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High deficit in trade balance, further weakening of rupee

Even as the Central Bank announced that the rate of inflation had reached one of the lowest levels in recent times, the signs of increasing prices were evident. The depreciation of the currency and new duties imposed on several articles of basic consumption would ensure that the cost of living index for May would rise appreciably. Gas prices were increased and perhaps an increase in petrol and other petroleum product prices are also in store. The boast of a lower rate of inflation may be quite short lived as the depreciation of the currency and fresh duties and taxes are imposed to make amends for the shortfall in government revenue.

In its monthly release on prices, the Bank quite rightly claimed that inflation dropped to its lowest level in five years. In April, 2009, the rate of inflation, as measured by the Department of Census and Statistics’ Colombo Consumers’ Price Index (CCPI), with its base year as 2002, fell sharply to 2.9 %. This, the Central Bank claimed, is the lowest level of inflation ever recorded since January, 2004. In fact, it may be one of the lowest levels of monthly inflation achieved since the liberalisation of the economy. There is however a statistical illusion as it follows a very high rate of inflation in the previous months.

This sharp decrease in prices in April also brought down the annual average inflation rate to 16.7 % in March, 2009 from its level of 18.6 per cent in February 2009. It is noteworthy that inflation reached this low level as a consequence of a continued deceleration during the last ten months. Readers would recall the very high rates of inflation in 2008 with a peak 28.2 % in June, 2008.  It is also significant that the CCPI decreased entirely due to the decline in food prices, mainly rice, big onion, vegetables, coconut and dhal. The implication of this is of special significance, in that the deceleration in prices recently, was of benefit to the poorer sections of the community, for whom these prices are of considerable significance, as these are in their basket of commodities they consume. Therefore, the deceleration of prices is of social, political and economic consequence.

Unfortunately the Central Bank’s expectation is that:   “Inflation is expected to continue to remain low, reflecting the impact of tight monetary policy adopted by the Central Bank during the past years and easing of commodity prices in the international market,” was a hasty and irresponsible prediction. The Central Bank was fully aware that at the time of the press release, the currency had been depreciated and that as a consequence import prices would rise. What is more the government had imposed increased duties on some basic consumer items. The price of sugar has increased and the control price for sugar that was in force is longer valid. The gas price was increased by over one hundred rupees. All these increase the cost of living of poor households once again, and should be reflected in the CCPI for May. Therefore the euphoria of achieving a lower rate of inflation will prove very temporary.

The upward movement in prices was inevitable. It was the result of the weakening of several facets of the economy. The precipitous decline in the country’s reserves, necessitated the depreciation of the currency from around Rs.108 for a US$ about six months ago to Rs 121 a US$ last week. Within about a fortnight it declined from about Rs. 113 for a US$ to Rs 121 for a US$. Then the shortfall in revenue required to be remedied, as the gap between revenue and expenditure was widening to unexpected and intolerable levels, while at the same time further decreases in imports were required to reduce the trade gap. Consequently fresh duties were imposed on several essential imports like dhal, sugar and wheat in the expectation of both increases in revenue and decreases in export expenditure. The likely impact of these is a price increase of around 15 percent on imported commodities, including some essential foods. Gas prices have also been increased by over Rs. 100. The depreciation of the currency would no doubt raise the prices of all imported goods. The rise in prices of all imported goods will not be captured in the CCPI, but some of the price increases will raise the price index.

Inflationary trend

The inflationary trend of the last year was largely blamed on the rise in import prices. Similarly the decline in prices was attributed largely to decreasing prices of oil and food imports. In contrast, the current increases are despite international commodity prices being more of less stable. It is the depreciation of the currency and the imposition of higher duties to reduce imports that are the causes for the increase in prices. If the country’s trade balance continues to record a high deficit and the balance of payments is strained, then we may see a further weakening of the Rupee that would lead to a further depreciation of the Rupee and imposition of still higher duties. It is therefore vital that we must look into ways and means of strengthening the country’s exports by becoming more competitive in the world market, and increasing the supply of goods that we can sell, as well  as  reduce imports through a measure of economically rational import substitution.

We have no leverage to change global conditions. These will remain as they are. Indications are that that the global recession will continue into next year. This is not altogether a disadvantage as prices of oil and several other intermediate imports will remain depressed.  We must turn to improving our trade performance by domestic reform policies that are conducive to increased investment, improved productivity and increased production. It has been repeatedly pointed out that fiscal discipline is vital to achieve this. The fiscal deficit would require to be reduced from the current high of 8 % to 6 % of GDP by cutting down unproductive expenditure and by increased revenue. Without an improvement in the management of public finance, corrective action elsewhere will have only a limited benefit.

There can be no doubt that bringing down the fiscal deficit is exceedingly difficult. Much of the government expenditure is committed expenditure on debt servicing, salaries and pensions of public servants, on defence and social welfare. Cutting these expenditures is near impossible. The end of the war may permit some cuts in expenditure. There are also other wasteful expenditures that the government has indulged in that require to be reigned in. For a start, the government must make a serious effort to bring down the deficit to around 6.5 % of GDP. Increased revenue measures too are needed but the current economic climate of a slowdown is hardly auspicious for such an effort. The foreign borrowing gives the country a respite during which remedial actions are needed. Will the government focus on economic and financial reforms to achieve this?