by Analyst
Those who thought that there will be no adverse effects on our economy from the S.E. Asian crisis must now recognise that we have now experienced a stock market collapse similar to those which characterised all the S.E. Asian countries. Of course it took one year for our stock market to collapse due to the lack of liquidity in the market unlike in the S.E. Asian countries where market capitalisation was very much higher, there were many more active players and where short selling was in vogue. Anyway, the collapse is now an established fact and the market is likely to remain for quite some time inspite of brokers attempts to talk up the market. A gain of 4 - 5 points in a day or two is insignificant and is caused by day to day imbalances in the market which are always corrected.

Stock Market collapse
The adverse effects of the stock market collapse bear on the borrowing capacity of the public quoted companies who wish to raise equity in the primary market. Companies can no longer issue new shares or rights shares at a premium as they did when the market prices for their shares were high. Even if they issue new shares or rights shares at a 10% discount to the market they are unlikely to find takers although investment relief under income tax has ben extended for another year.

The public can expect only dividends with little or no prospect of capital gains which are the life blood of stock markets. So the prospects of raising capital have been dimmed and with it the level of private sector capital investment will come down since the banks always look to appropriate debt equity ratios in financing companies. The banks will have to take a more lenient view and finance capital expenditure projects on their own merits.

Although universal banks as in Japan and Germany take equity stakes in companies and they lend to and serve on their boards as directors, the tradition is not established here. The banks will have to lend to good profitable projects and monitor their progress much more closely until better debt/equity ratios are re-established.

The level of investment is essential to keep the economy growing, particularly as the government is not in a position to undertake investment, being saddled with large budget deficit and an excessively high public debt. Expenditure on the war is mounting and is unlikely to come down. There are also allegations of large scale corruption in defence purchases. If true it must be noted that no war was ever won by a corrupt establishment against a dedicated if vile foe.

Currency crisis
The second aspect of the S.E. Asian crisis was the currency crisis. It all started in Thailand when speculators realised that the Central Bank was putting out bogus figures of foreign reserves, not setting off reserves earmarked against forward sales. The Thai Central Bank tried to maintain the value of its currency and had the worst of both worlds when it lost reserves and also failed to defend the currency.

The same episode was repeated in the Philippines but there the Central Bank did not commit any of its reserves to defend the currency but allowed it to depreciate. The same scenario was repeated in Indonesia and Malaysia.

The question is whether a similar sort of crisis in the currency will be likely here, just as the stock market crisis was replicated here even though it took an year to do so. It is argued that because we have controls on capital movements and the rupee is freely convertible to other currencies, we are sheltered from any such exchange rate crisis. But in 1967 Britain was forced to devalue the pound sterling after a period of inflation and over-borrowing even when there were strict controls on capital flows and far smaller financial markets. So economies that are open to trade but not to capital flows are also prone to exchange rate troubles.

Interest rates
Macro-economic policy is bound by certain fundamental constraints regardless of capital flows. One such constraint is that when a government borrows more and more, those who lend to it need to be compensated by high interest rates. So although interest rates have come down by 4 - 5 per cent with the reduction in the reserve ratio that the banks have to maintain with the Central Bank (which freed reserves for lending to the customers), there is no guarantee that interest rates will not rise again if government borrowing expands once again.

During the first half of 1998, government revenue collection was only Rs. 81.2 billion whereas the budgeted revenue for the whole year is Rs. 188.4 billion. Government expenditure however which was budgeted at Rs. 247.6 billion for the year is likely to be exceeded as usual. The expenditure for the first half year was Rs. 125.2 billion.

The total outstanding public debt has increased by 7.6% compared to the end of June 1997. The rate of government borrowing is expanding faster than the rate of economic growth in the economy, indicating a return to the previous pattern of a debt trap.

The privatisation proceeds in the last 2 years helped to freeze the increase in the public debt which had taken place previously. But the underlying structural deficit in the budget continues and hence the low interest rates are unlikely to persist.

