There are issues regarding grants from foreign countries, receipts from privatization which affect the computation of the budget deficit. When there is a deficit in the over-all budget then the deficit has to be covered by funding which means borrowing.
We can borrow from the public; from the banks ( as the Tudor kings and the European monarchs of the 16th and 17th Century did) or from foreigners. Here too we can borrow from the multilateral lending agencies like the World Bank or the ADB or bilaterally from other governments such as China, Japan or USA.
The latter are foreign currency loans to be repaid in a designated foreign currency. The Ports Authority has taken a large amount of loans denominated in yen. Most of the multilateral lending is for projects and the Rupees have to be spent first before the World Bank or the ADB will reimburse the money.
The narrower definition of deficit finance refers to borrowing locally from the Central Bank and the banking system. This is tantamount to printing money and developed countries have long given it up because of the dangers of stoking inflation.But developing countries were influenced by Raoul Prebisch in the 1960s who argued for it. So we started deficit finance in the sense of issuing Treasury securities to be subscribed to by the Central Bank and the banking system. This practice is still going on. The two state owned banks can be pressurized to take up these securities by the Central Bank or the Treasury. So we are continuing on the path of inflationary finance.
What happens then can be explained simply.
There is the fractional reserve banking system where the banks are required to keep only a statutory reserve of say 10% of the total deposits. This means that the banking system as a whole can create deposits by lending. Bank deposits are part of the Money Supply.
When the Central Bank increases the liquidity in the banking system ( open market operations) or lends to the government to cover the budget deficit by subscribing to the Treasury securities in the primary auctions it increases these Reserves in the banking system and enables the banks to expand credit which constitute increases in the Money Supply.
The connection between the increases in the Money Supply and the general Price level in the long run is well established in economic literature.
Our money supply has increased from Rs 3435 million in 1971 to Rs 1282104. The money supply has multiplied by 373 times since 1971. The Price Level as measured from the Colombo Consumers Price Index has increased from 142 to 5416 in 2007 or 38 times. The difference can be explained as due to several factors.
Money Supply growth, Economic Growth and Inflation
Now, fully to understand this unrestricted borrowing from the banks, we must free ourselves from what is a widespread but basically wrong belief that the government is the engine of growth.
There is little hope of ever again expecting a government in our populist democracy exercising monetary discipline as long as we subscribe to this belief. Nor can we ever expect an Independent Central Bank with the power of appointment of the Governor and the Monetary Board being in the hands of the President. The 17th Amendment is in limbo despite it being a part of the Constitution.
The public at large have learned to understand, and I am afraid a whole generation of economists in our universities have been teaching, that government has the power by increasing the quantity of money rapidly to relieve all kinds of economic evils, especially to reduce unemployment and increase economic growth. Unfortunately this is true only so far as the short run is concerned.
The fact is, that such expansions of the quantity of money which seems to have a short run beneficial effect, become in the long run the cause of a much greater unemployment and current account deficits in the balance of payments. But what politician can possibly care about long run effects if in the short run he buys support? The situation is almost irretrievable in our lop sided democracy where the winner takes all and all the democratic institutions that act as a check on the power of the government ( government really means a set of persons who exercise power in the name of the government) are no longer operational.
I have read the article by W.A Wijewardene in the Lanka Business On line regarding this naïve faith in inflation as promoting growth.
I am quoting from his article. “During the three decades beginning from 1978, Sri Lanka had recorded on average an annual inflation rate of slightly over 11 percent. During the same period, its annual average economic growth rate amounted to 5 percent. These two macroeconomic numbers have prompted many to argue that inflation does not matter since, despite the two digit inflation, a comfortable economic growth rate has been maintained by the country.
"This argument, at an extreme level, is extended to even scoff at price stability as a goal of the society. If the economy could grow at 5 percent and the real per capita income can grow closer to 4 percent per annum, why worry about inflation? Why not inflate the economy, the easiest way to generate financial resources for investment in a resource scarce economy, and raise wealth and well being of the people?
"Some have extended this argument even further that for a developing country, price stability should not be an appropriate policy goal and governments should mobilize resources through inflation. This easy-to-fix-the-economy-strategy has won favor with politicians, bureaucrats and top level policy makers. The result has been a tendency for the state to use bank credit liberally and maintain economic activities at a higher level to keep the much dreaded economic recessions at bay.
Mr Wijewardene quotes Goh Keng Swee, the economic architect behind Singapore’s economic miracle recalled in 1992 that his Cabinet colleagues in early 1960s did not believe that printing money could bring prosperity to Singapore. According to him, “diligence, education and skills will create wealth, not Central Bank credit". Accordingly, Singapore decided to continue with the self-disciplined currency board system, prohibited the Monetary Authority to lend to the government and maintained the strictest fiscal discipline by balancing the budget.
Thus, Singapore was able to create an environment conducive to economic growth, namely, the establishment of a low inflation regime, in addition to other real sector adjustment policies. The result attained was dramatic and without parallels: within a matter of about three decades, Singapore could elevate itself to the status of a developed country.
