When the war ended in 2009, expectations ran high among both local and international communities, that the economy would pick up, and that the socioeconomic problems faced by the ordinary people would ease up. In general, there is potential for such growth, as resources that are misallocated during war time, could be used optimally with the restoration of peace. It was also expected there would be a surge in inflows of tourists and foreign direct investment.
Responding to the peace dividend, the economy did grow at a faster rate initially. But the growth momentum faded away in no time, and thus, the peace dividend had a mere one-off effect. The policies of the then government were not geared to sustain the growth momentum over the long run. The government concentrated more on debt-funded infrastructure development in the war-affected North and East as well as in the rest of the country. That gave a temporary boost to economic growth. However, the country failed to sustain the benefits of the peace dividend for a variety of reasons including priority mix-up, debt burden, fiscal deficits, technological handicaps, foreign exchange shortages, corruption, policy reversals and macroeconomic instability.
The government’s failure to adopt an approach that balanced resources in macroeconomic policy formulation led to severe imbalances in fiscal operations and balance of payments. In the case of monetary policy, the tendency to lower interest rates to boost economic growth caused a surge in the import of durable consumer goods. The less-flexible exchange rate regime in place for a long period created an anti-export bias, discouraging export-oriented industries.
Defence expenditure burden remains high
The peace dividend was expected to bring about a reduction of budgetary allocation for defence expenditure. However, that has not happened in Sri Lanka. The total defence expenditure which amounted to Rs. 187 billion during the peak of the war in 2009 went up to Rs. 190 billion in the subsequent year, and reached Rs. 312 billion in 2017. In real terms, (excluding inflationary effects), our calculations show that the defence expenditure index rose from 106 in 2009 to 117 in 2017. (Chart 1). In fact, defence expenditure has not shown any significant reduction as a ratio of total government expenditure and as a ratio of the GDP. At present, defence spending accounts for as much as 12 percent of government expenditure causing severe pressures on budgetary management.
Growth momentum faded away
The end of the war in 2009 brought much hope for high sustained GDP growth, as there was potential for boost in production, particularly in the war-affected North and East, which account for one-third of the country’s coast line and land mass. Significant hikes in tourism and foreign direct investment (FDI) were also on the cards. Reflecting these tendencies, the country experienced growth momentum from 2010 onwards. That lasted only for about three years (Chart 2). Debt funded government infrastructure projects made a significant contribution to this upsurge in production.
However, the post-conflict economic boost appeared a one-off event, as it could not be sustained over a longer period. There are many reasons for this dismal performance. A major factor was that the country could not generate sufficient savings to meet the growing investment requirements. The government expenditure has always been in excess of its revenue, and thus the fiscal operations end up with dissavings. Hence, the government had to resort to short-term commercial borrowings from international capital markets at high premiums. This has, since then, resulted in a rapid accumulation of external debt severely pressurizing fiscal operations. Another reason was the lack of productivity growth coupled with setbacks in technology and innovation. There was hardly any emphasis on research and development (R&D) in policy formulation.
Although the debt-funded large infrastructure projects carried out by the government in the aftermath of the conflict, of course, facilitate the growth process in the long run, their adverse consequences on the government budget and external debt led to precarious macroeconomic imbalances in the subsequent years, and eventually inhibited the peace dividends.
Technological progress lacking
Sri Lanka’s average annual growth rate remains around 5 percent, as shown in Chart 2. With the end of the war, the government anticipated an increase of over 8 percent so as to raise the per capita income to an upper-middle income country status. This aspiration was fulfilled only in the three-year period of 2010-2012. Since then, the GDP growth has been on a downward path, falling to a 16-year lowest level of 3.1 percent last year. This reflects the growth limits faced by the country.
The singular most important reason for the growth setback is Sri Lanka’s technological backwardness. Historically, the country’s economic growth has been driven by expanding the factors of production, mainly labour and capital. In the aftermath of the economic liberalization in 1977, for instance, Sri Lanka had the advantage of utilizing its low-wage surplus labour in labour-intensive garment industries. That advantage is no longer due to global competition and the rise in local wages. Hence, the country has reached the maximum production capacity, and cannot accelerate GDP growth beyond 5 percent per annum, despite the rhetoric of politicians who promise to increase the growth rate to above 10 percent or so. Advancement of technological application in the production process through knowledge economy is the way to break the current growth barrier of 5 percent a year.
Having gone through the factor-driven phase, Sri Lanka needs to move to efficiency and innovation-driven growth phases to accelerate economic growth. The export sector has been continuing to rely on primary type industries, mainly the apparel industry. Apart from the policy drawbacks, this reflects the lack of innovative capabilities as well as poor commitment on the part of export-oriented companies to diversify their industrial structure with high-tech products. Foreign investors do not show much interest in setting up such sophisticated industries. In contrast, many fast-growing East Asian countries shifted to high-tech products in the 1970s when they lost their comparative advantage in low-tech products such as garments.
Such a product shift has not materialized in Sri Lanka due to inadequate technological progress. In the circumstances, high-tech exports account for only 0.6 per cent of total manufactured exports in Sri Lanka compared with the corresponding ratios of 29 per cent in Malaysia, 23 per cent in South Korea, 24 per cent in China, 15 percent in Japan and 5 per cent in India.
