Road to Prosperity through COVID-19 Pandemic

While the global economic fallout caused by the COVID-19 pandemic is unprecedented, Sri Lanka is one of the hardest-hit nations in the region even without a widespread pandemic issue. During the period of four months in 2020 from the end of January to the end of May, Sri Lanka has reported approximately 1,540 COVID-infected positive cases, over 750 recovered and 10 deaths. Two major infected clusters have been the accidental Navy cluster and close associates with over 750 positive cases and the returnees from abroad with over 460 positive cases. If these two clusters are left aside, Sri Lanka appears to have managed the pandemic issue well with less than 350 positive cases within the community.

Channels of economic fallout

The economic fallout of the COVID-19 in Sri Lanka emanates through three channels: Firstly, it is the negative effects of the “strict” lockdown approach that Sri Lanka has adopted. The country was under a strict lockdown since mid-March with curfew imposed throughout the island, while the government played an active role in tracing every single potentially infected person with the assistance of military forces. Given the weak capacity and limited resource base of the health sector, such a strict lockdown strategy had been extremely important to manage the COVID-19 issue without letting it go out of control. Sri Lanka spends only 1.6 per cent of GDP as public health expenditure, which is significantly lower than the average 2.8 per cent of GDP for the middle-income countries. Further, the country has only 1 physician and 2 nurses per 1000 people, which is an indicator of the weaker human resource base in the health sector, compared to many other middle-income countries in the region. The irony is that, however, the negative economic repercussions of a strict lockdown strategy have been significant. The paralyzed domestic economic activities – production, distribution, and consumption, have resulted in a loss of income and jobs.

Secondly, the global spread of COVID-19 pandemic at different rates and different sequences across the world has resulted in a breakdown in Sri Lanka’s global connectivity affecting the economy. As of now, the total number of COVID-infected people in the world are reaching six million and the related deaths to three hundred thousand. The USA and Europe – the two regions that are important as destinations for more than 50 per cent of Sri Lanka’s export trade, appear to be the epicenters of COVID spread. Apart from that, breakdown in the country’s supply chain, collapse in tourism and hotel industry, and the decline in foreign employment and private remittances have caused a standstill in the functioning of the globally connected economic activities. Even if Sri Lanka can return to some degree of normalcy with its strict lockdown strategy, the country’s global connectivity is unlikely to return to normalcy unless the rest of the world is able to recover from the COVID pandemic issue. This means that returning to normalcy in isolation does not mean much in terms of the country’s economic recovery.

Finally, the aggregate effects of the COVID pandemic issue leading to a global economic recession is bound to drag the economic recovery of Sri Lanka further away from the foreseeable future. Asian countries did not feel the previous global economic crisis of 2008-2009, because they continued to grow while the rest of the world was reporting negative growth rates. However, the forthcoming global economic crisis appears to be much deeper and wider in a sense that its negative impact is likely to spread across the world. The USA, Eurozone, China, Japan and the UK produce nearly two-thirds of the world’s output, while they all have reported a contraction in their GDP in the first quarter of 2020, which would continue during the rest of the year too. This means that even if the COVID issue is over, the global economic crisis that it has brought to the world and the resulting shift in economic policies continue to deter the countries like Sri Lanka to return to their normal growth path.

Economic impact

In general, the functioning of the economy came to a standstill with the lockdown. The supply chains of the production activities were broken at both ends – input supply and output sales. There has been a reduction in income and a loss of jobs and livelihoods. Some of the companies had laid off the jobs or cut down the salaries. However, the different production sectors and social groups felt the impact of the lockdown differently, informal sectors and the urbanized working classes appeared to be vulnerable to the economic fallout more than others.

Poverty effects of the economic fallout appear to be significant. By national poverty line, only a 4 per cent of people in Sri Lanka which amounts to 845,000 in number remained poor in 2016. However, according to World Bank estimates, there are 2 million people who live on less than US$3.20 or approximately LKR 600 a day. Sri Lanka’s poverty is largely a rural phenomenon with more than 90 per cent of the poor is attached to the rural sector which is dominated by the agriculture sector. More than a quarter of the country’s 8.5 million labour force are still occupied in the less-rewarding and less-productive agriculture sector which contributes less than 8 per cent of GDP.

Although rural agriculture sector is unlikely to get affected severely compared to industry and service sectors which suffered a direct hit, even the marginal impact due to the breakdown in supply chains and reduction in consumer demand has a greater impact on poverty. Moreover, it is part of the rural labor that has been employed in urban-based industry and service sectors that has suffered a loss of income and jobs so that the poverty incidence of COVID-19 issue is significant.

