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Austerity or business as usual on borrowed money? Vote_lcap68%Austerity or business as usual on borrowed money? Vote_rcap 68% [ 178 ]
Austerity or business as usual on borrowed money? Vote_lcap18%Austerity or business as usual on borrowed money? Vote_rcap 18% [ 47 ]
Austerity or business as usual on borrowed money? Vote_lcap13%Austerity or business as usual on borrowed money? Vote_rcap 13% [ 35 ]

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FINANCIAL CHRONICLE™ » DAILY CHRONICLE™ » Austerity or business as usual on borrowed money?

Austerity or business as usual on borrowed money?

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by R.M.B Senanayake

An individual who wants to live beyond his means can’t do so for long as no one will keep lending to him knowing how he busts the money. But it is not so with a government. With the introduction of paper money and the government making it its monopoly, it can borrow unlimited amounts of money from its citizens while at the same time increasing the money incomes of the people through the spending of the borrowings from the people, the banks and the Central Bank. Although the government has no problem in repaying the lenders with its new money, yet the public realize that the new money they get is does not have the same purchasing power as the original. They realize they are being cheated and hence demand higher rates of interest.

But the government is averse to paying out more for debt servicing. The short term interest rates are determined by the Liquidity Preference theory of money, which says the interest rates are determined by the supply and demand for money, not capital. So the government prefers to borrow from the Central Bank and the commercial banks which can afford to lend their funds at low rates of interest, rather than from the public who demand higher interest. So with money printing (lending by the Central Bank and the banking system) the money supply keeps increasing at a higher rate than the growth in the Gross Domestic Product, setting the stage ultimately for hyper inflation as in Zimbabwe.

But before that, the expansion in credit by the government to the state corporations by 37.3% and the private sector by 34.5% in 2011, there develops a crisis in the balance of payments. Remember the public buys not only domestic goods but also imported goods. So as more and more money is created and given to the government, and as the government proceeds to spend such money raising the money incomes of the people, the people demand more goods and more of imported goods (volumes up by 23.5%). But exports which depend on demand from world markets don’t expand at the same speed (volumes up by 10.4%) and with import prices rising much higher than export prices ( terms of trade adverse by 9.3%) there arose a huge trade deficit as much $ 9.9 billion in 2011.

Unlike in the past there is a huge amount of transfers from our workers abroad who keep sending money to their home folk. This money which comes through the banking system can be used to fund the increase in imports. But in 2011 even these were not enough to offset the trade deficit. So we had a current account deficit of US$ 4,615 million.

There is another source that can provide foreign exchange to fund the current account deficit. This is the capital account which shows the inflows and outflows of foreign capital to the government and the private sector either as direct foreign investment or as short term flows to the stock and bond markets. In 2011 this account showed a net inflow of $ 4,097. This was still not enough to cover the current account deficit of $4,615 and hence the shortfall (including errors & omissions) of $ 1,061 million was met by drawing down our official Foreign Exchange Reserve. This reserve must be sufficient not only to fund three months imports at a minimum but also to repay any maturing foreign debt. If we default on the foreign debt either due to insolvency or temporary lack of liquidity, the rest of the world will stop trade finance to us. So we cannot run down our Official Reserves below a certain critical level. The fall of the reserve was made worse by using them to defend an artificial and over-valued rupee which was unjustifiable. The over-valued rupee we had for 2011 also encouraged imports and discouraged exports.

The country is facing a balance of payments crisis owing to the large trade deficit. The foreign exchange to meet the deficit can be found from foreign borrowings but it has also to be brought down as it is unsustainable. Otherwise in two or three years time the balance of payments crisis would turn into a foreign debt crisis as in Greece, Ireland and Portugal. But any such correction takes time. If an individual were to lose his job which is his only livelihood, one can’t expect the person to die of hunger. He will have to borrow to survive. But nor can the person afford to live on borrowings forever. He must get a job and live within his means.

The same reasoning applies to a government. The government will have to borrow in foreign currency to meet its urgent foreign payments but merely because foreigners are willing to lend to it, it is not prudent for the government to borrow and carry on business as usual. It must borrow foreign money but also set in motion spending cuts. The government, business and the households must all curb their imports even if it means a reduction in their living standards. In short the government and the country must practice austerity.

These days Keynesians are preaching that there should be fiscal stimulus, another Quantitative Easing (meaning money printing) despite little evidence to show that the Quantitative Easing 1 and 2 followed by the Federal Reserve System in the USA has succeeded in reducing unemployment or increasing growth. In the Euro Zone there is the same debate - whether the countries whose governments are unable to honor their debt should practice austerity which leads to recession or stimulate their economies through fiscal expansion funded by money printing.

There is however one country in the Euro Zone - Estonia, which has come out of the recession of 2009 without borrowing more. It did so by practicing austerity. Estonian GDP 2008 was 16.3 billion euros. In the middle of the slump of 2009 it went down to 13.8 billion euros (-14,3 %) and last year 2011 it was 16 billion euros (all in current prices). Peak in the unemployment rate was 17 % in 2010 and now at the end of Q1 2012 it is 11.5 %. Estonian government debt is 0.4 billion euros (about 3 % of GDP and one of the lowest in the world as it has always been). Household debt has come down from the peak (2008) 7.6 billion euros to 6.9 billion euros (2012) which accounts for 43 % of the GDP. Corporate sector debt has come down from the peak (2008) 7.2 billion euros to 5.9 billion euros (2012). At the end of 2011Estonian current account balance was surplus 0.3 billion euros. Estonian gross external debt (government + households + corporate) is 97 % of GDP and the net external debt is 5 % of GDP. Estonian budget deficit in 2011 was 1 % surplus (by the way Estonian budget has been in balance past 20 years). Estonian consumption has started to recover and for example the import of cars has doubled since 2009. All this has been achieved without new debt.

We too were affected by the global financial melt down of 2008 and 2009.Our growth rate fell to 3.55% in 2009 from 6% in 2008. Our Gross Foreign Reserves fell below $ 1 billion in March 2009, as foreign investors repatriated their money from the stock and bond markets. But our solution to raise growth and restore the foreign reserve was more and more foreign borrowing and borrowing from the IMF. The government used these foreign borrowings to fund its infrastructure investments with scant attention being paid as to whether they produced a return in excess of the cost of interest and disregarding the fact that such foreign borrowings have to be repaid in the short term when our exports were not increasing sufficiently.

The Government is planning to go for fresh foreign borrowings by way of another Sovereign Bond issue to repay the $500 million previous bond issue which is maturing in October. While foreign borrowing may be necessary to roll-over the existing foreign debt, should the government carry on its expansionary policies and the Central Bank accommodate the budget deficits through money printing? Politicians have only a short term perspective and are unwilling to resort to austerity measures. They prefer business as usual at least until their term of office is over. So it would not be surprising if the government carries on regardless. But the public would have the problem not only this year but in every other year in the future with a worse crisis turning into a foreign debt crisis through more and more foreign borrowing unless measures are taken to reduce imports as well. The government seems to be depending on raising tariffs to reduce imports. But such policies also create inflation ( IMF estimates higher inflation at 9%) unless the money demand in the economy is also reduced. Otherwise the continued high spending quickly erodes any temporary improvements in the trade balance. Economists distinguish between expenditure switching policies and expenditure reducing policies. The government prefers expenditure switching policies by way of higher tariffs and restrictions on credit which affect only the private sector. But such expenditure switching polices are unlikely to succeed unless there is some reduction in over-all expenditure as well.


Director - Equity Analytics
Director - Equity Analytics
Good one from R.M.B Senanayake.
Thanks for sharing.

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