By W.A Wijewardena –

IPS SOE 2013

The Institute of Policy Studies or IPS, Sri Lanka’s independent economic policy think-tank, has issued its review of the State of the Sri Lanka’s Economy in 2013 or SOE 2013 under a theme which is both current and opportune. The theme is how Sri Lanka should ensure a smooth and seamless transition to a middle income economy. Ensuring sustainability and tackling middle income trap are issues in Sri Lanka

This may be puzzling to many because Sri Lanka is already in the Middle Income Country Category as claimed by the country’s top policy makers. Then why should IPS talk about the country’s transition to a middle income country now? The reasons are many.

One is that though Sri Lanka is in the middle income country category, it has just graduated from a poor country to a lower middle income country a few years ago. It has to go a long way to consolidate its position as a lower middle income country first and then move up in the league table as a higher middle income country and finally to be a rich country, the goal of the country’s top policy makers.

Though this growth path seems to be straight-forward and achievable without midway hassles, there are indeed some midway hassles which other countries in a similar category have faced in their journey toward becoming rich countries. That hassle is known as the Middle Income Trap in which a country is ensnared making it impossible for it to move further up.

Thus, there are two issues which a country like Sri Lanka has to resolve successfully in its current stage of economic development. One is the maintenance of the current economic growth initiatives unimpeded, known as the sustainability issue. The other is the problem of shooting the country from middle income to high income, known as the middle income country trap.

Sri Lanka may have been caught in the lower middle income trap

This writer in two previous My Views has brought these two issues to the attention of the readers. In the first My View titled ‘Will Sri Lanka be snared in a lower middle income country trap before it reaches the middle income country trap proper?’ the question was raised whether Sri Lanka would be trapped in a lower middle income country trap before it elevates itself to the middle income country trap proper in view of the rising wage costs, lack of appropriate foreign direct investments and the emerging macroeconomic imbalances in the style of untamed current account gap in the balance of payments and unfinanced gap in the budget (available at: http://www.ft.lk/2012/01/23/will-sri-lanka-be-snared-in-a-lower-middle-income-trap-before-it-reaches-the-middle-income-trap-proper/).

In the second My View titled ‘Want to beat the middle income trap? Follow Ten Commandments of Dr. Duvvuri Subrarao,’ the problems of the Middle Income Country Trap proper as presented to Sri Lankan audiences by the former Governor of the Reserve Bank of India, Dr Duvvuri Subrarao in his keynote address at the Annual Sessions of the Association of Professional Bankers in Colombo in September, were discussed (available at: http://www.ft.lk/2013/10/14/want-to-beat-the-middle-income-trap-follow-10-commandments-of-dr-duvvuri-subbarao/).

Now this debate has been further carried forward by a comprehensive analysis of the issue by IPS in its State of the Economy or SOE 2013 just released.

What is Middle Income Country Trap?

The Middle Income Country Trap is simply a situation where a country which has reached the Middle Income level being unable to move up and become a rich country, theory formulated on the basis of the observation of the growth pattern of countries like Malaysia, Chile, Brazil and Mexico to mention but a few of the countries faced by the problem.

It has been observed that it is easy for a poor country to become a middle income country by attracting foreign direct investments or FDIs that engage the cheap labour available in the country to produce mass products of low technology to the world market. With cheap labour and low technology, these countries can excel in growth and increase incomes. But when they become middle income countries, their wage levels go up and as a result they find it difficult to compete with new entrants to the market with cheap labour in their countries. So, the increase in income gets halted.

These countries will now have to compete with rich countries with high technology developed in-house; without high technology of their own, they find it difficult to compete with them and continue to increase incomes. Thus, they are trapped in their growth and that trap is known as the Middle Income Country Trap. Today, new countries that have been ensnared in this trap are Russia, China, India and South Africa, all the countries in the BRICS group since Brazil is already caught up in the trap.

Sri Lanka’s challenge: How to beat the Middle Income Country Trap?

In this context, the main challenge faced by Sri Lanka today is how to beat the Middle Income Country Trap. Hence, the comprehensive analysis done by IPS in its SOE 2013 focussing on aspects hitherto ignored by policy makers should provide guidance for Sri Lanka to map out its future growth strategies.

The IPS study has been broken into four parts, one on the issues relating to Growth and Stability, the tagline used by the country’s Central Bank to describe itself another on the problems involved in the transition to a Middle Income Economy, a third outlining policy briefs and finally a section highlighting the prospects for the country.  Since Sri Lanka is already in the lower part of the Middle Income Countries, what IPS actually means seems to be the transition to the higher part of those countries, the question raised by this writer too in his first My View on the subject.

Human capital to support physical capital

IPS has emphasised the need for having the correct economic policies in place in order to sustain the economic growth momentum shown by Sri Lanka in the two years immediately following the end of the conflict in the country. One such policy change is the maintenance of a proper balance between the development of the physical infrastructure and the human infrastructure. Physical infrastructure consisting of roads, ports, airports, buildings, power-plants etc contributes to economic growth by facilitating economic activities. However, it is necessary but not sufficient to sustain economic growth.

The sustenance of growth depends on a fine combination of physical infrastructure with the development of human skills, health, knowledge and talents, commonly known as the human infrastructure. IPS has noted that in the recent policy package of the government, attention has been paid to “connective infrastructure” such as roads, ports and airports; but what is lacking in Sri Lanka is that “sectors like education and health are beginning to show significant gaps resulting from underinvestment in recent years” (p 8).

Falling investments in education

In the case of education, what IPS has reported in SOE is a very gloomy picture. When an average upper middle income country has been spending about 5% of GDP on education and an average lower middle income country about 4%, Sri Lanka has reduced its expenditure from 2.3% of GDP 10 years ago to 1.8% in 2012. This is an appalling situation since education improves human skills and through human skills sustainable economic growth.

