Fixing Sri Lanka’s gaping trade deficit

Annual Report of the Ministry of Finance and Planning for 2012

Last week saw the release of the Annual Report of the Ministry of Finance and Planning for 2012. Though it is a report pertaining to a Ministry, since the Ministry of Finance is the focal point in the economy, it is a comprehensive analysis of the current state of the Sri Lanka’s economy with a detailed presentation of the economic strategies to be adopted by the Government to fix numerous issues presently facing the economy.

Thus, the Ministry Annual Report is the last of the four reports which one can peruse to learn of the state of the country’s economy. The first three were the State of the Economy 2012 issued by the independent think tank, Institute of Policy Studies in November 2012, Annual Report of the Central Bank for 2012 made public in early April 2013 and the Report issued by IMF after the consultations its staff had with Sri Lanka’s authorities in its Article IV Consultations series in February 2013 but released to the public domain in May 2013.

A well-written readable report

The issue of a comprehensive annual report covering the entire economy by the Ministry of Finance has been a recent development, the first of such report being issued only three years ago. Following its past traditions, this year’s report too has been very well written and presented in a reader-friendly manner with eye-catching graphs and charts to substantiate the facts and arguments it has presented to readers. The report contains a wealth of information that will be useful for any analyst to make an independent judgment about the economy.

However, independent analysts may have a different view on the diagnosis of or the policy strategy relating to many of the issues discussed in the Ministry’s Annual Report. One such issue relates to the gaping trade deficit experienced by Sri Lanka in the last few years.

Finance Ministry: Trade deficit is a major challenge

A trade deficit – the gap between the export earnings and import expenditures – is not uncommon in Sri Lanka since the country has had trade deficits of varying sizes in the post independence period except a few years in which it ran moderate trade surpluses. However, these moderate trade surpluses were one-off events and not repeated since their occurrence since they were not due to country’s achievements but due to some windfall gains arising from changes in the international environment.

In this background of having chronic trade deficits, the deficits encountered by the country since 2010 have risen to acute proportions requiring prompt measures for quick fixing. Even the Finance Ministry Annual Report has classified it as a “major challenge in the country’s economic management” since the trade deficit has arisen in an environment of import expenditures rising to almost double the size of the country’s export earnings.

However, the Central Bank in its Annual Report 2012 has looked at the trade deficit from a different perspective: It has shown its complacence about the decline in the trade deficit from $ 9.7 billion in 2011 to $ 9.4 billion in 2012 – just by a minute $ 300 million – reflecting, according to the Central Bank, “the effectiveness of the concerted policy measures adopted to reduce import expenditure”. Accordingly, it has not been considered necessary by the Central Bank to classify this gaping trade deficit – $ 9.4 billion or 16% of GDP – as a challenge in economic management.

Cause of the deficit diagnosed to errant imports

Both the Ministry of Finance and the Central Bank have diagnosed the cause of the trade deficit to rising import expenditures. Hence, their remedial measures have focused mainly on disciplining imports. This diagnosis is only partly true since the cause of the rising trade deficit is due both to an increase in imports and a sluggish growth in exports.

The IMF in its Article IV Consultation Report 2013 has very correctly diagnosed the cause to declining trend in exports since 2000. IMF has thus said that “after peaking in 2000, “exports have declined significantly as a share of GDP and of world exports, returning to the lows of the 1980s”.

Export complacency is not good

Independent analysts have also viewed Sri Lanka’s export growth in a perspective similar to that of IMF. It is true that Sri Lanka’s exports have increased over the years in absolute terms. For instance, the exports of the country which amounted to $ 5.5 billion in 2000 have increased to $ 10.6 billion in 2011 before they fell to $ 9.7 billion in 2012.

This doubling of exports over a decade has made the Sri Lanka’s authorities complacent about its performance overlooking the risks the country has been facing in the exports sector. One glaring oversight has been the declining share of exports, as also has been pointed out by IMF, in both the country’s own Gross Domestic Product or GDP and in the world’s total exports.

Decline in exports as a share of GDP

Exports as a share of GDP amounted to roughly to 33% in 2000. However, they declined by about a half to 17% in 2012. During this period, GDP has increased nearly four-fold from $ 16 billion to $ 59 billion. What does it mean? It means that growth has come basically from the growth in non-exported related domestic production and growth in services, specifically in growth in public service and use of mobile phones by the local population.

Such economic growth is not sustainable since when the country is saturated with the use of mobile phones, it cannot grow any more. Further, the growth in the public sector too has a limitation in the form of constraints to increase government revenue to run an ever increasing public sector.

Fall in dollar has reduced the purchasing power of exports

There is another compelling reason why Sri Lanka should not be complacent about its export growth from $ 5.5 billion to $ 9.7 billion during this period. That is the decline in the purchasing power of the US dollar during this period due to domestic inflation in USA. In 1999, the average US Consumer Price Index with a base year in 1982-84 stood at 166. It has risen to 229 in 2012 showing a decline in the domestic purchasing power of the dollar by about 27%. Thus, the export earnings of $ 9.7 billion in 2012 could purchase only a basket worth of $ 7 billion in terms of US prices that had prevailed as at the end of 1999.

Accordingly, compared to export earnings of $ 5.5 billion in 2000, export earnings of 2012, measured in real dollars, happened to be higher over the exports of 2000 only by about 27%. This is significantly lower than the absolute growth of 77% recorded in this period.

