Economic crisis in Sri Lanka: Policy challenges for the new Government – Part 2

Export-led production would provide greater opportunities for industrial expansion, benefitting from the economies of scale and providing incentives for innovations

Progress beyond recovery

The achievement of short-term macroeconomic stability and debt sustainability is only the first step in a long process. The process of reforms must continue to achieve medium-term and long-term economic progress beyond and above the recovery for several reasons:

• Despite the signs of an economic turnaround, the crisis-ridden Sri Lankan economy is not yet out of danger. It remains highly vulnerable to external shocks and can collapse even further. 

• Apart from that, economic stability must be sustained by unlocking the country’s growth potential. Only with economic growth can the Government maintain its fiscal consolidation by raising the tax revenue. 

• The room for improvement in debt sustainability through a negotiated debt-restructuring process is limited. Debt sustainability should be addressed meaningfully through economic growth. 

• “Recovery” means achieving the pre-crisis status quo of the economy, which is not at all the desired level of economic prosperity and living standards that the nation aspires to. Economic progress should be sustained in the long run as the key to ensuring the progression of Sri Lanka to a ‘developed country’ with higher incomes and living standards for the people.

Self-sustaining growth from the ‘tradable’ sector

The pre-crisis growth pattern of Sri Lanka must be overhauled, shifting away from the ‘non-tradable’ to the ‘tradable’ sector that would generate export production. The tradable sector growth supported by non-tradable sector inputs would set the conditions for establishing the required momentum for self-sustaining growth. The Government has an ambitious goal of achieving a ‘high-income’ status by 2048, which is not an unrealistic target by international experience. It requires maintaining a 7-8% annual average rate of GDP growth over the next 20-25 years. As per the 2023 classification of countries by income levels, the high-income threshold is $ 14,005 per capita, whereas Sri Lanka’s current per capita income level is $ 3,706. Consequently, the country is currently classified as a ‘lower-middle-income’ country.

Export expansion and investment promotion

Self-sustaining growth requires production for export markets, which are the global markets with billions of customers and competitive markets with many other suppliers. Therefore, export-led production would provide greater opportunities for industrial expansion, benefitting from the economies of scale and providing incentives for innovations. Increased production from the tradable sector aiming at export markets, in turn, requires accelerated private investment flows from both local private investment and foreign direct investment (FDI). 

The country needs to focus on multiplying its current export earnings of $ 11.9 billion (2023) to a target of $ 100 billion within the next 10-20 years. This ambitious export growth target cannot be realised without attracting FDI, which comes with state-of-the-art technology, management best practices, export market access, and supply chain connectivity. It also requires factor market reforms. Since Sri Lanka has a poor record of attracting FDI, it is necessary to establish a conducive business environment and to win investor confidence by undertaking reforms and setting the required conditions.

Policy reforms for export-orientation

In planning and designing the future direction of Sri Lankan policy reforms, it is crucially important to learn from one’s own past experiences to understand what policies have worked or failed in generating growth and employment. Sri Lanka has experimented with all manners of trade policy regimes, from a comprehensive socialist system to a major liberalisation experiment. Though it was a halfhearted exercise, the liberalisation program implemented in 1977 is widely considered a striking success in generating growth and employment. The resultant reforms helped transform a primary product-exporting economy into one dominated by manufactured goods for the export market. 

However, reforms failed to persist and were, reversed in the early 2000s, weakening the trade sector. Based on such experience, returning to an ‘inward-oriented’ policy regime with incentives for importing businesses and domestic sales will be a costly venture. This appears to be the policy scenario pursued during the post-crisis period. This policy orientation should be changed into an ‘outward-oriented’ one by adopting policies conducive to tradable production and export expansion, necessary to integrate with global value chains to take advantage of economies of scale and scope, benefit from and aimed at opening and facilitating international trade. 

Trade agreements

The unilateral reform is the first best policy option to transform the country into an export-oriented and globally competitive economy. As the second-best option, free trade agreements can promote regional economic integration, address market access barriers, and facilitate capacity development and structural reforms. Today, regional trade agreements have become integral to the multilateral trading system. Thus far, Sri Lanka has entered into four Free Trade Agreements (FTAs) with India, Pakistan, Singapore and recently Thailand. Sri Lanka is also a signatory to several regional trading groupings, such as the Asia Pacific Trade Agreement (APTA), the South Asia Free Trade Agreement (SAFTA) and the Global System of Tariff Preferences (GSTP), etc. 

