About five years ago, Sri Lanka faced three daunting economic challenges. To deal with these challenges, the Sri Lankan authorities implemented certain pragmatic strategies that challenged conventional wisdom.
At the time of defeating terrorism in May 2009, a massive investment was required to restore normalcy in the terror-torn Northern Provence. Conventional wisdom suggested that rebuilding, rehabilitation and restoration should be carried out at a moderate pace without burdening the economy unduly, and without placing government expenditure under stress.
However, even at the risk of experiencing a spike in the fiscal deficit in the years 2009 and 2010, Sri Lanka executed a rapid action plan to de-mine land, re-settle IDPs, and upgrade infrastructure in the war-affected areas. That investment brought quick relief to the hundreds of thousands of people who had suffered during the 30 year war.
The cost? A staggering $3.2 billion over 4 years, or exactly 6% of GDP! The direct benefit? Rapid clearance of over a million land mines from the Northern Provence: speedy resettlement of nearly 300,000 IDPs; early restoration of the infrastructure: considerable progress in agriculture, fisheries, and SME activity: significant increase in industrial production and domestic terrorism: major transformation in the financial sector; and creation of new entrepreneurs and job opportunities.
The overall outcome? A peaceful country without a single terrorist incident; significant country-wide economic growth; and sharp reduction in poverty levels. These incredible outcomes vividly reflected the extraordinary benefits that had been reaped via practical wisdom.
Around 2008, the country was trapped in a “vicious cycle” that had hampered growth since independence: high fiscal deficits leading to high inflation; high inflation leading to high interest rates; high interest rates leading to low investor confidence; low investor confidence leading to sluggish investment; sluggish investment leading to lover growth than potential; lower growth and high fiscal deficits leading to unfavorable debt dynamics which intern, impacted fiscal deficits adversely. This vicious cycle was deep rooted, and many of Sri Lanka’s economists who subscribed to conventional wisdom used to lament that this cycle was the country’s “karma” (fate), and that it would be impossible to break free from that grip.
To escape, a radical change in policies and perspectives was needed, and Sri Lanka responded by introducing several bold policy initiatives across several fronts: excessive monetary expansion was contained through unconventional monetary policies such as tight quantitative tightening; recurrent fiscal expenditure was curtailed while preserving public investment for infrastructure development; monetary and fiscal policies were coordinated to bring about overall macroeconomic stability; new foreign investment was targeted through a steady pipeline of major projects and investments in government bonds. These new measures led to an average growth of 7.5% over the four years, 2010 to 2013 and thus, the vicious cycle was converted into a new virtuous cycle, with inflation in single digits, shrinking debt to GDP ratios, and low interest rates.
In 2009, Sri Lanka also faced another major challenge: the threat to its external account. The effect of Global Financial Crisis had impacted Sri Lanka, and large scale overseas bond redemptions had resulted.
It was soon clear that some external support was required to stave off this challenge, and Sri Lanka decided to avail itself of the IMF facilities via a stand-by arrangement (SBA). The key objective of the SBA was of Sri Lanka to build up its foreign reserves to more comfortable levels to meet the uncertain global environment.
The issue however was that the IMF, in its conventional wisdom, was insisting that Sri Lanka sharply depreciate its currency in order to curb its trade and current account deficits which, in its view, would help the country build up reserves. The IMF ask held the view that Sri Lanka must significantly increase government revenue by raising taxes.
In theory and in normal circumstances, the IMF’s suggestions may have had merit. However, the Sri Lankan authorities who had a deep practical understanding of the socio-economic challenges facing Sri Lanka, held a different view.
The authorities’ view was that since the conflict had ended, there was an urgent need to reconstruct the terror-affected areas, which covered almost one-third of the country’s land mass, and two-thirds of its coastal belt.
New economic activities had to be promoted for the peace dividend to be realized. Such new activities would necessitate a high import expenditure, which in turn, would create new capacity for economic growth.
In such circumstances, it the Sri Lankan Rupee were to depreciate sharply, it would lead to significant reduction in the imports necessary for reconstruction and a slow-down of new economic activities. Those outdoes, together wight he resulting higher levels of inflation would have kept Sri Lanka trapped in the vicious cycle.