Reforming education is a must

But one may argue that a mere pumping of money into education without bringing about a complete reform will not help Sri Lanka to attain that goal. As South Korea has shown in the last five decades, reform of the education system through a quantitative expansion and a qualitative improvement will generate both educational development and scientific and technological development. It expands the pool of talented people in the country leading to socio-economic development. That improvement in socio-economic wellbeing will create new interest in investment in education thereby generating a virtuous circle of investment in education.

Therefore, investment in both relevant education and research and development or R&D should go hand in hand as shown by South Korea. In that country, R & D expenditure in 1963 has been a pittance remaining around 0.01% of GDP. But this was increased progressively over the last 50 years reaching a level close to 4% of GDP by 2012. Similarly, public expenditure in education which remained at around 2% of GDP in 1963 has risen sharply to over 5% of GDP by 2012. This process has been strengthened by changing focus from learning to creating and it has been an integral part of Korea’s Scientific and Technological Investment Policy.

Too many cooks will spoil the soup

IPS has not given a policy brief on the reform of the country’s education system based on the learning outcomes from success countries such as Singapore, Taiwan and South Korea in the region. This has been an urgent need in Sri Lanka since various ideas are being mooted piecemeal by those responsible for education without presenting a coherent program of action to suit its current development initiatives.

The matters in Sri Lanka today are worse because there are at least three ministries charged with education at school level and higher level and skills development. It does not appear that these three ministries are even in communication with each other, let alone coming up with a comprehensive reform program. Perhaps, IPS should as a matter of priority commission a special study on education reforms for guidance by the top policy makers of the country.

Introduce market reforms or perish

Another aspect which SOE 2013 has highlighted is the need for market reforms to sustain the current growth and drive Sri Lanka to the next stage of economic development. India made substantial gains through the initial market reforms undertaken by the country in early 1990s but the non-continuation of the reform program with the same zeal and vigour has caused growth to falter in the recent years.
Along with the faltering economic growth, India suffered from a severe foreign exchange problem that led to a sharp depreciation of its rupee first in 2009 and then in 2013. Though India had sufficient stock of foreign reserves to defend the rupee, it did not do so and allowed the rupee to find its value in the market.

China on the other hand, as reported by SOE 2013, in its 12th five year plan has clearly indicated pro-market reforms and policies to generate greater domestic demand as a way to stimulate growth. Recently, in a partial liberalisation of the capital account of the balance of payments, China went on setting up a free Renmimbi Zone in Shanghai. Sri Lanka should definitely learn lessons from both India and China.

Expansion of the public sector

Sri Lanka’s policy has been in the opposite direction to market reforms since 2005. Public sector has been elevated to a high pedestal making it the true contributor to the recent economic growth in the country. An undesired consequence of this policy has been the ever rising budgetary constraints that prevent the government to undertake needed capital expenditure programs unabated and undiminished. As a result, the initial growth that has been generated starts faltering after a few years for need of continuous public expenditure programs.

SOE 2013 has not minced words when it comes to identifying the causes of these budgetary problems in the country. It says that “the legacy of Sri Lanka’s welfare state, history of populist public spending programs, poorly managed State-owned enterprises, and a bloated public sector bureaucracy have made the rationalisation of expenditures an uphill task” (p 25).

In its Policy Brief, SOE 2013 has recommended the early implementation of tax reforms to generate revenue in order to finance an even increasing need of public expenditure programs including the development of education and health services in the country.

Pressure for exchange rate to depreciate

With respect to the prevailing severe pressure in the foreign exchange market for Sri Lanka rupee to depreciate, SOE 2013 has pointed to a dimension which the country’s Central Bank has not reckoned.  That is the aggressive push to stimulate the economy through the expansion of bank credit in the economy. The Central Bank has been doing this by continuously reducing the interest rate structure in the economy on the one hand and persuading banks to increase credit through what is known as “moral suasion tactics”.

But as this writer has pointed out in a previous My View under the title ‘The other side of low interest rates and Central Bank-sponsored lending policies,’ such government sponsored credit expansion necessarily leads to balance of payments difficulties in an open economy and through those difficulties, the pressure for the exchange rate to depreciate (available at: http://www.ft.lk/2013/06/17/the-other-side-of-low-interest-rates-and-central-bank-sponsored-lending-policies/).

This causal effect has been validated by SOE 2013 which says that “too much credit pumped to the economy will cause downward pressure on the exchange rate and may tempt CBSL once again to intervene at the cost of securing the country’s foreign exchange reserves” (p 32). The paradox here is that the Central Bank is the initial cause of exchange rate depreciation and then the ultimate cause of the continuing exchange rate depreciation due to the loss of foreign reserves.

A comprehensive policy brief

The Policy Brief suggested by SOE 2013 to ensure sustainable transition to a higher middle income country covers a very wide area of activities. It has recommended far-reaching tax reforms to secure sufficient revenue to finance the rising needs for public capital expenditure programs on one side and the development of the human capital through health services on the other. However, to make the development a true development, it has also come up with policy briefs on certain cross cutting issues as well. They involve addressing environmental and climate change issues and empowering women to make the maximum contribution to economic development.

Governance and related issues maybe too hot to touch

However, SOE 2013 has missed out the most important cross cutting issue in sustainable economic development. That is the economic governance and the related prerequisites for development namely, the observance of the rule of law, protection of property rights and the maintenance of law and order in the society. It appears that even for an independent think tank like IPS, these are too hot issues to touch in the current context.

*W.A. Wijewardena can be reached at waw1949@gmail.com