Why the government is deep in a financial crisis

by Anaalyst
People are now beginning to ask what the UNF Government has done to honour the promises in its election manifesto, such promises as to bring down the cost of living, to create jobs for the educated unemployed etc.

Asking for money that is not there

The Opposition political parties are organizing protests and strikes by university students alleging that the government has cut down the funds for the universities. The President has gratuitously written to the Minister of Finance to provide them more funds. But how can he do so without resorting to the financial jugglery of the PA Government, which is disastrous for the health of the whole economy and would not be acceptable to the IMF.

They created money on a massive scale to solve their problems of finance mulcting as much as Rs. 48.6 billion from the banking system which raised the annual debt service burden from Rs. 179 billion in 2000 to Rs. 326 billion in 2001. There is a massive increase in debt repayments due this year from Rs. 85 billion in 2000 to Rs. 209 billion in 2001 — an increase of 146%. Does the President expect the same reckless financial policy to be continued? How else can the universities or any other agency be given more money? Such money creation also causes inflation. Such inflation however takes time and its impact will be felt only about a year afterwards.

So the people are now beginning to feel the inflationary effects of the monetary expansion by the PA government. This point must be brought to the notice of the people and the people should be made aware of the delayed effects of money creation. Someone should answer for the financial recklessness of the previous government and that it should be the previous Minister of Finance — no less than the President herself.

Not only has money been recklessly squandered it has also been spirited away by high officials in charge in the universities and in the Central Province Education Department through fraud and misappropriation. The new government must hold these officials accountable and charge them in courts where evidence is available. Private auditors may have to be commissioned to assist the Audit Department. Those suspected of malpractices are usually interdicted so that they do not interfere with the investigations. Otherwise the miscreants could hire the Mafia to kill or maim the investigators.

The PA Government callously mismanaged the economy. They squandered money — money that was created by the Central Bank to fund the ballooning budget deficits. They used the money to fund the war and the welfare services like free education and free health care, the numerous political giveaways and subsidies, including the hidden subsidies for electricity and diesel. We saw recently how Rs. 25 million had been spent to refurbish the office of former Minister Mangala Samaraweera. Massive amounts of money were spent on luxury vehicles and on bullet proof vehicles for every Dick, Tom and Harry who were hardly at risk from the threats of the LTTE.

Creating inflation with its delayed effects

The Central Bank had no qualms in creating money for the government and permitted the two state banks to lend money to the government to fund the increasing losses of the CEB and the Petroleum Corporation. The Central Bank is supposed to control inflation but here it is creating inflation. So the rate of inflation came to be permanently raised above the level in competing countries like India whose products compete with our exports in foreign markets. Inflation in India has generally been below 9% in recent years, in Malaysia and Thailand about 2% while we have had double-digit inflation around 12-13% in the same period.

The inflation in developed countries like USA or the European Union is below 3%, which is the benchmark in the EU. If the rate of inflation exceeds 3% in any member of the EU, such member will be fined. We’re in a situation where our locally produced fruits cannot compete with imported apples, grapes and oranges, our industrial goods and commodity exports struggle to sell in foreign markets. Our subsidiary foods like onions and potatoes could be imported much cheaper than grown here. There’s hardly anything we can competitively produce and on strict economic logic we are destined to be consumers rather than producers. An unsustainable situation indeed. All this is due to the macro-economic mismanagement by successive governments.

The only remedy is to impose protectionist duties to raise the prices of imported goods and to give subsidies to export products. But our politicians believe in a free lunch. If agriculture and domestic industrial products are protected by tariffs, their prices will go up and worsen the cost of living. The vociferous urban middle classes and the working class don’t want to pay more for the rice and subsidiary foodstuffs produced locally by our farmers. So there is a tussle between the Ministers of Agriculture and Commerce. The problem is also complicated because the PA government gave away our rights to impose tariffs by unilaterally reducing them in the name of the open economy.

The open economy has to be managed and such management has to be done through market forces using fiscal and monetary policy. The PA Government failed miserably in the task of macro-economic management, creating all sorts of imbalances and feeding a massive black economy which has been estimated as Rs. 600 billion by the Deputy Minister of Finance, nearly half the official economy.

No quick remedies possible for our economic woes

These macro-economic imbalances cannot be put right in a short time. The huge accumulation of black money makes macro-economic management very difficult. These massive funds will go into raising purchasing power. Private consumption will continue to boom and imported goods will continue to be in demand. The demand for luxury vehicles, for consumer durables, for foreign travel will continue to boom, never mind the hardship caused to ordinary people by the increase in fuel prices and electricity prices. Such prices will have no effect in dampening aggregate consumer demand. The country will continue to import luxurious vehicles.

Singer which sells imported consumer durables has increased their turnover by 10%, last year in spite of the negative growth in the economy.

The Duty Free Complex will feed consumer durables to the black economy. The government must explain to the people the seriousness of the economic crisis and that there are insuperable constraints to the restoration of macro-economic balance.

