Development Under Stress

DEVELOPMENT UNDER STRESS DEVELOPMENT UNDER STRESS Sri Lankan Economy in Transition Saman Kelegama Copyright © Inst...

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DEVELOPMENT UNDER STRESS

DEVELOPMENT UNDER STRESS Sri Lankan Economy in Transition

Saman Kelegama

Copyright © Institute of Policy Studies of Sri Lanka, 2006

All rights reserved. No part of this book may be reproduced or utilised in any form or by any means, electronic or mechanical, including photocopying, recording or by any information storage or retrieval system, without permission in writing from the publisher. First published in 2006 by Sage Publications India Pvt Ltd B-42, Panchsheel Enclave New Delhi 110 017 www.indiasage.com Sage Publications Inc 2455 Teller Road Thousand Oaks, California 91320 Sage Publications Ltd 1 Oliver’s Yard, 55 City Road London EC1Y 1SP Published by Tejeshwar Singh for Sage Publications India Pvt Ltd, phototypeset in 9.5/11.5 pt Calisto MT by Star Compugraphics Private Limited, Delhi and printed at Chaman Enterprises, New Delhi. Library of Congress Cataloging-in-Publication Data Kelegama, Saman. Development under stress: Sri Lankan economy in transition/Saman Kelegama. p. cm. Includes bibliographical references and index. 1. Sri Lanka—Economic policy. 2. Sri Lanka—Economic conditions. I. Title. HC424.K45

338.95493—dc22

ISBN: 10: 0–7619–3536–3 (HB) 13: 978–0–7619–3536–0 (HB)

2006

2006027542

10: 81–7829–694–2 (India–HB) 13: 978–81–7829–694–4 (India–HB)

Sage Production Team: Anindita Majumdar, Rajib Chatterjee and Santosh Rawat

CONTENTS

List of Tables and Figures

7

List of Abbreviations

11

Preface

17

Introduction

20

Part I Fifty Years of Economic Development and the Challenge Ahead 1. Economic Development during the 50 Years of Independence: What Went Wrong? 2. Pre-Conditions for Achieving ‘NIC Status’

37 73

Part II Debate on Economic Liberalisation 3. Stabilisation and Adjustment: A Second Look at the Experience during 1977–93 4. Does Leadership Matter in the Economic Reform Process? Liberalisation and Governance during 1989–93

91 108

Part III Macroeconomic Management 5. The Economic Cost of the North-East Conflict 6. Free Float of Currency, Budget 2001 and the IMF Package: Managing the Economy during Turbulent Times, 2000–2001 7. Managing the Economy at a Time of Terrorism and War and the Prospects after the 2002 Ceasefire Agreement 8. Transforming the Conflict Using an Economic Dividend: The Experience during 2002–03

129 140 158 174

6

Development Under Stress: Sri Lankan Economy in Transition

Part IV Sectoral Policy 9. Industrialisation: An Overview 10. Ready-Made Garment Industry: Preparing to Face the Global Challenge 11. Market Reform and Diversification in Agriculture 12. Food Security Issues

201 212 227 237

Part V Employment and Poverty 13. Structural Adjustment and Employment Creation 14. The Poverty Situation and Policy

259 280

Index

299

About the Author

307

LIST OF TABLES AND FIGURES

Tables 1.1

Terms of Trade, Export Volume Index, Foreign Reserves and Balance of Payments Position, 1950–96

40

1.2

Economic Growth, Savings and Investments, 1950–96

43

1.3

Social Expenditure as Percentage of GNP, Sri Lanka, 1950–51 to 1977

48

1.4

Financing of Investment, 1978–96 (% of GDP)

52

1.5

Comparable Rates of Economic Growth: Sri Lanka and

1.6 1.7

Other Developing Countries, 1970–95 (% change per year)

58

Data on Tourism

58

Defence Expenditure as a Percentage of Total Expenditure and GDP (market prices), 1980–96

59

1.8

Fiscal Operations, 1980–96

60

1.9

Infrastructure Indicators

64

1.10 Selected Asian Countries: Social Indicators of Development

65

2.1

Growth, Investment and Savings, 1975–91

75

2.2

Investment-Savings Gap for Different Scenarios of ICORs and MPSs

76

2.3

Productivity Growth, 1985–90

82

3.1

Key Macroeconomic Indicators, 1970–77 (Average) and 1978–93

95

8


4.1

Key Macroeconomic Targets of the PFP, 1989–91

111

4.2

Economic Indicators, 1988–93

113

5.1

Economic Growth, 1980–96

131

5.2

Budget Deficits and Expenditure on Defence, 1982–96, Selected Years

5.3

132

Compounded Present Value (1996) of Estimated Cost of the War, 1984–96

135

5.4

Cost of Damage (Secondary Cost), 1995

137

6.1

Economic Growth, Exchange Rate and Interest Rates, 1995–2000

141

6.2

External Sector Indicators

144

6.3

Summary of Government Fiscal Operations

146

6.4

Comparison of Budgeted and Actual Fiscal Operations 1997–2001 as % of GDP

149

6.5

Financing of the Budget Deficits, 1995–99

150

7.1

Economic Growth, 1980–2001

159

7.2

Budget Deficits and Expenditure on Defence, 1982–2001 Selected Years

161

9.1

Export Diversification, 1980–2004

203

9.2

Regional Distribution of Industrial Activity

203

9.3

Concentration of Industrial Production by Industry as Percentage of Industrial Production Value

204

10.1 Sri Lanka Textile and Garment Sector: Macro Data

214

10.2 Export Performance of Textile and Garment (T&G) Industry in Sri Lanka: Key Indicators for 1995–2003

214

11.1 Value and Share of Food Imports in 2001

229

11.2 Paddy Production and Rice Imports

230

12.1 Food Imports Expenditure, 1955–99

239

12.2 Food Production Trends, 1950–99

240

12.3 Total Food Availability in Sri Lanka

243

12.4 PMB Capacity Utilisation, 1980–96

244

LIST OF TABLES AND FIGURES

9

12.5 CWE’s Percentage Share of Food Commodity Imports, 1995–98

245

12.6 Comparison of Food Expenditure among Sectors

247

13.1 Unemployment Rate, 1973–95

260

13.2 Employment in the Tourist Sector

262

13.3 Employment and Output Shares in the Sri Lankan Economy for Selected Years 13.4 Employment Patterns in Organised Sector Industries

263 264

13.5 Regional Distribution of Economic Activity in Manufacturing Sector by Provinces, 1981

266

13.6 Unemployment as a Percentage of the Labour Force in Different Economic Sectors for Selected Years

266

13.7 Employment in the State Sector, 1988–93

268

13.8 Unemployment Trends, 1994–2003

274

14.1 Social Indicators: Sri Lanka and Selected Asian Countries

281

14.2 Consumption Poverty in Sri Lanka by Sector (1985–86, 1990–91 and 1995–96)

282

14.3 GDP Growth and Poverty Incidence by Region

283

14.4 Income and Human Poverty by Province

284

14.5 Income Shares Spending Units

286

14.6 Gini Coefficient

286

14.7 Welfare and Social Infrastructure Expenditures

287

14.8 Social Development Expenditure in Five-Year Periods as a Percentage of GDP

290

Figures 1.1

Interlocking Initial Conditions

41

5.1

Trends in Foreign Direct Investment, 1970–96

136

5.2

Trends in Tourist Arrivals, 1970–95

137

6.1 6.2

Behaviour of the Exchange Rates, June–December 2000 Behaviour of the Interest Rates, January 1999–November 2000

142 142

10


6.3

How a Rupee was Spent—2000

147

6.4

How a Rupee was Earned—2000

148

8.1

Strategy of the UNF Government (2002–03)

187

8.2

Strategy of the PA Government (2000–2001)

188

LIST

ACP ADB AGOA AHFSI AMDP AMS AOA APA ARC ASEAN ATC ATPA BIMSTEC BOI BOO BOP BOT BTT CAA CAD/CAM CBC CBMs CBSL CBSLAR CBTPA CCC CFA CFSES CISIR

OF

ABBREVIATIONS

African, Caribbean and Pacific Asian Development Bank African Growth and Opportunity Act Aggregate Household Food Security Index Accelerated Mahaweli Development Programme Aggregate Measure of Support Agreement on Agriculture Agricultural Purchasing Authority Administrative Reforms Committee Association of South East Asian Nations Agreement on Textiles and Clothing Andean Trade Preferential Act Bay of Bengal Initiative for Multi Sector Technical and Economic Cooperation Board of Investment Build, Own and Operate Balance of Payments Build, Operate and Transfer Business Turnover Tax Consumer Affairs Authority Computer Aided Design/Computer Aided Manufacturing Central Bank of Ceylon Confidence Building Measures Central Bank of Sri Lanka Central Bank of Sri Lanka Annual Report Caribbean Basin Trade Preferential Act Ceylon Chamber of Commerce Ceasefire Agreement Consumer Finances and Socio-Economic Survey Ceylon Institute of Scientific and Industrial Research

12

CITI CSM CWC CWE DCS DES DFCC EBA EDB EFF EOI EPF EPZ ERD ESAF ESCAP EU FAO FCD FIAC FDI FTA GCE GCEC GDP GFP GNP GOSL GPS GSP GST HEIS HRID HSZ IA ICOR IDB IDPs IFS ILBFTA IL-CEPA ILO IMF IPA IPS IRDP


Clothing Industry Training Institute Colombo Stock Market Ceylon Workers Congress Cooperative Wholesale Establishment Department of Census and Statistics Dietary Energy Supply Development Finance Corporation of Ceylon Everything-But-Arms Export Development Board Extended Fund Facility Export-Oriented Industrialisation Employees’ Provident Fund Export Promotion Zone External Resources Department Enhanced Structural Adjustment Facility Economic and Social Commission for Asia and the Pacific European Union Food and Agriculture Organisation Food Commissioner’s Department Foreign Investment Advisory Committee Foreign Direct Investment Free Trade Agreement General Certificate of Education Greater Colombo Economic Commission Gross Domestic Product Garment Factory Programme Gross National Product Government of Sri Lanka Guaranteed Price Scheme Generalised System of Preferences Goods and Services Tax Household Expenditure and Income Survey Human Resources and Institution Development High Security Zones Interim Administration Incremental Capital Output Ratio Industrial Development Board Internally Displaced Persons Institute of Fundamental Studies Indo-Sri Lanka Bilateral Free Trade Agreement Indo-Sri Lanka Comprehensive Economic Partnership Agreement International Labour Organisation International Monetary Fund International Peace Academy Institute of Policy Studies Integrated Rural Development Programme

LIST OF ABBREVIATIONS

ISFP ISGA ISI IT JAAF JBIC JICA JSP JVP LDCs LTTE MALF MEFP MFA MOI MOU MPCS MPS MTBs NAITA NAFTA NCGE NDB NDC NDTF NE NERF NFE NGO NIBM NIC NPC NRFC NSL NTC NTC NYSCO OECD OPEC PA PERC PFP PIP PMB PQLI PRGF

Integrated Food Security Programme Interim Self-Governing Authority Import Substitution Industrialisation Information Technology Joint Apparel Association Forum Japan Bank for International Cooperation Japan International Cooperation Agency Janasaviya Programme Janatha Vimukthi Peramuna Least Developed Countries Liberation Tigers of Tamil Eelam Ministry of Agriculture, Lands and Forestry Memorandum of Economic and Financial Policies Multi-Fibre Arrangement Ministry of Industries Memorandum of Understanding Multi Purpose Cooperative Society System Marginal Propensity to Save Main Battle Tanks National Apprentice Industrial Training Authority North American Free Trade Agreement National Certificate of General Education National Development Bank National Development Council National Development Trust Fund North and East North-East Reconstruction Fund No Foreign Exchange Non-Government Organisation National Institute of Business Management Newly Industrialised Country National Planning Council Non-Resident Foreign Currency National Security Levy National Transport Commission Non-Trade Concern National Youth Service and Credit Organisation Organisation for Economic Cooperation and Development Organisation of Petroleum Exporting Countries People’s Alliance Public Enterprise Reform Commission Policy Framework Papers Public Investment Programme Paddy Marketing Board Physical Quality of Life Index Poverty Reduction and Growth Facility

13

14

PRSP PTC PUC QRs 3Rs R&D RIS RMG RSL SAARC SAF SAFTA SAP SAPTA SBP SCOPP SDR SIHRN SLFP SLIIT SLMC SLMM SMEs SMD SNC SPI STC SWOT T&G TBT TCI TEEDO TEWA THGFP TIFA TNCs TRIPs TT&SC TVEC UNCTAD UNDP UNF UNHCR


Poverty Reduction Strategy Paper Presidential Tariff Commission Public Utility Commission Quantitative Restrictions Relief, Rehabilitation and Reconstruction Research and Development Research and Information System for Non-Aligned and Other Developing Countries Ready-Made Garments Regaining Sri Lanka: (Vision and Strategy for Accelerated Development) South Asian Association for Regional Cooperation Structural Adjustment Facility South Asia Free Trade Agreement Structural Adjustment Package South Asian Preferential Trading Arrangement Stand-by Package Secretariat for Coordinating the Peace Process Special Drawing Rights Sub-Committee on Immediate Humanitarian Relief and Rehabilitation Needs Sri Lanka Freedom Party Sri Lanka Institute of Information Technology Sri Lanka Muslim Congress Sri Lanka Monitoring Mission Small and Medium Enterprises Sub-Committee on Military De-escalation Save the Nation Contribution Sub-Committee on Political Issues State Trading Corporation Strengths, Weaknesses, Opportunities and Threats Textile and Garment Technical Barriers to Trade The Competitiveness Initiative Tamil Eelam Economic Development Organisation Termination of Employment of Workmen Act Two Hundred Garment Factories Programme Trade and Investment Framework Agreement Trans-National Corporations Trade Related Intellectual Property Rights Textile Training and Service Centre Tertiary and Vocational Education Commission United Nations Conference on Trade and Development United Nations Development Programme United National Front United Nations High Commission for Refugees

LIST OF ABBREVIATIONS

UNICEF UNIDO UNITC UNP UPFA UPOV USAID VAT VRS WB WDR WFP WIDER WTO

United Nations International Children’s Emergency Fund United Nations Industrial Development Organisation United States International Trade Commission United National Party United People’s Freedom Alliance Union for Protection of New Plant Varieties United States Agency for International Development Value Added Tax Voluntary Retrenchment Scheme World Bank World Development Report World Food Programme World Institute of Development Economic Research World Trade Organisation

15

PREFACE

Sri Lanka is credited with the distinction of achieving a high physical quality of life in a relatively short period by maintaining social welfare programmes inclusive of a universal food-subsidy. Sri Lanka is also credited for being the pioneer of economic liberalisation in South Asia. But Sri Lanka still remains a developing country with a per capita income level of USD 1025 (2004) with an average growth rate of about 5 per cent and close to 23 per cent of the population living below the poverty line. Sri Lanka’s experience in enhancing its physical quality of life has some unique features. First, the social welfare programmes that contributed to the enhancement of the physical quality of life were maintained for nearly 30 years after Independence due to competitive political pressure rather than supporting economic growth. Second, although the social welfare programmes underwent some changes (removal of the universal food subsidy) after economic liberalisation was introduced; the performance in social services during the last two decades did not improve in consonance with earlier achievements. The adjustments in social policies were slow to meet the emerging needs of society due to various political pressures based on many hangovers from the closed economy period. Sri Lanka’s experience with economic liberalisation also has some unique features. First, the country lived with export pessimism for two decades after Independence and overstayed its experimentation with a closed economy before embarking on liberalisation. In other words, it was a late comer to export-led industrialisation. Second, it attempted to manage an open economy and engage in further economic liberalisation while there was an on-going war in the North-East of the country. Third, it tried to transform a conflict via a peace dividend based on economic gains from further liberalising the economy. Fourth, it experienced weak coalition governments after 1994, and 2000 in particular, and tried to push through reforms while managing and safeguarding the political coalitions. In short, Sri Lanka’s development over the years took place under a stressful environment. Thus, it could not match the development achievements of South Korea and Malaysia—countries that had similar per capita levels to that of Sri Lanka in

18


the late 1950s. This makes Sri Lanka a unique case study among developing countries when studying reform and development. A general book on the Sri Lankan economy which gives a broad picture on these themes has been lacking for some time. The book fills this lacuna. The book basically looks at various impediments faced in the development process and the implementation of reforms, particularly after economic liberalisation in 1977. It attempts to show some key features of the Sri Lankan socio-political economic system that prevented the country from achieving higher levels of economic development. It consists of a collection of 14 papers (in an edited format) written by the author (some jointly with others) and published in various journals and as chapters in books during the last decade. It is divided into five parts. The first part examines the 50 years of economic development and the challenges ahead, the second part examines the economic liberalisation debate, the third part looks at macroeconomic management during difficult times, the fourth part looks at sectoral issues with reference to industry and agriculture, and the final part examines employment and poverty. The contents of all the chapters have contemporary relevance. Each chapter stands on its own, with its tables and references, thus, some repetitions have been unavoidable. The use of quantitative techniques has been avoided to a great extent. The material covered in the book will be of interest to policy makers, academia, people in the private sector and those engaged in development activities. I am indebted to the editors/publishers of the following books/journals for granting me permission to make use of the previously published material. Milestones to Independence: A Publication by the People’s Bank to Commemorate the Golden Jubilee of National Independence (Chapter 1), Upanathi (The Journal of Sri Lanka Association of Economists) (Chapter 2), Developing Economies (Chapter 3), World Development (Chapter 4 and some sections of Chapter 5), Economic and Political Weekly (Chapters 6 and 7), The Round Table (Chapter 8), Business Today and W.D. Lakshman Felicitation Volume (Chapter 9), International Relations in a Globalizing World (Chapter 10), Economic Reforms and Food Security: The Impact of Trade and Technology in South Asia edited by Suresh Babu and Ashok Gulati (Chapter 11), Hector Kobbekaduwa Felicitation Volume (Chapter 12), Economic Review (People’s Bank) (Chapter 13) and Reducing Poverty in Asia edited by Christopher M. Edmonds, ADB and Edward Elgar Publishers (Chapter 14). The preparation of the book started sometime in 2002, however, due to various work commitments its finalisation got delayed. The book could not have been completed without the support of some individuals. I am grateful to my co-authors, viz., David Dunham (Chapters 3 and 4), Suresh Babu (Chapter 11), Nirgunan Tiruchelvam (Chapter 13), Sisira Jayasuriya and Nisha Arunatilake (Chapter 5) for fruitful research collaboration over the years and for permission to make use of the material from our joint papers. I am also grateful to Deshal De Mel for updating some chapters, Anushka Wijesinghe for editorial support and Premila Gamage for readily making available the reference material.

PREFACE

19

Many individuals were involved in the discussion regarding the organisation of the book at various stages. Among them Prema-chandra Athukorala, Sisira Jayasuriya, Laksiri Jayasuriya and Nimal Sanderatne deserve especial mention. I also received valuable advice and comments from D.D.M. Waidyasekera, Wimal Hettiarchchi, Dushni Weerakoon and Roshan Madawala. The final manuscript was edited by D.D.M. Waidyasekera and formatted by Asuntha Paul under the supervision of Manu Gunasekera. I am most grateful to all of them. If I have left out someone from this list of acknowledgements it would be an oversight on my part. Saman Kelegama

INTRODUCTION

Background At the time of Independence in 1948, Sri Lanka had inherited from the British colonial rule a commercially well-organised plantation sector (tea, rubber and coconut) contributing to 90 per cent of all export earnings, a well-entrenched welfare system and an efficient administrative structure. Since Independence, the process of development in Sri Lanka has captured the imagination of various economists and politicians. A former Governor-General of Sri Lanka, for instance, stated in the early 1950s that Sri Lanka may prove to be ‘the best bet in Asia’. Lee Kaun Yew (former Prime Minister of Singapore) stated in the mid-1950s that Singapore would like to emulate Sri Lanka. However, the Sri Lankan economic-development achievements over the years failed to live up to its initial expectations. Sri Lanka still remains an economy with a GDP close to USD 20 billion with per capita income of USD 1,025 (in 2004) with about 23 per cent of the population living below the poverty line. It has been overtaken by countries that were on par with it in the past, for example, South Korea and Malaysia, which are newly-industrialised countries today, actually had per capita income levels close to what Sri Lanka had in 1960. The Sri Lankan development story since Independence is an uneven one, characterised by slow adjustment to internal and external shocks, missed opportunities and policy errors. Unlike some East Asian success stories, the Sri Lankan economy progressed over the years under a stressful environment. Three key factors could be identified. First, the environment associated with the welfare state—whose roots can be traced to the universal adult franchise that Sri Lanka achieved in 1931—led to a highly politicised electorate. This electorate did not permit Sri Lanka to disassociate itself from the welfare state culture for most of the post-Independence period. The welfare measures were maintained more on the basis of competitive political pressures rather than sustainable economic growth. The rapid growth of population during the first three decades after Independence (population doubled between 1948 and 1978) determined the course of social and economic development in the country. The strain caused by the population upsurge

INTRODUCTION

21

on the country’s economic resources was enormous, particularly on social welfare expenditure that increased significantly, especially when food (rice, wheat, etc.) prices escalated in the international market. Increasingly, there was some degree of duality between economic growth and the maintenance of social welfare programmes, which was reflected in the inadequate support that the welfare state got from the growth process. Although, the social welfare programmes underwent some changes (for instance, removal of the universal food subsidy) after economic liberalisation was introduced; the performance in social services during the last two decades did not improve in consonance with earlier achievements. The adjustments in social policies were slow in meeting the emerging needs of society due to the various political pressures based on many hangovers, dating back to the closed economy period. Second, Sri Lanka was also stricken by the doctrinaire of export pessimism and delayed moving towards an export-oriented strategy by remaining a closed economy for nearly two decades. When economic liberalisation began in 1977, it was a late entrant in the export-led industrial world and thus, could not stage a significant breakthrough like the East Asian Tigers. Third, a concerted effort was not made to address the ethnic animosity between the two major communities (Sinhalese and Tamils) that erupted time and again during the post-Independence period and culminated into a civil war in North-East Sri Lanka during 1983–2001. This conflict substantially disturbed the economic management process. Despite the stressful environment, there were some achievements about which Sri Lanka is well known internationally. Sri Lanka came to be known as an exception among developing countries in improving its physical quality of life—achieved by an extensive social welfare programme, which cost between 8 and 10 per cent of the GDP from the mid-1950s to 1980 (Sanderatne, 1997). These achievements caught the attention of many economists in the late 1970s and early 1980s. The growth versus equity debate in Sri Lanka has been analysed by many of these economists. One school of thought believes that high achievements in basic-needs indicators came at a cost to economic growth (Bhalla and Glewwe, 1986). The other school of thought believes Sri Lanka achieved a reasonable rate of growth with equity (Isenman, 1980; Sen, 1981). This debate is often re-visited by economists (Osmani, 1994) and remains far from settled. Some have looked at the achievement of high basic-needs indicators along with the demographic changes that have taken place over the last 100 years (Sanderatne, 2000). Sri Lanka went through all three stages of the usual demographic transition in a comparatively short period of 70–100 years. The first phase, during the firsthalf of the 20th century when there was slow population growth (high levels of mortality offsetting high rates of fertility); the second phase starting soon after Independence and continuing through the 1970s where there was high population growth (sharp decline in mortality without an accompanying decrease in fertility); and finally, the third phase, picking up momentum in the 1980s and manifesting itself in the 1990s—once again slow population growth close to 1 per cent (where decline in mortality was accompanied by low fertility). These developments contributed to the stabilisation of the population in the third decade of the 21st century at a level estimated to be around 23 million.

22


The main feature of a low fertility rate and a low mortality rate, a result of the past social welfare expenditures, is a demographic transition where there will be a rapid ageing population in Sri Lanka—which would be the only country among developing countries to have a population of above 65 years constituting more than 20 per cent of its total population in the years 2020–25. While countries in Europe took between 45 and 145 years to double their 65+ population, in Sri Lanka this will happen in 20 years. Facing the rapid demographic transition remains a formidable challenge for policy makers. Sri Lanka also became one of the few developing countries to liberalise its economy in 1977, way before the Structural Adjustment Programmes were introduced by the Bretton Woods institutions. The country has now experienced more than 28 years of economic liberalisation, however, it also experienced a civil war for 17 years and a ceasefire (with negotiations on peace) for nearly four years (and continuing at the time of writing), during its economic liberalisation period. Thus, Sri Lanka is a unique example of a country that is managing an economy and driving reforms, while simultaneously trying to end a war by initiating and managing a peace process in order to obtain a peace dividend. Despite the erratic experience with liberalisation, according to the statistics provided by the Central Bank of Sri Lanka, the country achieved an average growth rate of 5 per cent during the postliberalisation period. This may perhaps be an achievement for a nation that went through a stressful period due to a war.

An Overview of the Chapters Sri Lanka’s unique development experience is captured in the ensuing chapters of this book. The first chapter basically provides a broad picture as to why Sri Lanka failed to live up to its initial promise. At the time of its Independence, Sri Lanka had the highest per capita income outside Japan, in Asia. Even by 1960, Sri Lanka’s per capita income was comparable to that of South Korea and higher than that of Thailand and Indonesia. However, by 1997, South Korea had a per capita income that was 14 times higher than Sri Lanka and Thailand’s per capita was four times higher, while Indonesia had marginally overtaken Sri Lanka. Chapter One provides an overview of the economy and discusses some of the broad factors that impeded Sri Lanka’s economic progress. It argues that Sri Lanka’s failures in achieving higher economic growth could be generally explained by (a) inability to get out of initial inter-locking conditions of the 1950s, which till the late-1970s due to political economy factors rooted in the country’s five year electoral cycle, (b) policy errors—the hallmark being the postponement of crucial policy initiatives until a crisis engulfed the economy, and (c) missed opportunities. The Sri Lankan development experience during the first 50 years of Independence clearly shows, the limitations of the state-led direct method of enhancing social welfare and the ability of a liberal trade and investment regime to generate reasonably high growth rates even during a chaotic war situation in a developing economy.

INTRODUCTION

23

Essentially the chapter argues that Sri Lanka moved too much towards a closed economy in its economic policy management during the late-1950s to mid-1970s, and that the two decades of excessive controls and restrictions was not very appropriate for a small economy with a limited market and a narrow supply base. A more centrist strategy may have worked better. An economic liberalisation programme that was started in 1977 was disturbed by a major internal shock, i.e., the NorthEast civil war that started in 1983 and continued till 2001, interrupted by occasional ceasefires. Sri Lanka at times found it difficult to pursue an economic liberalisation programme with an on-going war. Taking cognisance of the missed opportunities and the lead that competitors such as Malaysia have taken in economic development, the Sri Lankan president announced during the early 1990s, that the country should achieve NIC status by 2000. Perhaps, the more realistic interpretation of this statement is the doubling of the per capita income by the year 2000. Chapter Two uses a simple Harrod-Domar model and provides various scenarios of savings, investments and capital-output ratios as well as the required strategy needed to enhance investment and reduce capital-output ratio, in order to achieve higher growth and thereby, double the per capita income. Chapters Three and Four outline the policy framework at work to pursue the goal of doubling the per capita income. Chapter Three provides the background on reforms and Chapter Four spells out how unpopular reforms were pushed by a strong political leadership. The liberalisation programme was pursued without a proper stabilisation programme, during the first decade of economic reforms in 1977, which overheated the economy and put pressure on the incentive structure to be in favour of nontradables. A stabilisation programme was implemented in the late 1980s/early 1990s with the concurrence of the IMF. There was tension between stabilisation and adjustment policies since the initiation of reform in 1977. Adjustment policies proved to be costly in the short run and the bulk of this cost was borne by the poor. To add the cost of stabilisation in the short run to this adjustment cost was politically difficult. Thus, the adjustment reforms became ad hoc and were mostly governed by political imperatives. The argument put forward by some commentators that there was ‘an unfinished agenda’ in implementing economic reform (Lal and Rajapatirana, 1989), while correct, remains to be explained. Chapter Three shows that this is purely a technocratic perspective and completely ignores the political economy aspects. The Sociopolitical environment and other non-economic factors do not get adjusted according to the requirements of a market economy with the standard stabilisation and adjustment packages (Kelegama and Rodrigo, 2004). The reforms pursued were seen to be feasible from the political side. Any further implementation of reform may have even triggered a backlash especially during the first wave of liberalisation of 1977–88. It was during a period of strong leadership (1989–93) that the second wave of liberalisation began with a targeted poverty alleviation programme—officially dubbed as a ‘two legged strategy’. Key elements of the second wave package were

24


FDI liberalisation, share market reform and privatisation. The governance issues during the second wave were very questionable, however, reforms were implemented by a strong political leadership. Chapter Four argues that in Sri Lanka where the state is not strong, where it is not well coordinated and is neither cohesive nor disciplined in organisational terms, strong political leadership proved crucial in the second wave of reforms during 1989–93—even if it was illiberal in the process of implementation. Technical and political imperatives were seen to be interrelated and parts of a single reform package. An impediment to implementing reform was the five year electoral cycle in Sri Lanka. Politicians usually get their act together after about one-and-a-half years in office and when the time to implement reforms comes they realise that the next elections are just three years away. Hence, any costly reform that involves long-term investment, is avoided or implemented half-heartedly. Another key impediment in the implementation of reforms was the costly civil war that Sri Lanka faced during 1983–2001. Not only did it divert resources from infrastructural activities but made it difficult to contain the budget deficits and maintain stability in the macroeconomy to support private sector expansion in the economy. After mid-1994, an ‘open economy with a human face’ came into operation. The reforms implemented during the second wave of liberalisation were broadened and fine-tuned. Privatisation was extended to public utilities, the cascading tax structure was removed and a GST (Goods and Services Tax) was implemented, incentives offered by the BOI (Board of Investment) [off-shore borrowing facilities, duty-free importation of inputs, etc.] were harmonised to a great extent with prevailing non-BOI incentives. Some improvements were also seen in the area of bribery and corruption, and so on. But deepening of reform was kept at a slow pace due to the escalation of the war and various elections in the late 1990s/early 2000. Some have argued that by the end of 2001, the economic and social progress with a human face proved to be a ‘failed promise’ (Lakshman, 2002). A third wave of liberalisation where deepening of reform was involved came into operation in early 2002 with the implementation of deregulation measures, second generation reform and partial liberalisation of factor markets. New institutions such as the Public Utility Commission (Multisector Regulatory Authority), Consumer Affairs Authority, etc., were put in place. These adjustment measures were accompanied by strong stabilisation measures governed by a newly enacted Fiscal Management Responsibility Act in 2002. Tariffs were further reduced; labour and foreign exchange markets were further liberalised, etc. The implementation of the third wave of liberalisation was made possible with the signing of a ceasefire agreement with the North-East Separatist Movement (LTTE) in early 2002. Part III shows how the cost of the civil war was manifested in the economy and how the Sri Lankan regime struggled with macroeconomic management. It also shows the problems that Sri Lanka encountered in delivering a peace dividend during 2002–03. Chapters Five, Six, Seven and Eight deal with these subjects. The 17-year-war was costly and deterred foreign and local investment, reduced tourist arrivals, caused immense damage to the country’s infrastructure, brain drain

INTRODUCTION

25

of skilled labour and above all led to many deaths. There were both direct and indirect costs and Chapter Five attempts to capture a cost estimate of the conflict/ war and, in turn, suggests that it may be equivalent to at least twice Sri Lanka’s 1996 GDP. The costly war, among others, led to large budget deficits (exceeding 8 per cent of the GDP) during the 1990s. Large scale domestic and foreign borrowing to finance the budget deficit accumulated as large public debt over the years, so much so that by the year 2000, public debt to the GDP ratio had exceeded 100 per cent. In 2001, the country faced an economic crisis consequent to the escalation of the war and an international oil price hike in the year 2000. There was a foreign exchange and budget management crisis which demanded immediate remedial measures. In 2001, for the first time the People’s Alliance (PA) coalition regime had to sign a Stand-by Package (SBP) with the IMF (International Monetary Fund) to address a foreign exchange crisis and bring some discipline into macro-economic management. The re-election of the PA in late 2000 was an opportunity to implement second generation reform and thereby initiate a third wave of liberalisation. However, the break-up of the political coalition in the first year of the government led to a higher priority being given to the management of political coalitions rather than to the management of the economy. Chapter Six analyses the economic crisis and the remedial measures that were implemented in 2001. By the end of 2001, the IMF package started falling apart and macroeconomic management had gone haywire. Budget deficit was 10.8 per cent of the GDP and the rate of inflation was 14.2 per cent, with the economy receding to negative growth (–1.5 per cent) for the first time since Independence. Although, external and internal shocks contributed to the situation, an economy receiving directives as per political imperatives, aggravated the situation. The ruling party was defeated in the end2001 elections and a new government was elected to office. The new government had to rescue the IMF package, instill some order in macroeconomic management and implement reforms. This government was of the view that all this could not be done without the war coming to an end and a peaceful atmosphere coming into operation. A peace package was worked out with the LTTE with the hope of providing an economic dividend through aid mobilisation and revival of the economy. Chapter Seven analyses the challenge that the new government faced and the prospects for a peace dividend. Sri Lanka’s post-war period provides a good example of using an economic lever (economic dividend, reconstruction and development) for consolidation of the peace process and conflict resolution. Although, optimistic at the start of the peace process, a noteworthy economic dividend was not visible in southern Sri Lanka (no-conflict areas) because a costly stabilisation and structural adjustment programme of the IMF coincided with the peace process. The prevalent complex institutional and military structure in the war-torn North-East (N-E) (conflict area) and a multiplicity of factors relating to the progress of the peace package prevented an economic dividend from fully taking shape in the area. Furthermore, the government’s institutional structure delayed aid disbursement and reconstruction in the N-E. An additional factor was the aid donors’ ‘tool kit’ approach and bias towards large

26


infrastructure projects in the N-E, which contributed to slowing the realisation of the economic dividend. Among other factors, the lack of a peace dividend in the N-E halted the peace talks and a lack of the same in southern Sri Lanka led to a rejection of the government at the April 2004 polls. An international safety net that was devised to rescue the peace process did work in the sense of preventing the rebels from going back to war, however, it did not revive the peace talks or expedite the economic dividend. The Sri Lankan experience highlights some important lessons for the governments and donors on making use of an economic lever for consolidating a peace process and conflict resolution. Chapter Eight focuses on these issues. Part IV deals with the production structure, viz., industry and agriculture. Chapter Nine gives an overview of industrialisation in Sri Lanka and Chapter Ten specifically looks at the take-off of the ready-made garment industry and the challenges the industry is confronting. Chapter Eleven focuses on agriculture reform and diversification, while Chapter Twelve examines food security with some reference to the debate regarding agricultural policy. Sri Lanka was basically an agro-based economy at the time of Independence. A World Bank mission report immediately after Independence, argued that Sri Lanka’s comparative advantage is in the agriculture sector and it should not go into industrialisation. However, with the terms of trade shocks and lack of diversification in export-based agriculture, Sri Lanka decided to embark on industrialisation in the mid-1950s, in accordance with the then prevalent ideological thinking of importsubstitution industrialisation (ISI). Industrialisation in Sri Lanka continued with ISI till the mid-1960s. However, 1965–70 witnessed the partial liberalisation of the economy and experimenting with export-oriented industrialisation (EOI). Once again, in the period 1970–77 there was a reverting back to ISI. Finally, in the post-1977 period it was back again to EOI with a more aggressive liberalisation of the economy. According to Athukorala and Rajapatirana (2000), Sri Lanka’s case is a late-comer’s story on EOI. Foreign Direct Investment (FDI) support to EOI was substantially discouraged by the uncertainty created by the North-East war after 1983. Consequently, Sri Lanka’s industrial transformation was based on labourintensive products, viz., ready-made garments (RMG), gems and jewellery, rubber products, ceramics, etc. The industrial transformation from ISI to EOI was impressive, however industrial diversification was limited. There was no industrial policy during the first decade of liberalisation; however, since 1989, industrial policies were put into operation—with the initiation of the Industrial Promotion Act of 1990. Contrary to views expressed by some commentators, industries were promoted by selective incentives—tariffs and BOI incentives. There was geographical spread of RMG industries consequent to selective incentives offered under the BOI during the early 1990s for a 200-garment factory programme. Sri Lankan industrialisation cannot be considered a neo-liberal success story for that may amount to an overdramatisation of the success (Chapter Nine). The RMG industry showed the most impressive performance during EOI period after 1977. While the open liberal regime played a significant role in the growth of the RMG industry, it must be noted that the Multi-Fibre Arrangement (MFA) played

INTRODUCTION

27

an equally significant role in attracting quota-hopping East Asian industrialists and thereby, encouraging local entrepreneurs to embark on RMG production and export. Using cheap labour and incentives generated by the liberal economy, RMG exports grew to occupy 52 per cent of Sri Lanka’s exports by the year 2000, accounting for 330,000 jobs (6 per cent of the labour force) and 1.3 million livelihoods. Sri Lanka has established a reputation of being a quality RMG producer, in particular, intimate apparel. RMG exports, despite their low value addition, account for the largest foreign exchange earnings in Sri Lanka. The country is currently facing a challenge of maintaining its competitive edge in the global market in an MFA-free trading environment and the increasing threat from China and India. Chapter Ten examines these challenges and Sri Lanka’s preparatory work and strategies to cope with it. Agriculture, which was the backbone of the Sri Lankan economy, suffered a severe set-back in the 1970s with the nationalisation of the plantation sector, which accounted for 70 per cent of the GDP from agriculture in 1975. The massive public investment in irrigation in the late 1970s/early 1980s paid dividends by making Sri Lanka near self-sufficient in rice in the mid-1980s. However, the desired nonplantation agriculture diversification has been slow. A number of institutional and land market impediments contributed to this situation. In the mid-1990s, Sri Lanka bound its agricultural tariffs at a relatively low level of 50 per cent (with the WTO) with the intention of developing the agriculture sector to the country’s comparative advantage. By 2005, it was clear that this strategy did not achieve the desired objective. In fact, low binding was done when many outdated regulations (quarantine restrictions on seeds importation, restrictions on land ownership, etc.) were in operation and institutions (marketing systems, postharvest storage, etc.) were far from developed. Internationally, the EU (European Union) and US subsidies on agriculture were hardly reduced, thus, distorting the international prices of agricultural imports. Market access was hindered by various non-tariff barriers (SPS, TBT [Technical Barriers to Trade], etc.) thus, preventing some Sri Lankan agricultural exports from finding easy access in these markets. In such an environment, the agricultural sector could not develop to a position of comparative advantage. On the contrary, the low-tariffs binding led to a gradual erosion of some non-plantation agriculture production and triggered ad hoc tariff changes to satisfy various agriculture producer lobbies. This was in contrast to other South Asian countries that bound agricultural tariffs at a higher level and safeguarded their production base from the prevailing international price distortions in agricultural trade. These are highlighted in Chapter Eleven, which argues that tariff reduction should be well harmonised with institutional reform and the removal of regulatory impediments, in order to achieve the best results for both producer and consumer. Chapter Tweleve examines the food security situation and related debates in Sri Lanka. Food security has been a misunderstood concept in Sri Lanka—there are many who equate food security with food self-sufficiency. The chapter after highlighting shifts in policy vis-à-vis food imports shows that although at the macrolevel food security is maintained, at the micro-level food security is not properly addressed. For instance, the average dietary energy intake in Sri Lanka falls below

28


the minimum requirement by 2,200 calories, with 33 per cent of women and 37 per cent of men suffering chronic energy deficiency and 33 per cent of children under five years being malnourished (with 13 per cent actually malnourished) (FAO, 1999). The food and nutritional inadequacies are concentrated among the poor, the children and the population displaced by the war for nearly two decades. Food insecurity is clearly an issue of pressing concern in Sri Lanka. Although, its importance has been recognised by successive governments and non-governmental and donor agencies, eliminating food insecurity has been a challenge. This chapter, after examining some of the measures taken to address food security at the micro-level, highlights areas where new strategies are required to address the problems. Part V is on employment and poverty. Chapter Thirteen is on employment and the last chapter is on poverty. Unemployment is an explosive issue in Sri Lanka. Two youth insurrections in southern Sri Lanka (1971 and 1988–89) and the youth uprising in North-East Sri Lanka (1983 onwards) and recent terrorist activities have their roots in, among other factors, unemployment. Combating poverty is currently the most debated issue in Sri Lanka, especially among the donor agencies. Sri Lanka’s population below the poverty line has fallen from 29 per cent in 1980 to 23 per cent by late 1990s, however, the level is high compared to Thailand (13 per cent), Malaysia (15 per cent) and Indonesia (20 per cent) [World Bank, 2002]. There are regional variations on poverty and income distribution is highly skewed in favour of the top two deciles of the population, which are concentrated in the big cities. Health and education expenditure as a percentage of GDP has declined over the years and the state-led poverty alleviation programmes remain politicised and consequently improperly targeted. These are the areas that need urgent attention. Sri Lanka can no longer sit on her laurels for achieving high basic needs indicators. Chapter Thriteen examines Sri Lanka’s employment generation under the structural adjustment during 1977–94, in order to highlight the problems of employment generation in the economy. It shows that most of the employment generation during the 1977–88 period was not from liberalisation policies but rather from state-led programmes. However, during 1989–94 the liberalisation measures were more effective in generating employment with facilitation measures provided by the state. The chapter argues that there are a number of characteristics in the Sri Lankan labour market that act as impediments in more employment creation. Among others, three hypotheses are noteworthy. First, the skill mismatch hypothesis that argues that the type of skills produced by the Sri Lankan education system are not suitable for the job market. Dudley Seers in his 1971 report for the ILO used this explanation to describe unemployment in Sri Lanka (ILO, 1971). Second, the job queuing hypothesis that argues that Sri Lanka’s unemployment is voluntary because youth wait for public sector jobs and in the meantime depend on family income (Rama, 2003). Third, it is argued that unemployment is due to the rigidities in the labour market resulting from an outdated labour legislation. Such legislation prevents smooth labour exit. It is argued that due to this factor it is difficult for firms to expand in a labour intensive manner and thus, create large scale new employment. The chapter shows that all three explanations, among others, have some validity and that although Sri Lanka managed to reduce unemployment levels to a single

INTRODUCTION

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digit level in the late 1990s, some of the key impediments of the labour market still prevail and until they are directly addressed, the forces of liberalisation will find it difficult to create the required jobs in the market. The final chapter takes a multidimensional approach to look at poverty and place it in the macroeconomic context. It shows that poverty had declined little during the 1990s. Poverty is characterised by regional and sectoral variation with marginal decline in income inequality. Despite the existence of a number of safety nets for the lower income groups, the poor seem to be highly vulnerable to income fluctuations. The chapter looks at the problems of existing strategies to elevate poverty-related strategies and the political economy factors that are influencing them. The impediments for the effective operation of poverty-related strategies are both structural and political. Due to the prevailing macroeconomic situation, the government is reluctant to undertake reforms that may be costly in the short-run. Depoliticisation of the poverty programme and structural and market reform will go a long way in making the existing poverty-related programmes more effective and in addressing the problem of poverty in Sri Lanka.

Recent Changes in Economic Policy and the Challenge Ahead The fourteen chapters outlined above, however, do not elaborate on the post-2003 developments and changes in the Sri Lankan economic policy regime. In this section a brief overview of the post-2003 economic policy environment is provided. In order to comprehend the post-2003 economic regimes a revisit to the economic regime during the 2002–03 period is essential.

2002–03 Period By the end of 2001, the economy was characterised by an average 5 per cent growth rate but there were a number of concerns with regard to the kind of economic changes that had taken place by then. Poverty had declined only marginally by 2002 compared to the early 1990s—the percentage of population below the poverty line was 23 per cent in 2002 compared to 26 per cent in 1990–91. Moreover, poverty was high in the rural and estate sectors (24 and 30 per cent, respectively in 2002, and in the estate sector the level was higher than in 1990–91) compared to the urban sector (7 per cent in 2002) and there were deep pockets of high-level poverty in the country. In regard to economic liberalisation although the economy had been liberalising for 25 years, by 2002, there still remained areas in the economy that were regulated and these pockets of rigidities prevented the economy from effectively responding to market forces. According to the World Bank (2005), the restrictions on labour and land markets, and the less than fully competitive financial sector makes the

30


investment climate much less friendly in Sri Lanka than her competitors in East Asia. The business environment is constrained by inadequate institutions and policies and the regulatory framework is not in tune with the needs of a market economy. Consequently, the private sector had yet to realise its full potential. Accordingly, eliminating these rigidities and putting the economy back on track with the lead from the private sector was a priority item in 2002 under the Regaining Sri Lanka (RSL) policy initiative of the United National Front (UNF) regime. RSL strategy was to overcome the existing problems by implementing second generation reforms based on deepening economic liberalisation by deregulation and privatisation. Besides, the Poverty Reduction Strategy Paper (PRSP) was built-in to the RSL initiative and connecting economic growth to poverty reduction was envisaged by the trickle-down process. The macro policy package under the RSL initiative was based on the neo-liberal economic model—stabilisation and adjustment—perhaps with some justification in view of the macroeconomic situation but the package was more liberal than the economic policies pursued by successive governments during 1977–2001. The Multilateral Financial Institutions were content with the reform policy agenda and this enabled the regime to sign a Poverty Reduction and Growth Facility (PRGF) with the IMF in the second quarter of 2003. RSL was an ambitious grand reform programme that was pursued very aggressively. However, the question regarding the kind of reforms that would work and that would not work in the given environment, was not addressed. Moreover, there was no sequencing of reforms. The assumption was that the flow of foreign assistance would offset stabilisation and adjustment costs and buy off protest and opposition to reform. This was not to be the case and thus, the policy implementation strategy was vulnerable to capture by interested groups in coalition politics and by an Executive President who represented a different political party. By end 2003, there was a growing perception in the country that economic growth based on rapid deregulation/privatisation policies has been highly Western Province centred (accounting for 50 per cent of GDP and where the central city of Colombo is located) with little or no growth in the provinces and that growth had not benefited the masses either in cushioning poverty or in reducing income inequality. In other words, the fruits of liberal economic policies failed to reach the rural poor through the trickle-down effect. There was also a perception that the peace process was based on an appeasement strategy akin to ‘peace at any cost’, which was gradually laying the foundations for the separation of the country. In short, managing change in the economy was not politically successful during 2002–03. New political forces have recently emerged both in search of an economic middle ground and in search of a solution to the North-East conflict within a unitary state. They united and formed a coalition and found the leadership in the Executive President who was waiting to overcome the uneasy cohabitation. The 2004 General Election saw a rejection of the neoliberal policy package and the strategy of an appeasement-based peace process of the UNF regime. The newly elected government (United People’s Freedom Alliance—UPFA) saw internal coherence of economic and social policies as essential for growth and social stability.

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2004–06 Period The country witnessed a slight twist in its pro-liberalisation economic policy stance after the change of government. The new policy was aimed at generating more equitable distribution of income by providing enhanced relief to the vulnerable and poorer sections of society, encourage small and medium enterprises and shift the focus of economic activity from the urban to the rural sector. The new policy was also to accord a greater role for the public sector while abandoning the programme of privatisation of state-owned enterprises, initiated in the late 1980s and which continued till 2003. The UPFA government implemented some policies to redress poverty and lopsided growth—restoring the fertiliser subsidy, broadening the poverty alleviation programme, continuing with the electricity, petroleum and transport subsidies (even at a time of escalating oil prices in the global market), increasing public investment, etc. State-owned enterprises (includes public institutions and corporations) that were involved in delivering subsidised services were costing the government 3 per cent of the GDP, annually. These enterprises had to be substantially restructured and allowed to operate on a commercial basis with no political interference and be subject to hard budget constraints. But the government was slow in managing this change and restructuring these enterprises (IPS, 2005). These policies did not find favour with multilateral financial institutions, for example, the PRGF signed in 2003 with the IMF, fell through. The RSL’s PRSP was to be revised by the UPFA government and until it was in place the World Bank budgetary assistance and project lending were slow to come.1 Lack of reform in huge loss making state-owned enterprises such as the Ceylon Electricity Board, Ceylon Petroleum Corporation, Sri Lanka Railways, etc., also slowed down fund flows that were earmarked by other multilateral financial agencies such as ADB (Asian Development Bank). The escalating oil prices were making a huge dent on external reserves so much so the rupee was rapidly sliding down from mid to end 2004. The deteriorating reserves received a boost from the Tsunami funds that arrived in massive amounts in 2005, in turn, halting the rapid fall of the rupee. All these developments were taking place when the public debt to GDP was close to 106 per cent of GDP and the government revenue as a percentage of GDP had declined to about 15 per cent of GDP (when the developing country average was close to 20 per cent). The entire government revenue was absorbed by interest payments (6 per cent of GDP), the public sector wage bill (5 per cent of GDP), and subsidies and transfers (4 per cent of GDP). Thus, additional funds for government fulfilling its welfare-oriented programmes leave alone new development projects related to infrastructure were increasingly becoming scarce with concessional foreign funding no longer being available for Sri Lanka (such funding gradually came to an end when Sri Lanka’s per capita income exceeded USD 750 in 1997). The government saw commercial borrowing from the international financial markets as the only way out of the problem and to give some policy space (as such funds are non-conditional) for the government to engage in its desired activities.2 Thus, a sovereign rating was obtained in late 2005 where Fitch gave BB-rating and

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Standard and Poor gave B+ rating—both three to four points below the standard investment grading. With budget deficits running in the range of 8–9 per cent of GDP and public debt still close to 100 per cent of GDP, commercial borrowing unless accompanied by high growth can aggravate the macroeconomic situation. But the government seems to be optimistic in putting the Sri Lankan economy on an 8 per cent growth trajectory by 2007 and thus does not see many adverse impacts on macroeconomic stability by such borrowings. The following factors among others have contributed to the optimism with regard to the future growth scenario. First, an annual USD 800 million aid in flows from past commitments for various projects seems to be assured for the next 3–4 years.3 Second, a stable inflow of overseas remittances amounting to 7.5 per cent of GDP per annum (USD 1.6 billion—double the amount of aid inflows per annum) also seems to be assured in the coming years. Third, the expected adverse impact on growth from the end of the MFA did not materialise in 2005 and the RMG industry seems to have made some adjustments to face the challenge. Fourth, the proposed deep integration with the fast-growing Indian economy by the India–Sri Lanka Comprehensive Economic Partnership Agreement (IL-CEPA) in 2006 is expected to spillover some of the growth from India to the Sri Lankan economy. Fifth, the new policy-induced diversified domestic resource-based activities scattered through the country is expected to contribute to the overall growth. Finally, the economic impact of the Tsunami is considered marginal requiring no major policy changes in coping with it.4 The growth retardation from the adverse impact from Tsunami is estimated to be close to 0.5 per cent in 2005 (ADB, 2005). In fact, economic growth in 2006 to some extent will be driven by post-Tsunami reconstruction. The Presidential Election held in November 2005 was won by the ruling party candidate who campaigned for continuation of the policies initiated in 2004. He went on to further increase the government subsidies for the poor and underprivileged. The newly-formed government made further adjustments to the hitherto followed development strategy. While the liberalised policy framework has been basically maintained, the new policy stance has placed greater emphasis on pro-poor growth strategies and regional development (Ministry of Finance and Planning, 2005). The new government is also adopting a fresh approach (based on the unitary status of Sri Lanka compared to the united status of Sri Lanka earlier) to seek a negotiated settlement to the North-East conflict with a view to earning an early peace dividend. The challenge for the new government is to find a solution for the North-East crisis while preserving the unitary state of Sri Lanka. This will be the overriding objective on which the economic take-off will depend. The government has to work out a strategy on how to put the economy on an 8 per cent growth trajectory without being complacent about the positive factors working in favour of Sri Lanka. To achieve this target the investment has to increase from the current 25–32 per cent of GDP (assuming an Incremental Capital Output Ratio of 4). But for this to happen there is a need for further policy reforms as the additional investment will come from an increase in government investment, local private investment and FDI.

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For government investment to increase in development projects the current subsidies and transfers that amount to 4–5 per cent of the GDP need to be curtailed. This means that the government will have to make hard choices, which will not be popular in the short-term, such as introducing an automatic pricing system for petroleum and reducing the subsidy on diesel and kerosene, price revisions on electricity and public transport charges, curtailing the irrigation and fertiliser subsidies in the agriculture sector. Further, the public sector wage bill needs to be reduced and this will require restructuring of the public sector, but such restructuring may be sequenced after implementing deregulation measures in certain regulated pockets in the economy, as explained later. To increase local private investment, the government has to remove impediments and implement deregulation measures on a selective basis rather than going for grand reforms. Devarajan (2005) has pointed out that where there is heavy resistance to reforms the government should focus on one or two workable reforms to achieve positive results. The pockets in the economy where there is heavy state presence and where there is less resistance need to be gradually liberalised to unleash trade/investment-spurred growth. The challenge is to unleash the potential of the private sector by implementing deregulation measures on a sequential basis in agriculture, power, education and other sectors. When the private sector grows it will create additional employment and with that the gradual restructuring of the public sector can take place, which will further release funds for public investment. Improved infrastructure from public and private investment will obviously contribute to an increase in productivity and thereby, enhance economic growth. Improved infrastructure will also enable the country to attract more FDI and increase its share in GDP from the current level of 1 per cent to about 4 per cent in the medium-term. The challenge for the new government is to carve out a mixed economy with selected deregulation for unleashing more sectors for private sector participation, while at the same time strengthening the regulatory system for public delivery and strengthening the role of the state where the private sector involvement is weak for instance, physical infrastructure development. Meeting this challenge will be easier with the peace process moving forward and with political realignments that strengthen the ruling political coalition in the parliament. To what extent the new government will work in all these areas and move to meet the economic challenge remains to be seen.

Notes 1. Budgetary assistance was made available in 2005 in the absence of a PRSP—taking into account the adverse impact of the Tsunami of 26 December 2004. 2. The government felt that when the debt service ratio was averaging at 12 per cent that Sri Lanka could afford to engage in commercial borrowing from the international market. The following factors were taken into account: (a) although funds from multilateral financial institutions were available for various projects from past commitments the government required matching counterpart funds to complete those projects, (b) the government required

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funds to start new infrastructure projects and fulfil election pledges, (c) the government wanted to reduce borrowing from the domestic market to reduce the pressure on the interest rate and cost of living—the level of inflation was running at 11.6 per cent in 2005, and (d ) the government wanted to settle some expensive commercial debt from past borrowings before it became a greater burden on national debt. 3. This is mainly a result of the pledges of the Tokyo donor conference on the peace package (June 2003) and the Kandy donor conference on Tsunami rehabilitation (May 2005). 4. Since this book concentrates mainly on policy, it has excluded any analysis on the Tsunami— a totally extraneous event over which the Sri Lankan authorities had no control.

References ADB (2005), Asian Development Outlook: 2005, Asian Development Bank, Manila. Athukorala, P. and S. Rajapatirana (2000), Liberalization and Industrial Transformation: Sri Lanka in International Perspective, Oxford University Press, New Delhi, India. Bhalla, S. and P. Glewwe (1986), ‘Growth and Equity in Developing Countries: A Reinterpretation of the Sri Lankan Experience’, World Bank Economic Review, Vol. 1, No. 1. Devarajan, S. (2005), ‘South Asian Surprises’, Economic and Political Weekly, Vol. XI, No. 37. FAO (1999), ‘Food Security and Nutrition: Sri Lanka’, FAO Office, Colombo (mimeo). ILO (1971), Matching Employment Opportunities & Expectations—A Programme of Action for Ceylon, Report and Technical Papers, Geneva. IPS (2005), Sri Lanka: State of the Economy—2005, Institute of Policy Studies of Sri Lanka, Colombo. Isenman, P. (1980), ‘Basic Needs: The Case of Sri Lanka’, World Development, Vol. 8, March. Kelegama, S. and C. Rodrigo (2004), ‘Economic Theory and Development Practice: Stiglitz’s Critique and the Sri Lankan Experience’, in Partha Nath Mukherji and Chandan Sengupta (eds), Indigeneity and Universality in Social Science: A South Asian Response, Sage Publications, New Delhi. Lakshman, W.D. (2002), ‘Challenge of Development Beyond “Open Economy”’, The Island, 3 November 2002 (Felicitation Lecture for Gamani Corea at the N.M. Perera Centre, Colombo, 17 October 2002). Lal, D. and S. Rajapatirana (1989), Impediments to Trade Liberalization in Sri Lanka, Thames Essays, Trade Policy Research Centre, Gower, London. Ministry of Finance and Planning (2005), Budget Speech 2006 (8 December 2005), Government of Sri Lanka. Osmani, S. (1994), ‘Is there a Conflict between Growth and Welfarism: The Tale of Sri Lanka’, Development and Change, Vol. 25, No. 2. Rama, M. (2003), ‘The Sri Lankan Unemployment Problem Revisited’, Review of Development Economics, Vol. 7, No. 3. RSL (2003), Regaining Sri Lanka, Government of Sri Lanka. Sanderatne, N. (1997), ‘Social Development Expenditure: 1950–1995’, Upanathi (The Journal of the Sri Lanka Association of Economists), Vol. 8, No. 1. ——— (2000), Economic Growth and Social Transformations: Five Lectures on Sri Lanka, Tamarind Publications, Colombo. Sen, A.K. (1981), ‘Public Action & Quality of Life in Developing Countries’, Oxford Bulletin of Economics and Statistics, Vol. 43, No. 4. World Bank (2002), Sri Lanka: Poverty Assessment, Poverty Reduction and Economic Management Sector Unit, South Asia Region, Washington, D.C. ——— (2005), Sri Lanka: Improving the Rural and Urban Investment Climate, World Bank Colombo Office and ADB publication.

Part I FIFTY YEARS OF ECONOMIC DEVELOPMENT AND THE CHALLENGE AHEAD

1 ECONOMIC DEVELOPMENT DURING THE 50 YEARS OF INDEPENDENCE What Went Wrong?

Introduction When Sri Lanka achieved Independence in 1948 it was one of Asia’s most promising new nations. The country emerged unscathed from World War II and, unlike India and Pakistan, the country did not have to shed blood for its Independence. It inherited from the British a prosperous export sector organised along commercial lines, high literacy rates when compared to other Asian countries and a stable macroeconomy. Strategically located in the Indian Ocean, Sri Lanka had the best chance, compared to its neighbours, for a rapid economic take-off. The first GovernorGeneral of Sri Lanka made the observation that these initial conditions had provided the setting for the expectation that, of all post-colonial nations, Sri Lanka would prove ‘the best bet in Asia’ (Lal and Rajapatirana, 1989: 1).1 This rosy picture of the social-economic environment was somewhat deceptive. Politically, the nation was polarised between the conservative right and the communist-oriented left, trade unions had grown and industrial strikes had ended up as general strikes in the late 1940s and, above all, historical ethnic tensions remained dormant due to the anti-colonial struggle. Thus, some commentators had reservations on Sri Lanka’s future progress. For instance, Oliver (1957: i) noted,

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‘Ceylon reacquired its independence only in 1948, after being under European rule for nearly five centuries. Its civilization is old and hence probably more resistant to change than would be a younger and less integrated culture.’ Whatever the assessment in the early years after Independence may have been, Sri Lanka made quite an impressive progress in certain areas of the economy. The country became an exception among developing countries with regard to human development (Sen, 1981; Anand and Kanbur, 1991). Its long-term growth in per capita terms (2.5 per cent) compared favourably with most of the developing world (World Bank, 1995a; Ahmed and Ranjan, 1995: i). However, there were some disconcerting features in its pattern of development. Despite its human development record, the country remained a low-income country with substantial poverty. In 1990–91, for instance, 22.4 per cent of the country’s 17 million population lived below the poverty line (World Bank, 1995a: 6). Further, although its long-term growth compared favourably with developing countries, it fell well short of the growth rate achieved in the last three-and-a-half decades by high performing East Asian countries, such as Korea, Malaysia, Thailand and Indonesia. In 1960, for instance, Sri Lanka’s per capita GNP—USD 141—was substantially higher than that of Thailand (USD 96) and Indonesia (USD 51), about the same as Korea (USD 156), and only 50 per cent lower than Malaysia (USD 273).2 By 1995, however, a totally different picture emerged, Sri Lanka’s per capita income had risen to only USD 700 compared with USD 9,700 for South Korea, USD 3,890 for Malaysia, USD 2,740 for Thailand and USD 980 for Indonesia (World Bank, 1997: 214). It is obvious that the economic progress of Sri Lanka has experienced various difficulties. What went wrong? Why was Sri Lanka not able to achieve greater heights in economic growth and prosperity? Was it due to complacency on the part of politicans and thus, postponement of reforming the system or was it an outcome of policy errors and mismanagement, or was it simply a case of missed opportunities, or was it a combination of all these? This chapter makes a modest attempt to answer this question by looking at the initial conditions, economic policy patterns and opportunities lost in the country over the last 50 years. Sri Lanka achieved Universal Adult Franchise in 1931, thus, by the time it gained Independence, the country had a well-functioning democratic system in place. During the last 50 years, Sri Lanka’s democratic political system has been dominated by two political parties, viz., the centre-right United National Party (UNP) and the centre-left Sri Lanka Freedom Party (SLFP). The UNP has ruled the country for 30 years (1948–55, 1965–70 and 1977–94) and the SLFP (with coalition partners) has ruled the country for the remaining 20 years (1956–65, 1970–77, 1994–98). This chapter discusses the 50 year period from 1948–98 into two parts, viz., the period 1948–77 and the post-1977 period. The next section provides a brief survey of the former period and highlights the factors that constrained economic progress. A survey of the 1977–97 period highlights the major weaknesses in the economic system during that period followed by some concluding remarks.

ECONOMIC DEVELOPMENT DURING THE 50 YEARS OF INDEPENDENCE

39

The Story from 1948–77: A Review What happened during this period has been extensively discussed in the existing literature. The observations made in these studies would be useful in making an assessment on the economic policy framework of this period. If we divide the above period to 1948–60 and 1961–77, it becomes easier to shed light on the most important aspects in economic policy of these periods. Sri Lanka inherited a rich plantation export sector (tea, rubber and coconut) from the British colonial rule, which brought in 90 per cent of the foreign exchange earnings of the country. The bulk of these earnings was used for food imports. Part of it—rice—was for a food subsidy scheme promoted by the state. Rice accounted for nearly 25 per cent of imports to the country in the early 1950s. The scheme was a part of the welfare state ideology that the government inherited from colonial rule. The welfare state was basically kept going by taxation of the plantation exports and these exports were quite vulnerable in terms of trade deterioration (Table 1.1). Cuthbertson and Athukorala (1991: 328) sum up the 1948–60 period as follows: There is a plantation export sector which picks up the cost of extensive food subsidy programme, and the total import bill is dominated by imports of essential foodstuffs of this programme. When export revenues fall, the government has tended to take the softest short term option—cutting back expenditure is difficult and so is devaluation, and so successive governments have opted for selective controls on imports as a balancing measure, controls which were intended in the first instance as protective measures but which ended up encouraging and protecting particular industries and firms. In the long run, what did not happen in 1948–60 may be more important than what did. To sustain a moderate rate growth after 1960 would have required that export earnings be ploughed back into investment in other sectors of the economy. Instead, consumption claimed most of these flows while investment generally remained below 10 per cent of GNP until 1956, even then advancing only to 13 per cent by 1960. Major increases were achieved in paddy production (which doubled between 1947–49 and 1959–61) but progress in refurbishing existing export industries or diversifying into new areas in either agriculture or industry was far more modest. So, the structure of production changed little as population grew and, after 1955, the foreign exchange problem worsened rapidly (Snodgrass, 1974: 120). The mid-1950s was a time when the structuralism and dependency perspectives on ‘development’ and ‘underdevelopment’ began to wield an influence on development strategies for the Third World. Sri Lanka, characterised by its traditional dependence on a few primary commodities, fitted well into the prototype of an underdeveloped country, as portrayed by structuralists and dependency theorists. With the post-1956 deterioration of its external terms of trade, the country began to increasingly identify with the above image. The solution to the problem according

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Development Under Stress: Sri Lankan Economy in Transition Table 1.1 TERMS OF TRADE, EXPORT VOLUME INDEX, FOREIGN RESERVES AND BALANCE OF PAYMENTS POSITION, 1950–96 Current Account of the Balance Import of Payments SDR (Mn.) (Goods) Months % of GDP Foreign Reserves

Year 1950 1951 1952 1953 1954 1955 1956 1957 1958 1959 1960 1961 1962 1963 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996

Terms of Export Volume Trade Index (1990 = 100) 374 354 275 279 336 365 340 307 329 333 333 309 320 289 239 255 246 216 210 198 191 176 169 147 129 104 140 183 180 129 114 107 100 123 149 122 109 121 114 114 100 101 121 126 125 124 127

44 45 45 47 48 51 48 47 49 48 52 53 57 55 60 62 57 59 61 58 60 58 57 58 50 60 57 53 56 57 60 64 67 63 74 76 80 79 77 77 100 101 105 120 132 141 146

227.5 244.3 171.2 121.0 188.4 242.4 230.8 204.4 176.1 137.6 96.2 92.7 85.5 75.4 64.1 85.7 59.2 85.5 70.1 55.1 61.7 74.2 100.3 119.0 92.6 92.4 136.9 294.8 370.1 475.5 295.5 387.2 477.7 498.5 735.1 610.9 491.7 423.3 428.1 446.8 602.0 809.0 1,047.0 1,544.0 1,792.0 1,792.0 1,701.0

11.1 9.0 5.7 4.2 7.9 9.4 9.1 6.6 5.9 4.0 2.7 3.0 2.5 2.3 1.9 2.6 1.7 2.5 2.1 1.5 1.9 2.5 3.7 3.6 2.2 1.9 3.1 10.6 5.9 5.1 2.4 3.1 3.3 3.5 4.0 3.5 3.5 3.2 3.1 3.1 3.7 4.4 5.1 6.5 6.5 5.9 5.5

3.2 1.8 –9.6 –3.2 6.0 5.6 1.6 –3.6 –2.6 –3.2 –3.8 –1.4 –2.0 –2.3 –2.1 0.7 –3.5 –3.2 –3.3 –6.8 –2.6 –1.5 –1.3 –0.9 –3.8 –2.9 –0.2 3.5 –2.4 –6.8 –16.4 –10.0 –11.9 –9.1 –0.9 –7.0 –6.6 –5.1 –5.6 –4.4 –3.2 –5.4 –4.5 –3.8 –6.5 –4.9 –3.9

Source: Central Bank of Sri Lanka, Annual Report (various issues), and Snodgrass (1966: 269, 372–73).


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to the government was seen in diversification through import substitution in industry, in addition to import substitution in agriculture (Lakshman, 1997: 6–7). Clearly, the initial economic conditions in the country interlocked, i.e., welfare programmes depended on plantation taxes—these taxes depended on better prices in the world market—world market price reductions lead to foreign exchange problems—the need for controls to solve the foreign exchange problem, obviously lead to import substitution (see Figure 1.1). By 1960, the optimism of 1948 no longer prevailed. The dormant factors at the time of Independence were showing signs of emerging and disrupting the economic activities. For instance, Tresidder (1960: 168–69) observed, ‘Most thoughtful Ceylonese today agree with friendly foreign observers that the success of Ceylon’s development projects and her credit standing among the free nations of the world depend upon early settlement of communal quarrels and firm control of extremist elements.’ The 1961–77 period was far more complex with controls and restrictions governing trade and the financial sector—to avert the foreign exchange crisis during 1961–64; partial liberalisation of the economy during 1965–70 and controls and restrictions being reintroduced during 1970–77 to prevent what the government thought was a wasteful experiment during 1965–70, which allowed valuable foreign exchange to be squandered on non-essential imports. It is a story of tightening, partially relaxing and further tightening the trade regime and associated areas to overcome a perceived foreign exchange crisis. The strategy adopted in the early 1960s to face the foreign exchange crisis was the gradual closing up of the economy from external market forces. It was the beginning of a standard import substitution industrial regime with all the controls and restrictions associated with it. Nationalisation and state intervention in economic activities were common during these years. With the capacity to import Figure 1.1 INTERLOCKING INITIAL CONDITIONS

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severely constrained, the necessity to develop means of earning, or saving more foreign exchange, was even more urgent than during 1948–60. Yet, progress along either line continued to be slow—in part because export industries and import substitution industries themselves continued to be heavily dependent on imported intermediate capital goods.3 The import substitution industries did little to relieve the foreign exchange crisis and the average growth rate during this period (1960–65) was 3.6 per cent (Tables 1.1 and 1.2). The partial liberalisation exercise emphasised the importance of agriculture to produce food for the domestic market and was successful in increasing the average growth to 5.2 per cent per annum during 1966–70 (Table 1.2). With bleak prospects for export products and the newly-established industrial sector under strain apparently because of foreign exchange shortage, the government envisaged import substitution in agriculture as the best possible way out of what it saw as a balanceof-payment crisis (Cuthbertson and Athukorala, 1991: 329). Overall, the 1965–70 period can be categorised as one when a weak and hesitant attempt was made to liberalise the economy at a time when low cost external financing was not forthcoming. In this context, the government did not, and probably dared not, contemplate a policy that would redress external imbalance through cutting consumer subsidies and thereby reducing domestic absorption (Athukorala and Jayasuriya, 1994: 16). Thus, little headway was made with regard to overcoming the foreign exchange crisis. The ILO (1971: 14) observed: ‘Apart from Burma, Ceylon was the only country in Asia earning less foreign exchange in 1968 than in 1958.’ The 1971–77 period saw nationalisation in some sectors because of the necessity of stemming the drain of foreign exchange and the evasion of control. A similar need to control private sector leakages of foreign exchange led to the establishment of State Trading Corporations, export-oriented public sector firms and tightening of regulations and also extending nationalisation by enacting a new legislation called Business Acquisition Act (Kelegama, 1998). Driven by concern over the shortage of imported consumer goods, the government extended control over distribution of necessities and launched a ‘grow more food’ campaign. Snodgrass (1974: 119) observes that ‘increasing emphasis on averting a food crisis by growing more food domestically, rather than buying it abroad with the earnings of viable export industries represents a lowering of the sights of economic policy which reveals how difficult the past 25 years have been for the Ceylonese economy.’ The regime was severely affected by external shocks, such as the OPEC (Organisation of the Petroleum Exporting Countries) oil price hike, and consequently it was not uncommon to find some firms using more foreign exchange than they saved (Pyatt et al., 1977: 103). The balance-of-payments pos-ition aggravated to a situation where the foreign exchange crisis was no better than what it was during the early 1960s. After 25 years of Independence, Snodgrass (1974: 119) wrote: ‘The first quarter-century of Ceylonese independence began with high hopes of economic achievements .... It seems a fair judgement that achievement has fallen short of these hopes.’ Low growth was a hallmark of the 1971–77 period. Terms of trade became favourable to Sri Lanka by the end of 1975 (see Table 1.1). In 1976, the trade balance improved thanks to a reduction in import prices and higher prices for exports. But the economy was slow to respond. The traumatic


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Table 1.2 ECONOMIC GROWTH, SAVINGS AND INVESTMENTS, 1950–96 Year

Economic Growth

Investment (GDCF) per GDP

Domestic Savings per GDP

1950 1951 1952 1953 1954 1955 1956 1957 1958 1959 1960 1961 1962 1963 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996

– 6.2 4.5 1.9 2.7 5.8 0.7 1.5 2.9 1.4 3.7 2.1 4.6 2.8 6.4 2.3 3.8 5.1 8.3 4.8 4.3 0.2 3.2 3.7 3.2 2.8 3.0 4.2 8.2 6.3 5.8 5.8 5.1 5.0 5.1 5.0 4.3 1.5 2.7 2.3 6.2 4.6 4.3 6.9 5.6 5.5 3.8

– – – – – – – – – – – – 15.7 14.3 12.5 14.3 15.2 15.9 19.3 18.9 17.1 17.3 13.7 15.7 15.6 16.2 14.4 20.0 25.8 33.8 27.8 30.8 28.9 25.8 23.8 23.7 23.3 22.8 21.7 22.2 22.9 24.3 25.6 27.1 25.7 24.2

9.0 10.8 13.2 12.9 8.7 10.6 12.1 13.0 13.0 14.7 11.6 15.1 14.1 14.0 12.2 13.0 10.9 12.4 12.9 13.0 15.8 15.1 15.7 12.5 8.2 8.1 13.9 18.1 15.3 13.8 11.2 11.7 11.9 13.8 19.9 11.9 12.0 12.8 12.0 12.2 14.3 12.8 15.0 16.0 15.2 15.3 15.5

Source: Central Bank of Sri Lanka, Annual Report (various issues) and Snodgrass (1966: Tables A-2 and A-7).

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stresses of the 1973–75 period had sapped its vitality. The government was unable to take advantage of the improvement brought about by the changes in the terms of trade. The import controls inhibited the effective use of rising external reserves to ameliorate the consumer goods shortages and win back some popular support before the elections in 1977 (Athukorala and Jayasuriya, 1994: 74–75). So by mid-1977, the Sri Lankan economy was such that maintenance of welfare programmes had become a serious burden on the budget, and a situation had developed where the needs of government capital expenditure could no longer be met through domestic resource mobilisation. The productive sectors of the economy were starved of the much needed imported inputs. The overall result was underutilisation of production potential and, consequently, stagnation of growth. This situation provided the setting for a new government to come to power. The interlocking initial conditions governed by the five year electoral cycle finally had to give way when faced with the crisis situation. The electorate was for the first time ready for a radical change in economic policy. The welfare and import substitution strategy interwoven with the five year electoral cycle, was finally dismantled— the importance of the components was partially reduced in the economic strategy. A new beginning was made. The revisionist school of development categorised Sri Lanka as a success because of her achievements in social development. Even the World Bank, long critical of Sri Lanka’s social welfare programmes (nearly 10 per cent of GNP during 1960–77), commended Sri Lanka’s achievements in human development and argued that the trade-off between human development and growth ‘has not been so sharp as it is sometimes suggested’, but also noted that ‘Sri Lanka could have done even better had better economic policies been pursued’ (World Bank, 1980: 90). In fact, 25 years ago Snodgrass (1974: 123) observed, ‘Until some way is found to make the economy grow fast enough to finance sustained social progress, Sri Lanka will serve as a better illustration of the limitations of the direct approach to problems of social equity than of its benefits.’ In the next few years, this observation proved to be very accurate. By 1977, Sri Lanka managed to increase her per capita income only by about USD 60 to reach a level of USD 200 compared to South Korea—USD 820, Malaysia—USD 930, Thailand—USD 420 and Indonesia—USD 300 (World Bank, 1979: 126–27). This very broad picture emerged due to several key factors. A closer look at these factors would prove useful.

No Vision for the Country: Discontinuity in the Planning Process Since 1948, Sri Lanka has produced an array of planning documents, which often failed to survive their lifespan. Sri Lankan planning was a discontinued and sporadic exercise in contrast to that of India. In the process, the country lost out on its a long-term vision.


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On the basis of the early stages of development doctrine, a six-year plan was formulated in 1948. After the World Bank mission’s visit to Sri Lanka in 1951, a planning apparatus was set up in the Treasury with an emphasis on agriculture-led development. Subsequently, in 1954, a 6-Year Investment Programme was prepared by the Planning Secretariat and this was a fairly comprehensive statement of the capital budget, activities of the public sector, and the development priorities. The 6-Year Programme was intended to be a building block in order to integrate the entire economy to the planning process and thus become an overall national plan embracing the private sector too. Before much work could be started under this plan, the government was defeated at the polls and a new government came into power. The new regime did not want to continue the 6-Year Programme. It set up a new mechanism—a National Planning Council—and converted the Planning Secretariat into a servicing agency of the National Planning Council. It invited a number of distinguished experts from abroad to advise and work on the preparation of a new vision called the Ten Year Plan (NPC, 1959).4 This plan was comprehensive. It covered the public and private sectors. It identified the development goals of Sri Lanka and the direction in which the country had to progress. It also identified the ways in which different sectors needed to evolve. A sound warning was given in this plan that Sri Lanka may lose the lead it has over some East Asian countries if higher growth was not achieved in the subsequent years. The plan projected a 6 per cent growth rate annually, which implied that GDP would double every 12 years or so and, by 1997, the GDP would become eight times the GDP of 1959. The government elected to power in 1960 did not feel that the Ten Year Plan was a suitable guideline for its agenda and initiated a Short Term Implementation Programme in 1962. Thus, both the National Planning Council and the document itself were sidelined and new efforts were made to start afresh. Basically, all three plans after 1954 fell apart due to the foreign exchange crisis that the government faced during that period. In 1965, once again there was a change of government and it launched a ‘recovery programme’ for Sri Lanka. The Minister of Planning and Economic Affairs established an Aid Consortium for the first time and mobilised foreign aid to support the recovery process and induce economic growth. Some results were achieved. Exports were given incentives but, by 1970, this development strategy came to an end with a change in government. Consequently, the main thrust of the recovery programme during 1965–70 was not followed to the full. A fresh start was made in 1972. Thus, one of the major problems that Sri Lanka faced over the period was the great polarisation in the policies of the two major parties in the country. Since World War II, especially in the early 1940s, the ministers were conscious of the fact that the development process required leadership and involvement by the public sector, but this was not due to any ideological preference of the private sector vis-à-vis the public sector. It was a reflection of the fact that, at that stage of Sri Lanka’s development, the private sector was weak and largely led by foreign institutions and forces and also the fact that the resources, the skills and capabilities

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were to be found more in the public sector and had to be mobilised to set in motion the development process. Thus, the emphasis on the pubic sector was not due to any ideological vision. This changed in the course of time when politicians themselves became more polarised on ideological issues and the UNP was seen as a party committed to the capitalist mode of development, via the private sector, while the SLFP and its coalition members were seen to be more committed to the socialist pattern of development involving public enterprises. This polarisation did not give coherence and cohesion to the development policy. Consequently, although there were advances in economic development, the country lost because of the lack of a single-minded pursuit of an agreed course of action. There was the tendency in the country to give the ownership of the plans and guidelines to a particular regime and thus, when the government changed, there was an immediate tendency to abandon most of the work of the previous regime. Such acts have caused a major waste of resources and is a major factor that has constrained long-term vision and growth.

Welfare Politics Welfare was a part of the Sri Lankan economic system even before Independence. The foundations of Sri Lanka’s welfare state are comparable to those of Britain’s. Butler’s Education Act, Beveridge’s Social Security Act and Bevan’s National Insurance and Health Acts, were paralleled in Sri Lanka by the Education Act of 1945 (based on the Kannangara Report, 1943), Department of Social Services, 1948 (based on the Jennings Report, 1943) and Health Act of 1953 (based on the Cumpston Report, 1950), respectively (Jayasuriya, 1996: 6–8). There was a commitment by the government, before Independence, to provide a range of welfare benefits—subsidised basic foodstuffs (especially, rice), free education at the university level, free medical care and so on—to a large segment of the population. As stated earlier, the bulk of the revenue for these welfare measures was obtained by taxing the plantation exports. This was not a healthy arrangement. Jennings (1950: 180) observed, ‘If through some catastrophe ... the tea industry was wiped out, one-third of national income would disappear. It is a dangerous form of economy, because it places the welfare of the country under the control of forces which neither the people nor the government of the island can influence.’ These welfare services appeared affordable soon after Independence because of the high earnings from commodity exports as a result of the boom markets of the post-World War II and Korean War periods. The first post-Independence government was happy to provide these benefits as a way to attract voter support. When the cost of providing subsidised rice became unaffordable in 1953 and the government took measures to adjust the price of rice upwards, the eventual result was public protest and the resignation of the then prime minister. This event demonstrated the appeal of welfare programmes in the electorate where people had begun to consider social welfare measures as their inalienable right. Ever since this episode,


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welfare politics—centred around the provision of free rice—played a major role in Sri Lankan politics till the early 1980s. Politicians got the impression that the country is for a kind of government that panders to people’s short-sighted wishes. Since 1953, elections have been fought on ‘hand-outs’ or largess or on the promise of an easier life, and the two parties leapfrogged over one another with a series of economic promises that they made in order to secure power. Typically, an opposition party in Parliament expecting to win an election would campaign on the basis of enhancing the food subsidy and providing more social welfare. Once elected, the party would succeed in implementing at least part of its campaign promise in the immediate aftermath of political victory. Then an investigation begins into the constraints imposed by budget deficit considerations and their inflationary and balance-of-payments implications. With alternative pulling and pushing by domestic officialdom and IMF–World Bank missions, more or less feeble policy corrections occur midway through the government’s tenure of office. The typical sequel to such mid-term corrections would be at best a period of inaction until the run-up to the next elections. Also, typically, some form of hand-out at election time would be implemented in an attempt to retain power. Such attempts always left the successor government with additional economic problems (Jayawardena et al., 1987: 13). Table 1.3 shows welfare expenditure and the food subsidy as a percentage of GDP. Clearly around 4.2 per cent of GDP per annum, on average, has been consumed to maintain the food subsidy during the 1960–65 period. A distinguished visiting economist to Sri Lanka, Joan Robinson, once said that ‘Ceylon ate the fruit before growing the tree’ (as quoted in Jayawardena, 1998), and one can argue that if the food subsidy was abandoned in the early 1960s, Sri Lanka could have invested about 18 per cent on physical investment—same as East Asia during that time— instead of the average 14 per cent that was invested. If this extra investment was made in an export-oriented liberal trade and investment regime and compounded over 30 years, it would have accelerated economic growth to increase savings and investments as in East Asia.

Uncertainties in the Key Economic Sector The plantation economy was the centrepiece—the goose that laid the golden eggs (Jennings, 1950: 186)—of the Sri Lankan economy at the time of Independence. It was one of the best-run commercial enterprises in the Third World (Forrest, 1968). Although nationalisation of plantations was mooted before Independence, it was not taken up until 1958, when a memorandum on ‘A Scheme for Nationalization of Foreign-Owned Tea and Rubber Plantations’ was submitted to the government as a plan for agriculture (Gunawardana, 1958). The plan suggested a phased programme of nationalisation extended over 10 years to cover, altogether, about half the tea and rubber land. Kaldor (1959) writing on this stated that ‘the continuance of the present state of uncertainty is bound to have unfavourable effects on the efficiency of tea plantations, since the British plantation companies are not likely to

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Development Under Stress: Sri Lankan Economy in Transition Table 1.3 SOCIAL EXPENDITURE AS PERCENTAGE OF GNP, SRI LANKA, 1950–51 to 1977

Year 1950–51 1951–52 1952–53 1953–54 1954–55 1955–56 1956–57 1957–58 1958–59 1959–60 1960–61 1961–62 1962–63 1963–64 1964–65 1965–66 1966–67 1967–68 1968–69 1969–70 1970–71 1971–72a 1973 1974 1975 1976 1977

Education

Health

Food Subsidies

Other Social Welfare

Total Social Expenditure

2.5 3.0 3.1 2.9 2.7 3.2 3.5 3.8 4.1 3.8 4.7 4.7 4.7 4.8 4.9 4.7 4.6 4.1 4.3 4.6 4.3 4.4 3.5 2.8 2.8 3.1 2.7

1.5 1.9 2.0 1.9 1.8 2.0 2.1 2.2 2.4 2.2 2.5 2.2 2.2 2.0 2.1 2.1 2.2 2.0 2.1 2.1 2.1 2.6 1.5 1.3 1.4 1.6 1.4

NA 5.3 2.8 0.3 0.8 1.5 2.1 2.2 2.6 3.1 3.9 3.5 5.1 5.1 3.6 3.6 2.4 3.0 3.1 2.8 4.5 4.1 3.8 4.0 4.8 3.4 4.1

0.3 0.4 0.5 0.4 0.4 0.5 0.5 0.6 0.6 0.6 0.7 0.7 0.6 0.6 0.6 0.6 0.6 0.5 0.4 0.4 0.4 0.5 0.3 0.2 0.4 0.8 0.5

NA 10.6 8.4 5.5 5.7 7.2 8.2 8.8 9.7 9.7 11.8 11.1 11.0 12.5 11.2 11.0 9.8 9.6 9.9 9.9 11.3 11.6 9.1 9.3 9.4 8.9 8.7

Source: Anand and Kanbur (1991: 69). Notes: GNP for 1951–56 obtained from National Accounts of the Department of Census and Statistics. GNP for 1956 onwards obtained from the Central Bank Annual Reports. Expenditure figures obtained from Treasury Estimates. a Estimated from 15 months’ expenditure and GNP figures. NA—not available.

sink fresh capital as they are left in the dark as to their future status’ (as quoted in Cuthbertson and Athukorala, 1991: 326). Whether the British companies would have made additional investment in the plantation sector in an environment of declining terms of trade is another matter. But the uncertainty lasted till the mid1970s when actual nationalisation of the tea plantations took place. From the mid-1970s till upto 1992, the plantations were mismanaged and there was no proper marketing strategy nor were serious efforts made on increasing the yield and producing value-added items. In the mid-1980s, the plantation sector was overlooked by nearly six ministries, thereby further creating, coordinating and delegating problems (Kelegama, 1986: 50). The result of all this bungling was that


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Sri Lanka’s yield per hectare in both tea and rubber declined substantially by the early 1990s, when compared with its competitors (Sanderatne, 1995: 10). Although the nationalisation exercise was confined to services such as ports, insurance and bus transport—in the late-1950s it was extended to schools, foreignowned companies, like petroleum, in the early-1960s, there may have been a fear among local industrialists of a possible take-over by the state in the 1960s.5 This, coupled with the import controls (related to the foreign exchange crisis), which deprived many industrialists of the much-needed imported inputs, may perhaps have led the private sector to operate in the margin overlooking a horizon of about three years ahead. The Central Bank (1970: 29) provides some evidence to show that private investment in manufacturing declined substantially between 1964 and 1967. After 1970, with the passing of the Business Acquisition Act (1971), the threat of takeover became even more prominent with the result that the private sector may have operated at a thinner margin than in the 1960s. Despite this, there was optimism in the private sector regarding the government’s new plan. The private sector was expected to contribute approximately 52 per cent of the total planned investment of Rs 15,000 million, according to the Five Year Plan of 1972. The rationale for this expectation in a highly interventionist regime was unclear, especially when the Minister of Finance stated in his Budget Speech, ‘... private enterprise has a part to play in building up and exploiting the resources of the country, but the leading part must be in the hands of the public sector’ (Minister of Finance, 1970: 3).

