Was Sri Lanka forced into a ‘Balance Sheet Recession’? 0 648

By Dr. Kenneth De Zilwa

Background

The Central Bank of Sri Lanka had come under increasing criticism over its Inflation Targeting hedonistic regime adopted over the past 5.5 years which saw the country pushed to a virtual standstill. During this period we witnessed the real economy crumble, recording its worst GDP growth trend recording a decline in GDP from 5.0pct in 2015 to 2.3pct in 2019¹, the lowest growth recorded since 2001². Despite the glaring evidence of a declining GDP trend the Central Bank of Sri Lanka ably supported by the IMF continued to drum up the rhetoric on the need for austerity measures, as a solution for Sri Lanka’s economic pains. The announcement sent shivers down the spines of many alternative schooled economists. World-renowned economist
Paul Krugman was quoted saying

“every country that introduced significant austerity has seen its economy suffer, with the depth of the suffering closely related to the harshness of the austerity”

 

therefore, it is mind-blowing how Sri Lankan Central Bank could advocate such policies. Fueling this announcement was also the common belief by Central Bankers that excess money supply or printing money caused ‘galloping inflation’ – a myth, which resulted in hawkish policy measures being adopted by Central Bank. It was, therefore, a matter of time before the real economy was choked with high real interest rates, which was among the highest in the Asia Pacific countries in 2018 (Figure 1).

What is interesting to note is that contrary to the theory that high real interest rates lead to increased national savings, Sri Lanka’s national savings to GDP data (i.e. national savings rate measures the amount of income that households, businesses, and governments save), did not indicate any such linear progression, as the national savings trend had steadily declined from a high of 30pct in 2014 to 25pct in 20194.

The declining GDP data trend captured in (Figure-2), confirms that the country was now in dire straits and heading towards greater depression, requiring a significant change in direction from the hawkish monetary policy approach and growth retarding fiscal framework that existed, to a pro-production and pro-growth framework. It can be argued that an inevitable outcome of both high tax rates and inconsistent monetary policy measures contributed to the rising of non-performing loans in the banking system, thereby increasing the gross NPL ratio by 38pct on a year on year basis, from 3.4pct in 2018 to 4.7pct in 2019, or in other words, gross NPLs increased from LKR 263 billion to LKR 382 billion which was the highest year on year increase since 2015, according to the 2019 Central Bank Annual Report.

It is evident that fresh thinking needs to be adopted towards inflation targeting and the problem must be approached from a business model perspective. Unfortunately, this fresh perspective was not forthcoming during the period under review (i.e. 2014 to 2019). Cambridge University, development economist Prof. Ha Joon Chang has highlighted in his book titled “Bad Samaritans- the myth of free trade and the secret history of capitalism” that many such growth retarding monetary and fiscal policy tools and false theories have been used extensively against developing countries by developed countries, preventing and stifling their economic development journeys. Empirical evidence suggests that Sri Lanka too has fallen prey to this austerity and inflation targeting trap.

THE MYTH OF INFLATION TARGETING

With the collapse of the Bretton Woods system in 1970 which focused on maintaining a fixed exchange rate, global superpowers and neo-classical i.e. monetarist school of economic thought were looking for another similar type of a potent policy tool to support their global monetary supremacy agenda, which would ensure that the standards were set for other countries to follow. Central Banks of developed countries had to demonstrate that they cannot control inflation as both the business community and the general public had lost faith in their ability to do so, having often missed their target by a long shot on many occasions. This very fact was aptly highlighted in 2009 by Maurice Saatchi, Chairman, of the Centre for Policy Studies, United Kingdom.

A closer examination of ‘inflation targeting’ would reveal that the whole notion is based on the premise that long-term economic growth is best achieved by maintaining stable prices, and that it could be done by controlling prices i.e. inflation. This approach is typically characterized, by the announcement of official target ranges for inflation by the Central Banks at one or more time horizons, while they explicitly acknowledge that low and stable inflation is the overriding goal of monetary policy.

Herein lies the problem, when the National Consumer Price Index NCPI (Base 2013=100), is based on data from the Household Income and Expenditure Survey conducted in 2012/13 which is highly skewed towards food (45pct of the basket) and even the non-food components (55pct of the basket). The weights in both categories are dependent on import prices. In such situations, exchange rate pressure builds up and as a tradeoff for managing the pass-through of exchange rates, monetary policy i.e. inflation targeting mantra, has been predominantly used as its solution. How can price stability be achieved in a country when it has sacrificed its domestic food supply and is heavily import depended on its basic food requirements for its people, apart from energy supply, household items, and fuel supply? If inflation rises because of such external supply-side shocks, it is a no brainer that the Central Bank of Sri Lanka would be compelled to increase its key policy rates expecting to go by the rule of inflation targeting. But in fact what it does is make matters worse causing more damage to the real economy, as balance sheets of companies suffer from higher debt financing costs and raw material costs, thus eroding profitability i.e. national savings. The International Labor Organization in a research paper (2011) validated this observation when it stated that “implementing inflation targeting regimes represents a major challenge in the presence of supply-shocks which are a common phenomenon in developing countries”.

