Columns - The Sunday Times Economic Analysis

Three imperatives for economic growth and development

By the Economist

Economic growth is a multifaceted phenomenon dependent on a multiplicity of factors both economic and non-economic. There are many non-economic factors that impinge on economic growth such as political stability, law and order, the rule of law, integrity and honesty of the public service, levels of health and education, among others. These may be as important and perhaps even more so but are not discussed here as we confine ourselves to a discussion of three of the most important economic variables.

To limit a discussion of economic growth to just three variables is inadequate; it is a distortion of the growth process as it fails to capture the diversity of the factors that determine growth. In spite of this limitation, we discuss three of the most important economic variables that determine both short-term economic growth and long term economic development. The provocation for this discussion lies in the lack of understanding of the economic policy framework needed for strong economic growth and development among many.

First of all we must clear the ground of the current misconception that since peace has been attained the economy will grow whatever be the policies followed. This attitude of economic complacency has been buttressed by the fact that the country has emerged from a crisis in the foreign exchange reserve position to one of having comfortable foreign exchange reserves of over US$ 4 billion.

This large reserve has prompted some to think that the country can spend uncontrollably. There is nothing further from truth; especially as most of the reserves are an aggregation of foreign borrowing that are debts that must be repaid sooner or later. If these funds are not used prudently and wisely in a productive manner the economic condition of the country could deteriorate rather than improve and be a huge burden for the future.

Economic growth has recovered somewhat in the second quarter of this year compared to the performance in the first quarter. According to the Department of Census and Statistics the economy grew at 2.1 per cent in the second quarter of the year resulting in an economic growth of 1.8 per cent for the first half of the year. The growth momentum is expected to accelerate in the third quarter and increase further in the last quarter from October to December 2009. Both the Department of Census and Statistics and the Central Bank of Sri Lanka are of this view.

They expect the 2009 economic growth to be between 3.5 to 4 per cent which is not unlikely.
The Department of Census and Statistics foresees a robust growth in the economy owing to the developments in the second quarter. It states: “The economy is showing positive performance for all three main sub sectors of Agriculture, Industry and Services of GDP. The industry sector grew by 3.0 per cent and the services sector grew by 1.1 per cent for the second quarter of 2009. The total agriculture sector has shown 4.4 per cent growth….. The agriculture sector performance is really encouraging for the second quarter and it shows above 6% growth after excluding tea ...” When the trade union dispute has been resolved and fair weather prevails tea production too should increase. There is also the prospect of increased agricultural production from the East and the North and reason to believe that the current peace situation would increase production in several sectors such as tourism, industries catering to domestic demand and transport and communication services.

Notwithstanding these improved prospects and perhaps because of the complacency that these achievements may generate, there is the danger of not following the correct policies for economic stabilisation and growth. The three essential policies to place the economy on a path of economic stability and growth are: fiscal consolidation, exchange rate management and monetary management. Of these three the most important is fiscal consolidation as large budget deficits affect the foreign trade and balance of payments position and make monetary management difficult. If the country fails to rein in the deficit to manageable proportions inflationary pressures would destabilise the economy. With increased inflation, exports would be adversely affected and the trade deficit would widen further. The real effects would be the closure of export industries and consequent unemployment. Already the Department of Statistics has estimated a rise in unemployment to about 9.5 per cent. About 200,000 employees have lost their jobs and the number unemployed has reached 496,000.

In order to bring down the deficit there is a need to both increase revenue and reduce expenditure. Tax compliance has been identified as the means by which revenues would be increased. This is a tough task though a move in the correct direction. It is estimated that there should be about one million tax payers whereas there are only about 300,000 tax files. Tax dodgers far outweigh tax payers.

The inefficiency in the tax administration, corruption of officials and various loopholes are responsible for this. It is well known that among the worst offenders are professionals whose fees evade taxes by various ruses such as the acceptance of only cash. There is a need for drastic and innovative measures to curb evasion. Whether it would be practical to achieve the desired increase in revenues is a moot question.
The other approach is to reduce expenditure.

As President Mahinda Rajapaksa correctly pointed out soon after the victory in the war, waste must be wiped out. This means wasteful expenditure at all levels, with the priority on cutting down large amounts. Among the areas of reduction should be losses in public corporations, ineffective subsidies and waste. The ways in which public expenditure should be cut are well known but perhaps difficult to achieve owing to political constraints.Exchange rate management is vital for the country as it is very much dependent on exports. The country has a persistent problem of trade deficits and the more these widen the more pressure there is on the reserves.

In the first half of this year exports of industrial items like garments, rubber and ceramic products lost markets owing to the relative appreciation of the Rupee. What matters is not the nominal exchange rate but the real effective exchange rate that adjusts it to the rates of inflation in competing countries. This is not a very well understood aspect of the exchange rate management. Consequently some ask: why is it that the country remains uncompetitive despite the depreciation of the Rupee over time? The answer lies in the fact that we have not made adequate adjustments in the exchange rate vis-à-vis our competitors who have had lower rates of inflation. Once again we return to the issue of the fiscal balance as the magnitude of the deficit is an important determinant of the rate of inflation.

The third factor of importance is to ensure there is an adequate supply of credit to the private sector at costs that make it profitable to borrow. A current problem is that the cost of credit is still high in relation to the avenues for profitable employment of borrowed funds and the supply of credit is inadequate as banks prefer to use their funds for risk free lending to the government.

It would be imprudent to think that just because there is peace there would be economic prosperity. No doubt there would be a measure of growth owing to peaceful conditions in the country, but getting the economic policies correct is vital for realising the full potential of the economy.

The three variables of fiscal consolidation, exchange rate management and appropriate monetary policies are indeed vital components of a strategy to achieve the full potential of the economy.

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