Winning Economy Premachandra Athukorala ArndtCorden Department of Economics

Winning Economy Premachandra Athukorala Arndt-Corden Department of Economics College of Asia and the Pacific Australian National University 19 October, 2012 1

Sri Lanka’s Post-conflict Development Challenge 2

‘The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economists. … soon or later it is ideas, not vested interests, which are dangerous for good or evil’. John Maynard Keynes, The General Theory of Employment, Interest and Money, 1936, pp. 383 -4. 3

Purpose/scope To inform the policy debate on the post conflict development strategy: • What are the achievements of liberalization reforms initiated in 1977? • What are the implications of recent policy shifts for the sustainability of these achievements in the context of global economic slowdown? • Is there a case for reverting to the past paradigm of inward oriented, state-centered development strategy? 4

Structure 1. 2. 3. 4. Historical context Recent policy shifts Economic performance Concluding remarks 5

1. Historical context (‘Past is the prelude to the future’) • Sri Lankan economy at independence: one of Asia’s most promising new nations. ‘The best bet in Asia’ ‘An oasis of piece and stability’ See Table 2 6

Table 1: PPP GNP Relative to USA Sri Lanka India Pakistan Indonesia Malaysia Philippines Singapore South Korea Thailand 1950 11. 4 7. 1 9. 0 --14. 6 10. 3 --7. 6 9. 6 1960 12. 5 7. 4 6. 8 5. 8 15. 1 11. 5 16. 6 8. 7 9. 6 1970 9. 3 6. 0 8. 1 4. 8 15. 6 10. 8 24. 2 12. 8 11. 9 7

• Era of state-led, import substitution, late 1950 s- 1977 By 1970 s Sri Lankan economy was one of the most inward oriented and regulated outside the communist block - Poor relative growth performance - Diminished connectivity in the global economy (Figures 1) 8

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Figure 2: Trade Orientation of the Sri Lankan Economy, 1959 -2010 (%) 80. 0 60. 0 50. 0 40. 0 30. 0 20. 0 10. 0 2010 2007 2004 2001 1998 1995 1992 1989 1986 1983 1980 1977 1974 1971 1968 1965 1962 0. 0 1959 Trade/GDP (%) 70. 0 10

Liberalisation reforms • First wave: started in 1977 • Second wave: started in 1989/90 • By the mid-1990 s, Sri Lanka had become one of the most open economies in the developing work. • Reforms received bipartisan support: further reforms in the second half of 1990 s • Reform process lost momentum from about the late 1990 s, because of the escalation of the separatist war. 11

Reform outcome A dramatic transformation of the economy despite continuing civil war and the resultant macroeconomic instability • Emergence of the private sector as the engine of economic growth. • An annual average growth rate of over 5% • Increase in manufacturing share in GDP from 10% in the mid 1970 s to over 20% by 2000 12

• Export diversification: ending of heavy primarycommodity dependence, reversing the prolonged (1955 -1975) deterioration in the terms of trade (Figure 3) • Emergence of export-oriented manufacturing as the major generator of domestic employment. 13

500 1948 1950 1952 1954 1956 1958 1960 1962 1964 1966 1968 1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 BTT and ITT (1990 = 100) Figure 3: Sri Lanka: Barter Terms of Trade (BTT) and Income Terms of Trade (ITT), 1948 -2000 (1990 = 100) 600 BTT ITT 400 300 200 100 0 14

Notes to Figure 3 • BTT = PX/PM , where PX is the export price index and PM import price index (This is what we normally call ‘the terms of trade. • ITT = [PX/PM]*QX, where QX is the export volume index. ITT measures import purchasing power of total; export earnings. 15

2. Recent Policy Shifts Backsliding from liberalisation reforms from about 2005, in particular after the ending of the separatist war in 2009 16

Trade policy regime Increased complexity of the import duty (tariff) stature: a number of import taxes (para-tariffs and other) in addition to customs duties; Notable increase in the average levels import duties (tariffs) (Table 2) Increased variability of t rates among tariff lines (increased cascading nature) New export taxes (promoting resource-based industrialisation) Greater emphasis on free trade agreement (origin 17 complications)

Table 2: Sri Lanka: Unweighted Average Protection Rates, 2002, 2004, 2009 and 2011 Customs duties Para-tariffs Total protection rate November 2002 9. 6 2. 9 12. 5 January 2004 December 2009 11. 3 12. 4 2. 1 15. 5 13. 4 27. 9 January 2011 11. 5 12. 2 23. 7 18

