Report No. 38388-LK Sri Lanka Sri Lanka Development Forum The Economy, Regional Disparities, and Global Opportunities January 12, 2007 Poverty Reduction and Economic Management Unit South Asia Region Document of the World Bank TABLE OF CONTENTS INTRODUCTION .................................................................................................................................. i I TheEconomy:OverviewandStrategicDirections . .................................................................. 1 A. 1 B. Introduction............................................................................................................ Overview ofthe Economy ..................................................................................... 1 D. Macroeconomic Management................................................................................ C. Political Context..................................................................................................... 1 E. E. Conclusion ........................................................................................................... Strategic Economic Policy Directions: TenYear Development Framework........58 11 I1. UnderstandingRegionalDisparities ........................................................................................ 12 A. Introduction.......................................................................................................... 12 B. 12 D Pro-poor Reforms: Mythor Reality..................................................................... C. Regional Growth and Poverty Differentials ........................................................ Why didthe WesternProvince Grow Faster than the Rest of the Country?.......13 16 E EducationReforms in Sri Lanka: Lessons Learned............................................. 18 F... Conclusion ........................................................................................................... 19 I11 GlobalOpportunitiesin the KnowledgeEconomy . ................................................................. 20 A . 20 B. Sri Lanka andthe KnowledgeEconomy ............................................................. Introduction.......................................................................................................... 20 22 D. C. Turning Sri Lanka into an Offshoring Hub.......................................................... Global Trends inOffshoring................................................................................ 25 E. Conclusion........................................................................................................... 28 REFERENCES .................................................................................................................................... 29 ListofFigures Figure 1.1: Quarterly GDP Growth 2004-06 .................................................................................. 2 Figure 1.2: Sri Lanka Consumer Price InflationRate: 2005-2006 ................................................. 2 3 Figure 1.4: Growth inMonetary Indicators, 2005-06..................................................................... Figure 1.3: Movement inthe NominalExchange rate.................................................................... 7 Figure 1.5: Real Interest Rates. 2005-2006..................................................................................... 7 Figure 1.6: Import & Exports (US$) 2001-06................................................................................. 7 Figure 1.7: Gross Official Reserves (US$Mn) 2001-06 ................................................................. 7 Figure 2.1: RegionalVariations, 1990/91-2002............................................................................ 13 Figure 3.1: Link BetweenGrowth and the Knowledge Economy................................................ 20 Figure 3.2: Benchmarking Sri Lanka and the Knowledge Economy............................................ 21 Figure 3.3: Global Trends inICT ................................................................................................. 22 Figure3.4: BPO/IT Offshoringto Low-Wage LocationsVs.Total Global Service Exports Figure3.5: India's Offshore Services Growing Rapidly .............................................................. .......23 24 Figure3.6: Sri Lanka-Already Competitivebut More can be Done.......................................... 26 Figure3.7: BPO Entrybyyear (1999-2006) ................................................................................ 27 ListofTables Table 1.1: Trends inKey Macroeconomic Indicators 1990-2006................................................. Table 1.2: Summary o f Central Government Fiscal Operations (As a % o f GDP 2001-2007) .....46 Table 2.1: Poverty Headcount by Province. 1990/91-2002......................................................... 12 14 Table 2.3: Access to Economic Infrastructure............................................................................. Table 2.2: Literacy Rate and Educational Attainment by Province: 2003 .................................. 14 Table 2.4: Agricultural GDP Growth Rate (%)........................................................................... 16 Listof Boxes Box 1.1: The Economic Impact ofthe Tsunami in2005-2006 ................................................... 3 Box 1.2 Budget 2007 and Medium Term Budget Framework................................................... 9 Box 2.1: Economic Reforms since the 1970s ........................................................................... 15 ACKNOWLEDGEMENTS This report was prepared by a World Bank team consisting o f Rocio Castro, Rajatha Wijeweera, Ismail Radwan, Owen Smith, and Princess Ventura (Consultant). The team i s thankful to Peter C. Harrold, Saman Kelagama (peer reviewers) and Shantayanan Devarajan for providing comments on the content o f the report and to Deborah Bateman, Oxana Bricha, and Nishana Kuruppufor assisting in the completion o f the report. INTRODUCTION Sri Lanka's development is at a criticaljuncture. Thanks to relatively rapid economic growth that pushed per capita income over the US$l,OOO mark in 2004, and its traditionally high levels o f human development, Sri Lanka i s on the verge o f becoming a middle-income country. Furthermore, the country has maintained aggregate growth despite several adverse shocks, including a tsunami, a doubling o f world oil prices, and increased competition for its apparel exports following the end o f the Multi-Fiber Arrangement (MFA). At the same time, Sri Lanka's growth has been highly uneven. Most o f it was concentrated in the Western Province. In the rest o f the country, GDP growth has averaged less than 3 percent a year, and poverty remains stubbornly high. While the service sector and, to some extent, manufacturing boomed, agriculture-the main source o f income for people living outside the Western Province-has stagnated. Moreover, Sri Lanka's overall growth has not been commensurate with its human development achievements. Finally, the country i s facing a resumption o f the ethnic conflict that has permeated economic and political life over the last quarter century. To address these challenges by buildingon Sri Lanka's strengths, the Government last November issued a discussion draft o f its 10-year development framework, Mahinda Chintana: Visionfor a New Sri Lanka. The framework, along with an assessment o f tsunami reconstruction' and the country's recent economic performance, will be the subject o f the Sri Lanka Development Forum on January 29-30,2007. This report is intended to inform the discussions o f the Forum. Specifically, section Ireviews recent economic performance, the status o f macroeconomic management and the strategic directions outlined in Mahinda Chintana. It notes that the recent acceleration in Sri Lanka's growth can be partly attributed to large aid flows for tsunami reconstruction and to rapid growth in domestic demand. While Sri Lanka can sustain higher growth given its level o f human development and integration with global markets, this will require addressing structural constraints and managing the downside risks associated with rising inflation and the escalating conflict. Section I1o f the report addresses the regional disparities in growth and poverty reduction in Sri Lanka. Noting that differences in education levels and access to infrastructure cannot filly explain the sharp gaps inregional growth, it suggests that the limited scope o f market reforms in key sectors, such as agriculture, has played a more significant role. In particular, policy reforms in agriculture have been elusive, partly due to misperceptions that they will hurt the poor. Progress inreducing regional disparities will require politically-sensitive reforms that address these misperceptions, through inter alia public consultations. Finally, section I11takes up the question o f how Sri Lanka can accelerate growth firther by taking advantage o f its high levels o f educational attainment and tapping global opportunities in the information technology (IT) and knowledge sectors. The recent increase in foreign direct investment in telecommunications, IT, and business process off-shoring (BPO) in banking suggest that there i s potential for such growth. This potential can be enhanced by moving firther on the policy agenda that removes the obstacles facing a knowledge economy. 1The Government is inthe process o f finalizing a document entitled "Post Tsunami Recovery and Reconstruction" for presentation at the Forum. i 11 I. THEECONOMY:OVERVIEWANDSTRATEGICDIRECTIONS A. Introduction 1.1 The Sri Lankan economy has experienced accelerated growth over the past two years despite adverse shocks-such as oil price hikes, the tsunami, and the deterioration in internal security. Growth has averaged 6.5 percent during 2005-2006, which i s above the historical average o f 4-5 percent. This accelerated growth momentum has been supported by increased external financial flows for post-tsunami reconstruction and a rapid expansion in domestic demand. Sri Lanka has the potential to sustain even higher growth rates, as envisioned by the Mahinda Chintana Visionfor a New Sri Lanka, given its well educated labor force and substantial integration with global markets. But to achieve higher economic growth and hence lower the incidence o f poverty, there i s a need to address remaining structural constraints and effectively manage immediate downside risks linked to rising inflation and the recent intensificationo f the violence. B. PoliticalContext 1.2 The victory o f Mahinda Rajapakse, the Sri Lanka Freedom Party (SLFP) candidate in the Presidential elections o f November 2005, ensured the continuity o f the economic policies initiated by the UnitedPeople's Freedom Alliance (UPFA) government, the coalition that took power in April 2004. In 2006, the main opposition United National Party (UNP) and the SLFP signed a Memorandum of Understanding (MOU) to collaborate closely inbuildingconsensus in critical areas. 