Colombo Telegraph

Domesticating Economic Growth: Can The Puny Middle Class Make It Sustainable?

By W.A. Wijewardena  –

Dr. W.A. Wijewardena

An ominous decline in Sri Lanka’s exports to GDP ratio

An unexpected development, seemingly ominous, that has taken place in Sri Lanka’s recent economic developments has gone unnoticed by the country’s policy authorities, economic analysts and researchers.

 That development has been the continuous decline inSri Lanka’s exports as a ratio of its Gross Domestic Product or GDP from around 2005 though exports in US dollar and rupee terms had recorded increases during this period. While the export ratios were falling, the country’s situation was made more complicated by an import ratio which has stubbornly refused to record a similar decline; it has in fact remained unchanged almost at the high rate which it had in 2005 raising Sri Lanka’s trade deficit to critical levels.

Throughout the post-independence history, exports as a ratio ofGDPhad remained above 25 per cent except in early 1970s when it fell below 20 per cent. It stood at 28 per cent in 1950, just two years after the country gained independence. Since then, the country managed to increase its exports almost at the same rate as theGDPgrowth. In 2000, the ratio went up to 33 per cent and even in 2005, it remained at comfortable 26 per cent. However, since 2005, the ratio started to fall gradually recording 24 per cent in 2007, 20 per cent in 2008, 17 per cent in 2009 and finally settling at slightly above 17 per cent in 2010 and at 18 per cent in 2011. Meanwhile, imports as a ratio ofGDPwere 36 per cent in 2005 and remained almost closer to that level throughout since then. In 2011, that ratio was at 34 per cent.

However, since 2005, economic growth has accelerated to above 6 per cent from a low growth of below 5 per cent whichSri Lankahad throughout its post-independence period. In the last two years, according to official reports, the growth rate has even surpassed 8 per cent mark.

Domestication of economic growth: Sustainable or vulnerable?

The failure of exports to rise at least at the same rate as the GDP growth, while imports had maintained that rate continuously means that the economic growth since 2005 has come basically from domestic sources. In other words, it is not the foreigners consumingSri Lanka’s products that have created wealth in the country. On the contrary, it is the Sri Lankans consuming local products on one hand and using imported products to create economic activities such as transportation and trading on the other that have created wealth in the country. Thereagain, since growth has come more from the expansion of services and less from both the agriculture and industry, it is the consumption of services by Sri Lankans, mainly, the trade related services, banking and insurance services, the use of mobile phones and telephones and government services, which have created wealth in the country in this period.

I call this ‘domestication of economic growth’ since it relies on the domestic markets to generate growth in the country.  It is indeed a significant departure from the growth source which the country had had prior to 2005.

Domestication is according to current development philosophy

This domestication of growth is indeed in accordance with the development philosophy of the government as pronounced in Mahinda Chinthana and recently reconfirmed by the Ministry of Finance and Planning in its Annual Report for 2011. Mahinda Chinthana has rejected outright what economists call the ‘neo-liberal economic model’ which emphasises, among others, on the need for integrating an economy with the rest of the world for continuous and sustainable economic growth. The neo liberal economic model calls for the liberalisation of trade, exchange rate, interest rates, foreign direct investments as effective strategies for a country to deliver prosperity to a nation. Hence, by default, Mahinda Chinthana has advocated a self – supporting economy which endeavours to produce everything within its borders. Self – sufficiency and import substitution are the main pillars of such a domesticated economy.

Reconfirming the policy of the government to build a viable domestic economy, the Annual Report of the Ministry of Finance and Planning for 2011 says that its strategy is to build “a domestic economy and add value to domestic resources”. In the long list of strategies which the Ministry says that the government would follow to put this policy into practice, there has not been a specific strategy for exports; exports have in fact been mentioned only as a side reference in the strategy of modernising the country’s industry.

