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PESTEL analysis of the macro-environments

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There are many factors in the macro-environment that will effect the decisions of the managers of any organisation. Tax changes, new laws, trade barriers, demographic change and government policy changes are all examples of macro change. To help analyse these factors managers can categorise them using the PESTEL model. This classification distinguishes between:

Political factors. These refer to government policy such as the degree of intervention in the economy. What goods and services does a government want to provide? To what extent does it believe in subsidising firms? What are its priorities in terms of business support? Political decisions can impact on many vital areas for business such as the education of the workforce, the health of the nation and the quality of the infrastructure of the economy such as the road and rail system.

Economic factors. These include interest rates, taxation changes, economic growth, inflation and exchange rates. As you will see throughout the "Foundations of Economics" book economic change can have a major impact on a firm's behaviour. For example:

  • higher interest rates may deter investment because it costs more to borrow
  • a strong currency may make exporting more difficult because it may raise the price in terms of foreign currency
  • inflation may provoke higher wage demands from employees and raise costs
  • higher national income growth may boost demand for a firm's products

Social factors. Changes in social trends can impact on the demand for a firm's products and the availability and willingness of individuals to work. In the UK, for example, the population has been ageing. This has increased the costs for firms who are committed to pension payments for their employees because their staff are living longer. It also means some firms such as Asda have started to recruit older employees to tap into this growing labour pool. The ageing population also has impact on demand: for example, demand for sheltered accommodation and medicines has increased whereas demand for toys is falling.

Technological factors: new technologies create new products and new processes. MP3 players, computer games, online gambling and high definition TVs are all new markets created by technological advances. Online shopping, bar coding and computer aided design are all improvements to the way we do business as a result of better technology. Technology can reduce costs, improve quality and lead to innovation. These developments can benefit consumers as well as the organisations providing the products.

Environmental factors: environmental factors include the weather and climate change. Changes in temperature can impact on many industries including farming, tourism and insurance. With major climate changes occurring due to global warming and with greater environmental awareness this external factor is becoming a significant issue for firms to consider. The growing desire to protect the environment is having an impact on many industries such as the travel and transportation industries (for example, more taxes being placed on air travel and the success of hybrid cars) and the general move towards more environmentally friendly products and processes is affecting demand patterns and creating business opportunities.

Legal factors: these are related to the legal environment in which firms operate. In recent years in the UK there have been many significant legal changes that have affected firms' behaviour. The introduction of age discrimination and disability discrimination legislation, an increase in the minimum wage and greater requirements for firms to recycle are examples of relatively recent laws that affect an organisation's actions. Legal changes can affect a firm's costs (e.g. if new systems and procedures have to be developed) and demand (e.g. if the law affects the likelihood of customers buying the good or using the service).

Different categories of law include:

consumer laws; these are designed to protect customers against unfair practices such as misleading descriptions of the product

competition laws; these are aimed at protecting small firms against bullying by larger firms and ensuring customers are not exploited by firms with monopoly power

employment laws; these cover areas such as redundancy, dismissal, working hours and minimum wages. They aim to protect employees against the abuse of power by managers

health and safety legislation; these laws are aimed at ensuring the workplace is as safe as is reasonably practical. They cover issues such as training, reporting accidents and the appropriate provision of safety equipment

Typical PESTEL factors to consider include:

Factor

Could include:

Political

e.g. EU enlargement, the euro, international trade, taxation policy

Economic

e.g. interest rates, exchange rates, national income, inflation, unemployment, Stock Market

Social

e.g. ageing population, attitudes to work, income distribution

Technological

e.g. innovation, new product development, rate of technological obsolescence

Environmental

e.g. global warming, environmental issues

Legal

e.g. competition law, health and safety, employment law

By using the PESTEL framework we can analyse the many different factors in a firm's macro environment. In some cases particular issues may fit in several categories. For example, the creation of the Monetary Policy Committee by the Labour government in 1997 as a body that was independent of government but had the ability to set interest rates was a political decision but has economic consequences; meanwhile government economic policy can influence investment in technology via taxes and tax credits. If a factor can appear in several categories managers simply make a decision of where they think it best belongs.

