The rationale for the Sri Lanka - Singapore FTA

Originally appeared on Echelon

By Ravi Ratnasabapathy

Small countries have small domestic markets; a focus on exports will help overcome this natural limitation.

Sri Lanka’s economic growth has been sub-optimal for decades. The standard excuse for this was the war. When it ended in 2009, there was renewed hope that the country would at last reach its potential, but this was not to be. After a brief spurt, post-war growth has reverted back to the long-term average (4%) in each of the five years over 2013-2017. This will not be any better in 2018. Post-conflict countries expect to experience a sustained “peace dividend”, but Sri Lanka’s 2009-12 boom was surprisingly limited both in scale and duration.

There are several issues in the structure of the economy, the most important of which is the lack of export growth.

Small countries have small domestic markets, and a focus on exports will help overcome this natural limitation.

Sri Lanka retreated from a policy of openness since 2000’s raising tariffs and regulatory barriers, resulting in a sharp contraction in exports as a share of GDP, which fell from a high of 33.3% to about 12.7% of GDP in 2016. Sri Lanka’s share in global exports has also declined. The country’s share in world manufacturing exports increased from 0.05% in the mid-1980s to about 0.11% in 1999, but has since declined, reverting to the level in the 1980s. In Malaysia, which has a similar population, exports are 71.5% of GDP.

THE ROLE OF FREE TRADE AGREEMENTS
The government has re-prioritised international trade as a driver of economic growth, and FTAs are a part of this process. FTAs open opportunities for Sri Lankan exporters and investors to expand their businesses into overseas markets. Imports under FTAs mean greater competition in the local market, but this is no less important as it helps to maintain and stimulate the competitiveness of local firms.

It is only constant competition that drives productivity, which is the basis of sustainable growth. To take an analogy from sports, if Sri Lanka’s cricketers focused mainly on domestic club cricket, they are unlikely to perform well in the international arena.

Apart from keeping firms efficient, competition benefits local consumers through access to an increased range of better value goods and services.

There is a cost to this, as some firms may lose out; we will come to this.

GLOBAL CHALLENGES
Sri Lanka’s already-weak export game is about to take another knock from BREXIT and Trump. Therefore, it makes sense to increase regional trade to offset the potential decline in current markets. Countries generally trade with their neighbours, except in South Asia.

Regional trade in East Asia & the Pacific makes up 50% of total trade; in Sub-saharan Africa, the figure is 22%, but in South Asia, it is only 5%. Singapore is the current chair of ASEAN and one of its most respected members. For a small country thus far ignored by ASEAN due to the conflict and inconsistent policies, the FTA provides an important signal of a policy orientation towards greater trade and investment with the region.

Greater openness brings many benefits, but there are many stakeholders with different interests, so policy needs to take into account these varying interests.

THE IMPACT OF PARA TARIFFS ON PRICES
The customs tariff, together with the para tariffs of PAL and CESS, are taxes that are imposed on imported products that are not applied to the domestic equivalent. Since foreign exporters do not change the price that they charge for the product, the domestic price of the imported product rises by the amount of the tariff. The impact of this on various stakeholders is discussed below:

Domestic producers
Domestic producers competing with equivalent imports do not have to pay para tariffs, and so have an advantage over the imported product. As the prices of imported products rise, domestic producers have the opportunity to raise their own selling prices because competing with imported products now costs more.

It is always the case that the prices of domestic products rise when tariffs are imposed on imports. If it were otherwise, it would make no sense. The very purpose of the tariff is to enable the domestic producer to sell his product at a higher price. Therefore, domestic producers gain when the government imposes a tariff on competing
imports.

Domestic consumers
Domestic consumers of the product are equally affected by the imposition of the tariff. They must pay a higher price for both imported and local products. It is domestic consumers who pay for the protection of domestic producers, not foreign firms.

Government
The government collects tariff revenue on whatever quantity is imported, although they do not collect it on the local product. The benefit the government creates for the local producer by raising the price of imports is collected by the local producer.

There are two domestic winners (domestic producers and the government) and one domestic loser (domestic consumers) because of the imposition of a tariff.

On the face of it, there appears to be more winners than losers, but in terms of sheer numbers, consumers in any industry far exceed the number of producers (or their employees). Consumers, however, are unorganized, so their interests may end up being overlooked.

MANAGING THE DOWNSIDE
As seen above, there are losers and winners in tariffs. When tariffs are cut, local producers may lose, although the government may still gain as a greater volume may offset a reduced rate. Managing the downside is necessary; local firms will need to compete, but they may need support to improve productivity and a period of adjustment.

