Open or Balanced Economy? What is the best option?
 

BY G.V. Chandrasena

NOWADAYS there are many arguments being staged aiming the forthcoming Presidential Election regarding the suitability of two systems of economies. One party promotes the open economy while the other is campaigning for a balanced economy. What do these two models of economies mean?

It is obvious that no clear view is reached by either party in this regard. Sri Lanka for the last three decades has been a testing ground of two economic models i.e. open and closed. However no tangible development as far as the economy of the country is concerned has been realized so far.

The foreign indebtedness of the country has been rising while internally the cost of living is rising sky high.

This backward march of the economy is visible in the fields of agriculture, industry, which are the live focus of the economy as well as in the fields of education, health, transport and infrastructural areas such as energy and road construction.

Is this mean that both models have not been successful in Sri Lanka or conversely is that the faulty implementation of those models by the respective governments ?

Presently it deems that a system of open economy is in operation. The objective of this paper is to look as to what model is of the best advantage for this country.

Open Economy

The idea of the free economic system submitted by a well known economist John Stuart Mill in his Principles of Political Economy (1848) commended the trade liberalization idea which supports free movement of goods and services among the countries.

David Ricardo who was first to analyze the benefits of the comparative advantage said that countries could reach optimum levels of factor utilisation by allowing the free trade among countries.

Open economic system envisages the following, 1. Trade Liberalization This means removal of constraints to the free trade and make all facilities for free mobility of trade among countries 2. Minimise the involvement by the Government in economic activities 3. Operation of free banking and exchange system in order to attract foreign Investment.

So this is the gist of the open economic policy. The economic growth according to a model forwarded by Harrod-Domar is a function of the marginal propensity to save and the capitol/output ratio, or the rate of growth is equal to the savings ratio divided by the capital/output ratio.

If this is true the economic growth can be achieved by expanding the savings ratio or by lowering the capital/output relation.

However there was much criticism levelled against this model by Robert Sallow and Nicholas Caldor and subsequently more complex models were submitted by neo- classical economists.

The model by Harrod-Domer is regarded to be an acceptable one in terms of present day economies while the engine of growth is regarded as the capital formation.

Nowadays most of the countries either developed or developing hang on this theory and they consider the capital and investment as the key factor of the economic growth.

So there is an increasing view among those developing countries like Sri Lanka that the foreign investment could only be attracted if the economy is kept open. As far as the present day scenario of the world economy is considered just opening the economy would not attract investment. There are many other factors influencing the flow of foreign investment.

For instance after opening the Sri Lankan economy in 1977 there was a rapid inflow of foreign investment into the country since Sri Lanka was granted huge textile quotas in respect of the major markets in the developed countries.

To take the advantage of those quotas the world's largest suppliers of garments took shelter in Sri Lanka under the guise of investing.

Therefore it is clear that the investors came here not because of the open economy but for the quotas made available to Sri Lanka by USA and the other EU countries.

With the removal of the Multi Fibre Agreement beginning of this year the attraction of investors of the garment sector has been slackened. So the open economy is not the only solution to attract foreign investment.

Therefore there may be other reasons for attracting foreign investment. Today other than any factor, the market for a particular product, the cost of production and the quality factors are regarded to be most valid in this regard.

The market possibilities mean whether the relevant market is substantially large one and having a considerable purchasing power are regarded as a better place to invest. A prospective investor would see the market condition of the country where he is going to invest since he must have a ready market for his product.

For instance no investor would be scared to establish his business in India since the market is one of the world's largest and the labour and the other infrastructure are freely available. India is a market itself of one billion people.

So even during the periods where India was following closed economic policies the multinational corporations such as Levers, Proctor & Gamble and Lipton and many more multi nationals had established their businesses in India.

So it seems that the existence of an open economy is not a pre-condition to attract foreign investment but the other factors mentioned above are absolutely important.

One thing I see as an obstacle to attract foreign investment to Sri Lanka is the smallness of our market. The population of this country is negligible as far a foreign investor to come here and start his business. However this may not be the only factor.

In 1990 according to a survey by Asian Business magazine Sri Lanka had a population of 16.8 million while Malaysia in the same year had a 18.0 mn. Surprisingly the GDP per capita in the same year for Sri Lanka was US $ 428 while for Malaysia it was US $ 1640.

