Why Sri Lanka isn't an example of how low interest rate combined with fiscal deficit are necessarily bad

Some would see this as vindication, ironically or inadvertently, of the futile policy prescriptions of the IMF (International Monetary Policy) and World Bank – of the so-called Washington Consensus – characterised by “normalised” interest rate levels and “balanced” budgets or budgets with very low deficit levels with the corresponding counterpart of interest rate hikes and austerity under the appropriate conditions, respectively.

It doesn’t mean, notwithstanding, that loose fiscal and monetary policies can be implemented at all times. It all depends on the context-specific conditions of an economy.

When we look at the figures provided by the Central Bank of Sri Lanka, inflation only galloped from 5.7 percent in September 2021 onwards to 15.1 percent by February 2022 with food inflation rising to 25.7%.

In other words, inflation only accelerated this year – consistent with what we read in the news.

Inconsistent with the claim that the Rajapaksa regime had been consistently engaging in loose fiscal policy, in actual fact, deficit spending had to be cut by 15% and said to be only around 5.4% in 2019 – as part of the measures to qualify for IMF loan (“Exclusive: Sri Lanka to overshoot 2019 fiscal deficit target despite spending cuts – sources”, Reuters, September 3, 2019).

The deficit only started to balloon in 2020 due to the impact of the Covid-19 pandemic. The budget deficit was estimated to be 8.9% in 2021 and projected to be 10.7% for 2022.

That is, there’s no consistently and steady linear increase of inflation as such.

Instead, headline inflation in December 2020 actually declined to 4.6% and core inflation stabilised at 4.7% (National Consumer Price Index/NCPI, as published by the Central Bank of Sri Lanka). Whereas the Colombo Consumer Price Index/CCPI (covering the capital only) was at 4.2% and 3.5%, respectively.

Inflation came down again at the beginning of 2021 and only ever-so incrementally rose in September 2021 before surging thereafter. This is, of course, consistent with Malaysia’s own experience in then having to face the intensifying of the supply-side/supply-chain shocks due to port congestions, and extreme weather patterns and other cost-push factors.

Higher oil prices have pushed the economy deeper into crisis.

For a fuller picture, please refer to Chart 1.

Let’s now take a look at Sri Lanka’s unemployment levels and GDP growth as indicators of whether the economy had “overheated” – due to spending approximating the existing output gap of the productive resources available to determine whether it’s a matter of too much money chasing too few goods.

According to the Department of Census and Statistics (DCS) of Sri Lanka, unemployment reached 5.7% in the Q1 of 2020 and peaking at 5.8% in Q3 of 2020. On the whole, the country’s unemployment rate in 2020 was 5.5% (p. 24, DCS Annual Report, 2020).

Unemployment dropped only to 5.1% for Q2 of 2021. Current unemployment level should be above 5% given the worsening economic situation precipitated by the cost-pull pressures – nowhere near (loose) “full employment” and amidst income levels that have yet to returned to pre-pandemic levels (Asian Development Bank/ADB, October, 2021).

GDP growth rate contracted at (negative) -3.6% in 2020 and grew by 3.7% in 2021. No signs of attaining proximity to the “output gap”, if at all.

This isn’t to say that there are no parallels between Sri Lanka, Zimbabwe and even the Weimar Republic. Lessons from the Zimbabwe and the Weimar Republic are, indeed, applicable to the former.

However, as explained in EMIR Research article entitled, “The necessity of a low interest rate environment – or why inflation-targeting is unhelpful” (March 16, 2022), in the case of Zimbabwe, the destruction of the productive capacity of the economy upon which 70% of the nation depended, i.e., agriculture through land expropriation of European-owned farms, resulted in shortage of foreign earnings needed to purchase imports which quickly became a supply-side (i.e., supply shortage) issue. The corresponding rise in the general price levels then led to money printing to accommodate demand.

As for the Weimar Republic, increase in the general levels of price was due to the depreciation (price structuring) of the then Mark (i.e., quality – and not quantity – of the currency). In turn, this was originally caused by reparation demands which compelled the Weimar government to deficit spend to purchase foreign currencies and gold.

And as a result of inadequate taxation to offset that, this meant that deficit spending in general then outstripped the available productive resources which was exacerbated by the expropriation of the Ruhr industrial heartland by the Allies in order to exact payment under different forms.

The increase in the circulation of notes only came afterwards to accommodate the ever-rising spending by the private sector (as a result of increased deficit spending by the State, i.e., to keep up with the higher prices and) in competition with the State.

What’s not understood at all is the role and purpose of taxation – which is to regulate the “temperature” of demand like a thermostat, for example.

