Financial Times

Sri Lanka should double foreign investment flows
Sri Lanka should be looking to attract at least $350 million per year in FDI judged by the international comparisons presented above which is double the amount attracted per year in the 1990s, according to a UNDP-UNCTAD report on "Investment Policy Review: Sri Lanka". Excerpts of this very useful report will be serialized in two parts. This is the first part:

Impact of FDI
The impact of FDI on an economy can be considered in terms of a number of indicators. FDI clearly brings investment finance and can contribute to employment. Developing countries also seek FDI for its potential contribution to technology and skills; the pioneering of new industries and export markets; the formation of new clusters as anchor investors; and the creation of linkage with, and associated upgrading of competencies of local enterprises.

Technology-skills
Technology and skills transfer is perceived as one of the major benefits of FDI. Sri Lanka is in a good position to benefit from such transfer due to the potential of its workforce. In the absence of much substantial analysis dedicated to the subject, it is difficult to provide an overall picture of the contribution of FDI to such transfer in Sri Lanka. However, scattered evidence suggests that the impact may be substantial.

There are also indications of potential or actual skills and technology transfer to enterprises outside the firm. The system of engagement of Sri Lankan doctors as consultants and the training of Sri Lankan nationals as nurses by Apollo Hospital, Colombo may lead to substantial transfer of health care technology to other hospitals as and when these doctors or nurses take up employment elsewhere.

Domestic firms in the porcelain and cement industry have also benefited considerably from the examples of pioneering foreign investors. Unilever, a wholly owned foreign enterprise in Sri Lanka, appears to have made considerable contribution to transfer of management and marketing technologies. It is understood that many professionals in these fields who are working with Sri Lankan companies are ex-employees of Unilever.

Employment-linkage
In terms of employment, FDI has made a notable contribution in Sri lanka. As of end 2000, it is estimated that foreign affiliates (wholly owned plus joint ventures) employed some 200,000 people compared with total private sector employment of 2.7 million. Thus, the proportion of private sector employment accounted for by foreign affiliates is about 7.4 percent.

However, it appears that in some areas FDI has not had as significant an effect in terms of such linkages to domestic companies. An important example is the lack of development in backward linkages between the clothing and textile sectors. There is limited integration between the sectors with the majority of textiles being imported.

Reasons offered for the lack of success in forming supplier industries in the past include the high cost of machinery, lack of local raw material and electricity charges. However, the recent establishment of a number of textile and accessory manufacturers is improving the picture.

Diversification of output/exports
FDI has made a major contribution to Sri Lanka's exports. During 1996-2000, exports by foreign affiliates have been consistently of the order of one-third of total exports of the country. Moreover, FDI has been important in diversifying Sri Lanka's export base. FDI in garments has led the country's diversification in this manufacturing sector. Growth of the sector was in response to quota opportunities under the Multi-Fibre Agreement, the availability of low cost and educated labour, and convenient geographical location in international transportation networks.

There are grounds (but also caution) for concluding that the future for private investment can be very much brighter.

* Private investment responded quickly in the past to initiatives.

* FDI responded reasonably well to new opportunities in the 1990s although it is still narrowly based, flattered by one-off privatization opportunities and, in aggregate, well below inflows achieved in comparable countries. It will take excellent policies and promotional efforts to increase and diversify FDI.

* The low structural transformation of the economy and the negligible amounts of FDI prior to the 1990s raise questions about the business competencies of much of the private sector. On the other hand the high level of joint ventures associated with the (modest) inflows of FDI suggest a business and financial capability to move with the times. Local capacity to form joint ventures could be especially important in hotel and related tourist ventures, in transport, logistics, and business and professional services. It is already being demonstrated in export manufacturing and will be increasingly so as free trade privileges open up with India and perhaps the US.

* The business community believes there are skills' shortages although local labour is highly trainable. Standards of general education are very much better than would be expected in a country with a per capita income of only $800. It will be vital to improve the poor infrastructure to fully capitalise on the good skills based.

On balance there are grounds to be very optimistic that private investment can grow strongly once peace is fully restored. FDI should accelerate. Sri Lanka should be looking to attract at least $350 million per year in FDI judged by the international comparisons presented above (double the amount attracted per year in the 1990s). Even then, it would only match FDI inflows per capita in Vietnam. It would need to double again to approach Thailand's performance in per capita terms.

