C-19 economic recovery: Most probably it will be a flattened U-shaped one

The new world order of living in isolation

One thing that we now know for sure is that COVID-19, further abbreviated to C-19 for economy and convenience, is to deliver a massive negative shock to the entire world economy without exception. Economic growth at least in the current year is to recede to a negative range. If mishandled, economic recovery to pre-C-19 levels would be prolonged for another three to four years. 

The mobility of people, for work, health, education or pleasure, from country to country is to be curtailed if not totally disallowed. The established global economic order that ushered an era of interdependence among nations is to be abandoned. Instead, a new economic order that prevailed when Homo sapiens were living in caves many thousands of years ago is being advocated. In this order, men and women were living constantly in fear of and suspecting the other Homo sapiens cohabiting even in the neighbouring caves. 

The global goods and services as well as financial flows are to fall to levels well below those that could sustain the global economy. In a nutshell, people are cherishing and their political and religious leaders are promoting, self-isolation from the rest of the world as the new way of living. 

Sri Lanka’s economy was sick even before C-19

Sri Lanka has been successful in containing the spread of C-19 to a national epidemic level. But the same cannot be said about its economic fallout. Even before C-19 hit Sri Lanka, its economy had been limping forward having been infected for long by a number of ailments. 

Economic growth had been slowing down from 2013 and in 2019, it fell to 2.3%, the lowest in a decade. Exports have been virtually stagnant at around $ 11 billion on average during this period. Since the import bill was almost double this amount, the trade gap stood at about $ 10 billion on average. Since the net earnings on account of services, incomes and remittances could not fill this gap, the current account of the balance of payments was in deficit at around 2.5% of GDP. 

The government budget had been infected with a difficult-to-cure disease: the revenue base was falling, while expenditures were rising. As a result, the overall deficit in the budget amounted on average to 6% of GDP and was on the increase. The deficit had been financed in turn by borrowing leading to an unwarranted increase in the stock of public debt from 72% of GDP in 2013 to 87% in 2019. Debt servicing, that is, repayment of the principal and the payment of interest, became problematic forcing the government to borrow more year after year to avoid a possible debt default. This was specifically true for foreign debt. Without borrowing anew, the country could not honour its foreign debt obligations. 

Since the inflow of foreign exchange was insufficient to meet the annual foreign exchange demand, the rupee was under continuous pressure for depreciation. The Central Bank kept on holding onto the exchange rate by supplying dollars out of its foreign reserves to the market intermittently. However, this could not keep the exchange rate stable and it saw a one-way journey to depreciation. Accordingly, the US dollar that was traded at Rs. 127 at end-2012 fell to Rs. 182 at end 2019. In the first half of 2020, the rupee came under severe pressure for further depreciation and at one point it even crossed the mark of Rs. 200 per US dollar. Though there was a slight reversal of this trend recently pushing down the rate below Rs. 200, the uncured sickness in the external sector forebodes a massive adjustment in the rate in the coming months.

Playing the blame game by politicians 

Thus, Sri Lanka was hit by C-19 when it was sick with severe macroeconomic complications on all fronts. For this malaise, politicians on both sides of the main political stream have begun to play the usual blame-game of pointing fingers at each other. It is customary for them to claim that when they handed the government to their rivals, the economic situation was better than what the rivals had inherited to their successors. It is like a man falling from the 20th floor of a building shouting at a man at the window of the 10th floor that he is well and not to worry ignoring that he is falling and there are 10 more floors below him. 

Time to become a rich nation is to be further deferred

According to the Central Bank, the economic fallout of C-19 would be short-lived with a quick V-shaped recovery. The growth rate would fall from 2.3% in 2019 to 1.5% in 2020 but start to recover steadily though at a slow pace in the succeeding years. Accordingly, growth will bounce back to 4.5% in 2021, 6.0% in 2022, 6.2% in 2023 and finally, 6.5% in 2024. This 6.5% was the growth rate which President Gotabaya Rajapaksa had planned to attain from 2020 onwards in his drive of the country to a rich nation within roughly about 20 years after accommodating an annual average population growth of about 1%. It appears that C-19 has derailed this plan. However, this goal could still be attained in 25 years if the economy makes a quick recovery as predicted by the Central Bank, sets on an annual average growth of 6.5% and there are no other negative economic shocks hitting the economy in the intervening period.

Impediments created by the Government

Thus, the challenge before Sri Lanka’s economic policy makers has been to make this predicted quick economic recovery a reality. However, there are certain impeding factors that stand to foil the realisation of this goal. Some of these impediments have been created by the government itself. Some others have been delivered to them from outside and therefore are beyond their control.

Costly tax reforms 

Of the impediments created by the government, the most prominent one is the dearth of funds within the government – known as lack of fiscal space – to undertake expenditure programs needed to initiate a quick recovery. One reason for this is the erosion of the revenue base of the government by offering a series of generous tax concessions to income tax and VAT payers. Another is the absence of a budget for almost the entirety of 2020 and having to operate on a truncated expenditure programme known as a Vote on Account. As it is, a full budget could be offered only for 2021 after a new government is formed subsequent to the Parliamentary elections of early August. 