The draft Trade Adjustment Programme (TAP) prepared by the Ministry of Development Strategies and International Trade provides a framework to tackle problems faced by affected industries. The underlying principle is to smoothen the transition of firms and workers to new market conditions, post liberalisation.

The government needs to work closely with each sector to tackle policy and regulatory constraints, and fix missing ‘public goods’-inadequate public services, infrastructure, etc, that sap the productivity of local firms.

LIBERALISATION OF SERVICES, MOVEMENT OF PROFESSIONALS
There has been much debate over the movement of people. Various professional associations have alleged that the FTA will lead to an influx of incompetent people who will undercut professionals or provide substandard services.

These fears are misplaced. As per the Schedule of Specific Commitments (Chapter 7, Annex 7A ), the movement of persons is restricted to intra-firm transfers of specific categories, which is no different from current provisions under the BOI. The movement of professionals outside this limited sphere is closed, hence, the question does not arise.

In fact, Sri Lanka faces shortages of both unskilled and skilled workers. A survey by the Department of Census and Statistics indicates that nearly half a million vacancies exist in the private sector (excluding micro enterprises). The state sector employs far too many people, burdening taxpayers, while depriving the private sector of people, but even a drastic reduction in the size of the state may not solve the skills shortages and mismatches.

Labour scarcities have an adverse impact on growth, while shortages of skills impacts both productivity and growth. Studies have shown that the migration of people benefits both the sending country and the receiving country (van der Mensbrugghe and Roland-Holst 2009). The welfare gain for the destination country is because immigration increases the supply of labour, which raises employment, production and thus GDP (Ortega and Peri 2009).

A strong case can be made to allow specialised skilled migration to fill gaps that exist in the market. The skills of migrants will be complementary to those of existing workers, therefore, all workers experience increased productivity, which in turn, can be expected to lead to a rise in the wages of existing workers.

EXPERIENCE WITH THE FTA WITH INDIA
The discussion so far has been abstract, how do we know how the FTA will actually work?

The experience of the much-criticised FTA with India that was signed in 1999 may indicate some of the potential.

The Indian FTA is a very restrictive document: it outright excludes many major sectors in which both countries have comparative advantages – i.e. the very rationale for trade. India subjects 15 out of the top 20 Sri Lankan products to either a tariff or quota. Sri Lanka, in turn, offered additional concessions (of only 3.5%) on only 7 of India’s top 20 products, the rest being either excluded or were already tariff-free.

It was, in fact, an agreement designed to fail, entered into only as a formality.

Despite this, export volumes have grown significantly and India has become the third-largest destination for Sri Lankan exports:
“…nearly 70% of Sri Lanka’s exports go to India using FTA provisions… While India has been the largest source of imports for Sri Lanka (even before the FTA) for many years, India has acquired the position of being the third-largest destination for Sri Lankan exports – a rank achieved through the benefit of the tariff preferences in the FTA.” (Institute of Policy Studies)

The export basket has also diversified:
“If one looks at the Sri Lankan export basket destined for India before the FTA, which was dominated by agricultural products such as cloves, peppers, areca nuts, dried fruits, nutmeg, etc., exports have now (after the FTA) become more diversified. It includes boats/ships, wires and cables, glass and glassware, apparel, woven fabric, etc. In 2013, the largest Sri Lankan export to India was boats and ships.

Sri Lanka exported 505 product items to India before the FTA in 1999, the product items exported increased to 1062 by 2005, and to 2100 product items by 2012, after the implementation of the FTA. This quadrupling of the product items during 1999-2012 provides further evidence for Sri Lanka diversifying its export basket to India after the FTA came into operation in 2000.”

The impact of the FTA is not well known because it did not affect prominent export industries. The beneficiaries were firms that were working in other areas. Neil Marine is not exactly a household name, but is among South east Asia’s largest manufacturers of fiberglass boats. The North Sails Group, the world’s largest producer of sails and a sail technology leader, manufactures many of its products in Sri Lanka.

Trade only takes place to mutual benefit. Given sufficient time, the FTA with Singapore will have similarly beneficial outcomes.

SL is running out of input-led ‘perspiration’ growth: Sally

Originally appeared on Daily FT

Shortages of labour, land and an ageing population mean that Sri Lanka’s opportunities for rapid catch-up growth are diminishing and institutional transformation is needed for innovation and output-led growth, a top economist has said.

The first stage of growth involves a poor country catching up with more advanced economies, using inputs like cheap labour and land, involving ‘perspiration’. 

