03rd, November 1996

Q: In your view is the country facing an economic crisis?

Dr. Sanderatne: The word 'crisis' is highly emotive. Therefore I would prefer to discuss the facts of our current economic situation and leave you to judge whether the situation could be called an economic crisis.

Q: How do you read the facts of the current economic situation?

A: Let me first discuss the facts relating to our agriculture. Since 1993 tea production has been increasing. In 1995 tea production increased significantly to 246 million kilograms from 242 million kilograms in 1994.

This increase has been maintained in the first eight months of 1996 when our tea production was slightly above that of last year. And tea prices have been holding high. Consequently, our tea export earnings have increased and is one of the important facets of the economy which is supporting our balance of payments. Besides this aspect, I think the privatization and the private management of the estates are showing results.

There is clear evidence of improved cultural practices and increased productivity on the tea estates. The production performance in rubber is not as good but here again it is likely that the improvement in rubber prices would enable an improvement in rubber production in the years to come.

As it is rubber production is on a plateau but the industry is doing well once again due to good prices. It is also significant that this is one of the rare instances in Sri Lanka's post independent economic history that prices have held high when production has been good. Consequently agricultural exports have grown by 18 per cent this year.

Q: What about paddy production? Isn't it much lower this year?

A: Yes. I was about to come to that. This year's Maha crop has been adversely affected by the drought. The Maha paddy crop is estimated to be 25 per cent lower than last year's Maha crop. But the more significant issue with respect to paddy production is that farmers are facing a very serious cost price squeeze.

This 'crisis', if you like to use that word, was worst last year when the wheat subsidy was in operation and paddy prices fell sharply. Even with current prices the paddy farmer is rather badly placed. Even a two acre plot is hardly sufficient for his survival. Paddy cultivation is fast becoming a part-time operation. So I think there is a fundamental problem in paddy production. The shortfall in production this year is however mainly due to the drought. There are no statistics regarding the production of other food crops this year to make any meaningful comment on them. But these too would have been affected by the drought.

Q: What about industry. Aren't there signs of a crisis in our industrial sector?

A: Well let's be frank. Most people seem to think so. The best statistics we have about industrial production is from our export figures. In the first six months of this year industrial exports were only 3.5 per cent above those of the first six months of last year.

The performance in July was dismal and consequently in the first seven months of this year industrial exports showed a decline from that of the same period in the previous year. But the situation appears to have improved in August. There has been an increase in industrial exports by about 5 per cent in the first eight months. But this export growth is certainly inadequate. In 1995 our export growth was 13 per cent. If you go back to 1990, our annual industrial export growth was as much as 20 per cent. In fact in the 1980s and early 1990s it was the robust industrial growth and industrial exports which came to the rescue when our agricultural growth was low. The growth rate in the economy was mainly maintained by a high growth of industry. The garment industry in particular contributed much towards the high momentum of growth.

Q: Isn't the garment industry in a serious plight?

A: Again if we take the figures for the first six months, garment exports grew by 2.7 per cent. It was so in the first eight months as well - an increase of 2 per cent. Certainly the garments industry is not showing the high rate of growth it once displayed.

Q: In your view what are the reasons for this?

A: There are several types of reasons for the poor performance. There is of course the disruption which occurred owing to the power cuts. The smaller industries were worst affected. Then there is the issue of high interest rates which again changes the cost structures of garment manufacturers, as well as other industrialists. The firms in the garment industry which cater to quota items and the less sophisticated market is facing severe international competition. Countries like Bangladesh and Vietnam can compete against us more effectively as their labor costs are lower. In contrast, the garments manufacturers catering to the up market are doing very well. There is I think a structural change occurring in the garments manufacturing industry as well as in industry in general.

Q: Could you elaborate on what you describe as a structural change?

A: Yes. Structural change has several dimensions. The first relates to the effects which occur as a result of international competition as cost structures of countries change. We are facing a situation where Sri Lanka may not be the most competitive source for the manufacture of low value added labor intensive industries. Of course this problem has been aggravated by unplanned expansion of the industry as well. But while certain firms in the industry are facing severe difficulties others are prospering. So there is an intra-industry structural change which is occurring.

