The Institute of Policy Studies of Sri Lanka (IPS), apex think tank on socio-economic policy issues has been publishing the State of the Economy report since 1992 with a complementary theme selected each year. This year the report looks at “Sri Lanka’s Transition to a Middle Income Economy” and which areas require particular policy attention in order to facilitate this transition. 
 

After posting impressive growth rates of over 8 per cent in the two years following the end of the conflict, growth in 2012 moderated to 6.4 percent. Following economic overheating in the second half of 2011 – evidenced mainly by a rapidly expanding trade deficit - the government undertook a series of adjustment measures in early 2012. These came in the form of higher interest rates (with a credit ceiling on bank lending), allowing flexibility on the exchange rate, tax hikes on a major import item – cars, and higher energy prices (through allowing greater pass-through and a cut in subsidies). Coupled with adverse weather that affected agriculture, growth moderated considerably last year.

 

Export, Import decline

As 2012 progressed, the country saw a sharp decline in both exports and imports. The former was due to the weak growth of destination markets of Sri Lanka’s exports and the lower prices of key commodities like cotton and rubber which depressed export prices. The latter was due to the rupee depreciation, tighter credit conditions and duty hikes which curbed import demand, and also lower world commodity prices. The tighter credit conditions were a central feature of the 2012 growth slowdown in the country. Credit to the private sector saw a sharp decline throughout 2012 in response to the credit ceiling imposed by the Central Bank of Sri Lanka and higher policy rates. 
 

Recent trade patterns do not appear to have reversed this trend. In 2012, Sri Lanka’s exports contracted by 7.7 percent across all segments (except mining), and the main contributor to the decline was industrial exports (13 per cent). Latest results from the first quarter of 2013 showed an 8 percent contraction, with industrial exports declining the most. During the same period, Sri Lanka’s competitors like Bangladesh and Vietnam increased their exports, by 16.2 percent and 19.7 per cent, respectively. 
 

So, clearly, only part of Sri Lanka’s export performance can be attributed to the weak global economic climate, and depressed demand in Sri Lanka’s key markets. There are other more relevant factors as well.  Sri Lanka has not been successful in expanding its export markets through either bilateral or regional trading arrangements. Neither has it enhanced competitiveness from more value added exports or innovative products by enhanced research and development initiatives.

This focus away from export-led growth has manifested itself in a changing structure of the economy. 

 

Essential reforms

It is clear that Sri Lanka cannot keep postponing bold and essential reforms pertaining to the energy sector. Evidence from both domestic and international sources suggests a strong relationship between electricity supply and economic growth. Sri Lanka’s ambitions of rapid growth towards middle income status would certainly be hampered by insufficient and costly energy supply. Estimates suggest that a further 100MW of electricity is required to be added to the grid each year, to meet the annual demand of the country, which is set to nearly double from around 9,286 GWh in 2010, to 17,489 GWh in 2020. 
 

Household expenditure patterns suggest that electricity consumption is highest among those in the middle class income group. A growth in this group would no doubt put additional pressure on energy resources. In order to cater to rising energy demands, and increasing levels of expenditure by the rising middle class, it is essential that the government pays attention to securing the necessary investments. In this respect, revenue generation is a top priority.
 

On the revenue side, taxation continues to be a concern. Recognizing the taxation imperative in fiscal consolidation, the government appointed a Presidential Taxation Commission in 2009. Following the release of its final report in 2010, some significant tax reforms were undertaken through the 2011 Budget. This included lowering of corporate and personal income tax rates with a view to encouraging economic activity, removing the PAYE tax exemption enjoyed by public servants since the late 1970s, rationalizing some border taxes, and streamlining the tax incentives regime. But these reforms are yet to deliver higher revenue. In fact, in 2012, the tax to GDP ratio declined to its lowest level in 20 years – 11.1 percent. This is well below the average tax ratio of comparable lower middle-income countries of 18 per cent. Essential administrative reforms did not accompany the reduction in rates, which in turn impeded the widening of the tax base to offset the revenue loss. Meanwhile, VAT exemptions and zero ratings have increased to accommodate political lobbies. 

 

Physical infrastructure

Sri Lanka is increasingly investing in physical infrastructure. These forms of physical infrastructure are important to drive export led growth in a post-war context. While revenue generated by taxation is invested in physical infrastructure, it is far from sufficient. Hence there is a need for Public Private Partnerships in infrastructure development.
 

The next agenda needs to be private participation in infrastructure projects, to ease the financing burden on the government for the next raft of infrastructure projects. The opportunities are vast. The government estimates that, in port-related infrastructure alone, around US$ 10 billion of projects will open up for private investment over the next five-years. Mobilizing private capital for public projects isn’t easy. Recent experience in India amply demonstrates this. Despite a large infrastructure financing need, private capital in the form of private-public partnerships (PPPs) or infrastructure bonds have been slow to come in as investors are wary of tenuous processes and doing business with the state amidst concerns over corruption. This holds important lessons for Sri Lanka as well. While the policy of  welcoming private investment into infrastructure has been clear and consistent by the Government of Sri Lanka (GoSL), complicated  procedures and implementation problems have tended to detain many private investors from participation in public infrastructure projects. 
 

