Lack of fiscal discipline has plagued Governments

Economic downturn“Mirror Business” conducted an email interview with Dr. Arusha Cooray, the Lankan born Professor of Economics at the Nottingham University Business School (Malaysia), over the current economic situation of Sri Lanka. Dr. Cooray’s work is widely published and she is one of the leading academics in the field of economics Sri Lanka has produced.

Sri Lanka’s economy is currently undergoing extremely testing times amid depleting foreign reserves, an unsustainable debt pile and a looming balance of payment (BoP) crunch. The bad economic policies of successive governments are at fault for the current predicament the country is in, but the present global economic developments also haven’t been in favour of the US $ 82 billion economy.

Following are the excerpts of the interview.

Q:
What is your opinion of the current status of the Sri Lankan economy?

Sri Lanka has recorded an impressive growth rate averaging 7 percent over the 2010-2014 period. This has been accompanied by a stable unemployment rate of 4.2 percent. Inflation has in general been trending down. If Sri Lanka maintains the current growth rate of 7 percent, at current prices, it can attain the minimum gross national income (GNI) threshold (as defined by the World Bank) required for high-middle-income status
by 2019.

However, a number of challenges remain. In order to maintain the current growth rate, investment would have to increase from the existing rate of 29.7 percent (CBSL 2014). Strong aggregate growth has not contributed to greater equality in income distribution.

The richest 20 percent of households receive 52.9 percent of the total household income of Sri Lanka, while the poorest 20 percent receive only 4.5 percent (Department of Census and Statistics 2012/13).Sri Lanka’s public debt currently stands at 75.5 percent of gross development product (GDP) (CBSL 2014), which has given rise to increasing concerns about fiscal sustainability. The commitment of successive governments to social welfare spending has led to a gross primary enrolment rate of 98 percent (World Bank 2016), which is commendable. Now however, it is necessary to take measures to increase the tertiary enrolment rate, which currently stands at 19 percent (World Bank 2016), to add value to economic activity.

The remarkable growth rate exhibited at the aggregate level further masks a number of provincial and regional level disparities. To mention a few, the mean monthly household income in the Western Province as of 2012/13 was Rs.64,152, while in the Eastern Province it was Rs.30,676. Poverty measures indicate further imbalances.The number of poor households in the Mullaitivu District stood at 24.7 percent compared to 1.1 percent for the Colombo District (Department of Census and Statistics 2012/13). Although growth at the aggregate level is driven by the service sector, agriculture accounts for as much as 29.2 percent of average monthly income in the Uva Province, signifying the importance of the agricultural sector for some provinces.

This regional heterogeneity highlights the need for provincial and district level policy initiatives to create greater equity in income, employment and productivity.Greater cohesion across districts and provinces will ensure that growth is sustainable. Success in achieving high-middle-income status will further depend on the government’s ability to attain and sustain macroeconomic stability. Specifically, curtail large and persistent budget deficits, strengthen and restructure the higher education system and maintain its commitment to increasing investment.

Q:
As Prime Minister Ranil Wickremesinghe recently announced to parliament, is the country really in a debt trap?

When a country’s debt ratio increases indefinitely, a country is said to be in a ‘debt trap’. Sri Lanka’s government debt to GDP stands at 75.5 percent, foreign debt to export earnings is 142.5 percent and total debt service to government revenue is 90 percent (provisional figures for 2014, CBSL 2014), which is a cause for concern.

However, this does not imply that the country cannot get out of such a situation. Policymakers need to think of establishing a sustainable debt strategy as rising debt levels have adverse effects on an economy. Private investment is crowded out due to increased interest rate payments; private saving may have to increase in order to accommodate public dissaving leading to lower aggregate demand; the current account of the BoP can go into deficit depending on the level of private savings and higher public debt may come at the cost of higher future taxes.

