By W.A. Wijewardena –
IPS, the forerunner in reviewing the country’s economy
The Institute of Policy Studies (IPS), in issuing its 2014 State of the Economy Report, has drawn attention of Sri Lanka’s economic policy makers to a number of hidden risks and defects of the current economic policy package that is being pursued by the country.
IPS, the semi official economic policy think tank, has been issuing its State of the Economy Report well ahead of the official reports released by the other two policy authorities of the country, namely, the Central Bank and the Ministry of Finance. The Central Bank issues its report in late March of the following year, while the Ministry of Finance does so after three more months in June.
In preparing its report, IPS takes into account the actual data pertaining to the first half of the year and makes suitable estimates for the balance half by reckoning the emerging developments. Thus, its reading of the Sri Lanka economy in the year under reference is available in November every year as an early independent review of the economy.
Every IPS report has covered a special theme relating to economic policy. This year’s report has covered the issue of rising Asia and the opportunities it has thrown to Sri Lanka and the challenges which Sri Lanka faces when harnessing those opportunities.
Critical review of policy is needed
While the Central Bank of late and the Ministry of Finance throughout have resorted to praising every economic move of the Government uncritically, IPS in its reviewing of the state of the economy has taken a critical stand highlighting pitfalls and deficiencies involved in the country’s economic policy making.
For instance, while the Central Bank and the Ministry of Finance have been silent in all their reports on the implications of China’s growing economic ascendency in the region, IPS has drawn attention to a wider economic and political policy issue arising from such ascendency.
Says IPS: “While India continues to be an influential anchor in South Asia, China is strengthening its influence more broadly across the Asian region through strategic investments and assistance. Some argue that China’s rising pre-eminence in Asia could be countered by a growing US engagement in the region – rekindled by its ‘pivot to Asia’ strategy. The Trans-Pacific Partnership (TPP) appears to be the key tool in this. It is not a typical trade deal; it straddles trade, investment and strategic economic cooperation. Asian countries that are wary of the security implications of China’s rise may warmly welcome a heightened US presence in the region. The TPP could prove to be a key factor in the US-China rivalry over economic leverage in the region and a tool for Asia’s other economies to hedge against the rise of China.” (p 10).
The need for adopting a balanced economic relationship
This is a warning as well as a piece of advice to Sri Lanka how its policy directions should be made. Sri Lanka has been receiving Chinese aid in large volumes without looking at how it would affect Sri Lanka’s relationships with its neighbour to the north – India – and the global policeman – the United States.
IPS does not say that Sri Lanka is overly leaning toward China for medium term economic assistance in its drive for developing the much needed infrastructure facilities. But the reality has been that China has funded them by means of non-concessionary loans and built them by using its State-owned engineering facilities. Thus, China has emerged as the largest aid giver to Sri Lanka surpassing the historically largest aid giver to the country – Japan.
Sri Lanka has got its ports, airports, roads and power-generation plants. But in the process, Sri Lanka has given an extra foothold in the country to China which may antagonise not only India and the US but also the other ‘weary states in East Asia’. The need for having a proper balance in Sri Lanka’s economic relationships with the rest of the world having taken into account the geopolitical realities has been the highlight made by IPS in its report.
Avoiding hot money as a source of help
The risks associated with the global hot money which has flooded Sri Lanka recently to alleviate its growing balance of payments problems have been highlighted by many independent economic analysts in the country.
This writer in a previous article in this series under the title ‘Single-digit inflation for 5 years: Now the challenge is to get out of the Lowflation Trap’ highlighted the danger of depending on hot money for building foreign reserves as follows: “Sri Lanka has relied on foreign hot money to build its foreign reserves by permitting foreigners to invest in high yielding Government paper. Such funds, amounting to $ 3.5 billion as at end October and accounting for about 40% of total official foreign reserves, have been attracted by Sri Lanka mainly by offering higher yields on Government securities when in the home countries of those investors, the maximum yield receivable has been around 1%. This incentive will be narrowed and finally be negative if Sri Lanka reduces its interest rates to a low level. In such a scenario, the outflow of these funds cannot be avoided worsening the current imbalance in the external sector. It will put pressure on the rupee to further depreciate with adverse consequences on Sri Lanka’s future growth plans.” (available here ).
