Are we heading for deflation?

From Sunday Island 07/12/2014
by R.M.B Senanayake

Recently Mr. Nandalal Weerasinghe, Senior Deputy Governor of the Central Bank, thought loud about the possibility of deflation arising in our economy.

Sri Lanka is having low inflation and the rate of inflation is still falling. Inflation, as measured by the change in the Colombo Consumers’ Price Index (CCPI) (2006/07=100), declined from 1.6 per cent in October 2014 to 1.5 per cent in November 2014, on a year-on-year (YoY) basis. Annual average inflation also declined to 3.5 per cent in November 2014 from 3.8 per cent recorded in the previous month. Downward revision of administered prices in the non-food category, contributed mainly to the decline in inflation. The decline in inflation is also partly due to the decline in commodity prices and to the over-valued exchange rate. There is no economic rationale for having a fixed exchange rate when the country is running a high current account deficit in the balance of payments. But the time for corrective action may be too late for any such action now may reduce growth.

The private sector will not invest in a deflationary scenario for then prices tomorrow will be cheaper (money made tomorrow would then be worth less than money today.) Government revenue has fallen below 10% of GDP despite the growth. To sustain public expenditure more money has to be printed.

Deflation - good and bad

The London "Economist" recently discussed deflation. Deflation is the opposite of inflation. Inflation refers to a continuous increase in the price level while deflation refers to a continuous fall in the price level. What is wrong about a continuous fall in prices? Nothing really wrong provided the fall in prices is not accompanied by a decline in output and employment. The latter situation is characterized by economists as a recession and if it is severe they even call it a depression. The most severe depression was in 1929. Since then there have been recessions - some more severe than others. It seems to be in the nature of economic processes in a free market or capitalist economy for such periods of high growth to be followed by recessions. The process of economic growth, even if upwards as a long term trend, cannot avoid such fluctuations of upswings followed by downswings which are called the business cycle. Previously the business cycle was confined to the mature developed capitalist economies. But with globalization and more and more developing countries getting integrated with the global economy, it has come to prevail even in developing countries.

In the past there were deflations due to innovations and inventions in the production process caused by changes in technology which reduced cost per unit and increased vastly the output of finished goods. Such changes in technology caused changes in the structure of employment as well. But such benign deflation was always characterized by higher living standards since with the reduction in prices the goods became more affordable to a larger stratum of the economy which led to an increase in Aggregate Demand to match with the increased Aggregate Supply. But this may not always be the situation. Individual producers may face less demand for their products and to maintain their profitability they would have to consider reducing prices. The impact may be only on the price while production and employment would remain constant.  But it would definitely require a reduction in the price of the product to maintain sales.

To maintain the level of profit this may call for a reduction of costs. Since labor forms a significant element in the cost structure they would like to see a reduction in wages. But given the labor laws and the strong trade unions, it may not be possible to reduce wages. Then such producers have no choice but to reduce the number of employees. But there are labor laws which restrict retrenchment as well. The permission of the Commissioner of Labor has to be obtained before retrenching and even if approval is obtained high severance payments are required. The producer company may decide to close down the enterprise altogether. Several foreign enterprises which were set up in our Free Trade Zones found our labor laws so burdensome that they decided to abandon their enterprises and vanish to their own countries leaving unpaid debts to our banks, the CEB and workers instead of following the regular practice of closure. So producers may prefer to cut production and employment rather than produce at prices which do not provide a sufficient profit. It is in such circumstances that the deflation turns into a recession with a fall in output and employment and becomes a bad deflation.

Current global scenario

There was a global financial crisis in 2007 caused by the U.S mortgage lending excesses. It brought about a recession in the U.S but it spread globally. The USA has shown the best performance in recovery. But even there growth is below potential and there is still an output gap and production capacities are not fully utilized. Chinese growth which was earlier averaging 8-10% per annum is now down to 7.3% and likely to fall further in the next few quarters. Japan is already in a recession with two periods of negative growth. The EU is also in recession and even the German economy has failed to recover fully. France and Italy are suffering from high unemployment as does Spain, Ireland and Greece which had severe debt repayment problems.

Oil price decline

The only silver lining is the fall in crude oil prices from $110 to the level of US$ 65 last week.  If producers still could make a profit per barrel the price could fall much lower. The days of OPEC as a price-setter seem to be over. In the past Saudi Arabia used to cut supply to maintain the price. Today OPEC is unwilling to do so since Saudi Arabia wants to maintain its market share. Their concern is the expansion of shale gas in the US after the invention of the fracking process. Saudi Arabia wants to check the development of American shale gas industry by making the required investments unprofitable through lower crude oil prices. If the oil price were to fall significantly some shale gas investments would be unprofitable to develop and would have to be abandoned.  So to prevent the development of the supply of shale gas, OPEC has decided to allow the price of crude oil to fall- a situation arising both from supply side and demand side factors. Demand has fallen because global economic growth has failed to recover resulting in the demand for oil stagnating.  The development of shale gas has reduced U.S imports of oil from the Middle East. The USA is expected to be self sufficient in energy and even export shale gas by 2020. The low crude oil price should be good for global economic growth.

Deflation and debt

Will we be affected by the global deflation? We are a large consumer of imported goods and since they are essential commodities the demand for them is unlikely to fall. In fact it may rise owing to cheaper world prices. As for our products, we export primary products like tea which may be affected adversely owing to deflation in the Middle East and Russia. Similarly our apparel exports may be affected owing to the deflation in the EU. The effect is likely to be more on the price rather the quantity. Our current account deficits in the balance of payments may increase as a result and may have to be funded either through more foreign loans or by running down the Foreign Reserves.

Deflation raises the burden of repaying debt, particularly foreign debt. Heavily indebted countries will face difficulty in repaying debt. In the case of debt in domestic currency the Central Bank can print extra money to repay it. But in the case of foreign currency debt, the repayment requires foreign exchange. Several countries which are heavily indebted seek to roll-over or re-finance their foreign debt. Our exports and remittances from migrants abroad are not enough to cover both the foreign debt service charge ($2.9 billion this year) and finance a sufficient reserve for imports. Since the exchange rate is held at a fixed rate and fiscal policy is expansionary the risk is an increasing deficit in the current account and a possible drain on Foreign Reserves. But if corrective action is carried out then the GDP growth will slacken and the Debt/GDP ratio will rise fast and foreign lenders may ask for higher rates of interest which will increase the burden of debt service.

It may even upset the confidence that foreign investors have in the ability of the country to repay the existing debt which may prompt them to shun new loans to the indebted country or raise the interest rate. Then the country would have to utilize it Foreign Reserves to repay the foreign debt. If Foreign Reserves are not adequate to both repay the foreign debt and also provide a cushion for imports, then the country would face a serious foreign debt crisis. But as long as we can borrow in foreign currency we can tide over. But our political turmoil and the refusal to co-operate with the UNHRC could pose a problem for foreign borrowing.  Much will depend on continued access to foreign capital in the months ahead.

A much valued article on a probable, economic outcome on the future. Must read for everybody in my view.
Rep+ as always.

Money spent on the war kept the economy rolling untill 2009 but the money spent on recent development projects are mostly repatriated by way of salaries of expatriates, installment payments & imports etc. Hence money supply in the country is negatively affected causing deflation. CB is not worried as they like it more that inflation due to shortterm political gains.

Kenesian Theroy- pumping money in to the economy during peace time(similar to Obama's stimulous package recently) is a time tested tool to tackle deflationary effects. However, it may have a negative impact on the rupee.