The poor performance of Sri Lanka’s stock market and the rapid devaluation of the Rupee in recent weeks suggest all is not well with the economy. At the heart of the problem is the way energy prices are manipulated by the Government which is a key drag factor holding back industrial expansion and job creation.
The Government has to come clean and admit that the CEB and CPC are tottering under the weight of accumulated losses incurred during the final phase of the war against the LTTE. Fuel and electricity prices must be linked to international price levels, rather than being fixed in an arbitrary manner, so that these institutions can regain their profitability.
If this is not done soon, the state-owned banks which hold more than half the total banking deposits of the country and which lend vast sums to the loss-making CEB and CPC will lend less money to the rest of the economy. This will strangle the rate of growth of Sri Lanka’s economy.
It is not difficult to see that our policy-makers are getting nervous about the situation. The spat over devaluation of the Rupee between the Central Bank Governor and Treasury Secretary had to be resolved by the President in his budget speech. It was like the proverbial pulling of the finger from the hole in the dike.
But the debate over exchange rate policy is ultimately a waste of valuable government time at the highest levels. There are much more important economic issues looming.While Sri Lanka’s rate of consumer price inflation is falling, as is the case almost everywhere in the emerging markets as world food prices descend from their 2011 highs, the Central Bank (CB) of Sri Lanka is raising interest rates rather than following the example of several Asian countries in cutting interest rates.
Moreover, since the start of 2012 the Colombo Stock Exchange has languished while global stock markets have had their best two months in a year, powered by a resurgent US economy and cheaper credit worldwide.
What’s going on?
At first sight, it would appear that the CB is playing catch-up and making up for its delayed monetary tightening which should have started in mid-2011. That was when signs emerged that bank lending was surging to unsustainably high levels and needed to be reined-in.
Thus, while all the major emerging market central banks were in tightening mode in 2011, as they struggled to cope with the unusual surge in global agricultural prices that started in mid-2010, Sri Lanka adopted a radically different approach. Benchmark interest rates in Sri Lanka were deliberately targeted below the rate of inflation and banks were given explicit signals by policy-makers that they should step-up lending.
With hindsight it would appear that policy-makers should have been more careful about what they wished for.
When the surge in bank lending did finally happen it came in tsunami-like proportions. It appears that bank lending is currently running about 40% higher than it was a year ago. In itself, this statistic need not signal too much alarm. There is still a lot of spare unused capacity in Sri Lanka’s economy, particularly in the war-ravaged northern and eastern provinces which offer tremendous potential to uplift economic growth to sustainably higher rates. Higher bank lending to these areas is not merely desirable but is an economic imperative.The problem is that the new bank lending seems to be funding activity which can be characterized, at best, as being peripheral to the high-growth sectors in the country.
Thus, imports of gold in 2011 grew six-fold to half a billion US dollars. Imports of motor vehicles doubled to $1 billion. In consequence, the trade deficit, the difference between exports and imports, doubled in 2011 to about $9 billion.
It is moot whether higher imports of gold and cars will make an appreciable impact on growing more paddy in the eastern province or reviving industries in Jaffna. Nor for that matter is it likely to improve productivity in the garment export sector or raise yields in tea production in other areas of the country.
In fairness, there are more taxis on the roads which is good for tourism. But the rapidly growing number of ultra-luxury vehicles on Colombo roads somehow seems out of proportion to a country emerging from a 30-year civil war.
In short, the problem seems to lie in the manner in which all that bank lending is being disbursed. And to which sectors of the economy it ends up in.
We have been here before.
In the early 1990s the CB had a multiplicity of export sector bank refinance schemes, which guaranteed low rates of interest for extended periods. Bank lending was booming as the country emerged from the ravages of the southern insurgency. But surveys of where that concessional bank lending went suggested that it was funding the construction of luxury houses with swimming pools in Colombo and its suburbs and the purchase of duty-free vehicles by Board of Investment-approved company personnel.
The lessons learnt from that episode in the early 1990s should resonate in the current economic environment. Firstly, any interference in the normal functioning of the credit pricing and delivery mechanism of the commercial banking system will mostly lead to perverse outcomes, which largely vitiate the achievement of the original objective, viz. a boost to economic development.
The second and more important lesson, however, was that the country could not afford to maintain an over-valued currency. Between 1991 and 1993 the Rupee moved from 40 to 50 per USD, i.e. a 20% devaluation.
An over-valued Rupee gives rise to imaginary feelings of prosperity in the population at large. This fleeting perception of material well-being is politically convenient at times but merely delays the inevitable painful adjustment. As Abraham Lincoln once observed, you cannot fool all of the people all of the time.
A key element of the over-valued currency is that it aggravates the already-distorted and the most important price in any modern economy – the price of energy.
After the nationalization of Sri Lanka’s petroleum sector in the early 1960s, which co-incidentally invoked the provisions of the US Hickenlooper Amendment and put paid to any major US investment in Sri Lanka for decades thereafter, domestic energy prices have rarely kept pace with international costs of electricity and fuel ever since.
That episode, incidentally, sealed Singapore’s future as the oil refining hub of Asia by establishing a intermediary oil-refining port between the Middle East oil producers and the then-burgeoning Japanese economy. Sri Lanka simply bowed out of the global petroleum refining industry in one fell detachment-swoop.
Those responsible for nationalizing the sugar plantations recently would do well to recall that episode as well as the nationalization of tea plantations in the 1970s which gave away our expertise and markets in the tea trade to Kenya.
But let’s get back to the mess that is Sri Lanka’s energy sector.
