What is Wrong With the Sri Lankan Economy?AND HOW TO FIX IT

DESHAL DE MEL

Outline Debt – Fiscal Failings and Macroeconomic Imbalances

Big Government – Crowding Out

Uncompetitive Sectors

Trade

Education

Till Debt Do Us PartMost urgent risk to the SL economy is debt sustainability – particularly external debt.

Legacy of access to long term concessional debt – easy to manage repayments

Enabled the build up of a large government sector and cumulative debt burden

Post 2007 requirement to tap into global capital markets due to less access to concessional borrowings

Shorter repayment tenors and higher rates of interest – makes it essential to channel borrowings into remunerative investments

Dynamic financing environment but rigid – if not deteriorating – expenditure structures.

CBSL weekly economic indicators – July 22nd 2016 http://www.cbsl.gov.lk/pics_n_docs/_cei/_docs/ei/wei_20160722.pdf

Short Term Payment Stresses

Macroeconomic Imbalances Continuous high deficits and cumulative public debt has been one of the driving factors behind macroeconomic volatility in SL – adversely affecting the investment climate.

High government borrowing levels influences higher interest rates, crowding out private investment.

Recent Balance of Payments weakness has been largely influenced by external debt repayments with implications for LKR depreciation.

At other times fiscal expansion drives imports, contributing toBalance of Payments stress and LKR depreciation.

Episodes of inflation in the past influenced by Central Bankaccommodative monetary policy to ease government debtservicing.

Financing deficit requires high levels of indirect taxation – affects consumer freedom, high import taxes restrictdomestic competition.

Fixing the Fiscal Weakness in revenue along with misallocated publicexpenditure.

Revenue has improved in H1 2016 but sustainedimprovement needs a shift to direct taxes from regressiveindirect taxes.

Better use of information systems, simplification of taxes and returns – minimizing room for discretion in combination with heavier penalties, rationalization of tax holidays.

Expenditure – public sector of this scale is no longer affordable, more effective targeting of transfers and subsidies, rationalization of SOEs (outstanding SOE debt to banks is LKR 757 billion – that is equivalent to 4x GoSL expenditure on health services in 2015).

Compromises – Use of KPIs/performance linked pay in the public sector, better use of means testing in transfers/subsidies, SOEs can be addressed through management and limited divestment eg. SLT

Fairly well understood set of problems – political economy gets in the way due to politicized nature of public sector employment, subsidies, and ownership of state assets.

Big Government – Crowding Out Good economics is the allocation of resources (land, labour, capital) to their most productive use. Higher levels of productivity equates to higher output per unit of resource input – and thus higher returns (rent, income, interest) per unit of input – leading to higher aggregate wealth.

A large government sector is not just fiscally unaffordable – it is also a large consumer of scarce economic resources.

The state sector accounts for about 17% of the total labour force. There are approximately 245 state owned business enterprises – all consuming economic resources including over 220,000 staff. The state also owns large quantums of land.

Most private enterprises face worker shortages – state consumption of labour resources hinders this.

Ideally – the role of government should be to create an environment for private enterprise to compete to allocate scarce resources to its most productive use – the state should create a rules based framework for this and provide infrastructure that would be under-provided by the market.

This is not to say that markets are perfect. Markets fail under many circumstances - externalities, imperfect information, unfair competition. It is the government’s role to intervene in situations of market failure – not by replacing the market but by addressing the failure through smart, unobtrusive regulation.

The government also has a role in intervention to address social justice issues – particularly where unequal opportunities lead to inequitable distribution of wealth.

Uncompetitive Sectors: When Protection Isn’t Always Smart

In addition to significant resources being tied up in the government sector – there are also a lot resources “trapped” in economically unproductive sectors.

The agriculture sector accounts for approximately 30% of the labour force (including seasonal part time workers) but only around 9% of GDP – indicating poor productivity and poor returns to labour (income).

High levels of taxation on imported agriculture, along with guaranteed prices on several agricultural products ensures that resources remain tied up in sectors in which Sri Lanka does not necessarily have a competitive advantage. This also results in higher prices for domestic consumers.

Whilst these measures are meant to “protect” Sri Lanka’s farmers – in effect it keeps farmers in unproductive, low income activities. There is significant value to be drawn by tapping into global value chains in higher value agricultural products - but agricultural lands and resources are tied up in lower value domestic market oriented agriculture.