However, it is important not to just list PESTEL factors because this does not in itself tell managers very much. What managers need to do is to think about which factors are most likely to change and which ones will have the greatest impact on them i.e. each firm must identify the key factors in their own environment. For some such as pharmaceutical companies government regulation may be critical; for others, perhaps firms that have borrowed heavily, interest rate changes may be a huge issue. Managers must decide on the relative importance of various factors and one way of doing this is to rank or score the likelihood of a change occurring and also rate the impact if it did. The higher the likelihood of a change occurring and the greater the impact of any change the more significant this factor will be to the firm's planning.

It is also important when using PESTEL analysis to consider the level at which it is applied. When analysing companies such as Sony, Chrysler, Coca Cola, BP and Disney it is important to remember that they have many different parts to their overall business - they include many different divisions and in some cases many different brands. Whilst it may be useful to consider the whole business when using PESTEL in that it may highlight some important factors, managers may want to narrow it down to a particular part of the business (e.g. a specific division of Sony); this may be more useful because it will focus on the factors relevant to that part of the business. They may also want to differentiate between factors which are very local, other which are national and those which are global.

For example, a retailer undertaking PESTEL analysis may consider:

Local factors such as planning permission and local economic growth rates

National factors such as UK laws on retailer opening hours and trade descriptions legislation and UK interest rates

Global factors such as the opening up of new markets making trade easier. The entry of Bulgaria and Rumania into the European Union might make it easier to enter that market in terms of meeting the various regulations and provide new expansion opportunities. It might also change the labour force within the UK and recruitment opportunities.

This version of PESTEL analysis is called LoNGPESTEL. This is illustrated below:

LOCAL

NATIONAL

GLOBAL

POLITICAL

Provision of services by local council

UK government policy on subsidies

World trade agreements e.g. further expansion of the EU

ECONOMIC

Local income

UK interest rates

Overseas economic growth

SOCIAL

Local population growth

Demographic change (e.g. ageing population)

Migration flows

TECHNOLOGICAL

Improvements in local technologies e.g. availability of Digital TV

UK wide technology e.g. UK online services

International technological breakthroughs e.g. internet

ENVIRONMENTAL

Local waste issues

UK weather

Global climate change

LEGAL

Local licences/planning permission

UK law

International agreements on human rights or environmental policy

In "Foundations of Economics" we focus on the economic environment. We examine issues such as the effect of interest rate changes, changes in exchange rates, changes in trade policy, government intervention in an economy via spending and taxation and economic growth rates. These can be incredibly important factors in a firm's macro-environment. The growth of China and India, for example, have had massive effects on many organisations. Firms can relocate production there to benefit from lower costs; these emerging markets are also providing enormous markets for firms to aim their products at. With a population of over 1 billion, for example, the Chinese market is not one you would want to ignore; at the same time Chinese producers should not be ignored either. However, the relative importance of economic factors compared to other factors will depend on the particular position of a business. Exchange rate fluctuations may be critically important to a multinational but less significant to a local window cleaner. Rapid economic growth or economic decline may be very significant to a construction business that depends heavily on the level of income in the economy but may be slightly less significant to a milk producer whose product is less sensitive to income. So whilst the economy is important to all firms on both the supply side (e.g. unemployment levels affect the ease of recruitment) and demand side (e.g. income tax affects spending power) the relative importance of specific economic factors and the relative importance of the economy compared to, say, regulation or social trends will vary. Whilst we hope this book provides a good insight into the economy and the possible effects of economic change on a business these must be considered in the light of other macro and micro factors that influence a firms' decisions and success.

macro environment

  

Hide links within definitions

Definitions (2)

1. Major external and uncontrollable factors that influencean organization's decision making, and affect itsperformance and strategies. These factors include theeconomic, demographics, legal, political, and socialconditions, technological changes, and natural forces.

2. Factors that influence a company's or product'sHYPERLINK "http://www.businessdictionary.com/definition/development.html"development but that are outside of the company's control. For example, the macro environment could includecompetitors, changes in interest rates, changes in cultural tastes, or government regulations.