Ironically Malaysia had achieved that level of prosperity by gearing to a rate of economic growth of 4.4 percent whereas Sri Lanka had only 2.9 percent growth even under the open economy.

There may be extra territorial factors influencing countries to achieve a good level of growth. Malaysia is a member country of ASEAN and during the beginning of that economic integration, countries like Japan established her most of off- shore industries in Malaysia.

Big companies like Toyota - a world renowned automobile maker and giants in consumer electronics such as Sony and Matsushita opened their manufacturing plants in Malaysia aiming the cheap cost of production and targeting US and European markets.

For example the net direct foreign investment in Malaysia grew from US $ m.n 217 in 1992 to US$ 1430 m.n in 1993 whereas during the same period Sri Lanka grew her direct foreign investment from $ m.n 140 to $ m.n 165. The rate of growth for Malaysia was more than 500 percent while for Sri Lanka it was 17.8 per cent even less than 50 per cent.

The proximity to Japan and to the other target markets would have been a clear factor for choosing Malaysia. No doubt that Malaysia too had been following an open economy under Dr. Mahathir Mohammed but openness of the economy was not the prime factor whereas the other political and geographical factors have helped Malaysia to reach that level of progress

Trade Liberalisation

Most of the World Bank economists observe that the trade liberalisation is the key factor in an open economy. Martin Wolf one of the forefront speakers on this line gives several reasons as to why trade liberalisation is a good idea for a developing country.

1. There is full exploitation of factors of production through comparative advantage. This means according to him utilisation of resources like labour and land for comparative advantage in the world markets.

Sri Lanka had comparative advantage of having textile quotas against Hong Kong and Taiwan so that we could utilise that advantage to attract investors.

If wolf's viewpoint on labour advantage is correct how Malaysia had more volume of investment against Sri Lanka where the income level per head was $ 165 compared to $1430 per head in Malaysia in 1993.

This is a paradoxical situation on the determination of the criteria for the comparative advantage. According to the views of the supporters of this idea more investment should come to Sri Lanka but it did not happen despite the fully pledged open economy was in operation but the other factors may have influenced to attract such investment into Malaysia.

So it is clear that mere openness of the economy and the labour advantage have not dealt with the case of Malaysia.

Another important aspect is how far a country could adhere to the policy of comparative advantage allowing the global market forces to work? Should we consider trade intrusive policies adopted by some of world countries through various manipulations during the production process to bring the cost down?

A reasonable nation would not be able to allow its market to dump with such cheap items and allow her own industries to ruin.

Conversely just because of the comparative advantage enjoyed by the oil rich nations over the oil production will the other countries allow those oil rich nations to abuse the advantage or rather will they not search for a new source of energy?

Therefore there are limitations to the globalisation process and there are economic limitations that a country could adhere to those policies in reality.

2. Relaxation of foreign exchange constraints. Wolf says that for inward looking economies looking to save foreign exchange by imposing retractions is not good. This means that local currency should be released to float with the other foreign currencies.

In other words the par value of the local currency should be determined through the supply and demand of that currency in the open market. When our volumes of exports grow and when we receive investment from foreign countries or when our immigrant workers send a high volume of exchange our Rupee will become strong.

When our Rupee becomes strong we had to pay a lesser amount of Rupees to purchase foreign currencies to import goods and services from abroad.

So this system is good so long as we have good export levels and also the other two conditions remain favourable. Our exports have been fluctuating in real terms while the import bill has been rising at a rate. As a result we have been experiencing an acute imbalance of trade since our independence.

As a result of worsening trade balance which is not in favour of Sri Lanka the exchange rate of the local currency against other currencies deteriorated adversely. For instance the average annual rate for the US $ against rupee stood in 2003 for Rs 96.73 while in 2004 for Rs 104.61. This shows the extent of depreciation of the rupee against a major world currency.

Through this period trade balance deteriorated by 45.7 per cent while exchange rate of rupee for dollars devalued by 8.17 percent. So one could observe the ever growing relationship of the exchange rate with the trade balance.

