Financial Times

Poverty series – final one
Poverty and trade issues in Sri Lanka

Direct impact of trade on the poor
In the short and medium term, trade and trade policy can have a direct impact on the welfare of the poor from different dimensions.

Price effects
Trade affects the poor by affecting the prices of the goods they consume and the goods they produce. Import liberalisation generates more competition and pushes down retail prices, helping poor consumers. Removing anti-export bias raises export prices of goods helping poor export good producers. However, these benefits are conditional on the trade-affected border prices filtering down to the poor. If there are imperfect markets, then price gains may be captured by monopolistic distributors. In addition, it is often the case that a particular import liberalisation (say of rice) may benefit one poor sub-group (poor urban rice consumers) while at the same time hurting another (rural poor paddy producers).

Wages/employment opportunities
The traditional story that trade should raise the incomes of the poor in a developing country comes from a simple Heckscher-Ohlin framework, with a two-country (industrialised US – developing Sri Lanka), two factors (high skilled workers – low skilled workers) and two goods (skill intensive good – low skill intensive good). According to this model, the developing country would have a comparative advantage in producing and exporting goods intensive in the use of low skilled workers because of a relative abundance.
The poor are owners of such low skilled labour and benefit from trade with a country relatively scarce in low skilled workers, regardless of the sector in which they work.

However, this result relies on labour being able to easily move from contracting import-competing sectors to expanding export sectors, which is more relevant in the longer term. If we allow for labour immobility (as is often the case in the short run and modelled in the specific factors model), then any tariff reduction will lead to a fall in wages of workers in that sector and a rise in unemployment.

Wages also increase through tariff reform-induced productivity increases. Competition from imports leads to rationalisation of firms, as inefficient firms close down and the remaining ones increase productivity to maintain competitiveness. Over the 1990-99 period, there is evidence that wages in the manufacturing sector have risen with productivity increases.

Income volatility and job insecurity
Closer integration with world markets implies that countries are susceptible to international shocks beyond the control of national players. On the one hand, trade allows the reduction of volatility in goods prices due to domestic supply shocks like adverse weather, by allowing imports to suppress high domestic consumer prices.

On the other hand, it also argued that trade makes the demand for labour more elastic, through increased foreign product market competition, substitution for foreign workers, and by threats of internationally mobile capital. This reduces the bargaining power of labour, weakening unions and heightening job insecurity. Thus although wage levels may increase, trade is likely to lead to more job reallocation and dislocation.

Ad-hoc agricultural tariff changes
Since most of Sri Lanka’s poor are rural poor, trade policy towards agriculture and overall agricultural policy is vital for poverty alleviation. Although agriculture is the most protected sector in the economy (with ad value tariff averaging 21 per cent compared to 9 per cent for manufactured goods), it is not the tariff level that has had the major policy impact. Instead, it is the frequent fluctuations in the tariff that have affected behaviour. The record of accomplishment of successive governments has been one of gross policy inconsistencies and ad-hoc tariff policy changes that send confusing signals to potential investors. For example, tariffs on rice and coconut oil have fluctuated immensely, with tariffs on rice being adjusted over ten times since 1996.

In addition, tariff reductions in 1996 on many agricultural products like chillies and potatoes were frequently modified and reversed in 2002 as imports increased and domestic output declined. These fluctuations partly reflect the government’s efforts to deal with its conflicting dual goals of trying to have low food prices for consumers and high producer food prices for farmers. This has discouraged long-term new investment in agriculture, and induced behaviour that maximises short-term profit.

Very often, trade policy is not the main issue driving poverty in the agricultural sector. For example, paddy farmers have suffered as the sector has become increasingly unprofitable because farm-gate prices of paddy have not kept up with the rising cost of paddy production. This mainly reflects the strong bargaining power of monopolistic rice millers, and the weak position of cash constrained, indebted paddy farmers with inadequate storage facilities after harvest.

