STEERING AWAY FROM THE MIDDLE-INCOME TRAP

WITHOUT BIG REFORMS, SRI LANKA RISKS BEING TRAPPED. HOWEVER, THE OPPORTUNITY FOR BIG REFORMS IS CLOSING FAST

Telling things as they are isn’t a hallmark of Sri Lanka’s political leadership. Skirting a discussion about challenges is particularly pronounced in Sri Lanka’s economic debate. Together with its failure to address issues around ethnicity and identity, poor economic prospects have contributed significantly to Sri Lanka’s inability to meet the aspirations of vast sections of its population.

It’s not that Sri Lanka’s economy has done abysmally. In the decade since the conflict’s end, Sri Lanka’s GDP (economic output) has roughly doubled. Per capita GDP climbed from $2,000 to $4,000.

Other countries in Asia and SouthEast Asia have done as well or better than Sri Lanka. In countries including Vietnam, Laos, Myanmar, the Philippines, Bangladesh and India, per capita GDP more than doubled in the same decade. Only a few emerging Asian economies like Pakistan failed to double GDP (growing 60%) in that decade.

All these countries are now in the lower-middle income category. The World Bank divides countries into one of four groups based on their per capita Gross National Income (GNI); low income, lower-middle income, upper middle-income and high income. GNI adds salaries and property income of the country’s residents earned abroad to GDP. Often a country’s GNI is slightly higher than its GDP.

In 2018, Sri Lanka was elevated to upper middle-income rank by the bank along with Kosovo and Georgia. In that same year, Argentina, where the GNI per capita fell below $12,055 per capita, was downgraded from high income to upper middle-income status. The World Bank’s country classification is widely used and closely watched because it provides a useful and straightforward snapshot of economic achievement the world over.

In 2018, 81 countries had GNI per capita over $12,055, ranking them as high income. Sixty countries were upper middle-income, including Sri Lanka, and 47 lower middle-income ones. Thirty-one countries are classified as low income by the World Bank. While Sri Lanka’s doubling of its GDP in a decade is impressive, a vast majority of countries have achieved similar or better outcomes. Of the 219 countries and territories tracked by the World Bank, 65% fall into upper middle income and high income; 37% of countries and territories are high income. That so few countries are poor (low income), and the vast majority are relatively prosperous, or out-right wealthy, tells a story of remarkable economic achievement during the last couple of decades the world over.

Sri Lanka is only just creeping into the prosperity league table. Almost all 65% of rich and upper middle-income countries are ahead of it. Although the public discourse avoids a robust debate about economic advancement, people still admire and aspire for Sri Lanka to join the leagues of a rich country. The math is straightforward. If Sri Lanka’s economy grows at an annual 8% it will take 15 years to reach $12,000 per capita GNI, the approximate current level of a high-income country. If Sri Lanka’s growth averages 5.6% as it did in the decade following the war’s end, it will take 20 years to reach that level. (See chart 1)

GDP grew at 2.9% in the first half of 2019. The post-war boom, driven by the economically backward North and Eastern areas of the island being integrated with supply-chains and pent up demand being met, fueled the postwar boom. However, those triggers of growth are not exhausted. GDP expansion at 5.6% annually (the postwar rate), would take Sri Lanka 37 years to catch up to South Korea, 42 years to reach Japan and 49 years to match the levels of Singapore. It can catch up in that many years only if those countries stopped growing altogether (See chart 2).

Two indicators of economic performance—exports and foreign direct investment—have been performing poorly. As a percentage of GDP, exports were 13% in 2018 compared to 33% in 2000. Since the year 2000, exports have been growing at an annual 5.6% compared to an annual 10.7% in the two decades ending in 1999. Foreign direct investment has also been similarly weak. According to a World Bank study about the Chinese economy published several years ago, out of 101 countries in the middle-income category in 1960, only a paltry 13 had made it to high-income status. Somehow growth becomes harder to achieve as countries reach the stage of middle income. This problem is called the middle-income trap.

TWO INDICATORS OF ECONOMIC PERFORMANCE

—EXPORTS AND FOREIGN DIRECT INVESTMENT

—HAVE BEEN PERFORMING POORLY

Most countries that reach middle income do so out of the advantages of cheap labour. They import foreign technology and transfer agricultural labour to basic industries like manufacturing. However, this labour arbitrage opportunity is temporary for a growing economy; as the economy expands and incomes rise, the low-cost advantage disappears. Investment moves to countries with lower costs. This is what’s happening to Sri Lanka’s garment industry. Its low-cost advantage having been eroded, growth is harder to come by.

Several Latin American countries have languished at the middle-income level for decades, so this is something serious. Others, seeming to overshoot the mark in a wave of optimism and reckless borrowing have crashed back down with debt crises. Turkey, Brazil, Argentina and Greece, have managed to pick themselves up again but not before some serious jail time for their mistakes. However, not everything about the past is a good guide on overcoming the middle-income trap, because Sri Lanka’s economy has changed, and so has the global economic system. Two paradigm shifts have occurred in the Sri Lankan economic model that has alerted the policymaking landscape. First, Sri Lanka is now subject to the discipline of international financial markets and rating agencies. In 2012, Sri Lanka’s non-concessional foreign debt stock overtook the concessional external debt for the first time. In the next couple of years, Sri Lanka has to raise $3 billion from international financial markets. Unlike concessional funding, financial markets impose discipline on countries and punish those that aren’t responsible. For a country that is now facing the challenge of low growth, the limitations on policy imposed by financial markets will be a continuing challenge.

Second, Sri Lanka is getting old before it becomes rich; a demographic transition before an economic transition. Once a demographic pyramid becomes inverted, it becomes more difficult to drive growth by increasing the labour force. When the population is mainly young, as in most middle-income countries, more people joining the workforce drives growth even without any improvement in productivity or innovation. Once the workforce starts to shrink only productivity gains can drive growth. Poorer countries imitating successful rich ones can grow faster than rich ones because imitation is easier than innovation. China has shown in the past that catch-up growth can be scaled. However, Sri Lanka’s limited and ageing workforce and the poor FDI limits its catch-up growth potential

Income-trap_chart-1

Income-trap_chart-2

The second paradigm shift is in the global economic model that determines export success and foreign direct investment. Sri Lanka’s export performance has been below its competitors in Asia. The most dynamic component of the exporting system is the regional and global supply chains. 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. This is a dilemma. However, Sri Lanka’s challenges are more complex. There is a universal challenge about the lack of consistency and predictability in Sri Lankan policymaking. Much of Sri Lanka’s challenges step from weak macroeconomic policy. Large deficits in the budget mean Sri Lanka is a high inflation, high nominal interest rate and weak currency country. These are diametrically the opposite of what a successful South East Asia country has been.

SRI LANKA’S WINDOW OF OPPORTUNITY TO REFORM

IS CLOSING AT A MUCH FASTER PACE THAN

FOR OTHERS IN THE SAME LEAGUE

Sri Lanka’s window of opportunity to reform is closing at a much faster pace than for others in the same league position in the GNI table. Its ageing population, unpredictable policy and the overarching influence of international financial markets impost discipline due to the high debt constricting policy.

More than anything else, Sri Lanka’s new political leadership’s economic success will be defined by their ability to swerve away from the middle-income trap. They will have to move fast