Mme Kumaratunga, Mme Chair, ladies and gentlemen, let me first thank Eric for a very fulsome and overly generous introduction. I must also thank Mme Kumaratunga and the SAPRI Board for inviting me to be with you here today. It is a pleasure and an honour to make this presentation to you.
The title as you are aware is “Middle Income Sri Lanka: Opportunities & Challenges. I propose to organize my material by initially focusing on the opportunities. In this connection, I hope to make the case that this is the most propitious set of circumstances the country has faced for 50 years, not just for the 25 or 30 years of the conflict, but going back to the late-50s. In order to take advantage of the opportunities, there are some challenges that have to be addressed. I propose to highlight 5 such challenges.
First – The country’s adverse macroeconomic legacy needs to be addressed ie the twin deficits: the budget and the current account of the balance of payments.
Second – Sri Lanka’s export performance needs to be improved. A small resource and capital scarce economy cannot grow on a sustained basis without more buoyant export performance.
The third theme I’d like to address is Investment
The fourth related item is productivity and competitiveness.
Finally – Education, training and skills development.
Of course, there are a number of other important strategic issues. These include food and energy security, adapting to climate change, technology management and ageing. However, I am going to focus on the five themes above-mentioned themes because, in my view, they are arguably the most important for putting the country on an accelerated and sustained trajectory of growth and development. Finally, I propose to address some of the short-term policy challenges that confront the authorities today.
Before I get into the substance of my presentation, I’d like to make one point. As I was thinking about what to say on this occasion my friend Jivaka Weeratunga told me, “Look if you are going to say anything at all, please make it a point to say that we need to be more strategic than we have been in the past”. In this connection, I tried to identify what differentiates the very successful countries of East and South East Asia from the somewhat less successful countries of South Asia. One clear difference is the former’s capacity to be more strategic. Those countries have been able to take a ten, fifteen, twenty year view; a long-term perspective, whereas short-term political expedience has driven what has gone on in South Asia, including Sri Lanka. Of course, there are understandable reasons for this. When there is a competitive and adversarial political system, short-term political priorities tend to over-drive the development agenda.
Another strategic point that I would like to make is that there has been a paradigm shift now that Sri Lanka has attained lower-middle-income country status. With the country having greater exposure to international capital markets, the premium attached to sound macro-economic management is higher than it has ever been. The costs of policy mistakes are going to be much higher. So unless one takes a strategic perspective in terms of our development path, we could get ourselves into serious trouble.
Now let me get back to my initial outline. I started off by saying that this is the most propitious set of circumstances for the country for 50 years. Why do I say that? If you look back to the late- 50’s, there was a dramatic and secular decline in the terms of trade for about 25 years. Tea and rubber prices fell almost on a continuous basis. In fact, if you look at the World Development Report of 1982, there is a box on Sri Lanka where it is cited as a country that had experienced devastating terms of trade decline. So that was a major drag on the development prospects of the country for 25 years starting from the late-50s. At the same time, there was a demographic surge. This meant the surpluses were coming down in the economy at a time when the population was rising quickly. Clearly, those were a set of problems that were very challenging for policy-makers at that time. In addition, those problems were amplified by the dirigiste and inward-looking policies that were followed at that time. Then there was the liberalization of the economy in the late-70s. However, the country didn’t get the pay-off it might have got, due the onset of the conflict. If you look at the period from the late-50’s right through to 2009, there were major drags that were holding back the development prospects of the country.
I would submit to you that there are no such drags which are constraining the prospects of the country now. Not only that, economic geography has never been more favourable. Sri Lanka is in Asia. Sri Lanka is 20 miles from the large Indian market. In fact, if you look at the economic history of East and South East Asia over the last 40/45 years, you first had Japan and then China rising. The countries in East and South East Asia were able to benefit from the rise of these economies by tapping into the supply chains of first the Japanese and then the Chinese companies. The most dynamic component of the international trading system is intra-firm trade in Asia (i.e.) supply chains. Sadly, Sri Lanka has little or no presence in the Asian supply chains
When I came back about 3 years ago, having been away for about 20 years, I thought people would be tremendously excited about what was happening in Asia. The centre of gravity of the global economy was shifting from West to East and the Indian economy was growing fast. East and South East Asia had been booming for some time. So I thought people, not just the policy- makers, but the private sector as well, would be really jumping out of their skins. The war was over. There was a new set of circumstances and one would expect that there would have been tremendous excitement about being in Asia with a concerted focus on how one could take advantage of this favourable economic geography. Disappointingly, there was very little of that. The end of the war provided a good opportunity to examine the strategic prospects of the country. We are beginning now to move in the right direction but we may have lost a few years. One may conclude that these are the most propitious set of circumstances for the country for many years because there are no major drags on the economic prospects of the country and economic geography is more favourable than it has ever been.