1.3 Several rounds o f talks between the government and the Liberation Tigers o f Tamil Eelam (LTTE) have so far failed to produce tangible outcomes. The past year has seen an escalation o f conflict- related violence particularly in the North and East. Over 3,000 people have died and over 250,000 persons have been displaced.* Meanwhile, President Rajapakse has established an All-Party Conference (APC) mechanism which i s to submit a constitutional proposal for deliberation among key political parties. 1.4 The escalation o f the conflict poses additional challenges in the short-term to macroeconomic management, given increasing fiscal pressures. It also affects the implementation o f the development agenda-including tackling the key issues o f raising competitiveness and reducing regional disparities. Therefore, a political consensus-both to address the resolution of the conflict and to move forward with key reforms-will be important for Sri Lanka to achieve its development objectives. C. Overview of the Economy 1.5 Economic Outcomes. The Sri Lankan economy has posted impressive gains in the post-tsunami period, with a 6 percent growth rate in 2005 followed by 7.8 percent growth duringthe first three quarters o f 2006 (Figure 1.1). With per-capita income rising above US$l,OOO in 2004, Sri Lanka i s on a steady path to achieving status as a middle-income country. Higher economic growth has been accompanied by a decline inunemployment, excluding the North and East, from 8.1 percent in2004 to 7.2 percent in2005 and 6.4 percent during the first nine months o f 2006. The latest estimate for all districts was 7.7 percent inAugust 2005.3 The total number o f internally displaced persons (IDPs) presently stands at over half a million, including those displaced by the tsunami and those displaced during earlier phases o f the conflict. This figure i s based on a one-off labor force survey by the Department of Census and Statistics. 1 25.115 1 2 Box 1.1: The EconomicImpact of the Tsunami in 2005-2006* The tsunami which struck Sri Lanka on 26 December 2004 causedwidespread damage and loss of lives particularly inthe worst-affected Southern, Northern and Eastern coastal areas. Following the disaster, the expectation was that the impact on the economy would be contained, but that fiscal and external imbalances would widen as a result o f increased external aid flows. GDP: The impact o f the tsunami on the economy was largely contained given the relatively low contribution of fisheries and tourism to GDP-the sectors most affected by the tsunami. Meanwhile, an acceleration o f construction activities for rebuilding had an offsetting impact. In 2005, fishing output, mostly affecting the North and East, was 60 percent o f pre-tsunami levels (with a catch o f 163,000 tons). However, by September 2006, the output had recovered to about 80 percent o f pre-tsunami levels. The tsunami-affected areas accounted for about 40 percent o f overall tourist guest sites in the country. While the sector suffered in the immediate aftermath o f the disaster, by mid-2006 most damaged hotels and guest houses had been rebuilt. In 2005, tourist arrivals fell less than expected (by about 3 percent), as increased tourists from neighboring countries, particularly India, partly made up for the decline inEuropean tourists. Arrivals were on track to reach 600,000 in 2006. However, the recent deterioration in the security situation i s likely to deter further recovery o f the industry. Source: Central Bank of Sri Lanka; (a)=up to October Prices:Although increased demand for construction materials pushedup prices inrelated areas, the impact was not significant. More importantly, the appreciation o f the rupee following the large inflow o f external official and private aid hadthe effect o f containing price increases,particularly in2005. Aid Flows: Aid pledges at the May 2005 Development Forum amounted to US$2.2 billion, including US$ 157.5 million in emergency assistance by the IMF and US$260 million in debt moratorium. O f this, the bulk (60 percent) was pledgedby bilateral and multilateral donors and the balance by NGOs and private sector institutions. By April 2006, nearly half of the pledged assistance hadbeen disbursed. Fiscal position: The impact o f the tsunami on revenue collection was marginal, and the debt moratorium provided additional fiscal space (0.4 percent o f GDP in interest) in 2005. Tsunami-related expenditure amounted to 1.4 percent o f GDP in 2005 (1 percent for capital and 0.4 percent for recurrent) and about 0.8 percent o f GDP in 2006 (against a program o f 1.7 percent o f GDP). The 2007 budget has allocated a further 0.7 percent o f GDP for tsunami reconstruction. Balance of payments: The tsunami-related external inflows helpedto generate a balance of payments surplus of US$500million in2005. As a result, official gross reserves rose from 2.2 to 2.5 months o f imports. * For further discussion ofthe tsunami's economic impact, see "Post Tsunami Recovery andReconstruction". 1.7 The Sri Lanka rupee, which had been weakening in the course o f 2004, appreciated in the post- tsunami period largely due to the increased inflow o f official aid and private remittances. Although the nominal exchange rate depreciated marginally throughout 2005 it did not keep up with inflation differentials. By the end o f the year, the rupee had appreciated by nearly 9 percent inreal terms compared to the previous year. Higher inflation combined with the gradual waning o f tsunami-related aid inflows has recently put the rupee under pressure despite increased sales o f foreign currency by the Central Bank. (Figure 1.3) 3 Figure 1.3: Movement in the Nominal Exchange Rate Source: Central Bank of Sri Lanka 1.8 Sectoral Growth, Investment and Savings. Economic growth during the last two years continued to be dominated by the services sector, followed by the industrial sector (Table 1.1). Agricultural growth performance was initially affected by the tsunami-related setback to the fisheries sub- sector, but it bouncedback during2006. 1.9 The services sector, which accounts for over 55 percent o f GDP and close to 60 percent o f economic growth during the post-tsunami period, was spurred by the continued buoyancy of the telecommunications sub-sector (growth o f 27 percent in 2005 and 23 percent during the first nine months o f 2006). Table 1.1: Trends in Key Macroeconomic Indicators 1990-2006 1990-2000 Average 2001 2002 2003 2004 2005 2006" Agriculture Sector (% change) 2.5 -3.4 2.5 1.6 -0.3 1.5 4.8 Industrial Sector (% change) 6.8 -2.1 1 5.5 5.2 8.3 6.3 Manufacturing 8.1 -4.2 2.1 4.2 5.1 6.0 5.8 Construction 5.2 2.5 0.8 5.5 6.6 8.9 6.8 Services Sector (% change) 5.6 -0.5 6.1 7.9 7.6 6.4 8.1 Transport, Storage, and Communications 6.4 3.8 7.6 10.2 13.7 12.7 12.0 Wholesale and RetailTrade 5.5 -6.7 5.6 7.3 5.7 2.6 7.2 Banking, Insurance, and Real Estate 7.7 7.9 11.1 10.6 5.6 6.5 8.1 Public Administration and Defense 3.5 1.o 1.3 2.1 3.9 5.4 2.3 GDP 5.3 -1.5 4.0 6.0 5.4 6.0 7.0 National Savings (% o f GDP) 19.8 20.3 19.5 21.6 21.6 23.3 25.0 Total Investment (YOo f GDP) 25.2 22.0 21.3 22.1 25 26.5 30.0 Public Investment(% o f GDP) 6.8 5.8 4.6 5.3 5.2 6.9 6.6 Private Investment (% o f GDP) 18.4 16.2 16.7 16.8 19.6 23.4 ~~ 19.8 Source: Central Bank of Sri Lanka (*)Estimate for full year, based on data up to September 4 1.10 The industrial sector continuedto sustain robust growth, despite the challenges posed by the end o f the MFA in2005. The manufacturingsub-sector, containing the vital garments industries, continued to perform strongly although at a somewhat slower pace (from 6 percent in 2005 to 5.2 percent in the first nine months o f 2006). The construction sector has seen dynamic growth largely due to post-tsunami reconstruction and a rapid increase inreal state development particularly in the Western Province. 1.11 Agriculture continued to lag behind industry and services, but in 2006 the growth performance o f the sector improved largely on account o f a bumperharvest o fpaddy and the recovery infisheries-which contracted significantly in the aftermath o f the tsunami. Although fishing had recovered considerably by the third quarter o f 2006, it was yet to reach pre-tsunami levels. 1.12 Sri Lanka's investment and savings ratio improved somewhat in 2005, although the gap continued to widen. The improvement in the savings ratio was mainly due to an improvement in government dis-saving in 2005. The increased investment ratio in 2005 came from an increase in public investment expenditure for tsunami reconstruction. Private investment i s estimated to have picked up in 2006', despite uncertainties about the security situation, reflecting in part the rapid credit expansion experienced duringthe year. The country attracted US$272 million inFDI in2005 and a further US$240 million in the first half o f 2006. The bulk o f foreign direct investment (FDI) over the past two years has gone into the services (telecommunications, BPOs, etc.) and infrastructure sectors. Notably, Sri Lanka has made initial strides indeveloping a BPO industrywhich holds tremendous growth potential. This will be the subject o f Section 111. D. Macroeconomic Management 1.13 Fiscal management. The post-tsunami period posed many challenges to fiscal management, with additional expenditure needed for tsunami recovery activities and increased military outlays in the face o f the deteriorating security situation. In addition, higher public sector wages and pensions together with increased fuel subsidies (although eventually removed) created additional fiscal pressures. One positive aspect has been the recent improvements in revenue collection which has partly offset the increases in expenditures. Also, a large share o f the tsunami expenditures has been funded through additional external aid. 1.14 The fiscal deficit (including tsunami expenditures) has remained at around 8.7 percent o f GDP in 2005 and 2006. However, excluding tsunami expenditures the deficit has increased from 7.3 percent o f GDP in 2005 to an estimated 7.9 percent in 2006. In 2005, improved revenue performance and savings resultingfrom a debt service moratorium granted by the Paris Club after the tsunami helped contain the deficit, despite a substantial overrun infuel subsidies. 1.15 The 2006 budget envisaged an overall deficit o f 9.1 percent o f GDP on account o f higher capital expenditure for tsunami reconstruction (Table 1.2). Budget execution was mixed. While revenues increased and were closer to target than in previous years, there was a sizable overrun in recurrent expenditures (of about 1.1 percent o f GDP) reflecting higher wages, pensions and subsidies, and military expenditures. Capital spending fell short o f target partly because o f slower disbursement o f foreign- funded projects. Domestic borrowing was higher than planned (5.7 percent o f GDP) while net foreign financing was below program (3 percent o f GDP). 