Good News

The good news is that growth was high in 2006. No matter that it was due to the tsunami boost of 2005, and loose monetary policy; growth means jobs and employed poverty is better than un-employed poverty.

The 2006 budget can take credit for that.

The language in this budget was more responsible, unlike earlier ones. There was no more talk of why big deficits are good and that government spending has to be increased.

Previous budgets were liberally sprinkled with petty minded politicking and economic theory straight from the loony bin of our red-brothers, and showcased the economic illiteracy of our rulers.

Once a serious investor reads such a budget no amount of promotions by the Board of Investment would convince them that this country would go anywhere.

On the contrary he would win a gold medal as he sprinted away to China, Vietnam or India in his haste to get away from Sri Lanka.

A rating analyst would shake his head, and wonder whether to put the country on rating watch.

But this budget also showed a fait accompli, the ending of fuel subsidies. Actions speak louder than words, which may hopefully impress a rating analyst. An IMF study found that 76 percent of the fuel subsidy went to the richest 40 percent of the country.

So, after two years, the most damaging element of the Rata Perata madness is hopefully behind us.

In Hugo Chavez’s country Venezuela, a study in the early 1990’s found that the 20 percent richest households received six times the subsidy received by the bottom 30 percent.

Inflation in Venezuela, a member of the OPEC was 15.3 percent in September this year when ours was 15.4.

This is what the 2007 Budget said about fuel pricing, “The government would continue to allow monthly adjustments to retail fuel prices in line with international prices, under the supervision of the Public Utilities Commission.”

So far so good.

This column has said enough about the damage to the economy and the poor caused by fuel subsidies, so we will not dwell on it too much except to say that the excuse that fuel subsidies are the cause of inflation cannot be used by the authorities anymore, with crude prices plummeting.

In October inflation went up by 1.8 percent to 17.2 percent despite 3 cuts in retail fuel prices. So there! The reason of course is expansionary fiscal policy, or what you and I call money printing. That is the same reason the rupee is falling.

Deficit

The deficit for 2006 was 8.7 percent of GDP, lower than the 9.1 percent estimated in the original budget.

This is what fuss- budget said in The Thrift Column - Don't Panic soon after that budget was presented to parliament.

…..will the government bust the 9.1 percent target this year too? Doesn't 9.1 one sound like a 'credible target'? Surely the Mahinda Chinthanaya cannot be such a burden on the nation that even this target cannot be achieved?

If the war comes we can eliminate the fuel subsidy and get about 1 percent of GDP in revenue. Then again the capital budget can also be cut, like in 2005. So this looks like a weak enough target that even a populist government should be able to achieve?

So it came to pass. The government eliminated the fuel subsidy in July as the war intensified. Capital expenditure was cut from a budgeted 7.5 percent to 5.9 percent.

Sadly, the headline of that Thrift Column ‘ Don't worry, you can beat this deficit - if you are rich’ also came true, with inflation running at 17.2 percent so far.

These deficits are vicious, whether it is 8.7 percent of GDP or 9.1 percent. Also part of the problem stemmed from rising current expenditure, especially related to the war, which resulted in a supplementary estimate being passed.

The revenue deficit rose to 2.4 percent from 0.9 percent. This year a surplus of 0.1 percent of GDP is being projected. Ha ha, everybody laugh!

This has not happened since 1987 and it will not happen next year, with a bloated public sector sucking 49 percent of the tax revenue.

A tale of two budgets

It is amusing, how the authorities are tying themselves in knots in trying to fudge the budget numbers and deceive the legislature.

The central bank gives one deficit number, and the Finance Ministry gives two; one in the budget speech and one in the Medium Term Budgetary Framework documents, both of which were tabled in Parliament.

Only a country with a bankrupt opposition, would permit this kind of reporting. There were cases where our opposition leader has not even made a speech in parliament against the budget, despite drawing salary from the money of the people.

So next year we have three budget deficits. The 7.2 percent in the budget, 8.4 percent in the MTBF and the 9.1 percent that others have arrived at by adding the deficit and tsunami expenditure.

It is also good that the government is putting more emphasis on infrastructure. Capital Spending went up from 5 percent to 5.9 percent of GDP, even if it fell from the grossly exaggerated 7.5 percent.

This is far cry from the early eighties, when capital spending was about 60 percent of spending, like in East Asian countries. Now it is just 20 percent, while the current budget has ballooned from 40 percent to 80 percent of expenditure.

I only hope capital spending does not include the Land Rover Discovery 3s given to cabinet ministers.

There are more hopeful signs. The National Wealth Corporation idea looks like a back-door privatization mechanism of some kind, which can put state-owned assets to better use, and get some cash which may

Brickbats

The main problem with the budget is inflation. The first Mahinda Chinthana budget has so far produced inflation of 17.2 percent, with more to come. Only the rich can beat this type of inflation. The rupee has fallen to 109 to the dollar from 102 in January 2006.

The poor suffer terribly from this type of subsidy-oriented budgets that our politicos call like to call ‘people friendly’.

