IPS’s take on the State of the Economy 2013

Wednesday, 16 October 2013 00:00 -     - {{hitsCtrl.values.hits}}

The Institute of Policy Studies of Sri Lanka (IPS), apex think tank on socio-economic policy issues, has been publishing the State of the Economy report since 1992 with a complementary theme selected each year. This year’s report launched on Tuesday looks at Sri Lanka’s Transition to a Middle Income Economy and which areas require particular policy attention in order to facilitate this transition. After posting impressive growth rates of over 8% in the two years following the end of the conflict, growth in 2012 moderated to 6.4%. Following economic overheating in the second half of 2011 – evidenced mainly by a rapidly expanding trade deficit – the Government undertook a series of adjustment measures in early 2012. These came in the form of higher interest rates (with a credit ceiling on bank lending), allowing flexibility on the exchange rate, tax hikes on a major import item – cars, and higher energy prices (through allowing greater pass-through and a cut in subsidies). Coupled with adverse weather that affected agriculture, growth moderated considerably last year. Exports and imports As 2012 progressed, the country saw a sharp decline in both exports and imports. The former was due to the weak growth of destination markets of Sri Lanka’s exports and the lower prices of key commodities like cotton and rubber which depressed export prices. The latter was due to the rupee depreciation, tighter credit conditions and duty hikes which curbed import demand, and also lower world commodity prices. The tighter credit conditions were a central feature of the 2012 growth slowdown in the country. Credit to the private sector saw a sharp decline throughout 2012 in response to the credit ceiling imposed by the Central Bank of Sri Lanka and higher policy rates. Recent trade patterns do not appear to have reversed this trend. In 2012, Sri Lanka’s exports contracted by 7.7% across all segments (except mining), and the main contributor to the decline was industrial exports (13%). Latest results from the first quarter of 2013 showed an 8% contraction, with industrial exports declining the most. During the same period, Sri Lanka’s competitors like Bangladesh and Vietnam increased their exports, by 16.2% and 19.7%, respectively. So, clearly, only part of Sri Lanka’s export performance can be attributed to the weak global economic climate, and depressed demand in Sri Lanka’s key markets. There are other more relevant factors as well. Sri Lanka has not been successful in expanding its export markets through either bilateral or regional trading arrangements. Neither has it enhanced competitiveness from more value added exports or innovative products by enhanced research and development initiatives. This focus away from export-led growth has manifested itself in a changing structure of the economy. Much of the sources of growth in the post-conflict three years have been both directly from domestic non-tradable sectors like construction (infrastructure development) and retail, as well as the tourism sector, and indirectly through foreign worker remittances. It is understandable that following decades of constraint during the war, non-tradables like construction and retail would see a natural post-war boost. But literature suggests that countries which successfully navigated the middle-income transition saw their tradables sector grow much faster than non-tradables. Energy Energy is an essential component of driving Sri Lanka’s export growth. With rising costs of electricity, it is very essential that Sri Lanka places a significant amount of consideration on energy efficient production processes as well as renewable energy. It is clear that Sri Lanka cannot keep postponing bold and essential reforms pertaining to the energy sector. Evidence from both domestic and international sources suggests a strong relationship between electricity supply and economic growth. Sri Lanka’s ambitions of rapid growth towards middle income status would certainly be hampered by insufficient and costly energy supply. Estimates suggest that a further 100MW of electricity is required to be added to the grid each year, to meet the annual demand of the country, which is set to nearly double from around 9,286 GWh in 2010, to 17,489 GWh in 2020. Household expenditure patterns suggest that electricity consumption is highest among those in the middle class income group. A growth in this group would no doubt put additional pressure on energy resources. In order to cater to rising energy demands, and increasing levels of expenditure by the rising middle class, it is essential that the Government pays attention to securing the necessary investments. In this respect, revenue generation is a top priority. Taxation On the revenue side, taxation continues to be a concern. Recognising the taxation imperative in fiscal consolidation, the Government appointed a Presidential Taxation Commission in 2009. Following the release of its final report in 2010, some significant tax reforms were undertaken through the 2011 Budget. This included lowering of corporate and personal income tax rates with a view to encouraging economic activity, removing the PAYE tax exemption enjoyed by public servants since the late 1970s, rationalising some border taxes, and streamlining the tax incentives regime. But these reforms are yet to deliver higher revenue. In fact, in 2012, the tax to GDP ratio declined to its lowest level in 20 