1.16 The public debt ratio to GDP declined to 93.4 percent in 2005 largely reflecting the appreciation o f the rupee vis-a-vis major foreign currencies. In December 2005, the country received its first ever This forecastappears inthe government's FiscalManagement Report2007, presentedwith the 2007 budget. 5 international sovereign debt rating from Fitch (BB-) and Standard and Poor (B+) with a stable outlook, but the ratings' outlook was revised to negative in April 2006 in view o f the deteriorating security situation. Under the circumstances, the government postponed plans to raise funds in international capital markets and instead issued US$580 million in foreign currency bonds (Sri Lanka Development Bonds; SLDB).6 These proceeds were used in part to retire more expensive debt. In December 2006, the government also raised US$lOO million through a syndicated loan facility placed with several international banks. The cost o f the facility (103.5 bps above 6-month LIBOR) compared favorably to that o f the SLDBs. Table 1.2: Summary of Central GovernmentFiscalOperations2001-2007 (as YOof GDP) I Actuals Budg Est Budg 2001 2004 2005 2006 2006 2007 Total expenditures and net lending 27.5 23.5 24.7 26.9 26.1 27.6 Current expenditures 21.6 19.2 18.7 18.7 19.8 18.4 Subsidies and transfers 4.6 5.2 5.4 4.3 4.9 3.9 Wages and salaries 5.5 5.2 5.9 6.2 6.4 6.1 Interest payments 6.7 5.9 5.1 5.6 5.5 5.2 Capital expendituresand net lending 5.9 4.3 6.0 8.2 6.7 9.3a) Memo: Tsunami-relatedexpenditures 1.4 1.7 0.8 0.7 Total revenues 16.7 15.4 16.1 17.8 17.4 18.5 Tax 14.8 13.9 14.2 16.0 15.6 16.7 Non-tax 2.0 1.5 1.8 1.8 1.8 1.8 Current accountbalance -4.9 -3.9 -2.7 -0.9 -2.4 0.1 Overall budgetbalancew/o grants -10.8 -8.2 -8.7 -9.1 -8.7 -9.1 External financing 1.4 2.2 3.4 4.6 3.O 4.3 I Public Domestic financing 8.8 5.8 5.2 4.5 5.7 4.8 debt 103.2 105.5 93.9 91.5 90.0 86.5 Source: Ministry of Finance and Staff estimates. (a) Includesfullyfunded special projects in the amount of Rs 63.2billion shown below the line in the 2007 budget. 1.17 Monetary policy. Money supply has been growing rapidly during the past two years, mainly reflecting high credit expansion (Figure 1.4). Broad money increased by 19.1 percent in 2005 and by an estimated 19.5 percent in 2006. The Central Bank o f Sri Lanka (CBSL) succeeded in bringing down reserve money growth to 16 percent in 2005, mainly through open market operations. But increased financing o f the budget has pushedup reserve money growth to 21.2 percent in 2006 against a target o f 15 per~ent.~While upward revisions in policy rates (by 125 bps in 2005 and 2006) helped reverse the negative trend inreal rates for T-bills and prime bank lending, these adjustments have been insufficient to curb private sector credit growth, which was growing by more than 20 percent through most o f the year. Notwithstanding these outcomes, the Central Bank's monetary plan for 2007 envisages a curtailment o f reserve money growth to 11.6 percent by year end while broadmoney growth i s expected to be reduced to 13.2 percent. 1.18 While continued reliance on open market operations will help curb monetary expansion, further increases inpolicy rates mightbe warranted given that real domestic interest rates remain low or negative, while international interest rates are rising. More importantly, a tighter monetary policy stance will need ~~ 6 'Note With a 2-3 year maturity at weighted averagerates of 131-158 basis points above the 6 month LIBOR. that the monetaryprogram for the year assumed zero bank financing of the budget. 6 to be supported by consistent fiscal policies. In particular, domestic financing o f the budget, which has been rising inthe recent period, needs to be kept incheck to ensure consistency. Figure 1.4: Growth in Monetary Indicators, 2005-06 Figure 1.5: Real Interest Rates, 2005-2006 30% 6 - 25% 4 . I :--w- / - - o * 227 / - d _ _ _-~ 15% B 10% 4 5% , 0%L-- 6 Jnn- Feb Mar Api May Jun Jul Aug Sep Oct NOYDec Jan Feb Mar Apr May Jun Jul Aug Sep Oct 8 ' 05 06 Jut 05 Aug Sep Oct NOY Dec Jan06 Feb Mar Api May Jun Jul Aug Sept ,-Resew money Privatesector credit MOW supp~y(M2) 1.19 External sector. Sri Lanka's external position strengthened somewhat in 2005 with improvements in the trade and current account balances, higher inflows o f tsunami aid (including grants), and continued buoyancy in remittances (Figure 1.6). As a result, the overall balance o f payments recorded a surplus o f US$500 million and gross official foreign reserves increased to 2.5 months of imports (compared to 2.2 in 2004) (Figure 1.7). 1.20 In2006, the trade deficit has beenwidening (to about 13percent o fGDP) with exports growing at about 7 percent and imports at around 16 percent-reflecting a 30 percent rise in oil imports. Apparel exports are growing by only 4 percent and are projected to reach US$3 billion in the year as a whole (a level reached in 2001). The sustained momentum in remittances, which are expected to reach US$2.4 billion, once again i s helping ease hrther pressures and the balance o f payments i s likely to record a small surplus. Gross official foreign reserves are expected to remain at around 2.5 months o f imports o f goods and services, a level which i s insufficient to protect against external shocks. Figure 1.6: Import & Exports (US$Mn) 2001-06 Figure 1.7: Gross Official Reserves (US$Mn) 2001-06 ~ ~ _ _ Official Reserves I 3 2.5 2 : C 1.5 g c 1 r 0.5 0 2001 2002 2003 2004 2005 2006(F) Reserves (of) -# rnths of Imp 1 Source: Central Bank of Sri Lanka; (F)=forecast 7 1.21 In sum, the macroeconomic framework has deteriorated inthe past year on account o f continued fiscal pressures-part o f which are linked to the escalation o f the conflict-and accommodating monetary policies. While these policies have supported economic growth in the short term, they cannot be sustained over the long run. There i s a need to tighten the fiscal and monetary policy stance to restore price stability and ultimately to support higher growth on a more sustainable basis. E. Strategic Economic Policy Directions: Ten Year DevelopmentFramework 1.22 On November 16, 2006 the Government issued a discussion paper outlining its ten-year development framework, the Mahinda Chintana: Vision for a New Sri Lanka, for consultations with stakeholders. The document was produced following extensive consultations between the Ministry o f Finance and Planning and line ministries. It was issued together with the 2007 Budget and the MTBF for 2006-2009 (BOX1.2). 1.23 The vision sets out ambitious growth targets (over 8 percent by 2010) aimed at reducing poverty incidence to 12 percent o f the population by 2015 (from 23 percent in 2002). The rapid growth scenario assumes the continuation o f a favorable external environment and implies improved security conditions. A key target is to raise total investment from 28-30 percent o f GDP in 2006 to 34 percent in 2010, with the largest contribution coming from the public sector. Public sector savings (currently negative) are expected to contribute 5 percentage points o f GDP to gross domestic savings by 2010. FDIi s projected at around 2 percent o f GDP (compared to less than 1percent inthe past decade). 1.24 Sectorally, growth in agriculture i s targeted to double historical trends (reaching 4-5 percent a year), reflecting rapid growth in non-plantation agriculture, particularly livestock and fisheries (over 7 percent). Industryi s expected to grow around 8-9 percent with miningand quarrying, and construction as the main drivers. In services, the fastest growing sub-sectors are expected to include tourism, telecommunications and IT. Growth in public administration and defense are expected to remain high (5.5-6.5 percent a year). Economic Strategies 1.25 Macroeconomic policies. The discussion paper states that fiscal and monetary policies will aim at supporting higher growth rates through price stability while providing adequate resources for private sector growth. Fiscal policy will aim at reducing the budget deficit to 5 percent o f GDP by 2010 and public debt to 85 percent o f GDP by 2008.* A welcome objective is to turn the revenue deficit into a surplus, through an expanded tax base and higher non-tax revenue, phasing out o f subsidies to state- owned enterprises, and prudent debt management. Domestic borrowing is to be contained at 3 percent o f GDP and non-concessional foreign financing will be kept at 1-2 percent o f GDP (US$200-400 million a year). 1.26 The fiscal framework outlined in the discussion paper could be strengthened if it were explicitly linked to the MTBF for 2006-2009. It will also be important that the implications for recurrent expenditure o f the proposed large capital projects be explicitly included and that the debt management strategy be clearly articulated, especially as some o f these large projects are to be financed by non- concessional borrowing. 8 Underthe 2002 FMR, these targets were to be achievedby 2006. 8 Box. 1.2: Budget2007 andMedium-TermBudgetFramework The 2007 Budget issued last November was presented in the context o f a medium-term budgetary framework (MTBF) for 2006-2009. Both documents are consistent with the revised targets under the Fiscal Management Responsibility Act (FMRA), which envisages a reduction inthe budget deficit to 5 percent o f GDP by 2009. In2007, the overall deficit is expected to reach 9.1 percent o fGDP, reflecting a very ambitious public investment program amounting to 9.3 percent o f GDP (from 6.7 percent o f GDP in 2006). In contrast, recurrent expenditures are expected to decline sharply from 19.8 to 18.4 percent o f GDP, due to substantial decreases in fuel subsidies and household transfers. Financing o f the deficit from domestic sources is expected to drop somewhat in 2007 while net external financing rises to 4.4 percent o f GDP. Revenue collection is expected to continue to increase in the medium term starting with a substantial (1.1 percent o f GDP) increase in 2007 on account o f higher expected tax revenue collection. Non-tax revenues are expected to remain at the 2006 levels (1.8 percent o f GDP). Interms o f sectoral expenditures, the plannedhigher capital expenditure will be driven by a four-fold increase in expenditures in the power sector (0.4 to 1.7 percent o f GDP). Key power projects to be implemented starting in 2007 include the Chinese-government-funded Norochcholai coal power plant project, the Kerawalapitiya combined cycle power plant project and the Japan Bank for International Cooperation (JB1C)-funded Upper Kotmale Hydropower Project. Allocations to the roads sector are expected to remain at around 2 percent o f GDP during 2007-2009. 