IPS has endorsed this writer’s analysis in its report. Says IPS: “Sri Lanka is increasingly dependent on foreign investor demand for its Treasury bills and to finance its fiscal deficit. If interest rates reduce further, and consequently the yields on Treasury bonds, it would make these bonds less attractive to foreign investors. If it falls to a level where the spread between the return on Treasury bonds and the return on Sri Lanka’s Sovereign bonds is quite slim, foreign investors would consider the elevated currency risk and sell off these investments or at the least, avoid further investments in rupee denominated Treasury bills and bonds. This would adversely impact the Government’s ongoing and much needed capital raising efforts” (p 2).
Continuing this analysis, IPS has drawn the attention of the country’s policy makers to the risks which Sri Lanka might face if and when the US starts to reduce its money creation for stimulating the economy, known as ‘quantitative easing’. It would, according to IPS, increase global interest rates raising the international borrowing costs of Sri Lanka as well.
Risks of building foreign reserves through borrowing
While appreciating the beneficial impact which the bounced-back exports has brought in 2014, the growing concern about vulnerability of the exchange rate of which the country should take notice has been highlighted by IPS in very strong terms.
This is what IPS says about this issue: “The recovery of export performance is good news for Sri Lanka. The country’s economy is most vulnerable on the currency front. Despite reporting healthy official reserves of over US$ 9 billion, almost all of it is from accumulated borrowings. With a growing dependence on external sources of savings to meet the country’s development financing needs, stability on the external sector is needed to retain foreign investor confidence on the medium to long term outlook for the economy. This is all the more important in view of Sri Lanka’s rising exposure to external sector developments on multiple fronts, as direct Government foreign borrowing is increasingly accompanied by indirect Government foreign borrowing and private sector borrowing.” (p 3).
Ominous increase in external non-concessionary borrowings
In this brief paragraph, IPS has drawn attention to an ominous development that has taken place in the recent past which this writer too had highlighted in his analyses of the external sector vulnerability of Sri Lanka in this series of articles. The Government has resorted to direct borrowing through the issue of sovereign bonds in the international markets at commercial interest rates. That has increased the share of the commercial and non-concessionary borrowings of the Government in its total external borrowings to well over 50% by 2013 from a relatively low level of 4% in 2005.
In an article titled ‘Sri Lanka’s external debt sustainability: Complacency based on incomplete analysis may be the worst enemy’, this writer wrote on this issue as follows: “Another significant development during this period, especially after 2005, has been the phenomenal increase in the share of commercial and non-concessionary foreign borrowings of the central Government. This is understandable because after Sri Lanka graduated to a lower middle income country in 2010, it no longer could borrow at concessionary rates from international lending institutions and had to resort to commercial and non-concessionary borrowing to raise the required foreign financing. Thus, in 2005, commercial and non-concessionary borrowings of the central Government amounted only to 4% of the total foreign borrowings. However, the data for 2013 show that this share has now risen to 50%. This share is expected to rise further in the future since the country’s investment requirements are on the increase and the high consumption and the consequential low savings levels do not permit it to finance them from domestic sources alone. Hence, given the fragile external sector with a significant deficit in the current and capital account transactions amounting to about 4% of GDP, the country has to continue to borrow abroad in order to make annual interest payments and repay the maturing foreign loans on the one hand and meet the wide saving-investment gap on the other. This compulsory roll-over arising from the former is not a good sign which the public debt authorities should ignore if they are interested in ensuring external debt sustainability.” (available here ).
Window dressing through borrowings by State banks for the Government
What the Government has done in order to keep these non-concessionary borrowings at that level has been to get State banks to borrow in foreign currency and get them to invest in rupee denominated Treasury bills and bonds. The effect of this strategy has been to show the central Government borrowings as local borrowings and not as foreign borrowings. But in terms of the UN ESCAP Manual on Effective Debt Management as well as the 6th Edition of the IMF’s Balance of
Payments Manual known as BPM6, what is to be taken into account is not merely the central Government debt in order to make an effective analysis of a country’s external debt vulnerability. For that, a country should take into account the debt raised by the central Government as well as all those raised by Government banks and corporations plus the private external debt raised on Government guarantees issued by the Government.
