Rethinking Sri Lanka’s Industrialisation Strategy

The present Government has not so far come up with a definitive industrial development policy. However, according to the manifesto issued at the Presidential Election (Vistas of Prosperity and Splendour), the envisaged policy choice is a ‘mixed-economy’ model that combines selective import substitution with export-orientation – Pic by Shehan Gunasekara

The history of industrialisation strategy in Sri Lanka is characterised by abrupt episodes of substantial changes associated with political regime shifts without settling to a stable path required for self-sustained growth. 

During the first decade after independence in 1948, development of industry was not a policy priority in Sri Lanka, unlike in many other newly-independent nations. From about the late 1950s, a combination of the influence of the development thinking at the time and growing balance-of-payments problems induced a policy shift towards State-led import-substitution industrialisation. In 1977 Sri Lanka embarked on an extensive economic liberalisation reforms process that marked a decisive break with a two decades of State-led import-substitution industrialisation strategy. 

By the mid-1990s, Sri Lanka ranked amongst the few developing countries that had made a significant policy transition from inward orientation to global economic integration. However, over the past two decades, the merits of industrialisation under liberalisation reforms have become a hotly debated issue in the Sri Lankan policy circles. 

The anti-liberalisation lobby has begun to portray the failure of reforms to elevate the country to the league of dynamic East Asian economies as an intrinsic flaw of liberalisation reforms, while downplaying (or overlooking) the constraining effects on the reform outcome of the incomplete and staggered nature of the reform process and prolonged civil war. The policy pendulum has therefore begun to shift in favour of combining import substitution with export orientation with a specific focus that involves ‘guiding the markets’. The massive disruption in world trade caused by the Covid-19 pandemic has further strengthened the case for economic self-reliance, underpinning national development priorities. 

The paper aims to contribute to the contemporary policy debate in the country on the need for and modalities of redesigning the country’s industrialisation strategy by analysing changes and continuities in Sri Lanka’s industrialisation strategy during the post-independence era. The analysis is guided by the received body of knowledge relating to the challenges faced by a small economy that takes world prices as given and is unable to affect world demand and supply. 

The paper specifically focusses on factors behind shifts in industrialisation strategy away from and towards global economic integration and the outcomes with respect to export performance, growth and employment generation, while paying attention to rapidly changing global context in this era of economic globalisation. 

The paper begins with an overview of changes and continuities in Sri Lanka’s industrialisation strategy during the post-independence era. This is followed by a comparative analysis of Sri Lanka’s experience under import substation and export-oriented industrialisation strategies, with emphasis on fundamental sources of discontent in the Sri Lankan policy circles with export-oriented industrialisation strategy. The final sections summarises the key findings and their implications for the contemporary policy debate in Sri Lanka.

A brief policy history

During the first decade after independence in 1948, Sri Lanka maintained an open-market economy, with a liberal trade and Foreign Direct Investment (FDI) policy regime. Unlike in many other newly independent countries, the development of manufacturing was not a policy priority. The main emphasis of the Government’s development agenda was reviving domestic food crop agriculture, predominantly rice, mainly based on colonisation in the sparsely populated dry zone of the country (Snodgrass 1966). 

A major shift in development strategy towards import substitutional industrialisation with increased Government intervention and State monopoly over strategic industries, took place following political regime shift in 1956. At the beginning, the policy shift was consistent with the conventional wisdom of the day in favour of import-substitution industrialisation, but from the late 1950s import-restrictions became an integral part of the Government response to the worsening external payments situation. 

The import-substitution rhetoric merely provided an ideological facade that was politically useful as the Government was not willing to run the political risk of undertaking structural reforms in response to the balance of payment crisis. Import restrictions, initially imposed to address balance of payment difficulties, became increasingly tight with pervasive State interventions in the economy. The Business Acquisition Bill passed in 1971 allowed the Government the takeover of any business enterprise, without providing safeguard against arbitrary takeover. By the mid-1970s, the Sri Lankan economy had become one of the most inward-oriented and regulated economies in the world outside the Communist Bloc. The activities of the private sector remained caught up in a complicated cobweb of State controls. 

Export promotion became a key policy focus as an appendage to the control regime in the late 1960s. In 1966, a bonus voucher scheme for non-traditional exports (broadly defined to encompass all exports other than tea, rubber and coconut products) was introduced. During 1968-70, a foreign exchange entitlement certificate scheme (FEECS), a dual exchange rate system with an exchange rate premium of 40% for non-traditional exporters, was part of a mini-trade liberalisation episode. The FEECS premium was raised to 65% and a new convertible rupee account (CRA) scheme was introduced in 1972. 

A white paper of foreign direct investment issued in 1972 assured export-oriented foreign investors complete security of investment, complete compensation in the event of nationalisation, and remittance of profit and repatriation of assets on business closure. However, these policies had little impact on averting the worsening external payments conditions of the country because the overall policy and political context was highly unfavourable to private sector activities in general and to export production in particular.

