FROM THE SECOND DECADE
A selection from LMD’s Cover Stories

APRIL 2012

SOWING THE SEEDS OF SUCCESS

Deshamanya Dr. Indrajit Coomaraswamy in conversation with LMD

POSTWAR SRI LANKA has enjoyed a measure of success in many spheres. And there’s certainly been some light at the end of the dark tunnel that it took as many as 26 years to come out of.

Out in the open as it were, the skies have been blue and the sun has shone brightly at times. There’s been intermittent rain too and since of late, we’ve seen storm clouds gather on the horizon. In a sense, Sri Lanka is facing the ground realities that are part and parcel of a nation’s life.

The realities that confront our nation in peacetime include managing an economy that has been resilient during war and taken off in its aftermath, but is suddenly showing signs of instability in the face of both internal and external pressures.

There is also the perennial question of what if anything is being done to stem the spread of bribery and corruption? Then there is the root cause of the conflict itself to deal with – and it would seem that the fires are still burning out there because not a lot has been done to bring about national reconciliation and unity.

Perhaps for these reasons, we continue to witness a brain drain; and at the same time, the diaspora has shown little interest in returning to their land of birth… one feels because Sri Lankans living in lands afar aren’t convinced that all’s well here at home.

Dr. Indrajit Coomaraswamy is eminently qualified to address the burning questions of the day. He was educated at Royal, Harrow, Cambridge and the University of Sussex. Several decades ago, he made a name for himself in the sporting arena.

Coomaraswamy’s working life has revolved around his time at the Central Bank of Sri Lanka from 1974 to 1989 – which included a secondment to the Ministry of Finance for some eight years in the 1980s – followed by a distinguished career at the Commonwealth Secretariat in London spanning nearly two decades as its Director – Economic Affairs Division amongst other posts.

In an exclusive interview with LMD, Indrajit Coomaraswamy surveys the postwar landscape and explains what it will take to sow the seeds of success. The big picture has this question splashed across it: does postwar Sri Lanka present a paradise lost or found?

Q: How do you view the business sector here in Sri Lanka?

A: The business sector in Sri Lanka has been extremely resilient. It has played an important role in maintaining an average growth rate of five percent even during the 26 years of conflict. It has also played a significant part in achieving the 8.3 and eight percent growth recorded in 2010 and 2011 respectively.

Having said that, I would like to make three points. First, it is the private sector that will have to take the lead in achieving the government’s target of sustained growth of eight percent or more. This cannot be attained without increasing investment from about 28 percent of GDP to 35 percent, as the incremental capital output ratio (ICOR) in Sri Lanka is 4.2. The government has capped public investment at the current level of 6.5 percent of GDP. Therefore, additional investment will have to come from the private sector – both domestic and foreign. This casts heavy responsibilities on both business and the government. The private sector has to rise to the challenge and the government needs to provide a conducive enabling environment.

My second point is that business has to adopt a more strategic perspective and adjust its risk profile to take on more ambitious projects with longer payback periods. From a strategic point of view, the challenge is to respond to the West to East shift in the centre of gravity of the world economy.

About 60 percent of Sri Lanka’s exports are still destined for the US and European markets. Less than 10 percent goes to China, India and Japan. In addition, long haul tourists from Europe make up the largest share of foreign visitors. Given the slow growth in the US and stagnation in Europe at least in the medium term, Sri Lanka would need to look East for growth in tourism.

The question is often posed as to what Sri Lanka can export to Asia. The underlying assumption is that there is a lack of ‘complementarity.’ In my view, this is an outdated perspective. Intra-Asian trade is the most dynamic element of the international trading system. This is all about vertical integration of manufacturing and horizontal integration in services. Sadly, Sri Lanka has little or no presence in these vibrant Asian supply chains. The key challenge for business is to consolidate and hold on to market share in the traditional markets, while aggressively looking for ways and means of breaking into Asian supply chains. It is extremely difficult to export finished products to Asian markets. However, the dynamism of the region’s economies and the way in which modern production is organised generate supply chain opportunities that need to be pursued relentlessly

In this connection, one can identify three Asian countries where domestic demand will drive growth in the medium term. Growth in India is largely internally driven. The improvement in India’s growth performance has been largely driven by domestic demand and local investment. The recent improvement in Indonesia’s growth performance has also been driven by domestic demand. In addition, China is in the process of rebalancing its economy to reduce its dependence on external markets.

This process is likely to accelerate following the leadership change later this year. Of these countries, India offers the major advantage of proximity. For the entirety of India to average eight percent growth, the southern sub-region comprising Karnataka, Andhra Pradesh, Kerala and Tamil Nadu must record double digit growth. This encompasses a population mass of over 250 million and an expanding middle class that is experiencing a rapid rise in their disposable incomes.

