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FINANCIAL CHRONICLE™ » FINANCIAL CHRONICLE™ » Hoding the deficit: remove subsidies and cut investment

Hoding the deficit: remove subsidies and cut investment

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Jeremy

Jeremy
Assistant Vice President - Equity Analytics
Assistant Vice President - Equity Analytics
by R.M.B Senanayake

We face a crisis in the Balance of Payments on Current Account where exports including the remittances of our migrant workers and earnings from services like tourism etc are not enough to pay for our imports of goods and services. We really cannot afford to buy all these imported goods like the luxury cars which have invaded our roads. How do we correct it? Imports were made artificially cheap because we held the rupee against the dollar despite the higher differential inflation. At last we’ve allowed the rupee float. But our policy makers are not really committed to this. They talk of stabilizing it at Rs 125 to the dollar.

Nominal exchange rate needs correction

Failure to hold down differential inflation with our markets abroad and our competitors is the main problem for our exports. What we have to do is to reduce inflation to the low level of 3-5% which prevails in our developed country markets. A depreciation of the rupee was required to restore competitiveness to our exports. But this requires holding the wages unchanged. To the extent that wages are allowed to rise, the benefit of the rupee depreciation is eroded. The depreciation will make imports more expensive – no bad thing except that we import a lot of food and when food prices go up the cost of living goes up and this leads to wage demands which will undo the benefits of depreciation.

We need a deflation with a floating rupee and increases in labor productivity. We need to be a disciplined society. The fault is entirely due to the governments of the day which failed to control inflation. So trade unions demanded and obtained wage increases without compensating increases in productivity. Economists justify wage increases only if they are accompanied by increases in productivity. In our country this relationship is totally ignored and the trade unions want compensation for increases in the cost of living for which they can hardly be blamed.

But our society is not conscious of the need for productivity increases. We don’t even have adequate measures of productivity. The government set a bad example by pressurizing the tea plantation companies to raise wages without linking them to productivity and our tea plantations are perpetually facing the problem of cost increases without productivity increases. This erodes our ability to compete in the world markets. There are several obstacles to productivity increases. The severance pay payable when employees are retrenched is the highest in the world and could go up to the entire unexpired period of working life of the terminated employee; in the rest of the world it is limited to three months pay.

At the recent Annual sessions of the SLEA, Mr. Devaraja of SLASSCOM referred to one big foreign company which wanted to set up here changing its mind when it heard of the Termination of Employees Act. This company, he said, rates all its employees each year and the bottom 10% are terminated with the usual severance pay. Our over-protective labor law not only discourages foreign direct investment but also constitutes a serious drag on productivity.

Our trade union law also needs to be updated and modernized. These laws also prevent our export firms from enforcing productivity. Consider the BPO industry where work is done during the night after 10 pm. The industry employs females but women workers cannot be employed in the night according to our labor laws. Permission may be given but foreign investors don’t like to depend on the discretion of bureaucrats but prefer to go by the law.

The underlying problem why workers cannot be mobilized for productivity growth is due to the permanent inflation in our economy. Inflation of 9.5% is high even on a flawed Cost of Living Index where the base and the basket of goods consumed are changed often making comparison difficult. So the first priority is the reduction of inflation to the level prevailing in the world markets for our exports where inflation is below 3%. Higher differential inflation erodes the competitiveness of our exports and depreciation is no solution unless nominal wages are held down which is very difficult to achieve. It is better to settle for lower inflation instead eliminating the need for rupee depreciation.

The authorities discount the value of the GSP Plus from the European Union. But we are likely to lose a significant share of our exports of garments to the EU unless the government applies for its restoration after putting our human rights record right. Diversification of exports is good and necessary but it cannot be achieved in the short run.

Why persistently high inflation?

There are of course supply side factors and increases in world market prices. But these are often one-off price escalations and don’t account for inflation which is defined as a continuous increase in the price level. This requires an increase in money supply. So inflation in our economy is sustained only because of the continuously large increases in money supply. While the real GDP grows at 7-8% per annum the broad money supply grows by 20%. This drives inflation. The underlying factor is the increase in the reserve money or base money which lies within the control of the Central Bank.

