Sri Lanka: Selected Issues
Author: International Monetary Fund
Publication Date:
04 Nov 1997
eISBN:
9781451823370
ISBN:
9781451823370
Language:
English
Keywords:
ISCR; CR; liberalization; export; import; financial system; inflation rate; per capita income; section B; government intervention; Fiscal consolidation; Private savings; Income; Personal income; Financial sector development; East Asia
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This Selected Issues paper on Sri Lanka provides background information on economic developments and on selected policy issues facing Sri Lanka. The main economic developments in 1996 and the first quarter of 1997 are discussed. The paper highlights that in 1996, a severe drought, power shortages, and an escalation in the military conflict contributed to a sharp deterioration in the economic situation. With the end of the drought and power shortages, and a rise in investor confidence, macroeconomic conditions in 1997 were more favorable.

Abstract

This Selected Issues paper on Sri Lanka provides background information on economic developments and on selected policy issues facing Sri Lanka. The main economic developments in 1996 and the first quarter of 1997 are discussed. The paper highlights that in 1996, a severe drought, power shortages, and an escalation in the military conflict contributed to a sharp deterioration in the economic situation. With the end of the drought and power shortages, and a rise in investor confidence, macroeconomic conditions in 1997 were more favorable.

III. The Virtuous Circle of Growth, Saving, and Investment: Lessons for Sri Lanka from The Experience of Selected Asian Countries22

A. Introduction

80. The universally accepted goal of economic policy making is to achieve sustained rapid growth which is equitably distributed and generates a broad-based improvement in living standards. Recently, policy-makers and academic economists have paid increased attention to the experience of a handful of countries in East and Southeast Asia which have, in the last decade or so, generated some of the most remarkable success stories of modern economic history. Several of them have transformed themselves from relatively poor, primarily commodity-producing economies just three decades ago, to economic powerhouses experiencing sustained export-oriented and investment-led growth, financed largely by increased public and private sector saving in a general environment of overall macroeconomic stability. With a view to drawing policy lessons for Sri Lanka, this chapter examines the policy strategy pursued by four Asian countries—Korea, Indonesia, Malaysia and Thailand—that may have contributed to the breakthrough to a virtuous circle of market liberalization, growth, saving, investment and further growth. Special focus is placed on the role of fiscal policy and the composition of fiscal adjustment.

81. The chapter is organized as follows: To put the issues in perspective, section B presents a comparison of the economic and social characteristics in Sri Lanka and the four comparator countries. Section C contains a brief discussion of the main factors affecting saving behavior identified in the literature, together with a comparison of trends in these variables in the high performing Asian countries and in Sri Lanka. Section D focuses on the major elements of the adjustment strategy pursued by the Asian countries and its outcomes, and Section E outlines the main policy lessons that emerge from the country experiences for Sri Lanka.

B. Background

82. As recently as the early 1960s, Sri Lanka’s per capita income (expressed in US dollars, adjusted for purchasing power parity) was only slightly lower than that of Malaysia, and higher than that in Indonesia, Korea, and Thailand (Table III.1). In the roughly three decades since then, Sri Lanka has lost a lot of ground vis-à-vis these countries—per capita income in most of the comparator countries is now substantially higher than that of Sri Lanka.

Table III.1.

Per Capita Income in PPP-Adjusted U.S. Dollars

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Source: Penn World Tables, Mark 5.6.

83. At the same time, however, Sri Lanka has made impressive strides in the social aspects of development (Table III.2). The overall record in this regard compares very favorably with that of the comparator countries, both in the early 1970s and at present. Yet, Sri Lanka has not been able to capitalize on the high level of human capital development that is implied by these indicators and generate the high rates of growth experienced by the high-performing East Asian countries.

Table III.2.

Selected Asian Countries: Social Indicators of Development

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Source: World Bank, Social Indicators of Development database.

In most cases, data are for 1994. In others, they are for the most recent available year in the 1990s.

84. As pointed out by Jayawardena (1997a), Sri Lanka’s development strategy has emphasized human development and has achieved major progress in this area despite low per capita incomes through very high spending on the social sectors—education, health, and nutrition (through heavy subsidization of food).23 In general, notwithstanding the success of the public-sector-led development strategy in bringing about improvements in human development, the severe distortions associated with the large role assumed by the public sector in all aspects of economic activity were deterrents to private sector development and growth. Furthermore, high human development and high unemployment, coupled with the absence of private sector growth, created pressures on the government to become the employer of first resort. These pressures are arguably the source of one of the major problems facing the government, namely, an overstaffed and expensive public administration. The principal focus of this chapter is therefore to examine the implications of the pre-emption of national saving for financing the budget, and to examine ways in which to raise private and national saving in Sri Lanka.