Sri Lanka is situated only 20 miles away. There must be opportunities to plug into the supply chains of Indian and multinational companies operating not only in the southern sub-region but also in the rest of the country. Efforts should also be made to secure business in other parts of Asia as well.

Strong consideration should be given to completing negotiations on CEPA with India. There seems to be a consensus that after the initial problems, the Indo-Lanka FTA is working to Sri Lanka’s advantage.

Our exports have grown sharply and over 80 percent of imports from India are on an MFN basis (i.e. outside the trade preferences given by Sri Lanka under the agreement). This demonstrates that Sri Lanka has been able to negotiate an agreement on the trade in goods that has effectively taken account of the large asymmetry in the size of the two economies.

This begs the question as to why one cannot do the same regarding services and investment. India is going ahead with signing preferential trade agreements with other countries such as ASEAN members, EU nations and South Korea.

By delaying, Sri Lanka is in danger of forgoing major opportunities. Efforts should also be made to negotiate preferential trade agreements with other countries in Asia. With the stalling of the Doha Round of Multilateral Trade Negotiations, there has been a surge in bilateral trade agreements. Sri Lanka needs to add to its FTAs with India and Pakistan.

Overall, the prospects for the business sector are favourable. However, a focussed and concerted effort needs to be taken to realise this potential, particularly through exploiting opportunities that exist in the Asian region.

The third point is that the government must also play its role in creating a conducive environment for private sector growth. The key issues are political stability; consistency and predictability of policies; continued efforts to improve Sri Lanka’s rankings on various business-related indices; and steadfast and robust efforts to maintain macroeconomic stability.

Q: How do you view the state of the nation at the time?

A: I would again like to frame my response to this question in three parts: the immediate past, the short term and the medium to long term. The narrative in the first and third parts is upbeat. The short term will be extremely bumpy. The extent of the negativity will be determined by the strength or otherwise of the policy response to the imbalances in the economy. The medium-term prospects for the country are favourable, provided the authorities are able to withstand the inevitable political pressure and stay the course on their efforts to stabilise the economy; and introduce a fourth wave of structural reforms to increase competitiveness of the economy.

Looking back, it is impressive that Sri Lanka has achieved two successive years of eight percent growth. The official rate of inflation has been in mid-single figures, the unemployment rate has dropped to five percent and poverty has been reduced to 8.9 percent. These are very creditable achievements at a time of uncertainty in the global economy. Nevertheless, the next six to 12 months are going to be difficult. The problems in the US and Europe will have an impact on the Sri Lankan economy through several channels: trade, tourism and the impact on FDI, portfolio flows and commercial borrowing because of the decline in risk appetite in international markets.

The imbalances in the external account are also a matter of serious concern. The combination of an overvalued exchange rate and reductions in interest rates has inevitably resulted in a sharp rise in credit and a surge in imports in the second half of 2011. Consequently, the trade deficit ballooned from US$ 5.2 billion at end 2010 to 8.9 billion dollars at the end of November 2011.

It is worrying that this happened despite robust export growth. The resulting pressure on the rupee has led to 3.6 billion US Dollars of Sri Lanka’s external reserves being spent on defending the currency. This was a case of defending the indefensible.  Gross reserves have declined from US$ 8 billion in August to six billion dollars at the end of last year. Such a drain on reserves was clearly unsustainable, particularly as foreign borrowings (Eurobonds, foreign holdings of Treasury instruments and IMF purchases) now exceed gross reserves. Failure to change course would have resulted in a devastating financial crisis.

It is commendable however, that the government has shifted its policy stance. The Central Bank has adopted a more flexible exchange rate policy. The Monetary Policy Committee has increased key policy rates by 50 basis points. Credit growth of banks is being restricted to 18 percent (and 23% where the incremental lending is backed by funds raised abroad).

Additionally, the prices of petroleum, diesel and kerosene have been adjusted to reflect international prices. Other administered prices such as for electricity, bus transport, milk foods, bread and cement have also been increased or are under consideration for an upward adjustment. Fertiliser prices and rail fares will also come under pressure.

The combination of higher interest rates and the J-curve effect associated with exchange rate depreciation (meaning output decreases before rebounding) will mean that growth is likely to slow in the short term.

Also, inflation will be higher due to the impact of the weaker exchange rate on the cost of imported items and the pass-through of the high international price of petroleum products to tackle the enormous losses incurred by the Ceylon Petroleum Corporation and the Ceylon Electricity Board. The latter has the additional negative effect of undermining the balance sheet of state banks. Lending to loss making state-owned enterprises has become a major problem for the Bank of Ceylon and People’s Bank. The operations of these institutions are also pushing interest rates up and crowding out the private sector.

