A Tariffic Problem: Thoughts on the Impact of Trump Tariffs on Sri Lanka

Sri Lankans woke up today to the news that the United States will be imposing 44 percent tariffs on Sri Lanka. We were the 7th highest on the tariff hit list. 

Trump's Naughty List

We believe these tariffs are the largest global economic shock since COVID and will have significant repercussions across the world. The Americans are rearranging global trade the hard way. 

The below is not a prediction of what will happen. It is not meant to be a rigorous study on tariffs or Sri Lanka’s External Account. It is not meant to be a treatise on the benefits of free trade.  It is not meant to be advice of any form. It is simply an exploration of the different scenarios that will happen, as well as the second order effects of the tariffs. The purpose of the article is to demonstrate the complexity of an economic system through the lens of a very live economic shock. It is also to pound the table on the severity of this crisis which could derail an otherwise incredible economic recovery story if no action is taken.

What is the Trump Administration Attempting to Achieve?

The administration is of the view that multiple countries have been systematically taking advantage of the United States, enjoying relatively free access to massive American markets while creating tariff and non tariff barriers preventing American firms from accessing theirs. This is a view we are sympathetic with. 

It is theorised (but not yet confirmed) that the administration is judging how “open to trade” a country is by looking at their trade surplus with the U.S.A, divided by their exports to them (Explained well here) .  It is this percentage that is determining our tariff level. The fact that it has been adjusted by quantum of exports has caught most analysts off guard, and is why Sri Lanka ranks so highly while other countries with a larger trade surplus have got away with a lower penalty.  

They are then simply putting a tariff whose magnitude varies based on the above percentage. In doing so, they are hoping to change the behaviour of these countries and lower the deficit they are running with the United States. Either by importing more American goods, or losing exports to America, which will shift to countries with lower tariffs or even back to American manufacturing.

It is key to note, America is not penalising Sri Lanka based on our actual tariffs. We are being penalised based on our trade deficit with the USA. What they want is for us to export less to the US, or ideally, import more from the US. Even if we maintained high tariff barriers but somehow imported more from the US, then we would fare better according to this formula. 

Sri Lanka’s Problem

Sri Lanka has found itself ranked 7th out of 185 on the list of worst offenders, with commensurately harsh tariffs. While we think this is harsher than it should be, and is a function of American goods being less relevant to Sri Lanka (for instance our cars are right hand drive, our refinery cannot process American oil and so on) it is an inarguable fact that Sri Lanka has significant barriers to import as a structural feature of its economy.

Over the decades we have built an economy reliant on protectionist measures to defend inefficient firms from global competition. As global competition became increasingly efficient, and our firms lagged behind, our tariff barriers increased to protect them. Our ranking highlights how bad we are on a global scale. To be clear, this is also bad for Sri Lankan consumers, who face some of the highest regional prices for vehicles, electronics and even milk.  We now face the consequences of kicking this can down the road, and not dealing with the fundamental problem we have of inefficient businesses (caused by inefficient labour markets, land laws, regulators, poor technical knowledge and so on). 

Our general observation is that politicians, businesses and investors were generally caught off guard by the magnitude of the tariffs and Sri Lanka’s position on the “naughty list”. I certainly was. This has put us behind competitors such as India and Vietnam, who have already started the groundwork to mitigate these tariffs. Our weak economic position makes us further vulnerable to this shock. An even worse case scenario would be if rival exporters are able to achieve lower tariffs while ours remain at these uncompetitive levels due to government inaction. 

This will be the first real challenge that our new government faces and we hope they are up to the test.

Delays and/or Reductions

A lot of observers are of the view that this is just an initial negotiating position from Trump and there may be several mitigants:

• Trump is bluffing and will not implement the tariffs (no chance), or will implement much lower tariffs (possible).

• Court injunctions may delay the tariffs (possible). 

• Diplomacy (aka grovelling and pleading) could lead to delays and/or lower tariffs

• They may change the formula being used that would penalise Sri Lanka less

• There may be workarounds such as shipping via another lower tariff country.Given how serious the US is about this, loopholes will slowly be closed and hence will merely amount to a delay in the end result.

All the above basically sums to a hope for delayed or lower tariffs. They may be correct, but our view is that delays or lower tariffs will not save the situation. Falling from the 50th floor tomorrow is just as fatal as falling from the 100th floor today. 

Regardless of delays or reductions, the fundamental problem is that countries that rival us in our key exports (such as apparel) are facing lower tariffs than us. These exports are extremely low margin and price sensitive, so even the smallest variance in tariffs between competing countries could be fatal to our export sector. 

