Columns - The Sunday Times Economic Analysis

Perspectives on the economy

By Nimal Sanderatne

At the dawn of the New Year expectations of rapid economic growth are high. Post war peaceful conditions, the expected growth of about 8 per cent last year, a budget that ushered in a more friendly investment climate, the high foreign reserves of nearly US$ 7 billion, recent promise of World Bank assistance for reconstruction and the boom in tourism are foremost reasons for this expectation.

These conditions provide an environment for the pursuance of appropriate economic policies for growth. The current optimism itself is a positive factor for economic growth. However optimism without appropriate action will not achieve the potential growth. Being over optimistic would not by itself lead to high rates of economic growth. The benefits of the peaceful environment could be exploited in full measure only if the right economic policies are pursued and vigorously implemented.

Doubling per capita incomes

Optimistic expectations should not reach unrealistic proportions. The expectation of doubling per capita real incomes in six years is wholly unrealistic and impractical. It requires a real GDP growth of about 13 per cent sustained over the six year period and not the 8 per cent growth that is often bandied about as needed to achieve a doubling of per capita incomes. An 8 per cent growth will double per capita incomes in about 9 years. And that too assuming there is no increase in population. When an annual 1 per cent increase in population is factored in, the rate of growth would have to be 12 to 13 per cent to double per capita real income in 6 years.

In her enthusiasm to endorse the government’s development effort, the Managing Director of the World Bank, Dr. Ngozi Okonjo-iweala made a mistake that an 8 per cent growth would suffice to double per capita incomes in 6 years.

To her credit she pointed out that even an 8 per cent growth would be a challenging task requiring an investment of 35 per cent of GDP that is an increase of 10 percentage points from the current level. Therefore achieving an economic growth of 12 per cent to double per capita incomes in 6 years is a Herculean task. Attainment of an eight per cent growth over a six year period would itself be an impressive achievement, even though the much cherished objective of doubling per capita incomes in six years would not be achieved. If the intent is to double nominal or money income, that would be an easy task not worthy of achievement.

Preconditions for development

As Dr. Ngozi Okonjo-iweala pointed out there are many pre-conditions that have to be established to grow at 8 per cent each year. An increase in investment to 35 per cent of GDP is essential. This, as she observed, would have to come from mostly the private sector. Improvements in efficiency too would be needed.

She did not elaborate on all the conditions that are necessary to increase investment. The higher investment that is required for an 8 per cent growth necessitates many preconditions. Reforms would be essential for enhancement of efficiency.

Macroeconomic fundamentals have to be strengthened, inflationary pressures that are once again evident must be contained and institutional and legal reforms that are favourable to economic investments are essential. An economic policy framework conducive to development must be put in place. The budget made several changes that are conducive to a better environment for investment. Further changes and reforms are needed to enhance an investment friendly environment.

Fiscal consolidation

Among the essential requirements is the containment of the large fiscal deficits that have characterised previous years. The budget estimates for 2011 expect the fiscal deficit to be contained to 7 per cent of GDP. However, far too often in the past the fiscal out-turn has been quite different to the original budget estimates. In 2009 budget estimates expected to bring down the deficit to 7 per cent of GDP that was a condition of the IMF for the continuation of the standby credit arrangement. In spite of this the actual fiscal deficit turned out to be nearly 10 per cent of GDP. This must not be allowed to occur again. The strength and stability of the government must ensure there is fiscal discipline and that there are no overruns in expenditure.

The containment of the fiscal deficit is very difficult to achieve in the current fiscal context. Nevertheless, it is a basic condition for economic stabilization and sustained economic development. One of the important reasons why it is difficult is that debt servicing costs absorb the entirety of revenue. There is a huge committed expenditure on public service salaries and pensions, large losses in public enterprises, a large defence expenditure (that has been increased for 2011), wasteful conspicuous state consumption and expenditure on subsidies and welfare. With such committed expenditure a large fiscal deficit is inevitable.

Nevertheless it is these large expenditures that provide the opportunities for reductions that would bring down overall government expenditure. They are pointers to where the resolution of the problem lies. Now that the war is over there should be a curtailment of defence expenditure. In spite of the end of the war defence expenditure has risen partly owing to the differed payments on armament purchases that were incurred in the past. Military hardware expenditure should be brought down to a trickle and fresh recruitment of personnel should be discontinued. If the expenditure on defence can be brought down by 1 per cent of GDP, then its burden on the public finances could be relieved significantly.

The losses incurred by public enterprises like the Ceylon Electricity Board (CEB) and the Petroleum Corporation (CPC) are huge expenditures. Reforms of these public enterprises are an important means of expenditure cuts. In the past the privatization of loss making enterprises provided relief to public expenditure, as well as revenue from the privatization proceeds. This option is no longer available due to the ideological position of the government that it will not sell public enterprises.

Other public expenditure such as salaries of public servants and pensions, subsidies such as for fertilizer and Samurdhi payments are not likely to be reduced. Salaries may once again increase if trade union demands succeed. Further recruitment has so far been held back owing to fiscal constraints. Increasing unemployment among the educated youth could result in another wave of public service recruitment. If this were to happen there would be significant increases in government expenditure.

Increasing government revenue is vital. Much is expected in this direction from tax reforms in the budget. The revenue to GDP ratio of 15 per cent is below levels of countries with Sri Lanka’s per capita income. Tax avoidance and tax evasion are important reasons for this shortfall in revenue. An increase in revenue is expected from the tax reforms of the budget. This is vital to reduce the deficit.

The realization of a high trajectory of economic growth is not an easy one. The levels of domestic savings and investment have to be increased significantly. It requires a strong resolve on the part of the government to undertake reforms and to spend public money carefully. Reform of public institutions and pragmatic economic and political strategies are crucial. Without such an effort sustained economic growth is unattainable.

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