A few weeks back this column drew attention to the large trade deficit that was accruing and warned that it may reach an excessive figure by the end of this year. The latest trade figures released by the Central Bank confirm this suspicion as the countrycontinues to build up a massive trade deficit. In the first five months of this year the trade deficit reached US$ 2579 million. This is an increase of 79 per cent from that for the same five months of last year. If the deficit continues to grow at this rate the trade deficit can be expected to cross over the US $ 6000 mark, much higher than the record deficit of US $ 3560 reached last year. Is this a matter of concern?
Many countries incur large trade deficits without it being a serious problem to them. Conspicuous among them is the USA. However this is a special case, as other countries are willing to hold US dollars. There are other situations too when a trade deficit is not considered an indicator of an economy’s weak performance. In fact there are economic situations when trade deficits may be considered as indicative of potential growth. For instance, when increased import expenditure is on investment goods or intermediate goods for production of tradable goods, then such trade deficits are the basis of economic growth and eventually lead to an improvement in the balance of payments. Therefore it is not only the amount of the trade deficit that is significant but how the deficit is incurred, especially the nature of imports. Besides, when the trade deficit does not lead to a balance of payments problem, then it is quite legitimate to ask: why be concerned about the trade deficit, for after all, other items in the balance of payments off set the trade deficit? Are the massive trade deficits in the last few years and in the first five months of this year of serious concern for the economy?
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Admittedly there are situations when the trade deficit is a sign of better things to come. If the trade deficit is incurred owing to large capital imports for industrial development or the development of a country’s infrastructure, then the trade deficit is being incurred to finance the development of the country. The import of raw materials or intermediate goods can be due to a higher level of activity. These imports should lead to an increase in the output of the economy and an increase in tradable goods or reduction of imports in later years. There are circumstances when the incurring of a trade deficit could be a sign of a robust growth in an economy. In the years immediately after liberalisation in late 1977, the large trade deficits that were incurred were partly owing to this phenomenon. It was only partly so, as there was a surge in imports of consumer goods as well to satisfy the pent up demands of a community that had gone through a seven year period of stringent import and exchange controls that starved people of many consumer items as well as imports of cars and vehicles and other items.
On the other hand, it was a period of heavy investment such as on power generation and irrigation and the beginnings of an industrial base and an industrial export led strategy. Part of the strain in the trade account was set-off by foreign private investment, foreign aid, grants and concessionary borrowing for large capital investments. Despite these inflows the country had balance of payments deficits, some of which were met by facilities from the International Monetary Fund. Therefore by and large the trade deficits incurred and the balance of payments difficulties had an investment character. More broadly the issue is not merely the amount of the trade deficit but the reasons for incurring it. While in this situation it was incurred for developmental expenditure, much of the current trade deficit is for funding military hardware and imports that are not leading to increasing the production potential of the economy.
Even so, it could be argued that the trade deficit is but a component of the balance of payments and if other items in the balance of payments off-set this deficit, why be concerned about it? This is a very relevant question in the context of what has been happening in Sri Lanka. For many years now there have been increased inflows of remittances from Sri Lankans abroad. These large inflows of remittances are off-setting a high proportion of the trade deficit. In addition, capital inflows and foreign borrowing have turned the trade deficit into a balance of payments surplus in recent years. The first five months of this year are no exception as the balance of payments recorded a surplus of US$ 292 million by end-May 2008, despite the huge trade deficit noted earlier. The Central Bank also indicates that the gross official reserves amounted to US $ 3,355 million by end May 2008. This, according to the Central Bank, is sufficient to finance around 3.2 months of imports. Do these facts mean that we have cause to be concerned about the rising trade deficit?
We should be concerned about the large trade deficit, despite the balance of payments surplus, for many reasons. The magnitude of the trade deficit is so large this year that the remittances and other capital inflows other than foreign loans could be inadequate to meet the deficit this year. If the deficit is covered by foreign loans then these are contingent liabilities. Though the immediate balance of payments problem may be relieved, we would be acquiring liabilities that would strain the balance of payments in the not too distant future. This will mean we will have even a lesser amount of our export income to finance imports. The debt financing will not only strain the balance of payments but will be a fiscal burden and would distort government expenditure. Already the debt servicing is absorbing about 36 per cent of revenue that leaves inadequate funds for developmental expenditure and social services like health and education.
The reality is that we are amassing too large a trade deficit to be lulled into complacency by the small balance of payments surplus. Besides, the foreign borrowing to bridge the trade gap is increasingly worrisome. It is therefore vital to find ways and means of reducing our import expenditure and increasing export earnings. Complacency derived owing to a balance of payments surplus could be deceptive and could jeopardise the economy sooner rather than later. |
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