With this man-made Constitutional crisis, economy will be the casualty; resolve it quickly or perish

The President, while removing Prime Minister Ranil Wickremesinghe from office, has appointed former President Mahinda Rajapaksa to the post

Two prime ministers without a Government

The political change that took place in Sri Lanka last week has driven the country to a constitutional crisis. The President, while removing Prime Minister Ranil Wickremesinghe from office, has appointed former President Mahinda Rajapaksa to the post. A crisis has been created because Ranil Wickremesinghe has maintained that he is still the Prime Minister in terms of the Constitution. This is being refuted by those supporting Mahinda Rajapaksa. Thus, Sri Lanka now has two Prime Ministers appointed by the President in two points of time. 

But the reality has been that there is no properly constituted Government in the country, except the executive power being exercised by the President. That executive power has a limitation and cannot go on forever. Since Parliament does not meet, the symbiotic relationship between the legislature and the real executive has been severed. Thus, in terms of good governance, there is a blurred and grey mark in the country’s constitutional setup. This is unprecedented in the history of Sri Lanka and whatever its outcome, it has far-reaching social, political and economic consequences.

Manifestations of economic crisis: slowed down economic growth

This has happened when the country’s economy had been in deep trouble. Except on the inflation front where the nationwide inflation has now receded to near zero level, all other economic indicators have demonstrated signs of a chronically and acutely ailing economy. Economic growth has continued to slow down from above 8% recorded immediately after the end of the war in 2009. It fell below 5% in the two years beginning from 2013 and below 4% in the last two years. 

The most optimistic growth forecast for the next five year period has been about 4.5 to 5% per annum on average, pretty much below the rate of 9% needed for Sri Lanka to advance itself to a rich country within a generation. Hence, the dream of Sri Lankans to enjoy the fruits of a rich nation is getting blurred day by day. It is a big disappointment for a nation which has struggled to push itself up along the path to development. 

Unmanageable budget

On the fiscal front, the overall budget deficit has been high, stubbornly above 5% of the total size of the economy, called the Gross Domestic Product or GDP. This is despite the many pledges by all Governments in power to cut it down to below 4% of GDP progressively. The target for 2018 had been 4.8% of GDP, but it is likely that it would end up at around 5.3%. 

The unfavourable corollary of this sad outcome has been the continuous increase in the borrowings of the Government not only to finance the deficit but also to repay the loans and pay interest on them. It has trapped the country in a vicious debt cycle. Despite this, the Governments have been promising more and more unproductive expenditure programs to keep the electorate happy.

The year 2019 will be worse for Sri Lanka since, as it is, there will not be a proper budget. It has been announced that the Government is planning to have a temporary vote on account to maintain essential public services for three months. Without a proper budget, it will not be possible for Sri Lanka to attain and maintain budgetary discipline, a goal of both the Rajapaksa and Wickremesinghe administrations. It will convert the bad budgetary situation to worse in the next few years. This will not be viewed favourably by both the domestic and foreign investors. 

Worsened external sector

In the external sector, foreign exchange earnings in the form of export of goods and services and money sent by Sri Lankan workers abroad, called inward remittances, have been stagnating against a background of rising commitments for payments for imports, interest on foreign loans and Sri Lankans’ taste for travel abroad, etc. The resultant foreign exchange gap has put pressure on the exchange rate continuously. As a result, the value of the rupee is lower in terms of the benchmark currency, the US dollar, at the end of each year from the value it had at the beginning of the year.

Thus, the exchange rate has been the most popular ‘ball game’ played by all political parties. When they are in the opposition, they blame the Government in power for allowing the rupee to fall, implying that it is due to their bad economic management. But when they are in the Government, they justify its fall tooth and nail. Yet, like the caravan that moves while the dogs are barking, the rupee too continues to fall in value month after month because no proper remedial measures are taken by Governments driven by a populace that wants to import more and produce less. 

Any money given to them through liberal Government spending is immediately spent on imports rather than on investment. Recently, I asked MBA students of a State university what they would do if they are given Rs. 10 million each. The answer was unanimous that they would buy a car or travel abroad or spend that money to buy various electronic equipment that has become the fashion of the day. With that type of mentality, the increased income through expanded Government expenditure programs, financed of course by borrowing or printing new money, would end up as incomes of people in other countries. Thus, the pressure for the rupee to fall in the value in the market is unavoidable.

Economy will be the casualty

Against this background, if the country is hit by a Constitutional crisis where there is no Government or if there is one, a weak Government for that matter, the economy cannot recover from the depth to which it has fallen. The longer the crisis, it is worse for the economy. Hence, it would worsen the present economic crisis. 

It is an instance where the economy has been subject to ‘double prejudices’, the first being the slowing down of the economy and the second, the reinforcement of that trend by the on-going constitutional crisis. This is, as the local proverb says, like the man fallen from the tree is being attacked by a bull as well. Who is to suffer at the end? It is the people of Sri Lanka who are already frustrated about the country lagging behind even those which had been below it a few years ago. The most often quoted examples are Vietnam and Bangladesh, which are presently moving ahead of and faster than Sri Lanka. 

