Macroeconomic Environment and Project Performance In Sri Lanka

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B O A R D

O F

D I R E C T O R S

ASIAN DEVELOPMENT BANK

I N A S T 1 R C O P Y I

IN.1-98

2 January 1998

SPECIAL STUDY

The following Special Study prepared by the Post-Evaluation Office is

attached for information:

Macroeconomic Environment and Project Performance in Sri Lanka



(SPECIAL STUDY SERIES NUMBER 28)

SPECIAL STUDY

OFTHE

MACROECONOMIC ENVIRONMENT

AND PROJECT PERFORMANCE

IN SRI LANKA

December 1997



CURRENCY EQUIVALENTS

Currency Unit - Sri Lanka Rupee/s (SLRe/SLRs)

(as of September 1997)

SLRe1.00 = $0.017

$1.00 = SLRs58.63

ABBREVIATIONS

GOP -

REER -

Gross Domestic Product

Real Effective Exchange Rate

NOTES

(i) The fiscal year (FY) of the Government ends on 31 December.

(ii) In this Report, U $ " refers to US dollars.

SS - 28



CONTENTS

Page

EXECUTIVE SUMMARY

I. INTRODUCTION

A.

B.

C.

Background

Performance of Bank Projects in Sri Lanka .

Study Objectives and Methodology

1

1

1

II. MAIN FINDINGS 2

A. The Pervasive Effect of the Economic Environment and

of Economic Policies on Bank Projects 2

B. The Impact of Bank Projects on Policies and on the Economy 8

III. KEY ISSUES AND IMPLICATIONS FOR THE BANK'S CURRENT PROGRAM 9

IV. CONCLUSIONS AND RECOMMENDATIONS 9

A.

B.

C.

Overall Assessment

Lessons Learned

Recommendations

9

10

10

APPENDIXES 11



EXECUTIVE SUMMARY

The Bank's past assistance to Sri Lanka has shown varying degrees of success.

Out of 26 projects postevaluated, only 46 percent were successful. A number of projects have

met implementation difficulties rooted in macroeconomic policy changes. This Study arosefrom the need to assess the linkage between project performance and the specific conditions

associated with the macroeconomic environment.

The objectives of the Study are to assess the Sri Lankan macroeconomic

conditions and policies at the time of project implementation, evaluate the impact of such

conditions and policies on the projects, and establish lessons learned associated with policy

changes. The study was conducted over a three-week period in Sri Lanka and is based on a

review of selected projects that have been postevaluated.

The success of the postevaluated Bank projects in Sri Lanka was substantially

affected by changes in economic policy and the economic environment. The sectors exhibited

no systematic differences in the vulnerability of projects to changes in policy. Because SriLanka is a relatively open and small economy, projects were most seriously affected by

changes in world prices and in foreign trade policies, especially in the real effective exchange

rate. The civil conflict also had a profound effect on the success or failure of Bank-assisted

projects. Despite the substantial dismantling of Government controls over the economy since

1977, changes in the control regime still had a substantial impact. Fiscal policy was next in

importance, with monetary policy of least significance to the projects reviewed.

While Sri Lankan economic policies had a strong impact on Bank projects, Bank

projects had only a limited effect on economic policies and on the economy. One reason is that

most of the projects reviewed were developed before policy conditionalities became an

important element in Bank projects. The lessons are clear: it is important to take account of the

impact of policies and policy changes on Bank projects and, even more important, for the Bankto help shape these changes.

The key issues involved the need to pay greater attention to the macroeconomic

environment during project formulation and implementation, the sustainability of policy reforms,

and the challenge of pursuing policy reforms in an integrative, coherent, and focused manner

to effect the desired policy changes.

The most important conclusion of the study is to emphasize the importance of

economic policies for the success or failure of Bank programs and therefore the importance of

policy conditions in shaping a program strategy. Recommendations include the giving of

adequate consideration to the macroeconomic environment during project formulation and the

continuance of all projects and programs to have policy content designed to contribute towardsimprovement in the policy environment of Sri Lanka.



I. INTRODUCTION

A. Background

1. The Bank's past assistance to Sri Lanka (programs, projects, and technical

assistance) has shown varying degrees of success. A number of projects have met

implementation difficulties. They include the reversal of policy measures that were introduced

during past programs (such as the abolition of agricultural fertilizer subsidies), inability to

comply with conditions agreed upon under Bank assistance, or the budgetary constraints that

lead to lack of funds for maintenance of Bank-financed project facilities. Fundamental to these

difficulties is the macroeconomic environment including policy and other changes in the

country. At the macroeconomic management level, in part due to the ongoing Government

efforts to restore law and order, there is the constraint of the fiscal budget and the consequent

adjustment in public expenditure reviews from time to time. The need to assess the extent of

the linkage between project performance and specific conditions especially those associated

with macroeconomic management is obvious.

B. Performance of Bank Projects in Sri Lanka

2. Bank assistance to Sri Lanka as of October 1997 comprises 80 loan projects

and 157 technical assistance projects in various sectors. Of that number, 26 loans and 1

technical assistance have been postevaluated (including 26 Project Performance Audit

Reports, 1 Reevaluation Study, and 3 Impact Studies). The 26 Project Performance Audit

Reports completed rated only 12 projects (46 percent) as successful, 11 (42 percent) partly

successful, and 3 (12 percent) unsuccessful (Appendix 1). The specific reasons for the poor

performance of the projects are varied, ranging from changes in their economic viability to lack

of sustainability because of an inadequate maintenance budget. These reasons spring from

changes in the macroeconomic and other conditions in the course of project implementation.

C. Study Objectives and Methodology

3. The objectives of the Study are to (i) assess the Sri Lankan macroeconomic,

sector, institutional, social, and other policies; policy constraints; and conditions prevailing at

the time of formulation and implementation of the loan projects funded by the Bank; (ii)

evaluate the impact of such policies, policy constraints, and conditions on the performance of

the loan projects; and (iii) establish lessons associating policy changes and the performance of

projects.

4. The Study was based on a review of policy impact on 14 selected programs and

projects implemented from 1980 and which have been postevaluated, interviews with a wide

spectrum of respondents from both the public and private sector as well as funding agencies in

Sri Lanka, and consultations with Bank staff. The cutoff date of 1980 was adopted to limit thecase studies to a more manageable proportion as a result of time and budget constraints, and

as a result of interdepartmental consultation to limit the Study to more recent projects that

would have more relevance to the Bank's current portfolio management for Sri Lanka.



2

II. MAINFINDINGS

A. The Pervasive Effect of the Macroeconomic Environment and Economic Policies

on Bank Projects

5. It is striking that the success of every one of the postevaluated Bank projects in

Sri Lanka was substantially affected by changes in economic policy and the macroeconomic

environment. The impact of economic factors on project performance may have been greater

in Sri Lanka than in some other countries because of the importance of trade in the Sri Lankan

economy. Five of the projects studied involved the production of goods for exports and all

projects were affected by the price of imported inputs. Even health and power projects, which

might be thought to be little affected by changes in economic policy, were substantially

influenced by the price of imported medical equipment and medicines in one case, and the

cost of imported petroleum products on the other.

6. Because of the heavy trade dependence, every project was affected to some

degree by changes in

(i) world market prices of products exported or inputs imported, or of imports that

competed with project products;

(ii) the nominal exchange rate, which determined the rupee price of exports,

imported inputs, imports competing with domestic goods, and the cost of Sri

Lankan labor in competing in the world market; and the real effective exchange

rate (REER), which measured the real rupee benefit or cost of traded goods and

services, after taking account of inflation;

(iii) export duties and import tariffs;

(iv) import and export controls; and

(v) costs of shipping, ports, and insurance.

