Policy contradictions hold back economic prospects

Whilst fiscal adjustments are in disarray, the Central Bank which is supposed to conduct the country’s monetary policy independently is being increasingly subject to political influence, according to recent newspaper reports. The Central Bank being out of the hands of the Ministry of Finance makes fiscal-monetary policy coordination even more difficult

The year 2016, which started with the now forgotten Sri Lanka Economic Forum well-attended by the likes of George Soros and Joseph Stiglitz, is going to end up with disturbing economic fluctuations and continuing policy contradictions. The high-ranking politicians seem to grab every opportunity to attend such conferences abroad as well without gaining much benefits to the nation. 

As I predicted in the immediate aftermath of the local economic forum held in January this year, such glorified events do not help the country to attract foreign investments or to accelerate economic growth as long as the macroeconomic fundamentals remain fragile. The absence of a consistent policy framework prevents any correction of those disarrays in the foreseeable future. 

Hopes for economic stability fading

Just two weeks after presenting the Budget speech 2017, the very same parliamentarians, who endorsed the Budget proposals for raising the taxes on goods and services consumed by the ordinary people for the sake of fiscal consolidation, are now up in arms to raise their own perks on the initiative of the Prime Minister himself.  These include various forms of additional allowances and new vehicles to be given to the MPs. This ridicules the sacrifices that are being made by the masses in the name of the so-called fiscal consolidation which, of course, has little meaning to them. 

On the external front, exports are down by 4.1% raising the trade deficit to $ 5.5 billion in the first eight months of this year. Foreign Direct Investment (FDI) amounted to a meagre $ 336 million reflecting a decline of 37% from last year. This contrasts with the massive foreign investment inflows of over $ 8 billion a year anticipated for the Megapolis project alone. Such mammoth infrastructure projects will have to be funded by foreign loans on commercial terms posing severe risks to the already weak Government Budget and the country’s balance of payments in time to come.

Meanwhile, the emerging inflationary pressures are likely to aggravate the macroeconomic imbalances. The year on year inflation (as measured by the National Consumer Price Index) rose to 5.0% in last October, compared with 3.0% a year ago. 

Tax burden on the poor rising

Retention of the fiscal adjustments that are required to contain the budget deficit is a formidable challenge faced by the coalition Government. Most of the proposals in the last year’s Budget had to be reversed due to objections raised by certain groups within the Government and public protests. The recent decision taken by the President to review the proposed traffic fines is indicative of the difficulty in maintaining the Budget proposals intact this time too.    

Budget 2017 reflected much enthusiasm for fiscal consolidation, meaning a reduction in the persistent budget deficits so as to ease the debt burden. The increases in the Value Added Tax (VAT) and other indirect taxes are the main tools adopted by the Government to reduce the budget deficit whereas there are no immediate plans to raise income taxes or to curtail extravagant expenditure, as I elaborated in my previous columns in this newspaper. This exerts considerable burden on the poor as the goods and services subject to indirect taxes are levied irrespective of the income level of the consumers.  

The Government has been able to fulfil the fiscal consolidation commitments to a large extent by reducing the budget deficit from 7.4% of GDP in 2015 to 5.4% of GDP in 2016, as stipulated in the Extended Fund Facility (EFF) agreement with the IMF. This was achieved mainly by a 9% increase in indirect tax revenue. The share of indirect tax revenue increased from 81% in 2015 to 84% in 2016 reflecting a corresponding decline in the share of income taxes from 19% to 16%. The total collection of income taxes fell by 10.3% from Rs. 263 billion in 2015 to Rs. 236 billion in 2016

Higher perks for MPs nullify fiscal adjustments 

A supplementary estimate is to be presented to Parliament seeking approval to purchase 28 cars at a mammoth cost of Rs. 791 million for 27 Ministers, Deputy Ministers, State Ministers and Opposition Leader. This unbecoming move totally contradicts with the fiscal consolidation efforts envisaged in the Budget, though such perks might be politically necessary to minimise any possible breakups.  

The Prime Minister, joining the third reading of the Budget debate, is reported to have stressed the need to increase the salaries of parliamentarians so as to strengthen the parliamentary system. Accordingly, the PM has proposed to pay a monthly allowance of Rs. 100,000 to each MP to carry out his duties in his electorate, and to raise the daily allowance to Rs. 2,500 from the present level of Rs. 500. It was also proposed that air travel facilities should be made available to MPs in the north and east. 

