Budget 2015 – financial profligacy and a gamble with the economy

by R.M.B Senanayake

The present budget for 2015 is a populist exercise which ignores the cannons of macro-economic prudence. It plans to disburse billions of rupees by way of salary increases to public servants and pensioners and giveaways to various sectors and groups of the public by reduction of indirect taxes and charges for services such as the charges for water and electricity despite the providers not covering their costs including replacement provisions. The VAT rate is reduced to 11% from 12%.The charge for water is reduced by 10% for the first 25 units and there is a reduction of 15% in electricity tariff to industries. Duty on the import of vehicles has also been reduced

Budget Summary

Total Expenditure is to increase from this year's Rs 1,922 billion to Rs 2,210 billion - an increase of 15%. Total Recurrent Expenditure is to increase from this year's Rs 1,386 billion to Rs. 1,525 billion - an increase of 12%. Total Revenue & Grants will increase from Rs 1,422 billion to Rs 1,689 billion. A Revenue or Current Account surplus of Rs 129 billion is shown although we have never had a Revenue Surplus for the last several years - a violation of the golden rule of budgeting which allows a deficit only for investment expenditure. The Primary Account which shows whether debt repayments are from tax revenue or from more borrowings shows a deficit of Rs 96 billion. But this conceals the fact that borrowing for debt repayments are outside the budget- a wrong practice introduced by former Finance Minister Ronnie de Mel.

Previously the practice was to transfer funds in the annual budget to a Sinking Fund which accumulated would provide the funds for debt repayment. This provision was removed to play down the budget deficit. But as pointed out by MP Vijitha Herath it understates the budget deficit as a factor in the macro-economic balance. He has stated that the budget deficit proper is Rs 1,300 billion. For economic analysis the budget must include all government expenditure and income and debt repayment is an expenditure properly charged to the budget. (Expenditure items which are permitted by special laws may not require parliamentary approval but that is for legal purposes and not for economic analysis).

The budget deficit must equal the total government borrowing to fund the budget. The total borrowing requirement is Rs 521 billion after deducting the debt repayment of Rs 202 billion. To ascertain the impact on the macro-economic balance in the economy it should be added instead and the deficit becomes Rs 521 billion plus Rs 202 billion or Rs 722 billion. The local capital market cannot provide the necessary borrowings and Rs 261 billion has been budgeted from foreign sources including foreign commercial borrowings of Rs 195 billion.

Burden on the private sector

The government budget has directed that the private sector should raise monthly wages of their employees by Rs 500 and also make a higher employer contribution of 14% to the EPF. These are burdens on the private sector which will be disincentives to the creation of employment and investment in the private sector which is the engine of productive growth in the economy.

Unwarranted populism against development needs

This profligacy of the government has no economic rationale. The tax revenue is inadequate and a developing country like ours should raise at least 14-15% of GDP as tax to provide the minimum services such as public administration, education and health. Development economists have estimated that to provide for growth at 4% per year requires that a country withholds from personal consumption about a quarter of national output or GDP. (Our personal consumption is a high 85% of GDP). About 12% of GDP is needed to provide an adequate framework for the Public Service Administration which includes law enforcement and the administration of justice. It also should include at least 3% of GDP on education, 2% on public health; 3% on economic services such as community agriculture and 4% on general administration. Vide Leading Issues in Development Economics by Gerald Meir pages 90-115.

Expenditure on the public services is just as necessary to promote economic growth as investment. Law and order, education, agricultural extension, public health, are foundations for economic growth as much as investment. But since our personal consumption is 85% of GDP there is only 15% left for investment. But based on an Incremental Capital Output ratio of 4.5 we need over 30% of the GDP to be spent on investment to maintain a growth rate of 7%. But our infrastructure investments are not generating a stream of returns to the government. So we need more foreign funds for our investment needs to maintain a growth rate of 7%.

Foreign funding needed for investment

Public investment which is a part of total investment has been budgeted at Rs 696 billion or 6.2% of the GDP. But this requires foreign borrowing of Rs 453 billion or 65 % of the total investment. So we are highly dependent on foreign borrowing to sustain our investment and a good part of it on foreign commercial borrowings at international market rates of interest.

We are already a highly indebted to foreigners. How much is high? The government quotes the foreign debt to the GDP ratio and says the previous government had much higher ratios ignoring the fact that much of such foreign borrowing was long term concessional debt. Economics does not provide a prudent ratio for public debt. Countries like Ireland faced a financial debt repayment crisis in 2008/2009 with a debt ratio to GDP of 60%. It depends on the composition of the foreign debt, the rate of growth of the foreign debt, the mobility of international capital flows and the export proceeds plus foreign exchange reserves of the country. International capital is highly mobile and foreign capital inflows to our stock and bond markets can flow out as fast as they come in. Prudence requires that our Foreign Reserves equal the aggregate short term foreign capital investments or 100% of such foreign short term liabilities. Our Foreign Reserves are short of this ratio, although it has gone up recently due to the accumulation of foreign exchange from the market by the Central Bank.

Budget deficit excessive

What has economics to say about the prudent magnitude for a budget deficit? Economics recommends for developed countries the balancing the budget over the business cycle.- a deficit ( which exerts an expansionary influence ) during the a recession and a surplus when the economy is operating at its maximum potential capacity ( which exerts a dampening influence on Aggregate Demand to ensure that Aggregate Demand and Aggregate Supply are equal for macro-economic balance.) According to IMF Studies the gap between our potential output and actual output is zero and hence any artificial expansion of Aggregate Demand will overheat the economy leading to higher inflation or larger current account deficits in the balance of payments which requires more foreign funding.

The IMF and the Economist Intelligence Unit estimates our growth rate at 6.8% and not the 7 or 8% touted by the authorities. To make the budget deficit of Rs 521 billion equal to 4.4% of the GDP the estimated GDP for 2015 is Rs 11,840 billion (seems excessive). The nominal GDP for 2013 was Rs 8,674 billion. It is expected to grow at 8% this year and if we add 4.5% inflation the nominal GDP for 2014 is Rs 9,758 billion. Assuming the same 8% growth and 4.5% inflation the 2015 GDP is Rs 10,977 billion. Since the actual budget deficit is Rs 722 billion then the Deficit /GDP ratio is more like 6.5%. Since there is no corrective action for reduction in the current account deficit in the BOP it will increase foreign debt aggregate and weaken the intrinsic value of the rupee (although the Central Bank is holding it steady). With money printing going on, the real exchange rate will be eroded damaging the international competitiveness of our exports and cheapening imports. The public sector borrowing requirement is running at 6-7% of GDP.

Macro-economic objections to the budget

There are serious macro-economic objections to the 2015 budget. What the president has done is make policy looser while increasing current account deficit in the balance of payments, the over-valued rupee and the heavy foreign debt repayments which require both rupee funding (excluded from the budget but borrowed from the banking system which is the printing of money) as well as foreign financing. Owing to the Central Bank policy of holding the rupee steady the anti-inflationary burden of the money printing is borne by the exporters. Further interest rates are held down by the Central Bank by money printing and dictating them to the banks.

The interest rate differential between the domestic and foreign interest rates in the source countries for our foreign capital inflows should provide for a risk premium on top of the source interest rate. With interest rates abroad poised to rise while our foreign debt repayment capacity is worsening, it calls for still larger foreign capital inflows by borrowing when our rupee is weakening in the market and our interest rates are low raising the likelihood of a foreign capital outflow.. The president is gambling with the economy with a vulnerable rupee and any disturbance in foreign capital movements may bring us to foreign debt default situation.
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