Financial Times

The Central Bank’s annual report for 2005 has raised some interesting issues on a range of subjects like subsidies, the garment industry after the end to quotas, important remittances from Sri Lankan workers in the Middle East, the need for high denomination notes and restricting ownership in banks.

Here are excerpts of these reports:

Welfare cost of subsidies

Subsidies are of different types: transfers of budgetary resources, tax holidays, tax concessions, supplying goods or services below cost and policies that create transfers through the market mechanism. Subsidies are popular means of providing relief by governments to categories of persons (e.g. farmers), private agents and public enterprises, enabling them to either purchase or sell a good or a service at a cost below the market price.

The welfare cost of subsidies is multi faceted. They lead to governments incurring a budgetary burden, which has to be met through either increased taxing of the population or increasing the government’s indebtedness or covering the cost by cutting fiscal expenditure, frequently by reducing expenditure on public investment. Thus, subsidies often involve a serious opportunity cost of growth and development with the reallocation of resources from productive public investment to current expenditure. Furthermore, lower prices, mostly below the cost of production paid by economic agents on goods and services could lead to over exploitation and misallocation of resources. Utilities such as water, electricity and petroleum in many countries are subject to subsidies and those resources are being over exploited. Such over exploitation could lead to a worldwide shortage of resources.

The key issues in managing subsidies are the size, incidence and distortions in allocation. The adverse implications of subsidies could be minimised by their reduction through provision of subsidies only to the needy through proper targeting. Though the need for reducing subsidies has been recognised, intervention by various pressure groups and insufficient consensus on reforming subsidies, often does not allow the implementation of such policies.

Rationalisation of subsidies can remove economic distortions, thereby improving efficiency and growth, reduce the budgetary burden and significantly enhance much needed public investment.

Apparel industry after quotas ended

The Multi-Fibre Arrangement (MFA), which governed international trade in textile and apparel through a system of quota, was abolished from the beginning of 2005. The experience up to end 2005 indicated that the impact of the abolition varied from country to country. Some large exporting countries such as China and India have gained, while some smaller countries have lost. Yet, a few small countries including Sri Lanka have been able to retain their market share.

In the quota free market environment, Sri Lankan apparel exports are mainly destined for two markets, the United States (58 per cent) and the European Union (37 per cent). The quota restriction in the EU market was removed in 2003 preferentially for Sri Lanka and until end of 2004, around 90 per cent of the garment exports to the US market faced quota restrictions. In the quota free market environment, apparel exports from Sri Lanka to the US market have increased both in terms of value and volume during the first nine months of 2005. This was achieved through Sri Lanka’s key competitive advantage in the US market in some core categories of apparel products.

However, apparel exports from Sri Lanka to EU have declined both in terms of value and volume during the first nine months of 2005. Concessions received under the GSP+ scheme from the EU did not materialise due to difficulties in complying with the rule of origin (ROO) criteria, which requires an over 48 per cent of value addition for apparel products in the exporting country. With increased competition for apparel in the global market, some of the major firms in Sri Lanka have improved competitiveness through enhancing productivity, focusing on high value products, upgrading human capital, design and marketing skills, rationalising cost of production, enhancing supply chain management and developing forward and backward linkages.

Although larger firms have resources to shape their industry in line with global trends, the small and medium entrepreneurs (SMEs) have become increasingly vulnerable. SMEs have only limited direct marketing links and direct overseas buyer contacts. This forces them to depend on sub-contracts for larger players. The drop in prices of apparel in the international market and lack of resources to restructure their manufacturing process has adversely affected the SME sector. To address difficulties, the government announced several measures in the areas of financing, raw materials and training. The Joint Apparel Association Forum (JAAF), which is the key industry lobby, has also implemented a series of measures to upgrade the industry from a mere manufacturer to a provider of fully integrated services.

Worker remittances

Over the years, worker remittances have become a major source of foreign exchange inflows for developing countries. It has now become the second largest source of external financing available to many developing countries, after foreign direct investment (FDI) and amounts to more than twice the size of official aid.

Over one million Sri Lankans have migrated for foreign employment, with the largest number migrating to the Middle East. Remittances have now overtaken foreign inflows to government and are a significant source of financing the widening trade deficit. However, in terms of foreign receipts export earnings, especially from textile and garments remain a prime source, followed by remittances and earnings from export of services.