Investment framework
A new investor reading the business laws of Sri Lanka could understandably conclude that much of Sri Lanka's regulatory environment is archaic and unhelpful to business. In most respects current practice is better. This environment arises both from the activities of the BOI, which is an administering authority for much sensitive regulation, and from the good sense employed elsewhere in the line ministries. In most cases key ministries are headed by competent individuals who are fully aware of modern practice and business needs. Moreover, the government has a large pipeline of new legislation to modernise business regulation.

In time the BOI has become a powerful presence in the Sri Lanka business world. It is seem as being particularly helpful to new large investors. Almost all FDI (apart from some privatisations) in Sri Lanka enters through the BOI "gateway."

Taxation
The principal taxes that affect business in Sri Lanka are taxes on corporate profits and dividends, value-added tax (VAT), and import and excise duties. In the standard direct tax regime, profits are taxed at 30 percent with reasonably rapid depreciation allowances and loss carry forward of six years. Dividends distributed to residents are subject to a final tax of 10 percent. Non-resident dividend withholding tax (DWT) is also 10 percent. Sri Lanka has a wide network of double tax treaties (DTT's).

Personal taxation is in three bands of 10, 20 and 30 percent respectively with an allowance providing relief from tax on incomes up to the equivalent of about $2,500 per annum. This threshold is at least twice as high as average wages in manufacturing and higher than many typical wages in administrative positions.

Import duties are moderate by regional standards. Typical standard rates are 2.5-10 percent for industrial plant and office equipment and 20-25 percent for building materials and office furniture. Vehicle import and excise duties combined are in the range of 40-60 percent.

VAT was introduced in 2002 to replace two other forms of sales taxes. Taxes are two-tier - 10 percent on essentials and 20 percent on non-essentials. Exports are zero-rated. The registration threshold is about $20,000 per annum (high for a low income country). However, the effective implementation of VAT has been delayed due to a challenge as to whether the imposition of VAT on retail and wholesale trade is consistent with the sales tax prerogatives of Provincial Councils.

The general fiscal regime is perceived to be uncompetitive for particular kinds of investments. It is relieved by selective incentives rather than by addressing the uncompetitive elements in the general fiscal regime. Investors who obtain the incentives are satisfied but there are a number of pitfalls with this approach in Sri Lanka as elsewhere.

It discriminates against small and medium enterprises (SMEs) in most cases of incentives. Yet those investors not eligible for incentives face a tax burden that is 50-100 percent higher than that of incentive companies.

* It requires a substantial bureaucracy to approve and monitor size-based incentives. Any lowering of thresholds to curb discrimination against SMEs would increase the bureaucracy.

* It has masked the true investment attraction performance of the BOI. Many investors would approach the BOI as a gateway to incentives and not because of leads generated by the BOI. This further encourages the BOI to recommend incentives in marginal cases. For example, a large headquarters building constructed in Colombo by a leading bank is structured as a "BOI company" to gain tax incentives.

* It has almost certainly led to structuring of business so as to reduce tax in unanticipated ways. For example, there is an obvious incentive for banks to lend to zone companies (deemed to be non-residents) through their tax advantaged Foreign Currency Banking Units (FCBUs).

* The BOI does not provide facilitation services to SMEs because they are too small to become "BOI companies" via an entitlement to tax incentives.

Overall fiscal strategy is beyond the remit of this report. However, the application of lengthy tax concessions to most large investors over many years undoubtedly contributes to weak Budget revenue and a high fiscal deficit. This contributes to clearly inadequate public expenditure on infrastructure, which must be a serious constraint to private investment.

Reform of the standard tax regime
Consider cutting the headline profits tax rate to 15 percent (certainly no more than 20 percent). Retain other key elements of the corporate tax regime including rapid rates of depreciation allowances and 10 percent tax on dividends. This may well ensure that Sri Lanka's direct taxation is competitive without the need for special regimes in most sectors.

Develop special regimes: Special regimes should be developed where still required, after reform of the standard regime. Develop special measures to attract talented diaspora- These could include improved tax treatment of offshore sourced passive income, neutral tax treatment of offshore pension arrangements, concessions on income tax from gains on exercise of stock options and measures to cushion the impact of low personal relief thresholds on very high income earners.

