The rationale for the Sri Lanka - Singapore FTA

Originally appeared on Echelon

By Ravi Ratnasabapathy

Small countries have small domestic markets; a focus on exports will help overcome this natural limitation.

Sri Lanka’s economic growth has been sub-optimal for decades. The standard excuse for this was the war. When it ended in 2009, there was renewed hope that the country would at last reach its potential, but this was not to be. After a brief spurt, post-war growth has reverted back to the long-term average (4%) in each of the five years over 2013-2017. This will not be any better in 2018. Post-conflict countries expect to experience a sustained “peace dividend”, but Sri Lanka’s 2009-12 boom was surprisingly limited both in scale and duration.

There are several issues in the structure of the economy, the most important of which is the lack of export growth.

Small countries have small domestic markets, and a focus on exports will help overcome this natural limitation.

Sri Lanka retreated from a policy of openness since 2000’s raising tariffs and regulatory barriers, resulting in a sharp contraction in exports as a share of GDP, which fell from a high of 33.3% to about 12.7% of GDP in 2016. Sri Lanka’s share in global exports has also declined. The country’s share in world manufacturing exports increased from 0.05% in the mid-1980s to about 0.11% in 1999, but has since declined, reverting to the level in the 1980s. In Malaysia, which has a similar population, exports are 71.5% of GDP.

The government has re-prioritised international trade as a driver of economic growth, and FTAs are a part of this process. FTAs open opportunities for Sri Lankan exporters and investors to expand their businesses into overseas markets. Imports under FTAs mean greater competition in the local market, but this is no less important as it helps to maintain and stimulate the competitiveness of local firms.

It is only constant competition that drives productivity, which is the basis of sustainable growth. To take an analogy from sports, if Sri Lanka’s cricketers focused mainly on domestic club cricket, they are unlikely to perform well in the international arena.

Apart from keeping firms efficient, competition benefits local consumers through access to an increased range of better value goods and services.

There is a cost to this, as some firms may lose out; we will come to this.

Sri Lanka’s already-weak export game is about to take another knock from BREXIT and Trump. Therefore, it makes sense to increase regional trade to offset the potential decline in current markets. Countries generally trade with their neighbours, except in South Asia.

Regional trade in East Asia & the Pacific makes up 50% of total trade; in Sub-saharan Africa, the figure is 22%, but in South Asia, it is only 5%. Singapore is the current chair of ASEAN and one of its most respected members. For a small country thus far ignored by ASEAN due to the conflict and inconsistent policies, the FTA provides an important signal of a policy orientation towards greater trade and investment with the region.

Greater openness brings many benefits, but there are many stakeholders with different interests, so policy needs to take into account these varying interests.

The customs tariff, together with the para tariffs of PAL and CESS, are taxes that are imposed on imported products that are not applied to the domestic equivalent. Since foreign exporters do not change the price that they charge for the product, the domestic price of the imported product rises by the amount of the tariff. The impact of this on various stakeholders is discussed below:

Domestic producers
Domestic producers competing with equivalent imports do not have to pay para tariffs, and so have an advantage over the imported product. As the prices of imported products rise, domestic producers have the opportunity to raise their own selling prices because competing with imported products now costs more.

It is always the case that the prices of domestic products rise when tariffs are imposed on imports. If it were otherwise, it would make no sense. The very purpose of the tariff is to enable the domestic producer to sell his product at a higher price. Therefore, domestic producers gain when the government imposes a tariff on competing

Domestic consumers
Domestic consumers of the product are equally affected by the imposition of the tariff. They must pay a higher price for both imported and local products. It is domestic consumers who pay for the protection of domestic producers, not foreign firms.

The government collects tariff revenue on whatever quantity is imported, although they do not collect it on the local product. The benefit the government creates for the local producer by raising the price of imports is collected by the local producer.

There are two domestic winners (domestic producers and the government) and one domestic loser (domestic consumers) because of the imposition of a tariff.

On the face of it, there appears to be more winners than losers, but in terms of sheer numbers, consumers in any industry far exceed the number of producers (or their employees). Consumers, however, are unorganized, so their interests may end up being overlooked.

As seen above, there are losers and winners in tariffs. When tariffs are cut, local producers may lose, although the government may still gain as a greater volume may offset a reduced rate. Managing the downside is necessary; local firms will need to compete, but they may need support to improve productivity and a period of adjustment.