India has moved in the opposite way

WhileSri Lankahas domesticated economic growth, the neighbouringIndiahas done the opposite. It has orientedIndia’s economy to the rest of the world as the source of economic growth. For instance, in 1990,India’s exports amounted to less than 6 per cent of GDP. But by 2000, that ratio doubled to 12 per cent of GDP. Since then, it was a doubling of the export to GDP ratio in the subsequent ten year period. Accordingly, by end – April 2012, the export to GDP ratio shot up to 25 per cent. Over this period,Indiahas diversified its export structure too. In 1990,Indiawas principally a garment and raw material exporter. By 2012, its exports have been principally composed of manufacturing exports like motor cars, trucks and pharmaceuticals. Between 2007 and 2009,Indiahas increased its high tech exports by two and a half times from $ 4 billion in 2007 and $ 10 billion in 2009, according to World Bank data. Over this period,Indiahas maintained on average an economic growth rate of over 7 per cent for most of the period. But that economic growth has been created mainly by foreigners by purchasing a large quantity of its manufactured products and services like engineering, healthcare and software services.  Hence,India, instead of relying solely on domestic consumers, has used foreign consumers to generate and sustain high economic growth.

Relying on domestic markets is good to avoid external shocks

Strategically, there is nothing wrong in relying on domestic consumers to generate continued economic growth in a country provided that the country involved has a substantially large domestic consumer base. Such a policy helps a country to avoid ‘ups and downs’ in economic activities due to similar ‘ups and downs’ in economic activities in countries that principally buy its products. For instance, if a country earns its living mainly by selling its products to foreigners, an economic boom in buying countries will create a similar economic boom in the home country as well. In the opposite, if there is an economic recession in the buying countries, it generates a corresponding economic slowdown in the home country. Thus, the home country economy does well or badly in the same way the buying country economies would do well or badly. Economists call this phenomenon ‘external shocks’ and relying on the domestic consumers to generate economic growth will help a country to avoid being hit by such costly external shocks.

But the domestic market should be big and rich enough

But there is a prime requirement which has to be put in place if a country is to rely mainly on its domestic consumers for continued economic growth. That is, the domestic consumer base in the country should be large enough to buy its products in increasing numbers. In this connection, there are two factors that will determine the capacity of domestic consumers to continue to buy the products of their respective home countries in increasing quantities: the number of domestic consumers and their buying power. The number is determined by the availability of a large consumer base which is mainly made up of the country’s ‘middle class’ that has a high proneness to consume. Those in the poor class do not have a sufficient income base to make a significant impact on the country’s total demand for domestic goods. Similarly, those in the rich class, going for better taste and higher quality, will basically consume goods produced in other countries. Thus, in any country, the buying capacity of consumers is basically determined by the average income level of those in the middle class. Hence, even if a country has a large population, it does not necessarily guarantee a large domestic consumer base within the country.  Of that large population, a significantly large percentage should be middle class consumers and those middle class consumers should have a high enough income level to buy those products in increasing quantities.

Governments’ unsuccessful attempts at substituting for domestic markets

In many developing countries where there is no a sufficiently large middle class to buy goods produced within the country, the governments have filled the gaps by being the largest single buyers in the respective economies. The rationale for the governments’ intervention in the economy in this manner is that if the private people do not consume enough, let the government using its powers create a demand for the country’s output, a proposition made by the British economist John Maynard Keynes in the early part of the last century and followed by almost all the countries in the world since then.Sri Lankais a case in point whose government has been consuming about a quarter of the country’s total output throughout its post-independence history. However, for a government to do so, it has to grab resources from the private sector by way of taxation or print money and inflate the economy or borrow from domestic and foreign sources or resort to any combination or to all of them. Though a government can make a marginal contribution to economic growth by participating in the economy in this manner, it is not without long term economic costs. The experience in both developing and developed countries has been that the governments’ buying goods through their budgetary operations have led to an unhealthy expansion of the government sectors, proliferation of unproductive capital projects financed by governments, loss making public enterprises that eat up the country’s scarce resources and accumulation of unsustainable public debt levels that have hindered long term economic growth.Sri Lankais a classic example for this unsavoury development making it difficult for the government to generate domestically driven economic growth any more.

Sri Lankans cannot consume all what they produce

Sri Lankabeing a small nation with only 21 million people does not have a sufficiently large domestic market to consume all its products. For instance, consider its tea industry.Sri Lankaproduces about 330 million kg of tea on average per annum and its people on average drink annually about one and a half kilogram of tea per individual. Thus, its domestic market can absorb only about 32 to 34 million kg of tea per annum making it necessary for the country to sell about 296 to 298 million kg of tea to foreigners. If it does not do so, it cannot sustain its tea industry. This is true withSri Lanka’s garment industry too. If it does not sell its garments to foreigners, the local population cannot buy all the garments produced in the country. Similarly, ifSri Lankaproduces more rice and foreign markets are not found to sell that excess rice, the domestic rice prices are bound to collapse making the country’s rice farmers bankrupt.

