South Asia is at a turning point. After decades-long low economic growth, many of the region’s economies are emerging on the global stage. Their investments in infrastructure and education are enabling private businesses in these countries to compete in global markets. Sri Lanka – although a small economy – is a leader in many aspects of competitiveness among South Asian economies.
However, the achievements of the region’s private businesses also pale in comparison to those of East Asian countries. The region’s weak commercial environment hamstrings businesses. In the World Bank’s Doing Business ranking, the region’s business climate gets low marks. However, the report also finds that the region’s, and Sri Lanka’s, weak links with global supply chains, its low level of urbanisation and low productivity in private companies are much less well understood.
The South Asian competitiveness report’s co-authors Denis Medvedev and Vincent Palmade discussed the findings with Echelon.
How would you say private companies in South Asia, and Sri Lanka in particular, are doing in terms of their global competitiveness?
Denis Medvedev: There are a number of ways in thinking about what competitiveness means and there are a number of metrics that have been developed. What this report tries to do is not cast a net too widely, but focus on productivity. And when we look at different measures of productivity, we see that firm productivity in South Asia in general and in Sri Lanka in particular is lower compared to other countries.
So for us, it’s a story about firms and why they have difficulties improving their capabilities and growing. Why do firms have difficulties connecting both with each other domestically, as well as buyers internationally? That’s the story that we are trying to tell.
A number of firms have been successful. But a very large number of firms are not performing at those levels and that’s what gives rise to low average productivity. So the challenge is, how do you create more of the leading firm examples? It’s both about giving opportunities to new entrants to enter higher levels of productivity growth, as well as reallocating resources, in some way, from underperforming firms to the ones that do better.
There are some exceptions, but overall it’s not a great story so far for Sri Lanka. What has held firms and productivity back here?
Denis Medvedev: Let’s look at the four things the report looks at, which are business environment, value chain, agglomeration economies and firm capabilities. Let’s look at those in turn.
So where does Sri Lanka sit in terms of the business climate? It’s not the worst performing country in South Asia, but when you look at competitors in the region, there are many who are performing better as measured by the World Bank’s Ease of Doing Business indicators. So there are a number of challenges. If you start unpacking, one of the interesting patterns we see is when we switch from Doing Business indicators to what firms report in investment climate surveys as challenges. There are many challenges, but comparatively, with regard to South Asia, you see fewer infrastructure challenges. But you do see huge restraints in terms of policy environment, particularly on trade policy, trade regulations, some issues in access to finance and taxes.
When we look at how Sri Lanka has done in terms of value chains, you see a fantastic change in apparel, and maybe in a few other firms, but really not much else.
Sri Lanka is linking up with Bangladesh, India and China in terms of value chains for the supply of fabrics, but there is little progress outside of that. So it’s an issue of taking that performance and thinking about applying it to other sectors.
When we look at things like agglomeration economies, some of the better sets of data we had on that report were of Sri Lanka. We see a lot of productivity boosting opportunities in terms of leveraging agglomeration economies. What happens when you have access to diverse pools of workers tends to be really important for firms like access to a diversity of skills. So there are number of stories that we feel are particularly important to Sri Lanka.
[pullquote]In the World Bank’s Doing Business ranking, the region’s business climate gets low marks. However, the report also finds that the region’s, and Sri Lanka’s, weak links with global supply chains, low level of urbanisation and low productivity in private companies are much less well understood[/pullquote]
Vincent Palmade: If you take a historical perspective on Sri Lanka, back in the 1970s and to an extent the 80s, it was on the same track as East Asian countries. It was embracing trade, it was an export-driven economy with world-class ports, and it was investing a lot on skills and infrastructure. And these assets are still there today. Sri Lanka is, within the region, very well positioned when it comes to port and the skills of its population. And surely enough, it’s in Sri Lanka that we see the biggest number of islands of excellence in relation to the size of the country. We discussed Dilmah’s tea business, MAS and Brandix in apparel, TOS Lanka in electronics, and if you expand to other industries like ICT and tourism, Sri Lanka is also doing very well in these.
