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If we stifle competition like this Government, our companies will never become good, our citizens will never enjoy low prices: Murtaza Jafferjee

23 Jan 2022

  • Advocata Institute Chairperson and JB Securities CEO Murtaza Jafferjee on the Government’s economic policy, debt and the stock market
By Charindra Chandrasena Advocata Institute is a leading think tank that has been lobbying for free and open economic policies, particularly in the face of the import restrictions which have been in place since the mid-2020s. JB Securities is a leading stockbroker and founding member of the Colombo Stock Exchange (CSE). Murtaza Jafferjee is the Chairperson of the Advocata Institute and Chief Executive Officer (CEO) JB Securities. The Morning spoke to Jafferjee on the shortage of US dollars in Sri Lanka, the boom in the CSE, the trade and economic policy of the Government and his prescription for Sri Lanka to overcome the present crisis. The following are excerpts of the interview. Sri Lanka repaid a $ 500 million International Sovereign Bond (ISB) that matured last Tuesday (18) when there is a school of thought that Sri Lanka should restructure and reschedule its debt, in particular its ISBs. You recently said “it seems that Sri Lanka is prioritising the needs of creditors over the needs of the citizens of the country”. Do you not think we should have repaid the ISB last week? Let’s look at the headlines of your newspaper and other daily newspapers. They are talking about a power crisis and a shortage of fuel etc. These are essential needs of citizens. If these shortages are due to a lack of foreign exchange, then any right thinking person would say that the citizens of your own country should take priority over the needs of creditors. Therefore, I would have kept the $ 500 million and asked for a moratorium from all our creditors and used it for the needs of our economy. Prof. Lee C. Buchheit of the University of Edinburgh Law School, who has been involved in the debt restructuring processes of Greece and Iraq, recently said that if Sri Lanka were to embark on a debt restructuring process, the ISB holders would ask for the debt of bilateral creditors also to be restructured so that the pain is shared. Is this not accurate? That is accurate. That is what you call inter-creditor equity. Sri Lanka’s total creditor stack has about $ 10 billion debt owed to multilaterals, $ 5-6 billion owed to bilaterals with the Government of Japan being the largest bilateral creditor, followed by India and China. Then we have about $ 20 billion debt owed to private creditors or financial market creditors of which there are about $ 12.5 billion worth of Eurobonds or what we refer to as ISBs, and the balance $ 7 billion are mainly commercial loans, especially from the China Exim Bank and the China Development Bank. We also have about $ 2.2 billion worth of dollar denominated debt issued under Sri Lankan law which are called Sri Lanka Development Bonds owned by our banks.  So the challenge for us is, who will take the pain? You can’t cherry pick one set of creditors and say “we are going to suspend repayment to you”. It has to be done generally for everybody. However it is well accepted in debt restructuring that multilateral creditors such as the World Bank and Asian Development Bank generally don’t get haircutted because they have provided the money on concessional terms, for development projects and over a long period of time. What may happen is that they may loan us money to repay existing debt. It is like a rollover. What would the impact of a sovereign debt restructuring be on foreign equity investors’ confidence, and would it be as bad as a default scenario? First of all the word default has got a bad connotation. Technically, even in the literature, there is no clear definition of the word default, but it straddles the two extremes of a technical default, which is when there is a slight deviation in the covenants, or a substantive default, which is when there is a significant loss on an NPV (net present value) basis but within the terms of the agreement. For example, when we issue new bonds in lieu of old bonds, and the intersection of the two is called a contractual default, which is when principal for seven days from the due date or coupon payments for 30 days. What is required at the moment is a moratorium on all our external debt because we are not in a position to refinance to pay back. So we need to carry out a temporary cessation, I believe for around three to four years, which would provide time for the economy to recover. Now your question was what would be the impact to equity investors. At the moment a significant proportion of the portfolio investors have already exited Sri Lanka, especially since the market reopened following the closure during the first lockdown in March 2020. So for existing equity investors the impact would be minimal because the sooner we restructure our debt through a moratorium, the sooner our economy can recover. Domestic investors accounted for 95% of the daily turnover of the Colombo Stock Exchange (CSE) in 2021, when foreign investors accounted for 47% of daily turnover in 2017. How do you explain this progressive dip in foreign investor participation and should the CSE and its stakeholders be concerned? The primary reason foreign investors have exited Sri Lanka is the macroeconomic risks. There is a significant currency risk. Even a few months ago, when the die-hard investors who had a lot of faith and an emotional attachment to Sri Lanka exited, their funds could not be repatriated for two months. There are also issues such as the large listed multinationals not being able to pay dividends to their holding companies. So in that environment this is not a market that is attractive to foreign investors. I don’t think the absence of portfolio investors has much to do with