By W.A Wijewardena –
An IMF mission with a mission
The International Monetary Fund, better known as the IMF, has issued a press release on July 29, 2014 after its Executive Board had discussed the report presented to it by the Staff Mission that had visited Sri Lanka in May 2014 (available here ).
The staff mission had been fielded by the IMF under Article IV of its Articles of Agreement which is the constitution governing the Fund. This Article has stipulated that the IMF should have discussion with member countries, usually once a year, on their economic development and policies. The report submitted by the staff mission is discussed by the IMF’s Executive Board and a press release is issued thereafter outlining the conclusions of the Board.
IMF reports not for laymen
Several readers contacted this writer and inquired from him whether he could help them understand the IMF’s recent press release. This is understandable because the IMF reports and press releases are written in technical language addressed to professional economists with a sound background in economic theory. Ordinary laymen will find it difficult to understand what is conveyed in these reports; they also cannot make an appropriate comparison of the conclusions made in the IMF reports with official reports published by the policy-making authorities in the country.
The problem has been aggravated because the country’s media which has the responsibility of educating the laymen too has been in the habit of just reproducing the IMF press releases without clarifying the arguments made or points raised in those press releases. Today’s My View is therefore a layman’s guide to understanding the recent IMF press release. It also helps readers to compare and contrast the estimates which the IMF has based its conclusions with those of the Central Bank and the Ministry of Finance, the top two policy making authorities in the country.
It is called a ‘Child’s Guide’ because children, guided by their inquisitive and curious minds, are not shy to ask all kinds of silly questions about what they see or hear in satisfaction of their interest in learning new things.
IMF, the diplomat
However, one clarification about the IMF is in order before proceeding further. As this writer has emphasised in a previous article in this series, member countries are the owners of the IMF and therefore, the staff as well as the Executive Board uses the most diplomatic language to convey their points even when there is a severe disagreement with the policy authorities in those member countries (available here ).
Hence, what is written in the press release has to be read between the lines in order to get the true meaning of the message conveyed. They are sometimes, when translated into the language of an opposition party, serious strictures passed on a member country. But the tone and the politeness in the language does not convey such a serious connotation to a layman.
IMF has endorsed official growth rates
The second para of the press release is a summary of how Sri Lanka’s economy has performed in 2013 – called macroeconomic outlook in economists’ language – with comments on how it has moved in the recent past. It has agreed with the growth and inflation numbers published by the country’s statistics bureau, Department of Census and Statistics or
DCS, and the growth areas that have helped the country to attain that economic growth.
Growth has basically come from an improvement in services such as banking, trade, commerce, telecommunication, hotels and Government services, etc. A little more than a half of the economic growth of 7.3% in 2013 – or 3.8 percentage points – has been contributed by this sector.
The IMF has highlighted the support given by the manufacturing and construction sector to boost growth in 2013. This sector’s contribution has been at 41% thereby pushing the growth rate up by another three percentage points. Though the Central Bank in its Annual Report 2013 has declared that the growth had come from all the three sectors including agriculture, the IMF had been silent about agriculture. That is because agriculture’s contribution to growth has been only 7% and it has pushed up the growth rate only by negligible 0.5 percentage points.
Thus, Sri Lanka’s growth centre has been services, followed by manufacturing, and not agriculture, though it employs nearly a third of the country’s labour force. This explains the wide disparity in incomes between farmers and those employed in the services sector.
Negative net exports contribute to growth elsewhere
The IMF has said that Sri Lanka’s growth has benefited from ‘an increase in net exports’ and stands to gain from the global recovery and ‘stronger growth in advanced economies’. This reasoning of the IMF needs further examination. Net exports for economic growth purposes are simply the difference between the import and export of goods and services.
If these exports are higher than imports, a country will have a positive net export position. In the opposite, it will have a negative net export position. Having a positive net export position means that foreigners are helping the country to produce more goods and services by buying the same.
If exports are a significant component of the total output, it helps to increase its output and have a higher growth rate. But if the net exports are negative, it is the opposite: the country is helping foreign countries to produce more goods and services and have a higher growth rate there.
