The IMF Standby Credit has been obtained but it can’t be ‘business as usual’ with growth stressed over macro-economic stability as hitherto. We have to restore macro-economic equilibrium to correct the current account deficit in the balance of payments. We cannot go on borrowing from foreigners to fund our imports which greatly exceed our exports. We have to earn Foreign Reserves not borrow them for borrowings have to be repaid. The naïve faith in roll-over has been hopefully dented. There is no harm in borrowing if the funds are used to generate more tax revenue for otherwise loan repayment is not feasible. We must also increase foreign exchange earnings either through more exports or reduced imports.
Cutting the Budget Deficit
The government has agreed with the IMF to cut government spending. There is little or no room to maneuver on either the income or the expenditure side of the government’s budget. Our ministers splurge on the biggest and costliest five star hotels in New York, Tokyo and London. Surely such expenditure can be cut and foreign trips curtailed using the services of our embassies. Unfortunately, with the politicization of the public service there is no longer Treasury control of public finances.
Coping with the balance of payments crisis
The Central Bank lost a large volume of Foreign Reserves by holding the rupee at an over-valued parity. Exports have failed to grow and it has been difficult to find the foreign exchange to pay for imports, particularly oil. If the oil price were to go up again our problem would become hopeless. Unless the Foreign Reserves are built up by earnings not borrowings we run a risk of depreciating of the rupee. It will make everything from imported machinery to foreign travel and education more expensive. A weaker rupee could also reverse the recent slide in inflation.
What we should do
What we should do is to liberalize exchange control at least for the Sri Lankan expatriates to bring in and take out foreign exchange freely. The Exchange Control Act carried over from the colonial Defense Regulations draws a distinction not between citizen and foreigner but between residents and non-residents. There are also foreigners willing to invest here in our stock and bond markets hamstrung by Exchange Control. Why not allow foreigners who bring in foreign currency after a Customs declaration to place such funds into foreign currency accounts? Why not allow those with foreign currency accounts to buy shares or bonds and allow brokers and primary dealers to hold their funds in local currency or credit them to foreign currency accounts from which they could repatriate freely if necessary. Why have this peculiar requirement for SIERA and TIERA accounts which are rupee accounts?
We could also tap sovereign wealth funds including those of China and funds in the Middle East. But all efforts must be made to promote exports and foreign direct investment. Recently the Japanese Ambassador publicly referred to the problems faced by Japanese investors who had already invested here. If the Government doesn’t have funds to refund VAT on exports, it should exempt exports from VAT and eliminate both the need for refunds as well as the room for fraud and excessive paper work.
Monetary Policy must change course
Monetary policy, has kept short-term interest rates at negative real levels, hoping that the banks will reduce their lending rates to the private sector. But this has not happened. Admittedly the economic mainstream believes that a low interest rate policy is helpful for stimulating output and employment; lower borrowing costs are widely expected to translate into higher investment, job creation and, ultimately, growth. However, such an outcome is far from clear. In fact, a cheap monetary policy might not reach its goals but end up achieving quite the opposite of what is intended. The low interest rate policy has not benefited only the government and not the private sector. What is required is for the government to pay market rates of interest on its borrowings by way of Treasury bonds and bills instead of printing money by borrowing from the banks. We need more savings for the current account deficit is equal to the savings to investment gap locally.
The government will perhaps reduce its investment but the better solution is to increase domestic savings which requires positive real interest rates. The interest rates must be set by market forces not by printing money. Artificially repressed low interest rates promote more indebtedness within the economy. A low-yield environment reduces the economic incentive to adjust scarce resources to new circumstances. An artificially low interest rate can thus be expected to water down the need to bring about product and process innovations, a crucial ingredient for sustained growth. Low borrowing costs prevent the exit from the market of relatively inefficient suppliers; but it becomes harder for higher performers to gain market share, cementing inefficient market structures. Finally, there is a danger that a low interest rate policy encourages only low yield investment, which, should interest rates rise, become unprofitable causing a further business cycle crisis.
In any case given the balance of payments crisis we have to change our priorities from growth to macro-economic stability to correct the balance of payments. We would no doubt have to sacrifice some growth to achieve it but such decline will be temporary and when growth revives it will be a healthier growth pattern, not growth creating unsustainable current account deficits in the balance of payments sending wrong signals to the IMF.
The increase in the Reserves of the banks due to the central bank policy of monetary expansion to stimulate investment has not done what is intended but created a possibility of inflation in the future. It is perhaps one of the best proven hypotheses that when too much money is chasing too few goods, inflation will inevitably emerge. Although, on a global level, consumer price inflation appears rather muted at present, there are indications that the devaluation of our money might be taking a new route, via "asset price inflation" as excess money is actually flowing into asset markets. Already the stock market has begun to boom despite the fundamentals of the companies showing little or no improvement. Soon prices for real estate could go up.
Even though inflation is typically measured via consumer price changes, asset price inflation erodes the value of money in the same way as consumer price inflation and creates a bubble which will ultimately collapse. How can a monetary expansion reduce inflation?
The decline in point-to-point inflation is due entirely to the fall in world oil and food prices. ``Inflation builds its own constituency, at first merely producing conditions in which more people make profits (…). In order for inflation to retain its initial stimulating effect, it would have to continue at a rate always faster than expected." Borrowers realize that inflation relieves them of the burden of repayment for they will pay back in devalued money. Then when central banks try to curb the expansion there will be resistance from the private sector which realizes that inflation is useful to them.
We also have to accept the risks of integrating with the global economy. It is characterized by the business cycle with its booms and busts. We have to understand that booms built on artificial interest rates and monetary expansion are not sustainable.
Fiscal Expansion cannot go on
Fiscal expansion has already put the government in a foreign debt rap and forced it to go to the IMF. But unless remedial measures are taken there’s no getting out of it once the IMF funds are exhausted. The printing of money by borrowing from the central bank and the banking system must stop and this means the government will have to allow the interest rates to rise so as to borrow from the public’s savings and attract foreign money into the bond market.
The government can do something which can temporarily at least resolve the problem of cutting the budget deficit. It can privatize state owned enterprises. Of course a loss making concern cannot be sold unless the private sector sees an opportunity of turning them round. But there are still assets that the government can sell without causing hardship to the people. There is Telecom, the CEB, the Postal department, the Railway all of which are ‘eating money’ as one politician stated.
Whatever is said, the government cannot run these enterprises profitably because of the problem of principal-agent relationship. They can be run in a culture of private enterprise and market economy where there is a dictatorship as in Singapore or South Korea. Elsewhere in democracies they have failed to perform adequately in terms of returns on equity.