Given the severe technology and innovation drawbacks, escaping the middle-income trap is not an easy task for Sri Lanka. It requires an entirely new growth model. The old styled manufacturing industries dependent on cheap labour and foreign capital would not be sufficient to accelerate income growth. Labour and capital have to be used more productively, and in this context, creativity and innovation are critical. A new modus operandi of production process is needed. Local companies must invest heavily in R&D and introduce high-tech products with their own brand names, instead of merely assembling foreign products using imported technology and foreign capital.
A knowledge economy is all about creating, disseminating, and using know-how to accelerate economic growth and development. It consists of individuals, companies and sectors that create, develop and commercialize innovative products and export them across the world. Knowledge has always been at the center of a country’s development process. The rapid progress in creating and disseminating knowledge through fast developing information and communication technology (ICT) in recent times makes knowledge even more important as an input for accelerating economic growth. A successful knowledge economy is characterized by close links with science and technology, and high priority placed on innovation for economic growth as well as for export competitiveness. Research and development (R&D) is a key driver of knowledge economy.
The question is whether Sri Lanka has the necessary background to transform itself into a knowledge-based economy. The answer lies on the existence of the preconditions needed for such transformation which include conducive economic and institutional regime, modern education system and human resources, advanced innovations and information technology.
Sri Lanka has made very little progress in developing most of the above-mentioned characteristics to enable her transition towards a knowledge economy, whereas the fast-growing Asian countries such as Japan, South Korea, China, Singapore, Malaysia and Thailand have performed much better. Weak economic management coupled with institutional failures has restrained GDP growth in Sri Lanka.
The country’s outmoded education system is not geared to produce the necessary human resources for a knowledge-driven economy. It has been difficult to retain talented scientists (produced at the expense of public funds) within the country due to factors such as low remunerations and the lack of opportunities for scientific research. The country does not have an environment that is conducive for innovation, which would have resulted in acquiring international patent rights or generating new products. Development of information technology particularly in the software field is yet to reach international standards.
Backsliding from economic liberalization reforms in the last two decades has also faded away the benefits of the peace dividend. For instance, the Revival of Underperforming and Underutilized Act of 2012 empowered the government to acquire and manage some 37 such private enterprises. There was also a tendency toward import substitution. As regards to imports, the total protection rate (tariffs plus para-tariffs) more than doubled between 2004 and 2009. The Annual Report of the Ministry of Finance for the year 2012 emphasized the need to move towards import substitution in subsidiary food crops and manufacturing industry.
The expansion of the public sector in the last decade is also contradictory to free market economy policies. As the private sector could not absorb the growing labour force due to business setbacks, the government had to provide jobs to unemployed graduates and others resulting in public sector employment growing exponentially to the current number of nearly 1.5 million employees.
Given the above policy directions, the main driver of economic growth since the end of the war has been the non-tradable sector consisting of construction (eg. infrastructure, high-rise buildings), trading activities, public sector employment etc. Basically, there has been an anti-export bias in government policies, which resulted in worsening the ‘doing business’ status and export performance.
Macroeconomic instability precarious
The prolonged macroeconomic instability has been a major roadblock to FDI inflows to Sri Lanka in the post-conflict era. The country suffers from persistent deficits in the government budget and the balance of payments. The entire government revenue, which is highly dependent on indirect taxes, is hardly sufficient to meet the ever-increasing debt service payments, and therefore, debt rollover is the norm of the day. The outstanding government debt has gone up to around 80 percent of GDP as of today from 69 percent of GDP in 2012.
The foreign exchange front is equally fragile. The country heavily depends on the low value added and low-tech garment industry which is fast losing export competitiveness due to cost escalation, low productivity, labour unrest and emerging foreign competitors. The country’s total export earnings are sufficient to finance only a little over 50 percent of import outlays. If not for the worker remittances, which is equivalent to three fourths of the trade deficit, the country would have faced a severe balance of payments crisis long ago.
The economic benefits of the peace dividend remained for a very short period, and the country failed to sustain the advantages. A main reason for this failure was that Sri Lanka, which was ravaged by the conflict for three decades, was not ready to reap the benefits of the peace dividend. The country had to face an entirely different global economy when the war ended. Many developing countries, which were poor in the 1970s, were able to reach advanced stages of economic development by applying modern technology and innovation in their production process whilst Sri Lanka was engaged in the war. These modern production modes enabled those countries to graduate their economies from agriculture and primary industries to high-tech, high-value added industries. The beginning of this century marks the era of knowledge economy.
Following the war, the then government did not plan its economic policies along these lines. Rather it gave priority to rebuilding damaged infrastructure facilities, and to develop the road network with several modern highways. Also, a new airport and a port were built in Hambantota. Almost all these projects were funded through foreign commercial loans, mainly from China. The alleged corruptions associated with these projects too had detrimental effects on foreign direct investment. The accumulated debt that arose from these investments is a major burden today. In the backdrop of severe balance of payments difficulties compounded by the export setback, the present government also borrows from capital markets to roll-over the debt.