Financial Times

Govt. support crucial during crisis

The tea industry is perhaps Sri Lanka's most strategic economic sector and pure Ceylon tea our only internationally known brand. We are the world's biggest tea exporter, manufacturing more than 300 million kilos of black tea annually, almost all of which is exported. Our orthodox teas usually sell at a premium over other orthodox teas from elsewhere. Therefore, government support for the industry is vital at a time of crisis in much the same way as other governments, even in the most capitalist of countries, support their strategic industries, both at their inception and in times of crisis.

The Ceylon tea industry is today faced with two major crises in its two biggest markets. Tension in the Persian Gulf on account of American preparations for an attack on Iraq disrupted buying at the Colombo auctions, which led to a build up of stock and a fall in prices of low grown teas, and created cash flow problems for factory owners and planters. Low growns are produced mainly by smallholders in the southern districts, a significant support base for any political party that seeks power at the centre.

Although renewed buying interest has revived prices, the price levels are still below those that prevailed before the crisis, which means less income for factory owners and green leaf suppliers. The uncertainty still prevails and an actual war, if it does take place, could most likely affect demand and disrupt shipments.

On top of this comes the news that Russia, and possibly the Ukraine, which together with other members of the Commonwealth of Independent States, make up the biggest market for Ceylon tea, are planning to impose very high import duties on value-added teas. This, in effect, would price our value-added teas, particularly tea bags, out of the Russian and Ukrainian markets.

Urgent action is required on both fronts. It is a pity the government had to wait until the industry began making noises about the trouble it was in before announcing that it was considering relief measures. In fairness to the government it must also be said that certain sections of the industry, like so many of our businessmen, cry for state support at the slightest hint of trouble, forgetting the fact that doing business has its risks and that losses are a normal part of life in a capitalist, free market economy.

The looming Russian crisis may turn out to be a bigger problem, especially considering the expressed desire on the part of government and industry to increase value added tea exports as a way of getting out of the dependency on bulk commodity exports. The world is awash with cheap commodity exports by impoverished Third World countries. There is even a belief that these powers have a hidden agenda to increase such commodity exports so that they have access to cheap raw materials while retailers in developed markets make a killing on huge profit margins. A case in point is the aid given by the Asian Development Bank to increase coffee planting in Vietnam, which has resulted in a massive glut of coffee in the world market that has forced prices down. The same could happen with tea, considering the ADB support to increase tea planting in Vietnam, which could emerge as a significant threat to Ceylon tea in the future. World tea production is on average increasing slightly faster than tea consumption. Urgent action is therefore required to protect our access to the Russian market, perhaps by sending a government delegation to Moscow to plead our case, as our story on page 13 indicates . More support for building brands is also important. It is high time the government stops talking and takes action to provide the required support for the vital tea industry.

Is export-led growth a myth?

By Professor S.S. Colombage ,
The Open University of
Sri Lanka
Sri Lanka has just completed 25 years of economic liberalization. In November 1977 the then government embarked on a liberalization path by removing an array of administrative controls so as to create a market-friendly economic atmosphere conducive to the private sector, which was to be the engine of economic growth. The underlying objective of that package was to shift the policy focus from an inward-looking import substitution strategy to an outward-looking export-led growth strategy. The package included what is called the first-generation of economic reforms like relaxation of import controls, reduction of tariffs, adoption of a flexible exchange rate system, removal of price controls, liberalization of financial activities and introduction of incentives to foreign investors.

Benefits
It is widely believed that developing countries can enhance their growth prospects by adopting outward-oriented growth strategies. Underpinning this belief is the export-led growth hypothesis, which postulates a positive relationship between exports and economic growth. These empirical studies have revealed that export growth can stimulate economic growth mainly by way of expanding the domestic production and technology diffusion. As the debate on economic growth was shifting in favour of the export-led growth strategy, the world economy underwent dramatic changes in the last two decades with many countries adopting policies to integrate themselves with the rest of the world.

