Faltering growth: Urgent reforms or stagnation?

Declining growth

The balance of probability is that growth will decelerate sharply by the fourth quarter of this year to about 5% and inflation will be at a double digit level. There is urgent need for a mix of policies that not only curtail aggregate demand but also create the impetus for a robust supply response.

The Sri Lankan authorities have announced that growth amounted to 7.9% in 1Q2012 and they forecast growth of 7.2% for the whole of 2012. The IMF has downgraded its forecast to 6.5%. There is a strong case for arguing that the IMF’s forecast reflects better the combined effects of global developments and the necessary stabilisation measures introduced in Feb/March 2012. Even the prospects of achieving 6.5% growth can be undermined, particularly if there is a severe drought which affects agricultural and agro-based industrial production.

If one assumes that the economy will record 6.5% expansion this year, growth would average 6% over the last three quarters, after the 7.9% in 1Q2012. In practice, one is likely to see a steady slowing of the economy during the course of the year with growth tailing off to about 5% by 4Q2012.

The economy averaged 5% growth during the 30 years of the conflict. Hence, this would be a very disappointing post-conflict growth outcome. Even allowing for a non-propitious global economic landscape, Sri Lanka has the potential to record eight (or more) per cent growth on a sustained basis.

The slowdown in growth this year is due to external and internal factors. Global trends, particularly in Sri Lanka’s major markets (the debt crisis in Europe and ailing growth in the US), are likely to result in a slowdown in export growth which amounted to 22% in 2011.

The effects of the easing of external demand will be compounded by a dampening of domestic demand in the wake of the necessary contractionary measures introduced to address the imbalances that emerged last year in the trade and current accounts of the balance of payments.

The increased interest rates, the credit ceiling, the J-curve effects of exchange rate depreciation and the impact on disposable incomes of the sharp adjustments in tariffs and the administered prices of several goods will serve to exert both demand and supply side pressures on growth. Though the anticipated increase in remittances will mitigate these pressures, it will not be sufficient to offset the overall dampening of growth impulses in the economy.

The case for continued stabilisation

The authorities would need to monitor carefully not only the country’s external account but also its fiscal operations to determine whether further stabilisation measures become necessary. The balance of payments data for the first four months of the year indicate that though import growth has been curtailed significantly, this has been offset by the slowdown in exports.

Furthermore, there has been a deterioration in the government’s fiscal operations. W.A. Wijewardena (former Deputy Governor of the CBSL) has pointed out in a recent article that the target for the current (or revenue) account deficit has been greatly exceeded in 1Q2012.

The budget could come under further strain from a revenue shortfall with the slowing down of the economy and expenditure pressures to provide relief for those affected by the drought and the contractionary stabilisation measures.

One may conclude that while it is still too early to determine whether the bold measures introduced in Feb/March 2012 are sufficient to stabilise the economy, there are warning signs which have already emerged. They need to be heeded if the macroeconomic stability crucial for sustained growth is to be restored.

It would be inadvisable to seek to resolve the twin problems in the balance of payments and the budget only through additional borrowing, particularly foreign commercial borrowing. It would merely postpone the problem and increase the possibility of Sri Lanka experiencing a full-blown economic crisis of the type experienced by several middle-income countries in the 1980/1990’s, and Greece today.

Unfortunately, the combination of adverse global economic trends and the policy induced imbalances in the balance of payments means that there are no easy options. The authorities need to persist with contractionary policies to stabilise the economy (i.e. to live within one’s means). This will inevitably result in a slowdown in growth and productive employment.

The twin problems of the deficits in the current account of the balance of payments and the budget mean that Sri Lanka has no macroeconomic policy ammunition to stimulate the economy (i.e. there is no scope for expansionary monetary policies or a fiscal stimulus). Furthermore, as mentioned above, borrowing will merely postpone the problem while exacerbating the ultimate consequences.

The policy challenge

The challenge is to formulate a policy mix that would minimise the depth and duration of the downturn. This calls for a combination of stabilisation measures and a package of growth enhancing structural reforms. This would not only bring about much needed efficiency gains to increase productivity and competitiveness but also provide a strong confidence boosting signal to all economic agents, particularly domestic and foreign investors.

PF’s Economic Alert 27 sets out a range of structural reforms to strengthen the growth framework of the economy. Priority should be given at this point to reforms that can have an impact in the short-run. These include, inter alia, the following:

an acceleration of the Government’s infrastructure development through aggressive and transparent recourse to an ambitious Public Private Partnership (PPP) program;

development of a long-term debt market (corporate bonds), including promotion of support from the insurance sector;

sale of parts of the equity of commercial SOE’s in the stock market (with a reservation for workers) not only to raise much-needed non-debt creating financing for the government but also to trigger improved management, strengthened financial discipline and greater transparency through the increased disclosure that automatically ensues.

continue even more actively the ongoing program to improve the ‘Ease of Doing Business’ (i.e. debureaucratise and remove red tape), including restoration of the ‘One Stop Shop’.

Longer term structural reforms could include the following:

strengthening the operations of the land market, including the creation of a pre-cleared land bank;

labour market reform to reduce the costs of employment in order to address the perverse incentives that currently encourage the creation of part-time and causal employment, as well as expansion of the informal sector (i.e. current labour market conditions serve to reduce overall labour standards in the country.);

strengthening the capacity of regulatory agencies (including the SEC and PUCSL);

improving education, training and skills development (particularly maths and science education), including a pragmatic approach to public, private and mixed provision;

developing a Science and Technology policy to improve capabilities for technology management (adoption and adaption/innovation)

Concerted efforts should also be made to ensure the sanctity of commercial contracts and strengthen the rule of law. Sri Lanka can achieve a higher growth trajectory only through increased domestic and foreign private investment. The fiscal space does not exist for a state-driven recovery package.

Conclusion

One may conclude that the growth prospects for the economy are rather gloomy over the next six to twelve months. A proactive and pragmatic policy response is required both to stabilise the economy and to strengthen its growth framework. Such a holistic approach will be mutually reinforcing and reduce the depth and duration of the economic downturn.

The country’s growth framework has been strengthened by three previous waves of economic reforms (1977/78; 1990/91; 2001/02). The time has now come for a fourth wave of reforms to boost the flagging growth momentum.