By Dhanusha Pathirana –
Sri Lanka in 1H2013 underwent a real economic growth of 6.5% outpacing most regional economies amidst a general slowdown in world economic activity and becoming one of the fastest growing economies in Asia. The post-war growth in real output since 2010 averaged 7.5% indicating the rapid pace of expansion in real activity levels. In this backdrop, Sri Lanka emerged as a haven for foreign investors providing investment prospects even during times of general global uncertainty. However, these foreign investments were predominantly portfolio investments (government securities and equity) and not FDIs. The FDIs were mainly of a rentier nature (casinos, hotels, etc.,) and do not promote commodity production or transfer of technology to the host economy.
In this light, the ability of local producers to benefit from growth in Asian and world markets demands evaluation given that Sri Lanka’s production structure remains to advance technologically and organisationally, to be able to supply world demand for advanced products. A higher level of technical sophistication and application of science in production provides access to world markets that are constantly expanding in contrast to primary product exports. This is so given that technologically intensive production constantly invents entirely new product categories and hence forms new spheres of investment, permeating a self-expanding and an integrated character to economic growth in general. This is in contrast to technologically neutral production processes that characterise Sri Lanka’s exports and investments in general (garments, tea, trade, tourism, construction, etc.) which do not cause multiplication of new product categories over time.
Apart from the self-expansive effect of advanced technology oriented production, the latter further generates positive externalities in the home economy by raising the productivity of resources, which is in contrast to the neutrality of the technological impact on the economy of primary goods and services which dominate Sri Lanka’s exports and investments. The fact that in Sri Lanka services sector labour productivity is significantly higher than that of the industrial sector (by 17% in 2012) is empirically reflective of the necessity for transforming the economy’s backward industrial sector. Hence, it can be said that although growth has been high during the post-war years, the growth composition of the economy has led to a technological and organisational lag, which is more critical than the trade and fiscal deficits continuously highlighted by economists. The former, though of long term or medium term in nature are of fundamental concern. They involve questions of employment creation (qualitatively and quantitatively), income distribution, wage rates, poverty indices, aggregate profits and sustainability of whatever has been achieved.
The overall capability to effect improvements in the economy qualitatively and quantitatively in the face of the structural changes that are taking place at the world level should be enhanced by redirecting resources from consumption, infrastructure and trade to manufacturing industry availing of the existing domestic demand. Doing so would at the outset enhance the local knowledge base and transform the structure of investment matrix qualitatively to suit the requirements of world markets for advanced materials. The process will provide the economy with the means to penetrate the world markets for industrial goods and productively benefit from the growth in world economy. Such a turnaround should initially seek to alter the arrangement of the production factors in the economy in a way which enable the domestic economy to integrate with semi advanced and advanced supply chains abroad. The greater multiplier effect of a better integrated and interconnected investment process which is a critical characteristic of industrial advancement as opposed to services or agriculture would yield greater degree of scale advantage to the economy. This in turn tends to multiply the avenues through which locally produced commodities could penetrate world markets indicating the importance of the domestic market in preparing an economy to integrate industrially with world markets.
Rise in the Importance of National Economies at the World Level and Positioning Sri Lanka in the General Scenario
In the face of failure of conventional monetary and fiscal policy measures to assist economies from making their escape from the world recession now in its fourth consecutive year, key industrial economies have resorted to trade protectionism for boosting the demand for local industries and preventing a further increase in factory closures and unemployment. According to the World Trade Organisation (WTO) the ratio of growth of world trade to world GDP growth which stood at 2:1 historically has currently fallen to 1:1. This indicates that the world output growth is basing itself less on world trade than on domestic demand; growth within home markets doubled in terms of the world’s output growth compared to its historical average.
In this backdrop, it is in the interest of Sri Lanka to explore possibilities of greater utilisation of more freely available home demand ahead of attempting to penetrate world markets especially considering the relatively moderate industrial base and competitive power which the local exporters rely on. In the case of several commodities the home market has now grown to sufficient proportions that negate the indivisibilities arising from insufficient market demand. This shifts the comparative advantage in supply price from imports towards domestic production creating a transformation in market conditions that would assist the development of local industrial capabilities. This indicates that potential of the economy to restructure its productive base in response to continuously expanding home demand is yet to be explored through market forces. It would also tend to further expand the space for profitable investments and private capital formation given the self expansive propensities of manufacturing industry compared to other forms of investments.
