The role of national defence in a crisis-ridden economy

Unfortunately, they can make themselves available only when the reaction to the violations result in aggressive open protests – Pic Courtesy AFP

The role of the defence forces and the Police is to protect the property rights which is essential for the crisis-ridden Sri Lanka to get out of the present malaise and place the economy on a long-term sustainable growth path. Unfortunately, they can make themselves available only when the reaction to the violations result in aggressive open protests. They may suppress such open reactions, but it is not the long-term solution. The long-term solutions involve the removal of the possibilities for violating the property rights through a well-designed action plan. Defence forces and the Police can support this endeavour by helping the authorities to design such a long-term sustainable plan. That is how they can pay back the society which has made available resources for their existence

Sri Lanka is undergoing the worst of its economic crises in its post-independence history in the current period. The manifestation of the crisis is multifarious. 

A shrinking economy

Its total output of goods and services, known as real gross domestic product, has shrunk by about 8% in 2022 and it is widely projected to shrink further in 2023. Any economic recovery will be marginal in the period from 2024 and will not exceed 3% even in 2027. This is below the normal economic growth of 4% which Sri Lanka could achieve without any policy action. Since Sri Lanka has recorded a negative economic growth in the last three quarters of 2022 consecutively, it is now in economic recession officially. 

Its per capita GDP has declined from $ 4,000 in 2018 to $ 3,349 in 2022. Sri Lankans have become poorer on average, and this trend will be slightly reversed by 2027, the last year of the present IMF program. What this means is that if Sri Lanka aspires to become a rich country by 2048 by reaching a per capita income level of $ 12,000, it should have a real economic growth of about 7% year after year, given an annual population increase of about 1% over this period. This is a formidable challenge faced by the country. 

Cost of living is rising though inflation from year to year is slowing

On the inflation side, Sri Lanka cannot be complacent about the behaviour of the prices. According to the Colombo Consumer Price Index, the official price index of the country, the general prices have increased by about 95% from January 2021 to March 2023. A family of 3.8 members meaning two parents and two children would have spent Rs. 91,880 in January 2021 to buy the basket of goods and services underlying the index. The same family should spend Rs. 179,166 in March 2023 to that basket. If their income has not increased by at least 95% over this period, the living conditions of an average family in Colombo District have worsened. 

But the nationwide price increase, according to the Sri Lanka National Consumer Price Index or NCPI, is a little higher at 104% over the same period. Even though the annual inflation rate had begun to decelerate both in the Colombo District and the country as a whole, prices are still rising at a slower rate. Accordingly, the annual decrease is not due to the decline in prices but due to the high level of prices that had prevailed a year ago compared to the current month. 

Poverty among the upper middle-class is on the increase

These high prices, when converted to poverty, also have presented a gloomy picture. Sri Lanka’s official poverty level is measured by using NCPI numbers, but it has not been updated since December 2022 by using the new index that came into operation in February 2023. If poverty threshold is projected by using NCPI numbers, as at February 2023, a person earning below Rs. 17,429 per month or $ 1.61 a day is in poverty. To measure poverty, the World Bank uses the threshold of $ 2.15 per day basing its calculations on the 2017 Purchasing Power Parity or PPP GDP numbers. According to this measure, Sri Lanka’s poverty has increased from 1.5% in 2021 to 5.8% in 2022. It is expected to rise to 6.6% in 2023 and will remain at around 6% thereafter. 

But the biggest worry which Sri Lanka should have is the elevation of the upper middle income poverty rate of which the threshold limit is $ 6.85 a day. According to this measure, the poverty the upper income poverty level that amounted to 49.9% in 2020 has increased to 65% in 2022. Over the next three-year period, it will slightly accelerate to about 66%. What this means is that a large number of middle-income earners in Sri Lanka is in poverty and it is a worrisome development. 

Total gross government expenditure is the issue

The Government, on the advice of the IMF, is planning to bring the budget imbalances under control, a process known as budget consolidation, by increasing the revenue. Accordingly, a new tax system has been introduced to increase the tax revenue to Rs. 3.2 trillion in 2023 up from Rs. 2 trillion in 2022. The total revenue of the Government in 2023 is expected to be around Rs. 3.4 trillion. However, this revenue-based budget consolidation, without trimming the expenditures, has created a large hole in the budget. 