The Policy of Export Pessimism Lakshman (1997: 7–8) observes that in Sri Lanka the transition to import-substitution industrialisation from the classic ‘export economy’ was delayed by 10–12 years, compared to a number of developing countries. Those that entered import-substitution industrialisation early were able to exit from this strategy as its limits approached ans subsequent switch to export-oriented industrialisation was similar to what the NICs did in the early 1970s. By the late 1970s, the NICs had diversified their manufacturing export base when Sri Lanka embarked upon export-led industrialisation. There was a failure on Sri Lanka’s part to keep pace. One plausible explanation of this is the pessimism towards export on the part of policy-makers in the mid-1960s. In 1965, when the economy went through partial liberalisation, Sri Lanka had a very good chance of adopting an export-led growth strategy, but the opportunity was not exploited due to prevalent views on export pessimism. As Cuthbertson and Athukorala (1991: 340) state, ‘Policy makers were pessimistic about market prospects for traditional exports and the chance of diversifying exports into more product lines. Import substitution was the basic tenet of economic policy ... import liberalisation seems to have been perceived largely as an aid to import substitution by way of ensuring the availability of imported machinery for domestic industry and agriculture.’ It is perhaps due to this reason that a recovery programme was put into operation in 1965.6

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The structure of incentives to industry remained very discriminatory and was subject to administrative control. Traditional exports continued to be taxed and import licensing and quotas continued to apply for imports. There was no impressive performance in the export sector (Table 1.1). What emerged was a compromised policy of import substitution and export promotion clearly seen from the halfhearted dual exchange rate policy which the IMF described as ‘the wrong step in the right direction’ (Corea, 1985: 12). Of course, at that time there was no adequate literature on the East Asian model to emulate their strategy. However, even with the implementation of a compromised model, as mentioned earlier, Sri Lanka showed superior growth rates during 1965–70, than in the 1960–64 period. The reservations in regard to export diversification were based on the fact that it would take time to achieve results from such a strategy—once again illustrating the influence of four year electoral politics in determining crucial economic policies in Sri Lanka. When the political economy factor is taken into account, the pessimism on export diversification to overcome the foreign exchange problem can be seen more clearly. Bruton et al. (1992: 345) shed some light on this issue, ‘The difficulties of achieving the reform in the late 1960s were real. In particular, strengthening the balance of payments was a task that required a great deal more than conventional liberalisation and devaluation package. More than any other interval perhaps, the period from 1965 to 1970 illuminated the great transformation problems that faced Sri Lanka as she sought to remodel her economy. The fact that the UNP was defeated in 1970 also demonstrates the strong appeal of traditional policy to Sri Lankans. It seems likely that, even had the UNP retained power in 1970, their efforts to change policy would have proceeded much more slowly than was the case in the late 1970s. To be more accurate perhaps, had the UNP moved slowly in the period from 1965–69, it might have remained in power.’

Lack of Openness in the Economic Regime During the 1960–77 period, the Sri Lankan economy was significantly protected from the fluctuations of the world market. The closing of the economy in the early part of the 1970s was so extensive that Sri Lanka was considered as one of the most tightly controlled economies outside the Socialist bloc (Herring, 1987). The World Bank (1987: 97) and Cuthbertson and Athukorala (1991: 336) show that the closing of the Sri Lankan economy was at a peak during the 1970s and, by 1976, the state sector directly accounted for about 88 per cent of the total import trade and for about 30 per cent of the export trade. The major partner of the coalition government of 1970–77 was not very keen to have such a tightly-controlled economy and an attempt was made to create an Export Processing Zone, in 1972, to introduce some degree of openness to the economy (Ponnambalam, 1980: 125). This was shotdown at the early stages by the leftist coalition partners of the then government, never to be revived again during their tenure in office. The difference between the East Asian economies that were mentioned earlier and Sri Lanka was that, despite these economies having state intervention or the


51

state at commanding heights, the economies were never closed from taking advantage of the global economy. Analysing Malaysia’s development patterns, Athukorala (1997: 7) argues, ‘The key lesson from the Malaysian experience is that in a small open economy, the task of achieving conflicting objectives, growth and equity, is facilitated by a long term commitment to an open and liberal trade and investment policy regime. Unlike many other developing countries, Malaysia never resorted to stringent quantitative restrictions. Despite affirmative action policies under the National Economic Plan and the heavy industrialisation push in the early 1980s, the private sector was never marginalised and the policy emphasis on export orientation was never compromised .... With this policy pragmatism, coupled with stable political climate, the Malaysian economy has been able to take full advantage of the new opportunities arising from integration with the global economy.’ The lack of openness also constrained entrepreneurial development, which is endogenous to the policy regime. Sri Lanka did not have a strong entrepreneurial class at the time of Independence (see, for instance, Jennings, 1950: 34–35). From 1956 onwards, the entrepreneurs were not exposed fully to the discipline of the world market despite a partial liberalisation phase, during 1965–70.

Lack of External Assistance To avert the foreign exchange crisis there was very little external support. Wickremaratne (1977: 147) observes that in the 1950s policy-makers felt that ‘... even if there was a downward trend in export earnings Sri Lanka need not resort to foreign aid and foreign loans.’ Olson (1977) observes that, by nationalisation of Petroleum, Sri Lanka became the first country to which the Hickenlooper Amendment was applied where suspension of US aid was effected for expropriating American property without compensation. In general, the ideologies prevalent during the 1956–65 and 1971–77 regimes on external assistance made them somewhat unpopular within the Western donor community. The very partial nature of the liberalisation exercise in the 1965–70 period did not permit the funding community to fully back the liberalisation exercise with massive foreign assistance (see Table 1.4). But it could be argued that the converse of this scenario is more realistic, that is, had there been adequate foreign assistance as after the 1977 reforms (discussed later), Sri Lanka may have opened up more during the 1965 liberalisation experiment. In a nutshell, the period 1948–77 is a tale of trying to overcome a foreign exchange crisis by controlling the economy and partially opening it up. It became difficult during this period to identify the appropriate strategy. The ideological debate on ‘capitalism’ vs ‘socialism’ was far from settled and the initial conditions in Sri Lanka made ‘explicit action to modify the economy difficult and risky, and hence, easily postponable’ (Bruton et al., 1992: 343).

52

Development Under Stress: Sri Lankan Economy in Transition Table 1.4 FINANCING OF INVESTMENT, 1978–96 (% OF GDP)

Year 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996

(2) (3) (1) (1a) Net Factor Net Private Domestic Private Income from Transfers Savings Savings Abroad from Abroad 15.3 13.8 11.2 11.7 11.9 13.8 19.9 11.9 12.0 12.8 12.0 12.2 14.3 12.8 15.0 16.0 15.2 15.3 15.5

16.6 13.4 14.8 13.5 13.3 13.7 16.1 8.9 8.1 9.1 13.7 12.5 15.3 15.1 14.2 16.1 17.5 14.6 16.7

–0.6 –0.5 –0.6 –2.0 –2.0 –2.6 –2.2 –2.1 –2.1 –2.2 –2.4 –2.3 –2.0 –1.9 –1.8 –1.2 –1.4 –1.0 –1.5

0.8 1.4 3.4 4.6 5.5 5.3 4.5 4.4 4.4 4.7 4.6 4.7 4.5 4.3 4.8 5.4 5.3 5.2 5.1

(4) National (5) Savings Foreign (=[1]+[2]+[3]) Savings 15.5 14.8 14.0 14.3 15.4 16.4 22.2 14.2 14.5 15.3 14.2 14.6 16.8 15.2 17.9 20.3 19.1 19.5 19.2

4.5 11.1 19.8 13.7 15.3 12.4 3.6 9.6 9.3 8.0 8.5 7.1 5.4 7.6 6.3 5.3 7.9 6.3 5.0

(6) Gross Domestic Capital Formation (=[4]+[5]) 20.0 25.8 33.8 27.8 30.8 28.9 25.8 23.8 23.7 23.3 22.8 21.7 22.2 22.9 24.3 25.6 27.0 25.7 24.2

Source: Central Bank of Sri Lanka, Annual Reports (various issues).

The Story from 1977 to 1997 By 1977, of course, the economy was in an exceptionally unfortunate position. It was not only, or primarily, that the country sorely needed help, both society in general and government policy-makers could now genuinely appreciate that the old approach could not really work. They, therefore, accepted the notion that a major change was necessary. A radical departure from social welfare-oriented and inward-looking policies thus occurred in 1977. This radical departure was characterised by economic liberalisation and the implementation of various new policy measures to increase economic growth. Encouraging export-led industrialisation by offering incentives to domestic entrepreneurs and encouraging foreign direct investment in the newly established Export Processing Zone, were key features of the new policy regime. The latter policy was put into effect by the then president who stated, ‘Let the robber barons come!’— indicating how desperate the regime was to attract foreign investment to give a boost to the economy. The details of the policy measures implemented during the 1977–79 period have been documented extensively in the existing literature, hence it is not repeated here (Jayawardena et al., 1987; Athukorala and Jayasuriya, 1994).


53

Implementing the first Budget of the new regime was by no means an easy task. The majority of those in the existing private sector who were so used to the ‘licensing raj’, were against any attempts to liberalise the economy. So were the bureaucracy, most parliamentarians of the ruling party including some leading Cabinet members, the media, and so on. But despite this resistance, a small group around the Minister of Finance, with the backing of the prime minister, took a bold measure towards liberalising the economy. The bold measure of getting rid of the food subsidy was for the first time made possible by the massive mandate given to the new government, and the large amount of donor assistance for the development plans of the new regime. The government embarked on a large-scale public investment programme centred around the Mahaweli scheme, reviving glories of the country’s ancient civilisation and hopes of achieving self-sufficiency in rice production.7 This slogan went well with the electorate and the masses were prepared to do away with the food subsidy for a future benefit from the Mahaweli-centred development programme. Some commentators of the liberalisation exercise are of the opinion that Sri Lanka could have gained much more from liberalization if it had not been combined with this massive fiscal stimulus to the economy (see, for instance, Bruton et al., 1992: 347). But it is by no means clear whether the subsidy, for which leaders have paid the penalty for ‘disturbing the most cherished of Sri Lanka’s sacred cows’ (Athukorala and Jayasuriya, 1994: 17), could have been removed without this carrot. The new liberal policy environment started to attract large multinational companies to invest in Sri Lanka. The international media soon dubbed Sri Lanka ‘the new investment centre of Asia’ (Far Eastern Economic Review, 23 October 1978). Tourism picked up and tourist arrivals exceeded 400,000 in 1982. Export growth accelerated with the garment sector giving a high-growth momentum to the entire sector. The massive Mahaweli development programme, also gave a boost to the economic growth process.8 In fact, the only five-year period since Independence where Sri Lanka’s average growth rate exceeded 6 per cent was the 1977–82 period (see Table 1.2). All economic indicators during the 1977–82 period showed that, even though Sri Lanka had not shown a satisfactory growth performance vis-à-vis the high-performing East Asian countries during the period 1960–77, the country was now on the correct course towards rapid economic development. In fact, many economists at that time believed that Sri Lanka will be able to catch up with some high-performing East Asian nations by the early 1990s. Three positive external developments assisted the liberalisation initiative. Remittances from abroad, in particular, the Middle Eastern countries, increased from 0.8 per cent of GDP in 1978 to 5.5 per cent of GDP by 1982 (Table 1.4). Exports from garment industries increased from 2.1 per cent of all exports in 1977 to nearly 16 per cent of all exports by 1982 (Kelegama, 1992: 260). Annual arrival of tourists increased from 192,592 in 1978 to 407,230 in 1982 (Table 1.6), and brought in large sums of foreign exchange and provided employment to many people. These were three significant contributors to economic growth during the post-1977 period.9 However, the development in these sectors had their origins in other external developments.

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The entire opening of the Middle East for employment of Sri Lankan labour was not a reflection of efforts from the Sri Lankan side, but of a new enrichment of oil-producing countries as a result of the OPEC in the 1970s and the period thereafter. These countries faced a shortage of labour and thus, opened their doors to the labour from the world outside, and countries like Sri Lanka were able to take advantage of this situation. The growth of the garment industry was made possible not because of great efforts from the Sri Lankan side, but because of the emergence of protectionism in the developed countries. The Multi-Fibre Arrangement (MFA) made the difference, and had there been free trade in garments from the beginning, it is doubtful whether Sri Lanka would have seen a thriving garment industry, unlike the one at present. The fast growth of tourism was mainly due to the growing affluence of other countries whose populations were beginning to engage in travel and tourism on a bigger scale.10 Sri Lanka was able to benefit from this by advertising its unique beauty and biodiversity. In short, Sri Lanka was able to take advantage of these developments which had their origins outside the country. Liberalisation of the trade regime and, in particular, devaluation of the currency and exchange control liberalisation were indeed helpful in exploiting these external developments, but Sri Lanka’s development experience might have been very different if these external changes had not occurred. Another external consideration supported the growth process. Foreign assistance to the liberalisation effort was unprecedented. The Minister of Finance was able to boast in his Budget Speech for 1981 that ‘... due to confidence placed by the international community in our economic policies we have been able to obtain greater volume of foreign aid and foreign assistance per capita than perhaps any other third world country’ (Minister of Finance, 1981: 2). Table 1.4 shows that during 1979–83, on average, nearly half of the investment was financed by foreign savings. The Mahaweli programme was able to obtain an acceleration due to this massive foreign revenue inflow. In contrast to the 1960–77 period, during the post-1977 period there was a perception that resource constraints no longer mattered. The huge foreign aid flows encouraged many within the government to engage in lavish expenditure; ministries were able to obtain funds whenever they requested them (Athukorala and Jayasuriya, 1994: 83). It is in fact said that government officials were fishing for projects in order to allocate foreign funds. This clearly shows what large foreign assistance could do to avert a perceived foreign exchange crisis and give confidence to the officials to embark on further liberalisation measures. If these inflows had existed in 1965, the liberalisation attempts may have gone deeper than what actually took place. The optimism that prevailed in regard to economic growth during 1977–82 soon faded away. The ethnic conflict that started in 1983 came as a major ‘internal shock’ to the economy and put a brake on the liberalisation process initiated in 1977. The regime found it difficult to further liberalise the economy due to the political and economic instability that resulted from this shock. The growth rates decelerated from 1983 and averaged 3.7 per cent during the 1983–89 period (see Table 1.2).


55

Other factors besides the ethnic conflict, such as the Southern rebellion, policy mismanagement and political economy factors also disturbed the policy regime (Athukorala and Jayasuriya, 1994; Chapter Three of this book), but the war’s contribution to this disturbance was significant. Therefore, although Sri Lanka liberalised its economy three years before the World Bank embarked on its first structural adjustment loan, the reform process had substantially slowed down by the mid1980s. In 1977, Sri Lanka was one of the few pioneering countries among the developing countries to open up. At that time, the Soviet bloc was still powerful, the received evidence from the East Asian success stories was quite weak, neigbouring countries, including India, were closed economies and above all, there was no consensus on the virtues of an open economy. Given this situation, perhaps there could also have been some reservations about pushing the liberalisation process too far. During the 1983–88 period, hardly any further liberalisation measures took place and policy-makers were, inter alia, pre-occupied with the ethnic conflict. Rough estimates by the Statistics Department of the Central Bank have shown that a 5 per cent growth in the economy normally allows the absorption of about 60 per cent of the annual addition to the Sri Lankan labour force (140,000 per annum in recent years). Given the fact that Sri Lanka has not been growing at around 8 per cent—which may allow the entire annual additions to the labour force to be absorbed—unemployment has been a recurrent theme over the years. Moreover, with high achievements in literacy levels through the welfare state, the additions to the labour force had high aspirations of securing jobs. The inability to provide jobs according to aspirations led to a major youth insurrection during 1987–89. This, in turn, applied a severe brake on the growth process in the late 1980s (see Table 1.2). The low growth during the 1987–89 period also indicated the existing structural weaknesses in the economy. ‘It showed that management of key macroeconomic aggregates while being prerequisites for sustained growth was by itself not a sufficient condition. Much more had to be done by way of providing the appropriate framework of policies, institutions and incentives in each of the key sectors’ (Gunatilleke, 1993: 51–52). Several high-level commissions and task forces were allocated the responsibility of formulating policies in key areas and making recommendations, most of which were accepted by the government. The policy process reached out more specifically to the sectoral level, which had been relatively neglected. The second wave of liberalisation in the 1990s—which was made possible by crushing the JVP (Janatha Vimukthi Peramuna) rebellion in late 198911 and coming to a truce with the LTTE in early 1990—made some in-roads to the unfinished agenda of the liberalisation exercise of the 1980s in trade, financial markets and commodity markets, investment regime, public enterprise reform, etc. The new reforms in the investment regime paved the way for new foreign investment, while reforms in the financial market and in public enterprises facilitated the wooing of new portfolio investment to the share market, which was activated in the early1990s. By 1993, both foreign direct investment (1.8 per cent of GDP) and foreign portfolio investment (0.7 per cent of GDP) peaked in Sri Lanka (IPS, 1996: 51),

56


which in turn was reflected in the growth rate (6.9 per cent) achieved in that year. The government managed to keep defence expenditure under control in the range of 4.5–5 per cent of GDP. The private sector was declared as the ‘engine of growth’ in the economy for the first time in 1992 (and the 1990s) as the ‘decade of exports’. A target to double the per capita of the nation—which was erroneously referred to as ‘NIC Status’—by the year 2000 was set and the entire administration was twisted to suit these objectives (Chapter Four of this book). The regime found it very difficult to bring about macroeconomic stability due to high defence expenditure, wage increases and the increasing wage bill, increasing debt repayment and conspicuous consumption related to the pet projects of the president. Increasing authoritarianism of the state, escalating the war from time to time, allegation of ‘crony capitalism’ in various private sector transactions and corruption slowed down the liberalisation process by early 1994—after which the administration became pre-occupied with the general elections in that year. For the first time, there was a consensus between the two major political parties with regard to what economic policies best suited the nation. The consensus was on open economic policies but there was a difference in the areas of emphasis. A change in government was witnessed in August 1994. The new government accepted the open economy, but emphasised in its manifesto that it should be given a ‘human face’. In its inaugural budget, an elaborate plan to continue with public enterprise reform, which included several big service-oriented ventures such as gas, telecom, and airline, was announced (Minister of Finance, 1995). A number of private-sector-friendly policies were put into operation and the existing ad hoc incentives were streamlined. During the 1995–97 period, the war escalated to a level never seen before and the defence expenditure had to be significantly increased to face the situation (Table 1.7). This, together with labour problems that emerged soon after the new government came into power, capped by infrastructure deficiencies in the power sector, put brakes on the growth process. The year 1996 proved to be a bad one, but in all the other years the regime managed to keep the growth rate above 5 per cent. Sri Lanka achieved an average growth rate of 5 per cent during the two decades (1977–97) of liberalisation. This growth also contributed to diversifying the production structure. The share of agricultural exports in total exports declined from 79.3 per cent in 1977 to 42.4 per cent in 1987 and to 22.8 per cent in 1997 while industrial exports increased from 14.2 per cent in 1977 to 48.6 per cent in 1987 and 74 per cent in 1997. However, the increased share of industrial exports was mainly attributable to the increase in the share of textile and garment exports in total exports from 2.1 per cent in 1977 to 30.2 per cent in 1987 and 49 per cent in 1997 (Kelegama, 1992: 260; CBSLAR, 1997: 131). The export-led diversification of the production structure was also reflected in the GDP shares. While agricultural share in GDP declined from 29.1 per cent in 1977 to 23.6 per cent in 1987 and 18 per cent in 1997, manufacturing share increased from 15.5 per cent in 1977 to 16.2 per cent in 1987 and 22 per cent in 1997. For the first time, the industrial sector overtook the agriculture sector in terms of the share it occupied in the GDP in 1995 (all data from Central Bank of Sri Lanka, 1998 and CBSLAR, 1997).


57

What prevented Sri Lanka from achieving higher levels of growth during the 1983–97 period? A detailed look at some broader areas discussed earlier can shed more light on what exactly happened in the economic system.

The North-East War The uncertainty created by the war was the main deterrent to foreign investment— which acted as a catalyst to the growth process.12 Some examples would suffice to indicate the missed opportunities. Two major electronic multinational companies— Motorola and Harris Corporation—had finalised plans to establish plants in the Export Processing Zone prior to the change in the political climate in 1983. Harris Corporation even started building a plant with an initial employment capacity of 1,850 workers. Both these companies withdrew from Sri Lanka after the 1983 ethnic riots. Motorola shifted to Malaysia and Harris Corporation went elsewhere leaving a half-built plant in Sri Lanka. Besides these two corporations, Marubeni, Sony, Sanyo, Bank of Tokyo, Chase Manhattan Bank, were in the pipeline to invest in Sri Lanka in the early 1980s.13 All these big companies decided against investing in Sri Lanka after 1983. Sri Lanka lost a major opportunity to take a big leap forward because had these investments materialised other large multinational companies would have been given a strong signal to start industries in Sri Lanka (Athukorala, 1995). In the mid-1980s, after the appreciation of the Yen, the Japanese surplus was invested and recycled in South East Asian nations such as Malaysia, Thailand and the Philippines. Sri Lanka may have had a chance of attracting some of these funds if not for the 1983 crisis and the events that followed it.14 The Japanese are very risk-averse in their investments. WIDER (1987) did some studies with regard to devising a strategy to attract the Japanese surplus to Sri Lanka via South Asia in the early 1990s, but to no avail—as the Japanese had already made up their minds in wanting to take a cautious approach towards investing in Sri Lanka. Sri Lanka in its attempts to come to terms with the ethnic war, missed a major chance again in the mid-1980s, whereas, the economies in the South East Asian countries really picked up in the mid-1980s (see Table 1.5). The conflict also acted as an impediment to attracting more tourists to Sri Lanka (the fourth largest foreign exchange earner to the nation after garment exports and remittances). Sri Lanka’s tourist industry that had started picking up since the early 1970s—peaked, as stated earlier, just before the 1983 ethnic riots. As Table 1.6 shows, since then the tourist arrivals have been on the decline until the mid-1990s when there was an improvement. Sri Lanka is perhaps the only country in the world that offers the unique biodiversity of sea beaches, mountains, ancient cities and wildlife within short travelling distances. Many tourists attach a premium to this uniqueness. Unfortunately, Sri Lanka has not been able to make use of this because of the ongoing conflict. Late starters in tourism such as Mauritius, which has less biodiversity to offer, was able to overtake Sri Lanka in terms of tourist arrivals per annum by the early 1990s (annual tourist arrivals in Mauritius in mid1990s was 450,000 compared to the Sri Lankan average of 380,000).

58

Development Under Stress: Sri Lankan Economy in Transition Table 1.5 COMPARABLE RATES OF ECONOMIC GROWTH: SRI LANKA AND OTHER DEVELOPING COUNTRIES, 1970–95 (% CHANGE PER YEAR)

Sri Lanka South Asia Bangladesh India Pakistan Regional Average East Asia China Indonesia Korea Malaysia Philippines Thailand Regional Average Sub-Saharan Africa

1970–77

1977–83

1983–95

1970–95

4.0

5.8

4.1

4.5

0.2 3.3 4.3 1.6

5.4 4.1 5.6 4.5

4.1 5.6 5.4 5.6

3.8 4.6 5.1 4.9

4.3 7.3 10.6 7.9 6.1 6.8 5.6 4.2

8.7 7.7 7.0 7.2 4.1 6.1 7.3 2.2

10.8 6.0 8.8 6.6 0.9 8.7 8.7 3.3

8.5 6.8 8.9 7.1 3.6 7.5 7.5 3.3

Source: World Bank, World Development Indicators.

Table 1.6 DATA ON TOURISM Unit Tourist Arrivals Earnings

1978

19,259 No. 2 USD Mn. 56.0 1988

Tourist Arrivals Earnings

No. USD Mn.

18,266 2 76.6

1980

1981

1982

1983

1984

1985

1986

1987

32,178 37,074 40,723 33,753 31,773 25,725 23,010 18,262 0 2 0 0 4 6 6 0 110.7 132.4 146.6 125.8 104.9 82.2 82.1 82 1989

1990

1991

1992

1993

1994

1995

1996

18,473 29,788 31,770 39,366 39,225 40,751 40,310 30,226 2 8 3 9 0 1 1 5 76 132 156.8 201.4 208 230.7 225.4 168

Source: Central Bank of Sri Lanka, Annual Report (various issues).

Macroeonomic Instability Macroeconomic stability is an important factor in an open economy where the private sector has to play a leading role. Sri Lanka experienced massive budget deficits throughout the 1978–96 period. However, during the 1978–83 period, there were large budget deficits from the massive public investment programme centred around the accelerated Mahaweli scheme. The government was of the view that, once the projects under the programme were completed in the mid-1980s, the budget deficits would decrease to create a conducive environment for private sector investment. But this objective could not be achieved due to the escalating defence expenditure from the mid-1980s and the period 1985–96 witnessed budget deficits that averaged above 10 per cent of GDP (Table 1.8).


59

Table 1.7 shows that defence expenditure, which was 1.1 per cent of GDP in 1982, escalated to 4.8 per cent of GDP in 1988 and to 6 per cent of GDP by 1996. This increase in defence expenditure was a result of increased recruitment to the armed forces—whose strength more than quadrupled between 1986 and 1996— and increase in purchase of sophisticated defence equipment (Chapter Five). Switching from a welfare-oriented economy to an investment-oriented economy at a time when a war was going on thus turned out to be switching from ‘welfare to warfare’. Table 1.7 DEFENCE EXPENDITURE AS A PERCENTAGE OF TOTAL EXPENDITURE AND GDP (MARKET PRICES), 1980–96 Year

% Government Expenditure

% of GDP

1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996

3.8 3.3 4.4 5.2 10.2 16.4 17.8 14.0 10.7 14.6 13.1 15.4 14.8 15.2 18.1 21.6

1.2 1.1 1.4 1.6 3.5 5.4 5.8 4.8 3.4 4.5 4.2 4.2 4.2 4.4 5.4 6.0


In the 1990s, the budget deficits still remained above 7.5 per cent of GDP. In some years the government found it difficult even to create a surplus in the current account of the budget deficit. The capital expenditure component became the scapegoat when it came to the question of expenditure reduction in the 1990s (IPS, 1993). Inflation remained at a two-digit level throughout the period 1978–96, excepting five years (1985, 1986, 1987, 1994 and 1995), thus creating some degree of macroeconomic instability (Table 1.8). Inflation resulted from high bank borrowing in the early 1980s and from high non-bank borrowing in the 1990s (which required the government to jack-up the rate of Treasury Bills to mop-up excess liquidity in the economy, thus, creating some degree of cost-push inflation). A section of the private sector, which was basically looking at the domestic market for profits during 1960–77, managed to accumulate additional capital through the Mahaweli project-related construction boom and was in a position by the mid1980s to embark on more risky export-oriented ventures. But the uncertainty created by political and macroeconomic instability during the late-1980s, made the private sector operate at the margin with a three-year goal in mind. There was some

1.1

3. Current Account (surplus/deficit)

5.7

6.6 4.5 2.1

5.3

13.9 10.6 3.3

26.1

6. Inflation (CCPI)

10.8

9.3 3.7 5.5

4.8

–14.0

–17.4

–2.1

19.7 16.3 3.4

–0.3

33.8 18.5 15.5

1982

14.0

5.4 0.4 5.0

5.2

–10.6

–13.4

1.1

22.0 19.2 2.9

1.5

32.6 18.1 13.0

1983

16.6

2.6 –1.4 4.0

4.2

–6.8

–9.0

6.1

24.3 22.2 2.1

2.1

31.1 16.0 13.0

1984


18.0

–12.4

–19.2

–15.6

0.1

5. Budget Deficit (after grants) 5.1 Foreign Finance 5.2 Domestic Finance Bank Non-Bank

–23.1

23.5 19.6 3.9

2. Government Revenue 2.1 Revenue 2.2 Grants

4. Budget Deficit (before grants)

2.5

5.9

20.6 17.4 3.2

33.0 17.2 13.2

1981

42.7 18.5 18.2

1980

1. Government Expenditure 1.1 Current 1.2 Capital 1.3 Lending/ repayment

1.5

5.3 2.9 2.4

4.4

–9.7

–11.7

2.2

24.4 22.3 2.0

0.7

34.0 20.1 13.3

1985

8.0

5.1 1.7 3.4

5.0

–10.1

–12.2

1.8

22.8 20.7 2.1

1.1

33.0 18.9 12.9

1986

7.7

5.8 1.8 4.0

2.9

–8.7

–11.1

1.3

23.8 21.4 2.4

0.8

32.5 20.1 11.6

1987

–1.2

24.0 21.4 2.5

1.8

32.6 22.6 8.2

1989

14.0

0.5 4.6 4.9

3.2

–12.7

11.6

4.9 –1.3 6.2

2.4

–8.6

–15.7 –11.2

–2.0

21.8 8.8 3.0

3.4

34.5 20.8 10.3

1988

Table 1.8 FISCAL OPERATIONS, 1980–96

21.5

5.3 0.1 5.2

3.6

–7.8

–9.9

–1.2

23.2 21.0 2.1

2.8

31.0 22.3 6.0

1990

12.2

4.3 0.0 4.1

5.2

–9.5

–11.6

–2.0

22.6 20.4 2.1

2.8

32.1 22.5 6.8

1991

11.4

3.7 –0.5 5.0

1.7

–5.4

–7.3

–0.9

22.1 20.2 1.9

0.6

27.5 21.1 5.9

1992

–2.9

20.4 19.0 1.4

1.8

29.0 21.9 5.2

1994

11.7

4.9 –1.2 5.7

2.0

–6.8

8.4

6.5 0.2 6.4

2.0

–8.5

–8.4 –10.0

–0.8

21.4 19.7 1.6

0.9

28.1 20.5 6.7

1993

7.7

5.1 1.1 3.9

3.2

–8.3

–9.6

–2.7

21.8 20.4 1.4

0.7

30.0 23.1 6.2

1995

15.9

6.4 1.6 3.4

1.4

–7.8

–8.9

–3.2

20.1 19.0 1.1

0.5

27.9 22.2 5.2

1996

60 Development Under Stress: Sri Lankan Economy in Transition


61

breathing space for the private sector during 1990–93, which soon disappeared in 1994, as it was an election year. Labour problems and the escalation of the war during 1995–96 were also not very favourable to the private sector although some of the adverse effects of these problems were offset by the new incentives offered in the budgets of 1995 and 1996.

Low Investments and Domestic Savings The East Asian high performers invested in aggregate in 1990, 35 per cent of their GDP and saved 37 per cent of GDP and thus, as a group, were net exporters of capital. By 1990, Sri Lanka’s investment at 22 per cent of GDP was still stagnating at a little above East Asia’s 1965 investment level, while savings were not more than 17 per cent of GDP, which East Asia had achieved in 1965. Low growth explains low savings and this, in turn, explains low investments.15 But this explanation alone is inadequate as there are several factors that have reduced investment levels in Sri Lanka. As stated earlier, macroeconomic instability and an uncertain climate worked against creating a conducive environment for investment. Since the second wave of liberalisation started in 1990, the private sector activities in the economy have increased significantly but, as stated earlier, the private sector has been operating in the margins looking at returns within a three-year time period. There is some evidence to this effect in Fonseka (1996), where he shows that most export-oriented firms are at a lower stage of development in terms of export marketing, and shortterm oriented in conducting their activities. The research finds that only about five export-oriented firms have been able to establish their brand names in the international market and command a niche market. Firms are not thinking strategically with a long-term vision in the global market where there exists fierce competition. The low savings in Sri Lanka are not solely rooted in low growth in the economy. Sri Lanka’s domestic saving levels are comparatively low not only vis-à-vis East Asian nations but also compared to neighbouring India. The domestic savings have fluctuated in the range of 11–17 per cent of GDP over the last two decades. One obvious adverse contributor to savings was the low public saving. However, even private savings have not been very impressive, ranging from 9–20 per cent during 1980–95 (Table 1.4), compared to over 20 per cent in South East Asian countries and India. Snodgrass (1966: 186) argues that consumption patterns in Sri Lanka remained at a very high level during the 1950s. He attributes it to the export boom in the early 1950s, food subsidy, speculative purchase of import goods by those who saw signs of approaching import control and sought to beat the restriction and the then prevalent taxation structure discouraging corporate savings. During 1960–77, low growth and the increasing role of the public sector may have lowered savings. Athukorala and Jayasuriya (1994: 96), for instance, have shown that foreign savings crowded out domestic savings, both total and private. This may have been particularly valid for the post-1977 period. Radlet et al. (1997) have shown that the

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prevalence of political instability has a negative effect on domestic savings. This may have contributed to lowering saving patterns since 1983. While all these factors may have contributed to generating less domestic savings, the fact remains that the marginal propensity to consume in Sri Lanka has remained high. Even after liberalisation, there are no indications of a significant switch from consumption to savings. In short, Sri Lankans have heavy consuming habits; for instance, the country is globally ranked at the top with regard to alcohol consumption. In 1997, a leading minister stated in Parliament that Sri Lankans have a habit of overeating. These facts cannot be dismissed as arbitrary observations. In fact, impressionistic evidence clearly indicates that non-economic factors have contributed to lessening the saving habit in the country.

The Problem of Governance During the entire 1990–97 period, creating an environment to suit the private sector has been a continuous struggle due to the large budget deficit, outdated legislation governing labour and the corporate sector and a bloated bureaucracy. Large budget deficits, unlike during the 1980s, were financed mainly by non-bank borrowings (Table 1.8) which led to high interest rates, which in turn led to private sector lobbying for various tax concessions (Chapters Three and Four of this book). This was particularly acute during 1992–94, which not only led to ad hoc policy-making and tax concessions eroding the revenue base, but also allegations of cronyism. For the first time, the interest rates were brought down after 1991, in early 1997 to be precise, by reducing the statutory reserve ratio. This was possible due to more prudent budgetary management and by bringing money supply under control. The labour market is governed by outdated legislation that were designed at one time to suit the requirements of the closed economy. Consequently, some of the liberalisation and adjustment measures implemented to achieve various structural adjustments in the economy have not been effective because adjustment at the micro-level was hampered by the rigidities in the labour market. For example, when certain industries were made to face the pressures of world competition by reducing tariffs, they found it difficult to restructure the industries in an environment where there were difficulties in retrenching labour due to the existing legislation. The inability to retrench labour easily in this environment was perhaps one factor that contributed to heavy lobbying by the private sector against tariff reductions and ad hoc tariff adjustments in the early 1990s.16 Corporate laws have not been fully changed to suit the requirements of the market economy. For example, a simple leverage buy-out is not facilitated by the existing company laws (Kelegama, 1997: 179), bankruptcy laws still do not permit a smooth exit strategy for inefficient capital (World Bank, 1995b), etc. Moreover, enforcement of contracts is still a problem area and, as a result, agreements with large multinational companies for port, power or hotel development can take a long time or be subject to legal disputes. As a result of these problems, implementing liberalisation policies has been a complex and intricate exercise. The policy initiation has not been consistent but


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piecemeal in nature because there were practical problems in trying to follow both liberalisation and stabilisation in tandem (Chapter Three of this book). The government had to be constantly sensitive to the demands of the electorate and political opposition. Weerakoon (1997) states that policy making in Sri Lanka is reactive to situations rather than proactive. Although, Sri Lanka has the most mature liberalised regime in South Asia and among other developing countries, the administrative set-up has been very slow in adjusting itself to the liberalised environment and to the growing needs of the private sector. The bureaucratic procedures and paperwork are much less than in the late-1970s, but the administration is still not equipped to respond speedily to private sector requirements.17 The private sector is treated with suspicion and an effective dialogue with the private sector has been slow to emerge. Thus, while Sri Lanka has a market-friendly environment, 50 years after Independence with two decades of experience with a liberal regime, the country is still struggling to offer a ‘business-friendly’ environment to buttress the policy regime. The problem in Sri Lanka has been that the challenge of new public management process, which needs to be instituted in the context of the liberalization of the economy, has been approached with the same old tools—institutional process and human—that had served the cause of the earlier regulated economic regime. (ibid.: 14)18

Key Growth and Developmental Requisites Misplaced? A distinguished economist in Sri Lanka, drawing on the lines of Lenin’s equation of ‘Soviets plus Electrification equals Socialism,’ said in the early 1990s that infrastructure plus skills equals development.19 This simple statement has an immense importance in Sri Lanka’s development strategy.

Infrastructure Table 1.9 shows some comparable infrastructure indicators for the region. It is clear that Sri Lanka lags far behind many countries with regard to infrastructure. Several irrigation projects were implemented in the 1950s and the 1960s and they successfully contributed to increasing paddy production and human resettlement. In the late-1970s, the accelerated Mahaweli programme contributed significantly to providing irrigation to some parts of the dry zone. This scheme also contributed to power generation and provided the foundation for rapid industrialisation after 1977. However, infrastructural progress in the context of the increasing demands in the Sri Lankan economy, is far from satisfactory. In the 1965–70 period, the World Bank proposed a scheme of three major highways in Sri Lanka, viz., dual carriage-ways linking up to Colombo, with circular road from the south of Colombo to the central province and then to the north, branching out to Trincomalee on the one side and the Jaffna peninsula on the other. Around 1974–75 (before the Non-Aligned Countries’ Summit in 1976) there

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Development Under Stress: Sri Lankan Economy in Transition Table 1.9 INFRASTRUCTURE INDICATORS

Country Sri Lanka South Korea Malaysia Thailand Indonesia India

Telephones Road Density per 1,000 persons (Km per million (1990) persons) (1988) 7 310 89 24 6 6

536 236 – 513 160 893

Water (Per person with access to safe water–% total) (1990) 60 93 78 77 51 73

Power (Households with electricity– % 1984) 15 100 64 43 14 54

Source: World Bank (1994: Table 32, 224).

was a plan to construct a highway from the Katunayake Airport to Colombo City. But none of these mega projects came into being. They were grand ideas confined to paper. The governments were simply not alive to the importance of infrastructure and pandered to the short-term wishes of the electorate, keeping in mind the next general elections. In the 1980s decade, when the Mahaweli project was progressing and was completed, core infrastructure investment amounted to 4.1 per cent of GDP, but this declined to 3.4 per cent of GDP in the 1990s. In contrast, Malaysia, Thailand, the Philippines and Indonesia maintained 6–8 per cent of GDP on infrastructure investment in the 1990s (Jayawardena, 1997). With escalating defence expenditure, as stated earlier, budget balancing was often made by reducing capital expenditure, which, in turn, affected infrastructure (see, for instance, IPS, 1993: 12). From about 1993, major infrastructure projects were considered under BOO/BOT (Build, Own and Operate/Build, Operate and Transfer) arrangements for private sector investment, but the progress has been slow due to a weak regulatory framework, lack of proper procurement procedures and an uncertain investment climate because of the war.

Skills and Human Resource Development All governments in Sri Lanka have given substantial importance to human resource development. By the mid-1970s, Sri Lanka became the envy of other countries for its high basic needs indicators, such as literacy levels (see, for instance, Sen, 1981). However, even the vaunted basic needs achievements have become less distinctive in the course of time as faster-growing countries have begun to match Sri Lanka’s once outstanding social indicators. While many social indicators were indeed outstanding in the early years, slow economic growth has contributed to a situation where there has been less improvement in these indicators in Sri Lanka as compared to many other Asian countries, thereby, eroding the country’s initial advantage in social development (see Table 1.10). The case is similar with regard to poverty, where nearly a quarter of the country’s population still live below the poverty line, despite a history of extensive social welfare measures. This situation had begun to emerge as early as the mid-1970s (Snodgrass, 1974). By the mid-1990s, the fast-growing East Asian economies had


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Table 1.10 SELECTED ASIAN COUNTRIES: SOCIAL INDICATORS OF DEVELOPMENT Early 1970s Population growth (in per cent) Indonesia Korea Malaysia Thailand Sri Lanka Infant mortality (per thousand live births) Indonesia Korea Malaysia Thailand Sri Lanka Life expectancy at birth (in years) Indonesia Korea Malaysia Thailand Sri Lanka Gross primary school enrolment rates (percent of school age population) Indonesia Korea Malaysia Thailand Sri Lanka Illiteracy rate (percent of population 15 years and above) Indonesia Korea Malaysia Thailand Sri Lanka

2.4 2.1 2.5 3.0 2.1

Mid-1990s 1.6 0.9 2.4 1.2 1.4

114 47 42 65 48

53 12 12 35 16

49 61 63 60 65

63 71 71 69 72

80 103 87 83 99

114 102 93 98 106

43 12 42 21 22

23 2 17 6 10

Source: IMF (1997): 42.

all narrowed the gap in life expectancy vis-à-vis Sri Lanka and, in a few cases, passed Sri Lanka in these measures (see Table 1.10). Thus, what is dubbed as ‘growth mediated security’ à la Dreze and Sen (1991), where East Asian high growth permitted massive investment on people, has proved not only to be more effective but also sustainable in improving basic needs indicators and alleviating poverty. There is evidence to show that Sri Lanka neglected the area of R&D (Research and Development) (perhaps with the exception of the agriculture sector) in the 1960s and 1970s (see, for instance, Kelegama, 1992; World Bank, 1995b). Compared to the initiative taken by the Government of India during this period to establish engineering, science and management institutions, Sri Lanka paid little attention to this area and thought that she could rest on her laurels of high human resource development. By the early 1970s, India had well overtaken Sri Lanka in the areas of engineering, science and management.

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Sri Lanka’s high levels of human resource achievements, therefore, did not help the nation in its industrialisation or in overcoming the unemployment problem. In fact, there was a mismatch between the education system and the requirements of the job market. The education system that the country inherited from the British was supply oriented and was overly academic and did not provide the demanddriven skill requirements of the open economy. As a result of the down-grading of the English language and inadequate emphasis on science, engineering and management, graduates were unable to respond to the market demand for skills. The World Bank (1995b: 64) identified the lack of middle-level skills as a major deficiency, especially for export-oriented industries in Sri Lanka.

The Unforeseen Political Economy The World Bank, of course, has attributed Sri Lanka’s slow progress after 1977 to inadequate liberalisation of key sectors such as agriculture, the labour market, land market, financial markets, trade sector, etc. (see, for instance, Ahmed and Ranjan, 1995). It is not the intention of the author to examine the pros and cons of further liberalisation here. However, mention must be made that all policy reform in Sri Lanka is determined by the five-year (or six-year) electoral cycle. If the reform would provide net benefit before the five-year cycle a government would implement it. If, however, the cost of the adjustment process related to reform is not offset before the five-year cycle, such reform would be postponed. Thus, the political trade-offs of the reform process are the key to further liberalisation of the economy (see, for instance, Chapter Three). Without taking this factor into account no amount of pressure for reforms, by International Financial Institutions, can push a regime to implement them readily. Abrupt changes in broad strategy or in detailed components of a given strategy require considerable support and understanding by the population. This is not primarily because of the power of those who profit from possible rents, but rather because the community’s history, institutions and organisations create a milieu in which change that affects deeply-rooted views and practices cannot be seen as either appropriate or necessary. It then takes some event of some magnitude to convince the population and the government that new directions are necessary and possible. This is by no means an easy exercise as short-term costs can be very heavy. As the Indian Finance Minister, Manmohan Singh once said, ‘Finance Ministers must look after the short term if they want to survive in the medium term’ (IPS, 1993: 4). Despite all the problems, as stated earlier, Sri Lanka achieved an average growth rate of 5 per cent during 1977–97, which was quite remarkable given the chaotic situations the country encountered during this period. Commitment to a liberal trade and investment regime was one obvious contributory factor to this achievement. In other words, the answer to this performance could be found in the dynamics of capitalism. For example, writing on Asia’s reemergence, Radlet and Sachs (1997: 46) observed, ‘Corruption is rife, judicial systems are weak, and local


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governments often lack authority and adequate finance. But global capitalism stirs powerful forces for economic growth even in face of serious limitations in law, economic structure, and politics.’

Concluding Remarks Referred to as the ‘best bet in Asia’, Sri Lanka could not live up to that expectation. What eventually determined its destiny was governed by (a) two different political ideologies trying to unsuccessfully overcome a foreign exchange crisis during 1948–77, which was basically determined by the type of interlocking initial conditions that Sri Lanka inherited from colonial rule, and (b) the ethnic problems between the two main communities, dormant during the immediate post-Independence era, erupting like a volcano after 1983 and becoming an ‘Achilles Heel’ to the growth process. Sri Lanka’s economic development in the 50 years after Independence is a mixture of the inability to get out of interlocking initial conditions due to political economy factors rooted in the five-year electoral cycle, policy errors—where postponement of crucial policy introduction until a crisis engulfed the economy is a hallmark— and missed opportunities. Sri Lanka’s success in terms of high achievements in the area of social welfare was also the cause of its failure in terms of economic growth. The initial conditions in Sri Lanka made the policy-makers complacent. The plantation sector was taken for granted. The food subsidy was continued without any hesitation in the early 1950s. Despite deterioration of terms of trade, little attempt was made to diversify the export structure. The domestic production structure was diversified by import substitution industrialisation, but switching to exporting industrial products was postponed till the late 1970s. In contrast to this scenario, war-damaged economies such as Japan were forced to trade. This, in turn, forced them to realise that they had to find ways to increase productivity and to respond to trade opportunities, otherwise they would fall by the way-side in the world economy. They responded. The initial conditions in Sri Lanka did not permit such an attitude to emerge among policy makers, during the first decade after Independence. Thus, there was a struggle to overcome the foreign exchange crisis till 1977. Policy errors also played a role in Sri Lanka’s 50-year story of post-Independence development. The country could have performed so much better than what it did, if it had followed better policies. The foreign exchange crisis could have been managed better if export-led industrialisation was pursued vigorously instead of a recovery programme for import substitution industries in the late-1960s under partial liberalisation, and in the early 1970s, under the contemplated Export Processing Zone. Sri Lankan exports were able to take advantage during 1883–1913 when there was growth in the world economy, but when there was similar growth in the first three decades after World War II, Sri Lanka failed to take advantage, while Malaysia, Thailand, Taiwan, South Korea, etc., took full advantage of it during this time (Lal and Rajapatirana, 1989: 4–5).

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The ADB (1997: 8) attributes the success of East Asian economies to using ‘market institutions and openness earlier and much more than other developing economies ... they adopted a strategy of export-led growth and stuck to the discipline that this imposed. Governments generally struck an appropriate balance between private and public action. They relied heavily on the private sector as the engine of industrial growth, especially in the crucial area of export-oriented manufacturing, but they also provided selective support through direct credit and other mechanisms. A common error in South Asia and elsewhere was trying to do too much, not only providing public goods, but also run bakeries, mines, steel mills, hotels and banks.’ The ethnic crisis also could have been managed better through economic policies. For instance, Malaysia has been quite successful, compared to Sri Lanka, in maintaining harmony between the two ethnic groups—52 per cent Malays and 37 per cent Chinese at the time of Independence—via fine-tuning economic policies. Athukorala (1997) notes that economic policy-making in post-Independence Malaysia became a continuing struggle to achieve development objectives, while also preserving communal harmony and political stability. The missed opportunities were many. As discussed, 1983 was a turning point with regard to missing big international investors. All hopes of becoming the new investment centre of Asia faded away. In the mid-1980s, Sri Lanka missed the chance of attracting some portion of the Japanese surplus due to the war-related uncertain political climate. The South East Asian economies had a kickstart from recycling this surplus, during the mid-1980s. Besides, Sri Lanka had a competitive edge over most developing countries when its economy was liberalised in 1977, and was in a position to emerge as the regional hub in shipping, financial services, tourism, etc. Since Sri Lanka’s liberalisation was almost halted during 1983–88, relative newcomers were able to catch up with Sri Lanka’s lead and reduce its chances of becoming a hub. This is best exemplified by the South Asian region—Bangladesh liberalised its economy in 1987, Pakistan in 1988 and India in 1991. Thus, by the early 1990s, Sri Lanka lost the leading edge it had as these countries liberalised rapidly (India achieved full convertibility in the current account in 1994—the same year Sri Lanka achieved this status) and competed to attract FDI and also competed on its hub status. Thus, the Sri Lankan story is also a tale of missed opportunities. On a visit to Sri Lanka in 1979, the then prime minister of Singapore expressed the view, in answer to a question put to him, that Sri Lanka could overtake the level of development achieved by Singapore in 1979, by the year 1990, if she resolves the ethnic crisis (as stated by Ronnie De Mel, interview, Ayobowan Programme, Sri Lanka Rupavahini, 1 November 1997). Regrettably, no appreciable progress has been made in this regard in succeeding years. As a result, Sri Lanka’s per capita income, for instance in the year 1995, was USD 700—far behind Singapore’s per capita income of USD 3,830 in the year 1979, and as stated earlier, far below the per capita in 1995 of South Korea, Malaysia, Thailand and Indonesia. What can one say about the future? High social welfare achievements in Sri Lanka have led to a new problem, i.e., Sri Lanka’s over-65 years population is going to


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double from 9 per cent of the population in 1996 to 18 per cent by 2021 (De Silva, 1997: 28). In the USA, it took 70 years and in France it took 130 years, for the above 65 years population to double compared to the 25 years that Sri Lanka will take in the future. Thus, the pension budget and issues of old-age dependency are going to become major problems. The only way to confront this is by ‘growth mediated security’ as in the East Asian nations. Thus, the challenge for Sri Lanka is to achieve high-growth rates of about 8 per cent per annum in the next decade. If Sri Lanka is to sustain high-growth rates of about 8 per cent per annum—that would contribute to increasing the rate of savings and absorbing more labour and thus, reduce the level of unemployment—the investment level should be above 30 per cent of GDP. At present, Sri Lanka’s investment level is around 24 per cent of GDP. This investment is made possible by about 15 per cent of GDP domestic savings, about 5 per cent of GDP remittances from Sri Lankans abroad, about 1.2 per cent of GDP worth of foreign direct investment and about 2.8 per cent of GDP worth of foreign aid. Domestic savings cannot be increased much without cutting into the consumption levels of the population; worker remittances cannot be increased much above the current level; and foreign aid is drying up due to increased competition among developing countries for foreign assistance. Thus, the only short-term way to increase the level of investment is by attracting more foreign direct investment (Chapter Two). For this purpose, a stable and consistent economic environment is essential. This, in turn, will depend on the settlement of the ethnic crisis and prudent management of the government budget. The Asian Development Bank has argued that South Asia will become the growth centre in Asia in the next 30 years. The projections made for Sri Lanka are quite satisfactory (ADB, 1997: 122). Therefore Sri Lanka should not lament over the mistakes and missed opportunities of the past 50 years, but look to the future with optimism, for it still has a good foundation for a rapid economic take-off.

Notes 1. Colin Clark, a statistician from UK, who visited Sri Lanka in 1947 declared that barring Japan, Sri Lanka had the highest per capita income in Asia (Minister of Finance, 1948). Tunku Abdul Rahaman of Malaysia had expressed in 1956 that his aim was to equal the economic performance of Sri Lanka while Lee Kuan Yew of Singapore had stated, on his return from Cambridge after pursuing higher studies, he thought that Singapore would be doing extremely well if it could imitate Sri Lanka (see Jayawardena, 1998). 2. If estimates of purchasing power parity are used to adjust per capita income (à la Kravis), then in 1960, per capita income in Sri Lanka was higher than in either Brazil or Mexico (Lal and Rajapatirana, 1989: 4). 3. Instead of small labour-intensive industries, big capital-intensive industries, such as steel, textiles, chemicals, etc.—areas where Sri Lanka did not have a comparative advantage— were set up with the assistance of aid from socialist countries. 4. Among the visiting economists were Joan Robinson, J.R. Hicks and Lord Kaldor.

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5. Oliver (1957: 129) notes, ‘Restrictionist policies which nationalism has demanded probably have on balance lowered Ceylonese incomes somewhat, and foreign investors’ fears of an uncertain future have been distinctly unfavourable for the island’s economic advance.’ 6. By 1965, some of the import substitution industries may have run out of steam (after completing the easy phase of consumer goods production) and that may have been the time to embark on a full liberalisation exercise as happened in 1977. But the policy makers thought otherwise and thus, introduced a ‘recovery programme’. 7. The Prime Minister, J.R. Jayawardene, fully backed the acceleration of the Mahaweli Scheme from 30 years to 5 years because age was against him (72 years) and he wanted to make a mark in Sri Lanka’s history before the end of his five-year term. At that time, Jayawardene did not think he would live for another five-year term nor did he have confidence in reelection. 8. This was a Keynesian type of fiscal stimulus that was not directly related to liberalisation policies. 9. The following factors are noteworthy: (a) remittances increased national savings by about 4.5–5 per cent of GDP over the post-liberalisation period, (b) by 1986, garments accounted for the largest share of all commodity exports (27 per cent) and by 1992 was the largest net foreign exchange earner for the nation (USD 0.4 billion) and employed more than 230,000 people in 1994 (Kelegama and Foley, 1999), and (c) gross receipts from tourism increased from USD 56 million in 1978 to USD 226 million in 1995. 10. After the Boeing 707 Jumbo Jet came to the market in 1969, air travel gradually became cheaper in the 1970s. This factor also contributed to the growth of international tourism. 11. The years 1988 and 1989 witnessed the second southern youth uprising led by the militant Marxist group Janatha Vikmuthi Peramuna (JVP) or People’s Liberation Front. The benefits of liberalisation and development had not percolated down to everyone, especially the rural youth leading to this violent uprising, which was finally suppressed with unprecedented ferocity. 12. During 1979–82, nearly 50 per cent of the export increment came from firms with foreign direct investment (Kelegama, 1992: 262). 13. When a Japanese Bank shows an interest in investing in a country, it indicates that it is coming to support large scale Japanese investment in the country. The very fact that the Bank of Tokyo was ready to come to Sri Lanka shows that many Japanese were considering Sri Lanka as an investment centre at that time. 14. In May 1986, the LTTE blew up an Air Lanka passenger carrier which was ready to take a number of Japanese ‘Honeymoon couples’ to Maldives. This event was the real turning point for Japanese investment—Sri Lanka was now considered as a high-risk country for investment. 15. The virtuous cycle of growth, savings and investment is as follows: savings lead to investment, investment to growth and growth to savings. 16. When the World Bank (1995b) refers to further liberalisation of tariffs, there is hardly any mention of how tariff issues are closely linked to labour market reform. 17. ADB (1997: 8) states that East Asia organised their bureaucracy efficiently and insulated them from short-term political pressures. 18. For example, the goal of achieving self-sufficiency in rice has some sentimental value as historical texts refer to a glorious past in Sri Lanka when King Parakramabahu, the Great, not only achieved self-sufficiency in rice, but also exported it to Burma. Many politicians feel that matching the King’s achievements will go well with the electorate irrespective of the hard economic facts that any additional rice production could come only at a high cost to the government. Above all, many players in the system are unaware of the fact that forced ‘self-sufficiency’ is an outdated concept in an open economy. 19. Gamini Corea at Organisation of Professional Associations, Annual Session, 1991.


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References ADB (1997), Emerging Asia: Changes & Challenges, Asian Development Bank. Ahmed, S. and P. Ranjan (1995), Promoting Growth in Sri Lanka: Lessons from East Asia, Policy Research Working Paper, 1479, South Asia Country Department, World Bank, Washington, D.C. Anand, S. and R. Kanbur (1991), ‘Public Policy & Basic Needs Provision: Intervention & Achievement in Sri Lanka’, in J. Dreze and A. Sen (eds), The Political Economy of Hunger, Vol. 3, Clarendon Press, Oxford. Athukorala, P. (1995), ‘Foreign Direct Investment & Manufacturing for Export in a New Exporting Country: The Case of Sri Lanka’, The World Economy, Vol. 18, No. 4. ——— (1997), ‘Poverty, Ethnicity and Economics: Malaysia’s Challenges & Achievements’, Asia Pacific Economic Group, Australian National University, Canberra. Athukorala, P. and S. Jayasuriya (1994), Macroeconomic Policies, Crises, and Growth in Sri Lanka, 1969–90, World Bank, Washington, D.C. Bruton, H., G. Abeysekara, N. Sanderatne and Z.A. Yusof (1992), Sri Lanka & Malaysia: The Political Economy of Poverty, Equity, & Growth, Oxford University Press for the World Bank, New York. Central Bank of Sri Lanka (CBSLAR) (1970, 1997), Annual Reports, Colombo. ——— (1998), Economic Progress of Independent Sri Lanka: 1948–1998, Colombo. Corea, G. (1985), ‘Adjustment and Growth’, in Sri Lanka Association of Economists (eds), Structural Adjustment and Growth, SLAE, Colombo. Cuthbertson, A.G. and P. Athukorala (1991), ‘Sri Lanka’, in D. Papageougiou and M. Michaely and A.M. Choksi (eds), Liberalizing Foreign Trade, Vol. 5, Blackwell. De Silva, W.J. (1997), Population Projections for Sri Lanka: 1991–2041, Human Resource Development Series, No. 2, Institute of Policy Studies, Colombo. Dreze, J. and A. Sen (1991), The Political Economy of Hunger, Vol. 1, Clarendon Press, Oxford. Fonseka, T. (1996), ‘Planning Process in Sri Lankan Export Firms and Their Stage of Development’, Sri Lanka Journal of Management, Vol. 1, No. 1. Forrest, D.M. (1968), A Hundred Years of Ceylon Tea, 1867–1967, Chattoo and Windus, London. Gunatilleke, G. (1993), Development and Liberalization in Sri Lanka: Trends & Prospects, Marga Institute, Colombo. Gunawardana, Philip (1958), ‘Nationalization of Foreign-Owned Tea Plantations’, The Ceylon Economist, Vol. 4, No. 2. Herring, R.J. (1987), ‘Economic Liberalization Policies in Sri Lanka: International Pressures, Constraints and Support’, Economic and Political Weekly, Vol. 22, No. 8. ILO (1971), Matching Employment Opportunities & Expectations—A Programme of Action for Ceylon, Report and Technical Papers, Geneva. IPS (1993), Sri Lanka: Reform & Development 1993/94, Institute of Policy Studies, Colombo. ——— (1996), Sri Lanka: State of the Economy, Institute of Policy Studies, Colombo. IMF (1997), Sri Lanka: Selected Issues, IMF Staff Country Report No. 97/95, Washington, D.C. Jayasuriya, L. (1996), The Sri Lankan Welfare State: Retrospect & Prospect, CDS-IPS Monograph No. 1, Edith Cowan University, Western Australia. Jayawardena, L. (1997), ‘The Rationale for Private Sector Infrastructure’, Ceylon Daily News, 8 April. Jayawardena, L., A. Maasland and P.N. Radhakrishnan (1987), Stabilization & Adjustment Policies & Programmes: Sri Lanka, WIDER, Country Study No. 15, Helsinki. Jayawardena, N.U. (1998), ‘The Cost of War’, The Island, 29 and 30 April, Colombo. Jennings, Sir Ivor (1950), The Economy of Ceylon, 2nd edition, Oxford University Press, London. Kaldor, N. (1959), ‘Observations on the Problem of Economic Development in Ceylon’, in Papers by Visiting Economists, National Planning Council, Colombo.

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Kelegama, J.B. (1986), ‘Review of Economic Policies and Progress, 1977–1984’, Sri Lanka Economic Journal, Vol. 1, No. 1. ——— (1998), ‘Sri Lanka’s International Trade’, in A.D.V.de S. Indraratna (ed.), Fifty Years of Sri Lanka’s Independence: A Socio-Economic Review, Sri Lanka Institute of Social and Economic Studies, Colombo. Kelegama, S. (1992), ‘Liberalization and Industrialization: The Sri Lankan Experience of the 1980s’, South Asia Journal, Vol. 5, No. 3. ——— (1997), ‘Privatization in Sri Lanka: An Overview’, in Anthony Bennett (ed.), How Does Privatization Work? Essays on Privatization in Honour of Professor V.V. Ramanadham, Routledge, London. Kelegama, S. and F. Foley (1999), ‘Impediments to Promoting Backward Linkages from the Garment Industry in Sri Lanka’, World Development, Vol. 27, No. 8. Lakshman, W.D. (1997), ‘Introduction’, in W.D. Lakshman (ed.), Dilemmas of Development: Fifty Years of Economic Change in Sri Lanka, Sri Lanka Association of Economists, Colombo. Lal, D. and S. Rajapatirana (1989), Impediments to Trade Liberalization in Sri Lanka, Thames Essays, Trade Policy Research Centre, Gower, London. Minister of Finance (1948, 1970, 1981, 1995), Budget Speech, Government Press, Colombo. National Planning Council (NPC) (1959), The Ten Year Plan, Government Press, Colombo. Oliver, H.M. (1957), Economic Opinion and Policy in Ceylon, Duke University CommonwealthStudies Centre, Cambridge University Press, London. Olson, R.S. (1977), ‘Expropriation & International Economic Coercion—Ceylon and the West: 1961–65’, Journal of Developing Areas, Vol. 11, No. 2. Ponnambalam, S. (1980), Dependent Capitalism in Crisis: The Sri Lankan Economy, 1948–1980, Zed Books, London. Pyatt, G.F. and A. Roe (1977), Social Accounting for Development and Planning with Special Reference to Sri Lanka, Cambridge University Press, Cambridge. Radlet, S. and J. Sachs (1997), ‘Asia’s Reemergence’, Foreign Affairs, Vol. 76, No. 6 (November/ December). Radlet, S., J. Sachs and J.H. Lee (1997), ‘Economic Growth in Asia’, Harvard Institute of International Development, MA, USA (mimeo). Sanderatne, N. (1995), ‘The Economy’, in Centre for Regional Development Studies (ed.), Sri Lanka Year 2000: Towards the 21st Century, Ceylon Printers Limited. Sen, A.K. (1981), ‘Public Action & Quality of Life in Developing Countries’, Oxford Bulletin of Economics and Statistics, Vol. 43, No. 4. Snodgrass, D.R. (1966), Ceylon: An Export Economy in Transition, Richard D. Irwin, Inc, Homewood, 111. ——— (1974), ‘Sri Lanka’s Economic Development During Twenty-Five Years of Independence’, Ceylon Journal of Historical & Social Studies, Vol. 4. Tressider, A.J. (1960), Ceylon: An Introduction to the Resplendent Land, D. Van Nostrand, Princeton, N.J. Weerakoon, B. (1997), ‘Structural Roadblocks to Liberalizing the Sri Lankan Economy’ (Parts 1 and 2), Lanka Guardian, July and October. Wickremaratne, L.A. (1977), ‘Planning & Economic Development’, in K.M. De Silva (ed.), Sri Lanka: A Survey, University of Hawaii Press, Honolulu. WIDER (1987), Mobilizing International Surpluses for World Development: A WIDER Plan for a Japanese Initiative, Study Group Series, No. 2, United Nations University, Helsinki. World Bank (1979, 1980, 1987, 1994, 1997), World Development Report, World Bank, Washington, D.C. ——— (1995a), Sri Lanka: Poverty Assessment, Report No. 13431-CE, South Asia Region, World Bank, Washington, D.C. ——— (1995b), Sri Lanka: Private Sector Assessment, Report No. 12514-CE, South Asia Region, World Bank, Washington, D.C.

2 PRE-CONDITIONS FOR ACHIEVING ‘NIC STATUS’

Introduction Sri Lanka’s aim to achieve ‘NIC Status’ by the year 2000 was a popular theme in the country during the early 1990s. In this context, it is incumbent and vital to examine the connotation of ‘NIC Status’ and how such status could be defined to suit the present day world. There is no universally-accepted definition of an NIC (Newly Industrialised Country). Balassa (1979) defined a newly industrialised country without using the abbreviation of NIC as, ‘developing countries that had per capita incomes in excess of USD 1,100 in 1978 and where the share of the manufacturing sector in the GDP was 20 per cent or higher in 1977’.1 On this basis, Balassa identified the four East Asian Tigers, viz., South Korea, Hong Kong, Taiwan and Singapore as NICs in 1979. However, the future usage of such a definition requires a revision on the cut-off points.2 For example, quite different results would accrue on the assumption that the cut-off point with regard to the manufacturing sector share needs no revision and only the per capita income level needs revision. On this basis, if one revises the per capita income level using the world average annual inflation rate that is adjusted for population growth for the 1980–90 period, which

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was around 9 per cent, one gets a per capita income of USD 4,007 for 1993 and USD 7,324 for the year 2000 as cut-off points.3 In 1992, Sri Lanka’s GNP per capita income was about USD 500 and in 1993 it was about USD 510 (IPS, 1993). On this basis, in order to achieve a GNP per capita income of USD 7,000 by the year 2000, it was estimated that an average growth rate of about 39 per cent during the 1993–2000 period was required (see Appendix 1[a]). Even if Sri Lanka had managed to enhance its share in the manufacturing sector to 20 per cent of GDP by the year 2000, it would have been an impossible task to achieve an average growth rate of 39 per cent during 1993–2000. Thus, any discussion on Sri Lanka achieving ‘NIC status’ by the year 2000 would only have been an academic exercise.4 It would have been more realistic for Sri Lanka, instead of aiming at an NIC status by the year 2000, to rather have considered doubling her per capita income by the year 2000, i.e., achieve a GNP per capita income of USD 1,000 (taking 1992 as the base year when GNP per capita was USD 500) by the year 2000 and perhaps also increase her manufacturing sector share in GDP to about 20 per cent from the 1992 figure of 14 per cent of GDP. The analysis, in this chapter adheres to the assumption that the doubling of the per capita income was the required target for Sri Lanka in its development process in the post-1992 period. In that process, it is also assumed that Sri Lanka would have been able to enhance the manufacturing sector share in GDP to a level above 20 per cent. The objective in this process was to examine the quantity as well as the quality of investment, savings and foreign assistance required to double Sri Lanka’s per capita income by the year 2000. In analysing this area, the focus was on enhancing the level of investment managing and improving the efficiency of investment and various ways of increasing domestic and foreign savings in the country to achieve high and sustainable growth rates in the economy during the period 1993 to the year 2000. This chapter is accordingly organised as follows—the following section estimates the required growth rate, investment, domestic and foreign savings if Sri Lanka was to have doubled per capita income by the year 2000. The next section analyses various strategies that Sri Lanka could have adopted to meet the targets which is finally followed by some concluding remarks.

Estimation of Growth, Investment and Savings to Achieve the Per Capita Target It was evident that in order to double Sri Lanka’s per capita income by the year 2000, an average growth rate of 9 per cent was required during the period 1993 to the year 2000 (see Appendix 1[a]). The amount of investment needed to achieve the growth rate depends on the productivity of the investment. The productivity of investment is measured by the incremental capital output ratio (ICOR), i.e., the

PRE-CONDITIONS FOR ACHIEVING ‘NIC STATUS’

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investment rate required to produce 1 per cent increase in output. When the ICOR is high the productivity of investment is less. In 1992, the ICOR of the Sri Lankan economy was around 4.8 per cent. ICORs change over the years with the improvement in the efficiency of capital. For example, technological modernisation and enhancing technical skills in an economy could improve the ICOR, i.e., reduce its value. For Sri Lanka, the results of an exercise involving three possibilities for the ICOR during the 1993–2000 period and based on the Harrod–Domar static framework is given in the Appendix. The first takes a pessimistic scenario of ICOR remaining unchanged from the 1992 value during 1993–2000, i.e., a value of 5. The second possibility considers a scenario of ICOR at a value of 4, and third, an optimistic scenario where ICOR is reduced significantly to a value of 3. For the ICOR value of 5, an average investment rate of around 45 per cent was required during the year 1993 to the year 2000 period to double Sri Lanka’s per capita income. Under the second scenario, an average investment of 36 per cent was required. On the most optimistic scenario, the investment rate needed to be 27 per cent to meet the required target (see Appendix 1[b]). If one examines the investment figures for Sri Lanka, it can be seen that the rate peaked at nearly 30 per cent in the early 1980s, but averaged 26 per cent during the 1980s as a whole (see Table 2.1). In the 1990s, it averaged around 23 per cent. To examine how investment could be enhanced to the levels needed to maintain the government’s growth targets, it is imperative to examine the different sources of financing an investment. The amount of investment that takes place cannot exceed the total savings in the economy. The savings in the economy could be categorised into three areas: (a) Domestic—savings by Sri Lankans out of GDP; (b) National— domestic savings plus factor income from abroad and transfer payments (worker remittances, etc.); and (c) Foreign—aid, borrowing and direct investment. Each of these are examined later. Table 2.1 GROWTH, INVESTMENT AND SAVINGS, 1975–91

Growth Rate Investments = Savings National savings Foreign Savings

1975–77

1978–80

1981–83

1984–86

1987–89

1990

1991

3.6 15.3 13.3 2.0

6.8 27.6 14.6 13.0

5.3 29.2 15.5 13.7

4.8 24.4 16.8 7.4

2.2 22.5 14.7 7.8

6.2 22.6 17.5 5.1

6.0 23.0 13.0 10.0

Source: Central Bank of Sri Lanka, Annual Reports (various years).

Sri Lanka’s domestic savings depend primarily on the level of domestic income. The influence of the interest rate on determining savings in Sri Lanka is much less than that of the level of income (Shanmugalingam, 1993). The extent to which savings would increase as the income increases would very much depend on the value of the marginal propensity to save (MPS), in the economy. In 1992, according to the National Planning Department, the MPS in the Sri Lankan economy

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was around 0.1. The MPS can also change with time, depending on the type of policies that are pursued by the government. Assuming three different scenarios with regard to marginal propensity to save, i.e., 0.1, 0.2 and 0.3 the results would be as follows—in the worst case of 0.1, a domestic saving rate of only 14 per cent per annum could be obtained; in the second scenario, a rate of 16.5 per cent per annum could be obtained; and in the optimistic case of MPS = 0.3, a domestic saving rate of 19 per cent could be obtained (see Appendix 1[c]). During the 1980s, gross national savings were about 2.5 per cent points higher than gross domestic savings. Although, workers’ remittances have been high, so have net payments abroad due to foreign investment and borrowings. Assuming that this amount remains constant during the 1993–2000 period, one can estimate the corresponding national savings for the above estimated domestic savings. The national savings come out as 16.5, 19 and 21.5 for the three different scenarios. If all these estimated figures for investment and national savings under the three scenarios are put into a matrix form the results appear as in Table A1 (Appendix 1[d ]). In the worst case of an ICOR of 5 and an MPS of 0.1 the financ-ing gap is 28.5 per cent and in the optimistic case (with an ICOR of 3 and an MPS of 0.3), the financing gap is 5.5 per cent of GDP. It is to finance this gap that the country needs foreign savings. Foreign savings, as stated earlier, include aid, loans and foreign direct investment (FDI). During the 1990–92 period, foreign aid (including grants and concessional loans) accounted for about 6 per cent of GDP, loans accounted for about 1.2 per cent and FDI accounted for about 1 per cent. Thus, net foreign savings averaged to about 8.2 per cent of GDP. It is a moot point whether this amount of foreign savings could cover the investment and savings gap. As indicated in Table 2.2, only in the two most optimistic scenarios, viz., for ICOR = 3 and MPS = 0.3, and for ICOR = 3 and MPS = 0.2, will this amount of foreign savings bridge the investment-savings gap. If the current trends with ICOR at 5 continue, the uncovered gap would remain over 15 per cent even if the saving propensity improves during 1993–2000 (see Table 2.2). Table 2.2 INVESTMENT-SAVINGS GAP FOR DIFFERENT SCENARIOS OF ICORs AND MPSs MPS ICOR 3 4 5

0.1

0.2

0.3

2.3 11.3 20.3

–0.2 8.8 17.8

–2.7 6.3 15.3

Source: Appendix 1 of this chapter.

This gap may be closed in four ways: (a) by obtaining more foreign resources to cover a larger part of the gap left by the shortfall in national savings; (b) by increasing the share of the income that is saved; (c) by increasing the quantity of investment; and (d ) by improving the productivity of investment so that the ICOR falls.


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Strategy to Achieve the Required Target Increasing Foreign Savings If the foreign aid that is coming into Sri Lanka is profitably invested, it will generate sufficient surplus both to meet repayments and to increase national income and savings. Of the different private foreign inflows, direct investment is the one that is most likely to generate the surplus. The experience of many developing countries including Sri Lanka during the 1980–83 period shows that reliance on external borrowing from commercial sources leads to rapid growth in the debt burden. Moreover, there is massive competition for foreign aid by those less developing countries that had opened up their economies in the early 1990s, and from the CIS and Eastern European countries. With the prospects of increasing foreign aid in the foreseeable future being bleak, the government had to rely heavily on additional foreign investment. Net FDI in Sri Lanka increased after 1977, but since the mid-1980s has been somewhat less than 1 per cent of GDP. In 1993, FDI was about 1.5 per cent of GDP. China, Malaysia, Thailand, Indonesia, The Philippines, India and Pakistan were far ahead of Sri Lanka in terms of attracting FDI (see IPS, International Newsletter, 15 March 1992). For example, in 1991, FDI in Malaysia amounted to nearly 4.5 per cent of her GDP and in Thailand it was about 2.5 per cent (ibid.). Sri Lanka had made some efforts to attract more FDI in the early 1990s. Some of the incentives that were being offered were as follows: (a) a plethora of tax holidays and other incentives; (b) making the Board of Investment (BOI) a ‘onestop-shop’; (c) advertising the facilities for investment in Sri Lanka in international newspapers like the Financial Times, Asian Wall Street Journal, etc.; and (d ) making available training facilities for BOI investors by promoting institutions such as the National Apprentice Industrial Training Authority (NAITA). However, inspite of all these incentives, Sri Lanka has not been very successful in attracting large-scale foreign investment. The reasons are as follows: (a) political instability due to the North-East war; (b) macroeconomic instability due to ad hoc policy making and the large budget deficit (see IPS 1993); (c) infrastructural bottlenecks; (d) lack of technical skills; (e) the lack of effective cooperation by some local entrepreneurs in joint ventures because they tend to be mainly interested in making a ‘quick buck’ which is not the case with the foreign party; and ( f ) the lack of built-in factories according to international standards in the Free Trade Zones or in the industrial estates for foreign investors to move in immediately. It was imperative for Sri Lanka to address these issues seriously if she intended to attract large-scale foreign investment to achieve the high level of growth that was required to double her per capita by the year 2000. Thus, while foreign savings would help, it alone would not be adequate to meet the government’s objective, as the required amounts (as a percentage of GDP) is quite high (Table 2.2). As mentioned, increasing the productivity of investment

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and increasing the propensity to save are equally important. Leaving aside the most pessimistic and the optimistic scenarios with regard to ICORs and MPSs and assuming that the moderate scenario of ICOR = 4 and MPS = 0.2 as realistic for Sri Lanka, a gap of 8.8 per cent of GDP still remains to be financed by foreign savings (Table 2.2).

Increasing Domestic Savings If the propensity to save in all income groups increases, then living standards in general would not rise so fast with higher income. But no one’s living standard would fall either. However, in practice the increase in savings is often achieved by redistribution between groups—from poor to rich and from the private sector to the government. It is generally assumed that the rich save more from their income than do the poor, i.e., they have a higher MPS. Therefore, regressive redistribution from poor to rich is one way to achieve higher savings. Even if the poor themselves can be encouraged to save, this will entail sacrificing their current levels of consumption. In the long run, all would benefit from the growth target being met, but only at the expense of the living standards in the short run. Thus, in practice a policy choice has to be made in the trade-off between the drive for higher savings and the living standards of the poor, an area falling within the ambit of the government’s policy options.

Increasing Investment Three factors are vital for promoting large scale investment. They are: (a) macroeconomic stability, (b) dependable infrastructure, and (c) institutional support.

Macroeconomic Environment A stable and sound macroeconomic environment is essential for increasing the level of investment in an economy. However, such an environment cannot be achieved in the midst of large budget deficits. This is because large deficits contribute to high inflation and also crowd-out funds for private investment. High inflation, in turn, contributes to overvalued exchange rates and high interest rates. Needless to say, reduction of the budget deficit is imperative to create a suitable macroeconomic environment. In the year 1993, Sri Lanka’s budget deficit was around 8.1 per cent of GDP and the inflation level remained at a two-digit level of nearly 12 per cent. One of the main factors that contributed to the large budget deficit was the high defence expenditure (amounting to 4 per cent of GDP or 12 per cent of total expenditure) and the related expenditure (e.g., refugee rehabilitation) resulting from the ongoing war. In addition to the high defence expenditure, there are other aspects of government spending that relate to the budget deficit, viz., (a) the overlapping component of expenditure between the Central Government and the Provincial Councils, (b) the


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large number of ministries and the existing irrelevant closed market bodies in the open economy, and (c) the conspicuous consumption by the political system, etc. Remedying such deficiencies would contribute to reducing the budget deficit and thereby create a suitable macroeconomic environment in order to give the correct price signals for investors—both domestic and international. The government strategy of financing the budget deficit during the early 1990s was by foreign aid and non-bank funding. In order to increase the borrowing from non-bank sources, the government maintained the Treasury Bill rate at a level ranging from 20 to 22 per cent. While this policy has been effective in mobilising funds from non-bank sources, it has led to other repercussions such as: (a) increasing the cost of capital to the private sector, and (b) providing an assured source of investment (in Treasury Bills) to entrepreneurs instead of them taking risks in investing in industries and in agriculture.

Infrastructure Development Although, substantial improvement in the infrastructure has taken place over the years in Sri Lanka there are still major problems that reduce the efficiency of capital and the desire for investment. Roads, telecommunications, water supply, electricity etc., still suffer from various inadequacies. Roads are inadequate to accommodate the growing demand for vehicles by the Sri Lankan public. Water supply is vulnerable to ad hoc cuts during periods of drought. The electricity is subject to fluctuations and frequent breakdowns and the telecommunication system sometimes gets jammed as a result of inadequate technology/machinery to handle the increasing number of calls. From the government budget, capital expenditure is mainly concerned with infrastructure development. Given the trend on budget deficits, the government was unable to allocate much for capital expenditure unlike in the early 1980s. In the 1994 budget, Rs 75 billion was allocated for capital expenditure, which, in turn, was to be utilised for infrastructure development. However, when there is pressure to increase recurrent expenditure, the government tends to cut into capital expenditure in order to keep the budget within manageable targets. This happened in 1993 and had serious implications on investment in the infrastructure by the government. Similar cuts in the capital expenditure are to be expected because the government always tends to give priority to recurrent expenditure needs as they are concerned with the short-term political needs. The reduction of the capital expenditure for infrastructure development is a serious issue because so far the private sector response for infrastructural development under the BOO (Build, Own and Operate) and BOT (Build, Operate and Transfer) has not been very satisfactory. BOO/BOT schemes may be successful in areas such as telecommunication and electricity. However, their effectiveness in areas such as road development and water supply remains very much questionable in a country such as Sri Lanka. Thus, the government investment in such infrastructure is all the more important due to the private sector’s reluctance to get involved in such areas in a big way. Effort at infrastructure development by the state should be positively viewed as laying the foundation for future private sector activities.

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In other words, it has to be looked at in terms of ‘crowding in’ rather than in terms of ‘crowding out’.

Institutional Reform Institutional reforms are required to cater to the growing needs in the economy, and especially to an increase in the level of investment. There is substantial literature in Sri Lanka (Administrative Reforms Committee [ARC] Report, 1988; Taxation Commission Report, 1990; Finance and Banking Commission Report, 1991) that highlight this aspect. The banking system in Sri Lanka has to change its attitude according to the growing needs of the economy. Sri Lankan banks have been quite conservative in their lending patterns and the preferred area of lending even today is the trading sector. Banks lack the initiative to fund more risky projects and lack the expertise to evaluate projects objectively. The 1990 Amendment to the Debt Recovery Laws, enabled the banks to be more flexible with regard to demanding collateral from entrepreneurs. A reduction of funding in the form of debt financing and the promotion of equity finance would be a step in the right direction. In this context, the emergence of five venture capital companies by end of 1993 was a positive sign. However, it would be improper to lay the blame fully on banks for the lack of funds for projects because a major problem in Sri Lanka seems to be the lack of viable projects. In this context, entrepreneurial development has to be further encouraged in the economy, for instance, the efforts of the Sri Lanka Business Development Centre and a few other organisations. However, increased state involvement in entrepreneurial development and the support of United States Agency for International Development (USAID) and other international agencies are important factors in this respect. Sri Lanka has to aggressively pursue the establishment of industrial and science parks for which an initiative has already been made. However, no financial institution in Sri Lanka has so far gone out to take attractive projects out of industrial parks or from scientific laboratories. In fact, in countries such as South Korea and Thailand, financial institutions went all out in looking for new and viable projects. In Sri Lanka, although, innovative projects are available in industrial/science institutions, the link between industrial/scientific institutions and the banking system is quite weak. This is an area that needs to be developed in the future.

Increase in the Productivity of Investment The productivity of investment is very much related to technological modernisation and productivity of labour in the country.

Technological Modernisation The government expects the private sector-led growth strategy to enhance technological modernisation in the economy. Already, technical upgrading is


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occurring in the economy in two ways. First, with the on-going privatisation programme, substantial modernisation is taking place in the former public enterprises that were starved of the much-needed modern equipment. Second, the private sector is importing new machinery using the multitude of incentives that are in operation—duty-free facilities, less documentation at customs, etc. However, with regard to importing very expensive machinery, the prevailing high interest rate in the economy is a major impediment. Needless to say, the macro-management in general and budgetary management in particular, are vital in this context. It also needs to be mentioned that technological modernisation cannot be expected to take place at a rapid pace without upgrading the technical skills in the country according to new requirements. For technological modernisation, supporting institutions to encourage areas such as R&D are also very much required. Institutions such as the CISIR (Ceylon Institute of Scientific and Industrial Research) and the IFS (Institute of Fundamental Studies) should be geared more towards the industrial sector. Moreover, in government institutions that support technological development, the prevailing bureaucratic procedures and red tape need to be minimised. The government, in fact, has an important role to play in promoting institutions when the private sector response in creating such institutions is weak. For example, when private sector bodies do not come up to fill various market failures in the economy during the short run, then, the government has to take necessary action to rectify such market failures of the supply side. There is a notion that FDI could assist a country in upgrading technology. While this is partly true, such upgrading will however come only if there are supporting institutions. A study by Lall (1993) of the Institute of Economics and Statistics, University of Oxford, states that, foreign investors transfer skills and technologies that are appropriate to local conditions and improve them to the extent necessary for efficient operation. They also help local suppliers to meet quality standards if they have the basic manufacturing capabilities. They cannot, however, up-grade the broader skills and supply structures—this must be the responsibility of the government of the country concerned. FDI cannot, in other words, be a substitute for indigenous capability efforts.

Enhancing Productivity of Labour In mid-November 1993, at the NIBM (National Institute of Business Management) conference, it was stated that Sri Lanka’s productivity is one of the lowest in Asia. According to a survey conducted by the Tokyo-based Asian Productivity Organisation, Sri Lanka ranks lowest among the 14 Asian countries for which the data was available. As Table 2.3 shows, Sri Lanka’s productivity growth between 1985 and 1990 was a meagre 1.4 per cent and was ranked the lowest in the list. In fact, in neighbouring India, where more than half the population live below the poverty line and where the literacy rate is half that of Sri Lanka, the productivity growth was as high as 20 per cent. Low productivity is due to several reasons: (a) inadequate technical skills and (b) poor work ethics and low wages.

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Development Under Stress: Sri Lankan Economy in Transition Table 2.3 PRODUCTIVITY GROWTH, 1985–90 Country Hong Kong Thailand China South Korea Singapore India Japan Indonesia Malaysia Pakistan The Philippines Sri Lanka

Productivity Growth 40.8 37.0 36.5 34.5 27.6 19.8 17.9 17.7 16.4 14.1 10.3 1.4

Source: Asian Productivity Organisation (quoted in the Sunday Observer, 14 November 1993).

Skill Development Although, Sri Lanka is acclaimed by the World Bank and other international institutions for achieving high basic need indicators (high literacy, high school enrolments, etc.) over the last four decades, it is essential to realise that the country does not possess the required technical skills for rapid and progressive industrialisation. In the development process of any country, four stages of industrialisation could be considered according to the theory of ‘Stages of Comparative Advantage’. They are: (a) labour intensive (assembly type industries); (b) light engineering industries (scooters, motorcycles, etc.); (c) heavy engineering industries (chemical plants, ship building, etc.); and (d ) hi-tech industries (electronics, avionics, etc.)—this being the most advanced and developed stage. In this context, it is worth noting that although there has been a rapid growth of Sri Lanka’s non-traditional exports after 1977, the country is still in the first stage of assembly-type industrialisation. Lack of industrial skills, especially at the middle and lower management levels, is a major contributory factor that prevents Sri Lanka from progressing towards a higher stage of industrialisation. The type of skill development that Sri Lanka has been promoting over the last four decades has been basically ‘supply driven’ (Kelly, 1992). Such a system no longer suits the growing needs of the industrial sector in the country. The education system that Sri Lanka inherited from the British colonial rule, which was heavily geared towards ‘white collar’ jobs has undergone only a few changes in recent years. Though there were unsuccessful attempts to change the education system during the past (e.g., the GCE [General Certificate of Education] system being replaced by the NCGE [National Certificate of General Education] system in the mid-1970s) there seems to be a reluctance on the part of educationists to implement a new academic curriculum to schools and universities without a definite signal of its viability. The implementation of a new academic curriculum that not only suits Sri Lanka but would also be acceptable to the international community is an essential factor in promoting skill development in the country.