3.5% - SelectedFunctional Ekpenditures ( O h of GDP) e_ 3.0% - 2005 2006 2007 2008 2009 0 Power Roads 0 Livelihood and Regional Development S Social Protection incl Pensions 81 Defense Source: GoSL Budget Estimates 2007. On account o f the escalation o f the conflict, defense spending is expected to continue to increase to 3.3 percent o f GDP in 2007 and gradually decline thereafter. In human development, education (3 percent of GDP) and health (2.3 percent o f GDP) spending are expected to continue at the 2006 levels until2009. Social protection expenditures are expected to decline gradually in the medium term from 3 percent o f GDP in2006 to 2.3 percent o f GDP in2009, from lower spending on cashtransfer payments to households notably through the Samurdhi program. Although a number o f programs were introduced in the 2007 Budget in livelihood and regional development, expenditures are expected to increase only slightly in 2007 and then return to 2005/2006 levels thereafter. 1.27 On monetary policy, it is stated that policy interest rates will remain the main instrument and broad money growth i s expected to b e slightly above nominal GDP growth-implying a gradual decline 9 in the GDP deflator from about 10 percent in 2007 to 6.5 percent in 2009.' The exchange rate will continue to be subject to a floating foreign exchange regime and official gross foreign reserves will be maintained at around 3 months o f imports. lo 1.28 While the macroeconomic framework described above is broadly consistent with a sustainable growth path in the medium term, tighter fiscal and monetary policies may be warranted in the short term to restore price stability. The implementation o f the 2007 monetary program, as recently announced by the CBSL, would be instrumental inreaching this goal, but will need to be supported by appropriate fiscal tightening. It will also be desirable that the target for gross foreign reserves be revised upwards so as to reduce the country's vulnerability to external shocks. 1.29 Publicsector. The overall thrust is to make the public sector more efficient and modern through rationalizationo f functions o f public agencies to ensure they remain relevant and transparent. The vision notes the need to: (i) devolve power to communities to improve accountability o f public institutions; (ii) avoid overlap and duplication o fvarious structures; and (iii) strengthenthe capacity and authority of local institutions in service delivery. The role o f the central government is expected to focus on facilitating the environment for private sector growth and investments by setting national policies and regulation, and providing public infrastructure. The discussion paper recognizes the need for reforms in training and development, selection and recruitment, compensation and management o f civil servants, but does not spell out specific issues and measures in these areas. Additional areas o f public sector reform on which further clarification is warranted include the envisioned roles o f Provincial Councils and local authorities vis-a-vis the district secretariats, especially in service delivery; how the reforms o f public enterprises will be implemented, and the role o f the Strategic Enterprises Management Agency (SEMA). 1.30 Agricultural sector policies. The vision for agriculture gives particular emphasis to achieving food security and raising incomes o f small farmers. The strategies to be adopted include: (i)increasing competitiveness through modern technology; (ii) shiftingto commercial agriculture; and (iii) promoting diversification into higher value products (fruits, vegetables, livestock, and fisheries). The public sector i s envisaged to have a strong role, including in areas where the private sector could potentially be more appropriate and efficient, such as production and distribution o f improved seeds, land use and planning. Planned public expenditures appear somewhat biased toward the provision o f subsidies (34 percent o f proposed spending for non-plantation agriculture) in relation to productivity enhancing investments such as research, extension, and irrigation. Section I1 o f this report further discusses key issues related to agriculture reform and its impact on lagging regions. 1.31 Social protection. The vision predicts a shift in thrust from cash grants to the provision o f livelihood opportunities. It notes that the Samurdhi program i s now undergoing reform, with particular attention to the introduction o f efficient entry and exit mechanisms. Greater emphasis i s to be given to: (i) enhancing livelihood opportunities; (ii)supporting savings-based micro-finance; and (iii)improving coordination among existingprograms at the Divisional level. Implementation is envisioned to take place through the Gama Neguma (`village upliftment') program that aims to convert villages into small centers o f growth. 1.32 In sum, many strategies outlined in the discussion paper are consistent with the achievement o f faster economic growth over the long horizon. These include: (i) maintaining macroeconomic stability through further fiscal consolidation; (ii) scaling up public investment inpower and roads; and (iii) raising the efficiency o f public institutions for improved service delivery. In addition, the document also provides for private sector participation in the delivery o f key services. Agricultural policies, which will 9 This assumes an increase inthe money multiplier. loBased on imports o f goods only. Ifimports o f services are included the ratio would be 2.5 months. 10 be critical to unleash growth in lagging regions, includingthe North and East, contain a welcome focus on diversification into highvalue products and the use o f modem technologies to increase competitiveness. Going forward, further consideration needs to be given to increasing the role o f the private sector in other areas and placing greater emphasis on linking production with markets (demand side), particularly exports. 1.33 The document rightly identifies downside risks which include a less favorable external environment, particularly inthe context o fhighoil prices and risingworld inflation, and the risk o f delays in implementing proposed large infrastructure projects. However, the document is silent on perhaps the biggest downside risk, continued internalinsecurity. 1.34 Given its long term nature, the discussion paper needs further elaboration to provide a road map for implementation. It will be important that such a road map be developed and reflected in future public sector budgets and in the MTBF, so that specific policies can be linked to monitorable outputs and outcomes. E. Conclusion 1.35 Sri Lanka i s once again at a crossroads. The country has the potential to achieve higher growth and faster poverty reduction, as envisaged under Mahinda Chintana, given its level o f human development and integration with global markets. However, to achieve this will require addressing remaining structural constraints and managing immediate downside risks associated with the escalation o f the conflict and rising inflation. 11 11. UNDERSTANDINGREGIONALDISPARITIES A. Introduction 2.1 At first glance, Sri Lanka's experience seems to confirm the worst fears o f globalization. Following market reforms in the 1970s and 1980s, per capita GDP grew at over 3 percent between 1990 and 2002. Yet, during the same period, the share o f people living in poverty fell by only 3 percentage points. Inequality rose sharply. GDP in the Western Province, the wealthiest province, grew at a rate nearly three times faster than the rest o f the country. Although urban poverty fell, rural poverty hardly changed, and estate poverty actually increased. 2.2 However, a closer look suggests that Sri Lanka i s in fact a textbook example o f how market- oriented policies can unleash economic growth and prosperity, while the lack o f such policies can lead to economic stagnation and persistent poverty. Most o f the reforms o f the 1970s and 1980s affected the Western Province, which proceeded to generate a supply response in the industrial and service sectors, cutting its poverty rate in half. Meanwhile, market reforms have not reached the rest o f the country, which remains predominantly rural. In agriculture in particular, reforms in land markets and paddy cultivation, as well as policies to improve the marketability o f agricultural products, have been elusive. Rural incomes have stagnated. Furthermore, growth in Sri Lanka has been pro-poor. The Western Province, which had the fastest growth and poverty reduction in the country, also saw the smallest rise in inequality. This section takes a closer look at these regional growth patterns and their underlying causes. B. RegionalGrowthand Poverty Differentials 2.3 Growth and poverty outcomes among regions have been sharply uneven. For instance, during 1997-2003, GDP in the Western Province grew by an average o f 6.2 annually, while the rest of country grew on average by only 2.3 percent. With population growth o f about 2 percent annually in the Western Province, this translated into a significant increase in per capita incomes and consumption, averaging 4 percent annually over the period." As a result, the per-capita income o f the Western Province by 2002 was two to three times higher than in the rest o f the country. Table 2.1: Pove Province 1990/91 2002 Western 19 11 NorthCentral 24 21 Central 31 25 NorthWestern 26 27 Southern 30 28 Sabaragamuwa 31 34 Uva 32 37 Sri Lanka 23 Source: Department of Census and Statistics 2.4 Growth in the Western Province has been pro-poor. Not only has the Western Provincebeen the fastest growing region inSri Lanka, but ithas also experiencedthe steepest reductioninpoverty (from 19 to 11percent between 1990/91 and 2002). l2 As illustrated inFigure 2.1, the poverty headcount inthe Western Province decreased by over 40 percent alongside a similar proportional increase in real per- 11Population growth inthe WesternProvincereflects the impact of internal migration. Population growth inmost other provinces either declined or remainedstagnant during the period. '*Povertyheadcountdoes not cover the North and East. 12 capita con~umption.'~Moreover, the sharp reduction in poverty occurred with the lowest proportional increase inthe (consumption) Gini coefficient compared to other provinces.l4 Figure2.1: RegionalVariations, 1990/91-2002 Growth rates ofPoverty, GINI, and Expenditure 60 40 20 s o -20 -40 Source: Staff calculations based on HIES 1990-91 and 2002 Notes: "PCEXF"' refers to real per capita consumption expenditure(at 2002 prices); "POV" refers to poverty headcount rates; "GINI" refers to Ginicoefficients of real per capita consumption expenditure. 