These successes have been achieved on the back of a liberal trade regime. For example, in the apparel sector, it is where Sri Lanka has the lowest import duty – it’s actually zero import duty. So the sector has evolved and connected with global value chains. But over the last 10-15 years, there has been a policy shift from export-led growth to import substitution-led growth. If you combine high import tariffs like 70-80% with a small domestic market, where you are only going to have room for two entry level players, you are going to end up with little competition and therefore little pressure on firms to improve productivity, innovate and so on. For a country with assets like great geographical location, good ports, skilled people and a lot of natural assets for agribusiness or tourism, Sri Lanka can win by looking outward. That has been the basis of the historical success and I think the new government is going back to that old successful model.
The report observes that Sri Lankan firms have doubled in size during a timeframe when developed world firms have grown to be seven times bigger. What do you think has held firms back?
Denis Medvedev: The good news, if you will, is that a lot of the challenges that seem to be binding are the ones that are more amenable to policy solutions in the short-to-medium term. For instance, things like infrastructure can really take a long time to resolve, whereas what firms are saying seems to be that most challenges are related to trade facilitation and tax regimes. These challenges constrain firms’ performance relatively more and could be addressed in the short term.
The other point is, when you consider global value chains and how firms connect with buyers, what is important to buyers? It’s not only cost. It’s a number of other issues. It’s quality, it’s delivering things on time and things like compliance with standards. This is again where Sri Lanka can position itself relatively well versus the region.
Sri Lanka is not going to be able to compete on cost as much as some other countries, but it has these other advantages that are becoming more important to global players. There’s a lot of pushing of capabilities to the level of suppliers that is happening in global value chains. By this I mean, buyers relying more on suppliers for things like innovation, marketing and design. These are the things that firms here can rely on. But to do that, you really need the knowledge, expertise and access to mentorship.
Globally, there is a fair amount of emerging research that talks not only about the importance of pure productivity, but also connecting customers on the demand side. So what you see is that it’s not always the most productive firms that tend to survive. If you have a positive demand shock, if you find that you are able to link with a customer very well, then it is those firms that do well.
But some productive firms aren’t able to survive long enough to really make the linkage with the customer. The ability of firms to have access to information, being able to link with suppliers and buyers, and have knowledge of how to take care of those transactions – are critically important.
[pullquote]The South Asian competitiveness report tries not to cast a net too widely, but focus on productivity; and when looking at different measures of productivity, we see that firm productivity in South Asia in general and in Sri Lanka in particular is lower compared to other countries
– Denis Medvedev[/pullquote]
In a policy point of view, many things can be done to attract FDI. But if Sri Lanka was interested in attracting the sort of FDI that would link its companies better to those global value chains, and potentially use that as a lever to improve productivity, what could a potential strategy look like?
Vincent Palmade: First of all, there are different kinds of FDI. There is FDI that is interested in the domestic market, especially when there is low competition, and that is the type of FDI Sri Lanka has attracted in the recent past, into telecom and banking.
That is not the only kind of FDI you want in the long term. You also want FDI on technologically sophisticated industries and export-oriented industries. Sri Lanka has not attracted such FDI in the recent past. This FDI is looking for a few things.
First, they need access to output and input markets.That’s where the whole agenda of trade policy and trade facilitation becomes so important. In particular, if Sri Lanka could secure a deeper trade deal with India, that’s a huge plus. Given that India is one of the largest and fastest growing markets in the world, and Sri Lanka is ideally positioned for easy access to the Indian market is a big plus.
Second, FDI would be looking for access to well located and well-serviced land. Some of the transformative FDI are looking for 100, 200, 300 acres. So the question is, if Samsung comes to Sri Lanka tomorrow, can it find 300 acres of land easily? This kind of FDI is not going to sit around for one or two years until the land becomes available. You need a land bank that is ready for this kind of strategic FDI. And third, of course, FDI will be looking for access to skilled labour, but I think Sri Lanka is quite well positioned on that front. Because of all the investments in education, the labour is highly trainable. So I think you are in a good position here.
