It would be a sui­ci­dal mis­sion for the Cen­tral Bank to un­der­take in­fla­tion tar­get-based mone­tary pol­icy with­out strictly en­forc­ing bud­get dis­ci­pline by the gov­ern­ment, as I cau­tioned in my ar­ti­cle ap­peared in Daily Mir­ror of Oc­to­ber 31, 2017. Al­though I an­tic­i­pated it would spark a heated de­bate, sev­eral writ­ers have ex­pressed sim­i­lar sen­ti­ments favour­ing my ar­gu­ment in their sub­se­quent news­pa­per ar­ti­cles.

The point that I raised is that the Cen­tral Bank alone can­not tackle in­fla­tion whilst the fis­cal au­thor­ity, which is the Fi­nance Min­istry, con­tin­ues to fuel in­fla­tion by fi­nanc­ing its bud­get deficit through bank bor­row­ings. The prob­lem be­comes acute when such bor­row­ing is ob­tained from the Cen­tral Bank, which is known as seignior­age. It causes an in­crease in the mone­tary base ac­com­pa­nied by new money print­ing and mul­ti­ple ex­pan­sion of the to­tal money sup­ply lead­ing to speed up in­fla­tion. Hence, re­duc­tion of the bud­get deficit be­comes cru­cial in in­fla­tion tar­get­ing.

From mone­tary tar­get­ing to in­fla­tion tar­get­ing

Since the 1980s, the Cen­tral Bank has been con­duct­ing mone­tary pol­icy with a tar­geted mone­tary ag­gre­gate. Glob­ally, mone­tary tar­get­ing is found to be prob­lem­atic due to the in­sta­bil­ity be­tween mone­tary ag­gre­gates and goal vari­ables such as in­fla­tion. As a re­sult, mone­tary tar­get­ing frame­works have been down­played or aban­doned in sev­eral coun­tries.

A num­ber of mone­tary au­thor­i­ties have be­gun to use in­fla­tion tar­get­ing for the con­duct of mone­tary pol­icy fol­low­ing the suc­cess in New Zealand, which launched in­fla­tion tar­get­ing in 1990. Ac­cord­ingly, the cen­tral bank as­sumes the re­spon­si­bil­ity of main­tain­ing a pre-an­nounced in­fla­tion tar­get us­ing a mone­tary pol­icy tool such as in­ter­est rates. In this case, the Cen­tral Bank is to­tally ac­count­able to keep in­fla­tion within the tar­get. The suc­cess of in­fla­tion tar­get­ing de­pends on sev­eral fac­tors. In par­tic­u­lar, the fis­cal pol­icy con­sid­er­a­tions should not dic­tate mone­tary pol­icy.

The Cen­tral Bank is to em­bark upon a mone­tary pol­icy frame­work in due course with an in­fla­tion tar­get of 4-6 per­cent en­vis­ag­ing a de­cline in the bud­get deficit to 3.5 per­cent of gross do­mes­tic prod­uct (GDP) by 2020. Leav­ing aside the prac­ti­cal dif­fi­cul­ties in at­tain­ing such an op­ti­mistic fis­cal tar­get, a dis­turb­ing fea­ture in bud­get 2018 is that it makes no ref­er­ence to the crit­i­cal need of ad­her­ing to strict fis­cal dis­ci­pline in the con­text of the en­vis­aged in­fla­tion tar­get­ing frame­work.

Blue-green econ­omy vs. fis­cal rules

The theme of bud­get 2018 is ‘Blue-green bud­get; the launch of enterprise Sri Lanka’. In my opin­ion, fis­cal rules aim­ing at in­fla­tion tar­get­based mone­tary pol­icy should have been the un­der­ly­ing theme of the present bud­get speech rather than pe­riph­er­als such as ‘blue ocean’ and ‘green en­vi­ron­ment’ that are given promi­nence in the bud­get speech, though they may be im­por­tant in their own right.

But as far as macroe­co­nomic sta­bil­ity is con­cerned, noth­ing is im­por­tant than en­forc­ing fis­cal rules so as to bring down the bud­get deficit, which has given rise to mul­ti­ple eco­nomic haz­ards – to name a few, in­fla­tion, high cost of liv­ing, low real in­ter­est rates, over­val­ued ex­change rate, anti­ex­port bias, im­port rise, bal­ance of pay­ments deficits, un­cer­tain in­vest­ment cli­mate and as­set bub­bles.

