Financial Times

Assessing Sri Lanka’s investment climate
The World Bank and Asian Development Bank last week unveiled the results of their investment climate assessment aimed at understanding which factors have made it difficult for firms to do business in Sri Lanka and how these obstacles have affected their productivity. This investment climate assessment is the first to include an analysis of entrepreneurship in rural areas. Fostering the growth of the rural non-farm sector is critical to reducing poverty in Sri Lanka, still largely a rural society.

The survey findings suggest that the total value added by all rural non-farm enterprises in 2003 was Rs 185 billion-equivalent to 12 percent of GDP or 78 percent of agricultural GDP in 2003. Sri Lanka’s rural enterprises are largely based outside the home. Most are engaged in manufacturing or trading, with a far smaller share involved in services. Rural non-farm enterprises were defined as any income-generating activity (trade, production, or services) not related to primary production (crops, livestock, or fisheries) undertaken within the household or in any non-housing unit. Any value addition to primary production (processing) was considered to be a rural non-farm activity. Excerpts:

Sri Lanka’s slower growth and poverty reduction can be attributed, in part, to its civil conflict of 1983-2001, but a host of other institutional, macroeconomic, and microeconomic factors have also held the country back.
Sri Lanka stands out among developing countries for its good governance, and firms benefit from the low levels of red tape and corruption. But despite differences between the urban and rural investment climates, urban manufacturing and rural enterprises alike suffer from poor-quality infrastructure (especially energy and transport) and costly and limited access to finance.
Electricity, cited as a top constraint by Sri Lankan enterprises, represents an entry barrier and a significant operational cost for both rural and urban firms. Access to electricity is heavily concentrated in urban areas such as Western Province, leaving rural areas such as Uva Province grossly underserved. Less than 70 percent of rural enterprises use electricity from the national grid.

Where electricity is available, the cost is high and supply unreliable, exposing firms to frequent outages and raising their production costs. Unreliable supply, leads nearly 75 percent of urban manufacturing firms in Sri Lanka to own a generator, a significantly higher proportion than competitor countries such as China (27 percent). For these Sri Lankan firms, generators cost the equivalent of 12 percent of their fixed assets on average absorbing resources that could otherwise be invested productively in their core business. Not only is owning a generator costly, operating it is also expensive. It can cost 3 to 4 times as much to generate electricity with a generator. Lack of reliable electricity reduces the productivity of urban manufacturing firms by almost half, while among rural firms the productivity of those without connections to the grid is 25 percent lower than those with connections. Moreover, lack of electrification lessens the probability that rural households will set up a new enterprise.

Transport is the biggest constraint for rural firms. It also poses an important obstacle to urban manufacturing firms and the expansion of tourism. Nearly a third of rural enterprises cited transport as a major or severe obstacle to starting or operating a business. While Sri Lanka has a dense road network by regional standards, it performs poorly in road quality relative to its Asian competitors.

As much as 90 percent of the country’s paved road network is in poor condition because of lack of maintenance. As with electricity, transport conditions vary markedly across regions, with the inhabitants of Western Province enjoying the greatest mobility. For rural firms the poor quality of roads and lack of transport compound marketing problems and raise transport costs, reducing productivity. About a quarter of urban firms also suffer transport problems, resulting in losses equivalent to 7 percent of sales.

International competitiveness
Sri Lankan firms have gained from international integration, as results from the Investment Climate Survey confirm. Exporting firms enjoy faster sales and investment growth-and the longer they have been exporting, the higher their productivity, offering support for the "learning by exporting" hypothesis.
For Sri Lankan manufacturers the two most important sources of the technological innovation critical to this growth and productivity are acquiring new machinery and hiring key personnel-both closely tied to Sri Lanka’s openness. The acquisition of new machinery has been facilitated by the open trade regime. And firms with foreign personnel-even firms with no foreign direct investment perform better.

Despite generous fiscal incentives, flows of foreign direct investment to Sri Lanka trail behind those to other fast-growing Asian economies. In China, Malaysia, and Thailand annual investment inflows have reached or surpassed 3 percent of GDP, while in Sri Lanka inflows averaged 1.3 percent of GDP in 1990-2002.

