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Fiscal consolidation is crucial to stabilise the economy and achieve higher economic growth.

This year’s high fiscal deficit will destabilise the economy and affect the country’s medium-term economic growth. Macroeconomic fundamentals are being undermined by the government’s populist expenditure this year and the fiscal deficit for 2020 is also likely to be higher than the planned fiscal deficit targets.

The government’s commitment to progressively bring down the fiscal deficit and thereby reduce the outstanding debt to a sustainable level over the medium term is most unlikely. Achieving a fiscal deficit of 3.5 percent of GDP in 2020, as envisaged in the fiscal consolidation strategy is unrealistic.

Fiscal outcome

The fiscal outcome in 2019 and 2020 would deviate significantly from the government’s avowed intent of fiscal consolidation. This year’s fiscal deficit is likely to be above the target of 4.8 percent of GDP, perhaps about 5.5 percent of GDP. This is mainly due to increased public expenditure and shortfalls in revenue collection. Next year, that is also an election year, is likely to be one of excessive public expenditure that would result in a large fiscal deficit. It would be much above the target of 3.5 percent of GDP.

Reasons for fiscal slippage

The main reason for the increased fiscal deficit is the government’s populist expenditure in the run-up to the upcoming presidential election. The increased expenditure on salaries, pensions, employment of unemployed graduates and increased Samurdhi payments are likely to increase public expenditure significantly. Enterprise Sri Lanka and loan concessions and interest subsidies, among other additional expenditures are likely to increase government expenditure.

Furthermore, the April bomb blasts and compensation for victims are further additional public expenditure not envisaged in the 2019 Budget. New security concerns will entail higher military expenditure.

Revenue dip

On the other hand, the slow growth of the economy, the impact of the dip in tourism and lesser import duties are likely to result in a revenue shortfall that would increase the deficit beyond the budget target of 4 percent of GDP. There is also the possibility of some measures of tax relief that would expand the fiscal deficit by decreasing revenue. The fall in imports would also result in lower revenue from imports. Furthermore, the depreciation of the rupee is increasing the rupee cost of debt servicing that would also impact adversely on the fiscal outturn.

Increased fiscal deficit

These expenditure overruns and revenue shortfalls would increase this year’s fiscal deficit. The increase in public expenditure and shortfall in revenue are likely to expand the fiscal deficit to over 5 percent of the GDP. This would destabilise the economy and affect medium term economic growth.

As pointed out in this column last Sunday, this fiscal slippage is inevitable in the current political context when the government’s preoccupation is to gain votes. Such expenditure increases will not be confined to this year. It would continue next year which is the year for the parliamentary elections.

Not understood

Although, fiscal consolidation has far reaching benefits for the economy, the need for fiscal consolidation is neither understood nor appreciated by most lawmakers or the general public. Consequently, although the government’s fiscal strategy was to reduce the fiscal deficit and thereby the outstanding debt to a sustainable level over the medium term, the current spending spree of the government is likely to derail the fiscal consolidation process, destabilise the economy and slow economic growth.

Economic repercussions

The failure to achieve fiscal consolidation will undermine economic stability and economic growth, Much of the country’s  economic stability and performance rests on containing the fiscal deficit as a large deficit generates inflationary pressures, increases the public debt, distorts public expenditure, reduces export competitiveness and increases the trade deficit.

The large deficit is likely to increase inflationary pressures that increase the cost of living and causes severe hardships, especially to the lower end of wage earners. This in turn leads to higher wages that in turn increases the costs of production and erodes the country’s competitiveness in international markets.

The depreciation of the rupee is then necessary to remain competitive with other countries. Otherwise the lesser export earnings would increase the trade deficit that would be a strain on the balance of payments. Reduced export earnings imply loss of employment and lower incomes.

If the rupee is not depreciated to remain competitive the lesser export earnings would increase the trade deficit and strain the balance of payments. Reduced export earnings imply loss of employment and lower incomes to workers in export industries, such as garments, rubber goods and ceramics. On the other hand, the depreciation of the currency would ensure the competitiveness of exports but lead to further inflation and increased hardships to people.

Public debt

One of the serious consequences of a large fiscal deficit is that it increases the public debt that necessitates borrowing , which in turn leads to huge debt servicing costs. Sri Lanka’s large accumulated debt is the result of persistent fiscal deficits over the years. Debt servicing costs have risen to mammoth proportions that require the government to borrow to repay debt.

The massive crippling debt servicing costs distort public expenditure priorities and hamper economic development. Owing to the large debt servicing costs, the government is starved of funds for investment and social infrastructure development. Consequently economic development is severely hampered. Containing the fiscal deficit is of crucial importance for economic stability and economic growth.

Key to fiscal consolidation

The key to fiscal success is in ensuring that there are no cost overruns from the budgeted figures and that the revenue target of 17 percent of GDP is achieved. In the event that political pressures dictate new expenditures, these should be met by commensurate reductions in other budgeted expenditures.

The Central Bank cautions

The Central Bank’s 2018 Annual Report cautioned the government of the economic repercussions of a fiscal slippage. It said: “The sharp rise in government debt underscores the importance of the continuation of fiscal consolidation measures, particularly ahead of an election cycle. Any slippage from the envisaged fiscal consolidation path could result in an undermining of macroeconomic fundamentals thereby weakening the investor sentiment. This would intensify the refinancing risks of large debt servicing obligations due over the medium term. Major downside risks that emerged during 2018 include lower than expected revenue mobilisation, a notable moderation in public investment and a sharp increase in government debt, despite an improvement in the primary balance and the budget deficit.”

In conclusion

Fiscal consolidation is vital for economic stability and development. The paramount issue is whether government expenditure could be contained to not increase the fiscal deficit target by much this year.

Although governments should be concerned about economic stabilisation and long-run economic growth and have a strong resolve to achieve fiscal consolidation, it is too much to expect in a polity obsessed with success at elections. Electoral politics and fiscal consolidation are incompatibles.