You can see the damage the JVP does to the poor of this country through their sad ignorance of economic reality. That is what Hugo Chavez is doing also.

For more information on how such budgets concentrate wealth on real-asset owning classes and businessmen, see The Thrift Column - Trickle Up , and The Thrift Column - Friends and Enemies .

It is s succession of this type of budgets that has made a quarter of our households so poor that they earn less than a dollar a day and 40 percent who earn less than two dollars a day, despite unemployment falling to six percent.

We have employed poverty here, because of the ‘inflation tax’ as well as bad economic policies.

This column has pointed out many times that the reason we have so much poverty is because the government steals the income of the poor through inflation. You can see very well in the plantation sector which has also been hit by the overvalued rupee.

The farmers are given 12 billion rupees worth of subsidies to grow rice that they cannot sell. They are in effect given fiscal incentives to become poor. It would have been far better to give them some planting subsidies to diversify into different cash crops, or put the money into extension services and research.

Oh why, oh why?

Will the new budget produce low-inflation growth which is good for the poor? The short answer is, no, despite some hope.

Page 29 of the budget speech says that it has been designed to produce 9 percent inflation: “The budget itself has been designed to reduce inflation to 9 percent and sustain a growth in GDP at 7.5 percent.”

Why do we need inflation? We need it because this is how third world countries run fiscal policy, shocking as it may seem.

It is not simply a question of printing money to finance the deficit. This type of budget simply cannot be operated without inflation.

Third world Treasuries, not just Sri Lanka, usually depend the expansion of base money or seigniorage revenues to run the government. That is partly why all independent countries set up Central Banks.

But there is more to this. What happens is that inflation increases tax revenues. When prices go up, turnover based tax revenues like VAT go up. When the national currency falls, customs revenues also go up, even if imports contract.

Revenue Magic

Let’s consider what happened in 2006. After giving due credit to Inland Revenue and the Treasury for improving collection it must be said that the government originally said it would collect revenue to the tune of 17.8 percent of GDP. Eventually it collected only 17.4 percent.

Yet in rupee terms, the government budgeted to collect 484 billion and managed to collect 482 billion. Despite a revenue shortfall of 0.4 percent of GDP, in rupee terms the revenue was almost the same! Most of this is explained by inflation.

Look at it another way. Total expenditure was estimated at 26.9 percent of GDP. Now it looks like expenditure is being contained at 26.1 percent, despite a supplementary estimate being passed.

Debt Magic

This magic could not have been done without inflation, because growth was already factored in when doing these calculations. Take the debt to GDP ratio. It is projected to fall to 91.5 percent from last year’s 93.9. This is despite a fiscal deficit of 8.7 percent which is lower than the expected growth of about 7 percent.

How is this magic achieved? Inflation is the answer.

There is double digit nominal growth in our economy, just like the 2000 rupee note.

Loosely put, the economy in nominal terms, is growing faster than the accumulation of the debt stock, which is indicated by the budget deficit, and the expansion of the foreign debt due to depreciation.

For example take interest costs. In 2006, interest costs were originally estimated to be 151.2 billion rupees. Despite a supplementary estimate, interest costs would now be only 151.6 billion, because of money printing.

No wonder there is resistance to raising interest rates. You can cut government interest costs and raise inflation at the same time, by keeping monetary policy loose.

But this is actually an illusion. Though the government is ‘saving’ interest costs through financial repression and cheating the EPF, the money saved will eventually go to foreign lenders as the rupee falls due to loose monetary policy and foreign debt expands.

So the money lost by the private sector workers’ retirement fund will actually go to foreign lenders, while privately managed smart money of course, has gone out of T-bills elsewhere, and contributed to the bubble cum balance of payments crisis and high inflation.

See? There are no short cuts to reality.

As you can see, shocking and callous as it may seem, the government actually wants inflation. Otherwise it cannot balance its books.

That is why authorities have assume an inflation of 9 percent in producing the budget, and the Central Bank’s monetary program also allows this. How is that for a shocker? Et tu brute!

Samuel Johnson said that patriotism is the last refuge of the scoundrel, well inflation is the last refuge of third world economic managers. We have been doing this for 50 years. See (Thrift Column - Roots of Poverty) )

Elaborate Hoax

It is all very well to use inflation or expansionary fiscal policy (this is a polite way of saying money printing) as a device in managing public finances, but it would not do to let the people know that the government is stoking up inflation deliberately.

Then it may get booted out of office.

That is why elaborate hoaxes are created to cover up the real causes and blame inflation on all kinds of stuff. Oil, the drought, supply shocks, external shocks, and even infrastructure bottlenecks.

For fifty years we have blamed oil prices for balance of payments crises and inflation. But now it is getting difficult with knowledge of macro-economics spreading and people who are not the in the central bank speaking out.

With the oil prices now exposed as a hoax, the government is turning to the war as the next best option. The budget speech said the people had told the President that they would suffer inflation if he looked after the country.

Even the Central Bank tries to show that loose monetary policy (this is another polite way of saying money printing) is not the cause of high inflation in Sri Lanka.

