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Post-war Economic Progress: Investment, Positioning, and Reforms in a New Sri Lankan Economy

Photo courtesy The Nation

As the war was intensifying in the jungles of the Vanni in early 2009, another battle was being fought – the battle for the Sri Lankan economy. The global economic crisis had hit Sri Lanka badly, not through the direct channels of mortgage-backed securities or complex derivatives like in the West, but rather the indirect channels that swiftly followed. The Sri Lankan government, which had been borrowing short-term loans to finance the large budget deficits over the years, suddenly saw a reversal of those dollar loans when the financial crisis hit. Money from Sri Lankan securities flew out, exports were collapsing, and the Central Bank intervened heavily to stem the steep depreciation of the rupee. While in the North fighting had reached its peak in the early part of that year, in the capital Colombo, Sri Lanka was haemorrhaging foreign reserves threatening the financial stability of the country. Yet, at the same time the authorities were dismissing any need for external assistance. This soon proved to be a fallacy. By February and March that year, the government acknowledged that Sri Lanka’s balance of payments was in crisis and officially announced that it would be seeking a loan from the IMF. Amidst rumours of intense international political lobbying (US and UK in particular) to stall or delay the loan to Sri Lanka, IMF staff recommendations prevailed and Sri Lanka received a US$ 2.6 billion Stand-By Arrangement from the IMF[1]. At the time, the country had foreign reserves to finance only a few weeks of exports, precarious levels of dollar debt financing (as percentage of official reserves), and facing a hostile global economic climate.

An impressive come back?

Five years on, the Sri Lankan economy is in a very different place. The IMF SBA was successfully concluded by July 2012, just three years since it began. Sri Lanka’s foreign reserves are back on solid footing, and according to recent indications is up to an all-time high of US$ 8.5 billion, sufficient to support 6 months of imports. GDP growth has picked up from an average of 5.5% during the 2000-2009 period to 7.5% in the post-war period[2] – and is estimated to exceed 7% in 2014 as well. From having to seek exceptional external assistance from the IMF then, Sri Lanka is now managing to borrow on it’s own in international capital markets at interest rates that would be the envy of many crisis-ridden European countries. An impressive and far-ranging public infrastructure drive continues apace, and is strengthening the country’s prospects for attracting a new wave of foreign investment and for becoming a strong regional economic hub. Poverty rates have fallen from 22.7% in 2002 to 6.5% in 2012[3].

But something still seems amiss. In particular, private sector investment, particularly foreign investment, has been fairly uninspiring. Net inflows of foreign direct investment (FDI) in the immediate post-war period (around 1.5% of GDP) has not been materially higher than during the 2004-2008 period[4].  FDI in 20130 increased by just 2.8% on the previous year. As reported in the CBSL Annual Report (2013), even within this, more than half (56.6%) came into infrastructure, with the majority being in ‘telephone and telecommunication networks’ (driven by two telecom players), ‘housing and property development’ and ‘ports and container terminals’. Compared to the near 30% increase in 2011-12, the very modest 2013 increase is concerning. But only time will tell whether this becomes a secular trend.

Why investment?

The important role that investments play in economic growth is well-established. Sri Lanka has set itself an ambitious medium-term growth target of 8%+, and this would be key to satisfy the rising aspirations of post-war Sri Lanka’s population. To achieve this level of growth, the country needs around 35% investment as a share of GDP (at current levels of capital efficiency). Investment needs of a country are often constrained by the available domestic savings, and in Sri Lanka this is very low – 17% (around 24% if you add savings remitted by migrant workers). So the country must seek foreign investment sources to bridge the savings-investment gap – around 10% of GDP. Aspirations on the type of jobs young people seek are changing fast, and investment in new ventures can cater to these changing aspirations. Generating more good-paying jobs will, at the end of the day, be what grows household incomes and make or break a government in power.

In the immediate period following the end of the war, we certainly saw a noticeable bump in private sector activity. All major banks aggressively expanding their branch network. All major consumer durables and retail firms opened up outlets and showrooms in new regions. And the construction sector enjoyed a significant fillip. Yet, apart from a handful of prominent tourism/leisure and property development projects, what we haven’t seen is any major expansion in private sector investment in new and exciting sectors – either by domestic or foreign players.