This writer commented on this aspect in the article referred to above as follows: “According to the Manual, external debt consists of “both domestic and external debt” held by foreigners (p 11). In terms of this classification, Treasury bills and Treasury bonds held by foreigners, though they are in rupees, are a part of the country’s external public debt. The external debt thus consists of all borrowings of the Central Bank, central Government proper, banks and deposit taking institutions, non-bank financial institutions like insurance companies and other State-owned and private corporations (p 11). External public debt consists of, in addition to those borrowed by the Central Bank and the central Government proper, all borrowings of State commercial and other banks, State corporations and private sector borrowings with guarantees from the Government (pp 12-3). The outstanding external debt position reported by the Central Bank in its Annual Report 2013 (p 154) as per the 6th Edition of IMF’s Balance of Payments Manual, known as BPM6, is in accordance with this definition. It is this stock of external debt that has to be analysed for both risk management and debt sustainability analysis in terms of the UN ESCAP Manual.” IPS too has now drawn the attention of the country’s policy authorities to this aspect in its report.
Concentration of FDIs on hospitality is not desirable
The Central Bank as well as the Ministry of Finance has been vociferous about the increase in the Foreign Direct Investments or FDIs from below $ 500 million earlier to nearly $ 1 billion in the recent past. While the increase in FDIs is a beneficial development, its composition concentrating exclusively on the hospitality and the entertainment sectors have been a worrisome feature.
IPS has drawn attention to the need for attracting more and better FDIs to the country as follows: “Five years on from the end of the war, FDI has been a most conspicuous underperformer in an otherwise bullish economy. Net inflows of FDI in the immediate post-war period have not been materially higher than before, recording $ 916 million in 2013 compared to $ 941 million in 2012. Much of the recent FDI has not been in manufacturing export sectors, but in prominent mixed property development projects – the ‘Altair Tower’ set to be Sri Lanka’s tallest building, a $ 600+ million mixed-used development by the country’s leading conglomerate, a five star Shangri-La Hotel and ITC Hotel, etc. While these will boost growth in the short term through construction and allied sector growth and in the medium term through allied services and employment creation, they have little impact on technology transfer that boosts longer term growth through positive spillovers on labour force skills and productivity of domestic firms.” (p 3).
Cutting budget deficits by capping capital expenditure
Sri Lanka has cut the budget deficit from 9.9% in 2009 to 5.9% in 2013. This is viewed by many as a positive development but it has been achieved not by increasing the Government revenue or curtailing the Government’s consumption expenditure. Government revenue as a percent of GDP has remained around 14% in the last few years. However, Government consumption expenditure has stubbornly remained close to 15% of GDP necessitating it to attain the much praised reduction of the budget deficit by putting a cap on the capital expenditure at around 5% of GDP. This is not an appreciable attainment since it will deprive the country of the essential infrastructure development for long term sustainable growth.
IPS has emphasised this fact as follows: “For a country requiring continuing investment in critical modern infrastructure – whether it is connective infrastructure, technology infrastructure or social infrastructure (schools, universities etc.), Sri Lanka cannot afford to compromise on public investments in items that lay the foundations for competitiveness and sustained inclusive economic growth.” (p4)
But what has happened is that Sri Lanka has concentrated on the connective infrastructure side with roads, ports and airports etc to the almost exclusion of the other two types concerning research and development and human capital development. Even with respect to connective infrastructure, IPS notes that “the infrastructure development has been financed primarily through foreign loans or projects implemented by foreign state-backed firms (notably, Chinese)”.
The undesirable feature of this arrangement is, as highlighted by IPS, that they have been implemented by offering strong Government guarantees to institutions like the Road Development Authority and other non-revenue generating State entities. The end result has been the increase in the Government’s indirect liabilities known as contingent liabilities to these foreign firms. IPS says that “more worryingly, reliance on external borrowing has made Sri Lanka not only more vulnerable to external shocks but also weakened its ability to ride them out.” (p4)
Governments benefit from critics rather than from blind endorsers
IPS has made a critical review of the current economic policy stance from a professional point of view. The objective of establishing IPS in late 1980s was for the Government to get this critical review, which was not available from other public sector think-tanks. What IPS has said may not be sweet music to the ears of those who are involved in economic policy making in the country, yet they stand to benefit if they listen to IPS instead of those think-tanks in the Government which only see the good side of Government policy.
*W.A. Wijewardena, a former Deputy Governor of the Central Bank of Sri Lanka, could be reached at firstname.lastname@example.org