When looking for a new facility, global corporations consider a broad set of factors that will affect productivity and growth opportunities. Sri Lanka fares well on many of these indicators, such as a skilled labor force and low levels of red tape and corruption compared with other developing countries.

Moreover, its ports and customs are more efficient than those of competitors such as China and India, though there is scope for greater improvement. Sri Lanka performs poorly in many other aspects of the investment climate, however, particularly political stability, economic certainty, quality of infrastructure, and predictability of labor regulations. While the Board of Investment seeks to facilitate each stage of the investment process, survey findings suggest that it has been unable to isolate firms from most problems in the investment climate. Manufacturing firms benefiting from its regime are no more productive than others.

The civil war fought between 1983 and 2001 has not been the only source of instability; in the past four years Sri Lanka has had three different governments. The frequent changes in government have disrupted policymaking and slowed reform. Not surprisingly, economic and regulatory policy uncertainty ranks as the second most important constraint for urban manufacturing firms, with more than a third of these firms (though less than 5 percent of rural firms) citing it as a major or severe obstacle to doing business. Nearly a third of urban manufacturing firms regard macroeconomic instability as a major or severe constraint. Such perceptions also hold among foreign investors: when political uncertainties resurfaced in late 2003, foreign investors considering Sri Lanka as a location put their plans on hold.
Also an important constraint is Sri Lanka’s labor regulations, ranked among the top five obstacles in the investment climate by urban manufacturing firms. Rigid, inflexible, and arbitrary, these regulations offer no certainty to investors and discourage increased employment.

Payments mandated for redundancy in Sri Lanka are many times those legislated in other Asian countries. Perhaps most restrictive is the Termination of Employment of Workers Act of 1971, which makes it very difficult for firms to fire or lay off workers. Firms can try to avoid restrictive labor regulations by hiring temporary workers, but this too has costs: survey results show that the larger the share of temporary workers in a firm’s employment, the lower its productivity.

Challenges of export sectors
The economic prospects of Sri Lanka, as a small, open economy, depend on maintaining robust export growth. One of its biggest economic success stories is the development of the garment sector, which accounts for more than half the country’s exports. This concentration of exports, however, means that the phasing out of the Multifibre Agreement poses new challenges. This situation highlights the need for a better investment climate to maintain the competitiveness of the garment sector and support the diversification of exports.

Lacking a strong material base, the country imports around 85-90 percent of its fabrics, which inevitably increases turnaround time. Meanwhile, the average turnaround in the sector is rapidly declining, especially in key competitors such as China.

How competitive are Sri Lankan garment firms today? A comparison with Chinese garment firms, based on Investment Climate Survey data, shows that Sri Lankan firms have lower value added per worker. This difference can be attributed in part to higher capital investment by Chinese firms.

Other investment climate indicators also seem to favor Chinese firms, including access to more reliable energy, lower inventories, lower subcontracting of sales to clients, and greater investment in formal training.

Sri Lanka’s tourism industry stands to benefit greatly from a sustained peace and could become an important new source of foreign exchange and rural and urban employment. After facing bright prospects in the 1970s, tourism collapsed with the onset of the civil conflict.

While the sector struggled to survive in Sri Lanka, it expanded rapidly in neighboring destinations. Today tourism accounts for less than 5 percent of Sri Lanka’s export revenue, while it contributes nearly 10 percent in Thailand and 25 percent in Mauritius.

Investment climate for rural firms
For rural entrepreneurs a big constraint is limited access to regional markets. These entrepreneurs cite marketing problems, particularly lack of demand, as a major obstacle. The problems stem from a range of factors. Rural entrepreneurs have few contacts or links with larger firms or buyers that could increase their exposure to bigger and more diverse markets. Most are unable to realize economies of scale and face high marketing costs.

The goods they produce are often of low quality and have limited appeal in larger markets. Poor transport and telecommunications restrict their access to information.

Moreover, the voices of rural entrepreneurs have not been heard. Evidence suggests that rural enterprises are not yet effectively integrated into the policymaking process. Less than 10 percent of enterprises with more than three workers believe that they can influence the content of existing or proposed laws relating to their business. The government could do more to strengthen mechanisms ensuring greater voice for rural entrepreneurs.
Two regions of Sri Lanka are particularly disadvantaged: the northeast, which has suffered disproportionately from the conflict, and the south, which suffers disproportionately from poverty.