Depreciation of the rupee would be an advantage to increase the volume of exports since an importer will have to pay fewer dollars for exports but this is not happening as the importers are to pay the agreed dollar price for the products they buy irrespective of the rupee depreciation.

Price reduction may be asked on the renewal of the buying agreement. This may be an incentive for buyers but we cannot expect an increase of volume of exports realistically simply due to this factor.

So the idea of the promoters of freeing exchange rate for the developing countries like Sri Lanka is considered would not be acceptable. However restricting the exchange rate would also bring bitter results like black market operations.

So the only relief measure is to cut down unnecessary imports from the import bill and try to secure healthy trade balance which determines all these circumstances.

Under the guise of the open economy our people are used to import things like rush mats, incense sticks, pillows and kites etc. We import most of the items what we manufacture here such as ceramics, glassware, leather goods and rubber products. Although we export ceramics goods we flood the local market with imported ceramic items.

So the government should take remedial action to limit those type of imports that make harm to the local manufacturer by imposing countervailing duties thereby making those items expensive. We will be able to maintain some discipline over this matter favourable to the economy of the country.

Through these measures a country can protect the local market for the industries and simultaneously save foreign exchange thereby reducing the depreciation pressure.

Some economists recommend the application of Real Exchange Rate System as a solution. This means that a country should fix her exchange rate depending on the world inflation rate. In other words if the inflation rate of a country is higher than the existing world rate of inflation the value of the local currency should be depreciated against other international currencies.

The Sri Lankan Rupee is also tied up to a basket of five currencies such as US Dollar, Pound Sterling, Euro, Japanese Yen and Indian Rupee and the Nominal Effective Exchange Rate (NEER) is decided basing on those currencies So this is again tying up of the local condition to outside limitations.

Unless the country is developed miraculously the adoption of a real exchange rate system would not be the answer. Therefore to follow some discipline in respect of our import policies and allow healing of the trade gap difficulties gradually thereby making the exchange rate more realistic would be welcomed.

Conversely to control the inflationary pressure a country will have to increase its agricultural and industrial output so that price levels could be brought down decreasing the inflation.

Here irrespective of the comparative advantage on the natural resources available, a country will have to commence production and make more food and other consumer items for the local market.

For Instance although some foreign country could produce rice cheaper than Sri Lanka we have no option other than bringing all of our cultivable lands under the plough.

By this example it is clear that again a contrary situation is created for the comparative advantage which would become very hard to pursue as a practical solution, since the inflation which is a threat to the development only be subsided by increasing production.

One can argue that cheap items could be imported to bring down inflation rather than investing in non-economical projects and the resources transferred to a profitable venture. But nothing has happened positively so far except adding inflation on one side and depreciating the rupee on the other side.

3. Wolf's third suggestion is that trade liberalization is paving the way for economies of scale and scope. This is a true concept since during the large scale production a country could expect efficiency in the production.

Counsellors of free trade highlight the economic cost of trade restrictions. Jadish Bhagwati sees two kinds of protections i.e. price and quantity. Price instruments include tariff while the quantity instruments typically quotas.

He further observes as a result of the protection two types of cost viz. the consumption cost and production cost in the first case he finds a distortion of consumption decisions having protected import competing goods too expensive.

A study carried out by Hickok in the USA regarding clothing has found that the protection had cost the consumers nearly 8500 - 12000 m.n dollars in 1984. This is the price advantage the supplier countries having over USA. But in certain cases USA had to impose countervailing duties in order to protect her Garment industry from the cheap products coming from Hong Kong.

On several occasions USA imposed quantitative restrictions over rice imports from Japan in order to protect her farmers. So these are very subtle issues and a country cannot go to the extreme end of a policy and at the same time to accord protection for the local industries for them to flourish.

Balanced Economic policy

A balanced economic policy recommends operation of mixed economy both open and close policies in a balanced way adjusted to the requirements of a country. What are the prime features of this type of economy?

1. Trade is liberalised but the border restrictions are imposed in the case of protecting local agriculture and the industry.

In a country like Sri Lanka the operation of all forms of the open economy could not be practical since still in this country nearly 70 percent of the population make their livelihood through agriculture.

