By W.A. Wijewardena –

Dr W.A. Wijewardena

Professor Sisira Jayasuriya, a Sri Lankan born economist of international repute at Australia’s Monash University, in delivering the keynote address at the inauguration of the Annual Sessions of the Sri Lanka Economic Association or SLEA concluded recently, had an important message to Sri Lanka: External shocks are there and don’t ignore them.

Related countries’ downturns affect others too

In laymen’s language, what he said was as follows: Countries face unexpected economic downturns from time to time due to similar economic downturns in countries with which they have economic relationships. Those economic relationships may take many forms, like exporting their goods or importing vital raw materials or getting their workers to work in those countries and sending money back home or simply getting loans or free grants from those countries. If the other countries have problems, then, those problems would invariably land on the home country as well. The home country will then face the problem of failing to maintain exports or economic growth or both. Such problems will manifest themselves as an economic crisis and if these crises are not attended to immediately, they will start festering and get into economic disasters. What Sisira Jayasuriya advised Sri Lanka was that ‘be watchful of emerging economic downturns in other countries and be ready to arrest them before they cause major economic losses to the country’.

The economic crisis in the developed world

Jayasuriya then explained the nature of such recent economic shocks and took his audience through the sound economic policies adopted by another middle income country, Chile, to prevent the crisis from elevating to the state of a disaster. In the recent past, during 2007-8, the world was hit by a financial crisis in the developed countries and pretty soon that financial crisis degenerated to a prolonged economic recession in those countries reducing economic growth, increasing unemployment and raising poverty levels. Some of the countries in Europe, namely, Greece, Portugal, Ireland and Spain, became virtually bankrupt and had to be supported by generous financial packages from other European countries but of course subject to their agreeing to adopt very painful ‘belt-tightening measures’ known as ‘austerity measures’ in economists’ parlance.

The quick way out of recession: ‘Stimulus packages’

Since it was essential for the developed world to get out of the economic recession as quickly as possible, USA and European Union had introduced bigger spending by governments directly or through the respective central banks which is known as ‘economic stimulus packages’. The rationale behind the stimulus packages was that the countries could not produce more because there was no demand for what they produce. Hence, to boost the demand, easy money was delivered to the hands of the consumers. They were in turn expected to use that money to buy goods and services thereby creating a new demand for the output produced by these countries. It was therefore expected that the new demand would help these countries to get out of the recession and move along the normal growth path destined for these countries. This type of economic stimulus is in line with the economic policy package proposed by the British economist, John Maynard Keynes, some 75 years ago when the world had been hit by an economic depression of the worst kind. Since some of the contemporary economists had branded the current recession even as worse than the depression of 1930s, adopting these packages was considered quite rational and appropriate.

Stimulus to increase demand through an increase in money

But Sisira Jayasuriya has found that the stimulus packages had not worked in both USA and in the EU. There has been a drastic liquidity injection in both countries by showering the economic system with easy money through stimulus packages as demonstrated by the continuous high growth in reserve money base in them. The reserve money is simply the money produced by the central banks and made available to the economy as ‘seeds’ for creating further money by commercial banks by taking them through a procedure known as ‘multiple deposit and credit creation’. This multiple deposit and credit creation increases the money supply of a country and the increased money in the hands of the people will increase the demand for goods and services. The suppliers, having taken note of the increase in the demand for goods and services, are expected to step up production thereby taking the country out of recession and providing employment to people who are unemployed so that they can get out of poverty too.

So, stimulus packages are the way to solve the economic problems but for them to work properly, money supply should increase in response to the increase in the reserve money base.

Reserve money has gone up but not the money supply

Sisira Jayasuriya has used the data supplied by Nomura Research Institute from mid 2008 to mid 2012 and shown that the money supply in both USA and the EU has not increased during this period in response to the growth in reserve money base through stimulus packages. If money supply has not increased, there is no reason for the total demand for goods and services to increase providing a comfortable space for producers to produce more. But it is a fact that stimulus packages have been introduced, reserve money base has increased and liquidity has been injected to the economy. In USA, the reserve money base has increased by more than 300 per cent and in EU, by nearly 200 per cent during this period, according to the data reported by Sisira Jayasuriya. But money supply has increased in USA only by 29 per cent and in EU by 8 per cent. That is not that much of a stimulus to the respective domestic economies over a period of four years.

