Dr. J. B. Kelegama
The new government is facing a daunting economic situation of declining production and investment, negative growth, falling exports, tourist arrivals, migrants transfers and external reserves, yawning budget deficit, rising prices and trade unions agitating for higher wages. The challenge before the new government therefore is to arrest the economic decline, remedy the shortcomings, stabilize the economy and push it onto the path of development by sound economic management. The objectives are clear: to increase investment, production, exports, tourism and external reserves, to reduce the budget gap, arrest the inflationary rise in prices and deal with the trade unions, but the crucial question is whether the legacy of incompetent economic management, and the prevailing adverse external environment will permit quick solutions.

The Budget

The first thing the new government has to do is to prepare the Budget for 2002, for without it the government will not be able to spend money this year. In preparing this budget the government needs to provide adequate funds for current as well as capital expenditure of government without creating a large budget deficit. One of the major reasons for the economic mess today is the excessive budget deficits exceeding 10 per cent of GDP in 2000 and 2001. Excessive deficit financing needs to be reduced and this can be done by cutting unnecessary or low priority and wasteful expenditure on the one hand and increasing revenue on the other. Some of the unnecessary and wasteful expenditure which can be cut without any adverse effect on the economy or the people are the new luxury buildings in Kotte, fleets of a dozen or more motor vehicles used by ministers and unnecessary travelling, subsidized meals for Members of Parliament and high rents paid to luxury buildings used as ministry offices, but these are not enough. Consequently, measures need to be taken to raise revenue. Tax revenue has declined from 17.8 per cent of GDP in 1995 to 14.5 per cent in 2000 as result of tax reductions when the escalating war expenditure warranted higher taxation. Average import duty for example was reduced from 9.6 per cent in 1994 to 7.0 per cent in 1999 and then to 4.5 per cent in 2000. This is a very low ratio when compared to developed countries. The ratio of tax revenue to GDP exceeds 50 per cent in Sweden, 40-50 per cent in Denmark, Finland, Belgium, France, Italy, Netherlands and Norway, 30-40 per cent in Germany, Britain, Canada and Switzerland and 20-30 per cent in US, Japan and South Korea. Tax revenue must be increased and the most feasible ways seem to be an increase in a progressive way, income taxes and increase on a selective basis, import duties, excise taxes and goods and services taxes. Taxation should be progressive and the burdens should not be imposed on the lower income groups as far as possible. Normally, a new government would not like to increase taxes, but the fiscal situation is such that it does not have an alternative. It should at least begin by eliminating the current account deficit or the excess of recurrent expenditure over revenue, which was 3.4 per cent of GDP in 2000.

There are several other ways of reducing expenditure, but they are long-term measures and are not feasible in the first budget. Military expenditures accounting for about 17 per cent of the total expenditure (Rs. 71 billion in 2000 alone) can be reduced only by halting the war against terrorism and this is likely only through protracted negotiations. Besides, rehabilitation and employment-creation for the demobilized soldiers are likely to absorb a good part of the savings from ending the war. Subsidies and transfers account for about 10 per cent of the total expenditure but being sensitive items, they too cannot be reduced from the word go. The Samurdhi benefits for example are enjoyed by half the country’s population when only a quarter are in actual poverty; this scheme needs to target only those living below the poverty line but this will be bitterly opposed by those already enjoying the benefits. Appropriate measures to tackle this problem can be formulated — but not immediately. Subsidies to loss-making state-owned corporations can be stopped but it will result in unemployment — a prospect not to the liking of a new government. It is therefore necessary to take measures to increase the efficiency of state-owned enterprises to enable them to generate a surplus for government revenue. What is most important is to appoint independent and commercially oriented boards of directors to these enterprises and to stop politicizing them as in the past. Both India and China are restructuring their weak state-owned enterprises - not privatizing them as we have been doing; state-owned corporations in countries such as Taiwan and Singapore generate substantial revenue to the government; they are assets not liabilities and a source of income to which we have not paid enough attention.

Foreign loans and grants are generally for public investment and further a project related and they are normally not extended for recurrent expenditure and budget support. The government should negotiate them for some of their new projects and programmes, but they are unlikely to help the government in reducing the current budget deficits although they may help to reduce inflationary bank borrowing.

