Reviving Sri Lanka’s exports and attracting FDI to the export sector

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Sri Lanka’s export performance since 2000 has been dismal. As a percentage of GDP, exports have fallen steadily from a high of 33.3% to about 12.7% of GDP in 2016, a level last seen during the protectionist era of 1970-1976.

Not only are exports making up a declining proportion of GDP, they have started to contract in absolute terms. Exports shrank in 2016 for the second year in a row, declining to $10.3 billion from $10.5 billion in 2015 and $11.1 billion in 2014. In dollar terms, exports are now at a slightly lower level than they were in 2011 ($10.5 billion).

Sri Lanka’s share of 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.

On their own, these figures would be a cause for concern; however, in comparison to those of our peers, they are positively alarming. Our peers have grown rapidly, while Sri Lanka has stagnated.

Not only are exports making up a declining proportion of GDP, they have started to contract in absolute terms

In 1990, Sri Lanka’s exports were around $2 billion, roughly on par with Vietnam and slightly ahead of Bangladesh ($1.7 billion). Sri Lanka’s exports have since grown to $10.3 billion, which looks respectable; but in the same period, Bangladesh’s have grown to $34 billion, while Vietnam’s is at $170 billion.

To be overtaken 230% by Bangladesh and 1,550% by Vietnam is evidence that something radical has gone wrong for Sri Lanka.

Sri Lanka pioneered trade liberalisation in 1977. Vietnam and Bangladesh followed much later; but while they continued the programme, Sri Lanka’s reforms stalled and were then reversed.

In 1977, Sri Lanka was the first country in South Asia to move decisively away from protectionist import-substitution trade policies that for many years had damaged economic efficiency and hobbled growth. Exports and the economy responded rapidly to the reforms. In particular, the export of manufactured goods responded immediately and grew rapidly, at around 20% annually, between 1976 and 1984. Following the outbreak of the civil war, growth slowed drastically over the next five years, but accelerated to an average rate of 16% between 1989 and 2000. Despite a change in regime in 1994/5, trade policy reforms, especially reductions in the average level of import tariffs, were broadened and extended over the following 23 years until 2000.

Protectionist pressure began to build in 2001, and from 2004, the relatively open trade policies of the past were explicitly and systematically reversed. A policy paper by the World Bank titled “Increase in Protectionism and Its Impact on Sri Lanka’s Performance in Global Markets” shows that, today, through the proliferation of a variety of para-tariffs, Sri Lanka’s tariff policies are just as protective as they had been more than 20 years earlier.

Taxes on imports were increased with the imposition of a plethora of new taxes, as well as increases in the rates of existing tariffs. The Customs Surcharge was introduced in 2001, the Ports and Airports Development levy imposed in 2002, and the Regional Infrastructure Development Levy (RIDL) introduced in 2007. Rates of the Commodity Export Subsidy Scheme (Cess), Nation Building Tax (NBT), Social Responsibility Levy, Special Commodity Levy (SCL) and VAT were progressively increased.

Sri Lanka pioneered trade liberalisation in 1977. Vietnam and Bangladesh followed much later; but while they continued the programme, Sri Lanka’s reforms stalled and were then reversed

By 2009, Sri Lanka had a highly complex tariff system, which included up to nine other import taxes (in addition to Customs duty, referred to as “para tariffs”) that were imposed or potentially imposable on imports of products; this was a major reversal of the broadly liberal trade policies of the past. Some of these were later repealed or reduced, but the damage had already been done.

Despite minor reforms since, the import tax system remains highly protectionist, non-transparent, complex and likely to deter long-term business commitments, both in production and trade.

Imports and exports are closely linked; many exporters must import some of their raw materials, intermediate goods or components. Although many exporters have exemptions on Customs duty, they are liable to pay other tariffs. These tariffs are thus a tax on exports, making Sri Lanka relatively uncompetitive vis-a-vis its peers, which explains the relative decline of exports and failure to attract export-oriented FDI.

Apart from dissuading exports, high tariffs also protect some segments of the local market. This has had the effect of drawing investment to high-cost and highly protected import substitution farming and agricultural processing activities with low or negative economic rates of return. Diverting investment into these low-yielding activities drags down overall economic growth.

Given this tax structure, it’s hardly surprising that the FDI that does come in tends to cluster in the non-tradable sectors, particularly real estate, infrastructure and tourism.