High levels of public debt financed through external sources additionally increase the sensitivity of an economy to changes in global market conditions and the likelihood of defaulting. It also places a strain on fiscal authorities in implementing countercyclical fiscal policy. Debt sustainability can be achieved in a number of ways, including higher future taxes and curtailing government expenditure, both of which are contractionary. Another option is unanticipated high inflation, which could reduce the real cost of debt servicing (Reinhart and Rogoff, 2010). These measures, however, are accompanied by costs. Increasing taxes and cutting down on government welfare expenditure can lead to a loss of welfare, undermining growth. Similarly, reducing the cost of debt through inflation will result in higher interest rate payments.

In the short term, the government can evaluate its recurrent expenditure and make cuts in unproductive areas. In the long term however, the way forward is to ensure high economic growth, as higher growth is accompanied by higher investment and employment. This enables the government to increase tax revenues, without the need to raise taxes. The higher the GDP growth rate, the greater would be the prospects of avoiding debt insolvency.

Q:
The government portrays the present crisis in the economy is due to the bad economic management of the previous regime. How far do you agree?

In my view, the lack of fiscal discipline is a problem that has plagued Sri Lankan governments over the years. While the inefficiency of the market can be attributed to government intervention, this inefficiency would again provide the incentive for the government to influence the availability of securities and thereby interest rates. To the degree that governments tend to run debt-financed fiscal deficits, the main function of the money market would be to engage in the sale of government securities for financing the servicing requirements of the government debt.

This will constrain the use of open market operations as an effective means of policy and distort the level and structure of interest rates. Rather than dwell on the past, it is now important to work towards reducing this
debt burden for achieving greater macroeconomic stability.

Q:
Do you think that the government which promised fiscal consolidation should have given such freebies by way of salary hikes, administered prices on goods, etc., in the Interim Budget presented in January 2015?

Political commitment to effective debt management, in particular through the budget and regulatory frameworks are important for establishing policy credibility.

Credible fiscal consolidation programmes will in turn increase investor confidence and reduce risk premia. Sri Lanka’s public expenditure is largely made up of recurrent expenditure, which has consistently exceeded capital expenditure. Given the role played by capital expenditure in economic growth, I believe that greater effort needs to be made by the government in reducing current expenditure and diverting these resources to more productive use. This requires policy consistency and commitment over the long term.

Q:
Don’t you think the combined effect of bad fiscal management of the previous regime and the populist politics of the current regime is the main contributor to the current BoP difficulties the
country is facing?

Fiscal mismanagement and populist policies have been the downfall of many governments. Sri Lanka is no exception. In my opinion, Sri Lanka’s governments have tended to focus on short-term policy initiatives which are subject to change each time a new regime comes into office.When government expenditure exceeds government revenue, it can cause a deficit in the current account of the BoP and a fall in foreign exchange reserves. When payments of interest and amortization of foreign debt absorb a large proportion of export earnings making it difficult to finance imports it becomes an issue of concern. The level and structure of public debt can have a significant impact on the Central Bank’s foreign exchange reserves. While the issuance of foreign currency-denominated debt can increase international reserves, the repayment of public foreign currency debt will reduce the level of foreign exchange reserves. Although foreign exchange reserves can increase access to funds in the short term, this increases the country’s vulnerability to a depreciation of the currency which causes the debt burden to increase.

Foreign exchange issuance can also increase the country’s exposure to changes in investor sentiment. Policy reforms aimed at promoting export diversification, expanding export markets and attracting investment can help ease Sri Lanka’s international position. These measures however, need to be accompanied by complementary policies and institutions.

Q:
Foreign direct investments (FDIs) are looked at as the saviour that can uplift the country from the current peril. How plausible is that in the short and mid terms given the bleak global outlook?

While the hypothesized benefits from capital flows include increased access to capital, faster productivity growth, increased employment, transfer of managerial skills and risk diversification, it also requires stricter discipline in economic management as it leaves less room for policy errors. Greater openness increases the vulnerability of an economy to changes in investor sentiment. The East Asian crisis serves to highlight this.

Additionally, FDI in itself is not an engine of growth. Studies suggest that FDI will have positive spill-over effects on an economy only in the presence of a minimum threshold of human capital, well developed infrastructure facilities and strong economic fundamentals. The potential benefits from capital flows also depend on the uses to which they are channelled. Rather than global economic conditions, the high level of debt and resulting uncertainty will discourage foreign investors from investing in Sri Lanka.

