FDI: Not a strategy to be downplayed

An interesting open forum was held last week in Colombo on ‘Foreign Direct Investment for Growth and Equity in Sri Lanka’ under the patronage of the Sri Lanka Economic Association or SLEA and Germany’s Friedrich Ebert Stiftung. The Session Chair, Professor A.D.V.de S Indraratna, SLEA’s Chairman, opened the forum highlighting the country’s current development needs and the importance of using foreign direct investments or FDIs in filling the wide savings – investment gap in the country.

This was followed by brief presentations by three distinguished panellists, namely, Dr. Anura Ekanayake, Chairman, Ceylon Chamber of Commerce, Dr. Sarath Rajapatirana, former Economic Advisor of the World Bank and Professor Anoma Abhayaratne, Dean of the Faulty of Arts of the University of Peradeniya.

Anura Ekanayake, taking a broader view of the subject, highlighted the importance of investments in general for development refraining from calling FDIs the saviour of the country today. His stand was that local investments are as equally important as FDIs and therefore, the country’s policy package promoting investments should cover both. However, he cautioned that the local investments, while supplying the local market, should target to capture foreign markets too and for this purpose it is necessary for local investors to team up with foreign investors.

Sarath Rajapatirana, while agreeing with Anura, said that the most important contribution which FDIs could make to Sri Lanka was helping the country to acquire advanced technology and foreign markets. He also emphasised that Sri Lanka should now free itself from ‘cheap labour supply syndrome’ and ‘tax concession syndrome’ because it is the high tech and high brain – power industries that are moving into the emerging economies today. The shifting of industries on the ground of cheap labour to developing countries is now a thing in the past. Hence, it is necessary to upgrade the quality of the country’s labour force to facilitate the use of the high technology that comes along with FDIs.

Anoma Abhayaratne, in her presentation, examined the global direction of FDIs and found countries like USA, China, and India were receiving the lion’s share of FDIs. Sri Lanka’s performance in this respect has been woefully inadequate. Even according to the future projections, it is these three countries which have been lined up as the biggest recipients of global FDI flows.

In my view, the attractiveness of FDIs in Sri Lanka’s current economic strategies comes from a different policy issue. That policy issue is the need for keeping foreign commercial borrowings at a minimal level and avoid a future debt crisis.

Low FDIs and High Commercial Borrowings

Sri Lanka’s past experience in FDIs has been disappointing despite the massive incentive package offered by the country to foreign investors. The main ingredients of this incentive package were the generous tax holidays, supply of the needed infrastructure facilities and freeing the FDI enterprises registered with the Board of Investments from the country’s normal stringent labour laws. Yet, the country could attract only a few hundred million dollars as FDI inflows annually when other countries of comparable size were counting them in billions.  

One reason attributed to this poor performance was the uncertainty created by the disastrous internecine war that had plagued the country till mid 2009.

Now the war is over but the FDI flows have not shown a visible improvement as revealed by its poor performance in 2010. In that year, the country attracted only $ 475 million as FDIs.

Dr. Mahathir’s advice: Slow on debt and faster on FDIs

 The low FDI rate attained by Sri Lanka has compelled the policy makers to use external borrowings liberally for financing the country’s widening current account deficit in the balance of payments.

 Initially, these borrowings were from concessionary sources like the Asian Development Bank, International Development Association and some of the bilateral donors in the West.

However, with Sri Lanka’s move toward graduating from low income country to lower middle income country in the new millennium (this move culminated in early 2010), these concessionary funding sources have begun to dry up forcing Sri Lanka to tap the high cost commercial markets for acquiring the needed funding resources.

Accordingly, non – concessionary foreign loan stock in the total foreign loan stock owed by the Sri Lankan Government rose from 8 percent in 2006 to 38 percent in 2010. This is not a salutary development at all.

Noting the onset of this unfavourable development, Dr. Mahathir Mohamed, former Prime Minister of Malaysia and architect of its economic miracle, gave a fine piece of advice to Sri Lanka when he met the press after a three day visit to the country in June 2010: go slow on debt and faster on FDIs.

Why FDIs?

