Replicating Asian Miracle: Macroeconomic policy framework

Part TWO Replicating Asian Miracle: Macroeconomic policy framework By W.A. Wijewardena In the previous part, we discussed that, to replicate Asian Miracle in Post War Sri Lanka, the country should strive to diversify its trade relations leapfrogging its neighbours and moving to the rich west which has the capacity to buy on a continuous basis its exportable goods and globally saleable services. It is necessary to create the conditions conducive for sustaining such a long standing relationship with the West. This includes creating in Sri Lanka a society conscious of quality, good business practices, modernised roads, ports and airports, environmental upgrading and overall improvement in the governance structure which Lee Kuan Yew branded as ‘creating a developed world oasis’ among the poor developing neighbours.  Today, we will look at the appropriate macroeconomic policies which the country should adopt in order to make the dream of Asian Miracle a reality Budgetary imbalance: A curse inherited from the past One thing about which most macro economists agree today is that Sri Lanka’s current macroeconomic instability is sourced to a single factor: the liberal spending of the government over and above its revenue capacity during the whole of the post independence period except in 1954 and 1955. Economists call this practice ‘deficit financing’ and Sri Lanka very heavily relied on this practice in the belief that it would generate faster economic growth, wealth and prosperity. Accordingly, the budget deficits run by successive governments by following this practice were of a very high order. During 1950 to 2009, on average, the country’s budget deficits were as high as 7.5 percent of its total output known as Gross Domestic Product (GDP). In recent years, between 1980 and 2009, it was even higher at 9.1 percent of GDP. It is argued by macroeconomists that these high budget deficits beyond the country’s capacity have inflicted unintended adverse consequences on the country’s ability to tame inflation, have a stable exchange rate and push up the growth rate to a level that will create prosperity and wealth for the nation. It has also trapped the country in a vicious circle of debt accumulation by the government forcing it to borrow more to repay the debt and pay interest on such borrowings. Hence, imbalanced budgets have been a curse rather than a blessing which Sri Lanka has inherited from the past.  Keynesian economics Sri Lanka’s policymakers have resorted to deficit financing by embracing an economic philosophy propounded by the renowned British economist, John Maynard Keynes, in mid 1930s. According to this philosophy, popularly known as Keynesian Economics with due credit to its philosophical master, a government can stimulate an economy by spending more than its revenue thereby passing new money onto the hands of people for spending on goods and services. The new demand so created has now to be supplied by stepping up production by engaging more natural, physical and human resources. This new supply will then give rise to a series of subsequent economic activities generating more output, more income, more wealth and more employment. Deficit financing was then considered key to wealth creation and prosperity of a nation. Since it promised a ‘quick journey to richness’, all leaders of the newly independent countries in Africa and Asia had willingly embraced Keynesianism. According to the biographers of the late President J.R Jayewardene, the latter is said to have read the Keynes’ book, The General Theory of Employment, Interest and Money, in 1942 and become an instant convert! Though John Exter, founding Governor of the Central Bank, cautioned Sri Lanka’s leaders against the uncritical adoption of Keynesianism in both his report on the establishment of the Central Bank and his first public interview, it appears that they had not been in a fitting mood or mind to listen to such cautionary advice. Gravity of the curse Though Sri Lanka’s policymakers had been lured to deficit financing as a ‘quick-fix-method’ to solve the country’s pestering economic ailments, its results have not been up to the mark. The average economic growth from 1950 to 2009 amounted only to 4.2 percent, a rate which a country with a high trading sector could have anyway attained without implementing any growth strategy at all. Since the population has grown at an annual average growth rate of 1.9 percent during this period, the real improvement in the prosperity of Sri Lankans has been at a dismal 2.3 percent per annum. It is pertinent to note that in the period since 1970, countries in East Asia that had created the Asian Miracle, namely, Singapore, Hong Kong, South Korea and Taiwan, recorded on average annual growth rates of above 8 percent year after year.  Sri Lanka’s worst achievement during the deficit financing period has been in the area of taming inflation. The country’s inflation had been repressed through price controls and fixed exchange rates in the period prior to 1977, but the shortages and the consequential inflationary pressures were evident by the wide spread prevalence of queues, waiting lists and approval systems for distributing essential commodities. Since 1978, with the open market economy policies in place, inflation became explicit and, during this period, the annual average inflation has been slightly above 11 percent. The high inflation led to stagger exports, stimulate imports and consequential chronic deficits in the current account of the balance of payments. The result was, though the adjustment was always belated, a rapid and fast depreciation of the country’s currency: in 1950, one US dollar was equal to 4.77 Sri Lanka rupees. By 2009, it fell rapidly by more than 24 times to Rs.115 per US dollar. Though the exchange rate depreciated rapidly, the adjustment in the rate was not sufficient to solve the country’s chronic balance of payments issue permanently. The result was the fast erosion of the country’s foreign reserves, from an import coverage of more than 11 months in 1950 to 3 months in 2008 and a temporary improvement thereafter through a vast magnitude of reversible short term foreign exchange flows to the country. Hence, deficit financing, while failing to deliver the promised result of a quick economic growth, has created a number of irreversible macroeconomic imbalances across the economy. The present challenge  The budget is in a perilous situation today. In 2009, the target of the authorities was to reduce the budget deficit to at least 7.5 percent of GDP. But the year ended with a much higher deficit of 9.8 percent of GDP, when grants are also reckoned as revenue, and 10.3 percent, excluding grants. The budgetary performance in January, 2010 has been even more dismal. According to the provisional figures, the government has spent Rs.111 billion in that month as against a generated revenue of Rs 48 billion, creating a deficit of Rs 63 billion or 1.15 percent of GDP. When annualised, this works out to an annual budget deficit of a whopping 14 percent of GDP. Since it is unlikely that the government will be able to finance a deficit of this magnitude through borrowing, both local and foreign, unless the expenditure levels are drastically pruned, the only alternative available to the government is printing money for financing the deficit. Since this is the easy way adopted by the government during the whole of the post independence period, it appears that, the curse of its past profligacy is visiting it again and again, like a bull tied to a post has to come back to where the post is affixed to the ground after making circles and circles around it.  