The Central Bank feels obliged to accommodate the Treasury which is often short of money. Last week The Island quoted the Governor as saying that the Central Bank would run down its holdings of Treasury securities which amount to over Rs 200 billion. Fine, but it could also mean that the Central Bank will monetize the debt for it has no Treasury securities to sterilize any monetary expansion caused by purchasing dollars in the foreign exchange market. The Treasury has to borrow because the budget deficit is excessive and the budget deficit is excessive only because the government spends too much - way above its revenue.

The President should decide to limit spending and reduce the budget deficit not because the IMF says so but because it is sound policy. The budget deficit is the most de-stabilizing factor. The government must learn to live within its means which means spending only revenue from taxation for the recurrent budget. There is no harm in borrowing for capital expenditure on infrastructure but they must be cost effective and efficiently run and they must make their contribution to higher growth in the economy. There must be priorities even in the infrastructure investment program. The government has overspent, overpaid its employees and made the economy uncompetitive.

It is the people who must pressurize the government to cut its spending. The people must learn to be self reliant and not dependent on the State. Instead of asking for more money for education, people must ask the government to earmark one or two taxes to be set apart for education. The choice must be put to the people who are spending quite a lot of money on education. University education should be fee levying and the numbers must be limited to the available facilities so that those who cannot enter the universities can pay their own money to receive private university education. Big schools in the main cities should be handed over to the parents to run as fee levying institutions and the expenditure on free education should be disbursed to the rural schools which lack English and science teachers and laboratories. There is a global market in jobs for university graduates and we cannot afford to educate people for the global market incurring costs without benefits which will accrue to other countries. Medical and engineering education should not be free.

Limits to borrowing

We cannot afford to continue running huge budget deficits and accumulating debt. Our policy makers point out that our Debt/GDP ratio at 79% is low compared to the ratios in USA which is 100% and 140% in several EU countries. True, but all these countries including the USA are in deep trouble. What is good about our ratio is that it gives us sufficient time to correct the situation. But we must start now to stop the annual increase in debt without waiting for foreign investors who lend to us to pull the rug under our feet. What matters is how foreign investors who buy our government bonds and lend money to us will look at our economic situation. What they see is that we are rolling over the debt as well as the interest payable on debt. They may come to the conclusion that the government has lost control of public finances.

When they decide against investing or lending to us there could be a crisis just as in Greece. It would then be too late to take remedial action. We are living on borrowed time although such day of reckoning may take long to come. We have been running a deficit in the primary account of the budget which refers to the budget deficit excluding interest payments. This means the public debt will keep increasing. We must ensure that the primary account is balanced.

This means the deficit which exists for the current year will need to be covered by either more tax revenue or lower expenditure. If the recurrent budget cannot be reduced then the investment budget will have to take the cut. The fertilizer subsidy should be reduced if not eliminated. So should the diesel subsidy. Losses in the State owned enterprises must be reduced or eliminated. This includes the railway where the fares are abysmally low.

UKboy

UKboy
Senior Vice President - Equity Analytics
Senior Vice President - Equity Analytics
A good article. Can agree with most.

http://www.island.lk/index.php?page_cat=article-details&page=article-details&code_title=64705

Hawk Eye

Hawk Eye
Assistant Vice President - Equity Analytics
Assistant Vice President - Equity Analytics
First we should find a way to stop corruption in the system. Corrupted minds make corrupted decisions.

Kithsiri

Kithsiri
Senior Vice President - Equity Analytics
Senior Vice President - Equity Analytics
Do not Participate and or Endorse.
The Surest ways to eliminate the menace.
But if expecting someone to come and correct it is something like expecting the Sun to rise from the other side.
Just think of those two simple things principle that we all can practice easily (if we really mean what we say). Very Happy
@Hawk Eye wrote:First we should find a way to stop corruption in the system.

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