Is Sri Lanka ready for Free Trade Agreements? Part III

Many local stakeholders, industrialists, academics and think tanks have become critical of Sri Lanka’s current policy of negotiating Free Trade Agreements with more advanced industrial economies, starting with Singapore, China and India, and continuing with plans for doing so with half a dozen other more advanced countries, without Sri Lanka first establishing a competitive industrial and export base

By C.R. de Silva

In the global context of rising nationalism, populism, and near economic stagnation, a worldwide trend has started from the Western industrialised economies, towards increasing protectionist measure being adopted by their governments to safeguard the profitability of local industries, against progressively strong import competition from other countries, and also to safeguard domestic labour from losing their conventional role in local industry as a result of offshoring industries to locales with cheaper labour, as well as from the onslaught of robotics and artificial intelligence now contributing to higher industrial productivity – trends sweeping the fast growing economies of the world, including in Asia; as a result, greater protectionism and all manner of barriers to free trade have become the new norm, characterising largely-stagnating recent international trade volumes. 

Given these developments, many local stakeholders, industrialists, academics and think tanks have become critical of Sri Lanka’s current policy of negotiating Free Trade Agreements with more advanced industrial economies, starting with Singapore, China and India, and continuing with plans for doing so with half a dozen other more advanced countries, without Sri Lanka first establishing a competitive industrial and export base.

Economists’ collective observations

Sri Lanka’s Economists’ Association has been quite critical of the undue haste with which the Government is currently negotiating a series of supra-national, preferential trade agreements, without wide discussion and debate with major stakeholders and civil society representatives, almost secretively pushed under IMF conditionality, before first developing a national manufacturing capacity and a reasonable degree of industrial competitiveness – which are “essential ingredients and predominant components of a successful, sustainable export drive”, sorely needed to first arrest Sri Lanka’s still declining export volumes and progressively increasing import intensity, before deriving economic benefits from free trade.

The major reasons given by the association, which militate against the current FTA-centred trade policy Sri Lanka is pursuing, are as follows:

A well-established and executed industrial policy, emphasising the role of technological innovation and adaptation, should be a condition precedent to a national export trade policy. A vibrant and globally competitive industrial export base has been lacking in Sri Lanka since the economy was liberalised in 1977. 

The positive role that import substitution should play in the formative stages of a nascent industrial base being established, as was conceived and implemented in the East Asian ‘tiger’ economies before they became leading export power houses competing with the western industrial economies successfully, has not even been investigated in Sri Lanka, leave alone having been established. This first stage is an essential prerequisite given the small size of local consumer demand, and also given the already high import intensity of our exports. A globally competitive national production capacity, is therefore, essential for a successful and sustainable export drive; in its absence, it is a futile forecast that any meaningful advantage can be generated from any number of FTAs with more industrialised economies, with which Sri Lanka already has substantial, adverse trade balances.

Free trade policies per se have never led countries directly to economic development, leading to the absolute necessity to find an alternative – as was pioneered successfully by the above-mentioned ‘tiger’ economies – to the failed neo-liberal orthodoxy trotted out by the IMF, as now realised even by the new regime in the U.S. itself as well as other advanced countries. In fact, free market economic policies embraced by Sri Lanka since the 1977 liberalisation itself are a main cause of Sri Lanka’s current economic malaise, (though still unrealised by the authorities), centred on galloping imports and still lowering poor export volume, primarily because setting up a manufacturing and industrialisation base has been largely ignored, with little Government encouragement for entrepreneurship and innovation. Consequently, further increased free trade outcomes through FTAs will certainly lead to catastrophic consequences, as the economy is already teetering on the brink of a $ 60 billion foreign debt precipice. 

For all the above reasons, SLAPE has suggested that in FTAs being now negotiated by the Government, clauses should be incorporated to protect, groom, promote and develop competitive nascent local industries, not only in the State-Owned Enterprise and private sectors, but very importantly in the large small and medium enterprise (SME) sector – to make this country less vulnerable to BOP crises, for which IMF rescue is for ever ready; given the current, unlimited and rising import regime, leading to massive trade imbalances. On this issue, the free trade policy has failed to consequently address the negative implications of resulting, reduced import tariffs on Government revenue, already at a very low web leading to the need for regressive taxes.

In the above respect, the Government has failed to also review, and have corrected in actual practice, the continuing non-trade barriers inhibiting progress under the ongoing Indo-Lanka Free Trade Agreement, before seeking to even discuss the concept of a far more comprehensive ETCA, which the Indian Government is constantly pushing on the Sri Lankan authorities, under the feigned guise of neighbourly concern for Sri Lanka’s development, which was effectively scuttled and derailed for some thirty years by India actively funding, equipping, training, and supporting a virulent terrorist insurgency which destabilised this entire country; this is a fitting reaction to the renewed initiatives being now taken by the new Indian Ambassador in Colombo, as well as Dr. Sashi Tharoor in a completely-unbalanced India-centric recent speech, and should be realised by Sri Lankan policymakers before it is too late.