The draft Trade Adjustment Programme (TAP) prepared by the Ministry of Development Strategies and International Trade provides a framework to tackle problems faced by affected industries. The underlying principle is to smoothen the transition of firms and workers to new market conditions, post liberalisation.

The government needs to work closely with each sector to tackle policy and regulatory constraints, and fix missing ‘public goods’-inadequate public services, infrastructure, etc, that sap the productivity of local firms.

There has been much debate over the movement of people. Various professional associations have alleged that the FTA will lead to an influx of incompetent people who will undercut professionals or provide substandard services.

These fears are misplaced. As per the Schedule of Specific Commitments (Chapter 7, Annex 7A ), the movement of persons is restricted to intra-firm transfers of specific categories, which is no different from current provisions under the BOI. The movement of professionals outside this limited sphere is closed, hence, the question does not arise.

In fact, Sri Lanka faces shortages of both unskilled and skilled workers. A survey by the Department of Census and Statistics indicates that nearly half a million vacancies exist in the private sector (excluding micro enterprises). The state sector employs far too many people, burdening taxpayers, while depriving the private sector of people, but even a drastic reduction in the size of the state may not solve the skills shortages and mismatches.

Labour scarcities have an adverse impact on growth, while shortages of skills impacts both productivity and growth. Studies have shown that the migration of people benefits both the sending country and the receiving country (van der Mensbrugghe and Roland-Holst 2009). The welfare gain for the destination country is because immigration increases the supply of labour, which raises employment, production and thus GDP (Ortega and Peri 2009).

A strong case can be made to allow specialised skilled migration to fill gaps that exist in the market. The skills of migrants will be complementary to those of existing workers, therefore, all workers experience increased productivity, which in turn, can be expected to lead to a rise in the wages of existing workers.

The discussion so far has been abstract, how do we know how the FTA will actually work?

The experience of the much-criticised FTA with India that was signed in 1999 may indicate some of the potential.

The Indian FTA is a very restrictive document: it outright excludes many major sectors in which both countries have comparative advantages – i.e. the very rationale for trade. India subjects 15 out of the top 20 Sri Lankan products to either a tariff or quota. Sri Lanka, in turn, offered additional concessions (of only 3.5%) on only 7 of India’s top 20 products, the rest being either excluded or were already tariff-free.

It was, in fact, an agreement designed to fail, entered into only as a formality.

Despite this, export volumes have grown significantly and India has become the third-largest destination for Sri Lankan exports:
“…nearly 70% of Sri Lanka’s exports go to India using FTA provisions… While India has been the largest source of imports for Sri Lanka (even before the FTA) for many years, India has acquired the position of being the third-largest destination for Sri Lankan exports – a rank achieved through the benefit of the tariff preferences in the FTA.” (Institute of Policy Studies)

The export basket has also diversified:
“If one looks at the Sri Lankan export basket destined for India before the FTA, which was dominated by agricultural products such as cloves, peppers, areca nuts, dried fruits, nutmeg, etc., exports have now (after the FTA) become more diversified. It includes boats/ships, wires and cables, glass and glassware, apparel, woven fabric, etc. In 2013, the largest Sri Lankan export to India was boats and ships.

Sri Lanka exported 505 product items to India before the FTA in 1999, the product items exported increased to 1062 by 2005, and to 2100 product items by 2012, after the implementation of the FTA. This quadrupling of the product items during 1999-2012 provides further evidence for Sri Lanka diversifying its export basket to India after the FTA came into operation in 2000.”

The impact of the FTA is not well known because it did not affect prominent export industries. The beneficiaries were firms that were working in other areas. Neil Marine is not exactly a household name, but is among South east Asia’s largest manufacturers of fiberglass boats. The North Sails Group, the world’s largest producer of sails and a sail technology leader, manufactures many of its products in Sri Lanka.

Trade only takes place to mutual benefit. Given sufficient time, the FTA with Singapore will have similarly beneficial outcomes.

