The current economic crisis is generally looked upon as a problem in the balance of payments and a foreign exchange crisis. It is often interpreted as a crisis caused by the global downturn and recession. There is no doubt that the recession in the global economy has been an important cause for the economic crisis that the country is facing. However such an interpretation is only partially true and somewhat misleading as it tends to gloss over the fundamental weaknesses in the economy and in its management.
The balance of payments crisis and the dwindling of the foreign exchange reserves are symptomatic of fundamental weaknesses in the economy. While it is true that the country’s economic problems have been aggravated by global economic conditions, they are as much the result of a poor performance of the economy and a lack of proper policy responses in time to the emerging crisis. Even now there is some doubt as to whether there are adequate policy responses to set the economy on the correct path.
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Superficially the crisis is the result of a combination of high prices for imports and a declining demand for the country’s exports. These developments increased the trade deficit in 2008 to US dollars 5,871 compared to the deficit of US dollars 3,656 million in 2007. The deficit in 2007, though very high, did not result in a balance of payments crisis owing to high capital inflows. In fact owing to these capital inflows in 2007 the balance of payments was in surplus. Consequently, foreign exchange reserves increased by the end of 2007. The main components of these inflows were private remittances, mainly from Sri Lankans working abroad, and large amounts of commercial borrowing. Two features of this balancing act are worth noting. First, the large amounts of private remittances are an exogenous factor and have no bearing with respect to the performance of the economy. In fact the continuous inflows of these remittances have enabled the country to be complacent about the poor performance in its exports, on the one hand, and on the other hand, enabled the country to incur huge import expenditure.
Since the large trade deficits were offset by these capital inflows, there was no apparent balance of payments problem. It was very much in the mould of a household that was spending far in excess of its income and yet having no apparent problem as friends and relations were sending money and the household was borrowing money from banks.
The resolution of the huge trade deficit through these two exogenous contributions implies that the country did not have a capacity to meet its import needs through export earnings but relied on these capital inflows that were not due to any favourable factor in the domestic economy. The foreign borrowings that eased the balance of payments and enhanced the foreign exchange reserves were in fact liabilities on the future balance of payments. Therefore the situation in 2007 concealed the fundamental economic problem. There was in fact a balance of payments crisis that was swept under the carpet with the aid of these capital inflows. The huge trade deficit of US $ 3567 million was looked upon as “nothing to worry’, for after all it did not lead to a balance of payments deficit.
The fundamental problem continued into 2008. In 2008, export earnings amounted to US dollars 8,137 million a growth of about 6.5 percent. Most significant was the evidence that there was a declining trend in exports. Both agricultural and industrial exports were affected by the global recession. In the context of this situation Sri Lankan exports became less competitive with domestic costs of production rising. Policy changes were needed to reduce costs of production in a highly inflationary situation, such as by offering lower energy prices. Alternately or in tandem a depreciation of the currency was necessary to compensate exporters for their higher costs of production. Neither policy was adopted.
In contrast competing countries that had lower rates of inflation depreciated their currencies. Admittedly these were difficult options as the public finances were in a poor state with annual deficits of over 7 percent of GDP. The excess government expenditure over revenue was the most fundamental reason for the inability to resolve these problems. The fiscal deficits were basic reasons for the country’s inability to act in these various ways. It was not only the higher costs of the war but other expenditures as well that dragged the economy into a crisis.
On the other hand, import expenditure shot up to a massive US $ 14,008 million, an increase of 24.0 percent from that of 2007. This led to the massive trade deficit of US $ 5867 million. This huge deficit in the trade balance made it much more of a problem in 2008 than in 2007. Yet a favourable development was the continuing increase in private remittances. Private remittances increased significantly by 16.6 percent to US $ 2,918 million in 2008 and somewhat helped to contain the current account deficit, though not to the extent of the previous year. Besides the government had to repay loans it had borrowed. Consequently the country’s reserves fell. The level of reserves, though claimed to be adequate, soon proved to be otherwise. The country turned at first to friendly countries for loans on attractive terms and then when this effort proved inadequate turned to the IMF for a facility of US $ 1.9 billion.
Although international price movements had a serious impact on the crisis that we are facing today, it has been aggravated by the lack of appropriate domestic policies to cope with the adverse conditions. As pointed out many times before in this column, the fiscal deficit has been at the base of the problem.
The continuous fiscal deficits of over 7 percent of GDP resulted in inflationary pressures that eroded the competitiveness of exports. The inflationary pressures arising from high import prices compounded the problem. There was also a stubborn refusal to accept the evolving serious economic situation and to depreciate the currency to adjust to inflation. These compounded the problem to arrive at this critical situation.
What must be recognized is that international support to resolve our balance of payments problem, whether it comes from friendly countries or international agencies are only a palliative to tide over the immediate problems. Remedial action to resolve the fundamental problem requires good economic management. Chief among the needed reforms is fiscal consolidation. The fiscal deficit must be brought down to a much lower proportion of GDP to provide the conditions for the resolution of the foreign exchange problem. |
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