As recent events such as the COVID-19 pandemic have contributed to many countries experiencing inflation worldwide, there has emerged an interest in understanding the relationship between inflation and international trade. To guide us in understanding the nuanced ways in which inflation affects international trade, Ashwini Pereira (Program Manager) and Yasara Kodagoda (Events Manager – Internal) from the Moot Court Bench International Trade Law Program, interviewed Prof. Rajesh Sharma, Senior Lecturer for Legal and Dispute Studies, Criminology and Justice at the RMIT University in Melbourne, Australia. Prof. Sharma holds a PhD in Law from the Chinese University of Political Science and Law, Beijing, a Master of Business Law from Monash University, Australia, an M. Phil from the City University of Hong Kong and an LLB from the University of Delhi. Among the many distinguished positions, accolades and accomplishments he has held, Prof. Sharma is a Professor at the Academy of International Dispute Resolution and Professional Negotiations, has served as a legal advisor to the Macau University of Science and Technology, and has published on the areas of WTO law, international trade, arbitration and dispute resolution, commercial law and banking law.
Compiled by Naveera Perera
Q: Professor, could you please give us a brief understanding of what inflation is?
A: Well, in very simple terms, inflation means that the purchasing power of the currency has gone down. For example, what you buy today at 100 rupees or 100 dollars will cost more tomorrow or after one week. This means because of inflation, the amount of goods you can buy will reduce due to the decrease in the value of money. Inflation can additionally occur because the price has increased, requiring you to pay more than ever before for a certain type of good. Therefore, inflation occurs not only where the value of currency is decreased but also where the price of a good has increased, whilst your currency is valued less.
A very good example of inflation is when the COVID-19 pandemic occurred. During COVID-19, the very first thing that happened because of the lockdown was that supply chains got disturbed, which means that the supply of goods went down. In other words, while there was a scarcity of goods, simultaneously, the demand for such goods started to rise. For example, goods such as tissue paper, toilet paper, cleaning products and related materials were in high demand. However, despite the fact that so many people wanted to buy them, such items had less supply. So, because of the low supply, the price of those products went up due to their demand and as a result, people had to pay more.
But what other aspects led to inflation during or after COVID? During the pandemic, because of the lockdown, people were not travelling. Because people were not travelling, they were not spending extra money like they used to. So what happened was that they had more money to use. But immediately after COVID, when the lockdown was lifted and the pandemic “finished”, people had more money to spend. Because of the sudden urge to spend more money and travel elsewhere, prices of air tickets, for instance, went very, very high. So, in that case, since there was more supply of money, it resulted in prices being increased that means your money being devalued.
Q: In your opinion, what factors lead to inflation?
A: It could be various factors. In the example of COVID-19, which I previously mentioned, economically, there are two factors that lead to inflation. Inflation can be created either from a lower supply of goods or because there is more money. So, in terms of the first aspect, if the demand is high, supply will be less, and then, of course, the merchant or seller will start increasing the price because that is the way they will make their money. Since the price will go up and the people have to pay more, therefore the value of the money also goes down.
In terms of the second aspect, inflation can occur due to an oversupply of money. If a country has more money, or the people have more money to spend, then what will happen is that people have more money to buy goods. Then again, the seller will think, “If people are ready to buy more or pay more, then why should I not increase the price?” This is where the airline ticket example comes into play. So supply and demand, consumer demand and all related aspects can push inflation.
A third factor which people say creates inflation is the wages and the high wages of the labourer. If you have high wages for labour, and the raw materials also costs high, then the production cost will go high. If the production cost goes high, then the price of the goods will go high, and therefore, in the end, people will have to pay more money.
But in recent times, other situations, like the pandemic, have played an influential role in many countries worldwide facing inflation. For instance, following COVID-19, the Russia-Ukraine war that erupted had a direct impact on the supply of goods as well as on gas and petrol prices. Since gas and petrol are very much linked with the transportation of goods, this means that the cost of everything from the supply of goods to procurement would increase. Naturally, this would mean the selling price will also increase, and the money value will go down, thereby causing inflation. So COVID-19 and the Russia-Ukraine war have definitely caused the recent global inflation, which we are seeing now.
Some countries, however, face inflation specifically because of political instability. Due to flawed financial policies, lack of transparency and because of the corruption of the government, political instability causes its own kind of inflation which is an example of situational backed inflation. This is backed by economic theorists too. For instance, if you look at inflation in terms of Milton Friedman, he says that in history, you can see every time that it is always the overprinting of money that causes inflation. But that is not the only reason, there are many others.
Q: Could you please describe to us the relationship between inflation and trade?
