The new trade policy has dangerous Mercantilist myths
Sri Lanka’s new trade policy published by the ministry of development strategies and international trade says a lot of home truths about protectionism, but it also reinforces dangerous Mercantilist myths that can hurt the poor and increase public discontent. Such beliefs can undermine the entire reforms strategy, like it did in the 1980s.
An enduring myth in Sri Lanka has been that balance of payments crises are caused by trade deficits. This is one of the original classical Mercantilist myths dating back to the 17th century. It is the very same myth that drives protectionism and allows politically connected producers and farming lobbies to exploit poor consumers with import taxes.
CURRENT ACCOUNT FALLACY
● The New Trade Policy goes some way to debunk the classical Mercantilist myth, but replaces it with a neo-Mercantilist one. “The imposition of import controls does not reduce excess demand, which can be considered the main cause of a current account deficit,” it says.
“In addition, import restrictions can contribute to widening the trade deficit by discouraging exports (generally speaking, import restrictions are a tax on exports).”
If excess demand is a reference to money printing by the Central Bank, it’s true that a balance of payments crisis (an outflow of foreign exchange greater than inflows) occurs when money is printed by the Central Bank.
However, it is only partly true that current account deficits are caused by excess demand, though certainly an increase can happen when printed money turns into imports, either through straight state spending or bank credit.
Any country with a capital surplus can run a current account deficit when the proceeds of capital flows (foreign direct investment or foreign loans) are spent within an economy, generating imports. When FDI comes, it causes an import of material for factories, or buildings or machinery. If the government borrows from abroad for roads, it causes an import of cement or steel.
But, that does not have an effect on the exchange rate, as any import is financed by a capital inflow. Countries like Sri Lanka also get a lot of remittances officially, as well as from unofficial channels, which when spent will contribute to a trade deficit. On the other hand, a country like Germany, which has a surplus budget or whose companies invest heavily in factories in East Asia or Eastern Europe, can have a current account surplus. Sri Lanka borrows heavily abroad, generating a current account deficit, and has a persistent trade deficit because there is remittance inflow, which creates income above merchandise exports.
“Although this is not a large deficit by international standards, concerns about the current account deficit are justified because it has been a recurrent driver of macroeconomic imbalances and subsequent growth slowdowns in Sri Lanka,” the trade policy also claims.
“The current account deficit remains persistent despite the large windfall from lower oil prices, and Sri Lanka’s foreign currency reserves are barely adequate, currently standing at 3.8 months of imports.”
There is no windfall from lower oil prices. When oil prices are cut, non-oil imports will go up, as more money is left in the hands of people, just like oil price hikes reduce non-oil imports. This column warned that it will happen as early as late 2014, when then President Mahinda Rajapaksa announced oil price cuts as a part of election moves. However, oil price cuts will not cause BOP problems, unless the Central Bank also prints money. An outflow of money through capital flight may also reduce the money available for imports, and a currency may fall even if the current account deficit narrows.
For example, Sri Lanka’s current account deficit in 2014 was $1.99 billion; in 2015, it was $2.09 billion and later revised down to $1.89 billion, and $1.9 billion in 2016. All this shows not only that losing sleep over current account deficits is a waste of time, but also the powerful grip of Mercantilism in most countries that have pegged exchange rates.
‘NOMINAL EXCHANGE RAT E LOW’ MYTH
● Then, the trade policy goes on to state an outright lie. “The Central Bank of Sri Lanka attempted in the past to keep the nominal exchange rate low,” the policy says. “It led to large balance of payments deficits, loss of reserves and borrowing at commercial interest rates that increased external debt.”
For one thing, the rupee fell from around 105 to 120 to the US dollar during the 2008/9 BOP crisis, but was allowed to strengthen when credit eased; it also fell in 2012, but was kept at the fallen level of 130 to the US dollar. Admittedly, however, depreciation was less than in the 1980s, strike-driven turmoil years.
The Central Bank also did not lose reserves by trying to ‘keep the nominal exchange rate low’ (this is probably meant to say that the exchange rate is either fixed or strong), as it is claimed. The Central Bank lost reserves by selling reserves and printing money after dollar sales to stop interest rates from going up (sterilized forex sales). Put another way, the Central Bank kept interest rates low by printing money, creating excess demand.
It recovered the reserves by sterilizing the purchases (selling down Treasury bills it bought to create the BOP crisis in the first place), as it is doing now. The other claim made is that an exchange is ‘overvalued or undervalued’.In fact, the International Monetary Fund concluded that, when this administration came to power, the rupee was not noticeably ‘overvalued’ by several separate measures. Claims of exchange rate ‘undervaluation’, especially in East Asia, is a myth devised by US mercantilists.
This column has previously shown that it is a well-developed false doctrine, through which the Japanese and Chinese nominal exchange rates were forced to be appreciated, but which failed to narrow deficits with the US.
US mercantilists are also using circular arguments to make their case. One of the metrics through which there is ‘undervaluation’ in East Asia is a current account surplus. If a country in East Asia runs a current account surplus, it is assumed that the currency is undervalued. In reality, however an exchange rate moves based on the monetary policy that is adopted. There is no market-determined exchange rate. There is an exchange rate that is determined by a particular monetary regime that is adopted.
THE DEADLIEST FALLACY OF THEM ALL
● The deadliest fallacy in the New Trade Policy goes as follows: “Also, when real exchange rates appreciate, it encourages more capital-intensive production and discourages greater use of labour-abundant resources.” What labour-abundant resources? And, isn’t capital-intensive production just what this country needs?
