Sri Lanka President revises budget amid inflationary blow off
ECONOMYNEXT – Sri Lanka’s revised budget has set the path for some spending based consolidation backed by the worst inflationary blow off in the history of the island’s central bank, though prospects for monetary stability needed for long term growth and social stability are dim.
Any progress on monetary stability needed for long term growth by taming the central bank can easily make way to abolish Sri Lanka’s exchange control and import control laws.
Sri Lanka’s current currency collapse came from a combination of leftist/progressive revenue based fiscal consolidation aimed at expanding the state, which abandoned spending based consolidation (cost cutting) and money printing legitimized by targeting an output gap (stimulus).
The revised budget has proposed to expand Value Added Tax, which easily captures spending of higher income earners regardless of whether the funds are hidden from income tax or not and also protects low income earners by exempting items like essential foods from the tax.
Value added tax is also superior to income tax in that it does not destroy capital which is necessary for investment and job creation. Millions of Sri Lankans now travel to the Middle East where there is little or no income tax and employment exceeds the domestic population.
President Wickremesinghe has avoided the calls by leftist economists to fritter away job creating capital through higher taxes charged on earnings before they are spent or invested.
Before revenue based fiscal consolidation started, Sri Lanka’s central government spending was 17 percent of GDP before revenue based fiscal consolidation started.
The new budget aims to reduce spending to 18.6 percent of GDP after a steep inflation of the economy.
Inflationary blow off
Despite a contraction in the economy, the economy is expected to inflate to 23.8 trillion rupees in 2022 amid a massive ‘inflationary blow off’ from 16.8 trillion rupees in 2021.
There are three results from central bank interest rates suppression and stimulus.
A deflationary collapse – sometimes happens in the US as after the Greenspan-Bernanke bubble, stagflation (as warned in the current Powell bubble and found in Sri Lanka in 2017 and 2019) and an inflationary blow off usually found in Latin America and Sri Lanka in the 1980s.
The inflationary blow off from depreciation and monetary instability, eventually pushes up operating costs of the government, creates more demands for subsidies and salary hikes through strikes and social unrest.
But in the short term some costs can be managed if state salaries are not increased.
Such cost rises were a familiar sight in the budget of the 1980s where prices permanently rose and social unrest was triggered.
“With inflation reaching 60.8% by July 2022 (CCPI based), the costs of all goods and services has increased significantly compared to the costs assumed in the original budget estimates, resulting in higher costs for government procurement as well,” President Wickremesinghe said.
“This is reflected in items such as fuel… in spite of reduced usage, medical supplies , and diet for hospitals, armed forces, prisons etc.”
Large allocations has also been made for poor families, some money for pregnant mothers as monetary instability put basic foods out of the reach of the less affluent.
Spending based consolidation
However President Wickremesinghe has created a path for some spending based consolidation by bringing the retirement age back to 60 years and creating a bill for a contributed pension fund for all, as long as social democratic politicians avoid hiring unemployed graduates to the state.
Broader public sector fiscal consolidation is also attempted via state enterprise privatization and reform.
A separate unit has been created for the purpose.
President Wickremesinghe’s government has also made steep increases in prices of fuel, electricity and water to reduce the overall public sector deficit, after economists printed money for stimulus and steeply depreciated the currency.
In a country with a soft-pegged regime energy and other prices only go up.
There is also an attempt to consolidate some local government agencies. In the first step 22 pradeshiya sabhas will be consolidated with nearby municipalities.
The budget said foreign universities would be allowed to set up branches in Sri Lanka in a liberalization move.
Meanwhile natural resources use will also be expedited by inviting foreign investments.
Wickremesinghe said new taxes including those proposed in May 2022 will help reduce money printing.
“The implementation of these proposals will help increase the revenue. It will enable to gradually reduce the quantum of monetary financing for government expenditure,” he said.
However central banks with untamed open market operations in third world countries do not print money to finance the deficit.
It happens at a gross financing level, where maturing debt is taken in to the balance sheet of the central bank to suppress rates.