Reflecting the cumulative impact of stringent trade controls, high export taxes and the overvalued exchange rate, the overall incentive structure of the economy was characterised by a significant ‘anti-export’ bias throughout this period. In the early 1970s, there was a proposal in Government circles to set up a free-trade port at Trincomalee, but it was not acceptable to the left wing parties in the Coalition Government (Fitter 1974).

By the mid-1970s, the State-led import substitution strategy had made the Sri Lankan economy extremely vulnerable to external shocks. Consumer goods imports had gradually converted into essential imports needed to maintain domestic output. There were no longer any compressible import fat left to cushion the economy against unexpected shortages of foreign exchange. As noted, the expansion of non-traditional exports had only a marginal cushioning effect against the unsatisfactory performance of traditional exports. There was clear evidence exposing the myth that Sri Lanka could develop in isolation from the forces moulding the world economy. The groundswell of dissatisfaction of the populace with the Government paved the way for a regime change in 1977.

The new Government embarked on an extensive economic liberalisation process that marked a decisive break with the two decades of protectionist policies (Snodgrass 1998, Rajapatirana 1982, Athukorala and Rajapatirana 2000). 

The first round of reforms carried out during 1977-79 included (a) replacing quantitative import restriction with tariffs that provided lower levels of nominal protection for domestic import-substitution industries; (b) opening the economy to Foreign Direct Investment (FDI), with new incentives for export-oriented FDI under an attractive Free Trade Zone (FTZ) scheme and constitutional guarantee against nationalisation of foreign assets; (d) abolition of the multiple exchange rate system followed by a sharp devaluation of the unified exchange rate; (e) the introduction of limits on direct public sector participation in the economy, and (e) a wide ranging export promotion schemes, including a revamped duty rebate scheme for export producers, under a newly established export development board (EDB). 

A ‘second wave’ liberalisation package was implemented during 1990-93. This included abolishing export duties on all plantation products; extension of FTZ privileges to export-oriented firms located outside the EPZs, abolishing import duties on textile in order to help the expansion of the export-oriented garment industry, and significant fiscal consolidation (Dunham and Kelegama 1997). In 1994, Sri Lanka achieved Article VII status of the International Monetary Fund (IMF) after abolishing foreign exchange restrictions on current account transactions, including the foreign exchange surrender requirement on export proceeds.

The liberalisation reforms made a clear departure from the import substitution policy posture. However, the reform package was partial in nature in terms of the standard prerequisites for a market-oriented economy. First, while some loss-making public enterprises were either shifted to the private sector or closed down, a number of them continued to operate with heavy dependence on budgetary transfers. Second, a gazetted bill to reform the labour legislation to achieve greater labour market flexibility was abandoned in face of widespread opposition by the trade unions. 

Third, the complementarity between macroeconomic management and trade liberalisation required for maintaining competitiveness of tradable production in the liberalised economy was missing. The original reform package of 1977 was formulated with emphasis on the complementarity between macroeconomic management and trade liberalisation. The dual exchange rate system, which had been in operation since 1968, was abolished and the new unified exchange rate was allowed to adjust in response to foreign exchange market conditions. 

However, the Central Bank soon began to deviate gradually from the original plan and to intervene in the foreign exchange market to use the nominal exchange rate as an ‘anchor’ to contain domestic inflation. The policy emphasis on fiscal prudence, too, was short-lived. The main source of macroeconomic instability was a massive public-sector investment program that included the Mahaweli river basin development scheme, a large public housing program, and an urban development program (Jayasuriya 2004). 

The real exchange rate (RER) (the stranded measure of international competitiveness of an economy), which significantly depreciated showing improved international competiveness during the first few years following the economic opening, tended to appreciate during the ensuing years. Mild depreciation of the nominal exchange rate under the managed floating system was more than counterbalance by the rate of increase in domestic prices that was far greater than that of Sri Lanka’s trading partners. There was a notable reversal in RER appreciation during the second wave liberalisation, but it quickly dissipated. 

Reaping gains from liberalisation reforms was also seriously hampered by the escalation of the ethnic conflict from the early 1980s. The conflict virtually cut off the Northern Province and large parts of the Eastern Province (which together account for one-third of Sri Lanka’s total land area and almost 12% of the population) from the national economy. 

Even in the rest of the country, the prospects for attracting foreign investment, particularly in long-term ventures, were seriously hampered by the lingering fear of sporadic attacks by the rebels. The Government’s preoccupation with the civil war also hampered capturing the full benefits of economic opening through delays and inconsistencies in the implementation of the reform processes.

Despite the incomplete reforms and the debilitating effect of the civil war, the reforms significantly transformed the economic landscape of Sri Lanka (next section). The economic gains from reforms was substantial to make economic liberalisation by-patrician policy by the mid-1990s. However, as early as the late 1990s, the trade liberalisation process suffered a setback because of the pressure for raising additional revenue from import tariffs to finance the ballooning war budget. The planned reduction of tariffs into a single band was abandoned and from then on tariffs were adjusted frequently in an ad hoc manner. The protectionist tendencies soon received added impetus from the growing discontent amongst the electorate, which was propelled by the crisis economic conditions as the civil war accelerated. 

