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.

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 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.