Has the Government been convinced of the need to reduce the budget deficit? The decision to increase the prices of petrol and diesel to reduce the deficit of the Petroleum Corporation (CPC) to halve the loss of Rupees 89 billion seems to indicate it. At least the Government has realized the need to reduce the loss of the CPC which along with the losses in the Ceylon Electricity Board and other State Corporations threaten the viability of the state owned banks which could deprive them of their status in international banking circles.
The high budget deficits cause several problems for the economy. Firstly, it causes macro-economic imbalances to worsen, since government expenditure increases each year without a corresponding increase in the domestic supply of goods and services. As the government expenditure increases, so does the domestic incomes of the people they have more money to spend. And as the domestic supply does not increase proportionately, the prices of domestic goods rise causing higher inflation. To the extent that the government expenditure leaks out to foreigners in the form of imports, this effect is weakened. But as domestic incomes rise and people spend their higher incomes on imported goods the current account of the balance of payments turns adverse and will continue to worsen each year.
The budget deficit and the effects on imports and exports also weaken the fundamental value of the Rupee in the foreign exchange market. The higher inflation unless compensated for by a falling Rupee weakens the real exchange rate giving an incentive to imports which become more attractive and proving a disincentive to exports. Attempts by the Central Bank to maintain the nominal value of the Rupee unchanged through the selling of its Foreign Exchange Reserves (reserves which are costly borrowed and on which interest has to be paid) leads to further adverse consequences for our exports. This holding down of the Rupee from fetching its true market value leads to a worsening of the current account deficit in the balance of payments which requires foreign borrowing or foreign investment locally. The Central Bank has good reasons for holding down the Rupee, if not the foreign debt servicing charge will increase in terms of Rupees and an already cash strapped Treasury will have to borrow even more money to repay foreign debt and the interest thereon.
The budget deficit also means higher market interest rates although even here the Central Bank will do its utmost to keep interest rates low through its open market operations involving the printing of money. As the budget deficit increases in absolute numbers the Treasury has to increase its borrowings each year. But there is a limit to the capacity of the domestic market to supply money for government borrowings. The total quantity of savings that people hold and want to invest in government securities which is the way the government borrows depends on the real interest rate which is the nominal interest rate less the inflation rate. Since there is also a low level of savings in the country, the real rate must be sufficiently high (higher than in developed countries) to mobilize greater savings. Since inflation is high and is rising in the public perception (despite the official figures which seem to lack public credibility) the nominal interest rates must rise as the budget deficit rises. The Central Bank can keep the short-term interest rates low by carrying out open market operations (directly printing money in the primary market or indirectly through the secondary market) but it cannot easily transmit these changes to the rest of the market as the so-called transmission mechanism is weak. Nor can it reduce the long-term interest rates. But when the interest rates are artificially kept low the supply of savings to the Treasury as borrower will be less and more and more money will have to be printed via the banking system to satisfy the requirements of the Treasury. The lending capacity of the domestic debt market will be reduced as inflation rises while the nominal interest rates are kept down. When the nominal interest rates are held down while inflation is rising, means the real interest rates falls and if becomes negative, domestic savings will fall. In 2011, the aggregate domestic savings in the economy fell from 19 percent of GDP to 14 percent, a sharp decline. Similar adventures in the present or the future will lead to a repetition of the scenario.
Business investment decisions except for inventory build-up are affected by the long term rate of interest rather than the short-term money market rates. Here again it is the real interest rate that is material and expectations of inflation are an important consideration. When inflation is rising and unpredictable, businessmen prefer short term to long-term investments. But it is the latter that increases the productive capacity of the enterprise and the economy. Recently the Central Bank had to issue long-term bonds to roll-over maturing bonds. It managed to keep the rates on interest on such bonds unchanged (perhaps through intervention of the captive sources). But the yields on these bonds in the secondary market have since seen a rise although the volumes are low. Those who invested in such bonds will suffer capital losses unless they hold them to maturity. All these interventions by the authorities in markets bring on a false economy. In a false economy the private sector consisting of the households and the business firms will live beyond their means and increase their debt. Several financial institutions and stock broker firms have borrowed too much to buy assets and their leverage is excessive. Fitch Ratings have downgraded the rating of one such Finance Company. What is needed is equity not debt. But the stock market is in the doldrums and even listed firms cannot raise equity, but, only high interest debt. If a de-leverage process begins it could accelerate the slowdown in the economy.