By Bodh Maathura
It’s been two years since the discovery of the first Covid-19 patient and the ensuing lockdowns which pushed the global economy into turmoil. Sri Lanka was a victim of both the health and economic crises that came with the pandemic. But for a country that has gone through 16 International Monetary Fund (IMF) programmes, the macroeconomic data for 2020 and 2021 shows that these two years were not so different from the preceding decades.
Let’s start with the Sri Lankan currency, which depreciated against the US dollar by 3% in 2020 and 9% in 2021 (Figure 1). This may sound adverse, but it is hardly an outlier when compared to the 10-year average depreciation rate of 6%, and the high depreciation rates of 15% and 10% seen in 2012 and 2019, respectively. Indeed, the rupee has more or less maintained the same downward trend seen before the pandemic.
Conventional economists are of the view that the devaluation of currency necessarily promotes exports and helps settle trade imbalances. However, by comparing data of export revenue and annual rupee depreciation of Sri Lanka, we have previously proved that this theory does not hold in Sri Lanka.
Next, we may examine the current account, which has been in deficit since 1978 (Figure 2) and is a primary cause for depreciation. This deficit is driven by the widening gap in the merchandise trade account. Pandemic-induced lockdowns brought merchandise trade to a standstill, but after the first wave, exports grew faster than imports, thanks to government policies. This allowed for the 2020 current account deficit to be brought down, even with the collapse of the tourism sector. However, rising global commodity prices (particularly fuel) caused the deficit to widen again in 2021.
On the fiscal side, there was a rise in the country’s budget deficit as a percentage of gross domestic product (GDP) in 2020 and 2021 (Figure 3). However, even in 2019 (before the pandemic or the tax breaks), the budget deficit was a high 9.6% of GDP. The budget deficit levels reached during the pandemic, while high, are nothing new for the country when placed in historical perspective, especially during the 1980s and 1990s.
As a final indicator, public debt as a percentage of GDP has risen in 2020 and 2021 to above 100% (Figure 4). Again, these levels are not new for Sri Lanka which has experienced public debt higher than 100% of GDP in 1989, 2001, and 2004. Sri Lanka has historically maintained a higher debt-to-GDP ratio compared to its neighbours, and the pandemic has only continued this negative trajectory.
Two paths forward
Someone looking at Sri Lanka’s macroeconomic data without knowledge of the ongoing Covid-19 pandemic would not assume an external shock, but a continuation of a structural and cyclical problem.
The only difference brought about by the pandemic is a disruption to trade and global supply chains, and limited access to foreign loans brought about by rating downgrades. But the basic problem facing the country is the same that has existed for the past 70 years – not producing enough.
Following the global push to liberalise trade and finance in the 1970s, Sri Lanka became dependent on imports, while not increasing exports enough to cover its import bill. The ensuing deficit caused continuous currency depreciation while forcing the country to resort to foreign borrowing to manage balance of payments crises. Meanwhile, years of policy instability have discouraged investments in production and encouraged import-trade and financial speculation.
Sri Lanka now has two paths out of this crisis: 1) Go for a 17th IMF programme and restructure debt, and 2) muddle through to a production economy.
Reaching out for a 17th IMF programme would give the country a dollar lifeline to keep importing and a chance to reschedule its debt payments. However, the conditions that would be attached to such a programme would include currency depreciation, high interest rates, high taxation, and trade liberalisation, which would simply push the economy back into a vicious cycle of crisis.
Devaluation would push up the cost of living and importing much-needed capital goods for production. Higher interest rates too would push up the cost of working capital and discourage long-term loans for production. Austerity would hamper growth and fuel social instability, while trade liberalisation would push infant industries out of the market.
The path not taken
A muddle through approach means entering uncharted territory for most Sri Lankan policymakers and businesses. It is by no means less painless than the IMF path; however, it does provide an opportunity to break out of the vicious cycle of deficit-debt-depreciation, by building a production economy from the ground up.
Firstly, in order to maintain strong relations with foreign investors, Sri Lanka must make sure to pay all its dollar dues (including debts and imports). But in order to balance its dollar cash flow, inflows need to be increased and outflows reduced. An industry-targeted import replacement is a practical necessity as it would help internalise import expenditures.
Incentives are also needed to promote foreign and local investment in the export of value-added goods and services. This requires monetary and fiscal policies to be aligned. A stable low interest rate regime is needed to ease the cost of production, while sector-specific tax credit schemes can help to make strategic sectors more profitable. However, such subsidies should be conditional on firms complying with performance targets in order to prevent rentierism.
In the short to medium term before production picks up, the financial account will need to be managed to ensure sufficient dollar inflows. Port City Colombo and Board of Investment (BOI) industrial zones should play a key role in attracting non-debt dollar inflows which can be used to strengthen foreign exchange reserves.
The Covid-19 pandemic, while painful, has provided Sri Lankan a unique opportunity. The country can either resume its cycle foreign financing and production-throttling austerity, or it can opt to break out of the cycle through a holistic pro-production policy framework outlined above. The latter brings many challenges and uncertainties, but there is no other alternative to spur Sri Lanka into the status of a developed economy.
