Government should revisit State Expansion Policy

The World Bank Country Director for Sri Lanka and the Maldives, Diarietou Gaye, delivering the keynote address at the 172nd Annual General Meeting of the Ceylon Chamber of Commerce or CCC last month emphasised, inter alia, the need for raising the country’s investments in proportion to its total output or GDP from the current 28% to a level of about 35% in order to sustain an annual economic growth of 8-9% as targeted by the government in the medium to long term (available at: http://www.ft.lk/2011/08/01/emerging-sri-lanka-and-the-role-of-the-private-sector/#more-41432).

The burden of raising the investments to this level, she further elaborated, devolves on the country’s private sector which presently invests only about 22% of GDP. Accordingly, given an average investment rate of about 5% by the government, the private sector should raise its investments to a level of about 30% of GDP, requiring it to make a mega jump of 8% if it is to reach the target on investments.

This is a formidable challenge given the country’s low savings habits and government’s use of the lion’s share of the savings to pay for even its consumption expenditure year after year in most of the post independence period.

The veteran World Banker with a long track record as a practitioner in development and finance should be credited for highlighting the important role which the private sector should play in Sri Lanka’s post conflict economy.

However, in my view, the responsibility for generating funds for raising the country’s investments to the required level should not be placed squarely on the private sector. It should be supported by the government by generating savings in its revenue account. How should it do it? By keeping the consumption expenditure below the revenue and adding such savings to strengthen its investment initiatives.    

The magic required investment number

How has this required investment number of 35% of GDP come about? It is derived as ‘a rule of thumb’ from a celebrated economic theory developed independently by two economists, one British, Sir Roy Harrod in 1939 and the other a Russian-American, Evsey Domar in 1946. The theory is known as the Harrod-Domar Growth Model.

The logic behind the Harrod-Domar Growth Model is simple: it is necessary to use the physical capital such as plant, machinery, transport equipment etc. to produce goods and services. A country adds to this capital stock by way of investments and these investments are then converted to new goods and services. The rate at which such conversion is made depends on the efficiency of using capital by a country. If this efficiency level is high, then, with a small investment, a country can attain a higher rate of conversion, or in the laymen’s language, a higher rate of growth.

The level of the efficiency of using capital is known as the incremental capital output ratio or ICOR. It is simply the units of capital goods needed to produce one unit of goods and services. If ICOR is high, it means that capital is inefficiently used and if ICOR is low, it means that capital is efficiently used. This means that a high ICOR country has to have a bigger rate of investment to attain a given growth rate than a country with a low ICOR.

ICOR being the efficiency of the use of capital depends on a multitude of factors: the quality and the level of the capital stock, its maintenance standards, the managerial practices and their efficiency, the skills and talents of the people who operate such capital equipment, Research and Development outlays that improves the use of capital, supportive cultural practices of people and above all the ease of doing business and government’s facilitating role.

Sri Lanka’s ICOR has been historically at a level of about 5 meaning that, to attain a one percent growth rate, the country has to invest at least five percent of GDP. Accordingly, if one knows the required growth rate, one can calculate the required investment rate by multiplying it by 5.  

It appears that Gaye has used a lower ICOR of 4, that is, a higher efficiency of capital in Sri Lanka than its historical record, to estimate the required level of investments to attain and maintain a growth rate of 8-9%. She would have been prompted to use this number by the improved results of Sri Lanka in 2010.

How to pay for investments

The other side of the investments is how to find money to pay for them.

An individual wishing to construct a house may cut his consumption and save money or borrow from a bank or do both to finance his construction. The options available to a country to finance its national investments are practically the same.

Historically, Sri Lanka has been a high consumption country compared to some of its East Asian neighbours like Singapore, Japan or Malaysia. Its domestic savings have been in the range of some 18% of GDP meaning that for every rupee it earns, it consumes 82 cents on average. But its investment requirements, as calculated by Gaye, have been 35% plus. This means that it has to fill a gap of some 17% which the economists call ‘the saving-investment gap’.

