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Budget should address diversification and its funding

Thursday, September 14, 2017

The 2017-2018 Budget presentation is almost upon us. Further, it appears that the 2016-2017 Budget has resulted in a shortfall of some TT$8 billion. The recession faced by this government and the inability of this country to immediately increase exports have been instrumental in forcing a reduction in government’s expenditure from some TT$63 billion in 2014 to a planned TT$54 billion in 2017, which was adjusted to TT$48 billion in the midterm review.

Given the further shortfall of TT$8 billion it would appear that the 2017 revenue would indeed be some TT$40 billion. What this tells us in that our on-shore economic sector, which depends on government’s expenditure to do business, has been forced to contract due to the reduction in government capacity to spend—ie government has inadvertently done what is necessary in an economy that has lost billions of US$ in yearly foreign exchange earnings including some TT$20 billion in US$ from government energy sector taxes etc; it has reduced aggregate demand.

This has resulted in, for example, reduction in subsidies, increased unemployment, non-start of infrastructural projects, all of which has caused a backlash on government’s popularity by a population that appears to expect its standard of living to be maintained in this recession.

However, the focus has been on government’s spending, its ability to raise revenue, even to impose new taxes on, say, property or land or income, to which government’s income from the energy sector is a contributor. Instead, the main culprit is the reduction in foreign exchange earnings by the country, via exports, and the crucial role such earnings play in our economic well-being—well beyond simply increasing government’s income.

At the risk of being repetitive let us quickly review the characteristics of our economy. T&T is a small open economy with the fundamental characteristic that it is impossible to manufacture/produce all that is necessary to support the population locally. Hence most of what is consumed locally is imported. This demands that the exports from the energy sector earn the foreign exchange needed to purchase the imports. The on-shore economy is predominantly about importing-markup-sell to the population together with non-tradable activities, eg construction, that require imports also.

Therefore in economies like ours, the positive difference between the supply of and demand for foreign exchange (the FE constraint) drives economic growth, since this surplus allows the import of more consumables, materials, technology, services, so increasing economic activity on-shore. Hence the FE constraint is the single most important factor in the economic development of this country.

If, as now, this FE constraint is negative, ie the demand for foreign exchange to maintain the current lifestyle of the on-shore is greater than the supply (the supply in the short-term can include savings, reserves, borrowings), the immediate response of the on-shore economy has to be a reduction in economic activity, a reduction in aggregate demand, to which government’s enforced reduction in spending has contributed.

Some are also calling for a further devaluation of the TT$ and/or increases in taxes of on-shore business products and income to reduce demand for imports. But none of these addresses the underlying problem facing the country, ie the need to increase the supply of foreign exchange so maintaining or even increasing on-shore economic activity. But increasing exports in economies like ours is a long-term affair and it is even more difficult to substantially reduce imports by local production.

If this recession is long-term as it appears to be, the trajectory of the economy will be a period of decay to the state where demand equals the reduced supply of foreign exchange, then, hopefully, in the medium to long term the economy grows via its improved capability and capacity to export. The solution then is the diversification of the economy.

The diversification will require the importation of technology, equipment, materials, knowledge, the development of trade networks, marketing and market development, all of which require foreign exchange. Hence, in the economic trajectory as given in the above, the limited supply of foreign exchange will also have to support the initial funding of the diversification effort. Hence the stabilisation of the economy—the on-shore contraction—has to take place simultaneously with the start of the longer term diversification process. Hence the 2017-2018 Budget presentation should also address the diversification of the economy and its initial funding.

Still, it is interesting to get a feel for what kind of diversification spending, investment, would be required to provide, say, the government with its current rents of say TT$20 billion, in the absence of the energy sector. If one were to assume a tax rate of 25% and a return on investment of 30%, then the net present value of the diversification investment is some TT$260 billion or US$40 billion. Consider this in the context of our current reserves of US$9 billion and HSF of US$5 billion.