The Government expects growth to increase to 7.5% this year but this seems to be a vain hope. A leading company, John Keells Holdings. has reported a decline of 4% in revenue in the first quarter of this financial year. There have been falls in revenue and profits in the Leisure Sector (hotels) in Transportation and in Food & Beverage. So although the cheerleaders of the government expect growth to go up, we would be lucky to maintain our last year’s growth rate of 6.4%.
Sixty per cent of growth in GDP is from services. The kind of services that grows fastest are not those that contributes much to the economy or to the welfare of the masses. Large salary payments in government and large numbers recruited to the public service will boost GDP. The higher the salary, higher the addition to the GDP computation - although economic value may be low or even zero. Higher the number of public employees, higher is the GDP - which is how the methodology of national accounts works. But recent statistics show that growth of GDP does not translate to the same growth in per capita terms. It was 5.5%.
The decision by Hayleys this week to sell off its 28 percent stake in Dimo’s, the motor vehicle company best known as agents for Mercedes Benz and Tata, indicates that companies are becoming leaner. Business analysts say many companies were exiting from non-core business areas and concentrating on their core areas of activity.
The decline in exports continues and the loss of GSP Plus is now showing up. The loss caused to the apparel industry due to the withdrawal of the GSP+ facility is US$ 750 million, according to Dawn Austin, immediate past chairman of the Exporters’ Association of Sri Lanka (EASL). She said that this estimate covers a period of three years. Additionally some 60-70 other products were victims of the GSP+ loss, she said. GSP+ facility allowed Sri Lanka to export a few thousand items on a duty free basis to the EU, its largest export market. Chief among the beneficiaries was garments, the island’s largest tangible export commodity, though there were several other exports such as fish and ceramic related exports, which too suffered as a result of the loss of this duty free concession.
Loss of export competitiveness
The real reason to worry is that Sri Lanka has lost international competitiveness while expanding investments in infrastructure through foreign borrowings and has been buying time by borrowing from foreign lenders to fund the current account deficit in the balance of payments. Growth momentum has slowed down and, with the exchange rate held rigid despite the domestic inflation of 6.8% (recent estimate says 6.2%), exporters are struggling to compete in world markets. The current-account deficit is increasing relentlessly, owing to a widening trade deficit (now at 15.8% of GDP), and raising the danger of a balance-of-payments crisis. Today, private sector domestic investment is stagnant, exports are languishing, and GDP growth is down to around 6.4% per year.
Lower growth could pose a threat to external stability
We need to preserve our present growth rate for a decline in growth will undermine the confidence of foreigners who have invested in the bond and stock markets. Already there is the threat from the Fed announcement to taper bond purchases which has led to a rise in U.S Government Treasuries. If there is less money created by Fed there will be less foreign money flowing to Asian countries which includes us. If US bond yields rise and our balance of payments continues to weaken, the risk of exchange depreciation will increase for foreigners. The Central Bank imposed limit on foreign bond holdings has been reached and unless it is raised there cannot be inflows of foreign money to the local bonds. If the economy weakens there is a possibility that there may be outflows from the stock market as well.
Education needs urgent reform
What is required for growth to revive is economic reform. True that infrastructure did not keep pace with the economy’s needs during the long civil war. But more deplorably, educational standards have seriously lagged. We need more science and engineering graduates and not graduates in the liberal arts or commerce. Neglecting reforming education was a grave error. Only the best deserve university education. So admission should be entirely on merit and perhaps a new entrance examination for university admission is required along with the scrapping of district quotas. The universities should be privatized, preferably offered to foreign universities to manage at least for modern education (culture and oriental languages may be left to a traditional state university or two).
To continue free education, a scheme of vouchers should be introduced which can be used by students to pay the university. We should borrow on concessional terms to run the universities. Foreign lecturers may require to be hired for our local lecturers seem to be dispensing outdated learning.
Macro-economic scene disturbing
Inflation running at 6.8% (recent revision 6.2%) stubbornly refuses to come down to the level below 5% , due to excessive demand (thanks to persistent public deficits); too much money creation and an unhappy combination of supply bottlenecks caused by poor infrastructure particularly in the rural farming areas. Budget deficits and an overvalued rupee offer what appear to be a free lunch to the government, as the resulting inflation erodes the real value of public debt, while the government has privileged access to private savings at near-zero real interest rates even on the official inflation figures which lack credibility in the eyes of the public. No figures of inflationary expectations are now published. So the authorities are repressing deposit interest rates and when banks and primary dealers quote too much for the shorter end of the Treasury Bill market the market itself is suppressed.
With so much largesse to spread around, the government has become a source of lucrative contracts with regular annual earnings, which offer robust returns for those with political access. That has weakened the incentives for true entrepreneurship and made domestic businesses to look for political patronage for investment. And, as the external position deteriorates, the rupee will continue to become significantly overvalued, trading in a narrow range while domestic inflation will continue to be high in a global environment of relative price stability.
Amid weakening competitiveness, the rupee was propped up by increasingly unstable foreign sources of funds. But the good luck is unlikely to continue. We cannot hope to get foreign funds cheap or perhaps not at all. We still have a large inflow of remittances from migrant workers which should be tapped as savings rather than allowed to be frittered away on personal consumption.
Similarly, long-term foreign investors may pause if they think the economy is slowing down - particularly tourism .We cannot be seen as dependent on short term foreign capital to finance our external deficit for it is the most capricious form of international capital. Rudi Dornbusch, the late MIT economics professor, once warned that a crisis takes longer than expected to arrive but once it does, it moves faster than anticipated. An overvalued exchange rate strengthens foreign debt repayment capacity, but it damages exports and may induce international bankers to stop lending and even cut and run if the situation worsens here and improves in the developed world. Meanwhile the government is fueling rupee appreciation by easing companies’ ability to borrow abroad. Since the Government does not want to risk failure in attempts to raise foreign money for its own bond issues it encourages the banks to borrow and perhaps give the dollars to it or at least use it to fund their foreign exchange requirements. But the banks cannot overlook the exchange risk involved in such foreign borrowing. True they can cover the exchange risk in the forex swap market but it demands a premium of 8-9% and that too only for one year which will require rolling over each year. So foreign borrowing will not be cheaper than local deposit mobilization. But the banks are directed to reduce deposit interest rates instead.
Regulating by fiat
With an overvalued rupee, there are no good policy choices. To avert a disorderly fall, short-term macro-economic management requires officially engineered depreciation through administrative methods and restraints on banks buying dollars. So the Central Bank monitors closely all market transactions in the short term money markets and the forex market telling dealers what they should do or not do. A depreciated rupee should help revive exports and lift growth. But, in the absence of complementary action in the form of economic reform, depreciation – whether engineered or market-driven – will make matters worse.
To dampen the additional inflationary pressures implied by a weaker rupee, more aggressive fiscal retrenchment is needed. Even so, a depreciated rupee will increase the burden of repaying foreign debt, and deepen the woes of domestic companies and banks. We are skating on thin ice indeed.