Columns - The Sunday Times Economic Analysis

IMF says economy on track

International prices swell trade deficit
By the Economist

The IMF is satisfied with the economic progress this year and the next tranches of the IMF stand-by facility will undoubtedly be disbursed. This would further strengthen the foreign exchange reserves that have fallen somewhat recently. Not withstanding the IMF assessment, the external trade situation is not at all encouraging. The merchandise trade deficit is heading to a huge amount this year, very similar to the experience of 2008.

Current indications are that it would exceed US$ 5000 million, which is more than a doubling of last year’s merchandise trade deficit. However there is a vital difference this year in that, with even the massive merchandise trade imbalance it will not lead to a balance of payments crisis or serious erosion in the foreign reserves position. This is due to increased worker remittances, higher earnings from tourism and the continued borrowing from abroad. The next tranche of the IMF loan will further strengthen this position.

Increase in import prices has been primarily the reason for this deterioration in the trade balance. An imminent new threat to the trade balance comes from the likelihood of a sudden increase in wheat prices accompanied by increases in other food import costs as well. The price of petroleum has also been much higher than it was last year. On the side of exports, agricultural exports have fared well especially owing to an increase in prices, but industrial exports have performed badly.

Consequently the merchandise trade deficit in the first five months of the year was more than double compared to that of the same period last year. It is likely that the merchandise trade deficit would widen to over US$ 5000 million this year.

The imminent increase in wheat prices and loss in export earnings due to the loss of the GSP plus concession could raise the deficit to a much higher level. All major categories of imports increased in the first five months of this year. The highest increase in import expenditure was for intermediate goods. Expenditure on imports of intermediate goods increased mainly due to the higher crude oil prices that were nearly US $ 85 per barrel in May 2010 compared to US $ 62 per barrel in May 2009. Expenditure on chemicals and fertilizer also increased from that of 2009. There was an increase in expenditure on sugar and milk due to the higher volumes of imports and higher prices compared to the previous year. Higher imports of motor cars and motorcycles due to the reduction in tariffs also swelled import expenditure.
Consequently import expenditure in the first five months of this year increased by 42 per cent compared to that of the same period last year.

The total import bill for the first five months was US$ 5277 million compared to US$ 3706 million in the first five months of 2009. On the other hand, industrial exports increased by only 6.5 per cent to US $ 2132 million with garment export earnings declining by 7.5 per cent to US$ 1194 million in the first five months of this year. The IMF is more than satisfied with the current performance of the economy and government policy, including the external finances of the country. In its statement it states “Overall economic conditions are improving as expected in the last visit, and the economy is likely to show strong growth this year. External balances are strong, remittance inflows continue at a high rate, tourism prospects continue to improve rapidly, and gross reserves remain at comfortable levels.”

Apparently the analysts at the IMF do not think that the massive merchandise trade deficit is of any serious consequence. The plain truth is that the country is losing its competitiveness in industrial exports, incurring a large merchandise trade deficit and the country’s foreign debt is increasing. The servicing of the country’s public debt has put the country into a debt trap. The IMF has also given approval to the decrease in central bank rates as a means of retaining lending rates low to spur private investment. In its view, “We assess the central bank’s recent rate cut as appropriate—with bank lending only slowly beginning to rebound, and economic growth still below potential, we see little sign of emerging demand-driven inflationary pressures, and average inflation for the year as a whole is expected to remain in the single digits.”

The IMF is also satisfied with the fiscal consolidation measures. “With budget revenues increasing and expenditure restraint continuing, fiscal performance so far remains consistent with achieving the government’s full-year deficit target of 8 per cent of GDP. Financial sector reforms continue to go forward in line with the programme.” The IMF assessment of the fiscal situation is quite different to the assessment of local analysts who expect the fiscal deficit to be about 9 per cent this year too. Time will tell whether the IMF experts have been more correct than the local analysts. In any event there would be excuses of one sort or the other to justify the difficulties of restraining the deficit and the IMF stand-by agreement would continue.

There is every reason for the Sri Lankan government to be more than satisfied with the IMF assessment of the economy. It has painted a bright report of the current economic situation :“Since the last consultation two years ago a great deal has changed—the end of the 30-year war has led to a surge in investor enthusiasm, bolstered by the decline in the risk of a short-term balance of payments crisis—and future growth prospects have improved markedly.”

Despite the favourable outturn, as is usually the manner of speaking of the IMF, there are caveats too. They are warnings and admonitions diplomatically expressed. These are the challenges facing the economy and the need for reforms. In the words of the IMF, “Significant near-and medium-term macroeconomic challenges will need to be addressed however, if Sri Lanka is to take full advantage of the current favourable environment.”

These reforms include a fundamental tax reform “to simplify the existing system, broaden the tax base (including by restricting concessions), spread the tax burden more equitably, and support economic growth, all the while boosting the revenue-to-GDP ratio. The resulting fiscal space could allow increased public capital spending on reconstruction and infrastructure as well as social spending to support the vulnerable, but it is clear that the country’s large investment needs cannot be met through the government budget alone. Private-sector investment will need to play a critical role. To foster this investment, policies will need to be geared toward preserving macroeconomic stability, ensuring external competitiveness, facilitating capital market development, and improving the investment climate, all of which would lay the basis for higher sustainable growth in a post-war environment.”

The budget to be presented in November will give an indication whether the IMF advice is likely to be implemented. Meanwhile the weakening trade situation is likely to create serious hardships for the people with rising unemployment, increasing costs of imported food items and erosion of real incomes.

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