“Once you become middle-income, especially the upper middle income categories, your growth rate inevitably slows down; this model no longer works,” said Razeen Sally, the Associate Professor of the Lew Kwan Yew School of Public Policy in Singapore.

“We are already seeing that in Sri Lanka. The population begins to age. You have less availability of labour - particularly cheap labour. Capital becomes more expensive. Wasting capital becomes more obvious, land becomes scarcer.”

Sally was speaking at an event in Colombo on ‘Asian capitalism and what it means for Sri Lanka’ organised by the Advocata Institute, a free market think tank and Echelon, a business magazine.

Inspiration vs. perspiration

When a country exhausts catch-up growth, a second stage involving innovation, which economist Paul Krugman called ‘inspiration’ or output-led growth, was needed.

“Now you have to use your brains much more, less your sweat or brawn,” Sally said.

Output-led growth requires liberal institutions and a different type of entrepreneurial capitalism.

Economists and thinkers had defined free enterprise and capitalism in different ways.

Economist Adam Smith believed that if people had freedom to produce and consume, with secure property rights, then the market economy would flourish with increased specialisation driving efficiency. 

“Specialisation goes deeper and if you do it across borders with freer trade, it goes wider.”

This was ‘Smithian’ growth. It was not about technology as such and describes the catch-up phase.

Friedrich List, a German, wrote his ‘National System of Political Economy’ against the economics of freedom of Smith. 

While Smith believed in free trade and removing state blockages to entrepreneurship, List advocated state support for business through protectionism and a variety of state interventions for young and upcoming countries like Germany to catch up with a leader like Britain.

“And that is an argument for state intervention and industrial policy, particularly to support infant industry - so-called - that has been used in countries like Japan, South Korea and Taiwan,” Sally said. “And that argument finds it echoes here in Sri Lanka.”

Marx in turn had an apocalyptic vision, that capitalism would destroy itself while Weber had an almost religious view. 

Joseph Schumpeter, an Austrian finance minister and banker who became a professor at Harvard University and one of the top economist theorists of the 20th Century, observed another pattern.

Constant change vs. equilibrium

In contrast to standard neo-classical economics which is about a stable equilibrium, Schumpeter’s economic system is highly dynamic. Capitalist economies are constantly changing. Everything is being disrupted and re-created. It is disruptive innovation which has parallels to Anichcha in Buddhism, which means impermanence. It is about constant change the central agent of which is the entrepreneur. 

“What Schumpeter’s entrepreneur basically does is beg, borrow or steal ideas and turn them into marketable, profitable products - goods and services,” Sally said.

“So you take inventions, and rarely is the inventor the innovator and turn them into innovations. An invention is a new idea. And an innovation is turning that into something for the mass market, which makes profits, which generates investment, which creates jobs and livelihoods.

“Most of the really big ideas of the past like gun powder, the printing press and algebra had come from China and the Middle East. But they were not innovated in China and the Middle East,” said Sally. 

“They were innovated in Europe by European entrepreneurs in the commercial revolution and subsequent agriculture-industrial revolutions that Europe had but China and the Middle East did not. That is a genuine puzzle.”

Creative destruction

Schumpeter talks about “perennial gales of creative destruction” which is at the heart of his capitalist economic system. 

“So capitalism is not about stable equilibrium, but about creative destruction,” Sally said. “New entrepreneurs swarm around new ideas, inventions. And they turn them into innovations at crucial junctures, in the process destroying old incumbent industries.”

IBM was disrupted by Microsoft and Apple, who will in turn be destroyed by different technologies from more nimble firms. If the system is open enough, this kind of creative destruction will happen.

“In other words we cannot have prospering capitalism without this kind of disruption, which can be socially very disruptive,” Sally said. “This can upend politics, society and indeed the world.”

In poor Asia there was room for catch up growth but the opportunities dwindle as countries become richer so they must move to Schumpeterian growth, which means improving productivity.

Schumpeterian growth

“You want to improve the efficiency of your inputs, particularly your land, labour and capital. So it is not the quantity or mass of them but the quality or efficiency.”

Malaysia, Thailand and China had an urgent need for innovation-led growth. Middle Asian countries were seeing conditions similar to Japan in the 1970s and South Korea in the 1980s, when they exhausted the catch-up period. 

The Asian re-emergence of the last century was based on imitating the West, which was fine in the catch-up phase. Sally said in the first phase, it was possible to grow with weak institutions and rule of law and even corruption.  But the changes needed to go forward does not happen automatically.

“You need to be open to international trade,” Sally said. “It is crucial. You need to improve labour markets, primary and secondary education, you need to improve hard infrastructure.