Q: Is this confined to the garment industry?

A: No. There are other industries as well which are facing this problem. I am aware that in the printing industry several firms are having severe difficulties and are even closing down. Printing establishments have been adversely affected by the decline in the financial sector stock market and power cuts. On the other hand there is considerable investment in printing, particularly high quality printing that is taking place. Some of these new printing enterprises are so technologically advanced that they intend to cater to sophisticated international markets like Singapore and Western Europe. So while some firms decay in their industry, others may thrive. This is part of the technological transformations which occur in an economy and the effects of changes in the international situation.

But I must also say that some of the problems which industries face are inherent in a capitalist system. The capitalist system which we introduced but call it by different names such as liberalization, market oriented policies, open economic policies and so forth is a harsh system.

I think Sri Lanka's industrialists still have the psychology of a state system and a sheltered market. This is inevitable in a country which went through several decades of such industrial and economic development. Now we have adopted a policy of facing international competition. Facing the changes that are occurring in the international economy and snatching opportunities arising from these changes which are all leading towards greater competition, is the crucial test.

Q: Are the problems in our industrial sector solely due to these structural changes?

A: No. There are other aspects as well. I have already referred to the high interest costs. There is a problem of an inflexibility in our labor market and the recent problems of energy. We have not come to grips with the implementation of the structural changes I have spoken of in terms of labor mobility. If you accept what I have said that firms would have to reconcile themselves to changing their investments, face possible failures sometimes by cutting losses and retrenchment of labor, then the ability to change their composition of employees is a necessary complementary ingredient to support industrial survival in a context of industrial structural changes. It is in this context that the Workers' Charter and the provisions already in place in the country like the Termination of Employees Act are stumbling blocks to investment. We need a labor policy which looks at increasing total employment rather than enabling those who are in employment to remain in the same jobs. Much more contractual employment possibilities are needed to cope with this kind of situation. Also this policy of ensuring labor continuity is not conducive to enhancing labor productivity. However, one must not conclude that you can't increase labor productivity in such a system as well, as there are various incentives which employers could give to improve productivity.

Q: Isn't tourism in bad shape?

A: Yes. Tourism has been badly affected owing to the security situation. For the first eight months of this year tourist arrivals decreased by 31 per cent. And tourist earnings I believe decreased by about 27 per cent. This is quite serious. Because there has been an expansion of tourist hotel accommodation and huge investments made in this industry. When a sudden dip in tourist traffic occurs then the viability in these hotels is seriously affected. Besides the hotel industry, there are several other enterprises which are dependent on tourism. These include handicrafts, local sale of gems, travel trade and those providing hotel supplies. All these people are affected as they are backward linkages in the hotel industry.

Q: What about our foreign exchange situation?

A: Yes. Let me discuss the trade situation before I get to the foreign exchange situation. You would know that till 1994 for about 5 years we had a balance of payment surplus despite a trade deficit. This was due to our capital account inflows more than offsetting the trade and current account deficit. In 1995 for the first time in five years there was a reversal of this owing to the flow of foreign investment and capital flows official and unofficial being less. We were not able to offset our trade deficit by capital inflows. Consequently we had a balance of payment deficit. But interestingly in 1995 our trade gap which has been increasing since 1978 decreased. That is our trade deficit decreased. This was not due to a significant expansion in our exports but a decline in our imports. Most people may be inclined to interpret this as a healthy factor. On the face of it a reduced trade deficit is a favorable development. Yet if one examines the composition of the decreased imports which have been mainly of capital imports and to some extent intermediate imports then one sees that the 1994 balance of payments position showed signs of decreasing investment and economic activity. In the first eight months of this year this phenomenon has been repeated. Capital imports declined by 7 per cent and raw materials imports decreased by about 4 per cent. Now these are not healthy signs for an economy. It indicates that the investment climate is not propitious. They are certainly early warning signals which must be taken seriously.

In as far as foreign assets are concerned our foreign assets are slightly lower, about US $50 million lower at the end of August this year than it was 12 months before. Our gross external assets were a little less than US $2600 million compared to a little more than US $2600 million in August 1995. This is adequate to finance about four months of imports. So there is no real problem in so far as our external assets are concerned. But the flow of capital is not as healthy as it used to be.

