Tragic policy making and ‘Wonder of Asia’: What happened and what’s in store?

By a Special Correspondent
A year or back from today, Sri Lankan economy had been sailing strongly amidst global economic typhoons. Most of the macro variables were reflecting peace dividends and rejuvenated hope. However, by mid 2011, the country’s trade deficit, fuelled by credit expansion was signalling early signs of an economic turmoil.
Perhaps being dazzled by the 8% economic growth story, the country’s policymakers turned a blind eye to these adverse developments and fell short of implementing tightening measures to arrest an economy-wide crisis. Despite warnings of many non-partisan economists who voiced their concerns, the monetary authority continued with expansionary policies till the fiscal muscle was flexed to remind the need to tighten the interest rates and exchange rate.

The results of the delay in taking necessary policy measures are now felt across the economy with both households and firms are fighting hard for survival.
Economic model towards ‘Wonder of Asia’
The economic model advocated by the policymakers was mainly targeted at achieving growth through stimulated consumption. For example, all publications, speeches and media releases of the monetary authority were centred around 8% growth and increasing per capita GDP; and the words ‘external sector’ were omitted in important documents.
In the course, policymakers seemed to have overlooked that the country’s economic fundamentals were not supportive of such high persistent growth rates with savings and investments are grossly inadequate. They just leveraged the ability to inflate growth in the short run through stimulated consumption; as explained by the short run non-neutrality of money in economics. It was jubilantly cited that the country’s growth was only second to China in the Asian region.
Clearly, the secret of high growth rates are sustained savings translated into investments; and not continued lose policy. The table compares the savings and FDIs of selected high growth Asian countries that the policymakers have been trying to emulate in terms of growth.
The comparison is straightforward; it is a fundamental fallacy to emulate high growth countries when a country lacks prerequisites. A country shall adopt policies to create an enabling environment rather than to create artificial expansionary policy regimes if it wants to continue high growth.
Short-term expansionary policies will lead to high growth for a couple of years and destroy the potential of the economy thereafter; compelling implementation of painful stabilisation measures. Therefore, one could conclude that present economic conditions are a result of past expansionary policy measures implemented by the policymakers.
Let’s revisit the economic development model spearheaded by the policymakers of Sri Lanka in a nutshell. To support the growth, interest rates were kept low throughout the year 2011 although market liquidity had been continuously eroding: Excess liquidity in the market was wiped out by the end of the year from a beginning of Rs. 120 b. Low interest rates were used to spur domestic credit; especially import loans. Imports of ‘other’ consumer goods (including vehicles) and investment goods increased by 67% and 60% YoY, respectively. By August 2011, the trade deficit had exhausted monetary authority’s full year deficit forecast.
Dela Ru operation (money printing) was kept busy to support Government expenditure and the monetary authority’s holdings of Government securities shot up from Rs. 3 b at the beginning to Rs. 170 b at the end of the year 2011.
Moreover, the monetary authority financed 41% of the fiscal deficit, against that of 0% in the previous two years. Whilst lending to Government, monetary authority made a profit of Rs. 48 b, a 300% growth year-on-year. (It is widely accepted that abnormally profit making monetary authority is a burden to the economy, because it makes profits mainly through seigniorage and investments made on its assets – a clear explanation for the monetary authority’s 2011 financial statements.
Exchange rate pressure arising out of increased money supply (owing to credit expansion and money printing) and the bloated trade deficit was neutralised by releasing forex reserves to the market. Towards the end of the year, monetary authority acknowledged that its projections were unrealistic (if not far from reality). However, it took at least seven months from July 2011 to respond to deterioration of trade, exchange rate pressure and credit expansion.
Policy rates remained untouched after January 2011 till February 2012; and the exchange rate was vehemently defended depriving its real value in 2011 till a policy package including structural adjustments and flexible exchange rates was advocated in February 2012.
(The exchange rate was defended from May 2009 onwards i.e. it was prevented from appreciating and sterilised purchases were made steadily. Then un-sterilised purchases were made. From late 2010 it was defended in both directions. Sterilised sales began in June and August. Exchange rate defence itself had no problem).
Consequences
The delay in policy to arrest the situation was costly. Low interest rates fuelled credit demand and the private credit grew by 35% in 2011. Increased import credit along with overvalued currency drove imports up whilst expensive rupee discouraged exports; paving the way to the country’s largest trade deficit in the history at 17% of GDP.
The country lost one-third of reserves in a bid to exacerbate exchange rate pressure i.e. sterilised sales; and consequently net international reserves declined to around US$ 2.5 b by the end 2011. The exchange rate’s short term stability outlook was also endangered; and its stability was handed-over to the speculators’ hand.
Year-to-date 2012, the currency has depreciated by as much as 16%. (It is the Secretary to the Treasury now has to come forward and plead the speculators to control their activities to achieve exchange rate stability.) The inflation was given a booster to commence its upswing due to increased money supply. The Government was compelled to take explicit measures to reduce imports.
It is noted that giving more flexibility to exchange rate in mid 2011 would have minimised the trade imbalances and resultant exchange rate pressures; whilst increasing policy rates could have written off a significant portion of the credit expansion. These measures would have avoided the need of painful adjustments at a latter point in time.
A flexible exchange rate is widely accepted as the best stabiliser of imbalances in trade and forex flows. The monetary authority is expected to intervene only to tackle short-term imbalances, leaving structural adjustments to be handled by the equilibrium rates. Persistent intervention distorts a country’s international trade and leads to currency crisis.
