Recent developments in the economy must be confusing to many. The impression is that the Sri Lankan economy is faring well with a high growth rate of 8 % last year and a similar economic growth rate expected this year. With a boast of being the second hihest growing economy in the world gripped by economic slowdowns, especially in Western economies, could there be an economic problem?
In contrast, the country is facing a huge trade deficit and balance of payments crisis.
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The trade deficit for 2011 is likely to be about US$ 10 billion. It is expected to grow to as much as US$13 billion this year. The unprecedented widening of the trade gap is mostly due to import expenditure escalating. The Central Bank has not considered it a problem owing to expectations of higher remittances, foreign direct investments, tourism earnings, other service receipts and capital inflows. It has till recently characterised the problem as a temporary one that would be resolved by favourable developments during the course of the year.
According to the Road Map presented by the Governor of the Central Bank of Sri Lanka (CBSL), despite the huge trade deficit, the Balance of Payments is expected to record a surplus of around US$ 825 million in 2012. Although the trade deficit is likely to expand further this year, the Central Bank expects it to be cushioned by earnings from tourism projected at US$ 1.2 billion, worker remittances projected at US$ 6.5 billion and foreign direct investment (FDI), projected at US$ 2.0 billion. The Central Bank also expects high net inflows both to the government and private sector on account of long-term debt obtained mainly for projects.
The net foreign assets of the banking system are expected to increase in 2012. These were expected to “make a positive contribution to the financial system stability, support the continued expansion of domestic economic activity and create a favourable investment climate in the country, which will, in turn, augment the country’s growth potential.”
The monthly CBSL statements on external finances were optimistic to the extent of ignoring the emerging balance of payments crisis. In its statement on the external finances situation in October 2011, it said: “The expansion in exports of services and increased workers’ remittances helped contain the impact of the trade deficit, thereby mitigating the deficit of the current account to approximately US$3,253 million for the first 10 months of 2011. Furthermore, CBSL pointed out that “gross official reserves had reached a historically high level of $8,099 million by end July 2011 as a result of the Central Bank accumulating high reserves over a period of time thus avoiding fluctuations in the domestic foreign exchange market.”
The statement also admitted that: “A part of such reserves have now been utilized to deal with any pressure on the exchange rate due to increased demand for imports arising mainly from petroleum and investment goods. Total external reserves which includes gross official reserves and foreign assets of commercial banks, also increased to $8,136 million by end October 2011 from $8,035 million by end 2010.”
In its statement of the external finances situation of November 2011, the CBSL said: “The expansion in exports of services and increased workers’ remittances helped contain the impact of the trade deficit, thereby sharply reducing the deficit of the current account to approximately $3,999 million for the first eleven months of 2011. Inflows on account of short-term foreign financing obtained by commercial banks and funds to be secured from abroad as Tier II capital of banks are expected to further strengthen inflows to the country, as noted by the fact that banks have already contracted $490 million as short-term facilities extending up to one year. Meanwhile, several banks have also already negotiated Tier II capital which could potentially reach about $1 billion this year.”
It disclosed that by end November 2011, total external reserves, which includes gross official reserves and foreign assets of commercial banks amounted to $7,541 million and said it was a comfortable position as it was adequate to finance about four months imports.
These statements conveyed the impression that the country was not facing a problem in its external finances. Meanwhile the widening trade deficit required the Central Bank to defend the fairly static exchange rate by selling dollars and depleting the reserves. Commentators were drawing attention to the widening trade deficit and balance of payments problem, and the impending foreign exchange crisis.
The Treasury was at variance with the Central Bank and an unexpected shock came with the devaluation of the Rupee by 3 % in the Budget. A move that the Central Bank Governor was apparently not aware would be taken. Even this move was inadequate to stem the outflow of dollars. The Central Bank expended nearly $1.5 billion since the budget to defend the value of the Rupee. All together it appears that the Central Bank expended over $2 billion of the reserves to defend the Rupee.
Apart from this huge loss of reserves, exports were adversely affected by the overvalued exchange rate, while imports were continuing to increase. In these circumstances speculation that the exchange rate would depreciate further would lead to withholding of remittances, export earnings and other inflows. Sooner the exchange rate is brought in line with the realities of the trade situation the better.
The IMF mission that evaluated the country’s economic performance recently said that the economy was on a high growth trajectory despite global challenges. It was satisfied with the economic growth of 8 % last year and expected the economy to grow by about 7 % this year. It interpreted several developments in the economy, such as the widening trade deficit, as being due to the post war booming conditions.
