A child’s guide to IPS’s ‘State of the Economy 2021’ report

Governments have got the central banks to lower interest rates so that they could borrow money at a cheaper cost. SOE-21 says that that action can be justified due to the enormity of the problem faced by these countries. But if it is continued excessively without an exit timetable, it would build indebtedness, pressure for prices to increase, and a serious imbalance in the economy. For poor countries like ours it is like holding a tiger by its tail. When the grip on the tail is loosened, the tiger can turn back and swallow us

Aseni, the whiz-kid in economics, has come across a copy of the latest ‘Sri Lanka: State of the Economy’ report by the Institute of Policy Studies, better known as IPS, on the state of the economy of Sri Lanka in 2021. She has found the issue contains a valuable and enlightening analysis of the economy from an independent point. She discussed the revelations of the report with her grandpa, Sarath Mahatthaya, an ex-officer of the Ministry of Finance. Following is the dialogue between them:

Aseni: As usual, IPS has issued its report on the state of the economy in 2021 well before the end of the year. I remember you telling me that IPS reports are independent analyses of the state of the economy, even though it is a Government institution. What do you think of the report for 2021?

Sarath: There are three comprehensive reports on the state of the economy of Sri Lanka by three different agencies. The Central Bank releases its report for the year before end-April of the following year. The Ministry of Finance does it through its Annual Report which is normally issued by the middle of the following year. It is the IPS which is the early bird in this game. It usually releases its report on the state of the economy in October, before the Government presents its annual budget for the following year. As such, the Minister of Finance has the advantage of knowing about the economy from an independent source through this report. 

Besides, IPS has its clientele mostly outside Sri Lanka. Hence, it is a report addressed by scholars to scholars. For ordinary people to understand it, somebody has to write a commentary, like the Atuwa or Teeka, that had been written by subsequent Buddhist scholars explaining to laymen exactly what the Buddha meant by his different Suttas. 

Aseni: Good point Grandpa. I also find some arguments and analyses are too much for me to comprehend, though I am a student of economics. Let’s demystify the IPS’s ‘State of the Economy in 2021’.

Sarath: IPS always publishes its ‘State of the Economy’ report under a theme of current interest. Two years ago, it was on how Sri Lanka should transform itself to the Fourth Industrial Revolution which people have coded as 4IR or Industry 4.0. Last year, its theme was disruption caused by the COVID-19 pandemic and how the economy could be revived. This year’s issue is an extension of the same theme but in much more detail. It focuses on pandemics in general and how policy should be geared to protecting health and promoting economic recovery.

As a result of this pandemic, Sri Lanka has been very badly hit socially, politically, economically, culturally, and of course spiritually. The COVID-19 pandemic is attacking Sri Lanka as well as the global community in wave after wave. After each successive wave, the country’s progress is pushed a few steps back. Hence, it is the most crucial issue the country is facing today, and IPS has aptly selected that issue as its theme this year.

Aseni: Does that mean that IPS has spoken of only the pandemic? Has it not focused on other crucial economic issues the country is facing today?

Sarath: No. To its credit, this year’s report which we can call SOE-21 has presented a fine analysis of Sri Lanka’s economic performance, main issues, outlook for the year as well as for the future and how the country has been affected by the economic conditions emerging in other countries. These issues have been covered in the first three chapters of SOE-21. 

Aseni: Wonderful. Let me look at. Yes, this first chapter is an outline of economic policies which the country should adopt to come out of the present crisis. It says that, despite the good news of a fast economic recovery globally, there is bad news that that recovery is not even or not attained equally by rich countries and countries like ours. It says that the reason behind this uneven recovery is due to differences in access to money. What does it mean, Grandpa?

Sarath: Well, to have a fast recovery from any economic crisis, what is needed is the use of physical resources at a faster rate. During the times of ancient Sri Lankan kings, this was done by a command of the king. If the king commanded that you should come and rebuild this dam, all had to obey him because punishments were severe. But in modern money economies, resources are not mobilised by such commands of the government. For that purpose, people should be given incentives through monetary rewards. 

