By R.M.B Senanayake
According to the recent World Bank Review "The global economy is expected to grow 2.8 percent in 2015, slightly less than forecast in January, before strengthening moderately to 3.2 percent in 2016– 17. Developing country growth, buffeted by falling commodity prices, the stronger dollar, and tightening financial conditions has been revised downward to 4.4 percent in 2015 but is expected to pick up momentum and reach 5.3 percent in 2016–17".
How will we fare? We had high growth rates of 7.5% in 2014. But it was driven by extra government expenditure and is not sustainable. (The entirety of public capital expenditure is treated as investment and added to investment although economics strictly requires that capital expenditure must produce an economic return to be so treated). This year growth is expected to come down to 6.5%. No matter since we cannot depend on higher growth rates unless such growth is linked to a sustainable factor. Government expenditure is not such a factor.
Growth in 2014 driven by government expenditure
Development economists suggest export growth to be the driver of economic growth and the East Asian NICs did just that. Our growth in 2014 was largely from the government expenditure. But we cannot go on increasing government expenditure through money creation instead of taxation. Taxation of course has a reducing effect on national income which has to be offset.
Money creation has now become a standard practice with our governments - a convenient way to avoid taxing the people, although it eventually increases prices and worsens the current account of the balance of payments.
But we are running increasing budget deficits fortunately funded by foreign capital inflows. But presently such net foreign capital inflows seem to be drying up.
The new government seems to have allowed the market to determine the rate of exchange. But the problem in that is that it encourages speculators who take a pessimistic view and the rupee might fluctuate too much.
But can we depend on foreign borrowings to fund growth forever?
When will foreigners stop lending to us? Two things matter in the short term for the flow of foreign funds. They are the exchange rate and the rate of interest. The exchange rate was held more or less fixed for the last two years by the previous government which is good for foreign capital inflows. But it caused a loss of foreign exchange reserves. It is not feasible for a country with large current account deficits to have a fixed rate of exchange unless other corrective action for the current account deficit in the balance of payments is taken by way of say, direct controls on imports. Despite the worsening current account deficit the new government rashly reduced taxes and relaxed controls. But it has now realized its mistake and is allowing the rupee to depreciate. When the rupee depreciates imports are discouraged and exports promoted. Unfortunately since our exports are largely primary products we are unable to increased the supply in the short term. We are now exporting textile and garments but our benefit is limited to the value addition. Yet we must encourage more exports of industrial products and a floating exchange rate which depreciates is better than a fixed exchange rate for this purpose. The exporters must have confidence in the exchange rate policy of the government. It is now allowed to depreciate. But at what level will it settle at?
Money supply expansion
Our problem is the continuous expansion in money supply much more than is required to cope with the practical increase in output or GDP. Monetary expansion causes domestic inflation and or increases the current account of the balance of payments. When the public expect a sustained increase in money creation, then the forward rate of exchange will depreciate more than the amount of the interest rate - the differential between the present and the future. There is a regular and continued expansion in our money supply of about 15% although our growth rate is about half that. The other half over and above what is required to keep the growth, enters into the rate of inflation. The public believe that there will be continuous undue monetary expansion and they therefore expect the spot rupee to depreciate continuously. If the government wants to hold the rupee without allowing it to depreciate, it must stop money creation or money printing. This means the government must raise more taxes to fund its expenditure or it must reduce public expenditure to match the taxation.
The plethora of state corporations still continues to make losses which are in the first instance funded by credit expansion by the banks and later by the Treasury. We are a nation prone to living on credit and to funding losses in state corporations. Current transfers to meet the losses in the state corporations still continue to increase. Current transfers to public corporations increased by 40.3% to Rs 19.4 billion last year. The increase, says the Central Bank, was due to increased losses in the state-owned railways and the department of posts. There is no case to subsidize these services and the situation calls for an increase in the fees and the rates, a matter the minister of finance should consider. If not the railways and the posts departments should be privatized. The managements of these two institutions should be told to run the enterprises at break even level and if they cannot do so they must be privatized.
We have to run an efficient state machinery if we want economic growth without inflation. We cannot go on funding the public sector expenditure through money creation. Economists generally don’t want the government to reduce its capital expenditure because such expenditure is assumed to increase the growth rate. Yes the practice of adding all government expenditure to investment will prima facie increase capital expenditure. But it is extremely doubtful that even government capital expenditure is productive. In 2014 such capital expenditure and net lending increased to Rs 473 billion from 464 billion the previous year. It is better to reduce government capital expenditure (except for replacement of capital goods) although economists have opposed such reductions of government investment. At least the government should devote such capital expenditure to private public partnerships instead. There are inherent reasons why public expenditure in our country fails to achieve its objectives. There is of course the interference of the elected politicians in such spending plans. The MPs are elected to be legislators and not to be members of the executive.
We have not got used to the practice of feasibility studies and study of economic rates of return for capital expenditure unless they are required by international institutions for projects funded by them. But cost/benefit analysis should be the routine required practice for the inclusion of projects in the annual budget. The public officials do such studies only to conform to the requirements of the World Bank or some international financial institution. But it should be standard normal practice and the Treasury should not permit any new project to be included in the annual budget unless and until the cost/benefit analysis is included.
But public expenditure is incurred without proper feasibility studies (unless the World Bank or some International institution is also a partner in the project). We have still to practice cost benefit analyses in public expenditure. No public expenditure project should be included in the annual budget unless it has been cleared by the Ministry or Department of National Planning as providing a sufficient return on the investment to cover at least the cost of capital. Capital is a scarce resource and has alternative demands and any project should be selected after a comparison of its economic rate of return.
All public officials are not economists. But there is a cadre of economists now unlike in the past and they should be called upon to do an analysis of the cost and benefits of all projects to be included in the annual budget. In no way should such a study be dispensed with on the ground of urgency. The public doesn’t realize the damage done to their interests by the imprudent and excessive public expenditure. The government too must realize that the present policy of money creation can’t go on without adverse consequences on the economy. The next budget due in November provides an opportunity for the new government to retrace the steps and advance towards a more prudent policy.
If the new government is unwilling to raise taxes, both direct and indirect, its better to cut down on recurrent government expenditure. The scope to do so is limited as almost 70% of the budget is already earmarked expenditure. Then the only option is to reduce capital investment. There will be the fear that the growth rate will then sag. True, but it is better than creating more inflation and with it increasing the current account deficit in the balance of payments.
Another option which we have been using is to keep the import expenditure unchanged and fund it by running down our Foreign Reserves. But we need to preserve a minimum Foreign Exchange Reserve An excess of domestic spending over domestic production is financed in a direct way by the creation of new credit in the banking system which leads to the loss of Foreign Reserves. We therefore need to curb credit expansion to prevent the erosion of reserves even if it leads to a lower growth rate for the alternative in the form of a loss of Foreign Reserves is worse.
www.island.lk
No comments:
Post a Comment