Several issues relating to this need to be discussed.

A new era of ‘good’ FDI?

In the early to mid-1980s, several leading Japanese firms – Motorola, Sony, Sanyo, Matsushita Corporation, Bank of Tokyo – were readying to set up operations in Sri Lanka. They were part of the first wave of Japanese firms going abroad with their operations – the so-called ‘flying-geese’ model of FDI – as costs of production were rising at home. Sri Lanka seemed like an attractive destination – open-market reforms just a few years prior, good geographical location, a democratic parliamentary system of governance, capable bureaucracy, sound basic education of the workforce, the list goes on. However, as ethnic tensions erupted in July 1983 and the attack on a passenger aircraft in 1986, these firms – highly sensitive to political instability – left, and never came back. During the years of the conflict, when security and economic conditions weren’t ideal, Sri Lanka attracted mostly the opportunistic ‘fly-by-night’ investors, who were induced by generous tax and other incentives. They rarely had any significant technology or other positive spill-overs on the local economy, but certainly helped boost our light-manufactured exports and provide employment in those early years.

With the end of the armed conflict, it seems natural, then, that Sri Lanka can attract better FDI.

This has certainly manifested in the tourism and property development arena. The Altair Tower by Indocean Developers coming up opposite the Beira Lake, is set to be Sri Lanka’s tallest building and is designed by Moshe Safdie, famous for being the architect of the Marina Bay Sands in Singapore. Meanwhile, marking Sri Lanka’s biggest domestic private sector investment, the John Keells Group is setting up a US$ 600+ million mixed-used development (including proposed casino facilities) – the Waterfront Project – in the heart of the city, and is being designed by Lankan-born British architect, Cecil Balmond, famous for designing the ‘Accelor-Mittal Orbit’ located in the London 2012 Olympic Park. Other projects include the 5-star Shangri-La Hotel and ITC Hotel on Galle Face. All these are property development projects. In this new post-war phase Sri Lanka should be touting its achievements and attracting global players not only in mega real estate but also in the technology, finance, supply chain, and manufacturing categories. Sri Lanka should be attracting foreign investments that bring in new industrial and service technologies, boost Sri Lanka’s exports, and help us reach lucrative new markets abroad. Sri Lanka should be attracting regional operating head quarters; those looking for a South Asian foothold to complement their Dubai, Singapore or Hong Kong ones. Yet, we haven’t seen that happen. Maybe, the absence of war isn’t the only factor that ‘good’ FDI looks for?

‘Good’ biz climate

Sri Lanka does not offer a large domestic market (like, say, India), and so will not attract the market-seeking type of FDI. Sri Lanka does not offer vast tracts of natural mineral resources (like, say, Brazil, Chile or Myanmar), and so will not attract the resource-seeking FDI. The FDI Sri Lanka could attract is the efficiency-seeking type – investors looking for advantages that include skilled labour, geographical advantage, efficient and credible administrative systems and regulatory procedures, access to foreign markets, and an overall conducive climate to do business. This business climate – influenced by good governance, transparent rules, consistent and coherent government policies, and a biz-friendly bureaucracy, among others – is a critical consideration for foreign firms seeking new investment destinations[5]. Without having these in place, Sri Lanka will see more projects like the Krrish-type, where, out of desperation to boost FDI, the country grants an Indian company – essentially a brewery and distillery company with a limited track record in mixed property development – one of the most lucrative and prominent pieces of public land in the heart of the country’s business district. And has been widely reported, the project is now marred in controversy.

Sending out ‘mixed signals’?