Economic Growth

Perhaps the most important determinant of economic growth in Sri Lanka is rain: good rainfall generally results in high growth and drought spells low growth. If the current thunderstorm rains and the North East monsoon rains result in a good Maha crop, the new government can start on a firm footing. If power supplies and production are not interrupted by the failure of the South west monsoon this year, that will contribute to higher production. No one can predict what the rainfall will be this year, but unless there is adequate rainfall the current trend of declining production of paddy, subsidiary crops, tea, rubber, coconut and spices as well as industrial output will continue. The second major determinant of economic growth is the external demand for our exports, which determines the export prices and our export earnings. Exports are equal to about one-third of the GDP. Generally, high expansion of exports, like good rainfall, tends to promote high growth. A study of the figures of structure of the Gross Domestic Product and its annual changes indicates that economic growth is affected mainly by three factors: paddy output (depending on local rainfall), tea exports (depending on rainfall but more on world market) and textile and clothing exports (depending on the world market demand).

There were four years in the nineties which experienced high growth of 6.0 per cent and above - 1990, 1993, 1997 and 2000 - five years which had below 5 per cent growth - 1991, 1992, 1996, 1998 and 1999—and two years with growth between 5.0 and 6.0 per cent— 1994 and 1995. In the high growth years, all the three sectors - paddy, tea and clothing - combined to bring about high growth in three years: 1990, 1993 and 1997; in 2000, paddy and tea showed moderate growth but clothing compensated for that by achieving high growth. In the moderate growth years too, it was clothing exports, which showed high growth while paddy and tea experienced moderate growth. Actually, tea did badly in 1995, but it was offset by the jump in clothing exports. Coming to the low growth years, high growth of clothing failed to offset the marked fall in paddy production in 1991, 1992 and 1996 and the decline in tea production in 1992 and low growth in 1991; in 1998 and 1999, paddy production recovered but production of tea slowed down and prices actually fell in 1999; clothing exports too showed a moderate growth in both years, particularly 1999. Thus, the economic picture for 2002 will be shaped by rainfall as discussed above and the world economic situation, which determines the fate of our exports.

Adverse External Environment

The global downturn and the terrorist attacks in the US and the war against terrorism, according to the World Bank, are expected to result in a low economic growth of 1.4 per cent in the developed countries in 2001 and about the same in 2002. Economic growth in the US is estimated to fall from 1.0 per cent in 2001 + 0.6 per cent in 2002 and in the Euro area from 1.5 per cent to 1.0 per cent. The developing countries which achieved an economic growth rate of 5.5 per cent in 2000 are expected to have only 2.9 per cent growth in 2001 and about the same in 2002. This means slower growth in the world for Sri Lanka’s exports than even now. In the first ten months of 2001, Sri Lankan exports in dollar terms, were 9.1 per cent less than in the first ten months of 2000: agricultural exports were 5.8 per cent lower and industrial exports 9.6 per cent lower, with textile and apparel exports 11.4 per cent lower. Further, prices of exports are now lower than last year: dollar prices of tea, for example, in October 2001 was 17.5 per cent less than a year ago and the unit value of total exports in July 2001 was 11 per cent lower than a year ago. With the downturn deepening, indications are that our exports will continue to decline in 2002 too.

The World Bank estimates a fall in private capital flows to developing countries too, on account of the downturn and terrorist attacks in the US and war against terrorism, from $ 240 billion in 2000 to $ 160 billion or by 33 per cent in 2001. The picture is unlikely to show an improvement in 2002. Foreign direct investment to Asia alone is estimated to decline by 12 per cent this year. Both developed and developing countries experiencing low growth will be less able to invest abroad. The major foreign investors in Sri Lanka are the NICs in Asia such as South Korea and Singapore but they are all experiencing difficulties with the sharp fall in their electronic exports to the US and consequently will have less capacity to invest abroad. Singapore in fact had a negative growth of 2.2 per cent in 2001 - the worst performance in the country’s 36-year history and is estimated to experience between negative 2.0 per cent and positive 2.0 per cent in 2002, in contrast to 9.9 per cent growth in 2000. The number of people made bankrupt reached a record 2904 in 2001. South Korea is expected to have less than 2 per cent growth and Hong Kong negative growth of minus 0.2 per cent. Japan, which continues to be in deep recession and will have a negative growth of 0.8 per cent in 2002, too will be investing less overseas. In addition to foreign private capital, official development assistance too is expected to fall this year and the next with main donors mired in the slowdown. Currently aid claims only 0.22 per cent of the GNP of developed countries far short of the 0.7 per cent goal agreed to by the international community, but even this low figure is likely to fall further. Japan, the largest giver of ODA has cut its ODA budget for 2002 by 10 per cent. The global slowdown and the terrorist attacks are also expected to cause a sharp decline in tourism. Tourist arrivals in Sri Lanka in the first ten months of 2001 were 10.5 per cent lower than in the corresponding period in 2000. Uncertainty and fear of war in the Middle East may reduce the demand for foreign workers; in fact migrants’ transfers are already declining: net inflows in the first ten months of 2001 show a fall 3.3 per cent. It appears as if Sri Lankans may not find employment opportunities in the Middle East as before and this will tend to aggravate the problem of unemployment.

