âOur country is facing a serious currency crisis. Data from the Central Bank shows that the country’s net foreign exchange reserves are close to zero, meaning that almost all of its reserves are borrowed.
The importance of this declaration to Parliament by Mr. Basil Rajapaksa, Minister of Finance, on September 7, does not lie in the announcement of this well-known economic situation, but in its admission by the new Minister of Finance.
No pink picture
Contrary to the optimistic images painted by some other ministers, who went on to say that the problem of insufficient foreign exchange reserves would soon be solved by inflows of foreign currency, this statement recognizes the critical state of the country’s foreign exchange reserves and implies the need to solve it.
Recognizing the seriousness of the problem is an essential first step in finding solutions. However, the country’s external financial vulnerability can only be addressed with a new vision that adopts essential economic reforms. Persistent trade and balance of payments deficits are the result of inappropriate monetary, fiscal and trade policies.
While COVID has exacerbated the external financial difficulties due to the loss of tourism revenue, on the one hand, and increased spending, on the other hand, the precarious state of external finances has been caused by structural deficiencies and inappropriate fiscal and monetary policies.
Solving the problem requires economic policy reforms. International aid, whatever its source, is an essential and immediate need, but such palliatives, while essentially important, will not resolve the fundamental imbalances in the economy.
As the Minister of Finance himself noted in his September 7 speech to Parliament, public finances are in a precarious state with declining revenues and spending continuing to rise. Correcting this fiscal imbalance is vital for economic stability.
Large budget deficits negatively affect all sectors of the economy. Reducing the budget deficit or fiscal consolidation requires a dual strategy of reducing public spending and increasing public revenue.
The possibility of reducing public spending is limited due to rigidities in public spending. The bulk of government spending is on wages and pensions, debt service costs, and public enterprise (SOE) losses. However, prudence in public spending, reform of state-owned enterprises to reduce losses and not to undertake large unproductive capital expenditures are essential to reduce spending.
The improvement in income is the most important. As the Minister of Finance noted, many of the major sources of revenue have dried up. He told the House: “Due to COVID-19, government revenue for this year has fallen between 1.5 trillion and 1.6 trillion rupees from the estimated amount.”
These deficits included import duties on cars and other “non-essential imports” and on gasoline, excise duties on liquor and the income tax relief in the last budget.
Monetary expansion has been an underlying cause of economic destabilization. Now that it is clearly evident that the monetary policies adopted by the government have caused inflation and external financial instability, it is prudent to abandon it and pursue a moderate monetary policy.
Several prominent international trade economists have stressed that trade policy reforms are vital for increasing the country’s exports. In a recent webinar hosted by the Advocata Institute, Dr SarathRajapatirana, former head of the World Bank’s Trade Division, Dr Dayaratna Silva, former Ambassador of Sri Lanka to the World Trade Organization (WTO} and Australian National University (ANU) Emeritus Professor of Economics, Dr Prema-chandraAthukorala, stressed the need for trade reforms to expand the country’s exports by making them competitive in the global market.
âCountries that have grown rapidly, especially in East Asia, have understood the importance of trade reforms,â said Dr SarathRajapatirana.
The first step, he said, of such a reform program should be to simplify border taxes by removing paratrix. These are fees and charges in addition to the import duties that have been imposed. He advocated a single, uniform tariff of 15 percent for all imports.
Dr Rajapatirana pointed out that Sri Lanka’s trade as a percentage of GDP has been low compared to Thailand and Vietnam because we have not exploited our trade opportunity as we have high tariff rates compared to other developing countries.
In addition, although tariffs play a role in protecting domestic infant industries, if they are too high, they can become anti-competitive. Dr Rajapatirana observed that recent import restrictions, such as the ban on a wide range of consumer goods from April 2020, further worsened Sri Lanka’s growth potential and put Sri Lanka in contradiction with the rules of the WTO.
World Trade Organization (WTO)
Dr Dayaratna Silva explained the serious consequences for Sri Lanka’s economy if such import restrictions continue. There is a possibility of tariff retaliation.
“Prolonged import controls are not WTO-compliant, and it is high time they were corrected,” he said.
He also warned that such forms of retaliation could have a significant negative effect on our imports, exacerbating our current currency and balance of payments crisis.
“My concern is the long-term industrial development of the country due to these restrictions and the inefficiently allocated resources as a result,” he added.
Ambassador Denis Chaibi, head of the European Union delegation to Sri Lanka and the Maldives, stressed the importance of adhering to global trade rules.
âThe European Union is trying to have a rules-based order. When a country does not follow these rules, the rules-based structure is affected. Without trade, Sri Lanka’s prospects are not good, âhe explained.
EU trade sanctions would be a disaster.
âNo country in the world today produces goods from start to finish within its geographic boundaries. Countries specialize in different components of the production value chain. The Made in the country X label has become invalid, âexplained Professor Prema-chandraAthukorala, Emeritus Professor of Economics at Australian National University (ANU), who is an authority on global production networks.
Professor Athukorala underlined the importance for a country âto identify its comparative advantage within the production networkâ.
He stressed that Sri Lanka cannot achieve economic growth without joining global production networks through trade.
He concluded by commenting on recent developments in import controls.
âSelective intervention, without disrupting the country’s incentive structure as a policy, is going to be a recipe for disaster,â he said.
Foreign aid is of crucial importance to overcome the current external financial crisis. Whatever the source of such assistance, it is only a stopgap. The long-term economic stability and growth of the country depends on the adoption of a policy framework conducive to the competitiveness of exports.
The policies of import substations failed to improve the trade balance, on the one hand, and on the other hand, created shortages of basic goods and private industries of raw materials. Trade liberalization to ensure the competitiveness of international trade is the way forward.
While such trade policy reforms are necessary, they are insufficient. Comprehensive changes in monetary and fiscal policies are imperative. Fiscal reforms that are gradually moving towards fiscal consolidation are vital for the stability and growth of the economy.
The recognition that the country is in economic crisis is only the first step. The courage to change failed policies and adopt comprehensive economic reforms is imperative.
Will the government have the political courage and determination to adopt such reforms?
Isn’t it appropriate that all political parties unite in a national effort to save the country?