Key to macroeconomic challenges:

Environment conducive to productivity improvement

By Gamini Warushamana

Prudent macroeconomic policies and an environment conducive to productivity improvement is essential, said economic analyst Lloyd F. Yapa.

A former vice president and an active member of the Sri Lanka Economic Association, Yapa, was also a Director of Policy and Planning at the Export Development Board.

Q. There is a school of thought that prudent macroeconomic policies alone will not deliver the desired results. What is your view?

A. Yes, there should be a positive enabling environment to attract investment, improvement of international competitiveness on account of improved productivity and innovation all round and the elimination of the anti-export bias.

Q. What do you mean by an enabling environment?

A. The environment to enable rapid economic growth needs higher real (adjusted for inflation) incomes and poverty alleviation mainly by attracting investments.

The OECD current Country Risk classification dealing with political and credit risk 2013 for Sri Lanka is six and the previously also being six, Somalia and Zimbabwe carrying seven and seven. For Singapore it is zero and zero, Malaysia two and two, India and Thailand three and three.

Such a positive enabling environment could bring about a 'feel good factor,' a national consensus for the desired economic take off, a better international image for the country accompanied by a tremendous spurt in investment, especially FDIs.

Q. What are the medium and long-term strategies that we should follow to address macroeconomic implications created by huge external sector deficit?

A. Governments have faced budget deficits as public expenditure has been greater than revenue earned. In 2012, the government succeeded in reducing it to 5.3% of the GDP. To bridge this gap, the Government is compelled to take recourse to raising taxes and charging on utilities and other services maintained by it and since revenue from these sources is insufficient, borrow from the domestic market and foreign sources.

In 2012, the total government debt was around 79 percent of the GDP. Borrowing by the government from the domestic market 'crowds out' the private sector and reduces investments by it, besides exerting pressure on interest rates. According to the Global Competitiveness Index (GCI) 2012/13, Sri Lanka's ranking of the macro-economic environment is 127 out of 144 countries (116 in the previous year) -11 for Singapore, 35 for Malaysia and 87 for Mauritius.

The budget deficits also create inflationary pressure as the governments increase taxes and other levies to raise revenue to bridge the budget deficit and pay back the debt.

The resulting rises in prices of goods and services are a burden on the people. Inflation pushes up the cost of production and reduces export competitiveness. A trade deficit is created due to a drastic reduction of export revenue resulting from weak export competitiveness compared to a massive increase in the expenditure on imports due to the higher demand created. In 2012, our export revenue was $9.8 billion, while import expenditure was $19.2 billion.

Therefore, in the medium and long-term, Sri Lanka has no other option than to achieve fiscal and monetary (macroeconomic) stability by reducing government budget deficits, reducing interest rates and maintaining an exchange rate that is not over-valued.

This is not sufficient to raise international competitiveness to expand exports; improving productivity in all the sectors and attract investors, particularly foreign direct investors (FDI), who possess the capital, technologies, skills and access to export markets, to produce the goods and services, are important; an enabling environment of socio -political stability is a prerequisite to coax reputed and large FDIs such as Sony, Samsung, Apple and Motorola into the country instead of the 'foot loose' type who tend to leave the country after exploiting tax incentives.

Export competitiveness is important because Sri Lanka has a small domestic market and therefore domestic demand would not be adequate to speed economic growth.

Entry to global markets, without harping too much on import substitution, will enable realisation of economies of scale for improvement of productivity and competitiveness.

The GCI, 2012/13, ranks Sri Lanka's overall competitiveness at 68 (52 in previous year) out of 144 countries compared to Singapore's two, Hong Kong's nine, Taiwan's 13 and Malaysia's 25.

Q. How can we achieve this?

A. It involves creating an environment of socio-political stability, to attract investment and macroeconomic stability and enhancement of export competitiveness. What is most essential for the latter is an improvement of productivity and the removal of a serious anti-export bias.

Increasing productivity involves, increasing outputs or earnings with decreasing inputs for the reduction of unit prices, described as economies of scale.

This can be achieved by producing on a large scale, improving skills and technologies, using more capital and machinery (capital deepening).

