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.