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During 1988–93, in order to meet the rising demands for a skilled labour force, the Ministry of Higher Education did establish a few technical colleges. However, the total number employed in these technical schools in the late-1980s was about 25,000, which was less than 2 per cent of the unemployed (Bandaranayake, 1990: 15). Much of these training programmes have been created under the notion ‘training to create job opportunities’. Although, the technical colleges have become an attractive alternative to school pass-outs/dropouts, they have not been that attractive to those with specific interests in technical knowledge. Thus, the programme has tended to provide training for the unemployed rather than up-grading skills of those already employed. Sri Lanka operates within the legal framework of the Tertiary Education Act No. 20 of 1990 for skill development and under this Act there are two main institutions, viz., the Tertiary and Vocational Education Commission (TVEC) and the NAITA. The relationship of both these institutions with the relevant government body has not proved to be effective in enhancing skill development. Rather, the bureaucratic misappropriation of funds has resulted in the system becoming ineffective (Kelly 1992). Realising these factors, the government in 1992, announced its intention of funding a ‘demand driven’ institution called the Skill Development Fund for enhancing skills. This sort of funding has operated in Fiji, Singapore, Brazil, Jamaica, etc., and has proven to be successful. Such a fund operates on the basis of a ‘levy and a grant’. Normally, the government would first put in its share to the fund, then a levy would be imposed on the private sector to finance the remaining portion of the fund. The private sector, in turn, could obtain a grant from this fund to train its labour according to its wishes. This is a welcome suggestion for Sri Lanka. However, its implementation has to take into account three factors: (a) that adequate regulation would be there in order to prevent the private sector from misusing the funds; (b) that the Board of Governors of such a fund are not appointed on the basis of political considerations; and (c) that when deciding to give a grant to the private sector, small and medium industries are not neglected. Shortcomings of this nature could be adequately checked if there are strong representations from the private sector chambers as well as from NGOs. Once skills are upgraded in Sri Lanka, foreign investors would automatically develop adequate confidence, especially with regard to the low and middle-level management of the country and would bring in more advanced technology to the country, which, in turn, would lay the foundation for the second stage of industrialisation, i.e., the light engineering stage. Sri Lanka should aim to bring in more large multinational corporations, especially those that are quoted in the Fortune 500 list.5 Once a reputed multinational comes to Sri Lanka, it would create a precedent to attract bigger names in the multinational world such as Motorolla, Digital Equipment, etc. Work Ethics and Wages Work ethics are poor in Sri Lanka due to the existing work environment. For example, it is said that a Sri Lankan worker is far more productive when he/she is doing the same job in the Middle East. The reason being that the work environment in the Middle East compels him/her to change their attitude

84


with regard to work and thereby towards their responsibilities. Basically, this is an issue of work ethics. Factors such as fear of punishment, immediate promotion and reward for hard work, and discipline in the work place play a major role in determining work ethics and thereby, productivity. The large number of holidays, non punishment for absenteeism, lack of supervision with regard to workers spending long hours during work intervals, all contribute to reducing the productivity of output. This is an area where Sri Lanka has to develop innovative ideas and techniques and give the workers a sense of responsibility as well as reward for hard work. Labour laws in Sri Lanka are quite outdated and act as a major impediment for the private sector-led growth strategy that the government is promoting. Needless to say, these laws contribute in a major way towards reducing productivity because they overprotect the workers and thus, give them a sense of complacency, at the cost of responsibility. Since ‘hire and fire’ are restricted by legislation, industrialists find it difficult sometimes to increase wages according to productivity. Industrialists also find it difficult to increase wages due to the high corporate tax rate (35 per cent in 1993), defence levy, business turnover taxes, etc. A serious look at Sri Lanka’s labour laws and the taxation structure is urgently needed.6

Concluding Remarks In early 1992, the Government of Sri Lanka declared that the country should achieve NIC status by the year 2000. There is no universally accepted definition of an NIC. However, from the most well-known definition in literature, one could define the qualification for NIC status by the year 2000 as achieving a GNP per capita level above USD 7,000 and at the same time achieving a manufacturing sector share in GDP higher than 20 per cent. In this chapter, it is shown that it is impossible for Sri Lanka to achieve NIC status by the year 2000. A more realistic challenge for Sri Lanka was not to aim at NIC status by the year 2000 but rather, to double her per capita income. It can be assumed that Sri Lanka would be able to enhance the share of the manufacturing sector in GDP to a level close to 20 per cent in that process. In 1992, Sri Lanka’s GNP per capita income was about USD 500. In order to double the per capita income by the year 2000, the required average growth rate was about 9 per cent. This 9 per cent growth rate could have been achieved during the 1993–2000 period by: (a) boosting the level of investment from the prevalent rate of 23 per cent of GDP to a higher level; (b) increasing the productivity of investment from the prevalent level to a higher level (i.e., reducing the incremental capital output ratio); (c) enhancing the prevalent level of domestic savings rate of 15 per cent per GDP to a higher level; and (d ) increasing the level of foreign savings from the prevalent level of 8 per cent per GDP to a higher level. Increasing the level of domestic savings to a very high level was not easy because it involved cutting into the consumption level of the poorer sections of the population. Thus, the increase in investment had to necessarily take place mainly by attracting more FDI to the country. For this purpose and also for the purpose of boosting


85

the local level of investment—macroeconomic stability, further improvement in the infrastructure, additional institutional reforms, higher level of skills, etc., were prerequisites. For achieving the desired growth rate, improving the productivity of capital was equally important. This could have been achieved by technological modernisation and increasing the productivity of labour. Technological modernisation was supported by the privatisation programme and the private sector-led growth strategy. However, state support was required for creating the capabilities and the institutions required to support the private sector initiatives in the modernisation process. Increasing the productivity of labour required enhancing the industrial skills, improving the work ethics and reducing the existing rigidities of the labour market in Sri Lanka. The challenge for Sri Lanka in order to meet the 9 per cent growth target to double her per capita income by the end of the century was not impossible if the desirable political and economic system was in place.

Appendix 1 Estimation Procedure (a) Growth Rates Yt = Yo (I + g)t where g = growth rate, t = time, Yt = GDP at time t, Yo = GDP at time 0. For Yt = USD 7,000, Yo = USD 500 and t = 8 gives g = 39 per cent For Yt = USD 1,000, Yo = USD 500 and t = 8 gives g = 9 per cent (b) Investment per GDP I = ΔK + δ where I = investment, ΔK = change in the capital stock and δ = depreciation Assuming

δ=O I = ΔK g=

=

ΔY ; Y

(1) ΔY = Change in output

ΔY ΔK ΔK ⋅1 ⋅ = ΔK Y Y (ΔK / ΔY )

(2)

(1) and (2) give

g=

I 1 ⋅ Y ICOR

where ICOR = Incremental Capital Output Ratio = ΔK/ΔY

86


I ∴ = g × (ICOR) Y For g = 9% and ICOR = 3, 4 and 5 we get

I = 27% Y = 36%

for ICOR = 3

= 45%

,, ,,

=4

,, ,,

=5

(c) Saving Rates The Keynesian consumption function is given as C = ao + a1Y

(3)

where C = Consumption, Y = GDP, and ao and a1 are constant; a1 = marginal propensity to consume Savings in the economy is given by S=Y–C (3) and (4) give S = –ao + (1 – a1)Y

(4)

ΔS = (1 − a1 ) ΔY St – So = MPS (Yt – Yo ) where MPS = marginal propensity to save = (1 – a1) St = So + MPS (Yt – Yo ) ∴ S2000 = S1992 + MPS (Y2000 – Y1992) For MPS = 0.1, 0.2 and 0.3 we could estimate S 2000 as shown in the table below Y2000 MPS (S/Y )2000 (S/Y )Avg. 1992–2000 (NS/Y )

0.1

0.2

0.3

12.6% 14.0% 16.5%

17.6% 16.5% 19.0%

22.6% 19.0% 21.5%

(d ) Foreign Saving Requirement A matrix is prepared below with the three ICORs and three MPS for the investment and saving gap:

⎛I S⎞ ⎜ − ⎟ ⎝Y Y ⎠


87

Table A1 MPS ICOR 3 4 5

0.1

0.2

0.3

10.5 19.5 28.5

8.0 17.0 26.0

5.5 14.5 23.5

Taking 8.2 per cent of GDP as foreign savings (average for the 1990–92 period) and subtracting it from the estimated gaps give Table A2 below (reproduced as Table 2.2 in the text). Table A2 MPS ICOR 3 4 5

0.1

0.2

0.3

2.3 11.3 20.3

–0.2 8.8 17.8

–2.7 6.3 15.3

Notes 1. The level of 20 per cent for the manufacturing sector need not be sustained after having reached the per capita benchmark. 2. The need for such revision becomes clear even from the World Development Reports (WDRs) of the World Bank. For example, in 1979, the WDR defined middle-income countries using an income range of USD 320–3,190, while in 1993, the WDR defined middle-income countries using an income range of USD 650–7,820. 3. If one takes into account purchasing power parity factors and environmental degradation factors and estimate the cut-off point to achieve NIC status by the year 2000, then one may get a different cut-off point.These aspects are however not dealt with in this chapter. 4. In 1993, Malaysia’s per capita income was USD 3,115. Since this value is below USD 4,000, Malaysia was not considered as an NIC in 1993 despite her manufacturing share in GDP being above 20 per cent. Some commentators argued that Sri Lanka should achieve a GNP per capita income of USD 2,000 in the year 2000 to achieve NIC status. This is incorrect because Malaysia was not considered as an NIC in 1993. In fact, the Malaysian Prime Minister stated that Malaysia should aim for NIC status by the year 2020. 5. Sri Lanka had managed to attract only one Fortune 500 investor by 1993, i.e., Norske Hydro of Norway as the corporate investor of Ceylon Oxygen. 6. Though the Taxation Commission Report of 1991 came out with some attractive proposals to restructure the tax system, the government has not fully implemented most of its recommendations.

References Balassa, B. (1979), The Newly Industrialising Developing Countries After the Oil Crisis, World Bank. Bandaranayake, Dias A. (1990), ‘The Generation of Gainful Employment: An Overview of Unemployment in Sri Lanka’, Central Bank of Sri Lanka, Staff Studies, Vol. 17, Nos 1 and 2, (April/September 1987).

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GOSL (1988), Report of the Administrative Reforms Committee, sessional Paper No. XI, Government of Sri Lanka, Colombo. ——— (1990), Report of the Taxation Commission, Government of Sri Lanka, Colombo. ——— (1991), Report of the Commission on Finance and Banking, Government of Sri Lanka, Colombo. Institute of Policy Studies (1993), Sri Lanka: Reforms and Development, 1992/93 (referred to as IPS, 1993 in the text). Kelly, T.F. (1992), A Strategy for Skills Development and Employment Policy in Sri Lanka, Institute of Policy Studies, Colombo. Lall, S. (1993), ‘Foriegn Investment in South Asia’, Asian Development Review, Vol. 2, No. 1. Shanmugalingam, K. (1993), ‘Sri Lanka’s Structural Adjustment with Special Reference to Taxation, Tariff and Financial Sector Reforms’, address to the ‘aid group’ ambassadors, 2 June 1993 (mimeo). World Bank (various years), World Development Report, Washington, D.C.

Part II DEBATE

ON

ECONOMIC LIBERALISATION

3 STABILISATION

AND

ADJUSTMENT

A Second Look at the Experience during 1977–93

Introduction Three years before the World Bank embarked on its first structural adjustment loan in 1980, Sri Lanka had begun a process of economic liberalisation. It is, therefore, one of the very few countries that have had nearly two decades of reform experience. What was achieved has been extensively documented, at least till the end of the 1980s (Jayawardena et al., 1987; Herring, 1987; Lal and Rajapatirana, 1989; Cuthbertson and Athukorala, 1991; Kelegama, 1992; White and Kelegama, 1993; Athukorala and Rajapatirana, 1993; Athukorala and Jayasuriya, 1994). The discussion has been detailed and also very wide-ranging, but why the Sri Lankan reform effort faltered in the second half of the decade has still not been adequately explained. Part of the reason lies with the theoretical starting point. The contention of mainstream economists has been that liberalisation in Sri Lanka (as in so many developing countries) was not sufficiently far-reaching (Lal and Rajapatirana, 1989). The initial reforms are acknowledged to have been immensely important, but macroeconomic mismanagement is said to have left an ‘unfinished agenda’ (ibid.: 29). We argue that this explanation is insufficient; that initial conditions, economic circumstances and the nature of the political system reduced the government’s room

92


to manoeuvre; and that tensions between the differing needs of stabilisation and adjustment hindered the reform process. A crucial explanatory factor in all these elements is seen to lie in the political sustainability of the reform process and the need for the government to respond promptly to domestic social pressures. The presentation is in five sections. The first section sets out the theoretical standpoint that structures the ensuing discussion, and it is followed by a brief outline of the conditions in Sri Lanka at the start of the liberalisation process in 1977. The second section contains an overview of the country’s economic policy upto 1993. The third section looks at problems encountered by efforts to stabilise the economy, and the fourth looks at problems of adjustment. The last section brings the discussion together.

Stabilisation and Adjustment: A Theoretical Starting Point Stabilisation and liberalisation/adjustment dominate discussions of economic policy in developing countries. The orthodox distinction is that stabilisation is designed to minimise a short-term macroeconomic imbalance through the management of the demand side, while structural adjustment boosts the ‘supply side’ by releasing market forces and through institutional changes to increase the efficiency of the economy over the medium term (Thomas et al., 1991; Mosley, 1991). Economic liberalisation and an increasing market orientation are seen as the keys to achieving the aims of structural adjustment. Stabilisation and adjustment have traditionally been sponsored by the World Bank and the IMF, respectively, but over the 1980s, their views have in practice merged and become interlinked. Of the two, stabilisation is seen in theory to be the first priority. However, as the macroeconomic environment improves, emphasis is expected to shift to economic liberalisation and adjustment. Liberalisation, it is argued, is more likely to succeed when macroeconomic problems are of more manageable proportions, the economy is less vulnerable to external shocks and there is political stability. The problem is that this logical progression is rarely attainable. Most countries have had to embark on economic liberalisation under far more onerous conditions with an incipient balance-of-payments crisis, low growth, rising fiscal deficits, high inflation, and some threat of political instability (Rodrik, 1990). In many cases, IMF and World Bank conditionalities have made external finance contingent on the adoption of a stabilisation programme, and liberalisation and crisis management have had to move hand-in-hand. In this situation, when wide-ranging reforms under a structural adjustment package have had to be attempted simultaneously with stabilisation efforts, they have often created conflicting demands on economic policy. They have affected technical consistency, and they have put pressure on management, administrative capacities, and political support for the government. Reducing the budget deficit has in particular proved to be inordinately complex. Nevertheless, theory assumes

STABILISATION AND ADJUSTMENT DURING 1977–93

93

that the different components of a stabilisation-cum-liberalisation package can be implemented consistently and that they will logically tend to pull in the same direction. Allowance is made for ‘gearing problems’ with respect to the timing and sequencing of a liberalisation package (Michaely, 1986), but practical difficulties that are encountered when they are pursued together—problems of political palatability, overall policy consistency and institutional capacity receive less attention. Hesitancy, digressions, or backtracking tend to be interpreted as economic mismanagement. However, several commentators have challenged this perception of the process of economic reform. Thomas and Grindle (1990) have questioned the unilinear model that underlies it, and Rodrik (1990) has argued—we think quite correctly—that what really matters is not the pristine application of what is theoretically desirable, but sustainability. Illiberal and politically-motivated policies that generate political support for the government and for the government’s reform process, may (within certain bounds) be a price that has to be paid to sustain the overall momentum. One implication to be drawn from this position is that a different kind of theorisation may, in fact, be needed, which explores the underlying rationale and structure of piecemeal reform. This still has to be attempted. However, adopting this broad view, the extent to which policy failures are the result of economic mismanagement, may have to be reassessed. Political, economic and institutional constraints that impinge on the formulation and implementation of economic policy are likely to provide the rationale for a considerable proportion of it.

The Sri Lankan Setting Prior to 1977, Sri Lanka’s economy was inward-looking. The state pursued an import-substitution strategy. There were quantitative restrictions on imports and stringent exchange controls. Public corporations were dominant in almost all sectors of the economy; the state was committed to heavy social expenditures and a bloated state sector was sustained by surpluses squeezed from plantation exports. There was an entrenched tradition of political patronage and an astute awareness of ethnicity (Lal and Rajapatirana, 1989; Moore, 1990; Jayantha, 1992). However, by the mid-1970s, the basic model had been ruptured. A sharp deterioration in terms of trade, the nationalisation of estates and several years of drought culminated in a fall in the output of plantation crops. The country faced unsustainable budget deficits, a balance-of-payments crisis, and widespread hardship. Low growth, high unemployment, and the rationing and black marketing of essential goods nurtured disaffection. Whichever party had come to power in the 1977 elections, changes in economic policy were almost inevitable (Herring, 1987). In the event, the opposition (the United National Party—UNP) was swept to power with a landslide victory.1 Thereafter, more favourable external conditions, a strong mandate for reform and the absence of any effective opposition gave the new government and its policies enormous political momentum. There was widespread popular support for

94


the open economy and the government’s task was simplified because it did not have to rely on the acquiescence of import-substituting industrialists. There were clear indications by the end of 1977 that substantial foreign assistance would be forthcoming with the opening up of the economy. Devaluation, trade liberalisation, the partial liberalisation of financial markets, the replacement of food subsidies by more targeted food stamps and tangible benefits to consumers from deregulation were to have a major effect on investor attitudes and on growth performance.2 By 1982, however, the pace of reform had slackened. The government was becoming increasingly authoritarian. The constitution had been restructured on Gaullist lines with a strong executive presidency and increasing centralisation. Manipulation of the law and power struggles in the UNP to be ‘the heir apparent’ were creating political uncertainties (Manor, 1984). The government was embroiled in a massive Keynsian-type fiscal injection by way of infrastructural investment. It continued to be bound to loss-making public sector enterprises and there were signs of backtracking in trade liberalisation. The investment programme was comprised of three ‘lead projects’: the free trade zone, the Accelerated Mahaweli Development Programme (AMDP), and a public housing scheme, of which the largest and most magnificent was the AMDP. Initiated in 1970, its implementation was accelerated (in a slightly reduced form) from thirty to six years. It was a major endeavour—it overshadowed all other aspects of development policy, promising massive employment (during construction and in the later land settlement), rice selfsufficiency and hydroelectricity.3 Cost estimates for the AMDP soared (from USD 610 million in 1977 to USD 860 million in 1980) and its implementation raised the price of domestic resources (Cuthbertson and Athukorala, 1991). Since it was largely donor-funded, aid inflows, together with the cost-push effect from domestic and imported inputs, fuelled domestic inflation, massive budget deficits and balance-of-payments problems (see Table 3.1). The government interpreted the deteriorating trade balance as a J-curve effect and pushed ahead with its programme. But the situation was serious and a major crisis was only averted by the unprecedented capital inflows (not only from concessional aid but also worker remittances—the latter increasing from 0.3 per cent of GDP in 1977 to 5.2 per cent in 1982). The real exchange rate appreciated by 20 per cent between 1979 and 1982, reducing the gains to exporters of the earlier devaluation (Levy, 1985). All in all, therefore, the project ran counter to the stabilisation and liberalisation objectives that were agreed with the Bretton– Woods institutions. There were also other reversals in the reform process. Transfers to public sector enterprises increased; a number of ad hoc duty changes widened the variance of effective protection on different sectors; the government looked to non-price measures to promote exports; and ceilings on interest rates were used to ease the problems of financing the public sector deficit (Lal and Rajapatirana, 1989). The reform effort could not be sustained and, by 1985, crisis management and stabilisation were again the major issue. Macroeconomic imbalance, the ethnic crisis that escalated after 1983 and insurgency in the South from 1987 to 1989 effectively paralysed the process of economic reform and the economy gradually stagnated.

–2.4

–1.2

19.9

12.1

15.3 189 25.2 30.6 15.8 3.0

14.4

6.0

13.4 163 4.5 17.0 10.1 4.1

100

–13.8 12.1

–9.3 5.8

–

8.2

2.8

13.8 136 29.2 43.1 16.0 4.7

12.2

25.2

100

–6.8

–13.8 10.8

6.5

1979

11.2 110 26.5 51.0 21.1 –4.0

18.3

31.2

98

–16.4

–23.1 26.1

5.5

1980

11.7 87 24.1 42.6 21.1 2.6

14.6

31.2

99

–9.9

–15.5 18.0

6.1

1981

11.9 82 21.3 41.9 22.3 10.4

16.7

31.9

99

–11.9

–17.4 10.8

4.8

1982

13.8 100 20.5 37.1 21.8 6.8

–

31.0

93

–9.2

–13.4 14.0

4.9

1983

19.9 122 24.2 31.9 21.9 4.5

–

28.3

77

–0.9

–9.0 16.6

5.1

1984

11.9 100 20.4 31.6 21.2 19.4

–

25.9

101

–7.0

–11.7 1.5

4.9

1985

12.0 89 18.9 30.7 20.6 11.7

–

25.8

117

–6.6

–12.2 8.0

4.3

1986

12.8 99 20.9 31.0 19.8 11.2

–

23.3

118

–5.1

–11.1 7.7

1.5

1987

12.0 93 21.1 32.1 18.9 4.3

–

22.5

114

–5.6

–15.6 14.0

2.7

1988

12.2 91 22.3 31.8 20.0 7.5

–

21.5

121

–4.4

–11.2 11.6

2.3

1989

14.3 87 24.7 33.4 20.0 –1.2

–

21.9

118

–3.2

–9.9 21.5

6.2

1990

12.7 86 22.6 33.7 20.75 7.7

–

22.6

113

–5.4

–11.6 12.2

4.6

1991

–3.6

–7.4 11.4

4.3

1992

15.3 89 25.9 36.0 20.0 7.7

–

23.5

112

Sources: Central Bank of Sri Lanka, Annual Reports (various years); Institute of Policy Studies, Database. Notes: Inflation ( p) was estimated using the Colombo consumer price index and the real interest rate was estimated as [(1 + –r)/(1 + p) – 1]100. a Current account includes trade in services. b Public investment is not available for the post-1982 years.

Growth (% per annum) Budget deficit (before Grants) as a % of GDP Inflation (%) Current account (balance of payments) as a % of GDPa Real exchange rate (trading partner weighted) Investment as a a % of GDP Public investment (% of GDP)b Domestic savings as a % of GDP Terms of trade Exports as a % of GDP Imports as a % of GDP Nominal interest rate Real interest rate

1970–77 1978

Table 3.1 KEY MACROECONOMIC INDICATORS, 1970–77 (Average) AND 1978–93

15.5 – 26.6 39.3 21.5 9.3

–

24.0

–

–5.4

–8.1 11.2

6.9

1993

STABILISATION AND ADJUSTMENT DURING 1977–93 95

96


It was this experience that was gauged to have reflected macroeconomic mismanagement. However, with the re-election of the ruling party under a more populist president and the defeat of the insurgents in 1989, the government embarked on a second wave of economic reform. This time, donors who had been prepared to overlook the lack of any effective stabilisation policy in the early 1980s (Jayawardena et al., 1987) took a totally different stand and the government was compelled to embark on a serious stabilisation programme. Efforts were made to reduce the budget deficit and to bring down the rate of inflation; an ambitious programme of privatisation was initiated; and incentive reforms were introduced to invigorate the private sector (Chapter Four). The economy grew by 5.5 per cent per annum between 1989 and 1993, but there were still questions being raised about economic mismanagement. How far was the succession of criticism justified?

Stabilisation Sri Lanka’s experience with economic reform in the 1980s did not correspond with textbook views as to what should have been happening. However, it is important to see these reforms against the background of international events and the priorities the government had at that time. Export-oriented industrialisation (emulation of Singapore) was the long-term objective post-1977, but sustained pursuit of this objective also needed political support.4 We will argue that, from this perspective, there was a necessary trade-off between what might have been technically desirable by way of economic policy and the political gains that could be made from the foreign resources available, and that the social costs of reform made some kind of compromise inevitable. An important element in this respect was the creation of an increasingly centralised and authoritarian state.

External Shocks Orthodox views of the stabilisation/liberalisation process give much more weight to domestic economic management than they do to external developments. The potential destabilising effect of the latter is, nevertheless, acknowledged to be considerable and this was undoubtedly true in Sri Lanka. After the initial liberalisation effort in 1977–78, the Sri Lankan economy was hit by a sharp downturn in terms of trade in the wake of the second oil-price hike of 1979.5 The external terms of trade deteriorated by a massive 62.3 per cent between 1978 and 1983. Herring (1987) estimated that Sri Lanka lost the equivalent of 7 per cent of its GDP in 1982 and 8 per cent in 1983 in terms of trade effects—almost the annual cost of the three lead programmes. This complicated the task of macroeconomic management, though it elicited no immediate policy response from the government. This was partly because of the volume of the foreign-capital inflows and because it thought that the J-curve effect after devaluation would eventually work to its advantage. But it was also because of a fear that any kind of adjustment


97

would instigate recession. Unemployment was high, the period was not perceived by the population at large, as one of crisis (Athukorala and Jayasuriya, 1994: 92) and with elections due in 1982, a programme that dampened the public mood and implied renewed austerity was not politically expedient. After 1982, a slight upturn was recorded in terms of trade, only for the political situation to deteriorate with the eruption of ethnic violence and with new pressures being placed on macroeconomic management.

The Accelerated Mahaweli Development Programme A second area of controversy concerns the AMDP. Was the decision to accelerate the Mahaweli Project—and that too in a deteriorating macroeconomic situation— not in itself an example of economic mismanagement, especially when the country was supposedly in the throes of an economic reform programme? Since the AMDP had generated much of the macroeconomic imbalance, the answer was ostensibly positive. The scale of capital spending and the number of sub-projects it entailed posed serious problems of control and because of the large foreign-capital component available, it became overambitious. But, again, the situation in practice was more complex. The principal objective of the AMDP was to increase power production (which was a precondition for any substantial expansion of manufacturing) and to reduce the country’s import dependence on staple foods. However, at the same time, it projected a message that was politically crucial, namely, that the rural poor—the potential losers from economic reform—would also gain. In the late-1970s and early 1980s, the AMDP (which was in every sense highly visible) projected a vision of a ‘renewed’ and more just society which was important in sustaining popularity for the government and for its new economic policies. It promised employment for the poor and it provided the government with innumerable channels for the dispensation of patronage. The UNP’s reputation and its credibility was tied to the success of the venture.6 Moreover, outside the AMDP, the effects of liberalisation on income were soon seen to be seriously regressive. The government had assumed that growth would trickle down and alleviate poverty. The free-rice ration was abolished and replaced by food stamps (the latter’s real value was, within a few years, seriously eroded by inflation), jobs had been lost through the effects of trade liberalisation on domestic industry and real wage rates were stagnant or declining. However, set-backs for the poor were not offset by higher incomes. The urban ‘middle class’ dynamics of economic reform were soon visible and it was increasingly resented. The benefits of reform were heavily concentrated among the top 10 per cent of income receivers (UNICEF, 1985; Jayawardena et al., 1987; Lakshman, 1989; Kelegama, 1993). It was, therefore, crucial for the government that employment was created to maintain social stability. Much of the employment that was being generated, in the free trade zone and in tourism, was for female workers. It increased female participation rates, but most of the unemployed were rural, educated, young, male and Sinhalese—a phenomenon linked with Sri Lanka’s history of rural insurrection.

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The UNP had been particularly successful in securing the rural vote (Bruton et al., 1992) and it championed increased employment in the AMDP (in the construction phase, even if the work was transitory and in the subsequent land settlement) and in the public service.7 Western governments were open to large-scale foreign projects for their construction industries during the international recession (de Silva and Wriggins, 1994). Concessional aid was forthcoming for major projects, but the president was convinced that this might only be the case for a relatively short period of time. It seemed logical, therefore, to try to lock up funding for large long-term projects during his term in office (Athukorala and Jayasuriya, 1994: 80). It was then, extremely difficult to move into a lower gear. The government could not afford to step back from its commitment to the AMDP in the name of sound economic policy. By the end of the 1980s, major investment in the AMDP had ended.

The Budget Deficit and the Social Cost of Adjustment Government failure to rein in the budget deficit has been a continual source of instability, throughout Sri Lanka’s liberalisation experience. It averaged 16.7 per cent of GDP between 1978 and 1982 and though it was subsequently lower, there were persistent deficits after 1989 (see Table 3.1). As always, there were strong political imperatives that made reductions difficult. During the early period, there was also an inherent conflict between the need to raise revenue to reduce the fiscal deficit for macroeconomic stability and the needs of liberalisation. In the immediate post-liberalisation period, revenue was not an issue. Government revenue increased. Rents associated with quotas had gone to the government, and the shift from quotas to tariffs at the same level of protection produced additional income. The lowering of tariffs boosted revenue because there was a large influx of imports, but eventually lower tariffs on external trade and cuts in income tax had the reverse effect. There was no visible ‘Laffer curve’ effect in operation. Taxes from previously profitable firms in the import-competing sector declined with trade liberalisation, and they were not immediately replaced by taxes from newly profitable export firms. The problem was also exacerbated by external shocks. Export diversification was slow and with an appreciation of the real exchange rate and incentive structures biased against traditional exports, export volumes fell, and with them the government revenues. Lal and Rajapatirana (1989: 45) have argued that if taxes on traded goods had been reduced in the early 1980s, appreciation of the real exchange rate could have been accommodated without a rise in the general price level. However, at a time when they were already falling sharply (from 47 per cent of government revenue in 1980 to 32 per cent in 1982) this was by no means easy. The government found it difficult to find new sources of revenue and it resorted to ad hoc revenue measures. Moreover, 18–20 per cent of GDP (excluding grants) was a comparatively high revenue outturn in the early 1980s. Even in the post-1989 period, when the government embarked on a serious privatisation programme, there was no significant increase in revenue in terms of GDP percentages. There were two reasons for this. First, there were costs involved in the privatisation exercise. Most state-owned enterprises were in poor shape and substantial refurbishment was needed to make them attractive to private buyers.


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Legal, valuation and advertising costs had to be borne by the state, along with compensation costs for retrenched labour. And, second, there were questions of governance in the World Bank-sense of accountability and managerial propriety (World Bank, 1992).8 Enterprises were sold using tender procedures that were not always transparent. Cronies influenced sales and there were accusation that enterprises had been undervalued. There was clear mismanagement, though the Sri Lankan experience suggests that privatisation is unlikely to assist stabilisation in the short run, even if it eases the expenditure burden of the state over the longer term. On the expenditure side, there was also considerable rigidity in the early 1980s— a result of the commitment to the three lead projects. Capital costs of the AMDP rocketed and by 1985 the accumulated total had reached USD 456 million (Jogaratnam, 1995).9 The projects, once begun, had become practically irreversible for reasons we have already outlined and given their scale and their share of public expenditure (44 per cent of total capital expenditure in 1983) the government’s ability to respond to the macroeconomic imbalance was correspondingly limited. As Stern (1984) pointed out, donors who chided the government because it could not cut expenditure were often the first to complain when counterpart funds were threatened for the projects that they were financing. There was also difficulty in curtailing the subsidies to public enterprises which rose from less than 10 per cent of the total government expenditure between 1970 and 1977 to over 25 per cent between 1978 and 1985. However, here again the situation was complicated. In the immediate post-liberalisation period, private sector investment was heavily concentrated in the non-tradable sector. With large budget deficits, two-digit inflation and an appreciating exchange rate, the government tried to use commercial policy (export tax reduction and subsidies) to generate an export bias for the manufacturing sector (Cuthbertson and Athukorala, 1991; Kelegama, 1992). It was nevertheless ineffective; the private sector preferred non-tradables, leaving tradables to the state (other than in the then limited niche of the free trade zone).10 Inadequate development of the Sri Lankan private sector (not only in terms of capital accumulation but also in its orientation and management), together with what was perceived as an increasingly uncertain and risk-prone investment climate, made reorientation to the private sector extremely difficult. The Sri Lankan capitalist class of the early 1980s was mercantile in character and it was reluctant to jump from the comparative safety of trading, into productive investment in new areas (Moore, 1992). Despite the high cost of borrowing (with interest rates at 21–22 per cent), investment was limited more by the lack of bankable projects than by the credit to finance them (Lindgran et al., 1986: 34). Limited experience of the private sector in the preparation of saleable projects to risk-conscious banks and limited financial strength to backup credit were a disadvantage. Investors were aware that the high-import content of industrial raw materials in many of the newer subsectors made investment particularly vulnerable to the terms of trade. Besides, the violence of 1983 and its aftermath had clear repercussions on business confidence in the Sri Lankan economy. The net result was that state enterprises continued to account for over 60 per cent of the country’s industrial output. Most were poorly managed and heavily subsidised, but they could not be so easily dismantled or privatised. To have done

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so would have eroded the production base of the country and generated a political outcry. It would have led to difficult and politically-costly legal battles over employment dismissals and it would have eliminated a major avenue of patronage that cemented political support. Loss-making enterprises nevertheless met with increasing difficulty in the newly liberalised environment: some tariff reductions were reversed to offer them greater protection, they were to prove an increasing burden on the public purse, but they could not realistically be abandoned, at least not in the short term. Stabilisation in the post-1989 period was frustrated inter alia by an increase in welfare expenditure. Rural poverty—a factor of considerable concern in the wake of the southern insurgency—became the grounds for a major poverty alleviation programme (the Janasaviya Programme) that was over-ambitious, poorly targeted and reflected political imperatives.11 Thus, having fallen from 21 per cent of government current expenditure in 1979 to 4.5 per cent in 1988, welfare expenditure surged back to 12 per cent in 1990. Here again, in conventional terms, was apparent mismanagement. However, we have argued elsewhere (Chapter Four) that a strong distributive dimension was essential for the political sustainability of the reform process. The new president championed the poor. He was committed to the development of a market economy and aware of the economic costs of his welfare programme, but he needed support or acquiescence of the poor to take market reforms further. Political imperatives, therefore, made serious demands on the public budget and with the ongoing war in the north and east, costs involved in refugee rehabilitation, decentralisation (evinced as a partial solution to the ethnic crisis), increasing debt repayments—reducing the budget deficit was increasingly difficult.12 High defence expenditure was a major internal shock to the economy. The government found itself constrained financially and unable to identify any viable large new area for expenditure reduction, so it reduced capital expenditure. It sacrificed investment because cuts in current expenditure (salaries, pensions and welfare) were more difficult, politically. However, curtailed public investment in infrastructure development in areas such as telecommunications, transport, irrigation and power had the effect of raising private sector costs. This effect which was complemented by high interest rates and the high costs of borrowing pushed private sector firms to lobby (successfully) for tax concessions with ensuing revenue implications. The demands for stabilisation in terms of a tight monetary policy were seen as a hindrance to investment. There was a lack of coherence in government policy and a lack of consistency and predictability in implementation, which affected business confidence. There were inherent contradictions between the needs of stabilisation and those of structural adjustment.

Liberalisation and Adjustment The previous section has shown that, throughout the country’s liberalisation experience, Sri Lankan policymakers were forced to struggle with problems of


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macroeconomic stability. In this section, we ask whether the problems of economic management could have been reduced or avoided with better timing and sequencing of the liberalisation programme. We argue that expectations were too high and that many of the problems encountered were unavoidable.

The Question of Timing The timing of trade liberalisation in Sri Lanka was determined by elections and by a change of government rather than as a matter of technical choice. Cuthbertson and Athukorala (1991) have, nevertheless, argued that liberalisation had the best chance of sustained success during the early days of the government when it had strong political momentum. The UNP government was returned in 1977, as we have noted, with a massive majority and liberalisation as its mandate. However, the underlying weaknesses in the Sri Lankan economy still remained and by 1980 an unanticipated recession in the world economy had redefined the international environment. The economy was recovering from the effects of economic crisis; its export structure was dominated by weak primary products and the indigenous capitalist class, as we have already noted, was highly underdeveloped. Reorienting the economy was therefore not just a matter of economic liberalisation. Trade reforms, for example, were started before supportive institutions had been created. The Export Development Board (EDB) and the Presidential Tariff Commission (PTC) were instituted around 1980 as their need became clearer, when the basic pattern of development was already set. As a result, efforts to direct incentive structures towards tradables ran into established interests which were able to manoeuvre effectively between conflicting economic and political signals to the country’s business community. It was unlikely that better timing would have made a difference.

Problems of Sequencing It seems unlikely that there was any serious discussion on sequencing in the Sri Lankan government’s policy agenda. However, after the initial trade liberalisation, various agencies had views about what should have priority. Both the IMF and the World Bank singled out import protection as a major impediment for growth in the industrial sector after the 1977 reforms. The tariff structure, they claimed, was neither rational nor uniform, and the persistence of arbitrary tariffs was contributing to the lack of dynamism in particular industries (World Bank, 1984). The government was intent on a strategy of export-led industrialisation, and one policy objective in 1980 had been a rational tariff structure (in terms of comparative advantage and infant industry arguments). Was this then a case of mismanagement in the liberalisation exercise? The sequencing of trade liberalisation, as it evolved, was fairly conventional. Devaluation was followed by the replacement of most quantitative restrictions on imports by a hastily formed tariff system. But since there was no coherent industrial strategy on which tariff changes could be based, it was difficult to judge appropriate protection levels during the initial years. No attempt was made to rein in

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imports (which more than doubled in value in 1978) and tariff reform was not phased in pre-announced stages. Therefore, there were definite gray areas. The main reasons for disparities in protection levels appears to have been the fact that comprehensive data was not available and that additional in-depth studies could not be carried out rapidly. Internal inconsistencies in tariffs and the wide variance in effective levels of protection between product categories was, therefore, in part a function of the speed of the initial liberalisation (PTC, 1985: 81). It had adverse consequences. It dealt a severe blow to many domestic industries and it reinforced the creation of lobbies to reverse ‘ill-judged’ decisions. Further reductions in tariff levels were then slow in coming. Subsequent steps (including the creation of the PTC) were largely defensive. They reflected two main motives. There were ad hoc changes in response to demands from local manufacturers who had been adversely affected by lower duties (or who were heavily dependent on imports). There were also changes motivated by the government’s need to bolster its dwindling revenue.13 Neither was consistent with its liberalisation programme, but it was simply not possible to sustain the pace of reform.14 Lobbies had begun to form, the government’s room to manoeuvre was reduced and a more gradualist approach to liberalisation was then almost inevitable. The political imperatives surrounding unemployment also slowed the reform process. Though there was some redeployment of those who had lost jobs after liberalisation (there was improvement in the overall employment situation by 1981–82), losses were in no way offset by the opportunities that were being created in expanding activities—partly because the emerging industries were in other locations and partly because different skills and abilities were required. There was a reallocation of labour from the unorganized sector and from the rural sector in particular, towards the urban organized sector (factory industry and services). Those who lost jobs in rural areas, for example in the handloom sector, were not those employed in the free trade zone located near Colombo. Regional differences grew, accentuating disparities in income distribution and increasing regional ethnic differences. Taken together, these effects were socially divisive. Some people who lost jobs in rural areas were absorbed by the expanding construction and service sectors; some secured jobs in new industries or obtained land under AMDP and some 200,000 were economic migrants to the Middle East.15 But in the early 1980s, a large proportion of this displaced labour was still unemployed. Their presence exerted tremendous pressure on the government. It led to protective measures, for example for the handloom industry (regardless of the target of tariff rationalisation or norms of market efficiency) and to large-scale recruitment into state corporations, which were seen as sources of available employment. Rationalisation of state corporations was treated as very much a secondary objective and privatisation was complicated by overstaffing. Existing labour laws made retrenchment difficult.16 The other key element in trade liberalisation was devaluation. Significant devaluations in the real exchange rate are normally considered a crucial component of a liberalisation strategy, as a means of shifting the structure of incentives towards tradable goods. However, policy makers in Sri Lanka found real depreciations difficult for several reasons. Loss-making state enterprises were not only a


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burden on the government’s budget, they were also highly dependent on imported inputs. Devaluation, by increasing costs, inflated the size of the necessary transfers and, given the importance of the state sector in the economy, it was problematic. As Sri Lanka is, in general highly import-dependent, the costs of industrial and agricultural production and hence, the general price level were all similarly affected. Devaluation posed a serious threat of cost-push inflation. In the welfare-oriented and highly politicised environment that existed in Sri Lanka, partial wage indexation had been almost unavoidable and import and wage-related cost increases (combined with terms of trade) ate into the margins that devaluation had offered to exporters. Policy makers looked to commercial policies to restore export incentives (Kelegama, 1992). There has also been some dispute about the lack of any attempt to liberalise the capital account of the balance of payments, given real exchange rate appreciation in the wake of official capital inflows linked to the public investment programme in the early 1980s. The difficulty in absorbing large capital inflows has been discussed in the literature (Corden, 1984). Basically, the argument is that if they are absorbed by the domestic economy, an appreciation of the real exchange rate is likely to follow because of imported inflation and the increased demand for non-tradables (Levy, 1985). Lal and Rajapatirana (1989) argue that, in the case of Sri Lanka, restrictions on capital outflows meant that the real exchange rate appreciation was larger than it need have been. However, any suggestion that full liberalisation of the capital account was desirable would seem questionable in the highly volatile political environment of the 1980s. It could have led to a significant outflow of capital. However, what is clear is that—along with other factors—foreign capitalinduced exchange rate appreciation worked against efforts to boost production of tradable goods.17 The crisis management associated with adjustment was such that ad hoc policy making became the order of the day. The path that was followed reflected what was feasible and the Sri Lankan experience showed that the problems encountered in further liberalisation were not always amenable to rational technocratic management. There was an uneasy relationship between macroeconomic stabilisation and the country’s structural adjustment programme.

Concluding Remarks The argument in this chapter is not that the Sri Lankan reform process was adequately managed. There is sufficient evidence to the contrary. The AMDP was a digression from the liberalisation exercise that the country had embarked upon and it raised very serious questions about its management capacity because of the speed and scale at which resources were made available. There was a tendency to believe that resource constraints no longer mattered (Athukorala and Jayasuriya, 1994: 83) and that the allocation of funds or contracts on the grounds of political expediency was ultimately justified. Throughout the period 1977–93, there were

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serious problems of accountability and administrative propriety. The issue here, however, is rather different. It is the way the process of economic reform is understood and the way policy performance is assessed. The Sri Lankan experience (or any other) can be assessed from at least two different standpoints. From a textbook perspective, it is clear that the reform process the country embarked on was incomplete. The initial liberalisation in 1977 was not followed up by a sufficiently rapid reduction in tariffs to ensure trade neutrality and trade and financial reforms should have been completed before embarking on such a massive foreign-funded public sector investment as the AMDP. From this point of view, the Sri Lankan liberalisation process in the early 1980s was undone by ‘revisionist thinking’ that reversed some of the initial gains and by the creation of new and increasingly more serious imbalances in the macro economy (Lal and Rajapatirana, 1989). Similarly, it could be argued (though we have not documented it in detail) that high variance in effective protection rates, inadequate liberalisation of domestic financial markets, the external capital account and domestic labour markets were a further indication of mismanaged reform. Policy performance on this criterion is assessed against some stylised notion of a sound reform exercise. The alternative is to view the Sri Lankan reform experience in relation to economic and political circumstances and the economic and political objectives of the incumbent government. The focus is then not so much on the government’s resolve to liberalise the economy, as on the reasons why particular policy decisions were made or took the form that they did. In this perspective, economic and political concerns have to be seen together. External events and political imperatives (ethnic conflict, insurgency, the social costs of adjustment and existing political commitments) assume a more critical role in the explanation, and the political viability and sustainability of reform becomes the crucial issue. As Krueger (1981: 100–101) argued, it seems senseless ‘to incur the costs of adjustment only to reverse policies before they have had any chance to affect resource allocation and growth. Yet, the evidence is that a significant number of stabilisation programmes have foundered precisely because the authorities have been unwilling or unable politically to survive political pressure during the adjustment period.’ The purpose of this analysis, it seems to us, should be to elicit a better understanding of the problems entailed and of the ways of escaping them. This chapter has tried to illustrate the relevance of such an approach in understanding the Sri Lanka policy agenda. The economic reform programme that emerges is ‘not an application of economic principles, but rather an improvisation’ (Mosley, 1991: 227). It suggests that, in the inevitably politicised process of tradeoffs incorporating political responses, there is bound to be tension between stabilisation and adjustment policies and that in the Sri Lankan experience it was stabilisation that was given lower priority. Domestic political needs may have seriously weakened the economic reform process, but continuing political support was crucial for its sustainability. In that sense, ad hoc piecemeal reform had a rationale of its own.


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Notes 1. By the time of the election, the economy was improving, but there was widespread belief that earlier policies had failed and there was need for change. 2. Over the period 1977–82, real GDP grew on average by 6 per cent a year, despite the oil shock of 1979 and declining prices for the country’s main export crops. 3. The scale of the endeavour (to settle 140,000 families and construct five major dams in a six year period) was intended to capture the public imagination. It also appealed to the donor community, which rewarded policy reforms with concessional aid and funded a growing proportion of Mahaweli investment—though counterpart contributions still remained immense (Levy, 1985). The aid-funded share as a percentage of total investment in the AMDP rose from 30 per cent in 1979 to 83 per cent in 1985, falling back thereafter (Athukorala and Jayasuriya, 1994: Table 5.2). Total expenditure on the AMDP alone was 6 per cent of GDP in 1982 and 1983. 4. An important element in this respect was the creation of an increasingly centralised and authoritarian state. 5. Tea prices collapsed in 1979 and the prices of oil, fertilisers, sugar and investment goods rose the following year. 6. One member of the cabinet (Gamani Dissanayake) also made the telling point that, apart from the Mahaweli, there was little that the newly elected UNP government of 1977 had to put up immediately for funding (de Silva and Wriggins, 1994: 363). The president was to be closely associated with the AMDP, and the prime minister was personally associated with the housing programme. 7. Government employment increased by approximately 22 per cent between 1977 and 1982, most of it before 1980 (Bruton et al., 1992: 158). However, in practice, employment by the AMDP was far less than expected, Karunatilake (1988) has suggested that at its peak, employment in the construction sector was no more than 20,000. 8. See Chapter Four. 9. This figure is reached by aggregating annual expenditures in dollar terms at the respective annual exchange rates. 10. The establishment of an export processing (or free trade) zone was a key element in the 1977 government’s industrial strategy. 11. There were also a number of parallel measures, including a midday meal programme for school children and a free school uniform programme. 12. Provincial councils were built into the Indo-Lanka Accord of 1987. The president was also determined to make implementation of the micro-level poverty alleviation programme more effective. Prudent financial management in decentralisation was therefore difficult because of the underlying political imperatives. 13. As the 1980s progressed, constraints became a barrier to further reductions in levels of protection because the government raised much of its revenue from external trade. High duties across-the-board, while good for revenue purposes, raised the protection level and ran counter to the rationalisation of the tariff structure (PTC, 1985). Most effective protection coefficients were higher in 1983 than in 1981 (Athukorala, 1986). 14. In the process of fine tuning, the PTC appears to have been trapped by political lobbies. It was forced to yield to pressures to provide protection or to reduce particular import rates on a selective basis. This was hardly surprising given the patronage that characterised the country’s political system, appreciation of the real exchange rate and market failures on the supply side (Kelegama, 1992). 15. Questions were also being raised about the quality of the employment that was created. With the exception of the garment industry, labour absorption was concentrated in sectors that could not sustain a long-term growth in employment—most notably in construction, where a winding-down was inevitable. The increase in service sector employment had come

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largely from the expansion in import trading after liberalisation and the regime of liberalised imports was buttressed more by external props (in effect by foreign aid) than by any intrinsic strength of the domestic economy. There was also a large-scale out-migration of plantation workers of Indian origin for resettlement in India (Bruton et al., 1992: 152). 16. Liberalisation of the labour market was also partial. The power of the trade unions was significantly reduced in 1980 with a major show of strength by the government. However, while this lowered rigidities in the labour market, the process was far from complete. Existing labour laws remained in operation and still continue today. 17. It is also important to remember that massive foreign-capital inflows had a positive side as well. They came at a time when the economy was facing large external shocks, enabling the government to sustain the momentum its public investment programme had taked and avoid a deflationary policy stance that would otherwise have been necessary (Athukorala and Jayasuriya, 1994). They also enabled the basics of the liberalisation programme to be maintained without recourse to the extensive use of direct controls. In the short term, the economy could be said to have suffered less in terms of reduced growth, higher unemployment and added social tension.

References Athukorala, Prema-chandra (1986), ‘The Impact of 1977 Policy Reforms on Domestic Industry’, Upanathi 1, Nos 69–105. Athukorala, Prema-chandra and Sarath Rajapatirana (1993), ‘Domestic Financial Market and the Trade Liberalization Outcome: Evidence from Sri Lanka’, World Development 21, No.7, pp. 1191–203. Athukorala, Prema-chandra and Sisira Jayasuriya (1994), Macroeconomic Policies, Crises, and Growth in Sri Lanka, 1960–1990, World Bank, Washington, D.C. Bruton, Henry, Nimal Sanderatne and Gamini Abeysekera (1992), The Political Economy of Poverty, Equity and Growth: Sri Lanka and Malaysia, Oxford University Press, New York. Central Bank of Ceylon [Sri Lanka] (CBC), Various years, Annual Report, Colombo. Corden, W. Max (1984), ‘Booming Sector and Dutch Disease Economics: Survey and Consolidation’, Oxford Economic Papers 36, No. 3, pp. 359–80. Cuthbertson, Andrew G. and Prema-chandra Athukorala (1991), ‘Sri Lanka’, in Demetris Papageorgiou, Michael Michaely and Armeane M. Choksi (eds), Vol. 5, The Experience of Indonesia. Pakistan, and Sri Lanka, Basil Blackwell, Oxford. de Silva, Kingsley M. and Howard Wriggins (1994), J.R. Jayewardene of Sri Lanka: A Political Biography, 2 vols, Leo Cooper/Pen and Sword Books, London. Herring, Ronald J. (1987), ‘Economic Liberalization Policies in Sri Lanka: International Pressures, Constraints and Support,’ Economic and Political Weekly 22, No. 8, pp. 325–33. Jayantha, Dilesh (1992), Electoral Allegiance in Sri Lanka, Cambridge University Press, Cambridge. Jayawardena, Lal, Ann Maaslund and P.N. Radhakrishnan (1987), Stabilization and Adjustment Programmes and Policies: Case Study of Sri Lanka, World Institute of Development Economic Research, Helsinki. Jogaratnam, T. (1995), ‘Accelerated Mahaweli Development Programme: Its Implications for the Economy of Sri Lanka’, in H.P. Muller and Siti T. Hetlige (eds), The Blurring of a Vision: The Mahaweli, Sarvodaya Book Publishing Services, Ratmaland. Karunatilake, H. Neville S. (1988), The Accelerated Mahaweli Programme and Its Impact, Centre for Demographic and Socio-Economic Studies, Colombo. Kelegama, Saman (1992), ‘Liberalization and Industrialization: The Sri Lankan Experience of the 1980s,’ Industrialisation Series, No. 2, Institute of Policy Studies, Colombo. ———. (I993), ‘Trends in Income Distribution and Ownership of Assets in Sri Lanka’, Pravada 2, No. 8, pp. 15–22.


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Krueger, Anne O. (1981), ‘Interaction between Inflation and Trade Regime Objectives in Stabilization Programs’, in William R. Cline and Sidney Weintraub (eds), Economic Stabilization in Developing Countries, Brookings Institution, Washington, D.C. Lakshman, Weligamage D. (1989), ‘Lineages of Dependent Development: From State Control to the Open Economy in Sri Lanka’, in Ponna Wignaraja and Akmal Hussain (eds), The Challenge in South Asia: Development, Democracy and Regional Cooperation, United Nations University, Tokyo; Sage Publications, New Delhi. Lal, Deepak and Sarath Rajapatirana (1989), Impediments to Trade Liberalization in Sri Lanka, Thames Essay Series, No. 5, Aldershot, Gower for the Trade Policy Research Centre, London. Levy, Brian (1985), ‘Foreign Aid in the Making of Policy in Sri Lanka’, Williams College, Williamstown, Mass. Lindgran, Carl-Johan, Sergio Pereira-Leite, James Hanson and Peter Heyward (1986), ‘Sri Lanka: A Survey of the Financial System’, International Monetary Fund, Washington, D.C. Manor, James, ed. (1984), Sri Lanka in Change and Crisis, Croom Helm, London. Michaely, Michael (1986), ‘The Timing and Sequencing of a Trade Liberalization Policy’, in Armeane M. Choksi and Demetris Papageorgiou (eds), Economic Liberalization in Developing Countries, Basil Blackwell, Oxford. Moore, Mick (1990), ‘Economic Liberalization versus Political Pluralism in Sri Lanka?’ Modern Asian Studies 24, No. 2, pp. 345–82. ——— (1992), ‘What Type of Capitalism Does Sri Lanka Need’, Visiting Lecture Series, No. 2, Institute of Policy Studies, Colombo. Mosley, Paul (1991), ‘Str uctural Adjustment: A General Over view, 1980–9’, in V.N. Balasubramanyam and Sanjaya Lall (eds), Current Issues in Development Economics, Macmillan, London. Presidential Tariff Commission (PTC) (1985), Report of the Presidential Tariff Commission, 1985, Ministry of Finance and Planning, Colombo. Rodrik, Dani (1990), ‘How Should Structural Adjustment Programs Be Designed?’,World Development 18, No. 7, pp. 933–47. Stern, Joseph J. (1984), ‘Liberalization in Sri Lanka: A Preliminary Assessment’, Harvard Institute for International Development, Cambridge, Mass. Thomas, John W. and Merilee S. Grindle (1990), ‘After the Decision: Implementing Policy Reforms in Developing Countries’, World Development 18, No. 8, pp. 163–81. Thomas, Vinod et al. (1991), Restructuring Economies in Distress: Policy Reform and the World Bank, Oxford University Press, Oxford. United Nations International Children’s Emergency Fund (UNICEF) (1985), Sri Lanka: The Social Impact of Economic Policies during the Last Decade, UNICEF, Colombo. White, Howard and Saman Kelegama (1993), ‘External Shocks, Adjustment Policies, and the Current Account: The Case of Sri Lanka’, Macroeconomic Series, No. 7, Institute of Policy Studies, Colombo. World Bank (1984), Sri Lanka: Recent Economic Development, Prospect and Policies. South Asia Programs Department, World Bank, Washington D.C. ——— (1992), Governance and Development, World Bank, Washington D.C.

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4 DOES LEADERSHIP MATTER IN THE ECONOMIC REFORM PROCESS? LIBERALISATION AND GOVERNANCE DURING 1989–93

Introduction Although economic liberalisation has been the orthodox policy line in development circles since the early 1980s, it is now much less narrowly prescriptive. Debate has moved from the technical content of policy—from problems of stabilisation, timing and sequencing, social costs of adjustment and the need for safety nets (on which there is growing consensus)—to reasons for the observed unevenness in implementation. More attention is given to the environment in which policy decisions are made and to the capacity of the government to launch and then sustain the process of economic reform. Limited institutional and management capacity has been identified as a major cause of policy failure in the light of the analyses of developing countries, East Asian and East European experiences (Wade, 1990; Clague and Rausser, 1992; World Bank, 1993,1994a). This ability to carry out reforms effectively has proved, however, to be multifaceted and also inordinately complex. The World Bank, the most influential contributor to debate on economic policies, focuses on the technical elements of

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‘sound development management’ (World Bank, 1992b: 1). It looks to strengthen the state, through predictable, open and enlightened policy making, a bureaucracy imbued with a professional ethos and an executive arm of the government that is accountable for its actions (World Bank, 1994c: vii). Others emphasise the political environment in which reform takes place (Haggard and Webb, 1993; Frischtak, 1994) or see policy as the outcome of a bargaining process, both within the country and with external donors (Thomas and Grindle, 1990; Mosely et al., 1991; Hyden and Karlstrom, 1993). It is our contention that, while good governance may be highly desirable based on democratic criteria, it is not an essential condition for effective economic reform. On the contrary, when the state is not strong, as in the case of contemporary Sri Lanka—where it is neither sufficiently cohesive nor sufficiently disciplined to implement economic policy effectively—the capacity for economic reform and for better governance is likely to be a function of political will. Political authority and strong political leadership become the crucial issues. We argue that, from 1989 to 1993 (the Premadasa years), it was strong political leadership—entailing a powerfully articulated and compelling goal for Sri Lankan society; determination to achieve it; decisive decision making; an ability to pick and rely on officials who could get things done; and a capacity to think strategically about the sustainability of the programme—that was crucial in the implementation of the economic reform process, albeit at the price (in the technical sense of the bank) of conspicuously bad governance. The period in itself is one of considerable interest in the development history of Sri Lanka. A large body of literature exists on the early years of liberalisation from 1977–88 (Herring, 1987; Jayawardena et al., 1989; Lal and Rajapatirana, 1989; Cuthbertson and Athukorala, 1991; Athukorala and Jayasuriya, 1994). However, the second wave from 1989–93—a dynamic but controversial period in which the style of government was paramount—has not been seriously documented. This chapter is also an attempt to close this gap. Its structure is as follows. The next section sets the stage; it explains the need for a second wave of liberalisation at the end of the 1980s, provides a brief overview of the policies that were introduced and assesses what was achieved. The section after that, identifies technical problems in the implementation of policy and the influence of political priorities, followed by the section that analyses what happened from the stand-point of governance. The last section contains concluding remarks.

The Background The Need for a Second Wave of Economic Liberalisation Before 1977, the Sri Lankan economy was inward-looking and highly regulated. Exports were dominated by tree crops. State corporations were ubiquitous. The country had an entrenched welfare tradition and almost half-a-century of universal

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franchise, together with high rates of literacy, had nurtured strong political consciousness among the population. There was widespread politicisation of administrative processes (and of public life generally), an established culture of political patronage and an astute awareness of ethnicity (Lal and Rajapatirana, 1989; Moore, 1990; Jayantha, 1992). Liberalisation meant a major reorientation of the Sri Lankan economy, but one that was at some point, bound to encounter problems of governance. Nevertheless, managing the process of reform was not initially an issue. The United National Party (UNP) that came to power in 1977 had a four-fifths majority in the Sri Lankan Parliament; it had a strong political mandate for economic reform and executive power was centralised in the Presidency under a new (1978) constitution. Liberalisation measures were mainly concentrated in the first three years when the economy grew strongly (on an average 6.6 per cent a year during 1978–81) and when the population (and the urban middle class in particular) were buoyedup by the material gains from deregulation. A massive influx of foreign aid then helped distract from questions of governance. Liberalisation was overtaken by a commitment to major infrastructural projects and to the Accelerated Mahaweli Development Programme (AMDP) in particular—a billion dollar land settlementcum-hydroelectric project—that swamped all other endeavours. The AMDP was largely donor-funded and involved such an extraordinary inflow of concessionary aid that accountability and efficiency became low priority. It offered the politically important vision of a renewed (Sinhala) society—and it meant that the government was never forced to choose between economic reform and political patronage because it could afford to continue its commitment to loss-making state enterprises and also because aid provided a bonanza of state employment and influence (Moore, 1990).1 The AMDP however, had serious deleterious effects on the macroeconomy. The sheer scale of the project was such that it fuelled the budget deficit, generated inflationary pressures and created ‘Dutch disease’-type effects, undermining incentives to exporters from the initial liberalisation (Lal and Rajapatirana, 1989; Athukorala and Jayasuriya, 1994). Sri Lanka’s external terms of trade declined sharply, by 44 per cent between 1977 and 1982. External debt quadrupled in the early 1980s, official reserves were run down to plug the current account deficit and the government resorted to commercial borrowing to finance the budget deficit. The decade 1977–88 was one of mounting macroeconomic instability, exacerbated on the political front by manipulation of the law and by a growing atmosphere of violence after the July 1983 riots. By that time, the government’s honeymoon was over. A major conflict was developing in the north and east, there was increasing use of force and the government’s popularity was waning. Terrorism and insurgency then permeated the south during 1987–89. The situation was inconducive to any radical attempt to restructure the economy as the growth rate fell (to 1.5 per cent in 1987) and as presidential and parliamentary elections loomed large in late-1988 and 1989. Policy makers were preoccupied with crisis management and, as their room for manoeuvre narrowed, economic reform was put on hold.


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The Second Wave Policies By 1988, a stabilisation programme had been agreed the with the International Monetary Fund (IMF) under its Structural Adjustment Facility (SAF) and further reforms had been planned, only to be stymied by the insurgency and by demand pressures unleashed by the on-coming elections (PIP, 1989). But with the re-election of the UNP under its new leader Ranasinghe Premadasa in February 1989 and with a failed insurgency in the South (despite vehement opposition on the grounds of human rights abuse) the stage was set for a second wave of liberalisation in the Sri Lankan economy. Three broad areas of policy were to emerge2—the stabilisation programme or what we call the ‘bread and butter’ reforms and three initiatives that were heavily publicised and politically high profile. Preparation of all these initiatives had begun before the elections, but ‘the new vision’ that was conveyed in the UNP manifesto was to prove more a wave of reform than that of the earlier period.

The Stabilisation Programme In mid-1989, the Sri Lankan government embarked on a far more serious stabilisation programme than it had been prepared to consider in the past (Chapter Three). The programme was fairly conventional, involving tight monetary policy and sharp reductions in both the current account of the balance-of-payments and the budget deficit (see Table 4.1). It was also to keep the door open to substantial donor assistance.3 Table 4.1 KEY MACROECONOMIC TARGETS OF THE PFP, 1989–91 Indicator Real GDP growth Budget deficit Inflation External current account deficit

(% p.a.) (% GDP) (% GDP) (%GDP)

By End 1989 2–3 12.5 12 Around 10

By End 1993 Around 5 8 6 Around 5

Sources: Policy Framework Papers 1989–92 and 1990–93 and the Public Investment Programme.

Bread and Butter Reforms The stabilisation effort and the up-turn in the economy after the end of the insurgency paved the way for a series of technically important, but low-profile adjustments: 1. A reduction of the maximum nominal tariff on imports (to 45 per cent in 1993), the introduction of four tariff bands and the progressive elimination of duty on traditional exports.

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2. Devaluation of the rupee (from Rs 34/USD mid-year to Rs 40 in September 1989 and to almost Rs 50 by the end of 1993). 3. A reduction of income and corporate taxes (to 40 and 35 per cent respectively) and the abolition of wealth and capital gains taxes in 1991 (with a view to stimulating the capital market, improving tax compliance and increasing administrative efficiency); and further liberalisation of commodity and financial markets.4 Though the measures had negative consequences for groups in Sri Lankan society, they were never seriously contested.

High-Profile Projects The third series of measures were highly publicised and were the flagships of Premadasa’s policy—export promotion, ‘peoplisation’ and the alleviation of poverty. 1. Export promotion was the cornerstone of the new president’s vision of NIC status for Sri Lanka by the year 2000.5 Priority was given to export-oriented industrialisation and to a more liberalised trade regime (MOI, 1989; PIP, 1990), and in November 1990 an Investment Policy Statement made important changes to the foreign investment policy framework (Athukorala, 1995). An Export Development Plan was formulated and the 1990s were heralded as ‘The Decade of Exports’. Tax holidays, previously confined to Export Promotion Zones (EPZs) were extended to all exporters who met government export criteria.6 The Foreign Investment Advisory Committee (the approval body for foreign investment outside EPZs) was absorbed by the Greater Colombo Economic Commission (that for EPZs) in January 1990 and the latter was renamed the Board of Investment (BOI) in November 1992—as a ‘one-stop shop’ assisting investors and approving foreign investments. 2. Privatisation under Premadasa was designated peoplisation, reflecting concern for worker support by conferring broad-based ownership. In principle, corporate investors were to be the majority shareholders and exercise management control, 30 per cent of the shares were to be offered to the public and up to 10 per cent gifted to workers (PIP, 1990). Compulsory retrenchment was only to be resorted to as a final option (UNP, 1988). The necessary legal framework had been created in 1987 and two institutions, the Commission on Peoplisation (later absorbed in the Public Investment Management Board) and the Commercialisation Division of the Treasury, were to implement the process (Kelegama, 1993). New measures were announced in the 1990 and 1991 budgets to help mobilise savings.7 3. The UNP had committed itself to a major programme of poverty alleviation in its election manifesto. President Premadasa was quick to respond to perceptions of the rural poor and urban working class that the ‘middle-class’ dynamics of early liberalisation had effectively by-passed them. The cash-value


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of foodstamps was doubled and a major poverty-alleviation project (the Janasaviya Programme) was launched in 1989 as a lead project of the government under the personal supervision of the president.8 It was later supplemented by programmes providing school uniforms and midday meals and a programme to establish 200 garment factories in rural areas was launched in late 1991 (Chapter Three).

The Achievements The period between 1989 and 1993 demonstrated the remarkable resilience of the Sri Lankan economy as it bounced back from an insurgency that had brought most economic life to a halt. The macroeconomic situation improved (see Table 4.2) and there was a solid average annual GDP growth rate of 5.5 per cent—despite bomb blasts in the south and continuing war in the north and east. Most growth came from the private sector, with the mainstay, manufacturing (which grew at 7 per cent per annum) and more particularly, garments for export (12.2 per cent).9 Majority shareholdings of 35 state-owned enterprises had been divested by the end of 1993 (and a further 30 were in various stages of divestiture). The share of the public sector in GDP had seen a marked decline and the stock market surged in 1990–91 with inflows of foreign portfolio investment. The Quarterly Labour Force and Employment Survey recorded a drop in unemployment (DCS, 1994), the nutritional status of the poor improved and the incidence of poverty declined (World Bank, I994c). On all these scores, the government’s economic record seemed sound. Table 4.2 ECONOMIC INDICATORS, 1988–93 Criterion

1988

1989

1990

1991

1992

1993

GDP growth (% p.a.) Inflation (% p.a.) Budget deficit∗

2.7 14.0 15.6 5.6 22.5 12.0 21.1

2.3 11.6 11.2 4.4 21.5 12.2 22.3

6.2 21.5 9.9 3.2 21.9 14.3 24.7

4.6 12.2 11.6 5.4 22.6 12.7 22.6

4.3 11.4 7.4 4.5 23.5 15.3 25.9

6.9 11.2 8.1 3.8 24.0 15.5 26.6

External current account Investment∗ Domestic savings∗ Exports ∗

Sources: Central Bank of Sri Lanka, Annual Report (various years) and the Institute of Policy Studies Database. ∗ Expressed as a percentage of GDP.

Nevertheless, there was a pervasive view that it could still have done better. Economic performance lagged behind government projections in the Public Investment Programme (PIP). Foreign direct investment (at 1 per cent of GDP) was disappointingly low and it was increasingly apparent that the vision of NIC status by the year 2000 would prove elusive (Chapter Two). War also put a brake on the rate of foreign investment, but the problems ran deeper. There was less coherence and consistency in government policy and particularly in implementation. In the

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technical sense of the World Bank, there were problems of governance. The government hedged on key reforms (such as restructuring and privatisation of the two state banks that controlled almost 60 per cent of the banking assets of the country). There was insufficient regulation of private sector activities, discriminate use of fiscal incentives and a growing victimisation of those linked to political opponents. So was ‘bad governance’ impeding reform and retarding the rate of economic growth?

Impediments to Growth From the technical vantage point of the World Bank and of national planners in Sri Lanka, greater consistency and transparency in government policy would have seen higher rates of growth (World Bank, 1995). As we shall show in the next section, there was also, however, evidence that economic and political strategies were interlinked and that the capacity for reform was a function of ‘the kind of politics and state that can ... sustain and protect it’ (Leftwich, 1994: 365). This section illustrates technical problems that were emerging in the management of economic policy. It looks first at problems of stabilisation and then at the question of institutional support for the liberalisation agenda.

Macroeconomic Stability and Desire for Growth The Latin American experience, and more recently that of Eastern Europe, suggests that reforms are easier in a stable macroeconomic environment. That was also the case in Sri Lanka after 1989. The reform package nurtured contradictions, however, that were also potentially divisive. Tight monetary policy led to high interest rates and to private sector protests about the cost of capital (World Bank, 1992a; 1995).10 To what degree high interest rates were a deterrent to investment remains controversial but, as Nelson anticipated, in a poor country—where the private sector is small and less organised than in the NICs or advanced industrialised nations, firms tend to press for relief in the form of concessions rather than for changes in policy (Nelson, 1984: 996). Tax and tariff concessions were demanded (along with offshore borrowing) in order to fulfil the role the government had assigned to them as the engine of growth in the economy. What we show in this section is how the determination to spur higher levels of investment and to meet ambitious welfare targets affected the macroeconomy. The government awarded tax holidays and other incentives to stimulate the higher levels of investment that were needed to achieve NIC status for Sri Lanka. The process was to be export-led. By favouring new exporters at the expense of existing export and import-substituting firms, however, it created definite distortions. It also eroded the tax base because of the number of exemptions and because large companies could shift costs from tax-paying to tax holiday units (a move that was hard to police with limited tax enforcement facilities). Revenue losses had then to


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be offset by ad hoc measures—the imposition of a 15 per cent income tax surcharge (initially for two years to make up for low compliance and problems of administration during the years of insurgency, but subsequently continued) and a defence levy (1 per cent of turnover when introduced in 1992 and eventually 3 per cent in 1993). The defence levy alone yielded 6.7 per cent of total government revenue in 1993, up from 4.4 per cent in 1992 (Central Bank, 1993: Table 69). The extra costs fell largely on the corporate sector, but were passed on, wherever possible, to the consumer, leading to a ‘cost-push’ inflation. The situation was also complicated by private capital inflows. In the aftermath of the Gulf War, high real interest rates in Sri Lanka (over 7.5 per cent every year from 1989–93 except 1990 and 9.3 per cent in 1993) stimulated both increased remittances, up from SDR 258 million (5.2 per cent of GDP) in 1989 to SDR 453.6 million (or 6.7 per cent of GDP) in 1993 and short-term portfolio investment. The latter was interpreted as a sign of the country’s economic success—net inflows having risen from almost nothing in 1989, to SDR 48 million in 1993 (Central Bank, 1994). There was inevitably some conversion of these funds into local currency, adding to the money supply, strengthening the case for tight monetary policy and keeping up the real cost of borrowing. Liberalisation of exchange controls on current account transactions and the abolition of foreign exchange surrender requirements on export transactions towards the end of the period (in March 1993) reinforced the trend. The result was an increasingly unstable macroeconomic environment and mounting pressure for special treatment from the private sector. Moreover, once favours had been granted to industrialists who joined the president’s Two Hundred Garments Factories Programme (THGFP),11 it became increasingly difficult to deny them to others who made claims on the grounds of equity or loyalty to the government during the period of insurgency. Time-series data on the numbers of tax holidays are hard to interpret because they reflect a combination of factors (the increasing number of approvals, changing rules on entitlement, as well as irregularities). BOI data (which capture only a part) reveal a sharp increase in the number of concessions from 14 in 1989 to 325 in 1993, with a rising proportion of BOI approved projects being granted tax holidays (up from 40 per cent in 1989 to 70 per cent in 1993). Though equally difficult to evaluate in any quantitative sense, rationalisation of the tariff structure into a four-band system appears to have been accompanied by an increase in duty waivers. It is claimed that the government lost almost Rs 8 billion from these exemptions (Ministry of Finance, 1995). Rent-seeking increased: interest groups were created to win concessions and those who lacked an organised mouthpiece at the national level (such as the peasantry) were simply left behind. Moreover, despite the surcharge, the defence levy and net proceeds to the government from its privatisation programme (roughly Rs 8 billion by the end of 1993), the increasing number of concessions meant a shortfall in revenue. The Janasaviya Programme proved an over-ambitious, poorly targeted and potentially costly election promise (and it was viewed contemptuously by professional economists and by the Colombo urban elite). Nevertheless, it was pushed through; it made a major impression on the electorate and welfare expenditure—having fallen from 19.9 per cent

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of government expenditure in 1979 to 11.8 per cent in 1988—rose to 16.9 per cent in 1993. On-going war and decentralisation to reduce secessionist grievances were added expenditures. Defence expenditure was over 4 per cent of GDP and with the cost of rehabilitating refugees, made enormous demands on the budget. The government also awarded public servants an across-the-board wage increase of 30 per cent towards the end of 1992, to secure their support. The result was a persistently high budget deficit (an average 9.6 per cent of GDP) that was contained by holding down capital expenditure in real terms.12 Major investments in telecommunications, transport, irrigation and power, essential for longterm growth of the Sri Lankan economy, were postponed to protect recurrent expenditure which was more sensitive politically,13 and low investment in physical infrastructure (together with poor maintenance) increased costs of production and fuelled the pressure for concessions. Thus, behind the reforms and the growth that was achieved in the post-1989 period, there were pressures on the macroeconomy brought about partly by the war and by external factors, but far more by populist welfare measures and a determination to generate high levels of investment and employment at almost any cost to realise the president’s vision of NIC status by the year 2000. In the next section, we argue that these measures reflected a concern with the overall sustainability of the government’s policy package. First, however, we look briefly at the institutional setting.

Institutional Structures as a Brake on Growth? During the Premadasa reforms, the way institutions functioned was given low priority, despite the difficulty in implementing many policies effectively. So, was the institutional framework overstretched and inadequate? Institutional shortcomings certainly weakened the reform effort, but to what extent they were a brake on growth is again more contentious. Isolating such effects is extremely difficult, but there was little concrete evidence that institutional rigidities were a major deterrent to private sector investment. Presidential authority, as we shall see circumvented many of these difficulties. Technical concern with the need for institutional reform had been voiced in Sri Lanka by 1989. An Administrative Reforms Committee (ARC), set up to simplify the machinery of the government and equip it for the needs of a liberalised industrialising economy, had reported in 1988 (ARC, 1978).14 The World Bank was pressing for rationalisation as part of a programme of privatisation and cost containment. National planners were calling for the ‘streamlining of bureaucratic procedures which affect private sector activity’ (PIP, 1989: 3), and it was clear that the range of post-1989 reforms put pressure on administrative resources. There was no concerted effort, however, to strengthen public institutions other than through privatisation. Cadre reductions and up-grading were not, for example, achieved in the civil service. A voluntary retirement scheme was introduced; generous severance packages doubled the civil service pension bill, but new appointments continued. Competent


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managers, who could find private sector employment, took up the offer of retirement, reducing managerial capacity—and many were subsequently re-hired as consultants to fill the gap they had left (Wanasinghe, 1994). Overall, employment in central government, provincial councils and local authorities rose by 15 per cent during 1989–93 (Central Bank, 1991; 1994: Table 26), with no marked improvement in cadre quality. The chairman of the ARC, looking back, deplored, ‘the continuance of pre-ARC practices, based on a concept of partisan political control over public officers’ (Wanasinghe, 1994: 18). It nurtured low morale, low levels of accountability and reduced transparency. Difficulties were also experienced elsewhere in public sector management. Lowresult, supply-oriented training programmes exacerbated the shortage of managerial and technical skills in the Sri Lankan economy (Kelly, 1992; World Bank, 1994b). There was no attempt to reorient public sector research and development (R&D) to the needs of a market economy. New institutions were created (such as the Securities and Exchange Commission, the Plantation Restructuring Unit, the Public Investment Management Board and the Board of Investment) with mixed results, but a common ingredient in many of their problems was political interference. Technical coordination, as a result, was difficult. Regulatory frameworks were also a hindrance. Liberalisation had seen ad hoc efforts to update the legal system.15 But there had been no systematic legal review to meet the needs of a market economy. Debt recovery laws were weak (15,000 debt recovery cases were pending in Sri Lankan courts), which made it difficult for small and medium firms to obtain loans without substantial collateral. Orderly closure of firms was complex because the Termination of Employment of Workers Act governed loss of jobs and because of procedures for creditor filing and prosecution (significantly, no bankruptcies were declared during the period). Labour legislation was a perennial source of complaint by the private sector (Prywes, 1995).16 There was, therefore, a need for institutional reform that was overlooked. In part it was not surprising. Institutional changes tend to lag behind the opening up of an economy (Chapter Three of this book; Rajapatirana, 1995). Some weaknesses only become clear when policies are implemented and a hasty and inappropriate regulatory frame-work can be more a problem than a boon. In the Sri Lankan case, however, ‘far-reaching restructuring of the administration’ had been promised in the UNP’s re-election manifesto (UNP, 1988: 25) and there were repeated declarations by the president against the waste and inefficiency in the government bureaucracy. So why was so little done? Some reasons for the failure to act were fairly transparent. The political costs of adjustment were just too high. The crucial role of the public sector as a source of employment and patronage could not be changed in the short run. As a result, decentralisation was carried out without contraction at the centre and a scheme was drawn up (on the express instructions of the president) to employ 15,000 educated non-graduates in village schools. During 1989–93, the number of teachers rose from nearly 147,000 to 176,000, with most additions being at primary level, where declining birth rates meant that in future they would not be needed (World Bank, 1994b). Nor could labour legislation be easily modified. Codification of labour

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laws and repeal (or amendment) of the Termination of Employment of Workers Act of 1971 were elements of the government’s (1989) Strategy for Industrialization. Attempts at reform however threatened rights that people had fought for and they were bitterly resented. Privatisation, vigorously promoted in 1990–91 ran into problems partly for this reason.17 Opposition of trade unions to labour retrenchment in state-owned enterprises prior to privatisation (at a time of mounting allegations of corruption and ‘cronyism’) made the government increasingly cautious (Kelegama, 1993). The government found it difficult to broach the subject of dismantling of labour legislation because unions that had been repressed for almost a decade interpreted such moves as another attack on the tradition of labour protection. But, perhaps more importantly, the shortcomings in these areas were not considered to be crucial. Certainly, Premadasa did not view institutional change the same way as the economists did. Institutions were created (and adapted) to serve high-profile projects. But to an important extent, Premadasa’s political survival (and that of the economic reform effort) hinged on his ability to react to grass-roots perceptions of an often distant bureaucracy. Hence, the importance he attached to decentralisation and to a series of populist initiatives such as the ‘mobile secretariat’— where high-ranking officials were required to travel to outlying areas to solve local problems. These visits were viewed by officials as an unnecessary encumbrance, but they show institutions were changed to serve a political agenda—as a response to ethnic conflict in the north and east, to improve the effectiveness of policy and policy implementation and ‘to bring government to the people’. The adjustments made were politically motivated and they were unconventional, but reform and growth were sustained because the president convinced potential losers that they were not overlooked and would also gain.

Politics and Governance The Premadasa years have been characterised as a period of centralised, autocratic and authoritarian government, accentuating a trend that had been moulded with the creation of an executive presidency (Moore, 1990; Wijesinha, 1991; de Silva, 1993). That is not, however, a sufficient explanation of the Sri Lankan experience after 1989. The Premadasa government, for example, was never monolithic. Throughout 1989–93, there were two inputs to policy. There were efforts (mainly on the part of the Ministry of Finance and the Ministry of Industries) to pursue a fairly conventional stabilisation-cum-liberalisation/industrialisation programme, and there were populist concerns emphasising gains for the poor and the political sustainability of policies that had been introduced. These have been represented as two sets of policies (Lakshman, 1993), though we would argue that they were both integral parts of the reform process—that it had to make ‘not only economic but also political sense’ (Hyden and Karlstrom, 1993). It is this that we attempt to explain in the following paragraphs.


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The Premadasa government that came to power in 1988–89 had to tackle forceful realities. There was a macroeconomic crisis and it was under severe political pressure with insurgency and with opposition challenges to the validity of the presidential elections (de Silva, 1993). The macroeconomic situation had to be resolved quickly. The government was desperate for balance-of-payments support and for further concessional aid to rehabilitate the economy. Official reserves fell to the equivalent of three weeks of imports in June 1989 and it was clear that largescale aid would be contingent on stabilisation of the economy and further liberalisation (Chapter Three). The programme of economic reform was rapidly initiated and proceeded largely uninterrupted with the World Bank and other donor support. The second aspect was more complex. The new president came from a modest background and there was mutual antagonism between him and the Englishspeaking, professional and urban-based landed elite that had in the past dominated his party. Being an outsider and having genuine concern for the poor, he looked to non-elite groups for political support and was intent on radically changing the social base of the UNP and of the government machinery (Uyangoda, 1993). He was preoccupied with what Waterbury (1989) has referred to as ‘coalition building’ incorporating the rural poor, an urban underclass and a new politically created (largely Sinhalese) business class into the party structure. Many of the latter were not particularly committed to a market economy, but their support was considered to be necessary. There was also a price to be paid for the more professional party structure that had emerged in the 1970s and 1980s. Referring to that period, Moore argued that ‘unless it were to jeopardise its party machine in the electorates, the UNP could not have ignored the patronage demands in favour of sound economic policy’ (Moore, 1990: 351). This applied with equal force to the Premadasa years. Clearly, then, if the reform programme was to succeed, patronage had to continue. It was crucial that the government’s economic policies were seen to yield benefits for the non-elite strata of society. The 60,000–70,000 new jobs created each year (plus additional retirements) were not enough for the 120,000 new entrants to the job market, let alone to reduce the backlog of the already unemployed. The president was also aware that unemployment and marginalisation of the poor fed extremist agitation and the UNP manifesto for the 1989 parliamentary election accorded ‘the highest priority’ to job creation and to increasing the access to assets of poor groups in society. The time horizon for achieving results had, however, to be short to maintain credibility and if liberalisation failed to generate the desired investment (and with it employment and incomes) it was felt justified to force the pace using less-conventional methods. Hence, the drive for NIC status by the year 2000, something that had to be achieved by whatever means. Moreover, while the personal power of President Premadasa was hard to overemphasise and was sometimes used in a discriminatory and intimidatory manner, the economic situation as such was not unpredictable. The reform process was never in danger of reversal and the government was consistently and staunchly proprivate sector. There was a revitalised business climate; the private sector supported the thrust of the reforms and private sector industrial performance was particularly strong. Liberalisation and privatisation had made major advances. Nor was there

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any ambiguity about the clientelistic nature of the state or about the rewards that could be secured by close cooperation with government—about the incentives that would be granted, or the almost immediate redress of grievances or administrative encumbrances. Nor were investors unaware that demands might be made on them if they did cooperate, or that there could be a heavy price for intransigence. The post-1989 period was in that sense very clearly structured. These developments, together, had weighty implications on the formulation of policy. The government’s ‘high-profile’ projects became in important ways nontechnocratic. They had to be, above all else, visible and yield rapid results. The president, assisted by the presidential secretariat and a small coterie of carefully selected ministers and top civil servants, was decisive but not in general disposed to painstaking analysis. There was growing reluctance to accept any move that implied labour retrenchment and job creation was at times pursued regardless of the economic cost or of its ultimate effectiveness.18 There was also a creeping tendency to set up funds outside the control of parliament and heavy expenditure on prestige projects that entailed a considerable diversion of public funds (such as Gam Udawa—village reawakening, the upgrading of Air Lanka and rural housing development), which in the process earned popular support. The Janasaviya Programme (JSP) and the THGFP were, in contrast, forceful and highly innovative departures. They were examples of ‘shock therapy’—attempts to get quick results that could not have been achieved by more conventional measures. The president pushed the THGFP as a high-profile export drive, stretching the BOI to its limits to provide rural employment despite opposition from the bureaucracy. Both programmes were then foisted on the Treasury and the Ministry of Policy Planning, which were required to accommodate them almost regardless of their macroeconomic impact (though the JSP was later phased over 11 rounds as the massive economic implications of the programme became increasingly clear). This determination to accelerate results also had, as we have seen, serious budgetary consequences. It permeated the implementation of government policy. The government exerted pressure to accommodate supporters (and neutralise opponents), a process that was heightened after the attempted impeachment of the president in August 1991.19 The latter was in many ways a watershed. By the middle of 1992, when the THGFP had become a ‘lead project’ of the government, negotiation and lobbying for concessions had begun in earnest. Though little information is available, claims seem to have been considered initially on a case-by-case basis, with willingness to invest and employment creation (and to a lesser extent— party links) as the main criteria. But, over time, personal and party affiliation became more important. There was also a growing element of command, as investment and employment lagged behind expectations. Businessmen were coaxed to set up a garment factory and, though government banks offered ready finance, many ‘would not have participated in the programme if not for the “persuasion” of the government’ (CCC, 1994: 29). Those who complied gained access to tax concessions, off-shore borrowing facilities and export quotas that varied in amount with the difficulty of the location—which, in the aggregate, threatened to disrupt established firms, many of whom found their quotas had been cut to make way for the programme. Those who did not comply ran the risk of blacklisting or intimidation.


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The scope for independent technical assessment of projects or proposals was, therefore, limited. Officials were held accountable to the president and his principal associates. Many were required to acquiesce to political preferences and some were expected to apply regulations on a discretionary basis. This depressed the already low morale of the civil service, resulting in even less accountability and a growing lack of transparency. Lack of accountability had already been highlighted by the ARC and it led to ineffective audit controls and consideration of alternatives and to scope for corruption, negligence and wastage in the everyday business of government (ARC, 1998). Lack of transparency was particularly blatant in the privatisation exercise. One senior official maintained in the mid-1980s, that arrangements existed to hand over state enterprises to individuals and companies close to the government (Karunatilake, 1986) and there was a view that similar considerations were present later (Kelegama, 1993). This may have been the case. But in part the problem was one of haste and effective delivery. The government demanded quick results from the peoplisation exercise. It was not prepared to lose time over an agreed legal framework for divestiture or, in some cases, over the comprehensive annual reports needed to float a new company. In fact, the process was also a learning exercise. The result, however, was a tendency to resort to ad hoc procedures which, whether justified or not, were certainly much quicker but also more vulnerable to allegations of wrong-doing.20 Thus, increasingly after 1991, Sri Lanka revealed characteristics of what the World Bank (1992b: 9) was to define as ‘bad governance’, despite increasing liberalisation of its economy and achieving an average annual growth rate of 5.5 per cent. Public resources appeared to have been diverted to private hands, there was arbitrary application of rules and procedures, rent-seeking was rife and there was a definite lack of transparency in many areas of the government. At different times and to different groups in Sri Lankan society, the Premadasa government was intimidating, arbitrary, benevolent, even capricious, but always powerful and decisive in pushing its policies through. It is arguable that, particularly in the early years, strong (even authoritarian) leadership facilitated difficult decisions on economic policy. There may also have been a case for thinking that—within certain bounds (which the government exceeded)—the Sri Lankan electorate was more likely to vote for a tainted regime that achieved results, than for a saintly one that proved indecisive and then achieved nothing at all.

