|Athukorala’s message to the Government and the Central Bank has been very clear. Instead of seeking to resolve a deep-rooted economic issue through palliatives, the authorities should try to apply permanent measures to resolve them. Seeking IMF support is the best option available to the Government. Though it is the best option, in my view, it is now too late to go for that option
Professor Prema-chandra Athukorala
Forget innovations if the economy is to die
Delivering the keynote address at the International Conference on Business Innovation (ICOBI) hosted by Sri Lanka’s Green University, National School of Business Management, known as NSBM, Australian National University’s Emeritus Professor Prema-chandra Athukorala gave a fine warning to Sri Lanka’s economic policymakers (available at: https://www.youtube.com/watch?v=YJfQo18v-f8&t=2753s).
He said that at this point in time when Sri Lanka is faced with the deepest foreign exchange crisis in its history, there is no homegrown solution except seeking a financing arrangement from IMF. The theme of the conference was business innovation. But Athukorala stressed to organisers that talking about innovation is futile when the country is facing its biggest ever foreign exchange crisis which, if not handled prudently, will blow up into a kind of Tsunami destroying the entire system. Even though he did not say so, an appropriate parable will be ‘trying to teach how to exercise for good health for a patient who is in the intensive care unit waiting for the end of his life’.
IMF: Anathema of the policy leaders
IMF has been anathema to the policymakers of the Gotabaya Rajapaksa administration ever since it came to power in November 2019. The de facto economic policymaker of the Government, President’s Secretary Dr. P.B. Jayasundera, pronounced that IMF was not an option when the issue was brought before him. Later, he changed his hard stance and admitted that IMF could help if Sri Lanka can come up with a viable reform program. Now he seems to think that the worst is yet to come to Sri Lanka.
However, the Central Bank Governor Ajith Nivard Cabraal maintained this hard stance throughout believing in the efficacy of a homegrown economic policy package to take Sri Lanka out of its present malaise. According to the Six-Month Road Map he presented on 1 October, the country could get out of the grave foreign exchange crisis through increased inflows of foreign exchange flows from friendly central banks, sale of assets to foreigners and higher worker remittances and income from re-bounced tourist inflows.
Even though none of these expectations have materialised, he still believes that a homegrown policy package could take the patient out of the ICU and give him a life again. But that homegrown package is a short-term firefighting exercise compared to the diagnosis of the root cause made by Athukorala and the long-term solution he has suggested.
Forex crisis is not entirely due to COVID-19
Athukorala says that contrary to what many believe the present forex crisis is not entirely due to the outbreak of the COVID-19 pandemic that began to hit Sri Lanka in early 2020. The crisis had been looming over the country for quite some time, more specifically from around 2013. But because of the grave sickness of the economy, Sri Lanka had lost its immunity to the pandemic. As a result, its vulnerability level has increased, aggravating the situation.
Countries which had a high level of immunity, like those who have been vaccinated, have been able to wade through the pandemic without harming themselves. Had Sri Lanka also not lost its immunity, the COVID-19 pandemic would not have been so fatal to the country as it has been. Hence, the message given by Athukorala is that even if Sri Lanka is able to hide the disease through short-term palliatives, the country’s sickness would worsen in the future. Therefore, there is a necessity for the country to go for a permanent solution addressing the root-causes now.
Seeds of the crisis sown from independence
To find the root causes, Athukorala took his audience back in time to Sri Lanka’s independence in 1948. Governments of all hues that had been in power had messed up the fiscal power that had been entrusted to them. This had caused an imbalance in the domestic economy which had made its mirror image in the external economy. This has been explained by Athukorala to his learned audience using economics jargon. But a simple story will illustrate the point to ordinary readers.
A story to illustrate the crisis
Suppose there is a family made up of four, husband, wife, and two children – a son and a daughter. Let’s call it the family of John. John and his wife, Clara, are producing goods and services for use by the family. Son Peter and daughter Ann are still studying and, therefore, net consumers of those goods and services. This is their domestic economy. Everyone else out there is external to them and hence called their external sector. This consists of, say, their in-laws, relatives, and neighbours.
What happens if John’s family consumes less than what it produces? They can sell the surplus to those outside the family – the external sector – and accumulate some valuable mode of exchange, say, pebbles. At the time John and Clara got married, they got some inheritance from their in-laws which would have been sufficient for them to buy goods and services from the external sector for 17 long months. But after they were settled in a family and they had children too, their consumption exceeded the production creating a deficit.
This deficit was immediately financed using the pebbles they had inherited. But when that got depleted to a bare minimum level, to maintain their lavish lifestyle, they had to borrow pebbles from in-laws, relatives, and neighbours, in that order. As a result, the Johns accumulated a debt stock to the external sector. What is their position now? In the family, they consume more than what they produce running an internal imbalance. In the external sector, they run a similar imbalance to finance the domestic imbalance.
Gradually, that external imbalance grows to a severe crisis level. Without borrowing more pebbles, the family cannot settle its external debt. It leads to a severe external debt issue and the Johns are now heading to default their external debt obligations.
An internal deficit leading to an external sector deficit
This is exactly what has happened to Sri Lanka. Throughout the post-independence period, the country had consumed more than it had produced, a situation in which more has been absorbed for consumption than what has been produced. Thus, there has been a deficit in the domestic absorption level. But this was financed by running a deficit in the current account of the balance of payments year after year. These twin deficits are mirror images of each other. But who was responsible for the domestic deficit? The Government or the private sector?
In the case of the private sector, Athukorala says that there is a surplus, meaning consuming less than its production. But the Government, by running a deficit in its revenue and consumption, has eaten up a good part of that surplus. Hence, the root cause of the current balance of payments crisis is the profligate fiscal policy that had been adopted by the successive governments. Hence, the permanent solution to the balance of payments crisis is not the palliatives that have been employed but reforming the fiscal sector that had been the root cause of the ailment. So long as this necessity is ignored, Sri Lanka will continue to suffer from this balance of payments crisis.
