Q&A Sri Lanka economy

Officially ‘upper-middle income’ - Now what?

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In this weekly column on The Sunday Morning Business titled “The Coordination Problem”, the scholars and fellows associated with Advocata attempt to explore issues around economics, public policy, the institutions that govern them and their impact on our lives and society.

Originally appeared on The Morning

By Aneetha Warusavitarana

Sri Lanka is now an upper-middle-income country, with a per capita gross national income (GNI) that surpasses that of regional competitors like Indonesia and Vietnam. The threshold for eligibility as an upper-middle-income country is a per capita GNI of $ 3,996, and as at July 2019, Sri Lanka crossed that threshold with a per capita GNI of $ 4,060. While this appears to be a positive development, it should be taken in context. The eligibility criteria to be classed as an upper-middle-income country begin at $ 3,996 per capita GNI; however, all countries within the range of $ 3,996-$ 12,375 per capita GNI are categorised as upper-middle income. It’s glaringly obvious that we just about made the cut, and if we are to see the kind of growth and economic prosperity associated with upper-middle-income countries, we have a long way to go.

Middle-income trap

The fear is that the growth required to push our per capita GNI up by roughly another $ 8,000 will be elusive – the notorious “middle-income trap” could possibly impede upward mobility and economic prosperity. As a country leaves its demographic dividend, economic growth tends to slow. The growth that is seen in most developing countries is created by the shifting of labour from low-productive employment like agriculture to more productive sectors such as manufacturing. However, this is not a source of long-term growth. As labour flows into manufacturing, real wages will rise and productivity gains will reduce. As a result, a developing country will be unable to compete internationally with labour-intensive manufacturing. Low-productivity also means that competing with higher value-added goods will also be challenging.

The World Bank’s case study of the Middle East and North Africa (MENA) region and the challenges they face have some parallels with the Sri Lankan situation. The World Bank highlights the damage caused to the economy by a social contract where the state is expected to provide jobs in government and hand out universal subsidies, in exchange for a lack of accountability. The result is that entrepreneurship and innovation are stifled, public service delivery is poor, and there is widespread mistrust of the government. In addition, considerable debt burdens are forcing governments to cut public spending, which has long been the main driver of growth in the region.

The situation in Sri Lanka is quite similar. While we are now an upper-middle-income country, the description of the public service in MENA regions is apt, and could very easily describe the government service in Sri Lanka. As each election cycle begins, the incumbent government doles out an additional few thousand jobs, while the opposition promises to give more jobs and better wages in the government sector if they are voted in. A rigid labour market, where innovation is not encouraged, and productivity is not rewarded is just one factor that is likely to hold us back.

Maneuvering the minefield

The general solution presented is that middle-income countries need to shift gears – policy decisions now need to be taken with the objective of moving into a high-income country classification. Focusing on innovation, a strong export base, and creating decent jobs are just a few policy solutions that are presented on the topic. While this is challenging, our newfound title is also an indicator of the potential in the country. With the right policies in place, there is a lot that can be achieved, and with presidential elections coming up, now is the ideal time to bring up this topic of policy reform.

While the middle-income trap is a pervasive problem in the region, there are success stories of countries that have “escaped” the trap. The Asian Development Bank (ADB) has identified some common economic factors that these success-story countries have in common. The four key factors identified are as follows: (i) the country had a rapid transition from agriculture to industry, (ii) higher export shares, (iii) lower inflation, and (iv) decreases in inequality and dependency ratios. The ADB has also found that when looking at the drivers of growth for upper-middle-income countries, total factor productivity should not be underestimated – in other words, education, research and innovation, and structural reforms are vital.

Realising potential

Transforming the Sri Lankan economy will require a drastic shift in mentality. As a small island nation of only 21 million people, we need to open our borders for free movement of labour, technology, and investment. Sri Lankans require a shift in mindset, where the gains of free trade and integration into global value chains are not summarily dismissed. The risks of these actions are often over-exaggerated, or given sole focus, feeding into a larger protectionist mindset.

The positive is that Sri Lanka now has an idea of the challenges that lie ahead, and key policy reforms which would set the stage for the kind of economic growth that we aspire for. The hurdle lies in implementation. With presidential elections coming up, there is scope and policy room for new reforms to be brought in, and ideally, these reforms should be tailored to achieve the four success-story characteristics – a shift away from agriculture, a focus on exports, low inflation, and decreases in inequality and dependency ratios.

Deshal de Mel answers your questions on the Sri Lankan economy

The economist Deshal de Mel who delivered Advocata's inaugural lecture on our series on How to fix Sri Lanka's economy. Participated in a lively Q&A session after the lecture moderated by Shiran Fernando.  However, we couldn't cover all the questions. Deshal was kind enough to answer some of the questions left on slido.com via his blog.  Here is a reproduction of Deshal's blog post.

