Fixing the external sector crisis: Viable long-term strategy is now necessary

Beware of the emerging comfort zone

The external sector crisis which Sri Lanka has been facing since early 2011 has now been temporarily fixed by allowing the rupee to depreciate against the US dollar by about 18 per cent since late November, 2011.

The gravity of the problem has also been eased by the expected higher inflow of remittances by Sri Lankans working abroad during the festive month of April and the slowed down import payments in this month since most of the imports targeting the festive season have been effected in February and March.

The impending release of a tranche of $ 400 million by IMF out of the earlier abandoned SBA in April will also add to Central Bank’s foreign reserves thereby helping the country to build confidence among the market participants about the availability of foreign reserves.

These developments may temporarily release the pressure for the rupee to depreciate in the immediate future. The danger of such salutary developments is that the Sri Lanka’s policy authorities may fall into another comfort zone thinking that the problem has now been permanently fixed.

Yet, the root cause of the ailment is still very much active and can paralyse the patient at any moment of time when the system becomes weaker. Hence, it is only a temporary breathing space for Sri Lanka and it should use this breathing space effectively to think and adopt some long term strategies to fix the problem permanently.

The crisis which has hit Sri Lanka today had many manifestations from around early 2011though they were not noticed by the country’s policy authorities.

Ignored manifestations of the crisis

Beginning from January 2011, there were signs that the gap between the country’s exports and imports, known as the trade deficit, was on the increase to a record high level. When exports were rising in dollar terms by about 20 per cent, imports were rising at a phenomenally high rate of over 50 per cent.

Yet, there was complacency on the side of authorities because, according to the statements issued by them, the gap did not pose an immediate problem and it could be financed out of the moneys sent by Sri Lankans working abroad, known as foreign remittances, and higher inflows to the government and the stock market. Besides, the rise in imports was considered beneficial and the warning sign was grossly ignored on the claim that they supplied raw materials for the country’s prospective high economic growth.

With the increase in the trade gap which surpassed the level in 2010 by mid-2011, there was pressure for the rupee to depreciate in the market. But the authorities were again complacent in the belief that the country had adequate foreign exchange reserves to meet that eventuality.

By end July 2011, the country’s gross foreign reserves, that is, the amount of foreign assets available without considering its payment obligations, were more than US$ 8 billion and it was considered a safe level to meet that eventuality. The gross assets were in fact sufficient to pay for four and a half months’ prospective imports in the twelve month period beginning from mid-2011.

But the reserves started to fall drastically since then and, by December 2011, the country had lost about $ 2 billion of reserves pushing down the reserve level to some $ 5.8 billion. Prospectively, these reserves could finance only less than three months’ imports.

Sri Lanka’s Government budget too had a major weakness in the sense that, to pay interest on the foreign loans and repay the principal of maturing ones, it was necessary to borrow more money from the foreign sources. This contributed to increase the amount of foreign borrowings by the government, but again, foreign borrowings as a ratio of the country’s total output, called GDP, showed a decline due to the faster rise in money GDP than foreign borrowings which are now converted to rupees at an unchanged exchange rate of Rs. 110 per dollar.

The failure to notice these manifestations was deadly: The crisis knocked violently at the country’s doors and eventually, the rupee had to be allowed to depreciate against the dollar in a free-fall since mid-February 2012.

Now that the value of the rupee against the US dollar has stabilised at around Rs. 130, it is natural to be complacent once again that the country’s problems are over. But, that is not the case.

Depreciation has established only salutary ground conditions

The depreciation of the rupee has removed one of the bottlenecks which exporters had been facing in the international markets, namely, the loss of competitiveness of the local products when compared with Sri Lanka’s close competitors. It also has encouraged the migrant workers to send more money to Sri Lanka because they now get more rupees for every dollar they send at the new exchange rates.

On the other side of the country’s external payments, its imports are now more costly and there are all the incentives for the local producers to supply many of the products at a competitive price. But these are only favourable ground conditions which the depreciation of the rupee has established.

