Aid, Cost Inflation and 'Dutch Disease': Effects and Implications

The cost increases being observed in the construction industry are obviously due to increased demand for construction inputs as reconstruction activities get under way. Such increases are to be expected irrespective of whether the new construction activities are funded by domestic or foreign sources. However, these cost increases have a major bearing on the degree to which the reconstruction effort can be financed by available (or pledged) foreign funds. Given the importance of foreign funds in Sri Lanka’s reconstruction effort, we focus first on the link between utilisation of foreign funds and construction cost inflation, and then go on to discuss the implications for domestic financing issues.

Domestic cost inflation is often observed whenever there is a large inflow of foreign funds. These cost increases lead to reduced profitability in industries that do not gain an offsetting increase in their prices and can adversely affect a country’s export performance. This phenomenon is known as the Dutch Disease, named after the Netherlands experienced a contraction of its industries in the wake of large inflows of export revenues after discovery of North Sea Oil in the late 1970s. This is a common phenomenon whereby increased demand in one sector of the economy – for whatever reason – leads to bidding up of prices of production factors. ³³ The cost increases observed in the construction sector are a reflection of these Dutch Disease effects associated with absorption of capital inflows into an economy. However, there are some unique features associated with this phenomenon in the context of aid flows to finance asset replacement as part of the reconstruction effort. These have important policy implications.

Increases of prices and wages in response to increased demand for construction activities are greater the more difficult it is to increase their supply (i.e., when supply is relatively inelastic). This, for example, is the reason for the sharp increase in wages of skilled construction workers such as carpenters, whose skills cannot be easily acquired by others. If those factors can be imported from larger world markets – some building materials fall into this category – then their supply tends to be more elastic and resulting price increases can be moderated. But many factors, particularly labour, must be supplied from domestic sources (‘non-traded’), as for various reasons they cannot be bought from international markets. (Of course it is possible to import skilled labour from other countries, and it has been suggested that skilled labour shortages in Sri Lanka’s construction sector should be met by importing Indian labour. Whether this is politically feasible remains to be seen.) It is by offering higher rewards – higher wages, prices – that a particular sector is able to attract extra resources. Because this tends to increase costs for all other sectors that also employ those factors, there is a negative impact on their profitability, and the other sectors contract. Sometimes the higher incomes accruing to factor owners increase demand for certain goods and services, and those industries then experience an off-setting positive impact through price increases if their supplies are inelastic – which is normally the case if they are not internationally traded (‘non-traded’). Typically goods that enter international trade do not experience offsetting price increases because they can be imported at more or less exogenously fixed world prices and are the hardest hit. This fall in the relative profitability of tradeable industries is the standard ‘real exchange rate appreciation’ that is a necessary and unavoidable outcome of foreign capital absorption by the domestic economy. This can be minimized in the short-term through foreign exchange market interventions, but cannot be entirely avoided.

The rapid (‘localised’) inflation of domestic costs (at a rate higher than average inflation in the economy) will spill over into the rest of the economy, as aid flows increase expenditure on local non-tradeable factors. In principle, this is an unavoidable outcome of extra spending financed by foreign funds. However, there are several distinctive aspects of this phenomenon in the context of foreign aid funded capital asset replacement that are not adequately discussed in the standard analytical literature (see, for example, the reviews in Freeman, Keen and Mani (2003), and Benson and Clay (2004))..

Rehabilitation or replacement of capital assets destroyed by the tsunami will yield real income benefits once they are in place i.e. benefits come in the future. However, as demonstrated in the case of the housing sector, replacement of the capital asset requires use of not only importable materials but also domestic production factors. If all factors are internationally ‘tradeable’, and can be imported at fixed world prices, extra demand for factors will not lead to any price or cost increases. However, this is not generally the case, and certainly not the case with construction. Because the supply of some nontradeable factors, such as skilled labour, is quite inelastic in the short run, their prices increase as demand increases. Clearly, the more rapid is the pace of construction activity (whether financed by foreign or domestic sources) the greater will be the price and cost increases because supply of non-tradeable factors is lower in the short run than the long run. In the case of skilled workers, for example, firstly, they can offer a larger labour supply over a longer time period and secondly, it is possible for other workers to acquire skills thus expanding the total stock of skilled labour.

