A child’s guide to acute macro imbalances: Ignore it at your own peril

It is typical of all those in power to deny the existence of a major macro problem. That is because they falsely believe that acceptance of same is admission of failure

Aseni, the whiz kid, and her Grandpa, Sarath Mahatthaya, are examining the macroeconomic imbalances, turned from chronic to acute, in the country in the light of various promising statements made by the country’s leading policymakers. Here are the excerpts:

Aseni: Grandpa, I am confused because Government’s top leaders say that the economic fallout from COVID-19 is fully under control, while independent analysts have a different opinion on it. Some have even tried to malign the critics that they do not understand the rationale behind the new economic policies being followed by the Government. Do we or do we not have a macroeconomic problem today?

Sarath: It is typical of all those in power to deny the existence of a major macro problem. That is because they falsely believe that acceptance of same is admission of failure. Therefore, all governments are in a denying mode. But denial does not solve the problem. Without proper medication, the macro problem becomes chronic and finally acute. By the time the political leaders realise it, it is too late to treat it with effective medication. Consequently, the macro problem starts controlling the political leaders rather than the political leaders keeping the macro problem under control. This is exactly what has happened to Sri Lanka. 

The political leaders of the two major parties have been denying the existence of a major macro problem. But denial is not the proper cure for the problem. Hence, year after year, the problem, like a falling snowball in a ski resort, gets bigger and bigger. Citibank Research in a recent country update of Sri Lanka had warned the Government that denial of the economic problem is not a proper strategy. Read it at: http://www.ft.lk/top-story/Denial-is-not-a-strategy-Citi-cautions-Sri-Lanka/26-710033. 

Given this situation, it is quite natural that there is a difference of opinion among top economists as to what the county should do now. It is unfortunate that, instead of generating a free dialogue and listening to each other, top leaders in the Government are maligning the critics saying that they do not understand the policy being followed.

Aseni: Surely, the macro imbalance, if there is any, cannot be hidden from the public because many indicators about it are in public domain. In your opinion, what are the manifestations, Grandpa, that give us a shrilling signal in this regard?

Sarath: There are many, but President Gotabaya Rajapaksa is not responsible for them. He inherited an ailing economy and he now has to sit in presidency overlooking the deterioration of the system day after day.

The declining economic growth which had started from 2013 is one such manifestation. Immediately after the war, there was an economic boom raising the country’s average growth rate to above 8% from a historical average of 4.5% in the whole of the post-independence period. This sudden boom even prompted some strategists like Ruchir Sharma to brand Sri Lanka a ‘breakout nation’, the term coined by him to describe how a nation could break the fetters of underperformance and emerge as a winner. You can read his opinion at http://slembassyusa.org/NewsLetter/201301/NL13_p02.pdf.

But the economic policy followed by the Government was not all supportive of making this dream a reality. Even at that time, independent writers had questioned the ‘if’ factor that is necessary to make Sri Lanka a breakout nation. For instance, refer to this article at https://www.colombotelegraph.com/index.php/sri-lanka-as-a-breakout-nation/. Despite these warnings, the same policy package was continued, and the result was the moving away from the goal of being a breakout nation.

Today, economic growth has fallen to a negative range, partly as a continuation of the declining trend experienced from 2013 and partly because of the economic downturn due to the COVID-19 pandemic. What is expected in the next four-year period is a negative or low economic growth. This low growth has exacerbated the ailments in the budgetary, monetary, and external sectors.

Aseni: But the Government leaders are confident that Budget 2021 has laid the foundation for future economic growth. It plans to cut foreign borrowings for paying out foreign loans and interest, limits them only for project loans, depends on domestic resources to fill the budget gap and relies on the tax cuts to incentivise the local entrepreneurs. Then, why do you say that there is an ailment in the budgetary sector?

Sarath: We should appreciate that the Budget 2021 has been presented at a time when Sri Lanka was going through the most difficult period in its history. Apart from the internal economic ailments, the country has been hit by adverse global developments, again a fallout of the uncontrolled global spread of COVID-19 pandemic. Hence, we cannot expect much from this budget.

But as some analysts have pointed out, the numbers on which the budget is based are fragile. This was the point raised by former Central Bank Assistant Governor, Anila Dias Bandaranaike, in a recent analysis of the budget. You can read it at http://www.ft.lk/columns/Budget-2021-Playing-ostrich-or-parading-in-the-Emperor-s-new-clothes/4-711788 . She had branded it as an attempt at ‘playing ostrich or parading in Emperor’s new clothes’, a situation in which policy makers are fooling themselves by feeding on the wrong numbers they have created.

The fiscal year 2020 in which there was no budget was a write-off in every respect. We have data only for the first 10 months and they indicate that tax revenue was down by Rs. 441 billion compared to the previous year. Foreign borrowings had been kept at the previous year’s level, but the domestic borrowings had increased by staggering Rs. 1.6 trillion increasing the total debt stock to from Rs. 13 trillion to Rs. 14.6 trillion. Capital expenditure had been cut by Rs. 208 billion, while government’s consumption expenditure had increased in a compensatory manner by Rs. 250 billion. Since the revenue base has fallen and government’s consumption expenditure has shot up, its savings had been negative to the extent of Rs. 1,025 billion. This is about 7% of the country’s GDP.

