Columns - The Sunday Times Economic Analysis

Consumption habits and trade deficit: Be Sri Lankan and buy Sri Lankan

Changing Economic Scenarios
By Nimal Sanderatne

The policy agenda that is in place consisting of a flexible exchange rate; monetary policy to restrain credit and demand for imports; and fiscal policies that inerease costs of several imports are expected to contain the trade deficit to a manageable level.

However, there are structural characteristics in the import structure that make the country vulnerable in its external finances. It is for this reason that the country has had persistent trade deficits since 1950 with trade surpluses only in a few of the last 62 years. The last trade surplus was in 1977 when it was a mere US$ 41 million (about Rs. 200 million at that time). Even this small surplus was achieved by severe import and exchange controls. The structure of the country's imports makes it difficult to contract the trade deficit by the monetary, fiscal and exchange rate policy changes alone.

Import export structure

Although the import-export structure of the country has changed since the 1980s, the trade vulnerability remains. The export profile has changed from a predominantly agricultural one to one of manufactured exports. The economic transformation since the 1980s has resulted in a high dependence on raw materials or intermediate imports as well as capital imports. Consequently international prices of intermediate imports are a determining factor in the trade balance. Oil, fertilizer and other raw material prices are of considerable significance to the trade balance.

This weakness in the export-import structure has not got its due concern due to balance of payments surpluses in many years despite trade deficits in these years. This has been mainly owing to worker remittances and other capital inflows contributing towards turning the deficit in the merchandise account into a surplus in the current account of the balance of payments. For instance in 2010, some 70 percent of the trade deficit of US$ 5.2 billion was offset by worker remittances. As a result it was possible to achieve a lower current account deficit that was offset with earnings from services and other capital inflows to achieve a balance of payments surplus of US$ 921 million. Consequently, there was complacency with respect to the unfavourable trade balance and no corrective measures were put in place to stem the flow of imports.

In 2011, the trade deficit reached an unprecedented gap of almost US$ 10 billion that could not be offset by capital inflows. Worker remittances that increased by 25 percent were able to offset only 53 percent of this large trade deficit of last year. Accordingly a balance of payments problem emerged.

Furthermore, the trade deficit was expected to reach US$ 13 billion this year. This is an unsustainable deficit. Such a huge deficit in the merchandise (trade) account would continue to strain the balance of payments and drain our reserves. However, the package of policies that were put in place is expected to contain the trade deficit to a lower figure. Will the trade balance be reduced adequately by these measures?

Prospects of reduced imports

Relying on these measures alone would be inadequate. The nature of the country's imports is such that many imports are what economists call ones that have an inelastic demand. What this means is that when import prices increase due to the measures taken, the demand for them would not fall by much. This is owing to the nature of the import commodities whether they are consumer goods, intermediate goods or investment goods.¨

For instance, the increase in the price of bread makes it much dearer, yet many urban consumers in particular, find it the most convenient form of food. The price increases in wheat flour and bread would, no doubt, have an impact on decreasing demand. Yet this decrease in demand is not likely to be adequate in containing imports by a significant amount. This same argument applies to several of the other food imports whose tariffs have been increased. Although their cost will increase owing to the depreciation of the rupee, yet the reduction of imports may not be of an extent that would make a dent in the value of import expenditure.

Another reason why the costs of imports of food items will not make a significant impact on the trade balance is due to food imports constituting only a small proportion of import expenditure. Food imports accounted for only about 10 percent of total import expenditure. However, this should not deter efforts to reduce imports of food items. There are a large number of food items that could be substituted by local produce. Import of many processed foods like sauces could be produced locally. Local fruits could substitute for imported ones. What we advocate is that the import of many consumer items should be restrained not only by the policies that increase prices alone that have been mentioned, but also people's own actions to substitute imported items by domestically produced commodities. "Be Sri Lankan and buy Sri Lanka" is a much needed policy in consumption.

Raw material imports

The significant issue in the merchandise trade account is the intermediate category of imports that account for over 50 percent of import expenditure.

In 2011 intermediate imports accounted for 56 per cent of import expenditure.the main intermediate imported items being oil, fertilizer, textiles, chemicals and other raw material. Oil imports alone constituted nearly 23 per cent of total import expenditure in 2011. Textiles that are needed mostly for garment exports accounted for over 10 per cent of import expenditure. Other raw materials, a fair proportion of which are needed for the manufacture of exports, accounted for the remaining 17 percent of import expenditure last year.

Given this structure of intermediate import expenditure, the new policies are not likely to curtail investment import expenditure by much.

Expenditure on oil

The salient issue is by how much could oil imports be reduced? Oil imports are used for thermal generation of electricity, industrial production, public and private transport. The higher costs of electricity and of diesel, kerosene and petroleum are expected to reduce consumption of these.

However, these consumption needs too are more or less essential and would be difficult to curb to any significant extent. The curtailment of expenditure on petrol is also made difficult owing to the government`s failure to reduce consumption in the face of fuel price increases. Despite these limitations, curbing the demand for oil is essential to contain oil imports. Measures to conserve electricity and petroleum products would be necessary to achieve a significant curtailment of oil imports. The government needs to set an example in constraining its demand for petroleum and electricity.

Reducing oil imports is vital as the oil market is unstable. At the time of writing, oil prices had hiked to US$ 120 per barrel -- one of the highest levels in recent years. If prices continue to remain at these levels or rise further, the oil import bill could increase sharply. It's only by the reduction of oil imports that expenditure on imports could be contained at least around the current expenditure.

Besides this the oil embargo on Iran could pose further difficulties in obtaining adequate stocks of oil. In view of limitations in the processing of crude oil in the refinery, there may be a higher cost in obtaining processed products. The favourable payment terms that Iran gave is not likely from other countries. This would spell further difficulties for the balance of payments.

Investment goods

Investment goods imports have also strained the balance of payments. Investment goods imports increased by 60 per cent last year over that of 2010. Capital imports such as machinery, transport equipment and building materials accounted for an import expenditure of US$ 4.7 billion or 23 per cent of import expenditure. This is justified on the grounds that such expenditure contributes to economic growth. This reasoning could be deceptive. All investment goods imports are not necessarily for development projects. Even where they could be for such development expenditure as infrastructure, the returns on such investment could be low and slow.

Some infrastructure projects could yield very little returns and may hardly generate increased exports either directly or indirectly.

It appears that the infrastructure projects did not consider priorities and their impacts on the balance of payments. Even when infrastructure projects are financed through foreign funds, such expenditure has a high propensity to import. Besides this the foreign funding too creates a strain on the balance of payments as the funds have to be repaid and interest payments are a further drain on the country's earnings.

Given the current and foreseeable balance of payments difficulties due to high capital imports, there has to be a rethinking on the nature and extent of capital expenditure. Capital expenditure that has high import content and does not increase exports or has a long gestation period would require to be curtailed.

Wrapping up

The country has lived beyond its means and got itself into difficulties in its external finances. The remedial measures cannot be restricted to the exchange rate, monetary and fiscal policies that have been adopted alone. The analysis of import expenditure suggests that policies adopted to curtail imports may be inadequate to achieve an ample reduction in imports.

Therefore policies to rein in consumption of important import expenditures are necessary. The curtailment of government expenditure on imports would make a significant dent in the trade deficit. This the government must resolve to do lest the balance of payments problem gets aggravated. Private consumption too must be curbed in the national interest.

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