Even if tariffs are reduced or delayed, this relative disadvantage against rivals is likely to remain unless we improve our ranking on the naughty list. Furthermore, the US have now revealed their hand. Global supply chains will start adjusting to this new tariff structure, and we will be left behind. Our apparel customers are probably already adjusting orders on the basis of the ranking on this list and searching for capacity in less badly tariffed countries. 

Hence we urge all stakeholders not to bury their heads in the sand. This is a core part of the new American administration and we need to face reality head on. In the past Sri Lankan leaders have been guilty of ignoring facts until the dollars literally ran out. We hope this doesn’t happen again. 

A Focus on the Apparel Sector

As our primary source of exports to the United States, the apparel sector is particularly vulnerable to these tariffs. We have already spoken with people performing mental acrobatics to think the sector can take a 44% tariff hit. We do not believe so. 

Our local apparel manufacturers are extremely well run firms operating in a tough business. Margins are thin, customers are demanding and competitors are fierce. Firms based in Sri Lanka already have structural disadvantages with expensive labour costs (due to inefficient labour laws, and an ageing population), higher taxes and high electricity costs. When a customer buys a Nike t-shirt, they rarely care whether it was made in Sri Lanka or Vietnam. A Nike is a Nike. The brands also procure from multiple countries providing them with the flexibility to move production. 

While there is a hope that some of our capacity can be shifted to other nations like Europe, it is important to realise that countries like Vietnam will also have spare capacity and look to shift to Europe. Hence there may be huge overcapacity in European suppliers. 

Apparel factories need to run at high utilisation to justify the high fixed costs and capital investments required. Overtime, we do not think they will be viable in Sri Lanka if such a large tariff gap remains.

This is a shame, these are well run, businesses with good people creating thousands of jobs. It is important the government acts fast to save the industry.

The Paths we face

Our government now faces a pretty tough decision. 

Path 1: Reduce import barriers to allow more imports

• We will hence import more and face a worsening trade deficit

• This will lead to devastation of inefficient businesses that are unable to compete with the global economy (and hence job losses and capital destruction)

• Local consumers will benefit from lower prices

• It will be tough to divert this import demand to American products. For instance, importing more Indian tiles following blanket trade liberalisation may make the problem worse as we lose our American exports while also losing our local industry and growing the deficit.

Path 2: Accept lower exports while protecting the businesses reliant on tariffs.

• Our exports to the US will reduce dramatically. Hence we will face a worsening trade deficit.

• Tariffs at this level will be the end of the Sri Lankan Apparel industry. Full stop. Other exporters will also suffer. Many will shut down, while some will adjust to lower revenues or find new markets. Hence there will be job losses and capital destruction.

• We will continue to face the second order consequences of inefficient local businesses. (Such as higher local costs for consumers).

There may be more nuanced solutions which we will explore later. Either way, there will be two key first order consequences

1. Job losses and capital destruction (and the resulting economic malaise)

2. A significant increase in our trade deficit. Given our weak reserve position, this will likely lead to a weaker currency

Second Order Consequences

Like a set of dominos, these first order consequences will lead to multiple second order consequences that are also worth exploring. There are too many to name, and even more that we can’t think of. However, I have illustrated a few of these domino effects, in order to illustrate how large and complicated this situation will be. 

• A global recession may be caused by lower American consumption of foreign made goods (as well as higher American inflation). This could lead to Sri Lankan exporters not even exposed to the USA facing weaker demand.

  • For instance, consider a hypothetical industrial rubber glove manufacturer with 10% of its sales in the USA and 50% in Europe and 40% in Asia. Investors may think they are relatively insulated. However, if America buys fewer European and Asian manufactured goods, then it would be reasonable to expect European and Asian demand for industrial gloves to also reduce. Hence while 10% of its revenue is directly at risk, the remainder may also be at risk of a cyclical slowdown. This may happen even if we are able to get out of our currently poor relative tariff situation.

• A weaker currency will have multiple knock on effects on the Sri Lankan economy:

  • Higher fuel and electricity prices (possibly mitigated by weaker global oil prices caused by a recession)

  • Higher inflation and hence higher interest rates

  • An economic slowdown

  • Weaker consumer purchasing power caused by high inflation and higher interest rates 

  • A larger government deficit (higher foreign debt servicing costs, lower tax inflows from a weaker economy)

• A global recession could lead to higher gold prices (as we have already seen happen, but further amplified). This will benefit local finance companies focused on the gold loan market, who will face increased gold loan demand, and lower default rates.

