FIVE REFORMS TO FIT THE GROWTH AGENDA
Anxieties and fears about the future are widespread and deserved. Since the war’s end, a dozen years ago, Sri Lanka has perhaps failed to meet the expectations of some of its people about reconciliation; and all of its people about a ‘peace dividend’. As crucial as reconciliation, and a common Sri Lankan identity, is for all its citizens to feel a sense of belonging, happy and free, it’s not the intent of this piece to explore how to achieve that. Instead, we will discuss how Sri Lanka can deliver fast and sustainable economic growth even under the existing limitations. Our suggestions are bold, grounded in fact and can be implemented quickly. These ideas, which require reforms to enable them, will also generate enduring economic growth.
However, it’s important to appreciate three facts. The first is that any economic stimulus will only offer a temporary fillip. The tax cuts implemented by the government will reduce government revenue and increase the budget deficit. How far-reaching their effects will be depends on how people and companies respond to these changes.
The second fact is that, driven by technology, how the world functions has transformed in the last decade or two. The internet, manufacturing automation, and now artificial intelligence have transformed how things are made, productivity and consumer expectations.
The third is to realise that Sri Lanka’s economic position has relatively deteriorated and that any economic plan must account for that impact. Total public debt is equivalent to 83% of the country’s economic output (GDP). Around half of the government debt or $42 billion is owed in foreign currency. Foreign currency debt has doubled from $21 billion in 2010.
Sri Lanka’s total external debt, which includes the private sector’s foreign currency borrowings, stood at $55.5 billion, equal to 65% of GDP, by the second quarter of 2019. Over the last decade, the total external debt stock has risen by $3.7 billion annually.
When the government’s rupee debt is added to the total external debt (which includes the private sector’s foreign currency loans) the total exceeds 100% of Sri Lanka’s 2018 GDP. Total country debt has been higher in the past. In 2002 it peaked at 116% of GDP but declined to 77% by 2010.
Frontier Research, an economic consultancy, forecasts total country debt will rise to $62 billion by 2021 or by around $3.3 billion annually. Sri Lanka’s high debt payments, low economic growth and volatile reserve position led to a credit downgrade in 2018 and, after the tax cut led stimulus was announced in late 2019, a credit outlook downgrade. Economic growth has been falling continuously from 9% in 2012 to 3% in 2018. The growth projections for 2019 have been even below 3%.
Sri Lanka’s competitive position globally is also eroding. 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 early 1980s. As the home market is rather small, to scale, successful companies will have to sell products and services overseas. Based on the evidence it can be argued that the competitiveness of Sri Lankan firms has halved in the last two decades.
Worker remittances, Sri Lanka’s largest foreign currency earner, declined by almost 6% in the first eleven months of 2018 to $6.05 billion. Remittances have been stagnant around $7 billion a year for several years until the decline happened in 2019.
On top of these risks, other external ones like oil prices rising due to escalating tensions in the Middle East and the fallout from an escalating US-China trade war can worsen Sri Lanka’s economic malaise.
The world has changed and Sri Lanka may not be able to muddle its way out of the debt cycle and sidestep other challenges. It’s unclear if the far-reaching consumer and income tax cuts were due to an early realisation that other options for economic stimulus were unavailable. However, the impact of any economic stimulus on growth is temporary. If the economy’s current structure isn’t growth-friendly economic stimulus won’t fix that. There are many safe and prescriptive solutions for reform that ignore the challenges. None of these will meet the expectation and ambition of Sri Lanka’s now impatient citizens. For high growth, Sri Lanka must make structural changes in the economy.
We have five bold ideas, that if implemented, can yield significant long-term growth. The ideas are varied and some are known to be divisive, but underlying all of them is evidence and sound logic. Broadly they address foreign direct investment, integrating with global supply chains, transparency at state-owned enterprises, open borders and digitizing the economy.
The first idea is that Sri Lanka quickly establishes a clear framework to attract private investment into large infrastructure projects that will require also government concessions.
Private capital funding public infrastructure is now referred to as Public-Private Partnerships or PPPs. All stakeholders are served when a PPP’s structure aims to minimise risks. Investors then demand a lower risk premium because the operation is more predictable, regulations clear and disputes settled easily. Committed PPPs also perform poorly when private capital cannot gauge or reasonably bear risks.
On a PPP, how much risk can be pushed to private contractors will often depend on the project’s cash flows and the certainty of revenue meeting forecasts. When PPPs are structured well, infrastructure users also benefit from the innovation and efficiency that private capital brings to the table. However, simply applying private capital to infrastructure gaps isn’t guaranteed to solve problems. In fact, PPPs’ short history is also littered with examples of how some investments have failed to live up to expectations.
Sri Lanka was outstandingly successful with PPPs during the late nineties when a port terminal SAGT deal was arranged. In the 16 years since 2000, SAGT’s contribution to the government (to SLPA) in lease rentals, royalties and dividends was $182 million, just 9% short of the forecast $200 million for the period.
These, however, are only part of the revenue the SLPA earns. Wharf handling, wharfage (for the use of the wharf) and navigation charges from ships calling at SAGT were forecast at $263 million for the 16 years to 2016. However in the decades since those early successes, Sri Lanka has abandoned PPP-led deals. Its poor infrastructure bears testament to the effects.
I ts second opportunity is to ditch Import substitution, which pundits now push for, in favour of greater integration with global supply chains. For decades, the most prolific goods exporters have been successful because they have specialised in segments of the value chain rather than producing complete products.
