A new global economic strategy for Sri Lanka

Sri Lanka desperately needs a new global economic strategy, and that is what the Government has promised. But this is not just about dry economics: it must be part of a broader strategy for national renewal. Sri Lanka needs a decisive shift to markets and globalisation. This is going to be a gargantuan challenge. The good news is that Sri Lanka has its most golden opportunity to achieve its long-advertised potential since the victory of the UNP in June 1977. The bad news is that Sri Lankans squandered that opportunity, as they have squandered opportunities before and after since independence. How can this time be different?

What has gone wrong?

What has gone wrong with Sri Lanka in the global economy? Why is its trade and investment performance so under par? 

The decade of Rajapaksa rule is a study in retrogression, despite the end of the war and newfound peace. First, Sri Lanka swung to authoritarian politics; it became an “illiberal democracy”. Second, Sinhala-Buddhist chauvinism got worse, increasing ethnic tensions. Third, foreign policy became unbalanced, with China as “first friend” and deteriorating relations with the West and India. And fourth, the economy was deliberalised in the nationalist spirit of Mahinda Chinthana.

The Government intervened much more in the economy, with a predictable rise in cronyism and corruption. Trade protection increased. The tariff structure became more complicated, especially with cesses (additional duties) on imports and exports. Non-tariff barriers proliferated. Agricultural protectionism soared. One estimate is that import protection effectively doubled during the Rajapaksa years. Regulation of Foreign Direct Investment (FDI) also became more interventionist and opaque, with greater ministerial discretion to grant tax incentives. The Board of Investment was marginalised. 

More widely, a worsening domestic business climate – the result of bewildering ad hoc Government interventions on taxes, permits and sundry regulation – deterred foreign investors and traders. Last, post-war growth has been debt-fuelled and led by the low-productivity public sector, while crowding out private investment from local and foreign sources. It has wreaked havoc with public finances, and left Sri Lanka dangerously exposed to foreign commercial borrowings at a time of volatile capital flows to emerging markets. This type of growth has boosted non-tradable sectors at the expense of higher-productivity tradable sectors. 

So Sri Lanka has deliberalised and deglobalised at the same time. The big numbers tell the story. Sri Lanka is in 99th place in the World Bank’s Doing Business Index – OK by South Asian standards, but terrible by the standards of all but low-income countries in East Asia. Trade (imports and exports) has shrunk to little over 50% of GDP – extraordinarily low for an island of 20 million people. Sri Lanka’s export share in global markets has shrunk to 0.05%. East Asian countries with much larger populations, such as Vietnam, Thailand and South Korea, have trade-to-GDP ratios of more than 100%. Taiwan and Malaysia, with comparably small populations to Sri Lanka, have trade-to-GDP ratios of 140% and 160% respectively. Correspondingly, Sri Lanka receives about $ 1.5 billion annually in FDI – less than 2% of GDP. Again, this is not bad by South Asian standards but pathetic by East Asian standards. Apart from hotel and real-estate projects, FDI has practically dried up. 

The upshot is that, except for garments, Sri Lanka is absent from the global value chains (GVCs) that are key drivers of productivity, employment and growth. 

What has changed since the January presidential election that toppled the Rajapaksas? The authoritarian slide has been arrested, and the country is moving towards political liberalism. Sinhala-Buddhist chauvinism has been tempered, and early moves made to redress the grievances of the minorities, particularly Tamils in the north and east. And foreign policy has been rebalanced, repairing relations with the West and India while attempting not to alienate China. 

But the economy remains a black spot. The Rajapaksas’ illiberal economic policies have not been reversed. On the contrary, the UNP-led Government’s first Budget contained spending giveaways, price controls and other gimmicky interventions. The central bank has printed money freely. Opposition forces united to defeat Rajapaksa, but they had no consensus on market reforms, and lacked a majority in Parliament. Ahead of the Parliamentary election, Wickremesinghe campaigned for big market reforms under the label of a “social market economy”. Now he has a mandate for economic reform – not a decisive one, but a mandate nonetheless.

Pro-market reforms are imperative for sustained growth and prosperity – and to attain key non-economic objectives. Previous bouts of economic collectivism, going back to the 1950s, ruined the economy, destabilised politics, damaged relations with the West, and stoked ethnic conflict. A prospering, globalised market economy is the sturdiest foundation for a genuinely open society – for constitutional liberalism, the rule of law, ethnic peace and balanced international relations. Without it, all else fails. It has to be the Government’s top priority. And Wickremesinghe needs to proceed fast before his window of opportunity closes. 

 

What needs to be done?

