Dissecting the proposed National Policy for Industrial Development of Sri Lanka: Part 2

The ongoing debate on the preferred path for achieving rapid industrial growth in a small country that is unable to influence either the globally traded quantity or the price of a particular tradeable revolves around two schools of thought. One that espouses the merits of an industrialisation strategy that is based on a liberalised economy that is fully integrated with the global economy and the other, which places a premium on self-reliance and focusses on a strategy of import substitution, under the guiding hand of the State

Recent decisions by the Government in response to the spread of COVID, and the severe dearth of foreign currency even for financing the import of essential raw materials required for industry, appear to lead the country slowly but surely to the recreation of the closed economy model that prevailed in the pre- 1977 era

3. THE PATH TO ECONOMIC DEVELOPMENT

 Reference was made in the introductory section of this paper to the close relationship that exists between Industrial and Trade Policy. A liberalised Industrial Policy as proposed cannot co-exist within a restricted and protective trade regime. Trade as a percentage of GDP has come down drastically i.e. from almost 90% in the year 2000, to approx. 40% in 2020. The Government has a clear choice to make. 

The ongoing debate on the preferred path for achieving rapid industrial growth in a small country that is unable to influence either the globally traded quantity or the price of a particular tradeable revolves around two schools of thought. One that espouses the merits of an industrialisation strategy that is based on a liberalised economy that is fully integrated with the global economy and the other, which places a premium on self-reliance and focusses on a strategy of import substitution, under the guiding hand of the State. 

Industrial Policy in Sri Lanka has alternated between these two models depending on which political party was in power. While frequent changes in policy of the kind we have experienced in Sri Lanka brings about a sense of uncertainty and is likely to have discouraged investment in the industrial sector at times in the past, it has unwittingly provided useful information on the performance of the industrial sector as well as the economy under each policy regime. 

The diagnostic study accompanying the NaPID, includes a detailed analysis of the periodic political regime changes that have occurred during the 72-year post-independent history of Sri Lanka, the consequent changes in economic policy, as well as how the economy has reacted to such policy changes. Unfortunately, the above information is in different sections of the report, thereby rendering the cause and effect relationship between one change and the other less transparent. 

In contrast, the results of a similar analysis carried out by Professor Prema-chandra Athukorale (Arndt-Corden Department of Economics Crawford School of Public Policy, Australian National University) published first as a working paper on trade and development for the Australian National University and later as an article in the Daily FT is presented with greater clarity highlighting the causal relationship between one change and the other. 

The research paper of Prema-chandra Athukorale referred to above has dealt extensively with these regime changes and more importantly, the manner in which the economy and the industrial sector had responded to the different policy regimes that prevailed at different times. I cannot do better than summarising his submissions on the changing fortunes of the economy during the different policy regimes.

i. Growth of manufacturing in the Sri Lankan economy was lacklustre during the State-led import substitution era. The average annual growth in the early stages of import substitution era (1990s) was approx. 8.5%, dropping to a mere 3% by 1970-7. 

ii. The manufacturing sector entered a distinct growth phase following the liberalisation reforms. Contrary to gloomy predictions by the critics of reform, the lifting of import controls did not result in a sudden massive contraction. Following initial adjustments to the new the competitive market setting, manufacturing growth surpassed that of all other sectors during most years in the next two decades.

iii. From the 1970s to about the late 90s, manufacturing grew at an annual average growth rate of about 6.5%, compared to an overall GDP growth rate of 5.3%. The manufacturing share of GDP recorded an almost two-fold increase from 10% in the 1970s to nearly 20% by the early 2000s.

iv. There has been a dramatic shift in the ownership structure of the manufacturing sector, during this period. The share of SOEs in manufacturing output dropped from about 70% in the mid-70s to less than 3% by the turn of the century. The shrinking of the role of the SOEs in manufacturing had a salutary effect on productivity improvements in the manufacturing sector.

v. At the time the reforms started, manufacturing accounted for about 10% of total employment in the country. This increased continuously to over 18% by mid 2010s.

vi. The total employment in enterprises approved by the BOI increased from about 11,000 in 1980 increased to nearly half a million by 2015.

vii. The share of foreign invested enterprises in total manufacturing exports increased from 24% in 1977 to 80% in mid-1995. The share of BOI approved enterprises in total manufacturing exports ranged from 80% to 92% during the period 2002 to 2019.

viii. The share of developing countries in world manufacturing exports increased significantly in 1970s and thereafter. From 10% in the 1970s it increased to over 50% by the late 2010s. Sri Lanka’s share of manufacturing exports from that of all developing countries increased from 0.02 % in 1976 to over 0.28% by early 2000s.

Source: ‘Rethinking Sri Lanka’s industrialisation strategy,’ Prema-chandra Athukorale.

The NaPID does a similar analysis of the ups and downs experienced by the sector during the different Policy regimes and concludes as follows:

Quote: 

Learning from the past: Import substitution vs. export-oriented liberalisation. Over the last seven decades, since Sri Lanka claimed independence in 1948 Sri Lanka has experimented with a wide variety of trade policy regimes – from open, ‘non-interventionist,’ free market policies (1948 to 1959/60) through dirigisme import substitution industrialisation (ISI) (1960-1977) to export oriented liberalisation (post-1977). 

There is a large body of literature attempting to make an in-depth and systematic assessment on past trade policies and industrial strategies adopted over the last seven decades. A closer examination of this literature has revealed there are mixed views on which strategic trade policies have delivered desired results. Trade policy regimes adopted by Sri Lanka can be divided into the following two components: 

1. Import substitution or inward-oriented trade policies.

2. Export-oriented or outward-oriented trade policies. 

In theory, these two policy options when put into practice are distinctively different from each other.