Unattain­able deficit tar­gets

The pro­jected bud­get deficit for 2018 is 4.8 per­cent of GDP, ac­cord­ing to the bud­get speech. It is doubt­ful whether the ac­tual bud­get deficit could be re­tained within this tar­get next year, given the poor track record in the past and the pos­si­ble spend­ing spree with the up­com­ing elec­tions. The pro­jected deficit for 2017 was 4.7 per­cent of GDP as per last year’s bud­get speech, but the ac­tual deficit has gone up to 5.2 per­cent of GDP.

A ma­jor rea­son for over­step­ping the deficit tar­get is the ac­com­mo­da­tion of a large num­ber of sup­ple­men­tary es­ti­mates each year to cover up huge amounts of ad­di­tional ex­pen­di­ture, which were not in the orig­i­nal bud­get es­ti­mates. The most re­cent ex­am­ple is the seek­ing of par­lia­men­tary ap­proval for sup­ple­men­tary es­ti­mates just two days ahead of the bud­get speech to the tune of Rs.11,206 mil­lion to cover up the con­tin­gent li­a­bil­i­ties in­curred by sev­eral min­istries for for­eign trips, ve­hi­cle main­te­nance, etc. A se­ries of such sup­ple­men­tary es­ti­mates were ap­proved this year for pur­chas­ing of new ve­hi­cles for par­lia­men­tar­i­ans and sim­i­lar ex­trav­a­gant ex­penses.

Elec­tion good­ies

In order to sat­isfy the vot­ers so as to re­tain power at each elec­tion, politi­cians have a ten­dency to of­fer var­i­ous wel­fare ben­e­fits to house­holds such as hand­outs, cash trans­fers and food sub­si­dies and also to cre­ate jobs for them in the pub­lic sec­tor. Such pop­ulist pol­icy pref­er­ences in­vari­ably lead to raise the gov­ern­ment ex­pen­di­ture, bud­get deficit, pub­lic debt, money sup­ply, in­fla­tion bal­ance of pay­ments deficits. The out­comes are high cost of liv­ing, food short­ages, sub­sidy cuts and var­i­ous other hard­ships. This is the kind of po­lit­i­cal cul­ture nur­tured in this coun­try through­out the post-in­de­pen­dence pe­riod.

By and large, so­ci­ety has got ac­cus­tomed to the habit of de­pend­ing on such ben­e­fits pro­vided by the gov­ern­ment to meet their ba­sic needs. This de­pen­dency syn­drome has led to in­ef­fi­ciency, cor­rup­tion and var­i­ous other eco­nomic ills pulling down the econ­omy over the decades.

This process is con­tin­u­ing even now in the midst of the lo­cal gov­ern­ment elec­tions to be held soon. Just two days ahead of the bud­get speech, for in­stance, the gov­ern­ment re­duced im­port du­ties on se­lected food items – pota­toes, big onions, dhal, dry fish and sprats.

Frag­ile rev­enue out­look

Tax rev­enue is the main source of gov­ern­ment rev­enue ac­count­ing for 88 per­cent of the to­tal re­ceipts pro­jected for 2018. The en­tire bur­den of fis­cal im­prove­ment falls on in­di­rect taxes im­posed for goods and ser­vices con­sumed largely by the or­di­nary peo­ple. The ad­di­tional tax rev­enue ex­pected for 2018 is Rs.285 bil­lion, of which as much as Rs.218 bil­lion or 77 per­cent is to be col­lected from in­di­rect taxes con­sist­ing of taxes on goods and ser­vices and tar­iffs on for­eign trade.

The in­creased rev­enue to be gen­er­ated from in­come tax in 2018 is only Rs.67 bil­lion, ac­count­ing for 23 per­cent of the tax rev­enue hike. The gen­er­ous tax con­ces­sions granted to in­vestors and wide­spread tax eva­sion have re­stricted the growth of in­come tax rev­enue over the years.

As a re­sult, the in­di­rect tax com­po­nent will con­tinue to re­main high at 82 per­cent of the to­tal tax rev­enue in 2018, in con­trast to the repet­i­tive pol­icy an­nounce­ments made by the gov­ern­ment to re­v­erse the in­di­rect to di­rect tax ra­tio to 60:40. The gov­ern­ment ex­pects that the on­go­ing in­land rev­enue re­forms, in­clud­ing the new In­land Rev­enue Act, would raise rev­enue in years to come fa­cil­i­tat­ing fis­cal con­sol­i­da­tion.

