Reasons for volatility in Sri Lanka

A number of articles which appeared in print media in the recent past signify the volatility in the economy. High volatility leads to vulnerability. Volatility and vulnerability are reflections of the haphazard nature of the economic policies and poor economic governance in a country.

What is volatility?

Volatility is the severity and the frequency with which changes in the economy occur more specifically with the oscillating macroeconomic environment. The other reasons for volatility are inappropriate and ad-hoc economic policies, lack of exports, exchange rate fluctuations, and external pressures such as UNHRC. The greater the volatility, the higher the vulnerability and uncertainty. When volatility exists in an economy, anxiety, unpredictability and complexity become the order of the day.

The dominant reason for volatility which protrudes and precedes all others is exchange rate fluctuations. Greater the exchange rates fluctuation greater the volatility. Larger gaps between buying and selling rates reflect and validate the magnitude of the volatility and vice versa. The chart amply demonstrates a comparison between the ‘buying and selling’ gap in Sri Lanka and Australia. The rationalisation for selecting Australia is due to their sound economic policies and the emergence as a “super power’ in the Pacific Region.

Some conjectures regarding the exchange rates are delineated below:

• Due to destabilising speculation, flexible rates become unstable especially when the demand is artificially created.
• Depreciating exchange rates trigger a vicious inflationary cycle. High cost of imports cause price hikes due to the lack of proportionate increase in exports. This leads to a deficit in a country’s current account.
• Systematic association does exist between the fundamentals of economics and the exchange rates.
• Volatile exchange rates are harmful to international trade. This is the situation prevailing in Sri Lanka today.
• Flexible exchange rates are excessively volatile as the exchange rate would be determined by the market forces, factors such as Balance of Payment (BOP) and interest rates.
• Generally foreign exchange market is efficient. But Sri Lanka being a Less Developed Country (LDC) and in the absence of a developed financial market and an effective mechanism to arrest money laundering, one cannot expect the market to be efficient. Hence the projected estimates become inaccurate and the volatility is amplified in exponential terms.

Additional reasons for volatility

The additional reasons expounded below contribute directly or indirectly to volatility. Hence it is expedient to discuss these reasons briefly.

Ad-hoc economic policies

 National politics and economic policies are inseparable and go hand-in-hand. Any country with a visionary leadership will experience sound economic policies and vice versa. For instance one can no doubt agree that the Philippines, from the time of former President and Dictator Ferdinand Marcos, (thereafter Corozon Aquino, Fidel Ramos, Joseph Estrada, Gloria Macapagal Arroyo) to the present President Benigno Aquino has been in dire economic straits and many other woes with unemployment over 30%.

A similar situation can be observed in Indonesia too, from the time of former dictator Gen. Suharto to the present President Susilo Bambang Yudhoyono. However, contrary to these two Asian countries, India having endured some political instability in the early nineties after Rajiv Gandhi’s assassination, under the futuristic political leadership of the then Premier Narasimha Rao, embarked on a multi dimensional strategy and laid the foundation for present India.

In this endeavour, Prime Minister Rao appointed a three-member committee to take India towards the new millennium. Dr. Abdul Kalam was assigned the task of transforming India to a nuclear power; Oxford-educated Economist Dr. Manmohan Singh to liberalise the economy and Narayana Moorthy (now Dr. Moorthy) to transform India as the world’s ‘Information Technology Hub’. They all accomplished the assigned tasks under the able leadership of Rao. Today India is one of the emerging economies and a ‘BRICS’ (Brazil, Russia, India, China and South Africa) and a G-20 nation.

Hence, professionally, ethically, logically, and meticulously formulated economic strategies should be in place, under proper political guidance, to subdue volatility.

Indecorous management of international trade

The prime objective of any country should be to enhance exports and to curtail imports to its fullest extent to enjoy a surplus in the current account. Sri Lanka has to utilise all resources and the avenues to boost exports. In this endeavour, strengthening backward integration for exports, exploring new markets and congruenting with the evolving world, are a few crucial mechanisms.

For instance, Middle Eastern countries import water from the Scandinavian countries. Goods such as water, fish, ornamental fish, dry fish, flora and fauna, salt, and many more can be easily exported from Sri Lanka. Japan, also being an island, supplies 14% of the world’s fish requirements.