The forth thing FDI will look for is a predictable and reasonable cost and risk of doing business. So there is clarity in knowing the regulations and taxes, etc. If you put this together, I think Sri Lanka will be in a very good position.
This will also potentially help Sri Lanka solve this stale export basket issue that has been dogging us for a long time?
Vincent Palmade: Exactly. And just to give an example of what Vietnam is doing. Vietnam is making land available to attract FDI. It’s not completely free, because in exchange for land, Vietnam is asking FDI to link up with local SMEs to develop the capabilities of small businesses. So there is a strategic quid pro quo, which is what China did as well. So instead of giving tax holidays, make sure you know what strategic FDI is looking for, and then work with them to develop the capabilities of SMEs and its workers because it’s in the interest of the FDI to develop local suppliers and skills.
Sri Lanka’s size of workforce is limited. There is already almost full employment here?
Vincent Palmade: Everybody has to make a living. You have next to full employment even in Africa because everybody has to make a living.
Is there an opportunity for a country with a small population like Sri Lanka to ambition for large FDI from one of these global firms, and to be more open to labour from outside the country?
Vincent Palmade: That’s a very interesting question. It reminds me of the case of Chennai. Chennai, right next door, has been a very successful destination for FDI, manufacturing even though the local people in Chennai are skilled. But Chennai is making it relatively easy for workers to migrate from low-income states so firms can mix high skilled workers with lower skilled ones.
That could be a possibility; but I think, in Sri Lanka, this deserves a more detailed study. I think you still have extensive pockets of poverty and low income, where facilitating the movement of labour from these areas to where the productive firms might invest is one way. The other way is, as we are saying in the report, by developing second tier cities when you can spread investment closer to poor people. That is more of a medium-term agenda with infrastructure investments and empowerment of cities. That is where Vietnam and China are moving now, to decentralise growth through the empowerment of cities and investments in infrastructure.
You talked about resources trapped in small firms. What do you mean by this, and why is this a problem?
Denis Medvedev: When you think about growth of productivity at national level, where does that come from? You would normally think about four components, which together give you rapid aggregate productivity growth.
One is firms upgrading their own capability in terms of improving productivity within the firm. The firm invests in new processes, develops new products and invests in better management processes, so it’s able to become more productive. That’s one channel that can happen in a firm of any size.
The other channels have to do with how resources move around the economy. So one has to do with resources, meaning labour and capital moving from less productive firms to more productive firms, right? If you take a worker from a firm that’s less productive to one that is more productive, you increase aggregate productivity. You can also think about firms entering and exiting, you have a more productive firm that enters and raises national productivity.
If you think of firms exiting (going out of business), it’s the low productivity firms that are exiting, and overall productivity rises.
[pullquote]When we look at things like agglomeration economies, some of the better sets of data we had on that report were of Sri Lanka. We see a lot of productivity boosting opportunities in terms of leveraging agglomeration economies
– Denis Medvedev[/pullquote]
So, if you have a situation where you have a lot of firms that aren’t growing, that aren’t increasing their productivity, but they are also not exiting, then you’re blocking three of the four channels that I just described. That’s the challenge we observe in many developing countries, and that’s also the challenge we see here.
So again, it’s not an issue of small firms being small. It’s an issue of firms not growing, and therefore, those resources are being caught in low productivity uses. There are lots of reasons why that creates a drag on productivity.
Sometimes, a small firm is not able to meet the fixed cost for entering certain markets – for instance, if you think about firms exporting and raising productivity that way, there is a fixed cost in doing that. If you want to think about purchasing machinery or investing in training its workers, a lot of small firms are not able to do that. At the end of the day, the challenge of slow productivity growth and firms not increasing employment are symptoms of a distribution of very small firms that are not able to contribute as much to overall productivity growth. That’s the real challenge. It’s how you use resources most efficiently that matters.
