Framework for building investor confidence an urgent necessity

By Mandana Ismail Abeywickrema in Washington DC

The International Monetary Fund (IMF) last week said that the Sri Lankan government needed to put in place a proper framework to increase investor confidence as well as that of the international community to help improve the country’s present economic conditions. IMF, World Economic Studies Division Chief, Tim Callen told The Sunday Leader that the Sri Lankan government should put in place a framework as a confidence building measure in order to face the economic issues faced by the country, such as the vulnerability caused from a high level of inflation and a current account deficit.

"The government should look at a monetary policy that would help bring down inflation and build a stronger economy in the mid term," he said. Callen observed that although the country is facing several challenges due to the ongoing conflict, the government should focus on mitigating fiscal constraints to put the economy back on the path to growth.

Last year, the country’s economy grew 7.4% according to the Central Bank, underpinned by rising domestic and foreign investment and record inflows of remittances (equivalent to around 8% of GDP).

However, within a space of one year growth has now slowed to around 6% with the level of inflation rising sharply to 21% from 10% recorded in the first half of 2006.

According to analysts, steering inflation back down to single digits will be essential for sustaining strong economic growth and containing the government’s debt service costs.

With less than a month to go for the government to present its budget for 2008, analysts have also said that although the government may achieve the rupee value revenue targets because it includes inflation, currently at 17.3%, revenue as a ratio of GDP, which is the more important one would most definitely be off target along with the growth targets.

The Central Bank has already downgraded this year’s growth forecast to 7% from the earlier 7.5%, a figure economists have scoffed at.

Apart from the declining growth rates and the increasing level of inflation, the country’s economy is facing other serious problems with high interest rates hindering real investments.

In short, the macroeconomic fundamentals in the country are currently messed up as what should be on the increase like growth levels keep coming down while inflation, exchange rates and interest rates that should be on the decline keep increasing.

Releasing the IMF’s latest report on the global economy, World Economic Outlook, Director, IMF’s Research Department, Simon Johnson told the media here in Washington that the IMF was concerned over the downside risks related to high levels of inflation recorded by several countries and noted that monetary policies may need to be tightened where required to address the situation.

"While such concerns have taken a backseat in advanced economies since the recent bout of financial market turbulence, inflationary risks are more immediate in emerging markets and developing countries. Here, rising food prices, dwindling spare capacity, continuing high oil prices, and still strong foreign exchange inflows may mean that monetary policy needs to tighten further to contain inflation pressures," he said.

Speaking of the intervention of central banks to prevent currency from depreciating, Johnson said that intervening in exchange markets has not been very successful either in limiting real exchange rate appreciation or in avoiding a hard landing in growth once capital flows stop.

"Intervention may help initially to contain exchange rate pressures from capital flows, but intervention is not effective when these inflows are persistent," he said.

According to Johnson, intervention accompanied by sterilisation, meant that intervention is combined with measures that try at the same time to limit growth in the domestic money supply.

The only solution in terms of sustaining growth after the capital flows stop Johnson points out is being careful with fiscal spending.

"Countries in which the growth in public spending was contained experienced less pressure on real exchange rates and growth was better sustained with inflows moderated. The lesson here is not that a country needs to cut spending when there are inflows but, rather, it needs to exercise fiscal restraint.

Otherwise it risks over stimulating the economy through boosting domestic demand and exacerbating overheating pressures that raise the risk of a hard landing later on," he said.

Be that as it may, the Sri Lankan government has exhausted most its funds on public expenditure. In fact, out of every rupee earned by the government, 57 cents is spent on paying public sector salaries alone.

The level of expenditure increases several folds when other public expenses are also added on. Government revenue for the year 2007 was estimated at Rs. 584 billion against a total sum of Rs. 597 billion for current expenditure, which created a deficit of Rs. 13 billion in the last budget.

The latest IMF report on the world economy also stated that global growth would slow from 5.2% in 2007 to 4.8% in 2008, down from the 5.4% rate registered in 2006.

However, the largest downward revisions to growth have been reported in the United States, and in countries where financial and trade spillovers from the United States were likely to be the largest.