Ranil’s biggest woe: What to do when fiscal and monetary policies have failed and are still falling?

President Ranil Wickremesinghe

As new President, Ranil has inherited a failed fiscal policy and a failed monetary policy. Now he has to take a failing fiscal policy and a failing monetary policy too. Both are hitting very hard on his plans to make a quick turnaround in the economy. Since all Sri Lankan systems – public service, education, healthcare, transport, energy, agriculture, industry and so on – are in a state of paralysis, he should act quickly and decisively now. But his energy seems to be spent not on the economy but on bringing the protestors who paved way for his ascend to presidency to books on charges they are alleged to have committed while protesting against Gota who had to flee the country unceremoniously

A President with high hopes

President Ranil Wickremesinghe had very high hopes for the country’s dead economy when he assumed premiership in early May, acting presidency in early July and being elected as President by Parliament later in the month. He wanted to make a quick turnaround of the economy whose paralysis had paved way for his predecessor to flee the country without informing anyone in the middle of the night and for him to fill the vacuum, the most cost-effective way of becoming President, according to analysts. 

While the unprecedented economic crisis had been multi-faceted and multi-driven, the epicentre of the crisis at present had been the acute shortage of dollars to maintain a safe import program and service the country’s foreign debt. To resolve the dollar issue, Sri Lanka has been working on a bailout package with IMF. Recognising its importance, Ranil had planned to conclude a staff level agreement by end July which milestone he could not meet. Since Sri Lanka’s foreign debt was unsustainable, according to IMF, an effective debt restructuring plan was a precondition for a staff level agreement that leads to an eventual bailout package. This is because, according to the existing rules, IMF cannot lend a country whose public debt is unsustainable. To meet this condition, Sri Lanka’s Government had appointed two advisors – Lazard to look at the financial side and Clifford Chance to advise on legal matters – but their plan has not been submitted yet. 

If this report had come in time, Sri Lanka could have made its request formally to IMF for a loan facility. Ranil had expected to fast-track all these processes and to get IMF funding – about $ 1,200 million at the beginning and balance $ 2,800 million over a four-year period. 

Impediments to IMF bailout

The milestones announced by Ranil are no longer valid. Hence, they must be set anew and shifted forward. Meanwhile, there are additional impediments placed in Sri Lanka’s path in this regard.

The US Senate Committee on Foreign Relations has announced that giving any loan facility to Sri Lanka by IMF is also subject to three preconditions: making the central bank independent, observing the rule of law, and setting an effective anti-corruption machinery. Given the mood of and public expressions to the contrary by the legislators who support Ranil’s presidency, satisfying these preconditions will be a Herculean task for him. 

Another impediment placed before Sri Lanka has been the case filed by one of the investors-Hamilton Reserve Bank-in the International Sovereign Bond that just matured. This creditor in question demands that it should be paid in full when the government meets its liabilities. If the judgment is delivered in favour of the creditor, the other investors whose loans are to be reduced by offering a haircut might demand that the facility afforded to Hamilton Reserve Bank should be given to them also. 

The third and fourth impediments are Sri Lanka’s own making. One is relating to the delay in preparing a workable debt restructuring plan due to China’s reluctance to accept a haircut that is being given to other lenders. Instead, it says that it can give a new loan to Sri Lanka to settle the old loan and carry it as a new credit facility. In addition, China is not a member of the Paris Club at which both Sri Lanka and its lenders should sit and conclude the plan. 

Hence, IMF has warned that Sri Lanka should get China on board and compel it to agree to the proposed debt restructuring plan. The other impediment has been placed by the World Bank itself. It has announced that until Sri Lanka comes up with an acceptable macroeconomic stability plan, Sri Lanka cannot expect any funding from the World Bank. 

Meanwhile, the Fitch rating has opined that the new Cabinet appointed by the President is a continuation of the previous Gotabaya administration and, hence, runs the risk of being opposed by the people. These are all beyond Ranil’s control but issues he should resolve as the head of the state if Sri Lanka is to come out the current deadlock.