Unfortunately, now Sri Lanka is losing its ‘grip’ with regard to tea in the world market, slowly and gradually. Government encouragement to the cottage industry, the SME sector, Ambassadors and High Commissioners acting as ‘Trade Ambassadors’ and ‘Brand Ambassadors’ to garner trade to the country will boost exports immensely and Mother Lanka’s foreign exchange inflow would be multiplied in many folds and the volatility would be mitigated accordingly.

The table and the line chart signify the widening gap in trade balance due to ever increasing imports and the stagnant exports. During the year 2011 (provisional) imports have increased by 47.4% compared to 29.6% in 2010 whereas the exports did not record any significant growth during the year 2011 compared to 2010. The unprecedented deficit of 96.7% in the trade balance compared to 52% in 2010, is one of the causes for this level of volatility in the economic sector.

From the antithetical dimension, imports have to be curtailed to the lowest possible level through implementation of protectionism policies using tariff and non-tariff barriers prudently. Effectiveness of protectionism policies can be measured not only from the reduction of imports and the improvement of current account, but also judging the number of local companies sprouting and embarking as start-up projects and becoming MNCs within a short span of time.

When South Korean companies such as Samsung, Hyundai, Kumagai, and LG were struggling to come up as start-up concerns, the Korean Government not only introduced the protectionism policies effectively in mid eighties to curtail imports of similar products through tariff barriers in to Korea, but also embraced such companies with the required technical guidance and financial assistance to compete in the global market. The rest is history.

Today Samsung has overtaken Nokia in the global market for mobile phones, Hyundai latest car is virtually similar to Benz E class model and all other Korean products such as LG are outperforming most of the globally reputed brands as well. Mechanisms such as Local Content Requirement (LCR), administrative policies, and anti-dumping regulations must be implemented in addition to the trade barriers to curtail imports.

This is known as the strategic intervention of the government in international trade. Decorous management of international trade is a must to subdue volatility.

Lack of Foreign Direct Investments

Upon three years of ending the civil war, still as a nation we struggle to allure FDIs. Creating a conducive atmosphere to attract FDIs applying absolute, comparative and acquired advantages effectively is vital. FDIs provide adequate inflow of foreign exchange to the country. Striving to attract FDIs under volatile and unfavourable atmosphere can be compared to a collapsing bank with diminishing public image making a futile effort to mobilise deposits for survival. Customers with an iota of common sense will not place deposits in that bank.

Similarly, MNCs and wealthy investors too critically analyse and evaluate the political and the economic atmosphere in the country before they invest. They look in from out. Malaysia achieved the present status mainly through FDIs’. ‘London Eye’ in England and Disneyland in Hong Kong are FDIs. When the FDIs are growing, not only the volatility is subdued substantially due to inflow of foreign exchange but also employment generation, improvement of standard of living along with several other advantages can be experienced. All these reduce volatility.

Global pressures

The present level of volatility did not happen overnight and is the consequences of a series of blunders made over a period of time. Global pressures the country has been facing have created a negative impact and tarnished the image of Sri Lanka in the investors’ mind; the oil hedging deal, removal of GSP+, resolution at the United Nations Commission for Human Rights (UNCHR) to name a few. These fracases have unfortunately made Sri Lanka small in the eyes of the global community.

As professionals, it is worthy to understand that “interdependency and integration” are pivotal elements under globalisation. Interdependency and integration do not mean antagonising one part of the world and being friendly with the other part of the world. This has to be clearly understood. All these contretemps without any doubt have painted a negative picture globally and as a result, international trade, FDIs and tourism are hampered and hindered significantly. These negative alluviums need to be immediately removed.

Consequences of volatility

Commercial banks’ perspective: High volatility results banks adopting a ‘wait and see’ policy instead of encouraging new business ventures. Skyrocketing cost of living, reduction of money value will erode hard earned savings while declining FDIs and exports would increase volatility. The economy would ultimately be engulfed in a quagmire. In this scenario, a liquidity crunch becomes inevitable and as a result, interest rates increase, costs escalate, non performing advances increase. All these, undoubtedly create a negative impact on the economy.

Investors’ perspective: By nature, no investor or entrepreneur prefers losses over profits. High volatility pushes investors and entrepreneurs to explore other avenues and locations to invest their surplus funds. For instance, MNCs search for other countries with better comparative advantages to make FDIs and Corporate Companies postpone launching their “business plans” indefinitely. As a result, the country loses FDIs; employment generation is hampered and the Gross Domestic Product (GDP) growth is slowed down.