2.5 Meanwhile, other regions experienced modest growth and poverty reduction and in some provinces, such as North West, Uva and Sabaragamuwa, poverty even increased as modest growth was combined with higher income inequality. In these cases, the positive effect o f growth was more than offset by a worsening in distribution. It should be noted, however, that while the relationship between growth and poverty i s unambiguous, that between income distribution and poverty i s not. 2.6 The patternof income distribution has converged and is very similar across regions. While the Western Province, the richest region in the country, had the lowest proportional increase in the Gini coefficient (12 percent), Uva Province, the poorest region, recorded the highest proportional increase (53 per~ent).'~ a result o f these variations, the Gini coefficients for the richest and the poorest regions in As the country in2002 stood at about the same level (0.4). C. Why did the Western ProvinceGrow Faster than the Rest of the Country? 2.7 The sharp differences in growth between the Western Province and the rest of the country cannot be explained entirely by differences in literacy rates or education attainment. While these indicators are somewhat better in the Western Province, they are not significantly different from those in other provinces. Quality indicators such as mastery o f language and mathematics skills at primary schools and pass rates at the GCE ordinary level and advanced level examinations present a similar l3It should be noted that income levels in the Western Province in 2002 were just recovering from a significant contraction inreal GDP the previous year. l4These findings suggest that the elasticity o f growth to poverty reduction inthe Western Province i s significantly higher than one. l5 From 1990/91 to 2002, the (consumption) Gini coefficient for the Western Province increased from 0.356 to 0.4, while the Gini coefficient for the Uva Province increased from 0.257 to 0.392. 13 pattern. For example, in Sabaragamuwa, the GCE advanced level exam pass rate i s even higher than the national average (and the Western Province) (see Table 2.2). W P South Sabara Central Uva East NW NC North All Literacyrate 96 93 92 89 88 87 94 93 93 93 Educational attainment N o schooling 4 8 9 11 12 14 7 8 8 8 Primary 24 32 31 32 36 38 30 31 32 29 Secondary 46 38 43 40 39 31 42 44 32 41 Tertiary 27 22 17 18 14 17 21 17 29 21 2.8 Although regional gaps in terms of access to economic infrastructureare more acute, these differences cannot account fully for the sharp differences in growth outcomes either. For example, while over 90 percent o f households in the Western Province have access to electricity, the coverage in other regions ranges around 60-80 percent, Uva being the least endowed province with only 57 percent coverage. In terms o f access to markets, the accessibility index16 for the Western Province is only 25 percent higher than that o f Uva, which has the worst accessibility index inthe country. Provinces Average % of % of firms % of firms % of firms accessibility households with with a land located in a index I with electricity line/mobile community electricity I phone I with a bank Central 3.1 73 80 7 47 Southern 3.1 78 68 18 62 NorthWestern 3.1 69 61 15 70 North Central 2.9 66 61 8 75 Uva 2.8 57 62 23 78 Sabaragamuwa 3.3 62 76 15 70 2.9 The conflict has been an additional factor constraining growth particularly in the North and East, but its impact has been mitigated by significant remittances. Although it is estimated that the conflict has reduced overall GDP growth by 2-3 percent" for the country as a whole, the North and East have suffered the brunt o f its impact, particularly in terms o f access to basic economic infrastructure which according to available statistics i s worse than in other poor provinces. However, per-capita incomes in the North and East have remained at similar levels to those outside the Western Province thanks to significant remittances accounting for 37 percent o f incomes inthe North and 24 percent inEast (compared to a national average o f 18 percent).'* 2.10 Market reforms triggered rapid growth of manufacturing and services in the Western Province. Thanks to its proximity to ports, the Western Province was able to take advantage o f the opportunities from market reforms adopted since the late 1970s (see Box 2.1) and better integrate with global markets. The services sector (wholesale and retail trade, transport, communications) dominates l6The accessibility index measures at eachpoint the sumofthe population totals of surrounding cities and towns, inversely weighted by the road network travel time to each town. 17Central Bank o f Sri Lanka. Annual Report 2001. Central Bank o f Sri Lanka. Consumer Finance and Socio-Economic Survey 2003104. 14 economic activity in the Western Province, accounting for 65 percent o f provincial GDP and over 55 percent o f employment. Particularly notable is the recent rapid expansion o f the telecom sector following the opening o f the sector to competition and the privatization o f Sri Lanka Telecom. Manufacturing accounts for one-third o f GDP and employment in the province. Much o f the dynamism o f the sector reflects the rapid expansion o f labor-intensive garment exports, following the liberalization reforms inthe late 1970s and establishment o f export processing zones (EPZs). Over 70 percent o f garment factories are located in the Western Province, mainly the Colombo and Gampaha districts, employing about 200,000 workers (or about 65 percent o f employment inthe garment industry). Box 2.1. EconomicReformssince the 1970s In the post-independence period most economic activities including manufacturing, trade, transport, telecommunications and financial services were dominated by state monopolies and subjected to state controls. The initial phase o f reforms from 1977-82 focused mainly on liberalization o f trade and investment regimes. Quantitative restrictions on imports were removed and a more uniform tariff structure established. A highly overvalued currency, which was largely the result o f trade suppression, was realigned in 1978. On the investment front, several impediments to FDI were relaxed. The Greater Colombo Economic Commission (GCEC)-the forerunner to the Board o f Investments ( B O I t w a s established in 1978 to promote investments into export-oriented activities. The GCEC, while establishing several export processing zones (EPZ's) was also responsible for formulating and implementing an incentives package for foreign investments. These early reforms led to higher economic growth and the transformation o f the country's export base from agriculture to manufacturing. Although the country was riddled with the civil conflict since 1983, the benefits o f reforms continued and growth was sustained duringthe 1980s. The 1990s witnessed another wave o f reforms spanning two successive governments. Notably, the administration taking office in 1994 continued reforms initiated by the previous administration. Key reforms included the removal o f exchange control restrictions on current account transactions (Le., the opening up o f the current account) and the privatization o f large state-owned enterprises in the plantation, insurance, telecom, and airlines sectors. Steps were also taken to hrther lower and simplify the tariff structure and strengthen the policy framework for FDIand portfolio investment. The results o f these initiatives were considerable. The country's industrial exports expanded rapidly and gained market share, particularly toward the end o f the 1990s. By 2000, garment exports reached US$3 billion, contributing 50 percent o f total exports. In addition, the increased privatization efforts saw Sri Lanka attracting much FDI. In 1997, FDIreached the record level o f US$430 million. 2.11 By contrast, market reforms have been more limited outside the Western Province, which has remained predominantly rural. In particular, agricultural policies have been geared toward the achievement o f self-sufficiency in paddy production rather than the development o f high-value agricultural markets." As a result, private investment in commercial agriculture and agro-business has beenlimited. The shortcomings inthe provision o f economic infrastructure inrural areas, which have no doubt further constrained the development o f high-value agricultural markets, are themselves a reflection o f lack o f progress in reforming public sector entities delivering these services. These issues are further discussed inthe section below. 19Although the privatization o f estate companies in the mid-1990s contributed to unleash growth in the sector (tea, rubber), poverty among estate-dependent families has increased due to complex socio-economic factors, including: (i) incomedependencyratios,asmanyyouthhaveremainedunemployedbecauseofthestigmaassociatedwith high working as tea pluckers and lack o f alternative employment outside the estate; (ii) delivery o f basic social and the economic services (education, health, water, roads), which until recently was the responsibility o f plantation companies, has been ineffective; (iii) highlevel of alcoholism among the estate population. 15 D. Pro-poor Reforms: Myth or Reality 2.12 Ifthe WesternProvince could grow so rapidly andreducepovertyto almost single digits,what is stopping the rest o f the country from doing so? The previous section suggested that market-oriented reforms undertaken by Sri Lanka inthe 1980s and 1990swere pro-poor. These reforms were primarily in trade, industrial and investment areas which disproportionately benefited the Western Province. Thanks to its proximity to the port o f Colombo and its services and manufacturing base, the Western Province was able to take advantage o f these reforms, to unleash a private-sector-led boom that substantially improved the welfare o f its residents. 