How sustainable is our growth momentum?

by R.M.B Senanayake

We have been having good growth rates over 8% in 2010 and 2011. But as the economy overheated the authorities took corrective action and the growth rate came down in 2012 to 6.3% but recovered to 7.3% in 2013. The Government is predicting 8% growth in the future as well.

What drives this growth?

It is government expenditure, private consumption which is 85% of Gross National Expenditure and the foreign remittances from our migrant workers abroad. Private household consumption has weakened as the real incomes of the people have been eroded by higher prices with static nominal incomes. There was a significant improvement in the Terms of Trade in 2013 from a negative of 1.5% in 2012 to a positive 6.7% in 2013, which improved the Current Account balance in the balance of payments from negative of $3,982 million in 2012 to a negative of $2,607 in 2013. The expected fall in world oil prices should help further. But as against this improvement the debt profile has worsened. The Debt Service ratio as a percentage of total current receipts has worsened from 13.6% in 2012 to 17.6% in 2013. But total external debt and foreign liabilities as a percentage of the GDP improved   from 62.5% to 59.2%. It is not clear whether this includes the private sector foreign debt. Of course this debt ratio is no guarantee that we can service the foreign debt since Russia defaulted on its foreign debt in 1998 when its debt ratio was 50%. Our Gross Foreign Reserves have increased but they still do not cover the short term foreign debt and short term foreign liabilities of the banking system.

Investment

It would be an over-simplification to regard economic development as a matter of capital accumulation although it does play a key role in development. Capital accumulation requires that people should first save from their income. Since their incomes are low people cannot save much. Yet countries such as India and China save about 30-50% of their GDP whereas we save only about 20% of our GDP excluding the remittances received from our migrant employees abroad which go largely for consumption. This is not adequate to maintain a high rate of economic growth. How much investment do we need to have high growth rates? Economists use the concept of a Capital/Output ratio to determine how much investment there should be in an economy to produce a given rate of economic growth. If it is 4.5 then it takes 4.5 units of capital to produce one unit of extra GDP. If the rate of economic growth is to be 8% then the capital investment in the economy must be 8 x 4.5=36%. But our private sector investment which was 23.7 % in 2012 fell to 22.7% in 2013. Government Investment has remained unchanged at 6.9%, but the total of 29.6% fell from 30.6% in 2012. This amount of investment is not adequate to maintain 8% growth.

Dependence on Foreign Finance

The Government investment was funded largely by foreign finance.  We must therefore obtain foreign funds to carry out even the present level of public investment. Foreign funds could be by way of equity in companies or as loans to the government and business. The former would mean direct foreign investment into the private sector. Its advantage is that the foreign investor will not repatriate his capital in the short run. He may have invested the money in land to put up factory buildings or to install machinery and equipment for production. Such direct foreign investments don’t require repayment like loan capital. Of course, the foreigner can sell his investment and repatriate his money plus profits. It is different with regard to foreign loans whether obtained by the government or the private sector. Whoever borrows in foreign currency must also repay such loans in foreign currency.

If the borrower is in a business which is earning foreign exchange it can be reasonably sure of repaying the loans in foreign currency. But the government or the banks which have borrowed in foreign currency have to depend on the foreign currency earnings of the country to repay foreign loans in foreign currency. So the question of how prudent it is to borrow in foreign currency arises. Will there be sufficient Foreign Exchange Reserves to repay the foreign loans of the government and the banks? Foreign Exchange Reserves may be earned by way of exports or from remittances of migrant workers or they may be borrowed. But any borrowed foreign exchange reserves have to be repaid unlike earned foreign reserves.

The Central Bank buys from the market the foreign exchange received by way of exports or foreign remittances and adds to its Official Foreign Reserve.   The adequacy of the Foreign Reserve will have an impact on the ability of the government to borrow in the future. So far the foreigners have lent money to the government on its Sovereign guarantee. But the government will need to borrow every year to repay the foreign borrowings falling due for repayment each year. It is a vulnerable situation for the country. Since the cross-over of Minister Maitripala Sirisena the stock market has fallen and may stabilize lower or continue to fall. If the foreign investors in the stock market sell out their shares and repatriate their funds there may be a drain on the Official Foreign Reserve.

Dependent on foreign borrowing for ever more

We cannot give up foreign borrowings for the foreseeable future. This is partly to repay debts falling due for repayment. But to continue public investment at the same level we also need to borrow afresh. This is because our domestic savings is inadequate to maintain the level of investment required to maintain the growth required. So whether we can have sustainable growth and repay debt depends on our capacity to borrow from foreigners into the future. How much foreign capital inflows can we expect? In developed countries such capital inflows are around 60-70% of GDP. Both China and India receive substantial amounts of direct foreign investment. But we have failed to attract foreign capital to any significant extent.

Whatever foreign capital inflows we get are from foreign governments like China and from international lending institutions by way of loan capital. An important factor we are overlooking is the need for domestic savings. Economic growth at 4% over two years requires that a country withholds from personal consumption about a quarter of national output or GDP. Our personal consumption is 80%. so only 20% is available for investment. 12% of national output is needed to provide an adequate framework of public service. But the government must also spend about 3% of GDP on education (not the 6% demanded by the University Lecturers); 2% on public health; 3% on economic services such as agriculture and 4% on General Administration. All this costs another 12%.  These are as much necessary for development as investment to increase production. So the current 20% excess over consumption is not enough for our development demands on the budget. We need another 5% at least which requires a reduction of consumption by the same amount.

The crucial question is what amount of net National Output may be set apart for investment to be made in the economy. It is based on the Incremental   Capital Output ratio as referred to above. There is also the question of the gestation period for an investment to produce results or returns. The gestation period may be one year or several years. Our infrastructure investments have so far failed to produce results.

Investment yields also differ depending on the industries in which they are made. What is the practical maximum rate of investment? Economists refer to the absorptive capacity of investment which depends on the availability of local resources such labor supply, the level of technical and managerial skills in the economy.  It also depends on the efficiency of the Public Administration and the "technical mindedness" of the people. These capacities limit the amount of efficient investment physically possible. We are short of both technical engineering capacity as well as managerial capacity. In fact after 1956 we have lost the managerial capacity we had earlier. This loss is due to the interference of politicians in the operational activities of the government departments and organizations. We today lament the loss of good governance. But the conditions for good governance no longer exist. The Common Opposition candidate seems to have realized where the problem lies and wants to restore the 17th Amendment. Yes, unless that is done we cannot have good governance for unlimited power inevitably leads to abuse.

How sustainable is our foreign funded growth rate?

As the Economist magazine says "when economies are on an unsustainable course, international finance often acts as a fast forward button, pushing countries over the edge more quickly than politicians or investors expect" (Economist November 22nd page 11)

It has been suggested many times by economists that governments need to have two separate budgets: a standard one that reflects annual running costs which is to be paid out of taxation and an investment budget where debt is paid back from longer term returns on infrastructure, education, industrial policy and so on. So projects are included in our budget without adequate consideration of their costs and returns, which are often to be evaluated by a Ministry of Planning. So projects are included for political expediency rather than for the cost/benefits.
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