Economic crisis is one of mis-management and governance

Economic downturnThough Sri Lanka’s looming economic problems are explained as a fiscal, debt or an external crisis, the real problem is a crisis in governance and mis-management, an economist has said.

“That is the problem of governance,” Nishan de Mel, head of Verete Research, a consultancy, said at a forum organized by Asia Securities, a Colombo based brokerage.”The mis-management is really the key issue. The crux of the problem is there.” He said drivers of extra growth after 2010 appeared to come from construction and spikes of import led consumption.

De Mel said Sri Lanka runs into boom bust cycles often. In the boom period, there was an expansion of the budget deficit and imports also went up. A sharp correction in the exchange rate followed, de Mel said. Then imports also contracted.

“This is not just a problem of the last few years, but a problem of Sri Lanka’s economic management and policy-making for a long time,” he said. De Mel said the central bank held on to the exchange rate, triggering speculation. In Sri Lanka exchange rate was defended until the election and then let go in 2015, pointing to political rather than economic decision-making, he said.

Though Sri Lanka’s budgets get a lot of taxes from imports, he said import booms do not appear to have helped improve budgets. The ‘twin deficits’ is a recurring phenomenon and its effects are particularly pronounced in developing countries with soft or ‘contradictory policy’ exchange rate pegs. It is usually the underlying theme of nations that seek bailouts from the International Monetary Fund, economic analysts say.

When deficits are financed from abroad (even for infrastructure), imports will increase and the external current account deficit can expand without hurting the exchange rate. Private foreign borrowings will also have a similar effect. In a country like Sri Lanka, imports can also bring more revenues for the state, allowing it to expand spending or subsidies without worsening the deficit and help the boom along.

In a boom cycle, in most countries, income and capital gains taxes rise, allowing the state to run counter-cyclical policy, either by curtailing spending or running surplus budgets if the state wanted to be prudent. However it may not happen in practice since rulers always want to spend and engage in anti-austerity.

In theory, a domestically financed government deficit with perfect ‘crowding out’ of private activity may not create economic imbalances as real spending power is shifted from the private citizens to the state.

But in practice, in countries like Sri Lanka, soft-pegged central banks usually accommodate deficits by outright monetizing of debt or sterilized forex sales (which is why pegs are not hard) injecting synthetic demand to the economy, triggering a so-called balance of payments crisis, analysts have pointed out.

Even if foreign financing of the deficit slows down from prior years (which can reduce the external current account deficit or total imports) central bank accommodation of the deficit can trigger a balance of payments crisis and a currency collapse. Central Bank accommodation of the deficit and repayment of old debt with central bank credit will inject new nominal reserves into the banking sector, prevent any ‘crowding out’ of private borrowings and instead boost private credit as well.

Analysts have warned that Sri Lanka’s exchange rate will continue to deteriorate as long as central bank accommodation of the deficit continues as it is not possible to stabilize a currency by printing money every week.

Short boom-bust cycles can increase the volatility in economic output but has the advantage of reducing chances of a banking crisis analysts say, as firms are forced to de-leverage before debt gets too out of hand. In a short cycle that ended in 2012 at least two large business groups – including one connected to a large non-bank lender – slowed down their debt funded expansion.

Sri Lanka’s most recent relatively long boom which involved a cycle running from 2001 to 2009 led to the collapse of many sub-prime and property lenders, the effects of which are still lingering. (ECONOMY NEXT)

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