1) Would the Port City, now being positioned as a Financial City, help the Sri Lankan economy?

The Port City has potential to help position Colombo as a modern city that is an attractive destination for global professionals to live, work, and visit. However, the viability of this depends on the type of investments that come in, the management of the environment, the management of infrastructure (sewage, drainage, marine and shore environment) and the related regulatory policy. The feasibility of a Financial City would depend on the evolution of the financial market in Sri Lanka. At present our financial market is not very sophisticated – it remains highly regulated with significant interventions in foreign exchange, lending practices, ownership etc.

There is a suggestion that the Financial City would be positioned as an off-shore financial market, with different regulations including visa requirements and so on. However, if this is completely separate from the rest of the economy, the resultant benefits for the local economy may be limited to some employment creation and spill-over spending effects.

2) How would Brexit and a Donald Trump victory in the US election affect Sri Lanka? Particularly the apparel industry, which employs a lot of women.

Early indications are that the main impact of Brexit are through the weaker GBP and resultant constraints on UK importers of Sri Lankan apparel. This effect is likely to continue and may affect other Euro area countries as well if the viability of the European integration project gets further undermined. The weaker GBP will also affect tourist arrivals from the UK this winter season.

The effect of a Trump victory on the other hand is almost impossible to analyse given the difficulty in predicting his policy positions and the possible gap between campaign rhetoric and policy reality. Nonetheless, whoever comes into power in the US will necessarily have to take into account the sharp anti-establishment voter sentiment, and there are likely to be rollbacks in economic liberalism, particularly with regard to cross border movement of labour, both in the US and Europe and in setbacks to progress of international trade agreements. A weakening of trade institutions will be further detrimental to global trade and to countries like Sri Lanka which need trade for growth.

3) Given the VAT set back, how challenging would it be to meet the fiscal deficit targets in the IMF program? What are the implications if the government does not pursue the IMF agenda?

There has been an improvement in fiscal performance in the first 4 months of 2016, with revenue growth of 20% and budget deficit declining by 14%. Nonetheless, these figures remain below budgeted targets with revenue falling short by 13% and budget deficit being 34% higher than planned. Tax revenue continues to rely heavily on indirect taxes and particularly import based taxes. With economic growth expected to moderate in 2016, there will be challenges in achieving the envisaged fiscal targets, which amplifies the urgency of reform of the inland revenue department to optimize use of information technology in revenue collection, simplifying tax payment processes and simplifying the tax system, and minimizing room for discretion in tax related decisions by officials.
A failure to meet the IMF targets may result in a delay or holding back of tranches of the IMF loan. This would lead to an erosion of confidence in the Sri Lankan economy among global investors – which in turn would impede Sri Lanka’s ability to raise funds to meet short term external payment obligations.

4) What can the government do to drive SME’s, start-ups?

Continued focus on the simplification of business processes and reduction in costs of setting up and operating a business is the best way a government can support SMEs and startups. In addition, a government has a role in encouraging the development of conducive networks and ecosystems that bring small time businesses in contact with sources of finance, distribution channels and markets, knowledge, and technology.

5) How much are policy changes/reversals affecting Sri Lanka’s economy? How much would clearer communication of policies by the government help its acceptance by the public and thus implementation?

Regular reversals of economic policy decisions and conflicting messaging on economic issues from the government is very harmful to the business and investment climate. It becomes very difficult to plan commercial activities such as new investment or business expansion when the policy environment is uncertain. Ideally a government should have a clear three to five year policy framework with only incremental changes in the interim to respond to external developments. Unfortunately Sri Lanka’s recent experience has been the opposite, with even short term policy frameworks such as the budget, being regularly changed in response to stakeholder reactions. A more inclusive approach to policy making, taking into account stakeholder views prior to implementation, would be a way to deliver more sustainable and implementable policies.

6) Are apartment/real estate developments drawing out liquidity in the market?

Investment in apartments and real estate is just one source of demand for credit in the market. Considering 2015 statistics, out of private sector credit of 3.4 trillion, personal housing (construction, repairs, purchasing etc) accounted for 10.8%. Anecdotal evidence however does indicate that a lot of real estate investments have been on cash basis – and this is difficult to capture in statistical form.

Overall loan growth in the economy has been strong for the last 20 months or so – with private sector credit and borrowings by the government being significant. Steps have been taken in 2016 to curb this credit growth, including the recent policy rate hike by the Central Bank in June.

7) What is the likelihood of Sri Lanka being able to diversify its economic growth outside the Western Province? What steps can be taken to grow the rural economy?

