Officially ‘upper-middle income’ - Now what?

In this weekly column on The Sunday Morning Business titled “The Coordination Problem”, the scholars and fellows associated with Advocata attempt to explore issues around economics, public policy, the institutions that govern them and their impact on our lives and society.

Originally appeared on The Morning

---

By Aneetha Warusavitarana

Sri Lanka is now an upper-middle-income country, with a per capita gross national income (GNI) that surpasses that of regional competitors like Indonesia and Vietnam. The threshold for eligibility as an upper-middle-income country is a per capita GNI of $ 3,996, and as at July 2019, Sri Lanka crossed that threshold with a per capita GNI of $ 4,060. While this appears to be a positive development, it should be taken in context. The eligibility criteria to be classed as an upper-middle-income country begin at $ 3,996 per capita GNI; however, all countries within the range of $ 3,996-$ 12,375 per capita GNI are categorised as upper-middle income. It’s glaringly obvious that we just about made the cut, and if we are to see the kind of growth and economic prosperity associated with upper-middle-income countries, we have a long way to go.

Middle-income trap

The fear is that the growth required to push our per capita GNI up by roughly another $ 8,000 will be elusive – the notorious “middle-income trap” could possibly impede upward mobility and economic prosperity. As a country leaves its demographic dividend, economic growth tends to slow. The growth that is seen in most developing countries is created by the shifting of labour from low-productive employment like agriculture to more productive sectors such as manufacturing. However, this is not a source of long-term growth. As labour flows into manufacturing, real wages will rise and productivity gains will reduce. As a result, a developing country will be unable to compete internationally with labour-intensive manufacturing. Low-productivity also means that competing with higher value-added goods will also be challenging.

The World Bank’s case study of the Middle East and North Africa (MENA) region and the challenges they face have some parallels with the Sri Lankan situation. The World Bank highlights the damage caused to the economy by a social contract where the state is expected to provide jobs in government and hand out universal subsidies, in exchange for a lack of accountability. The result is that entrepreneurship and innovation are stifled, public service delivery is poor, and there is widespread mistrust of the government. In addition, considerable debt burdens are forcing governments to cut public spending, which has long been the main driver of growth in the region.

The situation in Sri Lanka is quite similar. While we are now an upper-middle-income country, the description of the public service in MENA regions is apt, and could very easily describe the government service in Sri Lanka. As each election cycle begins, the incumbent government doles out an additional few thousand jobs, while the opposition promises to give more jobs and better wages in the government sector if they are voted in. A rigid labour market, where innovation is not encouraged, and productivity is not rewarded is just one factor that is likely to hold us back.

Maneuvering the minefield

The general solution presented is that middle-income countries need to shift gears – policy decisions now need to be taken with the objective of moving into a high-income country classification. Focusing on innovation, a strong export base, and creating decent jobs are just a few policy solutions that are presented on the topic. While this is challenging, our newfound title is also an indicator of the potential in the country. With the right policies in place, there is a lot that can be achieved, and with presidential elections coming up, now is the ideal time to bring up this topic of policy reform.

While the middle-income trap is a pervasive problem in the region, there are success stories of countries that have “escaped” the trap. The Asian Development Bank (ADB) has identified some common economic factors that these success-story countries have in common. The four key factors identified are as follows: (i) the country had a rapid transition from agriculture to industry, (ii) higher export shares, (iii) lower inflation, and (iv) decreases in inequality and dependency ratios. The ADB has also found that when looking at the drivers of growth for upper-middle-income countries, total factor productivity should not be underestimated – in other words, education, research and innovation, and structural reforms are vital.

Realising potential

Transforming the Sri Lankan economy will require a drastic shift in mentality. As a small island nation of only 21 million people, we need to open our borders for free movement of labour, technology, and investment. Sri Lankans require a shift in mindset, where the gains of free trade and integration into global value chains are not summarily dismissed. The risks of these actions are often over-exaggerated, or given sole focus, feeding into a larger protectionist mindset.

