Financial Times

The Governor’s balancing act: A counter view
By Harsha de Silva

Much has been spoken of the Central Bank Governor’s recent presentation on his “Balancing Act” at the Ceylon Chamber’s Sri Lanka Economic Summit. This is an abridged version of a counter view to that of the Governor; and is to be considered as constructive criticism.

Hamlet without the Prince of Denmark
It is incredible that the Governor can talk about inflation in Sri Lanka without reference to the escalating public expenditure. In fact it is like staging Hamlet without the Prince of Denmark. His task would have been easier and more accurate if he began by saying that massive public expenditure routinely accommodated by the CBSL is the main domestic cause of inflation.

The Governor blithely talks about meeting reserve money targets and congratulates himself for a job well done. But, inflation, instead of coming down is going up. Whether it is 28 percent or 32 percent, inflation in Sri Lanka is the highest in the region. In this background, for the Governor to say that inflation cannot be compared across countries is plainly untrue. Would the Governor have the IMF, OECD, the Economist or the World Bank Development indicators not publish comparative inflation figures?

Impending crisis
One agrees that there have been strong supply shocks in energy and food price increases. But this has happened before during the first oil shock in 1973-75 and the second oil shock in 1979-80. The supply shock due to huge capital inflows during 1983-88 when the government at the time received large amounts of concessional assistance led to the appreciation of the rupee and double digit inflation as well. In those difficult situations the governments in office took measures to reduce expenditure and started reform programmes with some help from development agencies to turn things around.

But this time, the government is reluctant to go to development agencies because they would receive ‘unpalatable’ advice to cut down public expenditure and adjust the exchange rate. Instead, they are desperately borrowing at commercial rates and building up external debt obligations for unproductive purposes. If this trend continues the country would move towards that eventuality of an economic crisis of unprecedented magnitude where import restrictions, debt moratoriums and the like may very well become reality. The Treasury and the Central Bank must get their acts together to restrain the growth of expenditure and stop financing massive deficits through both external and domestic credit and money printing.

Amazing lack of understanding
The most worrisome part of the presentation is related to exchange rates. The Governor’s ‘finding’ that previous occupants of his seat had depreciated the exchange rate on IMF and World Bank advice ‘assuming’ it was a good thing but ended up creating artificial debt is startling to say the least. He claims that by not allowing the exchange rate to depreciate Sri Lanka could have saved huge amounts on debt repayments. While this may be a good sound-bite to a politician; to the professional economist it shows an amazing lack of understanding.

That with the macroeconomic imbalances that arose in the last 50 years [he refers to such a period] the exchange rate had to depreciate to restore equilibrium is something that is very well documented by those who have studied trade and exchange rate policy of Sri Lanka. It is ironic that the Governor has not been able to comprehend that if not, Sri Lanka’s export activities would have died long years ago and import substitution activities also would have had to reduce their scale of operations, if import controls were not introduced.

Also, the Governor fails to appreciate the fact that foreign debt is contracted in foreign currency and that it has to be paid in foreign currency by generating a trade surplus. If the exchange rate were allowed to appreciate then the tradable sector becomes less profitable and that would limit the extent of the surplus and the country's ability to service debt. Also, remarkably, just keeping the Sri Lanka rupee value of the foreign debt constant does not do anything to reduce the amount to be repaid abroad in foreign currency. So by not depreciating the currency as a part of the adjustment, the country does not ‘save’ resources as implied by the Governor.

An expensive illusion
What is dangerous at the moment is that the Governor seems to be going along with an exchange rate based stabilization programme keeping the exchange rate from depreciating. As clearly seen, the Central Bank has been borrowing abroad and intervening in the exchange market to keep the exchange rate largely unchanged over the last few months. This gives a false sense of stability as the repayment of accumulating debt becomes difficult with an appreciated exchange rate. To be sure, the logic is that an appreciated exchange rate is a tax on exports and a subsidy on imports. The country cannot generate an export surplus under these conditions.

Productivity puzzle
The Governor seems to consider that devaluation and productivity growth as alternatives. The fact is that the exchange rate is an important variable in determining short term competitiveness. In the long term however, productivity depends on the overall incentive structure of the economy, including the long term real exchange rates. So the Governor cannot push the private sector to increase productivity when the profitability of the tradable sectors is being squeezed by rising inflation and an over-valued exchange rate and now being forced to raise wages!

Enjoying the breeze
Finally, how does one explain the reasonably high growth and reduced unemployment in the last three years? Many countries have experienced these types of so-called Keynesian booms when credit led expenditures raise output and employment only to fall when these imbalances come to a head.

What this means is that the long term growth will be lower than a steady rate of growth that would have ensued while avoiding inflation and keeping the external accounts manageable; which is not the case now. It reminds me of the story of a man falling from the 20th floor; when asked how he feels as he falls past the 10th floor, he says he is enjoying the breeze!

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