by Jayampathy Molligoda

Basic economic models followed by successive governments:

Since 1978, the successive governments have been following an aggressive open economic policy framework for Sri Lanka and there has been some progress in the much-needed infrastructure development compared to the period governed under a somewhat ‘closed economic system’. Basically, their open economic policy framework is founded on the following two basic economic models (i) ‘neo-classical’, monetarists policy prescription or (ii) ‘Post-Keynesian’ Economic school of thought which builds upon John Maynard Keynes’s argument that effective demand is the key determinant of economic performance.

The difference between these theories is that ‘ economics believe in controlling the supply of money that flows into the economy, while Keynesian economics involves government expenditures. In contrast to the neoclassical (mainstream) approach, Keynes argued that investment is not constrained by the availability of saving, but may be constrained by the availability of credit.

Monetarists believe that government spending causes inflation. The level of the money supply, which they feel has a direct impact on inflation, must be used to control it. In contrast, Keynesian economists believe that a troubled economy continues in a downward spiral unless an intervention drives consumers to buy more goods and services. Governments should balance out the cyclical movement of the economy by spending more in downturns and less in prosperous times (thereby preventing inflation).

One can argue, the open economic policy framework in Sri Lanka has not worked for the benefit of the majority of people although the governments from time to time used to follow either the ‘neo-classical’ principles or Keynesian Economic school of thought. The result is that the overall performance of the economy has been unsatisfactory. The economists are of the view that the economic downturn has been mainly due to serious structural weaknesses in the economy during a long period of time.

Sri Lanka’s relative export performance, especially during the last ten- year period has drastically declined and thus widening the trade deficit around US $ 8- 10 billion per annum. It is clear that the poor export performance relative to increased import bill, together with the external ‘current account’ deficit and large fiscal deficits in the government budgets, popularly known as the ‘twin deficits’, have been identified as the key structural weaknesses that have affected the economy for several decades with continuing adverse trends into the future. The positive feature is the export of goods during the last three years (2021,2022 and 2023) recorded a notable increase and surpassed US $ 13 billion since 2022, however, trade deficit remains a major concern due to the heavy import bill.

The government which came in to power in 2020 was not keen to have an IMF programme as they were of the opinion that such action (i) will definitely contract economic growth, (ii) imposing high taxes and high bank interest rates will reduce business activities, (iii) having a widely fluctuating rupee puts enormous burden on the people with high imported inflation and unbearable cost of living impact and (iv) many other adverse consequences. In short, their view was that people’s purchasing power will be badly affected. From the present socio/economic situation faced by the majority of people, it can be seen that there is some truth of what they had predicted if they had adopted the IMF policy prescription.

Pros and cons of the major policy shift since April 2022:

President GR during the latter part of his tenure was reluctantly compelled to adopt a slightly different economic strategy (i) received a positive response from IMF (in March ’22) to his letter requesting EF (Extended Fund) facility (ii) allowed the rupee to fluctuate, initially a ‘managed float’ mechanism as decided by CB on March 7, 2022 (iii) dissolved the cabinet during the first week of April ‘22 and appointed a new economic team (iv) the Treasury secretary in consultation with the Governor, CB and the new Finance Minister had announced one of the most controversial decisions, i.e. ‘pre emptive’ debt default on April 12, ‘22. Since then, the CB used the term ‘debt standstill’ instead of default (Page 187 of the CB Annual Report-2022)

Upon resignation of President GR in July ’22 then Prime minister RW was elected as President through a ‘parliamentary majority vote’ in accordance with the constitutional provisions for the remaining period of GR’s tenure which ends in October 2024. Since then, the CB Governor and his team have been advising the government on the macro- economic policies, especially the monetary policy area based on IMF programme.

The CBSL has adopted a strategy of curbing inflation as a high priority by increasing the interest rate, imposing high taxation and further tightening monetary policy. President RW and his economic team have been able to manage to stabilize the macro economy to a certain extent thus eliminating the acute shortages in the market place, including petroleum products, gas etc. and also tackled the power cuts imposed by CEB during that time.

However, this was achieved at the expense of unbearable burden on households due to high cost of living, job losses and closure of a number of SME businesses, micro enterprises etc. The annual report of the Institute of Policy studies (IPS) – 2022 stated that only remedy on hand was to curb inflation through a forced ‘economic recession’.

The Monetary board of CBSL on March 7, ’22 decided to move away from the fixed exchange rate that prevailed since September 2021, it was announced that they expect an upper limit of Rs.230/-. Nevertheless, from March 8 or 9 onwards, the rupee was allowed to be floated based on market sentiments until May 12, ‘22 and by that time, the exchange rate of Rs.230 has gone up to Rs 377/- per US $. That’s the period, where inflation skyrocketed due to supply side ‘cost push’ imported inflation, more than the ‘demand pull’ inflation. On May 12, CB had to rectify this market behaviour (undue volatility) by shifting its policy to a ‘managed float’ with the introduction of middle rate to facilitate orderly behaviour of the FOREX market.

