Slide deck for the Public Lecture by Deshal de Mel on "What's wrong with the Sri Lankan Economy". #1 talk from a series of talks hosted by the Advocata Institute.

1. What is Wrong With the
Sri Lankan Economy?
AND HOW TO FIX IT
DESHAL DE MEL

2. Outline
Debt – Fiscal Failings and Macroeconomic Imbalances
Big Government – Crowding Out
Uncompetitive Sectors
Trade
Education

3. Till Debt Do Us Part
Most urgent risk to the SL economy is debt sustainability – particularly external debt.
Legacy of access to long term concessional debt – easy to manage repayments
Enabled the build up of a large government sector and cumulative debt burden
Post 2007 requirement to tap into global capital markets due to less access to concessional
borrowings
Shorter repayment tenors and higher rates of interest – makes it essential to channel borrowings
into remunerative investments
Dynamic financing environment but rigid – if not deteriorating – expenditure structures.

5. CBSL weekly economic indicators – July 22nd 2016
http://www.cbsl.gov.lk/pics_n_docs/_cei/_docs/ei/wei_20160722.pdf
Short Term Payment Stresses

6. Macroeconomic Imbalances
Continuous high deficits and cumulative public debt has been one of the driving factors behind
macroeconomic volatility in SL – adversely affecting the investment climate.
High government borrowing levels influences higher interest rates, crowding out private
investment.
Recent Balance of Payments weakness has been largely influenced by external debt repayments
with implications for LKR depreciation.
At other times fiscal expansion drives imports, contributing to
Balance of Payments stress and LKR depreciation.
Episodes of inflation in the past influenced by Central Bank
accommodative monetary policy to ease government debt
servicing.
Financing deficit requires high levels of indirect taxation –
affects consumer freedom, high import taxes restrict
domestic competition.

7. Fixing the Fiscal
Weakness in revenue along with misallocated public
expenditure.
Revenue has improved in H1 2016 but sustained
improvement needs a shift to direct taxes from regressive
indirect taxes.
Better use of information systems, simplification of taxes and returns – minimizing room for discretion
in combination with heavier penalties, rationalization of tax holidays.
Expenditure – public sector of this scale is no longer affordable, more effective targeting of transfers
and subsidies, rationalization of SOEs (outstanding SOE debt to banks is LKR 757 billion – that is
equivalent to 4x GoSL expenditure on health services in 2015).
Compromises – Use of KPIs/performance linked pay in the public sector, better use of means testing
in transfers/subsidies, SOEs can be addressed through management and limited divestment eg. SLT
Fairly well understood set of problems – political economy gets in the way due to politicized nature of
public sector employment, subsidies, and ownership of state assets.

8. Big Government – Crowding Out
Good economics is the allocation of resources (land, labour, capital) to their most productive use. Higher levels of
productivity equates to higher output per unit of resource input – and thus higher returns (rent, income, interest)
per unit of input – leading to higher aggregate wealth.
A large government sector is not just fiscally unaffordable – it is also a large consumer of scarce economic
resources.
The state sector accounts for about 17% of the total labour force. There are approximately 245 state owned
business enterprises – all consuming economic resources including over 220,000 staff. The state also owns large
quantums of land.
Most private enterprises face worker shortages – state consumption of labour resources hinders this.
Ideally – the role of government should be to create an environment for private enterprise to compete to allocate
scarce resources to its most productive use – the state should create a rules based framework for this and provide
infrastructure that would be under-provided by the market.
This is not to say that markets are perfect. Markets fail under many circumstances - externalities, imperfect
information, unfair competition. It is the government’s role to intervene in situations of market failure – not by
replacing the market but by addressing the failure through smart, unobtrusive regulation.
The government also has a role in intervention to address social justice issues – particularly where unequal
opportunities lead to inequitable distribution of wealth.

9. Uncompetitive Sectors: When Protection
Isn’t Always Smart
In addition to significant resources being tied up in the government sector – there are also a lot
resources “trapped” in economically unproductive sectors.
The agriculture sector accounts for approximately 30% of the labour force (including seasonal part
time workers) but only around 9% of GDP – indicating poor productivity and poor returns to labour
(income).
High levels of taxation on imported agriculture, along with guaranteed prices on several agricultural
products ensures that resources remain tied up in sectors in which Sri Lanka does not necessarily
have a competitive advantage. This also results in higher prices for domestic consumers.
Whilst these measures are meant to “protect” Sri Lanka’s farmers – in effect it keeps farmers in
unproductive, low income activities. There is significant value to be drawn by tapping into global
value chains in higher value agricultural products - but agricultural lands and resources are tied up in
lower value domestic market oriented agriculture.
The same principle applies for several domestic industries which enjoy significant protection from
imports and are thus not exposed to competition – this keeps prices high, reduces incentives to
innovate and provide better goods/services to consumers, and prevents optimal resource allocation.
Removing such protection is challenging due to political economy issues, lobbying, and revenue
impacts of tariff reduction. It is also not feasible unless jobs are created in alternative areas.