As Galbraith stated which used to be frequently repeated by the late N.U Jayawardene 'a little bit of inflation, like with a little bit of pregnancy, has the awkward habit of growing’.
So far we have been able to have moderate inflation because until President CBK came along, the inflation adjusted budget deficit did not increase. But this situation has changed and the present regime has increased the inflation adjusted budget deficit thanks to Dr P.B. Jayasundera.
I must state that the use of the budget deficit to GDP ratio is not useful. What is required is to ensure that the budget deficit does not grow faster than the rate of inflation. This is happening now and unless it is corrected we will see inflation increasing and beyond a point it will get out of hand. We had in 2007 28% inflation. If we go on like this the point of loss of control will be reached sooner rather than later.
Fortunately the global economic recession took place which reduced oil prices and food prices in the second half of 2008.If that had not happens inflation would have escalated and any gains in nominal growth would have been negated. Further the growth will lead to ever-increasing current account deficits which will have to be funded from borrowings which will have to come from foreigners.
They will lend but at higher and higher rates of interest. There is no way we can repay such foreign debt except by rolling over at still higher rates of interest. They day will come when foreigners will not lend to us and that is dooms day when we will have to default on foreign debt. The Central bank talks only of the Foreign Reserves in relation to 3 or 4 months of imports. But what about the debt repayment obligations which arise each year?
The Foreign Reserves must be sufficient to repay debt payments falling due as well. This factor is totally ignored. But economic reality requires us to build Foreign Reserves to be adequate to buy imports as well as repay foreign debt.
The Currency Board
The Currency Board system which prevailed in colonial times linked the money supply to the foreign exchange earnings and prevented excessive monetary expansion. Up to 1960 we had very little inflation and very little growth in the money supply. The establishment of the Central Bank allowed the government to resort to deficit financing.
The scope for deficit finance in Sri Lanka is limited and the Fiscal Management( Responsibility ) Act laid down that the budget deficits should be brought down and gradually eliminated. A limit was also placed on the debt/GDP ratio at 85% which was to be brought down gradually to 60%.
The current government has not taken serious notice of this Act. So it remains a dead letter in so far as the provisions regarding limits on deficit finance. Fiscal consolidation is paid lip service only.
Because of this reason I will discuss what are or could be the possibilities of budget deficit financing. What are their impacts on macroeconomic stability in the country? The fiscal stability (balanced public finance) is a useful indicator of the macroeconomic health. So the massive budget deficits in absolute numbers is clearly causing a lot of harm.
It is usual to relate the budget deficit in terms of the GDP ( in nominal terms) and argue that the budget deficit is coming down. But when there is inflation and when we take the GDP in nominal terms the ratio comes down. But this is not a proper measure. It is the absolute number or the inflation adjusted budget figure that is relevant. This figure is definitely going up since 2005.
The high budgetary deficits are considered as the cause of macroeconomic problems. Among those problems in many cases are:
• High level of inflation,
• Current account deficits,
• Highly indebted economy,
• Slow economic growth.
The Macroeconomic Connections of Budget Deficits
The relationship between the budget deficit and macro-economic stability depends particularly on the way the budget deficit is funded.
There are several options for budget deficit financing:
1. Selling Government bills and bonds to the public
2. Borrowing from abroad,
3. Monetization or the borrowing from the banking system
4. Selling of state assets.
The bond selling at the home financial market leads to decrease in availability of private savings for the private sector for capital expenditure. The more funds the government deficit demands the less money will remain for the private investments ( pre-emption of resources). The excess demand for money by the private sector will invoke a rise in interest rates.
Higher interest rates, according to the theory, stimulate private sector and households to increase savings and shift some investments towards the future. In this case we say, that public expenditures (deficits) crowds out private investments.
On the contrary, external borrowing usually causes appreciation of real exchange rate, deepening current account deficit, increase of foreign debt and loss of foreign reserves.
Extreme and very serious result of this foreign borrowing can be currency crises, for which this scenario is very common. In fact we have a currency crisis brought on by deficit finance over the years and aggravated in the present regime due to the need to fund the war.
This has led us to go to the IMF.
Income-expenditure imbalances in the public sector are the main reason why we were not able to control inflation from the 1970s to the present day. As part of IMF programs of the past we switched to a flexible exchange rate which allowed us to protect our export industries. Delays in structural and financial reforms caused serious crises to continue throughout the period from 1960 onwards.
We had to go to the IMF 24 times.
Several times we had to go along with IMF supported stabilization and disinflation programs by which it tried to prevent inflation reaching exploding levels and to maintain financial stability.
Previously we allowed the Rupee to depreciate to offset the domestic inflation. In this way we managed to protect our export industries. But since 2005 the government has preferred to hold the Rupee stable. During this period, however the fact that structural reforms couldn't be realized and that no revenue was expected from privatization led the state to continue to borrow at high interest rates, and accordingly the inflationary expectations of economic agents were increased.