Protect the property rights 

How will a constitutional crisis affect an economy? An economy is made up of thousands of small economic units that produce goods or services for use by people. Some goods are consumed locally, while some others are exported for consumption by foreigners. To continue in production, all these units need to invest new money to replace the capital that has worn out as well as expand the production capacity so that they can produce more. People will do so only if they have trust in the economy. This is specifically applicable to foreigners who are planning to invest in Sri Lanka. Those who invest in new buildings, machinery, factories or farms have a right to possess those investments and enjoy the fruits of those investments. Economists call this ‘property rights’. 

Investors, both local and foreign, have trust in the economy only if their property rights are protected through a proper legal, law enforcement and dispute settlement system. If someone can seize my property with total impunity and against my will or without compensating me, I have no incentive to invest and have new properties under my ownership. Property rights are protected by having a properly drafted constitution and everyone in power honouring the provisions of that constitution. It should be done not in letter but in spirit. If this is violated, markets face uncertainty. And markets do not like uncertainty.

Markets deliver the opposite of what the policy planners’ desire

When markets confront uncertainty, they overreact. They try to bring balance back to the market by producing what policy planners do not want to have. 

For instance, if the policy planners want to have the exchange rate fixed at a certain level, they have to supply continuously foreign exchange to the market to fill the gap. If the pressure is for the rate to depreciate, because there is a higher demand for foreign exchange than the availability, an uncertainty is created in the market. When foreign exchange is supplied to the market by the central bank, market participants knowing that they could buy foreign exchange at a given price in unlimited quantities, will continue to buy more. Hence, more is to be supplied by the central bank to meet the growing demand. It will be a futile attempt, like watering a sinking well. Sooner or later, they lose foreign exchange balances gradually reducing their ability to keep the market supplied. At that point, the market hits back mercilessly and the exchange rate would be exactly opposite to what the policy planners did not want. 

This happened to Sri Lanka in 2001, 2009, 2012, 2016 and now in 2018. On all these occasions, Sri Lanka lost foreign exchange; at the same time, it could not fix the exchange rate at a given level. Instead, the exchange rate depreciated even beyond what it had been previously. 

Thailand too had the same experience in 1997. In order to fix the baht rate at 25 baht per dollar, Thai Central Bank, the Bank of Thailand, wasted $ 25 billion by supplying to a market with a voracious demand for dollars. After losing all its reserves, it had to allow the baht rate to have a free fall and it ended at 50 baht per dollar overnight. That destabilised Thai private sector which had borrowed heavily in foreign currencies and Thai commercial banks which too had more borrowings in foreign currencies than the holding of same, a situation called having a ‘short position’ in bankers’ terminology. How did the market which did not like uncertainty hit back? By bankrupting both private companies and commercial banks and bringing in a general economic collapse. 

Uncertainty is the biggest threat

Hence, uncertainty is the biggest threat to any economic system. It frightens people and the fright drives them to a general panic. Those in panic do not see logic or reason. The illogical and unreasoned people begin to do more mistakes in the form of wrong reading of economic events, overreacting to general situations and accepting extreme proposals to cover losses. All these actions on the part of people will create more uncertainty and that more uncertainty will make them more panic. Hence, both panic and uncertainty begin to self-feed each other. Eventually, it would be disastrous to the whole economy.

Two warring parties oblivious of the impact on the economy 

The present Constitutional crisis, if prolonged, would also bring in the same results. The two factions led by Ranil Wickremesinghe and Mahinda Rajapaksa are at war with each other. Each party claims having majority power but it can be established only through a vote in Parliament. Since Parliament has been prorogued by the President for a different reason, there is no opportunity for them to show their strength and put a stop to the uncertainty. 

The corollary of this man-made uncertainty is simple. The two parties can get into verbal attacks, appear before media and do the same and bring in supporters to Colombo show strength. These are practically costless moves because they do not require the warning parties to spend real resources. However, as the experience has shown, the more the two factions may do so, greater the degree of panic to which they would drive people. Since this is to go on for some time, it keeps people in suspense. People in suspense do not have productive engagements except continually expressing their fears to each other. Hence, it is the economy that suffers and not the parties that are at war.

FDIs and credit ratings will be affected 

At this point in time, Sri Lanka very badly needs foreign investments to fill the gap in the foreign exchange requirements through a source that does not add to debt, on the one hand, and acquire new technology, on the other. It would also add new capacity to Sri Lanka’s economy facilitating it to produce more goods and services. Both will improve the wellbeing of the people. As mentioned before, foreign investors need a stable government to protect their property rights. If there is none, they would simply withdraw from the country. This will also cause rating agencies to downgrade Sri Lanka’s rating from the present ‘B1 negative level’ making it more costly for the country to raise foreign loans from the market. 

Hence, the present Constitutional crisis should be resolved as quickly as possible paving way for the establishment of political stability in the country.

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