Budget proposals in disarray, trigger macroeconomic imbalances
Farmers’ protest on Thursday in Colombo.
The economic policies of the newly elected government are said to be based on the concept of a “Social Market Economy” built on social justice principles. Social market economy, which combines market economy and social security, became the hallmark of ecnomic policies in Germany in the 1950s.It is a rather imprecise term though it would be politically appealing nowadays. This may be the first time that this phenomenon is appearing in the policy documents in Sri Lanka, but its elements in different forms could be found in the economic policies adopted throughout the post-Independence period.
While it is important to provide social security to the vulnerable groups, it is also equally important to execute economic reforms so as to rectify the macroeconomic imbalances. The reforms included in the Budget 2016 have been confined to a few tax revisions and expenditure cuts. As the government has failed to withstand the pressures of trade unions and other lobbying groups against such proposals, they had to be withdrawn shortly after the budget speech, thus, keeping the imbalances intact.
Coherent macroeconomic
strategy missing
The medium term strategies proposed in the Budget 2016 consist of (a) generating of one million employment opportunities, (b) enhancing income levels, (c) development of rural economies (d) ensuring land ownership to rural and estate sectors, the middle class and government employees, and (e) creating a wide and a strong middle class. These look more like policy goals, though they have been identified as strategies in the budget speech. Apart from the above misidentified strategies, the budget does not contain any logical macroeconomic strategy geared to navigate the economy to a higher growth trajectory or to address the deep-rooted macroeconomic imbalances, specifically, the budget deficit and the external current account deficit. These two deficits are known as ‘twin deficits’ in the economic literature due to their intimate relationship. Increased liquidity created by budget deficits leads to raise consumer spending. Such high spending induces imports causing deterioration in the current account deficit in the balance of payments.
Moreover, inflationary pressures emanating from high budget deficits result in an appreciation of the real exchange rate further worsening the balance of payments situation. Hence, any improvement in the balance of payments cannot be expected without reducing the budget deficit. The situation becomes even worse during a regime of low-interest rates and a less flexible exchange rate system as currently evident in Sri Lanka. Rightly balanced fiscal and monetary policies are imperative to rectify this situation. The budget has not addressed these critical policy issues at all. Ironically, the budget is silent with regard to monetary policy. Apart from the interest rate relief granted to senior citizens for their fixed deposits, there is no mention in the budget about the authorities’ stance on interest rates or other monetary policy measures. While the present monetary easing through low interest rates has helped to reduce the debt service burden of the government to a large extent, they have resulted in high consumer spending, increased imports (eg. motor vehicles) and less productive investments.
Imports have been further induced by the overvaluation of the exchange rate, as the rupee has not depreciated adequately in the recent past to reduce the import bias. The substantial inflows of worker remittances have helped to mask the actual current account deficit generated by huge trade deficits year after year. This also has been a consolation for the policy makers to practice a less flexible exchange rate system. All these factors have had a tendency to encourage imports and to depress exports.
Fiscal consolidation not forthcoming
The budget deficit is expected to decline to 3.5 per cent of GDP by 2020, according to the PM’s economic policy statement. However, Budget 2016 does not indicate any initial step towards achieving this ambitious target.The budget deficit for 2016 estimated at 5.9 per cent of GDP shows only an insignificant decline from 6 per cent this year. Even this target would not be achievable with the ongoing changes in the budget proposals.
Inadequate growth of tax revenue as against the increasing expenditure for public sector salaries, interest payments and subsidies has made fiscal consolidation more and more difficult. Meanwhile, substantial allocations have been made in the budget for some new projects such as the cluster village programmes and an ambitious Megapolis project. The financial viability and the rates of returns of these ambitious projects need to be assessed with much caution considering the fiscal and foreign exchange burden that they would exert in the years to come. In contrast to the planned increases in the proportion of direct taxes stated in the economic policy statement, the tax proposals in the budget are likely to further increase the share of indirect taxes overburdening the poor.
The withdrawal of the budget proposal to abolish duty free vehicle permits for the public sector within a very few days after the budget speech amply demonstrates the government’s inability to cut down the tax concessions in the face of mounting pressure from trade unions. Subsequently, further amendments pertaining to the public service including salary increases and restoration of pensions were effected due to trade union threats. The proposed increases in vehicle emission tax and revenue license fees were also revised downwards due to public resistance.
These instant reversals of the budget proposals not only upset the fiscal numbers but also pose a challenge to the credibility of the government.
Surprisingly, these amendments were announced in the parliament by the Prime Minister but not by the Finance Minister who originally presented the budget speech.