Hence, it would be comparatively advantageous for Sri Lanka to seize initially the opportunities that domestic demand offers where competitive forces are much more manageable as compared to the fierce competition in world markets. Furthermore, currently global demand is being captured by key export economies and entry into it is not entirely free. The more productive utilisation of the home market that is available at the doorstep of local investors should be availed of with the aim of improving the spread and depth of the industrial structure. This was the general development strategy pursued by the newly industrialised economies in East Asia such as Japan, Taiwan and South Korea. The home market was used as a launching pad to improve the industrial capabilities of the economy before gradually advancing to integrate with world supply chains. However in Sri Lanka currently, investments seem to be absorbed by trade and services led undertakings which affects the rate of productivity change in the economy and may not be ideal given that Sri Lanka is in need of investments that are capable of transforming the economy in line with investment patterns of East Asian NICs.
A Discussion on the Academics’ Perspective on Sources of Growth and Export Performance
In this connection, the view held by the academics concerning the need to expand exports rests on the belief that the deficits in the trade account and the current account of balance of payments have been high following independence and hence there has to be a shift from borrowing to earning more non-debt driven foreign inflows. The academics are of the view that despite Sri Lanka’s economic growth being one of the highest in Asia the sources of growth have been predominantly nontradables led by construction, trade and government services. The over-reliance of growth on nontradables prevents the generation of foreign exchange required to support the inputs and consumption in real GDP expansion, given that growth dependent on nontradables involves increased imports. It also points to the fact that growth has been foreign exchange consuming rather than foreign exchange generating.
Hence, in order to offset the investments/savings gap created in the growth process, the economy tends to accumulate foreign liabilities exceeding the pace of nominal GNP growth, which leads to short term boom and bust conditions when growth grounded on external debt faces sustainability issues characterised by periodical foreign exchange shortages. This is empirically reflected by contractionary monetary and fiscal policy measures adopted in 1Q2012 and in 2008 which curbed the rate of real growth to 5.6% in 2H2012 and 3.4% in 2009. The growth in foreign debt both in public and private sector relative to growth in nominal GNP is indicated by Net Foreign Assets of the economy recording LKR -126.8 billion in 1H2013 from a five year average of LKR 169.4 billion.
In this light, the academics explain that Sri Lanka now considered a middle income economy by international donor agencies has limited access to concessional foreign financing. This has led to expensive foreign commercial borrowings which increase external debt financing costs, intensifying the frequency of foreign exchange shortages. In this light, they point out that it is not possible to attain 8% growth on a sustainable basis without export expansion; hence it is imperative for Sri Lanka to expand exports to achieve growth sustainability in the long run.
This general conceptual position on the Sri Lankan economy held by the academics implies that the current need to revive the export sector of the economy spans from the need to earn foreign exchange and thereby offset the deficit in the trade account of the balance of payments. In contrast, concepts on international trade resting on Smith’s conceptual dictums are closely interwoven with the theory of domestic economic development and do not depend on its utility in offsetting balance of trade deficits. This is so because the trade account can be balanced by many means other than raising exports receipts, such as the growth in inward labour remittances, tourism, foreign inflows to capital markets or else a reduction in imports of which the direct impact on factor productivity of the domestic economy is neutral. In contrast, the theory of international trade studies the long run mutual interaction between foreign trade and domestic economic development essentially involving a rise in the productivity of domestic economic resources (capital and human) (see for example Myint, H. (Aug., 1977) ‘Adam Smith’s Theory of International Trade in the Perspective of Economic Development’, Economica). Trade theory is not based on the belief that the purpose of international trade is to offset the trade gap of an economy. If trade account deficit is taken as a yard stick of development, it would mean that in the colonial period Sri Lanka had well balanced trade accounts and was economically developed than most advanced economies in the world.
