Sri Lankan Open Economy Model – The Risk, Shock and Policy Challenge in the Model Remix

 

After the independence from the British rule, Sri Lanka has been operating in the global economy at different degrees depending on the concepts of the people who managed the economy at different times. The year 1977 is considered as the landmark as open economic policies were introduced as the economic management model opening both the private sector and foreign sector to do businesses largely in a market environment. The gradual liberalization in trade and foreign exchange and the government’s withdrawal from business activities to allow the private sector to expand were the ground conditions in the new model. This was nothing but an attempt to entering the global economy for seeking comparative advantages through the evolving economic globalization for the development and upliftment of living standards of the country.

Although debatable on micro details, the global economy provides the country with the opportunity to produce, consume, save, invest and employ on a wider or global window of resources and markets. Therefore, the open economy model works well for competitive nations for economic objectives much better than the nations closed from the rest of the world to live on its means within the country. The trade in goods, services and factors is the heart of the open economy.

All developed countries and many developing countries are ground examples for the countries benefiting from open economy models. However, it is not a one-size-fit-for-all due to the presence of the governments intervening in all corners of the economy and social life at different degrees in different countries. Therefore, geopolitical factors also have determining effects on the efficacy of the model.

Economic Fundamental in Sri Lankan Context

• Trade as a key economic fundamental

    Economic analysts talk about sound economic fundamentals by referring to certain economic variables such as GDP growth, inflation, budget deficit, monetary growth and exchange rate. However, these are only some of the policy and economic outcome variables. The fundamentals are the ingredients of the foundation of the economy such as the resource base and complementary systems that keep the economy functioning to produce those variables at desirable levels. Such fundamentals can be seen as strong or weak depending on the economic outcomes they produce.  In this context, access to the global economy has been a key strong fundamental that has been instrumental in the Sri Lankan economy evolving since its independence. Some analysts even cite Sri Lanka as an import-based economy while some criticize imports.

To be technically more precise, Sri Lanka is largely a foreign trade-based economy as foreign trade performs as the lever to almost all corners of the economy. One can look around in and out and understand the level of foreign content in the economy and the living standards of people.

• Present shock to the fundamental

     Many people are now agitating because the Coronavirus and certain policy responses have tended to disrupt this fundamental. Shortages seen in many markets and resulting erosion in income, employment and living standards are the direct hit from the disturbance to the trade base of the economy. Many experience it but lack understanding of the fundamental reasons. However, they all know that ad-hoc price controls imposed as solutions to such shortages only aggravate the shortages as they are unable to fix the disturbance in the fundamental.

How Sri Lankan Trade Economy Functions

• Imports provide inputs for export industries, domestic agriculture, investments, constructions and domestic or import substitution industries.
• Imports provide essential goods and services for general consumption to maintain living standards.
• Service exports such as tourism industry and ports generate a lot of economic activities and require imports.
• Large remittance inflow is de-facto exports of labor that cushion the trade economy.
• Foreign investment provides the inflow of foreign exchange to finance foreign payments as earnings on exports are not sufficient.
• The country accumulates a foreign reserve for future use when it receives foreign exchange more than its pays out.

        One can find how the life of a person living in a corner village depends on this foreign trade. An increase in the exchange rate or the price of foreign currency is not just a matter seen in the Colombo foreign exchange market unknown to many people but a matter that has a wide impact on all people directly and indirectly.

        In modern monetary economies, trade flows result in surpluses and deficits financed by financial/investment flows. Therefore, one cannot find fault with the deficit or surplus per se, but concerns can be raised on maintaining them at sustainable levels.

Where is the Model Risk? Facts from the BOP Numbers

The true nature how the economy has run on the trade fundamental can be figured out from the BOP. Although certain trends are seen in some periods, the macroeconomic story sketched from the BOP is largely the same as highlighted below.

• The trade deficit has got widened by raising import of resources to facilitate the economy.

• Services trade (including Sri Lankan labour abroad) has expended favorably to generate a surplus to finance the trade deficit to some extent while helping the growth of economic activities.

• The current account deficit (goods, services and remittances) is a routine course of the economy to import net real resources from the global economy.

• Therefore, foreign investment inflow or trade in finance/capital finances the current account deficit and the foreign reserve as the safeguard for the economy in the global economy.

• Although the private sector is dynamic on trade in goods and services, its position in foreign investment or capital trade is limited, mainly due to exchange controls and low profile of international business sentiments in the country. This shows a wide mismatch in trade liberalization, i.e., current account liberalization with controls on capital/investments.

• Therefore, foreign debt flow to the state sector (government and state institutions) has been the routine to finance the current account deficit and repayment of investment. This debt flow which had been from official sources has largely shifted to market sources and instruments during the last decade resulting in the state/country to be exposed to volatile financial markets.

