Another budget is around the corner. A journalist asked me what I thought were the issues or challenges that face the economy. Usually people look to the budget like children looking for Santa Claus at Christmas. But according to news reports there are 750 suggestions from the public and they are asking for money for infrastructure in a pathetic state of ruin particularly in the rural areas. I referred the journalist to the Central Bank Annual Report for 2005 which sets out the key issues involved in our budget making.
Structural Deficit in the Budget
The revenue of the government is not enough to meet the annual increases required in expenditure even without any new programs. About 70% of the budgeted expenditure is committed to paying salaries of public employees, pensions and interest on the public debt. In fact the total revenue of the government is not enough to service the debt for the year which includes interest and debt repayments falling due in the year. There is very little scope for any new discretionary expenditure. Nor is it possible to re-allocate the expenditure since practically all departments and programs need extra money to cope with the inevitable inflation due in the year.
Since revenue can only grow at the rate of growth of money GDP it is not enough to cope with the extra expenditure required in real terms to just maintain the current functions and programs. So how can the government provide any extra benefits without increasing the budget deficit? The over-all budget deficit was 8.7% of GDP in 2005 and it will keep on increasing. If we add up the losses of the state corporations, the public sector deficit exceeds 10% of GDP. Any new expenditure programs will increase the budget deficit further. It will keep on increasing even without such new programs.
Does it matter? It does because a budget deficit means higher inflation since savings are being borrowed by the government and spent even if it doesn`t create new money by pressurizing the Central Bank and the state banks to do so. This money the government can borrow from the EPF at low rates of interest, by cheating employees` retirement benefits.. Foreign borrowings are from the Aid Donors and the multilateral institutions. These institutions prefer to lend for capital investment projects and for promoting the welfare of the poorer segments of the population.
The golden rule in budgeting is that moneys should be borrowed only for investments since they provide a return for many years which exceed the cost of the project plus interest. But our governments run increasing deficits even in the current account of the budget. If an individual were to run a deficit for his current expenses year after year, he would soon declare bankruptcy as no one would lend to him to roll over his debt and also borrow more for his current needs. But the government with its monopoly of currency issue doesn`t have this problem. It can borrow and borrow more each year rolling over the past debts and raising new debt to carry on.
However dumb they are, the public eventually realize that they are being cheated when they lend to the government. They are being repaid with debased currency just as Henry VIII did when he re-minted the pound with less and less precious metals and more and more base metals. The money they receive has lost its purchasing power. So they stop lending to the government. But not to worry! There is an inexhaustible supply available with the banks. The banks can create money provided the Central Bank co-operates by expanding its own supply of reserves to maintain as a statutory reserve ratio of 10% of their total deposits.
The banks can create money up to 10 times the value of deposits. But the government is picking our pockets since such money creation pushes up inflation. The Central Bank has fixed a target for the expansion of the broad money supply to 15% per annum. But it has never succeeded in bringing it below 19-20%. It has also kept interest rates low so that the Treasury won`t have to cough out more money by way of interest. But the past borrowings are already too high.
Foreign debt- the Achilles heel
About half the debt also has to be repaid in foreign currency be it dollars or yen. When the rupee depreciates, what`s payable as interest and principal on foreign debt increases. So the rupee must not be allowed to depreciate. This is of course good to keep inflation low. But if in spite of its efforts inflation goes up because of the high budget deficit, then the Central bank has a hard time trying to maintain the rupee steady. It has to sell dollars from its Official Reserves. But prudence requires that some minimum Foreign Reserve should be maintained for we cannot wait for the arrival of the receipts from exports to carry out imports. We had such a situation in the 1970s and had to resort to foreign exchange budgeting and deferred payments for imports which meant higher cost of imports.
The future that never comes
The size of the budget deficit and how it is financed is an important issue in budgeting. The Central Bank has repeatedly pointed out in its annual reports that there must be fiscal consolidation - economic jargon for reducing the budget deficit and bringing down the public debt. What does this require? It is not possible to attend to these problems in a single year. So the Fiscal Management (Responsibility) Act of 2003 gave a time period to achieve these objectives. It specified that the budget deficit should be 5% of the GDP for 2006 and maintained at that level thereafter. It also specified that the government debt (including the external debt at the current exchange rates) and other liabilities should be brought down to 85% of GDP.
This means some amount of the public debt has to be repaid. But that requires what economists call a surplus in the primary account of the budget. (The over-all budget deficit must be less the interest payments). But the UPFA government has ignored this law and these limits. It has carried on deficit budgeting putting off the medium term for the never never. It continues to run deficits in the primary account, the current account and the over-all account. It seems to think that the debt/GDP ratio can be brought down through inflationary growth which raises GDP in nominal terms at an increasing rate. But this carnival can`t go on forever.
Increasing public investment
It is the empty boast of the UPFA government that it has increased public investment as a ratio of GDP. It was 6.3% of GDP. But only 3.4% really constitutes investment in economic services like transport and infrastructure. The rest goes to put up buildings for schools and hospitals which are often unutilized as they are not equipped with the required staff and equipment. All this is while existing school buildings and hospital buildings are in a state of disrepair and some on the verge of collapse as Action TV shows regularly. Roads, bridges, culverts, irrigation dams and channels are not being maintained. So while new assets are created the old assets are not maintained and net public investment is perhaps being reduced. What is important for economic growth is net investment.
Regional disparities in development
Everybody talks about the regional disparities in development with the Western Province provides 49% of the GDP. Several provinces contribute less than 5%. Are the provinces equal in area? Are they equal in population? Even after making some allowance there is no doubt that there is gross under-development of some provinces like the Uva and also the North & East. The way government politicians speak about these disparities one would expect them to do something about it. But do they?
A mere 10% of government expenditure goes through the Provincial Councils and the Pradesiya Sabhas. The Appropriation Bill for2007 provides a sum of Rs: 11.4 billion under the Ministry of Provincial Councils for development activities. How this is divided is not apparent from the Bill. There is separate provision for each Provincial Council and the Western Province gets the most for development activities while the North & East (two provinces) and the Uva gets least.
Most of the development expenditure ? about 80% is funded by foreign project aid. But these projects require rupee counterpart funds. These projects are delayed because the counterpart funds are not available on time although provided for in the budget. It is a question of cash flow. The Treasury dribbles the money to the departments under the imprest system. The government revenue is seasonal and government borrowing is largely short term and through treasury bills & bonds.
The available supply of funds for borrowing are limited each week to the interest rate payable and the funds availability of the EPF & NSB. Long term rupee securities apparently have no demand from the market as people have expectations of high inflation. So the Treasury is unable to make funds available as and when necessary. The departments have to give priority to pay salaries from the imprest. There perhaps is a need for a cash flow plan to accompany the budget. Some countries like New Zealand have even introduced accrual accounting and prepare draft Balance Sheets for the government.