The bottom line is that the government has embarked upon necessary remedial action to avoid a serious financial crisis. However, significant pain will have to be experienced in the short run as a result of developments abroad as well as the domestically induced imbalances.

It is crucial to avoid a financial crisis as Sri Lanka is now a lower middle income country and will not be bailed out with concessional money unlike in the past. This increases the pain associated with any austerity package, and the poor and vulnerable will bear a disproportionate share of the burden. The new context places an even higher premium on sound macroeconomic management and increases the costs of policy mistakes.

However, the medium to long-term prospects of the country are encouraging, particularly as the authorities have embarked upon changing the policy mix. Sri Lanka is currently experiencing the most propitious set of circumstances in 50 years. From the late 1950s, the country had to deal with the twin effects of a secular decline in terms of trade and a rapid rise in population.

The pressures emanating from these major drags on the economy were compounded by dirigiste policies that stifled investment, growth and employment. The period after the liberalisation of the economy was adversely affected by the civil conflict.

There are no such impediments at the present time. In addition, the economic geography is extremely favourable, with Sri Lanka being located in the fast-growing Asian region and in close proximity to the rapidly expanding Indian market.

Sri Lanka has the potential to have a very bright future. The government and business would need to work together to realise this potential.

Q: Is infrastructure building a necessity despite the high costs and borrowings, in your opinion?

A: Post-independence, Sri Lanka has had difficulty in balancing social development and wealth creation. The strength of the left-wing parties in the early postcolonial era resulted in considerable attention being paid to health, education and welfare expenditures.

Thereafter, the terms of trade decline and the demographic pressures experienced in the ’60s and ’70s rendered it difficult to generate sufficient surpluses for infrastructure development. This weakened the growth and wealth creating framework of the economy.

The upshot was a considerable backlog in infrastructure investment. Efforts have been made to address this in the post-1977 period. Since 2005, even greater attention has been paid to developing infrastructure. Roads, ports, airports and power plants are being built and upgraded.

It is important to remember however, that it is not sufficient to build these assets. The focus should be on delivering efficient economic services at internationally competitive prices. And this requires attention to costs and quality, as well as to maintenance and regulation. Such an approach would ensure that the rates of return on infrastructure investment are high enough to service the debt incurred to finance it.

As regards financing infrastructure development, Sri Lanka had significant headroom to borrow on non-concessional terms when it embarked upon its current ambitious infrastructure development programme. This may be attributed to the fact that Sri Lanka had little or no commercial borrowings when it was receiving generous amounts of aid as a low income country.

On graduating to lower middle income status a few years ago, Sri Lanka acquired a credit rating and the capacity to raise money on commercial terms. However, the headroom for additional borrowing is now greatly reduced. This means that there would need to be greater recourse to private participation to maintain the momentum of infrastructure development while ensuring the debt sustainability of the country.

Q: Your take on the progress made since the end of the conflict is?

A: The end of the conflict has transformed the development prospects of the entire country including the north and east. The boost to confidence has been considerable, not least through the removal of the war risk premium. Moreover, the government’s electoral successes have increased political stability.

I have already mentioned the achievements regarding growth, inflation, unemployment, poverty and infrastructure development. Another positive feature has been the reduction in the Western Province’s share of GDP. This reflects more balanced growth across the regions.

The end of the war has certainly given a boost to the performance of the economy. However, the low-lying fruits have already been picked; such as the bringing on stream of unutilised capacity in the conflict affected areas and benefitting from the base effects of below trend growth in 2009, which was affected by the global recession. In future, the successes will have to be more policy induced.

This would require a stable macroeconomic policy framework and an improved investment climate. The key challenge is to accelerate investment, both domestic and foreign. This is one area that has been disappointing so far. Investment outside the leisure sector has been relatively slow in recovering. The end of the conflict has not given the boost to investment one would have hoped for.

The government and business need to trust each other more, and work together to find ways and means of raising investment to 35 percent of GDP. In my view, there is an unhealthy level of mutual distrust that is holding back the country.

Progress has been made in the north and east in terms of resettlement, infrastructure development, normalisation of livelihoods, and providing financial and other services. The holding of elections has also strengthened the democratic framework. But there is still much more to be done in each of these areas before one can be satisfied.

Furthermore, there are considerable challenges in terms of training and skills development, strengthening civil administration, completing the political processes and consulting communities on their specific needs.

Q: What are your thoughts on the brain drain and why there is no end to it yet?

