Pathfinder Foundation

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Charting the Way Forward: Prosperity for All

Pathfinder Foundation
Colombo
November 2014

Table of Contents
Introduction 2
1. Maintaining Macroeconomic Fundamentals…………………………………..3
2. Improving the Business Climate 3
3. Factor Markets 4
3.1. Factor Markets – Land 4
3.2 Factor Markets – Labour 5
3.3 Facotr Markets - Financial & Capital Markets ……………………………5
4. Exports and FDI 6
5. SMEs 7
6. Increasing Agricultural Productivity.. 8
7. Education, Skills and Training 8
8. Reform of SOEs 9
9. Towards Efficient Public Service Delivery 10
10. Social Protection 10
11. Capitalizing on Emerging Mega Trends 11
Conclusion………………………………………………..12

Introduction

The Pathfinder Foundation (PF) has been a long-standing proponent of prudent economic policy-making in Sri Lanka. It has been a constant advocate of reforms to accelerate economic growth and development.

Sri Lanka is on the verge of entering a new political cycle which offers a window of opportunity to implement important changes.

It is timely, therefore, to seek to inform the manifesto preparation processes of the political parties and to stimulate public discussion. In this connection, the PF commissioned a series of studies on key policy areas which will be important determinants of a successful transition of the Sri Lankan economy to a sustained high growth path. This wassupported by several public seminars,comments from leading experts and enriched by drawing on the experiences of other countries.

In this document, the PF has avoided getting into specific prescriptions or models based on any particular dogma and has focused instead on putting forward practical, pragmatic andimplementable reforms for consideration by political parties. These are being put forward in the spirit of constructive engagement to promote the improvement of the lives of all Sri Lankans.

The Sri Lankan economy needs further reforms to achieve the objective of sustained high and inclusive growth – an avowed objective of all political parties. Sri Lanka has become an ‘aspirational society’ which seeks to achieve upper-middle income country status and beyond expeditiously.It is incumbent, therefore, on all political parties to be able to respond to the evolving aspirations for prosperity among all segments of Sri Lankan society.

This Blueprint is intended to inform the policy formulation processes of political parties to assist them to meet the aspirations of all Sri Lankans through promoting accelerated growth which is inclusive and regionally balanced. In advocating this Blueprint for change,cognizance has been taken of the need to transform the economy from one which is characterized by low productivity agriculture/low technology manufacturing/and traditional services (retail/wholesale trade, construction and public administration) into a modern economy based on higher productivity agriculture/higher technology manufacturing and modern services, such as shipping, aviation, ICT/BPO/KPO, financial services and education/health).

The PF has been motivated to produce this Blueprint, as the time is now ripe to unleash the considerable potential for Sri Lanka’s rapid development. The restoration of peace, the strategic location,a literate and trainable labour force, improved infrastructures and the commencement of a new political cycle all combine to make the timing right for a major policy effort as well as focused and well-coordinated action to chart the way forward.

1. Maintaining Sound Macroeconomic Fundamentals

Since the liberalization of the economy, Sri Lanka has been characterized by repeating cycles of stop-go policies as a result of unstable macroeconomic fundamentals. Unsustainable budget deficits have been the main cause of this instability. It is, therefore, important, that a sustainable medium-term budgetary framework is maintained. This would serve to contain inflation and stabilize the balance of payments. This would, in turn, create the enabling conditions for low interest rates as well as a stable and competitive currency. It also provides a conducive framework for maintaining sustainable debt dynamics. Strong macroeconomic fundamentals are an essential precondition for developing a robust growth framework. It is also important to recognize that Sri Lanka is now operating within a new paradigm, following its graduation to lower-middle-income-country status. It is becoming increasingly exposed to the discipline imposed by rating agencies and international capital markets. This will continue to be an important factor in macroeconomic policy-making.

Actions

• Maintaining a sustainable medium-term budgetary framework.
• Strengthening revenue performance by widening the tax base and improving tax administration.
• Increasing the share of direct taxes in revenue collection to achieve a less regressive tax system.
• Conductinga rigorous public expenditure review based on clearly established priorities.

While robust macroeconomic fundamentals are absolutely essential, sustained 8% plus growth cannot be achieved without an expansion in the productive capacity of the economy. The subsequent sections seek to elaborate upon ways and means of doing so.