Conclusions The Premadasa years from 1989 to 1993 saw substantial reform and palpable growth in the Sri Lankan economy. The government pushed hard to assist the poor and to support private sector initiatives that were consistent with its programme; it was anti-elitist and populist and when it came to the implementation of policy it brooked no opposition. What distinguished it from its predecessor (and from the

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regime which was to follow it) was not the adherence to reform or to better governance, however, but the strength of political leadership—‘the steering quality manifest in the state’s conduct of policy’ (Frischtak, 1994: 28). It is our contention that in a weak state, such as that of contemporary Sri Lanka, strong leadership is crucial for effective economic reform. The Premadasa government was ruthlessly efficient in crushing the insurgency and it was prepared to resort to coercion, clientelism or almost any other means to achieve its ends. Nevertheless, it succeeded in projecting a powerful image of the future—what seemed at the time to be a tantalising, almost plausible vision of NIC status for Sri Lanka by the year 2000 and the alleviation of poverty. This, and the determined, often unconventional manner in which it was to be subsequently pursued appealed strongly to the electorate and were in marked contrast to the Sri Lankan experience, both before and after. The president selected lieutenants who were fully committed to his policies and highly effective as managers and he was con-stantly aware that coalition-building and visible results were going to be necessary to maintain momentum and for the sustainability of his programme. Premadasa had inherited an administrative system that was highly politicised and more appropriate for the old interventionist, inward-looking economy than for the needs of liberalisation. This clearly posed a dilemma. It was incapable of the sustained and coordinated implementation of policy needed for effective reform. Any effort to change the system would, in itself, have proved to be a major longterm project and it would have yielded little by way of gains for the president or for the electorate. He, therefore, adapted the system to serve his political agenda. The widespread use of tax holidays, waivers and other favours to induce higher levels of investment, ad hoc arrangements for privatisation, the THGFP, the JSP and the mobile secretariats were all examples of adjustments to achieve well-defined political goals. Strong leadership, in this sense, could never have resulted in better governance. On the contrary, it led to ways of circumventing procedural and other bottlenecks under the guise of presidential authority. For Premadasa, the critical test of his methods was that they produced the desired results within his allocated time span. The significance of the political input was, therefore, paradoxical. On the one hand, strong leadership was necessary to push through difficult decisions and give firm signals of the continuity of the government’s open-market policies—a conclusion reflected in the experience of the East Asian NICs. On the other hand, politicians had to synchronise their time horizons with the electoral cycle and need to build the coalitions that are necessary to support reform. The result can then be a trade-off between ‘quick results’ (which politicians will be inclined to see as a measure of the efficiency of policy and of its sustainability) and ‘good governance’, in the World Bank sense of managerial propriety. This would also appear to have occurred in the case of Sri Lanka with rent-seeking, patronage and populist measures undermining the technical consistency of policy. Those who argued that the growth rate could have been markedly higher with better governance were, to a large extent, the professional economists and the Westernised urban intellectuals


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and businessmen who were also anti-Premadasa. They compared what was theoretically possible with what they endured in reality. But for basic political reasons— because of the intrinsic nature of the regime—shifting the weight from ‘bad’ to ‘good’ governance was not a viable alternative. Some of the domineering authority of the Premadasa government has to be attributed to the Sri Lankan Constitution of 1978 and to the excesses of the Executive Presidency. Nevertheless, President Premadasa’s government was particularly forceful and decisive. He believed that visible gains had to come rapidly if they were to offset adjustment fatigue and provide electoral benefits and to achieve them he felt that the government needed more than political stability. It needed a style of governance that permitted decisional mobility. He believed that the executive had to be in a position to make quick and effective decisions, and the Executive Presidency was an institutional instrument that permitted this type of behaviour. Though Premadasa’s style of governance could not perhaps have been sustained over the longer term, it showed quite clearly that good governance is not a necessary and may not be a sufficient condition for achieving high rates of growth and that decisive leadership can in itself be an important ingredient for economic success.

Notes 1. Whereas structural adjustment required a reduction in public sector employment, it actually rose by 23 per cent during 1977–83 (Central Bank, 1983: 114). In the mid-1980s, 40 per cent of all paid employees were still in the public sector (Athukorala and Jayasuriya, 1994). 2. Examples of earlier preparation can be found in Ministry of Industries (MOI) (1989), in the identification of state enterprises for privatisation (PIP, 1990: 49) and in the 1988 SAF. 3. SDR 156.2 million was made available under the IMF Structural Adjustment Facility (SAP) for the period 1988–90, and USD 600–700 million was forthcoming each year in the form of concessional aid and grants from the donor community. The main contributors were the World Bank, Japan and the Asian Development Bank. 4. Wheat and fertiliser prices were aligned with the world market, duties on imports of raw materials reduced and the Central Bank refinance scheme abolished. By September 1990, only pharmaceuticals remained under price control and a small number of health or securitysensitive items, remained under quantitative controls. Exchange controls on the current account of the balance-of-payments were also liberalised and compulsory surrender requirements for exporters were abolished at the end of the period in 1993. Full convertibility of currency in the current account was achieved in March 1994. 5. There was no strict definition of NIC status, but it was interpreted by politicians as a doubling of per capita income and a rise in the share of the manufacturing sector to over 20 per cent of GDP. 6. Incentives varied from sector to sector, but at least 70 per cent of production was destined for export (over 90 per cent in the case of industrial-based products), they had to be new businesses and they were not to involve the transfer of assets from an existing business in Sri Lanka. 7. It was important for privatisation that the capital market absorb the share issues that would be forthcoming and a number of constraints that inhibited the stock market had, therefore, to be removed. Foreign participants were permitted 40 per cent share-ownership (later 100 per cent in 1992) in all but a narrow range of activities. Measures were introduced permitting

124

8.

9.

10. 11.

12. 13.

14.

15. 16.

17. 18. 19.

20.

Development Under Stress: Sri Lankan Economy in Transition venture capital funds, the establishment of unit trusts with state participation to attract small savers, more effective debt recovery and tax relief on profits from the sale of shares. The Janasaviya Programme, as initially designed, implied an income transfer equivalent to almost 20 per cent of GDP to half the population over a two-year period, during which recipients were expected to develop the necessary skills for (self) employment. As fiscal, inflationary and the potentially divisive implications of the proposal became recognised it was subsequently reduced and staggered into stronger employment orientation. Recipients were to receive Rs 1,042 a month for consumption purposes with Rs 1,458 a month placed in a bank account as forced savings to be available as starting capital at the end of the period, a promise that was never realised. Services grew steadily (at 4.5 per cent)—especially external trade (all over 7 per cent), while agriculture lagged behind (at under 3–7 per cent). Tourist arrivals increased from 184,132 in 1989 to 392, 250 in 1993. Treasury Bills secured over 20 per cent in some years and averaged around 18 per cent over 1989–93. Tax concessions were granted to new enterprises or for the expansion of existing enterprises in the garment sector in 200 identified centres under the THGFP, provided they constructed a new building, employed at least 500 workers, paid a minimum wage of Rs 2,000 a month, provided free breakfast, cups of tea twice a day and medical care facilities on the premises, provided insurance coverage and made no reduction in levels of employment in the parent enterprise. The THGFP was initiated in late-1991. Real capital expenditure rose by 1.5 per cent over the period, while recurrent expenditure grew by 10.7 per cent (Central Bank, 1994). From early 1993, the government looked for private sector involvement in infrastructure development, under ‘Build-Own and Operate’ and ‘Build-Operate and Transfer’ schemes, but the response was weak. It set out to reduce the number of ministries, eliminate duplication and defunct agencies from the pre-reform period; to rationalise systems and procedures, streamline the civil service cadre and up-grade managements skills. The Code of Intellectual Property Law of 1979, the Companies Act of 1987, the Securities Commission Act of 1987 and the Banking Act of 1988 were important examples. There were 46 labour laws in operation in 1989—creating confusion and uncertainty, increasing the cost of labour and reducing labour mobility. Moreover, they provided no clear way out in many key situations, such as the determination of redundancy compensation (Fizbein, 1992). It was the Termination of Employment of Workers Act of 1971, however, that was the bête noire of the private sector. It prohibited the dismissal of a worker with more than one year’s service on non-disciplinary grounds in a firm of 15 or more employees, without the written consent of the worker or approval of the Labour Commissioner. There was also manipulation of trade unions by opposition parties, by factions in the ruling party and by some managers of state enterprises. The growing number of ministries, the self-employment component of the JSP and the block hiring of educated unemployed to be rural teachers are all relevant examples. In August 1991, a parliamentary motion to impeach the president was drafted and widely circulated, alleging impropriety and the misuse of power. The plotters were out-manoeuvred; the president exerted his authority over his party MPs who had courted it and the motion was eventually not introduced (Wijesinha, 1995). It was to have a profound effect on the president’s attitude to opposition. Other regulatory institutions, failed to provide adequate safeguards for similar reasons and partly because they lacked adequate powers and/or expertise. The regulatory body for the privatisation of bus transport (the National Transport Commission) failed, for example, to devise schemes to maintain services on uneconomic routes, to accommodate season ticket


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holders or to ensure that adequate services would be running at off-peak hours. Thus, while the privatisation programme may have been successful, as far as it went, in macroeconomic terms, it was not always perceived by the public to be so efficient. There was loss of public support, and this slowed the process of privatisation—however aggressively it may have been marketed.

References ARC (1998), ‘Report on financial management,’ Report No. 8 of the Administrative Reform Commission, Sessional Paper, No. XI, Parliament of Sri Lanka, Colombo. Athukorala, P. (1995), ‘Foreign direct investment and manufacturing for export in a new exporting country: The case of Sri Lanka,’ The World Economy, Vol. 18, No. 4. Athukorala, P. and S. Jayasuriya (1994), Macroeconomic Policies. Crises and Growth in Sri Lanka, 1969–90, World Bank, Washington, D.C. Central Bank (1983, 1991, 1994), Annual Report, Central Bank of Sri Lanka, Colombo. Ceylon Chamber of Commerce (CCC) (1994), ‘Current status of the Two Hundred Garment Factory Programme’, Ceylon Chamber of Commerce, Colombo. Clague, C. and G.C. Rausser (1992), The Emergence of Market Economies in Eastern Europe, Blackwell, Oxford. Cuthbertson, A.G. and P. Athukorala (1991), ‘Sri Lanka,’ in D. Papageorgiou, M. Michaely and A.M. Choksi (eds), Liberalising Foreign Trade, Blackwell, Oxford. Department of Census and Statistics (DCS) (1994), Quarterly Labour Force and Employment Survey, Department of Census and Statistics, Colombo. de Silva, K.M. (1993), ‘The Bureaucracy,’ in K.M. de Silva (ed.), Sri Lanka: Problems of Governance, ICES, Kandy, pp. 83–98. Fizbein, A. (1992), ‘Labour entrenchment and redundancy compensation in state owned enterprises: The case of Sri Lanka,’ Report No. IDP-121, World Bank, Washington, D.C. Frischtak, L.L. (1994), ‘Governance Capacity and Economic Reform in Developing Countries’, Policy Research Paper No. 254, World Bank, Washington, D.C. GOSL (various issues), ‘Sri Lanka: Policy Framework Paper’, Government of Sri Lanka, Colombo. Haggard, S. and S. Webb (1993), ‘What do we know about the political economy of economic policy reform?’, World Bank Research Observer, Vol. 18, No. 2, pp. 143–68. Herring, H.I. (1987), ‘Economic liberalisation policies in Sri Lanka: International pressures, constraints and support,’ Economic and Political Weekly, Vol. xxii, No. 8. Hyden, G. and B. Karlstrom (1993), ‘Structural adjustment as a policy process: The case of Tanzania,’ World Development, Vol. 21, No. 9, pp. 1395–404. Jayantha, D. (1992), Electoral Allegiance in Sri Lanka, Cambridge University Press, Cambridge. Jayawardena, L., A. Maasland and P.N. Radhikrishnan (1989), Stabilization and Adjustment Programmes and Policies: Case Study of Sri Lanka, WIDER, Helsinki. Karunatilake, H.N.S. (1986), ‘Public Enterprise and the Private Sector,’ Sri Lanka Economic Journal, Vol. I, No. 2, pp. 89–113. Kelegama, S. (1993), Privatization in Sri Lanka: The Experience During the Early Years of Implementation, Sri Lanka Economic Association, Colombo. Kelly, T. (1992), A Strategy for Skills Development and Employment Policy in Sri Lanka, Employment Series No. 11, Institute of Policy Studies, Colombo. Lakshman, W.D. (1993), ‘Notes on the Open Economy: Sri Lanka, 1978–92.’ Pravada, Vol. 2, No. 2, pp. 5–8. Lal, D.K. and S. Rajapatirana (1989), Impediments to Trade Liberalization in Sri Lanka, Thames Essays, Trade Policy Research Centre, Gower, London.

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Leftwich, A. (1994), ‘Governance, the state and the politics of development,’ Development and Change, Vol. 25, No. 2, pp. 363–86. Ministry of Finance (1995), Budget Speech, Government of Sri Lanka, Colombo. MOI (1989), A Strategy for Industrialization in Sri Lanka, Ministry of Industries, Colombo. Moore, M. (1990), ‘Economic liberalization versus political pluralism in Sri Lanka?’, Modern Asian Studies, Vol. 24. No. 2, pp. 345–82. Mosely, P., J. Harrigan and J. Toye (1991), Aid and Power: The World Bank and Policy-Based Lending, Routledge, London. Nelson, J. (1984), ‘The political economy of stabilization: Commitment, capacity and public response,’ World Development, Vol. 12, No. 10, pp. 983–1006. PIP (1989, 1990), Public Investment Programme, Department of National Planning, Colombo. Prywes, M. (1995), ‘Unemployment in Sri Lanka: sources and solutions,’ Report No. IDP-154, South Asia Regional Series, World Bank, Washington, D.C. Rajapatirana, S. (1995), ‘Post trade liberalization policy and institutional challenges in Latin America and the Caribbean’, Policy Research Working Paper No. 1465, World Bank, Washington, D.C. Thomas, J.W. and M.S. Grindle (1990), ‘After the decision: Implementing policy reforms in developing countries,’ World Development, Vol. 18, No. 8, pp. 1163–181. UNP (1988), Manifesto of Action for Investing in People, United National Party, Colombo. Uyangoda, J. (1993), ‘Premadasa as President: A posthumous assessment,’ Pravada, Vol. 2, No. 4, pp. 5–8. Wade, R. (1990), Governing the Market: Economic Theory and the Role of Government in East Asian Industrialization, Princeton University Press, Princeton. Wanasinghe, S. (1994), Activating the Administrative Reform Process in Sri Lanka, Governance Series No. 1, Institute of Policy Studies, Colombo. Waterbury, J. (1989), ‘The political management of economic adjustment and reform’, in J.M. Nelson (ed.), Fragile Coalitions: The Politics of Economic Adjustment, Transaction Books, Oxford, pp. 39–58. Wijesinha, R. (1991), Sri Lanka in Crisis, 1977–88: J.R. Jayawardene and the Erosion of Democracy, Council for Liberal Democracy, Colombo. ——— (1995), Civil Strife in Sri Lanka: The UNP Government 1989–94, McCallum Books Ltd, Colombo. World Bank (1992a), ‘Sri Lanka: Strengthened adjustment for growth and poverty reduction,’ Country Operations, Industry and Finance Department HI, World Bank, Washington, D.C. ——— (1992b), Governance and Development, World Bank, Washington, D.C. ——— (1993), The East Asian Miracle: Economic Growth and Public Policy, Oxford University Press, Oxford and New York. ——— (1994a), Governance: The World Bank’s experience, World Bank, Washington, D.C. ——— (1994b), ‘Sri Lanka: Education and training sector strategy review,’ Report No. 12460CE, 2 Vols, World Bank, Washington, D.C. ——— (1994c), ‘Sri Lanka: Poverty assessment,’ Report No. 13431-CE, Country Development III, South Asia Region, World Bank, Washington, D.C. ——— (1995), ‘Sri Lanka: Private sector assessment,’ Report No. 12514-CE, World Bank, Washington, D.C.

Part III MACROECONOMIC MANAGEMENT

5 THE ECONOMIC COST OF THE NORTH-EAST CONFLICT

Introduction Although, the ethnic conflict has been in existence for quite some time, it got aggravated to an extent where it became a burden on the economy only after 1983 when the LTTE commenced a guerrilla war against the state, known as the ‘Eelam Wars’ (I, II and III). The Eelam War I started in 1983 and continued till 1987–88 until the Indian Peace Keeping Forces established themselves at commanding positions in the North and the East. Eelam War II started in June 1990 after the break-up of the peace talks initiated early that year. The period from June 1990 to December 1994 covers the Eelam War II period. The period from mid-April 1995 to November 2001 is categorised as the Eelam War III period. Sri Lanka’s ethnic conflict is, without doubt, the most intractable problem the country faces. It has blighted its political, social and cultural traditions and has become the biggest obstacle to the country realising its full development potential. Much has been written about the ethnic conflict in Sri Lanka in recent years. Most of the existing literature covers areas such as military operations, socio-political and international aspects, the causes of the conflict, possible solutions, etc. However, an analysis of the economic cost of the conflict has for the most part been lacking. In order to fit the conflict within the broad economic framework of Sri Lanka, an approximate cost that could be associated with the conflict would be useful.

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However, putting numbers to these costs is very difficult. In particular, any attempt to quantify the human and social costs would require subjective and questionable judgements. Yet, an awareness of the magnitude of costs can facilitate more informed decision-making by the direct protagonists. A study by the Institute of Policy Studies of Sri Lanka (IPS) attempted to estimate the economic costs of the conflict for the 1984–96 period by employing an econometric model. The section, ‘Estimating the cost of the conflict’, details the basic approach adopted and highlights some of the findings of the study after a discussion on the background in the very next section. Some concluding remarks are made in the last section.

Background At the time of Independence in 1948, Sri Lanka had very good initial conditions, so much so, that the first Governor-General of Sri Lanka stated that of all post-colonial nations, Ceylon (Sri Lanka) would prove to be the ‘best bet in Asia’. Even by 1960, Sri Lanka’s economy was on a fairly sound footing with her per capita income at USD 141—comparable with that of South Korea (USD 156), higher than that of Thailand (USD 96) and Indonesia (USD 51). Whatever Sri Lanka’s development story had been during 1960–76, there was a radical departure in its economic policies in 1977 with the liberalisation of the economy. It was a new starting point to put the economy on a high growth path. The new liberal policy environment started to attract large multinational companies to invest in Sri Lanka. The international media soon dubbed Sri Lanka as ‘the new investment centre of Asia’ (Far Eastern Economic Review, 23 October 1978). Tourism picked up and tourist arrivals exceeded 400,000 in 1982. Export growth accelerated with the ready-made garment sector giving a high growth momentum to the entire sector. In fact, the only five-year period since Independence where Sri Lanka’s average growth rate exceeded 6 per cent was the 1977–82 period. All economic indicators during the 1977–82 period showed that even though Sri Lanka had not shown a satisfactory growth performance vis-à-vis the high performing East Asian countries during the period 1960–77, the country was on the correct course towards rapid economic development. In fact, many economists at that time believed that Sri Lanka will be able to catch up with some East Asian highperforming nations by the early 1990s (Chapter One). Unfortunately, this was not to be. The Eelam War I that started in 1983 came as a major ‘internal shock’ to the economy and put a brake on the liberalisation process initiated in 1977. The regime found it difficult to further liberalise the economy due to the political and economic instability that resulted from this shock. The growth rates decelerated from 1983 and averaged 3.7 per cent during the 1983–89 period (see Table 5.1). Many other factors other than the Eelam War I, such as the Southern rebellion, policy mismanagement, etc., disturbed the policy regime, but the war’s contribution to this was significant. This can be analysed by looking at the budget deficits during the 1983–89 period. Sri Lanka experienced massive budget deficits throughout the 1980–90 period.

THE ECONOMIC COST OF THE NORTH-EAST CONFLICT

131

Table 5.1 ECONOMIC GROWTH, 1980–96 Year 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 Gr

5.5

6.1

5.1

5.0

5.1

5.0

4.3

1.5 2.7

2.3 6.2

4.6 4.3

6.9

5.6 5.5

3.8

Sources: Central Bank of Sri Lanka, Annual Report (various issues).

However, during the 1980–83 period, large budget deficits were a result of the massive public investment programme centred around the accelerated Mahaweli scheme. The government was of the view that once the projects under the programme were completed in the mid-1980s, the budget deficits would decrease to create a conducive environment for private sector investment. But, this objective could not be achieved due to the escalating defence expenditure from the mid1980s and the period 1985–89 witnessed budget deficits that averaged 12.4 per cent of GDP. Table 5.2 shows that defence expenditure, which was 1.1 per cent of GDP in 1982, escalated to 4.8 per cent of GDP in 1988. The second wave of liberalisation started in early 1990 after the Southern rebellion was crushed in late-1989 and with the cessation of hostilities between the LTTE and the state in the first quarter of 1990. The country showed an impressive growth rate of 6.2 per cent in 1990 but this could not be sustained as Eelam War II started in mid-1990. During the period 1990–94, defence expenditure remained between the range of 4.2–4.5 per cent of GDP. Growth rates fluctuated from 4.6 per cent in 1992 to 6.9 per cent in 1993. Defence expenditure which was Rs 25.5 billion in 1994 (4.4 per cent of GDP) increased after Eelam War III started in April 1995 to Rs 36.4 billion in 1995 (5.4 per cent of GDP) and Rs 46.3 billion in 1996 (6 per cent of GDP). This increase in defence expenditure from 3.5 per cent of GDP in 1985 to 5.4 per cent of GDP in 1995 occurred in Sri Lanka when the average defence expenditure in the developing countries fell from 7.1 per cent of GDP in 1985 to 3.1 per cent of GDP by 1995 (UNDP, 1997: 189). A disaggregated analysis of defence expenditure shows that approximately 45–50 per cent goes for wages and the remainder for military hardware and equipment. The wage component has increased dramatically because of the increase in the recruitment of personnel to the armed forces. Armed forces, excluding the police, quadrapled in size during the decade of 1986–96 (Kelegama, 1999). The total strength of the armed forces in 1996 was above 200,000—higher than in Malaysia (114,500), the Philippines (107,500) and in Australia (57,800) (Asia Week, 1 August 1997). The non-wage component of defence expenditure increased significantly, especially after Eelam War III started, with the purchase of Kfir jets, MI 17, MI 24 and Bell Helicopters, Main Battle Tanks (MTBs), Dovra Gun Boats, ammunition, strategic defence equipment, etc. While an increase in defence expenditure had an overall adverse impact on the country’s investment levels, the damage caused by the war in the North and East has also led to a reduction in the production of goods and services in that area. Many industries such as, among others, the cement factory in Kankesanturai, the chemical factory in Paranthan, the salterns in Elephant Pass and Nilaweli, the ilmenite in Pulmoddai, ceramics at Odduchuddan and Amparai, the paper mill at Valaichenai,

13.5

1,182 572 1,754 121,601 4.4 1.4

804 313 1,117 99,238 3.1 1.1

39,637

17.4

33,531

1983

2,318 3,294 5,612 162,375 10.2 3.5

11.7

55,234

1985

Sources: Central Bank, Review of the Economy and Annual Report, various issues.

1. Govt. Expenditure (lending minus repayments) 2. Budget Deficit as a % of GDP (before grants) 3. Defence—Recurrent 4. Defence—Capital 5. Defence—Total 6. GDP (market prices) 7. 5 ÷1 % 8. 5÷6 %

1982

5,583 5,138 10,722 221,982 14.3 4.8

15.7

74,535

1988

10,317 4,285 14,602 321,784 14.6 4.5

9.9

99,814

1990

17,667 3,105 20,772 499,565 14.7 4.2

8.4

140,460

1993

21,989 3,538 25,527 579,084 15.2 4.4

9.9

167,768

1994

Table 5.2 BUDGET DEFICITS AND EXPENDITURE ON DEFENCE, 1982–96, SELECTED YEARS (RS MILLION)

25,815 10,539 36,354 667,772 18.1 5.4

8.4

200,482

1995

33,117 13,168 46,285 768,934 21.6 6.0

7.8

214,710

1996



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either stopped functioning or were running far below capacity. In the agriculture sector, the rice supply from the Eastern province declined substantially and so did livestock and fish supplies. The Northern and Eastern provinces accounts for nearly 59 per cent of the island’s fish production, but many fishermen ceased to operate in the waters from Kalpitiya in the West to Pottuvil in the East. In the services sector, many attractive tourist destinations such as Pasekudah, Nilaweli, Arugam Bay, Marble Bay and Wilpattu became ‘no go’ areas during the war years.

Estimating the Cost of the Conflict The above background may give an idea of the costs involved. The methodology adopted by the IPS study proceeds on the basis that the economic costs of a violent conflict or war can be classified into two categories: direct and indirect cost (Arunatilake et al., 2001). These may be further subdivided into short-term and longterm costs. Direct costs are those directly and immediately attributable to the conflict, such as destruction and damage to capital assets and labour, extra military expenditures incurred by all parties to the conflict and refugee care. Indirect costs include those that are the by-products of the conflict, and may include capital flight, loss of potential foreign capital and tourist inflows and emigration of skilled labour. Some of these costs, such as destruction of capital assets, obviously have both short-term and long-term impacts. For example, damage to a capital asset results in the loss of capital services not only in the short term but also over the entire duration of its projected lifetime. Other costs, such as refugee care, is primarily short term, while the cost of lost investment, which affects the rate of economic growth is primarily long term. But even in the case of refugee care, there can be long-term costs. In addition (and partly because of), the psychological stresses and trauma, education and other forms of productive human capital acquisition (such as learning by doing) are disrupted with the result that the average skill level of the work force falls, with long-term effects on output. Of course, it is possible that given the right kind of environment, some skills that are acquired in conflict situations—such as skills gained by military personnel—may have civilian uses and raise subsequent productivity. However, in an environment where the maintenance of law and order is weak, such skills can be put to criminal uses that are highly damaging to society. Several studies have explored the relationship between military expenditures and economic growth. Most of them have found a negative relationship between the two variables, consistent with the view that government investment is crowded out by higher-military expenditures. But this crowding out effect is not always the only, or even the main, reason why increased military spending may dampen growth. The response of private investment may be crucial: increases in military spending are not always associated with outbreaks of war, but they may signal the existence of underlying tensions with the potential for violent conflict. Thus, increases in military spending may be correlated with a poor investment climate which reduces private investment. The degree to which reductions in government investment have

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any significant direct effects on growth depend critically on the efficiency of those investments. In principle, this is true of all types of reduced investments, or potential higher investments foregone (which may occur if foreign investment flows that might otherwise have come are deterred by a conflict situation). A similar approach is valid when computing losses due to destruction or damage to ‘capital’ assets (including infrastructure, cultivable or otherwise productive land and other durable assets). Investments are basically additions to existing capital stock, though the efficiency of new investments may differ, both relative to old capital stock and among themselves. In principle, the cost of damage or destruction to capital can be computed as the sum of discounted net present value of the stream of capital services that would have been generated by them. Thus, to take an example, the cost of a power plant that is destroyed is the loss of power over its lifetime. If that plant can be and is replaced, then this cost is not incurred and the relevant social cost then is its replacement cost. Labour force reductions due to death, disability or emigration imposes similar costs, with the costs varying with the level of human capital (education and other skill levels, etc.) embodied in the different categories of labour. Some of the economic costs that are related to political and social changes brought about by conflicts can be less tangible and extremely difficult to measure. But they may be large in magnitude. Thus, a protracted conflict constrains the political ability of governments to pursue economically optimal policies and may force the abandonment of well-designed development strategies and policy reforms. For example, trade reforms identified as potentially beneficial may be abandoned because they may alienate a particular producer group whose political support is considered vital. A common hazard associated with such conflicts is that the scope for corruption increases dramatically due to the lack of transparency in arrangements for military procurement. Table 5.3 sets out a summary of the estimated direct and indirect costs of the conflict computed by the IPS study. All reported costs are for the period 1984–96, in prices that were valid in 1996. They are compounded using an interest rate of 5 per cent unless otherwise stated. It can be seen that the conflict has cost the economy nearly 170 per cent of its total output for 1996. Indirect costs are of a far greater magnitude than the direct costs and the lost earnings due to lost foreign investment tops the bill by a significant margin. However, these figures are probably an understatement, as there are many other economic costs that cannot be quantified. For example, it is not only in the conflict areas in the North, the East, but also in border areas of the North–Central and North Western Provinces, that there is widespread, abject poverty and destitution. The conflict has also reduced the health stock of people in these areas: malnutrition, infant and maternal mortality rates have increased and many people were suffering from trauma due to conflict-related violence. The education system has been disrupted, there has been an increased militarisation of Sri Lankan society, and a general breakdown in law and order. There has been capital flight on the one hand and the migration of skilled labour, on the other. At the same time, the need for increased security has created infrastructural bottlenecks, increased traffic congestion— particularly in the capital—and so imposed further costs on the economy.


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Table 5.3 COMPOUNDED PRESENT VALUE (1996) OF ESTIMATED COST OF THE WAR, 1984–96 (MILLION OF 1996 RS) Interest Rate (r = 0.05) Direct costs Direct government military expenditure LTTE military expenditure Government expenditure on relief services1 Cost of lost infrastructure1, 2 Indirect costs Lost income due to forgone public investment Lost income from reduced tourist arrivals Lost earnings due to lost foreign investment Lost income due to displacement (up to 1995) Lost income due to lost human capital of dead or injured persons3 Output foregone in the Northern Province in 19964 Total

287,543 41.33% 28,754 4.13% 20,742 2.98% 93,584 13.45% 59,884 8.61% 118,365 17.01% 495,252 71.19% 38,219 5.49% 17,229 2.48% 9,031 1.30% 1,168,603 167.99%

Source: Arunatilake et al., 2001. Notes: 1. Due to lack of yearly data, values given in the last two columns are not compounded. 2. This includes rehabilitation and reconstruction in the North and the East up to 1995 (85,034), infrastructure in the greater Colombo area up to 1996 (4,500), damages to houses in Jaffna in 1996 (4,050). 3. Income could also have been lost due to ‘brain-drain’, however, because of data problems this cost is not included in this calculation. 4. Cost of damages on top of damages to houses.

Even so, the most obvious direct cost related to the conflict is the sharp increase in defence expenditure, constituting the second largest item of the economic costs of the conflict. Altogether, the government has spent nearly Rs 288 billion, or roughly 41 per cent of Sri Lanka’s GDP in 1996 on defence during the 1984–96 period. The LTTE has also expended substantial resources on military operations, believed to be at least 10–20 per cent of what the government has spent. Moreover, over the years, the conflict-driven deficit has crowded out private investment on the one hand, and, by reducing the amount of resources available for public investment, failed to crowd in adequate levels of private investment. Government borrowing to bridge the deficit has exerted an upward pressure on interest rates and created liquidity problems in the financial system. On the other hand, the IPS study shows that government military expenditure has had a significant, negative effect on government investment both in the short run and the long run, implying

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that military expenditure has crowded-out government investment. Every one per cent increase in military expenditure has been estimated to reduce public investment by 2.4 per cent. In turn, foregone public investment has meant that Sri Lanka could not realise its full growth potential. Thus, the extent of lost income due to foregone public investment has amounted to nearly Rs 60 billion in 1996 prices. However, the hardest hit has been the flow of foreign direct investment (FDI) to the economy. The estimated cost of foregone foreign investment flows amounted to a staggering 71 per cent of Sri Lanka’s GDP in 1996. The impact of the conflict on FDI flows is clearly apparent in Figure 5.1. There was a marked increase in FDI following the policy turn-around in 1977, followed by a sharp collapse immediately following the escalation of the conflict in 1983 and the bombing of economic and civilian targets in the South by the LTTE. Opportunities for Sri Lanka to upgrade its industrial base were eliminated as many prospective investors relocated to less-risky sites. For example, Motorola and Harris Corporation, two renowned multi-nationals in the electronics field who had finalised plans to establish plants in Sri Lanka, withdrew because of the unstable security situation (Athukorala, 1995). The second wave of policy liberalisation in 1990 saw a revival of FDI flows, only to trickle away once peace negotiations between the government and the LTTE broke off in 1994. The risky investment climate has been conducive only to investment in light industries where fixed capital costs are limited. This has, in turn, meant that the economy’s employment structure continues to be dominated by low skill labour, whose real wage growth has been marginal.

% GDP

Figure 5.1 TRENDS IN FOREIGN DIRECT INVESTMENT, 1970–96

3 2 1 0 –1 1970

1975

1980

Year

1985

1990

1995

Source: Data from the Central Bank of Sri Lanka.

The impact on the tourist sector has also been substantial with costs amounting to 17 per cent of Sri Lanka’s GDP in 1996. While the number of tourist arrivals grew exponentially between 1975 and 1982, peaking at 407,000 arrivals in 1982, the ethnic riots of 1983 and the adverse publicity generated abroad saw the number of tourist arrivals falling off sharply. And by 1988, when the Southern insurrection compounded the negative image of Sri Lanka as a tourist destination, this number plummeted to 183,000 (see Figure 5.2). Thereafter, the crushing of the JVP and concerted efforts by the government to rebuild Sri Lanka’s image abroad, saw a revival in the number of tourist arrivals. Even so, tourist arrivals to Sri Lanka has grown much more slowly in comparrison rival destinations. The sector has clearly not been able to recover the momentum of the initial trajectory of 1975–82.


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No.

Figure 5.2 TRENDS IN TOURIST ARRIVALS, 1970–95 500,000 400,000 300,000 200,000 100,000 0 1970

1975

1980

1985 Year

1990

1995

Source: Data from the Central Bank of Sri Lanka.

The conflict-related damage to public and private property has been extensive (see Table 5.4—the cumulative sum of the cost of damages to physical and social infrastructure amounts to approximately USD 1 billion). Since the early 1980s, production in the agriculture, livestock and fisheries sectors has declined significantly, not only because of population displacement as we discuss later, but also due to the partial and complete destruction of productive assets and supportive institutions. Social infrastructure services such as health and education have been badly disrupted. The sharp drop in students passing the GCE Advanced Level Examination in Jaffna district alone (from 63 per cent in 1994 to 33 per cent in 1996) is evidence of the decline in the standards of education in the conflict zone. Infrastructural services such as power, telecommunications, railways, public transport, roads and bridges have also been partly or wholly destroyed, largely in the conflict areas, but also in the LTTE-targeted areas in the South, notably Colombo. Table 5.4 COST OF DAMAGE (SECONDARY COST), 1995 Rs (Billion) Physical infrastructure Power Telecommunications Railways Public transport Roads and bridges Irrigation Fisheries Forestry Agriculture Livestock sector Industries Postal, administration, cooperatives, food department, ports, petroleum, etc.

2.8 3.0 5.0 0.6 5.0 9.5 3.2 1.5 1.6 0.8 7.8 0.6

Sub total

41.4

Social infrastructure Health Education Local authorities Housing

0.6 1.4 1.8 11.3

Sub total Total

15.1 56.5 (USD 1 bn)

Source: Compiled using Ministry of Shipping, Ports, Rehabilitation and Reconstruction (1995).

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The conflict has claimed a large number of lives and disabled many more. According to data from the Ministry of Defence, roughly 10,000 people in the armed forces were killed in action between 1983 and 1996. An additional 13,500 were wounded. Data on LTTE casualties are less reliable. Depending on the source, the number of LTTE cadres who lost their lives in the conflict varies from roughly 22,000–9,000. The actual number probably lies between the two. Given the nature of the military conflict, many more civilians than combatants—20,000–30,000—have lost their lives (Goonetileke, 1997). Substantial numbers are reportedly missing. The country has lost nearly 55,000 people at the prime of life, on both sides of the conflict. The human capital losses have not been limited to the number of individuals who died or were disabled due to the war. Seriously injured and disabled armed forces personnel have become a burden on the state budget and the national economy as they are now dependent on the state for their sustenance because they are no longer employable. As the war continues, more and more persons could get into this category, further intensifying the burden on the economy. A considerable number have left the country and are living abroad. Few are willing to return, not only because of the uncertain security situation but also because of the unfavourable economic conditions back home. It has been estimated that roughly 645,500 individuals of Sri Lankan–Tamil origin are living outside the country. In relative terms, the economic costs of the human capital losses are not very large, at Rs 17 billion in 1996 prices. However, the psychological and social costs are clearly immeasurable. In the North and East, an entire generation exists which has experienced nothing but continuous warfare and seen death and suffering from a very early age. When the conflict ends, there will be tremendous psychological problems among the citizens of the affected areas. Furthermore, the LTTE recruits and trains children in their early teens. These children, who have grown up using sophisticated weaponry and have little formal education, will find it extremely difficult to fit into society when the conflict ends. Such costs obviously cannot be quantified. Likewise, the psychological and social costs associated with the displacement of masses of people (many of whom have been displaced several times) in the North, the East, as well as the border areas in Anuradhapura, Polonnaruwa and Puttalam districts, cannot be quantified. In terms of providing relief and compensation alone, the displacement of people has cost the government nearly Rs 21 billion (the amount has been estimated by taking into account the nearly 750,000 displaced persons), while the disruption to production activities caused is estimated to be more than Rs 38 billion in 1996 prices.

Concluding Remarks The economic costs of Sri Lanka’s secessionist conflict have been substantial. Its costs to the country’s social fabric appear to be even larger, even though they cannot be measured. It is a burden that Sri Lanka can ill afford, particularly at this stage of its development. The country’s development prospects depend heavily on how speedily a lasting peace can be achieved.


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The country that was known as the ‘Granary of the East’ during the ancient times due to its rich natural resource endowments, known as ‘serendipity’ in the 18th century for its natural beauty and which was referred to as the ‘best bet in Asia’ at the time of Independence, failed to take advantage of its rich natural endowments and its initial position for a rapid economic take-off. The primary reason after the 1977 reforms was the disruptions and uncertainty created by the war that started in 1983 and as indicated in the foregoing paragraphs, it has imposed a very heavy toll on the economy. Citing the Malaysian experience in the context of ethnic diversity and economic policy, Athukorala (1997) indicates that economic policy-making in Malaysia after Independence turned out to be a continuous struggle to achieve development objectives, while simultaneously preserving communal harmony and political stability. Regrettably, in Sri Lanka, this factor was not taken into account in the economic policy-making process.

References Arunatilake, N., S. Jayasuriya and S. Kelegama (2001), ‘The Economic Cost of the War in Sri Lanka’, World Development, Vol. 29, No. 9. Athukorala, P. (1995), ‘Foreign Direct Investment and Manufacturing for Export in a New Exporting Country: The Case of Sri Lanka’, World Economy, Vol. 18, No. 4. ——— (1997), ‘Poverty, Ethnicity and Economics: Malaysia’s Challenges and Achievements’, Asia Pacific Magazine, Canberra. Goonetileke, H. (1997), ‘The Ethnic Conflict in Sri Lanka: A Military Perspective’, HIID/World Peace Foundation/ICES, memo. Kelegama, S. (1999), ‘Economic Costs of Conflict in Sri Lanka’, in R. Rotberg (ed.), Creating Peace in Sri Lanka: Civil War and Reconciliation, Brookings Institution Press, Washington, D.C. Ministry of Shipping, Ports, Reconstruction and Rehabilitation (1995), Emergency Reconstruction and Rehabilitation Programme—Phase II, Final Report, Colombo. UNDP (1997), Human Development Report, UNDP, New York.

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6 FREE FLOAT OF CURRENCY, BUDGET 2001 AND THE IMF PACKAGE Managing the Economy during Turbulent Times, 2000–2001

‘Nobody should underestimate the crisis we are facing today. It is a crisis within a crisis’ (a former Finance Minister of Sri Lanka in Parliament).

Introduction The dawn of 2001 was not auspicious for the Sri Lankan economy. On 23 January 2001, Sri Lanka implemented a ‘free float’ exchange rate system. This policy became inevitable when the Central Bank was no longer able to defend the currency due to shortage of foreign reserves. This was followed by the government announcing on 21 February 2001 a 40 per cent surcharge on all imports except a few essential items.1 The imposition of the surcharge gave the signal that a ‘free float’ exchange rate alone was inadequate to boost the depleted foreign reserves. When the budget (of the government elected in October 2000) was presented to the Parliament on 8 March 2001 by the Deputy Minister of Finance, a number of revenue-enhancing and expenditure-cutting measures were introduced and he said that the people will have to temporarily bear with the situation. All this meant that

THE ECONOMY DURING TURBULENT TIMES, 2000–2001

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the economy was in a serious situation that needed immediate remedial measures. The culmination of all these events was an IMF-led stand-by package of USD 530 million which was announced in late April 2001. What are the conditions that led to this situation? In end 1999, Sri Lanka was just recovering from the adverse impacts of the East Asian currency crisis and showed a growth rate of 4.3 per cent (Table 6.1). By early 2000, the economy had fully recovered from the ill effects of the East Asian crisis and showed a growth rate of nearly 7 per cent in the first six months, which slowed down in the secondhalf of the year to give an overall growth rate of 6 per cent in 2000. Underlying the high growth was a serious imbalance in the economy, both in the domestic and external fronts reflected in a budget deficit of 9.9 per cent of GDP in 2000 and a balance-of-payment deficit of 3.1 per cent of GDP (a current account deficit of 6.4 per cent of GDP). Exchange rates were sliding down (the rupee depreciated by 14.5 per cent per USD in 2000) and the interest rates were escalating (increased by 7 percentage points in 2000) (see Figures 6.1 and 6.2). And at the Paris Aid Group meeting in December 2000, the aid donors emphasised that Sri Lanka has to get its act together and put its economy on a sustainable growth path. Table 6.1 ECONOMIC GROWTH, EXCHANGE RATE AND INTEREST RATES, 1995–2000 Year

Economic Growth

1995 1996 1997 1998 1999 2000

5.5 3.8 6.3 4.7 4.3 6.0

Exchange Rate (annual average Rs/USD) 51.25 55.27 58.99 64.59 70.39 75.78

(54.05) (56.71) (61.29) (67.78) (72.12) (80.06)

Interest Rate (3-month Treasury Bill rate) 19.3 17.5 10.2 12.0 11.8 18.0

Source: Central Bank of Sri Lanka, Annual Reports, 1999 and 2000. Note: The end-of-the-year exchange rate is given in parenthesis.

Two years prior to the crisis, the country’s economic situation was described along the following lines by the Institute of Policy Studies in Sri Lanka (1999: 2): The adverse impact of a deteriorating external economic environment has brought into sharper focus the underlying weaknesses in the domestic economy. The reasonably favourable external environment that prevailed earlier had camouflaged these shortcomings. It had also made it easier for policy-makers to postpone basic structural reforms that were still outstanding. But the current situation has demonstrated that ensuring strong domestic economic fundamentals is even more important in times of external crisis and underlined the importance of easing domestic constraints to economic growth. Timely action was not taken to rectify the structural imbalances in the economy. As in many developing economies there was a tendency to treat a boom as permanent and any downturn in the economy as temporary.

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Development Under Stress: Sri Lankan Economy in Transition Figure 6.1 BEHAVIOUR OF THE EXCHANGE RATES, JUNE–DECEMBER 2000 84 82

Rs/USD

80 78 76 74 72 70

Jan 3 Jan 25 Feb 15 Mar 6 Mar 27 Apr 19 May 11 June 2 June 26 July 14 Aug 3 Aug 24 Sep 14 Oct 4 Oct 25 Nov 15 Dec 5 Dec 26

68

Comm. bank average spot CBSL buying CBSL selling

Source: Central Bank of Sri Lanka, Annual Report (2000).

Figure 6.2 BEHAVIOUR OF THE INTEREST RATES, JANUARY 1999–NOVEMBER 2000

25

Per cent

20 15 10

Sep

Nov

July

May

Mar

Jan–2000

Sep

Nov

July

May

Mar

0

Jan–1999

5

Average weighted prime lending rate Treasury bill rate (3 months) Inflation (12 month moving average) Source: Central Bank of Sri Lanka, Annual Report (2000).

While the economy moved satisfactorily in terms of growth with the favourable external situation in late-1999 and early 2000, two shocks hit the economy in mid-2000. On the domestic front, the on-going war in the North-East of Sri Lanka escalated in April–May 2000, requiring the government to put the nation on a ‘war footing’ and, thereby, jack-up the defence budget (increased from Rs 48 billion in 1999 to Rs 80 billion in 2000). On the external front, the oil price escalation since June 2000 (from USD 19 per barrel in 1999 to USD 28 per barrel in 2000) made severe in-roads to the nation’s foreign exchange reserves (foreign reserves declined by USD 596 million). The policy measures to face this situation began in June 2000. However, due to General Elections in October 2000 some of the remedial measures that should have been undertaken, were postponed. In the ensuing sections, we take a look at some of the policy measures that were implemented.


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Free Float In mid-June 2000, when the rupee was 74.4 per USD, the exchange band was increased from 2 per cent to 5 per cent, which resulted in some depreciation (CBSLAR, 2000: 6). This was a bold measure given the fact that the General Elections were due in the same year. The measure basically showed the gravity of the underlying economic situation. This move was followed by introducing a horizontal band (replacing the crawling band) and widening it (by 10 per cent) under the then managed float exchange rate system. This attempt lasted only for a short period because a bulk of the market transactions took place in the upper level of the rupee band indicating that there was pressure in the market for further depreciation of currency. The second and third attempts at widening the bands in late-2000 (by 6 per cent in November and by 8 per cent in December) produced a similar result and the dollar hit a rate of Rs 80.06 by end 2000 (Table 6.1). By January 2001, the foreign exchange (gross) reserves were adequate to finance only one-and-half months of imports and the Central Bank was no longer in a position to sell dollars to defend the currency. Although, Sri Lankan exports recorded an impressive growth rate of 14 per cent in the year 2000, these earnings were inadequate to match the massive increase in the import bill by 23 per cent. The overall result was a current account deficit in the BOP amounting to 6.4 per cent of GDP in 2000 and the gross official reserves declining by 36 per cent (Table 6.2). The IMF mission visited Sri Lanka in mid-January 2001 and on 23 January the Central Bank gave up the managed float and introduced the free float system. However, it was not a 100 per cent free float, as a number of regulations governed the free float. These were: 1. Imposing limits on daily working balances maintained by commercial banks in foreign exchange, on the basis of past import and export credit transactions. This was to prevent banks holding excess foreign exchange or building up foreign exchange balances for speculative trading. 2. Instructing banks to ensure the settlement of export loans by exporters with export proceeds within 90 days (increased to 120 days for some exporters). Banks were instructed to charge an additional interest rate of 10 percentage points where the settlements were overdue by one month and 2 percentage points per month, thereafter. 3. Requiring forward sales and purchases of foreign exchange to be backed by a rupee deposit of 50 per cent of the value of the contract and to be retained till the date of the performance of the contract, in order to discourage speculative types of forward contracting. 4. Advising banks not to permit customers early or pre-payment of import bills in anticipation of depreciation. 5. Instructing banks to limit their forward market operations only to trade-based transactions of goods and services.

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Development Under Stress: Sri Lankan Economy in Transition Table 6.2 EXTERNAL SECTOR INDICATORS

Item As per cent of GDP Trade deficit/GDP Current account deficit/GDP Overall BOP/GDP External reserves USD Mn. Gross official reserves Total reserves

1996

1997

1998

1999

2000

–9.7 –4.9 –0.5

–8.1 –2.6 1.1

–6.9 –1.4 0.2

–8.7 –3.6 –1.7

–10.8 –6.4 –3.1

1,957 2,717

2,029 3,132

1,984 2,907

1,639 2,582

1,049 2,131

Source: Central Bank of Sri Lanka, Annual Report (various issues). Note: 24 currency basket, 1995 = 100.

Given the conditions governing it, can one pose the question whether this arrangement resembles a different kind of managed float? In fact, soon after the free float was introduced the regulatory measures were less known and the dollar hit Rs 98 on 25 January 2001. Thereafter, with the proper announcement of the regulatory measures the dollar stabilised at Rs 86–88. Two factors contributed to this temporary stability: (a) regulatory measures and (b) speculation that the IMF may come with a relief package to assist Sri Lanka. This speculation became rife particularly because the free float system was introduced during the presence of the IMF mission in Sri Lanka. There was also an unwritten regulation, i.e., all state-owned enterprises were requested to route their import bills through the state banks and all their import payments were deferred for three months. While this regulatory clause gave stability to the market, it made the exchange rate vulnerable to large import bills by state corporations when unloaded in the market after the three-month period. For example, when the Ceylon Petroleum Corporation paid a large import bill on 4 May 2001, the dollar hit the rate of Rs 93. The Central Bank intervened by selling dollars to stop the rupee sliding. Besides, the Central Bank used ‘moral-suasion’ with the banking system to maintain currency stability. All these indicated that the new system is a different type of management of the exchange rate. It is possible to believe that a pure free float system was not allowed to come into operation due to the following reasons: (a) exchange rate would have gone into a downward spiral (with inflationary implications) given the weak economic fundamentals and political uncertainties, (b) the foreign exchange market is very thin in Sri Lanka—daily transactions amount to only about USD 30 million. Forward sales and hedging mechanisms are weak. Hence, the supporting mechanism for the float system was weak. These reasons may have compelled the authorities to play safe and opt for a partial regulatory framework, and (c) though the IMF strongly advocates the so-called corner solutions for exchange rates, the debate is far from settled and there is new thinking that a managed float system has some merit.2 Ever since the free float came into operation, a number of articles appeared in the Sri Lankan newspapers questioning whether the free float of currency could address the then prevalent BOP crisis in the country. Most of the articles argued that the price inelastic nature of most of the large imports and exports did not


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permit a short-term rectification of the BOPs problem by currency depreciation. There are merits in this argument in a static framework, particularly for imports and this may be one reason why a 40 per cent surcharge was imposed on imports in February 2001, despite the new free float exchange rate.3 At this juncture it is appropriate to briefly revisit economic theory. From the simple Keynesian identity of a market economy, it is well known that the current account of the BOPs is the difference between national income and national expenditure (i.e., X – M = Y – A, where Y = income and A = expenditure, i.e., C + 1 + G, where X = exports, M = imports, C = consumption, I = investment and G = government expenditure). The reality in Sri Lanka in early 2001 was that national expenditure far exceeded national income (A>>Y). This expenditure had to be cut to bring about a reduction in the current account of the BOPs. The expenditure reduction would have facilitated maintaining a realistic exchange rate that would enable switching resources from non-tradables to tradables. Currency depreciation produces a relative price change where tradables become more expensive than non-tradables. When consumption of non-tradables goes down (with expenditure reduction) resources move to produce tradables. Of course, the current account deficit can be eliminated also by increasing income, but in practice, income cannot be increased significantly in the short term. This is because productivity improvements take time and GDP growth normally increases expenditure at the same time. Thus, expenditure cuts are essential, for switching resources to tradables. In other words, for higher incentives to produce more tradables, domestic cost increases must not erode the incentives given by higher prices (see, for instance, Corden, 1985). The Central Bank argued that the interest rates would come down as bulk of the adjustment has been taken over by the freely floating exchange rate. However, as the exchange rate was indirectly managed, unless expenditures were substantially cut, there would have been pressure on the interest rate in the upward direction. In fact, substantial cuts in expenditures in the economic system normally comes through higher interest rates, if expenditures were not adequately cut. That is how the market operates to bring the necessary balance in the economic system. The budget presented in March 2001 gave an insight on how the government intended to curb expenditure and reduce the deficit.

Budget 2001 As Table 6.3 shows Sri Lanka had been experiencing large budget deficits throughout the 1990s. In the context of the overall economic management of Sri Lanka, where the private sector had been declared the ‘engine of growth’, these deficits were of serious concern to policy makers. It is in this background that Budget 2001 has to be analysed. It is not the intention here to go into each and every detail of the budget proposals, but to look whether the measures introduced in the budget would have redressed the imbalances in the Sri Lankan economy. The Deputy Minister of

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Development Under Stress: Sri Lankan Economy in Transition Table 6.3 SUMMARY OF GOVERNMENT FISCAL OPERATIONS (As a percentage of GDP)

Item

1996

1997

1998

1999

2000

2001

Total revenue Tax revenue Income taxes Goods and services tax (GST) National security levy Taxes on international trade Expenditure and lending minus repayments Current Security Wages (b) Interest payments Foreign Domestic (a) Current transfers and subsidies Janasaviya/Samurdhi Pensions Capital and net lending Current account surplus/deficit (–) Overall deficit (before grants) Financing Foreign financing Net borrowings Grants Domestic financing Market borrowings Non-bank Bank Monetary authority Commercial banks (a) Other borrowings Privatisation proceeds

19.0 17.0 2.7 – 2.1 3.3

18.5 16.0 2.4 – 1.9 3.0

17.2 14.5 2.0 2.3 2.1 2.8

17.7 15.0 2.6 3.2 2.5 2.5

16.8 14.5 2.2 3.5 2.7 1.9

16.7 14.6 2.5 3.3 3.1 1.9

28.5 22.8 5.8 3.3 6.4 0.9 5.5 6.0 1.1 2.0 5.7 –3.8 –9.4 9.4 2.3 1.3 1.0 6.5 5.1 3.4 1.7 1.3 0.4 1.3 0.6

26.4 20.8 5.1 3.1 6.2 0.8 5.5 5.1 1.0 2.0 5.7 –2.2 –7.9 7.9 1.9 1.1 0.8 3.4 4.5 4.7 –0.2 –1.6 1.3 –1.1 2.5

26.3 19.6 5.0 3.0 5.4 0.7 4.7 4.6 0.8 1.9 6.7 –2.4 –9.2 9.2 1.7 1.0 0.7 7.0 7.1 5.2 1.9 0.6 1.3 –0.1 0.4

25.2 18.7 4.4 3.0 5.6 0.8 4.8 4.2 0.7 1.7 6.5 –1.0 –7.5 7.5 0.7 0.1 0.6 6.8 6.8 4.4 2.5 1.9 0.6 –0.1 –

26.7 20.2 5.6 3.2 5.7 0.7 4.9 4.2 0.8 1.7 6.5 –3.4 –9.9 9.9 0.4 0.0 0.4 9.4 9.2 4.7 4.5 3.6 0.9 0.3 –

27.5 21.6 4.8 3.4 6.7 0.7 6.0 4.6 0.9 1.9 5.9 –4.9 –10.8 10.8 1.4 1.0 0.4 8.8 8.7 5.3 3.5 –0.5 3.9 0.1 0.6

Source: Central Bank of Sri Lanka, Annual Report (various years). Note: Excluding those paid to defence staff.

Finance stated in his budget speech that he was taking measures to bring down the budget deficit from 9.9 per cent of GDP in 2000 to 8.5 per cent of GDP in 2001— an adjustment of nearly 1.5 per cent of GDP. Also, the aim was to convert the BOP deficit of 3.6 per cent of GDP in 2000 to a surplus in 2001. The government was expecting a growth rate of 4–4.5 per cent in 2001. As Table 6.3 shows, large budget deficits above 7 per cent of GDP were not a new phenomenon in Sri Lanka. The defence expenditure related to the war in the North and East of Sri Lanka averaging in the range of 5–6 per cent of GDP was one of the major contributory factors to the large budget deficits. Had this expenditure been at the level of 0.8 per cent of GDP—the level before the war started in


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1983—Sri Lanka would have been facing much lower budget deficits perhaps in the range of 3–4 per cent of GDP. In the year 2000, there were expenditure overruns and revenue shortfalls, which resulted in a budget deficit of 9.9 per cent of GDP. As a percentage of GDP, expenditure showed a declining trend from 1996 to 1999, however it increased in 2000 to 26.7 per cent of GDP. On the other hand, revenue has been showing a declining trend since 1996 (Table 6.3). It is worth examining the fiscal slippage in 2000 in some detail, before going into the 2001 Budget proposals. Figure 6.3 gives composition of expenditure in Sri Lanka during the year 2000: defence expenditure amounted to 21.1 per cent of overall expenditure (5.6 per cent of GDP), interest payments amounted to 21.2 per cent (5.7 per cent of GDP), transfers to households amounted to 12.4 per cent (4.2 per cent of GDP), followed by civil salaries and wages amounting to 11.9 per cent. High budget deficits in the previous years and increased borrowings from domestic sources at market interest rates were responsible for high-interest cost in the budget. Transfers to households remained large due to pensions which amounted to 1.7 per cent GDP and the poverty programme (Samurdhi) which amounted to 0.8 per cent of GDP. Figure 6.3 HOW A RUPEE WAS SPENT—2000 Defence and Public Order and Safety 21.1% Capital and Net Lending 24.3%

Other Transfers 9.2%

Transfers to Households 12.4%

Civil Salaries and Wages 11.9%

Interest Payments 21.2%

Source: Central Bank of Sri Lanka, 2000.

The overall expenditure increased by 20 per cent in 2000 and this was consequent to the massive increase in the defence budget from Rs 48 billion in 1999 (4.4 per cent of GDP) to Rs 80 billion in 2000 (5.6 per cent of GDP). Although, defence was the major contributory factor for fiscal slippage, other expenditures also showed an increase—interest payments by 15 per cent, salaries and wages by 17 per cent and transfers and subsidies by 11 per cent. Both salaries and wages, and transfers and subsidies increased due to payment of allowances to cushion the impact of cost of living in a crucial year of General Elections. The payment of the poverty alleviation programme also saw an increase of 20 per cent in the second half of 2000 before the General Elections.

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On the revenue side, 20.8 per cent came from the Goods and Services Tax (GST), 15.9 per cent from the National Security Levy (NSL), 13 per cent from income taxes and 11.3 per cent from import duties (Figure 6.4). The GST (single rate of 12.5 per cent) which replaced the business turnover tax (BTT [Business Turnover Tax]— with three rates, 6, 12 and 18 per cent) was not in a position to bring in the same amount of revenue as the former BTT. In fact, GST brought in only 3.5 per cent of GDP revenue compared to BTT, which brought in 4.9 per cent of GDP revenue in its last year of operation in 1997. Revenue from income taxes have more or less remained the same over the 1990s with a decline shown in 2000 due to the poor performance of the corporate sector. In fact, revenues from income tax are far below potential.4 Import duty revenue has been on the decline due to low average duty rate (4.5 per cent in 2000 compared to 7 per cent in 1999) and higher value of duty free import allowance (CBSLAR, 2000: 141). Figure 6.4 HOW A RUPEE WAS EARNED—2000 Revenue 13.7% Income Tax 13.0% Other Taxes 5.1% Import Duty 11.3%

Excise Tax 20.2%

GST 20.8%

NSL 15.9%

Source: Central Bank of Sri Lanka, 2000.

Bulk of the tax revenue in Sri Lanka comes from indirect taxes (80 per cent). In this regard, the NSL (which is a cascading tax) was a buoyant source of revenue. The NSL that came into operation in 1992 brought in about 2.7 per cent of GDP in revenue in 2000 compared to 0.9 per cent in 1992. It has increased from 3 per cent in value in 1992 to 6.5 per cent in 2000. It financed 48 per cent of the defence budget.5 However, the increasing role of the NSL has nullified the progressive nature of the tax regime that the GST attempted to introduce in 1998. Revenue from privatisation proceeds has also played a role in particular years, like 1997, in retiring public debt and enhancing revenue. Most ‘cash cows’ in the state-owned sector had been privatised and thus, revenue from privatisation was on the decline. The Sri Lanka Telecommunication shares were expected to bring in a bulk of the revenue in 2000. The much anticipated sale did not take place in 2000 due to the depressed state of the Colombo Stock Market (CSM) and the inability to obtain the desired revenue from the sale. The Budget 2001 proposals targeted a recurrent expenditure of 19.5 per cent of GDP capital expenditure and net lending 7.4 per cent GDP and a revenue of


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18.3 per cent of GDP for 2001. It is on these figures that a budget deficit of 8.5 per cent of GDP was estimated for 2001. It assumed containing the increase in recurrent expenditure to 11 per cent when it was 22 per cent in 2000 and assumed a revenue growth of 25 per cent as against 8 per cent in 1999. Comparison of budget estimates with actual performance for the 1997–2000 period is given in Table 6.4. Clearly, there is a great disparity in estimated and actual figures.6 Given this record, the achievement of the budgetary targets appeared wishful thinking. The Ceylon Chamber of Commerce pointed out this fact soon after the budget (see The Island, 9 March 2001). Table 6.4 COMPARISON OF BUDGETED AND ACTUAL FISCAL OPERATIONS 1997–2001 AS % OF GDP Revenue

Recurrent Expenditure

Current Account

Capital Expenditure

Overall Deficit

Year Budgeted Actual Budgeted Actual Budgeted Actual Budgeted Actual Budgeted Actual 1997 1998 1999 2000 2001

19.1 18.4 18.5 18.6 18.3

18.5 17.2 17.6 16.8 16.7

19.9 18.3 17.2 18.0 19.5

20.8 19.6 18.7 20.2 21.6

– 0.1 1.3 0.6 –1.2

– –2.4 –1.0 –3.4 –4.9

6.8 6.9 7.3 8.1 7.4

5.8 6.7 6.4 6.4 5.9

7.6 6.5 6.0 7.6 8.5

7.9 9.2 7.5 9.9 10.8

Source: Ministry of Finance, 2001.

In order to achieve the budgetary targets a number of measures were announced both from the expenditure side and revenue side. Prominent items from the expenditure side were: (a) reduction of defence expenditure to Rs 63 billion for 2001 (by 1.25 per cent of GDP), (b) banning the importation of duty free vehicles by Parliamentarians, (c) cutting down office expenses in state departments and public corporations, and (d ) radical restructuring of expenditure including closure of 35 redundant public entities that had already been identified, reductions in the topheavy administration, expenditure cuts in construction of official residence, etc. Revenue was to be increased by 1.5 per cent of GDP through the following main measures: (a) 20 per cent surcharge on corporate income tax for a period of one year (commencing 1 April 2001); additional revenue of Rs 2.6 billion, (b) increase in NSL by 1 per cent (6.5–7.5 per cent); expected revenue Rs 6.1 billion, (c) 40 per cent surcharge on import duty from 21 February to 31 December 2001; anticipated revenue of Rs 18.5 billion, (d ) doubling Embarkation tax; expected revenue Rs 250 million, and (e) increasing betting and gaming levy to bring in Rs 500 million, and finally divestiture proceeds to bring in revenue of 1.7 per cent of GDP or Rs 26 billion (out of which Rs 21.2 billion or USD 250 million was expected from the deferred Sri Lankan Telecom). Critics pointed out that the reductions in wasteful expenditures were inadequate.7 In a number of ministries there was adequate room for drastic expenditure cuts.8 On the revenue side, given that the volume of imports would decline with devaluation (especially luxury items) whether the import surcharge could deliver the anticipated revenue remained questionable.9 Moreover, less consumer spending was going to affect tax revenue and corporate surcharge would not have brought the anticipated revenue because of the decline in private sector activity due to high interest rates.

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There were no indications of the CSM picking up in 2001, given the decline in most global share markets. In this scenario, fetching USD 250 million for telecom shares appeared optimistic. Moreover, Telecom shares had been depressed in the world market and the obsolete copper-based technology used by the Sri Lanka Telecom was not attractive to foreign buyers for the given price. Thus, privatisation proceeds were bound to fall below expectation just as it did in 2000—the expected amount was Rs 30 billion or 2.4 per cent of GDP but the actual amount received was only Rs 401 million. And reduction of domestic debt financing of the budget through increased privatisation proceeds was also difficult to achieve. As Table 6.4 shows that the government has been aiming for a current account surplus in the budget but in all the years it had turned into a deficit. In 2000, the current account deficit alone was 3.4 per cent of GDP. This shows that the government has been borrowing to meet current expenditures. As is well known, prudent budgetary management is generating a surplus in the current account for capital expenditure and topping the surplus with foreign funds for achieving higher growth in the long run. The very absence of such a strategy raised questions on the sustainability of the deficit. For the first time in the 1990s, provision was made in the budget for a deficit (1.2 per cent GDP) in the current account. This showed the gravity of the financial situation in the country. Under such a scenario, it was unrealistic to expect an increase in capital expenditure by 0.9 per cent of GDP in 2001 as estimated in the budget (Table 6.3). Normally, the capital expenditure has been the victim in the budget management process, thus, impacting on long-term growth (Chapter Four). Thus, the adverse consequences on long-term growth were bound to continue. The most important area in the context of policy was the financing of the deficit. Let us look at the changing structure of budgetary financing in Sri Lanka during 1995–99 (Table 6.5). Foreign grants, foreign loans, domestic borrowing from banking and non-banking sources and privatisation proceeds played a major role in budgetary financing in the 1990s. As Table 6.5 shows, domestic borrowings financed two-thirds (67.4 per cent) of the deficit in the five-year-period, 1995–99. Over half of the borrowings were from non-bank sources (51.2 per cent). Borrowing from bank sources amounted to 16.3 per cent—8.5 per cent from commercial banks and Table 6.5 FINANCING OF THE BUDGET DEFICITS, 1995–99 (RS BILLION) Average Annual Amount 1995–99 Foreign finance Foreign loans Foreign grants Domestic borrowing Non-bank Commercial bank Central bank Privatisation proceeds Total

18.2 10.5 7.6 52.0 39.5 6.6 6.0 7.0 77.2

% 23.6 13.6 9.8 67.4 51.2 8.5 7.8 9.0 100.0

1995

%

30.3 21.2 9.0 34.0 26.4 –0.6 7.7 3.0 67.2

45.1 31.5 13.4 50.6 39.3 –0.9 11.5 4.5 100.0

Source: Estimated from Central Bank of Sri Lanka, Annual Reports.

1999 8.0 1.2 6.8 74.9 49.7 5.2 20.8 0.1 83.0

% 9.6 1.4 8.2 90.2 59.9 6.3 25.1 0.1 100.0


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7.8 per cent from the Central Bank. Foreign financing amounted to nearly a quarter of the budget deficit (23.6 per cent)—foreign loans amounted to 13.6 per cent and foreign grants amounted to 9.8 per cent. Privatisation proceeds financed 9 per cent of the deficit. If the figures in 1995 are compared to the figures in 1999, it is clear that both foreign financing as well as privatisation proceeds have drastically declined.10 First, Sri Lanka achieved lower middle income country status in 1999 (per capita income above USD 795) and thus, became less qualified for concessional aid.11 Second, most ‘cash cows’ were privatised by 1997 and what was left were the more complex public utilities (that take time for privatisation) and a few cash earners such as the telecom and insurance corporation. Consequent to the decline in foreign financing and privatisation proceeds, 90.2 per cent of the budget deficit was financed by domestic borrowings compared to 50.6 per cent in 1995. It is also noteworthy that the financing of the deficit by the Central Bank, increased from 11.5 per cent in 1995 to 25.1 per cent in 1999. In the exceptional year of 2000, the estimated amount of domestic borrowing of 3.5 per cent of GDP increased to 9.4 per cent of GDP, out of which 4.3 per cent came from bank borrowings (Table 6.3)—the highest level during the past 12 years (CBSLAR, 2000: 5). Heavy bank borrowing took place to cover losses of state petroleum, electricity and transport corporations, which amounted to 2 per cent of GDP compared to 0.75 per cent in 1999.12 Bank borrowing by the public sector amounted to more than 140 per cent of broad money growth in 2000 (IMF, 2001). Needless to say, the shortfall of the expected privatisation proceeds also led to heavy bank borrowing. It is against this background that the budget proposals for deficit financing have to be analysed. For the year 2001, 2 per cent GDP was estimated as foreign financing, 1.7 per cent from privatisation proceeds and 4.8 per cent from domestic borrowings—all of which were going to be non-bank borrowings (Table 6.3). For the 56 per cent of the deficit financing through domestic borrowing, a contingency measure (in case of revenue shortfalls) was in-built in the budget, i.e., the limits of borrowing of Treasury Bills was raised from Rs 135 billion to Rs 175 billion (by 30 per cent). This was the highest ever imposed and exceeded the authorised limits announced in 1997. As stated earlier, the expectations from the privatisation programme were too optimistic. Foreign financing had been on the decline since 1996 (see Table 6.3). Moreover, in the past, realising the foreign funding target had been difficult. With the expected shortfall in privatisation proceeds and foreign borrowings and revenue, domestic borrowing was bound to exceed the targeted figure as in the past. The very fact that the treasury bill limits were increased implied that domestic borrowing was going to come from a combination of bank and non-bank sources as in the past.13 Increased domestic borrowing was not going to bring down the interest rates. And above all, the tight monetary policy was not going to loosen until inflation declined and from this perspective also there were no indications of downward pressure on the interest rates in the short term. The large borrowings to finance budget deficits over the years have contributed to increasing the public debt. Public debt, which was 95 per cent of GDP in 1999,

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increased to 97 per cent of GDP by 2000. About 55 per cent of this debt was domestic debt while the remaining amount was foreign debt. Debt-servicing cost was bound to be higher in 2001, owing to increase in accumulated debt, higher domestic and external borrowings, higher interest cost due to increased interest rates and higher rupee costs of foreign debt owing to large depreciation of the rupee. In fact, about one-third of the government revenue was going to service the debt, which was a heavy burden on the public finance of the country, since the finances required for other expenditures became restricted. Inflation increased to 10 per cent in 2000 from 6 per cent in 1999 (MoF, 2001 Part 1: 23). Increase in utility charges (transport [by 15 per cent], electricity [by 6 per cent], etc.), surcharges on import duty prior to the budget, surcharge on corporate profits, imposition of GST on private health services in the 2001 Budget, increase in NSL, etc., were expected to accelerate inflation in 2001 and it was going to be difficult to bring down inflation to a single digit level as expressed in IMF (2001).

BOP Adjustment Sri Lanka has not experienced a surplus in the trade account of the BOP since 1977. But Sri Lanka has been experiencing surpluses in the BOP in most of the years in the 1990s. This is mainly due to remittances from nationals abroad and capital inflows in various forms that offset the deficit in the current account of the BOP. The situation gradually changed after the mid-1990s when substantial capital inflows were less forthcoming (Table 6.2). In fact, there has been a significant outflow from the stock market. The CSM All Share price index has fallen from 663 in 1995 to 448 in 2000. The budget stated that the USD 516 million BOP deficit will be turned into a USD 140 million surplus in 2001. Budget 2001 lacked details on how this will take place. The IMF package for Sri Lanka under the name Memorandum of Economic and Financial Policies (MEFP) was more specific, and stated that the external current account of the BOP was expected to fall from 6.4 per cent of GDP in 2000 to 3 per cent of GDP in 2001. It stated: privatization receipts, net government borrowings of about US$ 130 million, and foreign direct investment close to US$ 190 million, are expected to finance the current account deficit. However, to rebuild the low level of reserves to at least above 2 months imports in 2001, i.e., $1½ billion, and to avoid excessive slowing down of the economy, balance of payments support of $530 million is required. Of this amount, about $200 million is expected to be financed from commercial borrowing (of which $100 million is refinancing of the syndicated loan extended to the Ministry of Finance in 2000), while multilateral and bilateral official creditors provide the remaining amount. Assurances on financial support have been received from the international community, especially the World Bank, the Asian Development Bank, bilateral creditors and the private sector, that would be sufficient to meet financing needs in 2001 and 2002.


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Improvement in the current account of the BOP was expected with devaluation, and also with the expected decline in defence-related imports. It was also expected that there would be more foreign fund inflows with the improvement of the security situation in the country. However, some of these estimates were not achievable. Foreign capital inflows for direct as well as portfolio investment was likely to be less than expected given the security as well as the macroeconomic situation. Since there was no convertibility in the capital account of the BOP, the high interest rates acting as an instrument of attracting foreign funds, was weak. If USD 200 million was to be raised at 8–16 per cent in the international market, it was a sure way to increase public debt, which was already high. The improvement of the current account balance due to the floating exchange rate and the import surcharge was not going to be very significant. The 40 per cent surcharge made the existing 35, 25, 10, 5 duty band equivalent to 49, 35, 14 and 7.14 The devaluation-cum-surcharge was expected to bring some cuts in imports at least till December 2001, when the surcharge was to be removed. Theory states that the current account deterioration will be rectified by the free floating exchange rate, or in other words, the exchange rate will absorb the problem. But since the exchange rate was indirectly managed, the current account would have deteriorated and the bulk of the adjustment burden would have passed to the interest rate. The export sector had already shown signs that the same momentum as the year 2000 could not be maintained in the year 2001. Inflation and the resulting wage hikes gradually eroded the competitiveness that the exchange rate provided.15 The US recession made an adverse impact on the garment exports in the first three months of 2001 (CBSL, 2001). The excessive dependence of Sri Lankan exports on US and EU economy has not changed in recent years. Moreover, the much expected entry to the Indian market of Sri Lankan exportable consumer products did not take place in 2000. India removed all non-tariff barriers on 1 April 2001. Sri Lanka was expected to gain the ‘early move advantage’ to the Indian market via the Indo-Sri Lanka Bilateral Free Trade Agreement, before this date. However, due to a plethora of problems governing the agreement, this did not take place. Although, the other exports in the manufacturing sector were supposed to benefit from the devaluation, it was bound to be considerably offset by the increase in cost of production resulting from increase in corporate taxes (with surcharge), increase in NSL, increase in interest rates, increase in electricity/gas prices and increase in cost of imported inputs.16 So the overall export gains that were predicted did not manifest in 2001. This together with the lower than anticipated foreign capital flows exerted pressure on the exchange rate to depreciate further.

IMF Package The MEFP that the government signed with the IMF, went further than what was mentioned in the Budget proposals. Perhaps realising that the targets cannot be achieved by budgetary measures alone, these new measures were agreed upon for

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implementation in 2001–02. Some of the noteworthy measures were as follows: (a) defence expenditure to be reduced to the level announced in the budget, however, ‘any overspending … would be off-set instantaneously by further measures’, (b) public servants would not receive a pay rise in 2001 and there would be a freeze on hiring civil servants, (c) no new incentives were to be provided by the Board of Investment (BOI), (d) significant reduction of the regressive NSL rate and a compensating increase in the progressive GST (NSL would be integrated with the GST by 2004), (e) reduction in transfers and subsidies to public corporations by prompt increase in administrative prices. It went on to say that an automatic pricing mechanism would be put in place that will ensure that domestic fuel prices are adjusted sufficiently and on a timely basis to pass the changes in international prices to the consumers, ( f ) the government would not inject capital to the state-owned bank called People’s Bank and steps would be taken for rapid restructuring of the two state banks, ( g) rebuilding gross official reserves to about USD 1.5 billion by end 2001, and (h) improvement in the functioning of the labour market, etc. The MEFP elaborates in full detail how the government intended to put the economy back on course (see IMF, 2001).17 The IMF approved a 14 month stand-by package (SBP) of USD 253 million for the above economic programme for 2001–02 of which USD 131 million was released in the last week of April 2001.18 The rest was going to be disbursed in four installments of USD 35 million each on the basis of economic performance. The IMF stated that the programme ‘aims to restore macroeconomic stability through an improvement in the financial position of the public sector and rebuilding official reserves, supported by a flexible exchange rate’. It went on to state that ‘fiscal consolidation will be the key component of the programme ... government deficit will be reduced to ... 8.5 per cent of GDP with a further reduction in the medium term to 5 per cent’. The IMF and the government were particularly optimistic on revenue enhancement.19 These new measures while providing the required discipline in economic management would have increased the burdens on the public. In other words, the adjustment costs in the short term were going to be painful despite the IMF SBP. The IMF resident representative in Sri Lanka expressed his concerns about the slow progress of structural reform during 1999–2000 and expressed his optimism about the future economic prospects under the IMF programme (Ceylon Daily News, 15 May 2001). The SBP was a short-term package and the intention was to introduce Poverty Reduction and Growth Facilitation (PRGF) to take over from the SBP in early 2002 and the facility would be at a lower interest rate than the SBP. Since the People’s Alliance government came to power in 1994 there was no IMF package either in ESAF (Enhanced Structural Adjustment Facility—the former name of PRGF) or any other form. The foreign reserves were healthy—thanks to favourable prices for tea in the world market, increased remittances from Sri Lankan expatriates, particularly, from the Middle East and booming garment exports. Moreover, despite the war, Sri Lanka has been recording reasonably good growth rates averaging 5 per cent during 1995–2000.20 The economy was undergoing pain but was not sick and thus, unless there were some externally imposed conditionalities there


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were bound to be fiscal slippages from time-to-time creating problems for macroeconomic management.21 The IMF package was expected to bring in the muchneeded discipline for economic management in Sri Lanka. Given the stringent conditions in the package there was a possibility that the government would go all out to achieve the budgetary targets. However, given the constraints highlighted in the earlier section, there were serious doubts as to whether such an attempt was realistic.

Concluding Remarks Two shocks hitting the Sri Lankan economy almost simultaneously and the crisis that followed compelled the government to address the key structural problems of the economy. The external supervision by the IMF gave discipline to the reform implementation process. The IMF-led stand-by facility did not come in one package. It was going to come in instalments with continuous monitoring taking place. The government was compelled to put an extra effort to fulfil the conditionalities. Thus, room for fiscal slippage was minimised. It was a crisis that triggered the second wave of liberalisation in 1990 in Sri Lanka (Chapter Four). Similarly, the 2001 crisis could have triggered the third wave of liberalisation, where in addition to planned reform, factor market reforms to support the liberal trade regime could have been implemented. The Sri Lankan labour market was rigid and governed by outdated legislation. Corporate restructuring was hampered by rigid labour exit laws. (The private sector has been clamouring for reforms in the labour market for quite some time.) Land market was governed by an outdated titling and deed system that restricted it from responding to market forces. Factormarket liberalisation could have strengthened the effects of resource allocation and lock-in the existing trade reforms. However, the cost of the adjustment process was bound to be high because the backlog of adjustment from previous years had added to the adjustment resulting from the two shocks that Sri Lanka faced in 2000. Revision of administrative prices in particular coming on top of devaluation and import surcharges was going to increase the burden on the poor. If there were going to be any demands for wage increases (like what happened in the plantation sector in March 2001) and social unrest, the government had to be prepared to act tough, for had it not, reforms would have suffered reversals and whatever short-term political gains that would have come with the accommodation of wage increases would have come at the cost of economic stability. The IMF package brought temporary relief, but given the gravity of the problem, the pressure on the exchange rate and interest rates continued. In other words, given the situation, bulk of the adjustment was taken over by the exchange rate and interest rate. In this scenario, Sri Lanka faced a turbulent period in managing the economy. The situation was aggravated by two political factors. First, the Norwegian peace initiative with the LTTE and the government did not indicate any significant

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results. (Thus, there were no significant savings in defence expenditure in 2001.) Second, political coalition management received priority over economic management issues, given the fact that the ruling coalition then, encountered a split and lost its majority in Parliament in June 2001. The fact that an economic crisis engulfed a government in its early days in office could have been a blessing-in-disguise because the Sri Lankan experience over the years has shown that most unpopular reforms can best be implemented in the early days of office. But this opportunity was missed due to the political cross currents where economic policy has always been put on the back burner, albeit temporarily.

Notes 1. The exempted items include: (a) Consumer items like drugs, milk powder, sugar, potatoes, cooking oil, dried fish, textiles, (b) capital goods like tractors and lorries, (c) intermediary goods like crude oil, and (d ) all goods subject to nil tariffs. 2. The corner solutions are either a fixed exchange rate with a Currency Board system or a flexible exchange rate with a Central Bank. In between solutions, such as managed float with a Central Bank are considered inefficient. The thinking may have shortcomings and there is a need for further review (see, for instance, The Economist, 18 November 2000: 110). 3. The surcharge was both a revenue as well as a protective measure. It was enforced to address both the domestic and external imbalances. 4. The black money market amounts to approximately USD 3 billion (The Economist, 15 July 2000). Only 1,656 individuals in the annual income range of Rs 1–5 million have tax files. And only 137 individuals in the annual income range of Rs 5 million and above have tax files. Many Sri Lankans feel that if you open an income tax file, the Inland Revenue Department will harass you for the rest of your life (Waidyasekera, 2001). 5. This was the case in the 1980s and early 1990s (Kelegama and Gunatilleke, 1991). 6. See, for instance, ‘Budget Vision’ by Kanes in The Island, 27 March 2001. 7. See, the interview of a former Minister of Finance in Business Today, March 2001: 60. 8. Imports declined by 2.8 per cent from January–March 2001 (CBSL, 2001). 9. 1999 was selected to show the prevailing trends before the exceptional year of 2000. 10. For more borrowing from the international market at commercial rates, Sri Lanka was planning to obtain a sovereign rating. However, due to the uncertainty caused by the escalation of the war and the macroeconomic imbalances due to the large budget deficit the rating achievement had been put on hold. 11. Domestic price adjustments lagged behind the increases in world oil prices. This contributed to the massive losses and the increase in public transfers. With regard to fuel, not only did the government subsidise the prices but also followed a cross-subsidising policy, where kerosene and diesel were subsidised at the cost of petrol. Bus and railway transport costs were subsidised by the government, while in electricity another cross-subsidising policy, where households and religious places are subsidised at the cost of manufacturing units, prevailed. 12. For instance, in the 1999 Budget, the entire domestic borrowing of Rs 40.6 billion was estimated to come from non-bank sources, but the outcome was non-bank borrowing to Rs 49.7 and bank borrowing amounting to Rs 26 billion (of which 21 billion was from the Central Bank) to meet the actual domestic borrowing of Rs 76 billion (due to a shortfall of foreign loans). 13. The 35 per cent duty band was applicable to the agriculture sector which is bound by a 50 per cent duty with the WTO Agreement on Agriculture. The selection of 40 per cent surcharge may have been influenced by the need to provide maximum protection to the agriculture sector within the bound level.


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14. A wage hike in the plantation sector had already hit the tea exports. On 17 March 2001, after a protracted dialogue the government agreed to grant a Rs 20 per-day wage increase to the plantation workers. Even before the wage hike Sri Lanka was a high cost tea producer compared to Kenya and India and with this price hike the competitiveness was further eroded. 15. Sri Lankan manufacturing sector is highly import-intensive. 16. Unlike in the past, where most of the IMF packages were always shrouded in secrecy, with the leadership of the new Managing Director, Horst Koehler there is increased transparency in IMF packages (see Far Eastern Economic Review, 12 April 2001: 24). The package with the Sri Lankan government was made available on the IMF Website within a month of signing the agreement. Nowadays IMF considers its position as a ‘partner in the solution’ to the crisis rather than the ‘sole provider of the solution’. 17. The amount was worked out on the basis of building up the foreign exchange reserves to USD 1.5 billion—which was considered as the ‘comfort zone’—by end 2001. The loan was given at near market interest rates. 18. Sri Lankan fiscal system is not perverse to an increase in revenue as a recent study conducted by the Indian National Institute of Public Finance (New Delhi) showed (as quoted in Waidyasekera, 2001). 19. The war has retarded Sri Lanka’s economic growth and has incurred a cost equivalent to nearly twice the GDP of 1996 (Arunatilake et al., 2001). However, Sri Lanka stands as an exception among war-torn economies around the world due to the average growth rate of 5 per cent during the last two decades. 20. The most common forms of expenditure slippage manifestation is via supplementary estimates presented to Parliament, while on the revenue side it is manifested in the form of ad hoc tax and tariff incentives. 21. The ‘Way Forward’ document prepared by the chambers that was submitted to the new government in November 2000 reemphasised this aspect.

References Arunatilake, N., S. Jayasuriya and S. Kelegama (2001), ‘The Economic Cost of the War in Sri Lanka’, World Development, Vol. 29, No. 9. Central Bank of Sri Lanka (1999, 2000), Annual Report, Colombo (referred to in the text as CBSLAR, 2000). ——— (2001), ‘Selected Economic Indicators—April 2001’, Economic Research Department, Central Bank, 15 May 2001 (referred to in the text as CBSLAR, 2001). Corden, M. (1985), Inflation, Exchange Rate, and the World Economy, Oxford University Press, Clarendon, Oxford. IMF (2001), www.imf.org [search—Sri Lanka]. IPS (1999), Sri Lanka: State of the Economy—1999, Institute of Policy Studies, Colombo. Kelegama, S. and N. Gunatilleke (1991), ‘Budget 1991: Some Macroeconomic Implications’, Lanka Guardian, Vol. 13, Nos 19 and 20 (1 and 15 February). Ministry of Finance (2001), ‘Budget Speech’, Parts I & II, Colombo (referred to in the text as MoF, 2001). Waidyasekera, D.D.M. (2001), ‘Sri Lanka’s Budget 2001: Tax and Revenue Implications’, Tax Notes International, Tax Analysts, Arlington, USA.

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7 MANAGING THE ECONOMY AT A TIME OF TERRORISM AND WAR AND THE PROSPECTS AFTER THE 2002 CEASEFIRE AGREEMENT Introduction The Sri Lankan economy has 28 years of experience in economic liberalisation. It was the first South Asian country to implement economic liberalisation policies in 1977, yet, its experience with such policies has been a bumpy ride. The war that took place in the North and East of the country has affected the economic liberalisation programme by not only diverting the attention of the governments from implementing economic reform, but also by extracting significant resources that would have otherwise gone for development activities. It has substantially shaken the Sri Lankan economy. As the war commenced only five years after economic liberalisation, for nearly 20 years, Sri Lanka has experienced the management of an open economy amidst a war with occasional peace. The war that commenced as Eelam War I in 1983 had two subsequent phases, viz., Eelam War II: 1990–94 and Eelam War III: 1995–2001. The temporary cessation of hostilities when peace was negotiated has only given a breather for the Sri Lankan government to implement some new reforms in the economic system only to be slowed down when the war commences once again, as has been the case over the last two decades. Mutual cessation of hostilities has always been used by the Liberation Tigers of Tamil Eelam (LTTE) to regroup and obtain new armaments. The disturbances caused by the war have added to other internal and external shocks that the Sri Lankan economy faced during the last two decades. This made managing the economy a difficult task.

THE ECONOMY AT A TIME OF TERRORISM AND WAR

159

Also, the last two decades saw changes in the political leadership in 1989 (Premadasa took over from President Jayawardena) and 1993 (Wijetunge took over from President Premadasa) and change of governments in 1994 (the People’s Alliance [PA] took over from the United National Party [UNP]) and in 2001 (the UNP took over from the PA). Yet, the uniqueness of the Sri Lankan experience is that despite all the problems that the country faced, it has managed to maintain an average growth rate of 5 per cent during 1983–2001 (Table 7.1). It was an indication of the resilience of the private sector in Sri Lanka and also the natural recuperative powers of the economy (à la Krugman) given its high basic needs indicators. Table 7.1 ECONOMIC GROWTH (GR.), 1980–2001 Years Gr Years Gr

1980

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

5.5

6.1

5.1

5.0

5.1

5.0

4.3

1.5

2.7

2.3

6.2

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

4.6

4.3

6.9

5.6

5.5

3.8

6.3

4.7

4.3

6.0

–1.4


In this chapter, we trace the economic reform programme over the years after the war started in 1983 and highlight how the economy has been shaken by the war. The rest of the chapter is organised as follows. The succeeding section looks at the 1983–99 period, while the section after that focuses on the 2000–2001 period. The subsequent section looks at the economic cost of the war and the characteristics of defence expenditure. The fifth section analyses the economic revival package of 2002 and the challenges to the economy. The sixth section looks at the peace dividend and the last section has some concluding remarks.