Sri Lanka’s negative export position
In Sri Lanka’s case, import of goods and services has always been higher than the export of goods and services, thus generating a negative net export position. This has been 14% and 10% of GDP respectively in 2012 and 2013. If 2013 is taken as an example, what this means is that if domestic people, including the Government, had demanded 110 units of the country’s output, the actual demand had been reduced to 100 units. It therefore makes a negative contribution to the country’s output.
What the IMF has meant by an increase in ‘net exports’ is therefore a decline in the negative net position from 14% in 2012 to 10% in 2013. This change may reduce the impact of negative contribution but it is not something which can support economic growth as highlighted by the IMF.
Will Sri Lanka benefit from global recovery?
The IMF has predicted that Sri Lanka will benefit in the years to come from a ‘global economic recovery’ and ‘stronger growth in advanced economies’. This benefit comes from Sri Lanka being able to produce more goods and services and sell them to those advanced economies. This is true for Sri Lanka’s apparel industry of which the major markets have been in USA, the UK and the Euro area. However, in the context of boosting the country’s economic growth, this has to be viewed with two qualifications.
First is that though the apparel industry generates export earnings, about 60% of those earnings go out of the country for the importation of the required inputs leaving only the balance 40% behind to increase domestic income. Second, on a net basis, as explained above, the country has a negative net export position that does not add to output but reduces it by increasing output growth in the rest of the world. Subject to these two qualifications, Sri Lanka’s economic growth is sensitive to the stronger economic growth in advanced countries.
IMF’s illusive global economic recovery
However, according to the IMF’s own estimates, this stronger growth is not that much of a significance to boost economic growth on a sustainable basis in a small economy like Sri Lanka. The IMF has projected in July 2014 (available here ).
The growth in USA in fact falls from 1.9% in 2013 to 1.7% in 2014. Euro Area had a negative economic growth in both 2012 and 2013 amounting to 0.7% and 0.4% respectively. In 2014, it is projected to have a positive growth of 1.1%, but given the negative growth in the two previous years, its total output will basically be around the level in 2011. The UK of course is expected to accelerate its growth from 1.7% in 2013 to 3.2% in 2014.
These growth rates are very marginally stronger than the previous year but they are not strong enough to give a boost to Sri Lanka’s economic growth as predicted by the IMF. Hence, it is not advisable for the country’s economic policy makers to rely on the ‘stronger economic growth in the advanced countries’ to sustain its current economic growth rate.
IMF is not on a linear growth path
A salient feature of the IMF press release is that, unlike the Central Bank which has been very positive, the IMF has been conservative in projecting the economic growth rate of Sri Lanka for 2014. In 2013, Sri Lanka’s economy grew by 7.3%, but the IMF has reduced its projection for 2014 to 7.0%, more or less same as the previous year. However, the Central Bank in its medium term outlook has projected a higher economic growth that increases year after year in the next few years (Table 1.5 of the Annual Report 2013, p 25). Accordingly, growth will accelerate to 7.8% in 2014 and continue to increase at an increasing rate till 2017 in which year it will be 8.4%.
The fallacy of this type of linear economic growth projections has been discussed by this writer in a previous article titled “Sri Lanka’s linear growth projections to prosperity in a non-linear world”. What was argued in this article was that without the essential economic reforms in the structure of the budget, public sector enterprises, human capital development and a policy to encourage the migrant workers to return and work in Sri Lanka called reverse brain-drain highlighted in the ‘Mahinda Chinthana,’ the realisation of the linear economic growth targets will become a non-reality. The need for these reforms has been highlighted by the IMF too in its press release.
Praise exchange rate management before criticising it
The IMF has both praised and criticised Sri Lanka’s exchange rate management. It has endorsed the Central Bank’s practice of purchasing dollars in the market to prevent the exchange rate from appreciating in the market. Such purchases, says the IMF, will help Sri Lanka to build its foreign exchange reserves which are now at a level just sufficient to meet 3.5 months of imports or “at the lower end of the reserve adequacy metrics” meaning that it could fall below the required safe level at any time. Hence, buying in the market is beneficial.