Q: Let me return to my original question. Is your considered judgment that we are not having an economic crisis?

A:Well, as the preceding facts disclose, there are elements of a crisis. But since some of the factors such as the power crisis is over, it is likely that the economy would hold better in the 3rd and 4th quarters. There is some evidence of this. But the way I view economic development, the significant issue is not whether we have a crisis or not, but whether we are responding to any crisis with the vigor, speed and urgency that a crisis demands.

Albert Hirschman in his book, 'The Strategy of Economic Development ' argues that developing countries resolve their problem only after facing crises. His book was based mainly on Latin American experiences.

A good example closer home is how the Maldivians responded to the Sri Lankan ban on the import of Maldives fish, which was their main export at that time, by diversifying into tourism. The crisis was transformed into an opportunity and the Maldivian economy has thrived better because it had to face this crisis. In the case of the power crisis even Malaysia, which is a very well governed country, faced a power crisis recently. So too the Philippines. Malaysia moved faster and at the initial stage of the crisis took measures to resolve it. Philippines took a longer time. But both countries resolved the problem only after facing a crisis. So the issue is whether the government, private sector and in fact all of us are really geared to respond to any crisis which is with us or any crisis which we may face soon. We haven't a sense of urgency, we are not willing to take decisions which are not palatable in the short run, we are over politicized and view everything in a political perspective. We are unwilling or unable to make the sacrifices needed to mobilize the resources for development, in short, in the words of Joan Robinson in the 1950s, we 'want to taste the fruits of development without planting the tree and nurturing it'.

Q: Could you be more specific on what are the essential ingredients necessary for our development?

A: There are many ingredients. We must be very clear about our policies, not merely in statements, but in our actions. In a democracy there will be dissident views but the government must decide on its policy and stick to it unitedly. The bureaucracy must be strengthened and geared to quick decision making and implementation. Our work ethic must be improved and we require to be a much more disciplined society.

The private sector must not be dependent on the government as much as they are. They must themselves take action to improve their productivity and competitiveness and not expect the government to support their failures. And of course most of all we must end this war and establish a really pluralistic society in which all citizens are committed to the country's development. As the Vice President of the World Bank, Woods said, 'we are a Malaysia awaiting to happen'. But we can do that only if we look to the opportunities around us and work through them rather than look back at the past.

All eyes are on the 1997 budget, to be presented on Wednesday. Unlike last year, when the government confounded all expectations by presenting a give-away budget, we expect the 1997 budget to contain tough measures to check runaway spending and bring the budget deficit under control. The Appropriation Bill containing the government's revenue and expenditure estimates, envisages a reduction of the budget deficit to 8% of GDP in 1997. Official estimates are for the budget deficit to be around 10% of GDP this year although we are more pessimistic and forecast the deficit at 11.8% of GDP in 1996.

We expect the budget deficit to fall to 9.4% of GDP in 1997, on account of lower spending on subsidies and defense account.

Nevertheless, given the structure of government finances, with current spending accounting for 76% of total spending substantial cost reductions will be limited in the short term. Likewise, on the revenue front, in the absence of substantial fiscal reform to broadbase the tax administration, prospects for raising revenue remain limited in the near term.

Expenditure will increase

The Approved Estimates (AE) for 1997 provide for an expenditure of Rs. 283.3 bn, which is a 3.9% increase from 1996 AE. Key provisions include:

Defence gets less

Defense has been allocated Rs. 44 bn in 1997, down from our estimates of Rs. 55 bn this year. We expect defense spending to fall to around 5% of GDP from almost 7% of GDP this year.

Welfare will not feel the brunt

Most of the price adjustments on heavily subsidized items (i.e., fuel transport, bread) have already been made. In view of its impact on cost of living we don't expect the government to further burden low income groups by reducing welfare allocations.

About Rs. 15 bn has been allocated for subsidies on wheat, fertilizer, free school uniforms/travel, and the Samurdhi poverty relief program. This Rs. 1.5 bn fertilizer subsidy is also not likely to be terminated. However, we expect further rationalization of the wheat subsidy (present cost around Rs. 6 bn) as it is an untargeted and non-productive subsidy .The subsidy is likely to be targeted only to low income groups.