Because of these reasons, the budget deficit has increased to 9% of GDP. This is a serious situation and Budget 2021 was expected to announce the exit strategy for this. But this had not been done. Worse, as Bandaranaike had argued in her article, fragile numbers have made it more alarming.

Aseni: What about the monetary sector. It cannot have a crisis because the present Government follows a new ideology in monetary policy called Modern Monetary Theory or MMT. True that MMT is being advocated by a breakaway group from mainstream economists and there is not much following. Yet, they say that they have the solution to the present global economic crisis. And that solution relies on increasing Government expenditure not through taxation but through printing money. They argue that once the economic growth is set in, the increased money supply can be flushed out of the system by taxing people more. Isn’t it a viable solution?

Sarath: The track record of the present Government in 2020 is indicative of following MMT knowingly or unknowingly. Since foreign borrowings have been kept at the previous levels, all their expenses have been met out of domestic borrowings. That again it has done largely from the banking sector, made up of the Central Bank and commercial banks. According to the Central Bank’s data, during the first 11 months of 2020, the Government had borrowed Rs. 2,019 billion on a net basis. 

What we mean by a net basis is that Government’s deposits with banks have been taken out of its gross borrowings. Out of them, borrowings from the Central Bank have been increased by Rs. 437 billion. This Rs. 2,019 billion coming from the banking sector is the contributor to the increase in the country’s money supply, which is represented by what common man refers to as money printing. Hence, it is MMT at work.

MMT has been supported by keeping interest rates low. The objective of the low interest rate policy had been to promote private investments, on one side, and keep the Government interest expenditure under control, on the other. Since inflation is running at about 6%, the present interest rate regime depicts a picture of negative real interest rates.

It is a haven for borrowers, especially the Government, but not for savers. The disgruntled savers, searching for a better rate of return, will shift their savings to speculative types of investments such as the share market. The present upsurge in the share market which has not been supported by foreign investors has been boosted by local retail investors. When the companies concerned are limping unsteadily due to COVID-19 pandemic, there is no reason for the share prices to rise suddenly. By any standard, it is a bubble and when the bubble bursts, many will end up burning their fingers.

Aseni: But can’t we print money continuously and resolve our problems? For instance, we print money and use that money to complete development projects like roads, power plants, irrigation schemes, water for all projects, etc. They will increase the country’s output and help the country to get out of this crisis. This is what we have been told by some of the Government leaders.

Sarath: That is also an argument presented to justify the use of the money printing machine of the central bank by the Government. They argue that money so created will lead to economic prosperity. But there is a limit which a Government can do so. Everything will depend on whether people are willing to accept the money printed by a Government. They would do so when the inflation rate is at a low tolerable rate. But if inflation rises to high levels which we call a state of hyperinflation nobody would accept the money supplied by the Government and the Government ceases to exist. That is because to finance the Government budget, they cannot borrow or print money.

This happened to Russia in 1990s when its inflation rate rose to a staggering 86%. The Government could no longer print money and finance its expenditure because no one wanted to accept Rouble as a currency. Hence, the Russian Government went into arrears of paying salaries and pensions. A report by Associated Press in 1998 said that teachers were paid not in Roubles but in vodka, each getting 15 bottles per month. You can read it at https://news.google.com/newspapers?nid=2026&dat=19980922&id=HO8qAAAAIBAJ&sjid=qdAFAAAAIBAJ&pg=4645,1762474. So, finally Russia was forced to adjust exchange rate upward and increase interest rates to above 150% per annum. That is an extreme case, but it shows the limit within which a government could print money and spend.

Aseni: But Sri Lanka’s inflation rate is not at 1000% and it is within 10% for most of the years. Hence, we may still print money and spend away without having to pay salaries and pensions in commodities. Isn’t it the case, Grandpa?

Sarath: Yes, Sri Lanka is still within the limit and people still accept the money issued by the Government. But Sri Lanka is not a country without inflation. If you go by the old Colombo Consumers’ Price Index with its base year 1952, the value of index at end-December 2020 was 12,222. So, a rupee in 1952 is worth less than one cent today.

The people have not revolted against the Government but have transferred their assets into areas where they are safe from the fall in the value of the rupee. It has also promoted the consumption of imported goods. The result has been the continuous decline in the value of the rupee against the US dollar. For instance, at independence, one US dollar was traded for Rs. 4.76. Today it is a little less than Rs. 200. And the agitation for wage increases has also arisen due to the increase in the cost of living through inflation. Such a wage spiral does not add to the increase in productivity. That is why Sri Lanka is eternally a developing country.

Aseni: What about the external sector? Especially, the debt repayment and protecting the exchange rate?

Sarath: The final victim is the external sector due to this high inflation. The external sector imbalances have forced the Government to borrow more to repay maturing debt and pay interest on the existing debt stock. That is why the foreign borrowings of the Government have increased from 3% of GDP in 1950 to 42% of GDP in 2019. As a result, the Government has been trapped in an inescapable debt crisis. The situation today is acute. According to the Central Bank data, within the next 12-month period, the total debt repayment commitments amount to $ 5.8 billion. On top of that, there are some short-term

commitments amounting to about $ 1.4 billion. To meet this, we have foreign reserves amounting only to $ 5.2 billion. Surely, Sri Lanka is in a debt crisis.

Aseni: Thanks, Grandpa. Our macro problems are not something which we can ignore anymore. They have now reached beyond the boiling point. Unless we make immediate corrective measures, the result will be a catastrophe.

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