How Macro Environment affects Financial Management Decision?

Macro environment is a dynamic factor and has changed drastically in last few years, leading to increase in avenues, competition and complexity. Efficient financial management calls for better financial decisions. This is only possible when every factor is reviewed which can affect the decision in any way and macro environment is one of the most important factors. This has made financial management more critical and sensitive for any business.

Effective evaluation of alternatives is very critical in financial decisions. The evaluation calls for analysis of various factors belonging to both macro as well as micro environment. Financial management; a specialized field of general management is affected to a large extent by macro situations. We have to make various decisions related to finance; broadly such decisions include capital budgeting, capital structure & working capital decisions. Capital budgeting facilitates investment decisions, capital structure takes care of decisions relating to mix of sources of funds and, working capital assesses the day to day needs of business.

 

While taking these decisions, one needs to understand the criticality of environmental forces. Since, there is no single factor that makes our macro environment but group of various forces like political, legal, economical, social, technological etc, together build it. An effective financial decision needs assessment of these factors.

 

To evaluate various macro forces, it is necessary to be aware of the system and processes of the country constituting the economy. For e.g. financial system of a country which plays a major role while making financial decision. Awareness about financial environment helps us understand how it constraints or facilitate implementation of decisions. Financial environment comprises of various intermediaries as well as regulatory bodies.

 

A simple example will help us understand the criticality of macro factors thoroughly. A change in credit policy like tightening of prudential norms for banks (for e.g. Increase in Cash Reserve Ratio and Statutory Liquidity Ratio by central bank of a country) will reduce the money supply in the economy. Decreased money supply will push up the interest rates and make credit costlier for people who want to borrow. Costly credit will directly affect the capital structure decision. It will also affect capital budgeting decision while assessing the feasibility of the investment alternative. Since, a higher cost of capital will increase the percentage of discounting factor (opportunity cost) with which the future cash flows are discounted. This may cause deferring or canceling the capital expenditure (CAPEX) plans.

 

Also, one should be updated with various changes taking place around the world. We are living in an era of globalization where, nothing is stable and information technology has made the access to news and information of the world just a click away. World is becoming a level playing field where, not only national but international factor can also cause a threat. Like, "Sub-prime Crisis" brought a challenging time for almost entire world.

 

To summarize, financial management and its decisions are greatly based on some major assumptions. These assumptions are greatly based on the macro factors such as country or worldwide interest rates, gross domestic product (GDP) of a country, growth rate of economy, production and sales figures, population census etc. It clarifies to a great extent that financial decisions may go wrong if proper study of macro factors is not done. If the foundation go wrong, dreaming about a strong building would be equivalent to day dreaming.

 

The new Thinking

The role of the Ministry ought to be facilitating industrialists to achieve their vision and being a catalyst in that process

I was curious when invited to deliver the keynote address at a seminar which is on Investment Opportunities in the New Economy because the last person you would want to speak on investment opportunities is a bureaucrat. 

I think investment opportunities come from the market. And if by the New Economy you are referring to the post-peace era, what we would want to see is not bureaucrats deciding on new investment opportunities, but letting the private sector decide what new opportunities are available for investment. 

I have been in the Ministry for the last three months. And during the three months I have encouraged a soul-searching exercise within the Ministry as to what the role of the Ministry ought to be. We have asked ourselves the questions: What is the vision of the Ministry? Together with the Minister and with the senior staff of the Ministry, we have been trying to define the vision we hold for industry in Sri Lanka. And in order to achieve that vision, what is the mission of the Industries Ministry? I would like to share with you some of our conclusions. 

We believe that the vision of the industrial sector, as well as that of the Ministry should be to create an internationally competitive, robust, modern industrial sector in Sri Lanka. If we are looking at five years or ten years from now, we would like to see our industrial sector being internationally competitive, self dependent, robust and modern. The age when government subsidized industry, when industry existed with handouts from government is over.

If that is the vision that we hold out for industry, what is the mission of the Ministry? We intend sharing with the chambers our views on this matter because we want the chambers to either endorse or suggest what the Ministry ought to do. And in that context we will be unfolding before them the work programme of the Ministry. We will be accountable to industry and the chambers. Every six months we will tell them what we have achieved. 