The travel and tourism sector and the hotel and hospitality industry that barely recovered from the Easter Sunday attack in April 2019, experienced a major blow affecting incomes and jobs of the people who are directly and indirectly employed by the sectors. It was also hard for the SME sector to survive without a continuity in cash flows to meet the working capital and the debt obligations. There are beneficiaries too. The ICT sector and the companies that employed digital and delivery technology appear to have made a significant improvement. However, at least partially it is the utilization of excess capacity more than the expansion of the industry with net increase in job opportunities.

Policy response

The typical policy responses to economic crises as such involve both fiscal and monetary stimuli, in addition to the direct spending on handling the COVID-19 pandemic issue. Fiscal policy stimulus includes increased government spending in compensating for the weakened private spending by both the household and business sectors. The governments spend in order to mitigate the negative impact on aggregate demand as well as on social security systems. Part of the increased spending may be directed at supporting the business ventures to mitigate the losses and even bailing out troubled business ventures. In effect, fiscal stimulus is likely to result in increased budget deficits and increased debt financing of such deficits.

The idea of monetary policy stimulus is to increase the liquidity level by injecting money into the financial sector and to make the bank credits cheaper by lowering the interest rates. The central banks undertake monetary policy measures aimed primarily at these outcomes sustaining the aggregate demand, in addition to the provision of various financial incentive mechanisms to create breathing space for the households and the businesses. As the inflationary pressure is often eased in the face of an economic crisis, the central banks usually enjoy more room for expansionary monetary policy measures.

Unlike in most of the advanced countries, Sri Lanka had more space for monetary policy stimulus than for fiscal policy stimulus. Advanced countries had already undertaken monetary expansion through quantitative easing, injecting massive amounts of money into the financial sector and bringing down their interest rates to zero level or even below zero levels. Therefore, they resorted more to fiscal stimulus packages. However, in Sri Lanka the narrow fiscal space coupled with an increased debt burden did not allow the government to design a wide range of spending programmes. However, the Central Bank of Sri Lanka (CBSL) had a comfortable space for monetary policy stimulus, though such policy measures had negative repercussions on the external balance. Besides, part of the excess money was reported to have returned to the CBSL as bank deposits because credit growth was far below the expectation.

There are, however, structural issues that limit the effectiveness of the monetary and fiscal policy stimuli in reaching the targeted beneficiary groups. On the demand side, individuals, households, and SMEs which need be targeted with such assistance programmes are difficult to identify in the absence of accurate and updated information systems. For small businesses, the structural issues including information bottlenecks limit their ability to get access to the financial assistance that is available through the banking system.

To which extent a country can respond effectively to an economic crisis of that magnitude depends on the medium-term economic performance of the country itself. Even prior to the COVID issue, Sri Lanka was not doing well. According to the Road Map 2020 presented by the Governor of the CBSL on January 6, 2020, Sri Lanka had to deal with tough challenges such as “below potential growth, persistence of poverty pockets, underutilization of productive resources, inadequate expansion and diversification of exports, shortfall of non-debt creating capital inflows, large credit and interest rate cycles, and high fiscal deficits and public debt levels.” Over the years, growth prospects of Sri Lanka were fading away steadily year by year reaching the lowest rate of 2.3 per cent in 2019. In consistent with that, exports have declined resulting in an increased trade deficit as big as export earnings. Tax revenue has been depleting against rising public expenditure, often resulting in a deficit in the primary account. Public debt has increased to an alarming level of LKR 13 trillion (over 85 per cent of GDP) by the end of 2019. With increased foreign commercial borrowings over the past 12 years, foreign debt now accounts for about half of the total debt. In the current year 2020, foreign debt repayment obligation remains to be US$4.8 billion, while the official foreign reserve position of the CBSL is limited to about US$7 billion. All these indicators show that the economic status of the country was far from being satisfactory even before the outbreak of the COVID issue. In effect, the capacity of the government to respond effectively to the negative economic fallout due to COVID-19 is absolutely limited and the potential economic hardship caused by the COVID-19 issue is unquestionably significant by the dismal performance of the economy in the past.

Beyond COVID-19

How deep the recession might be and how long it would last are important questions that have drawn much attention among academics and policy makers around the world. While economic crises have often brought about a shift in economic policies, there is also much concern about the possibility of strengthening the “national distancing” as guiding the post-COVID policy thrust. The world has already seen the emerging protectionism between the global financial crisis in 2008 and the COVID-led economic crisis in 2020.

