Are we focusing on the wrong deficit?
Sri Lanka is known to be plagued by twin deficits: The Government budget deficit (income being far less than expenditure) and the external current account deficit (importing a lot more goods and services than exporting).
Main focus is on budget deficit
The policymakers seem to be keen to control the Government budget deficit. Not only the program with IMF was centred around “fiscal consolidation” (to reduce the budget deficit), but the sharp increase in general tax rates in recent times (along with the new inland Revenue Act) was aimed to achieve that.
This column has previously pointed out that increasing tax rates would not help to reduce budget deficit as a sharp slowdown in the economy would pull back tax revenue. The data up to September justifies that, as tax revenue has increased by only 3% while budget deficit has expanded by 7% despite a reduction in capital expenditure. In fact, this column has argued that reducing the Government budget should not be the priority of the Government.
Foreign earnings up by a meagre 7-8% in 2018
The remedial actions that have been taken on the external current account deficit are largely limited to words. Unlike in the case of the budget deficit, where a genuine effort has been made, in terms of boosting foreign currency earnings and/or curtailing foreign currency expenses, little structural, sustainable measures have been undertaken. The data clearly indicates that. Sri Lanka’s external current account deficit which was $ 2 b in 2014 increased to $ 2.3 b in 2017 and the first half of 2018 records a deficit of $ 1.8 b. Therefore instead of the position improving, it is deteriorating, fast.
Based on Central Bank data, Merchandise exports are higher by 5.1% up to October in 2018 to $ 9.9 b (from $ 9.4 b in 2017) and Tourism earnings for 2018 are higher by 10% to $ 4.3 b (from $ 3.9 b). Therefore, unless a miraculous jump in merchandise exports was seen in November – December (highly unlikely during the political chaos that took place), the foreign earnings from merchandise exports and Tourism would have increased from $ 15.3 b in 2017 to around $ 16.5 b (an increase of around 7-8%).
In fact, Merchandise exports have increased only marginally by 2% from $ 11.13 b in 2014 to $ 11.36 b in 2017. It is the Tourism earnings that have really jumped by 63% during this period from $ 2.4 b to $ 3.9 b. The growth in Tourism earnings is actually the natural growth since the end of war and not due to any noteworthy intervention or contribution by the Government.
Why external deficit is more important
Why we view the budget deficit is of secondary importance is because it is in Sri Lankan Rupees. Hence it is within the control of the Central Bank. In the worst case scenario, the Central Bank could print Rupees. It is not the ideal scenario as printing money has subsequent inflationary pressures. However it is not catastrophic in comparison to the external current account deficit.
The external current account deficit is in US Dollars. When the country buys more goods and services from other countries (in US Dollars) compared to the goods and services the country sells to other countries (in US Dollars), the difference has to be borrowed (in US Dollars). This is the prime reason for consistent rise in foreign currency borrowings and the continuous depreciation of the Rupee and the shocks we face every now and then such as what is being witnessed in recent months. The Rupee has depreciated from 160 per US Dollar in August to 180 by December. A staggering 12.5% depreciation in four months (37.5% p.a). Such scenarios result in ad hoc, knee-jerk reactions such as import restrictions which affect the living conditions of most.
Even worse is the possible default risk. When foreign currency borrowings are due for renewal (or repayment) there is an unavoidable need to go back to lenders. If the country has not properly utilised the US Dollars borrowed previously, the external current account deficit would have continued to widen and hence the need for foreign borrowings would be greater. Such a scenario reduces the confidence of lenders who would seek a higher interest rate to lend more.
If the global environment is also weak where the trend is for higher interest rates and less appetite for emerging markets, the interest cost would rise and/or it would be more difficult to obtain foreign funding to repay (or renew) foreign debt, i.e. the possibility of default is increased.
Expand budget deficit to boost external current account
The above data clearly indicates what should be done. The number one priority should be to increase foreign currency earnings or reduce foreign currency expenses on a sustainable basis. Also setting of targets should be realistic. One can’t achieve too many things in quick time. Hence the priority should be to bridge the external current account deficit and not the budget deficit.
What this means is, budget should decisively support initiatives to reduce the external current account deficit. Basically tax incentives, subsidies and required infrastructure development (training institutes and acquisition of relevant technology) should be provided to develop industries that would boost foreign earnings or substitute foreign currency expenses (imports).
In that light, trying to reduce budget deficit from 5.5% of GDP to 4.5% or 3.5% is imprudent. In fact the right target would be to reduce the external current account deficit, from around $ 3 b currently to $ 2 b and then towards $ 1 b and ideally towards a surplus. In the process, if the budget deficit increases towards 6.5% or even 7%, it should not be a worry.
As long as the exposure to foreign currencies is being eliminated, bridging the budget deficit in Rupees is not a big problem, as the Central Bank could print rupees. Clearly it should be a temporary measure. Once the external current account is turned to a surplus on a sustainable basis, the focus could turn on the fiscal deficit and it should be possible to reduce it thereafter with the economy on a stable footing. Trying to reduce both deficits while the economy is in a weak footing has resulted in both deficits deteriorating. Have we realised it when the data is so clear?
(The writers can be contacted via email@example.com.)