Vincent Palmade: There are two fundamental type of issues that explain why you end up with a lot of small low-productivity firms that are not growing. One is barriers to growth, as well as difficulties to access finance, markets and land (and that would be true in particular in the protected domestic sectors), and lack of competition. So you have two or three large firms that are making huge profits, setting prices very high, and these high prices allow a long tail of low productivity firms to co-exist with them. So it’s the combination of barriers to growth, as well as barriers to competition, especially for the domestic parts of the economy.
Denis Medvedev: There is a growing volume of literature particularly in high-income countries, and now some of it is emerging for developing countries as well, about high-growth firms, what makes them high growth and why they are important. And the basic evidence, at least in high-income countries, is that if you look at who creates the majority of new jobs and who contributes most to output growth, it’s really this very small share of firms in terms of world distribution. Let’s take the US economy as an example. Of all the firms that enter, about half will exit within the first five years. If you take the ones that survive, on average, those firms did not grow at the top or increase their employment. It’s only about 10% of all those firms that will create more than half of all new jobs.
It’s really these very few firms that are able to enter, that are able to grow rapidly that really create all the dynamism in high-income economies, and that’s generally speaking true in developing countries too. We are just starting to build the evidence base there. But when we talk about this predominance of small firms, it’s a disguise for not making it, who don’t have the potential, the ability to become high growth firms. But if these firms also don’t exit in some way, their workers cannot go and work for high-growth firms. It’s that kind of challenge that we see.
Improving competitiveness requires many long-term fixes. In the short term, are there any incentive-based fixes that a government can offer? Is it wise to look at improving competitiveness by offering carrots?
Denis Medvedev: I think it depends on specifics. But generally speaking, and one needs to be extremely careful with that kind of argument, it is an easy path to start with, and it’s a very difficult path to get off. So very quickly you can end up in situations where you have thousands and hundreds of different incentives, and variou tax regimes and tax breaks, and these create an incredibly complicated environment that, at the end of the day, doesn’t really help anyone.
It’s also true that it is in many ways going too far down the path of an incentive, and it takes the public-private dialogue down a wrong path. When you talk to the industry, it will say we’re facing difficulties here and there, and therefore, what we need from the government is an incentive to somehow offset these costs rather than dealing with the issues directly. Now it’s true, some of those may take a long time and may be difficult to overcome, and you don’t want to have your firms facing disadvantages in every way. But that’s a path one needs to tread very, very carefully.
Vincent Palmade: Specifically in the case of Sri Lanka, and somewhat broadly to the region, if you look at the trade policy, in the trade facilitation agenda, there are two separate but complimentary sets of actions. The first is to help exporters. There are a lot of taxes, barriers for exporters starting with difficulties to import and export, and export taxes, and you have to register in every country if you have a new product or a new brand. There are a lot of disincentives for exporters, which frankly should be removed immediately. I don’t see any justification for keeping those.
[pullquote]A very practical example of a policy that has proven successful to help small firms grow, coming from China, is what they call “plug and play” industrial zones. All SMEs have to do is rent a space in the standardised international building, and ‘plug and play’.
– Vincent Palmade[/pullquote]
In parallel, it’s starting to gradually reduce protections on domestic markets because the protection of the domestic market diverts resources to the wrong sectors as opposed to these resources being available to exporters. This is not something you do overnight, but you set the stage, by saying, over the next 10 years, we are going to reduce import tariffs from 70% to 10%. That’s exactly what China and Vietnam have done. They announced as they joined WTO that they will start at 70%, and be at 10% in 10 years. So the industry knows that they better get their act together. So these would be the two sets of measures, especially for Sri Lanka.
Denis Medvedev: The two additional cautionary flags that I’m sure would come as no surprise to you is on incentives.
One is, who do these incentives apply to. There are a lot of examples both within and outside the region of government initiatives to help small and medium firms in some ways, which at the end of the day, end up creating incentives for the firms to remain small. Everything that has to do with being eligible for certain tax breaks, certain kinds of incentives for up to a certain size level, all that does is create incentives for firms not to grow, or to grow in very convoluted ways – that’s really not conducive to the economy.
