SL needs new paradigm of economic policy-making unconnected to short-term political expedience
View(s):Sri Lankans are now aspirational and impatient. Governments will be judged by their capacity to deliver improving living standards, says the Pathfinder Foundation in its latest “Pathfinder Economic Flash”. Addressed to the President and the Prime Minister, the report said, “The old stop-go policies of deceiving people with hand-outs and then imposing burdens on them are unlikely to be politically and socially tenable in the future. The country needs a new paradigm of economic policy-making which breaks away from the short-term political expedience of the past”.
Here are extracts of the report:
Short-term dangers
At present, the economy is confronted with the unusual combination of below potential growth and pressure on the external account (the current account of the balance of payments, the currency and reserves). The present strategy of borrowing (including the Indian swap arrangements) and defending the exchange rate by depleting resources is unsustainable.
Balance of Payments pressure is usually associated with an overheating economy (high and unsustainable growth) not one with an output gap. The muted inflationary pressure also reinforces the fact that the economy is growing below potential (though imported deflation is also an important explanatory factor). The low growth may be attributed to a lack of structural reform after the stabilisation package in 2012; an uncertain business environment with inconsistent and unpredictable policies; and the political uncertainty over the last 9 months.
The combination of low growth and external account pressure can occur when there is a major exogenous shock, such as a sharp rise in oil prices and /or a collapse of key export production/markets. While tea and rubber exports have been experiencing difficulties, this has been easily offset by the substantial foreign exchange savings generated by low oil prices. This means that the current combination of low growth and external account pressure cannot be attributed to an exogenous shock.
So, why is there pressure on the external account when growth is low? The answer lies in the massive boost to consumption given by the non-productivity linked giveaways in the Budget (Nov. 2014) and the Interim Budget (Jan. 2015). Consumers have used their higher disposable incomes to increase their purchases of imported items (particularly motor vehicles). At the same time, nothing has happened to earn or save more foreign exchange. In fact, exports have declined in 1H 2015.
The result is inevitable pressure on the external account. In the current context, fiscal austerity in the short-term will depress already low growth (though the structural budget deficit needs to be addressed in the medium-term). Tightening monetary policy and/or exchange rate depreciation is likely to accelerate the outflow of foreign funds from Rupee securities and the stock market. There is a global trend of money flowing out of emerging markets, especially Asia. Countries, like Sri Lanka, with fiscal and current account of the balance of payments deficits are particularly vulnerable. Consequently, aggressive monetary or exchange rate adjustment, at this point, can be counterproductive by triggering outflows thereby exerting even more pressure on the balance of payments, the currency and external reserves.
Measures for urgent attention
The macroeconomic policy-making landscape is complex and difficult. This may be attributed to adverse trends in global markets as well as electorally motivated and irrationally over-exuberant fiscal measures. In this context, the policy-makers may wish to consider, inter alia, the following measures.
- Demonstrate a firm commitment to tackling the structural fiscal deficit by announcing a credible back-loaded medium-term fiscal consolidation framework (back-loading the adjustment would avoid further dampening growth in the short-term while the investment climate is improved.)
- Some combination of monetary tightening and exchange rate depreciation. It would be a political call as to how the burden of adjustment is distributed between these two macroeconomic policy instruments. Greater reliance on the exchange rate is more growth – friendly (despite the J-curve effects). The current low-inflation environment and higher disposable incomes offer room to manoeuvre.
- The combination of a deteriorating balance of payments and defence of the Rupee with external borrowing, including swap arrangements, is unsustainable. This needs to be addressed with some stabilisation measures, especially in the current uncertain global environment.
- n An early IMF arrangement would provide financing to reduce the burden of short-term stabilisation and also boost sentiment in global markets at a time when Sri Lanka is vulnerable. The IMF today is different. It is no longer overly preoccupied with austerity measures. It has a greater focus on growth and distributional issues.
- Boost growth through a laser-like focus on improving the investment climate. This is the low hanging fruit with little financial, legislative and political costs.
- Urgent action to take forward foreign and local investment projects which have been temporarily suspended or delayed due to reviews during the 100-day programme in order to transmit the right signals to domestic and foreign investors.
Medium-term challenges
Sri Lanka needs structural reforms to achieve sustained high and inclusive growth. The economy needs to be transformed from one which is characterised by low productivity agriculture/low-technology manufacturing and traditional services (retail/wholesale trade, transport and public administration) into a modern economy based on higher productivity agriculture/ higher technology manufacturing and modern services, (such as shipping, aviation, ICT/BPO/KPO, financial services and health and education).
The new political cycle, and the formation of a national government, presents an opportunity to forge consensus on the tough reforms necessary to transform the economy. It provides an opportunity to break out of the repeating cycle of stop-go policies which have characterised the last four decades. A key lesson to be learnt from the 2012-2014 period is that stabilisation measures alone are not enough to achieve sustained growth that touches the lives of the people. Stabilisation measures are a necessary but not sufficient condition to strengthen the growth framework in the medium and long – term. They need to be complemented by structural reforms which boost productivity/competitiveness. This is the recipe for achieving sustained increases in people’s incomes. Not hand-outs and subsidies, which are not linked to productivity, and are unsustainable.