A: It is very, very interesting. If you look at trade, we have to look at it from the domestic trade point of view and in an international trade point of view. Sometimes, inflation can happen because of the domestic demand and supply. For example, if you look at a country that experiences a sudden stop in the supply of goods or has very little access to goods whilst the domestic demand is very high, then the people have to pay more money for that, and that can create inflation as well. So, within the country, if domestic trade and commerce are affected, it could lead to inflation.
Another aspect of domestic trade is in situations where people have money. People can get money only if they have other sources of income or free money, which they can get in the form of a subsidy, as some kind of help, or as some kind of aid from the government. If they have more money, then, of course, the local trader will think, “Oh, people have more money, so why should I sell my product at a lower price? I should increase the price on that one”. This can negatively affect the domestic market. A third point to note is that in the domestic market, the labour or the labour price is very high, as is the case in America. So, if the labour price is high, the cost of product will be very high, and that will contribute to causing inflation.
Now, if you look at the relationship between inflation and trade in an international sense, there are a couple of things that could cause inflation. For example, take imports and exports. If you are exporting something from your country and selling it outside, then you are bringing foreign currency into your country. If you are bringing the foreign currency into the country, then the country’s foreign reserve will increase and that foreign reserve can be used for something else. But if your country is importing most of the goods from outside because you do not have enough for domestic consumption, then what will happen? You have to buy from outside. When you buy from outside, it means you are importing the goods. When you are importing goods, you are buying them, not in your local currency, but, like most countries, you will have to buy in the US dollar or in euro. So because of the foreign currency, what happens is that the country has to pay the money in dollars or euros. On the one hand, paying it in foreign currency can lead to inflation if your currency is weaker than the dollar since you have to pay more. If, on the other hand, your currency is at par with the dollar, then you are paying the same. But if your currency is stronger than the dollar, then you are paying less. Most of the countries do not have this last facility and are therefore paying more. Because of this exchange rate, the cost of your imports would also increase. The moment the cost increases, it will make the prices higher, which means your currency value will go down, leading to inflation.
However, I must tell you in international trade, if you look at the 80s and 90s, the partial inflation or partial devaluation of the currency was a strategy for the developing countries and the less developed countries to export more goods. So all the developing countries who are a producer of cotton items, for example, would intentionally devalue their money by a bit so that they could reduce prices. This would mean, after devaluing the currency, by comparing it to the US dollar, goods were priced less, which helped in increasing exports. For instance, say if earlier, the US buyer was paying USD 1 for a T-shirt, now they will only have to pay 75 cents for a T-shirt. So it will become even cheaper. The cheaper it is, the more other countries will buy from you, which in turn means your country can export more. The more they export, the easier it becomes to earn more foreign currency and add it to a country’s reserve. The foreign reserve is always good for the country because they can be used for anything. For example, an energy-dependent country can pay for the oil using that money. This is how inflation and trade are related.
Q: During the past few years, it has been quite evident that Sri Lanka has been experiencing inflation. In your opinion, Professor, what effect has inflation had on Sri Lanka’s trade?
A: Well, I mean, you are from Sri Lanka, so you have really felt the impact of inflation over there. So, it is only you or others living in Sri Lanka that can truly comment on this. But from the point of view of someone observing from the outside, for one thing, we find that Sri Lanka particularly was very much dependent on, like any other developing country, on energy. By energy, I mean petrol or gas, which had to be imported and for which the price, because of the Russia-Ukraine war and other events, went very high.
In so many countries, the money in the foreign reserve, as was the case in Sri Lanka, was not enough. This meant that countries needed to get more money into the reserve. Even if you did have the money to buy, you were buying at a higher price. So again, if you buy some raw material, gas or anything at a very high price and then you bring it to the country, you cannot sell it at a lower price and must instead sell it at a higher price to gain a profit or to avoid any loss. If you sell it for a higher price, it is the consumer that must ultimately bear the cost. But how can they bear it?
The cost of a good would go up based on travelling costs as well. So if you have to supply the goods to a specific point in the country via a truck, then the price of petrol would be a factor sellers will take into account. Even if people have the money to spend, they must now spend double or triple the previous price. So, it is very hard to buy any essential product because it would be priced at an amount that reflects the total cost the seller spent. This is one kind of impact we have seen in the way inflation has affected Sri Lanka. Sri Lanka got into a very difficult situation because of COVID-19, followed by the Russia-Ukraine war, among other events that led to the increase in gas prices, which resulted in the country’s foreign reserves being dried up. It was the drying up of the foreign reserve that essentially created the problem for Sri Lanka, which affected the general public.