Money supply
Another constraint on macro-economic policy is that any persistent expansion of the money supply will push up prices. Of course economic growth requires some increase in the money supply each year. But if the increase in money supply exceeds what is required to sustain real growth in output, then some inflation is inevitable. Presently our real output or G.D.P. is growing at 5 - 6% per annum. It is likely to be less than 5% this year. But money supply grows at 16% for M1 and 11.6% for M2, which is more than double the rate of economic growth.

As long as there is some inflation, credit has to expand by a similar percentage to enable firms to replenish their stocks since stocks increase in value with the increase in prices. Similarly as the rupee depreciates, the stock holding costs of imports increases and more credit is required to finance them. Even purchase and holding of goods for exports requires more credit since the domestic prices of exportable foods also increase with inflation via increases in wages.

Exchange rate
Where does the exchange rate enter the scene of macro-economics. We do not have an outright peg to the US dollar at a fixed rate as in Hongkong. Nor do we have a freely fluctuating exchange rate determined by the market. We follow an awkward hybrid in which the Central Bank attempts to peg the rate to iron out temporary disorders in the market while permitting long run adjustments. Although easy to state, this is not an easy policy to follow. So far we have had a depreciation of about 7% this year.

There are many variants of floating exchange rate policies. In many cases the exchange rates is adjusted "ex post facto" to previous domestic inflation. Exporters and producers of import - substitute need assurance that the exchange rate will not go against them.

The S.E. Asian crisis showed that with free capital movements any pegging of the exchange rate is extremely difficult. It also shows that with foreign capital inflows, any pegging of the exchange rate requires the money supply to be determined by market forces. When capital flows in there is an increase in liquidity in the banking system and the temptation is for the banks to lend liberally. Such liberal lending spilled over to risky and speculative investments. Such liberal lending also pushes up the prices of assets like land and stocks. This investment boom continues while the external balance deteriorates. The bubble bursts exposing the banks with non-performing loans.

In short, during such a boom, monetary policy is rendered ineffective. The Central Bank may try to neutralise the expansion by sterilising the capital inflows. But this is extremely difficult.

The burden of maintaining macro-economic balance thus falls on fiscal policy. But governments are notoriously imprudent too and fail to budget for surpluses or even balance their budgets. The burden of maintaining macro-economic balance is lightened with strong capital controls as we have had and which Malaysia has now introduced. With such controls it is possible to use both monetary and fiscal policy to maintain macro-economic balance.

During the last few years when we had capital inflows the government's privatisation programme offset the expansionary impact of such inflows. But with weak capital controls or none at all, a sharper choice has to be made. Fix the currency and use fiscal policy for stabilisation or let it float and use monetary policy to that end.

We had hitherto used both measures and made our way with reasonable inflation. But can the government continue to contain its budget deficit. If not interest rates will have to be raised to maintain macro-economic balance. If it is more profitable to take out money and bring it back when the exchange rate is depreciated sufficiently, then there will be capital flight and more tightening of exchange controls will become necessary. But a weak administrative apparatus tinged with corruption is unlikely to contain capital flight. So a currency crisis cannot be ruled out entirely.

The stock market collapse took one year. A currency crisis may take longer, but it cannot be ruled out, given the global environment. We have been adversely affected already by the Russian crisis. Several million dollars have already been lost on tea exports to Russia, commodity prices are coming down and our production of rubber and coconut products is less this year than last year. How will our industrial exports fare. Although the current account of the Balance of Payments will fare better, an overall deficit in the Balance of Payments is likely. The outlook for the immediate future is bleak indeed.

Welfare services
Can the welfare services be maintained without further erosion in their quality and value given the increasing expenditure on the war. We are about to introduce reforms in education. The benefits are being trumpeted even before the changes are introduced. One thing that is evident in our bureaucracy is the lack of administrative skills. The bureaucrats can muddle up the best schemes as the introduction of G.S.T. showed. Whilst tax increases always lead to increases in prices, tax reductions make no impact on bringing prices down.