1983–99 Period In 1977, Sri Lanka became the first South Asian country to initiate an economic liberalisation programme. Although, the initial reform efforts were bold, the country has been unable to sustain the same momentum of liberalisation over the 1980s due to large fiscal deficits associated with an ambitious public investment programme (centred around the Accelerated Mahaweli Development Programme) that was unleashed to lay the foundation for future private sector activities. Increasing both the hydro-electric power capacity and irrigation coverage in the country was central to this programme. By the early 1980s, the reforms slowed down and the momentum was further decelerated once the Eelam War I commenced in 1983. The period 1983–89 was very turbulent for Sri Lanka’s economic management, with Eelam War I (mostly confined to the North and East) coinciding with a rebellion in the South of the country initiated by a militant Marxist group—the Janatha Vimukthi Peramuna (JVP). During the 1987–89 period Sri Lanka was known as

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‘the killing fields of Asia’. The average economic growth rate during 1987–89 was 2.2 per cent reflecting the impact of the twin internal shocks from both North-East and South of the country (see Table 7.1). The liberalisation programme hardly progressed during this period because the government was preoccupied with law and order maintenance and political crisis management. In early 1990, the JVP rebellion was crushed and peace negotiations with the LTTE were initiated. This gave some political space to accommodate the unfinished agenda of the economic liberalisation programme. Thus, a second wave of liberalisation came into operation that had as its main pillars: further liberalisation of foreign capital inflows, a privatisation programme and measures to revive the share market (Chapter Four). By the time the second wave of liberalisation came into effect, the earlier ambitious public investment programme had achieved its objective to support more private sector activities both in the industrial and agriculture sectors. For the first time, the private sector was named ‘the engine of growth’. Sri Lanka’s president was influenced by Prime Minister Mahathir Mohammed’s 2020 Vision for Malaysia and declared that Sri Lanka should achieve NIC status by 2000 (Chapter Two).1 The breakdown of the peace talks with the LTTE in June 1990 and the commencement of the Eelam War II completely reversed the president’s programme. A number of military operations in the early 1990s escalated the defence budget to about 4.5 per cent of GDP (see Table 7.2). This led the government to introduce a Defence Levy (later termed as the National Security Levy) of 1 per cent of turnover as a source of defence financing in 1992. Although, the president’s dream of an NIC status tapered away, his autocratic approach to policy making gave a sense of continuity and stability to the economic regime (Chapter Four). This acted as a fillip for attracting new FDI as well as foreign portfolio investment for the privatisation programme. The president’s regional development programmes, which extended to the eastern province and some parts of the northern province (like the 200 garment factory programme, mobile presidential services, radio station in the North, etc.) were not to the liking of the LTTE and thus, the groundwork was initiated by the movement to eliminate the president (Sunday Island, 26 April 2002). The president was assassinated by the LTTE in May 1993. A change of political leadership was seen in mid-1993. The economic regime was weakened by this change of leadership. By early 1994, the government was preoccupied with the General Elections and the implementation of economic reforms was put on hold. Despite the new reforms and strong leadership during the 1990–mid-1993 period, the LTTE-led war and the resulting political disturbance reduced the growth to an average of 4.8 per cent during 1990–93 (Table 7.1). Consequent to the change of government in August 1994, the new PA regime made a commitment to continue with the open economy but added a catch phrase ‘with a human face’, as it was of the view that the previous regime ruthlessly implemented reforms ignoring the human cost. A new aura of optimism engulfed the economy with this announcement and the cessation of hostilities between the government and the LTTE. An ambitious privatisation programme was initiated with the formation of the Public Enterprise Reform Commission (PERC) in March 1995.

39,637

1983

55,234

1985

74,535

1988

99,814

1990

140,460

1993

167,768

1994

1996

1997

200,482 214,710 235,097

1995

268,179

1998

279,159

1999

335,823

2000

387,537

2001

17.4 13.5 11.7 15.7 9.9 8.4 9.9 8.4 7.8 7.9 9.2 7.5 9.9 10.8 804 1,182 2,318 5,583 10,317 17,667 21,989 25,815 33,117 37,062 42,496 40,071 56,915 54,242 313 572 3,294 5,138 4,285 3,105 3,538 10,539 13,168 10,874 11,832 8,307 19,313 15,977 1,117 1,754 5,612 10,722 14,602 20,772 25,527 36,354 46,285 47,936 54,328 48,378 76,228 64,138 99,238 121,601 162,375 221,982 321,784 499,565 579,084 667,772 768,934 890,272 1,017,986 1,105,963 1,257,634 1,407,398 3.1 4.4 10.2 14.3 14.6 14.7 15.2 18.1 21.6 20.4 20.3 17.3 22.7 16.5 1.1 1.4 3.5 4.8 4.5 4.2 4.4 5.4 6.0 5.4 5.3 4.4 6.1 4.6

33,531

1982


1. Government expenditure (lending minus repayments) 2. Budget deficit as a % of GDP (before grants) 3. Defence—Recurrent 4. Defence—Capital 5. Defence—Total 6. GDP (market prices) 7. 5÷1% 8. 5÷6%

Table 7.2 BUDGET DEFICITS AND EXPENDITURE ON DEFENCE, 1982–2001, SELECTED YEARS (RS MILLION)

THE ECONOMY AT A TIME OF TERRORISM AND WAR 161

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This was done to show the government’s commitment to a private-sector-friendly reform agenda. The peace lasted only for eight months and Eelam War III commenced in late-April 1995. The government made a concerted effort to increase the defence budget and purchase new equipment to fight the war to its end. Recruitment to the armed forces was also accelerated. This was manifested when a decision was taken in May 1995 to increase the Defence Levy from 3.5 to 4.5 per cent and the privatisation programme was requested to deliver an additional Rs 1 billion (IPS, 1995). A Save the Nation Contribution (SNC) was also introduced in the 1996 Budget. It was imposed on the employees of the public and private sector at the rate of 3 per cent on those who earned monthly emoluments of over Rs 30,000. Realising that the government was increasing the defence spending, the LTTE made a concerted effort to attack economic targets and paralyse the economy. This was seen throughout the 1995–97 period with a series of attacks on economic targets: oil refinery (October 1995), Central Bank (January 1996), failed attempt on the Colombo Sea Port (April 1996) and Colombo Stock Market (October 1997). These attacks dealt a severe blow to the economy. Meanwhile, the government pursued its military operations in the North—Operation Rivi Rasa (capturing of Jaffna), Operation Sath Jaya (capturing of Killinochchi), etc. While these operations were successful there were a number of reversals—fall of the Mulaitivu camp in July 1996, failure of operation Jaya Sikuru (which planned to capture the Vavniya– Jaffna highway), etc., during 1995–97. After the fall of the Mulaitivu camp, the LTTE which had basically remained a guerilla force and was unable to face a conventional army, underwent a transformation for conventional warfare and this was clearly evident in their subsequent military successes in, among other places, Kilinochchi (1999) and Elephant Pass (2000). The PA government’s strategy was to negotiate with the LTTE from a position of strength and the war was referred to as a ‘war for peace’. The Devolution Proposals that the PA introduced as a solution to the North-East problem in August 1995 was rejected by the LTTE. Economists who analysed the Devolution Proposals showed that there would be serious fiscal implications if the package was introduced (Hewavitharana, 1997). After widespread discussion with various political parties and groups including the main opposition party, a diluted version of the 1995 Devolution Proposal was introduced in Parliament in August 2000 in the form of a Bill to amend the Constitution of Sri Lanka, which, however, was met with much resistance by the Opposition in Parliament and could not be passed due to a failure to obtain a two-thirds majority.

2000–2001 Period: War Escalation, External Shocks and Political Coalition Management In March–April 2000, the LTTE captured Elephant Pass with a large capture of armaments and proceeded to the periphery of Jaffna. This was a time when the


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government had to make large expenditure commitments to purchase sophisticated defence equipment such as multibarrel rocket propelled launchers. In 2000, the defence budget amounted to 6 per cent of GDP—the highest since 1983 (Table 7.2). The year 2000 was not a favourable year for Sri Lankan economic management, but was a good year in terms of achieving 6 per cent growth due to high export earnings from garments and tea. Increased defence purchases coincided with the world oil price increase in mid-2000. This led to a severe erosion of foreign exchange reserves in the country and by the end of 2000 foreign reserves were able to sustain only two months of imports. The economy was simply not strong enough to bear the two shocks. The situation led to a crisis management in early 2001—a free float of the currency was introduced in January and a 40 per cent surcharge was introduced on all non-essential imports in February. These measures were followed by a radical budget in March and the signing of a Stand-By Package (SBP) with the IMF (IPS, 2001; Chapter Six of this book). The PA government did not have a SBP with the IMF during its tenure because there was no foreign exchange crisis and the government did not want to be conditioned by the IMF in economic policy making. The circumstances in 2000 compelled the government to come to this agreement. When the first instalment of USD 131 million was released in April 2001, it appeared that a new era of economic policy making had begun. The much-needed third wave of liberalisation to install second-generation reforms could have started (Chapter Six). In Sri Lanka, it has been shown that tough reforms that involve heavy short-term costs could be implemented during the early years of a new government in power. Although, the re-elected PA government in October 2000 was a weaker coalition than the previous PA coalition government, given the president’s coalition management skills (that were demonstrated during 1994–2000), there was no indication of the break-up of the coalition even by March–April 2001. In fact, in February 2001, the UK banned the LTTE, and in March 2001, there was a failed attempt of a coup d’état on the Leader of the Opposition from a group within the UNP and the English cricket team visited Sri Lanka during February–March and this led to a massive influx of British tourists, so much so that all hotels in Southern Sri Lanka were fully booked. The PA administration was riding high and thus, with the IMF support, the stage was set for a new reform package to take-off (Chapter Six). But, this was not to be. A minor incident in the hill country in early May 2001 triggered small scale riots in various pockets between the Sinhalese and Muslims. This led to an uneasy relationship between the Sri Lanka Muslim Congress (SLMC)— a coalition partner of the PA and the president, which culminated in the sacking of the leader of the SLMC from the Cabinet. The president’s calculation that this sacking will not shake the government proved to be wrong. The cross over of five members of the SLMC to the opposition made the PA coalition government extremely fragile and vulnerable to a no-confidence motion by the Opposition. Consequently, management of the political coalition with the support of various groups in the opposition took precedence over all the economic management issues—so much so, that all commitments with the IMF were not fulfilled by the due date, in order to receive the instalment payment of the SBP. In fact, there were substantial departures

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from the commitments. By July 2001, it was clear that the 4.5 per cent growth target announced in the March 2001 Budget speech was not going to be realised. To make matters worse, the economy faced four major shocks during 2001: (a) a massive electric power shortage starting May 2001, (b) drought with adverse impact on both hydropower generation and the agriculture sector starting June 2001, (c) the Air Port terror attack by the LTTE incurring losses close to USD 30 million in July 2001 (more than the USD 25 million that the government earned from the privatisation of the national airline—Air Lanka), and (d ) recession in the US market that was aggravated after the September 11 incident. The heavy toll of all these events severely disrupted the economy. For example, the airport attack led to one airline pulling out of Sri Lanka and some other airlines reducing the frequency of flights to the country. Ships coming to Sri Lanka introduced a surcharge and an insurance premium, all of which had to be borne by the Sri Lankan economy. The recession in the US (the biggest market for Sri Lankan exports) slowed down Sri Lankan exports and aggravated the economic situation. The Indo-Sri Lanka Bilateral Free Trade Agreement (ILBFTA), which came into effect in early 2000 never really gave the much-needed economic space during 2001 to Sri Lankan exporters when the major markets in the West were experiencing recession. A number of shortcomings prevented the ILBFTA from delivering the expected results (Kelegama, 2001). During the period from September–November 2001, Sri Lanka witnessed nothing but back-room deals being worked out for sustaining the PA political coalition.2 It peaked when the leftist JVP supported the government in September 2001 to follow an agenda determined by them (IPS, 2001). On the other side, the Tamil moderate parties formed the Tamil National Alliance, which had the backing of the LTTE and supported the UNP to topple the government.3 And the CWC (Ceylon Workers Congress) of the estate Tamil people pulled out of the PA coalition in early October. To make matters worse for the PA, several heavy-weights in the PA Cabinet crossed over to the Opposition in early October 2001 and the final blow to the fragile PA coalition came on 10 October, when the president dissolved the Parliament for new General Elections. A sum close to Rs 600 million was allocated for conducting the General Elections. The December 2001 elections gave a resounding victory to the UNP led by Ranil Wickremasinghe. With a number of young technocrats in Wickremasinghe’s team, the UNP embarked on an ambitious scheme to revive the economy which experienced a –1.4 per cent growth rate in 2001—the worst growth that Sri Lanka had experienced since Independence. The prime minister made his intentions clear by lifting the partial goods embargo, enforced in the North and East and coming to a ceasefire with the LTTE, negotiated with the assistance of a third party—the Norwegians. He visited India in early 2002, to update the Indian government on the situation and obtain the support of India for working out a peace deal. In February 2002, an MoU was signed with the LTTE for a formal cessation of hostilities. Before embarking on an analysis of the challenge ahead for the new government it would be prudent to look back at the damage the war has inflicted on the Sri Lankan economy.


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Economic Cost of the War The economic cost of the war cannot be measured with accuracy. A comprehensive study done found the cost during 1984–96 to be approximately 168 per cent of the 1996 GDP (Chapter Five). This is a huge sum for a developing economy with a per capita income below USD 1000. In fact, the per capita expenditure on defence in Sri Lanka was the highest in South Asia (World Bank, 2000: 20). The adverse direct impact that the war has made on the overall investment regime has been highlighted in the previous studies (Chapter Five). There are a number of indirect costs that the Sri Lanka economy faced due to the war. For example, by going to make up for the uncertain investment climate by offering an additional package to investors, Sri Lanka ended up in difficult situations. Despite making the BOI a ‘one stop shop’ in 1992, Sri Lanka failed to attract large well-known companies under its FDI strategy. The privatisation programme did attract a few big companies listed in Fortune 500—Noske Hydro (Norway), Caltex (US), Shell (Dutch), P&O (Australia), Nippon Telegraph and Telecom (Japan), etc., for portfolio investment. Given the war-related uncertainty in the investment regime, Sri Lanka had to go the ‘extra mile’ to attract some of these investors by providing them an exclusive incentive package. For example, Caltex that took over the import and distribution of lubricants was given an exclusive monopoly status with regard to importation and distribution of lubricants till 2004. Consequently, a number of companies that showed an interest in the Sri Lankan lubricant market later on like BP, Esso, Mobil, etc., shied away from the Sri Lankan market due to the situation. Similarly, the Shell company was given exclusive monopoly status in 1995, till December 2000, for all transactions in gas. This strategy worked against promoting a more competitive market in the long run and the company utilised the exclusive period to establish an infrastructure and distributional network to maintain a market dominant position in the future. Since capital expenditure was curtailed to accommodate the rising defence budget, infrastructure projects under BOO (Build, Own and Operate)/BOT (Build, Operate and Transfer) became a priority item for the government. But projects earmarked for BOO/BOT consideration could not effectively take-off because foreign investors asked for an above international average rate of return to cover-up the war risk. For instance, if the standard rate of return is around 22 per cent, the rate set for Sri Lanka was close to 27 per cent. Among other factors, the government simply could not accommodate such demands. Thus, the government had to abandon the BOO/BOT option in some projects and opt for a soft loan debt financing by an international donor. This was especially the case for some highway projects. A number of other indirect costs can be highlighted. The war has caused enormous brain drain and loss of skilled manpower (nearly, 65,000 people have been killed by the war), frequent security checks and road blocks have created long delays and loss of productivity, some legislation implemented to control LTTE activities, such as the Prevention of Terrorism Act has been misused to harass political opponents, army deserters have contributed to worsening the law and order situation

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and so on. While these costs were borne by the formal economy, the war economy had its own dynamics in the informal sector. The LTTE generated an informal economy nourished by the remittances of the Tamil diaspora, drug/narcotics smuggling, arms sales, etc. Some goods, petrol, kerosene, etc., were smuggled from southern India. In the South too, there were informal transactions due to the war, for instance, defence purchase kickbacks enriching a closely net circle of businessmen/politicians. A flourishing sex worker industry in major cities in the North Central province where armed forces were kept at stand-by for war, or came-in for a stop-over for rest/recreation, has also been a trend.

Defence Expenditure The government budget deficits could have been manageable if not for the high defence expenditures. Consequent to a high defence expenditure there was a overheating of the economy at a time when generous overseas assistance had dried-up. It was thought that after 1977, Sri Lanka could shift expenditure from social infrastructure to physical infrastructure. During the 1977–82 period, this was possible with the unleashing of the massive public investment programme, but not thereafter. What happened after 1983 was a reallocation of expenditure from ‘welfare to warfare’ (Chapter One). Despite the war there was no rapid expansion of defence expenditure during 1987–89. This is because of the presence of the Indian Peace Keeping Forces (IPKF) which absorbed the bulk of the burden of defence expenditures in the North-East. An analysis of defence expenditure shows that about 40 per cent is accounted for by wages and about 60 per cent on capital/equipment. Defence expenditure did not fall significantly after 2000–2001 due to the nature of deferred payment of the defence expenditure. Defence expenditure went down from Rs 80 billion in 2000 to Rs 76 billion in 2001. As Table 7.2 shows, Sri Lanka has been facing high budget deficits for a number of years. Had the defence expenditure been at the level of 1.1 per cent of GDP— the level before the war started in 1983—Sri Lanka would have been facing much lower deficits, perhaps in the range of 3–4 per cent of GDP. As argued, there would have in any case, been meagre savings on defence expenditures. These savings would have got absorbed for the 900,000 people that had been displaced (Sunday Observer, 28 April 2002: 4). A number of refugees from southern Sri Lanka and southern India would have returned to the North-East. They need 10 times more money than what the government allocates. Backward linkages from the defence industry hardly developed over the last two decades. A Keynesian-multiplier type of an effect was not visible for forward and backward integration. There were times when requests were made by the government for special orders for the armed forces, like the Leather Products Corporation being asked to produce boots, required for army personnel and a garment factory being requested to make some clothing for the army. In the late1990s, the Colombo Dockyard manufactured some Naval craft for the Navy. But none of these ventures became industries on their own. Massive recruitment to


167

the armed forces and security guards brought in income to rural households at a time when rural economies were facing difficulties due to an agrarian crisis (Dunham and Edwards, 1997).

2002: Economic Revival Package Based on the Peace Deal and the Immediate Economic Challenges The government depended heavily on the peace package to rescue the economy. This was reflected in the March 2002 Budget which was basically a budget that cleared some of the existing obstacles for private sector growth and cut capital expenditures. A number of tax incentives that were difficult to consider when the budget deficit was running at 10.8 per cent of GDP in 2001 were offered. Tax amnesties, corporate tax reductions, reduction of the income tax threshold, reducing the import surcharge by 50 per cent, etc., were offered. There was not much offered to the poor other than a package to revive the rural economy and increasing agricultural tariffs for some domestic food crops. In addition to the economic revival package announced in the Budget 2002, the government took several measures to kick-start the economy. A 100-Day programme was initiated soon after the government took over office. The energy sector was resuscitated by June 2002 by initiating a number of new thermal power projects. The ILBFTA was strengthened by talks with the Indian government in June/July. Discussion on a bilateral free trade agreement (FTA) with Pakistan was initiated4 and a Trade and Investment Framework Agreement (TIFA) with USA was signed in late July 2002. The massive victory at the local government elections in mid-March 2002 gave the government adequate confidence to implement, via the 2002 Budget, some tough measures with short-term costs. The GST (Goods and Services Tax) which had many loopholes and which was subject to three amendments, and which failed to bring in the anticipated revenue during the 1999–2001 period was abolished. So was the NSL (National Security Levy), which brought in nearly 2.7 per cent of GDP revenue in 2000. Instead of these two taxes a two band (10 and 20 per cent) value added tax (VAT), was introduced. The automatic pricing system for petroleum that was introduced in the budget had an impact on the cost of living. According to the IMF–Government of Sri Lanka MOU the integration of the GST and NSL was supposed to take place over a four-year period ending in 2004. However, the 2002 Budget did it in one go by introducing the two-bands VAT. NSL was a very effective tax, which met 45 per cent of the defence spending in 2000. However, it was a cascading tax that nullified what the GST tried to achieve by removing the cascading nature of the tax system in the country. Thus, its elimination is no doubt favourable for simplifying and making the tax system more efficient. However, the NSL did have a positive feature, i.e., whenever there were

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revenue problems the government managed to increase it by 1–1.5 per cent and justified it as the sacrifice that the private sector should make to meet additional defence expenditures to safeguard the unitary status of Sri Lanka. But any increase in the VAT rate and justifying it would be difficult and thus, could meet with severe resistance by the private sector. The other major source of revenue in the 1990s has been proceeds from the privatisation programme. After 2000, there were hardly any ‘cash cows’ for privatisation. The privatisation programme has been uneven and erratic with the actual proceeds often falling far short of the anticipated revenue. For example, in the year 2000, out of the anticipated revenue proceeds of Rs 30 billion the amount actually realised was Rs 401 million and in 2001 of the anticipated revenue of Rs 25 billion only Rs 8.6 billion was realised. Thus, the privatisation programme becoming a source of funding additional defence expenditure needs was no longer the case. Cutting down capital expenditure to meet defence-expenditure needs had, hence, become a policy in the budget. This has had an adverse impact on medium and long-term growth of the economy. The government’s current expenditure was very difficult to cut because nearly 73 per cent of expenditure was of a fixed nature and is sensitive in the context of the political economy. Approximately 31 per cent of the expenditure was absorbed for interest payment, 15 per cent on wages and salaries of the central government civil sector (nearly 850,000 government employees), 23 per cent on defence and security measures and 4 per cent on the poverty alleviation programme (Samurdhi). What was envisaged as a solution to the North-East problem in 1987 was the 13th Amendment to the Sri Lankan constitution and the implementation of the Provincial Council system. Instead of becoming a solution to the problem it became a problem in itself in the context of budgetary management. It accounted for 9 per cent of current expenditure in 2001 (CBSLAR, 2001: 161). There was a large amount of overlapping of expenditure between the central government and provincial councils. It also created an additional layer of bureaucracy to no avail. This is perhaps one area that could have been considered for expenditure reduction. Among other factors, defence expenditure escalations have prevented the government in achieving the targeted budget deficits in practically every year in the 1990s (Chapter Six). For example, in 2001, the estimated budget deficit was 8.5 per cent of GDP but what actually turned out was 10.8 per cent of the GDP deficit. Given the limited flexibility of the current expenditure and the limitations of the privatisation programme, as stated earlier, the targeted budget deficit of 8.5 per cent of GDP in 2002 was unlikely to be achieved. Consequently, the macroeconomic imbalance was going to remain a persistent problem for the government. It would not have been sustainable without some structural and policy reforms being implemented to revive the economy. These reforms are basically the second-generation reforms that were outlined in the IMF–SBP package and these reforms go deeper than the economic kick-start package implemented by the government. Sri Lanka passed the per capita income threshold of USD 785 in 1998 and became a middle-income country. (It has the second highest per capita income in South Asia after Maldives.) Consequently, foreign concessional aid to finance budgetary problems and projects had declined. Sri Lanka has been contemplating gaining


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a sovereign rating in order to raise funds in the international market for quite some time. But these ideas have been non-starters given the macroeconomic instability in the country. Even the much-desired attempt to liberalise the capital account of the BOP has been delayed due to the macroeconomic situation. Needless to say, the East Asian financial crisis, which led to the collapse of capital markets, also invited a cautious approach in this direction. The main outcome of the past social welfare expenditures is a demographic transition where there will be a rapid ageing population in Sri Lanka—which would be the only country among developing countries to have a population of above 65 years constituting more than 20 per cent of the population in the years 2020–25. While countries in Europe took 45–145 years for the above 65-aged population to double, in Sri Lanka this will happen in 20 years. Consequently, the social care will need substantial revisions. Ageing also has implications on the budgetary side. The pensions system needs substantial reform because government pensions can absorb about 20 per cent of the expenditure in the future and distort public expenditure patterns with serious implications for public investment and economic growth (Sanderatne, 2000). There are almost 400,000 pensioners in Sri Lanka and the pension budget accounts for 9 per cent of current expenditure and nearly 2 per cent of GDP. The first step towards moving to a funded pension scheme was implemented in the 2002 Budget, but the process needs to be expedited. As stated, the third wave of liberalisation and the implementation of the secondgeneration reforms could not take place in 2001. Factor markets still remained rigid and marginally influenced by the forces of liberalisation. The institutional structure to support the market economy was still not in place. A number of structural impediments prevailed that constrained the efficient functioning of markets. Infrastructure still remained far from international standards. In this context, implementing second-generation reforms was timely. The IMF–SBP package that provided a loan at 4.34 per cent interest came to an end in December 2002. The PRGF (Poverty Reduction and Growth Facility) took over from April 2003 and the loan from PRGF was at a concessional level of 0.5 per cent interest rate. Almost 22 per cent of the population lives below the poverty line, thus, addressing the poverty issue was paramount in any future development strategy of the country. Sri Lanka submitted the Poverty Reduction Strategy Paper (PRSP) and the Relief, Rehabilitation and Reconstruction (3Rs) report to the Development Forum in early June 2002. These reports constituted a vital part of the government’s policy document called Regaining Sri Lanka that was published in May 2003.

Peace Dividend? The much talked about peace dividend was an illusion. First, it was far from certain how the cessation of hostilities was going to end. The thinking of the government was that once business ventures go into the North-East and the economy takes off

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in the regions, the support for war would reduce substantially and with the third party support and international goodwill, Sri Lanka will be able to lock in the cessation of hostilities and negotiations about peace talks in order to embark on a higher level of political negotiations. The stakes were high for both the sides. The LTTE, although bargaining from a position of strength, was not able to win the war by taking control of all areas in the North-East from the Sri Lankan armed forces. Its funding channels have been considerably weakened after the organisation was banned in the US, the UK, India, Malaysia and Australia. The LTTE needed some breather from hectic warfare after 11 September 2001 as world events were not favourable to their activities. Their cadre recruitment was becoming difficult with a number of children being recruited despite serious concerns expressed by international observers. The Sri Lanka armed forces morale was also low after a string of defeats (the last one being Operation Agni Kheela in late-April 2001), lack of leadership and lack of coordination (Sunday Leader, 14 April 2002). Thus, both parties needed the ceasefire. For the Sri Lankan government, it had to show the world outside that it was prepared to offer a solution, short of separation of the country, that addresses the fears and aspirations of the Tamil people. There were a number of road blocks to this process in 2002. First, after stating that LTTE will come for peace talks without any conditions, the LTTE reneged on the pledge by not only demanding deproscription prior to the commencement of talks but also laid down the Thimpu principles (Recognition of: [a] Tamil homeland, [b] right of Tamil self-determination, and [c] Tamil nationalism) as the basis of a solution. Second, in an interview the LTTE leader stated that he has not given up the idea of a separate state of Eelam. It was also stated that the then Sri Lankan prime minister was not recognised as the prime minister of the North and East and both the president and prime minister of the North and East is the LTTE leader. These statements shrouded the whole peace process with uncertainty. The Thimpu principles, among others, caused the previous peace process to come a cropper, after months of negotiations. Given this scenario, there was uncertainty as to how the cessation of hostilities would finally manifest by 2003. The most likely scenario was a ‘no-war no peace’ situation where the LTTE would use the cessation of hostilities, humanitarian and development assistance to extend their administration and influence in the North and East. Basically, the government would grant de facto control of the North-East to LTTE along with economic assistance in exchange for LTTE not violating the ceasefire. The LTTE would seek to extend this scenario in hope of an ‘interim council’. Some commentators argued that with the passage of time the LTTE will transform the ‘interim council’ into a separate state and when this is thwarted by the government, and with the end of the ceasefire the problem will begin once again. On the other hand, some other commentators have argued that the prolonging of the negotiations during the ceasefire would create its own dynamics. Citizens of the North-East who were sick and tired of the war, having tasted the benefits of the economic take-off in the North, will constitute a major pressure group against the war. These dynamics could work only if donor support came in soon. Economic


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gains, it is argued, is the key to the consolidation of a ceasefire and preventing the LTTE from going into another war. A number of donor agencies were active in the North-East of Sri Lanka in 2002. The FAO was planning to support 15 projects involved in fisheries, rice farming, home gardening, livestock development, etc., and allocated nearly USD 14 million (The Island, 28 April 2002: 3). Japan allocated USD 42,880 for integrated development of 30 villages under 3Rs. The UN promised to raise money to help some of the poorest victims of the ethnic war (The Island, 29 April 2002). These were positive signs from the donors. But the bulk of the burden of the 3Rs was going to fall on the government if the donor support did not arrive soon. Some donors watched the situation in 2002 in the light of the LTTE press statements before making any firm commitment on a collective plan. Donors conducted business with the LTTE with the concurrence of the government. However, donors had to be mindful that adhering to all demands of the LTTE in order to ensure that development projects could be implemented for the benefit of the civilians living in the North and East could easily lead to strengthening the LTTE. By end 2002, there was no clear statement from donors as to how they were going to conduct business with the LTTE. The government, on the other hand, had to put in an effective monitoring system to ensure that donor assistance was not misused by the LTTE.5 A factor, irrespective of peace, that was bound to slow down the implementation of policy, was the visible conflict between the ruling party and the president. A number of key items needed the final approval of the president. In fact, the president stated that the MOU was not legally valid because it did not have her concurrence. (However, the ceasefire and peace negotiations were not based on constitutional reform or even legislative support.)6

Concluding Remarks The question has been posed whether putting the economy back on track was based on obtaining peace at any cost. Commentators such as Paul Harris (2002) argued that the MOU was a give-away package where the LTTE was using the ceasefire for a whole series of sophisticated strategies designed to occupy all the political and social space throughout the North and East of the country and possibly other areas including the tea estate hill country. He argued that in addition to undermining the government control and authority, the enhancement of LTTE military authority was aggressively undertaken.7 ‘Sri Lanka has held the optimism on a number of occasions when ceasefires of hostilities were announced, only to be disappointed within a couple of months.’ The more optimistic commentators argued that the factors that were working against this happening again were the full involvement of a third party, the world watching the situation, and as stated earlier, the high stakes on credibility for both sides. These factors were holding both parties to a negotiating process in 2002. Both parties were aware that the ‘no war—no peace’ scenario cannot last indefinitely.

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In mid-September 2002, the first round of peace talks took place in Thailand. The government lifted the ban on the LTTE a few days before the scheduled talks in Thailand. The government was of the view that as long as the LTTE remained banned, it would have no political space outside the areas of its direct control. The government was also of the view that proscription would encourage the LTTE’s military track and what was needed was to permit the organisation to engage in political activities. The second round of peace talks took place in Thailand in lateOctober 2002. The outcome of both rounds of peace talks were positive. Thus, by end 2002, the situation was tilted more towards the optimists. The macroeconomic imbalance was unsustainable. The public debt exceeded the GDP in 2001 and projections in 2001 showed that debt service payments would exceed government revenue in 2002. The prorata share of country’s debt burden on an individual citizen of Sri Lanka amounted to Rs 77,500 (USD 807). The economy, in 2002, was no longer in a position to absorb another war in the form of Eelam War IV. The growth for the first half of 2002 was 1.3 per cent, indicating the slow recovery. The continuation of high expenditure-oriented macroeconomic policies without structural reform on policy adjustments would neither increase growth nor address the macroeconomic imbalance. In fact, it would have led to an economic crisis with heavy social and economic cost. Given the fact that defence expenditure would remain a major expenditure item in the budget, the medium-term economic outlook for Sri Lanka will depend on the magnitude and speed of policy adjustments and implementation of structural reforms. The adjustment and policy reform have shortterm costs. There were two scenarios that were possible: (a) the ceasefire ending and the commencement of the war, and (b) the ceasefire leading to peace via a major involvement of the international community. If scenario (a) was the outcome, the speed of implementing reform would have slowed down and the economy would have fallen into a deep crisis. If scenario (b) was the outcome, the speed of implementing reforms would have accelerated and the economy could be gradually uplifted. But it was vital to note that under this scenario, foreign funds coming into North and East would require substantial counterpart funds and relief, rehabilitation and reconstruction were going to be costly. There was no peace dividend at the beginning; in fact, peace was going to be costly. In any case, economic management together with ceasefire management was going to be a cumbersome exercise for the government. Indeed, it was going to be an uphill task to put the economy back on track.

Notes 1. Basically what the president meant by NIC status was to achieve a GDP per capita income of USD 1,000. 2. In mid-July 2001, the Parliament was prorogued and a referendum for a constitutional change in mid-August 2001 was announced. In August, when the government realised that the referendum would be difficult to win, it cancelled the referendum and looked for political partners to keep the PA coalition in power.


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3. The LTTE paralyses a government when it is weak. This strategy has been used effectively in the past to topple elected governments. 4. This came into force from 12 June 2005. 5. ‘The LTTE and the Politics of Aid’, by Sasanka Perera, The Island, 15 May 2002. 6. In fact some cases have been filed in courts contesting the legal validity of the MOU. 7. It is argued that even at present, there are no indications that the LTTE has undergone a political transformation. It does not tolerate dissent and claims that it is the only representative of the Tamil people. There are no indications of LTTE turning itself into a mainstream democratic force. The usual practices of LTTE such as, smuggling of weapons, extortion of money from civilians, recruitment of children, etc., have still not come to an end (see ‘Evidence of LTTE Atrocities during Ceasefire,’ by Defence Correspondent, The Island, 19 May 2002).

References Arunatilake, N., S. Jayasuriya and S. Kelegama (2001), ‘The Economic Cost of the War in Sri Lanka’, World Development, Vol. 29, No. 9. Central Bank of Sri Lanka (2001), Annual Report, Colombo (referred to in the text as CBSLAR, 2001). Dunham, D. and C. Edwards (1997), Rural Poverty and an Agrarian Crisis in Sri Lanka, 1985–95: Making Sense of the Picture, Poverty and Income Distribution Series, No. 2, Institute of Policy Studies, Colombo. Harris, P. (2002), ‘The Greatest Giveaway in History’, 23 April 2002 (internet download: Daily Telegraph, London, correspondent, Sri Lanka and specialist contributor on Global Insurgency and Terrorism). Hewavitharana, B. (1997), Economic Consequences of the Devolution Package, Systematic Print, Colombo. IPS (1995), Sri Lanka: State of the Economy—1995, Institute of Policy Studies, Colombo. ——— (2001), Sri Lanka: State of the Economy—2001, Institute of Policy Studies, Colombo. Kelegama, S. (2001), ‘Indo-Lanka Bilateral FTA: Progress of Sri Lankan Exports in Year 2000’, Sri Lanka Exporter, Vol. 34 (June–August). Sanderatne, N. (2000), Economic Growth and Social Transformations: Five Lectures on Sri Lanka, Tamarind Publications, Colombo. World Bank (2000), Sri Lanka: Recapturing Missed Opportunities, SASPR, Washington, D.C.

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8 TRANSFORMING THE CONFLICT USING AN ECONOMIC DIVIDEND The Experience during 2002–03

Introduction There is a growing body of literature on the characteristics of war-torn economies and on policies of post-conflict reconstruction. This has led to substantial policy initiatives and new mechanisms of peace building. Surprisingly, however, there has been no systematic analysis of how economic factors contribute to the success or failure of peace agreements (Woodward, 2002; Addison, 2003). The 2002–03 development experience in Sri Lanka, provides a good case study of using an economic lever for conflict transformation. By 2001, Sri Lanka had experienced nearly two decades of conflict with the Liberation Tigers of Tamil Eelam (LTTE) who has been waging wars for a separate state in North-East Sri Lanka. The economy of Sri Lanka was burdened by the costly war and was in a crisis situation in 2001. A conflict-resolution package was put into operation in early 2002 and peace talks were initiated; simultaneously, steps were taken to revive the economy. The conflict-resolution exercise basically kept the controversial political issues out from the beginning and focused instead on the confidence-building exercise with an economic dividend to stimulate the process and take it to a higher stage of negotiations. It had three major components, viz., an economic rebuilding exercise, forming a new institutional set-up for re-building the North-East—where for the

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first time, the LTTE was treated as an equal partner in the dialogue (rebuilding also included relief and rehabilitation)—and lastly, an aid mobilisation exercise for both rebuilding the economy and for relief and reconciliation work in the North-East. Consequent to the aid mobilisation process, international actors were also brought into play in the conflict resolution exercise. The economic revival was based on the standard IMF structural adjustment package. The conflict resolution exercise was much influenced by the Norwegians who played the role of facilitators. For instance, the Foreign Minister of Norway has stated: ‘Most armed conflicts are complex, and have deep ethnic and historical roots. Often they have their origin in poverty and discrimination. But it is increasingly clear that lack of economic opportunities and pure greed are prominent causes as well. Hence, in preventing and resolving armed conflicts, we must focus on the economic dimensions of the war’ (Jan Peterson quoted in IPA, 2002: 17). The peace talks failed or came to a halt after one-and-a-quarter years in April 2003, however, the war did not resume. The LTTE spokesman said that the process was not moving fast enough to deliver an economic dividend to the North-East. While the political and strategic element of the LTTE pulling out of the peace talks cannot be underrated, there was indeed a problem of the much-expected economic dividend not materialising. This needs an explanation. The ambitious economic dividend-led peace programme brought much relief from tension and fear for people living in southern Sri Lanka after nearly two decades of war and terror. The support from the Southern people was essential for advancing the peace talks to higher levels. Yet, in the April 2004 general elections, the Southern electorate rejected the government. This too needs an explanation. Sri Lanka succeeded in putting a crisis-ridden economy back on track. However, delivering an economic dividend to consolidate the peace process and thereby gain support for the government, became a difficult task due to the very complex nature of the problems that faced the government. In this chapter, it is argued that an economic dividend can get delayed due to impediments from both the government and rebels and from the donors’ attitude to rehabilitation work. Moreover, an economic dividend by itself is inadequate to advance a peace process to higher stages of negotiations. Thus, it was not easy to transform and resolve the conflict by using economic levers in Sri Lanka. An exercise of this nature has some limitations. First, proponents of the economic lever as a means to transform conflict, may argue that two years (2002–03) is too short a period to measure an economic dividend. This may perhaps be correct, however, even within a short period of two years it is possible to see whether there are signs of an economic dividend working. It is this area that this chapter focuses on in the remaining sections. Second, the peace process was put into effect at a time when there was an uneasy cohabitation between the executive president and the government (different political party) and the power base of the prime minister was weak. This limitation may have influenced the final outcome and that is recognised in this chapter. The rest of the chapter is organised as follows—the next section provides the background work done for the purpose of providing an economic dividend. The third section analyses the economic dividend in southern Sri Lanka while the

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following section examines the same in North-East (N-E) Sri Lanka. The secondlast section examines the political economy of the peace process and is followed by concluding remarks.

Background to the Peace Process The year 2001 was a noteworthy year in terms of economic performance. After a number of military reversals in the years 1999–2000, the economy recorded the lowest growth of –1.4 per cent. It was the only country in South Asia to show a negative growth rate that year. Partly, the performance was a result of factors beyond the control of the country, however, domestic mismanagement of the economy also contributed to the outcome (IPS, 2002; Chapter Seven of this book). A Standby Package (SBP) signed with the IMF in early 2001 was falling apart, the budget deficit had reached nearly 11 per cent of the GDP, public debt to GDP was above 100 per cent and inflation was running at a two-digit level, all of which characterised the dire straits the economy had reached. A new government that assumed office in late-2001 (United National Front— UNF) was of the view that the only way to revive the economy was to work out a peace formula with the rebel group LTTE. This was because the government’s budget deficit bore a heavy burden from the defence expenditure ranging between 5 and 6 per cent of GDP and short-term revenue increasing measures were gradually getting diminished.1 The government was of the view that without reducing the defence budget, it would be difficult to reduce the deficit. Moreover, the uncertainty created in the investment climate by the ongoing war made many potential foreign investors shy away from Sri Lanka. On the LTTE side, there was a depletion in their cadre and war-weariness had gradually made inroads. Moreover, the LTTE was very vulnerable to the global anti-terrorism momentum that had increased after the 9/11 incident in the USA. Thus, the LTTE also needed a breather to regroup itself and disengage from terrorrelated activities (Gunaratna, 2003). Thus, it was a ‘win-win’ situation for both parties. The timing was most appropriate for both to get involved in peace talks.

Basic Steps for Confidence Building The government and the donors recognised the LTTE as the most important political player in the development of the North-East and in building peace. For the peace package a number of measures were put into operation—lifting of the embargo of goods from southern Sri Lanka to the North-East (15 January 2002), signing of a ceasefire agreement (CFA) with the LTTE (22 February 2002) with the facilitation of the Norwegian government (third party) and a Sri Lanka Monitoring Mission (SLMM), as well as the opening up of the A-9 highway for easy movement of goods/services/labour (8 April 2002).2 This package led to a cessation of hostilities between the two warring factions that made the government focus more on putting the economy back on track.


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After these initial steps the LTTE was de-proscribed (September 2002) and the government and the LTTE had six rounds of peace talks.3 The peace talks were unconditional and were not based on the condition of de-commissioning of weapons by either party. The two structures of power in North-East Sri Lanka—the government-controlled areas at the time of the CFA, were earmarked as High Security Zones (HSZ), and the LTTE-controlled areas were allowed to remain as they were in early 2002. A de-mining exercise was put into operation with the assistance of the donors to facilitate the resettlement of internally displaced persons (IDPs) who have been subjected to varying degrees of deprivation in the past. The rapid return of the IDPs after peace demanded immediate resettlement. Land and water rights of returning IDPs, fishing rights and restrictions on navigation, resettlement of IDPs in the HSZs were some of the complicated issues that needed to be addressed. The strategy was to adopt a step-by-step approach and negotiate a political solution at the end after the process of confidence building, mobilisation of foreign resources to reconstruct war-torn areas and the economic dividend was delivered to the North-East (see section ‘Political Economy and the Dynamics of Peace’).

Institutional Structure for Peace Building Beyond a ceasefire, a peace agreement needs a new political order—institutions (Woodward, 2002). The institutional structure for the relief and rehabilitation of the North-East under the previous government was based on the 3 Rs (Relief, Rehabilitation and Reconciliation) strategy where the cooperation between government and NGOs on relief was emphasised, especially in government-controlled areas. However, the LTTE was left out of the process and it was entirely led by the government. Consequently, it did not recognise a parallel structure of administration in the LTTE-controlled areas, neglected the issue of rights of fishing and land for the returning IDPs, etc. Moreover, the LTTE was of the view that the government was trying to woo people from LTTE-controlled areas using relief measures (JBIC, 2003). These shortcomings and concerns had to be addressed in the new institutional structure. The Secretariat for Coordinating the Peace Process (SCOPP) was established under the Prime Minister’s Office in January 2002. The LTTE Peace Secretariat— as a counterpart to SCOPP—was opened in Kilinochchi (northern Sri Lanka) in December 2002. A decision was made during the September 2002 talks to set up a Joint Task Force (JTF) to deal with relief, resettlement and development. The LTTE was treated as an equal partner in the JTF. However, the JTF was not defined properly and was therefore, abandoned in late-2002 (after the second round of peace talks in Thailand) in favour of three sub-committees—Sub-Committee on Immediate Humanitarian Relief and Rehabilitation Needs (SIHRN); SubCommittee on Military De-escalation (SMD) and Sub-Committee on Political Issues (SPI). There was a shared concern that the war-affected people should become beneficiaries of the peace dividend.

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The UNF government’s political power was built on a shaky foundation. There was a dual power structure—the legislative was in conflict with the executive and the state system was not very stable. The prime minister’s authority in the fragmented power system was limited. The constitution precluded him from embarking on any radical and innovative measures to find solutions to a variety of issues that underlie the North-East conflict. Thus, from the very beginning the government was reluctant to seek legislative authority to build up institutional structures for fear of constitutional constraints. SIHRN, SMD and SPI were all loose bodies without any legislative status. An interim administration for the North-East, which was advocated in the UNF manifesto, was avoided due to constitutional problems and the desire was to form ‘a provisional mechanism as “pre-interim” structure or rather a “nucleus” which could be systematically evolved into a substantial framework for an interim administration’ (Balasingham, 2004: 383). SIHRN was an important body, which was entrusted with the responsibility to decide on the allocation of financial resources required for prioritised activities, select appropriate agencies for implementation and identify humanitarian and reconstruction needs.4 The activities and projects initiated by SIHRN were to be financed through a fund called the North-East Reconstruction Fund (NERF) associated with the World Bank.

Economic Revival Package The IMF-SBP that was falling apart had to be rescued, budget deficits (that have been mentioned earlier) had to be reduced, the aid utilisation rate had to be improved and the economy had to be put back on a growth track. The March 2002 Budget implemented a number of measures to put the economy back on track, however, the measures had very little to offer for the poor. The government depended heavily on the growth process to address poverty.5 The introduction of second-generation reforms had been much delayed in the Sri Lankan economy. Although, economic reforms had been carried out and privatisation had been extended to public utilities, only a few areas of utilities such as gas, telecom, seaport and airline were covered. There were many public utilities that had become a burden on the state budget and needed restructuring such as Ceylon Electricity Board, Sri Lanka Railway, Sri Lanka Transport Board, Sri Lanka Postal Services, Bank of Ceylon and People’s Bank. These were postponed due to the provincial council and presidential elections in 1999, war escalation and general elections in 2000, economic crisis and political coalition management in 2001. It was left to the newly-elected UNF government to pursue this unfinished agenda and embark on second generation reforms. Legislative reforms to support the market economy (in the labour and foreign exchange market among others), formation of market supportive institutions (multi-sector regulatory authority, consumer affairs authority, etc.), and deregulation (removing impediments to private sector growth, RSL, 2003 Annex) were the main ingredients of the new policy package. It is worth noting that an already weak government due to its thin majority in Parliament and an uneasy cohabitation with an executive president, got further weakened by some deregulation measures.


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The implementation of reform was quite quick, so much so that in mid-2003 around 10 Acts relevant to the economy, were bulldozed through the Parliament. The achievements were quite impressive. The economy recorded a growth rate of 4 per cent in 2002 and 5.9 per cent in 2003. The picking up of the economy was manifested well by October 2003 before the cohabitation crisis between the executive and the legislature started. There was a remarkable pick-up on tourism, so much so that for the first time the annual tourist arrivals exceeded 500,000 in 2003. The Total fishing figures in the North-East doubled consequent to the relaxation of fishing restrictions. There was also a five-fold increase in rice production in the North-East due to increased cultivation by end 2002. The net FDI inflow increased from USD 82 million in 2001, to USD 230 million in 2002, to USD 300 million by 2003. There was a large inflow of portfolio investment and the all share price index at the Colombo Stock Exchange surpassed the 1994 peak value. All indications pointed towards a prospering market economy was working well with mergers and acquisitions taking place at regular intervals.6

Donor Assistance The reliance on donors for working out a solution was an explicit policy of the government. As Moragoda (2003b: 261) states, ‘... the international community should recognize that they too have a stake in the outcome of these negotiations, that we believe, is our surest guarantee of success’. Donor assistance that had been flowing in since 2002 contributed to the rehabilitation in the North-East of 45 kms of the A-9 highway, 238 kms of small roads, 108 irrigation tanks, 156 wells, 55 schools, 25 health facilities and rehabilitation of 32,735 Internally Displaced Peoples (IDP) families. Foreign donor assistance increased after the IMF-SBP was fulfilled by end 2002. Based on reform implementation evaluations, the IMF approved a Poverty Reduction and Growth Facility (PRGF) and Extended Fund Facility (EFF) in April 2003 that are valid till 2006, combined with facilities that total USD 567 million. The focus of the IMF programme was two fold: (a) fiscal consolidation to reduce public debt, and (b) structural reforms to reduce the role of the public sector. The World Bank also stepped up its activities in Sri Lanka, supporting the government’s economic programme—the key target of which was to halve the number under the poverty line by 2015. The Bank committed USD 2.7 billion in loans, credits and grants to support 98 different projects, while the ADB (Asian Development Bank) loans totalled USD 2.7 billion. The base case for the World Bank lending programme through 2006 consists of about four projects per year amounting to a total of USD 800 million. The European Commission adopted a €3.27 million decision under its Rapid Reaction Mechanism in support of the peace process in Sri Lanka. By mid-2003 the rate of aid utilisation had increased from 13 per cent in 2001 to about 21 per cent (CBSL, 2003: 197). The reforms undertaken and the government’s medium-term economic strategy outlined in RSL (2003) received strong support from the donors. The culmination of all these aid pledges was the pledge of USD 4.5 billion donor assistance in the June 2003 Tokyo aid donor meeting (25 per cent

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of 2003 GDP).7 Around 16 per cent of the total pledges were for the reconstruction of the North-East (ERD, 2004). However, the release of funds in addition to progress in the implementation of economic reform was conditional the progress of the peace package, which was in any case very vaguely defined (Ladduwahetty, 2004). Normally aid donors would like to see improvements in human rights, democracy and good governance, pluralism, etc., to release aid. For example, JBIC (2003) argued that Japanese aid is linked to (a) strict compliance with the CFA and rulings of the SLMM, (b) substantial progress on human rights in the North-East; (c) visible end to child recruitment and release to their parents; (d) evident progress of democracy and pluralism in LTTE controlled areas; (e) detailed undertaking with regard to the establishment of an acceptable system of governance/federal structure; and ( f ) commitment to phase military disengagement by the LTTE and government. The foreign aid driven economic dividend was crucial in the government’s strategy for peace. A leading actor in the peace process stated, There is no doubt that without donor support from the outset, economic recovery could turn out to be a distant prospect. If we are unable to demonstrate now, in a preliminary way, the dividend that the peace will bring we risk the negative effect of frustration among the parties, a breakdown of negotiations, and the resumption of hostilities. By allowing the flow of assistance to commence now we could begin to show to every section of our people, including the LTTE, that a peaceful accommodation of interests will bring tangible prosperity and a better quality of life to all. (Moragoda, 2003a: 261) The Norwegians also supported aid mobilisation for the peace process; ‘For the peace process to succeed, popular support for peace must be sustained. People must see tangible benefits of peace in their daily lives. Without significant international assistance, this opportunity will be lost’ (Norwegian Foreign Minister, Jan Peterson, as quoted in Balasingham, 2004: 391). The Sri Lankan ethnic conflict is complex with social, political, cultural and economic dimensions. For conflict resolution and peace building, the economic lever was used heavily (economic dividend, reconstruction and development) by the government. The government was of the view that by consolidating the economic dividend, via such measures, the peace process could be strengthened, sustained and moved forward. With all these measures/activities it was expected that the economic dividend would work favourably both in sustaining the stability of the government among the southern population and from a large constituency of people from the NorthEast, who will be beneficiaries of the dividend.

Economic Dividend in Southern Sri Lanka As has been argued elsewhere, the war was costly and it prevented Sri Lanka from growing at a rate close to 6–8 per cent (Chapter Five in this book; Arunatilake et al., 2001). However, despite the war, the Sri Lankan economy managed to grow at an


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average rate of 5 per cent during 1983–2000, mainly due to sectors such as tea, ready-made garments, worker remittances, etc., not getting adversely affected by the destruction created by the war. The cost of the war was felt mainly through taxes such as the National Defence Levy (NDL), Save the Nation Contribution (SNC) and high interest rates (the new taxes were required to meet the growing defence expenditure, which amounted close to 6 per cent of GDP in the late-1990s). However, this cost was mainly felt by the middle classes as they were the key people who were subject to hardships of increased taxation and high interest rates. In the rural areas, the cost of the war was hardly felt, other than of course the thought that ‘lifestyles would have been better without the war’. Rural people did feel the inadequate allocation of funds for rural development (electrification, water supply, irrigation, roads, etc.) but this was not an issue from the people’s perception that could be directly attributed to the war. On the contrary, there were some benefits from the war, i.e., increase in remittances for rural households from the rural youth serving in the armed forces. At a time when the agricultural base was gradually eroding in rural areas, it was these remittances from others (remittances from the workers in the Middle East and workers employed in garment factories) that kept rural households alive (Dunham and Edwards, 1997). With the increase in recruitment to the armed forces when the war aggravated, the rural economies benefited by additional flows of remittances. It is in this background that one has to analyse the economic dividend. First, the peace process came simultaneously with the costly structural adjustment package of the IMF. The Structural Adjustment Package started under the PA government in March 2001, but fell apart due to the break-up of the PA (People’s Alliance) coalition in June 2001—thereafter, political coalition management received priority over economic management issues till the General Elections of December 2001 (Chapter Seven). The IMF-SBP had to be rescued by the new UNF government in order to secure the much-needed aid package and in this process some hard decisions had to be made and policies that had short-term costs had to be put into operation: 1. Depoliticisation and targeting of the poverty alleviation programme (Samurdhi). Consequently, the Samurdhi allowance had to be taken away from 250,000 recipients. 2. Fertiliser subsidy granted to farmers had to be substantially curtailed. 3. Electricity, telecom and water charges had to be revised upwards to make the respective government bodies in charge of them to be less dependent on the state budget. 4. An automatic pricing system had to be introduced to petroleum, which was subsidised by the government earlier. 5. A new VAT (Value Added Tax) tax system (two bands of 10 and 20 per cent and later one band of 15 per cent) that replaced the former GST (Goods and Services Tax –12.5 per cent) and NSL (6.5 per cent) had some inflationary implications. 6. Public sector restructuring meant a freeze on public sector recruitment and trimming down the work force in overstaffed public enterprises—labour dismissals were not immediately relocated, and so on.

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There was no alternative course of action available for the government other than the implementation of some of these stabilisation measures, given the serious economic situation in the country by end 2001. The government was counting on the rapid inflow of foreign aid for macroeconomic management, but this did not take place on the scale the government expected. For instance, only USD 80 million was released from the PRGF-EFF in 2003. Thus, the cost of the stabilisation programme was not effectively cushioned in the short-run and there was no dividend for rural households. Second, the defence expenditure did not come down significantly as a result of the cessation of hostilities and there were hardly any savings from defence expenditure, for capital expenditure.8 Whatever savings on defence was absorbed by the increasing expenditure needs for refugee rehabilitation (350,000 IDPs returned home and 380,000 IDPs remained displaced).9 Insignificant decline of defence expenditure meant that the government had to select other areas to cut down the budget deficit to fulfil the IMF commitments. Corporate tax reductions and tax amnesties offered made severe dents on the government revenue, therefore, expenditurecutting received priority over revenue enhancement. In fact, capital expenditure was trimmed down by 1.5 per cent of GDP in 2002, thus, adversely affecting rural infrastructure development activities (electrification, water, irrigation, tanks, etc.). Various kinds of patchwork done to spread economic development activities to rural Sri Lanka, by creating five economic zones did not produce much benefits. The government gave priority to fiscal discipline and a Fiscal Management Responsibility Act was passed in 2003. Thus, the government budget was subjected to tight targets at a time when expenditure was required for peace building. Addison (2003: 4), studying Africa’s post-conflict scenario notes, ‘… unrealistic and excessively tight targets for overall fiscal deficit should be avoided when it endangers essential development spending’. This over-obsession with fiscal targets proved to be counter-productive in terms of timing, i.e., delivering an immediate economic dividend. Third, in the first year after the war ended, the private sector took a ‘wait and see’ attitude and refrained from embarking on risky and long-term projects due to: (a) the executive president who had on an uneasy cohabitation with the prime minister, had the powers to dissolve the Parliament anytime after 5 December 2002; and (b) fear that the LTTE might go back to war as it has done on many previous occasions when the peace talks failed. Thus, the anticipated response from the private sector was far from visible with less jobs being created in the economy. This was at a time when the government imposed a freeze on further recruitment in the public sector and embarked on implementing a VRS (Voluntary Retrenchment Scheme) to further shed labour from the public sector. Among others, due to these factors the economic dividend was hardly in existence. Other than the peaceful environment and the cessation of explosions of bombs in southern Sri Lanka, there was no material benefit for the majority of the people. Although, USD 4.5 billion aid package was a huge package, its disbursement was USD 557 million in 2003 (ERD, 2004)—a crucial year for more aid disbursement.


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Economic Dividend in North-East Balasingham (2004: 395) stated, For the suffering masses, peace negotiations have little or no meaning unless they gain the peace dividend in concrete monetary and material assistance without delay .... If the hardships of the people are not remedied and their humanitarian needs are not met, the momentum, the optimism and confidence that arose from the peace process will be severely undermined. It will be argued here that there were impediments for an economic dividend from all three players, viz., (a) government of Sri Lanka, (b) LTTE, and (c) aid donors. One cannot deny the fact that some economic dividend came into being in the North-East as a result of the CFA. Improved security conditions, better interrelationship among communities after the CFA, greater access of goods and services, access to income earning and skill development opportunities, all contributed to the dividend. Nearly 80,000 displaced families were settled. In 2002, school enrolment in the North-East increased by 17,500 (IPS, 2003). But the dividend could have been more than this, because the Northern Province is estimated to account for less than 2.5 per cent of GDP with high incidence of poverty. For example, only 3 per cent and 64 per cent have access to piped water and electricity for houses, respectively, compared with 52 per cent and 93 per cent in the Western Province (ADB, 2005). From the LTTE perspective, there was a serious concern with regard to the HSZ. According to the LTTE, the Sri Lankan army refused to comply with the obligation of the CFA and continued to occupy public buildings (houses, schools, colleges, temples, hotels, etc.) in towns and villages of the HSZ causing a huge humanitarian crisis of displacement—denying the rights of the people to return to their homes and villages (Balasingham, 2004: 382–83). However, according to the Satish Nambiar report, the withdrawal of armed forces from locations in the HSZ was conditional on the LTTE de-commissioning long-range weapons, which the LTTE flatly refused to do (Godage, 2004). Which takes precedence (CFA or Nambiar Report) is not clear, however, this issue was a major problem that contributed to the natural death of the Sub-Committee on De-escalation by the time the Fourth round of talks had started and delayed the economic dividend in the North-East. On the government side, there were procedural delays in tenders for contracts in the North-East and bureaucratic delays in line ministries. The same problems that governed aid utilisation were applicable for some of the projects ear-marked for the North-East.10 In the Fourth round of talks, the LTTE claimed the delay in getting humanitarian relief resulted in a significant erosion of confidence among the Tamil people in the peace process. The socio-economic conditions of the people were deteriorating. The displaced and the refugee population

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were languishing in camps and welfare centres in despair and frustration .... The Tamil people who bore the brunt of the war and suffering were becoming more and more impatient .... Tamilselvam [Leader of the LTTE Political-Wing] complained that several government institutions and beauracratic structures concerned with rehabilitation work in North-East were working in cross purposes and was not streamlined under SIHRN (Balasingham, 2004: 415–16). According to the LTTE, SIHRN was not functioning effectively and the urgent humanitarian needs of the Tamil people were not addressed. Bureaucratic delays coupled with government lethargy in appointing persons to the District Needs Assessment Panels, were causing impediments to the effective functioning of SIHRN. Besides, SIHRN had identified projects based on the immediate needs of the people, but funds were not available to implement the projects. By end March 2003 after the Sixth round was completed, the North-East Rehabilitation Fund was still to be activated.11 The provisional mechanisms in SIHRN made it a body without substantive implementing powers and personnel resources (Ferdinands et al., 2004). Balasingham criticised the RSL document, by stating: (a) it fails to examine the causality of the phenomenon of poverty, (b) fails to take into account the unique conditions of devastation prevailing in the North-East. ‘Ignoring the distinctive reality, your government posits poverty as a common phenomenon across the country and attempts to seek a solution with a common approach. This approach grossly understates the severity of the problems faced by the people in the North-East’ (Balasingham, 2004: 438). There is merit is this statement. War over a period of 20 years had considerably weakened local state institutions in the North-East. Even though government expenditure under relief and rehabilitation had grown after 1999, many beneficiaries felt that these resources had failed to make any appreciable impact on the quality of life of the people (Sivanathan and Thillainathan, 2004). The absorptive capacity of the state’s development institutions in the North-East had diminished to low levels, so much so, they ‘were unable to utilize more than 20–30 per cent of the allocations for rehabilitation’ (JBIC, 2003: 30). In April 2003, the LTTE stated that there is a lack of demonstrable progress in the North-East due to the ineffective government administration system, and pulledout of the peace talks. The LTTE, in turn, demanded an interim administration in order to have a control over finances and development matters. However, there were problems in the LTTE institutions and system of governance in the North-East that did not permit the dividend to fully materialise. The LTTE’s style of administration is very much akin to its military style. The imposition of taxes for all vehicles and individuals travelling on the A-9 highway contributed to an increase in the price of commodities transported from southern Sri Lanka to the North-East. Various checks that the LTTE conducts on vans, lorries, etc., also contributed to increasing the travelling time from Colombo to Jaffna to close to three days and this effected the delivery of goods and services in the market. Lack of storage facilities created additional problems for perishable food items, petroleum, etc.12 The LTTE following a different time to that of Colombo, in relation to GMT, created confusion to the people living in the North-East. Moreover, banks were


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reluctant to give loans without secure collateral as most collaterals were not acceptable to banks because they were vulnerable to LTTE control. The LTTE restricted movement, particularly, of people in the age range of 15–35, in the territory that they controlled. This led to a mass exodus of talented people from the North-East, contrary to the initial expectation of more people coming to the North-East. Continuous migration undermined the human capacity to undertake urgently required rehabilitation and reconstruction activities. This became a dilemma for the donors—inadequate human capacity to absorb donor assistance. According to Godage (2005), 642 projects had been identified in six districts of the North-East by April 2003, when the LTTE pulled-out from the SIHRN. Whether all these projects could have been implemented in the given circumstances is another question. All assistance to prevent starvation in the war-affected areas during 1990–2001 made by the international relief organisations UNHCR, WFP, Care International, Oxfam, etc., were not strengthened by the LTTE. There is a body called TEEDO (Tamil Eelam Economic Development Organisation) under the LTTE, but its economic programme is far from clear.13 Further, the LTTE made no attempt to woo the entrepreneurs who fled the LTTE-controlled areas to places in the border such as Vavuniya.14 Rebuilding of roads, power, telecom, water, railway, etc., are a sine qua non for the full realisation of the business potential. The LTTE depends heavily on the government and donors to undertake rehabilitation work but demands a percentage commission from the contractors. This was not seen favourably by many donors. For more foreign aid mobilisation for the region there has to be transparency, accountability and economic freedom—none of which exist in the North-East.15 Little effort is made by the LTTE to woo expatriate Tamils who are living in Western countries and are accustomed to a new way of life including freedom of thought, expression and movement. The LTTE has failed to come to terms with the fact that running an efficient economy is a different ball game from executing an effective guerilla or military attack. It was within such an LTTE structure of missing markets, missing institutions and non-democratic administrative structure that the government was expecting the economic dividend to manifest in the North-East and to trickle down from southern Sri Lanka. There were some constraints from the donors too. The well-known multilateral ‘Needs Assessment’ is a ‘tool kit’ approach based on the assumption that these conflicts are generally similar and they are culturally insensitive (JBIC, 2003: 49). According to Bastian (2003: 150), ‘they ignore specific histories, struggles and evolution of societies … Sri Lanka, Uganda and Afghanistan [are seen] in the same breath. There is an intellectual laziness and institutional reluctance to look into complex problems that societies facing conflicts go through’. There was an assumption that the market forces will work and the private sector response would be effective. The so-called good policies do not always work. What is required is immediate relief and not lagged growth. There was an infrastructural bias, based on the Marshall Plan approach in the reconstruction strategies (see, for instance, www.mrrr.lk) whereas immediate relief was due in other areas such as agriculture, poultry and fisheries. Shanmugaratnam (2003), for instance, argues that much could have been done within the existing

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security framework by implementing a special livelihood construction package for the fisheries sector. Questions have been raised by some commentators as to who actually benefited from the funds—is it the people of the region affected by the war, community households and women—or a network of local and foreign firms bidding for large infrastructure projects/contracts (Rajasingham-Senanayake, 2003). There was a marginalisation of local knowledge in this ‘tool kit’ approach where the emphasis was on international technical knowledge and undervaluing local knowledge and socio-political analysis. According to the World Bank assessment of Bosnia and Herzegovina, implementation of the reconstruction programme had been most effective in those sectors where priorities of donor assistance has been established jointly with the local authorities (Woodward, 2002). The geo-strategic interests of foreign powers have generated a complex agenda on their side, which are often contradictory to each other (Ferdinands et al., 2004). Current international support for post-conflict peace building needs to be strengthened through greater coherence across various policy areas at the global level (Tschirgi, 2004). Discussion among donors and pressure from civil society groups to ensure that funds pledged would in some way be linked to progress towards a political settlement and towards full protection of human rights, imposed problems on the LTTE, given its continuing abuse of human rights. The LTTE, strategy was to delink its participation in the peace talks to progress towards a political settlement and human rights protection. These issues were factored in by the donors in late-2003.

Political Economy and the Dynamics of Peace Problems for the Peace Process Although an institutional structure, aid mobilisation programme, Confidence Building Measures (CBMs), etc., were in place, there were serious problems in the management of the peace process. To comprehend this, the sequencing of the peace process has to be first examined. The prime minister’s strategy was to extend the immediate economic dividend from the peace process to the North-East so that the people in the area who were disgruntled by the war could form a coalition against the war and weaken the LTTE. The prime minister was of the view that the material dividend arising from peace can, at least in the short-run, consolidate the efforts of conflict resolution. When the LTTE is weak in terms of people’s support, with third party support (Norwegians) and international goodwill and donor support, the prime minister’s idea was to lock-in the cessation of hostilities.16 Once this is achieved, his strategy was to embark on the negotiation of core issues (political). In short, economic levers were used to transform the conflict (see Figure 8.1). Since the economic lever alone was inadequate, appeasement of the LTTE was also used as another lever to consolidate the peace talks.17 The maximum political position to which the UNF government moved was to agree on a federal structure for the North-East with the LTTE in December 2002 in Oslo—also known as the ‘Oslo Declaration’.18

Will Make LTTE to come into the Negotiating table with a position of strength and dignity—equal partners

Negotiate core issues

Negotiate till a final solution is reached

Mobilise donor support to fast track N-E economic development

Lock in LTTE to peace talks via an economic dividend to N-E

Third party monitoring

Notes: HSZ = High Security Zones; N-E = North-East; CBM = Confidence Building Measures; IA = Interim Administration.

Build an international safety net to further stabilise the peace process

• Negotiate Peripheral Issues concerning well-being of citizens, flow of goods to N-E • Strengthen CBMs • Build an institutional structure IA to stabilise and lock—in the peace process

Use appeasement as another CBM

Lift economic embargo and use economic levers for conflict resolution + CBM

Militarily, other than HSZs give a relatively free hand to the LTTE in N-E to control affairs

De-proscribe LTTE and give it political space and a sense of dignity

Figure 8.1 STRATEGY OF THE UNF GOVERNMENT (2002–03)

THE EXPERIENCE DURING 2002–03 187

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In contrast, the pre-2002 PA (People’s Alliance) government’s strategy was to use the ‘war for peace’ and negotiate with the LTTE from a position of strength with core issues immediately put on the table (see Figure 8.2). It was a head-on confrontation with the LTTE and the solution was outlined in a constitutional format, and de facto systems were less tolerated compared to the UNF peace strategy. A comparison of Figures 8.1 and 8.2 shows that the sequencing of each strategy was different. While the PA strategy aimed at isolating the LTTE from the Tamil people and using military power to weaken them and force them to the negotiation table (Ofstad, 2002), the UNF treated the LTTE as equal partners and engaged in a confidence-building exercise keeping the politically sensitive issues for a later time. Questions have been raised as to whether the sequencing of the strategy has been realistic—whether the economic development activities should have preceded before the core activities were discussed. Sriskandarajah (2003) has argued that this was something similar to putting the cart before the horse. Core issues could have been gradually discussed after a federal solution was mooted in the ‘Oslo Declaration’ but it would have been difficult to start negotiations with core-political issues when there was a large humanitarian problem and the LTTE was committed to a separate state through an armed struggle and uncompromising on Thimpu principles.19 It may have been a very complex exercise for the LTTE. Moreover, the electorate in southern Sri Lanka was not in the frame of mind to immediately support a fundamental restructuring of the Sri Lankan state to accommodate LTTE demands. From this perspective, the prime minister’s sequencing was correct but there were a number of loose ends and shortcomings in the process. Figure 8.2 STRATEGY OF THE PA GOVERNMENT (2000–2001)

International strangulation of the LTTE—proscribing the LTTE in major countries Militarily weaken the LTTE by the government gaining more control over North-East

Will force LTTE to come into the negotiating table from a position of weakness

If negotiations move well, use economic levers for conflict resolution—lift embargo, implement 3Rs in LTTE controlled areas and use CBMs

Third party monitoring

August 2000 devolution package—core issues are addressed—put on negotiating table

Negotiate till a final solution is reached

Note: 3Rs = Relief, Rehabilitation and Reconciliation.

In addition to the impediments already highlighted, there were other problems. Despite the peace process being in operation, the LTTE resorted to eliminating its rivals, recruiting child soldiers, violating the MOU (Memorandum of Understanding), ignoring the directives of the SLMM, etc. By 2003, the LTTE had violated the CFA 1,935 times with impunity (Godage, 2004). It continued to be a monolithic


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organisation with no tolerance for democracy and forcibly acquired the status of the ‘sole representative of the Tamil community in Sri Lanka’. It wanted to use relief and rehabilitation work to strengthen itself and any democratic-pluralistic mechanism that undermined this was not acceptable to the LTTE. These actions by the LTTE disturbed the southern electorate and raised issues regarding the credibility of the peace package. The opposition was left out from the peace talks and peace delegations—the fears and aspirations of the Muslims living in the East were not subject to full discussion during negotiations, core issues were left out till a later stage on the other hand by the government. In fact, core issues were left for the very end (see Figure 8.1), instead of taking them up with other issues after the ‘Oslo Declaration’. Since the government treated the peace talks leveraged on an economic dividend under the above explained loose framework as a confidence-building exercise and did not have an agenda, the LTTE and the Norwegian facilitators set the agenda and shaped events. Given this situation, the LTTE together with the Norwegian facilitators smartly narrowed the negotiations to a single issue—an interim administration with full autonomy, where obviously the core issue of a final political solution became imperative. All these problems added to the toll of diluting the dividend. For example, local and foreign investors who showed an interest in rebuilding and investing in northern Sri Lanka in early 2002 became more pessimistic by early 2003 with uncertainty engulfing the peace talks.

International Safety Net for the Peace Process The prime minister was planning to come back to power in the event of dissolution of the Parliament by the executive president before the due date based on the economic dividend of the peace package. When the prime minister realised that the economic dividend in the North-East was slow to materialise, and which was confirmed by Balasingham’s letter in April 2003, and the peace talks failed with the opposition threatening to discard the CFA by toppling the government, a new interim administration structure to replace SIHRN was offered in June 2003. This was rejected by the LTTE on the ground of inadequate self governing powers.20 The government made it clear that any institutional structure has to be within the Constitution of Sri Lanka and that this could be worked out via negotiations. When all efforts to rescue the peace talks failed, the prime minister decided that he should create an international safety net and internationalise the peace process. ‘The Prime Minister’s international safety net means that we no longer have to face the challenge alone’ (Moragoda, 2003b: 244). Meanwhile, the LTTE started work on a proposal for an Interim Self-Governing Authority (ISGA) for submission to the government by end October 2003. The prime minister made a number of visits to foreign countries after April 2003 (China, USA, India, Japan, etc.). The success of the Tokyo aid donors meeting (June 2003) in mobilising a USD 4.5 billion aid package in the absence of the LTTE, gave an added boost to consolidation of the peace process.21 The prime minister

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visited China (May 2003) to seek Chinese support for his peace initiative and India (in October 2003) for support—the discussion especially focused on a possible IndoSri Lanka Defence Pact (in addition to strengthening the existing Indo-Sri Lanka Bilateral Free Trade Agreement by implementing a Indo-Sri Lanka Comprehensive Economic Partnership Agreement). The two visits to USA (September and October– November 2003) were significant. These visits were made with the hope of getting US-backing for the peace process, strengthening defence ties with US (an Acquisition and Cross Servicing Agreement with USA was under consideration for signing) and to obtain a bilateral free trade agreement with USA to support the ready-made garment industry in Sri Lanka.22 The October visit was made with the hope of clinching the Bilateral FTA deal and obtaining an assurance of US support for the peace package. The consolidation of the international safety net using economic issues has been a unique feature of the peace process. By internationalisation of the peace process, the prime minister managed to bring the LTTE to international visibility. By this strategy, the prime minister managed to lock-in the LTTE to the peace process despite the breakdown of talks. He was of the view that the ‘no-war, no-peace’ scenario will create its own dynamics and will make it hard for the LTTE to go back to war. This process also had certain drawback. Critiques have highlighted the ‘over internationalisation’ of the peace process and consequently the donors dictating terms to the government. For instance, instead of supporting the government, donors were putting pressure on the government to negotiate with the LTTE on the terms laid out by the LTTE. Godage (2004) writes, The donors have not put any pressure on the LTTE other than for pleading with them. Their pleas have of course been treated with contempt. It is only Americans that have called upon the LTTE to demilitarize. But they too have done nothing beyond making statements. Balasingham (2004: 434) on the other hand states that: … the LTTE leadership found it faced a new phenomenon, the intervention, or rather excessive involvement of the ‘international custodian of peace’ in the negotiation process. Inter-linking political pressure with economic assistance, the international actors intervened to promote the interests of the Sri Lankan state, which severely undermined the status and the power relationship between the protagonists. As a non-state actor caught up in the intrigue ridden network of the international state system, the LTTE was compelled to act to free from the overpowering forces of containment. The safety net influenced the power balance between the parties and disturbed the existing status-quo (Ferdinands et al., 2004). For instance, it strengthened the patriotic forces who were opposed to the government’s peace package in southern Sri Lanka. Despite the international safety net ‘... the uncertainty that prevailed towards the end of the year (2003) slowed down foreign assistance. For example, the disbursement of the second tranche of the PRGF-EFF, expected within a year was postponed. Other donors also adopted a “wait and see” approach in finalising their


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donor assistance programme for 2004 as a larger part of assistance would depend on the success of the PRGF-EFF arrangement with the IMF’ (CBSL, 2003: 198). As stated, shortfalls in foreign assistance led to the cost of the stabilisation programme not being cushioned in the short-run and the majority of the poor people having to bear the hardships during 2003. Each donor had its own policy though they generally agreed on the need for the progress of the peace process for the release of pledges in Tokyo. In actual practice, even though there was no progress on peace talks after April 2003, most donors did release aid for North-East projects since the optimism in this respect did not fully disappear till end 2003. Pre-CFA projects in the North-East under 3Rs continued, so did the arrival of funds for NGOs working on rehabilitation and livelihood issues in the North-East. Adherence to human rights, good governance, pluralism, etc., for release of aid was only confined to paper. Many donors felt that these conditions could overburden the fragile peace process.

Setback to the Peace Process: ISGA and Electoral Defeat Meanwhile, the uneasy cohabitation between the executive president and the prime minister had matured to the extent that the president felt that the appeasement strategy towards the LTTE had gone too far to the extent of threatening the unitary status of Sri Lanka, and it was time for her to use her executive powers to take over three Ministries, including defence. Such action was eventually taken on 4 November 2003 and it shook the government substantially. It was the time when the LTTE forwarded its ISGA proposal as a counter-proposal to the June 2003 Interim Administration proposal of the government. The LTTE saw the ISGA as an absolute necessity to ensure the fulfilment of both short-term development needs and longterm demands for internal self-determination (Stokke and Shanmugaratnam, 2005). It was clear that the six rounds of talks, which Balasingham later described as a ‘complete waste of time’, were finally reduced to a single issue, namely the setting up of an ISGA—with full plenary powers of governance over the North-East under the hegemony of the LTTE, through extra-constitutional means. Expert commentators have described the ISGA as basically a blue-print for a separate state (Gunasekera, 2004; Godage, 2004; De Silva, 2004). There were problems in the ISGA: the LTTE was not a legitimate body and the question of granting financial and political power to a body controlled by the LTTE would have been difficult under the Sri Lankan constitution. The government’s reaction to the ISGA was that it considered it to be a maximalist position, but it could be a starting point for negotiations on an interim administration. The Indian position was that an interim administration could be granted, however, it should be linked to the final solution based on a federal structure. While the presidential action relieved the government from immediately responding to the LTTE proposal on the ISGA, it strengthened the president’s hand in manoeuvering the state establishment and weakening the government. The government’s focus shifted from peace management and conflict resolution to

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consolidating the political group to face a general election. In February 2004, the Parliament was dissolved and general elections were held in early April. The PM was depending on the peace package-related economic dividend to deliver a victory and raised the bogey of re-starting the war in the event of an opposition victory. The result was a resounding defeat for the ruling party and the emergence of the political party to which the president gave leadership. Whether the defeat was more a result of the appeasement strategy of the government towards the LTTE or due to a lack of an economic dividend is difficult to quantify. But, at least, according to the pre-election opinion polls that were conducted, surprisingly, the majority preferred the opposition on economic and social management compared to the incumbent UNF government.23 Traditionally, the UNF has been identified as a better manager than the PA in economic affairs, but for people to think otherwise indicates that the people were dissatisfied about a lack of an economic dividend through the peace package. The appeasement strategy may also have contributed to the defeat. In the public eye, appeasement had no returns other than of course the LTTE not exploding bombs in various cities in the South. In the public perception, ‘peace at any cost’ was increasingly becoming unacceptable. It did strengthen the LTTE further, 12 ship loads of military equipment had come during the period 2002–03.24 As stated, decommissioning of weapons was not part of the negotiations. Thus, people felt that the LTTE had got stronger during the two years of peace negotiations. Clearly, the prime minister’s peace strategy failed to convince the public that he was on the correct track. For the North-East, the prime minister failed to deliver an economic dividend. The SIHRN, a potential institution that was capable of effectively addressing humanitarian issues and delivering an economic dividend failed to live up to its expectation. After the electoral defeat of the government, Head of the Tamil Tiger Peace Secretariat, Puleedevan stated: ‘What we want is to improve the living condition of the people in areas under our control .... We find the bureaucratic mechanisms are inefficient and that is why we need the ISGA to deliver a peace dividend .... If there is no peace dividend for our people, they will lose faith in us and what happened to the previous government will happen to us’ (‘Tigers Demand Self Rule’, The Island, 21 May 2004). Balasingham (2004: 463) reflecting on the events and the overall scenario writes: ‘A powerless, unstable government caught up in a cohabitation conflict with the Presidency, could not address immediate existential problems or the underlying core issues ... a crucial factor for the setback of talks.’ One could in fact argue that had the prime minister inherited a stronger economy and a better majority in the Parliament, the strategy based on economic levers could have been made more effective to obtain a short-term dividend. As argued, there are limitations of a dividend based on economic levers due to lack of institutions and structures, especially in the war-affected areas. A peace package should be based on many levers, but the levers for the political, cultural and sociological issues cannot be immediately addressed like that of economic issues and they have to be factored in as soon as the peace process moves forward. Addison (2003: 5) notes: ‘there is no single lever that can be pulled to achieve peace’.


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Concluding Remarks There was some progress with regard to achieving a peaceful environment and blocking the LTTE from going back to war, but there was no concrete economic dividend and significant progress towards conflict resolution. The Sri Lankan outcome from the perspective of an economic dividend can be looked at from three angles: government, rebels and aid donors. On the part of the government, there were many shortcomings in the peace talks, for example, it was a ‘top-down approach’—there was little consultation with civil society, they were just by-standers and there was hardly any widespread discussion. The political opposition was excluded from the discussions. It was a very openended ‘trial balloon’ approach where the government was prepared to wait till things happened. There was no specific agenda and it was basically talking to each other to build confidence. Moragoda (2003a: 260) states that the ‘peace process in Sri Lanka has been a matter of learning by doing’. The lack of an agenda made the LTTE take the upper hand and led to their dictating the peace process. The LTTE smartly propelled the peace process towards a ‘single-issue agenda’ trajectory of ISGA. The government increasingly became reactive to LTTE dictates and this appeared to the public as appeasement. The appeasement component went too far and gave the impression that the government was bending over backwards to please the LTTE. Moderate Tamil politicians also felt that the government gave in too much to the LTTE (Anandasangari, 2005). This strategy also contributed to the general deterioration of the law and order situation in the rest of the country. The peace package was not marketed effectively in southern Sri Lanka. For example, if there was a rationale for the appeasement strategy it was far from clear to the general public. There was a misreading of the North-East economy and there was an assumption that an economic dividend would be immediate with the measures taken by the government. In the context of missing markets and institutions in the North-East, one could seriously question whether an economic dividend, even with a large amount of donor assistance, could materialise in the short term. One could also question whether it was sensible to depend on an economic lever alone to transform a conflict. The Sri Lankan experience has shown that moving from addressing humanitarian needs and economic reconstruction to conflict resolution is a complex exercise. It has to be contextualised with reference to politico-military realities and the LTTE’s demand for self-determination in North-East Sri Lanka and this was not factored in. To work out an institutional structure acceptable to both parties, was a tedious task. The donor conference secured pledges of support for reconstruction and development in the war-ravaged areas before institutionalising an effective mechanism for utilisation of funds. Avoidance of the core-issues in the negotiations led to deferring of major tasks for substitute structures (e.g., SIHRN), which lacked capacity and political clout to cope with the challenges. The institutional structure was not linked to the final solution, for example, federalism; because core issues to

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a large extent were kept out of discussion till the very end after the LTTE is weakened via an economic dividend and the prime minister overcomes the constitutional hurdles by becoming executive president by late-2005–06. An economic dividend should prove effective in the rest of the country to gain support for peace talks. Needless to say, an economic dividend-based peace package is substantially dependent on economic achievements. In terms of aggregate figures there was an economic resurgence in Sri Lanka, but not in terms of distribution of economic gains. The growth process must be inclusive of the poor. It was clear that the LTTE was not interested in the delivery of relief and reconstruction unless they took full control. A strong economic dividend with no LTTE ownership was bound to weaken the LTTE’s stranglehold on the Tamil people in the North-East and undermine its ultimate objective of self-determination. The LTTE was aware of this and that is the reason why it stood against the flow of assistance, unless under its control. From the LTTE perspective, it was apparently beset by fears of marginalisation. It felt that the PA government was trying to marginalise it by the devolution proposals while the UNF government was trying to do the same via the rehabilitation exercise and economic development. This fear was not effectively addressed by the government. In sum, a guerilla group can pre-empt any serious attempt at generating an economic dividend, which they consider would marginalise them. In the existing literature, this area has received very little attention.25 One could question whether the LTTE was genuinely motivated by a desire to come to a satisfactory political settlement within the framework of a united Sri Lanka. One could also question whether in signing the CFA the LTTE was hoping to further their military capability in achieving their goal of separation. If these were the case, no amount of economic dividend to the North-East would have yielded much tangible results in germinating a political solution within the framework of united Sri Lanka. In fact, the LTTE behaviour during the peace talks raises a number of questions. From the donors’ side, there were some problems. It was not clear how the progress of the peace package would be measured by the donors. Most donors, however, relaxed their conditions on the progress of peace and released aid, but what was clear by late-2003 was that for some donors granting of an ISGA or an equivalent was the only indicator of progress of the peace talks. ‘The very presence of an international peace mission, ... aid agencies has economic consequences that are directly contrary to the political goals of self governance and economic and political stability. This problem is rarely discussed, but emerges vividly in every case study’ (Woodward, 2002: 208). In a new agenda of foreign aid, there has to be emphasis and support for capacity building to strengthen aid absorption. In war-torn areas, aid absorption is an issue due to lack of human resources and institutions. It is thus not lack of finance but the inability to create the required environment to absorb it that proved to be the main issue vis-à-vis donors. Strengthening the capacity of the national actors was essential for international assistance to work well. Tschirgi (2004: i) observes that, ‘One of the persistent obstacles to more effective peace building outcomes is the


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chronic inability of international actors to adapt their assistance to the political dynamics of the war-torn societies they seek to support.’ There is a need for developing a minimum trust by both parties and assure that neither is seeking deliberately to do harm and injury to the other. An economic dividend may be inadequate to develop mutual trust among groups who have deeprooted mistrust. Thus, in order to make the economic dividend more effective many other factors have to be simultaneously addressed. It is only then that the desired dividend could be achieved for strengthening peace and conflict resolution.

Notes 1. For example, most of the ‘cash cows’ available for privatisation had declined by 2002. 2. The CFA did not have any constitutional status. It was almost a ‘fait accompli’ based on pre-election agreements that existed between the UNF and the LTTE. 3. The First and Second rounds were held in Sattahip and Rose Garden Resort, respectively in Thailand in September and October 2002. The Third and Fourth rounds in Oslo, Norway in December 2002 and Rose Garden Resort, Thailand, in January 2003, respectively. The Fifth round in Berlin, Germany in February 2003. Finally, the Sixth round in Hakone, Japan in March 2003. 4. SIHRN had representatives from the government (4), LTTE (4) and Muslim community (2). 5. RSL (2003: 102) clearly indicate that the government had no specific poverty alleviation committee among many task forces appointed to address poverty reduction and economic restructuring. 6. For example, John Keells Holdings acquired Colombo Plaza Hotel in September 2003 and Pheonix ventures merged with Jewelknit to form Brandix in mid-2003. 7. Japan (USD 1 billion), multilaterals—ADB (USD 1 billion), World Bank (USD 1 billion), and the IMF (USD 560 million)—providing the bulk of the funds (IMF, 2004). 8. Defence expenditure fell from Rs 54 billion in 2001 to Rs 49 billion in 2002, and to Rs 47 billion in 2003. Previous defence purchases were made according to deferred payments on instalments and fulfilling this obligation meant that there was little reduction in defence expenditure. 9. http://www.peaceinsrilanka.org/insidepages/Internationalsuppoer/UN/PressRel 130204.asp. 10. For the problems in aid utilisation, see IPS (2001). 11. http://www.peaceinsrilanka.org/insidepages/Pressrelease/March/PressRel19March03.asp. 12. Shanmugaratnam (2003) highlights the lack of storage facilities in the fishing sector. 13. See www.teedor.org. 14. The LTTE institutional structure comprising of judicial system, police and public administration were not favourably disposed towards business activities. 15. This account is based on Sarvananthan (2003). 16. The locking-in process was consolidated by some strategic moves. For instance, when the Ceylon Petroleum Corporation was privatised, the major stake holder, i.e., Indian Oil was requested to manage the oil tank in Trincomalee—a strategic city for the LTTE. 17. The appeasement strategy extended from divulging military intelligence (for example, Millennium City, Athurugiriya) to granting duty free status for importation of a radio transmission tower for the LTTE. 18. This position is contested by the LTTE. Balasingham (2004: 403) says that there is nothing called an ‘Oslo Declaration’ and there was only a suggestion to explore a solution based on federalism. The lack of minutes on the five peace rounds prevents one from verifying the authentic position.