The backlash against liberalisation reforms gained added impetus as the country returned to a state of normalcy at the end of the three-decade old civil war in May 2009 (Pursell 2011, Kaminski and Ng 2013). The Government begun to emphasise the role of the State in ‘guiding the markets’ with a view to redressing untoward effects of economic globalisation. Privatisation of key State enterprises (banking, power, energy, transport, and ports) was explicitly ruled out, while conspicuously avoiding any reference to trade policy reforms (GSL 2010). 

By 2009 the Sri Lankan tariff schedule included nine import taxes in addition to the standard customs duty. Of these nine taxes, five were ‘para-tariffs’: taxes which are only applied to imports and hence added to whatever protection is provided to domestic production by customs duties. The total nominal protection rate (customs duty + para-tariff) more than doubled (13.4% to 27.9%) between 2004 and 2009 (Pursell 2011). During the ensuing years, there were also many ad hoc duty exceptions and case-by-case adjustment of duties on many manufacturing imports which directly compete with domestic production. By 2015, the average effective rate of protection for manufacturing production was 63%, and production for the domestic market was over 70% more profitable compared to production for exporting (DCS 2018). 

In 2008 the Parliament passed a Strategic Development Projects (SDP) Act, empowering the minister in charge of the BOI to grant exemptions to ‘strategic development projects’ from all taxes for a period of up to 25 years. In the Act, a strategic development project meant ‘a project which is in the national interest and likely to bring economic and social benefits to the country and which is also likely to change the landscape of the country, primarily through provision of goods and services which will be of benefit to the public, substantial inflow of foreign exchange, substantial employment, and technology transfer’ (Government of Sri Lanka 2008). This definition left a great deal of room for the minister’s discretion in the investment approval process, thus undermining the role of the BOI. 

A Revival of Underperforming Enterprises and Underutilised Assets Act was passed in November 2011 empowering the Government to acquire and manage 37 ‘underperforming’ or ‘underutilised’ private enterprises. The list included seven enterprises with foreign capital participation. Two major credit rating agencies (the Fitch Group and Moody Corporation) warned that the bill would erode investor confidence and affect Sri Lanka’s investment rating (Goodhand 2012). 

The period from 2015 to 2019 was an era of policy inaction. In spite of the promised commitment to outward-oriented development strategy, no attempt was made to redress policy reversals. The Government was active in preferential trade liberalisation by entering into Free Trade Agreements (FTAs), overlooking the fact that Sri Lanka’s lacklustre export performance was primarily rooted in unilateral policy reversals and other supply-side impediments. There was also an undue emphasis on achieving ‘sophistication of the export composition’ within the ‘global product space’ while ignoring the country’s unexploited opportunities for export expansion by specialising in task within global production networks that fit with the country’s relative cost advantage (Thompson and Athukorala 2019). 

The present Government has not so far come up with a definitive industrial development policy. However, according to the manifesto issued at the Presidential Election (Vistas of Prosperity and Splendour), the envisaged policy choice is a ‘mixed-economy’ model that combines selective import substitution with export-orientation. 

In April 2019, the Government appointed a Presidential Task Force on Economic Reveal and Poverty Eradication (PTFERPE) to recommend establishing ‘a people-centric economy that encourages local industrialists and entrepreneurs, blending new technologies with expansion of import substitution products, local farmer products, agricultural products and other small and medium scale industries to encourage exports and reduce the trade gap by devising measures to diversify the production economy’ (Government of Sri Lanka, 2020, p. 5A). 

The Task Force has come up with a list of potential winning industries, ‘pharmaceuticals, rubber products, coconut related products, spices, electronics and electrical components, ship and boat building, food and beverages, cosmetics, toys, machinery and machinery appliances, and ceramic products among others’ for selective policy intervention (CBSL, 2021, p 20).

The Central Bank endorsed that ‘the novel economic policy framework of the Government is expected to address impediments to growth and promote domestic production especially though the agricultural sector and earmarked manufacturing and export industries, while enhancing non debt creating foreign exchange inflows’ (CBSL 2021, p 3). 

The Bank further stated that ‘ ... in the short term, prioritising winning industries of the country, will drive the overall export performance, while enhancing domestic production ... [and] resolve the numerous legacy issues that straddle the performance of the export sector’ (CBSL 2021, p. 20), without spelling out what these so-called ‘legacy issues’ are. 

(To be continued)

(The full paper, with figures, tables and references, is available at https://acde.crawford.anu.edu.au/publication/working-papers-trade-and-development)

(The writer is attached to the Arndt-Corden Department of Economics, Crawford School of Public Policy, Australian National University and can be reached via [email protected])