Third generation reforms in jeopardy
Although the structural reforms towards building up a market-oriented economy have been implemented from time to time in Sri Lanka since 1977 with a range of policies including trade liberalisation, financial sector reforms and privatisation, the reform agenda is yet to be completed. Globally, the reforms listed under the much debated “Washington Consensus” include fiscal discipline, public expenditure rationalisation, tax reforms, interest rate liberalisation, trade liberalisation, free FDI flows, and secured property rights. This list has been extended further under the “Augmented Washington Consensus” to include reforms like flexible labour markets, independent central banking/inflation targeting, targeted poverty reduction strategies and anti-corruption.
Taking into account the crucial role of international competitiveness in entering the global value system, the PM’s policy statement emphasises the need to implement the much delayed third generation reforms. However, the budget has not articulated any such policy reforms. Labour market deregulation, targeted social safety nets, welfare subsidy rationalisation, public expenditure cuts and flexible exchange rates and interest rates have not been focused in the budget. Most of these reforms are politically sensitive, and therefore, they call for bold decisions. It is doubtful whether such reforms could be implemented successfully in the near future, considering the ideological differences between the political parties of the coalition government and the mounting pressures of trade unions and other groups against such reforms.
Pre-requisites for international
financial centre yet to emerge
It is encouraging to note that the budget contains a proposal to set up an international financial centre in a demarcated area in the Colombo city on the lines of international financial centres in Dubai and other major cities. The proposed centre is expected to provide infrastructure facilities for financial activities including resolution of commercial disputes. Although this could be regarded as an innovative proposal, many other pre-requisites, apart from the provision of infrastructure facilities, are essential to foster a sophisticated financial centre of this nature. Most importantly, the economy needs to be vibrant and stable with internationally integrated exchange and interest rates. Financial policies should be effective in mitigating risks, enhancing market efficiency and transparency so as to ensure financial soundness and safety. An appropriate regulatory mechanism is also needed to promote stability and international competitiveness in the financial system. Needless to say, the fragmented money and capital markets of Sri Lanka have a long way to go to cater to international and cross-border financial activities.
Impractical price controls
The maximum selling price of a few selected consumer goods have been announced in the budget. These include locally manufactured milk powder, canned fish, sprats, dhal, selected dried fish, chickpea, LP gas and kerosene. The price controls have proved to be inefficient in a free market economy though they are geared to provide relief specifically to the poor. They have the disadvantage of their blanket application covering all income groups, and therefore, the subsidy element goes to high income earners as well. The selection of the consumer goods for price control by the authorities is arbitrary and it is difficult to fix prices of different goods at the so called “fair” levels. Enforcement of price controls has always been a problem due to administrative difficulties. Moreover, the price controls restrict freedom of choice of consumers, and create market distortions.
Macro-financial risks imminent
with mega infrastructure projects sans structural reforms
Major infrastructure projects, mainly the flagship Megapolis project and the related sub-projects, are expected to be the major drivers of economic growth, according to the economic agenda of the new government. It is anticipated that these city projects would enhance output and employment opportunities by way of promoting urban utility services, business and financial ventures, ICT, transport, logistics, tourism and allied activities.
Thus, the growth in the services sector would accelerate compared with the less-focused agricultural and industrial sectors. It may be noted here that a major criticism levelled against the previous government’s economic strategy was the excessive growth of the services sector at the expense of production growth in agricultural and industrial sectors. The same trend is likely to continue with the urban-based infrastructure projects undertaken by the new administration.
Much of the funding for these infrastructure projects would come in the form of foreign borrowings and foreign direct investment, given Public Private Partnerships (PPPs) as the first option. The likely burden of these ventures on the government budget, debt service commitments and balance of payments would be substantial in the coming years. The heavy reliance on ambitious infrastructure projects depending on speculative foreign investment was a major cause of the financial crisis experienced by the East Asian countries from 1997 onwards. The surge of foreign capital inflows made those countries vulnerable to financial panics. The lack of an effective risk management mechanism aggravated the crisis.
The deterioration in the overall balance of payments, depletion of foreign exchange reserves, weak state of public finances and rising public debt have raised financial risks for Sri Lanka, as pointed out by the IMF’s Executive Board in its recent report following the fourth post-programme monitoring in the island.
Hence, fiscal consolidation should be effected through tax reforms and expenditure rationalisation. It should be supplemented by monetary policy tightening with market-determined interest rates so as to arrest inflation and to contain import demand. Greater flexibility in the exchange rate too is essential to improve the trade balance. All these measures are politically sensitive, and therefore, they cannot be implemented at ease. It is doubtful whether the government is in a position to execute such far reaching economic reforms, considering its failure to implement even the limited tax revisions and expenditure cuts proposed in the recent budget in the face of trade union reactions. This means that the severe macroeconomic imbalances are unlikely to disappear in the foreseeable future.
The launching of the proposed mega infrastructure projects in the absence of a robust macroeconomic environment, supported by rigorous economic reforms, exposes the economy to extreme financial risks further worsening the already deteriorated public finances and balance of payments.(The writer, a former Central Bank official and university academic, may be reached at sscolom@gmail.com)