the CSE itself, but a macro issue affecting the whole country. So unless those macro imbalances are addressed I’m afraid we are not going to be able to attract investments from foreign portfolio managers. The CSE has been on a record breaking spree for some time now and every week the All Share Price Index (ASPI) hits an all time high. How reflective is the CSE’s performance of the macroeconomic situation? Generally, the stock market is forward looking and it is a leading indicator of where the economy would go in six months. There has to be a substantive increase in interest rates which will increase the cost of money. Last December inflation came in at 12% and our policy rates at 6%. In the government securities market, the interest rates have already adjusted and the 10 year bond is already trading close to 12%. So then you have to ask the question, is the collective wisdom of the market seeing something that makes them far more optimistic? Now, the rearview mirror indicates that there were certain companies that were massive winners from Covid-19. An obvious one was Expo Lanka, which is a company with 90% turnover outside Sri Lanka or even more, and they have had a once in a century boom, which the entire logistics industry globally has experienced. That's mainly because the sea freight and air freight rates into the US probably went up 400% and there was excess demand coming from the US. If you keep aside those Covid-19 winners, there have also been domestic companies that have made record profits, because of government policies – for example, with import restrictions. So in the absence of competition, they have had increased pricing power and therefore their margins have expanded. But going forward, take for example if we have an electricity crisis, all of us are going to be impacted, except maybe companies that derive most of their revenues from outside Sri Lanka. Previously, when we used to have power cuts, they were due to weather-related issues and we had an alternative in diesel generators, etc. But this time around, since it’s a shortage of dollars, it is a fuel shortage, not only an electricity shortage. Even candles may run out if there is an electricity crisis because the raw material for a candle, which is crude oil, is also imported. So that creates a huge headwind for the economy and that is going to be a problem for most businesses. This is going to have a significant impact on the financial sector, which is already reflected in the prices which are almost at a 50% discount to book value. So I think there is an element of irrational exuberance in the market. You have suggested at certain points that the CSE is a closed and exclusive club, and that it is driven by a few wealthy domestic investors. Do you still believe that and if so why? What I did say was that if you add the membership of two recreational clubs in Colombo, that would constitute the larger proportion of the investors. Of course, since I said that there are many investors who have said “I’m not a member of those clubs”. But I said that metaphorically to show that Colombo still is a relatively small place. If you look at the statistics, it would indicate that the number of investors have significantly expanded but it’s a long tail. So there are thousands of investors, who would probably only account for 20 or 30% of the total volume and perhaps 200 individuals, through multiple accounts, would account for probably 50% of the turnover. So we’ve always had a problem that our markets don’t have the depth and the breadth. And that is because equity investing is yet restricted to a smaller number of people because the inherent risk appetite is very low. Currently, the new investors who are coming in are young, and perhaps, haven’t seen a bear market before and they may be excessively optimistic, not seeing the downside. So when the tide recedes, as Warren Buffett said, we will know who’s swimming naked. So the broad-basing of the market that the CSE talks about all the time is not accurate? There is a significant amount of concentration in the activity also. So ideally what you want is for the Sri Lankan household to have a long-term investment horizon. Things like institutional funds, mutual funds, which we call unit trusts, pension funds, etc. are dominated by the Government through the EPF because it’s the private sector savings. These institutional mechanisms encourage contractual savings over your lifetime to put away something for after retirement. We don’t really have that system well developed in this country. So most of the activity that we are seeing, I suspect, is more speculative. They all feel that you can make quick money, and they have been right for the last one year or more where we have seen an unprecedented bull market. I have been in the markets for close to 30 years and I am amazed at the way the market keeps going up every day and the rate at which the prices go up. My sense is that this is not sustainable and there will be a time where the market will either go sideways or the prices will come back down. Coming back to your thoughts about the CSE being an exclusive or closed club, in a small economy such as Sri Lanka's is it fair to expect the high net worth investor pool to be larger than it is at the moment? Let me give you certain statistics. 