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HomeEconomyProspects for recovery of Sri Lankan economy: Lessons from East Asian recovery

Prospects for recovery of Sri Lankan economy: Lessons from East Asian recovery

Sri Lanka’s ongoing economic crisis and the policy responses taken to resolve the crisis have plunged the country into a worsening recession, causing disproportionate suffering to the poor, who make up the majority of the population. I am giving

Sri Lanka was hit by an economic crisis in early 2022 and has continued to languish in crisis without any apparent recovery. East Asia also experienced an economic crisis in 1997, but recovered within a year. This memo explains why the current macroeconomic policy package adopted in Sri Lanka will not bring about an East Asian-style recovery in Sri Lanka. The note also outlines long-term strategies to achieve a recovery similar to that in East Asia.

Sri Lanka’s ongoing economic crisis and the policy responses taken to resolve the crisis have plunged the country into a worsening economic recession, causing disproportionate suffering to the poor, who make up the bulk of the population. I’m here. The crisis was not the people’s fault, but arose from bad macroeconomic management and unsound external debt management exacerbated by the global energy shock.

The country must be in deep recession because of the massive supply shock. High prices and uncertainty in energy availability pushed the economy away from equilibrium. Aggregate demand must have contracted as well, as the sharp depreciation of the currency and high inflation shock exacerbated the recession. The default would have hit the economy further, jeopardizing the prospects for recovery and growth.

High interest rates, high tax rates, administrative fixed exchange rates, and import restrictions are the main components of the macroeconomic policy package introduced in Sri Lanka to recover from the crisis. This macroeconomic policy package appears to have had the opposite effect.

High interest rates and high taxes discourage private investment. Reduced government spending will further crowd out private investment. Maintaining a fixed exchange rate even after significant depreciation creates future uncertainty, adversely affects a country’s competitiveness and hinders industrialization. Import controls the consumption and industrial production of further strains. The compounding effect is to worsen the recession and plunge the economy into a dark tunnel of high unemployment, high inflation and extreme poverty. Recent reports indicate that poorer parts of the population are already suffering from severe malnutrition, while wealthier parts of the population seek to migrate to the first available opportunities that inhibit human capital development.

A similar macroeconomic policy package was introduced in 1997 in the East Asian countries that encountered the financial crisis. This policy package has been a success in these countries unlike the failure in Sri Lanka. The reason for this is that the characteristics of the Sri Lankan economy and the East Asian economy differ greatly.

Unlike Sri Lanka, these countries did not default on their sovereign debt after the crisis, although private companies experienced some external debt restructuring. was.

The East Asian crisis began in Thailand. This is because the overvalued exchange rate has led to speculative attacks on the central bank. The attack was successful and the Bank of Thailand lost a significant amount of its reserves defending an overvalued currency. After that, the Thai baht, the currency, fell sharply, and the country fell into an economic crisis. The crisis has spread further to several countries in East Asia. South Korea, Indonesia, the Philippines and Malaysia faced the most severe impacts of the epidemic, while Hong Kong and Singapore felt some impact. At the time, Sri Lanka was completely insulated from contagion due to its closed capital account, low exposure to external debt, and a realistic exchange rate adjustment to avoid overvaluation.

East Asian countries were economic powerhouses when the crisis hit. They were growing rapidly, fueled by excellent infrastructure development, human capital development, technological adaptation, high international competitiveness, a relatively low degree of corruption, and a fully liberalized economy. In the course of economic liberalization, the capital account was also fully liberalized following the advice of the International Monetary Fund (IMF).

This required countries facing large inflows and outflows of capital, not just for speculative purposes, but for investment. The banking system and large corporations have also been significantly exposed to foreign debt as a result of liberalization of the capital account. To keep these banks and companies viable, East Asian countries maintained fixed exchange rates. At the same time, these countries were pursuing their own monetary policies. As a result of maintaining this “impossible trinity”, speculative attacks by operators of large foreign funds were inevitable.