2. Improving the Business Climate

Recording a growth rate of 8% or more over a sustained period of 10 – 20 years, as achieved by the successful countries of East and South East Asia, is eminently feasible. For this to be possible, high priority should be attached to strengthening the business climate. The strength and dynamism of the private sector will be the crucial determinant of Sri Lanka’s development prospects. A country with Sri Lanka’s budget deficit and debt profile does not have the headroom to sustain a dynamic state-driven development process (unlike a country like China which has robust deficit and debt outcomes). The key challenge is to boost the confidence of both domestic and foreign investors. A combination of transparent pro-business policies and a reduction of transaction costs through a rigorous deregulation process would be important in this respect.

Actions
• Predictable and consistent policies based on consultation with stakeholders.
• Streamlining regulations and processes to reduce transaction costs (establishing effective one-stop shops where ever feasible).
• A robust legal framework which reinforces the sanctity of contracts and enables speedy arbitration.
• Reducing rent-seeking opportunities through rigorous application of streamlined rules and regulations and minimizing discretion.
• Providing clarity regarding the respective roles of the public and private sectors. Where the state sector is involved in commercial activity in competition with the private sector, it should be on the basis of a level playing field.
• Identifying opportunities for PPPs in major infrastructure and other projects.
• Introducing transparency and competition in contracts and procurement processes.
• Maintaining the rule of law and avoiding impunityin order to create a propitious environment to boost investor confidence and enable the attaining of a range of economic and social objectives.
• Building a harmonious society to minimize the risk premium attached to the economy due to ethno-religious tensions.
• Strengthening Sri Lanka’s diplomatic relations with both traditional and emerging economic partners and leveraging these to meet Sri Lanka’s socio-economic goals.

3. Factor Markets

3.1 Land

Priority should be attached to making the land market work better for all Sri Lankans. At present, difficult access to land is a major obstacle for businesses. Nearly 80% of land is owned by the State.Hence it is important to have clear and transparent policies related to the ownership, lease and utilization of land. At present 30% of the workforce is employed in agriculture accounting for only 11% of GDP. It is important, therefore, to address patterns of land-use and product mix to increase productivity as a means of increasing rural incomes. In urban areas, government agencies such as the Railways and the Postal Department own valuable land around the country which are currently underutilized. It is important to release the value of such land through its more productive commercial use. In the process, much needed revenue can also be mobilized for the government. Priority should be attached to a comprehensive approach to optimize land utilization in a pragmatic non-ideological manner, which generates benefits for the people of the country through increased employment and income in a manner which balances the national interest and commercial realities.

Actions
• Reviewing land use and product mix in the light of self-sufficiency (excess production) in paddy and declining profitability of some tea, rubber and coconut lands.
• Releasing value of under-utilized state land in urban areas, including those owned by Government Agencies like the Railways and Postal Department.
• Reviewing land legislation which currently obstructs more productive use of land.
• Clear and transparent policies in relation to ownership and/or leasing of land for industrial purposes. There should be clarity regarding the purpose and scope of Industrial Parks.
• Development of a land bank, involving pre-cleared properties which is accessible online.

3.2 Labour Markets

The current rigidities in the labour market act as disincentivesto the creation of more higher-value jobs. It is important to adopt an approach which brings about a better balance between workers’ rights, rates of return to investors and employment creation. The current labour laws are leading to a casualization of employment in the formal sector with an increase in temporary and causal jobs. In addition, enterprises in the informal sector are discouraged from upgrading their operations and entering the formal sector due to the high costs involved, especially in relation to labour. The upshot is that overall labour standards in the country are probably lower than one would expect in a context of more flexible labour laws. In addition, higher productivity/income employment is being curtailed.

Action
• A constructive tripartite (government/employer/trade union) review of legislation to introduce greater flexibility to the labour market while maintaining a balance between worker protection, rates of return to investors and generation of higher value employment.

3.3 Financial and Capital Markets

Developing the financial sector and capital markets, the lifeblood of the economy, is important for increasing the efficiency of financial intermediation and the allocation of capital for productive purposes. The ongoing financial sector consolidation and capital market development should be deepened to foster the stability of institutions and the development of new products to meet the needs of a modernizing economy. The special needs of an ageing population would also have to be addressed.

