Stability, but at what cost?

• Sri Lanka also has to focus on investment to reduce inflation
• In December 2022, UK inflation as per the Consumer Prices Index stood at 10.5%, the highest in 40 years
• Sri Lanka also has just 1% of total exports in the ‘high technology’ category
• Illanperuma believes that Sri Lanka has to immediately build production capacity
• In the long-term Sri Lanka needs to consider a variety of other tools aside from deflationary policies that seek to reduce the size of the proverbial pie by contracting demand
• Traditional manufacturing countries such as South Korea (0.35) and Japan (0.34) score highly on the CIP index

Last week, much of the UK came to a standstill as the country saw its single largest day of industrial action in over a decade; some estimates put the number at around 500,000 protesters. Seen in the thick of this industrial action were nurses, teachers, university staff, civil servants and train drivers; forming a broad coalition from across the gamut of the British working class.  

The protests are a response to what the BBC, the Guardian and many others have referred to as ‘soaring’ inflation in the UK; higher food prices and what Bloomberg has described as an ‘unbearable’ rise in energy costs. Millions of households in the UK are unable to afford their energy bills while businesses are “struggling to survive” as per another BBC report.

In December 2022, UK inflation as per the Consumer Prices Index stood at 10.5%, the highest in 40 years, the Bank of England’s (BOE) target for inflation was 2% and in response, interest rates were increased to 3.5%, the highest in14 years since 2008’s financial crisis. In Sri Lanka, as per the Central Bank of Sri Lanka’s (CBSL) National Consumer Price Index (NCPI), inflation stands at 59.2% at end December 2022, having peaked at 73% in September 2022. Interest rates are down around 3% as the average commercial bank lending rates (AWPLR) creep around 25-26%, down from an average of around 29% in Q4 2022.

As part of the interview series: ’Insight’ which airs on the DailyMirror Online platform, I interviewed Shiran Illanperuma, an economist and researcher, to gain some clarity on the Government’s policy trajectory and to analyse their plans to reduce inflation by some meaningful measure in the near future. Considering the protests of the Aragalaya and the urgency of Sri Lanka’s economic collapse, especially considering the mass protests we have just witnessed in the UK, the Sri Lankan Government must make every effort to ease the burden of suffering on the poorest and most vulnerable if our society is to survive this once-in-a-generation economic crisis.

The Liberal Antidote

Illanperuma notes the “relative stability” in contrast to near dystopian scenes around shops and petrol sheds throughout much of 2022, a far cry from the post-war peace dividend the people were promised in 2009. Now, as the new tax brackets come into force, even the once prosperous professional class has begun a broad agitation, citing the cost of living and subsequent brain- drain.

The broadly deflationary policies, including higher interest rates, were perhaps a necessary evil to stabilise the economy, but Illanperuma notes that “disgruntled young professionals, as much as they might criticise the so-called populist policies that some economists claim to have brought us here; once the liberal antidote to that is administered, they also react to it, so there is a little bit of an irony there.”

It is important to first investigate the source of Sri Lanka’s inflation.  Illanperuma states that much of the inflation in Sri Lanka is ‘imported’; the devaluation of the currency led to a massive spike and thus, deflationary policies have aimed to tame this spike. Illanperuma believes that it is difficult to conceive of how a deflationary policy can reduce imported inflation materially and also notes that the Government’s policy to revert to a ‘soft peg’ of the Sri Lanka Rupee against the US dollar will be one reason that inflation has ‘stabilised’.

This brings us to the following statement from President Ranil Wickremesinghe at a forum for Tea Factory Owners in November 2022: “The only way in which we can raise foreign exchange reserves is by selling off some of our enterprises for dollars, so that we can at least put $ 3-4 billion into the reserve, strengthening the rupee further...” There were similar statements in the aftermath of the budget, whereby the President reiterated calls to generate revenue by selling even those profit-making SOEs in order to “strengthen” the country’s reserves and the bring down the price of imports by introducing a peg at a lower rate. In the event that Sri Lanka is unable to raise the ‘$ 3-4 billion’ that the President mentioned, the alternative will be to build reserves with fresh borrowings, as has been the case in Sri Lanka for many years. This appears to be the only real plan to tackle inflation.

Illanperuma is clear that this is a complex process and that alternatives may not seem immediately evident, but that in the long-term Sri Lanka needs to consider a variety of other tools aside from deflationary policies that seek to reduce the size of the proverbial pie by contracting demand.