The other way of course is when you have a sufficiently complex incentive regime, it may not be so easy for the intended beneficiaries to actually access it. It takes a lot of time and a lot of information to be constantly aware of what is available and how one can access it. The way the firms get access might not be the way that you want, so again there is a danger of there being a very large disconnect between the intended outcome and what actually happens.
You may end up in a situation where firms who are able to access some of the incentives are firms that may not even need them in the first place. Generally speaking, larger firms are better positioned to deal with these kinds of issues.
They have more capacity to do so. They are more experienced in dealing with governments, they sometimes find their own way of addressing those things. The same kind of capabilities also apply to navigating the incentive regime.
So again, your intention is to help small firms grow, but using incentives is not necessarily the best way to address some of those issues.
Anything you want to add in conclusion?
Vincent Palmade: Maybe one example. A very practical example of a policy that has proven successful to help small firms grow, coming from China, is what they call “plug and play” industrial zones. In partnership with the private sector, they have developed large standardised international buildings that enable SMEs to go from the informal sector to the formal sector without having to look for and buy land, and put up a building. No SMEs have this kind of time and resources. All they have to do is rent the space in the standardised international building, and ‘plug and play’. The Chinese have pushed the model even further by having plug and play for workers, including women, where they have large scale standardised housing. It’s safe and decent housing at a very low cost right next to the factories, which saves a lot of time and effort for the workers and a safe environment for the women. As a result of this, workers get to keep 80% of what they make. That’s one of the secrets for the high retention rates in China and also high worker motivation. These are low-tech solutions to promote organic growth of SMEs.
Denis Medvedev: May I just add two points? The report makes a point of emphasis on addressing competitiveness challenges being a very urgent issue for the region. I think that particularly applies to Sri Lanka. When we look at the pattern of growth in the region, it has been largely driven by accumulation on a quantity of factors of production, rather than improving the quality or efficiency of that. Of course, that’s a challenge that the players have brought to this region, but unlike countries like India and Pakistan that still have a large quantity of labour, Sri Lanka doesn’t.
Sri Lanka is much closer to where China is in terms of their population, having gone through demographic transition, and therefore really thinking of quality improvements, improving productivity, but also the use of technologies such as ICT that have increasing returns. That’s where their opportunity lies and that’s really something that is even more urgent for Sri Lanka than for the region on average.
On this point of technology and firm capabilities, this is not an area where we explored Sri Lankan data in detail because some of the information simply was not available. But generally speaking, management capabilities, the ability of managers to use the right processes and the right technologies is something that globally can explain up to 30% of differences in productivity.
[pullquote]There are a lot of new frontiers in terms of how one thinks of productivity, in terms of using technology and management techniques to boost productivity. Sri Lanka is a country that faces particular challenges, but on the other hand has high levels of human capital that sets it apart from the rest of the region. Perhaps that could be the area that is important to consider in moving forward
– Denis Medvedev[/pullquote]
So there is a lot of evidence from within the region in India as well as Sri Lanka, in terms of making interventions such as technology extension services and access to management consulting services that actually improve productivity. And many times, demand isn’t there because the firms are just not aware that there are gaps. But once those changes are implemented, you see a lot of improvements. And again, these are models that have been applied very successfully in a number of high-income countries. So this is definitely something that ought to be considered.
The other thing that we saw broadly in the region, and again in the case of Sri Lanka although we didn’t have all the data to explore it, was firms taking the next step in terms of the use of technology.
Broadly speaking, the rate of technology adoption in the region is relatively high. A lot of firms have access to computers and the internet. But the way they use them isn’t necessarily as effective as it could be. In the region, we see a lot of gaps in terms of firms just having access to internet and actually using e-commerce to connect with suppliers and buyers to aggressively market online. So there are a lot of new frontiers in terms of how one thinks of productivity, in terms of using technology and management techniques to boost productivity.
Sri Lanka is a country that faces particular challenges, but on the other hand has high levels of human capital that sets it apart from the rest of the region. Perhaps that could be the area that is important to consider in moving forward.