C. Factors Affecting Saving Behavior

85. In recent years, there has been a resurgence of interest in the determinants of saving and capital accumulation and their links with economic growth, in part prompted by the widely held view that the success of the high performing Asian countries was due to their high-saving rates. New paradigms have been constructed and much empirical work has been conducted to examine the relevance of the various influences and to guide the design of better policies aimed at raising saving and investment rates. Theoretical analyses of saving behavior have identified a number of potential determinants of saving rates, although not all are undisputed or universally supported by the data. These are, inter alia, the level and growth of per capita incomes, demographic factors, especially age-dependency ratios, external factors (such as terms of trade changes, foreign saving, etc.), financial sector development, macroeconomic stability, and public saving.24

86. Income levels and growth. A prediction that follows directly from the role of subsistence consumption in low-income developing countries is that saving would increase with the level of income, as the share of subsistence consumption in total consumption declines. In particular, the largest increases in saving can be expected to occur as a country moves from the low- to the middle-income range. Empirical studies have typically confirmed that the level of income is positively correlated with the saving rate. These findings are in contrast to several theoretical models, such as those that emphasize the role of liquidity constraints, which predict that poorer consumers who cannot borrow are the ones who save more, and therefore that saving rates may fall with rising income.

87. The relationship between the rate of saving and income growth, however, is somewhat more complex. The strong positive correlation between saving and growth is robust, but it is difficult to identify the precise links between these two variables (Chart III.1). The two leading models of consumption—the permanent-income and the life-cycle models—predict that growth would have a negative impact on saving, as individuals adjust current consumption in anticipation of higher future income. However, if growth is assumed to take place across the overlapping cohorts in the life-cycle model, then the implication would be that growth increases aggregate saving, on the grounds that growth would tend to raise the income of the young relative to the old. Other hypotheses, such as that of subsistence consumption, would also predict a positive effect of growth on saving.

CHART III.1
CHART III.1

GROWTH AND SAVING, 1988–96

(Averages over the period 1988 to 1996)

Citation: IMF Staff Country Reports 1997, 095; 10.5089/9781451823370.002.A003

Sources: IMF: World Economic Outlook; and country authorities

88. As for the direction of causality, the jury is still out on whether it is growth or saving that causally “precedes” the other, although a body of evidence is now emerging that suggests that causation generally goes from growth to saving, especially private saving (Carroll and Weil, 1994; Muhleisen, 1997).

89. Demographics. Following from the life-cycle hypothesis of consumption, the proportion of working age population in total population (or the age-dependency ratio) can be an important determinant of saving—the higher the age-dependency ratio, the higher the saving rate. Empirical studies have typically found support for this link between the age composition of the population.

90. Financial sector development. From a theoretical standpoint, the effect of financial sector development has an ambiguous effect on saving. On the one hand, the increased availability of saving instruments and greater access to financial markets should raise saving. On the other hand, since financial sector development affords greater access to credit to previously liquidity-constrained individuals, it could actually lower saving. Indeed, relaxing constraints on consumer borrowing, without commensurate improvements in banking supervision and credit risk appraisal can lead to unsustainable consumption booms, such as those in Latin America in the early 1980s. One problem with empirical tests of this link is the difficulty of measuring financial market development. Typically studies use the ratio of broad money to GDP as a measure of financial deepening and have found evidence for a positive relationship between financial deepening and saving (Edwards, 1995; Johansson, 1996; Savastano, 1995).

91. Another aspect of financial sector development is the elimination of financial repression in the form on negative real interest rates. A widely-held view (first postulated by McKinnon, 1973; and Shaw, 1973) is that a rise in real interest rates will encourage saving and expand the supply of credit and raise growth rates. The empirical support for this theory has, however, been weak (Giovannini, 1985; Rossi, 1988). In part, this is because of the offsetting impact on saving of income and substitution effects arising from changes in real interest rates. However, Ogaki, Ostry and Reinhart (1995), find strong empirical support for the hypothesis that the sensitivity of saving to interest rate changes varies with a country’s income level. Their results may help explain why the rise in interest rates that typically accompanies financial liberalization fails to elicit an appreciable rise in private saving, especially in low-income countries.