Steps have been taken to improve transport infrastructure in parts of the country outside the western province. More needs to be done to reduce transport costs, particularly to the central, eastern, and northern parts of the country in order to improve connectivity with the larger local markets in the western province and access to global markets through the port and airport. In addition to expressways, investment in domestic airports will be an important driver of connectivity. However transport connectivity is not the only factor that determines attractiveness of investment in rural regions. Investment in health and education services are important factors in retaining management talent and other white collar skills in these regions, whilst also developing home grown talent from the regions themselves.

8) Has Sri Lanka’s peace dividend materialized?

Sri Lanka enjoyed strong economic growth in the years immediately after the war. However, growth was concentrated in a few narrow sectors such as construction, domestic trading, domestic transportation, financial services and so on. This growth was also contingent on fairly accommodative monetary policy, which had to come to an end in 2012 as the economy began to overheat. A more sustainable growth path would be one which has more diversified growth sources, including a more substantial share of external growth drivers through the export of goods and services. Thus far tourism and logistics related industries are the most promising sectors on the horizon to help this diversification of growth factors to enable a more sustained peace dividend.

9) In the context of privatization and other divestment of state assets – what happens to those who have no other source of livelihood?

A structural change in an economy where resources shift from uncompetitive sectors to competitive ones is necessarily a change which entails dislocations in the labour market. Workers in those industries which are uncompetitive will need to develop skills to cater to the new industries that do emerge in their place. This is never an easy and trouble free process – and there is a role of the state in the provision of such training facilities and temporary safety nets to support livelihoods of those who do lose jobs. To minimize the time of transitions, it is essential to proactively drive the FDI attraction process to create new jobs in the new, more competitive sectors of the economy.

10) What measures could be taken to enable citizens/interest groups to communicate issues to the government instead of resorting to disruptive strikes?

A more inclusive approach to policy making can be constructive here – particularly through greater consultations prior to significant policy changes. The communication needs to be two-way, with the government clearly articulating the reasons behind such policy changes and making best endeavours to take into account the reasonable concerns of citizen groups. In today’s context technology can be used in a much more effective way to obtain citizen feedback on policy and to address concerns through more effective communication. Policy reform will always lead to winners and losers, and the effective management of the losers from the process is crucial to ensuring the longevity of the reform process.

11) Can Sri Lanka contribute to value addition in India’s economic sectors?

Sri Lanka already is contributing to value addition in India’s economic sectors through Sri Lankan investments in logistics, apparel, and leisure, among others, in the Indian economy. However, further value could be created by better integration of supply chains between the two countries, enabling more efficient manufacturing, taking advantage of comparative advantages and Sri Lanka’s natural logistical/locational strengths.

12) Do you think the government is giving enough weight towards entrepot trading?

Steps have been taking towards creating an enabling environment for entrepot trading by the enactment of the Commercial Hub Regulation Act of 2013. This creates bonded zones in 6 locations in the country that are free of customs duties and processes, enabling activities such as entrepot trade and other logistics/warehousing related businesses. However more needs to be done to promote this to improve uptake – such as proactively approaching multinationals to set up their warehousing/distribution operations in Sri Lanka, catering to their buyers in the Indian sub-continent and beyond.

13) Can Sri Lanka pursue sustainability whilst also focusing on growth in manufacturing?

Considering global trends in manufacturing, Sri Lankan manufacturers will necessarily have to engrain sustainability in their operational processes. This is necessary both in terms of streamlining operational costs and optimizing efficiency, and also in terms of marketability of products, which is increasingly influenced by sustainability factors.

14) How far away are we from default in our foreign debt? Is the relationship with China adding to this debt burden?

With the IMF programme brining some confidence and the new Central Bank Governor bringing credibility to Sri Lanka’s economic policy making machinery, Sri Lanka’s ability to borrow from global markets has returned, at least for now. Therefore, the country will likely be able to roll-over its near term debt obligations, barring a significant risk event in the global market, or a reversal of these recent domestic policy measures. The long term sustainability of debt remains contingent on Sri Lanka’s ability to anchor meaningful fiscal consolidation through sustained revenue improvements and rationalization of government expenditure. It is also necessary to develop external inflows through greater exports of goods and services, and FDI.

Whilst Sri Lanka has seen greater borrowings from China during the last decade, the feasibility of such loan repayments is more to do with the choice of project, which is the role of the Sri Lankan government, than the choice of lender. Sri Lanka has had positive outcomes from the Chinese relationship such as the extension to the Colombo South Harbour’s new deep water terminal, as well as less positive outcomes such as the Mattala Airport – therefore it is a question of how Sri Lanka chooses to utilize the investments from China in an optimal manner.

15) Considering your titillating presentation, with the government swaying left and right on issues, do you see the two coming together instead of being unhooked?

It is important for a government to keep abreast of all policy issues, speak in a unified voice and avoid lingering doubts. This will help provide optimal support to Sri Lankan enterprise, big or small.

16) What’s your outlook on interest rates?

