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Tuesday January 25th, 2022
Economy

Sri Lanka President warns of unpopular measures as stimulus hits external stability

ECONOMYNEXT – Sri Lanka’s President Gotabaya Rajapaksa has warned of unpopular measures ahead as unprecedented fiscal and monetary stimulus has shattered the country’s external sector, putting pressure on the rupee and depleting forex reserves.

Sri Lanka is among countries in the world that has handled the Coronavirus better than most, keeping exports up and vaccination levels, boosted by Chinese vaccines are higher than many developed nations.

However due to unprecedented easy money policies by a Latin America style central bank to keep rates down, despite having a pegged exchange rate, the country’s external sector has been shattered.

Rating agencies have downgraded the country to ‘CCC’ as doubts over foreign debt service worsened as money was printed and taxes were cut.

The general public and politicians are now paying the price for the inevitable results of the stimulus and liquidity injections, through price rises and foreign exchange shortages. Inflation has topped 8 percent.

Fiscal breaks have also been partially hit with higher taxes on private firms and the general public in a attempt to prevent worsening deficits which hit close to 14 percent of GDP in 2020.

The public has been told that no more unemployed graduates will be given jobs to burden them for the time being – a key driver of soaring state spending despite the end of a long running civil war in 2009.

While reducing the burden on the general public, spending brakes, tend to make politicians unpopular among the anti-state austerity brigade who are more vocal than the tax-paying public, as well as those who were key beneficiaries of tax collected from the people, like unemployed graduates.

In 2020, state salaries and pensions took up 86 percent of tax collections.

Warning

President Gotabaya Rajapaksa has said difficult policy choices are in store.

“Managing this situation and keeping the country on the path to prosperity will require policy interventions, especially in the short term, that may be unpopular,” he told a forum of exporters who had won awards for best performance.

“I know that many of you are critical of these interventions.

“I urge you to recognise and understand that these measures are being imposed because we have little other choice in our present situation.

“Once the immediate crisis is overcome, some of these interventions can be mitigated.”

Sri Lanka’s economic troubles involving exchange controls and trade controls date from 1950 when a Latin America style money printing central bank was created by a US money doctor.

Easy Money

In December 2019, following an economic downturn from a currency crises triggered by money printing in 2018 which sent the rupee sliding 151 to 182, taxes were slashed.

From early 2020 an unprecedented easy money program was started through rate cuts, reserve ratio cuts and liquidity injections to enforce a call money rate, despite the tax cuts.

Instead of selling bonds to generate cash for a deficit suddenly expanded by tax cuts, new money was created to repay maturing bonds of past deficits, as well as to fund current spending such as state salaries, generating never-before-seen levels of excess liquidity in the banking system.

As the new money was used for investment and consumption by the recipients, ending up in the forex markets as imports, foreign reserves were used to exchange for the new money (provide convertibility) to maintain a pegged rate.

Instead of allowing interest rates to correct, channelling private savings to fund the deficit, yet more new money was created to generate excess liquidity and target bond yields through price controls.

The price controls failed bond auctions, generating more liquidity, losing yet more reserves.

Excess liquidity was boosted to around 200 billion rupees at one time, or over 20 percent of reserve money as the economy and credit system started to recover from lockdowns.

Economic Controls

In cascading policy errors, tax revenue generating imports like cars have been blocked while other imports were soaring to above pre-pandemic levels as the new money was used by their recipients or were re-cycled through the credit system.

Price controls were also imposed most targeting free trading importers, in another cascading policy error seen in money printing countries, through import substitution rent-seekers, who have political clout, are allowed to raise prices as they wished.

An Argentina style ‘care prices’ program was also started.

Analysts had warned that even Roman Emperor Diocletian who ‘printed money’ by enegaging in mass-issue of copper coins instead of gold and silver, failed to bring down prices until monetary reforms were made by his successor.

Related

Sri Lanka follows Argentina into ‘precios cuidados’ as rice prices soar amid money printing

Sri Lanka parliament follows Emperor Diocletian after printing money

Sri Lanka raised fines for breaking price controls to 2000 percent, as economic controls tightened amid state spending and money printing.

Sri Lanka has a long history of politicians who have been made unpopular by monetary excesses and private companies that were demonized as black marketeers as the monetary consequences and controls burst upon the real sector.