Review the fiscal stability agreements - Fiscal stability certificates should no longer be required for new investments except in the case of major projects, especially those requiring substantial debt financing (e.g., large-scale mining and infrastructure projects). Existing agreements should, of course, be honoured.

This approach would make competitive tax arrangements available to all investors and would reduce the need for case-by-case approval.

Foreign exchange arrangements
Access to foreign exchange presents no difficulties for investors in Sri Lanka. The existing regulations contained in the Exchange Control Act are old-fashioned and highly restrictive. But, like much of the Sri Lankan investment framework, the reality is more accommodating for investors.

The issue of shares to non-residents and subsequent remittance of dividends or repatriation of sales proceeds must be conducted through a Share Investment External Rupee Account (SIERA) opened in a commercial bank.

This procedure has all the appearance of a control device to limit foreign currency repatriation to the amount of equity invested. However, it appears to be not an "account" but a record-keeping device. It is potentially misleading and should be removed as a central feature in describing foreign exchange arrangements for foreign investors.

A modern foreign exchange management law is being developed in consultation with the private sector to entrench current good practice. It is likely to propose the abolition of equity controls and further liberalization of debt controls. The main impediment to complete abolition foreign exchange control in these reforms is a concern to restrain volatile foreign debt flows. As elsewhere in the region, memories of the Asian financial crisis are still fresh.

For investors, the complete abolition of exchange controls would be a very positive step. This would also boost Sri Lanka's chances of positioning itself as an international business hub focused on the region.

Labour regulation
The tenor of much of the labour law reflects a historical view that a strong role for government is needed to protect workers. Sri Lanka also has industrially active and politically influential trade unions. Trade union activities can be driven by political agendas and can be confrontational. In turn, some employers almost certainly have outdated views on labour relations.

More modern management practice is to regard employees as a valuable asset to be nurtured and managed in a collaborative atmosphere. Interviews with employers conducted for this report found evidence of both kinds of approach.

The relatively poor state of employer and organized labour relationships is well illustrated by the BOI's efforts to keep its EPZs free of union activity in favour of workers' councils

Investors' principal interests in labour regulation are having (a) impartial and speedy mechanisms to settle industrial grievances and disputes, (b) no undue regulatory impositions on labour costs, and (c) the ability to hire and fire employees as commercial needs dictate.

There is comprehensive machinery in the Industrial Disputes Act to resolve industrial disputes. However, decisions are slow and many employers feel that the system and its administration favour the interests of employees. The government recognizes that delays are an impediment to business.

It has introduced recent legislative amendments to set deadlines for procedural matters and decisions but it remains to be seen if these have any practical effect. Imposing mandatory deadlines for government decisions is no substitute for implementing the required operational reforms.

In respect of labour costs, there is a minimum wage set for a wide range of industries and occupational levels. Statutory minimum wage rates (about $25-30 per month) appear to genuinely set the floor for wages as actual wages paid tend to be considerably higher (e.g., manufacturing wages average about $90 per month). Real minimum wage levels have fallen in recent years.

Employers are required to contribute to two statutory employee welfare funds. Pensions are provided by the Employees' Provident Fund (EPF) to which both employers (12 per cent of wage) and employees (8 per cent) contribute.

Employers' contributions are known (unlike a defined benefit fund) and are not excessive by international standards. It is understood that at current yield the EPF can pay a pension of around 25 per cent of the final wage to men and 20 per cent to women. Sri Lanka has also established an unusual vehicle, the Employees' Trust Fund (ETF).

This is funded entirely by employer contributions (3 per cent of salary). Part of its original intention was to fund employee share ownership. Its principal use is to provide a form of unemployment benefit for workers between jobs.

A very serious impediment for investors lies in the Termination of Employment of Workmen (Special Provisions) Act (TEWA) of 1971, as amended. Under TEWA, an employer cannot dismiss an employee, except for serious disciplinary infractions, unless there is prior written consent by the employee or prior written approval of the Labour Commissioner.

In effect, an investor does not have the commercial freedom to reduce its workhorse without the consent either of the affected employees or the Labour Commissioner. Moreover, the compensation for termination is determined on a case-by-case basis by the Labour Commissioner and includes consideration of the employer's capacity to pay.

(To be continued next week)

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