Finally, none of the country’s professional economic bodies nor other stakeholders, have hitherto been explicitly involved in a transparent, active consultative process with Government functionaries in trade policy discussions, nor has emerging free trade policies been guided by an established, agreed, national development vision of where Sri Lanka is going in the context of the future prosperity and welfare of the Sri Lankan people, national sovereignty and autonomy (now being seriously eroded in several other respects), largely motivated by geo-political imperatives of regional countries in promoting Sri Lanka’s rush into supra-national international commitments, inimical to its economic future, for reasons detailed by the association (and extracted above in summary, from its own published commentary on this subject).

Sri Lanka Exporters’ Association concerns

The Exporter’s Association of Sri Lanka has also raised several significant concerns about the last budget’s provisions, regarded as very favourable by both the IMF and World Bank, that result in creating an unfavourable taxation environment for Sri Lanka’s exports, e.g. first, the increase in taxes for exports from 12 to 14%; second, the withdrawal of SVAT exemption; and third, the imposition of the Trade in Services Tax of 14% - all measures resulting in discouragement of exports and reduction in export volumes, which is a phenomenon already occurring according to recent export data.

EASL has further complained, with reference to specific industries, that the Cess on rubber exports has increased from Rs 4. to Rs 15, which makes this important commodity, uncompetitive in the world market; and added that budgetary incentives offered for the branding of tea, should have been extended by the Government to lines of non-traditional agricultural exports, where exporters with dynamic and innovative plans, are attempting to diversify the country’s hitherto neglected new varieties of agricultural exports, in order to stimulate the viability and vitality of a sector on which a vast majority of the rural communities depend for their livelihood; and where the lack of markets, both locally and overseas, have depressed these sectors of activity; and transformed a large proportion of the Sri Lankan population’s 40%, reputed to be in classical poor conditions, destined to live on less than $ 2 per day, which is the globally recognised poverty standard.

CCC guidance: Trade liberalisation support needed

Since the International Trade Minister sought ideas in 2016 on measures to put in place to assist domestic businesses to meet the challenges of the Government’s FTA plans (without to date announcing the clear dimensions or specific substance of the trade liberalisation exercise), although they are now in the final phase of active FTA negotiation in the cases of China, Singapore and India, and in a conceptual stage with several others including Thailand, Malaysia, Indonesia, etc., the Ceylon Chamber of Commerce has recently formulated the following proposals for the Government to consider, in order to help businesses cope with FTAs’ challenges; these can now feed into initial NES preparation:

First, the Government must proactively chart and formulate an adjustment strategy with clearly identified and adequately resourced support measures for business enterprises;

Second, responsible Ministries, regulatory bodies and related agencies must be reoriented to be more ‘industry facing’ and business friendly, to support firms’ survival and growth;

Third, relevant agencies should address “well known pain-points” in trade facilitation, including non-tariff barriers, customs delays, testing and standards issues, (including quarantining and technical barriers), and regulatory gaps, in order to reduce enterprise transaction costs;

Fourth, Government funding and other support to target SMEs and other beneficiaries, to help them progress to foreign market exploration and development;

Fifth, specialised banking support, including credit lines, for businesses impacted by trade liberalisation, and also to exploit its advantages, e.g. access technology, diversify and expand export product lines; 

Sixth, improve utilisation of industrial parks by small, adversely affected import-substitution businesses to upgrade technology and modernise facilities;

Seventh, facilitate access to technology upgrading and absorption to make businesses more competitive through subsidy schemes, linking them with academia, as well as upgrade and invest in process and product innovation, to enhance export market competitiveness;

Eighth, intensify extension by Government agencies to liaise with firms, to help bridge export market information gaps and subsidise market exploratory studies; 

Ninth, assist export enterprises to find online buyers and suppliers, leveraging ICTA’s e-commerce expertise;

Tenth, assist greater labour market flexibility, by re-training workers for new sectors and improve efficient re-allocation of labour, including establishing satisfactory safety-nets; and

Lastly, cater with specially targeted programs to assist the vulnerable among micro-enterprises in the huge (93%) SME sector, of which 61% of export-oriented enterprises have less than 25 employees, given the catalytic impact SMEs have on countrywide employment, inclusive growth, and poverty alleviation. (The section which follows, covers the special issues faced by SMEs facing the coming liberalised trade competition).