Before I embark upon the strategic challenges, I think it would be fair to record some of the positive developments that have taken place in the last 7, 8 years.
One clearly is infrastructure development. There has been a major backlog in terms of Infrastructure development for many years. However, we have seen an effort to accelerate the infrastructure build. There are clearly concerns –
- about unit costs,
- about rates of return,
- about opportunity costs
These are all issues that need to be addressed. There is also a strong case for a more robust planning process.
However, the bottom line is that significant progress has been made, particularly in terms of road development. The much improved connectivity will reduce transaction costs. The coal-fired power plant at Norochcholai and the completion of Sampur will reduce unit costs in the power sector. As far as the Port and Airport in the deep South are concerned, there is a lot of ancillary development that has to take place before they begin to yield a sufficient return. The infrastructure build, on balance, can be recorded as a positive development.
Secondly, some key economic indicators are favourable. The rate of unemployment is now below 5%. The proportion of the population in absolute poverty is down to 8.9%. Both are now in single digits. These are clearly impressive numbers. However, I think it is important not to be complacent. When one unpacks these numbers, it becomes clear that we need to reinforce our efforts. If you look at the unemployment rate, it has come down to 4% primarily due to the large numbers of people going out of the country as migrant labour. In addition, there has also been a rapid increase in the size of the public service, much of it nonproductive employment. Some research, conducted by Verite, has indicated that total employment has not increased. On the improved poverty rate, contributory factors have been the remittance inflows from abroad and also the transfer from military families.
These headline numbers are impressive, and I don’t think one should take credit away from that. However, they have not been generated by a transformation of the economy. We have not had economic transformation. The positive outcomes are due to factors that are either exogenous, like temporary migration, or unsustainable like the increase in the public service. So the challenge of economic transformation is still out there. It is in this context that I would now like to move on to the five strategic challenges that I identified earlier.
First, the macroeconomic legacy: the twin deficits, the Budget and the Current Account and Balance of Payments.
The Budget Deficit has been the cancer in the system. The current account of the Budget has been in deficit every year since 1987 and the overall deficit has often been unsustainable from the early 80’s. In fact, the last fiscal conservative was Dr. N.M. Perera. Given the fact that he was a Socialist, this is rather a paradox. As a Trotskyite, one would have expected him to be a “tax and spend” Finance Minister. However, he was actually a very frugal and prudent Finance Minister.
Since then however, we’ve had difficulty in containing the budget deficit and this has had a corrosive effect right through the system. It has made Sri Lanka an economy, which is characterized by high budget deficits that pump excess demand into the system causing high inflation. When inflation is high, nominal interest rates have to be high; if they are below the rate of inflation, people won’t save because their money would be worth less tomorrow than it is today. Equally, if the rate of inflation is higher than that of Sri Lanka’s competitors and trading partners, the exchange rate comes under pressure as domestic costs rise faster and competitiveness is lost. However, it is difficult to have an active exchange rate policy when the basic consumption bundle has a high import component.
I remember the 80’s when I was seconded to the Finance Ministry and was working under Mr. Chandi Chanmugam, who is here. At that time, I asked the Central Bank Governor at that time, Dr. Rasaputra, “Sir, why don’t you have an active exchange policy? Why don’t you have a realistic and competitive exchange rate?” He turned to me and said – “You guys in the Finance Ministry should first fix the Budget because if you don’t fix the budget and I depreciate the currency we will get caught up in a cycle of continuous depreciation and an inflationary spiral”
Sri Lanka has done diametrically the opposite of what the successful countries in East and South East Asia have done. Those countires had robust fiscal outcomes, low inflation, low interest rates and undervalued as well as competitive exchange rates. Sri Lanka did the opposite as a result of unsustainable budget deficits which pumped excess demand into the economy. When there is excess demand in the economy, there is also a higher propensity to suck in imports and that, in turn, exerts pressure on the balance of payments.