Remittances ease foreign exchange constraints and pressure on the exchange rate, while improving the balance of payments (BOP). Remittances enhance a country’s creditworthiness and its access to international capital markets. While capital flows tend to rise during the upturn of economic cycles and decline during the downturn, remittances tend to rise with the recipient country’s economic downturn and vice versa. These remittances have become counter cyclical reducing the volatility in the external balance.

Remittances are also less volatile than other sources of foreign exchange earnings for developing countries and have a more equitable income distributional impact. Though remittances from migrants are useful, migration for employment is not without associated costs. The foremost cost is the social cost emanating from family breakdown, however, temporary. The brain drain and skills drain could also hurt economic growth. Some skills demanded by foreign countries could create scarcities in the labour exporting country.

Of the total migration, housemaids and unskilled labour together account for over 70 per cent of the total foreign employment migration and skilled migration accounts for around 20 per cent. Considering, the greater potential for increasing future remittance inflows by encouraging migration of highly capable professionals in the fields of accountancy, legal, engineering, architecture, information technology and software development, Sri Lanka’s foreign employment policies could be re-oriented to encourage skill migration.

Under the provisions of the General Agreement on Trade in Services (GATS), trade in services are now being gradually liberalised and there has been a growing recognition that movement of natural persons is an important mode of delivering services. Since Sri Lanka produces highly qualified professionals in several fields there is a comparative advantage in this trade. The government should formulate a migration policy aimed at encouraging short-term migration of human capital, particularly in skilled categories.

Establishing partnerships between remittance service providers and existing postal and bank networks would help to expand capacity and improve efficiency in remittance services. There is a need for close regulation and supervision of foreign employment agencies to avoid undue harassment faced by migrants. Existing economic partnership agreements could be renewed or new agreements could be reached aiming at increasing the migrant flows and strengthening safety measures.

Though remittances have been one of the prime sources of foreign financing, government should not rely on these inflows as a long-term source of foreign financing because expanding productive domestic job opportunities in the process of accelerating economic growth and increasing average income in the country may discourage migration for foreign employment. The alternative is the encouragement of FDI with a greater potential to bring in sophisticated technology, expand export markets, improve skills and increase productivity in the economy.

High denomination currency

At the time of establishing the Central Bank of Sri Lanka in 1950, the country had been using currency notes in denominations of Rs. 1 and Rs 2, 5, 10, 50, 100, 500 and 1,000 and coins in denominations of cents 1, 2, 5, 10, 25, 50 and Rs. 1 issued by the Board of Commissioners of Currency.

The Central Bank started to print its own currency notes in denominations of Re. 1 and Rs 2, 5, 10, 50, and 100 in 1951/52. Subsequently, a Rs 20 denomination note was introduced in 1979, followed by Rs 500 and 1,000 notes issued in 1981. Since then a note of a higher denomination has not been issued.

In a modern economy, in addition to currency notes and coins, a variety of instruments is available for payments and settlements. The most common instruments are cheques, credit cards, debit cards, and electronic means. Although the use of currency has been declining slowly in relative terms in modern economies, it remains by far the most popular payment instrument throughout the world.

The demand for currency increases due to increased volumes of transactions and increases in prices.

When the value of transactions is increasing, the general public seeks more convenient modes of payments, in particular high value currency notes, to effect large value transactions. At the time when the high denomination rupees 1,000 note was first issued in 1981, the demand for currency had increased substantially to Rs.380 per person from Rs.49 per person in 1952.

Moreover, with the increased transactions, the share of the Rs 1,000 note in currency in circulation has also increased, in terms of value, to 77 per cent by 2005.

The currency in circulation in terms of the highest denomination note, increased from 3.9 million notes in 1952 to 56.4 million notes in 1981. After the introduction of the Rs.1000 note, the currency in circulation in terms of the highest denomination fell to 5.6 million notes. By 2005, this has again increased to 132.4 million notes, indicating the need for a note of an even higher denomination. Although the demand has increased sharply, there has not been a note of a higher denomination to match the demand.

There are several benefits as well as costs associated with the introduction of new higher denomination currency notes. The currency denominations required for automated teller machines (ATMs) are often found to be large value notes since it may not be economical to stock the machines with small denominations. With the increase in the use of ATMs, there is an increased demand for high value notes as small denominations increase the operating costs of banks.

The non-availability of non-cash payment facilities in remote areas further increases the need for higher denomination currency notes. For example, high denomination notes increase the convenience provided to tourists who wish to purchase high value goods at rural or remote locations. Printing of higher denomination notes is more economical, since the printing cost does not significantly vary with the denomination of the note.