Erosion of the revenue base

The tax cut offered by the government with effect from January 2020 was an unconventional stimulus package. When this was announced in December 2019, I warned the government in an article in this series that it could backfire and measures should be taken to control the damage forthwith (available at: http://www.ft.lk/columns/Tax-cuts-Control-the-damage-before-the-unconventional-stimulus-backfires/4-691207). The objective of the government by offering these tax concessions was to reduce tax rates and relieve the taxpayers, catch more potential individuals to the tax-net and rely on large taxpayers for generating revenue for the government in the long run. 

Though it might help the government to establish a viable tax regime in the country in the long run, immediately, it would eat into the revenue base of the government. My prediction at that time, based on the revenue generation in 2019, was that the government would lose between Rs. 650 billion and Rs. 680 billion in 2020. This is a significant income loss amounting to about 4-4.5% of GDP. What it meant was that in 2020, tax revenue would fall to about 8% of GDP from around the historical average of 12% during the preceding four-year period. 

Since it would take time for the new tax regime to get established and fully operational, it was predicted that the government would have to live in a low-revenue regime in the next few years too. This was to adversely affect the government programs, especially those targeting higher public sector investments in infrastructure, human capital advancement and research and development. 

The option available to the government was to borrow more money, both from domestic and foreign sources, and increase the stock of public debt further to unaffordable levels. Surely, this was not a gamble which the government would have played at the present juncture of development of the country.

An alarming fiscal situation in the first four months of 2020

These fears have now been confirmed by the Minister of Finance in his mid-year Fiscal Position Report 2020 just released (available at: http://www.treasury.gov.lk/documents/10181/858130/Mid-Year-FPR2020-eng/1223516e-2092-4df3-bf03-d95701f259ba). In terms of this report, the fiscal position during January-April 2020 has been alarming. The tax revenue has fallen by Rs. 143 billion from what the government had raised during January-April 2019. Government’s consumption expenditure – known as the recurrent expenditure – has increased by Rs. 80 billion. 

The reduction in revenue and the increase in the expenditure have caused the government to run a bigger deficit in its revenue account meaning that the government was consuming more than what it was earning or making dissaving in its financial operations. This deficit amounted to Rs. 344 billion in the first four months of 2020 compared to Rs. 152 billion in the corresponding period in 2019. It is an unaffordable 7% of GDP projected for 2020. Consequently, the budget deficit too has shot up to Rs. 452 billion amounting to about 9% of GDP. 

This deficit has been financed by borrowing, on a net basis, Rs. 26 billion from foreign sources and Rs. 426 billion from domestic sources. These new borrowings have increased the debt stock of the government from Rs. 13,031 billion at end-2019 to Rs. 13,483 billion at end-April 2020. This is a further increase in the debt stock as a ratio of GDP from 87% 

to 90%.

A flattened U-shaped recovery 

Thus, the budgetary outcome in 2020 and in the next few years will not help the government to undertake the needed expenditure programs to realise a quick economic recovery. Contrary to the prediction of the Central Bank that the economy would grow at a reduced rate of 1.5% in 2020, the available information point to a negative growth of about 6% in 2020 followed by a slow recovery in the next few years. Economic growth would become slightly positive only after 2024 due to the prolonged effect of C-19 pandemic. Accordingly, it would be a flattened U-shaped recovery and not a quick V-shaped recovery which Sri Lanka would realise in the post C-19 period.

Need for postponing tax reforms 

Noting these adverse developments, I argued in a previous article in this series in May 2020 that the government should suspend the implementation of the tax reform programme immediately (available at: http://www.ft.lk/columns/Constrained-fiscal-space-for-post-COVID-19-reconstruction-Consider-postponing-costly-tax-reforms/4-700327). Given the need for introducing measures to have a quick economic recovery, I argued that the present state of the economy does not support trying out costly economic reform programmes. They should be postponed for implementation until the economy returns to normalcy and it would be after 2024.

Difficulty to borrow from external sources 

As it is, the government itself has created a huge budgetary gap which has to be funded by resorting to borrowing. Its ability to borrow from foreign financial markets has been impeded by the eroding confidence which the investors have about the bonds to be issued by Sri Lanka. This is evident from the deep discount at which the bonds already issued by Sri Lanka is trading in the secondary markets for same. Before March, these bonds were traded at a premium. But today, they are traded at $ 94 per $ 100 bond in the case of those maturing in October 2020 and at $ 66 in the case of those maturing in 2030. 

The other bonds maturing in between are traded at prices within this range. What this means is that if Sri Lanka goes to the market now to raise funds for undertaking C-19 recovery programmes, it has to offer those bonds at a relatively higher yield. Hence, the government has resorted to other tactics like getting a SWAP facility from India or entering into a REPO with the Federal Reserve Bank. Both these measures would help the Central Bank to boost its foreign reserves but not the government to finance the budget. 

As a result, the increased expenditures have been funded by borrowing from domestic sources. There-again, these borrowings have been made principally from the Central Bank and commercial banks – two inflationary sources of financing. 

In these circumstances, it is a flattened U-shaped recovery that Sri Lanka could bargain for at the present moment. If it desires to have a quick V-shaped recovery, its government has to put its house in order by attaining a sufficient fiscal space to undertake expenditure 

programs.

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