So, how have we got away with it for so long? How is it that since the early 80’s we have had an unsustainable budget deficit for most of the time? For much of the time, Sri Lanka was a donor darling! The traditional donors were very keen that a country which was not only the first to liberalize and move away from highly dirigiste policies, but also had a pluralistic polity, should deliver good development outcomes. They were keen to support such a country to show that this model could work. So throughout the period from the early 80’s, we received generous flows of foreign aid. The problem with that was that we did not have to take the tough decisions that were necessary to live within our means. Some of the tough structural reforms that had to be taken to address the budget deficit could be avoided. However, now that Sri Lanka has graduated to lower-middle-income country status, we are no longer eligible for concessional aid. When we talk about concessional aid we are talking about 2/3s of the money coming from the concessional windows of the World Bank and the ADB. This involved 10 year grace periods ; 30/40 year maturity and a 0.75% administration charge. This was never- never money! Another 10-15% came from Japan at about 2.5% interest and the rest of the money came as grants or from other donors at less than the 2.5% interest that Japan was charging. As a result, there was no pressure on Sri Lanka to take the tough decisions that had to be taken to bring the budget under control. So this basic instability in our macro-economic framework has continued right through.
Now that Sri Lanka has attained lower-middle-income country status, we have substituted commercial borrowing for ODA. We have been able to do this because there was sufficient headroom as we had little commercial borrowing until 3-4 years ago. Now that headroom is running out as far as the Sovereign is concerned, so banks and corporates are being encouraged to borrow. But clearly there is a limit to what you can do in this respect. There is no harm at all in borrowing abroad. However, that money must create the capacity to earn or save foreign exchange to repay the money and yield a return to the country. It is a matter of concern that one is not seeing the export growth or improvement in the trade balance necessary for this. Furthermore, while there have been high levels of borrowing, we are not seeing sufficiently high levels of non- debt creating foreign exchange inflows. So that is something that has to be addressed, and I will come to that.
Let me say a little bit more about the debt dynamics. The total debt-to-GDP ratio is about 79%. It has been over 100%. It has been 102 and 103%, but it at that level when we were receiving the type of never-never money that I was talking about. But now, we are borrowing at 6% and sometimes at 9% and 10% when it is money coming into the Treasury debt instruments. So Sri Lanka has now entered a different paradigm. The share of external debt in total debt has increased. Within that, the share of commercial debt has increased. Within that, the share of short-term debt has increased. Are we vulnerable? In my view, we are certainly not in the red light zone. Sri Lanka is not near a crisis. However, we are in an amber light zone. It is now time for caution. Often it is said that we have reserve cover of over 4 or 5 months worth of imports. But that is not the best index, in my view, particularly when there is exposure to international capital markets. There is another index called the EVI (the External Vulnerability Index) which looks at the ratio between the liabilities of the country over the next 12 months and its gross reserves. The comfortable level is 100%. Our liabilities are 125% of our reserves. This is not a crisis level but the amber light is flashing. So clearly one thing we have to do is to get the budget in order to contain our debt. That is not politically easy. There are problems on the revenue side. I am willing to discuss how to address this during the Q and A as I am running behind time..
There are also concerns regarding current expenditure. It is not easy to cut this as about 85-90% are interest payments, public sector emoluments or subsidies and transfers. On interest payments, there is little one can do about interest on debt that has already being incurred. The other two items are politically very difficult to tackle. Then, there is about 6.5% of GDP that is going into the public investment program which is being protected. Going forward, it is going to be difficult to maintain such a level of capital expenditure and achieve the fiscal consolidation targets the government has set for itself: to bring the budget deficit down to 5.8% this year and 5% by 2015. There is considerable fiscal consolidation that has to take place. Tough decisions are necessary on the revenue front to widen the tax base and improve tax administration. Tough decisions are also necessary on the current expenditure side. There will be difficulty in maintaining the momentum of capital expenditure without increased recourse to public-private partnerships. One is already beginning to see movement in this direction. There is a Chinese company involved in the Colombo Port development. Another Chinese company is also going to be involved in the Northern Highway. In these instances, it will be equity and not loans. This is the direction we would need to go, if we are to maintain the momentum of the infrastructure build.
