Sri Lanka:  Correct The Price Distortion for A Sustainable Development – Part 1

After introducing the open economic policy, the inflow of foreign grants and concessionary credits increased considerably.

12 mins read
A man rests while waiting in a line to buy diesel near a fuel station in Colombo, Sri Lanka [ File Photo © Dinuka Liyanawatte/Reuters]

A riot in Sri Lanka dethroned the democratically elected prime minister and the president in May and June 2022, respectively. Ranil Wickremesinghe, who did not contest the presidential election and could not get the support of at least one per cent of the constituents during the general election, was elected as the president by the parliament. However, he did not have a single MP in the parliament from his party to vote for him. He doesn’t have members of parliament from his party to appoint to the cabinet of ministers. As such, his political opponents who are entirely against his liberal policies have been appointed to the cabinet, and he is yet to find MPs to fill all portfolios. Under these circumstances, since the beginning of 2022, Sri Lanka has been in Socio-political and economic turbulence. The country is bankrupt, people are suffering, and the economy is in reverse gear. 

Historically, Sri Lanka is accustomed to a welfare-oriented economic culture. During the colonial period, universal free health and vernacular education were available. In addition, universal and generous food subsidies with rationing started during World War II. Probably this would have been done to keep Sri Lankans contented, considering the strategic importance of Sri Lanka for the war. However, since independence, providing welfare and subsidies for the whole gamut of life of Sri Lankan has become a perpetual feature of the annual budgets. At the inception, the cost of subsidies and welfare was met from the surpluses generated from the plantation sector and the export of natural resources as raw materials to advanced countries. Even after depleting those resources, welfare programs and subsidies continued at the development budget’s cost but within the domestic economy’s capacity.

After introducing the open economic policy, the inflow of foreign grants and concessionary credits increased considerably. The government entered a comfortable zone enabling it to continue with the welfare budget and various subsidies without any attempt to increase the government revenue and foreign exchange earnings. Even after exhausting the concessionary foreign credit and grants, the government remained in the comfortable zone with high-cost local and foreign borrowings without enhancing the revenue. In addition to that, money printing was also done. The ability to brow and provide welfare and subsidies became a success indicator for all successive governments. The citizens are also accustomed to thinking on the same line. The political leaders, administrators, and economists, who managed the economy, did not seriously consider how to do debt servicing without being insolvent on a future date but continued with ceaseless borrowings. By living with a plethora of subsidies, individuals became accustomed to enjoying artificial prosperity and living beyond their means. Maintaining the rupee at an artificially high value in the recent past did not allow people to feel the actual cost of imported goods. Hence consumer preference was also for imported goods creating a high demand for foreign exchange, which was in short supply for debt servicing and essential imports. Over-dependency on foreign grants, domestic and external borrowings at a high cost, and lack of attempt to improve the government revenue and export earnings are the leading causes of the economic crisis/ bankruptcy in 2022.

 For this article, the word “Subsidies” covers a wide range of wasteful public expenditures that don’t contribute to the national economy, distort the market prices/demand, and lead to mal allocation of resources. It covers (a) cash and material grants without rendering goods or services, (b) price subsidies for various goods and services, (c) subsidising the losses of state-owned enterprises, (d) overstaffing in the public sector institutions, (e) losses due to corruptions, mismanagements, and wrong decisions (f) and all kinds of unproductive public expenditure and wastages.

There are different types of subsidies and welfare programs, such as direct cash and material grants, price subsidies for consumer goods and inputs, cross-subsidies between sectors and subsectors of the economy, cross-subsidies between institutions and different products of the same institution, tax holidays, different tax rates for industry types, subsidising the losses of SOEs, overstaffing in government institutions, etc. All these expenditures become an income for some people without contributing to the economy. Subsidies for inputs and consumer prices prevent reflecting the actual economic cost of local products and distort the consumer’s price in the market. Consequently, the demand also doesn’t reflect the people’s real needs and purchasing power. The ultimate result is the mal allocation of resources, low productivity, high cost of production, low income, and inefficiency of the economy at the macro level. The impact of a few subsidies and resultant market-price distortion are discussed below.