When production is undertaken on a larger scale, revenue per unit will increase consistently not only due to the greater demand generated by lower prices, but also on account of the possibility of innovation to increase value to satisfy the needs of customers and differentiation of the product and service and even the activities of the firms, to avoid competition.

A high level of innovation is the reason for the continued demand for Japanese electrical appliances despite the relatively higher prices. Sri Lanka's labour productivity per hour (data on total factor productivity unavailable) was $6.7 (in agriculture 1/3 of this) versus $15.0 in Malaysia, $ 40.2 in Singapore, according to the APO Productivity Data Base 2012.

Innovations enable a firm to find better ways of competing by adding value to products or services to satisfy customers and by differentiating product design, quality, after sales service, advertising and bringing them to market. The higher earnings will enable the firm to pay higher wages for employees; the wages paid to workers in some of the export sectors in Sri Lanka are low due to the fact their products are sold in the primary form without value addition or differentiation by resorting to innovation.

It is a higher level of motivation, knowledge, creativity and technology that enables the generation of ideas to undertake innovation. In this respect too Sri Lanka needs further improvement. According to the GCI 12/13 the rank for Sri Lanka with regards to the capacity for innovation is 93-one for Japan, 17 for Malaysia and 20 for Singapore.

The private sector can play a direct role in raising productivity. But the public sector has to play a more vital role, though an indirect one, by way of appropriate policies and incentives and a direct role where the private sector is reluctant to invest as in the case of infrastructure due to the fact that returns on such investments cannot be obtained in the short term.

The anti-export bias arises from the heavy protection available to domestic-oriented production from the high import tariffs and levies and cumbersome procedures and documentation. According to the GCI 12/13 the trade tariff/ the trade weighted tariff rate of SL is 124 versus two for Singapore, 73 for Taiwan and 76 for Malaysia.

With regard to the cumbersome procedures, an index that could be cited is the (trade) Logistics Performance Index 2012 of the World Bank dealing with Customs procedures, infrastructure, international shipments, logistics competence, tracking, tracing and timeliness; it ranks Sri Lanka at 81 out of 155 countries followed by Madagascar at 84; Singapore is ranked at one and Hong Kong at two, Malaysia at 29 and India at 46.

Q. How do we improve our state sector productivity and competitiveness?

A. The general belief is that public sector institutions are inefficient and their productivity is low due to poorrecruitment. There is also a belief that the inefficiency and low productivity of the public sector may be due to excess employment - about 1.3 million people when it could do with much less.

The Global Competitiveness Index (GCI) 2012/13 ranks our institutions at 49 out of 144 countries compared to a rank of one for Singapore 10 for Hong Kong and 22 for Japan.

This inefficiency is exemplified by the heavy losses, which are reported to be around Rs 200 billion incurred by the State Owned Enterprises (SOE); these losses also happen to be one of the main challenges the government faces in macroeconomic management - in controlling the budget deficit to be exact.

One must hasten to add that the losses may be due to other factors as well; besides poor management arising from the low quality of staffing, the losses could be attributed to their questionable technical and financial feasibility and their location in an arbitrary manner over the years.

Q. It seems that the government is reluctant to maintain a tight monetary policy at present. What is your view?

A. Our import expenditure is double the size of export revenue and the gap is ever widening. There could be several reasons for this; higher credit growth especially for imports due to loose monetary policy under which interest rates are maintained at lower level, was one.

Mega infrastructure projects and associated capital goods imports is another.

There is a decline of imports after the introduction of tight monetary policy in February 2012 but still we are not out of danger; the trade deficit is still high. In addition inflation is at a single digit but is still high; therefore continuation of a tight monetary policy stance for some time may be appropriate. This is what the IMF also pointed out; our economists too agree with this view.

However, the loosening, which took place recently could be due to the worry that tight monitory policy may slow down economic growth; for instance if interest rates are maintained at a high level as before it may be difficult to induce the private sector to investment, which is an essential prerequisite for growth.

However, loose monetary policy alone may not produce the desired results in this connection; as stated before what is required, as some analysts point out, is an enabling environment, the absence of which has cost the country dearly; in 1960 Sri Lanka's per capita income was $162 while that of South Korea was $110. As of 2012 our per capita income is $2,923, while that of South Korea zoomed to $ 23,000.