Domestic Investment

If the external situation is unfavourable, can we stimulate the economy by increasing domestic consumption and investment which account for about two thirds of the GDP; Consumption is already high and it accounts for 83 per cent of the GDP: besides, further increase in consumption will result in more imports and strain the balance of payments and reduce our external reserves. As it is the high level of consumption which reduces the resources available for investment, the appropriate approach is to not to increase but reduce consumption in order to expand investment. Sri Lanka’s investment has been about 25 per cent of GDP in the last six years whereas that of East and South East Asian countries has been 35 to 40 per cent before the currency crisis. This relatively low level of investment has resulted from the low level of gross domestic savings in Sri Lanka, averaging about 17 per cent of GDP in recent years as compared to 30 to 50 per cent in East and South East Asian countries. Some of these countries have been receiving substantial foreign direct investment too, particularly Singapore, Hong Kong, Malaysia, but FDI has accounted for only about 7 per cent of the gross fixed capital formation in Thailand and below 3 per cent in Taiwan and South Korea in the nineties, bearing testimony to the importance of domestic savings. One of the surest ways of increasing savings is to achieve, budget surpluses by measures to reduce current expenditure and to raise revenue which were discussed earlier. Current budget deficits, as shown earlier, are about 10 per cent of GDP. Budget surpluses would enable the government to make further improvements in the economic and social infrastructure and at the same time to expand the production base of the economy by establishing industrial undertakings which are shunned by the private sector, not to compete with private enterprise but to complement it.

Private investment may be deterred by the unfavourable external environment, particularly its effect in reducing exports and foreign capital inflows, but there is much scope for import substitution industries. It is unfortunate that for several years, the authorities concentrated on export industries and neglected import substitution industries, instead of encouraging both as Japan, and East and South East Asia have been doing. Further, import substitution industries of today can become the export industries of tomorrow as some of our early import substitution industries like garments, biscuits, rubber products, ceramics and leather products have demonstrated.

Import substitution industries, like domestic food production, however, may not be able to get off the ground if imports are allowed freely: they need to be protected by selective restrictive measures and supported by concessional credit and subsidies at least in the initial stages. The developed countries like the US protect their weak industries even today, for example, steel, textiles, clothing, automobiles, sugar, groundnuts and tobacco. As the world market for exports has weakened, we have no alternative but to develop and expand import substitution industries to provide employment and income to the rising unemployed while conserving foreign exchange and increasing government revenue through higher import duties. It is difficult to see why we are importing cement, building glass, sanitary ware, hardware and rubber goods on a large scale when we can produce them here. What is blocking import substitution industrial development is our "free trade" mindset and our mistaken belief that import substitutes are necessarily of poor quality. Can anyone really say that our import substitutes like biscuits, chocolates, garments, ceramics and rubber and plastic goods are inferior? The new government should therefore review our industrial policy, taking into account the external situation, not only with the objective of conserving foreign exchange but also of expanding the country’s production base to create employment and income and accelerate growth.

