Preserving foreign exchange or earning foreign exchange?

Originally appeared on The Morning

By Dhananath Fernando

A cricket game I played as a kid is still fresh in my memory. I did not know the rules of the game at the time. It was just me and my friend. We played against each other taking turns to bat and bowl. My friend batted first and I got him out when he had scored 25 runs after three overs in a five-over match. Then he started bowling. I was defending most of his deliveries and I scored 20 runs not-out after the end of five overs. I claimed the victory because I defended my wicket. My friend too claimed the victory as I couldn’t exceed the runs he scored. After a few arguments, my friend explained that in cricket, the victory of a game is decided not on the number of wickets defended, but by the runs scored. 

This childhood memory makes me question as to whether Sri Lankans and local policymakers, throughout history and to date, have ever fully comprehended the basics of an economy.

The recent commentaries and people’s reactions to the national GDP data for the second and third quarters by the Department of Census and Statistics and the external sector performance report by the Central Bank, make me question whether we in Sri Lanka understand our economic problem. Or are we continuing to drive further in the wrong direction?

The main objective of a well-performing economy is to raise national income, which will also help to reduce poverty and to allow more people to consume a wide range of goods and services in order to improve their quality of life. Simultaneously, sustainable consumption too is important to ensure long-term prosperity. To achieve these objectives, our strategy has to have a concentrated focus on providing equal access for all people across the country to enter into the economy. Special attention should be given to vulnerable sectors of the economy whose only tradable good is their labour. Efforts must be actively taken to integrate these vulnerable sectors to global production networks, as it will not only provide them with new opportunities to trade their labour but will also eventually help to eradicate their conditions of extreme poverty.

The Central Bank’s recent report on the external sector for October 2020 reveals that in the first 10 months, Sri Lanka’s exports have dropped from about 16% and our imports have reduced by about 19%. As a result, our trade deficit has shrunk to $ 4.8 billion from a corresponding $ 6.4 billion in 2019. 

It is imperative that we understand that the trade deficit/surplus (balance in the trade account)  is not necessarily the main indication of the direction of our economy. In reality, the most important indicators are the level of income and poverty, quality of life, and purchasing power of income. These indicators provide a better signal of the state of our economy and the wellbeing of Sri Lankans than mere trade balances and fiscal deficits and surpluses.

Our imports have shrunk, mostly as a result of the import restrictions, and our exports have dropped as a result of Covid-19 and the bias against export in our trade regime. The impact of Covid-19 was the very same reason why import controls were placed in the first place. Most of the imports are inputs for the manufacturing of goods to be exported. The scarcity or the lack of these imports result in exports being uncompetitive in the global market. Following an ideology that calls for defending the foreign exchange rate and targeting only the trade deficit as a strategy, may bring some long-term adverse consequences to our economy. Solely targeting a trade account deficit or surplus is similar to how I tried to defend the wicket without understanding the need to surpass the runs the opposing team has already accumulated. 

We need to realize the problem of trade is mainly due to the larger macroeconomic problems that have been ignored for the last few decades. Of aggregate demand running ahead of aggregate supply

We need to realise the problem of trade is mainly due to the larger macroeconomic problems that have been ignored for the last few decades; of aggregate demand running ahead of aggregate supply. Imports and exports are mainly a function of the private sector. What a government imports and exports compared to the private sector is negligible. In other words, the Government doesn’t import or export (except for direct government imports such as vehicles, food items for Sathosa, etc.), yet their intervention, through the imposition of restrictions through tariffs and non-tariffs, is very sensitive for the functioning of both import and export markets. So improvement of trade is a market function, and the Government should not intervene, except in the case of public goods. The role of the Government should largely be to set up a level playing field for our exports and assist and boost competitiveness. The current state of the trade account is just an outcome of poor macroeconomic policies implemented by consecutive governments.

On the fiscal management side, money printing (quantitative easing) to finance our budget deficit every year, while maintaining a long list of loss-making and unproductive SOEs (state-owned enterprises) is like adding fuel to fire. When we do quantitative easing to bridge the budget deficit, it may automatically distort markets as demand for available imports may increase, causing further market distortion, leading to further pressure on our currency.

It is a positive indication that our economy has achieved a growth of 1.5% compared to the corresponding period in 2019 as per the recent numbers by the Department of Census and Statistics. However, without addressing macroeconomic reforms and solely targeting the trade deficit alone, Sri Lanka will have a feeble chance in achieving the main objective of a well-performing economy. 

Rather than focusing on defending our foreign exchange rate, we have to shift our gears to a better strategy where we focus on a competitive exchange rate. To do this, we must acknowledge the problem and find a suitable strategy to meet this objective. 

The fundamental understanding has to be that the Sri Lankan economy is plagued by macroeconomic imbalances, and governments cannot fix the outcome of a problem without fixing the problem in itself. The island’s low growth, from the recent low exports to GDP, quality of life, pressure on external debt, pressure on the currency, poor productivity, and a stagnant economy are a result of poor understanding on the way the system operates. As we did not comprehend the magnitude of our problems, we failed to address macroeconomic reforms or we postponed it every year.

If we continue to defend our foreign exchange like defending wickets in cricket and continue to fail at earning foreign exchange by fixing our macroeconomic fundamentals, the situation is prone to worsen. Sri Lanka must strive at scoring runs that exceed our opponents’ instead of defending wickets.

The opinions expressed are the author’s own views. They may not necessarily reflect the views of the Advocata Institute or anyone affiliated with the institute.