If making the industrial sector modern and internationally competitive is our vision, what is the role or the mission of the Ministry? We believe that the role of the Ministry ought to be facilitating industrialists to achieve their vision and being the catalyst in that process. And we have tried to ask ourselves the question, if we are a facilitator, if we want to be a catalyst in helping industry to achieve their vision, what should we be doing. The new organizational structure of the Ministry will reflect that mission. 

Let me share some thoughts with you on what we feel are the areas that we should be involved in and we intend to get involved in. Firstly, all of you as business men and industrialists would agree that more than all the incentives and the tax breaks that you would desire, the fundamental question for industrialists is the macro environment. If you do not have a conducive macro environment in which to operate, I do not think we can talk of business or industry. 

What do we mean by the macro environment? Macro environment comprises several factors like interest rates, labour policy, tariff regime, the regulatory framework, investment policy, entry policy and exit policy. There is a whole heap of factors including the legislative framework that creates the macro environment. If that macro environment is not right, I do not think any industry can flourish in a country. So we would have a Director in the Ministry in charge of these macro environmental issues.

The last budget included a proposal to set up a permanent Tariff Commission to decide on tariff issues. The market is dynamic and tariff issues keep changing. The government will very soon appoint a Tariff Commission. 

Similarly we intend to be represented on bodies that decide on other areas pertaining to industry, in creating that macro environment for industry, labour policy and interest rates. 

The second area is industrial policy itself. I am sure many of you have either listened to or participated in debates which discussed what industries ought to be protected in Sri Lanka, if any. We find criticism at many fora where people say we opened up our economy too soon and too sudden. We did not give a chance to local industry to face competition from imported products. Even today there are people who believe that we should not allow some foreign products which have captured the markets to come into this country. 

What is Government policy on this issue? We would like to develop that policy in the Ministry after discussions with industry and the chambers. 

If you take a simple example, today the shoe industry is facing competition from imports from China. Huge amounts of shoes are on the pavements and in shops that have been imported at very low prices. The shoe industry in Sri Lanka employs more than 5,000 workers. And that is in the organised sector. I am ignoring the informal sector. That industry is crying for protection. Should we protect the shoe industry? There are some who argue that if our industry is to survive, they should be able to compete with any imported product. 

In all the sectors of industry that we have dealt with, there are major issues of this kind. So, I think it is necessary for the Government to announce, after a dialogue with the industry and chambers, the policy of the government on protection. I am sure as consumers we would all like to pay a cheap price. We would not like to pay even more, even for the cause of protecting industry. I don't think our national consciousness goes to such an extent that we would agree to the government levying a duty of say, Rs. 900 in order to protect a local industry which manufactures the same products at a cost of Rs. 1,000 while the imported price is only Rs. 100. 

If on the other hand, the imported product is Rs. 100 and the cost of the local product is Rs. 110, and there is also a likelihood that given the requisite support, given the assistance needed to upgrade technology and be more productive, the local product can also be sold at Rs 100 within a reasonable period of time, then you and I may not mind a duty of Rs. 10 being levied on the imported product in order to give that local industry a chance to improve and be competitive. In fact, if you look at examples in other countries, if you look at the Indian example, there was a time when milk produced in India was far more costly than imported milk. At that time, they imposed a duty on imported milk and used the money that was recovered to help the local milk industry. Today India is in a position to export milk.

We should think carefully what our policy ought to be on tariff issues. So the Ministry would like to get into that exercise and help government make a declaration of its policy on tariffs.

Similarly, there are other issues of industrial policy - like the BOI and the non BOI regime. I am sure most of you are aware that the same industry within the BOI enjoys certain privileges which are not available to a similar non BOI industry operating in Sri Lanka. The budget has tried to take those differences away and unify the system. Similar issues are there on industrial policy with regard to environment, location of industries and the zones. All those areas are matters on which the Ministry wants to focus its attention.