Actions

• Ensuring financial sector consolidation leads to greater stability while increasing the access to financing of the different segments of the economy, including SMEs, start-ups and business expansions.
• Further developing the long -term debt market.
• Encouraging angel investors and venture capitalists.
• Developing the mortgage industry to increase the affordability of home ownership for an aspirational society.
• Boosting the pension industry to address the needs of an ageing population in a sustainable manner.

4. Exports and Foreign Direct Investment

As growth is constrained by the size of the market, small countries like Sri Lanka need to attach the highest priority to export growth. With a domestic market of only 20 million people, it is not possible to attain sustained 8% plus growth without rapid export expansion. Currently, goods and services exports amount to about 20% of GDP. The corresponding figures for Malaysia, Thailand and Vietnam are 70% - 75% of GDP. In addition, experience from the successful countries of East and South East Asia reinforces thevery strong nexus between an increase of FDI, export expansion (the trade – investment nexus) and accelerated growth on a sustained basis. A key challenge, therefore, is to double FDI from the current 2% of GDP to at least 5%.

Sri Lanka can benefit from the enormous potential stemming from the preferential access to a market of 2.5 billion people through the FTAs with China (to be completed next year) and India. The combined effects of these bilateral FTAs, infrastructure development in both Sri Lanka and India as well as our Commercial Hub Legislation, which provides off-shore status for FDI, can have a transformative impact on the development prospects of the country. The overall landscape for both FDI and exports will also be improved by Prime Minister Modi’s ‘Make in India’ policy and China’s “Maritime Silk Road (MSR) Initiative”. The ‘Make in India’ policy is likely to introduce dynamism into India’s hitherto sluggish manufacturing sector opening up opportunities for developing regional supply chains. The MSR provides the opportunity to capitalize on Sri Lanka’s strategic location, particularly for services such as shipping and activities related to a commercial hub.

One may conclude that proximity to India and closeness to China can be key drivers of transformation to a sustainable growth – model based on FDI – led export expansion.

It is also important to recognize that over 50% of Sri Lanka’s exports continue to be directed to Europe and the USA. It is important, therefore, that these markets are consolidated and built upon. In addition, US investment funds account for a major share of the inflows into the Sri Lankan bond and stock markets.

Actions

• A competitive exchange rate and trade policies which do not create a bias against exports.
• The Export Development Board should complete its preparation of an export strategy expeditiously. It should prioritize product and market diversification.
• Expanding market access through regional and bilateral trade agreements while consolidating and building upon the traditional commercial relationships.
• Prioritizing trade facilitation, particularly to take advantage of the FTAs with China and India (e.g. customs clearance, harmonization of standards through Mutual Recognition Agreements and integrated check points to expedite clearance).
• Investment promotion, which is aligned with the country’s development strategy (growth sectors).
• Continuing infrastructure development to improve both domestic and external connectivity.
• Improving the capacity for economic diplomacy by strengthening the Commercial Sections of Sri Lankan missions abroad.
• Providing incentives to companies and business associations to establish investment and trade promotion offices in the major commercial centers in China and India.
• Requesting China and India to establish trade and investment facilitation centers in Colombo as other countries have done.

5. Small and Medium Enterprises (SMEs)

The SMEs tend to be the main source of employment generation in a modernizing economy. The overall business environment should assist SMEs to improve their competitiveness and market access. The major internal challenges related to SMEs include their sub-standard technology, low productivity, inferior product quality, weak access to new markets, lack of financing and financial management and scarcity of skilled labour. Their expansion is also constrained by institutional bottlenecks, lengthy and onerous bureaucratic procedures, fragmented support schemes, and a heavy regulatory burden.

Actions

• Streamlining the current highly fragmented institutional structure to improve coordination for effective delivery of support services.
• Coherent and well-coordinated interventions on training, inputs (including technology), financing and marketing in order to create an echo system which encourages start-ups, innovation and business expansion.
• Increased market access by creating/strengthening links to domestic and/or international supply chains. This also generates other benefits such as access to technology, knowledge and financing through links to larger enterprises.
• Strengthening the capacity and empowering Regional Chambers.