It is further pointed out that export receipts have declined from 33% of GDP in 2000 to 16% in 2012 and that Sri Lanka’s share of global exports has also dipped sharply. This is to say that the exports sector of Sri Lanka performed better in 2000 given the fact that its share of the GDP in 2000 was over twice the current figure. In the same line of argument, it could further point out that export performance of Sri Lanka during the colonial period was even better given that the share of exports to GDP would have been higher than the 33% in 2000 (Professor S. B. D. De Silva). In fact Sri Lanka during the period of colonialism was an export economy par excellence while currently the growth in the economy has been mainly led by infrastructure and construction activity coupled with the continuous growth in inward labour remittances. The problem in gauging export performance as a share of the GDP is that it’s not reflective of the technological composition of exports which has remained unchanged over the years and export volumes have increased without a qualitative effect on its production structure (i.e capital to labour ratio and depth of industrial linkages) and on the economy in general.
International trade theory incorporates into its analysis the impact of international trade on capital accumulation, division of labour, long run factor supply and factor productivity of the domestic economy. Further, Smith’s theory of international trade rests on the dictum that ‘the division of labour is limited by the extent of the market’. That is to say that the extent of the division of labour in the economy determines the extent of specialisation of knowledge employed in the process of production. Increasing complexity of division of labour and hence specialisation is availed by access to wider markets. Therefore, one of the key objectives of entering international trade is to improve the general level of specialisation and technological complexity of the economy rather than as a means of offsetting the deficit in the trade account. The transformative effect of international trade on the domestic economy pointed out by Smith however, would not materialise if the economy continues to supply primary goods to world market which do not depend for their success on scale economies and specialisation.
The Real Exchange Rate Model and Growth in Industrial Output
The drop in exports income as a share of the GDP over time in Sri Lanka is attributed to the current incentive structure in the economy, which is such that resources are being directed to nontradable sectors. It is held that though growth has been buoyant the source of growth has been nontradables: construction, mining and quarrying, retail/wholesale trade and public administration. This has been attributed mainly to the overvalued real exchange rate and the tariff regime.
However, it should be mentioned in this regard that the resources in the economy are utilised within a framework of primary technique. The framework is not disturbed by an improvement of relative prices of production factors in favour of capital against labour nor the improvement of relative prices of the output of advanced product categories by the depreciation of the real effective exchange rate (REER). The REER determines the sectoral relative price of nontradables and tradables and hence governs the flow of resources within the two sectors with other conditions remaining the same. However, the effect of REER is neutral in deciding the flow of production factors within the tradable sector; i.e., the flow of resources from primary products to semi advanced and advanced industrial products. Also the REER is neutral in deciding the flow of production factors from nontradables to advanced industrial investments. This is evident from the depreciation of the domestic currency by as much as 225% over the past 23 years (from LKR 40.00/USD to circa LKR 133.00/USD since 1990) but exports continuing to preserve its primary goods character and is a decreasing share of the GDP. Further, the REER shows a depreciation of circa 32% over the past ten years as shown in the accompanying graph, indicating that there is little connection between the REER and growth in nontradables and other more critical factors are at work. In spite of the depreciation of the REER the growth in nontradables has been phenomenal and is continuing.
The preceding discussion points out that rather than the overvaluation of the REER, it is the regional disparity in factor productivity and factor organisation which prevents the flow of resources from nonindustrial to industrial products; an advanced production structure is required from the outset for industrial investments to expand. The technological and organisational gap at the regional level prevents the allocation of resources in the domestic economy from responding to favourable relative prices in industrial products (excluding construction, mining & quarrying, infrastructure and power generation). Relative prices determine the flow of resources only within the low technological and nonindustrial framework, i.e., from one sphere of investment to another within the nonindustrial structure. This is to say the production factors are not developed sufficiently to exploit the full range of investment spheres offered by relative prices and comparative costs in the economy. Hence, although relative prices of industrial production being favourable, investments may not breach its traditional organisational structure for the reason that production factors are insufficiently developed and organised to exploit the full range of avenues offered by relative prices. Therefore, the problem in the economy does not lie with the flow of resources from tradables to nontradables as suggested by academics but the absence of resource flow from primary product categories to semi advanced and advanced industrial investments, and this is not a function of the REER as shown earlier. The state in this regard has a crucial role in designing a proper stream of nonmarket interventions replicating the experience of East Asian NICs to restructure the economy in favour of industrial development from its current over reliance on construction, leisure and labour remittances led development.
*Dhanusha Pathirana work as an Economic Analyst at the Asia Wealth Management (pvt) ltd.
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