Countries elsewhere who followed similar policies have also ended up with similar troubles.

“European governments and parliaments have been eager for more than sixty years to hamper the operation of the market, to interfere with business, and to cripple capitalism,” explained economist Ludwig von Mises in the middle of the last century as such policies were taught in English speaking universities.

“They have blithely ignored the warnings of economists. They have erected trade barriers,
they have fostered credit expansion and an easy money policy, they have taken recourse to price control, to minimum wage rates, and to subsidies.

“They have transformed taxation into confiscation and expropriation; they have proclaimed heedless spending as the best method to increase wealth and welfare.

“But when the inevitable consequences of such policies, long before predicted by the economists, became more and more obvious, public opinion did not place the blame on these cherished policies, it indicted capitalism.

“In the eyes of the public not anti-capitalistic policies but capitalism is the root cause of economic depression, of unemployment, of inflation and rising prices, of monopoly and of waste, of social unrest and of war.”

Sri Lanka has since lifted most price controls, except fuel, where fears of shortages persist.

Related

Sri Lanka Minister apologizes for creating shortages, gives up on price controls

Import Substitution

Sri Lanka is also now mired in import controls, which have dislocated the price system, sending anything from vehicles to auto parts to turmeric to green gram to unbelievable new highs.

Forex shortages have disrupted supplies.

Rice is also above world prices with a 65 rupees tax per kilogram and an import controls.

Rent-seeking “anti-capitalists” or mercantilists are making record windfalls profits under cover of import duties which have tied the hands of poor consumers and blocked competition.

President Rajapaksa urged the firms which have been shielded from competition, not to exploit consumers any more.

“Several policy interventions, however, such as the restrictions on certain imports in place since last year, have had beneficial consequences,

“They have created space for new local industries to develop. It is essential that these new industries are fostered intelligently.

“Instead of short-term profiteering through reducing quality and creating artificial shortages, these new industries should strive to create quality products that could become globally competitive.

“This will be to everybody’s benefit.”

A fertilizer ban proposed by an influential group of state doctors and a Buddhist monk which disrupted agriculture has also been ended.

Monetary brakes have been partially hit through the ending of price controls on bond auctions, which has reduced the wholesale convertion of government securities into reserve money.

However money is still injected overnight to maintain a 6.0 percent policy rates, undermining the credibility of a soft-peg at 203 to the US dollar and creating forex shortages.

Due to the dented credibility of peg remittances are also being diverted to unofficial channels.

In a new cascading policy error, mandatory forex conversion rules, have been imposed giving an incentive for hard good and service exporters to park funds outside the country.

Plus ça change

Sri Lanka’s Mercantilists had been practising such policies for many decades after independence. The worst controls and shortages were seen in the 1970s, though they started much earlier.

The Import and Export Control Act which is created many economic disruptions including on exporters, was enacted in 1960.

Classical economists as far back as the 1960s have advised Sri Lanka (then Ceylon) not to follow Mercantilists and try to control trade, but to stop printing money to solve balance of payments problems.

“.. Balance of Payments difficulties cannot be solved by intensifying the rigorous of exchange control and import restrictions; nor by extending the schemes for expanding domestic production to
substitute import goods — the so called measures for “economising” on foreign exchange,” explained economist B R Shenoy in a policy document in 1966.

It cannot reduce the flow of moneys seeking to purchase goods, either for consumption or for investment. This flow of money is determined by the national product and the inflationary part of the Net Cash Operating Deficit.

“The remedy to this problem lies in putting a stop to inflationary financing, not in tampering with the normal course of international trade.”

Similarly he warned that exchange controls also do not have the intended results. Sri Lanka is now trying to crack down on traditional Hawala net settlement system.

“The restrictions on remittances of savings and on capital transfers abroad, first imposed in 1957 and further tightened in 1960 and 1964, did not stop this trend,” Shenoy said in 1966.

“Remittances and transfers in excess of the permitted minima passed through the free market for foreign exchange.

“Foreign exchange to feed this market was drawn from the proceeds of under-invoicing exports, over-invoicing imports, and smuggling out Ceylon gems, other domestic produce, and manufactured consumer goods imported into Ceylon from abroad.” (Colombo/Nov28/2021)

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