20% of the top households in Sri Lanka account for 50% of national income, and the top 10% account for 35%. Somebody asked me how much does the top 1% account for. I don’t have that number but I would guess that it is about 15% or even as high as 20%. So, as in many economies, the wealth is concentrated. Now, the recent activity that you are seeing is not necessarily all the business people in Sri Lanka who have taken some of their other assets and charged into the market, but a group of professional traders and active investors who are participating. Perhaps they have taken money away from other businesses that they had – for example, importing cars, because that is now banned. They have probably already made three times to four times the money that they initially invested in the market. Now, the really smart people are the ones who would read the tea leaves and say enough is enough, I’m going to take my chips off the table and walk away, even if I miss out on earning another 20%. But individuals like that who can control their own emotions and lock in the profits and walk away, are rare. The think tank that you are heading, Advocata Institute, has strongly advocated for a free market economy. Is it not unrestrained free trade which has resulted in us running continuous trade deficits and got us to the current economic position? This is a fundamentally important question. What Advocata wants is an economy whose activity is co-ordinated through the pricing mechanism. So if you have a scarce resource, for example, diesel, which is the single largest import item in our import basket and which costs over $ 1 billion a year, you need to price the scarcity value of that resource. A barrel of diesel in the international market costs $ 95 and if you take 95 and divide by 159 litres to a barrel and multiply by the exchange rate and add about 3%, which is the cost of insurance and freight, the landed cost is about $ 125. Then you add all the other costs, and there are taxes of about Rs. 35 that are applied on diesel, which is also relatively low, the prices should be substantially higher than they are now. So, in a market economy, there are many items and many activities and economic agents make choices on what to consume and what not to consume based on the signals that prices give us, because you are constrained by the income that you have. So, the way we consume and the way we invest in a market economy will shift because the prices are signalling to us the scarcity value. Now, what we have here is repeated current account deficits, which has been going on ever since Independence, and we have turned to the International Monetary Fund (IMF) 16 times. So Sri Lanka, contrary to what people think, actually has a spending problem. We have excess spending. So, if an economy only gets $ 100 of inflows, and the exchange rate is Rs. 100, then it can sustain Rs. 10,000 of spending. Now, if you print money and create Rs. 12,000, then the exchange rate, which is Rs. 100 has to go to Rs. 120 to reach equilibrium. So, what we need to have is policies that restrict spending, the excess spending is a reason we are having this macroeconomic instability. How does excess spending come? One channel is through the fiscal sector. Either the government is imposing too low taxes so that the private citizens are having more money to spend, and the government is spending a lot of money and not collecting enough taxes so that its deficit is reduced. Or it’s a case of the central bank running excessively loose monetary policy, where the real interest rates are not high enough to incentivise people like myself not to spend, and to forego consumption for investment so that I earn a real return on what I save, or to dissuade people who borrow and spend by making the cost of borrowing in real terms too high. Now, if these two mechanisms are operating optimally, that imbalance between how much is coming into the country and how much you can spend, can be restored. Now instead of attempting to address the root of the problem, which has to be addressed through fiscal and monetary policy, they’re deciding what is an essential import and what needs for a so-called production economy, and trying to pick winners and losers themselves, which no bureaucrat can ever do. Invariably, it will be susceptible to rent seeking or corruption, because somebody is incentivised to put up the barriers so that it benefits a particular individual or a particular producer. Ultimately, it’s the consumer who is losing out big time. The producers are very well organised and well resourced so their case is being put forward. Unfortunately, the consumers are all dispersed and can’t put across a unified voice. That is where organisations like Advocata Institute are trying to act as a think tank and a voice for the consumer, because there are millions of consumers. Do you not see any merit in the Government’s stated policy of import substitution and export development? It’s a contradiction to try to implement import protection or domestic industry protection and export development because the two don’t go together. If you want to export you will need to import. Unless you’re doing extremely simple products every product will have many steps to it and many raw materials, many inputs. So if your export product is going to be competitive in the world market you need to ensure you can buy your inputs at the lowest possible price. Let me explain in an indirect export – tourism. I’ve also been a businessman and I come from a family that has had manufacturing industries over many decades. If a company needs this kind of protection, it shouldn’t be in business. This is excessive protectionism and therefore these companies will never become efficient. There is also the problem of excess profit, and when you’re making supernormal profits, you have more money and you can even influence the political process. So this trade strategy that we have, does not support economic growth. Vietnam has been a stellar success story in terms of exports over a 20-year period where they increased their exports from approximately $ 10 billion to $ 220 billion, while we took it from approximately $ 3 billion to approximately $ 10 billion in merchandise exports. Vietnam’s export performance contributed, a few years ago, something around 15% to the total growth. In Sri Lanka, export contribution to total growth is less than 5%. So most of it has been domestic growth through the expansion of non-tradable sectors. Therefore, our