2.13 One reason why the rest o f the country has not grown as rapidly is the absence o f agricultural reforms and lack o f private sector investment in the sector, particularly in commercial agriculture and agro-businesses. This point i s clearest inthe case o f agriculture where, as noted earlier, the poverty rate i s 40 percent. The cause i s slow growth in agricultural GDP in general (barely 2 percent a year in the 199Os), and in rice value added in particular, which has been negligible or negative over the past two decades (Table 2.4). Table 2.4: Agricultural GDP GrowthRate (YO) 1982-90 1991-00 1998-02 Agriculture 2.8 1.6 0.4 Tea 2.9 3.4 2.5 Rubber -1.2 4.3 -2.3 Coconut -3.8 2.5 -3.2 Rice -0.3 -0.7 0.6 Other 6.3 1.9 0.8 Source: Central Bank of Sri Lanka and staffestimates 2.14 The lack o fpolicy convergence in Sri Lanka reflects misperceptions, partly rooted in Sri Lanka's longstanding socialist tradition, that certain market-oriented reforms may have a negative social impact. Therefore, the state has continued to play an important role in key economic areas such as agricultural commodities, factor markets (land, labor), and the provision o f economic infrastructure, with the result that related markets often do not work well. 2.15 While the immediate intention o f policies in these areas has been to achieve seemingly sound social objectives, these policies have ultimately hurtthe poor. Below are some examples: 2.16 Agricultural policies aimed at self-sufficiency in rice production, have not helped farmers rise out of poverty. Sri Lanka has a legacy o f policies, such as land provisioning, fertilizer subsidies and protective import tariffs, aimed at achieving self-sufficiency in rice. While they have helped the country achieve self-sufficiency, the cost has been extremely high, especially for the poor. For example, the paddy land's provision makes it difficult for farmers to use highly productive, irrigated land to cultivate more lucrative crops. Fertilizer subsidies mainly benefit rice farmers-and the richer ones at that-while undermining soil conditions without much impact on yields. In the 1990s, fertilizer application rates more than doubled while average yields increased by only 8 percent. Finally, unpredictable and frequent changes to agricultural tariffs heighten price risk to farmers and dampen incentives to invest. Furthermore, these import tariffs increase costs to consumers, while keeping farmers in low-value crops such as rice. 2.17 If these policies are undermining Sri Lanka's agricultural performance, why do they persist, especially since over 80 percent o f the population and 90 percent o f the poor live in rural areas? There 16 are a number o freasons. First, while import tariffs may be harmful to the poor, removing them may leave farmers exposed to unfamiliar competitive pressures. There i s also a possibility that, in the absence o f complementary actions to lift constraints on land, seeds, technology and water, the removal o f tariff protection alone may not lead to increased production in higher value added crops. Secondly, most o f these farmers are poor. Yet, the needed reforms involve reducing subsidies or protection which, in the short-run, may leave them worse off. But perhaps the most compelling reason i s related to the fluid nature o f politics in Sri Lanka and the historical experience that agricultural reforms have often been contentious. For instance, farmers granted land through the Land Development Ordinance (LDO) cannot use the land as collateral to access credit, nor can they lease or sell the land. Relaxing any o f these constraints would benefit farmers and permit a more efficient allocation o f land resources. Yet efforts at introducing mortgage rights to farmers or a lease market for land are attacked as the first step on a slippery slope towards privatization. A draft Land Ownership Bill granting full ownership rights to farmers cultivating L D O land, which was submittedto parliament inNovember 2003, was withdrawn due to court challenges. 2.18 A similar syndrome afflicts other reform areas as well. Two o f the more prominent pertain to power and labor regulations. 2.19 Power subsidies aim at social protection, but have led to high electricity costs and benefit the upper-income groups. Sri Lanka has some o f the highest electricity costs inAsia. Yet the Ceylon Electricity Board (CEB) loses about Rs. 50 million - the cost o f constructing one rural hospital - each day. The reasons have to do with management weaknesses and the tariff structure. But reforms such as the introduction o f corporate management principles to the CEB have been resisted by some o f the most powerful unions for fear that they will lead to privatization andjob losses. In actuality the poor financial performance o f CEB has hurt the poor by restrictingthe expansion o f access to electricity o f poorer areas such as Uva and Sabaragamuwa (only 57 percent o f households in Uva and 62 percent in Sabaragamuwa have access to electricity compared to 92 percent o f households inthe Western Province). 2.20 Labor regulations aim at protecting workers, but discourage job creation and productivity gains. Sri Lanka has some o f the most restrictive labor regulations in Asia, including one o f the most generous severance pay clauses in the world. The consequence i s that firms are reluctant to hire workers, thereby discouraging job creation. In terms o f productivity, a number o f firms restrict their staffing to less than 15 employees or rely heavily on casual labor in a bid to avoid falling under the ambit o f labor laws, which prevent them from benefiting from possible economies o f scale o f production. In addition, the restrictive labor laws only protect employees inthe formal sector since they only apply to permanent employees o f firms with 15 or more employees. Therefore, one can argue that in addition to labor laws restrictingjob creation and productivity, they are also not pro-poor. 2.21 Past public road programs emphasized the expansion of rural roads, but links to markets remain weak. Road expansion since post-independence has focused on building rural roads, which account for about 70 percent o f the road network in Sri Lanka. Although the number o f kilometers of roads in Sri Lanka i s internationally comparatively high, most are poorly maintained and do not connect remote areas to main markets. Road programs in Sri Lanka have not paid due attention to the economic return o f investments in this area. 2.22 It may seem therefore that Sri Lanka (outside the Western Province) is tuck" in a low-level equilibrium, from which it is unable to emerge because o fmisguided opposition to pro-poor reforms. But the recent experience with controversial reforms in education, as discussed below, offers hope that some o f these difficult problems could be resolved with sufficient public consultations and knowledge awareness campaigns. 17 E. EducationReforms inSriLanka:LessonsLearned 2.23 Sri Lanka's education system has been celebrated around the world for having achieved universal primary education and highlevels o f literacy at very low per-capita income and with relatively low levels o f public spending (around 3 percent o f GDP). Towards the end o f the 1990s, however, it was becoming clear that Sri Lanka's education system was facing serious "second-generation" challenges. First, although schooling was compulsory up to grade 9, net enrolment and survival rates in grades 6-9 were only 81 and 78 percent, respectively. Second, despite universal primary enrolment, the learningoutcomes o f primary school children were disappointing.20 Third, the pass rate in the GCE ordinary level examination was only 37 percent. 2.24 The problems facing Sri Lanka's education system can be traced back to the reasons for its success. Central government financing and provision o f education was successful in achieving high enrolment rates because these outcomes are relatively easy to monitor. Quality, on the other hand, i s harder to monitor and often requires local knowledge about the school's and student's circumstances. Likewise, the abandonment o f English and introduction o f Sinhala and Tamil as the medium o f instruction in the late 1950s probably contributed to achieving universal access to primary and secondary education in the country (when Englishwas the medium o f instruction, urban elites had an advantage in education). But this same policy has resulted in only 10 percent o f 4`h grade students mastering English. To compete inthe global marketplace, Sri Lankans are findingthat Englishskills are essential. 2.25 The apparently successful public education system has created enough vested interests, such as among teachers' unions, to resist necessary reforms which would involve giving greater power to local entities, including school districts and the schools themselves. Also, the reintroduction o f Englishin the curriculum from grade 1, and as a medium o f instruction, could be portrayed by opponents as a reversion to the elitist education systemo f the pre-Swabasha era. 2.26 Despite these obstacles, Sri Lanka has embarked on a reform program, the Education Sector Development Framework and Program (ESDFP), which includes devolving managerial authority to schools, enabling schools to forge links with local communities to improve resource mobilization and public accountability, strengthening the teaching o f English at all levels and reintroducing English as a medium o f instruction in government schools in a phased manner. The five-year program includes a series o f monitorable indicators which, if achieved, will leave Sri Lanka with a significantly changed education system by 2010. Notably, this reform program was initiated by the previous UNP-led coalition government, but was continued and approved by the current SLFP-led coalition government. 2.27 In trying to understand how these reforms were achieved, at least two aspects are worth highlighting. First, many o f the accountability-changing reforms, such as devolving responsibility to schools and local communities, included a major initiative to enhance the training o f and support to teachers, thus making it difficult for teachers to oppose reforms that offered them a scaled-up program o f development. Second, the National Education Commission (NEC) developed the reform framework in a highlyconsultative manner, including consultations with civil society, the private sector, donors, teachers, parents and the general public. Duringthe consultations, opponents o f reforms were heard. As has been the experience in other countries (Devarajan, Dollar and Holmgren, 2001) these consultations increased the chance that reforms would survive political transitions. 2.28 The experience with educationreforms suggest the following ways to break the deadlock on other pro-poor reforms, namely: (i)adequately address the concerns o f those who lose out in reforms; (ii) 20Ofthe childrencompletinggrade 4, only 37 percenthadmasteryof their first language,38 percentmasteryof mathematicsand 10percenthadthe requiredmastery o fEnglish. 18 reforms should include systematic consultations; and (iii)consultations and implementation o f reforms need to be given sufficient time. F. Conclusion 2.29 The rapid growth and poverty reduction in the Western Province over the past twenty-five years shows that Sri Lanka has the potential to sharply reduce, if not eliminate, poverty. The reasons for the Western Province's rapid growth, including trade and industrial reforms undertaken since the 1970s, indicate that Sri Lanka i s a country where reform works. These reasons also suggest how to get the rest o f the country growing-by reforming agriculture so that the same market forces that propelled industrial Sri Lanka can propel the rural sector. However, the politics o freform are such that it i s difficult to build a winning coalition that will support these reforms. Nevertheless, the recent experience with the education sector shows that it i s possible to make progress with seemingly intractable problems. One can only hope that the forces behind trade, industrial and now education reforms will rally behind the remaining reforms, thereby enabling Sri Lanka to achieve its true potential. 