscal policy in 2015 was certainly expansionary given the large increases in recurrent expenditure," said Deshal de Mel, a Colombo-based economist. "This compounded an existing challenge of rising short-term external debt repayments -- which in turn is a legacy of accumulated foreign borrowings in the past."

A new VAT law, however, may not be enough to ease the government's fiscal worries, even though indirect taxes account for 80% of revenue collection. "The finance ministry's competence to tax smart is low, and I cannot see how Sri Lanka can succeed without a major overhaul of its bureaucracy," said Nishan de Mel, executive director of Verite Research, an independent think tank. "Many people are not getting into the threshold and there are far too many tax holidays."

As a result, the budget in November is shaping up as a crucial element in the government's efforts to build financial credibility. "If fiscal policy doesn't add much pressure and sound measures are properly executed in the budget, stability will ensue," said Shiran Fernando, lead economist at Frontier Research, a Colombo-based think tank. "But if the budget is populist then it would apply pressure on borrowings."

This uncertainty about the direction of policy is a growing political problem for the government, which faces local government elections early 2017. The economy is expected to loom large on the campaign trail, particularly after the VAT hike comes into effect. But there are also fears of a backlash from traders, who might seek to avoid paying more VAT, either by reducing business activity to stay below the tax threshold or by keeping some transactions off the books by not issuing invoices.

"There is no force in the economy that suggests we are heading somewhere," said a senior company executive. "It feels like we are stuck in second gear."

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