Sunday Times 2
The party is over: No easy options
View(s):The Pathfinder Foundation (PF), a non-profit, organisation, believes that the formation of a new government now provides the opportunity for greater attention to economic management. There are domestic and international pressures, which make early and decisive action a priority. The immediate compulsion is macroeconomic policy adjustment to address the difficult combination of weak growth and pressure on the external account. This macroeconomic policy recalibration will have to take place in an uncertain international environment: the anticipated US Federal Reserve interest rate lift-off and global deflationary pressures emanating from a slowing economy as well as exchange rate and stock market uncertainty in China.
The new economic model will have to be private sector-led and based on export expansion with a major role for FDI.
Clear dir++ection needs to be given regarding medium-term structural reforms to increase the growth and productive employment capacity of the economy.
New development paradigm
The policy framework needs to focus on a new development paradigm: a move from the current welfarist model to a laser like focus on productivity/competitiveness. Priority should be attached to accelerating the growth trajectory while generating higher value employment.
A strong human resource development programme should focus on empowering the population to share in increasing prosperity. The current model is trapping large numbers of the population in low income/low productivity livelihoods. A quarter of Sri Lankans live below $2.50 (about Rs. 330) a day. Furthermore, the present model is becoming increasingly unaffordable now that Sri Lanka has graduated to lower-middle-income-country status. The country is now living beyond its means through increased foreign commercial borrowings rather than highly concessional foreign aid. This is unsustainable. It places the country on a ‘flight path to Greece-style crash’.
Growth oriented stabilisation
Short-term macroeconomic policy-making is faced by a combination of challenges. There is an output gap. The revised GDP data reveal there was a sharp slowdown in growth: 3.7% (2013) and 4.5 % (2014). Growth was 5.1% in 1Q 2015, still well below the potential growth rate of 6.8% (IMF assessment). The recovery in growth has been weak, despite an accommodative monetary and fiscal stance. This may be attributed to: the failure to introduce structural reforms to support the stabilisation policies of 2012; a policy orientation imbued with statism and economic nationalism which affected investor confidence at a time when fiscal space was being squeezed; and an uncertain political environment since 4Q 2014.
The macroeconomic policy challenges have been compounded by the emergence of balance of payments/reserves/currency pressures even though growth is still below potential. This may be attributed to the ‘auction of non-existent resources’ seen in the Budget Speech (November 2014) and greatly compounded in the Interim Budget (January 2015). The boost to consumption from populist fiscal measures, combined with historically low interest rates, has led to these pressures on the external account, despite the cushion provided by the sharp decline in global oil prices. This cushion has been squandered on unsustainable consumption imports such as motor vehicles. In addition, external reserves have been under pressure due to the deterioration in the current account deficit; unsustainable defence of the currency and the outflows from government securities.
The challenge for the authorities, in the short-term, is to adopt a policy stance which delivers growth-friendly outcomes whilst stabilising the external account. This reduces the room to manoeuvre in terms of fiscal consolidation and tightening monetary policy until private investment led recovery in growth kicks-in. Depreciating the currency is the most growth-friendly means (despite the J-Curve effect) of stabilising the external account. The current low-inflation will also make it easier to accommodate the price-pressure from a weaker Rupee. However, depreciation is likely to aggravate the outflows from Rupee securities ($638 million during mid-April to mid-August 2015). A reduction in interest rates will also have the same effect.
This scenario is compounded by negative sentiments regarding emerging markets among global investors in the context of the expected US interest rate rise and uncertainties in China. The up-shot is that there is no easy option. The authorities are confronted with the complex short-term challenge of balancing growth and stability. The distribution of the burden of stabilisation across fiscal, monetary and exchange rate policies will have to be a political call. This will have to be done in an international context which is becoming more challenging for countries with fiscal and external account pressures like Sri Lanka.
There is a strong case for securing early IMF assistance. This will provide additional financing to support a more growth-oriented adjustment path. It will also serve to boost investor sentiment, particularly in international capital markets, at a time when Sri Lanka is vulnerable.
Accelerating growth and generating higher value employment
In the present context, it is difficult to boost growth through recalibrating macroeconomic policies; particularly as international portfolio flows are very sensitive to interest rate and currency adjustment. This highlights the urgency for structural reforms which strengthen the growth framework through productivity/competitiveness improvement. Sri Lanka needs a new growth model. The previous one (2010-2014) was based on foreign commercial borrowing financed public investment in infrastructure development. This no longer has any headroom because of the country’s debt profile. Given the lack of fiscal space and the limited size of the domestic market, the new model will have to be private sector led and based on export expansion with a major role for FDI. The transformation to the new growth model is not possible without structural reforms which focus, inter alia on the following: addressing the structural weaknesses in the government budget; reversing the trend towards an increasingly closed economy (tariff and para-tariff reforms); improving the investment climate; SOE and public service reform; reformulating agricultural and industrial policies and above all strengthening education, training and skills development. The PF will elaborate upon these in a longer memorandum as a follow-up to its Blueprint.
Grasping the opportunity
The country has not made a good fist of taking advantage of the opportunities that emerged with the end of the conflict. Today, we have another chance. We cannot afford to squander yet another opportunity. To do so would accelerate our path to a Greece-like crisis.