This high saving-investment gap is the basic constraint which Sri Lanka faces in its drive to increase the investment levels to attain and maintain a growth rate of 8-9%. Gaye has simply asked the private sector to increase its investments by 8% of GDP, but there are no moneys of that magnitude available in the market for it to tap. Given the projected growth rate of 13% in nominal terms for 2012, this requirement amounts to some Rs. 600 billion or $ 5.5 billion. A credit expansion of that magnitude in a single year will raise money supply and cause the economy to overheat, the first symptom of high inflation which both India and China are now trying to avoid at all costs.

So, Sri Lanka has no choice but to go for tapping the savings of foreigners in the form of both borrowings and private direct investments. Since Sri Lanka has now graduated from concessionary borrowing to market borrowing on account of its rapid increase in average income per head known as per capita income, in the case of borrowing, the choice is to borrow from commercial markets under extremely non-concessionary terms. These non-concessionary terms involve market interest rates (about 6.25%), shorter maturity periods (between 4 to 6 years), repayment mostly in a single shot called ‘bullet repayments’ and practically insignificant grace periods (usually one year). Hence, it is absolutely necessary for a country to use such market borrowings for projects that generate an adequate income in foreign exchange to repay these loans, while adding net wealth to the country.

If this golden rule is not observed, it is inevitable that the country gets into a debt trap and has to sink to the bottom before it gets rescued by others as experienced by Greece and Ireland recently. This is a very painful and costly experience for the peoples of a country who had earlier been promised of a great future by their leaders.

The other option available to Sri Lanka is to tap foreign direct investments or FDIs in larger volumes.

Gaye has very correctly noted that Sri Lanka’s track record in this respect is not very impressive despite the end of the war two years ago. According to the Central Bank data, the net inflow of FDIs in 2010 has been a paltry $435 million which includes reinvested earnings of $ 195 million as well. Even an FDI flow of 2% of GDP in 2012 as projected by the authorities amounts only to $ 1.3 billion, falling short of the required amount of $ 5.5 billion by a significant margin.  It appears that Sri Lanka’s destiny requires it to go for a mega commercial borrowing of $ 4 billion in 2012 and in progressively increasing numbers thereafter to maintain its required rate of investments at 35% of GDP. This is surely a debt trap toward which Sri Lanka is fast walking.

Government’s

supporting hand

The gravity of the problem could be alleviated if the government makes an adjustment to its policy and budgetary numbers.

During the 10 years to 2010, Sri Lankan government’s annual consumption expenditure exceeded its revenue on average by 3% of GDP. Economists call this a deficit in the current or revenue account of the government. Since it is a dissaving by the government, it reduces the savings of the private sector by that amount.

The reasons for this deficit are numerous but could have been avoided: the overexpansion of the government sector, losses made by government enterprises, the need for keeping some of the government enterprises afloat by paying even for their consumption expenditure, high borrowings of the government requiring it to pay interest and untargeted subsidy schemes like the Samurdhi scheme and the fertiliser subsidy.

If the government is to give the best supporting hand to the private sector and the nation to raise the investment levels to the required amount and thereby build the country’s capital stock, it should do a rapid budgetary reform in the form of cutting its consumption spending to a manageable level. If the government goes on a spending spree, the consequences are all unpalatable: rising public debts, trapping in a debt trap, stunting the private sector, wastage of national resources and breeding of corruption.  The countries which did not pay attention to this golden rule such as modern Greece, Ireland and Portugal had to pay a huge social, economic and political price eventually when the respective economies became bankrupt and could no longer raise funds in the international markets to feed the voracious thirst for funding. The minority government of David Cameron in the UK, having noted the festering sore in time, took measures to cut unnecessary spending by Sterling 1.2 trillion over the next four year period. This he did despite the enormous political pressure mounted against him. President Barack Obama of USA failed to take timely corrective action and continued to enjoy the lavish lifestyle without any control contrary to what he preached when he was not in government. The consequence was that he was driven to the wall by August 2011 and had to bend backward in order to accommodate the harsh conditions of his rival Republicans to avoid default of the government payments.

Though he averted a crisis, the rating agency Standard and Poor’s has downgraded USA’s ‘triple A credit rating’ to ‘double A plus’ with a negative outlook thereby seriously wounding the American pride. It has also warned that, if Obama fails to cut the spending in two years as he has promised, even the double A plus would be downgraded to simple ‘double A’.  