7. Virtually all projects in Sri Lanka were also affected by civil conflicts-some of

whose impact came through their economic effects-and by fiscal (tax, subsidy, and other

Government expenditure) policies. Other policies had less universal but still very powerful

effects on the success or failure of projects. Especially far-reaching were the effects of various

Government controls. Monetary policy was less important. A detailed discussion is given in the

following paragraphs, a tabulated summary is given in Appendix 2, and details of the selected

projects are in Appendix 3.

1. Systematic Differences in Economic Effects Among Groups of Projects

8. It may be assumed that some sectors or categories of projects are more

insulated or protected from changes in economic policies or in the economic environment than

others. But the study found that there were no systematic differences among sectors in thevulnerability of projects to changes in policy.

9. Instead there seem to be three overlapping factors that influenced the impact ofeconomic policies on a project:



3

(i) the importance to the project of the prices of imported inputs, of competing

imports, and of exports;

(ii) the extent to which there are taxes, controls, or other forms of Governmentintervention with respect to goods and services important to the project; and

(iii) the ambitiousness or modesty of the project's objectives.

10. The first of these factors has already been discussed (paras. 5 and 6). The

second is largely self-evident: for instance, if the Government controls the price of milk and

sets it low to benefit consumers, then a project to increase milk production may fail because

policies have made it unprofitable.

11. If the aims of the project are modest, for instance, to improve the technical

efficiency of already established units, then economic policy may have little impact. An

increase in technical efficiency, which lowers cost, can be sought by both private and publicenterprises. The prices of inputs and outputs, which are strongly affected by policies, would

have minimal impact. The Secondary Town Power Distribution Project' is a case in point. It

was to increase the efficiency in the distribution of electricity and in collecting energy charges.

Macroeconomic policies had little impact on this project with its narrow technical goals.

12. But if the purpose of a power project is more ambitious, then economic policies

would be crucial. If the aim, for example, is to increase power availability efficiently without

raising the cost to productive sectors and to poor consumers, while reducing the cost to the

Government, then the following issues become crucial:

(i) how world petroleum, coal, and gas prices are changing;

(ii) what the Sri Lankan exchange rate is and whether it reflects the true scarcity offoreign exchange:

(iii) whether there are tariffs/ taxes/ subsidies on imported oil; and

(iv) above all: what prices are set for electricity; are cross-subsidies involved and, if

so, who benefits and who loses; and do prices reflect costs.

13. Even within a single project, one component can be more affected by economic

policies than another. In the Livestock Project, 2 the pig production component was minimally

affected by economic factors. Pork products are not exported and most are not imported, so

world prices and trade policies had little effect. Nor did the Government control, tax, or

subsidize the activity. The aim was to upgrade the stock of pigs and thus to increase output, a

modest goal little affected by prices of inputs and outputs. The milk production component of

the same project, however, was substantially affected by policies. Most milk products wereimported, producer prices were controlled by the Government, and consumer prices weredetermined by trade and payments policies. The aim was to increase domestic production and

farmers' income without raising consumers' prices. When world prices for milk powder were

low and tariffs were reduced to benefit consumers, farmers' incentives were negatively

2

Loan No. 732-SRI(SF):Secondary Towns Power Distribution Project, for $12.4 million, approved on 22

January 1985.

Loan No. 606(SF):Uvestock Development, for $15.2 million, approved on 7 December 1982.



4

affected (or the Government had to subsidize the processors). Changed tariff and price policies

meant that the project resulted in only modest increases in output.

2. Effect of Exogenous Economic Changes

14. World prices are the most important exogenous economic variable affecting

Bank projects. Not under Sri Lankan control are the international prices of imported inputs, or of

goods exported by Sri Lanka, or of imports that compete with domestic products. For example,

the major elements of tree crops sector projects, such as those involving replanting and

upgrading, were difficult to implement when world prices of products were low. They are now

easier for tea producers to execute because world prices have risen. On the other hand, in

1994 there were strong and successful pressures to reintroduce the fertilizer subsidy because

the world prices of tea were low at the time. This involved reversal of a policy condition in the

Plantation Sector Project.'

15. The Coconut Development Projece fell far short of its production target because

of the combined effect of increased land and fertilizer prices and declining world prices ofcoconut products. With declining demand for coconut oil in developed countries and increased

production fostered in other countries by various aid agencies, there was a downward trend in

world prices, which decreased the profitability of coconut production. Combined with higher

costs, the result was that the project's planned output and returns could not be achieved.

16. The effect on other projects was more subtle than the effect on export crops. The

centerpiece of the Livestock Development Project was increased production of milk.

Domestically produced milk had to compete with imported milk powder, which accounted for

about half of all dairy products consumed in the country. World prices of milk powder were low

when the project started. Domestic production therefore was not sufficiently profitable to

stimulate a substantial increase in output. Moreover, world prices fluctuated by over 20 percent

from year to year, increasing the risk of domestic producers. However, there is an upward trend

in world milk powder prices (at least partly because Europe is phasing out its subsidies). A

project started in the future will therefore have a better chance of success.

17. The Second Fisheries Development Project'' was affected by the world price of

imported canned fish. Firewood produced by the Community Forestry Project" competed with

imported kerosene. The Rural Credit Project5might be considered largely isolated from

economic, and especially exogenous, factors, but an important element was the provision of

tractors and other machinery. Farmers' demand for them was affected by the world price of

diesel fuel. Moreover, the profitability of dryland crops to be fostered by the project depended in

part on the price of competing vegetables imported from India.

18. A much less important exogenous economic variable than world prices was the

price of land. It rose quite rapidly near cities as industry and service activities expanded,

especially in the area around Colombo. That is also the prime coconut growing area. Farmers

2

3

4

5

Loan No. 712(SF):Plantation Sector, for $45 million, approved on 4 December 1984.

Loan No. 526(SF):Coconut Development, for $12 million, approved on 24 September 1981.

Loan No. 520(SF):Second Fisheries Development, for $13.5 million, approved on 20 August 1981.

Loan No. 568(SF):Community Forestry, for $10 million, approved on 25 March 1982.

Loan No. 432(SF):Rural Credit, for $10.9 million, approved on 6 December 1979.



5

near urban centers found it far more profitable to sell land for development than to grow

coconuts there, with negative effects on the coconut project.

19. There is little evidence that the potential impact of exogenous economic

changes was taken into account in project design, implementation, or postevaluation. But suchvariables had some effect on results for about 80 percent of the projects analyzed and had

substantial effects on perhaps half that number.

3. CivilConflict

20. The two civil conflicts that have affected Sri Lanka involving the Tamil Tigers in

the north and northeast since 1983 and the Janatha Vimukthi Peramuna (People's liberation

Front) in the South in 1986-1988 are, of course, not economic factors. But they have had

substantial economic consequences and clearly have affected a number of projects.

21. Some projects have not been implemented or have been poorly implemented in

some areas as the result of the conflict. livestock, fisheries, and tourism projects have beenparticularly damaged. The northern areas have been important for both livestock and fisheries.

As a result the livestock Project, which started in 1983, was delayed and was only partly

successful since it could not be implemented in one of its two principal target areas. The

Second Fisheries Project, started in 1981, was also badly affected.