Agriculture products

Rice, the staple food of Sri Lanka, was sold at a highly subsidised price on a ration for everybody, regardless of family income, from 1945 to 1978, with some modifications to the scheme from time to time. Consequently, two different prices, subsidised and open market prices, existed for many years. From the 1960s to the 1980s, the government purchased paddy at a relatively higher guaranteed price, encouraging farmers and sold it at a subsidised price to relieve poverty. Further, irrigation water, the most important and valuable input of paddy farming, is still free to the farmer, though it is a hefty cost to the nation. In addition, low-cost finances were also provided through the cooperative banking system. The fertiliser was also supplied at a nominal price, virtually free from 2006 to 2020. Research findings and extension services are also provided free for everybody. Due to the guaranteed price and availability of low-cost/free inputs, farmers do not pay the actual cost of inputs.  Though the government has spent a lot of public resources to increase paddy output, farmers remained poor. But the market price of rice is unaffordable for many people and high compared to imported rice. If all subsidies are removed, the actual cost of production of a kilo of rice could be doubled. In addition to subsidies, tariff protection and the guaranteed price are also available for rice production. The farmers could not reap the optimal Productivity and income of these support packages due to inappropriate technology and farming practices.

Tariff protection and guaranteed prices are available from time to time for certain other field crops, such as lentils, big onions, potatoes, dried chillies, maise, turmeric, milk, sugar, and poultry products, but it is inconsistent. Farmer’s reaction to intermittent ad-hoc tariff protection distorts the market (demand and supply) and gets them into a further disaster. High prices in a season encourage farmers to produce more in the next season, dropping prices below the cost of production.  Hence, often, it brings more fortune to traders/stockists than farmers. If everything works well, farmers may occasionally benefit from crops like potatoes and onions, but at a very high hidden cost to the macroeconomy, consumers, and the environment. Under these circumstances, much research is needed to produce those crops competitively. Otherwise, those land and resources may be used for other high-value crops and economic activities, which have the capacity to generate more income, employment, and foreign exchange. Having different climatic zones and two rainy seasons and two dry seasons, anything can be cultivated in Sri Lanka. But tariff protections, subsidies, and incentives should not encourage the misuse of valuable resources. Perhaps, instead of using those resources for import substitutions, cultivating export-oriented crops may bring more benefits to the economy. However, rice is not a product that can respond immediately to the demand and price. Also, there is no surplus rice production in the world market.  As rice is the staple food, reaching near self-sufficiency, even at a comparatively higher cost, is justified to ensure food security. However, producing a surplus is detrimental to paddy cultivation’s sustainability as the production cost is higher than in other rice-producing countries. Also, subsidising the cultivation of paddy fields in the low country wet zone is justifiable to ensure those will remain as lowlands for water retention.

As discussed above, Sri Lanka has spent a colossal amount to subsidise paddy farming and to increase the area under cultivation for over seven decades.  For the government, researchers, and the public, agriculture means paddy farming, but not very wide other varieties of grains, lentils, vegetables, fruits, and animal products. Prices of those nutritious foods are relatively high and unaffordable to ordinary people.  As a result, though we are a middle-income country, our malnutrition level is much higher than other developing countries in the region. Even with a plethora of subsidies, agriculture has become a survival strategy for the rural poor and reinforced the subsistent farming system. Sri Lanka needs more research on technological innovations in seed production, livestock breeding, farming practices, tools and equipment, post-harvest technology, etc., appropriate for smallholder farming to improve productivity and make it profitable.

Transport and petroleum

During the last three decades, government policy on energy was inconsistent and kept changing with party politics.  Unlike other countries, Sri Lanka kept fuel prices low, even at times of high prices in the world market. From 2007 to 2014, while fuel price in the world market was very high, Sri Lanka kept the kerosene and diesel prices relatively low by keeping the petrol price high. Very often, fuel prices in Sri Lanka are kept low compared to other countries in the region. In 2016, the Gasoline price in Sri Lanka was US$0.88 per litter. During the same period, gasoline prices in India, China, and the United Kingdom were US$ 0.97, US$ 0.96, and US$ 1.46. respectively. Though CPC is highly indebted to banks, the fuel is being supplied to CEB, Railway Department, the Armed forces, and Sri Lankan Air Line on credit and subsidised price. The CPC meets the financing cost of these credit supplies. On many occasions, the government used to tax the CPC exceeding its cost of production, compelling it to borrow to fill the gap. The CEB, Sri Lankan, and Railway are not concerned very much about their cost of production as a significant part of it is met by the CPC. Consumers also opt to use more diesel and kerosene to increase profitability, disregarding the actual economic cost to the nation.