This could be explained by an analogy. Suppose that a student is unable to study because of the disturbance made by an offending noise. Suppose further that the source of noise has been found and effective action has been taken to put a stop to it. But, does it mean that the student would necessarily study? No, because the main incentive to study comes from motivation to pass the examination and not from the absence of the noise.

Similarly, the depreciation of the rupee is like the removal of the noise. It helps a country to fix its problems temporarily by creating the suitable ground conditions for it to search for a permanent solution. Hence, there is a lot more to be done to attain that goal. That is where a viable long term strategy is needed.

Permanent solution: Go for high tech exports

The viable strategy requires Sri Lanka to concentrate on developing an export structure that would rise faster than its imports and thereby reduce its currently high trade deficit. The development of such a structure requires the country to diversify its industrial exports to new areas, namely, high tech exports.

Since the opening of the Sri Lanka’s economy in 1977, there has been a remarkable transformation in the country’s external trade. In 1977, about 79 per cent of the country’s exports consisted of tea, rubber, coconut and other minor agricultural exports, an insignificant diversification from its position in 1948 where these products accounted for 90 per cent of its exports.

Industrial exports in 1977 were just 14 per cent of total exports. By 1996, industrial exports had risen to 73 per cent and agricultural exports shrunk to 24 per cent. In 2011, the share of industrial exports rose to 76 per cent and that of agricultural exports fell to 22 per cent.

A similar transformation took place in the import structure as well. In 1948, consumer goods accounted for about 52 per cent of total imports. Even in 1977, they had a share of 42 per cent. But by 1996, their share fell to 19 per cent and continued to be around that level since then. The combined share of intermediate and investment goods imports increased from 48 per cent in 1948 to 56 per cent in 1977 and further to 77 per cent by 1996. In 2011, they accounted for 79 per cent of imports.

This transformation that has taken place in Sri Lanka’s external trade since 1977 is salutary. But it is not enough in terms of the changing external trade pattern of the world and, therefore, it is not sustainable either.

Low tech exports can easily be copied

Though the share of the industrial exports in total exports has increased significantly, those industrial exports are basically low tech products like garments and textiles and rubber products that have gone through simple manufacturing processes. The risk which a country faces when such low tech products dominate its export structure is that its competitors and those who enter the export market anew could easily copy them. It is simply a matter of getting the required machinery and raw materials and training the staff to operate those machines.

As a result, the country starts facing stiff competition from the prospective new entrants to the market. Further, when the labour costs in the country increases due to increase in income and inflation, its competitive edge is gradually eroded eventually driving it out of the export market. Hence, if a country desires to sustain its market place, it should necessarily go for products which cannot easily be copied by others.

Jack Welch: Driving of GE to high tech manufacturing

A good example in this regard is provided by Jack Welch, CEO of the US giant General Electric, popularly known as GE, in 1980s and 1990s. In his 2001 autobiography “Straight from the Gut”, Jack says that when he became GE’s CEO in 1981, the company was sailing in stormy weather toward bankruptcy because it could not compete with cheap Japanese products that had invaded its markets at home as well as abroad.

The company had made a name for itself for decades for its low tech electric household implements like ovens, cookers, refrigerators, irons and deep freezers. The success story it had in those products for so long had built a ‘comfort zone’ around it and no one had anticipated a change in the market conditions putting GE to peril one day. But the problem with those products was that they involved simple technology and could be easily copied by anyone. In 1970s, the Japanese did it and the result was the ailing American giant’s fast move toward bankruptcy due its being unable to compete with cheap Japanese products.

Jack says that he made a strategic plan to attack the very source of the problem. The Japanese had succeeded in penetrating its markets because its products could be easily copied. Even if GE succeeded in competing out the Japanese, it would not have solved the problem because in the next round, South Koreans would beat GE by copying them.