(The writer is an Economic Research Analyst at Econsult Asia, which is an economic research and management consultancy firm with an alternative development outlook)
……………………………………………….………………
The views and opinions expressed in this column are those of the author, and do not necessarily reflect those of this publication.
Let’s start with the Sri Lankan currency, which depreciated against the US dollar by 3% in 2020 and 9% in 2021 (Figure 1). This may sound adverse, but it is hardly an outlier when compared to the 10-year average depreciation rate of 6%, and the high depreciation rates of 15% and 10% seen in 2012 and 2019, respectively. Indeed, the rupee has more or less maintained the same downward trend seen before the pandemic.
Conventional economists are of the view that the devaluation of currency necessarily promotes exports and helps settle trade imbalances. However, by comparing data of export revenue and annual rupee depreciation of Sri Lanka, we have previously proved that this theory does not hold in Sri Lanka.
Next, we may examine the current account, which has been in deficit since 1978 (Figure 2) and is a primary cause for depreciation. This deficit is driven by the widening gap in the merchandise trade account. Pandemic-induced lockdowns brought merchandise trade to a standstill, but after the first wave, exports grew faster than imports, thanks to government policies. This allowed for the 2020 current account deficit to be brought down, even with the collapse of the tourism sector. However, rising global commodity prices (particularly fuel) caused the deficit to widen again in 2021.
On the fiscal side, there was a rise in the country’s budget deficit as a percentage of gross domestic product (GDP) in 2020 and 2021 (Figure 3). However, even in 2019 (before the pandemic or the tax breaks), the budget deficit was a high 9.6% of GDP. The budget deficit levels reached during the pandemic, while high, are nothing new for the country when placed in historical perspective, especially during the 1980s and 1990s.
As a final indicator, public debt as a percentage of GDP has risen in 2020 and 2021 to above 100% (Figure 4). Again, these levels are not new for Sri Lanka which has experienced public debt higher than 100% of GDP in 1989, 2001, and 2004. Sri Lanka has historically maintained a higher debt-to-GDP ratio compared to its neighbours, and the pandemic has only continued this negative trajectory.
Two paths forward
Someone looking at Sri Lanka’s macroeconomic data without knowledge of the ongoing Covid-19 pandemic would not assume an external shock, but a continuation of a structural and cyclical problem.
The only difference brought about by the pandemic is a disruption to trade and global supply chains, and limited access to foreign loans brought about by rating downgrades. But the basic problem facing the country is the same that has existed for the past 70 years – not producing enough.
Following the global push to liberalise trade and finance in the 1970s, Sri Lanka became dependent on imports, while not increasing exports enough to cover its import bill. The ensuing deficit caused continuous currency depreciation while forcing the country to resort to foreign borrowing to manage balance of payments crises. Meanwhile, years of policy instability have discouraged investments in production and encouraged import-trade and financial speculation.
Sri Lanka now has two paths out of this crisis: 1) Go for a 17th IMF programme and restructure debt, and 2) muddle through to a production economy.
Reaching out for a 17th IMF programme would give the country a dollar lifeline to keep importing and a chance to reschedule its debt payments. However, the conditions that would be attached to such a programme would include currency depreciation, high interest rates, high taxation, and trade liberalisation, which would simply push the economy back into a vicious cycle of crisis.
Devaluation would push up the cost of living and importing much-needed capital goods for production. Higher interest rates too would push up the cost of working capital and discourage long-term loans for production. Austerity would hamper growth and fuel social instability, while trade liberalisation would push infant industries out of the market.
The path not taken
A muddle through approach means entering uncharted territory for most Sri Lankan policymakers and businesses. It is by no means less painless than the IMF path; however, it does provide an opportunity to break out of the vicious cycle of deficit-debt-depreciation, by building a production economy from the ground up.
Firstly, in order to maintain strong relations with foreign investors, Sri Lanka must make sure to pay all its dollar dues (including debts and imports). But in order to balance its dollar cash flow, inflows need to be increased and outflows reduced. An industry-targeted import replacement is a practical necessity as it would help internalise import expenditures.
Incentives are also needed to promote foreign and local investment in the export of value-added goods and services. This requires monetary and fiscal policies to be aligned. A stable low interest rate regime is needed to ease the cost of production, while sector-specific tax credit schemes can help to make strategic sectors more profitable. However, such subsidies should be conditional on firms complying with performance targets in order to prevent rentierism.
In the short to medium term before production picks up, the financial account will need to be managed to ensure sufficient dollar inflows. Port City Colombo and Board of Investment (BOI) industrial zones should play a key role in attracting non-debt dollar inflows which can be used to strengthen foreign exchange reserves.
The Covid-19 pandemic, while painful, has provided Sri Lankan a unique opportunity. The country can either resume its cycle foreign financing and production-throttling austerity, or it can opt to break out of the cycle through a holistic pro-production policy framework outlined above. The latter brings many challenges and uncertainties, but there is no other alternative to spur Sri Lanka into the status of a developed economy.
(The writer is an Economic Research Analyst at Econsult Asia, which is an economic research and management consultancy firm with an alternative development outlook)
……………………………………………….………………
The views and opinions expressed in this column are those of the author, and do not necessarily reflect those of this publication.