19 111. GLOBAL OPPORTUNITIESINTHE KNOWLEDGEECONOMY A. Introduction 3.1 Sri Lanka's sustained economic growth over the past twenty five years has had much to do with its ability to tap into emerging opportunities in global markets. This was certainly the case o f the boom in garment exports that took place when opportunities opened by the quota system under the MFA were supported by appropriate domestic policies. The country has thus far been able to withstand tougher competition in world markets following the abolition of the MFA in January 2005. However, as in other sectors o f the economy, maintaining market share will require further improvements in productivity, as well as the quality and cost o f domestic economic infrastructure. Meanwhile, new opportunities should be explored. The provision o f services in the IT and knowledge sector also offers opportunities for growth, particularly given Sri Lanka's good track record in literacy and secondary education enrolment, and its established global reputation for quality in garments. This chapter briefly surveys the knowledge economy, and Sri Lanka's prospects inone o f the knowledge economy's most vibrant sectors, offshoring. B. Sri Lanka and the KnowledgeEconomy 3.2 Growth based on knowledge and innovation has become an important driver behindrising living standards and poverty reduction the world over. At the start o f the 2IStcentury, with the increasing reach o f the internet and digital communication technologies, the world has witnessed a tremendous acceleration in the creation and dissemination o f knowledge. The knowledge revolution manifests itself ina variety ofways: (i) is greater importance attached to education and life-long learning; (ii)shift there a ininvestment towards intangibles (research and development, software, and education) rather than fixed capital; (iii)an increasedemphasis on the application o f science and technology and the role o f innovation ineconomic growth; and (iv) the explosion o f information communication technology (ICT) inthe form o f worldwide interdependency and connectivity. The concept o f a knowledge economy (KE) has been introduced to describe economies in which "organizations and people acquire, create, disseminate, and use knowledge more effectively for greater economic and social development"." Figure 3.1 illustrates a strong link between income level and the knowledge economy globally. Figure 3.1: Link betweenIncomeLevel and the KnowledgeEconomy Knowledge Economy 40000 35000 1 2 30000 8 25000 k 20000 n a 15000 (3 10000 5000 , 0 0 00 2 00 6 00 10 00 I 4 00 8 00 KEI 1999 , ~ Source: World Bank (2002). *'WorldBankInstitute (2006). 20 3.3 Successful economies o f the future will be those that can harness knowledge in an increasingly competitive and global world economy. Four elements o f a successful strategy in such an environment include: (i) a solid base o f educated, skilled and creative people; (ii)dynamic information infrastructure a that reaches all sectors o f the population; (iii)an effective national innovation system; and (iv) an economic and institutionalregime that creates incentives for the efficient use o f knowledge. 3.4 The Government's ten-year development framework, Mahinda Chintana: Visionfor a New Sri Lanka, recognizes the importance o f the knowledge economy. BuildingIT infrastructure, improving the IT literacy o f the workforce, and strengthening the science and technology sectors are all recognized as important priorities. An overall improvement in the knowledge economy can also help contribute to the achievement o f several goals, including those related to growth, exports, employment, and FDI. 3.5 Figure 3.2 demonstrates that although Sri Lanka i s ahead on some measures o f developing a knowledge economy, most notably high secondary school enrolment and literacy, it i s still some way behind the more dynamic economies o f East Asia. A few areas stand out in need o f more attention including tertiary enrolment and access to "knowledge infrastructure" including the use o f computers, telephones and the internet. Closely tied to low tertiary enrolment is the limited scientific research and development that currently takes place in Sri Lanka. Figure3.2: BenchmarkingSri Lankaand the KnowledgeEconomy GDP Growth(%) Internet Users per 10, n Development Index Computers per 1,OO riff & Nontariff Barriers Telephones per 1,000 Regulatory Quality Tertiary Enrollment Rule of Law Secondary Enrollment esearchers in R&D / million Adult Literacy Rate (% age >= 15) cientific and Technical Journal Articles Patent Applications Granted by the USPTO / mil. pop. - Singapore -Malaysia -Sri Lanka Source: World Bank Institute (2006) 3.6 A key aspect o fbuildinga knowledge economy indeveloping countries is the task o fbridgingthe digital divide: that is, providing access to information and communication technology at an affordable price to all citizens. Sri Lanka i s currently at a disadvantage, with limited access to the internet and very highprices for connectivity when compared to competitors in South and Southeast Asia, as indicated in Figure 3.3. This shortcoming needs to be addressed in order to benefit from knowledge economy opportunities. 21 Figure 3.3: Global ICT indicators Broadband Prices -per month USD (June 2003) 35 - 32.6 30 - - - - - -- -~ 25 ~~ - 20 ~~ 15- - 10 5 -~ 2.6- 0 . 7 0 I I -1 , , Sri Lanka Singapore Malaysia Source: ITU Wodd Telecommunications Indicators (2006) Cost o f h e r n e t (monthly USD) ICT Expenditure as a % ofGDP :a ?i . - Sti Lanka Singapore India Malaysia India Sri Lanka Malaysia Singapore Sources: ITU (2006) and World Bank (2006b) 3.7 Against this broad overview o f Sri Lanka and the knowledge economy, the section now shifts its focus to a key sector within this economy, offshoring. C. GlobalTrends in Offshoring 3.8 A key characteristic o f the knowledge economy is that it has opened up opportunities for growth that did not previously exist. One o f the most important features o f the twenty-first century i s that the service sector has increasingly become tradable. In the past, goods and capital could be exported relatively easily while services and labor could not. However, recent technological advances including cheap mobile connectivity and high-speedinternet access mean that i s no longer true. These have helped to create a truly global marketplace for services, especially those that are labor intensive and can be commoditized and digitized. Such services include legal advice, accounting and management consulting services, ICT services, software development, IT training and call centers. In the industrial era, such services were delivered domestically and often produced very close to the point o f demand. Increasingly, they are beingproduced in locations that are able to deliver the lowest cost and the highest quality. This trend is just beginning and will continue to grow rapidly for the foreseeable future, offering excellent opportunities for developing countries. 22 3.9 Offshoring, the process whereby a company contracts out a function or series o f tasks to another company abroad, now represents a US$lOO billion market. World trade has been expanding at a rate o f 6.9 percent annually over the last twenty years, while offshoring o f services to developing countries, although still small in absolute terms, has been growing at a much faster rate. McKinsey projects annual growth o f 30 percent from 2003 to 2008, raising the offshore market's share o f services trade from 3 percent to 10 percent during this five year period (see Figure 3.4). Almost all the current demand for offshore services comes from developed countries. On the supply-side, India i s by far the largest player. Other large players include China, Mexico and 3.10 The nature o f offshoring is changing rapidly. Initially firms moved parts o f their operations to offshore locations to reduce operating costs, reduce their capital requirements and to increase productivity. Increasingly firms are also moving offshore to gain access to skills that are in short supply domestically, reduce their time to market, and deepen their local knowledge. Countries wishing to attract offshore investments must therefore offer a stable political and economic climate, a low cost structure, an educated workforce that i s open to innovation, and sound infrastructure. Services that will be offshored in the future will go far beyond the traditional call centers and back-office functions and will include: investment and financial services, human resources, health services, retail functions, logistics and customer support functions. It i s estimated that this will result in 18 million jobs being offshored with a multiplier effect that could inturn create a further 60 millionjobs indeveloping countries.23 Figure 3.4: BPO/IT Offshoring to Low-Wage Locations vs. Total Global Service Exports rn 2500 2000 - 1500 -1 c :: 1000 l I 500 I 0 2003 2008 Source: WTOand McKinsey Global Institute 3.1 1 Current global trends highlight the potential contribution of offshoring to GDP growth, employment,and FDI. Specifically: 0 The contribution o f services offshoring to GDP growth o f provider countries has increased substantially over the last few years. As a pioneer and leader within the offshoring market, India's McKinsey(2005). 23World Bank(2005). 23 growth in this area has exceeded all expectations. "In the fiscal year that ended March 2003, India's IT industryrevenue was US$12 billion, and US$9.5 billion o f this was from offshore IT projects and services".24 It is predicted that the country's IT-enabled services exports will reach US$20 billion by 2007 and make up over half o f all Indian IT export^.'^ International Data Corporation predicted that the global IT-enabledservices market would account for revenues o f US$1.2 trillion by 2006.26 0 Services offshoring expands employment opportunities in developing countries. IT-enabled services are projectedto to Figure 3.5: India's Offshore ServicesGrowing Rapidly million people in India by 2008 and 3.3 million by 2015. In the IT Market inIndia: Sofhwv andServices Exports Indian software services 40 38 industry alone, direct job 35 creation i s forecast to reach 2.2 30 DomesticMarket million by 2O0EL2' There is also .se .