Solving Sri Lanka’s growth conundrum: lessons from East Asia

Originally appeared on Echelon

By Ravi Ratnasabapathy

Sri Lanka’s economy has lagged its potential for decades. Even nine years after the end of the war, growth remains elusive. Something is wrong, but what? Sri Lanka, like other developing countries, experienced short spurts of growth, but nothing like sustained growth over decades that took place in East Asia.

Between 1965 and 1993, the high-performing countries of East Asia (HPEA) – Hong Kong, Singapore, Taiwan and South Korea – broke the mould of history: they brought about, within a single generation, a process of socioeconomic development that took the advanced economies of Western Europe centuries to achieve. Malaysia, Thailand and Indonesia also experienced rapid progress, although not to the same extent as the others. These nations used a range of policies, from hands-off to highly interventionist, so no single “East Asian model” exists, but economic openness, macroeconomic stability and flexible labour markets were common factors that provided the enabling environment for growth.

DRIVERS OF GROWTH
There is a general agreement that the two principal drivers were as follows:
(a) rapid capital accumulation, both human and physical
(b) superior allocation of physical and human resources among various sectors of the economy

High levels of investment created jobs, which together with ongoing investments in education, improved skills and enabled workers to move into new industries as they opened up.

OPENNESS TO TRADE
Sri Lanka’s educational standards, like India and the Philippines, exceeded those of East Asia in the 1950s. The difference was the environment in which investments in education took place: an openness to trade. While Sri Lanka, India and the Philippines adopted a path of self-sufficiency, closing themselves to outside influences, the rest of East Asia opened up.

After an early phase of import substitution, the miracle economies embarked on a strategy of outward orientation from the 1960s. This outward orientation was reflected in their lowering of tariff rates and export taxes, the removal of quantitative restrictions on trade and reduced barriers to international investment flows (ADB, 1997).

FDI brought new production techniques, quality control and access to external markets. It created competitive pressure on local firms to acquire new skills. An important spillover effect was the demonstration effect to domestic firms regarding feasibility in terms of production and quality, thus heightening demand for new technology and sophisticated skills by local firms. This created a virtuous cycle of accumulation and assimilation: rapid acquisition of new technology went hand in hand with the formation of new skills, some of which took place outside schools; on-the-job-training, informal acquisition of knowledge and learning by doing. Some innovations originated on the shop-floor.

Growing levels of income, in turn, increased both private and public investment in education including, specifically, higher education, and science and technology. The outcome is reflected in the rising shares of exports and imports as a proportion of these economies.

MACROECONOMIC STABILITY, FISCAL PRUDENCE AND DEBT
Exceptional macroeconomic management created the stable environment essential for private investment. Fiscal prudence is key to macroeconomic stability. Balanced budgets lead to low inflation, low interest rates and stable exchange rates. Some countries did run small deficits: between 1961 and 1996, South Korean deficits averaged 0.86% of GDP, Thailand (0.79%), Indonesia (1.09%) and Malaysia (4.04%), but nothing like Sri Lanka’s deficits, which averaged 8.2%.

Countries that did run deficits financed them prudently, avoiding money printing, which causes inflation and currency depreciation, unlike Sri Lanka.

TECHNOLOGY AND PRODUCTIVITY
East Asia’s extraordinary growth was not only due to superior accumulation of physical and human capital, but also to better allocation of capital. The more easily accessible resources in an economy can move from lower to higher productivity activities, the greater the overall productivity.

Lower-income countries are less developed not only because they have less physical and human capital per worker than developed economies, but more importantly, because firms use their tangible input of labour, capital and raw materials less efficiently – and without combining them with sufficient complementary, knowledge-intensive intangible assets (Dutz & O’Connell, 2013).

Sustainable economic growth is based on productivity growth.

Productivity growth in Sri Lanka increased following reforms in 1977/78, but slowed steadily between 1988 and 1997 mainly due to slower adoption of technology (Bandara and Karunaratne). In an open world, there is always competition from low-wage economies that compete on cost. Established players may start with low wages, but must move up the value chain, redesigning and improving their production systems to increase competitiveness.

Competitive pressure forces firms to improve, restructure or close. Inefficient firms being closed or taken over (by more efficient ones) is not harmful, but increases overall productivity, a process termed “creative destruction”. In common, East Asia did not have high levels of labour protection, making it easier to downsize or close businesses.

Instead of minimum wages or job protection, governments focused on job generation, boosting demand for workers, resulting in rising employment levels, which was followed by market- and productivity-driven increases in wages. Low inflation meant workers experienced real increases in living standards, unlike in Sri Lanka where inflation erodes wage increases.

Resource allocation is also dependent on prices and regulation, prices for energy, raw materials, and indeed all factors of production including labour and capital. For example, mispricing energy may change the relative competitiveness of certain industries, and subsidised credit could end up propping up inefficient firms. Despite some limited intervention, all HPEAs kept price distortions within reasonable bounds. Regulations can create rigidity that impedes optimal resource allocation (e.g. Paddy Lands Act prevents alternative use of land).

SELECTIVE INTERVENTION
Many HPEAs practised intervention to foster development, with variable results. Where guided by political considerations, such as Malaysia’s efforts at heavy industrialisation in the 1980s and Indonesia’s high-tech industrialisation in the 1990s, they did not succeed. (Jumo 2001).