“Friedrich List would argue that you also need industrial policy. The reality is that results are mixed. Asian Tiger countries have used a combination of policies from the Adam Smith and Friedrich list textbook, but not from the Schumpeterian textbook.”

Liberal institutions and complex reforms

“But when you come to that second stage, when you really need to boost your factors of production, your overall productivity and innovation, not only do you need to get your basics right, you need to improve the quality of your institutions,” Sally says.

“You need to improve the quality of your financial system including regulations, education, skills,  better public administration, a more efficient judiciary and legal system, a tax system and bankruptcy procedures, going well beyond the basics.”

The World Bank’s Ease of Doing Business Index was a reflection of how good the business climate and institutions were. Only Singapore, Hong Kong and Korea were in the global top 10. Taiwan was 15. All are part of rich Asia. For middle and poorer Asia to join this club their institutions must be as good but Sally says improving financial systems, legal systems and educations systems is politically difficult and complicated.

“Improving institutions depends on politics,” Sally said. “So I have my doubts about Asia being successful in the future as it has in the past.” 

There was a growing belief that China’s ‘Mao and Markets’ system, where a few people at the top made decisions, may allow it to overtake the West. But doubts remained whether real innovation could take place. Sally says there were questions whether people in the top would really give up the power and rents that can be earned in an autocracy.

Sally says innovation is happening in Asia, especially in the digital space. Young people in Asia are adopting digital technologies quickly. In China, a number of tech companies were emerging. The venture capital market in China for tech was now worth $ 60 billion a year, the same as the US.

China was now promoting some state and private tech firms aggressively in a type of industrial policy. But less efficient state firms were a drag. There was also a crony private sector. Productivity growth was slowing.

Power shift

Meanwhile, the so-called Pax America which provided a relative stable geopolitical environment which allowed Asia to grow was changing, Sally said. There was a possibility of a Chinese-led ‘Pax Sinica’ emerging under different rules.

The US had maintained the peace in Asia and prevented China, India and Japan from getting into a major war with each other. After 9/11, the US became increasingly fixated on the problems in the Middle East. Obama was reluctant to intervene in Asia and Trump, a ‘gut isolationist’, is even less engaged. Another possibility was a power vacuum, which could lead to a major conflict. Meanwhile, it was not a foregone conclusion that the US would continue to pull back and a Pax Sinica will come.

Meanwhile, Sri Lanka had not initiated the major reforms required and was coming increasingly under China. Sri Lanka’s current administration had initially got the basics wrong and had to go to the IMF. It was now sticking to a broad program agreed with the IMF in getting some of the basics right.

But no major reforms had taken place in land, the banking system or education. The reform window was closing and perhaps had already closed, he said.

On PM's economic statement: most important is to liberalize trade and investment

By Ravi Ratanasabapathy

The article first appeared on the Daily News

The Prime Minister’s statement on the economy to parliament on October 27 struck many a right note and has the ingredients to take the country to the goal of doubling per capita income by 2025.

Most important was the promise of reforms to liberalise trade and investment, to attract foreign investment and restore emphasis on exports.

It is important that the sentiments expressed in the Prime Minister’s statement must follow with practical yet bold economic policy reform. A detailed policy document has been promised and would hopefully contain the necessary implementation plans.

The rest of this brief note is aimed at understanding the policy pronouncements in the context of Sri Lanka’s political and socio-economic priorities.

Improving the business and investment climate

The statement promises a lot: simplifying the process of registering a business, getting construction permits, electricity connections and bank credit, registering property, protecting minority investors, the payment of taxes, trading across borders, the enforcement of contracts, the resolution of insolvency and reforming labour laws.

The Prime Minister’s target to bring Sri Lanka into the top 70 countries in the World Bank’s Doing Business Index by 2020 is welcome. Sri Lanka currently languishes at 110 in the index amongst 185 countries and its position has actually dropped by one place under the current administration. Policy reform to increase the ease of doing business is uncontentious and will draw broad political support from across the spectrum.

However the government must be bolder. Whilst ease of doing business has improved in the last few years, Sri Lanka can do much more to expand general economic freedom in the economy. The Fraser Institute, which publishes the annual index of economic freedom ranked Sri Lanka 111 among 160 countries. The index now ranks countries in the region like Nepal higher in terms of economic freedom than Sri Lanka with India only just behind. Beyond just looking at ease of doing business, Sri Lanka should also focus on other aspects of economic freedom including removing of outdated and arbitrary regulation, reversing recent follies such as Soviet-style price controls and truly living up to the promises of liberalising international trade and investment. In this vein, the proposed establishment of a single window for investment approval in the Prime Minister’s speech is a welcome move.