Mixed results
In Sri Lanka, the liberalization process has had far-reaching socioeconomic implications. On the positive side, the liberalization has fostered a certain degree of export diversification, employment creation, output growth and poverty reduction. The liberalization has helped the country to graduate from the low-income category to the middle-income category in the World Bank country classification. Income growth was associated with certain improvements in health, education and housing conditions. But the liberalization exercise has many negative fall-outs as well. The actual income growth realized through liberalization was far below expectations. Sri Lanka has now settled down to a low growth trajectory of 3-4 percent a year. As a result, there is widespread poverty and unemployment.

Slowdown
The economy has not followed a smooth growth path in the post-liberalization period. In the short run, the year-to-year growth in GDP was highly volatile. In the long run, economic growth in the post-liberalization regime is not very different from the pre-liberalization regime. The GDP growth averaging 4.4 percent a year in 1978-2002 is marginally higher than the 3.8 percent growth in 1960-77.

The story for the recent years is even worse. Following a peak GDP growth rate in 1997, the economy has been experiencing a setback owing to a multitude of factors including macroeconomic instability, the prolonged northeast conflict, political uncertainties, infrastructure breakdowns and global recession. Thus, the economy is now on a downward path; the average growth is only 2.3 percent in 1998-2002. The GDP recorded a negative growth rate of 1.4 percent in 2001 for the first time since independence. Although a positive growth of 2-3 percent is estimated for 2002, owing to an increase in the services sector output, the economy has still not recovered from the slump.

Limited diversification
A primary aim of the liberalization was to diversify the production structure by way of promoting export-oriented industrialization and thereby reducing reliance on agriculture-based primary commodity exports. Now let us see whether the liberalization has helped the country to transform the above unhealthy economic structure. The contribution of the industrial sector to the overall output hardly increased even after the liberalization. This sector still accounts for only 17 percent of GDP, compared with 12 percent in 1977. The share of agriculture declined significantly from 35 percent in 1977 and to 20 percent in 2001. The services sector has increased its share from 46 percent in 1977 to 56 percent in 2001. This was due to a rapid increase in the service activities relating to trade, transportation, information and communication technology, banking and finance in the post-liberalization period. As the economy grows, this kind of an expansion in the services sector and a downward trend in agriculture are quite normal. But the excessive growth of the services sector without an accompanying expansion in the production base of agriculture or industry has weakened the country's capacity to sustain a steady growth path.

A major cause of the sluggishness in the industrial sector is inadequate product diversification. Manufacturing enterprises have been concentrating on a limited range of labour-intensive and low value-added products. Of the total manufacturing output, wearing apparel and leather products account for 40 percent, food and beverages 22 percent and chemical, petroleum, rubber and plastic products 18 percent. Other products include non-metallic mineral products, metal products and paper products. In comparison, the manufacturing industries in East Asian countries graduated from labour-intensive products like textiles and garments, which were dominant in the 1960s, to capital-intensive and high value-added industries such as automobiles, computers and televisions in the 1980s. These are considered as dynamic products whose trade is growing faster than the world average. Sri Lanka's industrial exports are still confined to less dynamic products of yesteryear. Failure to identify and develop a dynamic mix of products has retarded industrial transformation and export growth in Sri Lanka.

Inadequate diversification in the industrial sector is also reflected in the export structure. Garments account for 70 percent of total industrial exports. Other major industrial exports are similar less-sophisticated products like food and beverages, footwear, and chemical and rubber products. High-technology exports accounted for less than 3 percent of manufactured exports in 2000.

High inflation
The macroeconomic setting was somewhat uncomfortable in the post-liberalization period, and this has been a major impediment to economic growth. The rate of inflation, which means the rate of change of consumer prices, was high at 12 percent a year during 1978-2002. High inflation means high cost of living. It has dampened the living standards of people, particularly the low-income earners. Inflation has adversely affected production activities as well. In the high inflationary situation, production costs like wages and raw material costs have tended to increase, reducing the already low profitability of entrepreneurs. This has had depressing effects on investment and production. Inflation has also discouraged savings, as it exerts dampening effects on real interest rates.