In the Sri Lankan case, the monetary authority tried to dictate terms over interest rates and artificially suppressed the exchange rate, requiring painful adjustments for stabilisation at a later stage. It is not worth mentioning the impact of these policies on the common man and corporate sector.
The bottom-line is that policymakers’ dream of sustained 8% growth became the Achilles Heel for Sri Lanka. The economy has ‘just started’ paying the price for 8% delusion with a period of painful adjustment. Without future structural adjustments towards an enabling environment, growth honeymoon is over for Sri Lanka.
What next?
The next logical question would be ‘what next?’ A rational person may expect the policymakers would rectify its own ‘pride and prejudice’. Unfortunately, this will not come true in Sri Lanka with a set of officials and regularly boasted ‘400 economists’ at the centre who are not willing to engage in a constructive dialogue and self criticism.
The institutional capacity in economics and finance appears to be malnourished and overall modelling frameworks are malfunctioning. Out of many, let me quote two examples in relation to the monetary authority.
1. Exchange rate projections
Monetary authority’s annual report 2011 discusses the impact of policy package that it implemented in February 2012 on the short to medium term outlook of the country in detail. However, it fails to add even a one liner on the outlook of the exchange rate.
Nevertheless, the table below computes the implicit exchange rate (last row) used by monetary authority in its annual report 2011. The total nominal GDP value and GDP per capita in US$ terms extracted from the annual report are used to compute the exchange rate forecasts of the monetary authority. Accordingly, the implied exchange rates are declining from 121/US$ in 2012 to 114/US$ in 2015 – may be in line with unprecedented growth of BOP surplus as projected by the monetary authority into the future. As citizens of this country why mot we ask for the assumptions behind these exchange rate?
1. Population was projected applying 1% growth rate on the midyear population based on historics given in the Annual Report of the monetary authority.
2. Per capita was computed by dividing the GDP by the population
3. The ratio between the per capita GDP in rupees and in USD is the implicit exchange rate.
These projections could amount to gross professional negligence from the part of the policymakers. One could sincerely hope that some legal activist with means will go for public interest litigation against these almost criminal behaviours of policymakers.
Unless this happens, the people of this country should not be surprised if the policymakers admit in 2015 that its projections were little off (like it did in 2012) and that $4,000 per capita target as charted in the ‘Mahinda Chinthana’ was not achieved because of a minute projection error. For the moment, there is one burning question to be raised: Are the policymakers trying to deceive His Excellency the President? Or the economists and analysts of this country? Or the general public?
2. Monetary policy projections
Monetary policy is the bread and butter for a monetary authority. In Sri Lanka, the monetary authority uses broad money (M2b) as the intermediate target of monetary policy, which is linked to reserve money, which is the operating target, through the money multiplier. Let’s look at the forecasts in relation to money multiplier.
For 2012 onwards, the forecasts are more or less the same; more interestingly reserve money and broad money are expected to grow at the same rates. This implies that money multiplier (M2b/reserve money) for the forthcoming years would be held constant 5.67, which is the figure reported for 2011. Generally, the money multiplier is influenced by the monetary authority’s Statutory Reserve Ratio as well as deposits drained out from the banking system. Therefore, it is highly unlikely that money multiplier will remain constant as the deposit habits of the people depend on many factors.
The monetary authority forecasts that among other variables inflation measured in terms of GDP deflator is expected to decrease; and this itself is a factor that would bring about changes in the multiplier thorough its impact on deposits to currency ratio. Although the assumptions are not clear, one thing is clear – that is the monetary authority’s forecasting does not rely on an integrated platform. And the calculations are made on a modular approach.
The monetary sector roadmap 2011 charts the monetary authority moving towards an inflation targeting framework. One would think it is better to stay in the monetary targeting framework rather than to go for inflation targeting with the present skill level at the monetary authority, as inflationary targeting demands significant modelling and forecasting capabilities compared to the present framework.
Why this?
Many allege that the decision making at policymaking bodies is not objective; and less independent. To support this view, analysts quote many recent instances such as EPF investment saga, action taken in TFC and hedging deals and issues in financial statements of deposit insurance scheme of the monetary authority. The Governor of the monetary authority himself was getting distracted with involvement in unrelated activities like IIFA and Commonwealth bid. The job of a Central Bank Governor is not a part-time activity.
On the other hand, the policymaking institutions suffer lack of quality human resources. Unlike in many other countries such as Singapore, Canada; the monetary authority does not have mid career programs to attract experience. The management positions of the monetary authority are filled only with those who enter the institution at a very young age as management trainees. The other institutions are dominated by SLAS officers whom by definition are administrators and not specialists/economists. These people generally do not have experience in the financial markets and mostly unaware of the complex real world financial and economic transactions and modelling.
So there is an urgent need for reforms at policymaking bodies in terms of independence and capacity. It is the time for those who are concerned, interested and knowledgeable to come forward and demand that the country is in safe hands – who know how to handle monetary and fiscal policy and the economy, who have experience in real world financial markets, who believe in integrity and professionalism.
“The world suffers a lot… Not because of the violence of bad people…But because of the silence of good people.”
(The author invites a constructive dialogue for improvement in economic management of the country and can be reached on analystsl@yahoo.com.)