23 October, 2017

Way Forward For Sustained Growth

By W.A Wijewardena –

Dr. W.A. Wijewardena

Way forward for sustained growth: Challenging but can be tackled with correct policies

SLEA Annual Sessions 2013

The Sri Lanka Economic Association or SLEA in its 2013 Annual Sessions held last week had a very important topic as its theme: ‘The Way Forward for Sustained Growth’. At the inaugural sessions, two eminent economists, Professor A.D.V. de S. Indraratna and Dr. G. Usvattearatchi, made a microscopic dissection of the current state of the economy and came up with some important suggestions which the Sri Lankan authorities may consider if they are interested in a sustained economic growth.

Growth driven by borrowings

Professor Indraratna delivering the Presidential Address noted that Sri Lanka was able to reverse the low economic growth which the country had had prior to 2009 after the third quarter of the same year. But that growth had come not by using the domestic savings and thereby investing the domestic savings but by borrowing and allowing the trade deficit to deteriorate with increasing pressure on the exchange rate.

What Indraratna meant by this is the setting up of a vicious circle of economic malady through deliberate policy action. This can be explained as follows: When the exchange rate is under pressure for depreciation due to the domestic inflation rising significantly above that of competitor countries, the rate has to be depreciated to maintain the country’s competitiveness, promote exports and discourage imports. If the rate is not depreciated, it gets overvalued bringing about the opposite results. Thus, the trade deficit becomes bigger, leading to a similarly big current account deficit of the balance of payments reducing the country’s domestic savings.

To fill the shortage of domestic savings, the country has to borrow more from abroad which boosts growth initially but causes the current account deficit expand further. The latter has the effect of people spending more on foreign goods and services than they earn from foreigners thereby further shrinking domestic savings. Thus, the initial growth obtained through borrowing becomes unsustainable. Indraratna’s hypothesis has been proved by Sri Lanka’s recent economic growth statistics. The high economic growth of above 8% achieved in 2010 and 2011 has now fallen below 7% in 2013.

Borrowings become increasingly costly

Now the country has been ensnared in a new kind of a trap before it gets into the Middle Income Country Trap about which many have been speaking of lately. That is, Sri Lanka has to continue to borrow if it wants to increase its economic growth to the desired levels, but when it continues to borrow in larger amounts, it loses the sustainability of the economy. Indraratna found fault with the National Savings Bank, the premier institution for savings mobilisation, raising external commercial loans at high interest rates of 8.875%.

According to market sources, NSB has on-lent this money in the form of domestic lending to the Government to finance its untameable consumption expenses known as current expenditure. The corollary is that it will not ease the current account deficit of the balance of payments and encourage domestic savings. Thus, NSB through this action has cut its own throat. The reduction in domestic savings will push the bank to go for more external borrowings until it reaches its foreign borrowing limit as determined by its own internal borrowing capacity. At that level, there is no ‘moving forward or turning back’ for NSB causing it to implode itself from within since, without new domestic savings, it becomes difficult for it to earn enough to maintain itself while serving its foreign debt as well.

Generate domestic savings for investment

Thus, Indra-ratna’s prescription for the national economy to generate sustainable growth was based on cutting down the consumption expenditure of the government by reducing “waste, corruption, and ostentation of the public sector” and “improvement in the management and the productive efficiency of the public sector institutions” on the domestic side and encouraging non-debt foreign direct investments or FDIs on the external side.

But for Sri Lanka to attract FDIs, says Indraratna that just peace and law and order are not sufficient. In addition, the country should have good governance, rule of law, right to information, efficient, honest and independent public sector institutions, enlightened free media and simple rules and procedures in customs and immigration. Without these essential requirements in place, the country will have to forget about the attainment of the sustainable growth in the long run.

Usvattearatchi: Perils to sustained growth

Usvattearatchi titling his keynote ‘Perils to Sustained Growth’ subjected these issues to further critical analysis drawing on the lessons of economic history, arguments by mainstream economists, and the current developments in the country. His focus was how economic growth could be sustained even in the short run. It is the growth rate that will determine how long it will take a country to double its per capita income.