According to the presentation made by the Central Bank and the Ministry of Finance to the bilateral foreign lenders, the total unfinanced gap has been estimated at 35% of a gross domestic product of Rs. 30 trillion in 2023. This amounts to a gap of Rs. 10.5 trillion. When the estimated revenue of Rs. 3.4 trillion is added to this amount, the total gross expenditure of the government in 2023 will be around Rs. 14 trillion. This is to be financed by the estimated revenue of Rs. 3.4 trillion and borrowing of Rs. 10.5 trillion from both foreign and domestic sources. 

All the citizens bear the burden

This situation raises another issue relating to who bears the burden of Government’s financing gap. The general belief by many is that it is only the taxpayers who will bear the full burden of the Government’s financing gap. This myth was shattered by the English economist David Ricardo as far back as the 19th century. He said that when people pay taxes, they bear the burden immediately because they must transfer a part of resources to the government and forego an opportunity to use them for their own consumption. But if the government spends more than the tax income by borrowing in the market, those taxpayers assume a liability to pay more taxes when these borrowings are repaid. Therefore, all the citizens of the country bear a burden for the increased government expenditure by more taxes today and tomorrow. 

During Ricardo’s time, there was no possibility for financing the government expenditure by printing money. But today, in addition to taxing people and borrowing from the market, which is imposing a tax liability on people tomorrow, governments have been financing budget deficits by printing money. Nothing is wrong in money printing for this purpose if that money printing is set at the same rate as the real economic growth. In that case, the impact of money printing on inflation is zero. But if money is printed more than the real economic growth, the excess money causes inflation and inflation reduces the real value of assets which people are holding. That reduction of the real value of assets is a tax paid by people to the government and therefore it is called the inflation tax. Hence, the actual burden of people is the total gross government expenditure which is set at Rs. 14 trillion for 2023. 

If the Government is desirous of providing relief to people, it should cut the total gross expenditure and reduce the burden of paying taxes today, tomorrow, and paying taxes via inflation. According to the IMF staff report to its Executive Board, the gross expenditure is expected to be maintained at this level even in 2028 by successfully completing a debt restructuring program, increasing the revenue to Rs. 7 trillion in 2028 from Rs. 3.4 trillion in 2023, and allowing other expenditure to increase from Rs. 5.8 trillion to Rs. 9 trillion If the burden to people is to be kept at this level, it is essential for Sri Lanka to complete the IMF program as it has promised the Fund.

Debt restructuring is crucial for financing the external sector gap

On the external front, though there is a temporary solace in the form of a marginal improvement in foreign reserves, the country is still in red with a massive financing gap as projected by the IMF staff. Accordingly, the total financing gap during 2022-27 amounts to $ 25.2 billion. Against this gap, the funds to be received from IMF under the EFF will amount to $ 3 billion and those from the World Bank and ADB, $ 3.75 billion. This leaves a gap of $ 18.45 billion. This is to be financed largely by debt restructuring and borrowing from commercial markets by issuing International Sovereign Bonds or ISBs for a value of $ 1.5 billion in 2027. 

The debt restructuring is expected to bring in $ 14.1 billion, while the country has already got a benefit out of the debt repayment suspension in 2022 amounting to $ 2.8 billion. The last item is not cancelled but is added to the principal increasing the total debt obligations of the country. As it is, the restructured amount is about 40% of the total debt obligations to bilateral and commercial lenders. This is the minimum amount of haircut which Sri Lanka should get through the negotiations with creditors. It is therefore essential that the Sri Lanka government should be successful in getting this concession from its creditors. 

Domestic debt is also to be restructured in a different way

So far, there was no question of restructuring the domestic debt of the central government issued under local lows. They are made up of the Sri Lanka Development Bonds or SLDBs issued in US dollars, Treasury bills and Treasury bonds issued in rupees. Since Sri Lanka did not have foreign exchange to repay SLDBs, they were settled in rupees subject to a time lag of about one month and the availability of rupee funds with the Treasury. It is a default because the government has failed to honour the terms and conditions of the issue of those bonds to investors. However, Treasury bills and Treasury bonds did not fall into this category because the central bank was able to repay them by reissuing to the market. 