Comment: The critical observation is pertinent that while every one of the above long list of 11 CCC recommendations is salutary and exceedingly well conceived in every aspect, implicit in the Chamber’s ‘Guidance’ is the judgement that the planned trade liberalisation is premature, without preparing the industrial, especially SME, sector to withstand and survive foreign competition. Therefore, given the long lead time needed to formulate details of the above-suggested initiatives and execute national programs at standard public sector slow motion, in the current light of the Government’s expeditious and almost unseemly rush to enter into at least three FTAs in 2017, possibly motivated by political expediency, without completing the necessary preparations on the ground to moderate and minimise the adverse FTA impact on local business, speedy planned execution of Government’s trade liberalisation policy can be disastrous for local industry. It will be particularly so for the vulnerable SME sector, as it will erode businesses and wipe out jobs of a large cross-section of employees, among them principally women and youth, already facing difficulties in securing gainful employment, as articulated below..  

SMEs – Reasons for low export viability

In Sri Lanka, approximately 99.8% of domestic sales are the product of small business concerns, and 83% of these are from medium-sized enterprises, both together accounting for more than 50% of GDP, and also 45% of total employment. Research done by the Institute of Policy Studies (IPS) has also shown that Small and Medium Enterprises (SMEs) are significant in the employment sphere as employers of women and youth, a disadvantaged minority in our country.

A large number of constraints to the operation and growth of SMEs, which are, therefore, so critically important to the Sri Lankan economy, have not been relieved hitherto by policy makers but difficulties affecting their business prospects will also be aggravated by liberalising further the country’s trade regime; as well as by the proposed adoption of IMF-advised and supported free trade pacts with several countries, which are now at a more advanced stage of industrialisation. These FTAs are now in almost confidential but active negotiation status, without full consultation with SME representatives, who are potentially the adversely affected stakeholders, vulnerable to increased foreign competition at this early stage of the country’s industrialisation.

The research done by IPS has also revealed that “trade barriers, poor access to information, costly requirements in regulations, burdensome customs procedures and shortage of trade finance, as being major barriers to SME’s role in the export trade”. Lack of access to information about border procedures and regulations operative in foreign markets; easy access to trade finance; unfamiliarity with the marketing know-how needed to adapt SMEs’ local products and packaging techniques in order to meet external market requirements; their inability to provide collateral, bank guarantees and credit history, entailing higher interest rates for SMEs; and lack of dedicated trade facilitation-related financial services have variously been identified in the same IPS study. These constraints cumulatively contribute to substantially reduce SMEs’ export potential, and should be ameliorated to stimulate and encourage their ability to compete in foreign markets. Opening domestic demand to more sophisticated import competition will operate as a serious drawback to SME business viability.

The noteworthy neglect hitherto by the Government of the constraints identified above and presented by SMEs is surprising, not only in formulating trade policy but also in ongoing negotiations for FTAs, which, per se, entail neglect of the prime need to ‘protect’ these SME businesses, employing a large proportion of the population, dependent on employment countrywide by them. A very late progressive development is the EU-funded preparation of a National Export Strategy, reported to be implemented over a four-year period, and inter alia, assist SMEs to increase their exports, especially to EU and SAARC country markets; improve their capacity for compliance with export destination requirements; and enhance SME’s performance at accessing global value chains for their products. The Government will also establish a joint task force to help promote Sri Lanka’s exports as well as FDI (both having hit rock bottom in 2016), by providing policy direction, prescribing guidelines and undertaking supervision. The Government plans to introduce well-focused incentives to attract FDI. While these are all laudable initiatives, the overriding issue remains – what adverse consequences will ensue for SMEs from three or many more FTAs being implemented during the initial phase of a four-year NES plan gestation period? Only time will tell, but peoples’ livelihood are at stake.

Already, the steep increase in living costs resulting from IMF-decreed increased VAT and the imposition of a Nation Building Tax (NBT) on SMEs, which pass on these regressive taxes to consumers, have not only reduced consumer demand, but also contributed substantially to inhibit SMEs export drive, resulting in reduced profitability, and caused problems for the livelihood of a large segment of the people employed in SMEs, importantly women and youth (who already have other constraints in obtaining gainful employment, as commented earlier), and a sizeable number of SMEs which are owned and run by women. (This writer is indebted to studies done by IPS, and its outstanding trade policy analysts, for data and related arguments presented in the foregoing section as summarised by Dr. Janaka Wijayasiri in ‘The Island’ of 1 December 2016, and also used elsewhere in this essay). 

