Mahoshada

This week the government released its Mid Year Fiscal Position Report, required under the Fiscal Responsibility Act passed by the UNF government in 2002. The thinking behind the Act was to require the government of the day to make public its economic record so that the public could better judge their performance managing the economy. The Act also set targets for reducing the government’s budget deficit over time, targets which have evidently been abandoned and forgotten by the current government.

The major news from the Report is the sharp, 31 percent, increase in the budget deficit during the first four months of this year, going from Rs 67.9 billion for the corresponding period last year to 88.8 billion. The budget deficit for the entire year last year was 8.7 percent of GDP (according to the Central Bank Annual Report). If the deficit for the rest of the year was to show the same 31 percent increase as it did for the first four months – the total deficit for 2006 would be 11.4 percent. This would be the highest budget deficit for more than a quarter of a century.

This rapid rise in the deficit may be the clearest indication of the government’s very poor management of the country’s finances. Year after year the government continues to spend far more the revenues it receives through taxes. It makes up the difference by borrowing, increasing the country’s public debt to ever higher levels. For 2005, total public debt is estimated to be equal to about 94 percent of GDP – in other words, the government owes to foreign and domestic lenders almost as much as the total income generated by the country during the course of an entire year.

To put this into perspective, consider that in any given year it is possible for a family to spend considerably more than it receives in income by drawing down its savings or by going into debt, borrowing the additional money needed. If this family tries to do this year after year, it will quickly exhaust its savings and its total debt will rise. Eventually, as the family’s debt reaches the point where potential lenders must begin to be concerned about their ability to pay back the money they have borrowed, they will either refuse to lend the family additional money or will demand higher interest rates to reflect the additional risk in lending to a heavily indebted borrower. And of course, as this family’s debt grows and the interest rates they must pay go up, they will inevitably spend an increasing amount of the money available to them to pay the interest on the debt that they have accumulated. Sooner or later, if the family does not do a better job of managing its finances and living within their means, their only option will be to default on their debts and declare bankruptcy.

There is an important consideration to keep in mind with this analogy. If this family was borrowing beyond its income in order to invest rather than to pay their ordinary day to day expenses, their incomes will rise if their investments are successful. This additional income could be used to pay off the debt. In simple terms, their investments could be said to be successful if they earn more than they cost. More specifically, if the yield on the investment is greater than the interest on the debt incurred to make the investment – the family will be financially better off. If this family is following a strategy of borrowing and investing successfully, rather than borrowing to live beyond their means, they will see their net worth increase over time instead of going to zero and facing bankruptcy. After borrowing money for an investment, they would still own an asset. If they spent the money on consumption, they would have nothing.

A government’s finances differ from those of a family because a country’s government rarely faces bankruptcy. Instead, when a government faces a major debt crisis, the real incomes of the country’s people will continue to contract and public services will rapidly decline as general misery ensures. (The most obvious example today of a country that has followed this path is Zimbabwe.) For a government, there is usually no relatively easy way out of a serious debt crisis. The high and growing budget deficit of the Sri Lankan government should raise increasing concerns that this country may be heading in much the same direction as Zimbabwe unless much greater fiscal responsibility is restored.

What the Government Says
Not surprisingly, the government has tried to put the best spin possible on what is should be seen as negative economic news. The Treasury Secretary Dr P B Jayasundara was reported as saying: “We are confident of keeping the deficit under 8 percent of GDP this year.” He also said: “What is worrying us is inflation, with oil prices costing over 70 dollars a barrel. The government has responded by passing on some of the costs to consumers which have had an impact.” The inflation rate, measured by the Colombo Consumer Price Index, surged to 17.7 percent in June, after the government twice raised prices of fuel.

For the government to hold the deficit to less than 8 percent for 2006, after already putting a substantially higher deficit for the first four months of the year on the board, it will have to substantially cut the deficit for the next eight months. Realistically, this can only be done through a combination of cutting expenditures and increasing revenues, both of which will be hard to carry out in a difficult, unstable political environment.

The Mid Year Fiscal Position Report noted that government expenditures increased during the first four months by 24 percent, significantly less than the 19 percent increase in revenues. The government has indicated that it aims to cut expenditures in several key areas, including sharply reducing fertilizer subsidies and increasing fuel prices. It remains to be seen whether they will be able to politically sustain much reduced fertilizer subsidies or whether they will gamble successfully on stable or falling international oil prices. It also appears that the government would like to exert greater control over the costs of maintaining the large public sector workforce, but substantial changes are extremely difficult to make in the short term.

In contrast, it is usually somewhat easier to increase revenues quickly by raising taxes. This government has demonstrated a proclivity to resort to indirect taxes to boost revenues, essentially VAT and taxes on imports. The drawback with this approach is that increases in these types of taxes pass through quickly and directly to the cost of living. With a current inflation rate of nearly 18 percent, and which has accelerated rapidly during the last three months (even before the fuel price increases were introduced), adding to the rapidly increasing cost of living will be politically difficult, to say the least.

An Emerging Economic Crisis
The government finds itself in an increasingly difficult and precarious economic position. It remains to be seen whether the budget deficit for the full year will reach as much as 11.4 percent of GDP, as implied by the partial-year results released by the government this week. Nevertheless, despite the assurances of the Treasury Secretary to the contrary, it appears that the budget deficit this year will record another sharp increase. The government will find it extremely difficult politically and practically to reverse the trend in fiscal performance during the first four months of this year. Interest payments by the government cannot be substantially reduced. (Interest charges already account for the largest share of current expenditures in the budget – 27 percent of the total.) Severely cutting fertilizer subsidies or cutting the costs of the public sector work force would be almost as difficult to sustain.

A higher budget deficit will inevitable lead to a further increase in the country’s public debt with corresponding increases in the interest costs being borne by the budget. It will also very likely lead to further inflation and lower economic growth than would otherwise have been the case. Every year that fiscal irresponsibility to this extent continues, the greater are the chances of a serious and sustained economic crisis developing.

It is fortunate that the legally required Mid Year Fiscal Position Report has led to the government making this information publicly available. This government, more than most, seems to have done its best to obfuscate and spin the economic information that is released. It seems that questionable reports of high economic growth are regularly interspersed with assertions that all is well with the economy. One can only hope that an increased realization of the deteriorating economic management by the government will lead to public pressure to reverse this irresponsible trend.