From a national viewpoint, higher incomes that accrue to inelastically supplied factors such as skilled labour can be seen as an income redistribution whereby part of the aid funds raise their incomes at the expense of tsunami affected capital asset replacement. Thus it is not surprising that post-tsunami reconstruction is generating something of a bonanza for some groups in the community. In the longer term higher expenditures by households that gain these higher incomes will tend to raise costs throughout the economy, thereby tending to squeeze profits in export and import competing industries. On the other hand, the availability of services from reconstructed infrastructure and other assets has an offsetting impact in the future on costs, facilitating increased supplies. Thus investment in the domestic capital stock tends to produce an initial real exchange rate appreciation but this is followed by improved international competitiveness once the capital assets begin to provide services used in the tradeable industries.

What do these imply for capital asset replacement with foreign assistance?

8.1 Exchange Rate and Capital Asset Replacement

Suppose for simplicity that the tradeable (imported) amount of inputs and domestic (nontradeable) inputs are required in fixed proportions for asset replacement. For given world prices of imported imports, a unit of foreign currency will buy a fixed quantity of imported inputs, irrespective of the exchange rate of the recipient country.³⁴ But the amount of domestic non-tradeable inputs that a unit of foreign currency can purchase depends on the nominal exchange rate and the domestic currency price of those domestic inputs.

If the nominal exchange rate is fixed, this implies that the amount of capital assets that can be replaced for a given unit of foreign assistance is lower, the higher the domestic cost increase. If the capital inflow produces an appreciation of the nominal exchange rate, this effect is aggravated because less domestic inputs can then be bought with a unit of foreign currency.

Obviously the country’s exchange rate policy becomes important here. In particular, a policy of propping up the nominal exchange rate by ‘leaning against the wind’ in foreign exchange markets makes it much harder to fund rehabilitation/reconstruction programmes with a given amount of foreign assistance. On the other hand, domestic price and cost inflation can be mitigated by trade liberalisation, which tends to reduce costs of tradeable goods and imported intermediate goods

If replacement of capital assets is staggered over time, demand increases in a given time period are lower, factor supplies become more elastic, and cost increases will be correspondingly lower. More domestic capital assets can now be replaced for a given amount of foreign funds. However, a slower pace of capital replacement imposes costs because it delays the generation of the flow of services from the capital asset. Ideally a balance must be struck between the high costs associated with faster pace of capital asset replacement, and the losses due to loss of services resulting from delayed replacement, and a programme of reconstruction must be formulated that takes into consideration the different costs and benefits associated with different rehabilitation projects, so that priorities can be established on an economically sound basis. However, an important consideration in relation to projects funded with foreign assistance is that, unless the funds are obtained and used quickly, they may simply disappear as donors’ priorities change. Further, even in domestic political economy terms, delays in reconstruction may lead to priorities being set in a manner that is prejudicial to the interests of the needs of the worst affected groups. In other words, the costs of delay in reconstruction may fall largely on the poor and politically weak groups. This issue is particularly important because, as discussed below, a financing gap is emerging which may result in a rationing of available funds.

8.2 Financing the Emerging Funding Gap

The immediate issue for the reconstruction effort in Sri Lanka relates to the capacity of households and the government to meet capital asset replacement targets with a given amount of foreign assistance. For households hit by the tsunami, particularly poorer households, cost increases make the task of reconstruction much more difficult. Given 30-40 per cent plus cost inflation, the fixed cash grant of Rs 250,000 ($2,500) for a fully damaged house, for example, is woefully inadequate. As cost increases escalate the real value of subsequent instalments will fall even more. When this same scenario is extended to the reconstruction programme for public infrastructure, a funding gap will be inevitable.

How will this funding gap be addressed? More affluent households with access to savings and/or relatively cheap credit will draw down their savings or cut back on consumption to finance the necessary additional expenditure. Note, however, that this represents domestic household financing of asset replacement, at the expense of other types of expenditure. In other words, a substantial (and increasing) part of the burden of rehabilitation will be borne by the affected households themselves. This suggests that there will be a depletion of accumulated household savings – in effect allowing some substitution to take place between consumption spending and savings. Sri Lanka may therefore see a reduction in the savings rate which has remained virtually stagnant at around 16 per cent of GDP in recent years.

The situation will be much more difficult for the poorer households who lack both savings, access to cheap credit (and capacity to repay). We have already mentioned the optimism expressed by the World Bank about the rebuilding programme progress in this sector. According to field studies by the IPS, a significant number of poorer tsunami affected households had already spent the first instalment of the grant (Rs 50,000 - $500) on pressing immediate needs, including payment of outstanding loans. They would struggle to make much progress with the construction tasks that need to be completed to become eligible for the next instalment. In the context of rapidly increasing costs, these poorer households will find it extremely hard to rehabilitate their damaged houses and other assets without substantial additional assistance.