A new global economic strategy has to be part of a bigger market reform package. 

Most urgent is macroeconomic stability. Continuing macroeconomic volatility will derail liberalisation attempts, as it has done before. Taxation and expenditure need radical surgery to prevent further public-debt accumulation and make debt financing more sustainable. The printing press must be stopped rather than continuing to fund Government profligacy. 

Second, there should be an overhaul of domestic business regulation – a bonfire of red tape to liberate the private sector. This should focus on product and factor (land, labour and capital) markets. Licensing needs to be simplified radically. Third, education reform is needed to upgrade knowledge and skills, given that Sri Lanka is now a lower middle-income country that cannot compete with cheap labour. Fourth, bloated, loss-making public-sector enterprises should be restructured and downsized. That should include partial or full privatisations, and more reliance on public-private partnerships. And there are other important reforms besides. 

Now turn to a new global economic strategy. The overall objective should be to make Sri Lanka the most open, globalised and competitive economy in South Asia by 2020-2025. By then it should be integrated into GVCs, and be an Indian Ocean hub for trade, investment and foreign talent. This would be a reconnection with Sri Lanka’s ancient history, when its ports – Manthai, Gokanna, and later Colombo and Galle – were magnets for seagoing trade, halfway between the Arabian Gulf and Southeast Asia and on India’s doorstep.

The Government must set key targets to achieve its global economic objectives. These should be ambitious but realistic, with a five-to-10 year timeframe. I suggest five.

• Trade: The trade-to-GDP ratio should at least double to over 100% by 2020-2025. This would take Sri Lanka out of the South Asian second division and into the East Asian first division. Given the connection between exports and imports, especially in GVCs, imports would rise correspondingly. That should be welcomed, not disparaged.
• Export markets: The USA and EU will remain the two key export markets, though with a diversified export basket – not only garments and plantation crops. India should be a much bigger export market, especially the four states of South India with a population of 300 million. Southeast Asia and the Far East, including China, should also be bigger export markets. But the Big Three will remain the EU, USA and India.
• FDI: The FDI-to-GDP ratio should at least double to 4-5% by 2020. Sri Lanka should get about $ 5 billion in inward investment annually. And it should be in manufacturing, assorted services and agro-processing, in addition to hotels and real estate. Sri Lanka should play host to a wide array of multinationals from the USA, Europe, India, ASEAN and the Far East.
• GVCs: Sri Lanka should be embedded in GVCs beyond garments. That will happen if the afore-mentioned trade and FDI targets are achieved. Multinationals with export operations will occupy manufacturing niches. But I do not expect a manufacturing take-off, since Sri Lanka lacks a labour-cost advantage (for labour-intensive production) and lags behind East Asian countries in education, skills and connectivity (for mid-value production). Rather the greater promise lies in services. ICT services should expand, though its potential is limited by Sri Lanka’s small skill pool. But the biggest prize is for Sri Lanka – Colombo in particular – to become a logistics hub. This would be centred on the port and perhaps the airport, with feed-in from a cluster of transport, financial and business services. These GVC niches depend critically on Sri Lanka linking up with value chains in South India. 
• Domestic competitiveness: Attracting international trade and FDI depends as much on improving the domestic business climate as it does on trade and investment policies in the narrow sense. Sri Lanka should be in the top 50 of the World Bank’s Doing Business Index by 2020. A domestic deregulation agenda should be geared to that end. Corresponding targets should be set for other global scorecards that foreign investors track keenly, such as Trading Across Borders (a Doing Business sub-index), the World Bank’s Logistics Performance Index, the World Economic Forum’s Global Competitiveness Index and its Enabling Trade Index, and the Simon Fraser Institute’s Economic Freedom of the World Index.

Overall, these targets should be aimed at lifting Sri Lanka out of a South Asian bracket and into an East Asian bracket of comparison, especially with foreign traders and investors in mind. Hence Sri Lanka should benchmark itself against middle and upper-income East Asian countries. That is where most of the relevant best-practice examples lie. I would add one other benchmark: the five best-performing states in India, including Tamil Nadu and Gujarat. They are the locus of India’s economic reforms and its globalisation. Sri Lanka should track these states carefully.

 

How to do it?

Let’s move to concrete measures to meet economic targets. The watchword should be: KEEP IT SIMPLE. The measures needed are not rocket science; they should not be overcomplicated. The mantra should be: Deregulate as much as possible to expand individuals’ economic freedom and unleash the animal spirits of entrepreneurs. And simplify rules of the game for market actors. “Getting the basics right” – prudent fiscal and monetary policies, a stable exchange rate, domestic competition, openness to trade and foreign investment, improving education, skills and infrastructure – is the essence of the East Asian Miracle. That is what Sri Lanka should emulate. And simplicity is as important as anything else.