In the Northeast Province, the site of most of the fighting during the conflict, businesses appear to have been established as part of household coping strategies and have been unable to grow in the difficult circumstances. Enterprises in the region are typically smaller and much more likely to engage in household-based production than enterprises in other areas. Production enterprises account for 60 percent of firms in the northeast, compared with 36 percent elsewhere. This structure suggests that entrepreneurs were unwilling to invest in alternative premises for their business that might be destroyed in the fighting or that might have to be evacuated.

The insecurity has imposed a high cost. As many as 20 percent of firms in the northeast have incurred losses as a result of crime and violence in the past year, compared with just 1-2 percent in the rest of the country. In addition, much of the local infrastructure was destroyed during the conflict. Not surprisingly, a larger share of rural firms in the northeast than in the rest of the country consider public infrastructure to be a constraint.

Excluding the northeast, where poverty data are not yet available, the southern provinces of Uva and Sabaragamuwa have the country’s highest poverty rates. In Uva Province one symptom of poverty is the small manufacturing base in rural areas: half its rural enterprises are trading firms, which require fewer assets than production firms. Given the lower incomes in Uva, it is unsurprising that households resort to small services and trading businesses to smooth their incomes during the slack agricultural periods. Uva also stands out for its greater problems in access to services. Only 62 percent of its enterprises use electricity, compared with an average of 69 percent in the rest of the country. Its rural firms also are physically isolated, limiting their access to markets.

Recommendations
Achieving a permanent peace is undoubtedly the most important step Sri Lanka can take toward improving its investment climate. Policies paying greater attention to the differences between the urban and rural investment climates could do much to increase rural employment and incomes and reduce the tremendous disparities between regions. Among the five most important issues in the investment climate, however, some are common to both urban and rural firms.

Sri Lanka is already undertaking several important energy reforms, including restructuring the Ceylon Electricity Board under the Electricity Reform Act of 2002 and establishing the Public Utilities Commission of Sri Lanka. Continuing to implement the regulatory framework is also a priority for the energy sector. In the medium term essential reforms include introducing competition and commercial relationships within the industry to drive improvements in performance.

In the road sector the main policy priorities are driven by lack of access to good-quality roads, a key impediment to existing businesses and a severe barrier to starting or participating in rural non-farm enterprises. Priority actions include providing adequate funding for maintaining and rehabilitating roads, selecting a core network of roads to be maintained, developing an overall pricing policy for the sector, and strengthening the capacity of agencies responsible for formulating and implementing sector policies.

Reducing the cost of finance in Sri Lanka will require stabilizing the macroeconomic situation, reducing the deficit, and reforming the two state-owned commercial banks, the Bank of Ceylon and the People’s Bank. Other key policy priorities in the finance sector include enhancing debt recovery mechanisms, expanding and upgrading the capacity of the Credit Information Bureau, improving the regulatory framework for microfinance institutions, and reforming the contractual savings system.

In 2003 the government moved to reform labor regulations. While the details of the proposed reforms remain under discussion, they include introducing a formula for employee severance payments, imposing strict limits on the duration of labor tribunal cases, and establishing an unemployment benefit system. To encourage foreign direct investment, foster efficient reallocation of labor, and promote employment in the formal sector, Sri Lanka also needs to transform its discretionary and costly severance payment into modern, affordable, and equitable income support for the unemployed.

Beyond enhancing the coverage and quality of rural infrastructure, several other initiatives would also help improve access to markets for rural firms. Business organizations and local chambers of commerce could strengthen marketing channels for rural enterprises by holding product fairs to expose local producers to buying habits and consumer behavior in different markets, helping to develop business directories, and sharing information on prices, quality standards, and ways to obtain technical and financial services for greater value addition. In addition, supporting group marketing (for example, through associations and cooperatives) and business clusters would help rural firms take advantage of scale economies.

As the survey revealed, policy uncertainty and macroeconomic instability have a tremendously adverse effect on urban enterprises. A policy framework geared to improving policy certainty and macroeconomic stability would include reducing the deficit and pblic debt, strengthening revenue collection through better tax administration, reforming the civil service and reducing the wage bill, and decreasing the losses of state-owned enterprises.

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