Sri Lanka is short of labour. The population is ageing. We are no Vietnam, with a massive young population. The population in Sri Lanka is visibly old now. The old argument for currency depreciation to boost exports was based on two arguments: slave labour and poverty.
The poverty argument simply says that a weaker exchange rate will reduce the incomes of domestic citizens and create a greater exportable surplus. This does not hold now because industrial goods exports, which the elites want, requires technological and marketing know-how to produce and sell, and Sri Lankan firms make protected expensive products.
The slave labour argument says that, when the currency falls, wages will fall, and producers will get more profits at the expense of labour and there will be more investment flowing into exports, and they may also be able to cut some prices and win market share.
For one thing, this strategy implies a subsidy to exports over all other sectors of the economy. For another, it assumes that people will stay in one place and move like cattle to the factory floor for low salaries as the hard goods export-happy elites want.
PRODUCTIVITY AND REAL WAGES
● The claim that a strong exchange rate ‘encourages more capital-intensive production’ is actually quite true. Prime Minister Ranil Wickremesinghe has said that he wants to create high-paying jobs. The only way to increase labour productivity is to have more capital investment. If the currency is depreciated, capital will be destroyed.
It is an undeniable fact that industrial export growth is linked to foreign direct investment. This is because foreign companies in competitive markets develop the latest designs and technology to keep customers happy.
These two come when FDI comes in and transforms a sector. In many countries, export firms pay the highest wages. Higher wages will only come to exports when (and if) new investments and factories are built. Existing firms will not want to raise wages too much. That is why these firms find it difficult to get new hires. Domestic industries that have seen a lot of investment now pay higher wages. Construction was driven by foreign borrowings. But, areas like IT are driven by real private investment.
According to an analysis by Ricardo Hausmann, domestic industries like construction pay higher wages than export industries. This is in sharp contrast to Panama, where export industries and services pay higher wages than non-traded sectors.
Hausman’s choice of Panama is interesting. Panama is a country where the option to generate slave labour-driven exports is not available to policymakers. Panama is a dollarized country, which is like a currency board, and no currency depreciation is possible to combat perceived Mercantilist overvaluation.
While many South American nations built Sri Lanka-style central banks and deteriorated into revolutionary hell-holes, Panama stood tall. When a country is dollarized or there is a currency board, a hard budget constraint is created to make deficit spending difficult.
Panama is also a financial centre, like other countries that do not have soft pegs. Sri Lanka’s aspirations to be a financial centre will be doomed if it continues to have a soft peg. No longer can rulers print money, borrow excessively, and impose backdoor ‘hair cuts’ on public and private debt (bank deposits holders and pensioners) through currency depreciation under the guise of boosting exports.
Any haircuts like in Greece will be transparent and visible.
From construction to even road cleaning, capital investment is boosting labour productivity. Abans is using mechanised sweepers to clean roads. If elite policymakers expect to depreciate the currency and expect exports to be boosted by unsound money amid labour shortages, they are sadly mistaken. Slave labour will not sit still as currency depreciators expect.
SLAVE LABOUR IS MOBILE
● In Sri Lanka, massive migrations of labour started to happen from the severe currency depreciation years of the 1980s, and freedom was given for people to move out. Even government servants went abroad. Highly qualified people migrated to international agencies and western countries, while labourers and housemaids went to the Middle East, Singapore and the Maldives. Middle-level government workers like teachers went to the Maldives.
The Maldives, which is based on fishing and tourism, has a much more stable exchange rate than Sri Lanka. Even now, many skilled workers are giving up jobs they already have and moving to the Middle East, the Maldives, Korea, Japan or even Malaysia, legally and illegally.
They have aspirations that do not match the elites’ view of herding them to the factory floor to earn wages, and whose purchasing power has been robbed by the Central Bank through currency deprecation.
If there was no ecosystem of job agencies, friends and neighbours who have already made good going abroad for one or two years to come back with savings, the slave labour-weak currency strategy may work. But, that is not the reality. The reality is that people know how to go out of the country, there are job agencies, and there are a bunch of countries like the Middle East, the Maldives and East Asia that are willing to accept them.
There are even people, like mechanics, working for US defence contractors in the Middle East.
At the moment, prospects of getting jobs in the Middle East are dim due to low fuel prices. But, people still have aspirations. Each time the currency falls, the number of passports issued goes up steeply.
While association may not be causation, clearly at least a part of this enthusiasm for passports is due to the relative attractiveness of foreign jobs, after currency depreciation destroys real wages.
New passport issues grew relatively anaemically from 507,949 to 523,000 in 2011, with the exchange rate stable. Only in the latter part of 2011 did the rupee start to weaken, with a cycle of money printing and currency defence.
In 2012, the rupee was floated.
The currency fell to 127 by year-end. Passport issues jumped to 570,000 by the end of the year. Middle Eastern passports jumped to 230,000 from 196,000. By 2015, when this administration came to power, new passport issues to the Middle East fell to 176,000 a year, although the total to all countries rose.
The rupee started to weaken only in the second half of the year. By end-2016, the rupee had collapsed to 150. Middle Eastern passport issues rose to 200,311 despite a downturn, and all countries rose to a record 422,394. Total passport issues soared to an all-time high of 658,000, from 491,000 a year earlier. While the reasons for the record passport issues need deeper study, anecdotal evidence shows that at least a part of those who bought the passports were foreign job seekers.
The pressure on the working class from currency depreciation is unlikely to make for a contented workforce.