years – 11.1%. This is well below the average tax ratio of comparable lower middle-income countries of 18%. Essential administrative reforms did not accompany the reduction in rates, which in turn impeded the widening of the tax base to offset the revenue loss. Meanwhile, VAT exemptions and zero ratings have increased to accommodate political lobbies. Physical infrastructure Sri Lanka is increasingly investing in physical infrastructure. These forms of physical infrastructure are important to drive export led growth in a post-war context. While revenue generated by taxation is invested in physical infrastructure, it is far from sufficient. Hence there is a need for Public Private Partnerships in infrastructure development. The next agenda needs to be private participation in infrastructure projects, to ease the financing burden on the Government for the next raft of infrastructure projects. The opportunities are vast. The Government estimates that, in port-related infrastructure alone, around US$ 10 billion of projects will open up for private investment over the next five-years. Mobilising private capital for public projects isn’t easy. Recent experience in India amply demonstrates this. Despite a large infrastructure financing need, private capital in the form of private-public partnerships (PPPs) or infrastructure bonds have been slow to come in as investors are wary of tenuous processes and doing business with the state amidst concerns over corruption. This holds important lessons for Sri Lanka as well. While the policy of welcoming private investment into infrastructure has been clear and consistent by the Government of Sri Lanka (GoSL), complicated procedures and implementation problems have tended to detain many private investors from participation in public infrastructure projects. With a relatively small domestic private sector capable of undertaking such costly projects with long gestation periods, accompanied by their often risk-averse nature, foreign investment and joint ventures become ever more important. To what extent foreign investors are willing to navigate complicated procedures and undertake long-term commitments under Build-Own-Operate or Build-Operate-Transfer types of PPPs is still unclear. Meanwhile, for the domestic private sector, the recent relaxing of restrictions on overseas borrowing may ease the fundraising constraint faced by them, and could help position them to play a greater role in public infrastructure projects. Social infrastructure Physical infrastructure is only part of the arsenal the Sri Lankan economy needs to make a strong middle income transition, and sustain growth over a longer period. Social infrastructure will determine the quality of the country’s workforce that truly drives growth. While connective infrastructure has been getting much attention in Sri Lanka, sectors like education and health are beginning to show significant gaps resulting from underinvestment in recent years. While physical infrastructure is essential for economic growth and Sri Lanka’s transition to middle income status, social infrastructures should also be developed at the same time.  Sri Lanka is continuing to reap the benefits of impressive investments in education and health in the post-independence period. However, the transition to middle-income status brings with it new challenges to human development. Public expenditure in education has fallen from an average 2.3% of GDP during the 2000 to 2010 period, to a 10-year low of 1.8% of GDP in 2012. The average upper middle-income country spends 5% of GDP, and the average lower middle-income country spends 4% of GDP on education. Meanwhile, over 100,000 A/L graduates each year are not able to pursue higher education as state universities are unable to accommodate them, and the alternative of private higher education is affordable mainly to more affluent households. In 2012, 40,000 more were left out, than in 2011. The effects of Sri Lanka’s waning demographic dividend are already manifesting itself in labour force participation rates. 7% fewer young people were in the labour force in 2010 compared to 2006. This means that with the demographic dividend on its way out, Sri Lanka is expecting to reach upper middle-income status and beyond, with fewer people working to get there. This means greater investment in education and skills development, so that the smaller cohort of young people still in the labour force generates more output per person. Challenges in the health sector are also emerging, with changes appearing in the demographic and socio-economic character of the country, associated with the transition to middle-income status. This is particularly true of Non-Communicable Diseases (NCDs) and malnutrition. Along with lifestyle changes that accompany higher living standards, the epidemiological profile of the population will change, and it has already begun. An ageing population will bring additional health care burdens too, as health demands of the old are generally higher than those for other groups. Youth employment With middle-income status come changes in the aspirations of youth with regard to the type of employment they seek. Anecdotal evidence suggests that manufacturing enterprises are facing difficulties finding workers for the ‘factory floor’. With a shifting of preferences away from blue-collar work, the pressure on the education system to deliver the required training and skills is immense. These changes seem to be influencing youth participation in the labour force. For instance, youth labour force participation rates in the estate sector saw the biggest decline between 2006 and 2010, falling by almost 12% (compared to 7% nationally). This could be a reflection of the changing aspirations of young people, away from the opportunities available in the estate sector, towards jobs elsewhere. With aspirations towards urban jobs (especially in the services sector, like retail) on the rise, and the consequent tighter competition for these jobs, urban unemployment among youth has shown an increase from 12 to 14% between 2006 and 2010 – the only sector to see a rise in youth unemployment during this period.     