Reportedly, the PM had quipped that his wife, a university professor, is paid a much higher salary in comparison with the salary he earns as the Prime Minister of the country. Referring to these remarks of the PM, a staff writer of a website has this to say, “On an unrelated note, if you are planning on becoming a career politician, don’t do it for the money. You’ll end up just as unlucky as most of us. Maybe you’ll be better off as an engineer, a doctor, or a senior lecturer” (www.roar.lk).

FDIs diminishing

The success of the Government’s infrastructure-led development programme, which forms the backbone of the current economic agenda, depends heavily on foreign capital inflows. A whopping $ 44 billion of foreign capital within five years is envisaged for the flagship Megapolis project alone, whereas the actual FDI inflow for this year is going to be not more than $ 600 million. This is in spite of the generous tax concessions and various other benefits given to foreign investors. 

Globally, it is evident that foreign investors in making their investment decisions give high priority to factors such as political stability, social cohesion, macroeconomic fundamentals, labour discipline, law and order, ease of doing business and corruption-free administration. Sri Lanka has had a poor track record in most of these attributes. In particular, policy inconsistences are a major constraint to attract foreign investment to this country. The frequent strikes and public protests too discourage foreign investors.  

Central Bank under siege

Whilst fiscal adjustments are in disarray, the Central Bank which is supposed to conduct the country’s monetary policy independently is being increasingly subject to political influence, according to recent newspaper reports. The Central Bank being out of the hands of the Ministry of Finance makes fiscal-monetary policy coordination even more difficult.

The PM and the Finance Minister had reportedly questioned the officials of the Central Bank last week over their failure to control the depreciation of the Rupee against the US dollar which had reached Rs. 150. Needless to say, market-determined exchange rate and interest rates are crucial in managing an open economy in the absence of import controls. The suppression of these two policy instruments at the whims and fancies of the administrators always leads to destabilise economies, as evident from many countries including Sri Lanka. 

The current depreciation of the rupee is a reflection of the weakening of the balance of payments which shows a larger trade deficit and drying-up FDI inflows this year, as mentioned above. Undoubtedly, prevention of the rupee depreciation will worsen this precarious situation.  

Strangely, the recent Budget contains several directives given to commercial banks with regard to credit allocation among different sectors. Arguably, it is a prerogative of the Central Bank. Besides, the Bank had abandoned such credit directives when the country transited to a liberalised economy decades ago. Reversal of this well-tested policy is unwarranted at this stage.

In the meantime, certain functions of the Central Bank are to be transferred to other agencies. These include the country’s payments platform, public debt management and Employees’ Provident Fund. While such transfers may be necessary from the viewpoint of financial sector modernisation in the current digital era, it is critically important to ensure the autonomy of the Central Bank in making such reforms. 

W.A. Wijewardena, a former Deputy Governor of the Central Bank, has articulated the adverse implications of these reforms in recent news media pointing out the perils of shifting the national payments platform to an outside body.

Policy mix-up 

The absence of a consistent policy framework is detrimental to harness Sri Lanka’s growth potential even at this later stage while the other emerging market economies in the neighbourhood are forging ahead rapidly using modern technology and innovations. The concept of ‘knowledge economy’, which is the driving force of such economies, is reduced to a mere political slogan in this country without making any headway towards knowledge-driven economic growth, as reiterated in my previous articles in this newspaper.  

Policy contradictions evident in many spheres drive away potential foreign investors. As already noted above, FDIs are essential to carry out the infrastructure projects earmarked by the Government. The downfall of FDIs this year once again signals the difficulties in attracting foreign capital. This compels the Government to draw more and more foreign loans to execute its infrastructure projects with diminishing opportunities for Public-Private Partnerships (PPPs) in the gloomy economic outlook. 

Considering the longer gestation periods of such projects and the widespread concessions given to foreign investors, any significant economic returns cannot be expected from them in the near future. Hence, settling the foreign debt commitments linked with those debt-funded projects in years to come is going to be extremely difficult, given the already persistent debt sustainability risks.  

(Prof. Sirimevan Colombage, an economist, academic and former central banker can be contacted at [email protected].)