However, in 2022, petroleum price distortion has been corrected to a considerable extent. In June 2022, the diesel price in Sri Lanka stood at US$ 1.28, while India, China, and Pakistan stood at US$ 1.18, 1.03, and 1.35, respectively. Kerosine price also increased to reflect the actual cost. Gasoline price has also increased to US$ 1.53, which is relatively higher than the above-said countries. Further, the cross-subsidization has been removed, reflecting the actual cost of production of each product. This price correction should continue without distorting it again for cheap political gains. However, losses sustained due to mismanagement, inefficiency and corruption shall be eliminated to reduce the cost of production.

Due to the subsidised/ distorted fuel price and the low priority for public transport, ownership of private vehicles has increased rapidly. The annual per capita petroleum consumption in Sri Lanka in 2021 stood at 350.5 Lt, while India, Bangladesh, Pakistan, and Nepal stood at 194.5, 41.6, 158.6, and 91.6Lt. respectively. The number of road motor vehicles per 1,000 inhabitants of Sri Lanka, excluding two-wheelers, was 157 in 2019. The same for Pakistan, Nepal, India, and Bangladesh was 111 in 2019, 110 in 1918, 45 in 2016, and 27 in2021, respectively.

The policies and strategies in the transport sector, including subsidised fuel, encouraged the use of private vehicles. Today Sri Lankans are reluctant to walk even a 200-meter distance; instead opt for a car, three-wheeler, or motorbike. Since 2022, Sri Lanka has had no foreign exchange to import fuel to satisfy the demand, but still harping on to maintain the previous lifestyle.

Electricity

The government policy was to achieve a hundred per cent coverage of households with electricity connections. According to the World Bank Collection of Development Indicators, 100% of the country’s population had access to electricity in 2020. This achievement is due to the political commitment of all governments to ensure 100% electricity coverage of households. For several decades, subnational-level development programs such as the Decentralised Budget have emphasised rural electrification. It was used by all political parties as bait to lure votes in all elections. Rural electrification has several negative economic aspects, such as high capital outlay due to scattered housing, low demand, low purchasing power, lack of commercial demand, high transmission loss, etc. Though rural electrification has no significant contribution to economic growth, it has improved the living standard of rural communities by uplifting the status of health, education, welfare, and use of household electrical equipment. So, the quality of human capital has improved tremendously, which would lay the foundation for future economic advancement if appropriately used.

The government and CPC highly subsidise the CEB to generate and distribute electricity. Further, the capital cost of rural electricity is 100% funded by the government. But CEB is running at a massive loss. It is reported that from 2006 to 2017, the cumulative net loss of energy sector institutions was 363.9 billion. According to the CEB Annual Report 2019, 37% of the electricity sale was for highly subsidised domestic and religious uses, but revenue was only 31.6%. The Average selling price was Rs. 16.63 per kWh, while the average cost of production was Rs 23.29. Cross-subsidising between consumer categories couldn’t fill this considerable revenue gap without passing the burden to the taxpayers. According to the same report, the total number of employees was 26,114; perhaps about 50% could be overstaffed. Overstaff also amounts to a considerable subsidy or payment of unemployment benefits by a commercial entity, which the Treasury should have done through a welfare program.

According to a consultative document of PUCSL, the average cost of production of one unit of electricity is forecasted as Rs.32.87 for 2022. The cost increase of Rs.9.58 in 3 years from 2018 to 2022 is unrealistic. The average selling price for 2022 has yet to be made available. According to the “Electricity Tariff Revision -2022”, the subsidy element to domestic use and religious places has been removed to a considerable extent. However, compared to the forecasted average unit cost of production (Rs.32.87), the tariff is extremely low for the domestic user category, 0 to 60kWh per month (Rs. 8.00 for the first 30 units and Rs.10.00 per unit for the following 30 units). The religious places are subsidised up to 120 units a month (Rs.8.00 for the First 30 units, Rs. 15 for the second 60 units, and Rs.20.00 for the following 30 units). Exceeding the consumption of 180 units a month, Rs.65.00 per unit is charged, much higher than the forecasted average unit cost of production.