A third area is entrepreneurship development. Sri Lanka has a history of being a protected economy. We have few entrepreneurs in the country. Much less than the desired number we would need in a market economy. We have over the years got our people used to a static, comfortable state of affairs where risk taking is no more in our genes. We need to take some steps in the universities and in the schools to inculcate the spirit of entrepreneurship in our future generations. 

There is an excellent programme in schools, executed with the collaboration of an American organisation for creating entrepreneurship in the schools. There are 300 schools that have formed companies with the students. They produce and market products. We need similar exercises like the incubation programmes, the Vasanthaya Programme, and so on to create enterpreneurs in the country. Thus, the third area that we would like to get into is to invest in entrepreneur development.

A fourth area that the Ministry would like to get into is small and medium industry. 

With the assistance of the Asian Development Bank, we are now engaged in the process of finishing a white paper which will outline the strategy for development of SME industry in the county for the next five years. There is a short term plan and a medium and long term plan. That paper will be out for public scrutiny. There will be public hearings held about the white paper throughout the country. And we intend publishing and implementing the proposals embodied in that white paper. 

These four areas are not sector specific. They cut across all sectors. In fact, without having a conducive macro environment, a rational industrial policy and entrepreneurs, I do not think we can develop industry. And the Ministry would devote much attention to those areas in the forthcoming years. 

But, that alone will not do. There are sector specific problems and we need to get involved with such issues. For that purpose, we have selected 15 sectors based on two studies done for Sri Lanka. One, the JICA sponsored, Japanese assisted study, and the other, the USAID Competitiveness study. Based on those two studies we have selected 15 sectors and formed task forces in each of these sectors. 14 have already been formed. These task forces are led by the private sector and the Ministry only has a director who acts as the secretary to each task force. 

The task force in each group will prepare a five year plan for the sector. The five year plan will have four elements. One, the state of the sector today in the country - how many units are there, how many are employed, how much exports, what is the degree of technology, competitiveness in that particular sector. In other words, they will prepare a profile of the sector as it is today. 

Secondly, they will do a SWOT analysis for that industry. They would look at the strengths and weaknesses of that industry in Sri Lanka and analyse the opportunities and threats faced by that industry.

Thirdly, they would decide what would be reasonable targets for that sector to achieve in five years. They will create a vision for the sector in terms of increased number of units, increased exports and increased employment.

And lastly, they will specify what they want the government to do in order to help them realize their vision. A simple five year plan is to be prepared by all 15 sectors.

Two sectors have already completed their assignment and handed over the documents to the Ministry. The Ministry will monitor them and help them reach those targets. There could be policy changes that are required. Areas in which the industry needs the support of the Government as identified in these sector studies will receive the attention of the Ministry. 

In reinventing the Ministry to playing that role of facilitator and catalyst, there is a tremendous contribution that the Ministry could make for industry. It is a challenge that I and my colleagues in the Ministry are eager to take on.

PEST analysis

From Wikipedia, the free encyclopedia

  (Redirected from PESTLE)

PEST analysis stands for "Political, Economic, Social, and Technological analysis" and describes a framework of macro-environmental factors used in the environmental scanning component of strategic management. Some analysts added Legal and rearranged the mnemonic to SLEPT;1 inserting Environmental factors expanded it to PESTEL or PESTLE, which is popular in the UK.2 The model has recently been further extended to STEEPLE and STEEPLED, adding education and demographicfactors. It is a part of the external analysis when conducting a strategic analysis or doing market research, and gives an overview of the different macroenvironmental factors that the company has to take into consideration. It is a useful strategic tool for understanding market growth or decline, business position, potential and direction for operations.

The growing importance of environmental or ecological factors in the first decade of the 21st century have given rise to green business and encouraged widespread use of an updated version of the PEST framework. STEER analysis systematically considers Socio-cultural, Technological, Economic, Ecological, and Regulatory factors.