Consumers’ perspective: Depreciation of domestic currency adversely affects cost of living, cost of imports and results in money value erosion. This leads to low purchasing power of consumers even for day-to-day expenses. Savings will then be eroded, resulting in a drop in banks’ savings deposit base. Cost of funds will also increase as the banks would be compelled to offer higher rates not only to garner deposits but also to retain the existing deposits. Reduction in savings means low investment opportunities.

How to reduce volatility from a macroeconomic perspective

• Curtail imports: Implementing effective protectionism policies through tariff and non-tariff barriers and curtailing the imports of luxury items with the prevailing volatile situation would help the economy as well as implementing Local Content Requirements (LCR), Administrative policies and Anti Dumping legislature will curtail imports substantially.
• Avoid International Monetary Fund (IMF) and the World Bank (WB) regulations as much as possible (The World Bank was initially constituted after the 2nd world war only to reconstruct the already destroyed Europe under George Marshall’s plan). Economists with a sound background can counter argue and rationalise their suggestions/conditions to avoid detrimental conditions imposed by them. Critics say the IMF and the WB have “one size fits all” policies and they are not accountable for their actions (Hill, 2007, p. 391-392). For instance, Argentina strictly adhered to the advice given by IMF, but the economy collapsed in 2001. Hence there’s no assurance to say by adhering to IMF instructions, a country can be economically transformed or developed. From an antithetical perspective, another example is, during the South East Asian crisis, Dr. Mahathir Mohamed refused the IMF loan yet, resurrected the Malaysian economy within two years. However Indonesia was granted $ 43 b by the IMF but the economy compared to other countries in the region is still in a quagmire. Hence heavy dependence on IMF can be detrimental without having proper economic policies internally.
• Formulate and execute sound economic policies to the country based on fundamentals. “Failing to plan is planning to fail”. Haphazardly decided policies which are detrimental to the economy, increase the volatility further. High volatility in the country is the reflection of poor economic governance. For instance, 2009 recession did not create a negative impact for economies such as Australia, New Zealand, India and China as their economies are well planned.
• Devaluation – Rupee devaluation is not the answer. Devaluation aggravates volatility in many folds for a country like Sri Lanka. As per Marshall Lerner theorem, a country should export and import elastic goods to reap the anticipated objectives of devaluation. Since most of our exports and imports are inelastic, except for a few imports such as cosmetics, automobiles and home appliances, anticipated benefits through devaluation cannot be achieved. Best option is to enhance exports.
• Enhance exports as much as possible. Strategic and Economic intervention of the government is a must to boost exports in any country. Exports provide the much needed foreign exchange to the country which will in turn reduce volatility substantially. Any country’s prime objective must be to maximise exports, minimise imports and to have a surplus in the current account. Forming Export Management Companies (EMC), exploring new markets, territories, products for exports, utilise the diplomatic community as “trade agents” and “brand ambassadors,” strengthening the backward integration for exports, reducing the production cost (i.e. electricity) in order to compete in the global market are some ways in which exports can be increased. Germany which is the richest nation in Europe is economically strong being the third largest exporter in value terms in the world. China has become the ‘world’s factory’ and the Yuan is becoming stronger due to exports. Obtaining foreign loans, and issuing ‘bonds’ one after the other without generating adequate export opportunities and pay back mechanisms will further enhance the volatility in the country. Very soon we will have to issue new bonds to settle the interest of the earlier bonds.
• Garner Foreign Direct Investments (FDIs) – This is a must. Use absolute, comparative and the acquired advantages to the maximum. Carefully analyse the pros and cons of the other countries in the region and design an effective and pragmatic plan to allure FDIs to the country. Offering incentives alone is futile to attract FDIs in the contemporary world.

   When the volatility is high, the country naturally becomes vulnerable in the global market. Hence, reducing volatility is of paramount importance.

(The writer is the Course Director at IIHE for University of Wales, UK, BSc and MBA programs. He possesses a wealth of hands-on exposure as a banker, management consultant, university senior lecturer and a strategist. He has, in addition to several professional qualifications, double Masters Degrees; an MBA from PIM, Sri J’pura, and Massey University, Auckland. Presently he is reading for his PhD on Corporate Governance. Trevor can be contacted on [email protected].)