In the case of public infrastructure spending, a similar story can be told. It should be recalled that the bulk of reconstruction funds are expected to come from external assistance. If foreign donors (including NGOs) have made commitments to rebuild specific infrastructure assets, then they will need to find extra funding if they were to honour those commitments. If – as is likely – such commitments are more or less fixed in foreign currency terms, what can be financed with them will fall, leaving gaps to be filled by the government from other sources. It would be highly optimistic to expect that significant extra donor assistance will be forthcoming in the future as global donor attention shifts to other disasters and other issues. The conclusion that there will be additional demands on the government for rehabilitation funding appears compelling.

8.3 Fiscal and Monetary Policy

This raises sharply the issue of the ability of the government to meet these new funding requirements. Fiscal targets set for 2005 have been already revised following the tsunami disaster to take account of a significant level of additional expenditures (Table 7 [ PDF 254KB | 10 pages ]). According to the revised estimates, capital expenditure is expected to see a significant increase, raising the overall deficit to 9.6 per cent of GDP from the pre-tsunami target of 7.6 per cent. While the Ministry of Finance has maintained that the post-tsunami reconstruction will be ‘budget neutral’ as much of the funding requirement is expected to be met by donor commitments, the reality is likely to be quite different if initial estimates did not factor in this cost escalation. If a shortfall should arise, the government will have quite limited options, particularly in the context of pressure on the fiscal balance due to the election cycle expenses and the rising costs of the fuel subsidy.

The above discussion on the link between the exchange rate and the ability to finance rehabilitation projects with foreign funds also pin points some implications for exchange rate policy. Obviously the inflow of foreign funds – both private remittances and donor funding - and debt relief has allowed maintenance of healthy foreign exchange reserves, despite the soaring oil price and a ballooning oil import bill that has widened the trade deficit. In turn this permits monetary authorities greater room to exercise influence in foreign exchange markets.

There are difficult policy issues that need careful thought and analysis. Cost inflation in the construction sector is yet to spill over fully into other sectors of the economy, including the export (and more generally other tradeable) sectors. In this sense, the sector specific real exchange rate relevant to the construction sector has appreciated much more than that for the entire economy. Hence the immediate pressures on the export sectors emanating directly from the tsunami reconstruction activities are not as pressing today as they will be sometime later in the future. On the other hand, independently of the tsunami expenditures, other factors such as high oil prices and projected increases in government expenditures aggravate external sector imbalances.

Though the Central Bank had to intervene in the immediate aftermath of the tsunami to minimize appreciation of the currency, this situation did not last. In recent months there have been significant downward pressures on the rupee in foreign currency markets. The temptation to slow down tsunami expenditures and use available foreign reserves to prop up the currency is certainly present. The IMF recently warned about the dangers of intervening in foreign exchange markets to prevent rupee depreciations, and it is difficult to assume that the observed stability of the Rs/US$ rate is driven entirely by market forces.³⁵ At some stage the monetary authorities will be compelled to face up to the implications of current exchange rate policies for the long term post-tsunami rehabilitation issues.

The bottom line is that inability to fully fund rehabilitation of assets will mean that Sri Lanka ends up with an inferior capital stock compared with the pre-tsunami situation. If funds are not diverted from consumption expenditures, the country’s immediate macroeconomic imbalances maybe sorted out by meeting current consumption needs at the expense of capital stock replacement, but this will be at the expense of its longer-term growth prospects.

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Comment(s)

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1. Dushi Weerakoon, one of the co-authors
   (posted 31 March 2006 / 11:43:50 AM)
   
   In response to the comment below:
   
   Besides funeral expenses, etc. a cash grant of $50 per month and $3.75 cash and food ration were given to all affected households (for approximately 4 months). For residents outside the buffer zone, if a house is more than 40% damaged, a grant of $2,500 is given in 4 instalments, based on progress. If a house is less than 40% damaged, then a grant of $1,000 is provided, disbursed in 2 stages. For residents within the buffer zone, the government planned to assist not only landowners, but all residents (including encroachers) with some form of housing. This was estimated to require around 50,000 permanent houses. Further quite considerable details on government handouts are contained in the report itself.
   
2. ken bacon
   (posted 18 December 2005 / 06:57:36 PM)
   
   This chapter notes that the government immediately paid money for funeral expenses, livelihood and cooking utensils. What additional government compensation has been provided? I am particularly interested in how the relatively generous post earthquake compensation program in Pakistan compares to government compensation for loss following the tsunami.