Therefore, in adopting such a one-dimensional approach the Central Bank of Sri Lanka could be literally ‘shooting itself in the foot’ and together with it the entire real economy. This phenomenon is because most Central Banks are not trained to look at corporate balance sheet behavior, leverage, and factors affecting revenue conditions. Inflation targeting has been globally rebuked and many Central Banks do not go by this indicator alone, anymore. According
to a research paper published in 2015 by the Peterson Institute for International Economics (PIIE) claimed that inflation targeting is a myth and said to be the root cause for retarding economic growth of developing countries, quote, “Simple inflation targeting lowers growth in developing countries”. In a separate research study undertaken by Ricardo Brito and Brianne Bystedt titled ‘Inflation Targeting in Emerging Economies: Panel Evidence’, published in the Journal of Development Economics, 2010, (volume 91, issue 2, pages 198-210), the authors examined panel data samples of 46 developing countries over 27 years, (from 1980 to 2007), in which they found evidence that “inflation targeting by the developing country Central Banks, in fact, was the cause of reduced (economic) growth”.

This is could not be truer from a Sri Lankan perspective too. For at a time when corporate business sales turnovers have been negatively impacted as a result of internal shocks caused by draughts, floods, and terror attacks and the exchange rate depreciation viz a viz the US dollar, any form of growth reviving strategy seems to be a miss. While more growth retarding austerity measures were spoken of such as increased taxes (i.e. fiscal strangulation) more inflation targeting policy measures saw real interest rates at its highest making matters worse for corporate balance sheets as they hemorrhaged cash on the back of higher debt levels and continued low earnings saw the collapse in real GDP (Figure-3). Evidence indicates that the Central Bank without understating the implication on corporate balance sheets given their hedonistic inflation targeting policy approach – a purely mechanical process, caused many businesses to involuntarily close down, pushing the banking sector into jeopardy with un-serviceable loans that kept piling on in the books of banks and (i.e. banking non-performing loans reached 13.0 percent in some instances), thereby increasing the overall risk to the country’s financial stability (Figure-4). The decline of economic activity in the country also saw the national unemployment rate increase to 5.1pct in Q3 of 2019 from 4.4pct in Q2 2019.

 

 

 

 

 

 

BALANCE SHEET RECESSION, INFLATION TARGETING, AND DEMAND FOR CREDIT

Bank of Japan (BOJ) was faced with a balance sheet recession and attempted inflation targeting in the 1990s and until 2000s, and finally admitted that it failed to inflate the economy despite the flood of money in the domestic market. The excess money supply did not create inflation nor did it help pull the economy out of its 20-year long recession. In 2013 too Bank of Japan once again set an inflation target of 2.0pct as Governor Haruhiko Kuroda took office, seven years on, inflation has remained a significant distance from that goal. Data showed core consumer prices rose by just 0.37pct during this period. Unlike Japan, the USA’s President Donald Trump did understand that inflation cannot rise despite the flush of money supply when corporate balance sheets are significantly stressed with debt, and thus the demand for money is not plausible. While accelerated loan repayments i.e. debt repayments, only makes matters worse as BOJ too faced similar problems and was flushed with money supply, that no one wanted, as demand for money disappeared causing commercial bank lending to decline sharply recording a negative 1.0pct in the 1990s reaching negative 7.0pct by 20005. Nomura Research Institute economist, Richard Koo, wrote extensively on this matter and argued that deleveraging (i.e.paying down debt) by private sector companies caused the recession in Japan. He pointed out that when corporate balance sheet debt stock rises, servicing runs into trouble when there is a lack of domestic demand, resulting in an asset price collapse while debt i.e. liabilities remain on the balance sheet.

This phenomenon of cash flow compression causes private sector balance sheets to go underwater and deleveraging commences. During the period between 2002 and 2003 Japanese companies paid down USD 260 billion worth of loans, when as per the monetary theory companies should be borrowing at near-zero interest rates.