This is, however, not unique to Sri Lanka. Many times, government policies or practices, such as the unreasonable borrowing of money beyond a country’s capacity or the choice of not diversifying an economy due to historical reasons or otherwise, lead countries to face problems. Sadly, when this kind of inflation hits, it is the general public that suffers. In the past, this has happened in Argentina and Chile. So I would say that because of the heavy dependency of Sri Lanka on oil and the government’s tendency to excessively borrow beyond their capacity of repayment, in addition to the effects of COVID-19, such as the disruption of supply chains, as well as the high energy costs, all of these events have all cumulatively impacted Sri Lanka very much along with its population for which I sympathise.
On a positive note, recently, because of international cooperation and the help Sri Lanka now has, there is enough foreign reserve to buy gas. Because of that, inflation is now coming under control, which hopefully would lead to a positive turn. At least, compared to the state Sri Lanka was last year, people are no longer standing in long queues at gas stations. The recovery in Sri Lanka from the economic crisis for the past few months has been really amazing. If it continues for at least another six months, I think the situation will improve dramatically. That’s our assessment from the outside.
Q: Professor, in your opinion, does inflation react negatively when you are faced with government tax deductions?
A: So if you mean that the government tax deduction should be removed or reduced, there are two ways to look at it, one from the government’s point of view and the other, from the public’s point of view, who are at the end of the day, paying taxes. So generally, when you get the tax deduction, it is the taxpayer who saves money and has extra money in their pocket. But if the government reduces those deductions, then the taxpayer has to pay more, and the government will have more income. Both sides are okay. There is no problem because paying taxes is not a bad idea, and collecting taxes is also not a bad idea. But what is more important is for what purpose this collected money is being used for. If this money is used for purposes of the general public, then it is okay – people can see it. But if this money is collected from the public, goes to the government, and the government spends it in the wrong way, or because of corruption, the money is diverted somewhere else, then this is a problem.
Many times, the government can ask the public in times of crisis (including during an economic crisis), “Please come together. Let’s build a nation together”. And if it is done in a transparent manner, then that is fine. Then everybody will think about it as “okay, it is very good”. So say, for example, if I pay more tax, and that tax can be used to pay the cost for the labour, in terms of their salary, or used for healthcare, for construction, railroads, bridges and all, then the people will be very happy to contribute to that. That is not a problem. But in this developing and developed country, the problem is that the government collects the tax, but they never give a clear idea. They are never transparent about how this money is used. Instead, if the political party or the political leaders run away with this money, then they are cheating the general public.
But then, if you see the other way around – say, for example, if the government gives you some kind of a subsidy or gives you more deductions than what you were getting before or by getting you some extra money, then what will happen? The supply of money towards the consumer side will be more. So the consumer will have more money in their hand. This leads to the same cycle I explained before – they will be spending more, and when they have more money, the seller knows that consumers have more money, resulting in them increasing the price artificially. If the government does not control the price, sellers will increase the price as they please. The seller will increase the price with the assurance that the buyer has extra money. In that same line of thought, the buyer will think, “I have extra money, so I can celebrate and spend extra money”. In this way, the consumer will start buying extra goods, spending more on restaurants, more on travelling, more on tickets, etc.
Overall, if the government removes tax deductions, then it will still cause some kind of inflation. If, for instance, the supply of money goes to the consumer side more, it will lead to inflation, and this is why you need to consider both sides.
Q: To give us an overall understanding of the topic, how has the world reacted to growing inflation amidst trade wars? And secondly, what approach would you prescribe Sri Lanka takes going forward?
A: Let me answer the first part of your question. This is very interesting because every country has taken a different approach. I am not an economist, but what I see everywhere in the world is that the banks or any government agency which makes the monetary policy for a country to fight against the global economy can take a different approach to fight inflation. For example, a very common approach that some countries believe will help them control inflation is by increasing the interest rate. This could work in some countries while it would not for some others. For instance, I can give you my personal experience. In Australia, the government bank was increasing the interest rate on and on and on. They increased interest rates very high, thinking that it would control inflation. We have not seen the report yet whether it is actually controlling inflation or not. But during this period, definitely, it has become very difficult for the bank to lend money. So the prices of property and everything have gone very high in Australia.
Another example is to increase the supply of goods. However, it is important to remember that similar to the policy of increasing interest rates, there is no one size fit for all, nor is there one formula that can help a country combat inflation. Every country and every monetary policy agency is taking different actions. Which one is the right action? We do not know. I mean, nobody can say it for sure. But one thing is very clear – as a common strategy, you can increase the interest rate, and that will control the inflation. Otherwise, a state has to intervene in the market and then control the price of goods. If the government can control the price, keep it lower so that it balances with the income a person receives so that the general expenditure a person has to spend to live will be at par with their income. In that situation, inflation can be controlled.