One must reiterate that the budget is the main source of instability. Some progress has been made in terms of fiscal consolidation but one must remember that there is about 2% of GDP as State Owned Enterprise losses which have to be considered as the quasi budget deficit of the government. It is sitting in the balance sheets of the state banks but it is effectively a contingent liability for the Government. The Treasury Secretary himself is on record as saying that these enterprises, particularly the CPC, CEB and Sri Lankan Airlines, need to work much better. On top of this unpaid arrears amounted to about 0.5% of GDP last year. There is a major challenge in terms of getting the budget right. Unless this is done, we will have difficulty in terms of managing the country’s debt sustainably. We will have difficulty in creating an environment for boosting exports. The subject I propose addreess now.
The second strategic challenge is the anti-export bias in the policy framework. For years and years, Sri Lanka has said exports are our priority. But we have had difficulty in getting a policy environment that has been supportive of rapid export growth of the sort that the East and South East Asian countries have been able to achieve. As I have already told you, the Sri Lankan economy has been characterized by high inflation, high interest rates and an over-valued exchange rate. Clearly, an over-valued exchange rate does not boost exports nor does the high cost of funds. More recently, there has also been a reduction in the openness of the economy. These are all factors which militate against export growth. So we have seen exports decline from about 32% GDP in 2000 to 17% last year. Sri Lanka’s share of global exports has also come down. The challenge now is to shift resources from the non-tradables to tradables. In recent years, the main sources of growth have been non-tradable sectors: construction; internal trade ie retail and wholesale trade; and public administration. Clearly, theses sectors cannot drive sustained growth over a period of time, given the size and purchasing power of the domestic market. In a small economy, it is imperative to have export growth. So what do we need to do?
First, diversification of markets. 54% of our exports go to the US and Europe. The US is recovering and but the EU continues to be sluggish. Less than 10% of exports go to India, China and Japan collectively. We certainly need to do much better. It is encouraging that, more recently, efforts are being made to boost trade with Asia. The recent meeting which was co-chaired by the Treasury Secretary and the Secretary to the Ministry of Commerce, India was productive. Certainly the final statement that came out was quite encouraging. The Government has also announced that it is pursuing free trade agreements with Japan and China. These are all very good. But in the end you have got to have something to export. You have got to have competitive supplies. You have got to have something that you can sell to the world at competitive prices and that has been the real challenge for Sri Lanka. As I said, when I came back, people did not seem excited about being in Asia and I kept asking business people why they were not selling more in India. They kept saying it is impossible to do business in India. They erect non-tariff barriers. The bureaucracy is impossible. Each State has different regulations. It is just an impossible business environment. While we say that, the Chinese, who do not have a trade agreement with India, have increased their exports from US$ 1.5 Billion in 2000 to US$ 50 Billion in 2012. They have had to deal with the same difficulties that we have had to deal with. However, they have been able to do this far more successfully than us. Equally, the Malaysians and the Singaporeans, have been able to do better than us.
So we need to ask ourselves whether we make excuses for ourselves too easily. In the end, one has to be competitive. One has got to be hard-nosed and not constantly look for excuses. I remember when I was working in the system, writing briefs for Mr. Chanmugan (the then Secretary to the Treasury) and others indicating that the world economy was terrible; the world economy was buffeting us. The Malaysians at that same time increased the productivity in their rubber and palm oil sectors. When we were moaning about what was happening to tea and rubber, they were increasing productivity fivefold. This was said by Dr. Premachandra Athukorale. He has done a lot of firm-level research. One cannot escape the conclusion that in the end it is domestic policy that really matters. It is very easy to blame the international economy and problems in other countries. They are material bit the bigger problem is that our policies have not been right. Our private sector has perhaps been in a comfort zone and has not been active enough. The challenge is out there for us to do better on the export front. It is crucial to do so.