So far, Sri Lanka has received a total disbursement of two tranches amounting to US$ 670 million out of the US$ 3 billion Extended Fund Facility (EFF) approved by the IMF. The government of the day has been managing the ‘day- today’ inflows/outflows in the ‘forex account’ satisfactorily and, also managed to improve the government revenue collection through higher taxes imposed on the people. The private players who operate businesses especially the exporters and other foreign exchange earners have been able to build up some confidence on the government policy environment and started remitting their ‘forex income’ to the country through established banking systems. The Tourism sector is performing relatively well and ‘forex’ income to the country continues to flow in, thus relieving some burden on the people.

On the negative side, there is an undue delay in the negotiation process of the ‘debt restructuring’ with foreign creditors. (Debt to GDP ratio remains a major concern) Most of the sub sectors of the economy i.e. the so called ‘production economy’ both in the agriculture and manufacturing sub-sectors are not performing well. Although, the government tax revenue has increased significantly, the budget deficit in nominal terms has not made any progress showing reductions.

According to recent surveys conducted by independent research teams, majority of the people – five million households, SMEs, micro enterprises – are really suffering due to high cost of living, higher unemployment rate, further job losses, lack of purchasing power as well as deteriorating health care and educational sectors. The real issue has been that our country’s economic growth has been ‘negative’ during the last five consecutive quarters since 2021.

Solution lies in putting Sri Lanka back to work:

As indicated in my previous published articles, the government must focus on economic (GDP) growth– meaning real economics not financial numbers (transfer payments) etc only. In simple terms, the fundamental solution lies in making one thing to happen;

GDP growth = C+I+ G+ (exports-imports), where, C- consumption and I- investment, G- government spending.

We don’t have to reinvent the wheel. During the great depression period in 1930’s, the US/western economies were able to overcome the crisis successfully by practicing the ‘school of thought’ recommended by John Maynard Keynes, not necessarily based on neo-classical economic principles. Since then, many governments have been adopting the same principles and eminent economists of the calibre Professor Joseph E Stiglitz, winner of Nobel Prize /former Chief Economist of World Bank, Thomas Piketty, French economist who wrote the landmark analysis of Western economic inequality, “Capital in the 21st Century” and others have further developed the Keynesian model.

These economists urge governments to embrace real solutions: investing in education, science, technology and infrastructure, offering more help to the children of the poor, doing more to restore the economy to full employment etc. It is interesting to note that even the IMF, an organisation not taking radical positions, has taken up the position that inequality is associated with instability. (‘Inequality and unsustainable growth; two sides of the same coin?’ – IMF staff discussion note- 2011)

According to Stiglitz, monetary policy instruments for managing the macro economy have proved ineffective. Here are some home truths:

(i) The single most important thing is how to put the country back to work.

(ii) The country should be focussed on job creation. We can’t raise economic growth, create jobs by cutting spending and firing workers. The reason that businesses with access to capital are not investing/hiring people is that there is insufficient demand for their products. Weakening demand in the market place only discourages investment and hiring people.

(iii) The advantage of having underinvestment in the public and private sector for so long (nearly 10 years) is that we have many high return opportunities. Use this opportunity with low ‘long term’ bank interest rates to focus high return, labour intensive- investments in infrastructure, education, health care, technology etc.

(iv) Increased output can generate higher tax revenue to the treasury to pay low interest on the debt. Higher income to people means higher tax revenue to treasury without unnecessarily increasing the VAT rate to 18% and other tax rates.

(v) Government can change the design of the tax system and expenditure pattern. Increasing taxes at the top five percent and lowering taxes at the middle class. This will lead to more consumption spending, which is not happening now- in other words create demand in the market place.

(vi) Review Indirect taxes: Direct taxes ratio. The revenue from Indirect taxes such as VAT compared to Direct taxes (income taxes) is disproportionately very high, thus creating inequality in the society and negating the cardinal principle of progressive tax system.

(vii) Sri Lanka’s debt burden will reduce and economic growth increases, meaning debt to GDP ratio will improve.

It is simply a matter of politics:

Presidential elections are due to be held in early October ’24 and it appears that the two main opposition parties tend to gain popularity among the people, who are eligible to vote, especially the NPP and SJB. The present government and the two main opposition parties are in possession of somewhat comprehensive policy packages. However, whether they could offer a viable economic model at the elections as against the two economic models practiced by successive governments is yet to be seen. My own view is the success depends on how to put Sri Lanka back to work.