Un­man­age­able ex­pen­di­ture out­lays

The re­cur­rent ex­pen­di­ture is ex­pected to ac­count for 75 per­cent of the to­tal gov­ern­ment ex­pen­di­ture (15.8 per­cent of GDP) in 2018 leav­ing the bal­ance 25 per­cent for pub­lic in­vest­ment (5.4 per­cent of GDP). As in the pre­vi­ous years, the bulk of the re­cur­rent ex­pen­di­ture in 2018 will go to in­ter­est pay­ments, salaries and wages, sub­si­dies and trans­fers. The in­ter­est pay­ments on ac­cu­mu­lated pub­lic debt will be Rs.820 bil­lion. The widen­ing fis­cal deficits have com­pelled the suc­ces­sive govern­ments to rely on ex­ten­sive do­mes­tic bor­row­ings and for­eign com­mer­cial bor­row­ings aug­ment­ing the debt ser­vice bur­den to un­sus­tain­able lev­els.

The ex­pen­di­ture on salaries and wages will amount to Rs.705 bil­lion next year. The gov­ern­ment’s wage bill has gone up mainly due to an un­prece­dented ex­pan­sion of the pub­lic sec­tor with a huge work­force run­ning into over 1.3 mil­lion em­ploy­ees. In other words, one per­son out of ev­ery 15 per­sons is a gov­ern­ment em­ployee.

Wel­fare sub­si­dies to house­holds and trans­fers to loss-mak­ing state-owned en­ter­prises amount to Rs.507 bil­lion. The pop­ulist con­ces­sions in­tro­duced in suc­ces­sive bud­gets have con­trib­uted to aug­ment the sub­si­dies and trans­fers con­tin­u­ously.

Fis­cal rules es­sen­tial for in­fla­tion tar­get­ing

In 2018, the bank­ing sys­tem will be com­pelled to fi­nance as much as Rs.120 bil­lion, ac­count­ing for 18 per­cent of the bud­get deficit. This fig­ure is likely to go up fur­ther in the back­ground of this year’s phe­nom­e­nal in­crease in ac­tual bank bor­row­ings to the tune of Rs.170 bil­lion as against the orig­i­nal es­ti­mate of only Rs.32 bil­lion in­di­cated in bud­get 2017.

Part of the an­tic­i­pated bank bor­row­ings will un­doubt­edly be raised from the Cen­tral Bank by way of print­ing new money caus­ing a mul­ti­ple rise in the to­tal money stock. The ex­pan­sion­ary fi­nanc­ing by fis­cal au­thor­i­ties goes against the Cen­tral Bank’s tran­si­tion to­wards in­fla­tion tar­get­ing.

Cen­tral Bank’s lonely bat­tle

This brings us to the prob­lem of fis­cal dom­i­nance over mone­tary pol­icy, in which the fis­cal au­thor­ity pre­pares the an­nual bud­get on its own com­pelling the Cen­tral Bank to fi­nance the un­bridged por­tion of the bud­get deficit by way of print­ing money so as to se­cure fis­cal sol­vency. In such a sit­u­a­tion, the space avail­able to the Cen­tral Bank to con­duct in­de­pen­dent mone­tary pol­icy is ex­tremely lim­ited and as a re­sult, in­fla­tion tar­get­ing be­comes un­vi­able.

The ex­pan­sion­ary bor­row­ing by the gov­ern­ment from the bank­ing sys­tem has been a ma­jor source of core in­fla­tion, which shows an in­creas­ing trend in re­cent years, as shown in the chart. The core in­fla­tion, which is cal­cu­lated by re­mov­ing the tem­po­rary price ef­fects of sup­ply shocks from the head­line in­fla­tion, re­flects the un­der­ly­ing in­fla­tion caused by mone­tary fac­tors.

The present fis­cal con­sol­i­da­tion ini­tia­tives are lim­ited only to the rev­enue side leav­ing the ex­pen­di­ture side in­tact. In­fla­tion tar­get­ing calls for ro­bust fis­cal pol­icy re­forms to re­v­erse the fis­cal de­te­ri­o­ra­tion not only by mo­bi­liz­ing more rev­enue but also by ra­tio­nal­iz­ing the ex­pen­di­ture struc­ture for which un­wa­ver­ing po­lit­i­cal com­mit­ment is im­per­a­tive.

The Cen­tral Bank can­not fight a lonely bat­tle against in­fla­tion. Its in­fla­tion tar­get­ing drive would be­come fu­tile un­less it is ef­fec­tively sup­ported by strin­gent fis­cal rules with a longterm eco­nomic fo­cus, putting aside short-sighted po­lit­i­cal mo­tives, as I re­it­er­ated in my pre­vi­ous col­umns. This ap­proach is lack­ing in the present bud­get speech too. (Prof. Sirimevan Colom­bage is Emer­i­tus Pro­fes­sor, Open Univer­sity of Sri Lanka)


Fi­nance Min­is­ter Man­gala Sa­ma­raweera pre­sents bud­get 2018

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