92. Pension systems. The search for policies that have succeeded in raising private saving has inevitably led to an examination of the effects of fully-funded versus pay-as-you-go (PAYG) and government- and privately-funded pension plans on saving. Theoretical models typically analyze these questions in an overlapping generations framework. Econometric evidence for developing countries (Edwards, 1995) suggests that government-funded social security schemes, typically PAYG, lower private saving. By contrast, there is evidence that the Singaporean and Chilean mandatory fully-funded pension schemes have contributed to the large increase in private and total saving.

93. Macroeconomic Stability. Macroeconomic stability may be proxied by the inflation rate, its variance and the black market premium, although the latter can also be seen as a proxy for overall structural distortions. Several studies (World Bank, 1993; and Dayal-Gulati and Thimann, 1996) have found macroeconomic instability can be a significant deterrent to private saving.

94. Public saving. The efficacy of fiscal policy in raising national saving depends on the strength of the Ricardian offset between public and private saving. Most empirical studies strongly reject Ricardian equivalence, or a complete offset. Thus, cross-country and individual country studies suggest that public saving tends almost always tends to increase national saving; any offsetting reduction in private sector saving tends to only be partial (Masson, Bayoumi and Samiei, 1995; Savastano, 1995; Dayal-Gulati and Thimann, 1996, etc.). There is also growing evidence, particularly from cross-country growth studies, that public saving is strongly positively associated with growth (Sachs and Warner, 1997). Together, these findings suggest that, although the issue of the direction of causation between growth and saving remains open to debate, higher public saving is associated with higher growth, which, in turn, is associated with higher private saving. Hence, an increase in public sector saving rates is one of the most effective policy instruments to raise national saving and growth and thereby to initiate a virtuous circle (Chart III.2).25

CHART III.2
CHART III.2

GROWTH AND SAVING: THE VIRTUOUS CIRCLE 1/

Citation: IMF Staff Country Reports 1997, 095; 10.5089/9781451823370.002.A003

Sources: IMF, World Economic Outlook; and country authorities.1/ Dates in parentheses refer to the year (t) for each country.

95. Where does Sri Lanka stand? Table III.3 contains data for some of these determinants of saving for Sri Lanka and for the selected high performing Asian counties.26 It highlights not only the gap between Sri Lanka and the comparator countries in national saving, but also that this gap has widened over the past 15 years. National saving rates ranged from 20 to 30 percent of GDP in the early 1980s in the comparator countries, compared to Sri Lanka’s 17 percent of GDP. By the early 1990s, saving rates in Sri Lanka had barely risen to 18 percent of GDP, while those of the comparator countries ranged from 30 to 35 percent of GDP. The gap in private saving rates in Sri Lanka, by contrast, was relatively narrow and has not widened by as much as the gap in overall saving. Private saving rates averaged about 15 percent of GDP in the early 1980s in Sri Lanka, compared to a range of 12 to 20 percent in the comparator countries. By the early 1990s, Sri Lanka’s private saving rate had risen to 20 percent of GDP and remained well within the range of rates attained in the comparator countries.

Table III.3

Determinants of Saving Rates: A Comparison of Trends

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Source: IMF, World Economic Outlook database, IMF, International Financial Statistics; World Bank, World Tables; the Global Currency Yearbook; and staff estimates

96. Of the array of determinants of saving rates, the gaps are the largest in per capita income levels, inflation rates, the measure of financial sector development, and in public saving. A major policy prescription arising from this analysis is that there an urgent need to raise public saving through sustainable fiscal consolidation, which would in turn facilitate a durable reduction in inflation rates.

97. In addition, several previous analyses of growth in Sri Lanka have pointed to the inefficiencies in the financial sector as a being major structural impediment.27 A sustainable reduction in fiscal imbalances would permit the acceleration of financial sector reforms, as the need to rely on financial repression as a source of revenue would be progressively lower. Financial repression refers to the effect of controls or constraints in domestic financial markets and on access to international capital markets which results in artificially low cost of funding to governments. Following the methodology outlined in Giovannini and De Melo (1993)—who define government revenue from financial repression as the difference between foreign and domestic cost of funds multiplied by the domestic stock of government debt, a calculation of revenue from financial repression in Sri Lanka indicates that such revenues has amounted to about 1½ percent of GDP and about 8 percent of tax revenue over the past decade, compared to a negligible fraction of GDP and below 2 percent of tax revenue in the comparator countries in the same time period.