But this did not satisfy the ISB holders, and an ad hoc group of such holders had written to the IMF and the Ministry of Finance that the government should reorganise those bonds. The Central Bank and the Ministry of Finance while addressing the bilateral creditors on 30 March 2023 had announced that those entities holding these bills and bonds could voluntarily optimise the bonds and bills. What it meant was that the Government will not ask them to go for it but the investors could go for it on their own. It will be compulsorily done in the case of the central bank where it is holding about Rs. 3 trillion worth of bills and provisional advances in terms of the new central bank law. That law stipulates that the government will issue a negotiable bond maturing in 10 years to the bank in settlement of that liability. It is this option that will be offered to other holders of bills and bonds in their attempt at optimising the losses. However, whatever the solution being followed, it will mean that the government does not have funds to repay these loans as and when they mature. 

There is a big gap in the budget too

This is a fragile macroeconomic scenario in which the Government does not earn enough revenue to meet its expenditure. The expenditure involves the day-to-day expenditure covering current or consumption expenditure, the long-term expenditure supporting the public sector capital formation, and the expenditure needed to repay the maturing central government public debt. In the case of the budget 2023, as the IMF staff in its report to the Executive Board has projected, the revenue from all sources will amount to Rs. 3.3 trillion. 

The consumption expenditure will be Rs. 4.6 trillion leaving gap, known as government’s dissavings, of Rs. 1.3 trillion or 4.35% of the estimated GDP for the year. The capital expenditure will amount to Rs. 1 trillion or 3.3% of GDP, an amount less than the consumption account gap. The balance amount of Rs. 8.4 trillion out of the total gross expenditure of Rs. 14 trillion involves the borrowings on account of financing the overall balance of Rs. 2.4 trillion and Rs. 6 trillion on account of debt repayment if there is no debt restructuring of both the foreign debt and the local debt. 

The defence expenditure which the Government should incur will be subject to these limitations. It includes the salaries and other day-to-day expenses of the armed forces and the police and any material of which the services are obtained over a period of more than one year. 

Man is a selfish creature

In this background, what is the role of the defence forces and the police in helping the economy to recover? Economic recovery comes from the individual initiatives to first help himself and through that help, all others in the society. This is purely a selfish motive but that is the way all species behave. The underlying logic is that if one is unable to help oneself, he is not able to help all others on a sustainable basis. That is why in Compassion Meditation preached by the Buddha that one starts wishing oneself free from sorrow, free from illness, and be blessed with happiness and gradually extend the same to all others. 

Adams Smith, the 18th century English economist, presented this in The Wealth of Nations that we expect to have dinner not from the benevolence of Butcher, Brewer, or the Baker but from their regard to their own interest. Thus, people will develop their talents and skills first, and then, help others by making available the benefits of those talents and skills to others. But if somebody in the government or outside destroys those talents and skills or forcibly deny them of using them, or acquires them forcibly, then, there is no incentive anymore for them to develop the same. 

Protect the property rights

In economics, this is known as property rights. Property here has a wider meaning to include physical property, right to life, and right to one’s intellectual skills. Individuals should be able to dispose of these properties in a market in a voluntary exchange acceptable to both the giver and the recipient. In this voluntary exchange, while one gives up his property, the recipient compensates him at the rate agreed between them. If these property rights are violated, people will react in two ways to the loss. One is the aggressive reaction in which they openly fight against it. The other is inactive reaction in which they either leave the country or refrain from making their contributions to society. We observe all these three types of reactions in Sri Lanka today. 

People react to repressive measures by both active and silent protests

The role of the defence forces and the Police is to protect the property rights which is essential for the crisis-ridden Sri Lanka to get out of the present malaise and place the economy on a long-term sustainable growth path. Unfortunately, they can make themselves available only when the reaction to the violations result in aggressive open protests. They may suppress such open reactions, but it is not the long-term solution. The long-term solutions involve the removal of the possibilities for violating the property rights through a well-designed action plan. Defence forces and the Police can support this endeavour by helping the authorities to design such a long-term sustainable plan. That is how they can pay back the society which has made available resources for their existence. 

Sri Lanka is aspiring to get foreign direct investments and through it the much-desired technology. If the security forces and the Police fail to protect the property rights, the prospect of attracting such investments will be dim. It is unlikely that any investor will come to Sri Lanka with advanced technology if the security forces and the Police allow their property rights to be violated by the Government or anyone outside the Government. 

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