If you can control the market price or the price of the good through market intervention or through government intervention, then you can keep it balanced, and then there will be no inflation. But most of the countries pride themselves on saying that they are a market economy and they do not interfere. So they will not control the price. And if they do not control the price, then the price will go up and then it will create inflation. So that is the problem we are facing.
Now, coming to the second part of your question, what should be the way forward for Sri Lanka? Well, if you look at it from the government perspective, and I think your government has already said that they want to implement reforms compatible with their obligations to the IMF so that they can get the money- it is a short-term solution. But for the long-term solution, if you look at it, we have to go to the root cause of inflation, which is balancing the demand and supply side. In this respect, Sri Lanka has a demand for its tea, tourism and garments, three areas the country should work on. Focusing on improving such industries is important because if you export, then you can get foreign currency and having that gives us some kind of leverage.
The second thing is that we have to think about how to diversify the economy. By that, what I mean is that while we continue to sell tea in the traditional way of exporting it, we also need to be innovative. For instance, introducing different flavoured teas or different types of teas would increase the demand for Sri Lankan tea. Additionally, as Sri Lanka is a tourist destination, putting in more effort to think of innovative ways the number of arrivals can be increased will bring more foreign currency. As a plus, this will also be beneficial for local restaurants and hotels.
We have to essentially go beyond the traditional way of garment sales and think about some new innovative ideas. Innovative ideas will only come if we allow and create an environment that helps small and medium-sized enterprises to think outside the box. I can give you one example from my personal experience. My friend and colleague have a garment business in India. During COVID, when the lockdown happened, everybody was suffering. But this guy was very innovative. He changed his strategy and decided that instead of making a t-shirt and the jacket and everything, “why should I not start making other types of garments?” He started making face masks or items needed for the doctors at that time, and it was very easy. So, his labourers started producing them, and he ended up having a big turnover in terms of money. At that time, when everybody was complaining, he made good money because he used the opportunity. So this kind of creativity, this kind of innovation, you need to give to the medium and small-sized enterprises to innovate and support them long term. It will help Sri Lanka.
Another important point is understanding or influencing consumer behaviour in the country. Think about it. When Sri Lanka was facing the gas crisis, and there was no supply of petrol and foreign money, the little money that was available was used to purchase gas. Now, think if everybody in Sri Lanka or most of the people in Sri Lanka could have taken a decision like “Okay, we will not buy petrol, we will not use our cars, we will not use any automobiles during this period, and instead, we will take the bicycle, and we will ride on bicycles” – then what? Then the people will say “I do not need petrol”. So the government does not have to buy petrol from outside. After all, it is not that the use of bicycles is very unheard of. Long ago in China, everybody was using bicycles to travel. So, if we change our behaviour as consumers, then we can control the supply and demand. For example, if we cannot buy a certain product, then we will start looking for a different product. This means if we cannot buy an Apple computer, for instance, we will look for some other computer that is within our means. So, in that way, the consumer can also change themselves and help control inflation in some ways.
Moreover, if the consumer behaviour pattern does change, then it can also help in controlling the prices. If the demand is high, then definitely the price will be high. If we lower our demand, then certainly prices will be lower. Take the agricultural sector, for instance. If we are too dependent on importing day-to-day items like rice or vegetables or other forms of food or meat, which may be described as necessities, then we have to find how we can produce locally. It is a slow process, and it is not that easy to do. For many of these things, I think Sri Lanka also has to think about bringing in a strategic foreign investment in a country in a strategic area where it can sustainably develop. Mind you, just having gas and petrol does not mean that a country can do very well. Nigeria is a good example in this regard. They have petrol and gas resources, and yet they, too, suffer from inflation.
So all these things – changes in consumer behaviour, smart governmental policies, and good foreign or strategic foreign investment, can collectively help Sri Lanka to grow further. A country’s size is not a measure of how successful they are in avoiding inflation. Take Singapore, Hong Kong and Taiwan – they are very small countries, but still, they are doing very well because of the smart, strategic use of their human and natural resources. So Sri Lanka, too, needs to brainstorm and use its younger generation of innovative thinkers to implement better measures in the next 25, 30 and 50 years. So that kind of thinking is needed as, at times of crisis, creativity is needed to rise. If this is found, perhaps Sri Lanka can create a good example for many other countries to follow in future.
The views and opinions expressed by experts in the In-Discussion Series of the Comparative Advantage Blog are those of the experts and do not necessarily reflect the views of the Moot Court Bench.