At least temporarily, the policy focus on domestic agriculture, food security and economic activities based on “home market” could be seen widespread under the given circumstances. Such movements are inevitable, but it might pose a danger when such policy thrust is guided by protectionist ideological positions. However, under any economic ideology an undisputable economic principle is that the progress of an economy is constrained by the size of the market. This means that there would be time that the economic activities need to overcome the boundaries of the home market penetrating into the international markets, if the progress is to continue.

There are opportunities in difficulties too. Long-term economic performance of Sri Lanka did not appear to be impressive for nothing. The reform process of the country did not review for decades so that the policy and regulatory environment does not remain attractive to investment. The difficulties in the COVID-19 pandemic era has opened valuable opportunities to address the deep-rooted fundamental weakness with a bold reform agenda as well in preparing the country for the post-COVID take off.

Reform agenda

1. As a temporary and short-term policy measure it is necessary to continue with monetary and fiscal policy stimuli in order to mitigate the economic downfall, but it is advisable to move beyond them as quickly as possible focusing on longer-term policies that would ensure development and stability.
2. In order to improve the effectiveness of such fiscal and monetary policy stimuli, it is recommended that the country should establish a multi-purpose centralized National Information System of the country’s population, which would be managed by a central authority such as the Department of Census and Statistics, and of which relevant information would be shared with relevant public bodies.
3. The expansion and upgrading of the digital infrastructure covering the entire island is another important move in order to maximize the emerging usage of ICT in various fields of economic activity including e-commerce and e-governance, not only in the short-run but also in the long-run
4. Short-term relief measures to mitigate poverty implications of the COVID-19 need to be replaced with the deliberate support for the expansion of industry and service sector development in the peripheral areas providing modern jobs to rural youth and reducing population pressure in the rural agriculture.
5. Protectionist policy measures such as those which are in place at present may be necessary as immediate remedies, but economic progress beyond recovery requires expansion into international markets and exposure to international competition. In order to prepare for long-term acceleration of economic growth, an investment-friendly business environment needs to be restored for the purpose of raising both local and foreign investment by removing the regulatory bottlenecks and improving the policy framework.
6. The SME sector has been faced with a series of structural issues and regulatory bottlenecks which limit their business performance and raise the costs of production. It is time to address the problems at source, and to give up compensating them with import protection.
7. As the acceleration of growth is constrained by the size of the market, export promotion should receive priority while a proper balance between tradable sector and non-tradable sector expansion should be maintained. This would also help the stabilization of the exchange rate which is currently being more vulnerable to short-term capital inflows and outflows.
8. A couple of special economic zones (SEZs) free from the country’s general regulatory systems can be established, first in the Colombo Port City, secondly in Hambantota, and thirdly in Trincomalee, to position Sri Lanka as an international business enclave in between the West and the Far East. The policies of the SEZs can be extended to transform Sri Lanka to a competitive international centre for ports and aviation, ICT, finance, trade and commerce, and education and vocational training, by attracting foreign investment and “world-class” human resources.
9. Labour market rigidities due to regulatory mechanisms and the labour condition disparities between the private and public sectors need to be removed with reforms aimed at flexible labour markets, incentives to human resource upgrading and work performance, and competitive labour conditions between private and public sectors. Labour market reforms should also be aimed at accommodating “foreign talents” particularly in the areas where there is labour shortage and lack of competitive exposure.
10. Sri Lanka should focus on resolving its human resource gap by opening its higher education and vocational training to import knowledge and skills (recruiting professors and trainers from abroad) and to export knowledge and skills (admitting foreign students). Both requires opening this area with the removal of its “closed economy” model and granting autonomy to the institutions to reduce their state-dependence.
11. State-owned enterprises need to be reformed, at least by moving into broad-based ownership structures, by converting into listed companies, adopting different management practices, and mandating them with publishing not only the audit reports but also the economic and financial information. This is necessary not only to reduce their financial burden on the government budget, but also to improve the country’s cost competitiveness in production.
12. The fiscal consolidation requires not only rationalizing the expenditure side, but also adopting modern revenue collection systems. The centralized information system as mentioned above would help the Inland Revenue Department to maintain a fiscal database for the entire population, identifying potential taxpayers and eliminating tax evasion. Improving direct tax base has been a long-due requirement for fiscal consolidation.
13. Public sector reform is an important area of reforms that has never been undertaken during the liberalization period of the country. The public sector needs to be reformed in order to provide a demand-driven and efficient public sector service, reducing complicated and lengthy bureaucratic procedures and facilitating private investment and business expansion.
14. The current crisis period is the best time to exploit the emerging opportunities to undertake most of the above reforms and to correct the deep-rooted structural issues and weaknesses.