98. Based on these facts, the next section undertakes a closer examination of fiscal adjustment in the four Asian countries under review to draw specific policy lessons for fiscal adjustment in Sri Lanka.

D. Experience with Fiscal Adjustment in the High Performing Asian Countries

99. There were probably more common elements in the conditions faced by the four Asian countries just prior to the start of their adjustment programs than there were differences. In the 1970s and early 1980s, all the countries under review had pursued, to varying degrees, a development strategy relying on protection and heavy government intervention to “pick winners” and influence the direction of industrialization. For example, Korea’s intervention in economic activity was in many ways more pervasive than in other developing countries pursuing import substitution policies (for example, India and Brazil), but it was initially relatively successful in altering its industrial structure and generating very rapid export growth. By contrast, similar attempts at selective industrialization in Indonesia and Malaysia met with less success.

100. In any event, these policies proved not to be sustainable, and were responsible for generating large domestic and external imbalances—a large public sector, widening external current account deficits, rising external debt and structural problems. As a result, these countries were already in a precarious and vulnerable position when hit with the series of adverse external shocks of the late 1970s and early 1980s, and all of them underwent an economic crisis, of varying intensities, before adjustment efforts were initiated.

Adjustment strategy and principal outcomes

101. Fiscal consolidation was at the heart of the adjustment strategy in all cases.28 First, the size of the initial fiscal correction that was undertaken in most cases signaled a major shift in the policy orientation and served to enhance the credibility of the strategy. In particular, the fiscal deficit was reduced by more than half in all four cases within just two years of the start of adjustment (Table III.4). The rebound in private investment and the scale of capital inflows that followed the initiation of adjustment in these countries serve as evidence of the high degree of credibility of the adjustment strategy.

Table III. 4.

Size of the Fiscal Correction

(Central government overall balance, excluding grants, in percent of GDP) 1/

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Sources: IMF, World Economic Outlook, International Financial Statistics, and staff estimates.

Data limitations preclude an examination of structural fiscal deficits, which would have been the preferred measure of fiscal adjustment.

102. Second, after the initial sharp reduction in fiscal deficits, the fiscal consolidation effort has been sustained and strengthened, with the result that all four countries are running fiscal surpluses ranging from ½ percent of GDP (Korea) to about 2½ percent of GDP (Thailand) (Table III.5). The strengthening of the fiscal consolidation came primarily on the back of strong GDP growth, but also a continuation of vigilant expenditure policies and further structural reforms.

Table III.5.

Durability of Fiscal Adjustment

(Central government overall balance, excluding grants, in percent of GDP)

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Sources: IMF, World Economic Outlook, International Financial Statistics, and staff estimates.

103. Third, all four countries have gone well below the level of fiscal deficits that would be consistent with a conventionally defined sustainable fiscal position, that is, one that ensures a stable ratio of public debt to GDP. Instead, they have reduced in public indebtedness substantially (Table III.6). Experience from these and other developing countries suggests that seeking to stabilize the public debt to GDP ratio, while providing a useful benchmark of a sustainable fiscal position is not, in general, sufficiently ambitious. The speed with which debt can surge when adverse developments (such as major terms of trade shocks, or reversals of capital inflows) occur, and the fact that debt burdens can quickly ratchet up to progressively higher levels suggests the critical need for a buffer to deal with such shocks, especially in the countries with higher debt burdens—Indonesia and Malaysia. An additional advantage of having such a buffer is that it helped to contain the impact of the capital inflows and avoided pressures for large real exchange rate appreciations.

Table III.6.

Central Government Debt

(Domestic and foreign debt, in percent of GDP)

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Sources: IMF, International Financial Statistics; and staff estimates.

104. Turning next to the composition of fiscal adjustment (Chart III.3): First, capital spending bore the initial brunt of expenditure reduction in all four cases. To some extent, this was justified because the large and inefficient public investment programs were seen as being at the root of the earlier fiscal imbalances. As a share of GDP, the reduction in capital spending ranged from the equivalent of 1 to 2 percentage points of GDP (Indonesia, Korea and Thailand) to about 6 percent in Malaysia. In real per capita terms, however, all countries implemented sizeable cuts in capital spending in the early years of their fiscal adjustment. In hindsight, in some countries, notably Thailand, these cuts may have been too deep as evidenced by the severe infrastructure bottlenecks that emerged in the early 1990s during the economic boom. However, the policy response to these problems has been pragmatic—public sector capital spending has been increased and the private sector has been invited to step in and fill the gaps in infrastructure needs.

