The Central Bank has released the economic indicators for the second quarter saying GDP growth at 2.1%  is an improvement on the 1.5% from the first quarter. The growth in agriculture is 4.4%, industry 3% and services 1.1%.Figures available for the export crops show that for the first nine months tea production was down 16.8%, a sizeable decline,  while rubber increased by 1.2% and coconut by 8.5%.

Electricity generation is a good double check on the GDP figures as production increases leads to a greater use of energy. Since electricity is our main energy source, its generation should show how the economy is faring. Electricity generation fell by 2.2% for the period Jan-Aug 2009 compared to the same period last year. Electricity sales to industry declined by 12% for the period Jan-July 2009 over the same period last year.

The private sector industrial volume index showed a slight decline over the period Jan-Sept over the corresponding period last year. The recovery from the recession is still not strong. The production of cement and building materials show declines indicating that the reconstruction projects for the north and east have so far not had any visible effect. Apparel, textiles and leather have recovered to the last September levels. Ceramics have not. Housing approvals are below last year. Private sector credit was still down by 5.9% between January and August 2009. This shows that the private sector is not recovered yet. New vehicle registrations for both public and private transport are down over previous periods.

External finances

Since we are a highly trade dependent economy, it is useful to consider the external trade and payments figures. Exports for the period Jan-Aug 2009 declined by 17% in dollar terms from the comparable period last year while imports declined by 35% improving the balance of trade by 59%. The trade balance has improved but what matters is the current account in the balance of payments which too has show a marginal improvement owing  to higher worker remittances.

Last year we had a very high import figure owing to the oil price hike which prevailed in the first half, with a current account deficit of $1,823 million; but the first half this year shows a surplus of Rs 143.7 million. However, there were still some capital outflows and there was an over-all  deficit of Rs 191 million for the first half. We have been running current account deficits in the balance of payments from 1978 onwards having such deficits every year since then. In the past the deficits were funded from long term concessional loans from the multilateral institutions like the World Bank and ADB and from bilateral sources like Japan and the European countries. But this source has now dried up because we have become a middle income country. Such countries are expected to borrow from the world’s capital markets.

The current account deficit in 2003 was a low of $71 million but since 2004 the deficits have been increasing to over $1,000 million each year. This was due to increases in imports arising from the faster economic growth driven by the war expenditure and the government’s infrastructure investment program. So the deficit of $650 million in 2005 shot up to $1,498 million in 2006. With the oil price hike of 2007 the deficit shot up to $3,775 million in 2008 - a whopping 9.3% of GDP.

The government resorted to commercial borrowing of $ 500 million from international banks and the Central Bank also lifted the ceilings on foreigners buying government bills and bonds in December 2007. We expected to raise funds from the world’s capital markets and borrowed $500 million in 2007 at a high rate of interest. Everything seemed fine as the authorities thought they could roll over foreign debts by fresh borrowings. Then came the global financial meltdown with the collapse of Lehman Brothers in September 2008. Foreign capital invested in the bond and stock markets started fleeing through the secondary markets and the CB lost over $2 billion from its official foreign reserves. There was also downward pressure on the rupee with these outflows and the CB was forced to un-peg the rupee and let it depreciate. Next the government was forced to go to the IMF for a Standby Credit. With the receipt of the IMF credit the confidence of the foreigners was restored and foreign funds began to flow in again to the stock and bond markets.

The most touted aspect of our external payments is this sharp increase in our Official Gross Foreign Reserves which now top $ 5 billion. Last year and the year before, we had to draw on foreign borrowings by the government and foreign short term capital inflows to the bond market to fund current account deficits in the balance of payments.  What of the future? As the developed economies revive and the government continues its infrastructure investments the current account deficit will worsen again and we will have to borrow foreign currency from abroad. If the oil price also rises to previous high levels we are doomed. The danger of depending on short term borrowings instead of foreign direct investment or earnings through net exports and migrants remittances was shown with the flight of foreign capital after the collapse of Lehman Brothers.

The IMF target for rebuilding Foreign Reserves is based on Net Foreign Reserves and excludes short term capital inflows in its computation of Net Reserves. Even this doesn’t include large foreign short term borrowings by the banks since they are not part of the Official Reserves but only part of the country’s external assets and liabilities.

Weak dollar drives foreign capital to emerging markets

Reserves have increased not due to any special confidence in the country or to any prowess of the authorities but due to the international financial situation. The underlying weakness in the US economy is now plain and visible to all. The US has been enjoying the luxury of cheap credit and over-consuming. Over-consumption meant that between 2000 and last year, the US outspent its national income by a cumulative 45 per cent. Goods imported from China accounted for about a third of that. On the other hand China quadrupled its gross domestic product between 2000 and last year, raised exports by a factor of five, imported Western technology and created tens of millions of manufacturing jobs for the rural poor- a lesson for us.

As Chinese exports soared, the authorities in Beijing consistently bought dollars to avoid appreciation of their currency, pegging it at about 8.28 renminbi to the dollar from the mid-1980s to the mid-90s, then allowing a modest 17 per cent appreciation in the three years after July 2005, only to restore the dollar peg at 6.83 when the global financial crisis intensified last year. In essence, China by buying dollars as its mode of payment and building Reserves and investing in Treasuries issued by the U.S Government constituted a credit line from the People’s Republic to the US that allowed Americans to save nothing but invest in real estate and financial bubbles which suddenly burst and engulfed the whole world.

The stimulus package is working but it has not reduced unemployment below 10%.The US must export more and to do so it has to let the dollar depreciate or the Chinese yuan to appreciate. Despite much talk of the need to reduce global imbalances, the biggest imbalance of all persists. This year, America’s trade deficit with China will be about USD 200 bn., the same as last year. And China has again intervened in the currency markets buying USD 300 bn. to keep its currency and hence its exports cheap.

Obama’s visit has not produced results. The US lets the dollar slide and American investors then look for investment in the emerging markets which includes Sri Lanka. So the   attraction of our bond market for foreigners is due to our pegging of the rupee and our comparatively high interest yields on bonds. The core issue is that the high Reserves are not a reflection of the country’s ability to earn foreign exchange.

Policy options   

Do we allow short term foreign capital inflows which puts upward pressure on the rupee when it is over-valued already and acting as a disincentive to exports? The CB is finding it difficult to  prevent an appreciation of the rupee while also mopping up the excess liquidity generated by buying the incoming dollars. Brazil has put a 2% tax on such inflows. We could accommodate such inflows up to the current account deficit that needs to be financed. But what if we get a much larger supply? Unlike China whose Foreign Reserves are earned not borrowed, the high Reserves in India and Sri Lanka are  accumulations of borrowings. This extra foreign debt is being spent by the government to fund its budgeted expenditure.