Today’s budgetary challenge is, therefore, to make a colossal adjustment to both the revenue and the expenditure of the government in order to restrict the budget deficit to a manageable level immediately and reduce it further to tolerable levels thereafter. Macroeconomic stability  When a country has attained macroeconomic stability, its inflation is very low, balance of payments does not have continuous chronic deficits, there is no pressure for the exchange rate to depreciate and the government sector is in balance and contributing to economic prosperity effectively. Such a stability encourages people to save and invest more, take risks and have a long term view when making all economic decisions. It also encourages foreigners to bring capital to the country and invest in economic enterprises. With low inflation and stable exchange rates, the demand for wage increases will dwindle and be confined only to compensations needed to remunerate productivity increases. With the private sector taking a long term view, investments will be made in research and development thereby spawning innovation and individuals will take trouble to improve their skills and competencies through learning and training. These are the ideal conditions necessary for continuous and rapid economic growth. Singaporean experience Singapore, in its strategies for rapid growth and eventually creating a miracle, made a conscious effort to attain and maintain macroeconomic stability in the country. Its leaders appreciated the importance of macroeconomic stability and as pronounced by Lee Kuan Yew in the second volume of his autobiography, From Third World to First, sound macroeconomic policies are fundamentals that enable the private enterprises to operate successfully. Unlike the leaders in other newly independent countries, Singaporean leaders suspected that Keynesian policies could work in creating wealth. Hence, they decided to continue with the currency board system which they inherited from the British, since it enforced a fiscal discipline on the rulers. The irony was that the colonial master did not have this wisdom and went ahead of embracing Keynesianism as the major policy thrust in the post world war era and ruined the once most powerful British economy. It was then left to Margaret Thatcher who herself did not trust Keynes to reverse the trend in late 1970s. Wisdom of S’pore leaders The wisdom of Singapore’s leaders has been summarised by Goh Keng Swee, Singapore’s economic architect and its first Finance Minister, in an article he penned in 1992 on the occasion of the Silver Jubilee of the Singapore Currency Board. In this article titled ‘Why a Currency Board?’, Swee says that as a student when he read Keynes’ book, The General Theory, he could not understand how the Keynesian system which was valid for a closed economy without international relations could be applied to an open economy like Singapore. He therefore, says that, ‘since all modern states engage in foreign trade, a Keynesian stimulus will lead eventually to balance of payments deficits if governments do not exercise restraint in time. A part of the increased income people receive will be spent on imports and when exports do not increase in proportion, a trade deficit will occur’.  Swee then goes on to explain that both the UK and USA which had deficit budgets in terms of Keynesian prescription to attain economic growth and reach full employment ran into troubles. In the UK which had chronic balance of payments troubles, the sterling pound had to be devalued unilaterally in 1967. In USA, it eventually led to the abandonment, in 1971, of the Gold Exchange Standard under which USA had promised the rest of the world that it would keep the value of gold fixed at $ 35 per fine ounce so that the rest of the world could use US dollar as a transaction and reserve currency. According to Swee, the Singaporean leaders were very much alive to these changes taking place in world’s major financial markets. Swee says, “My cabinet colleagues took careful note of these dramatic events as they unfolded on the world’s financial scene. None of us believed that Keynesian economic policies could serve as Singapore’s guide to economic well being. Our economy was and is both small and open. Financing budget deficits through Central Bank credit creation appeared to us as an invitation to disaster. There was no effective way of exchange control in an open trading economy like ours to deal with inevitable balance of payments troubles’.  Since Singapore’s leaders all believed that the way to a better life was through hard work and not through Central Bank credit, the Monetary Authority of Singapore was prohibited to lend to the government for financing budget deficits. Hence, Swee says, ‘we were not impressed – excessive as they turned out to be – that governments could bring about prosperity through spending’. It therefore did not surprise Singapore’s leaders when they observed later that the governments in the UK and other European countries which adopted such spending policies through deficit financing got into trouble soon. Singapore, through its dedicated policy of working hard for creating wealth and prosperity and also later ‘Asian Miracle’, avoided deficit financing, abstained from printing excessive money by having a currency board system and maintained a low inflation. As Lee Kuan Yew says, it did the miracle. It created conditions conducive for continuous productivity improvement and establishing a low Inflation regime. Thus, Singapore maintaining its competitive edge over its competitors, witnessed a continuous appreciation of its currency from Singapore Dollars 3.06 to a US Dollar in 1950 to S$ 1.40 to US $ by 2010. Swee says the strong Singapore dollar generated through low inflation and productivity improvements was the key to ‘keep the consumer prices down’ and through that, the cost of living down. In the next part, we will discuss what Sri Lanka should do to get out of the current budgetary malaise. (W.A. Wijewardena can be reached on waw1949@gmail.com)