A public representation made recently relates to “the havoc wreaked in this country due to the removal of duty from imported wheat, (another component of the free trade policy agreed with the IMF as part of its economic reform program). An entrepreneur in the food processing industry had stated that 6,000 SME rice mills had closed as a result throwing 100,000 out of employment. The previous import of 800,000 tons of wheat had also now increased to 1,700,000 tons. Another Government instruction to reduce rice production because it was in surplus, had resulted in a reduction of 700,000 tons in rice production, causing a countrywide shortage and Government appeals to Indonesia and Pakistan to donate rice to Sri Lanka, as well as increased imports. A $ 3.8 billion food import bill before 2015 had now increased to $ 5 Billion due to liberalised imports of increased milk foods, sugar and wheat. (Sunday Island, 16 April, p 10).

Now, the Government has issued mandatory instructions through the Central Bank to all commercial banks urging them to lend at least 10% of their total loan portfolio to SME businesses throughout the country. (Whether the instruction to also lend 10% for agriculture, 5% to women and 5% to youth is in addition to the special lending allocation to qualified SMEs is not clear), but critics have pointed out structural deficiencies in the system, including the lack of information to potential borrowers about which business sectors are profitable; the lack of technical knowledge and skills to undertake businesses in their respective areas; the inability of many borrowers to present their cases for loans in a way acceptable to lending banks; the lack among borrowers, especially women and youth, of needed collateral and security demanded by such banks; and the perception among banks that the sector of business identified by potential borrowers may not be a profitable one or the borrower is not creditworthy. A mandatory Central Bank direction to lend a minimum proportion to SMEs, women or youth, without and before policy makers take adequate measures to address these preliminary but significant, structural issues may be doomed to failure.

Export finance – Role and significance

The Government has allocated Rs. 10 billion to establish an EXIM bank in Sri Lanka, now recognised universally as a significant facilitator of export promotion, and helpful in meeting export targets. Export finance has an important role to play in the country’s efforts to revive its declining exports by: facilitating payment and export terms to exporters; help the exporter and buyer to share risks in international transactions; provide export insurance, loans to meet working capital requirements for export as well as for strategic export credit schemes, e.g. credit guarantees, interest rate support, etc.; provide buyers’ credit even to the importer; reduce the risk premiums levied on loans to SME exporters, which now increases their borrowing costs; and help incentivise the private sector to explore, access and diversify into new foreign markets and add value to products. (Extracted from a Verite Research Study summary, December 2016).

International investment – Poor Sri Lanka experience?

A primary objective of Sri Lanka entering into FTAs with industrialised, more advanced countries is also to mobilise foreign, bilateral investment through an investment component, with attendant technology transfer. In addition, Sri Lanka has entered into separate Bilateral Investment Treaties (BITs) with the same foreign investment objective – 21 in the 1980s-90s, and five during the 2000s; of the latter, only one has been ratified and is in force. Evidence does not support the “conclusion of causality between the presence of BITs and increase in FDI flows…and also reveals inconclusive evidence that FDI flows increased after entry into force of a BIT… Sri Lanka avoided finalising or ratifying any new BIT since 2009…Sri Lanka seems to be very careful in entering into new BITs in the future” (Malalgoda and Samaraweera, ‘The Experience of Sri Lanka with International Investment Treaties,’ South Centre-Investment Policy Brief, December 2016).

Foreign Direct Investment is, however, a dominant Government objective of FTAs being now negotiated with more advanced economies, given that FDI flows have bottomed in 2016 to its lowest recent level. Why? As a former Chief Economist of the IMF has explained in a different context, a country must gain the trust of foreign investors to convert their foreign resources into a depreciating currency for investment. A sound institutional framework certainly helps – including an independent judiciary, an open and democratic government, preferably in a properly functioning parliamentary democracy (not with a token, nominal Opposition), and robust public institutions managed by competent bureaucrats, not political appointees; and especially, a credible Central Bank. The reader himself can evaluate whether Sri Lanka qualifies, applying these objective criteria. 

Moreover, “foreign investors typically want to know if they will be treated fairly, according to well-established legal procedures, rather than subject to the whims of the Government. They also tend to value independence of public institutions such as the Central Bank from Government interference – important for maintaining the credibility and value of the local currency. (Professor Easwar Prasad, A Middle Ground, Finance & Development, March 2017). Alleged multi-billion rupee unresolved bond scams certainly may not help!

The top official of the Bribery Commission (CIABOC) is reported as stating that alleged bribery at the provincial level was hampering private sector investment and FDI from benefiting Sri Lanka. The issue for the authorities to address is whether this so-called “personal agenda” is systemic or only prevalent at provincial level (Ceylon FT, headline news, 21 April).

(The writer was a member of the former C.C.S. and later a senior professional at World Bank Headquarters 

for over 30 years).

(Part 4 will be published 

tomorrow.)