Sri Lanka can emulate, and where necessary adapt, the best practice policies from other countries such as New Zealand and Australia which rank highly in terms of economic freedom

Trade liberalisation: repeal of the Export and Import Control Act

The Government promises to repeal this archaic piece of legislation and replace it with new legislation based on that of Singapore. If implemented in the true spirit of Singapore’s legislation, this would be extremely positive.

Singapore is generally regarded as a free port and the Government only restricts the import of goods seen as posing a threat to health, security, safety and social decency. Around 99% of imports to Singapore are duty-free.

The policy statement makes reference to “a low tax regime”, the lessons from East Asia and other parts of the world is that the tariff regime needs to be low and uniform. This minimises loopholes, corruption and simplifies customs processing. A low uniform rate of duty eliminates disputes with classification and enables documents to be processed on a self-declared basis (with customs only focusing on misstatements of price and quantities) which results in faster, simpler clearing of goods.

While sentiments to keep a low tax regimes are laudable, a commitment for a low uniform tariff policy should be the goal.

State enterprise reforms and financing of infrastructure

The proposed debt/equity swaps of the Mattala Airport and the Hambantota mark an important step towards reducing the Government’s debt burden. The Government should also convert other infrastructure projects such as the highways into PPP projects by auctioning operational rights.

The statement promises investment in infrastructure in logistics to improve connectivity to global supply chains. Whilst we all welcome investments in critical infrastructure, all new projects should be implemented through public private partnerships to prevent further accumulation of public debt.

The report published by the Advocata Institute on “The State of State Enterprises in 2015” shows that the state has over 245 enterprises in its books, of which only a small number actually reported their financial position. The proposed formation of a Public Commercial Enterprise Board to manage SOEs and the creation a Public Wealth Trust, a centralised body to hold the shares in SOEs is therefore timely. Hopefully these mechanisms may prove to be the first step in imposing accepted reporting practices and better management of State enterprises. Sri Lanka can learn from Singapore’s state enterprise holding company Temasek and other experiences around the world.

Additionally, the listing of the shares of SOE’s on the Stock Exchange would also impose discipline in reporting and is something the Government should explore. Minority stakes could be offered to the public which would raise revenue to the state, allow public participation in SOE’s and broad-base the CSE; even while the majority stake is still controlled by the Government.

The recent announcements regarding the closure and amalgamation of Mihin Lanka into SriLankan Airlines is encouraging but the previously announced partial privatisation of the debt-ridden airline has not yet materialised.

The proposed Public Enterprise Commercial Board should be given a wide mandate to restructure and reform SOE’s including assessing the strategic need for such enterprises, the closure of unviable enterprises and to privatise enterprises where there’s enough commercial interest. The new structure will hopefully be just the first step on the long road to improve overall accountability and governance of these state enterprises.

It is unlikely a one size fits all solution would work for reforming all state enterprises in what would inevitably become a politically charged issue. However the public appetite for bold reform in this area is high with the realisation that the cumulative losses over the last ten years amongst the 55 strategically important enterprises amounted to Rs.636 billion.

Some areas of concern: SME’s rural agriculture

Several proposals including the one to expand SME finance through quantitative targets enforced by the Central Bank must be viewed with caution. Dirigiste lending to push bank exposure further to higher-risk sectors may boomerang on lenders, especially public sector banks, resulting in losses. Any difficulties SME’s may face with access to credit need to be examined carefully and appropriate solutions developed in consultation with financiers.

The establishment of rural modernisation boards and agricultural marketing boards will need to be examined more closely. No details are available so the exact role of these bodies is not clear but the current flawed agricultural policies have pushed up food prices for consumers. Sri Lanka’s food prices are the highest in the region and the priority should be to lower the cost of living through appropriate reforms to the sector.

Apart from a few areas of doubt the overall economic statement is broadly in the right direction and if properly implemented could boost growth and improve the welfare and prosperity of Sri Lankans. The government however has a demonstrable problem with policy inconsistency over the last few years, even amongst its own ministries and between Ministers of the same party. Whilst some diversity of opinion is expected from a coalition government, some of the policies enacted in the recent past have run counter to this and other broad policy pronouncement from the Prime Minister.

These broad ideas will hopefully pass the implementation test and we await the publication of the detailed strategy document.

The writer is a Fellow of the Advocata Institute, a fee-market think tank based in Colombo. www.advocata.org