Meanwhile, the high inflation has weakened the country's export competitiveness considerably, as its exports became more expensive relative to the competing countries due to rising production costs. With high inflation, it has always been difficult to maintain the exchange rate at realistic levels so as to safeguard export competitiveness. This vicious circle of rising prices, rising production costs, deteriorating export competitiveness and exchange rate depreciation, has haunted the economy after the liberalization, and depressed the growth potential.

Many factors including the dismantling of price controls, reduction of subsidies, high fiscal deficits, rising money supply and rising import costs have contributed to accelerate inflation. Among them, a major reason for high inflation is "too much money chasing too few goods". The excessive expansion of the money stock tended to raise demand for goods and services and thereby induced inflation. Reflecting the lack of independence on the part of the Central Bank, it has allowed the money supply to increase so as to accommodate the fiscal deficits.

Forex shortages
The country has also encountered difficulties in maintaining the external balance. As we spent more than what we earned from the rest of the world, the current account of the balance of payments has always been in deficit after liberalization. A rapid increase in imports that resulted from the greater openness outpaced the sluggish export growth. As the inflows of foreign direct investment (FDI) and portfolio investment (in the share market) have been rather dismal, the country had to rely heavily on foreign borrowings to finance its current account deficits.

This has led to raise the country's debt service burden; the outstanding foreign debt now amounts to nearly 50 percent of GDP.

Low investment, savings
A major factor that determines economic growth is investment in physical capital, which is also known as physical capital accumulation. The inadequacy of domestic savings has been a major reason for the low investment levels. In the household sector, the low levels of per capita income do not warrant any substantial growth in savings. Besides, the high inflation has discouraged savings during the liberalization period. The corporate sector could not perform too well in the context of the economic setback in recent years and as a result, its savings have been stagnant. In the government sector, the current expenditure has always exceeded its revenue resulting in current account deficits or net savings. Heavy government borrowings from the financial market to finance the budget deficit have preempted resources available to the private sector. If Sri Lanka is to grow at a faster rate, more investment is needed and this will entail larger inflows of foreign direct investment or loans. Various impediments in the financial sector also have had detrimental effects on both savings and investment. As the reform agenda pertaining to the financial sector has not been fully implemented, this sector still remains non-competitive and less efficient.

Poor technical skills
In spite of the human resource endowments, Sri Lanka's economic growth falls short of what could have been achieved. This means that the country's relatively high educational levels have not been translated into a highly productive labour force. Deficiencies in human capital are reflected in the wide disparities in the student participation rates at different levels of education. At the university level, the enrolment ratio is as low as 2-3 percent. Expansion of education in science and technology is crucial to take advantage of the current technology revolution. In this regard, we have not made much progress. The gross tertiary science enrolment ratio remains around 1.4 percent for Sri Lanka.

The technology revolution, particularly in the field of information and communication technology (ICT), has changed the development paradigm dramatically in recent decades. Technological transformation is occurring rapidly today. In Sri Lanka, much technological progress does not seem to have occurred in production activities. This is reflected in the Technology Achievement Index (TAI) introduced by the UNDP (2001) The TAI value for Sri Lanka is only 0.203, compared with 0.585 for Singapore, 0.455 for Hong Kong and 0.396 for Malaysia. Inadequate technical progress has prevented any significant improvement in factor productivity.

As capital productivity declines, more and more investment is needed to increase economic growth.

Missed opportunities
Sri Lanka's past growth performance has remained much below its potential growth. Her economic growth is low, compared with some fast growing Asian countries like India, China or Vietnam. Many factors including the stop-and-go type economic reforms, North-East war, infrastructure deficiencies coupled with the above-mentioned shortcomings inhibited our growth. If the growth momentum that emerged during the period 1978-1982 continued unabated throughout the liberalization period, we would have enjoyed a high growth path.