Gota’s failure

His predecessor, Gotabaya Rajapaksa, suffered from the failure of the two main policy strategies available to a government, fiscal policy, and monetary policy. The former is exercised by the Treasury on behalf of the Government, while the latter is exercised by the semi-independent central bank on behalf of the nation. 

Gota lost control over fiscal policy when he agreed to a reduction in government revenue by offering a series of unsolicited but very attractive income tax and value added tax concessions to taxpayers. He was warned against this dangerous move by independent economists, but those warnings were not heeded to. 

As a result, he lost revenue on average Rs. 500 billion every year since 2020. On top of that, his expenditure ballooned due to some imprudent policies such as giving employment to 100,000 Samurdhi children and the outbreak of COVID-19 pandemic in early 2020. The corollary was the dramatic increase in the overall budget deficit from an average of 6% of GDP to 12% plus making it necessary for him to borrow, especially from the banking sector, to fill the gap. Thus, he lost the fiscal space necessary for him to intervene in the economy to take the pandemic affected economy out of the crisis. 

Central Bank’s loose monetary policy

Meanwhile, his central bank adopted a loose monetary policy that consisted of a low interest rate regime on one side and permitting money growth on the other. This was contrary to the standard monetary theory which the central bank had followed ever since it was established in 1950. According to this monetary theory, money growth above the real economic growth-known as excess money growth-will lead to domestic inflation and currency depreciation. 

Governor W.D. Lakshman who defended the new monetary policy claimed that there was no evidence that there was a direct link with money growth and currency depreciation. A similar view was held by State Minister of Finance who later became the Governor of the Central Bank, Ajith Nivard Cabraal. This view was akin to the views held by a breakaway group of economists who claimed that they were following a new theory called Modern Monetary Theory or MMT. Hence, the market legitimately called that the central bank was not following monetary theory but modern monetary theory. 

This obvious claim was hotly rejected by the technical staff of the central bank too. The Monetary Board which has been charged with the responsibility of protecting the value of moneys held by people too became a yielding hand to this new monetary theory. 

Effect of following loose monetary policy

The failed fiscal policy prompted the government to borrow from the central bank and commercial banks a net amount-that is, after the gross borrowings are netted against the government’s deposits-to the tune of Rs. 4.4 trillion during the 29-month period from December 2019 to May 2022. The failed monetary policy allowed the money stock-defined as currency, demand deposits, time and savings deposits, and 50% of balances in non-resident foreign currency accounts-to increase by an equal amount marking a growth of 53% when the economic growth was negative by an estimated rate of about 8% during this period. Naturally, inflation got set in the system and it is now rising at 61% with food inflation rising by 91%. This is going to be still higher in the next few months. 

The corollary was the depletion of foreign reserves, depreciation of the currency, and the development of a lucrative black market in foreign currency parallel to the formal market. These are all ills brought on the Sri Lanka’s economy by the failed monetary policy. 

Still failing fiscal and monetary policies

The new Central Bank Governor Nandalal Weerasinghe has very correctly tightened the monetary policy by allowing interest rates to go up, curtailing lending to the Government from the Central Bank to a bare minimum and initiating action to get a bailout package from IMF. But it was too late and now things are beyond the control of the Central Bank. 

Despite some new tax measures introduced by the Government in June, the fiscal scenario is getting deteriorated month after month. The failing fiscal policy is rubbing on the action taken by the Central Bank making its policy actions ineffective. Hence, as new President, Ranil has inherited a failed fiscal policy and a failed monetary policy. Now he has to take a failing fiscal policy and a failing monetary policy too. 

Both are hitting very hard on his plans to make a quick turnaround in the economy. Since all Sri Lankan systems – public service, education, healthcare, transport, energy, agriculture, industry and so on – are in a state of paralysis, he should act quickly and decisively now. But his energy seems to be spent not on the economy but on bringing the protestors who paved way for his ascend to presidency to books on charges they are alleged to have committed while protesting against Gota who had to flee the country unceremoniously. 