Shrinking share in world exports

Sri Lanka being a tiny economy has an insignificant share of exports in the world exports. It is even less than 1%. Thus, its share in world exports amounted to about 0.085% in 2000 and that share had declined to about 0.055% in 2012. What this means is that when the world exports have been rising, Sri Lanka has failed to keep pace with the global growth trends. It is demonstrative of the existence of a serious structural problem relating to Sri Lanka’s export sector and immediate measures are needed to be applied to correct those structural issues.

What are those structural problems that have prevented Sri Lanka’s exports to show a super performance? One is the failure of the country to move away from the simple type of products to more complex type products. Another is the non-availability of a skilled work-force to man new type of export industries.

Sri Lanka, the simple product producer

Sri Lanka has been producing simple products which could be produced by using only simple technology. Before 1977, Sri Lanka did not have worthwhile industrial exports and it had been exporting principally commercial agriculture based tea, rubber and coconut products. After 1977, it has increased its industrial exports but that again has principally been the export of garments and textiles. Both types of these exports are based on simple technology and as a result it faces strict competition from countries which can copy these technologies easily.

For instance, to produce garments, a country needs only industrial sewing machines, textile, designs and cheap and easily trainable labour force. Today, many countries in the developing world such as Bangladesh, Myanmar and Cambodia are blessed with that resource endowment.

Sri Lanka ranked low in the economic complexity index

Accordingly, in the Economic Complexity Index prepared by Harvard University and Massachusetts Institute of Technology in USA, Sri Lanka ranks very low toward the middle of the second half of the index. In the Index pertaining to 2010, Sri Lanka is ranked at 71 out of 128 countries lower than the emerging Asian economies like India (51), Philippines (59), Indonesia (61) and Vietnam (67). This is because Sri Lanka has been producing and exporting largely simple products like tea, rubber and coconut from the agricultural side and textiles and garments from the industry side.

The countries which also started with these types of products at the initial phase of their economic development such as Singapore and South Korea have moved in the Complexity index even higher than the advanced Western world. Singapore is ranked at No. 7 and South Korea at 12, higher than the world’s technology giant USA which occupies the 13th place in the Index.

Technology and skilled labour are an obstacle

One obstacle which Sri Lanka faces when moving into a complex production system has been the lack of technology. Even if it can acquire technology, it is faced with the problem of not having a skilled and competent work force. The acquisition of technology depends on the country’s investment in research and development and in this area, Sri Lanka’s past track record has not been very encouraging.

Instead of using the scarce resources of the country for research and development, it has been wasting such resources on subsidies, loss making and inefficient public enterprises and a huge public sector. The periodical absorption of the unemployed youth to the government sector to appease their agitations for jobs has cut the work force that is available to operate the factories and other economic enterprises.

FDIs will solve the problem of technology

To solve the problem of not having the required technological base within the country, the IMF has recommended that Sri Lanka should go for a fast drive for foreign direct investments or FDIs. That will also help Sri Lanka to have access to markets by getting integrated to the global market place. Even if Sri Lanka is successful in attracting FDIs on a significant scale, that move will be constrained by the absence of a skilled and competent work force. Perhaps, the Government may have to consider releasing the youth it has already absorbed to the Government sector back to industry since such youth are unproductively utilised in the Government sector at present.

Recently this writer was visited by a couple of graduates absorbed under the graduate trainee scheme with packets of vegetable seeds which they have been required to distribute among urban populace. They were particular about getting the writer’s signature which was a procedural requirement to prove that they have done the job. This is certainly a job which the market can do more efficiently and at low distribution costs and, therefore, such graduates can be released back to the economy without reducing the current output in the public sector.

To fix the trade deficit permanently, go for structural reforms

Thus, to tackle the country’s gaping trade deficit what it should do is to go for a structural reform program. Those reforms involve the reform of the public sector and public enterprises to release resources for the development of science and technological base and human resources. Along with these reforms, Sri Lanka has to introduce measures to remove or abolish regulations that have impeded the private sector business initiatives.

On top of these measures, the country has to ensure the protection of property rights to assure the enterprising private businessmen that what they invest has been free from arbitrary take-overs by the government or government sponsored private parties. That can be assured only if the country is successful in observing the Rule of Law, maintaining law and order and having an independent judicial system.

Ministry solution: Import substitution and increase in value addition

However, to fix the problem of gaping trade deficit, the Ministry of Finance has suggested going for an import substitution program that would make the current problem worse in the long run. It has suggested that annual import cost on milk-foods and dairy products, sugar, fish and grains in the consumer goods baskets and cement, building materials, steel, sanitary-ware and furniture in the basic industry and durable goods baskets could be saved by adopting appropriate local production methods.

To transform the export structure, it has also suggested having more value addition in local exports such as tea, rubber, light engineering and gem and jewellery products. The objective of these measures has been as the Ministry has claimed “to cut down imports through domestic value creation”. Though the Ministry has identified the need for improving productivity in all areas in order to reap the best benefit to the country from all these measures, improving productivity requires the adoption of economy-wide structural reforms.

What is suggested as the medium term strategy by Ministry of Finance to fix the gaping trade deficit is short of economy-wide structural reforms. It, therefore, does not appear to be the appropriate strategy which the country should follow to give a permanent solution to the problem.