22. Less obvious is the effect on the Second Development Finance Corporation1

and the First National Development Bank2 projects. Both institutions were suostantial lenders

to the tourism sector. Many of these loans are in arrears as tourism income has dramatically

declined after each incident of terrorism or civil disturbance. Industry loans were also affected

after some factories were burned in 1983.

23. The conflicts have also inflicted serious damage on the budget, on economicstability, and on both public and private investment. Some 6 percent of the gross domestic

product (GOP) is now spent on defense and another 6 percent on debt servicing, much of it for

loans incurred to finance past defense expenditure.

24. As a result, funds for Government investment have been sharply cut, from

around 16 percent of GOP in 1978-1983 to about 7 percent in the last few years. The impact of

the First Agricultural Program Loan" and other projects in that sector was reduced by the

decline in public investment for agriculture from 5 percent to 1 percent of GOP. Other projects

have been slowed by inadequate counterpart funds or been less effective for lack ofmaintenance funding (e.g., Health and Population Project). 4

25. Private investors, and especially foreign investors, have been deterred by theadditional perceived risk. Existing foreign investors have not withdrawn and, indeed, have

often reinvested profits and expanded. But many potential new investors have stayed away

2

3

4

Loan No. 451-SRI(SF):Second Development Finance Corporation, for $10 million, approved on 14February 1980.

Loan No. 519-SRI{SF):First National Development Bank, for $10 million, approved on 29 June 1981.

Loan No. 994-SRI(SF):First Agricultural Program Loan, for $80 million, approved on 28 November 1989.

Loan No. 576-SRI{SF):Health and Population Project, for $9.3 million, approved on 22 July 1982.



6

because of perceived risks. Domestic investors have also been less inclined to commit their

funds for projects after any escalation of the violence.

26. Moreover, Government borrowing needed to fund defense has "crowded out"

private borrowing and has resulted in high interest rates and greater difficulty of borrowing forthe private sector. The civil conflict was by no means the only factor explaining the budget

deficit and inflation, but it was a major factor. Inflation and high interest rates deterred

investment in tourism and industry and affected the Development Finance and National

Development Bank Projects as well as all projects that required private investment.

4. Trade and Payments Policies

27. In a trade-dependent economy like Sri Lanka, changes in the REER have a

widespread impact. During reform periods, as in 1977-1979, the REER is often depreciated:

the exchange rate is devalued substantially while domestic prices change much less. Imports

become more expensive and exports more profitable, providing strong incentives to increase

domestic production and exports and to reduce imports. On the other hand, if the rate ofinflation exceeds the rate of devaluation then the REER appreciates. A more than 20 percent

appreciation of the REER, as in 1979-1984 and again in 1988-1996, hampered all export-

based projects and all efforts to increase domestic production and to reduce imports (Appendix

4).

28. The Sri Lankan import policy regime is more complicated than would appear at

first glance. For instance, the highest official rate of import tariffs is 35 percent with only three

major bands (35 percent, 20 percent, 10 percent). But some commodities are outside the

system. In addition to higher tariffs for these commodities, there is a defense levy, and another

tariff based on the assumed trade margin that can result in an effective tariff estimated at 70

percent, or double the official top rate.

29. There are no longer export duties. But a number of tree crop products bear

cesses. These are not, as the name would imply, universally levied, but levied only on exports.

The result is that producers for domestic markets have a small advantage over producers for

exports.

30. The exemptions from all import duties under the Board of Investment

concessions are so widespread that some commodities effectively do not bear any import duty,

while the nominal tariff may be high. This is especially true of textiles and other imported inputs

into the garment industry. With an Export Processing Zone status for over 100 garment

factories set up all over the country, virtually all textiles sold in Sri Lanka come in duty-free for

these Board of Investment export enterprises and then leak into the domestic market. As a

result, the domestic textile industry is operating without protection and many firms are inserious trouble. This reality is forcing further policy changes on the Government and needs to

be taken into account in designing Bank projects in the future.

5. Fiscal Policy

31. Despite major fiscal policy reforms and a substantial reduction in some taxes,

the tax and expenditure regime still has a substantial impact on Bank projects. Further reforms

are needed. The budget deficit has been rising, and Government investment and maintenance



7

expenditures have been falling as a result of heavy defense, debt, subsidy, and social welfare

expenditures. Some projects have been affected by the drastic cut in the Government's

investment program from nearly 13 percent in the mid-1980s to 5.4 percent estimated for 1996

(World Bank estimate). The impact on agriculture projects of a decline in Government

investment in that sector from nearly 5 percent in 1985 to just above 1 percent in 1994 hasalready been mentioned (para. 24). Health and transport projects suffered from inadequate

funds for maintenance. Several postevaluation reports indicated that projects were slowed by

shortages of counterpart funds to cover the contribution of the Government.

32. More broadly, the budget deficit and its financing were the principal reasons for

high and increasing rates of inflation recently (para. 26). These in turn increased the risk of

investment as perceived by the private sector. The resulting high interest rates are cited as a

major problem by Sri Lankan enterprises in industry, tourism, and other service activities and

plantations. That has directly affected the two loans to development finance institutions and,indirectly, the rate of investment and growth of the economy.

6. Monetary Policy

33. The fiscal deficit and its financing have contributed to a high rate of interest

which has been an obstacle to investment. It might be assumed that both savers and investors

would be concerned only with the real rate of interest, the rate after adjusting for inflation; that

what matters for borrowers is not the nominal rate of 20 percent, about average in 1996, but a

real rate of about 9 percent, if inflation is about 11 percent. Borrowers pay back in rupees that

are worth 11 percent less at the end of the year, so their real cost is 9 percent.

34. Private borrowers in Sri Lanka, as elsewhere, also build in an inflation risk

premium into their calculations. They are concerned not only about high real rates, but also

about high nominal rates. If inflation slows from 11 percent to 6 percent, and they have

borrowed at a fixed nominal rate of 20 percent, then they are suddenly faced with real rates of14 percent. Such a rate would bankrupt many firms.

35. Also, if investor/borrowers are exporting some of their production, they face an

exchange risk. In 1996, the devaluation of the rupee was only 6.5 percent, so an exporter who

received only 6.5 percent more rupees for every dollar exported had a high real interest cost of

13.5 percent if he borrowed at 20 percent. To put it another way, high rates of inflation, if not

fully compensated by exchange rate devaluation, resulted in an appreciation of the REER.

That had profound effects on the profitability of a wide range of products.

36. In short, fiscal and monetary policy during the period under review resulted in a

high real cost of borrowing and increased the risk of borrowing and investing for the long term.

The impact was most direct on the two credit projects. But it affected to a lesser degree manyother projects involving credit financing. But since most of the effects of monetary policy on

Bank projects were indirect and limited, they had little clear impact on project success.

7. Controls

37. It seemed likely that Government controls would have little impact on Bank

projects. After all, Sri Lanka had been carrying out a reform program for 20 years and most of

the reforms involved the reduction or elimination of controls, of direct Government intervention



8

in the economy. By now, it might be assumed that controls would largely be gone. But this

assumption proved ill-founded, especially for projects completed between 1980 and 1992.

Virtually all the projects examined were affected by controls.

38. Some examples follow: The Government set the price of milk; fish and woodhad to be sold to a Government agency; tea had to be sold at the Colombo auction or its price

had to be approved by a Government-established Board; the Government determined

electricity and water rates and instituted a massive system of cross-subsidization from

industrial/commercial to residential consumers; a Government agency was the principal

importer of fertilizer; through its ownership of the two largest commercial banks, theGovernment substantially influenced interest rates and lending patterns; the Paddy Marketing

Board intervened in the rice market; and so on.