Two of the set of elements of a good investment climate are infrastructure and macroeconomic stability – both of which are now in impressive territory, compared to five years ago. The ongoing infrastructure drive – mainly in connective infrastructure like new ports, highways, and roads – is unparalleled since the Accelerated Mahaweli Development Programme. Meanwhile, policies to ensure a stable macroeconomic environment have paid dividends – inflation in single digits (compared to over 20% in 2008), low and stable interest rates, and the budget deficit being steadily reigned in. So these should certainly be encouraging signs for for investors. Yet, some other policies on private sector development have sent unfavourable signals and got investors worried. In 2011, the government introduced a controversial bill that expropriated 37 private enterprises which it described as ‘under-performing and under-utilised assets’. It included 7 companies with foreign capital participation like the stock exchange-listed Hotel Developers Lanka PLC, which owns the five-star Hilton Colombo hotel building and a waterfront convention centre owned in part by a Singaporean firm. In 2013, the government did little to negotiate misplaced public protests regarding alleged toxic effluents from a rubber gloves factory and instead forced its closure and relocation. The factory was a leading exporter of value-added rubber gloves, and owned by one of Sri Lanka’s oldest blue-chip companies. Meanwhile, new policies regarding foreign ownership of land were introduced which bans sale of land to foreign nationals and instead imposes very high tax requirements on foreigners leasing land, creating disincentives for foreign investment.

Sri Lanka is fighting with many others to secure ‘mindshare’ among international investors. We can spend all we want on global PR efforts – through films and lobby firms, but Simon Anholt, the nation branding expert and advisor to many governments, says, “countries are judged by what they do”. Sri Lanka must ‘live’ the brand. The message we deliver to investors at a forum in a glitzy foreign hotel must be congruent with the reality at home. While pitching to them the virtues of doing business in Sri Lanka – “a rising post-war middle-income country with fresh opportunities”, back at home private businesses are made to feel like they are ‘allowed’ to thrive, but only at pleasure of the government. This causes a serious mismatch in the storyline, and at some point, will become untenable.

Reforms to become and stay ‘attractive

We must remember that, unlike when the Japanese firms were at our doorstep in the early 1980s, ready to invest in a refreshing new location, Sri Lanka is no longer the pioneering liberalising country of the late 1970s. Although we would like to believe otherwise, Sri Lanka is not the cynosure in the eyes of emerging markets investors; it’s Myanmar, Vietnam, Cambodia, Kenya, Cololmbia, etc. As Athukorala and Jayasuriya (2012) remind us, Sri Lanka “is now forced to compete for foreign investment and export markets with the giant labour rich economies of China and India as well as with countries such as Vietnam and Bangladesh” (p.22)[6]. Undertaking bold and fundamental reforms to policy and governance structures in the country will be key to becoming and staying an attractive investment location and promote growth.

Often at business forums in Colombo, a senior government Minister quips, “We are not the only girl on the beach, but Sri Lanka is quite attractive in its own bikini”. Yet, in a world with plenty of choice for investors looking for a favourable destination to locate in, Sri Lanka cannot continue to believe that the constant refrain of ‘there is no war anymore’ or ‘we have defeated terrorism’ is good enough on its own to attract investors to come here and stay here. Policy reforms matter. The right signals matter.

Many economists believed that the government would use it’s unprecedented political capital bought on by the military defeat of the LTTE to unleash a wave of comprehensive reforms and get the tough jobs done.

Some in the private sector often argue with me that it is not easy to expect everything to be done in a matter of 4 to 5 years – “It has only been 5 years. We have to be patient. The government needs more time to create a friendly environment”. This may well be so. Undertaking reforms are by no means politically easy, and easier said than done. Fending off pressure from special interests and domestic lobbies, administrative feasibility, competing political imperatives, etc., have to all be considered. Which is probably why areas like education, energy, land, regulatory procedures, etc., – all with strong competing interests, have been largely untouched. On the trade side, Sri Lanka has regressed in to greater protectionism (measured by tariff and para-tariffs imposed on imports) in the last ten years, as reported by Pursell and Ahsan (2011)[7].

But some key reforms to tax policy were undertaken in 2010/11 – reducing income tax rates, streamlining tax incentives, drawing back ‘nuisance taxes’, and bringing public sector employees within the income tax ambit, etc. Furthermore, new legislation like the Commercial Hub Act have the potential to be transformative. With these changes underway, then, are we then being too impatient?

