|
||||
Central
Bank printed new money Macro
imbalances The budget to be presented in a few days is no exception. The set of macroeconomic imbalances that we face today is a textbook example for students reading economics. It illustrates how a change in a single macroeconomic variable affects all other variables, and disturbs the entire economy pushing it towards disequilibrium. For example, let us consider the effects of the recent petroleum price hike. It led to an increase in import expenditure resulting in a widening of the trade deficit, and depletion of the country's foreign reserves. What happened after that? With the decline in foreign reserves, the exchange rate began to depreciate at a faster rate. As a result the cost of imports, in rupee terms, rose pushing up the general price level of consumer goods. This meant a rise in inflation. High inflation is usually associated with wage demands from the trade unions as evident now. High oil import costs also led to a rise in government expenditure, because of the subsidies paid to the Ceylon Petroleum Corporation and the Indian Oil Corporation. The oil subsidy is said to be over Rs. 8.5 billion in the first eight months of this year. These subsidies, on top of other expenditure items, widened the budget deficit. The government is compelled to depend heavily on bank borrowings to finance its rising deficit. This is called inflationary financing because such borrowings bring about a rise in the money supply creating "demand-pull" inflation. What are the policy options available to deal with the macroeconomic imbalances that I outlined above? These days, we hear various policy recommendations coming from various quarters. As a solution to the depletion of foreign reserves measures like high tariffs, import controls and margin requirements on LCs are recommended. In fact, some of these measures are already implemented; import duties have been raised for about 100 non-essential items and margin requirements for motor vehicle imports were reintroduced. It is reported that certain taxes would be raised to deal with the budget deficit. Meanwhile, some politicians and policy makers contemplate traditional policy measures like price controls and rations to combat price increases. At the same time, election pledges like public sector pay hikes and employment are to be fulfilled. Can the government meet all these demands in the context of the current macroeconomic imbalances and slow economic growth? I will address these issues in the following sections. Inflation
The inflation rate, which declined in 2002 and 2003, began to rise since early this year. In October, point-to-point inflation rose to 12.1 percent and the average annual inflation was 6.1 percent. By the end of this year, the average inflation is likely to be more than 6.5 percent. The oil price hike is a major reason for the high inflation. However inflation would have gone up even without the oil price increase, as inflationary pressures were building up due to faster money growth emanating from the fiscal deficit. This year's budget deficit would go up to over 8 percent of GDP. This is a reversal of the downward trend experienced in the previous two years. Fuel subsidy and other welfare measures are a major contributory factor for the high fiscal deficit. As already mentioned, bank borrowings are used to a great extent to finance the budget deficit. The Central Bank bought Treasury Bills to prevent a rise in interest rates. The Central Bank's Treasury Bill holdings went up to Rs. 64 billion in October from Rs. 7 billion a year ago. To that extent the Bank printed new money. The broad money supply has gone up to nearly Rs. 800 billion by last August reflecting an increase of about 17 percent compared with August 2003. What are the effects of inflation? The impact of inflation is immediately felt by fixed wage earners and they agitate for high nominal wages. Although the ruling coalition promised a 70 percent salary increase during the election, it is not that easy to grant it. The salary bill of the government for 2004 is around Rs. 105 billion, which accounts for about one fourth of total government expenditure. Based on rough calculations, a 10 percent salary increase will cost the government about Rs. 10 billion more. Obviously, a 70 percent increase is seven times that amount. Unless revenue measures are taken to compensate for such an increase in expenditure, the fiscal implications would be severe with such a salary increase. Foreign
trade deficit Imports rose by 20 percent and exports by 8 percent in the first eight months. As a result, the country's foreign reserves declined from $ 3.2 million in December 2003 to $ 3.2 million in last August. Gross official reserves are down from $ 2,329 million in December 2003 to $ 2,069 million in August. These are sufficient to finance about 3 months' imports. CB
and exchange rates Thus, the equilibrium exchange rate is largely determined by demand and supply forces in the foreign exchange market. I am not going to discuss the pros and cons of this system which were covered by my earlier article that appeared in the Sunday Times of February 11, 2001. What I want to stress here is that it is difficult to accept the theory that officials of the Central Bank could deliberately depreciate or appreciate the currency at their will in a floating exchange rate system. In an open and free-market economy, the exchange rate reflects the trends of exports and imports, and the resulting ups and downs of foreign reserves, rather than the whims and fancies of a few individuals. The conventional wisdom is that a depreciation of the currency boosts exports, because exporters get more earnings, in local currency terms, than before. But the concomitant inflation siphons off any gain derived from the depreciation of the nominal exchange rate. This is exactly what happened in Sri Lanka in recent times. The Real Effective Exchange Rate (REER) has not depreciated, in spite of the substantial depreciation of Nominal Effective Exchange Rate (NEER). Conflict
between policies If the capital account of the balance of payments is open, low interest rates lead to capital flight. But the Central Bank keeps its policy rates (repo and reverse repo rates) unchanged so as to prevent any rise in market interest rates. A main reason might be to avoid a rise in interest commitments relating to the public debt. Meanwhile, the monetary authorities should have taken action to curb money growth so as to arrest inflation. But the Central Bank could not do so, as it had to accommodate government borrowings by buying Treasury Bills. This has led to a further increase in the money supply fueling inflation. These developments remind us of an old story - the conflict between monetary and fiscal policies. This conflict usually aggravates when fiscal deficits are larger. In the circumstances, it is questionable, whether the Central Bank could stick to its 'inflation targeting' policy that was initiated some time ago. Also the government would find it difficult to comply with the Fiscal Responsibility Act. Growth-oriented
policies needed The country is unable to sustain a high growth path. Around 4-5 percent of growth has been the norm in the post-liberalization period. The economy seems to have reached this growth even without any proactive intervention by the government. But the country fails to reach a growth rate above this trajectory. The reason is the failure to expand the country's Production Possibility Frontier. A country's economic growth depends on its ability to expand production by utilizing its available resources (human, physical and natural capital) and technology in an optimum manner. Nowadays, productivity improvements, backed by technology and innovation, are considered as the key sources of economic growth. In that context, investment is crucial. The investment rate should go up to about 35-40 percent of GDP to achieve 6-8 percent GDP growth. For this purpose, investment climate needs to be improved. Various economic and non-economic factors influence a country's investment climate. They include policy uncertainty, corruption, legal system, crimes, tax administration, financial sector, infrastructure, and labour regulations. Needless to say, Sri Lanka is handicapped by many shortcomings in each of these dimensions. People-friendly
Budget? Who is going to bear these additional costs? Somebody will have to pay for them, as "there is no free lunch". The government will have to meet the additional expenses by raising taxes and/or printing new money. Both measures will lead to accelerate inflation. In the short-run, it may be possible to provide relief through such means. That is how relief to masses have been provided by most governments since independence. As a result, both economic growth and stability have been adversely affected over the decades. There should be political will and courage, at least now, to face the reality and adopt corrective policies to move forward the country in the highly competitive and fast growing global economy. Otherwise, a people-friendly budget may soon become unfriendly to the people as in the past. (The above is an abstract of a lecture delivered by the author at a recent seminar on 'The State of the Economy' held at the auditorium of the SLAAS .) |
||||
Copyright © 2001 Wijeya Newspapers
Ltd. All rights reserved. |