Inflation

One of the major reasons for the inflationary rise in prices - 13-14 per cent a year—is the increase in import prices, by as much as 16 per cent in 2000, on account of higher prices in the supplying countries and depreciation of the rupee. Although we are powerless against price increases in the world market, we could stabilize the rupee by increased production and sound fiscal policy. Another is the excessive budget deficit, which we must try to reduce in order to stabilize prices. Yet another is inadequate production and excessive middlemen’s margins in items like vegetables and fruits. As the production of potatoes, chillies, pulses, red onions, maize and others have fallen in the last six years, vigorous efforts need to be taken to step up their production. It is to bring down their prices that the cooperatives, Markfed and the Marketing Department were used to provide competition by the authorities in the past. It is not too late for the new government to at least revive Markfed and the cooperatives which played an important role in ensuring reasonable prices to the consumer as well as the producer. The role of cooperatives was neglected under the free market policies in recent years but the extensive use of the CWE to purchase and sell grains, vegetables and fruits is clear proof that the free market had not been a success; the role of the cooperatives needs to be restored. In fact one of the principal reasons for the demand of trade unions for higher wages is the high cost of living and this can be tackled to some expert by arresting inflation, increasing production and sale of vegetables and fruits through Markfed and the cooperatives in competition with private trade. The successful efforts made by the new Minister of Commerce and Consumer Affairs to reduce the prices of milk powder, tyres, batteries; cooking gas and diesel oil by persuasion rather than by fiat are laudable; price reduction of more items is envisaged by the Minister in the same way in the near future.

It will be difficult however, for the new government to resist higher salaries and wages, particularly if the Salaries Commission in fact recommends their increase. Further, a part of the salary increase has already been given by way of the interim allowance of Rs. 1,200. As an increase in salaries and wages in the public sector will enlarge the budget deficit, the authorities may have no alternative but to find the required funds from higher taxation. The authorities should not insist that the private sector too pays these higher wages as a large number of firms are in difficulties because of the world economic downturn and are clearly unable to pay them. In the tea sector for example, it is not possible to pay higher wages when world tea market prices are falling; in fact, they have, as shown earlier, declined by 17.5 cent in the last 12 months. Export prices are also falling in other agricultural exports and garments and some factories have been closed down.

The IMF

The new government will find it very difficult to implement the reforms prescribed by the IMF in March 2001 without creating public unrest. For example, it may not be in a position to raise prices of petroleum products when the trade unions are already complaining of the high cost of living; it may not be able to undertake reforms in the labour market to facilitate greater mobility if the trade unions which have presumably supported the governing party at the election, are opposed to it. It will, for reasons discussed earlier, not succeed in freezing public servant’s salaries and wages and it may find it difficult to privatize Shell and Telecom shares if the same trade unions do not support it. Besides, the stock market may not be favourable in the context of the global downturn. It behoves the new government therefore to convince the IMF of its difficulties and attempt to modify the reforms agreed to by the previous authorities. The IMF, it is reported, has become less rigid in its orthodox recommendations, and there is no reason why it should not appreciate the difficulties of the new government and approve new policy measures it may formulate while releasing the balance $ 122 million of the trench and recommending other donors to release loans amounting to $ 700 million withheld on account of the unsound policies.

Make no mistake, the balance of payments is going to be critical this year with the continuation of the global economic downturn, recession in Japan and uncertainty and fear created by terrorism. Our exports will continue to face bleak export markets and our export earnings are likely to decline. This will be compound by the reduced inflow of migrants’ transfers on account of the uncertain situation in the Middle East and the decline in tourism and foreign capital inflows. Unless imports are restricted, these adverse factors are bound to enlarge the deficit in the balance of payments and reduce our external reserves., In such a situation we may not have an alternatives other than borrowing from the IMF. It is of crucial importance therefore to prepare the groundwork now regarding negotiations with the IMF. The government will have to face the dilemma of placating the IMF with at least some unpopular reforms in order to obtain assistance on the one hand and avoiding public unrest by taking such measures on the other. A middle path needs to be worked out with the help of the leading economists and negotiators to keep both sides happy.

It is hoped that the IMF, on its part, will follow the advice of Stanley Fischer, the former first deputy managing director at the IMF and its chief crisis manager until last August, given in his article on "What I learned at the IMF" in the Newsweek special edition December 200l-January 2002 as follows:

"The role of the international institutions should be to support and advise, not to hector and impose. To that end financial support should not have too many strings attached. For the IMF, this means confining conditions to what is necessary to get the macro economy back on an even keel and to get financial and other key markets working properly".