Sri Lanka’s foreign exchange market is very thin and even a small shortage or a surplus could lead to a wide fluctuation in the exchange rate. However, the IMF is worried about the perception which people will get as a result of this ‘fixing of the exchange rate’ by the Central Bank. If people feel that exchange rate does not change over time, says the IMF, that people and firms will not take action to protect themselves from the sudden changes in the exchange rate.
Since markets are not stable over time, if a change occurs without notice, firms will have to suffer losses due to the risks they are presently taking. In other words, the Central Bank has given an insurance policy to people that the exchange rate will not change but the Bank has no capacity to honour that policy obligation for ever.
Further, if the balance of payments continues to improve and inflation remains low as it is now, exchange rate has to appreciate in order to maintain its balance with the rest of the economy. Thus, by keeping the exchange rate fixed, the Central Bank is creating a situation where the exchange rate becomes out of alignment. Thus, the IMF recommends that the Central Bank should allow flexibility in the exchange rate.
What it means by flexibility is that if the exchange rate is needed to depreciate, it should be permitted by the Central Bank and if the exchange rate is needed to appreciate, that too should be permitted by the Central Bank. In other words, the Central Bank should be flexible in its market intervention exercises and this recommendation is contrary to the IMF’s initial endorsement of the bank’s current practice.
Warning on rising external debt position
The IMF has also kept Sri Lanka under warning in its comment on the rising external debt position of the country. Here-again, what the IMF has said between the lines should also be properly understood. To create the path for its critical warning, it has first praised the Government for its ‘solidly committed’ attempt at reducing the budget deficit and public debt to acceptable levels.
The main thrust of the Government has been to cut expenditure to bring about a safe deficit in the budget but, according to the IMF, the country has now reached its limit of cutting expenditure programs. Any further reduction in expenditure will result in curtailing investments thereby affecting future economic growth. Hence, says the IMF, the Government should seek ways of improving revenue. The country has to go for a comprehensive tax reform program.
Here again, the IMF has been very diplomatic in its comment. It has said that it is happy about the action so far taken, but it sees the need for reasonably accelerating the reform program. In other words, it says that the Government is not fast enough in introducing tax reforms. The implication is that too late and too short reform programs will not deliver the desired results.
Falling debt to GDP ratio amid rising debt level is just a statistical window-dressing
About public debt management, it has used the same diplomatic language to persuade the Government to be more cautious. There is a need for reducing public debt and the sure way for doing it is to reduce the budget deficit. Any other way of reducing the debt to GDP ratio is simply a ‘statistical window-dressing’. This is because if debt to GDP ratio falls when there is an increase in the absolute level of public debt, that is because of the faster growth in the GDP which includes the rising inflation component as well.
If inflation is higher, so is the GDP and the beneficial statistical effect is the decline in the debt to GDP ratio. Hence, the IMF has emphasised on the need for re-examining the medium and long term strategy for debt reduction and has called for having even more ambitious debt reduction targets. Currently, the country’s debt has a high vulnerability and a faster reduction of debt will improve its position.
Use commercial external borrowings judiciously
The IMF has also called on the Government to use foreign borrowings judiciously. What this means is that foreign borrowings should be used in priority areas which will generate adequate earnings to repay those loans. This is exactly what this writer pointed out in his debate with the anonymous analyst, Practical Economist, in this series of articles (available here ).
The IMF has warned, contrary to what many believe, that debt servicing costs are rising rapidly due to the shift from concessionary borrowings to commercial and non-concessionary borrowings. Thus, the country has to be careful about debt management. Further, the Market Access Debt Sustainability Analysis done by the IMF on Sri Lanka shows that if there are adverse changes in the growth or the exchange rate, the country’s debt sustainability too will face adverse consequences. Given this situation, the IMF has cautioned Sri Lanka that it should be careful in promoting banks to borrow abroad, which is the position taken by many economists outside the Central Bank.
It appears that the IMF press release has got both sound economics and contradictory or untenable analyses.
*W.A. Wijewardena, a former Deputy Governor of the Central Bank of Sri Lanka, can be reached at email@example.com.