39. Perhaps the most important was Government control and management of the

plantations until 1992. In that year, private firms were given five-year contracts to manage the

plantations. The contract period was clearly too short to allow for any private investment. In

1996, private managers were allowed to buy 53-year leases of the plantations, fundamentallychanging the incentive system for investment and management of this important sector.

40. In short, by 1997 the importance of controls had diminished, with the most

dramatic change coming in the plantation sector. Some controls had disappeared. But a very

large array continued. One of the unfinished tasks of reform is to further reduce or eliminate

the controls that cause the biggest distortions (para. 38).

B. The Impact of Bank Projects on Policies and the Economy

1. The Limited Effect of Bank Assistance

41. A rough impression of the impact of 14 postevaluated projects on policies andthe economy is given in Appendix 2 and summarized by tabulated individual projects in

Appendix 3. There is no rigorous, scientific method for evaluating the impact of aided projects

or programs on the economy or policy because there is no sure way of knowing what wouldhave happened in their absence. Compounded by the time constraint in the field, such an

assessment is largely judgmental. However, it is based on information from Bank documents,

and extensive discussions with Sri Lankan and foreign economists.

42. All the 14 projects examined seemed to have either a small effect on the

economy or an uncertain, but probably small effect. However, they had a greater effect on

policies. For two projects, the policy impact seemed to be unambiguously large and positive;

for two others, it was probably large. For the remaining ten projects, the impact on policy was

either small, or negative or uncertain.

2. Reasons for Limited Effect of Bank Assistance

43. One reason for the seemingly limited impact of the Bank's projects on the

economy and policies was that most of the projects examined were started in the early 1980s

before the Bank's evaluation of projects and decisions on priority consciously included the

impact of the project on policy, and before policy condition was part of project design. Any

impact on policy would therefore be largely accidental for most projects. The impact on the



9

economy was also likely to be limited if the project did not lead to a change in policy, because

the Bank's whole program was too small for the investment by itself to have much of an effect.

44. Even when the Bank did impose policy conditions these were not always

appropriate or effective and, especially in the early years, largely supported the conditionsimposed by the World Bank and the International Monetary Fund. Among conditions that had

some negative consequences were the requirements that timber be sold to a Government

agency and that milk prices had to be fixed by the Government. The abolition of the fertilizer

subsidy, a major condition, was reversed after a brief period. The most important and effective

policy conditions imposed by the Bank included a greater scope for private banks and

privatization of the management of the plantations. But in both cases Government officials felt

that the impetus for reform came primarily from within the Government and as a result of

pressure from the World Bank and the International Monetary Fund. The Bank was seen as

playing a definitely secondary role.

45. A contributory explanation could be that the Study included those projects not

likely to have an important catalytic effect on the economy. Assistance in support oftelecommunications and power generation, for instance, could have a greater impact on the

economy.

III. KEY ISSUES AND RECOMMENDATIONS

46. The importance of economic policies and the economic environment in

determining the fundamental success or failure of virtually all Bank projects in Sri Lanka is

unquestioned. When policies provided the wrong incentives, even substantial investments

produced only limited results. The clearest example is in the plantation sector: as long as the

plantations were managed by the Government, the overriding objective was not their long-term

profitability, but rather a variety of short-term and political goals. Similarly, with falling world

prices for commodities or an appreciating REER, any project to increase crop production from

the plantations could not perform well. As a result, the substantial investment funded by

external agencies had only a limited effect in increasing output and efficiency.

47. The implication is that greater attention to the macroeconomic environment and

policies in Sri Lanka at the project design stage would enhance the likelihood of successful

project performance. Moreover, considerinq the volatile policy context in Sri Lanka, careful

monitoring would be needed during project implementation to track possible adverse impacts

and to provide remedial actions.

48. Certainly, there are policies that would be difficult to implement, important as

they may be. But policy reforms should be pursued according to their practicality inimplementation and their sustainability once implemented. Reforms that are likely to meet with

difficulties even though important could perhaps be deferred to a more opportune time.

Nevertheless, in some cases, the objectives for reforming such policies can be attained through

other reforms that are more workable. There are a number of potential areas where external

support would generate more productive results.

49. Past Bank projects did not have much impact on the policies of Sri Lanka. A

major reason for this was that policy conditions were not part of the project desiqn for Bank

projects implemented in the 1980s. Recent projects and programs have more policy content



10

and their impact on Sri Lanka's economic policies should be reviewed in the future. Thechallenge in framing policy reforms comes from pursuing them in an integrated, coherent, andfocused manner so as to catalyze a reform process.



11

APPENDIXES

Number Title Page Number Cited on

(page, para no.)

1 Postevaluation Reports on

Programs, Projects and Technical

Assistance in Sri Lanka

as of November 1997 12 1,2

2 Summary of Table of Impacts

on Bank Projects 15 2, 7

3 Details of Selected Projectsunder the Study 16 2, 7

4 Movement of Real Effective

Exchange Rate 29 6, 27



POSTEVALUATION REPORTS ON

PROGRAMS, PROJECTS AND TECHNICAL ASSISTANCE IN SRI LANKA

AS OF NOVEMBER 1997

Table 1: Proaram/Project Performance Audit Re~orts

Report Number, LoanlTA Number Perfonnance Report Tit le SectorlSubsector

Circulation Date Rating"

PE0001 Sep 73 0002-SRI Generally First Tea Factory Modernization Project Industrial Crops and Agro-industry

successful

PE0026 Sep 79 0078-SRI Generally Mineral Sands Project Nonfuel Minerals

0202-SRI successful

PE0032 Jun 80 0071-SRI(SF) Generally Communications Satellite Earth Station Telecommunications

0203-SRI(SF) successful

PE0054 Oct 81 0064 TA Partly Gal Oya Sugar Industry Project Industrial Crops and Agro-industry


PE0059 Mar 82 0115-SRI(SF) Unsuccessful Fisheries Development Project Fisheries

PE0070 Aug 82 0016-SRI(SF) Partly Walawe Development Project Irrigation and Rural Development

0017-SRI successful. .

PE0114 Jun 84 0118-SRI(SF) Generally Bowatenna Power Project Electric PowerI

successful

PE0126 Dec 84 0288-SRI(SF) Partly First Development Finance Corporation Development Finance Institution

successful of Ceylon Project

PE0165 Dec 85 0299-SRI(SF) Generally Canyon Hydropower Project Electric Power

successful

PE0207 Jun 87 0060 TA Unsuccessful Urea Ferti lizer Pro ject Fertilizer Production0231 -SRI(SF)

0403-SRI(SF)

PE0210 Aug 87 0451-SRI(SF) Generally Second Development Finance Corporation Development Finance Institution »successful of Ceylon

""

Development Finance InstitutionPE0254 Sep 88 0519-SRI(SF) Generally National Development Bank of Sri Lanka

successful

PE0293 Dec 89 0241 TA Partly Rural Credit Project Agricultural Support Services "

0432-SRI(SF) successful c

PE0298 Dec 89 0219 TA Generally Rural Electrification Project Electric Power

0436-SRI(SFl successful

a Performance rating as of report circulation.