A gallon of petrol in Sri Lanka today costs about $5.50 compared to $3.75 in the US. This premium charged to the presumed ‘rich’ owners of gas-guzzling limos (mostly purchased with bank loans) is then used to fund the reduction in the local price of diesel which in turn is subsidized to below international prices to keep public transport (trains and buses) affordable. The fact that petrol (and engine oil) is used by the vast majority of trishaw-owners and their long-suffering passengers is an inconvenient truth which is regrettably ignored.
As a consequence the state-owned petroleum refinery, which is in dire need of modernization, has a surplus of petrol (naphtha) for which demand is weak and insufficient diesel to meet the strong demand (not least from the owners of diesel-guzzling SUVs).
To complicate things further the private diesel-fired power generation plants buy diesel at another set of prices and sell the electricity to the CEB at prices much higher than the price paid to the CEB by the bulk of its retail consumers. So we have to sympathise with CEB engineers who have absolutely no control over the profitability of their operations since electricity prices are kept artificially low by politicians looking at winning the next election.
This is just one example of the huge distortions that make the Sri Lanka economy less competitive than it should be and arguably a difficult place in which to establish heavy industries that could thrive here such as ship-repairing, oil rig building and petroleum refining which require huge inputs of energy at internationally competitive prices to make their operations cost-effective.
A policy measure which helped Sri Lanka persist with these energy price distortions was the 2008 agreement with Iran for Sri Lanka to purchase its crude oil on deferred payment terms over several years. That agreement crashed to a halt recently when the US called on the international community to impose sanctions on Iran, for defying international calls on it to stop building nuclear weapons, and threatened to cut trade links with countries which defied the sanctions.
To continue buying Iranian oil would thus imperil billions of dollars of Sri Lanka garment exports to the US, among other things.
The loss of the Iranian deferred-payment crude oil facility could not have come at a worse time for Sri Lanka. Given the surge in imports of gold and cars etc, foreign currency reserves have plummeted to just over three months worth of imports which is considered the borderline between a sustainable balance of payments situation for a country, or something worse.
So the recent sharp price increases were unavoidable. But it is a pity that an opportunity to link fuel and electricity prices to the actual cost of supplying them was missed. This means when global oil prices fall in the future, the government will extract the windfall profits and use it to purchase a new fleet of cars for parliamentarians or some such useless gimmick.
In the meantime, given that the price increases in retail petroleum products were as high as 30-40%, this measure is going to place very severe strains on consumer and producer balance sheets in the coming months. And it could knock a few points off GDP growth, which I forecast will be 6.5% in 2012 or even lower.
From a stock market point of view, these problems in the economy were anticipated in early 2011 when foreign institutional buyers of Sri Lankan stocks turned net sellers. These investors are unlikely to return until there is more clarity on the impact a devalued Rupee and drastically higher energy prices will have on the earnings of banks and companies listed here.
It is also important for policy makers in Sri Lanka to recognize, going forward, that the changes in energy prices and the currency have to be signaled through a more transparent economic mechanism which is not subject to the vagaries of the political calendar.
Merely praying for the discovery of oil in the Mannar Basin will not suffice or send the problems away. Even if oil is finally discovered in Sri Lankan waters it will take 2-3 years to drill and extract supplies by which time international oil prices would have fallen. Large new supplies of oil are expected in the Atlantic Ocean basins abutting Brazil and Ghana/Ivory Coast. These will flood world oil markets from 2013 onwards, raising supply and depressing prices.
Thus, if Sri Lanka did strike oil soon this will be used by the current policy regime to continuously distort local fuel and electricity prices and discourage large industries from setting up in Sri Lanka. Powerful vested interest groups have now grown in the CEB, CPC, Private Bus Owners’ Association, etc who will strongly resist changes to the way prices are set through administrative fiat.
Energy price transparency has therefore got to be backed at the highest political levels for it to be implemented over the heads of these powerful vested interests. The genuinely poor citizens of Sri Lanka should be looked after by providing a social safety net which must be applied on a means-tested basis, while the transition to world energy prices takes place. Aid agencies will almost certainly fund such a safety net so long as the transition to efficient energy pricing is transparently executed.
Financial markets have evolved several methods of hedging corporate exposure to volatile energy prices and currency movements. But they cannot and will not attempt to price these movements when they are subject to anything other than a well-functioning market mechanism. Otherwise Sri Lankan companies will have to pay unnecessarily high premia to shield themselves against these uncertain price and currency movements.
And that uncertainty will translate into uncertain forecasts of the growth of corporate earnings, which, in turn, make for a more volatile stock market.
To mitigate some of this volatility it would help to factor into stock market analysts expectations a steady gradual depreciation of the currency over time. This would blend with the view recently expressed by the Treasury that it expects a fiscal deficit of 6% of GDP annually in the medium-term. If that implies annual consumer price inflation of 5-10% and productivity increases of 1%, an annual rolling depreciation of the Sri Lanka Rupee by 5-6% would be appropriate.
Perhaps the President should take over the delicate job of setting the exchange rate. His commonsensical approach seen in the recent budget speech will be better than that of the Monetary Board.
The comment of John Maynard Keynes comes to mind: “The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist.”
A lot of work has to be on re-crafting Sri Lanka’s economic policies to face the challenges of the post-war era. But there are no signs that these are even being thought of by the powers that be. The only signal is that the government hopes it will strike oil and become rich. Much like it became rich after the 2004 tsunami. Future generations will curse us if we do not lay the basis for future growth. Time, as they say, is fast running out.