After South Koreans, the Singaporeans, Malaysians, Thais and Filipinos would join the line to compete out GE. Hence, the permanent solution for GE rested on moving into a product line which cannot be copied by others easily. That product line came from high tech industries. So, Jack says that GE concentrated in producing only three items which involved advanced technology and therefore could not be copied by others.

These three products were advanced medical equipment like MRI machines, jet engines and power generating turbines. For these products, GE has only two or three competitors worldwide and the entire global market is being shared by GE with them. Within a few years, according to Jack, GE had market dominance over these products and was successful in converting it from a vast electrical product manufacturer to a vibrant high tech US corporation.

Sri Lanka has low high tech exports

Sri Lanka’s future lies in transforming its industrial base from low tech to high tech industries. It cannot have all types of high tech industries, but only some selected ones to begin with. The likely candidates are new generation computers and office equipment, pharmaceutical products, telecommunication equipment and some of the chemical products for which the country can get the necessary technology and technical knowhow by teaming up with the world’s giant corporations. But it is not an easy and a quickly achievable goal. It therefore requires the country to go for a long term strategic plan and create the necessary ground conditions for moving toward that goal.

Sri Lanka’s high tech exports as reported by the World Bank (available at: http://data.worldbank.org/indicator/TX.VAL.TECH.CD) have been peanuts in the past. In 2007, its high tech exports amounted to US $ 107 million or 1.4 per cent of exports in that year. This number fell drastically to $ 44 million in 2009 accounting for a mere 0.6 per cent of exports in that year.

Neighbouring India has increased its high tech exports from $ 5 billion in 2007 to $ 10 billion in 2009. As a per cent of total exports, the share has jumped from 4 per cent to 8 per cent. India was able to raise its high tech export content in total exports by acquiring the necessary technology from American, European and Japanese companies.

Sri Lanka should be a partner of Western high tech companies

What should Sri Lanka do to promote its high tech exports? It has to acquire technology from abroad since it cannot develop technology at home in the immediate future. It also has to train the needed workforce to get employed in those industries. Above all, it should have an open mind toward foreign countries, especially the Western countries, so that companies in those countries can come and set up their industries here.

Who has the ever changing advanced technology in the world today? It is the countries which spend a greater proportion of their income on research and development in the first place and research and marketing later. The countries which come within this category are the US, EU, Canada, Japan and Australia, which are traditionally known as the Western world. Then, what about India and China? They too are engaged in research and development to some extent, but not to the extent of the Western world.

Singapore and China: Give up slogan-muttering and collaborate with the West

Knowing this global reality, Singaporean authorities at the turn of the new millennium instructed all the higher educational institutions in that country to concentrate only in four areas with generous support from the government: genetic engineering, information and communication technology, nano technology and entertainment. The reason was that in the next 100 years, it is those countries which would master in these areas that would rule the world.

At that time, it was the US and the UK which had a leading edge in them. So, Singapore’s strategy was to jump the bandwagon of the US and the UK and be an associate of the global leadership. Since technology is developed by the world’s leading universities and the universities in China have been lagging behind them, Chinese President Hu Jintao, as the chief guest of the Tsinghua University’s centenary celebrations in 2011 advised the university authorities to work toward upgrading that university which was 58th in the global league at that time to be within the first 10 universities in the world.

Since it was a gigantic task to come within the first 10 universities, a long time line was given to Tsinghua University to attain that goal in collaboration with the best of the US and the British universities. That is to join the league of top 10 by 2050. So, instead of ranting offending and self-defeating slogans against the Americans and the West, both Singapore and China have chosen to collaborate with them.

Sri Lanka too should learn lessons from Singapore and China. It should develop its university system in association with the world’s leading universities to supply the needed manpower to the high tech industry it should establish in the country as a permanent solution to its external sector crisis.

This requires seeing beyond the temporary inflows to the foreign exchange market and strategising on the broader macroeconomic picture to be a collaborating partner of global development.

(W.A Wijewardena could be reached at [email protected].)