The problem with the Rajapaksa government’s tax cuts policy, including reducing the Value Added Tax (VAT) from 15% to 8% isn’t that per se, simplistically.

But precisely that was combined with a fiscal deficit in which the State competed with the private sector to pay higher prices for the productive resources available in the economy, especially via imports.

Now, as “[forex] [r]eserves were built up by borrowing …, rather than through higher earnings from exports of goods and services. This left Sri Lanka highly exposed to external shocks” (as per Dushni Weerakoon, Executive Director at the Institute of Policy Studies of Sri Lanka).

Furthermore, “… the government spent the foreign currency on repaying the debt (as per Alex Holmes, Capital Economics).

This then led to pressure on the Sri Lankan rupee which “forced” the central bank to further devalue the currency – by as much as 15% lately.

The result meant that Rajapaksa government (i.e., the State as the monopoly currency issuer and, therefore, the ultimate price setter) has to pay higher prices in the form of salaries and procurement payments. Higher prices, of course, includes the euphemism for corruption also, especially in relation to the state-owned enterprises (SOEs).

To accommodate the higher prices, the Rajapaksa government via the central bank then only resorted to OMF which exacerbated the import bill, i.e., outflow of funds, that further worsened the forex shortage.

As the Financial Times (FT) puts it, the principal culprit is currency devaluation of the Sri Lanka rupee – which have been dubbed as the world’s worst performer (“Sri Lanka’s currency plunges to world’s worst-performing in economic meltdown”, April 6, 2022).

As in the case of both Zimbabwe and Weimar Republic, currency devaluation led to accelerating inflation in Sri Lanka as a country that’s heavily reliant on imports – from petroleum, food, paper, sugar, lentils, medicines, and transportation equipment.

In the final analysis, currency devaluation of the Sri Lankan rupee is caused by the depletion of foreign exchange reserves – in common with Zimbabwe and the Weimar Republic.

To these classic examples, we can add the contemporaneous economic crises in Turkey and Lebanon.

Contextually, the shortage of foreign currency (forex) has also been caused by the drastic drop in tourism as one of the three top revenue earners for Sri Lanka, especially after the Easter bombings around this time in 2019.

This is compounded by the continuing decline in foreign direct investment (FDI) into the country FDI into Sri Lanka which saw a decrease to USD548 million in 2020, compared to USD793 million in 2019 and USD1.6 billion in 2018.

As it takes more Sri Lankan rupees now to purchase foreign currency needed for imports, so has the domestic prices affected – with the cost pass through effects and with implications on the fiscal deficit and, by extension, the national debt.

What are policy recommendations or solutions?

It’s worth mentioning that when Malaysia was hit by the Asian Financial Crisis (1997/98), instead of slavishly adopting the prescription of the Washington Consensus, we defied by keeping interest rate low and shirking from austerity measures.

The same policy measures as advised by Tan Sri Nor Mohamed Yakcop (see Notes to the Prime Minister: The Untold Story of How Malaysia Beat the Currency Speculators) and formulated by the National Economic Action Council or NEAC (see Rewriting the rules: The Malaysian Crisis Management Model by the late Dr Mahani Zainal Abidin who was a leading member of the NEAC) should be applicable to Sri Lanka’s situation.

Briefly, it’s recommended that Sri Lanka implement:

1. selective capital controls (e.g., disallowing the transfer of funds between external accounts by non-residents – onshore (i.e., local) banks and countries of origin – mitigation of capital account deficit;

2. the non-internationalisation of the rupee (non-recognition and non-facilitation of non-deliverable forwards/ NDFs) and as a non-tradable currency outside the country and the forex market (with only the Central Bank of Sri Lanka as the authorised buyer and seller).

3. managed pegging of the Sri Lankan rupee to the USD with allowances for limited fluctuations on a time-limited basis – after which “reversion” to a free-floating currency.

In addition, Sri Lankan exporters should convert 70% (for example) of their forex earnings into the rupee by selling the USD (for example) to the central bank.

To further supplement and complement Sri Lanka’s forex reserves, it’s recommended that the country makes use of the special drawing rights (SDRs) of members countries (trading partners) via the IMF. SDRs should be used a proxy or “stand-in” currency relative to other currencies.

At the same time, Sri Lanka should manage its exports by creating special accounts for importers for payments in solely in the rupees (voluntary arrangements, e.g., with India) together with currency swap lines (e.g., with China’s yuan also) – mitigation of current account deficit.

In conclusion, the situation in Sri Lanka was caused by the external factors which affected the country’s forex with the further depletion attributed to the government’s policy shortcomings.

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Jason Loh Seong Wei is Head of Social, Law & Human Rights at EMIR Research, an independent think tank focussed on strategic policy recommendations based on rigorous research.