Engagement of B.R. Shenoy by J.R. in 1966
But this is something that had been known to economists even earlier. In 1966 when Sri Lanka had been suffering from a similar balance of payments crisis with slow economic growth and the net foreign assets of the central bank had turned to be negative, Indian economist B.R. Shenoy was engaged by J.R. Jayewardene who was the Minister of State and Deputy Prime Minister of the then government. I have discussed the contents of the Shenoy Report and how it was killed elsewhere (available at: https://swarajyamag.com/economy/the-ignored-b-r-shenoy-report-of-1966).
Shenoy’s diagnosis was that Sri Lanka was suffering from 3Ps of maladies – production, prices, and (balance of) payments. This is exactly what Athukorala attributed to internal and external imbalances. Shenoy had told J.R. in his report that correct diagnosis of these ailments is only half the cure, and the full cure lies in taking remedial policies to address them.
Even in 50s and 60s, economy was in deep trouble
Shenoy found that economic growth during 1960-65 amounted to less than 2% a year and, with a population growth of 2.7% the per capita income had been declining. However, even this meagre economic growth was conveniently appropriated by the higher echelon of society facilitating them to “maintain their consumption standards at undiminished levels of affluence”.
What it meant was, according to him, a more rapid erosion of mass wellbeing than what the national income statistics suggested. His prognosis was that such growing inequality in income distribution was a “serious matter in a democracy, especially in the context of two more or less evenly balanced party alignments, where the opposition is ever on the alert to capitalise on the errors of policy ill-effects of the party in power”.
Hence, he opined that “a major policy objective should be to halt the decline in the living standards of the masses and to reverse this trend without delay”. Shenoy was prophetic in his prognosis, as was demonstrated by the youth insurrection of 1971. Had the political leaders taken his advice seriously, the bloody insurrection that ended in the loss of thousands of young lives could have been avoided. Noting that Sri Lanka’s consumer price index is a misleading indicator of the country’s true inflation rate because the index had been vitiated by controlled prices, he suggested that the Government should go into a full reform program to remove the inflationary pressures from the economy.
To attack the twin demons of shortage of domestic savings and inflationary pressures, he suggested that the Government should seek to balance its budget. According to him, trying to resolve the problem without going into such a fiscal reform program is like trying to control floods by restricting the water down the canals. Hence, according to him, it is the source that should be beaten and not the symptoms. Thus, both Athukorala and Shenoy are talking the same language.
Use foreign funding for producing tradeables
Athukorala says that running a deficit in the current account of the balance of payments per se is not evil. That is because the current account deficit gives an opportunity for a country to attract foreign savings to fill the savings-investment gap in the domestic economy. But those foreign savings, no matter whether they are loans or direct investments, should be put to produce goods and services that can be sold to outsiders. In other words, they should produce tradeable goods and services and not those for only domestic consumption.
According to Athukorala, Australia has run a current account deficit for more than 100 years. But the savings attracted from outside had been invested in tradeable goods and therefore, the country had not run into the type of crisis which Sri Lanka has gone into. But Sri Lanka which has attracted foreign savings mainly by way of loans and not investments has used them for producing non-tradeables. That had denied the country the ability to service that debt.
Smart cooking of data
Athukorala brought to the notice of his audience two statistical errors relating to the computation of the external debt burden of the country. One is the recording of the value of the outstanding International Sovereign Bonds or ISBs at the market price which has plummeted significantly instead of recording at the face value and treating ISBs held by the local entities as domestic debt and not external debt. This is a smart statistical cooking carried out by the Central Bank in 2020.
This wrong interpretation has helped the Central Bank to record the outstanding value of the external debt below its actual liability obligation. The other is the presentation of the external debt as a percent of GDP which is predominantly made up of non-tradable services in the recent years. Hence, the more appropriate presentation, according to Athukorala, should be the expression of the external debt as a percent of the value of exports. That comes to about three and a half times in the case of the government debt and five and a half times in the case of both the government and private external debt. This is a significantly high constraint making it difficult for the country to use its scanty foreign resources efficiently.
Banning complementary inputs and losing output
The recent measures taken by the Central Bank are all firefighting measures and not long-term remedial measures. For instance, the imposition of import controls on selected items without proper evaluation has entailed innumerable suffering to people and the economy. When these items have been selected, no proper consideration has been made to the complementarity of them. As a result, they have adversely affected the local resource utilisation. For instance, when the chemical fertilisers and pesticides have been banned, there is no way for the effective utilisation of land and labour which are the main resource inputs of the agriculture sector. As a result, they have remained unused adversely affecting the agricultural output of the country. Hence, sooner these import controls are removed, better for the economy.
Stop playing ostrich games
The Government has throughout denied the existence of an economic crisis. According to Athukorala, it is like the proverbial ostrich playing his popular game. In this game, the ostrich runs and hides its head in the sand thinking that the rest of the world does not see it. However, its weakness is exposed to everyone. Athukorala has warned that the Government should stop playing these ostrich games.
Going to IMF is now too late
Athukorala’s message to the Government and the Central Bank has been very clear. Instead of seeking to resolve a deep-rooted economic issue through palliatives, the authorities should try to apply permanent measures to resolve them. Seeking IMF support is the best option available to the Government. Though it is the best option, in my view, it is now too late to go for that option.
|Athukorala stressed that talking about innovation is futile when the country is facing its biggest ever foreign exchange crisis which, if not handled prudently, will blow up into a kind of Tsunami destroying the entire system
(The writer, a former Deputy Governor of the Central Bank of Sri Lanka, can be reached at [email protected].)