by R.M.B Senanayake
The Chief Executives of two companies told me that their sales of consumer products is stagnant and one other company in the business of making packaging materials as an intermediate product said he is producing far below capacity. Cargills head has reported a decline in consumer sales. Is the economy slipping into a slump and if so what policy changes would be needed?
Actually the authorities both the Treasury and the Central Bank are doing their best to promote economic growth. The Treasury is running increasing budget deficits and the Central Bank recently reduced the policy interest rates on top of the earlier reduction in the statutory reserve ratio. The Central Bank is also creating enough Reserve Money even buying Treasury Bills in the primary market.
Are these expansionary fiscal and monetary measures promoting private sector growth? Credit to the private sector is not growing at the same rate as last year and the year on year growth as at August 2013 has fallen to 7.9%.
When a country runs a deficit in the balance of payments, the money supply gets reduced. But the external sector is only one factor that determines the money supply. The other factor is the fiscal deficit. The public sector deficit is funded mainly from the central bank and the banking system. The central bank and the banks collectively can create enough money to offset the decrease in the money supply due to the external deficit and this is being done. The relevant deficit in the balance of payments for this purpose is not the current account deficit but the over-all deficit including the capital account. In 2011 it was a deficit of US$ 1061 million.
This large deficit eroded the Official Foreign Exchange Reserve and hence corrective action was required. The rupee was allowed to float instead of being fixed and the credit to the private sector from the banking system was brought down from Rs 35 million in 2011 to Rs 20 million in 2012. When the Treasury runs up arrears in payments to the private sector for goods and services obtained by the government during the fiscal year, there is a further contraction in private sector finance. This reduced the growth momentum and brought down the current account deficit in the balance of payments from $4,615 m in 2011 to $3,915 m in 2012. But owing to foreign capital inflows, particularly by way of portfolio investments to the government securities market, the over-all deficit was converted to a small surplus of $151 m in 2012.
The surplus would have been larger but for the foreign debt repayments which included the repayment of the first Sovereign Bond of $ 500 million and an increase in repayments of maturing Treasury securities held by foreigners. Foreign debt repayments are expected to be about $ 1.5 billion in 2013 as well. So we need foreign capital inflows to fund the maturing foreign debt repayments as well as to meet the resource gap in the current account of the balance of payments- excess of imports over exports.
How much foreign capital inflows do we need?
We need sufficient inflows of foreign capital to cover the gap between national savings and investment which is about 5-6% of GDP. This gets translated into the investment component of the budget. This is the entirety of government capital expenditure. To maintain the growth funded by government infrastructure program, foreign funds are needed.
So foreign capital inflows to maintain the growth rate must firstly cover the foreign exchange gap; secondly the government investment program; and thirdly the deficit in the government’s requirements of funds from the public to fund the budget deficits. There is a limit to the availability of public funds for government borrowing and hence there is a need for foreign borrowing to augment the domestic availability of resources. So we need at least 5% of the GDP by way of foreign capital inflows per year.
They could be Direct Foreign Investments (DFIs), government borrowings or foreign portfolio investments. DFI flows have been low and cannot be expected to generate the required foreign capital. It will have to be foreign portfolio investments and bilateral government foreign loans not tied to projects but available to be utilized freely for all three purposes. In 2012 DFIs were $ 813 million while portfolio investments were $2,148 million net (balance of payments figures). Portfolio investments had doubled from $1,062 million in 2011 to $2,148 million in 2012. So we had no difficulty in obtaining the foreign capital inflows required. But portfolio investments are essentially short term and can flow out as fast as they come in. Normally the Official Gross Foreign Reserve should be able to meet all short term liabilities including the short term liabilities of the banks. The figure of Net Foreign Reserves after deducting the short term liabilities is what really matters for external sector prudential stability. How much are our Net Foreign Reserves?
Outlook for foreign capital inflows
In May this year the Federal Reserve System of USA announced that it would scale down its bond purchase program under the Quantitative Easing stimulus program. Immediately interest rates on U S Treasuries increased and there was an outflow of foreign money from the emerging countries back to USA. The Federal Reserve has since changed its mind and there is no likelihood of tapering of money creation at least until 2014. But we are unlikely to get new foreign capital inflows to the government Treasury securities unlike in 2012. But we directly need such an inflow to maintain current growth rate.
The Internal Transfer Problem
In 2012 the net credit to the government increased from Rs 1,154 billion in 2011 to 1,390 billion in 2012. The problem arose from the fact that the government revenue in 2012 failed to increase even at the same rate of increase as the debt service charge. So the debt service charge, at 105% of the receipts of government, is now absorbing the entirety of government revenue. It shows that the government needs to borrow rupees to repay the debt. It is unlikely that the government will ever be able to repay debt without borrowing; and if there is foreign borrowing then only will there be room to expand credit to the private sector.
So the foreign debt must increase by an amount at least as much as the foreign debt service charge of $1.5 billion. In 2012 the debt service charge increased by 13.6% over the previous year 2011. If the debt service charge grows at even 10% per year the need for foreign capital will also increase by 10% to bridge the gap in the government’s revenue. This internal transfer problem arises only where the government is the borrower. In 2012 the government forced the banks like the NSB and the DFCC to borrow in foreign currency so as to alleviate this transfer problem since they can pay back debt from their resources.
Servicing of the public sector deficit requires borrowings from the banking system today (given that the tax revenue is already inadequate). But to overcome the external situation the rupee has to be allowed to depreciate to reduce the resource gap between exports and imports of goods & services. But such depreciation increases the cost of servicing the foreign debt to the Treasury. Previously the Central Bank held the rupee constant at the cost of depleting the official foreign reserves. The Treasury stepped in and pressurized the Central Bank to allow the rupee to float. But this increases the internal foreign debt servicing cost of the government. This then is the dilemma the authorities face today.
So we have no alternative today but to borrow externally as much as possible to repay the foreign debt in dollars, to fund the current account deficit in the balance of payments in dollars and to fund the public sector rupee deficit .
But new lending by foreign lenders begets more need for foreign borrowings by stimulating domestic growth. It also permits further investment by the government. But the recent increase in the interest rate on the foreign currency borrowing of $100 million by the DFCC to 9.5% should set us re-thinking. Apart from the increase in the interest rate, there was also a reduction in the amount the foreigners were willing to lend even at this high rate since the DFCC wanted to borrow $250 million not 100 million. This rate will now be the benchmark for future borrowings applying even to sovereign bonds. So will we be able to borrow all the foreign capital we need in the future? Realized FDI is unlikely to increase. We are not committed to a free market economy and apply too many controls on FDI to attract DFI. The increased risk of rupee depreciation also deters them.
Is there too much foreign debt?
Debt capacity magnitudes are conventionally figured with regard to the Debt/GDP ratio. We need much more foreign borrowing and like the proverbial tiger’s tail we cannot let go of foreign borrowing.
To get back to the issue of debt deflation the two chief executives could be right if we can’t borrow enough foreign money.