In that context, the countries which have money can have a faster recovery than the countries which do not have money. Since it is the government which has to spearhead this recovery program, finally it boils down to the financing ability of the government. That ability comes from the ability to tax, ability to borrow, or ability to print new money without causing inflation. Rich countries have been blessed by all these abilities, while poor countries like ours have not been. That is the reason for uneven recovery. 

Aseni: Oh I see. It is like how a man with good physical fitness can recover faster from an ailment than a man without. What this means is that a country should have enough space to operate in a pandemic like this. I think that that space comes from good fiscal policy in the past, an independent central bank which has tamed inflation, and the ability to act quickly by favourably combining the fiscal policy with that of the central bank. This is what we are lacking, aren’t we?

Sarath: SOE-21 has analysed this from a global perspective because the methods used by different countries to gain a quick recovery have been a combination of all the above three options in varying degrees. But they have created unexpected new issues as well. Since there is an economic downturn due to the pandemic, additional taxation to raise money is out. Hence, countries have used their borrowing and money printing powers to get the needed money to cause those physical resources to act faster. 

Governments have got the central banks to lower interest rates so that they could borrow money at a cheaper cost. SOE-21 says that that action can be justified due to the enormity of the problem faced by these countries. But if it is continued excessively without an exit timetable, it would build indebtedness, pressure for prices to increase, and a serious imbalance in the economy. Rich countries can face them without serious risks to their economies because they are the issuers of currencies which others use as their foreign reserves. But for poor countries like ours it is like holding a tiger by its tail. When the grip on the tail is loosened, the tiger can turn back and swallow us.

SOE-21 says that it would mean high inflation, depreciation of the exchange rate, and an increase in the cost of repaying the public debt. This is specifically relevant to Sri Lanka because it has already lost its ability to raise taxation, its borrowings are mounting, and high rate of printing money has caused domestic inflationary pressures, on one side, and put pressure for the exchange rate to depreciate in the market. Therefore, converting Sri Lanka’s low economic recovery in 2021 to sustained high growth in the long run is challenging. 

Aseni: Critics have said that our Central Bank has adopted a strategy of printing more money by following a policy recommendation promoted by a breakaway group of economists who call themselves modern monetary theorists. Strangely, SOE-21 has not referred to this element in the Central Bank’s policy action. What is the reason for this?

Sarath: Adoption of this new policy framework called Modern Monetary Theory or MMT has been hotly denied by Sri Lanka’s policy authorities. Hence, it is not something officially recognised. But the analysis in Chapter 2 of SOE-21 provides ample evidence that Sri Lanka has been following MMT, though it has not been explicitly mentioned. It says that the low interest rate policy has killed the private savings which have increased in nominal terms but remaining stagnant in real terms after inflation is taken out. This is due to the inflation rate exceeding the average deposit rate yielding a negative real return on savings, the common income of average savers in Sri Lanka. But it has helped the Government to borrow at a cheaper cost, mainly from the Central Bank. Though this leads to the expansion of the money stock, SOE-21 says that it is guided by a notion that sovereign governments can create and print their own money. 

This is the fundamental premise of MMT which has been cogently propounded recently by Stehanie Kelton in her 2020 book published under the title ‘The Deficit Myth’. Though desperation might compel a country to resort to this tactic, the people do not view it as a sustainable policy. They have experienced that such policies introduced as emergency measures are eventually converted to permanent policies. To prevent that, SOE-21 argues that strong institutions should be there as a safeguard. What it means as strong institutions is the presence of an independent central bank which is in a position to tell the government that the party is over, and it should go back to a system of conventional fiscal policy based on tax revenues and productive spending of limited resources.

Aseni: So, the Central Bank instead of becoming a collaborative partner should have courage to tell the Government that more prudent policies should be adopted once the initial shock of the pandemic has been tackled. But the former Central Bank Governor, W.D. Lakshman, is reported to have said that since the Central Bank is a Government institution, it should always toe in the line of the Government. Is there any validity in that statement?

