The Sunday Times Economic Analysis

The Sunday Times Economic Analysis By the Economist

War fears, rising oil price haunt economy
The uncertainties and fears expressed in this column last Sunday have turned into a horrific reality. The bomb explosion within the army headquarters is a shocking reminder to the country that we are on the verge of terrible calamities and terrorist bombings.

No doubt selected targets would include strategic economic targets, as had been the LTTE's practice before. We may in fact be on the verge of another period of war as the actions of the LTTE have clearly indicated that war, not peace, is what it wants.

It may be a last ditch effort, an action in desperation, a response to the international actions taken to ban them and make financing activities in particular difficult or some other internal issue or their carefully planned strategy to resort to terror acts once again. Whatever the reasons, war is at our doorstep. The realities of the emerging situation underscore the economic difficulties we noted last week to a greater measure.

It has been the nation's misfortune that we have not had and do not have a leadership that could tell the plain truth about the economy that we need sacrifices of "sweat, blood and tears". We do not have a leadership that can explain that the economy is in a week and unstable situation that requires unpalatable decisions that would involve hardships and sacrifices.
Instead we keep harking that exports have grown, the economy has grown by a fraction above the previous year's growth or that the economy is faring well considering adverse international economic developments or natural disasters.

All these are misleading interpretations of the country's economic performance. The realities are that the country is living beyond its means, that the trade deficit is progressively widening to alarming proportions each successive year, the foreign debt is increasing and, in tandem with it, the public debt is rising and absorbing a disproportionate share of government revenue. The budget deficit also keeps escalating despite assurances that it would be contained while economic reforms are being postponed. The medium and long-term prospects of rapid economic growth remain unrealisable under these conditions.

Sri Lanka's defence expenditure has been much higher than it could afford. The special circumstances of the civil conflict have been adduced as making such expenditure imperative.

In the last three years or so additional expenditure has been contained owing to the ceasefire. Now that open war is closer than ever, even irrespective of whether it would happen or not, the preparedness for it means huge military expenditure with high import content.

Now once again there is likelihood of increased and sudden increases in military expenditure. If these additional expenditure amount to around US$ 1,000 million, a likely prospect, it would be almost an unbearable burden on the balance of payments and would no doubt have to be financed by borrowings and deferred payment agreements.

This means that the foreign debt and public debt would rise to horrendous proportions making future development expenditure well nigh impossible. The additional fiscal deficit would destabilise the economy through the inflationary pressures that it would generate.

Containing these inflationary pressures through monetary measures means that tight monetary measures would cripple private sector investment. So resumption of war would indeed put the country's economy backward. The growth rate may remain good considering the statistical fact that war expenditure, however destructive, would add to the country's economic growth in the same way as graduate employment and public service salary payments did last year. Fighting a war requires sacrifices. The additional expenditure has to be borne by the people; economic hardships are inevitable. At the current levels of the trade deficit and the escalating oil prices the trade deficit is likely to surpass last year's record level of US $ 2.4 billion.

The magnitude of this deficit can be gauged by the fact that this is more than one half of country's foreign exchange reserves of 4.2 billion at the end of February 2006. The balance of payments deficit will however be of a much lower magnitude as remittances abroad and receipts from services and capital inflows could reduce it.

In fact at the end of February despite a trade deficit the balance of payments recorded a surplus of about US$ 100 million. There have been special reasons why the balance of payments turned surplus last year and into the first few months of this year. Some of these compensating items could be affected adversely. Tourist earnings could decline, there could be an outflow from portfolio investments and inflows for investment would dry up. Inward remittances from Sri Lankan's abroad that have continued to increase in the first few months of this year are likely to be the only stable source of financial inflows.

The resumption of foreign debt repayments and the repayment of the loans from Iran and India for last year's petroleum imports on credit would increase our capital outflows. There could be increased costs as well that could be serious for the country, such as surcharges on transport by foreign shipping lines and airlines and insurance surcharges. All these could further deteriorate the balance of payments, create pressures on the currency that would lead to a depreciation of the Rupee and increase import costs further thereby setting in motion further import-led inflationary pressures.

In these circumstances we need to act in a prudent and far-sighted manner. At the crux of the issue in the trade balance is the expenditure on oil. Since the price of oil is beyond our control, we have to control the volume of imports. This can be done only through higher prices to the consumer and an awareness programme of the need for people to curtail their expenditure on transport and electricity. These are difficult to achieve but high prices would have an effect on curtailing expenditure. It is here that there is need for political courage to face the inevitable unpopularity of higher prices.

An immediate energy crisis management policy is needed. In addition there would be a need for the curtailment of other expenditure. Wasteful and avoidable expenditure must be identified and curtailed. The lead must be given by reducing the cabinet forthwith to a manageable number. There may be a need to raise import tariffs on consumer imports to reduce import expenditure.

The emerging conditions require the adoption of emergency policy measures to cope with the crisis. Failure to do so would postpone the problems and aggravate the economic crisis. The current security crisis may put the clock back on economic growth unless countervailing measures are taken to at least mitigate its impact on growth.

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