The rationale behind this advice is clear enough. Sri Lanka’s foreign debt is already at unmanageable levels rising from 37 percent of GDP in 2008 to 43 percent in 2010, though it has come down to that level from a peak of 74 percent in 1989. The country has not defaulted any foreign loan so far, but its fragile foreign reserve base consisting largely of short term borrowed funds poses a great deal of risk of default in the short to medium term. The government’s planned borrowing of a further US $ 1000 million from international markets in 2011 and other foreign commercial borrowings from friendly countries for capital projects already started or in the pipeline will add more to the country’s debt stock instead of reducing it. FDIs on the other hand are a non-debt source and will help Sri Lanka to acquire the much needed technology, better production techniques, markets, improved management practices and an easy gateway to the rest of the world.

Colonial Era: Large Scale FDIs and minor Scale Prudent Market Borrowings

There were massive investments in roads, transport systems, town developments and new economic enterprises in Sri Lanka during the colonial era. Yet, the bulk of this resource requirement was met through FDIs. According to the late Mr. N.U Jayawardena (NUJ) who wrote a seminal paper in 1934 titled ‘Development of

Ceylon’s Trade Since 1834 – From the Coffee Bubble to the latest Depression’, the resources needed for investment during the early 19th century were brought in physical form, namely, bullion and specie (or coins), by the daring entrepreneurs at that time. NUJ calls them coffee prospectors similar to the gold prospectors in 19th Century California and remarks that ‘vast sums of money were released for expenditure by (these) prospectors’. The result was the development of a vibrant plantation industry, with ups and downs from time to time, in the country. According to Professor B. Bastiampillai who submitted a thesis on ‘The Administration of Sir William Gregory 1872 - 1877’ to the University of London for M.A Degree, the Colombo Port was developed during Sir Gregory’s time on a loan from the British Treasury amounting to Sterling 250,000 and a market borrowing of Sterling 380,000. Professor Indrani Munasinghe in her ‘Colonial Economy on Track’ (her PhD Thesis submitted to the University of London) says that the country’s railway system was built during the colonial time by raising loans from time to time in the London capital market. On all these occasions when borrowings were made, the Secretary of State had not approved of them until the relevant borrowing units of the government came up with viable plans to repay the loans in a bid to ensure proper repayment and effective use of the funds.

Thus, borrowings were used by colonial rulers as sparingly as possible. This was shown by the low level of foreign borrowings of the country at the time of independence which amounted to about 4 percent of GDP.

Post – Independence Era: High foreign debt dependency

The fiscal prudence which the colonial rulers maintained so laboriously during the colonial time underwent ‘a 180 degree turn’ after independence. The country’s new rulers were guided by the desire to attain quick prosperity through a ‘big push’ of the economy, a development model which had gained popularity at that time. They were also ideologically strengthened by the then popular Keynesian economics which advocated deficit financing as a desirable strategy for accelerating economic growth. To make it a reality, an enormous amount of resources had to be invested in physical as well as human infrastructure. But the nation lacked domestically generated savings to finance such expenditure programmes on account of high consumption levels. The average savings during the first two decades after independence amounted to about 12 percent of GDP, while investments amounted to about 18 percent of GDP. The terms of trade were unfavourable to Sri Lanka, meaning that the country had to sacrifice more than one unit of exports to bring in one unit of imports to the country. The current account of the Balance of Payments was eternally in deficit except in the rubber boom years of the early 1950s. Consequently, with no adequate domestic savings, the country did not have a choice except resorting to foreign borrowings.

The liberal use of Concessionary Funding

Thus, Sri Lanka went for foreign borrowings in a big way and they were facilitated by the availability of multilateral and bilateral concessionary funding during the first five decades after independence. Foreign debt component as a percent of GDP amounted to mere 3 percent in 1950. But it rose slowly and steadily to 18 percent by 1970, 41 percent by 1980 and 72 percent by 1990. Thereafter, there was a decline in foreign borrowings as a percent of GDP, but it did not mean that the country had reduced its total public debt levels. The decline in foreign borrowing ratio was simply replaced by domestic borrowings which rose from 42 percent of GDP in 1990 to 54 percent in 2000.

 Increased reliance on Commercial Borrowings

In the first decade of the new millennium, Sri Lanka’s per capita income crossed the $ 1000 threshold, elevating the country from a low income one to a lower middle income one. It also resulted in the country’s losing its access to concessionary funding, thereby forcing it to tap commercial markets. The result was the gradual increase in the non – concessionary and commercial loans in the total foreign borrowings of the government: in 2005, they accounted for 4 percent of total foreign borrowings; by 2009, the share went up to 28 percent and in 2010, they peaked 38 percent.