Contents

 [hide]

1HYPERLINK "http://www.srilankadot.com/wiki-PESTLE#The_Model.27s_Factors" HYPERLINK "http://www.srilankadot.com/wiki-PESTLE#The_Model.27s_Factors"The Model's Factors

2HYPERLINK "http://www.srilankadot.com/wiki-PESTLE#Applicability_of_the_Factors" HYPERLINK "http://www.srilankadot.com/wiki-PESTLE#Applicability_of_the_Factors"Applicability of the Factors

3HYPERLINK "http://www.srilankadot.com/wiki-PESTLE#Use_of_PEST_analysis_with_other_models" HYPERLINK "http://www.srilankadot.com/wiki-PESTLE#Use_of_PEST_analysis_with_other_models"Use of PEST analysis with other models

4HYPERLINK "http://www.srilankadot.com/wiki-PESTLE#See_also" HYPERLINK "http://www.srilankadot.com/wiki-PESTLE#See_also"See also

5HYPERLINK "http://www.srilankadot.com/wiki-PESTLE#References" HYPERLINK "http://www.srilankadot.com/wiki-PESTLE#References"References

6HYPERLINK "http://www.srilankadot.com/wiki-PESTLE#External_links" HYPERLINK "http://www.srilankadot.com/wiki-PESTLE#External_links"External links

The Model's Factors

Political factors, are how and to what degree a government intervenes in the economy. Specifically, political factors include areas such as tax policy, labour law, environmental law, trade restrictions, tariffs, and political stability. Political factors may also include goods and services which the government wants to provide or be provided (merit goods) and those that the government does not want to be provided (demerit goods or merit bads). Furthermore, governments have great influence on the health, education, and infrastructure of a nation.

Economic factors include economic growth, interest rates, exchange rates and the inflation rate. These factors have major impacts on how businesses operate and make decisions. For example, interest rates affect a firm's cost of HYPERLINK "http://www.srilankadot.com/wiki-Cost_of_capital"capital and therefore to what extent a business grows and expands. Exchange rates affect the costs of exporting goods and the supply and price of imported goods in an economy

Social factors include the cultural aspects and include health consciousness, population growth rate, age distribution, career attitudes and emphasis on safety. Trends in social factors affect the demand for a company's products and how that company operates. For example, an aging population may imply a smaller and less-willing workforce (thus increasing the cost of labor). Furthermore, companies may change various management strategies to adapt to these social trends (such as recruiting older workers).

Technological factors include ecological and environmental aspects, such as RHYPERLINK "http://www.srilankadot.com/wiki-R&D"&HYPERLINK "http://www.srilankadot.com/wiki-R&D"D activity, automation, technology incentives and the rate of technological change. They can determine barriers to entry, minimum efficient production level and influence outsourcing decisions. Furthermore, technological shifts can affect costs, quality, and lead to innovation.

Environmental factors include weather, climate, and climate change, which may especially affect industries such as tourism, farming, and insurance.Furthermore, growing awareness to climate change is affecting how companies operate and the products they offer--it is both creating new markets and diminishing or destroying existing ones.

Legal factors include discrimination law, consumer law, antitrust law, employment law, and health and safety law. These factors can affect how a company operates, its costs, and the demand for its products.

Applicability of the Factors

The model's factors will vary in importance to a given company based on its industry and the goods it produces. For example, consumer and B2B companies tend to be more affected by the social factors, while a global defense contractor would tend to be more affected by political factors.3 Additionally, factors that are more likely to change in the future or more relevant to a given company will carry greater importance. For example, a company who has borrowed heavily will need to focus more on the economic factors (especially interest rates).4

Furthermore, conglomerate companies who produce a wide range of products (such as Sony, Disney, or BP) may find it more useful to analyze one department of its company at a time with the PESTEL model, thus focusing on the specific factors relevant to that one department. A company may also wish to divide factors into geographical relevance, such as local, national, and global (also known as LoNGPESTEL).

Use of PEST analysis with other models

Investment Deterrents

06 Dec, 2005 00:00:00

Sri Lanka needs to focus on a better macro-economic policy matrix to face the challenges ahead

Though Sri Lanka badly needs higher levels of investment, to boost growth and reduce poverty, economists are warning that chronic macro-economic instability is hindering progress, with the deteriorating security situation also adding to the country's woes.

The effect of macro-economic instability is felt by economic players and the ordinary public in the form of high and volatile interest rates, a permanently weakening currency, high levels of inflation and poverty.

