Overcoming the Unexpected
Sri Lanka is some two weeks away from its 16th General Election since Independence. It follows the COVID-19 pandemic and the resulting global lockdown, a truly black swan event to affect the modern world. We have to go back over a century to witness a similar previous episode i.e. the Spanish flu in 1918. Never before was the global economy deliberately placed in an induced coma. What Sri Lanka and the rest of the world are experiencing is no normal recession, but one that results from explicit policies enforced to avoid a widespread public health disaster.
Such unique characteristics of this yet unfolding recession pose unfamiliar challenges. On the demand side, lockdowns and social distancing have made policy stimulus insensitive to consumer spending. On the supply side, government control measures have directly slowed production, impacting all supply chains.
These induced disruptions and resulting cash flow mismatches can potentially permanently scar any economy with large-scale lay-offs and liquidations. The impact of the pandemic on financial markets was also unprecedented, with heavy sell-offs followed by sharp tightening. A variety of commentators wheeled in by news agencies offering instant remedies became commonplace, as well as a spate of webinars – which soon ran out of value-add.
What can we say about the response? Equally unprecedented, governments and central banks across the world responded decisively to limit the consequences of the sudden end to spending and activity, and the financial markets’ nosedive. Oil at an unthinkable negative price reflected the general widespread turmoil. To cushion the impact, some authorities exhibited innovation and speed; Sri Lanka did so belatedly, accompanied by silence and poor execution. Lessons need to be learnt here.
On the fiscal side, governments globally launched bulge-bracket stimulus packages and forecast fiscal deficits on a scale unseen since the Second World War. The US led the charge with an injection exceeding US$ 2 trillion, some 10 per cent of their GDP. But local critics noted that Sri Lanka offered only peanuts when a bazooka was needed. The miserly amount was rapidly up-rated when the scale of the issue became more visible.
Sri Lanka’s historical macro-economic stress has resulted in Sri Lanka becoming a twin-deficit country.Three trends provide insight into how Sri Lanka became a twin-deficit country. Revenue declined from 19-20 per cent of GDP in the 1980s, ‘90s and early ‘20s, to 11.5 per cent of GDP in 2015 (now 13.5 per cent of GDP). Exports declined from 32 per cent of GDP in 2000 to 12.5 per cent in 2015 and it has further worsened with COVID-19 impact. Remittances and Tourism earnings is also in a crisis situation. External commercial borrowing increased from 5 per cent of total debt in 2006 to 25-30 per cent in 2019. It will further widen with upcoming Government borrowing plans.
Given the vulnerability engendered by these negative trends, sound macro-economic policy making must be prioritised to avoid a severe financial crisis, particularly as Sri Lanka has entered the new paradigm of being exposed to rating agencies and international capital markets.
Central banks were swift to cut policy interest rates and launch large-scale balance sheet measures. As they can mobilise financial resources faster than any other authority, central banks were in the forefront. Their action focused on large-scale purchases of government debt as well as credit support for firms and households. Hence, we saw the funding-for-lending schemes, purchases of corporate debt, and support provisions for SMEs. The main objective was to prevent strained liquidity leading to bankruptcy of solvent firms, thereby maintaining growth potential.
In the context of gigantic government borrowing needs as fiscal deficits rise and debt levels elevate, large-scale government bond purchases aimed to lower interest rates, provide monetary stimulus and assist the functioning of the markets. This reflects the rarely employed role of the central bank as a market stabiliser and financial intermediary between fiscal authorities and financial markets. Its use should be temporary, limited by scale, and in line with their mandate to retain financial stability in managing a sudden ramp-up of fiscal spending induced by an abnormal but transient event.
The life cycle of such externally-induced crises is likely to travel via three phases: liquidity, solvency and recovery. Many would say we are now at the end of the first stage, approaching the limits of monetary policy. For the next two phases, there will have to be more reliance on fiscal and structural policies while guarding against the growing nexus between fiscal and monetary policies and central bank independence.
As the resulting elevated debt levels can be inflated away, fiscal sustainability should be assured. Thus in the case of Sri Lanka, the new budget of the post-election Government should focus on fiscal strategies, restraint in future spending and generating sound revenue policies. The most direct route to fiscal sustainability lies in economic growth. This means implementing structural reforms to lift potential growth rates, mitigating failure of healthy firms, orienting fiscal policies towards investment, preserving global supply chains and promoting free trade.
The bottom line is to recognise the limits of monetary policy. We end with some specific ideas for the forthcoming newly-elected Government:
Refrain from promoting local uncompetitive sectors
Undertaking essential sector reforms
Refrain from funding free cash flow negative capital projects
Undertake privatisations and capital market reforms
Lift ease of doing business and similar indexes
Close the gaping holes in international relations and practice as a non-aligned nation.