The positive is that Sri Lanka now has an idea of the challenges that lie ahead, and key policy reforms which would set the stage for the kind of economic growth that we aspire for. The hurdle lies in implementation. With presidential elections coming up, there is scope and policy room for new reforms to be brought in, and ideally, these reforms should be tailored to achieve the four success-story characteristics – a shift away from agriculture, a focus on exports, low inflation, and decreases in inequality and dependency ratios.

Growth, productivity and competition: Time to shift gears

Originally appeared on Echelon

By Ravi Ratnasabapathy

The Sri Lankan economy has been running, metaphorically speaking, in second gear. It’s time to shift up if we want standards of living to improve.

What determines the ‘standard of living’? Economists measure it in terms of the value of goods and services; when this grows, living standards improve.

Resources – land, labour and capital – and the extent to which they can be harnessed for productive purposes through entrepreneurship are the building blocks of the economy: what people use to produce goods and services. Having a large resource endowment, like oil, is an advantage. Sri Lanka has restarted efforts in oil exploration. In any case, it is better not to pin all our hopes of development on a chance oil strike.

So far, our development has been conventional. Like other poor countries, Sri Lanka has brought previously idle factors of production – land, labour and capital – into productive use.

Post-war, the integration of the North and the East expanded its limited pool of resources. This stage of growth is termed input-led, and is determined by the amount of input that a country can muster.

Once a country reaches middle-income status, especially upper-middle income levels, marginal returns to resources diminish and growth slows. The country also runs out of resources to bring into production: available land gets used, labour is fully employed, the population ages and incremental returns of capital slow down. The growth model is exhausted, so the economy stagnates. The production possibility frontier is reached. Sri Lanka is approaching this stage, as there is not a lot more stuff that can be thrown into our economic ‘pie’.

Sri Lankans today are, on average, much better off than their grandparents were. Some have become very wealthy, but there are still too many people who are relatively poor. The rich will be content, but less so the poor. If the population grows, living standards will fall, unless growth of the economy exceeds that of the population. Now, we face a conundrum. The total value of goods and services must increase, but such idle ‘factors’ are no longer available. The limits of its input have been reached.

From this point, the way to grow is through ‘productivity’. In economic terms, productivity depends on both the value of a nation’s products and services, measured by the prices they can command in open markets, and the efficiency with which they can be produced. It is the overall increase in value that makes high wages possible.

“Once a country reaches middle-income status, especially upper-middle income levels, marginal returns to resources diminish and growth slows”

Productivity matters at all stages of growth, but its importance increases as the production possibility frontier is reached. The New York Times columnist Paul Krugman said, “Productivity isn’t everything, but in the long run, it is almost everything. A country’s ability to improve its standard of living over time depends almost entirely on its ability to raise its output per worker.”

The challenge for a middle-income country such as Sri Lanka is how to create the conditions for rapid and sustained productivity growth. Rich economies produce, consume and invest in entirely different goods and services than poor economies. Economies typically move from primary products such as agriculture into manufacturing and services. This structural transformation—the movement of labour from low-productivity to high-productivity sectors—depends on the demand for labour in high-productivity sectors, and the supply of labour from low-productivity sectors. A multitude of factors affect this, but it is broadly driven by investment in more productive sectors and a regulatory regime that facilitates the movement of labour and other resources.

While new investment is important, export-oriented investment is especially important in smaller countries. According to an IMF working paper titled ‘Economic Benefits of Export Diversification in Small States’ (McIntyre et al, April 2018), “Openness to trade provides small states the chance to overcome the limitations of size through access to larger markets and opportunities to achieve economies of scale in production. Moreover, openness to foreign investment generally promotes long run growth through knowledge and technology transfers from foreign to domestic firms.”

However, the productivity of the domestic market cannot be neglected and the spur to this is competition. In ‘Building the Microeconomic Foundations of Prosperity: Findings from the Business Competitiveness Index’, Porter says, “Purely local industries also matter for competitiveness because their productivity has a major influence on the cost of living and the cost of doing business, not to mention their level of wages. The productivity of the entire economy matters for the standard of living, not just the traded goods sector.”