 

Trade

There should be a bonfire of cesses and non-tariff barriers on imports and exports as soon as possible. Exports should face no restrictions except on narrow national-security grounds. Import protection should be confined to ad valorem tariffs. But the tariff structure needs to be simplified radically, and average nominal tariff protection more than halved. Sri Lanka should move to a uniform tariff of 5% on industrial goods by 2020. All other industrial goods should enter duty-free. This is what Chile did, with spectacular results. 

Why a modest uniform tariff? First, it is the best way of removing distortions, including corruption, arising from different tariffs on different products and at different stages of production. It has the cardinal virtue of simplicity. And second, East Asian trade-weighted import tariffs average 5% or less – which is where Sri Lanka should be. 

The obvious objection to tariff-slashing is that the Government would lose much-needed revenue. That is why tariff cuts should be accompanied by tax reform, so that more revenue is raised from domestic taxes, preferably a simple consumption tax. Furthermore, evidence from other countries shows that revenue loss is minimised because simple, low tariffs increase trade volumes and provide the incentive for previously illicit trade to become licit. In many instances, the effect is to increase, not decrease, revenues.

Sadly, it is politically impossible to reduce agricultural protectionism in the same way. But the Government should move to reduce it gradually. Import protection, price controls and subsidies to agriculture condemn a large percentage of the population to living in a low-productivity welfare trap, while forcing up taxes and consumer prices.

Finally, Customs administration needs to be simplified radically to reduce paperwork, delays at the border and corruption. Studies show these trade costs are higher than tariffs. “Automation” and “automaticity” should be the watchwords. Many customs procedures could be put online, with more automatic approval procedures. Where checking is required, there should be tight deadlines for inspection and approval. There are several best-practice models that Sri Lanka could follow, including APEC’s Single Window procedure.

 

FDI

Sri Lanka has a fairly liberal regime on inward investment by developing-country standards. Full foreign ownership and non-discriminatory treatment are allowed in many sectors. But the Government should go further. All sectors should be fully open except for a short negative list. 

That leaves the question of tax incentives and the role of the Board of Investment. Tax holidays have dominated investment policy since the economy was opened up in the late 1970s. The results have disappointed. Indeed, tax incentives have probably done more harm than good. 

Investment policy needs a thorough reorientation. There should be much less emphasis on tax incentives. They should be simplified, with less room for the bureaucratic and political discretion that invites delays and corruption. Where investment policy can add value is by providing the foreign investor with a genuine “one-stop-shop” – a statutory agency that advertises Sri Lanka as an investment destination abroad, and deals with paperwork and approvals so that the investor’s path to operating a local business is smooth and seamless. That should be the BOI’s central function, rather than dishing out incentives as a “one-more-stop-shop” among the thicket of ministries and agencies the investor has to deal with. 

 

Trade negotiations

All measures recommended above should be implemented unilaterally, not, in the first instance, through trade negotiations. I call this the Nike strategy: “Just Do It!” This will benefit Sri Lanka by signalling it is wide open for business. It will lose precious time and benefits if it delays liberalisation in order to extract concessions from negotiating partners. 

International trade agreements, however, can be a helpful auxiliary to unilateral liberalisation. If done well, they lock in and extend domestic reforms, as well as open export markets. But they should never be seen as a substitute for unilateral reforms. So what should be Sri Lanka’s trade-negotiations strategy? It should be ambitious but realistic. Let’s look first at FTAs.

nIndia: The Government should aim to complete the Indo-Lanka CEPA as soon as possible, and be ambitious about market-opening on both sides. But India is generally protectionist, and the CEPA will inevitably be partial, with lots of exemptions and loopholes. Like other Indian FTAs, it will be “trade-light” by international standards.

• USA and TPP: The Government should aim for an FTA with the USA. This should be its top priority for trade negotiations. Why? Because the USA is Sri Lanka’s second biggest export market; it is and will remain the most innovative economy in the world; it is home to the world’s best multinationals who can integrate Sri Lanka into GVCs, particularly in services; and, geopolitically, it would cement an alliance with the world’s only superpower and “balancing power” in Asia, which is also a civilised liberal democracy. Also, US FTAs, unlike Asian FTAs, are serious: they are comprehensive and deep. They demand substantial liberalisation in goods, services, investment and public procurement, underpinned by strong disciplines and enforced by strong dispute-settlement procedures. Unlike FTAs with China, India and other Asian partners, an FTA with the USA would spur domestic market reforms and expand competition in the economy, in addition to gaining extra access to the US market. But negotiating an FTA with the USA is usually excruciating and often induces a domestic political backlash. So it is important to do a careful cost-benefit analysis before proceeding. However, there may be no need to negotiate a bilateral FTA with the USA. It and 10 other Asia-Pacific countries are in the final stages of negotiating the Trans-Pacific Partnership (TPP), intended to be an ambitious FTA covering 40% of the world economy. If and when the TPP is concluded, Sri Lanka should consider lodging an application to join it. 