Sri Lanka should revisit its state expansion policy

The current policy of the government appears to be pro-state sector. Accordingly, the divestiture of ownership of state enterprises even when they continue to make losses and could be run profitably by private entrepreneurship has been desisted; furthermore, when previously state owned but subsequently privatised enterprises are available for sale, there appears to be a willingness by the government to reacquire them. In addition, the public sector is continuously being strengthened through new recruitment to its lower grades to appease the rebellious youth joining the unemployment pool.

All these measures entail additional consumption expenditure on the budget and have raised borrowing requirements to fund the consequential government’s dissavings. The signs of growing uncontrolled consumption expenditure are already visible.

The current account deficit of the budget for the whole year had been estimated to be at Rs. 54 billion. This number was exceeded in the first quarter itself and amounted to Rs. 75 billion by end April. It appears that the deficit is on its way now to exceed even the peak of Rs. 179 billion in 2009 if effective measures are not taken to control government’s consumption expenditure. There are no economic objections to expanding the government sector if there is a need for same. However, it should be done after a careful analysis of the economics of such expansion not only as it is relevant to the current period but also to the future as well. Common business sense always requires a person to put his money into projects that are relevant, essential and paying back. This rule applies to the government as well.  Hence, it may be worth its while if the government revisits all its recent state sector expansion measures to identify whether there are prospects for  making a cost saving or simply to abandon them if they do not pay back to the nation.

Northumbria University’s State-of-the-Art Sports Complex

A good example of a state organisation’s going into a mega investment project after making a careful analysis and a business plan is the State-of-the-Art Sports Complex of Northumbria University in the UK. The writer had the fortune of visiting this complex recently.

The Sports Complex had been built at a cost of 32 million Sterling Pounds. It has all the modern facilities equipped with the latest technology and including an indoor football field that could be used for playing the sport even in the freezing winters. For a relatively small university located in the north of the UK in New Castle, I wondered whether it was another white elephant created by the university authorities. I put the question directly to them.

“No” was the answer I got. The explanation I received was amazing and well fitted with the Five Forces Competitive Strategies Model put forward by the Harvard Business School Professor Michael Porter in 1980. Porter said that in addition to the conventional rivals, a business should be mindful of the forces exerted by new entrants, customers, suppliers and substitutes to remain competitive in the long run.

That was the only modern sports complex in New Castle and therefore it did not have rivals close by. In view of the high capital costs, there was no threat of new entrants. Given the obsessive cultural habit of the university students and residents in New Castle to remain in good health with a good physique, the customers of the complex were all tied to it and did not wield an uncompetitive bargaining power. The suppliers of equipment to the complex had some measure of power over the management, but by going into long term contracts suitable to both parties, the complex was able to keep the threat at a low level. In view of the harsh wintry conditions in New Castle, the substitutes in the form outdoor physical training facilities were limited.

The sports complex had sold its facilities to about a half of the students numbering some 15,000 and about 2000 residents in New Castle without overstretching its facilities. There was a dual price system, a low price for the students and a high price for the staff and the residents.

 In addition, international sports events are also to be attracted to New Castle by the new sports complex of the university. Benefitted from the differentiated pricing system, another invention of Michael Porter in his generic value chain, and the superior business plan, the net cash flow the complex is sufficient to recover the capital expenditure of the sports complex within eight years.

This is a good example of state expansion based on a viable business plan and the use of the common sense involved in business entrepreneurship.

I was told that a swimming pool opened in a state university in Sri Lanka had only the patronage of about 20 students a day despite the free availability of the facility.

Time for the Government to wake up

There is the need for raising the country’s investments to a high level to increase, maintain and sustain a high growth rate. The burden of raising the investments to this required level should not be squarely passed onto the private sector when the government is happily overspending even for its consumption expenditure. The recent data show that its consumption expenditures are ballooning because of the government’s conscious state expansion policy. Lessons in this respect could be learned from the recent tragedy of Barack Obama, the unrivalled leader of the world’s strongest economy.

In my view, it is time for the government to wake up, learn from the emerging global trends and revisit its state expansion policy.

(W.A. Wijewardena can be reached at [email protected] )