In the 1990s, imported content in exported products globally was around 20%; by 2015, this has risen to 40%, and in 15 years, trade analysts forecast it will rise to 60% or more of the final goods. Of Sri Lanka’s 2013 manufacturing exports, only 6.1% were parts and components ending up in finished products elsewhere in the world. The rest of Sri Lanka’s exports were all finished products. Sri Lanka didn’t do any final assembly by importing components. On average, UN Comtrade estimates that 47% of goods exported globally by value were either parts or stuff assembled off imported components. Of developing country exports, the agency estimates that 62% comprised parts and assembled products. For instance, Thailand and Malaysia achieved 70% and 73%, respectively, of global production share in their exports. Sri Lanka added an average 10% of so-called para-tariff on imports since 2004. This includes cess and various import levies. Its nominal import tariff has also doubled in the period since 2004 to an average of over 20%. These have contributed to creating one of the most complex tariff systems in the world.
In these cross border production-sharing networks, the distinction between imports and exports gets blurred. Goods are brought in, value-added and sent out. When a country imposes para tariffs unpredictably, as Sri Lanka has done from time to time, its ability to join or maintain a role in these supply chains is destroyed.
FDI now invests behind these global supply chains rewarding nations that integrate quickly and shunning those that haven’t. As countries graduate to upper-middle-income status, policymakers are often torn between supporting old growth strategies still generating results (like agriculture and low-end manufacturing) and embracing the innovation economy. Our third idea, for open borders, is perhaps the most decisive because it is the least understood. The economic case for migration is identical to that made for free trade. However, unlike free trade, immigration is an afterthought in most countries. Sri Lanka’s debate around open borders has been framed by its labour shortage. The lack of construction workers, hotel chefs, teachers, and medical staff is already hurting the economy and the cost and quality of services to citizens. It is also a bottleneck for economic growth in a country aspiring to quickly rise up the middle-income league table. Singapore and Dubai have shown recently, that a country can rise from upper middle income (defined as $4,000 per capita GDP) to high income (GDP per capita over $12,000) in little over a decade. A confluence of positive factors now exists that can potentially propel the country to high-income status in a decade. But to achieve this, Sri Lanka will have to attract a disproportionate share of global FDI flows by being one of the best places in the world to invest.
Economists have long argued that regulations around Sri Lanka’s main factors – markets capital, land and labour are impeding investment potential. If Sri Lanka limits the relative share of government deficit spending it will release enough capital for private investment. It can also free up capital flows with small legislative tweaks. Plenty of land can also be released for investment easily.
Open borders, however, have the potential to unleash growth that neither land nor capital factor market reforms can achieve. In the rich world, Harvard University’s Lant Pritchett estimates, a 3% rise in the labour force as a result of migration would yield an economic contribution greater than can be achieved by removing all the remaining barriers to trade.
Throughout history, migration is linked to prosperity. Sri Lanka’s only experience with mass migration also proves this. Detractors may point that the South Indian plantation workers here are desperately poor. They are right. However, poverty is relative. The lot of Indian migrant workers also deteriorated after the government’s takeover of private tea estates and their desperately incompetent management.
A rapid burst of immigration might cause wages to temporarily dip. But when talent is available investment will catch up soon enough. Outsiders who look different and don’t speak your language will be distrusted. These apprehensions are real and need to be dealt with rather than be allowed to be captured by a fearful private sector or nationalists who will then drive them to their selfish advantage. Immigrants may push out of jobs Sri Lanka’s least skilled and uneducated. However, even without immigrants, these workers are at risk of being replaced by technology and automation. The vulnerable must be retrained, and if necessary, protected by a safety net. It does not make sense to deny the opportunity to almost everybody because a few are unable to compete. Immigration also no longer flows from a poor country to a rich one. Many immigrants are now going from one poor country to another or to a middle-income country. Bangladeshis now find jobs in the Middle East and Zimbabweans in South Africa. For decades rich economies have been vigorously competing for the best talent from the outside. Sri Lanka has stood ideally by. The fourth idea is to improve transparency in key state-owned enterprises and improve their governance by listing their shares in the stock exchange and opening the avenue for these to tap the capital market in the future. Not all state enterprises can be listed. But the commercial ones like banks and even an airline can be listed. Capital markets are regulated to protect the interest of shareholders, in this case the government, and subject company boards and management to meet those transparency and good governance requirements. In 2018, 16 state-owned enterprises lost Rs157 billion rupees or a billion dollars at the then prevailing exchange rate. Lossmaking businesses, not a going concern, aren’t the most feasible to be listed. However, by listing those that are ready will create the path for better governance at others. The fifth and final idea that can drive quick results is implementing a digital ID for all Sri Lankans. For people to carry out transactions and perform significant tasks online they first have to prove that they are who they say they are. That’s where a digital ID matters. Every digitization success anywhere in the world has been preceded by a digital ID first being available. Solving this does not require entirely new systems because most Sri Lankans already have an ID.
All that is required is to digitise the existing ID. Digital ID is one of the foundation blocks of fintech. Because structural reforms have been neglected for so long the potential list is long. Among others it will include agriculture, improving women’s participation in the workforce and making it easier for businesses to operate. Among a sea of potential structural reforms these disparate five, however, offer an outsized opportunity to aid a quick economic turnaround and sustain the momentum.
The window for enacting bold policies will not stay open for long. The mountain of debt and other challenges have not yet hurt the economy too badly. But the economic environment is becoming unfriendlier as the new government’s honeymoon comes to an end. If it wants to swerve away from the looming crisis, it will have to act fast.