The agricultural sector has suffered from the absence of a clear and consistent agricultural strategy for the country over the last decade. The result has been low agricultural productivity (real value added per agricultural worker is 40 percent of the value added by a worker in manufacturing and services), an annual output growth rate of less than 2 per cent over the last decade (compared to a 7 per cent growth in manufacturing and a 5 per cent growth for services) and persistent rural poverty.

Recent calls for increased blanket trade protection for all agriculture are disturbing. They are often only justified by the fact that developed countries protect agriculture too – the high cost of doing so is rarely considered. Moreover, it detracts from addressing fundamental issues facing the agricultural sector, such as low productivity, lack of efficient extension services and technology dissemination, as well as ineffective credit and insurance markets. Trade protection cannot compensate for these domestic failures.

A dynamic consistent strategy for agriculture should be a ‘hand up’ strategy instead of a system of ‘handouts’. Such a policy would include a tariff policy that has credibility as a signal of the government’s long-term policy towards particular sub-sectors. Even if the government seeks to insulate changes in food prices in times of shortfall and surplus, it should adopt a more rules-based predictable system, such as price bands. Innovative new instruments such as forward sales contracts need to be evaluated to check whether they are helping the poor, and if so, should be expanded. Consistent with food security objectives, incentives should be provided to promote the production of crops that would be profitable to farmers given the natural conditions in their area. Land reforms – including land titling coupled with insurance mechanisms to prevent landlessness– could also stimulate new investment and appropriate land use. New reforms should be aimed at increasing the likelihood of the price benefits of trade reaching the poor producers, and stimulating new investment in agriculture.

Apparel quotas
The most dramatic trade policy issue facing the Sri Lankan nation is responding to the January 2005 final component of the phase out of the apparel quota system under the Agreement on Textiles and Clothing (ATC), which allowed for managed access to industrial markets. The end of designated quotas for apparel producing countries will lead to much greater competition in trying to penetrate American and European markets, with competition from China likely to be very strong. While some Sri Lankan factories are internationally competitive, many smaller firms were sustained by the guaranteed access through the quota allocation. There will be an inevitable rationalisation of the garment industry with adverse employment consequences, as low productivity firms close.

Given that 88 per cent of the total employed in the industry are women, plant closures will hurt female earning power the most. Further, since most of the low productivity garment factories are outside the Western Province, the regional consequences will also be noticeable. Assistance in the form of productivity enhancing techniques and technology is needed, as well as assistance in improving quality and marketing products abroad.

Sri Lanka has a bilateral FTA with India (ISLFTA), with negotiations underway to extend it to a Comprehensive Economic Partnership Agreement (CEPA) that would extend liberalisation beyond trade to selected services and investment. Sri Lanka also signed a FTA with Pakistan in February 2005. These FTAs reduce Sri Lankan tariffs for imports solely from the partner countries. In the same manner, Sri Lankan exports receive deeper tariff preferences beyond what other World Trade Organization (WTO) members receive to the markets of partner countries.

Poor local producers may be adversely affected to the extent that preferential tariff reduction leads to increased competition from imported Indian and Pakistani goods. However, the poor gain as consumers of cheaper products from India and Pakistan, as well as producers with greater opportunities to export their products to the vast Indian and Pakistani markets, thus stimulating employment and incomes. As suggested earlier, agricultural liberalisation will be of key importance to the poor. Agricultural protection was significant in the ISLFTA (with most of agriculture placed on a ‘negative list’ which involves no liberalisation). However, in negotiations with Pakistan, some liberalisation of the sector was negotiated.

Pakistan lobbied to get preferential access for its citrus fruit, basmati rice and potatoes in return for liberalisation of the Pakistani tea market. Besides tea, Sri Lankan exports of betel, rubber and coconut products, spices and paper products should grow due to preferential access. Sri Lankan spice exporters (particularly, exporters of cinnamon, pepper and cloves) have also been successful in penetrating the Indian market, due to the preferential access granted by the ISLFTA. However, now the government faces the issue of how to deal with the differences between the Indian and Pakistani agreements. Careful analysis should be made of the impact on the agricultural sector before streamlining the two agreements, and giving India the same preferences as Pakistan in agriculture.