The drawing of the remaining $800 million tranche of the $2.6 billion standby agreement was left to the government. It is very important that the $800 million of the standby facility is utilised to replenish the reserves. The continuing commitment of the IMF would add international confidence. Besides this, it is at a comparatively low interest rate of 4 % at which the country cannot expect to borrow from international markets. Contrary to earlier assertions that borrowing the additional amount would raise the overall interest rate to 4 %, this higher interest rate will apply to only this tranche. The interest rate on the earlier $1.8 billion would be less than 2 %.
What stance the IMF took in its discussions with the government is not known. Their real assessment of the situation of the economy has to be gathered from what is in-between the lines, the qualifications in the statement and the actions that follow. One clear indicator was that the Central Bank allowed the Rupee to depreciate and this may be an indicator of the Central Bank changing its policies and adopting a more flexible exchange rate policy. Together with this change was an in increase in the Bank policy interest rates and instructions to banks to raise their interest rates, especially for consumption purposes. A higher interest rate regime is on the cards.
The IMF Staff Mission Head Dr. Brian Aitken said. "Sri Lanka has been growing rapidly and our broader view is that it will continue the strong growth. We feel the economy is growing very strong and inflation is under control. However, the widening of trade deficit and more rapid credit growth are two key areas of concern." The IMF said the economy continued to expand rapidly in 2011, with growth likely to come in around 8 % and inflation continued to moderate to solid mid-single digit levels.
However, the IMF assessment was not without a subtle qualification as it referred to the weak economic fundamentals and the need to change economic and financial policies. The IMF comments were couched in discreet ways demonstrating its diplomatic stance. It said that Sri Lanka’s economy will grow rapidly despite the slow global growth. However commending the policy decisions taken by the government to address economic fundamentals in going forward, was the IMF’s way of indicating that the economic fundamentals were weak. It has therefore impliedly suggested that the exchange rate be depreciated, interest rates increased and measures taken to curb demand. In brief, this would be a reversal of the stubborn policies pursued by the Central Bank of not allowing the currency to depreciate and not increase interest rates.
The IMF interpreted the trade deficit as being due to the post war consumer environment and said “it is a challenge to the economic success.” A challenge in IMF terminology it appears is a problem. It is quite clear that the country is facing a severe trade imbalance that has been leading to a balance of payments deficit, pressure on the currency and the depletion of foreign exchange reserves. No doubt the IMF is correct that the trade account is a “challenge”, more correctly a serious challenge. This is why Dr Aitkin said “The country needs to make a qualitative shift in policy direction,"
The seriousness of the situation in the external finances was implied in the IMF statement that said that “The monetary policy should bring about sustainable current account deficit. The deficit reduction efforts will tighten credit growth while more flexible exchange rate is important. The policy stance to devalue exchange rate by 3% is a step in the right direction.”
Elaborating further he said "We like to see monetary, fiscal and exchange rate policies supporting the country going forward with right economic fundamentals. We stand ready to support the government and looking for policy actions on sustainable basis to limit the credit growth."
The policy prescriptions indicate the prognosis. It is good bedside manners for doctors not to tell patients the seriousness of the problem. Yet insist on following the prescription. The pursuance of the appropriate exchange rate policies, monetary policies and fiscal policies are vital to ensure economic stability and growth. The trinity of economic policies should be consistent with each other and the entire thrust of polices should support each other. The depreciation of the currency is but one of the means of correcting the trade deficit to manageable proportion. Higher interest rates, somewhat selectively applied to curtail imports and containment of the fiscal deficit, are crucial to avoiding a continuing widening of the trade deficit that would cause a severe strain on the balance of payments and an erosion of foreign exchange reserves. The curtailment of the fiscal deficit should also go in tandem with measures to control public expenditure that restrains imports. This is especially so with respect to oil imports that is the single most import expenditure.
The expectation of larger amounts of remittances, foreign investment and tourist earnings cannot bridge the massive trade deficit that may arise if appropriate policies are not adopted. While these may increase they would be quite inadequate to bridge the huge trade deficit that is likely this year. Besides, balancing the trade deficit through capital inflows ignores fundamental reasons for the trade imbalance. The government should not take comfort in these inflows contributing towards reducing the balance of payments deficit and not take remedial measures to correct the trade imbalance. It is important that realistic exchange rate policies and increased interest rate policies be adopted to ensure a healthier export performance and reduced imports.
(The writer is the Sunday Times’ specialist on economic issues). |
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