Negotiations of several comprehensive economic partnership agreements (CEPA) with China and India are underway. Sri Lanka has also submitted a letter of intent to join the Regional Comprehensive Economic Partnership (RCEP), which stands out as a significant opportunity for Sri Lanka, offering a platform to integrate into broader Asian supply chains. By aligning with RCEP, Sri Lanka can leverage economies of scale and scope, enhancing its competitiveness in global markets.

There have been many concerns about whether these trade agreements have brought about commensurate gains for the country. Hence, before entering into FTAs, an assessment of the potential costs and benefits of the prospective trade deals must be undertaken. It is also crucially important to carefully select the partner countries, as FTAs would not promote trade in the absence of significant compatibility in trade patterns of the parties to the agreement. Finally, the outcome of FTAs or unilateral liberalisation also depends on supply-side reforms needed to improve the capability of business enterprises to reap gains from market opening.

Transparent and predictable tariff policy

Tariff policy, the centrepiece of trade policy in a market system, can play a critical role in creating a more competitive and export-oriented economy.  Under the GATT/WTO discipline, tariffs are superior and acceptable trade policy instruments for legitimate protection. Rationalising the tariff structure with a long-term vision should be a priority for the Government, striking a delicate balance between safeguarding sensitive industries and ensuring efficient resource allocation to achieve greater economic diversification and more robust export growth. 

Unlike other countries in the region, Sri Lanka has a complex tariff regime that maintains a two-tiered tariff schedule that distorts the structure of the economy. This is because, in addition to regular customs duties, the country has imposed multiple taxes and levies known as para-tariffs with various exemption schemes. Adding to the complexity, these levies and charges have been subjected to frequent changes, either raising or lowering the rates; hence, it is argued that Sri Lanka’s tariff regime lacks predictability and transparency. Though the country’s tariff structure is characterised by a relatively low Most Favored Nation (MFN) average duty of 5.9%, with a trade-weighted average of 5.4% (2022), these low MFN averages conceal the actual level of protection as there is a second layer of duties and charges described above as para tariffs creating an anti-export bias in the economy. 

The Effective Rate of Protection (ERP) is a better measurement than the Nominal Rate of Protection (NRP), such as the MFN tariff level, for evaluating the impact of tariff policies on domestic industries and trade distortion. In the case of Sri Lanka, the ERP initially declined after economic liberalisation in 1977—from a peak of 137% to 56% by the early 2000s. According to the recent estimates by the Department of Census and Statistics (DCS), this trend has lately reversed, recording high ERP for most protected industries. Finally, the complexity of the tariff regime has resulted in corruption and inefficiencies in the trade system. 

For the above reasons, Sri Lanka’s tariff policy requires significant reform to produce a more transparent, predictable, and resource-mobilising tariff regime beyond the objective of mere revenue generation. Designing, formulating, and implementing a transparent, affordable, and predictable tariff regime with a long-term vision is needed for addressing the anti-export bias, minimising trade distortions, and paving the way for the country to better integrate into the regional and global value chain while safeguarding domestic agriculture and industries and ensuring availability of goods for consumers at affordable prices. 

Investment promotion and ease of doing business

Investment promotion and the environment for doing business should be enhanced with regulatory and institutional reforms to make the country a competitive business enclave in the region. The regulatory framework within which investment promotion and doing business operate should be simplified and rationalised, lengthy and cumbersome bureaucratic procedures should be eliminated, and an efficient institutional network should be established. 

Public sector reforms should create a ‘demand-driven’ sector serving the nation’s development needs with responsibility and accountability. In undertaking a wide range of reforms for investment promotion and doing business, Sri Lanka must restore ‘investor confidence’ and avoid differentiated treatment between local and foreign investment. A conducive business environment is far more important than tax concessions and special favours in attracting foreign investment.