For instance, in India during the first half of the 20th century, per capita income has increased on a net basis according to C. Sivasubramaniam who wrote in 2000 ‘The National Income of India in the Twentieth Century’ by a minuscule 0.1% per annum taking about 700 years for the country to double its per capita income. However, this trend has been substantially reversed in the first decade of the 2000s where per capita income had grown at a rate of 6% per annum drastically reducing the number of years for the income to double if that growth rate is sustained. However, in India there have been perils to such growth rates in the recent past.

Yesterday’s business cycles are today’s economic crises

According to Usvattearatchi, these perils were earlier known as business cycles or trade cycles but today they are called ‘economic crises’. He has quoted Carmen Reinhart and Kenneth Rogoff’s 2011 book titled ‘This Time is Different: Eight Centuries of Financial Folly’ in which the two authors have linked the merry borrowing and spending by governments and corporations to eventual debt default and economic crises. The crises start when the borrowers go on rolling over the short-term debt without gaining capacity for repayment and the lenders losing confidence in the borrowers. Accordingly, the lenders disappear from the scene creating liquidity problems and the crisis hits the borrowing country or the corporation. Thus, business cycles or economic crises today are man-made rather than something arising from the economic systems themselves as presumed earlier.

Though Reinhart and Rogoff have been countered by many fellow economists – by Paul Krugman, New York Times columnist and Nobel Laureate on the ground of ‘austerity promotion’ and by three lesser known peers at the University of Massachusetts, Amherst, on the ground of omitting important GDP data series – the basic tenet of their finding has all-time validity. That is, when governments and corporations borrow and spend, the growth becomes less because the bubbles they create burst sooner or later putting economies in trouble. That is because when money becomes cheap and available in plenty as in the case of stimulus packages and central bank sponsored lending schemes, it is spent on less important areas without going through the rigorous screening and assessment processes. The outcome is the loss of economic efficiency and creation of white elephants, as evidenced in many developing countries including Sri Lanka.

Losing reserves to protect a currency

The disappearance of lenders can now happen at the speed of light where the funds could be transferred electronically from one place to another. Even to gain a small advantage in the interest rate differences, the lenders could now transfer funds from one place to another with a very minute transaction cost. That is why countries with borrowed foreign reserves – borrowed from the short term money markets – should be careful about handling their economic matters.

Usvattearatchi compares the case of India and Sri Lanka. India has a huge foreign exchange reserve of some $ 285 billion; but when the Indian rupee came under pressure for depreciation, the Indian central bank, Reserve Bank of India or RBI, did not think it prudent to spend those foreign reserves to prevent the rupee from falling. Sri Lanka has only a reserve of $ 7 billion and even if only a fraction of that leaves the country’s shores in search of higher interest rates, the country will really be in trouble due to the loss of foreign reserves. Usvattearatchi therefore recommends that Sri Lanka should avoid relying on borrowed funds and instead should depend on sensible economic policies.

Ground necessities for attracting FDIs

Sri Lanka is notorious for spending more than it earns. This generates a gap in the combined trade, services and income accounts of the balance of payments. But when it does so, it has to incur new foreign debt. That gap is partly closed through remittances and partly by borrowing abroad. But borrowings increase the gap further because a country has to spend now a sizeable amount of its foreign exchange resources to pay interest. Hence, as recommended by Indraratna too, a country may attract more FDIs.

But Sri Lanka’s track record of attracting FDIs has not been that encouraging contrary to, in Usvattearatchi’s words, “widely publicised expectations”. He attributes three most important reasons to this: The poor law and order situation, faulty dispute settlement mechanisms and lack of quality manpower at middle levels. The first two can be tackled within a short period but the third requires long term attention. Without them, the actual realisation of FDIs is much less than the expectations.

Benchmark to competitor countries’ inflation

The Sri Lankan Government has been depending on short term foreign funding to finance its expenditure since the foreign interest rates at the moment are lower than those in the domestic market. That also is due to government’s failure to keep inflation rate at low levels in line with foreign inflation rates. For instance, the inflation rates in USA and EU have been at 1.5% as at August 2013 in comparison to

Sri Lanka’s inflation rate of 6.8%. Though inflation rate has come down a little since then, it still is above 6% in Sri Lanka. Hence, despite the attempts of the Central Bank at reducing the interest rates in the domestic economy through a relaxed monetary policy, interest rates have been sticky downward. This is the reason for Sri Lanka, like India, Thailand and Indonesia, to get short term foreign money, known as hot money in the markets, into the investment in Treasury bills and Treasury bonds in large amounts.