Thong Bikini

The latest gimmick is to parade a core-inflation index. It is going in the opposite direction to headline inflation.

The core inflation index is like Central Bank’s ‘amude’, to use village parlance. They have taken so many things out of the index that only a few items remain, like rent, which could be responding to inflationary expectations based on last year’s inflation.

The sins of money printing cannot be covered with a core inflation index.

Anyway the excuses of the economic research department, and government’s are increasingly looking not like an ‘amude’, but a thong bikini made of plastic wrap.

If we went by that index we should now loosen monetary policy further. So we had better cut rates and reflate the economy before we go down a deflationary spiral. Ha ha!

This country has galloping inflation, at 17.2 percent in 12-months it is basically a milder case of hyperinflation. We do not need a core-inflation index to sort this out.

Small Print

A question that someone may ask is why did the government print so much money, if rupee revenues, were up to targeted levels?

Part of the answer we already know, inflation is needed. But inflation of 17.2 percent is embarrassing. So how come?

According to Central Bank’s Recent Economic Development 2006 report it has only printed 15.7 billion (5.9 billion rupees through t-bills and 9.8 billion through Central Bank advances) on an absolute basis (See page 40, 41), while credit from the rest of the banking system was 16.6 billion rupees, in total around 1 percent of GDP.

But as pointed out in Thrift Column – Handiye Kade this is because of a problem with accounting periods. In actual fact the central bank has printed much more (more than 40 billion rupees at one time) which has given rise to a balance of payments crisis.

In order to find out why the government is doing that you have to look at what is happening to the government net cash deficit.

If it grows too fast from one year to the next, it is difficult to finance, especially when foreign aid slows, unless rates are raised drastically.

In both 2003 and 2004, the government’s net cash operating deficit was lower in nominal terms than in 2001. It jumped in 2004 when foreign funding fell. But in 2005, there was lot of grant funding as well.

Outlook

What of the future?

The war is hotting up. Will there be more military hardware purchases? According to media reports we are trying to buy MiG fighter jets. We need to replace naval vessels that are destroyed.

Tourists are slowing. FDI is low. It has so far been boosted partly with telecoms, which may be peaking. Economic growth itself seems to be slowing. Year-end growth is now forecast at 7 percent. This means the last quarter is quite low.

The closure of the A-9 and the shutting off mobile networks in the North and the East must also slow activity.

Things do not look too hot. During the last few weeks, the printed money stock has come down from around 65 billion on October 27 to just over 53 billion in November 17.

This is good monetary tightening. At least 120 million dollars of pressure off the exchange rate!

There is another problem. Our foreign debt service is rising, reflecting the increasingly commercial and short term nature of our debt. Debt service as a percentage of exports rose to 11.9 percent in 2006 from to 7.9 percent in 2005 and 11.6 in 2004. As a percentage of all current receipts it was up to 9.1 percent from 6.3 in 2005 and 9.4 percent in 2005. Next year tsunami debt relief re-payments will also come in.

Exchange Rate

So in the near term the exchange rate is the concern.

The way the Central Bank is behaving does not seem to be helping the exchange rate. Thrift Column – Rupee Slide , expressed the hope that the rupee would not fall beyond 110 because fundamentals did not demand a correction beyond that at the current time.

However the Central Bank’s erratic behaviour is giving an impression of quiet desperation and of not knowing exactly what it is doing, because its actions are contrary to its public pronouncements. It spent massive amounts of money to push the rupee up to 102 at one time, and got burnt.

Now it seems to be trying to push it up again, maybe to 106 or seven levels. According to reports auditors from the Central Bank had visited three banks to put pressure on them not to speculate. This also happened in the balance of payments crisis of 2000.

But dealers know that the rupee is fundamentally overvalued. Exporters know that. So it is difficult to hold the dollar at 106 or 107.

Though oil prices are falling, retail prices are being cut. So the impact is neutral on the BOP.

According to the IMF, reserves are down to 2.6 months of imports, though the Central Bank is claiming 3 months. Is this on past performance or future trade?

It is puzzling to know why the Central Bank does not allow the rupee to stabilize at a level which will stop capital flight and also encourage exporters to bring back dollars.

We can only speculate that that authorities want to keep the year end rupee/dollar rate low, because it will make the debt to GDP ratio look good, and per capita GDP to be high.

Though fuel subsidies have been eliminated, public sector salaries have taken their place as the biggest destabilizing force in the economy. Salaries and pensions now consume about half the government revenue. Last year alone the increase was 40 billion rupees.

The stock market is breaking records within a balance of payments crisis. Shudder! Shudder! We badly need a budget of stability.

With a lame duck, lackadaisical opposition leadership which has failed to take the fight to the opposite camp and has instead managed to attract the wrath of its own membership, the government has a good chance to do what is good for the country, and not follow so-called ‘home grown’ policies imported from Africa and Latin America, like in the case of the fuel subsidy.

If sufficient fiscal restraint is not coming, further monetary tightening is needed. What cannot be achieved from fiscal policy must be achieved by monetary policy if we are to protect the national economy, the national currency and poor people.