The IMF came to the rescue in the immediate aftermath of the crisis with a policy package very similar to that introduced in Sri Lanka. Interest rates were raised as a means of tightening monetary policy to prevent excessive currency depreciation. It prevented the vicious circle of currency depreciation and inflation. Fiscal policy was tightened by cutting government spending to reduce the budget deficit. The IMF provided loans to meet immediate international financial needs. Structural reforms were also introduced in these countries to ensure policy transparency and political stability.

Policy packages have helped stabilize these economies and restore investor confidence. A stable exchange rate after a combination of deep devaluation and high interest rates reversed the outflow of speculative capital and encouraged further inflows of capital to those countries. After stabilization, tight macroeconomic policies were eased rapidly to encourage private investment, foreign direct investment and economic growth. Each country’s economy responded positively to the policy.

Economic growth was feasible because these countries were economic powerhouses before the crisis and all the growth drivers were already in place. The central banks of these countries have learned their lessons and let exchange rates roam freely to stave off speculative attacks. All but Indonesia recovered faster than anyone expected. Recovery took only a year. However, although Indonesia experienced a major political crisis, the country eventually recovered.

The IMF and Sri Lankan policymakers may be hoping for an East Asian-style return. Her 2023 budget speech for Sri Lanka shows a recovery within the next 12 months, but falls short of explaining how the recovery will happen. However, Sri Lanka is unlikely to see a similar recovery as a result of its current policy package.

In East Asia, policy packages have reversed the outflow of speculative capital and provided a haven for these economies. In Sri Lanka, such capital flows do not exist and the policy package has unintended negative consequences. Sri Lanka continuously borrowed long-term foreign money at high interest rates and invested it sparingly. Sri Lanka also may not have had an external debt management system or debt sustainability framework that should have been put in place with the first installment of commercial debt in 2007. For reasons I don’t understand. As a result, foreign exchange became cheaper, imports surged, industrialization was hampered, and the trade deficit widened. To maintain a fixed exchange rate and finance its ever-widening trade deficit, Sri Lanka continued to borrow from international markets until its creditworthiness ran out. At the start of 2022, it was impossible to borrow any more foreign currency.

Yet Sri Lanka continued to use its foreign exchange reserves to maintain a fixed exchange rate for several more months until all its reserves were exhausted. After this happened, it had no means of financing essential imports such as fuel and meeting its sovereign debt service obligations. After that, the exchange rate plummeted, imports of energy and daily necessities stopped, and Sri Lanka defaulted on its government bonds for the first time. These culminated in Sri Lanka, which plunged into recession and whose population faces unprecedented hardships, as if back in the Stone Age.

To recover, Sri Lanka must earn foreign currency through export promotion and industrialization. To achieve this, Sri Lanka needs to ease macroeconomic policies to encourage private investment and implement structural reforms to remove impediments to economic growth.

Even before the economic crisis began, Sri Lanka was powerless to spur growth. There are many reasons for these lack of power. Two of the summary indicators are global competitiveness and perceptions of corruption. According to the World Economic Forum, more than half the countries in the world are more competitive than Sri Lanka. Sri Lanka has occupied this mediocre position since the country entered the competitiveness rankings. Their report clearly states where Sri Lanka is failing. Sri Lanka also ranks mediocre in the Corruption Perceptions Index published by Transparency International. Only 78 countries in the world are more corrupt than Sri Lanka. It is not clear whether the 2023 budget proposals can address these key shortcomings.

The path to recovery and long-term growth will depend on devising the right macroeconomic policy package, strengthening the public policies needed to deliver the industrial revolution and rapid economic growth, restoring competitiveness and eliminating corruption. , to strengthen institutions and strengthen law and order. It protects property rights, maintains economic stability, regulates unhealthy economic activity, and cares for the poor and vulnerable segments of the population. But none of these policies will be effective until strong measures of accountability and appropriate checks and balances are imposed on the government sector.

Without these measures, the country will be pushed further into crisis. It is also worth noting that even with these measures, a country will not prosper unless its politicians and bureaucrats have the entrepreneurial spirit and skills to formulate innovative strategies and put them on a high-growth trajectory. increase.

(The author has worked as Public Debt Supervisor, Economic Research Director and Assistant Governor at the Central Bank of Sri Lanka. He currently teaches Economic Theory and Policy at the University of Iowa in the United States. [email protected])

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