10. Wither Trade
Being a small island economy with a population of 20 mn and market size of US$ 82 bn –
sustained economic growth necessarily requires expansion into global markets.
However – Sri Lanka’s export (goods) intensity has declined from 33% of GDP in 1990 to 12% of
GDP in 2015.
The drivers of economic growth in post-war Sri Lanka have largely been domestic industry
oriented sectors such as construction, domestic trading, finance, Transportation – these sectors
have accounted for around 60% of the increase in post war GDP.
Exports meanwhile have remained modest and continue to be characterised by narrow product
base (apparel and tea still account for 60% of export earnings) and weak market diversification
(55% of exports are to the US and EU).
Limited sectors of global competitiveness – no longer a destination for cost arbitrage and also
poor on productivity and technological sophistication of exports.

11. Global Competitive Index 2015, WEF World Bank data

12. Location, Location, Location
Sri Lanka finds it difficult to compete on price with countries like Bangladesh and Viet Nam but also
can not compete with Thailand, Malaysia etc. on productivity/technology.
The best short cut to leap frogging into new products, markets, and technology is by attracting export
oriented FDI.
Until recently SL has received disappointing levels of FDI post war – around 1% of GDP per annum.
That too dominated by tourism, condominiums, and domestic services. Very little FDI has gone into
export oriented manufacturing/agriculture.
A lack of policy consistency, conflicting messaging, barriers in access to land/approvals etc continue to
deter investment.
Location is SL’s greatest comparative advantage and can be leveraged to attract industries and services
seeking nimble logistical access to markets in the Indian subcontinent.
It is necessary to take a pro-active approach to FDI – eg. targeting multinationals with operations in
the Southern states of India and identifying segments of their value chain that can be carried out in Sri
Lanka and making the case to relocate these operations.

13. We Don’t Need No Education
Sri Lanka needs to play in the higher value segments of the global value chain – also moving beyond manufacturing –
backward in the value chain (design, product development, R&D) and forward (packaging, branding etc.)
The challenge in reaching into these segments is that it requires a higher level of skill. And in spite of Sri Lanka’s strong
history in creating access to basic education – at higher levels, educational outcomes fall well short of expectations of
the global market place.
Sri Lanka has failed to invest in ensuring quality of education, particularly at secondary and tertiary levels as indicative
in educational outcomes – particularly in sciences. The education system continues to be examination centric and fails
to inculcate the skills needed in today’s innovation driven working culture – creativity, problem solving, analytics.
With limited space in public universities – it becomes all the more important to develop a better balance
between private delivery of education and public sector education.
This would help create competition, and add supply capacity.
Sri Lanka also has very weak labour force participation at 54%.
This is particularly pronounced among females at 35%. Steps can be
taken to enhance this by improving flexibility of working hours,
subsidizing maternal leave pay, popularizing work from home options,
investment in pre-school facilities.
Source: Ministry of Education 2014 AL

14. What to do?
1) Rationalisation of recurrent government expenditure – cutting back on cadre, targeting of transfers
and subsidies, management and ownership of SOEs.
2) Enhance government revenue – shift towards more direct taxes by better use of information,
simplification of taxes and returns to minimize room for discretion, rationalize tax holidays.
3) Re-orient the role of government to one that focuses on addressing market failure through smart,
unobtrusive regulation, rather than one that attempts to replace the market by fixing prices and
engaging in business.
4) Rebalance the supply of education to enable more private participation to create competition,
enable better supply, thus freeing up resources to invest more meaningfully in state education to
improve curriculums to meet the requirements of a modern market.
5) Proactively approach export oriented FDI – 1) companies based in South India that could operate
part of value chain in SL using logistics advantage 2) companies needing quick logistical channels into
Indian sub-continent (eg. FMCG)
6) Gradually ease out of excessive domestic protection in agriculture and industry once linked with
such export value chains.

15. “We all know what to do. We just don’t know
how to get re-elected after we do it.”
- Jean Claude Juncker, Ex – EU Commissioner.