Some economists also point to mounting evidence that Sri Lanka's inflation and poverty is primarily fiscally induced and usually compounded by fiscal dominance of monetary policy.

Inflation leader

Sri Lanka's high level of inflation contrasts starkly with the rest of the world, while the gap between this country and the rest of South Asia is also widening.

All over the world, inflation is trending down, because of labour flexibility, outsourcing, the China effect and increasingly independent central banks that are aggressively focusing on lowering inflation.

Even in Latin American and African economies, which used to be mis-managed to an extraordinary degree, inflation is coming down.

"Developing countries worldwide, you might note, were averaging 35% inflation in the 1980's," Peter Harrold, Resident Representative of the World Bank in Sri Lanka told members of the Chartered Institute of Management Accountants, during a presentation on how macro-economic factors affect business.

Average Inflation is South Asia

 

1970s

1980s

1990s

2000-04

Nepal

7.6

10.1

8.8

3.3

India

7.8

8.9

9.0

3.8

Pakistan

12.2

7.0

9.2

4.1

Bangladesh

19.3

10.4

5.2

4.6

Dev. Countries

23.0

35.6

25.6

5.9

Africa

13.0

15.9

18.8

8.0

Sri Lanka

8.7

12.2

9.7

9.7

Source : IMF, IFS Yearbooks 2000-2004 /World Bank

"This is especially influenced by Latin America which was famous for extraordinarily high rates of inflation. This has come down somewhat in the 1990's and then very, very, dramatically down to about 6% in developing countries as a whole; again reflecting Latin America's much stronger monetary control in recent years."

Closer to home, even Bangladesh now has better monetary policy with its Central Bank headed by an ex-World Bank staffer.

Bangladesh's average inflation has fallen from 10.4 percent in 1980s to 5.2 percent in the 1990s and to as low as 4.6 percent in 2000-04.

Sri Lanka on the other hand has not been able to make significant gains in achieving price stability.

Inflation which averaged 12.2 percent in the 1980s in Sri Lanka has remained around 9.7 percent in the 1990s and stayed around 9.7 percent between 2000-2004.

Indian Prudence

India (whose Prime Minister is himself an economist), recorded an average inflation of 3.8 percent in 2000-2004, down from 8.9 percent in the 1980s and 9 percent in the 1990s.

"We see that in South Asia we've moved down from around about 11% on average in the 1980's to, excluding Sri Lanka, to under 4% in South Asia now," says Harrold

"The Indian minister of Finance expressed concern last week, that inflation was trending towards 5% in India. And therefore this would require some measures to ensure that it stayed below 5%. Five percent, that's when India gets worried."

After two years of exceptionally tight fiscal policies in Sri Lanka under donor backed economic strategy, year-on-year consumer inflation nudged zero in the first quarter of 2004.

But in January 2005 Sri Lanka's year on year consumer inflation hit 18 percent, as the Central Bank printed Rs. 65 billion to finance government handouts and oil subsidies under a new Marxist driven "people friendly" policy framework.

Later in 2005, monetary tightening and an improvement in the fiscal sector, brought by a tsunami debt relief has helped lower inflation.

Negative Rates

The effects of weak monetary and fiscal policy come to the surface not only through rising prices but also through negative real rates.

Sri Lanka's real interest rates tend to fluctuate widely.

"Over the last ten years, the real interest rates being the nominal interest rate minus the rates of inflation has moved around dramatically," says Harrold.

"In many countries the real interest rates are very, very stable. Very often around 3% historically. Nominal rates may move up and down with inflation, but not the real rate. But here, the real rate moves around a great deal from as high as 12% down to as it is currently minus 3%. That means whenever you are depositing money you are subsidizing the people who are borrowing it in real terms."

Exchange overhang

Though real interest rates are now starting to turn positive, other effects are lingering.

Sri Lanka's exchange rate which started to depreciate under the weak monetary policy and massive amounts of subsidies paid for imported commodities in 2004, appreciated sharply after the tsunami aid flows and debt relief came in early 2005.

As a result, the inflation differential with our trading partners has not yet been worked through the exchange rate.

But this may happen sometime in the future.