Turnover tax rates were brought down from 18 - 20% to accommodate a uniform G.S.T. But no one reduced the prices when turnover tax came down. But when G.S.T. was introduced, the same prices went up again rather than coming down by 6%. Such is the woeful lack of competition in the economy.

Nobody promotes the entry of new comers into business, not the government with its purchase procedures weighted in favour of existing suppliers, not the banks.

So the chances of success in educational reform are low. Better education cannot be dictated from the top, by the Minister of Education. Unless central control by the Ministry of Education is liberalised and the parents and principals of schools given more power in the implementation of reforms, there is hardly any hope of success. Reform normally creates more confusion.

It would seem that the government has at last had the courage to make English compulsory. English has long been accepted as necessary by both parents and students. But politicians are frightened by interested lobbies who pretend to speak on behalf of the people and whip opposition. English is essential to acquire modern knowledge not only in the hard sciences but even in the soft sciences like economics. More important, the ability to read English enables the students to equip themselves to acquire knowledge by their own efforts without depending entirely on lecture notes provided by their lecturers.

Presently, the libraries in universities are stacked with English books which gather dust. Universities are no different from tutories. Students in the universities are supposed to read for the degree, but not since the change over to swabasha have they been able to do so. The authorities are to blame since neither the students nor the parents have any choice in the matter of the medium of education. This is not to denigrate swabhasha.

Sinhala and Tamil must be studied, used and developed as a means of mass communication. The educated should be able to communicate with the ordinary people, to disseminate modern ideas. But scholars, like university graduates must first master their subjects which they are unable to do in swabasha. This is not to promote decadent western moves like their sexual permissiveness, promiscuity or conspicuous consumption.

State run educational systems seem to suffer from many of the problems experienced in other state owned industries or state owned enterprises, notably the lack of competition and the exercise of political patronage in the running of the schools. The state monopoly in education has meant that education has been captured by the educational establishment in Battaramulla and is run exclusively for the benefit of the teachers and the local politicians, just as the health services are run for the benefit of doctors, nurses and health workers.

Most of the money voted on education and health goes to pay higher salaries to the personnel. There is no incentive, not even the possibility of innovation at the school level owing to the monolithic control from the Ministry.

Even if the government continue to pay for education, to educate every student free of charge, standards could be raised by moving to a more competitive form of delivery of the service, achieved in other countries by the use of vouchers. But there is a good case for moving further and sharply reducing both public spending on education and the taxes needed to pay for it like G.S.T. and other indirect taxes, which invariably fall in the people who receive education free.

When parents have to spend their own money on education, they demand more from their schools and get better results than the government, Ministry of Education. There is no sense in education being a nationalised industry, just as there is no sense in nationalising the bread or housing industry to ensure that the poor have food and shelter.

Although education particularly at the primary level and to a lesser extent in secondary education have the characteristics of a public good, the same cannot be said of university education. Since, whatever the benefits of such university   education, they flow to the student rather than to society at large, it seems right to make the student bear the costs at the time or later - which will encourage the student to consider those costs when choosing the courses.

Doctors and engineers who pass out from state universities should be called upon to pay back the costs of their university education or they should be given loans by the state to pay the costs of education while they are studying. These measures operate in developed countries.

It time that parents are made aware that university education cannot be provided free for ever. Soon there will be a surplus of doctors since the government doesn't have the funds to employ them. The problem must be addressed now without waiting for the first batch of unemployed doctors. Those doctors who are already employed should be asked to give up private practice at least in the case of the general medical officers. Specialists should be allowed private practice only if they observe the rules. Those caught practising in private hospitals when they should be treating patients in the government hospitals should be deprived of the concession of private practice. Private hospitals cannot develop because they are dependent on specialists in government hospitals.

Lack of ethical conduct in all walks of life, be it in the professions or in politics or economics is the cause of all the ills of our society. What is required is to restore ethical values in the conduct of politics and economics. It is easy to blame systems for the failure of human beings.