CHART III.3
CHART III.3

COMPOSITION OF FISCAL ADJUSTMENT 1/

(based on central government accounts, in percent of GDP)

Citation: IMF Staff Country Reports 1997, 095; 10.5089/9781451823370.002.A003

Sources: IMF, World Economic Outlook; and country authorities.1/ The dates in parentheses refer to the year (t) for each country.2/ Non-oil revenues in the case of Indonesia.

105. Second, all four countries initially reduced the share of current expenditures in GDP, by anywhere from 2 percentage points (Indonesia) to 6 percentage points (Malaysia). In some cases, these reductions were achieved by actual cuts in real per capita current expenditures, but, for the most part, they resulted from a slowing in the growth of expenditure. The reduction in current spending was mainly focused on containing the public sector wage bill, reducing subsidies, both to consumers and to public sector corporations, and interest payments, while spending on social services, health and education was protected or even expanded (Table III.7).

Table III.7.

Trends in Current Expenditure

(Central government, in percent of GDP)

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Includes education, health and social welfare (where available).

Sources: IMF, Government Finance Statistics; and staff estimates.

106. Third, with respect to revenues, the four countries fall into two groups—countries with stable or declining revenues relative to GDP (Korea and Malaysia) on the one hand, and countries with rising revenues (Thailand and Indonesia), on the other. Korea’s revenue to GDP ratio was broadly unchanged during the first five years after the start of adjustment, while in Malaysia, the ratio of revenue to GDP fell steeply after the start of fiscal consolidation. However, given that the revenue-GDP ratio in Malaysia averaged about 33 percent in the three years prior to fiscal consolidation—a level far exceeding that in most similar developing countries—it can be argued that a reduction in revenues was consistent with reducing the role of the government in the economy. There has been some recovery since then, but the ratio remains considerably lower than in the mid-1980s.

107. In contrast, Thailand and Indonesia experienced rapid revenue growth, with tax buoyancy in the range of 1.2 to 1.4 during the first five years after adjustment. These countries succeeded in increasing the ratio of revenue to GDP and raising the growth rate of revenues in real per capita terms. In Indonesia, the increase in real per capita non-oil revenues was quite dramatic, reflecting the success of the government’s strategy to reduce the budget’s dependence on oil revenues. This increase in revenues was a result both of more rapid growth following the implementation of adjustment measures but also of several discretionary measures that were taken to improve tax administration and broaden the tax base. In particular, although virtually all countries lowered tariffs, the base for trade taxation was widened with the reduction in non-tariff barriers. Likewise, all countries also simplified the structure of corporate and personal income taxation, rationalized exemptions and deductions, lowered the rates of income taxation and introduced broad-based consumption taxes. In tandem, strong measures were implemented to improve tax administration.

Other major reforms

108. While fiscal consolidation was the central pillar of the adjustment strategy, it was accompanied in all cases by important structural reforms in key areas—trade liberalization, liberalization and active promotion of foreign investment, and, in Indonesia, major steps to liberalize the domestic financial sector. Coupled with the fact that these countries had, relative to other low- and middle-income developing countries, a less distorted structure to begin with, that they had a well-developed stock of human capital, flexible labor markets, and lower labor costs relative to countries elsewhere in the region, the fiscal adjustment and structural reforms were instrumental in propelling them onto the virtuous circle of sustained growth and high saving rates.

Key outcomes of the adjustment strategy

109. The outcome of the macroeconomic and structural policies in terms of key activity variables—growth, saving and investment—have been nothing short of spectacular and have, in general, surpassed the expectations of policy makers in these countries. Per capita growth rates in excess of 6 percent per annum have been maintained in all countries over the past 10 years; indeed, Korea and Thailand have experienced sustained per capita growth of over 8 percent a year during this period. Per capita incomes have trebled or quadrupled between the early 1970s and the present. This has led to a dramatic improvement in living standards. It is this enviable record that has made these countries the model other developing countries have been trying to emulate.