Report Number, loanlTA Number Performance Report Title SectorlSubsector

Circulation Date Ratins

PE0330 May91 0338 TA Partly Coconut Development Project Industrial Crops and Agro-industry


PE0357 Mar 92 0410 TA Partly Second Fisheries Development Project Fisheries


PE0361 Jun 92 0732-SRI(SF) Generally Secondary Towns Power Distribution Project Electric Power

successful

PE0366 Oct 92 0359 TA Generally Community Forestry Project Forestry


PE0365 Oct 92 0276 TA Partly Third Tea Development Project Industrial Crops and Agro-industry


PE0399 Aug 93 0576-SRI(SF) Generally Health and Population Project Health and Population

successful~

PE0406 Dec 93 0765 TA Partly Agricultural Inputs Program Irrigation and Rural Developmentw

OB20-SRI(SF) successful

PE0438 Feb 95 0712-SRI(SF) Generally Plantation Sector Project Industrial Crops and Agro-industrysuccessful

PE0443 Aug 95 OB48-SRI(SF) Partly Aquaculture Development Project Fisheries

successful

PE0446 Aug 95 0191 TA Unsuccessful Sevanagala Sugar Development Project Industrial Crops and Agro-industry

0369-SRI(SF)

PE0452 Nov 95 0371 TA Partly Livestock Development Project LivestockOB06-SRI(SF) successful »

-0

-0

PE0477 Dec 96 0994-SRI(SF) Partly Agriculture Program Loan Agricultural Support Services (1

:

successful Qx~--0

Ico(1

N



Table 2: Technical Assistance Performance Audit Reports

ulationDate

LoanlTANumber Performance Report Title

Ratinga

SectorlSu bsector

E 0010 Dec 94 1735-TA Partly

successful

SSTA for Study on Pol icy Impact of Agricu ltural Program

Loans

Agricultural Support Services

Performance rating as of report circulation.

Table 3: Impact Evaluation Reports

ReportNumber, LoanlTA Number

Circulation Date

SectorlS ubsectoreportTitle

IE0001 Jun 84 0115-SRI{SF)

0410 TA

0520-SRI{SF)

Dec 95 0576-SRI{SF)

1291 TA

Bank Assistance in the Fisher ies Sector in Sri Lanka

An Impact Evaluat ion Study of Bank's Assistance in the

Heal th and Populat ion Sector in Sri Lanka

An Impact Evaluation Study of Bank Assistance to the

Indust rial Crops and Agro-Indust ry Sector in Sri Lanka

Fisheries

Health and Population

Industrial Crops and Agro-industry

IE0033

IE0038 Jul 96 0002-SRI

0039-SRI

0064 TA

0123-SRI( SF)

0191 TA

0369-SRI(SF)

0276 TA0472-SRI{SF)

0338 TA

0526-SRI(SF)

0712-SRI{SF)

0897 TA



SUMMARY TABLE OF IMPACTS ON BANK PROJECTS

Project Economic Civil Trade & Fiscal Monetary Controls Effect on Effect on Bank's

Exogenous Conflict Pal!ments POlicl! Policl! Economl! Policl! Rating

1. Rural Credit n,s n,s n,p,s n,s n,s n,1 p,s x PS

2. Second DevelopmentFinanceCorp. Project p,s n,1 n,p,l,s n,s n,s n,p,s p,? ? GS

3. Third Tea Development n,1 n,s n,p,1 n,1 x n,s p,s p,I,? PS

4. First National Development Bank Project p,s n,1 n,p,l,s n,s n,s p,s p,? ? GS

5. Second Fisheries Development n,?,s n,1 n,p,s p,1 n,s n,1 p,s n,s PS

6. Coconut Development n,l n,s n,p,1 n,1 x ? p,s x PS

7. Community Forestry p,s x n,p,1 x x n,l x p,s GS

8. Health and Population ?,s n,s n,p,s x x x p,s p,l GS

~9. Livestock (Dairy) n,1 n,1 n,p,1 p,s x n,l p,s n,l PS <

10. Aquaculture Development n,p,l n,l n,p,s x x n,s p,s x PS

11. Plantation Sector n,l n,s n,p,l n,s x n,l p,s p,I,? GS

12. Secondary Towns Power Distribution n,s x n,p,s n,s x n,s p,s p,s GS

13. Agricultural Inputs Program n,l n,s n,p,l p,1 x n,p,s p,s p,s PS

14. First Agriculture Program Loan n,l n,s n,p,l p,l n,s n,l p,s p,l GS

n = negative, p = positive, I = large,s = small, x = no effect, ? = uncertain/unknown, PS = partially successful, GS = generally successful.



16 Appendix 3, page 1

DETAILS OF SELECTED PROJECTS UNDER THE STUDY

A. Loan No. 432-SRI(SF): Rural Credit Project

1. Objective: To improve the incomes of small farmers in Sri Lanka's Dry Zone,

and to strengthen the rural credit system in the country through the two state-

owned commercial banks-including credit for tractors and other equipment.

2. Time Period: 1980-1986

3. Economic Factors That Affected the Project

(i) Economic Exogenous: Due to the more attractive World Bank Small and

Medium Industries Project, rice milling facilities were scaled down. The

high world prices of fuel hurt the project.

(ii) Civil Conflict: Ethnic disturbances in 1983, and especially the People's

Liberation Front (JVP) in the south in the late 1980s affected the ability

of banks to operate.

(iii) Trade and Exchange Rate Policy: Undervaluation of the yen at the time

of importation of tractors was helpful for the project.

(iv) Fiscal Policy: Farmers in default continued to receive bank credit, largely

on noncommercial considerations, thus disrupting loan discipline and

weakening the financial bases of credit institutions.

(v) Monetary Policy: Rural lending from the informal sector is estimated at

around 75-80 percent of total rural credit needs. Out of this, around 31

percent is interest free, obtained from friends and relatives. The average

loan size is small, with informal interest rates averaging around an

estimated 60 percent per annum. Medium- and long-term loans are

relatively few. The consumer price index rose on average by 16.4

percent during 1980-1984, while it rose on average by only 6.8 percent

in the next four years.

(vi) Controls: The Paddy Marketing Board (PMB) did not protect paddy

farmers' interests effectively. There was no guaranteed quota system

through PMB; the paddy millers had to rely on their own resources to

finance relatively large stocks of paddy during harvest seasons, or to

accept low sale prices.

4. Effect on Economy/Policy

The impact was very small where the key issue, which was marketing, was not

addressed.




B. Loan No. 4S1-SRI{SF): Second Development Finance Corporation

1. Objective: To extend the Development Finance Corporation of Ceylon's

(DFCC) foreign currency resources for on-lending to the country'smanufacturing and tourism sectors either through loans or equity investments.



(i) Economic Exogenous: Increasing industrial labor costs and exhaustionof quotas in East Asia resulted in investment moving to Southeast andSouth Asia.

(ii) Reform Cycles: Reforms of 1977-1979 were crucial to the industry

sector.

(iii) Civil Conflict: Due to the ethnic conflict in 1983 when factories wereburned down, the tourist industry suffered with a fall in tourist arrivals.

(iv) Trade and Exchange Rate Policies: Real effective exchange rate(REER) appreciated during the project period, hurting exports.Subprojects that were in difficulty sector-wise (as they had arrears inloans) were chemicals, packaging and printing, building materials,construction and engineering, and tourism. The chemicals sector, whichwas mostly state controlled in the previous decade, operated with verylow nominal rates of effective protection. Both chemicals, and packaging

and printing sectors faced competition with imports due to the openingup of the economy in 1977-1979 and had difficulties in adjusting to thenew environment. The tourist industry faced a different situation wherewith liberalization, new hotels came up with the increased arrival oftourists. When ethnic conflict erupted in 1983, the tourist arrivalsdropped and even construction of tourist facilities suffered due touncertainty in the security situation in the country.