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19. These are (a) right to self determination, (b) recognition of Tamil homeland, and (c) recognition of Tamil nationalism. 20. The June 2003 proposed Structure for an Interim Administration for the North-East was quite comprehensive and was within the Sri Lankan constitutional framework. And it was not specifically rejected by the LTTE according to key government officials (Weerakoon, 2004). However, the LTTE’s view was that any interim administration structure within the unitary constitution would inevitably reduce them to junior partners with no formal power. 21. The LTTE did not participate in the Tokyo donor conference. The LTTE position was that it was deliberately excluded from a donor meeting that took place in April 2003 in the USA. However, some analysts say, that the LTTE was not prepared for responsibilities that will arise from the Tokyo conference in terms of meeting donor requirements for disbursement of assistance. 22. For details, see Kelegama (2004). Before the prime minister’s visit to the US in September, the Minister of Commerce attended the WTO Ministerial in Cancun, Mexico in midSeptember 2003. At this meeting, Sri Lanka made a complete departure on certain trade issues from its support for the developing country position (as manifested in the Like-Minded Group in Doha in 2001 and G-20 in Cancun) and supported the US position on some WTO issues. A week later at the UN Annual Meeting, the Sri Lankan Prime Minister went to the extent of supporting the US invasion of Iraq. 23. Pre-election survey by the Centre for Policy Alternatives published in the Sunday Times, March 2004. 24. This fact was revealed by Karuna who broke away from the LTTE leader in March 2004. 25. See, for instance, OECD (2003).

References ADB (2005), Asian Development Outlook: 2005, Asian Development Bank, Manila. Addison, Tony (2003), ‘Africa’s Recovery from Conflict: Making Peace Work for the Poor’, Policy Brief No. 6, UNU/WIDER, Helsinki. Anandasangari, A. (2005), ‘Peace Process and Fundamental Rights of Tamil People’, The Island, 21 March. Arunatilake, N., S. Jayasuriya and S. Kelegama (2001), ‘The Economic Cost of the War in Sri Lanka’, World Development, Vol. 29, No. 9. Balasingham, Anton (2004), War and Peace: Armed Struggle and Peace Efforts of Liberation Tigers, Fairmax Publishers, UK. Bastian, S. (2003), ‘Foreign Aid, Globalization, and Conflict in Sri Lanka’, in M. Mayer et al. (eds), Building Local Capacities for Peace: Rethinking Conflict and Development in Sri Lanka, Macmillan, New Delhi. CBSL (2003), Annual Report, Central Bank of Sri Lanka, Colombo. De Silva, H.L. (2004), ‘ISGA: Birth of one State, Death of Another’, The Sunday Times, 3 October, Colombo. Dunham, D. and C. Edwards (1997), ‘Rural Poverty and an Agrarian Crisis in Sri Lanka, 1988–1995: Making Sense of the Picture’, Institute of Policy Studies, Poverty & Income Distribution Series, No. 1. ERD (2004), Foreign Aid Review—2003, External Resources Department, Ministry of Finance, Colombo. Ferdinands, T. et al. (2004), The Sri Lankan Peace Process at Crossroads: Lessons, Opportunities, and Ideas for Principled Negotiations and Conflict Transformation, Centre for Policy Alternatives, Colombo. Gunaratna, R. (2003), ‘Sri Lanka: Feeding the Tamil Tigers’, in K. Ballentine and J. Sherman (eds), The Political Economy of Armed Conflict: Beyond Greed and Grievance, Rienner, London.


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Gunasekera, S.L. (2004), Abomination, Samayawardana Publishers, Colombo. Godage, K. (2004), ‘The Brussels Peace Trap’, The Island, 1 June, Colombo. ——— (2005), ‘On the Harrold Affair and More Important Matters’, The Island, 11 March, Colombo. IMF (2004), ‘Sri Lanka: 2003 Article IV Consultation—Staff Report’, www.imf.org. IPA (2002), ‘Economic Agendas in Armed Conflict: Defining and Developing the Role of UN’, International Peace Academy (IPA), New York, USA. IPS (2001, 2002, 2003), Sri Lanka: State of the Economy, Institute of Policy Studies (IPS), Colombo. JBIC (2003), Conflict and Development: Role of JBIC—Development Assistance Strategy for Peace Building and Reconstruction in Sri Lanka, Japan Bank for International Cooperation (JBIC) Institute, Japan. Kelegama, S. (1999), ‘Economic Costs of Conflict in Sri Lanka’, in R. Rotberg (ed.), Creating Peace in Sri Lanka: Civil War and Reconciliation, Brookings Institution Press, Washington, D.C. ——— (2003), ‘Managing the Sri Lankan Economy at a Time of Terrorism and War’, in S. Khatri and G. Kueck (eds), Terrorism in South Asia: Impact on Development and Democratic Process, Shipra Publications, New Delhi. ——— (ed.) (2004), Ready-Made Garment Industry in Sri Lanka: Facing the Global Challenge, Institute of Policy Studies, Colombo. Ladduwahetty, N. (2004), ‘What Constitutes Progress of Peace Talks ?’, The Island, 28 May, Colombo. Moragoda, M. (2003a), ‘Washington Donors’ Conference’, in M.D.D. Pieris (ed.), A Warm Heart, a Cool Head, and a Deep Breath, IDU/Lake House Publication, Colombo. ——— (2003b), ‘Oslo Donors’ Conference’, in M.D.D. Pieris (ed.), A Warm Heart, a Cool Head, and a Deep Breath, IDU/Lake House Publication, Colombo. OECD (2003), A Development Cooperation Lens on Terrorism Prevention: Key Entry Points for Action, A Development Assistance Committee Reference Document, OECD, Paris. Ofstad, A. (2002), ‘Countries in Violent Conflict and Aid Strategy: The Case of Sri Lanka’, World Development, Vol. 30, No. 2. Rajasingham-Senanayake, D. (2003), ‘The International Post Conflict Industry: Myths, Rituals, Market Imperfections and the Need for a New Paradigm’, Polity, Vol. 1, No. 3, Colombo. RSL (2003), Regaining Sri Lanka: Vision and Strategy for Accelerated Development, Government of Sri Lanka, Department of Government Printing, Colombo. Sarvananthan, M. (2003), ‘What Impede Economic Revival in North and East Province of Sri Lanka?’, Working Paper 2, International Centre for Ethnic Studies, Colombo. Shanmugaratnam, N. (2003), ‘Jaffna Fishing Communities: Persistent Crisis and Possible Solutions’, Polity, Vol. 1, No. 5. Sivanathan, V.P. and M. Thillainathan (2004), ‘Trends and Prospects of the Northern Economy’, in G. Freks and B. Klem (eds), Dealing with Diversity: Sri Lankan Discourse on Peace and Conflict, The Netherlands Institute of International Relations ‘Clingendael’, Tharanjee Prints, Colombo. Sriskandarajah, D. (2003), ‘The Return of Peace in Sri Lanka: The Development Cart before the Conflict Resolution Horse?’, ICES Lecture/Discussion Series. Stokke, K. and N. Shanmugaratnam (2005), ‘From Relief and Rehabilitation to Peace in Sri Lanka?’, Polity, Vol. 2, No. 3. Tschirgi, N. (2004), ‘Post-Conflict Peacebuilding Revisited: Achievements, Limitations, Challenges’, The Security-Development Nexus Programme, International Peace Academy, New York, USA. Weerakoon, Bradman (2004), ‘Devising Structures for North-East Interim Administration’ (Parts I and II), The Sunday Times, 12 and 19 December, Colombo. Woodward, Susan L. (2002), ‘Economic Priorities for Successful Peace Implementation’, in S.J. Stedman, D. Rothchild and E.M. Cousens (eds), Ending Civil Wars: The Implementing of Peace Agreements, Rienner, London, UK.

Part IV SECTORAL POLICY

9 INDUSTRIALISATION An Overview

Introduction Sri Lanka is an interesting case study of industrialisation because of its small market and a relatively well educated labour force. After starting with import substitution industrialisation in the early 1960s, Sri Lanka made a transition to exportoriented industrialisation (EOI) in 1977. Some commentators have referred to Sri Lanka’s experience with EOI as a ‘late comers story’ because compared to most East Asian countries, Sri Lanka made the transition in strategy approximately a decade later (Athukorala and Rajapatirana, 2000). Moreover, EOI was managed in an uncertain policy environment during 1983–2001, thus, there was considerable change in policy during the 1990s. In this chapter, the background and current status is examined in the next section followed by a discussion on the industrial policy during the 1995–2005 period. The challenges for industrialisation are highlighted in the subsequent section and in the final section some concluding remarks are made.

Background At the time of Independence, in 1948, Sri Lanka was basically an agro-based economy where a plantation export sector existed in parallel with a peasant subsistence

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sector. The plantation exports accounted for nearly 90 per cent of the country’s foreign exchange earnings. The industrial sector was hardly developed with minor industries in mining and simple consumer goods industries existing to cater mainly to domestic needs. From 1948 till the mid-1950s industrialisation took place under a market economy with minimum state intervention. After the mid-1950s, a conscious effort was made to industrialise the country by the state intervening to establish industries in accordance with the Soviet model of industrialisation of the 1930s and 1940s. Industries were established even in areas where the country did not possess a comparative advantage and they were mostly of an import-substitution character. This industrialisation process was assisted by a controlled economy (with import licensing and other regulations implemented in the early 1960s) and foreign assistance from socialist countries. By the late-1960s, the easy phase of consumer goods import substitution industrialisation had run out of steam. Yet, import substitution industrialisation was pursued with much aggression in the 1970s until the economy was liberalised in 1977. By 1977, most import substitution industries had become highly import-dependent, hardly saving any foreign exchange and functioning at below capacity level (Athukorala, 1986). With economic liberalisation in 1977, industrialisation was emphasised with specific incentives geared towards export-oriented industrialisation. State planning was abandoned and basically the trade policy of the open economic regime was allowed to dictate industrial development. In other words, trade policy was the main instrument of industrial promotion in the country from 1977 till about 1987 (Kelegama, 1992). There was a significant transformation in the Sri Lankan economy, around 1990, with industrial exports accounting for 54.2 per cent of overall exports, and the plantation exports gradually declining in significance (Table 9.1). However, the development of industrialisation that emerged after a decade of liberalisation was very much lopsided with less diversification and was highly urban-based. Out of the industrial exports nearly 60 per cent originated from the textile and garment sector and 70–80 per cent of the industry in output terms was concentrated in the Western Province (Tables 9.1 and 9.2). FDI played a major role in export-led industrialisation and firms with FDI contributed to the export expansion significantly during the 1977–87 period. The industrialisation process during this period benefited from the hydroelectric power generated from a major infrastructure development programme of the government. The industrial structure was split between a domestically-oriented sector and an export-oriented sector. This duality was very visible by the mid-1980s (Edwards, 1993). The trade liberalisation process slowed down during mid-1980s after the political turbulence in the country in 1983. Industrial growth too, declined significantly during the late-1980s. In 1989, an industrialisation policy was announced for the first time after liberalisation, in order to promote more industrial diversification and to geographically spread industries in the country. For this purpose, an Industrial Promotion Act, 1990 was enacted with a powerful policy-making arm called the ‘Industrialisation Commission’. The other objective of the policy was to remove the existing rigidities and impediments for industrial development in the country. The industrial policy of 1989 received a boost from the second wave of liberalisation unleashed in the early 1990s. This liberalisation programme had several components

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Table 9.1 EXPORT DIVERSIFICATION, 1980–2004 (SELECTED YEARS) Classification

1980

1990

2000

2004

Agriculture Tea Rubber Coconut Other Industries Garments and textiles Gems/jewellery Other

61.8 35.1 14.7 7.0 5.1 33.8 10.4 3.8 0.6

37.7 25.9 4.0 3.6 4.2 54.2 32.8 3.9 4.3

18.2 12.7 0.5 2.2 2.8 77.6 54.0 1.7 2.5

19.0 13.0 1.0 2.0 1.0 77.0 50.0 2.0 7.0

Source: CBSL, Annual Report (various issues).

Table 9.2 REGIONAL DISTRIBUTION OF INDUSTRIAL ACTIVITY (SELECTED YEARS) Contribution to Output % Province

1981

1989

2000

Western Southern Sabaragamuva Central Uva Eastern North Western North Central Northern

88.8 2.7 2.2 1.3 0.0 2.0 1.2 0.4 1.4

70.9 3.8 3.4 5.7 3.6 8.5 3.0 0.5 0.6

79.6 3.8 3.8 4.8 1.2 – 3.3 0.5 –

Source: DCS, Annual Survey of Industries (various issues). Note: For industries with at least five or more people employed.

that assisted industrialisation. First, FDI inflows were further liberalised. Second, privatisation of industries were initiated with foreign equity ownership in the ventures being considerably liberalised. Third, the institutional framework to support FDI was strengthened by the establishment of the Board of Investment (BOI) in 1992. Fourth, a 200-Garment Factory Programme was initiated with new incentives offered for opening industries in rural areas (Chapter Four). The objective of some of these liberalisation and institutional measures was to exploit the trade-investment nexus. By the early 1990s some degree of diversification was visible in the industrial sector with items such as non-metallic minerals (ceramics, gems and jewellery, cement, etc.) and food, beverages and tobacco, accounting for some additional portion of industrial production (Table 9.3). However, not much activity was seen in the mining and mineral sector due to various legislative impediments. Despite various incentives offered to geographically spread industries, other than garment industries moving into the rural areas under the 200 Garment Factory Programme, little activity took place in other industries moving to rural areas. This was primarily due to the poor infrastructure in rural areas that could not be significantly upgraded due to massive expenditure allocations for the defence budget to meet the requirements of the North-East war.

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Development Under Stress: Sri Lankan Economy in Transition Table 9.3 CONCENTRATION OF INDUSTRIAL PRODUCTION BY INDUSTRY AS PERCENTAGE OF INDUSTRIAL PRODUCTION VALUE (SELECTED YEARS)

Category

1982

1992

2002

Food, beverage and tobacco Textile, apparel and leather Wood and wood products Paper and paper products Chemical, petroleum, rubber and plastic products Non-metallic minerals Fabricated metal, mineral and transport products Others Total

20.3 14.9 1.4 2.8 50.6 5.3 3.5 1.2 100.0

25.1 39.6 0.7 1.9 17.4 7.8 4.4 3.1 100.0

22.7 39.9 0.7 1.7 19.5 7.7 4.5 3.3 100.0

Source: CBSL, Annual Report (various issues).

From the early 1990s, the defence budget gradually increased with the interest rate and the exchange rate bearing much of the burden of defence expenditure induced budget deficits. From time to time, exchange rate appreciations and high interest rates became major impediments to the growth of industrial exports in the early 1990s. The industrial tariff liberalisation process also suffered from policy requirements such as revenue considerations, BOI tax concessions, meeting World Bank obligations, etc. In other words, tariff liberalisation process became ad hoc in the early 1990s, which in turn, gave confusing signals for industrial restructuring in the early 1990s. Most of these problems were rectified by the mid1990s with tariff liberalisation taking place without ad hoc policy interventions and interest rates brought down by the prudent budgetary management. The exchange rate was also better managed under the ‘managed float’ system to support exportoriented industries. In 1995, a new industrial strategy was initiated with special emphasis given to establishing industrial estates in order to promote industries in various provinces of Sri Lanka. It was a more interventionist policy than the 1989 strategy. Moreover, the Government Policy Statement of 1995 announced the movement to a threeband tariff structure and the desire to move towards a 15 per cent uniform tariff band by the year 1998. These two policy announcements played a key role in industrial progress during the post-1994 period. By the mid-1990s some degree of de-industrialisation was visible both from nontransparent privatisation exercises and ad hoc tariff liberalisations that took place during the early 1990s. Two textile industries, two sugar factories and two mining factories were virtually closed down in the mid-1990s due to unplanned privatisation. A number of textile industries, light engineering industries (for example, refrigerators) and tea machinery industries had to be closed down due to unplanned tariff liberalisation or tariff liberalisation to meet requirements of stronger commercial lobbies in the countries. The government took various policy measures to rectify the de-industrialisation process by enacting the Public Enterprises Rehabilitation Bill (1996) to restructure the failed privatised industries and offering interest rates subsidies for textile industries that suffered due to abrupt tariff reduction. Industrial


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estates were created (Sitawaka, Mirijjhawila, etc.) to locate industries outside the Western Province with some degree of success. By the late-1990s, the share of the manufacturing sector in GDP amounted to 16.4 per cent—which is low compared to 20 per cent in India and 23–34 per cent in the Association of South East Asian Nations (ASEAN) countries. The sector employed nearly 14 per cent of the workforce in the country. In 2000, industrial exports amounted to 77.6 per cent of overall exports in Sri Lanka compared to 33.8 per cent in 1980 (Table 9.1). While the performance of industrial exports seems to be satisfactory, the low share of the manufacturing sector in GDP is a cause for concern. Sri Lanka’s potential for industri-alisation seems to have not fully materialised due to a number of impediments in the policy environment (Vidanapthirana, 2004).

Changes in Policy for Industrialisation: 1995–2005 While the uncertainty in the investment regime caused by the war is one factor, this alone is not responsible for lack of industrial expansion. The impediments to industrialisation that were identified both by the Industrial Policy Statement of 1989 and the Industrialisation Strategy of 1995 were not fully addressed. In fact, these impediments were further elaborated in a 1995 World Bank study on: ‘Sri Lanka: Private Sector Assessment’. For example, rigidities in the labour market, procedural delays, etc., were not effectively addressed during the 1995–99 period. This unfinished agenda has to be completed while taking steps in moving towards more ambitious industrialisation. After the mid-1990s, the industrial sector in Sri Lanka faced a different challenge. With SAPTA (South Asian Preferential Trade Arrangement), Indo-Sri Lanka Bilateral Free Trade Agreement, WTO-tariff liberalisation, phased abolition of the Multi-Fibre Arrangement by the year 2005 and the general globalisation process, domestic and international competitiveness of industrial products was going to become an important issue in the industrialisation process in Sri Lanka. Tariff liberalisation under SAPTA and the ILBFTA came into criticism by industrialists. This is because in early 1995, Sri Lanka announced its intention to move towards a uniform tariff rate of 15 per cent. Subsequent commitments to SAPTA tariffs and the ILBFTA tariffs indicated a clear departure from the principle of uniform tariff protection. This sent confusing signals to the industrialists and thus, created a platform for protest. While the government took all efforts to reduce the budget deficits and create a market-friendly economy for industries, more input was needed by the industrialists themselves to face the modern challenges of the world and the domestic market. The year 1996 was declared as the ‘Year of Productivity’ and 1996–2006 was declared as the ‘Decade of Productivity’. The Ministry of Industrial Development played a major role in educating entrepreneurs about the importance of enhancing productivity to meet the global situation. To increase product competitiveness, the turn-around time of highly import-dependent industries had to be improved. In particular, for garment industry, a quick turn-around time is important in the context

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of global competition. For this purpose all efforts were made to attract FDI to the capital-intensive sector of garment accessories and textiles to promote more backward linkages to the export-oriented garment sector of Sri Lanka. To increase competitiveness, FDI was increasingly promoted with an aggressive international campaign by the BOI. For example, investment in the form of joint ventures was increasingly promoted not only for technological upgrading but also to capture new markets for industrial products of Sri Lanka. Increasing global competition also led to a number of mergers and acquisitions in the domestic market. However, the commercial legal framework was not adequate to fully handle some of the complex mergers and acquisitions in the market (Kelegama, 2002a). The need to increase the competitiveness of Sri Lankan industrial products was fully recognised. The National Development Council (NDC) brought out a study titled Building Sri Lankan Competitiveness: A Strategy for Manufacture Export Growth in mid-1996 (done by Sanjay Lall and others). In September 1998, the USAID brought out a study titled Sri Lankan Competitiveness Study. This study provided more of a ‘business school’ perspective of improving competitiveness. Both these reports have been extensively discussed in both government circles and Chambers of Commerce. The USAID report led to the formation of The Competitiveness Initiative (TCI) in Sri Lanka, which in turn, contributed to the formation of about eight competitive clusters (ceramics, gems and jewellery, rubber, etc.) in 2000–2001 period. The clusters have grown over the years and are working towards an effective networking of the industrial players in order to reduce the transaction costs and thereby, improve the competitiveness of products. This initiative is very much a donor-cum-private sector driven one with less government involvement. In the late-1990s, there was some revival of the ‘picking winners’ strategy for industrialisation. JICA/UNIDO did a study on these lines and submitted a report to the government in 2000 which had a ‘rainbow’ plan of targeting seven wellestablished industries (apparel, leather, rubber, plastic, machinery, electric/electronic and IT) for future growth and modernisation. Basically, it was more akin to a ‘hosting the winners’ strategy where the aim was to move from resource-based and labour-intensive industries to more knowledge-based and technology-intensive industries by 2010 (JICA, 2000a). However, with the change of the minister in charge of industries in mid-2000 and the IMF stand-by-package signed in March 2001 to come out of an economic crisis, JICA/UNIDO plan got sidelined and those who advocated ‘deregulation’ in the industrial sector consolidated their position. Deregulation initiatives were backed by the IMF office in Colombo and early 2001 also saw measures being introduced to create a more level playing field between BOI incentive beneficiary industries and others. In late-2001, it was decided to promote small and medium industries (SMIs) and a task force for Small and Medium Enterprises (SMEs) was established for this purpose. The change of government in late-2001 almost saw the abandoning of the JICA/ UNIDO plan. The government’s industrial policy was basically based on deregulation and creating five economic zones for industries to move into the provinces. Key deregulation measures were implemented including revising labour laws pertaining to overtime and termination of employment, etc. Meanwhile, the SME


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task force report was submitted to the government in early 2003, which initiated work to create a structure for SMI promotion (SME, 2002). Moreover, steps were taken to create industrial incubators and promote an industrial culture in Sri Lanka (Ministry of Industries, 2002). The government also signed a Trade and Investment Framework Agreement (TIFA) with USA in mid-2002 with the hope of converting it into an FTA especially to support the garment industry that was heavily dependent on the US market for its survival. This initiative was further consolidated by the Five Year Strategy for the apparel industry and the formation of the Joint Apparel Association Forum in late-2002 in order to prepare for the post-MFA scenario (Ministry of Finance and Planning, 2004). Despite these efforts, there remained major challenges to be overcome at the macroeconomic level to create a better investment climate for industrialisation (Vidanapathirana, 2004). Since 2000, what was noteworthy was the complete marginalisation of the industrialisation commission, which was a powerful arm of the Industrial Promotion Act of 1990. It was the key industrial policy-making arm till about 1999, however, thereafter various committees under Regaining Sri Lanka (RSL) Initiative (2002–03) and the National Council for Economic Development (NCED) Cluster Initiative (2004–) have taken full powers on industrial policy making. The strengthening of export-oriented industrialisation on a sectoral basis seems to have been revived under the post-2003 new government (Ministry of Finance and Planning, 2004). Frequent reference is made to promoting ‘thrust industries’ and these include the seven industries identified in the JICA report and a few additional industries. There is also a renewed emphasis on SMI development with the creation of a SME bank and the creation of a SME authority, the latter was a key recommendation of the SME White Paper of 2002.

Challenges for Industrialisation The future industrialisation process in Sri Lanka will take place in an environment characterised by a more liberalised trade regime promoted under WTO, SAPTA converted into SAFTA (South Asia Free Trade Agreement) (by 1 July 2006), the ILBFTA converted into an Indo-Sri Lanka Comprehensive Economic Partnership (by 1 January 2008), BIMSTEC FTA (Bay of Bengal Initiative for Multi Sector and Technical Economic Cooperation FTA), etc. Expiration of the MFA will also exert global competitive pressures on the leading industrial export—ready-made garments. The challenge, therefore, is to strengthen the current export-led industrial strategy, while making the import substitution sector more competitive. The import substitution sector in Sri Lanka is still not in a position to face free competition from international goods. Therefore, it is imperative that some of the import substitution industries are given reasonable protection by using the ‘reserve list’ of SAFTA or the ‘negative list’ of the ILBFTA. This is already taking place. Also, the government should consider making such protection in the domestic market conditional on the firm exporting a proportion of the production or

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becoming competitive in the domestic market. Such a policy minimises the risk of ‘picking winners’ for the world. The ready-made garment sector that accounts for nearly 50 per cent of industrial exports has to gear itself to face the post-MFA challenges. At present, Sri Lanka has only a limited number of garment exporters operating at the high end of the market and the balance 500–700 operate at the lower end. The firms at the lower end should upgrade their products to compete in the up market, failing which they would have to consider merging with more established garments firms in the country. Besides, there are a number of weaknesses in the garment production base: lack of a fabric base, fragmented nature of the industry with inadequate specialisation, labour-related issues, limited technology upgrading, lack of design and style capabilities, lack of management skills, poor database, inadequate infrastructure and a high level of waste and rejects, etc. (Chapter Ten). These weaknesses are being addressed now by the JAAF for the ready-made garment sector to effectively face the post-MFA competitive challenges in the global economy. The 2005 Budget had an attractive package for the garment industry, which was welcomed by the JAAF. Commercialisation of agriculture may also need an additional boost in the coming year. A positive strategy in this regard has been the privatisation of the plantation sector. The new private companies are increasingly switching to value-added products such as value-added teas, value-added rubber products and value-added coconut products (activated carbon), etc. There has been a reluctance by many entrepreneurs to shift towards export of non-plantation agriculture because of the high risk involved and insufficient information with respect to price forecasts, market share, etc., to pass on to farmers (Chapter Twelve). Although, there have been instances where the risk factor has been minimised by the private companies and farmers’ reluctance overcome, such efforts have not produced desired results. A necessary condition for export-oriented non-plantation agriculture to be successful is that there must be a demand for the crop from the local market. This enables the exporter to sell the product that is sub-standard in the local market and export the rest. The policy should focus on developing crops for which there is a local as well as an international demand rather than encouraging cultivation of crops for which there is no local demand. Besides, all efforts have to be made to create a well-functioning land market to support commercialisation of agriculture (IPS, 2004). Countries such as Thailand and Malaysia have become major exporters of canned fruits, vegetables and processed foods. Sri Lanka is still in the early stages of development in the foods and beverages industry. Since the early 1990s, various steps have been taken to promote the mining and mineral sector. The Mines and Mineral Act No. 33 of 1992 established the Geological Survey and Mines Bureau and enacted regulations in respect of all matters required by this Act in late-1993. With this Act, the monopoly held by some institutional bodies that overlooked various areas of mines and mineral was removed. The National Mineral Policy of 1999 developed an agenda to manage the locally available mineral resources and encourage local mineral-based industries for maximum value addition through product development. Such policy initiatives have encouraged private sector initiatives in the sector and this is all the more important due to


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the high cost and capital-intensive nature of mineral exploration. However, there are still anomalies in the regulatory framework and there is a need for a special tax regime for the sector that would encourage value addition. At present, only ceramics and gems are exported in the value-added form from Sri Lanka. There are a number of other minerals that could be exported with value addition if an appropriate regulatory framework prevails. While sectoral strategies will assist industrial diversification, the overall macroeconomy and supporting institutions need to be improved. The JICA report gives a list of comprehensive measures that need to be taken in administration, legal and institutional areas and they still remain valid (JICA, 2000b). Targeting transnational companies for investment in Sri Lanka could also enhance industrial diversification. The BOI needs to pursue such a strategy with international branches established in powerful nations in the West as well as in the East. While incentives for value additions such as special BOI status for advanced technology projects would assist in promoting new industries, in the overall environment, infrastructure and skills need further upgrading. Privatisation of the infrastructure has not produced the desired results in Sri Lanka due to the high risk factor for private sector participation in infrastructural development. The government, on the other hand, cannot make a major contribution to infrastructural development due to the prevailing high budget deficits. Thus, some type of a private–public strategic partnership should be considered for infrastructural development in the current macroeconomic environment of Sri Lanka. The Skill Development Fund has to be projected as the most effective demand-driven skill development system in the country. At present, however, very few entrepreneurs are aware of the Skill Development Fund. Export-led industrialisation is a process of graduation where the highest stage is brand marketing. There is a need to develop large-scale specialisation to reach the highest stage. Presently, Sri Lankan entrepreneurs seem to be content with adhering to the basic production level of exporting (Fonseka, 2001). Entrepreneurs should be made aware of the need to change their production strategy and to graduate to higher stages in the export-led industrialisation process (Kelegama, 2002b). The chambers should play a leading role in the dissemination of such information among leading industrialists in the country. Full benefits of trade and investment liberalisation could be captured only if a supporting set of macroeconomic policies and stable investment climate exists. These ingredients have been absent during much of the post-reform period in Sri Lanka. Export-led industrialisation, so far, can be explained as the joint outcome of trade liberalisation that increased the potential returns to investment and investment liberalisation that permitted the entry of international firms, which have the capacity to take advantage of profit opportunities. Despite political risk and political uncertainty, rapid export growth is consistent with this policy configuration as it ensures a handsome profit in labour-intensive export production, which is usually characterised by short payback periods, in a labour surplus economy (Athukorala and Rajapatirana, 2000).

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Concluding Remarks Although, Sri Lanka was a late-comer for EOI, there has been a significant structural transformation in the industrial sector. The role of the state has also diminished with the EOI strategy and initiation of privatisation in the early 1990s. Today, very few industries are state owned and FDI-led EOI plays a major role in the overall private sector-led industrialisation in Sri Lanka. An active industrial policy was initiated in 1989 and since then various interventionist policies were put into operation to support industrialisation. However, in this process little attention was paid to removing key impediments to industrialisation, particularly from the factor markets: land, labour and capital. Land and labour markets were governed by outdated legislation that did not suit the requirements of an open economy and consequently these markets could not effectively respond to the immediate requirements of industrialisation. Consequently, the tariff policy got considerably diluted as a weapon of industrial promotion. Thus, among other factors, an industrial policy was designed to make up for this shortcoming. With the MFA coming to an end and an increasing threat of Chinese competition, there is a school of thought that believes Sri Lanka may not make much headway in the industrial sector, but more on the services sector. Such thinking may be correct; however, Sri Lanka should remove the existing impediments and create a supporting macroeconomic environment for industrialisation. Industrial policy should focus on facilitation measures, as highlighted in the chapter. These steps will assist Sri Lanka to achieve targeted heights in industrialisation that Sri Lanka has not been able to achieve using its current comparative advantage.

References Athukorala, P. (1986), ‘The Impact of 1977 Policy Reforms on Domestic Industry’, Upanathi, Vol. 1, No. 1. Athukorala, P. and S. Rajapatirana (2000), Liberalization and Industrial Transformation: Sri Lanka in International Perspective, Oxford University Press, New Delhi, India. Edwards, C. (1993), Development Strategy and Industrial Policy—Issues for Sri Lanka, Industrialisation Series No. 3, Institute of Policy Studies, Colombo. Fonseka, T. (2001), ‘Uncompetitive Trends in Sri Lankan Industries and the Mind Set of Industrialists’, Sri Lanka Journal of Management, Vol. 6, Nos 1 and 2. IPS (2004), Sri Lanka: State of the Economy—2004, Institute of Policy Studies (IPS), Colombo. JICA (2000a), Master Plan study for Industrialization and Investment Promotion in the Democratic Socialist Republic of Sri Lanka: Main Report, Japan International Cooperation Agency (JICA)/ Ministry of Industrial Development. ——— (2000b), Master Plan Study for Industrialization and Investment Promotion in the Democratic Socialist Republic of Sri Lanka: Appendix-I, Japan International Cooperation Agency (JICA)/ Ministry of Industrial Development. Kelegama, S. (1992), Liberalization and Industrialization: The Sri Lankan Experience of the 1980s, Industrialization Series No. 2, Institute of Policy Studies, Colombo.


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Kelegama, S. (2002a), ‘Competition Policy in Sri Lanka: An Overview’, in M. Knight-John (ed.), Competition Policy and Utility Regulation: The Sri Lankan Experience, Law and Society Trust, Colombo. ——— (2002b), ‘Policy Reforms Critical for Competitiveness in Sri Lanka’, Business Today, November. Ministry of Enterprise Development, Industrial Policy and Investment Promotion (2002), National Strategy for Small and Medium Enterprise Sector Development in Sri Lanka—White Paper, Task Force for Small and Medium Enterprise Sector Development Programme, Colombo (referred to as SME, 2002 in the text). Ministry of Finance and Planning (2004), ‘Budget Speech—2005 (Part-II)’, Minister of Finance and Planning, Colombo. Ministry of Industries (2002), Activities of the Ministry of Industries—2002, Ministry of Industries, Colombo. National Development Council (NDC) (1996), ‘Building Sri Lankan Competitiveness: A Strategy for Manufacture Export Growth’, National Development Council, Colombo. SME (2002), ‘National Strategy for Small and Medium Enterprise Sector Development in Sri Lanka’, White Paper, Task Force for Small and Medium Enterprise (SME) Sector Development Programme, Colombo. USAID (1998), ‘Sri Lankan Competitiveness Study’, JE Austin Association, USAID, Colombo. Vidanapathirana, U. (2004), ‘Industrial Reforms for Accelerating Growth in Sri Lanka’, Sri Lanka Economic Journal, Special Issue, September. World Bank (1995), ‘Sri Lanka Private Sector Assessment’, Report No. 13, South Asia Region, The World Bank, Washington, D.C.

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10 READY-MADE GARMENT INDUSTRY Preparing to Face the Global Challenge

The garment industry expanded rapidly in Sri Lanka after liberalisation of the economy in 1977. During the 1990s, the garment industry grew at 18.5 per cent per annum. The export-led expansion of the industry led to the replacement of tea by garments as the largest contributor of foreign exchange for the nation. Moreover, the industry has been contributing to the livelihood of nearly 1.2 million people. However, the boom period for the industry is gradually coming to an end with the quota system having ended on 1 January 2005, regional trading blocs and bilateral free trade agreements proliferating and governing nearly 33 per cent of global trade and China emerging as a major supplier of garments at very competitive rates. The Sri Lankan garment industry is now gearing itself up to face these challenges. This chapter provides a broad overview of the industry and analyses how the industry is preparing itself to meet the global challenges. The next section provides a brief background to the garment industry in Sri Lanka. The second section gives a broad picture of the competitiveness of the Sri Lankan garment industry. New trends in the global trading environment and Sri Lanka’s measures to meet the challenges are discussed in the third section. Some concluding remarks are made in the last section.

Introduction When Sri Lanka liberalised its economy in 1977, the country’s garment industry took off immediately, mainly as a result of quota-hopping East Asian garment

THE READY-MADE GARMENT INDUSTRY

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exporters, attracted by the country’s liberal trade regime, relocating their already well-established garment industries in Sri Lanka. This relocation encouraged local entrepreneurs to start their own garment enterprises to exploit markets guaranteed by quotas, assisted by the liberal trade regime for importation and subsequently, incentives granted by the Board of Investment (BOI) to selected industries.1 Paradoxically, protectionism in the form of MFA quotas helped Sri Lanka and many other developing countries to develop their export-oriented garment industries by insulating them from direct competition from established producers. Sri Lanka did not have a well-developed export-quality textile industry base; neither did it have a base for garment industry accessories. Thus, from the very beginning garment production was based on imported inputs and the value added remained low—close to 30 per cent. By about the early 1980s, garment exports grew rapidly and by 1986, garments accounted for the largest share of all exports (27 per cent). By the late-1980s, garment industries in Sri Lanka were referred to as ‘glorified tailor shops’ because, despite a decade of growth, its links with other industries were weak and the value added remained low as before. In 1992, the BOI came into operation. The BOI offered an attractive incentive package to entice garment industries to move to rural areas of Sri Lanka under the so-called 200 Garment Factory Programme (GFP). A Textile Quota Board was established in the same year to streamline the allocation of quotas for the garment industries, including those coming under the 200 GFP. This programme enticed well-established garment industries to open a rural branch and, in addition, new enterprises with no background in garment production came into operation to make use of the quotas. Under the GFP, about 154 factories were in operation and five factories were closed down or merged by 1996 (Heward, 1997: 12). By 1992, the garment industry became the largest foreign exchange earner in the country (USD 0.4 billion)—overtaking the tea industry. By 2002, Sri Lanka’s textile and garment sector accounted for 6 per cent of GDP, 39 per cent of industrial production, 33 per cent of manufacturing employment, 52 per cent of total exports and 67 per cent of industrial exports (Tables 10.1 and 10.2). Sri Lanka commands 1.34 per cent of global garment exports (Table 10.2). These statistics clearly indicate that Sri Lanka is highly dependent on the industry for both employment and foreign exchange earnings. Foreign direct investment (FDI) has been very significant in the sector, accounting for 10.4 per cent of total cumulative FDI in 2003. According to the available data from the BOI, foreign investors own close to 50 per cent of total garment factories and account for nearly 50 per cent of total textile and garment exports (USITC, 2004)2. Greater dependence on imported textile materials indicates that Sri Lanka has a large export-oriented garment sector, but a small textile industry that has no capacity to supply the quantity and quality of yarn and fabrics required by the garment industry. In the early 1990s, a concerted effort was made to promote backward linkages in the garment industry. Government-appointed delegations were sent overseas to attract large textile producers to Sri Lanka. A number of textile industries that came up during the pre-1977 import-substitution regime and found it difficult to survive in the liberalised economy, were privatised in the early 1990s. Despite all such efforts,

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Development Under Stress: Sri Lankan Economy in Transition Table 10.1 SRI LANKA TEXTILE AND GARMENT SECTOR: MACRO DATA Under Agreement on Textiles and Clothing (ATC)

Textile and garment export (USD Mn) as % of total exports as % of industrial exports Export market (as a % of total textile and garment exports) USA UK Cotton yarn and textiles imports (USD Mn) Employment (’000) No. of establishments (garments) Cumulative foreign investment (USD Mn) (a) Average exchange rate (Rs per USD)

Under MFA Regime

After First Phaseout

After Second Phaseout

After Third Phaseout

1990

1995

1998

2002

643.5 33 64

1,852.5 49 65

2,466.2 52 69

2,425.5 52 67

67 6 427.8 102 142 36 41.37

61 14 1,237.1 250 678 108 51.25

64 18 1,477.6 227 891 158 64.59

63 20 1,429.0 330 NA 158 95.66

Sources: Central Bank of Sri Lanka, Annual Report (various issues); Department of Census & Statistics, Annual Survey of Industries (various issues); Sri Lanka Garments, Issue No 80; and the data is derived from the Apparel Digest/Sri Lanka Garment Journal, 2001. (It should be noted that sometimes it is difficult to separate the data for garments from the joint textiles and garments.) Notes: (a) Realized cumulative investment in garments at the end of the year, Board of Investment, Sri Lanka; (b) NA—not available.

Table 10.2 EXPORT PERFORMANCE OF TEXTILE AND GARMENT (T&G) INDUSTRY IN SRI LANKA: KEY INDICATORS FOR 1995–2003

Year

Textile (T)

Export Value (USD Mn) Garments (G) T&G

1995 1996 1997 1998 1999 2000 2001 2002 2003

43.2 199.2 306.7 228.6 225.2 271.5 209.7 179.1 175.3

1,465.5 1,688.6 1,972.6 2,237.8 2,205.1 2,723.1 2,334.6 2,246.4 2,400.0

1,852.6 1,905.9 2,279.3 2,466.4 2,430.3 2,994.6 2,544.3 2,425.5 2,575.3

Export Indices of T&G 1990 = 100 Volume 226 237 264 272 291 341 302 306 313

Value∗ 295 303 363 393 387 477 405 386 410

T&G Exports as a % of Total Unit Merchandise Value∗ Exports 130 128 137 144 133 140 134 126 131

Source: Central Bank of Sri Lanka, Annual Report (various issues). Note: ∗At constant (1990) dollar.

48.7 46.4 49.0 51.3 52.6 54.0 52.8 51.6 50.2

Sri Lanka’s Share in World Garment Exports (%) 1.00

1.33 1.34


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due to a number of reasons, the development of backward linkages from the garment industry to the textiles sector was very slow (Kelegama and Foley, 1999). In 1997, the textile industry faced a major setback. The East Asian crisis had triggered currency depreciation in Indonesia and the Philippines—two of Sri Lanka’s competitors in garment exports. The garment exporters found it difficult to compete without a devaluation of the Sri Lankan currency and started to lobby the government to this effect. Since the government did not allow a devaluation of the currency, the garment industry lobbied for duty-free status for textiles imports with the aim of bringing down their production costs.3 The government granted this request without considering the repercussions on the domestic textile industry. Consequently, the textile industry virtually collapsed and all efforts made by the government, by offering subsidised interest rates to rescue the textile industry, had no major impact. In fact, three of the privatised textile factories (Veyangoda, Pugoda and Mattegoda) that were gradually switching to manufacture textiles to meet the needs of the exportoriented garment industries had to be closed down. Today, the Sri Lankan garment industry remains a low value-added industry, though some backward linkages had developed by the mid-1990s. There were 891 garment factories in operation in 1999—out of which 18 per cent was categorised as large, 50 per cent categorized as medium and 32 per cent as small (TVEC, 1999). Seventy-two per cent of the industries were geographically located in the Western Province in 1999. Twelve per cent of the factories control around 72 per cent of the exports (CBSL, 2002: 103). Some of the top industries have developed strong and reliable links with well-known international retailers indirectly through buying intermediaries. Sri Lankan garments that were initially highly quota-dependent have now become less dependent on quotas with 47 per cent of exports coming under non-quota in 2002.4 Most of Sri Lankan garment exports are concentrated in the United States (63 per cent) and European Union (30 per cent) and hence, there is not much market diversification. The key varieties of garments that Sri Lanka exports are: HS 6204 (women’s or girls’ suits and similar items under this category), HS 6203 (men’s or boys’ suits, and similar items under this category) and HS 6206 (women’s or girls’ blouses and similar items under this category). Sri Lanka is well known as a top exporter of women’s lingerie. Sri Lanka’s garment industry has a fairly reputable status in the international market. Sri Lankan garment exports to the United States market, coped well with the emergence of NAFTA in 1994 despite many pessimistic views expressed at that time.5 The Sri Lankan garment industrialists have opened factories in Bangladesh, Maldives, Jordan, Kenya, Mauritius, among others, and are performing well. The large and well-established garment industries have featured in international books (Friedman, 2000). The Sri Lankan garment industry has gone through turbulent times as, for instance, during the 1988–89 civil conflict; in 1993, when countervailing duties and embargoes were imposed by the United States; and in 2001, when war-risk premiums and surcharges were imposed after the bomb attack on the Colombo International Airport. The industry currently employs around 330,000 and the livelihood of around 1.2 million people depends on the industry.

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Competitiveness of the Sri Lankan Garment Industry The competitive strength of the Sri Lankan garment industry is based on cheap labour, a literate labour-force, high labour standards, investment-friendly government policies and strategic shipping lanes. On the other hand, there are also competitive disadvantages such as long lead times, weak marketing, lack of product development and low labour productivity partly due to outdated technology. In 1983, Sri Lanka experienced civil conflict and many foreign investors, including foreign garment industrialists, shied away from the country. Some moved to Bangladesh, others moved to newly emerging low labour-cost East Asian countries such as Cambodia and Vietnam. Labour costs were comparatively low in these countries and gradually by the mid-1990s, Sri Lanka could no longer compete on the basis of low-cost labour and measures had to be taken to improve the productivity of the sector. Low productivity has offset to some extent the low labour-cost advantage of Sri Lanka. A study on the productivity of the garment sector shows that there are a number of issues pertaining to low labour productivity in the garment industry and that there is substantial room for improvement (Kelegama and Epaarachchi, 2002). One area that requires upgrading is the development of human skills to deal with the technological changes taking place in the garment industry. To meet the growing demand for semi-skilled workers in the industry, two training institutions, viz., the Textile Training and Service Centre (TT&SC, established in 1984) and the Clothing Industry Training Institute (CITI, established in 1984) came into operation. In addition, in 1998, a private sector training institute, the Phoenix Clothing Training Institute, was established. A number of design schools have emerged, with the Department of Textiles in the University of Moratuwa becoming the apex body for design. Design courses have been introduced, with the collaboration of the London School of Fashion Design, to keep pace with the latest fashion developments in the world and to train workers to match the demand. The Asian Development Bank (ADB) has given a grant to set up a major fashion school at the University of Moratuwa. Labour cost, however, amounts to 15–20 per cent of the overall cost. Thus, there are a number of non-labour aspects that contribute to low productivity. The introduction of CAD/CAM machinery to the garment industry has been painfully slow. At the firm level, competitive issues have not featured in strategic planning due to the assured market guaranteed by the quota system and the laid-back attitude of some entrepreneurs (Fonseka and Fonseka, 1998). Little effort has been made to produce high value-added garments by most companies and there is heavy dependence on buyers to channel garments to international markets (about 65 per cent of garment exports).6 Until recently, most garment orders have been on No Foreign Exchange (NFE) basis and many garment industries preferred such orders due to the level of risk involved being much less.7 Little effort has been made at the firm level to reduce wastage and improve the quality of work.


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Due to lack of a fabric and accessory base (a lack of vertical integration), the turnaround time of Sri Lanka’s garment industry remains close to 90–150 days compared to the ideal international lead-time of around 60 days. This large turn-around time is an issue in the context of competitiveness, particularly when Eastern European countries have become major suppliers of garments to the EU, and Mexico and Caribbean countries have become major suppliers to the United States under preferential tariff arrangements. Moreover, this problem is of particular concern at a time when ‘Just-In-Time’ delivery has become an accepted principle and requirement in the global market.8 Sri Lanka’s lack of competitiveness in garment products is not solely determined by low labour productivity, inadequacies at the level of the firm and high turnaround time, but also by government policies. The cost of production in Sri Lanka has escalated during recent times due to the high cost of public utilities such as electricity, water, telecom, etc. (IPS, 2003). In fact, Sri Lanka’s electricity charges remain the highest in Asia as a result of poor government policy contributing to the mismanagement of the electric power sector. If Sri Lanka is to gear itself to the post-2004 challenges, a number of restructuring measures have to be put in place for the garment industry. Some measures have already been taken. Until recently, the Sri Lankan garment industry did not have a strategy or plan for its future expansion. In 2002, the industry came up with a fiveyear strategy report for the industry. This report contains a comprehensive analysis of ‘Strengths’, ‘Weaknesses’, ‘Opportunities’ and ‘Threats’ (SWOT) and recommends a strategy to eliminate weakness, consolidate strengths, make use of opportunities and minimise threats. The report argues for the establishment of a special research cell for the industry to keep track of international trends in garment trading, which came into operation in late-2002. Having realised the need for one voice for the industry to achieve a common goal, garment industrialists and stakeholders set up the Joint Apparel Association Forum (JAAF) in 2002, which is a combination of five different associations.9 Meanwhile, the airport bomb attack in mid-2001 was a wake-up call for the industry. After this event, a war-risk insurance charge was imposed on Sri Lankan exports which undermined the competitiveness of the garment industry. This triggered a social engineering process in the industry where many companies started implementing various cost cutting measures to make the industry more competitive. Although, Sri Lanka supplies garments to many leading retailers such as Victoria’s Secret, Liz Claiborne, May Department Stores, Marks & Spencer, C&A, etc., the country does not possess well-known local brand names. Most garment exporters do not have direct contact with the final buyer and remain nameless suppliers to such leading stores via buying offices. To address this lacuna, the industry introduced a garment-marketing course in collaboration with the Chartered Institute of Marketing in the United Kingdom. Recognising the need for a brand that could withstand shocks in the Western market, measures were taken by two leading companies (Phoenix Ventures and Jewelknit) to merge and develop a branded product (Brandix) in 2003. This was a positive sign in the overall progress of the garment industry in Sri Lanka.

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New Trends in the Global Trading Environment: Meeting the Challenges The Sri Lankan garment industry not only needs to become competitive to face the post-2004 quota-free global challenges, but also has to take cognisance of the new trends in the global trading environment. There are new trends in the EU and the US markets, while the emergence of China as a significant global supplier is also an important issue. Sri Lanka gained quota-free status entry to the EU market in March 2001, with the expectation of increased garment supply to the EU market. Sri Lanka currently faces competition in the EU market from Least Developed Countries (LDCs) such as Bangladesh—which has duty and quota-free access to the EU under the Everything-But-Arms (EBA) scheme—African, Caribbean and Pacific (ACP) countries—which enjoy preferential market access to the EU under the Cotonou Agreement and lately from Eastern European countries—some of which have become EU members and where some of the EU garment factories have relocated to exploit cheap labour and proximity to the EU market. A comparison of Sri Lankan export performance with other countries’ export performance in the EU market during 2000–03 does not provide strong evidence that the quota-free entry to the EU market has resulted in significant gains for the Sri Lankan garment exports (Kelegama, 2004; Chapter 2). It appears that the window of opportunity for EU market consolidation has been lost due to the relatively late quota-free entry.10 However, Sri Lanka has gained from the reduction of GSP rates for Sri Lankan garment exports by the EU.11 Sri Lanka has managed to maintain relatively high labour standards in factories to convince EU inspectors that working conditions in factories are relatively satisfactory.12 There are doubts whether these concessions would be significantly beneficial given the fact that GSP concessions are conditional on fulfilling the SAARC Rules of Origin (RIS, 1999).13 After the enactment of the Trade Development Act 2000, the United States subsequently adopted the Caribbean Basin Trade Preferential Act (CBTPA), the Andean Trade Preferential Act (ATPA), and the African Growth and Opportunity Act (AGOA) in 2001–02. Under these acts, garment exports of Caribbean, Latin American and Sub-Saharan African countries are entitled to quota-free and preferential duty entry to the United States market after fulfilling certain conditions. These conditions are mainly related to selected textile and garment articles and fulfilling the applicable rules of origin (or reverse preferences) involving the use of United States fabrics and other inputs, which the United States demands as a quid pro quo and is known as the ‘yarn-forward rule’. There are mixed views regarding the effectiveness of these arrangements. While some critics claim that the in-built reversed preferences governing these agreements have nullified the preferential advantages (J. Bhagwati, The Economist, June 2002), others have argued that despite the reverse-preference conditionality, there are overall gains from these agreements (UNCTAD, 2003; Mattoo et al., 2003). In fact, a


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number of Sri Lankan garment entrepreneurs have set up businesses in Mauritius, Madagascar, Kenya and other African countries to exploit the advantages of AGOA—just like the East Asian quota-hopping garment manufacturers who came to Sri Lanka in the late-1970s to gain the quota advantage in Sri Lanka. The departure of the United States from multilateralism is not confined to these arrangements alone. Of late, the United States has been offering bilateral agreements to various countries on the basis of ‘WTO-Plus’ considerations.14 Chile, Singapore and Jordan have already completed bilateral free trade agreements (BFTAs) with the United States. These agreements were signed on the basis of initial agreements called Trade and Investment Framework Agreement (TIFA). Sri Lankan garment companies are of the view that if a United States–Sri Lanka bilateral free trade agreement could be worked out any time soon, Sri Lanka could consolidate its garment export share in the United States market (2.7 per cent of United States garment imports in 2003 was from Sri Lanka and 63 per cent of Sri Lankan overall garment exports are to the United States market) and thus, could face the post-2004 challenges more effectively. In July 2002, the two countries signed a TIFA and since then substantial groundwork has been done to convert the TIFA to a full-fledged bilateral free trade agreement (Daily Mirror, 20 February 2004). Sri Lanka’s enthusiasm for achieving a bilateral free trade agreement with the United States was such, that for the first time, the country made a complete departure on some issues from the developing countries’ position in the Fifth WTO Ministerial Conference in Cancún to support the United States position (Kelegama and Mukherji, 2003). Obviously, it was a quid pro quo to expedite the possible United States–Sri Lanka bilateral free trade agreement. What is clear is that a United States–Sri Lanka FTA has been delayed due to the fact that 2004 was an election year in the United States with the political establishment under pressure for more protectionist measures by the clothing sector and it was also an election year in Sri Lanka with considerable political instability. The recent disaster as a result of the December 2004 Tsunami Wave may lead to further delays as immediate government priorities lie elsewhere. Such delays may lead to the abandoning of the FTA, which may be in any case too late to be of significant assistance, similarly to the earlier mentioned EU quota-free status. The Indo-Sri Lanka Bilateral Free Trade Agreement (ILBFTA) came into operation in March 2000 and one objective of this agreement was to give an opportunity for Sri Lankan garment exports to diversify and capture a share of the Indian market. However, given the various para-tariffs and specific duties operating in the Indian market and the rules of origin governing the agreement, Sri Lankan garments have not been very competitive in the Indian market, to the extent that only a small amount of garments has been exported to India and the quota under the ILBFTA remains significantly unutilised (Kelegama, 2004: Chapter 8). China’s threat to the garment exports from developing countries is important and cannot be set aside. The World Bank has predicted that China’s share in garment exports will rise to 50 per cent in the world by 2010 (The Economist, 15 February, 2003). In other words, Chinese exports are expected to double in six years time,

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mostly at the cost of exports of other developing countries. Already, the rapid rise of China’s garment exports, in particular categories after earlier quota removals, has demonstrated how China could swallow up the share of garment exports from other developing countries. In addition to possessing a low wage rate per worker (average USD 40 per month), China benefits from a disciplined workforce, economies of scale through largescale production and the presence of many trans-national corporations (TNCs) in the garment industry. Moreover, upon its accession to the WTO in December 2001, China enjoys MFN (Most Favoured Nation) status for its exports—a privilege that did not exist before. The number of product items under quota in China amounted to 20 per cent of Chinese garment exports, before 1 January 2005, which is large in quantity. Thus, it is believed that there will be a significant domination of Chinese clothing in the post-2004 period. However, arguments have also been put forward to show that the threat from China may be exaggerated. First, it is argued, that with WTO entry, China will have to become more transparent and some of the past practices to maintain low cost of production may have to be abandoned. Consequently, the low cost advantage may get somewhat eroded (RIS, 2002). It is also argued that although labour wages in the provinces remain low, there has been a significant increase in wages in the Eastern Coast where the key garment industries are located. Monthly wages in some of these factories exceed USD 90, which is above the monthly wages in Indonesia, Bangladesh, Vietnam, India and Sri Lanka. Second, there is a view that the United States (and EU) will have a significant control over the expansion of Chinese garments in the US (EU) market due to two prevailing legislative regulations, viz., (a) Safeguard regulation from 2005–08, and (b) Anti-dumping regulation from 2005–15.15 It is argued that both these regulations will ensure a significant control over a sudden influx of Chinese garments into the United States (and EU) markets, and thus, preserve the existing United States (and EU) market foothold of garment exports from other developing countries.16 It is also argued that the United States may exert pressure on China to revalue its currency—the Yuan—like in the case of Japan in 1971. A revaluation of the Chinese currency would further erode the competitive advantage of Chinese garments. It is difficult to exactly say what threat China will pose for a garment exporter in Sri Lanka. At least from the Sri Lankan experience so far, the threat seems to be real. Three items—bag and luggage (670), W/G [Women’s or Girls] Coats (835), W/G Suits (844)—that were removed from the quota categories in January 2002 completely went out of production by mid-2003 due to competition from China. Two leading industries that were producing some of the above-mentioned items and employing a large number of people had to close down consequently.17 The prevailing uncertainty has been further aggravated by the WTO Agreement on Textiles and Clothing (ATC), which stipulates the phase-out of the MFA. Developed countries did not strictly adhere to the phase-out mechanism of the MFA, for instance, by 1 January 1998, compared to the target of 33 per cent of product integration, the United States and the EU had integrated only 1 per cent and 7 per cent, respectively (ESCAP, 2000: 71). Moreover, developed countries have exploited a loophole in the MFA, where the ATC does not provide any


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obligation on countries to limit their integration to particular products subject to restrictions. Therefore, Sri Lanka did not feel the full impact of the final phase out of the MFA in 2004. It has been estimated that the items to be relaxed in 2002 constituted only about 4 per cent of all restricted products exported by Sri Lanka to the United States. The remaining 96 per cent of the restricted products were under restraint until end 2004 (Weerakoon and Wijayasiri, 2004). Thus, a sense of complacency crept in among garment companies to make the required adjustments, although, this changed somewhat after the social engineering process that started after mid-2001. An earlier study highlighted that nearly 40 per cent of the Sri Lankan garment industries will go out of production after 2004 (Kelegama and Epaarachchi, 2002). The study argues that there would be a number of new mergers and acquisitions taking place in the industry. Some large industries may resort to sub-contracting by using small units, while some small units that fail to obtain orders, will have to close down. To support small and medium units of the garment industry, the government has launched a credit guarantee scheme as proposed in the 2004 Budget. Under this scheme, loans could be obtained without collateral. The Five-Year Strategy (JAAF, 2002) has argued that Sri Lanka should now shift from the low-end of the market to the middle and upper levels. Currently, only 10 per cent of local manufactures end up as specialty brands, while 50 per cent are taken by foreign department stores and the balance 40 per cent by foreign discount stores. During the five-year period ending in 2007, the industry plans to increase penetration into specialty stores by 20 per cent, department stores by 60–70 per cent and reduce dependence on discount stores by 10–30 per cent. The plan outlines a format for achieving these objectives with a detailed discussion on: (a) a strategic framework for implementation, (b) strategic initiative and relevant action plans for the industry, (c) additional strategic initiative in support of small and medium scale industries, (d ) implementation plans, and (e) cost estimates of the strategic plan. The industry has formed eight committees to look into various aspects of the industry: (a) bilateral and multilateral issues, (b) marketing, (c) logistics and infrastructure, (d ) backward integration, (e) small and medium enterprises (SMEs), ( f ) human resources, technology and productivity,( g) labour, and (h) finance. The government has allocated Rs 100 million to increase the productivity in the garment industry through the Five-Year Strategy. The Sri Lanka Joint Apparel Association Forum coordinates the strategy management. The association has hired a number of experts to coordinate and support its work. Although, strategies have been put in place to effectively face the post-2004 challenges, the debate goes on for the post-2004 scenario—both optimistic and pessimistic views have been voiced. Optimists, like the Central Bank of Sri Lanka, have put forward the following viewpoints. First, it is stated that since 12 per cent of the garment manufacturers control 72 per cent of exports, there are reasons to believe that these top-end factory units are well-established commanding market niches and thus well-placed to meet the post-2004 challenges. Thus, it is argued that these top-end manufacturing units can absorb some of the smaller factories and expand their production to be competitive in the market. Second, it is argued

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that the non-quota exports, at present, amount to 47 per cent of garment exports, thus, quota phase-out will not create a serious problem. Third, it is argued that if the high-end of the market could be captured by producing value-added garment products—which larger units have done—Sri Lanka need not worry about competing in the world market. While one can agree with the first point, there are serious reservations about the others. First, it is inappropriate to form a judgement based on increasing non-quota exports because what is a non-quota product for Sri Lanka may be under quota for another country, say, for example, China. How such a non-quota product will perform when the same product comes out of quota in China—at least if one goes by past experience—may not be positive. Second, the top-end of the market is equally competitive—other countries that see their quotas in this segment removed will also be aiming at this segment and thus, competition would be intensive at this end of the market as well. Sri Lanka will face an uphill battle in the competitive top-end of the market (Fonseka, 2004). The pessimists, on the other hand, argue that whatever the percentage of exports that are controlled by the top 12 per cent firms, the garment industry as a whole is not competitive enough to show solid performance in the post-2004 period (ibid.). From the global demand front, it is said that the threat from China will be overwhelming. Moreover, it is argued that the share controlled by other Asian countries is expected to shrink from the current 32–20 per cent by 2010. Consequently, there will be competition among Asian countries to capture part of this shrinking share and in that process Sri Lanka may not necessarily be a winner. Further, inadequate preparation for the post-2004 period due to the back loading factor of the MFA phase-out is also highlighted by the pessimists. From the domestic supply side, the inadequate development of backward linkages, weak forward integration, low labour productivity, increasing cost of production, etc., are pointed out by the pessimists to highlight the lack of competitiveness. Those who argue on these lines show that at least 100,000 workers will lose jobs and various new mechanisms will have to be devised to look into those displaced from the garment industry. A mixed picture emerges from current trends in the garment industry. On the negative side, it is observed that out of the 859 firms operating in 2001, about 150 had closed down by mid-2002.18 There is a shortage of labour for garment factories due to poor working and accommodation conditions prevailing in some of the factories.19 In the years 2003 and 2004, garment exports have shown a decline in performance compared to the year 2000 (Table 10.2). On the positive side, it is observed that the top 12 per cent of factories are performing well, there is an increase in international orders and a number of foreign garment companies, like Levis, are opening up factories in Sri Lanka. Given the strong foundations of the garment industry, Sri Lanka still has a chance of being a supplier of choice in the major international markets; however, to retain such a position substantial restructuring is essential. Thus, irrespective of the current mixed picture, there is an urgent need to restructure the industry to face the post2004 period without being complacent about a possible United States–Sri Lanka


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FTA that will come to Sri Lanka’s rescue, or that the Chinese safeguards will cushion the adverse impact after 2004 due to concerns in the EU and the US markets.

Concluding Remarks The Sri Lankan garment industry is at crossroads. The challenge is to improve its competitiveness. Rectification of the anomalies highlighted in the preceding sections alone would be inadequate; other methods of increasing competitiveness should be explored. One strategy is to re-position the Sri Lankan garment industry from a South Asian context and thereby, increase competitiveness by increasing vertical integration, capturing economies of scale, focusing on horizontal specialisation, incorporating innovative designs and building a stake in global marketing networks. A recent report by the RIS (2004) argues that the region as a whole could meet the challenge collectively if horizontal integration is pursued, i.e., cooperation in the same or similar lines of production and exports. Such a South Asian strategy envisages a particular South Asian country which has gained export specialisation in certain textile or clothing product lines, acting as a host for relocated plants from other South Asian countries. In this way, the textile and clothing sector can become a regionally integrated sector as countries vacate certain lines of production and gain in other lines of production according to their relative competitive advantage in the global market. Such restructuring would promote intra-South Asian investment flows that would create trade vis-à-vis the global and regional markets. Vertical integration from one stage of processing to another according to comparative advantage can be considered in the subsequent phase. South Asia would, thus, not lose in the value-added chain. Ramaswamy and Gereffi (1998) showed that the buyer determined value-added chain is prominent in garment manufacturing. One way of getting into the chain is by having a stake in the global marketing network. For example, in the tea sector, the Indian company Tata bought over the global marketing network of Tetley. A similar strategy can be adopted in the garment sector. But a regional strategy in this regard will be more effective than an individual South Asian country effort. RIS (2004: 36) argues: Much of the value addition in garments for instance takes place at the stage of branding and marketing. The South Asian countries should consider setting up South Asian level mega-companies to foster an integrated South Asian garment sector …. In order to secure their market overseas and to realize a greater proportion of value added, the South Asian exporters should consider taking over a few marketing and distribution chains in their lines of production in developed countries. Given the scale of resources involved in such take-overs, it may be beyond the capacity of individual exporting companies or individual member countries. However, this could be done by forming a regional consortia of the South Asian exporters.

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The Sri Lankan garment industry has gone through turbulent times and it is now facing new challenges. The groundwork has already started to prepare and face this challenge. What Sri Lanka would like to see is a minimum disruption in the adjustment process because the garment sector is the largest foreign exchange earner and a key generator of employment. However, if Sri Lanka can no longer maintain its comparative advantage in the garment sector, the market will forge the emergence of new sectors replacing the garment sector in the economy, but in the short run, such industrial restructuring will incur a significant cost, including a social cost on the economy. It is for this reason that both the government and private sector industry are going all out to support the garment sector in order to minimise the adjustment costs.

Notes 1. The Board of Investment at the time of the take-off of garment exports was known as the Greater Colombo Economic Commission (GCEC). 2. All firms with FDI are treated as foreign firms regardless of the size of the ownership share. 3. The benefit of this was mainly for non-BOI garment exporters that were in a majority in terms of numbers at that time. 4. Sri Lanka depends less on quotas compared to Bangladesh (95 per cent), Pakistan (90 per cent), Nepal (80 per cent) and India (73 per cent) (ILO, 2002). 5. Sri Lanka’s competitive position in the US market was not significantly disturbed by NAFTA (for details, see Chapter 7, Kelegama, 2004). 6. Business Page, The Island, 22 February 2004. 7. No foreign exchange basis—the buyer provides inputs and the garment manufacturer makes no payment for these inputs and thus, there is no importation on the part of the manufacturer. 8. Electronic point-of-sale technology—that is, the barcode—has been increasing retailers’ command over suppliers since the 1980s. Retailers no longer have to buy goods upfront and carry the risk of selling them. Now, when consumer purchases are tracked by barcodes, retailers can automatically reorder just enough products, just in time for restocking their shelves. It maximises their retail sales per square metre of shop space and shifts order risks back on to the suppliers and producers. With this just in-time response comes the pressure on producers to deliver smaller orders, less time and according to tightly planned shipping schedules—or face fines for delays. 9. The five associations are: Sri Lanka Apparel Exporters Association, National Apparel Exporters Association, Sri Lanka Chamber of Garment Exporters, Free Trade Zone Manufacturers Association and Sri Lanka Garment Buying Offices Association. 10. Sri Lanka’s ability to sustain in the EU market might weaken further when the EU phase out quota restriction on garment exports of India and China. 11. The overall reduction is about 40 per cent for the garment sector—20 per cent under the GSP and 20 per cent under a Special Incentive Arrangement. For details, see Quarterly Economic Review: Sri Lanka, Fourth Quarter 2003, The Ceylon Chamber of Commerce (2004: 9–10) 12. Apparel-industry Labour Rights Movement (AlaRM) Sri Lanka, will not necessarily agree with this viewpoint (also see, Kelegama and Epaarachchi, 2002). 13. The rules of origin stipulate that the fabric must be knitted or woven in a SAARC region from the yarn of the same SAARC country. Cumulation can only take place between two SAARC countries, for example, yarn spun and woven in India and garment made in Sri Lanka. Imported woven fabric can be used if it has been printed and finished in SAARC


14. 15.

16.

17. 18. 19.

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region on condition that the imported greige accounts for no more than 47.5 per cent of the ex-works value of the finished fabric. Non-originating non-textile trims (e.g., buttons and zips) can be used freely. Non-originating textile trims (e.g., elastic) can be used provided that they do not exceed 8 per cent of the value of the ex-works price of the finished garments. The use of non-originating linings and interlinings will automatically disqualify the garment product for GSP. See, for instance, Kelegama and Mukherji (2003). The Textile and Clothing Safeguard regulation that China agreed to as part of its WTO accession package allows WTO member countries to impose temporary quotas on Chinese textile and clothing imports in the event these imports cause ‘market disruption’ (instead of the standard ‘serious injury’ clause). And the Anti-dumping measures that China agreed to are defined as unilateral remedies, which can be applied by a WTO member after an investigation and determination by the member that an imported good is ‘dumped’ and that dumped imports are causing material injury to a domestic industry producing a like product. In response to these, the Chinese government announced export tariffs on 148 textile and clothing products. However, the tariffs are low, for instance, for men’s cotton shirts the levy is 0.2 Yuan, or 2.5 cents—a price increase of about 1 per cent. Despite this being a marginal difference, the low profit margins in China make it difficult to impose a more pressing tariff. The American Textile Manufacturers’ Institute recently estimated that without safeguards, approximately 1,300 firms could go out of production with the loss of 630,000 jobs by 2006 (The Island, 27 August 2003). Due to the closure of North Carolina Sheet and Towel and Pillowtext Corporation, 6,450 jobs were lost (The Island, 27 August 2003). ‘Treasury Officials Fail to Provide Succour to Garment Industry’ (The Island, 21 June 2002). The JAAF recently launched a media programme to build the image of the garment employees after realising that the shortage of workers is due to the social stigma attached to garment workers and poor working conditions in some firms.

References CBSL (various issues, 2002), Annual Report, Central Bank of Sri Lanka, Colombo. ESCAP (2000), Development through Globalization and Partnership in the Twenty-First Century: An Asia-Pacific Perspective for Integrating Developing Countries and Economies in Transition into the International Trading System on a Fair and Equitable Basis, ESCAP, United Nations, New York. Fonseka, A.T. and D. Fonseka (1998), ‘Garment Industry of Sri Lanka: Challenges and Responses’, Sri Lanka Journal of Management, Vol. 3, Nos 3 and 4 (July, December), pp. 250–91. Fonseka, T. (2004), ‘Forward Integration and Supply Capacity of the Garment Industry’, in S. Kelegama (ed.), Ready-Made Garment Industry in Sri Lanka: Facing the Global Challenge, Institute of Policy Studies, Colombo. Friedman, T. (2000), The Lexus and the Olive Tree, HarperCollins, London. Heward, S. (1997), ‘Garment Workers and the 200 Garment Factory Programme’, Centre for Welfare of Garment Workers, Colombo (mimeo). ILO (2002), Garment Industry in South Asia: Rags or Riches?—Competitiveness, Productivity, and Job Quality in the Post-MFA Environment, ILO, Delhi. IPS (2003), Sri Lanka: State of the Economy—2003, Institute of Policy Studies, Colombo, Sri Lanka. JAAF (2002), 5 Year Strategy for the Sri Lankan Apparel Industry, Joint Apparel Association Forum, Colombo. Kelegama, S. (ed.) (2004), Ready-Made Garment Industry in Sri Lanka: Facing the Global Challenge, Institute of Policy Studies, Colombo.

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Kelegama, S. and Fritz Foley (1999), ‘Impediments to Promoting Backward Linkages from the Garment Industry in Sri Lanka’, World Development, Vol. 27, No. 8, pp. 1445–60. Kelegama, S. and I.N. Mukherji (2003), ‘WTO and South Asia: From Doha to Cancun’, Economic and Political Weekly, Vol. XXXVIII, No. 37 (13–19 September), pp. 3864–67. Kelegama, S. and R. Epaarachchi (2002), ‘Garment Industry in Sri Lanka’, in ILO (ed.), Garment Industry in South Asia: Rags or Riches?—Competitiveness, Productivity, and Job Quality in the PostMFA Environment, ILO, Delhi. Mattoo, A., D. Roy and A. Subramanian (2003), ‘The African Growth and Opportunity Act and its Rules of Origin: Generosity Undermined?’, The World Economy, Vol. 26, No. 6. Ramaswamy, K.V. and G. Gereffi (1998), ‘India’s Apparel Sector in the Global Economy: Catching Up or Falling Behind’, Economic and Political Weekly, 17 January, pp. 122–29. RIS (1999), SAARC Survey of Development and Cooperation 1998/99, Research and Information System for Non-Aligned and Other Developing Countries, New Delhi, India. ——— (2002), South Asia Development and Cooperation Report 2001/02, Research and Information System for Non-Aligned and Other Developing Countries, New Delhi, India. ——— (2004), South Asia Development and Cooperation Report 2004, Research and Information System for Non-Aligned and Other Developing Countries, New Delhi, India. TVEC (1999), Sector Profile—Garment Industry, Industry Sector Profile Series, Issue No. 1, November, Tertiary and Vocational Education Commission, Labour Market Information Unit, Colombo. UNCTAD (2003), The African Growth and Opportunities Act: A Preliminary Assessment, UNCTAD/ ITCD/TSB/2003/1. United States International Trade Commission (USITC) (2004), Textile & Apparel: Assessment of the Competitiveness of Certain Foreign Suppliers to the U.S. Market, Vol. 1, USITC, Washington. Weerakoon, D. and J. Wijayasiri (2004), ‘WTO Agreement on Textile and Clothing: Implications for the Garment Industry’, in S. Kelegama (ed.), Ready-Made Garment Industry in Sri Lanka: Facing the Global Challenge, Institute of Policy Studies, Colombo.

MARKET REFORM AND DIVERSIFICATION IN AGRICULTURE

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11 MARKET REFORM AND DIVERSIFICATION IN AGRICULTURE

Introduction Sri Lankan policy-makers are at the crossroads of furthering domestic market reforms and trade liberalisation in the agricultural sector. Major tasks for planners and policy makers include understanding the role of the market in increasing agricultural productivity, designing and implementing policies that will facilitate increased employment in the rural sector, and identifying and nurturing institutional reforms that will increase the participation of agricultural producers, both in regional and international markets. The major objective of this chapter is to provide an overview of the issues and challenges facing Sri Lankan policy-makers in their efforts to introduce market reforms, liberalise external trade and diversify the agricultural production base. The chapter is organized as follows. An overview of Sri Lanka’s agricultural sector is provided in the succeeding section to illustrate the contribution it has made to the economy and gives a broad picture of the current status. The issues on WTO-related market reforms are then addressed in the third section. The challenges encountered in employing agricultural diversification as a means to boost rural employment and incomes are discussed in section four followed by some concluding remarks.

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Overview of Sri Lankan Agriculture Agriculture is the mainstay of Sri Lanka’s rural population. Yet, in the past decade, the sector’s growth has been around 2 per cent per annum—the lowest in South Asia (RIS, 2002). Because the agricultural sector still accounts for 18 per cent of GDP and 65 per cent of the population largely depends on it for their livelihood, the government is particularly concerned about its poor performance over the past decade. Despite the significant structural transformation of the Sri Lankan economy over the past three decades, the agricultural sector still provides employment to about 32 per cent of the labour force, surpassing the contribution of any other sector. Land for agriculture is mainly located within the dry zone where water availability limits land utilisation to its full potential. Sri Lanka’s land area under cultivation has decreased significantly during the past decade, by about 18 per cent. The agricultural sector has two components, the plantation and the nonplantation. The three main plantation crops, tea, rubber and coconut, account for 15.6 per cent of the agricultural GDP and 3 per cent of the GDP. About 40 per cent of the lands in the tea and rubber sectors are in large plantations and the small landholders have the balance. The plantation sector accounts for 15.3 per cent of total foreign exchange earnings. Total direct and indirect employment in the sector is estimated at around 1.5 million people. The plantation sector was under state control from the mid-1970s to 1992 after which it was privatised. In 1995, the land ownership lease of the management companies was extended to 99 years. The non-plantation sector, also referred to as the domestic food production sector, produces mainly paddy and subsidiary food crops. Paddy (rice), the main staple crop, dominates non-plantation agriculture. The area under paddy cultivation is 930,000 hectares or 45 per cent of the total area under the agricultural sector. The majority of the farmers in the paddy sector are small-scale producers; more than 70 per cent of paddy holdings are less than one hectare and only about 5 per cent have a holding size greater than 2 hectares. The rice sector employs about half of the total agricultural labour force in Sri Lanka (about 16 per cent of the total labour force). Rice accounts for approximately 25 per cent of the consumer goods basket, about 75 per cent of total grain consumption and 45 per cent of caloric intake in the country. Nearly 90 per cent of the total domestic rice requirement is now met from local production and rice imports amount to only 2 per cent of overall food imports (Table 11.1). The other non-plantation crops include subsidiary food crops such as maize, pulses, chillies, onions and potatoes. With the emphasis on the promotion of domestic food production, most of the subsidiary food crops have also benefited from government investment in irrigation schemes, subsidised inputs, concessionary bank credit and tariff protection/import restrictions aimed at maintaining domestic market prices above competitive world prices.1 Despite this, production of potatoes, chillies and big onions has been severely affected lately, as local producers whose costs are higher could not compete with cheap imports, mainly from India and Pakistan. The paddy sector too is characterised by relatively low and stagnating

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MARKET REFORM AND DIVERSIFICATION IN AGRICULTURE Table 11.1 VALUE AND SHARE OF FOOD IMPORTS IN 2001 Item Total food imports Rice Flour Sugar Milk and milk products Fish and fish products Other food items

Value in 2001 (Rs. Million) 48,683 969 122 10,289 10,223 6,360 20,720

Percentage Contribution 100.00 1.99 0.25 21.13 20.99 13.06 42.56

Source: Central Bank of Sri Lanka, 2001, Annual Report.

yields, escalating costs of inputs and thus, slow growth. Land area under subsidiary food production declined by 40 per cent and paddy production by 15 per cent during the 1990–97 period. In fact, the entire non-plantation sector has lost its growth momentum over the past 10–15 years. Agricultural policy, since 1977, has been more liberal than what it was in the period prior to 1977. Although, this has been the case, achieving self-sufficiency in rice has remained a primary goal among policy makers (Chapter Twelve) (see Table 11.2). Although, general tariffs were lowered from 1977 onward, those for the agricultural sector were still high. Quantitative restrictions were applied for some domestic food crop sectors in order to promote domestic production with less competition. A number of state-owned enterprises involved in the purchase and distribution of agricultural products operated actively until about the mid-1990s, but their role has gradually diminished over the past five years (Chapter Twelve). The land market was hardly liberalised, with restrictions on ownership and land sales still operating in many areas. Thus, the first phase of policy reforms, begun in 1977, which continued until the mid-1990s, did not go far enough to remove the distortions in the land market. This issue has been of concern to policy makers discussed in the fourth section. However, compared to the other South Asian countries, Sri Lanka, despite various distortions in the agricultural market, had the most liberal regime for agriculture (Athukorala, 2000). Just before the World Trade Organisation Agreement on Agriculture (WTO-AOA) came into operation, Sri Lanka’s situation was, briefly, as follows: 1. All agricultural export taxes were abolished. 2. All agricultural export and domestic production subsidies were within the AOA limits. 3. The tariff band for agriculture was 45 per cent. Quantitative restrictions (QRs) were applicable on potatoes, chillies, big onions, wheat flour and rice. 4. Special tariffs applied to sugar and milk because the government assured foreign direct investment (FDI) in these two sectors and a special rate of return (Athukorala and Kelegama, 1998). 5. State trading enterprises involved in importing agricultural items were still in operation with a reduced role.

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Development Under Stress: Sri Lankan Economy in Transition Table 11.2 PADDY PRODUCTION AND RICE IMPORTS

Year 1970 1975 1980 1985 1990 1995 1996 1997 1998 1999 2000 2001

Gross Extent Sown (in thousand Ha) 759 696 845 882 857 915 749 730 848 896 878 798

Production (in thousand MT) 1,616 1,154 2,133 2,661 2,538 2,810 2,061 2,239 2,692 2,868 2,860 2,695

Yield (Kg/Ha)

Imports Year (in thousand MT)

1,129 2,270 2,927 3,465 3,453 3,535 3,513 3,618 3,634 3,672 3,856 3,954

526 457 167 182 172 9 341 306 168 214 15 52

Source: Central Bank of Sri Lanka, 2001, Annual Report.

WTO-Related Market Reform After considering various options available under the WTO-AOA, Sri Lanka decided to bind all its agricultural tariffs at 50 per cent so that it could align it with the ongoing reforms in the agricultural sector and develop the sector according to its comparative advantage. However, QRs were retained on selected agricultural products after the AOA came into operation with a justification on balance-ofpayments grounds (Athukorala and Kelegama, 1998).2 This action was overruled by the WTO—and Sri Lanka, in July 1996, removed all QRs other than those on wheat. In the case of wheat, it was not possible due to a condition with a Singaporean FDI firm in the wheat-flour sector. The rationale on low-tariff binding can be found in the fact that Sri Lanka had a low-tariff structure with agriculture tariffs at 45 per cent in 1994. Although, the tariff equivalent of the QRs for sensitive products such as potato, onions, chillies, etc., were not taken into account, 50 per cent binding was seen to be reasonable for a net food importing country such as Sri Lanka. Sri Lanka’s food imports had increased over the years, although, as a percentage of total imports, food imports declined from 43.7 per cent in 1995 to 9.2 per cent in 1999. The removal of QRs in the domestic food crop sector dealt a severe blow to the production of potatoes, onions and chillies. It resulted in the disappearance of the price advantage enjoyed by local farmers in the protected market. The situation compelled the policy makers to implement a seasonal tariff policy for the sectors in which imports were liberalised (even with zero tariffs)—when there was a shortage of domestic production, and normal agricultural tariffs were imposed when there was a glut in domestic production. The seasonal tariffs had a number of problems associated with them: timing, hoarding, and unscrupulous traders making maximum use of the loopholes to gain profits. Various lobbies also influenced the seasonal tariffs thus, resulting in ad hoc manipulations.


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Agricultural import duties were periodically waived for all essential food items that the government deemed were in the national interest (Kelegama, 2003). The periodic application and revocation of import duties gave confusing signals to the producers and contributed to price volatility, thereby, reducing incentives for domestic storage and adding to the uncertainties faced by the farmers. The producers constituted a strong lobby and with the support of the Minister of Agriculture, exerted pressure for more protectionist policies for their products during the post-1996 period. This was evident in early 1999, when they managed to convince the government to put the entire agricultural sector into the negative list of the Indo-Sri Lanka Bilateral Free Trade Agreement (ILBFTA). To accommodate the concerns of the protectionist lobby, various surcharges were implemented on the importation of food crops. Ad hoc tariff changes and imposition of surcharges raised the effective tariffs to close to 50 per cent in some years (IPS, 2002). Despite reducing tariffs to zero to please consumers, in certain seasons, protection to producers has come at the expense of consumers regarding all four items, chillies, potatoes, onions and rice. Welivita et al. (2002) report that the average effective protection rates (EPRs) for the 1990–2000 period for rice, potatoes, chillies and big onions were 59, 179, 109 and 39, respectively. The case of paddy illustrates the ad hoc nature of the tariff policy. When there was a shortage of production the rice price increased. To lower the domestic prices, the government, in November 1997, liberalised rice imports by waiving the 35 per cent duty effective at the time. Zero tariffs applied until February 1998 when the 35 per cent duty was reimposed. In October 1999, the duty was reduced to 10 per cent. Again, in January 2000, the 35 per cent duty was reintroduced. In mid-2000, the government of Sri Lanka introduced licence requirements for rice trading.3 In early 2001, Sri Lanka indirectly protected the agricultural sector by imposing a 40 per cent surcharge on imports to address a BOP problem. The 40 per cent surcharge effectively brought agricultural tariffs close to the bound rate of 50 per cent (Chapter Six). This surcharge was reduced to 20 per cent in March 2002, bringing the nominal agricultural tariffs close to 42 per cent. The country did not succeed in allowing the agricultural sector to develop according to its comparative advantage by further trade policy reform. The binding of tariffs at 50 per cent in 1995 and the alignment of the agricultural sector reforms with trade liberalisation proved to be an unsuccessful strategy. Perhaps, Sri Lanka should have followed the strategy of other South Asian countries, which bound the tariffs at a high level to use as a bargaining chip in multilateral negotiations.4 This strategy succeeded especially because many countries did not reduce their subsidies and thus, international market prices could not be taken as a guide for comparative advantage. Using trade policy to drive agricultural development was not successful in Sri Lanka, inter alia, due to ad hoc tariff changes that were put into operation from time to time. As a result of the WTO-related reforms, the inefficiencies of the key parastatal agencies involved in food trade became apparent. Four key state-owned enterprises were involved in either importing or purchasing agricultural items, (a) Cooperative Wholesale Establishment (CWE), (b) State Trading Corporation (STC), (c) Multipurpose Cooperative System (MPCS), and (d) Paddy Marketing Board (PMB).

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The PMB, which was involved in purchasing paddy from farmers at a guaranteed price, could not compete with private sector purchases and thus, ran at a loss for a number of years before the government decided to close it down in 1997 (Chapter Twelve). However, the forward sales contract programme, which was introduced by the Central Bank of Sri Lanka in 1999 to fill the void created by state purchasing institutions going out of operation, has not been effective as a purchasing instrument to assist the farmers (Chapter Twelve; Welivita and Epaarchchi, 2002). Thus, the CWE, which did not possess any expertise in paddy purchasing, had to step in. The CWE was stretched to its limits in the absence of alternative effective market instruments to ensure paddy purchases from the farmers. The forward sales contract scheme seems to be still in its infancy and needs to be popularised. Once the forward sales contract mechanism takes-off, the public purchasing system will be redundant. At least at this stage the government finds it very difficult to dismantle the CWE given the important role it plays in the market.

Agricultural Diversification Although, the trade reforms were implemented (with some reversals later), because of a number of structural problems, significant diversification of agriculture has not taken place. In addition to the subsidies, which are within AOA regulations, there are a number of incentives for investment in the agricultural sector. There is an incentive package offered by the Sri Lanka Board of Investment and general incentives exist under the Inland Revenue Law for both foreign and domestic investment in the agricultural sector (Tabor et al., 2000; Welivita and Epaarachchi, 2002). However, as attractive as these packages may be, the incentives are nullified because of various impediments related to land acquisition and the material that can be planted. Agro-based industries have been slow to emerge due to these impediments. The state owns approximately 80 per cent of the land. According to land reform legislation enacted in 1972, no individual can own more than 25 acres of paddy land and 50 acres of highland. This legislation remains intact even after 25 years of liberalisation. Besides, it is difficult to acquire commercially viable land due to procedural delays and many governmental agencies, such as the Department of Railways, have some ownership over land. Moreover, private land transactions are restricted by the absence of a unified transparent system of title registration. To make matters worse, approximately half of the privately-owned land in Sri Lanka is subject to conflict-of-ownership claims (World Bank, 1996). Diversification to higher-value crops requires significant areas of land to provide the critical volume to ensure continuous supply.5 The World Bank (ibid.) argued that a major factor working against agricultural diversification is the in-built bias in favour of paddy cultivation in the agricultural incentive regime. In fact, there are a number of factors related to the land market that encourage rice production and discourage commercial crops. For example, in the government-irrigation areas, farmers are given land permits that severely limit tenure rights. In other words,


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there is no free-holding of land and farmers are virtually locked into these holdings. Besides, through land transfer to offspring, land fragmentation has occurred. There is also the problem of attachment to ancestral landholdings. All these factors have prevented land consolidation and promoted rice cultivation in the agricultural policy regime. The Agricultural Development Authority Act No. 46 of 2000 was enacted to eliminate the tenant cultivation system and facilitate the sale of land to the private sector without any hindrance from cultivators. However, the Act requires the written approval of the Commissioner-General of the Agricultural Development Authority before paddy land can he used for the cultivation of any other crop. Such bureaucratic procedures have also acted as impediments for diversification. Diversification takes place when farmers have the strength to bear risks (Dunham and Edwards, 1997). Because paddy farmers have low profit margins they are risk averse (Sanderatne, 2000). Other factors that have worked against agricultural diversification are the following: 1. A new seed and planting material policy was approved in 1996 by the government with the objective of promoting seed industry with the participation of the private sector to produce and market seeds. Although a Seeds Bill based on this policy was formulated in 1998, it has still not been enacted. In 1998, a seed paddy farm was privatised as a first step in the new policy set-up. However, some seed and planting materials are banned from import. This is a major problem because a permit requirement to import agricultural raw material is a time-consuming exercise. Restrictive quarantine regulations have indirectly constrained potential exports because of the inability to access improved varieties of seeds—for example, in ornamental flowers—has meant an inability to meet international market requirements. 2. R&D in agriculture for higher-value-added crops is not demand-driven. United States Agency for International Development (USAID), jointly with the Ministry of Mahaweli Development supported gherkins, asparagus, and cantaloupe cultivation in the late-1980s on an experimental basis. Some bluechip companies also embarked on this exercise. However, the out-grower model did not work because of a number of factors centred on marketing (EDB, 1998). 3. Marketing is disorganised in Sri Lanka. No attempt has been made to set up a national private company with private traders and farmers’ organisations as stakeholders to undertake the purchasing and marketing of agricultural items. In fact, only after the government lost two vital paddy cultivation areas in the October 2000 general elections did it propose to establish an Agricultural Purchasing Authority (APA).6 4. Post-harvest losses of fruits and vegetables due to improper packing, handling and transfer are significant. Some suggestions made to rectify the problem have still not caught the attention of policy makers (Bamunuarchchi, 2001). 5. High duties on agricultural raw materials increased the costs of Sri Lanka’s agro-industrial goods and rendered many of these products uncompetitive in global markets. Import duties on agricultural inputs also significantly

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increased the costs of agro-industrial goods sold in domestic markets. Higher domestic prices constrain domestic markets and limit the ability of the agroindustries to achieve economies of scale or scope (Tabor et al., 2000). 6. Much of the fertile top-soil layer on most of the lands has become eroded due to improper land management in the past. Basically, the supply potential of the agricultural sector has not been improved. Consequently, diversification of the non-plantation sector away from the focus on rice to other foods has not been accelerated. As argued, this is due to a plethora of domestic impediments and not due to any hindrances from the AOA. This points to the need for reform in the domestic agricultural sector so that it is aligned with the trade liberalisation policies on which the Sri Lankan government has embarked.