Symptom vs the disease

The symptoms of the disease are the trade deficit and high foreign currency borrowings; the disease itself is a lack of foreign exchange revenue created by a failure to diversify inflows over many decades, becoming reliant on the global trading networks to bring us the cheapest products which disincentivize local production. Illanperuma states that trade deficit issues are not unique to Sri Lanka: “the reason the Rupee is devaluing is due to the trade account”, there is simply not enough demand for Rupees in the global market and in fact many developing nations face problems due to their manufacturing and exports usually being mainly agricultural primary commodities and very low value-added products, inevitably creating “downward pressure on the currency which is upward pressure on inflation”.

Illanperuma believes that Sri Lanka has to immediately build production capacity by reorganising the agricultural sector to produce the bare minimum that the country needs to survive, be it vegetables, grain, eggs, dairy; creating some level of self-sufficiency and thus reducing our exposure to volatility in external markets. He further notes that the “energy sector is heavily underinvested, meaning we do not have the ability to build reserves” while also stating that reserves do not just have to be money, they can be absolutely anything that make up the key inputs that you need for consumption and production, it could be grain, it could be some other commodity, it could be other currencies like the Yuan. The point is to build buffers in a sustainable manner.

The most worrying aspect of the policy discourse over the last two years has been the lack of attention paid to diversifying our foreign currency inflows. Illanperuma calls this the ‘tunnel vision’ of mainstream economic discourse, “which has narrowed the conversation down to a few sets of very broad macro tools” that revolve around the interest rates, exchange rate and tax policy. “Anything in the realm of industrial policy is not discussed at all because as they say the government should not be picking winners, that of course has no relation to the actual historic experience of development in a lot of countries: Japan, China, South Korea, Post-War Germany. There is always an assumption that if we just got these things right, if we balance the budget, if we set the interest rate to the ‘right’ level and the exchange rate at whatever the ‘correct’ market rate is, that things will just happen, as if by some force of nature, but you actually need positive organised human intervention to get production going and to get a productive eco-system up and running”.

The Competitive Performance Index (CIP) is a measure of industrialisation, it aims to “benchmark competitive industrial activity by countries against the backdrop of liberalisation and globalisation” (UNIDO). The CIP is a composite of MVA per capita, manufactured exports per capita, industrialisation intensity and export quality. Traditional manufacturing countries such as South Korea (0.35) and Japan (0.34) score highly on the CIP index, but Singapore, which you might perceive as having a more service-oriented economy, had a score of 0.26. Sri Lanka has a CIP of 0.03. Sri Lanka also has just 1% of total exports in the ‘high technology’ category; which requires investments in research and development; Japan has ‘high-tech’ exports at 19%, South Korea at 36%, Vietnam at 42% and Singapore at 55%. (Figures are for 2018)

A new phase of development and growth

When one asks the question as to what is the alternative to the neo-classical solution, Illanperuma notes that this is the wrong question, as the current path does not offer a real solution. “Let’s say you get a budget surplus, then what? Let’s say the exchange rate reaches the market level, whatever it is, what are you going to do next? That’s not a question anyone is looking at answering”

He provides Japan as a classic example, which required interventions which might seem extreme by today’s standards. Stretching back to before the mid-20th century, Japan was planning its industrialisation. There was a strict tracking of export proceeds, one hundred percent of which had to be handed over to the government. The State would in turn prioritise the allocation of foreign currency, they even had separate budgets, one for Dollars and one for the local currency; the Dollars were rationalised to pay for patents and technology transfers which were deemed essential to climbing the manufacturing value chain. Mr. Illanperuma notes the challenges faced by Japan including fiscal restraints during US occupation post-World War II and the austerity measures implemented. “The Japanese bureaucracy knew they had to play the game” satisfying American interests and engaging the industrial class while keeping workers happy enough to prevent them from turning to lingering communist movements.
The Japanese implemented monetary financing through setting up several development and policy banks to support industry and technological advancement. Instead of providing subsidies, the Japanese state provided credit to particular sectors to support activities related to industrialization. This is perhaps a good starting point as Sri Lanka already has a rich history of Development Banking, crucial to the economy’s long-term sustainability. In a country that is 85% rural, with rising poverty, food insecurity and child malnourishment, the need for development has never been greater while the hunger for growth has never been more urgent. We must ensure that while we grow, the country is also able to develop, and that society can envision a path to some form of relative prosperity.

(INSIGHT with Kusum Wijetilleke is available on YouTube, Facebook, Instagram) : https://www.instagram.com/tv/Cn03L6YPmx3/?igshid=MDJmNzVkMjY=
Email: [email protected]
Twitter: @kusumw