Interest rates have already increased significantly in the first half of 2016 and with the rate hike by the Central Bank in July, I would expect interest rates (particularly the benchmark bond yields) to have peaked by now and remain around these levels through the rest of the year. Credit growth is likely to moderate in the second half of the year and thus ease liquidity pressures in the market and recovery of foreign investment in LKR treasuries will also help stabilize interest rates.

17) Today’s firms are underpaying workers and earning excess profits. Why doesn’t competition cause market prices of goods and services to decline?

Perfect competition would cause prices to find equilibrium at a level where supply equates to demand. However, in most cases, particularly in developing economies, markets have several imperfections and do not result in optimally competitive environments. Governments in such cases need to take steps to mitigate such market failure, be it through effective competition policy to prevent formation of monopolies and oligopolies, or by supporting improvements in information to reduce information asymmetries.
In Sri Lanka’s case however a lot of the high and sticky prices are due to high taxation or administered prices, that do not allow the price level to settle at a true market rate. This is the case for several agricultural products and protected domestic industries.

18) Do you think rehabilitation, reconciliation and reconstruction bolster the economy?

Rehabilitation, reconciliation, and reconstruction are important elements in sustaining peace in the country, and this in turn is crucial to ensuring economic stability and creating an environment that encourages long term investment. The relationship works both ways, since the expansion of economic opportunity in turn is important to create livelihoods for those in post-war provinces, which again is an essential component of normalization.

20) Why hasn’t protectionism of infant industries and uncompetitive industries been removed?

One of the main reasons is very effective and strong lobbying of successive governments by the industries concerned. A second reason is the fact that there hasn’t been significant investment in new sectors which creates alternative employment opportunities for those employed in such protected industries. Another reason is that a reduction of trade tariffs on such industries would have a negative impact on government revenue, which is particularly problematic in a situation where 50% of government revenue is based on import based taxes.

21) Is a reduction of agricultural subsidies and protection practical? Or is it only sound in theory?

The removal of protection cannot be implemented overnight. Several pre-requisites need to be fulfilled in preparation for this, namely; 1) a robust network of well targeted safety nets to provide cushion for those affected by labour market dislocation, 2) investment in skill development/re-training activities to engrain the relevant capabilities to enable workers to shift to new industries, 3) Pro-actively drive FDI in higher value agriculture – particularly targeting global companies that implement higher technology based agriculture catering to global export markets. This entire process takes time but it has to start somewhere, to enable the economy to gradually shift from low productivity, low wage activities, to higher productivity, more remunerative activities.

23) Should there be a change in the government’s incentives towards developing the economy, as opposed to the prevailing incentive of getting re-elected at the next election?

Government incentives are driven by voter demands. If voters demand state jobs, domestic industry protection, subsidies, and so on, that is what the government is incentivized to provide. Voters need to understand the true costs of these activities, particularly in a different fiscal and financial paradigm to what Sri Lanka has been accustomed to until the last 6 or 7 years. The government and policy makers (by and large) know what is required but will continue to pander to voter demands until voters make more educated demands of their government.

24) Africa has astonishing stories of creativity and innovation. Are we as a nation far less creativity oriented and more interested in imports and consumption?

Sri Lanka’s education system has been an exam-centric one, which trains students to acquire and retain knowledge and use it to pass an exam. A lot more can be done to inculcate skills such as creativity, problem solving, analysis – this requires an overhaul of the curriculum and teaching methods. It is these skills that are needed to build an innovation centric culture. We do have pockets of excellent creativity and innovation, but these are success stories despite the education system, not because of it. By re-orienting our education practices, such successes can be made the norm and not the exception.

25) Which industries can be built to a level that would be able to produce competitive exportable products and services?

It is difficult to predict which sectors can thrive in an economy. For instance, it is unlikely that someone could have predicted that Sri Lanka would be the global market leader in solid tyre exports, and fly fishing rods. From a policy perspective, I believe it is better to be sector agnostic, and to focus on creating an environment in which the best investments could thrive. Sri Lanka is likely to succeed in niches which are inherently tough to predict – but will have requirements such as skilled labour, good logistical processes, good access to global markets, and robust physical infrastructure – these are the areas a government should focus its attention.

26) Is SOE privatization likely to take place?

Privatization may not happen in the same manner in which it occurred in the 1990s and early 2000s – but I would expect the divestment of stakes of public companies in a manner similar to what happened with SLT. The viability of this process requires excellent communication with the industry stakeholders (unions, employees), the general public, and also ensuring a healthy competitive market in which the industry operates.

27) Is it feasible to abolish VAT and replace it with a BTT of around 7 to 8%

I would argue that the VAT is a superior tax to BTT since it taxes value addition and minimizes tax duplication. A lot of work has gone into developing VAT to the level we are at today, so I think it should be persevered with and continue to focus on improving collection and minimizing leakage.