• There will be a race for American products. 184 countries (and an island of penguins) have all been hit by the same formula. While the penguins may fight, many countries will try to improve their situation in this ranking by shifting imports to American goods. This could further exacerbate American inflation.

• The weakness in the currency and the fact that we are not facing “tariffs” on tourism could lead to hotels being a net beneficiary and our already well performing tourism sector doing better.

Possible Nuanced Alternatives

There may be more nuanced solutions available to reduce the impact of these tariffs:

1. Diplomacy. This will be hard. Every country will be attempting the approach, and Sri Lanka has less to offer than larger economies like India. The administration is adopting a formula based approach. Exceptions to this formula just for Sri Lanka are unlikely in my view.

2. Reducing tariffs only for American made goods. This puts us at risk of angering other partners who will want similar treatment (China comes to mind). 

3. Targeted procurement of American goods

   1. We believe this may be the best option in the near term (with progressive trade liberalisation always the longer term goal) to improve our position on the list.

   2. In this situation, the government would encourage the procurement of certain goods from the USA. (Either as substitutes to other imports, or to compete with inefficiently made local goods). 

   3. We would essentially be shifting demand. Some of this from what we would import from other countries, others from local inefficient tariff protected industries. 

   4. There may be win-win scenarios for this, as shown below

An Example of a Win-Win

One of the more damning examples of Sri Lankan inefficiency is our grain market. Due to fragmented land and poor agricultural techniques, Sri Lanka produces a fraction of the grain it requires at a very high cost relative to other economies. This inefficient sector of the economy is protected by high tariffs preventing import of grain at a lower price. This leads to significantly higher animal feed costs than the global average, and as a consequence, animal products such as milk are produced at a high cost and low yield. This has led to Sri Lanka having one of the most expensive liquid milk markets in the world as well as being one of the few countries in the world reliant on imported milk powder (which is bad for the trade deficit in any case!). This affects childhood nutrition and hits the poorest in our society hardest.

A simple win-win would be to import American grain, significantly lowering our feed costs and hence lowering milk prices. The loss in foreign currency will be partly if not fully mitigated by lower imports of powdered milk. There will be losers (such as the grain farmers), but now that the gun is to our head, we have to face difficult decisions which we have deferred for too long. 

Who might benefit

1. Exporters not reliant on the United States, directly or indirectly

   1. A depreciation in our currency, could benefit exporters who do not have significant demand from the United States. However, we expect the entire global economy to be weaker (as mentioned above) so they may struggle

   2. Exporters that are not particularly cyclical will be a safer bet.

2. Tourism and other Service Exporters

   1. As the Americans are not targeting the service sector (and we can’t see how they can), the service sector (Particularly tourism) will benefit significantly from the weaker currency (and possibly a job market with more employees available)

3. Import substitution

   1. There are several businesses producing products targeting the local market which are not overly reliant on protectionist trade barriers to survive. These firms should benefit from a weaker currency making their competing imports more expensive. 

4. Consumer staples targeting the local economy (such as cigarettes and alcohol) should generally see a limited positive or negative impact from the crisis. 

So What are we Doing

As mentioned above, there are two paths the country can take, with multiple first and second order consequences from each. It is still too early to make predictions let alone investment decisions. 

At times like this, we prefer to watch the data points and government actions carefully and react fast and decisively, instead of attempting to predict the impossible. While we feel the future has suddenly become especially uncertain, we also feel that there are some firms that may be less affected regardless of whether we go down Path 1 or Path 2. These are what we will focus on. 

For instance, regardless of whether we choose to save our exporters or defend our local businesses, Sri Lankans will continue to drink Arrack and use toothpaste (we hope). At this stage, we prefer to make attractive bets that are not reliant on any particular outcome related to Tariffs, until we have more visibility on the situation. 

Conclusion

While we anticipate the impact of these tariffs to be dramatic (even if delayed or reduced), we do not think they are fatal to the country. We (both Sri Lanka, and the world) have been through worse, and we remain confident that the country as a whole will make it. 

The key driver of “how bad it will be” is down to our government and the tough decisions they will make. We are uniquely blessed with a government with the parliamentary majority to do what is required. Correct action, taken quickly and decisively can still salvage the situation. Who knows, this may even be an opportunity to take the tough decisions and fix the structural protectionist driven inefficiencies in our economy. Never let a good crisis go to waste.