Let me quickly talk about Investment. The incremental capital-output ratio in Sri Lanka is about 4.3. Without getting into too much technical detail, let me just say that we need investment of 35% of GDP to achieve the 8% growth target of the government. We have got to 30%; we need 5% of GDP more. Government public investment has been capped at the current 6.5% of GDP level. As I said, it may be difficult to maintain. So the incremental 5% of GDP investment, or maybe a bit more because the government may have to scale back, has to come from private investment, domestic and foreign. There is plenty of empirical evidence that in a country, which doesn’t have a rich natural resource endowment of large domestic market, domestic investment takes off before FDI, because local businessmen know the business environment much better than any foreigner. So when the business environment is right you see domestic investment increase followed by FDI. One of the disappointing things of the post- conflict period is that domestic investment has not really taken off. So it is hardly surprising that foreign investment has not as increased as much as we would like.
So what do we have to do to address this? Clearly, the World Bank’s Doing Business Index is a useful indicator. Sri Lanka’s ranking has improved significantly. It has gone up by from 107 to 79 in about 3 years. That is a positive development but the components of the Doing Business Index are process oriented. They do not include important issues, such as land policies, labour market policies, macro economic stability, the skill level of the labour force, the strength of the financial system, corruption, rule of law etc. Those things are not in that index. So these are some of the areas where there is still work to be done. When I first joined the Commonwealth Secretariat, there was a real challenge in getting investment into Africa. I recall going around asking people what it would it take to get investment into Africa. Is corruption the problem; is it the rule of law? They said those things are not unimportant but they were not the main constraint. They know how to deal with those issues. What they wanted above all was consistency and predictability of policies. That is the No. 1 item. Of course, they also want macro-economic stability; they like a nice tax environment but above all they want predictability and consistency of policies. That is again an area in which we need to improve. Senior Minister Amunugama said as much when speaking at the CCC Economic Summit recently.
Now, let me make a few remarks about the Role of the State. If you look around the world, there have been a whole range of development strategies that have delivered good outcomes. Right across the spectrum from state capitalism to market economies. One needs to ask oneself what options are realistically possible for Sri Lanka. In a country with a fiscal deficit and debt profile like Sri Lanka’s, it is not possible to get much mileage out of state capitalism simply because the state does not have sufficient resources.
In contrast, a country like China has the financial strength for state capitalism to be more successful. The budgetary outcome is robust and debt is only 30% of GDP. In addition, external reserves exceed US$ 3 trillion. They have the fire power for the State to be a very strong economic actor. Our debt is 79% of GDP. Even when compared with countries having the same rating, we are significantly higher than the median of 44%. So when one has Sri Lanka’s fiscal deficit and debt profile, the limits to state- led development are constrained. It doesn’t mean that you can’t have a strong role for the State. In fact there isn’t a contradiction between a strong developmental State and a vibrant private sector. They can work side by side. All over South East and East Asia, you see this happening. However, there must be clarity on what the State is going to do and what the private sector is going to do. As I said, predictability and consistency of policies are of paramount importance. As long as the policy framework is clear, then people can plan and invest.
Let me quickly address the productivity and the competiveness challenge. In Sri Lanka, it is quite common for us to say the cost of living is very high. Actually, in my view the problem is not that the cost of living is very high. The problem is our extremely low productivity. As a result our incomes are low. Our incomes are so low that we find it very difficult to absorb the international prices of oil, fertilizer, power etc. That is really the problem. The problem is that we have very low productivity. Our productivity is half that of Thailand. So we cannot have non-inflationary increases in income, withot an increase in productivity. There are two very large wells of low productivity which absorb a lot of resources, human and financial, and yield a low return. One is agriculture. Agriculture employs 32% of the workforce and accounts for 11% of GDP. So the productivity in the agricultural sector is one third of the national average. and the national average, is , in turn, half that of Thailand. So you can imagine how low the productivity is in our agricultural sector.
It doesn’t have to be so because companies like CIC, Haleys and others have shown that you can have an exponential increase in productivity. But while it is easy enough to stand here and talk about these issues, politically it is very challenging because people and money have to be shifted around from low productivity agriculture to higher productivity economic activities. There are tough issues to be addressed like land titling, the sale and leasing of government land, land use patterns, the product mix and the role of commercial agriculture. These are all politically very difficult issues that we are going to have to address to overcome very low productivity in agriculture. If we continue sucking up so much of our resources into agriculture through irrigation systems, free water, large extension services, fertilizer subsidies and the guaranteed price scheme and obtaining such a low return, then clearly we are not going to be able to move to higher income levels. Of course, one can say look we are a quite happy, we will go with 5% growth. We are not really bothered. That’s fine, but if one wants to get 8% growth one has to tackle this problem of low productivity in agriculture.