Apart from the expenditure on the war, the massive borrowings by the government are for funding the free education, free health care and the subsidies. It is not possible to go on borrowing to finance free education, free health and subsidies. We are in a debt trap and to get over this the government must run a primary account surplus. (A primary account balance is the difference between revenue and expenditure excluding interest payments.) As it is the government is running a deficit even in the primary account and it must soon aim for balance and even a surplus there to get out of the debt trap.

The prime minister has pointed out that the total government revenue is not sufficient to service the debt, to pay the instalments falling due on loans taken and the interest payable. Dr. N. M. Perera who inherited a similar empty cupboard in the 1970s followed prudent financial policies and repaid debts before undertaking any fiscal expansion. He was dubbed "No Money" Perera for his trouble.

There’s no money for expansion, so the government cannot expand expenditure. This means it cannot increase the salaries of public sector employees. It also means it cannot continue with subsidies on electricity or fuel or even fertilizers for the farmers. It also means that government cannot afford to increase spending on education or health and carry on the old populist policy of putting up a school here or a hospital there to indulge the people. Party supporters who expected jobs when they worked for their MPs to get elected will be disappointed.

It also means high rates of indirect taxation like VAT. Such indirect taxes cause inflationary pressures on prices. Such price increases make the economy uncompetitive. It is useless talking of improving productivity through the Five Ss or other techniques at the micro-level as long as there is no macro-economic balance. When prices are raised to recover costs or to cover indirect taxes, the cost of living will increase. But there cannot be any compensatory wage increases. There has to be a wage freeze if we are to come out of this economic crisis. The public will have to endure pain before it can increase its real income.

The banks, which carry a large volume of bad loans, provision for which have not been adequate, will have to clean their balance sheets by writing off these bad loans. Such bad loans in other countries have either been taken over by the state or sold to investors at a discount to recover through legal proceedings. No amount of fudging can conceal the fact that the state banks as well as some private banks are insolvent.

If the Central Bank concentrates on its principal task of controlling inflation, it will not keep down the short-term interest rates. If it fails to control inflation it will be unable to prevent the depreciation of the rupee and with every depreciation a fresh round of inflation takes place with consequent pressure on wages to go up. So austerity is inevitable. But the government ministers and bureaucrats should set an example in austerity. This is where the government has failed. However necessary it is to throw perks to politicians to win their support and reward them with ministerial portfolios, the economy cannot stand it. The public finances do not permit such extravaganza. The government cannot borrow to fund current expenditure as the PA government did during their term of office.

Brake on reckless govt. spending

Borrowing is justified only for capital expenditure. A very necessary constitutional amendment is to provide that if the Official Foreign Reserves decline below 2 months import requirement, the President should dismiss the government. This will make it mandatory for a government to manage the economy prudently and prevent the type of macro-economic mismanagement carried out by the PA. The irony is that the dismissing authority will be the very lady, who as finance minister, was largely responsible for the mess!

It’s necessary to ensure that the Central Bank is provided with independence and charged with the task of maintaining inflation below a targeted figure. In New Zealand the Governor of the Central Bank is liable to be dismissed or his contract terminated prematurely if he fails to maintain the prescribed rate of inflation. Our Central Bank last year allowed inflation to exceed 14% when the economy was in decline and recorded negative real growth of 1.3%. The bank also failed to maintain the external value of the rupee, sold foreign exchange from its official reserves to defend its value and when everything failed floated the rupee.

It’s easy to mismanage and destroy an economy but very hard to repair the damage. The UNF Government has failed to explain the position to the people. If the Central Bank fails to control inflation and allows the rupee to depreciate continuously and funds budget deficits by money creation, the disastrous monetary and fiscal policy will worsen the economic crisis. Our agriculture as well as industry will then be unable to face competition in the domestic market or in the foreign markets. If the government wants to maintain economic growth, it must maintain capital expenditure at the same level but cut the current account deficit and the overall deficit in the budget.

Priority should be given in capital expenditure to rural roads and rural infrastructure rather than to expressways unless the latter can be financed by foreign aid. If expressways are built then tolls should be levied to recover the costs and obtain a return on the investment. The return on investment is the best guide to the choice of investments in a free market economy.

Law and order is the bedrock on which a market economy functions. Not enough money is spent on the operation and maintenance of the system of courts. The Chief Justice, according to a newspaper report, has suggested the retention of fines for the upkeep of the courts. Normally economists support a consolidated fund for all government revenue so that the policy makers can make the optimal choice in spending after considering all the needs of the government. Earmarked funds deprive such a free choice in the allocation of government revenue. But our politicians have shown themselves to be imprudent and to be guided only by vote-catching expenditure and expenditure that builds up their own power and influence rather than consider the priorities of the economy or the people.

They have under-funded the courts and the judicial system. It is therefore better to agree to the suggestion of the Chief Justice to earmark court fines for expenditure by the courts. It will provide for better maintenance of the courts buildings. The public who are summoned as witnesses do not even have toilets in some court premises where they are expected to attend at 9.00 a.m. and remain till the end of the court day. Judges seldom start proceedings before 10.00 a.m. or even 10.30. Spending money on the courts will not win votes for politicians and hence the courts do not receive the priority they deserve. Our Superior Courts complex was a gift from the Chinese government. We can’t all the time depend on others for help in solving our problems.