economic growth model has collapsed because we have been driving those non-tradable sectors by borrowing from overseas. Going by what you are saying it seems you are completely opposed to excessive protectionism. However, is it fair to expect Sri Lankan companies to have to compete with global brands even on their home turf here in Sri Lanka, without that advantage of protectionism? This is a tough question. There is something called the Infant-Industry Theory. When does a human being stop being an infant? I would think it’s two years. So, what the theory says is that when you are a new industry, you need time to grow and get stronger. There is a theory that you protect in that initial period. But what has happened in Sri Lanka, as the Advocata Institute Academic Chair Dr. Sarath Rajapatirana said, is that there are too many infants in geriatric wards. Even if we are going to say that we would like to have a certain sector that we want to expand, then we should have a reasonable sunset period. The protection cannot be encouraged to go on forever and ever. In our current policy, the poor consumer is paying 30-40% more for than they would have to in a more free market. This policy is privileging a few at the expense of the many. I don’t think in a democratic country that is sustainable. Finally, what is your prescription for Sri Lanka, or the short-term and long-term solution, for Sri Lanka to overcome this economic crisis? Is it the IMF, or is it a homegrown solution? In the very short-term, we need what is called macro stabilisation, because our system is not balanced. The dollar denominated debt that we have accumulated is about $ 37 billion, but the totality of the debt is snowballing at an astronomical rate. So the problem is debt growing much faster than our economy, because the interest is compounding. We are running what is called a primary deficit and from the budget we are borrowing further to fund it. Besides the interest, the primary balance is revenue minus all expenditure and things like the recent salary increases of public servants is going to add another Rs. 100-120 billion to an already very high Rs. 800 billion expenditure on salaries and wages. So this is a totally unsustainable situation. So the first thing is that the foreign external debt that we have will need a moratorium. We simply don’t have the dollars because we can’t access the markets again to refinance. We can never generate those dollars through the current account. We have to regain market access so that we can borrow, hoping to repay what is coming due. Now in the absence of market access because our rating has been downgraded two times to one step above default, we have absolutely no choice but to ask for a moratorium on our external debt. Second thing is we cannot go to the IMF without doing a moratorium on the debt because they do not want to lend us money if that money is going to be used to pay our external creditors. The IMF is a necessary condition for any kind of restructuring of our debt, because the creditors want to ensure that somebody is monitoring the economy. They don’t have the ability to monitor and even if they agree to a moratorium, they want to ensure that they will get paid after the moratorium. Our growth model that we have had, for the last decade or more, has been borrowing from overseas, and refinancing domestic industries, and this is not sustainable anymore. We don’t have the benefit of a demographic dividend as the prime working population as a proportion of the total population peaked about 15 years ago. Now our population is ageing. For us to grow, we need to create more jobs and we can’t be creating jobs through the government, so instead we need to incentivise businesses. I estimate that if you want to create 1 million new jobs, you will have to create between 50,000 and 100,000 new establishments and we will have to attract the female population into the labour force because our female labour force participation is only 35% while male participation is between 65-70%. We also need a massive productivity revolution in this country and we have to improve our land productivity. To give you an example, the yield on a rubber plantation is only 950 kg per hectare. While in Thailand, Malaysia, and Indonesia, it’s about 1,500 kg per hectare. The average coconut tree in Sri Lanka produces 62 coconuts but in Pollachi in South India, they can produce as much as 150 coconuts per tree. We also have estates in Sri Lanka that produce 90 coconuts per tree. So all we have to do is to increase the national average by 10% which would create a massive exportable surplus. Last year, which was a good year because of the rain, we produced about 3 billion coconuts, out of which 2 billion were used domestically and only 1 billion was the exportable surplus. So if you take the national output up by 10%, the exportable surplus increases by about 30%. That alone on a net basis can earn $ 100 million. I gave you examples of agricultural production. But all over the economy, we have low productivity sectors. So we have to have a significant increase in productivity in the economy and it is through productivity that lifestyles will improve. In order to improve productivity, the key is competition. It is competition that forces enterprises and firms and individuals to improve. If we stifle competition, like the present Government, our companies will never become good and our citizens will never enjoy low prices, low costs. It is through productivity that you can have a sustainable life. And to me, we have to put in policies to significantly improve productivity going forward. Through productivity, wages will increase, profitability of firms will increase, and that’s how you create a surplus you create a savings base, which then in turn can be reinvested and that virtuous cycle will keep repeating itself.

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