Concluding Remarks The Sri Lankan agricultural sector has no doubt been subject to reform, but ad hoc policy changes have prevented more investment in the agricultural sector. Internal agricultural markets have been substantially liberalised from numerous state controls, export taxes have been eliminated and import restrictions have been reduced. However, the import competing agriculture segment has been subjected to an uncertain trade policy environment. Agriculture remains an area of continuing state intervention with regard to trade policy. A steady decrease has occurred in both real producer and consumer prices for several food crops, which undermines the profitability of these products. These trends have not been compensated by adequate productivity improvements or favourable trends in input prices. When considered together with the level of protection, these trends confirm that Sri Lanka is a high-cost producer of rice and of many subsidiary food crops. Thus, continuation of, and increase in further production, unless brought about by productivity improvements, will be at a very high cost to the economy. Given this situation, agricultural diversification has been slow to emerge. A number of restrictions in the land market created a bias toward rice production and posed other obstacles to diversification. The environment was not conducive to commercialised agriculture. Institutional constraints and tariff policy on agricultural inputs also acted as impediments to agricultural diversification. Sri Lanka bound its agricultural tariffs at 50 per cent with the intention of allowing the agriculture sector to develop according to its comparative advantage. The developed countries did not live up to the AOA of reducing large agricultural subsidies and improving market access to developing country agricultural exports. Thus, the international trading environment for agricultural commodities remained distorted and left little room for the agriculture sector to develop according to the comparative advantage of developing countries.


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In such an environment, Sri Lanka did not address ‘behind the border’ problems before liberalisation of tariffs, i.e., the institutional framework was not in place— marketing problems were not addressed, availability of seeds was not addressed, and so on. Thus agriculture trade liberalisation was not in accordance with the ground level situation with regard to the production structure. Tariff reductions were mainly influenced by cost of living and consumer welfare considerations. Thus, the agriculture production base, particularly, in the import competing segment, was gradually eroded and the average 2 per cent growth of the sector during the last decade should not come as a surprise to any vigilant observer of the Sri Lankan agriculture sector. If not for the plantation-sector restructuring via the privatisation programme, it would have been difficult to achieve even this growth rate.

Notes 1. 2. 3. 4.

Irrigation is still supplied free-of-charge by the government. The items were chillies, big onions, potatoes, wheat and rice. See Welivita and Epaarachchi, 2002: Table 1. See Athukorala (2000) for a discussion on the agricultural trade reforms in other South Asian countries. 5. Dunham and Edwards (1997) report that in certain areas in North-Western Sri Lanka even in small plots of land the productivity has been very high, but these are rare exceptions. 6. See 2002 Budget Speech (Minister of Finance, 2001). Before the authority could be established the government was defeated in the polls in December 2001.

References Athukorala, P. (2000), ‘Agricultural Trade Policy Reform in South Asia: The Role of the Uruguay Round and Policy Options for the Future WTO Agenda’, Journal of Asian Economics, Vol. 11, pp. 169–93. Athukorala, P. and S. Kelegama (1998), ‘The Political Economy of Agricultural Trade Policy: Sri Lanka in the Uruguay Round’, Contemporary South Asia, Vol. 7, No. 1, pp. 7–26. Bamunuarchchi, A. (2001), Minimizing of Post Harvest Losses in Fruits and Vegetables, National Task Force for Minimizing of Post Har-vest Losses, Colombo, Sri Lanka. Central Bank of Sri Lanka (2001), Annual Report, Available online at http://www.1anka.net/ centralbank/Ar_Index.html. Dunham, D. and C. Edwards (1997), Rural Poverty and an Agrarian Crisis in Sri Lanka, 1988–95: Making Sense of the Picture, Institute of Policy Studies, Poverty and Income Distribution Series No. 1. EDB (1998), ‘Export Development: Concepts and the Role of the Participants in the Process’, Study prepared for the Export Development Board of Sri Lanka. IPS (2002), Sri Lanka: State of the Economy—2002, Institute of Policy Studies (IPS), Colombo. Kelegama, S. (2003), ‘Sri Lanka’, in Merlinda D. Ingco (ed.), Agriculture, Trade, and the WTO in South Asia, The World Bank, Washington, D.C. Minister of Finance (2001), Budget Speech: 2001, Government of Sri Lanka. RIS (2002), South Asia: Development and Cooperation Report—2001/02, Research and Information Systems for Non-Aligned and Other Developing Countries, RIS, New Delhi.

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Sanderatne, N. (2000), ‘The Rice Economy: Challenges in the Next Decade’, Inaugural Address at the Rice Symposium, 2000, Postgraduate Institute of Agriculture, University of Peradeniya, Sri Lanka. ——— (2001), ‘Food Security: Concepts, Situation, and Policy Perspectives’, Sri Lanka Economic Journal, Vol. 2, No. 2. Tabor, S. et al. (2000), ‘An Agro-Industry Strategy and Policy Reform Action Plan for Sri Lanka’, Report prepared by agent for Ministry of Industrial Development, Sri Lanka. Welivita, A. and R. Epaarachchi (2002), ‘Agricultural Policies and their Implications for the Non-Plantation Agriculture Sector, 1995–2000’, Report prepared for the World Bank Resident Mission by the IPS. Welivita, A., S. Jayanetti and R. Epaarachchi (2002), ‘The Level and Structure of Trade Protection in Domestic Agriculture Sector of Sri Lanka: 1995–2000’, Sri Lanka Economic Journal, Vol. 3, No. 1. World Bank (1996), Sri Lanka: Non Plantation Crop Sector Alternatives, Agriculture and Natural Resources Division, Country Department 1, South Asia Region, World Bank, Washington, D.C. ——— (2000), Sri Lanka: Recapturing Missed Opportunities, World Bank Country Report, World Bank, Washington, D.C.

FOOD SECURITY ISSUES

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12 FOOD SECURITY ISSUES1

Introduction Food Security is still not a well-understood concept. Thus, some conceptual clarity is in order. First, food security is not determined solely by the capacity of a country to produce food. In fact, food security may be better served, in certain national contexts, by producing less food, domestically. Food security is determined by a host of factors such as global food production, trade policies, terms of trade, agriculture policies, income distribution patterns and social security. It is not a problem confined solely to the agriculture sector and hence, the solution to food insecurity does not lie in the domain of agriculture policy alone. It must also be noted that food security is not synonymous with food selfsufficiency. Food security is the capacity to obtain the required quantum of food rather than the ability to produce all the food a country needs. Thus, food security is a state of affairs where, ‘all people at all times have access to safe and nutritious food to maintain a healthy and active life’ (as quoted in Adhikari et al., 2000: 63). Food security may, therefore, be defined as the availability of adequate supply of food, which people can access, to obtain their food needs (basket of basic commodities) at prices they can afford. Food insecurity, on the other hand, is the lack of access to enough food. The Food and Agriculture Organisation (FAO) emphasises the three ‘A’s in food security: Availability, Access and Affordability.

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Food security at the household level depends mainly on the cost of food and income levels. The problems of household food insecurity may affect urban and rural households in different ways. In urban areas, it is related to the real wage rate and level of employment; in rural areas, as many people produce their own food, household income and employment play a lesser role in food security. Since achieving Independence in 1948, Sri Lanka’s food security strategy was determined by three sets of policies: (a) achieving self-sufficiency in basic food items such as rice, milk, fish, etc. (this policy was pursued till about 1996); (b) a public distribution system centred around the multipurpose cooperative system, and public institutions such as the Cooperative Wholesale Establishment (CWE), Paddy Marketing Board (PMB), and the Food Commissioner’s Department (FCD); and (c) welfare programmes which included either a food subsidy or a food stamp or an income transfer component. In the ensuing sections of this chapter the approach to food security in Sri Lanka and the changing nature of policy are discussed. It does not intend to discuss food security from a dietary or nutritional perspective, but from a more overall macro and micro economic perspective. The remaining sections are organised as follows: the immediate section discusses the evolution of the agriculture policy and the attitude to food security, while the next section highlights the policy debate on agriculture and food self-sufficiency during the mid-1990s; the fourth section describes the changing role of policies and institutions involved in food security, and the fifth section analyses the current food security situation in Sri Lanka; the sixth section discusses food security issues at the household level; the seventh section looks at the food security issue from the international context and the final section provides concluding remarks.

Agriculture Policy and Food Security When the World Bank Mission presented its draft report on Sri Lanka’s future development strategy in 1951, it suggested that Sri Lanka’s comparative advantage was mainly in the agriculture sector and all efforts should be made to promote that sector. This suggestion was indeed close to the development strategy that the first prime minister of Sri Lanka had in mind for quite some time before Independence in 1948. Thus, agricultural promotion and development with colonisation and irrigation schemes formed the centrepiece of the development strategy in the early 1950s. In the early years of Independence there was a strong desire to reduce dependence on imports and achieve self-sufficiency in many agricultural products.2 Rice which is the staple food of all Sri Lankans became the prime candidate in targeting for self sufficiency. Historical claims of Sri Lanka achieving self-sufficiency in rice, for instance, in the 12th century may also have provided the impetus to pursue the goal of self-sufficiency in rice later on.3 In the early 1950s, the bulk of the requirements for items such as pulses, sugar, milk, poultry, fish, etc., were imported to meet the domestic needs. Sri Lanka’s


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food imports amounted to nearly 44 per cent of the total import bill of the country (see Table 12.1) and hence, food security from the BOP perspective was a cause for concern especially because 90 per cent of the foreign exchange earnings came from the plantation sector that was very vulnerable to terms-of- trade fluctuations in the international market. Table 12.1 FOOD IMPORTS EXPENDITURE, 1955–99

Year 1955 1960 1965 1970 1975 1980 1985 1990 1995 1999

Value of Food Imports (Rs million) 638 785 605 1,051 2,687 6,940 5,906 15,624 26,746 38,324

Total Imports (Rs million) 1,460 1,960 1,474 2,313 5,251 33,942 54,049 107,729 272,200 415,902

Food Imports as a Percentage of Total Imports 43.7 40.1 41.0 45.4 51.2 20.4 10.9 14.5 9.8 9.2

Source: Central Bank of Sri Lanka: Annual Report (various issues). Note: Value of food imports includes rice, flour, sugar, milk and milk products, fish and fish products and other food items.

In the early 1950s, Sri Lanka benefited from the Korean boom due to attractive prices for rubber. Thus, the vulnerability of agricultural exports to terms-of-trade fluctuations did not catch the attention of the policy makers. However, when terms-of-trade for plantation exports became unfavourable and foreign exchange shortages were visible in the mid-1950s, Sri Lanka made a departure from agricultureled development to industry-led development with import substitution industrialisation playing the major role in the industrialisation drive. Although, this was the case from the mid-1950s to mid-1960s, the agricultural sector was not neglected Achieving self-sufficiency, particularly in therice sector, remained a cherished goal. Sri Lankan politics, which centred around the food subsidy influenced the thinking on rice policy. In the mid-1960s the policy of import substitution via agriculture was seen in the launch of the ‘green revolution’. The early 1970s saw a severe foreign exchange crisis resulting from deteriorating terms-of-trade, the OPEC oil price hike and a severe drought, all of which led to the initiation of the ‘grow more food campaign’. These programmes centred around the idea of achieving self-sufficiency contributed to enhancing the food production in the country (see, for instance, Table 12.2). After liberalisation of the economy in 1977, there was no specific sectoral strategy for the agriculture sector. The emphasis at the start was once again on the rice sector—for which the accelerated Mahaweli programme was supposed to provide new irrigation, especially to the dry zone—to achieve self-sufficiency in rice.

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Development Under Stress: Sri Lankan Economy in Transition Table 12.2 FOOD PRODUCTION TRENDS, 1950–99

Food Commodity Rice (MT) Sugar (MT) Milk (million litres) Fish (MT)

1950

1960

1970

1980

1990

1999

185,000 n.a n.a 42,300

509,700 n.a 108 52,527

1,066,577 13,000 133 98,152

1,035,000 26,289 283 167,412

1,675,000 57,165 288 177,063

1,892,000 65,220 342 280,000


Sri Lanka achieved near self-sufficiency in rice in the mid-1980s, which also saw the emergence of a new policy statement for the agriculture sector called, National Agriculture, Food and Nutrition Strategy (1984). It prepared most of the programmes for the agriculture sector for the 1984–94 period and one of the objectives of this strategy was to achieve self-sufficiency in basic foods—rice, milk, sugar, fish and pulses (MALF, 1996). It is, thus, clear that despite liberalisation of the economy in 1977, the policy makers did not give up the obsession with self-sufficiency. After the change of government in 1994, the new policy for the agriculture sector was announced in the government’s ‘Policy Statement’ (GOSL, 1995). For the first time the need for self-sufficiency in any crop was not mentioned and the policy ‘was designed to ensure that the creative energy and independent spirit of [the] farmers are not stifled by bureaucracy and overregulation’ (p. 30). However, another policy statement that was announced by the Ministry of Agriculture had a different message. The policy for agriculture as outlined by the Ministry of Agriculture, Lands and Forestry (MALF), 1995 notes, ‘Paddy is a staple carbohydrate of the Sri Lankans and its importance to the nation’s economy via saving of foreign exchange through import substitution and employment of a large segment of rural population cannot be over-emphasized. About 1.8 million farmers or 10 per cent of the total population are engaged in paddy cultivation. Rice accounts for 45 per cent and 40 per cent of per capita calories and proteins respectively, in the Sri Lankan diet. Hence, food security, by pursuing a policy towards achieving self-sufficiency in major staple, rice, should be a major policy goal’ (MALF, 1995: 3). This difference in policy stance opened the debate in Sri Lanka on the relevance of the concept of self-sufficiency in the globalised economic environment. Issues in relation to rice is a source of passion and emotions in Sri Lanka, which cannot be ignored in developing any viable and politically acceptable strategy for the nonplantation sector. Over the years, food security and indeed overall economic prosperity has been identified with rice self-sufficiency. Massive investment in new irrigation and rehabilitation of old systems, fertiliser and other input subsidies, various government interventions in the output market (e.g., Paddy Marketing Board), focussing of almost all non-plantation crop research on rice, etc., obviously contributed to an increase in rice production, so much so, that it went on to achieve 97 per cent self-sufficiency in 1985. In fact, Barker and Samad (1998) show that the degree of self-sufficiency in rice is strongly correlated with an expansion of the area under irrigation.


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Increasingly, however, there was evidence to the effect that Sri Lanka was a high-cost rice producer by international standards. Increased rice production, unless brought about by productivity improvements was going to come at a very high cost to the economy. The opportunity costs of investment in rice was going to increase over time as almost all long-term rice price projections showed a decline in real international prices. It was around this time that the World Bank came out with a comprehensive study on Sri Lanka’s non-plantation sector.

Departure from Food Self-Sufficiency in Agriculture Development: Policy Debate The World Bank (1996) argued that by the mid-1990s Sri Lanka had lost its comparative advantage in the production of rice and other field crops in both major and minor irrigation schemes or under rain-fed conditions. The study stated that ‘food security in terms of “physical self sufficiency” was purchased at high cost through investment in very capital-intensive irrigation schemes to produce a low value added commodity’ and the continued focus on rice self-sufficiency inevitably constrained the performance of the agriculture sector. It argued that concentration on paddy is one of the reasons for stagnation of the non-plantation agriculture. It identified other field crops as a potential source of growth and asserted that a shift is prevented by factor market imperfections and state policies that directly and indirectly subsidise paddy. Barker and Samad (1998) have argued that while the concept of food security should be broadened beyond the focus on rice self-sufficiency, it is not correct to say that Sri Lanka does not have a comparative advantage in producing rice, particularly in the Maha season when there are no suitable crop alternatives. De Silva et al. (1999) have also expressed reservations on the World Bank viewpoint and argued: (a) the current paddy yields in Sri Lanka are comparable and in fact superior to those in South Asia and Thailand; and (b) paddy grown on commercial lines may be profitable. World Bank (1996) argued that the lack of well-functioning land markets is a major contributor to perpetuating very small land holdings and precluding the economies-of-scale and specialisation needed for long run performance of other field crops. A well-functioning land market was considered necessary to collateralise land and enable low productivity farmers to get out of agriculture without abandoning their asset base. Increased farm size was seen to be essential for commercialisation that was considered necessary to generate incomes comparable to those in the non-farm sector. It also argued that public support (such as irrigation) should be made cost effective, and where possible and appropriate—transferred to the private sector. World Bank (ibid.) came into criticism as it had totally overlooked the nature of rural markets and disregarded the adjustment costs and political economy. While trade policy reforms and the removal of distortionary subsides were desirable, the

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World Bank (1996) suggestions such as providing clean land titling and imposing water taxes were not seen as a panacea or a quick-fix solution to the problems of developing a more productive non-plantation agriculture sector (Dunham and Edwards, 1997). The World Bank (ibid.) view was seen as too simplistic in the sense that the adjustment costs in the rice sector were dangerously underestimated and a policy of full cost-recovery (including all past [sunk] land and irrigation system development cost) was not seen as essential to achieve economic efficient outcomes, and given the political realities, an immediate implementation of these measures was not seen as desirable. In practice, attempts to implement such a policy would probably have succeeded only in pushing back the liberalisation policy process by playing into the hands of the populists and lobbyists for vested interests. The policy package for the nonplantation sector had to be carefully tailored to ensure that it was both economically and politically sustainable. The NDC (1996) attempted to offer such a package with a comprehensive action plan to revive the sector. NDC (ibid.) differed in details from World Bank (1996), while the recommendations were similar. The Presidential Task Force on Agriculture, however, only selected the thrust areas from the NDC (1996) taking into account the political economy and adjustment costs. Accordingly, the government took cognisance of the fact that the standard remedy to address the efficiency losses to the economy from paddy-bias policies is the removal of resource allocation distortions by trade policy reforms, which align domestic prices with international prices and the removal of subsidies, which favour particular sectors at the expense of others, where there is no obvious market failure. Also, the government took note of adjustment costs and time lags when formulating a policy of trade liberalisation. With increased trade, diversification in consumption patterns became more pronounced. Food security was also influenced by changing household consumption patterns. For example, wheat became an important component of the Sri Lankan diet and this was encouraged by the government by subsidies on the price of wheat from 1994. While per capita consumption of rice has ranged from 105–115 kg per annum with no apparent trends, annual per capita consumption of wheat had risen from less than 20 kg in the early 1960s to 50 kg in mid-1990s (Barker and Samad, 1998; also see Table 12.3 for the increasing trend of wheat importation). ‘Maintaining rice production at 85–90 per cent of domestic needs and increasing imports and per capita consumption of wheat has been an acceptable food security strategy to date’ (Barker and Samad, 1998). Prices of both have been somewhat stable and there has been a steady supply to all segments of the economy. With the new policy package, all other essential food items also gradually came out of the self-sufficiency focus after 1996. The increased liberalisation of tariffs for the agriculture sector and allowing the agriculture sector to develop according to comparative advantage has seen items such as potato, sugar, fish, milk, etc., declining in production. Imports of all these items have increased considerably over the last two decades, in particular, during the past four years (see, for instance, CBSLAR, Annual Report, 2000). Sri Lanka imports 85 per cent of potato, 88 per cent of sugar, 19 per cent of fish and 56 per cent of milk requirements at present (see Table 12.3). Increase in the


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production of potato in the liberalised environment requires an increase in productivity and this has been slow to emerge despite the high tariffs that were offered to the sector in the recent past. Increase in sugar production is hampered by two of the sugar factories being closed-down, due to failed privatisation and locational problems. Besides, studies have shown that Sri Lanka is a high-cost sugar producer. Fish production was hampered by two-thirds of the Sri Lankan coastal belt coming under security surveillance due to the on-going war. And milk production is disrupted by the strong hand of multinational milk powder importers. They have a vested interest in ensuring that no large scale milk producer establish themselves in Sri Lanka and cut into their profit margins. Table 12.3 TOTAL FOOD AVAILABILITY IN SRI LANKA Food Commodity

Quantity (MT)

1980

1990

1999

Rice

Local production Imports Total availability Self sufficiency (%)

1,035,000 168,000 1,203,000 86

1,675,000 172,000 1,847,000 91

1,892,000 214,000 2,106,000 90

Sugar


26,289 209,000 235,289 11

57,165 305,000 362,165 16

65,220 479,000 544,220 12

Milk


35,375 23,381 58,756 60

36,000 65,610 101,610 35

42,750 54,000 96,750 44

Fish


167,412 17,679 185,091 90

177,063 48,000 225,063 79

280,000 65,187 345,187 81

Wheat

Imports

295,900

577,000

859,000

Sources: Central Bank of Sri Lanka, Annual Report (various issues); MILCO Industries, food balance sheets; National Aquatic Resources Research and Development Agency. Note: Food self-sufficiency calculations based on local production and imports, milk self-sufficiency calculation based on converting liquid milk into solid form, in terms of metric tons of local production.

Changing Role of Institutions and Policies for Food Security While all governments in Sri Lanka have given high priority to ensuring food security for the people, there is nevertheless, no formal legal framework to govern food security in the country. The macro-level institutional framework used to ensure food security in Sri Lanka has undergone many changes. The policies and institutions

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used by the government have ranged from import tariffs, trade regulatory controls, buffer stock maintenance and direct participation in marketing and distribution. With increased liberalisation of the economy, policies and institutions used to ensure food security have undergone major changes. Food Import Policy Since the early 1990s, food imports were mainly in the hands of the private sector, except for wheat where government intervention prevailed to ensure reasonable consumer prices. Before 1996, the government also followed a seasonal tariff policy and certain commodities such as potatoes, onions, chillies, rice and vegetable oil were banned through quantitative restrictions, during the periods when there was a glut in local production. This policy was used to safeguard local production. The management of such a policy, however, became cumbersome and gave confusing signals to traders and the growers, and thus, it was abandoned in 1996 and the government used a 35 per cent tariff wall for all agricultural imports (liquor and tobacco remaining outside this system). However, an ad hoc tariff policy was followed for rice imports after 1996 where the Ministry of Trade reduced the duty of rice imports when it anticipated a short-fall in production. Although, the maximum general tariff level which was also 35 per cent was reduced to 30 per cent in 1999 and 25 per cent in 2000, the agricultural imports remained unchanged under the 35 per cent band. Sri Lanka bound all its agricultural tariffs below 50 per cent to lock-in its liberalisation policies with the Uruguay Round Table Agreement on Agriculture. Paddy Marketing Board (PMB) PMB had two objectives: to operate a paddy Guaranteed Price Scheme (GPS) in order to ensure a reasonable price for the farmer and to provide milled rice to the consumer at a fair price. It also played a marginal role in purchasing grains and pulses at a guaranteed price. With increased liberalisation of the economy, the PMB’s role gradually diminished, so much so, that during 1989–93 paddy purchased by the PMB was roughly 2 per cent of total paddy production (because average farm-gate price was above the PMB price). During the year of low farm-gate prices (1995), PMB purchases increased to about 10 per cent of total paddy production (Table 12.4), but the PMB was not able to sell the purchased paddy at a profit, thus, incurring losses. Basically, the PMB could not operate as a profit-making body in the new economic environment. It ceased to function in 1997 and formally wound-up in the year 2000. Table 12.4 PMB CAPACITY UTILISATION, 1980–96 Year

Total Paddy Production (’000 MT)

1980 1985 1990 1995 1996

2,133 2,628 2,538 2,810 2,061

Total PMB Purchase (’000 MT) 10.1 4.8 31.0 282.0 1.0

Source: Central Bank of Sri Lanka, Annual Report (various years).

Purchase of PMB (%) 0.5 0.2 1.2 10.0 0.0


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Cooperative Wholesale Establishment (CWE) The CWE is the largest government trading organisation with 42 wholesale warehouses, 149 retail outlets and 4,000 active franchise-holders. Until 1996, it played a key role in ensuring food security by importing, and through the wholesale and retail sale of major food items. It concentrated mainly in importing wheat, wheat flour, lentils, sugar, onions and dried fish. After the licensing system for the private sector was abolished in 1996, CWE’s share of imports of the above mentioned goods, bar wheat and wheat flour, declined dramatically (see Table 12.5). Table 12.5 CWE’s PERCENTAGE SHARE OF FOOD COMMODITY IMPORTS, 1995–98 Commodity Potato Chillies Onion Rice Sugar

1995

1996

1997

1998

11 18 8 – –

6 5 – 10 –

3 – 5 7 7

2 1 5 8 6

Source: CWE and Department of Customs.

Although, the CWE imported nearly 40 per cent of lentils in 1995, the amount had considerably gone down during the ensuing years to reach 14 per cent in 1998. This shows the increased role of the private sector in the importation of foodstuff. CWE margins are low because it sells below the price that the private sector sells. It has also got to act on various political directives such asto bring down the price of flour and make mandatory purchase of rice when farmers are unable to sell their rice. The latter has become particularly the case since the PMB ceased to operate after 1997. The CWE is compelled to purchase paddy at a guaranteed price just as the PMB did in the past, although it is not equipped to perform this task. The CWE still plays its traditional role of keeping buffer stocks in staple food items in case of civil disturbances or natural disasters. Normally, 2–3 months worth of stocks are maintained. The Food Commissioner’s Department (FCD) When the PMB was functioning it procured, milled and stored paddy to distribute through the cooperatives via the FCD. In the past, the FCD imported any shortfalls in domestic rice production as well as the total wheat requirements and distributed them via the cooperative network. It also played the role of an advocacy body to the treasury, the Department of Agriculture and the Ministry of Trade on adjusting import duties to stabilise the prices of essential food commodities. With regard to rice, the FCD had a monopoly position for importation and issued licences for import with the sole objective of protecting the domestic producer and maintaining a reasonable price for the consumer. Rice was imported to the country whenever there was a shortfall in domestic production. When the market price of rice went up, the government stabilised the price by releasing imported stocks to the market and by adjusting import duty. The government thereby maintained food security especially for the low income segments by preventing an

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excessive increase in the price of rice. At present, the import of rice is totally liberalised and subject to the maximum duty of 35 per cent and whatever other duty rate that the Ministry of Trade determines. The Ministry of Trade has the authority to adjust this duty to a low level whenever it feels that downward pressure should be brought on the price of rice.4 The FCD at present has no role in rice importation or distribution. A foreign company—PRIMA—operates the only flour mill in Sri Lanka; the government supplies (via the CWE) the contractual wheat grain requirements on the condition that the company provides 75 per cent flour (made from the wheat supplied) to the FCD. The FCD acts as the sole authority in purchase and distribution of wheat flour milled by PRIMA. The importation of wheat flour was opened to the private sector under a licensing scheme in mid-1997. The licensing scheme was removed in early 2000. The responsibilities of the FCD at present are to ensure uninterrupted supply of wheat flour to the entire population through the nearly 8,000 cooperative outlets and ensure supply stability of sugar. For the latter purpose there are bonded warehouses with five bondsmen deployed to manage them and in situations where there are problems of importing, these stocks are released to the market. Its role as an advocacy body has ceased. Welfare Programmes In Sri Lanka, all governments have implemented welfare programmes to alleviate poverty and improve living conditions. From the time of Independence till 1977 the food subsidy programme was offered as a food security safety net where the prices of essential consumer goods were reduced. But this was not targeted and offered across-the-board (universal) and thus, had a depressing effect on production. The food subsidy programmes were abolished and a food stamp scheme was introduced in 1979, targeted to about 10 per cent of households (50 per cent of the population). This programme functioned with two minor programmes: Triposha and School Biscuit programmes.5 In 1989, the Janasaviya programme—designed to enhance income and consumption of selected poor households in selected areas, by stages, was put into operation. This was accompanied by ad hoc welfare measures such as the school midday meals and uniforms. However, by the end of six years, only a third of the targeted poor had benefited. In 1995, the Samurdhi Programme replaced the Janasaviya Programme. It is envisaged as an income transfer to poor households to get out of the poverty trap and unlike Janasaviya it was applied throughout the country.

Current Food Security Situation Macro-Level This background information may assist to comprehend the food security situation in the country. Table 12.1 provides data for food imports as a percentage of overall imports. As indicated therein, despite increasing food imports, as a percentage of overall imports, food imports have declined from 43.7 per cent in 1955 to


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20.4 per cent in 1980 and to 9.2 per cent in 1999 (Table 12.1). In 1998, the food imports amounted to 15 per cent of overall export earnings, 20 per cent of industrial export earnings and 66 per cent of agricultural export earnings. Clearly, there has been a substantial reduction in food imports in terms of overall imports and agricultural exports alone have been more than adequate to sustain food imports. In other words, the liberalisation-induced export earnings have the capacity to ensure food security from the BOP side. Sanderatne (2000: 16) argues: ‘National food security must be placed within the overall context of the economy and the developments which have taken place. The discussion must not be based on past structures of the economy.’ His analysis shows that the food security situation is satisfactory even with 50 per cent increase in food imports where agriculture exports alone can cover the overall food imports. A gradual rise in food imports should not be viewed as a serious threat to food security as the import bill is a small part of all domestic imports.

Micro-Level But do these aggregate statistics reveal anything of the food security status at the household level? The FAO has estimated that the Aggregate Household Food Security Index (AHFSI) fluctuates between 70 and 77 for Sri Lanka during 1988– 93 (FAO, 1996). Countries with medium level of food security are defined as the countries with AHFSI of more than 75 and less than 85. Clearly, Sri Lanka does not fall into this category and can be considered as a low-level food-secure country. As statistics show, there is adequate food supplies in the country. However, the Consumer Finance Surveys revealed that on average 53 per cent of the income was spent by Sri Lankan households on food in 1986–87 which reduced to 47 per cent in 1996–97. The sector-wise food share is given in Table 12.6. In the USA, for instance, households with a food share of more than 33 per cent of the total income are considered to fall below the poverty line (MALF, 1996). Therefore, although there has been a decline on the household income spent on food over a 10-year-period in Sri Lanka, still the amount spent on food is quite high compared to international standards. According to the FAO (1999), the dietary energy supply (DES) in Sri Lanka has dropped from 2,267 calories in 1968–71 to 2,233 calories in 1990–92. Further, about 30 per cent of households consume less than 90 per cent Table 12.6 COMPARISON OF FOOD EXPENDITURE AMONG SECTORS Sector Urban Rural Estate Sri Lanka

Percentage Share of Food Expenditure 1985–86 1996–97 41 57 69 53

38 51 67 47

Source: Consumer Finances and Socio-Economic Survey, Central Bank of Sri Lanka, 1986–87 and 1996–97.

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of the calorie requirements. The main cause for food insecurity is not the lack of supply but the weak purchasing power of some households, the purchasing power in low-income households being limited. Although, Sri Lanka is an exception among developing countries in raising basic needs indicators, it cannot boast of similar achievements in increasing nutritional levels—especially among infants and pre-school children. The major problems according to the Ministry of Plan Implementation are protein energy malnutrition, low birth weights, iodine deficiency, vitamin A deficiency and iron deficiency. The most vulnerable are pregnant mothers and children below two years of age. The low birth weight (less than 2.5 kg) associated with maternal malnutrition was 18.7 per cent. Household food security depends mainly on the ability to secure enough food to ensure an adequate dietary intake for all its members at all times for a healthy and active life. High food prices and low incomes have reduced food security at the household level, especially in those areas where the incomes are low (MALF, 1996). In those households where there is absolute poverty, chronic food insecurity prevails. It is, thus, clear that the welfare programmes implemented since the 1950s, food purchase and distribution institutions operational till mid-1990s, and whatever food gains and income enhancement that accrued through agricultural growth has had limited impact on addressing the problem of household food security.

Food Security: Issues at Household Level Role of Welfare Programmes Herse et al. (1989) found that the food stamps scheme introduced in 1979 contributed to about 13 per cent of the household food expenses in the lowest expenditure quintile of the food recipients in their sample. In the next three quintiles, the value of food stamps accounted for about 5–8 per cent of the food expenditure and in the highest quintile it accounted for 2.3 per cent of the food expenditure of the food stamp recipient households. Besides, they show that food stamps contributed only to about 11 per cent of the total household budget in the poorest quintile, and 7–2 per cent in the highest quintile. Based on these findings they conclude: ‘... both in absolute and relative terms, the contribution of food stamps to the sample of beneficiaries is small. In the highest income group, the contribution of food stamps to the household budget is virtually insignificant’ (ibid.: 108–9). The beneficiaries of the Janasaviya poverty alleviation programme introduced in 1989 were identified from the households originally entitled to receive food stamps. Four key programmes were implemented under Janasaviya; the Human Resources and Institution Development (HRID) programme, the Credit programme, the Community Projects programme and the Nutrition programme. The HRID programme develops human resources of the poor by increasing awareness within poor households, promoting group action and facilitating self-reliance through


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the provision of technical and financial assistance to partner organisations. The partner organisations, in turn, train the beneficiaries in income-generating skills. The Community Projects programme addresses the ‘poverty pockets’ by creating wage employment through short-term labour-intensive rural works. The Credit programme supplies credit at the market rate to socially-mobilised poor groups through partner organisations such as local financial institutions and NGOs. The poor, who have recently acquired organisational strengths and skills, are given credit to initiate self-employment activities and micro-enterprises. The Nutrition programme includes a set of activities with specific nutritional goals. Despite the lack of rigorous evaluation on the impact of the Janasaviya programme, there is a consensus that the programme has not been effective in reducing poverty among the participating households. Several reasons are attributed to this poor performance. First, the poverty alleviation objective of the programme has been sidelined by the emphasis given to transferring resources to the participating households. Second, the targeting mechanism has not been effective in keeping the non-poor out and ensuring the inclusion of the ultrapoor. Third, the poor choice of partner organisations, mostly NGOs and their strained relationships with government officials, have reduced the cooperationof these organisations in implementing the programmes. Fourth, the lack of inter-divisional collaboration and coordination among the four programmes has resulted in a poor follow-up and a patchy approach to poverty alleviation. Finally, the lack of a rigorous monitoring and evaluation system has resulted in poor feedback on the impact of the programme on the beneficiaries and has reduced the opportunity to improve the programme design and implementation. The Samurdhi programme implemented in 1995 covered roughly 1.5 million households, which is approximately 40 per cent of the households in Sri Lanka. The main thrust of the Samurdhi programme is the participation of the poor in the production process by ensuring their access to resources for self-employment opportunities. Development of village-level institutions and grass-roots level task forces are the key elements of the programme that increase the participation of the rural poor. The Samurdhi programme also includes a social security scheme to provide insurance for the participating families through their voluntary contribution to the Samurdhi Social Security Fund. In addition, a Samurdhi Banking Society was established to manage and operate savings and credit schemes for the beneficiaries of the Samurdhi programme. Both the Janasaviya and Samurdhi programmes suffered from design and implementation weaknesses that have reduced their effectiveness in terms of allocative efficiency. The World Bank (2000: 36–37) highlights this problem as follows: Both Janasaviya and Samurdhi have been large income transfer programmes covering over 50 per cent of the population or twice the percentage actually living in poverty ... data shows that transfers from poverty programmes (Janasaviya, Samurdhi, Food Stamps) reach 66 per cent of households in the poorest decile and 14 per cent of the households in the top three deciles .... This inadequate targeting is also confirmed by the preliminary findings of the

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Sri Lanka Integrated Survey which reveals that only 60 per cent of households in the lowest expenditure quintile receive Samurdhi transfers .... The thin spread of income transfers across the population and poor targeting divert resources away from the most needy segments of the population. A recent survey conducted by the Ministry of Health and Indigenous Medicine reveals that over 25 per cent of children between the ages of 3–36 months suffer from protein energy malnutrition in 13 of the 23 districts. The minimum level of child malnutrition in the country remains at about 15 per cent despite the fact that the overall malnutrition levels decreased from 38 per cent in 1987 to 24.5 per cent in 1998. In order to address this problem, a Presidential Committee to develop a National Food and Nutrition Programme was appointed in mid-1998. This committee consisted of 17 persons, including pediatricians, nutritionists and community health specialists, who have identified areas in which a new action plan should be implemented. Already, the Samurdhi Nutritional Project works with target groups such as pregnant women, breast-feeding mothers, malnourished children, etc. Around 1,532 Samurdhi animators and 238 managers in 24 AGA divisions were trained to implement this project.6 GOSL (1995: 25) aims at raising the income level of the poorest 8 million by increasing their share of income from the current 4 per cent to 15 per cent by the year 2010, which is a laudable objective. However, given the current shortcomings in the welfare (or poverty alleviation) programmes there is need for some rethinking on the poverty strategy.

Role of Agriculture It is well known that agriculture policy and performance has an important role on household food security, both directly and indirectly. Increased agricultural productivity would enhance food security of rural households since they derive their income directly and indirectly from agriculture activity. Sanderatne (1999: 16) has argued that ‘… a strategy to enhance agricultural production is an equity approach and addresses the household food security more directly than through industrial development and exports’. According to Sen (1981) agricultural earnings and production affects the ‘entitlements’ of farms and rural households. World Bank (1995) argued that per capita value added in agriculture must have gone up between 1985 and 1990 and the growth in agriculture is among one of the factors that contributed to bringing down the proportion of rural households under the poverty line from 32 per cent in 1985–86 to 24 per cent in 1990–91. Dunham and Edwards (1997) have argued that on the contrary there was an agrarian crisis dur-ing this period and consequently a decline in farm incomes, and highlights the changing nature of the Sri Lankan rural economy in the context of inflow of remittances and other income transfers. They argue that if at all poverty had declined in rural areas it may be due to such inflows, and this fact needs to be taken into account when designing agriculture policy.


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Due to poor marketing facilities, high marketing costs and volatile prices, production of other field crops involve a high element of risk. The opportunity cost of household labour combined with uncertain markets and increased risk associated with higher value-added crops has discouraged on-farm diversification on a commercial basis. Crop yields have stagnated, cost of production has risen and there has been a cost-price squeeze (NDC, 1996). The classic answer to this dilemma is that surplus labour will increasingly be absorbed in industrial and service employment. Urban demand for agriculture products will rise and, as labour move out, prices and wages will be bolstered and restructuring of the agriculture sector will become increasingly viable. The problem with the Sri Lankan case at present is that remunerative off-farm jobs are just not available in sufficient numbers. To what extent does off-farm employment support rural households? A recent study shows that 30 per cent of the rural household incomes come from off-farm activities (De Silva et al., 1999). Such off-farm incomes help to sustain paddy growing to which farmers were attached for some non-economic reasons. The study confirms that most farmers are ‘locked in’ uneconomical paddy cultivation in miniscule holdings due to a combination of factors and they have prevented more dynamic farmers from commercial efforts who go back to subsistence farming, poor-cash remunerative but safer paddy cultivation and a preference for off-farm employment.7 According to De Silva’s study, while there is an overall stagnation in the nonplantation agriculture, there are strong undercurrents of commercialisation. While acknowledging both the positive and negative effects on poverty due to commercialisation on agriculture, they argue that in the final analysis the positive effects would dominate. There is no evidence of widespread resistance to commercialisation and farmers are generally agreeable to moving into commercial farming. Increased commercialisation is a prerequisite for solving current problems of non-plantation agriculture because the long-term viability of smallholder agriculture is questionable. New findings on off-farm incomes in De Silva’s study are as follows: 1. Higher household incomes are not necessarily associated with high shares of off-farm or non paddy incomes. Higher income households appear to get more income from paddy and farming in general than lower income groups. 2. It is the lower income groups that have a higher share of income from nonfarm and non-paddy farming. 3. Within the poorer households, there is strong correlation between total income and off-farm incomes. 4. The source of off-farm incomes also vary as between different income groups. The most important source: (a) for higher income is salaries employment, (b) for middle income is foreign employment, and (c) for lower Income is wage labour. 5. The figures are consistent with the idea that off-farm and income non-paddy agriculture help to support the paddy-farming activity. The higher income groups are doing it better.

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Overall, in the rice-based areas, rural non-farm employment creation has been limited. Dunham and Edwards (1997) have shown that there has been an increased dependence on the inflow of funds from outside the rural areas—from public sector transfers, Middle East employment and from employment in armed forces and security-related jobs. An impoverished sector has not only been just stagnating but is highly vulnerable to exogenous events. From the emerging trends of the non-plantation sector, it is evident that food security policy needs rethinking. In fact, Dunham and Edwards (ibid.: 39) state: ‘Agriculture policy—if it is serious about alleviating rural poverty—has to take a much longer and harder look at prevailing local conditions in Sri Lanka.’ De Silva et al. (1999: 3) argue: A rethinking in the design of the poverty alleviation programmes is necessary as some of the anti-poverty strategies may merely serve to perpetuate unproductive small farms …. The effectiveness of the safety nets must be enhanced through better targeting and increasing the volume of support to the needy while development programmes must stimulate growth by concentrating on potential growth centres and commercially-oriented farmers .... Also new forms of organizations such as commercially-organized farmer companies, management firms in charge of irrigation systems for instance, consultancy and financial services may be beneficial for promotion of farmer interest in a competitive market environment.

Role of Public Distribution Institutions and NGOs With increasing liberalisation, the role of the private sector will increase in the economy in areas previously controlled by the state. For example, the PMB found it extremely difficult to function after importation of rice was permitted for the private sector without licensing. Likewise, the role of the FCD will diminish once the monopoly of the Prima Mill comes to an end in 2005 and more firms embark on the importation of wheat and flour milling. Perhaps the CWE will be the only public institution that may be left with a role to play especially using its buffer stocks at a time of emergency or any other crisis. The CWE, however, cannot play the role of the PMB to support farmer incomes, although it is compelled to do so from time to time. Effective coordination between the Ministry of Trade and the Ministry of Agriculture with regard to importation of rice and strengthening voluntary organisations such as Markfed are essential to solve problems related to paddy farmer income. This is particularly important since price stabilisation measures through the market mechanism such as ‘Govi Sahanaya’ (forward sales contract implemented by the Central Bank) has not fully established themselves in the Sri Lankan economic system.8 The public food distribution system will be mostly needed to address the household food security problem in the war-torn areas of the country. The question could be raised whether food security issues are effectively addressed in the wartorn areas. The government ensures that all the required food is supplied to accessible


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war-torn areas by land transport and inaccessible areas (by land) by both sea and air. O’Sullivan (1997) analysing the household entitlements in the Northern and Eastern Provinces, refutes the notion that government services cannot be effective in war time and emphasises the role that alternative society structures play in maintaining household entitlements. She argues that a complex network of providers for market, public and civil entitlements have evolved in the North and East to ensure household well-being. One such example is the Integrated Food Security Programme in Trincomalee initiated in mid-1998. The programme established communication and cooperation with government departments and NGOs. Food-for-work projects to improve infrastructure for village development were initiated and modes of cooperation were exercised with partner institutions and organisations. The programme took note of the fact that the ground situation in the district does not encourage investment and employment generation. Besides, the bulk of the production infrastructure was idle and traffic and movements of goods were severely restricted. Thus, the project calls for a pragmatic approach based on an active involvement of the village community. It is funded by the GTZ Programme of Germany.

Challenges to Food Security from the International Context With the WTO coming into operation in early 1995, new challenges have been posed for developing countries such as Sri Lanka, on the food security issues. WTO agreements such as the Uruguay Round Agreement on Agriculture (AOA) and TradeRelated Intellectual Property Rights (TRIPs), have not specifically addressed the food security issue and, in fact, the TRIPs agreement is not favourable for maintaining food security in the future. Food security is a key concern for developing countries such as Sri Lanka. The AOA provided only lip service to food security. According to AOA, developing countries will be allowed to use public stock holdings of grains for food security purpose ‘provided that the differences between the acquisition price and external reference price is accounted in the Aggregate Measure of Support (AMS)’. Many developing countries feel that food security needs should be recognised as a nontrade concern (NTC) and should be treated like R&D for the agriculture sector. It has been suggested that the so-called ‘green box measures’ should be revised to include food security issues that are of concern for developing countries. Most developing countries also argue that the multi-functional role of agriculture that has been emphasised by OECD countries should be rejected. The multifunctional role of agriculture basically refers to maintaining the landscape, maintaining an ecological balance, being a source of rural employment and means of living, and ensuring food security. It is argued that food security could get blurred when giving emphasis to other items coming under the multifunctional role (see Adhikari et al., 2000).

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TRIPs agreement states that there must be ‘... protection of plant varieties either by patents or effective sui generis system’ (sui generis means of its own kind). One of the clauses of the TRIPs allows companies to take out patents on the ‘product and process of technology’ (Article 27.3[b]). This includes genetic engineering process and genetically engineered animals and plant varieties. It gives a free hand to private commercial firms to exploit patent laws to gain maximum benefits from their biotechnology research. Multinational companies such as Monsanto and Dupont are patenting genetic resources of seeds. They are producing seeds that are dependent on their pesticides and chemical promoters. Only with the promoter will the seed germinate and the plant will not grow until the chemical fertiliser is supplied. Moreover, with the socalled ‘terminator’ seed the farmer cannot reap the seed for the next crop. This type of technology will make farmers totally dependent on the multinational corporations that sell these seeds, threatening biodiversity and food security. Research shows that nearly 70 per cent of the food supply in developing countries come from a few plants. The patent systems in many countries prohibit the patenting of plants and plant varieties since they form the backbone of crop production, plant breeding, and therefore, food security. Local communities and farmers have for years been engaged in agricultural practices which include carefully selecting and breeding plants. Seeds are the property of the local communities. The question arises as to what kind of property rights developing countries should provide for their plants and seeds. Most developing countries have adopted the sui generis system of protection for plants and seeds. Plant breeders’ rights and farmers’ rights should enjoy the flexibility of the sui generis system. Developing countries like Sri Lanka should not accept the UPOV (Union for Protection of New Plant Varieties) as the only sui generis system and develop its own own sui generis law that ensures farmers and plant breeders rights are safeguarded.9 From the food security perspective, it is, therefore, essential that modifications be made to the AOA, and maximum use be made of the sui generis option in the TRIPs agreement in order to maintain household level food security in developing countries such as Sri Lanka.

Concluding Remarks As stated in the introduction, food security is a complex issue. It cannot be equated with food self-sufficiency. Food production in a market economy environment should give some allowance to the comparative advantage doctrine to function. Under such a framework, areas of high cost of production can be identified. If the production cost cannot be lowered by increasing productivity then the option of importing at a cheaper rate may be the desirable option. It is not possible to devise an agriculture strategy that is favourable to both consumers and producers when producers are not competitive. Sri Lanka has gradually come to terms with this thinking and equating food security with food self-sufficiency is less prevalent in policy circles nowadays.


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At the macro-level even if all statistical measures indicate that Sri Lanka is a food secure country, there is no guarantee that at the micro-level there exists food security. Household food security depends on the affordability more than availability and accessibility. And affordability at the household level depends on the effectiveness of the government welfare or safety net programmes and the rural incomes (both farm and off-farm incomes). It also depends on the prices of food, which in turn would be determined by international prices or/and domestic macroeconomic policies. In Sri Lanka, household food security is far from satisfactory. The current welfare programmes need more fine-tuning with regard to their targets. Already, some programmes are under way to address serious household problems related to food in-take deficiencies. Rural incomes from agriculture have not been satisfactory. There has not been adequate diversification or commercialisation in the agriculture sector for agriculture incomes to increase. Hence, agricultural incomes have to be supplemented with off-farm incomes. However, off-farm employment opportunities have not been very forthcoming and rural economies have been basically kept afloat by income transfers and remittances, the latter being an unstable source of support. There needs to be serious rethinking on both poverty alleviation and agriculture strategy from the food security perspective. Sri Lanka can no longer stand on its laurels of being an exception among developing countries in raising living standards. The PQLI (Physical Quality of Life Index) may not fully reveal the food intake deficiencies at the household level. Concerted efforts have to be made using both agriculture policy and poverty alleviation policy to address the household food security problem. This is particularly important at a time when the public food distribution system is gradually giving way to the private sector and market forces. Sri Lanka has also to take cognisance of the events taking place around the world. WTO agreements on agriculture and intellectual property have had unfavourable impacts on food security. Sri Lanka should join hands with other developing countries, particularly other SAARC countries, and take necessary steps to overcome these adverse impacts. Moreover, a major water shortage is predicted in the year 2020, followed by a food shortage. Appropriate policy measures need to be taken to face such realities in the current globalised economic environment.

Notes 1. Research Assistance of Roshan Epparachchi, Research Officer, Institute of Policy Studies, is gratefully acknowledged with the usual disclaimer. 2. After World War II, Europe followed a policy of self-sufficiency in agriculture and this led to large subsidies and protection for the sector in subsequent years. This strategy influenced the agricultural development strategy in many developing countries. 3. The Mahawansa documents that during the reign of King Parakramabahu, Sri Lanka not only achieved self-sufficiency in rice but also exported to countries such as Burma. 4. There has been very little coordination between the Ministry of Trade that imports rice and the Ministry of Agriculture, which is concerned about production of paddy and farmer welfare. When cheap imports overshoot, the farmers find it difficult to sell their paddy at a reasonable price in the absence of the PMB. The CWE and organisations such as Farmer

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5.

6. 7.

8. 9.


Companies have not been able to purchase adequate quantities of paddy from the farmers resulting in massive protests by the farmers. A solution to this problem has not yet been worked out. Triposha is the main food-based nutrition intervention programme in Sri Lanka. Introduced in 1973, it provides pre-cooked food fortified with vitamins and minerals. The programme is targeted at pregnant and lactating mothers and pre-school children. See Ceylon Daily News, 12 August 2000, p. 3. The factors include policy-induced market imperfections, cultural attachment to paddy cultivation and increased fragmentation of land holdings in every successive generation, risk averness, paddy bias in government policy and compatibility between sub-optimal paddy cultivation and demands of the increasingly more important off-farm employment. For a discussion of forward sales contracts in Sri Lanka, see CBSL, Annual Report (2000) For a detailed discussion, see Adhikari et al. (2000).

References Adhikari, R. et al. (2000), Impact of TRIPs Agreement on Nepal, Actionaid/Pro-public, Kathmandu. Athukorala, P. and S. Jayasuriya (1994), Macroeconomic Policies, Crises, and Growth in Sri Lanka, 1969–90, The World Bank, Wasinghton, D.C. Barker, R. and M. Samad (1998), ‘Irrigation Development & Food Security in Sri Lanka’, Economic Review, Vol. 23, No. 12, People’s Bank, Sri Lanka. Central Bank of Sri Lanka (various surveys), Consumer Finance Survey, Colombo. De Silva, K.T. et al. (1999), No Future for Farming?: The Potential Impact of Non-Plantation Agriculture on Rural Poverty in Sri Lanka, Centre for Intersectoral Community Health Studies, Kandy. Dunham, D. and C. Edwards (1997), ‘Rural Poverty and an Agrarian Crisis in Sri Lanka, 1988–95: Making Sense of the Picture’, Institute of Policy Studies, Poverty and Income Distribution Series, No. 1. FAO (1996), ‘Implications of Economic Policy for Food Security’, FAO Training Document, (unpublished). ——— (1999), ‘Food Security and Nutrition: Sri Lanka’, FAO Office, Colombo (mimeo). GOSL (1995), Policy Statement, Government Press. Herse, D., W.A.T. Abeysekera and T.N. Wikramanayake (1989), ‘Food Consumption Behaviour of Urban Food Stamp Recipient in Sri Lanka’, Ceylon Journal of Medical Sciences, Vol. 32, No. 2. MALF (1995), National Policy Framework: Agriculture, Lands, & Forestry, MALF, Sri Lanka. ——— (1996), World Food Summit: Position Paper—Sri Lanka, MALF, Sri Lanka. NDC (1996), ‘Agriculture Policy Recommendations’, Report of the National Development Council Working Group on Agriculture Policy, Colombo. O’Sullivan, M. (1997), ‘Household Entitlements During Wartime: The Experience of Sri Lanka’, Oxford Development Studies, Vol. 25, No. 1. Sanderatne, N. (2000), ‘Food Security: Self Sufficiency or Self-Reliance?’, Achievers, NDB, April. Sen, A.K. (1981), Poverty and Famines: An Essay on Entitlements and Deprivation, Clarendon Press, Oxford. World Bank (1995), Sri Lanka Poverty Assessment, Report No. 13431-CE, Washington, D.C. ——— (1996), Sri Lanka: Non-Plantation Crop Sector Policy Alternatives, Report No. 14564-CE, Washington, D.C. ——— (2000), Sri Lanka: Recapturing Missed Opportunities, World Bank Country Report, Washington, D.C.

Part V EMPLOYMENT AND POVERTY

13 STRUCTURAL ADJUSTMENT AND EMPLOYMENT CREATION

Introduction Structural adjustment started in Sri Lanka with the liberalisation process initiated in 1977. The liberalisation policies were a means towards achieving structural adjustment in the economy. Thus, the impact of structural adjustment on employment could be examined by analysing the impact of liberalisation policies on the same. The liberalisation policies that started in 1977 were carried out further in the ensuing years. The 1977–88 period could be considered as the first wave of liberalisation and the period during 1989–94 could be considered as the second wave of liberalisation. The government of Sri Lanka played a crucial role during the first phase of liberalisation by embarking on a massive public investment programme. Thus, when examining the role of liberalisation it is essential to separate those employment created by the state. Liberalisation helped reduce unemployment in its early stages however, during the mid-1980s unemployment was on an increasing trend. Since 1994 however, unemployment has been on a downward trend. This chapter attempts to analyse these trends considering the role of liberalisation and other factors that have contributed to changes in unemployment patterns in Sri Lanka. These factors include, among others, the role of government generated employment, patterns and changes

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to the labour force. Due to the infrequency and incomparability of labour surveys in Sri Lanka during the 1980s, it is difficult to obtain accurate data on this subject. The chapter is organised as follows. The next section examines employment creation during the first wave of liberalisation during 1977–88. The section after that examines employment creation during the second wave of liberalisation during 1989–94 while the fourth section provides some explanations for persistent unemployment in the country. The final section has some concluding remarks followed by a short postscript on the employment situation during 1995–2004.

First Wave of Liberalisation: 1977–88 Subsequent to implementing the economic liberalisation programme in 1977, employment generation increased in the immediate aftermath. Consequently, the level of unemployment, which was 20 per cent in 1977, came down significantly to 11 per cent by 1981–82.1 However, the initial spurt of employment-creation was not sustainable and by the mid-1980s the level of unemployment reached 14.1 per cent (Table 13.1). In the following discussion the role of liberalisation policies in shaping the employment structure is examined. Table 13.1 UNEMPLOYMENT RATE, 1973–95∗ Title of Survey Survey of Sri Lanka Consumer Finance Land and Labour Utilisation Survey Consumer Finances and Socio-Economic Survey (CFSES) Labour Force and Socio-Economic Survey (LFSES) CFSES LFSES CFSES Labour Force Survey (LFS) LFS

Sample

Unemployment Rate (%)

1973 1975

5,000 Households 5,000 Households

24.0 19.7

1978–79

5,000 Households

14.8

1980–81 1981–82 1985–86 1986–87 1990 1995

10,000 Households 8,000 Households 25,000 Households 8,000 Households

15.3 11.7 14.1 15.5 15.9 12.3

Year

Sources: Korale (1992) and CFSES, 1986/87. ∗The different surveys are difficult to compare due to differences in sample, differences in Note: definitions of unemployment and methodological differences. However this is the best available data.

Accurate data on overall employment and unemployment on an yearly basis are hard to obtain in Sri Lanka. According to an authoritative survey, 175,000– 200,000 employment opportunities were created annually during the 1978–82 period and overall unemployment fell to a level of 850,000–900,000 by 1982 (Korale, 1988: 19). The average employment-creation per annum during the 1982–85 period was roughly 94,000 compared to the normal Sri Lankan average annual addition

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to the labour force of 120,000 (the value varies between 120,000 and 140,000). What is clear from the above mentioned statistics is that annual employment creation has declined during the 1982–85 period compared with the 1972–82 period. In the immediate aftermath of the new economic measures in 1977, the strategy which produced almost immediate results on the employment situation was the decision to permit people to go overseas for employment. The sharp devaluation of the rupee in (and after) 1977 contributed to increasing the rupee earnings of those who had found employment abroad and devaluations became an incentive to other employed and unemployed persons to explore the possibilities of finding jobs abroad (Karunatilake, 1987). Thus, job opportunities overseas became the most lucrative avenue to new employment after 1977. Available estimates indicate that about 1.3 million people found employment abroad during the 1977–84 period and most of them were in the Middle East.2 It must be noted, however, that the second oil-price hike in 1979 increased the demand for labour in the Middle-Eastern countries. Thus, liberalisation policies per se were not responsible for the massive exodus of workers to these countries. A survey carried out by the Ministry of Plan Implementation showed that about 250,000 families, or one-tenth of the country’s population, had at least one member of their family who worked abroad. Many who went to the Middle East, except housemaids, had jobs in Sri Lanka, and their departure created job opportunities for the unemployed. In considering the increase in employment during the 1977–82 period, some interesting observations can be made. According to Rodrigo and Jayatissa (1989), nearly 200,000 workers migrated to the Middle East during this period. Further, under the Sirimavo-Shastri agreement of 1964 nearly 337,000 persons of Indian origin from the estate sector were repatriated during the period 1977–82. Furthermore, there were demographic factors that led to a slight ageing of the population. All these factors reduced the labour force participation rates (Sanderatne, 1985: 20). Thus, viewed against these factors, the increase in domestic employment during this period seems to have been of modest proportions. Domestic employment during this period came mainly from the service and construction sectors and not from the agriculture and industry sectors. For instance, liberalisation of trade and payments, such as the removal of restrictions on travel, had a fairly immediate impact on employment. It gave opportunities for a large number of newcomers to enter import trade, transport and tourism and also helped to provide jobs for clerks, typists, bookkeepers, accountants, stenographers, drivers and other workers in these sectors (employment in the tourist sector is shown in Table 13.2). The resulting larger availability of goods led to a sharp rise in the level of business activity, and consequently employment in the wholesale and retail trade increased.3 In the retail trade, the secondary effects of import liberalisation were felt in the large informal sector outside the urban areas, with a considerable expansion in the volume of transactions of economic activity in the village trading centres and fairs. All service sector areas showed a rapid increase in employment after 1977. Moreover, self-employment increased after 1977 with the increase in personal services such as repair work, particularly in electronics, electrical equipment, airconditioning and motor repairs.

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Development Under Stress: Sri Lankan Economy in Transition Table 13.2 EMPLOYMENT IN THE TOURIST SECTOR Year

Total Employment

1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994

15,404 18,472 47,900 52,800 64,262 53,608 58,898 54,533 53,484 48,811 47,904 48,000 60,000 64,800 69,096 73,706 81,495

Source: Central Bank of Sri Lanka, Annual Report (various years).

The massive Mahaweli project and other construction programmes (housing, urban development) that did not come under liberalisation policies, also provided employment during their construction phases. Accurate figures on employment generated by the above mentioned schemes are not available. However, according to Stern (1984), employment generated by these programmes over the 1978–82 period accounted for nearly half the total employment increase during this period. Thus, it appears that policies other than liberalisation contributed a significant share to the domestic employment-creation during the 1978–82 period. Table 13.3 indicates the share of employment and output in the main sectors of the Sri Lankan economy for selected years.4 The agricultural sector accounted for nearly 50 per cent of total employment during the first half of the 1980s. Despite the agricultural sector being a large employer, labour absorption in the major tree-crops sub-sector had been declining from 1950 onwards (Gooneratne and Wesumperuma, 1984: 5–6). The paddy sub-sector which grew rapidly after 1977 also ceased to be a source of employment in the mid-1980s (Korale, 1986: 111–12). Although accurate figures for employment increase in the agricultural sector are not available, it would appear that employment levels rose and fell with levels of production;5 and rise in employment in this sector must however be classed as insignificant in comparison with the huge expansion of the service sector, and the substantial employment creation generated by the Mahaweli project-centred Public Investment Programme. Table 13.3 shows that the manufacturing sector accounted for nearly 12.5 per cent of total employment during the first half of the 1980s. According to Korale (ibid.: 112) the manufacturing sector is ‘the key determinant of employment in the medium and long-run in Sri Lanka’. One of the main aims of economic liberalisation was to generate more employment in the manufacturing sector.


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Table 13.3 EMPLOYMENT AND OUTPUT SHARES IN THE SRI LANKAN ECONOMY FOR SELECTED YEARS 1971 1981–82 1985–86 1990–91 1994–95 Output Empl. Output Empl. Output Empl. Output Empl. Output Empl. Agriculture Industry Manufacturing Mining Service and construction

28.3 17.4 16.7 0.7

50.1 9.7 9.3 0.4

24.6 17.0 13.6 3.4

51.2 14.1 12.4 1.7

27.7 17.0 14.7 2.3

49.3 13.9 12.6 1.3

26.9 16.4 14.3 2.1

47.7 15.7 14.1 1.6

20.5 22.2 19.9 2.5

40.0 14.8 14.0 0.8

54.3

40.2

58.4

34.7

55.3

36.8

56.7

36.6

57.4

41.3

Sources: Employment figures from Korale (1986) and Department of Census and Statistics (1987: 164), output figures from Central Bank of Ceylon, Annual Report, various issues. Department of Census and Statistics (1990: 9).

But increasing unemployment by the mid-1980s suggests, that employment creation by the manufacturing sector was not very satisfactory during the 1977–85 period (also see Kelegama and Wignaraja, 1992). According to the estimates of the IDB (1980) survey, employment in new industries (those which came into production after 1977) increased by 7 per cent. Even if allowance is made for the fact that export industries take time to respond to policy reforms, the unemployment level increase in the mid-1980s clearly shows that labour absorption in the new exportoriented industries was low in relation to annual additions to the labour force. While the industrial sector as a whole generated employment after liberalisation, certain sub-sectors experienced adverse effects. This was primarily due to the adverse effects of import liberalisation on domestic industries. It has been estimated that the total loss of employment from the handloom sector alone during the 1977–80 period was 40,000 (Waidyanatha, 1980: 32). This figure increased to a little over 120,000 by 1986.6 The total employment losses from rural and other small industries in the unorganised sector during the same period were at least 30,000.7 Thus, the overall loss of employment from the above mentioned sub-sectors of the industrial sector during 1977–80 amounted to at least 70,000, but this loss in employment was not matched by an increase in employment in the organised industrial sector, which by 1980 amounted to 35,987 (see Table 13.4). The industrial employment figures in Table 13.4 clearly show a highly unequal pattern of increase in employment in the organised sector. Out of the total employment increment between 1977 and 1980, 71 per cent came from two sectors: textile and wearing apparel (44 per cent) and the non-metallic mineral sector (27 per cent). Even in 1985, for instance, nearly 54 per cent of the total employment increment came from these two sectors, with the former contributing 44.5 per cent and the latter contributing 8.5 per cent. Employment increase in the textile and wearing apparel sector reflects the expansion of garment industries under FDI, while the increase in non-metallic minerals reflects the expansion of construction industries. In both cases, growth occurred chiefly owing to non-liberalisation factors.8 The contribution of new industries with foreign capital participation (set up after 1977) to overall increase in industrial employment was 59.5 per cent in 1980 and 65.2 per cent in 1985. Although these percentage figures appear impressive, it must be noted

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Development Under Stress: Sri Lankan Economy in Transition Table 13.4 EMPLOYMENT PATTERNS IN ORGANISED SECTOR INDUSTRIES

Industry Food, beverages and tobacco Textiles, wearing apparel and leather products Wood and wood products Paper and paper products Petrochemicals and others Bib-metallic and minerals Basic metal products Fabricated metal products, machinery and transport equipment Other manufacturing products Total manufacturing Employment in firms with FDI (a) GCEC (b) FIAC Total (a + b)

1977 Level

Increment, 1977–80 Increment, 1977–85

28,429

3,936

35,453

33,180 6,476 7,650 14,446 9,963 1,790

15,793 2,252 612 2,750 9,960 453

41,658 3,385 –66 7,808 7,951 –222

15,513 1,129 118,576

–437 668 35,987

–3,937 870 93,576

11,942 (33.2) 9,465 (26.3) 21,407 (59.5)

31,846 (36.4) 25,239 (28.8) 57,085 (65.2)

Sources: Estimated from Central Bank of Ceylon, Review of the Economy (1986: 69) and Ministry of Finance and Planning (1988: Table III). Note: The figures in parenthesis show the FDI firms employment increase as a percentage of total manufacturing employment increase.

that in relation to the growing unemployment problem the labour absorption in the GCEC and FIAC industries was negligible. Of the total addition to the labour force of about 120,000 per year, the GCEC has provided, on the average, employment to about 4,000 per annum or less than 4 per cent of the additions to the labour force while the FIAC has provided, on average 3,000 per annum or less than 3 per cent of the labour force. Thus, overall post-1977 FDI related employment amounted to less than 7 per cent of the addition to the labour force. What about the redeployment of the large proportion of displaced labour from the pre-1977 protected industrial sector? Were they all absorbed by the expanding activities of the economy? There is no doubt that such redeployment took place to a certain degree, as is seen from the improvement in the overall unemployment situation by 1981–82. However, the massive job losses were not immediately compensated by new job opportunities in the expanding activities, since different skills and abilities were required for these. Some who lost jobs were absorbed by the expanding construction and service sectors, while others migrated abroad, in particular, to the Middle East. A few also secured jobs in the expanding new industries and in the Mahaweli project. Stern (1984) has shown that under the Mahaweli project, generation of employment reached a peak in 1981 and thereafter, most people who were employed became unemployed on project completion. Thus, by 1980–81 a substantial portion of this displaced labour remained unemployed until new job opportunities arose. The presence of these workers in the unemployed reservoir exerted tremendous


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pressure on the government to find new employment opportunities. Besides, by the end of 1980, 60,000 skilled labourers9 who were sacked after a general strike in July that year,10 swelled the unemployed reservoir and gave it a militant tendency. In order to dissipate these tendencies the government recruited a large number of the displaced labourers (excluding those who participated in the 1980 strike) in government corporations (mostly by overstaffing). In fact government employment did not reduce despite the result of the general strike, this can be explained by prompt re-recruitment and strikers breaking ranks and rejoining the labour force. Thus, public enterprises became sources of readily available employment for the unemployed, and consequently the idea of rationalising of these public enterprises to make them more efficient became a secondary objective. Even the idea of privatisation became very difficult owing to the employment problem and to the strong roots that public enterprises possessed in the economy.11 The foregoing discussion reveals several disconcerting features of the quality of the new employment. First, the major thrust in labour absorption came from sectors which were unable to generate sustained growth in employment. Consider, for instance, construction-related employment. As well known, the construction boom was not matched by a corresponding domestic resource mobilisation: it was financed partly by deficit financing and partly by foreign aid. Also, by the early 1980s the government had to cut down its construction programme in order to balance its budget (as well as the BOP). Second, the expansion of service-sector employment was largely due to import-trading spurred by import-liberalisation. Most of the industrial sub-sectors that had shown some dynamism since 1977 also benefited from import liberalisation which allowed greater availability of raw materials and capital equipment. But, the whole regime of liberalised imports was sustained through external props rather than by any intrinsic strength of the domestic economy during 1977–85. In short, new employment took place in areas financed either by monetary expansion, increased capital inflow, or worker remittances, all of which showed a considerable fluctuation. One of the most disconcerting features of the quality of new employment pertains to the social value of that employment. There are several aspects to this problem. First, in the process of structural transformation in the country’s industrial sector after 1977, there took place a reallocation of labour from the unorganised sector in general, and from the rural sector in particular, towards the organised sector (industry and services). This had detrimental effects on regional balance in growth. Table 13.5 provides some evidence for this. Moreover, it was the urban sector that showed the highest employment expansion. As Table 13.6 shows, the highest decline in unemployment is seen in the urban sector, in particular in the capital city of Colombo. It may also be noted that within the urban sector it was the female unemployment rate that recorded the highest decline, reflecting the Middle-East migration, expansion of services (e.g., tourism) and garments industry which employ mostly females.12 There is evidence to believe that in some parts of rural districts unemployment not merely failed to decline but, in fact, increased during the 1977–85 period. In particular, the level of unemployment among rural youth increased significantly

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Development Under Stress: Sri Lankan Economy in Transition Table 13.5 REGIONAL DISTRIBUTION OF ECONOMIC ACTIVITY IN MANUFACTURING SECTOR BY PROVINCES, 1981

Province

No. of Establishments (%)

Western Central South North East North West Uva Sabaragamuwa Total

Employment (%)

74.4 5.8 6.2 3.1 1.0 0.5 0.6 3.4 100.0

74.8 5.0 3.9 2.8 4.1 1.0 0.1 5.0 100.0

Source: Estimated from Department of Census and Statistics (1981). Note: These statistics cannot be compared owing to a difference in surveying techniques.

Table 13.6 UNEMPLOYMENT AS A PERCENTAGE OF THE LABOUR FORCE IN DIFFERENT ECONOMIC SECTORS FOR SELECTED YEARS

Urban sector City of Colombo Rural sector Estate sector

1978–79

1981–82

1985–86

1990–91

1993–94

20.7 20.5 14.6 5.6

14.2 12.3 12.0 5.0

19.5 – 13.2 7.8

18.4 – 15.9 –

15.6 – 10.5 –

Sources: CFS 1978–79, CFS 1981–82, and Department of Census and Statistics (1987: 218).

after 1977. The unemployment rate in the age group 15–25 was in the range of 30–40 per cent during the years 1984–85 (Department of Census and Statistics, 1987: 281). Further, a majority of those who were employed in rural handlooms and cottage industries, but were not prepared to migrate, had to join the ranks of the unemployed since there were hardly any new employment opportunities in the agricultural sector or in rural non-farm activities.13 Second, the regional balance distortion also accentuated inequality in the distribution of income. The third disconcerting factor is that labour diversion from basic industries to construction and services deprived the economy of powerful linkage effects. Similar adverse effects, related to employment in the manufacturing sector also slowed down the speed of trade liberalisation and prevented it being carried to the second stage (Kelegama, 1988). The reverse trend of employment creation in the 1982–85/86 period can be understood by examining the overall pattern of employment generation in the country. First, although activities related to the Mahaweli scheme created much employment during their construction phase—the total of direct and indirect permanent employment from the Mahaweli scheme was estimated to be about 200,000 by the mid-1980s—it declined after the construction was completed. Second, certain sub-sectors of the service sector (e.g., transport) reached saturation levels in employment creation. Third, the labour absorption in the manufacturing sector remained low (Kelegama and Wignaraja, 1992). These factors, together with


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the disconcerting problems in regard to employment generation that were highlighted explain the unemployment situation that resulted in mid-1980s. As discussed earlier, state intervention was the major creator of new employment from 1977 to 1986/87. The liberalisation measures launched played a secondary role in employment creation while state intervention in the form of the Mahaweli irrigation scheme and other construction programme was at the forefront of employment creation. In the late-1980s, the unemployment rate remained high at the level close to about 14 per cent. The slight decline from the 1986–87 level may be due to the large out-migration that resulted from the deteriorating security situation during 1987–89. The decline of unemployment was marginal because of the slowdown in growth of the economy as a result of the internal crisis in the country. The occupation of Indian forces in the North and the East contributed to escalating the ethnic crisis and thus many industries such as cement in Kankasanturai, caustic soda in Paranthan, salterns in Elephant Pass and Nilaweli, ilmenite at Pulmoddai, ceramics at Odduchuddan and Amparai, paper mill at Valaichenai, etc., either stopped functioning or ran far below capacity with consequent job displacements. In agriculture, rice in areas such as Mulativu and Vavuniya, coconut cultivation in the eastern coastal areas of Mulativu and Kilinochi were adversely affected by the war with adverse consequences on employment. In fishing, nearly the entire coastal stretch from Puttalam to about Potuvil was adversely affected and many fishermen ceased to carry on as fishermen. There were job losses in the tourist sector as a result of areas such as Pasekudah, Nilaweli, Arugam Bay, Marble Bay, Wilpattu, etc., being out of reach for tourists. The JVP crisis in the South too contributed to the closing down of some factories and employment losses and also large migration from the country. Both the NorthEast conflict and JVP crisis should be seen as massive internal shocks that are not related directly to the liberalisation policies that were unleased. With the gradual waning away of the shocks and the renewal of liberalisation in 1990, the high unemployment trend was reversed. The economic recovery was accompanied by a rise in private sector employment. This trend was indicated in the surge in tourist sector employment in the early 1990s (Table 13.2), new EPF registrations and the increase in GCEC employment (from 10,538 in 1980 to 104,220 in 1992). Despite these advances through private sector-led growth, the unemployment level did not reduce significantly. The labour force survey (1993, 3rd quarter) indicated unemployment at around 13 per cent. This compares with the 15–16 per cent unemployment recorded for 1990 (Department of Census and Statistics, 1990).14 At this juncture it is imperative to examine how effective the liberalisation policies have been in generating additional employment.

Second Wave of Liberalisation: 1989–94 There were three policy initiatives in the context of employment creation that may be categorised as liberalisation during this period. First, the preliminary divestiture

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of the assets of state-owned enterprises (SOEs) took place around 1987 and the pace of divestiture was accelerated after 1989. This was accompanied by some degree of administration restructuring. Second, further liberalisation of the financial sector, prices, foreign investment, exchange controls, etc., took place in the 1990s. Third, self-employment schemes such as Janasaviya and the credit schemes for small and medium-sized industrialists came in the form of market supporting policies. First, let us consider the privatisation programme. According to the available evidence, this scheme has generated employment reversals in the labour markets. This is because of early retirement and retrenchment policies. There were 43 enterprises that were privatised during the period 1989 to mid-August 1994. The divestiture of state assets is preceded by compensation payments being offered. If the workers accept the compensation package, they are retrenched. According to the Labour Commissioner, about 20,000 workers were retrenched voluntarily in privatisation during the period under consideration. However, trade union sources put the figure at about 60,000 workers.15 This takes into account the workers who were forcibly retrenched. The restructuring of the administration, however, did not lead to employment losses; on the contrary, employment in the state sector increased after 1989. In an effort to achieve the target of retrenching 25 per cent or 80,000–90,000 staff over a four-to-five year period based on the recommendations made by the Administrative Reforms Committee (ARC), the government put into operation a ‘golden handshake’ package for the central and provincial staff in 1990. The statistics shown in Table 13.7 show that there had been no reduction in the strength of the state sector. Table 13.7 EMPLOYMENT IN THE STATE SECTOR, 1988–93 Year

Government

Semi-Government

Both Sectors

1988 1989 1990 1991 1992 1993

535,500 588,500 609,750 652,600 653,959 676,483

752,900 749,700 708,400 654,400 637,271 618,799

1,288,400 1,338,200 1,318,150 1,307,000 1,291,230 1,295,282


The public service cadres had continued to grow despite the dislocation of work in many industries located in the Northern and Eastern provinces and divestiture of some industries from 1987, the employment in the semi-government sector declined only by as much as the growth of new employment in the public service. The golden handshake basically resulted in the retirement or resignation of a large number of state and public corporation officials, especially those who had skills to find alternative employment in the private sector. Although, the short-term missions from international lending institutions that proposed the restructuring of the public sector had believed that it would reduce excess unskilled and semi-skilled staff, what happened in practice was not what


269

was expected. In fact, in 1990–91 arrangements were made with the ARC to raise the cadre of Department of Census and Statistics by over 30 per cent in 1990–91 to compensate for the loss of staff and on the grounds that the work involved was of a technical nature. Although, privatisation contributes to short-term employment losses, in the long run, with the expansion and diversification of privatised ventures they would create new employment opportunities. Thus, the overall employment losses from this restructuring process should be viewed as a feature of a public sector restructuring exercise that is temporary. Second, the further liberalisation measures did contribute to the creation of new employment opportunities. There were many new employment opportunities emerging in the financial market with the development of stock market activities, venture capital, merchant banking, etc. In the manufacturing sector too, many new employment opportunities were created. Total employment in non-GCEC projects approved after 1977 increased from about 2,500 in 1978 to about 70,000 by about 1992. Moreover, FDI made a significant contribution to employment creation— local employment in GCEC firms recorded a 10-fold increase, from 10,538 to 104,220, between 1980 and in 1992. About half of these employment opportunities were in manufacturing (Athukorala, 1995). The increase in the manufacturing sector employment was due to various concessional schemes such as tax holidays granted by the Board of Investment (BOI). The most noteworthy among them was the 200 Garment Factory Programme that was partly incentive-induced and partly forced scheme. It was designed to create mass employment with a rural emphasis. Each factory was supposed to employ between 200 and 400 workers. From the factories that came up during 1989–94 a total of 50,000 new jobs were created.16 The stock of Sri Lankan workers abroad by 1989 has been estimated at around 317,000—the equivalent of 5 per cent of the national labour force (Rodrigo, 1991). About 80 per cent of the overseas employment migration was to the Gulf.17 On an average since 1989, about 80,000 workers have been going to the Gulf for employment—a reverse from the slackening demand for jobs in the Gulf during the mid-1980s. Further liberalisation of exchange controls, opening up Non-Resident Foreign Currency (NRFC) accounts, etc., did assist to increase the migration for overseas employment. Third, there was a rise, since late-1980s, of self-employment schemes spurred on by especially financial liberalisation. One of these schemes includes the liberalisation of credit to small and medium-sized business enterprises starting in 1989. This provided an opportunity for a far greater access to credit among smaller entrepre-neurs. The most significant policy break of this credit scheme launched by lending bodies such as the DFCC and the NDB is the reduction of the bureaucratic barriers which block access to credit. As the loans were given on a concessionary basis, they have had a major impact on self-employment schemes. The most important self-employment scheme was the Janasaviya poverty alleviation scheme. Though the scheme appeared as an interventionist incomesubstitution scheme, in practice it was linked to a training-cum-production programme which aimed at encouraging self-support. Thus it was a market-supporting

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or market-auxiliary measure. The specially targeted disadvantaged groups were assisted over a two-year period with a monthly allowance of Rs 1,458 per month for financing consumption needs. A savings component of Rs 1,042 per month was supposed to add upto a fund of Rs 25,000 at the end of two years. The supposed savings component could be used as collateral to obtain a bank loan to establish a business. To accompany the scheme, special credit programmes were established (Janashakti banks). Preliminary evidence suggests that the number of people who found employment as a result of the poverty alleviation programme was about 40,000–60,000. However, given its informal nature these figures cannot be substantiated. Special self-employment creation schemes were also launched by various NGOs such as, the National Youth Service and Credit Organisation (NYSCO), Women’s Bureau, Sarvodaya, Sanasa, etc. A large part of the increase in employment in the 1980s was due to self-employment and unpaid family work (i.e., informal sector). The share of self-employment remained high at around 25–30 per cent throughout the 1980s (Korale, 1992: Table 13.6). The greater casualisation of the workforce appears to have accompanied the expansion of employment. The Central Bank’s Consumer Finance Survey of 1986–87 reports one half of the paid employees as being in casual employment. In the Labour Force Survey of 1980–81 the corresponding share was 41 per cent (Rodrigo, 1994). Clearly, liberalisation measures contributed to generating more employment opportunities compared to the employment dismissals during the second wave. However, the employment generation has not been adequate to reduce the unemployment level to a single-digit level. In an overall sense, it appears that the liberalisation process by its very nature has failed to make significant dents in the unemployment rate. The explanation seems to lie elsewhere. The following factors explains the unemployment level to a great extent.

Explanation of Persistent Unemployment Labour Market Regulations One explanation is that the liberalisation process itself did not go far enough in the labour market in order to remove certain rigidities that were related to some labour legislation. Thus, the private sector faced considerable difficulties in generating large-scale employment due, inter alia, to some of the prevailing labour legislation. For example, restrictions imposed on the Termination of Employment of Workmen Act (TEWA) greatly reduced the scope for job retrenchment and job creation which were essential for production restructuring and expansion.18 There were cases of private sector opting for capital-intensive methods to avoid the hazards of the TEWA. This extensive protection also contributes to the long job search periods that is explained later. The well protected ‘good’ jobs in the formal sector of the economy make the informal, smaller scale sector less attractive, therefore workers were willing to wait for openings in the formal sector.


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Long Job Search Periods Unemployment in Sri Lanka is largely voluntary. Poverty surveys suggest that poverty is due to inadequate earnings rather than the lack of employment (World Bank, 1990, 1992). Underemployment seems to be the major problem for the poorest quarter of the population. Even though the poor engage themselves in what is technically defined as employment, this employment is often of low marginal productivity. Unemployment among the section of the population defined as poor (those who fall below the World Bank definition of a daily income of a dollar day), is estimated to be not very different from those of the entire labour force (Korale, 1992). Further evidence of involuntary unemployment is seen in that more than 90 per cent of unemployed people finance their consumption through family assistance. It appears that the unemployed are more interested in the scarce jobs in the regulated sector of the economy, but are disinterested by abundant jobs in the nonregulated sector. Partly, this could be explained by the job security that prevails in the regulated sector. There is an implied guarantee of employment in the terms of recruitment for the regulated sector whether it is government or private sector. On the other hand, in the unregualted sector, jobs are less secure and benefits are meagre. The responsiveness of sectoral wage increases to the unemployment rate is a way of testing the reluctance to obtain jobs in the unregualted sector. If the unemployed do not compete for jobs in the non-regulated sector, then high unemployment should not restrain wage increases in this sector. Thus, there should be wage increases in spite of high unemployment. In addition, because higher unemployment is associated with lower manpower availability, wages could increase proportionately with the unemployment rate. A study by the World Bank has shown that this is the case in the unregulated sector (Prywes, 1995).

Nature of Public Sector Wages and Hiring Public sector pay in well functioning markets is below that of the private sector due to more job security, relatively less effort required to secure the job, and other benefits such as pensions. In Sri Lanka, public sector pay exceeds private sector wages at the lower levels on average.19 Therefore, there is strong incentive for the unemployed to wait for a vacancy in the public sector. Governments have historically pandered to this ‘queuing’ by regularly hiring unemployed workers in order to reduce unemployment. Furthermore, a relative lack of competition in the public sector generates rents which are shared among employers and employees, further contributing to the attraction to this sector. Accordingly, the unemployed seem to prefer to engage in a job search for a long period until a suitable job comes their way. It is reported that 85 per cent of unemployed spent more than a year searching for jobs in 1990 (Prywes, 1995).

272


Increase in the Labour Force Participation Rates A further explanation for the prevalence of unemployment in the 13–14 per cent range is that with employment expansion there has been an increase in the labour force participation rates during the post-1982 period in contrast to the period 1977–82. In particular, the entry of women into the labour force has increased the participation rates. Young female workers form the majority of the workers in the FTZ work force (78.2 per cent or 81,412). The predominance of young women is a feature of FTZs all over the world. These young women would have remained outside the labour force in the absence of FTZ job opportunities. The overseas workers also consists mostly of women and these women may have remained outside the labour force if not for new migration opportunities. With increase in education, those young women who come forward for jobs but fail to find work adds to the increasing labour force. This explains the rise in the labour force participation from 47 per cent in 1985–86 to 52.2 per cent in 1990, while absolute employment increased annually by 0.6 per cent (Kelly, 1994).

Inflow of Migrant Labour and Voluntary Unemployment The migration of labour overseas has in one sense reduced the unemployment rate by creating an average of 50,000 domestic jobs annually since the mid-1980s. However, a point often missed in discussing the employment effects is the inflow of workers from abroad in search of domestic employment. Rodrigo (1991) points out that the inherent nature of contract migration implies a return flow. At the termination of their contracts an equal number of workers return annually. The annual return was an estimated at 67,000 in 1989 (ibid.). Available statistics point to the high rate of reported unemployment among returned migrants. The unemployment rate works out to 45 per cent according to a 1986 Marga survey. The rate of unemployment among returned workers is particularly adverse for women. The higher wage expectations, inferior working conditions and inappropriate skills are the main obstacles. For instance, the Marga survey found that housemaids who returned, prefered to live off their savings than work for lower pay and worse conditions domestically. A further aspect of overseas migration which keeps the unemployment level at a relatively static level is the dependency of relatives on overseas workers. This phenomenon is common to the Tamil youth who have left the country as IDPs (Internally Displaced People) since 1983. Because spouses, children and other relatives are dependent on foreign remittances, they choose not to work at wage levels below what they receive as family assistance. This phenomenon is often the case among the husbands of housemaids who are overseas.


273

Skills Mismatch Thus far, unemployment has been explained primarily from the supply side, demand too plays an important role in explaining persisting unemployment in Sri Lanka. The skills mismatch hypothesis suggests that new entrants into the labour market lack the relevant skills in demand in the labour market at the time of entry (Gunatilleke, 1986). A possible cure would be improving some of the ‘softer’ skills of workers such as communication and creativity, skills that are in demand in the private sector.