Social and economic infrastructure

Allocations for Education, transport, environment, health, highways and social services have been increased. Reductions have been made in allocations for posts, telecommunications, agriculture, shipping, ports, reconstruction, public administration and plantations which have seen lower allocations. Privatization and greater private sector involvement in infrastructure will enable lower provisions for some of these Ministries.

Revenue more buoyant in 1997

The government is hoping to raise Rs. 185.7 bn in 1997, an increase of 8.2% from official estimates of revenue collections in 1996. Since our expectations are for a more subdued revenue growth this year, we expect a 21% growth in revenue in 1997 to Rs. 178.5 bn. In the absence of a significant improvement in the economy, more robust revenue collection will remain difficult.

GST expected by late 1997

The government has now set a deadline of early 1997 for implementing the oft-postponed Goods and Services Tax (GDST). However given the logistics involved the expected initial revenue shortfall as well as its inflationary impact we expect GDT to be delayed until at least the third quarter of 1996. The taxation rates are yet to be announced, however, we expect two bands: a zero rate for exports and essential goods, and a standard rate of between 10% - 15 %.

Import duty reduction unlikely

Import duties were reduced to 3 bands (35%, 20% and 10%) last year. The government had originally supported moving toward a single tariff band in the medium-term. However, we think that revenue constraints will check further reductions for the moment. More importantly, recent comments by the Finance Minister over the difficulties faced by small and medium scale industries from cheap imports due to tariff reductions suggest a subtle policy shift towards encouraging local industry through tariff protection. We don't think this is tantamount to a reversal of the export-oriented strategy of growth towards an import substitution policy.

Nevertheless a greater degree of protection for domestic industry through selective tariffs on imports remains possible.

Sin taxes could go up

As has been the practice each year, further increases in excise duties on liquor (around 9%) and tobacco is possible. Although the experience of the 71% excise duty reduction on beer last year confirmed Laffer Curve effects, speculation exists over a modest increase for beer taxes in the budget. Upward revisions of import duties on selected 'luxury' goods also remain a possibility.

Direct tax increases not likely

There is speculation that the government will remove the Pay As You Earn (PAYE) tax to provide relief to income tax payers. Since the contribution of PAYE to tax revenue is fairly small (less than 5% of tax revenue) the multiplier effects on consumption is expected to outweigh loss of revenue. There is pressure to grant concessions to the private sector as well in light of the 50% wage hike promised to the public sector over 1997-1998. We don't however expect reductions in the Corporate Tax rate (presently 35%) as it is a more significant contributor to revenue. Also, the tax incidence was lowered with the abolition of the 15% surcharge on Corporate Tax with effect from April 1997. At the same time we are not anticipating increases in direct taxes either in view of the depressed economic environment and high rates of inflation.

Incentives to promote small industry

The budget is likely to contain concessions for the development of small and medium scale industries The government is keen to develop domestic industry as well as to encourage self employment projects to increase employment. We expect the government to provide loans at concessionary rates for target sectors.

Foreign investment incentives for infrastructure

Last year, the government announced a comprehensive incentive scheme for high technology foreign investment projects. Since the need of the hour is developing infrastructure, further concessions for investment in this area are likely.

Government will try to provide more infrastructure

Over the years capital spending has fallen victim to current spending, with less than 5% of GDP spent on providing essential economic infrastructure. The government has sought to fill the vacuum by encouraging private sector investment into infrastructure. However, as progress on BOT/BOO project has tended to be painfully slow, we expect the government to allocate a few high priority projects such as power and highways, within its own capital spending budget.

Privatisation likely to gather momentum

Given the limited options for increasing tax revenue in the medium term, privatization will provide a vital source of revenue to bridge the fiscal gap. We expect the privatization program to gather momentum next year, after setbacks this year on account of trade union opposition. We expect the government to raise Rs. 17.6 bn in privatization receipts over 1996-1998 significantly less than the Rs. 21 bn the government hoped to raise this year alone. Key companies we expect to come up for sale next year include Sri Lanka Telecom, AirLanka and the remaining plantations companies. We expect privatization receipts to be less than Rs. 4 bn in the current year.