Dr Wignaraja: Can Sri Lanka join Asian Supply chains?

by Dr Wignaraja on Daily Mirror

President Trump’s pledge to put America first during a global trade slowdown has sparked worries that the era of export-led growth has ended. Trade in Asia and globally has slowed since the 2008 global financial crisis but it is not the end of export-led growth. The real issue, however, is whether Sri Lanka can follow East Asia’s success in global supply chains amid slower trade growth and a likely rise in protectionism. Global supply chains refer to the geographical location of stages of production (design, production, marketing and service activities) in a cost-effective manner and linked by trade in intermediate inputs and final goods. For instance, the Toyota Prius—a hybrid electric mid-size hatchback car—for the US market was designed in Japan and is largely assembled there, but some parts and components are made in Southeast Asia and China. Supply chains exist in a wide range of manufacturing and services activities.  East Asia’s shift from a poor, less developed agricultural periphery to a wealthy global factory over the last half a century is an economic miracle. The extent of the region’s participation in global supply chains is significantly greater than elsewhere and has spurred East Asia’s global rise to the coveted “Factory Asia” league with the middle-income status for many economies.  In 2015, the developing economies in East Asia accounted for 34 percent of global supply chain trade with China making up 15 percent and Southeast Asia for 7 percent. This compares with 34 percent for the European Union, 10 percent for the United States and 5 percent for Japan.  However, South Asia is a relatively small player. India accounts for 1.7 percent of global supply chain trade and the rest of South Asia, including Sri Lanka, for 0.13 percent. Structural transformation and rising wages in China have encouraged an outward shift of labour-intensive segments of supply chains ranging from clothing to electronics. Sri Lanka has the potential to attract such supply chains from China. It is strategically located on the way to Europe, offers low wages with reasonable labour productivity and has a dynamic clothing industry. Close proximity to the large Indian market, which is a magnet for Chinese outward investment, is another advantage.  Smart business strategies and market-friendly national policies have supported East Asia’s achievement in supply chains. Being a big firm naturally creates advantages to participating in supply chains due to a larger scale of production, better access to technology from abroad and the ability to spend more on marketing.  It is crucial for small and medium-sized enterprises (SMEs) to work with large firms. Hence, smart business strategies, such as mergers, acquisitions and forming business alliances with multinationals or large local business houses are all rational approaches, as is investing in domestic technological capabilities to achieve international standards of price, quality and delivery. East Asia’s experience suggests that nimble SMEs can also join supply chains by locating to industrial clusters and reap the benefits of interdependence such as co-financing a training centre or a technical consultant to upgrade skills. Business associations can facilitate clustering by mitigating trust deficits to cooperation among SMEs and by coordinating collective actions for cluster formation. For instance, major industrial clusters are visible in Viet Nam near Ha Noi and Ho Chi Minh City, where large firms are surrounded by thousands of SME suppliers and subcontractors making garments, agricultural machinery and electronics goods. Turning to national policies in East Asia, modern cost-competitive infrastructure is crucial for supply chains. This means investing in world-class ports, roads to ports, logistics, electricity supply and information technology infrastructure. Maintaining open trade and investment regimes which encourage investment and transmit price signals to business are likewise important, as well as sound financial systems which emphasize competition among commercial banks and financial inclusion. High-quality, affordable technical and marketing support services and investing in education to develop skilled labour both help SMEs join supply chains. More controversial is the use of industrial policies in East Asia to target credit and subsidies to particular sectors or firms. Some oft-cited examples of failures include Korea’s heavy and chemical industry push, Malaysia’s national car project (the Proton) and China’s home-grown 3G mobile technology TD-SCDMA. More research is needed on good practices, as there is a high risk of government failure and cronyism associated with industrial policies. Joining supply chains will boost industrialization, jobs and incomes in Sri Lanka. There is no one-size-fits-all approach for Sri Lankan firms to join supply chains. Smart business strategies, facilitating business associations and market-friendly policies are all useful ingredients, while business and government collaboration is essential to tailor these ingredients to national circumstances. (Ganeshan Wignaraja is Advisor in the Economic Research and Regional Cooperation Department of the Asian Development Bank (ADB). The views expressed here are solely the author’s own and do not represent the position of the ADB. This is a guest article for the Ceylon Chamber of Commerce ‘Trade Intelligence for the Private Sector’ (TIPS) initiative that helps its member businesses be up-to-date on new developments in international trade. For more on the subject of this article, refer Production Networks and Enterprises in East Asia an edited volume by G. Wignaraja (2016))