Don’t make domestic economic policy a ransom to foreign investors

But Usvattearatchi says that this strategy is fraught with serious risks. Even a slight increase in foreign interest rates could result in a massive outflow of foreign funds creating a serious situation within the domestic economy just like the bad experiences of India recently. Such outflows would put pressure for exchange rate to depreciate but the Indian authorities did not spend their reserves to defend the rupee. The result was for Indian rupee to fall to its lowest level at IR 70 per US dollar. This was slightly reversed when the good news came from USA that its central bank, Federal Reserve Bank, will continue to pump dollars to the market at the rate $ 85 billion per month and keep its interest rates low. As a result, both India and Sri Lanka had a temporary lease of life. Usvattearatchi says that to that extent “domestic economic policy is ransom to foreign investors”.

The corollary of this that a government should not make a nation a hostage of foreigners by seeking to depend on short term loans from overseas to fill the resource gap when the country has no capacity to pay those loans due to its wasteful use of same.

The need for urgent economic reforms

Usvattearatchi then calls for proper economic reforms to avoid such a situation. Reforms are numerous and cover a wide range. With respect to government, he notes the alarming trend of falling revenue of the government in proportion to GDP. This was highlighted by Indraratna too in his inaugural address. In early 1980s, the government revenue accounted for slightly more than 20 percent of GDP. But by 2012, it has fallen to 13% of GDP. But the government expenditure has remained at 20 percent of GDP creating a deficit of 7%.

Thus, the government has to go into a wide scale reform program though such reforms are not sweet to many. A populist government is unwilling to do this but it is essential that it has to raise its revenue before it thinks of increasing its expenditure.  The current policy has been to increase expenditure without looking at its adverse repercussions and then borrow from external commercial markets either directly or through government entities like National Savings Bank or the Bank of Ceylon. These are populist policies just to make a living for the day. Usvattearatchi says that at that point, “the long term growth becomes a hostage of short term stability” If there is a hostage-taking, definitely there is a ransom to be paid. But when governments have borrowed heavily from commercial markets and countries that lend on commercial terms like China, that ransom is paid to foreigners. At that time, everyone – irrespective of race, caste, religion, gender or age – has to contribute toward the ransom payment.

Step-motherly treatment of education

Usvattearatchi says that there has been a marked shift of government expenditure away from education recently. He says: “There is a woeful neglect of education at all levels, much of it reversible with far more money spent on them. One is not arguing naively that more government money on schools and universities will automatically produce better students and teachers and research besides.  There is much besides that go to improve education and pre-empt places like that College of London with ‘branches in Dematagoda,  Nugegoda and  Bambalapitiya’ to teach cooking pizzas.”

He has reservations on the quality of private sector educational institutions compared to State sector institutions. While private sector institutions should be welcome, the State sector educational institutions should set the benchmarks and standards which the private sector institutions should follow. His message is clear: Quality education pioneered by the State sector institutions will be followed by the private sector institutions and both will produce the needed manpower for the future sustainable growth in Sri Lanka.

Remove perils to sustained growth

Both Indra-ratna and Usvattearatchi have candidly and boldly looked at the perils of the sustainable growth in Sri Lanka. This is laudable because unlike in neighbouring India, Sri Lankan academics and intellectuals have been maintaining an unexplainable silence when it comes to critically analysing and evaluating the country’s economic policies and strategies. If the perils which these two bold economists have highlighted are not removed, the result will be the loss of the growth momentum which the country started with much hope and hype after the end of the conflict in 2009. But Usvattearatchi has gone beyond that. He has warned that unless the current policy of depending on the short-term foreign money is reversed, the country may not be able to avoid a serious economic crisis that is at present looming over it.

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    Thanks for the presentation summarizing the presentations at the SLEA 2013 sessions. I learn much from your blogs.

    Dr.Rajasingham Narendran

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