Accordingly, we would have reached a per capita income level of around $ 2,500 by now, which is about three times of the present per capita income. This would have been possible, had not the reform process been disrupted by various factors including the North-East war, political instability and macroeconomic imbalances.

Growth prospects
Looking ahead, the future growth prospects will depend to a large extent on the pace at which the growth constraints are going to be tackled, according to a recent IMF country report. The GDP growth would rise steadily to 6.5 percent over the medium term in a moderate scenario, assuming significant structural reforms, sustained competitiveness and global recovery. But the medium-term growth would come down to around 1 percent a year accompanied by poor export growth in the low case scenario, if we assume non-implementation of structural reforms, continuing power cuts, drought conditions, slow peace process, weaker global recovery and higher oil prices. In the high case scenario, the GDP growth would rise to 8.5 percent over the medium-term, assuming a rapid progress in the peace process, implementation of an ambitious structural reform agenda and faster rehabilitation of the North-East. These positive developments would bring about improvements in domestic investments, exports and foreign capital inflows. Thus, the extent of the effectiveness of the export-led growth strategy in fostering economic progress will depend on so many factors.

Future lessons
We have seen that the road to prosperity through market reforms has not been a smooth one for Sri Lanka. The social, political, ethnic and economic upheavals that surfaced throughout the post-liberalization period have jeopardized the adjustment path. The North-East war that erupted five years after the launch of the economic reforms has continued to be a major roadblock for the last twenty years. The outcome of these impediments is that the country has failed to achieve socioeconomic progress through economic reforms as originally envisaged. Maintenance of macroeconomic stability is an essential prerequisite of a successful outward-oriented policy regime. Policy makers attempting to stimulate export growth should curb the inflation rate, external current account deficits and budget deficit. In this regard, fiscal discipline, coupled with prudent monetary polices, is critical.

The Central Bank should act as an independent monetary authority, and focus on inflation targeting rather than merely satisfying the fiscal authorities.

Macroeconomic policy coordination in the areas of monetary and fiscal policies and exchange rate adjustments is vital to sustain export competitiveness.

Policy makers should pay attention to the solvency of banks, which depends to a large extent on the ability to recover loans. Loan defaults have risen alarmingly in recent times partly as a result of the poor institutional governance and sluggish economic performance. Some financial institutions are already facing liquidity problems. The Central Bank liquidated a licensed specialized bank recently due to alleged misconduct. This partly reflects the shortcomings of the post-mortem type bank supervision methods currently practiced by the Central Bank. In the light of these emerging problems, urgent action is necessary to strengthen the supervision mechanism with a greater focus on early-warning devices.

Capital Account
liberalization
Liberalization of the capital account of the balance of payments has received much attention in recent policy discussions. Proponents argue that capital account liberalization would help to attract long-term foreign capital. But we may note here that capital account liberalization should proceed cautiously in an orderly manner. The country should have sufficient foreign reserves to open its capital account; our reserves are barely sufficient to finance only about two months' imports.

A strong regulatory mechanism is needed to prevent financial crises that may arise after liberalizing the capital account, as happened in East Asia in 1997. The East Asian experience also displayed that poor macro economic policies leave a country vulnerable to financial crises. In all these spheres, Sri Lanka has a long way to go, and therefore capital account liberalization seems to be premature at this juncture.

Public policies
The reform agenda needs to be reactivated with a clear macroeconomic vision, taking into account its socioeconomic implications carefully. Although the private sector is the engine of economic growth in a liberalized economic regime, the entire responsibility of economic activities should not be left in the hands of private entities.
This is why public policy becomes important. Government interactions, in the form of second-generation reforms, are needed in areas such as institutional reforms, public utilities, monopoly and mergers, labour management, financial sector surveillance and corporate governance. Liberalization itself is not a panacea for all economic ills. The experience of Sri Lanka clearly demonstrates that the political, social and economic atmosphere of the country should have the desirable characteristics to realize the objectives envisaged in an export-led growth strategy.

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