It is important for the government to have a strategy for agriculture before pushing forward with free trade agreements. If they do not, Sri Lankan agriculture will be shaped by negotiation capabilities of external trade partners.

Work has also progressed on bilateral FTAs with Egypt, Singapore and the US.During the 2002-4 period under the United National Front government, Sri Lanka embarked on a rampant journey of securing bilateral free trade agreements with all interested parties, apparently in a bid to expand tea export markets. In fact, a FTA consisting of preferential treatment on just a handful of goods was almost signed with Thailand, thwarted only due to changes in the government.

While the increased activity in trying to penetrate new markets was welcome, it was not clear that a bilateral FTA was necessary or sufficient to promote trade. In fact, it would be quite dangerous. The preferential agreements (regional and bilateral) create a complex system (a “spaghetti bowl”) of preferences (by product, by partner, by varying timetable to full liberalisation), which coupled with varying rules of origin create an administrative nightmare for customs as well as business. In such an environment, resource-constrained small and medium enterprises that employ the poor are unlikely to know under which agreement it would be most profi- table to export to markets such as India which come under more than one agreement. For example, it is more advantageous to export cloves under SAPTA than under the ISLFTA.

A combination of a few important FTAs could make Sri Lanka an attractive investment location, stimulating employment creation and poverty reduction.
For example, the FTAs with India and Pakistan may encourage Pakistani investment in Sri Lanka to penetrate the Indian market, as well as Indian investment to penetrate the Pakistani market. In this context, an FTA with the US would be attractive as it may lead to more US investment in Sri Lanka, as Americans use Sri Lanka as a base to penetrate the large Indian market.
Although the traditional selling point of Sri Lanka as a gateway to India is a little passé, Sri Lanka may still be able to attract investors based on a better educated labour force, better infrastructure (especially the port) and a more transparent rules-based system. In addition, Indian and Pakistani investors may come to Sri Lanka to penetrate the US market. Encouraging investment from more than one large country will also allay local fears of a single foreign country becoming a very dominant investor in Sri Lanka.

Dumping
Currently Sri Lanka has no legislation to respond to the dumping (products sold in Sri Lanka below the market price in source countries) of goods by foreigners, as well as to imports that have received substantial support of foreign governments that make it unfair competition to domestic import competitors. Appropriate responses to such imports are needed.

The traditional approach taken by developed and developing countries have been anti-dumping duties and countervailing duty legislation. However, the procedures to embark on such cases tend to be very expensive and have generally been taken on only by larger sectors in developing countries, such as the pharmaceuticals and steel industries in India.

The challenge in Sri Lanka is to come up with procedures that are fairly streamlined and cheap so that they are accessible to small and medium enterprises that will most likely be adversely affected by such ‘unfair’ imports.
An alternative approach may be to build such procedures into the dispute settlement mechanisms in free trade agreements. While formal anti-dumping legislation may not be in Sri Lanka’s interests as anti-dumping duties have often become hijacked by protectionist interests, inactivity in this area is also unacceptable. This is because it is likely to most adversely impact small and medium enterprises (SMEs), throwing their employees into poverty. A first step is to enact “safeguards” legislation, which provides temporary protection for domestic producers from import surges.

Trade and growth to help poor
It is widely argued that the 2004 election loss in spite of robust economic growth of the incumbent government in India (and some would argue in Sri Lanka too), reflected the protest vote of the poor, because the benefits of growth were not reaching the poor (fast enough), and sufficient policies were not in place to protect the losers from reform. Democracy gives the poor a voice, and they are a constituency that should not be ignored.
Trade and trade policy produce both winners and losers among the overall population, as well as among the poor.

If governments want to garner support for their trade policies, they must put in place additional policies that will 1) compensate losers from the policy and 2) address distortions that lead to insuffi cient gains for anticipated winners.
In terms of the former, Sri Lanka has a system of social safety nets but since trade liberalisation as well as trade protection create winners and losers among the poor, these government interventions have to be well targeted.
Targeting and administration difficulties, as well as occasional politicisation have plagued poverty alleviation programmes. Sri Lanka clearly has to be integrated with the world economy, but that does not imply blanket trade liberalisation.