Therefore a certain level of protection is necessary in this field to relieve the burden on the rural farmer who is suppressed by indebtedness.

Under the guise of the open economic policies what the both ruling parties did was the removal of tax barriers on the agriculture and made an environment for the private traders to import commodities like rice and onions.

Ironically the importation of those essential items was done just during the harvesting time thereby pushing the local price at a low ebb. So this has made the local farmers sell their produce to the hoarders below their cost.

It seemed this manipulation by the private traders had been done purposely to make higher profits for them. So the plight of the rural farmer went from bad to worse. However in a balanced economy importation of such items would be done only when there is a scarcity in the market

2. Secondly the protection of the infant industries of the country from fierce competition put forward by the imported industrial products. For instance a number of industries started during the last two decades was closed down being unable to face the foreign competition.

For instance a company which manufactured telecommunication parts used in overhead distribution networks had to close down facing the importation of similar items from India.

Infant industry is a valid argument against full scale liberalization. A study carried out by Krueger and Tuncer (1982) found that the protection of infant industry was successful.

It is evident that the Ministry of Trade & Industry (MTI) in Japan imposed heavy non tariff barriers to protect her industries such as steel, automobiles, fertilizers, synthetic fibres, and micro electronics during early stages of development.

So it is imperative that Government intervention is essential to protect the local industries otherwise those industries will meet the fierce competition from the exudes of foreign products.

For instance automobile manufacturing plant established in Sri Lanka recently is facing bitter competition and government regulations. So the protection must be available for such industries until they gain the ground. Those industries use the local raw materials and provide employment.

3. There is much argument on the matter of tariff protection which according to open economic theory creates a negative effect. However most of the economists suggest an effective rate of protection for the importable and exportable.

The effective rate of protection can be reached by the difference between the domestic value added price minus world value added price of a product.

The overall bias of the country can be estimated as a ratio of the average nominal rate of protection for importable to the average nominal rate of protection for exportable. If this ratio is greater than one i.e. if importable have a higher rate of protection than exportable it reveals a bias in favour of import substitution.

Effective rate of protection would nor be very much practical for a country like Sri Lanka where there is an adverse balance of trade is prevalent and therefore under a balanced economy as mentioned earlier steps should be taken to apply border measures assuring protection .

4. Curtailment of unnecessary imports. This is an area a government should take immediate steps. Today we can find things such as Rush mats and Incense sticks imported from India.

I believe that there is no point of importing such items since those are already available here and the government should give every support to develop those industries locally rather than allowing imports to destroy them. I believe that the Government would be able to cut down the trade imbalance to a certain extent by resorting to curtailment of unnecessary imports.

Still we spend two percent of our import bill to import wheat flour which is used to produce bakery products such as bread.

Our total paddy production in the last year was in the range of 2628000 MT and it is a real fact that the farmers are facing a great debacle being unable to sell their paddy harvest at the price they want to sell. In 2004 we spent US $ 183.0 m.n for the importation of wheat flour.

In rupee terms if we take a Dollar to Rs.100 we have spent approximately Rs 18.3 b.n for this purpose If the Government could cut down a percentage of the wheat imports and substitute rice wherever possible it would be a big relief for the paddy farmer and also for the state coffers suffering from a dearth of Dollars.

A balanced economy does not oppose the free trade idea at the same time it does not allow the economy to be controlled by outside forces.

A very bad example of following open economic policy is found in Indonesia when the country's banking system collapsed overnight. But this did not take place in the neighbouring country Malaysia since she was not depending solely on foreign investment.

So a balanced economy as is found in most of the world countries even in USA where border protection is available whenever necessary, and which does not pose a threat to free trade concept is the most practical model.

I do not believe that no country in the world, except free ports such as Singapore, Hong Kong and, Dubai is following a hundred per cent open economic policy since it is harmful for a substantial economy having sectors like agriculture and industry.

Sources Used 1. World Development Report - World Bank 2. Handbook on the Multilateral Trade Negotiations - World Bank 3. Economic Development - C.P.Kindleberger 4. Annual Report 2004 Central Bank of Sri Lanka 5. Asian Business Vol 30 No4 April 1994 6. Asian Business Vol 9 No. 25 Sept.1989.