110. In particular, all four countries experienced a sharp and almost immediate increase in domestic investment, led by private investment. In part, the private investment boom was financed by foreign capital inflows (with the exception of Korea) which surged into these countries in the aftermath of their fiscal adjustment (Chart III.4). Studies of private investment behavior have identified the following empirical regularities with respect to the determinants of private investment: first, the rate of growth of economic activity which acts as a proxy for aggregate demand is positively correlated with private investment; second, relative factor prices (user cost of capital, levels of taxation, real interest rates, relative unit labor costs, the cost of imported capital) tend to be negatively correlated with private investment; third, the private sector’s access to credit and a reduction in the extent of financial repression is generally found to be strongly positively correlated with investment; fourth, indicators of economic instability and uncertainty such as inflation rates, inflation variance, budget deficits, black market exchange rate premia, measures of external indebtedness, are usually negatively correlated with investment; fifth, financial sector deepening has been found to have a positive effect in private investment; and finally, the impact of public sector investment is generally found to be ambiguous. Total public sector investment tends to be negatively correlated with private investment, while there is some evidence of complementarity with public infrastructure investment.29

CHART III.4
CHART III.4

TRENDS IN INVESTMENT 1/

(in percent of GDP)

Citation: IMF Staff Country Reports 1997, 095; 10.5089/9781451823370.002.A003

Sources: IMF, World Economic Outlook; and country authorities.1/ Dates in parentheses refer to the year (t) for each country.2/ Includes direct, portfolio and other investment inflows.

111. As noted, inter alia, by Bercuson and Koenig (1993), in each of these countries, the surge in capital inflows occurred after a process of fiscal consolidation had been initiated suggesting that the magnitude of the improvement in the public sector’s financial balances helped to convince investors of the credibility of the authorities’ commitment to their chosen adjustment strategy. This together with competitive labor markets, financial sector reforms, and low overall uncertainty contributed to the investment boom, which, in turn, resulted in strongly export-led growth. Average growth rates of (non-oil) export volumes in the first five years after adjustment were in the range of 15–20 percent per year.

112. All four countries also experienced a marked increase in national saving rates. It is clear that there was early recognition in the successful Asian countries that the private sector must be the engine of growth and that the public sector must facilitate the increase in investment necessary to lead to a sustained acceleration in growth by generating sizeable savings and thereby sending strong signals of the credibility of the adjustment strategy. The authorities also correctly perceived the combination of rising capital inflows, rapidly increasing investment, especially by the private sector, and higher per capita incomes, as offering them the opportunity to undertake further fiscal adjustment and generate higher public saving, thereby reinforcing the virtuous circle of growth, investment and saving (Chart III.5).

CHART III.5
CHART III.5

FISCAL ADJUSTMENT, SAVING AND GROWTH 1/

Citation: IMF Staff Country Reports 1997, 095; 10.5089/9781451823370.002.A003

Sources: IMF, World Economic Outlook; and country authorities.1/ Dates in parentheses refer to the year (t) for each country.

113. The increased integration of these economies with the rest of the world through trade and financial flows has not, however, come without its own challenges. For example, the enormous increase in the volume of capital flows has put strains on the domestic banking systems in some of these countries, which have been called upon to intermediate these resources. Furthermore, in some cases, the large capital inflows have also generated strong demand pressures, which are manifested in widening current account deficits and rising domestic prices. Reducing these imbalances and the concomitant risks of overheating, while improving the health of financial systems and strengthening regulation and supervision, will remain important challenges in these economies.

E. Policy Lessons for Sri Lanka

114. Although there were many common elements in the country experiences discussed so far, their starting points and structural problems were sufficiently different as to dismiss the notion that their experiences are sui generis. Importantly, their resource and export bases were different—Thailand and Malaysia were mainly primary commodity exporters, Indonesia depended heavily on oil, while Korea had pursued a relatively successful strategy of industrialization and had a reasonably diversified export base. However, as noted by the World Bank (1993) in the analysis of the East Asian miracle, generally pragmatic policy-making, especially the willingness to swiftly repudiate policies that proved not to be effective, has been at the heart of the success of the East Asian “tigers”. This coupled with the emphasis on macroeconomic discipline, the decisive embracing of an outward-oriented development strategy, and a strong record on investment in human capital have been identified as the main common elements of the success of these countries. Other elements are labor market flexibility and a dynamic and flexible private sector.

115. Where does Sri Lanka stand with respect to these lessons? Notwithstanding the major achievements in human capital development, and despite the passage of two decades since the launching of the major reorientation of the economy toward the market in 1977, Sri Lanka has not yet succeeded in initiating a strong virtuous circle of growth, saving and investment. In particular, while some progress has been made in reducing the fiscal deficit as a share of GDP, the extent of fiscal consolidation falls well short of what was achieved by the East Asian countries (Tables III.4 to III.6). As a result, Sri Lanka still records public dissaving, while the comparator countries have public saving rates of between 7 and 15 percent of GDP. This, together with the fact that the level of private saving is already broadly comparable to those of the successful comparator countries, suggests that the additional increases necessary to finance further expansion in a credible, non-inflationary manner can be expected primarily from increases in public saving.

