Not for a few dollars more!
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This file picture tells the story of Sri Lanka’s current cooking gas crisis.
How did the government find dollars overnight? It was a question that a couple of my friends asked me, after reading my column on “Import controls, then and now” last week. I explained the government’s import controls and the Central Bank’s foreign exchange restrictions in the 1970s and its consequences on domestic production in Sri Lanka: As raw materials, parts, and components were in short supply, the factories which used these intermediate inputs were not operated fully.
The machines and workers remained idle, and 60 – 65 per cent of the country’s industrial capacity was reported to have remained unutilised. As a result, the domestic supply shortage worsened, growth rate slowed down, unemployment increased and, poverty continued.
Then, the government changed in 1977, and the economy was opened overnight. As import controls were lifted and foreign exchange restrictions were removed, inputs were imported, production re-started, and industries expanded. The opening question is about where the country found dollars suddenly, and why that foreign exchange was not available earlier. In some way completing our last week’s discussion, I thought of answering this question today.
Opening in crisis
When countries decide to open their economies, generally they all are faced with the problem of foreign exchange shortage. This means that they usually open their economies in bad times, and not in good times! It’s true that the severity of the foreign exchange problem was different in different countries, but they all had the same problem.
When the countries continue to depend too much and too long on their primary exports, as a matter of fact they all had to face the growing foreign exchange shortages. In response to the problem, the government in those days adopted import controls and foreign exchange restrictions. And the same policy was intended to promote domestic production of import-substitutes. As they realised that this strategy did not take the country forward, but it only takes them backward, they opened the economies mostly in the backdrop of a foreign exchange crisis.
The answer to the opening question needs to be understood on a short-term and long-term basis: On a short-term basis, the country is now importing freely with no adequate foreign exchange to pay for that; this will result in an increased trade deficit, causing further pressure on exchange rate. As a result, the exchange rate would depreciate further. Moreover, the countries have to cover the trade deficit with other forms of foreign exchange earnings, including borrowings.
In fact, countries with trade deficits should have foreign capital inflows, irrespective of whether the country is rich or poor. The US is a rich country with a trade deficit, and the deficit is covered with international borrowings or capital inflows. Countries with trade surpluses would lend internationally or invest abroad. China is a country with a trade surplus, out of which it provides foreign lending and investment to other countries.
Immediately after opening the economy, Sri Lanka was able to import resulting in an increased trade deficit, which was seen as an “economic problem” by non-economists! It is a usual trade outcome in any country when the economic policy is shifted from a controlled regime to an open regime. In fact, the fundamental economic problem in Sri Lanka is its long-term continuation of the deficit for over 40 years, and not its immediate “overshooting” after opening the economy.
Long-term issue
Policy changes require a time lag for adjustment – the so-called cost of adjustment, which sometimes may be too painful and politically may not be attractive. However, the reason for the increased trade deficit is that imports can be made available overnight, but to pay for that it takes time to generate exports; until then, the payment for increased imports should come from capital inflows, including borrowings.
The long-term source of foreign exchange earnings should come from none other than export growth. Even the flow of foreign direct investment (FDI) is important, because FDI contributes to export growth directly or indirectly, and not because foreign investors come with foreign exchange.
In fact, it’s not possible to underestimate the export growth that Sri Lanka achieved, particularly during the first 20 years period after liberalisation. By 1977, it has been almost three decades after Sri Lanka gained political independence; still our agricultural exports accounted for about 80 per cent of the total export mix. Within the next 20-year period, Sri Lanka’s industrial exports increased growing by over 75 per cent by 1998.
If Sri Lanka had a fascinating export growth outcome as such, what was the problem? The problem centred around “not enough export growth” compared to our own import requirement as well as compared to export growth in other successful exporting countries! It’s a problem that we nurtured, and not a problem that we inherited.
When Sri Lanka reported US$10 billion exports in 2020, India recorded $276 billion, Malaysia $234 billion, Singapore $362 billion, Thailand $231 billion, and Vietnam $282 billion. We also ignored the potential contribution that our service sectors such as education and health care would have made in generating foreign exchange. One important issue was Sri Lanka’s inability to attract foreign investment even at a time that FDI was not as much attracted to our neighbouring countries. The importance of FDI in export growth is outstanding because they have already established their competitive position in the global markets.
Main issue
The year 1977 was one of the biggest opportunities that Sri Lanka missed throughout the history of the country. The country had already been prepared for a big change, while the government that came to office had the political mandate and the power to make that change. But the opportunity was utterly wasted.
It is true that the “open economy” was introduced by eliminating import controls and relaxing foreign exchange restrictions. But the reforms were merely lopsided and half-done so that the open economy was superimposed on the old structures of the regulated economy. Public sector reforms and regulatory barriers continued to remain intact. More than 350 state-owned enterprises, including the plantations run by the government agencies continued to remain, while the role of the government as the “job provider” to its loyal followers was protected.
The reforms in the legal system were never undertaken, while a serious setback in the law and order continued to haunt the economy and the polity. On top of all the above, the flood gates for corruption, bribery and commissions were wide open. Thus, the open economy was built on shaky ground, which didn’t support the steady progress of the economy.
The second problem was the abandonment of the reform process particularly after 1995. This means that we are left without purposive reforms for over a quarter century now; even after seeing that the country’s export growth was slowing down and FDI flows were not picking up, reforms were neglected. If it was the 30-year war that has to be blamed, the time after 2009 came with another golden opportunity to undertake reforms; that was also missed.
No stopping or turning!
The need for export growth and the role of FDI for Sri Lanka’s economic future was understood well enough even as far back as the mid-1960s. A white paper on foreign investment with an incentive package to foreign investors was issued in 1966, while the role of FDI in export promotion received official recognition for the first time. At the same time, the need for “non-traditional export growth” received policy priority. But the attempts for both FDI and export growth were futile, confirming that the economic policies cannot move simultaneously in opposite directions.
Further, the experience since the 1960s confirmed that the countries cannot wait until the foreign exchange problem gets reactivated in order to undertake reforms for export growth. And once adopted, the reforms should be comprehensive and continuous; there is no stopping or turning!
(The writer is a Professor of Economics at the University of Colombo and can be reached at sirimal@econ.cmb.ac.lk and follow on
Twitter @SirimalAshoka).
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