A: While employed by the Commonwealth Secretariat, one of the key lessons that I learned from working on several countries was that the capacity to retain the best and brightest is a key indicator of successful development. When almost all the talented people are convinced to live, work, save and invest in their own country, a major threshold on the development path has been crossed.

As your question implies, Sri Lanka has not reached that point as yet. Of course, the conflict ended less than three years ago. That is not a very long time in the greater scheme of things. However, there is more to be done in terms of creating a stable society that encourages openness, opportunities, enterprise and innovation.

Security and the related issue of law and order, as well as the availability of high-class education – particularly at the tertiary level for their children – also feature high on the list of priorities when people decide on where they and their families should live.

Sri Lanka is certainly not the only country in the world with an unfinished agenda in terms of combatting the brain drain. It is important to note however, that perceptions can be changed very quickly.

A survey of students at the Indian Institute of Management in Ahmedabad (the Harvard Business School of India) about 10 years ago revealed that around 90 percent of them intended to look for employment abroad. Today, the situation is completely reversed. On a positive note, it is encouraging to come across a number of very talented and committed young people in Sri Lanka.

Q: How does the diaspora view Sri Lanka and what role can it play in contributing towards nation building?

A: It is important not to treat the diaspora as a monolithic entity. It is extremely diverse in terms of ethnicity, race, religion and socioeconomic class. There are also a great range of views and perspectives within each of these groups. Furthermore, there are interests and opinions that cut across the different segments of the diaspora. It comprises a mosaic of great diversity, which reflects the character of the country.

Given this, it is inadvisable to adopt a one-size-fits-all approach to the whole of the diaspora or even one section of it. The challenge is to create an overall environment that encourages and facilitates diaspora engagement. I suspect it will be difficult to micromanage the process. A favourable overall environment will encourage people to find ways and means of making their contribution.

Many members of the diaspora are engaged in social service and welfare activities in Sri Lanka. There are fewer examples of people bringing in investment and/or sharing their experience and knowledge. But it is happening and this will increase.

One very good example is the work being done by the Association of Professional Sri Lankans in the UK. This is a nonpartisan and independent organisation of high quality professionals of all backgrounds who have a great deal to offer. It is encouraging that a number of them are already involved in various initiatives to bring investment and knowledge to Sri Lanka.

Elements of the Tamil diaspora have the capacity to have a transformative impact on the development prospects of the north and east. So far, their engagement has been limited due to trust-related issues on both sides.

Q: Would you agree that corruption is rampant and that it is undermining Sri Lanka’s development prospects? Could this be one factor that dissuades the diaspora from contemplating a return to Sri Lanka? And what remedies are there to reduce the incidence of bribery and corruption?

A: Corruption is a tax on development and it distorts resource allocation, thereby reducing growth and productive employment. It also casts a greater burden on the ordinary person through higher prices and taxes. Corruption is endemic in all countries and Sri Lanka has not been an exception over the years.

As for the threshold for bribery and corruption in any society, it is ultimately determined by its people. The Lokpal movement in India is an example of a society that has decided that corruption has assumed levels that will no longer be tolerated.

Q: What should Sri Lanka focus on most in the coming decade?

A: The key challenge is to grasp the opportunity for transformative change in the country. This requires a shift from the opportunistic deal by deal attitude to business decisions and policy-making, which was unavoidable during the conflict period, to a more strategic approach.

A growth-friendly development strategy for Sri Lanka would need to focus inter alia on maintaining macroeconomic stability, based on a predictable and transparent policy framework; implementing structural reforms that improve the competitiveness of the economy including microeconomic measures to strengthen factor and product markets; ensuring that growth is inclusive by maximising its productive employment intensity; developing a well-designed and targeted social safety net that protects the poor and vulnerable, as well as those affected by the transitional cost of reforms; achieving sustainability by containing the carbon intensity of the economy; and developing regional and international links that promote the country’s commercial interests in the context of a rapidly changing global economic landscape.

This framework needs to be supported by well-formulated physical infrastructure and human resource development programmes.

Q: What is your vision for Sri Lanka in 2025?

A: My hope is that Sri Lanka will be an advanced middle income country by 2025, where all its citizens of all ethnicities and religions are positive about the prospects for their families, friends and themselves; where they have faith in the capacity of the system to deliver safety, security, basic services and a prosperous future.

On the economy, one would hope that Sri Lanka has capitalised on its economic geography to develop internationally competitive services as well as manufacturing niches. An important prerequisite will be an education system that is better aligned to the labour market and the dynamic comparative advantage of the economy.

Another hope is that the relationship between India and Pakistan would have improved to the point at which the enormous potential of the SAARC region can be unleashed through greater economic integration. This would also greatly benefit Sri Lanka.