Land and labour market reforms

Currently, Sri Lanka adopts an outdated and complex set of laws for labour utilisation and land allocation for investment, which deviates Sri Lanka from being a competitive business enclave among its peers in the region. These laws should be revised and modernised to meet the modern factor market requirements and to establish a competitive factor market in the country. Furthermore, being a smaller country with 22 million people, Sri Lanka has a scarcity of skilled labour and professionals, hindering potential investment promotion. Many countries overcome their labour shortages by adopting flexible regulatory procedures for recruiting “foreign talents”.

State-owned enterprise reforms (SOEs)

In recent years, reforms of State-Owned Enterprises (SOEs) have become a focal point in both public and academic discussions. The chronic poor performance and persistent losses of many SOEs have increasingly burdened the economy, exacerbated government budget deficits and contributed to rising national debt. There are about 527 SOEs engaged in a wide variety of economic activities, of which 52 SOEs are considered strategically important. Alarmingly, the cumulative losses incurred by these SOEs have reached Rs. 1.5 trillion between 2007 and 2021. The emerging consensus in public policy circles is that rationalisation and restructuring of SOEs are essential. The goal is for strategically placed SOEs to operate profitably, blending public sector ownership with private sector management.

Meanwhile, other SOEs should be transferred to the private sector. There are several reasons why such reforms are crucial. Many SOEs operate inefficiently, leading to significant financial losses. Poor management systems, widespread corruption, and high levels of political interference have created weak and underperforming SOEs. Politicians have often used SOEs to employ loyalists and extended family members, many lacking the business acumen and qualifications to run these enterprises efficiently. This practice has further compounded the inefficiency and financial woes of SOEs. The continued operation of loss-making SOEs drains government resources. If these SOEs ceased operations, the government could save substantial resources, redirecting funds towards more productive areas. 

Given the extensive role of SOEs in the economy, their restructuring and reform must be a priority for the Government. Such reforms can be undertaken in both immediate and long-term contexts. In the immediate context, the Government can pursue restructuring and disinvestment initiatives. This involves reorganising SOEs’ operational and managerial structures to enhance efficiency and reduce losses. Gradually reducing Government stakes in SOEs and inviting private sector participation can improve management practices and financial performance. Wherever possible, forming public-private partnerships (PPPs) can leverage private-sector efficiency while maintaining public-sector oversight. 

Long-term reforms require a comprehensive approach to address the underlying issues plaguing SOEs. Implementing robust governance frameworks to limit corruption and political influence is critical. Transparent and accountable management practices must be established to restore the credibility and performance of SOEs. Enhancing operational efficiency through modern management practices, technological adoption, and performance-based incentives for employees can significantly improve the productivity of SOEs. SOEs should adopt pricing strategies that reflect actual costs, reducing the financial burden on the Government and ensuring sustainability. 

In sectors where SOEs hold monopolies, unbundling operations can introduce competition, driving efficiency and better service delivery. Allowing private sector competition in sectors dominated by SOEs can improve service quality and financial performance through market-driven practices.

A detailed examination of financial data from 2007 to 2021 highlights the urgency for SOE reform. The cumulative losses of Rs. 1.5 trillion underscore the economic drain caused by inefficient SOEs. In contrast, privatised entities or those operating under PPPs often show marked improvements in efficiency and profitability. For instance, the partial privatisation of Sri Lanka Telecom in the early 2000s led to a significant turnaround in its financial performance and service quality. 

The reform of SOEs is not just an economic imperative but a strategic necessity for the sustainable development of Sri Lanka. The Government can transform SOEs into valuable assets rather than liabilities by adopting immediate restructuring measures and pursuing long-term governance and efficiency improvements. Integrating private sector management practices and fostering competitive markets will be crucial in this transformative journey.

Digitisation and digitalisation

Converting data into digital forms and transforming manual systems and processes into digitalised forms are two key areas that need to be improved to accelerate the country’s development. Although these changes have been taking place in an ad-hoc and piecemeal manner in both private and public sectors, the lack of infrastructure, knowledge and skills, regulatory mechanisms, and incentives have prevented digitisation and digitalisation by international standards. 

In business operations, agriculture development, and industrialisation, digitisation and digitalisation remain fragmented and often, in many cases, limited to outdated technological standards. Reforms aimed at digitisation and digitalisation enhance productivity and efficiency while improving in many other areas, such as evidence-based decision-making, time and cost saving, and reducing corruption vulnerabilities.