6. Increasing Agricultural Productivity

The basic issue in the agricultural sector is that too many people produce too little. As a result, even with extensive support in the form of subsidies, free water, guaranteed prices and tax exemption, productivity and incomes remain low.Despite this, a large proportion of the population remains in agriculture due to the security provided by the support measures. The upshot is that there is a misallocation of financial and human resources to a low productivity sector, thereby diverting scarce resources from the newer more dynamic sectors in the economy. Furthermore, the population, as a whole, is compelled to bear the burden of this expensive support through higher taxes and food prices.

Actions

• Introducing legal reforms and policies which address land fragmentation while incentivizing land consolidation.
• Encouraging commercially viable agriculture while very gradually phasing out inefficient support measures, thereby releasing both financial and human resources needed for higher productivity economic activities as a means of addressing rural poverty.
• Introducing health and environmental standards for agricultural production to address problems such as chronic kidney disease.
• Reducing post-harvest losses by encouraging improved transport and storage.
• Strengthening extension services and research capacity to improve seed varieties and agricultural practices. This assumes even greater importance in the context of the adaptation requirements associated with more frequent extreme weather events (floods and droughts) as a result of climate change.

7. Education, Training and Skills Development 

Sri Lanka can no longer depend on a growth strategy which leverages low wages. The next phase of development will have to be driven by more skilled labour and technological upgrading. The lack of human resources could well become the binding constraint which restrains the country’s development prospects.

The current education system has been successful in terms of attaining very high participation rates, including for girls. However, learning outcomes have not been aligned with the needs of a rapidly modernizing economy. Education, training and skills development should be better aligned with the country’s development strategy i.e. the needs of those sectors which drive the growth model.

Actions

• Shifting the focus of the entire education system from exam-based learning by rote to one where there is emphasis on fostering creativity, creative thinking and innovation.
• Strengthening Maths, Science and English education.
• Aligning training and skills development to the priority sectors of the country’s development strategy.
• Increasing investment in tertiary education on the basis of a pragmatic and non-ideological approach to public, private and mixed provision.
• Restructuring and upgrading the multitude of learning and skills development institutions and schemes (lessons can be learnt from East Asia and Germany).
• Reforming the state-owned Universities in order to make them internationally competitive.

8. Reform of State Owned Enterprises (SOEs)

Sri Lanka has over 300 SOEs operating under different legal structures. While there has been improvement in the overall performance of SOEs, they continue to be a drag on the economic prospects of the country. The rates of return are low and some SOEs incur losses/arrears which have a negative impact on the state banks’ balance sheets and contribute to the build-up of contingent liabilities of the government which undermines its financial stability. SOEs also constrain the development prospects of the country by providing a low return on the considerable financial and human resources absorbed by them. SOE reform can contribute significantly towards strengthening the growth framework of the economy by increasing productivity/competitiveness.

Actions

• Increasing the autonomy and accountability of decision-making processes while strengthening the Boards and Management of SOEs.
• Introducing flexibility into ownership structures through adoption of a pragmatic attitude to private and employee shareholding.
• Where majority private ownership is considered unfeasible, a stock market listing of minority stakes of commercial SOEs brings about increased disclosure which strengthens corporate governance and increases operational efficiency.
• Increasing operational independence to respond to market signals thereby reducing the need for: (I) government assistance from a constrained budget; and (II) protective barriers which limit competition thereby increasing prices and lowering quality for the consumer.
• Benchmarking performance of state-owned monopolies against international standards.
• Expeditious implementing of the findings contained in COPE reports.


9. Towards Efficient Public Service Delivery

The efficiency of the public service, in terms of policy development and service delivery, is a crucial determinant of the competitiveness of an economy. Modern economies attach a high premium to sophisticated regulation to balance competing interests in liberalized markets. In addition, efficient service delivery is crucial not only to achieve a competitive economy but also to meet the needs of poor and vulnerable sections of the society. The Sri Lankan public service is one of the largest in the world on a per capita basis. High priority needs to be attached to improving productivity, morale and accountability.

Actions

• Increasing autonomy and accountability of public servants.
• Introducing an independent and demand-driven recruitment system.
• Introducing an independent institutional arrangement for appointments, promotions, etc.
• Strengthening induction and subsequent in-service training programs.
• Improving the performance appraisal system and exploring greater recourse to performance – based pay.
• Using electronic databases and ICT solutions to improve service delivery.