The tariff for industries (Rs. 20.00 per unit), general-purpose users (Rs. 25.00 per unit below 180 kWh and Rs 32.00 for 181 and above), agriculture, and street lighting (Rs.20.00), are also below the cost of production. However, all these categories have a monthly service charge which is increasing parallel to the increasing usage. Also, there is an optional time of use; the low tariff for the daytime and off-peak hours and a slightly higher tariff than the cost of production for peak hours (agriculture and industries Rs.35 and general-purpose Rs.34). However, the peak time tariff and monthly service charges are grossly insufficient to meet the cost of the subsidy.

 The second category of domestic users (consumption above 06kWh), up to 90 units per month, is entitled to a subsidised tariff of Rs 16 .00 per unit. Compared to the tariff of the low quantity user category, this group pays a two times higher tariff for the first 60 units. There is no subsidy element beyond 90 units a month (Rs50.00 for 91-180 units and Rs.75.50 above 180 units). Most households consume more than 90 units monthly, resulting in an automatically annulled subsidy. Therefore, this is punitive and much higher than the forecasted average cost of production of Rs. 32.87.  According to the revised tariff, the entire cost of the subsidies to the low-quantity domestic user category, production-oriented sectors, street lighting, etc., has been passed on to the high-quantity user domestic customer category and religious institutions, which is highly unfair. Further, the tariff applicable to electric vehicle charging is Rs.81.00 per unit in the daytime. This discourages the use of electric vehicles and contradicts the overall policy of reducing the use of fossil fuels.

Increasing the total revenue is very doubtful if the high-quantity domestic user category becomes unaffordable for the revised tariff. If the above-said forecasted cost of production is correct, the loss may be increased further. The Optional Time Use (daytime, peak, and off-peak) is reasonable to discourage the overuse of power during peak hours. However, the monthly service charge is not a strategic tool but an attempt to collect additional money from those who can afford to pay.  The tariff structure has become complicated and irrational because of several tariff blocks, user categories and loading with various charges. Instead of having many user categories, such as low-income, middle-income, rich, small industries, large-scale industries, tourism, agriculture, government institutions, streetlights, etc., tariff Blocks may be rationalised with a small number of user categories. It must structure to discourage excessive non-productive consumption, allow reasonable domestic use without punitive tariffs, encourage consumption for production-oriented activities and make the poor affordable for the minimum requirements. In doing so, the underlying principle shall be ‘operating the business above the breakeven point’. Under any circumstances, subsidising the inefficiency, corruption, and negative impacts of individual or group hypocrisy and wilful sabotage is not acceptable.

Energy prices and consumption are not guided by economic forces but by the interest of politicians and pressure groups. Social and political concerns have overshadowed economic considerations. If all subsidies are removed, the optimal combination of the energy source is used, corruption is minimised, and the electricity is sold at a cost-reflective price, the CEB can become profitable. Then it will save the vast amount spent to subsidise the loss. Ultimately, the energy sector price distortions have encouraged the outflow of foreign exchange earnings for importing motor vehicles and fuel and for constructing costly highways. Also, the distorted price in the energy and transport sectors distorts the prices of many other products. It is worthwhile to do an in-depth study to understand whether the huge loss incurred by the CEB justifies the social benefits achieved through subsidised electricity and to identify a cheaper solution to achieve the same results.

To be continued

Sirisena Amarasekara

Sirisena Amarasekara is a Sri Lankan public servant and diplomat. He is the former Sri Lankan High Commissioner to South Africa, Mozambique, Namibia, Zambia, Zimbabwe, Lesotho, Angola, Botswana, and Eswatin. He had functioned as the secretary to the Prime Minister on two occasions, and as the secretary to the Cabinet of Sri Lanka. Having completed more than 50 years of public service, Amarasekara is one of the most senior Sri Lankan public servants.

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