Tuesday, June 10, 2014

Can Sri Lanka build a prosperous post-war future?

After decades of low growth and stifled economic progress because of the debilitating conflict, the Sri Lankan economy has demonstrated impressive post-war progress. 2010–13 GDP growth has averaged 7 per cent, and is likely to exceed that in 2014. Poverty rates have fallen sharply (from around 20 per cent in 2000 to under 9 per cent in 2013) and greater price stability has been achieved (from inflation at over 20 per cent in 2008 to between 5–10 per cent in 2012 and 2013). Sri Lanka’s private sector is bullish, and has successfully tapped international capital markets with its sovereign bonds, at yields that would be the envy of many debt-ridden European countries.

Public infrastructure projects have occupied much of the attention of post-war economic planning, with several new projects — including two ports, an airport, a power plant, and three expressways—coming to fruition after years of delay.

As a small economy just getting back to vibrancy after being stifled for decades, where is the financing for this impressive hardware push coming from? The answer: China, mostly.

Most projects have been fully or partially financed through Chinese government loans (and some by Chinese companies). China has now emerged as the number-one lender to Sri Lanka, accounting for as much as one-fourth of all donor commitments.

The Chinese presence is also quickly moving beyond loans for development projects, with Chinese companies (typically state-owned ones) becoming the leading foreign investors recently. Last year, China became the largest source of FDI into Sri Lanka.

Political and business ties are increasing rapidly, and Sri Lanka is due to sign an FTA with China this year, although very little is known about its possible terms. Chinese state-linked companies are investing in hotels, a golf course, an iconic telecommunications tower, and mixed-purpose real estate developments. The Colombo Port City is the latest project, one for which the Chinese developer is getting a 25-year tax concession for developing waterfront real estate.

If there is one noticeable trend in Sri Lanka’s post-war FDI trend, it is that the majority of investments have been in projects related to real estate (including mixed-use property development) and tourism. In contrast, there has not been a substantial flow of FDI into industrial activities. More generally, too, manufacturing has taken a backseat in Sri Lanka’s recent economic performance. Much of it has stemmed from the growth in domestic non-tradables like construction and wholesale and retail trade, while manufacturing’s share of GDP has remained stagnant at around 17 per cent, and nearly 60 per cent of Sri Lanka’s GDP now comes from the services sector, especially the nascent IT and software services industry, which has expanded domestically and begun to win lucrative niches abroad. Between 2007 and 2013 exports tripled to US$600 million, and employment and the number of companies doubled.

In the manufacturing sector it appears that both domestic and foreign investors are unsure of Sri Lanka’s prospects. Although manufactured exports like apparels, rubber products and the like, have shown resilience and indeed made impressive global inroads through innovation and value addition, Sri Lanka’s middle-income transition is bringing up new challenges.

With rising wage and other input costs, Sri Lanka can no longer compete at the lower end of the spectrum. Yet it is also struggling to move higher up the spectrum, with limited capacity for innovation and upgrading technology. This is shown by the continued low investment in R&D (less than 0.2 per cent of GDP, and of that less than 10 per cent is by the private sector) and a very narrow talent pool of knowledge workers (less than 15 per cent of all state university graduates are in science and engineering, and only one in ten schools teaches high school science).

Education continues to be a critical constraint in Sri Lanka’s forward-and-upward march, particularly higher education. State institutions are unable to meet the demand (around 140,000 students who qualify to enter annually have to be shut out) and long-overdue reforms to permit private investment in higher education were introduced and then rolled back amidst political pressures from vested interest groups.

The type of FDI Sri Lanka desperately needs is one that produces technology spillovers and links Sri Lanka to new markets abroad. And a broader talent pool with skills beyond basic education will be essential to Sri Lanka’s destination attractiveness.

Of course, skills will not be the sole determining factor. A consistent and favourable policy environment matters. While policies to ensure a stable and creditable macroeconomic performance post-war have been encouraging for investors, some policies on private sector development have sent wrong signals and got investors worried. Examples include a controversial bill that expropriated 37 private enterprises (thinly guised as an act to ‘revive underperforming and underutilized assets’); the forced closure and relocation of a high-performing rubber gloves exporter’s factory (owned by a leading blue-chip company) due to misplaced public protests and a misguided government response to it; ongoing moves to ban the sale of land to foreign ownership; and the imposition of very high tax requirements on foreigners leasing land, creating significant disincentives for foreign investment.

Amidst all of this, Sri Lanka’s transition from low income to lower-middle and subsequently upper-middle income (government projects GDP per capita exceeding US$4000 by 2016) is bringing with it new challenges that aren’t easily addressed.

The aspirations of Sri Lanka’s people are changing, and catering to those desires, particularly in the growing urban class, will be a key medium-term economic and political challenge for the government. In the south, attitudes towards types of jobs are changing. The continued growth of migrant worker remittances is putting cash into the hands of people at the lowest social level and, along with a fall in import duties, has resulted in a rise in ownership of consumer durables like TVs and refrigerators. In the conflict-affected north and east, basic needs are fast being fulfilled — like reconstruction of roads and bridges, expanded electricity access to homes, and kids getting back to steady schooling.

As these needs are met, people’s aspirations of greater political rights and freedoms and the desire to determine their own development path not imposed by the centre will come strongly to the fore. The rejection of the ruling UPFA and resounding victory of the Tamil National Alliance in the recent Northern Provincial Council elections is one manifestation of this. The next round of provincial council elections, set for late March 2014, is likely to be a test bed for the ruling party before it calls national elections well ahead of schedule.

Beyond this, however, two major imperatives are likely to continue to occupy the attention of Sri Lanka’s highest decision-makers. On the one hand, a ruthless focus on consolidating power at the centre, navigating growing international pressures on human rights issues, and preserving post-war popularity among the government’s primary vote base — the Sinhala Buddhist majority; on the other hand, delivering the promised high post-war economic growth, undertaking critical growth-boosting reforms, and meeting the fast-evolving socio-economic aspirations of people across the country. Whether the relentless preoccupation with the former will distract effort from the latter will be a critical determinant of whether Sri Lanka builds on the post-war gains and transitions towards a prosperous future.

Anushka Wijesinha is Research Economist at the Institute of Policy Studies of Sri Lanka and editor of its contemporary issues blog Talking Economics at www.ips.lk/talkingeconomics. He was recently appointed ‘Special Advisor on Industrial Policy’ to Sri Lanka’s Minister of Industry and Commerce.

This article appeared in the most recent edition of the East Asia Forum Quarterly,‘On the edge in Asia’.


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