How protectionism killed Sri Lankan industry

Originally appeared on The Morning.

By Dhananath Fernando

Sri Lanka’s economic crisis was probably a crisis which was analysed (indeed over-analysed) and predicted from an early stage, but we failed to avoid it. We all knew that it was coming and therefore remedies were presented much earlier, but our policymakers simply turned a blind eye. They didn’t have the courage to face reality. Instead, they thought that wishful thinking would save Sri Lanka from the current crisis, and today, we have hit rock bottom. Unfortunately, we are just at the beginning of the crisis and have not even reached the recovery phase.  

It is important to reiterate that self-sufficiency, Modern Monetary Theory, industrial policy, protectionism, and import substitution failed yet again, and this time brought our people down on their knees. While we look towards solutions, we must also understand that it is not easy to rebuild an economy once it collapses. Recovery takes time, and recovery can only happen with the right set of policies.

There is one school of thought that argues that the lack of industrialisation is the reason for Sri Lanka’s balance of payments crisis. The main argument is that if we produced more to export, we would have had more USD revenue and this crisis would not have taken place. So the argument again comes back to import substitution, which involves banning imports or imposing higher tariffs on imports in order to produce locally. The argument is that this can save import expenditure while local manufacturing can scale up in order to focus on exports and bring export revenue. In the same theory, it is recommended that the government picks up which industries should be supported and which industries should not. This is simply going back to the same theory of the central planning model where a few officers decide which industries are good and which are bad. Often quoted examples for this are Japan, South Korea, and Vietnam. So today, let’s evaluate the strategy of industrialisation based on market principles. 

In simple terms, you become a good sailor by facing rough waters. Similarly the government selecting which industries to support and which industries to avoid will have consequences for all industries. Industrialisation should take place in a market system that optimally allocates all the available resources. If the government intervenes to assist one industry, it will have a knock-on effect on all other industries. Japan is indeed a classic example. The high-powered Japanese Ministry of Trade and Industry (MITI) recommended that Toyoda not produce cars. But he ignored their advice and today no explanations are required on Toyota’s success and competitiveness. In fact, in our apparel industry, big companies follow Toyoda’s example in the lean manufacturing techniques they pioneered. Rather than providing government support, price controls imposed by the Japanese Government impacted the automobile industry. So government intervention in the markets and industries is a sure recipe for failure. 

In Sri Lanka’s case, industries such as wall tiles, floor tiles, steel, aluminium, bathware, shoes, confectionery, and many others have been protected for decades. Have they become globally competitive due to protectionism and import substitution? In fact, import substitution is the worst we can do to develop exports because it creates an incentive to only produce for the local markets and discourages producers from producing for the global market given the tariff and non-tariff protection. Do our rubber, seafood, apparel, and electronic chips industries require any protection for them to be globally competitive? The simple answer is: no.  

In cricket terms, we can’t create a world class batsman by asking the bowlers to bowl loose deliveries. We can’t create a good bowler by asking the batsman to go soft on bowlers. Only in a competitive environment are heroes created. The protection is a sure way of killing the heroes and robbing poor consumers and exporters simultaneously. That is exactly what we have been doing for the last few decades. 

No export promotion can be done through import substitution; in fact, import substitution is killing our export potential. When the exporters have to pay more than 40% higher for construction materials, it is impossible for even our best performing exports to be competitive in global markets. 

If we observe the trade data, it is clear that our imports and exports are both declining as a percentage of GDP. In 2009, Sri Lanka had nine import taxes in addition to standard customs duties, and five of them are ‘para-tariffs’. Between 2004-2009, our total nominal protection doubled from 13.4% to 27.9%. Higher protectionism also indicates our continuous drop in both imports and exports.

Things got worse over time. The average effective rate of protection for manufacturing production increased from 47% to 63% from 2000 to 2015, and production for the domestic market was over 70% more profitable compared to production for exporting (World Bank, 2005; DCS, 2018). 

Accordingly, industrial policy and import substitution are contributory factors to where we are today with low exports and low productivity in the economy. 

In the history of industrialisation there are certain instances where some countries protected local industries, but in the success stories, protection had been given for a specified, strict time period or output and had a price-based structure.

Countries such as South Korea and Vietnam too became competitive not through import substitution but by allowing the markets to work. In a paper authored by Advocata Advisor Prof. Premachandra Athukorala, he quotes General Park Chung-Hee, who is considered the father of the Korean economic miracle: 

“The economic planning or long-range development programme must not be allowed to stifle creativity or spontaneity of private enterprises. We should utilise to the maximum extent the merit usually introduced by the price mechanism of free competition, thus avoiding the possible damages accompanying a monopoly system. There can be and will be no economic planning for the sake of planning itself.”

The opinions expressed are the author’s own views. They may not necessarily reflect the views of the Advocata Institute or anyone affiliated with the institute.