The Island, 19/06/2011, by R.M.B Senanayake
The IMF last week denied any involvement in the formulation of the controversial Pension Bill, insisting that "we had nothing to do with it". But it noted that it had come up in discussions in the context of the rapidly ageing population.
Higher Savings for higher Investment
Higher domestic savings is very necessary for higher investment which in turn is a sine qua non for a higher growth rate. Since the government continuously runs budget deficits it has to borrow domestic savings or the foreign savings if it is to avoid borrowing from the banks (printing money) which is highly inflationary. The former is preferable since repayment is in local currency. Low domestic savings means that the government is limited in the amount of domestic market borrowings it can mobilize to fund the budget deficit. For macro-economic balance the budget deficit equals the private sector surplus in a closed economy (without foreign borrowing). So as the budget deficit increases the domestic savings must also increase if the budget deficit in absolute terms is to increase.
It is almost impossible for the government to reduce its ballooning budget deficit and no policy to contain the increase in the National Debt in absolute numbers has even been considered. Instead the present government puts its faith on a high growth rate to prevent the Debt/GDP ratio getting out of hand as in Greece. But funding budget deficit through domestic savings also affects the credit needs of the private sector. The countries that have achieved high growth rates over 7% on a sustainable basis in recent years like China and India, have done so through the private sector investment. They removed all the regulatory barriers to private investment (India did away with the `licence raj’). China welcomed foreign investors.
So if a pool of capital can be created like the Employees Provident Fund it could invest in private sector business or in Treasury securities or Corporate Bonds. But the investment decision is best left to private pension funds. Our retiring employees lack the skills to invest and often they bust up their retirement benefits intended for the rest of thieve lives in retirement. Perhaps part of the EPF may be converted to the Pension Fund resolving the problem created by the ageing population.
Both India and China have achieved higher savings to GDP ratios of as much as 30-35% whereas our ratio is 17% and if we add the foreign remittances from the migrant workers a mere 24.7%.
Exchange Rate Management
The IMF team referred to the management of the exchange rate. They would like the exchange rate to be more flexible. They suggest that the Central Bank should allow the rupee to depreciate when it supplies foreign exchange from its Official Reserve. When the market is short of foreign exchange to supply the demand for settlement of oil bills or other large payments, the Central Bank provides the short fall since the banks may not be able to buy dollars for rupees in the international market except at higher costs.
But the Central Bank should provide the dollars at the day’s market rate which is known to the bank’s agent - the Bank of Ceylon. The present rupee/ dollar rate is unsustainable particularly if the Balance of Payments deficit on current account widens considerably as is likely with the rise in oil price and food import prices causing adverse terms of trade. Then if the inward capital inflows are not sufficient the Central Bank would have to run down its Foreign Reserves. Whether the Reserves can cope with a sustained outflow in the current account of the Balance of Payments is debatable.
The Inflow of Foreign Capital
There are two components that are critical to the exchange rate management system. One is a set of capital controls that, in principle, allow the Central Bank to manage domestic inflation and the exchange rate independently without using it for inflation control. The second is the accumulation of reserves. A net inflow of foreign currency can result from a surplus on the current account and from net private capital inflows. Our current account in the Balance of Payments is perpetually in deficit - the last time it was in surplus was in1978. We are receiving foreign capital inflows from government to government sources, multilateral institutions and from private foreign investors. We run massive and increasing trade deficits.
So the appreciation of the rupee is not due to any surplus on our goods and services sectors. The Central Bank intervenes to buy the foreign currency to prevent the dollar going down (rupee appreciates). But such purchases against rupees increase the supply of created new money and can lead to a multiple expansion of the money supply through the banking system. So the Central Bank tries to buy back such created rupees by selling Treasury or Central Bank securities. But this sterilizing is not always successful since the Bank also wants to pay low rates of interest on such securities. The Bank does not allow a free market for interest rate determination in the Treasury bill and Bond markets, getting the BOC and captive institutions to quote low at the auctions.
Exchange Rate Management Policy must be re-thought
The foreign capital inflows have led to a rapid increase in foreign reserves held by the Central Bank—currently estimated to be about US$ 7 billion. The Central Bank has allowed the rupee to appreciate because it checks domestic inflation increasing. The reserve accumulation has been largely the effect of neutralizing the exchange rate effect of large inbound private capital flows, rather than any trade surplus. But this situation may change in the near future. If and when we are forced to depreciate we may have to do a large dose which will create a domestic price upheaval.
Exchange Rate policy has never been used in this way by any growth economy in the world. Usually the focus in exchange rate management policy has been t o preserve if not promote export competitiveness and the retention of exports as a driver of growth and productive employment and for repayment of foreign borrowings. The export industries like the garments are the only large source of productive employment creation. Our unemployment figures have come down but that is due to the large number recruited to the Armed Services (unproductive employment) and the migration of workers abroad.
Traditional agricultural economies have surplus labor in agriculture. Growth strategies have focused on removing such surplus labor which has zero social opportunity cost (no consequential loss of production) and directing them to industry. This is the general economic model in all countries that have achieved high growth .Why are we downplaying exports as a source of growth and depending only on government directed high cost infrastructure investment which creates employment only during the construction period while any subsequent increases will depend on the indirect effects on the economy if the project succeeds.
The productivity differential between the urban/modern sectors and agriculture is estimated to be of the order of four to six times, in favor of the modern sectors including exports. A significant loss of competitiveness in the export sector would reduce growth and employment opportunities, leading to unfulfilled expectations in the population and the risk of a chaotic situation economically, socially, and politically. Fortunately our exports have grown despite the rupee appreciation. But it will not be always so.
Wages of plantation workers are to be increased. A new concern is arising with the rising oil price and higher food prices which will have to be balanced against the mounting inflationary impact of incomplete sterilization. Economic decisions must be timely and any delay will lead to new problems which may make the correct decision more difficult to implement.
Generally, the exchange rate sets the relative prices of traded and non-traded goods and services. Holding the exchange rate down keeps the relative price of non-traded goods and services, including labor, down and promotes investment and growth in tradable goods. As an industrial policy, exchange rate management favors exports over investment for domestic consumption which promotes the earning of foreign exchange needed for import of capital goods and technology and to repay foreign debt. So the Central Bank is trading off growth and employment creation for maintaining price stability- a policy not easily justifiable. It will adversely affect growth and employment generation.
Restrictions on capital inflows (foreign direct investment is exempt) will raise the cost of capital. Recently the Central Bank allowed local businesses to borrow abroad in foreign currency. But approval is on a case by case basis and one requirement - tax clearance - is a huge administrative block. Shouldn’t whatever control exercised be done through the banks who are the agents of the Central Bank to implement Exchange Control Act? Why not follow India and allow corporates to raise equity or loan capital abroad without insisting on a case by case approval. This would increase the availability of capital in the economy; and the cost of capital could come down through market forces rather than through the present unsustainable repression of interest rates.
This will assist the government to fund its budget deficit cheaper without printing money to keep interest rates low. It could promote the trade in financial assets - options, swaps, currency futures, corporate bonds etc to make the country a financial hub. There is a strong case for freeing the inward capital account and continue only with the outward capital restrictions.