The cost savings arise not only through the reduction in printing a large number of lower denomination notes, but also through the increase in the life span of higher value denomination notes, because of lower circulation. In addition, the weighted average lifetime of the Rs.1,000 and the Rs. 500 currency notes is about 6-7 years.

In comparison, lower denomination notes such as Rs.10 have a very short average lifespan of less than a year. Further, high value denominations help save time, particularly, in large value transactions, thus improving the efficiency of transactions.

The risk of counterfeiting is more prominent in higher denomination currency notes. It could provide a convenient means for money laundering and underground economic activities. However, these drawbacks can be addressed effectively to a large extent by taking precautionary measures.

The risk of counterfeiting could be reduced by the use of advanced security features built into higher value notes and increasing alertness of the public when accepting such notes. This would require enhancement of public awareness through appropriate measures. The cost of improved security features of high denominations would be marginal due to savings on printing cost.

Ownership restrictions complement the efforts of regulation and supervision of banks. Banking firms are regulated and supervised for three major reasons.

First, the banking industry in many countries is an oligopoly. The entry into the industry is not free, and is constrained by licensing requirements, entry capital requirements, economic needs tests, fit and proper tests of owners and senior management etc.The exit of a banking firm is also not simple and straightforward.

Second, the body of consumers of the services of the banking industry could be constrained in the choice of a banking firm by appropriate restrictions on capital account transactions, such as restrictions on cross border trade in financial services. Hence, the domestic industry enjoys privileges of serving a captive body of consumers.

Third, the banking industry acquires contingent liabilities, develops serious inter-connections among various firms in the industry and firms and households in the entire economy.

Hence, in the absence of sufficiently strict and effective regulation and supervision coupled with weak enforcement of banking laws, there are possibilities that an owner could run the banking firm in ways that are harmful to the depositors and the country as a whole. Thus, these three considerations require establishing rules, effective regulation, and supervision that ensure smooth functioning of the banking industry displaying sound corporate governance practices. The extent of those rules, regulatory and supervisory norms and practices are diverse among countries.

Objectives of ownership restrictions are to have a well diversified ownership, which could minimise the risk of misuse or imprudent use of leveraged funds. Meanwhile, low levels of ownership may not provide adequate incentives for owners to employ sufficient attention to the banking firm. It should also be emphasised that ownership restrictions are not substitutes for effective supervision and regulation. Further, the fit and proper criteria, on a continuing basis, have to be the over-riding consideration in the path of ensuring corporate governance. Ownership restrictions have to be complemented with adequate equity investments, appropriate restructuring and consolidation in the banking sector.

The World Bank conducts surveys on features of financial sectors in its member countries. As per the 2003 survey, out of 157 countries, 112 countries do not have any ownership limitations. A majority of those countries have efficient financial systems, low capital account restrictions, and are at a higher level of economic development. The remaining 45 countries impose restrictions ranging from 5- 50 per cent. However, some of those countries are at a lower level of economic development, displaying weak regulation and supervision, and are at low degrees of financial system efficiency.

Those countries have preferred to impose restrictions to establish ‘rules’ on ownership which are effective in replacing weak supervision and regulation, and as an alternative to weak enforcement of regulatory norms on good governance. The ownership structure could be categorised into three, those with no restrictions, those requiring at least two owners, and those with ownership limits mostly in the range of 5-20 percent.

Sri Lanka has restricted single ownership to 10 per cent in the Banking Act, but has allowed increases through a direction permitting up to 15, 20 and 25 per cent for specified entities. In the case of Sri Lanka, the two major concerns that arise in the context of corporate governance in banks and which need to be addressed are (i) the concentration of ownership and (ii) the type of people who control the bank i.e. the fit and proper status of major shareholders and directors.

There are unique corporate governance challenges posed where the bank ownership structure either lacks transparency or where there are insufficient checks and balances on inappropriate activities or influences of controlling shareholders.

Further measures are needed to support the effective supervisory mechanism currently in place.

Among them: major measures are adequate legal force to strengthen enforcement action, well developed public infrastructure covering contract enforcement, a general insolvency regime, an accounting framework, a corporate governance regime, market discipline based on transparency and disclosure procedures for effective resolution of problem banks, and a mechanism for providing either an appropriate level of systemic protection or a public safety net.