The same principle applies for several domestic industries which enjoy significant protection from imports and are thus not exposed to competition – this keeps prices high, reduces incentives to innovate and provide better goods/services to consumers, and prevents optimal resource allocation.

Removing such protection is challenging due to political economy issues, lobbying, and revenue impacts of tariff reduction. It is also not feasible unless jobs are created in alternative areas.

Wither Trade Being a small island economy with a population of 20 mn and market size of US$ 82 bn – sustained economic growth necessarily requires expansion into global markets.

However – Sri Lanka’s export (goods) intensity has declined from 33% of GDP in 1990 to 12% of GDP in 2015.

The drivers of economic growth in post-war Sri Lanka have largely been domestic industry oriented sectors such as construction, domestic trading, finance, Transportation – these sectors have accounted for around 60% of the increase in post war GDP.

Exports meanwhile have remained modest and continue to be characterised by narrow product base (apparel and tea still account for 60% of export earnings) and weak market diversification (55% of exports are to the US and EU).

Limited sectors of global competitiveness – no longer a destination for cost arbitrage and also poor on productivity and technological sophistication of exports.

Global Competitive Index 2015, WEF World Bank data

Location, Location, Location Sri Lanka finds it difficult to compete on price with countries like Bangladesh and Viet Nam but also can not compete with Thailand, Malaysia etc. on productivity/technology.

The best short cut to leap frogging into new products, markets, and technology is by attracting export oriented FDI.

Until recently SL has received disappointing levels of FDI post war – around 1% of GDP per annum. That too dominated by tourism, condominiums, and domestic services. Very little FDI has gone into export oriented manufacturing/agriculture.

A lack of policy consistency, conflicting messaging, barriers in access to land/approvals etc continue to deter investment.

Location is SL’s greatest comparative advantage and can be leveraged to attract industries and services seeking nimble logistical access to markets in the Indian subcontinent.

It is necessary to take a pro-active approach to FDI – eg. targeting multinationals with operations in the Southern states of India and identifying segments of their value chain that can be carried out in Sri Lanka and making the case to relocate these operations.

We Don’t Need No Education Sri Lanka needs to play in the higher value segments of the global value chain – also moving beyond manufacturing – backward in the value chain (design, product development, R&D) and forward (packaging, branding etc.)

The challenge in reaching into these segments is that it requires a higher level of skill. And in spite of Sri Lanka’s strong history in creating access to basic education – at higher levels, educational outcomes fall well short of expectations of the global market place.

Sri Lanka has failed to invest in ensuring quality of education, particularly at secondary and tertiary levels as indicative in educational outcomes – particularly in sciences. The education system continues to be examination centric and fails to inculcate the skills needed in today’s innovation driven working culture – creativity, problem solving, analytics. With limited space in public universities – it becomes all the more important to develop a better balancebetween private delivery of education and public sector education. This would help create competition, and add supply capacity.

Sri Lanka also has very weak labour force participation at 54%. This is particularly pronounced among females at 35%. Steps can betaken to enhance this by improving flexibility of working hours,subsidizing maternal leave pay, popularizing work from home options,investment in pre-school facilities. Source: Ministry of Education 2014 AL

What to do? 1) Rationalisation of recurrent government expenditure – cutting back on cadre, targeting of transfers and subsidies, management and ownership of SOEs.

2) Enhance government revenue – shift towards more direct taxes by better use of information, simplification of taxes and returns to minimize room for discretion, rationalize tax holidays.

3) Re-orient the role of government to one that focuses on addressing market failure through smart, unobtrusive regulation, rather than one that attempts to replace the market by fixing prices and engaging in business.

4) Rebalance the supply of education to enable more private participation to create competition, enable better supply, thus freeing up resources to invest more meaningfully in state education to improve curriculums to meet the requirements of a modern market.

5) Proactively approach export oriented FDI – 1) companies based in South India that could operate part of value chain in SL using logistics advantage 2) companies needing quick logistical channels into Indian sub-continent (eg. FMCG)

6) Gradually ease out of excessive domestic protection in agriculture and industry once linked with such export value chains.

“We all know what to do. We just don’t know how to get re-elected after we do it.” - Jean Claude Juncker, Ex – EU Commissioner.