In such a situation, the turnaround is only possible with debt deflation (i.e. writing off/downsizing), and economic policies are targeted at regaining the financial health of companies and improving their balance sheets. It is important to note that in situations of debt deflation i.e. downsizing, (as a result of slower GDP and declining revenues) businesses are forced to take drastic action to repair their balance sheets by either increasing internal savings i.e. cutting costs, or paying down debt by fire sales of assets or a mix of both methods could also be on the table. This desperate act of deleveraging reduces aggregate demand for money and inflationary pressures decline, thereby throwing the economy into a tailspin and subsequent recession, which can be termed ‘Balance Sheet Recession’. It is important to have a mechanism to insulate companies when faced with or unknowingly placed in such balance sheet recessionary situation by the Central Bank’s own austerity measures. Therefore, in such situations, businesses should get some reprieve by way of a debt-moratorium or a write off as they require time to restructure their debt. In the USA according to Chapter-11 bankruptcy code 6, a petition could be filed, and voluntary bankruptcy could be declared by the debtor to reorganize existing debt, or it could be an involuntary petition, which is filed by creditors or creditors that meet certain requirements. Sri Lankan businesses do not have this luxury when faced with a ‘Balance Sheet Recession’ situation.

Therefore, until such time businesses are back in good shape with strong balance sheets, having gained production capacity in order to capture market share, growing revenues, and expanding its asset base any form of monetary stimulus or fiscal stimulus will not have any significant impact on inflation. For the lack of demand for money or credit, paves the way into the decline for goods and services. This is what saw in Japan and now we see it happening in the USA too and President Donald Trump has managed to put a stop to Federal Reserve’s inflation targeting phobia, understanding the implications of balance sheets and the need to gradually deleverage post an economic crisis, such as that witnessed in 2009/2010 period. President Trump was critical of the Fed’s hawkish monetary policy stance and called it “very, very disruptive” as they were contemplating raising interest rates too quickly too soon, thereby squeezing out the air in profitability and not making room for businesses’ balance sheets to be cured and repaired.

GROWTH ORIENTATED MONETARY POLICY

Thankfully in Sri Lanka too we see the dawn of a new monetary policy framework that is now gradually taking shape in the parlance of decision making, and that too is based on ‘Balance sheet based economics’ which is considered when factoring monetary and fiscal policies. Therefore, we could expect a more growth-oriented Central Banking to emerge in the months ahead. A pre-condition in this process must be to stimulate businesses and to create new
business models to look at external markets by enlarging the economic pie by way of using unconventional monetary and fiscal policy in the new normal economic environment that we have come to embrace. Herein, the restructuring of SME and ushering an Agro industrialization transformation is pivotal in this process of reorienting the economy. The Central Bank of Sri Lanka and Monetary Board should think out of the box and adopt new tools and have in place new mechanisms to examine corporate balance sheets, understand them, and work towards strengthening them as part of key focuses in achieving full employment and macroeconomic stability. Thus moving away from its preconditioned (flexible) inflation targeting and balance sheet contracting ‘austerity mindset’ which world-renowned economist Paul Krugman admitted has failed miserably globally7.

The Monetary Board and the present government seems to have understood this “Balance Sheet Recession” aspect and have moved expeditiously with initially providing fiscal support by way of tax cuts and also have decided to inject liquidity and reduce the cost of borrowing for companies by slashing the Statutory Reserve Ratio (SRR) by 2pct, and the Standing Deposit Facility Rate (SDFR) and the Standing Lending Facility Rate (SLFR) of the Central Bank to 5.5pct and 6.5pct respectively. The cost of debt was reduced on four occasions within the year initially by 50 basis points and 25 basis points, respectively, with effect from 30 January, 16th March, and thereafter by 50 basis points once again on the 3rd April and on 6th May 2020. While introducing the debt repayment moratorium and credit guarantee scheme to enable businesses to access much-needed funds to function and encouraging banks to restructure corporate balance sheet debt with the intention of gradually deleverage over time. This synchronized
action is a very important point of departure in the context of the Sri Lanka inflation-targeting approach, which suffered in the past 5 years with below-par growth rates achieved, and was placed even below the Afghanistan rate of growth of 2.3 pct.

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To be nationally poor is a public choice 0 792

By Bradley Emerson MBA Sri Jayawardenepura

The inception of my career as a banker in the late 70s was about the same time that Sri Lanka acted on a revolutionizing move to become the first South Asian nation to liberalize its trading economy. Ever since I have been hearing Sri Lanka as a “developing” nation. Fast forward to four decades and several regimes later we are still a “developing nation”. What is it to be a developing nation; What is to be a rich nation and what is it to be a poor nation. The Department of Census and Statistics records Sri Lankans per capita GDP for the year 2019 at $ 3,852 per annum whilst Singapore, who’s open trade regime were developed much later recorded a thumping $65,977. Singapore’s benchmark strategies are spoken of at many forums to highlight its economic ascension from what was once a poor country with a GDP per capita of only $320 in par with Sri Lanka. The success story of Singapore’s economic and demographic development surpasses a single systematic exposition, however, it is crucial in this context to act as an expediential comparison and maybe give an insight or two for Sri Lankans.