Who has swallowed all that stimulus money?

Then, what has happened to the moneys delivered to the hands of the people? Sisira Jayasuriya has not ventured into answering this question but the answer lies in the massive current account deficits which these countries have experienced in their respective balances of payments during this period. In EU, the current account deficits have been around closer to a half a per cent of GDP while that in USA has been a whopping 3 per cent of GDP. So, the moneys created by USA and the EU have created income in their major importing countries, mainly, China, emerging East Asia, India and to some extent Sri Lanka too. While the stimulus packages have been costly to USA and the EU because their tax payers have to pay for them in the long run, they have been a boon for emerging Asia by temporarily pushing up their growth rates. Sri Lanka has specifically been a beneficiary because its growth rates jumped up from below 5 per cent before 2009 to above 8 per cent in both 2010 and 2011 driven by high exports to USA and the EU.

Stimulus too will run its steam delivering another external shock

If the Western world can continue with stimulus packages, then, it is good for the rest of the world. But can they do so into an indefinite future? Unlikely, because at one stage or another, they will come to grip with the reality and have to restrain themselves in offering such lavish expenditure programmes. USA is moving toward its ‘fiscal cliff’ by the end of 2012 under which expenditure will be cut and taxes will be raised in a bid to reduce the budget deficit and public debt levels and many countries in the EU are considering austerity programmes for implementation in the immediate future. Britain’s David Cameron has been a forerunner because he introduced these measures two years ago before any nation even thought of them. Despite the official recession to which the UK has now been driven, there are no signs of reversing that policy by the British government. So, in my view, the global growth triggered by stimulus packages is to come to an end pretty soon. The signs of this are visible across the world. Both China and India, two nations that contributed much to the recent global economic growth, have admitted in public that their economies are slowing down and accordingly cut the growth rates for 2012 and 2013 drastically. Sri Lanka which had experienced a super economic growth of above 8 per cent in 2010 and 2011 and projected even higher growth rates for 2012 and beyond has now scaled it down its growth in 2012 to 6.2 per cent in the midst of falling exports which have fallen as much as 6 per cent during the first eight months of the year.

In open economies, stimulus will create income in other countries

Stimulus packages are being implemented by major developed countries quite for some time now, but the results have not been that encouraging. In the earnest, the objective of these packages has not been to promote global growth but to get out of the economic crises faced by the individual countries before they degenerate to the state of disasters. If the economies of these countries had responded quickly, it would have been much better. But, the economies of the two major giants have not responded adequately as shown by the below two per cent economic growth they have experienced. In a global open economy system, these results are not unexpected.

John Exter: Have deficit budgets and harvest BOP difficulties

Sixty three years ago, John Exter, founding Governor of the Central Bank of Sri Lanka, cautioned, in his Exter Report, the deficit-budget lovers who wished to promote growth and prosperity in Ceylon by resorting to that practice. While a country like USA which was self sufficient at that time would have benefited from them, in an import-dependent country like Ceylon, he said that it would simply lead to “raise domestic prices without producing an adequate response in domestic output” He further said that “instead, higher domestic incomes would stimulate the consumption of imported goods and precipitate serious balance of payments difficulties” (p 26-7). Though Exter inferred that such policies might work in USA where imports were less than 1 per cent of GDP at that time, it is not so today with a huge import bill amounting to some 17 per cent of GDP in that country. The EU is not better with its import bill standing at 16 per cent of GDP. Sri Lanka is in a worse position with an import bill of some 36 per cent of GDP. What Exter predicted for Ceylon and now equally applicable to USA and the EU has been prophetic in driving Sri Lanka to continuous BOP difficulties.

