Investors need to be confident that Sri Lanka is a safe choice to invest in! | Print edition
By Dr Ruchith Dissanayake (Senior Lecturer, Queensland University of Technology)
The Sri Lankan economy is in the grip of a debt crisis. Sri Lanka’s debt to GDP ratio is over 100%. However, the same can be said for many countries like France, Japan, and the United States. This begs the question what is really hurting the Sri Lankan economy? Yes, currency played a role. However, the price of the currency is largely determined by the current state of the economy and expectations regarding future investment opportunities.
Irresponsible budget spending is the main culprit of the crisis. The senseless public spending undertaken by current and previous administrations should bear the brunt of the blame. A simple understanding of the net present value (NPV) rule of investing is enough to make a good investment. Future benefits to the population should be discounted at a rate that takes into account unforeseen negative shocks to the economic system (eg, a liquidity crisis or a demand shock). If the expected discounted benefits to the public outweigh the costs, then the government should assume the investment.
Now, the question must be asked, do investments such as Hambantota port and airport pass the NPV rule? Keep in mind that the real cost of such infrastructure projects goes beyond simple accounting costs. Consider the opportunity costs of foregoing other viable investment opportunities. For example, the government might have considered creating a system of higher technical universities to keep up with the rapid scientific and technological advances in the world.
Now that the economy is in tatters, policymakers need to take prudent steps to recover from the crisis relatively quickly. A huge issue is investor confidence in the economy. A series of steps should be taken to address trust issues.
First, the government must establish a special police force to stop bribery and corruption and enforce contracts. There is ample evidence that countries with better legal protections foster better financial markets. Careful analysis of a series of papers by economists LaPorta, Lopez-de-Silanes, Shleifer, and Vishny shows that legal protections and enforcement actions help financial markets, which then help economic growth. Without the application of laws and regulations, there is no economic growth.
Second, the government should establish independent institutions run by experts in the field. For example, the Central Bank should set monetary policy based on economic conditions. Other independent institutions (eg Treasury, Justice and Commerce Departments) should be created. Along the same lines, the people should appoint competent new decision-makers to government. Investors are less likely to engage in inherently riskier investments in an emerging market with an unstable political system and poor institutions.
Third, excessive public debt must be reduced to a manageable level. The latest research shows that high public debt tends to reduce business investment. In a series of articles, economists Graham, Leary and Roberts show that investors are actively substituting government and corporate loans.
This type of debt substitution can have long-term negative effects on private companies. In a recent co-authored paper, I show that rising public debt has reduced mergers and acquisitions (M&A) activity in the United States. Excessive public debt hinders mergers and acquisitions because public debt increases fiscal policy uncertainty. The same problems we see in the United States apply in Sri Lanka, perhaps even more so given the instability.
Sri Lanka is at a crossroads. I believe these simple but important steps can be used as a starting point on the road to recovery. Political and political uncertainties must be reduced to increase confidence in the economy and stimulate investment.
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