• The debt/financial packages from the IMF and World Bank group have been a routine source in resolving short-term BOP difficulties and encouraging policy reform while attracting business confidence from international investors. This is the use of the international financial system available for the macroeconomic safeguards of the countries as evolved from time to time since 1944.

• As there is no surplus in the current account, the country’s foreign reserve also has been funded by the proceeds of state foreign debt on interim basis. Therefore, the country’s money printing and money market liquidity also have linked to such debt flows where the balance sheet of the central bank is around 70%-80% on foreign assets and changes in the monetary liquidity are caused by investment flow to the government securities market.

• The exchange rate is virtually a policy variable controlled by the debt-financed foreign reserve at levels desired by the relevant bureaucracy to subsidize the economy from the pressure from the currency depreciation arising from protracted BOP deficits or shortages of foreign exchange. This is another typical price control that has destabilizing effects on markets, despite the claim on price control for stability.

• Therefore, Sri Lanka’s trade economy model has been functioning on the state foreign debt. This is the model's risk point built up over the past decades where the government has become the victim. During the past decade, the relevant bureaucracy was on a regular game with a network of investment bankers to raise foreign debt from market sources as a part of the macroeconomic management strategy based on ambitious targets of the foreign reserve and exchange rate. As a result, frequent roll-over of foreign debt has become necessary to settle the existing debt and maintain the foreign reserve. This has created uncertainties and difficulties in debt servicing. Therefore, some cite this as the debt trap.

The Coronavirus Shock to the Model 

        The disruption in global supply chains caused by the global Coronavirus and immediate policy responses have shocked this state debt-financed trade economy model and led to acute shortages of debt roll-overs. Therefore, debt service has led to a run on the foreign reserve and acute shortages of foreign exchange whereas the relevant bureaucracy seeks to grab the existing supply of foreign exchange from the private sector. This is channel through which the Coronavirus shock has created economic difficulties and shortages to businesses and households across the country. This has been the case for many emerging market economies.

        The global economy and financial system are evolving to assist the countries to fight this crisis as in the past. The IMF has provided nearly US$ 116 bn to 85 countries by means of new credit, extension of existing credit and debt service relief. The ultra-loose monetary policies pursued by the developed countries have supplied abundance of reserve currencies that will ensure the global financial system operating without liquidity crunches. There are several instances of debt reliefs provided by lenders on a merit base. Therefore, the international flow of debt/capital has the potential to be restored no sooner than the global instabilities created by the Coronavirus are eased as the global economy has no alternative. Therefore, the policy option available for Sri Lanka is to hang on to the present financing model for the time being.

The Policy Challenge

• The first is to resume the existing model so that the economy and people are able to fight the Coronavirus and stay alive economically. There are bureaucracy lines responsible for this.

• The second is to detect the defects of the model and refix it gradually. As highlighted above, the defect is the BOP finance by the state foreign debt as the capital control system was not complementary to the private sector. Therefore, it is necessary to facilitate the private sector to take part in its own sourcing of finance for global trade transactions. A system that has evolved through several decades cannot be refixed overnight or in few years. Therefore, the refix will take several years as the government has to play the key role in restoring the international business confidence which is the precondition for the private sector to take risks.

• Thirdly, the economy has to evolve to reduce the current account deficit over time to manage the foreign debt level at sustainable levels. This requires periodical policy-finetuning based on BOP targets. In this regard, it is necessary to examine failures of present line bureaucracies that have caused the risky state debt-financed economy and ensure that they take charge of their respective policy duties to resolve failures in the interest of achieving national targets. The role of the state foreign debt is primarily connected with the fiscal front and not connected with financing the country’s BOP or ambitious targets of the foreign reserves.

Modern monetary economies function on money created by credit/debt domestically and globally. Therefore, there is no alternative to debt finance until the world finds a new system. However, the challenge is to prevent debt bubbles beyond the economic capacity to ensure that economy is sustainable on a going basis. That exercise has no benchmarks but has to be carried out on a trial-and-error basis. It is not uncommon to confront crises, despite the lines of the bureaucracy that is mandated to prevent them. Therefore, the present debt level is not a matter to be resolved now, given other national issues presently at hand.

Otherwise, the continuation of imposition of control after control by the scattered and panic bureaucracy in the present fashion will no doubt push the economy to the pre-1980s world of closed economies and living standards which nobody wishes. People do not need to know Economic Principles to understand disruptions created by all sorts of price controls to the economy and living standards. As markets are driven by people and the price in markets is a result of a discovery process taking place frequently, bureaucratic interventions will always lead to unpredictabele adjustments in the market forces and prices.