116. First, greater progress needs to be made in reducing current spending and reorienting its composition away from unproductive expenditures—such as interest payments and expensive commodity subsidies—and toward education and health expenditures. Experience in East Asian countries, especially Malaysia, has shown that current expenditure reduction can take place without compromising the government’s poverty alleviation and income distribution objectives.

117. In addition, reduction of the civil service wage bill (amounting to nearly 4 percent of GDP) and the pension bill must also be a priority. The Sri Lankan civil service is overstaffed and expensive—a legacy of a system in which the government has been the “employer of first resort”. With the on—going civil conflict requiring military spending to remain high, there is little choice but to tackle the civil service wage bill in order to achieve durable reductions in current spending. And finally, pension reform is of crucial importance, both because of its implications for the fiscal deficit and government saving and for the behavior of private saving. With respect to public saving, demographic trends in Sri Lanka suggest a rapid aging of the population in the next two to three decades and, ceteris paribus, would imply a ballooning of pension payments under the current government-funded civil service pension scheme (see Jayawardena, 1997b). There is therefore the urgent need for pension reform and the move to a contributory system. In addition, there is growing empirical evidence that starting a mandatory privately-funded pension scheme of the kind operating in Chile or Singapore may boost private saving considerably.

118. Second, with respect to capital spending, with the rationalization of Mahaweli and other major public investment projects of the late 1970s and early 1980s, there is much less scope for further sizeable cuts in capital spending. Moreover, it is widely acknowledged that an important constraint to growth in Sri Lanka is inadequate physical infrastructure. However, as emphasized by Jayawardena (1997a), it is critical that, in view of the tight limit on budgetary resources, Sri Lanka follows the example of some of its successful neighbors and entrusts the infrastructure development effort primarily to the private sector.

119. Third, measures need to be implemented to restore buoyancy to the tax system. Although the revenue-to-GDP ratio is at a level that compares favorably with the East Asian comparator countries, revenue buoyancy is low. This suggests that much greater effort needs to be made to widen the tax base. The recent and prospective reductions in income and import tax rates will undoubtedly enhance efficiency, but experience with tax reforms in other countries has shown that, without base broadening measures such as reductions in exemptions, concessions and deductions, the hoped-for revenue response may not be forthcoming. Of particular concern in this regard is the role of industries set up under the Board of Investments (BOI). Such industries are generally engaged in production for export, are exempt from import duties, and enjoy generous income tax holidays and other fiscal incentives. Not only does the differential treatment of BOI and non-BOI investment create a major distortion in the system, there is also evidence of leakage in that goods imported by BOI-registered industries find their way into the domestic market, thus subverting the main objective of the policy and denying the government of much needed revenues. Moreover, with the tilt in the playing field in favor of BOI investments, a growing proportion of activity may be taking place outside the tax net, resulting in further reductions in revenue buoyancy and with it, the loss of a potentially important source of revenues with which to build up public saving.

120. Fourth, Sri Lanka’s public debt now stands at almost 100 percent of GDP, substantially higher than the comparator countries in this study. While conventional analyses of debt sustainability—ex-ante solvency tests involving the government’s ability to meet its future debt obligations without recourse to debt write-offs or repudiation—suggest that Sri Lanka’s fiscal stance is sustainable, it is not optimal.30 The favorable debt dynamics are largely due to the high percentage of concessional external financing received by Sri Lanka and the relatively high degree of financial repression arising from artificially low non-market determined interest rates. The burden of macroeconomic stabilization therefore falls disproportionately on monetary policy and the resultant high real interest rates have been identified, by the private sector, as a major impediment to private investment. In addition, the reliance on revenues from financial repression act as a disincentive to pushing ahead with reforms aimed at creating a more open and market-oriented financial sector.

121. A final policy implication is that financial sector reforms, regardless of their impact on private saving, are necessary in their own right to increase the efficiency of resource allocation through better financial intermediation. There is, by now, considerable empirical evidence that supports the positive effect of financial sector development on growth and investment through one or more of the following mechanisms—financial sector development enables savers to pool resources and share risks; savings channeled through financial intermediaries are allocated more efficiently because such intermediation tends to reduce liquidity risks and partly overcomes the problem of adverse selection in credit markets; and financial intermediaries facilitate innovative activity (King and Levine, 1993; Roubini and Sala-i-Martin, 1991).