It is essential that workers are equipped with necessary skills in order to meet the emerging income opportunities. At the same time, it is important to create a safety net for the poorest and those most likely to be ‘left out’. An important part of moving towards a middle-income country is ensuring adequate protection for the most disadvantaged population groups and those that are most vulnerable to shocks. Poverty While Sri Lanka has made impressive gains in reducing poverty, the fact remains that a significant share of households are clustered just above the poverty line and various shocks – be it at household level or macroeconomic – could easily push them back into poverty. While there are a multitude of social protection programs currently operational, most of them deliver grossly insufficient benefits, are poorly targeted, and do not cover the risks and vulnerabilities adequately. This is most evident in the country’s largest program, Samurdhi. The maximum amount of income transfer delivered by Samurdhi to a household is Rs. 1,500, while the national poverty line dictates that a person requires at least Rs. 3,300 per month to meet his/her consumption needs. Better targeting in social protection schemes like Samurdhi can free up more funds to give to those who most need it. Estimates reveal that only around 15% of Samurdhi recipient households are actually poor, while as much as 49% of households identified as poor do not receive any Samurdhi benefits. At a time when fiscal pressures are rising, the Government will have to move away from a blanket-approach to social welfare towards a more targeted and effective social protection architecture. Urbanisation Effective social protection architecture needs to carefully look at inevitable changes such as urbanisation.  While Sri Lanka’s rate of urbanisation has been quite slow compared to other developing countries, this could change as the country makes the transition to middle-income status. Associated with this is the creation of new vulnerable groups, especially those who are categorised as urban unemployed and who slip into urban poverty. Looking at just the poverty head count index, or HCI may be misleading. Although evidence shows that urban poverty HCI is very much lower than that in the estate sector, the actual number of poor in urban areas is higher. Moreover, the depth of urban poverty is more acute than in other sectors. The amount of monthly transfers needed to bring an urban poor individual out of poverty is Rs. 680 compared to Rs. 587 for an average poor individual in the country. It is not just in the urban sector but the skill-based technological change that is likely to be a feature of Sri Lanka’s middle-income transition can have an impact on overall wage dispersion. Rising income inequality could reduce both social mobility and future prosperity.  At the aggregate level, more than half of all income in the country is received by the richest 20% of households, while the poorest 20% receive just 4.5% of the income. Weather Another source of vulnerability emanates from changing weather patterns and natural disaster-related shocks. Severe adverse rainfall events in Sri Lanka’s dry zone in early 2011 and late 2012 heavily impacted farmers’ livelihoods, while severe cyclonic conditions in an unusually strong monsoon season in June 2013 hit fishing communities across the southern and south-eastern parts of the country causing nearly 50 fatalities. While social protection schemes must expand coverage to these emerging types of risk, a big part of guarding against these vulnerabilities is to have better information and provide it to those who need it. Called Climate Information Products (CIP), these can help communities, and the country at large, make adaptation decisions and be better prepared for the fallout from adverse climatic changes. In Sri Lanka, credible CIPs are scarce – especially in the areas of agriculture, water resource management, energy generation planning, and disaster risk management. Overall, Sri Lanka is facing new challenges as it makes the transition to a middle-income economy. A key characteristic of other economies that have made, or are in the process of making, this change is a growing global middle class and the acknowledgement that this class can have positive impacts on growth and development. The best means of growing this middle class is to strengthen what is at the heart of their emergence – access to secure, well-paying employment opportunities. This means that Sri Lanka must focus on expanding tertiary education and vocational training. The rising socio-economic prosperity in Sri Lanka, if fostered cleverly and inclusively with progressive public policies, can spur economic dynamism, innovation, and social progress, and place the country on firmer ground, as it makes a decisive transition into a middle-income economy and beyond.