Was Sri Lanka forced into a ‘Balance Sheet Recession’? 0 334

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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India, the next Global profit story 0 849

China and India are two large countries with India occupying a greater part of South Asia. China has its territory spanning across East Asia. The two countries together, account for 36pct of global population. China has sustained double digit GDP growth for 30 years up to 2010. India on the other hand, has grown at half the Chinese growth-rate over the same period. China has consolidated its global position becoming the second largest economy in the global landscape. In contrast, India is counted the seventh largest economy as of now, having bypassed many established economies in the traditional developed world. The economic production values and population size of these two countries make them a significant catalyst for driving global growth trends.

Many have spoken about China and its phenomenal ascent on to the global economic stage. It is common knowledge now that China would dislodge the USA from the number one position in the global ranking of economies and would come to dominate the world GDP by 2030. There is no doubt that China has been the most extraordinary growth story in the history of mankind. It has become a classic model of development economics too. For liberating 600 million people from poverty in a span of 40 years, building of course on the socialist foundations laid down since 1949, is an achievement no other democracy can boast of.

The China growth story i.e. profit story, shows that state enterprises need not necessarily be a hindrance to growth, rather they can make the difference; that public investments on infrastructure provides the big push; that import substitution is as important as exports to exploit to full advantage the advances in technology, investment and trade for economic progress; and that state-guided market forces are development friendly. This success story and underlying business cycle fundamentals continue to unfold at a rapid pace across all asset markets. Many economic commentators and businesses alike share the sentiment that China’s dominance would continue in the next 50 years.

A careful analysis of past trends seems to highlight another view. I tend to argue that India would be the next Asian miracle in terms of its Global growth story i.e. profit story, and would match China in 30 years i.e. by 2050. Imagine the emerging Asian economic landscape with China and India free of poverty, with full employment and giving leadership to a new economic order, replacing the hegemony of the West.

Population projections indicate that by 2050, India would have a population of 1,730 million whereas China would reach a population saturation point of 1,400 million (East Asian Forum.Org). These two countries combined would account for 36pct of the world population by this time. This would be a rich population, with new aspirations and changing lifestyles.

Demographic data show that India would be endowed with a relatively younger population compared to that of China (Table-1). India’s young workforce with knowledge and skills would be India’s strength. Those between 15 and 64, are expected to rise from around 64pct of its population in 2009 to 70pct in 2020. Meanwhile, China’s relatively cheap and semi-skilled cohorts of population are expected to start declining from 2014, resulting in labor shortfalls by 2050. This would mean that a more intellectually hungry, urban based middle class would take over the driving of India’s profit story and would unleash a wave of innovation in the sphere of manufacturing, technology and music and film industry. One expects an Indian resurgence in the horizon waiting to explode on the world stage.

By 2050 the Indian economy would be in a much stronger position with leading brands such as Tata, Maruti, Godrej, Infosys, Amul, Bajaj, Ashok Leyland, Asian Paints, Dabur, Apollo Tyres, Britannia, and the zestful Bollywood influencing the world on a much larger scale than what we have seen so far. In this expected scenario India would outpace China by growing at a compound rate of 8.50pct (Table-2) and would reach USD 57.2 trillion with a per capita income of USD 33,700. China in the meantime would struggle to consolidate its current growth momentum over the next 20 to 30 years. It would grow at a compounded growth rate of that of an advanced economy, growing at 3.3pct reaching 47.6 trillion USD dollars with a per capita income of USD 33,900. When compared, the numbers added together are staggering. Additionally, when we look at the merchandise trade turnover between China and India the data indicates these two countries would account for circa 30pct (USD 100 Trillion) of world merchandise exports by 2055 from its current 14.5pct.

In fact data indicates that China’s economy is already showing signs of losing steam. Slowing down has commenced, with 2018 data indicating that it grew at the weakest pace since the first quarter of 2009. This slowing down has been caused by the higher base effect, growing costs of production and labor costs are now seeping into the real economy. Chinese companies have begun to search for other Asian and South Asian economies to house their industries affected by high domestic production costs. This is an indication of how China would now be challenged in the competitive capitalist environment. A declining profit story would only compound the longer term growth trajectory (Figure-1). Added to the Chinese woes is their new breed of westernized economists who are now showing signs of losing sight of its competitive advantage obtained over the golden years of development.

Undeniable Asian Dominance in 2055

The rise of Asia spurred by India and China is inevitable, therefore Asian economies/policy makers and businesses should gradually look at their business models, cultural and geopolitical linkages and synergies thereby carving out their growth plans to suit the new world order by 2055 given that the US will be the only western country to make it into the top five economies in the world.

Whatever the superficial debates that are out there, the ground realities are undeniable and must be taken seriously or we will definitely be left behind in the dinosaur era. It is therefore crucial that Sri Lankan policy makers value both India and China as they are in the Asian continent with significant consumer markets and a burgeoning middle class fueled up with an appetite for modernity. These consumers will be pleasantly drumming up the tune of the Asian Century of World Dominance and we must be ready to dance to the beat. This outcome is indeed sweet music to the ears of Asians (Global Sri Lankans). Unfortunately, many of Sri Lankan and Asian business models are ill-prepared for this eventual reality of the Asian Century.

The Silver Lining, in the Emerging ‘Silver Economy’ 0 573

By: Dr. Kenneth De Zilwa

It has become a fad to argue that political and corporate leaders ought to be younger, the world around us has undergone extensive change over the past few decades. In the context of population ageing experienced in many parts of the world, it is argued in political and business realms that leaders require to be more age appropriate and not aged. The old guard, it is contended, is not in keeping with the winds of rapid technological transformation that is taking place.

Silver-lining-01

The 21st century business leadership belongs to the youth who are keeping abreast with technological innovations, robotics, and artificial intelligence in the corporate world. The global economic system seems to be sending out signals suggesting a need for change in the age composition of political and corporate leadership.

Silver-lining-02

Yet there are tendencies in the world today to embark upon a new strategy of capturing the potential of the silver economy which is estimated to be USD 15 trillion per year by 2020. The silver economy is thus becoming a significant mega trend that is shaping the world. In contrast to the past, we are living in an unprecedented era of the global longevity cycle. The age composition of world leaders and policy makers shaping this thought process is indicative of the fact that as the world population is ageing, & more and more business and political leaders will invariably be those with silver hair tips, representing the silver economic ethos. The data indicates that by 2050 the population segment of silver tips, i.e. those above the age of 60 years, will double from its current 890 million to reach 2 billion people, thereby accounting for 22percent of the global population. The UNDP projections also indicate that between 2018 and  2040, China’s 65+  population  would  jump  by  almost  150  percent,  from  135 to 340  million.  Thus by 2040, China will be a “super aged society” with 25 percent of its people being 62 years of age or older, while the Asia-Pacific region would be home to approximately 1.2 billion older people out of a total of 2.1 billion worldwide in that category by the year 2050. It’s not only the sheer numbers of individuals, but the sheer spending power of the silver hair tips that plays an even more important part in shaping global mega trends. According to Merrill Lynch, the investment bankers, the silver economy will grow from its current USD 7 trillion to a population segment with the spending power of USD 15 trillion per year by 2020. This would amount to approximately 16.4 percent of World GDP.  Such will be the scale and influence of this market segment.

Cont..

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