Therefore, policymakers need to implement sound macroeconomic policies to minimize the uncertainty generated by high debt levels, meet infrastructure deficits that have arisen due to many years of conflict and improve the country’s stock of human capital to attract and retain FDI.The structure of capital markets should be reinforced through appropriate policies in the areas of information and accounting systems, regulation, property rights and taxation regimes. If not, this could lead to capital flight and further future indebtedness.


Q:

Also, do you see the key element for FDIs—policy consistency—is there for foreign investors to throng?

South Asia has attracted a disproportionately small share of total FDI inflows (US $ 41.2 billion) compared to East and Southeast Asia (US $ 347 billion). Of the FDI inflows into South Asia, 83 percent is concentrated in India (US $ 34.4 billion). Sri Lanka has attracted only US $ 0.9 billion of the flows into South Asia compared to Pakistan’s US $ 1.7 billion and Bangladesh’s US $ 1.5 billion (UNCTAD 2014).

I think that it is unlikely for investors to throng unless local firms have the capacity to invest in absorbing these technologies and skills. Moreover, Sri Lanka has to compete against countries such as China and India which have large advantages of scope.

Low research and development spending, together with the lack of necessary skills and infrastructure bottlenecks in Sri Lanka has led to FDI in low value-added industries, where profit margins are small.
The East Asian tigers demonstrated that strong economic fundamentals are a necessary pre-condition for attracting FDI. In order to attract FDI in high-tech industries, policy should be aimed at promoting investment in infrastructure, research and development, promoting learning, competencies and skill development through education and on-the job training. This will enable Sri Lanka to reap the full benefits of externalities generated by FDI inflows. Developing and maintaining a competitive advantage in niche products and services which other countries cannot easily duplicate is a strategic alternative.

Singapore provides an example of a country which managed to create a niche market for biotechnology manufacturing and succeeded in attracting biotechnology-related FDI inflows primarily due to the government’s initiatives of becoming more competitive in that industry. This however, requires long-term strategic planning and commitment.

Q:
How crucial do you think a funding arrangement with the International Monetary Fund (IMF) at this juncture?

Although the IMF financing can help to increase the Central’s Bank’s foreign exchange reserves, meet the government’s financing requirements and help stabilize the financial system, the IMF funding is conditional. The structural adjustment policies attached to these loans may not necessarily benefit Sri Lanka.

These policies include among others, currency devaluation, trade liberalization, capital market liberalization, higher interest rates, cuts in government expenditure and social spending. Cutting subsidies and government services can lead to a loss of welfare increasing conditions of poverty and inequality which in turn will constrain growth. While exchange rate depreciation can stimulate exports by enhancing export competitiveness, it will also increase the cost of debt servicing. Capital market liberalization in thin capital markets can lead to capital inflows generated by ‘herd instincts’. Higher interest rates will reduce access to credit and discourage private sector investment. These policies therefore could further aggravate rather than assist the
current situation.

Q:
Would the conditions that may come with the IMF be tougher this time compared to 2009-2011 facility?

The enforcement of structural adjustment policies will only be effective in a macro-economically stable environment. I believe the conditions will be tougher in which case they could further exacerbate conditions of poverty and inequality as I have mentioned above.

The IMF should design its structural adjustment policies on the basis of whether these policies are sustainable for the country in question. They should additionally pay greater attention to monitoring lending activities to confirm that they are spent on the activities for which they are borrowed and to ensure that they are channelled into investment rather than wasteful consumption activities.

Q:Also, how important the proposed bilateral trade arrangements with India, Singapore, China and several other nations in the recovery process?

Trade agreements will have important implications for Sri Lanka enabling the country to benefit from positive spill-over effects through greater co-ordination intrade and FDI policy. This is likely to increase infrastructure investment and enhance the business climate through greater capital formation, technology generation and distribution, financing of commercial activity and employment. (Daily Mirror)

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