Where selective interventions succeeded, they did so because of three essential prerequisites. First, they addressed problems in the functioning of markets. Second, they took place within the context of good, fundamental policies. Third, their success depended on the ability of governments to establish and monitor appropriate economic-performance criteria related to the interventions (World Bank, 1993). A technocratic bureaucracy, insulated from political pressure with capacity to conceive and implement the policy designs, is essential. This requirement, and the fact that the WTO rules now bar some of these policies, means that this has limited application for Sri Lanka. The World Bank concludes that “the market-oriented aspects of East Asia’s policies can be recommended with few reservations, but the more institutionally demanding aspects, such as contest-based interventions, have not been successfully used in other settings” (World Bank,1993).

CONCLUSION
East Asia’s success was based on set complementary factors that worked in concert. Economic openness is critical, but must go with macroeconomic stability, low price distortions, and a conducive regulatory environment that encourages investment and permits efficient allocation of resources. Sri Lanka retreated from a policy of openness since 2000, raising tariff 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% in 2016. Total nominal protection doubled from 13.4% to 27.9% between 2004 and 2009 (Pursell 2011).

Tariffs and policies favour import substitution in agriculture and industry. Domestic industries have thrived, but at the expense of productivity. Low productivity growth means wages rise slowly, but high tariffs from food and household products translate to high costs of living. This prompts workers to seek high wages (which deters some investments) or better paying jobs overseas. Worker remittances support families, propping up consumption and local industries. Trade and regulatory barriers make Sri Lanka unattractive for investment, which means lower levels of technology transfer and, in turn, productivity; a cycle that needs to be broken.

KEY RECOMMENDATIONS
1. Trade and commercial policy liberalisation
2. Macroeconomic reforms
3. Investment and regulatory reform Trade reforms

Eliminating the anti-export bias of import protection (resulting in exports being less profitable than domestic sales, propped up by high protection) encourages trade and investment in exports. This overcomes limitations of the domestic market and creates the competitive pressures that drive productivity. This works through three channels.

First, it lowers prices, benefiting consumers by increasing purchasing power (pro-competitive effect); second, it forces less competitive firms out of the market, reallocating resources to more competitive ones (selection effect); finally, it induces innovation to improve productivity (innovation effect). Higher productivity growth produces not just one-off price reductions, but a sequence of reductions over time, increasingly benefiting present and future consumers.

Macroeconomic reforms
There is acceptance on the need for fiscal consolidation and balancing budgets, but adopting a Medium-Term Expenditure Framework; an annual, rolling three year-expenditure plan that sets expenditure priorities; and hard budget constraints increase predictability and credibility of commitment to macroeconomic stability. Creating externally imposed constraints on Central Bank operations based on commitments to the IMF or, more radically, by adopting the German Bundesbank Law as done in some East European nations will enhance this further.

Investment and Regulatory reforms
Broad-based regulatory reform must include agriculture, which contributes about 8.7% of GDP, but absorbs 28% employment. Reforms to seed, planting material and land policy to increase productivity are needed. Incentives should promote the adoption of technology (greenhouses, drip irrigation) and mechanisation. Withdraw price and marketing interventions. Divert expenditures to provision of agricultural insurance, finance, irrigation infrastructure and R&D.

In East Asia, agriculture productivity improvements released labour to work in non-farm employment, and reduced food prices helped increase the value of real incomes (ADB 1997).

Encourage private provision of tertiary education to meet the evolving skills needs of an outward-oriented economy. The impact of policy reforms will be enhanced by investments to eliminate infrastructure bottlenecks. Investments must be characterised by transparency, efficiency and quality, and privately financed to minimise budget strain. These are merely the outline of a large reform process to ease investment and trade. Post-war, the economy experienced a brief spurt of debt-fueled reconstruction and infrastructure-driven growth, but this petered out. Apart from questionable improvements to productivity, it is a path that is closed to a heavily indebted government.

East Asia grew in different circumstances, but openness and trade underpinned by decent macroeconomic fundamentals still offer opportunities for growth, as demonstrated by later reformers like Vietnam. It is the path Sri Lanka should return to.

References
1. ADB (Asian Development Bank). 1997. Emerging Asia: Changes and Challenges. Manila.
2. Productivity, Innovation and Growth in Sri Lanka, An Empirical Investigation, Mark A. Dutz Stephen D. O’Connell, World Bank 2013
3. An empirical analysis of Sri Lanka’s Manufacturing Productivity slow-down, Bandara, Yapa M. W. Y. and Karunaratne, Neil D. (2010) An empirical analysis of Sri Lanka’s Manufacturing Productivity slow-down. Journal of Asian Economics
4. Jumo, K. 2001. “Rethinking the Role of Government Policy in Southeast Asia.” In Joseph E. Stiglitz and Shahid Yusuf, eds., Rethinking the East Asian Miracle. Oxford, U.K.: Oxford University Press.
5. The East Asian Miracle, Economic Growth and Public Policy, World Bank 1993.
6. Pursell, Garry and F.M.Z. Ahsan (2011), ‘Sri Lanka’s Trade Policies: Back to Protectionism’, Australia South Asia Research Centre Working Paper 2011/03, Canberra: Australian National University
7. Growth and Poverty: Lessons from the East Asian Miracle Revisited, M. G. Quibria, 2002.
8. Giammario Impullitti and Omar Licandro. 2018.We may be underestimating the gains from globalisation. [ONLINE] Available at:http://blogs.lse.ac.uk/businessreview/2018/03/09/we-may-b-underestimating-the-gains-from-globalisation/. [Accessed 10 April 2018].