Physical infrastructure is only part of the arsenal the Sri Lankan economy needs to make a strong middle income transition, and sustain growth over a longer period. Social infrastructure will determine the quality of the country’s workforce that truly drives growth. While connective infrastructure has been getting much attention in Sri Lanka, sectors like education and health are beginning to show significant gaps resulting from underinvestment in recent years. While physical infrastructure is essential for economic growth and Sri Lanka’s transition to middle income status, social infrastructures should also be developed at the same time. 
 

Sri Lanka is continuing to reap the benefits of impressive investments in education and health in the post-independence period. However, the transition to middle-income status brings with it new challenges to human development. Public expenditure in education has fallen from an average 2.3 per cent of GDP during the 2000 to 2010 period, to a 10-year low of 1.8 per cent of GDP in 2012. The average upper middle-income country spends 5 percent of GDP, and the average lower middle-income country spends 4 percent of GDP on education. Meanwhile, over 100,000 A/L graduates each year are not able to pursue higher education as state universities are unable to accommodate them, and the alternative of private higher education is affordable mainly to more affluent households. In 2012, 40,000 more were left out, than in 2011. 

 

Emerging health challenges

Challenges in the health sector are also emerging, with changes appearing in the demographic and socio-economic character of the country, associated with the transition to middle-income status. This is particularly true of Non-Communicable Diseases (NCDs) and malnutrition. Along with lifestyle changes that accompany higher living standards, the epidemiological profile of the population will change, and it has already begun. An ageing population will bring additional health care burdens too, as health demands of the old are generally higher than those for other groups.
 

With middle-income status come changes in the aspirations of youth with regard to the type of employment they seek. Anecdotal evidence suggests that manufacturing enterprises are facing difficulties finding workers for the ‘factory floor’. With a shifting of preferences away from blue-collar work, the pressure on the education system to deliver the required training and skills is immense. These changes seem to be influencing youth participation in the labour force. For instance, youth labour force participation rates in the estate sector saw the biggest decline between 2006 and 2010, falling by almost 12 per cent (compared to 7 percent nationally). This could be a reflection of the changing aspirations of young people, away from the opportunities available in the estate sector, towards jobs elsewhere. 

It is essential that workers are equipped with necessary skills in order to meet the emerging income opportunities. At the same time, it is important to create a safety net for the poorest and those most likely to be ‘left out’. An important part of moving towards a middle-income country is ensuring adequate protection for the most disadvantaged population groups and those that are most vulnerable to shocks. 

 

Tackling poverty

While Sri Lanka has made impressive gains in reducing poverty, the fact remains that a significant share of households are clustered just above the poverty line and various shocks – be it at household level or macroeconomic – could easily push them back into poverty. While there are a multitude of social protection programmes currently operational, most of them deliver grossly insufficient benefits, are poorly targeted, and do not cover the risks and vulnerabilities adequately. 
 

This is most evident in the country’s largest programme, Samurdhi. The maximum amount of income transfer delivered by Samurdhi to a household is Rs.1,500, while the national poverty line dictates that a person requires at least LKR 3,300 per month to meet his/her consumption needs. Better targeting in social protection schemes like Samurdhi can free up more funds to give to those who most need it. Estimates reveal that only around 15 per cent of Samurdhi recipient households are actually poor, while as much as 49 per cent of households identified as poor do not receive any Samurdhi benefits. At a time when fiscal pressures are rising, the government will have to move away from a blanket-approach to social welfare towards a more targeted and effective social protection architecture.
 

Effective social protection architecture needs to carefully look at inevitable changes such as urbanization.  While Sri Lanka’s rate of urbanization has been quite slow compared to other developing countries, this could change as the country makes the transition to middle-income status. 

 

Natural disaster-related shocks

Another source of vulnerability emanates from changing weather patterns and natural disaster-related shocks. Severe adverse rainfall events in Sri Lanka’s dry zone in early 2011 and late 2012 heavily impacted farmers’ livelihoods, while severe cyclonic conditions in an unusually strong monsoon season in June 2013 hit fishing communities across the Southern and South-Eastern parts of the country causing nearly fifty fatalities. 
 

While social protection schemes must expand coverage to these emerging types of risk, a big part of guarding against these vulnerabilities is to have better information and provide it to those who need it. Called Climate Information Products (CIP), these can help communities, and the country at large, make adaptation decisions and be better prepared for the fallout from adverse climatic changes. In Sri Lanka, credible CIPs are scarce – especially in the areas of agriculture, water resource management, energy generation planning, and disaster risk management.
 

Overall, Sri Lanka is facing new challenges as it makes the transition to a middle-income economy. A key characteristic of other economies that have made, or are in the process of making, this change is a growing global middle class and the acknowledgement that this class can have positive impacts on growth and development. The best means of growing this middle class is to strengthen what is at the heart of their emergence – access to secure, well-paying employment opportunities.