Open and vigorous competition in the local market will see the least efficient firms exiting the market, while market shares are reallocated from less efficient to more efficient firms, which causes overall productivity to rise. Porter also states, “Productivity is the goal, not whether firms operating in the country are domestic or foreign owned. What matters most is not ownership, but the nature and productivity of the companies’ activities in a particular country.”

The government has a two-fold role to play in this structural transformation; it must facilitate the increase in productivity and help manage the costs. Many elements are involved. Investment is needed, especially in new areas, so prudent fiscal and monetary policy is a precondition.

Investors seek low transaction costs and high certainty, and these characteristics are best secured by institutions (judiciary, public administration, the financial system, regulatory agencies). High-quality laws, courts and bureaucracy increase efficiency. Stable, accessible and clear laws; limited discretion (bureaucratic/ministerial); low corruption; and consistent/ impartial court rulings increase predictability. All these influence investments in physical and human capital, technology, and the organisation of production.

The importance of exports has already been stressed, but we cannot rely on garments and tourism; diversification is needed for much faster growth. In 2000, export revenue of both Vietnam and Sri Lanka was around $2 billion. In 2017, Sri Lanka’s exports reached $11.4 billion, but Vietnam achieved $162 billion. Over the period 2000-14, Vietnam added 48 new products to its export basket with a per capita value of $545, while Sri Lanka added seven, with a per capita value of $5. Moving to higher-value sectors will support higher wages in exports.

In the domestic market, the weakest sector is agriculture, which absorbs about 28% of the workforce but contributes only 8% to GDP. Policy to speed up the modernisation of agriculture – helping producers acquire scale, invest in food processing, encourage crop diversification and improve productivity (mechanisation, drip irrigation, greenhouses, quality seeds etc) – is needed. Land policy needs review, and support for R&D must replace subsidies and price guarantees. Reforms to provide tenants and smallholders proper ownership or tenure could inject dynamism to agriculture. It requires careful study and needs to be geared to local circumstances, but the experience of Korea and Taiwan are worthy of study: “Land reforms in the Republic of Korea and Taipei, China, also led to rapid structural transformation in three ways. First, the land reforms led to increased incomes among poor farmers in the two countries, who could then invest some of the income in the schooling of their children. [The increase in agricultural productivity in Taipei, China, was particularly striking, with yields of traditional crops such as rice and sugar increasing by half, and that of fruits and vegetables doubling (Studwell 2013).] This led to the availability of a skilled workforce in the Republic of Korea and Taipei, China, necessary for rapid export-oriented industrialization. Second, increased incomes in rural areas led to an expansion of the domestic market in the manufacturing sector, fostering rapid industrialization. Third, the more egalitarian land distribution provided a stable political environment, which allowed the political leaders of the two countries to concentrate their attention on rapid industrialization.” (Ban, Mun, and Perkins 1980; Putzel 2000; Studwell 2013).

Trade liberalisation is needed to promote competition and improve efficiency in the domestic market. Tariffs or subsidies may be replaced by supporting the adoption of new technology and R&D, and enhancing worker skills.

Improving the quality of the factors will improve productivity: infrastructure to improve physical capital, and education to improve human capital.

“The richer sections of society may not see a need for reforms, but if broad-based growth is not maintained, the destructive ethnic tensions of the past could resurface”

The process of reallocation is disruptive, it involves changes in the size and make-up of an economy, and the distribution of activity and resources among firms and industries. Some sectors will
shrink, or even disappear, and new ones will appear. Firms will close or downsize, while others set up or expand. Some workers may find it difficult to transition, so there is a need for income support for displaced workers and to foster reintegration through training and job search assistance. The focus should be on protecting the worker, not the job.

Sri Lanka’s economy has undergone some structural changes since 1960. According to ‘The Sri Lankan Economy.

Charting A New Course (ADB 2017), “The share of agriculturehas shrunk quite rapidly, from about 30% of GDP to a little over 10%. Industry has expanded from about 20% of GDP in 1960 to over 30% by 2015.” Post-war reconstruction helped boost growth, but this has petered out.

The richer sections of society may not see a need for reforms, but if broad-based growth is not maintained, the destructive ethnic tensions of the past could resurface. Improving living standards is the surest way to avoid a return to our troubled past.