If we are to regain our position in export markets and attract investment to the sector, we need to return to the liberalisation agenda that was abandoned in the early 2000s: Cut import taxes, simplify the tariff structure and improve facilitation of investments. Some suggestions are as follows:

Broad Policy Reforms
SIMPLIFY AND REDUCE TARIFFS
1. Announce a simplification of tariffs and an intention to move towards a single flat tariff. This gives some reforms and sets the direction for future reforms.

2. Initially, for raw materials and components for industry, move to a low, single flat tariff. Unify the existing Customs duty and the plethora of para  ariffs (PAL, VAT, CESS, Customs Surcharge etc.) into a single Customs duty OR Special Commodity Levy (if administratively simpler) at the individual customs code level.

A study needs to be carried out to identify the specific HS codes/current tariff structure/revenue collected, but moving towards a low uniform tariff structure has the potential to increase tariff revenues as increased volumes compensate for the lower rate. This would also speed up Customs clearance and reduce the potential for corruption as it reduces the discretion of customs officials and makes the trade regime predictable.

3. On the export side, remove all cess as it reduces the effective price received by exporters, and thereby discourages exports. (There is no evidence to suggest that these cess promote local downstream processing of primary products that are now exported in ‘raw’ (unprocessed) form.

4. Join the Information Technology Agreement of the WTO to create free trade in electronics, which will attract FDI to this sector.

IMPROVE FACILITATION OF FDI
Restore the role of the Board of Investment as the ‘one-stop shop’ for investment approval/promotion (as envisaged in the BOI charter). The role of the BOI has been undermined, for example, by the Strategic Development Projects Act, which gives wide ministerial discretion in investment approval to the Tourism Development Authority, which seems to play a parallel role  in tourism projects. This also requires repealing the Revival of Underperforming Enterprises and Underutilized Assets Act (2011) and the Strategic Development Projects (2011) Act, or passing new legislation to supersede these two acts.

It is, of course, necessary to rationalise the fiscal incentives offered to investors, but there is a strong case for providing export- oriented foreign investors with time-bound tax holidays and investment tax allowances beyond the tax-holiday period. There is evidence that tax incentives play an important role in influencing location decisions of export-oriented (efficiency-seeking) FDI, especially where competing countries still offer them, provided other preconditions are ‘reasonably’ met. Removing all tax incentives, other negatives that continue to weigh on the overall competitiveness in investment and trade may be counterproductive. Sri Lanka has to improve property rights to draw investment. The guarantee against the nationalisation of foreign assets without compensation provided under Article 157 of the present Constitution needs to be maintained under the ongoing constitutional reforms.

Avoid the current practice of ‘domestic value added’ [which is defined as the per unit domestic retained value (wages + profit + domestically procured intermediate inputs) as a percentage of growth output] as an evaluation criterion in approving investment projects.

Protectionist pressure began to build in 2001, and from 2004, the relatively open trade policies of the past were explicitly and systematically reversed

FACILITATE TRADE THROUGH SIMPLIFYING CUSTOMS PROCEDURES
1. Move to fully electronic Customs processing.
Customs entries are currently being filed electronically. We now need to move to getting the appraisal/verification of Customs entry to be done electronically on the system. This obviates the need to visit the Customs office, and will greatly speed up and simplify the processing of documents.

2. To facilitate moving to full online processing, a generous incentive scheme to reward Customs officials for speed in processing documents should be considered. Basically, a reward scheme based on the number of applications approved per day, to align the interests of the importer and the Customs staff.

3. Allow pre-documentation as standard, not only for perishable goods. Importers should not have to wait for the vessel to arrive to file documents. Currently, this facility is available only for perishable cargo; it should be extended to all cargo, to minimise bottlenecks when vessels arrive.

4. Valuation by Customs. This is usually a time-consuming process. A fast-track option is available for a few firms only. Expand this fast track option to all export firms. All new investors should be eligible for fast-track processing.

5. Automate Customs inspections by installing scanners. Replace physical inspection with electronic scanning as a standard procedure. Physical inspection should only take place where there is some doubt.

These reforms should send a clear message to investors that Sri Lanka is once again open for business. Together with the GSP+ concession, this should make Sri Lanka an attractive investment destination. This should be followed up with an extensive promotion campaign to market the country to investors