10. Social Protection

A well designed, targeted and efficiently delivered social safety net becomes even more important when accelerating progress to a more competitive economy. It becomes necessary to provide social protection to meet the inevitable transitional costs, as the structure of the Sri Lankan economy evolves. The underlying principle should be protecting workers not unproductive jobs. A second objective for social protection is to support the poor and vulnerable in society. The social safety netsfor both these purposes should be based on well-designed income transfer programs and not on subsidies and guaranteed prices which lead to an inefficient use of resources. They also have the perverse consequences of increasing the burden on the people through higher taxes and prices.

Sri Lanka has a long tradition of poorly designed and targeted social protection programs. The currently operational programs are no exception.

Actions

• Designing an income transfer program for those living below a carefully calibrated poverty line.
• Providing time-bound income support for those who lose their jobs as a result of economic progress. This should be supported by re-training programs.
• Using technological advances to strengthen the delivery systems for social protection programs.

11. Capitalizing on Emerging Mega Trends

There are some mega trends which would need to be addressed as part of a forward looking development agenda for the country. It is expected that urbanization would take place at the rate of 3% of the population per year. Priority would need to be attached to keeping pace by creating cities with a high quality of life to meet the expectations of an increasingly aspirational and growing urban population. This will require investment in infrastructure, housing, commercial, and leisure space. In this connection, it is important to build upon the ongoing Metro-Region and ‘SecondTier Cities’ development programmesthat are designed to bring about regionally-balanced development by fostering growth poles in different parts of the country.

Climate Change is likely to have an increasing impact on development outcomes in all countries, and in turn needs to be factored into policy-making. More frequent extreme weather events will require a higher premium being attached to adaptation measures and disaster management. In addition, the recent pledges made by China and the US on reducing CO2 emissions has made it more likely that there will be a long overdue agreement on a post-Kyoto Protocol UN International Climate Convention. The implications of such an agreement would need to be factored into future policy-making.

One such implication could be an international commitment to move towards greater use of renewable energy. In this respect, priority should be attached to explore the potential of solar and wind energy in the context of Sri Lanka. The shift to clean energy also requires expeditious action to develop Sri Lanka’s natural gas discoveries which can also have a positive impact on the historically large oil import bill.

Mega technological trends, such as big data, cloud technology,smart connected devices, and advanced robotics (including automation of knowledge work) is likely both to create opportunities and cause disruptions, globally. Sri Lanka would need to respond to these trends in a way which addresses both the opportunities and challenges from a local perspective.

There is also a case for signing the WTO’s Information Technology Agreement (ITA) which would entail elimination of all tariffs on products listed in the document. At present, 77.5% of IT products are not subject to tariffs and the average tariff stands at only 4%. Hence there would not be major changes in the tariff structure not a loss of much revenue. Most imports are capital goods which would serve to lower cost of production in this sector that has considerable potential for growth. In addition, signing the ITA would keep tariffs at a constant level thereby facilitating long-term planning. This would enhance the attractiveness of Sri Lanka as a location for investment in the IT sector for both domestic and foreign investors.
Conclusion

Sri Lanka has the most propitious set of circumstances for over 50 years. Over the last five decades there have been major drags on the economic prospects of the country, such as severe terms of trade decline, rapid population increase and a high dependency ratio; inappropriate inward-looking policies and most damagingly the civil conflict. Today, there are no such major drags on the economic prospects of the country. In addition, economic geography is particularly favourable. Sri Lanka is located in Asia, the most dynamic region in the world. It also enjoys the advantages of close relations with China and proximity to India, the two emerging giants in the global economy. However, the benefits of such a positive historical conjuncture can only be realized through a concerted program to increase productivity/competitiveness of the economy which also strengthens the growth framework. This Blueprint seeks to contribute towards charting the way forward. It presents a menu of options. The government of the day would need to calibrate the speed and sequencing of the changes. The overall thrust is to shift from a culture of entitlements to one which unleashes the capabilities of Sri Lankans, especially the young, through their empowerment based on increased opportunities for human resource development on the one hand and productive high value employment on the other.

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