During this period, the lack of confidence in the monetary and fiscal management not only caused an increase of inflationary expectations but also of devaluation expectations. This resulted in foreign exchange demand on the part of the investors and domestic banks. Then came the global financial crisis of 2007 onwards which began to affect us from about August 2008. The central bank was nearly depleted of international reserves and had to seek IMF Standby Credit.
After the currency crisis of 2008, the CB has now stuck to the fixed rate regime, something not new for the present regime. We had previously always allowed the Rupee to depreciate by 7-10% each year to offset the higher domestic inflation. This allowed the domestic export industries to survive and even forge ahead when export prices improved. We are now in danger of undermining the few export industries we have particularly the rubber goods export industry and the ceramic industry. A depreciation will be essential if the wage demands now before the plantation owners are conceded.
I do not see the slightest prospect that with the present type of, I emphasize, the present type of democratic government under which every little group can force the government to serve its particular needs, government, even if it were restricted by strict law, can ever again manage the macro-economy.
The Government has a huge domestic Rupee debt which it can in no way repay from taxes. So it will be tempted to resort to inflation to erode the value money. Don’t be lulled by the fall in inflation. It is due to the fall in world market prices of grains, milk foods etc. the Central Bank claims to have controlled inflation.
But I fail to understand how a lax monetary policy with the Central bank pumping up liquidity and forcing down interest rates will reduce inflation. If world oil price goes up with the revival of growth in the developed countries inflation is likely to return. Then the government and the central bank will have to decide whether to continue with the present lax monetary policy or tighten monetary policy.
The chances are that it will go ahead with its infrastructure investments and borrow money from the banks to fund the Rupee expenditure. Hopefully it will borrow the foreign currency from the commercial bond market. Money supply expansion is then inevitable and with it will come higher inflation.
At present the prospects are really only a choice between two alternatives: either continuing an accelerating open inflation, which is, as you all know, absolutely destructive of an economic system or a market order; but I think much more likely is an even worse alternative: government will not cease inflating, but will, as it has been doing, try to suppress the open effects of this inflation; it will be driven by continual inflation into price controls, into increasing direction of the whole economic system.
It is therefore now not merely a question of giving us better money, under which the market system will function infinitely better than it has ever done before, but of warding off the gradual decline into a totalitarian, planned system, which will come step by step in an effort to suppress the effects of the inflation which is going on.
Central banks abroad have played an instrumental role in the current financial crisis in mature markets. With the aim of bringing money markets back to normal functioning and stemming financial turmoil, central banks have extended sizable financial assistance to failing banks and other intermediaries – although at the cost of increasing the size of their balance sheets and creating moral hazard and other microeconomic distortions.
Today, systemic liquidity has been restored but credit conditions have not been normalized and, hence, economic activity has declined and inflation has started to fall.
The financial crisis has receded in industrial countries. We have had an inflow of foreign money to the government bond market. Our Foreign Reserves have gone up as a result and the Central bank will soon have to intervene in the foreign exchange market to prevent an appreciation of the Rupee which could be disastrous to our export sector.
The government is squeezing out the private sector from resources and the private sector has to shrink not expand.
The Way Ahead
• What then is the way ahead?
The Government is resorting to foreign borrowing to fund the budget deficit. But this is also undesirable because more and more foreign inflows by way of investments to government bonds would cause upward pressure on the Rupee.
What we require is a depreciation policy similar to what we followed earlier to stimulate the export industries and protect the plantations crop exports. The extent of depreciation should at least be the amount of inflation during the previous year. Depreciation will also act as a stimulus to the economy.
• The crisis has been ascribed to the lack of regulation.
This may apply to the new fangled financial instruments. But the current crisis was triggered by the trade in US sub-prime mortgages - home loans given to people with bad credit histories. In our case it was the failure of regulation rather than the lack of regulation. The Golden Key collapse could have been avoided if the rules regarding deposit taking were enforced.
But critics are blaming the free market system and calling for protectionism- less exposure to the global economy. This I think is a mistake.
It is only the exposure to global markets and global capital that can pull us out of the current deflation. We don’t have any of the new financial products. But risk management by our captains of business has shown up weaknesses. If we follow economic nationalist policies we are unlikely to get out of the mess.
• But fraud and failures of governance should be rectified.
We need stronger enforcement of the regulations not more regulations. Corporate governance needs to be monitored.
But while saying all that we must also realize that the capitalist system is prone to the business cycle. Business people expect prosperity to last even when the under-lying economic fundamentals are flawed. The deficit financing is the chief problem which requires attention. The inflation adjusted budget deficit should not be increased. The deficit/GDP ratio is not a satisfactory measure.
I like to conclude with what Alan Greenspan said recently They [financial crises] are all different, but they have one fundamental source," he said. "That is the unquenchable capability of human beings when confronted with long periods of prosperity to presume that it will continue."
So there are bubbles created and they burst suddenly.
This article is based on a speech delivered at the 2009 annual sessions of the Sri Lanka Economic Association (SLEA). R M B Senanayake is vice president of the SLEA.