Budget follows IMF guidelines

By R.M.B. Senanayake-2017-11-22

As orthodox economists, we cannot criticise the macro-economic factors and balance underlying the Budget. The expenditure aggregate is limited in accordance with the government's inclination to raise tax revenue. So, if the government wants to spend more it will automatically have to tax more under IMF tutelage. Our governments generally do not like to raise taxes, although they like to increase government expenditure.

This means they run budget deficits and unless the deficit is met from the transfer of savings from the public (a limited option since our private savings are also low), they are then tempted to borrow money not only from the savings of the people, but also from the banking system (which is tantamount to the creation of new money) to fund budget deficits. So, a large quantity of new money is created without it being linked to any increase in the production process for goods and services.
Production process

Money is normally created through the production process when domestic production and exports exceed imports. The excess can then be accumulated as extra foreign exchange which can be converted to domestic money. Similarly, if exports fall short of imports there will be a shortage of domestic money. If we did not have a Central Bank, the money supply will vary with the balance in the balance of payments. All money was created only through the export and import process for money was linked to the surplus or deficit in the current account of the balance of payments. There were both advantages and disadvantages in the system since the domestic money supply varied with the external balance, providing an automatic correction to a balance of payments deficit. But it also meant the country had no control over its money supply.

The domestic economy which did not require imports was hampered thereby. It meant that the fluctuations in the external account automatically generated similar fluctuations in domestic aggregate demand which caused unnecessary fluctuations in domestic economic activity. Those who opposed it argued that there was no reason why domestic economic activity, which did not require imports should be curtailed. Theoretically, the criticism was valid, but in practice domestic economic activity was too highly linked to the external balance in any case.

So, when the nexus between the two was severed, this resulted in the build up of unsustainable domestic imbalances which required periodic devaluations and depreciations. Earlier, there were regular and continuous fluctuations in the exchange rate which automatically smoothed out imbalances in the balance of payments, but it meant continuous fluctuations in the exchange rate – a variable instead of a fixed exchange rate.

World powers

The IMF set up by world powers after the war, opted for fixed exchange rates except to correct periodic unsustainable imbalances in the balance of payments. So, countries were required to fix their exchange rates with the IMF and only if there were continuous unsustainable imbalances in their balances of payments were they allowed to depreciate the currency. There had been competitive exchange rate depreciations to promote exports by Western countries after World War I.

There are disadvantages in a freely fluctuating exchange rate since this could lead to speculative changes in demand and supply, whereas economists would prefer the exchange rate to be determined by fundamental factors instead.

After World War I, the exchange rate was linked to the external bank balances in foreign exchange. So, the exchange rates fluctuated with the external balances, but devaluations and depreciations raise the cost of living which make governments unpopular, but where there are continuous unsustainable deficits in the balance of payments, governments have no alternative, but to depreciate when necessary.

Since we are also a highly import dependent economy and consume many imported goods, our living costs can go up steeply due to changes in the exchange rate. So, a fluctuating exchange rate was not desirable for us. It would make living costs fluctuate too much.

It would also adversely affect our foreign trade. So, they opted for governments to stabilize and hold the exchange rates stable as far as possible, but this meant holding an adequate foreign reserve at all times. This task could not be left to the market and hence the Central Bank took over the task of holding the foreign exchange reserve of the country.

The commercial banks were allowed to hold only working balances of foreign exchange and not to hold or build reserves. So, any surplus over the working balances had to be sold by the commercial banks to the Central Bank, but there was merit in automatically linking the external value of the rupee to the external balance since it eliminated the need for the governments to undertake periodic devaluations which became explosive matters under independent democratic governments.
Devaluation or depreciation raises the cost of living and was therefore, unpopular with the people.
But it may be necessary if there are unsustainable deficits in the balance of payments for otherwise the foreign reserves would be drained out completely and the country would become incapable of importing at all. So, conserving a minimum level of foreign reserves was a sine qua non since there was no automatic mechanism linking exports and imports. They are made by two different sets of people who are exporters and importers although a few may engage in both.

So, some public authority was required to regulate our foreign reserves and conserve a minimum level of them to provide for unforeseen eventualities. Export production for example could suffer due to adverse weather conditions, while continued imports would be required at the same level, but this would mean a shortfall in our foreign exchange balances, but we depend a lot on imported goods for our essential consumption requirements. At one time, we were importing rice, flour and sugar for our day-to-day requirements. And any shortage in the market for them would create public outcries and even bring down democratically elected governments. So, post-war democratically elected governments continued the government monopolies on the import and distribution of rice, flour and sugar.

The Food Commissioner was entrusted with the task and he had several large stores in the Chalmers Granaries and the Manning Market where these goods were stored and distributed through the cooperative unions who in turn sold them through cooperative societies.

So, the importing and distribution of rice, flour, sugar and even some subsidiary foodstuffs like Mysore dhal were made government monopolies or were mainly imported by the Food Commissioner and the cooperative wholesale establishments which were expected to act in the public interest rather than to exclusively pursue private profit.

Domestic money supply

As for the domestic money supply, there was much criticism in making it vary with the external payments position since some domestic economic activity could expend without causing problems in the balance of payments. This realization led to the demand for the setting up of a Central Bank which could create money to cater better to the needs of the economy without domestic monetary expansion being at the mercy of external demand.

During World War II, when we were under the British, our foreign exchange balances accumulated since imports were limited by enemy attacks as well as shortages of world supplies. So, our foreign exchange balances accumulated at the end of the war.

Our post-war independent government saw the opportunity to spend money freely to enhance their popularity and develop the country faster since they thought development depended on spending more money on investment. (this is true only if the investments are successful and increase incomes as a result)

World War II

Immediately after World War II we had a large volume of foreign reserves accumulated by denying expenditure. This has been used to undertake deficit budgeting funded by borrowings from the Central Bank and the banking system which economists refer to as the creation of new money. Such new money creation unlinked to the process of production or the surplus in the external account of the nation means more money is created while the supply of goods and services is not increased by domestic production.

So, the extra aggregate demand spills over to an increased demand for imported goods and services without a corresponding increase in exports. This results in an increased deficit in the balance of payments which has to be funded by drawing down foreign reserves of the country.

A certain minimum level of foreign reserves expressed in terms of the capacity for several months imports, say 5-6 months, is considered as a prudential level to deal with the fluctuations in world trade. Exports and imports don't match automatically in a free market economy since foreign reserves are used to fund the imports.

Exporters and importers are not the same people. The exporters are not allowed to keep the foreign exchange earned from their exports. They must surrender them to the banks and the latter in turn to the Central Bank (except for working balances).

The Central Bank becomes the holder of the foreign reserve of the country, built up from the surplus of exports over imports of goods, services and unilateral payments or receipts (such as remittances from our migrant workers). Only the Central Bank can keep unlimited amounts of foreign currency and the commercial banks are allowed to retain only working balances for their day-to-day operations. Let us conserve our foreign exchange earnings for a rainy day.