External finances and fiscal consolidation: What’s the real position?
The divergent assessments of the current economic situation are confusing. The Central Bank’s assessment of the current state of the economy, especially two key economic indicators, the level of foreign reserves and fiscal consolidation, contrasts with that of Moody’s. Are the external finances in a strong position as the Central Bank claims? Have we made adequate progress towards fiscal consolidation?
The Central Bank’s view is that the economy is in a strong position and that the external finances are healthy. This is the stance the Bank has taken in response to Moody’s change of Sri Lanka’s Sovereign Rating Outlook from ‘Positive’ to ‘Stable’. The Central Bank has argued that the downward revision of Moody’s rating was not justified.
The Bank takes the view that the country’s external finances are healthy. Whether the Bank believes in what it says, or whether it is an exercise in maintaining confidence, is difficult to fathom. Even when the country was facing a serious balance of payments crisis in 2011, the Bank maintained that there were no concerns over the external finances and reserves.
In fact the initial action to correct the crisis in the balance of payments was taken by the Finance Minister in November 2011, when the Budget for 2012 announced a 3 per cent devaluation to avert a balance of payments crisis. This was followed by an inevitable depreciation of the currency that came in tandem with a bailout package of US$ 2.6 billion from the IMF to strengthen the dwindling reserves,
Are we heading towards a similar situation? It is unlikely as the large trade deficit of about US$ 9 billion that is likely this year will be substantially offset by workers’ remittances, tourist earnings and other expected capital inflows. There is however concern that debt service commitments are heavy this year and would once again strain the external reserves.
The Central Bank Assessment
The Central Bank refutes the Moody assessment of the external finances position. It claims that a strong consolidation of international reserves in terms of standard reserve adequacy measures has taken place since June 2012 and that the country’s foreign exchange reserves (including commercial bank assets) in July 2012 stood at 4.2 months and 5.2 months respectively whereas in May 2013, these have risen to 4.3 months and 5.4 months, respectively. Further, the Bank claims that the reserve cover for short-term liabilities has improved steadily during the last year.
The other argument is that in the recent past, several commercial banks have raised mostly medium to long-term funds via foreign capital markets. Hence, it argues that there would not be any new additional pressure on Sri Lanka’s external payments position and that the claim that a substantial increase in net foreign liabilities of commercial banks has occurred does not recognise the maturity profile of such liabilities.
The third argument of the Bank is that Sri Lanka’s external sector has performed satisfactorily in the first four months of 2013, with earnings from tourism continuing to grow. Furthermore, it points out that Workers’ remittances are continuing to increase. According to the Central Bank, foreign investment at the Colombo Stock Exchange (CSE) is continuing to grow, with increased activity at the CSE, indicating a gradual build-up of investor confidence.
The Central Bank also claims that foreign direct investments are poised to record a historically high level of US dollars 1.8 billion in 2013 and that substantial inflows have also been recorded in the government securities market.
The Central Bank observes that there has been a marked contraction in the trade deficit during the first four months of the year. Yet the country is heading to another huge trade deficit of around US $ 9 billion.
Analysing the claims
Each of these claims for stability in external finances has weaknesses. Even as the ink on the CBSL press release was drying, the continuing depreciation of the rupee, the poor performance of the stock market and the outflow of funds from the securities market contradicted the claims. Both the foreign exchange market and the stock market are reflecting perceived weakness of the country’s financial position.
The external reserves position does not take into account the liabilities, especially the debt service payments due in the coming months. Debt service payments are about US$ 1.4 billion during the course of the year. Therefore, the net foreign reserves are much less, about US$ US$ 4.5 billion adequate for about 2.6 months of imports. Further, as explained in last week’s column, the reserves in terms of the number of months imports is an unsatisfactory measure as the economy is dependent on capital flows and there are short term contingent liabilities.
Furthermore, the foreign debt has been increasing and according to the Central Bank Annual Report of 2012, it had reached Rs 2767 billion by the end of last year. The foreign debt to GDP ratio had increased to 36.5 percent of GDP.
It is somewhat strange to interpret the trade statistics of the first four months of this year as healthy. Although the trade deficit had decreased by 14.6 per cent, it was in fact large at US$ 2.96 billion in the first four months and heading towards a deficit of about US$ 9 billion, if it continues with imports being twice that of exports. The plain truth is that our trade balance is extremely unhealthy and a threat to external financial stability.
The bright spots in our external finances are the increasing workers’ remittances of US$ 2.1 billion and the increasing tourist earnings of US$ 407 million in the first four months. These are the saving graces of the country’s external finances. Although they are likely to offset much of the large trade deficit, perhaps as much as 85 per cent of the trade deficit, debt service payments would dip into the external reserves of the country during the course of the year.
With regard to Moody’s assertion that there is a slower pace of fiscal consolidation, the Central Bank bases its stance on the Government’s strong commitment to continue the fiscal consolidation process as evident in the reduction of the budget deficit progressively since 2009. It is true that there has been a degree of improvement in the public finances. Yet, even here the targets have not been achieved and the fiscal deficit is underestimated by some creative accounting.
The Government’s liabilities to the banks on account of losses in public enterprises have not been taken into account and as the IMF pointed out the actual deficit is much higher.
This year’s fiscal performance has once again been adverse with revenue shortfalls and expenditure overruns. According to the Ministry of Finance, the fiscal deficit for the first four months expanded by 20.3 per cent to Rs. 343.5 billion — from Rs. 285.5 billion a year ago. The deficit was 3.9 per cent of GDP, marginally up from 3.8 per cent last year. With this outcome in the first four months, it would be exceedingly difficult to achieve the deficit target for the full year of 5.8 per cent of GDP.
Face up to the weaknesses
It would be much better to recognise the weaknesses of the economy and take countervailing measures to correct them than get engaged in weak arguments in defence of the emerging economic performance. Nevertheless we hope that the Central Bank’s expectation of a surplus in the balance of payments, strengthening of the reserves, decreases in foreign borrowing and a reduction of the fiscal deficit to 5.8 per cent of GDP would be achieved at the end of the year and that Moody’s would revise its assessment upwards in the fullness of time.
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