Pouring advice on a duck's back

When advice based on fundamental economic principles is flouted a county's economy could drift into crises. Good economic advice repeatedly given by international agencies and economists is like pouring water on a duck's back: it runs away as rapidly as given.

The International Monetary Fund (IMF) has once again given sound advice on the management of the economy based on fundamental principles of good economic management. The advice is highlighted and underscored in the expectation that it would be taken seriously at a time when economic policies of the Government are being formulated for the budget of 2014.

Three key areas

The IMF's advice refers to three related areas -- foreign borrowing, monetary policy and exchange rate management. Policies in these three areas have an important bearing on the balance of payments and external balance that is its mandate. There are certainly other areas of significance for the country's economic development outside its purview.

Caution in foreign borrowing and use of borrowed funds is a critical area of its advice. The IMF advised Sri Lanka to be careful of foreign borrowing at high rates, amid low growth and flat state revenues.

It warned against high cost borrowing being utilised for projects with low returns. "New external borrowings should be done with a close eye on sustainability, and the need to ensure that investments generate the resources needed to service these obligations."

Recent foreign borrowing has been at high interest rates. The National Savings Bank (NSB) borrowed US$ 750 million at an interest rate of 8.875 per cent. This is about 300 basis points higher than the last bond sale by the Bank of Ceylon. No Asian country has recently borrowed at such an exorbitant interest rate.

Use of funds

Prudent management of funds borrowed from abroad at high interest costs is essential. They must be utilised for projects that bring returns in terms of foreign earnings or savings. Not adhering to this principle could increase the foreign-debtservicing costs and make the servicing of the foreign debt unsustainable. This is the essence of advice given by the IMF.

How will these borrowed funds be used by the NSB? Will it be lent for export earning or foreign exchange saving enterprises? Will NSB's lending be for enterprises that increase imports? These are vital concerns.

Recently the NSB lent Rs. 50 million to finance road construction by the Road Development Authority (RDA). This is imprudent lending as the RDA has no capacity to repay the loan. The investment is likely to benefit the economy in indirect ways in the long run and the Government would have to repay this loan in rupees. It jeopardises the finances of the NSB as well as violates the principles of parliamentary accountability, as the expenditure is not accounted for in the Government budget.

Debt must be incurred to finance enterprises that would bring in returns that enable repayment. It is most important that foreign borrowing increases production of tradable goods and services adequate to finance the debt servicing and repayment of the loan.

Interest rates

The Central Bank and the IMF have divergent views on monetary policy. The Central Bank is of the view that high interest rates are the reason for sluggish private investments and therefore adopted policies to ease interest rates. These have included a reduction in policy interest rates as well as the reduction of the statutory reserve requirement for banks with the Central Bank that increased the supply of credit.

The IMF has been concerned with the effect that lower interest rates would have on increasing consumption and aggregate demand, because an increase in demand for consumer spending, as well as intermediate and investment goods would increase imports that would increase the already large trade deficit of US$ 5.3 billion in the first seven months.

Therefore, the IMF has cautioned against the easing of interest rates and advocated a hold on easing monetary policy arguing that this will also give time to assess the impact of the loosening monetary policy measures that have already been done.

The reduction in the cost of credit would increase demand for imports and strain the trade balance. This basic consequence must be remembered in managing monetary policy. However, import demand is also enhanced by public spending that may not face such monetary constraints but leads to increased imports as has happened.

It is unlikely that interest rate cuts by the Central Bank would stimulate private investment much as commercial banks have now become captive sources of lending to the Government and government agencies such as the Urban Development Authority. The 'crowding-out' by the Government, not high interest rates, is the major deterrent to bank financing of private investment. Furthermore, the investment climate that is of paramount influence for private investment is not conducive.

Exchange rate management

The IMF has shown its displeasure on interventions by the Central Bank to maintain the exchange rate from sliding further. It has warned that such interventions could lead to depletion in foreign reserves to crisis proportions.

Besides, foreign borrowing naturally leads to exchange rate appreciation that erodes international competitiveness of both exports and import-competing production. The IMF cautioned against prolonged currency defence by the Central Bank sales of dollars. It advises the exchange rate to weaken through a flexible exchange rate.

Todd Schneider the IMF head of mission said. "In this more complex global environment, it will be essential to adhere to the flexible exchange rate regime that has been a core component of the policy framework since early 2012,"

The defence of the rupee has two disadvantages. It results in an overvalued exchange rate that is detrimental to exports and depletes the country's reserves.

"Intervention" Schneider said "should be limited to dealing with excessive short-term volatility".

Interconnected

A country's fiscal and monetary policies are inextricably interconnected with the exchange rate and the state of reserves. It is essential to manage these policies in a manner that will ensure that the country's foreign exchange reserves are strengthened and does not lead to a foreign debt trap.

Short sighted policies that ignore the basic principles of good economic management could have serious long-term consequences.