However in Sri Lanka the central bank has printed money in the past despite raising taxes and bringing down deficits such as in 2018 and in earlier years to suppress interest rates and for stimulus.
After initially printing money to suppress rates, made possible by flexible inflation targeting, forex shortage are created in a reserve collecting pegged regime, triggering reserve sales for imports.
The reserves for imports are then sterilized with more money printing by purchasing Treasury bills, pushing up back credit and setting off vicious cycle until steep interest rates hikes and an economic crisis and bank bad loans are created.
Bangladesh is now experiencing a similar crisis.
Wickremesinghe’s United National Party has been the biggest victims of monetary instability with exchange and trade control laws being enacted or attempts to liberalize trade reversed with import controls.
Import controls were brought during the Yahapalana administration, two weeks before the budget and the import control law itself was enacted during the time of UNP Prime Minister Dudley Senanayake where attempts were initially made to liberalize trade.
Sri Lanka had free trade before the central bank was set up in 1950.
Sri Lanka’s politicians, especially in the United National Party have made the most difficult economic reforms imaginable, but have been tripped by economists and the soft-peg who do not understand the link between money printing and external imbalances.
In 1977, J R Jayewardene made some of the most difficult economic reforms imaginable as politicians do after economists or interventionists in third world countries create monetary instability and economic and price controls.
He brought in Singapore’s economic architect Goh Keng Swee, who kept the island’s currency board to prevent budget exercise and maintain free trade and social stability.
“You introduced a number of economic reforms which most people had considered politically impossible,” Singapore’s economic architect Goh Keng Swee told Jayawardena in a report as money printing triggered forex shortages as the economy recovered strongly and the country was driven to the International Monetary Fund stabilization program.
“The abolition of price controls for most commodities, the abolition of the food ration system, which provided free rice to the general public, the increase in the nine administered prices – rice sold by co-operatives, flour, bread, kerosene, electricity, bus transport, coconuts, coconut oil and milk powder – virtually ended the black market in these goods as supplies from official sources were adequate to meet demand.”
“The exchange rates were unified in November 1977; imports were liberalized.”
“These are actions which required considerable courage. They constitute a break with the conventional wisdom of past decades based on a re-distributive ethic, extensive state control and hostility of free enterprise and private ownership.”
However the central bank was buying Treasury bills in 1980 as foreign reserves were lost.
“In March, the Parliament approved an increase to Rs4,000 million and by June 16, this limit was reached. In July, the limit was raised to Rs6,000 million and by September, the limit was reached,” Goh said.
“On October 17, the limit was again raised to Rs8,000 million and during my stay Colombo, Parliament against raised it to Rs10,000 million.”
Goh told Jayewardene to watch five indicators. Number 01 was “The volume of Treasury bills bought by the central bank.”
“This is by far the most important statistic to watch,” he said.
However all this fell on deaf years as in Sri Lanka and similar third world countries forex troubles and monetary instability are blamed on other factors than the flexible policies and open market operations of the central bank.
Read more on column by economist W A Wijewardene: JR and expert advice: Failing to implement Goh Keng Swee Report of 1980
42 years later Jayewardene’s nephew is facing identical circumstances.
However there is no end to such instability in sight.
Wickremesinghe said a new monetary law will be enacted.
A draft monetary law in circulation however institutionalizes flexible inflation targeting and a flexible exchange rate, the latest label for reserve colleting pegs with anchor conflicts, where monetary policy errors are compensated with depreciation as happened from 2015 to 2022 and eventually drove the country to default.
In any case under an IMF program a reserve collecting peg has to be operated to re-build reserves with deflationary policy (slowing domestic credit and selling down the Treasury bills stock to create BOP surpluses.
Analysts have called for ceilings on Central Bank domestic assets to be set as performance criteria to stop teh centarl bank from printing money by circumventing the monetary policy consultation clause and creating forex shortages as happened in the last program.
Under a monetary law with a flexible exchange rate which is neither a hard peg nor a clean float, there is no legal barrier to creating currency crises and social unrest and bringing charlatans to power who will reverse whatever liberalizations that are done.
