Our governments since about 1956, with the possible exception during the tenure of Dr N.M Perera as the Minister of Finance, has been indulging in budget deficits and the Fiscal Management ( Responsibility) Act of 2003 has been ignored. Governments have paid some lip service to ‘fiscal consolidation’ but it was to be achieved only in the medium term and such medium term never came. So the governments have run ever increasing budget deficits by borrowing all the peoples’ savings and then proceeded to dis-save themselves reducing net national savings. When savings were not enough they resorted to borrowing from the central bank and the banking system - the equivalent of printing money. Such borrowed or printed money was used to fund the war and to keep the politicians happy by giving them perks which the country cannot afford. Money was also used to capture and retain political power by bribing the voters generally as well as specifically, flouting all principles underlying a free and fair election.

The process of deficit finance has caused a large increase in the money supply leading to inflation and balance of payments deficits on current account, appreciation of the real exchange rate causing an excessive demand for imports and destroying the competitiveness of the economy such that no product locally made can compete in the world market without protection from imports. It has also distorted the price signaling system, causing pyramid schemes to flourish with the nominal interest rates repressed and the real interest rate negative.

The result is that bad investments are encouraged as in the case of the vehicle leasing and apartment building. With the global oil price hike it became impossible for the government to fund the current account deficit and hence was forced to borrow commercially. While this is alright for the immediate short term, it is necessary to put into effect policy measures to rectify the deficit.  Expansionary monetary policy plus excessive budget deficits are the opposite of what is required. The CB justifies its new monetary policy since September as required to cope with the global financial crisis. This is valid only up to a point.

True the foreigners pulled out their moneys from the stock and bond markets with the stock market falling by 40% and the bond market losing $ 200 million invested in Treasury Bills & bonds. There was a drying up of liquidity.  But in my opinion the CB should have confined its liquidity replenishment to banks only up to the reduction and that too only for a short while, for the medium term and the short term interests clash and somehow they must be made to mesh together. What was required was perhaps to prevent a drying up of trade finance for the import export trade due to the drying up of liquidity. This doesn’t seem to have happened and the banks continue to restrict credit to the private sector for fear of an increase in loan defaults. CB exhortations will not have an effect since the Treasury Bill rate is still high and the banks cost of funds has not come down.  I would suggest the CB to re-discount commercial bills of exchange as the Bank of England has done.

To reduce the pressure on the rupee the CB resorted to direct controls like the 100% LC margin for less essential imports. The drying up of bank credit has also meant half built apartment complexes and a slowdown of the building construction industry with its knock on effect on the wages of those engaged in it. There may be non-performing loans in this sector. The business thrived on expatriate demand for apartments for both investment as well as for occupation. Soon the demand for office space too declined and the high rents of yesteryear cannot be maintained.

There are no statistics available on the state of this industry and the CB should carry out a survey of all sectors suffering from the decline. The fall in the stock market also had what is called the ``wealth effect.’’ It made rich individuals feel poorer and reduce their consumption. 

An  event not particularly related to the global meltdown is the collapse of Golden Key Credit Card Co and the threat to the whole Ceylinco Group owing to inter-connected borrowings and cross-holdings. This has led to a run on the finance companies which were suffering from a decline in their leasing business because of the high duties imposed on vehicle imports. Of course the business over-expanded and was not sustainable in any case.

Next came the global decline of commodity prices which affected our tea, rubber and coconut exports. The manufactured exports are faring badly all over the world but we are not a manufacturing country. So the effects here have been confined to garments, shoes, ceramics and some lesser exports. The problem was worsened by the currency depreciation in India and Kenya as well as Russia. Our failure to depreciate makes it impossible to compete. So there was not only a decline in the export earnings but also a reduction in incomes of smallholders of tea and rubber.

This has a knock on effect on the import and sale of consumer durables and brought recession on to a host of import based companies causing retrenchment of their staff and reduction in their profits. The garment industry has had its own problems with the peril of losing GSP+ preferences and several factories have closed down leading to mass retrenchment of their employees. There is worse to come if we don’t get the GSP+ from the EU. 

The CB has been pumping printed money to the banking system which now has reached Rs 200 billion. The effects on inflation will take time - perhaps an year or so. It has reduced the Statutory Reserve Ratio to 7% and brought down the overnight Reverse Repo rate. The Inter-bank rate of interest is now down but the banks will not lend. They have reduced credit to business and put to risk the existence of several businesses both in the import-export trade and domestic wholesale business.

What should be done

This depends on the priorities of the CB and the Government. We are particularly vulnerable on the balance of payments front. The CB has been losing Foreign Reserves of about $ 200 million each month for the past several months. The Foreign Reserves are now dangerously low at $1,400 million, inadequate to fund imports and debt repayments in the pipeline. The priority in policy measures have to be to restore the Foreign Reserves to a safer level. The maturing debt obligations over the short term are not available to make a judgment on this score.

Policies to address this problem can be either a depreciation of the rupee or rigorous import and exchange controls. The latter are unlikely to succeed as the 1970s showed for they merely lead to smuggling, to shortages and queues and ultimately a rigid rationing system which also means more corruption. Depreciation has its advantages and disadvantages. It will help to maintain the competitiveness of the export sector and thereby our foreign markets for thesew products. But depreciation is unlikely to succeed unless accompanied by a strict austerity in the government finances.

Depreciation works only with deflation not inflation. Nor can the government afford to provide stimulus packages to anyone. They will worsen the budget deficit and cause monetary expansion and worsening of the current account deficit in the balance of payments. We need more foreign exchange, and removal of exchange controls on capital to enable the privates sector to borrow externally would be desirable. Depreciation would also promote tourist earnings and migrant remittances. We also need direct foreign investments to fund investments by both the private and the public sectors.

The best stimulus to private business would be to reduce corporate taxes to even zero since there is presently double taxation - first the corporate and secondly the income distributed to the stakeholders –the shareholders and directors.

The CB is giving the wrong signal to foreign investors in the bond market by reducing the rate of interest. We need to promote more savings and the incentive to do so is a positive real rate of interest. Inflation is coming down but the cost of capital in a capital short economy must be at least 4% in real terms.

There is an easy way  to bring more funds into the organized sector by re-introducing Bearer Certificates of Deposit (CDs) which are negotiable. With the Money Laundering Act, the CB killed the instrument by insisting  on the name and NIC of the depositor. These cheap funds held in CDs flowed to the banks and were available for credit expansion.  

Similarly there is a large community of Sri Lankan expatriates who will invest in the country after a depreciation and an increase in interest rate. The expatriate Tamil community is very rich and can easily send money if we only treat Tamils more humanely and respect their human rights.