Middle class to the rescue

In a recent book edited by World Bank’s Ejaz Ghani under the title ‘Reshaping Tomorrow: Is South Asia Ready for the Big Leap?’, Washington DC based Brookings Institution’s Senior Fellow Homi Kharas has discussed the role of the middle class in economic development in South Asia in a paper titled ‘The Rise of the Middle Class’. Kharas says that the rise of the middle class in any country is a positive contribution to economic growth, because of the unique characteristics it possesses compared to other income groups. Those in the middle class, says Kharas, “usually enjoy stable housing, healthcare and educational opportunities (including the college) for its children, reasonable retirement and job security, and discretionary income that can be spent on vacations and leisure pursuits”. Thus, the middle class gains the capacity to consume a wide variety of goods and services in an economy. And that consumption creates demand for goods and services thereby making available ready markets for them. Hence, larger the middle class with its high buying power, higher the possibility for a society to attain economic growth.

Sri Lanka’s middle class is puny

According to Kharas’ estimates,Sri Lanka’s middle class in 2010 numbering some 3.6 million people or 18.5 per cent of the population is to rise to 6.2 million people by 2025. Even then, it is just less than a third of the country’s projected population in that year. In contrast,India’s middle class who numbered 59.5 million people in 2010 accounting for just 5 per cent of the population is to jump phenomenally to 1026 million people or 71 per cent of the population by 2025. This is more or less the same share of the current middle class inUSAthereby providing a huge domestic market forIndia’s products. Thus, forIndia, even without relying on exports, it is possible to ensure sustainable growth purely fuelled by domestic market sources. But,Sri Lankacannot do so and has to rely more on exports to sustain its growth than the domestic sources.

Singapore’s reliance on exports for growth

This is the choice to be made by small nations if they are desirous of attaining high economic growth and sustaining it over time.Singaporerealised it right from the very beginning and therefore went for a massive export drive with the support of many multinational corporations which it invited to that country. The necessary ground conditions were created for foreign firms to invest inSingapore. According to Lee Kuan Yew, the founding father ofSingapore, conscious efforts were made to create Western oases within the country so that the foreign firms which choseSingaporefor setting up their branches felt as if they were operating within their own home countries. The Rule of Law and property rights were guaranteed to give additional security to foreign investors who brought not only advanced technology but also export markets for the country’s products. By following this technique,Singaporewas able to acquire advanced Western technology and transform that country from a mere garment and labour intensive product exporter to a high tech product exporter within a matter of one generation. Its high tech exports as at the end of 2006, nearly a half of its total exports, accounted for about 7 per cent of the global high tech market ranking it in the fifth place among the world’s high tech giants with onlyChina,USA, EU andJapanbefore it.

Sri Lankacannot beSingapore, but can certainly follow its neighbour to the north,India, which has now moved away from the domesticated economic policy that it followed for decades without success to an outward oriented policy relying on exports for growth.

Sri Lanka should revisit the declining export to GDP ratio

Sri Lankashould therefore take serious note of the declining share of its exports in GDP. The recent decline is massive from about 26 per cent of GDP in 2005 to 18 per cent in 2011. Even to maintain the 2011 level in 2012, the country’s exports have to rise by 10 per cent given the projected GDP of $ 65 billion in that year.  Instead of being complacent about the rising exports in US dollar terms and overly proud of domesticating the economy, it should fix its problems right away and try to regain its lost past in export performance. Relying on its puny domestic market composed of an equally puny middle class for sustainable economic growth appears to be an ill – conceived strategy.

Hence, the much proclaimed domestication of economic growth needs a revisit by the country’s policy authorities.

(Writer is a former Deputy Governor – Central Bank of Sri Lanka and teaches Development Economics at the University of Sri Jayewardenepura. This article first appeared in Daily FT  – W.A. Wijewardena can be reached at )

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