The Sunday Times Economic Analysis                 By the Economist  

Fuelling the inflationary spiral
The increase in fuel prices announced earlier this week would undoubtedly fuel prices further. The price increases will not be confined to transport costs but raise prices of most other goods as well. The several cost of living indices of May demonstrate this fact. They displayed increases in domestically produced goods such as vegetables that are in season. The inevitability of inflation has to be accepted by the government and people.

The impact of the oil price increase is several folds. It affects the cost of living both directly - in petrol, diesel and kerosene price hikes - and indirectly - through its impact on electricity and transport costs. These in turn affect costs of production and transport of domestically produced goods as well. The increase in prices of vegetables during a season is indicative of the impact of transport costs. So the import induced inflationary spiral is inevitable.

The government does not know how to handle it politically. On the other hand, the political situation only helps to exacerbate it. Here once again is an instance when economics and politics are dialectical. The opposition is quite jubilant about the turn of international events that has made the election promises of reducing prices impossible to fulfill. Yet such jubilation can well be short-lived if they achieve their ambition of regaining power. Already the opposition is promising a reduction in prices, if they are returned to office. That is once again a promise that is well nigh impossible to fulfill. They would be saddled with the same problem again as much of the problem lies in the oil price hikes that have induced a large trade deficit and a strain on the balance of payments. These in turn have weakened the rupee and contributed to the inflationary spiral through higher import prices.

The way to cope with the ever-rising increases in international oil prices is a long run issue of structural change and economic development. A monetary response is needed to ensure that the inflationary spiral does not get out of control. However the short-term measures at stabilisation could even be harmful in the long run to growth and consequently to long-run price stability.

This column has pointed out the inevitability of a rising trend in international oil prices owing to increasing demand on the one hand, and diminishing reserves of oil globally. The solution to the problem lies in conservation of energy use and the development of alternate sources of energy to replace oil based needs. This is both the local and global solution. Meanwhile Sri Lanka has to cope with the problem of sharp increases in prices that could choke the economy. Sri Lanka's vulnerability lies in her being an importer of oil, as well as being an import-export dependent economy.

The damage to the economy could be more serious and long-term. The higher costs of production of this chain of events mean that our exports, especially of manufactured goods would rise. This would render our exports relatively more expensive, particularly with countries that have their own reserves of oil. Further the rise in the costs of living would result in a rise in wages that would in turn increase costs of production. This would in turn make our exports more expensive and less competitive. One answer is the inevitable depreciation of the currency that would further aggravate the problem of higher import costs and increasing prices of essential items and the cost of living.

There are several ways of coping with this problem in the long run. First the dependence on oil has to be reduced over a period of time by more realistic pricing, conservation in its use, alternate sources of energy and augmenting electricity generation.

Second the dependence on other imports should be reduced by increased production of the same or substitute commodities. This must be done through productivity gains, rather than import substitution for its own sake. Increased productivity in agriculture is an obvious option to reduce the dependence on food of around 8 to 10 per cent at present. The increased production of agricultural commodities must be achieved through improved productivity. Otherwise domestic production at higher than international costs and imports could itself be a factor in inducing further inflation.

Third would be increased production of value added agriculture-based products for domestic consumption and exports. Fourth, higher value added and lesser import dependent exports should be explored and encouraged.

Fifth, improved productivity in all sectors of the economy would add to the country's international competitiveness and export earnings and import substitution. The consequent economic growth would make the international pressures manageable.

These are some options that must be explored to cope with what appears to be a deadly scenario for an oil import economy. These considerations must seep into the thinking of the government's fiscal, monetary, investment and long-run development policies. They are policy options and strategies that would take time to show results. Action has to be taken now to avert an economic disaster in the near future.

In our political context an awareness programme that makes people cognisant of the nature of the problem would render economic policy measures politically less unpalatable. Cooperation of political parties in this is too fanciful an expectation, but consensual policy measures could help to not aggravate the problem. Inflation is inevitable; the issue is how do we cope with it.

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