Unrealistic Expectations Hypothesis This theory suggests that new entrants to the market who have higher educational qualifications expect an unrealistically high wage. That is, education increases expected wage more than it increases actual wage. This theory could partly explain the queuing behaviour seen empirically.20 However, statistical backing for the unrealistic expectations hypothesis is scratchy as different studies have produced contradictory evidence.21 This, coupled with the unrealistic expectations hypothesis results in workers not wishing to take the jobs on offer and employers not demanding the skills these new entrants present. The skills mismatch and unrealistic expectations are forms of imperfect information in the labour market. Steps taken to improve interaction and sharing of information between employers and potential employees could help mitigate this problem.

Concluding Remarks While these features partly explain the high two digit level of unemployment during the mid-1990s, in Sri Lanka it is imperative that the issues highlighted in a previous section are addressed to reduce the fragmentation of the labour market and thereby, reduce the unemployment level in the future within the broad structural adjustment framework. Market liberalisation will then be able to generate more employment in the years to come. In this context, it may be noted that nearly 25 per cent of the employment generated depends on overseas markets (13 per cent overseas, 4.5 per cent in ready-made garment industry, 3 per cent of plantation industry and 4.5 per cent by the tourist industry and various other BOI industries). At a very broad macro-level the unemployment problem should be conceptualised in the following manner. The estimates of labour force components from the Labour Force Survey conducted by Department of Census and Statistics show that the unemployment rate had declined from 15.9 per cent in 1990 to 12.3 per cent in 1995.

274


The net additions to the labour force was estimated to grow at around 150,000– 160,000 per year during this period. In order for the unemployment rate to decline to the reported level of 12.3 per cent at the end of the period, it implies that the rate of growth of the economy sustained during that period (growth rates had average to about 5 per cent per year during the period 1990–95) had been adequate to absorb the net additions to the labour supply and also to absorb a part of the backlog in unemployment. However, the absorption of the backlog of unemployed and net additions to the labour force had been achieved by spreading underemployment in many sectors.22 The agricultural sector had traditionally functioned as a reservoir that kept a part of the new entrants in low productivity tasks until they secured employment of their choice (the queuing behaviour). It appears that even other sectors such as manufacturing had taken up this role. The growth rates required to absorb employment depends on the sector in which employment is created and also on type of skill level required for the opportunities that are created. New entrants to the labour market have higher educational qualifications, a better grasp of the English language and IT skills. The type of growth that is required should cater to this sort of employment creation, that is, growth in the service sector and more advanced manufacturing sectors. Furthermore, the gap between ‘good’ and ‘bad’ jobs needs to be curbed, public sector wages and hiring methods need reconsidering as these continue to generate queuing behaviour among new entrants into the labour market and labour market regulations need to be less stringent. On the demand side, skills mismatch continues to be troublesome, particularly in the more advanced private sector. This is the challenge for Sri Lanka in its march towards economic progress.

Postscript: Employment Creation after 1994 Table 13.8 UNEMPLOYMENT TRENDS, 1994–2003 Year

1994

1995

1996

1997

1998

1999

2000

2001

Unemployment (%)

13.1

12.3

11.3

10.5

9.2

8.9

7.6

7.9

2002 2003 8.8

8.3∗

Source: DCS, Labour Force Survey (various years).

Note:

∗2003 first three quarter average.

Since 1994 certain steps have been taken by the government to address the problem of unemployment, these have had variable success, however, the key underlying problems highlighted have not been fully addressed. BOI and EPZs The Board of Investment (BOI) continues to promote investment in Sri Lanka along with export promotion zones (EPZs). The growing investment, particularly in the garment industry has resulted in significant job creation through the 1990s. Unfortunately, the BOI and EPZ jobs tend to bypass many of Sri Lanka’s regular labour laws, and therefore, they do not fall into the category of ‘good’ jobs.


275

Many of those employed in these new industries are young females without significant education levels. Therefore, whilst the BOI and EPZs continue to contribute to job creation, the main cohort of the unemployed population, viz., educated youth, are not attracted by the opportunities provided by these jobs.

Migration Migration, in search of employment, continued to increase in the 1990s. There has, in fact, been almost a 10-fold increase in outward migration, 75 per cent of which was to the Middle East. This phenomenon is not without consequence as there are significant social costs. Children are left without a maternal figure during their tender ages, divorce is prominent amongst workers who have migrated and many of the workers suffer human rights abuses in their country of work. Furthermore, many of the jobs available abroad require unskilled labour and thus do not attract educated youth that are unemployed. Education Reforms Trade reforms in Sri Lanka in 1977 were not accompanied by labour market and educational reforms. Liberalisation has expanded job opportunities in higher levels of the private sector but relatively few people are equipped with the necessary skills to handle these jobs. Education reforms in the late-1990s have intended to incorporate these skills into Sri Lanka’s workforce, skills such as competency in the English language, IT, problem solving and creativity. At the same time there has been a proliferation of vocational skills institutes of varying quality. The government in the late-1990s stepped in to modernise the system by establishing SLIIT (Sri Lanka Institute of Information Technology), providing accreditation and upgrading curricula. The returns to vocational training have seen an increase.23 Government Hiring The story of the 1980s continued in the 1990s as the government continued to play the role of employer of the last resort. Between 1988 and 1998 there has been a 50 per cent growth in government employment. The military has been one of the largest absorbers of unemployed individuals, it was estimated that in 1998, 240,000 military personnel served in the Sri Lanka armed forces. The education sector has also absorbed a large share of the workforce, for instance, in 1995, 35,000 teachers were recruited whilst in 1998 a further 12,000 joined the ranks. Thirty thousand Samurdhi Development officers were absorbed into the permanent cadre in 1998–99. In 2004, 40,000 unemployed graduates were given permanent jobs in the government sector as a solution to the youth unemployment crisis. Furthermore, the benefits of working in the public sector were increased as wages received a boost and a health insurance package for public sector workers was introduced along with improved maternal benefits. This chapter has emphasised the long term problems that result from such mass scale hiring into the public sector and by exacerbating the wedge between public sector and private sector benefits, particularly, at lower level jobs. Recent policies will increase the disparity between ‘good’ public sector jobs and ‘bad’ private sector jobs, further encouraging queuing behaviour by potential employees.24 The problem with Sri Lanka’s public sector employment continues to be that of too low wages at the highest levels making it difficult to attract and retain top professionals, whilst having relatively high wages at lower levels result in queuing

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behaviour which adds to unemployment. That said, it is also important to keep in mind political realities that face Sri Lanka. There have been two significant youth uprisings in 1971 and 1988–89 which destabilised the economy of the time. The fear of a repetition is a motivating factor for government recruitment of unemployed youth. The private sector has been slow at generating sufficient growth to absorb the growing labour force. Therefore the failure of the private sector to generate employment leaves it to the government to provide jobs. This is a second best solution until education and labour market reforms kick into full effect. However, the extent of government hiring maybe too great, it is more advisable to provide more short term productive contracts rather than enlisting a lot of people on the permanent cadre. Increased Competition The 1990s has seen Sri Lanka continue to liberalise trade. Between 1995 and 2002, Sri Lanka’s applied unweighted tariff reduced from 20 per cent to 9.4 per cent. Sri Lanka has also encouraged regional free trade by signing SAPTA and FTAs with India and Pakistan. The same applies to domestic competition as many former government monopolies have been exposed to greater competition. Examples include industries such as telecommunication, banking and petroleum. Competition in the long run is more conducive to job creation as markets are opened up to more private producers. International competition whilst creating short-run structural unemployment has the effect of long run job creation in industries where the country has a more defined comparative advantage.

Notes 1. The 20 per cent figure corresponds to the Budget Speech of 1978, 11 per cent figure corresponds to the CFS 1981–82. 2. Although migration towards these countries started around 1975, a plethora of exchange control and other restrictions during the pre-1977 period restricted large numbers of people from going abroad. 3. This is reflected by the number of enterprises paying business turnover tax, which rose from 40,000 in 1977 to 62,000 in 1982. 4. These years were chosen because of scarcity of data on sector-wise employment. 5. The use of labour-saving technology in agriculture still remains very small. Thus, it is extremely unlikely that labour was displaced because of new technology. 6. Estimates from the Minisry of Textiles indicate that out of the111,000 looms in 1977, only 81,000 remained in 1980 and by 1986 this total was further reduced to 15,000. If the figure for employment losses for 1980 is expatriated for the corresponding number of looms in 1986, the total employment losses during the 1977–86 period amount roughly to 128,000. 7. According to IDB (1980), the total number of units, excluding handlooms, operating in the unorganised sector in 1976 was roughly 14,600. If we assume half of them ceased to function by 1980 (which is an underestimate because, as already mentioned, the share of value-added contributed by small industries with fixed real assets of less than Rs 1 lakh declined from 6 per cent in 1977 to 1.2 per cent in 1980) and if we also assume that each unit had four people employed (which is also an underestimate) then the total employment losses would be roughly 30,000. 8. Although the incentives produced by liberalisation may have been an added attraction, it could be said that the redirection of foreign investment for garment industry would have occurred in any case, due to quota exhaustion in East Asian countries, and because of


9. 10.

11.

12.

13. 14.

15. 16.

17.

18.

19. 20.

21. 22. 23. 24.

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Sri Lanka’s convenient geographical location in the international transport network. The non-liberalisation factor in regard to the non-metallic industry was the public investment programme. The unofficial figure is around 100,000. This action could be considered as a measure to reduce the rigidities in the labour market (or liberalisation of labour market) and also to demonstrate the government’s commitment to new policy reforms. In fact, after 1980, trade unions were in decline as a major social force. Union power in wage-setting reduced considerably. The governemnt, from the very beginning opted to strengthen its own union—the Jathika Sevaka Sangamaya (JSS)—and weakened other traditional leftist-orietned unions so that it could push through the new reforms with less resistance from the labour market. It was only in 1986 that privatisation was seriously considered. Thus, a number of state enterprises continued to operate despite widespread inefficiencies and the resultant drain of public funds. Employment in state industries remained at high levels, averaging nearly 66,000 during 1980–84 compared to a level of 55,000 in 1975 (see UNIDO, 1986: 27 and Karunatilake, 1987: 153). Female unemployment declined by 33 per cent during 1978–79 to 1981–82, while male unemployment declined by 19 per cent during the same period. In contrast, the female unemployment rate in rural sectors remained virtually unchanged duirng this period (see CFS 1978–79 and CFS 1981–82). See Sirisena (1988: 71–72). Sri Lanka faced a massive external shock when there was a sudden inflow of migrant labour from the Middle East during the Gulf crisis in 1990–91. The number of workers that returned as a result of the Gulf crisis is put somewhere close to 125,000 (estimated from Lakshman, 1993). However, after the crisis most of them returned back to the Gulf. Interview with Amerasinghe, Employers’ Federation of Ceylon, September 1994. Anecdotal evidence suggests that the 200 garment factory scheme has had a great deal of difficulties in sustaining the employment creation. Due to the tax holidays and special incentives provided to the owners, some of the factories were established inspite of the inefficient nature of the investment. There are reports of phantom workers, poor attendance and huge losses. It seems that some of the factories have been established to capture the special benefits. Figures and studies of overseas employment do not include the estimated 400,000 Tamil refugees who have gone to the West and North America. Many are gainfully employed and remitting funds to relatives. The TEWA prevents any retrenchment on non-disciplinary grounds without the written consent of the displaced workers in firms with 15 or more personnel. Since consent typically requires generous severance pay, the TEWA is seen as a major constraint to employment creation by the private sector. See Rama (2003). ‘Broad definition of unemployment doesn’t distinguish between those looking for any job or specific jobs. Those who are looking for any job are included in the narrow definition. Unemployment falls by 75 per cent when the narrow definition is used, this is across the board and across age groups. However, unemployment does increase as education increases but not by much, thus education slightly increases queuing behaviour’—ILO (2001)—See Tables 2 and Figure 3, pp. 109–10. See Rama (2003) and ILO (2003). Disguised unemployment and under-employment are widespread in the agriculture and services (especially, wholesale and retail trade sub-sectors) in Sri Lanka. World Bank (2004). See World Bank (1999).

278


References Athukorala, P. (1995), ‘Foreign Direct Investment and Manufacturing for Export in a New Exporting Country: The Case of Sri Lanka’, The World Economy. Central Bank of Sri Lanka (various years), Annual Report, Colombo (referred to as CBSL in all places in the text except in tables). Department of Census and Statistics (1981), Report on the Survey on Manufacturing Industries in Sri Lanka, Colombo. ——— (1987), Labour Force and Socio-Economic Survey 1985/86, Department of Census and Statistics, Colombo. DCS (various years), Quarterly Reports of the Sri Lanka Labour Force Survey, Department of Census and Statistics (DCS), Colombo. Gooneratne, W. and D. Wesumperuma (1984), ‘Plantation Agriculture in Sri Lanka—An Overview of Employment and Development Prospects’, in W. Gooneratne and D. Wesumperuma (eds), Plantation Agriculture in Sri Lanka, ARTEP, ILO, Bangkok. Gunatilleke, G. (1986), The Extent and Nature of the Structural Mismatch in the Domestic Labour Market, Research Studies, Employment Series No. 10, Institute of Policy Studies, Colombo. ILO (2001), Towards an Employment Strategy Framework—Country Profile: Sri Lanka, CEPR Unit, Employment Strategy Department, ILO, Geneva. Industrial Development Board (1980), ‘A Study on the Effects of Liberalisation of Imports on Local Industries’, Unpublished Working Paper, Colombo (referred to as IDB [1980] in the text). IPS (various years), Sri Lanka: Sate of the Economy, Institute of Policy Studies (IPS), Colombo. Jayanntha, D. (1988), ‘An Assessment of the Accelerated Mahaweli Development Programme’, Sri Lanka Economic Journal, Vol. 3, No. 2. Karunatilake, H.N.S. (1987), The Economy of Sri Lanka, Centre for Demographic and SocioEconomic Studies, Colombo. Kelegama, S. (1988), ‘The Speed and Stages of a Trade Liberalisation Strategy: The Case of Sri Lanka’, Marga Quarterly Journal, Vol. 10, No. 1. Kelegama, S. and Wignaraja (1992), ‘Labour Absorption in Industries; Some Observations from the Post-liberalisation Experience of Sri Lanka’, Industry and Development, No. 31, UNIDO, Vienna. Kelly, T. (1994), ‘Trends and Outlook for Sri Lanka Labour Markets’, Human Resource Development Review, 1992/93, HRD Council, Colombo. Korale, R.B.M. (1986), ‘Employment Trends’, Sri Lanka Economic Journal, Vol. 1, No. 1 ——— (1988), ‘Sri Lanka in the Year 2015: Demographic Trends and Projections’, Sri Lanka Economic Journal, Vol. 3, No. 2. ——— (1992), A Statistical Overview of Employment and Unemployment Trends, Research Studies: Employment Series No. 5, Institute of Policy Studies, Sri Lanka. Lakshman, W.D. (1993), ‘The Gulf Crisis of 90–91: Economic Impact and Policy Response in Sri Lanka’, in P. Wickremasekera (ed.), The Gulf Crisis and South Asia: Studies on Economic Impact, ILO, ARTEP, New Delhi. Marga (1986), Migrant Workers to the Arab World, Marga Institute, Colombo. Ministry of Finance and Planning (1988), Field Survey of Projects Approved by the Foreign Investment Advisory Committee, 1977–87, International Economic Co-operation, Division, Colombo. Ministry of Plan Implementation (1985), Foreign Employment: Sri Lanka Experience, Colombo. Prywes, M. (1995), ‘Unemployment in Sri Lanka: Sources and Solutions’, World Bank, Washington, D.C. (mimeo). Rama, M. (2003), ‘The Sri Lankan Unemployment Problem Revisited’, Review of Development Economics, Vol. 7, No. 3. Rodrigo, C. (1991), ‘Overseas Migration: Magnitude, Patterns and Trends’ (mimeo).


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Rodrigo, C. (1994), ‘Background Paper on Expansion of Productive Employment in Sri Lanka’, Paper prepared for the World Summit for Social Development, Denmark. Rodrigo, C. and R.A. Jayatissa (1989), ‘Maximising Benefits from Labour Migration: Sri Lanka’, in R. Amjad (ed.), To the Gulf and Back: Studies on the Economic Impact of Asian Labour Migration, UNDP and ARTEP, ILO, New Delhi. Sanderatne, N. (1985), ‘The Effects of Policies on Real Income and Employment in UNICEF (ed.), Sri Lanka: The Social Impact of Economic Policies during the Last Decade, Colombo. Sirisena, N.L. (1988), ‘The Impact of Trade Liberalisation and Industrial Energy Pricing Policy on the Manufacturing Sector in Sri Lanka’, Sri Lanka Economic Journal, Vol. 3, No. 1. Statistics Department, Central Bank of Ceylon (1982), Report on Consumer Finances and SocioEconomic Survey 1978/79, Sri Lanka, Parts I and II, Colombo (referred to as CFS 1978/79 in the text). ——— (1984), Report on Consumer Finances and Socio Economic Survey 1981/82, Sri Lanka, Parts I and II, Colombo (referred to as CFS 1981/82 in the text). Stern, J.J. (1984), ‘Liberalization in Sri Lanka: A Preliminary Assessment’, Harvard Institute of International Development, Cambridge, Mass. (mimeo). UNIDO (1986), Industrial Development Review Series: Sri Lanka, Regional and Country Studies Branch, Division for Industries, UNIDO, Vienna. Waidyanatha, W.G.S. (1980), ‘Textile Industry in Sri Lanka’, Economic Review, Vol. 6, No. 2, People’s Bank, Colombo. World Bank (1999), Sri Lanka: A Fresh Look at Unemployment, Poverty Reduction and Economic Mangement Unit, South Asia Region, World Bank, Washington, D.C. ——— (2004), Sri Lanka: Development Policy Review, Poverty Reduction and Economic Mangement Unit, South Asia Region, World Bank, Washington, D.C.

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14 THE POVERTY SITUATION AND POLICY

Introduction Since its Independence, Sri Lanka has shown impressive progress in reducing the level of poverty, reflected in terms of improvements in human development indicators as well as consumption. Two general factors contributed to this progress: (a) a satisfactory long-term growth performance, with real per capita GDP growth of about 2.5 per cent per year on average during the last five decades; and (b) satisfactory provision of basic health and education, together with either food subsidies or income transfers that made higher consumption by the poor possible. Sri Lanka is well known as an exception among developing countries for its achievements in human development indicators (see, for instance, Table 14.1). However, the country still remains a low-income country. Although, Sri Lanka’s long-term growth compares favourably with developing countries, it falls short of the growth achieved during the last 50 years by the high-performing East Asian economies such as Republic of Korea, Malaysia and Thailand. This was partly due to policy mismanagement and the ongoing civil war that has now continued for 17 years. It was also a case of missed opportunities (Chapter One). In Sri Lankan policy, it has been a tradition to put efforts to reduce poverty at the top of the government agenda. It was one of the first developing countries, by accident or by design, to understand the multidimensional nature of poverty and

THE POVERTY SITUATION AND POLICY

281

Table 14.1 SOCIAL INDICATORS: SRI LANKA AND SELECTED ASIAN COUNTRIES Indicators

Sri Lanka Bangladesh India

Populations, mid-year (millions) 1998 Population—average annual growth, 1992–98 (%) GNP per capita (USD), 1998 GNP growth rate (1988–98) Life expectancy at birth (years) Infant mortality (per 1,000 live births) Child malnutrition (% of children under 5) Access to safe water (% of population) Access to sanitation (% of population) Illiteracy (% of population age 15+) Gross primary enrolment (% of school age population) Male Female Urban population (% of total population) Expenditure on health and education Per capita expenditure on defence (USD, 1997 prices)

Pakistan

Malaysia Thailand

18.8

125.6

979.7

131.6

22.2

61.1

1.3 810 5 73

1.6 350 4.8 61

1.7 440 5.6 63

2.5 480 4.5 62

2.5 3,600 7.8 72

1.1 2,200 6.9 69

14

57

70

95

11

33

38

68

53

38

20

NA

70

84

81

62

89

89

63 9

48 47

29 44

47 59

94 14

96 5

109 110 108

96 93 100

100 109 90

74 101 45

102 101 103

87 – –

23 48 31.0

20 3.8

28 3.8

36 3.6

– –

21 –

5.0

14.0

28.0

–

–

Source: World Bank (2000). Notes: Most recent estimate (latest year available, 1992–98) for indicators 5–12.

to strongly emphasise policies of free health and education as early as the 1930s. In addition to its achievements in social indicators, Sri Lanka managed to completely eradicate starvation and destitution. Despite these achievements, between one-fifth and one-third of the population remains poor, depending on the poverty line used (Table 14.2). A much deeper reduction in poverty would have been possible with stronger economic performance. One reason for the lack of good economic performance—the social welfare programmes themselves, which created problems for economic management. Sri Lanka went through all three stages of demographic transition in a relatively short period of 50–70 years, thanks to the social welfare programmes. The second stage of demographic transition led to a population explosion that the economic growth process simply could not accommodate and cater to (Sanderatne, 2000). For example, the population below 20 years constituted 50 per cent of the population in the early 1970s and the economy at prevailing rates of growth could not offer employment opportunities to these youth, resulting in socio-political disruptions. Some Asian countries too faced such demographic transitions, but these were of a different nature (ADB, 1997).

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Table 14.2 CONSUMPTION POVERTY IN SRI LANKA BY SECTOR (1985–86, 1990–91 AND 1995–96) Incidence of Poverty (%) Lower Poverty Line 1985–86

Higher Poverty Line

1990–91

1995–96 21 23 12 12

Sri Lanka Rural sector Urban sector Estate sector

27 32 16 14

22 24 18 13

Sri Lanka Rural sector Urban sector Estate sector

7 8 3 4

5 5 4 2

1985–86 41 45 27 31

1990–91

1995–96

35 38 28 28

33 35 21 27

9 10 7 5

8 9 5 5

Depth of Poverty (%) 4 5 2 2

11 13 7 8

Source: All estimates based on data for the first quarter from the Household Income and Expenditure Surveys of 1985–86 and 1995–96, Central Bank of Sri Lanka. Notes: Estimates based on consumption needs. Lower poverty line denotes minimum expenditure necessary to reach minimum nutrition requirements and minimum level of clothing and footwear. This was calculated as Rs 471.20 per person per month in 1985–86 and in 1990–91 at 1990–91 Sri Lanka prices, and Rs 717.09 per person per month in 1995–96. Higher poverty line denotes minimum consumption necessary to achieve a decent standard of living and includes a small amount of discretionary expenditure over essentials such as food, clothing, housing, transport, communications and health expenses. The higher poverty line was Rs 565.44 per person per month in 1985–86 and 1990–91 at 1990–91 Sri Lanka prices and Rs 860.51 per person per month in 1995–96.

After experimenting with an inward-looking strategy for nearly two decades, Sri Lanka embarked on an economic liberalisation exercise in 1977. The historical bias in policy that favoured social infrastructure at the expense of physical infrastructure underwent a change. There was also a shift in emphasis from universal food subsidies to targeted income transfer programmes and interventions aimed at assisting the poor to participate in the growth process. Since the mid-1980s, the relationships between the overall economic performance and reduction of poverty have preoccupied policy makers. And since the late-1990s, rural poverty alleviation has become a major plank in Sri Lanka’s development policy framework.

Poverty Profile of Sri Lanka People fall below the poverty line because stocks of productive assets owned by them, given the prevailing returns to the assets and the availability and cost of publicly-provided goods and services, are insufficient to enable them to attain a minimum acceptable standard of living. Thus, it is essential to have a broad look at several areas that influence poverty directly as well as indirectly. As stated, Sri Lanka experienced a tragic civil war in the North-Eastern provinces for


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over 20 years, so much so that its per capita defence expenditure was higher than in the neighbouring countries (Table 14.1). Due to the disruption created by the war, the data from these two provinces are highly questionable. Thus, the rest of the chapter excludes these two provinces in the analysis. Although, poverty in Sri Lanka has been subject to debate for many years, there is no clearly defined poverty line. There is no officially designated poverty line that is applicable across all sectors (see, for instance, Tudawe, 2000). This is a major problem in obtaining information on changes in poverty status in the country (Dutt and Gunawardena, 1995). Poverty is observed to be greatest in the rural sector and least in the estate (mainly, tea and rubber plantation areas where most of the Indian Tamil community works) sector, with the urban sector in the intermediate position in the early 1990s, but equalling the position of the estate sector in the mid-1990s (according to the lower poverty line; Table 14.2). The shares of the rural, urban and estate sectors in total number of poor are 79, 17 and 4 per cent respectively, compared with their respective population shares of 72, 21 and 7 per cent (ibid.). The rural sector accounts for approximately four-fifths of aggregate poverty. Rural poverty appears to have declined much more slowly than urban poverty during the early to mid-1990s (Table 14.2). According to Dutt and Gunawardena (ibid.), this proportion is largely invariant over different poverty measures and poverty lines. A little less than half the poor depend on agriculture for their livelihood, while another 30 per cent depend on other rural non-agriculture activity. Within a region rural poverty is generally higher than urban poverty. Over the late-1980s, there was a considerable narrowing of rural–urban poverty differentials within regions. Sri Lankan poverty varies on the basis of regions: Western vs. other provinces (Table 14.3); sectors: urban vs. rural (Table 14.2); agriculture vs. nonagriculture, etc. Regional disparity, particularly between the economically dynamic Western province and the rest (Table 14.4) and between urban and rural sectors, continues to concern policy makers. Table 14.3 GDP GROWTH AND POVERTY INCIDENCE BY REGION

Province North-Central Western Southern Sabaragamuwa Central Eastern North-Western Uva Northern

Annual Average Growth, 1990–95 (%) 9.9 6.4 6.1 5.3 5.0 5.0 4.3 3.5 –6.2

Source: World Bank (2000).

Poverty Incidence (%)

Poverty Ranking

Growth Ranking

1990–91

1995–96

1990–91

1995–96

1 2 3 4 5 5 6 7 8

18.2 15.2 23.7 23.1 23.5 NA 18.0 23.7 NA

31.2 13.6 26.5 31.6 27.9 NA 33.9 37.0 NA

3 1 6 4 5 NA 2 7 NA

4 1 2 5 3 NA 6 7 NA

4.7 3.9 2.6 2.0 1.3 1.0 1.1

Source: World Bank (2000).

Western Central Southern North-Western North-Central Uva Sabaragamuwa

Density

1,174 385 389 51 94 122 332

13.6 27.9 26.5 33.9 31.2 37.0 31.6

Population Population Density Income 1994 per Sq. Km Poverty (Millions) (1991) Incidence

0.09 0.10 0.07 0.09 0.15 0.10 0.07

Deaths before Age 40 6.2 15.3 11.2 8.1 9.6 17.1 11.2

Adult Illiteracy 18.2 26.1 35.0 34.6 48.0 44.6 32.1

No Access to Safe Water 14.4 13.8 10.4 3.8 2.1 12.3 12.0

3.0 21.5 8.6 12.8 20.0 36.1 16.9

35.3 65.0 59.2 68.7 72.2 73.5 74.4

11.2 24.4 20.3 30.3 31.7 34.1 22.7

19 40 37 42 56 57 57

1.89 3.60 2.50 5.80 8.84 4.58 3.58

Road No access (km/100 to Hygienic population) Children Births No Access Toilet Rural not Fully not in No Access to Safe Facilities Roads Immunised Institutions to Electricity Sanitation (1994) (1995)

Table 14.4 INCOME AND HUMAN POVERTY BY PROVINCE (PERCENTAGE OF POPULATION)



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Despite reducing poverty from 27 per cent of the population in the mid-1980s to 21 per cent by the mid-1990s, the experience during 1990–95 was not very impressive. As Table 14.2 shows, poverty declined very little between 1990–91 and 1995–96: from 22 to 21 per cent of the population. Some have argued that the year 1995–96 should be excluded from poverty trend analyses in Sri Lanka because it happened to be a drought year. However, the slow progress in consumption–poverty reduction was striking in the backdrop of relatively faster GDP growth (average 5 per cent) during the first half of the 1990s. Per capita GDP growth was in the order of 3 per cent per year between 1990 and 1995/96. According to various surveys, many of the poor experienced an increase in poverty. The slow decline in poverty during 1990–91 to 1995–96 is puzzling in the light of these facts: (a) economic growth recorded an average 5 per cent; (b) unemployment declined from 17 per cent in 1990 to 11 per cent in 1996; (c) private remittances doubled; and (d) expenditure on education and health was maintained despite escalation of defence outlays. What explains the modest decline in poverty? Poverty is highest (32 per cent) in households that derive their income from agriculture: 38 per cent of the Sri Lankan labour force is still engaged in the agriculture sector. Slow growth in agriculture was perhaps the main determinant of slow poverty reduction during 1990–96. Agriculture grew by only 1 per cent during 1990–96. The restructuring of estates in the early stages of privatisation, low paddy production and other factors contributed to poverty in the estates and rural areas. Availability of two data points calls for caution in interpreting the trends. Even so, the slow decline in poverty during the first five years of the 1990s shows that the poor remain highly vulnerable to income shocks and were unable to take advantage of the opportunities generated by high growth in the early 1990s. The favourable impact of economic growth on consumption–poverty may be reduced if there is a contemporaneous increase in income inequality. Some rise in inequality in the process of rapid economic growth is, however, unavoidable, as the classic Kuznets income–inequality relationship would imply (inverted-U hypothesis). A sharp rise in inequality in the early 1980s is thus, understandable in the context of rapid economic growth and structural change (Kelegama, 1993 and Table 14.5). However, the Sri Lankan experience in the context of 5 per cent average growth during the 1990s shows little decline in inequality. Note that the Gini index of income (expenditure) distribution as a measure of relative income (expenditure) inequality did not vary much (Table 14.6). Sri Lanka has not achieved high growth rates like China to compensate for the increase in income inequality. Also, as Ravallion (1997) has argued, initial inequality matters and this could dampen the impact of economic growth on poverty alleviation. To summarise, first, consumption poverty remains high in Sri Lanka and it is primarily a rural phenomenon. Second, there was slow progress in poverty reduction in the first half of the 1990s and also greater volatility in poverty levels. Third, there are acute regional disparities in poverty.

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Development Under Stress: Sri Lankan Economy in Transition Table 14.5 INCOME SHARES SPENDING UNITS

Category

1978–79

1981–82

1986–87

1996–97

Bottom 40 Top 20

16.6 48.9

15.2 52.0

14.1 52.3

14.6 51.6

Source: Based on Dunham and Jayasuriya (1998).

Table 14.6 GINI COEFFICIENT

Income receivers Spending units

1953

1963

1973

1978–79

1981–86

1986–87

1996–97

0.50 0.46

0.49 0.45

0.41 0.35

0.50 0.44

0.52 0.45

0.52 0.46

0.50 0.45

Source: Central Bank of Sri Lanka, Consumer Finances and Socio-Economic Surveys. Note: Preliminary estimates (Round 1).

Poverty Strategy in Sri Lanka Poverty Alleviation Programme—Samurdhi The food subsidy programme, centred on free or concessional rice and applied universally across the population, was the main poverty support system in Sri Lanka until 1977. This programme was dismantled and a targeted food stamp programme was introduced in the late-1970s. However, this programme suffered from various shortcomings (Herse et al., 1989) and there were indications of poverty increasing and income inequality worsening by the mid-1980s (UNICEF, 1985). A high-level Poverty Committee that was appointed in 1988 made several recommendations to arrest the situation. Consequent to this report, a targeted safety net programme called Janasaviya came into operation. It was an income–transfer programme that was designed to supplement the growth process (Lakshman, 1997). The programme also had a credit-based entrepreneurial development dimension (see World Bank, 1995). There were various add-ons such as the free midday meal programme, free school textbooks, etc., that complemented the Janasaviya programme (see Table 14.7). In 1995, a more ambitious programme called Samurdhi replaced the Janasaviya programme. There were a number of differences between the two programmes, especially in terms coverage (see Dissanayaka, 1995). The programme is basically an income transfer to the poor to help them get out of their poverty trap. It covers 55 per cent of the population by targeting 2 million households. The allocation for the programme (1998) amounted to 1.3 per cent of GDP and 3.6 per cent of government expenditure. As can be seen in Table 14.7, the poverty–focused programmes accounted for nearly 2 per cent of GDP in 1997. The Samurdhi programme has three components. The first is a welfare grant to poor households to purchase essential commodities; the grant acts both as


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Table 14.7 WELFARE AND SOCIAL INFRASTRUCTURE EXPENDITURES (SL Rs million) Type of Programme Poverty-focused programmes 1. Samurdhi 2. NDTF 3. IRDP 4. Public assistance 5. Food stamps 6. Kerosene stamps 7. Infant milk subsidy 8. Triposha 9. Midday meals (school children) 10. School textbooks and season tickets 11. School uniforms 12. Emergency food (refugees) Other programmes 13. Wheat flour subsidy 14. Fertiliser subsidy 15. Public health services 16. Public education services Poverty-focused programmes and transfers as % of GDP (items 1–12) Poverty-focused plus other social welfare expenditures as % of GDP (items 1–16)

1996 (Actual)

1997 (Provisional)

7,340 510 1,092 240 831 228 70 250 0 816 1,157 3,185

9,040 250 1,375 240 0 0 132 264 0 950 1,100 3,077

7,500 1,500 12,028 15,911

0 1,500 16,338 17,959

2.0

1.9

6.9

5.9

Source: Central Bank of Sri Lanka, Annual Report (various years). Notes: NDTF = National Development Trust Fund; IRDP = Integrated Rural Development Programme; GDP = Gross Domestic Product.

a consumption subsidy and a nutrition supplement. In 1998, 80 per cent of the Samurdhi expenditure was allocated for this grant. The grant amounts to Rs 100– 1,000 (USD 1.00–11.80) per household per month depending on its level of poverty and demographic composition. The second component comprises of the savings, credit, insurance and social security schemes that improve access to finance for households. The credit is used for microenterprise launch and income-generating activities. It is basically intended to expand the productive assets available to the poor. The credit is obtained from Samurdhi banks and Samurdhi Bank societies holding deposits of Rs 400 million (USD 4.7 million) and Rs 230 million (USD 2.7 million), respectively. The third component is a community infrastructure development programme where irrigation, roads and water supply projects, among others, are undertaken by the community. Some 11,000 such projects have been implemented at the cost of Rs 560 million (USD 6.6 million) and have generated nearly 37,000 jobs for youth. This increases incomes among households and reduces political unrest. The Samurdhi programme is overseen at the grass-roots level by 36,000 Samurdhi animators working under 1,500 Samurdhi managers. The administrative cost was 10 per cent of the Samurdhi budget in 1998.

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Employment Creation and the Labour Market In general, the strategy for poverty reduction is equated by such institutions as the World Bank with employment generation and the economic growth process. The general consensus is that to absorb the annual addition of about 160,000 to the Sri Lankan labour force, the economy should grow by at least 8 per cent. The economy has grown at an average rate of 5 per cent during the 1990s and is, therefore, not in a position to absorb all the labour that enters the market. Overseas migration and self-employment have been two major sources of employment generation and this had helped decrease unemployment from about 16 per cent in 1990 to 11 per cent in 1999. The usual link between poverty and unemployment exists in Sri Lanka (Dutt and Gunawardena, 1995). The unemployment rate declined from about 25 per cent for the poorest group (below 80 per cent of the poverty line) to 5.5 per cent for the richest (above 400 per cent of the poverty line) (World Bank, 1995: 27). But the link is not obvious and there are unemployed people who are not necessarily poor, while there are employed people who are poor (ADB, 1998: 23). Unemployment is to be found sometimes with the better educated and the less poor, mainly in the rural areas. Female unemployment continues to be twice the rate amongst men, and there has been an increase in the number of women involved in unpaid work. The 5 per cent growth rate could have absorbed more labour if not for structural problems in the economic system. Based on structural factors, there are three explanations that have been provided to explain the unemployment problem in Sri Lanka: the ‘skills mismatch’ hypothesis, the queuing hypothesis and the labour market rigidities hypothesis. The ‘skills mismatch’ hypothesis argues that Sri Lanka’s education system produces skills that are not valued by employers, even while they raise the expectations of those who acquire them. As a result, the unemployed are not interested in existing job vacancies, and employers are not willing to fill the vacancies with available candidates. Thus, it is suggested that there should be educational reform with emphasis on vocational training geared to the needs of the labour market. The queuing hypothesis is linked to public sector employment and pay policies. At the lower level of the public sector in Sri Lanka, payments and fringe benefits are higher than in the private sector. Hence, new entrants to the labour market have an incentive to wait for such attractive job openings in the public sector, with the majority choosing to remain inactive instead of taking available jobs outside the public sector. Since the government recruits people to the public sector to reduce unemployment, job-seekers wait for their opportunity. The waiting period is facilitated by remittances and income transfers to rural households. It is suggested that the public sector recruitment and pay policies should be reformed to discourage ‘queuing’. Rigidities in the labour market have prevented the poor from reaping the benefits of the economic growth process. In other words, the rigid laws governing the labour market have been identified as an impediment to employment creation. It is argued that due to these laws, low-quality jobs are created because there is evidence that


289

casual labour, sub-contracting, fixed period consultancies, etc., are on the increase (CBSL, 1999). Furthermore, it is argued that these laws discourage firms from restructuring and future expansion. Many youth employed in the informal sector look for jobs in the formal sector. It is suggested that less rigid labour legislation would facilitate labour mobility and reduce the wedge between protected and unprotected jobs. The government acknowledges that to reduce the unemployment rate significantly there is a need to create good jobs (such as those in the regulated sector) faster than the labour force grows, by improving the flexibility of the labour market. However, political economy considerations go hand-in-hand with such good intentions, thus, diluting any reform efforts.

Irrigation and Land Settlement Policies Since Independence in 1948, irrigation and land settlement were used for poverty alleviation purposes. Due to historical reasons, land settlement schemes centred on irrigation schemes were regarded as the best way to restore the country’s past prosperity. The poor living in rural agricultural areas face a scarcity of land, small-sized land holdings and lack of adequate water. Since Independence, various governments have designed policies to make fresh land available for cultivation and to assist farmers to settle in new, cultivable areas. Irrigation and land settlement policies may have contributed to poverty alleviation among the rural agrarian poor (Sanderatne, 2000). The land to man ratio worsened, despite a significant decline in forest cover in the country since Independence. The agricultural land per family fell to 1.9 acres in 1982. The Accelerated Mahaweli Development Programme resulted in the award of slightly larger allotments to assist the poor. The shortage of new land has had an adverse impact on poverty in the rural sector, with the average land holding falling below commercially viable levels. Roughly 67 per cent of the land holdings in Sri Lanka are less than two hectares. As the size of agricultural plots decrease, rural farmers become more risk averse, relying more on low-risk, low-yield crops such as paddy. Lately, many rural households have increasingly become more dependent on transfers and remittances from family members working in urban areas or abroad. Land distributed by the government under various protected tenure arrangements such as land settlement schemes, colonisation schemes and village expansion schemes do not contain freehold rights. Freehold rights were not granted, based on the thinking that if granted free-hold, indebted farmers may sell the land and such sales of land could increase landlessness and poverty. This policy encouraged rural small-holder agriculture and restricted the transfer of cultivable land. The World Bank (1995) argues that the lack of freehold decreases investment efforts by farmers, as they do not fully own the properties and it intensifies uneconomical land fragmentation by preventing farmers from selling their land and moving to other activities. The pros and cons of these arguments are currently being analysed by the government.

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Social Welfare Expenditure After liberalisation in 1977, expenditure on all social services as a percentage of GDP fell from 9 per cent during 1970–77 to 5.5 per cent during 1981–85 and remained at 6 per cent of the GDP during 1986–90 (Table 14.8). This reduction in overall expenditure in social welfare was reflected in the performance quality of both the health and education sectors. In the 1990s, there was once again an increase in social welfare expenditure to 9.3 per cent of GDP (1991–95 average). World Bank (1995: 27) estimates that health and personal care account for 3 per cent of total expenditure of the poor, while education accounts for a little over 1 per cent. Public Expenditure on Health As Table 14.8 indicates, total expenditure on health declined from 1.5 per cent of GDP during 1971–75 to around 1 per cent of GDP during 1981–85, but remained around 1.5 per cent of GDP from 1986–95. In the late-1990s, public expenditure on health remained at 1.5 per cent of GDP and 5.7 per cent of total government expenditure. Approximately 3 million in-patient days and 35 million out-patient visits a year are provided by 550 government hospitals with 55,000 beds and 380 central dispensaries in the country. As is well known, the Sri Lankan government offers universal free health care, which has made a significant contribution to improving health among the poor. However, the overall health environment in the country is relatively weak. The prevalence of malnutrition, lack of access to safe water, poor sanitary conditions and disease outbreaks are common (see Table 14.4). Although, the number of nurses increased from 9,000 in 1991 to 16,699 in 1997 and doctors from 2,900 to 5,300 during the same period, there are problems of quality—there is a shortage of qualified medical specialists and trained nurses. In rural areas, where a high proportion of the poor live, the scarcity is felt more. Moreover, there is congestion in government hospitals; standards of hygiene are low and maintenance of facilities is poor. Only 30 per cent of government health expenditure reaches the poorest 2 per cent (Rannan-Eliya and De Mel, 1997). Sri Lanka’s health sector needs qualitative Table 14.8 SOCIAL DEVELOPMENT EXPENDITURE IN FIVE-YEAR PERIODS AS A PERCENTAGE OF GDP 1951–55 1956–60 1961–65 1966–70 1971–75 1976–80 1981–85 1986–90 1991–95 Social development expenditure Food security Education Health Other social Services

7.1 2.4 NS NA

8.1 2.1 3.3 2.0

10.5 3.7 4.0 2.0

9.0 2.7 3.6 1.8

9.9 4.3 2.9 1.5

9.1 3.4 2.3 1.2

5.5 0.2 1.9 1.0

6.0 1.1 2.6 1.6

9.3 0.9 2.8 1.5

0

0

0.1

0.2

0.2

0.2

0.1

1.9

4.1

Source: CBSL, Annual Reports, 1950–95.


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improvement. Environmental health also needs improvement. There is a chance to improve the quality of Sri Lankan health services as explained later in the text. Public Expenditure on Education As Table 14.8 indicates, expenditure on education, which declined from 2.9 per cent of GDP during 1970–75 to 1.9 per cent during 1981–85, once again increased to 2.8 per cent during 1990–95. Primary education is offered free. Every village in the country has, at least, a primary school. Total enrolment in education was 4.1 million, of whom 50 per cent were females. It has been estimated that the poor attain approximately seven years of education (Dutt and Gunawardena, 1995). The government makes special efforts to attract poor children to schools by offering free school textbooks and uniforms (each child is entitled to one set of uniforms a year). The long-term impact of investment in education on poverty reduction depends on its effectiveness on enhancing human capital formation and labour productivity. Here, again, the low quality of education has nullified the efficiency impact of educational investment. Rates of return at the primary end of education are low (Athurupana, 1997). Overall government expenditure on education has made an important contribution to enhancing welfare. However, the quality of education is questionable. Athurupana (ibid.) shows that there is a willingness to pay for high-quality education. But for quite some time, the government has not provided a favourable environment for the establishment of new private schools and universities. However, there seems to have been a revision of this attitude in 2000, when there were attempts to relax regulations with regard to private sector participation in the education sector (Sunday Leader, 2001).

Problems in the Poverty Strategy Several studies have shown that the rate of rural poverty reduction is strongly influenced by the rate of agricultural growth. There has been a general decline in agricultural growth in Sri Lanka. The slow growth was coupled with a decline in real wages in the agriculture sector. According to Dunham and Edwards (1997) the poverty situation in rural areas would have been further aggravated if not for the following income transfers to the rural areas: (a) transfer of remittances from Middle East migrants, (b) income transfers from armed forces engaged in the North and East of Sri Lanka, and (c) income transfers from rural young females employed in the garment factories located mainly in the western province. The average per capita inflows of remittances and transfers as a percentage of the World Bank Poverty Line increased from 31 per cent in 1985 to 65 per cent in 1997 (Dunham and Jayasuriya, 1998). All these incomes are somewhat unstable. This has become a concern for policy makers, particularly when there is stagnation in the agriculture sector. The problem of poverty in Sri Lanka is thus multidimensional. The problems in the existing strategies are identified and discussed here.

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Politicisation of Targeted Poverty Programmes All poverty alleviation programmes put into operation by the state since 1989 became highly politicised at the implementation stage. This politicisation has resulted in two flaws in the programmes that, in turn, have curbed their effectiveness. These are political bias governing the programme and poor allocative efficiency (World Bank, 2000). Genuine poverty alleviation programmes have been diluted into vehicles of political patronage at the grass-roots level. The current poverty alleviation programme (Samurdhi) has utilised an extensive network of administrators for identifying beneficiaries and this process has had a political dimension. The Samurdhi programme has a network of 20,000 Samurdhi development officers and 10,000 Govi Niyamakas (Animators of Farmer Organisations) in charge of identifying beneficiaries. Party affiliation influences the allocation of income transfers to the beneficiaries. All new evidence from the international literature on poverty alleviation clearly shows that for poverty programmes to be most effective in reaching the poor, the poor themselves should participate actively and freely in the political process. Poor allocation of resources is another problem. Several different classes of criteria are being used to target the poor. These are: (a) those based on indicators of household income; (b) those based on indicators derived from correlates of poverty (such as landlessness, lack of regular employment, poor nutrition and impermanent or semi-permanent housing); (c) special groups-based criteria (such as female-headed or single-headed households); and (d ) criteria that are area- or region-based, considering a geographic area’s weak infrastructure facilities and large concentration of poor people. These indicators have been used either singly or in combination with each other to varying degrees of effectiveness in terms of the ‘E’ and ‘F’ errors that have occurred (Gunatilaka, 1997: 15). The Household Expenditure and Income Survey (HEIS) 1995–96 showed that transfers from poverty programmes reached 66 per cent of households in the poorest decile and 14 per cent of households in the top three deciles. The Sri Lanka Integrated Survey revealed that only 60 per cent of households in the lowest expenditure quintile receive Samurdhi transfers. Gunatilaka and Salih (1999) have argued that Samurdhi’s group savings and intragroup credit component and the Samurdhi Bank programme are functioning as vital sources of emergency credit for Samurdhi beneficiaries. However, programme sustainability is heavily reliant on the income transfer component. They also find that the micro-enterprise credit component has failed in its objective of promoting the poor to a higher income growth path. The high rate of default makes the micro-enterprise development credit programme completely unsustainable in the long run.

Problems of the Rural Development Programmes The pattern of distribution of growth is crucial in fathoming whether economic growth translates into an equivalent reduction in poverty (UNDP, 1997). The


293

regional imbalance in growth is also visible. Compared to the western province, the other provinces did not show any decline in poverty between 1990 and 1996 (Gunawardena, 2000; see also Table 14.3 of the book). Current poverty analysis is looking into the role of several structural factors such as assets, human capital, credit and financial markets, existence of income-earning opportunities, etc., which could explain persistent poverty in some regions (GOSL, 2000). Preliminary surveys show that the regional imbalance in growth and poverty reduction are due to both the dependence on agriculture and the inadequate availability of infrastructure facilities in rural areas. The promotion of off-farm employment for poverty reduction is also an issue in Sri Lanka. The current state of agricultural growth and the lack of technological modernisation in the sector imply that the poor have to be absorbed by off-farm activities. The major impediment to creating off-farm employment in rural areas is the lack of proper infrastructure. Some statistics to reveal this situation may prove useful. Only 44 per cent of households had access to electricity in 1994 and in some areas only 30 per cent benefited from it. Less than 15 per cent of the rural population has access to telecommunication services or subpost offices (ibid.). Capital grants provided to the provinces for the purpose of alleviating regional disparities have remained at less than 0.2 per cent of GDP over the years. This partly explains why growth has not trickled down to the countryside, while urban poverty levels, by contrast, have fallen. The question could be posed whether rural development programmes could be effective in poverty alleviation. Take, for instance, Integrated Rural Development Programmes (IRDPs). Gunatilaka and Williams (1999) argue that these programmes typically benefited the non-poor who had other inputs such as irrigable land that could benefit from such projects. The study further shows that access to infrastructural facilities are most often denied due to the quasi-public nature of many such assets. ‘Given the unequal power relations that typify rural communities, the local elite is usually well-placed to capture decision making about development projects, frequently working through decentralised structures of Government themselves, and the poor are often unable to challenge the established social organisation and hierarchy’ (Gunatilaka, 2000: 120). Poverty alleviation strategies that try to encourage the development of micro-enterprises in rural areas may actually spawn only survival strategies as rural producers are unable to access larger, higherincome markets due to high transport costs (Gunatilaka and Williams, 1999). Under the 13th Amendment to the Sri Lankan Constitution in 1987, decentralisation of finance was supposed to come into operation and poverty programmes were supposed to be decentralised. But delivery of poverty programmes remained under the Central government’s control. Policy makers and aid providers have become increasingly convinced that local governments may be better able to develop rural areas, increase inter-regional equity and reduce poverty. Reducing poverty through fiscal decentralisation and thereby, promoting rural infrastructure development and other development has received emphasis in recent years. Gunatilaka (2000) argues that whether local governments provide efficient public services depends on both their capacities and the extent to which they are accountable and transparent in their activities. Whether financial resources really reach or

294


benefit the poor depends on factors such as the initial endowment of complementary resources among the poor themselves, the quasi-public nature of assets and the ability of the non-poor to capture the decision-making process. Gunatilaka (2000) also argues that rural development policies, with or without fiscal decentralisation, can reduce rural poverty and urban–rural differences only marginally, when implemented alongside macroeconomic policies that favour the dynamic forces of urban agglomeration. Contrary to conventional wisdom, rural poverty reduction may actually need policies that favour planned urbanisation in line with centripetal forces, and higher rates of rural–urban migration that ease the pressure on agricultural holdings, making them more viable for those who remain in rural areas. The rural development paradigm as currently conceived is fundamentally flawed. Agglomeration forces unleashed by economic liberalisation policies alongside equity-oriented rural development policies may have reinforced urban–rural differentials in Sri Lanka, perpetuated dualism, encouraged low agricultural productivity and helped transform the rural economy into a remittance and transfer economy. This happens even when the overall policy framework does not contain an overt urban bias and may in fact be tilted favourably toward the rural sector.

Social Sector and Poverty Poverty in Sri Lanka is highly correlated with levels of human development that reflect gaps in the provision of publicly-provided goods and services. HEIS 1995–96 showed that the incidence of poverty by education level of the household head is highest among those with no schooling (38 per cent) and with only primary schooling (34 per cent). Similarly, from a health perspective, in both rural and estate sectors, malnutrition reflected in low birth weights, stunting, wasting and anaemia is high. The poor suffer from low-quality social services, with disparities especially prominent in rural and estate areas where health, education, housing, safe water and sanitation services are far below the national average. The ongoing war in Sri Lanka and the high defence expenditure has prevented the government from allocating more funds for health and education expenditure to improve quality. However, irrespective of the war expenditures, Sri Lanka now has an opportunity to improve the quality of both health and education, due to the rapid demographic transition that has taken place. The proportion of children in the population rapidly declined in the late-1990s, due to low population growth combined with effective family planning. Since the proportion of children in the population is declining, there is less need to increase the number of schools and teachers, and less need for expanding preand post-natal health services. This has provided an opportunity to improve the quality of both educational services and health services. This opportunity has to be grabbed now, because after 2006, the reduction in the child dependency ratio will be gradually offset by an increase in old-age dependency. Beyond 2036, the advantage would be completely offset by the increase in old-age dependants (Sanderatne, 2000).


295

The danger, however, is that a government faced with fiscal difficulties may use the opportunity to reduce expenditure on education and health. This should be avoided and both education and health planning should be geared to qualitative improvement taking into account the demographic changes.

Unemployment and Labour Market The World Bank (1999) took a fresh look at the three main hypotheses that purport to explain Sri Lanka’s unemployment situation and highlighted their shortcomings. Basically, the study found little evidence for the skills-mismatch hypothesis, but found evidence for both the queuing and the labour market-legislative framework hypotheses. Thus, the suggested solution is reform in public sector recruitment strategy and labour market liberalisation. The need for labour market reform is accepted, but little political consensus exists for increasing employment flexibility or eliminating expectations that the government will somehow create large numbers of positions in the civil service for educated youth. Given the socio-political setup in Sri Lanka, the government’s regular resort to ad hoc creation of jobs in the public sector to satisfy the educated youth is quite understandable, particularly when private sector expansion is inadequate due to the uncertainty created by the war. It is not practical in a highly politicised economy such as Sri Lanka to wait till the private sector generates employment. The direct effect of labour legislation on poverty among employed workers can be favourable because of minimum wage stipulations by the Wages Boards and by the Employees’ Provident Fund and Employees’ Trust Fund, which guarantee retirement funds. The sharp decline in poverty in the estate sector during 1985–86 and 1990–91 can be attributed inter alia to the application of minimum wage regulations through organised union activity. The total employed labour force was estimated at 5.3 million in 1994. The number employed by the formal sector covered by labour laws was estimated to be 2.9 million (1.6 million in the private sector and 1.3 million in government institutions). Thus, labour laws do not cover 45 per cent of the employed labour force. Evasion of labour laws is also on the increase (CBSL, 1999). To the extent that coverage by labour legislation is reduced by these factors, the positive impact on poverty reduction is reduced. The net impact of relaxation of labour laws on poverty depends on the extent to which flexibility in the labour market is translated into economic growth, and the strength of the trickle-down mechanism to the poor, in comparison to the potential loss of worker welfare due to weakening of employee protection in the formal sector. The Sri Lankan government is of the view that labour market reform should be easy when the economy is growing fast. However, due to the war, Sri Lanka has not been able to achieve high growth rates.

296


Vulnerability of the Poor HEIS 1995–96 data shows the significant effect of fluctuating income growth on poverty trends. A significant proportion of the population is clustered around the poverty line and is vulnerable to small changes in income. This is reflected by the fact that a 20 per cent increase in the income poverty line raised the incidence of poverty in 1995–96 from 25 to 39 per cent. Such a rise in the poverty line represents only a slight increase in consumption expenditure. As the World Bank (2000) argues, ‘[the] insufficient mechanism for risk management in agriculture, the large increase in casual and temporary employment in recent years, [and] the poor targeting of beneficiaries through poverty programmes contribute to the vulnerability and insecurity of Sri Lanka’s poor’. Such vulnerability could also be due to the high dependence of remittances by rural households in recent years. Increasingly, aid providers have highlighted the politicisation of the poverty strategy in the context of the broader issue of ‘good governance’. Over the last two to three years, the government has made an effort to understand the nature of poverty in order to formulate an effective policy framework for poverty reduction. This framework was presented to the aid providers’ meeting in Paris in December 2000 and the government was commended for its efforts in preparing the document.

Conclusion Since the mid-1980s, there has been a decline in poverty in Sri Lanka. Economic growth that averaged about 5 per cent during 1985–2000 certainly contributed to reducing poverty. Simulation studies on the impact of growth on future poverty alleviation (assuming that relative inequalities remain unchanged at the observed 1990–91 levels) estimated that a 2 per cent annual rate of growth of real consumption per capita would, by the turn of the century, reduce the proportion of ultra-poor from 22 per cent to 12 per cent and the proportion of poor from 35 to 21 per cent. Economic growth of 5 per cent annually has not been broad-based enough to realise a breakthrough in poverty reduction. In other words, economic growth has not automatically trickled down to the poor. Links between growth and poverty reduction are weak in some provinces; this situation calls for new policy measures to maintain outreach to the poor. Liberalisation of the factor markets needs serious attention. Market liberalisation has not gone far enough in the labour and land market, due to political economy factors. The rigidities in the land market have acted as a constraint to agricultural growth, while rigidities in the labour market have reduced the labour absorption capacity of the economy. Gradual liberalisation could somewhat offset high shortrun adjustment costs. A start has to be made while promoting dialogue with the stakeholders.


297

While liberalisation is essential for growth, it will underuse the resources of the poor if their specific problems are not addressed directly. Sri Lanka recognised this long before many other developing countries, but the existing programmes for directly addressing the problems of the poor suffer from various deficiencies. Specific poverty policies need fine-tuning to meet the current issues. The problem of targeting Samurdhi recipients has received attention in the government’s poverty framework document: ‘[Categorical measures of impoverishment should be used to determine eligibility instead of ... income-based criteria’ (GOSL, 2000: 53). In some regions, the combination of private remittances and Samurdhi payments has raised the reservation wage and discouraged the poor from seeking employment. The report argues for exit procedures and incentives for households to graduate from Samurdhi and prevent welfare dependency. Both the education and health sectors require urgent reform. Notwithstanding the comparative edge that Sri Lanka commands over other developing countries in these two areas, their performance record in the last two decades has not improved in consonance with earlier achievements, especially when taking into account the quality of services provided and new indicators of sector performance. This is mainly due to the slow adjustment of policies to the emerging needs of society and an open economy. For example, the existing financial and managerial systems for the health and education sectors established over the years are no longer adequate to meet the new challenges. It is commendable that the government began to address some of these issues (ibid.). It was also shown that the poor are very vulnerable to income fluctuations. This area received increased attention in the World Development Report 2000/2001. One reason for this is that growth-promoting policies have been implemented unevenly, with insufficient emphasis on structural reforms in agriculture. All these problems have been viewed from a holistic perspective in the new poverty framework paper. The government is geared to address these issues. In its Vision for the 21st Century, the government has spelled out its aim of raising the income levels of the poorest 8 million by increasing their share of income from the current 4 per cent in 2000 to 15 per cent by 2010.

References ADB (Asian Development Bank) (1997), Emerging Asia: Changes and Challenges, Asian Development Bank, Manila. ——— (1998), Social Sector Development in Sri Lanka: Issues and Options, A background study prepared for the 1998–2001 Country Operation Strategy, Manila. Athurupana, H. (1997), ‘Earning Functions and Rate of Return to Education’, University of Colombo, ISS Working Paper No. 9701. CBSL (Central Bank of Sri Lanka) (1999), Central Bank of Sri Lanka—Annual Report, 1999, Central Bank, Colombo. De Haan, A. and M. Lipton (1998), ‘Poverty in Emerging Asia: Progress, Setbacks, and LogJams’, Asian Development Review, Vol. 116, No. 2. Dissanayaka, S.B. (1995), ‘Samurdhi Programme: Concepts and Challenges’, Economic Review, Vol. 21, No. 5.

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Dunham, D. and C. Edwards (1997), Rural Poverty and an Agrarian Crisis in Sri Lanka, 1985–95: Making Sense of the Picture, Poverty and Income Distribution Series, No. 2, Institute of Policy Studies, Colombo. Dunham, D. and S. Jayasuriya (1998), ‘Economic Crisis, Poverty and War in Contemporary Sri Lanka: On Ostriches and Tinderboxes’, Economic and Political Weekly, Vol. XXXIII, No. 49, December. Dutt, G. and D. Gunawardena (1995), ‘Some Aspects of Poverty in Sri Lanka: 1985–90’, Sri Lanka Economic Journal, Vol. 10, No. 2 (the paper was written in 1997 as a World Bank Policy Research Working Paper, No. 1738, but was published in the above-mentioned journal dated 1995). GOSL (Government of Sri Lanka) (2000), ‘A Framework for Poverty Reduction in Sri Lanka’, Final Draft, Colombo, June. Gunatilaka, R. (1997), Credit-Based Participatory Poverty Alleviation Strategies in Sri Lanka: What Have We Learned? Poverty and Income Distribution Series, No. 2, Institute of Policy Studies, Colombo. ——— (2000), ‘Fiscal Decentralization, Rural Development, and Poverty Reduction’, Vol. 1, No. 1. Gunatilaka, R. and R. Salih (1999), How Successful is Samurdhi’s Savings and Credit Programme in Reaching the Poor in Sri Lanka? Poverty and Income Distribution Series, No. 3, Institute of Policy Studies, Colombo. Gunatilaka, R. and T. Williams (1999), The Integrated Rural Development Programme in Sri Lanka: Lessons of Experience for Poverty Reduction, Poverty and Income Distribution Series, No. 4, Institute of Policy Studies, Colombo. Gunawardena, D. (2000), ‘Consumption Poverty in Sri Lanka 1985–1996’, External Resources Department, Colombo, Ministry of Finance and Planning (mimeo). Herse, D., W.A.T. Abeysekera and T.N. Wikramanayake (1989), ‘Food Consumption Behaviour of Urban Food Stamp Recipients in Sri Lanka’, Ceylon Journal of Medical Sciences, Vol. 32, No. 22. Kelegama, S. (1993), ‘Distribution of Income and Ownership of Assets: Trends in Sri Lanka’, Pravada, September/October, Colombo. ——— (2000), ‘Development in Independent Sri Lanka: What Went Wrong?’, Economic and Political Weekly, Vol. XXXV, No. 17, 22–28 April. Lakshman, W.D. (1997), Income Distribution and Poverty’, in W.D. Lakshman (ed.), Dilemmas of Development: Fifty Years of Economic Change in Sri Lanka, Sri Lanka Association of Economists, Colombo. Rannan-Eliya, R. and N. de Mel (1997), ‘Resource Mobilization for the Health Sector in Sri Lanka’, Institute of Policy Studies/Harvard University Report, Cambridge, MS. Ravallion, M. (1997), Can High-Inequality Developing Countries Escape Absolute Poverty? Poverty and Human Resources Division, the World Bank (mimeo). Sanderatne, N. (2000), Economic Growth and Social Transformations: Five Lectures on Sri Lanka, Tamarind Publications, Colombo. Sunday Leader (2001), Sri Lankan Newspaper, 20 January. Tudawe, I. (2000), Review of Poverty Related Data and Data Sources in Sri Lanka, MIMAPSri Lanka Series, No. 4, Institute of Policy Studies, Colombo. UNDP (United Nations Development Programme) (1997), Human Development Report (Human Development to Eradicate Poverty), Oxford University Press, New York. UNICEF (United Nations Childrens’ Fund) (1985), Sri Lanka: The Social Impact of Economic Policies During the Last Decade, Colombo. World Bank (1995), Sri Lanka: Poverty Assessment, Report No. 13431-CE, Country Department 1, South Asia Region, Washington, D.C. ——— (1999), Sri Lanka: A Fresh Look at Unemployment, South Asia Region, PREM Unit. Washington, D.C. ——— (2000), Sri Lanka: Recapturing Missed Opportunities, SASPR, Washington, D.C. ——— (2001), World Development Report, Washington, D.C.

INDEX

299

INDEX

Accelerated Mahaweli Development Programme (AMDP): 93, 97, 110, 240, 289; increased employment in, 98 Administrative Reforms Committee (ARC), 116, 269 African Growth Opportunity Act (AGOA), 218–19 Aggregate Household Food Security Index (AHFSI), 247 Aggregate Measure of Support (AMS), 253 Agricultural Development Authority Act No. 46 of 2000, 233 agricultural diversification, 234 agricultural export: and domestic production subsidies, 229; taxes, 229 agricultural import duties, 231 Agricultural Purchasing Authority (APA), 233 agricultural sector, Sri Lankan, 234 agriculture policy: and food security, 238; and performance, 250 agriculture: commercialisation of, 208; overview of Sri Lankan, 228; R&D in, for higher-value-added crops, 233; rural incomes from, 255; tariff band for, 229 aid: donors, 180; mobilisation for the peace process, 180; mobilisation process, 175 Andean Trade Preferential Act (ATPA), 218 Anti-dumping Regulation, 220 armed forces, recruitment to, 162, 181 Asian Development Bank, 31, 69, 152 automatic pricing system for petroleum, 167 Balance of payments (BOP): 143; crisis, 93; deficit, 141, 146; problems, 93

bank borrowings, 151 Bank of Ceylon, 178 bankruptcy laws, 62 Bevan’s National Insurance and Health Acts, 46 Beveridge’s Social Security Act, 46 Bilateral Free Trade Agreements (BFTAs), 219 Board of Investment (BOI), 24, 213, 275 borrowings, non-bank, 151 Bread and Butter Reforms, 111 budget deficit, 93, 98, 145 Business Acquisition Act (1971), 42, 49 Butler’s Education Act, 46 capital: assets, destruction of, 133–34; expenditure, 150; expenditure for infrastructure development, 79; foreign, inflows, 153 capitalism, global, 67 Care International, 185 Caribbean Basin Trade Preferential Act (CBTPA), 218 Ceylon Chamber of Commerce, 149 Ceylon Electricity Board, 31, 178 Ceylon Institute of Scientific and Industrial Research (CISIR), 81 Ceylon Petroleum Corporation, 31 Ceylon Workers Congress (CWC), 164 Chartered Institute of Marketing in the United Kingdom, 217 Chinese competition, threat of, 210 Chinese currency, revaluation of, 220 Chinese garments, advantage of, 220 Civil Service Pension Bill, 116

300


civil war in North-East Sri Lanka, 21 Clothing Industry Training Institute (CITI), 216 Colombo Stock Market (CSM), 148, 179 Commission on Peoplisation, 112 Community Projects Programme, 248–49 Confidence Building Measure (CBMs), 176, 186 conflict: driven deficit, 135; ethnic, 54–55, 129; impact of the, on FDI flows, 136; related damage to public and private property, 137; resolution package, 174; Sri Lanka’s ethnic, 129, 180 Consumer Affairs Authority, 24 consumption: of non-tradables, 145; patterns in Sri Lanka, 61; per capita, of rice, 242; per capita, of wheat, 242 Cooperative Wholesale Establishment (CWE), 231, 238, 245 corporate income tax, 149 corporate restructuring, 155 corporate tax reductions, 182 cost: debt-servicing, 152; economic, of a violent conflict, 133; economic, of Sri Lanka’s secessionist conflict, 138; economic, of the conflict, 135; economic, of the NorthEast conflict, 129; economic, of the war, 165–67; indirect, of the conflict, 134; of production in Sri Lanka, 217; replacement, 134; social, 134; social, of adjustment, 98; of Sri Lanka’s agro-industrial goods, 233; of the war, 181 Cotonou Agreement, 218 Credit programme, 248 crisis: economic, 156; economic, effects of, 101; ethnic, 267; management associated, 103 crops: diversification to higher-value, 232; non-plantation, 228 currency: depreciation, 145; devaluation of the Sri Lankan, 215; free float of, 144; stability, 144 current account deterioration, 153 debt: external, 110; financing, 80; recovery laws, 80, 117; soft loan, financing, 165 defence: expenditure, 131, 166; expenditure induced budget deficits, 204; financing, 160 Defence Levy (later termed as the National Security Levy), 160, 162 Department of Social Services, 46 Development Forum, 169 Devolution Proposals, 162

District Needs Assessment Panels, 184 East Asian crisis: 214–15; ill effects of, 141 East Asian Tigers, 21 economic development, 20, 37, 130 economic dividend: 175; foreign aid driven, 180; in North-East, 183–86; in Southern Sri Lanka, 180–83 economic growth, 296 economic management, Sri Lanka’s, 159 economic reforms, implementation of, 160 Economic Revival Package, 167 economic targets, attacks on, 162 economy: agro-based, 201; controlled, 202; domestic mismanagement of, 176; ICOR of the Sri Lankan, 75; imbalances in the Sri Lankan, 145; investment-oriented, 59; labour surplus, 209; open, 160; political, 66; political, and the dynamics of peace, 186–92; prior to 1977, Sri Lanka’s, 93; Sri Lankan, 20, 44, 50, 96, 109, 113, 121, 130, 140, 158, 164, 174; structural transformation of the Sri Lankan, 228; transformation in the Sri Lankan, 202; welfare-oriented, 59 Education Act of 1945 (based on the Kannangara Report, 1943), 46 Eelam War I, 130, 158–59 Eelam War II, 129, 131, 158, 160 Eelam War III, 158, 162 Embarkation Tax, 149 Employees’ Provident Fund and Employees’ Trust Fund, 295 employment: creation after 1994, 274; creation and the labour market, 288; increase in, in the organised sector, 263; industrial, 263; in manufacturing sector, 266; migration, in search of, 275; in non-GCEC projects, 269; promotion of off-farm, for poverty reduction, 293; reverse trend of, creation in the 1982–85/86, 266; rural non-farm, creation, 252; structural adjustment and, creation, 259; in tourist sector, 262 entrepreneurial development, 80 ESAF (Enhanced Structural Adjustment Facility—the former name of PRGF), 154 Everything-But-Arms (EBA) scheme, 218 exchange crisis during 1961–64, 41 expenditure: public, on education, 291; public, on health, 290; reductions in wasteful, 149; social welfare, 290 Export Development Board (EDB), 101

INDEX Export Oriented Industrialisation (EOI), 26, 49, 201, 209 Export Processing Zones (EPZs), 67, 112, 274 export: dependence of Sri Lankan, on US and EU economy, 153; economy, 49; liberalisation-induced, earnings, 247; policy of, pessimism, 49–50, 49; promotion, 50, 112; recession in the US the biggest market for Sri Lankan, 164; settlement of, loans, 143; Sri Lankan, 164, 217; Sri Lankan, performance, 218; views on, pessimism, 49 Extended Fund Facility (EFF), 179 external assistance, lack of, 51 fashion school at the University of Moratuwa, 216 female workers, 97 Fifth WTO Ministerial Conference in Cancún, 219 Fiscal Management Responsibility Act, 182 Five Year Strategy for the Apparel Industry, 207 Food Commissioner’s Department (FCD), 238, 245 food crop, removal of QRs in the domestic, sector, 230 Food Import Policy, 244 food security: 237, 253; challenges to, 253; changing role of institutions and policies for, 243; issues at household level, 238, 248; issues at macro level, 246–47 food subsidy: 53; programme, 246, 286 Food-for-Work projects, 253 foreign aid, 76 Foreign Direct Investment (FDI): 55, 69, 213; in Sri Lanka, 76; revival of, flows, 136 foreign exchange: abolition of, surrender requirements, 115; crisis, 51, 67; erosion of, reserves, 163 foreign financing, 151 foreign funding target, 151 foreign funds, 153 foreign investors, 83 foreign portfolio investment, 55 foreign savings, 76 forward sales contract programme, 232 free float: 143; pure, system, 144 Free Trade Agreement (FTA) with Pakistan, 167 Free Trade Zone (FTZ): 97; job opportunities, 272; work force, 272

301 garment: East Asian quota-hopping, manufacturers, 219; exporters, 213, 217; industry, competitive strength of Sri Lankan, 216–17; industry, competitiveness of, 217; industry, growth of, 54; industry, progress of the, in Sri Lanka, 217; industry, readymade, 212; Sri Lanka’s lack of competitiveness in, products, 217; Sri Lankan, entrepreneurs, 219; Sri Lankan, exports, 215, 218; Sri Lankan, industrialists, 215; Sri Lankan, industry, 212–13, 215, 217–18, 221, 223–24; value-added, products, 222 GCE [General Certificate of Education] system, 82 GCE Advanced Level Examination in Jaffna district, 137 Goods and Services Tax (GST): 24, 148, 167, 181; integration of the, and NSL, 167; progressive, 154 government: employment, 264; hiring, 275 Govi Sahanaya (forward sales contract implemented by the Central Bank), 252 Greater Colombo Economic Commission, 112 green revolution, 139 Guaranteed Price Scheme (GPS), 244 Health Act of 1953 (based on the Cumpston Report, 1950), 46 High Security Zone (HSZ), 177, 183 Household Expenditure and Income Survey (HEIS) 1995–96, 292, 296 human capital: acquisition, 133; capital losses, 138 human resource development, skills and, 64 Human Resources and Institution Development (HRID) programme, 248 human rights: abuses, 275; progress on, in the North-East, 180 illiteracy rate, 65 International Monitory Fund (IMF): commitments, 182; package, 153–55 import duties: 148; on agricultural inputs, 233 import: decline in defence-related, 153; duty free, allowance, 148; standard, substitution industrial regime, 41; substituting industrialists, acquiescence of, 93; substitution, 49–50; substitution in agriculture, 42; substitution industrialisation, 139; substitution industries, 42, 67; substitution sector in Sri Lanka, 207; substitution via agriculture, 139; surcharge, 153

302


income taxes, 148 Incremental Capital Output Ratio (ICOR), 74 Indian Peace Keeping Forces (IPKF), 129, 166 India–Sri Lanka Comprehensive Economic Partnership Agreement (IL-CEPA), 32 Indo-Sri Lanka Bilateral Free Trade Agreement (ILBFTA): 153, 164, 167, 191, 205, 207, 219, 231; quota under, 219 Indo-Sri Lanka Comprehensive Economic Partnership, 191, 207 Industrial Policy Statement of 1989, 205 Industrial Promotion Act of 1990, 26, 202 industrialisation: 201–10; challenges for, 207; changes in policy for, 205; commission, 202; development of, 202; impediments to, 205; import-substitution, 49; in Sri Lanka, 26; policy, 202; process in Sri Lanka, 202–7; Soviet model of, 202; Sri Lankan, 26; strategy of 1995, 205 industries in Sri Lanka, 57 infant mortality, 65 infrastructure development, 79 Inland Revenue Law, 232 instability: macroeconomic, 58–59, 61, 98, 110; political and macroeconomic, 59; prevalence of political, 62 Institute of Fundamental Studies (IFS), 81 insurgency: 122; terrorism and, 110 Integrated Food Security Programme in Trincomalee, 253 Integrated Rural Development Programmes (IRDPs), 293 Interim Administration proposal of the government, 192 Interim Self-Governing Authority (ISGA); 189, 193; and electoral defeat, 192; proposal, 192 Internally Displaced People (IDPs): 272; rapid return of the, after peace, 177 International Safety Net for the Peace Process, 189 international safety, consolidation of, 191 investment: large scale, 78; low, and domestic savings, 61; portfolio, 153; private, 135; public, in infrastructure development, 100; reductions in government, 133 Irrigation and Land Settlement Policies, 289 Janasaviya and Samurdhi programmes. 249 Janasaviya poverty alleviation scheme, 269 Janasaviya Programme (JSP), 113, 115, 120, 246, 248, 268, 286

Janatha Vimukthi Peramuna (JVP): 159; crisis in the South, 267; rebellion, 55 Joint Apparel Association Forum (JAAF), 207–8, 217 labour: absorption in the manufacturing sector, 266; compensation costs for retrenched, 98; demand for, in the MiddleEastern countries, 261; exit laws, 155; inflow of migrant, 272; laws in Sri Lanka, 84; legislation, 117; legislation, dismantling of, 118; migration of, overseas, 272; retrenchment in state-owned enterprises, 118 land: market, 155; private, transactions, 232; titling, 242 liberalisation: 92, 110, 259, 275; and adjustment, 100; and crisis management, 92; and governance, 109; and privatisation, 119; and stabilisation, 63; benefits of trade and investment, 209; economic, 21, 52, 91–92, 101, 109, 158, 240, 282; economic, in 1977, 202; economic, policies, 294; economic, programme, 158–60, 260; of exchange controls, 115; of the factor markets, 296; of foreign capital inflows, 160; first wave of, 1977–88, 260; import, 264; import, on domestic industries, 263; in 1977, 290; in Sri Lanka, 91; industrial tariff, process, 204; initial, in 1977, 104; market, 296; needs of, 98; partial, 42; partial, of financial markets, 93; partial, of the economy during 1965–70, 41; policies, 62, 261; policy process, 242; programme, 160; renewal of, in 1990, 267; second wave of, 155, 267; sequencing of trade, 101; speed of trade, 266; Sri Lanka’s, 68; Sri Lankan, process, 104; stabilisation and, 92; stabilisation and, objectives, 93; tariff, under SAPTA, 205; third wave of, 169; trade, 102; of the trade regime, 54; trade, in Sri Lanka, 101; trade, in the agricultural sector, 227; trade, process, 202; WTO-tariff, 205 Liberation Tigers of Tamil Eelam (LTTE): 129, 135, 138, 158, 160, 175–76, 184, 189, 193; Air Port terror attack by, 164; appeasement strategy of the government towards, 193; appeasement strategy towards, 192; behaviour during the peace talks, 194; breakdown of the peace talks with, 160; ceasefire agreement (CFA) with

INDEX

303

the, 176; data on, casualties, 137; enhancement of, military authority, 171; and the government, 155; and the Norwegian facilitators, 190; peace negotiations with, 160; restricted movement, 185 licensing raj, 53 life expectancy at birth, 65 local employment in GCEC firms, 269 loss-making enterprises, 100, 102, 110

oil-price hike in 1979, 261 Operation Agni Kheela, 170 Operation Jaya Sikuru, failure of, 162 Operation Rivi Rasa (capturing of Jaffna), 162 Operation Sath Jaya (capturing of Killinochchi), 162 Oslo Declaration, 186, 188 Oxfam, 185

Mahaweli Development Programme, 53, 63, 64, 264, 266 Marshall Plan approach, 185 Memorandum of Economic and Financial Policies (MEFP), 152, 154 migration, overseas, 272 militarisation of Sri Lankan society, 134 Mines and Mineral Act No. 33 of 1992, 208 Ministry of Higher Education, 83 modernisation: technological, 81, 85; technological, in the economy, 80 Multi-Fibre Arrangement (MFA), 26, 54, 210 Multipurpose Cooperative System (MPCS), 231

Paddy Marketing Board (PMB), 231, 238, 244 paddy yields in Sri Lanka, 241 pension scheme: 169; funded, 169 People’s Alliance (PA): 25; coalition government, 163; government, 154; re-election of, 25 People’s Bank, 154, 178 peoplisation, 112, 121 Phoenix Clothing Training Institute, 216 physical infrastructure, 166 Physical Quality of Life Index (PQLI), 255 plantation: British, companies, 47; economy, 47; exports, 202 policy makers in Sri Lanka, 102 political coalition management, 162 political system, Sri Lanka’s democratic, 38 politicisation: of administrative processes, 110; of targeted poverty programmes, 292 Property Reduction and Growth Facility (PRGF), 30, 154, 169, 179 Property Reduction Strategy Paper (PRSP), 30, 169 poverty: alleviation, 112, 289; alleviation and agriculture strategy, 255; alleviation programme, 23, 147, 181, 286, 292; alleviation programmes, genuine, 292; alleviation project, 113; decline in, in Sri Lanka, 296; in Sri Lanka, 283, 291; profile of Sri Lanka, 282; relaxation of labour laws on, 295; rural, 100; situation and policy, 280; strategy in Sri Lanka, 286–91; transfers from, programmes, 292 Premadasa: government, 119, 122; government, authority of, 122; privatisation under, 112; reforms, 116 Presidential Tariff Commission (PTC), 101 Presidential Task Force on Agriculture, 242 Prevention of Terrorism Act, 165 primary education, 291; primary school enrolment, 65 private sector, development of the Sri Lankan, 98

National Apprentice Industrial Training Authority (NAITA), 76 National Council for Economic Development (NCED) Cluster Initiative, 207 National Defence Levy (NDL), 181 National Economic Plan, 51 National Food and Nutrition Programme, 250 National Institute of Business Management (NIBM), 81 National Mineral Policy of 1999, 208 National Planning Council, 45 National Security Levy (NSL), 148, 181 National Youth Service and Credit Organisation (NYSCO), 270 nationalisation: of the plantation sector, 27, 47; of the tea plantations, 48 NCGE [National Certificate of General Education] system, 82 newly industralised country (NIC): drive for, status, 119; status, 73; status for Sri Lanka, 114; vision of, status for Sri Lanka, 122 NGOs: arrival of funds for, 191; role of public distribution institutions and, 252 North-East civil war, 23 North-East Reconstruction Fund (NERF), 178, 184 Nutrition Programme, 248–49

304


privatisation: 118; decline in foreign financing and, proceeds, 151; expectations from the, programme, 151; of the infrastructure, 209; programme, 81, 85, 160, 235, 268; revenue from, 148 problem: for the peace process, 186; in the ISGA, 192; in the poverty strategy, 291; of economic management, 101; of governance, 62; of stabilisation, 109; of the rural development programmes, 292 productivity: of investment, 80; of labour, 81; of the garment sector, 216 Public Enter prise Reform Commission (PERC), 160 Public Enterprises Rehabilitation Bill (1996), 204 Public Investment Programme (PIP): 113; Mahaweli project-centred, 262 Public Utility Commission (Multisector Regulatory Authority), 24 rationalisation of state corporations, 102 reform: domestic market, 227; economic, process, 109; economic, programme, 104, 159; education, 275; implementation of, 179; implementation of the second generation, 169; in the labour market, 155; institutional, 80, 227; introduction of secondgeneration, 178; land, legislation enacted in 1972, 232; market, and diversification in agriculture, 227–37; policy, in Sri Lanka, 66; post-WTO, 231; second-generation, 163; Sri Lankan, experience, 104; Sri Lanka’s experience with economic, 96; structural, during 1999–2000, 154; trade, 101, 134, 232; trade policy, 242; trade, in Sri Lanka, 275 Regaining Sri Lanka (RSL) Initiative, 30, 207 Relief, Rehabilitation and Reconciliation (3Rs), 171, 169 rice self-sufficiency, 241 rights: farmers, 254; freehold, 289; plant breeders, 254 South Asian Preferential Trade Arrangement (SAPTA), 205 SAARC Rules of Origin, 218 Samurdhi, 286; Samurdhi Bank Societies, 249, 287; Samurdhi Banks, 287; Samurdhi Nu-tritional Project, 250; Samurdhi Programme, 246, 249 Sanasa, 270 Sarvodaya, 270

Satish Nambiar Report, 183 Save the Nation Contribution (SNC), 162, 181 School Biscuit Programmes, 246 seasonal tariff policy, 244 Secretariat for Coordinating the Peace Process (SCOPP), 177 Seeds Bill, 233 self-determination, LTTE’s demand for, in North-East Sri Lanka, 194 self-employment scheme, 269 September 11, 164, 176 Short Term Implementation Programme, 45 Sirimavo-Shastri agreement of 1964, 261 Six-Year Investment Programme, 45 Skill Development Fund, 83, 209 social indicators: 64; of development, 65 social welfare achievements in Sri Lanka, 68 South Asia Free Trade Agreement (SAFTA), 207 special credit programmes, 270 Sri Lanka Board of Investment, 232 Sri Lanka Business Development Centre, 80 Sri Lanka Defence, 191 Sri Lanka Freedom Party (SLFP), 38 Sri Lanka Joint Apparel Association Forum, 221 Sri Lanka Monitoring Mission (SLMM), 176 Sri Lanka Muslim Congress (SLMC), 163 Sri Lanka Postal Services, 178 Sri Lanka Railway, 31, 178 Sri Lanka Telecommunication, 148 Sri Lanka Transport Board, 178 Sri Lankan Constitution of 1978, 122 Sri Lankan Constitution, 13th Amendment to, 168 Sri Lanka, unitary status of, 168 stabilisation: cum-liberalisation package, 93; liberalisation process, 96; macroeconomic, 103; programme, 111 stability, macroeconomic, and desire for growth, 114 Stand-by-Package (SBP): 163; signed with the IMF, 176 State Trading Corporation (STC), 42, 231 Structural Adjustment Facility (SAF), 111, 273 structural adjustment: 259; impact of, on employment, 259; programme, 103, 181 Sub-Committee on Immediate Humanitarian Relief and Rehabilitation Needs (SIHRN), 177, 178, 184–85, 189, 193–94 Sub-Committee on Military De-escalation (SMD), 177–78, 183

INDEX Sub-Committee on Political Issue (SPI), 177–78 subsidiary food crops, 228 Tamil Eelam Economic Development Organisation (TEEDO), 185 Tamil National Alliance, 164 Tamil Tiger Peace Secretariat, 193 Tamils, expatriate, 185; workers, Sri Lankan, abroad, 269; tariff reductions, 235 Task Force for Small and Medium Enterprises (SMEs), 206 tax revenue in Sri Lanka, 148 technical skills: 82; managerial and, in the Sri Lankan economy, 117 Telecom shares, 150 tenant cultivation system, 233 Termination of Employment of Workers Act (TEWA), 117, 270 Termination of Employment of Workers Act of 1971, 118 terms of trade: deterioration of, 67; vulnerability of agricultural exports to, fluctuations, 139 terrorism and insurgency, 110 Tertiary Education Act No. 20 of 1990, 83 Textile Quota Board, 213 Textile Training and Service Centre, 216 The Competitiveness Initiative (TCI) in Sri Lanka, 206 Thimpu principles, 170, 188 titling and deed system, 155 Tokyo aid donors, 190 tourism, growth of, 54 tourist industry, Sri Lanka’s, 57 Trade and Investment Framework Agreement (TIFA), 219, 167 Trade Development Act 2000, 218 Trade-Related Intellectual Property Rights (TRIPs), 253 Training and Vocational Education Commission (TVEC), 83 transparency, Lack of, 121 Triposha, 246

305 Two Hundred Garment Factories Programme (THGFP), 115, 120, 203, 213, 269 underemployment, 271 unemployment; and labour market, 295; among rural youth, 264; in Sri Lanka, 271; political imperatives surrounding, 102; problem in Sri Lanka, 288; voluntary, 272 UNF manifesto, 178 Union for Protection of New Plant Varieties (UPOV), 254 United National Front (UNF): 38, 110, 159, 176; regime, 30 United National Party (UNP): 93; re-election of, 111 United Nations High Commission for Refugees (UNHCR), 185 United States–Sri Lanka bilateral free trade agreement, 219 Universal Adult Franchise, 38 Uruguay Round Agreement on Agriculture (AOA), 244, 253 value added tax (VAT), 167, 181 voluntary retirement scheme, 116 Volunteer Retrenchment Scheme (VRS), 182 Wages Boards, 295 wages: private sector, 271; Public Sector, and Hiring, 271 war-risk insurance charge, 217 water taxes, 242 weapons, decommissioning of, 193 welfare: expenditure, 100; politics, 46 Women’s Bureau, 270 World Bank, 152; mission’s visit to Sri Lanka, 45 World Food Programme (WFP), 185 World Trade Organisation Agreement on Agriculture (WTO-AOA), 229; WTOAOA, options available under the, 230 WTO Agreement on Textiles and Clothing (ATC), 220 Yen, appreciation of, 57

ABOUT

THE

AUTHOR

Saman Kelegama is Executive Director, Institute of Policy Studies of Sri Lanka. He was the former President of the Sri Lanka Economic Association. Dr Kelegama received his Doctorate from Oxford and Masters from IIT, Kanpur, India. He is also a Fellow of the National Academy of Sciences of Sri Lanka and co-editor of the South Asia Economic Journal. Among Dr Kelegama’s recent publications are Contemporary Economic Issues: Sri Lanka in the Global Context (2006), South Asia after the Quota System: The Impact of the MFA Phase-Out (2005) and Economic Policy in Sri Lanka: Issues and Debates (2004).

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