(v) Fiscal Policy: High income taxes were not helpful in achieving positiveresults from the project.

(vi) Monetary Policy: High nominal interest rates due to massive budgetdeficits mainly because of the ambitious public expenditure programscombined with high inflation made Sri Lanka's export products lesscompetitive in the world market. Loans were rescheduled for projectsthat were in difficulty.

(vii) Controls: Abolition of licensing and controls helped exports andefficiency, but import substitution industries, especially those operatingunder a controlled economy, faced difficulty.




4. Effect on Economy/Policy: Effect on the economy was positive mainly due to

extending of loans, but it was small. End effect on policy is not clear.

c. Loan No. 472-SRI(SF): Third Tea Development Project

1. Objective: To increase the productivity of tea lands, enhance the quality of

processed tea, and improve the living conditions of plantation workers in a

specified area. The Bank's first two projects focused on modernizing tea

factories.



(i) Economic Exogenous: Downward trend in tea prices due to new entrants

in the world market.

(ii) Reform Cycles: Slowing down of reforms and some reversals in 1980s;

no plans on privatizing plantations. Return of some smaller estates to

previous owners.

(iii) Civil Conflict: Some project areas were affected by deteriorating security

situation during the JVP insurrection in 1987-1988.

(iv) Trade and Exchange Rate Policies: The tea sector was taxed directly

through a combination of taxes and export duty from the 1970's throuqh

1992. Due to taxes combined with appreciating REER from 1981-1984

and 1988-1991, the producers were in much difficulty.

(v) Fiscal Policy: Ad valorem taxes and cesses were part of taxes that were

borne by the tea industry where cess was returned to industry amidst

high transaction costs. Only cess on tea is still applicable. Direct

subsidies for replanting and machinery and indirect subsidies for

research and extension services were estimated to amount to 3 percent

of the production costs.

(vi) Controls:

(a) The cost of labor has been rising since the mid-1970s due to (1)

political interference that was not related to inflation or

productivity growth; (2) union pressure; (3) guaranteed work

period; and (4) need for monitoring labor performance.

(b) Estates were government-owned: (1) small estates were returned

to owners; (2) management was privatized in 1992, but with only

5-year contracts; (3) in 1996, management contract with private

firms was extended to 53-year leases.




4. Effect on Economy/Policy: Effect on the economy was small, but that on policy

was large because of the move toward privatization. The role of the Bank in this

is unclear.

D. Loan No. 519-SRI{SF): First National Development Bank of Sri Lanka

1. Objective: To provide the National Development Bank with foreign currency to

spur the development of the country's private and public industry sectors.



(i) Economic Exogenous: With the availability of quotas for garments and

East Asian countries experiencing increasing wages, the tendency of

investors was to move toward this part of the world.

(ii) Reform Cycles: Rapid liberalization that took place from 1977 through

1979 drifted until 1983, slowing down until 1986 when the JVP

insurrection created some uncertainty in the industry sector. Reforms

accelerated again from 1989.

(iii) Civil Conflict: Factories were burned and foreign direct investment and

domestic investment curtailed. Due to the conflict, some cancellations

occurred for entire subprojects; in other instances, there were reductions

in the scope of projects. Tourism sector projects suffered due to

reduction in tourist arrivals because of the riots in 1983.

(iv) Trade and Exchange Rate Policies: As far as import duties were

concerned, liberalization took place in 1977-1978 and continued at a

slower pace. REER appreciated in certain periods, making Sri Lanka's

import substitution industries less competitive.

(v) Fiscal Policy: High income taxes were not helpful in achieving positive

results from the project.

(vi) Monetary Policy: High nominal interest rates due to massive budget

deficits mainly because of the ambitious public expenditure programs

combined with high inflation made Sri Lanka's export products less

competitive in the world market. Loans for projects that were in difficulty

were rescheduled.

(vii) Controls: Abolition of licensing and controls helped exports and

efficiency, but import substitution industries, especially those operatingunder a controlled economy, faced difficulty.

4. Effect on Economy/Policy: Effect on the economy was positive mainly due to

extending of loans, but it was small. End effect on policy is not clear.




E. Loan No. 520-SRI(SF}: Second Fisheries Development Project

1. Objective: To expand fishing operations in the private sector involved extending

credit from the two state banks to fishermen for the purchase of new vessels,and replacement of engines and sails; and to investors for chill storage facilities

and insulated trucks. Construction of a fish landing jetty and institutional support

were also provided.


3. Economi.c Factors That Affected the Project

(i) Economic Exogenous: World price of canned fish had some effect

(though undetermined) on the price of fish during this period. (That

depends on how close a substitute canned fish is for fresh fish.)

(ii) Civil Conflict: The northeast coastal area is a major fishing area for Sri

Lanka but there is very little fishing due to the ethnic conflict. Prices of

fish have escalated because of this conflict.

(iv) Trade and Exchange Rate Policies: Import duty on fish was at 10

percent, while that for canned fish was at 5 percent. Consumers bought

canned and dried fish as a substitute for the relatively expensive fresh

fish. The exchange rate also affected the demand for fresh fish via the

price of canned fish.

(v) Fiscal Policy: Investment targets mentioned in the Fisheries Master Plan

(1979-1983) were met largely due to a 35 percent subsidy for hulls,

engines, and gear, and concessionary financing from Government-

owned banks.

(vi) Monetary Policy: People were not willing to borrow at high interest rates.

(vii) Controls: There were controls on the marketing side where the shippers

were required to turn their catch over to Fishermen's Cooperative

Societies (CSs); mainly because if the CSs were to assist effectively in

loan recovery, they must collect fish directly from shippers upon landing.

Two new marketing cooperatives were created. But after two years of

operation, one cooperative was liquidated and the other was operating

with losses. Private traders took over the bulk of fish marketing.

4. Effect on Economy/Policy: Net effect small, possibility of reduced catch for

smaller boats. Subsidy gave rise to distortions.

F. Loan No. 526-SRI(SF}: Coconut Development Project

1. Objective: To increase coconut production and farm incomes of coconut

smallholders and improve the standards for quality and output of the coconut




processing industry. The first Bank project aimed at increasing coconut

production and processing in Sri Lanka.



(i) Economic Exogenous: World market prices of coconut and coconut-

related products were declining, affecting Sri Lanka's exports of coconut

and coconut-related products.

(ii) Reform Cycles: The reform cycles influenced coconut production mainly

through the fertilizer subsidy. This project was dependent on one single

input, Le., fertilizer. The fertilizer subsidy was eliminated in 1990 and

reintroduced in 1994.

(iii) Civil Conflict Civil disturbances (JVP activities in the south) had a

negative effect. Not the ethnic conflict because the project area was

away from the area of ethnic conflict.

(iv) Trade and Exchange Rate Policies: Export taxes on the coconut sector

were higher relative to the other coconut-producing countries during the

late 19705 and early 19805. It has been estimated that since all the

taxes were passed on to the producers, the 12-35 percent tax rate on

free-on-board price of coconut oil resulted in a price reduction paid to the

producers of 13-43 percent. REER which depreciated by around 25

percent during 1984 to 1988, significantly benefited the industry.

