Is the country bankrupt ? If so what is the hope of sustaining the growth rate?

Island - February 22, 2015

by R.M.B Senanayake

Earlier the Central Bank planned to go for another Sovereign Bond issue to repay the foreign debt falling due for repayment this year - the re-financing or roll-over of debt as was the practice of the previous regime. Perhaps this year with the fall in Foreign Reserves and the continuing current account deficits with no effective remedial action being taken, the authorities thought they would have to pay higher rates of interest. So now the new government has decided to go to the IMF for balance of payments assistance. The country was virtually bankrupted by the previous regime. 

Foreign portfolio outflows

According to newspaper reports Sri Lanka is expecting to tap the IMF for about $4.0 billion while additional funding is also sought from the World Bank. The previous IMF bail-out was $2.6 billion in 2009 and was due to the global financial crisis with foreigners exiting both the bond and the stock markets. A similar situation arose during the last month of the previous government. But the outflow from the government bond market has stopped. But it may not be so with the stock market. Foreign investors in the stock market have brought in their foreign money at the prevailing fixed rate of exchange and may fear there will be a depreciation of the rupee as a result of IMF conditionality.

The exit from the stock market may well continue since ours is not particularly cheap considering that the average Market PE ratio is 20 whereas it is much lower in other developing countries.

 In the second half of 2009, the country faced a similar foreign capital outflow which led to a drastic erosion of Foreign Reserves. The then government was forced to go to the IMF. IMF loans are intended to be a short term palliative and it demands measures by the borrowing government to put its house in order by cutting its budget deficit and depreciating the rupee. Ranil was forced to accept the IMF austerity measures and lost power. He is unlikely to repeat the experience. But what the IMF prescribes is the required medicine for our economic sickness. Avoiding the medicine and going for growth will still lead to continuing current account deficits and loss of Foreign Reserves. So it is difficult for the new Government to spend and invest to keep the people happy and also maintain the growth rate.

How governments become irresponsible

The problem with public debt is that governments that borrow impose burdens on other people - future taxpayers (many of whom don’t vote in today’s elections!) – who carry the obligation to repay.  As a result, governments tend to borrow excessively and to spend the proceeds carelessly as the previous government did.  The costs to society of the resulting misuse and misdirection of resources are not in the least reduced by the fact that the debt is held internally or externally. The assets created by the investments funded by the loans do not increase the value of the assets and make the country more creditworthy. The previous government took no corrective action for the continuing current account deficits in the balance of payments hoping that it would cure itself because the deficit was coming down. But in 2013 it was still too high at US$2,607 million.

Living beyond our means

 Our politicians have since Independence given the wrong message to the people. As Joan Robinson said, the Sri Lankans want to eat the fruit before even planting the tree. The then government introduced free rice, free health care and free education for all. But this meant an increasing burden with the annual increase in population. Soon the government did not have money to invest for development. It taxed the tea and rubber plantations heavily which led the foreign owners to give up re-investment in them. They also reduced the working week and gave a plethora of holidays oblivious to its impact on costs and output. But development comes only from hard work and involves austerity or postponing any increase in consumption for an increase in investment which will increase future production.

The looming debt crisis

According to available figures the Official Foreign Exchange Reserve is likely to have fallen below US$5 billion from  $7.5 billion about a year ago. There is continuing downward pressure on the rupee. The Central Bank is using artificial unorthodox tactics to keep it steady. But one reporter has queried whether such tactics will benefit the consumer for it will not prevent rising costs being passed to the importer as the banks will recover the higher cost of the rupee from the importer even if the spot market is repressed and they have to buy only in forward markets at the permitted rates. Exports have picked up recently but there is a long way to go. The terms of trade have also improved. But the Foreign Exchange Reserve is too low and will affect the interest payable on future sovereign foreign borrowings. So going to the IMF is a better option. But no amount of goodwill to the new government will make them change their conditions. If depreciation is to be avoided, alternative measures are required to limit imports and increase exports. Why did we have to import so many vehicles when our roads are congested and luxury vehicles at that?  

Reforms required

We need to become more competitive in global markets in our export products. That can be achieved only by a variety of policy changes, such as keeping company tax rates at sensible levels and regulatory reforms that would give companies more freedom to manage their businesses as they see fit, including, when necessary, closing plants and reducing head counts. That is the only viable path to sustainable growth and, ultimately, more jobs. The labor laws are an obstacle to such freedom. We see much talk of lower taxes, less regulation, and less government spending. But such policies could fit sensibly only in a framework of free enterprise and limited government. Limited government is something neither the people nor the politicians are willing to accept.

So it is time for the new government politicians to change their mindset of populism and concentrate on allowing the private sector to produce more and promote more exports to earn the foreign exchange to repay the foreign debt. Our Foreign Reserves are not enough to both fund the foreign debt repayment and also provide a cushion for imports. Promoting exports is difficult in the short run. The priority will have to be to cut down on imports. It will mean reducing economic growth but there is no alternative unless we can attract sufficient extra direct foreign investment quickly to cover the continuing deficits in the current account of the balance of payments. Foreign loans will not do. FDI requires speedy processing of foreign investment approvals by the bureaucracy. What is also required is to stem the erosion of resources by the public sector by stopping the corporations and government enterprises from continuing with their losses. If they can be privatized let them be privatized with minority stakes by the government. If not, let them be closed down. The redundant employees may have to be looked after.  If they have to be paid by the State they should be made to contribute to output. Why not ‘second’ them to work in o-operative societies and the private sector while drawing their salaries from the public sector.

Living beyond our means

We have been living beyond our means by artificially keeping down the exchange rate while pumping up aggregate demand through money printing by the Central Bank to fund the government to repay the foreign debt falling due for repayment. The government cannot afford to raise the money through higher taxes and the infrastructure investments are not producing returns - which are their fatal flaw. The government must look at ways and means to raise more revenue from these infrastructure investments of the previous regime. Fortunately the additional aggregate demand is not leading to higher inflation and unlikely to do so since the current account deficit in the balance of payments is having a deflationary effect. But the new government cannot afford to have either inflation or deflation which is worse. So it must keep the economy growing. How to do so? Not by public investment unless the funds are obtained from foreign investors. Public-Private Partnerships is the sole way forward to investment in infrastructure. While existing projects will have to be completed, the government has to find ways and means to attract such partnerships. Here the best option is to attract foreign direct investments.

We could promote entrepot trade. We could import raw materials and spices from Indonesia and process them here for export. It requires a review of our duty structures and customs procedures,  We could now offer storage facilities in the port of Hambantota for exports from the Far East to be sent to the Middle East and Europe. But nothing will happen unless we reduce the bureaucratic hurdles. We have to actively woo these countries and build our facilities to serve the regional production and service networks. The bureaucrats don’t understand trade. So any such program must be directed by private sector personnel who know markets. Some of the big names in the private sector themselves have not much experience in markets and how they operate. It is the smaller companies in trade which are dynamic and could take us further. But they are generally looked upon with suspicion by the customs if they seek to take advantage of a market opportunity.