The other big well of low productivity is the public service. It has increased from about 600,000 in 2004 to 1.3 million. Of course about 200,000 of this increase was a necessary increase in the military. But even allowing for that, there has been a very large increase. If one takes 500,000 people out from the public service, the labour shortages that the private sector is now experiencing would be addressed. So what are we trying to do. We are trying to move from a low productivity agriculture, low technology manufacturing, traditional services, like retail and wholesale trade, public services etc. to a high productivity agriculture, higher value manufacturing and modern services, like ICT/BPO shipping, aviation, financial services etc. Hence the strategic challenge is to make this shift. However, this will involve political and social pain in the short-run. It is very easy for me to stand here and say do this. But labour is going to get displaced and there are tremendous political and social challenges that need to be addressed. However, if we are to get 8% growth on a sustained basis, these are the choices that we have to make. It becomes easier to do make these choices if the conditions are created to soften the pain of such adjustment. This can be done through a well designed safety-net to meet what economists, in an anaesthetized way, call transitional costs of adjustment. Time-bound unemployment benefits, re-training would need to be a part of such a package. That is something that international financial institutions are willing to support.
The last strategic challenge is education, training and skills development. Sri Lanka has been very successful in terms of what I call the first generation outcomes in terms of coverage and access to primary and secondary education ie participation rates for boys and girls. We’ve done very well and that is one of the reasons why even in worst of times like the height of the conflict, the economy grew at 5%. The people have to wherewithal to do something. There is enough education, enough human capital built into people in Sri Lanka for them not to starve. For instance, females in Sri Lanka are able to get on a plane, go to a strange land, work and earn. But the human capital that we produce is okay for 5% growth but it is not enough to sustain 8% growth. For the latter, we need more maths, more science, we need more IT, we need more English. So, we’ve done well in terms of participation rates and access but we have done poorly in terms of learning outcomes. The strategic challenge is to align the comparative advantage of the country, the labour market and education, training and skills development much better. Given the current fiscal constraints, public expenditure on education is getting squeezed, particularly as there is this, a much needed focus on infrastructure. This means that in terms of provision, one needs to be pragmatic across public, mixed and private provision of education, training and skills development.
What are the short-term challenges that the policy-makers face right now? Let me go back a little bit. The economy, if you look at the conflict period, grew at about 5%. But when it got to 6% it over -heated, simply because growth was often overly dependent on the budget deficit. It you look at the correlation between the budget deficit and the rate of growth there is a very strong relationship. So it was public expenditure that drove growth to a significant extent. What you really want is growth driven by the current account of the balance of payments, which is really a fancy way of saying exports that have to drive growth as in East and South East Asia. So the fact that we had this unsustainable model meant that as soon as growth hit 6%, the economy over- heated.
Now that the war has ended, can we get above 6% and hit that 8% growth target without structural changes? Can we do it by what economists call demand management? Shifting the interest rate up and down, moving the exchange rate etc. Is that enough or do we need structural change? I would like to submit to you that we need structural change. The experience in 2010 and 2011 is very instructive in this regard. After the end of the war, there was a lot of pressure on the authorities to deliver a peace dividend. So they took short cuts, they drove down interest rates, allowed the real effective exchange rates to be 25% over-valued, They ignored one of the fundamental laws of economics and of course we paid for it. There was pressure on the currency, a run on our reserves and a package of very tough reforms had to be implemented. The government has to be given credit for that. They did implement politically tough reforms in February / March of last year.
If one looks back over the last 35 years since liberalization, there has been this repeating cycle. The economy over-heats when growth reaches 6%, then the brakes are applied this cycle has been repeated. However, to attain 8% growth, we need structural reforms and I am happy to talk about what those might be during the discussion as my time has run out.
One final point – Economics cannot be separated from politics. However, in post-independence Sri Lanka, politics has over-driven economics. However, with graduation to lower-middle income country with exposure to rating agencies and international capital markets, the balance between politics and economics, must now be re-calibrated.
Thank you very much.