That would obviate bilateral FTAs with other potentially important trading partners such as Japan, Australia, Malaysia and Singapore. And it would be a great signal to foreign investors: Sri Lanka would be the first South Asian country in the TPP.

• EU: The Government should aim for an FTA with the EU as well. EU FTAs are relatively strong, though not as strong as US FTAs. The EU has a long-stalled FTA negotiation with India, so an EU-Lanka FTA could be the EU’s first in South Asia.
• China: The Government should complete the China-Lanka FTA. But this will be trade-light, like China’s other FTAs.
• Prioritisation: It is imperative the Government does not agree to FTA negotiations with all and sundry. Rather its priorities should be India, the USA (ideally via the TPP) and EU. For one thing, Sri Lanka has hardly any trade-negotiating capacity. It will have to be built up virtually from scratch; and it will have more than enough on its plate with India, TPP, the EU and China.
• WTO: The Doha Round has been stalled for many years, and action on trade negotiations shifted to FTAs over a decade ago. But a multilateral rules-based trading system is still important, especially for small economies like Sri Lanka. So Sri Lanka should re-engage, only this time with a different strategy. It should break ranks with India and other Third World foot draggers, and join forces with the OECD and emerging-market countries (like Chile, Colombia, Costa Rica, Singapore and Hong Kong) that favour liberalisation and pro-market rules. In this spirit, Sri Lanka should join the Information Technology Agreement, which has zero tariffs on IT goods, as well as the plurilateral TISA negotiations to liberalise trade in services.
• Process issues: Having the right ideas and policies is one thing. But, ultimately, success depends on effective implementation. The national unity Government’s monstrously large Cabinet does not augur well. No serious country has a Cabinet of almost fifty ministers. On the other hand, it was the right decision to create a new Ministry of International Trade and Investment, and to have a senior figure enjoying the Prime Minister’s full confidence at its helm. Trade and FDI are joined at the hip in today’s world of GVCs, so they should be housed in a single ministry. All relevant statutory boards such as the BOI and EDB should come under this ministry. 

The politics of trade and other economic reforms will be extremely difficult. Ultimately, reforms depend on Wickremesinghe – Sri Lanka’s only senior politician who gets the case for markets and globalisation – and a handful of clean, competent professionals in his inner circle. It is vital they control the major reform areas. The danger is that a large, unwieldy national unity Government, full of old-style populist politicians, will dilute and slow down reforms, thereby perpetuating Sri Lanka’s pattern of squandering heaven-sent opportunities.

Conclusion: a plea for 

economic liberalism

Economic collectivism is the central source of Sri Lanka’s post-independence failure. It has bred too much politics at all levels of society. It has metastasised a political class that has served the country so disastrously since independence. Political connections are needed to get even the most basic things done – fine for the rich and influential, but terrible for everyone else, particularly the poor and excluded. 

Very few Sri Lankan politicians, intellectuals and even businesspeople understand the damage done by collectivist policies and the importance of economic freedom. There is a growing constituency for liberalism in politics, but still a tiny one for economic liberalism. But what Sri Lankans need most is economic freedom – the freedom to produce and consume goods and services. This is the kind of freedom that affects ordinary people’s daily lives most. That demands better rules of the game for markets and competition, and much less room for politicians to control people’s livelihoods. 

This is what Adam Smith had in mind when he called for “natural liberty, upon the liberal plan of freedom, equality and justice” almost two-and-a-half centuries ago. In his Wealth of Nations, he conceived of government as an effective umpire, policing the rule-framework of a free market economy. He assailed governments that were also players in the market, distorting the game and compromising their umpiring role. As the German sociologist Alexander Rüstow put it, the state should be “small but strong”, performing its legitimate limited functions well. But the modern state has become “big and weak”, intervening badly left, right and centre while neglecting its core functions.

A new global economic strategy for Sri Lanka should be seen in this frame. It should be part of a bigger agenda to limit the state and expand economic freedom. Without greater economic freedom, Sri Lanka will never achieve its potential for prosperity with political stability, the rule of law and ethnic harmony.