Sarath: It is most unfortunate that Governor Lakshman has said so in public. Perhaps he may have mistaken the Government for the State. The Central Bank is owned by the State and not by the Government, which is only an arm of the State like the Central Bank. Hence, both are required to work collaboratively to deliver the best to the nation. What it means is that there should be a proper balance between the Government’s fiscal policy and Central Bank’s monetary policy. If this balance is not maintained, there will be undue consequences. 

SOE-21 has put this in scholarly language, and I will read it for you. It says that ‘under these conditions, the moment firms, workers, and markets doubt the sustainability of a country’s monetary and fiscal policy mix, the scepticism can generate volatility and instability across the macroeconomic front’. What it means is that the Government and the Central Bank can fool themselves but not the people out there.

Aseni: I think it is a serious warning which the SOE-21 has delivered to the Government which it should not ignore. But I find that the new Governor Ajith Nivard Cabraal has been gradually dismantling the Lakshman era contractionary policies. Drawing a parallel from cricket matches, he has said that four wickets have already fallen and now it is duty of the Central Bank to play the game while preserving the remaining matches. I think it is a good sign.

Sarath: It is indeed an encouraging development. He has already started dismantling the low interest rate regime. He has said that money printing should be gradually phased out in a way not to cause pain to the Government and the economy. 

To begin with, the Treasury bill rates have been permitted to increase from 5% previously to about 8%, the latest. Even at these rates, his Public Debt Department has not been able to borrow the entire amount which the Government wants to raise from the market. The balance residual needed to be financed by the Central Bank, but that amount is on the decline. But he is faced with the fallout from the Lakshman era policies during which four wickets have fallen. SOE-21 has warned that the inflationary pressures are building pushing it above the Central Bank’s tolerant rate of 6%. To tackle this successfully, it says that the Central Bank should have independence to set its monetary policies. 

Governor Cabraal has also started to dismantle the import and exchange controls that had been introduced in the four-wicket falling era. But he is still not ready to accept the need for allowing the exchange rate to fall and seeking IMF support. But the emerging grave economic conditions are forcing him to make that choice sooner than later. 

Aseni: Has SOE-21 spoken of these two needs?

Sarath: It has not directly said so but has cautioned indirectly that the situation is becoming more acute day by day. It has pointed out that due to the fast drying out of normal foreign exchange flows to the country, the market is without dollars to meet the needs of importers. As a result, a parallel black market has sprung up. 

Sri Lanka got a windfall gain when the IMF allocated new Special Drawing Rights or SDRs amounting to about $ 800 million. But SOE-21 says that this gain is temporary because of the mounting obligations to be met in the period to come. This prediction became a reality when the official reserves fell from $ 3.5 billion in August to $ 2.5 billion in September. Hence, without asking the Government to seek IMF support immediately, SOE-21 has recommended that it should build effective policy strategies. To its credit, it has also not commented on Sri Lanka’s present home-grown policy package. 

Aseni: Thanks Grandpa for helping me to understand the SOE-21 report.

Governor Ajith Nivard Cabraal has already started dismantling the low interest rate regime. He has said that money printing should be gradually phased out in a way not to cause pain to the Government and the economy… But he is faced with the fallout from the Lakshman era policies during which four wickets have fallen. SOE-21 has warned that the inflationary pressures are building pushing it above the Central Bank’s tolerant rate of 6%. To tackle this successfully, it says that the Central Bank should have independence to set its monetary policies. Governor Cabraal has also started to dismantle the import and exchange controls that had been introduced in the four-wicket falling era. But he is still not ready to accept the need for allowing the exchange rate to fall and seeking IMF support. But the emerging grave economic conditions are forcing him to make that choice sooner than later

(The writer, a former Deputy Governor of the Central Bank of Sri Lanka, can be reached at [email protected])