1. Import substitution and performance from 1960-1977 

Import substitution, a term both descriptive and prescriptive, is one of the development economics frameworks largely pioneered in the 1950s by economists Raúl Prebisch, Gunnar Myrdal, W. Arthur Lewis, Albert Hirschman, and Ragnar Nurkse. The key policy aspects focus on imports and exchange controls, using tariffs for protection of domestic industries on the basis of infant industry arguments. The key thrust to the strategy was an assumption that replacing imports would reduce dependence on imports and set the stage for self-sustained growth. Thinking that these policies would be beneficial, Sri Lanka pursued a State-led import-substitution development strategy beginning from the 1960s and this foreign trade strategy prevailed in most of the 1970s, making the Sri Lankan economy one of the most restrictive economies until 1977. By the mid-1970s the Sri Lankan economy was one of the most inward-oriented and regulated economies outside the communist bloc, characterised by stringent trade and exchange controls and pervasive state interventions in all areas of economic activity. 

In terms of the performance achieved during this closed economic regime it has been pointed out that Sri Lanka encountered a range of economic setbacks. Inflation, unemployment and poverty were rising; Sri Lanka was facing severe pressure due to a widening trade deficit which emerged in the mid-1970s. The situation in the external sector further worsened.

Immediately after the first oil shock in 1973, to which the government responded by introducing more stringent measures, increasing controls on imports. The unsustainability resulting from these inward-looking protectionist trade and industrialisation policies led to a regime change in 1977, with a landslide victory for, a pro-western, market-oriented right-wing government. 

2. Export-oriented trade liberalisation policies from 1977 to 2003 

As a response to the poor economic performance of inward-looking import substitution policies, in 1977, Sri Lanka embarked on a comprehensive economic liberalisation process, introducing a landmark economic reform package. It became the first country in the South Asian region to introduce a set of policy changes introducing a far-reaching trade liberalisation reform agenda. Accordingly, the first wave of trade reforms implemented during 1977-79 included the replacement of quantitative import restrictions with tariffs and the revision of the tariff system to achieve greater uniformity; the reduction of foreign investment restrictions with new incentives for export-oriented foreign investment under the attractive Free Trade Zone (FTZ) scheme.; financial reform and the adjustment of interest rates supported for exports to grow more positively. In order to further strengthen the outward orientation of the country, Sri Lanka implemented a second trade liberalisation package in 1990. The key elements of this reform package included Government privatisation programs, simplification of the tariff structure with further tariff cuts and removal of restrictions on current account transaction, and several important changes to foreign investment policy. An export-oriented open trade regime dictated the industrial development agenda, which remained in place until the late 1990s. 

An assessment carried out by World Bank in 2004 on Sri Lanka’s economic performance during the reform era stated that ‘It would be hard to find a more convincing case of trade and industrial transformation of a small island economy through market-friendly policy reforms’. By the late 1900s, the Sri Lankan economy was considered as one of the most open economies in the developing world.

End quote. (Sources: Industry Diagnosis Report. Pages 90 and 91).

Recent decisions by the Government in response to the spread of COVID, and the severe dearth of foreign currency even for financing the import of essential raw materials required for industry, appear to lead the country slowly but surely to the recreation of the closed economy model that prevailed in the pre-1977 era. The recently-released ‘State of the Economy 2021’ publication by the Institute of Policy Studies of Sri Lanka, refers to these developments as follows:

“Recently Sri Lanka started to use Restrictive Trade Policy Tools to mitigate the COVID-19 induced foreign exchange crisis. Various forms of quantitative restrictions and Tariff increases were used to discourage imports. For instance, in April 2020 imports of 750 products at eight digit HS code, worth $ 1,353 million at 2019 import prices were suspended temporarily. Additionally, imports of 634 products at eight digit HS code worth $ 3232 million at 2019 import prices were subjected to the requirement of a credit facility of three months.” (Chapter 4 page 67)

The detailed analysis in Chapter 4 clearly demonstrates that import restrictions are not the solution to the problems it is supposed to solve. The analysis which is too lengthy to reproduce here concludes: “Hence inward-looking policies will not solve the forex crisis but aggravate it, resulting in additional costs like domestic monopolies, rent seeking quotas, corruption in granting licenses, encouraging black market and smuggling activities and opening the door to retaliation from trade partners.” (Page 68)

The ‘door to retaliation’ referred to in the final part of the above quote was opened recently as predicted, when the EEC issued a statement that it cannot accept for long, the recent restrictions imposed on imports, from the EU countries too, when the latter keeps assisting exports from Sri Lanka to the EU countries via the GSP + scheme. 

Much of the same empirical and research data referred to above, supporting the view that an export led Industrial Policy together with a liberalised Trade Policy has and will best serve the growth of the industrial sector, is included in the Industry Diagnostic Report accompanying the IaPID. The IaPID however, does not make a categorical statement that an export-led liberalised Trade Policy will be maintained throughout the currency of the proposed policy. What is proposed is a ‘mixed economy’ with selective import substitution, picking of winners and export orientation. 

While specific intervention in support of import substitution projects, exceptionally selected, can be justified for reasons such as those set out on page 9, the extension of State support for winners (euphemistically referred to as  “thrust” industries) picked by committees of whatever composition, is not only a misallocation of State resources, but also a cause of confusion in the market.

(The writer is former Secretary to the Ministry of Industrial Policy, Investment Promotion, and Entrepreneurship development, and former Director/CEO of The National Development Bank of Sri Lanka.)