Singapore’s old guard: deficit budgets are an invitation to disaster

Twenty five years after Exter, Singapore’s Goh Keng Swee too by reference to Keynesian policies in general remarked that the old guard in Singapore did not believe in the working of deficit financing in the long run for an open economy like Singapore. Writing a special article titled “Why a Currency Board?” to its Silver Jubilee Commemoration Volume in 1992, Swee said that “financing budget deficit through central bank credit appeared to us as an invitation to disaster”. He further qualified his statement by saying that “hence, we were not impressed by claims that governments could bring about prosperity through spending. It did not surprise us that Anglo-Saxon countries which adopted such policies got into trouble” (p 33).

Next shock by saying good bye to stimulus packages

Hence, the next external shock, in my view, is to be delivered to the global economy, including Sri Lanka, by the stimulus packages running out of their steam and the developed nations’ adopting austerity measures to manage their own economies which have now got out of control.

According to Sisira Jayasuriya, the current policy challenge has been to maintain macroeconomic stability without cutting investments in infrastructure and human capital development and without passing the burden of the adjustment unduly on to the poor. He further elaborated that Sri Lanka cannot remain complacent with a “business as usual” attitude and any policy mistake made by it will become extremely costly.

Chile: Make hay while the sun shines

In this context, Sisira Jayasuriya’s Chilean example is an eye opener for Sri Lanka.

Chile too had an economic crisis following the global economic downturn in 2007 but managed to come out of it before it degenerated to a disaster. The secret lay in its maintaining a good macroeconomic picture so that it had enough space to move when the country was hit by the crisis.

As presented by Sisira Jayasuriya, Chile is the most open economy in Latin America. It still depends on commodity exports but is highly integrated to the global financial markets. When a country is so integrated to the global financial markets, it also suffers from the weakness of being hit by volatile financial flows from abroad: In one year, these flows will come as a blessing but at the same time put pressure on the exchange rate to appreciate making Chile’s export uncompetitive. In order to prevent the exchange rate from appreciating, the central bank may be prompted to buy the foreign exchange flows that are coming, but at the same time, it will increase money supply and generate inflation in the country. If the central bank keeps the interest rates unchanged, the consequent inflation will cause a reserve outflow causing the exchange rate to fall in the market again. Chile’s monetary policy, according to Sisira Jayasuriya, had been designed to avoid this pitfall.

Chile: Long practiced budget discipline handy when hit by crisis

Chile had an encouraging budgetary position. Its government expenditure had been tied to the long term copper prices and not to their short run upswings. Hence, even when the Chilean government got a massive income due to the temporarily increased copper prices, it did not spend it because the long term copper prices had not moved so much. Thus, in good times, the Chilean government had saved for what the folk would say “for a rainy day”. Accordingly, it maintained a constant budget deficit and its public debt therefore remained below 10 per cent of GDP. Hence, when the country was hit by the crisis, it could increase the government expenditure by using the past savings without disturbing the inflation targets or causing problems for the balance of payments. Economists call this ‘taking counter cyclical measures’ because when the economy is moving down in the falling growth cycle, the government steps up its expenditure to compensate for the reduced private sector expenditure. Chile could do so, because it had enough monetary and fiscal space to increase spending with its long practiced budgetary discipline and sound monetary policies.

Sisira Jayasuriya: Take corrective policies well in advance

Sisira Jayasuriya had a message to Sri Lanka without mentioning Sri Lanka. Probably, he would have wanted Sri Lankan policy makers to study the Chilean case and adopt appropriate policy packages to rescue the country from external shocks that are abundant in the global economy. When he says that external shocks are there and do not ignore them, it is sound enough. It requires Sri Lanka to identify the emerging external shocks well in advance and be ready with a suitable policy package to avoid their harmful effects.

*Writer is a former Deputy Governor – Central Bank of Sri Lanka and teaches Development Economics at the University of Sri Jayewardenepura. This article first appeared in Daily FT  – W.A. Wijewardena can be reached at waw1949@gmail.com