FDI policy • The Strategic Development Project (SDP) Act (2008) - leaves room for ample discretion in the investment approval process • Revival of Underperforming Enterprises and Underutilised Assets Act (November 2011) - empowered the government to acquire and manage 37 ‘under performing enterprises • A minimum, across-the-board, capital requirement for FDI projects to become eligible for five-year tax holiday (US$ 500, 000) (Malaysia 65, 000; Thailand 65, 000; South Korea 50, 000, India 2, 100) 19

FDI policy (continued) Heavy emphasis placed on ‘domestic value added’ (or domestic content) in approving new projects (discuss inconsistency of this criterion with promoting FDI in an era of economic globalisation 20

State-owned enterprise Abandoning the privatization program following change of government in 2005. Renationalisation of some previously privatised firms and some fresh nationalisations. Loss-making SOEs have become a huge drain on the government budget. 21

Macroeconomic policy ‘Stable exchange rate regime’ (2005 - February 2012) and real exchange rate appreciation (Figure 4) Managed floating since February 2012. Discuss • The link between nominal and real exchange rate. • The link between budget deficit, current account deficit and the future course of the nominal exchange rate (Box 1 and Box 2) 22

20 2004 Q 1 2004 Q 2 2004 Q 3 2004 Q 4 2005 Q 1 2005 Q 2 2005 Q 3 2005 Q 4 2006 Q 1 2006 Q 2 2006 Q 3 2006 Q 4 2007 Q 1 2007 Q 2 2007 Q 3 2007 Q 4 2008 Q 1 2008 Q 2 2008 Q 3 2008 Q 4 2009 Q 1 2009 Q 2 2009 Q 3 2009 Q 4 2010 Q 1 2010 Q 2 2010 Q 3 2010 Q 4 2011 Q 1 2011 Q 2 2011 Q 3 2011 Q 4 2012 Q 1 2012 Q 2 Index, 2004 = 100 140 Figure 4: Sri Lanka: Real exchange rate and its components, 2004 Q 1 – 2012 Q 2 120 100 80 60 Nominal effective exchnage rate (NEER) 40 Real effective exchnage rate (REER) Relative price (RP=PW/PD) 0 23

Real exchange rate RER = [NER*PW]/PD ------Current account balance (CAB) and the budget deficit CAB = (S - I) + (TX - TR - G) (8) = private sector balance + public sector balance (or budget deficit/surplus) 24

Sri Lanka in 2011 (% of GDP) CAB = private sector balance + public sector balance -7. 8 = -0. 9 - 6. 9 (Source: Central Bank of Sri Lanka, Annual Report 2011, Key Economic Indicators) 25

3. Economic Performance In terms of the standard indicators (GDP growth rate, per capita income, unemployment rate, inflation etc) growth performance in the immediate post-conflict period looks impressive, but these indicators hide a number of concern regarding the sustainability of growth 26

• The main drivers of growth are the non-tradable sectors (construction, transport, utilities and trade and other services). • The doubling of per capita income in current US$ partly reflects domestic inflation and the artificial stability of the exchange rate during 2005 - Feb 2012 (Figure 5). • The decline in the unemployment rate was largely dote public sector recruitments and labour outmigration. 27

Figure 5: Sri Lanka, per capital GDP in current and constant (2000) price (US$), 1970 -2010 3000 Per capital GDP, current US$ 2500 2000 1500 1000 2010 2008 2006 2004 2002 2000 1998 1996 1994 1992 1990 1988 1986 1984 1982 1980 1978 1976 1974 1972 0 1970 500 28

• External payments position remains fragile: - current account deficit has widened (poor export performance, faster import growth despite increased import duties) - Net foreign reserves are very low (Figure 6) - The share of non-concessional loans in total external debt increased from 7. 3% to 42. 9% in 2011. 29

Figure 6: Sri Lanka’s International Reserves (in Billions of US$) 30

• A number of export-oriented foreign firms seems to have stopped operations (and/or left the country). • The budget deficit as a percentage of GDP is very high (2010: 9. 9%; 2001: 6. 6%) 31

4. Concluding Remarks The Sri Lankan experience under liberalisation reforms has clearly demonstrated that an outward-oriented policy regime can yield a superior development outcome compared to a closed-economy regime, even under severe strains of a protracted ethnic conflict and macroeconomic instability. Viewed against this backdrop, recent developments in the Sri Lankan policy scene do not seem to augur well for the future of the Sri Lankan economy. Policies based on the past paradigm of inward oriented, state centred development offer no viable long term solution to the huge challenges facing Sri Lanka in face of a global economy that is in deeper trouble than at any time since the 1930 s. 32

Thank you. 33