Following an economic growth of just 5.3% after the civil war ended and low fiscal revenues combined with mountains of debt,Sri Lanka is classified as among the developing economies by the United Nations Secretariat (UN/ DESA). Comparatively, Singapore ranks sixth highest in the world for a country that possesses half the natural resources as Sri Lanka.

How do we allow this term to dominate us?

I have been hearing of Sri Lanka being trapped by this economic definition for as long as fifty years. Our present standard of living is at least ten times behind that of Singapore, and our drastically slow pace is only weighed down by our debt portfolio. Whilst searching for answers, numerous evidence pointed to the lack of persistence and political instability coupled with low demographic development with a relatively large population earning an income that is just enough to survive.

A radical change is required to overcome this crisis, but what will continue to be a barrier to growth is only ourselves, which arrives at the core lesson to be learned before we begin our mandate. To be nationally poor is a public choice; to navigate this crisis is dependent on our determination. Only we are stopping ourselves from capitalizing on our potential.

Mynt (1973) suggests the key indicators of economic development are the level of per capita income, rate of growth of per capita income, and the widening inequality in the distribution of income, but there is much debate on the contribution of economic production to the country’s prosperity. Sri Lanka’s current account deficit in 2018 amounted to $7.57 billion which was exacerbated by a challenging external environment with the Easter attacks and now the latest COVID-19 outbreak. The country’s export performance declined from a growth rate of 4.1% to 1.44% by the end of 2019, losing out on much-needed foreign exchange that can be utilized to pay off debts. With little to no reserves and a declining rate in the exports, a call for transformation in the policies is imperative to focus on export growth.

Performance into perspective:

In 1969 following the independence of Singapore from the Malaysian Federation, a Singaporean Dollar was exchanged at $0.35 against the Sterling Pound whilst the same could be purchased at SLRS 13.40 in Ceylon. Since 1981, the monetary policy in Singapore was centered on the control of the exchange rate, and today, their currency is equal to £0.57 whilst the SLRS is 237. How did we get here? Is it not by choice? Sri Lanka like any other developing nation is a political economy. What does it mean? It means that every economic policy has the flavour or influence of the political agenda of the incumbent regime. The result is that our direct debt to GDP is around 70% and nearly 90% of our national revenue is expended to service these debts. How do we survive? Just imagine if 90% of your family income is used to service debts, how could you sustain your family without sinking deeper into debt?

There is no doubt that our country is in dire need of an effective policy to reduce an approximate one billion trade deficit a month. The deficit stems from importing more than we export which impacts our reserves. The exchange rate against the dollar reached an alltime high of Rs. 191 in April 2020. The early 2000s experienced a 2.8% yearly depreciation and it was as high as 9.1% for the four year period of 2015-2018 alone. The public has failed to grasp the reason behind the depreciation over the rupee – but the Central Bank’s quick-fixes through injection of money contributed towards a further hindrance to the growth.

In attempts to achieve the government’s export target or rather reduce the trade deficit, stringent measures and banning mechanisms have come into play. However, the effectiveness of these proposals are far from favourable along with strong opposition from the public. From an accountant’s point of view, where we are today as a nation with political interventions on the implementation of policies, fiscal account deterioration and racks of debt; we will easily be written off as ‘bankrupt’. Sri Lanka is in a fight for survival and it is our responsibility to help the nation get back on its feet.

An appeal for long-term change:

The late Prime Minister Hon. Sirimavo Bandaranaike took oath in 1960 as the world’s first female Prime Minister, yet another disruption against the conventional norms in the political economy. Her regime prioritized incentivizing the local industries and capitalizing on domestic knowledge for production. It is agreeable that the lack of an open economy failed to drive economic opportunities, however, the brutal “produce or perish” notion encourages self-sufficiency that which we lack today due to our dependency on international trade.

‘Tea, rubber, cocoa and coconut is a common man’s answer to what our main drivers of export revenue were, yet it is shameful that during 2018, our imports consisted of 5.13% of rubber and 1.89% of tea. We even import coconuts.