(v) Fiscal Policy: Transfers from the coconut sector to other sectors of the

economy were substantial and far outweighed the value of all the

subsidies combined. Only about 12 percent of the total tax income from

the producers was returned to them mostly as fertilizer subsidy. Of the

60 loan covenants, one was to ensure a "reasonable price ratio between

fertilizer and coconut prices." But in 1990, the removal of the 50 percent

subsidy on the price of fertilizer had a negative impact on coconut, which

outweighed the benefits of the project.

4. Effect on Economy/Policy: Coconut production did not increase as expected

mainly due to the reduction in fertilizer usage. For example, fertilizer application

resulted in a 40 percent yield increment by 1988 over a three- to five-year periodafter application.

,

G. Loan No , 568-SRI(SF): Community Forestry Project

1. Objective: To support conventional reforestation in the block plantations

program of the Forest Department and to pursue tree cultivation in rural

communities by individual and collective efforts. The Bank's first project in this

sector.






(i) Economic Exogenous: Kerosene is a substitute for fuelwood in Sri

Lanka. Not only is kerosene subsidized, but there also exists a Kerosene

Stamps Scheme for the poor. Therefore, the extent of the subsidy and

the international price of kerosene had an effect on the project.

(ii) Trade and Exchange Rate Policy: Import duty on wood and wood

products (other than fuelwood) was reduced in 1995 from 10 percent to

zero. According to the REER fluctuations, the price of import-competing

commodities would fluctuate.

(iii) Controls: State Timber Corporation, a Government monopoly, harvests,

sets prices, and markets forestry products.

4. Effect on Economy/Policy: The Project has become viable mainly because of

the shift in the trees' end use from fuelwood to higher valued sawlogs.

H. Loan No. 576-SRI(SF): Health and Population Project

1. Objective: To improve the health status of the rural population in eight selected

districts and assist the Government to curb the population growth rate. The

Bank's first project in this sector.


3. Economic factors That Affected the Project

(i) Economic Exogenous: The world prices of health care equipment and

products. (It is not clear whether the price went up or down.)

(ii) Civil Conflict: In Northern and Eastern Provinces, the project could not

be implemented due to the security situation and also the JVP

insurrection in 1987-1988.

(iii) Trade and Exchange Rate Policy: Fluctuations of the REER had effects

on imported medical equipment, vehicles, and other accessories.

(iv) Fiscal Policy: Although no data are available, the maintenance costs of

several health establishments would add to the burden of the budget.

(v) Controls: The Government bears the full cost of public health services,

with some limited cost recovery in the larger hospitals. (The country

provides free health care services to its people.)

4. Effect on Economy/Policy: The establishment of 400 Gramodaya Health

Centers was very positive as health care services were subsequently channeled




through them. There was a large positive effect on policy, but the effect on the

economy was small, and also positive.

I. Loan No. 606-SRI(SF): Livestock Development Project

1. Objective: To improve smallholder dairy, pig, and poultry production so as to

increase food supply and improve rural incomes and employment. The major

focus was dairy production from cattle.



(i) Economic Exogenous: Sri Lanka remains heavily dependent on

commercial imports of milk products, and domestic prices are

significantly influenced by international prices. Imported milk powder

accounted for half of the dairy products. The world price of full creammilk powder demonstrated a secular upward trend where in certain years

it fluctuated by over 20 percent, affecting the domestic price by the same

proportion.

(ii) Civil Conflict: Due to ethnic conflict, the project was not implemented in

the northern area, which is an important area for the livestock industry.

The completion date of the project was also delayed by around two and

a half years mostly due to civil unrest, and $1.63 milliion of the loan

amount was allocated for the rehabilitation of agrarian centers damaged

during the conflict.

(iii) Trade and Exchange Rate Policies: The Government resorted to ad hocchanges in the import duty of milk powder mainly for cost of living

considerations. The import duty was 5 percent in 1983, increased to 15

percent by 1987, brought down to zero in 1988, and increased to 20

percent in 1990. Presently, the import duty of full cream powder is 10

percent. The REER appreciated by about 5 percent from 1983 to 1985,

cheapening imports; depreciated by 25 percent from 1986 to 1988

raising the price of competing imports; and appreciated by 20 percent

during the subsequent period up to 1991. Therefore, the domestic price

fluctuated with the exchange rate and import duty.

(iv) Fiscal Policy: During different periods, various subsidies were given for

pasture, fresh milk producers, and milk processors.

(v) Controls: The Government has been "setting" the producer price for raw

milk by establishing the chilling center price through the Government-

owned milk processor (MILCO) where other milk processors (Nestle)

have to purchase fresh milk at the "set" price. The loan requires the

Government to maintain an adequately attractive buying price for milk

procured under the project. Local milk processors had difficulty in




producing milk powder due to the reduction in import duties of milk

powder and increase in farmgate price of milk.

4. Effect on Economy/Policy The Project has a small and positive effect on the

economy but had a large and negative effect on policy as the loan requires theGovernment to maintain price support for milk procured at an adequately

attractive level.

J. Loan No. 648-SRI(SF): Aquaculture Development Project

1. Objective: To exploit the abundant inland freshwater resources and promote

shrimp culture in brackish water through credit and support schemes.



(i) Economic Exogenous: World price of shrimp (mainly increase) had an

effect on the project.

(ii) Reform Cycles: In mid-1990, the Government made a sudden policy

change to end provision of Government services to all inland fisheries

and to privatize such activity as fingerling production. This resulted in the

termination of most project activities and reduction in production scope.

With the election of the new Government in 1994, the policy change of

1990 was reversed.

(iii) Civil Conflict: Civil conflict had a direct effect on the project. Fingerling

production went down due to the conflict's effect on inland freshwater

fisheries stations. The commissioning of the shrimp hatchery complex

was also delayed because of the disturbance.

(iv) Trade and Exchange Rate Policies: Inputs such as shrimp feed were

exempted from import duty during the later part of the project and a duty

of 10 percent was reintroduced in 1995, which was again removed to

relieve the industry because of the spread of a disease. REER

depreciated from 1984 until 1988 when it started appreciating, hurting

exports until 1991, after which depreciation occurred again.

(v) Controls: Inland fisheries, freshwater stations, and shrimp hatcherycomplexes were state-controlled, but privatized in 1994. There is no

control over the number of small-scale operators and no enforcement of

regulatory measures on the use of common canals for water supply. This

unregulated growth of the industry led to disastrous consequences as an

outbreak of shrimp disease wiped out some of the farms.

4. Effect on Economy/Policy: The impact of the project was overwhelmed by a

policy change, i.e., to privatize activities such as fingerling production. Overalleffect was positive but small.




K. Loan No. 712-SRI(SF): Plantation Sector Project

1. Objective: To increase productivity of the two public sector plantationcorporations-Janatha Estates Development Board (JEDB) and the State

Plantations Corporation (SPC).



(i) Economic Exogenous: Since the 1980s, there has been a downward

trend in world prices for tree crops because of decreasing demand and

increasing production. New competitive market entrants like Kenya has

taken away the market share of tea from traditional exporters like Sri

Lanka.

(ii) Reform Cycles: Due to the nationalization of the estates in the early

1970s, new investments did not take place. Because of inefficient

management, the plantation sector suffered from monopolistic

inefficiencies. Privatization of management took place in 1992.

(iii) Civil Conflict: Insurgency in the south affected most of the project area

and loan utilization during 1986-1990.

(iv) Trade and Exchange Rate Policies: Export taxes were operational until

1992. From the start of the project, the REER depreciated until 1988,

helping exports, and then appreciated to 1991, hurting competitivenessduring the later part of the project.

