ISSN: 1391 - 0531
Sunday October 7, 2007
Vol. 42 - No 19
Columns - The Sunday Times Economic Analysis  

Vital to get economic fundamentals right

By the Economist

Last week’s column discussed how several favourable developments in the international finances of the country had failed to stabilise the exchange rate. The explanation we offered was that the weaknesses in the country’s economic fundamentals such as the large fiscal deficit, high rate of inflation, huge public debt and its foreign debt component were having adverse influences on exchange rate expectations. And these expectations themselves triggered a spiralling of self-fulfilling expectations. There is now evidence that the deteriorating economic fundamentals have had an effect on these expectations and were responsible for the continuing depreciation of the exchange rate.

Besides this, there were certain flaws in the Central Bank argument as well. The Bank said that the depreciation was unwarranted on the basis of several indicators. The Central Bank’s argument based on the Purchasing Power Parity (PPP) was misleading for quite a few reasons. The PPP estimates do not account for capital flows, both official and unofficial. And the PPP measure assumes that all goods are tradable when they are not. Therefore, to lump tradable and non tradable goods together is quite incorrect.

We are also not aware what base year or weights were used in the index numbers. Index numbers are susceptible to choice of base year, weights used and how inflation is measured. The indices used for calculating the rate of inflation too have many deficiencies. Many items in the index are subsidized even in the new index and the Colombo Consumer’s Price Index has been widely criticised as not being an accurate measure of inflation.

The current rate of inflation is affecting production costs quite severely. This could hurt the competitiveness of exports. Therefore, the depreciation of the Rupee may not be a bad thing for exports. In fact the increase in exports that were noted last week may have been assisted by what the Central Bank considers as an “over-shoot in the exchange rate”. Without it exports will become more uncompetitive, export growth will fail and GDP growth will be adversely affected. If the worry is that the depreciation is inflationary, then the Central Bank has to limit the rate of money growth and control inflation through primarily fiscal measures and secondarily monetary policy measures. Some would argue that the so called “overshoot” is not an overshoot at all on the basis of a number of criteria such as the differences in interest rates between Sri Lanka and the world capital market such as the relative growth in money supplies between Sri Lanka and its trading partners. If these are considered it may be arguable that the depreciation should be even more.

Of course a further depreciation of the currency would accentuate the other adverse effects that we are facing by the ballooning of import prices of a large number of import commodities of a basic nature such as bread and flour, milk powder and fuel to name a few among the essentials. Bread at Rs. 30 is an unbearable burden to especially urban poor households, while the flour price rise is a heavy increase in costs of living of estate workers who are bound to ask for more in wages soon.

Expectations play an important role. The exchange rate reflects the uncertainty in the exchange market. It is expecting the exchange rate to depreciate further and that is realized every time. What happens is what is expected. The issue then is why the market is expecting it. We know the answer. It is because of the public lack of confidence in Government policy to manage the economy including the fiscal deficit.

Yet the government and the Central Bank continue to hedge under the cover of a mirage of a high growth rate as indicative of the economy’s good health. However, the Central Bank has now lowered the 2007 growth rate from the previous 7.5 percent to 6 percent that was described by the Governor as a "slightly lower than seven percent" due to "constraints”. Notwithstanding this admission the economy was described as resilient and the 2008 growth rate upped to 8 percent. Presumably the “constraints” would disappear in the next few months.

In contrast, the multilateral agencies have pointed out the deteriorating state of the economy’s fundamentals. Recently the IMF drew our attention to the fact that the country had high and sustained fiscal deficits of around 8.0 to 9.5 percent of GDP for more than 10 years. It pointed out the large proportion of government spending that accounted for 35 percent of GDP in the past decade.

These weaknesses were by no means of recent origin. They have persisted over a long period and as the deficiencies increase their cumulative effects destabilize the economy and are dangerous. This is seen in the large accumulated public debt. The IMF has pointed out that Government debt has averaged 101 percent of GDP over the past five years far exceeding those of our neighbouring poor countries It pointed out that in Nepal it was 63 percent, in Bangladesh 49 percent and 85 percent in India. The IMF is of the view that Sri Lanka needs to slash state spending and contain the budget deficit as the national debt exceeds gross national production.

The large public debt burden now hovering around 100 percent of GDP, the high rate of inflation, the continuing large fiscal deficit and huge public expenditure on the war and other unproductive purposes are weakening the economy. It is these that are continuing to weaken the country’s exchange rate. There is no possibility of improving the fundamentals of the economy without the alignment of public expenditure to the levels of public revenue collection. The exchange rate depreciation is a warning signal of this. The optimistic forecasts of the economy are a red herring.

The bottom line is that the fundamentals of the economy are weak and would soon impact on the country’s production, trade and balance of payments. Yet some significant government spokesmen state quite boldly that the fundamentals of the economy are sound!

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