Ills of Commercial Borrowings

Commercial lenders do not try to impose conditions on the borrowers, especially those relating to economic reforms and human rights. The negotiations on such borrowings could also be completed in a shorter period than concessionary borrowings. Money is also available promptly for the borrower to use for any budgetary purpose. Hence, many governments have found commercial borrowings more palatable than concessionary borrowings.

Yet, the terms and conditions of commercial borrowings are harsher than those of concessionary borrowings forcing the borrowing countries to make tougher sacrifices. Their interest rates are significantly higher, maturity and grace periods are shorter and repayments are in a single payment known as a ‘single bullet payment’. Hence, unless a country utilises these borrowings for projects which are priorities, have shorter gestation periods and generate higher rates of return than the interest paid on them, the borrowing country cannot avoid falling into an inescapable foreign debt trap. The observation of these prudent norms are specifically relevant for commercial borrowings from countries like Iran and China whose loan conditions are much harsher than those raised from international financial markets in view of the tie-up of the loans to purchase of goods and services from the respective domestic markets.

No Ponzi Schemes

Though Sri Lanka has not got into a serious foreign debt problem as yet, the fast increase in its borrowings from commercial sources may increase the country’s vulnerability significantly. It now appears that, to repay the commercial loans raised in the last few years, the country will have to borrow more in the next few years. The critics have equated this to operating a huge ‘Ponzi Scheme’ by the government because, like the legendary Charles Ponzi of early 20th Century who paid his previous lenders out of the money borrowed from the new lenders, the government too has to continually raise new loans to repay the previous loans. The critics have brought out the risk factor involved in this type of an operation: Ponzi had to default everyone when he later found it impossible to find new investors; the same fate may befall on the government if it too is unable to raise new loans, especially in periods of global financial crises.

The Colonial Wisdom comes in handy

The colonial wisdom in raising commercial loans for investment was that the borrower had to build a sinking fund to repay the loan out of the sale proceeds of the enterprise. For instance, when the Ceylon Railway Authorities raised commercial loans in the London financial market to build the country’s railway system, the Secretary of State made it mandatory for the railway authorities to charge economic fares from railway users and build sinking funds to repay the loans when they matured. According to Professor Indrani Munasinghe, the prudent management made railways remunerative from the start and, after transferring the required amounts to sinking funds, there was a balance surplus available to be credited to the general revenue of the government. It, therefore, took the Ponzi feature present in the current commercial borrowings out of the system by avoiding the necessity for raising new loans to repay old ones.

It behoves the government to infuse this colonial wisdom of prudent debt management to large scale commercial borrowers like the Ports Authority and Ceylon Electricity Board by making it mandatory for them to build the required sinking funds out of revenue to save the country from potential future foreign debt crises.

 FDIs: Non - Repayable Debt involved

As Dr Mahathir Mohamed has advised and as was practised by colonial authorities, Sri Lanka should promote FDIs to compensate for the inadequacy of country’s savings. Since FDIs do not help the government directly to fill the budget gap, it may have to go for a certain amount of loans in the short to medium term. But, it is necessary that the government should go slow on such borrowings.

To facilitate the government to reduce its reliance on borrowings, it should reduce its expenditure programmes and raise its revenue sources.

When the government cuts down its budget deficit, it will be able to release funds for the private sector to engage in economic activities, a process known as ‘crowding in’ of the private sector rather than ‘crowding it out’ as is being presently done.

 Improve Human Capital and get Technology through FDIs

 FDIs help a country to acquire new technology without costs. This is specifically important to Sri Lanka because it does not invest sufficiently in the development of new technology. Without technology, it cannot produce goods for the global market. This was the strategy adopted by the original Asian tigers, namely, Singapore, Hong Kong, Taiwan and South Korea in their initial phase of economic development and the strategy being adopted by new Asian tigers, China, Malaysia and Thailand in their present phase of development.

It is also important to develop the country’s human capital base to enable it to use the advanced technology. Singapore and South Korea did it by developing the higher education systems in the line of the best universities in the world. China is also presently engaged in a similar exercise.

 For Sri Lanka to attract high tech related FDIs, it is absolutely necessary to build the required human capital base. Sri Lanka could not attract any giant in the pharmaceutical industry in the past because of the shortage of biomedical scientists.

It is, therefore, time for Sri Lanka to take measures to train the scientists, engineers and managers needed by the high tech industries which may show interest in the country.  

In my view, though domestic investments are important, FDIs are more important and should not be downplayed by Sri Lanka in its current push for rapid economic development.

(W.A. Wijewardena can be reached at

[email protected] )