122. The financial system in Sri Lanka is relatively underdeveloped (the depth of financial system as proxied by the ratio of broad money to GDP is much lower than the comparator countries, Table III.3) and is comparatively inefficient (as evidenced by the high intermediation costs measured by the spread between representative deposit and lending rates, which has averaged about 10 percentage points over the past two decades). Monetary management is also hampered by the lack of depth and competition in money and securities markets. Foremost amongst the measures that are needed in this area are those aimed at permitting the two state commercial banks to operate autonomously, minimizing government intervention in their credit decisions, increasing the focus on their profitability, leveling the playing field with private commercial banks thereby increasing competition, and finally, permitting the state-owned contractual savings institutions—currently captive sources of deficit financing—greater autonomy in their investment decisions. Reducing the deficit and the need for deficit financing would therefore be a prerequisite to lowering the incentive for government intervention in the banking system.

123. In conclusion it should be noted that a major stumbling block to a sustained growth response in low-income developing countries undertaking fiscal and structural adjustment efforts is typically the low initial human capital resource base and the long lags between investments and outputs in this area. By contrast, Sri Lanka has a head start in that it already has a well-developed human capital base with which to reap the benefits of a regime in which the private sector is unambiguously permitted to become the engine of growth. Together with the strong start that has already been made in creating an outward-oriented, open trade and exchange regime, the generation of public saving through sustainable fiscal consolidation, coupled with the completion of the structural reform agenda in a few critical areas such as the financial sector, and the trade and tax systems could be sufficient to propel Sri Lanka onto a virtuous circle of saving and growth, similar to those experienced by its East and Southeast neighbors for the last decade.

References

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22

Prepared by Kalpana Kochhar.

23

See Chapter VI of this paper for an analysis of Sri Lanka’s social sector policies.

24

For a good review of recent theoretical and empirical work on the determinants of saving, including of the unresolved questions and puzzles, see Schmidt-Hebbel, Servén and Solimano (1996).

25

Clearly, part of the observed correlation is possibly due to cyclical factors.

26

An empirical analysis of saving behavior in Sri Lanka would be necessary to determine which of these determinants are most relevant to policy formulation. However, the overall robustness of the determinants listed here in other empirical studies suggest their general relevance for Sri Lanka as well.

27

See for example, Sri Lanka—Selected Issues, SM/96/182.

28

To facilitate the discussion, specific adjustment periods are identified for each country. The choice of such periods is necessarily somewhat arbitrary, but, in general, the start of the period (referred to below as period ‘t’) was chosen to coincide with the start of a phase during which a distinct change appears to have taken place in the orientation of fiscal policies. The year ‘t’ is chosen to be 1983 for Korea, and 1987 for Indonesia, Malaysia and Thailand. However, in the case of Indonesia, the start of fiscal consolidation could be dated as far back as 1983 when some adjustment was initiated in adjusting public investment.

29

Blejer and Khan (1984) find that private sector investment is a positive function of long-term (or infrastructural) public investment, but not of the deviations from that trend. This suggests long-term complementarity, but short-term substitutability; the latter implying that public investment crowds out private investment, in the short term.

30

See SM/95/94, Sri Lanka—Background Papers, and SM/96/182, Sri Lanka—Selected Issues for more detailed analyses of debt dynamics and fiscal sustainability in Sri Lanka.

Same Series

Other IMF Content

Other Publishers

Cover IMF Staff Country Reports
Sri Lanka: Selected Issues
Author: International Monetary Fund
Volume/Issue:
Volume 1997: Issue 095
Publisher:
International Monetary Fund
ISBN:
9781451823370
ISSN:
1934-7685
Pages:
180
DOI:
https://doi.org/10.5089/9781451823370.002

GROWTH AND SAVING, 1988–96

(Averages over the period 1988 to 1996)

GROWTH AND SAVING: THE VIRTUOUS CIRCLE 1/

COMPOSITION OF FISCAL ADJUSTMENT 1/

(based on central government accounts, in percent of GDP)

TRENDS IN INVESTMENT 1/

(in percent of GDP)

FISCAL ADJUSTMENT, SAVING AND GROWTH 1/