Lee Kuan Yew, the founding father of Modern Singapore implemented systems based upon the development of the country’s resources to improve trade and the quality of life. A notable example being the revival of the Singapore River around which businesses and factories developed. The project which took up to 10 years created a foundation for innovation, improvements in transportation, tourism, and water supply.

We possess abundant resources for our island to thrive; the agriculture industry, tea destinations and massive potential to become a global tourism hub. Known as the pearl of the Indian Ocean, our island is at a prominent location which is of the essence to create a competitive advantage. Yet, it is ironic that we import salt and fish when the sea surrounds us. In 1978 when I embarked on my first trip to India, we carried bags full of spices to be locally sold to a country where the demand for our spices was unaccountable but now we are importing spices from India. The largest contributor to export revenue of spices in 2018 was Cinnamon, which totaled at only 11.1% traded to India. The great voyager Vasco da Gama referred to then Ceylon as the land of spices and we chose to lose out on that status.

Paddy cultivation in Sri Lanka traces its roots back to 161 B.C. when Sri Lankans were skilled at making a living out of this industry. Rice crops occupy 34% of total cultivation with over 1.8 million of our population engaged in producing around 2.7 million metric tons of rice annually. The trading of cheaper and quality rice from other nations exerts pressure on Sri Lanka to improve on production. Sri Lanka has the capacity to gain international recognition as the primary rice exporter as well as create a source of employment to improve the livelihoods of many.

However, the policymakers must prioritize their earnings to invest in equipment for pre-harvest operations and marketing of the produce. According to research done by TB Adhikarinayake, the majority of the problems farmers face are related to high losses in the production chain and lack of skilled workers.

The Choice –
a change in direction:

Where are we heading? We are importing what we can produce, increasing the trade deficit, increasing the pressure on the exchange rates, and depriving our children of foreign education. In such a competitive world, the need to solve the Balance of Payment crisis is pivotal to managing the country’s finances in order to avoid a disastrous downfall. The government’s attempt to reduce the deficit by imposing import controls will only create inflationary pressures in the country if we don’t optimize the encouragement given by the government to grow.

Science and technology have given us “formula one” seeds for rice, chilies, and potatoes which can treble the output per acre. Are we making a choice to optimize these opportunities to be self-sufficient?

We have a choice, to change our destiny. Can we, yes, we can! We are poor because we chose to be so. Likewise, we can make the choice to be rich as a nation. Let’s look at a change in direction by seizing opportunities to make exports competitive, using innovative methods of technology, and by utilizing our human resources. It is about time we make use of our knowledge in agriculture, natural resources, land, diverse cultures, and our climate to attract foreign investors.

Every generation has a responsibility towards creating a sustainable nation. It is our choice to change directions to reach the destination we intend. It is our obligation to ensure that majority of our children do not experience a poor quality of life, rather a high standard of living and not to be referred to as people of a poor nation.

 

 

BiZnomics Global Out-front Comments Off on BiZnomics Global Out-front 621

Global-Outfront

President Trump offered to meet North Korean leader Kin Jong Un at the demilitarised zone following the G 20 Summit raised prospects for a third face to face meeting between the two leaders.

G -20 Osaka Summit 

14th G-20 Summit – a forum of 19 member countries and European Union was held in Osaka, Japan 28 -29 June 2019 with the participation of heads of G 20 Governments. International Monetary Fund, Asian Development Bank (ADB), International Labour Organization (ILO), Organization for Economic Corporation and Development (OECD), United Nations (UN), World Bank (WB), World Health Organization (WHO), World Trade Organization (WTO), represented in the summit by their respective heads of Institutions. 

Global-Outfront-01

Collectively G 20 nations represent more than 80 percent of global output and 2/3 of its people. Easing the global tension centred around US – China trade dispute, President Trump announced that he has agreed to allow US companies to sell high tech components to Chinese telecommunication giant Huawei. He also announced that China will buy more US farm goods. US President indicated that US will call off raising tariff on Chinese goods and negotiations to end the trade dispute between two countries will continue.

Prime Minister Abe who hosted the G 20 Summit explained that global leaders have affirmed free and fair and inclusive economy and open competition are the principals to lead the world economy in future.

Global-Outfront
Source: IMF Economic Outlook

 

 

Global Outfront
Source: IMF Economic Outlook

 

As estimated by IMF total GDP of G20 nations of nearly USD 60 trillion account for 78 percent of the world total GDP of USD 88 trillion. In terms of population, G20 nations is estimated to have 4.6 billion people in 2019 accounting for 61 percent of the world total population of 7.5 billion. China takes the lead with 31 percent and India accounts for 29 percent making two emerging nations in Asia having 60 percent of the population of G20 nation.

By: BiZnomics research team

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