Since the root causes for mass protest campaigns are still there unremoved, bringing to books a select number of leaders will not create the peaceful and healthy environment for him to make a quick fix of the economy. Having noticed this deficiency, the Fitch Ratings had recently warned that the much-needed stability of the Government to introduce a suitable macro policy package is not existent. 

When both fiscal and monetary policies have failed and there is no prospect to get assistance from the rest of the world on the scale required, Ranil should now extend a friendly hand to all, especially those who carried out protest campaigns against Gota and paved way for him to ascend to presidency. If he fails to do that, he is proving that the Fitch Rating is correct

Crisis is now extended to local and geopolitics

As such, Sri Lanka’s present economic problems are not pure economics. They have got two new dimensions, one domestic politics, and the other geopolitics. 

To push Sri Lanka back to positive growth from the current negative growth, painful and bitter economic reforms need be introduced. In this connection, Sri Lankans should make a supreme sacrifice in the form of changing their established lifestyles, comforts, and consumption patterns. This sacrifice should be made by President downward to the common man in the street. 

Sri Lanka can take some lessons from the Japanese who managed to convert their war-ravaged economy after the World War II to a nation of prosperity within a decade. The Japanese cut their consumption to a bare minimum-to a level of about 50%-saved resources which were reinvested in income generating and exportable goods producing industries. Sri Lankans presently consume about 80% of their income. The resultant domestic savings at about 20% are insufficient to meet the needed investments which stand at about 30% of GDP. 

The ensuing savings-investment gap of about 10% need be financed by using the savings of foreigners. To fill this gap, Sri Lanka had resorted to tapping this source by borrowing rather than getting the same through non-debt strategies. As a result, the debt liabilities ballooned year after year-at independence in 1948 it amounted to 4% in contrast to 82% of GDP today-pushing Sri Lanka hard to a foreign debt problem. It is necessary to borrow from foreign sources to fill the savings-investment gap in the next few years since it is difficult to change the source of foreign savings to non-debt immediately. But this creates a geopolitical problem now.

Since the root causes for mass protest campaigns are still there unremoved, bringing to books a select number of leaders will not create the peaceful and healthy environment for him to make a quick fix of the economy. Having noticed this deficiency, the Fitch Ratings had recently warned that the much-needed stability of the Government to introduce a suitable macro policy package is not existent.

Alienating of traditional Sri Lanka supporters

Sri Lanka being a non-aligned nation had been using the resources of all the power groups in the world. This is the policy to be adopted by the present administration too. However, it seems that due to some shortsighted action Sri Lanka is alienating itself from its traditional supporters in the West. When these nations advised Sri Lanka not to violate human rights when dealing with protestors, it was reported that they were met with an angry rebuttal. 

This is uncalled for at a time when Sri Lanka is deep buried in the worst of economic crises it has faced in the whole of its post-independence history. Sri Lanka is presently having a trade surplus with three of these countries-USA, UK, and EU-amounting to about $ 4 billion on average. This surplus is used by the country to part finance the trade deficit with India and China amounting to about $ 7 billion per annum. Sri Lanka does not have the luxury to antagonise these countries and still remain stable. 

China is the saviour? 

If the Western help is not availed, Sri Lanka’s next choice is to get the support of India and China. Both countries have helped Sri Lanka to survive through the crisis, but the country cannot depend on them permanently. 

In the case of India, certain domestic economic crises-mainly rising inflation and falling reserves-have manifested themselves making it difficult for it to continue its support on the grand scale Sri Lanka needs. Hence, the country has to turn to China which is also unable to give the support on the needed scale. 

Sri Lanka: Stand on your own feet

What this means is that Sri Lanka needs to stand on its feet to come out of the crisis. One thing which Sri Lankans should now accept is that no one owes a living to Sri Lankans. Hence, we owe it to ourselves. 

When both fiscal and monetary policies have failed and there is no prospect to get assistance from the rest of the world on the scale required, Ranil should now extend a friendly hand to all, especially those who carried out protest campaigns against Gota and paved way for him to ascend to presidency. If he fails to do that, he is proving that the Fitch Rating is correct.  

(The writer, a former Deputy Governor of the Central Bank of Sri Lanka, can be reached at [email protected].)