Can current economic indicators be sustained?

By the Economist

With the nose dive in the Colombo Stock Exchange last week, suspension of aid by Britain and the United States and the continuous rise in prices, there was a general view that the economy was in a dire predicament. Fortunately, the share price indices recovered and then fluctuated this week. According to the Central Bank, inflation too is showing signs of deceleration. However, price increases this month may reverse that expectation.

In contrast to the popular perception that the economy is faring badly and in even a crisis, the official position of the Central Bank is that the economy is faring well and that this year’s economic growth would even exceed last year’s 7.4 per cent to reach a commendable 8 percent.

The fact is that some of the key economic indicators have been and are disconcerting. They are the fiscal deficit reaching towards two digit proportions, a massive trade deficit last year, the increasing public debt with the foreign debt component increasing to uncomfortable levels, a depreciating currency and the increasing domestic price level. Each of these unfavourable developments feed the others and generates unfavourable economic conditions. In addition, the deteriorating security situation is a paramount concern that affects the economy in diverse ways. The likely increase in military expenditure, the drop in tourism and a continuing stalemate in providing a viable solution to the ethnic problem are real concerns.

At the current rate of public expenditure it is likely that the fiscal deficit would rise to around 10 per cent of GDP, a level considered extremely unfavourable and one generating inflationary pressures with consequent adverse impact on economic growth. The public debt had risen to rupees 2,668 billion by the end of February and was 17 percent higher than it was a year ago. The foreign debt had risen by 18 percent in the 12 months between February 2006 and 2007 to Rs. 1,148 billion. The increasing public debt would further aggravate the fiscal situation as debt servicing costs that are the highest component of public expenditure, would rise to crippling levels. Even more significant is the rise in the foreign debt through commercial borrowing. Last year’s trade deficit was massive. In the first quarter of this year however the trade deficit had declined by about 16 percent in comparison with the deficit of last year’s first three months. This much improved performance in the trade balance in the first quarter (January-March 2007) gives some hope.

Unlike in the past, export growth was not offset by higher growth in imports. While exports grew by 13 per cent, imports grew by only 3.2 per cent during the first quarter. This was mainly the result of imports declining by 2.4 per cent in March, owing to lower imports of petroleum. Export growth was also favourable in March. Exports increased by 17.7 per cent during March 2007. This was mainly due to higher exports of industrial goods and agricultural produce.

During the first quarter industrial exports grew by 14.7 percent with exports of textiles and garments increasing by 13.5 percent compared to that of the same period last year. Agricultural exports grew by 9.2 percent mainly due to the higher value of exports of tea and rubber.

It is pertinent to ask whether these developments in the first quarter trade balance could be sustained. Was the reduction in the oil bill a flash in the pan? Are we not facing a trend of increasing international prices? Can industrial exports increase continue to increase at the rate of the first quarter? With the decline in tea production by over 17 percent in the first quarter, the prospect of any increase in agricultural exports is bleak. Tourist arrivals have declined and the forecast and expectation is a reduction in earnings from tourism.

The favourable development in the trade balance was buttressed by higher worker remittances and inflows to the government by way of loans and sale of Treasury bonds to non-residents. Consequently, according to the Central Bank of Sri Lanka, the balance of payments is expected to record a surplus of US dollars 292 million by end April. The gross official reserves are estimated to be around US dollars 2,820 million by end April 2007. However this increase must be counterbalanced by the fact that government borrowing from international markets at commercial rates was a good part of the explanation for this improvement. The apparent improvement in the balance of payments was largely the result of increased foreign borrowing at commercial interest rates, as in the case of the recent borrowing of US $ 200 million in the money market. In addition the balance of payments in the coming months may reflect huge increases in the purchase of military hardware that would certainly cause a dent in the balance of payments.

For these reasons and the weak underlying economic fundamentals of the economy, the apparent turnaround in the external finances cannot be expected to last and ultimately result in an improvement in the country’s economy. The fundamental reason for the unfavourable economic situation is that public expenditure is not in line with the government’s revenue. The root causes for the burgeoning fiscal deficit are the high costs of debt servicing, large expenditure on public service salaries and pensions, the high costs of the war, including huge expenditure on import of military hardware, large expenditures on subsidies and wasteful expenditures for political gain. All these expenditures have increased and are increasing. Consequently they would have an impact on prices, the trade balance and balance of payments and the public debt. The domestic price level would therefore increase and exert pressures on the exchange rate. In the past year the exchange rate depreciated by nearly 8 percent in terms of the US dollar.

The improvement in the trade balance and the improvements in the balance of payments are indeed good news. However, the weaknesses in several fundamental features of the economy makes one wonder whether these improvements could be sustained in the coming months of the year. The improvements in the trade balance and the balance of payments must be interpreted carefully as they do not necessarily portend improvements in the coming months.