Labour market flexibility
Labour market flexibility is desirable but the movement to it should involve two features. First, less job security should be compensated with higher wages to workers. Second, Sri Lanka should develop an unemployment insurance system that would ease the ill effects of job insecurity. Developing a credible system of worker adjustment assistance, which includes income support, worker training and job search assistance, would be an appropriate accompaniment to any major changes in existing labour laws. Some form of social insurance will reduce job insecurity and perhaps ultimately facilitate reform of the bloated public sector. It appears as if successive governments treat public employment as a pseudo social insurance scheme, absorbing new cadres during times of low economic growth and before elections.

Infrastructure
The development of roadways / highways is important for getting the products of the poor to main markets, for receiving new and cheaper products and for labour markets to respond to new opportunities. However, for over a decade, capital expenditures have been declining in government budgetary allocations. In fact, actual capital spending has been below budgetary targets, as governments try to trim budget deficits while maintaining or expanding spending on current expenditures like wages, interest and pensions.
Following the tsunami, coastal infrastructure such as roads, railways, power, telecommunications, water supply and fishing ports will have to be reconstructed. Besides the benefits of linking the poor to markets, the reconstruction process can be a significant source of local job creation and hence tenders should be given to firms that use labour intensive techniques.

Access
The substantial share of rural credit is through the informal sector with very high interest rates, putting a large burden on the poor. While rural banking with subsidised credit has expanded, spearheaded by the two State banks and rural development banks, it has often resulted in bad debts. The regular waiving of loan repayments by the government during bad harvests, have created a culture where default is prevalent.

Promoting SME’s
SMEs are increasingly becoming an important segment of the industrial sector in Sri Lanka. Encouraging entrepreneurship and the expansion of the SME sector is a vital element in enhancing the existing industrial base, export performance, job creation and income generation in both rural and urban areas. It is likely that SMEs will be more vulnerable to the forces of trade liberalisation than many of their larger counterparts. As a result, supportive measures for the development and growth of this sector need to be adopted. This is particularly important because the country still has no anti-dumping duty, countervailing duty or safeguards legislation that can address unfair trade practices and import surges.

Macroeconomy and policy
Policy consistency is key because it reduces an element of uncertainty in an unstable global economy, and sends a signal to businesses and labour upon which long-term investment commitments are made. Fluctuations in policy lead to greater uncertainty and fear of investing in the country.
Fragile coalition governments are also bad for the poor as they draw attention and resources away from the process of economic growth and poverty alleviation, and towards power maintenance and politically motivated, short-term support for particular groups.

Conclusion
As a small economy, Sri Lanka must be integrated with world markets. However, blanket trade liberalisation is not the solution to poverty and lacklustre agricultural performance. It is also not the cause of it. Similarly, reverting to trade protection will not remedy the poverty situation. The key to poverty alleviation is robust economic growth, and to the extent that trade stimulates growth, trade alleviates poverty. In light of the devastation caused by the tsunami, poverty reduction should be a policy priority, and a more focussed approach to policy making is needed. Technocratic policy makers should identify only the most significant constraints to a growth take-off and then channel resources and gather coalitions in a concentrated manner to eliminate them.

Letter
Colombo and the Urban Poor
I wish to thank you for focussing attention on urban poverty in Financial Times on Sunday in its November 27 issue. I travel daily from Kelaniya to Colombo and what we all see is abject poverty and helplessness on the roads and pavements from Pettah to Fort and in Bambalapitiya, Wellawatte and Borella. The position may be similar in the sub-urban areas and in Kandy, Kurunegala, etc.

I would like to draw the compassionate attention of your readers, many of whom are leading figures in the world of business, to the old, the sick, the blind, the crippled and the deaf and dumb, men and women, mothers with infants and children, destitute children – all on the pavements begging for a rupee or two for their daily bread.

I would like to appeal to you, gentlemen of standing in society, to set up a voluntary organisation to provide shelter and a daily meal or two to these helpless people with the help of local and foreign donors or with state funds.

Ananda Dharmapala
Kelaniya.

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