Three fundamental issues in economic management

By the Economist

This column has for sometime focused on three fundamental issues confronting the economy-inflation, fiscal imbalance and foreign borrowing. These three issues have been understandably the focus of the latest State of the Economy 2007 report of the Institute of Policy Studies (IPS). The policy perspectives on these issues are indeed enlightening. They deserve to be extensively quoted for an understanding of these most critical issues in the economy. At least the first chapter on Policy Perspectives is mandatory for policy makers. As we near the end of the Budget debate these issues have a special relevance for parliamentarians who would be passing the Budget. They should be aware of the far reaching consequence of fiscal policy and the budget figures.

Inflation is indeed the problem that we are most obsessed with, perhaps more than even the war. The rate of inflation has reached a dangerous level of 20 per cent. Quite apart from the statistic quoted it is affecting the 'common man' more disproportionately than others. The Institute of Policy Studies warns that "Amidst such signs of a weakening in the macroeconomic environment, the predominant policy concern remains the risk that inflation may fail to moderate sufficiently." The State of the Economy 2007 Report contends that there are several areas of excess demand in the economy, many of which, we would argue, are due to the expansion in government expenditure beyond the capacity to collect revenue. The report blames these inflationary developments on the country's fiscal and monetary policies. It states that "The problems stem from the fact that Sri Lanka's recent economic expansion has been driven partly by relatively relaxed fiscal and monetary policies.

The fiscal deficit has been of serious concern and has been the underlying factor in causing many of the country's economic woes. Although the deficit was curtailed to 8.4 per cent of GDP in 2006, this was achieved by cutting back sharply on allotted capital expenditure. The quality of the government's expenditure is such that much of it is unproductive both in the short run and in the long. The report points out that "the borrowing requirement remained high. With the domestic financing burden rising to 5.8 per cent of GDP in the face of a progressive rise in inflationary pressures experienced since mid-2004, significant pressure was placed on the conduct of monetary policy." The increase in money supply in response to the increased demand has fuelled inflation. It argues that continuation of inflation is so harmful to the economy that monetary measures must be put in place to control inflation. In the words of the report: "an over modest response in the face of a progressive build-up of inflationary pressures carries its own risks. The most pervasive risk perhaps is that, in an environment of heightening inflationary expectations, monetary policy may need to be tightened more than in an environment of low inflationary expectations."

The report contends that the interest rate policy response was moderate in relation to the fiscal deficit. However, it must be recognised that the sources of the problem lie in the excessive government expenditure and that government expenditure requires to be reduced in order to make a dent on the problem of inflation. The capacity of monetary policies to curb inflation is limited and has adverse impacts on growth and development. Tight money policies affect growth and thereby generate inflationary pressures in the long-run. There is recognition of this when it says "Policy makers are understandably reluctant to choke off growth by raising interest rates too much at a time when Sri Lanka needs rapid growth to create jobs and reduce poverty." One should say that mindful of this they should curb government expenditure on the non-committed areas.

The issue of foreign borrowing has dominated the discussion of economic issues recently. The report draws attention to the dangers of accumulating a large debt, though admitting a role for foreign borrowing in the development process. It states that "foreign borrowings carry additional risks. Large amounts of external public debt, especially short-term un-hedged foreign denominated debt, can lead to greater financial risk exposure." It points out that "As the ratio of short-term debt to GDP increases or the debt servicing obligations increase, there will be more questions about the viability of rolling over existing external debt. While such risks are greater under fixed or pegged exchange rate regimes, governments operating under floating exchange rate regimes are also not immune to these risks: a loss in market confidence can trigger capital flight and exchange rate depreciation. Whatever the balance between domestic and foreign borrowing is opted for, the room for manoeuvre is limited."

Sri Lanka's total debt to GDP ratio remains high - at around 100 percent of GDP and the foreign debt component is nearly half of it. It warns that reliance on foreign loans to bridge the fiscal deficit is an option fraught with danger for the future. " Opting for foreign financing in the current climate of high domestic interest rates, and the absence of a deep and liquid capital market capable of handling domestic debt instruments without placing further stresses on interest rates, might seem an attractive option. In 2006, for example, the government raised US$ 680 million (by issuing 2-3 year maturity dollar bonds and raising a syndicated loan). Similar borrowings have been announced in 2007 too. In June 2007, the government called for proposals to raise US$ 500 million through bond issue to serve as a buffer fund for infrastructure development.

The three problems are inextricably connected but primacy of seriousness must be placed on fiscal extravagance that amounts to fiscal irresponsibility. That is the root of the problem. Unless public expenditure is curbed, there is no way in which monetary policy could cope with the inflationary pressures it unleashes without affecting growth adversely. When will the government be fiscally responsible?