- 25 evidence that since many IT- = n 20 related jobs are relatively well 9 15 paid, each new position 10 generates a .furtherthree jobs in 5 0 the rest o f the economy. The 200243 2003-04 200445 200546 2006473 ability to carry out responsibilities from remote Sources: World Bank, India and the KnoMedge Economy. Carl Dahlman 2005 NASSCOM locations that might be located IhffD'/w.nasscom.oraI in (or closer to) homes has also allowed more women to enter the workforce. For instance, 49 percent o f Wipro's (a large Indian offshoring company) workforce is female, while ICICI Onesource's workforce i s 60 percent female.28With female education and literacy at par with that o f males and highunemployment among women in Sri Lanka, the country i s well positionedto take advantage o fthis potential. 0 Offshoring provides a significant contribution to FDI. In turn, FDI is often directly linked to economic growth because o f the increased income sources andjobs generated. FDIcan also increase the productivity o f the recipient country through the adoption o f managerial and technical best practices from foreign c~untries.~'Inrecent years, there has been a documented shift o f FDItowards the services sector. The world's inward stock o f FDIin services quadrupled between 1990 and 2002 while the share o f services in the world's total FDI stock rose from 25 percent inthe 1970s to about 60 percent in2OOL3' 3.12 Inview o f these potential benefits, developing ICT offshoring opportunities should be a priority for Sri Lanka. Its international position and policy imperatives are the subject o fthe next section. 24Kim(2004), 25Mauritius Board o f Investment(2003). 26InternationalData Corporation. 27UNCTAD (2003). 28hid. 29World Bank (2001). 30Ibid. 24 D. TurningSri Lanka intoan OffshoringHub 3.13 As a small island economy, developing export markets will be critical to Sri Lanka's growth prospects. When past governments have embraced this view and sought to promote greater export orientation, rapid economic growth has followed. For example, the economy took o f f in the late 1970s when government enacted a series o f trade reforms. In the 1990s, the privatization o f the plantations led to a remarkable rise in tea exports. The same imperative applies to the potential offshoring market today. 3.14 Sri Lanka's many strengths should make the country attractive to companies looking to offshore: a productive and well-trained labor force, some o f the cheapest office rental costs in the region, and a relatively welcoming business environment. Even highly skilled and well-qualified workers in Sri Lanka are paid low salaries relative to other Asian countries. Despite its small size, the country turns out a significant number o f technically qualified individuals especially in IT, accounting and business management. Tax incentives in Sri Lanka have also been successful in attracting business process outsourcing (BPO) investments, particularly foreign investments. A study by the Information and Communications Technology Agency (ICTA) found that the country's geographical situation and resultingtime/distance considerations to be an ad~antage.~' 3.15 Figure 3.6 presents a summary o f an assessment o f Sri Lanka as an offshoring destination for IT and professional services. It compares Sri Lanka with other Asian countries. The figure illustrates that Sri Lanka performs relatively well in terms o f pure financial costs, i.e., the cost o f labor, rent and other input costs. For many companies, this is the primary driver for offshoring. However, there is clearly room to improve the island's people skills and business environment. 3.16 With regard to reputation and worldwide recognition, some o f Sri Lanka's neighboring competitors have already developed brand names and broadly marketed their comparative advantages in certain sectors o f the global offshoring services market. For example, India has established its position as a leader in software development based on an early start and extensive IT experience. The Philippines has leveraged its large English-speaking population and rapid telecommunication and technological advances to develop a prominent call center industry.32 Sri Lanka, on the other hand, has yet to establish itself as a high-caliber services offshore location. 3.17 Sri Lanka can build on its current strengths as an offshore destination. Offshore manufacturing already exists in Sri Lanka and has been particularly successful within the garments industry. Although the offshoring o f professional services is quite different from manufacturingexports, the existence o f this export sector could potentially provide insightinto appropriate policies. It could also serve as a platform for establishing a reputation for Sri Lanka as a viable offshoring destination. 3.18 There are signs that India's advantage is being eroded. Increasingly, factors that offset the advantages o f India's reputation are emerging as certain cities are now experiencing congestion, rising wages, staff turnover and increased insecurity o f property rights. These negative effects give additional hope for countries like Sri Lanka that have not yet developed mature offshoring markets as firms look for additional locations to disperse their service outsourcing requirements. 3' Lirneasia (2006). 32 A.T.Kearney(2004). 25 Figure3.6: Sri Lanka-Already Competitivebut More can beDone I Offshore LocationAttractivenessIndex Scores for Asia I I 8l Business Score Rople Score Financial Score , 1.36 0.94 0.73 0.57 3.72 3.32 3.09 3.59 3.44 3.5 3.65 I ` 0 4I India China Malaysia Fhilippines Thailand Sri Lanka Vietnam Source: AT Kearney (2004), except for Sri Lanka (World Bank 2005). 3.19 Sri Lanka has a world class legal framework for ICT development and e-commerce that protects copyright and intellectual property. The IT industries in countries with advanced IT developments are extremely protective o f intellectual property rights and will want to operate in environments where such rights are respected.33 Most countries in Asia face significant challenges in establishing strong intellectual property protection to fight rampant piracy. In Sri Lanka, several intellectual property agreements have been signed in the last few years, although enforcement and public awareness still pose significant challenge^.^^ 3.20 However, Sri Lanka's weaknesses, including the ongoing conflict, have kept it from becoming the ideal location for BPOs. The ICTA BPO study found that the most significant obstacle to operations and growth in Sri Lanka i s the weaknesses in English language skills o f available employees. The survey found that almost all BPOs considered the ability to communicate in Englishto be the most important skill requirement for their work. 3.21 Unfortunately, after a successful start at the turn o f the century, Sri Lanka's ability to attract additional players to the BPO space has waned inrecent months given the deteriorating security situation (see Figure 3.7). InwardFDI in the BPO/IT sector fell from US$29.6m in 2004 to US$2.2m in 2005 and US$2.7m in 2006.35 A survey has shown that interest from international investors for Sri Lanka's BPO industry has declined for a number o f reasons. Limitedsuitable land is proving to be a bottleneck as are weak telecommunication capabilities and services, high electricity costs, shortage o f available skilled workers, and long delays associated with the large number o f agencies to be visited in order to obtain required approvals. 3.22 What do these strengths and weaknesses imply? Due to its population size, Sri Lanka cannot offer the large numbers o f ICT and professional employees that India and China can, and as such it may be more difficult to compete in terms o f developing large generic call centers or R&D facilities. Instead, the most promising strategy for Sri Lanka lies in developing a niche market for common corporate functions including legal, finance and accounting, human resource, and IT services. Sri Lanka i s also 33Kim(2004). 34U S Trade Representative(2004) 35BoardofInvestmentof Sri Lanka (2007). 26 well poised to provide disaster recovery and business continuity services to companies currently offshoring to India. Figure3.7: BPO Entryby Year (1999-2006) 9 1 6 - 7 - .-8c6 - E :5 8 - m II r 4 - n 1E 3 - 2 , 0l 1 1999 2000 2001 2002 2003 2004 2005 2006a Source: Lirneasia (2006). (a) =Approved or pending as of August. 3.23 The main policy imperatives for Sri Lanka to promote its offshore industry may be broadly grouped under two headings: business climate and education. A successful business climate strategy to promote offshore services would include: (i) completing the unfinished telecom reform agenda; (ii)improving regulation, quality and competition to reduce telecom connectivity prices (as Pakistan has done); (iii)expanding internet access and usage by rolling out a reliable fibre-optic network (as India has done); (iv) increasing electricity generation and reducing tariffs; and (v) in the long term expanding access to scientific and technical tertiary education (as realized in both India and China). Government can also consider mobilizing the Sri Lankan diaspora interested in investing in the island, providing tax incentives to the industry (e.g., removal o f VAT on software products), providing incentives for training and supporting the branding and marketing efforts o f the local industry. Less rigid labor laws would also be beneficial for the nascent industry. Concerted government and industry action can overcome these various challenges and help turn Sri Lanka into an offshoring destination o f choice. 0 As noted in Section 11, Sri Lanka's education system has achieved one o f the highest literacy rates in the region. However, the ICTA study revealed that Sri Lanka needs to improve English language skills, if the country i s to take advantage o f the export oriented nature o f the BPO industry. Improved use o f the Englishlanguage i s not just necessary to communicate with much o f the rest o f the world. It is also vital for knowledge since the vast majority o f information available on the internet and in scientific and technical journals is inEnglish. Improving science training as well as linkingacademia to industry to make education more relevant i s also needed. Achieving a higher rate o f tertiary education enrolment will also be important in this regard. Finally, the country will need to work on making the internet more readily available to the general population. 27 E. Conclusion 3.24 Successful economies o f the future will be those that can harness knowledge in an increasingly competitive and global world economy. Sri Lanka is ahead on some measures o f developing a knowledge economy, most notably high secondary school enrolment and literacy, but it i s still someway behind the more dynamic economies o f East Asia. Offshoring i s a key component o f the knowledge economy in which Sri Lanka i s poised to compete internationally in view o f its strengths. 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