Two key facts remain. First, Sri Lanka is not the only player in the game, we are competing with new champions like Vietnam, Cambodia, Myanmar, etc., who are all making the ‘right noises’ when it comes to attracting investors. So, time is not on our side. Second, examples from other post-war contexts show that reform in a short period is possible. In Georgia, for instance, post-war government reforms helped take it from 112th of 183 countries in the world in the ease of doing business to the top 20th easiest countries in the world, between 2006 and 2011. Policy reforms based on research findings steered the government towards deregulation of the economy. The number of licenses and permission needed to start or run a business was reduced. The effect of these reforms on FDI flows was seen early. By 2007 itself, FDI inflows amounted to around 18% of GDP (it was just 8% in 2003). Meanwhile, fiscal policy reforms helped boost tax revenue, from under 10% of GDP in 2004 to nearly 25% in 2012[8].

Concluding Remarks

It will be only be for so long that Sri Lanka can put off critical economic reforms, before the multiple windows of opportunity begin to close. As respected economist Dr. Indrajit Coomaraswamy often observes, “this is the most propitious set of circumstances Sri Lanka has had in a very long time”. Even during the height of the war, Sri Lanka grew at between 5 – 6% – we are a resilient economy with inherent dynamism. But Sri Lanka is aspiring to achieve, and indeed breach, the 8% growth level, and sustain it over a long period. Sri Lanka needs this in order to cater to the rising and evolving socio-economic aspirations of a post-war populace. As Athukorala and Jayasuriya (2012) also caution, the current security and stability won at a considerable human cost, would be the first victims of a stagnation in good jobs and economic growth. Whether the relentless preoccupation with consolidating power at the centre, by catering to myopic vested interests will mean a distraction away from tackling structural weaknesses with bold and coherent economic policies, will determine whether the private sector at home and abroad invest in Sri Lanka , and helps the country consolidate the post-war gains and build a prosperous future for all its people.

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Anushka Wijesinha is an Economist at a leading Sri Lankan socio-economic policy think-tank, and was recently listed in the ’40 Under 40’ list of young Sri Lankans by premier business magazine, Echelon. He works on issues of industry, competitiveness, and economic governance, and serves on several public private sector policy advisory committees. During the final phase of the war, Anushka was Assistant Director – Economic Affairs, at the Government Peace Secretariat. He has previously worked at the World Bank Sri Lanka and the Presidential Commission on Taxation. He holds a BSc (Hons) in Economics from University College London and a Masters in Economics and Development from the University of Leeds. Follow him on Twitter @anushwij.

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[1] the first disbursement was around July 2009

[2] Indraratna, A.D.V. de S., Vidanagama, S., and Wijesinha, A. (forthcoming, 2014), Way Forward for Sustained Growth, Sri Lanka Economic Association: Colombo.

[3] Source: Household Income and Expenditure Survey (various), Department of Census and Statistics. Note: The author acknowledges that the basic poverty line alone does not fully capture a realistic picture of poverty in the country, and other indicators like Multidimensional Poverty can provide more nuanced insights. But the overall sharp downward trend in poverty is clear.

[4] World Bank World Development Indicators, available at http://data.worldbank.org/indicator/BX.KLT.DINV.WD.GD.ZS

[5] for an overview of the international literature on this area, refer Wijesinha, A., Ekanayake, R., and Mahendra, G. (2013), ‘Incentivizing Foreign Investment in Sri Lanka and the Role of Tax Incentives’, Research Studies: Working Paper Series No. 17 (April 2013), Institute of Policy Studies of Sri Lanka: Colombo.

[6] Athukorala, P. and Jayasuriya, S. (2012), ‘Economic Policy Shifts in Sri Lanka: The Post- conflict Development Challenge’, Working Paper No. 2012/15 (September 2012), Working Papers in Trade and Development, Australian National University: Canberra.

[7] Pursell, Garry and F.M.Z. Ahsan (2011), ‘Sri Lanka’s Trade Policies: Back to Protectionism’, Australia South Asia Research Centre Working Paper 2011/03, Canberra: Australian National University

[8] Attygalle, K. (2013), ‘Reforming a Post-war Economy in Four Years?’, Talking Economics Digest (July-December 2013), Institute of Policy Studies of Sri Lanka: Colombo.

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This article is part of a  larger collection of articles and content commemorating five years after the end of war in Sri Lanka. An introduction to this special edition by the Editor of Groundviews can be read here. This, and all other articles in the special edition, is published under a Creative Commons license that allows for republication with attribution.