(v) Fiscal Policy: Subsidies on fertilizer until 1990 substantially lowered the

price of inputs. The fertilizer subsidy was removed in 1990 and

reintroduced in 1994. Cesses on exports were reduced over time.

(vi) Controls: Project investment was restricted to the two state-controlled

corporations, which were operating under a nonmarket orientation. The

two corporations frequently faced political pressures and interferences

mainly in the area of wages where wage increases were not linked to

productivity, market price of the product, or the industry's profitability.

Also, the Government's requirement that the estates provide workers six

days work per week, 25 days work per month, 300 days work per year

had an adverse effect on profitability. Overstaffing was also another

problem. The remedies to the problems that were diagnosed sector-wise

were limited to the two state-controlled corporations. (The privatesmallholders who escaped controls comprise 47 percent for tea, 72

percent for rubber, and 93 percent for coconut by area). Fixing of

minimum prices for green tea leaves, ceilings on individual landholdings,

regulation against termination of services of workers were some of the

other controls that hurt the industry.




4. Effect on Economy/Policy: The impact was limited because the key issue of

inefficiency of the public sector enterprise was not addressed. Privatization of

management under donor pressure in 1992 subsequently improved thesituation. Role of the Bank in this is unclear.

L. Loan No. 732-SRI(SF): Secondary Towns Power Distribution Project

1. Objective: To assist the Government-controlled private sector company Lanka

Electricity Company (Pvt.) Ltd. (LECO) take over, rehabilitate, and expand the

electric power distribution of local authorities and to improve the quality of

supply and reduce system losses.



(i) Economic Exogenous: Depreciation of the dollar affected the project

through imports.

(ii) Trade and Exchange Rate Policy: Appreciating REER in 1981-1984 and

1988-1991 decreased domestic fuel prices. Appreciation of the REER in

other periods increased domestic fuel prices.

(iii) Fiscal Policy: From 1978 through 1992, Sri Lanka's electricity tariffs were

adjusted five times. There were long intervals before tariff adjustments,

followed by large increases.

(iv) Controls: Consumer prices are controlled with the same consumer

electricity tariff schedule for LECO and Ceylon Electricity Board.

4. Effect on Economy/Policy: Effect is not clear, but moving the energy sector

toward a less controlled regime was positive.

M. Loan No. 820-SRI(SF): Agriculture Inputs Program

1. Objective: Loan for fertilizer imports with policy conditions on (i) elimination of

price subsidies for fertilizer by 1990, (ii) reduction in the number of mixed

fertilizer products, (iii) enactment of new fertilizer legislation, and (iv) more

effective cost recovery from irrigation water provided to farmers.



(i) Economic Exogenous: Deteriorating foreign exchange situation in 1986-

1987 (official reserve level dropped to two months of imports) provided

impetus for the project. The world price of fertilizer also had an effect on

the project. The landed cost of imported fertilizer was higher under the



(ii)

(iii)

(iv)

(v)

(vi)

\


Bank program because imports were restricted to Bank member

countries and the cost of fertilizer exceeded the open market price.

Consequently, the National Fertilizer Secretariat was authorized to apply

for a rebate of $5 million per metric ton in payment to counterpart fundswith effect from 12 October 1987.

Reform Cycle: The fertilizer subsidy was eliminated with the support of

the program in 1990, but was reintroduced in 1994.

Civil Conflict: The project was implemented at the height of disturbances

in the south. Such disturbances had an impact on the project.

Trade and Exchange Rate Policy: Fertilizer was imported free of duty

throughout the period. Since 95 percent of the fertilizer used in Sri Lanka

are imported, appreciation of the REER from 1988 through 1991 made

fertilizer imports less expensive. But during the periods when the REERdepreciated, local prices (and subsidy) were high. Importation of fertilizer

was liberalized with more private sector participation.

Fiscal Policy: In 1981, the fertilizer subsidy was 8.2 percent of total

budget expenditure. The percentage dropped to 3.2 in 1983, increased

to 5.3 in 1984, and dropped until its withdrawal in 1990.

Controls: Sri Lanka's leading fertilizer importer and wholesaler was

Ceylon Fertilizer Corporation, which accounted for 73 percent of program

imports. The Government also encouraged private sector participation in

fertilizer sales.

4. Effect on Economy/Policy: The overall effect was small as the pressure for the

removal of the fertilizer subsidy came mainly from other aid agencies,

N. Loan No. 994-SRI(SF): First Agriculture Program Loan

1. Objective: To revitalize the agriculture sector by improving overall productivity

and growth in agriculture, achieving a high degree of self-reliance in rice,

enhancing export earnings from tree and minor export crops, and promoting

agro-industries. Funding was provided to move to a more market-oriented

approach, removing taxes on tree crops, recovering irrigation costs, and

improving extension services. Increase in output was based on greater reliance

on the market.



(i) Economic Exogenous: External conditions for agriculture were relatively

favorable when the agricultural program loan was implemented, but Sri

Lanka later experienced a sharp price increase in agricultural inputs(mainly fertilizer).




(ii) Reform Cycle: Three periods since 1985 are clearly identifiable: 1985-

1987, 1988-1993, and 1994 to present. During 1988-1993, real

agricultural wages rose by 19.4 percent mainly due to a 20 percentadministrative increase in plantation sector wages, Janasaviya Program

in 1989 followed by a new program called Samurdhi in 1995. The

increased growth in the garment sector and the overseas migration of

unskilled laborers, which had escalated since 1989, also put pressure on

the agricultural labor market. Policy reversal took place in 1994 with the

reintroduction of the fertilizer subsidy and also the reactivation of

support-price purchases of paddy by PMB.

(iii) Civil Conflict: Not only the ethnic conflict, but also the disturbances in the

south had an impact on the project. Due to mounting fiscal pressures

(mainly due to the conflict), public investment in agriculture was sharply

reduced.

(iv) Trade and Exchange Rate Policy: Reduction of export duties and

subsequent elimination of export duties in 1992 were helpful and had an

impact on the project. The high and irrational tariff system especially in

the agriculture sector where most of the commodities carried specific

duties did not contribute to the goals of the project. Appreciation of the

REER from 1988 through 1991 made exports less profitable than import

substitution. Imports and distribution of fertilizer were liberalized with

more private sector participation.

(v) Fiscal Policy: The fertilizer subsidy was removed during the project

implementation period, but was reintroduced in 1994 with the arrival ofthe new Government. Due to mounting fiscal pressure, public investment

in agriculture was sharply reduced, from 4.9 percent of GOP in 1985 to

1.1 percent of GOP in 1994, also in part due to debt servicing.

(vi) Monetary Policy: Interest rates remained high throughout the period. The

policy of increasing rural interest rates remained ineffective due to the

persistence of subsidized term lending.

(vii) Controls: Distribution of fertilizer was liberalized, but import licensing in

agricultural products was in place. This had a negative effect on the

project because, to import agricultural seed, one had to obtain a license.

Private sector participation in the rice market increased, but support pricepurchase of paddy by PMB was reactivated.

4. Effect on Economy/Policy: The overall effect on the economy was positive

where more private sector participation and enhanced incentives for export

agriculture reduced the fiscal burden.



29

MOVEMENT OF REAL EFFECTIVE EXCHANGE RATE

Time Period Percentage Changeffect

1977-1979 Depreciation 40

1979-1984 Appreciation 21

1984-1988 Depreciation 26

1988-1986 Appreciation 23

Source: Consultant's Report.

Appendix 4

Documents

Macroeconomic Environment and Project Performance In Sri Lanka