"If your inflation is higher than everybody else's sooner or later your exchange rate will change. This is an inescapable, fundamental law of economics."- Peter Harrold, World Bank

"We saw that Sri Lanka was the only country is the notable exception to the international experience in recent years, where across South Asia, across the world and even in Africa we have seen sharp decline in inflation," says Harrold

"If your inflation is higher than everybody else's sooner or later your exchange rate will change. This is an inescapable, fundamental law of economics. I have never seen in my 30 years of doing this a country that can run a higher inflation rate and not have their exchange rate change eventually. Doesn't mean it's going to change tomorrow or even next year, but eventually there will be a re-alignment of that exchange rate."

Though Sri Lanka badly needs higher levels of investment, to boost growth and reduce poverty, economists are warning that chronic macro-economic instability is hindering progress, with the deteriorating security situation also adding to the country's woes.

An appreciation of the real effective exchange rates, caused by adverse inflation differentials will eventually hurt domestic producers.

High inflation and macro-economic instability not only causes widespread poverty but also discourages investment, because it makes in difficult for businesses to operate.

A World Bank study found that, urban firms listed macro-economic instability as the third biggest constraint for doing business, after high electricity tariffs and policy uncertainty.

The fourth reason was high interest rates, which is usually a result tight monetary policy compensating for fiscal profligacy.

Guesswork

But in 2004, Sri Lanka's interest rates went sharply negative in real terms, as Central Bank eased monetary policy in the face of expansionary fiscal policy, and an emerging exchange rate crisis, while financial market players watched in awed disbelief.

As a result, the bond markets in particular, had to anticipate future interest rates based on their assessment on how imprudent the rate setting Monetary Board of the Central Bank would be, rather than economic fundamentals, in order to make investment decisions.

"If you have a very unstable environment; if the exchange rate is moving in unpredictable ways, if inflation goes up and down in unpredictable ways, if these factors are impacting on the stock market and we have little confidence in the direction of these signals then we are going to find it very difficult to make, you are going to find it very difficult to make business choices" says Harold.

"The evidence for this relevance is demonstrated time and time again over history in this country and every other country. These are fundamental economic laws that apply everywhere they do not discriminate; they are very very clear in their impact."

Sri Lanka's high overall budget also deficit scares foreign investors, despite various tax incentives given to attract them.

Unsustainable mix

Foreign analysts know that tax breaks on top of deficit spending is a vicious combination.

"If a country has a budget deficit of 8 percent, and promises to spend a lot of money for companies to come in, if you are smart you would know that it is not sustainable." - Prof. Norbert Walter, Chief Economist of Deutsche Bank Group

"If a country has a budget deficit of 8 percent, and promises to spend a lot of money for companies to come in, if you are smart you would know that it is not sustainable," says Prof. Norbert Walter, Chief Economist of Deutsche Bank Group who visited Sri Lanka recently.

"And you do not trust that this would help make your business model a victory. Therefore, if there is a tax advantage, make use of it, but do not make your economic decisions on it; that would be my very strict advice for any company."

Sri Lanka's budget deficits have range between 7.5 percent and 10 percent in the last five years, causing the country to have the highest debt to GDP ratio in the region.

Public Debt % /GDP

1995

2000

2004

Bangladesh

55.5

47.9

48.5

India

71.7

76.7

86.1

Pakistan

79.2

88.8

96.8

Sri Lanka

95.2

96.9

105.4

Source: World Bank

For years, current expenditure in the budget has been rising, due to an expanding public sector and vote catching hand outs, at the expense of public investment.

Though Sri Lanka attracts around US $ 200 mn in foreign direct investment a year, the pure risk capital have come to mostly footloose, low capital incentive industries, which come in search of cheap labour, which in itself is a condition brought about by chronic high inflation and exchange depreciation.

Sri Lanka has been able to attract capital into infrastructure such as power generation and ports by giving high returns and the government taking on most of the commercial risks.

With the security situation again starting to deteriorate, analysts say, Sri Lanka needs to focus on a better macro-economic policy matrix to face the challenges ahead.

-LBO Newsdesk: [email protected]


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