Sri Lanka to remain on deficit-cutting path despite Keynesian debacle de-railing national debt

ECONOMYNEXT – Sri Lanka will remain on a path to fiscal consolidation despite being an election year, State Minister for Finance Eran Wickramarate said as an attempt to boost growth by an over-issue of currency triggered a currency collapse, wiping out gains on the fiscal front.

Sri Lanka presented a budget for 2019 targeting a 4.4 percent of gross domestic product deficit, the lowest in decades, after posting a deficit of 5.3 percent of GDP for 2018, before currency depreciation.

"We are continuing with the path of fiscal consolidation," Wickramaratne told a business forum in Colombo.

"We are not moving away from it."

Fiscal Prudence

Finance Minister Mangala Samaraweera, sometimes known as Khema’s Boy, did not give much subsidies in this budget, with Sri Lanka requiring a good budget to convince foreign investors to buy bonds, though it planned to increase beneficiaries of an income support scheme.

"All in all, the Budget 2019 has taken a forward look at the economy and made proposals for the future growth of the country," economist W A Wijewardene said in his column in Sri Lanka’s Daily FT newspaper.

"In that way, Khema’s Boy has broken tradition and it should be a new tradition which all future finance ministers should follow."

Minister Wickramaratne said last year’s budget deficit would have been lower than 5.3 percent of GDP if not for a drought.

Sri Lanka has also raised revenue to GDP from around 11.7 percent in 2014 to close to 14 percent, arresting a fall. Other than Bangladesh, which had revenues of about 10 percent of GDP, most countries had 15 percent or higher levels.





But all gains made by fiscal authorities were nullified by what some analysts have called reckless monetary policy, sending national debt soaring.

Monetary Dominance

The Central Bank stopped mopping up inflows (halted repo sterilisation auctions) in February 2018, released cash into the banking system by terminating earlier repo deals as the economy recovered and credit expanded, in the same way as Argentina’s central bank bought back its own sterilisation securities, during its latest crisis.

In April, the Central Bank cut rates and printed tens of billions or rupees to generate excess liquidity in the banking system even as external conditions worsened with tighter US policy in a classic Keynesian type ‘stimulus’ to prevent rates going up and boost activity.

The currency first collapsed from 153 to over 160 against the US dollar. When the currency stabilised at a little over 160 to the US dollar, again excess liquidity was allowed to build up, including through Soros-style swaps, generating pressure on the currency and bond invstors fled. A political crisis worsened capital flight and the rupee ended at 180 to the US dollar.

The currency collapse, partly defended on the grounds of targeting a real effective exchange rate, has sent the national debt soaring to 84 percent of GDP from 77.6 percent in 2017, while state enterprises have made further losses.

Ceylon Petroleum Corporation alone has made an 82 billion rupee forex loss, or more than half a percent of GDP.

Ministers Wickramaratne and Samaraweera gave full independence to the Central Bank, making clear that there was no fiscal dominance of monetary policy.

But to correct monetary policy errors, Samaraweera was forced to bring trade restrictions, in a monetary dominance of fiscal policy, just as President Richard Nixon placed trade controls as the Fed’s peg came under pressure from stimulus and began to lose large volumes of gold reserves.

In Sri Lanka, falling reserves from the Keynesian stimulus and political uncertainty led to the suspension of an IMF program and a downgrade to ‘B’ amid a political crisis triggered by President Maithripala Sirisena, which further undermined confidence in the rupee and bond markets in the second half of the year.

Sri Lanka is forced to peg the currency and collect extra forex reserves under an IMF program, which requires slightly higher rates than the free market rate to maintain an exchange rate peg (currency board rate) and match forex reserves to domestic money supply.

Deadly Stimulus

Keynesian stimulus is a deadly remedy, especially when the credit demand is recovering, generating monetary instability and balance of payments trouble in a peg, as the collapse of the Bretton-Woods system showed in 1971-3 when Fed Governor Arthur Burns attempted similar actions.

Even with a floating rate, inflation and mal-investment and steep downturns come, if the stimulus is kept up long enough, as the US Fed proved in the ‘Great Recession’ and the earlier Great Depression, which followed the ‘Roaring Twenties’ bubble.

Keynesian stimulus is a revival of money printing-led economic activity originally proposed by the likes of Scottish Mercantilist John Law, who brought France to its knees.

"It was John Maynard Keynes, a man of great intellect but limited knowledge of economic theory, who ultimately succeeded in rehabilitating a view long the preserve of cranks…" Austrian economist F A Hayek, who had shown the errors of his ‘Treatise in Money’ in the 1930s, said many decades later.

"The claim of an eminent public figure and brilliant polemicist to provide a cheap and easy means of permanently preventing serious unemployment conquered public opinion and, after his death, professional opinion too."

Hayek said Keynes’ General Theory, inroduced in 1936, managed to gain more professional support and later when everyone supported the ‘wholly Keynesian’ Bretton Woods deal, he withdrew from the debate since opposing the orthodox juggernaut would have deprived him of a hearing on other matters.

The Bretton-Woods was a soft-pegged system that falsely claimed it could maintain a peg to gold, while pursuing ‘independent monetary policy’ or money printing.

Hayek was awarded a Nobel prize in 1974 shortly after the collapse of the Bretton-Woods system. The prize was shared with Gunnar Myrdal, who was noted for his work on race relations, and who ironically was a backer of Keynesian policy.

Wickramaratne said in 1960, Sri Lanka had per capita income of 144 dollars, now it was 4,300.

"Singapore had an income of 400 dollars and now it was 55,000 dollar," he said. "Korea was at 87 dollars, now it is 35,000 dollars.

Keynesian Destruction

Unlike countries like Sri Lanka, South East Asian nations like Singapore refused to be seduced by money printing and currency depreciation. Sri Lanka, Singapore (and Malaysia) had currency boards at independence, where money printing was banned and exchange rates were fixed as a result.

There was some monetary instability leading to boom-bust cycles in Korea but permanent depreciation ended after nation-wide strikes from attempts to lower the real effective exchange rate and keep wages down in the mid-1980s.

Goh Keng Swee, the first Finance Minister of independent Singapore said Keynesian remedies led to the devaluation of the pound in 1967.

"In the end, gold convertibility of the US dollar was suspended in August 1971 and, shortly thereafter, the regime of floating currencies came into being," Goh said.

"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.

"There was no effective way of exchange control in an open trading economy like ours to deal with the inevitable balance of payments troubles."

Since the break-up of the Bretton Woods system, the Singapore dollar had appreciated from 3.0 to about 1.2 to the US dollar, while Sri Lanka fell from around 5 to 180 against the US dollar, destroying living standards and investible capital.

The Maldives which also had a firm peg which had broken a few times, has a per capita GDP of 11,000 US dollars.  (Colombo/Mar10/2019-SB)

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